‭300Hours: CFA Level 2 Mock Exam‬

‭This Chartered Financial Analyst (CFA®) Mock Exam has 44 item set questions, courtesy of IFT.‬

‭ o best simulate the exam day experience, candidates are advised to allocate a total of 2 hours 12‬
T
‭minutes for this session of the exam.‬

‭ nce completed, please submit your answers at‬‭https://3h.rs/CFAL2Mock‬‭to get your score,‬
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‭performance benchmark and answer explanations.‬
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‭Questions 1-6 relate to Ethical and Professional Standards.‬

‭Alpine Investment Case Scenario‬

‭ elina Sharma, CFA, is a portfolio manager at Alpine Investments with discretionary authority over‬
S
‭her clients’ portfolios. As per Alpine’s policy, she reviews the investment policy statements of her‬
‭clients annually. Sometimes changes in clients’ circumstances or in capital market expectations‬
‭dictate more frequent reviews. She updates the investors’ IPS to reflect changes in circumstances‬
‭and capital market expectations.‬

‭ aleb Jones, a former business colleague of Sharma, is the Chief Investment Officer (CIO) of‬
C
‭Chrome Manufacturing Company (CMC) and an Alpine client. Jones has been very helpful to‬
‭Sharma by providing her with information on attractive stocks in the manufacturing industry.‬
‭Sharma has capitalized on this information for her clients’ portfolios and her personal portfolio.‬
‭She has more than once purchased stocks of the companies recommended by Jones for her own‬
‭account prior to placing a purchase order for her clients which has resulted in her personal‬
‭portfolio showing a better performance than her other portfolios.‬

‭ t one of their lunch meetings, Jones informs Sharma that he will be leaving CMC and joining a‬
A
‭competitor firm, AID, where he will receive a generous package including stock options in the‬
‭company. “Because of this increased wealth, I feel I can take additional risk and become more‬
‭aggressive with my asset allocation.” Jones then proceeds to discuss the various aspects of the‬
‭change in his financial situation, risk tolerance, and financial objectives. Sharma agrees to modify‬
‭his IPS to reflect the change in his circumstances. As he is leaving, Jones asks Sharma about one‬
‭of her clients. “I believe your firm manages the ABC Pension Fund. Perhaps you can share with me‬
‭its asset allocations.” Sharma responds, “The pension fund is indeed managed by Alpine and it is‬
‭aggressive in its allocations.” She however, refrains from telling him that she is no longer the‬
‭portfolio manager and the fund is undergoing a change in its investment policy.‬

‭ month later, Sharma reads a report by an Alpine analyst on a small biotechnology firm with a‬
A
‭promising outlook. Based on the report’s extensive analysis and buy recommendation, she feels‬
‭that it would be a suitable investment for Jones’ account under his new IPS, and two other‬
‭accounts with objectives and constraints similar to Jones. Sharma places a buy order of equal‬
‭amount for two of her clients including Jones, and doesn’t purchase shares for her third client‬
‭since his account does not have cash available and his existing assets meet his investment‬
‭objectives, hence selling them will not be prudent. Sharma calls Jones to discuss the stock in more‬
‭detail. Jones is not satisfied and retorts, “I’m not comfortable with some of your recent stock‬
‭picks. Maybe it is time that I change my money manager.” In order to pacify Jones, Sharma‬
‭responds, “Our firm has just received notification of our allocation in a hot new issue. I will make‬
‭sure that you receive a significant allocation since the investment matches with your new‬
‭investment profile. You will lose out on this lucrative investment by moving your account‬
‭elsewhere.”‬

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‭ lpine discloses a copy of its firm’s policies regarding IPO allocations to all its clients and‬
A
‭prospects, according to which Alpine allocates IPO securities to portfolio managers. It is the‬
‭responsibility of the portfolio managers to allocate the IPO shares according to the suitability of‬
‭each of their accounts. Alpine also reveals that it offers different levels of service to clients for‬
‭different fees.‬

‭ harma, after careful consideration, decides that the proposed IPO is suitable for seven of her‬
S
‭clients including Jones. But she receives only three-fourth of the shares due to oversubscription.‬
‭She directs half to Jones’ account and divides the remaining half amongst the other six clients,‬
‭because of their account value being less than half of Jones’ account.‬

