2020 Mock Exam A - Afternoon Session (With Solutions)

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2020 Level II Mock Exam (A) PM

The afternoon session of the 2020 Level II Chartered Financial Analyst® Mock
Examination has 60 questions. To best simulate the exam day experience, candidates
are advised to allocate an average of 18 minutes per item set (vignette and multiple
choice questions) for a total of 180 minutes (3 hours) for this session of the exam.
THE FOLLOWING INFORMATION RELATES TO

QUESTIONS 1–6
Forster Investment Advisors (Forster) is a small asset management firm managing funds for
both retail and institutional clients. Forster also undertakes investment banking activities,
including market making, but only for the shares of a few companies that it follows closely.
Forster’s finance director, who also serves as the firm’s compliance officer, has given
notice that he will retire in one month’s time. Forster’s managing director asks Terry
McGuinn, CFA, if he would be interested in being the compliance officer after the finance
director retires. McGuinn, an independent compliance consultant whose clients mostly
include pension funds, agrees to meet the managing director to discuss the position.
At the meeting, McGuinn is told, “Forster adopted the CFA Institute Code and
Standards 10 years ago. The outgoing finance director assured us at the time that we
adopted the Code and Standards that all of Forster’s policies and procedures met the
requirements most of the recommendations as well. As a result, we mention com-
pliance with the Code and Standards in all of our marketing material. We encourage
you to implement new changes, but the implementation will need to be coordinated
through the human resources department.” After agreeing on written specific duties
and responsibilities for the role, McGuinn accepts the offer to act as Forster’s com-
pliance officer on a part-time consultancy basis.
On his first day as the new compliance officer, McGuinn immediately reviews
a draft response to a request for proposal (RFP) to be submitted the next day to a
potential pension fund client. The proposal is identical to another RFP sent out three
months ago and includes Forster’s organizational chart, an in-depth description of
its investment process and the occasional use of third-party research providers, and
a guarantee of a minimum 5% investment return and return of principal through a
guaranteed structured savings product, underwritten by an investment-grade life insur-
ance company. McGuinn approves the RFP document without making any changes.
That same day, Colleen Collins, a research analyst, approaches McGuinn, con-
cerned that she may be in possession of insider information. Collins relates that she
was at a party the night before and overheard a conversation between two CEOs of
competing, publicly listed manufacturing companies. The CEOs discussed, but did
not express their opinions on, the validity of a recent article published in an online
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2 2020 Level II Mock Exam (A) PM
industry newsletter, which was speculating on the benefits of a merger between their
two companies. The newsletter is available by subscription only. One of these com-
panies is on Forster’s recommended buy list.
Following this conversation, McGuinn feels it is necessary to enhance Forster’s
rules and procedures when dealing with possible insider information. He recommends
the following changes to the company’s policies and procedures:
Recommendation 1: Stop market-making activities when in possession of mate-
rial nonpublic information.
Recommendation 2: Regularly review employee and proprietary trading.
Recommendation 3: Require all employees to attend an annual refresher course
on how to identify and handle material nonpublic information.
After reviewing how Forster chooses and retains its stockbrokers every year,
McGuinn makes several changes in the policy. The following guidelines are imple-
mented and communicated to clients. Stockbroker selection must be based on the
brokers’ ability to:
Guideline 1: provide accounting software.
Guideline 2: execute client transactions efficiently.
Guideline 3: obtain invitations to investment conferences for loyal clients.
After undertaking investigations based on an anonymous report, McGuinn con-
firms that several Forster fund managers were witnessed being wined and dined over
the past few weeks by large brokerage firms trying to get Forster’s business. The same
employees have not notified him about these dinners, a violation of Forster’s internal
policies. McGuinn notifies the employees in writing that they have been violating the
company policy. In the letter of notification, he requires the employees to abide by
the policy in the future.
1 Is McGuinn’s proposed compliance officer structure most likely consistent with
the CFA Institute Code and Standards?
A No, with regard to authority and responsibility.
B Yes.
C No, with regard to policies and procedures.
C is correct. Forster’s adoption of the CFA Code and Standards does not necessarily imply
that they currently have in place proper policies and procedures to ensure compliance
with the Code and Standards and local legal and regulatory requirements. According to
Standard IV(C)–Responsibilities of Supervisors, if a compliance system is non-existent or
if an existing compliance system is inadequate, a member should not accept supervisory
responsibility until the firm adopts reasonable procedures to allow adequate exercise of
supervisory responsibilities. McGuinn should thus undertake a review prior to accepting
the position, ascertaining that proper policies and procedures are in place. McGuinn’s
authority and responsibility appear to have been clearly defined through his written
terms of reference, and he was given authority to implement needed changes. McGuinn
would be required, however, to supervise and coordinate the implementation through
the human resources department.
A is incorrect because McGuinn’s authority and responsibility appear to have been
clearly defined through his written Terms of Reference and he is being given authority
to implement needed changes. McGuinn would be required, however, to supervise and
coordinate the implementation through the human resources department
2020 Level II Mock Exam (A) PM 3
B is incorrect because Forster’s adoption of the CFA Institute Code and Standards
does not necessarily imply that they currently have in place proper policies and proce-
dures to ensure compliance with the Code and Standards and local legal and regulatory
requirements.
Guidance for Standards I–VII
2 Which item in the request for proposal (RFP) is least likely consistent with
Standard I(C)–Misrepresentation?
A Guaranteed investment return
B The firm’s organizational structure
C Use of third-party research providers
B is correct. The RFP was done on the basis of the old organizational structure, which
would have included the retired finance director. Standard I(C) requires members not
to misrepresent the qualifications of a firm. With a senior professional leaving the firm,
the organizational structure should be updated prior to submitting a RFP for a potential
client’s consideration.
A is incorrect. The mention of a minimum 5% guarantee is not a violation as it is a
guaranteed product, underwritten by an investment grade insurance company.
C is incorrect. The use of third-party research services is allowable and not a violation.
3 Did Collins most likely receive insider information as defined by the CFA
Institute Code and Standards?
A No, because the information is considered non-material.
B Yes.
C No, because the information is considered public.
A is correct. When determining whether information is considered “insider,” the source

of the information must be assessed as required by Standard II(A)–Material Nonpublic
Information. Having an industry or trade newsletter speculate on the benefits of a merger
between two companies does not necessarily mean the two companies are actually
merging. The two CEOs are overheard discussing the newsletter but never provide
their perspectives or opinions on the article, so the information is only related to the
newsletter. Thus, the information is not considered material.
B is incorrect because an industry or trade newsletter that speculates on the benefits
of a merger between two companies does not necessarily mean the two companies are
actually planning on merging
C is incorrect because the newsletter is only available via subscription and is selectively
disclosed, so the information contained in it could not be considered public.

4 Which of McGuinn’s recommendations is least appropriate to implement as

per recommended procedures for compliance of Standard II(A)–Material
Nonpublic Information?
A Recommendation 1
B Recommendation 2
C Recommendation 3
A is correct. When a firm acts as a market maker, a prohibition on proprietary trading

may be counterproductive to the goals of maintaining the confidentiality of information
and market liquidity, as outlined in Standard II(A)–Material Nonpublic Information. In
some cases, a withdrawal by the firm from market-making activities would be a clear
tip to outsiders. Firms that continue market-making activity while in the possession of
material nonpublic information should, however, instruct their market makers to remain
passive to the market (i.e., take only the opposing side of unsolicited customer trades).
B is incorrect because regularly reviewing employee and proprietary trading is one
recommendation to assess whether trades are being done on the basis of nonpublic
material information.
C is incorrect because requiring all employees to attend an annual refresher course
in how to identify and handle material nonpublic information is a recommendation that
helps to increase awareness of insider information issues. With increased awareness, the
likelihood of a violation decreases.
5 Which guideline with regard to choosing stockbroking services is most likely

consistent with Standard III(A)–Duty to Clients?
A Guideline 2
B Guideline 3
C Guideline 1
A is correct. Members and candidates have a responsibility under Standard III(A)–Loyalty,

Prudence, and Care to obtain best execution (i.e., a trading process that seeks to maxi-
mize the value of the client’s portfolio within the client’s stated investment objectives
and constraints). Standard III(A)–Loyalty, Prudence, and Care requires an investment
manager to use client brokerage to the benefit of the client and not to the firm unless
the methods or policies followed to address the potential conflict of interests is disclosed
to the client prior to the firm receiving the benefit. Forster did not do this with regard
to the accounting software. In addition, members and candidates have a responsibility
under Standard III–Duties to Clients to use client brokerage to the benefit of all clients,
not a group of select clients, unless it is under a directed brokerage arrangement. That
is not the case in this scenario.
B is incorrect because members and candidates have a responsibility under
Standard III–Duties to Clients to use client brokerage to the benefit of all clients, not a
group of select clients unless it is under a directed brokerage arrangement that is not
the case in this scenario.
C is incorrect because Standard III(A)–Duties to Clients requires an investment manager

to use client brokerage to the benefit of the client and not the firm unless the methods
or policies followed to address the potential conflict of interests is disclosed to the client
prior to the firm receiving the benefit. Forster did not do this.
6 With regard to the fund managers under investigation, the most appropriate
additional action McGuinn should take is to:
A monitor their future actions.
B report the misconduct up the chain of command.
C require a statement stating the behavior will cease.
A is correct. As a supervisor, under Standard IV(C)–Responsibilities of Supervisors,

McGuinn has a responsibility after he notices and investigates the violation to monitor
the employees to ensure that the errant behavior has changed and conforms to the Code
and Standards. Reporting the violation up the chain of command along with requiring a
statement from the employees stating the behavior will not be repeated is not enough.
B is incorrect because reporting the violation up the chain of command is not enough
as per Standard IV(C)–Responsibilities of Supervisors.
C is incorrect because a statement from the errant employees stating they will cease
the violating activity is not enough.

QUESTIONS 7–12
Fiona O’Connor, CFA, who is based in Dublin, runs the asset management firm that
manages the assets for the Step Up Social Impact Private Equity Fund (the Fund), which
is registered in Ireland. The general partner of the Fund has asked O’Connor to meet
with Elise Jensen, CFA, a pension asset consultant, to find out whether Jensen will
pitch the Fund to her institutional clients looking for an environmental, social, and
governance (ESG) approach. Jensen specializes in working with continental European–
based pension funds, many of which are Swiss pension funds required by Swiss pen-
sion regulations to undertake an ESG assessment prior to making an investment. In
addition, all her clients have a relatively low risk profile, because they are small funds.
The few pension funds Jensen works with that do not require an ESG assessment still
include the desire for this type of evaluation in their investment mandate.
During an introductory meeting that lasts about an hour, Jensen asks O’Connor
to give an overview of the Fund. O’Connor makes the following three statements:
First, as you are aware, the Step Up Fund is a global social impact fund.
Therefore, we have allocated 85% of our investment portfolio to education
and health care. In addition, some of the companies we invest in offer
scholarships or free services to those who cannot afford their services. As
a result, our investment returns may not be as high as those of funds that
have a strict “for-profit” investment strategy, but we still track our Fund
against ESG indexes. We have also developed a set of “social impact” metrics
that aim to show the Fund has a positive impact on people’s lives. Details
of the investment strategy and how we select investments are clearly and
extensively described in our fund prospectus. In addition, investors are
notified prior to any changes being made in our investment process.
Second, let me explain how we select investments. I’ll give you the
prospectus, too, for your further reference, because it contains all the
details, and they’re quite extensive. We identify potential investments from
around the globe through our own analysts’ research within the education
and health care industries. We also use third-party agents to find potential
investments. If we make an investment in the companies they present to
us, we pay them a finder’s fee. One such agent we use is Make-a-Difference
Consultants, an asset consulting firm that has adopted the CFA Institute
Code and Standards.
Finally, I also want to disclose to you the compensation arrangements
for the asset management firm’s six investment analysts, all of whom report
to me directly. Two of the analysts work part-time, because they made
earlier commitments with other asset management firms before I found
them. But they do not work for other social impact funds, so I’m OK with
this arrangement because we consider them independent contractors. We
disclose this and other forms of management compensation to all clients
and potential clients. All the analysts are paid monthly and participate in the
firm’s year-end bonus program. The value of the bonus pool is determined
by how well the company has performed.
Prior to the end of the meeting, O’Connor invites Jensen to join her and one of
her analysts on an upcoming trip to Harare, Zimbabwe, to undertake an annual ESG
assessment for one of their social impact investments. The Fund has invested in a
private university for women that was founded a couple of years ago, with 40% of the
students coming from disadvantaged families. O’Connor adds, “This way, you can see
our investment process in action.” Jensen expresses interest in going to Zimbabwe as
part of her due diligence process and asks, “Who pays for my trip expenses?”
During their trip to Zimbabwe, O’Connor and Jensen meet with the university’s
chief financial officer and learn about the increasing success of the school and the
impact the school programs are having on their students. Jensen expresses her excite-
ment about the potential of the school and cannot wait to return home to present the
school as a potential investment to her clients. After returning home, Jensen makes
her first presentation to her smallest client, with assets totaling EUR20 million. She
makes the following statement:
I just got back from a due diligence trip to Zimbabwe with Fiona O’Connor,
the portfolio manager of the Step Up Fund, which has an ESG investment
mandate. We visited an amazing women’s university that has solicited
donations for a scholarship program for disadvantaged women. The school
is very well run, and with the new scholarship program, investment returns
are expected to increase, because they will no longer need to subsidize
tuition. I’ve been assured the other holdings within the Step Up Fund are
of equal caliber. I got to know O’Connor during the trip and feel she has
a good grasp of ESG issues. I really believe you should invest in the Step
Up Fund, because it meets your investment objectives. I would start with
a EUR5 million investment.
7 Based only on the information given, when providing investment advice to her
clients, Jensen should most likely adhere to which of the following to avoid vio-
lating Standard I(A): Knowledge of the Law?
A Irish legislation
B Swiss regulations
C CFA Institute Standards of Professional Conduct
B is correct. Jensen should adhere to Swiss regulations. Standard I(A): Knowledge of the

