2021 CFA Level II Mock Exam Answers – AM Session

Alan Watson Case Study

1.
A is correct. The first scenario Watson notes provides no evidence of
any violation of the CFA Institute Standards of Professional Conduct. The
discussion prior to the meeting is not a violation of Standard II(A): Material
Nonpublic Information. Standard II(A) states Members and Candidates who
possess material nonpublic information that could affect the value of an
investment must not act or cause others to act on the information. While a
merger would be considered material information, this merger had already
been announced so the information is public. Additionally, no details were
given about the merger and no company names were disclosed, so it is unclear
which companies she is discussing. There is no evidence she violated Standard
III(B): Fair Dealing or Standard V(B): Communication with Clients and
Prospective Clients in her discussion of her research process and
published investment recommendations or in the comments she made about
the merger during an interview on a major television network. Standard III(B)
states Members and Candidates must deal fairly and objectively with all clients
when providing investment analysis, making investment recommendations,
taking investment action, or engaging in other professional activities. Standard
V(B) states Members and Candidates must disclose to clients and prospective
clients the basic format and general principles of the investment processes they
use to analyze investments, select securities, and construct portfolios and must
promptly disclose any changes that might materially affect those processes.
There is no evidence to indicate she treated the clients in the meeting
differently than any other clients. She simply talked about the research process
and her research recommendations and opinions that had already been
published.
 B and C are incorrect. The first scenario Watson notes provides no
evidence of any violation of the Standards of Professional Conduct.

Guidance for Standards I-VII

LOS a

Standard II(A) Integrity of Capital Markets, Standard III(B) Fair

Dealing and Standard V(B) Communication with Clients and
Prospective Clients

2.
A is correct. Both Recommendation 1 (“Firms should require prior
approval for employees participating in initial public offerings.”) and
Recommendation 2 (“Firms should implement effective supervisory and review
procedures to ensure compliance with personal investment policies.”) apply to
Standard I(B): Independence and Objectivity. Standard I(B) states Members
and Candidates must use reasonable care and judgment to achieve and
maintain independence and objectivity in their professional activities. Members
and Candidates must not offer, solicit, or accept any gift, benefit,
compensation, or consideration that reasonably could be expected to
compromise their own or another’s independence and objectivity. The
recommended procedures for compliance suggest investments be restricted and
require prior approval for employee participation in IPOs. The recommended
procedures also suggest review procedures be implemented to ensure
compliance with policies relating to their personal investment activities.

B and C are incorrect. Both Recommendation 1 and Recommendation 2

apply to Standard I(B): Independence and Objectivity.

Guidance for Standards I-VII

LOS b

Standard I(B) Independence and Objectivity

3.
 B is correct. 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 medial post.”) is not fully compliant with Standard
V: Investment Analysis, Recommendations, and Actions. When using social
media, every effort should be made to treat clients fairly. However, to be
consistent with Standard V(B), when utilizing capsule form or a condensed
form of communication, clients should be notified that additional information
and analyses are available from the producer of the report. Notifying all clients
that a social media post has been made does not meet this requirement.
Specifically, Standard V(B): Communication with Clients and Prospective
Clients states Members and Candidates must: 1) Disclose to clients and
prospective clients the basic format and general principles of the investment
processes they use to analyze investments, select securities, and construct
portfolios and must promptly disclose any changes that might materially affect
those processes; 2) Disclose to clients and prospective clients significant
limitations and risks associated with the investment process; 3) Use reasonable
judgment in identifying which factors are important to their investment
analyses, recommendations, or actions and include those factors in
communications with clients and prospective clients; and 4) Distinguish
between fact and opinion in the presentation of investment analysis and
recommendations. Policy 1 (“When discussing earnings estimates, caution
should be exercised to avoid overconfidence regarding the accuracy of the
earnings model.”) and Policy 3 (“Significant changes in risk characteristics for
either a security or asset strategy should be communicated to all clients.”) are
both consistent with Standard V(B): Communication with Clients and
Prospective Clients.

A and C are incorrect. Policy 1 and Policy 3 are both consistent

with Standard V(B): Communication with Clients and Prospective Clients.

Guidance for Standards I-VII

 LOS b

Standard V(B) Communication with Clients and Prospective Clients

4.
C is correct. Pledge 3 (Avoid discussing the
particulars of the topic areas tested with each other.) would be required to
ensure compliance with Standard VII: Responsibilities as a CFA Institute
Member or CFA Candidate. Specifically, Standard VII(A): Conduct as
Participants in CFA Institute Programs states Members and Candidates must
not engage in any conduct that compromises the reputation or integrity of CFA
Institute or the CFA designation or the integrity, validity, or security of the CFA
Institute programs. All aspects of the exam, including questions, broad topical
areas, and formulas tested or not tested, are considered confidential until such
time as CFA Institute elects to release them publicly. Therefore, members of the
group should not discuss any exam-related content, including the
particulars of the topic areas tested on the exam, with each other. Given the
increased use of online forums as well as new technologies, CFA Institute
polices blogs, forums, and related social networking groups for information
considered confidential. Pledge 1 (Abstain from making any comments about
the curriculum on social media.) and Pledge 2 (Refrain from expressing
negative comments about the CFA Program.) are not in violation of Standard
VII(A). The standard does not prohibit candidates from discussing
nonconfidential information or curriculum material with
others, nor does it prohibit expressing opinions regarding CFA Institute, the
CFA Program, or other CFA Institute programs. Members and Candidates are
free to disagree and express their disagreement with CFA Institute or its
policies, its procedures, or any advocacy positions taken by the
organization. The group is therefore free to express their negative opinions to
others and on social media.
 A and B are incorrect. Pledge 1 (Abstain from making any comments
about the curriculum on social media.) and Pledge 2 (Refrain from expressing
negative comments about the CFA Program.) are not violations of Standard
VII(A).

