2001 CFA® Level II Examination FOR AIMR USE ONLY

Morning Section - Essay

Candidate Number:
FOR AIMR USE ONLY

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The following list contains the command words used on the Morning Section of
the 2001 Level II examination. Candidates may want to refer to this list as they
formulate their answers.

Calculate: To ascertain or determine by mathematical processes.

Compute: To determine, especially by mathematical means.

Construct: To create by organizing ideas or concepts logically and coherently.

Describe: To transmit a mental image, an impression, or an understanding of the nature

and characteristics of.

Determine: To come to a decision as the result of investigation or reasoning; to settle or

decide by choice among alternatives or possibilities.

Discuss: To discourse about through reasoning or argument; to present in detail.

Explain: To give the meaning or significance of; to provide an understanding of; to give
the reason for or cause of.

Identify: To establish the identity of; to show or prove the sameness of.

Indicate: To point out or point to with more or less exactness; to show or make known
with a fair degree of certainty.

Justify: To prove or show to be valid, sound, or conforming to fact or reason; to

furnish grounds or evidence for.

Name: To mention or identify by name.

Relate: To show or establish logical or causal connection between.

Select: To choose from a number or group – usually, by fitness, excellence, or other

distinguishing feature.

Show: To set forth in a statement, account, or description; to make evident or clear.

State: To express in words.

Support: To provide with verification, corroboration, or substantiation.

The Morning Section of the 2001 CFA Level II Examination has 14 questions.
For grading purposes, the maximum point value for each question is equal to the
number of minutes allocated to that question.

Question Topic Minutes

1 Asset Valuation 10
2 Asset Valuation 14
3 Asset Valuation 16
4 Asset Valuation 9
5 Asset Valuation 11
6 Asset Valuation 16
7 Portfolio Management 6
8 Portfolio Management 26
9 Asset Valuation 10
10 Asset Valuation 8
11 Asset Valuation 12
12 Asset Valuation 10
13 Asset Valuation 22
14 Asset Valuation 10

Total: 180
Questions 1 through 5 relate to Peninsular Research. A total of 60 minutes is allocated to
these questions. Candidates should answer these questions in the order presented.

QUESTION 1 HAS TWO PARTS FOR A TOTAL OF 10 MINUTES.

Peninsular Research is initiating coverage of a mature manufacturing industry. John Jones, CFA,
head of the research department, gathers the data given in Exhibit 1-1 to help in his analysis.

Exhibit 1-1
Fundamental Industry and Market Data
Forecasted Industry Earnings Retention Rate 40%
Forecasted Industry Return on Equity 25%
Industry Beta 1.2
Government Bond Yield 6%
Equity Risk Premium 5%

A. Compute the price-to-earnings (P0/E1) ratio for the industry based on the fundamental
data in Exhibit 1-1. Show your work.

(4 minutes)

Jones wants to analyze how fundamental P/E ratios might differ among countries. He gathers the
data given in Exhibit 1-2.

Exhibit 1-2
Economic and Market Data
Fundamental Factors Country A Country B
Forecasted Growth in 5% 2%
Real Gross Domestic Product (GDP)
Government Bond Yield 10% 6%
Equity Risk Premium 5% 4%

B. Determine whether each of the fundamental factors in Exhibit 1-2 would cause P/E
ratios to be generally higher for Country A or higher for Country B. Justify each of your
conclusions with one reason.

Note: Consider each fundamental factor in isolation, with all else remaining equal.

Answer Question 1-B in the Template provided on page 4.

(6 minutes)
Template for Question 1-B
Determine whether
P/E ratios
Fundamental Factor Higher for Country A or Justify with one reason
Higher for Country B
(Circle One)

Higher for Country A

Forecasted Growth in
Real Gross Domestic
Product (GDP) Higher for Country B

Higher for Country A

Government Bond Yield

Higher for Country B

Higher for Country A

Equity Risk Premium

Higher for Country B
Candidates should use Exhibits 2-1, 2-2, and 2-3 to answer Questions 2 and 3.

