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CFA Level II Mock Exam 6 – Solutions (AM)

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CFA Level II Mock Exam 6 June, 2016

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CFA Level II Mock Exam 6 – Solutions (AM)

FinQuiz.com – 6 th Mock Exam 2016 (AM Session)

Questions

1-6

7-12

13-18

19-24

25-36

37-48

49-54

55-60

Topic Ethical and Professional Standards Quantitative Methods Economics Corporate Finance Financial Reporting and Analysis Equity Investments Fixed Income Derivatives

Minutes

18

18

18

18

36

36

18

18

Total

180

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CFA Level II Mock Exam 6 – Solutions (AM)

Questions 1 through 6 relate to Ethical and Professional Standards

Count Associates (CA) Case Scenario

Count Associates (CA) is an asset management firm that provides portfolio management and research services. Trisha Boyle is CA’s senior most fixed income manager who overlooks three fixed income funds offered by the firm. Rita Lucas is CA’s senior equity manager responsible for overlooking the firm’s equity fund.

CA’s client accounts are divided into two categories, asset-based and performance-fee based. The compensation of managers responsible for the latter category is based on the returns generated in excess of a designated benchmark index rate. Performance-fee based accounts pay a higher portfolio management fee.

CA’s equity fund’s written mandate exclusive requires the selection of stocks of companies with sound corporate governance practices, a high dividend yield. Any securities selected must have a low correlation with existing fund assets. Portfolio manager Nigel Hill is evaluating V-Line, a privately traded concern, which is undertaking an IPO of its stock. Prospects of positive earnings growth has led the issue to being oversubscribed. Hill submits an order to buy 100,000 shares of V-Line at a price of $25/share. By the time the order is allocated to suitable client accounts, the price per share drops to $22. In compliance with the trade allocation policy Hill allocates 60% of the trading profits to the performance-fee based accounts and the remainder to asset-based accounts and makes a disclosure of the transaction to Lucas.

Hill employs client funds to invest in the equity of a starter manufacturing concern. Hill has selected the company for its promising growth prospects, high expected returns and low correlation with existing fund holdings.

Upon reviewing Hill’s trade, Lucas is alarmed because he has strayed from the fund’s stated mandate by selecting an investment with a zero dividend yield. She considers the actions Hill should have taken to avoid making bad judgment.

Lucas instructs her subordinate, Harry Stone, to submit an order for the block purchase of 4,000 shares of Lamda Inc.’s stock. Stone allocates the shares to the portfolio managers responsible for managing three client accounts on January 30, 2014 at 09:10:00, ten minutes prior to the execution of the buy order by the dealer. The portfolio managers allocate the shares to their clients’ accounts after learning of their interest in the stock. Two of the client accounts receive an allocation price at the average trade price of $45 while one client (Marcus) receives a price of $50 as the order is relatively larger. All trades are charged a 5% commission. Boyle collects Information concerning the allocation for presenting to Stone (Exhibit). He asks Stone what action should be undertaken in the event an order cancellation request is received.

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CFA Level II Mock Exam 6 – Solutions (AM)

Exhibit:

Allocation of the Lamda Inc. Buy Order to Client Accounts A, B and C

 

Investible

 

Allocation Price (Prior to Commission)

Asset Base*

Number of Shares Allocated

Client

(Millions)

 

Ian Cox

$1.0

800

$45

Knowles Smith

$1.5

1,200

$45

Grace Marcus

$2.5

2,000

$50

*Prior to share allocation

Boyle is considering an investment in the equity tranches of collateralized debt obligations for the firm’s fixed income fund. He has contacted CA’s research department which will make use of a commercially developed financial model to forecast the value of the investment if the CDO manager earns a positive spread. The research analysts evaluate the potential investment by undertaking an in-depth study of model parameters. The analysts, however, lack technical knowledge with respect to the model.

1. With respect to allocating the gains generated from V-Line, Hill is most likely in violation of the CFA Institute Standards of Professional Conduct because:

A. he has violated his duty of loyalty to clients.

B. clients have not given prior consent to the allocation.

C. he has failed to disclose the trade allocation to clients.

Correct Answer: A

Reference:

CFA Level II, Volume 1, Study Session 2, Reading 7, LOS a

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CFA Level II Mock Exam 6 – Solutions (AM)

Hill has violated his duty of loyalty to clients by unfairly allocating the gains generated from the ‘hot’ IPO trade. Given that performance-fee based accounts pay higher management fees, Hill may have been motivated to increase future business or fees. Hill has not allocated the trades to asset-based and performance-fee based accounts in an equitable manner and is thus has breached his duty to his clients.

B is incorrect. Receiving a client’s consent to an unfair allocation does not render such a

policy as being consistent with the CFA Institute Standards of Professional Conduct.

C is incorrect. A member or candidate cannot absolve himself of his duty to allocate

trades in a fair and equitable manner by simply disclosing the unfair trade allocation policy.

2. Which of the following actions should Hill least likely have taken in order to avoid a violation of the CFA Institute Standards of Professional Conduct with respect to the startup manufacturing concern?

A. Secure authorization of the change in strategy from clients.

B. Disclose the impact of the change in mandate on portfolios.

C. Allocate trades to the accounts of clients with capital growth preferences.

Correct Answer: C

Reference:

CFA Level II, Volume 1, Study Session 2, Reading 8, LOS b

Hill is in violation of the CFA Institute Standards of Professional Conduct concerning V (B) Communication with Clients and Prospects which requires members and candidates

to disclose any changes that might materially affect the processes used to analyze

investments, select securities, and construct portfolios. In order to avoid a violation, Hill should have communicated the proposed change in investment strategy (zero dividend

yield equities) to clients and prospects prior to making a fund allocation to the venture capital fund. Other actions which members and candidates should take include fully disclosing the impact the change will have on the portfolio and secure documented authorization of the change in strategy from the client.

C is incorrect. Allocating the trade to the accounts of client with capital growth

preferences may be appropriate when considering the suitability of the action. However, given that allocation is made using client assets, the change in strategy is likely to affect

the accounts of those clients who prefer high dividend yield stocks.

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CFA Level II Mock Exam 6 – Solutions (AM)

3. With respect to the Lamda Inc. block trade, Stone is most likely in violation of the CFA Institute Standards of Professional Conduct with respect to the:

A. price of trade allocated.

B. number of shares allocated.

C. timeliness of order execution.

Correct Answer: A

Reference:

CFA Level II, Volume 1, Study Session 2, Reading 7, LOS a

Stone has violated the CFA Institute Standards of Professional Conduct with respect to fair dealing by not fairly dealing with clients when allocating the block trade. All clients participating in the block trade should be given the same execution price and same commission. By giving client Marcus’ order a higher execution price, Stone is in violation.

B is incorrect. The shares are distributed to each client’s account on a pro rata basis and

thus Stone is in compliance with the fair dealing standard in this respect. Considering the investible asset base, Cox should receive 800 ($1.0/$5.0 × 4,000), Smith should receive

1,200 shares ($1.5/$5.0 × 4,000) and Marcus should receive 2,000 ($2.5/$5.0 × 4,000). This confirms the fairness with which the number of shares has been allocated.

C is incorrect. The standard relating to fair dealing requires allocating the block trade just

prior to or immediately following each segment of the block trade in order to establish a fair price for the trade. The ten minute gap between the allocation of trade to client accounts and order execution provides evidence that Hill is in compliance in this respect.

4. The trade allocation practices adopted for the Lamda Inc. block trade are least likely in violation of the CFA Institute Standards of Professional Conduct with respect to the:

A. timing of the receipt of client interest.

B. delegation of trade allocation responsibility.

C. receipt of a request for purchase from portfolio managers.

Correct Answer: B

Reference:

CFA Level II, Volume 1, Study Session 1, Reading 2, LOS a

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CFA Level II Mock Exam 6 – Solutions (AM)

There is nothing inherently unethical with delegating responsibilities to subordinates as such practice is required for the efficient functioning and running of businesses.

A is incorrect. Members and candidates should receive advance notification of client

interests when allocating trades for new issues. CA’s trade allocation policy is not consistent with the CFA Institute Standards of Professional Conduct as portfolio managers receive notification of client interests after they have received an allocation of the Lamda Inc. stock.

C is incorrect. Receiving advance notification of interest from portfolio managers as

opposed to clients represents an action which is inconsistent with the CFA Institute Standards of Professional Conduct.

5. CFA Institute Standards of Professional Conduct recommends cancelled orders:

A. to be time stamped.

B. supported with a suitability analysis.

C. documented on a first-in, first-out basis.

Correct Answer: A

Reference:

CFA Level II, Volume 1, Study Session 1, Reading 2, LOS b

The CFA Institute Standards of Professional Conduct concerning fair dealing requires cancelled orders to be time-stamped.

C is incorrect. The standard concerning fair dealing requires orders to be processed and

executed on a first-in, first-out basis.

6. In order to comply with the CFA Institute Standards of Professional Conduct with respect

to investment analysis, recommendations, and actions, the head of the research

department should:

A. assign analysts who have relevant technical expertise.

B. consider the impact of a decline in spreads on investment performance.

C. disclose to clients that the model is limited in the range of scenarios which are considered.

Correct Answer: B

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CFA Level II Mock Exam 6 – Solutions (AM)

Reference:

CFA Level II, Volume 1, Study Session 1, Reading 2, LOS b

When using a quantitatively-oriented research model which does not incorporate both positive and negative scenarios (in this case, an increase and decrease in spreads, respectively), such as that being used by CA’s research analysts, the CFA Institute Standards of Professional Conduct concerning diligence and reasonable basis requires members and candidates to test the models for scenarios which fall outside the observable database. This would include modeling the impact of a decline in spreads on investment performance.

A is incorrect. The standard concerning diligence and reasonable basis requires members

and candidates to have an understanding of the parameters used in the model. However,

they are not required to become technical experts of the model.

C is incorrect. A model which incorporates only positive scenarios reflects an incomplete

model as opposed to one which is limited in its ability to analyze investments.