Guidance for Standards I-VII

LOS b

VII(A) Conduct as Participants in CFA Institute Programs

Rebecca Matheson Case Scenario

1.
B is correct. LaRue has least likely violated Standard VI, Conflicts of
Interest, specifically, Standard VI(B), Priority of Transactions. This standard
states investment transactions for clients and employers must have priority
over investment transactions in which a CFA Institute member or CFA
candidate is the beneficial owner. The account in question is owned by Brooke
Montgomery, LaRue’s cousin, and there is no evidence that LaRue is a
beneficial owner. LaRue, however, has violated Standard III, Duties to Clients,
specifically Standard III(A), Loyalty, Prudence, and Care, which states members
and candidates have a duty of loyalty to their clients and must act with
reasonable care and exercise prudent judgement. members and candidates
must act for the benefit of their clients and place their clients’ interest before
their employers or their own interest. By discussing trades being executed,
LaRue has neither acted reasonably nor for the benefit of the firm’s clients.
When he discussed his job with his cousin, he should have taken care not to
mention the names of the firm being trading. Although he may not have known
his cousin would front run the firm’s trades, as a CFA® charterholder, he
should have known the possibility existed. Leaving the names of the companies
being traded out of their conversation would have prevented the violation from
occurring. LaRue also violated Standard II, Integrity of Capital Markets,
specifically, Standard II(A), Material Nonpublic Information, which states,
members and candidates who possess material nonpublic information that
could affect the value of an investment must not act or cause others to act on
the information. Communicating information about the firm’s trades to a
person who then traded the security would be a misappropriation of
information and a violation of Standard II(A), Material Nonpublic Information.
Discussing the names of the companies being traded with his cousin, who in
turn traded in the security, therefore would be a violation of Standard II(A).

A is incorrect. LaRue has violated Standard III, Duties to Clients,

specifically Standard III(A), Loyalty, Prudence, and Care,, which states
members and candidates have a duty of loyalty to their clients and must act
with reasonable care and exercise prudent judgement. members and
candidates must act for the benefit of their clients and place their clients’
interest before their employers or their own interest. By discussing trades being
executed, LaRue has neither acted reasonably nor for the benefit of the firm’s
clients.

C is incorrect. LaRue has violated Standard II, Integrity of Capital

Markets, specifically, Standard II(A), Material Nonpublic Information.
Communicating information about the firm’s trades to a person who then
traded the security would be a misappropriation of information and a violation
of Standard II(A), Material Nonpublic Information. Discussing the names of the
companies being traded with his cousin, who in turn traded in the security,
therefore would be a violation of Standard II(A).

Guidance for Standards I-VII

Section: Standard II(A) Material Nonpublic Information, Standard

III(A) Loyalty, Prudence and Care, and Standard VI(B) Priority of
Transactions.

LOS a

2.
 B is correct. LaRue has violated Standard I, Professionalism, specifically,
Standard I(B), Independence and Objectivity, which states that CFA Institute
members and CFA candidates must not offer, solicit, or accept any gift, benefit,
compensation, or consideration that reasonably could be expected to
compromise their own or another’s independence and objectivity. Benefits
include gifts, invitations to lavish functions, tickets, favors, or job referrals.
Allowing R&R to sponsor his full attendance at a three-day conference
compromises LaRue’s independence and objectivity. It appears R&R has tried
to influence LaRue by sponsoring his attendance. Although modest gifts and
entertainment are acceptable, special care must be taken by members and
candidates to resist subtle and not-so-subtle pressures to act in conflict with
the interests of their clients. Best practice dictates members and candidates
reject any offer of gift or entertainment that could be expected to threaten their
independence and objectivity. When travel is involved, best practice dictates
members and candidates use commercial transportation at their expense or at
the expense of their firm rather than accept paid travel arrangements from an
outside company. The fact that he disclosed R&R sponsored his attendance
prevented him from violating Standard VI(A), Disclosure of Conflicts. The
disclosure, however, does not alleviate the violation of Standard I(B).

A is incorrect. LaRue has violated Standard I, Professionalism,

specifically Standard I(B), Independence and Objectivity. Allowing R&R to
sponsor his full attendance at a three-day conference compromises LaRue’s
independence and objectivity. It appears R&R has tried to influence LaRue by
sponsoring his attendance. Although modest gifts and entertainment are
acceptable, special care must be taken by members and candidates to resist
subtle and not-so-subtle pressures to act in conflict with the interests of their
clients. Best practice dictates members and candidates reject any offer of gift or
entertainment that could be expected to threaten their independence and
objectivity. When travel is involved, best practice dictates members and
candidates use commercial transportation at their expense or at the expense of
their firm rather than accept paid travel arrangements from an outside
company.

C is incorrect. LaRue has violated Standard I, Professionalism,

specifically Standard I(B), Independence and Objectivity. He has not violated
Standard VI, Conflicts of Interest. The fact that he disclosed R&R sponsored his
attendance prevented him from violating Standard VI(A), Disclosure of
Conflicts.

