CFA Mock Ans

2019 Level II Mock Exam PM
The afternoon session of the 2019 Level II Chartered Financial Analyst Mock ®
Examination has 60 questions. To best simulate the exam day experience, candidates
are advised to allocate an average of 18 minutes per item set (vignette and 6 multiple
choice questions) for a total of 180 minutes (3 hours) for this session of the exam.
Questions Topic Minutes
1–6 Ethical and Professional Standards 18

7–12 Ethical and Professional Standards 18
13–18 Quantitative Methods 18
19–24 Economics 18
25–30 Financial Reporting and Analysis 18
31–36 Equity 18
37–42 Fixed Income 18
43–48 Derivatives 18
49–54 Alternative Investments 18
55–60 Portfolio Management 18
Total: 180
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© 2018 CFA Institute. All rights reserved.
2 2019 Level II Mock Exam PM
2019 LEVEL II MOCK EXAM PM
Jacob Kostecka Case Scenario

Jacob Kostecka, CFA, is a portfolio manager at Forkson Investment Management,
an asset management and research focused organization. After obtaining his CFA
charter last month, Kostecka was transferred to the private wealth management
division at Forkson.
Dharshi Bope, a private wealth client, was involved in a major motorcycle accident
and is in critical condition, fighting for his life. Bope is a single parent with a daughter,
Paveen Nathoo, in her mid-twenties. Since the accident, Nathoo has managed her
father’s affairs, paying all expenses, including investment advisory fees. In several
conversations with Nathoo, Kostecka highlighted Bope’s low risk tolerance and invest-
ment goal of capital preservation. Nathoo has indicated her interest in managing the
account more aggressively and possibly moving to another management firm. Nathoo
recently petitioned the court to appoint her full power of attorney to legally manage
Bope’s affairs. Prior to the court decision, Nathoo asks Kostecka to invest her father’s
account in the initial public offering (IPO) of Chatterbox, a highly sought after social
media company that has yet to generate a profit.
The following week, the court approves Nathoo’s request to act on behalf of her
father. Going through records in her father’s home, Nathoo discovers documents
showing Bope embezzled several million dollars from his employer, a real estate
development company. Most of these funds were placed directly into Bope’s personal
account, for which Nathoo is now responsible. Nathoo informs Kostecka about her
discovery; however, Kostecka does not act on this information, however, because it
is a large account for Forkson.
Nathoo establishes a non-discretionary investment account at Forkson tied to her
newly established business. Shortly thereafter, Kostecka joins the board of Jabbertalk.
com, a smaller social media competitor to Chatterbox. Based on his knowledge of
Chatterbox, Kostecka believes the stock of Jabbertalk is a good investment, even
though it is not yet profitable. Buoyed by his faith in social media, Kostecka ultimately
purchases shares of Jabbertalk’s IPO for Nathoo’s account, as well as for all clients he
currently manages. When Kostecka informs Nathoo of the purchase, she expresses
concern about her legal responsibilities and lack of accounting knowledge in over-
seeing the account. Kostecka provides Nathoo a list of recommended professionals
he has worked with in the past, including attorneys and accountants. When he was
in college 10 years earlier, Kostecka was engaged to one of the attorneys but broke
off the relationship prior to their wedding, and one of the accountants was Kostecka’s
college roommate. Since then, Kostecka has not had any contact with the lawyer and
accountant.
The Jabbertalk investment is profitable on the first day of trading, doubling from
its opening price. Kostecka tells his clients the multifactor valuation model used by
Forkson shows Jabbertalk stock is still undervalued. Forkson’s research report, due
out the next day, will recommend investors hold their Jabbertalk shares. However,
Kostecka tells all his clients simultaneously they should sell their shares because he
believes Jabbertalk is overvalued and the stock price will fall soon. Kostecka notes
he has followed through on this belief by selling his personal holdings of Jabbertalk
shares. Nathoo ignores Kostecka’s recommendation to sell Jabbertalk. Over the next
week, the stock declines 75%.
Watching Jabbertalk’s severe share price decline, Nathoo becomes furious with
Kostecka because he did not sell shares of Jabbertalk in her account. She files a com-
plaint with Kostecka’s supervisor, Sally Fang, CFA, claiming she was misled on the value
2019 Level II Mock Exam PM 3
of the IPO in the days immediately after the stock started trading. Kostecka responds
to the complaint by telling Fang, “the analyst who wrote the hold recommendation
on Jabbertalk has only passed his CFA Level II examination. As a charterholder, I
have earned the right to use the CFA designation, so I am more qualified to manage
clients’ investments.”
In order to build his client base, Kostecka prepares performance information to
show prospective clients. He includes the firm’s c omposite p erformance b ased o n
similar discretionary client portfolios that are in compliance with the GIPS Standards.
In addition, Kostecka prepares his own composite performance, including all accounts
he manages. This presentation includes Nathoo’s account assuming she had sold her
shares of Jabbertalk. Along with his performance record, Kostecka provides a footnote
disclosing the following language: “If your account is managed on a discretionary
basis, you might expect results similar to those shown above.”
1 With regard to the investment request made by Nathoo to invest in Chatterbox,
Kostecka should most likely:
A follow Bope’s investment goals.
B seek advice from the court.
C comply with her request.
A is correct. The account should be managed according to the client’s investment goal
of capital preservation and a low risk tolerance. Under Standard III(A) –Loyalty, Prudence,
and Care, the first step for members and candidates in fulfilling their duty of loyalty to
clients is to determine the identity of the “client” to whom the duty of loyalty is owed.
Only when the daughter is granted legal responsibility over her father’s affairs by the
court does she become the client.
B is incorrect because the account should still be managed as the client requested
since the daughter has not yet been granted legal responsibility over her father’s affairs
by the court. An investment in an IPO of an unprofitable social networking company
most likely does not meet the father’s investment goal.
C is incorrect because the account should still be managed as the client requested,
an investment goal of capital preservation and a low risk tolerance. An investment in
an IPO of an unprofitable social networking company most likely does not meet Bope’s
investment goal. Since the daughter has not yet been granted legal responsibility over her
father’s affairs by the court, the adviser is not required to follow through on this request.
Guidance for Standards I–VII

LOS a
Standard III(A)–Loyalty, Prudence, and Care; Standard III(C)–Suitability
2 By not acting on the information reported by Nathoo, which CFA Institute

Standard of Professional Conduct has Kostecka least likely violated?
A Loyalty, Prudence, and Care
B Duties to Employers
C Knowledge of the Law
A is correct. Kostecka has not violated Standard III(A)–Loyalty, Prudence, and Care
because he has put his client’s interests first. However, by not dissociating himself from
the illegally embezzled funds, Kostecka has violated Standard I(A)–Knowledge of the
Law. By managing these funds, Kostecka benefits directly via management fees and
could be associating himself with suspicious financial transactions and potentially vio-
lating anti-money-laundering regulations. In addition, by not dissociating himself from
the embezzled funds, Kostecka has also placed his firm in a position where it may suffer
reputational harm, so he has also violated Standard IV(A)–Duties to Employers (Loyalty).
B is incorrect. Kostecka has violated Standard IV(A)–Loyalty, which requires that, in
matters related to their employment, members and candidates must act for the benefit
of their employer and not deprive their employer of the advantage of their skills and
abilities, divulge confidential information, or otherwise cause harm to their employer.
By not dissociating himself from the embezzled funds, Kostecka has placed his firm in a
position where they may suffer reputational harm.
C is incorrect. Kostecka has violated Standard IV(A)–Loyalty, which requires that, in
matters related to their employment, members and candidates must act for the benefit
of their employer and not deprive their employer of the advantage of their skills and
abilities, divulge confidential information, or otherwise cause harm to their employer.
By not dissociating himself from the embezzled funds, Kostecka has placed his firm in a
position where they may suffer reputational harm.

LOS a
Standard I(A)–Knowledge of the Law, Standard III(A)–Loyalty, Prudence, and Care, Standard IV(A)–
Duties to Employers (Loyalty)
3 With regard to investing in Jabbertalk and recommending experts, Kostecka

most likely needs to disclose conflicts related to his:
A attorney relationship.
B board membership.
C accountant relationship.
B is correct. Kostecka’s board service creates the opportunity to receive material nonpublic
information involving Jabbertalk and is a basic conflict of interest. As a result, according
to Standard VI(A)–Conflicts of Interest, the directorship should be disclosed. Members
and candidates must make full and fair disclosure of all matters that could reasonably be
expected to impair their independence and objectivity or interfere with respective duties
to their clients, prospective clients, and their employer. Because the member has not made
any disclosure concerning his board membership, he is in violation of Standard VI(A).
Kostecka has also ignored his clients mandate of low risk tolerance and capital preser-
vation and is in violation of Standard III(C)–Suitability. In addition, Nathoo has violated her
fiduciary duty as a “trustee” of the account as she failed to manage her father’s portfolio
in accordance with his wishes.
A is incorrect because even though Kostecka was previously engaged to one of the
attorneys, the relationship ended a decade ago and it is unlikely that this relationship
poses a potential conflict of interest at this time.
C is incorrect because even though one of the accountants Kostecka recommended
is his college roommate, this is only one of several individuals he recommended and it
is not a basic conflict of interest, which needs to be disclosed.

LOS a
Standard III(C)–Suitability, Standard VI(A)–Conflicts of Interest
4 In relation to Kostecka’s handling of the Jabbertalk stock recommendation,

which of the following CFA Institute Standards of Professional Conduct did he
least likely violate?
A Priority of Transactions
B Fair Dealing
C Communication with Clients
B is correct. Standard III(B)–Fair Dealing requires members and candidates to deal fairly

and objectively with all clients when providing investment analysis, making investment
recommendations, taking investment action, or engaging in other professional activi-
ties. When Kostecka informs clients of the upcoming investment recommendation by
Forkson, he has treated all clients fairly because this disclosure is provided to all of his
current clients.
A is incorrect because Kostecka has violated Standard VI(B)–Priority of Transactions.
There is a potential conflict of interest because the client and the adviser hold the same
stock, so the client should be given first priority to trade Jabbertalk.
C is incorrect because according to Standard V(B)–Communication with Clients and
Prospective Clients, Kostecka should have distinguished fact from opinion. In addition,
Kostecka should also disclose to clients and prospective clients the basic format and gen-
eral principles of the investment processes used to analyze investments, select securities,
and construct portfolios and must promptly disclose any changes that might materially
affect those processes and use reasonable judgment in identifying which factors are
important to his investment analyses, recommendations, or actions and include those
factors in communications with clients and prospective clients.

LOS a
Standard III(B)–Fair Dealing, Standard V(B)–Communication with Clients and Prospective Clients,
Standard VI(B)–Priority of Transactions
5 When Kostecka defends himself against Nathoo’s complaint, he most likely vio-
lated the CFA Institute Code of Ethics and Standards of Professional Conduct
concerning the:
A reference to candidacy in the CFA Program.
B misrepresentation of the meaning of the designation.
C right to use the CFA designation.
B is correct. Statements overstating the competency of an individual or imply, either

directly or indirectly, that superior performance can be expected from someone with
the CFA designation are not allowed under Standard VII(B)–Reference to CFA Institute,
the CFA Designation, and the CFA Program. The Standard specifically states that when
referring to CFA Institute, CFA Institute membership, the CFA designation, or candidacy
in the CFA Program, members and candidates must not misrepresent or exaggerate the
meaning or implications of membership in the CFA Institute, holding the CFA designation,
or candidacy in the CFA Program.
A is incorrect because he properly references his colleague as a Level II candidate.
C is incorrect because there is no indication that Kostecka does not have the right to
use the CFA designation especially since he recently received his charter.

LOS a
Standard VII(B)–Reference to CFA Institute, the CFA Designation, and the CFA Program
6 Kostecka’s performance presentation most likely conforms to CFA Institute

Standard III(D)–Performance Presentation with regard to:
A disclosure in the footnote.
B composites representing similar discretionary investment portfolios.
C fair and accurate representation of performance.
B is correct. Kostecka’s performance presentation of his firm’s composite performance

is in compliance with Standard III(D)–Performance Presentation.
A is incorrect. Kostecka’s disclosure in the footnote is not in compliance with
Standard III(D).
C is incorrect. Kostecka’s performance presentation of the accounts he manages is in
not compliance with Standard III(D).

