2019 All L2 Exam Questions

Last Updated: 06/03/2019
2019 Exam Prep
MarkMeldrum.com Mock Exams

Level II
Exam 1
AM Session: Questions
This document should be used in conjunction with the corresponding reading in the 2019 Level II CFA®
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Institute. Reproduced and republished with permission from CFA Institute. All rights reserved.
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Exam 1 AM Session Questions 2
Exam 1 Morning Session
Questions Topic Minutes
1-6 Ethical and Professional Standards Authored By: Bill Campbell III, CFA 18
7 - 12 Ethical and Professional Standards Authored By: Bill Campbell III, CFA 18
13 - 18 Economics Authored By: Mark Meldrum, Ph.D. 18
19 - 24 Financial Reporting and Analysis Authored By: Bill Campbell III, CFA 18
25 - 30 Corporate Finance Authored By: Bill Campbell III, CFA 18
31 - 36 Equity Valuation Authored By: Bill Campbell III, CFA 18
43 - 48 Fixed Income Authored By: Bill Campbell III, CFA 18
49 - 54 Derivatives Authored By: Mark Meldrum, Ph.D. 18
55 - 60 Portfolio Management Authored By: Bill Campbell III, CFA 18
Total: 180
*** Allocate an average of 3 minutes per question for a total of 180 minutes (3 hours). ***

ETHICAL AND PROFESSIONAL STANDARDS

Questions 1-6 (18 minutes)
Goolagong Financial (GF) is a nationwide financial advisory and asset management firm located in Sydney,
Australia. Tomi Rogic, CFA, is financial advisor at GF. One of his clients, Alfred Koulibaly, recently moved
from Sydney to Florence, and decided to get an Italian financial advisor, so he closed his account with Rogic.
After 3 months, Koulibaly e-mailed Rogic to let him know that he still hadn’t found a suitable advisor.
Through his CFA networking, Rogic knows an advisor in Florence, so he e-mails Koulibaly’s IPS and contact
information to that advisor and suggests that she contact Koulibaly immediately. She does so the next day,
and two weeks later, after she has a meeting with Koulibaly, he becomes her client.
Although Rogic is skilled in equity research, he is not skilled in fixed income. One of his clients has heard
about agency mortgage-backed securities (MBSs) and asks Rogic’s opinion on investing in them. Rogic tells
her that these are bonds, that he knows that the bondholder receives periodic interest payments and a
principal payment at maturity, and that because the bonds are backed by the government, they have very
low risk. He recommends that she add some to her portfolio.
TGY Pharmaceuticals has spent 8 years developing a new weight-loss drug that would likely see their annual
sales triple and which is nearing approval by the Australian government. Rogic just learned from a friend
who works at TGY that the clinical trials are about to be cut short because of a rare but crippling side effect
that was recently discovered but not yet made headlines. Although Rogic doesn’t own any TGY stock, many
of his clients do, so he quickly sends an e-mail to all of them to let them know of the side effect. By that
afternoon, 80% of Rogic’s clients who owned TGY common stock notified Rogic that they wanted it sold.
Rogic handles the portfolio for the defined benefit pension plan for Teller Corporation (TC). Rogic has met
with the plan sponsors from TC to determine an appropriate asset allocation for the plan. During the
meeting, Rogic lists the following objectives for the portfolio:
Objective 1: As there are a number of retired employees already receiving benefits, the portfolio should
contain a suitable amount of coupon-paying bonds and dividend-paying stocks to be able to
match the cash flows for those benefits.
Objective 2: As the plan is currently underfunded and TC management wants to reduce its future
contributions to the plan, the portfolio should include a suitable amount of high-yield bonds
and high-growth stocks to increase the return on assets above the discount rate for the
liabilities.
Objective 3: As the benefits will increase each year according to inflation, the portfolio should contain a
suitable amount of inflation-protected securities (such as Australian Capital Indexed Bonds) to
ensure that the cash flows will keep pace with the increased pension benefits.

Rogic is planning to leave his position at GF to start his own firm. Rogic knows that he cannot print out client
lists from his current employer and take with him nor can he download them to a thumb drive. So, during
his final two weeks he spends two hours each day memorizing the names, phone numbers and e-mail
addresses of 20 clients, then, upon leaving work for the day writes down the information.
Mercedes Rodríguez is an equity analyst at GF who has just finished a report on Culbertson Engineering (CE)
common stock, which she has posted on her blog for clients and prospective clients of GF. In the report
Rodríguez goes into considerable detail describing the major risks that could affect an investment in CE
(such as increased competition and currency exchange rate fluctuations) but explains that there are many
other risks that are, in her opinion, so minor that she does not believe that they warrant that level of detail:
these she summarizes in a list.

1. By passing along Koulibaly’s information to the Italian advisor is Rogic likely to have violated Standard
III(E) Preservation of Confidentiality?
A. Yes.
B. No, because Koulibaly’s e-mail to Rogic implied that he consented to having his information
forwarded to a suitable advisor.
C. No, because at the time Rogic sent the information to her, Koulibaly was no longer Rogic’s client, so
he has no duty to preserve confidentiality.
2. With regard to recommending agency MBSs to his client, Rogic has most likely:
A. not violated the Standards.
B. violated both Standard I(C) Misrepresentation and Standard I(D) Misconduct.
C. violated Standard I(C) Misrepresentation but not violated Standard I(D) Misconduct.
3. In the matter of TGY Pharmaceuticals, with regard to Standard II(A) Material Non-public Information,
Rogic has most likely:
A. violated the Standard.
B. not violated the Standard because he did not sell any TGY stock of his own.
C. not violated the Standard because he did not advise his clients to sell TGY stock.
4. If Rogic implements the three objectives listed for Teller Corporation, which one will most likely violate
CFA Institute Standards of Professional Conduct?
A. Objective 1
B. Objective 2
C. Objective 3
5. Are Rogic’s actions in preparation for leaving GF likely to violate Standard IV(A) Loyalty (to employers)?
A. Yes.
B. No, because lists of clients’ names and contact information are not considered confidential
information.
C. No, because he did not take physical copies of the information, and he wrote down the information
on his own time, not on the company’s time.

6. Are Rodríguez’s actions regarding the CE common stock report likely to have violated Standard V(B)
Communication with Clients and Prospective Clients?
A. No.
B. Yes, because Rodríguez should provide the same level of detailed analysis on every risk that affects
an investment in CE common stock.
C. Yes, because Rodríguez should not be communicating through a blog; she should be sending the
report to GF’s clients and prospective clients directly to ensure that they receive it.


(Original Question By: Bill Campbell III, CFA, has since been modified by Mark Meldrum, Ph.D.)
Nicolai Schöne, CFA, is an account manager at Verdandi Investment Services (VIS). Schöne has a client
whose portfolio had an exceptionally good return last year. To show their appreciation, the client has
offered Schöne a week’s vacation at their cabin at a local ski resort. Schöne e-mailed his supervisor about
the offer. Twenty minutes later his supervisor came into Schöne’s office to discuss a presentation that
Schöne was preparing for prospective clients. After the discussion, as he was walking out the door, the
supervisor turned to Schöne and said, “About that ski trip thing: sure, why not? Have fun, and don’t break a
leg.”
Later that day, Schöne was talking to Ramin Taremi, CFA, head of VIS’ equity analysis team, about the
vacation. Schöne told Taremi, “When you remember that your first duty is to your clients, this is how you
get rewarded. One week on the slopes for free! Woohoo!” Taremi replies that Schöne’s first duty is toward
his employer; “Remember, your supervisor had to give it the OK. If he had been upset with you, you’d be
spending a week sitting on your couch watching skiers on television.” Rosie Williams, CFA, an equity analyst
who just recently earned her CFA charter, overheard the conversation. As she walked by Schöne and
Taremi, she said, “You both have it wrong. Your first duty is not to your clients and it’s not to your
employer.” Then she left.
Schöne went back to his office to finish up the presentation that he had been discussing with his supervisor.
In presenting VIS’ historical performance, he has decided to eliminate all terminated accounts as they do not
represent current assets under management. With the severe time constraints on the presentation, he has
summarized the performance across broad asset classes instead of breaking them into composites of
similar accounts. He will make a more detailed breakdown available to anyone who requests it.
Although he has an analytics team at VIS to back him up, Schöne prefers to do much of his own research.
He follows the stocks of a number of publicly traded companies, updating his files with press releases, news
articles, and his own projections on their prices, at least quarterly, and often more frequently if there is
significant breaking news. For fixed income investments he recommends only option-free, investment-
grade government securities with at least an AA rating, and his analysis consists only of estimating their risk
and return effect on a portfolio via expected returns and correlations of returns.
Williams is extremely unhappy with the salary she earns as an equity analyst at VIS but does not want to
resign and lose the benefits (medical insurance and pension) that the company offers. Williams decides that
she would like to start an independent practice and discusses it with Taremi in his office. Taremi confers
with upper management and they laugh at the idea that Williams could compete with VIS, so they say, “Let
her try! This will be fun!” Taremi phones Williams to tell her the news. Within two weeks she gets her first
independent client, a foundation with a portfolio valued at 300 million Danish kroner (DKK 300 million,
about EUR 40 million).
Historically, VIS has used a bottom-up approach to equity analysis, but, at Taremi’s suggestion, has recently
transitioned to a hybrid top-down/bottom-up approach. Taremi writes the quarterly newsletter to VIS’
clients and prospective clients, having published the most recent one just before the transition. He plans to
include a description of the new approach, how it compares to VIS’ old approach, and the reasons behind
the change in his next newsletter.

7. If Schöne accepts the ski vacation, with regard to Standard I(B) Independence and Objectivity, he has
most likely:
A. not violated the Standard.
B. violated the Standard by not notifying his supervisor in writing.
C. violated the Standard by not obtaining written permission from his supervisor.
8. In the conversation amongst Williams, Taremi and Schöne, whose comment about a charter holder’s
foremost duty most likely conforms to the CFA Institute Standards of Professional Conduct?
A. Williams’
B. Taremi’s
C. Schöne’s
9. Concerning the presentation that Schöne is preparing for prospective clients, which of his actions most
likely violates the recommended procedures for Standard III(D) Performance Presentation?
A. Only elimination of terminated accounts.
B. Only summarizing performance across asset classes.
C. Both elimination of terminated accounts and summarizing performance across asset classes.
10. Do any of Schöne’s actions most likely violate Standard V(A) Diligence and Reasonable Basis with regard
to equities and fixed income?
Equities Fixed Income

A. No No
B. No Yes
C. Yes Yes
11. Are any of Williams’ actions with regard to independent practice likely to violate CFA Institute Standards
of Professional Conduct?
A. No.
B. Yes, because Williams must inform her employer in writing of her intent to engage in independent
practice.
C. Yes, because Williams must receive permission from her employer in writing before she may engage
in independent practice for compensation.

12. Have Taremi’s actions with regard to the change in equity analysis approach most likely complied with
Standard V(B) Communication with Clients and Prospective Clients?
A. No.
B. Yes, because VIS’ analysis methods are proprietary, so Taremi is not required to disclose them.
C. Yes, as long as Taremi follows his plan by explaining the change in the next quarterly newsletter.

ECONOMICS
Harriet McCreety is a currency strategist for a large Canadian bank. Harriet is training Tim Givers, a recent
CFA Level 3 candidate. Tim confides in Harriet that he needs more work on currency calculations and
theory. To assess what “more work” implies Harriet first lets Tim calculate all quotes required for the day.
The first task requires the bank to provide a cross quote for the EUR/GBP pair. Time checks the intermarket
rates for the USD/EUR and USD/GBP pairs and develops the output in Table 1.
Before the quote goes live on the bank’s trading desk, Harriet checks to see if there is an arbitrage
opportunity between the calculated cross quote, which will become the dealer quote for the bank, and the
intermarket cross quote.
Next Harriet needs to provide a 6-month forward rate to the sales desk related to the Veston account. Sales
had asked for a 6-month forward rate on the CAD/EUR pair earlier in the day. Harriet has Tim look up the
necessary interest rates for 4 currencies and the intermarket quotes for three pairs. Tim assembles the
information is Table 2. Harriet checks the information for accuracy and is satisfied that Tim has used the
correct risk-free rates. Harriet asks Tim to calculate the forward rate required for the sales desk.
Harriet feels it is time to test Tim on some economic theory related to currencies. She tells Tim that parity
conditions are important to forecasting currency directions. They show how expected inflation differentials,
interest rate differentials, forward rates, current spot rates and expected future spot rates are interrelated.
She asks Tim to tell her what he can recall about these parity conditions. Tim states:
Statement 1: International parity conditions rarely hold in the medium to long-term
Statement 2: Forward rates are a poor predictor of future spot rates
Statement 3: UIRP holds only if there is a forward market

Harriet pushes Tim more on UIRP. She asks: “If a client held a USD money market security for 1-year, and if
UIRP held, what would be the CAD return at the end of the holding period?”
Finally, Harriet presents Tim with 3 conclusions based on parity conditions and asks which one is incorrect.
Conclusion 1: The interest rate differential between a price and a base currency is equal to the expected
percentage change in the spot exchange rate. Therefore, under UIRP, the country with the
higher interest rate should see its currency appreciate.
Conclusion 2: The expected inflation differential between a price and a base currency is equal to the
expected percentage change in the spot exchange rate. Therefore, the currency of the high
inflation country should depreciate relative to the currency of the low inflation country.
Conclusion 3: The Fisher effect combines conclusions from UIRP and ex ante PPP to conclude that if both
held, real interest rates across all countries would be equal.

13. Based on the currency quotes in Table 1, if the bank’s dealer desk used the quotes given by Tim, is there
a triangular arbitrage opportunity and if so, how would it be exploited?
A. No
B. Yes, buy GBP in the intermarket, sell to the bank’s dealer desk
C. Yes, buy GBP from the bank’s dealer desk, sell in the intermarket
14. Calculate the CAD/EUR forward rate for the Veston account.
A. 1.5810
B. 1.6095
C. 1.6238
15. Based on the information in Table 2, on which pair would the forward rate be at a discount to the spot
rate?
A. CAD/USD
B. GBP/EUR
C. EUR/USD
16. Which of Tim’s statements regarding parity conditions is inaccurate?

A. Statement 1
B. Statement 2
C. Statement 3
17. Based on the information in Table 2, Tim’s answer to Harriet regarding the CAD return on the 1-year
USD money market security would be:
A. -0.5%
B. 1.75%
C. 2.25%
18. Which conclusion presented to Tim is incorrect?

A. Conclusion 1
B. Conclusion 2
C. Conclusion 3

FINANCIAL REPORTING AND ANALYSIS

Gordon & Sons (G&S) is a manufacturing firm located in the United States. They report under US GAAP. On
January 2, 2018, G&S purchased USD 2,000,000 par of Sampson Industries 5-year, annual pay, 4% coupon
bonds for USD 1,871,891, with a yield to maturity (YTM) of 5.5%. G&S has designated these bonds as held-
to-maturity. On 12/31/19 these bonds had a fair market value of USD 1,908,444, reflecting a YTM of 5.3%.
G&S has several other investments in securities, details of which are included in Exhibit 1 (USD):
Exhibit 1
G&S Investments in Securities
Selected Data as of 12/31/18
Date of Market Carrying
Security Designation
Purchase Value Value*
FQH common stock 5/17/2018 Available for Sale 85,717 84,018
JNM bonds 9/15/2016 Held for Trading 406,227 425,181
US Treasury notes 1/23/2014 Designated at Fair Value 202,914 192,442
*As of date of purchase or 12/31/17, whichever is more recent
During 2018, the FQH common stock paid USD 3,500 in dividends, the JNM bonds paid USD 20,000 in
interest, and the T-notes paid USD 6,250 in interest on a par value of USD 200,000. G&S had considered
designating the T-notes as held-to-maturity but decided that designated-at-fair-value was more appropriate.
On 12/6/18, G&S purchased 25% ownership of Schroth Metals, which supplies G&S with some of the raw
material used in its manufacturing. With that purchase, G&S gained significant influence over Schroth,
though it does not have control of Schroth. Schroth’s balance sheet as of the purchase date is shown in
Exhibit 2, and its 2018 income statement is shown in Exhibit 3:
Exhibit 2
Schroth Metals
Balance Sheet, 12/6/18
Assets Liabilities
Cash $5,000,000 Accounts Payable $12,000,000
Short-Term Investments 7,000,000 Wages Payable 3,000,000
Accounts Receivable 12,000,000 Bonds Payable 20,000,000
Inventory 24,000,000 Mortgage Payable 16,000,000
Prepaid Insurance, Rent 4,000,000 Total Liabilities $51,000,000
Long-Term Investments 15,000,000
Land 20,000,000
PP&E, Gross $35,000,000 Equity
Less: Accumulated Depreciation (5,000,000) Common Stock $30,000,000
PP&E, Net 30,000,000 Retained Earnings 47,000,000
Patents 11,000,000 Total Equity $77,000,000
Total Assets $128,000,000 Total Liabilities and Equity $128,000,000

Exhibit 3
Schroth Metals
Income Statement, Year Ended 12/31/18
Revenue
Sales $120,000,000
Total Revenue $120,000,000
Expenses
COGS $84,000,000
SG&A 22,000,000
Depreciation 4,000,000
Interest 1,800,000
Total Expenses $111,800,000
Earnings before Taxes $8,200,000

Income Taxes 2,460,000
Net Income $5,740,000
G&S paid USD 22 million for its share of Schroth, with the excess over book value attributable to the value of
Schroth’s investment in land. Schroth depreciates its depreciable long-term assets straight-line over a 10-
year life with zero salvage value.
On 12/27/18, Schroth paid a dividend of USD 960,000 to its shareholders. At that time, the market value of
G&S’s shares of Schroth was USD 22,485,000.

19. On their 12/31/18 income statement, G&S should include interest income from the Sampson Industries
bonds that is closest to:
A. USD 98,627
B. USD 102,954
C. USD 116,553
20. On G&S’s 12/31/18 financial statements, the amounts shown on the income statement and in Other
Comprehensive Income (OCI), respectively, for the FQH common stock will be closest to:
Income Statement OCI

A. USD 1,699 USD 3,500
B. USD 3,500 USD 1,699
C. USD 5,199 USD 0
21. On G&S’s 12/31/18 financial statements, the amounts shown on the income statement and in Other
Comprehensive Income (OCI), respectively, for the JNM bonds will be closest to:
Income Statement OCI

A. USD 20,000 USD -18,954
B. USD 1,046 USD 0
C. USD 0 USD 1,046
22. If G&S had designated the T-notes as held-to-maturity (HTM), how would the amount they would have
shown on their 12/31/18 income statement most likely compare to the amount actually shown? The
amount under HTM would have been:
A. Lower
B. Higher
C. The same
23. To account for the investment in Schroth Metals, G&S will most likely show on its 2018 income
statement:
A. Dividend Income
B. Income from Affiliate
C. Consolidated revenue and expenses, and Minority Interest

24. The value of the investment in Schroth Metals that G&S will report on its 12/31/18 balance sheet is
closest to:
A. USD 22,485,000
B. USD 22,920,000
C. USD 23,195,000

CORPORATE FINANCE
Jacinta Santamaría is the CFO of Carmona & Molina Manufacturing (CMM). CMM is considering replacing
some of its heavy machine tools with newer, more efficient models. Santamaría wants to see a net present
value (NPV) analysis on the project before deciding whether to undertake it. If the NPV analysis suggests
that CMM should not undertake the project now, Santamaría is content to wait a year and redo the analysis.
CMM’s comptroller has assembled the relevant data in Exhibit 1:
Exhibit 1
Heavy Machine Tool Replacement Project
Selected Data (EUR 1,000s)
Existing New
Book value 35,000 129,000
Working capital investment n/a 10,000
Market value 24,000 n/a
Salvage value 15,000 33,000
Annual cash operating expenses 6,000 4,000
Annual sales 9,000 22,000
Useful life 4 years 12 years
Depreciation method Straight-line Straight-line
The book value of the new machine tools is their cost. CMM’s marginal tax rate is 25% and their required
rate of return on this project is 8%. CMM always expects to sell its fully depreciated machine tools for their
salvage value. Santamaría is also interested in the effect of using double-declining balance (DDB)
depreciation on the NPV of the new project.
Santamaría is also concerned about how her staff has assessed the stand-alone risk of this project. The
comptroller tells her that they started with the data shown in Exhibit 1 and calculated the project’s NPV.
Then, one-by-one, they made changes (typically 1%) to the input values – working capital investment,
salvage value, each year’s cash operating expenses, each year’s sales, and so on – and determined the effect
that each change had on the NPV. They ranked the inputs by the ratio of the percent change in NPV to the
percent change in the input value, from highest to lowest. Those variables that led to the highest percent
change in NPV they checked and rechecked to satisfy themselves fully that they had good numbers; those
that led to the lowest percent change in NPV were subjected to less scrutiny. In the end, they were satisfied
that they had done the best job possible in estimating the variables that will affect the project’s NPV.
Santamaría is curious about how the comptroller decided on the required rate of return for this project, so
she asks him to show her his calculations. He told her that he used market risk methods and compiled the
data he used in Exhibit 2. After computing the required rate of return, he rounded it off to 8%.

Exhibit 2
Required Rate of Return
Selected Data
Risk-free rate 2.05%
CMM beta 1.15
Asset beta 1.27
Expected market risk premium 4.85%
YTM on CMM long-term bonds 5.85%
Equity risk premium 1.93%
CMM decides to replace the heavy machinery despite the fact that the incremental NPV is negative, because
they believe that delaying the replacement will be costlier (they anticipate a price increase on the new
machinery). One year later, Santamaría wants an accounting of the performance of the new project, so her
new comptroller compiles relevant data in Exhibit 3:
Exhibit 3
First Year Results
Selected Data
Fixed capital investment EUR 129,000
Working capital investment 10,000
Original project NPV 21,635
Ending market value of investment 129,096
Sales 22,842
Variable cash expenses 3,135
Fixed cash expenses 502
Depreciation 8,000
Interest expense 116
Taxes 2,176
CMM has some lighter machinery that it needs to replace. Two alternative replacements are available, and
Santamaría must decide which to select. Exhibit 4 contains the relevant data on these alternatives:
Exhibit 4
Light Machine Replacement Alternatives
Selected Data
Machine 1 Machine 2
Cost EUR 280,000 EUR 250,000
Useful life 4 years 3 years
After-tax cash flows:
Year 1 150,000 140,000
Year 2 110,000 100,000
Year 3 70,000 80,000
Year 4 30,000 n/a
CMM requires an 8% rate of return on this project as well.

25. The most likely real option that CMM has with regard to the heavy machine tool replacement project is a:
A. Timing option
B. Price-setting option
C. Fundamental option
26. Given the data in Exhibit 1, the year 1 incremental cash flow for the heavy machine tool replacement
project is closest to, and the effect on NPV of switching to DDB depreciation is most likely, respectively:
Year 1 Incremental CF Effect of DDB on NPV

A. EUR 9,000 Decrease
B. EUR 9,000 Increase
C. EUR 12,000 Increase
27. The method that the comptroller used to assess the stand-alone risk of the heavy machinery
replacement project is best described as:
A. Scenario analysis
B. Sensitivity analysis
C. Monte Carlo simulation
28. Using the data in Exhibit 2, the comptroller’s calculation of the required rate of return for the heavy
machinery replacement project is closest to:
A. 7.63%
B. 7.78%
C. 8.21%
29. Given the information in Exhibit 3, the replacement project’s first year accounting income and economic
income, respectively, are closest to:
Accounting Income Economic Income

A. EUR 8,900 EUR −14,500
B. EUR 8,900 EUR 7,000
C. EUR 30,500 EUR 7,000

30. Given the data in Exhibit 4, the equivalent annual annuity (EAA) for machine 1 is closest to, and the
machine that Santamaría should select is most likely, respectively:
Machine 1 EAA Machine to Select

A. EUR 9,300 Machine 2
B. EUR 12,000 Machine 1
C. EUR 12,000 Machine 2

EQUITY VALUATION
Andrei Gabulov is an equity analyst at Odessa Partners (OP). He has been studying equity value for quite a
long time and has formulated some ideas on how value is created, determined, and perceived. In Exhibit 1
Gabulov has listed several companies whose stock he has valued, along with their market prices.
Exhibit 1
Equity Pricing per Share (RUB*)
OP vs. Market
Company OP’s Estimate of Stock Value Market Price of Stock
Gdansk Manufacturing, GM 1,276 1,223
Bylinkin Industries, BI 2,015 2,077
Petrov & Yakushin, P&Y 502 647
Troika Group 1,815 2,184
*
RUB = Russian ruble; RUB 1.00 ≈ EUR 0.0135
Although the value is not observable, the intrinsic (true) value of GM common stock is RUB 1,304 per share.
In arriving at his estimate of the value of GM, Gabulov analyzed both the existing rivalry in GM’s industry and
whether that rivalry could change significantly based on the possibility of new companies entering the
industry. He also analyzed GM’s bargaining power with both its suppliers and its customers. He then
turned to GM’s financial statements and determined that he would have to make substantial adjustments
before he could start projecting pro forma statements to use in a free cash flow to equity (FCFE) valuation
model.
Although Gabulov has estimated the value of BI stock as RUB 2,017 per share (based on price-to-earnings
and price-to-book-value ratios from BI’s industry), he knows that OP’s management is willing to pay up to
the market price of RUB 2,077 for a controlling interest in BI shares (and perhaps a premium beyond that),
because of the synergies that they believe would accrue between a BI investment and another company in
which they own a controlling interest.
Over the last year, the market price of P&Y’s common stock has declined from RUB 3,759 to RUB 647,
primarily because P&Y has been experiencing severe financial distress recently and is likely to declare
bankruptcy. The primary explanation for the difference between Gabulov’s estimate of the stock price and
the market’s price on the stock is that he disagrees with the market about the amount of time that can be
taken to liquidate P&Y’s remaining inventory.
The Troika Group began as a small machine tool manufacturing company, Minsk Manufacturing. When
Minsk acquired an agricultural supply company and a pharmaceutical firm, it became Troika. Since then, it
has grown primarily through acquisition to include divisions and subsidiaries in industries ranging from
consumer durable goods to automotive parts, from software development to industrial security, and from
tax accounting services to government infrastructure contracting. When Gabulov was estimating the value
of Troika common stock, he valued each division and subsidiary separately, but ultimately settled on a value
that is less than the aggregation of all of the values for the individual divisions and subsidiaries.

31. The true mispricing of GM common stock is closest to:

A. RUB −28
B. RUB 53
C. RUB 81
32. The analyses that Gaboluv did to arrive at his estimate of GM’s value are best described as:
A. Industry analysis and sensitivity analysis
B. Sensitivity analysis and competitive analysis
C. Quality of earnings analysis and industry analysis
33. The approaches that Gabulov uses to value Gdansk Manufacturing and Bylinkin Industries, respectively,
are best classified as:
Gdansk Manufacturing Bylinkin Industries

A. Absolute valuation Absolute valuation
B. Absolute valuation Relative valuation
C. Relative valuation Absolute valuation
34. The share price that OP’s management is willing to pay for BI common stock is most likely an example of:
A. Fair value
B. Investment value
C. Fair market value
35. The difference between Gabulov’s estimate of the time to liquidate P&Y’s inventory and the market’s
estimate of that time most likely:
A. Is that Gabulov believes that the liquidation will happen more quickly than the market believes
B. Is that Gabulov believes that the liquidation will happen more slowly than the market believes
C. Cannot be determined from the information given
36. Gabulov’s approach to valuing Troika is best described as:

A. Relative value with a conglomerate premium
B. Absolute value with a conglomerate discount
C. Sum-of-the-parts with a conglomerate discount

EQUITY VALUATION
Tyrolean Pharmaceuticals (TP) is a small, relatively new research company primarily focused on drugs for
mental disorders. Gödel & Alt Equity Analysts (G&A) have been hired by a large Austrian bank to determine
the value of TP; the bank is considering making a sizable loan to TP, and the valuation will greatly influence
their decision. G&A has assigned Sandro Kean to head the valuation team. Two of Kean’s team members,
Joan Draxler and Román Baloy, are discussing the approach they will use to value TP. During the course of
their discussion, they make the following comments:
Draxler: Once the loan is made, TP’s capital structure will change dramatically from its current structure,
and the possible equity investment that they’ve been discussing will change it once again. Under
those circumstances, a free cash flow to the firm (FCFF) approach makes more sense than using
free cash flow to equity (FCFE).
Baloy: The advantage of FCFE is that it’s a one-step process: value the equity. With FCFF we first have to
value the entire company – liabilities plus equity – then subtract the book value of the liabilities to
get the value of equity. The extra steps simply introduce more potential for errors.
Draxler and Baloy discuss with the youngest member of Kean’s team, David Busquets, how to adjust net
income and EBIT to arrive at FCFF and FCFE. Busquets makes the following statements:
Statement 1: To calculate FCFF starting with net income, you add interest, add noncash charges net of
income taxes, and subtract off both investment in working capital and investment in fixed
capital.
Statement 2: To calculate FCFE starting with EBIT, the first step is to multiply EBIT by (1 − marginal tax
rate), then add interest net of taxes, add noncash charges times the marginal tax rate,
subtract off both investment in working capital and investment in fixed capital, and add net
borrowing.
Draxler and Baloy also ask Busquets about using either net income or EBITDA as a proxy for free cash flow.
Busquets replies:
Statement 3: Net income is a poor proxy for both FCFF and FCFE. As a post-leverage amount, it is
definitely a better proxy for FCFE than for FCFF, but it still requires substantial adjustments.
Statement 4: EBITDA is a poor proxy for both FCFF and FCFE. As a pre-leverage amount is it is definitely a
better proxy for FCFF than for FCFE, but it still requires substantial adjustments.

Kean’s team has amassed information to compute TP’s FCFE for 2019 and 2020, shown in Exhibit 1:
Exhibit 1
Tyrolean Pharmaceuticals
Selected Financial Projections (EUR millions)
2019 2020
EBITDA --- 49,600,000
Depreciation 8,200,000 14,000,000
Amortization 1,300,000 1,300,000
Interest 4,600,000 7,900,000
Average tax rate 28% 26%
Marginal tax rate 30% 30%
WCInv 5,600,000 4,800,000
FCInv 57,600,000 43,200,000
Net borrowing 48,900,000 37,800,000
CFO 24,200,000 ---
Kean decides that the team will use a FCFE approach to value TP’s equity. He believes that over the next five
years TP’s FCFE will grow at a higher than average (and higher than is sustainable) rate, which will then
decline to a sustainable growth rate consistent with the industry. Consequently, the team estimates the
elements of FCFE in detail for the next 5 years but plans to incorporate a terminal value for TP after that.
They have put together data for determining the terminal value in Exhibit 2:
Exhibit 2
Tyrolean Pharmaceuticals
Estimated Terminal Value Parameters
rCE 8.20%
g 2.10%
WACC 5.94%
P/FCFE 15.5
Kean has to determine whether to use a constant growth rate approach or a price multiple approach for the
terminal value.
As TP is clearly in the growth sTPe, their management is not considering paying dividends or repurchasing
shares, but they have considered a secondary stock offering to raise additional capital. Draxler and Baloy
ask Busquets what he thinks would happen to TP’s FCFF and FCFE if it issued new stock. Busquets replies:
Comment 1: Issuing stock will not affect FCFF directly. However, to the extent that the funds raised are
used for investments in working capital or fixed capital that would not have been made
without the stock issue, it will reduce FCFF indirectly.
Comment 2: Just as issuing new debt increases FCFE, issuing new stock increases FCFE directly. But, as in
the case of FCFF, if the proceeds from the stock issue are used for investments in working
capital or fixed capital, it will reduce FCFE. Ultimately, FCFE might remain unchanged or
increase by less than the proceeds from the stock issue.

37. Considering the comments made by Draxler and Baloy, it is most likely the case that:
A. Both comments are accurate
B. Baloy’s comment is accurate, but Draxler’s comment is inaccurate
C. Draxler’s comment is accurate, but Baloy’s comment is inaccurate
38. Concerning Busquets’ statements about how to calculate FCFF and FCFE (Statements 1 & 2) it is most
likely the case that:
A. Both statements are true
B. Both statements are false
C. One statement is true and the other is false
39. Concerning Busquets’ statements about using net income and EBITDA as proxies for free cash flow
(Statements 3 & 4), it is most likely the case that:
40. Based on the information in Exhibit 1, TP’s estimated FCFE in 2019 and 2020, respectively, are closest to:
2019 2020
A. EUR −30,180,000 EUR −8,690,000
B. EUR 15,500,000 EUR 23,580,000
C. EUR 16,080,000 EUR 23,936,000
41. Based on the data in Exhibit 2, compared to the terminal value using the constant growth rate, the
terminal value using the price multiple will most likely be:
A. Lower
B. Higher
C. The same
42. Considering the comments made by Busquets about TP issuing new stock and its effect on FCFF and
FCFE, it is most likely the case that:
B. Both comments are inaccurate
C. One comment is accurate and the other is inaccurate

FIXED INCOME
Ivona Rebić and Rafał Cionek are fixed income analysts with Lopes & Torre (L&T). While discussing bond
investments, Rebić and Cionek make these statements:
Rebić: If you’re going to buy risk-free bonds, the maturity you choose doesn’t matter as much as your
holding period. You’ll get the same return holding a 4-year bond to maturity as you would holding
a 10-year bond for 4 years.
Cionek: Fixed income investors generally have maturities that they like, but they can be induced to buy
bonds of shorter or longer maturities if they’re offered enough incentive: additional yield.
Rebić is somewhat familiar with binomial interest rate trees and has created a binomial interest-rate tree to
value risk-free, annual-pay bonds, shown in Exhibit 1:
Exhibit 1
Binomial Interest Rate Tree
Rebić wants to use this tree to value Bond A: a 3-year, risk-free, option-free, annual-pay, EUR 1,000 par bond
with a 4% coupon. She also wants to compute the effective duration and effective convexity of this bond,
using ±50 bp as the change in yield, but she isn’t quite sure how to incorporate the yield change into the
tree. Cionek explains to her that she needs to add the change in yield to the underlying spot curve,
recompute the forward rates, then calibrate the new tree based on those new forward rates.

Using the tree in Exhibit 1 and correctly incorporating a ±50 bp change in yield, Rebić has priced another
bond, Bond B, with results shown in Exhibit 2:
Exhibit 2
Bond B Valuation
Yield Change Bond B Value
−50 bp EUR 994.77
0 bp EUR 985.21
+50 bp EUR 975.79
Rebić then considers two floating-rate bonds: Bond C and Bond D. Bond C has no cap and no floor and is
priced at EUR 1,005.22. Bond D has both a cap and a floor but is otherwise identical to Bond C and is priced
at EUR 1,003.17.
Rebić next uses the tree to calculate the OAS on Bond E, an option-free corporate bond. She calculated the
OAS as 121.3 bp. She then calculated the OAS on Bond F, a callable corporate bond that is otherwise
identical to Bond E. Her calculated OAS was 147.6 bp.

43. Based on the statements made by Rebić and Cionek, the most likely yield curve term structure theories
that they believe are, respectively:
Rebić Cionek
A. Pure expectations Preferred habitat
B. Liquidity preference Preferred habitat
C. Liquidity preference Segmented markets
44. Using the binomial tree in Exhibit 1, the value of Bond A is closest to:
A. EUR 1,003
B. EUR 1,007
C. EUR 1,011
45. The explanation that Cionek gives to Rebić about adjusting the tree to compute effective duration and
effective convexity is most likely:
A. Correct
B. Incorrect because the yield change is added to the par curve, not added to the spot curve
C. Incorrect because after adding the yield to the spot curve and recomputing the forward rates, the
tree will already be calibrated because the calibration was already done on the base tree
46. Using the information in Exhibit 2, the effective duration of Bond B is closest to:
A. 1.0 years
B. 1.4 years
C. 1.9 years
47. The relationship of the value of the cap to the value of the floor embedded in Bond D most likely:
A. Cannot be determined from the information given
B. Is that the value of the cap is less than the value of the floor
C. Is that the value of the cap is greater than the value of the floor
48. Assuming that Bond F is fairly priced, the price of Bond E most likely:
A. Is too low
B. Is too high
C. Cannot be determined from only the information given

DERIVATIVES
Jarry O’Reilly, CFA is an asset manager with responsibility for two portfolios. The first is a balanced fund of
bonds and equities with rather restrictive constraints on allowable strategies. The second is an active equity
fund with a wide latitude of discretion as to allowable securities and strategies. Jarry manages the active
fund’s risk and return in such a way as to maximize his Sharpe ratio.
Balanced Fund:
The balanced fund is a CAD 100 million portfolio of CAD 50 million in bonds with a duration of 6.4 and CAD
50 million in equities with a beta of 1.2. Anticipating two interest rate hikes from the Bank of Canada over
the next two quarters along with an expectation of strong equity market performance, Jarry would like to
reduce the portfolio’s interest rate risk exposure and increase its market risk exposure. However, the IPS
restricts him from portfolio turnover in excess of 12% per year. Jarry would like to reach his new risk
objectives without using any of his turnover capacity. Jarry is permitted to use fixed-for-floating interest rate
swaps, interest rate and equity futures and equity swaps.
Active Equity Fund:

Jarry manages a CAD 250 million active equity portfolio. Jarry has positioned the holdings in the fund to be
either underweight, equal weight or overweight those in his benchmark index. To increase his Sharpe ratio
for the year, in the final quarter he would like to reduce portfolio volatility by using a variant of a collar.
Rather than collar a single stock, he will sell calls on some stocks and use the proceeds from those sales to
buy puts on others within the portfolio. This will result in zero cost so as not to hurt his return. Jarry will
close out all in-the-money options just before expiration so as not to incur any portfolio turnover.
As an example of the variant collar strategy, Jarry has bought a put on a stock with ticker ABC and sold a call
on a stock with ticker XZY. Information about both stocks is in Table 1.
Table 1:
ABC XYZ
S0 = 42.10 S0 = 67.80
X = 40.00 X = 70.00
St = 43.60 St = 69.10
p = 1.05 c = 1.04
Jarry works with Andre Hocke, a junior asset manager. Andre presents Jarry with an alternative to buying
puts. Andre uses one of Jarry’s recent trades as an example. On a long position of 500 shares of a non-
dividend paying stock, 5 exchange-traded, at-the-money, CAD 75 puts were purchased (exchanged-traded
options are for 100 shares each) at a cost of CAD 1.68 per share. Each option has a delta of 0.5. Rather than
paying for puts, Andre recommends selling 250 shares forward with a forward price of CAD 76.88 (rf =
2.25%). The net result in terms of deltas will be the same. If you sell 5 puts on 500 shares, you are long 500
deltas and short 500 x 0.5 = 250 deltas for a net long position of 250 deltas. But it costs money to get that
done. The forward contract is free to enter, and the position would still be net long 250 deltas. Jarry points
out that one of those strategies has a lower maximum loss.

As the last decision to be made today, Jarry is holding a stock that is expected to report earnings after the
close. This stock tends to move 8.4% on average on earnings results. Jarry is not sure on the direction of
the move and also does not believe it will be as high as 8.4%. Jarry is considering selling the 80 calls and 70
puts. Information regarding calls and puts at various strikes are given in Table 2. Jarry notes that the CAD
75 put option has 54 cents of intrinsic value.

49. To reach Jarry’s new risk objectives with respect to the bond/equity portfolio, he should:
A. enter into a receive-fixed interest rate swap and buy equity futures
B. sell interest rate futures, enter into a receive-fixed/pay-equity swap
C. Enter into a receive floating interest rate swap and a receive-equity/pay-floating swap
50. To achieve Jarry’s goal of lowering portfolio volatility in the active equity portfolio, Jarry’s best course of
action would be to:
A. Sell calls and buy puts on equal-weight positions.
B. Sell calls on overweight positions and buy puts on underweight positions.
C. Sell calls on underweight positions and buy puts on overweight positions.
51. Based on the information in Table 1, the maximum loss on the combined positions of ABC and XYZ is:
A. CAD -0.01
B. CAD -4.31
C. CAD – 69.91
52. With respect to Andre’s suggestion of using forwards instead of options, which is a correct statement?
A. The maximum loss on the options is CAD 18,750 less than using forwards
B. The maximum loss on the forward strategy is CAD 17,440 more than the maximum loss on put
strategy
C. The maximum loss on the put strategy is greater than the loss on the forward strategy by the cost of
the puts
53. If the stock with expected earnings realizes a price move consistent with its average, then the highest
paying strategy would be:
A. the 75 straddle
B. the 75 – 80 Bull spread
C. the 75 – 70 Bear spread
54. Jarry’s gain and loss if he is wrong on his assessment of the magnitude of the price move would be:
Gain Loss
A. CAD 1.05 CAD 0.03
B. CAD 1.76 CAD 6.25
C. CAD 1.76 CAD 4.49

PORTFOLIO MANAGEMENT
Dejan Jedvaj is the head of the risk management team at Mangrove Investment Company (MIT). MIT
employs a number of risk measures for its investment portfolios, including value at risk (VaR). As VaR is a
new idea to MIT’s management, Jedvaj has had to explain it to them and give them examples, such as “Client
1’s portfolio has a one-month, 5% VaR of HRK* 75 million” (*HRK = Croatian kuna; HRK 75 million ≈ EUR 10
million).
Jedvaj asks MIT’s management to interpret this statement, and gets these replies from three of the
managers:
Manager 1: There’s a five percent chance that Client 1’s portfolio will lose HRK 75 million or more in value
over the course of one month.
Manager 2: Ninety-five percent of the time that Client 1’s portfolio loses money in a given month, the loss
will be less than HRK 75 million.
Manager 3: In a given month, there’s a five percent chance that the ending value of Client 1’s portfolio will
be less than the beginning value less HRK 75 million, ignoring contributions and withdrawals.
For another portfolio, currently valued at HRK 800 million, Jedvaj ran a Monte Carlo simulation on its returns
and summarized the results in Exhibit 1:
Exhibit 1
Monte Carlo Simulation of 100 Monthly Returns
Client 2’s Portfolio
Selected Results
Lowest Returns Highest Returns
1 −9.99% 1 7.51%
2 −6.10% 2 6.24%
3 −5.27% 3 6.16%
4 −4.13% 4 6.11%
5 −4.02% 5 6.11%
6 −3.51% 6 5.91%
7 −3.40% 7 5.80%
8 −3.17% 8 5.77%
9 −3.05% 9 5.47%
10 −3.03% 10 5.41%
Based on these simulation results, Jedvaj estimated that the mean monthly return on Client 2’s portfolio
would be +0.83% with a standard deviation of returns of 1.18%.

With MIT managing portfolios comprised of equity, fixed income, and derivatives, Jedvaj has had to
incorporate a number of asset-specific risk measures into his risk management models. In describing these
models to MIT’s management, Jedvaj made the following statements:
Statement 1: Beta is a first-order measure of the sensitivity of a stock’s price to changes in the market’s
price. If the market is expected to be volatile, we can decrease our portfolios’ betas to
reduce their volatility.
Statement 2: Modified (or effective) duration is a first-order measure of the sensitivity of a bond’s relative
price to changes in its yield to maturity (YTM) and modified (or effective) convexity is a
second-order measure of the same sensitivity. If interest rates are expected to be volatile,
we can decrease our portfolios’ durations to reduce their volatility.
Statement 3: Delta is a first-order measure of the sensitivity of an option’s price to a change in the price of
the underlying, and gamma is a second-order measure of the same sensitivity. If the price of
the underlying is expected to be volatile, we can decrease our portfolios’ delta to reduce
their volatility.
One of Jedvaj’s responsibilities is to determine the situations or exposures to which MIT’s portfolios are
most vulnerable. He needs to answer questions such as:
1. What are the most critical risk drivers for each portfolio?
2. Under what circumstances will our risk hedges be least effective?
3. What combination of macroeconomic factors will lead to the greatest losses in each portfolio?
MIT has a number of institutional clients, including Client 3, a defined benefit pension plan, and Client 4, a
property and casualty insurance company. In Exhibit 2, Jedvaj has identified a number of risk measures that
MIT uses, which might be applicable to these clients.
Exhibit 2
Selected MIT Risk Measures
Risk Measure Description
A Active share
B Economic capital
C Ex post vs. ex ante tracking error
D Glide path
E Liquidity gap
F Scenario analysis
G Surplus at risk

One of MIT’s clients, Client 5, has asked Jedvaj to assist in its capital allocation. Client 5’s management team
describes to Jedvaj the policies that it uses in determining its capital allocation:
Policy 1: Because we have a number of leveraged positions (forwards and OTC options), we generally
allocate excess capital to those positions above what was needed to enter into the position.
Policy 2: When we enter into a new venture in which we have little experience, we generally allocate
substantial capital to it so that we are protected against unexpectedly large losses.
Policy 3: We typically use VaR as a risk measure in establishing our capital allocation. We take the VaR for
each position and divide it by the VaR for all positions combined to get the percentage of capital to
allocate.

55. Of the three comments from MIT’s managers about the meaning of Jedvaj’s VaR statement about Client
1’s portfolio, the one that is least likely to be accurate is the comment from manager:
A. Manager 1
B. Manager 2
C. Manager 3
56. Based on the data in Exhibit 1 and the statistics Jedvaj calculated for Client 2’s portfolio, the 5% monthly
VaRs under the Monte Carlo simulation and parametric methods, respectively, are closest to:
Monte Carlo Parametric
A. HRK 32,000,000 HRK 8,880,000
B. HRK 32,000,000 HRK 43,000,000
C. HRK 49,000,000 HRK 43,000,000
57. Of the three statements that Jedvaj made about risk measurements, the one that is least likely to be
accurate is:
A. Statement 1
B. Statement 2
C. Statement 3
58. To answer the three questions that Jedvaj has posed, the technique or process that he will employ is
most likely:
A. Reverse stress testing
B. Historical scenario analysis
C. Monte Carlo simulation VaR analysis
59. Of the risk measures identified in Exhibit 2, those that are most likely to apply to Client 3 and Client 4,
respectively, are risk measures:
Client 3 Client 4
A. A&G C&E
B. B&D E&F
C. D&G B&F
60. Of the policies that Client 5 uses for capital allocation, the one that is most likely appropriate is policy:
A. Policy 1
B. Policy 2
C. Policy 3



2019 Exam Prep

Level II
Exam 1
PM Session: Questions

Exam 1 PM Session Questions 2
Exam 1 Afternoon Session
7 - 12 Quantitative Methods Authored By: Charterholder; Contract Provider 18
31 - 36 Equity Valuation Authored By: Bilal Nadeem, CFA 18
49 - 54 Alternative Investments Authored By: Remek Debski, CFA 18
Total: 180


The main office of Colombo and Romano Equity Investments (CREI) is located in Milan. CREI comprises a
financial advisement and portfolio management division as well as an investment banking division.
Nadia Amrabat, CFA, is a financial advisor at CREI. Many of CREI’s clients would benefit from having more
diversified portfolios that included fixed income and alternative investments, so management has given
Amrabat the task of researching advisory firms specializing in these areas and recommending one firm in
each area. She gets recommendations for fixed income firms and alternative investment firms from her
acquaintances in the local CFA society. After researching the recommended firms, she narrows down the
field to those that follow the Asset Manager Code of Professional Conduct and GIPS: four fixed income firms
and one alternative investment firm. Amrabat compares the quarterly returns, volatilities of returns, asset
turnover, fees and management experience of the fixed income firms over the last 10 years and settles on
the one she considers the best. She recommends that fixed income firm and the alternative investment
firm to CREI’s management.
Amrabat generally directs her clients’ brokerage to her sister-in-law, Lola Rojo. In addition to executing
trades, Rojo provides Amrabat with research that benefits some of Amrabat’s clients. However, one of
Amrabat’s clients, Ragnar Magnússon, insists that his brokerage go through his uncle, whose fees are higher
than Rojo’s and who provides no research. Amrabat tells Magnússon that he is paying too much for the
service he is receiving, but he refuses to switch brokerage firms.
Amrabat is making a presentation to prospective clients. One of the people attending the presentation is
Mikael Krafth, who speaks to Amrabat after the presentation and tells her that he has EUR 11 million that he
wants to invest, primarily in fixed income, as he is near retirement. Amrabat’s strength is in equities, but
she has a good friend at another firm who specializes in fixed income. Amrabat e-mails her friend and
suggests that she contact Krafth, mentioning that he has “a sizable sum” to invest including Krafth’s e-mail
address and phone number in her email.
Marvin Trapp, CFA, is a portfolio manager at CREI who manages portfolios for individual and institutional
clients as well as CREI’s own portfolios. When Trapp identifies an investment opportunity suitable for his
clients, he informs them by tweet and e-mail and phones the ones who have opted for CREI’s Diamond
Service. If the opportunity is also suitable for CREI he waits for 15 minutes before making any trades on
CREI’s portfolios.