Law requires members and candidates to adhere to the stricter of any applicable legis-
lation or regulations and the CFA Institute Standards of Professional Conduct. Therefore,
when providing investment advice to her Swiss pension clients, Jensen should most
likely adhere to the stricter Swiss regulations requiring ESG assessments prior to the
pension funds making an investment. Jensen would not likely be required to adhere to
Irish legislation, because she is not directly associated with the Fund nor are her clients
based in Ireland. In this instance, the CFA Institute Standards are less strict than Swiss
regulations, because they do not require members to undertake ESG assessments prior
to taking investment action or making an investment recommendation.
A is incorrect because Jensen would not likely be required to adhere to Irish legislation,
because she is not directly associated with the Fund nor are her clients based in Ireland.
C is incorrect because in this instance, the CFA Institute Code and Standards are
less strict than Swiss regulations since they do not require members to undertake ESG
assessments prior to taking investment action or making an investment recommendation.
Guidance for Standards I-VII
8 Given O’Connor’s first statement about the asset allocation, expected returns,
and strategy of the Step Up Social Impact Private Equity Fund, does O’Connor
most likely violate the CFA Institute Standards?
A No
B Yes, with regard to Standard III(A): Loyalty, Prudence, and Care
C Yes, with regard to Standard V(B): Communication with Clients and
Prospective Clients
A is correct because there is no indication O’Connor violated Standard III(A): Loyalty,

Prudence, and Care or Standard V(B): Communication with Clients and Prospective Clients.
With regard to Standard III(A), investors in this type of social impact fund are likely look-
ing to achieve high levels of social impact as well as to obtain somewhat competitive
investment returns. Consequently, returns may not be the primary focus so the Fund
can still meet its fiduciary duty to clients. As long as this strategy is clearly indicated
in the prospectus prior to entry into the Fund, O’Connor would not be in violation of
Standard III(A). In addition, with regard to Standard V(B), since the investment strategy is
clearly stated in detail in the prospectus and notifications of changes are sent to clients
prior to changes being made, O’Connor, as part of the senior management team, would
not be in violation of Standard V(B).
B is incorrect because there is no indication O’Connor violated Standard III(A): Loyalty,
Prudence, and Care.
C is incorrect because there is no indication the information contained in the prospec-
tus is incorrect or misleading. Therefore, O’Connor, as part of the senior management team,
is not in violation of Standard V(B): Communication with Clients and Prospective Clients.

9 Given O’Connor’s second statement to Jensen, which further action should

O’Connor least likely take to comply with required or recommended proce-
dures for the CFA Institute Standards of Professional Conduct?
A Monitor the consultants’ compliance policy execution.
B Disclose the finder’s fee arrangement in the fund prospectus.
C Notify clients of the finder’s fee policy on a semiannual basis.
C is correct. O’Connor should least likely notify clients of the finder’s fee policy on a
semiannual basis. Recommended procedures to implement Standard VI(C): Referral Fees
are to notify clients at least quarterly, not semiannually.
A is incorrect. Make-a-Difference has made claims that it abides by the CFA Institute
Code and Standards. O’Connor has a responsibility under Standard I(A): Knowledge
of the Law to not knowingly participate or assist others in violating any CFA Institute
Standards. Therefore, she must seek assurances that Make-a-Difference Consultants
also disclose the receipt of finder’s fees to their clients where applicable as required by
Standard VI(C): Referral Fees.
B is incorrect. O’Connor should ensure that the potential use of paying finder’s fees
to Make-a-Difference Consultants or any other third-party agents is disclosed in the
prospectus to avoid violating Standard VI(C): Referral Fees.
10 With regard to the asset management firm’s compensation arrangements for the
investment analysts as mentioned in O’Connor’s final statement, does O’Connor
most likely violate any CFA Institute Standards?
A No
B Yes, relating to the bonus pool
C Yes, relating to the part-time policy
A is correct. O’Connor has not violated any CFA Institute Standards relating to the firm’s
bonus pool or its part-time policy. With regard to the year-end bonus pool, Standard VI(A):
Disclosure of Conflicts is not violated, because the participation in the bonus pool is
not structured to provide immediate compensation or give returns based on short-
term investment action with little or no long-term value creation. In compliance with
Standard III(A): Loyalty, Prudence, and Care recommendations, the firm discloses all
forms of management compensation arrangements. With regard to the part-time pol-
icy, O’Connor has also not violated any CFA Institute Standards. The Standards do not
prohibit independent contractors. Standard VI(A): Disclosure of Conflicts is being upheld
in that the firm discloses the part-time relationship with its clients and potential clients.
B is incorrect because O’Connor has not violated any CFA Institute Standards relating
to the firm’s bonus pool.
C is incorrect because O’Connor has not violated any CFA Institute Standards relating
to the hiring of part-time analysts.

11 To avoid violating any of the CFA Institute Standards of Professional Conduct,

how should O’Connor most likely reply to Jensen’s question regarding the trip to
Zimbabwe?
A My firm
B Your clients
C The Step Up Fund
B is correct. O’Connor should explain to Jensen that Jensen’s clients should pay for her
trip to Zimbabwe. Although Jensen would likely directly pay for the expenses associ-
ated with the trip to Zimbabwe, her clients would ultimately pay for the cost of the trip
through their management fees to Jensen. Standard I(B): Independence and Objectivity
requires members and candidates to use reasonable care and judgment to achieve and
maintain independence and objectivity. Jensen, therefore, needs to take care to not
allow any benefit, or any perceived benefit, from her trip to influence any decision to
recommend that her clients invest in the Fund. To avoid this, Jensen’s clients, typically
through fees and disbursements they pay, should pay for her trip as part of their required
due diligence process expenses.
A is incorrect. O’Connor should not suggest her firm pay for Jensen’s trip expenses.
If O’Connor’s firm were to pay for Jensen’s trip, it would be viewed as trying to influence
Jensen’s recommendation to her clients. O’Connor would then knowingly be assisting
Jensen to be in violation of Standard I(B): Independence and Objectivity, causing O’Connor
to be in violation of Standard I(A): Knowledge of the Law.
C is incorrect. O’Connor should not suggest that the Fund pay for Jensen’s expenses.
If the Step Up Fund paid for potential investors’ due diligence costs, it would harm exist-
ing investors’ investment returns and be a potential violation of Standard III(A): Loyalty,
Prudence, and Care, causing O’Connor to be in violation of Standard I(A): Knowledge
of the Law.
12 During Jensen’s meeting with her client, did she most likely make any inappro-
priate comments related to Standard III(C): Suitability?
A No
B Yes, with regard to due diligence
C Yes, with regard to due diligence and asset allocation
C is correct. During Jensen’s client meeting, she made at least two inappropriate com-
ments related to Standard III(C): Suitability. Jensen has a duty to judge the suitability
of an investment in the context of the client’s total portfolio. However, Jensen has not
undertaken a proper due diligence assessment on the Fund; she attended an introduc-
tory meeting lasting about one hour, which would not be considered in-depth due
diligence of the Step Up Fund. The due diligence trip to Zimbabwe pertained only to
one single investment within the Fund and thus would not be considered a fund due
diligence evaluation. Consequently, at this point in time, she would not be able to
determine whether the fund was suitable for her client’s portfolio without undertaking
further analysis. Jensen also has a duty under Standard III(C): Suitability to determine
whether an investment is suitable to the client’s financial situation and consistent with
the client’s written objectives, mandates, and constraints before making an investment
recommendation or taking investment actions. Jensen has recommended her client
invest a minimum of EUR5 million in the Step Up Fund. Because her clients are small
pension funds with low risk profiles, investing 25% of the portfolio in the Step Up Fund
would not likely be appropriate.
A and B are incorrect because Jensen has made at least two violations of Standard III(C):
Suitability by not performing proper due diligence on the Step Up Fund and by rec-
ommending an inappropriate asset allocation (25%) to a low-risk pension fund. Under
Standard III(C): Suitability, members and candidates have a responsibility to judge the
suitability of an investment in the context of the client’s total portfolio and to determine
whether an investment is suitable to the client’s financial situation and consistent with
the client’s written objectives, mandates, and constraints.

QUESTIONS 13–18
Brendan Dennehy works for Transon Investments, PLC, a Dublin-based hedge fund
with significant equity investments in technology companies in Asia, North America,
and Europe. Transon is concerned about the recent poor performance of one of the
fund’s Chinese investments, Winston Communications, an assembler of telecommu-
nications equipment. Transon’s chief of information technology (IT) is Sean Malloy.
Yesterday, Winston’s IT office sent Malloy data related to the assembly process and
a printout of an analysis of the number of defective assemblies per hour. Winston’s
IT people believe that the number of defective assemblies per hour is a function of
the outside air temperature and the speed (production rate) of the assembly lines.
Malloy recalls that Dennehy has had substantial training in statistics while working
on his MBA. He asks Dennehy to help him interpret the regression results supplied
by Winston.
Exhibit 1 Regression Results

Dt = b0 + b1Airt + b2Rt + εt
Coefficient Standard Error
Constant (b0) 0.016 0.0942

Outside air temperature 0.0006 0.001
(b1)
Assembly line speed 0.5984 0.3
(b2)
Number of observations used in the regression 384
Critical t-value at 5% significance (two-tail test where 1.96
coefficient equals zero)
Standard Error of Durbin–Watson Significance

R2 the Estimate Statistic F-Statistic of F
0.414 0.333 1.89 157.699 0

Durbin–Watson critical
1.63 1.72
values (5% significance)
Exhibit 1 (Continued)
Standard Error of Durbin–Watson Significance

R2 the Estimate Statistic F-Statistic of F
Correlation between
outside air temperature 0.015
and assembly line speed
Using the data provided in Exhibit 1, Dennehy tests the hypothesis that the coef-
ficients for outside air temperature and assembly line speed are significantly different
from zero, using a significance level of 5%. Dennehy also uses the results given in
Exhibit 1 to evaluate the potential for multicollinearity in the data.
Finally, Dennehy would like to confirm that nonstationarity is not a problem. To
test for this he conducts Dickey–Fuller tests for a unit root on each of the time series.
The results are reported in Exhibit 2.
Exhibit 2 Results of the Dickey-Fuller Tests