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CFA Level II Mock Exam 6 – Solutions (AM)

Questions 7 through 12 relate to Quantitative Methods

Ian Walker Case Scenario

Ian Walker is the head of research at Circle Associates, an equity research firm. Walker along with his two research analysts, Jean Rice and Spencer Dike, are preparing a research report on the factors influencing emerging stock returns and why they differ from developed market stock returns.

Walker would like to confirm whether difference in stock returns in the two markets is solely due to differences in GDP growth forecasts. Walker tests his hypothesis by comparing Indian to U.S. stocks. Each analyst builds his/her own linear regression model using stock return differences as the dependent variable and GDP growth differences as the independent variable. The annual GDP growth data pertains to three time periods in the past; 1990-2005, 2006-2012 and 2013- 2014. Walker has calculated the sum of squared deviations of the independent and dependent variable in the exhibit below (Exhibit 1) for the purposes of identifying the model which will generate the most accurate forecast.

Exhibit 1:

Linear Regression Analysis

 

Model 1

Model 2

Model 3

Sum of squared residuals Sum of squared deviation of the dependent variable from mean Observations

0.00015

0.00030

0.00005

0.00018

0.00010

0.00200

24

24

24

Dike feels that the models are restricted in their comparison of stock returns and that many important variables have not been considered. He includes three limitations of the assumptions used to build the linear regression models.

Limitation 1: The error terms are assumed to be normally distributed. This assumption conflicts with reality and so the existing regression analysis is invalid.

Limitation 2: Differences in GDP growth forecasts are assumed to be nonrandom.

Limitation 3: Error terms are subject to the heteroskedastic assumption when they should reflect the homoskedastic assumption.

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CFA Level II Mock Exam 6 – Solutions (AM)

Before exploring the addition of an additional variable, Walker evaluates the three models in order to determine which model’s fraction of total variation in stock return differences is best explained by the variation in GDP growth differences.

Next, Walker takes Dike’s consideration into account and, with the help of the two analysts, redesigns the model by including differences in the pace of technological advancements as the main variable influencing stock returns over the three time periods as a qualitative variable.

Details relevant to the analysis are summarized in an exhibit (Exhibit 2). A 5% significance level is being used for the analysis and the formulated null hypothesis is that differences in the pace of developments do not drive stock return differences.

Exhibit 2:

Qualitative Regression Model

Standard

 

Coefficient

Error

t-Statistic

Intercept

0.2507

0.2085

1.2024

1990-2005

0.0480

0.0257

1.8677

2006-2012

- 0.0150

0.0098

- 1.5306

2013-2014

0.0512

0.0319

1.6050

Multiple R 2 Observations F-statistic Significance F (ANOVA Table)

Multiple R 2 Observations F-statistic Significance F (ANOVA Table)
Multiple R 2 Observations F-statistic Significance F (ANOVA Table)
Multiple R 2 Observations F-statistic Significance F (ANOVA Table)

0.0359

24

3.8056

0.0819

Rice asks Walker why an adjusted R 2 (

redesigned. Walters replies by stating, “

model includes the correct set of variables.”

R

2 ) will become more relevant when the model is

R

2 is more relevant relative to R 2 as it indicates that the

more relevant relative to R 2 as it indicates that the 7. Using the data in

7. Using the data in Exhibit 1, the model which will provide the most accurate forecast for the difference in stock returns is most likely:

A. 1.

B. 2.

C. 3.

Correct Answer: C

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CFA Level II Mock Exam 6 – Solutions (AM)

Reference:

CFA Level II, Volume 1, Study Session 3, Reading 9, LOS f

In order for the regression model to generate an accurate forecast, the error in predicting the dependent variable using its forecasted value (squared residual) should be less than the error in predicting the dependent variable using its mean (squared standard deviation from the mean).

Relative to the sum of squared residuals, the sum of squared deviation of the dependent variable from its mean is higher for Model 1 and 3 (0.00015 vs. 0.00018 and 0.000200 vs. 0.00005 respectively). However, the difference for Model 3 is the greatest (0.000200 – 0.00005 = 0.000150) compared to Model 1 (0.00018 – 0.00015 = 0.000030) and thus the former has greater forecasting accuracy.

8. In context of the limitations presented by Dike, he is most accurate with respect to:

A. Limitation 1.

B. Limitation 2.

C. Limitation 3.

Correct Answer: B

Reference:

CFA Level II, Volume 1, Study Session 3, Reading 9, LOS e

Dike is correct with respect to Limitation 2. The linear regression model unrealistically assumes that the independent variable is nonrandom which is unrealistic.

Dike is incorrect with respect to Limitation 1. Even if the error terms are not normally distributed, as assumed by linear regression models, regression analysis can still be used.

Dike is incorrect with respect to Limitation 3. The linear regression model assumes that the variance of the error term is the same for all observations. In other words, the model undertakes the homoskedastic assumption with respect to error terms.

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CFA Level II Mock Exam 6 – Solutions (AM)

9. Based on the data collected in Exhibit 1, Walker will most likely that the variation in stock return differences is best explained by Model:

A. 1 because it has the highest R 2 .

B. 3 because it has the highest explained variation.

C. 2 because it has the highest coefficient of determination.

Correct Answer: B

Reference:

CFA Level II, Volume 1, Study Session 3, Reading 9, LOS f

Coefficient of determination = R 2 = Explained variation/total variation

Total variation = Explained variation + Unexplained variation

s = Sum of squared deviation from mean + sum of squared residuals R 2 (Model 1) = 0.00018/(0.00018 + 0.00015) = 0.545455 R 2 (Model 2) = 0.00010/(0.00010 + 0.00030) = 0.250000 R 2 (Model 3) = 0.00020/(0.00020 + 0.00005) = 0.800000

Based on the calculations, the analysts can conclude:

Model 3 has the highest R 2 and coefficient of determination

Model 3 has the highest explained variation and thus the variation in the dependent variable (stock return differences) is best explained by the variation in the independent variable.

10. Using the data in Exhibit 2, the analysts will conclude that the null hypothesis is most likely:

A. false based on the p-value.

B. true based on the F-statistic.

C. false based on the F-statistic.

Correct Answer: B

Reference:

CFA Level II, Volume 1, Study Session 3, Reading 10, LOS j

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CFA Level II Mock Exam 6 – Solutions (AM)

There are three regression coefficients and so the number of degrees of freedom in the

numerator for the F-test is 3 while the number of degrees of freedom in the denominator

is 20 [24 – (3 + 1)]. Using a 5% significance level, the critical value of the F-statistic is

4.9382. Given that the value of the F-test statistic value of 3.8056 is lower than its critical value, the null hypothesis cannot be rejected. In other words, the null hypothesis holds

true.

A is incorrect. The p-value of 8.19%, which is the smallest level of significance at which

the null hypothesis can be rejected, is higher than the significance level of 5%. This implies that null hypothesis that differences in the pace of technological advancements do not drive return differences holds true.

11. Walters’ statement concerning

A. have a random walk.

B. have a dummy variable.

C. have a peculiar dataset.

Correct Answer: C

Reference:

R

2 will be inappropriate should the model:

CFA Level II, Volume 1, Study Session 3, Reading 9, LOS h

Analysts should interpret a high adjusted R 2 with caution as it does not necessarily indicate that the regression is well specified in the sense of including the correct set of variables. One reason for a high adjusted R 2 may be associated with a peculiar dataset.

A is incorrect. Random walks occur when the time series in every period is equal to the

value from a previous period plus an error term. However, it has no impact on the

adjusted R, 2 which is relevant for multiple regressions.

B is incorrect. The inclusion of a dummy variable does not necessarily produce a high

adjusted R 2 .

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CFA Level II Mock Exam 6 – Solutions (AM)

12. Walker decides to expand the multiple regression model by including political risk as a

variable. He predicts that the forecasted

the R 2 measure will respond. Based on his analysis, Walker can reasonably conclude that:

R

2 will decrease by 20% but is unsure of how

A. R 2 is a negative value.

B. R 2 has increased a small amount.

C. R 2 has declined by more than 20%.

Correct Answer: B

Reference:

CFA Level II, Volume 1, Study Session 3, Reading 9, LOS h

Given that

R

2 is projected to decrease, Walker can conclude that:

R 2 increased by a small amount and the absolute amount of the change is lower than 20%.

R 2 is always nonnegative but

R

2 can become negative.

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CFA Level II Mock Exam 6 – Solutions (AM)

Questions 13 through 18 relate to Economics

Beta Associates Case Scenario

Beta Associates (BA) is a U.S. based asset management firm, which manages the IEF, an international equity fund. Presently, IEF is allocated to domestic and emerging market equities. Foreign exchange risks associated with the investments are managed by Ian Johnson, a currency overlay manager.

IEF’s equity manager is exploring Mexican equities for inclusion in the fund. A portion of the purchased securities will be allocated to two of BA’s private wealth clients, Paul Singh and Marie Ferns. To execute the transaction, Johnson will be required to evaluate foreign exchange uncertainty associated with the transaction and make relevant purchases of the MXN. Johnson summarizes the details that he feels will be relevant to the transaction and in turn will influence the USD/MXN bid-ask spread quoted by the dealer.

Detail 1: A total of MXN 0.5 million worth of equities will need to be purchased for the clients’ portfolios of which 20% will be purchased for Singh’s portfolio and the remainder for Ferns’ portfolio.

Detail 2: The order to buy MXN will be submitted at a time when both the U.S. and Mexican markets are open for trading.

Detail 3: Mexico is currently in a state of civil unrest.

Detail 4: The inflation rate in Mexico has been steadily increasing over the course of the previous two years.

Johnson’s colleague, Ryan Ellis, joins him for lunch during which they discuss their latest

assignments.

markets is incomplete without an evaluation of the impact of the Mexican central bank’s latest policy announcement to increase domestic money supply on the USD/MXN rate. Ellis adds, “We cannot assume that the latest policy announcement will have no immediate impact on the current exchange rate.”