Sami Rudy, CFA, is an equity analyst at CREI who was recently asked to write a report on Mercury Sporting
Goods (MSG). Rudy exercises due diligence in researching MSG – reviewing their financial statements and
industry reports as well as interviewing MSG management – and concludes with a “sell” recommendation.
Rudy had owned 20,000 shares of MSG for which he had paid EUR 47.25 per share, but he sold the shares
for EUR 43.50 per share before he issued his report. As he didn’t own any MSG shares when he issued his
report, Rudy did not disclose his previous holdings.
Rudy participates in a meeting between the CEO of SuPerformance Automotive (SPA) and CREI’s investment
banking team, in which they discuss SPA’s upcoming secondary stock issue. The SPA CEO says that they are
in negotiations with a new client and that they expect that their revenue will increase by 15% over the
coming year. Rudy takes notes and asks his assistant to log them into his computer. Rudy’s assistant
mentions the SPA negotiations and projections to his fiancée, Lina Al Khaibari, CFA, a trader at CREI. Al
Khaibari immediately purchases shares of SPA stock for her personal portfolio.

1. With respect to the fixed income firm and the alternative asset firm, respectively, that she
recommended, has Amrabat most likely violated Standard V(A) Diligence and Reasonable Basis?
Fixed Income Firm Alternative Investment Firm

A. No Yes
B. Yes No
C. Yes Yes
2. With regards to directing her clients’ brokerage, which of Amrabat’s actions, most likely violate CFA
Institute Standards of Professional Conduct?
A. Directing most clients’ brokerage to Rojo.
B. Not directing Magnússon’s brokerage to Rojo.
C. None of Amrabat’s actions violate the Standards.
3. Has Amrabat most likely violated Standard III(E) Preservation of Confidentiality by passing along Krafth’s
information to her friend?
A. Yes.
B. No, because at the time Amrabat sent the information to her Krafth was only a prospective client, so
she has no duty to preserve confidentiality.
C. No, because Amrabat was deliberately vague about the amount Krafth had to invest and contact
information (such as e-mail address or phone number) is not confidential.
4. Which, if any, of the CFA Institute Standards of Professional Conduct does Trapp most likely violate by his
actions?
A. None.
B. Standard III(B) Fair Dealing.
C. Standard VI(B) Priority of Transactions.
5. Which of Rudy’s actions most likely violated the CFA Institute Standards of Professional Conduct?
A. Only Rudy’s failure to disclose his previous ownership of MSG shares
B. Only Rudy’s sale of his MSG shares prior to the publication of his report
C. Both Rudy’s sale of his MSG shares prior to the publication of his report and his failure to disclose
his previous ownership of MSG shares

6. With regard to Standard II(A) Material Nonpublic Information, it is most likely that:
A. only Rudy violated the Standard.
B. only Al Khaibari violated the Standard.
C. both Rudy and Al Khaibari violated the Standard.

QUANTITATIVE METHODS
Erin Johnson is an analyst at a hedge fund based in Chicago. She is deliberating developing a short-term
pairs trading strategy in the stocks of Microsoft Corporation (“MSFT”) and Alphabet Inc (“GOOGL” – Google
stock class A shares). Erin understands that pairs trading is a market-neutral strategy that matches a long
position with a short position in a pair of highly correlated instruments. Essentially this involves buying one
stock while selling short another within the same sector. Erin has chosen MSFT and GOOGL because the two
stocks are part of the technology sector as per the Russell Global Sectors Classification System.
Erin believes that the stock prices of MSFT and GOOGL can be predicted with time series analysis during the
period from January 2018 to January 2019. Erin develops three autoregressive models for each stock as
follows:
• First-order, autoregression, AR(1) model
• Second-order, autoregression, AR(2) model
• Third-order, autoregression, AR(3) model
The estimated regression equations are given in Exhibit 1 below:
Exhibit 1 – Estimated Regression Equations
Model MSFT
AR(1) model 𝑀𝑆𝐹𝑇% = 𝑏( + 𝑏* 𝑀𝑆𝐹𝑇% +* + 𝑒%
AR(2) model 𝑀𝑆𝐹𝑇% = 𝑏( + 𝑏* 𝑀𝑆𝐹𝑇% +* + 𝑏- 𝑀𝑆𝐹𝑇% +- + 𝑒%
AR(3) model 𝑀𝑆𝐹𝑇% = 𝑏( + 𝑏*𝑀𝑆𝐹𝑇% +* + 𝑏- 𝑀𝑆𝐹𝑇% +- + 𝑏.𝑀𝑆𝐹𝑇% +. + 𝑒%
Model GOOGL
AR(1) model 𝐺𝑂𝑂𝐺𝐿% = 𝑏( + 𝑏* 𝐺𝑂𝑂𝐺𝐿% +* + 𝑒%
AR(2) model 𝐺𝑂𝑂𝐺𝐿% = 𝑏( + 𝑏* 𝐺𝑂𝑂𝐺𝐿% +* + 𝑏- 𝐺𝑂𝑂𝐺𝐿% +- + 𝑒%
AR(3) model 𝐺𝑂𝑂𝐺𝐿% = 𝑏( + 𝑏* 𝐺𝑂𝑂𝐺𝐿% +* + 𝑏- 𝐺𝑂𝑂𝐺𝐿% +- + 𝑏.𝐺𝑂𝑂𝐺𝐿% +. + 𝑒%

Erin produces the output from the MSFT time series analysis, which is presented in Exhibit 2. She notes that
the Durbin-Watson statistic is very close to 2 for all three models. Erin’s boss, Alex Scott, suspects that they
are dealing with a random walk. Erin also generates the autocorrelation data from the three models
(selected data is presented in Exhibit 3).
Exhibit 2 - MSFT stock price, USD (January 2018 to January 2019)

Regression Statistics (t-statistics for coefficients are reported in
parentheses)
AR(1) AR(2) AR(3)
R2 0.9503 0.9514 0.9525
Standard Error 1.7829 1.7666 1.7514
Observations 246 246 246
Durbin-Watson 2.27 2.02 1.97
Coefficients
Intercept 3.1771 2.9070 2.7149
(2.2206) (2.0439) (1.9220)
MSFT pricet-1 0.9089 0.8219 0.7994

(68.3272) (12.8462) (12.4536)
MSFT pricet-2 0.1497 0.0281

(2.3535) (0.3411)
MSFT pricet-3 0.1461

(2.2896)
*In Exhibit 3, at the 5% significance level, the lower critical values for the Durbin-
Watson test statistic are between 1.59 and 1.63.
**At the 5% significance level, the critical value for a t-statistic is 1.96

Exhibit 3 - MSFT Regression Statistics

Autocorrelations of the Residual from MSFT AR(1) Model
Lag Autocorrelation t-statistic
1 (0.1445) -2.2666
2 (0.1076) -1.6879
3 0.0938 1.4717
4 (0.0333) -0.5220
1 (0.0220) 1.9600
2 (0.1290) 1.9609
3 0.0699 1.9932
4 (0.0448) 2.0026
1 0.0066 0.1029
2 0.0024 0.0370
3 0.0194 0.3043
4 (0.0636) -0.9969
Note: At the 5% significance level, the critical value for a t-
statistic is 1.96.
After assessing the regression results of MSFT, Erin makes the following conclusions about the
autoregressive models.
Conclusion 1: The intercepts of the AR(1) and AR(2) models are statistically significant and
individually not equal to 0.
Conclusion 2: None of the slope coefficients of the AR(2) and AR(3) models are individually
equal to 0.
Conclusion 3: The standard error of the autocorrelations of the autoregressive models are
equal to 0.0638.
Alex asks Erin to ascertain if the MSFT time series is covariance stationary or has a unit root, Erin uses the
Dickey-Fuller test based on a transformed version of the MSFT AR(1) model. She presents this as Exhibit 4:
Exhibit 4 – Dickey-Fuller test on MSFT AR(1) model
𝑀𝑆𝐹𝑇% = 𝑏( + 𝑏* 𝑀𝑆𝐹𝑇% +* + 𝑒%
𝑀𝑆𝐹𝑇% − 𝑀𝑆𝐹𝑇% +* = 𝑏( + (𝑏* − 1) 𝑀𝑆𝐹𝑇% +* + 𝑒%
𝑀𝑆𝐹𝑇% − 𝑀𝑆𝐹𝑇% +* = 𝑏( + 𝑔* 𝑀𝑆𝐹𝑇% +* + 𝑒%
𝑔* = 𝑏* − 1
If b1 = 1, then g1 = 0

Next Erin also produces the output from the GOOGL time series analysis, which is presented in Exhibit 5.
She notices that the R2 of all the models is very high (i.e. above 0.90) for each one of them. She also notes
that the Durbin-Watson statistic is below 2 for all three models. Erin also generates the autocorrelation data
from the three models (selected data is presented in Exhibit 6).
Exhibit 5 - GOOGL stock price, USD (January 2018 to January 2019)

Regression Statistics (t-statistics for coefficients are reported in
parentheses)
AR(1) AR(2) AR(3)
R2 0.9232 0.9233 0.9218
Standard Error 19.4808 19.6235 19.8651
Observations 246 246 246
Durbin-Watson 1.95 1.99 1.95
Coefficients
Intercept 336.6443 326.1204 305.2366
(2.0492) (2.0004) (1.9793)
GOOGL pricet-1 0.6843 0.6462 0.7218
(54.1756) (15.3057) (14.9652)
GOOGL pricet-2 0.0479 -0.1510
(2.0592) -(2.0264)
GOOGL pricet-3 0.1269
(2.1660)
*In Exhibit 1, at the 5% significance level, the lower critical values for the Durbin-Watson
test statistic are between 1.59 and 1.63.
**At the 5% significance level, the critical value for a t-statistic is 1.96

Exhibit 6 - GOOGL Regression Statistics

Autocorrelations of the Residual from GOOGL AR(1) Model
1 0.0263 0.4129
2 (0.0809) -1.2690
3 0.1207 1.8939
4 0.0332 0.5215

1 0.0020 0.0308
2 (0.0818) -1.2826
3 0.1244 1.9513
4 0.0364 0.5710

1 0.0090 0.1418
2 0.0016 0.0246
3 0.1123 1.7614
4 0.0205 0.3215
Note: At the 5% significance level, the critical value for a t-statistic is 1.96.
Exhibit 7 shows the actual stock price of GOOGL from 31-Dec-2018 to 8-Jan-2019. It also shows the errors
and squared errors from the GOOGL AR(1) and AR(2) models for the period 9-Jan-2019 to 15-Jan-2019.
Exhibit 7 - GOOGL - Actual Stock prices and Out-of-Sample Forecast Error Comparisons
Date Stock Price AR(1) Error Squared Error AR(2) Error Squared Error
31-Dec-18 1,044.96
2-Jan-19 1,054.68
3-Jan-19 1,025.47
4-Jan-19 1,078.07
7-Jan-19 1,075.92
8-Jan-19 1,085.37
9-Jan-19 2.2870 5.2304 2.6054 6.7882
10-Jan-19 3.5776 12.7993 3.4201 11.6968
11-Jan-19 (7.9695) 63.5131 (8.2881) 68.6929
14-Jan-19 (19.0047) 361.1771 (19.3603) 374.8228
15-Jan-19 17.3125 299.7233 16.9866 288.5452
Average 148.4886 Average 150.1092

Erin and Alex are discussing and deliberating whether the AR(1) or AR(2) model for GOOGL should be used
to predict the stock price. Based on the data in Exhibit 5 and regression outputs in Exhibit 6 and Exhibit 7,
they make the following statements regarding the accuracy of the models:
Statement 1: GOOGL’s AR(1) has lower in-sample forecast error and also lower out-of-sample
forecast error.
Statement 2: GOOGL’s AR(1) has lower in-sample forecast error but higher out-of-sample forecast
error.
Statement 3: GOOGL’s AR(2) has lower in-sample forecast error but higher out-of-sample forecast
error.

7. Based only Exhibit 2 and Exhibit 3, there is evidence of residual autocorrelation in which of the following
models of MSFT:
A. AR(1) and AR(2) only
B. AR(1) and AR(3) only
C. AR(3) only
8. Which of Erin’s conclusion about the autoregressive models of MSFT is most likely incorrect?
A. Conclusion 1
B. Conclusion 2
C. Conclusion 3
9. Which of the following most accurately describes the null hypothesis and alternative hypothesis of the
Dickey-Fuller test that Erin has developed to determine if the MSFT time series is actually a random
walk?
A. H0: g1 = 0
H1: g1 < 0
B. H0: g1 < 0
H1: g1 = 0
C. H0: g1 > 0
H1: g1 = 0
10. Erin determines that the GOOGL time series is covariance stationary. Her boss is interested in finding
out the mean reverting level of the stock. Based on the GOOGL AR(1) model regression equation, the
mean-reverting level of GOOGL’s stock price is closest to:
A. USD 1,066
B. USD 1,075
C. USD 1079
11. Erin considers to use the AR(3) model to develop a trading strategy for GOOGL. The predicted stock
price of GOOGL’s on January 10, 2019 would be closest to:
A. USD 1,032
B. USD 1,045
C. USD 1,063

12. Which of the following is the most correct statement by Erin and Alex regarding the accuracy of the
AR(1) and AR(2) models for GOOGL:
A. Statement 1
B. Statement 2
C. Statement 3

ECONOMICS
Richard Starkey is an economist with Fourbeats Global Marketplace, a firm providing country specific
economic forecasts to sovereign debt funds. Richard releases free reports from time to time but disguises
the names of the countries so as not to give too much information away for free. In one recent report,
Table 1 can be found with a forecast of real potential GDP growth for each country:
Table 1
Country α ΔY/Y ΔK/K ΔL/L
A 0.3 2.40% 1.00% 1.00%
B 0.5 3.40% 1.80% 1.60%
C 0.7 1.20% 1.00% 0.00%
Richard tries to educate his readers as much as inform them. At the end of each report, Richard offers the
opportunity to receive the full report for free. To do so, readers must answer two questions online. Richard
then selects a correct respondent each month to receive the full report. This ends up being one of the best
marketing efforts he has tried since people love tests of knowledge.
His first question is as follows:
“In a steady state, since Y/K is a constant, and both k and y grow at θ/(1 - α), this implies that capital
deepening has:
Answer 1: no effect on the growth rate of the economy and that MPK < r
Answer 2: a decreasing effect on the growth rate of the economy and that MPK = r
Answer 3: no effect on the growth rate of the economy and that MPK = r”
In his second question, Rickard first briefly describes neoclassical and endogenous growth theory. He then
lists a number of statements and asks that readers identify each conclusion with the proper theory:
Statement A: We should observe convergence in per capita incomes since the growth rate of
developing countries should exceed the growth rate of developed countries.
Statement B: Increases in the savings rate permanently increases the rate of economic growth
Statement C: The economy does not necessarily converge to a steady state rate of growth
Statement D: In the steady state, the growth rate of output does not depend on capital deepening
Statement E: There is no reason why per capita incomes should converge
Statement F: In the steady state, growth in output does not depend on savings
Richard ends with a clue:
“The big idea with endogenous growth theory is that the definition is capital has been expanded.”

13. For which economy would an increase in the growth rate of labour have the largest effect?
A. Country A
B. Country B
C. Country C
14. With reference to Table 1, for which Country does technological progress contribute the most to real
potential GDP?
A. Country A
B. Country B
C. Country C
15. If Country A’s α were 0.1 instead of 0.3, by how much would the steady state growth rate of output
change?
A. No change
B. Increase of 1.44%
C. Decrease of .44%
16. Who is correct regarding the outcome of capital deepening in the steady state?
A. Answer 1
B. Answer 2
C. Answer 3
17. With respect to the list of conclusions, which one represents endogenous growth theory?
A. B, C and E
B. B, C and F
C. B, D and F
18. With respect to Richard’s statement about the expanded definition of capital in endogenous growth
theory, he is referring to the inclusion of:
A. Knowledge and ideas
B. Capital that embodies new technology
C. Imported capital with a value in excess of the domestic savings rate


Bavarian Brewers Inc (BBI) offers its employees a defined benefit pension plan (the Plan). As of 31
December 2018, there were 547 active employees and 145 retired employees subject to the Plan. The
formula that BBI uses to determine the annual pension payment to retired employees is based on both
their length of employment at BBI and their final salary:
Annual payment = 1.5% × years of service × final year’s salary
Exhibit 1 contains selected data about the Plan, including the actuarial assumptions used. BBI follows IFRS
accounting standards. During 2018 BBI made no changes to the formula used to compute the annual
pension payment and made no changes in the actuarial assumptions about the Plan.
Exhibit 1
Bayerische Brauer Inc.
Defined Benefit Pension Plan (EUR)
Average annual salary increase 4%
Average length of employment, years 40
Average longevity after retirement, years 25
Discount rate 7%
PVDBO, 1 January 2018 204,451,890
Plan assets, 1 January 2018 175,285,806
2018 Employer contribution to the Plan 2,839,007
2018 Pension benefits paid 12,048,715
2018 Pension benefits earned 6,466,608
2018 Actual rate of return on Plan assets 7.2%
BBI make their annual contributions to the Plan on the last business day of each year, and benefits earned
are credited to the liability on the last business day of the year.
For 2019, BBI is considering two changes to the Plan:
1. Changing the formula for the annual payment to:

Annual payment = 1.6% × years of service × final year’s salary
2. Changing the discount rate to 6.5%
Alberto Loyola is an equity analyst who follows the brewing industry in the Eurozone. He has been assigned
to analyze BBI and to write a report with a recommendation on its common stock: buy, hold, or sell. As part
of his analysis he studies BBI’s published financial statements and makes appropriate changes to those
statements (generally to reflect economic reality instead of following accounting conventions) before doing
any calculations. He looks through the footnotes for the balance sheet and changes the reported net
pension asset / liability to reflect the full amount of the assets and of the liability. Once he has done this, he
calculates a standard set of financial ratios, including debt-to-equity and return on total assets.

19. The pension asset/liability that BBI should report on its 31 December 2018 balance sheet is most likely
a(n):
A. Asset of EUR 34,280,332
B. Liability of EUR 34,280,332
C. Liability of EUR 34,484,740
20. BBI’s periodic pension cost for 2018 is closest to:

A. EUR 2,839,007
B. EUR 8,157,662
C. EUR 8,508,234
21. The amount of BBI’s periodic pension cost for 2018 that will be included in other comprehensive income
(OCI) is most likely to:
A. Decrease OCI by EUR 350,572
B. Increase OCI by EUR 350,572
C. Increase OCI by EUR 8,508,234
22. The most likely effects of BBI adopting only the first change it is considering for 2019 are:
A. An actuarial gain and a decrease in pension expense
B. A decrease in the funded status and an increase in the periodic pension cost
C. An increase in past service costs and a decrease in the amount of periodic pension cost that is
included in other comprehensive income (OCI)
23. The most likely effects of BBI adopting only the second change it is considering for 2019 are:
A. An actuarial loss and a decrease in the funded status
B. An increase in net interest expense and an increase in past service costs
C. An increase in the PVDBO and a decrease in the amount of periodic pension cost that is included in
other comprehensive income (OCI)

24. The adjustments that Loyola makes to net pension asset / liability will most likely cause in the values of
BBI’s debt-to-equity ratio and return on assets (ROA), respectively, to:
Debt-to-Equity ROA
A. Decrease Decrease
B. Increase Decrease
C. Increase Increase

CORPORATE FINANCE
Federico Donnarumma is an equity analyst at Bologna Equity Investments (BEI). Recently, he has been
researching Andretti Motors (AM). AM has paid a semiannual dividend without interruption for over 20
years. AM has recently decided to start manufacturing electric vehicles, a departure from its traditional
gasoline-powered vehicle production, and one that will require considerable investment in plant and
equipment. Therefore, it will cut its next dividend by almost 75% and invest the retained funds in its new
venture, with the expectation of a long-term increase in the company’s value.
AM operates in a jurisdiction that has a tax imputation system and pays 27% income tax on its corporate
earnings. One of AM’s shareholders, Rodrigo Suárez, whose marginal tax rate on dividends is 22%, receives
a dividend of EUR 7,300.
Donnarumma follows another company, Trieste Engineering (TE), which has historically followed a residual
dividend policy, believing that it maximizes shareholder wealth in this manner. In 2018, TE’s net income was
EUR 80 million. It anticipates starting projects in 2019 requiring an initial investment of EUR 110 million. IT’s
target debt-to-equity ratio is 1.5.
A third company that Donnarumma follows is NPSM Shipping (NPSM). NPSM’s income statement and
balance sheet are shown in Exhibits 1 and 2:
Exhibit 1 Exhibit 2
NPSM N.V Statement of Earnings NPSM N.V Statements of Financial Position
Year Ended 12/31/18 As of 12/31/18
(EUR Thousands) (EUR Thousands)
Sales 140,000 Assets
COGS (90,000) Cash 9,000
SG&A (15,500) A/R 65,000
Depreciation (12,500) Inventory 105,000
EBIT 22,000 PP&E, net 250,000
Interest Expense (10,500) Intangibles 32,000
EBT 11,500 Total Assets 461,000
Income Taxes (4,500) Liabilities
Net Income EUR 7,000 Current Liabilities 98,000
Bonds Payable 200,000
Equity
Paid-In Capital, net 65,000
R/E 98,000
Total Liabilities + Equity EUR 461,000
NPSM has 4 million shares of common stock outstanding. At the end of 2018, NPSM plans to repurchase
200,000 shares of stock at EUR 50/share, after which it will issue a dividend of EUR 0.50 per share. To
finance the repurchase, they will borrow the necessary funds at an after-tax borrowing cost of 4%. NPSM’s
fixed capital investment in 2018 was EUR 22,500,000 and its investment in working capital was EUR
5,000,000.

25. The signal(s) sent by AM’s planned change in its dividend will most likely be perceived as:
A. Purely positive
B. Purely negative
C. A mixture of positive and negative
26. The tax due from Suárez on the dividend he receives from AM is closest to:
A. EUR −500
B. EUR 0
C. EUR 1,606
27. If TE maintains its current dividend policy, its 2018 dividend payout ratio will be closest to:
A. 0%
B. 31%
C. 45%
28. The effect of the share repurchase on NPSM’s EPS will most likely be:
A. A decrease
B. No change
C. An increase
29. The effect of the share repurchase on NPSM’s book value per share will most likely be:
A. A decrease
B. No change
C. An increase
30. NPSM’s 2018 FCFE coverage ratio is closest to:

A. 0.17
B. 0.75
C. 4.68

EQUITY VALUATION
Andrew Smith joined Houston Asset Management as a domestic equity analyst. Houston Asset Management
uses a hybrid approach to portfolio management and stock selection. James Anderson, the company’s
domestic equities fund manager, has assigned Smith to cover companies across multiple sectors.
Smith starts by evaluating a steel manufacturer, Alba Limited, which trades on the domestic bourse at a
current price of USD 44 per share. Alba Limited has recently experienced rapid growth and it has enjoyed
the benefits of heavy government spending on infrastructure development over the past few years.
However, due to increasing competition and changing market dynamics, Alba has reverted to its long-term
sustainable growth rate. Alba is expected to report EPS of USD 3.35 for the upcoming year. Smith gathers
information regarding Alba Limited as outlined in Exhibit 1:
Exhibit 1
Alba Limited
Market Price of the stock USD 44
Return on market 8.25%
Return on equity 10.25%
Risk free rate 3.00%
Dividend paid USD 2.50
Beta 1.25
Anderson then asks Smith to analyze Nelson Inc., a construction material manufacturing company. Nelson
Inc. is in its mature phase of growth. The stock of Nelson is currently trading at USD 29. The last dividend
paid was USD 1.5 on an EPS of USD 3.25. Using CAPM, Smith estimates the required return on equity to be
8.5%. Based on an in-depth fundamental analysis Smith expects dividends to continue to grow at 4%,
indefinitely. Given the expectations of a stable growth rate in dividends, Smith plans to rely on the Gordon
growth model to value Nelson Inc.
Anderson plans to hire another equity analyst to cover mid cap equities across different sectors. He
schedules interviews for multiple candidates. While conducting an interview with Jason Holt, one of the
probable candidates for the position, Anderson discusses the case of Azgard Limited. The company is a
manufactures tires and has a target market in Asia and the Middle East. Anderson expects the company to
pay an annual dividend of USD 2.75 next year, with a constant growth rate of 3%, thereafter. He also
provides Holt with information to estimate the cost of equity as seen in Exhibit 2:
Exhibit 2
Return on equity 12.50%
Risk free rate 3.75%
Beta 1.30

After seeing Holt’s estimate of Azgard’s stock, Anderson presents him with the case of Pioneer Inc. Pioneer
Inc. is a home appliance manufacturer and its stock currently trades at USD 22.5. The dividends paid out
every year by the company are well above the free cash flow to equity. In the recent past it has twice
received a qualified opinion from its auditors. After careful analysis, Holt expects Pioneer Inc. to generate
positive free cash flow to the firm over the forecast horizon. He estimates the cost of equity, based on
CAPM, to be 16%. To finish off the interview, Anderson asks Holt about the most appropriate cash flow
measure to value Pioneer Inc.’s stock.

31. Based on Exhibit 1 and the information gathered by Smith, what is Alba’s PVGO?
A. USD 8.97
B. USD 11.31
C. USD 17.80
32. With what Smith has learned about Alba Limited and the information within Exhibit 1, the implied
dividend growth rate of Alba’s stock should be closest to:
A. 2.43%
B. 3.67%
C. 4.32%
33. Using the information given, Smith’s estimate of the value of Nelson Inc. stock should be closest to:
A. USD 26.57
B. USD 33.33
C. USD 34.67
34. With the justified trailing P/E for Nelson Inc., the stock of Nelson is most likely:
A. Overvalued
B. Fairly valued
C. Undervalued
35. Based on the Gordon growth model, the value of Azgard’s stock should be closest to:
A. USD 16.17
B. USD 20.48
C. USD 32.16
36. Which of the following cash flow measures is Holt most likely to choose to value Pioneer Inc.?
A. Residual Income
B. Dividend Discount
C. Free cash flow to equity

FIXED INCOME
Nina Veljković was recently hired by TriState Asset Management Company (TRAMCO) as a junior analyst in
their fixed income division. She has little experience in fixed income, so much of what she will need to know
to do her job will come in the form of on-the-job training. One of TRAMCO’s senior fixed income analysts,
Amr El Said, has offered to help her.
On Monday, Veljković’s first day at TRAMCO, El Said gives her the par yield curve shown in Exhibit 1. He tells
her that her first job is to compute the 2-year spot rate.
Exhibit 1
Treasury Par Yields
Maturity, Years Par Yield
1 0.900%
2 2.400%
3 3.450%
4 4.185%
5 4.700%
6 5.060%
Once Veljković finishes that calculation (and gets the correct answer), El Said gives her a break for the rest of
the day. On Tuesday, he has another yield curve problem for her: suppose that the spot yield curve is
inverted (i.e., downward sloping: longer-term spot rates are less than shorter-term spot rates). He asks her
to determine whether the forward curve would be above or below the spot curve, and to explain her
reasoning. Of course, if there is not enough information to answer the question, he expects her to say so.
Veljković answers the question correctly and gives an accurate explanation.
On Wednesday, El Said gives Veljković another yield curve, this time a spot curve, shown in Exhibit 2. Her
task is to determine the arbitrage-free value of a 3-year, annual-pay, USD 1,000 par, risk-free, 3% coupon
bond. To be clear, he tells her that this spot curve does not correspond to the par curve he gave her on
Monday.
Exhibit 2
Treasury Spot Yields
Maturity, Years Spot Yield
1 1.200%
2 2.500%
3 3.410%
4 4.047%
5 4.493%
6 4.805%
Veljković gets the correct value for the bond. El Said is beginning to think that TRAMCO had done a good job
hiring her.

When Veljković arrives at TRAMCO Thursday morning, El Said has another situation for her to consider. He
gives her the table of bond values in Exhibit 3. Except for the embedded options, all three bonds are
otherwise identical.
Exhibit 3
10-Year, 6% Coupon Bonds
Bond Callable Putable Price
A No No USD 1,021.43
B No Yes USD 1,026.10
C Yes Yes USD 1,020.82
El Said asks Veljković to determine the value of bond D, a callable (but not putable) bond otherwise
equivalent to bonds A, B, and C. She gets the value with ease.
For the remainder of Thursday, El Said and Veljković discuss binomial interest rate trees, and how they can
be used to value straight bonds and bonds with embedded options, and how they can be used to determine
the option adjusted spread (OAS) for a bond. On Friday – the end of Veljković’s first week at TRAMCO – El
Said tells her that he just used a binomial interest rate tree with 15% volatility to compute the OAS on a
putable bond, and got an OAS of 82.5 bp. He wants to compute the OAS if he changes the volatility in the
tree to 20% and asks her how the new OAS will compare to the value of 82.5 bp from the original tree. Of
course, he wants her to explain her reasoning as well. He is not at all surprised when she answers this
question quickly and correctly, with a solid explanation.
After a refreshing weekend, Veljković arrives at TRAMCO the following Monday morning and El Said gives
her one final problem. Starting with the spot curve from Exhibit 2, above, he built and calibrated (using par
bonds) a 6-year binomial tree. Veljković’s job is to determine the value of the bond from last Wednesday – a
3-year, annual-pay, USD 1,000 par, risk-free, 3% coupon bond – using the tree. More specifically, would that
value be less than the value obtained from the spot curve, the same as the value obtained from the spot
curve, or greater than the value obtained from the spot curve. Once again, if there is not enough
information to determine this, she is to say so, and, in any case, explain her reasoning.
Once Veljković solved that problem, El Said was certain that she was ready to tackle anything that TRAMCO
could throw at her.

37. Based on the data in Exhibit 1, the 2-year spot rate is closest to:
A. 2.400%
B. 2.418%
C. 4.895%
38. Given the spot curve the El Said described on Tuesday, the relationship between the forward curve and
the spot curve most likely:
A. is that the forward curve lies above the spot curve.
B. is that the forward curve lies below the spot curve.
C. cannot be determined from only the information given.
39. Based on the data in Exhibit 2, the arbitrage-free value of a 3-year, annual-pay, USD 1,000 par, risk-free,
3% coupon bond is closest to:
A. USD 988
B. USD 990
C. USD 1,018
40. Based on the data in Exhibit 3, the value of bond D is closest to:
A. USD 1,011.48
B. USD 1,016.15
C. USD 1,016.76
41. For the bond El Said and Veljković discuss on Friday, compared to the original OAS of 82.5 bp, the OAS
calculated from the tree with 20% volatility will most likely be:
A. Lower than 82.5 bp
B. Equal to 82.5 bp
C. Higher than 82.5 bp
42. Given the information that El Said gave to Veljković on the second Monday about the binomial interest
rate tree that he constructed, the relationship between the value obtained using the spot curve and the
value obtained using the tree most likely:
A. Is that they will be the same
B. Is that they will be different
C. Cannot be determined from only the information given

DERIVATIVES
Abcde Smith (pronounced Ab-sed-ee) is one of Fuardamshire Bank’s most experienced derivatives
specialists. Abcde is responsible for dealing with the more advanced models required for pricing out
certain derivative contracts and for implementing internal risk management trades.
Abcde is reviewing the possible sale of a two-year interest rate option to a client based on a notional
amount of GBP 500,000. Abcde quickly draws out an interest rate tree for a two-year period based on some
internal assumptions about the path and the volatility of interest rates. Abcde’s tree and notes regarding
option values at expiration are shown in Figure 1.
Laura Tescott is the point person in sales for the client requesting the interest rate call. Laura asks what the
effect would be on the call price if the strike price were 20 bps higher?
Abcde then moves on to determine how a client can get call option exposure on an underlying stock that
does not have call options that trade. The client is open to a position that would cost the same amount of
money and put him in the same position had Fuardamshire Bank created an OTC option internally. Abcde
requests that David, her assistant, collect the required information for this task. David presents the data in
Table 1 and states that BSM is not his area of expertise and that he is sure he is missing some data that
Abcde would need:

Abcde offers to help David learn a bit more about BSM. She believes it is critical to begin with the
assumptions of the model. Abcde asks David to list some assumptions he can recall about the model.
David lists the following assumptions:
Assumption 1: Stock prices are lognormally distributed
Assumption 2: The natural log of the returns are normally distributed, that is LN(St/S0) ~N(0,1)
Assumption 3: Both the risk-free rate and the volatility of the underlying are random from period to period
Abcde then moves on the assess David’s understanding of the components of the model. David admits that
he finds it difficult to remember the relationships between N(d1), N(d2), N(-d1) and N(-d2). Abcde tells David
not to feel bad about that as very few people actually understand the BSM. As a demonstration she brings
David into a training session in progress and asks the instructor if she can pose a question to the group.
Abcde asks the group to identify a relationship between the N(d)s that sum to 100%. In response several
trainees make the following response:
Alvin: N(d1) + N(d2)
Simon: N(d1) + N(-d1)
Theodore: N(d1) + N(-d2)
Abcde now asks David if he can determine how a call option can be structured based on the information in
Table 1.
As a last task, Abcde must price out some options on derivatives contracts. For this she knows that the BSM
model is inappropriate and must use the Black model.

43. Assuming π = 0.5, based on Figure 1, the value of a call is closest to:
A. GBP 1,251
B. GBP 2,503
C. GBP 6,400
44. In answer to Laura’s question, Abcde calculates the price of c+ to be closest to:
A. GBP 1,015
B. GBP 2,085
C. GBP 4,400
45. Which of David’s assumptions regarding the BSM model is incorrect?

A. Assumption 1
B. Assumption 2
C. Assumption 3
46. With respect to Abcde’s question about a relationship between the N(d)s that sum to 100%, the correct
response would be:
A. Alvin
B. Simon
C. Theodore
47. With respect to the information in Table 1, to replicate a long call option on 12,000 shares, David would
most likely suggest that the client:
A. Buy 4,294 shares and sell 5,540 bonds valued at GBP 60e-rT each
B. Buy 6,422 shares and sell 5,383 bonds valued at GBP 60e-rT each
C. Buy 7,706 shares and sell 6,460 bonds valued at GBP 60e-rT each
48. The reason Abcde would most likely give with respect to why she cannot use the BSM model to price out
options on derivatives is that:
A. The underlying of the option is costless to carry
B. The underlying of the option is not the deliverable
C. The strike price of the option is on the contract, not on the underlying of the contract

ALTERNATIVE INVESTMENTS
Jane Ly is the Chief Investment Officer at Delta One Asset Management, a Canadian investment firm
specializing in global real estate catering to high net worth and institutional clients. Today she will be
meeting with two potential investors interested in adding real estate to their portfolios.
Jane has a morning meeting with Sanjay Bhasin, a consultant for a local pension plan that is considering
investing in Delta One’s most recent closed-end fund focusing on multi-family private equity projects in
Alberta. Reviewing the presentation, he stops at a slide with a recently completed transaction that causes
some concern. After reviewing the information, which is presented in Exhibit 1, he believes the calculated
project return is understated. He asks analyst, Jonathan Solomon, to check the information and have
marketing update the presentation in time for the meeting.
Exhibit 1 (in CAD)

Purchase Price 20,000,000
Initial NOI 2,000,000
First Year NOI 2,500,000
Loan Amount 12,000,000
Loan interest 8.00%
Loan Type Interest Only
Sale Price 25,000,000
Holding Period 4 Years
Return 19.25%
Once the meeting gets underway, Jane and Sanjay discuss the diversification benefits of adding real estate
to a broad portfolio. Sanjay has concerns about the frequency of how often the pricing of the underlying
holdings will be updated making the follow two statements:
Statement 1: Asset allocation modeling using appraisal-based indexes will result in higher allocations to
real estate because they overstate the volatility of returns.
Statement 2: Unsmoothing the returns of an appraisal-based index is used to increase the dispersion of
returns, and this typically results in reduced correlations with other assets.
Sanjay, satisfied with Jane’s recommendations on broad asset allocation strategies, moves to more specific
questions about investment strategy. Sanjay is concerned that the current rising interest rate environment
will result in lower valuations. Jane shows Sanjay Exhibit 2 and walks him through a planned project that is
expected to double the current NOI in five years and includes pricing in a 1% increase in interest rates over
the next 5 years.

Exhibit 2 (in CAD)

Property Name West Calgary Heights
Next Year NOI CAD 350,000
Expected NOI in Year 6 CAD 700,000
Going in Cap rate 7.0%
Required Return 8.5%
Long-term growth rate 1.5%
Increase in required returns in Year 5 1.0%
Later in the afternoon, Jane meets with Emily Brown, the wealthy CEO of Cannex, a pharmaceutical company
specializing in gene therapy. Emily is planning to retire next year and is looking to diversify her portfolio.
Most of her assets are locked in Cannex so she is looking for the most liquid investment options available at
Delta One – she plans to allocate CAD 2,000,000 to real estate.
Jane recommends that Emily consider one of Delta One’s publicly traded REIT funds that invests in a
diversified portfolio of commercial real estate. The portfolio is structured to take advantage of economic
growth in major developed markets and seeks investment opportunities in geographies that have
comparatively short lease terms. Emily would like Jane to detail the benefits of investing in the proposed
REIT fund over investing in a joint venture that has a rent stabilized office building as the underlying asset,
as proposed by her existing financial advisor. Jane lists the benefits by making the following statements:
Statement 1: Emily will be able to better control her costs of investing by hiring her own property
management team.
Statement 2: Emily will be able to invest in multiple projects simultaneously and benefit from income and
capital returns of a diversified portfolio.
Statement 3: Publicly traded REITs have a lower correlation with stocks and bonds, offering better
diversification benefits than private real estate.

49. What is the return type shown in Exhibit 1?

A. The stated return is the levered IRR
B. The stated return is the unlevered IRR
C. The stated return is the equity dividend rate
50. Based only on the information in Exhibit 1, the unlevered IRR for this transaction would have been
closest to:
A. 15%
B. 17%
C. 29%
51. Which statement made by Jane is most likely correct?

A. Statement 1 only
B. Statement 2 only
C. Neither Statement or Statement 2
52. Based only on the details presented in Exhibit 2, and assuming the successful execution of Delta One’s
strategy, the most likely sale price of West Calgary Heights in 5 years is closest to:
A. CAD 7.4M
B. CAD 8.8M
C. CAD 10.0M
53. Given Emily’s need for liquidity what is the least likely investment option that Jane would recommend?
A. An open-ended private REIT with a 30-day notice of redemption
B. A publically traded mortgage REIT with an average term to maturity of 10 years
C. A publicly traded equity REIT with a per share price of CAD 12 and trades an average 200,000 shares
daily
54. Which of Jane’s statements is most likely correct regarding the benefits of investing in Delta One’s
publically traded REIT over investing in the proposed joint venture alternative?
A. Statement 1 only
B. Statement 2 only
C. Statement 3 only

Cristiano Grifo is an economic consultant at Milan Consulting (MC). One of Grifo’s clients, Bergamo Asset
Management (BAM), manages a wide variety of portfolios, including equity, fixed income, and alternative
investments. BAM has hired Grifo to prepare an economic outlook for the next five years, and to help them
understand how various economic factors will affect the portfolios that they manage.
Grifo starts with an illustration of the effects of various macroeconomic factors. In Exhibit 1 he lists three
macroeconomic factors and the effects that an increase in each factor will have on default-free interest
rates, the magnitude of expected cash flows, and risk premia for corporate investments (both stocks and
bonds). He notes that a decrease in each factor will have the opposite effect of an increase.
Exhibit 1
Effects of Increases in
Macroeconomic Factors
Economic Factor Default-Free Rates Cash Flows Risk Premia
Factor 1 Increase No Change Increase
Factor 2 No Change Decrease No Change
Factor 3 No Change No Change Decrease
In particular, Grifo cites long-term GDP growth and volatility of the GDP growth rate as macroeconomic
factors and summarizes their relationship to short-term interest rates in Exhibit 2.
Exhibit 2
Correlation between Macroeconomic Factors
and Short-Term Interest Rates
Correlation with Short-
Macroeconomic Factor
Term Interest Rates
GDP growth rate Positive
Volatility of GDP growth rate Positive
BAM’s management doesn’t understand fully the idea of the inter-temporal rate of substitution, so they ask
Grifo whether the positive risk premium for equities in their portfolios is related to that rate. Grifo replies
that, in fact, it is, and that the relationship depends on the consumption hedging properties of equities,
which is quite poor.
Some of the highlights of Grifo’s economic outlook are shown in Exhibit 3, in which he compares his
forecasts to those of a wide group of economists whose opinions appear to be shared by the majority of
market participants.

Exhibit 3
5-Year Economic Forecast
Consulenza Milanese N.V.
Selected Data
Economic Variable Grifo's Forecast Consensus Forecast
Average annual GDP growth rate 1.2% 2.6%
Average unemployment rate 5.7% 4.2%
Average inflation rate 1.8% 1.0%
Uncertainty about inflation rate (1 σ) 0.2% 0.5%
Average 6-month nominal interest rate 2.0% 1.8%
Average 10-year nominal interest rate 4.5% 4.1%
Average annual salary growth rate 0.9% 1.5%
Grifo explains that the primary driver behind the differences in his forecasts and the consensus forecasts is
where the economy is in the business cycle. GBP’s management is quite interested in the implications of
Grifo’s outlook with regard to P/E ratios, growth versus value investing, and sector rotation (specifically
rotating into or out of cyclical or non-cyclical stocks).

55. Based on the information in Exhibit 1, the macroeconomic factor that is least likely to have an effect on
the market value of BAM’s government bond portfolio is:
A. Factor 1
B. Factor 2
C. Factor 3
56. The most likely explanation for the correlations shown in Exhibit 2 is the:
A. Negative correlation of GDP growth and the inter-temporal rate of substitution, and the negative
correlation of the volatility of GDP growth and the inter-temporal rate of substitution
B. Negative correlation of GDP growth and the inter-temporal rate of substitution, and the positive
C. Positive correlation of GDP growth and the inter-temporal rate of substitution, and the positive
57. Grifo’s conclusion about the consumption hedging ability of equities is most likely:
A. Accurate, because equities pay off well in bad times, but pay off poorly in good times
B. Accurate, because equities pay off well in good times, but pay off poorly in bad times
C. Inaccurate, because equities pay off well in good times, but pay off poorly in bad times
58. Based on the information in Exhibit 3, the conclusion about P/E ratios based on Grifo’s outlook
compared to the consensus outlook would most likely be that:
(Original Solution By: Bill Campbell III, CFA, has since been modified by Mark Meldrum, Ph.D.)
A. Whether they will be above or below the average for an entire business cycle cannot be determined
from the information provided
B. Under Grifo’s outlook they will be below the average of an entire business cycle, while under the
consensus outlook they will be above the average
C. Under Grifo’s outlook they will be above the average of an entire business cycle, while under the
consensus outlook they will be below the average
59. Based on the information in Exhibit 3, the conclusion about growth versus value investing based on
Grifo’s outlook compared to the consensus outlook would most likely be that:
A. Whether growth investing will outperform value investing or vice-versa cannot be determined from
the information provided
B. Under Grifo’s outlook value investing will outperform growth investing, while under the consensus
outlook growth investing will outperform value investing
C. Under Grifo’s outlook growth investing will outperform value investing, while under the consensus
outlook value investing will outperform growth investing

60. Using the information in Exhibit 3, the conclusion about a rotation strategy between cyclical and non-
cyclical stocks based on Grifo’s outlook compared to the consensus outlook would most likely be that:
A. Whether cyclical stocks will outperform non-cyclical stocks or vice-versa cannot be determined from
the information provided
B. Under Grifo’s BAM should rotate out of non-cyclical stocks into cyclical stocks, while under the
consensus outlook rotate out of cyclical stocks into non-cyclical stocks
C. Under Grifo’s BAM should rotate out of cyclical stocks into non-cyclical stocks, while under the
consensus outlook rotate out of non-cyclical stocks into cyclical stocks
End of Exam



2019 Exam Prep

Level II
Exam 2
Required disclaimer: CFA Institute does not endorse, promote, or warrant accuracy or quality of the
products or services offered by MarkMeldrum.com. CFA Institute, CFA®, and Chartered Financial Analyst®
are trademarks owned by CFA Institute.

7 - 12 Ethical and Professional Standards Authored By: Bill Campbell III, CFA 18
Total: 180


Brabant Capital Management (BCM) encompasses an investment banking division, a portfolio management
division, and a financial advisory division. Romelu Carrasco, a Level III CFA candidate, is a research analyst
at BCM, specializing in the automotive industry. One of the companies that Carrasco is analyzing is Cailliau
Motors (CM); it was his intention to finish his research and issue a report with a recommendation on CM
common stock (buy, hold, sell) consistent with his findings. Carrasco just learned that CM is planning a large
bond issue and has hired BCM’s investment banking division to underwrite the issue.
Carrasco is an avid bridge player who frequently partners with Harold Ávila, who works for a large software
company. Ávila’s company is considering a strategic investment in a competitor, and, as Ávila knows that
Carrasco is an equity analyst, he asks Carrasco if he would be able assist in valuing the company. Carrasco
tells Ávila that he will have to get permission from BCM’s management before he could do any work with
Ávila’s company.
BCM has a committee that reviews all reports before they are published, with every committee member
being given the opportunity to suggest changes (with a reasonable basis for any suggestion) before the
committee makes a final vote. Carrasco has written a report on Werner-Koch (Automotive) and submitted it
to the committee. Although Carrasco has considerable data to support his conclusions, after considerable
discussion the committee votes to make significant changes to some of the conclusions, while leaving others
unchanged. Carrasco is somewhat incensed by the changes and must decide how he will handle the
situation.
Carrasco was recently asked to write a research report on Van Dyck Motor Company (DMC). Carrasco’s
mother- and father-in-law have a sizable investment portfolio, and recently created a discretionary trust for
their daughter, Carrasco’s wife, into which they contributed a portion of their stock holdings, including a
large investment in DMC common stock.
One of Carrasco’s colleagues, Laleh Pouraliganji, CFA, is a financial advisor at BCM. She is creating a
presentation for prospective clients in which she uses an equity return model created by Carrasco, without
mentioning that he created the model (although she does say that it is a BCM proprietary model). She also
includes GDP and unemployment data which he obtained from a government website, without mentioning
the source.
Finally, the day has arrived for Carrasco to take the Level III CFA exam. He has always had difficulty
remembering all of the different formulae for the future value of an investment under the various tax
scenarios (accrual taxes, deferred taxes, and so on) and for the relative value of a gift versus a bequest
under various tax scenarios. Before the morning session of the exam, Carrasco spends 20 minutes with his
notebook, writing and rewriting the formulae. As soon as candidates are given the signal to start the exam,
he opens the exam booklet to the last page and writes down every formula. As it turns out, there is a
question in the morning session about accrual equivalent tax rates and another about the relative value of a
gift versus a bequest, and Carrasco is able to answer both questions correctly because he had written down
the formulae.