Guidance for Standards I-VII

Section: Standard I(B) Independence and Objectivity and Standard

VI(A) Disclosure of Conflicts

LOS a

3.
C is correct. Policy 3, “Send periodic reminders regarding investment
club membership to those employees who failed to report and outline
permissible conduct,” is insufficient to prevent a violation of CFA Standards of
Professional Conduct. Periodic reminders regarding the investment club
requirement and an outline regarding permissible conduct should be sent to all
the firm’s employees. Standard IV (C), Responsibilities of Supervisors, states
CFA Institute members and CFA candidates must make reasonable efforts to
ensure that anyone subject to their supervision or authority complies with
applicable laws, rules, regulations, and the Code and Standards. Among other
items, adequate compliance procedures should outline permissible conduct.
Once a program is in place, supervisors should issue periodic reminders of the
procedures to appropriate personnel. Once a violation is discovered increase
supervision or place appropriate limitations on the wrongdoer pending the
outcome of the investigation. Policy 1, “Membership in online investment clubs
is permissible but must be reported to the Compliance Department before
joining,” and Policy 2, “When it is discovered that a membership was not
reported, increase supervision on employee who failed to report,” would help to
prevent and detect violation of CFA Standards of Professional Conduct.

A is incorrect. Policy 1, “Membership in online investment clubs is

permissible but must be reported to the Compliance Department before
joining,” would help to prevent and detect violation of CFA Standards of
Professional Conduct.

B is incorrect. Policy 2, “When it is discovered that a membership was

not reported, increase supervision on employee who failed to report,” would
help to prevent and detect violation of CFA Standards of Professional Conduct.

Guidance for Standards I-VII

Section: Standard IV(C) Responsibilities of Supervisors

LOS b

4.
A is correct. Recommendation 1 regarding what Matheson should do
next, “Consult with the firm’s securities attorney,” would be Matheson’s best
course of action. Standard I(A), Knowledge of the Law, requires that CFA
Institute members and CFA candidates must not knowingly participate or
assist in and must dissociate from any violation of such laws, rules, or
regulations. By terminating LaRue, the firm has moved to dissociate from him.
The Code and Standards do not compel members and candidates to report
violations to their governmental or regulatory organizations unless such
disclosure is mandatory under applicable law, but such disclosure may be
prudent under certain circumstances. Therefore, given LaRue’s violations,
Matheson should consult with their legal and compliance advisers for
guidance. Neither Recommendation 2, “Wait for the PCP to provide her with
additional information,” nor Recommendation 3, “Inform the local CFA Society
about the complaint,” regarding what Matheson should do next would be her
best course of action. Once the complaint is filed, it becomes an issue between
LaRue and the CFA Institute. The PCP is unlikely to contact Matheson and
would not provide her with any further information. She also should not inform
her local CFA Society because the issue is undecided and no sanction has been
issued, and even if one is issued, it may not be public. Notifying the local
society could be considered a breach of confidentiality, and Matheson could be
at risk of violating CFA Standards of Professional Conduct. Also, Matheson
should not simply wait to see if anything comes of her complaint, especially if
reporting the violation to her governmental or regulatory organization is
mandatory. Matheson’s best course of action is to consult with their legal and
compliance advisers for guidance.

B is incorrect. Recommendation 2, “Wait for the PCP to provide her with

additional information,” regarding what Matheson should do next would not be
her best course of action. Once the complaint is filed, it becomes an issue
between LaRue and the CFA Institute. The PCP is unlikely to contact Matheson
and would not provide her with any further information. She also should not
inform her local CFA Society because the issue is undecided and no sanction
has been issued, and even if one is issued, it may not be public. Notifying the
local society could be considered a breach of confidentiality, and Matheson
could be at risk of violating CFA Standards of Professional Conduct. Also,
Matheson should not simply wait to see if anything comes of her complaint,
especially if reporting the violation to her governmental or regulatory
organization is mandatory. Matheson’s best course of action is to consult with
their legal and compliance advisers for guidance.

C is incorrect. Recommendation 3, “Inform the local CFA Society about

the complaint,” regarding what Matheson should do next would not be her best
course of action. Once the complaint is filed, it becomes an issue between
LaRue and the CFA Institute. The PCP is unlikely to contact Matheson and
would not provide her with any further information. She also should not inform
her local CFA Society because the issue is undecided and no sanction has been
issued, and even if one is issued, it may not be public. Notifying the local
society could be considered a breach of confidentiality, and Matheson could be
at risk of violating CFA Standards of Professional Conduct. Also, Matheson
should not simply wait to see if anything comes of her complaint, especially if
reporting the violation to her governmental or regulatory organization is
mandatory. Matheson’s best course of action is to consult with their legal and
compliance advisers for guidance.

Guidance for Standards I-VII

Section: Standard I(A) Knowledge of the Law

LOS b

DeMolay Case Scenario

1.
A is correct. When modeled using a AR(1) model, as in the formula given
in Exhibit 1, random walks will have an estimated intercept coefficient near
zero and an estimated slope coefficient on the first lag near 1. Therefore, his
statement is correct.

B is incorrect because random walks are likely to have a slope coefficient

(b1) close to one.

C is incorrect because random walks are likely to have an intercept

coefficient (b0) close to zero.

Time-Series Analysis

LOS i

Section 5.1

2.
A is correct. If a time series is a random walk, the best forecast of xt that
can be made in period t – 1 is xt–1. So, the best forecast of the next period’s
trailing P/E is the current period’s trailing P/E.
 B is incorrect because random walks are not covariance stationary, so
AR(1) models are not appropriate.

C is incorrect because random walks have undefined mean-reverting

levels. A mean-reverting process would allow for improved forecasts by
incorporating the average value.

