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2017 CFA L2 Mock PM 01.05
2017 CFA L2 Mock PM 01.05
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2 2017 Level II Mock Exam PM
sell-side analyst whom I know to be thorough and competent. I liked her ideas, so
with her permission and acknowledgement, I replicated portions of her report. The
sell-side analyst’s report was so thorough I did not have to add much to my report.
But I did add my own recommendation, risk rating, and a time frame over which I
think her target price will be met. Her report was published just two days after she
visited the company’s management, and I sent my report to our clients only one day
after I received her report, so I know the information was timely.”
1 Austin’s description of the objectives of the CFA Institute ROS is least likely
correct with regard to the impact of:
A policies and procedures.
B self-regulation.
C the firm’s work environment.
KEY = A
CFA Institute Research Objectivity Standards
Modular Level II, Vol. 1, Reading 3, Section 3
Study Session 1-3-a
Explain the objectives of the Research Objectivity Standards.
A is correct. Conflicts of interests are not eliminated through the implementation of
the CFA Institute ROS. One of the CFA Institute ROS’ objectives is to promote policies
and procedures that minimize and manage conflicts of interests that may jeopardize a
Research Analyst’s independence and objectivity.
KEY = B
CFA Institute Research Objectivity Standards
Modular Level II, Vol. 1, Reading 3, Section 4 – Standard 1.0 Research Objectivity Policy
Study Session 1-3-b
Evaluate company policies and practices related to research objectivity, and distin-
guish between changes required and changes recommended for compliance with the
Research Objectivity Standards.
B is correct. The CFA Institute ROS requires the formal written policy on the inde-
pendence and objectivity of research to be disseminated to all employees of the firm,
not just those involved with the preparation of research reports and their supervisors.
KEY = A
CFA Institute Research Objectivity Standards
Modular Level II, Vol. 1, Reading 3, Section 4 – Standard 6.0 Relationships with Subject
Companies
Study Session 1-3-b
Evaluate company policies and practices related to research objectivity, and distin-
guish between changes required and changes recommended for compliance with the
Research Objectivity Standards.
A is correct. Standard 6 Relationships with Subject Companies prohibits research
analysts from directly or indirectly promising a subject company a specific price target
or rating. This is a requirement of Standard 6, not just a recommendation.
KEY = C
CFA Institute Research Objectivity Standards
Modular Level II, Vol. 1, Reading 3, Section 4 – Standard 7.0 Personal Investments and
Trading Requirements and Recommendations
Study Session 1-3-b
Evaluate company policies and practices related to research objectivity, and distin-
guish between changes required and changes recommended for compliance with the
Research Objectivity Standards.
C is correct. Evergreen’s trading restrictions for all employee transactions is stricter than
that required or recommended within Standard 7.0 Personal Investments and Trading.
Evergreen requires all employees to report all transactions, whereas Standard 7.0 only
requires covered employees to report their transactions. Standard 7.0 does not require
or recommend that transactions in diversified investment companies be reported. The
trading restriction period is consistent with recommendations for Standard 7.0
KEY = B
CFA Institute Research Objectivity Standards
Modular Level II, Vol. 1, Reading 3, Section 4 – Standards 2.0 Public Appearances, and
7.0 Personal Investments and Trading
Study Session 1-3-b
2017 Level II Mock Exam PM 5
Evaluate company policies and practices related to research objectivity, and distin-
guish between changes required and changes recommended for compliance with the
Research Objectivity Standards.
B is correct. Standard 2 Public Appearances requires the disclosure of personal and
firm conflicts of interests to the host or interviewer and where possible to the audience.
Since Osram is in a position to benefit personally from his spouse’s interests in the firm
he is recommending, the spouse’s investment position should be disclosed.
6 Which of the CFA Institute ROS did Shera most likely violate by issuing her last
research report?
A Standard 8.0 Timeliness of Research Reports and Recommendations
B Standard 11.0 Rating System
C Standard 3.0 Reasonable and Adequate Basis
KEY = C
CFA Institute Research Objectivity Standards
Modular Level II, Vol. 1, Reading 3, Section 4 – Standards 3.0 Reasonable and Adequate
Basis, 8.0 Timeliness of Research Reports and Recommendations, and 11.0 Rating System
Study Session 1-3-b
Evaluate company policies and practices related to research objectivity, and distin-
guish between changes required and changes recommended for compliance with the
Research Objectivity Standards.
C is correct. By using another analyst’s research information, Shera violated Standard 3
Reasonable and Adequate Basis. Firms must be able to provide supporting information
for the investment recommendation to investing clients. Shera would not be able to
provide this as she did not do her own research, prepare her own financial model to
determine the target price, nor did she independently verify the information in the sell
side analyst’s report.
(continued)
6 2017 Level II Mock Exam PM
Exhibit 1 (Continued)
Degrees of
ANOVA Freedom (DF) Sum of Squares (SS) Mean Square (MS)
Garfield presents the regression results to the investment committee with the
following three conclusions:
1 The regression intercept is statistically significant.
2 The model explains more than half of the variation in HighTech’s returns.
3 The NASDAQ index return and the HighTech return are positively correlated.
The committee asks Garfield whether he can use the model to predict the return
on HighTech’s stock. Ram Gupta, a committee member, asks:
“What would HighTech’s return be in a month when the return on the
NASDAQ index is 0.05633?”
Another committee member, Riko Samora, thinks that the simple regression model
omits important factors that might affect HighTech’s performance. Samora believes
that because more than 40% of HighTech’s customers are in Tokyo, the value of the
Japanese currency should influence HighTech’s sales and that the model’s significance
would considerably improve if Garfield considers this fact.
Following Samora’s suggestion, Garfield runs a multiple linear regression adding
the change in the JPY/USD exchange rate as a second independent variable. The results
from this regression are shown in Exhibit 2.
Exhibit 2 (Continued)
Garfield presents the new results to Samora, who asks him two questions:
1 Are the results of this second regression significant?
2 Do you suspect that the model has problems with multicollinearity or serial
correlation?
Garfield responds to the Samora’s questions by examining the F-, t-, and DW
statistics in the regression output to see whether they are significant.
7 The standard error of estimate of the regression model shown in Exhibit 1 is
closest to:
A 0.0031.
B 0.1802.
C 0.0557.
KEY = C
Correlation and Regression, Richard A. Defusco, CFA, Dennis W. McLeavey, CFA, Jerald E.
Pinto, CFA, and David E. Runkle, CFA
Modular Level II, Vol. 1, Reading 9, Section 3.3
Study Session 3-9 -f
Calculate and interpret the standard error of estimate, the coefficient of determination,
and a confidence interval for a regression coefficient.
C is correct.
12
SSE
SEE =
n − 2
12
0.1802
= = 0.0031 = 0.0557
58
C 3
KEY = A
Correlation and Regression, Richard A. Defusco, CFA, Dennis W. McLeavey, CFA, Jerald E.
Pinto, CFA, and David E. Runkle, CFA
Modular Level II, Vol. 1, Reading 9, Sections 3.2, 3.4, and 3.5
Study Session 3-9 -f, g
Calculate and interpret the standard error of estimate, the coefficient of determination,
and a confidence interval for a regression coefficient.
Formulate a null and alternative hypothesis about a population value of a regression
coefficient, and determine the appropriate test statistic and whether the null hypothesis
is rejected at a given level of significance.