LOS a
Standard III(D)–Performance Presentation
Northside Capital Advisers Case Scenario

Brian Patrick, CFA, has recently joined Northside Capital Advisers (Northside) as
the firm’s assistant compliance officer. Northside manages individual accounts with
conservative mandates for a variety of retirements funds, as well as individual accounts
for high-net-worth investors with long investment horizons. Kyle Sang, CFA, is
Northside’s chief compliance officer and Patrick’s supervisor. Sang has been with the
firm since its inception and wrote the firm’s original Code of Ethics and Compliance
Manual. Sang provides Patrick with a copy of both documents and asks Patrick to
review them. He instructs Patrick to highlight any areas he feels should be revised or
enhanced. Patrick lists the items that need to be addressed. The first item on his list
is the lack of whistle-blowing guidance for an employee who could potentially find
herself in a position of needing to report the firm’s activities.
The second item Patrick adds to his list concerns the responsibilities of supervi-
sors. Although the information contained in the Compliance Manual is accurate, he
believes it needs to be augmented so the firm’s supervisors have a clear understanding
of their responsibilities. He advises adding the following items to the firm’s Compliance
Manual, recommending Supervisors should do the following:
Recommendation 1: Conduct an initial review of the firm’s Policies and

Procedures, and review as necessary to ensure they are con-
sistent with applicable laws and regulations.
Recommendation 2: Incorporate a professional conduct evaluation as part of the
employee’s performance review.
Recommendation 3: Review the actions of all the firm’s employees, and identify
violators.
Patrick believes he needs a better understanding of the investment process before

he makes any investment-policy-related recommendations. He meets with Staci
Canton, the firm’s chief investment officer. Following his meeting with Canton, Patrick
suggests the following enhancements to the firm’s Compliance Manual related to
investment research:
Proposal 1: Develop criteria for assessing analysts’ research quality and
contribution, including the accuracy and timing of their
recommendations.
Proposal 2: Appoint a supervisor to review and approve communication
material.
Proposal 3: Develop detailed, written guidance that establishes the due
diligence procedures.
Patrick asks Canton to provide him with a copy of a recent research report that
would have been distributed to the firm’s clients. Patrick is provided a copy of the PT
Matias (PT) report, written by Amanda Burt, CFA. PT is involved in the manufacture of
aluminum cans supplied to the soft drink industry. She mentions that PT has recently
gone through a reorganization and is in a turnaround situation, so the potential returns
are quite large. The shares were recently purchased for all client portfolios in a block
trade. After reviewing the report, Patrick meets with Burt to discuss her approach to
researching companies, meeting with company management, and determining earn-
ings estimates. Burt explains to Patrick how carefully she documents her meetings
with management and shares her notes with him. He compares the meeting notes
with Burt’s recent report and notices she has included management’s guidance for
earnings and margins along with her own estimates.
While talking with Burt, Patrick asks if she ever plays a role when the marketing
department makes new business presentations. She tells him that because of her stock
selection track record, she is frequently involved in those types of meetings. She adds
that she typically reviews the methodology used to research a company and deter-
mine a recommendation. They discuss the potential clients, and she jokes that she
even made a presentation to an investment committee for the retirement assets of a
company under her coverage. The firm’s business development manager was unhappy
that she had a sell rating on the potential client’s stock when the sales pitch took place.
Patrick’s review of the firm’s Code and Compliance Policies and Procedures is
almost complete. The final item to review is how the firm handles employees’ trading.
He notices the current Policies and Procedures are lacking. He notes that the firm
currently restricts employee participation in IPOs, has a very narrow blackout period
for employees trading securities on their buy list, and ensures personal trading policies
are kept confidential. Sang tells Patrick of the difficulty he experienced in trying to
get more robust personal trading policies and procedures approved. The board has
historically been reluctant to put restrictions in place that limit the staff ’s ability to
invest their personal funds.
7 Under CFA Institute Standard IV: Duties to Employers, with regard to the
subject matter of the first item on Patrick’s list, whose interest is least likely of
importance?
A Northside’s
B The capital markets’
C Northside’s clients’
A is correct. Northside’s interest would be of least importance relative to capital markets

and Northside’s clients and should be reflected in any whistle-blowing policy. Under
CFA Institute Standard IV(A): Loyalty, an employee’s personal interest and an employer’s
interest are secondary to protecting the integrity of capital markets and the interests
of clients. If Northside becomes involved in illegal or unethical activities, an employee
would need to act against Northside’s interest to comply with his obligations to uphold
Standard II: Integrity of Capital Markets and Standard III: Duties to Clients.
B and C are incorrect because employees have an obligation under Standard IV: Duties
to Employers to protect the integrity of the capital markets and the firm’s clients before
either Northside’s interest or employees’ personal interest.

LOS a
Section: Standard IV: Duties to Employers
8 Which of Patrick’s recommendations is most likely insufficient to comply with

Standard IV(C): Responsibilities of Supervisors?
A Recommendation 1
B Recommendation 2
C Recommendation 3
A is correct. Recommendation 1 is insufficient to comply with Standard IV(C): Responsibilities

of Supervisors, because it does not meet the requirement to perform periodic reviews.
Under Standard IV(C), once a compliance program is in place, supervisors should perform
periodic updates of their procedures to ensure the measures are adequate under the
law. They should also review and revise their procedures as necessary as new laws and
regulations are put in place to ensure the measures are adequate.
B and C are incorrect because those recommendations are sufficient under
Standard IV(C): Responsibilities of Supervisors and could be incorporated into Northside’s
Policies and Procedures as recommended.

LOS b
Section: Standard IV(C) Responsibilities of Supervisors
9 To indicate the area of the investment research process he wants to address,

Patrick should most likely label the proposals as follows:
A Proposal 1 = Compensation, Proposal 2 = Reasonable Basis, Proposal 3 =
Distribution
B Proposal 1 = Reasonable Basis, Proposal 2 = Distribution, Proposal 3 =
Compensation
C Proposal 1 = Compensation, Proposal 2 = Distribution, Proposal 3 =
Reasonable Basis
C is correct. Standard V(A): Diligence and Reasonable Basis recommends Patrick should

most likely label the proposals as follows:
Proposal 1 = Compensation. Patrick should have the firm develop measurable
criteria for assessing the quality and contribution of research received and the
accuracy of the recommendations over time.
Proposal 2 = Distribution. A supervisory analyst should be appointed to review
and approve items prior to external circulation to determine whether the criteria
established in the policy have been met.
Proposal 3 = Reasonable Basis. Develop detailed, written guidance for supervi-
sory analysts that establishes the due diligence procedures for judging whether a
particular recommendation has a reasonable and adequate basis.
A and B are incorrect. Standard V(A): Diligence and Reasonable Basis recommends
Patrick should most likely label the suggestion as follows:
Proposal 1 = Compensation. Patrick should have the firm develop measurable
criteria for assessing the quality and contribution of research received and the
accuracy of the recommendations over time.
Proposal 2 = Distribution. A supervisory analyst should be appointed to review
and approve items prior to external circulation to determine whether the criteria
established in the policy have been met.
Proposal 3 = Reasonable Basis. Develop detailed, written guidance for supervi-
sory analyst that establishes the due diligence procedures for judging whether a
particular recommendation has a reasonable and adequate basis.

LOS b
Section: Standard V(A): Diligence and Reasonable Basis
10 Which of the following CFA Institute Standards of Professional Conduct has

most likely been violated in relation to the research report and purchase of PT
Matias?
A Suitability
B Fair Dealing
C Misrepresentation
A is correct. CFA Institute Standard III(C): Suitability has most likely been violated with
the purchase of PT Matias since it was purchased for all client portfolios. The standard
requires Members and Candidates responsible for managing a portfolio with a specific
mandate, strategy, or style to take only investment actions that are consistent with the
stated objectives and constraints of the portfolio. Northside manages individual accounts
with conservative mandates for a variety of retirements funds. PT Matias most likely was
not appropriate for those client accounts since it would be considered high risk because
it has gone through a reorganization and is in a turnaround situation.
B is incorrect because there is no violation of CFA Institute Standard III(B): Fair Dealing,
which requires Members and Candidates to deal fairly and objectively with all clients
when providing investment analysis, making investment recommendations, taking
investment action, or engaging in other professional activities. In this instance, all the
clients were treated fairly because the stock was purchased in block trade.
C is incorrect because Burt has not violated CFA Institute Standard I(C): Misrepresentation,
which requires that Members and Candidates not knowingly make any misrepresenta-
tions relating to investment analysis, recommendations, or actions or other professional
activities. Burt sited management’s guidance alongside her own; therefore, there is no
evidence of plagiarism.

LOS a
Section: Standard III(C): Suitability
11 Has Burt most likely violated the CFA Institute Standards of Professional
Conduct during the new business presentations?
A No
B Yes, with regard to Duties to Clients
C Yes, with regard to Disclosure of Conflicts
A is correct. Burt has most likely not violated any CFA Institute Standards of Professional
Conduct during the new business presentations. She did not violate Standard VI(A):
Disclosure of Conflicts, because there are no evident conflicts to disclose, even when she
presented to the company under her coverage. At the time of the presentation, she had
a sell rating on the stock, and there is no evidence of cross-departmental conflicts from
the marketing department trying to influence her rating. She most likely did not violate
Standard III: Duties to Clients either, because she has only reviewed the methodology
used to research companies and determine a recommendation.
B and C are incorrect because Burt has not violated any CFA Institute Standards of
Professional Conduct during the new business presentations. 4

LOS a
Section: Standard VI(A): Disclosure of Conflicts
12 Which of Northside’s current personal trading policies is least consistent

with CFA Institute recommended procedures for Standard VI(B): Priority of
Transactions?
A IPO restriction
B Policy confidentiality
C Blackout trading window
B is correct. Northside’s policy of keeping its employee trading policies confidential is not
consistent with the CFA Institute recommended procedure for Standard VI(B): Priority of
Transactions. The Standard states that upon request, Members and Candidates should
fully disclose to investors their firm’s policies regarding personal investing. Northside’s
policies restricting participation in IPOs and maintaining a blackout period, although
narrow, are consistent with recommendations under Standard VI(B).
A is incorrect because Northside’s policy regarding IPOs is consistent with the recom-
mendation under Standard VI(B) that states purchases of IPOs by investment personnel
create conflicts of interest in two principal ways: First, participation in an IPO may have
the appearance of taking away an attractive investment opportunity from clients for
personal gain—a clear breach of the duty of loyalty to clients. Second, personal purchases
in IPOs may have the appearance that the investment opportunity is being bestowed as
an incentive to make future investment decisions for the benefit of the party providing
the opportunity. Members and Candidates can avoid these conflicts or appearances of
conflicts of interest by not participating in IPOs.
C is incorrect because Northside’s policy regarding a blackout period, although narrow,
is consistent with the recommendation under Standard VI(B). The Standard states that
investment personnel involved in the investment decision-making process should estab-
lish blackout periods prior to trades for clients so that managers cannot take advantage
of their knowledge of client activity by “front-running” client trades.

LOS b
Section: Standard VI(B): Priority of Transactions
Jorge Reyes Case Scenario

Jorge Reyes is a financial analyst with Valores de Playa SA de CV, located in a suburb
of Mexico City, Mexico. Two nights a week he works as an adjunct professor at a local
technical institute, lecturing on investments and serving as a consultant in statistics
and related fields.
During one of his lectures, Reyes points out that regression plays an important
part in many empirical studies in finance. As an exercise, Reyes presents the results
of a regression of returns (Rt) on the company that owns the Mexican stock exchange
(ticker symbol BOLSAA.MX) against the US dollar/Mexican peso exchange rate
(Et). The data cover the period from late 2011 through early 2012. There are 64 daily
observations in the study. Exhibit 1 reports the results of the regression.
Exhibit 1 Regression Results: Rt = b0 + b1Et + εt

Coefficient Standard Error
Constant (b0) 0.0011 0.0019

USD/MXN exchange –0.5789 0.2221
rate (b1)
Number of observations used in the regression 64
Critical t-value at the 5% level of significance (two- 2
tailed test that the coefficient equals zero)
Standard
Adjusted Error of the Durbin– Significance of
R2 R2 Estimate Watson F-Value F-Value
0.0987 0.0842 0.0153 2.3434 6.7927 0.0114
One of the students asks Reyes about the adjusted R2 reported in Exhibit 1. Reyes
explains that adjusted R2 adjusts for the effects of serial correlation in the data.
A second student recalls that the presence of heteroskedasticity affects interpre-
tation of the test statistics computed by a regression. Reyes confirms that that is true
and suggests the students examine a plot of the predicted BOLSAA return values
minus their actual values (the BOLSAA residuals) against the independent variable
(USD/MXN exchange rate). Exhibit 2 provides such a graph.
Exhibit 2 Plot of BOLSAA Residuals against the USD/MXN Exchange Rate
Y = BOLSAA residuals
X = USD-MXN exchange rate
Interpreting the graph, Reyes states:

The presence of heteroskedasticity is indicated when there is a systematic
relationship between the values of the residuals and the independent vari-
able. As shown in Exhibit 2, there is no systematic relationship between
the BOLSAA residuals and the USD/MXN exchange rate. Therefore, het-
eroskedasticity does not appear to be a problem in this regression.
In a later exercise, Reyes asks his students to consider a time series of weekly prices
of Maya 22 crude oil. A substantial proportion of Mexico’s oil production is Maya 22
heavy crude. The period of the study is from January 1997 to July 2008. At Reyes’s
suggestion, the students first model the prices as an exponential trend (log-linear
model). They test for correlated errors from the model using the Durbin–Watson
statistic. The results are reported in Exhibit 3.
Exhibit 3 Durbin–Watson Test: Log-Linear Model