QUESTION 2 HAS TWO PARTS FOR A TOTAL OF 14 MINUTES.

One of the companies that Jones is researching is Mackinac Inc., a U.S.-based manufacturing
company. Mackinac has released its June 2001 financial statements, which are shown in
Exhibits 2-1, 2-2, and 2-3.

Exhibit 2-1
Mackinac Inc.
Annual Income Statement
for the Year ended June 30, 2001
(in thousands, except per-share data)

Sales $250,000
Cost of Goods Sold 125,000
Gross Operating Profit $125,000
Selling, General, and Administrative Expenses 50,000
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) $75,000
Depreciation and Amortization 10,500
Earnings Before Interest and Taxes (EBIT) $64,500
Interest Expense 11,000
Pretax Income $53,500
Income Taxes 16,050
Net Income $37,450
Shares Outstanding 13,000
Earnings Per Share (EPS) $2.88
 Exhibit 2-2
Mackinac Inc.
Balance Sheet
as of June 30, 2001
(in thousands)

Current Assets:
Cash and Equivalents $20,000
Receivables 40,000
Inventories 29,000
Other Current Assets 23,000
Total Current Assets $112,000

Non-Current Assets:
Property, Plant, and Equipment $145,000
Less: Accumulated Depreciation (43,000)
Net Property, Plant, and Equipment $102,000
Investments 70,000
Other Non-Current Assets 36,000
Total Non-Current Assets $208,000
Total Assets $320,000

Current Liabilities:
Accounts Payable $41,000
Short Term Debt 12,000
Other Current Liabilities 17,000
Total Current Liabilities $70,000

Non-Current Liabilities:
Long Term Debt $100,000
Total Non-Current Liabilities $100,000
Total Liabilities $170,000

Shareholders’ Equity:
Common Equity $40,000
Retained Earnings 110,000
Total Equity $150,000
Total Liabilities and Equity $320,000
 Exhibit 2-3
Mackinac Inc.
Cash Flow Statement
for the Year ended June 30, 2001
(in thousands)

Cash Flow from Operating Activities:

Net Income $37,450
Depreciation and Amortization 10,500

Change in Working Capital:

(Increase) Decrease in Receivables ($5,000)
(Increase) Decrease in Inventories (8,000)
Increase (Decrease) in Payables 6,000
Increase (Decrease) in Other Current Liabilities 1,500
Net Change in Working Capital ($5,500)
Net Cash from Operating Activities $42,450

Cash Flow from Investing Activities:

Purchase of Property, Plant, and Equipment ($15,000)
Net Cash from Investing Activities ($15,000)

Cash Flow from Financing Activities:

Change in Debt Outstanding $4,000
Payment of Cash Dividends (22,470)
Net Cash from Financing Activities ($18,470)

Net Change in Cash and Cash Equivalents $8,980

Cash at Beginning of Period 11,020
Cash at End of Period $20,000
Jones is particularly interested in Mackinac’s sustainable growth and sources of return.

A. Calculate Mackinac’s sustainable growth rate. Show your calculations.

Note: Use June 30, 2001 year-end balance sheet data rather than averages in ratio
calculations.

(4 minutes)
B. Name each of the five components in the extended DuPont System and calculate a value
for each component for Mackinac.

Note: Use June 30, 2001 year-end balance sheet data rather than averages in ratio
calculations.

(10 minutes)
QUESTION 3 HAS TWO PARTS FOR A TOTAL OF 16 MINUTES.