A is correct. The p-value of 0.80 for the intercept implies that there is about an
80% chance that the true value of the intercept is not significantly different from zero.
Therefore, conclusion 1 is incorrect.
KEY = C
Correlation and Regression, Richard A. Defusco, CFA, Dennis W. McLeavey, CFA, Jerald E.
Pinto, CFA, and David E. Runkle, CFA
Modular Level II, Vol. 1, Reading 9, Section 3.7
Study Session 3-9 -h, i
Calculate a predicted value for the dependent variable, given an estimated regression
model and a value for the independent variable.
Calculate and interpret a confidence interval for the predicted value of a dependent
variable.
C is correct. The predicted value equals the intercept plus the coefficient times the
value of the independent variable: 0.001795 + (1.08601 × 0.05633) = 0.06297.
10 Using the results shown in Exhibit 2, the value of the F-statistic is closest to:
A 9.63.
B 37.51.
C 16.76.
KEY = B
Multiple Regression and Issues in Regression Analysis, Richard A. Defusco, CFA, Dennis
W. McLeavey, CFA, Jerald E. Pinto, CFA, and David E. Runkle, CFA
Modular Level II, Vol. 1, Reading 10, Section 2.3
Study Session 3-10- g
Calculate and interpret the F-statistic, and describe how it is used in regression analysis.
2017 Level II Mock Exam PM 9
11 Based on the results of the regression model shown in Exhibit 2, the best
conclusion Garfield can make about a hypothesis that the coefficient JPY/USD
change is zero is to:
A reject the alternative hypothesis.
B reject the null hypothesis.
C fail to reject the null hypothesis.
KEY = C
Multiple Regression and Issues in Regression Analysis, Richard A. Defusco, CFA, Dennis
W. McLeavey, CFA, Jerald E. Pinto, CFA, and David E. Runkle, CFA
Modular Level II, Vol. 1, Reading 10, Section 2
Study Session 3-10-a, b
Formulate a multiple regression equation to describe the relation between a depen-
dent variable and several independent variables, determine the statistical significance
of each independent variable.
Interpret estimated regression coefficients and their p-values.
C is correct. The p-value is the smallest level of significance at which the null hypoth-
esis can be rejected. The null hypothesis here is that the JPY/USD test statistic is not
related to the return on HighTech. In this case the p-value 0.33 is high; therefore, we fail
to reject the null hypothesis.
KEY = C
Multiple Regression and Issues in Regression Analysis, Richard A. Defusco, CFA, Dennis
W. McLeavey, CFA, Jerald E. Pinto, CFA, and David E. Runkle, CFA
Modular Level II, Vol. 1, Reading 10, Sections 4.2 and 4.3
Study Session 3-10-k , l
10 2017 Level II Mock Exam PM
Explain the types of heteroskedasticity and the effects of heteroskedasticity and serial
correlation on statistical inference.
Describe multicollinearity, and explain its causes and effects in regression analysis.
C is correct. The significant t-statistic (8.617) on the NASDAQ return suggests that
multicollinearity is not a problem. The Durbin–Watson statistic close to 2 indicates there
is no serial correlation.
Thibodeaux and Beauregard discuss some of CapFX’s recent trades using the cur-
rency quotes and rates provided in Exhibits 1 and 2. For all currency pairs provided
the notation used is, for example: USD/AUD: US dollars per Australian dollar.
■ Based on the data in Exhibit 1, a European client recently entered into a
one-year JPY/EUR carry trade based on the projected outlook for the two
currencies.
■ A Hong Kong based client producing electronic components, signed a long-
term contract to deliver components to a Canadian aircraft parts manufacturer.
The client wanted to estimate the hedging cost for a sale scheduled to close in
nine months. Based on the data presented in Exhibit 2, the client entered into a
nine-month (270-day) HKD/CAD forward contract.
KEY = A
Currency Exchange Rates: Determination and Forecasting, Michael R. Rosenberg and
William A. Barker
Vol. 1, Reading 13, Section 3.2
Study Session 4-13-h
Explain approaches to assessing the long-run fair value of an exchange rate.
A is correct. The approach preferred by Thibodeaux is the reduced-form econometric
model which seeks to estimate the equilibrium path that a currency should take on the
basis of the trends in several key macroeconomic variables, such as a country’s net foreign
12 2017 Level II Mock Exam PM
asset positon, terms of trade, and relative productivity. The approach combines elements
of both the current account imbalance of the macroeconomic balance approach and the
capital account focus of the external sustainability approach.
KEY = A
Currency Exchange Rates: Determination and Forecasting, Michael R. Rosenberg and
William A. Barker
Vol. 1, Reading 13, Section 8
Study Session 4-13- o
Describe warning signs of a currency crisis.
A is correct. Statement 3 is the most accurate. Inflation tends to be significantly higher
in pre-crisis periods compared with tranquil periods.
15 Which of the comments about short-term exchange rate forecasting is the most
accurate? The comment by:
A Beauregard regarding their emerging market trades.
B Beauregard regarding monitoring market sentiment.
C Thibodeaux regarding their carry trade strategy.
KEY = C
Currency Exchange Rates: Determination and Forecasting, Michael R. Rosenberg and
William A. Barker
Vol. 1, Reading 13, Sections 9.1, 9.2.2
Study Session 4-13-p
Describe uses of technical analysis in forecasting exchange rates.
C is correct. Thibodeaux’s comment about the carry trade strategy is the most accurate.
Although carry trade strategies can generate attractive returns over long periods, the
distribution of the returns suggest that carry trades are sometimes prone to significant
downside tail risk during carry trade unwinds. Thus, a trend-following trading system
overlaid on a carry trade strategy could warn investors to step aside during unwinds.
16 Based on the data in Exhibit 1, the bid EUR/AUD cross-rate implied by the
interbank market is closest to:
A 0.6497.
B 0.6484.
C 0.7650.
KEY = B
Currency Exchange Rates: Determination and Forecasting, Michael R. Rosenberg and
William A. Barker
2017 Level II Mock Exam PM 13
17 Based on the data in Exhibit 1, the expected net investment return on a one-
year carry trade based on the JPY/EUR currency pair, measured in JPY terms, is
closest to:
A 2.86%. borrow in low IR currency (JPY) and lend in high IR currency (EUR) -> use spot ask rate (down the ask) to calc future rate
B 3.10%.
C 3.01%.
KEY = A
Currency Exchange Rates: Determination and Forecasting, Michael R. Rosenberg and
William A. Barker
Vol. 1, Reading 13, Section 4
Study Session 4-13-i
Describe the carry trade and its relation to uncovered interest rate parity and calculate
the profit from a carry trade.
A is correct. In a carry trade, an investor will borrow in the low interest rate currency,
the JPY, at 0.15%, and invest in the high interest rate currency, the EUR, at 1.40%.
Calculate the current and one year later JPY/EUR cross-rates.