Durbin–Watson test statistic 3.97
Durbin–Watson critical values for the null hypothesis that:
• there is no positive serial correlation (at the 5% level) 1.65 1.69
• there is no negative serial correlation (at the 5% level) 2.35
Reyes next suggests they use a first-order autoregressive model [AR(1)]. To reduce
the effect of the exponential trend, the students continue to use the natural logarithms
of the prices, but now they also take the first differences of these logarithms of the
prices (xt). They fit an AR(1) to the differences of logs. The results of the regression
are reported in Exhibit 4.
Exhibit 4 Regression Results: xt+1 = b0 + b1xt + εt+1 where xt = ln(Pt+1) –

ln(Pt)
Coefficient Standard Error t-Statistic
Constant (b0) 0.002381 0.002056 1.1582

xt (b1) 0.235546 0.039778 5.9214
Number of observations used in the 599
regression
Because nonstationarity or heteroskedasticity would negatively affect use of the

AR(1) model, Reyes asks the students to test for the presence of each. Results of the
unit root test for nonstationarity and of a test for the presence of heteroskedasticity
are reported in Exhibit 5.
Exhibit 5 Unit Root Test for Nonstationarity and the Test

for Heteroskedasticity
Unit root test statistic –18.7402
Unit root test critical value at the 5% level of –2.89
significance
Heteroskedasticity test statistic 2.016733
Heteroskedasticity test critical value at the 5% 1.96
level of significance
13 In the regression of the returns of BOLSAA.MX against the USD/MXN

exchange rate (Exhibit 1), the coefficient of the USD/MXN exchange rate is
most accurately described as:
A indeterminate because Exhibit 1 provides insufficient information.
B significantly different from zero.
C not significantly different from zero.
B is correct. A two-tailed t-test is appropriate to test whether the coefficient is signifi-

cantly different from zero. The test statistic is the estimate of the coefficient (–0.5789)
divided by its standard error (0.2221), –0.5789/0.2221 = –2.61. Because –2.61 is less than
–2.00 (the negative critical value for the two-tailed test), the coefficient is significantly
different from zero at the 5% level of significance.
A is incorrect. The coefficient is significantly different from zero based on a t-test.
C is incorrect. The coefficient is significantly different from zero based on a t-test.
Correlation and Regression

LOS g
Section 3.5
14 Reyes's explanation regarding Adjusted R2 is best characterized as:

A correct.
B incorrect, because adjusted R2 adjusts for the loss of degrees of freedom

when additional independent variables are added to a regression.
C incorrect, because adjusted R2 adjusts for heteroskedasticity in the indepen-
dent variables.
B is correct. Adjusted R2 adjusts for the loss of degrees of freedom when additional
independent variables are added to a regression. It does not adjust for the effects of
serial correlation in the data, nor does it adjust for heteroskedasticity.
A is incorrect. Adjusted R2 does not compensate for serial correlation in the data.
C is incorrect. Adjusted R2 does not compensate for heteroskedasticity in the data.
Multiple Regression and Issues in Regression Analysis

LOS h
Section 2.4
15 Reyes's interpretation of the graph in Exhibit 2 is best described as:

A correct.
B incorrect, because the effects of heteroskedasticity are, in a regression such
as this one, hidden by the negative slope of the regression line.
C incorrect, because heteroskedasticity is indicated when there is not a sys-
tematic relationship between the residuals and the independent variable.
A is correct. The presence of heteroskedasticity is indicated when there is a systematic

relationship between the residuals and the independent variable. The graph in Exhibit 2
displays no systematic relationship. Therefore, heteroskedasticity does not appear to be
a problem in this regression.
B is incorrect. The slope of the regression line is irrelevant to the issue of
heteroskedasticity.
C is incorrect. It states that the lack of a systematic relationship suggests
heteroskedasticity.

LOS k
Section 4.1
16 The Durbin–Watson test reported in Exhibit 3 is most accurately interpreted as

indicating that the correlation in the errors is:
A insignificant.
B significantly positive.
C significantly negative.
C is correct. Significantly large values of the Durbin–Watson statistic point to negative

serial correlation. Specifically, if the DW statistic exceeds 4 – dl, where dl is the lower
critical value of the Durbin–Watson test, there is significant negative serial correlation. In
this case, Durbin–Watson = 3.97 and dl = 1.65. Because 3.97 > [4 – 1.65], the test indicates
that there is significant negative serial correlation.
A is incorrect. The DW statistic is greater than 4 – dl, indicating statistically significant
negative correlation.
B is incorrect. The DW statistic is greater than 4 – dl, indicating statistically significant
negative correlation.

LOS k
Section 4.2.2
Time-Series Analysis
LOS e
Section 3.2
17 Based on the regression results reported in Exhibit 4, the mean-reverting level

of the differences of logarithms of the Maya 22 prices [i.e., the time series as
modeled in the AR(1) model] is closest to:
A 0.30812.
B 0.00239.
C 0.00311.
C is correct. For an AR(1) model, xt+1 = b0 + b1xt + εt+1

At the mean reverting level where x t+1 = x t :
b0
xt =
1 − b1
0.002381
In this case, xt = = 0.00311.
1 − 0.235546
B is incorrect. It erroneously uses b0 in both the numerator and in the denominator.
A is incorrect. It erroneously uses b1 in both the numerator and in the denominator.
LOS f
Section 4.3
18 Based on the results reported in Exhibit 5, the AR(1) model is best described as
having:
A a unit root.
B heteroskedasticity in the error term variance.
C reliable standard errors.
B is correct. Because the unit root test statistic (–18.7402) is smaller than the critical value
(–2.89), the AR(1) model does not exhibit a unit root. The test for heteroskedasticity,
however, suggests that the error term variances are heteroskedastic. The heteroskedas-
ticity test statistic (2.016733) is greater than the critical value (1.96). A more sophisticated
approach, such as generalized least squares, is needed.
A is incorrect. The significantly negative test statistic strongly suggests the absence
of a unit root.
C is incorrect. When a model exhibits ARCH, the standard errors for the regression
parameters will not be correct.
Sections 5.2 and 9
LOS m, n
Central Aldorria Case Scenario

The Current Situation
Central Aldorria (CA) is a country located close to the equator with farming and
manufacturing interests. CA has ocean to its east and west but has plenty of fresh
water flowing through the central part of the country that is dammed by farmers for
irrigation purposes. As part of a compromise for ending a civil war 50 years earlier,
the farmers, rather than the central government, effectively own the rights to the
fresh water.
Since the end of the civil war, manufacturing firms that require fresh water have
located downstream from the farms. The manufacturers frequently need to negotiate
with the farmers to release water from the dams for a price.
Recently, a dispute between the country’s manufacturing interests and farm-
ing interests arose over the price of water. The farmers believe the price is too low
and have not let the dams release water, to the point that some fields have flooded.
Correspondingly, the manufacturers insist that the price is fair and want the farmers
to increase the availability of fresh water given the excess water available.
Regulatory Proposals
CA’s president, Celina Suarez, has brought together representatives from both groups
to consider a regulatory solution. Joseph Antoli represents the farmers, and Andrew
Benez represents the manufacturers.
Suarez proposes having the legislature empower a new agency, the Water Regulatory
Board (WRB), to deal with this conflict. The WRB would be funded by the govern-
ment and would have seven members (three members representing the farmers, three
members representing the manufacturers, and one appointed by the government).
The WRB will determine the appropriate price and volume of water, with the agency’s
decisions being legally binding.
Antoli asks Suarez why the seventh member of the WRB would be a government
appointee, and Suarez responds:
“The government-appointed member would prevent preferential treatment
to either of the regulated groups. To prevent preferential treatment from
developing over time, the government-appointed member will have only
a three-year term and cannot serve consecutive terms.”
Antoli states that the dams, which are currently privately owned, need significant
maintenance, and so the price of water must increase from current price levels.
Benez counters that if the government expects manufacturing to grow, a guaranteed

supply of fresh water at a fair price is necessary.
Suarez begins a discussion on the ownership interests in the dams. He proposes
that the government, through the WRB, purchase the dams at a fair market price and
then maintain them to benefit all. The WRB would then set the price of water and
guarantee a minimum level to downstream consumers.
Antoli proposes keeping the dams privately owned, with maintenance costs
(estimated to be 30% of the current value of the dam as an initial expense followed
by very low ongoing annual expenses) directly offsetting taxes owed by the owners
of the dams. In return, the owners of the dams must guarantee that a set amount of
water be made available at a price set by the WRB. Any additional water will be priced
through individual bargaining.
Benez proposes a compromise in which the government leases the dams with an
annual lease payment set at 10% of the current dam value for a period of 30 years,
with maintenance costs offsetting up to one- third of the lease payment in any given
year. The WRB would then set the price and limits on water availability in the manner
suggested by Suarez. Further, the issue can be re-addressed upon expiration of the lease.
The Regulatory Solution

After months of negotiation, the WRB is created. The WRB regulates the price and
the amount of water flowing from the dams, which are leased and maintained by the
government for 20 years. During this time, the government pays all maintenance costs
without any offset to lease payments.
Upon leasing the dams, the government needs to invest in roads to gain access to
the dams. This sort of investment had not been considered when assessing the repair
and maintenance of the dams. Although delayed, the improved dams allow for more
water than had been anticipated to become available and at lower prices owing to
the actions of the WRB.
As part of the compromise to have water regulated, the farming and manufac-
turing groups had agreed to invest in technology and practices for the more efficient
use of water. Although the manufacturers have been making these investments to use
water more efficiently, th ereby re ducing de mand an d he lping to ke ep wa ter pr ices
low, the farmers have chosen not to do so. Given the lower price of water because of
improvements to the dams, the farmers perceive no net revenue benefits from addi-
tional investment in the more efficient use of water.
19 Prior to the president’s intervention, the actions by the farmers relative to the
manufacturers over the disputed price of water is best described as:
A moral hazard.
B adverse selection.
C regulatory arbitrage.
A is correct. The farmers’ having the ability to restrict the release of water to the detri-
ment of the manufacturers during the pricing dispute is an example of a moral hazard.
B is incorrect because there are no informational asymmetries between the groups
to create adverse selection.
C is incorrect because regulatory arbitrage requires two different regulatory juris-

dictions and the ability to choose the jurisdiction that is most advantageous. No such
ability exists in this case.
Economics of Regulation
LOS c
Section 2.2
20 The WRB, as initially proposed by Suarez, is best described as a(n):

A independent regulator.
B self-regulating organization.
C regulator created by statute.
C is correct. As initially proposed by Suarez, the WRB is to be created through the legis-
lature, making it exist by statute. The agency is to be government funded and has one
member appointed by the government. The funding makes the agency non-independent,
and the existence of the government-appointed member makes the agency not a self-
regulating organization.
A is incorrect because the government funding makes the agency non-independent.
B is incorrect because the existence of a government-appointed member makes the
agency not self-regulating.
LOS a
Section 2.1
21 Suarez’s justification for the seventh member of the WRB is best described as
preventing regulatory:
A capture.
B arbitrage.
C competition.
A is correct. The purpose of the government-appointed member is to prevent a major-

ity for either the farmers or the manufacturers within the regulatory agency. Further,
the limit to the service of the government-appointed member prevents preferential
treatment to the regulated entities that could develop over time. Both constructs are
to prevent “regulatory capture,” which is preferential treatment toward one or both of
the regulated groups.
B is incorrect because regulatory arbitrage occurs when a regulated entity uses dif-
ferent regulatory environments to its economic advantage.
C is incorrect because regulatory competition occurs when regulatory agencies
compete to attract certain “regulated” entities by creating a desirable regulatory envi-
ronment for a given entity.
LOS d
Section 2.2.1
22 Suarez’s proposal for the ownership of the dams is best classified as which of the
following regulatory tools?
A Regulated monopoly
B Provision of public goods
C Public financing of private projects
B is correct. Because the dams are purchased and then maintained by the government,
the dams become a public good that is being made available to provide for a minimum
guaranteed amount of water to downstream consumers.
A is incorrect because the dams will not be owned by one private entity (i.e., a
monopoly) and then regulated.
C is incorrect because the dams become a public good, not a private one.
LOS e
Section 2.3
23 Of the three proposals concerning dam ownership and maintenance, the pro-
posal that provides the least amount of regulatory burden is the one given by:
A Antoli.
B Benez.
C Suarez.
A is correct. In this case, regulatory burden is measured by the cost imposed on the
government to implement the regulations. The government costs associated with each
proposal are as follows:
Proposal Government cost
Antoli Tax credit for maintenance costs

Benez 30-year lease plus maintenance costs that partially reduce lease
payments
Suarez Purchase of dams and maintenance costs
Antoli’s proposal would result in the lowest level of government spending, because
no cash outlay is necessary, and consequently results in the least amount of regulatory
burden.
B is incorrect because Benez’s proposal is not the lowest-cost proposal (cost being
the measure for regulatory burden) for the government.
C is incorrect because Suarez’s proposal is the most expensive proposal (cost being
the measure for regulatory burden) for the government.
LOS h
Section 5
24 When assessing the outcomes from the regulatory solution for Central
Aldorria’s water problem, which of the following statements is most accurate?
A There is an indirect cost due to the farmer’s behavior.
B The behavior of the farmers is an example of a “hold out” problem.