Value of the Standard
Time Series Test Statistic Error t-Statistic Significance of t
Defective assemblies 0.0036 0.0023 1.591 0.1123

per hour
Outside air –0.423 0.0724 –5.846 0
temperature
Assembly line speed –0.586 0.043 –13.510 0
Dennehy tells Malloy about the Dickey-Fuller test results, stating:

“We can safely use regression to estimate the relationship between the dependent
variable and the independent variables if 1) none of the three time series exhibit a
unit root or 2) all three time series exhibit a unit root but they are also mutually
cointegrated.”
13 Based on Exhibit 1 and statistical tests, the best conclusion Dennehy can make
is that the regression coefficient is significantly different from zero with respect
to the coefficient(s) for:
A assembly line speed (b2) only.
B both outside air temperature (b1) and assembly line speed (b2).
C outside air temperature (b1) only.
A is correct. The null hypotheses are that the coefficients equal zero. The alternative
hypotheses are that the coefficients do not equal zero (two-tailed tests). The appropri-
ate test statistics, t, are calculated by dividing the estimates of the coefficients by their
respective standard error.
tb1 = 0.0006/0.0010 = 0.60
tb2 = 0.5984/0.30 = 1.9947
The test statistic for outside air temperature is less than the critical value of 1.96.
The test statistic for assembly line speed exceeds the critical value of 1.96. Dennehy
cannot reject the null hypothesis that the population regression coefficient for outside
air temperature, b1, is zero. Dennehy can reject the null hypothesis that b2 is zero at the
5% level of significance.
B is incorrect. Only assembly line speed is significant.
C is incorrect. Outside air temperature is not significant.
Introduction to Linear Regression
14 The most appropriate interpretation of the results reported in Exhibit 1 is that:

A the F-statistic of the regression is not significant.
B predictions of defective assemblies per hour made using the regression have
only about a 41% chance of being correct.
C variations in the independent variables explain approximately 41% of the
variation in the defective assemblies per hour.
C is correct. The R2 indicates that variations in the independent variables explain approxi-
mately 41% of the variation in the dependent variable. The F-statistic is highly significant.
R2 does not inform us regarding the probability of a dependent variable prediction
being correct.
A is incorrect. The F-test of the regression is highly significant.
B is incorrect. R2 does not inform us regarding the probability of a dependent variable
prediction being correct.
Introduction to Linear Regression
15 What is the most appropriate inference from the Durbin–Watson statistic

reported in Exhibit 1? The Durbin–Watson test:
A is inconclusive.
B rejects the null hypothesis of no positive serial correlation.
C fails to reject the null hypothesis of no positive serial correlation.
C is correct. The value of the Durbin–Watson statistic is given in Exhibit 1 as 1.890. The
critical values are given as 1.63 and 1.72. Because the value (1.890) exceeds the upper
critical value (1.72), the Durbin–Watson test fails to reject the null hypothesis of no
positive serial correlation.
A is incorrect. A value between the lower Durbin–Watson and the upper Durbin–
Watson is inconclusive.
B is incorrect. Rejection of the null requires a Durbin–Watson below the lower critical
value.
Multiple Regression and Issues in Regression Analysis
16 The results reported in Exhibit 1 are most accurately interpreted as indicating

that:
A the reported R2 is spurious.

B multicollinearity is not present.
C the regression coefficients have inflated standard errors.
B is correct. The pairwise correlation is low. The only case in which correlation between
independent variables may be a reasonable indicator of multicollinearity occurs in
a regression with exactly two independent variables, as is the case in this problem.
Furthermore, the additional classic symptoms of multicollinearity (high R2 and significant
F-statistic but not significant coefficients) are not present.
A is incorrect. Even in the face of multicollinearity, a regression may have a high R2.
C is incorrect. At least one coefficient (b2) is different from zero.
Multiple Regression and Issues in Regression Analysis
17 Assuming a 5% level of significance, the most appropriate conclusion that can

be drawn from the Dickey–Fuller results reported in Exhibit 2 is that the:
A test for a unit root is inconclusive for the dependent variable.
B independent variables exhibit unit roots but the dependent variable does
not.
C dependent variable exhibits a unit root but the independent variables do
not.
C is correct. The Dickey–Fuller test uses the following type of regression:

xt – xt–1 = b0 + g1xt–1 + εt, E(εt) = 0
The null hypothesis is H0: g1 = 0 versus the alternative hypothesis Ha: g1 < 0 (a one-
tail test). If g1 = 0, the time series has a unit root and is nonstationary. Thus, if the null
hypothesis fails to be rejected, then the possibility exists that the time series has a unit
root and is nonstationary.
Based on the t ratios and their significance levels in Exhibit 2, the null hypothesis
that the coefficient is zero is rejected for both outside air temperature and assembly
line speed (i.e., the independent variables). But the null hypothesis is not rejected for
the dependent variable, defective assemblies per hour.
A is incorrect because the p-value for the Dickey–Fuller test of the dependent variable
time series (11.23%) clearly fails to reject the null at 5% level of significance.
B is incorrect. We reject the null hypothesis that the coefficient is zero for both outside
air temperature and assembly line speed. We do not reject the null for the independent
variable, defective assemblies per hour.
Time-Series Analysis
18 Dennehy’s statement about the Dickey–Fuller test is best characterized as:

A incorrect, because only the independent variables series need to be tested
for the absence of a unit root
B incorrect, because only the dependent variable series needs to be tested for
the absence of a unit root.
C correct.
C is correct. One possibility is that none of the time series used in a regression exhibit
a unit root. In that case, regression analysis can safely be used. Alternatively, if at least
one time series (the dependent variable or one of the independent variables) has a unit
root while at least one time series (the dependent variable or one of the independent
variables) does not, the error term in the regression cannot be covariance stationary.
Consequently, multiple linear regression should not be used to analyze the relationship
among the time series in this scenario.
Another possibility is that each time series, including the dependent variable and each
of the independent variables, has a unit root. If this is the case, it needs to be established
whether the time series are cointegrated. When all series used in a regression display unit
roots, but they are also mutually cointegrated, regression analysis can safely be used.
B is incorrect.
A is incorrect.
Time-Series Analysis

QUESTIONS 19–22
Sunjet Airlines Ltd. (Sunjet), a US-based “no frills” carrier, has the following existing
non-domestic operations.
■■ Nanuk Air Inc. (Nanuk) is a Canadian carrier that Sunjet purchased several
years ago. It provides service to remote mining operations in the Canadian
north. The company has been very profitable, and it recently financed a renewal
of its fleet of seaplanes with CAD-denominated long-term debt.
■■ Sunjet Mexico SA (SunMex) was established on 1 April 2016 to facilitate expan-
sion of the Sunjet network to six Mexican destinations. The company purchased
hangar assets in Mexico that were 100% financed with MXN-denominated
loans guaranteed by Sunjet, and operations began shortly thereafter. Although
most of SunMex’s revenues are generated in the US vacation travel market, the
company also serves domestic Mexican passengers. These MXN-denominated
sales amounted to approximately 10% of SunMex’s fiscal 2016–17 revenues, and
they are expected to remain below 15% in the future.
Today is 30 April 2017, one month after Sunjet’s fiscal year end, and the CEO,
Mark Napier, is meeting with the CFO, Lisa Cameron, to discuss the international
operations. Napier mentions that he will be meeting next week with the president
of SunMex to discuss the first year of operations. Cameron pulls out the draft year-
end results (Exhibit 1) and some exchange rate data (Exhibit 2). She notes that the
SunMex president’s bonus is tied to fixed asset turnover and net income targets. She
reminds Napier that the bonus thresholds are evaluated based on the translated USD-
denominated financial statements rather than the MXN-denominated ones, and she
promises to send the translated version once the results are finalized.
Exhibit 1 Summarized Draft Financial Statements for SunMex, Fiscal

2016–17 (MXN millions)
Cash and accounts receivable 47
Fixed assets (net) 370
Total assets 417
Current liabilities 33
Long-term debt 224
Common shares 160
Retained earnings 0
Total liabilities and shareholders’ equity 417

Sales 140
Depreciation expense 20
Other expenses 120
Tax expense 0
Net income 0
Exhibit 2 Selected Exchange Rates

USD per MXN CAD per USD
31 March 2017 0.0513 1.352

Average for fiscal 2016–17 0.0538 1.340
1 June 2016 0.0625 1.300
31 March 2016 0.0625 1.303
Average for fiscal 2015–16 0.0855 1.312
Nanuk, which prepares its translated statements using the current rate method,
is next on the agenda. Cameron reports that annual translated USD-equivalent sales
are up from 22.3 million last year to 23.7 million this year. Cameron reminds Napier
that one of the performance metrics in the bonus calculation for Nanuk’s president
is Nanuk’s sales growth determined in the local currency. Napier asks Cameron to
calculate that figure for the 2016–17 fiscal year.
Napier also asks Cameron what effect Nanuk’s translated statements will have on
Sunjet’s other comprehensive income for the current year.
19 Under which translation method for non-domestic operations will SunMex’s
fixed asset turnover most likely be higher?
A The temporal method
B The current rate method
C There will be no difference.
B is correct. Fixed asset turnover is higher under the current rate method, as shown in the
following table. Although sales are translated at the average rate under both methods,
the fixed assets are translated at the historical rate under the temporal method and at
the year-end rate under the current rate method. Because the peso has weakened since
the assets were purchased, the translated value is lower under the current rate method,
resulting in a higher fixed asset turnover rate.
Temporal Method Current Rate Method

Exchange Exchange
Rate Rate
MXN (USD per USD (USD per USD
(millions) MXN) (millions) MXN) (millions)
Sales 140 0.0538 7.532 0.0538 7.532

Fixed assets 370 0.0625 23.125 0.0513 18.981
(net)
Fixed asset turn- 0.326 0.397
over (Sales/Fixed
assets)
A is incorrect. Under the temporal method, the fixed asset turnover is lower.
C is incorrect. This answer incorrectly assumes that fixed assets are translated at the
same rate under both the current rate and temporal methods.
Multinational Operations
20 On translation, SunMex’s USD-denominated net income most likely includes:

A a re-measurement gain of $2.526 million.
B a re-measurement loss of $1.792 million.
C no re-measurement gains or losses.
A is correct. SunMex will be translated using the temporal method because the competitive
environment that mainly determines SunMex’s sales prices is that of the United States.
Under this approach, monetary assets and liabilities are translated at the year-end rate,
and non-monetary items are translated at historical rates.
Because it is SunMex’s first year of operations, the retained earnings will include
only the translated net income for the year. The translated net income will include the
re-measurement gain or loss in accordance with the temporal method. As shown in the
following table, the retained earnings balance required to balance the balance sheet is
USD2.352 million.
Exchange
Rate
Item MXN (MXN per USD
Balance Sheet Type (millions) USD) (millions)
Cash and A/R Monetary 47 0.0513 2.411

(year-end)
Fixed assets (net) Non- 370 0.0625 23.125
monetary (historical)
Total assets 417 25.536
Current liabilities Monetary 33 0.0513 1.693

(year-end)
Exchange
Rate
Item MXN (MXN per USD
Balance Sheet Type (millions) USD) (millions)
Long term debt Monetary 224 0.0513 11.491
(year-end)
Common shares Non- 160 0.0625 10.000
monetary (historical)
Retained earnings* Used to 0 X = 2.352
balance
Total liabilities and equity 417 25.536
* Retained earnings: 25.536 – (1.693 + 11.491 + 10.000) = $2.352 million
Under the temporal method, the income statement is translated at the average rate,
except for expenses linked to non-monetary items on the balance sheet. For SunMex,
depreciation is translated at the historical rate, but the rest of the income statement is
translated at the average.
Exchange
Rate
MXN (MXN per USD
Income Statement (millions) USD) (millions)
Sales 140 0.0538 7.532