1 Borrow JPY and buy USD for 117.66 JPY (offer), then use USD to buy EUR for 1.0873
USD (offer). This generates a cross-rate of 117.66 × 1.0873 = 127.932 = 127.93 JPY/
EUR
2 The one year later cross-rate for the JPY/EUR is calculated as 118.32 × 1.0984 =
129.963 = 129.96
The net investment return for the unhedged EUR deposit, measured in JPY is calcu-
lated as:
1
127.93 × (1 + 0.0140) × 129.96 − 1.0000 × (1 + 0.0015) = 1.0301 − 1.0015
= 0.0286 = 2.86%
KEY = A
Currency Exchange Rates: Determination and Forecasting, Michael R. Rosenberg and
William A. Barker
Vol. 1, Reading 13, Section 2.2
Study Session 4-13-c
Distinguish between spot and forward rates and calculate the forward premium/
discount for a given currency.
A is correct. The mid-market HKD/CAD is (5.6019 + 5.6037)/2 = 5.6028. The mid-market
forward premium (discount) is calculated as:
Actual
360
FP B − SP B = SP B
Actual (iP − iB )
1 + iB
360
where
FP B = forward rate
SP B = spot rate
270
360
FP B − SP B = 5.6028 (0.0050 − 0.0216)
1 + 0.0216 × 270
360
= 5.6028 × 0.7380 × −0.0166
= −0.06864 = −0.0686
Below is an alternative method to calculate the forward discount.
Consider the alternatives of currently investing in Canada and Hong Kong:
Current 1 Year
Exhibit 2 (Continued)
Worried that the balance-sheet-based and cash-flow based accruals ratios (not
shown) raise some concerns about the possible use of accruals to manage earnings,
Petersen asks Berg, for advice on what further type of analysis he should do as a
follow-up on this issue.
19 Using Petersen's preferred method and 2013 divisional data, the best conclusion
Peterson can make about which division will potentially become less significant
in the future is that it will be:
A home furnishings.
B recreational products.
C children's products.
KEY = B
Integration of Financial Analysis Techniques, Jack T. Ciesielski Jr., CFA
Modular Level II, Vol. 2, Section 2
Study Session 6-20-a, b
Demonstrate the use of a framework for the analysis of financial statements, given
a particular problem, question, or purpose (e.g., valuing equity based on comparables,
critiquing a credit rating, obtaining a comprehensive picture of financial leverage, eval-
uating the perspectives given in management’s discussion of financial results).
Identify financial reporting choices and biases that affect the quality and comparability
of companies’ financial statements and explain how such biases affect financial decisions.
B is correct. Peterson prefers to use the relationship between capital expenditures and
total assets by operating division and hence would use the ratio of capital expenditure
proportion to total asset proportion for each division. This ratio for the Recreational
Products division is less than 1 (see table below) indicating that Rhine is allocating a
lower proportion of capital expenditures to that division relative to asset proportions. If
this continues, the Recreational Products division will become less significant over time.
20 If the children's products division had been able to maintain its 2012 operating
margin in 2013, the company’s overall operating margin in 2013, compared to
2012, would have been:
2017 Level II Mock Exam PM 17
A higher.
B the same.
C lower.
KEY = C
Integration of Financial Analysis Techniques, Jack T. Ciesielski Jr., CFA
Modular Level II, Vol. 2, Section 2
Study Session 6-20-a
Demonstrate the use of a framework for the analysis of financial statements, given
a particular problem, question, or purpose (e.g., valuing equity based on comparables,
critiquing a credit rating, obtaining a comprehensive picture of financial leverage, eval-
uating the perspectives given in management’s discussion of financial results).
C is correct. Apply the 2012 operating margin for the Children’s Division to the 2013
revenues for the division to determine what the 2013 overall operating profit margin
would have been if the margin had been maintained, then compare it to the 2012 overall
operating profit margin.
Even if the Children’s division had maintained its operating margin in 2013 the overall
company operating margin would still have decreased slightly (7.7% vs. 7.9%).
21 Which of the following is the most appropriate use of Berg’s reminder about the
US versus euro exchange rate in 2013? Peterson should use the information:
A to determine the exchange gains or losses included in net income.
B to confirm that the division's organic growth was less than 11.2%.
C when evaluating management's historical performance.
KEY = C
Multinational Operations, Timothy S. Doupnik, PhD, and Elaine Henry, CFA
Modular Level II, Vol. 2, Section 5.1
Study Session 5-18-i, j
Explain how changes in the components of sales affect earnings sustainability
Analyze how currency fluctuations potentially affect financial results, given a com-
pany’s countries of operation.
C is correct. Analysts should consider the foreign currency effect on sales growth for
evaluating management’s historical performance. Foreign currency fluctuations are out
of management’s control so management should not be held accountable for it when
evaluating their performance.
18 2017 Level II Mock Exam PM
22 The best conclusion Petersen can make about the geographic mix of Rhine’s
profit in 2013 is that compared with 2012 the mix is:
A more international.
B about the same.
C more domestic.
KEY = A
Multinational Operations, Timothy S. Doupnik, PhD, and Elaine Henry, CFA
Modular Level II, Vol. 2, Section 4
Study Session 5-18-h
Describe how multinational operations affect a company’s effective tax rate.
A is correct. The 2013 effective tax rate on earnings is lower than 2012 (see table
below) implying that more profits were earned in a lower tax jurisdiction. The foreign
operations are in lower tax regimes, therefore, it is reasonable to conclude that more of
the profits were earned internationally.
23 Compared with 2011, the change in which working capital account most likely
had the largest effect on Petersen’s observed deterioration in liquidity?
A Accounts payable
B Accounts receivable
C Inventory
KEY = C
Integration of Financial Analysis Techniques, Jack T. Ciesielski Jr., CFA
Modular Level II, Vol. 2, Section 2
Study Session 6-20-a, c
Demonstrate the use of a framework for the analysis of financial statements, given
a particular problem, question, or purpose (e.g., valuing equity based on comparables,
critiquing a credit rating, obtaining a comprehensive picture of financial leverage, eval-
uating the perspectives given in management’s discussion of financial results).
Evaluate the quality of a company’s financial data and recommend appropriate
adjustments to improve quality and comparability with similar companies, including
adjustments for differences in accounting standards, methods, and assumptions.
C is correct. Petersen interprets the changes in the cash conversion cycle (CCC) indi-
cate a deterioration in liquidity. The CCC has increased since 2011 from 84 days to 95
days (see table below). The working capital account that had the largest effect on the
increase was inventory, as the holding period has increased 6.4 days.
2017 Level II Mock Exam PM 19
2013 2011
Working Capital Days
Account Turnover (365/turnover) Turnover Days
24 Berg’s best answer to Petersen’s question about further analysis is that he should
conduct a:
A Cash flow ratio analysis.
B DuPont analysis.
C Discounted cash flow analysis.
KEY = A
Integration of Financial Analysis Techniques, Jack T. Ciesielski Jr., CFA
Modular Level II, Vol. 2, Section 2
Study Session 6-20-a, c
Demonstrate the use of a framework for the analysis of financial statements, given
a particular problem, question, or purpose (e.g., valuing equity based on comparables,
critiquing a credit rating, obtaining a comprehensive picture of financial leverage, eval-
uating the perspectives given in management’s discussion of financial results).
Evaluate the quality of a company’s financial data and recommend appropriate
adjustments to improve quality and comparability with similar companies, including
adjustments for differences in accounting standards, methods, and assumptions.
A is correct. Concerns about earning manipulation are best addressed by cash flow
ratios such as operating cash flow before interest and taxes to operating income.
