2021 CFA Level II Mock Exam – AM Session

Alan Watson Case Study

Alan Watson is a Level II CFA candidate. In addition to studying the
curriculum independently, he and several of his coworkers have formed a
study group that uses many of the resources provided by CFA Institute to
prepare for the exam. They meet every Monday to review the previous week’s
study materials and discuss items needing further clarification.
This week’s reading is the CFA Institute Standards of Professional
Conduct. After studying the Standards, Watson answers the topic questions
offered by CFA Institute. He notes three scenarios he wants to
clarify with the group.

Watson brings up the first scenario and lays out the following facts given:
A research analyst makes a presentation to a small group of investors. Prior to
the start of the meeting, the analyst chatted with several individuals outside
the meeting room. The analyst commented that she had just gotten off the
phone with the CFO of a company she follows where they talked about a
recently announced merger by a competitor. The analyst starts
the presentation and discusses her research process and her
published investment recommendations on the companies under her
coverage. She mentions her call with the CFO as well as the comments she
made during an interview on a major television network relating to the merger.

In the second scenario, Watson states, “I'm really struggling to

understand the following two recommendations and question if they apply to
Standard I(B): Independence and Objectivity:

Recommendation 1: Firms should require prior approval for employees

participating in initial public offerings.
Recommendation 2: Firms should implement effective supervisory and review
procedures to ensure compliance with personal investment policies.”

The final scenario he wants to discuss with the group has to do with
policy recommendations made by a firm’s chief compliance officer regarding
communication with clients and prospective clients. The officer provided her
firm’s board the following policies for approval:

Policy 1: When discussing earnings estimates, caution should be exercised to

avoid overconfidence regarding the accuracy of the earnings model.

Policy 2: If a capsule or condensed form of a recommendation is

utilized in social media communications, reasonable efforts should be
made to notify all clients about the social media post.

Policy 3: Significant changes in risk characteristics for either a security or asset

strategy should be communicated to all clients.

During their gathering, Watson and his coworkers also discuss how they
could unintentionally violate Standard VII: Responsibilities as a CFA Institute
Member or CFA Candidate. The group affirms their commitment to the high
ethical standards of CFA Institute and talks about how a violation might
occur. They make the following pledges to help each other stay in compliance
with Standard VII following the exam:

Pledge 1: Abstain from making any comments about the curriculum on social
media.

Pledge 2: Refrain from expressing negative comments about the CFA Program.

Pledge 3: Avoid discussing the particulars of the topic areas tested with each
other.

In the first scenario Watson discusses, did the research analyst most
likely violate any CFA Institute Standards of Professional Conduct?
1.
A. No.

B. Yes, with regard to the presentation.

C. Yes, with regard to the discussion prior to the presentation.

2.
Do the recommendations Watson outlines in the second scenario most
likely apply to Standard I(B): Independence and Objectivity?

A. Yes.

B. No, with regard to Recommendation 1.

C. No, with regard to Recommendation 2.

3.
In the third scenario, which policy presented by the chief compliance officer
would least likely be fully compliant with Standard V: Investment
Analysis, Recommendations, and Actions?

A. Policy 1

B. Policy 2

C. Policy 3

4.
Which of the study group’s pledges would most likely be required to ensure
compliance with Standard VII: Responsibilities as a CFA Institute
Member or CFA Candidate?

A. Pledge 1

B. Pledge 2
 C. Pledge 3

Rebecca Matheson Case Scenario

Rebecca Matheson, CFA, is the chief compliance officer for AM&C
Partners (AM&C), a midsize investment management firm managing equities.
AM&C recently terminated Thorsten LaRue, CFA, for multiple violations of firm
policies that included violations of the CFA Institute Code of Ethics and
Standards of Professional Conduct (hereafter CFA Standards of Professional
Conduct). Matheson composed an email to file a complaint against LaRue with
the Professional Conduct Program (PCP) of the CFA Institute. Her email
outlines LaRue’s actions as follows:

1. LaRue was an assistant trader and worked closely with the firm’s head
trader. Together, they executed trades for the firm’s equity portfolios that
ranged across the market capitalization spectrum. LaRue specialized in
executing trades for the firm’s small-cap products and was instrumental in
implementing several technology-based trading platforms. He was excited
about his position and often talked with his cousin Brooke Montgomery about
his job as well as the companies and trades being executed. It was later
discovered his cousin was trading in the equities LaRue discussed with
Matheson, without his knowledge. The firm did not receive copies of
Montgomery’s brokerage statements.