Mackinac has announced that it has finalized an agreement to handle North American production
of a successful product currently marketed by a foreign company. Jones decides to value
Mackinac using the dividend discount model (DDM) and the free cash flow-to-equity (FCFE)
model. After reviewing Mackinac’s financial statements in Exhibits 2-1, 2-2, and 2-3 and
forecasts related to the new production agreement, Jones concludes the following:

• Mackinac’s earnings and FCFE are expected to grow 17 percent per year over the
next three years before stabilizing at an annual growth rate of 9 percent.
• Mackinac will maintain the current payout ratio.
• Mackinac’s beta is 1.25.
• The government bond yield is 6 percent and the market equity risk premium is
5 percent.

A. Calculate the value of a share of Mackinac’s common stock using the two-stage DDM.
Show your calculations.

(8 minutes)

B. Calculate the value of a share of Mackinac’s common stock using the two-stage FCFE
model. Show your calculations.

(8 minutes)
QUESTION 4 HAS TWO PARTS FOR A TOTAL OF 9 MINUTES.

Jones is discussing with a corporate client the possibility of that client acquiring a 70 percent
interest in Mackinac.

A. Discuss whether the dividend discount model (DDM) or free cash flow-to-equity (FCFE)
model is more appropriate for this client’s valuation purposes.

(3 minutes)

The proposed takeover could be hostile in nature, and both Jones and the client are concerned
about possible defensive measures that Mackinac management might adopt to discourage the
takeover. The client has asked Jones about the following:

• Employee Stock Ownership Plans (ESOP)

• Stock purchase rights
• Golden parachutes

B. Explain how each of these three measures could be used as a defense against a hostile
takeover.

(6 minutes)
QUESTION 5 HAS TWO PARTS FOR A TOTAL OF 11 MINUTES.

Peninsular has another client who has inquired about the valuation method best suited for
comparison of companies in an industry that has the following characteristics:

• Principal competitors within the industry are located in the United States, France,
Japan, and Brazil.
• The industry is currently operating at a cyclical low, with many firms reporting losses.
• The industry is subject to rapid technological change.

Jones recommends that the client consider the following valuation ratios:

1. Price-to-earnings
2. Price-to-book value
3. Price-to-sales

A. Determine which one of the three valuation ratios is most appropriate for comparing
companies in this industry. Support your answer with two reasons that make that ratio
superior to either of the other two ratios.

(5 minutes)

The client also has expressed interest in Economic Value Added (EVA®) as a measure of
company performance. Jones asks his assistant to prepare a presentation about EVA for the
client. The assistant’s presentation includes the following statements:

1. EVA is a measure of a firm’s excess shareholder value generated over a long period
of time.

2. In calculating EVA, the cost of capital is the weighted average of the after-tax yield
on long-term bonds with similar risk and the cost of equity as calculated by the
capital asset pricing model.

3. EVA provides a consistent measure of performance across firms.

B. Determine whether each of the statements is correct or incorrect and, if incorrect,

explain why.

Note: Explanations cannot repeat the statement in negative form, but must indicate what
is needed to make the statement correct.

Answer Question 5-B in the Template provided on page 29.

(6 minutes)
Template for Question 5-B
Determine
whether
Statement Correct or If incorrect, explain why
Incorrect
(Circle One)

1. EVA is a measure of a
Correct
firm’s excess shareholder
value generated over a
long period of time.
Incorrect

2. In calculating EVA, the

cost of capital is the
weighted average of the
Correct
after-tax yield on long-
term bonds with similar
risk and the cost of equity
as calculated by the
Incorrect
capital asset pricing
model.

3. EVA provides a Correct

consistent measure of
performance across firms.

Incorrect
QUESTION 6 HAS ONE PART FOR A TOTAL OF 16 MINUTES.

Katherine Cooper is preparing a report on the optical network component business. She begins
her research by analyzing the competitive conditions of the industry.

One of the dominant firms in the industry is Rubylight Inc. Exhibit 6-1 contains an excerpt from
the President’s Letter in the annual report.

Exhibit 6-1
Rubylight Inc.
2000 Annual Report
Excerpt from President’s Letter

The reference number preceding each sentence is for your use in answering the question.