Revenues $6,456
Earnings before interest, taxes, depreciation, and amortization 1,349
(EBITDA)
(continued)
20 2017 Level II Mock Exam PM
Exhibit 1 (Continued)
Assets
Cash and cash equivalents $32 $21
Accounts receivable 413 417
Inventories 709 638
Other current assets 136 123
Total current assets 1,290 1,199
Yee plans to perform two different valuations of McLaughlin, which she calls the
“base case” valuation and the “alternative” valuation. Critical assumptions for each
are given in the following lists.
Alternative valuation
KEY = B
Free Cash Flow Valuation, by Jerald Pinto, CFA, Elaine Henry, CFA, Thomas Robinson,
CFA, and John Stowe, CFA
Modular Level II, Vol. 4, Reading 31, Section 3.1
Study Session 11-31-c, d
Explain the appropriate adjustments to net income, earnings before interest and
taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA),
and cash flow from operations (CFO) to calculate FCFF and FCFE.
Calculate FCFF and FCFE.
B is correct. FCFF = NI + NCC + Int(1 – Tax Rate) – FCInv – WCInv
Net income (given) = $626; Interest Expense (given) = $186; Tax rate = 294/920 = 32%
Non-cash charges (depreciation) (given) = $243; Fixed capital investment (given) = $535
22 2017 Level II Mock Exam PM
Net increase
WC Investment 2012 ($) 2011 ($) ($)
FCFF = 626 + 243 + 186(1 – 0.32) – 535 – (–25) = 485.48 = $485 million
26 Assuming 2012 FCFF equals $500 million, McLaughlin’s FCFE ($ millions) for
2012 is closest to:
A $574.
B $174.
C $114.
KEY = B
Free Cash Flow Valuation, by Jerald Pinto, CFA, Elaine Henry, CFA, Thomas Robinson,
CFA, and John Stowe, CFA
Modular Level II, Vol. 4, Reading 31, Section 3.4
Study Session 11-31-c, d
Explain the appropriate adjustments to net income, earnings before interest and
taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA),
and cash flow from operations (CFO) to calculate FCFF and FCFE.
Calculate FCFF and FCFE.
B is correct. FCFE = FCFF – Interest (1 – T) + Net borrowing
Given: 2012 FCFF base case estimate = $500; Interest exp = $186; Tax rate = 32%
27 Using Yee’s base case valuation assumptions and the FCFF valuation approach,
the year-end 2012 value per share of McLaughlin common stock is closest to:
A $29.20.
B $12.78.
C $23.73.
KEY = C
Free Cash Flow Valuation, by Jerald Pinto, CFA, Elaine Henry, CFA, Thomas Robinson,
CFA, and John Stowe, CFA
Modular Level II, Vol. 4, Reading 31, Section 2.3.1
Study Session 11-31-i, j
Explain the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE
models, and select and justify the appropriate model given a company’s characteristics.
Estimate a company’s value using the appropriate free cash flow model(s).
2017 Level II Mock Exam PM 23
C is correct. In the base case the growth rate is stable therefore using the Constant-
Growth FCFF model the value of the firm is:
FCFF1 600
Firm value = = = $12, 000 million
WACC − g 0.09 − 0.04
28 Using Yee’s alternative valuation assumptions and the FCFE valuation approach,
the year-end 2012 value per share of McLaughlin’s common stock is closest to:
A $24.17.
B $18.00.
C $22.80.
KEY = C
Free Cash Flow Valuation, by Jerald Pinto, CFA, Elaine Henry, CFA, Thomas Robinson,
CFA, and John Stowe, CFA
Modular Level II, Vol. 4, Reading 31, Sections 2.3.2, 3.7
Study Session 11-31-i, j
Explain the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE
models, and select and justify the appropriate model given a company’s characteristics.
Estimate a company’s value using the appropriate free cash flow model(s).
C is correct. First it is necessary to estimate FCFE2013
FCFE = Net income – (1 – DR)(FCInv – Depreciation) – (1 – DR)(WCInv)
where
29 The most likely combined effect of the three possible financial actions identified
by Yee will reduce McLaughlin’s 2013 FCFE ($ millions) by:
A $100.
B $270.
C $160.
24 2017 Level II Mock Exam PM
KEY = A
Free Cash Flow Valuation, by Jerald Pinto, CFA, Elaine Henry, CFA, Thomas Robinson,
CFA, and John Stowe, CFA
Modular Level II, Vol. 4, Reading 31, Section 3.8.3
Study Session 11-31- g
Explain how dividends, share repurchases, share issues, and changes in leverage may
affect FCFF and FCFE.
A is correct. The three possible actions are: dividend increase = 110; share repurchase
= 60; and the debt repayment = 100. Reducing debt by $100 million reduces FCFE (the
amount of cash available to equity holders) by that amount. The cash dividend and the
share repurchase are uses of FCFE, and do not change the amount of cash available to
equity holders. Therefore FCFE will decrease by $100 million.
KEY = C
Free Cash Flow Valuation, by Jerald Pinto, CFA, Elaine Henry, CFA, Thomas Robinson,
CFA, and John Stowe, CFA
Modular Level II, Vol. 4, Reading 31, Section 1, 4.3
Study Session 11-31-f, g
Compare the FCFE model and dividend discount models.
Explain how dividends, share repurchases, share issues, and changes in leverage may
affect future FCFF and FCFE.
C is correct. Analysts should use a free cash flow to equity valuation whenever divi-
dends differ significantly from the company’s capacity to pay dividends or when a change
of control is anticipated. A FCFF valuation is preferred over a FCFE valuation whenever
the capital structure is unstable or ever-changing. So Nicosia’s first statement is correct,
and her second and third statements are incorrect.
Exhibit 1 Selected Stock Data for XRL and ZTL and Additional Market
Information
XRL ZTL
EPS ($) DPS ($) EPS ($) DPS ($)
Additional information:
Note: DPS is dividends per share and EPS is earnings per share
Barton begins her analysis by looking at XRL. After doing some research, she con-
cludes that a reasonable growth estimate for the company is the sustainable growth
rate using the most recent year’s retention ratio, and calculates a price for XRL using
this information. She makes the following note:
■■ it will not be possible to use the Gordon growth model for her analysis of XRL.
Barton and Eckhart discuss the impact of a company’s growth rate on its future
stock price. Barton determines XRL’s growth rate of earnings for the period from 2011
to 2015 and compares it to the current nominal growth rate of the US economy. She
concludes that XRL is likely to be in the transition stage of growth.
Next Eckhart asks Barton to calculate the intrinsic value of ZTL shares using the
Gordon model to determine if it meets the fund’s investment objectives. He suggests
that rather than using the sustainable growth rate, she should use the growth rate of
dividends over the past five years.
Eckhart tells Barton that he has heard rumors that ZTL is contemplating selling
one of its major manufacturing facilities. He believes that if that should happen, the
company would pay a series of special dividends in each of the three years following
the sale. Barton asks him how she could best incorporate such a possibility into the
valuation of the shares.
Turning to the private equity fund, Eckhart informs Barton that the fund is
considering buying a controlling interest in a closely held company, H-Tron (HTR),
which pays infrequent dividends that are well below the free cash flow from equity.
HTR has healthy cash flows with significant growth potential and holds patents on a
key innovation in electronics technology. Eckhart believes the value of these patents
26 2017 Level II Mock Exam PM
is not fully reflected in HTR’s balance sheet. He asks her how HTR’s common equity
should be valued given these circumstances. Barton states that she will assess which
valuation method will be the most suitable.