Time-Series Analysis

LOS i

Section 5.1

3.
A is correct. We can test whether a time series is ARCH by regressing the
squared residuals from a previously estimated time series model on a constant
and one lag of the squared residuals (as in Exhibit 2). If the estimate of the
slope (c1 in Exhibit 2) of the regression of the squared residuals on the lagged
one period squared residuals is statistically significantly different from 0, the
time series is ARCH(1).

B is incorrect because it uses the wrong value to test the slope

coefficient.

C is incorrect because it tests the intercept term rather than the slope
term.

Time-Series Analysis

LOS m

Section 9

4.
A is correct. If ARCH exists, the standard errors for the regression
parameters will not be correct. In the case that ARCH exists, you will need to
use generalized least squares or other methods that correct for
heteroskedasticity to correctly estimate the standard error of the parameters in
the time series model.

B is incorrect because interpretation of any AR(1) result is problematic

when ARCH exists.

C is incorrect because the results in Exhibit 2 suggest that ARCH does

exist in the data, so the time-series is not a random walk.

Time-Series Analysis

LOS m, o

Section 9

5.
A is correct. When working with two time series in a regression analysis,
both of the series must be tested for the presence of a unit root. If neither
series has a unit root, you can safely use linear regression to test the
relationship between the two time series.

B is incorrect because if the independent series has a unit root and the
dependent series does not, we should not use linear regression.

C is incorrect because if the dependent series has a unit root and the
independent series does not, we should not use linear regression.

Time-Series Analysis

LOS n

Section 10

6.
C. correct.

A is correct. If the two series each have a unit root, regression results will
be consistent, provided that the two series are cointegrated.
 B is incorrect because two series each having a unit root should exhibit
cointegration to yield consistent results.

C is incorrect because two series each having a unit root should exhibit
cointegration to yield consistent results.

Time-Series Analysis

LOS n

Section 10

Galaxy Case Scenario

1.
C is correct. The change in revenue recognition to an earlier point, before
the product has been produced or delivered, is an aggressive accounting policy
that would lower the company’s quality of earnings.

A is incorrect. The change in the warranty expense reflects updated

information, and failure to act on it would underestimate earnings.

B is incorrect. The stock grants are expensed over the estimated service
life of the employees, in this case the 3 years till it vests, and does not distort
the quality of earnings.

Evaluating Quality of Financial Reports

LOS h

Sections 2.2.1, 3.1

2.

Deposits received $3 million

Deposit as percentage of order 25%

Revenue recognized on receipt of order $3 million/0.25 = $12
million

Gross profit margin Gross profit/Sales =

$53,000/$100,000 = 53%

Increment to gross profit from early 53% × $12 million = $6.36

recognition policy million

C is correct.

A is incorrect. It calculates the change in gross profit based on the

difference between the actual amount of revenue and the amount of the
deposit: 0.53 × (12 – 3) = $4.77.

B is incorrect. It calculates the change in gross profit based on the

deposit: 0.53 × $3 = $1.59.

Evaluating Quality of Financial Reports

LOS h

Section 4.2.1

Integration of Financial Statement Analysis Techniques

LOS d, e

Section 1

3.
A is correct. The classification of warranty expense as a non-operating
item reduces Galaxy’s earnings quality. High-quality earnings allow investors to
identify core or recurring earnings, and Galaxy’s core earnings are overstated
when an operating cost, like warranties, are classified as non-operating. The
company disclosed the change in classification in both the MD&A and notes to
the financial statements, thereby exhibiting high financial reporting quality.
 B is incorrect. Galaxy has explained the change—the change may not be
GAAP, but they did disclose it, exhibiting a reasonable level of reporting quality
because it is still possible to assess a company’s results

C is incorrect. The reclassification of an expense between operating and

non-operating or non-recurring does not affect net income (and hence return
on sales) but would affect the operating margin and the interpretation of core
earnings.

Evaluating Quality of Financial Reports

LOS c, h

Sections 2.1, 2.2.2, 3.1, 4.1.1

4.
B is correct. A DSRI (days sales in receivable index) greater than 1
indicates an inappropriate relationship between accounts receivable and
revenue recognition and is a potential signal of earnings manipulation. For
Galaxy, it is the largest positive contributor (DSRI = 1.619) that would increase
the M score. Larger values for the M-score (and contributors) are more
indicative of earnings manipulation. Increasing leverage could predispose a
company to manipulate earnings, but here the leverage index is negative
indicating that leverage has decreased.

A is incorrect. Higher M-scores (less negative) indicate an increased

probability of earnings manipulation. Here the lower (more negative score)
would indicate that the company is less likely to be manipulating earnings.

C is incorrect. Increasing leverage could predispose a company to

manipulate earnings, but here the leverage index is negative, indicating that
leverage has decreased.

Evaluating Quality of Financial Reports

LOS f, h
 Section 3.2.1

5.
A is correct. The compensation expense for restricted stock grants is the
fair market value of the shares on the grant date, and this amount is allocated
over the three-year service period because of the three-year vesting period: $4.2
million/3 = $1.4 million.

B is incorrect. It expenses the entire amount on the grant date.

C is incorrect. It assumes that nothing is expensed until the vesting

period is over.

Employee Compensation: Post-Employment and Share-Based

LOS h

Section 3.1

6.
A is correct. Only the executive stock option plan is affected by volatility
of the company’s stock. The volatility affects the initial valuation of the stock
options granted, for example through the use of the Black–Scholes model to
determine the fair value of the options. The initial valuation of the options
determines the expense recognized. Compensation expense for stock grants is
based on the fair market value of the stock on the day of the grant and is not
affected by the stock’s volatility.