[1]Rubylight Inc. had an exceptional year in 2000. [2]The results in almost every corner
of the business exceeded our expectations. [3]Sales at Rubylight climbed 73 percent
over fiscal 1999 to $135 million, representing the strongest year-on-year sales growth in
the company’s history. [4]Our gross margin remained constant, compared to the prior
year, at a respectable 67 percent. [5]We managed to maintain our margins, despite an
increase in direct materials cost, through an improvement in product mix and price
increases. [6]The capital markets have rewarded us for this superior financial
performance; the company’s stock price closed the year at an all time high. [7]We have
an outstanding team here at Rubylight, deserving high praise for performance.

[8]The backlog (unfulfilled orders) expanded by 39 percent. [9]This was principally

due to an inability of our supplier to ship two application-specific integrated circuits
(“ASIC”) that are critical to the superior performance of the Rubylight product.
[10]Although the ASIC designs are owned by Rubylight, the integrated circuits must be
fabricated in highly specialized facilities, of which there are only two worldwide.
[11]The extremely capital intensive nature of these facilities prevents us from
manufacturing the integrated circuits ourselves. [12]Shortages of electronic component
supplies and fabrication time are worldwide phenomena that have also plagued our major
competitor.

[13]One of the strategic imperatives in the optical components industry is to get your
components incorporated into the designs of your customers’ products, known as
“design wins,” which makes it very expensive for the customer to make a component
substitution. [14]Early in the year we announced the appointment of Dr. Brian Richards
as the Chief Technology Officer. [15]Dr. Richards is one of the pioneers of the optical
switching industry and has numerous patents to his credit. [16]He and his very fine
team in our Research and Development department continue to work closely with our
customers to ensure design wins for the next generation of products.
 [17]On the competitive landscape, we have seen some interesting developments over the
last year. [18]Our major competitor has focused on building distribution in the
European market. [19]That competitor appears to be exiting North America and the Far
East, which are our strongholds. [20]However, we have seen several start-ups enter the
North American market. [21]They have been able to attract significant venture capital
financing, which gives them greater ability to build brand recognition than start-ups have
enjoyed in the past.

[22]On the technology front, recent developments in micro-electronic mechanical

technology have created the promise of a dramatic improvement in product performance.
[23]Typically the start-ups have been focused on this technology.

Name each of the competitive forces faced by Rubylight, using Porter’s five-force model.
Determine whether each competitive force is favorable or unfavorable for Rubylight. Select,
for each competitive force, only two sentences from the President’s Letter that support whether
the competitive force is favorable or unfavorable for Rubylight.

Note: No sentence may be selected more than once; only the sentence reference numbers are
needed for your selection.

(16 minutes)

Answer Question 6 in the Template provided on page 33.

Template for Question 6
No sentence may be selected more than once; only the sentence reference numbers are needed in
the third column. The first row of the template is completed for illustrative purposes.
Determine whether Select two sentences
Favorable or that support whether
Name the Competitive Force
Unfavorable favorable or
(Circle One) unfavorable
SAMPLE SAMPLE SAMPLE

Bargaining power of customers Favorable 5 and 8

Unfavorable

Favorable

Unfavorable

Favorable

Unfavorable

Favorable

Unfavorable

Favorable

Unfavorable
QUESTION 7 HAS ONE PART FOR A TOTAL OF 6 MINUTES.

Jeffrey Bruner, CFA, uses the capital asset pricing model (CAPM) to help identify mispriced
securities. A consultant suggests Bruner use arbitrage pricing theory (APT) instead. In
comparing CAPM and APT, the consultant made the following arguments:

1. Both the CAPM and APT require a mean–variance efficient market portfolio.

2. Neither the CAPM nor APT assumes normally distributed security returns.

3. The CAPM assumes that one specific factor explains security returns but APT does
not.

State whether each of the consultant’s arguments is correct or incorrect. Indicate, for each
incorrect argument, why the argument is incorrect.