Finally, Eckhart asks Barton to value HTR’s non-callable perpetual preferred stock
as a potential investment for the fund. The stock, currently privately held, pays a fixed
annual dividend of $7.50. After performing some industry analysis, Barton decides to
use an equity risk premium of 6% in valuing the stock.
31 Using the data in Exhibit 1, Barton’s note about the use of the Gordon growth
model to value XRL is most likely:
A correct because the required return on equity is less than the expected
growth rate.
B incorrect because the sustainable growth rate is greater than the US econo-
my’s growth rate.
C incorrect because the required return on equity is greater than the US econ-
omy’s growth rate.
KEY = A
Discounted Dividend Valuation, Jerald E. Pinto, Elaine Henry, Thomas R. Robinson, and
John D. Stowe
Vol. 4, Reading 30, Section 4, 6.1
Study Session: 10-30-h, m, o
Describe strengths and limitations of the Gordon growth model and justify its selec-
tion to value a company’s common shares.
Estimate a required return based on any DDM, including the Gordon growth model
and the H-model.
Calculate and interpret the sustainable growth rate of a company and demonstrate
the use of DuPont analysis to estimate a company’s sustainable growth rate.
A is correct. The Gordon growth model, shown below, cannot be used when r < g. In
this case r = 8.84% and g = 13.84% calculations shown below.
D1
Gordon growth model: P0 =
r−g
where
P0 = Current price
D1 = next period’s dividend
r = required return on equity
g = growth rate of dividends
Barton’s calculated growth rate based on the sustainable growth rate model is g = b
× ROE, where b = 1 – (DPS/EPS).
= [1 – (1.77/3.15)] × 0.316 = 0.1384 = 13.84%
2017 Level II Mock Exam PM 27
32 Barton's conclusion that XRL is in the transition phase is best described as:
A correct.
B incorrect, because the company is in the supernormal growth phase.
C incorrect, because the company is in the mature phase.
KEY = C
Discounted Dividend Valuation, Jerald E. Pinto, Elaine Henry, Thomas R. Robinson, and
John D. Stowe
Vol. 4, Reading 30, Section 4
Study Session: 10-30-j, h
Explain the growth phase, transitional phase, and maturity phase of a business.
Describe strengths and limitations of the Gordon growth model and justify its selec-
tion to value a company’s common shares.
C is correct. Barton’s statement is incorrect because the company is in the mature
phase. The economy’s nominal growth rate, from Exhibit 1, is real growth rate + inflation
= 3.7% + 2% = 5.7%. XRL’s compound growth rate, over the four-year period is 5.7%,
approximately equal to the economy’s growth rate.
14 14
EPS2015 3.15
g = = = 5.7%
EPS2011 2.52
Where g is the compound growth rate in earnings and EPS is earnings per share.
A company in the mature phase typically has earnings growing at a rate comparable
to the economy’s growth rate.
33 Using the data in Exhibit 1 and following Eckhart’s suggestions regarding the
valuation of ZTL, the most appropriate conclusion that Barton should make
about the ZTL shares is that the fund should:
A take a long position in ZTL.
B not add ZTL to the portfolio.
C take a short position in ZTL.
KEY = B
Discounted Dividend Valuation, Jerald E. Pinto, Elaine Henry, Thomas R. Robinson, and
John D. Stowe
Vol. 4, Reading 30, Section 4
Study Session: 10-30-c, p
28 2017 Level II Mock Exam PM
Calculate the value of a common stock using the Gordon growth model and explain
the model’s underlying assumptions.
Evaluate whether a stock is overvalued, fairly valued, or undervalued by the market
based on a DDM estimate of value.
B is correct. The growth rate of dividends over the past five years is:
1n 14
D5 2.53
−1 = − 1 = 7.56%
D1 1.89
where
34 Eckhart’s best response to Barton’s question about the valuation of ZTL consid-
ering the potential sale of its manufacturing facility would be to use:
A the H-model to reflect the change in dividends.
B the Gordon growth model to incorporate the decrease in firm value after the
sale.
C a spreadsheet model that incorporates the special dividends.
KEY = C
Discounted Dividend Valuation, Jerald E. Pinto, Elaine Henry, Thomas R. Robinson, and
John D. Stowe
Vol. 4, Reading 30, Section 5.5
Study Session: 10-30-n, i
Explain the use of spreadsheet modeling to forecast dividends and to value common
shares.
Explain the assumptions and justify the selection of the two-stage DDM, the H-model,
the three-stage DDM, or spreadsheet modeling to value a company’s common shares.
C is correct. Dividend discount models assume stylized patterns of dividend growth,
while a spreadsheet allows any assumed dividend pattern therefore, a spreadsheet model
would be best suited for these anticipated special dividends.
35 Based on the information Eckhart provides to Barton about HTR, the most suit-
able method for her to use in determining the fair value of its common equity is
to discount future:
2017 Level II Mock Exam PM 29
KEY = B
Discounted Dividend Valuation, Jerald E. Pinto, Elaine Henry, Thomas R. Robinson, and
John D. Stowe
Vol. 4, Reading 30, Section 2.2
Study Session: 10-30-a
Compare dividends, free cash flow, and residual income as inputs to discounted
cash flow models and identify investment situations for which each measure is suitable.
B is correct. Free cash flow to equity (FCFE) is appropriate for investors who want to take
a control perspective and for companies that are not currently paying regular dividends.
36 Barton’s estimate of the fair value for HTR’s preferred stock is closest to:
A $125.
B $84.
C $81.
KEY = B
Discounted Dividend Valuation, Jerald E. Pinto, Elaine Henry, Thomas R. Robinson, and
John D. Stowe
Vol. 4, Reading 30, Section 4.1
Return Concepts, Jerald E. Pinto, Elaine Henry, Thomas R. Robinson, and John D. Stowe
Vol. 4, Reading 28, Section 3
Study Session: 10-30- g, 9-28-c
Calculate the value of noncallable fixed-rate perpetual preferred stock.
Estimate the required return on an equity investment using the capital asset pricing
model, the Fama–French model, the Pastor–Stambaugh model, macroeconomic multi-
factor models, and the build-up method (e.g., bond yield plus risk premium.
B is correct. Fair value for a non-callable fixed rate perpetual preferred stock is the
Gordon growth model result with g = 0.
D 7.50
V0 = = = $83.89 = $84
r 0.0294 + 0.06
where
D = dividend
r = required rate of return, defined as r = RF + equity risk premium =
0.0294 + 0.06
At their first meeting, Maalouf notes Fujioka currently values option-free bonds
by discounting their future expected cash flows using the zero-coupon yield curve. He
asks her why she hasn’t adopted the more flexible binomial interest rate tree frame-
work. She replies, “My approach will calculate the same values for option-free bonds
as those produced by a properly calibrated binomial tree. Further, it would require
special programming techniques to calibrate a binomial tree to match benchmark
risk-free bond prices, making implementation of that approach quite costly.”
Maalouf explains, “Valuation using a binomial interest rate tree is based on the
principle of no arbitrage. In order for there to be no arbitrage in a financial market,
three conditions must be met:”
Condition 1: If the risk of any security is higher than that of another, its
expected return must also be higher.
Condition 2: The price of any two risk-free securities with the same timing and
amount of payoffs must be the same.