C The additional net regulatory burden due to unanticipated events is equal to
the cost of building roads.
A is correct. Because water became more plentiful as a result of the repaired dams and
cheaper because of the WRB, the farmers have chosen not to make investments related
to the more efficient use of water. The inefficient use of water by the farmers is an indirect
cost due to the regulatory solution.
B is incorrect because there is no evidence of the farmers renegotiating the regulatory
agreement after an unrecoverable investment has been made by the manufacturers or
government.
C is incorrect because the total net regulatory burden due to unanticipated events
equals the unanticipated cost of the roads plus the cost of delaying the dam repair less
the unanticipated benefit of greater water availability.
LOS i, h
Section 6
Panorama Investment Partners Case Scenario

Inside the offices of Panorama Investment Partners, Aisha Ishmael and Liam Lenihan,
principals at the firm, are meeting to discuss some investment decisions for their
flagship equity fund. Newly hired analyst Brandon Burgess joined the meeting to
observe and to provide some information he had gathered researching the potential
investments.
The two companies they are discussing are networking equipment makers, Zip
Technologies Ltd. (ZipTech) and Euronet GmBH (Euronet), both of which recently
reported results for the fiscal year ending 31 December 2017. Ishmael starts off by
mentioning an anomaly she had picked up on while listening to the analyst calls of
network and telecommunications providers, which are customers of the networking
equipment makers. Several of these customer organizations had reported higher-
than-originally-forecasted capital spending in the final three months of 2017, and a
few had bragged about the favorable pricing they had been able to negotiate. Ishmael
further observes that all those with the unexpectedly higher spending were known
to use ZipTech as their primary equipment provider. Ishmael is concerned about the
possibility of earnings manipulation by ZipTech.
Lenihan states that he too is not impressed with Euronet. He notes that the com-
pany has again increased the proportion of its sales where it provides the financing.
He is also concerned that Euronet has categorized the associated loans receivable
from customers as a component of other assets rather than as accounts receivable.
Lenihan asks Burgess to calculate Euronet’s Beneish M-score before their next
meeting. He provides Burgess with the Beneish coefficients for each variable (see
Exhibit 1). Lenihan wonders about the effect on the DSR value of reporting the loans
receivable as other assets and, in turn, the probability that Euronet’s M-score will flag
it as a possible earnings manipulator.
Exhibit 1 Coefficients for Beneish M-Score Variables

DSR (days sales receivables) 0.920
GMI (gross margin) 0.528
AQI (asset quality) 0.404
SG (sales growth) 0.892
DEPI (depreciation) 0.115
SGAI (sales, general, and administrative expenses) –0.172
Accruals ([Income before extraordinary items – Cash from opera- 4.670
tions]/Total assets)
LEVI (leverage) –0.327
Ishmael asks Burgess, “What have you come across with respect to the companies’
post-retirement benefits?”
Burgess replies, “I noticed that both companies are reporting net pension liabilities.
Both companies amended their defined benefit pension plans during the year that just
ended, providing enhanced benefits on past service to retain key technical employees.
But I don’t understand why Euronet’s pension expenses were proportionately much
higher year over year than were those of ZipTech, because both companies have similar
workforces and the pension benefits were on par both before the amendments and after.”
Lenihan responds, “I think it’s because ZipTech reports under US GAAP while
Euronet reports under IFRS and because of how those reporting frameworks account
for past service costs.”
Burgess agrees to revisit the effect of the pension amendments and quickly moves
on to the exhibit he had brought along, showing some of the key assumptions under-
lying both companies’ other post-employment benefit calculations (Exhibit 2).
Exhibit 2 Post-Employment Benefit Assumptions Used by

ZipTech and Euronet
ZipTech Euronet
Discount rate 3.9% 3.4%

Estimated annual compensation increase 3.2% 2.8%
Near-term health care cost trend rate 3.6% 4.1%
Ultimate health care trend rate 3.2% 3.1%
Years until ultimate trend rate is reached 8 years 10 years
Inflation rate 1.3% 1.5%
Lenihan studies the exhibit and comments, “This looks like useful information, but
now we need some analysis. Can you use this information to give us insights about
the impact of the post-employment benefit reporting? Why don’t you write a report
and put it on my desk before you leave this evening.”
Ishmael makes a final suggestion: “See whether you can find any information on
how sensitive both companies are to changes in their actuarial assumptions. That
would provide additional richness in your report.”
25 If Ishmael’s concern about ZipTech’s possible earnings manipulation is valid, the
tactic the company is using is best described as:
A channel stuffing.
B classification shifting.
C contingent selling.
A is correct. Ishmael’s concern about manipulating income is based on the calls with
analysts who follow ZipTech’s customers and those companies’ unusually high year-end
purchases at favorable prices. Channel stuffing is the tactic of inducing customers to
order products just before year-end that they would otherwise not order, or order at a
later date, by offering them generous terms, such as favorable pricing.
B is incorrect. Classification shifting relates to how an item is classified within a
particular financial statement. ZipTech’s actions to drive sales by potentially inducing
purchases by its customers result in additional sales on its income statement. There is no
indication that an attempt was made to classify the sales as another type of transaction.
C is incorrect. Contingent sales induce customers to buy by offering the right to return.
There is no indication ZipTech offered return rights; they offered more favorable pricing.
Evaluating Quality of Financial Reports

LOS b, d
Section 2.2
26 Lenihan’s concern about Euronet’s loans receivable from customers most likely
indicates that he suspects that the company may be engaging in:
A off-balance-sheet financing.
B classification shifting.
C manipulative discretionary accruals.
B is correct. Euronet’s reporting of the loans receivable from customers as other assets
reduces its accounts receivable balance and may result in more favorable accounts
receivable measures. This is known as “classification shifting”.
A is incorrect. In this situation, Euronet is providing loans (financing) to its customers.
Further, the financing provided is listed on the balance sheet as another asset. Off-
balance-sheet financing refers to liabilities incurred by an entity that are not reported
on its balance sheet.
C is incorrect. Discretionary accruals typically involve transactions or accounting
choices outside the normal course. In this situation, Euronet is described as increasing
the proportion of its vendor-financed sales, implying that vendor loans are a normal
activity for the company.

LOS b, d
Section 2.2.2
27 The most likely effect of Euronet’s choice for reporting the loans receivable on
the Beneish M-score is that the company’s probability of being flagged as an
earnings manipulator is:
A unchanged.
B increased.
C decreased.
C is correct. Euronet’s likelihood of being flagged as a possible earnings manipulator is

decreased because lower M-scores are correlated with lower probabilities of earnings
manipulation. Euronet’s reporting of the vendor loans receivable as other assets results in
a lower accounts receivable value and thus a lower days sales receivable index. Because
the coefficient of DSR is a positive value, the end result is a lower M-score than Euronet
would have if the vendor loans receivable were properly reported.
A is incorrect. Because one of the variables in the Beneish model is changing, the
M-score will also change. M-scores are correlated with earnings manipulation; thus, a
change in the value of a variable results in a change in the likelihood that Euronet will
be flagged as a manipulator.
B is incorrect. The DSR variable will be lower as a result of the categorization of vendor
loans receivable as other assets. This situation will lead to a lower M-score and thus a
lower likelihood of being flagged as a manipulator.

LOS d, h
Section 3.2.1
28 Lenihan’s response about the difference in ZipTech’s and Euronet’s pension

costs is most likely:
A correct because Euronet would have reported past service costs in net
income immediately.
B incorrect because ZipTech’s past service costs are reported in OCI and are
not subsequently amortized to net income.
C incorrect because both companies would have accounted for pension costs
in the same way.
A is correct. Lenihan is correct. Under IFRS (Euronet), past service costs are reported in
net income in the year of the decision. Under US GAAP (ZipTech), they are reported in
OCI and amortized to net income over the service life of the employees. As a result, in
the year of the decision to award past service costs, the past service costs reported in
net income under US GAAP are a fraction of those reported under IFRS.
B is incorrect because the statement does not reflect US GAAP treatment. Under US
GAAP, past service costs are initially reported in OCI, but they are subsequently amor-
tized to net income.
C is incorrect. IFRS and US GAAP treat past service costs differently. Under IFRS, past
service costs are reported in net income in the year of the decision. Under US GAAP, they
are reported in OCI and amortized to net income over the service life of the employees.
As a result, in the year of the decision to award past service costs, the past service costs
reported in net income under US GAAP (ZipTech) are a fraction of those reported under
IFRS (Euronet).
Employee Compensation: Post-Employment and Share-Based

LOS c
Section 2.3.2.2
29 Which of the assumptions in Exhibit 2 would most likely result in a lower

reported post-employment benefit obligation for Euronet as compared with
ZipTech?
A Near-term health care trend rate
B Ultimate health care cost trend rate

C Years until the ultimate trend rate is reached
B is correct. Other things equal, a lower assumed ultimate health care trend rate would
result in a lower benefit obligation and a lower periodic cost. Euronet’s 3.1% rate is lower
than ZipTech’s 3.2% rate. A higher assumed near-term health care cost trend rate or a
greater number of years until the ultimate trend rate is reached would result in a higher
benefit obligation and a higher periodic cost. Both of these assumptions are higher for
Euronet.
A is incorrect. Other things equal, a higher assumed near-term health care cost trend
rate would result in a higher benefit obligation and a higher periodic cost. Euronet’s 4.1%
rate is higher than ZipTech’s 3.6% rate.
C is incorrect. Other things equal, a greater assumed number of years until the ultimate
trend rate is reached would result in a higher benefit obligation and a higher periodic
cost. Euronet’s 10 years are greater than ZipTech’s 8 years.

LOS d
Section 2.4.1
30 In response to Ishmael’s final suggestion, Lenihan is most likely to find the

required information in the:
A regulatory filings for the pension plan.
B management discussion and analysis.
C notes to the financial statements.
C is correct. Risk-related note disclosures about pensions and post-employment ben-

efits include information about actuarial risks that could result in differences between
reported obligations and actual benefits paid and are found in the notes to the finan-
cial statements. This information may be presented as the effects of a change in their
assumptions, or a sensitivity analysis.
A is incorrect. Although risk-related disclosures in the management commentary
sometimes overlap with disclosures contained in the financial statement notes or else-
where in regulatory filings, the content often differs from the note disclosures.
B is incorrect. The management discussion and analysis requires disclosure of infor-
mation about the company’s exposure to market risks. Although this would be relevant
to pension-related assumptions, such as discount rates or expected returns, it does not
encompass actuarial assumptions specific to the entity’s employee and retiree populations.

LOS m
Section 7.2
LOS f
Section 2.4.1
Cuyahoga River Navigators Case Scenario

Cuyahoga River Navigators, Inc. (CRN), based in Cleveland, Ohio, has a fleet of 30
watercraft consisting of riverboats, yachts, barges, and ships navigating the Cuyahoga
River and Lake Erie. CRN is a high-beta stock, and its market liquidity is quite low.
Insiders own more than 50% and institutions own less than 30% of the firm’s common
stock. The company pays dividends and follows a constant payout ratio policy. The
company’s management is confident of a huge increase in revenue growth over the
next four to five years. To meet the c apital needs for g rowth opportunities, C RN’s
management is contemplating the issuance of debt or common stock.
Abhishek Alahtab is a junior equity analyst at Cleveland Investment Research,
LLC, and follows regional small-cap stocks trading in the over-the-counter market.
Amit Jatin, a senior equity analyst at Cleveland Investment Research, asks Alahtab to
evaluate CRN and prepare a research report for updating the firm’s recommendation
about the stock. He gives Alahtab CRN’s financial data, which are shown in Exhibits
1 and 2.
Exhibit 1 Income Statement Excerpts, Years Ending 31 December ($

millions)
2013 2012
EBITDA 275 250

Depreciation expense 82.5 75
Operating income 192.5 175
Interest expense 16 14.9
Income before taxes 176.5 160.2
Income taxes 56.5 48
Net income 120 112.1
Common dividend 48 44.8
Exhibit 2 Selected Balance Sheet Data, Years Ending 31 December ($

millions)
Net investment in fixed capital 165.3
Net increase in working capital –1.80
2013 2012
Current assets 354.2 322

Accumulated depreciation 257.5 175
Notes payable 20 15
Long-term debt 157.5 150
Common stock (50 million shares 800 800
outstanding)
Retained earnings 159.3 87.3
Total liabilities and equity 1,265.00 1,150.00
Ratios are calculated using year-end values