2. LaRue was often involved in new client presentations to explain the

different trading technologies utilized by the trading department. During such
a meeting, a potential client talked about using a directed brokerage
arrangement. They explained they had not yet decided on a broker and asked if
the traders had any recommendation. LaRue talked about the advantages and
disadvantages of such an arrangement and mentioned how several of AM&C’s
clients used Robinson & Robinson (R&R). He also talked about how R&R was
committed to professional development, and they had sponsored his full
attendance at a three-day conference held at an exclusive winter resort.
 3. Another incident was discovered by one of our portfolio managers who
is a member of a large online investment club. The manager noticed a new
member of the group continually talked about the small-cap stocks AM&C was
actively trading and his arguments went against the firm’s recommendations.
The manager notified me, and after several weeks of investigation, we
determined that LaRue was the individual discussing the companies the firm
was trading. After outlining this last item, Matheson drafted the following
polices to prevent and detect this type of violation going forward:

Policy 1: Membership in online investment clubs is permissible but must be

reported to the Compliance Department before joining.

Policy 2: When it is discovered that a membership has not been reported,

increase supervision on the employee who failed to report.

Policy 3: Send periodic reminders regarding investment club membership to

those employees who failed to report and outline permissible conduct.

Matheson completed the email and sent it as well as the evidence she
had gathered to the appropriate email address at the CFA Institute. She then
met with AM&C’s CEO to update him about the complaint and discuss what
she should do next. He made the following recommendations:

Recommendation 1: Consult with the firm’s securities attorney.

Recommendation 2: Wait for the PCP to provide her with additional

information.

Recommendation 3: Inform the local CFA Society about the complaint.

1.
As described in point 1 of the email, which CFA Standards of Professional
Conduct has LaRue least likely violated?

A. Standard III, Duties to Clients

 B. Standard VI, Conflicts of Interest

C. Standard II, Integrity of Capital Markets

2.
In point 2 of the email, did LaRue most likely indicate any violation of CFA
Standards of Professional Conduct during the new client presentation
meeting?

A. No.

B. Yes, with regards to Standard I, Professionalism.

C. Yes, with regards to Standard VI, Conflicts of Interest.

3.
In point 3 of the email, which of the policies Matheson drafted is most likely
insufficient to prevent a violation of CFA Standards of Professional
Conduct?

A. Policy 1

B. Policy 2

C. Policy 3

4.
Which of the CEO’s recommendations regarding what Matheson should do next
is her best course of action to avoid violating any CFA Standards of
Professional Conduct?

A. Recommendation 1

B. Recommendation 2

C. Recommendation 3
DeMolay Case Scenario
Eduardo DeMolay, a research analyst at Mumbai Securities, is studying
the time-series behavior of price-to-earnings ratios (P/Es) computed with
trailing 12-month earnings (Etrailing). He and his assistant, Deepa Kamini, are
reviewing the results of the ordinary least squares time series regression shown
in Exhibit 1.

Exhibit 1 Results of Regression of P/E on Lagged P/E (P/Et = b0 + b1P/Et–1

+ ε t)

Standard Significance
Coefficient Error t of t

Constant (b0) 0.143 0.153 0.935 0.176

Lagged P/E (b1) 0.991 0.003 292.958 0

Standard Error of Significance of

R2 the Estimate Durbin–Watson F F

0.075 1.48978 2.094 130.066 0

DeMolay states: “This regression is a special case of a first-order

autoregressive [AR(1)] model in which the value for b0 is close to zero and the
value of b1 is close to 1. These values suggest that the time series is a random
walk.”

Kamini replies: “I’m convinced the P/E series based on trailing earnings
truly is a random walk.”

Kamini and DeMolay next examine the behavior of P/Es calculated using
forward 12-month earnings (Eforward). Kamini estimates another AR(1) model but
uses the forward P/E values this time. She denotes the errors from this second
regression as ηt. She states: “The presence of first-order autoregressive
conditional heteroskedasticity [ARCH(1)] errors in this regression is highly
likely given the results reported in Exhibit 2.”
Exhibit 2 Results of Regression of Squared Residuals, ηt2 , on Lagged
Squared Residuals, ηt2−1

(ηt2 = c0 + c1ηt2−1 + ut )
Standard Significance
Coefficient Error t of t

Constant (c0) 0.339 0.039 8.768 0

Lag 1 (c1) 0.273 0.024 11.405 0

Standard Error Durbin– Significance

R2 of the Estimate Watson F of F

0.075 1.48978 2.094 130.066 0

After further discussion, DeMolay proposes that he and Kamini

incorporate more variables into the analysis. He suggests they use a variation
of the Fed model, in which the earnings-to-price ratio (E/P) is regressed on
long-term interest rates.