B is incorrect. Stock options are directly affected by volatility, but stock

grants are not.

C is incorrect. Stock options are directly affected by volatility, but stock

grants are not.

Employee Compensation: Post-Employment and Share-Based

LOS h
 Sections 3.1, 3.2

Compañia Mineras Cóndores Case Scenario

1.
B is correct. The payoffs from the copper mine development are
contingent on the price of copper, as is the case with many commodity
investments. This is a fundamental option because the entire project is
essentially an option.

A is incorrect. Price-setting options exist when management is able to

increase prices when demand exceeds capacity. Copper prices are set in
commodities markets and cannot be controlled by CMC management.

C is incorrect. Abandonment options exist after an investment is made,

and management determines that the initial results are disappointing. CMC’s
classification system applies before any investment takes place.

Capital Budgeting

LOS f

Section 7.5

2.
B is correct.

CLP$ billions Year

0 1 2 3 4

Initial outlay

Fixed capital –36

Net working capital –5

Total –41
Annual after-tax operating
cash flows

Operating income before tax 13.00 13.00 13.00 13.00

Tax on operating income @ 3.12 3.12 3.12 3.12
24%

Operating income after tax 9.88 9.88 9.88 9.88

Add back: Depreciation 9.00 9.00 9.00 9.00

After-tax operating cash flow 18.88 18.88 18.88 18.88

Terminal year after-tax
nonoperating cash flows
After-tax salvage value 0

Return of net working capital 5

Total 5

Total after-tax cash flow –41 18.88 18.88 18.88 23.88

Net present value @ 18% 12.37

A is incorrect. This calculation ignores the return of net working capital

at the end of the four-year project.

CLP$ billions Year

0 1 2 3 4

Total after-tax cash flow per –41 18.88 18.88 18.88 18.88
table in correct response –
excluding the return of
working capital

Net present value @ 18% 9.79

C is incorrect. This calculation ignores tax.

CLP$ billions Year

0 1 2 3 4
Total after-tax cash flow per –41 18.88 18.88 18.88 23.88
table in correct response
Add back: tax on operating 3.12 3.12 3.12 3.12
income per table in correct
response

Total before-tax cash flows -41 22 22 22 27

Net present value @ 18% 20.76

Capital Budgeting

LOS a

Section 5.1

3.
C is correct. Project Chestnut will be operated in a country without debt
financing available (100% equity financed); therefore, the most appropriate
hurdle rate is determined using the security market line and the project’s β , as
follows:

RF Risk-free rate of 4.5%

return

βi Beta of project i 2.20

E(RM) Expected market 14%

return

ri RF + βi  E ( RM ) − RF 
=

= 4.5% + 2.20 × (14% - 4.5%)

= 4.5% + 20.9%

= 25.4%

A is incorrect. This is the required rate of return assuming the unlevered

CMC β rather than the project β :
 ri RF + βi  E ( RM ) − RF 
=

= 4.5% + 1.36 × (14% - 4.5%)

= 4.5% + 12.9%

= 17.4%

B is incorrect. This is the product of β and the market risk premium and
is also the second term of the equation for the security market line:

βi  E ( RM ) − RF 

= 2.20(14% - 4.5%)

= 20.9%

Capital Budgeting

LOS e

Section 7.4

4.
C is correct. Simulation or Monte Carlo analysis involves creating a
probability distribution of outcomes, often for a key indicator like NPV.

A is incorrect. Scenario analysis typically compares the NPVs generated

by adjusting a number of variables to generate just three scenarios: the best,
worst, and most likely cases.

B is incorrect. Sensitivity analysis typically compares the NPVs generated

through the adjustment of a single variable within the base case. This
approach enables the analyst to determine which variables the project is most
sensitive to.

Capital Budgeting
 LOS d

Section 7.3

Jackson Case Scenario

1.
A is correct. A dividend discount model (DDM) is most suitable when an
investor takes a noncontrol perspective because he does not have the ability to
meaningfully influence the timing or magnitude of a company’s cash flows and
is therefore reliant on dividend policy. Because Jackson is looking for an
investment for his personal portfolio, it is most likely that he has a noncontrol
perspective.

B is incorrect. If a company has intense capital demands — as DDL does

based on its investment cash flows exceeding its operating ones — it may have
negative free cash flow and be unable to pay dividends. In this situation, a
residual income model would be the most appropriate model to use.

C is incorrect. The residual income model considers the opportunity cost

to an investor of investing in a stock, not a dividend discount model.

Discount Dividend Valuation

LOS a

Section 2.2

2.
B is correct. The share can be valued using a two-stage DDM model with
no dividends in the first stage, as follows:

- Calculate the terminal value of the stock using the Gordon growth
model

D1
- P0 = , where D1 = $0.50, r = 7.25% and g = 2%
(r − g )
 - That yields the present value at the start of year 4; the first dividend is
expected at the end of year 4, thus D4 = $0.50 and value is at end the of year 3
(beginning of year 4)

0.50
=- P3 = $9.52
0.0725 − 0.020

- Discount that value for 3 years at 7.25% = $9.52/(1.0725)3 = $7.72

A is incorrect. It discounts the $9.52 value for four periods not three
periods: $9.52/(1.0725)4 = $7.20

C is incorrect. It discounts the terminal value the correct number of

years but continues to use r-g (0.0725 – 0.02 = 0.0525) as the discount rate:
$9.52/(1.0525)3 = $8.17