Note: Indications cannot repeat the argument in negative form, but must indicate what is needed
to make the argument correct.

Answer Question 7 in the Template on page 37.

(6 minutes)
Template for Question 7
State whether
Argument is Indicate, for each incorrect
Argument Correct or argument, why the argument is
Incorrect incorrect
(Circle One)

Correct
1. Both the CAPM and APT
require a mean–variance
efficient market portfolio. Incorrect

Correct
2. Neither the CAPM nor APT
assumes normally distributed
security returns.
Incorrect

3. The CAPM assumes that one Correct

specific factor explains
security returns but APT does Incorrect
not.
QUESTION 8 HAS FIVE PARTS FOR A TOTAL OF 26 MINUTES.

Abigail Grace has a $900,000 fully diversified portfolio. She subsequently inherits ABC
Company common stock worth $100,000. Her financial advisor provided her with the forecasted
information given in Exhibit 8-1.

Exhibit 8-1
Risk and Return Characteristics
Expected
Expected
Standard Deviation
Monthly Returns
of Monthly Returns
Original Portfolio 0.67% 2.37%
ABC Company 1.25% 2.95%

The expected correlation coefficient of ABC stock returns with the original portfolio returns is
0.40.

The inheritance changes her overall portfolio and she is deciding whether or not to keep the ABC
stock.

Assuming Grace keeps the ABC stock,

A. Calculate the:

i. expected return of her new portfolio that includes the ABC stock
ii. expected covariance of ABC stock returns with the original portfolio returns
iii. expected standard deviation of her new portfolio that includes the ABC stock

(6 minutes)

If Grace sells the ABC stock, she will invest the proceeds in risk-free government securities
yielding 0.42 percent monthly.

Assuming Grace sells the ABC stock and replaces it with the government securities,

B. Calculate the:

i. expected return of her new portfolio that includes the government securities
ii. expected covariance of the government security returns with the original portfolio
returns
iii. expected standard deviation of her new portfolio that includes the government
securities

(6 minutes)
C. Determine whether the beta of her new portfolio that includes the government securities
will be higher or lower than the beta of her original portfolio. Justify your response with
one reason. No calculations are required.

(4 minutes)

Based on conversations with her husband, Grace is considering selling the $100,000 of ABC
stock and acquiring $100,000 of XYZ Company common stock instead. XYZ stock has the same
expected return and standard deviation as ABC stock. Her husband comments, “It doesn’t matter
whether you keep all of the ABC stock or replace it with $100,000 of XYZ stock.”

D. State whether her husband’s comment is correct or incorrect. Justify your response with
one reason. No calculations are required.

(4 minutes)

In a recent discussion with her financial advisor, Grace commented, “If I just don’t lose money
in my portfolio, I will be satisfied.” She went on to say, “I am more afraid of losing money than
I am concerned about achieving high returns.”

E. i. Describe one weakness of using expected standard deviation of returns as a risk

measure for Grace.

ii. Identify one alternate risk measure that is more appropriate under the
circumstances and justify your response with one reason.

(6 minutes)
QUESTION 9 HAS TWO PARTS FOR A TOTAL OF 10 MINUTES.

Buckner Industries has prepared the condensed forecast income statement for the year ending
December 31, 2002, shown in Exhibit 9-1.

Exhibit 9-1
Buckner Industries
Condensed Forecast Income Statement
Year Ending December 31, 2002
(in thousands except for per share data)

Earnings Before Interest and Taxes (EBIT) $94,500

Interest Expense 11,000
Pretax Income $83,500
Income Taxes (30% tax rate) 25,050
Net Income $58,450
Shares Outstanding 12,000
Earnings Per Share (EPS) $4.87

After creating the forecast, Buckner develops a new product, which will require $100 million in
additional capital expenditures at the beginning of 2002. With the new product, EBIT in 2002 is
expected to be 15 percent higher than the amount forecast in Exhibit 9-1. To finance the increase
in the capital budget, Buckner is considering a plan using 50 percent equity and 50 percent long-
term debt. New equity would be issued at $25.00 net proceeds per share and the interest rate on
the new long-term debt would be 8.50 percent. Buckner is reviewing how this financing, if
completed on December 31, 2001, would affect the company’s EPS.