Alahtab uses the Gordon growth model to estimate CRN’s intrinsic value. He
uses the firm’s sustainable growth rate for 2013 as a measure of dividend growth.
Using the capital asset pricing model (CAPM), he arrives at 11% as the required rate
of return on the stock.
Jatin disagrees with Alahtab’s preference for the Gordon growth model. He thinks
that CRN’s stock should be valued using sophisticated techniques that correctly
account for the huge increase in revenues expected over the next four to five years.
In particular, he suggests a couple of two-stage valuation models: the H-model and
the free cash flow to equity (FCFE) model. Upon a closer examination of the data and
expectations of high growth from the increased tourism and transportation on the
revitalized Cuyahoga River, Jatin suggests that Alahtab incorporate the following as
inputs into his H-model and FCFE model computations:
■ A growth rate of 20% per year over the next four years (2014 through 2017) and
a 6% constant growth rate beyond 2017
■ An estimate of FCFE of $0.96 per share for 2014
■ The addition of a small-firm risk premium of 2% to the rate of return on the
stock
■ A tax rate of 35%
Additionally, Jatin makes the following statements concerning the valuation models
that he prefers:
1 The H-model assumes that the dividend growth begins at a high rate and
declines linearly throughout the supernormal growth period until it reaches
a normal growth rate at the end. A smoother transition to the mature phase
growth rate would be more realistic than the erratic growth rate in dividends
displayed by the data.
2 The FCFE model ignores a company’s investment and financing policies as
well as its dividend policy. This model would be appropriate because free cash
flow is not affected by the firm’s dividend payout policy, but any stock issuance
in the future can have a significant impact on cash flow available to common
stockholders.
3 An increase in leverage will lead to a decrease in FCFE in the year the debt is
issued, thereby potentially reducing the value per share.
Alahtab reevaluates the stock following Jatin’s suggestions, but prior to issuing
the new price target and recommendation on CRN, Jatin and Alahtab meet with
Julia Lederman, the chief investment officer at Cleveland Investment Research, for
her approval. After taking a close look at the data and analyses, Lederman makes the
following statements:
1 I suggest we use a forward-looking beta by making the Blume adjustment to
CRN’s raw beta. The adjustment increases the required return on CRN’s stock
as well as its intrinsic value.
2 It is good to see an adjustment for small-firm risk premium, but the Pastor–
Stambaugh model should be used for estimating the required return on CRN’s
stock in order to capture the liquidity premium given the stock’s low liquidity.
3 I also suggest using a residual income model because, unlike free cash flows,
the accounting data used in residual income models may not require significant
adjustments.
The meeting concludes with the understanding that Alahtab will redo the analyses
per Lederman’s suggestions and bring the results back for her approval.
31 According to the Gordon growth model and the inputs used by Alahtab, CRN's
intrinsic value per share as of 2013 is closest to:
A $29.49.
B $16.80.
C $27.43.
A is correct. Using the Gordon growth model

V0 = D0 (1 + g)/(r – g).
So,
g = b × ROE
b = 1 – Payout ratio = 1 – (48/120) = 0.6
ROE = Net income/Shareholders’ equity = 120/(800 + 159.3) = 12.5
g = 0.6 × 12.5 = 7.5%
D0 = $48 million/50 million shares = $0.96/share
V0 = (0.96 × 1 + 0.075)/(0.11 – 0.075) = $29.49
B is incorrect. It uses payout ratio (instead of retention ratio) to compute g: g = 0.4 ×
12.5 = 5%; V0 = 0.96 × 1.05/(0.11 – 0.05) = $16.80.
C is incorrect. It uses D0 (instead of D1) in computing V0: V0 = 0.96/(0.11 – 0.075) = $27.43.
Discounted Dividend Valuation

LOS c, o
Section 4.1
32 Using the H-model, the information in Exhibits 1 and 2, and Jatin’s estimates for
growth and required return on the stock, the intrinsic value of CRN’s stock as
of 2013 is closest to:
A $22.22.
B $17.55.
C $18.38.
C is correct. The H-model is

D0 (1 + g L ) + D0 H (g S − g L )
V0 =
r − gL
where
D0 = Dividend/Number of shares
D0 = $48/$50 = $0.96
gS = Initial short-term dividend growth rate = 20%
gL = Normal long-term dividend growth rate = 6%
r = 11% + 2% = 13%
H = 4/2 = 2
D0 (1 + g L ) 0.96(1.06)
= = 14.54
r − gL 0.13 − 0.06
D0 H (g S − g L ) 0.96 × 2(0.20 − 0.06)

= = $3.84
r − gL 0.13 − 0.06
V0 = $14.54 + $3.84
= $18.38
B is incorrect. It neglects to multiply D0 by the long-term growth rate in the first part
of the equation.
D0/(r – gL) = 0.96/(0.13 – 0.06) = $13.71;

D0H(gS – gL)/(r – gL) = 0.96 × 2(0.20 – 0.06)/(0.13 – 0.06) = $3.84
V0 = $13.71 + $3.84
= $17.55
A is incorrect. It uses 2H (instead of H) in the second part of the equation.
D0(1 + gL)/(r – gL) = 0.96 × 1.06/(0.13 – 0.06) = $14.54;

D02H(gS – gL)/(r – gL) = 0.96 × 4(0.20 – 0.06)/(0.13 – 0.06) = $7.68
V0 = $14.54 + $7.68 = $22.22

LOS l
Section 5.3
33 Using the data in Exhibits 1 and 2 and the tax rate suggested by Jatin, CRN’s
FCFE per share for 2013 is closest to:
A $0.85.
B $0.82.
C $0.92.
C is correct.
FCFF = EBITDA(1 – Tax rate) + Depreciation(Tax rate) – FCInv – WCInv
FCFE = FCFF – Interest(1 – Tax rate) + Net borrowing
($ millions)
EBITDA (1 – Tax rate)a 275 (1 – 0.35) $178.75

Plus: Depreciation (Tax rate)a 82.5(0.35) 28.87
Less: Net investment in fixed capital (165.3)
Less: Net increase in working capitalb 1.8
($ millions)
Less: Interest (1 – Tax rate)a 16 (1 – 0.35) (10.38)
Plus: Net borrowing (157.5 + 20) – (150 + 15) 12.5
Free cash flow to equity 46.24
FCFE per share 46.24/50 0.92
a Jatin’s tax rate = 35%, which is different from the original tax rate.
b Net increase in Net Working Capital 2013 is less by $1.80, so it is a positive number.
B is incorrect. It uses the incorrect value for net borrowing because it ignores the
change in notes payable.
EBITDA (1 – Tax rate) 275 (1 – 0.35) $178.75

Plus: Depreciation (Tax rate) 82.5(0.35) 28.87
Less: Net increase in working capital 1.80
Less: Interest (1 – Tax rate) 16 (1 – 0.35) (10.38)
Plus: Net borrowing 157.5 – 150.0 7.50
Free cash flow to equity (FCFE) $41.24
FCFE per share 41.24/50 $0.82
A is incorrect. It uses the wrong sign for net increase in working capital.
EBITDA (1 – Tax rate) 275 (1 – 0.35) $178.75

Plus: Depreciation (Tax rate) 82.5(0.35) 28.87
Less: Net increase in working capital (1.80)
Less: Interest (1 – Tax rate) 16 (1 – 0.35) (10.38)
Plus: Net borrowing (157.5 + 20) – (150 + 15) 12.50
Free cash flow to equity (FCFE) $42.64
FCFE per share 42.64/50 $0.85
Free Cash Flow Valuation

LOS d
Section 3.5
34 Using Jatin’s 2014 estimate for FCFE per share and his other suggested inputs
for growth and required return on the stock, the intrinsic value of CRN’s stock
as of 2013 is closest to:
A $21.27.
B $19.15.
C $17.37.
B is correct.
2014 2015 2016 2017
FCFE per share for the $0.96 (Jatin’s est.) $0.96(1.2) = $0.96(1.2)2 = $0.96(1.2)3 = $1.66
year $1.15 $1.38
Present value (2013) $0.96/$1.13 = $1.15/$1.132 = $1.38/$1.133 = $1.66/$1.134=$1.02;
of FCFE and total $0.85 $0.90 $0.96 ($1.66 × $1.06) ($0.13 − $0.06)
value2014
$1.134 ;
25.13/1.63=$15.42
V0 as of 2013 $0.85 + $0.90 + $0.96 + $1.02 + $15.42 = $19.15
A is incorrect. The mistakes are not discounting the 2014 FCFE and then follow-up
mistakes in the number of periods for discounting.
2014 2015 2016 2017
FCFE for the year $0.96 (Jatin’s 0.96(1.2) = 0.96(1.2)2 = 0.96(1.2)3 = $1.66
est.) $1.15 $1.38
PV (2013) of FCFE and TV2014 0.96/1.130 = 1.15/1.13 = 1.38/1.132 = 1.66/1.133 = $1.15;
0.96 $0.85 $0.90 [(1.66 × 1.06)/(0.13-
0.06)]/1.133 = $17.41
V0 as of 2013 $0.96 + $0.85 + $0.90 + $1.15 + $17.41 = $21.27
C is incorrect. The mistake is in discounting the terminal value with n = 5 (instead of 4).
2014 2015 2016 2017
FCFE for the year $0.96 (Jatin’s est.) 0.96(1.2) = 0.96(1.2)2 = 0.96(1.2)3 = $1.66
$1.15 $1.38
PV (2013) of FCFE and TV2014 0.96/1.13=$0.85 1.15/1.132 = 1.38/1.133 = 1.66/1.134 = $1.02
$0.90 $0.96 [(1.66 × 1.06)/(0.13-
0.06)]/1.135 = $13.64
V0 as of 2013 $0.85 + $0.90 + $0.96 + $1.02 + $13.64 = $17.37

LOS i, j
Section 4.3
35 In regard to Jatin’s three statements concerning valuation models, he is most

accurate with respect to statement:
A 3.
B 1.
C 2.
B is correct. Jatin is correct with respect to Statement 1 only. The H-model is a variant
of the two-stage model in which growth begins at a high rate and declines linearly
throughout the supernormal growth period until it reaches a normal growth rate at the
end. A smoother transition to the mature phase growth rate would be more realistic
than the erratic growth rate in dividends displayed by the data.
A is incorrect. With an increase in leverage, FCFE will increase in the year debt is
issued, not decrease.
C is incorrect. The FCFE model explicitly recognizes the company’s investment and
financing policies as well as its dividend policy.

LOS i
Section 5.3
LOS g
Section 3.8.3
36 In regard to her three statements, Lederman is most accurate with respect to

statement:
A 3.
B 1.
C 2.
C is correct. Lederman is correct with respect to Statement 2 only. The Pastor–Stambaugh

model adds a liquidity premium as a fourth factor to the Fama–French model and thus
helps make an adjustment for the liquidity concerns surrounding the stock.
A is incorrect. The accounting data used in residual income models may require
significant adjustments.
B is incorrect. CRN is a high-beta stock, and with Blume adjustment the adjusted beta
will be smaller than its unadjusted counterpart; thus, the required return on the stock
will decrease, not increase.
Return Concepts
LOS c, d
Section 4.1.1, 4.2.2
Residual Income Valuation
LOS j
Section 4.1
Stellwagen Investment Partners Case Scenario

Stellwagen Investment Partners is an institutional investment manager located in
Boston that offers advice on both equity and fixed-income strategies. Stellwagen man-
ages a number of separate accounts for large institutional investors and also serves as
a subadviser for mutual funds.
Thomas Harding, a fixed-income portfolio manager at Stellwagen, is a member
of the firm’s investment committee. Harding is responsible for management of the
firm’s short-and intermediate-duration credit strategies. When making investment
decisions, he often relies on input from Stellwagen’s team of 15 credit analysts. Sarah
Hamilton is a credit analyst at Stellwagen and covers the technology and telecom-
munication sectors.
Hamilton is analyzing three bonds being considered for investment by Harding:
CommCo, which is currently callable at par; StorageTech, which is currently putable
at par; and NexTec, which has a make-whole call provision. All three bonds have a
five-year maturity, are of equivalent credit quality, and pay the same coupon (3.5%).
Harding believes that interest rates will increase more rapidly than currently implied
by the market.
Harding asks Hamilton what the impact of increased interest rate volatility and
changes to the shape of the yield curve would have on the value of these bonds. She
states that all else being equal,
Comment 1 increased interest rate volatility decreases the value of the
CommCo bond,
Comment 2 the value of NexTec’s make-whole call provision increases as the
yield curve flattens,
Comment 3 and the value of StorageTech’s option will be more valuable with a
downward-sloping yield curve than with a flat yield curve.
Hamilton has been working on interest rate scenarios to model how bond prices
would change given a 40 bp (basis point) upward or downward shift in the yield curve.
Her work is shown in Exhibit 1.
Exhibit 1 Bond Sensitivity Analysis to 40 bp Interest Rate Shifts