‭1.‬ I‭s Alpine’s policy of updating the IPS consistent with required and recommended CFA‬
‭Institute Standards?‬

‭ .‬ Y
A ‭ es.‬
‭B.‬ ‭No, update is only when there is a change in investor constraints.‬
‭C.‬ ‭No, update is only when the performance benchmarks are not met.‬

‭2.‬ ‭ oes Sharma violate any CFA Institute Standards by trading for her personal account prior to‬
D
‭her clients’ trades?‬

‭ .‬ Y
A ‭ es, relating to conflicts of interest.‬
‭B.‬ ‭Yes, relating to fair dealing.‬
‭C.‬ ‭No.‬

‭3.‬ ‭When discussing the ABC Pension Fund, does Sharma violate any CFA Institute Standards?‬

‭ .‬ Y
A ‭ es, relating to misrepresentation.‬
‭B.‬ ‭No.‬
‭C.‬ ‭Yes, relating to duties to clients.‬

‭4.‬ ‭ oes Sharma violate any CFA Institute Standards when she places a buy order for shares in‬
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‭the biotechnology firm for two of her clients’ accounts?‬

‭ .‬ Y
A ‭ es, relating to fair dealing.‬
‭B.‬ ‭No.‬

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‭C.‬ ‭Yes, relating to diligence and reasonable basis.‬

‭5.‬ I‭s Alpine’s IPO policy with respect to trade allocations of new shares consistent with the CFA‬
‭Institute Standards?‬

‭ .‬ Y
A ‭ es.‬
‭B.‬ ‭No, because the different fees disadvantage certain clients.‬
‭C.‬ ‭No, because the IPO policy disadvantages certain clients.‬

‭6.‬ ‭ oes Sharma violate any CFA Institute Standards in her allocation of IPO shares to her‬
D
‭clients’ accounts?‬

‭ .‬ N
A ‭ o.‬
‭B.‬ ‭Yes, because she does not treat all her clients fairly.‬
‭C.‬ ‭Yes, because the IPO is not suitable for Jones.‬

‭Questions 7-10 relate to Economics.‬

‭Debra Spalding Case Scenario‬

‭ ebra Spalding, is a portfolio manager for Altvest Wealth Management (AWM), a boutique wealth‬
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‭management firm based in New York, U.S.A. which specializes in developing customized‬
‭investment solutions for high net worth individuals and institutions. She meets with the firm’s‬
‭economist Nathan Vanya, CFA to discuss his outlook for the economies of Australia and China and‬
‭talk about certain issues pertaining to foreign exchange relations and international asset pricing.‬
‭Spalding has no previous exposure in foreign stocks of Australia and China, but is presently‬
‭considering adding them to her portfolio. During the meeting, Vanya presents the following‬
‭comparative information of both countries as shown in Exhibit 1.‬

‭Exhibit 1: Selected Currency Exchange Rates and Market Rates‬

‭‬ ‭‬ ‭‬ ‭ ne Year‬
O ‭ xpected‬
E
‭ ountry‬
C ‭ urrency‬
C ‭ pot Exchange Rate*‬
S ‭Risk-free Rate‬ ‭Annual‬‭Inflation Rate‬

‭U.S.‬ ‭USD‬ ‭N/A‬ ‭1.90%‬ ‭1.60%‬

‭Australia‬ ‭AUD‬ ‭1.3019-1.3140‬ ‭2.50%‬ ‭1.30%‬
‭China‬ ‭CNY‬ ‭6.6303-6.6504‬ ‭4.50%‬ ‭2.60 %‬
‭*Number of foreign currency units per one U.S. dollar‬

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‭ palding and Vanya review some basic relations that are useful in understanding the interplay‬
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‭between exchange rates, interest rates, and inflation. Spalding observes, “According to one of the‬
‭international interest rate parity conditions, the expected change in the spot exchange rate‬
‭between two countries over the investment horizon should on average equal the interest rate‬
‭differential between them.” Vanya adds, “Exchange rates are also interpreted in terms of inflation‬
‭differentials, for instance under a Purchasing Power Parity (PPP) framework, countries that have‬
‭persistent high inflation rates will see their currencies depreciate over time, while countries with‬
‭relatively low inflation rates will find that their currencies appreciate over time.”‬