Ellis tells Johnson that his analysis of the USD/MXN spread and currency

Johnson agrees with Ellis by stating that the best model to use in this scenario is the Dornbusch Overshooting model. The managers apply the model assuming inflexible output prices in the short run and evaluate the impact of an increase in nominal money supply on domestic interest rates as well as the real and nominal values of the USD/MXN rate.

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CFA Level II Mock Exam 6 – Solutions (AM)

During their conversation, Ellis shares with Johnson his analysis of Rica, an emerging market country in South America, facing a surge of foreign capital inflows. His analysis focuses on the increasing investor interest in Rica and its implication for local currency value, RC, and the volume of capital inflows. He shares his market observation of Rica with Johnson based on his study of the country’s economy.

Observation 1: The current account balance has improved as a result of expatriates shifting their wealth from abroad to invest in local businesses.

Observation 2: The government has announced its intention to liberalize financial markets.

Observation 3: A heightened global investor interest in emerging market (EM) stocks has attracted more investment to local private businesses. Previously, these investors preferred developed market (DM) stocks.

Johnson predicts that the surge in capital flows cannot be indefinite and policymakers are bound to step in should the RC become overvalued. He predicts, “If inflation concerns become substantial, Rica’s authorities will need to engage in a sterilized operation.” Ellis asks what his prediction would imply for Rica’s monetary base and domestic short-term interest rates.

The managers conclude their discussion by comparing the effectiveness of central bank intervention in managing foreign exchange risk in DMs and EMs.

in managing foreign exchange risk in DMs and EMs. 13. In context of the transaction details

13. In context of the transaction details provided by Johnson, which of the following is least likely to influence the magnitude of the USD/MXN bid-ask spread?

A. Detail 1

B. Detail 3

C. Detail 4

Correct Answer: C

Reference:

CFA Level II, Volume 1, Study Session 4, Reading 13, LOS a

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CFA Level II Mock Exam 6 – Solutions (AM)

The steady increase in inflation is unlikely to influence the magnitude of the bid-ask spread.

The magnitude of the bid-ask spread is influenced by the size of the transaction. The bid- offer spread quoted for Singh’s transaction is considerably smaller relative to that for Paul’s transaction.

Market volatility will influence the size of the bid-ask spread. It is highly likely that civil unrest will result in wider bid-ask spreads as dealers seek compensation for a heightened level of risk.

14. Considering Ellis’s comment concerning the impact of the monetary policy on the USD/MXN rate, he most likely believes that:

A. real exchange rates are not constant in the short run.

B. purchasing power parity (PPP) holds in the short and long run.

C. changes in the inflation rate and price level do not play a role in exchange rate determination.

Correct Answer: A

Reference:

CFA Level II, Volume 1, Study Session 4, Reading 13, LOS k

Ellis’s comment reflects his opinion that the application of the monetary approach with flexible prices to modeling exchange rates is limited. This approach assumes that real exchange rates remain constant and equal to its long-run equilibrium value in the short- and long-run. Given Ellis’s comment, he most likely believes that real exchange rates are not constant in the short-run.

Furthermore, the approach assumes PPP holds in the short and long run. Ellis’s will most likely be of the opinion that the PPP does not hold in the short run. The Mundell-Fleming model fails to consider changes in the price level and/or inflation rate when determining the impact of monetary policy on exchange rates. This model is not relevant to Ellis’s comment.

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CFA Level II Mock Exam 6 – Solutions (AM)

15. Using the Dornbusch Overshooting model, the managers’ analysis will lead them to conclude that an increase in Mexico’s domestic nominal money supply will be followed by a:

A. decline in interest rates.

B. relatively lower increase in real money supply.

C. decline in the domestic currency regardless of capital mobility.

Correct Answer: A

Reference:

CFA Level II, Volume 1, Study Session 4, Reading 13, LOS k and l

According to the Dornbusch Overshooting model, if domestic prices are assumed to be inflexible, an increase in the domestic nominal money supply can result in an identical increase in the real money supply, which in turn will induce a decline in interest rates.

As long as capital is highly mobile, a decline in interest rates precipitated by an increase in the money supply will lead to capital outflow and a decline in the real and nominal value of the domestic currency. Therefore, in the absence of capital mobility the decline in interest may have no or a less significant impact on the value of the exchange rate in the short run.

16. In context of the observations presented by Ellis, which of the following represents a push factor?

A. Observation 1

B. Observation 2

C. Observation 3

Correct Answer: C

Reference:

CFA Level II, Volume 1, Study Session 4, Reading 13, LOS n

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CFA Level II Mock Exam 6 – Solutions (AM)

The change in the long-run trend of asset allocation by global investors (Observation 3) and their interest in EM stocks represent a push factor.

The improvement in the current account balance (Observation 1) is a potential pull factor.

The announcement of a liberalization of financial markets (Observation 2) is a pull factor.

17. The most likely impact of a sterilized operation in Rica is that:

A. the monetary base will expand.

B. short-term interest rates will decrease.

C. short-term interest rates will remain unchanged.

Correct Answer: C

Reference:

CFA Level II, Volume 1, Study Session 4, Reading 13, LOS n

A sterilized operation involves the central bank selling domestic securities to absorb any excess liquidity created by its FX intervention activities. The end result of such an operation is that the monetary base and the level of short-term interest rates would not be altered by the intervention operation.

18. Which of the following conclusions will the two managers least likely reach in their comparison of the effectiveness of central bank intervention?

A. The effect of EM central bank intervention in their currencies is statistically insignificant.

B. EM central banks are in a stronger position to influence the path of exchange rates relative to their DM counterparts.

C. The volume of intervention in DMs is large relative to the daily turnover of DM currencies in the foreign currency market.

Correct Answer: A

Reference:

CFA Level II, Volume 1, Study Session 4, Reading 13, LOS n

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CFA Level II Mock Exam 6 – Solutions (AM)

Evidence on the effectiveness of central bank intervention concludes that the effect of intervention in EM currencies is mixed. While intervention appears to lower EM exchange rate volatility, no statistically significant relationship exists between the level of EM exchange rates and intervention. Some studies have found EM central banks to have been more successful than their DM counterparts in terms of their ability to influence the path and level of exchange rates.

The volume of intervention by DM central banks is often quite small relative to the average daily turnover of DM currencies in the foreign exchange markets.

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CFA Level II Mock Exam 6 – Solutions (AM)

Questions 19 through 24 relate to Corporate Finance

Rockthorn plc Case Scenario Rockthorn plc is a manufacturer of lead-acid batteries which are purchased by motorboat riders and camper owners. Rockthorn’s management has redesigned the firm’s production policy and under the new policy, plastic encasing used to cover batteries will be of lower quality but will be purchased at a cheaper price. By doing so, management aims to fulfill two objectives:

By doing so, management aims to fulfill two objectives: Objective 1: Lower production costs to improve

Objective 1: Lower production costs to improve profitability.

Objective 2: Increase fund availability to finance the revised dividend policy.

Sergius Ivanovich is Rockthorn’s quality control manager. He is evaluating the implications of the production policy which has been implemented. He has come to determine that while the new policy has achieved Objective 1, the latest batteries being produced have a shorter average life and are susceptible to leakages resulting from a deterioration of the outer casing over a period of time. In addition, the exposure of production employees to sulfuric acid, a substance which is a vital component to lead acid batteries, and toxic if inhaled has been inadequately dealt with. This situation will deteriorate with the new policy as the cheaper plastic casing requires a higher content of sulfuric acid.

In a conversation with Marcus Tyke, Rockthorn’s production manager, regarding the new policy, Ivanovich states, “I am a proponent of Utilitarian ethics which, when applied to the situation, would recommend a reversion to higher quality plastic encasing as well as the implementation of and adherence to a stricter worker safety policy. In this way, even if we compromise on maximizing stockholder wealth by a small fraction, the rights of customers and employees will be secured.”

Tyke strongly opposes Ivanovich’s point of view by stating, “While workplace safety must be addressed, we are not legally obliged to deliver superior quality products. Our responsibility is to maximize shareholder wealth and this we can only achieve by reducing operating costs in the long run.”

Upon the conclusion of their discussion, Ivanovich comes to know that the primary motive behind the policy change was to secure a procurement contract with a plastic casing supplier who is an acquaintance of Rockthorn’s chief operating officer (COO). The latter will be receiving a 5% commission from the supplier for every dispatched order.

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CFA Level II Mock Exam 6 – Solutions (AM)

Ivanovich would like to know how the new policy will help increase the availability of funds for paying dividends and turns to Lydia Cox, a member of the compensation committee. Cox informs him that the committee aims to distribute an average of 60% of its earnings over the next ten years.

Cox also shares that the new policy represents a shift from a stable dividend policy but will continue to focus on the generation of dividends. When asked why dividend income is preferred to capital gains, Lydia responds, “Many of our investors rely on dividends to sustain lifestyles and with the lower tax rate on dividends versus capital gains we will be satisfying their investment objectives.”

gains we will be satisfying their investment objectives.” 19. Will the new production policy give rise

19. Will the new production policy give rise to unethical behavior?

A. No.

B. Yes, the policy will lead to substandard working conditions.

C. Yes, the firm intends to increase dividends at the expense of reducing product quality.

Correct Answer: B

Reference:

CFA Level II, Volume 3, Study Session 9, Reading 26, LOS c

The new production policy will exacerbate the existing substandard working conditions. The new policy may lead to a potential failure to respect the rights of employees to basic safety and so lead to unethical behavior.

C is incorrect. The company’s new production policy will lead to a deterioration of product quality as evidenced by Ivanovich’s observations. By using cost savings as a means to increase retained earnings and hence dividends, the firm has not acted in an unethical manner in this regard. Not meeting customer claims with respect to high reliable quality products does not necessarily reflect unethical behavior.

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CFA Level II Mock Exam 6 – Solutions (AM)

20.

Is

Ivanonich’s statement with respect to the new production policy consistent with

Utilitarian ethics?