DeMolay cautions Kamini: “Remember that when we analyze two time

series in regression analysis, we need to ensure that

1) neither the dependent variable series nor the independent variable series
has a unit root, or

2) that both series have a unit root and are not cointegrated.

Unless Condition 1 or Condition 2 holds, we cannot rely on the validity of

the estimated regression coefficients.”

1.
DeMolay’s statement that the coefficients depicted in Exhibit 1 are consistent
with a random walk is most likely:

A. correct.
 B. incorrect because b1 should be close to 0.

C. incorrect because b0 should be close to 1.

2.
If Kamini is correct regarding the trailing P/E time series, the best forecast of
next period’s trailing P/E is most likely to be the:

A. current period’s trailing P/E.

B. forecast derived from applying the AR(1) model depicted in Exhibit 1 to

the data.

C. average P/E of the time series.

3.
The results depicted in Exhibit 2 are best described as consistent with a
regression that has ARCH(1) errors because:

A. c1 is significantly different from 0.

B. c1 is significantly different from 1.

C. c0 is significantly different from 0.

4.
Based on the results depicted in Exhibit 2, DeMolay and Kamini should most
likely model the forward P/E data using a(n):

A. generalized least squares model.

B. AR(1) model.

C. random walk model.

5.
DeMolay’s caution given in Condition 1 is best described as:

A. correct.

B. incorrect because only the independent variable series needs to be

tested for the absence of a unit root.

C. incorrect because only the dependent variable series needs to be

tested for the absence of a unit root.

6.
DeMolay’s caution given in Condition 2 is best described as:

A. incorrect because if both series have unit roots, they must exhibit
cointegration for the results of the regression to be valid.

B. incorrect because the regression results are valid whether

cointegration exists or does not exist.

Galaxy Case Scenario

Bogdan Andrei, an independent equity analyst, is working on his
analysis of Galaxy Electronics Ltd. Galaxy is a manufacturer and distributor of
foldable smartphones that focus on security, encryption, and identity
protection. The company prepares its financial statements in accordance with
US GAAP. From its inception in 2009, the company grew rapidly to 2013, but
in early 2014 sales growth slowed significantly. Andrei is reviewing recent
changes in the company’s financial reporting to assess the company’s quality of
financial reporting and earnings.

Andrei starts with the notes he made following an update issued by

Nadeen Bhatty, Galaxy’s vice president of finance, on financial reporting
changes Galaxy implemented in 2014.
• Galaxy produces its smart phones based on orders received. A 25% deposit is
required for all orders, and then Galaxy manufactures and usually ships
the units in two to four weeks. Some orders are placed even further in
advance, and some shipments may not occur for up to two months
following an order. Galaxy had been recording a sale when the product
was shipped, but under Bhatty’s revised policy, the revenue recognition
point now occurs when the deposit is received. “If the products are made
to order, then the critical event is the receipt of the order,” she had
explained.

• As of 31 August 2014, Galaxy received deposits of $3 million for orders yet to

be shipped.

Andrei compares the descriptions of warranty expenses from the 2013

and 2014 management discussion and analysis (MD&A), shown in Exhibit 1,
and observes that similar information is included among the notes to the
financial statements.

Exhibit 1 Excerpts from Galaxy’s MD&A ($ thousands)

2013 Warranties 2014 Warranties

• The company provides a one-year • The company provides a one-year

warranty on its products and warranty on its products. After
records it as a selling and five years of experience the
administrative expense at company has realized that the
the time of sale. The 2013 actual claims experience has
warranty expense recognized been less than the amounts
is $5,000 accrued and has revised our
warranty estimation rate.

• The company also believes its

production process has become
very reliable. Therefore, in 2014
 warranty expense ($2,000) is
included in non-operating
expenses.

Andrei next reviews the comparative financial information for Galaxy in

Exhibit 2

Exhibit 2 Galaxy Electronics Ltd. (US$ thousands)

Condensed Income Statement Year Ended 31 August

2014 2013 2012

Sales $100,000 $95,000 $65,000

Gross profit 53,000 47,500 31,200

Operating expenses 32,000 38,000 28,000

Non-operating expenses 4,400 2,700 3,000

Earnings before taxes 16,600 6,800 200

Net Income $11,122 $4,556 $134

Excerpts from Galaxy’s Balance Sheet, 31 August

2014 2013

Assets

Cash and investments $21,122 $25,000

Accounts receivable 25,000 13,500

Inventories 9,000 6,500

Prepaids and deferrals 4,000 2,000

Total current assets $59,122 $47,000

Total Assets $131,122 $127,000

Liabilities

Accounts payable $15,000 $11,000

Unearned revenue 4,000

Warranty provision 2,000 4,000

Current portion of long term debt 5,000 5,000

Total current liabilities $22,000 $24,000

Long term debt 35,000 40,000

Total liabilities $57,000 $64,000

Andrei prepares a Beneish Model analysis, shown in Exhibit 3, to assess

the likelihood that Galaxy is manipulating its earnings. He recalls that an M-
score of –1.78 corresponds to a probability of earnings manipulation of 3.8%.