(average)
Depreciation 20 0.0625 1.250
expense (historical)
Other expenses 120 0.0538 6.456
(average)
Income before re- (0.174)
measurement gain
or loss
Re-measurement Y = 2.526 See calculation

gain**
Net income 0 2.352 From earlier
required = balance sheet
retained earnings calculations
** The re-measurement (translation) gain or loss = 2.352 – (–0.174) = 2.526 gain
B is incorrect. This is the re-measurement loss that would be calculated under the
current rate method.
Exchange
MXN rate USD
Balance sheet (millions) (MXN/ USD) (millions)
Net assets (417 – 33 – 224) = 160 0.0513 8.208

Common shares 160 0.0625 10.000
Retained earnings* 0 0
(continued)
Exchange
MXN rate USD
Balance sheet (millions) (MXN/ USD) (millions)
Re-measurement loss 1.792
(OCI)
Total equity 160 8.208
* AOCI = 10.0 – 8.208 = 1.792
C is incorrect. This answer assumes that the translational adjustment is shown on the
balance sheet, as is the case for the current rate method.
21 In the bonus calculation for Nanuk’s president, the sales growth that is to be
used is closest to:
A 10.3%.
B 6.3%.
C 8.5%.
C is correct. Nanuk’s sales growth, in the local Canadian currency, is its CAD-denominated
sales growth.
USD Average Exchange Rate CAD

(millions) (CAD per USD) (millions)
2016–17 revenues 23.7 1.340 31.76

2015–16 revenues 22.3 1.312 29.26
Increase in sales 1.4 2.5
CAD-denominated sales growth is 2.5 million/29.26 million = 8.5%.
B is incorrect. This is the USD-denominated growth rate of 6.3% (USD1.4 million/

USD22.3 million).
A is incorrect. This is the CAD-denominated growth rate incorrectly translated back
to CAD using year-end exchange rates: CAD2.98 million/CAD29.06 million = 10.3%.
USD Year-end exchange rate CAD

(millions) (CAD per USD) (millions)
2016/17 revenues 23.7 1.352 32.04

2015/16 revenues 22.3 1.303 29.06
Revenue growth 1.4 2.98
22 The best answer to Napier’s question about the effect of Nanuk on Sunjet’s other
comprehensive income is that Nanuk’s:
A net asset exposure will generate a re-measurement gain.

B net liability exposure will generate a re-measurement gain.
C net asset exposure will generate a re-measurement loss.
C is correct. Nanuk is translated under the current rate method, so its translational
exposure is its net asset position. The weakening CAD (see Exhibit 2) will generate a
re-measurement loss in Sunjet’s other comprehensive income.
A is incorrect. It is the net asset position that is exposed to exchange fluctuations
under the current rate method. Per Exhibit 2, the CAD is depreciating vs. the USD so
would generate a loss. Candidates may think the CAD is strengthening.
B is incorrect. Nanuk’s net monetary liability position would generate a re-measurement
gain under the temporal method, but it is the net asset position that is exposed to
exchange fluctuations under the current rate method.

QUESTIONS 23–28
Joseph Cioffi and Amanda Yu, interns in the financial institutions division of an
investment firm, are cleaning up outstanding issues in a few files.
They start by examining the investment allocation and returns on the investment
portfolio for NANLife Group, a life and health insurance company, using data Cioffi
prepared (Exhibit 1).
Exhibit 1 Investment Allocation and Returns, NANLife Group, in $ Millions

Investment portfolio as of 31 December 2018 2017
Loans and deposits 8,800 9,000

Debt securities 141,000 130,800
Equity securities 40,250 34,000
Derivative financial instruments 130 90
Total financial investments 190,180 173,890
Investment properties 4,900 4,600
Total investment portfolio 195,080 178,490
Investment returns for the year ending 31

December 2018 2017
Interest income 6,610 5,850

Dividend income 820 750
Rental income 175 170
Investment income 7,605 6,770
Gains (losses) on fixed-income investments 300 (125)
(continued)
Investment returns for the year ending 31

December 2018 2017
Gains (losses) on other investments 1,540 1,665
Total investment returns 9,445 8,310
Cioffi asks, “Why does NANLife have a much larger portion of its investment
portfolio in equity securities compared with the property and casualty company we
were working on yesterday?”
Yu replies, “NANLife can take greater risks with its investments for two reasons:
First, its claims are relatively more predictable, and second, the claims have a shorter
duration.”
Before moving on Cioffi comments,
“It was interesting to learn about the insurance industry when working on
the NANLife file. Unlike the banking industry, it does not have to follow
international standards for capital adequacy, but as a US-based insurer,
NANLife still has some US requirements to meet. The company also pre-
pares its financial statements using statutory accounting rules that differ
from both US GAAP and IFRS.”
Next, they turn their attention to a commercial bank file that still required some
work on the assessment of earnings quality, using summary earnings information
prepared by Yu (Exhibit 2).
Exhibit 2 Selected Earnings Information from Bank File, in $ Thousands

2018 2017 2016 2015 2014
Interest income 640,400 614,000 606,300 607,300 599,000

Interest expense 225,800 231,700 246,600 260,300 262,700
Net interest income 414,600 382,300 359,700 347,000 336,300
Trading income 3,200 5,140 6,600 (900) 15,430

Other income 135,400 125,200 116,500 117,200 100,300
Total income net of 553,200 512,640 482,800 463,300 452,030

interest expense
Provision for credit 8,400 13,800 9,900 10,500 7,090

losses
Earnings before taxes 117,600 95,800 91,600 78,800 87,211
Yu states,
“We have to finish the CAMELS (capital adequacy, asset quality, manage-
ment capabilities, earnings sufficiency, liquidity position, and sensitivity
to market risk) analysis on this file. In my preliminary review of the bank’s
earnings information, I assigned a score reflecting high quality of earnings,
based on the following points:
■■ The trading income is volatile, but it is a small portion of the earnings.

■■ Net interest income has been growing at a constant rate over the period.
■■ The proportion of total income from net interest income has been stable in the
most recent years.”
Cioffi replies,
“I think we need to dig a little deeper. We need to look at the estimates
that are used to determine earnings and whether the bank is using them
to manage earnings before taxes (EBT). The provision for credit losses is
an estimate where management can exercise wide discretion. Let’s look at
what portion of the 2018 increase in EBT comes from the change in that
estimate.”
23 The average return on fixed-income assets for NANLife in 2018 is closest to:
A 4.6%.
B 4.8%.
C 5.1%.
B is correct. The average return on fixed-income assets is calculated as follows: Investment

income from fixed income ÷ Average fixed-income assets.
Investment income = Interest income + Gains/losses from fixed-income investments
= $6,610 + $300 = $6,910.
Average fixed-income assets including debt securities + Loan and deposits = (½)
($8,800 + $141,000) + (½)($9,000 + $130,800) = $144,800.
Average return = 6,910 ÷ 144,800 = 4.8%.
A is incorrect. It does not include the gains and losses on fixed-income investments:
6,610 ÷ 144,800 = 4.6%.
C is incorrect. It does not include the loans and deposits as fixed-income investments:
Average debt securities = ($141,000 + $130,800) × ½ = $135,900.
6,910 ÷ 135,900 = 5.1%.
Analysis of Financial Institutions
24 From 2017 to 2018, the risk related to the investment allocation for NANLife is
best described as having shown:
A no change.
B a decrease.
C an increase.
C is correct. When the investment portfolio is examined using a common-size format,

the proportion of the portfolio invested in equity securities has increased from 19.0%
to 20.6% (see table below) whereas the proportion allocated to loans and deposits and
debt securities has decreased. Equity investments are normally riskier than fixed-income
investments, which would indicate that the investment portfolio’s asset allocation is
riskier in 2018 than in 2017.
Analysis of NANLife’s Investment Portfolio Asset Allocation

2018 2017
Loans and deposits 8,800 4.5% 9,000 5.0%

Debt securities 141,000 72.3% 130,800 73.3%
Equity securities 40,250 20.6% 34,000 19.0%
Derivative financial 130 0.1% 90 0.1%
instruments
Total financial investments 190,180 97.5% 173,890 97.4%
Investment properties 4,900 2.5% 4,600 2.6%
Total investment portfolio 195,080 100.0% 178,490 100.0%
A is incorrect. The total financial investments have not changed materially (97.4% to
97.5%), but that is not the best measure of the risk of the investment portfolio. The allo-
cation of the portfolio between fixed-income and equity securities is a better measure
of portfolio risk.
B is incorrect. The proportion allocated to loans and deposits and debt securities has
decreased, but this would decrease the overall risk of the investment portfolio because
fixed-income investments are less risky than equity investments. The higher proportion
allocated to equity would increase the portfolio risk.
25 Yu’s reply to Cioffi’s question concerning the higher portion of equity securities
in NANLife’s investment portfolio is best described as correct with respect to:
A both reasons.
B only the first reason.
C only the second reason.
B is correct. Yu is incorrect about the duration of the claims of NANLife. NANLife is a life and
health insurance (L&H) company. L&H companies’ claims are more predictable than those
of property and casualty (P&C) companies, and their claims also have a longer duration
than P&C those of companies. It is the combination of both of these factors that allows
L&H companies to hold a greater proportion of equity investments than P&C companies.
A and C are incorrect. The products of a P&C company are usually shorter duration
than those of an L&H company; thus, that part of Yu’s answer is incorrect.

26 Cioffi’s comments about the regulatory requirements for NANLife are best
described as:
A correct.
B incorrect with respect to accounting rules.
C incorrect with respect to capital adequacy requirements.
A is correct. Cioffi’s comments about the regulatory requirements for US-based insurance
companies are all correct. The insurance industry does not have a set of global regulatory
standards like Basel III, but capital standards do exist in various jurisdictions, including
the United States. In the United States, the NAIC (National Association of Insurance
Commissioners) has established minimum capital adequacy standards. Also in the United
States, insurance companies prepare financial reports according to statutory accounting
rules, which differ from US GAAP and IFRS.
B is incorrect. Cioffi’s comments with respect to accounting rules are correct. In the
United States, insurance companies prepare financial reports according to statutory
accounting rules, which differ from US GAAP and IFRS.
C is incorrect. Cioffi’s comments with respect to capital adequacy are correct. The
insurance industry does not have a set of global regulatory standards as the banking
industry has with its Basel III regulations, but capital standards do exist in various juris-
dictions, including the United States. In the United States, the NAIC has established
minimum capital adequacy standards.
27 Using Exhibit 2, which of Yu’s points in support of the CAMELS score she
assigns for earnings quality is least accurate? The point concerning:
A trading income volatility.
B growth in net interest income.
C net interest income proportion.
B is correct. Yu’s point about the constant rate of growth of net interest income is not
accurate. As shown in the table below (Part A), the growth rate for net interest income has
been increasing, not stable, over the five-year period. Her point about trading income is
accurate. Although it is volatile, it is a small portion of net income, which supports a rating
of higher quality of earnings. Trading income is the least sustainable of the three types
of income; therefore, low reliance on it is better for earnings quality. As shown in Part
B of the table below, the mix between net interest income and other income has been
stable over the last three years, which is also a sign in support of high-quality earnings.
Analysis of Bank Income

2018 2017 2016 2015 2014
Part A
Year-to-year growth
rate
Net interest income 8.4% 6.3% 3.7% 3.2%
Part B
(continued)
(Continued)
2018 2017 2016 2015 2014

Portion of total
income net of interest
expense
Trading income 0.6% 1.0% 1.4% –0.2% 3.4%
Net interest income 74.9% 74.6% 74.5% 74.9% 74.4%
Other income 24.5% 24.4% 24.1% 25.3% 22.2%
Total income net of 100.0% 100.0% 100.0% 100.0% 100.0%
interest expense
A is incorrect. Her point about trading income is accurate. Although it is volatile, it is

a small portion of net income in support of higher quality of earnings. Trading income is
the least sustainable of the three types of income; therefore, low reliance on it is better
for earnings quality.
C is incorrect. As shown in Part B of the table above, the mix between net interest
income and other income has been stable over the last three years, which is also a sign
in support of high-quality earnings.
28 Based on Exhibit 2, the proportion of the increase in the 2018 earnings before
taxes that comes from the change in the provision for credit losses is closest to:
A 4.6%.
B 7.1%.
C 24.8%.
C is correct. A decrease in the provision for credit losses would have the effect of
increasing earnings before taxes. As shown in the table below, in 2018, EBT increased
by $21,800 but the provision for credit losses decreased by $5,400, thus accounting for
24.8% of the change in EBT.
Analysis of Change in EBT and Provision for Credit Losses, in $

Thousands
2018 2017 Change
Provision for credit losses 8,400 13,800 (5,400)

EBT 117,600 95,800 21,800
Percentage increase in EBT 24.8%
from decrease in provision
A is incorrect; it is the change in the provision ($5,400) as a proportion of EBT but

does not consider the change in EBT: 5,400 ÷ 117,600 = 4.6%.
B is incorrect; it is the provision for credit losses as a proportion of EBT but does not
consider the change in the two values: $8,400 ÷ $117,600 = 7.1%.