CommCo StorageTech NexTec
Current price 99.70 100.35 100.05

Price rates up 40 bps 98.20 100.00 98.40
Price rates down 40 bps 100.00 101.85 101.70
To prepare for rising rates, Harding asks Hamilton to evaluate floating-rate bond
issues. She reviews a two-year floater issued by NexTec and creates a two-year bino-
mial interest rate tree for valuation purposes, as shown in Exhibit 2. The bond pays
annual coupons based in the one-year Libor. The Libor swap curve is the same as the
par yield curve: 2.5% at one year and 3.0% at two years.
Year 0 Year 1 Year 2
5.5258
3.8695
2.5000 4.5242
3.1681
3.7041
Harding subadvises a core-plus bond fund that allows for up to 5% of assets to

be invested in convertible debt. Hamilton has read research from Stellwagen’s equity
team that has identified StorageTech equity as a top idea, with a price target of $120
per share. The stock does not pay a dividend and is trading for $90.00 per share on 2
April 2017. Harding asks Hamilton to provide him with the current conversion price,
conversion value, and market conversion premium per share based on data in Exhibit 3.
Exhibit 3 StorageTech Convertible Bond Data

Issue Date 1 April 2015
Maturity 1 April 2020
Issue Par Price $1,000.00
Stock Price at Issue $80.00
Initial Conversion Premium 20.0%
Exhibit 3 (Continued)
Convertible Price 2 April 2017 $1,050.00

Annual Coupon 2.5%
Based on this information, Hamilton calculates the conversion value to be $937.50

and the market conversion premium per share to be $10.80 per share.
37 Which of the bonds that Hamilton analyzes in Exhibit 1 is most likely to outper-
form given Harding’s expectations?
A NexTec
B CommCo
C StorageTech
C is correct. StorageTech is most likely to outperform given the put feature, which is
valuable to investors during a period of rising interest rates because they can put the
bond back to the issuer and reinvest at higher rates. The call feature is of benefit to the
issuer and does not provide any protection to investors in a period of rising rates.
A is incorrect. NexTec is a straight bond with a make-whole call provision and would
underperform an equivalent putable bond in a period of rising rates.
B is incorrect. CommCo is callable. As rates rise, the bond is less likely to be called, but
the investor does not have the ability to redeem the bond and reinvest at higher rates.
Valuation and Analysis: Bonds with Embedded Options

LOS a
Section 2
38 Which of the bonds that Hamilton analyzes in Exhibit 1 is most likely to exhibit
effective negative convexity?
A StorageTech
B CommCo
C NexTec
B is correct. When rates rise and the value of the call option is low, both callable and
straight bonds exhibit positive convexity. However, the effective convexity of the callable
bond turns negative when the call option is near the money because when interest rates
decline, the price of the bond is capped by the price of the call option as it nears the
exercise date. Putable bonds always have positive convexity.
A is incorrect. Putable bonds always have positive convexity.
C is incorrect. Callable bonds are more likely than option-free bonds to exhibit neg-
ative convexity.

LOS l
Section 3
39 Which of Hamilton’s comments regarding interest rate volatility and the yield
curve is most likely correct?
A Comment 2
B Comment 1
C Comment 3
B is correct. Increased interest rate volatility will increase the value of the call option,
which will decrease the value of the CommCo bond.
Value of callable bond = Value of straight bond – Value of issuer call option
The make-whole call provision for the NexTec bond is not affected by the shape of
the yield curve. With a make-whole call, the bondholders are more than “made whole”
(compensated) in exchange for surrendering their bonds, as calculated by a narrow
spread to an on-the-run sovereign bond, and investors should have no fear of receiving
less than their bonds are worth. A downward-sloping yield curve decreases the value of
the put option on StorageTech’s bond relative to a flat or upward-sloping curve.
Value of investor put option = Value of putable bond – Value of straight
bond
A is incorrect. The make-whole call provision for the NexTec bond is not affected by
the shape of the yield curve. With a make-whole call, the bondholders are more than
“made whole” (compensated) in exchange for surrendering their bonds, as calculated
by a narrow spread to an on-the-run sovereign bond, and investors should have no fear
of receiving less than their bonds are worth.
C is incorrect. A downward-sloping yield curve decreases the value of the put option
on StorageTech’s bond relative to a flat or upward-sloping curve.

LOS d, e
Section 3
40 Based on Exhibit 1, which bond most likely has the shortest effective duration?
A CommCo
B StorageTech
C NexTec
A is correct. The formula for calculating effective duration is

(PV− ) − (PV+ )
Effective duration =
2(∆Curve)(PV0 )
Because of the put feature of the StorageTech bond, the value if rates go up is effec-
tively floored at 100; likewise, if rates go down, the call feature of the CommCo bond
will effectively cap the price at 100. Based on the formula, the CommCo bond has the
shortest effective duration.
CommCo effective duration calculation:
= (100.00 – 98.20)/(2 × 0.004 × 99.70)

= (1.80)/(0.7976)
= 2.257
StorageTech effective duration calculation:
= (101.85 – 100.00)/(2 × 0.004 × 100.35)

= (1.85)/(0.8028)
= 2.304
NexTec effective duration calculation:
= (101.70 – 98.40)/(2 × 0.004 × 100.05)

= (3.30)/(0.8004)
= 4.123
B is incorrect. StorageTech has a longer effective duration than CommCo (see calcu-
lations above).
C is incorrect. NexTec has a longer effective duration than CommCo or StorageTech
(see calculations above).

LOS i
Section 4
41 If the NexTec floater had a 3% cap, the value of this embedded cap for the issuer
would be closest to:
A 1.57.
B 1.09.
C 0.49.
C is correct. Value of capped bond = Value of the straight bond – Value of embedded
cap. To calculate this value, we need to calculate the value from the binomial interest
rate tree, capping all cash flows at $3 (3% of $100). The valuation is highlighted below.
Year 0 Year 1 Year 2
99.163 103
3.8695% 103.8695
99.512
2.5000
2.5000%
99.837 103
3.1681% 103.1681
Without a cap, the value of this floater would be 100 because in every scenario, the
coupon paid would be equal to the discount rate. But because the coupon rate is capped
at 3.000%, which is lower than the highest interest rates in the tree, the value of the
capped floater will be lower than the value of the straight bond
We start by calculating the bond values at Year 1 by discounting the cash flow (capped
at 3% of par) for Year 2 with the two possible rates:
99.163 = 103/1.038695
99.837 = 103/1.031681
Year 0 is calculated by discounting the values in the two future states emanating from
the present state plus the coupon at the appropriate rate in the present state:
2.5 + (0.5 × 99.163 + 0.5 × 99.837)
99.512 =
1.025
Valuation of the embedded cap = 100 – 99.512 = 0.488

B is incorrect: 1.09 reflects the updated value in the up scenario for Year 1 minus the
par value of the bond (101.088 – 100.000).
A is incorrect: 1.57 reflects the updated value in Year 0 minus the updated value of
the bond in the down scenario for Year 1 (103.348 – 101.776).

LOS q
Section 5.1
42 Is Hamilton most likely accurate regarding her convertible bond calculations?

A Yes
B No. The conversion value is incorrect.
C No. The market conversion premium is incorrect.
A is correct. The conversion ratio is the par value of the bond divided by the conversion
price per share: $1,000/$96 = 10.4167. The conversion value of a convertible bond is equal
to the underlying share price times the conversion ratio: 10.4167 × $90.00 = $937.50. The
market conversion premium is the convertible bond price divided by the conversion ratio
minus the stock price: $1,050/10.4167 = $100.80 – $90.00 = $10.80.
B is incorrect. The conversion value of a convertible bond is equal to the underlying
share price times the conversion ratio: 10.4167 × $90.00 = $937.50.
C is incorrect. The market conversion premium is the convertible bond price divided
by the conversion ratio minus the stock price: $1,050/10.4167 = $100.80 – $90.00 = $10.80.

LOS n
Section 6
Mafadi Case Scenario

Mafadi Consulting Limited is a boutique financial services company located in
Johannesburg, South Africa. Mafadi specializes in providing commodity and currency
hedging solutions to institutional investors and corporations.
Andre Fourie is a senior client services consultant for Mafadi. He manages rela-
tionships with a number of institutions to assist with their hedging needs. One of
Fourie’s client’s is Global Bullion, a mining and exploration company headquartered
in the United States.
Fourie is discussing forward contracts with Patrick Jacob, a new risk analyst at
Global Bullion. Jacob is asking about similarities and differences between forward and
futures contracts. Fourie makes the following comments to Jacob:
Comment 1 If you are long a futures or forward contract and the price of the
underlying has risen, the value of a futures contract is most likely
lower than that of the equivalent forward contract.
Comment 2 Forward contracts are marked to market each day, whereas
futures contracts are not.
Comment 3 The market value of both futures and forward contracts at initia-
tion is zero.
Jacob wants to understand more about the carry arbitrage approach to valuation
and, as part of the discussion, Fourie describes the two fundamental rules for the
arbitrageur:
Rule 1 The arbitrageur never uses her own money to purchase the underlying
security and always invests any proceeds from short selling transac-
tions at the risk-free rate.
Rule 2 The arbitrageur does not take any market price risk on the total trade,
but individual components of the trade may involve price risk.
Mbali Ndlovu, a trader on Mafadi’s derivatives desk, works closely with Fourie to
implement solutions for his clients. Fourie asks Ndlovu to review and calculate the
value of a five-year ZAR20,000,000 swap into which Global Bullion entered two years
ago. It is a receive-fixed, Libor-based interest rate swap with annual resets (30/360 day
count). The fixed rate in the swap contract established two years ago was 3%. Exhibit 1
estimates the present value factors.
Exhibit 1 Present Value Factors for Five-Year Swap

Maturity (years) Present Value Factor
1 0.9802
2 0.9560
3 0.9311
In addition to assisting Fourie, Ndlovu focuses on finding profitable trades for

Mafadi by investing the firm’s own capital. Ndlovu has noticed some unusual activity in
foreign exchange forward rates, especially the rates for the New Zealand dollar (NZD)
and the South African rand (ZAR), ZAR/NZD. The foreign exchange forward rate,
F0(ZAR/NZD, T), is currently below the foreign exchange spot rate, S0(ZAR/NZD).
Ndlovu is also evaluating the forward contract in Zulu Mineral Mining (Zulu) stock
to determine if an arbitrage opportunity exists. The South African 12-month prime
rate is 3.25%. The spot price for Zulu is ZAR 60.50. Zulu pays an annual dividend
of ZAR3.00 on a semiannual basis, and the next dividend is paid in three months.
Interest compounds annually.
Ndlovu receives a request from Fourie to structure an OTC swap transaction for
one of his clients. After reviewing the request, Ndlovu agrees to be the counterparty
for a one-year swap on Tanzanite Resources (Tanzanite) stock in which the client is
seeking to enter into a receive-equity returns and pay-fixed arrangement. Tanzanite
does not pay a dividend. The swap is structured as a quarterly reset, 30/360 day count,
with a notional value of ZAR 5,000,000. The fixed rate is 3.2% annually. Zulu has a
return of –3.6% for the first quarter.
43 Which of Fourie’s comments to Jacob is least likely accurate?
A Comment 1
B Comment 2
C Comment 3
B is correct. Fourie’s second comment to Jacob regarding marking to market is incorrect.

Futures contracts are marked to market each day, whereas forward contracts are not.
Comments 1 and 3 are accurate.
A is incorrect. Fourie’s first comment is accurate. Because futures contracts are marked
to market daily, profits are paid out and the value is reset to zero. As a result if you are
long a contract and the price has risen, the forward contract will likely have a higher
value than the futures contract.
C is incorrect. Fourie’s last comment is accurate. The market value of both futures and
forward contracts at initiation is zero.
Pricing and Valuation of Forward Commitments

LOS a
Section 3.7
44 Are Fourie’s comments regarding fundamental rules for arbitrageurs most likely
correct?
A No, Rule 1 is incorrect
B Yes
C No, Rule 2 is incorrect
B is correct. Fourie’s fundamental rules for arbitrageurs are correct. The two fundamental
rules of the arbitrageur are (a) do not use your own money and (b) do not take any price
risk. The arbitrageur does not spend proceeds from short selling transactions but invests
them at the risk-free rate. The arbitrageur does not take market price risk, even though
each step of the transaction may individually involve price risk. Because the steps are
undertaken simultaneously, however, the price risk is offset.
A is incorrect. The arbitrageur does not use their own money. Also, they do not spend
proceeds from short selling transactions but invests them at the risk-free rate.
C is incorrect. The arbitrageur does not take market price risk but component trans-
actions may individually involve price risk.