 

A. Yes.

B. No, the utilitarian philosophy does not support injustice amongst stakeholder groups.

C. No, the policy will not lead to the best possible balance between good and bad consequences.

 

Correct Answer: C

 

Reference:

 

CFA Level II, Volume 3, Study Session 9, Reading 26, LOS d

C

is correct. Ivanovich’s statement is not consistent with Utilitarian philosophy because

the new policy will not lead to the greatest good for the greatest number of people, an approach, which is typically taken by proponents. Stockholders are a key stakeholder group and compromising on their interests to satisfy employee and customer interests is not consistent with this approach.

B

is incorrect. A problem with utilitarianism is that the philosophy does not consider

justice. Therefore, the argument that the strategy results in injustice amongst stakeholder groups is not relevant to this philosophical approach.

21.

Tyke’s response to Ivanovich’s statement is most consistent with:

A. justice theories.

B. utilitarian ethics.

C. the Friedman Doctrine.

Correct Answer: C

Reference:

CFA Level II, Volume 3, Study Session 9, Reading 26, LOS d

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CFA Level II Mock Exam 6 – Solutions (AM)

The production line manager’s response to Ivanovich’s statement is consistent with the

Friedman Doctrine. This philosophical approach asserts that the only social responsibility

of businesses is to increase profits as long as it stays within the rules of the law.

According to Tyke, management’s sole responsibility is to satisfy shareholder interests (by profit maximization). Management is not legally obliged to deliver superior quality products and by rejecting the need to employ company resources for this purpose, his statement is consistent with this philosophical approach.

A is incorrect. The justice theories would view a policy, which solely considers the

interest of stockholders and ignores the rights of employees and customers as ‘unjust’.

B is incorrect. Proponents of the utilitarian philosophy strive to maximize good and

minimize harm. This approach would interpret the statement made by the manager as being inconsistent with the philosophy.

22. The responsibility towards stockholders that Tyke is referring to in his statement most accurately reflects:

A. the agency theory.

B. stakeholder impact analysis.

C. a tradeoff between profitability and revenue growth.

Correct Answer: A

Reference:

CFA Level II, Volume 3, Study Session 9, Reading 26, LOS a & b

A is correct. Tyke’s statement reflects the agency theory. As agents, the management of a

company owes responsibility towards shareholders to make decisions that are in their interests. Decisions that seek to maximize long-term profitability reflect an action consistent with the agency theory and the responsibilities it ordains on managers.

B is incorrect. Stakeholder impact analysis focuses on the identification of stakeholder

interests and concerns, identifying what claims stakeholders are likely to make on an organization, identifying the most important stakeholders and satisfying their needs. By solely focusing on one stakeholder group and ignoring the rights and interests of other

key stakeholder groups, the approach taken by the manager does not reflect this approach.

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CFA Level II Mock Exam 6 – Solutions (AM)

23. By engaging in a procurement contract with an alternative supplier, the COO has least likely demonstrated his tendency to engage in:

A. self-dealing.

B. a principal-agent conflict.

C. an opportunistic exploitation of value chain participants.

Correct Answer: C

Reference:

CFA Level II, Volume 3, Study Session 9, Reading 26, LOS c

C is incorrect. Opportunistic exploitation of participants in the value chain is a form of

unethical behavior when the managers of a firm unilaterally rewrite the terms of a contract with suppliers, buyers, or complement providers in a way that is more favorable

to the firm. There is no evidence that the COO has engaged in this form of unethical

behavior.

A is correct. The COO has engaged in self-dealing as he is seeking to enter into a contract

on behalf of the firm which will benefit him personally. By prioritizing his interests over those of stockholders, to whom he holds responsibility as an agent, his actions will give

rise to a principal-agent conflict.

24. Which of the following philosophical approaches to ethics is most likely reflected by Cox’s statement with respect to the new dividend policy?

A. Kantian ethics

B. Rights theories

C. Utilitarian ethics.

Correct Answer: C

Reference:

CFA Level II, Volume 3, Study Session 9, Reading 26, LOS d

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CFA Level II Mock Exam 6 – Solutions (AM)

C is correct. Cox’s statement is consistent with Utilitarian ethics. She is attempting to

justify the new dividend policy based on the fact that it will satisfy the majority of investors (greatest good for the greatest number of people). However it is important to note that this philosophy fails to consider justice and Cox clearly demonstrates this in her disregard of the importance of satisfying stockholder’s requirements with respect to

capital gains.

A is incorrect. If Cox’s statement was consistent with Kantian ethics, she would have

considered long-term investor’s right to financial income.

B is incorrect. By failing to consider the basic rights of all stockholders to financial

income on an equal footing, Cox has behaved unethically toward long-term investors. Therefore, her actions can be seen as being inconsistent with this philosophical approach.

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CFA Level II Mock Exam 6 – Solutions (AM)

Questions 25 through 30 relate to Financial Reporting and Analysis

Jose Armelo Case Scenario

Jose Armelo, CFA, is a financial statement analyst evaluating the financial reporting quality of three corporations in the real estate industry in the current year, 2014. Each of the firms being subject to evaluation constructs real estate properties for commercial and residential purposes. Armelo will be engaging his recently inducted associate, Gloria Whitman, in the assignment.

Smitax In the year 2013, a client sued Smitax for the faulty construction of apartment complexes demanding $1 million in compensation. At the time, the likelihood of Smitax paying the damages was very low. The dispute has still not been resolved and the company’s legal estate advisor has advised an out-of-court settlement by paying 50% of the claim in the current year. The company’s CEO finds the proposal agreeable. Details of the compensation to be paid have been disclosed in the notes to the financial statements. However, no accounting entry has been made with respect to the proposed transaction.

V-Line Associates V-Line Associates is a global real estate developer with divisions operating across the globe. The management of its Nairobian division has unanimously decided to cease operations following an unexpected rise in safety concerns. The (translated) costs to shut down the division are $30 million. V-Line has classified these restructuring charges as discontinued operations in the current year’s income statement.

Bass Inc. Following a conversation with a senior manager, it has come to Armelo’s knowledge that Bass’s financial officers are suspected of manipulating the company’s earnings. Armelo decides to apply the Beneish model to assess the likelihood of these claims and has tasked Whitman with gathering the necessary data and performing the analysis (Exhibit). A -1.78 M-score is used as the cutoff value. Whitman summarizes the results of her analysis in a report.

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CFA Level II Mock Exam 6 – Solutions (AM)

Exhibit:

Beneish Model for Bass Inc.

 

Value of

Coefficient from

Variable

Beneish Model

Days Sales Receivables Index

0.560

0.920

Asset Quality Index

0.800

0.404

Accruals

1.500

4.670

Leverage Index

1.210

-0.327

M-score

-1.54%

While reading Whitman’s report, Amelio concludes that she may have committed a Type-I error. Amelio tasks Whitman with exploring why Bass Inc. may have reported an accrual index value greater than 1.0. Whitman provides her supervisor with two possible justifications:

Justification 1: A large number of non-discretionary accruals have been reported.

Justification 2: Operating cash flows are being manipulated.

Whitman believes that the financial statement analysis of the three companies is incomplete without an evaluation of bankruptcy probability. She has chosen the Altman model to forecast bankruptcy risk and intends to undertake the following tasks:

Task 1: Evaluate the risk over multiple time horizons holding the ratios constant.

Task 2: Conduct scenario analysis with different ratios assumed for each scenario across multiple time horizons.

assumed for each scenario across multiple time horizons. 25. By choosing not to report the claims

25. By choosing not to report the claims settlement, is Smitax’s financial reporting quality undermined?

A. No.

B. Yes, assets are overstated.

C. Yes, total equity is overstated.

Correct Answer: C

Reference:

CFA Level II, Volume 2, Study Session 7, Reading 21, LOS b

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CFA Level II Mock Exam 6 – Solutions (AM)

Smitax’s financial reporting quality is undermined by not reporting an accrued liability and expenses associated with the claims settlement. Given that the company’s CEO finds an out-of-court settlement agreeable, the outcome of the contingent liability is probable. Therefore, the company must record an expense as well as an accrued liability equal to the amount of the claim. By not doing so, expenses will be understated and net income will be overstatement leading to an overstatement of total equity.

B is incorrect. Total assets will not be affected by the transaction.

26. Has V-Line Associates dealt with the restructuring charges in an appropriate manner?

A. Yes.

B. No, the current year’s earnings will be overstated.

C. No, the previous year’s earnings will be overstated.

Correct Answer: A

Reference:

CFA Level II, Volume 2, Study Session 7, Reading 21, LOS b

V-Line Associates has adequately dealt with the restructuring charges. The decision to shut down the division due to (unexpected) rising safety concerns reflects a one-off event and thus the associated restructuring costs should be excluded from normalized earnings.

27. Based on Amelio’s conclusion, the supervisor has determined that the calculated M-score

in the exhibit should be:

A. lower.

B. higher.

C. based on more variables.

Correct Answer: A

Reference:

CFA Level II, Volume 2, Study Session 7, Reading 21, LOS d

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CFA Level II Mock Exam 6 – Solutions (AM)

A Type-I error occurs when a manipulator has been incorrectly classified as a non-

manipulator. This will occur when the calculated M-score is lower relative to the cutoff value.

C is incorrect. The existence of a Type-I error does not have any implication for the

number of variables used in the model.

28. Using the data in the Exhibit and considering all indicators except for the accruals index, Amelo may conclude that Bass Limited (‘s):

A. short-term liquidity risk is high.

B. customer credit quality has improved.

C. has excessively capitalized expenditures.

Correct Answer: B

Reference:

CFA Level II, Volume 2, Study Session 7, Reading 21, LOS d

The value reported for the days’ sales receivable index is less than 1.0 which indicates the percentage of receivables relative to sales has declined. A decline in this index could imply that there is an increase in the collection of customer accounts which may be due to an improvement in credit quality.

A is incorrect. Short-term liquidity risk is a factor considered in the Altman bankruptcy

prediction model.

C is incorrect. The reported asset quality index is less than 1.0 which may indicate that

the change in property, plant and equipment and working capital relative to other assets is lower. Therefore, the conclusion that the company has excessively capitalized its expenditures is inappropriate.