Condition 3: The price of any portfolio of securities must equal the sum of the
prices of the individual securities in the portfolio.
Maalouf provides Fujioka the zero-coupon yield curve in Exhibit 1 and asks her to
use her current approach to calculate the arbitrage-free value of an option-free, fixed-
rate, 4-year bond with a 3.5% coupon rate, annual payments, and a face value of 100.
1 2.15%
2 3.45%
3 4.01%
4 4.40%
Using a different set of benchmark bond values, Maalouf constructs the calibrated
binomial interest rate tree shown in Exhibit 2. He shows Fujioka how to value a 3-year
option-free, fixed-rate bond with a 2.8% coupon rate, annual payments, and a face
value of 100 using this interest rate tree.
6.76%
4.56%
2.85% 5.11%
1.50% 3.45%
2.16% 3.86%
2.60%
2.92%
2017 Level II Mock Exam PM 31
Maalouf explains, “An alternative to the calculations I just showed you is path-wise
valuation. In this variation, you would determine all of the possible paths interest
rates could take in our binomial tree and value the bond along each path. The value
of the bond is then calculated as the average of the values across all paths. For the
4-year bond you evaluated earlier, you would need to calculate its value for 24 or 16
different paths.”
Fujioka tells Maalouf that she has been reading about the use of Monte Carlo
forward-rate simulation for fixed i ncome v aluation. S he a sks M aalouf t o f urther
explain this approach to her. Maalouf replies, “The Monte C arlo approach i s q uite
different from the binomial tree approach I’ve been describing to you. Some of these
differences include:”
Difference 1: The Monte Carlo approach does not require calibration, whereas
the binomial tree approach does.
Difference 2: The Monte Carlo approach is typically employed when cash
flows are path dependent, whereas the binomial tree approach only allows one
expected cash flow per node, regardless of the path of interest rates.
Difference 3: The Monte Carlo approach randomly simulates a fixed number of
interest rate paths and values the security only across those paths, whereas the
binomial tree approach values the security across all possible interest rate paths
on the tree.
37 Is Fujioka most likely correct when comparing her approach to valuation with
the binomial interest rate tree framework?
A No, the values estimated by the two approaches will likely be different
B Yes
C No, she is incorrect regarding calibration of interest rate trees easy and cheap when accomplishing using spreadsheet software
KEY = C
The Arbitrage-Free Valuation Framework, Steven V. Mann
Modular Level II, Vol. 5, Reading 36, Sections 3.1 & 3.4
Study Session 12-36-e, f
Describe the process of calibrating a binomial interest rate tree to match a specific
term structure.
Compare pricing using the zero-coupon yield curve with pricing using an arbitrage-
free binomial lattice.
C is correct. Calibrating an interest rate tree can be accomplished using spreadsheet
software (e.g., the Solver function in Excel) and is therefore relatively easy to do without
a knowledge of special programming techniques and without great expense.
38 Of the three conditions Maalouf claims are necessary for a market to be arbi-
trage free, he is least likely correct regarding:
A Condition 1.
B Condition 3.
C Condition 2.
KEY = A
The Arbitrage-Free Valuation Framework, Steven V. Mann
Modular Level II, Vol. 5, Reading 36, Section 2
Study Session 12-36-a
32 2017 Level II Mock Exam PM
39 The value Fujioka calculates for the four-year bond is closest to:
A 98.149.
B 96.764.
C 96.931.
KEY = C
The Arbitrage-Free Valuation Framework, Steven V. Mann
Modular Level II, Vol. 5, Reading 36, Section 3
Study Session 12-36-b
Calculate the arbitrage-free value of an option-free, fixed-rate coupon bond.
C is correct. The zero-coupon yield curve provides spot rates. The value of the bond
with each cash flow discounted using the appropriate spot rate is
3.5 3.5 3.5 103.5
96.931 = + + +
1 2 3
1.0215 1.0345 1.0401 1.04404
40 The value Maalouf estimates for the three-year bond using the binomial tree in
Exhibit 2 is closest to:
A 100.623
B 100.908
C 103.708
KEY = B
The Arbitrage-Free Valuation Framework, Steven V. Mann
Modular Level II, Vol. 5, Reading 36, Section 3.3
Study Session 12-36- d
Describe the backward induction valuation methodology and calculate the value of
a fixed-income instrument given its cash flow at each node.
B is correct. Because the bond is option-free and fixed rate, whatever the level of
interest rates at time 3, its cash flow will be par value plus the final coupon rate, or 102.8.
Therefore, using backward induction, its value at the three nodes at time 2 will be
102.8 102.8
vu ,u = 0.5 × + + 2.8 = 101.117
1.0456 1.0456
102.8 102.8
vu ,d = vd ,u = 0.5 × + + 2.8 = 102.172 , and
1.0345 1.0345
102.8 102.8
vd ,d = 0.5 × + + 2.8 = 102.995
1.0260 1.0260
Its value at the two nodes at time 1 will be
101.117 102.172
vu = 0.5 × + + 2.8 = 101.628 and
1.0285 1.0285
2017 Level II Mock Exam PM 33
102.172 102.995
vd = 0.5 × + + 2.8 = 103.215
1.0216 1.0216
101.628 103.215
Finally, its value at time 0 is v = 0.5 × + = 100.908 .
1.0150 1.0150
KEY = C
The Arbitrage-Free Valuation Framework, Steven V. Mann
Modular Level II, Vol. 5, Reading 36, Section 3.6
Study Session 12-36- g
Describe path-wise valuation in a binomial interest rate framework and calculate the
value of a fixed-income instrument given its cash flows along each path.
C is correct. Valuing a 4-year bond requires 23 = 8 interest rate paths. The discount
rate for cash flows occurring in the first period is known with certainty and forms the
base of the interest rate tree. The one-year forward rates for one, two, and three years
from now are unknown and described by the branches of the tree. For a 1-year tree, the
choices from time 0 are u or d, where u indicates interest rates going up and d indicates
interest rates going down. For a 2-year tree, interest rates can increase or decrease from
where they are after one year, so there are 2 × 2 = 22 = 4 paths or uu, ud, du, and dd. In
general, the number of paths is 2N, where N is the number of periods. For the 3-year tree,
the possible paths from time 0 are uuu, uud, udu, udd, duu, dud, ddu, and ddd.
42 Of the three differences Maalouf describes between the binomial tree approach
to fixed-income valuation and the Monte Carlo simulation approach, he is least
likely correct regarding:
A Difference 3.
B Difference 2.
C Difference 1.
KEY = C
The Arbitrage-Free Valuation Framework, Steven V. Mann
2016 Modular Level II, Vol. 5, Reading 36, Section 4
Study Session 12-36-h
Describe a Monte Carlo forward-rate simulation and its application.
C is correct. A Monte Carlo forward rate simulation randomly generates a large num-
ber of interest rate paths that will correctly value benchmark bonds only by chance. A
fixed amount, known as a drift term, is added to every forward interest rate on every
simulated path to calibrate the simulation so that the values estimated for benchmark
bonds equal their market prices.
34 2017 Level II Mock Exam PM
Messer explains, “Of course, with the index moving down 10% in the last twelve
months, the payoffs with these options could have been replicated without using
options.” Szillat responds, “My understanding is that the payoff would have been the
same as the call option if you had purchased 0.5697 index units and lent EUR 356.79
at the 1-year interest rate.”