‭7.‬ ‭ iven a bid-side quote on the three-month forward contract of AUD1.3028 per U.S. dollar, the‬
G
‭three-month forward U.S. dollar is quoted at an annualized:‬

‭ .‬ 0
A ‭ .28% discount.‬
‭B.‬ ‭0.28% premium.‬
‭C.‬ ‭0.36% premium.‬

‭8.‬ ‭ sing Exhibit 1, according to the international Fisher effect, Spalding should most likely‬
U
‭increase holdings in:‬

‭ .‬ A
A ‭ ustralia.‬
‭B.‬ ‭China.‬
‭C.‬ ‭neither countries.‬

‭9.‬ I‭f a dealer’s bid-side quote for the Australian Dollar/Chinese Yuan is AUD 0.2020, Spalding’s‬
‭profit on a USD 1,000,000 initial investment in the triangular arbitrage opportunity is closest‬
‭to:‬

‭ .‬ U
A ‭ SD 12,278.‬
‭B.‬ ‭USD 21,269.‬
‭C.‬ ‭USD 19,270.‬

‭10.‬ ‭The specific parity condition referred to by Spalding is most likely the:‬

‭ .‬ c
A ‭ overed interest rate parity.‬
‭B.‬ ‭ex ante PPP.‬
‭C.‬ ‭uncovered interest rate parity.‬

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‭Questions 11-14 relate to Financial Reporting and Analysis.‬

‭Palladium Corporation Case Scenario‬

‭ alladium Corporation Limited is a clothing and accessories retailer headquartered in‬

P
‭Pennsylvania, U.S.A. Jeremy Dimon, Palladium’s CFO, is reviewing the company’s remuneration‬
‭report which describes the executive compensation plan. Palladium prepares its financial‬
‭statements in accordance with US GAAP and its year ends on December 31.‬

‭The current executive compensation and incentive plan has the following four elements:‬

‭ .‬
1 ‭ ase Salary‬
B
‭2.‬ ‭Performance Shares‬
‭3.‬ ‭Restricted Stock, and‬
‭4.‬ ‭Non-Qualified Stock Options.‬

‭ he purpose of Dimon’s review of the compensation plan is to suggest changes to the incentive‬
T
‭plan in the next board meeting. The current plan requires the forfeiture of Performance Shares if‬
‭the Company does not achieve threshold performance goals by the close of the fiscal year.‬
‭Restricted Stock and Non-Qualified Stock Options are provided if the vesting requirements – a‬
‭service period of 5 years after the grant date, are met and share price appreciates. The‬
‭compensation plan comprises of equity awards to ensure that executive compensation closely‬
‭aligns with performance objectives and executives are held accountable for results.‬

‭Dimon recommends the following proposed changes to the incentive plan:‬

‭1.‬ T ‭ o achieve the proposed financial performance metrics in addition to the existing terms‬
‭before the options can be exercised and restricted stock is issued. The additional metrics‬
‭are: a target annual growth rate in earnings per share (EPS) and positive return on invested‬
‭capital (ROIC).‬
‭2.‬ ‭To introduce cash-settled stock appreciation rights (SARs) as compensation and retention‬
‭of executives. With SARs, the compensation will be determined by a target percentage‬
‭increase in a company’s share price.‬
‭3.‬ ‭Black-Scholes model (BSM) will continue to be used for the valuation of options, but the‬
‭assumptions of the model are to be updated every two years. The following are the current‬
‭and proposed assumptions of BSM:‬

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‭Exhibit 1‬

‭Input Assumptions for the Black-Scholes Model‬

‭Current‬ ‭Proposed‬
‭Risk-free rate‬ ‭3.5%‬ ‭2.5%‬
‭Volatility‬ ‭25%‬ ‭28%‬
‭Expected life of options‬ ‭5 years‬ ‭5 years‬
‭Dividend yield‬ ‭4.8%‬ ‭5.2%‬

‭ imon examines the options and stocks granted this year under the incentive plan. Exhibit 2 lists‬
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‭excerpts from the financial statement.‬