29. In context of the justifications provided by Whitman, she is most likely correct regarding:

A. Justification 1 only.

B. Justification 2 only.

C. neither of the justifications.

Correct Answer: C

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CFA Level II Mock Exam 6 – Solutions (AM)

Reference:

CFA Level II, Volume 2, Study Session 7, Reading 21, LOS d

Justification 1 is incorrect. The value of an accruals index, which is greater than 1.0 can indicate earnings manipulation. Furthermore, discretionary accruals may result from transactions or decisions made with the intent to distort reported earnings and are an indicator of possibly manipulated earnings. Non-discretionary accruals arise during the course of normal business and do not indicate earnings manipulation.

Justification 2 is incorrect. The manipulation of operating cash flows can be determined by comparing net income to cash flows.

30. Considering both tasks in isolation, Whitman’s will not be able to evaluate bankruptcy risk by performing:

A. Task 1 only.

B. Task 2 only.

C. both of the set tasks.

Correct Answer: B

Reference:

CFA Level II, Volume 2, Study Session 7, Reading 21, LOS h

Due to the limitations of the bankruptcy model, Whitman will not be able to perform the second task. However, she can expect to perform the first task with relative ease. The Altman model allows the evaluation of bankruptcy risk a single point in time using one set of financial measures. Since all else is assumed to be held constant, changing the time horizon to predict bankruptcy risk is achievable using this model.

However, the single-period, static nature of the model will prohibit Whitman from assuming different values for financial variables at different points in time.

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CFA Level II Mock Exam 6 – Solutions (AM)

Questions 31 through 36 relate to Financial Reporting and Analysis

Evan Gill and Rita McGregor Case Scenario

Financial analysts Evan Gill and Rita McGregor are analyzing the financial statements of their employer, Glace Manufacturing. On January 1, 2014, Glace purchased a five-year, annual coupon-paying bond issue (Exhibit 1). Glace Manufacturing prepares and presents its financial statements in accordance with the IFRS. The investment will be accounted for in accordance with IFRS 9 Financial Instruments. Gill concludes the issue should be held at amortized cost by providing the following justifications:

Justification 1: “Glace will solely rely on principal repayments and interest payments generated by the issue.”

Justification 2: “Glace intends to hold the issue for the purpose of collecting contractual cash flows.”

Justification 3: “The management does not intend to sell the issue in the foreseeable future.”

On January 1, 2015, Glace’s senior investment officer announces the investment committee’s decision to now rely on the issue as a source of generating arbitrage profits. The market value at the date of policy change is $325,000.

In response to the announcement, Gill and McGregor proceed to compare how IFRS 9 and IAS 39 differ with respect to the reclassification restrictions and criteria. The two individuals arrive at the following conclusion:

Conclusion: “The impact of a reclassification of a debt instrument on a company’s financial statements is prospective under IFRS 9. On the other hand, under IAS 39, any unamortized gains and losses previously recorded in other comprehensive income are recognized immediately in profit and loss on the date of reclassification.”

Glace Manufacturing is part of a group of companies with the parent organization, South Sea Inc. (SSI), operating in the U.S. The parent prepares and presents its financial statements in accordance with U.S. GAAP. On June 30, 2014 SSI acquired 35% of the common shares of Holmes Corp, a shipping company, by paying a cash amount of $110,000 on the acquisition date. McGregor summarized details concerning Holmes’ balance sheet (Exhibit 2). The management of SSI has elected to use the fair value option to account for the investment. The difference between book values and fair values is due to a parcel of land.

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CFA Level II Mock Exam 6 – Solutions (AM)

For the financial year 2014, Holmes Corp generated income of $250,000 and paid dividends of

$60,000.

During 2014, SSI also acquired 20% of the common stock of VR Tech, a software engineering firm. 35% of VR Tech’s common stock is owned by Frasr Limited, SSI’s competitor. The transaction will not give SSI’s shareowners any voting privileges. However, 70% of the potential losses generated by VR will be absorbed by SSI. This contrasts to Frasr Limited’s ownership rights which permit owners to absorb 80% of VR’s expected residual returns and enjoy voting rights. The remainder 20% of the expected residual returns will be absorbed by SSI.

The two analysts conclude their discussion by exploring how contingent assets and liabilities are recognized in business combinations.

Exhibit 1:

Details Concerning Bond Issue on January 1, 2014

Acquisition cost (equal to par value) Market value Annual coupon rate Market interest rate

Acquisition cost (equal to par value) Market value Annual coupon rate Market interest rate
Acquisition cost (equal to par value) Market value Annual coupon rate Market interest rate
Acquisition cost (equal to par value) Market value Annual coupon rate Market interest rate

$250,000

$240,000

10%

8%

Exhibit 2:

Holmes Corp’s Selective Balance Sheet Information as at June 30, 2014

Book Value

Fair Value

Current assets Property, plant and equipment Other noncurrent assets Total liabilities Net assets

$40,000

$40,000

$158,500

$165,000

$8,200

$8,200

$240,000

$240,000

$446,700

$453,200

$8,200 $240,000 $240,000 $446,700 $453,200 31. Which of the justifications supplied by Gill is least

31. Which of the justifications supplied by Gill is least likely mandated by IFRS 9 when classifying debt instruments?

A. Justification 1.

B. Justification 2.

C. Justification 3.

Correct Answer: C

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CFA Level II Mock Exam 6 – Solutions (AM)

Reference:

CFA Level II, Volume 2, Study Session 6, Reading 20, LOS a

Justification 3 is not one of the criteria typically used to determine whether a financial asset can be held at amortized cost. It is only when a financial asset fails to meet the criteria can it be designated at fair value through profit and loss and classified as held for trading.

To be measured at amortized cost, financial assets must meet at least two criteria:

1. A business model test: The financial assets are being held to collect contractual cash flows (Justification 2 meets this test).

2. A cash flow characteristic test: The contractual cash flows are solely payments of principal and interest on principal (Justification 1 meets this test).

32. Considering the change in intention, can the debt issue be reclassified under IFRS 9?

A. No, reclassifications are prohibited.

B. Yes, and the issue will be measured at $325,000 on the balance sheet.

C. Yes, and $85,000 will recognized as unrealized gains in other comprehensive income.

Correct Answer: B

Reference:

CFA Level II, Volume 2, Study Session 6, Reading 20, LOS a

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CFA Level II Mock Exam 6 – Solutions (AM)

Debt instruments can only be reclassified when there is a change in the business model which significantly affects operations. Given that the instrument will now be looked at as a source of arbitrage profits, the debt issue can be reclassified. When a debt issue is

reclassified from amortized cost to fair value through profit or loss, the asset is measured

at fair value, in this case at its market value of $325,000 and with the gain or loss

recognized in profit or loss.

A is incorrect. Due to a valid change in the business model (objective for holding

financial assets) reclassification is permitted.

B is incorrect. The difference between the amortized cost and fair value is recognized in

profit or loss.

Amortized cost (January 1, 2015) = $250,000 – ($250,000 × 10%) – ($250,000 × 8%) =

$245,000.

Gain recognized in profit or loss = Fair value – Amortized cost = $325,000 - $245,000 =

$80,000.

33. The conclusion drawn by the two analysts is most accurate with respect to:

A. IAS 39.

B. IFRS 9.

C. both of the standards.

Correct Answer: B

Reference:

CFA Level II, Volume 2, Study Session 6, Reading 18, LOS a

The conclusion drawn by the analysts is only correct with respect to IFRS 9. There is no restatement of prior periods at the reclassification date and so any changes are made prospectively.

IAS 39 requires that any previous unamortized gains and losses recognized in other comprehensive income are amortized to profit or loss over the remaining life of the security using the effective interest rate method.

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CFA Level II Mock Exam 6 – Solutions (AM)

34. On December 31, 2015 the investment in Holmes Corp will be recorded on South Sea Inc.’s balance sheet at:

A. $110,000.

B. $113,300.

C. $176,500.

Correct Answer: A

Reference:

CFA Level II, Volume 2, Study Session 6, Reading 18, LOS b

Under the fair value option, the investment account on the investor’s balance sheet does not reflect the investor’s proportionate share of the investee’s profit or loss, dividends or other distributions. In addition, the excess of the cost over the fair value of the investee’s identifiable assets is not amortized nor is goodwill created. Therefore, the investment in Holmes Corp will continue to remain at the fair value of the acquisition price until it is revalued.

Fair value at the time of acquisition = $453,200 × 0.35 = $113,300

35. The company required to consolidate VR Tech is:

A. SSI.

B. Frasr Limited.

C. both SSI and Fasr Limited.

Correct Answer: A

Reference:

CFA Level II, Volume 2, Study Session 6, Reading 18, LOS b

U.S. GAAP requires the primary beneficiary of a variable interest entity (VIE) to consolidate the VIE regardless of its voting interests in the VIE or its decision making authority. An entity is a primary beneficiary if absorbs the majority of the gains, or the majority of the losses or both. If one entity absorbs the majority of the losses, as is the case with SSI, while another absorbs the majority of the expected residual returns, as is the case with Frasr Limited, U.S. GAAP requires the entity absorbing the majority of losses to consolidate the VIE. Therefore, SSI must consolidate VR Tech.

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CFA Level II Mock Exam 6 – Solutions (AM)

36. Under IFRS, contractual contingent assets are:

A. not recognized.

B. recognized if they more likely than not meet the definition of an asset on the acquisition date.

C. subsequently measured at the higher of acquisition date fair value and best estimate of future settlement amount.

Correct Answer: A

Reference:

CFA Level II, Volume 2, Study Session 6, Reading 18, LOS b

Contractual assets (whether contractual or non-contractual) are not recognized under IFRS. This contrasts with U.S. GAAP where the recognition and subsequent measurement of contingent assets varies depending on whether they are contractual or non-contractual.