Messer continues, “Twelve months ago, I noted that 2-year puts with a strike price
of EUR 750 cost EUR 38.48. Using the information in Exhibit 1 and today’s index value,
the binomial valuation model calculates the current price of the put as EUR 80.15. It
is actually trading now above that price at EUR 92.
Szillat responds, “I am curious whether you also use the Black–Scholes–Merton
(BSM) model for valuation. I understand the BSM and binomial models both have
the following three assumptions in common:
Assumption 1 Trading is possible at every instant.
Assumption 2 Volatility can be predicted with certainty.
Assumption 3 The annualized returns on the underlying follow a normal
distribution.
Szillat then asks, “How do you utilize the BSM model?”
2017 Level II Mock Exam PM 35
Messer answers, “We use the BSM model to calculate estimates on a wide array
of comparative option variables, such as how much the option value will change for
a change in a particular parameter. For example, we can estimate how the rate of
change of an option price speeds up or slows down for a given change in the price of
the underlying index.”
Messer concludes, “We also use the BSM model to calculate the implied volatility.
The implied volatilities of the index options expiring in one year are shown in Exhibit 2.”
700 18.71
710 17.98
720 17.38
730 16.69
740 15.83
750 15.40
760 14.50
770 14.03
780 13.21
790 12.11
800 11.09
43 Using the binomial valuation method and the data in Exhibit 1, the price
Messer paid one year ago for the call option with a strike price of EUR750 is
closest to:
A EUR 51.54.
B EUR 47.57.
C EUR 102.08.
KEY = A
Valuation of Contingent Claims, Robert Brooks and David Gentle
Modular Level II, Reading 41, Section 3.2
Study Session 14- 41-b
Calculate the no-arbitrage values of European and American options using a two-
period binomial model.
A is correct. The price of the call option at time 0 was EUR 51.5363. The following is
the two-step binomial tree:
36 2017 Level II Mock Exam PM
Item Value
Underlying 952.20
Item Value Call 202.20
Underlying 828
Call 102.0816
44 With respect to his assessment of replicating the option payoff, Szillat is least
likely correct about:
A lending EUR 356.79.
B using the one-year interest rate.
C purchasing 0.5697 index units.
KEY = A
Valuation of Contingent Claims, Robert Brooks and David Gentle
Modular Level II, Reading 41, Section 3.1
Study Session 14- 41-a
Describe and interpret the binomial option valuation model and its component terms.
A is correct. Szillat is incorrect in his method of replicating the call option. It can be
replicated by purchasing the amount of the underlying shares designated by the hedge
ratio and then borrowing (not lending) an amount equal to the present value of ((hedge
ratio × S –) + c–) or
(1 ÷ 1.03) × ((0.5671 × 648) + 0) = 356.79.
45 Does the put option with a strike price of EUR 750 currently offer an arbitrage
opportunity?
A No, because the market has bid up the price of the put.
B No, because the put is deep in the money.
C Yes.
KEY = C
Valuation of Contingent Claims, Robert Brooks and David Gentle
Modular Level II, Reading 41, Section 3.2
Study Session 14- 41-c
Identify an arbitrage opportunity involving options and describe the related arbitrage.
C is correct. An arbitrage opportunity does exist. The underlying index has fallen 10%
to 648, and the exercise value of the American style index option with a strike price of
750 is 102. If the option costs less than 102, the holder has an arbitrage opportunity in
purchasing and exercising the option and simultaneously purchasing the underlying.
2017 Level II Mock Exam PM 37
KEY = B
Valuation of Contingent Claims, Robert Brooks and David Gentle
Modular Level II, Reading 41, Section 4.2
Study Session 14- 41- g
Identify assumptions of the Black–Scholes–Merton option valuation model.
B is correct. Assumption 3 is not consistent with the BSM model.
47 In describing how call option prices change, Messer is most likely referring to:
A delta.
B vega.
C gamma.
KEY = C
Valuation of Contingent Claims, Robert Brooks and David Gentle
Modular Level II, Reading 41, Section 6.2
Study Session 14- 41-l
Interpret each of the option Greeks.
C is correct. Gamma is the change in delta, or the change in the rate of change.
48 Which of the following would Messer most likely conclude from the implied
volatility data in Exhibit 2, if he excludes the effects of moneyness and time to
expiration?
A Using out-of-the-money options to hedge is more expensive than establish- Hedge using put
ing a long position with out-of-the-money options. Long position refer to long call
KEY = A
Valuation of Contingent Claims by Robert Brooks and David Gentle
Modular Level II, Reading 41, Section 6.6
Study Session 14- 41- o
Define implied volatility and explain how it is used in options trading.
A is correct. Out-of-the-money puts will be more expensive than out-of-the-money
calls, since implied volatility is higher for lower strike prices.
38 2017 Level II Mock Exam PM
Moreno continues, “One of Wabash’s oldest clients, Fond du Lac, has been in
business for over 100 years and has developed sophisticated pricing models. Currently
their models predict that the price of corn is poised to more than double in the next
six months. Fond du Lac has purchased a large amount of corn in the spot market
and has taken delivery at its storage facilities. When the price increase occurs, they
intend to sell the corn in the spot market.”
Moreno asks Gorski to help her prepare a market overview to include in all client
presentations. Gorski collects the spot and futures prices of three commodities.
2017 Level II Mock Exam PM 39
KEY = C
Commodities and Commodity Derivatives: An Introduction, David Burkart and James
Alan Finnegan
Modular Level II, Vol. 6, Reading 46, Section 2.3
Study Session 15- 46-c
Contrast the valuation of commodities with the valuation of equities and bonds.
C is correct. Equities represent financial assets, whereas commodities are almost
always physical assets (the exception being newer classes of commodities, such as
electricity or weather).
KEY = B
Commodities and Commodity Derivatives: An Introduction, David Burkart and James
Alan Finnegan
Modular Level II, Vol. 6, Reading 46, Section 2.1
Study Session 15- 46-a
Compare characteristics of commodity sectors.
B is correct. Because energy production is often located in coastal zones, it can be
susceptible to severe weather conditions, such as hurricanes. In addition, energy demand
is seasonal, with gasoline consumption rising in summer months, and fuel oil consumption
increasing in cold weather. All of the commodities mentioned (energy, metals, grains,
and livestock) can be stored, although in the case of livestock, only for a short period.
Livestock is highly perishable.
51 The total return for the Platte River Foods hedge position is closest to:
A 5.5%.
B 5.7%.
V 5.3%.
40 2017 Level II Mock Exam PM
KEY = B
Commodities and Commodity Derivatives: An Introduction, David Burkart and James
Alan Finnegan
Modular Level II, Vol. 6, Reading 46, Section 3.3.2
Study Session 15- 46- g
Describe, calculate, and interpret the components of total return for a fully collater-
alized commodity futures contract.
B is correct, because total return is the sum of the price return, the roll return, and
the collateral return. Total return = 4.0% +1.5% + 0.2% = 5.7%.
52 In order to roll forward Platte River Foods’s current exposure and maintain its
dollar value, Moreno would:
A buy 2,000 near-term contracts and sell 3,000 of the longer-term contracts.
B sell 2,000 near-term contracts and buy 2,000 of the longer-term contracts.