Exhibit 3 Galaxy 2014 Beneish Model M-Score Determination

Value of Beneish Model
Variable Name Variable Variable Coefficient Contribution

Days sales in receivables index DSRI 1.759 0.92 1.619

Gross margin index GMI 0.943 0.528 0.498

Asset quality index AQI 0.814 0.404 0.329

Sales growth index SGI 1.053 0.892 0.939

Depreciation index DEPI 0.932 0.115 0.107

Sales, general, and SGAI 0.95 –0.172 –0.163
administrative expenses index

Accruals Accruals 0.107 4.67 0.499

Leverage index LEVI 0.861 –3.270 –2.815

Intercept –4.840

M-score –3.83

Finally, Andrei reviews his notes on Galaxy’s executive compensation.

Since 2011, annual executive compensation has included stock options on the
company’s stock. On 1 September 2014, the company introduced a restricted
stock grant program for all non-executive employees who had worked at the
company for three years or more:

• The fair value of the company’s stock at the grant date was $4.2 million.

• For the shares to vest, it requires a three-year service period—that is, the
employee has to remain with the company for another three years.

The average volatility of the company’s stock had been in the range of
38%–42% during 2009–2011, but since 2012, it has declined to the 19%–24%
range.

1.
Which of the following is most likely a warning sign of deteriorating earnings
quality? The new policy relating to:

A. warranty expenses.

B. compensation using stock grants.

C. revenue recognition.

2.
The amount that the new revenue recognition policy contributed to gross profit
in fiscal 2014 ($ millions) is closest to:

A. 4.8.

B. 1.6.

C. 6.4.

3.
The best conclusion Andrei can make about the classification of warranty
expenses in 2014 is that Galaxy’s:

A. earnings quality is lower.

B. financial reporting quality is lower.

C. return on sales is improved.

4.
Which of the following from Andrei’s Beneish M-score determination is the best
indicator that Galaxy could be manipulating earnings?

A. The total M-score

B. The days sales in receivable index

C. The leverage index

5.
The fiscal year 2015 stock-based compensation expense from the stock grant
program will be closest to:

A. 1.4 million.

B. 4.2 million.
 C. 0.

6.
If the recent changes in the volatility of the company’s stock persist, it will most
likely affect the company’s compensation expense for:

A. executives only.

B. non-executive employees only.

C. both non-executive employees and executives.

Compañia Mineras Cóndores Case Scenario

Rubén Díaz is a finance director working at the Santiago office of
Compañia Mineras Condores (CMC), a mining company with copper operations
in several South American countries. Díaz is reviewing several project
proposals that are under consideration at CMC.

He first looks at his file on Project Russet. In this project, CMC is

considering some new technology that will enable it to extract high copper
yields from an otherwise inaccessible deposit in the Atacama Desert. The extra
costs of the specialized technology place the project in CMC’s Tier 3 category.
Tier 3 projects are activated only if the price of copper is above US$2.75/pound
and is expected to remain at that level for the duration of the project.

The deposit will be fully depleted after four years. At that point, the
CLP$36 billion of customized equipment will be scrapped. Díaz prepares the
information in Exhibit 1 based on a long-term copper price forecast, which is
well above US$2.75/pound.

Exhibit 1: Key Project Information for Project Russet

(CLP$
billions
 except tax
rate)

Annual operating income before tax

(including annual, straight-line 13
depreciation* of 9)
Required investment in 36
equipment/technology

Initial investment in working capital 5

Tax rate 24%

* Depreciation is the same for accounting and tax

purposes.

He further estimates that the project’s upfront investment in working

capital will be fully recovered after the deposit is depleted in four years. He
decides to calculate the net present value (NPV) for the project using a required
rate of return of 18%.

Díaz then turns to Project Chestnut, an existing but idle mine site within
a country that has faced persistent political unrest over the past decade. As a
result of the political unrest, Díaz estimates a project beta (β) of 2.20 if CMC
goes ahead. CMC has negotiated a limited term contract with the government
to update the infrastructure and operate the mine while employing hundreds of
local residents. As debt financing is not available for this country, the operation
would be run through a wholly owned local subsidiary that is 100% equity
financed.

Díaz has gathered some industry and company data to support the
analysis of Project Chestnut, as shown in Exhibit 2. He decides to calculate a
risk-adjusted hurdle rate for the project using the capital asset pricing model
(CAPM).