LOS a
Section 3.2
45 The value of Global Bullion’s swap contract is closest to:

A ZAR1,720,380.
B ZAR1,324,380.
C ZAR344,076.
C is correct.
Calculate the sum of PV = 0.9802 + 0.9560 + 0.9311 = 2.8673.
Calculate the fixed swap rate = (1 – 0.9311)/2.8673 = 0.0240.
Calculate swap value per ZAR = (0.0300 – 0.0240) 2.8673 = 0.0172.
Thus, total swap value = 0.01720 × ZAR20,000,000 = ZAR344,076.
B is incorrect. B uses wrong PV factor for Fixed swap rate (1 – 0.9311)/2.8673 = 0.6905 =
(0.0300 – 0.006905) × 2.8673 = 0.066219 × 20,000,000 = 1,324,380.
A is incorrect. A does not subtract Fixed Swap rate in step 3 so = (0.0300) × 2.8673 =
0.0860 × 20,000,000 = 1,720,380.

LOS d
Section 4.1
46 Based on the carry arbitrage model, New Zealand interest rates, compared with
South African interest rates, are most likely:
A higher.
B the same.
C lower.
A is correct. If the ZAR/NZD forward rate is less than the spot rate, then the carry arbitrage
model indicates the South African interest rate will be lower than the New Zealand rate.
This dynamic occurs because when interest rates fall, forward prices decline.
B is incorrect. If the forward and spot rates are different it indicates a difference in
interest rates under the carry arbitrage model.
C is incorrect. The rates should be higher not lower per the carry arbitrage model.

LOS a
Section 3.6
47 The three-month forward price for Zulu stock is closest to:

A ZAR63.99.
B ZAR59.47.
C ZAR57.99.
C is correct. The formula for calculating the forward price (F0[T]), where S denotes
the spot market price, γ (gamma) denotes carry benefits such as dividends or interest
payments, and θ (theta) denotes carry costs, is: F0(T) = FV0,T (S0 + θ0 – γ0) = FV0,T (S0) +
FV0,T (θ0) – FV0,T (γ0) = 60.5(1 + 0.325)3/12 + 0 – 3.00 = ZAR57.99. The dividend received is
a carry benefit that decreases the cost of the forward price.
B is incorrect. This answer results from failing to account that the 3.25 percent interest
is on an annualized basis: 60.5(1 + 0.325) + 0 – 3.00 = ZAR59.47.
A is incorrect. This answer results from adding the 3.00 dividend instead of subtracting
it: 60.5(1 + 0.325)3/12 + 0 + 3.00 = ZAR63.99.

LOS b
Section 3.3
48 The cash flow to Ndlovu after the first quarter of the Tanzanite swap is closest
to:
A ZAR219,529.
B –ZAR140,471.
C ZAR340,000.
A is correct. The quarterly interest rate is calculated as [(1 + 3.2%)(1/4)] – 1 = 0.0079, so the
fixed cash flow Ndlovu receives is ZAR5,000,000 × 0.0079 = ZAR39,528.77. The return of
the equity is negative, so Ndlovu will also receive ZAR5,000,000 × 0.0360 = ZAR180,000.00
from the Zulu return. Therefore, the net cash flow to Ndlovu is ZAR219,528.77 (39,528.77 +
180,000.00).
B is incorrect. This answer results from subtracting the ZAR180,000 equity related
return instead of adding it.
C is incorrect. This answer results from using the annual fixed rate of 0.0320 for the
quarter resulting in a fixed payment of ZAR160,000 plus the equity returns of ZAR180,000.

LOS c, d
Section 4.3
Premier Immobilier Case Scenario

Premier Immobilier facilitates North American private real estate investment for
ultra-high-net-worth investors by constructing and managing investment partnerships,
each of which focuses on specific sectors of the real estate market. Premier’s chief
investment officer, John Beaudiment, is meeting with a new client, Harris Lang. Lang,
who manages the Lang Family Office for members of his own family, is interested in
working with Premier for the family’s private real estate investments.
Beaudiment explains to Lang, “We enable our clients to bypass some of the
common disadvantages facing individual investors in private real estate. Structuring
our funds as partnerships allows investors to invest directly in real estate. Each part-
nership focuses on diversifying within a specific sector of the real estate market and
targets an exit strategy approximately 10 years following the fund’s creation. Over
that time frame, the plan is for investors to have received back at least the amount
of their initial capital in the form of dividends and/or capital gains. The exact life of
each fund is dependent on future economic conditions, and this avoids the need to
liquidate properties during an unfavorable market environment. The following list
provides three common benefits to investors in our funds, and Exhibit 1 describes
the characteristics of the four funds currently raising capital.”
Benefit 1: Stable income from investments not correlated to equity markets
Benefit 2: Reduction of reportable taxable income due to depreciation tax
credits
Benefit 3: Geographical diversification of real estate property investments
Exhibit 1 Fund Characteristics

Fund Name Description of Investment Activities Fund Exit Strategy
1 Golden Age Equity Building and operation of senior independent Sale of portfolio in public REIT offer-
Partners living facilities in coastal metropolitan areas ing in next 9–12 years
2 Multifam Equity Construction of 15–20 luxury multifamily Building sale within 14–24 months of
Partners apartment building projects in high-growth each respective project initiation; sale
metropolitan areas contracts generally agreed upon prior
to project initiation
3 Multifam Debt Provides floating-rate financing for Multifam Public sale of debt as mortgage-
Partners Equity Partners and for qualified project backed securities pool in 6–10 years
purchasers
4 Timbrian Equity Purchase and management of diverse timber- Sale of timberlands over next 9–12
Partners lands in North America years
Beaudiment continues, “Multifam Debt Partners, which provides financing for

Multifam Equity Partners, evaluates the credit quality of each proposed project in
order to negotiate the LTV or debt service coverage ratio (DSCR) required for each.
Multifam Equity Partners has already initiated building projects in three different
cities. The projects have similar expected rates of return. Multifam Debt Partners
has based its required debt service coverage ratios partially on the pro forma data
shown in Exhibit 2.”
Exhibit 2 Multifam Equity Partners Pro Forma Data

Number of NOI expected Estimated mkt
Property units per unit DSCR value
Multifam I 90 CAD25,000 1.30 CAD45,000,000

Multifam II 100 CAD30,000 1.40 CAD50,000,000
Multifam III 120 CAD20,000 1.50 CAD60,000,000
Beaudiment adds, “Each of the four funds has its own team that conducts due
diligence of target properties. They start by preparing initial due diligence reports that
are submitted to Premier’s investment committee. The summary page of one fund’s
report highlights the following sections:
I. Property survey
II. Physical/engineering inspection for structural issues
III. Zoning compliance regulations, parking ratios, etc.
IV. Cash flow statements for operating expenses and revenues”
49 Which of the funds listed in Exhibit 1 would most likely enable investors to
meet all three of the benefits?
A Timbrian Equity Partners
B Multifam Equity Partners
C Golden Age Equity Partners
C is correct. An investor in Golden Age Equity Partners would most likely enjoy all three
benefits. All three (Timbrian Equity, Multifam Equity, and Golden Age Equity) are diver-
sified geographically, and their returns should not be highly correlated with the equity
markets. Both Golden Age and Timbrian would generate income—Golden Age from
resident fees and Timbrian from the periodic sale of timber. Because trees grow over
time and become increasingly valuable (owing to the longer growing cycle before the
product is sellable), depreciation would not be a reason to invest. Multifam Equity inves-
tors would hope primarily to realize period capital gains from periodic sales expected
to occur within 14–24 months of each project initiation. Depreciation is not a primary
goal for Multifam Equity but is not impossible if properties do not sell. Only investors in
Golden Age, which intentionally owns properties subject to depreciation, could typically
pass those tax benefits on to investors and would explicitly seek all three benefits.
Private Real Estate Investments

LOS b
Sections 3.1, 3.2, and 4
50 Unexpected inflation and rising interest rates would have the greatest negative
short-term impact on the earnings of:
A Timbrian Equity Partners.
B Multifam Equity Partners.
C Golden Age Equity Partners.
B is correct. Multifam Equity Partners would likely see the greatest negative impact
from unexpected inflation because of rising ongoing construction costs, which would
reduce profit potential from property sales whose sale prices have already been agreed
upon. Rising interest rates would increase financing costs since Multifam Debt Partners’
financing is floating-rate debt. As a private investment, Golden Age Equity Partners
would probably not see its income affected as much by unexpected inflation or higher
interest rates because these property investments would be expected to have stable
cash flows and longer time horizons than those of Multifam Equity Partners. Timbrian
Partners could actually benefit from unexpected inflation since it would be in a position
to sell more timber at higher prices due to higher inflation.
A and C are incorrect.

LOS c
Section 4.1
51 Would data from Multifam Equity Partners be more useful than data from
Golden Age Equity Partners for the construction of a hedonic price index?
A Yes
B No, because Golden Age Equity Partners can more easily supply NOI data
C No, unless the data from Multifam Equity Partners were adjusted for the
appraisal lag
A is correct. A hedonic index is a transaction-based real estate index, which relies on

a single sale of a property as opposed to repeat sales of the same property. Multifam
Equity Partners will be selling multiple newly constructed apartment buildings and have
sales data for each transaction individually. It would not be contributing appraisal data,
because its activities consist of single sales of multiple newly built properties. Golden
Age Partners is engaged in building, but not selling, of properties. NOI is a component
of return in an appraisal-based index.
B and C are incorrect.

LOS k
Section 11.1 and 11.2
52 Which of Multifam Equity Partners’ properties listed in Exhibit 2 most likely

has the highest assumed growth rate?
A Multifam I
B Multifam II
C Multifam III
C is correct. Multifam III has the highest assumed growth rate. According to the dis-
counted cash flow method approach to valuation, the relationship between the discount
rate and the cap rate is
Capitalization rate = Discount rate – Growth rate.
The cap rate is defined as
Cap rate = NOI/Value,
where the NOI is usually based on what is expected during the current or first year
of ownership. Cap rates of the three properties are as follows:
(NOI × Number of units) ÷ Value
Multifam I: (25,000 × 90) ÷ 45,000,000 = 5.0%.
Multifam II: (30,000 × 100) ÷ 50,000,000 = 6.0%.
Multifam III: (20,000 × 120) ÷ 60,000,000 = 4.0%.
The discount rate is the required rate of return, and each property has a similar
expected rate of return. For any given discount rate, the growth rate will be
Discount rate – Cap rate = Growth rate.
Therefore, the property with the lowest cap rate has the highest assumed growth rate.

LOS f
Section 6.2
53 Which of Multifam Equity Partners’ properties listed in Exhibit 2 is most likely

permitted the highest maximum LTV on an interest-only loan?
A Multifam I
B Multifam II
C Multifam III
B is correct. Multifam II would have the highest permitted LTV. The relationship
between debt service, NOI, and the debt service coverage ratio is
DSCR = NOI/Debt service, or
Debt service = NOI/DSCR.
An interest-only loan has no principal payments, so the loan balance remains con-
stant over time. Debt service, as a percentage of market value, for the three properties
is as follows:
Multifam I: [(90 × 25,000) ÷ 1.30] ÷ 45,000,000 = 3.85%.
Multifam II: [(100 × 30,000) ÷ 1.40] ÷ 50,000,000 = 4.29%.
Multifam III: [(120 × 20,000) ÷ 1.50] ÷ 60,000,000 = 2.67%.
Multifam II has the highest permitted debt service as a percentage of market value
and, therefore, also has the highest permitted LTV.

LOS l, m
Section 12
54 Which fund’s due diligence report will least likely contain the listed sections
from the summary page?
A Timbrian Equity Partners
B Multifam Equity Partners
C Golden Age Equity Partners
A is correct. Due diligence for Timbrian Equity Partners would not emphasize structural
engineering issues or zoning compliance. Golden Age Equity Partners invests in and
operates facilities for senior living. Due diligence would include structural inspection,
compliance with local zoning ordinances, operating expenses (such as utilities), and
property taxes. These would not be necessary for Timbrian’s timberlands and would
be necessary only to a small extent for the new construction being done by Multifam
Equity Partners.