1. According Standard I(B) Independence and Objectivity, with regard to his research on CM, Carrasco
should most likely:
A. Stop his research and not issue any report
B. Continue his research and issue a report that contains factual information, but without a
recommendation
C. Continue as planned and issue a report that contains a recommendation consistent with his
research
2. With regard to assisting Ávila’s company with the equity valuation, to comply with the CFA Institute
Standards of Professional Conduct, Carrasco will most likely have to inform his employer of only the:
A. Nature of the analysis he will be doing, and how long he will be working for Ávila’s company
B. Nature of analysis, the amount of money he will receive for the work, and how long he will take to do
it
C. Length of time for the analysis, the amount and type of compensation he will receive, and the nature
of his relationship with Ávila
3. With regard to the report on Werner-Koch, for Carrasco to comply with the CFA Institute Standards of
Professional Conduct he should most likely:
A. Remove his name from the report, and issue another report with his original text
B. Leave his name attached to the report, and encourage BCM’s advisors and portfolio managers to
follow the recommendations of the revised report
C. Leave his name attached to the report, but tell BCM’s advisors and portfolio managers that he
disagrees with the conclusions, and that they should follow the recommendations in his original
report
4. Concerning the request for him to write a research report on DMC, to comply with the CFA Institute
Standards of Professional Conduct, must Carrasco most likely disclose to BCM management the
investment that his parents-in-law have in DMC?
A. Yes
B. No, because trust accounts do not confer beneficial ownership
C. No, because neither he nor his wife has any control over the trust account or its disbursements

5. With regard to Standard I(C) Misrepresentation, Pouraliganji has most likely:

A. Not violated the Standard
B. Violated the Standard by not attributing the equity return model to Carrasco
C. Violated the Standard by not mentioning the government source for the GDP and unemployment
data
6. Do Carrasco’s actions on the morning of the Level III CFA exam most likely violate Standard VII(A)
Conduct as Participants in CFA Institute Programs?
A. No
B. Yes, because he is not allowed to write down the formula; he must have it memorized
C. Yes, because he is not allowed to write anything in the exam booklet; he should have written the
formula on scratch paper


Kevin Vermaelen, a Level II CFA candidate, is an investment advisor / portfolio manager with Jacobs Bertrand
& Davignon SA (JB&D) with 97 clients whose portfolios he manages. JB&D offers its portfolio managers a
choice of brokers to use to execute their trades:
 EconoTrade, a low-cost broker that can take a relatively long time to execute some trades
 FasTrade, a more expensive broker, but one that offers access to many more markets than
EconoTrade and nearly always executes trades very quickly
Amongst the accounts that Vermaelen handles are three particular accounts:
1. His parents-in-law’s account

2. His ex-brother-in-law’s account
3. An account for a discretionary trust for which his uncle is beneficiary
Vermaelen generously has decided not to charge fees for any of these accounts, and JB&D management
has, reluctantly, agreed.
Vermaelen just took his Level II CFA exam and is awaiting the results. He is active in an online CFA exam
forum website to find out what other candidates thought of the exam. In one of the threads another user
says that he found the Portfolio Management section particularly easy this year, which surprises Vermaelen.
He replied to that user saying that he thought that Portfolio Management was much more difficult this year
than last year. In another thread he mentioned that he was grateful that there were a few questions about
pricing FRAs and swaps, because he had done poorly on those the previous year, so he put a lot of effort
into studying and remembering those formulae this year.
While attending a conference on financial risk management, Vermaelen hears of a particular stock that is
believed to be considerably underpriced. He skips a breakout session on buy-write investing strategies
(buying an index, then writing out-of-the-money call options on the index to enhance returns) and spends
the time researching the stock. His research confirms what he heard, so he phones his office to instruct his
assistant to purchase shares for his 10 largest clients. Upon returning from the conference four days later,
he reviews the IPSs and portfolios of his remaining clients and, over the course of the next two weeks,
purchases shares for 27 other clients for whom they are suitable.

Now that he is back at the JB&D office, Vermaelen is discussing investments in short-term (zero-coupon)
government bonds with one of his clients. He explains that a common method of describing the return on
these bonds is known as the bank discount yield (BDY). He gives the client an example from that day’s bond
prices on the internet: a 90-day bond with a par value of EUR 1,000 and a price of EUR 995. Vermaelen
calculates the BDY to be 2.00% and tells the client that if he were to buy that bond today and hold it to
maturity, he will earn a BDY of 2.00%. He is careful to explain that the effective annual yield (EAY) and
holding period yield (HPY) would not be 2.00% but does not calculate what these yields would be.
One of the equity analysts with whom Vermaelen works at JB&D is Erick Calderón, who came to JB&D two
years ago from Tactical Asset Management Company (Société de Gestion Tactique des Actifs, SGTA). While
at SGTA, Calderón learned how to analyze equity securities, and designed several spreadsheet models to
help in his analysis. He left SGTA after five years to join JB&D. In the last two years, Calderón has created
many spreadsheet models that are very similar to those he had created at SGTA.

7. In deciding which broker to use for his clients’ trades, and to comply with his duty to clients under
Standard III(A) Loyalty, Prudence, and Care, Vermaelen should most likely:
A. Choose FasTrade, placing more importance on the speed with which trades are executed than on
the fees charged for the trades
B. Choose EconoTrade, placing more importance on the fees charged for trades than on the speed
with which the trades are executed
C. Consider whether the fees or the speed of execution on trades is more important case-by-case, and
choose EconoTrade or FasTrade accordingly
8. In determining the order of transactions for his client accounts, Vermaelen should most likely give
preference to his other client accounts over which, if any, of the particular accounts named?
A. None of them
B. All three of the accounts
C. Only his parents-in-law’s account and his uncle’s discretionary trust account
9. Which of Vermaelen’s comments on the CFA exam forum are likely to have violated the CFA Institute
Standards of Professional Conduct? His comments about:
A. Portfolio Management only
B. Derivatives (FRAs and swaps) only
C. Portfolio Management and his comments about derivatives
10. With regard to his actions involving the underpriced stock, which of the CFA Institute Standards of
Professional Conduct has Vermaelen most likely violated?
A. Only III(B) Fair Dealing
B. Only III(C) Suitability
C. Both III(B) and III(C)
11. Does Vermaelen’s conversation with his client about government bonds most likely violated Standard
V(B) Communication with Clients and Prospective Clients?
A. No
B. Yes, because Vermaelen has failed to distinguish fact from opinion
C. Yes, because Vermaelen should have explained the holding period yield (HPY) or the effective annual
yield (EAY), not the BDY

12. Are Calderón’s actions in building the models at JB&D likely to violate Standard IV(A) Loyalty (to
employers)?
A. Yes
B. No, but they would have violated the Standard if the new models were essentially identical to those
at SGTA
C. No, because the skills and knowledge that Calderón learned while at SGTA do not constitute
confidential information

ECONOMICS
Sam Yuns is considering dedicating a large portion of his portfolio to carry trades. Sam thinks it just makes
sense to borrow in a low-yielding currency and invest in a high yielding currency. Sam has been around the
block a few times, so he is aware that everything has risks. Sam sets out to educate himself as much as
possible before he considers his first carry trade. Knowing where the risks are is half the battle in
generating a return.
Sam first looks at a very common carry trade from the recent past, that between Japan and Australia. He
wonders if it would still have a positive return today. In a research report sent to him by his broker, Sam
reads that real interest rates between Japan and Australia are believed to be equal. Sam notes that nominal
rates in Japan are 0.10% while in Australia they are 3.1%. Sam thinks, “If I can earn more in Australia than in
Japan, then clearly it should be profitable.” After doing some background research on the difference
between real and nominal exchange rates, Sam jots down 3 potential outcomes, as per his understanding,
that would reconcile the differences between the nominal rates he can see and the research report about
the real rates being equal. Since he is not clear on the subject matter, he is unsure which outcome is the
correct one. If in fact real interest rates are equal in both countries, then either:
Outcome 1: Expected inflation in Japan will be 3% higher than expected inflation in Australia
or
Outcome 2: Expected inflation in Japan will be 3% lower than expected inflation in Australia
or
Outcome 3: Risk premiums related to Japan are 3% higher than risk premiums associated with Australia
Sam learns that capital will respond to nominal interest rate differentials, inflation expectation differentials
and risk premium differentials. Sam comes to conclude that the best carry trades between a high yielding
currency (H) and a low yielding currency (L) are ones that have the following characteristics over the carry
trade horizon:
Characteristic 1: Nominal spreads (iH – iL) widen
Characteristic 2: Risk premiums (φH – φL) tighten
Characteristic 3: Inflation expectation differentials (𝜋𝐻𝑒 − 𝜋𝐿𝑒 ) widen

Sam in now ready to assess his first carry trade. Sam assembles the information in Table 1. Sam sees
several potential carry trades between high and low yielding currencies but is drawn to the Japanese yen
and Mexican peso trade. He also knows now that the carry trade is possible despite what some aspects of
economic theory suggest.
Table 1
6-month Currency 6-month
Libor Pair Today Forecast
MXN 7.25% MXN/USD 19.4310 18.2160
CAD 2.25% JPY/USD 111.46 115.8200
EUR 0.45% USD/EUR 1.1842 1.2000
JPY 0.10%
USD 1.75%
There is a belief that the Bank of Japan (BOJ) will move to rebalance its foreign exchange reserves. The
central bank currently has very large foreign exchange reserves that have built up over the years due to a
persistently large trade surplus. Sam is uncertain whether this would add to the carry trade return or the
carry trade risk.
Sam recognizes that high interest rates in Mexico are indicative of restrictive monetary policy but feels that
the new governing party will pursue expansionary fiscal policy. Sam remembers reading about the
combination of monetary and fiscal policy effects on the currency. He is not sure but thinks it was
something like the Fundell-Melfing model?

13. If real interest rates in Japan and Australia are equal, then which outcome is correct given the nominal
differences in rates Sam observes?
A. Outcome 1
B. Outcome 2
C. Outcome 3
14. Which characteristic would actually lead to a deterioration of the carry trade?
A. Characteristic 1
B. Characteristic 2
C. Characteristic 3
15. With respect to Sam’s thoughts about economic theories, for a carry trade to provide a return:
A. CIRP must not hold
B. UIRP must not hold
C. ex ante PPP must not hold
16. Calculate the all-in return for the carry trade in which Sam is interested.
A. -6.6%
B. 14.8%
C. 18.8%
17. Rebalancing by the BOJ will have what effect on the currency?
A. Rebalancing will lead to a depreciation of the currency
B. Rebalancing will have no effect on the currency
C. Rebalancing will lead to an appreciation of the currency
18. With respect to the Mundell-Fleming model that Sam recalls, however incorrectly, the most likely effect
for Mexico would be:
A. The currency depreciates
B. The currency effect is indeterminate
C. The currency appreciates


Milano Plastics (MP) has been offering its employees a defined benefit pension plan (the Plan) for over 60
years. Five years ago, it began offering life insurance, and health insurance. Alessio Mancini, MP’s head of
human resources, makes these statements about MP’s post-retirement benefits:
Statement 1: Estimating the cost of our pension plan is substantially more difficult than estimating the
cost of post-retirement health insurance. There are more uncertainties in the pension plan
(length of employment, final salary, longevity after retirement, inflation, and so on) than
there are in health insurance (who will get sick, and when).
Statement 2: Although it is common (in fact, legally required) to fund the cost of defined benefit pension
plans, it is not common to fund the cost of post-retirement life insurance and health
insurance.
Exhibit 1 contains selected data about the Plan for 2018:
Exhibit 1
Milano Plastica N.V.
Defined Benefit Pension Plan
Average annual salary increase 3%
Average length of employment, years 35
Average longevity after retirement, years 25
Discount rate 6%
PVDBO, 1 January 2018 EUR 1,043,117,337
Plan assets, 1 January 2018 EUR 894,311,433
2018 Employer contribution to the Plan EUR 21,852,746
2018 Pension benefits paid EUR 46,828,272
2018 Pension benefits earned EUR 41,476,996
2018 Past service costs recognized EUR 1,759,250
2018 Actuarial loss EUR 720,573
2018 Actual rate of return on Plan assets 5.9%
MP’s effective tax rate is 26.2%.

Beginning in early 2018, MP’s senior management decided that giving its management team corporate stock
options would align their interests with the long-term goals of the company, and thereby improve the
company’s bottom line and increase share value. Remo Schär, MP’s comptroller, mentioned these
disclosures that would have to be made in the footnotes to MP’s financial statements:
Disclosure 1: The type of share-based compensation (stock options) and the extent of their use
(management team)
Disclosure 2: How MP decided who would receive share-based compensation and how much they would
receive
Disclosure 3: How the share-based compensation affected MP’s income statement and balance sheet
Exhibit 2 provides details on MP’s stock option grant program for performance in 2018:
Exhibit 2
Milano Plastica N.V.
Stock Option Grants
2018 Performance
Grant date 1 January 2019
Vesting date 1 January 2022
Expiration date 1 January 2024
Number of options granted 12,000,000
Fair value of options granted EUR 29,425,953
The stock options were granted based on performance in 2018 and are not contingent on future
performance by the managers who received them.

19. Concerning Mancini’s statements about post-retirement benefits, it is most likely that:
20. MP’s periodic pension cost for 2018 is closest to:

A. EUR 41,476,996
B. EUR 52,885,173
C. EUR 53,779,484
21. MP’s pension expense for 2018 is closest to:

A. EUR 51,125,923
B. EUR 52,164,600
C. EUR 53,779,484
22. Assuming that employer contributions were less than the periodic expense in 2018, an analyst would
most likely make which adjustment to MP’s cash flow statement?
A. Increase CFI
B. Decrease CFF
C. Decrease CFO
23. Of the three disclosures that Schär’s listed, the one that is least likely to be required under IFRS is
disclosure:
A. 1
B. 2
C. 3
24. The expense that MP will show on its 2019 income statement for the stock option grant will be closest to:
A. EUR 0
B. EUR 9,808,651
C. EUR 29,425,953

CORPORATE FINANCE
Lefebvre-Renard (LR) is a steel manufacturing company headquartered in Ghent, Belgium. Martín Muslera,
LR’s CFO, has recently been analyzing LR’s capital structure to determine what changes, if any, should be
made to increase the company’s value. In researching the theory of capital structure, Muslera has studied
the Modigliani-Miller (MM) propositions. He is preparing a presentation for LR’s senior management about
his ideas on the company’s capital structure and begins by explaining the MM propositions.
Although he realizes that it is unrealistic, Muslera starts with MM propositions 1 and 2 with the assumption
that the company pays no taxes and has no distress costs. He describes this situation with two statements:
Statement 1: Under the assumption of no taxes, the value of the company does not depend on the capital
structure (i.e., the percentage debt and the percentage equity).
Statement 2: Under the assumption of no taxes, the cost of equity is an increasing, linear function of the
percentage of debt in the capital structure.
From there, Muslera moves to MM propositions 1 and 2 with the assumption that the company pays income
taxes, but still has no distress costs. He explains this situation with two observations:
Observation 1: Under the assumption that the company pays income taxes, the value of the company
increases as the level of debt increases; the value of a levered firm is greater than the
value of the corresponding unlevered firm by an amount equal to (1 − tax rate) times the
amount of debt.
Observation 2: Under the assumption that the company pays income taxes, the cost of equity is still an
increasing, linear function of the percentage of debt in the capital structure, but the slope
is lower than in the no-taxes case.
Muslera then adds in the idea of distress costs. Obvious are the costs of bankruptcy, but equally important,
even if less obvious, is the impact of debt ratings. He makes these comments:
Comment 1: As the debt-to-equity ratio increases, it’s likely that the credit ratings on the company’s debt
could decline, leading to costlier debt and a WACC that eventually increases
Comment 2: The change in the cost of debt for a 1-step rating change is relatively constant no matter if it’s a
change from, say, AAA to AA+, or from B− to CCC+. This makes it relatively easy to estimate
the shape of the WACC curve.

Muslera then turns to the idea of LR’s target capital structure. After analyzing the cost of debt as the debt-
to-equity ratio increases, he concludes that LR’s optimal capital structure is 65% debt and 35% equity, a D/E
of 1.86, based on long-term average debt and equity costs. LR’s current D/E ratio is 2.12. Muslera believes
that LR should not try to restore the D/E ratio to the optimal level in the short run, and cites two reasons for
his belief:
Reason 1: The yield to maturity (YTM) on LR’s long-term debt is higher than the long-term average and
would be higher still when the floatation costs of a new issue are included.
Reason 2: LR’s common stock is selling at a price that is above its long-term trend price, and even the net
amount that LR would receive after floatation costs on a new issue would be higher than the
long-term trend price.
Muslera mentions that analysts look at a number of factors to try to determine the optimal capital structure
for a company. Three of these factors that specifically pertain to LR with its current capital structure are:
Factor 1: LR has fairly high information asymmetry costs.
Factor 2: Most of LR’s assets are tangible assets (e.g., property, plant, and equipment).
Factor 3: LR’s cash flows are relatively stable.
Although LR does not currently have international operations, for completeness Muslera covers some of the
international differences in capital structure and their influences. He mentions three characteristics of LR’s
business environment that can affect the typical debt-to-equity ratio of companies:
Characteristic 1: LR’s business environment operates under civil law, not common law.
Characteristic 2: LR’s business environment tends to be more bank-based rather than market-based.
Characteristic 3: LR’s current business environment is experiencing low growth in GDP.

25. Of the two statements that Muslera makes about the situation in which the company pays no taxes, it is
most likely the case that:
A. Both statements are false
B. Statement 1 is false and statement 2 is true
C. Statement 1 is true and statement 2 is false
26. Of the two observations that Muslera makes about the situation in which the company pays taxes, it is
A. Both observations are true
B. Both observations are false
C. One observation is true, and one observation is false
27. Of the two comments that Muslera made concerning credit ratings, it is most likely the case that:
C. One comment is accurate, and one comment is inaccurate
28. Of the two reasons that Muslera gives for not restoring LR’s capital structure to its optimal level, it is
A. Both reasons are valid
B. Both reasons are invalid
C. One reason is valid, and one reason is invalid
29. Of the three factors that Muslera mentions that analysts consider in evaluating a company’s capital
structure, the ones that most likely argue for more debt rather than less debt are:
A. All three factors
B. Factor 1 and Factor 2 only
C. Factor 2 and Factor 3 only
30. Of the three characteristics that Muslera mentions about LR’s business environment, the ones that
suggest higher debt-to-equity ratios rather than lower are most likely:
A. All three characteristics
B. Characteristic 1 and Characteristic 2 only
C. Characteristic 2 and Characteristic 3 only

EQUITY VALUATION
Emerson Berardi is an equity analyst with Valachi & Sons Investments. One of the companies that Berardi
analyzes is Regazzoni Automotive Industries (RIA). Berardi has compiled information about RIA common
stock in Exhibit 1. RIA common stock pays no dividends.
Exhibit 1
RIA Common Stock
Selected Data
Market price per share EUR 62.50
Consensus intrinsic value per share EUR 77.85
*
Time to convergence 15 months
Required annual return on RIA shares 6.4%
*
Convergence of market price to intrinsic value
Berardi has been using a number of models to estimate the required return on stocks, including the CAPM,
the Fama-French model (FFM), and the Pastor-Stambaugh model (PSM). He has compiled data he has
calculated for another company he is analyzing, WN Motors (WNM); the data are shown in Exhibit 2. Exhibit
3 contains his expected market data.
Exhibit 2
WN Motori S.p.A.
Model Data
CAPM FFM/PSM
Market beta 1.3 1.6
Size beta 0.45
Value beta −0.85
Liquidity beta 0.15
Exhibit 3
Expected Market Data
2019
Equity market return 8.70%
Size premium 0.003
Value premium 0.027
Liquidity premium 0.045
In estimating the equity market return in Exhibit 3, Berardi looked at the equity market returns (using a
broad market index as a proxy for the market) and risk-free rates for the past 10 years and computed an
average equity risk premium. He knows that there are disadvantages to this approach, but he decided that
its simplicity overcame any other considerations, which he regarded as quite small.

Berardi wants to use the CAPM model to estimate the required return on a privately held company: Bertoli
Industries (BI). To estimate BI’s equity beta, Berardi compares BI to a similar publicly traded company, and
compiles the comparative data in Exhibit 4. Bertoli knows that BI adjusts its debt level to achieve its target
capital structure as the value of the company changes
Exhibit 4
Comparative Data
Bertoli Industries vs. Public Company (EUR)
Bertoli Industries Public Company
Share price 47.16 28.21
EPS 3.30 1.58
Market value of assets 62 million 217 million
Market value of debt 27 million 135 million
YTM, long-term debt 8.15% 7.43%
Beta 1.62
Having computed BI’s beta, Berardi calculates BI’s cost of equity as 9.22%. He then needs to determine its
weighted average cost of capital (WACC) based on the current capital structure, and a marginal tax rate of
28%.
BI is considering a new project in an attempt to expand their market share. The project will take BI about
one year to develop fully; if it is successful, BI expects its market share to nearly double in size. That reward
doesn’t come without risks, of course, and BI considers this project to be substantially riskier than the
normal projects that it undertakes. BI’s plan is to finance the project with the same proportion of debt and
equity that it has in its current capital structure. Their first order of business is to do a full NPV analysis on
the project.

31. Based on the data in Exhibit 1, the expected 15-month holding period return on RIA common stock is
closest to:
A. 27.8%
B. 31.0%
C. 32.6%
32. Based on the data in Exhibits 2 and 3, the estimated required return on WNM common stock in 2019
under the Fama-French and Pastor-Stambaugh models, respectively, is closest to:
Fama-French Pastor-Stambaugh
A. 10.3% 10.9%
B. 10.6% 10.9%
C. 10.9% 10.3%
33. The least likely disadvantage of the approach that Berardi used to estimate the equity market return in
Exhibit 3 is that it:
A. Assumes that the mean and variance of returns are constant over time
B. Assumes that there is no sample bias in the historical data that he used; i.e., that those data
reasonably predict what will happen in the future
C. May underestimate the equity market return because of survivorship bias included in historical
index returns
34. Based on the data in Exhibit 4, the estimated beta for BI’s common stock is closest to:
A. 0.61
B. 1.08
C. 2.42
35. Given the information in Exhibit 4 along with BI’s cost of equity and marginal tax rate, BI’s weighted
average cost of capital (WACC) is closest to:
A. 6.30%
B. 7.76%
C. 8.75%

36. The discount rate that BI should use in the NPV analysis of its new project is most likely:
A. Equal to its current WACC
B. Less than its current WACC
C. Greater than its current WACC

FIXED INCOME
Luisa Krychowiak is a fixed income advisor at Wroclaw Investments (WI). Krychowiak recently acquired a
new client, Nowak Industries’ defined benefit pension plan (the Plan) and is discussing management of the
Plan’s fixed income portfolio with Marie Boyata, a benefits manager at Nowak. Boyata is unfamiliar with
active bond portfolio management and asks Krychowiak why she wouldn’t simply buy bonds that mature
when the cash flows are needed. In response, Krychowiak makes these comments:
Comment 1: If the original yield curve (when you buy a bond) slopes upward and doesn’t change, then
holding a bond and selling it before maturity can earn a higher yield than the original YTM.
Comment 2: If the yield curve slopes upward but experiences a positive shift during the holding period,
then you won’t earn a higher yield than the original YTM.
Krychowiak goes on to tell Boyata that there are models that are used to predict how interest rates will
change (or evolve) over time which can be used in active bond management. Amongst those are the Cox-
Ingersoll-Ross (CIR), Vasicek, and Ho-Lee models. She offers Boyata these observations on these models:
Observation 1: The CIR and Vasicek models are single-factor equilibrium models which contain a
stochastic (i.e., random) term, and model how short-term interest rates change from one
time period to the next. The CIR model has constant volatility of interest rates, and the
Vasicek model can theoretically produce negative interest rates. Neither model will
necessarily approximate a given yield curve.
Observation 2: The Ho-Lee model is an arbitrage-free model which contains a stochastic (i.e., random
term), and also models how short-term interest rates change from one time period to the
next. It has a constant volatility of interest rates and can be calibrated to match a given
yield curve.

When Krychowiak examines the Plan’s fixed income portfolio she discovers that it holds a number of
corporate bonds. Boyata mentions that she likes the corporate bonds because they generally have higher
yields than similar government bonds, but that she is not sure if they’re really getting as much additional
yield as they should. She asks Krychowiak if there is a way to calculate the proper amount of additional
yield they should get. Krychowiak says that there is, that it incorporates the possibility that the issuer could
default on any payment date, and she outlines these steps:
1. Calculate the exposure (the total value you could lose in case of default) at each payment date, any
expected recovery amount in case of default at each payment date, and the net loss (known as the
loss given default, or LGD) at each payment date.
2. Determine the probability of default at each payment date
3. Multiply the probability of default by the LGD to get the expected loss at each coupon date.
4. Discount the expected losses back to today. The total is the credit valuation adjustment (CVA).
5. Subtract the CVA from the price of a default-free bond to get the price of the bond in question.
6. Compute the yield on the bond in question using the price from Step 5 and compare that to the
yield on the default-free bond; the difference is the proper amount of additional yield.
Krychowiak tells Boyata that investors often use a bond’s credit rating to help them determine the
appropriate additional yield for the riskiness of the bond, and that there are models that credit-rating
agencies use to develop those ratings. She describes one type of model, a structural model, with these
statements:
Statement 1: Structural models are so-called because they are based on the structure of a company’s
balance sheet: assets and liabilities. One underlying assumption is that the assets trade in a
frictionless, no-arbitrage market. Another is that the liabilities are equivalent to a zero-
coupon bond.
Statement 2: In structural models, the debtholders’ position is equivalent to owning a risk-free, zero-
coupon bond, and selling a call option on the company’s assets with a strike price equal to
the par value of the bond.

Krychowiak notes that the Plan’s portfolio holds convertible bonds from two issuers: Woźniak Systems (WS)
and Jankowski Industries (JI). Exhibit 1 lists the details on these bonds, as well as their non-convertible
bonds. Krychowiak wants to determine the riskiness of the convertible bonds.
Exhibit 1
Nowak Industries’ Defined Benefit Pension Plan
Convertible Bonds
Characteristic WS JI
*
Par value, bond PLN 1,000 PLN 1,000
Market price, bond PLN 986 PLN 1,022
Conversion ratio 20:1 10:1
Market price, stock PLN 65/share PLN 75/share
Annual return volatility (σ), stock 20% 30%
*PLN = Polish Złoty
Non-Convertible Bonds
Characteristic WS JI
Annual return volatility (σ) 5% 6%
Boyata is concerned about downside protection on the portfolio but does not want to incur costs to buy that
protection, so Krychowiak suggests to her that she add bonds with embedded options to the portfolio. In
Exhibit 2 Krychowiak has put together a list of bonds she would like Boyata to consider for the portfolio.
Exhibit 2
Nowak Industries’ Defined Benefit Pension Plan
Suggested Option-Embedded Bonds
Bond Maturity Coupon Characteristics
A 10 years 5.2% Callable @ 102 after 5 years
B 10 years 5.2% Putable @ 98 after 5 years
C 10 years 5.2% Callable @ 102 and putable @ 98 after 5 years

37. Concerning Krychowiak’s comments about active bond portfolio management, it is most likely that:
A. Both comments are true
B. Both comments are false
C. One comment is true and the other is false
38. Concerning Krychowiak’s observations about the CIR, Vasicek, and Ho-Lee models, it is most likely that:
A. Both observations are true
B. Both observations are false
C. One observation is true and the other is false
39. The steps that Krychowiak outlines for estimating the appropriate additional yield on a bond that may
default are most likely:
A. Correct
B. Incorrect: there is an error in step 2
C. Incorrect: there is an error in step 5
40. Concerning Krychowiak’s statements about structural models, it is most likely that:
41. Based on the data in Exhibit 1, the annual volatilities (standard deviations of returns) of WS’s and JI’s
convertible bonds, respectively, are closest to:
WS’s Bonds JI’s Bonds

A. 5% 6%
B. 20% 6%
C. 20% 30%
42. Based on the data in Exhibit 2 and Boyata’s stated objectives, the most appropriate bond to add to the
portfolio is most likely:
A. Bond A
B. Bond B
C. Bond C

FIXED INCOME
Marco Moreira is a fixed income consultant who spends a lot of time educating his clients; he wants them to
understand all of the subtleties of fixed income investing.
One of Moreira’s clients, Ikechukwu Akpeyi, needs to prepare a report on the bonds he owns. As part of the
report, he needs to compute the swap spread for each bond. Moreira has prepared a table of GBP
government bond (gilt) yields and GBP swap yields, and a table containing information on some of the GBP-
denominated bonds that Akpeyi owns, in Exhibits 1 and 2, respectively:
Exhibit 1
GBP On-The-Run Yields & Swap Fixed Rates
Maturity Gilt YTM Swap Fixed Rate
3 months 1.118% 1.223%
6 months 1.295% 1.405%
1 year 1.573% 1.693%
2 years 1.959% 2.099%
3 years 2.226% 2.386%
5 years 2.592% 2.792%
7 years 2.839% 3.079%
10 years 3.098% 3.398%
Exhibit 2
Ikechukwu Akpeyi
Selected GBP-Denominated Bonds
Bond Maturity Coupon Rate YTM
A 1 year, 3 months 4.20% 2.045%
B 2 years, 7 months 3.10% 2.646%
C 3 years, 1 month 6.40% 3.243%
D 8 years, 8 months 5.70% 3.866%
Akpeyi owns a number of callable bonds and wants to be able to determine their value. Moreira explains
that he can use a binomial tree approach to valuing those bonds. In describing to Akpeyi the process of
creating and calibrating a binomial tree, he makes these statements:
Statement 1: Calibrating a binomial is an iterative process. To determine the rates in the tree at a
particular time (say, t = 3), you must value a bond paying the par coupon rate that matures
one period later (t = 4, here) and adjust the rates until you get a price of par.
Statement 2: You start the iterative process on the right side of the tree (at the longest maturity) and work
your way to the left, at shorter maturities each step.

The current GBP yield curve is relatively flat, but Akpeyi anticipates that any day now it will steepen
considerably (a twist, resulting in the spread of the 10-year yield over the 1-year yield rising by about 100 bp)
and also experience an upward shift (the 5-year yield increasing by about 50 bp). He asks Moreira what
effect that will have on the value of the embedded options in his 10-year callable bonds.
Akpeyi also holds a number of BBB-rated, USD-denominated bonds issued by Dakota Manufacturing, Inc.
(DMI) and is concerned about credit migration. The bonds have 10 years to maturity, a modified duration of
7.4 years, and a spread duration 7.2 years. Akpeyi expects that the US yield curve will remain relatively
unchanged for the next year. Moreira has prepared a credit transition matrix, shown in Exhibit 3, which
includes average credit spreads.
Exhibit 3
One-Year Corporate Bond Transition Matrix
From/To AAA AA A BBB BB B CCC,CC,C D
AAA 90.00% 9.00% 0.50% 0.20% 0.15% 0.10% 0.05% 0.00%
AA 1.50% 88.50% 8.80% 1.00% 0.10% 0.05% 0.05% 0.00%
A 0.05% 2.50% 86.80% 8.50% 1.20% 0.60% 0.25% 0.10%
BBB 0.00% 0.30% 4.50% 84.50% 7.00% 2.10% 1.10% 0.50%
BB 0.00% 0.05% 0.30% 7.50% 81.30% 7.75% 2.20% 0.90%
B 0.00% 0.05% 0.15% 1.40% 9.75% 76.00% 8.45% 4.20%
CCC,CC,C 0.00% 0.00% 0.10% 0.90% 1.70% 18.50% 49.30% 29.50%
Credit
0.60% 0.90% 1.20% 1.50% 3.50% 6.50% 10.50% 15.50%
Spread
When investigating the spreads on Akpeyi’s DMI bonds, Moreira noticed that the term structure of credit
spreads for the DMI is inverted, as shown in Exhibit 4:
Exhibit 4
DMI BBB-Rated Bonds
Yield Spread over On-The-Run Treasury Curve
Maturity, Years Spread
1 2.24%
2 2.14%
3 2.05%
4 1.96%
5 1.88%
10 1.50%
15 1.21%
20 1.00%
Moreira believes that over the next year the DMI BBB-rated credit spread curve will likely change to normal
(upward-sloping), but he is much less certain about what will happen to the USD yield curve.

43. Based on the information in Exhibits 1 and 2, the swap spread corresponding to Bond C is closest to:
A. 16 bp
B. 20 bp
C. 84 bp
44. Concerning Moreira’s statements about calibrating a binomial tree, it is most likely that:
45. If Akpeyi’s expectations for the change in the yield curve occur in the next few days, the most likely effect
on the value of the embedded options in his callable bonds will be:
A. A decrease, because the twist and the shift will each decrease the value of the embedded call
options
B. An increase, because the twist and the shift will each increase the value of the embedded call
options
C. Unknown, because the twist will increase the value of the embedded call options while the shift will
decrease the value of the embedded call options
46. Given the data from Exhibit 3, the expected price change from credit migration for Akpeyi’s BBB-rated
bonds is closest to:
A. −2.95%
B. −2.87%
C. +2.95%
47. A possible explanation for the shape of the DMI BBB-rated bond’s term structure of credit spreads is
most likely that:
A. The US economy is at the peak of a business cycle, and DMI is a cyclical company
B. Compared to its industry averages, DMI has low leverage, stable cash flows, and high profit margins
C. DMI was recently acquired in a leveraged buyout by a private equity firm with a reputation for
improving the efficiency of the companies it purchases

48. Assuming that Moreira’s expectation for the DMI credit spread curve is accurate, for Akpeyi to profit
from it Moreira should most likely recommend that he:
A. Sell long-term DMI bonds and buy short-term DMI bonds
B. Buy short-term DMI bonds and buy a short-term DMI CDS
C. Take a long position in a long-term DMI CDS and a short position in a short-term DMI CDS

DERIVATIVES
Rodney Alexander has been learning about options valuation and is eager to put some of his knowledge to
work. Rodney identifies a non-dividend paying stock trading without exchange-traded options. His broker
does offer access to a dealer network that will quote him on one and two-year European-style LEAPs only.
Rodney assembles the data in Table 1. He calculates both u and d from historical return data for the stock.
Rodney notes that the current yield curve is flat out to the 5-year. Thus, both the one and the two-year rates
are the same.
Volatility is the troubling thing for Rodney. He has learned that increased volatility will increase option
prices. However, he wonders if call prices would increase if volatility only increased to the downside.
Rodney has also learned that it is possible to derive the price of one option from the price of another. He
obtains two-year European-style call prices in Table 2 from a dealer. He notes that the call prices from the
dealer are all higher at each strike than the ones he has calculated. However, the strike price of EUR 85 is
an ATM strike since the share price is also EUR 85. Rodney feels he already knows the put price for that
option at least.
Table 2
Strike European
80 EUR 12.83
85 EUR 9.99
90 EUR 8.12

Rodney feels he needs some help with understanding the effect of volatility on option prices. On an online
forum he posts several statements and asks for input as to which understanding is correct.
Statement 1: If volatility increases the price of a European call by EUR 0.20, then the value of the put at the
same strike price, keeping both the share price and risk-free rate constant, should drop by
EUR 0.20
same strike, keeping both the share price and risk-free rate constant, would either remain
unchanged or decrease but not necessarily by the same amount
same strike, keeping both the share price and risk-free rate constant, would also increase by
the same EUR 0.20
As a last exercise, Rodney wants to see if he can set up a hedged position on 100 shares of a stock. He has
+ -
calculated c as EUR 15.21 and c as 0.04 for a call with a strike price of EUR 60.

49. Based on the information in Table 1, the value of a two-year European call with a strike of X1 is closest to:
A. EUR 1027
B. EUR 12.16
C. EUR 24.80
50. If u remained unchanged at 1.12, but only d decreased to 0.76, the value of a call with a strike of X 1
would:
A. Decrease
B. Remain unchanged
C. Increase
51. Based only on the information in Table 2, the price of a put option with a strike of EUR 85 is closest to:
A. EUR 4.19
B. EUR 7.04
C. EUR 9.99
52. With regards to the statements posted in the online forum by Rodney, which one is most likely correct?
A. Statement 1
B. Statement 2
C. Statement 3
53. Based on Table 1, the price of an American put option with a strike of X 2, given a call price of EUR 7.59
would be closest to:
A. EUR 6.44
B. EUR 7.35
C. EUR 7.59
54. To set up the hedged position Rodney describes, he would most likely:
A. Sell 25 calls
B. Sell 60 calls
C. Sell 100 calls

Ashkan Shojaei was recently hired by Midwest Asset Management Company (MAMCO) as a junior portfolio
manager. Shojaei just landed his first clients, Oussama and Malinda Sliti, and they have arranged a meeting.
The Slitis are both 45 years old, married, with two children: a daughter who is 15 years old and a son who is
12 years old. The Slitis expect that the children will be attending university starting in three years and six
years, respectively (for which the Slitis will pay annual tuition of roughly USD 10,000 per year apiece for four
years), that Oussama will be retiring in 20 years, and that Malinda will retire at the same time. At their first
meeting, Shojaei outlines the steps in the portfolio management process, making, amongst others, these
statements:
Statement 1: The planning step includes the development of an investment policy statement (IPS),
forming expectations about how asset classes will perform (expected returns and volatilities
of returns), and creating a tactical asset allocation.
Statement 2: The execution step comprises selecting the specific assets for the portfolio and revising the
asset allocation as circumstances (either the investor’s circumstances, or capital market
circumstances) change.
Statement 3: The feedback step includes monitoring the portfolio performance, rebalancing the portfolio
as necessary (consistent with the guidelines of the IPS), and conducting performance
evaluation/appraisal.
Shojaei describes to the Slitis the elements of an IPS. He explains that:
 The objective in an IPS consists of the required or desired return on the investment portfolio, which
may be nominal or real, and may be before or after taxes
 The constraints in an IPS consist of all of the restrictions that must be followed when trying to
achieve the return objective, including:
o Risk tolerance
o Time horizon
o Taxes
o Legal and regulatory requirements
o Liquidity
o Unique circumstances
Shojaei tells the Slitis that the IPS and his capital market expectations can have a significant influence on the
Slitis’ strategic asset allocation (SAA), and that a significant consideration in the IPS is whether they take a
single-period perspective or a multiperiod perspective. With a multiperiod perspective, Shojaei can consider
the tax effects of rebalancing as well a serial correlation of returns, but it will generally be costlier to
implement than a single-period perspective would be. Capital market expectations will influence the SAA
directly through the expected returns, and volatilities of returns and correlations of returns that will affect
the standard deviation of returns of the portfolio.

In describing the return objective to the Slitis, Shojaei mentions that the return can be an absolute number,
or can be relative to a given benchmark, return, that it can be before taxes or after taxes, and that it can be
a real return or a nominal return. In describing the constraints, Shojaei says that the time horizon can be
single-stage or multistage, that unique circumstances can encompass such factors as socially responsible
investing, and that legal and regulatory factors generally affect institutional investors (such as ERISA for
pension plans in the US), but do not affect individual investors.
While talking with the Slitis, Shojaei explains his approach to investing with these comments:
Comment 1: I consider some investments – such as some option positions – to be inherently too risky to
recommend them to my clients.
Comment 2: Many clients have separate accounts dedicated to specific objectives, such as funding the
education of their children, or providing retirement income. I believe that this can be a
useful approach as long as the accounts are each managed with their specific goal in mind.
Comment 3: When I have to decide whether or not to have a client invest in a particular asset, I consider
not only that asset’s expected return and volatility of returns, but also its correlation of
returns with the other assets held by the client.

55. Sliti’s time horizon is best described as:

A. Single-stage, lasting 20 years
B. Multi-stage, with stages ending 3, 10, and 20 years from today
C. Multi-stage, with stages ending 3, 6, 7, 10, 20, and 40 – 50 years from today
56. Of the statements that Shojaei makes about the steps in the portfolio management process, the one
that is least likely to be accurate is:
A. Statement 1
B. Statement 2
C. Statement 3
57. In his description of the elements of an IPS to Sliti, Shojaei is most likely accurate in describing:
A. The objectives, but not the constraints
B. The constraints, but not the objectives
C. Neither the objectives nor the constraints
58. When discussing how capital market expectations and Sliti’s IPS will affect the strategic asset allocation
(SAA), Shojaei is most likely accurate in describing the effects of:
A. Sliti’s IPS only
B. Capital market expectations only
C. Both capital market expectations and Sliti’s IPS
59. In describing the objectives and constraints in an investment policy statement (IPS), Shojaei is most likely
accurate in describing:
A. The return objective, but not the constraints
B. The constraints, but not the return objective
C. Both the return objective and the constraints
60. Of the comments Shojaei makes about his investing approach, the one that is most likely consistent with
the portfolio perspective is:
A. Comment 1
B. Comment 2
C. Comment 3
End of Exam



2019 Exam Prep

Level II
Exam 2

Minute
Questions Topic
s
7 - 12 Quantitative Methods Authored By: Bill Campbell III, CFA 18
Total: 180


Farid Arias, Lee Yueng, Ivan Pivarić, Benjamin Tolisso, Zeina Diallo, and Joel Ndidi are sitting together at their
local CFA society dinner. They’re there to congratulate the members who recently passed their Level III CFA
exams and are new charterholders. They’ve never met each other, but as they are awaiting their food, they
go around the table, relating interesting stories about themselves.
First up is Farid Arias, CFA, who, that morning, was making a presentation to a group of prospective clients
when he noticed that there is an error in one of the tables: the table showed that one of the account values
was EUR 25 million when the true value was EUR 255 million. Arias hadn’t noticed the error before making
the presentation, but he promised to e-mail an updated table to everyone as soon as he returned to his
office. That afternoon, he made the correction to the table and e-mailed the revised presentation to each
person who included their e-mail address on their registration form. However, about 10% of those who
registered did not include their e-mail address, so he was unable to send the updated presentation to them.
Next is Lee Yueng, a research analyst at Archer Advisors, where he focuses on mining companies. One of
his target companies, Metallurgical Resources (MR), has invited him to visit their state-of-the-art mining
operation in Western Australia. To reach the mine, Yueng must fly to Perth, then fly 350 km in MR’s
company helicopter as no other air transportation is available. He will stay at the mine for five days in
modest accommodations as MR’s guest. Archer has paid for a commercial flight to Goa, and for the fuel
required for the round-trip on the helicopter.
After Yueng comes Ivan Pivarić, an equity analyst who has an interesting situation to share. Company A
(Pivarić declined to name the actual companies involved) is secretly negotiating to purchase Company B.
Depending on the final negotiated price, Company A’s stock price may increase, remain unchanged, or
decrease. Pivarić learned about the negotiations from a relative of his who works at Company A, and is
considering buying common stock in Company A.
Following Pivarić is Benjamin Tolisso, who manages a number of mutual funds according to a variety of
mandates. Two of the funds – FUNEX and FDEUX – have holdings for which proxy votes are being held in
the near future: in one month for FUNEX’s holdings and in two months for FDEUX’s holdings. Tolisso
researches the issues for the proxy vote for FUNEX and determines that a “Yes” vote probably will not
benefit the shareholders, while a “No” vote probably will benefit the shareholders. Therefore, he plans to
vote “No” for all of the shares held by FUNEX.
When Tolisso begins to research the issues for the proxy vote for FDEUX, he determines that the maximum
benefit to the shareholders is likely to be less than AUD 0.25 per share, and that it will likely cost him more
than AUD 1.00 per share to research the issues fully. Therefore, he plans not to vote the shares held by
FDEUX.

Next is Zeina Diallo, a vice president at Bologna Investment Consultancy (Consulenza per gli Investimenti di
Bologna, CIB). For the past three years, Diallo has directed CIB portfolio managers to use ItalTrade to
execute their trades. In exchange for this exclusive arrangement, ItalTrade pays CIB 15% of their brokerage
as a referral fee; even with the referral fee, ItalTrade’s brokerage fees are comparable to, and, in some
cases, lower than, those of other brokers. Diallo has not felt that she needs to disclose this arrangement to
the portfolio managers at CIB, nor to CIB’s clients, because she does not benefit personally from the
arrangement; only her employer, CIB, benefits.
Last up is Joel Ndidi, who earned his CFA charter in 2012, while working as a sell-side analyst. In 2015 he left
that position and began working as a project risk analyst, which fit his educational background better than
finance did. Because he was no longer in the finance industry, he stopped paying her dues to CFA Institute.
His business card reads, “Joel Ndidi, CFA”, but he is careful to point out that he is not a current member of
CFA Institute. He is attending this CFA dinner because he is considering returning to finance (because he
believes that the career opportunities – i.e., the money – is better), and wanted to do some networking.

1. Are any of Arias’ actions likely to violate CFA Institute Standards of Professional Conduct?
A. No
B. Yes, because he should have proofread the original table and caught the error before making the
presentation
C. Yes, because he is obligated to send the corrected presentation to all of the people who registered,
not merely those who included their e-mail addresses
2. With regard to Standard I(B) Independence and Objectivity, Yueng has most likely:
A. Not violated the Standard
B. Violated the Standard because his company did not pay for his stay at the mine
C. Violated the Standard because his company paid only for the fuel for the helicopter flight, rather
than paying the full cost of the flight
3. With regard to Standard II(A) Material Nonpublic Information, if Pivarić were to purchase Company A
stock:
A. He would most likely violate the Standard
B. He would most likely not violate the Standard
C. Whether he would violate the Standard or not cannot be determined
4. Which of Tolisso’s actions, if any, most likely violate CFA Institute Standards of Professional Conduct?
A. Neither of Tolisso’s actions violate the Standards
B. His choice not to vote the shares held by FDEUX
C. His choice to vote “No” for the shares held by FUNEX
5. Are Diallo’s actions likely to violate Standard VI(A) Disclosure of Conflicts?

A. Yes
B. No, because Diallo does not benefit personally from the referral fees
C. No, because the fees that ItalTrade charges are comparable to those of other brokers
6. Do Ndidi’s actions most likely violate Standard VII(B) Reference to CFA Institute, the CFA Designation, and
the CFA Program?
A. Yes
B. No, because he makes it clear that he is not a member of CFA Institute
C. No, because he earned the right to use the CFA designation and is planning to return to finance

Iyawa Mikel is a portfolio manager at Évreux Advisors (Conseillers Évreux SA, CE). Florian Sidibe, one of CE’s
portfolio managers, instructs Mikel to analyze a fund (Fund A) which he is considering adding to his
portfolio; he wants to make sure that it will provide adequate diversification of returns. Mikel plots the
monthly returns of Fund A versus the monthly returns of Sidibe’s portfolio for the last 36 months in Exhibit
1:
Exhibit 1
Monthly Returns: Fund A vs. Sidibe’s Portfolio
2016 – 2018
Sidibe also instructs Mikel to analyze another fund (Fund B) which he was considering adding to his
portfolio. Mikel runs an analysis and tells Sidibe that the correlation of returns between Fund B and Sidibe’s
portfolio for the past three years (using monthly returns) is +0.80. Sidibe says that’s too high, so Fund B will
provide too little diversification benefit. Mikel says that is not necessarily so – that the diversification benefit
might be higher than the correlation calculation suggests – and provides these reasons that the correlation
might not provide the whole picture:
Reason 1: The relationship between Fund B’s return and Sidibe’s portfolio’s return may be nonlinear, so the
correlation coefficient, being a measure of a linear relationship, might be too high.
Reason 2: The correlation may be spurious, and future correlations could be quite different from past
correlations.