A. Construct a pro forma income statement for 2002, assuming the financing plan is
adopted.

Answer Question 9-A in the Template provided on page 51.

(6 minutes)

Instead of using 50 percent equity and 50 percent long-term debt, Buckner decides to finance the
entire capital budget increase by issuing $100 million in new long-term debt.

Jack Deven, a fixed income portfolio manager with LightStreet Investments, is concerned about
the effect of such a large debt issuance on Buckner’s credit quality and calculates selected pro
forma financial credit quality ratios, shown in Exhibit 9-2 on page 50. LightStreet owns
previously issued option-free Buckner bonds in its U.S. Corporate Bond portfolio. These bonds
have a 10-year maturity and a modified duration of 6.5 years.
 Deven wants to compare his recalculated credit ratios to LightStreet’s credit quality standards,
also shown in Exhibit 9-2. Buckner satisfied each of these credit quality standards prior to the
new debt issue. For each standard no longer satisfied after the new debt issue, Deven believes
the yield on the previously issued Buckner bonds will increase by 10 basis points.

Exhibit 9-2
Buckner Industries
LightStreet Credit Quality Standards and
Selected Pro Forma Financial Credit Quality Ratios
LightStreet Pro Forma Credit Quality
Financial Credit Quality Ratios Credit Quality Ratios with Financing by
Standards $100 Million Long-Term
Debt
Interest Coverage Ratio 4.00x 5.57x
Cash Flow from Operations (CFO)-to-Total Debt 0.50x 0.44x
Pretax Return on Total Capital 18% 22%
Pretax Income-to-Sales 28% 33%
Total Debt-to-Total Capital 50% 54%

B. i. Identify the ratios that would contribute to an increase in the total yield on the
previously issued Buckner bonds if Deven’s analysis is correct.

ii. Calculate the direction and magnitude of the percentage price change due to the
change in yield.

(4 minutes)
Template for Question 9-A
Forecast from
Exhibit 9-1 Construct a pro forma income
Condensed Income Statement (in thousands statement for 2002, if the
except for per financing plan is adopted
share data)

Earnings Before Interest and Taxes (EBIT) $94,500

Interest Expense 11,000

Pretax Income $83,500

Income Taxes 25,050

Net Income $58,450

Shares Outstanding 12,000

Earnings Per Share $4.87

Questions 10 and 11 relate to Rajiv Singh. A total of 20 minutes is allocated to these
questions. Candidates should answer these questions in the order presented.

QUESTION 10 HAS TWO PARTS FOR A TOTAL OF 8 MINUTES.

Rajiv Singh, a bond analyst, is examining the risk and return characteristics of mortgage pass-
through securities.

A. Describe each of the two prepayment risks for a mortgage pass-through security and
relate each risk to changes in interest rates.

(4 minutes)

Information about two tranches of collateralized mortgage obligations (CMOs) is given in

Exhibit 10-1.

Exhibit 10-1
Option-Adjusted Spread (OAS) Output
from a Monte Carlo Simulation of Two CMO Tranches
(15% annual volatility)
OAS Option Cost Z Spread Effective Duration
Tranche (Basis points) (Basis points) (Basis points) (Years)
I 108 28 136 2.5
II 76 99 175 2.5

Using only the information in Exhibit 10-1,

B. Identify which CMO tranche is less expensive on a relative value basis and justify your
response.

(4 minutes)
QUESTION 11 HAS TWO PARTS FOR A TOTAL OF 12 MINUTES.