Exhibit 2: Selected Information for Project Chestnut

 Risk-free rate of return 4.5%

Expected market return for mining 14%

sector

Beta ( β ) for CMC (unlevered) 1.36

The CEO is confident that Project Chestnut will be approved and would
like to feature it at the upcoming annual general meeting (AGM) for
shareholders. Díaz reviews the Project Chestnut analysis in the draft
presentation: it includes a distribution of the project NPVs that was generated
by specifying pessimistic and optimistic boundaries for each of the key project
variables. The distribution shows, with 90% confidence, that the actual NPV
will fall between –CLP$400 million and CLP$12.3 billion.

1.
The conditions associated with Project Russet’s classification as a Tier 3 project
are best described as an example of a/an:

A. price-setting option.

B. fundamental option.

C. abandonment option.

2.
The NPV (in CLP$ billions) for Project Russet is closest to:

A. 9.79.

B. 12.37.

C. 20.76.

3.
The most appropriate hurdle rate for the analysis of Project Chestnut is:
 A. 17.4%.

B. 20.9%.

C. 25.4%.

4.
The Project Chestnut analysis within the draft AGM presentation is most likely
an example of:

A. scenario analysis.

B. sensitivity analysis.

C. simulation analysis.

Jackson Case Scenario

D’Shaun Jackson, an individual do-it-yourself investor, is reviewing retail
companies for potential addition to his portfolio. The first company he
considers is Discount Days Ltd. (DDL) an up-and-coming regional competitor
in the dollar store segment. Jackson’s analysis shows that the company is
profitable and has strong positive operating cash flows. While the company is
working to expand the number of stores in its network, investing cash flows are
exceeding operating cash flows. To date, the company has not paid dividends,
but Jackson believes it will likely start once it has finished its expansion plans.
Jackson decides to use a dividend discount model to value the shares and
estimates that DDL will start paying an annual dividend of $0.50 per share at
the end of year 4 with a modest growth rate of 2% per year. He uses the capital
asset pricing model to estimate a cost of equity of 7.25%.

Next, Jackson looks at a stock that has caught his eye due to its high
current dividend and high growth rate. He summarizes the information he has
gathered about the stock (Exhibit 1). He expects the growth rate to decline
consistently over the next six years and decides to use the H-model to estimate
a value for the stock.

Exhibit 1: Information About High Growth Stock

Current dividend $2.00

Growth rate expected years 8%

1–6

Growth rate expected after 4%

year 6

Required rate of return 12%

Jackson has been researching how to value shares using a dividend

growth model if the transition from one growth rate to a lower one is gradual.
In that scenario, he understands he would use the H-model to evaluate the
shares. If, however, the difference in growth rates is large, or the length of the
high growth rate is extraordinarily long, then he would have to use a
spreadsheet model instead.

1.
Which of the following factors would make the model Jackson selects to value
DDL’s shares the most appropriate model to use?

A. Jackson has a noncontrol perspective.

B. The company has intense capital demands for the next few years.

C. The model considers Jackson’s opportunity cost of investing in the

stock.

2.
Based on Jackson’s estimates and his selected model for DDL, the current
share price is closest to:

A. $7.20.
 B. $7.72.

C. $8.17.

3.
Using Exhibit 1 and Jackson’s selected model for the high growth stock, the
value is closest to:

A. $29.00.

B. $30.00.

C. $32.00.

4.
Jackson’s understanding of when he would switch from an H-model to a
spreadsheet model is best described as:

A. correct.

B. incorrect with respect to the difference in growth rates.

C. incorrect with respect to the length of the first growth period.

Lumis Case Study

Lumis Ltd. is the registered investment adviser subsidiary of
the Lumis family office. Thomas Lutz, who oversees fixed-income investment
analysis for Lumis, seeks mispriced fixed-income securities in thinly traded
markets. Lutz is discussing fixed-income valuation concepts with junior
analyst Winston Fong and asks him to take notes.

Lutz explains: “The framework of the arbitrage-free value of a bond is

central to identifying opportunities in inefficient markets for our portfolio. I am
currently interested in developing market supranational debt, which is a part of
the debt market that has not yet gained a large investor following. The
International Economic Development Bank (IED Bank) has issued a four-year
infrastructure financing bond at par with a 6.90% coupon; both are collectively
backed by the member countries of the IED Bank.”

Fong states, “An arbitrage-free approach would discount each interest

payment to the present using the corresponding rate on the yield curve.
Therefore, in a positively sloped yield curve, the last interest coupon and
principal payments at maturity would be discounted at a rate equal to the
yield-to-maturity, while the discount rates applied to the annual interest
payments prior to maturity would be lower than the discount rate applied to
the cash flows occurring at maturity.”