Another portfolio manager at CE, Fakhreddine Khazri, believes that there might be a linear relationship
between the probability of companies defaulting on high-yield (HY) bonds and the unemployment rate. He
tells Mikel that he wants her to put together monthly data over the last 20 years to determine whether the
relationship is linear and to build a simple regression model that relates those quantities.
A third manager at CE, Niklas Rüdiger, asks Mikel to create a simple regression model to try to predict the
annual return (in %) on a stock given the annual growth rate (in %) in sales for its industry. As a test case,
Mikel gathers information on one particular stock, Stock X, and its industry. The results of her analysis are
shown in Exhibit 2. The mean annual industry growth rate over this period was 4.4%, and the mean annual
return for Stock X was 2.7% with a standard deviation of 3.12%.
Exhibit 2
Evaluation of Stock Return vs. Industry Growth
1996 – 2018
Regression Statistics
Multiple R 0.6843
R-squared 0.4683
Standard error of estimate 2.8486%
Observations 23
Degrees of Sum of Mean Sum of
ANOVA Freedom (df) Squares (SS)* Squares (MSS)* F
Regression 1 150.07
Residual 21 170.41
Total 22
Coefficients Standard Error t-Statistic p-Value

b0 −0.0098 0.0087 −1.1306 0.2773
b1 0.8375 0.1591 5.2630 0.0000
* 2 2
The units on SS and MSS are percent (% )

Mikel wonders whether the slope coefficient could, in fact, equal 1.0 and decides to test that at a 95%
confidence level. Exhibit 3 is an excerpt from a Student’s t-table.
Exhibit 3
Student’s t-Distribution
Upper Tail Probability p
df
0.25 0.20 0.15 0.10 0.05 0.025 0.02 0.01 0.005 0.0025
1 1.0000 1.3764 1.9626 3.0777 6.3138 12.71 15.89 31.82 63.66 127.3
2 0.8165 1.0607 1.3862 1.8856 2.9200 4.3027 4.8487 6.965 9.925 14.09
3 0.7649 0.9785 1.2498 1.6377 2.3534 3.1824 3.4819 4.5407 5.841 7.453
4 0.7407 0.9410 1.1896 1.5332 2.1318 2.7764 2.9985 3.7469 4.6041 5.598
5 0.7267 0.9195 1.1558 1.4759 2.0150 2.5706 2.7565 3.3649 4.0321 4.7733
6 0.7176 0.9057 1.1342 1.4398 1.9432 2.4469 2.6122 3.1427 3.7074 4.3168
7 0.7111 0.8960 1.1192 1.4149 1.8946 2.3646 2.5168 2.9980 3.4995 4.0293
8 0.7064 0.8889 1.1081 1.3968 1.8595 2.3060 2.4490 2.8965 3.3554 3.8325
9 0.7027 0.8834 1.0997 1.3830 1.8331 2.2622 2.3984 2.8214 3.2498 3.6897
10 0.6998 0.8791 1.0931 1.3722 1.8125 2.2281 2.3593 2.7638 3.1693 3.5814
11 0.6974 0.8755 1.0877 1.3634 1.7959 2.2010 2.3281 2.7181 3.1058 3.4966
12 0.6955 0.8726 1.0832 1.3562 1.7823 2.1788 2.3027 2.6810 3.0545 3.4284
13 0.6938 0.8702 1.0795 1.3502 1.7709 2.1604 2.2816 2.6503 3.0123 3.3725
14 0.6924 0.8681 1.0763 1.3450 1.7613 2.1448 2.2638 2.6245 2.9768 3.3257
15 0.6912 0.8662 1.0735 1.3406 1.7531 2.1314 2.2485 2.6025 2.9467 3.2860
16 0.6901 0.8647 1.0711 1.3368 1.7459 2.1199 2.2354 2.5835 2.9208 3.2520
17 0.6892 0.8633 1.0690 1.3334 1.7396 2.1098 2.2238 2.5669 2.8982 3.2224
18 0.6884 0.8620 1.0672 1.3304 1.7341 2.1009 2.2137 2.5524 2.8784 3.1966
19 0.6876 0.8610 1.0655 1.3277 1.7291 2.0930 2.2047 2.5395 2.8609 3.1737
20 0.6870 0.8600 1.0640 1.3253 1.7247 2.0860 2.1967 2.5280 2.8453 3.1534
21 0.6864 0.8591 1.0627 1.3232 1.7207 2.0796 2.1894 2.5176 2.8314 3.1352
22 0.6858 0.8583 1.0614 1.3212 1.7171 2.0739 2.1829 2.5083 2.8188 3.1188
23 0.6853 0.8575 1.0603 1.3195 1.7139 2.0687 2.1770 2.4999 2.8073 3.1040
24 0.6848 0.8569 1.0593 1.3178 1.7109 2.0639 2.1715 2.4922 2.7969 3.0905
25 0.6844 0.8562 1.0584 1.3163 1.7081 2.0595 2.1666 2.4851 2.7874 3.0782
26 0.6840 0.8557 1.0575 1.3150 1.7056 2.0555 2.1620 2.4786 2.7787 3.0669
27 0.6837 0.8551 1.0567 1.3137 1.7033 2.0518 2.1578 2.4727 2.7707 3.0565
28 0.6834 0.8546 1.0560 1.3125 1.7011 2.0484 2.1539 2.4671 2.7633 3.0469
29 0.6830 0.8542 1.0553 1.3114 1.6991 2.0452 2.1503 2.4620 2.7564 3.0380
30 0.6828 0.8538 1.0547 1.3104 1.6973 2.0423 2.1470 2.4573 2.7500 3.0298
50% 60% 70% 80% 90% 95% 96% 98% 99% 99.5%
Confidence Level 2-Tail

Rüdiger notices that the F statistic is missing from Mikel’s ANOVA table and asks Mikel what the value should
be and what it would mean at the 5% significance level. Mikel does the calculation and puts together an F-
statistic table in Exhibit 4.
Exhibit 4
F-Distribution, α = 5%
Numerator df
1 2 3 4 5 6 7 8 9 10
1 161.45 199.50 215.71 224.58 230.16 233.99 236.77 238.88 240.54 241.88
2 18.513 19.000 19.164 19.247 19.296 19.330 19.353 19.371 19.385 19.396
3 10.128 9.5521 9.2766 9.1172 9.0135 8.9406 8.8867 8.8452 8.8123 8.7855
4 7.7086 6.9443 6.5914 6.3882 6.2561 6.1631 6.0942 6.0410 5.9988 5.9644
5 6.6079 5.7861 5.4095 5.1922 5.0503 4.9503 4.8759 4.8183 4.7725 4.7351
6 5.9874 5.1433 4.7571 4.5337 4.3874 4.2839 4.2067 4.1468 4.0990 4.0600
7 5.5914 4.7374 4.3468 4.1203 3.9715 3.8660 3.7870 3.7257 3.6767 3.6365
8 5.3177 4.4590 4.0662 3.8379 3.6875 3.5806 3.5005 3.4381 3.3881 3.3472
9 5.1174 4.2565 3.8625 3.6331 3.4817 3.3738 3.2927 3.2296 3.1789 3.1373
10 4.9646 4.1028 3.7083 3.4780 3.3258 3.2172 3.1355 3.0717 3.0204 2.9782
11 4.8443 3.9823 3.5874 3.3567 3.2039 3.0946 3.0123 2.9480 2.8962 2.8536
12 4.7472 3.8853 3.4903 3.2592 3.1059 2.9961 2.9134 2.8486 2.7964 2.7534
Denominator df
13 4.6672 3.8056 3.4105 3.1791 3.0254 2.9153 2.8321 2.7669 2.7144 2.6710
14 4.6001 3.7389 3.3439 3.1122 2.9582 2.8477 2.7642 2.6987 2.6458 2.6022
15 4.5431 3.6823 3.2874 3.0556 2.9013 2.7905 2.7066 2.6408 2.5876 2.5437
16 4.4940 3.6337 3.2389 3.0069 2.8524 2.7413 2.6572 2.5911 2.5377 2.4935
17 4.4513 3.5915 3.1968 2.9647 2.8100 2.6987 2.6143 2.5480 2.4943 2.4499
18 4.4139 3.5546 3.1599 2.9277 2.7729 2.6613 2.5767 2.5102 2.4563 2.4117
19 4.3807 3.5219 3.1274 2.8951 2.7401 2.6283 2.5435 2.4768 2.4227 2.3779
20 4.3512 3.4928 3.0984 2.8661 2.7109 2.5990 2.5140 2.4471 2.3928 2.3479
21 4.3248 3.4668 3.0725 2.8401 2.6848 2.5727 2.4876 2.4205 2.3660 2.3210
22 4.3009 3.4434 3.0491 2.8167 2.6613 2.5491 2.4638 2.3965 2.3419 2.2967
23 4.2793 3.4221 3.0280 2.7955 2.6400 2.5277 2.4422 2.3748 2.3201 2.2747
24 4.2597 3.4028 3.0088 2.7763 2.6207 2.5082 2.4226 2.3551 2.3002 2.2547
25 4.2417 3.3852 2.9912 2.7587 2.6030 2.4904 2.4047 2.3371 2.2821 2.2365
26 4.2252 3.3690 2.9752 2.7426 2.5868 2.4741 2.3883 2.3205 2.2655 2.2197
27 4.2100 3.3541 2.9604 2.7278 2.5719 2.4591 2.3732 2.3053 2.2501 2.2043
28 4.1960 3.3404 2.9467 2.7141 2.5581 2.4453 2.3593 2.2913 2.2360 2.1900
29 4.1830 3.3277 2.9340 2.7014 2.5454 2.4324 2.3463 2.2783 2.2229 2.1768
30 4.1709 3.3158 2.9223 2.6896 2.5336 2.4205 2.3343 2.2662 2.2107 2.1646
Rüdiger believes that the industry’s sales will grow 6% in 2019, and he asks Mikel to create a 95% confidence
interval for Stock X’s return given that growth rate in industry sales. Mikel notes that the standard deviation
of the industry annual sales growth rate is 3.12%.

7. Based on the data in Exhibit 1, the correlation of Fund A’s returns with Sidibe’s portfolio’s returns is
closest to:
A. −0.60
B. +0.70
C. +0.95
8. Of the two reasons that Mikel gives to Sidibe that the true diversification benefit might be higher than
his calculation suggests, it is most likely the case that:
A. Both reasons are valid
B. Both reasons are invalid
C. One reason is valid, and one reason is invalid
9. In the HY bond default rate / unemployment rate model that Khazri wants Mikel to build, the
independent variable most likely:
A. Is the unemployment rate, with the default rate on HY bonds being the dependent variable
B. Is the default rate on HY bonds, with the unemployment rate being the dependent variable
C. Could be either the default rate on HY bonds or the unemployment rate, depending on how Mikel
creates the model
10. Based on the information in Exhibit 2, to test whether or not the slope coefficient could equal 1.0, the
value of the test statistic is closest to, and the correct decision regarding the null hypothesis is most likely,
respectively:
Test Statistic Value Decision

A. −1.02 Fail to reject H0
B. −1.02 Reject H0
C. 5.26 Reject H0
11. Using the data in Exhibit 2, the value of the F-statistic is closest to:
A. 0.88, and Mikel should conclude that b1 is not equal to zero
B. 18.5, and Mikel should conclude that b0 is not equal to zero
C. 18.5, and Mikel should conclude that b1 is not equal to zero

12. A 95% confidence interval for Stock X’s return in 2019 given 6% annual growth in sales for the industry is
closest to:
A. (−13.77%, 21.85%)
B. (−2.05%, 10.13%)
C. (−1.88%, 9.96%)

ECONOMICS
Samuel Plinkett has recently taken over the position as the chief economist at a large investment fund. The
previous employee, Diana Suminiacal died recently and suddenly after contracting an otherwise obsolete
disease from her unvaccinated children. Samuel’s task today is to try to make sense of where Diana left off.
Samuel begins to work through the notes she has left but comes to realize that there are missing segments.
From what Samuel can make out, in one country that Diana was following, the government in power had
approved a new corporate tax rate. The increase in the tax rate will be from 15% to 40%. All the funds
collected by the new tax are to be used for infrastructure upgrading/additions. This dual policy of increased
taxes and infrastructure spending is expected to increase potential GDP by 1.4% per year according the
central bank economists. There is some question remaining as to the effect on inflationary pressure in the
wake of the tax increase. As such, the central bank has announced, at its last policy meeting, that in light of
the new fiscal policies, monetary policy will now take a wait and see approach. Based on what Samuel can
piece together, he expects the central bank to be on hold for the next 12 months at least. Samuel finds
Table 1 along with Diana’s notes on this matter.
Table 1
Year
1 2 3 4
%ΔGDP 1.80% 2.10% 3.0%
GDP 2,333 2382 2432 2505
E/GDP 6% 8% 6% 4.2%
Earnings $140 $191 $146 $106
%ΔP/E 4.50% 0% 12%
P/E 12 12.54 12.54 14.04
Equity Index $1,680 $2,395 $1,831 $1,489
Samuel eventually finds a long-term equity market forecast produced by Diana. Particulars of the
assumptions used are in Table 2:
Table 2
Potential GDP 3.10%
Dividend Yield 2.70%
Expected Inflation 2.40%
Long-Term Equity Price Appreciation 7.80%

As Samuel continues through the remaining files, he notes that some of the notes are out of order with a
few of the files missing some content. However, he did find Table 3 posted below and, what he believes are
related to the table, the following key points:
• Planned increases in investment in primary/secondary education

• Higher levels of investment in capital stock
• New legislation that will increase property rights
Table 3
Country GDPr/Capita
A $39,468
B $8,619
C $55,342
Samuel can make out one more point on the notes; Country A has invested in STEM1 education and
research over the last 10 years. Over this period of time potential GDP in country A has increased however
labour continued to earn the real wage rate while the K/L ratio remained constant.
Samuel ends the day hoping tomorrow he can begin to work forward now that piecing together the current
work has been done.
1
STEM is a curriculum based on the idea of educating students in four specific disciplines — science,
technology, engineering and mathematics — in an interdisciplinary and applied approach.

13. With reference to Table 1, in which year did the tax hike most likely take effect?
A. Year 2
B. Year 3
C. Year 4
14. With respect to the uncertainty regarding inflation in the wake of the tax increase, inflationary pressure
will most likely:
A. increase.
B. decrease.
C. remain unchanged.
15. Based on Table 2, Samuel would most likely conclude that the previous estimate of the long-term price
appreciation of the equity market, given the other assumptions noted, is:
A. too low.
B. too high.
C. reasonable.
16. Which country in Table 3 would benefit the most from the key points listed?
A. Country A
B. Country B
C. Country C
17. The most likely outcome from a planned increase in the capital stock for an economy with a low
GDPr/capita ratio would be a:
A. higher y at a given k if K is currently earning the real interest rate
B. higher y at a higher k if K is being paid less than the real interest rate
C. higher y at a higher k if K is being paid more than the real interest rate
18. Given the final note regarding the period of STEM education and research investment, Country A most
likely experienced:
A. Capital deepening
B. Steady state growth
C. Technological advancement


Saxony Petroleum (SAXP) has its headquarters in Dresden, Germany. It prepares its financial statements
under IFRS standards with values denominated in EUR. SAXP owns 60% of Venezuelan Oil Producers (VOP).
Exhibit 1 contains selected data on the Venezuelan bolívar soberano to euro (VES/EUR) exchange rate during
2018. VOP’s functional currency is VES.
Exhibit 1
2018 VES/EUR Exchange Rates
Date VES/EUR
12/31/18 731.1107
11/30/18 171.3821
10/31/18 73.1355
9/28/18 72.0830
8/31/18 70.7897
7/31/18 2.0177
6/29/18 1.3420
5/31/18 0.9343
4/30/18 0.8325
3/30/18 0.6089
2/28/18 0.4296
1/31/18 0.0001
1/1/18 0.0001
SAXP has operations in several countries around the world, including Australia, South Africa, and India.
Exhibit 2 lists the corporate tax rates for the jurisdictions in which SAXP operates. SAXP’s year end is
December 31st.
Exhibit 2
Corporate Tax Rate by Jurisdiction
Jurisdiction Corporate Tax Rate
Germany 29.7%
Australia 28.5%
South Africa 28.0%
India 31.2%

On 12/21/18, SAXP sold a shipment of heating oil to a customer in New Zealand for a contracted price of
NZD 20 million. The terms of the purchase were net 30. On 20 January 2019, SAXP received payment for
the heating oil. Exhibit 3 contains selected exchange rate data for EUR/NZD:
Exhibit 3
Selected EUR/NZD Exchange Rates
Date EUR/NZD
12/21/2018 0.5908
12/31/2018 0.5857
1/20/2019 0.5929
The 2018 income statement and balance sheet for SAXP’s Australian operation (SAXP-AUS) are shown in
Exhibits 4 and 5, respectively. Exhibit 6 contains selected USD/EUR exchange rate data. The functional
currency for SAXP-AUS is AUD.
Exhibit 4
SAXP-AUS
Income Statement, Year Ending 12/31/18
(Amounts in Millions)
Sales AUD 30,000
COGS (20,000)
SG&A (3,500)
Depreciation (2,000)
Amortization (400)
Interest Expense (1,500)
Income Taxes (2,000)
Net Income AUD 600
Exhibit 5
SAXP-AUS
Balance Sheet, 12/31/18
(Amounts in Millions)
Current Assets Current Liabilities
Cash AUD 3,500 A/P AUD 5,000
A/R 10,000 Long-Term Liabilities
Inventory 15,000 Bonds Payable 35,000
Noncurrent Assets Equity

PP&E, net 40,000 Paid-In Capital 10,000
Intangibles 6,500 R/E 25,000
Total Assets AUD 75,000 Total Liab. + Eq. AUD 75,000

Exhibit 6
Selected EUR/AUD Exchange Rates
Date EUR/AUD
12/31/2018 0.6148
2018 Average 0.6329
Oct – Dec 2018 Average 0.6285
Nov. 2017 – Sep. 2018 Average 0.6367
1/1/2018 0.6499
7/19/04* 0.5887
†
6/14/02 0.5923
4/24/02‡ 0.6087
*
Date of purchase of patent (intangible asset)
†
Date of purchase of PP&E
‡
Date of incorporation, contribution of capital
Nick Pope is an equity analyst who follows the oil and gas industry. He compares the components of net
sales growth for SAXP and one of its competitors, UK Petrol (UKP) in Exhibit 7:
Exhibit 7
Components of International Net Sales Growth
2018 vs. 2017
Component SAXP UKP
Sales volume +4% +6%
Net price realization +1% +1%
Foreign currency exchange +3% +1%
Net sales growth +8% +8%
SAXP’s biggest foreign markets are China, Canada, and the US. Pope has prepared data on currency
exchange rates between EUR and CNY, CAD, and USD, respectively, as shown in Exhibit 8:
Exhibit 8
2018 Currency Exchange Rates vs. EUR
Currency Mean CV*
CNY 0.1281 1.92%
CAD 0.6546 1.86%
USD 0.8477 3.08%
*Coefficient of Variation: σ/μ

19. When SAXP consolidates VOP’s financial statements into its own for 2018, the method that it should use
is most likely:
A. The temporal method
B. The current rate method
C. Restating the values for inflation, then translating at the current rate
20. Based on the data in Exhibit 2, assuming that profits are taxed only in the jurisdiction in which they are
earned, to maximize its after-tax profits, SAXP should most likely:
A. Have all of its other operations sell their products to the South African operation at their cost, and
have the South African operation sell the products to customers at the retail price
B. Have all of its other operations sell their products to the South African operation at the retail price
and have the South African operation sell the products to customers at the retail price
C. Have the Indian operation sell its products to the South African operation at the retail price, have the
South African operation sell its products to the Indian operation at its cost, and have both sell the
transferred products to customers at the retail price.
21. With regard to the 12/21/18 sale of heating oil to their New Zealand customer, on the payment date
(1/20/19), SAXP will most likely record a foreign currency accounting:
A. Loss of EUR 102,000
B. Gain of EUR 42,000
C. Gain of EUR 144,000
22. In 2018, the net income in EUR that SAXP-AUS will report on its translated financial statements, in
millions, is closest to:
A. EUR 369
B. EUR 380
C. EUR 567
23. Based on the data in Exhibit 7, the company that is more likely to be able to sustain its level of sales
growth:
A. Is SAXP
B. Is UKP
C. Cannot be determined

24. Based on the data in Exhibit 8, SAXP most likely faces the largest and smallest exchange rate risks,
respectively, in which currencies?
Largest Risk Smallest Risk

A. USD CNY
B. USD CAD
C. CNY CAD

CORPORATE FINANCE
Canberra Computer Systems Ltd. (CCS) has been interested in purchasing Wallaroo Electronics Ltd. (WE) in
an all-stock purchase. WE supply many of the electronic components in CCS’s laptop and notebook
computers, and CCS wants stronger control of that supply chain. After the merger, CCS plans to retain its
identity.
WE’s management has not been happy with the proposed purchase, and had encouraged another
company, Wagga Wagga Tech, Ltd. (WWT), to purchase a substantial portion of WE’s outstanding shares in
an effort to prevent the takeover. WE’s management had hoped that a purchase by WWT, along with a
board of directors only one-quarter of whom are elected each year, would be sufficient to prevent the
takeover. Unfortunately, WWT wasn’t able to purchase WE’s shares, and CCS went directly to WE’s board,
which overwhelmingly approved the purchase and recommended it to WE’s shareholders.
CCS’s chief financial officer (CFO), Josh Mooy, has put together information in Exhibit 1 about CCS and WE
before the merger.
Exhibit 1
CCS/WE Merger
Selected Pre-Merger Data
CCS WE
Stock price per share AUD 80.00 AUD 24.00
Shares outstanding 3,500,000 2,000,000
2018 net income AUD 11,200,000 AUD 2,800,000
CCS expects to purchase 100% of WE’s outstanding common stock by exchanging CCS’s common stock for it
at a 20% premium over WE’s current market price. Mooy has justified the premium because he anticipates
synergies with a present value of AUD 30 million. CCS’s upper management has asked Mooy to calculate the
post-merger P/E ratio and EPS for CCS, as well as the gains that will accrue to existing CCS shareholders.
As a check on the value of WE, Mooy has put together in Exhibit 2 excerpts from the pro forma financial
statements he prepared for WE.
Exhibit 2
Selected WE Pro Forma Financial Data
(Values in Thousands, AUD)
2019 2020 2021
Depreciation 4,400 4,750 5,200
Net interest expense 6,150 5,900 5,650
Net income 16,800 18,000 19,250
ΔNWC 4,050 4,400 4,800
ΔDeferred tax 200 200 200
CapEx 12,500 13,500 14,600
NOPLAT 21,305 22,330 23,405
Mooy expects that the appropriate tax rate for WE is 30%, and has calculated its WACC as 9.6%, with an
adjusted WACC of 8.5%. Mooy will use a terminal FCFF growth rate of 1.5% per year and expects a capital
structure of 60% debt and 40% equity.

25. CCS’s motivation for the merger with WE is best classified as:
A. Diversification
B. Unlocking hidden value
C. Increasing market power
26. CCS’s purchase of WE is best classified as a:

A. Forward integration consolidation
B. Backward integration consolidation
C. Backward integration statutory merger
27. WE’s takeover defenses – the configuration of its board of directors and the request made to WWT – are,
respectively, best classified as:
Board Configuration WWT Request

A. Pre-offer Pre-offer
B. Pre-offer Post-offer
C. Post-offer Post-offer
28. Based on the data in Exhibit 1, CCS’s post-merger P/E ratio and EPS, respectively, are closest to:
P/E Ratio Earnings per Share

A. 23.4 AUD 2.55
B. 25.6 AUD 2.55
C. 25.6 AUD 3.32
29. The total gain that will accrue to current CCS shareholders from the merger is closest to:
A. AUD 15.0 million
B. AUD 16.9 million
C. AUD 20.4 million
30. Based on the information in Exhibit 2, the value of WE’s equity based on discounted cash flows is closest
to:
A. AUD 44,200,000
B. AUD 47,900,000
C. AUD 51,200,000

EQUITY VALUATION
Raúl Ramos and Gianluigi Pavoletti are consultants in private company valuation. In discussing why they
chose private company valuation over public company valuation, they make these statements:
Ramos: I like the fact that there are so many more variables in valuing private companies. They tend to
have greater agency problems than publicly traded companies, and many more adjustments
needed in their financial statements. I like the challenge.
Pavoletti: I also like getting into the financial statements and seeing what needs to be adjusted to make
them comparable to those of public companies (or, at least, compliant with accounting
standards). Because there tends to be more pressure for short-term performance in private
companies, there are often lots of changes that have to be made. It’s exciting!
Ramos has been hired by a lender who has been approached about a loan to a private company, Trident
Industries, Inc. (TI2). The lender will require TI2’s tangible assets to be pledged as collateral for the loan and
wants to be sure that the value will be sufficient to protect its interest. Pavoletti has been hired by a public
company that is considering acquiring a private company, Harris & Campbell (H&C), and wants to determine
an appropriate price to pay, considering any synergies that may accrue.
In evaluating H&C, Pavoletti writes these notes:
• H&C holds title to several vehicles that are used by the company’s owners and their families. All
expenses for these vehicles (fuel, maintenance, insurance, registration, and so on) are paid by the
company.
• The salaries that the owners and their family members take are, on average, about 50% higher than
the industry norm for their positions.
• Three of the owners have received loans from H&C for which they pay no interest.

After normalizing earnings, Pavoletti estimates H&C’s free cash flow to the firm for the next five years. He
plans to use those projections, along with an estimated terminal value, to determine H&C’s value today. He
has gathered the pertinent information in Exhibit 1:
Exhibit 1
Harris & Campbell
Forecasted Cash Flows and
Other Pertinent Information, 12/31/18
2019 Estimated FCFF USD 9,120,000
Post-2023 FCFF growth rate 2.50%
Weighted average cost of capital 6.60%
Required return on common equity 9.40%
Expected industry average P/CF, 2023 22.5
Pavoletti’s client asked him how he determined the required return on common equity (rCE) and the
weighted average cost of capital (WACC) that appear in Exhibit 1. Pavoletti explained that for rCE he used
CAPM, and estimated H&C’s beta by using an average beta for comparable publicly traded companies. He
said that for WACC he used the rCE he that he had estimated, the YTM on H&C’s existing long-term bank
loans (as they haven’t issued any bonds), H&C’s current marginal tax rate, and his anticipated capital
structure for H&C after acquisition, which he believes will be closer to the parent’s capital structure than to
H&C’s existing capital structure (which is mostly equity).

31. Considering the statements that Ramos and Pavoletti make about private equity valuation versus public
company valuation, it is most likely the case that:
A. Both statements are accurate
B. Both statements are inaccurate
C. One statement is accurate, and the other statement is inaccurate
32. The definitions of value that Ramos and Pavoletti, respectively, will use for their valuations are most
likely:
Ramos Pavoletti
A. Fair Market Value Market Value
B. Market Value Investment Value
C. Investment Value Fair Market Value
33. The approaches that Ramos and Pavoletti, respectively, will use for their valuations are most likely:
Ramos Pavoletti
A. Asset-Based Approach Income Approach
B. Asset-Based Approach Market Approach
C. Market Approach Income Approach
34. Based on Pavolatti’s notes, the most likely result of his adjustments to normalize the private company’s
earnings:
A. Will decrease the earnings compared to those shown on their financial statements
B. Will increase the earnings compared to those shown on their financial statements
35. Based on the information in Exhibit 1, Pavolatti’s estimate of the value of H&C is closest to:
A. USD 143 million
B. USD 222 million
C. USD 242 million
36. Of the approaches that Pavoletti used to estimate H&C’s cost of common equity and WACC, it is most
A. Neither approach is reasonable
B. Exactly one approach is reasonable
C. Both approaches are reasonable

FIXED INCOME
Bryan Waston is a credit analyst at Duarte, Wallace, and Campbell (DWC), a fixed income consulting firm.
DWC have just acquired a new client, the Doyle Family Foundation (the Foundation), and have assigned
Waston to the account. Daniel Doyle, trustee for the Foundation, is interested in ways to improve the
performance of the Foundation’s fixed income portfolio. He believes that credit bonds are the means to do
just that, but he is unfamiliar with the nuances of these securities, which is why he hired DWC.
At their first meeting, Waston tries to explain how credit analysis works but finds that Doyle is unfamiliar
with most of the terms that he is using. He backtracks a bit and begins again, this time defining the terms.
In part, he tells Doyle:
“Expected exposure is the total amount that you could lose if the issuer defaults; it is the future value of all
future contractual payments. It does not consider any possible recovery, for example, through bankruptcy
proceedings.”
“Loss given default is the expected amount you will lose if the issuer defaults. It differs from expected
exposure in that it considers the likely recovery amount from, say, a bankruptcy court.”
“Credit valuation adjustment is the total present value of expected losses, considering the probability of
default on each payment date, and the possible recovery in case of default on each payment date. It is the
amount you subtract from the value of a default-free bond to get the value of a bond that might default.”
Doyle is familiar with FICO scores – he says that his has never dropped below 800 – but does not
understand credit ratings nearly as well. Waston tells him,
“The ratings use letters instead of numbers: highest to lowest they are AAA, AA, A, BBB, BB,
and so on down to D. A rating might also have a plus or a minus: A+ is higher than A, which
is higher than A−, which is higher than BBB+. The ratings are based not only on probability
of default, but also on loss given default. In addition to rating specific bond issues, the rating
agencies also rate the issuers themselves.”

Waston tells Doyle that a change in a bond’s rating can have a great impact on the value of the bond. To
illustrate this, he has prepared a credit transition matrix, shown in Exhibit 1, which includes average credit
spreads.
Exhibit 1
One-Year Corporate Bond Transition Matrix
From/To AAA AA A BBB BB B CCC,CC,C D
AAA 90.00% 9.00% 0.50% 0.20% 0.15% 0.10% 0.05% 0.00%
AA 1.50% 88.50% 8.80% 1.00% 0.10% 0.05% 0.05% 0.00%
A 0.05% 2.50% 86.80% 8.50% 1.20% 0.60% 0.25% 0.10%
BBB 0.00% 0.30% 4.50% 84.50% 7.00% 2.10% 1.10% 0.50%
BB 0.00% 0.05% 0.30% 7.50% 81.30% 7.75% 2.20% 0.90%
B 0.00% 0.05% 0.15% 1.40% 9.75% 76.00% 8.45% 4.20%
CCC,CC,C 0.00% 0.00% 0.10% 0.90% 1.70% 18.50% 49.30% 29.50%
Credit
0.60% 0.90% 1.20% 1.50% 3.50% 6.50% 10.50% 15.50%
Spread
Waston then shows Doyle how a change in credit rating, known as credit migration, for, say, a BB-rated
bond can affect the credit spread.
When Doyle asked about how the credit spreads were calculated in Exhibit 1, Waston gave him an example
of a hypothetical bond, shown in Exhibit 2. The yield on a benchmark 5-year bond is 4.5%, and that bond
would sell at USD 978.05 today.
Exhibit 2
Analysis of Credit Risk
Hypothetical 4%, 5-Year, Risky Bond
Loss
Discount PV of
Date Exposure Recovery Given P(Default) P(Survival) E(Loss)
Factor E(Loss)
Default
1 1,022.06 408.82 613.24 5.00% 95.00% 30.66 0.9569 29.34
2 1,026.26 410.50 615.75 4.75% 90.25% 29.25 0.9157 26.78
3 1,030.64 412.25 618.38 4.51% 85.74% 27.90 0.8763 24.45
4 1,035.22 414.09 621.13 4.29% 81.45% 26.63 0.8386 22.33
5 1,040.00 416.00 624.00 4.07% 77.38% 25.41 0.8025 20.39
Note: Exposure, Recovery, Loss Given Default, E(Loss), and PV of E(Loss) are all given in USD.
Waston shows Doyle an example of an A-rated bond whose credit spread had changed over the last month
from 105 bp to 147 bp, without a change in the credit rating. Doyle asks Waston about the reason for the
spread change.

Finally, Waston tells Doyle about securitized bonds. In Exhibit 3 he shows Doyle some details on two
securitized bonds to illustrate their similarities and differences.
Exhibit 3
Asset-Backed Securities
Selected Details
Characteristic Bond 1 Bond 2
Underlying collateral Automobile loans Real estate construction loans
Number of loans 224,183 192
Outstanding balance USD 7,863,000,000 USD 17,357,000,000
Granularity Granular Non-granular
Homogeneity Homogeneous Heterogeneous
Risk horizon Medium-term Medium-term

37. Of the three terms that Waston defined for Doyle, the one that is least likely to be accurate is:
A. Expected exposure
B. Loss given default
C. Credit valuation adjustment
38. Is Waston’s description of credit ratings most likely accurate?

A. Yes
B. No, because the ratings are based on probability of default but not on loss given default
C. No, because the ratings are given only for bond issues, but not for the issuers themselves
39. Given the data from Exhibit 1, the expected credit spread change from credit migration for BB-rated
bonds is closest to:
A. −34 bp
B. 34 bp
C. 40 bp
40. Given the data in Exhibit 2, the appropriate credit spread on the hypothetical bond is closest to:
A. 310 bp
B. 356 bp
C. 760 bp
41. In explaining the credit spread change of the A-rated bond, Waston should most likely include as reasons
changes in:
A. Liquidity, expected loss from default and expected inflation
B. Uncertainty regarding default, uncertainty regarding inflation and liquidity
C. Expected loss from default, uncertainty about loss from default and uncertainty about liquidity
42. Based on the data in Exhibit 3, the appropriate credit analysis approaches for Bond 1 and Bond 2,
respectively, are most likely:
Bond 1 Bond 2
A. Portfolio-based Loan-by-loan
B. Statistical-based Portfolio-based
C. Statistical-based Loan-by-loan

DERIVATIVES
David Chatters, CFA is an independent corporate financial consultant with a dozen small business clients.
Each client’s business does not have the size to justify a full-time CFO, so they contract that function out to
David. Each morning David’s routine involves checking e-mails for urgent business matters that are time
sensitive. He determines that three e-mails are of a time sensitive nature.
The first is from Anita Vally. Anita holds an equity position in a dividend paying company named Clairmont
Inc. that she wishes to sell. It is currently mid-July and Anita asks if there is a way to defer the actual sale to
January for tax purposes. David replies and recommends two strategies to Anita.
Strategy 1: Sell a deep ITM call option with an expiration date in January, which is 6 months away.
Strategy 2: Take a short position on a 6-month forward contract, which will expire mid-January.
Anita responds several minutes later with a decision to take a short position in a 6-month forward contract.
Stock and dividend information for Clairmont Inc., along with 3 and 6-month risk free rates, are given in
Table 1:
David then opens Sara Cantor’s e-mail. Sara has USD 5 million arriving in 6 months that will not be required
for general business use for 12 months. She would like to arrange a rate on that deposit today. Sara tells
David that she has concluded, based on the quoted Libor rates this morning, that a fixed rate on a 6×12 FRA
would be 3.46%. Sara indicates that she would like to have that in pace by noon. Current Libor rates are
given in Table 2:

Assume that in 6-months time, the structure of Libor rates is as shown in Table 3:
Finally, David gets to George Dastitas e-mail. George was long Treasury bond futures and does not wish to
offset his position before expiration. George wants to opt for delivery. Several bonds that qualify for
delivery are listed in Table 4 below.
George makes the following statement regarding the Treasury bond futures contract: “Since the long side
decides which bond to deliver, I believe we should select Bond 2 as it is the cheapest to deliver.”
George also writes that he would like to convert EUR 1 million in 12 months time to USD. George includes in
his e-mail the rates in Table 5 and asks David to enter into a forward agreement to get this done ASAP.
David confirms the spot rate online and finds that the SUSD/EUR rate is currently 1.1425 and that the interest
rates George has selected are continuously compounded.

43. Based on the information in Table 1, the forward price for a short position would be closest to:
A. USD 64.83
B. USD 66.10
C. USD 67.36
44. Based on the information in Table 1, the value of Anita’s position in the Clairmont Inc. forward contract
at T=3 months would be closest to:
A. USD -3.66
B. USD -2.41
C. USD 3.66
45. Based on the rates in Table 2, determine if Sara is correct regarding the price of the 6×12 FRA.
A. Yes, she is correct
B. No, the price of the FRA should be lower
C. No, the price of the FRA should be higher
46. Based on the rates in Table 2 and Table 3, on settlement of the FRA, Sara would:
A. Pay 19,000
B. Receive USD 18,747
C. Receive USD 19,000
47. Is George correct regarding his statement about the Treasury bond futures contract?
A. No as to which side delivers and no as to the cheapest to deliver
B. No as to which side delivers but yes as to the cheapest to deliver
C. Yes, as to which side delivers but no as to the cheapest to deliver
48. Based on the rates in Table 5, calculate the price of the currency forward and the position David would
take.
A. A long position at a forward rate of 1.1589
B. A short position at a forward rate of 1.1283
C. A short position at a forward rate of 1.1589

Toa Xu is a Portfolio Manager with Northcreek Counselors, a multi-family office in Germany. Northcreek’s
management has decided to bring all publicly traded investment activities in -house and started building a
team responsible for making investment recommendations that will be added to the firm’s multi-asset
portfolio. Toa’s first meeting of the day is with Susan Millstone, a REIT analyst he is considering adding to the
team.
Toa begins the meeting by asking Susan to make real estate sector recommendations based on the
following economic outlook generated by Northcreek’s macro strategist:
1. GDP is expected to remain stable at the current growth rate

2. Two international technology companies will be opening new corporate head offices within the next six
months and have a strong demand for new employees
3. The country has recently launched the WorkGermany program, a tax incentive program designed to
encourage small businesses to hire new grads
Impressed with Susan’s answers, Toa presents her with a buy recommendation note he received that
morning sent from Farah Janarkur, a sell-side analyst at Arnold Golds, a brokerage firm Northcreek uses for
the majority of their trading activity. Farah is recommending that Timberline Properties, a health care REIT,
is a buy at EUR 9.50. Key financial data from Farah’s report are presented in Exhibit 1:

Toa and Susan next discuss Juniper REIT, a storage REIT that Northcreek currently holds in their portfolio.
Juniper recently paid EUR 2.50 as its annual dividend, and last traded at EUR 43. Toa’s team has been doing
scenario testing to determine if it might be time to replace the holding with a better opportunity. Key inputs
in the team’s work are found in Exhibit 2:
Exhibit 2
Scenario 1 Scenario 2 Scenario 3
Growth of dividend next year and in year 2 4.50% 4.50% 5.00%
Long term dividend growth rate 2.00% 1.75% 1.75%
Investor required return 8.25% 8.00% 8.00%
Toa describes the method used by the team to arrive at target prices for their investments before adding
names to the portfolio.
Toa: “We equal weight the income, NAV and relative value approaches to arrive at a target price.”
He presents Susan with Exhibit 3, detailing key income statement data used in a recent valuation. In
describing the teams use of relative value metrics such as P/FFO and P/AFFO, he makes the following three
statements:
Statement 1: Price-to-AFFO is best described as the REIT equivalent of the Price-to-Earnings ratio used in
non-REIT equity stock valuation.
Statement 2: Depreciation and amortization charges are added back to net income when calculating FFO
because real estate tends to appreciate in value over the long term.
Statement 3: AFFO is a superior measure of economic income as compared to FFO and is therefore
standardized and widely reported through market data reporting services such as
Bloomberg or Thomson Reuters.

Finally, Toa explains to Susan that part of the analyst’s role will be supporting the portfolio managers in
client meetings.
Toa: “If asked by a client, or prospect, about the advantages of REITs, briefly discuss the tax advantages that
might be present in the investment vehicle.”
Susan replies with the following two statements:
Statement 1: REITs are more tax-advantaged than direct property ownership because tax losses can be
passed on to investors.
Statement 2: REITs are more tax-advantaged than public equity stocks because they avoid taxation at the
corporate level.

49. Which REIT subgroup is Susan least likely to recommend based on the economic forecast presented by
the macro strategist?
A. Office
B. Industrial
C. Multi-family
50. Using the NAVPS approach to valuation, based on the information in Exhibit 1, and the current market
price, Timberline Properties is most likely:
A. Overvalued
B. Fairly Valued
C. Undervalued
51. Using the dividend discount approach, which scenario presented in Exhibit 2 is least likely to produce the
lowest intrinsic value?
A. Scenario 1
B. Scenario 2
C. Scenario 3
52. Which of Toa’s statements related to relative valuation is most likely correct?
A. Statement 1
B. Statement 2
C. Statement 3
53. Based only on Exhibit 3, the per share dividend payout ratio on FFO for MPOW REIT is closest to:
A. 64%
B. 90%
C. Not enough information
54. Which of Susan’s statements regarding the tax advantages of investing in REITs is most likely correct?
A. Statement 1
B. Statement 2
C. Neither Statement 1 or Statement 2

Esparanza Higuaín recently attended a conference on computer trading and returned to her firm,
Montalbán & Villechaize Investments (MVI), agog with a wealth of new information and ideas. Her first
assignment was to explain to MVI’s traders what she had learned at the conference. During her
presentation, Higuaín made the following statements:
Statement 1: In algorithmic trading, computers do essentially what you guys (the traders) do: they make
the same sort of buy and sell decisions that humans make, but they do it a lot faster.
Statement 2: The “algorithmic” part of algorithmic trading means that the computer has a set of rules
that it follows to determine whether, when, how, and where to make trades. There are
execution algorithms and high-frequency algorithms.
Statement 3: Execution algorithms are given small trades which they execute very quickly, but without
considering a follow-up transaction; i.e., they do not buy a security with the intent of
reselling it quickly, nor do they sell a security with the intent of repurchasing it quickly.
Statement 4: High-frequency algorithms analyze market data and search for patterns that indicate
profitable trades. They will often buy a security and resell it very quickly, or sell a security
and repurchase it very quickly, all with the idea of making a profit (after transaction costs)
on the entire set of transactions.
Higuaín goes on to describe the types of execution algorithms and high-frequency algorithms, including the
following two descriptions:
Execution algorithms: There are several types of execution algorithms, including volume-weighted
average price (VWAP), implementation shortfall, and market participation. In
implementation shortfall, the goal is to ensure favorable price movement between
the price at which the decision to trade is made and the actual price at which the
trade is executed.
High-frequency algorithms: There are also several types of high-frequency algorithms, including
statistical arbitrage, liquidity aggregation, real-time security pricing, and
genetic tuning. Real-time security pricing is useful to dealers in helping them
establish their bid-ask spreads to maximize their profit.
Higuaín explains the idea of market fragmentation: that a given security can trade in a number of markets at
different prices and with different levels of liquidity. She says that liquidity aggregation is a high-frequency
algorithm approach to overcome market fragmentation by increasing the liquidity in the less liquid markets
until the liquidity levels are roughly equal across all markets.

Higuaín then turns to risk management uses of algorithmic trading. She mentions two specific applications
with regard to risk management:
Application 1: Testing algorithms both with actual historical data and with specialized hypothetical
scenarios to ensure that the algorithms behave as expected before going live.
Application 2: Real-time pre-trade risk firewalls that can ensure that trades:
• Do not run afoul of compliance restrictions

• Do not exceed established risk limits
• Are sensible in price and quantity (e.g., disallowing a trade at $120 per share
when the market price is $12 per share, an example of a typographical error)
Higuaín concludes by enumerating the positive and negative aspects of algorithmic trading. Amongst the
positive aspects, she lists:
1. Lower cost of execution

2. Lower risk of trading errors
3. Minimized market impact of large trades
Amongst the negative aspects, she cites:
1. Unfair advantage
2. Algorithms gone wild
3. Decreased efficiency in certain markets

55. Concerning Higuaín’s description of algorithmic trading – Statements 1 and 2 – it is most likely the case
that:
C. One statement is true, and the other statement is false
56. Concerning Higuaín’s contrast of execution algorithms and high-frequency algorithms – Statements 3
and 4 – it is most likely the case that:
C. One statement is true, and the other statement is false
57. Concerning Higuaín’s descriptions of execution algorithms and high-frequency algorithms, it is most
A. Both descriptions are accurate
B. Both descriptions are inaccurate
C. One description is accurate, and the other description is inaccurate
58. Without regard to market fragmentation, it is most likely the case that Higuaín’s description of market
fragmentation is:
A. Incorrect
B. Correct, but her description of how algorithmic trading handles it is incorrect
C. Correct, and her description of how algorithmic trading handles it is also correct
59. Concerning Higuaín’s descriptions of the risk management applications of algorithmic trading, it is most
A. Both applications are accurate
B. Both applications are inaccurate
C. One application is accurate, and the other application is inaccurate
60. Of the positive and negative aspects of algorithmic trading enumerated by Higuaín, the ones that are
least likely to be accurate are:
A. positive aspect 2 and negative aspect 1
B. positive aspect 2 and negative aspect 3
C. positive aspect 3 and negative aspect 1



2019 Exam Prep

Level II
Exam 3

Total: 180


João Martins is an equity analyst at Amadora Investments (AI). The jurisdiction which governs AI requires
that financial professionals disclose the source of information that they use in reports and presentations
that are distributed to clients or the general public, but not if they are only for internal use. Martins recently
wrote a research report on a manufacturing company in which he used a considerable amount of material
from an analyst’s report that he read online. Because the report was for internal use only – it would not be
distributed to clients or the general public – Martins did not cite the source of the information.
Martins wrote another research report on Castro Verde Mining (CVM). When AI management assigned this
research to Martins, they were unaware that the fiancée of Martins’ nephew is the compliance officer at
CVM. Martins saw no need to disclose this relationship in the report because she was not yet part of
Martins’ family, and, furthermore, his analysis led him to a “sell” recommendation for CVM common stock.
One of Martins’ colleagues at AI is Wojciech Blaszczykowski, CFA, an account manager who goes by the
nickname “Blaze”. He has just finished reading one of Martins’ reports on a manufacturer of sporting goods
in which Martins’ recommendation was “buy” and is about to distribute the report to AI clients. Blaze has
determined which clients would find this investment unsuitable, so he does not contact them. For the
clients for whom it a suitable investment, he e-mails the report and recommendation. AI has some clients –
their “platinum service” clients – who have paid extra to receive a phone call with the latest
recommendations, so after sending the e-mails, Blaze phones these clients to let them know the
recommendation.
One of Blaze’s clients has offered him a bonus of EUR 25,000 if the return on her portfolio over the next year
should exceed 12%. Blaze e-mails his supervisor to tell him about the offer, he discusses it with AI’s
management, then phones Blaze to let him know that he has permission to accept the offer.
Blaze just had new business cards printed. They read:
Wojciech “Blaze” Blaszczykowski CAIA CFA
Blaze is preparing presentations for two groups of prospective clients. The first group consists of a number
of relative newcomers to investing, while the second group comprises a group of sophisticated investors.
Typically, Blaze will not include the details of AI’s investment and analysis strategies, because he believes
that it is beyond the understanding of even average investors. Therefore, he had decided not to include
those details in the presentation for the first group. Because the second group has more experience and
knowledge than the average investor, Blaze has decided to include those details in their presentation.