Singh is also analyzing a convertible bond. The characteristics of the bond and the underlying
common stock are given in Exhibit 11-1:

Exhibit 11-1
Convertible Bond and Underlying Stock Characteristics
Convertible Bond Characteristics
Par Value $1,000
Annual Coupon Rate (annual pay) 6.5%
Conversion Ratio 22
Market Price 105% of par value
Straight Value 99% of par value
Underlying Stock Characteristics
Current Market Price $40 per share
Annual Cash Dividend $1.20 per share

A. Compute the bond’s:

i. Conversion value
ii. Market conversion price
iii. Premium payback period

(6 minutes)

B. Determine whether the value of a callable convertible bond will increase, decrease, or
remain unchanged in response to each of the following changes, and justify each of your
responses with one reason:

i. An increase in stock price volatility

ii. An increase in interest rate volatility

(6 minutes)

Answer Question 11-B in the Template provided on page 65.

Template for Question 11-B
Determine whether the
value will Increase,
Justify your response with one reason
Change Decrease, or
Remain Unchanged
(Circle One)

Increase

An increase in
Decrease
stock price
volatility
Remain Unchanged

Increase

An increase in
Decrease
interest rate
volatility
Remain Unchanged
QUESTION 12 HAS TWO PARTS FOR A TOTAL OF 10 MINUTES.

Noah Kramer, a fixed income portfolio manager based in the country of Sevista, is considering
the purchase of a Sevista government bond. The Sevista government is issuing new 25-year
maturity debt in an amount equal to one-fourth of the total Sevista government debt outstanding.
The proceeds from the new debt issue will be used to retire an equal amount of existing 5-year
maturity government debt. Prior to the new issue, total outstanding debt of the Sevista
government is evenly distributed among 5-, 15-, and 25-year maturities.

A. Indicate how the Sevista government bond yield curve is likely to change as a result of
the new 25-year maturity debt issue. Support your answer using the Preferred Habitat
Theory of the term structure of interest rates.

Note: Limit your response to the effects of the refinancing.

(4 minutes)

Kramer decides to evaluate two strategies for implementing his investment in Sevista bonds.
Exhibit 12-1 gives the details of the two strategies, and Exhibit 12-2 contains the assumptions
that apply to both strategies.

Exhibit 12-1
Investment Strategies
(Amounts are Market Value Invested)
Strategy 5 Year Maturity 15 Year Maturity 25 Year Maturity
(Modified Duration (Modified Duration (Modified Duration
= 4.83) = 14.35) = 23.81)
I $5 million 0 $5 million
II 0 $10 million 0

Exhibit 12-2
Investment Strategy Assumptions
Market Value of Bonds $10 million
Bond Maturities 5 and 25 years
or
15 years
Bond Coupon Rates 0.00%
Target Modified Duration 15 years
Before choosing one of the two bond investment strategies, Kramer wants to analyze how the
market value of the bonds will change if an instantaneous interest rate shift occurs immediately
after his investment. The details of the interest rate shift are shown in Exhibit 12-3.

Exhibit 12-3
Instantaneous Interest Rate Shift
Immediately After Investment
Interest Key Rate Maturity Interest Key Rate Change
5 Year Down 75 basis points (bps)
15 Year Up 25 bps
25 Year Up 50 bps

B. Calculate, for the instantaneous interest rate shift shown in Exhibit 12-3, the percent
change in the market value of the bonds that will occur under:

i. Strategy I
ii. Strategy II

(6 minutes)
QUESTION 13 HAS THREE PARTS FOR A TOTAL OF 22 MINUTES.

Ashton Bishop is the debt manager for World Telephone, which needs €3.33 billion Euro
financing for its operations. Bishop is considering the choice between issuance of debt
denominated in:

• Euros (€), or
• U.S. dollars, accompanied by a combined interest rate and currency swap.