Lutz continues: “IED Bank has also issued a three-year callable bond at
par. Callable bonds have cash flows that are not known in advance because
they change depending on the level of interest rates. A visual representation of
the values of future interest rates for use in valuing callable bonds can be
presented with a binomial interest rate tree. The binomial tree in Exhibit 1 is
incomplete; it is missing the interest rates at a few of its nodes. It is based on
the yield curve shown in Exhibit 2.

Exhibit 1. Binomial Interest Rate Tree

Exhibit 2. Benchmark Yields

Maturity Par Rate Spot Rate 1-Year Implied

(Years) Forward Rate

1 5.25% 5.25% 5.25% (current)

2 5.61% 5.62% 5.98%

3 6.31% 6.36% 7.83%

We use i0 to denote the current one-period rate used to discount T1 cash

flows back to T0. At T1, there are two potential interest rates, i1 H and i1 L,
representing the potential high rate if rates move up or the low rate if rates
move down. They are obtained by applying an interest rate model and an
assumption of the volatility of interest rates. Using a lognormal random walk,
we derive the three potential rates, i2 HH, i2 LL, and i2 HL, at T2. The i’s are known
as nodes of the tree, and the period between interest payments are time steps.
Our interest rate model is assuming i1 H will be 5.95%, i2 HH will be 6.75%, and
the volatility of rates will exhibit a standard deviation of 15% within a
lognormal tree structure.”

Fong begins to calculate the missing rates in the binomial tree

and adds the following to his notes while doing so: “Using this yield curve
information, i2 LL must be approximately 3.704%, must be close to 5.98% for
a three-year bond, and the value at i3 LLH is 100.”

Lutz concludes: “After calculating the rates at each node, we must

calibrate the rates within the interest rate tree to fit the current yield curve.
This is an iterative process, where we select trial rates based on our model and
raise or lower them until the rates match the term structure of the benchmark
yield curve. Please try this for the binomial tree using the benchmark yields in
Exhibit 2, starting with the trial rate for i1 H remaining at 5.95% and
the standard deviation at 15%.”

1.
Is Fong most likely correct in his assessment of the discount rates applied to
the interest and principal payments of the four-year infrastructure bond?

A. Yes.

B. No, he is incorrect with respect to the discount rate applied to the last
interest coupon and principal payment.

C. No, he is incorrect with respect to the discount rates applied to the

annual interest payments prior to maturity.

2.
Fong’s notes regarding the construction of the binomial interest rate
tree are least likely correct with respect to:

A. the value at i2LL.

B. the value at i2LH.

C. the value at i3LLH.

3.
If the binomial tree of the three-year IED Bank callable bond has node i2HH
= 6.75%, then the value of the bond according to the yield curve
in Exhibit 2 at i2HH is closest to:

A. 93.677.

B. 95.012.

C. 98.595.

4.
The trial rate Lutz suggests for calibrating the binomial tree is most likely:

A. too high.
 B. too low.

C. correct.

Matthew Riley Case Scenario

Matthew Riley is a managing director in the Derivatives Group at Stone
Ridge Capital Partners (SRCP). Riley specializes in advising clients on the use of
derivatives to manage portfolio management strategies. Riley is preparing to
meet with four of the firm’s clients: Kaeun Kim, Erin Cline, Rahul Mehta, and
Michael Mensah.

Three months ago (90 days), Kim purchased a bond with a 3% annual
coupon and a maturity date of seven years from the date of purchase. The bond
has a face value of US$1,000 and pays interest every 180 days from the date of
issue. Kim is concerned about a potential increase in interest rates over the
next year and has approached Riley for advice on how to use forward contracts
to manage this risk. Riley advises Kim to enter into a short position in a fixed-
income forward contract expiring in 360 days. The annualized risk-free rate
now is 1.5% per year and the price of the bond with accrued interest is
US$1,103.45.

One month ago (30 days), Cline entered a pay floating 3 × 6 forward rate
agreement (FRA) at a rate of 2.31% with a notional amount of US$5,000,000.
At the time, the three-month LIBOR was 1.28% and the six-month LIBOR was
1.8%. Now, 30 days after entering the FRA, two-month LIBOR is 1.5% and the
five-month LIBOR is 2.5%.