1. With regard to the research report that he wrote, Martins most likely:
A. Did not violate CFA Institute Standards of Professional Conduct
B. Violated Standard I(A) Knowledge of the Law
C. Violated Standard I(C) Misrepresentation
2. Are Martins’ actions with regard to the CVM report likely to have violated Standard VI(A) Disclosure of
Conflicts?
A. Yes
B. No, because there is not yet a familial relationship, so disclosure is not required
C. No, because the unfavorable recommendation makes it clear that Martins’ independence and
objectivity were not influenced
3. With regard to his communications with clients about the sporting goods manufacturer, which of Blaze’s
actions, if any, most likely violate Standard III(B) Fair Dealing?
A. None of Blaze’s actions violate the Standard
B. E-mailing one group of clients, then telephoning only a subset of that group
C. Failure to communicate the report and recommendation to all of AI’s clients
4. If Blaze accepts the payment from his client, will he most likely have violated the CFA Institute Standards
of Professional Conduct?
A. No
B. Yes, because he must receive permission in writing from his employer
C. Yes, because he must inform his employer in writing about outside compensation arrangements,
and e-mail does not qualify as being in writing
5. Do Meunier’s business cards most likely violate Standard VII(B) Reference to CFA Institute, the CFA
Designation, and the CFA Program?
A. No
B. Yes, because “CFA” should come before “CAIA”
C. Yes, because his business card should not include his nickname

6. Concerning his presentations to the two groups of investors, which, if any, of the CFA Institute Standards
of Professional Conduct has Blaze most likely violated?
A. None
B. Standard III(B) Fair Dealing
C. Standard III(D) Performance Presentation

Thinking that their correlation of returns might be zero (so that there would be extremely good
diversification benefits), Yana Kompany, a portfolio manager at Verhoeven, Aerts, Renard, and Associates
(VAR), compares the monthly returns of Peeters & Peeters SA (P&P) common stock and Arpel NV (Arpel)
common stock. Exhibit 1 contains the pertinent data. Kompany wants to determine whether the
hypothesis that their true (population) correlation of returns is zero can be rejected at the 95% confidence
level. Exhibit 2 is an excerpt from a Student’s t-table.
Exhibit 1
Peeters & Peeters SA and Arpel NV
Correlation of Returns Analysis
Months of data 36
Average monthly return, P&P 1.00%
Std. dev. of P&P monthly returns 4.24%
Average monthly return, Arpel 1.81%
Std. dev. of Arpel monthly returns 7.58%
Sample correlation 0.3034
Exhibit 2
df
0.25 0.20 0.15 0.10 0.05 0.025 0.02 0.01 0.005 0.0025
20 0.6870 0.8600 1.0640 1.3253 1.7247 2.0860 2.1967 2.5280 2.8453 3.1534
21 0.6864 0.8591 1.0627 1.3232 1.7207 2.0796 2.1894 2.5176 2.8314 3.1352
22 0.6858 0.8583 1.0614 1.3212 1.7171 2.0739 2.1829 2.5083 2.8188 3.1188
23 0.6853 0.8575 1.0603 1.3195 1.7139 2.0687 2.1770 2.4999 2.8073 3.1040
24 0.6848 0.8569 1.0593 1.3178 1.7109 2.0639 2.1715 2.4922 2.7969 3.0905
25 0.6844 0.8562 1.0584 1.3163 1.7081 2.0595 2.1666 2.4851 2.7874 3.0782
26 0.6840 0.8557 1.0575 1.3150 1.7056 2.0555 2.1620 2.4786 2.7787 3.0669
27 0.6837 0.8551 1.0567 1.3137 1.7033 2.0518 2.1578 2.4727 2.7707 3.0565
28 0.6834 0.8546 1.0560 1.3125 1.7011 2.0484 2.1539 2.4671 2.7633 3.0469
29 0.6830 0.8542 1.0553 1.3114 1.6991 2.0452 2.1503 2.4620 2.7564 3.0380
30 0.6828 0.8538 1.0547 1.3104 1.6973 2.0423 2.1470 2.4573 2.7500 3.0298
31 0.6825 0.8534 1.0541 1.3095 1.6955 2.0395 2.1438 2.4528 2.7440 3.0221
32 0.6822 0.8530 1.0535 1.3086 1.6939 2.0369 2.1409 2.4487 2.7385 3.0149
33 0.6820 0.8526 1.0530 1.3077 1.6924 2.0345 2.1382 2.4448 2.7333 3.0082
34 0.6818 0.8523 1.0525 1.3070 1.6909 2.0322 2.1356 2.4411 2.7284 3.0020
35 0.6816 0.8520 1.0520 1.3062 1.6896 2.0301 2.1332 2.4377 2.7238 2.9960
36 0.6814 0.8517 1.0516 1.3055 1.6883 2.0281 2.1309 2.4345 2.7195 2.9905
37 0.6812 0.8514 1.0512 1.3049 1.6871 2.0262 2.1287 2.4314 2.7154 2.9852
38 0.6810 0.8512 1.0508 1.3042 1.6860 2.0244 2.1267 2.4286 2.7116 2.9803
39 0.6808 0.8509 1.0504 1.3036 1.6849 2.0227 2.1247 2.4258 2.7079 2.9756
40 0.6807 0.8507 1.0500 1.3031 1.6839 2.0211 2.1229 2.4233 2.7045 2.9712
50% 60% 70% 80% 90% 95% 96% 98% 99% 99.5%

Kompany decides to compute the beta of P&P’s common stock using a broad market equity index (the
Index) as a proxy for the overall market. She runs a simple regression of the monthly returns of P&P’s
common stock vs. the Index’s monthly returns and notes that the slope coefficient is the estimate of P&P’s
beta. The results of the regression analysis are shown in Exhibit 3:
Exhibit 3
Regression Analysis
P&P’s Monthly Returns vs. Market Returns
Multiple R 0.4684
R-squared 0.2194
Observations 36
ANOVA Freedom (df) Squares (SS) Squares (MSS) F
Regression 1 0.0138 0.0138 9.55
Residual 34 0.0491 0.0014
Total 35 0.0629
Coefficients Standard Error t-Statistic p-Value

b0 0.4325% 1.0305% 0.4197 0.6747
b1 0.6400 0.3235 1.9783 0.0479
Kompany is not sure whether her regression analysis for beta is correct because she cannot recall all of the
assumptions necessary for a regression model, so she resolves to find a textbook on statistics and look
them up.
Kompany has estimated that the return on the Index next month will be 1.2% and wants to use her model
to predict P&P’s return next month. She is a little surprised at the estimate for beta, as she thought that
P&P’s beta was closer to 1.0. She decides to test that hypothesis at a 2% level of significance. After a little
thought, she decides to go further than that and construct a 95% confidence interval for P&P’s beta.
Kompany keeps a journal about her thoughts regarding her work. She finished today at the office by writing
the following observations about regression analysis:
Observation 1: Regression analysis is useful primarily because it is easy to do (especially with statistical
software packages) and because the results are useful for quite a long while, so I don’t
need to rerun analyses every few months.
Observation 2: Unfortunately, many other analysts know how to use regression analysis, so its usefulness
in that regard may be limited. I need to start developing my own techniques.

7. Based on the information in Exhibit 1, to test whether or not the population correlation coefficient could
equal zero, the value of the test statistic is closest to, and the correct decision regarding the null
hypothesis is most likely, respectively:

A. 1.86 Fail to reject H0
B. 1.86 Reject H0
C. 2.12 Reject H0
8. Of the assumptions about linear regression models, it is most likely that Kompany’s model for estimating
P&P’s beta violates:
A. None of the assumptions
B. The assumption about the expected value of the error term
C. The assumption about the randomness of the independent variable
9. Based on the information in Exhibit 3, the estimated value for the monthly return on P&P common stock
when the Index has a monthly return of 1.2% is closest to:
A. 0.43%
B. 0.77%
C. 1.20%
10. Based on the information in Exhibit 3, to test whether or not the slope coefficient (beta) could equal 1.0,
the value of the test statistic is closest to, and the correct decision regarding the null hypothesis is most
likely, respectively:

C. 1.98 Reject H0
11. Based on the information in Exhibit 3, a 95% confidence interval for P&P’s beta is closest to:
A. (−0.02, 1.30)
B. (0.00, 1.28)
C. (0.32, 0.96)

12. Of the two observations that Kompany made about regression analysis in her journal, it is most likely the
case that:
A. Both observations are accurate
B. Both observations are inaccurate
C. One observation is accurate, and one observation is inaccurate

ECONOMICS
Ottar Schwimmer is the deputy chief economist at a large European bank. Ottar must review data on 10
countries. So as not to be swayed by any national or regional allegiance, all country data will be coded as
Country A to Country J. Ottar will need assistance in gathering the information so that he does not match
the data to any country name. To make sure the assistant is familiar with economic data and theory, Ottar
first presents his assistant with brief descriptions of 2 hypothetical countries. Ottar asks in which country
would capital deepening have the greatest effect?
Country 1:
• MPK is well above r
• Share of GDP paid to labour is quite high
Country 2:
• MPK = r
• K/L ratio is 6 time larger than in Country B (kB = 6 × kA)
Ottar then makes the following two statements and asks the assistant if they are correct.
Statement 1: Technological progress increases real potential GDP only in an economy that reaches a
steady state and capital deepening no longer provides growth
Statement 2: Capital deepening can provide gains as long as MPK < r
Ottar, satisfied that he can rely on the assistant to gather the correct aggregate data, allows the assistant
access to the online economic database maintained by the bank’s economic forecasting department. The
assistant, understanding that brevity and consolidation are critical skills in data presentation, provides three
concise tables (1 through 3 below).
Table 1 presents trend growth rates for a number of components required to determine the growth rate of
real potential GDP:
Table 1 Long-term Long-term

Rate of Growth Growth growth rate growth rate
Elasticity
technological rate of rate of of the of labour
of capital
Country change capital labour labour force productivity
A 0.3 3.20% -1% 1.10%
B 0.1 0.80% 0.80% 0.80%
C 0.1 0.80% 0.40% 0.40% 1.10%
D 0.3 1.40% 0.60% 2.10% 0.04%

Some of the counties differ in terms of the granularity of labour data that is available. While Ottar
determines the rate of growth of real potential GDP, he asks the assistant to determine the steady-state
growth rates for each country for comparison purposes.
Table 2 provides some demographic information on another set of countries. Ottar is evaluating the ability
of each of the three counties to provide a labour growth rate that could support an increase in potential
GDP.
Table 2
Age Participation Net
Country < 16 > 65 Rate Migration
E 12% 18% 62% 1%
F 8% 24% 48% 0.5%
G 14% 16% 69% 2%
Table 3 provides data on three countries in terms of the growth rate of GDP. Ottar can directly see the
effect of capital deepening as a source of growth but will need to do some work to determine the
contribution to growth from technological progress.
Table 3
Growth
Growth in Growth in
due to Growth of
total hours labour
Capital GDP
worked productivity
Country Deepening
H -0.30% 1.60% 0.70% 1.30%
I 0.60% 2.20% 1.60% 2.80%
J 4.20% 4.20% 3.80% 8.40%

13. What would be the effect of capital deepening on the output-to-labour (y) ratio of Country 1 and Country
2?
Country 1 Country 2
A. Large Small
B. Large Large
C. Small Small
14. Which of Ottar’s statements is most likely incorrect?

A. Statement 1 only
B. Both Statement 1 and Statement 2
C. Neither Statement 1 nor Statement 2
15. With reference to Table 1, which countries are expected to have the highest and lowest growth rate of
output?
Highest Lowest
A. Country D Country B
B. Country A Country C
C. Country D Country C
16. Based on the data in Table 2, which country would benefit the most from an increase in net migration?
A. Country E
B. Country F
C. Country G
17. Based on the information collected in Table 3, for which Country did technological progress contribute
the most to GDP growth?
A. Country H
B. Country I
C. Country J
18. With reference to Table 1, what would be the steady state growth rate of output for Country D?
A. 2.14%
B. 3.50%
C. 4.10%


Masaaki Muto is an equity analyst at Tanaka, Suzuki, and Itō who has specialized in financial institutions
(banks and insurance companies) for the last 20 years. Muto has been training junior associates to analyze
financial institutions in anticipation of his retirement in two months; two of his trainees are Keisuke Yoshida
and Wataru Nakamura. Muto asks Yoshida to describe how financial institutions differ from other
companies. In response, Yoshida makes these comments:
Comment 1: Unlike nonfinancial companies, financial institutions can be the source of financial contagion
exclusively through their failure.
Comment 2: The assets of financial institutions are primarily short-term in nature, whereas the assets of
nonfinancial companies are predominantly long-term.
Comment 3: Financial institutions are much more heavily restricted in their ability to assume risk than
most nonfinancial companies are.
Muto then asks Nakamura to describe the key aspects of financial regulations that apply to financial
institutions. Nakamura makes these statements:
Statement 1: Capital requirements are designed to ensure that even in the event of asset write-downs
(loan losses), a bank’s equity is not likely to become negative.
Statement 2: Liquidity requirements apply to all liquid assets regardless of quality and are designed to
ensure that in the event of partial losses of funding sources or off-balance-sheet funding
commitments, the bank will have enough cash to cover any shortfall.
Statement 3: Stable funding requirements specify a minimum level of stable funds relative to annual
liquidity needs and specify what makes funds stable vs. unstable (e.g., long-term deposits
are more stable than short-term deposits, and customer deposits are more stable than
interbank loans).
Next, Muto wants to see how Yoshida and Nakamura analyze a bank, so he gives them financial statements
for Hayashi Bank, shown in Exhibits 1 and 2:

Exhibit 1
Hayashi Bank
Income Statement, Millions (JPY)
Year Ended 12/31/2018
Revenue
Interest Income 28,451
Noninterest Income 18,754
47,205
Expenses
Interest Expense 4,517
Noninterest Expenses 28,245
32,762
Income before taxes 14,443
Income tax expense 2,594
Net income JPY 11,849
Exhibit 2
Hayashi Bank
Balance Sheet, Millions (JPY)
12/31/2018
Assets
Cash and equivalents 187,533
Investment securities 224,701
Loans 489,766
Mortgages 7,268
Premises and equipment, net 4,273
Goodwill 12,840
Total assets 926,381
Liabilities
Total deposits 645,229
Short-term borrowings 49,868
Accrued expenses 34,104
Long-term debt 108,675
Total liabilities 837,876
Shareholders' Equity
Common stock 4,412
Additional paid-in capital 29,409
Retained earnings 70,156
Cumulative other comprehensive income (loss) (1,035)
Treasury stock (14,437)
Total equity 88,505
Total liabilities and equity JPY 926,381

Muto suggests a risk rating of 100% for corporate loans and mortgages in good standing, and 150% for
questionable loans and mortgages. He estimates that 40% of the loans and 70% of the mortgages are
questionable and asks Yoshida and Nakamura to determine Hayashi’s capital adequacy.
Muto gives Yoshida and Nakamura more details about Hayashi’s operations and environment:
Detail 1: Recently, several smaller banks operating in the same markets as Hayashi were in poor financial
condition, and the government negotiated on their behalf to arrange mergers with more stable
banks, a practice that the government employs commonly.
Detail 2: Hayashi’s international operations represent a significant portion of its revenue, which is
denominated in currencies other than JPY.
Detail 3: Hayashi has partnerships with a number of other banks in special-purpose entities (SPEs) that it
does not consolidate on its financial statements because its ownership share is less than 50%.
Muto also gives Yoshida and Nakamura the footnotes to Hayashi’s financial statements and suggests that
they concentrate on the quality of Hayashi’s earnings. Yoshida and Nakamura note these items in the
footnotes:
• Included in Hayashi’s 2018 interest income is a provision for loan losses of JPY 536, representing
1.85% of Hayashi’s 2018 gross interest income.
• Over the last 5 years the Hayashi’s annual provision for loan losses has ranged from a low of 1.75%
of interest income to a high of 3.25% of interest income.
• Included in Hayashi’s 12/31/2018 loans (balance sheet account) is an allowance for loan losses of JPY
15,929, representing 3.15% of Hayashi’s outstanding loan balance.
For a change of pace, Muto turns to the analysis of insurance companies, the second area in which he has
specialized. Muto has gathered selected data for Hokkaido & Honshu Insurance Company (HHI) in Exhibit 3.
Exhibit 3
HHI
Selected Data, Millions
Year Ended 12/31/2018
Loss expense and loss adjustment expense JPY 1,689,078
Underwriting expense 951,820
Dividends to policyholders 76,169
Net premium earned 2,783,945
Net premium written 2,865,827

19. Of the three comments that Yoshida made about financial institutions vs. nonfinancial companies, the
one that is most likely to be accurate is comment:
A. 1
B. 2
C. 3
20. Of the three statements that Nakamura made about financial regulations that apply to financial
institutions, the one that is least likely to be accurate is statement:
A. 1
B. 2
C. 3
21. Hayashi’s capital is most likely:

A. Adequate, with a capital-to-risk-weighted-assets ratio of 9.6%
B. Adequate, with a capital-to-risk-weighted-assets ratio of 14.8%
C. Inadequate, with a capital-to-risk-weighted-assets ratio of 9.6%
22. Of the details on Hayashi’s operations and environment, the one that is least likely to be a cause of
concern for an analyst is detail:
A. 1
B. 2
C. 3
23. Based on the information contained in Hayashi’s footnotes, Yoshida and Nakamura should most likely
conclude that Hayashi’s earnings quality is:
A. Low, because their earnings appear to be subject to management manipulation
B. High, because they have acknowledged potential losses in revenue in the form of a provision for
loan losses
C. Low, because the percentage of interest income represented by the provision for loan losses differs
from the percentage of loans outstanding represented by the allowance for loan losses

24. Based on the data in Exhibit 3, HHI’s underwriting expense ratio and combined ratio, respectively, are
closest to:
Underwriting Expense Ratio Combined Ratio

A. 33.2% 93.9%
B. 34.2% 93.1%
C. 34.2% 93.9%

CORPORATE FINANCE
Over the last year, Aragon Manufacturing (AM) has been experiencing increasing conflicts amongst its
stakeholders, to the extent that AM’s management recently created the position of chief governance officer
(CGO) and hired Renato Flores to fill the position. Upon arriving at AM, Flores’ first objective is to determine
who all of AM’s stakeholders are and what they expect from the company. In Exhibit 1, he summarizes his
findings:
Exhibit 1
Aragon Manufacturing
Key Stakeholders
Internal Stakeholder Expectation
Adequate wages, job satisfaction,
Employees
job security, good working conditions
Adequate salary, job satisfaction,
Management
job security, good working conditions
Help meet all other stakeholders’ expectations,
Board members
represent shareholders’ interests
External Stakeholder Expectation
Shareholders Maximize ROI
Customers Quality, dependable products, good value
Suppliers Stable, long-term relationship, timely payments
Creditors Timely principal, interest payments
Governments Company will obey the law
Unions Member benefits commensurate with contribution to company
Communities Responsible behavior by company
General public Responsible behavior by company
Looking over his list of stakeholders and expectations, Flores considers the types of conflicts on interest that
arise. He makes the following statements about those conflicts:
Statement 1: By virtue of it being a corporation, AM can experience owner-management conflicts of

interest that would not be present if it were a partnership or sole proprietorship.
Statement 2: Because AM is a corporation, it avoids some of the conflicts of interest that would occur in a
partnership or sole proprietorship, such as management-supplier conflicts.

Flores decides to interview managers, board members, and employees to get an understanding of the
workings of AM. After the interviews, Flores formulated some observations about how AM operates,
including:
• AM’s management, from the CEO down to the production floor managers, is treated well, with good
salaries and working conditions (both above average for the industry), but there is no evidence of
special favors or perquisites being given to managers.
• The board of directors has created compensation packages for management that rewards long-term
stock appreciation more than short-term (but with positive rewards for both).
• The CEO is also the chairman of the board and wants to ensure that board members serve for a long
time to preserve continuity; therefore, the compensation for board members is significantly higher
than the industry (and national) average.
Flores’ next objective is to assess the ethical environment at AM. His investigation uncovers the following
behaviors:
1. AM’s management sets unrealistic goals for its employees, and pressures them to attain those goals.
2. AM’s organizational culture encourages the employees to make decisions based on maximizing the
economic benefit to the company.
3. AM’s management tends to promote employees with a strong sense of community responsibility
Flores then turns to environmental, social, and governance (ESG) factors. His research leads him to the
following conclusions:
Conclusion A: Although AM’s operations comply with existing laws about greenhouse gas emissions,
there has been talk that the regulations may be tightened in the near future, and that they
would not comply with the more stringent limits expected.
Conclusion B: AM’s management has been in discussion with labor unions about the working conditions
for its employees. Although AM’s management sincerely believes that conditions are
adequate, the unions have disputed this and there have been three labor actions (strikes)
over the last two years, with management and labor ultimately compromising to end each
such action.
Flores wants to know whether AM has an effective corporate governance system, so he turns to a
presentation that AM’s CEO made to AM’s employees, in which he said:
“At Aragon Manufacturing, we aspire to the highest ideals of corporate governance and
ethical behavior. To that end, I have made it my mission to ensure that AM:
Point 1. Clearly describes the rights of shareholders and other stakeholders

Point 2. Ensures fairness and equitable treatment in all dealings between managers,
directors, and shareholders
Point 3. Ensures transparency and accuracy in disclosures regarding operations,
performance, and risk.”

25. Considering the information in Exhibit 1, Flores is most likely incorrect in:
A. The expectations of unions
B. Including the general public as a stakeholder
C. Classifying shareholders as external stakeholders
26. Concerning the statements Flores makes about conflicts of interest at AM, it is most likely the case that:
C. One statement is true, and one statement is false
27. Given Flores’ observations about how AM operates, his most likely conclusion about evidence of agency
conflicts between the shareholders and, respectively, management and the board of directors is that
there is most likely:
Management Board of Directors

A. Evidence No evidence
B. No evidence Evidence
C. No evidence No evidence
28. Which of the behaviors that Flores uncovered, is/are most likely promoting unethical behavior?
A. Behavior 1 only
B. All three behaviors
C. Behavior 1 and Behavior 2 only
29. The two observations that Flores made about environmental, social, and governance (ESG) factors are
best categorized, respectively, as:
Observation A Observation B
A. Environmental Governance
B. Environmental Social
C. Social Governance
30. Of the points that AM’s COE outlined in his speech to the employees, the one that most likely falls short
of the goals for a sound corporate governance system is:
A. Point 1
B. Point 2
C. Point 3

EQUITY VALUATION
Karim Hosseini is an equity analyst at Abedzadeh & Ghoddos (A&G). He is working on a research report on
Marmara Industries (MI) and must first forecast MI’s revenues over the next five years. He is considering
two approaches: growth relative to GDP growth, and market growth and market share. He has compiled
information to use in the projections in Exhibit 1. Hosseini anticipates that MI’s market share will increase
because it will be introducing innovative products over the next few years, a move that Hosseini expects will
improve MI’s gross margin. Hosseini views the introduction of new products and the consequent increase in
market share as an indication of the strong competitive advantage that MI enjoys in its industry.
Exhibit 1
Marmara Industries
Economic Projections, 2019 – 2023 (TRY*)
Industry-wide sales, 2018 150 billion
Industry growth per year 4.4 billion
MI's market share, 2018 6.45%
MI's market share growth per year 1.40%
MI's sales growth above GDP growth 2.50%
National GDP, 2018 3,100 billion
GDP growth per year 55 billion
*
TRY = Turkish lira; TRY 1.0 ≈ EUR 0.16
After forecasting MI’s revenues, Hosseini turns to forecasting MI’s expenses: cost of goods sold (COGS),
selling, general, and administrative (SG&A) expenses, financing costs, and income taxes. He is aware that
most variable costs are commonly estimated as a percentage of sales.
From there, Hosseini turns to forecasting MI’s balance sheet. He has been studying industry trends and
finds that both days of sales outstanding (DSO) and days of inventory on hand (DOH) have been decreasing
steadily. He expects that MI’s ratios will follow the industry trend. He is also aware that MI will need to
increase its PP&E for the new products it plans to introduce over the next few years.
Wanting to understand MI’s industry, especially with regard to economies of scale, Hosseini compares
financial statements of MI and the industry leader. Exhibit 2 has details from their 2018 income statements.
Exhibit 2
Income Statements, 2018
Marmara Industries vs. Industry Leader
MI Industry Leader
Sales TRY 9,675 TRY 59,550
COGS (6,700) (44,650)
SG&A (1,925) (11,900)
Interest Expense (150) (300)
Income Taxes (225) (1,200)
Net Income TRY 675 TRY 1,500

31. Based on Porter’s five competitive forces, the reason for MI’s competitive advantage is most likely
attributable to:
A. Low availability of substitutes
B. Low bargaining power of customers
C. Low threat of new entrants into the industry
32. Based on the information in Exhibit 1 and Hosseini’s analysis of that information, Hosseini’s projections
of MI’s return on invested capital (ROIC) over the next few years is most likely that it will:
A. Increase
B. Decrease
C. Remain unchanged
33. Based on the information in Exhibit 1, compared to MI’s 2019 estimated sales growth using the relative-
to-GDP-approach, MI’s 2019 estimated sales growth using the market-growth-and-market-share
approach is most likely:
A. Lower
B. Higher
C. The same
34. In forecasting MI’s cost of goods sold (COGS), Hosseini should most likely use:
A. A lower ratio of COGS to sales as existed in 2018
B. A higher ratio of COGS to sales as existed in 2018
C. The same ratio of COGS to sales as existed in 2018
35. How will Hosseini’s projections of the growth rate in 2019 of MI’s inventory and fixed assets,
respectively, most likely compare to the growth rate of its sales?
Inventory Fixed Assets
A. Lower Lower
B. Lower Higher
C. Higher Higher

36. Based on the data in Exhibit 2, Hosseini’s most likely conclusion about economies of scale in ME’s
industry is that:
A. The industry is experiencing economies of scale
B. The industry is experiencing diseconomies of scale
C. Whether the industry is experiencing economies of scale or diseconomies of scale cannot be
determined from the information given

FIXED INCOME
Yussuf Dalsgaard manages a fixed income portfolio for the Aarhus University Endowment. The Endowment
plans an expenditure of EUR 50 million in one year for renovation of the University’s football stadium.
Dalsgaard wants to earmark certain bonds to fund the renovation but would prefer to earn a higher yield
over the next year than current 1-year rates. He wants to employ a strategy of rolling down the yield curve
and has compiled data on the yield curves in three currencies in Exhibit 1. He believes that all three yield
curves will be, on average, essentially unchanged for the next year, and he can hedge any currency
exchange rate risk.
Exhibit 1
Par Yield Curves
Maturity, Years AUD EUR USD
1 2.60% 2.48% 2.31%
2 2.56% 2.50% 2.39%
3 2.53% 2.52% 2.46%
4 2.51% 2.54% 2.52%
5 2.50% 2.56% 2.60%
The Endowment’s portfolio holds a number of bonds with embedded options and floating-rate bonds – all
denominated in CAD – so Dalsgaard has created a binomial interest-rate tree with 20% (annual) volatility for
CAD to value risk-free, annual-pay bonds, shown in Exhibit 2:
Exhibit 2
Binomial Interest Rate Tree, CAD
Dalsgaard decides to use a pathwise approach to valuing a 3-year, 4.5% coupon, CAD 1,000 par bond. Using
U to denote the upper node and L to denote the lower node moving left-to-right through the tree, he
creates Exhibit 3 in which he identifies the paths and the value of the bond along each path. He still has the
value along one path to compute, as well as the overall bond value from the tree.

Exhibit 3
Pathwise Valuation of 4-Year, 4.5% Bond
Path Nodes Pathwise Value
1 UUU CAD 962.91
2 UUL CAD 986.90
3 ULU CAD 1,005.62
4 ULL CAD 1,022.85
5 LUU
6 LUL CAD 1,036.64
7 LLU CAD 1,050.03
8 LLL CAD 1,062.33
Exhibit 4 lists three EUR-denominated bonds held in the Endowment’s portfolio. Although Dalsgaard
expects the EUR yield curve, on average, to be unchanged for the next year, he believes that interest rate
volatility will increase across all maturities and is concerned about the effect that will have on these bonds.
Exhibit 4
Aarhus University Endowment
Selected EUR-Denominated Bonds
Bond Maturity Characteristics
A 4 years No embedded options
B 3 years Callable @ 102
C 5 years Putable @ 98
The Endowment’s portfolio also holds a variety of bonds denominated in Swiss francs (CHF): straight bonds,
callable bonds, and putable bonds; apart from the embedded options, these bonds are essentially identical
in all other respects. Dalsgaard anticipates that CHF interest rates will increase over the next 12 months
and that all of those bonds will be priced at a discount to par. He is keenly interested in the effective
duration and effective convexity of the callable and putable bonds compared to that of the straight bonds.
Dalsgaard is considering buying some convertible bonds issued by Rasmussen Shipbuilding (RS). As there is
no ready market for these bonds, he has to estimate a fair price by looking at the prices of other RS
securities, shown in Exhibit 5. The characteristics of all of the options are consistent with those of the
convertible bonds.
Exhibit 5
RS Securities
Current Market Prices
Security Market Price
RS straight bond DKK 992.15
RS callable bond DKK 983.35
RS putable bond DKK 1,002.60
RS common stock DKK 47.55
Call options on RS common stock DKK 38.80
Put options on RS common stock DKK 82.80
*
DKK = Danish krone

37. Using the data from Exhibit 1, Dalsgaard’s best choice for employing his desired strategy is most likely to
purchase:
A. 1-year AUD bonds
B. 5-year EUR bonds
C. 5-year USD bonds
38. Using the data from Exhibits 2 and 3, the path 5 value for the bond and the overall value for the bond
from the tree, respectively, are closest to:
Path 5 Bond Value Overall Bond Value

A. CAD 1,014.36 CAD 1,017.71
B. CAD 1,019.17 CAD 1,017.71
C. CAD 1,019.17 CAD 1,018.31
39. Given the data in Exhibit 4 and Dalsgaard’s expectations about EUR interest rates, the value of Bond B
and Bond C, respectively, will most likely:
Bond B Bond C
A. Decrease Decrease
B. Decrease Increase
C. Increase Decrease
40. Given Dalsgaard’s expectations for CHF interest rates, in 12 months the effective durations of the
Endowment’s CHF-denominated callable and putable bonds, respectively, compared to the effective
duration of their CHF-denominated straight bonds, is most likely:
Callable Bonds Putable Bonds

A. Lower Equal
B. Equal Lower
C. Equal Higher
41. Given Dalsgaard’s expectations for CHF interest rates, in 12 months the effective convexities of the
Endowment’s CHF-denominated callable and putable bonds, respectively, compared to the effective
convexity of their CHF-denominated straight bonds, is most likely:
Callable Bonds Putable Bonds

A. Lower Equal
B. Lower Higher
C. Equal Higher

42. Based on the data in Exhibit 5, the value of an RS convertible bond is closest to:
A. DKK 1,030.95
B. DKK 1,041.40
C. DKK 1,074.95

FIXED INCOME
Jensen & Sorensen Wealth Management (J&S) specializes in managing fixed income portfolios. They recently
hired Samuel Rami as a junior analyst. One of the senior analysts at J&S, Kasper Vestergaard, has given
Rami an assignment to value a callable bond using an arbitrage-free approach. Rami is not sure how to do
that when the cash flows are uncertain and asks if he needs to add a risk premium to the risk-free spot rates
to accomplish this. Vestergaard tells Rami:
“You can implement an arbitrage-free approach by using a binomial interest rate tree. Once you
have decided on an appropriate level of interest rate volatility and calibrated the tree, then you need
to make an assumption about when the call option will be exercised. For example, you may assume
that it will be exercised any time it is in the money. After that you determine the cash flows and
discount them back to today to get the value.”
J&S wants to purchase some putable GBP-denominated bonds for their clients, so Vestergaard creates a
GBP binomial interest rate tree, shown in Exhibit 1:
Exhibit 1
GBP Binomial Interest Rate Tree
Vestergaard wants Rami to use the GBP tree to value a 3-year, GBP 1,000 par, 4% coupon, annual pay bond
putable on any coupon date at 100 (i.e., 100% of par). For simplicity, he tells Rami to assume that the bond
will be put any time the put option is in the money.
Vestergaard asks Rami to use the tree shown in Exhibit 1 to determine the OAS on a callable corporate
bond; Rami got a value of 72.4 bp. Vestergaard is not happy with that value, so he plans to create a new
tree with 15% interest rate volatility and compute the OAS from that tree.
Using the tree in Exhibit 1 and incorporating a ±50 bp change in yield, Vestergaard has Rami price a putable
bond, with results shown in Exhibit 2:
Exhibit 2
Putable Bond Valuation
Yield Change Bond Value
−50 bp GBP 1,049.84
0 bp GBP 1,037.74

+50 bp GBP 1,029.29
At Vestergaard’s suggestion, Rami investigates some EUR-denominated convertible bonds. Exhibit 3

contains data on WNY 10-year, callable, convertible bonds.
Exhibit 3
WNY 10-year, Callable, Convertible Bonds
Excerpts from the Bond’s Offering Circular
Par Value EUR 1,000
Annual Interest 5.00% of par
Issue Date 23 January 2016
Maturity Date 23 January 2026
Initial Conversion Ratio 80:1
Threshold Dividend per Share EUR 0.75
Call Price, 23 January 2021 110
Stock Price per Share, 23 January 2016 EUR 11.45
On 1/28/19 WNY common stock closed at EUR 13.87, the convertible bonds were selling at 131.42 (i.e.,
131.42% of par), and WNY declared a dividend of EUR 0.72 per share, payable on 2/28/19.

43. Is Vestergaard’s description of an arbitrage-free approach to valuing a callable bond most likely accurate?
A. Yes
B. No, because different volatility assumptions will give different values, so there may be an arbitrage
opportunity if Rami assumes the wrong volatility
C. No, because Rami does not know the rule that the issuer will use to call the bond, so there may be
an arbitrage opportunity if he assumes an incorrect rule
44. Given the data in Exhibit 1 and Vestergaard’s assumption about when the put option will be exercised,
the value of the putable bond is closest to:
A. GBP 1,022.55
B. GBP 1,031.49
C. GBP 1,037.74
45. For the corporate bond that Vestergaard analyzed using the tree in Exhibit 1, compared to the original
OAS of 72.4 bp, the OAS calculated from the tree with 15% volatility will most likely be:
A. Lower than 72.4 bp
B. Equal to 72.4 bp
C. Higher than 72.4 bp
46. Using the information in Exhibit 2, the effective duration of Bond B is closest to:
A. 1.0 years
B. 2.0 years
C. 4.0 years
47. Using the data in Exhibit 3, on 28 January 2019 the conversion price for the WNY convertible bonds on is
closest to:
A. EUR 11.45
B. EUR 12.50
C. EUR 13.87

48. Based on the data in Exhibit 3, on 28 January 2019 the market conversion price and market conversion
premium ratio, respectively, are closest to:
Market Conversion Price Market Conversion Premium Ratio

A. EUR 13.87 18.5%
B. EUR 16.43 18.5%
C. EUR 16.43 31.5%

Rene Rousseau is the treasurer of Descartes Foundation, an organization set up to fund grants for graduate
students doing research in the liberal arts. The foundation's leadership is looking to expand their
investment portfolio’s asset allocation beyond public securities. The group has decided to allocate 15% of
the portfolio to private equity investments. Rene has asked Bernadette Soubirous, CFA, a consultant with
Voltaire Inc, to help choose the best funds to allocate capital.
Bernadette has set an appointment with Gustave Eiffel, the principal at Eiffel AM. The meeting begins with
Gustave doing a presentation about Eiffel's competencies and the fund. He makes the following statements:
Statement 1: The focus of our business is the biotechnology space. Eiffel has a strong advisory team to
help make allocation decisions; we hire former CEO’s, retired academics, and sell-side equity
research analysts who have history in the biotechnology space. Our primary focus is on
companies that do not generate income but have well-articulated business and marketing
plans. Sometimes, we also help finance strong leadership teams at established companies
that wish to carve out a unique and profitable business segment as a separate entity.
However, such situations occur infrequently.
Statement 2: As I mentioned, the companies we primarily work with have a business plan and a marketing
plan, but they need our expertise to help them achieve their potential. With our team being
active members of the boards of these businesses we have a lot of input in the kind of
decisions and projects the companies undertake or abandons, assessing the risks and
rewards on a case-by-case basis.
Statement 3: Exhibit 1 details a recent company we added to the portfolio, Anabolism Inc. We are very
excited about the prospects of this company. However, there is always some risk and we
always price in a 10% probability of failure. We had initially thought we could sell the
company in 4 years, but we believe it will only take 3 years to complete an exit.
Exhibit 1 (EUR)
Company name Anabolism Inc.
Original exit term 4 Years
Expected sale price 45,000,000
Eiffel AM Investment 4,000,000
Discount rate 25%
Current shares 2,000,000

Statement 4: Exhibit 2 details recent transactions where we sold the companies to private equity firms
that specialize in later stage businesses. However, I just noticed a mistake on Investment 3:
our exit price was EUR 40 Million, and we invested EUR 6 Million.
Exhibit 2 (EUR)
Investment Investment 1 Investment 2 Investment 3
Term 5 years 4 years 6 years
Exit price 45,000,000 100,000,000 35,000,000
Eiffel investment 4,000,000 10,000,000 5,000,000
IRR 35% 20% 30%
Founders shares 3,000,000 4,000,000 500,000
Statement 5: We know that our clients are fee sensitive, so we try to be as transparent as possible. We
charge 10% carried interest when the portfolio value exceeds 15% of invested capital. I’ve
included Exhibit 3 to demonstrate. The fund had EUR 250 Million in committed capital.
Exhibit 3 (EUR)
Company Investment Amount Sale Price
Portfolio Company 1 90,000,000 125,000,000

49. Based on Gustave’s introduction in Statement 1, Eiffel AM is least likely engaged in:
A. Management buyouts
B. Start-up stage investing
C. One-time opportunities
50. Based on Gustave’s Statement 1 and 2, what valuation technique is Eiffel most likely using to value
portfolio companies?
A. Real option
B. Income approach
C. Replacement cost
51. Based on Gustave’s Statement 3, and the information in Exhibit 1, Anabolisms pre-money valuation was
closest to:
A. EUR 8 Million
B. EUR 13 Million
C. EUR 19 Million
52. Based on Gustave’s Statement 4, and the information in Exhibit 2, Eiffel’s ownership share in Investment
3 is closest to:
A. 69%
B. 72%
C. 83%
53. Gustave is most likely describing what kind of distribution waterfall in Statement 5?
A. Deal-by-deal waterfall distribution
B. First alternative waterfall distribution
C. Second alternative waterfall distribution
54. Based on Gustave’s Statement 5, and Exhibit 3, the carried interest charged by Eiffel AM is closest to:
A. EUR 2.5 Million
B. EUR 5.0 Million
C. EUR 7.5 Million

Lasse Braithwaite has been studying risk factors and how they affect portfolio returns for the last 25 years.
In Exhibit 1 he has enumerated three portfolios that depend on a single risk factor and wants to determine
whether there is an arbitrage opportunity amongst these portfolios. The risk-free rate is 1.2%.
Exhibit 1
Sample Portfolios for a One-Factor Model
Portfolio Factor Sensitivity Expected Return
A 0.1 2.7%
B 0.2 4.3%
C 0.5 8.7%
Braithwaite has developed a four-factor model that he uses for estimating the returns on equity securities:
E(R) = rf + βWRPW + βXRPX + βYRPY + βZRPZ
He chooses not to disclose the exact nature of the factors but has prepared a table of the factor risk premia
in Exhibit 2 and examples of factor sensitivities in Exhibit 3:
Exhibit 2
Braithwaite Four-Factor Model
Factor Risk Premia
Factor Risk Premium
W 0.3%
X −0.4%
Y 1.1%
Z 0.7%
Exhibit 3
Factor Sensitivities, Selected Securities
Braithwaite Four-Factor Model
Security βW βX βY βZ
1 1.3 −2.5 3.2 −0.6
2 2.1 0.5 2.8 0.8
3 −0.2 −3.1 2.5 2.4
4 0.2 0.3 −0.5 0.1
Although Braithwaite will not disclose the specific nature of the factors in his model, he was overheard
saying that he developed the factors by analyzing the returns on a specific set of securities, and then
grouped the securities into portfolios to generate the factors.

In describing how his model can be used in constructing portfolios, Braithwaite makes these comments:
Comment 1: Passive managers who choose not to replicate an index can use the model to select securities
to ensure that the factor exposures of their portfolio closely match the corresponding factor
exposures of the index.
Comment 2: Active managers can use the model to adjust the risk exposure or factor exposure of their
portfolios to the level and mix that they want, adding exposures that they believe will generate
higher risk-adjusted returns and reducing or eliminating exposures that they believe will
generate lower risk-adjusted returns.
Comment 3: Rules-based managers can create portfolios tilted toward or away from specific factor or risk
exposures, essentially replacing manager skill with an analytical model.
To illustrate how he uses his model, Braithwaite describes one of his clients: a local bank (LB), whose goal is
to earn a positive spread on its investments over what it pays in interest to its depositors. LB has a relatively
short time horizon based on the average term of deposits, and is comfortable with using derivatives (e.g.,
interest rate swaps, bond futures, and total return equity swaps) to match the effective duration of its assets
and liabilities.
Apart from his intellectual pursuits in building factor models, Braithwaite earns a living as a portfolio
manager. Many of his portfolios have broad market indices for their benchmarks, but Braithwaite often
engages in active management (using his model as a guide in security selection). In Exhibit 4 he has
compiled information on one of his portfolios over the last 5 years:
Exhibit 4
Braithwaite Portfolio 15f
Selected Data, 1/1/2014 – 12/31/2018
Characteristic Value
Average monthly return, benchmark 0.75%
Monthly tracking error 0.18%
Information ratio 0.4572

55. Given the data in Exhibit 1, Braithwaite should most likely conclude that there is:
A. No arbitrage opportunity
B. An arbitrage opportunity, which he can capture by a long position in Portfolio B and short positions
in Portfolios A and C
C. An arbitrage opportunity, which he can capture by long positions in both Portfolio A and Portfolio B,
and a short position in Portfolio C
56. Given the data in Exhibits 2 and 3, the expected return on Security 3 is closest to:
A. 4.3%
B. 4.5%
C. 6.8%
57. Braithwaite’s model is most accurately described as a:

A. Statistical factor model
B. Fundamental factor model
C. Macroeconomic factor model
58. Of the comments Braithwaite makes about how his model can be used, it is most likely the case that:
A. All three comments are accurate
B. Only comments 1 and 2 are accurate
C. Only comments 1 and 3 are accurate
59. Amongst the benefits of a multifactor model to LB would most likely be the ability to:
A. Increase its exposure to business cycle risk and decrease its exposure to momentum
B. Increase its exposure to large cap stocks and decrease its exposure to small cap stocks
C. Decrease its exposure to business cycle risk and increase its exposure to interest rate risk
60. Based on the data in Exhibit 4, the average monthly return of Braithwaite’s Portfolio 15f is closest to:
A. 0.34%
B. 0.83%
C. 1.15%
End of Exam



2019 Exam Prep

Level II
Exam 3

Minute
Questions Topic
s
31 - 36 Equity Valuation Authored By: Remek Debski, CFA 18
49 - 54 Alternative Investments Authored By: Mark Meldrum, Ph.D. 18
Total: 180


Alonzo Financial Group (AFG), whose headquarters is in Madrid, manages individual and institutional
portfolios, as well as a number of investment funds. Somewhat unique in the industry, account holders are
considered clients of their individual account managers, rather than clients of AFG. AFG’s management
believes that this arrangement leads to a closer relationship between account manager and client and gives
the account managers a greater sense of being in control of their own destiny.
Kamharida Uzoho, a financial advisor at AFG, recently acquired a new client, Alireza Azmoun. Azmoun was
dissatisfied with his former advisor, believing that he was not looking after Azmoun’s best interests. Uzoho
meets with Azmoun and reviews Uzoho’s existing portfolio, which comprises 70% large-cap European equity
and 30% long-term (10 – 30 years maturity) government bonds. Uzoho believes that interest rates are likely
to rise in the near future and tells Azmoun that he should decrease his large-cap equity to at most 50% of
his portfolio, replacing the large-cap equity with small-cap equity, and that he should replace all of his long-
term bonds with short-term corporate bonds, shortening his duration substantially.
The minimum size portfolio that Uzoho will agree to manage is EUR 100,000, and the sizes of the portfolios
she manages range from EUR 100,000 to over EUR 100 million. Often, she will give many of her clients the
same advice about particular investments, so she finds that she frequently has a number of clients pursuing
identical transactions (i.e., all want to buy the same security, or all want to sell the same security). In such
cases, she processes the transactions for the smaller clients before those of the larger clients. Her
reasoning is that the smaller transactions will tend to cause less price movement than the larger
transactions will, and this way it is less likely to disadvantage any of her clients.
Uzoho has a wide range of individual clients, from young professionals to retirees. Her first step with a new
client is to develop an appropriate IPS, whether the client has no IPS to start or has an IPS from a previous
financial advisory relationship. Uzoho reviews and updates each client’s IPS regularly: semi-annually for
those clients whose circumstances change often, and annually for those whose circumstances are less
volatile.
Uzoho specializes in equities and fixed income and has little experience in alternative investments. She
believes that one of her clients would benefit from the addition of real estate to his portfolio, so she
forwards his account information (including his IPS) to one of her colleagues at AFG, Phil Henderson, who
understands real estate much better than Uzoho does, and asks Henderson for his opinion on adding real
estate investments to the portfolio. Henderson reviews the information and recommends several REITs
from which Uzoho may choose.
One of Uzoho’s clients has offered her a bonus of EUR 20,000 if the return on his portfolio over the next
year should exceed 10%. Uzoho knows that she must inform AFG management about the offer and wants
to make sure that she handles it correctly.
Uzoho’s supervisor at AFG is a vice president, Ryota Nagatomo, CFA. Nagatomo has negotiated an
arrangement with Montoya Funds in which AFG receives a 0.25% referral fee for any client funds invested in
Montoya Funds mutual funds. Nagatomo has instructed his financial advisors to use his borther-in-law’s
firm, Jerez Brokerage, for executing all client transactions. AFG receives a referral fee of 10% of the
brokerage fees charged by Jerez Brokerage for all client transactions.