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CFA Level II Mock Exam 6 – Solutions (AM)

Questions 37 through 42 relate to Equity Investments

Stan-Davis Case Scenario

Stan-Davis is an automobile manufacturer, which is publically listed on the NYSE. The senior manager at Stan-Davis’s acquisition department, Lisa Gunn, is exploring TS Inc., a supplier of the rubber used to manufacturer tires as a potential acquisition target. TS is a privately traded concern. Upon evaluating TS, Gunn opts for the capitalized cash flow method (CCM) to value the supplier. She justifies her decision based on the following reasons:

Reason 1: “TS’s operating structure and operations will be relatively stable in the foreseeable future with limited growth potential.”

Reason 2: “Financial projections are difficult to develop due to the lack of adequate financial statement footnotes.”

Reason 3: “The method is a popular choice for valuing potential acquisition targets.” Gunn is exploring which definition of value will be most suitable for the acquisition target given that an arm’s length transaction is unlikely between Stan-Davis and TS. Many analysts do not share the view that operations will be stable in the future. Thus a diverse range of projections concerning TS’s potential level of risks, earnings power, as well as potential synergies arising from the acquisition will exist amongst potential buyers.

Gunn notes that the valuation process for public and private companies can differ significantly and is attributed to various factors.

Gunn collects the data necessary to derive the value of Stan-Davis using the CCM (Exhibit). The data collected reflects projections for the coming fiscal year. The weighted average cost of capital (WACC) used to discount free cash flows is based on an implicit assumption.

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CFA Level II Mock Exam 6 – Solutions (AM)

Exhibit:

TS Valuation Data for the CCM

Free cash flows to equity* Working capital investment Fixed capital investment Non-cash charges Required return on equity Capitalization rate

equity* Working capital investment Fixed capital investment Non-cash charges Required return on equity Capitalization rate
equity* Working capital investment Fixed capital investment Non-cash charges Required return on equity Capitalization rate
equity* Working capital investment Fixed capital investment Non-cash charges Required return on equity Capitalization rate
equity* Working capital investment Fixed capital investment Non-cash charges Required return on equity Capitalization rate
equity* Working capital investment Fixed capital investment Non-cash charges Required return on equity Capitalization rate

$45,000

$8,500

$10,400

$1,200

10%

8%

*Cash flows at T =1. Thereafter cash flows will grow at a long-term sustainable rate.

Gunn would like to determine the role of business valuation standards and practices in private equity valuation and decides to engage in a discussion with Raul Martinez, a private equity specialist. Martinez makes the following comments:

Comment 1: “The objective behind valuation standards is to impose a framework which legally binds valuators to a set of standards.”

Comment 2: “Business valuations vary according to companies and across time. Therefore, valuation standards cannot be relied on to provide technical guidance.”

cannot be relied on to provide technical guidance.” 37. Which of the following reasons presented by

37. Which of the following reasons presented by Gunn negates the use of the CCM to value TS?

A. Reason 1.

B. Reason 2.

C. Reason 3.

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CFA Level II Mock Exam 6 – Solutions (AM)

Correct Answer: C

Reference:

CFA Level II, Volume 4, Study Session 12, Reading 38, LOS f

C is correct. The CCM is rarely used in the context of acquisitions and this reason

negates the use of the method to value TS.

A is incorrect. Reason 1 is a valid justification for using CCM to value TS. The CCM is

appropriate for valuing a private company when there is an expectation of stable future operations.

B is incorrect. The CCM Is appropriate for valuing private entities in which no

projections are available.

38. The definition of value which is most suitable for TS is:

A. market value.

B. intrinsic value.

C. investment value.

Correct Answer: C

Reference:

CFA Level II, Volume 4, Study Session 12, Reading 38, LOS b

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CFA Level II Mock Exam 6 – Solutions (AM)

Investment value is the most appropriate definition of value for TS. Differing expectations with respect to earnings power, potential risks, and potential synergies may produce different company values. In addition, this definition of value is more focused on a specific buyer rather than value in a market context. Given that the focus of valuation is on potential buyers, this definition is most appropriate.

A is incorrect. Market value is not an appropriate value definition as it is relevant for real

estate and tangible asset appraisals when money is borrowed against the value of such assets. In addition, the absence of an arm’s-length transaction further provides evidence

of

the inappropriateness of this definition.

B

is incorrect. Intrinsic value is arrived at by considering all available facts with the result

that the derived (“true” or “real”) value will become the market value when other investors reach the same conclusion. Given that the buyers are expected to arrive at different conclusions with regards to value, this method is not suitable for valuation purposes.

39. Gunn will conclude that, in contrast to Stan-Davis, TS will have:

A. have more management depth.

B. a greater preference for tax-exempt municipals.

C. have greater pressure from long-term investors.

Correct Answer: B

Reference:

CFA Level II, Volume 4, Study Session 12, Reading 38, LOS a

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CFA Level II Mock Exam 6 – Solutions (AM)

B is correct. Reduction of reportable taxable income and corporate tax payable may be a

more important goal for private companies compared with public companies because of greater benefit to owners. As a result, there will be a greater preference for tax-exempt securities by the owners of private entities.

A is incorrect. In contrast to publically traded enterprises, privately traded enterprises

have less management depth. This particularly applies to TS which is a small private company and is expected to have limited growth potential according to Gunn.

C is incorrect. Being a publically traded enterprise, Stan-Davis will face greater pressure

from short-term investors as investors’ trading interests may be of short-term nature. As a result company management will be pressurized to or motivated to support share price in

the short-term. In contrast the management of private entities can take a long-term investment focus as they do not experience similar stock price performance pressure.

40. The implicit assumption being used by Gunn to value TS is that the:

A. debt and equity are being held at their optimal weights.

B. debt and equity weights are quoted based on their book values.

C. size of the capital structure will decline in the foreseeable future.

Correct Answer: A

Reference:

CFA Level II, Volume 4, Study Session 12, Reading 38, LOS f

A is correct. The constant capital structure assumption assumes that debt and equity will

be constant and therefore implies that these components will be held at their optimal weights.

B is incorrect. Debt and equity weights are quoted using market values.

C is incorrect. The implicit assumption to derive the WACC in the CCM is that a

constant capital structure at market values in the future exists.

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CFA Level II Mock Exam 6 – Solutions (AM)

41. Using the information in the exhibit, the value of the invested capital in TS is equal to:

A. $273,000.

B. $341,250.

C. $562,500.

Correct Answer: B

Reference:

CFA Level II, Volume 4, Study Session 12, Reading 38, LOS f

Value of invested capital = FCFF 1 /(WACC – g f )

FCFF = FCFE – Working capital investment – fixed capital investment + non-cash charges

FCFF = $45,000 – $8,500 – $10,400 + $1,200 = $27,300

Value of invested capital = FCFF 1 /Capitalization rate = $27,300/0.08 = $341,250

42. Martinez is most accurate with respect to:

A. Comment 1 only.

B. Comment 2 only.

C. both of his comments.

Correct Answer: B

Reference:

CFA Level II, Volume 4, Study Session 12, Reading 38, LOS l

Martinez is inaccurate with respect to Comment 1; accurate with respect to Comment 2. Martinez is inaccurate with respect to Comment 1. Business valuations performed in accordance with valuation standards do not involve mandatory compliance.

Martinez is accurate with respect to Comment 2. Valuation standards provide limited technical guidance as a result of the diverse and dynamic nature of valuations. The individual circumstances of companies as well as time contribute towards the aforementioned nature of valuation.

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CFA Level II Mock Exam 6 – Solutions (AM)

Questions 43 through 48 relate to Equity Investments

Maxim Inc. Case Scenario

Maxim Inc. is a privately traded manufacturing concern operating in the timber industry. Mark Jamestown, Maxim’s CEO, has organized a meeting with Ian Knight and Linda Scholes, two private equity specialists. Jamestown aims to address the following objectives in the meeting:

Objective 1: Value Maxim Inc. using a fundamental factor model.

Objective 2: Forecast Maxim Inc.’s future free cash flows.

At the commencement of the meeting, Jamestown poses the following question to the analysts:

“What are the typical reasons for performing valuation of private equity businesses and interests?” The analysts respond as follows:

Statement 1: “Valuation is necessary when a company undertakes transactions that have both accounting and tax implications such as those involving an employee stock ownership plan (ESOP).”

Statement 2: “An acquisition of one company by the other may call for valuation.”

Statement 3: “Corporate activities such as transfer pricing often have tax implications calling for valuation.”

The two analysts are divided in their opinion regarding which model to use to achieve the first objective. Knight proposes the residual income model for the sole reason that it captures the shortcomings of traditional accounting.

To demonstrate the application of the residual income technique, Knight collects relevant details (Exhibit 1). Using the single-stage residual model, he arrives at an intrinsic per share value of

$60.00.

Scholes joins the conversation by pointing out that residual income, which is based on a company’s earnings, is inappropriate for comparing Maxim to the average industry. Instead, she advocates for the free cash flow valuation approaches to achieve the first objective.

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CFA Level II Mock Exam 6 – Solutions (AM)

To achieve Objective 2, Scholes collects the necessary data (Exhibit 2). Her analysis is based on historical data and the current and expected economic environment. She expects the proportions of incremental fixed capital and working capital to maintain their historical relations with sales.

Exhibit 1:

Residual Income Model Details

Current market price per share

 

$55

Sustainable growth rate

 

4%

Cost of equity

 

6%

Retention rate

 

40%

Exhibit 2:

FCFF Forecast Data

 

Forecasted EBIT margin

15%

Tax rate

30%

Current capital expenditures

$50,000

Current depreciation expenses

$45,500

Current sales

$800,000

Forecasted sales

$1,000,000

Increase in working capital

$30,000

Target debt ratio

0.40

in working capital $30,000 Target debt ratio 0.40 43. The most appropriate classification of the reasons

43. The most appropriate classification of the reasons for performing private equity valuations provided by the analysts is:

Statement 1:

Statement 2:

Statement 3:

A. transaction-related

B. transaction-related

C. compliance-related

transaction-related

compliance-related

transaction-related

compliance-related.

transaction-related.

transaction-related.