QUESTIONS 29–32
Ouse Inc., based in England, is a private company that produces and retails skin care
products, primarily soaps and lotions. Catherine Ferguson and her sister co-founded
the company 10 years ago because of their shared interest in developing plant-based
products that are not tested on animals. Initially the two sisters owned all the shares,
but two years ago they implemented performance-based compensation for the top
five senior managers, and as part of this process, the managers now own a combined
10% of the equity.
The company is looking to expand its equity base to help fund a new production
facility and support growth plans. Ferguson, who is responsible for the company’s
financial management, is meeting with Haji Malik, a financial consultant, to explore
Ouse’s equity financing options. Ferguson asks if they were to go public, could they
have a share structure similar to a company like Facebook, where the co-founders
could retain voting control of the company through the issuance of multi-voting
ordinary (common) shares.
Malik informs her that the dual class shares she has described are not permitted
in the United Kingdom. He states that before Ouse considers going public, there
are other options available. He suggests they look for private equity investment. He
mentions being familiar with a private equity fund that runs a socially responsible
investment (SRI) pool that could potentially be interested in Ouse. He says in order
to qualify to be included in the SRI pool, a company needs to demonstrate positive
attributes in all areas of ESG (environmental, social, and governance) considerations.
Ferguson is very interested in being associated with an SRI fund and asks how
Ouse could qualify for the investment. Malik explains that the private equity fund
he is thinking of uses data provided by the company and looks for other information
from industry organizations, news reports, and environmental groups.
Ferguson explains to Malik that Ouse is implementing a new initiative to reduce
the packaging associated with their products. The company will stock the majority
of their products in bulk containers in their retail outlets. Customers will purchase
refillable bottles, available in three different sizes, to be used for future purchases.
This change will attract customers interested in reducing their plastic footprint. The
company also expects the change to reduce shipping, packaging, and handling costs,
both at the distribution centers and in the retail stores. The numerous individual bottles
that would have been packaged for shipping and then unpacked and shelved at the
stores will be replaced with larger bulk containers. Malik notes that when announced,
analysts will use this information in their valuation of Ouse.
29 The change in ownership structure that occurred two years ago most likely
addressed which of the following issues associated with family-owned
businesses?
A Poor transparency
B Interlocking directorships
C Ability to attract quality management
C is correct. Ouse was initially a family-owned business, owned by Catherine Ferguson and
her sister, which can make it difficult to attract quality talent for management positions.
However, the implementation of a performance-based compensation plan two years
ago would improve the motivation and rewards available to management and make it
easier to attract quality talent.
A is incorrect. Family-owned businesses often suffer from a lack of transparency. The
granting of some equity to senior management might not necessarily improve transpar-
ency because the Fergusons are still majority shareholders.
B is incorrect. Interlocking directorships can be a problem in family-owned businesses
when there is a corporate group controlling several corporations. There is no mention
here of other related companies.
Corporate Governance and Other ESG Considerations in Investment Analysis
30 If Ouse were to go public with the share structure similar to Facebook that
Ferguson asked about, which governance issue would most likely arise?
A Voting cap restrictions
B Principal–agent problem
C Principal–principal problem
C is correct. Ferguson asked about the possibility of a dual class share structure, which
creates concentrated ownership and concentrated voting power. The controlling share-
holders may be able to allocate resources to their own benefit at the expense of the
minority shareholders. This situation is known as the principal–principal problem.
A is incorrect. Voting caps describe legal restrictions on the voting rights of large share
positions and are usually designed to deter foreign investors from obtaining control of
strategically important local companies.
B is incorrect. The principal–agent problem arises when voting power and ownership
are both dispersed, leading to weak shareholders and strong managers. In this situation,
managers may seek to use company resources to pursue their own interests.
31 Which of the following approaches to identifying a company’s ESG factors best

describes the one used by the private equity fund that Malik mentions?
A ESG data providers
B Proprietary methods
C Not-for-profit initiatives
B is correct. The private equity fund is using proprietary methods to identify and assess
ESG investments. Proprietary methods include analysts using their own judgement based
on information available from corporate reports, industry organizations, news reports,
and environmental groups.
A is incorrect. ESG data providers would be independent organizations, such as MSCI
or Sustainalytics, from whom the private equity fund would purchase information.
C is incorrect. GRI (Global Reporting Initiative) and SASB (Sustainable Accounting

Standards Board) are examples of not-for-profit organizations working to develop sus-
tainability reporting standards. The private equity firm is not relying on those sources.
32 Analysts interested in incorporating ESG factors into their analysis will most
likely adjust for the announcement of the changes arising from Ouse’s new
packaging initiative by:
A increasing the risk premium.
B increasing the company’s fair value.
C modifying only the qualitative ESG analysis.
B is correct. The new packaging initiative is expected to reduce costs associated with
shipping, packaging, and handling. These savings should increase Ouse’s operating
margins and operating cash flows. The higher earnings should result in an increase in
the fair value estimate of Ouse.
A is incorrect. The new packaging initiative is expected to reduce costs associated
with shipping, packaging, and handling. These savings should increase Ouse’s operating
margins and operating cash flows. The increase in margins and cash flow would decrease
the risk premium, not increase it.
C is incorrect. Reducing packaging and the plastic footprint of customers increases
the company’s reputation as a leader in environmental initiatives and would be reflected
positively in the qualitative ESG analysis. But the plan will also save costs that will increase
operating margins and cash flows, which are quantitative ESG factors.

QUESTIONS 33–36
Mary Barton is a junior equity analyst for an investment company. She is currently
working on a large US-based equity fund.
The large US-based fund uses discount models to estimate the value of stock prices.
For this fund, a difference in price of $1 or more between the market and estimated
prices indicates that the shares are mispriced for the fund’s investment purposes. The
fund is allowed to take either long or short positions in shares identified as misvalued.
Barton’s manager, George Eckhart, asks her to evaluate the stocks of two companies
for possible inclusion in that fund: XRail Company (XRL) and Z-Tarp Limited (ZTL).
Selected data for the stocks are shown in Exhibit 1.
Exhibit 1 Selected Stock Data for XRL and ZTL and Additional Market
Information
XRL ZTL
EPS ($) DPS ($) EPS ($) DPS ($)
2015 3.15 1.77 5.62 2.53

2014 3.08 1.52 4.98 2.24
2013 2.99 1.36 4.73 2.13
2012 2.77 1.21 4.5 2.02
2011 2.52 0.9 4.2 1.89
Current market price $77.23 $93.05
Return on assets 27.40% 25.80%
Return on common equity 31.60% 32.80%
Beta 0.94 1.2
Required rate of return on 8.84% 10.48%
common equity
Additional information
Risk-free rate 2.94%
Equity risk premium for common shares 6.28%
US economy real growth rate 3.70%
US inflation rate 2.00%
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 the 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 with 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 growth model to determine whether 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. If that should happen, he believes that 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.
33 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.
A is correct. The Gordon growth model cannot be used when r < g. In this case, r = 8.84%,
and g = 13.84%. The calculations are as follows:
Gordon growth model: P0 = D1/(r – g)
where
P0 = current price
D1 = next period’s dividend
r = required return on equity
g = growth rate of dividends.
The calculated expected growth rate of dividends is based on the sustainable growth
rate model:
g = b × ROE, where b = 1 – (DPS/EPS)

= [1 – (1.77/3.15)] × 0.316
= 0.1384
where
g = sustainable growth rate

b = retention ratio
DPS = dividends per share
EPS = earnings per share
The required return on equity is RF + βi[E(RM) – RF] = 0.0294 + (0.94 × 0.0628) =
0.0884 = 8.84%.
B is incorrect. The sustainable growth must be less than the economy’s growth rate
(3.7%) for the Gordon growth model to be appropriate,
C is incorrect. Although r must be greater than g, the appropriate growth rate is the
company’s growth rate in dividends rather than the economy’s growth rate (3.7%).
Discounted Dividend Valuation
34 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.
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 rate
= 3.7% + 2% = 5.7%.
XRL’s compound growth rate over the four-year period is 5.7%, which is approximately
equal to the economy’s growth rate and calculated as follows:
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 growth at a rate comparable
with the economy’s growth rate.
A is incorrect. A company in the transition phase is characterized by earnings growth
rates above the average nominal growth for the economy but with the growth rate
declining. The growth rate is not above the economy’s nominal growth rate, so the fact
that it is declining (2.7% for 2015 vs. 2014) is not relevant.
B is incorrect. A company in the supernormal growth phase has growth higher than
the economy’s nominal growth rate.
35 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.
B is correct. The growth rate of dividends over the past five years is calculated as follows:
1n 14
 D5   2.53 
  −1 =   − 1 = 7.56%
 D1   1.89 
where
D5 = 2015 dividend
D1 = 2011 dividend
n = number of years between the first and last dividends
Using the Gordon growth model, the intrinsic value is
D0 × (1 + g ) 2.53 × 1.0756
= = $93.19
r−g (0.1048 − 0.0756)
where
D0 = dividend just paid (in 2015)

g = compound growth rate in dividends
r = required return on the stock, given in Exhibit 1
With a current market price of $93.05, the stock is fairly valued according to the fund’s
definition of mispricing (i.e., mispriced by less than $1). It should not be added to the
portfolio as either a short or long position.
Note that the answer is calculated without rounding intermediate steps. If rounding
is used, the calculated answer may differ slightly.
A is incorrect. The stock’s intrinsic value differs by less than $1 from the market price,
so it should not be added to the portfolio.
C is incorrect. The stock’s intrinsic value differs by less than $1 from the market price,
so it should not be added to the portfolio.
36 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.
C is correct. Dividend discount models assume stylized patterns of dividend growth, but
a spreadsheet allows any assumed dividend pattern. Therefore, a spreadsheet model
would be best suited for these anticipated special dividends.
A is incorrect. Dividend discount models assume stylized patterns of dividend growth,
but a spreadsheet allows any assumed dividend pattern.
B is incorrect. Dividend discount models assume stylized patterns of dividend growth,
but a spreadsheet allows any assumed dividend pattern.