1. In making her investment recommendations to Azmoun, Uzoho has most likely violated:
A. Only Standard III(A) Loyalty, Prudence, and Care
B. Only Standard III(C) Suitability
C. Both Standard III(A) and Standard III(C)
2. When processing transactions on a single security for a number of her clients, which of the CFA Institute
Standards of Professional Conduct has Uzoho most likely violated?
A. Only Standard III(B) Fair Dealing
B. Only Standard VI(B) Priority of Transactions
C. Both Standard III(B) and Standard VI(B)
3. With regard to her clients’ IPSs, are any of Uzoho’s actions likely to violate CFA Institute Standards of
Professional Conduct?
A. No
B. Yes, because all clients’ IPSs should be reviewed at least quarterly
C. Yes, because all clients’ IPSs should be reviewed at least semi-annually
4. When giving her client’s account information to Henderson, which of the CFA Institute Standards of
Professional Conduct does Uzoho most likely violate by these actions?
A. Only Standard III(C) Suitability
B. Only Standard III(E) Preservation of Confidentiality
C. Both Standard III(C) Suitability and Standard III(E) Preservation of Confidentiality
5. Concerning the bonus offer from her client, to comply with the CFA Institute Standards of Professional
Conduct, Uzoho will most likely have to inform AFG management:
A. In writing, and receive permission from AFG management in writing
B. Either verbally or in writing, and receive permission from AFG management in writing
C. Either verbally or in writing, and receive permission from AFG management either verbally or in
writing
6. To comply with Standard VI(C) Referral Fees, Nagatomo should most likely disclose the referral fees
received from:
A. Montoya Funds, but not those received from Jerez Brokerage
B. Jerez Brokerage, but not those received from Montoya Funds
C. Montoya Funds and the referral fees received from Jerez Brokerage

Leander Witsel is an equity analyst with Brabant Wealth Management. Witsel hopes that he can predict the
annualized return on a company’s stock in any given month using a linear regression model whose
independent variables are the 6-month government interest rate (Interest), the unemployment rate
(Unemployment), and the annual GDP growth rate (GDP Growth), all from the previous month. He ran an
analysis on Van Damme Manufacturing (VDM) using 60 months of data and summarized the results in
Exhibit 1:
Exhibit 1
Linear Regression Results
Van Damme Manufacturing Monthly Return
Multiple R 0.8891
R-squared
Adjusted R-squared 0.7793
Standard Error of estimate 0.6264%
Observations 60
Regression 3 82.9249
Residual 56 21.9715
Total 59
Coefficient Standard Error t-Statistic p-Value

b0 1.8698% 2.3774% 0.7865 0.4316
bInterest −0.7650 0.6483 −1.1800 0.2380
bUnemployment 0.1577 0.3372 0.4677 0.6400
bGDP Growth 3.0869 0.4861 6.3505 0.0000
*
Units on SS and MSS are percent2 (%2)
The current month’s interest rate, unemployment, and GDP growth numbers are, respectively, 2.5%, 4.7%,
and 1.5%. Witsel wants to use his model to predict the annualized return on VDM common stock for next
month and wants to know how well the independent variables explain the dependent variable.
Witsel wonders if the population coefficient for short-term interest rates might actually equal negative one,
so he tests that hypothesis at the 5% level of significance. He uses the table for t-statistics in Exhibit 2:

Exhibit 2
df
0.25 0.20 0.15 0.10 0.05 0.025 0.02 0.01 0.005 0.0025
41 0.6805 0.8505 1.0497 1.3025 1.6829 2.0195 2.1212 2.4208 2.7012 2.9670
42 0.6804 0.8503 1.0494 1.3020 1.6820 2.0181 2.1195 2.4185 2.6981 2.9630
43 0.6802 0.8501 1.0491 1.3016 1.6811 2.0167 2.1179 2.4163 2.6951 2.9592
44 0.6801 0.8499 1.0488 1.3011 1.6802 2.0154 2.1164 2.4141 2.6923 2.9555
45 0.6800 0.8497 1.0485 1.3006 1.6794 2.0141 2.1150 2.4121 2.6896 2.9521
46 0.6799 0.8495 1.0483 1.3002 1.6787 2.0129 2.1136 2.4102 2.6870 2.9488
47 0.6797 0.8493 1.0480 1.2998 1.6779 2.0117 2.1123 2.4083 2.6846 2.9456
48 0.6796 0.8492 1.0478 1.2994 1.6772 2.0106 2.1111 2.4066 2.6822 2.9426
49 0.6795 0.8490 1.0475 1.2991 1.6766 2.0096 2.1099 2.4049 2.6800 2.9397
50 0.6794 0.8489 1.0473 1.2987 1.6759 2.0086 2.1087 2.4033 2.6778 2.9370
51 0.6793 0.8487 1.0471 1.2984 1.6753 2.0076 2.1076 2.4017 2.6757 2.9343
52 0.6792 0.8486 1.0469 1.2980 1.6747 2.0066 2.1066 2.4002 2.6737 2.9318
53 0.6791 0.8485 1.0467 1.2977 1.6741 2.0057 2.1055 2.3988 2.6718 2.9293
54 0.6791 0.8483 1.0465 1.2974 1.6736 2.0049 2.1046 2.3974 2.6700 2.9270
55 0.6790 0.8482 1.0463 1.2971 1.6730 2.0040 2.1036 2.3961 2.6682 2.9247
56 0.6789 0.8481 1.0461 1.2969 1.6725 2.0032 2.1027 2.3948 2.6665 2.9225
57 0.6788 0.8480 1.0459 1.2966 1.6720 2.0025 2.1018 2.3936 2.6649 2.9204
58 0.6787 0.8479 1.0458 1.2963 1.6716 2.0017 2.1010 2.3924 2.6633 2.9184
59 0.6787 0.8478 1.0456 1.2961 1.6711 2.0010 2.1002 2.3912 2.6618 2.9164
60 0.6786 0.8477 1.0455 1.2958 1.6706 2.0003 2.0994 2.3901 2.6603 2.9146
61 0.6785 0.8476 1.0453 1.2956 1.6702 1.9996 2.0986 2.3890 2.6589 2.9127
62 0.6785 0.8475 1.0452 1.2954 1.6698 1.9990 2.0979 2.3880 2.6575 2.9110
63 0.6784 0.8474 1.0450 1.2951 1.6694 1.9983 2.0971 2.3870 2.6561 2.9093
64 0.6783 0.8473 1.0449 1.2949 1.6690 1.9977 2.0965 2.3860 2.6549 2.9076
65 0.6783 0.8472 1.0448 1.2947 1.6686 1.9971 2.0958 2.3851 2.6536 2.9060
66 0.6782 0.8471 1.0446 1.2945 1.6683 1.9966 2.0951 2.3842 2.6524 2.9045
67 0.6782 0.8470 1.0445 1.2943 1.6679 1.9960 2.0945 2.3833 2.6512 2.9030
68 0.6781 0.8469 1.0444 1.2941 1.6676 1.9955 2.0939 2.3824 2.6501 2.9015
69 0.6781 0.8469 1.0443 1.2939 1.6672 1.9949 2.0933 2.3816 2.6490 2.9001
70 0.6780 0.8468 1.0442 1.2938 1.6669 1.9944 2.0927 2.3808 2.6479 2.8987
50% 60% 70% 80% 90% 95% 96% 98% 99% 99.5%
Next, Witsel wants to construct a 90% confidence interval for the coefficient for GDP growth, which he
believes is the most important factor in his model.
Witsel notices that the F statistic is missing from the ANOVA wonders what the value should be and what it
would mean at the 10% significance level. He uses the F-statistic table in Exhibit 3:

Exhibit 3
F-Distribution, α = 10%
Numerator df
1 2 3 4 5 6 7 8 9 10
41 2.8321 2.4369 2.2225 2.0872 1.9930 1.9230 1.8686 1.8249 1.7888 1.7586
42 2.8290 2.4336 2.2191 2.0837 1.9894 1.9193 1.8649 1.8211 1.7850 1.7547
43 2.8260 2.4304 2.2158 2.0804 1.9860 1.9159 1.8613 1.8175 1.7813 1.7509
44 2.8232 2.4274 2.2127 2.0772 1.9828 1.9125 1.8579 1.8140 1.7778 1.7474
45 2.8205 2.4245 2.2097 2.0742 1.9796 1.9094 1.8547 1.8107 1.7745 1.7440
46 2.8179 2.4218 2.2069 2.0712 1.9767 1.9063 1.8516 1.8076 1.7713 1.7408
47 2.8154 2.4192 2.2042 2.0685 1.9738 1.9034 1.8486 1.8046 1.7682 1.7377
48 2.8131 2.4167 2.2016 2.0658 1.9711 1.9006 1.8458 1.8017 1.7653 1.7347
49 2.8108 2.4143 2.1991 2.0633 1.9685 1.8980 1.8431 1.7989 1.7625 1.7319
50 2.8087 2.4120 2.1967 2.0608 1.9660 1.8954 1.8405 1.7963 1.7598 1.7291
51 2.8066 2.4097 2.1944 2.0585 1.9636 1.8930 1.8380 1.7938 1.7573 1.7265
52 2.8046 2.4076 2.1923 2.0562 1.9613 1.8906 1.8356 1.7913 1.7548 1.7240
Denominator df
53 2.8027 2.4056 2.1901 2.0541 1.9591 1.8884 1.8333 1.7890 1.7524 1.7216
54 2.8008 2.4036 2.1881 2.0520 1.9570 1.8862 1.8311 1.7867 1.7501 1.7193
55 2.7990 2.4017 2.1862 2.0500 1.9549 1.8841 1.8290 1.7846 1.7479 1.7171
56 2.7973 2.3999 2.1843 2.0480 1.9529 1.8821 1.8269 1.7825 1.7458 1.7149
57 2.7957 2.3982 2.1825 2.0462 1.9510 1.8802 1.8249 1.7805 1.7437 1.7128
58 2.7941 2.3965 2.1807 2.0444 1.9492 1.8783 1.8230 1.7785 1.7418 1.7108
59 2.7926 2.3948 2.1790 2.0427 1.9474 1.8765 1.8212 1.7766 1.7399 1.7089
60 2.7911 2.3933 2.1774 2.0410 1.9457 1.8747 1.8194 1.7748 1.7380 1.7070
61 2.7896 2.3917 2.1758 2.0394 1.9441 1.8730 1.8177 1.7731 1.7362 1.7052
62 2.7882 2.3903 2.1743 2.0378 1.9425 1.8714 1.8160 1.7714 1.7345 1.7035
63 2.7869 2.3888 2.1728 2.0363 1.9409 1.8698 1.8144 1.7697 1.7329 1.7018
64 2.7856 2.3875 2.1714 2.0348 1.9394 1.8683 1.8128 1.7682 1.7312 1.7001
65 2.7843 2.3861 2.1700 2.0334 1.9380 1.8668 1.8113 1.7666 1.7297 1.6985
66 2.7831 2.3848 2.1687 2.0320 1.9366 1.8654 1.8099 1.7651 1.7282 1.6970
67 2.7819 2.3836 2.1674 2.0307 1.9352 1.8640 1.8084 1.7637 1.7267 1.6955
68 2.7808 2.3823 2.1661 2.0294 1.9339 1.8626 1.8071 1.7623 1.7253 1.6941
69 2.7797 2.3812 2.1649 2.0282 1.9326 1.8613 1.8057 1.7609 1.7239 1.6927
70 2.7786 2.3800 2.1637 2.0269 1.9313 1.8600 1.8044 1.7596 1.7225 1.6913
Witsel decides to add a variable to his model to indicate whether exchange rates have increased (+1),
remained unchanged (0), or decreased (−1) over the previous month. Exhibit 4 shows the results when the
new variable is incorporated:

Exhibit 4
Modified Linear Regression Results
Van Damme Manufacturing Monthly Return
Multiple R 0.8894
R-squared 0.7910
Observations 60

ANOVA Freedom (df) Squares (SS) Squares (MSS) F
Regression 4 82.9775
Residual 55 21.9209
Total 59

b0 2.3031% 5.6446% 0.4080 0.6833
bInterest −0.6766 1.0729 −0.6307 0.5283
bUnemployment 0.1116 0.3881 0.2875 0.7738
bGDP Growth 2.7615 1.8314 1.5078 0.1316
bExchange Rate 0.0028 0.0052 0.5479 0.5838

7. Given the data in Exhibit 1, along with the current month’s values for short-term interest rate,
unemployment, and GDP growth, the prediction for VDM’s annualized return next month is closest to:
A. 5.33%
B. 6.31%
C. 9.15%
8. Given the data in Exhibit 1, the percentage of the variability in the returns of VDM’s common stock that
is explained by the variability in the independent variables is closest to:
A. 77.9%
B. 79.1%
C. 88.9%
9. Based on the information in Exhibit 2, to test whether or not the coefficient on interest rates could equal
negative one, the value of the test statistic is closest to, and the correct decision regarding the null
hypothesis is most likely, respectively:
A. 0.36 Fail to reject H0
B. 0.36 Reject H0
C. −1.18 Reject H0
10. Based on the information in Exhibit 1, a 90% confidence interval for the GDP growth coefficient is closest
to:
A. (0.00, 6.17)
B. (2.27, 3.90)
C. (2.60, 3.56)
11. Based on the data in Exhibit 1, the value of the F-statistic is closest to:
A. 3.77, and Witsel should conclude that bInterest, bUnemployment, and bGDP Growth could all equal to zero
B. 70.5, and Witsel should conclude that bInterest, bUnemployment, and bGDP Growth could all equal to zero
C. 70.5, and Witsel should conclude that at least one of bInterest, bUnemployment, and bGDP Growth is not equal
to zero
12. Based on the data in Exhibits 1 and 4, Witsel should most likely:
A. Include the exchange rate variable because the multiple R increases when he includes it
B. Exclude the exchange rate variable because the adjusted R2 decreases when he includes it
C. Exclude the exchange rate variable because the standard error of the estimate increases when he
includes it

ECONOMICS
Sweeny McFinny is an auditor with a focus on derivative valuation. Sweeny has been charged with verifying
the value of a sample of open contracts held by a Pinosa McLeod Inc. (PMI), a global financial services firm.
As part of the audit process, Sweeney also assesses specific members of the audit committee for their
knowledge of the company’s line of products and the risks the company faces.
Sample Contract 1: Ninety days ago, PMI entered in on the short side of a forward contract for the
delivery of €10 million in 180 days. Valuation details for the contract at initiation
(T=0) and today (T=90) are in the Table 1:
Sample Contract 2: Four months ago, PMI bought USD 5 million forward at a rate of 1.3368 (FCAD/USD).
Today, the SCAD/USD is 1.3445/48 with 3-month forward points of -16/-19. Ninety-day
Libor rates in Canada are 2.25% and 1.75% in the US.
Sweeny meets with the first member of the audit committee to get a feel for her level of knowledge of the
types of products and services the company deals in and the nature of the risk faced by the company. The
last annual report classified her as an expert based on NYSE definitions of an expert. Sweeney needs to
assess that attribution. During the course of their conversation, the committee member stated the
following:
Statement 1: UIRP states that no excess return could be gained by going long a high-yielding currency and
going short a low-yielding currency. Therefore, no carry trade opportunities would exist.
Statement 2: The equilibrium exchange rate between two countries is determined by the ratio of their
nominal price levels. Therefore, goods arbitrage would not exist.
The committee member then stated that if those statements were true, it would be hard to justify the risks
the company takes in conducting carry trades. Sweeney decides to follow up on this by examining the
process that would be followed in evaluating the profit potential of a carry trade in order to better evaluate
the risk management systems of PMI. Sweeney meets with an asset manager that focuses on carry trade
opportunities.

The asset manager is considering buying Mexican government bonds for their high yields. US 1-year
interest rates are 1.75% while Mexican 1-year interest rates are 7.25%. The Mexican peso is estimated to be
6% undervalued relative to the USD based on purchasing power parity. His job is to assess the likely course
of action in the market and assess the risks of a carry trade.
Table 2
1-year Currency Forecast
Libor Pair Today in 1 Year
CAD 2.25% CAD/USD 1.3445 1.4000
JPY 0.10% JPY/USD 118.41 1.2200
CHF 0.25% CHF/USD 0.9806 1.0000
The asset manager is considering borrowing in CHF and investing in CAD. Before he proceeds, risk
management processes require that a forecast on expected return be completed. Sweeney notes the
process does in fact guide investment decisions.
Sweeney notes that during the analysis of another possible carry trade, it has been noted that this
opportunity has been active for the last 9 months. During that period of time, there have been 3 quarters of
trade deficits potentially signalling that a depreciation of the high yield currency is on the horizon. The
analysis then argues that such a depreciation could take several years since there are long lags between an
increase in the exchange rate to import and export price changes and finally to demand changes for
imports and exports. The carry trade is to be approved with this factor being highlighted as low to
moderate risk.

13. Based on the information in Table 1, the value of that forward contract today is closest to:
A. USD – 108,400
B. USD - 59,000
C. USD - 58,300
14. For sample contract 2, the value of the forward is closest to:
A. CAD 30,300
B. USD 30,400
C. CAD 30,500
15. Which statement is correct?

A. Statement 1 only
B. Statement 2 only
C. Both Statements 1 and 2
16. If relative PPP held, the most likely forecast the manager assessing the US/Mexican carry trade would
make is that:
A. the US inflation rate will increase by 6%
B. the US inflation rate will decrease by 6%
C. the Mexican inflation will rate increases by 6%
17. Based on the information in Table 2, the forecasted return on CHF/CAD carry trade of CHF 10 million for
1 year would be closest to:
A. CAD -15,400
B. CAD 15.400
C. CAD 582,000
18. For the last potential carry trade described, in terms of the current account imbalance’s potential effect
on the high-yielding currency’s exchange rate, which mechanism is being described?
A. The portfolio balance channel
B. The debt sustainability channel
C. The flow supply/demand channel


Liva Delaney is an equity analyst at Myers & Stratton (M&S), specializing in manufacturing. Two months ago,
she analyzed Quantic Machine Tool Corp. (QMT) and CalFab Machines, Inc. (CFM), strong competitors of
each other. Her comparative analysis revealed that:
• Both QMT and CFM had earnings over the last two years that were well above what their respective
trend growth rates would have predicted.
• QMT’s receivables turnover has been consistently higher than CFM’s for at least the last 10 years.
• For the last two years, QMT’s receivables turnover was significantly higher than its long-run average,
while CFM’s receivables turnover was noticeably lower than its long-run average.
In her analysis of QMT’s earnings quality, Delaney observed that:
1. days of sales outstanding (DSO) has remained steady for the last 4 years, and is somewhat shorter
than the industry average
2. for the last 5 years revenue per unit has been slightly lower than the industry average, while QMT’s
gross profit margin has been a little above the industry average
While analyzing QMT’s balance sheet, Delaney makes only two changes:
Change One: QMT shows a net pension liability, which Delany replaces with the pension assets and
pension obligation shown in QMT’s footnotes.
Change Two: QMT has a number of operating leases on capital equipment, which Delaney replaces with
capital (finance) leases, adding an asset and a liability, based on information contained in
QMT’s footnotes.
She recently submitted a report on her analysis of Trueblood Manufacturing, Inc. (TMI). In studying TMI’s
financial statements, Delaney discovered that, amongst other things, TMI:
• Recognizes 100% of revenue when the customer is billed

• Does not record any allowance for doubtful accounts
• Uses straight-line depreciation on its PP&E with longer useful lives and higher salvage values than
are common for the industry
• Uses a higher discount rate on its pension liability and a higher expected return on its pension
assets than are common for the industry
• Uses a shorter estimated working life and a shorter estimated longevity after retirement for its
pension recipients than are common for the industry
• Uses the Black-Scholes-Merton model for valuing stock options granted to its management, but uses
an estimated volatility of returns that is about 50% of the historical average for TMI’s common stock

Delaney has been researching another manufacturing company: Worldwide Numerics, Inc. (WNI). She has
formulated these conclusions:
Conclusion 1: WNI’s financial statement follow generally accepted accounting principles (GAAP), with no
material overstatement or understatement of net income, cash flow, assets, or liabilities.
Conclusion 2: WNI’s choices of GAAP-compliant accounting methods include aggressive approaches (e.g.,
percentage-of-completion method instead of completed contract method) and conservative
approaches (e.g., double declining balance depreciation of PP&E).
Conclusion 3: Since 2016, WNI’s ratio of net operating profit after taxes (NOPAT) to cash flow from
operations (CFO) has been 1.24 (2016), 1.47 (2017), and 1.35 (2018). CFO has been fairly
constant over the last 5 years, after accounting for inflation.
Overall, Delaney believes that WNI’s financial statements do not rise to the highest level in the quality
spectrum (GAAP, decision-useful, sustainable, adequate returns).

19. Given Delaney’s comparative analysis of QMT and CFM, the company whose earnings will probably
revert to the mean more quickly most likely:
A. Is CFM
B. Is QMT
20. Given Delaney’s analysis of QMT’s earnings quality, it is most likely the case that:
A. Her first observation suggests lower earnings quality
B. Her second observation suggests lower earnings quality
C. Neither of her observations suggest lower earnings quality
21. The two changes that Delaney makes to QMT’s balance sheet, for the pension liability and the operating
leases, will most likely improve, respectively, the balance sheet’s:
Pension Liability Operating Leases

A. Completeness Unbiased Measurement
B. Clear Presentation Completeness
C. Unbiased Measurement Clear Presentation
22. Overall, Delany should most likely conclude that the quality of QMT’s balance sheet:
A. Is low
B. Is high
23. Along the quality spectrum, TMI’s financial statements would most likely be described as:
A. Within GAAP, but biased choices
B. GAAP, decision-useful, sustainable
C. Within GAAP, but real earnings management
24. Based on Delaney’s conclusions about WNI, the most likely reason for her overall belief that their
financial statements are not of the highest quality is that:
A. WNI’s earnings are unsustainable
B. WNI employs biased accounting choices
C. WNI does not generate adequate returns for its shareholders

EQUITY VALUATION
Domenico Chiesa is the newest employee at Genovese Valuation Specialists (GVS). While discussing various
definitions of value with Dominga Tapia, one of GVS’s senior valuation consultants, Chiesa says that most of
his work at his previous employer was in the accounting department where he was responsible for
determining the value of various assets, generally fixed assets and inventory, but occasionally the cash-
generating units of subsidiaries, primarily for the purpose of determining whether the asset (goodwill in the
case of cash-generating units of subs) was impaired and, if so, by how much.
Tapia has asked Chiesa to assist her in the valuation of a private company, Gorizia Distributers (GD): one of
her clients, Ferraresi Steel Works (FSW) is planning to acquire a controlling share in GD. Tapia wants to
determine an appropriate return on common equity and has gathered data in Exhibit 1 to assist in that task:
Exhibit 1
Gorizia Distributers and Ferraresi Steel Works
Company and Market Data, 18 March 2019
Market risk premium 6.10%
GD's cost of debt 6.70%
GD's equity risk premium 2.10%
GD's size premium 1.80%
GD comparable company beta 1.28
FSW's cost of debt 5.20%
FSW's equity risk premium 2.50%
FSW's beta 0.85
To value GD, Tapia considers using the guideline public company method (GPCM). She and Chiesa gather
data for applying the method, shown in Exhibit 2:
Exhibit 2
Gorizia Distributers
Guideline Public Company Data
Average MVIC/EBITDA multiple 15.2
Adjustment to MVIC/EBITDA for GD’s risk, growth −15%
Control premium 25%
GD’s normalized EBITDA EUR 10.5 million
Market value of GD’s debt EUR 85 million
GD’s normalized D/E ratio 1.4

Tapia then gives Chiesa two valuation assignments: Golden Shell Investments (GSI), a real estate investment
holding company, and Seven Hills Manufacturing (SHM), each of which has been operating for over twenty
years. She asks Chiesa to describe the approach that he would use to value each company. Chiesa replies:
GSI: I would determine the fair market value of GSI’s assets and subtract the fair market value of its
liabilities. This seems more appropriate than simply looking at the book values of the assets and
liabilities.
SHM: I would probably choose a discounted cash flow approach, such as free cash flow to equity (FCFE) or
free cash flow to the firm (FCFF). I would want to know more about the stability of SHM’s capital
structure before deciding between those two. If it’s stable, I’d prefer FCFE, but if it’s changing, then I’d
go with FCFF, and subtract the market value of its liabilities (not the book value).
Tapia has a client who is interested in acquiring a 60% interest in SHM. Once Tapia and Chiesa have a value
for SHM as a stand-alone company, they still need to determine whether that is an appropriate valuation for
Tapia’s client to use. Tapia believes that a 15% adjustment is appropriate because her client will be acquire
a controlling interest. Chiesa agrees, and suggests that, additionally, they consider a 25% adjustment
because SHM’s shares lack the liquidity of a publicly traded company. Tapia concurs.
After a hard day’s work, Tapia and Chiesa discuss private company valuation over a nice grappa. Eventually,
the discussion makes its way to valuation standards, and Tapia and Chiesa make the following comments:
Tapia: Many of the valuation standards arose out of financial crises (such as the savings and loan crisis in
the US in the 1980s and 1990s) in an effort to protect users of valuations and the community at
large.
Chiesa: Fortunately, there is a consistent set of standards that applies to the valuation of private
companies, so it is easy for people in our profession to determine what the standards are and
comply with them.

25. In Chiesa’s previous work, the standard of value with which he was concerned is most likely:
A. Fair value
B. Intrinsic value
C. Investment value
26. Given the date in Exhibit 1, the cost of common equity that Tapia should use in determining the value of
GD is closest to:
A. 7.70%
B. 10.11%
C. 10.60%
27. Based on the data in Exhibit 2, the estimated value of GD’s equity is closest to:
A. EUR 50,700,000
B. EUR 64,800,000
C. EUR 90,600,000
28. Considering Chiesa’s descriptions of the approaches he would use to value GSI and SHM, it is most likely
the case that:
A. Both descriptions are appropriate
B. Both descriptions are inappropriate
C. One description is appropriate and the other is inappropriate
29. Based on Tapia’s and Chiesa’s agreement about adjustments for control and liquidity, the amount they
believe that Tapia’s client should pay for SHM’s shares, compared to the share price they calculated for
SHM as a stand-alone company, is closest to a:
A. 6% premium
B. 10% discount
C. 14% discount
30. Concerning Tapia’s and Chiesa’s comments about valuation standards, it is most likely the case that:
C. One comment is accurate, and one is inaccurate

EQUITY VALUATION
Nguyen Dung is a senior analyst at Can Tho Mutual, an insurance company in Vietnam. Dung specializes in
equity research and makes recommendations on investment ideas for addition to the return seeking
components of the Can Tho’s portfolios.
Dung’s first meeting of the day is with his team of associates. The group presents their report on Sa Pa LLC,
an industrials company that recently listed on the Ho Chi Minh City Stock Exchange. Dung reviews Exhibit 1
and then asks the team about their valuation technique and the assumptions they used to arrive at their
target price. Phan Dan, one of Dung's associates, said they chose to use the residual income model and
made the following statements about Sa Pa:
Statement 1: We expect that Sa Pa will have negative free cash flow for the next 3 years.
Statement 2: We think Sa Pa will have unpredictable cash flows starting in year 4.
Statement 3: We are not confident in Sa Pa management’s accounting practices.
Statement 4: Year 7, we expect the WACC to drop to 5%
Statement 5: Year 7, we expect to ROE to decay and have a persistence factor of 0.10
Exhibit 1
Terminal book value VND 61.57
Book value end of year 6 VND 55.50
Year 7 ROE 10%
Cost of equity 7.00%
Cost of capital 5.00%
Persistence factor 0.10
Next, the team moves the discussion to Hanoi Corp, a telecommunications company that provides
telephone and internet services to 75% of Vietnams residents and businesses. Hanoi frequently records
non-recurring charges on their income statement and has a low dividend payout. Hoang Chu, Dung’s second
associate, who was responsible for the majority of the analysis, presents Dung with Exhibit 2, and makes the
following comments:
Explanation 1: We had to make some adjustments from the income statement and capitalize
approximately VND 1 Million.
Explanation 2: We calculated the total invested capital as VND 85 Million.
Exhibit 2
EBIT VND 18,500,00
Capitalized expenses VND 1,000,000
Tax rate 25%

Cost of capital 13%

Cost of equity 16%
Total invested equity VND 65,000,000
When Dung returns to his desk, he sees an email containing Exhibit 3 from Mai Thuy, an equity research
analyst with Halong and Associates, an investment bank Dung occasionally sources IPOs he considers
adding to the portfolios. Dung asked Thuy to send some comparable information for the automotive sector
to complete a valuation he plans on presenting to his supervisor.
Exhibit 3
Variable Investment 1 Investment 2 Investment 3
ROE 10.00% 9.00% 12.00%
Growth rate 2.50% 3.00% 3.00%
Required return 12.00% 11.10% 12.00%
ROA 11.00% 10.25% 10.00%
Expected price next year VND 14.15 VND 2.75 VND 25.00
Current book value VND 15.00 VND 3.00 VND 25.00
Before leaving for the day, Dung is stopped by Tsui Than, an intern working with the team for the summer.
Than says he was confused in the morning meeting but did not want to interrupt the rest of the team. She
does not understand why the team chose to use the residual income model rather than the other discount
cash flow methods she learned in school. Dung answers the question by making the following statements:
Comment 1: The models you mention work by forecasting future cash flows which are harder to predict,
while the residual income models use current accounting data which is easier to calculate
from the financial statements.
Comment 2: If the assumptions for DCF and residual income models are the same then, the models should
have the same results.

31. Which of Phan Dan’s statements is least likely a reason to use the residual income model?
A. Statement 1
B. Statement 2
C. Statement 3
32. Based on Phan Dan’s statements about Sa Pa, and Exhibit 1, the present value of the terminal value is
closest to:
A. VND 1.04
B. VND 1.07
C. VND 1.14
33. Based on Hoang’s explanations, and the information provided in Exhibit 2, economic value added is
closest to:
A. VND 2.825 Million
B. VND 3.575 Million
C. VND 4.225 Million
34. Based on the information provided about Hanoi Corp, and Chu’s statements, what is the most likely
reason for the low persistence factor?
A. Market position
B. Low dividend payout
C. Frequent recording of non-recurring items
35. Based on Exhibit 3, the justified price-to-book ratio of Investment 2 is closest to:
A. 0.74
B. 0.90
C. 0.92
36. Which of the comments made by Dung to Tuan is/are most likely correct?
A. Comment 1
B. Comment 2
C. Both Comment 1 and Comment 2

FIXED INCOME
Kowalski & Stivic Manufacturing (KSM) has 873 full-time employees and 193 retirees, all of whom are eligible
for the KSM defined benefit pension plan (the Plan). Lukasz Peszko manages the fixed income portfolio for
the Plan.
As many of the Plan’s trustees have little more than a general understanding of fixed income securities, they
have asked Peszko to put together a brief presentation on bonds. As part of the presentation, he describes
the idea of arbitrage-free valuation, mentions that it applies to other types of securities in addition to bonds
(such as futures and swaps), and makes three statements about arbitrage-free valuation:
Statement 1: The derivation of the spot curve from the par curve is dictated by arbitrage-free valuation,
because you have to get the same price for a coupon-paying par bond by discounting all of
its cash flows at the bond’s YTM as you get by discounting each cash flow by its spot rate
(and summing them up).
Statement 2: If you do not put up any of your own money and take no risk in your investments, your
expected rate of return should be the risk-free rate.
Statement 3: Bond markets enforce arbitrage-free valuation through the processes of stripping bonds and
reconstituting bonds.
As Peszko commonly refers to the Z-spread on the bonds the Plan holds, he also explains to the trustees
what that term means. He makes these comments:
Comment 1: The Z-spread is one way to describe the additional yield that a risky bond earns above the
yield of a risk-free bond. It’s an incremental amount added to each interest rate on the par
curve, so that the discounted cash flows equal the market price of the bond.
Comment 2: For a callable bond or a putable bond, the Z-spread is the same as the option-adjusted
spread (OAS) in a tree with 0% interest rate volatility.
Amongst the bonds that Peszko considers for the Plan’s portfolio are those issued by QWZ Corporation: 6%
coupon, annual-pay, 5-year, PLN 1,000 par. (PLN = Polish złoty; PLN 1,000 is about EUR 250). Peszko
believes that there is a possibility that QWZ will default on these bonds, so he puts together Exhibit 1 to help
in his analysis. The yield on a benchmark 5-year bond is 4%, and that bond would sell at PLN 1,089.04
today.

Exhibit 1
Analysis of Credit Risk
QWZ 6%, 5-Year Bond
Loss
Discount PV of
Date Exposure Recovery Given P(Default) P(Survival) E(Loss)
Factor E(Loss)
Default
1 1,132.60 509.67 622.93 3.00% 97.00% 18.69 0.9615 17.97
2 1,115.50 501.98 613.53 2.91% 94.09% 17.85 0.9246 16.51
3 1,097.72 493.97 603.75 2.82% 91.27% 17.04 0.8890 15.15
4 1,079.23 485.65 593.58 2.74% 88.53% 16.25 0.8548 13.89
5 1,060.00 477.00 583.00 2.66% 85.87% 15.48 0.8219 12.73
Note: Exposure, Recovery, Loss Given Default, E(Loss), and PV of E(Loss) are all given in PLN.
Peszko has decided to purchase a number of the QWZ bonds. However, because the default rate is higher
than what the Plan’s trustees would find comfortable, he will be purchasing protection in the form of a
credit default swap (CDS). Although they want full protection on the QWZ bonds, the trustees do not want
to pay for any more protection than they need.
Three years later, QWZ experiences a credit event, and the Plan needs to settle with the CDS issuer. Exhibit
2 lists the four QWZ bond issues that are covered by the CDS.
Exhibit 2
QWZ Bonds Covered by the Plan’s CDS
Remaining Market Price
Bond Coupon Rate Issue Size Defaulted?
Maturity (% of Par)
A 4.5 years 5.20% PLN 100,000,000 No 65
B 3.5 years 7.30% PLN 100,000,000 Yes 55
*
C 2.0 years 6.00% PLN 50,000,000 No 50
D 5.0 years 5.00% PLN 200,000,000 No 45
*
Bonds owned by the Plan
Peszko has created a factor model for EUR interest rate movements with factors of Level, Steepness, and
Curvature. In Exhibit 3 he has identified three EUR-denominated bonds, along with their durations with
respect to these factors. He wants to know the proper mix of these bonds to minimize his yield curve
exposure.
Exhibit 3
EUR-Denominated Bonds
Factor Sensitivities (Durations)
Bond DL DS DC
A 8 years 6 years 4 years
B 8 years 5 years 6 years
C 4 years 2 years 4 years

37. Of the three statements that Peszko makes about arbitrage-free valuation, the one that is least likely true
is:
A. Statement 1
B. Statement 2
C. Statement 3
38. Concerning Peszko’s comments about the Z-spread, it is most likely that:
C. One comment is true and the other is false
39. Given the data in Exhibit 1, the appropriate credit spread on the QWZ bonds is closest to:
A. 151 bp
B. 170 bp
C. 200 bp
40. The appropriate type of CDS for Peszko to purchase for the Plan is most likely:
A. An index CDS
B. A tranche CDS
C. Neither an index CDS nor a tranche CDS
41. Given the data in Exhibit 2, the Plan will most likely:
A. Prefer a cash settlement of the CDS
B. Prefer a physical settlement of the CDS
C. Be indifferent between a cash settlement and a physical settlement
42. Using the data from Exhibit 3, an appropriate investment strategy to minimize yield curve exposure is
most likely to:
A. Purchase EUR 1 million in market value of Bond A and EUR 2 million in market value of Bond C, and
to sell (short) EUR 2 million in market value of Bond B
B. Purchase EUR 1 million in market value of Bond B and EUR 2 million in market value of Bond A, and
to sell (short) EUR 2 million in market value of Bond C
C. Purchase EUR 1 million in market value of Bond C and EUR 2 million in market value of Bond B, and
to sell (short) EUR 2 million in market value of Bond A

DERIVATIVES
Frederic Longmount is a trader for a hedge fund. It is currently the first of the month and Frederic must
submit an unrealized profit and loss report for trades that are currently open. Frederic has open trades on
an interest rate forward contract, a Treasury Bond futures contract, and a 5-year Libor-based interest rate
swap. Frederic finds these contracts the most challenging to value but tries to keep a few rules in mind.
Six months ago, Frederic initially sold GBP 8 million forward at a rate of $1.3144 for one year. Today the
spot rate for SUSD/GBP is 1.3068. Frederic now needs to calculate the gain or loss on this contract. The rates
for both the GBP and the USD are given in Exhibit 1. Frederic notes that GBP rates have remained
unchanged over this period of time.
Exhibit 1
Frederic remembers the following from his CFA books:
Point 1: For Sf/d, if if > id, the forward rate will always be at a discount
Point 2: Always remember that for SP/B, the P currency should always be the higher yielding currency
Next, Frederic turns to a Treasury Bond futures contract opened at a price of 91 on the long side. Frederic
has difficulty understanding the underlying of this specific futures contract. He seems to remember that the
quoted futures price of the contract is what the forward price would be on the cheapest to deliver bond
and, as such, the underlying must be the cheapest to deliver bond. For more clarification, Frederic asks
Mary who sits to his right to explain what the underlying is for this contract.
Mary: The underlying is any government bond with more than 15 years to maturity as of the first day of
the delivery period and priced to yield 6%. Typically, one bond will be identified as the cheapest to
deliver at any given time, but the CTD may vary over the life of the contract.
Frederic turns to his left and asks Choyun, another colleague.
Choyun: The underlying is a generic USD 100,000 face value bond with a 6% semi-annual coupon.

Frederic understands what the underlying is now and proceeds to value the Treasury Bond futures contract
with 6 months remaining based on the available information in Exhibit 2:
Exhibit 2
Finally, Frederic turns to the interest rate swap. The Libor-based interest rate swap was entered into 1 year
ago as a 5-year pay-fixed swap at a rate of 1.9634% with a notional amount of USD 8 million. The current
discount factors based for the remaining 4 years of the swap are given in Exhibit 3:
Exhibit 3
Frederic feels he has a very solid understanding of interest rate swaps. In his report he writes the following
statements:
Statement 1: The interest rate swap was entered into one year ago by going short the fixed rate.
Statement 2: Since the notional amount must be repaid at maturity, the fixed rate on the swap is very
close to the interest rate in the final year of the swap. It is the size of this final cash flow
relative to the other cash flows that weights the fixed rate much more heavily towards the
final year rate.

43. The gain or loss on the interest rate forward contract is closest to:
A. Gain of GBP 89,132
B. Gain of USD 89,132
C. Gain of USD 116,749
44. With respect to the points that Frederic remembers, he is most likely incorrect with respect to:
A. Point 2 only
B. Both Point 1 and Point 2
C. Neither since both points are remembered correctly
45. Who is the most correct regarding the underlying of the Treasury Bond futures contract?
A. Mary
B. Choyun
C. Frederic
46. Based on the information in Exhibit 2, the unrealized profit or loss that will be recorded on Frederic’s
monthly report for the Treasury Bond futures contract will be closest to:
A. USD -2,730
B. USD -2,709
C. USD –2,030
47. The value of the interest rate swap is closest to:

A. USD -36,902
B. USD 9,640
C. USD 36,902
48. Which of Frederic’s statement s in his report about the interest rate swap is most likely correct?
A. Statement 1 only
B. Statement 2 only

So, you think you are ready to be a derivatives trader? Let’s just see how ready you are. I am going to take
you through a series of scenarios, and we will just see, ok?
Imagine that its late September, and you really should be back at school. But at the same time, the natural
gas market had the following characteristics:
• high inventory levels

• cash (spot) prices are depressed
• front month futures are trading at a premium to the spot
There are some scary stories about natural gas traders and hedge funds going broke trying to play this
commodity. Unless you really have an informational advantage, best to steer clear of natural gas. Instead,
let’s look at oil, gold and soybean. Table 1 presents the closing contract prices in each respective futures
market on the last day of trading for the April contract. Details for each contract can be found in Table 2.
Table 1
Oil Gold Soybean
April $58.34 $1,302.30
May $57.86 $1,304.90 909 ¼
June $57.11 $1,307.50
July $56.44 $1,310.10 923
August $56.01 $1,312.70
September $55.32 $1,315.30 944 ½
October $55.00 $1,317.90
November $54.48 $1,320.50 964 ¼
Table 2
Underlying Storage costs/unit
Oil 1,000 barrels 0.70%
Gold 100 ounces 0.20%
Soybeans 5,000 bushels 0.35%
Oil responds to economic activity, global tensions – though not as much as it used to – and inventory
conditions – more so today than it used to. Gold responds to inflation expectations predominantly, either
through inflation reports or through interest rate decisions. Soybean is heavily weather dependant.
Growing conditions are critical.

So, let’s say the oil April contract was entered into at $56.20 when the spot price was $55.80. During the
holding period, the spot price climbed to $58.98. The April contract was open for 60 days, was fully
collateralized, and the reference risk-free rate for that period of time was 1.75%. On expiration of the April
contract, the position was rolled forward into the May contract.
Now let’s look at a swap. A commodity swap is basically a series of call options on a futures contract with
the same strike across all months. A swap is used in place of a series of options since options 6 and 7
months out are not very liquid and come with wide spreads. The swap performs the same thing at lower
cost (you don’t have to cross wide spreads). The option prices given in Table 3 below are the mid-quotes for
each option.
A buyer of oil, could be a refiner, went long a swap that pays the amount exceeding $58 a barrel every
month from June to December. The price of the swap was the sum total of the call options that would have
been required to mimic the swap. The buyer planned to buy 2,000 barrels of oil per month. Table 3 fast-
forwards all the way to the end of the December contract and presents the closing prices of each contract
for each of the 7 months. The options prices listed are as of the start of the swap period.
Table 3
Call Option
Pricing/barrel at
Closing Price Start of Swap
June $57.90 $1.11
July $57.40 $1.01
August $57.80 $0.94
September $58.40 $0.83
October $59.60 $0.76
November $59.60 $0.71
December $59.50 $0.68

49. With respect to natural gas, the futures curve is most likely showing:
A. Backwardation
B. A positive calendar spread
C. A negative calendar spread
50. With respect to Table 1, which of the following is a correct statement?

A. Oil storage costs are greater than the convenience yield
B. Hedging demand from oil consumers is greater then hedging demand from oil producers
C. Hedging demand from oil producers is greater then hedging demand from oil consumers
51. The total return for the April oil contract is closest to:
A. 4.9%
B. 5.7%
C. 6.0%
52. With reference to Table 1, which commodity is currently displaying the highest convenience yield?
A. Oil
B. Gold
C. Soybeans
53. A short position in soybean contracts would:

A. Create a positive roll yield
B. Simulate a futures curve in backwardation
C. Consistently lose money as each futures contract rolled up to the next higher-priced futures contract
54. How much did the swap add to the cost of every barrel of oil for the buyer?
A. $0.73
B. $0.86
C. $0.94

Cristiano Grifo is an economic consultant at Milan Consulting. One of Grifo’s clients, Lombardy Investments
(LI), a fixed income management firm, has asked him to prepare an economic outlook for the next five
years. Some of the highlights of Grifo’s report are shown in Exhibit 1, in which he compares his forecasts to
those of a wide group of economists whose opinions appear to be shared by the majority of market
participants. The Central bank has indicated that it believes the neutral rate to be 1.6%.
Exhibit 1
5-Year Economic Forecast
Milan Consulting: Selected Data
Economic Variable Grifo's Forecast Consensus Forecast
Average annual GDP growth rate 1.2% 2.6%
Average unemployment rate 5.7% 4.2%
Average inflation rate 1.8% 1.0%
Uncertainty about inflation rate (1 σ) 0.2% 0.5%
Average 6-month nominal interest rate 2.0% 1.8%
Average 10-year nominal interest rate 4.5% 4.1%
Average annual salary growth rate 0.9% 1.5%
Grifo explains that the primary driver behind the differences in his forecasts and the consensus forecasts is
where the economy is in the business cycle: The consensus opinion is that the economy is in the late
upswing stage and hasn’t reached its peak, while Grifo believes that the economy has already reached its
peak and is well into the downswing stage. He further explains that because of his view on the stage of the
business cycle, his expectation of changes in credit spreads is quite different from the consensus view.
Naturally, LI’s managers are interested in the future monetary actions of the central bank and ask Grifo for
his views on this. He replies that the central bank uses the Taylor rule in establishing its policy rate. Grifo
agrees with the consensus view that the central bank’s target inflation rate is 1.2%, that its target GDP
growth rate is 2.2%, and that it uses the actual GDP growth rate minus the target GDP growth rate as a
proxy for the output gap.
LI’s managers are particularly interested in Grifo’s views on the relative performance of two of their
portfolios, selected details of which are shown in Exhibit 2:
Exhibit 2
Two Bond Portfolios
Lombardy Investments: Selected Data
Portfolio 1 Portfolio 2
Description Consumer Cyclicals Consumer Non-Cyclicals
Number of bond issues held 847 422
Weighted average maturity 5.6 years 8.2 years
Weighted average duration 4.8 years 6.7 years
Weighted average coupon 4.9% 5.2%
Weighted average credit spread 121 bp 145 bp
Average credit rating AA AA
Their concerns run to the earnings growth of the companies whose bonds are included in each portfolio, as
well as the credit quality of the companies whose bonds are included in each portfolio.

55. Based on the information in Exhibit 1, Grifo would most likely conclude that:
A. The inter-temporal rate of substitution is too high, and bond prices should decrease
B. Bond prices should decrease, and expectations of future utility of consumption are too low
C. Expectations of future utility of consumption are too high, and the inter-temporal rate of
substitution is too low
56. Based on the information in Exhibit 1, concerning the spread between the yield on a nominal bond and
the yield on an inflation-adjusted bond, it is most likely that:
A. Grifo’s expected spread will be larger than the consensus expected spread
B. Grifo’s expected spread will be smaller than the consensus expected spread
C. The relationship between Grifo’s expected spread and the consensus expected spread cannot be
determined with the information given
57. The difference between the consensus expectation for credit spreads and Grifo’s expectation, as well as
the reason for the difference, are most likely that the consensus expectation is for credit spreads to:
A. Widen or remain unchanged, while Grifo expects credit spreads to narrow because of an increase in
the probability of defaults on credit bonds
B. Narrow or remain unchanged, while Grifo expects credit spreads to widen because of an increase in
the probability and size of defaults on credit bonds
C. Narrow or remain unchanged, while Grifo expects credit spreads to widen because of an increase in
the probability (but not the size) of defaults on credit bonds
58. Based on the information in Exhibit 1 and the central bank’s targets for inflation and GDP growth, the
central bank’s policy rate given Grifo’s outlook will most likely be:
A. Equal to its policy rate given the consensus outlook
B. Less than its policy rate given the consensus outlook
C. Greater than its policy rate given the consensus outlook

59. Given the information in Exhibit 2 and Grifo’s economic outlook, the most likely effect on the average
credit quality of the companies represented in Portfolio 1 compared to the effect on the average credit
quality of the companies represented in Portfolio 2 is that the:
A. Negative effect on the Portfolio 1 companies will be greater than the negative effect on the Portfolio
2 companies
B. Negative effect on the Portfolio 2 companies will be greater than the negative effect on the Portfolio
1 companies
C. Relative magnitudes of the effects on Portfolio 1 companies and Portfolio 2 companies cannot be
determined from the information given
60. Given the information in Exhibit 2 and the consensus economic outlook, the average short-term
earnings growth of the companies represented in portfolio 1 is most likely:
A. Less than the average short-term earnings growth of the companies represented in portfolio 2
B. Equal to the average short-term earnings growth of the companies represented in portfolio 2
C. Greater than the average short-term earnings growth of the companies represented in portfolio 2
End of Exam



2019 Exam Prep

Level II
Exam 4

Minute
Questions Topic
s
25 - 30 Equity Valuation Authored By: Bilal Nadeem, CFA 18
43 - 48 Derivatives Authored By: Charterholder; Contract Provider 18
Total: 180


Andreas Stryger, CFA, is an equity research analyst at Corbin & Associates (C&A). He has recently completed
his research on Larsen Construction (LC), and the recommendation he plans to issue is a “sell”. Milt Larsen,
CEO at LC, challenges Stryger to a golf match, and Stryger, an avid golfer (though not particularly good),
accepts. To “keep it interesting”, Larsen, who has a reputation as an excellent golfer, proposes a wager of
USD 1,000 per hole, to which Stryger agrees. During the match, Larsen clearly plays poorly – well below his
potential – and finishes the match owing Stryger USD 9,000. The following week, Stryger receives a cheque
from Larsen in the post, and publishes his research report, along with the “sell” recommendation.
Stryger’s next assignment was to research Irrawaddy Manufacturing (IM). Based on his analysis of IM’s
financial statements, press releases, industry projections, and interviews with IM’s senior management,
Stryger’s recommendation for IM common stock was a hold. One month after his report was released, IM
announced a new contract with a foreign cell phone manufacturer. The consensus amongst analysts that
follow IM is that the new contract is expected to increase IM’s revenues by 15%, but Stryger’s own research
leads him to believe that it will be closer to a 20% increase in revenues. Because Stryger typically updates
his recommendations semi-annually, he did not change his report or recommendation, even when other
analysts were recommending buying IM common stock.
Stryger has a personal retirement account that he set up through his credit union. While some of Stryger’s
portfolio is invested in individual stocks, over 80% of his portfolio is invested in a number of large,
diversified mutual funds. One of the equity funds has a significant holding in Irrawaddy Manufacturing.
Stryger did not disclose that investment when he issued his report on IM.
Jan De Bruyne is an investment advisor at C&A, working in a branch office in a jurisdiction that requires that
all clients’ financial records be discarded six years after the initial transaction. He is reviewing the portfolio
of one of his clients, Hannes Halldórsson. Halldórsson’s IPS calls for a strategic asset allocation of 70%
equity and 30% fixed income, with a specific restriction against high-risk investments. Clarke believes that
one of the stocks in Halldórsson’s portfolio is likely to decrease in price in the near future and recommends
that Halldórsson purchase put options on the stock with a strike price 3% below the current market price of
the stock.
De Bruyne has arrangements with a number of brokerage firms under which he receives referral fees for
the transactions he sends to them. The brokerage fees paid to these firms are not the lowest in the
industry, nor are they the highest, but De Bruyne believes that they are appropriate for the services that the
brokers provide, and that the choice of brokers to use meets the CFA Institute Standards of Professional
Conduct with respect to best execution. De Bruyne is diligent in disclosing the referral fees to his employer,
his clients, and his prospective clients semi-annually.