Discount Dividend Valuation

LOS l

Section 4.6 & 5.2

3.
A is correct. Using the H-model, the value is $29,00 calculated as
follows:

DO (1 + g L ) DO H ( g S − g L )
+
r − gL r − gL

Where:

D0 = the current dividend: $2.00

gL = the long-term growth rate: 4%

gS = the short-term growth rate: 8%

H = the half-life of the high growth period: 6/2 = 3

 2.00 (1 + g L ) 2.00 × 3 (.08 − .04 )
+
0.12 − .04 0.12 − .04

= $26.00 +3.00 = $29.00

B is incorrect. It grows the dividend in the first term by the higher growth
rate 8% not 4% making the first term $27.00 and the total = $27.00 + 3.00 =
$30.00

C is incorrect. It uses the full six years not the half-life value for H;
therefore, the second term = $6.00 and the total = $26.00 + 6 = $32.00

Discount Dividend Valuation

LOS l

Section 5.3

4.
A is correct. Jackson’s understanding is correct. The H-model is
appropriate to use when the transition from a higher rate of growth to a lower
one is linear over time but does not provide a very close approximation for a
long extraordinary growth period or for a large difference in growth rates.

B is incorrect. Jackson’s understanding is correct with respect to the

growth rates. The H-model is appropriate to use when the transition from a
higher rate of growth to a lower one is linear over time.

C is incorrect. Jackson’s understanding is correct with respect to the

length of the first growth period. The H-model is appropriate to use when the
transition from a higher rate of growth to a lower one is linear over time, but it
does not provide a very close approximation for a long extraordinary growth
period.

Discount Dividend Valuation

LOS i, n
 Section 5.3

Lumis Case Study

1.
B is correct. A coupon-paying bond can be thought of as a portfolio of
zero-coupon bonds, each valued separately at the spot interest rate
derived from the spot curve. The yield-to-maturity calculation reflects the
traditional approach to valuing bonds, where all cash flows are discounted at
the same rate as if the yield curve were flat. In a positively sloped yield curve,
the spot rate at maturity will be higher than the yield-to-maturity. The par rate
equals the yield-to-maturity on the IED bond.

A is incorrect.

C is incorrect because with a positively sloped yield curve, the interest

payments prior to maturity will be discounted at rates lower than the rate
applied to the final cash flows.

The Arbitrage-Free Valuation Framework

LOS a

Section 3

2.
C is correct. The value of the cash flow at i3LLH is 105.25 (not 100) since
that node is at maturity of the bond. The final cash flow at maturity consists of
principal plus the last coupon payment of 5.25%.

A is incorrect, because the value at i2LL has the following relationship to

i2HH:

i2 LL e4σ , or 6.75 ÷ e4σ , or 6.75 ÷ 1.8222 =

3.704%
 B is incorrect, because the value at i2LH is at the center, or average, of
interest rate paths, which should be close to the implied forward rate of
5.98% at T2.

The Arbitrage-Free Valuation Framework

LOS c

Section 3

3.
C is correct. The three-year bond matures at T3 and will generate a cash
flow of 105.25 according to the par rate for the three-year bond (5.25 coupon
plus 100 maturity). All branches of the binomial tree will have a value
of 105.25 at T3. The price of the bond at i2HH is calculated as

98.595 .
105.25 ÷ 1.0675 =

A is incorrect, because it discounts a final cash flow at maturity of 100 at

a rate of 6.75%.

C is incorrect, because it discounts a final cash flow at maturity of

100 at the par rate of 5.25%.

The Arbitrage-Free Valuation Framework

LOS d

Section 3

4.
B is correct. Trial rates are used when calibrating a binomial tree in an
iterative process. If i1H is 5.95%, i1L can be calculated since

i1H = i1L e2σ , or i1L=4.41.

 The values at ih and il are the average of the cash flows at T1, including
the coupon payment of 5.25 and principal discounted at the rate of the node:

99.339 ,
105.25 ÷ 1.0595 = and 105.25 ÷ 1.0441 =
100.804 .

Using backward induction, the value at T0 = 100.33:

(5.25 + (0.05 × (99.339 + 100.072))) ÷ 1.0525 =

100.33 ,

which is too high since the price at T0 must be par or 100. Therefore, the
rate is too low.

A and C are incorrect because the rate is too low.

The Arbitrage-Free Valuation Framework

LOS d, e

Section 3

Matthew Riley Case Scenario

1.
B is correct. Note that time 0 is the forward contract initiation date, that
is, 90 days after the purchase of the bond. Time T is the contract expiration
date, that is, 360 days.

The forward contract price follows:

F0(T) = FV0,T [S0 – PVCI0,T]

Present value (PV) of coupons = PVCI0,T = 15/(1.015)90/360 +

15/(1.015)270/360 = 14.944 + 14.833 = US$29.778

F0(T) = (1103.45 – 29.778)(1.015)360/360 = US$1,090

A is incorrect.
 PV of coupons = PVCI0,T = 15/(1.015)90/360 + 15/(1.015)270/360 = 14.944 +
14.833 = US$29.778

This calculation then incorrectly uses 1.015(180/360)

F0(T) = (1103.45 – 29.778)(1.015)180/360 = US$1,082

C is incorrect. This calculation does not deduct the PV of coupon.