QUESTIONS 37–42
Halstead Capital Advisors is an investment advisory firm that specializes in taxable
fixed-income investing. Its clients consist of medium sized foundations and endow-
ments who select outside managers such as Halstead after having formulated their
investment policy and asset allocation targets.
Halstead’s chief investment strategist, Charles Scott, and quantitative analyst,
Catherine Bird, are meeting to discuss a research report that Bird is producing. The
report will address various fixed-income investing topics, including investment strat-
egies, credit spreads, and yield curve movements.
Bird is evaluating two US Treasury instruments. The first is a newly issued 7.00%
coupon bond with a 5-year maturity issued at a price of $101.15 ($100.00 face value)
with a yield to maturity of 6.72%. The second is newly issued zero-coupon bond with a
5-year maturity issued at a price of $71.30 ($100.00 face value) with a yield to maturity
of 7.00%. Current US Treasury spot rates and extrapolated forward rates are provided
in Exhibit 1. Bird expects that the future path of interest rates will follow that which
is implied by the forward curve.
Exhibit 1 Spot and Forward Interest Rates

Maturity Spot Forward Rates (1 year) Forward Rates (n – 1 year)
(Years) Rates (n – 1 years forward) (1 year forward)
(n) r(n) f(n – 1,1) f(1,n – 1)
1 3.00% 3.00% 3.00%

2 4.00% 5.01% 5.01%
3 5.00% 7.03% 6.01%
4 6.00% 9.06% 7.02%
5 7.00% 11.10% 8.02%
Scott reminds Bird to include an update on credit instruments. He provides details

on a bond issued by Coores, rated A1/A+, with 5 years to maturity priced to yield
7.30%. At the time that the Coores bond was priced, the 5-year risk-free spot rate was
7.00%, and the 5-year swap spread was 0.30%.
Bird proposes to review other credit spread indicators that measure credit and
liquidity risk for money market securities, general creditworthiness of individual debt
issuers, and counterparty risk. Bird offers the following statements about measures
of credit risk:
Statement 1 The TED spread represents the difference between Libor and
overnight bank lending rates.
Statement 2 The Libor–OIS spread represents the difference between Libor
and corporate bond spreads.
Statement 3 The Z spread represents the constant basis point spread that is
added to the implied spot yield curve to measure the price of
credit risky bonds.
Scott asks Bird to evaluate the impact of yield curve movements on fixed-income
securities. Bird constructs a yield curve factor model in which a change in the yield
curve contains three independent factors. The yield curve movements are contained
in Exhibit 2.
Exhibit 2 Yield Curve Movements

Time to Maturity 1 year 2 years 3 years 4 years 5 years
Factor 1 0.75% 1.10% 1.62% 2.27% 3.03%

Factor 2 –0.47% 1.03% 2.05% 1.02% –0.45%
Factor 3 0.98% 0.99% 1.00% 1.01% 1.02%
37 Using the information provided in Exhibit 1 and assuming that Bird’s interest
rate expectation materializes, the realized return for an investor who buys and
holds to maturity the US Treasury 7.00% coupon bond would most likely be:
A less than the yield to maturity.
B equal to the yield to maturity.
C greater than the yield to maturity.
C is correct. The realized return would be greater than the yield to maturity (YTM) because
the coupons would be reinvested at forward rates that increase and eventually exceed
the YTM because the spot curve is upward sloping. The YTM can be a poor estimate of
expected return if interest rates are volatile and if the yield curve is steeply sloped. YTM
assumes that all reinvestment of coupons is made at the assumed rate, which is the YTM.
Although this math is not necessary to answer the question, the present value of the
bond is 101.15; the future value of the bond assuming that all coupons are reinvested at
the forward rates is 141.87; the annualized realized return is 7.0%, which is greater than
the 6.72% yield to maturity.
Where 141.87 =
Year 1 FVCFs = 7(1 + 0.05)(1 + 0.07)(1.091)(1.111) = 9.53
Year 2 FVCFs = 7(1 + 0.07)(1.091)(1.111) = 9.08
Year 3 FVCFs = 7(1.091)(1.111) = 8.48

Year 4 FVCFs = 7(1.111) = 7.78
Year 5 FVCFs = 107
And where (141.87 – 101.15)/101.15 = 0.40257 [solve 1.075 = 1 + 0.40257].
A is incorrect because the realized return will be less than the yield to maturity only
when the yield curve is downward sloping.
B is incorrect because the realized return will equal the yield to maturity only when
the coupons are reinvested at the YTM.
The Term Structure and Interest Rate Dynamics
rate expectation materializes, the year one holding period return for the Zero
Coupon bond is closest to:
A 5.01%.
B 3.00%.
C 7.00%.
B is correct. The return of a zero-coupon bond over the year one holding period is the
one-year rate (r,1) (the risk-free rate over the year one holding period) whenever the
spot rates evolve as implied by the current forward curve. Note the calculations below.
n +1
1 + r (n + 1)
= 1 + r (1)
n
1 + f (1, n)
(1 + 0.07)5 1.4026
= = 1.03
(1 + 0.0802)4 1.3615
r (1) = 0.03 = 3.00%
For the five-year zero-coupon bond, the return over the year one holding period is
3.00%. The bond is purchased at a price of 71.30. One year from today, the five-year bond
has a remaining maturity of four years. Its price one year from today of 73.45 reflects the
forward rate for a four-year bond issued one year from today. Note the calculations below.
4 4
100 1 + f (1, 4) 100 (1 + 0.0802)
=
5 5
100 1 + r (5) 100 (1 + 0.07)
73.45
=
71.30
= 1.03 − 1 = 0.03 = 3.00%
A is incorrect. The one year rate is 3.00%.
C is incorrect. The one year rate is 3.00%.
rate expectation materializes, the forward rate at which an investor would be
indifferent to purchasing the US Treasury zero coupon note today or one year
from today is closest to:
A 8.02%.
B 7.02%.
C 11.10%.
A is correct. The breakeven rate with respect to purchasing the US Treasury zero-coupon
note either today or one year from today is equal to the one year rate, four years forward:
f(1,4) = 8.02%
where
r(1) = 3%
r(2) = 4%
r(3) = 5%
r(4) = 6%
r(5) = 7%
5
{ 1
1 + r (5) = 1 + (r1) 1 + f (1, 4) }
4
(1.07)5 1 4
= (1.03) (1.0802) 
 
Note that after one year, the one year rate for year 5 transforms to the one year rate
for year 4 (i.e., 8.02% is f(1,5) today; 8.02% is f(1,4) one year from today).
B is incorrect because the breakeven rate is 8.02%. Refer to calculation above.
C is incorrect because the breakeven rate is 8.02%. Refer to calculation above.
40 Using the information provided about the Coores bond and assuming that there
are no unusual factors affecting either the government or corporate debt mar-
kets, is Coores bond likely mispriced?
A Yes, because of the difference between the swap rate and the yield to
maturity.
B Yes, because of the difference between the swap rate and the spot rate.
C No.
C is correct. The Coores bond is likely not mispriced because its 7.30% yield to maturity
is equivalent to the rate for an equivalent maturity swap (7.00% spot rate plus 0.30%
swap spread equals 7.30% swap rate). The Libor/Swap curve is a widely used interest
rate curve because it is often viewed as reflecting the default risk of private entities at a
rating of about A1/A+. Coores’ default risk rating is A1/A+.
A is incorrect because the Coores bond is likely not mispriced.
B is incorrect because the Coores bond is likely not mispriced.
41 Which of Bird’s statements regarding measures of credit risk is most likely

correct?
A Statement 2
B Statement 3
C Statement 1
B is correct. Statement 3 relates to Z-spreads, which represent the constant basis point
spread that would need to be added to the implied spot curve in order to determine
the price of a bond which has credit risk. Accordingly, the Z-spread is directly affected
by the general creditworthiness of individual debt issuers.
A is incorrect. Statement 2 relates to The Libor–OIS. The Libor–OIS represents the
difference between Libor and the overnight index swap rate. Since the Libor–OIS spread
is affected by bank’s lending rates for unsecured overnight loans, the Libor–OIS spread
is a measure of risk in the money markets.
C is incorrect. Statement 1 relates to the TED spread. The TED spread represents the
difference between the yield on treasury bills and Libor for a specific maturity date.
Since the TED spread is affected by banks’ analysis of default of interbank loans, the TED
spread is a measure of counterparty risk.
42 Given the sample yield curve change shown in Exhibit 2, Factor 1, Factor 2 and
Factor 3 are most likely:
A steepness, curvature, and level.
B level, steepness, and curvature.
C curvature, level, and steepness.
A is correct. Factor 1, Factor 2, and Factor 3 represent movements in steepness, curva-

ture, and level, respectively. Factor 1 represents a change in steepness in the yield curve
because the changes in yield increase through each maturity point. Factor 2 represents
a change in curvature in the yield curve because the changes in the front end and back
end of the curve are different from the change in the middle of the curve. Factor 3 rep-
resents a change in level in the yield curve because the changes in yield are essentially
the same across all maturity points.
B is incorrect because Factor 1, Factor 2, and Factor 3 represent movements in steep-
ness, curvature, and level, respectively.
C is incorrect because Factor 1, Factor 2, and Factor 3 represent movements in steep-
ness, curvature, and level, respectively.

QUESTIONS 43–48
Vladimir Kozorez is chief investment officer of MegaArb Associates (MAA), a multi-
asset-class arbitrage hedge fund he recently launched. He has hired Ludvig Nils, an
analyst with a deep and broad background in security analysis but no experience in
arbitrage investing. At their first research meeting, Kozorez, who is mentoring Nils,
makes the following comments regarding arbitrage using derivative contracts.
Comment 1 A forward commitment is a derivative instrument in the form

of a contract that provides the ability to lock in a price or rate
at which one can buy or sell the underlying instrument at some
future date or exchange an agreed-on amount of money on a
series of dates.
Comment 2 There is a difference between the pricing and the valuation of for-
ward commitments. Pricing involves determining the appropriate
forward commitment price or rate, typically after it has been
initiated. Valuation involves determining the appropriate rate of
the forward commitment when initiating the contract.
Comment 3 The two fundamental rules of arbitrage are that one does not use
any of one’s own money in a transaction, and one does not take
any price risk.
Kozorez asks Nils to evaluate a carry arbitrage trade for a S&P 500 Index forward
contract. He believes the contract may be mispriced. The index is currently trading at
1,900, and the forward contract expiring in one year is priced at 1,863. The index has
a continuously compounded dividend yield of 2.50%, and the one-year continuously
compounded interest rate is 0.75%. Kozorez believes that at the time of the contract’s
expiration, the index will be trading at 1903.
Nils sets out to evaluate arbitrage opportunities using forward rate agreements
(FRAs). Kozorez makes the following comments to Nils regarding FRAs: “An FRA
has two counterparties, a fixed-rate receiver that is short Euribor and a floating-rate
receiver that is long Euribor. The party that is long a 3 × 9 FRA must make a Euribor
deposit in three months and earns the Euribor rate for the subsequent six months.”
Nils also analyzes a US Treasury futures contract that he plans to use to hedge
a corporate bond’s interest rate risk. He researches the characteristics of Treasury
futures and observes the following characteristics.
Characteristic 1 The underlying deliverable bond in a US Treasury futures
contract consists of a basket of bonds from which the short
position can deliver the cheapest bond.
Characteristic 2 Eligible deliverable bonds can have various maturities and
coupon rates, and the seller will receive the futures price
adjusted by a conversion factor to account for any accrued
interest.
Characteristic 3 Long and short positions are marked to market each day.
Therefore, the contract’s market value at the end of each day
is zero.
Kozorez has a position in Spanish sovereign bonds that he wants to hold during
the next year because he believes euro rates will rally as the European Central Bank
continues with its quantitative easing program. He is less hopeful, however, about the
EUR currency, which he wants hedged back to USD. Kozorez asks Nils to evaluate
this hedging strategy. The US risk-free rate is 0.27%, and the eurozone risk-free rate
is 0.94%. Nils also uses the data in Exhibit 1 for his analysis.
Exhibit 1 Foreign Exchange Rates

USD/EUR EUR/USD
Spot 1.1156 0.8964

Forward 1.1104 0.9006
Lastly, MAA has a number of fixed-rate investments, which Kozorez is looking

to hedge against rising rates. He asks Nils to review interest rate swap contracts.
Nils determines that MAA should enter into a receive-floating, pay-fixed swap. He
recognizes that this arrangement will require an exchange of cash flows at initiation,
and he sets out to calculate the arbitrage-free amount of the cash flows. Based on his
work on other types of derivative instruments, he realizes that he could synthetically
create a swap contract through either a portfolio of underlying instruments or a
portfolio of forward contracts.
43 Which of the comments made by Kozorez regarding arbitrage is least likely
correct?
A Comment 2
B Comment 3
C Comment 1
A is correct. Comment 2 is incorrect. There is a difference between the pricing and the
valuation of forward commitments. Pricing involves determining the appropriate forward
commitment price or rate when initiating the forward commitment contract. Valuation
involves determining the appropriate value of the forward commitment, typically after it
has been initiated. Note that in the vignette, the timing of both the pricing and valuation
has been reversed.
B is incorrect because Comment 3 is correct.
C is incorrect because Comment 1 is correct.
Pricing and Valuation of Forward Contracts
44 Does Nils’s stock index evaluation most likely identify an arbitrage opportunity?
A Yes, there is a reverse carry arbitrage opportunity.
B Yes, there is a carry arbitrage opportunity.
C No, the forward is fairly priced.
A is correct. The forward price relationship should be F0(T) =FV(S0). If F0(T) < FV(S0), then
the forward contract is purchased and the underlying is short sold. This represents a
reverse carry arbitrage opportunity.
In this case, S0 = 1900, r = 0.75%, T = 1, γT = 2.5%. Therefore,
F0 (T ) = S0 e( e
r − γ)T
= F (T ) = 1,900e(
0.0075 − 0.025)1
= 1,900 × 0.982652 = 1,867.04
Because the price of the forward contract expiring in one year of 1,863 is less than
1,867.04, the forward is underpriced relative to the underlying. The index’s expected
future value has no effect on the arbitrage analysis.
B is incorrect because to be a carry arbitrage opportunity, F0(T) > FV(S0), not F0(T)
< FV(S0).
C is incorrect because the forward price is not fairly valued because the forward price
is below fair value.
45 Kozorez’s comments to Nils regarding FRAs are most likely:

A correct regarding counterparties and correct regarding their transactions.