1. Concerning the golf match with Larsen, and with regard to Standard I(B) Independence and Objectivity,
Stryger has most likely:
A. Violated the Standard
B. Not violated the Standard because he didn’t change his recommendation
C. Not violated the Standard because he had no way of knowing that Larsen would deliberately lose
the match
2. With regard to his report on Irrawaddy Manufacturing, has Stryger most likely violated Standard V(A)
Diligence and Reasonable Basis?
A. Yes
B. No, because Semi-annual updates on recommendations are a common business practice
C. No because the expected increase in revenue hasn’t occurred yet, and there is no way to determine
the exact effect on HS’s net income
3. By not mentioning his investment in Irrawaddy Manufacturing, has Stryger most likely violated CFA
Institute Standards of Professional Conduct?
A. No
B. Yes, Standard VI(A) Disclosure of Conflicts
C. Yes, Standard V(B) Communication with Clients and Prospective Clients
4. With regard to Standard V(C) Record Retention, De Bruyne most likely:

A. Cannot comply with the Standard
B. Can comply with the Standard by discarding all of his clients’ financial records after 6 years
C. Can comply with the Standard by retaining all of his clients’ financial records for at least 7 years
5. Is De Bruyne’s recommendation of the purchase of put options for Halldórsson’s portfolio likely to
violate the CFA Institute Standards of Professional Conduct?
A. No
B. Yes, because options are not considered low-risk investments
C. Yes, because if De Bruyne believes that the stock will decrease in price he should sell the stock
6. Does De Bruyne’s policy on providing updated referral fee information to his employer most likely
comply with the recommendations for Standard VI(C) Referral Fees?
A. No
B. Yes, as updates should be made at least annually
C. Yes, as updates should be made at least semi-annually

Marwan Hamed, a fixed income analyst at Heron & Alhazen Investments (H&A), wants to estimate the
probability that a company will default on its bonds. To that end, he has created a linear regression model
in which the independent variables are the company’s net profit margin and debt-to-equity ratio, whether or
not the company regularly pays a dividend (Yes/No), and whether or not the company has had a default on
its bonds in the last 10 years (Yes/No). He ran an analysis of 50 companies and summarized the data in
Exhibit 1:
Exhibit 1
Linear Regression Results
Probability of Corporate Bond Default
Multiple R 0.9184
R-squared 0.8434
Observations 50
Regression 4 104.1443 26.0361 60.59
Residual 45 19.3357 0.4297
Total 49 123.4801

b0 −0.5171% 0.4457% −1.1601 0.2460
bPM 0.0595 0.0146 4.0792 0.0000
bD/E 1.2761% 0.0024 5.2719 0.0000
bDiv −0.4843% 0.2954% −1.6393 0.1012
bPrior default 4.3719% 1.8650% 2.3442 0.0191
*
Units on SS and MSS are percent2 (%2)
Hamed also computed the correlations of the input variables with each other and summarized them in the
correlation matrix shown in Exhibit 2:
Exhibit 2
Input Data Correlations
Probability of Corporate Bond Default
Profit Margin D/E Ratio Dividend Prior Default
Profit Margin 1.0000 −0.7408 0.2003 −0.4304
D/E Ratio −0.7408 1.0000 −0.1048 0.2880
Dividend 0.2003 −0.1048 1.0000 0.0308
Prior Default −0.4304 0.2880 0.0308 1.0000

Hamed’s supervisor has asked him to explain the results of the model to the other analysts. One of the
analysts asks Hamed about the “p-value” column in the ANOVA table. Hamed makes the following
statements:
Statement 1: The p-value for a given coefficient is the probability that true population value of that
coefficient is equal to the hypothesized value.
Statement 2: The p-value for a given coefficient applies specifically to the hypothesis test that the true
population value of that coefficient is zero.
Statement 3: The p-value for a given coefficient is compared to the chosen level of significance (α); if p > α,
the null hypothesis is not rejected, but if p < α, the null hypothesis is rejected.
Another analyst asks Hamed about the coefficient bDIV. Hamed replies with the following comments:
Comment 1: The dividend is modeled with what is known as a dummy variable that simply indicates
whether they pay a regular dividend or not. The estimated value of the coefficient is the
additional probability of default for companies that pay regular dividends.
Comment 2: The estimated value of the coefficient, −0.4843%, suggests that companies that pay regular
dividends are less likely to default on their bonds than companies that do not pay regular
dividends.
Hamed is somewhat puzzled about the value for the slope coefficient bP/M. As he expects that companies
with higher profit margins are less likely to default on their bonds than companies with lower profit
margins, he thinks that the coefficient should be negative, not positive. He plans to investigate this.

Before running his analysis, Hamed believed that a prior default would increase the probability of another
default by at least 8%. He decides to test that hypothesis at the 5% significance level. To do so, he uses the
table for t-statistics in Exhibit 3:
Exhibit 3
df
0.25 0.20 0.15 0.10 0.05 0.025 0.02 0.01 0.005 0.0025
31 0.6825 0.8534 1.0541 1.3095 1.6955 2.0395 2.1438 2.4528 2.7440 3.0221
32 0.6822 0.8530 1.0535 1.3086 1.6939 2.0369 2.1409 2.4487 2.7385 3.0149
33 0.6820 0.8526 1.0530 1.3077 1.6924 2.0345 2.1382 2.4448 2.7333 3.0082
34 0.6818 0.8523 1.0525 1.3070 1.6909 2.0322 2.1356 2.4411 2.7284 3.0020
35 0.6816 0.8520 1.0520 1.3062 1.6896 2.0301 2.1332 2.4377 2.7238 2.9960
36 0.6814 0.8517 1.0516 1.3055 1.6883 2.0281 2.1309 2.4345 2.7195 2.9905
37 0.6812 0.8514 1.0512 1.3049 1.6871 2.0262 2.1287 2.4314 2.7154 2.9852
38 0.6810 0.8512 1.0508 1.3042 1.6860 2.0244 2.1267 2.4286 2.7116 2.9803
39 0.6808 0.8509 1.0504 1.3036 1.6849 2.0227 2.1247 2.4258 2.7079 2.9756
40 0.6807 0.8507 1.0500 1.3031 1.6839 2.0211 2.1229 2.4233 2.7045 2.9712
41 0.6805 0.8505 1.0497 1.3025 1.6829 2.0195 2.1212 2.4208 2.7012 2.9670
42 0.6804 0.8503 1.0494 1.3020 1.6820 2.0181 2.1195 2.4185 2.6981 2.9630
43 0.6802 0.8501 1.0491 1.3016 1.6811 2.0167 2.1179 2.4163 2.6951 2.9592
44 0.6801 0.8499 1.0488 1.3011 1.6802 2.0154 2.1164 2.4141 2.6923 2.9555
45 0.6800 0.8497 1.0485 1.3006 1.6794 2.0141 2.1150 2.4121 2.6896 2.9521
46 0.6799 0.8495 1.0483 1.3002 1.6787 2.0129 2.1136 2.4102 2.6870 2.9488
47 0.6797 0.8493 1.0480 1.2998 1.6779 2.0117 2.1123 2.4083 2.6846 2.9456
48 0.6796 0.8492 1.0478 1.2994 1.6772 2.0106 2.1111 2.4066 2.6822 2.9426
49 0.6795 0.8490 1.0475 1.2991 1.6766 2.0096 2.1099 2.4049 2.6800 2.9397
50 0.6794 0.8489 1.0473 1.2987 1.6759 2.0086 2.1087 2.4033 2.6778 2.9370
51 0.6793 0.8487 1.0471 1.2984 1.6753 2.0076 2.1076 2.4017 2.6757 2.9343
52 0.6792 0.8486 1.0469 1.2980 1.6747 2.0066 2.1066 2.4002 2.6737 2.9318
53 0.6791 0.8485 1.0467 1.2977 1.6741 2.0057 2.1055 2.3988 2.6718 2.9293
54 0.6791 0.8483 1.0465 1.2974 1.6736 2.0049 2.1046 2.3974 2.6700 2.9270
55 0.6790 0.8482 1.0463 1.2971 1.6730 2.0040 2.1036 2.3961 2.6682 2.9247
56 0.6789 0.8481 1.0461 1.2969 1.6725 2.0032 2.1027 2.3948 2.6665 2.9225
57 0.6788 0.8480 1.0459 1.2966 1.6720 2.0025 2.1018 2.3936 2.6649 2.9204
58 0.6787 0.8479 1.0458 1.2963 1.6716 2.0017 2.1010 2.3924 2.6633 2.9184
59 0.6787 0.8478 1.0456 1.2961 1.6711 2.0010 2.1002 2.3912 2.6618 2.9164
60 0.6786 0.8477 1.0455 1.2958 1.6706 2.0003 2.0994 2.3901 2.6603 2.9146
50% 60% 70% 80% 90% 95% 96% 98% 99% 99.5%

Hamed believes that creating models such as these is tedious work, especially with the amount of data that
is available. He therefore talks with the information technology (IT) team at H&A about developing machine
learning (ML) capabilities so that, ultimately, H&A’s computers can determine the appropriate inputs into
models such as these. Hamed believes that the best approach would be to develop algorithms that would
allow H&A’s computers to sift through market data and determine on their own the appropriate analysis
outputs and the models to determine the patterns in the data.
Hamed explains the steps in training an ML model to H&A’s IT team:
1. Specify the ML technique/algorithm.

2. Specify the associated hyperparameters (values chosen before training begins); these may include
the number of training cycles.
3. Create training sample data which will be used to train or fit the algorithm, and
4. Evaluate learning with performance measure P and adjust (“tune”) the hyperparameters.
5. Repeat the training cycle the specified number of times or until the required performance level (e.g.,
level of accuracy) is obtained.

7. Of the three statements that Hamed makes about the p-value, the least likely to be accurate is:
A. Statement 1
B. Statement 2
C. Statement 3
8. Concerning the comments that Hamed makes about the model’s treatment of companies paying regular
dividends, it is most likely the case that:
C. One comment is accurate, and one is inaccurate
9. The reason that the estimated value for bPM is positive is most likely that the:
A. Model exhibits significant multicollinearity
B. Error terms in the model are not normally distributed
C. Model exhibits significant conditional heteroskedasticity
10. Based on the information in Exhibit 1, to test Hamed’s hypothesis about the coefficient on prior defaults,
the value of the test statistic is closest to, and the correct decision regarding the null hypothesis is most
likely, respectively:

C. 2.33 Reject H0
11. Hamed’s suggested approach to machine learning for creating models is best described as:
A. Supervised learning
B. Unsupervised learning
C. Reinforcement learning
12. Concerning the steps in machine learning (ML) that Hamed outlines for H&A’s IT team, it is most likely the
case that:
A. The list of steps is complete and accurate
B. There is a significant step missing from the list
C. All steps are present, but the order of the steps is inaccurate


Albert SA owns 45% of Cornice SA, and accounts for its investment using the equity method. Albert bought
its share in Cornice in 2016 for EUR 67.5 million: it issued EUR 54 million in bonds and paid the balance in
cash. Albert’s financial statements for 2016, 2017, and 2018 are shown in Exhibits 1 and 2:
Exhibit 1
Albert SA Statements of Earnings
Years Ended 31 December _____
(EUR, Thousands)
2018 2017 2016
Sales 280,000 260,000 250,000
COGS (185,000) (170,000) (160,000)
SG&A (55,000) (50,000) (45,000)
Income from Cornice 3,150 2,700 2,250
EBIT 43,150 42,700 47,250
Interest Expense (20,000) (19,000) (18,500)
EBT 23,150 23,700 28,750
Income Taxes (7,000) (7,600) (8,500)
Net Income 16,150 16,100 20,250
Exhibit 2
Albert SA Statements of Financial Position
As of 31 December, _____
(EUR, Thousands)
2018 2017 2016
Assets
Cash 53,400 37,900 32,000
A/R 85,000 90,000 95,000
Inventory 175,000 170,000 160,000
PP&E, net 410,000 400,000 385,000
Investment in Cornice 73,350 70,200 67,500
Intangibles 60,000 67,500 75,000
Total Assets 856,750 835,600 814,500
Liabilities
A/P 70,000 65,000 60,000
Bonds Payable 534,000 474,000 474,000
Equity
Paid-In Capital, net 60,000 120,000 120,000
R/E 192,750 176,600 160,500
Total Liabilities + Equity 856,750 835,600 EUR 814,500

Cornice’s financial statements for 2016, 2017, and 2018 are shown in Exhibits 3 and 4:
Exhibit 3
Cornice SA Statements of Earnings
Years Ended 31 December, _____
(EUR, Thousands)
2018 2017 2016
Sales 140,000 115,000 75,000
COGS (90,000) (75,000) (48,000)
SG&A (28,000) (23,000) (14,000)
EBIT 22,000 17,000 13,000
Interest Expense (10,500) (7,500) (5,500)
EBT 11,500 9,500 7,500
Income Taxes (4,500) (3,500) (2,500)
Net Income 7,000 6,000 5,000
Exhibit 4
Cornice SA Statements of Financial Position
As of 31 December, _____
(EUR, Thousands)
2018 2017 2016
Assets
Cash 9,000 13,000 17,000
A/R 65,000 62,000 60,000
Inventory 105,000 100,000 95,000
PP&E, net 250,000 240,000 230,000
Intangibles 32,000 36,000 40,000
Total Assets 461,000 451,000 442,000
Liabilities
A/P 38,000 35,000 32,000
Bonds Payable 260,000 260,000 260,000
Equity
Paid-In Capital, net 65,000 65,000 65,000
R/E 98,000 91,000 85,000
Total Liabilities + Equity 461,000 451,000 442,000
Jaime Godoy is an equity analyst with Hale & Bay. He has been assigned to research Albert and issue a
recommendation on its common stock. As part of his research, Godoy wants to compare Albert with other
companies in its industry; therefore, he plans to make appropriate adjustments to Albert’s financial
statements so that they more closely follow common industry practice. Although Albert owns only 45% of
Cornice, Godoy strongly believes that Albert exerts control over Cornice.

Godoy initially compares the accounting methods that Albert uses and choices that Albert makes to the
most common methods and choices used in the industry. Exhibit 5 lists the details of this comparison. He
notes that inventory costs have rising steadily over the last 10 years and wants to determine whether
Albert’s accounting methods and choices are notably more aggressive than the industry’s, notably more
conservative than the industry’s, or a balance of aggressive and conservative.
Exhibit 5
Accounting Methods and Choices
Albert vs. Industry
Albert Industry
Depreciation of fixed assets Straight-line Accelerated
Salvage value of fixed assets 10.5% of cost 12.8% of cost
Useful life of fixed assets 10.1 years 9.8 years
Inventory costing method Average cost FIFO
Equipment leasing method Operating Finance
Bad debt allowance 2% of total sales 6% of A/R*
Investment in associates Equity method Consolidation
*Accounts Receivable
With his belief that Albert exercises control over Cornice, Godoy decides that it is appropriate for Albert to
use consolidation. His normal approach is to exclude any minority interest on the balance sheet from the
Equity section (putting it between Liabilities and Equity). He is primarily concerned with the effect on
Albert’s quick ratio and return on equity for 2018.
As several of Albert’s direct competitors do not have investments in affiliated companies, Godoy also
decides to adjust Albert’s financial statements to remove the effect of the purchase of Cornice. Once again,
he plans to look at the quick ratio and return on equity for 2018.
Finally, Godoy turns to Albert’s leases. While Albert owns much of the equipment it uses, some of it, such as
delivery trucks, is leased. Albert’s annual (end-of-year) lease payments are EUR 10 million for the next 6
years (including the 12/31/2018 payment), and the average interest rate on the leases is 6.4%. To make
Albert’s financial statements comparable to the rest of the industry, Godoy adjusts them by replacing the
operating leases with finance leases as of 1/1/2018. For simplicity, he assumes that the leased equipment
has zero salvage value.

13. Given the reason for Godoy’s analysis of Albert’s financial statements, the least likely analytical data
processing he would perform is:
A. Adjusting Albert’s liabilities to their fair market values
B. Creating common-size income statements and balance sheets
C. Forecasting Albert’s future sales revenue and operating expenses
14. Based on the data in Exhibit 5, Albert’s accounting methods and choices compared to those common in
its industry would most likely be described as:
A. Aggressive
B. Balanced
C. Conservative
15. To increase the comparability of Albert’s financial statements to industry average financial statements,
the adjustment that is least likely to be necessary is:
A. Changing Albert’s inventory costing method
B. Changing Albert’s method of accounting for its investment in Cornice
C. Changing Albert’s depreciation methods and choices to match those of the industry
16. If Godoy changes Albert’s method of accounting for its investment in Cornice to consolidation, Albert’s
2018 quick ratio and return on equity (ROE), respectively, will be closest to:
Quick Ratio Return on Equity

A. 1.97 4.46%
B. 1.97 5.88%
C. 4.56 5.88%
17. If Godoy removes from Albert’s financial statements the effects of the purchase of Cornice, Albert’s 2018
quick ratio and return on equity (ROE), respectively, will be closest to:
Quick Ratio Return on Equity

A. 1.98 4.81%
B. 2.17 4.81%
C. 2.17 5.88%

18. Starting with Albert’s existing financial statements, and assuming that the income tax rate does not
change, Godoy’s adjustments for Albert’s leases will result in a value for assets on 31 December 2018
that is closest to:
A. EUR 897,218
B. EUR 897,581
C. EUR 905,311

CORPORATE FINANCE
Essam Samir and Khadim Sarr are equity analysts who are discussing corporate governance at Leclerc
Industries (LI), a company which they each follow closely. Samir brings up the subject of agency problems,
on which Sarr holds strong views.
Sarr: I know that the managers at LI generally have more information about the company’s resources than
the shareholders do, but that’s where the board of directors is supposed to come in. It’s their
responsibility to ensure that the shareholders have as much information as the managers so that they
can make sure that management is acting in their best interest.
Samir: The annual reports will be far more useful in ensuring that shareholders have the information that
they need, especially if they compare those reports to the reports of other companies in the
industry. That will tell them whether LI’s managers are using their capital efficiently.
As Sarr mentioned the board of directors, Samir steers the conversation to LI’s board. The qualifications
that he believes board members should have include:
• At least ⅔ of the board should be independent members

• Directors should possess skills and experience necessary to fulfill their fiduciary responsibilities to
stakeholders
• Directors must show their commitment to protecting shareholder interest
• Independent directors should meet at least annually, to engage in open discussions about the
company’s affairs
• The nominating committee should comprise only independent members
• The board should use in-house counsel whenever possible to ensure the company’s regulatory
compliance and confidentiality
Sarr looks over LI’s board of directors and makes these observations:
• Eighty percent of the board is independent members

• None of the directors serve on more than 5 boards, and all but four serve on no more than 3 boards
• Board elections are held annually, with the entire board up for election each year
• Board members conduct self-assessments every two years
• Eighty percent of the audit committee is independent members
• One hundred percent of the nominating committee is independent members
• Two-thirds of the compensation committee is independent members
• Related-party transactions must be disclosed to the board at least 30 days in advance of the
transaction

In assessing LI’s corporate governance, Samir and Sarr periodically review LI’s statement of corporate
governance policies. There are four main elements in LI’s statement:
1. Code of ethics
2. Statements of management’s responsibilities
3. Board and committee performance self-assessments
4. Management performance assessments
For a number of years, LI gradually changed its corporate governance statement until it reached what it
considers to be the most appropriate wording, which has remained unchanged for the last 20 years.
Samir and Sarr have been trying to decide how LI’s management makes ethical decisions. Their
assessments are:
Sarr: I feel that LI’s management truly believes that people – whether its employees, its customers, or the
general public – are ends unto themselves, not merely a means for management or the company to
achieve its goals.
Samir: I believe that LI’s management makes decisions based on what will provide the greatest good for the
greatest number of people, whether those people are their employees, their customers, or the
general public.
Finally, Sarr and Samir get to the point of their discussion, how LI’s corporate governance might affect the
value of the company, which, as equity analysts, is their chief concern. Sarr is concerned that the annual
reports that Samir cited as providing valuable information to shareholders might be misleading or
incomplete, while Samir fears that LI’s management might be granting themselves excessive compensation
and other perks that aren’t in the best interests of the shareholders.

19. Concerning Sarr’s and Samir’s comments about agency problems at LI, it is most likely the case that:
C. One comment is true, and the other comment is false
20. Of the six qualifications that Samir outlined for board members, the number that represent best
practices for corporate governance is most likely:
A. All of them
B. Four of them
C. Five of them
21. Concerning Sarr’s observations about LI’s board of directors, LI’s corporate governance is most likely:
A. Fair, as five of the characteristics that Sarr notes qualify as best corporate governance practices
B. Quite weak, as only two of the characteristics that Sarr notes qualify as best corporate governance
practices
C. Quite strong, as seven of the characteristics that Sarr notes qualify as best corporate governance
practices
22. Concerning Samir’s and Sarr’s assessment of LI’s statement of corporate governance, the elements in
that statement are most likely:
A. Adequate in both the number and quality of its elements
B. Inadequate in both the number and quality of its elements
C. Adequate in the number of elements, but inadequate in the quality of those elements
23. Based on their statements, the ethical theories that Sarr and Samir, respectively, ascribe to LI’s
management are most likely:
Sarr Samir
A. Utilitarianism Friedman Doctrine
B. Kantian Ethics Utilitarianism
C. Friedman Doctrine Kantian Ethics
24. The valuation concerns expressed by Sarr and Samir, respectively, are best characterized as:
Sarr Samir
A. Accounting Risk Asset Risk
B. Asset Risk Strategic Policy Risk
C. Strategic Policy Risk Accounting Risk

EQUITY VALUATION
Jerome Taylor, an equity research analyst at Marcus Securities, covers the fertilizer, automobile and cement
sectors in North America. He primarily relies on absolute valuation techniques to value stocks. In an
informal meeting with two of his peers, Jerome discusses the following companies.
Company Alpha: Alpha is an automobile assembler with a global outreach. The company is classified
as a large cap stock on the NYSE. In the recent past Alpha Inc. has experienced a
significant drop in sales. The majority of the analysts following Alpha believe the
drastic drop in sales might hurt the dividend paying capacity of the company until it
is able to recapture its market share or target a niche market. The consensus
expectations of the market are for a suspension of the dividend sometime in the
near future.
Company Beta: Beta is a mid-cap fertilizer manufacturer with a stable growth rate. Beta has a required
rate of return of 9.75% and has maintained an average retention ratio of 60%. Jerome
expects earnings and dividends to grow at a constant rate of 3.75%. The market price of
the stock is USD 44.80: implying an earnings growth rate of 4.17%. Beta Inc.’s trailing P/E
ratio is 7.46x, ROE is 11.40% and last reported EPS is USD 6.0.
Company Gamma: Gamma is a mid-cap, inefficiently run cement manufacturer with a required rate of
return of 11.50%. Gamma recently paid an annual dividend of USD 0.75. Jerome
forecasts a dividend growth rate of 8% for the next three years before falling to 4.0%
in perpetuity. The other two analysts partially agree with Jerome’s forecast. The
sponsors of Gamma have recently shown interest in getting acquired which suggests
it is a potential acquisition target.
Emily Jayson, an intern at Marcus securities, was assigned to value Hercules Limited, a cement
manufacturing company. The stock of Hercules Limited trades at USD 66. She estimates the required rate of
return to be 13.25% on Hercules Limited stock. Hercules recently reported an annual EPS of USD 6.40 and
Emily expects an EPS of USD 7.50 in the current year. The company regularly pays dividends and has an
average ROE of 15%. Emily decides to value Hercules using a dividend discount model based on a three-year
holding period. She forecasts dividends of USD 3.10, USD 3.85, USD 4.45 in the first three years. Moreover,
Emily expects the value of the stock to be USD 70 at the end of the third year.
She discusses her expectations with Jerome, her supervisor, who then asks her to compute the PVGO for
Hercules based on a required rate of return of 14.5%.
While discussing the dividend discount model with Jerome, Emily makes the following statements:
Statement 1: The dividend discount model takes a control perspective and it can also be applied in equity
valuation of companies which don’t pay dividends but have the capacity to pay dividends.
Statement 2: In the Gordon growth model, the long-term growth rate should be lower than the required
rate of return on equity and equal to or lower than the GDP growth rate.

25. Which of the following companies would the dividend discount model be most appropriate?
A. Company Beta
B. Company Alpha
C. Company Gamma
26. Which of the following discounted cash flow (DCF) models is most appropriate for valuing Company
Gamma?
A. Free cash flow model
B. Residual income model
C. Dividend discount model
27. Based on dividend discount model, the value of Company Beta’s stock should be closest to:
A. USD 38.5
B. USD 41.5
C. USD 44.8
28. Which of the following should be closest to Emily’s estimate of fair value of Hercules Limited stock?
A. USD 51.35
B. USD 54.55
C. USD 57.00
29. Assuming the stock of Hercules is fairly valued, Emily’s estimate of Hercules PVGO should be closest to:
A. USD 14.28
B. USD 16.00
C. USD 21.86
30. Which of Emily’s statements regarding the dividend discount model is/are most accurate?
A. Statement 1only
B. Statement 2 only
C. Both Statements are correct

FIXED INCOME
Moussa Sakho manages a fixed income portfolio for the Keïta Balde Family Foundation. Sakho believes in
active management for fixed income portfolios and often employs such strategies as rolling down the yield
curve to increase the portfolio’s returns. An example uses the EUR spot yield curve shown in Exhibit 1.
Sakho wants to compute the 1-year forward rate starting one year from today and the 2-year forward rate
starting one year from today.
Exhibit 1
EUR Spot Yield Curve
Maturity, Years Spot Rate
1 1.800%
2 2.600%
3 3.160%
4 3.552%
5 3.826%
Sakho is planning to purchase some EUR-denominated callable and putable bonds and GBP-denominated
callable and putable bonds for the Foundation’s portfolio and wants to be able to analyze the prices of these
bonds. He therefore creates a EUR binomial interest rate tree, a portion of which is shown in Exhibit 2, and
a GBP binomial interest rate tree, shown in Exhibit 3:
Exhibit 2
EUR Binomial Interest Rate Tree

Exhibit 3
GBP Binomial Interest Rate Tree
Sakho wants to use the GBP tree to value a 3-year, GBP 1,000 par, 4% coupon, annual pay bond callable on
any coupon date at 100 (i.e., 100% of par). For simplicity, he assumes that the bond will be called any time
the call option is in the money.
Having valued all of the callable and putable bonds he has considered, Sakho also wants to investigate
measures of the price sensitivity of these bonds to changes in interest rates. In particular, he wants to
compare the effective duration of the three bonds shown in Exhibit 4 at a yield of 2% and at a yield of 6%.
Exhibit 4
GBP-Denominated Bonds
Characteristic Bond A Bond B Bond C
Type No embedded options Callable @ 102 Putable @ 98
Maturity 8 years 8 years 8 years
Coupon 3.95% 3.95% 3.95%
Price GBP 978.97 GBP 973.91 GBP 1,032.51
Modified Duration 6.7 years 6.7 years 6.67 years
Sakho also wants to investigate measures of the price sensitivity of these bonds to changes in interest rates
other than effective duration. In particular, he is interested in two analyses:
Analysis 1: Investigating the sensitivity of the prices of these bonds to a flattening or a steepening of the
yield curve
Analysis 2: Investigating the difference between the sensitivity of the prices of these bonds to a
decrease in interest rates and the sensitivity of the prices of these bonds to an increase in
interest rates
Sakho would also like to add some mortgage-backed securities to the Foundation’s portfolio, and, as with
the other bonds he’s considering, he would like to create a binomial interest rate tree to value them. He
realizes, however, that the number of paths through such a tree would be impossibly huge, so he decides to
use a Monte Carlo simulation of only 1,000 paths through such a tree. He calibrates the (monthly, 30-year)
tree to get current market prices on benchmark bonds, then runs the Monte Carlo simulation to generate
1,000 random paths through the tree. However, when he prices those same benchmark bonds by averaging
their prices along only those 1,000 paths, he discovers that none of the bonds is priced correctly. He
abandons the idea of analyzing these securities.

31. Using the data from Exhibit 1, the 1-year forward rate starting one year from today and the 2-year
forward rate starting one year from today, respectively, are closest to:
1-year Forward Rate 2-Year Forward Rate
A. 3.400% 3.840%
B. 3.406% 3.847%
C. 3.406% 4.289%
32. In the binomial interest rate tree shown in Exhibit 2, the annual interest rate volatility and the rate i3,HHH,
respectively, are closest to:
Volatility i3,HHH
A. 15% 7.224%
B. 30% 5.352%
C. 30% 7.224%
33. Given the data in Exhibit 3 and Sakho’s assumption about when the call option will be exercised, the
value of the callable bond is closest to:
A. GBP 1,022.55
B. GBP 1,031.49
C. GBP 1,037.74
34. Given the data in Exhibit 4, the bond with the lowest effective duration at a yield of 2% and the bond
with the lowest effective duration at a yield of 6%, respectively, are most likely:
2% Yield 6% Yield
A. Bond A Bond B
B. Bond B Bond C
C. Bond C Bond A
35. The appropriate risk measures for determining price sensitivities of the callable and putable bonds in
Analysis 1 and Analysis 2, respectively, are most likely:
Analysis 1 Analysis 2
A. Effective convexity One-sided durations
B. Key-rate durations Effective convexity
C. Key-rate durations One-sided durations

36. The reason that Sakho’s Monte Carlo simulation did not price the benchmark bonds correctly is most
likely that:
a. He calibrated the tree incorrectly
b. He failed to add a drift term to the interest rates on each path
c. One thousand (1,000) paths is too few to get a proper Monte Carlo simulation of a monthly, 30-
year tree

DERIVATIVES
Nancy Putnam had been the point person for a client named Canaco Co, a Canadian firm specializing in the
production of maple syrup. Nancy was run over by a train recently and died. The Canaco Co. file has been
moved over to Bill Brader. Bill first wants to review the three open positions the company holds:
Position 1: Currency Swap: Ninety days ago, Canaco Co. entered into a one-year fixed-for-fixed
currency swap with quarterly interest rate payments. The swap involved 50 million
Canadian dollars (CAD) for Mexican Pesos (MXN) when the spot rate was SMXN/CAD = 14.91.
The spot rate is currently SMXN/CAD = 13.96. Selected Libor data for this swap is presented in
Table 1:
Bill believes that the value of the swap to Canaco will have increased if CAD-based Libor interest rates
decreased, MXN-based Libor interest rates decreased, or the SMXN/CAD decreased.
Position 2: Equity swap: One year ago, Canaco. Co entered into a receive equity-pay floating swap
based on Libor with quarterly resets with a notional amount of CAD 15 million. Information
about the equity returns and Libor rates are in Table 2 below:

Position 3: Total Return Equity-swap: The last position was a 4-year receive equity-pay fixed swap
entered into 6 months ago at a fixed rate of 2.2%. The equity position is a concentrated
position in the stock of another Canadian company. The notional amount was for CAD 30
million and the underlying price per share was $30. The price today per share is CAD 31.63.
Bill wonders about the use of the total return swap since the stock does not currently pay a
dividend.

37. The value to Canaco Co. of the currency swap today would be closest to:
A. CAD -8.4M
B. CAD -3.4M
C. CAD 8.4M
38. With respect to Bill’s belief regarding the value of the swap to the Canadian company, he is correct with
respect to:
A. The SMXN/CAD only
B. CAD interest rates only
C. MXN interest rates only
39. Over the year, the payoff of the swap to Canaco was closest to:
A. CAD -1.2M
B. CAD 74K
C. CAD 1.2M
40. With respect to the Canaco equity swap, the value to the receive-equity side will increase if:
A. Libor rates decline
B. Libor rates increase
C. The price of the equity declines
41. Based on the information in Table 3, the value of the receive equity side of the 4-year equity swap is
closest to:
A. CAD -1.63M
B. CAD 1.63M
C. CAD 1.65M
42. With respect to Position 3, the value of the swap would not have changed since contract initiation if the
value of the stock today were closest to:
A. CAD 29.98
B. CAD 30.00
C. CAD 30.66

DERIVATIVES
Swapnil Gore is interning at Magna-Corp, which specializes in derivatives trading. Gore has been assigned a
mentor, Miss Bhandari, who is a senior analyst in the firm. To track Gore’s progress, Miss Bhandari
schedules a meeting with him to test his understanding and gauge the progress he has made. They discuss
calendar spreads and Miss Bhandari makes two statements.
Statement 1: Generally, the initial investment needed for a long calendar spread, if using call options,
should be less than 0.
Statement 2: Calendar spreads do not help much in capturing the decay in option premium as it involves
a short as well as a long option at the same strike price.
Gore thinks for a while and says one of them is correct but is not able to justify his reasoning. Miss Bhandari
proceeds to present him some scenarios that the firm faced recently.
Scenario 1: February 2014: Analysts at Magna-Corp had a strong reason to believe that firm Easy-max
was involved in manipulating their earnings and expected that the stock price would be
negatively affected once the annual results were declared the following year. The analysts
have also expected that the stock would increase in value within the next month due to
regulatory changes that would benefit firm Easy-max.
Scenario 2: January 2017: Analysts at Magna-Corp execute a short calendar spread for the firm Asta-
world using put options.
Scenario 3: August 2017: Analysts at Magna-Corp are anticipating a decrease in interest rates and seek
to take advantage of the situation by modifying the duration of the bond portfolio held by
Magna-Corp.
Scenario 4: Analysts at Magna-Corp are evaluating the protective put strategy applied in the following
case. The current price of the stock is the same as the buying price of the stock.
Firm Current price of Cost of put Exercise price of the Maximum loss
the stock option put option possible
Creta $39 X USD 31 USD 12

After the above discussion, Gore and Miss Bhandari are discussing the straddle strategy and its suitability in
the following scenario.
Jan 2018: Results of a new drug test carried out by a pharma company, Magna-Farm, are scheduled to be
released and the market has been anticipating the news. Analysts at Magna-Corp execute a long
straddle based on the assumption that the stock will move by at least X%.
Exhibit 1: Magna-Farm
stock price USD 40
call and put strike price 40
cost of call option 3
cost of put option 3
Time to expiration 45 days
Implied volatility 25%
Gore makes the following two statements regarding the straddle:

1. The straddle strategy will pay-off only if the stock price exceeds USD 46
2. If the outlook changes to reflect a very low volatility of the stock, the best course of action would be
to execute a short straddle.

43. Of the two Statements made by Miss Bhandari regarding calendar spreads, which is/are incorrect?
A. Only Statement 1 is incorrect
B. Only Statement 2 is incorrect
C. Both Statements 1 and 2 are incorrect
44. According to the Situation that Magna-Corp faced in February 2014, if the assumptions of the analysts at
Magna-Corp are true, the best possible course of action for them would most likely be to execute a:
A. Short Calendar spread using Put options.
B. Short Calendar spread using Call options.
C. Short Calendar spread using either Call or Put options are valid.
45. According to the Situation that Magna-Corp faced in August 2017, if the assumptions of the analysts at
Magna-Corp are true, the best possible course of action would be to:
A. Increase the overall duration of the bond portfolio by entering as a fixed rate payer in an interest
rate swap
B. Increase the overall duration of the bond portfolio by entering as a floating rate payer in an interest
rate swap
C. Decrease the overall duration of the bond portfolio by entering as a fixed rate receiver in an interest
rate swap
46. According to scenario 4, the cost of the put option is:

A. USD 4
B. USD 8
C. USD 12
47. In case of Magna-Farm, assume the analysts at Magna-Corp discovered a possible delay in the
announcement of the results by a year, and the analysts then expect the price will remain fairly flat in
2018. The best possible course of action for them would most likely be to:
A. Execute a long straddle with options expiring in 2018.
B. Execute a short straddle with options expiring in 2018.
C. Execute a short straddle with options expiring in 2019.

48. Which Comment(s) made by Gore regarding the straddle strategy is/are incorrect?
A. Comment 1 only
B. Comment 2 only
C. Both Comment 1 and Comment 2 are incorrect

ALTERNATIVE INVESMENTS
Monolyth Asset Management (MAM) is a real estate investment management company located in South
Africa that specializes in private real estate and direct mortgage lending. MAM just launched South African
Value- Add Two (SAVA2), the company’s second private closed-end fund. Oluchi Botha, a principal at MAM,
will be spending the morning with Sharik Govender of Govender & Associates (G&A). G&A is an appraisal
and valuation firm that MAM contracts before adding a property to their portfolios. Oluchi has planned two
property tours of buildings she would like Sharik’s firm to appraise.
The first building Oluchi and Sharik visit is Windy Acres, a retirement property on the coast of Cape Town.
Windy Acres is one of several condo-style, independent living, communities in the country. The residents
that move there find the facility desirable because of its secluded location away from the city.
After reviewing Exhibit 1, walking through the property, and scouting the location, Sharik makes the
following comments.
Comment 1: With the ageing demographics in the country, there has been a significant focus on
developing these types of condo-style communities in the last 15 years. When I get back to
my office, I will send you the database of transactions my team has compiled.
Comment 2: I am concerned that Cape Town Tours, a national resort company, has just received zoning
for an adventure park. I anticipate this will significantly increase traffic and noise: we will
need to factor that into the valuation.
Comment 3: I noticed the foundation was cracked. I estimate the cost to fix the problem at ZAR 2 Million,
but the good news is that it is a curable problem. Unfortunately, I noticed there is some
flooding occurring on the west side of the building - I think there might be a sewage
problem. I estimate this will likely add 5 years to the effective age of the building.
Exhibit 1
Estimated value of land ZAR 5,000,000
Current replacements costs (per sqr foot) ZAR 150
Total are (sqr feet) 250,000
Developers profit 5%
Total economic life 60 years
Remaining economic life 40 years

The next property Oluchi and Sharik visit is a warehouse on the outskirts of Cape Town. The property, 55
Kloof Street, is leased by a large international online retailer and is used as a “last mile” fulfillment center for
Cape Town and the surrounding region. The warehouse is located in an industrial park surrounded by
nearly identical structures. Sharik has recently helped other buyers make acquisitions of similar property in
the area; she presents Oluchi with Exhibit 2 detailing those transactions.
Exhibit 2
Variable 55 Kloof Street Comparable 1 Comparable 2
Size (sqr feet) 15,000 22,000 15,000
Age(1) 8 years 14 years 8 years
Condition(2) Good Poor Average
Location(3) Prime Prime Prime
Date since sale(4) 12 months 2 months
Sale price ZA 10,000,000 ZAR 12,000,000
NOTE:
(1) Comparable buildings depreciate at 2%
(2) In addition to average depreciation condition is accounted for: Good, none; Average, 5%; Poor, 15%
(3) There is a location discount for secondary locations: 10%
(4) Market appreciation has been 2.5% per month
On her way back to the office, Oluchi receives a call from Miranda Pillay, a wealthy private client who was an
early investor in SAVA1, which helped Oluchi start MAM. Miranda voices concerns that given the types of
assets that SAVA2 will hold the investment will likely pay very little regular income and will pay the majority
of distributions when the underlying holdings are sold.
When Oluchi returns to her desk, she sees an email from her analyst, Jonathan Roberts regarding a
development called Hanover Park. The email reads: “The lender said they will underwrite the loan up to 76%
LTV and are willing to lend at 6.5%. Personally, to manage our risk, I don’t think we should exceed 1.5x
DSCR.”
Exhibit 3
Purchase price ZAR 35,000,000
Current NOI ZAR 2,000,000
First Year NOI ZAR 2,300,000
Loan type Interest Only

49. Based only on Sharik’s concerns about Cape Town Tours, relating to Windy Acres, she is most likely
describing:
A. Economic obsolescence
B. Locational obsolescence
C. Functional obsolescence
50. Based on Sharki’s comments, and the information presented in Exhibit 1, what is the most likely
reduction for incurable deterioration of the Windy Acres property?
A. ZAR 12.4 Million
B. ZAR 15.6 Million
C. ZAR 17.7 Million
51. Based only on Sharik’s comments about her transaction database, what is the most likely approach she
will recommend to arrive at a valuation of Windy Acres?
A. Cost approach
B. Income approach
C. Sales comparable approach
52. Based on the information presented in Exhibit 2, the most likely adjusted value per square foot of
Comparable 2 is closest to:
A. ZAR 880
B. ZAR 920
C. ZAR 960
53. If Oluchi wanted to improve the regular income distributions but wanted to only include private
investments in SAVA2, which form of real estate is she is least likely to include:
A. Mortgages MAM has underwritten as part of its regular business
B. Joint venture in a rent-stabilized office building with a partner firm
C. Shares in an illiquid REIT trading on the South African stock exchange
54. Based on Exhibit 3, and assuming Oluchi takes Jonathan’s recommendations, the most likely LTV for the
Hanover Park development is closest to:
A. 58%
B. 67%
C. 76%

Son Joo is an equity portfolio manager at Hwangbo Asset Management (HAM). Joo is an active manager
whose benchmark on his K100 portfolio is the KOSPI 100 (Korean Composite Stock Price Index, 100
companies). Joo is quite selective about the active positions he takes, and in 2018 took active positions in
only four stocks.
Exhibit 1 summarizes Joo’s expected active returns on these stocks for 2018 and their actual active returns:
Exhibit 1
HAM K100 Portfolio
2018 Active Positions
Expected versus Actual Returns
Total Return Active Return
Stock
Expected Actual Expected Actual
Stock A 8.9% 8.6% 5.1% 20.6%
Stock B 3.6% 4.2% -0.2% 16.2%
Stock C 4.1% -6.4% 0.3% 5.6%
Stock D -4.5% -3.6% -8.3% 8.4%
Exhibit 2 summarizes Joo’s active positions and results:
Exhibit 2
HAM K100 Portfolio
2018 Selected Data
Stock A active weight 1.60%
Stock B active weight −0.60%
Stock C active weight 0.30%
Stock D active weight −1.30%
Benchmark return −12.00%
K100 beta 1.03
Joo also manages (actively) a portfolio – US500 – benchmarked to the S&P 500 index.
Exhibit 2 contains selected data for the portfolio and the benchmark from 1 July 2017 to 30 June 2018:
Exhibit 3
HAM US500 Portfolio
1 July 2017 - 30 June 2018
Selected Data
Benchmark return 14.01%
Benchmark risk (σ of returns) 9.17%
US500 return 15.22%
US500 risk (σ of returns) 9.70%
US500 active risk (σ of active returns) 3.22%

Two other managers at HAM, Juana Cavani and Omar Ashraf, manage equity portfolios without constraints
on long and short positions. Cavani focuses on sector rotation with a benchmark of 10 sectors, while Ashraf
prefers individual stock selection with the KOSPI 100 as his benchmark. Each manager decides on her/his
portfolio at the beginning of each year and maintains it unchanged throughout the year, and forecasts are
considered independent from year to year. Historically, Cavani’s information ratio has averaged 0.18 while
Ashraf’s has averaged 0.43.
In reviewing Cavani’s performance over several years, Joo begins to suspect that her investment decisions
might not be independent, and that the returns in the sectors she uses have an average correlation of +0.4.
Jung Seung manages the investment portfolio for the Jeong University Endowment and is interested in
hiring an active portfolio manager for their international equity investments. Joo is in the running, as he
also manages an international portfolio, as well as two managers from other firms. Seung has compiled
data on the performance of these three managers versus the same benchmark in Exhibit 4 and must decide
which manager to select.
Exhibit 4
Active International Equity Portfolio Mangers
Selected Data
Information Transfer Information
Manager
Coefficient Coefficient Ratio
Son Joo 0.35 0.91 0.46
Manager 1 0.68 0.84 0.61
Manager 2 0.92 0.69 0.37

55. Based on the information in Exhibits 1 and 2, Joo’s transfer coefficient and information coefficient,
respectively, for portfolio K100 are closest to:
Transfer Coefficient Information Coefficient
A. −0.47 0.63
B. 0.92 0.63
C. 0.92 1.04
56. Based on the information in Exhibit 2, the return on portfolio K100 and its risk-adjusted value added
(alpha), respectively, are closest to:
K100 Return Alpha
A. −11.86% 0.14%
B. −11.86% 0.50%
C. −12.14% 0.50%
57. Given the information in Exhibit 3, the US500 portfolio’s information ratio and Sharpe ratio, respectively,
are closest to:
Information Ratio Sharpe Ratio
A. 0.12 1.30
B. 0.12 1.36
C. 0.38 1.36
58. Without regard to Joo’s concern, compared to Ashraf’s information coefficient, Cavani’s information
coefficient is most likely:
A. Lower
B. Higher
C. The same
59. If Joo’s analysis of the sectors that Cavani uses in her portfolio proves to be correct, then his most likely
conclusion is that Cavani’s breadth is:
A. Lower than it would appear to be if the decisions were independent, and that her information
coefficient is lower than it would appear to be
B. Lower than it would appear to be if the decisions were independent, and that her information
coefficient is higher than it would appear to be
C. Higher than it would appear to be if the decisions were independent, and that her information
coefficient is higher than it would appear to be

60. Based on the information in Exhibit 4, Seung should most likely select:
A. Son Joo
B. Manager 1
C. Manager 2
End of Exam



2019 Exam Prep

Level II
Exam 4

Total: 180


Viktor Olsen is an account manager at Tyresta Asset Management (TAM). Olsen earned a BS degree in Civil
Engineering from a state university in the US. After a 10-year career in civil engineering, Olsen decided that
he wanted to change careers and become a financial advisor. TAM hired him based, in part, on his résumé,
on which he falsely stated that he held a BS degree in Computational Finance from a private university in
the UK. When advising clients on investments in short-term, zero coupon, government bonds, Olsen will
often explain that the return on these bonds is known for certain if the bonds are held to maturity, because
the par value is guaranteed by the government and there are no coupons, so there is no reinvestment risk.
A client of Olsen’s recently told him that she wants to make a charitable contribution to help provide fresh
drinking water in underdeveloped countries. Olsen had mentioned that he has done a lot of charitable
work, so she asked him if he could recommend a suitable charity. Olsen said that he knew of one, and that
he would ask one of their representatives to phone her. That afternoon, he contacted the group, told them
of his client’s wish to donate, gave them her mobile number, and reminded them that all of the information
he had shared was confidential.
One of Olsen’s coworkers is Roman Lunyov, a portfolio manager at TAM. When Lunyov passed the Level III
CFA exam, he became the first charterholder at TAM. At the time, he was concerned that TAM didn’t have
any formal ethical or professional standards.
Amongst the portfolios that Lunyov manages is a pension fund for a consortium of 50 dentists. For the past
year, Lunyov has noticed an unusual pattern of cash flows in the pension fund’s portfolio. He now suspects
that someone in the consortium’s management may be diverting money from the pension fund to their own
personal account. Although the jurisdiction in which TAM operates does not require that suspected illegal
activities be reported to legal authorities, Lunyov is still considering handing over the evidence to local law
enforcement.
Lunyov also manages a European large-cap mutual fund. His benchmark is the STOXX Europe 600, an index
that contains 600 large-cap, mid-cap, and small-cap companies in Europe, and represents about 90% of the
European stock market capitalization. Lunyov believes that adding some mid-cap and small-cap stocks to
the fund will likely enhance the return and reduce the risk of the fund, so he allocates 25% of the portfolio
to these investments. With his benchmark already containing mid-cap and small-cap stocks, he sees no
reason to change benchmarks, nor does he change the large-cap mandate for the fund. Over the following
year, his fund outperforms the benchmark by 50bp with only 90% of the benchmark’s return volatility.
TAM recently hired Aymen Srarfi as their chief compliance officer. Srarfi’s first task is to review TAM’s
policies and procedures for ensuring that all investment recommendations comply with the recommended
procedures for Standard I(B) Independence and Objectivity.