Correct Answer: A

Reference:

CFA Level II, Volume 4, Study Session 12, Reading 38, LOS b

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CFA Level II Mock Exam 6 – Solutions (AM)

Statement 1 reflects a transaction-related reason for performing valuations. Share-based payments arising from ESOPs have accounting implications for the issuer (company) and employees who are parties to the transaction.

Statement 2 reflects a transaction-related reason for performing valuations. Acquisition- related valuations may be performed (and negotiated) by the target and/or buyer.

Statement 3 reflects a compliance-related reason for performing valuations. Corporate activities such as transfer pricing are examples of tax-related reasons for performing valuations.

44. The ‘shortcomings’ of traditional accounting overcome by residual income referred to by Knight is that the measure:

A. recognizes the opportunity cost of generating capital.

B. is based on economic profitability and not subject to manipulation.

C. does not assume that interest expense is a representative cost of debt financing.

Correct Answer: A

Reference:

CFA Level II, Volume 4, Study Session 12, Reading 37, LOS a & j

Traditional accounting recognizes a charge for the cost of debt capital in the form of interest expense while ignores the cost of raising equity capital. On the other hand, residual income recognizes the latter cost by deducting from net income the opportunity cost incurred by shareholders in generating net income.

B

is incorrect. Although residual income may be identified as economic profit because it

is

an estimate of the profit of the company after deducting the cost of raising capital (both

equity and debt), deriving this estimate relies on accounting data which can be subject to management manipulation.

C is incorrect. Residual income models make use of accounting income which assumes

that the cost of debt capital is reflected appropriately by interest expense.

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CFA Level II Mock Exam 6 – Solutions (AM)

45. Using the data in Exhibit 1, Knight will conclude that the:

A. justified price-to-book ratio is greater than 1.

B. intrinsic value is equivalent to the book value per share.

C. present value of expected future residual earnings is negative.

Correct Answer: A

Reference:

CFA Level II, Volume 4, Study Session 12, Reading 37, LOS e

Based on the calculations (below) justified price-to-book ratio is greater than 1. A greater than 1 justified P/B ratio indicates the present value of future residual earnings is positive.

The intrinsic value is greater than the book value per share as ROE (10%) exceeds the cost of equity (6%).

The present value of expected residual income is positive as ROE exceeds the cost of equity.

Justified P 0 /B 0 = 1 + (ROE – r)/(r – g) = 1 + [(0.10) – 0.06]/(0.06 – 0.04) =3.0

ROE = Growth rate/(Retention rate) = 0.04/0.40 = 0.10

46. Which of the following arguments least likely supports Scholes’ argument in favor of free cash flow valuation approaches?

A. Differences in capital structure between companies are accounted for.

B. Terminal values can be forecasted with a reasonable degree of certainty.

C. The reinvestment of cash flows made in capital assets to maximize firm value in the long-run is considered.

Correct Answer: B

Reference:

CFA Level II, Volume 4, Study Session 12, Reading 35, LOS a

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CFA Level II Mock Exam 6 – Solutions (AM)

B is correct. The terminal value is a significant component of the present value of the

company calculated using free cash flow models.

A is incorrect. An advantage of the free cash flow valuation approaches is that it accounts

for differences in capital structures across corporations making them ideal for comparing

the valuation of companies.

C is incorrect. Free cash flow valuation approaches consider the reinvestment of cash

flows that the company makes in capital assets to maximize firm value in the long run.

47. Using the data in Exhibit 2, the forecasted free cash flows to the firm (FCFF) is closest

to:

A. $70,500.

B. $71,000.

C. $115,500.

Correct Answer: A

Reference:

CFA Level II, Volume 4, Study Session 12, Reading 35, LOS e

Forecasted FCFF:

Sales EBIT = $1,000,00 × 0.15 = EBIT (1 – tax rate) = $150,000(1 – 0.30) Incremental fixed capital* Incremental working capital** FCFF

$1,000,000

$150,000

$105,000

$4,500

$30,000

$70,500

Increase in sales = $1,000,000 – $800,000 = $200,000 *Incremental fixed capital = (Capital expenditures – depreciation expenses)/increase in sales = ($50,000 – $45,500)/($200,000) = 2.25%

Incremental fixed capital = 2.25% of sales increase = 0.0225 × $200,000 = $4,500 **Incremental working capital = Increase in working capital/increase in sales = $30,000/$200,000 = 15%

Incremental working capital = 15% of sales increase = 0.15 × $200,000 = $30,000

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CFA Level II Mock Exam 6 – Solutions (AM)

48. The target debt ratio in Exhibit 2:

A. assumes there are no noncash charges.

B. represents the debt capital necessary for growth.

C. represents the cost of maintaining existing capital stock.

Correct Answer: B

Reference:

CFA Level II, Volume 4, Study Session 12, Reading 35, LOS e

The target debt ratio assumes that depreciation is the only noncash charge. Furthermore, the ratio indicates the percentage of investment in fixed capital in excess of depreciation also called the net new investment in fixed capital or the capital required to grow the company.

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CFA Level II Mock Exam 6 – Solutions (AM)

Questions 49 through 54 relate to Fixed Income

Gus Weaver Case Scenario

Gus Weaver is a fixed income analyst a Caramel Alliance (CA), an asset management firm. CA maintains a fixed income fund, which is currently invested in option-free fixed rate corporate and Treasury bonds. He is seeking to expand the fund holdings and is evaluating two potential investments, a putableand convertible issue.

Investment A: Three-Year Putable Bond Issued by Samson Corp. To exploit yield curve movements, Weaver decides to invest in a 2-year bond issue. The embedded option is currently exercisable at 100. Weaver projects the full price and effective duration of the issue when the yield curve is flat at 2% and moves down by 100 basis points (Exhibit 1). Using this information, he aims to determine how these two variables will respond to an upward parallel shift of 100 basis points.

Exhibit 1:

Effective Duration and Full Price of Putable Bond Issue

 

At a 2% Flat Yield Curve

Interest Rate Up by 100 Basis Points

Interest Rate Down by 100 Basis Points

Full Price

$101.25

?

$102.50

Effective Duration

4.52

?

5.60

Investment B: Ten-Year Westham Interiors (WI) Convertible Bond Issue Weaver is primarily interested in the potential equity exposure associated with the WI convertible. The prospectus of the convertible includes a provision whereby investors may forgo lending to WI if the latter is merged or acquired by another company during the life of the issue. Selective details concerning the issue are summarized in an exhibit (Exhibit 2).

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CFA Level II Mock Exam 6 – Solutions (AM)

Exhibit 2:

Convertible Bond Issue Prospectus

Issue date

January 1, 2014

Issue price

100% of par denominated into bonds of $1,000 each

Conversion period

January 31, 2015 to December 22, 2024

Initial conversion price

$8.00 per share

Conversion ratio

Each bond is convertible into 14,000 shares of WI common stock

Issuer call price

110%; starting two years after issue date up to one year before maturity

Change of control provision

The exercise of the embedded put option following a change in control event will entitle investors to receive compensation in the form of cash and/or subordinated notes.

Market Information:

 

Share price on January 1, 2015

$7.23

Share price on February 25, 2015

$8.15

Convertible bond price on February 25, 2015

$110,850

Straight bond value on February 25, 2015

$110,850

Joanne Buck is a junior fixed-income analyst at CA. Buck has recently been tasked with preparing a report on the WI convertible. By using the data in Exhibit 2, Buck aims to address the following questions in her report:

Question 1: When should we expect a forced conversion to occur and will the occurrence of such an event strengthen or weaken WI’s capital structure?

Question 2: How will WI’s debt-to-equity ratio be affected when the embedded conversion option is exercised?

Question 3: Which factors will significantly influence the risk-return characteristics of the WI issue?

will significantly influence the risk-return characteristics of the WI issue? FinQuiz.com © 2016 - All rights

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CFA Level II Mock Exam 6 – Solutions (AM)

49. Using the information in Exhibit 1, the effective duration of the putable issue if rates rise by 100 basis points is:

A. less than 4.52.

B. less than 5.60.

C. greater than 5.60.

Correct Answer: A

Reference:

CFA Level II, Volume 5, Study Session 14, Reading 45, LOS k

A

putable bond issue has limited downside potential when interest rates rise as the value

of

the issue cannot decline below 100.00. On the other hand, there is no limit to a rise in

price if yields decline. Therefore, a putable bond is less sensitive to a rise in yields than it

is to a decline in yields. The effective duration of the bond when yields rise by 100 basis

points is less than 4.52.

50. The change in control provision described in Exhibit 2 is an example of a:

A. soft put.

B. hard put.

C. threshold put.

Correct Answer: A

Reference:

CFA Level II, Volume 5, Study Session 14, Reading 45, LOS m

The change in control provision described in Exhibit 2 is a soft put; this is because the issuer has a choice of how investors will be compensated if bonds are redeemed for cash (either in the form of cash, subordinated notes, common stock or a combination of the three).

B is incorrect. In the case of a hard put, the issuer must redeem the convertible bond for

cash. Given that subordinated notes are an alternative for providing compensation, the

embedded put is not “hard” in nature.

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CFA Level II Mock Exam 6 – Solutions (AM)

51. Using the information in Exhibit 2, does an arbitrage opportunity exist on February 25, 2015 with respect to the WI convertible?

A. No.

B. Yes; there is an opportunity to earn $3,250 in profit.

C. Yes; there is an opportunity to earn in $9,630 in profit.

Correct Answer: B

Reference:

CFA Level II, Volume 5, Study Session 14, Reading 45, LOS o

If the value of the convertible bond is lower than the greater of the conversion value and the straight value, an arbitrage opportunity exists (as discussed below).

On February 25, 2015 the convertible bond is selling at its straight value of $110,850 and at a price, which is lower than the conversion value of the bond (14,000 × $8.15 = $114,100). The arbitrageur can buy the convertible bond for $110,850, convert is to 14,000 shares, and sell the shares to earn an arbitrage profit of $3,250 ($114,100 –

$110,850).