Mehta, who is based in Hong Kong SAR and requires a €25,000,000 one-
year bridge loan to fund operations in Germany. He wants to fund this loan at
a competitive rate. Riley advises Mehta to borrow in HK dollars and enter into a
one-year foreign currency swap to swap into euros. The current exchange rate
is HK$9.15 per euro. Exhibit 1 below provides Hong Kong and euro spot
interest rates and present value factors.
Exhibit 1: Hong Kong and Euro Spot Interest Rates

Days to HK Dollars HK Dollars Euro Euro Present

Maturity Present
Spot Interest Spot Interest Value
Rates (%) Value Rates (%)
Factors
Factors

90 0.610 0.9985 0.372 0.9991

180 0.765 0.9962 0.422 0.9979

270 0.850 0.9937 0.448 0.9967

360 0.935 0.9907 0.468 0.9953

Michael Mensah is based in Australia and entered into a one-year equity

swap 30 days ago. Under the terms of the swap, he would receive the return on
the S&P/ASX 300 Metals and Mining Index and pay a fixed annual interest
rate of 4.8% on a notional amount of AUD75,000,000. The swap payments are
quarterly. At the time the swap was initiated 30 days ago, the value of the
S&P/ASX 300 index was 3,250. Today, the value of the S&P/ASX 300 index is
3,738. Exhibit 2 provides present value factors based on the current Australian
terms structure of interest rates.

Exhibit 2: Present Value Factors Based on Current Australian Term

Structure

Days to Present
Maturity Value
Factors

60 0.9976

150 0.9924

240 0.9861

330 0.9696

1.
Based on a 360-day year, the price of the forward contract on the bond
purchased by Kim is closest to:

A. US$1,082.

B. US$1,090.

C. US$1,120.

2.
The current value of Cline’s FRA is closest to:

A. −US$10,625.

B. −US$10,515.

C. US$10,612.

3.
Based on the information in Exhibit 1, the annual fixed swap rate Mehta would
pay is closest to:

A. 0.48%.

B. 0.92%.

C. 1.88%.

4.
Based on the information in Exhibit 2, the market value of Mensah’s equity
swap is closest to:

A. AUD 7,665,000.

B. AUD 7,713,870.

C. AUD 9,993,870.
Rosse Case Study
Mary Rosse is the North American REIT analyst for Chatham Equity
Partners, a Canadian investment advisory firm based in Windsor that analyzes
public real estate globally. She is explaining Chatham’s investment process and
valuation criteria to Chatham’s new junior analyst, Gordon Annear.

Rosse explains to Annear: “We focus primarily on economic income and

current appraised market values minus liabilities as benchmarks when
selecting REITs for investment. I have started to look at Northeast Community
Properties (NECP), a newly listed US multifamily apartment REIT.”

Adjustments to NECP’s financial data at the end of last quarter are

summarized in Exhibits 1 and 2.

Exhibit 1: NECP Financial Data with Analyst Adjustments (in 000s US$)

Property cost 365,000

Property book value 289,250

Pro forma cash NOI for last 12

months 26,600

Estimated next 12 months

cash NOI 27,930

Assumed cap rate 6.50%

Estimated value of operating

real estate 430,000

Tangible assets 12,350

Estimated gross asset value 442,350

Total debt (and other

liabilities) 75,750

Other liabilities 35,335

Net asset value 331,265

Shares outstanding 6,335

 Market capitalization 304,226

Annear comments, “Some valuation approaches require a measure of

current economic income. I believe it is better to use adjusted funds from
operations for this than the more widely used funds from operations measure
because it takes into account maintenance and leasing expenses needed to
maintain the income stream and is less subject to error or variation in
estimation.”

Rosse continues: “I prefer to employ the following three factors for REIT
valuation.”

Factor 1: Capitalization rates,

Factor 2: Cash flow variability of properties, and

Factor 3: Year-ahead estimated funds from operations (FFO) and adjusted

funds from operations AFFOs.

Rosse then states: “We can also value REITs using the dividend discount
model. Yesterday the NECP share price closed at US$62.81.”

The data in Exhibit 2 can be used to calculate NECP’s fair value, using a
historical beta to the broader market of 0.9 and an equity risk premium of 4%
with the risk-free rate of 3%.

Exhibit 2: NECP Analyst Forecasts

in
Year 1 Year 2 Year 3 Year 4 Perpetuity

AFFO/share 3.13 3.38 3.57

Growth 8.1% 5.5% 3.0%

Dividends/share 2.54 2.58 2.67 2.745

Growth 8.0% 6.9% 3.0%

 Dividend payout on
AFFO 81.0% 81.0% 82.0% 80.0%

P/AFFO of peers 19 18.7 17.9

1.
Using the data in Exhibit 1, NECP’s net worth per share is closest to:

A. US$45.66.

B. US$48.02.

C. US$52.29.

2.
Is Annear most likely correct in his reasons for preferring adjusted funds from
operations as a measure of economic income?