1. Olsen has most likely violated Standard I(C) Misrepresentation with regard to:
A. His résumé
B. His characterization of government bond yields
C. Both his résumé and his characterization of government bond yields
2. With regard to his client who wanted to make a charitable donation, are Olsen’s actions likely to violate
CFA Institute Standards of Professional Conduct?
A. No
B. Yes, because he is not allowed to disclose the confidential information that a client wants to donate
C. Yes, because he is not allowed to disclose a client’s personal contact information (such as a personal
e-mail address or a private phone number)
3. Upon earning his CFA charter, to comply with Standard IV(A) Loyalty (to employer), Lunyov’s best course
of action would most likely have been to:
A. Do nothing
B. Give his employer a copy of the CFA Institute Code and Standards, and insist that the company
adopt them
C. Give his employer a copy of the CFA Institute Code and Standards, and encourage the company to
adopt them
4. With regard to Lunyov’s suspicions about the dental pension plan, his best course of action is most likely
to:
A. Say nothing, as he has an obligation to preserve the confidentiality of client information
B. Consult with his general counsel about whether or not he should turn over the evidence
C. Turn over the evidence to local law enforcement, because he believes that the client is engaging in
illegal activity
5. With regard to managing the mutual fund, which of the CFA Institute Standards of Professional Conduct
has Lunyov most likely violated?
A. Only Standard III(C) Suitability
B. Only Standard V(B) Communication with Clients and Prospective Clients
C. Both Standard III(C) and Standard V(B)

6. Amongst the policies and procedures that TAM should have in place, Srarfi would most likely expect to
find:
A. Restrict special cost arrangements to only fixed fees charged to investment clients
B. Ensure that research analysts do not report to the investment banking department
C. Create a list of securities which the firm is restricted from discussing with clients and potential
clients


Johan Sommer is an equity analyst with EuroPartners (EP); he focuses on the household durables industry.
He recently analyzed Dortmunder Designs GmbH (DDG), which is negotiating to acquire Lippstadt Furniture
(LF) in a share-for-share merger. Sommer has enumerated concerns related to the acquisition:
Concern 1: Leading up to the acquisition, DDG might manipulate its earnings to reduce their reported
value, in an effort to reduce the number of shares they have to deliver to LF shareholders.
Concern 2: Leading up to the acquisition, LF might manipulate its earnings to increase their reported
value, in an effort to increase the number of DDG shares that must be delivered to LF
shareholders.
Concern 3: After the acquisition, DDG might manipulate its earnings to increase their reported value, in
an effort to justify the price paid for LF.
Sommer is analyzing Schmidt & Klein Appliances (SKA), and, using historical data for the last 10 years, has
created a regression model of SKA’s annual earnings (in EUR millions):
Earningst+1 = 0.0625 + 1.0403(Earningst) + εt+1
When evaluating SKA’s earnings quality, Sommer noted that SKA has historically offered an appliance repair
service, but at the end of last year decided to discontinue it as it had had negative profits for the last two
years.
Sommer next turns to SKA’s cash flow statement. He first enumerates the indicators of cash flow quality:
Indicator 1: Positive CFO

Indicator 2: CFO derived from sustainable sources
Indicator 3: CFO sufficient to cover capital expenditures, dividends, and debt servicing
Indicator 4: CFO higher than the industry average

Sommer summarizes SKA’s last 10 years of cash flow statements in Exhibit 1:
Exhibit 1
Schmidt & Klein Appliances
Cash Flow, 2009 – 2018 (EUR)
CapEx, Dividends,
Year CFO CFI CFF
Debt Servicing
2009 22,961,000 (6,165,000) (9,895,000) 19,662,000
2010 15,497,000 (6,952,000) (5,051,000) 15,729,000
2011 22,963,000 (10,424,000) 17,097,000 23,393,000
2012 22,446,000 (10,567,000) 20,591,000 19,120,000
2013 22,176,000 (10,761,000) 35,801,000 20,633,000
2014 19,496,000 (9,167,000) 9,207,000 19,428,000
2015 12,563,000 (6,514,000) (9,745,000) 10,247,000
2016 17,433,000 (7,574,000) 8,848,000 17,792,000
2017 18,099,000 (5,662,000) (16,502,000) 15,618,000
2018 18,294,000 (7,106,000) 2,524,000 16,512,000
The coefficient of variation (CV, σ/μ) for SKA’s CFO is 17.3%, compared to the industry average of 15.0%.
As part of his analysis of the risks faced by SKA, Sommer has analyzed SKA’s financial statements (including
ratio analysis, as well as the Beneish and Altman calculations), the auditor’s opinion, and the notes to SKA’s
financial statements

7. Of the concerns about DDG’s acquisition of LF that Sommer enumerated, the one that is least likely to be
valid is concern:
A. Concern 1
B. Concern 2
C. Concern 3
8. What would Sommer’s analysis most likely suggest regarding the sustainability of SKA’s earnings?
A. It is low
B. It is high
C. It cannot be determined
9. The effect of SKA’s discontinued operations on the quality of its earnings is most likely that it will:
A. Increase the quality of its earnings
B. Decrease the quality of its earnings
C. Have no effect on the quality of its earnings
10. Of the indicators of cash flow quality enumerated by Sommer, the one that is least likely to be accurate is
indicator:
A. Indicator 2
B. Indicator 3
C. Indicator 4
11. Based on Sommer’s summary of SKA’s cash flow, the aspect that most likely raises concerns about cash
flow quality is:
A. SKA’s negative CFI
B. The volatility of SKA’s CFO relative to the industry average
C. The inability of SKA’s CFO to cover capital expenditures, dividends, and debt servicing in 3 of the last
10 years
12. A primary source of risk information about SKA that Sommer has omitted is most likely:
A. SKA’s MD&A only
B. Financial press only
C. Both SKA’s MD&A and financial press

CORPORATE FINANCE
Midwest Manufacturing, Inc. (MMI) is in negotiations to purchase South Coast Tooling Corp. (SCT). MMI’s
management has yet to decide whether they’ll pay for SCT with cash, or with MMI stock, or with a
combination of cash and stock. MMI’s stock price is well above its 52-week average, and its leading P/E ratio
is higher than it has been in over 5 years, even after accounting for the growth in sales that it anticipates
over the next three years. SCT’s shareholders are somewhat surprised that MMI has such a keen interest in
purchasing SCT as they do not see a great deal of value that will be generated from the merger.
MMI’s chief financial officer (CFO), Gianluca Biraghi, has enumerated the reasons he believes that the
merger will create value:
1. For the last 5 years, MMI has had earnings growth above the industry average, and he projects that
they will continue to do so for the foreseeable future.
2. There have been a large number of bidders for SCT, suggesting that there is extra value to be
uncovered.
3. MMI believes that they can pay a lower than average premium for SCT’s shares.
MMI and SCT are, respectively, the second largest and fifth largest companies in their industry.
Exhibit 1 lists the companies in the industry and their respective market shares:
Exhibit 1
Specialized Manufacturing Industry
Companies by Market Share
Company Market Share
1 25%
2 (MMI) 20%
3 15%
4 10%
5 (SCT) 5%
6 5%
7 – 36 20%
Before getting too far into the merger negotiations, MMI’s management wants to know whether it’s likely
that they will face an antitrust challenge on the merger. They assume that companies 7 to 36 will add only
20 to the Herfindahl-Hirschman Index (HHI).

To value SCT, Biraghi plans to use a discounted free cash flow approach. He outlines the steps in this
approach to the rest of MMI’s senior management:
1. After looking at SCT’s financial statements, we will develop pro forma financial statements for SCT
for the next five years, incorporating the synergies that we expect to realize. From the pro forma
income statements, we will get net operating profit less adjusted taxes (NOPLAT), and from NOPLAT
we will adjust for non-cash charges, and fixed and working capital investments to arrive at free cash
flow to the firm (FCFF).
2. Because projecting full-blown financial statements after five years is extremely difficult and
extremely subjective, we will estimate a terminal value based on our projected FCFF in year 5 and a
projected P/FCFF ratio that we will estimate using current P/FCFF ratios and trends in those ratios.
3. Finally, we will discount each year’s FCFF along with the terminal value using SCT’s current weighted
average cost of capital (WACC) and add them together to arrive at the value of the firm.
As a double-check on the value that he calculated for SCT using discounted free cash flow, Biraghi has
decided to do a comparable company analysis using mean company values. In Exhibit 2 he has data on
several of the firms in the industry as SCT (companies 3, 4, and 6 from Exhibit 1). In Exhibit 3 he has
compiled data on recent mergers in the industry.
Exhibit 2
Selected Comparable Company Data (USD)
SCT Company 3 Company 4 Company 6
Share Price --- 76.50 22.50 31.50
EPS 5.75 USD 7.00 2.75 5.00
BV/Share 29.00 52.75 19.50 18.50
CF/Share 4.50 7.75 4.00 3.50
Exhibit 3
Selected Merger Data (USD)
Target 1 Target 2 Target 3
Pre-Merger Price 26.65 38.70 19.15
Post-Merger Price 32.20 50.60 23.05
Biraghi has estimated the value of SCT at USD 100 million. MMI is considering two options for the purchase
of SCT:
1. Cash, at a premium of 20% to the market price

2. MMI common stock at market price
MMI has 20 million shares of common stock outstanding with a market value of USD 25 per share. Biraghi
estimates that the present value of the synergies that will result from the merger is USD 48 million. To
decide which purchase approach to use, Biraghi wants to determine the gain that will accrue to the existing
MMI shareholders under each approach.

13. For MMI’s acquisition of SCT, MMI’s management and SCT’s shareholders, respectively, will most likely
push for payment in:
MMI’s Management SCT’s Shareholders
A. Cash MMI Stock
B. MMI Stock Cash
C. MMI Stock MMI Stock
14. Of the three reasons that Biraghi lists for creating value in a merger, it is most likely the case that:
A. All three are valid
B. Only reasons 1 and 3 are valid
C. Only reasons 2 and 3 are valid
15. Based on the information in Exhibit 1, the pre-merger HHI is closest to, and the possibility of an antitrust
challenge by the government is most likely, respectively:
Pre-Merger HHI Government Action
A. 1,420 No Challenge
B. 1,420 Possible Challenge
C. 1,620 Possible Challenge
16. Regarding Biraghi’s approach to valuing SCT, it is most likely that his description of:
A. All three steps is accurate and appropriate
B. Two of the steps is accurate and appropriate, but his description of the other step is not
C. One of the steps is accurate and appropriate, but his description of the other two is not
17. Based on the data in Exhibits 2 and 3, the share price for SCT using comparable company analysis is
closest to:
A. USD 42.36
B. USD 52.52
C. USD 54.17

18. The gains that will accrue to existing MMI shareholders under a cash purchase of SCT and a stock
purchase of SCT, respectively, are closest to:
Cash Purchase Stock Purchase
A. USD 28 million USD 40 million
B. USD 28 million USD 28 million
C. USD 40 million USD 28 million

EQUITY VALUATION
Albert Park Automotive (APA) plans to purchase an 80% interest in Paul Ricard Auto Parts (PRAP). PRAP has
a long history of sustained growth, dividends, and stable capital structure, and those characteristics, along
with perceived synergies with their own operations, lead APA to believe that PRAP will be an excellent
investment. APA’s first order of business, therefore, was to hire Younès El Ahmadi, a senior equity valuation
consultant with Bottas & Verstappen (B&V), to determine the value of PRAP. APA’s management is rather
impatient, and on their first meeting with El Ahmadi, asks him what approach he will likely use to value
PRAP.
El Ahmadi notes that PRAP has paid out, on average, about 60% of its free cash flow to equity (FCFE) as
dividends, but that that has not been a constant amount; it started paying a small percentage FCFE as
dividends many years ago and that percentage has generally increased over the years. When APA’s
managers hear this, they mention that that makes it sound as if using a dividend discount model will result
in a lower value than using a FCFE model.
B&V recently hired a junior analyst, Silvia Monreal, who will be assisting El Ahmadi. To give Monreal
practice, El Ahmadi assembles some data about PRAP in Exhibit 1 and asks her to estimate PRAP’s FCFE for
2019:
Exhibit 1
Paul Ricard Auto Parts
Estimated Data, 2019 (AUD)
Net income 29,500,000
WCInv 1,500,000
FCInv 62,100,000
Depreciation 16,400,000
Target debt ratio 0.58
El Ahmadi and Monreal discuss the likely future of PRAP with APA’s managers. The managers tell El Ahmadi
and Monreal that PRAP has been developing some innovative performance parts that it believes will lead to
relatively high growth for several years. Unfortunately, they know that in the auto parts business
competition is keen and clever, and within a few years there will be competing parts on the market that will
cause PRAP’s growth to decline over several years thereafter until it reaches the average industry growth
rate, at which it will continue for the foreseeable future.

After the conversation with APA’s managers, El Ahmadi and Monreal meet with PRAP management to gather
information about the new products, their rollout schedule, and the level of competition. Based on the data
they obtain in this meeting, El Ahmadi prepares estimates of PRAP’s FCFE, shown in Exhibit 2:
Exhibit 2
Paul Ricard Auto Parts
Estimated FCFE (AUD)
Year Estimated FCFE
1 11,200,000
2 12,100,000
3 13,700,000
4 15,500,000
5 17,400,000
After year 5, PRAP’s FCFE growth rate is expected to decline linearly from 14.4% to 2.1% over five years, then
remain at 2.1% thereafter. The required rate of return on PRAP common stock is 8.5%.
In estimating the values in Exhibit 2, the decline in FCFE growth rate (both the amount of the decline and the
length of time for it to occur), and the ultimate long-run growth rate, El Ahmadi acknowledges that he has
made a number of assumptions. Upon mentioning this to APA’s management, their CFO said, “We’re
concerned about the assumptions that you have had to make in your analysis, how accurate they are, and,
specifically, how much the actual value of PRAP could differ from your estimate if any one of those
assumptions were incorrect.”

19. The approach that El Ahmadi will most likely use to value PRAP is:
A. A discounted dividend model (DDM)
B. Discounted free cash flow to equity (FCFE)
C. Discounted free cash flow to the firm (FCFF)
20. Concerning APA’s managers’ comments about the value of PRAP using a dividend discount model (DDM)
versus the value of PRAP using a free cash flow to equity (FCFE) model, it is most likely that their
conclusion is:
A. Incorrect
B. Correct, because dividends have been less than FCFE
C. Correct, because the value received in the DDM is farther in the future than the value received in the
discounted FCFE
21. Based on the data in Exhibit 1, PRAP’s estimated FCFE for 2019 is closest to:
A. AUD −17,700,000
B. AUD 1,180,000
C. AUD 9,600,000
22. The appropriate form of free cash flow (FCF) model for valuing PRAP is most likely a:
A. Single-stage model
B. Two-stage model
C. Three-stage model
23. Based on the information in Exhibit 2, the value of PRAP’s equity today is closest to:
A. AUD 275,500,000
B. AUD 294,300,000
C. AUD 349,900,000
24. To address the concerns of APA’s CFO, El Ahmadi should most likely:
A. Perform a sensitivity analysis of his FCFE valuation and use the results to suggest where further
investigation is warranted
B. Estimate the value of PRAP using a dividend discount model and compare the result with the
estimate he got from the FCFE model
C. Run a scenario analysis for the FCFE valuation incorporating a worst-case scenario, a most likely
scenario, and a best-case scenario

EQUITY VALUATION
Martin Godín is an equity analyst with Gibraltar Financial (GF). At the moment he is analyzing Woking
Manufacturing (WM), a cyclical company. In Exhibits 1, 2 and 3 Godín has compiled financial data for WM.
Exhibit 4 contains other data for WM. Godín believes that the business cycle is at a peak and will be starting
to decline in the next year or two.
Exhibit 1
Woking Manufacturing
Statement of Earnings (GBP thousands)
Year Ending 31 December 2018
Sales 140,000
COGS (90,000)
Gross profit 50,000
SG&A (15,000)
EBITDA 35,000
Depreciation (10,000)
Amortization (2,000)
EBIT 23,000
Interest Expense (8,000)
EBT GBP 15,000
Income Taxes @ 30% (4,500)
Net Income GBP 10,500
Exhibit 2
Statement of Financial Position (thousands)
31 December 2017
Cash GBP 23,000 A/P GBP 20,000
A/R 47,000 Other Payables 4,000
Inventory 39,000 Long-Term Liabilities
Noncurrent Assets
PP&E, net 153,000 Equity
Intangibles 30,000 Paid-In Capital 43,000
Goodwill 7,000 R/E 102,000
Total Assets GBP 299,000 Total Liabilities + Equity GBP 299,000

Exhibit 3
Statement of Financial Position (thousands)
31 December 2018
Cash GBP 15,000 A/P GBP 24,000
A/R 44,000 Other Payables 6,000
Inventory 69,000 Long-Term Liabilities
Noncurrent Assets
PP&E, net 174,000 Equity
Intangibles 28,000 Paid-In Capital 43,000
Goodwill 5,000 R/E 107,000
Total Assets GBP 335,000 Total Liabilities + Equity GBP 335,000
Exhibit 4
Selected Data
31 Dec 2018
Market capitalization (thousands) GBP 150,000.00
Shares outstanding 10,000,000
2018 dividend per share GBP 0.55
Expected earnings, dividend growth 3.00%
Payout ratio 52.38%
Required return on common stock 6.40%
Godín wants to determine whether WM’s common stock is overvalued or undervalued, so he starts by
computing the justified trailing P/E ratio and the P/S ratio. Because of the cyclical nature of WM’s business,
he believes that he should adjust their actual trailing P/E ratio before comparing it to the justified ratio.
Godín gathers some information in Exhibit 5 on trailing P/E ratios for other companies in MW’s industry. He
believes that the arithmetic mean of those ratios is an appropriate benchmark for determining whether
MW’s common stock is overvalued or undervalued.
Exhibit 5
Comparable Trailing P/E Ratios
31 December 2018
Company Trailing P/E Ratio
1 15.62
2 14.18
3 15.17
4 14.06
5 13.78

Some of the portfolio managers (PMs) at GF have asked Godín to automate the ranking of companies from
best to worst using P/E ratio, so he worked with GF’s IT team and created a screen for the PMs that allows
them to rank companies from best to worst either by P/E ratio (lowest P/E to highest P/E) or by earnings
yield (highest earnings yield to lowest earnings yield). The screen seemed to be working fine until last week
when one of the PMs phoned Godín to tell him that there was a problem: the P/E ranking was different from
the earnings yield ranking. He encouraged Godín to fix it and wasn’t particularly polite in his
encouragement. Godín checked the screen and, although the rankings were lowest to highest for P/E and
highest to lowest for earnings yield, the rankings were, in fact, different.
GF recently hired two junior equity analysts, Vincenzo Rugani and Moise De Sciglio, and Godín has to explain
justified ratios to them. After a week of working with them, Godín asks them to explain the factors that
affect justified ratios. Rugani and De Sciglio reply:
Rugani: The factors that influence the P/B ratio are ROE, growth rate of earnings and dividends (g), and the
required rate of return on common equity (rCE). All else equal, a higher ROE will increase the P/B
ratio while a higher rCE will decrease the P/B. The effect of an increase in g, however, is more
complicated because it is in both the numerator and the denominator; how it affects the ratio
depends on whether ROE is bigger or smaller than rCE.
De Sciglio: The factors that influence the P/CF ratio are g and rCE. The effect of rCE is easy: if it increases,
P/CF will decrease. The effect of a change in g is more complicated because it is in both the
numerator and the denominator; an increase in g could cause the P/CF ratio to increase or to
decrease.
GF has many investments in foreign countries, so, although Godín has a good feel for the size of ratios
domestically, he has to make allowances that those ratios may have very different values in foreign
countries, even when he’s comparing companies in the same industry. He explains to Rugani and De Sciglio
that the ratios can be different because of economic factors (such as different risks and growth
opportunities, or different economic or political environments) as well as accounting differences. He notes
that the accounting differences have the greatest effect on cash flow ratios (P/CFO, P/FCFE), and less effect
on P/B, P/E, and EBITDA ratios.

25. Based on the information in Exhibits 1 – 4, WM’s justified trailing P/E ratio and P/S ratio, respectively, are
closest to:
Trailing P/E P/S
A. 14.4 1.08
B. 16.7 1.08
C. 16.7 1.25
26. When Godín adjusts WM’s actual trailing P/E ratio, the adjustment will most likely:
A. Increase the P/E value
B. Decrease the P/E value
C. Change the P/E value, but there is not enough information to know whether it will increase or
decrease
27. Based on the information in Exhibit 5 and Godín’s preferred analysis approach, on 31 December 2018,
the fair value on WM’s common stock was closest to:
A. GBP 149 million, and WM’s stock was overvalued
B. GBP 153 million, and WM’s stock was undervalued
C. GBP 153 million, and WM’s stock was overvalued
28. The most likely reason that the P/E ranking on the PMs screen differed from the earnings yield ranking is
that:
A. All of the companies had negative earnings, and the earnings yield ranking was correct while the P/E
ranking was incorrect
B. At least one of the companies had negative earnings and another had positive earnings, and the
earnings yield ranking was correct while the P/E ranking was incorrect
C. At least one of the companies had negative earnings and another had positive earnings, and the P/E
ranking was correct while the earnings yield ranking was incorrect
29. Concerning the analyses that Rugani and De Sciglio made about how various factors affect justified
ratios, it is most likely the case that:
A. Both Rugani’s and De Sciglio’s analyses are correct
B. Both Rugani’s and De Sciglio’s analyses are incorrect
C. One of their analyses is correct and the other is incorrect

30. Concerning Godín’s explanation of cross-border differences in ratios, he is most likely:

A. Accurate in his assessment of economic and accounting differences
B. Accurate in his assessment of accounting differences, but inaccurate in his assessment of economic
differences
C. Accurate in his assessment of economic differences, but inaccurate in his assessment of accounting
differences

FIXED INCOME
Xiao & Jiang Consulting (XJC) is a fixed income consulting firm with a number of institutional clients. Yun
Chan, a senior consultant at XJC, has just been given a new client: the defined benefit pension plan (the Plan)
for the Zhao Shen Group.
The Plan owns a number of zero-coupon bonds denominated in various currencies, including the Chinese
yuan (CNY). The Plan’s trustees, who are not intimately familiar with fixed income, have put together a table
of 1-year forward interest rates on the CNY in Exhibit 1. The current one-year spot rate is 1.205%:
Exhibit 1
CNY 1-Year Forward Rates
Starting at t = Forward Rates
1 2.200%
2 2.707%
3 3.054%
4 3.322%
5 3.542%
6 3.731%
7 3.898%
8 4.048%
9 4.187%
Chan believes that over the next year spot rates will evolve exactly in line with current forward rates. The
Plan’s trustees have asked her what that means for the price of their risk-free, CNY-denominated zero-
coupon bonds, and how that differs from what would happen if the yield curve remained unchanged over
the next year.
The trustees have heard about using a swap curve instead of the government bond yield curve for
determining the value of their bonds, but they’re not quite certain what the difference is between these two
curves, and why they might use one versus the other. In explaining the difference, Chan makes these
statements:
Statement 1: A swap curve for a particular currency is generally based on interest rates that banks pay
each other to borrow that currency, not on the interest rates that governments pay to
borrow that currency. There may be more than one swap curve for a given currency, so you
must be careful to make sure that you are using an appropriate swap curve.
Statement 2: The choice of whether to use the government par curve or a swap curve may depend on the
relative liquidity of the government bond market and the swap market, or on the specific
financial activities you undertake. Retail banks are typically more inclined to use a swap
curve to value assets, whereas wholesale banks would tend to use the government par
curve.

Because of the trustees’ concern about how the prices of their bonds can change, Chan explains the idea of
duration to them. When the trustees conclude that long-term bonds will have greater price changes than
short-term bonds, Chan tells them that that isn’t necessarily true. She then explains the term structure of
interest rate volatilities, and gives them an example:
“Suppose that you have a 5-year bond with a modified duration of 4 years, and a 10-year
bond with a modified duration of 8 years. If the 10-year interest rate volatility is only half as
big as the 5-year interest rate volatility, then the bonds have the same price volatility. And if
the 10-year interest rate volatility is less than that, the 10-year bond will have less price
volatility than the 5-year bond.”
The trustees have also been thinking about investing in US Treasuries and have asked Chan what she thinks
about doing so. Chan replies that both the TED spread and the USD LIBOR-OIS spread have been widening
recently, and she believes that they are likely to widen more over the next 6 months to one year.

31. Given the data in Exhibit 1, the 3-year CNY spot rate, and the price of a risk-free, CNY 1,000 par, 3-year,
zero coupon bond are, respectively, closest to:
3-Year Spot Rate 3-Year Bond Price
A. 2.035% CNY 941.50
B. 2.035% CNY 980.00
C. 2.707% CNY 923.00
32. Given Chan’s expectations about the evolution of CNY interest rates, the percentage increase in the
value of the risk-free, CNY-denominated, 3-year, zero coupon bond over the next year will be closest to:
A. 1.21%
B. 2.04%
C. 2.08%
33. If the CNY yield curve were to remain unchanged over the next year, the percentage increase in the
value of the CNY-denominated zero-coupon bond over that time period will be closest to:
A. 1.21%
B. 2.71%
C. 3.05%
34. Concerning Chan’s statements about swap curves, it is most likely that:
35. Is Chan’s example about price volatility most likely accurate?

A. Yes
B. No, because it is not true if the 10-year yield is less than the 5-year yield
C. No, because it is only true if the 10-year yield is the same as the 5-year yield
36. Given the recent changes in the TED and USD LIBOR-OIS spreads and Chan’s expectations for future
changes, which, if either, most likely is a warning sign against the trustees’ proposed USD investments?
A. Only the change in the TED spread
B. Only the change in the USD LIBOR-OIS spread
C. Neither the change in the TED spread nor the change in the USD LIBOR-OIS spread

DERIVATIVES
John Tread is a derivatives trader for a subsidiary of a large Canadian bank. Each day John scans market
information provided by other dealers for profitable trading opportunities. The forward market for equities
in Canada is quite small and only a few dealers will quote forward prices on select Canadian equities. John
is a proprietary trader and trades exclusively for his own book. John notes this morning that the current
risk-free rate is 2.71% compounded annually and that implied volatility on the main equity index, the TSX
Composite, is 16.4%.
Tina Saltin, a dealer at a competing bank, posts forward prices every morning for three equities for which
she regularly makes a market. Those companies, their current market prices and the quoted forward prices
are presented in Exhibit 1. John recognizes all three names as non-dividend paying stocks that are traded
on the Toronto Stock Exchange. John also knows that two of the three equities have options that trade as
well.
Exhibit 1
Current Price Company 6-month Quoted Forward Price
$63.50 Danforth Inc. $65.65
$115.25 Steeles Co. $116.20
$178.15 Hurontario Enterprises $180.55
John has been tasked today with interviewing several potential candidates for a position as a derivatives
analyst. John shows Able, the first candidate, the forward quotes from Exhibit 1 and asks for his opinion on
the pricing of the 6-month forward on Hurontario Enterprises. Able makes the following statement:
Statement 1: The expected return on the 6-month forward contract for Hurontario Enterprises is 2.71% on
an annualized basis.
John then asks Able what would happen if the Bank of Canada raised interest rates at their regular policy
meeting today, to which Able makes the following statement:
Statement 2: If rates were to increase by 25bps immediately after taking a long position in a forward
contract, the value of the position would be negative.
Between interviews, John contacts Tina and negotiates a long position in the 6-month forward at the quoted
price in Exhibit 1.

John then holds his second interview with a candidate named Nicole. John is interested in entering into an
8-month forward contract on the TSX Composite index. Select data for the index are presented in Exhibit 2.
John asks Nicole a series of questions about this potential trade:
John: What effect will the dividend yield have on the forward price versus an otherwise dividend-free
index?
Nicole: A dividend yield will raise the price of a forward contract since the underlying will earn a return
during the forward period.
John: If index volatility were to increase during the forward contract period, would the value of the
contract increase or decrease?
Nicole: An increase in the volatility of the index will affect option pricing but would have no effect on
forward pricing.
Exhibit 2
Index Price CAD 14,658
Dividend yield 2.10%
(continuously compounded)
Index volatility 16.40%

37. Based on Exhibit 1, a reverse carry trade is available with the forward contract on:
A. Steeles Co.
B. Danforth Inc.
C. Hurontario Enterprises
38. Calculate the riskless profit that can be earned today from the carry trade opportunity available based
on the data in Exhibit 1.
A. CAD 0.59
B. CAD 1.28
C. CAD 1.30
39. Which of Harris’s statements are correct?

A. Statement 1 only
B. Statement 2 only
40. Given that three months have passed, calculate the value of the long forward position on Steeles Co.
The current risk-free rate is 1.91% and the price of Steeles, Co., despite great volatility, is currently
modestly higher at CAD 117.10.
A. CAD 0.86
B. CAD 0.90
C. CAD 1.45
41. Is Nicole correct with respect to her answers to John’s questions?

A. No with respect to both the dividend yield and volatility
B. Yes, with respect to both the dividend yield and volatility
C. No with respect to the dividend yield but yes with respect to volatility
42. Based on the information in exhibit 2, the 8-month no-arbitrage forward price on the index would be
closest to:
A. CAD 14,714
B. CAD 14,718
C. CAD 14,921

Oliver Turner is a Portfolio Manager with Adelaide and Partners, a small mutual fund manufacturer in
Australia. Oliver runs a global real estate mutual fund with a flexible mandate. The only restriction is that
the fund must be 100% invested in real estate stocks that trade on public stock exchanges.
Oliver is looking to add more variety to the portfolio holdings. He is looking to add an investment that has
the flexibility to generate cash flows from a more a diverse set of operating activities such as developments,
and value-add improvements, not just lease and rental income.
Oliver is considering adding Brady REIT to the portfolio. He has compiled key information from the last
reported balance sheet and income statement and presented it in Exhibit 1. He has also completed site
visits to the properties owned by Brady REIT and produced his own appraisal of the properties with the
results found in Exhibit 2. Brady REIT last closed at AUD 12.50.
Exhibit 1 (AUD)
Name of REIT Brady REIT
NOI 34,200,000
Value of operating real estate 645,000,000
Cash and cash equivalents 15,000,000
Market value of mortgages 570,000,000
Book value of mortgages 585,000,000
Shares 6,400,000
Exhibit 2 (AUD)
Brady REIT Properties Property 1 Property 2 Property 3
Expected NOI in 12 months 12,500,000 15,300,000 9,400,000
Oliver’s appraised values 195,000,000 285,000,000 165,000,000
Oliver currently holds Payton REIT in the portfolio and is trying to decide if it is time to replace the holding
with a better opportunity. He prepares Exhibit 3 and Exhibit 4, to help guide his decision:
Exhibit 3 (SGD)
Payton REIT Properties Property 1 Property 2 Property 3
Expected NOI in 12 months 2,500,000 12,300,000 8,500,000
Oliver’s appraised values 45,000,000 250,000,000 145,000,000
Exhibit 4
Long-term growth rate 1.5%
GDP growth rate 1.5%
Beta of Payton REIT 0.95
Last closing price SGD 23.20
P/FFO 18.2 x
P/AFFO 21.7 x
10-year Treasury rate 2.5%

Oliver is considering adding a German REIT he recently came across to the portfolio. The REIT currently
trades at EUR 9.15, the industry P/AFFO multiple is 15.3 x, and there are 650 Million shares outstanding.
Exhibit 5 (EUR)
Net income to common 250 million
Cash and cash equivalents 20 million
Non-cash rents 15 million
Recurring maintenance Capex 5 million
FFO 350 million
Oliver has an afternoon meeting with Peter Quinn, a junior analyst, that works with Peter. Oliver and Peter
discuss the advantages of using a multiples approach to value REIT’s.
Advantage 1: FFO and AFFO fully captures intrinsic value of all types of real estate assets including non-
income generating land parcels.
Advantage 2: Multiples are widely accepted in the industry as valuation tools because they facilitate
comparisons across global stock markets.
Advantage 3: FFO is a standardized measure used to approximate the firms cash flow and the information
is readily available through data providers such as Bloomberg.
Next, Oliver asks Peter to list three REIT sectors and identify the economics drivers and characteristics of
those sectors. Peter answers by making the following statements:
Statement 1: Analysts need to pay attention to the rate of construction of new supply in Storage REITs
because the ease of entry makes oversupply a real concern.
Statement 2: The major economic factor for multi-family REITS is local demographics. Analysts need to pay
attention to job creation and population growth statistics.
Statement 3: Hotel REITs are characterized as being insensitive to economic cycles since they rely on leisure
and business travelers. Hotel REITs have extremely short-term leases.

43. Based on the diversification criteria, what type of investment is Oliver most likely to add to the portfolio?
A. A REIT trading on the Warsaw Stock Exchange
B. A REOC trading on the Hong Kong Stock Exchange
C. A mortgage REIT trading the Toronto Stock Exchange
44. Given the information presented in Exhibit 1 and Exhibit 2, the percent of NAV that Brady REIT is most
likely trading at is closest to:
A. 89%
B. 100%
C. 107%
45. Based on Exhibit 3 and Exhibit 4, the implied risk rate on the underlying real estate holdings in Payton
REIT is closest to:
A. 5.3%
B. 6.8%
C. 7.3%
46. Based on information provided for the German REIT and Exhibit 5, the fair value price based on the
P/AFFO multiple is closest to:
A. EUR 5.41
B. EUR 7.77
C. EUR 8.24
47. Of the advantages of using multiples approach to valuing REITs listed by Oliver, which advantage is least
likely correct?
A. Advantage 1
B. Advantage 2
C. Advantage 3
48. Based on Oliver’s statements regarding the economic drivers and characteristics of different types of
REITs, he is least likely correct describing:
A. Hotel REITs
B. Storage REITs
C. Multi-family REITs

Bismarck LLC is a large integrated asset management firm located in the United States. Bismarck's private
equity divisions offer products that invest in all broad private equity category’s, including venture capital,
buyout, and special situations.
Anna Minot, CFA is relationship manager at Bismarck who works with ultra-high-net-worth individuals.
Today, she is preparing for a portfolio review with one of her largest clients, George and Jennifer King. The
focus of today’s meeting will be on the private equity allocation in the King’s portfolio. Emily Steele, her
associate, is new to private equity and wants to learn some of the differences between buyout funds and
venture capital funds. To help Emily understand better, Anna makes the following statements about buyout
funds:
Statement 1: Returns are generally characterized by lower variances across the underlying portfolio
holdings.
Statement 2: Investments are primarily equity funded
Statement 3: Portfolio companies are run by experienced management teams
Anna shows Emily a recent transaction that Bismarck completed to help her better understand how private
equity funds generate returns and makes the following comments:
Comment 1: Take a look at Exhibit 1 for Fargo Inc. This was a public company that the firm took private.
This was an interesting transaction because the loan was interest only. Also, Fargo’s
management were strong negotiators, they were firm on taking 20% of the residual value
rather than the 15% that Bismarck usually mandates.
Exhibit 1 (USD)
Total investment 2,000 Million
Debt amount 1,500 Million
PE preferred shares rolled up at 9% 350 Million
PE common shares 130 Million
Management common shares 20 Million
Interest paid on debt through the term 500 Million
Exit multiple 2.3 x
Term 6 years
Comment 2: As you know, we also finance start-up companies in our venture funds. There is a lot of risks
involved in taking on a start-up company with an unproven management team, so we usually
assume a 40% discount rate and a 15% probability of failure. Specifically, we just added
Mandon Inc to one of our funds, and we plan to do an IPO in three years. Management was
initially looking for Bismarck to invest USD 8 Million, but the GP decided to invest USD 10
Million because they thought it would accelerate how quickly Mandon will be cash flow
positive.

To get ready for their meeting with the Kings, Anna and Emily review the cash flows and distribution data for
the Wilco Fund, a fund Anna allocated in the King’s portfolio.
Emily: I see here that the fund had USD 500 Million in committed capital, but only called down USD 325
Million?
Anna: Yes, The GP on the fund did not see enough profitable opportunities to put all the capital to work.
The fund has been doing well, it has already distributed a total of USD 125 Million, and the NAV
after distribution is USD 400 Million.
Anna and Emily finally sit down with Jennifer and George and begin to discuss the holdings in the King's
portfolio. Jennifer begins the meeting by asking the following questions.
Question 1: Could you describe the advantages that management has in running a private firm instead of a
publicly traded company?
Question 2: Can you explain why every investment we make has an initial negative return, and then the
returns turn positive near the end of the term?
In addition to being invested in several of Bismarck’s funds, five years ago the King’s participated in a co-
investment in a single company, Cavalier LP. They would like to know what the exit strategy will be for that
investment since the investment term is two quarters away. Anna responds by making the following
comment:
“Cavalier has launched several new products that have been well received by the market. The current
management team has shown a lot of enthusiasm for continuing to run the business indefinitely, and
we’ve been discussing financing options with them. At the moment, we are concerned with the recent
volatility in the public equity markets, and we anticipate this uncertainty will continue for the next nine
months. We will explore all options and find the highest valuation possible.”

49. Which statement made by Anna to Emily about buyout funds is least likely correct?
A. Statement 1
B. Statement 2
C. Statement 3
50. Based on Exhibit 1, and Anna’s comment about Fargo Inc, the payout multiple realized by Bismarck is
closest to:
A. 5.4 x
B. 5.7 x
C. 6.2 x
51. Based on Anna’s second comment, the required wealth by Bismarck for investing in Mandon Inc is
closest to:
A. USD 27.4 Million
B. USD 35.7 Million
C. USD 44.7 Million
52. Based on Anna and Emily’s conversation, the TVPI of the Wilco Fund is closest to:
A. 1.05x
B. 1.54x
C. 1.62x
53. What effect is Anne most likely to describe if she answers Jennifer’s second question?
A. “J” curve
B. Dilution of shares
C. Management fees
54. Based on Anna’s answer about exit options for Cavalier LP what is the least likely exit option Bismarck
will use at this time?
A. Initial public offering
B. Management buyout
C. Secondary market sale

Ousmane Fekir is a portfolio manager at Lyon Investment Management (LIM). LIM has recently instituted
risk management protocols and expects their portfolio managers to implement them. Fekir’s understanding
of risk management isn’t very strong, and the same can be said for the rest of the portfolio managers at LIM,
so LIM has hired a risk management consultant, N'Golo Lemar, to assist in the implementation of the
protocols and the education of the portfolio managers.
Lemar begins with value at risk (VaR) and asks Fekir if he knows the assumptions that underlie the three
methods of estimating VaR: parametric, historical simulation, and Monte Carlo simulation. Fekir gives the
following replies:
Parametric: The primary assumption in the parametric (variance-covariance) method is that asset returns
follow a normal distribution. We estimate the mean and standard deviation of each asset’s
returns, and the correlations of returns for each pair of assets, from which we can get the
mean and standard deviation of the portfolio’s returns, which will also have a normal
distribution, and use standard normal critical values to estimate VaR.
Historical: The main assumption in historical simulation method is that the historical or past frequency of
daily returns is a good representation of the future frequency of daily returns. Therefore, we
can sort historical daily returns from lowest to highest and estimate daily VaR at any probability
level using that sorted list of returns.
Monte Carlo: In the Monte Carlo simulation method the user makes assumptions about the characteristics
of the returns for each asset: the shape of the distribution (e.g., normal, uniform, and so on),
the parameters for the distribution (mean, standard deviation, skewness, kurtosis, and so
on), and the correlations of returns for each pair of assets. With those inputs, the user runs
a Monte Carlo simulation and uses the resulting histogram of portfolio returns to estimate
VaR.
Lemar then asks Fekir to enumerate some of the advantages and limitations of VaR. Fekir makes the
following two lists:
• Advantages
1. Easy idea to communicate
2. Accounts for liquidity of assets
3. Can be used in capital allocation decisions
• Disadvantages
1. Subjective
2. Disregards right-tail events
3. Is not accepted by regulators

Fekir then asks Lemar about a shortcoming he sees in VaR: it gives the minimum loss at a given level of
significance, but not the maximum loss, or even the average loss. He asks if there is some way to handle
that shortcoming. In response, Lemar says that there is a method for calculating the average or expected
loss when the VaR cutoff is exceeded, which is to calculate the weighted average loss in the lower tail of the
probability distribution. He mentions that it is commonly used in practice alongside VaR.
Lemar now turns to sensitivity risk measures and describes beta for equity portfolios, duration for fixed
income portfolios, and delta for option portfolios. Fekir is quite familiar with these but is not sure how they
compare with VaR. “For example,” Fekir asks Lemar, “How can I compare the key rate durations, or even the
key rate money durations, of a bond portfolio to the VaR for that portfolio?” Lemar replies that they cannot
be compared directly because there is an important element that is missing in the key rate duration or key
rate money duration analysis.
Continuing this theme, Lemar asks Fekir what some of the advantages and limitations are for sensitivity risk
measures and scenario risk measures. With regard to scenario risk measures, Fekir responds with the
following two lists:
• Advantages
1. They do not need to rely on history
2. They do not need to assume normal distributions
3. Hypothetical scenarios are generally easy to create and maintain
• Disadvantages
1. Historical scenarios may not cover all future possibilities
2. Hypothetical scenarios may not take liquidity into account
3. Hypothetical scenarios may incorrectly specify how assets will co-move
Finally, Lemar discusses with Fekir how risk analysis might be implemented to manage the risks of the
portfolios in general and LIM in particular. After the discussion, Fekir makes these comments:
Comment 1: To use VaR in risk budgeting, we need to aggregate VaR at the firm level, then apportion it
amongst the various portfolios or asset classes. One of the difficulties in doing this is that
VaR is not strictly additive, so the total of the apportioned VaRs may not equal the firm-level
VaR.
Comment 2: VaR often has trouble with correlations of events, so it’s a good idea to establish position
limits for a given issuer or a given currency that are lower than the VaR analysis might allow.
Comment 3: Stop-loss limits are a valuable risk management tool which can easily be incorporated into
VaR.
Clearly, Fekir still has a lot to learn.

55. Concerning Fekir’s descriptions of the assumptions for VaR methods, the one that is least likely to be
accurate is his description of the assumptions for the:
A. Parametric method
B. Historical simulation method
C. Monte Carlo simulation method
56. Of the advantages and limitations of VaR listed by Fekir, the ones that are least likely to be accurate are:
A. Advantage 2 and disadvantage 3
B. Advantage 3 and disadvantage 1
C. Advantage 3 and disadvantage 3
57. The measure to which Lemar refers in response to Fekir’s question about a shortcoming of VaR is most
likely:
A. Relative VaR
B. Incremental VaR (IVaR)
C. Conditional VaR (CVaR)
58. The important element in the key rate duration analysis to which Lemar refers is most likely:
A. The volatility of interest rates along the yield curve
B. The presence of embedded options in the bonds in the portfolio
C. The portfolio’s relative allocation to bonds of different durations
59. Of the advantages and limitations of scenario analysis listed by Fekir, the ones that are least likely to be
accurate are:
A. Advantage 2 and disadvantage 1
B. Advantage 3 and disadvantage 2
C. Advantage 3 and disadvantage 3
60. Of the comments that Fekir makes about implementing risk management analysis into specific
procedures, the one that is least likely accurate is:
A. Comment 1
B. Comment 2
C. Comment 3
End of Exam




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2019 Exam Prep

MarkMeldrum.com Mock Exams

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Exam 1 Morning Session

Questions Topic Minutes

13 - 18 Economics Authored By: Mark Meldrum, Ph.D. 18

25 - 30 Corporate Finance Authored By: Bill Campbell III, CFA 18

31 - 36 Equity Valuation Authored By: Bill Campbell III, CFA 18

37 - 42 Equity Valuation Authored By: Bill Campbell III, CFA 18

43 - 48 Fixed Income Authored By: Bill Campbell III, CFA 18

49 - 54 Derivatives Authored By: Mark Meldrum, Ph.D. 18

55 - 60 Portfolio Management Authored By: Bill Campbell III, CFA 18

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ETHICAL AND PROFESSIONAL STANDARDS

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ETHICAL AND PROFESSIONAL STANDARDS

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Equities Fixed Income

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Statement 1: International parity conditions rarely hold in the medium to long-term

Statement 2: Forward rates are a poor predictor of future spot rates

Statement 3: UIRP holds only if there is a forward market

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16. Which of Tim’s statements regarding parity conditions is inaccurate?

18. Which conclusion presented to Tim is incorrect?

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FINANCIAL REPORTING AND ANALYSIS

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Earnings before Taxes $8,200,000

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Income Statement OCI

Income Statement OCI

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CMM requires an 8% rate of return on this project as well.

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Year 1 Incremental CF Effect of DDB on NPV

Accounting Income Economic Income

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Machine 1 EAA Machine to Select

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31. The true mispricing of GM common stock is closest to:

Gdansk Manufacturing Bylinkin Industries

36. Gabulov’s approach to valuing Troika is best described as:

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Active Equity Fund:

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AR(3) model 𝑀𝑆𝐹𝑇% = 𝑏( + 𝑏𝑀𝑆𝐹𝑇% + + 𝑏- 𝑀𝑆𝐹𝑇% +- + 𝑏.𝑀𝑆𝐹𝑇% +. + 𝑒%