B correct regarding counterparties and incorrect regarding their transactions.
C incorrect regarding counterparties and incorrect regarding their
transactions.
B is correct. Kozorez has accurately described the short and long positions in an FRA.
He has also correctly described the timing of the transactions of a 3 × 9 FRA. The coun-
terparties are not required to exchange cash flows, however. Although an FRA can be
done in conjunction with a Euribor deposit, it is not a requirement.
A is incorrect because Kozorez is correct regarding counterparty positions but incorrect
regarding being required to make a Euribor deposit.
C is incorrect because Kozorez is correct regarding counterparty positions.
46 Which characteristic observed by Nils regarding Treasury futures is least likely

correct?
A Characteristic 1
B Characteristic 2
C Characteristic 3
B is correct. Characteristic 2 is incorrect. The conversion factor in a futures contract does

not apply to accrued interest. It is a mathematical adjustment to the amount required
when settling a futures contract that is supposed to make all eligible bonds equal the
same amount—for example, adjust each bond to an equivalent 6% coupon bond.
When multiple bonds can be delivered for a particular maturity of a futures contract,
a cheapest-to-deliver bond typically emerges after adjusting for the conversion factor.
A is incorrect because Characteristic 1 is correct.
C is incorrect because Characteristic 3 is correct.
47 Based on the data in Exhibit 1, using covered interest rate arbitrage, Nils’ evalu-
ation reveals that the USD/EUR forward rate is most likely:
A below fair value.
B above fair value.
C at fair value.
B is correct. The USD/EUR forward rate of 1.1104 is above the USD/EUR fair value of 1.1082
based on the domestic and foreign interest rates using covered interest rate arbitrage.
Based on the information given, we have S0($/€) = 1.1156, T = 1 year, r$ = 0.27%, and r€
= 0.94% (both with annual compounding). Therefore, F0($/€) = S0($/€)FV$,1(1$)/FV€,1(1€)
= 1.1156(1 + 0.0027)1/(1 + 0.0094)1 = 1.1082, or $0.9024/€.
A is incorrect because the USD/EUR forward rate is above fair value based on covered
interest rate arbitrage.
C is incorrect because the USD/EUR forward rate is above fair value based on covered
interest rate arbitrage.
48 Which of Nils’ determinations in his analysis of the interest rate swap contracts
is least likely correct?
A Exchange of cash flows
B The structure of the swap
C The equivalency to using instruments or forwards
A is correct. A swap contract value at initiation is zero, and there is no exchange of cash
flows except on the coupon payment dates.
B is incorrect because the structure of the swap is correct.
C is incorrect because its equivalency to using instruments or forwards is correct.

QUESTIONS 49–54
Eric Silverman is a senior portfolio manager for the endowment of Sawyer University
based in California. Sawyer’s investment policy currently only allows allocations to
domestic equity and corporate bonds. The investment committee has tasked Silverman
with assessing the endowment’s foray into real estate investments. He is meeting with
two of his team members to discuss the assignment: Jenny Lin, a senior associate, and
Rohan Dua, a senior financial analyst.
The endowment’s investment committee has asked Silverman to consider the impli-
cations of direct real estate investments in the endowment portfolio. The committee’s
view is that such investments will likely generate income and capital appreciation but
have no significant impact on portfolio risk because of their high correlations with
the existing investments.
Silverman has asked Dua to carry out some preliminary research on commercial
real estate and to report on his findings. Dua reports that commercial real estate
property types include office properties, industrial and warehouse space, and retail
space. Dua indicates that demand for office space depends on employment growth,
whereas a strong economy drives demand for warehouse space. Demand for retail
space depends on the level of import and export activity.
Silverman and his team are evaluating an investment in an office property. They
propose to use three valuation methods: the discounted cash flow method (DCF), the
cost approach, and the sales comparison approach. There are four years remaining in
the property lease, and annual net operating income (NOI) from lease payments is
$750,000. When the lease rolls over in Year 5, there is expected to be a one-time 15%
increase in NOI. Information about the evaluation is provided in Exhibits 1 and 2.
Exhibit 1 Selected Information to Evaluate Subject Property

Discount rate 7.50%
Terminal cap rate 5.50%
Market value of land $2,500,000
Replacement building costs $20,000,000
Curable physical depreciation costs $500,000
Incurable physical depreciation costs $3,500,000
Cost of modernizing heating and cooling system $1,200,000
Exhibit 2 Sales Comparison Information to Evaluate Subject Property

Size Price
(square Age (per square
feet) (years) Condition foot)
Subject office property 12,000 7 Excellent

Comparable office property 1 8,000 10 Average $1,150
Comparable office property 2 14,000 4 Average $1,325
To adjust for age, the price per square foot (PSF) of the comparable property is
adjusted by 3% per year of age difference. The adjustment for the condition of the
office property is 14% for properties in average condition.
Silverman asks the group to provide some characteristics of the three valuation
methods. Lin responds, “the DCF method takes into account cash flows that are
relevant to investors and incorporates the cyclical nature of the real estate market.
The cost approach works best for newer properties, whereas the sales comparison
approach provides reliable value estimates in an active real estate market in which
there are numerous transactions.”
49 The investment committee’s view on direct real estate investment is least likely
correct with regard to:
A income.
B portfolio risk.
C capital appreciation.
B is correct. The investment committee is correct in that direct real investment will likely
generate income and price appreciation, but their view on the diversification is incorrect.
Real estate returns generally have low correlations with returns on other assets classes,
such as stocks and bonds, and thus allow the endowment to diversify portfolio risk.
A is incorrect. Investors in direct real estate can expect to generate income by leasing
or renting the property.
C is incorrect. Investors in direct real estate can expect price appreciation on the real
estate investment.
Private Real Estate Investments

50 Is Dua most likely correct with regard to the factors that drive demand for dif-
ferent commercial real estate property types?
A No, he is incorrect about retail space.
B Yes.
C No, he is incorrect about industrial and warehouse space.
A is correct. Dua is correct about factors that drive demand for office space and indus-
trial and warehouse space but incorrect about retail space. Employment growth drives
demand for office space, while warehouse space demand depends broadly on economic
strength. The level of import and export activity is more directly related to demand for
industrial and warehouse space, not retail space. Demand for retail space depends on
consumer spending, job growth, and economic strength.
B is incorrect. Dua is correct about factors that drive demand for office space and
industrial and warehouse space but incorrect about retail space.
C is incorrect. Dua is correct about factors that drive demand for and industrial and
warehouse space
51 Based on the information provided and Exhibit 1, the value of the office prop-
erty based on the DCF approach is closest to:
A $14,254,549
B $16,265,226
C $18,193,813
A is correct. Under the DCF approach the value of the office property is the sum of the
present value of lease payments (NOI) of $750,000 per year for 4 years plus the present
value of the estimated resale value in Year 4.
PV of level NOI over 4 years:
$750, 000 $750, 000 $750, 000 $750, 000
+ + + = $2,511,994.70
2 3
1.075 1.075 1.075 1.0754
Year 5 NOI = 750,000 × (1.15) = $862,500
Estimated resale value after 4 years = ($862,500/0.055) = $15,681,818.18
PV of estimated resale value = [$15,681,818.18/(1.0754)] = $11,742.553.76
Current value of property = $2,511,994.70 + $11,742,553.76 = $14,254,548.46
C is incorrect. The estimated resale value is not discounted to PV. The current value
of property is incorrectly calculated as $18,193,812.88 = $2,511,994.70/$15,681,818.18.
B is incorrect. Here the PV of NOI is incorrect, but the estimated resale value after 4
years is not discounted to PV and is incorrectly calculated.
$750, 000 $750, 000 $750, 000 $750, 000
PV of NOI = + + + = $2, 628,862.59
2 3
1.055 1.055 1.055 1.0554
Estimated resale value after 4 years = ($750,000/0.055) = $13,636,363.64
Incorrect value of property = $16,265,226.23 = $2,628,862.59 +

$13,636,363.64.
52 Using the cost approach, the estimated value of the office property based on
Exhibit 1 and other information provided is closest to:
A $14,800,000.
B $15,300,000.
C $17,300,000.
C is correct. The calculation of the estimated property value using the cost approach is
shown in the following table.
Market value (MV) of land $2,500,000

Replacement building costs $20,000,000
Curable physical depreciation costs $500,000
Incurable physical depreciation costs $3,500,000
Cost of modernizing heating and cooling system $1,200,000
Estimated property value $17,300,000
Estimated property value = MV of land + Replacement building costs – Curable physical

depreciation costs – Incurable physical depreciations costs – Cost of modernizing heating
and cooling system.
A is incorrect. This calculation excludes the market value of land.

B is incorrect. This calculation excludes the market value of land and does not deduct
curable physical depreciation costs.
53 Based on Exhibit 2 and other information provided, the value of the office prop-
erty using the sales comparison approach is closest to:
A $16,834,500.
B $17,023,500.
C $13,875,000.
A is correct. Using the sales comparison approach, the price PSF of the comparable
properties is adjusted relative to the subject property to account for age and condition.
For example, Property 1 is 10 years old, and the subject property is 7 years old. Because
the subject property is newer by three years, the price PSF of Property 1 is adjusted up
by 3% per year for three years, or 9%. Property 1 is in average condition, but the subject
property is in excellent condition. Thus, the value of Property 1 is adjusted up 14%, the
adjustment factor provided for the condition adjustment. Thus, the price PSF of Property
1 is adjusted up by 23% from $1,150: Adjusted price PSF for Property 1 = $1,150 × 1.23 =
$1,415.50. A similar calculation is made for Property 2. The average adjusted price PSF
of both properties is $1,403. The value of the subject property is calculated by applying
$1,402.88 to the size of the property (12,000 square feet):
Value of subject property = $1,402.88 × 12,000 = $16,834,500
The following table shows the calculations:
Adjustment Property 1 Property 2
Price PSF $1,150 $1,325

Age 9.0% –9.0%
Condition 14.0% 14.0%
Total 23.0% 5.0%
Adjusted price PSF $1,414.50 $1,391.25
Average price PSF $1,402.88
Estimated value $16,834,500
B is incorrect. The adjustment for age is incorrect. Property 1 is adjusted down instead
of up, and Property 2 is adjusted up instead of down.
Adjustment Property 1 Property 2
Age –9.0% 9.0%

Condition 14.0% 14.0%
Total 5.0% 23.0%
Adjusted PSF $1,207.50 $1,629.75
Average $1,418.63
Value $17,023,500
C is incorrect. It is a simple average of the sales prices of Property 1 and Property 2.