A. Yes.

B. No, because he is incorrect about treatment of capital expenditures.

C. No, because he is incorrect about the potential for variation and error
in estimation.

3.
Which of Rosse’s three valuation factors would most likely be used in a
nonmarket-based valuation approach?

A. Factor 1

B. Factor 2

C. Factor 3

4.
Based on Exhibit 2, Annear will most likely conclude that the NECP shares are:
 A. overvalued according to the two-step DDM and overvalued using
AFFO.

B. overvalued according to the two-step DDM but undervalued using

AFFO.

C. undervalued according to the two-step DDM but overvalued using

AFFO.

Beaumont Case Scenario

Maelys Beaumont is a corporate bond portfolio manager at Marseilles
Funds, LLC in Montpelier, VT. She manages a US$500 million fund of
primarily investment grade corporate bonds. The fund can also invest in fixed-
income securities within the high-yield emerging market and in the sovereign
and municipal sectors. As a result of market volatility, Beaumont has been
noting that inflows and outflows are larger and more frequent than in the past.
Because her fund is benchmarked against the Barclays Bloomberg Corporate
Bond Index, and her peer universe is competitive, Beaumont is looking at ways
to ensure that the cash flows do not adversely affect fund performance. She
considers the use of exchange-traded funds (ETFs) to manage her market
exposures in the fund.

Maxime Dupuis, an analyst on Beaumont’s team is not familiar with

ETFs. He asks Beaumont to explain how the mechanics of ETFs work and what
parties are involved in the process. Beaumont describes the roles to Dupuis of
different parties involved in ETFs by making the following statements:

Statement 1: ETFs trade in the secondary market throughout the course of the
day at the then-current market price. In that regard, they are like any
other stock in which buyers and sellers are matched.

Statement 2: There is a primary market for ETFs in which there is a creation

and redemption process for shares. Here, the arbitrage gap is reduced to
 a narrow band to ensure that the price of the ETF and the underlying
securities trade around a barrow band.

Statement 3: If, for example, ETF shares are being created, an intermediary
receives the basket of in-kind securities at settlement.

Beaumont then asks Dupuis to analyze in more detail the economics

surrounding ETFs. Dupuis conducts a thorough analysis of the costs of an
ETF, such as bid-ask spreads and sources of premiums and discounts. He
summarizes his findings to Beaumont in the following notes:

Note 1: A number of factors can determine the width of bid-ask spreads. These
include creation or redemption fees, trading costs, and importantly, the
bid-ask spread of the underlying securities. Similar to any other stock,
the market maker is compensated, including a profit spread, for the risks
of holding and hedging a security which are a function of liquidity.

Note 2: ETFs can trade at either a premium or discount to the underlying,

which affect trading costs negatively or positively. Exchanges disclose the
indicated intraday net asset values (NAVs), which are estimates of fair
value based on the creation basket. Premiums and discounts are driven
by a number of factors, including timing differences and stale pricing,
which can be meaningful for foreign securities.

Beaumont continues to assess the use of ETFs in her portfolio. She

constantly evaluates risks that different investments can introduce into her
strategy. She asks Dupuis to work with the risk management group to identify
these risks and report back to her. Dupuis provides Beaumont a report with
his findings on ETF risks starting with an executive summary, which is
provided in Exhibit 1.

Exhibit 1: Executive Summary of ETF Risks

ETFs introduce unique risks because of their structure, holdings, and

underlying exposures. Counterparty risk is prevalent in certain ETF legal
structures, such as synthetic ETFs in which investors could lose all the
principal invested if the issuer defaults. Funds that use over-the-counter
(OTC) derivatives, such as exchange traded notes (ETNs), are subject to
settlement risk, which is the result of counterparty risk between settlement
periods. Leveraged and inverse funds might not deliver the expected
performance over the desired time horizon that was expected based on the
underlying exposures.

1.
Based on Beaumont’s objectives in managing her fund, which application of
ETFs is least likely applicable?

A. Portfolio liquidity management

B. Portfolio completion strategies

C. Portfolio transition management

2.
The roles of the parties involved in the mechanics of ETFs that Beaumont
describes to Dupuis in her three statements, can most likely be described
in order as those of the:

A. ETF sponsor, market maker, and authorized participant.

B. market maker, authorized participant and ETF sponsor.

C. authorized participant, ETF sponsor, and market maker.

3.
Are Dupuis’s notes regarding the economics surrounding ETFs most likely
correct?

A. Yes.

B. No, he is incorrect with regard to Note 1.

 C. No, he is incorrect with regard to Note 2.

4.
Which type of ETF has Dupuis least likely associated correctly with the risks
described in his executive summary in Exhibit 1?

A. Synthetic ETFs

B. Leveraged and inverse funds

C. ETNs