C sell 2,000 near-term contracts and buy 3,000 of the longer-term contracts.
KEY = C
Commodities and Commodity Derivatives: An Introduction, David Burkart and James
Alan Finnegan
Modular Level II, Vol. 6, Reading 46, Section 3.3.2
Study Session 15- 46- g
Describe, calculate, and interpret the components of total return for a fully collater-
alized commodity futures contract.
C is correct. In order to maintain the $1,500,000 exposure to the commodity, Moreno
would need to sell the current contracts and purchase enough contracts to maintain the
$1,500,000 exposure. The $1.5 million exposure represents 2,000 near-term contracts
($1,500,000 ÷ $750 = 2,000 contracts). In turn, Moreno would need to purchase 3,000
contracts at $500 ($1,500,000 ÷ $500 = 3,000 contracts).
KEY = B
Commodities and Commodity Derivatives: An Introduction, David Burkart and James
Alan Finnegan
Modular Level II, Vol. 6, Reading 46, Section 3.1.2
Study Session 15- 46-d
Describe the different types of participants in commodity futures markets.
B is correct. Arbitrageurs have the ability to inventory physical commodities and can
capitalize on mispricing between the commodity (along with storage and financing cost)
versus the futures price by purchasing the commodity in the spot market and holding
it in storage until a future date.
KEY = C
Commodities and Commodity Derivatives: An Introduction, David Burkart and James
Alan Finnegan
Modular Level II, Vol. 6, Reading 46, Section 3.2
Study Session 15- 46-e
Analyze the relationship between spot prices and expected futures prices in markets
in contango and markets in backwardation.
C is correct. Spot prices for corn are lower than its futures prices. When the spot price
of a commodity is lower than its futures prices, the situation is called contango.
Alexander then asks Jun Lee, a senior risk analyst in the group, to explain to
Woolridge how Citadel employs scenario risk measures. Lee explains, “Scenario anal-
ysis complements VaR because it can better account for market liquidity. However,
a limitation of scenario analysis is that it has a greater reliance on historical market
data than does VaR.”
Lee then explains how the risk exposures of option positions may increase or
decrease overall portfolio risk. Lee and Woolridge discuss delta, gamma, and vega
as option sensitivity measures. Woolridge summarizes what she has learned to make
sure she has understood correctly: “Delta measures the sensitivity of an option to the
42 2017 Level II Mock Exam PM
price of the underlying security and ranges from –0.5 to +0.5. Gamma is a second-
order effect that measures the sensitivity of delta to price changes in the underlying.
Vega is a first-order effect that measures the change in the volatility of an option to
the change in price of the underlying.”
Alexander receives a call from Sandra Patterson, Citadel’s CEO. Patterson expresses
her concern that the firm’s $500 million multi-asset fund has failed to protect investors
during a recent market decline. Alexander drafts an updated risk management policy
to present to the investment committee. The goal of this policy is to ensure that the
fund limits the likelihood of severe downside losses for investors.
“The multi-asset fund has a 5-day, 1% VaR limit of $10 million, and the fund
will undertake hedging activities, including the purchase of protective put
options, if its cumulative 30-day loss ever exceeds $15 million. In addition,
the magnitude of the hedge shall be designed to increase as losses increase.”
Following the investment committee’s approval, Patterson references the updated
risk management policy in her quarterly letter to investors. She states: “At Citadel, we
take risk management very seriously. In response to recent investor concerns about
volatility in our multi-asset fund, we have implemented a new policy. We limit fund
losses to 2% of assets with a 99% level of confidence, with additional measures to limit
total losses to 3% over a rolling 30-day period.”
55 Woolridge’s comments on the advantages of VaR are most likely correct
regarding:
A downside exposure.
B performance evaluation.
C subjectivity.
KEY = B
Measuring and Managing Market Risk, Don M. Chance and Michelle McCarthy
Modular Level II, Vol. 6, Reading 49, Section 2.3
Study Session 16- 49-d
Describe the advantages and limitations of VaR.
B is correct. VaR can be used as the basis for risk adjustment of returns, which is
required in performance evaluation. VaR is not a worst case scenario, and losses can and
will exceed VaR. VaR does rely on subjective inputs such as the desired VaR cutoff, over
what time horizon VaR will be measured, and the estimation method.
56 Using the inputs in Exhibit 1, Woolridge’s estimate of VaR is most likely closest
to:
A $6.5 million.
B $18.9 million.
C $10.5 million.
KEY = C
Measuring and Managing Market Risk, Don M. Chance and Michelle McCarthy
Modular Level 2, Vol. 6, Reading 49, Section 2.2
Study Session 16- 49-c
Estimate and interpret VaR under the parametric, historical simulation, and Monte
Carlo simulation methods
C is correct.
2017 Level II Mock Exam PM 43
KEY = B
Measuring and Managing Market Risk, Don M. Chance and Michelle McCarthy
Modular Level 2, Vol. 6, Reading 49, Section 3.3
Study Session 16-49-f, i
Describe sensitivity risk measures and scenario risk measures, and compare these
measures to VaR
Describe advantages and limitations of sensitivity risk measures and scenario risk
measures
B is correct. Since scenario analysis does not need to rely on history, it can be free
of the volatility and correlation behavior of recent market history, which may not be
representative of market conditions.
KEY = C
Measuring and Managing Market Risk, Don M. Chance and Michelle McCarthy
Modular Level 2, Vol. 6, Reading 49, Section 3.1
Study Session 16- 49- g
Demonstrate how equity, fixed income, and options exposure measures may be used
in measuring and managing market risk and volatility risk
C is correct. Gamma is a second-order effect which measures the sensitivity of delta
to price changes in the underlying.
59 Alexander’s risk management policy for the multi-asset fund is least likely an
example of:
A stop-loss limits.
B risk budgeting.
44 2017 Level II Mock Exam PM
C scenario limits.
KEY = C
Measuring and Managing Market Risk, Don M. Chance and Michelle McCarthy
Modular Level 2, Vol. 6, Reading 49, Section 5.1–5.3
Study Session 16- 49-k
Explain constraints used in managing market risks, including risk budgeting, position
limits, scenario limits, and stop-loss limits
C is correct. Alexander’s policy does not incorporate scenario limits, which establishes
a limit on the estimated loss for a given scenario, which if exceeded, would require
corrective action in the portfolio. An example of a scenario limit would be to create a
policy that describes an action to take if interest rates increased by 100 basis points.
The 5-day, 1% VaR limit of $10 million is an example of risk budgeting. The initiation of
hedges above a certain loss level is an alternative form of a stop-loss limit called draw-
down control or portfolio insurance.
60 Patterson’s comments to Citadel’s investors are least likely accurate with regard
to her:
A use of confidence levels.
B discussion of limiting losses.
C implied percentage declines from dollar VaR limits.
KEY = B
Measuring and Managing Market Risk, Don M. Chance and Michelle McCarthy
Modular Level 2, Vol. 6, Reading 49, Section 2.1
Study Session 16- 49-a
Explain the use of value at risk (VaR) in measuring portfolio risk.
B is correct. VaR is an expression of a minimum loss. It is incorrect for Patterson to
state that the policy will limit fund losses to 2% ($10 million ÷ $500 million) over a 5-day
period. In practice, the maximum loss possible in an unleveraged portfolio is the entire
value of the portfolio.