Sales price Property 1 = 8,000 × $1,150 = $9,200,000
Sales price Property 2 = 14,000 × $1,325 = $18,550,000
54 In her response to Silverman regarding the characteristics of the three valuation

approaches, Lin is least likely correct with respect to the:
A DCF approach.
B sales comparison approach.
C cost approach.
A is correct. Although Lin is correct that the DCF method takes into account the cash
flows that investors care about, she is not correct in stating that DCF takes into account
the cyclical nature of the real estate market.
C is incorrect. Lin is correct about the cost approach.
B is incorrect. Lin is correct about the sales comparison approach.


QUESTIONS 55–60
Pari Patel is a senior portfolio manager at Applegate Capital Management, an insti-
tutional hedge fund manager in San Francisco that offers a variety of strategies. Patel
oversees the management of the Applegate Hedged Alpha Fund, a mutual fund with
the objective of providing capital appreciation while minimizing downside risk. Justin
Flaherty is a junior analyst on Patel’s team.
Patel works closely with Applegate’s risk and compliance teams to ensure he
understands the inherent risks in the portfolio. Each morning, Patel receives a risk
report with a number of metrics to help him assess portfolio exposures and risks.
Patel is reviewing the daily risk report with Flaherty to discuss why value at risk
(VaR) is an important measure of risk. Flaherty makes the following three statements
regarding VaR:
Statement 1 VaR measures the minimum expected loss, rather than the maxi-
mum expected loss, in a portfolio.
Statement 2 VaR is used to estimate portfolio losses that are likely to occur at
a fixed point in time, rather than over a period of time.
Statement 3 VaR measures portfolio volatility in percentage terms.
Patel replies to Flaherty’s statements by focusing on specific aspects of VaR:
“Applegate’s process begins with a risk decomposition of the portfolio holdings, typ-
ically assumes normal distribution of risk factors, and then uses the expected return
and standard deviation for each risk factor to estimate the VaR. The VaR threshold is
converted to a z-distribution. We then calculate the expected return and volatility of
the portfolio and adjust to the desired time interval. Finally, we can obtain VaR and
convert it into a dollar amount by multiplying by the portfolio value.”
In reviewing the VaR report, Patel would like more insight on the average loss that
would occur if the VaR cutoff is extended and asks Flaherty to contact the risk team to
improve the reporting metrics. After discussing with his colleague on the risk team,
Flaherty responds that going forward they will add conditional VaR, incremental VaR,
and marginal VaR to the report.
In addition to VaR, the risk report includes other measures that assist Patel in
better understanding portfolio sensitivities. Patel uses option strategies within the
fund to manage exposures. Patel asks Flaherty to review sensitivity risk measures
to better understand the option exposure within the fund. Flaherty uses gamma to
understand how sensitive option prices are to an increase in volatility of the underlying
stock and delta to determine how large moves in the value of the fund positions will
affect associated option values.
Marcus Thompson oversees risk management at Applegate on a firm-wide basis.
Because of the use of leverage, Thompson pays particular attention to risk measures
to understand the sources and uses of cash and the risk of hitting leverage limits and
facing margin calls. He uses a number of metrics in his risk dashboard and communi-
cates to managers and firm leadership when actions need to be taken to mitigate risk.
Thompson frequently reviews Applegate’s strategies to identify those with greater-
than-expected tail risk. Doing so helps him understand potential capital allocation
requirements for meeting tail risk losses. He is asked to review the following three
newly proposed fund strategies and to assess potential tail risk and capital requirements:
Strategy 1: Long–short equity fund targeting an equity market beta of 0.2 based
on fundamental long and short equity research
Strategy 2: Long-only option strategy that uses technical analysis and momen-
tum to trade call and put options on a short-term basis
Strategy 3: Alternative income strategy focused on long credit positions com-

bined with selling insurance and writing options to generate premium income
55 Which one of Flaherty’s statements on VaR is most likely correct?

A Statement 1
B Statement 2
C Statement 3
A is correct. Statement 1 is accurate. VaR can be used to measure the minimum, not
maximum, expected loss.
B is incorrect. Flaherty is incorrect regarding VaR being expressed at a fixed point
in time. VaR is expressed over a period of time. VaR can be expressed in terms of either
percentage loss or value loss.
C is incorrect. Statement 3 is incorrect. VaR measures not portfolio volatility but, rather,
portfolio losses expressed in terms of either percentage loss or value loss.
Measuring and Managing Market Risk
56 Which estimation of VaR is Patel most likely describing?

A Historical simulation
B Monte Carlo
C Parametric
C is correct. Patel is describing the parametric approach to estimating VaR. The parametric
method uses the expected return and standard deviation for each risk factor to estimate
the VaR. The VaR threshold is converted to a z-distribution value. The expected return
and volatility of the portfolio is calculated and adjusted to the desired time interval.
Parametric VaR is obtained by taking a point on the distribution that is to the left of the
mean and convert it into a dollar amount by multiplying by the portfolio value.
A is incorrect. The historical simulation method uses the current portfolio and
reprices it using the actual historical changes in the key factors experienced during the
look-back period.
B is incorrect. In the Monte Carlo method, the user develops assumptions about the
statistical characteristics of the distribution and uses those characteristics to generate
random outcomes that represent hypothetical returns to a portfolio with specified
characteristics.
57 Which extension of VaR will most likely meet Patel’s needs?

A Conditional
B Incremental
C Marginal
A is correct. Conditional VaR, also referred to as expected tail loss or expected shortfall, is
used to determine the average loss that would be incurred if the VaR cutoff is exceeded.
B is incorrect. Incremental VaR is used to determine how VaR will change if a position
size is changed relative to the remaining positions.
C is incorrect. Marginal VaR is similar to incremental VaR and measures the effect of
an anticipated change to the portfolio.
58 Is Flaherty most likely correct in his use of sensitivity measures to assess the
impact of the option positions in the fund?
A Yes
B No, with regard to delta
C No, with regard to gamma
C is correct. Gamma is the measure of the change in value of the delta (second derivative)
relative to the change in value of the underlying and also does not address changes in
volatility.
Vega is expressed as the change in the value of an option over the change in volatility
of the underlying.
A is incorrect. Flaherty is incorrect with regard to the discussion of gamma.
B is incorrect. Delta is the measure of the change in value of the option relative to the
change in value of the underlying and does not address changes in volatility.
59 Which risk measure is Thompson least likely to use in his analysis?

A VaR
B Active share
C Gross exposure
B is correct. Active share is the measure of the percentage of the portfolio that differs
from the benchmark and would not be an appropriate measure of firm-wide risk. In
addition, active share is more frequently used for traditional asset managers who have
explicit benchmarks, compared with hedge funds, such as Applegate, which are typically
absolute return oriented.
A is incorrect. VaR can be used by hedge funds at a high confidence level for short
holding periods to help understand the magnitude of exposure.
C is incorrect. Gross exposure measures the combination of long and short exposures
and can be an important metric in the management of hedge fund exposure.
60 Which of the strategies Thompson is asked to review is most likely to involve

significant tail risk and potential capital requirements?
A Strategy 1
B Strategy 2
C Strategy 3
C is correct. An alternative income strategy focused on long credit positions combined with
selling insurance and writing options to generate premium income would have greater-
than-expected tail risk because of the writing of insurance and options. A significant
unexpected outcome in these strategies could result in potential capital requirements.
A is incorrect. A long–short equity fund targeting an equity market beta of 0.2 is
unlikely to require capital even in a tail risk event.
B is incorrect. A long-only option strategy may experience significant loss of value,
but because it involves buying and then selling options, it does not involve the same
tail risk as a short option strategy.

2020 Mock Exam A - Afternoon Session (With Solutions)

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1

2020 Level II Mock Exam (A) PM

THE FOLLOWING INFORMATION RELATES TO

Guidance for Standards I–VII

Guidance for Standards I–VII

A is correct. When determining whether information is considered “insider,” the source

Guidance for Standards I–VII

4 Which of McGuinn’s recommendations is least appropriate to implement as

A is correct. When a firm acts as a market maker, a prohibition on proprietary trading

Guidance for Standards I–VII

5 Which guideline with regard to choosing stockbroking services is most likely

A is correct. Members and candidates have a responsibility under Standard III(A)–Loyalty,

C is incorrect because Standard III(A)–Duties to Clients requires an investment manager

Guidance for Standards I–VII

A is correct. As a supervisor, under Standard IV(C)–Responsibilities of Supervisors,

Guidance for Standards I–VII

THE FOLLOWING INFORMATION RELATES TO

B is correct. Jensen should adhere to Swiss regulations. Standard I(A): Knowledge of the

Guidance for Standards I-­VII

A is correct because there is no indication O’Connor violated Standard III(A): Loyalty,

Guidance for Standards I-­VII

9 Given O’Connor’s second statement to Jensen, which further action should

Guidance for Standards I-­VII

Guidance for Standards I-­VII

11 To avoid violating any of the CFA Institute Standards of Professional Conduct,

Guidance for Standards I-­VII

Guidance for Standards I-­VII

THE FOLLOWING INFORMATION RELATES TO

Exhibit 1 Regression Results

Coefficient Standard Error

Constant (b0) 0.016 0.0942

Standard Error of Durbin–Watson Significance

0.414 0.333 1.89 157.699 0

Standard Error of Durbin–Watson Significance

Exhibit 2 Results of the Dickey-­Fuller Tests

Defective assemblies 0.0036 0.0023 1.591 0.1123

Dennehy tells Malloy about the Dickey-­Fuller test results, stating:

Introduction to Linear Regression

14 The most appropriate interpretation of the results reported in Exhibit 1 is that:

Introduction to Linear Regression

15 What is the most appropriate inference from the Durbin–Watson statistic

Multiple Regression and Issues in Regression Analysis

16 The results reported in Exhibit 1 are most accurately interpreted as indicating

A the reported R2 is spurious.

Multiple Regression and Issues in Regression Analysis

17 Assuming a 5% level of significance, the most appropriate conclusion that can

C is correct. The Dickey–Fuller test uses the following type of regression:

18 Dennehy’s statement about the Dickey–Fuller test is best characterized as:

THE FOLLOWING INFORMATION RELATES TO

Exhibit 1 Summarized Draft Financial Statements for SunMex, Fiscal

Total assets 417

Exhibit 2 Selected Exchange Rates

31 March 2017 0.0513 1.352

Temporal Method Current Rate Method

Sales 140 0.0538 7.532 0.0538 7.532

20 On translation, SunMex’s USD-­denominated net income most likely includes:

Cash and A/R Monetary 47 0.0513 2.411

Current liabilities Monetary 33 0.0513 1.693

* Retained earnings: 25.536 – (1.693 + 11.491 + 10.000) = $2.352 million

Sales 140 0.0538 7.532

** The re-­measurement (translation) gain or loss = 2.352 – (–0.174) = 2.526 gain

Net assets (417 – 33 – 224) = 160 0.0513 8.208

* AOCI = 10.0 – 8.208 = 1.792

Guidance for Standards I-VII

Guidance for Standards I-VII

Guidance for Standards I-VII

Guidance for Standards I-VII

Guidance for Standards I-VII

Guidance for Standards I-VII

Exhibit 1 Regression Results

Exhibit 2 Results of the Dickey-Fuller Tests

Dennehy tells Malloy about the Dickey-Fuller test results, stating:

Exhibit 1 Summarized Draft Financial Statements for SunMex, Fiscal

Exhibit 2 Selected Exchange Rates

20 On translation, SunMex’s USD-denominated net income most likely includes:

** The re-measurement (translation) gain or loss = 2.352 – (–0.174) = 2.526 gain

CAD-denominated sales growth is 2.5 million/29.26 million = 8.5%.

B is incorrect. This is the USD-denominated growth rate of 6.3% (USD1.4 million/

USD Year-end exchange rate CAD

A net asset exposure will generate a re-measurement gain.

Exhibit 1 Investment Allocation and Returns, NANLife Group, in $ Millions

Exhibit 2 Selected Earnings Information from Bank File, in $ Thousands

B is correct. The average return on fixed-income assets is calculated as follows: Investment

C is correct. When the investment portfolio is examined using a common-size format,

A the H-model to reflect the change in dividends.

Exhibit 1 Spot and Forward Interest Rates

Exhibit 2 Yield Curve Movements