LOS j
Section 9
Hoskins Bank Corporation Case Scenario

Hoskins Bank Corporation (HB) is a US bank holding company with lines of business
in corporate banking, retail banking, capital markets, and private wealth management.
HB’s annual risk assessment meeting with its external regulator will be in 90 days.
In preparation for this meeting, Richard Hextall, CEO, and Alice Klink, chief risk
officer, are meeting with independent risk consultant David Donovan, a principal of
Donovan and MacNab Risk Advisory LLC.
Hextall asks Klink to review HB’s primary risk exposures. Klink begins by sug-
gesting that the liquidity gap is a primary risk exposure for retail banking, stating
that “with a 99% level of confidence, we expect our ratio of interest-earning assets to
interest-paying liabilities will range between 90% and 110%.” For corporate banking,
Klink believes that credit deterioration is a primary risk exposure and states that “over
any one-month period, there is a 1% probability of incurring a single-name loan loss
for an amount that is not greater than 0.55% of the loan portfolio.” Klink believes that
market risk is a primary risk exposure for capital markets, stating that “there is a 1%
chance of HB losing at least 1.30% of its Tier 1 capital over a one-day period.”
During last year’s review, the regulator expressed concern that HB did not have
an effective risk management process in place for its short- term, investment- grade
bond portfolio. Donovan asks about the bank’s progress in addressing this concern.
Hextall explains that HB has implemented a value at risk (VaR) approach and notes
that there are three distinct methods to estimate VaR. The parametric method assumes
that the distribution of returns on the risk factors is normal, and it is considered to
be a straightforward approach. The historical simulation method also relies on the
normal distribution assumption. The Monte Carlo simulation method relies on neither
a normal distribution nor past returns and, as a result, is able to accommodate bonds
that may contain embedded options.
Donovan cautions Hextall that VaR may not capture information related to large
losses, portfolio composition, and performance. He states that these limitations may
be addressed by variations, or extensions, to VaR. For example, CVaR captures the
potential loss if VaR is exceeded. IVaR measures ex ante tracking error. Relative VaR
is used to determine the effect on VaR from any changes in portfolio composition.
Recalling the financial c risis, H extall a sks K link a bout H B’s p otential e xposure
to any future adverse, extreme events. Klink replies that HB’s investment portfolio
currently holds short-duration, high-investment-grade bonds but does not hold any
equity securities or derivative instruments. Klink adds that the illiquidity conditions
that were prevalent during the financial crisis continue to exist, according to a reverse
stress test she conducted on 10 plausible independent risk factors.
Donovan transitions the discussion to the private wealth division by asking Hextall
to discuss the differences in risk measurement for banks in comparison to traditional
asset managers, such as HB’s private wealth division. Hextall states that risk measures
for banks typically consider liquidity, solvency, and capital sufficiency, whereas risk
measures for traditional asset managers typically are focused on investment perfor-
mance. Hextall provides an example, stating that “HB, for its private wealth clients,
calculates active share for each client and uses ex ante tracking error to measure the
degree to which clients’ current portfolios might underperform their benchmarks
in the future. For equity-only portfolios, forward-looking beta is used to measure
sensitivity to the broad equity market.”
Hextall asks Klink to review the constraints used in the context of measuring the
risk of the corporate banking division. Klink responds by stating that the corporate
banking division’s capital allocation is $2,800 million. This amount considers market
risk, credit risk, and operational risk for which the minimum required return is 11%.
Capital limits, position limits, and stop-loss limits are assigned to manage both overall
exposure and exposure to single-name event risk. The market risk management con-
straints for each of the corporate banking division’s lending groups are summarized
in Exhibit 1.
Exhibit 1 Market Risk Management Constraints for Corporate Banking

Lending Groups ($ millions)
Lending Group Return Capital Limit Position Limit Stop-Loss Limit
Secured 120 800 32 80

Cash Flow 120 1,200 24 60
Real Estate 120 1,000 10 70
55 Which of Klink’s statements regarding HB’s risk exposures is most likely correct
as it relates to value at risk?
A The statement about retail banking
B The statement about capital markets
C The statement about corporate banking
B is correct. Klink’s statement about the risk exposure in capital markets is correct in the
context of value at risk. The VaR statement contains each of these elements: (1) a minimum
loss (2) over a defined time period (3) with a stated probability. Klink’s statement about
capital markets correctly captures each of these elements: (1) Minimum loss is “1.30% of
Tier 1 capital”; (2) the defined time period is “over a one-day period”; and (3) the stated
probability is “our risk of losing . . . is 1%.”
A is incorrect. Klink’s statement about the risk exposure in retail banking is not correct
in the context of value at risk. There is no reference to a time period.
C is incorrect. Klink’s statement about the risk exposure in corporate banking is not
correct in the context of value at risk. The statement incorrectly references the single-
name loan loss as a maximum loss, not a minimum loss.
Measuring and Managing Market Risk

LOS a
Section 2.1
56 Which of Hextall’s explanations regarding the three distinct methods of VaR is

least likely correct?
A Historical
B Parametric
C Monte Carlo
A is correct. Hextall incorrectly explains the historical method by stating that it relies on
the assumption that the distribution of returns on the risk factors is a normal distribution.
The historical method is based on actual returns and, accordingly, is not constrained by
the assumption of a normal distribution.
B is incorrect. Hextall’s explanation about the parametric method is correct.
C is incorrect. Hextall’s explanation about the Monte Carlo simulation method is correct.

LOS b, c
Section 2.2
57 Donavan’s statement about extensions to VaR is most likely correct with respect
to:
A IVaR.
B CVaR.
C relative VaR.
B is correct. CVaR (conditional value at risk) answers the question, How much can I expect
to lose if VaR is exceeded? This measure is also referred to as “expected tail loss” and
“expected shortfall.” CVaR is best derived by using either the Monte Carlo or historical
methods, in which returns beyond the VaR cutoff may be averaged.
A is incorrect. IVaR (incremental value at risk) measures how changes in the portfolio’s
composition affect the portfolio’s VaR. Ex ante tracking error is measured by relative VaR.
C is incorrect. Relative VaR is a measure of the degree to which the performance of
the portfolio might deviate from its benchmark. Relative VaR is also referred to as “ex
ante tracking error.”

LOS e
Section 2.4
58 In replying to Hextall’s recollection of the financial crisis, Klink most likely con-
sidered which risk measure?
A VaR
B Scenario analysis
C Sensitivity analysis
B is correct. Scenario analysis is used for estimating how a portfolio might perform
under conditions of market stress. Scenario risk measures estimate the portfolio returns
that would result from a hypothetical change in markets. Stress tests and reverse stress
tests are closely related to scenario risk measures. In addressing the possibility of direct
exposure to extreme, negative events, Klink is describing a reverse stress test in which
specific exposures of the portfolio (10 in this example) are identified. A hypothetical stress
test (“reverse stress test”) is designed to measure its effect on each of these exposures.
A is incorrect. VaR is used to measure the probability of a large loss. One limitation
of VaR is its failure to take into account illiquidity.
C is incorrect. Sensitivity analysis is used to estimate how gains and losses in the
portfolio change with changes in the underlying risk factors. For a short-term invest-
ment portfolio consisting entirely of short-duration, high-credit-quality fixed-income
securities, there is likely little or no exposure to market sensitivity risk measures, such
as beta, duration, convexity, delta, and gamma.

LOS f, g, h
Section 3
59 Is Hextall’s statement regarding the private wealth division likely correct?

A Yes.
B No, it is incorrect about forward-looking beta.
C No, it is incorrect about ex ante tracking error.
A is correct. Hextall’s statement is correct. Risk measures for banks are typically focused
on liquidity, solvency, and capital sufficiency, whereas risk measures for traditional
asset managers are typically focused on investment performance. Ex ante tracking error
correctly compares the current portfolio with its benchmark in attempting to measure
future potential performance. Forward-looking beta is a current risk measure of a cur-
rent portfolio and measures an equity portfolio’s sensitivity to the broad equity market.
B is incorrect. Hextall’s statement about forward-looking beta is correct.
C is incorrect. Hextall’s statement about ex ante tracking error is correct.

LOS j
Section 4.1.2
60 With respect to capital allocation, which lending group listed in Exhibit 1 is

least likely attractive?
A Secured
B Cash Flow
C Real Estate
B is correct. From a capital allocation perspective, the Cash Flow lending group is least
attractive because its 10% rate of return is below the 11% minimum return (hurdle rate)
required for the corporate banking division. The hurdle rate is being used as a risk measure
since the $3,000 million aggregate amount of economic capital currently being consumed
by the three lending groups exceeds the $2,800 million regulatory amount established
for corporate banking. The rate of return is calculated as Portfolio return/Economic
capital. The calculation for the Cash Flow group is $120 million/$1,200 million = 10%.
A is incorrect. The Secured lending group is not least attractive, because its 15% rate
of return ($120 million/$800 million) exceeds the 11% hurdle rate.
C is incorrect. The Real Estate lending group is not least attractive, because its 12%
rate of return ($120 million/$1,000 million) exceeds the 11% hurdle rate.

LOS k, l
Section 4.1.1, 5, 5.5

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2019 Level II Mock Exam PM

Questions Topic Minutes

1–6 Ethical and Professional Standards 18

2019 LEVEL II MOCK EXAM PM

Jacob Kostecka Case Scenario

Guidance for Standards I–VII

2 By not acting on the information reported by Nathoo, which CFA Institute

Guidance for Standards I–VII

3 With regard to investing in Jabbertalk and recommending experts, Kostecka

Guidance for Standards I–VII

4 In relation to Kostecka’s handling of the Jabbertalk stock recommendation,

B is correct. Standard III(B)–Fair Dealing requires members and candidates to deal fairly

Guidance for Standards I–VII

B is correct. Statements overstating the competency of an individual or imply, either

Guidance for Standards I–VII

6 Kostecka’s performance presentation most likely conforms to CFA Institute

B is correct. Kostecka’s performance presentation of his firm’s composite performance

Guidance for Standards I–VII

Northside Capital Advisers Case Scenario

Recommendation 1: Conduct an initial review of the firm’s Policies and

Patrick believes he needs a better understanding of the investment process before

A is correct. Northside’s interest would be of least importance relative to capital markets

Guidance for Standards I–VII

8 Which of Patrick’s recommendations is most likely insufficient to comply with

A is correct. Recommendation 1 is insufficient to comply with Standard IV(C): Responsibilities

Guidance for Standards I–VII

9 To indicate the area of the investment research process he wants to address,

C is correct. Standard V(A): Diligence and Reasonable Basis recommends Patrick should

Guidance for Standards I–VII

10 Which of the following CFA Institute Standards of Professional Conduct has

Guidance for Standards I–VII

Guidance for Standards I–VII

12 Which of Northside’s current personal trading policies is least consistent

Guidance for Standards I–VII

Jorge Reyes Case Scenario

Exhibit 1 Regression Results: Rt = b0 + b1Et + εt

Constant (b0) 0.0011 0.0019

0.0987 0.0842 0.0153 2.3434 6.7927 0.0114

Exhibit 2 Plot of BOLSAA Residuals against the USD/MXN Exchange Rate

X = USD-MXN exchange rate

Interpreting the graph, Reyes states:

Exhibit 3 Durbin–Watson Test: Log-­Linear Model

Exhibit 4 Regression Results: xt+1 = b0 + b1xt + εt+1 where xt = ln(Pt+1) –

Constant (b0) 0.002381 0.002056 1.1582

Because nonstationarity or heteroskedasticity would negatively affect use of the

Exhibit 5 Unit Root Test for Nonstationarity and the Test

13 In the regression of the returns of BOLSAA.MX against the USD/MXN

B is correct. A two-­tailed t-test is appropriate to test whether the coefficient is signifi-

Correlation and Regression

14 Reyes's explanation regarding Adjusted R2 is best characterized as:

B incorrect, because adjusted R2 adjusts for the loss of degrees of freedom

Multiple Regression and Issues in Regression Analysis

15 Reyes's interpretation of the graph in Exhibit 2 is best described as:

A is correct. The presence of heteroskedasticity is indicated when there is a systematic

Multiple Regression and Issues in Regression Analysis

16 The Durbin–Watson test reported in Exhibit 3 is most accurately interpreted as

C is correct. Significantly large values of the Durbin–Watson statistic point to negative

Multiple Regression and Issues in Regression Analysis

17 Based on the regression results reported in Exhibit 4, the mean-­reverting level

C is correct. For an AR(1) model, xt+1 = b0 + b1xt + εt+1

Central Aldorria Case Scenario

Benez counters that if the government expects manufacturing to grow, a guaranteed

The Regulatory Solution

C is incorrect because regulatory arbitrage requires two different regulatory juris-

Exhibit 1 Regression Results: Rt = b0 + b1Et + εt

Exhibit 2 Plot of BOLSAA Residuals against the USD/MXN Exchange Rate

Exhibit 3 Durbin–Watson Test: Log-Linear Model

Exhibit 4 Regression Results: xt+1 = b0 + b1xt + εt+1 where xt = ln(Pt+1) –

Exhibit 5 Unit Root Test for Nonstationarity and the Test

B is correct. A two-tailed t-test is appropriate to test whether the coefficient is signifi-

17 Based on the regression results reported in Exhibit 4, the mean-reverting level

A is correct. The purpose of the government-appointed member is to prevent a major-

Exhibit 1 Coefficients for Beneish M-Score Variables

Exhibit 2 Post-Employment Benefit Assumptions Used by

Employee Compensation: Post-Employment and Share-Based

Employee Compensation: Post-Employment and Share-Based

C is correct. Risk-related note disclosures about pensions and post-employment ben-

Exhibit 1 Income Statement Excerpts, Years Ending 31 December ($

Exhibit 2 Selected Balance Sheet Data, Years Ending 31 December ($

Ratios are calculated using year-end values

C is correct. The H-model is

Exhibit 1 Bond Sensitivity Analysis to 40 bp Interest Rate Shifts

Harding subadvises a core-plus bond fund that allows for up to 5% of assets to

Exhibit 3 StorageTech Convertible Bond Data

Exhibit 1 Present Value Factors for Five-Year Swap