A. Explain one risk World would assume by entering into the combined interest rate and
currency swap.

(4 minutes)

Bishop believes that issuing the U.S. dollar debt and entering into the swap can lower World’s
cost of debt by 45 basis points. Immediately after selling the debt issue, World would swap the
U.S. dollar payments for Euro payments throughout the maturity of the debt. She assumes a
constant currency exchange rate throughout the tenor of the swap.

Exhibit 13-1 gives details for the two alternative debt issues. Exhibit 13-2 provides current
information about spot currency exchange rates and the 3-year tenor Euro/U.S. Dollar currency
and interest rate swap.

Exhibit 13-1
World Telephone Debt Details
Characteristic Euro Currency Debt U.S. Dollar Currency Debt
Par Value €3.33 billion $3 billion
Term to Maturity 3 Years 3 Years
Fixed Interest Rate 6.25% 7.75%
Interest Payment Annual Annual

Exhibit 13-2
Currency Exchange Rate and Swap Information
Spot currency exchange rate $0.90 per Euro ($0.90/€1.00)
3-year tenor Euro/U.S. Dollar
fixed interest rates 5.80% Euro/7.30% U.S. Dollar
B. Show the notional principal and interest payment cash flows of the combined interest rate
and currency swap.

Note: Your response should show both the correct currency ($ or €) and amount for each
cash flow.

Answer Question 13-B in the Template provided on page 77.

(12 minutes)

C. State whether or not World would reduce its borrowing cost by issuing the debt
denominated in U.S. dollars, accompanied by the combined interest rate and currency
swap. Justify your response with one reason.

(6 minutes)
Template for Question 13-B
Cash Flows Year 0 Year 1 Year 2 Year 3
of the Swap

World Pays

Notional Principal

Interest Payment

World Receives

Notional Principal

Interest Payment
QUESTION 14 HAS TWO PARTS FOR A TOTAL OF 10 MINUTES.

Donna Doni, CFA, wants to explore potential inefficiencies in the futures market. The TOBEC
stock index has a spot value of 185.00 now. TOBEC futures contracts are settled in cash and
underlying contract values are determined by multiplying $100 times the index value. The
current annual risk-free interest rate is 6.0 percent.

A. Calculate the theoretical price of the futures contract expiring six months from now,
using the cost-of-carry model. Show your calculations.

(4 minutes)

The total (round-trip) transaction cost for trading a futures contract is $15.00.

B. Calculate the lower bound for the price of the futures contract expiring six months from
now. Show your calculations.

(6 minutes)
2001 CFA Level II Examination
Morning Section – Essay

IMPORTANT INSTRUCTIONS TO CANDIDATES

1. Write your candidate number in the spaces provided on the front cover of this
Essay examination book.

2. Complete and sign the pledge attached to the front cover of this examination book.
Your examination will not be graded unless the pledge is signed. The pledge will
be detached prior to grading.

3. Write your answers in blue or black ink on the designated answer pages in the
examination book.

4. Label each part of your answer (A, B, C, D or i, ii, iii, etc.).

5. Use only the Texas Instruments BAII Plus or the Hewlett Packard 12C calculator.
All other calculators will be confiscated and a report will be submitted to AIMR.

6. Only answers written on the correct answer pages will be graded. You may make
marks and notes on the question pages, but these marks will not be graded.

7. If you use all of the designated pages, check the box at the bottom of the last page
of your answer and continue your answer on the unnumbered extra pages at the
back of the examination book. Label extra pages with the correct question
number.

8. You must stop writing immediately when instructed to do so at the conclusion of

the examination.

9. Violations of any of AIMR's examination rules will result in AIMR voiding your
examination results and may lead to a suspension or termination of candidacy in
the CFA Program.

DO NOT OPEN THIS EXAMINATION BOOK

UNTIL INSTRUCTED TO DO SO BY THE PROCTOR.

DO NOT REMOVE ANY EXAMINATION MATERIALS

FROM THE EXAMINATION ROOM.