F0(T) = (1103.45)(1.015)360/360 = US$1,120

Pricing and Valuation of Forward Commitments

Section 3.5

LOS a

2.
B is correct.

V (0, h, m
= ) V (0,90,90)
= NP ×
( FRA( g , h − g , m ) − FRA(0, h, m))tm
1 + Lg ( h + m − g ) th + m + g

FRA(0,h,m) = FRA(0, 90, 90) = .0231

1 + Lg ( h + m − g ) th + m − g
−1
1 + Lg ( h − g ) th − g
FRA ( g , =
h − g , m ) FRA ( 30,
= 60,90 )
tm

 150 
1 + ( 0.025 )  
 360  − 1
 60 
1 + ( 0.015 )  
 360  = 0.0316
 90 
 
 360 
 90 
( 0.0316 − 0.0231)  
V ( 0,90,90 ) =
5, 000, 000 ×  360  =
US$10,515.46
 150 
1 + ( 0.025 )  
 360 

Because this a pay floating FRA, V(0.90,90) = −US$10,515

A is incorrect. It is incorrectly calculated as follows:

 90 
V ( 0,90,90 )= 5, 000, 000 × ( 0.0316 − 0.0231)  = US$10, 625
 360 

Then for pay floating −US$10,625

C is incorrect. It is incorrectly calculated as follows:

90 
( 0.0316 − 0.0231)  
 360 
V ( 0,90,90 ) =
5, 000, 000 × US$10, 612
=
 30 
1 + ( 0.015 )  
 360 

Pricing and Valuation of Forward Commitments

Section 3.4

LOS b

3.
B is correct. PV factors for euros are provided along with an explanation
of how they are calculated:

Maturity PV
(Days) Factor

90 0.9991

180 0.9979

270 0.9967
360 0.9953

For example, PV(90) is calculated as follows:

1
= 0.991
 90 
1 + 0.003721×  
 360 

Other present value factors are calculated in a similar manner.

The fixed rate is calculated as follows:

1.0 − PV0,t4 Euro (1)

∑ PV0,ti Euro (1)
4
i =1

1.0 − 0.9907
= 0.0023
0.9985 + 0.9962 + 0.9937 + 0.9907

The annualized rate = 0.0023 × 4 = 0.0092

A is incorrect. This is the annual fixed swap rate for HK dollars and is
calculated as follows:

1.0 − 0.9953
= 0.0012
0.9991 + 0.9979 + 0.9967 + 0.9953

The annualized rate = 0.0012 × 4 = 0.0048

C is incorrect. This is incorrectly calculated as follows:

1.0 − 0.9953
= 0.0047
0.9953

The annualized rate = 0.0047 × 4 = 0.0188

Pricing and Valuation of Forward Commitments

Section 4.2
 LOS c

4.
C is correct.

Because this is a pay fixed rate receive equity swap the MV of the swap =
PV equity receipts – MV of fixed rate bond.

Vt = (St/St-)NAE – FBt(C0)

Note that PV(Par – NAE) in 𝑉𝑉𝑡𝑡 = 𝐹𝐹𝐹𝐹𝑡𝑡 (𝐶𝐶0 ) − (𝑆𝑆𝑡𝑡 ⁄𝑆𝑆𝑡𝑡− )𝑁𝑁𝑁𝑁𝐸𝐸 − 𝑃𝑃𝑃𝑃 (𝑃𝑃𝑃𝑃𝑃𝑃 − 𝑁𝑁𝑁𝑁𝐸𝐸 ) is 0,
because Par and NAE are equal.

The market value of the equity swap is calculated as follows:

3, 738
× 75, 000, 000 − ( 900, 000 )( 0.9976 + 0.9924 + 0.9861 + 0.9696 ) + 75, 000, 000 × 0.9696  =
9,993,87
3, 250

A is incorrect. This is incorrectly calculated as the difference between the

return on the equity index and the fixed rate on the swap multiplied by the
notational principal.

(0.1502 – 0.048) × 75,000,000 = 7,665,000

B is incorrect. This is incorrectly calculated as follows:

 3, 738 
 3, 250  × 75, 000, 000 − ( 900, 000 )( 0.9976 + 0.9924 + 0.9861 + 0.9696 ) + 75, 000, 000  =
7, 713,870
 

Pricing and Valuation of Forward Commitments

Section 4.3

LOS d

Rosse Case Study

1.
C is correct. The net asset value per share (NAVPS) is 52.29
(𝑁𝑁𝑁𝑁𝑁𝑁 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 ÷ 𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 𝑜𝑜𝑜𝑜 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 = (331,265,000 ÷ 6,335,000 = 52.29). The
NAVPS often is used as a fundamental benchmark for the value of a REIT.
Discounts in the REIT share price from NAVPS are interpreted as indications of
potential undervaluation. NAVPS is considered to be a superior measure of the
net worth of a real estate company compared with book value per share.

A is incorrect. This is the book value per share (𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 ÷
𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 𝑜𝑜𝑜𝑜 𝑠𝑠ℎ𝑎𝑎𝑟𝑟𝑒𝑒𝑒𝑒). Book values are based on depreciated historical costs rather
than current appraised values.

C is incorrect. This is the current share price (𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 ÷

𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 𝑜𝑜𝑜𝑜 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎).

Publicly Traded Real Estate Securities

Section 5.2

LOS e

2.
C is correct. Annear is incorrect in his assessment of the potential for
variation or error in estimation. Adjusted funds from operations (AFFO) is a
refinement of funds from operations (FFO), which takes into consideration the
leasing and maintenance-type capital expenditures necessary to maintain the
economic income of a property. It is, however, subject to more variation and
error in estimation than FFO. The precise annual provision required to
maintain and lease space in a property is difficult to predict and the actual
expense in any single year may be more or less because of the timing of capital
expenditures and the uneven expiration schedules of leases.
 A is incorrect. Annear is incorrect about the potential for variation and
error in estimation of maintenance and leasing expenses needed to maintain
the income stream of the property.