52. The most appropriate response to Question 1 is when:

A. credit spreads have widened and the capital structure will strengthen.

B. interest rates have declined and the capital structure will not be unaffected.

C. interest rates are constant but the current share price exceeds conversion price and the capital structure will strengthen.

Correct Answer: C

Reference:

CFA Level II, Volume 5, Study Session 14, Reading 45, LOS m

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CFA Level II Mock Exam 6 – Solutions (AM)

Given that the WI bond issue has an embedded call, the issuer has an incentive to call the bond when the underlying share price exceeds the conversion price to avoid paying further coupons. In addition, a decline in interest rates or a narrowing of the credit spread will give the issuer an incentive to refinance the bond at a lower cost.

Even if interest rates do not decline or credit spreads do not narrow, an issuer may exercise the call option when the share price exceeds the conversion price. This will allow the issuer to take advantage of favorable equity market conditions. The forced conversion should strengthen the issuer’s capital structure.

53. The most appropriate response to Question 2 is that WI’s debt-to-equity ratio will:

A. improve.

B. deteriorate.

C. not be affected.

Correct Answer: A

Reference:

CFA Level II, Volume 5, Study Session 14, Reading 45, LOS m

When the conversion option embedded is exercised and each bond is converted into common stock, the issuer’s debt-to-equity ratio will improve due to a dilution in the equity structure. Each bond will be converted and additional shares will be issued at a time when the share price exceeds the conversion price. The combination of an increase in share price and number of shares outstanding will lead to a higher reported total equity balance and a decline (or improvement) in the debt-to-equity ratio.

54. On February 25, 2015 the Westham issue will resemble a (n):

A. hybrid instrument.

B. busted convertible.

C. common share issued by the company.

Correct Answer: C

Reference:

CFA Level II, Volume 5, Study Session 14, Reading 45, LOS p

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CFA Level II Mock Exam 6 – Solutions (AM)

On February 25, 2015, the share price exceeds the initial conversion price ($8.15 versus $8.00 respectively) and so the embedded call option is in the money. Therefore, the convertible will exhibit stock risk-return characteristics and will resemble WIs common stock.

A is incorrect. The convertible issue will trade as a hybrid instrument when the 1)

underlying share price is below the conversion price and increases toward it and 2) when the underlying share price is above the conversion price but decreases toward it. Given that this is not the scenario the WI issue does not trade as a hybrid instrument.

B is incorrect. When the underlying share price is below the conversion price, the

convertible bond exhibits bond risk-return characteristics and resembles the underlying

(option-free) straight bond.

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CFA Level II Mock Exam 6 – Solutions (AM)

Questions 55 through 60 relate to Derivatives

Alpha Associates Case Scenario

Alpha Associates is a derivatives dealer firm and a member of the CDS industry. AA provides credit solutions to lenders across the globe. Sean Vaughn is AA’s senior most derivatives trader. Vaughn is examining the current credit exposures of some of his clients. As part of his survey, Vaughn has collected details concerning three independent events affecting protection buyers.

Event 1: Buyer A lives in a country where the economy has entered into a recession.

Event 2: Buyer B originates from a country where the monetary authorities have announced a policy to increase interest rates. This announcement will increase borrowing costs.

Event 3: Buyer C resides in a country in which the municipal government authorities and bond issuers are observing a moratorium in order to deal with the existing economic crisis.

Vaughn moves on to evaluate a three-year CDS issued by AA (Exhibit 1). The reference obligation is a three-year, $10 million bond issued by Tike Limited with an annual coupon rate of 4.2%. Vaughn projects the hazard rates as 3%, 5% and 7%, respectively, for the three years of the issue. In addition, Tike Limited has two other issues trading at 30% and 40% of par respectively.

Exhibit 1:

Details Concerning CDS

Coupon rate

4%

Coupon payment frequency

Quarterly

Original credit spread

520 basis points

Duration

Two years

Notional principal

$100 million

Recovery rate

40%

Vaughn notes that the original credit spread is highly unlikely to remain constant given that the credit curve is sloping steeply upwards and the credit spread on the CDS under evaluation is expected to widen by 150 basis points.

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CFA Level II Mock Exam 6 – Solutions (AM)

Once Vaughn has completed his evaluation of the CDS, he undertakes a study of how the pricing and compensation of credit risk in bond and CDS markets can give rise to arbitrage opportunities. He evaluates whether a similar opportunity exists with respect to a potential long position in the credit risk of Yalt Inc., a lender of credit. The position is currently under evaluation. Details concerning the potential CDS to be issued and the underlying obligation have been summarized for the purpose of analysis (Exhibit 2).

Exhibit 2:

Analysis of CDS Issued to Yalt Inc.

Underlying annual yield-to-maturity

 

5%

Underlying term to maturity

 

3

years

CDS credit spread

350

basis points

CDS term to maturity

 

4

years

Yalt Inc’s funding cost

275

basis points

years Yalt Inc’s funding cost 275 basis points 55. In context of the events being analyzed

55. In context of the events being analyzed by Vaughn, which of the following represents a potential credit event, which is likely to trigger a CDS payment from AA?

A. Event 1.

B. Event 2.

C. Event 3.

Correct Answer: C

Reference:

CFA Level II, Volume 6, Study Session 17, Reading 52, LOS b

Event 3 represents a potential credit event as the observation of a moratorium by bond issuers will lead to a restructuring of debt and an event which may quality as a credit event.

Event 1 does not classify as a credit event as a recession may or may not imply default for the reference entity. In other words, the credit event is ambiguous.

Event 2 does not classify as a credit event as a rise in borrowing costs may or may not result in the failure of a borrower to default on its reference obligation. Again the credit event is ambiguous as its outcome cannot be determined with certainty.

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CFA Level II Mock Exam 6 – Solutions (AM)

56. Using the information provided in Exhibit 1, the price of the CDS per 100 par amounts to:

A. $98.4.

B. $100.8.

C. $101.6.

Correct Answer: C

Reference:

CFA Level II, Volume 6, Study Session 17, Reading 52, LOS c

Upfront premium = (Credit spread – Fixed Coupon) × Duration

Upfront premium = (3.2% – 4.0%) × 2 = - 0.016 or – 1.6%

Given that the upfront premium is negative, the present value of the credit spread is lower relative to the present value of the fixed coupon. Thus, AA will be responsible for making an upfront payment to the protection buyer.

Price of CDS in currency per 100 par = 100 – Upfront premium in % = 100 – (- 1.6%) =

101.6

57. Using the information provided in Exhibit 1 and the vignette concerning the Tike Limited reference obligation, the expected loss for the first two years of the issue is closest to (in millions):

A. $0.26.

B. $0.35.

C. $0.50.

Correct Answer: A

Reference:

CFA Level II, Volume 6, Study Session 17, Reading 52, LOS c

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CFA Level II Mock Exam 6 – Solutions (AM)

Expected loss = Loss given default × probability of default There are three possible outcomes (loss given default will be calculated for outcomes 1 and 2):

Outcome 1: The issuer does not default

Outcome 2: The issuer defaults on the payment due in Year 2 only.

Outcome 3: The issuer defaults on the payment due in Years 1 and 2

If the buyer defaults on the first and second payments, the amount lost is $2.4 million (4% × $100 million × 0.6) each year. Total loss given default would equal to $4.8 million.

In the case of outcome 2, expected loss is equal to $2.4 million. Expected loss is equal to $4.8 million in the case of outcome 3.

There is a 3% chance of losing $4.8 million and a (0.97 × 0.05) = 0.0485 or 4.85% chance of losing $2.4 million. The undiscounted expected loss is thus equal to $0.26 million ($4.8 million × 3% + $2.4 million × 4.85%).

58. If the forecast for credit spreads does materialize and AA elects to unwind the CDS contract by buying a new contract, it will:

A. monetize a loss.

B. face a decline in the market value of the original CDS.

C. need to pay a lower upfront premium on the new CDS.

Correct Answer: A

Reference:

CFA Level II, Volume 6, Study Session 17, Reading 52, LOS c

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CFA Level II Mock Exam 6 – Solutions (AM)

A widening of credit spreads is an indicator of an increase in credit risk. As a result, the

upfront premium rate on any new CDS contract being traded in the market will exceed that which is currently being received on the existing CDS. Should AA elect to unwind its existing position it will need to buy protection on the Tike Limited issue. The premium paid to buy protection will be higher relative to the income currently being

received as protection seller. Therefore, AA will monetize a loss.

B is incorrect. The premium rate on any CDS being traded on Tike Limited in the market

will be higher relative to the original CDS.

C is incorrect. The implied upfront premium on a new CDS which matches the terms of

the original CDS with adjusted maturity is now the market value of the original CDS. An

increase in the implied upfront premium represents an increase in market value.

59. With respect to the CDS issued to Yalt Inc., the trade being explored by Vaughn is most likely classified as:

A. basis.

B. curve.

C. long/short.

Correct Answer: A

Reference:

CFA Level II, Volume 6, Study Session 17, Reading 52, LOS d & e

The trade being explored by Vaughn is referred to a basis trade. The foundation of the basis trade is a difference in credit spreads between the CDS and bond markets.

B is incorrect. A curve trade exploits the difference in maturities of two CDSs on the

same reference entity.

C is incorrect. A long/short trade involves taking a long position in one CDS on one

reference entity and a short position in a second CDS in another reference entity. The trade represents a bet that the credit position of one entity will improve relative to the other.

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CFA Level II Mock Exam 6 – Solutions (AM)

60. To exploit arbitrage opportunities with respect to the CDS issued to Yalt Inc., AA should:

A. sell protection in the CDS market and go long the bond.

B. buy protection in the CDS market and go long the bond.

C. sell protection in the CDS market and go short the bond.

Correct Answer: C

Reference:

CFA Level II, Volume 6, Study Session 17, Reading 52, LOS e

The reference bond’s credit spread is equal to 2.25% (bond yield – investor’s funding cost = 5% - 2.75%).

Credit risk is cheaper in the bond market (2.25%) relative to the CDS market (3.50%).

Therefore, AA should sell CDS protection and go short the bond thereby earning 3.50% for assuming credit risk.

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