B is incorrect. AFFO does take maintenance-type capital expenditures

and leasing costs into consideration.

Publicly Traded Real Estate Securities

Section 6.2

LOS f

3.
A is correct. Capitalization rates are used as an input to calculate net
operating income when calculating net worth, or net asset value, which is not a
market-based approach.

B is incorrect. Factor 2 describes inputs to a relative value (or market-

based) approach to valuing REIT stocks.

C is incorrect. Factor 3 describes inputs to a relative value (or market-

based) approach to valuing REIT stocks.

Publicly Traded Real Estate Securities

Section 5.2, Section 6

LOS g

4.
C is correct. The first step of the DDM uses the estimates for NECP’s
dividend in years 1, 2, and 3. In the second step, a long-run dividend growth
rate of 3% is assumed. In addition, it is assumed NECP maintains an 80%
dividend payout ratio. If NECP’s historical beta is 0.9, the risk-free rate is 3%
and the assumed equity risk premium is 4%, the cost of equity capital is 6.6%
 Risk free rate + ( Beta × Risk premium ) =
6.6%

The value of the stock at the end of year 3 is 76.25 or

2.745 ÷ (6.6% − 3%)

The present values of the cash flows discounted at the cost of capital is:

78.92 2.58 2.54

+ + 69.80
=
(1 + .066 ) (1 + .066 )
3 2
1 + .066

Step One Step Two

Year Year Year

1E 2E 3E Year 4E

Dividends/share 2.54 2.58 2.67 2.745

Value of stock end year
3 76.25

Cash flow to investors 2.54 2.58 78.91

Present value of cash

flows 69.80

The present value of cash flows according to the two-step DDM is 69.80,
compared to which the share price of 62.81 is undervalued. AFFO/share is
3.13 and with a peer multiple of 19, the price is 59.47 compared to which the
share price of 62.81 is overvalued.

A is incorrect. NECP is not overvalued when using the two-step DDM.

B is incorrect. NECP is neither overvalued according to the two-step

DDM nor undervalued when using AFFO.

Publicly Traded Real Estate Securities

Section 7 and Section 8.3

LOS h
Beaumont Case Scenario

1.
C is correct. Transition management refers to the process of hiring and
firing managers — or making changes to allocations with existing managers. In
this application, the manager can add the desired exposure to a market
segment with ETFs while shedding exposure to the market segment she has
received in kind. Beaumont is experiencing inflows and outflows in her
corporate bond fund. An efficient way to maintain the desired exposure is to
buy and sell ETFs as flows occur. Using ETFs for portfolio completion can help
fill in temporary gaps in exposure while she finds individual bonds to trade.
The liquidity of ETFs relative to individual bonds allows Beaumont to quickly
invest inflows or meet redemptions.

A is incorrect. Portfolio liquidity management is easily achieved with the

use of ETFs.

B is incorrect. Beaumont can use ETFs to invest the outflows or meet

redemptions and keep her exposure to the market.

Exchange-Traded Funds: Mechanics and Applications

Section 4.2

LOS h

2.
B is correct. Several parties are involved in the primary or creation or
redemption and secondary trading of ETFs. If the trade is submitted through a
broker in the secondary market, a market maker will execute the transaction. If
ETF shares need to be created or redeemed because of demand or supply, the
only group of investors permitted in this process is a special group of
institutional investors called authorized participants. The ETF issuer or the
sponsor transacts with the authorized participant receiving or providing in-
kind securities in the settlement process.

A is incorrect. Activities listed are conducted first by the market maker,

second by the authorized participant, and third by the ETF sponsor.

C is incorrect. Activities listed are conducted first by the market maker,

second by the authorized participant, and third by the ETF sponsor.

Exchange-Traded Funds: Mechanics and Applications

Section 2.1

LOS a, b

3.
A is correct. Dupuis is correct with regard to both notes. He has
accurately described the economics surrounding ETFs pertaining to both bid-
ask spreads and premiums and discounts.

B is incorrect. Note 1 regarding bid-ask spreads is correct.

C is incorrect. Note 2 regarding premiums and discounts is correct.

Exchange-Traded Funds: Mechanics and Applications

Section 3.4

LOS d, e

4.
C is correct. Dupuis has correctly identified a number of risks that
investors face when investing in ETFs. Certain risk are more closely associated
with specific types of ETFs. He correctly notes the risks associated with
leveraged and inverse funds, which are intended to deliver their expected
return relative to their exposure over very short periods. These are not intended
to be buy-and-hold investments for periods generally longer than a month or
even days in some cases without rebalancing of the position. He also correctly
associates synthetic ETFs, such as swap-based funds that use OTC derivatives
to gain exposure and are subject to both counterparty and settlement risk.
Dupuis has incorrectly associated ETNs with settlement risk, which is the
result of counterparty risk between settlement periods. ETNs do not hold
underlying securities but rather are unsecured obligations of the institutions
that issue them and therefore are subject to counterparty risk.

A is incorrect. Dupuis has correctly described the risks associated with

synthetic ETFs.

B is incorrect. Dupuis has correctly described the risks associated with

leveraged and inverse funds.

Exchange-Traded Funds: Mechanics and Applications

Section 3.6

LOS g