‭Exhibit 2: Excerpts from Note 42 Palladium Corp.‬

‭Stock Options and Restricted Stock Granted for 2016‬

‭Number of Options‬ ‭Weighted Average Exercise Price‬

‭Balance on January 2016‬ ‭4,200,100‬ ‭$14.15‬
‭Options Granted during 2016‬ ‭990,000‬ ‭$14.40‬
‭Exercised during 2016‬ ‭-297,000‬ ‭$14.00‬
‭Forfeited during 2016‬ ‭-148,500‬ ‭$14.08‬
‭Balance on December 2016‬ ‭4,744,600‬ ‭$14.22‬
‭Number of Shares‬
‭Restricted Stock Granted during 2016‬ ‭10,000‬ ‭–‬

‭ ll stock and option grants in 2016 were awarded on July 1, 2016. The market price of the shares‬
A
‭and the fair value of stock options on those dates are shown in Exhibit 3.‬

‭Exhibit 3 Share Prices and Option Values 2016‬

‭Share Price‬ ‭Option Fair Value‬

‭January 1, 2016‬ ‭$13.18‬ ‭$1.71‬
‭July 1, 2016‬ ‭$13.09‬ ‭$1.80‬
‭December 31, 2016‬ ‭$13.90‬ ‭$1.85‬

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‭ imon next inspects the Palladium’s defined benefit pension plan as the pension costs have‬
D
‭increased over the previous year leading to a deficit funding status for 2016. Dimon notes down the‬
‭following changes to the plan in order to curtail pension costs:‬

‭1.‬ E ‭ stimated future salary increases for pension benefits to be reduced by 100 basis points‬
‭from 2016, because of a significant decrease in expected inflation from previous years.‬
‭2.‬ ‭A positive expected rate of return on plan assets to be sought after changing the‬
‭investment mix while staying within the allowable risk tolerance range.‬

‭ o review the accounting policies used for pension expense calculation, and evaluate the plan’s‬
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‭performance, Dimon considers the following information and realizes that though current service‬
‭costs decreased from $72 million from the previous year, the plan’s funding position did not‬
‭improve. Further Palladium recognizes actuarial gains and losses in Other Comprehensive Income‬
‭(OCI) and uses the corridor approach to subsequently amortize to P&L.‬

‭Exhibit 4 Palladium Corp. Pension Plan Information‬

‭Values in $ Millions December 31‬

‭2016‬
‭Employer Contributions‬ ‭90.00‬
‭Current service cost‬ ‭60.00‬
‭Past service cost‬ ‭30.00‬
‭Benefit obligation at the beginning of year‬ ‭3,350.00‬
‭Benefit obligation at end of year‬ ‭3,920.00‬
‭Actuarial loss‬ ‭340.00‬
‭Plan assets at beginning of year‬ ‭3,740.00‬
‭Plan assets at end of year‬ ‭3,694.20‬
‭Actual return on plan assets‬ ‭-2.00%‬
‭Expected rate of return on plan assets‬ ‭7.00%‬
‭Discount rate used to estimate plan liabilities‬ ‭6.00%‬

‭11.‬ R
‭ egarding Dimon’s proposed changes to the incentive plan, which of the following‬
‭statements is‬‭most accurate‬‭?‬

‭A.‬ ‭By introducing SARs, the downside risk becomes unlimited.‬

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‭B.‬ T ‭ he proposed performance metrics can increase the chances of financial information‬
‭manipulation by management.‬
‭C.‬ ‭The option pricing model is not required to determine the compensation expense.‬

‭12.‬ B
‭ ased on Exhibit 1, which change in assumptions will most likely result in an increase in‬
‭compensation expense?‬

‭ .‬ T
A ‭ he change in the risk-free rate.‬
‭B.‬ ‭The change in volatility.‬
‭C.‬ ‭The change in dividend yield.‬

‭13.‬ T
‭ he portion of the compensation expense related to the stock option component awarded in‬
‭2016 is‬‭closest‬‭to:‬

‭ .‬ U
A ‭ SD 317,200.‬
‭B.‬ ‭USD 487,300.‬
‭C.‬ ‭USD 178,200.‬

‭14.‬ T
‭ he poor investment performance most likely caused the periodic pension cost (in‬
‭$-millions) reported in the 2016 income statement (assuming no amortization of past service‬
‭costs or actuarial losses) to be:‬

‭ .‬ u
A ‭ naffected.‬
‭B.‬ ‭higher by $74.80 million.‬
‭C.‬ ‭higher by $340 million.‬

‭Questions 15-18 relate to Corporate Issuers.‬

‭Essential Woodworks Case Scenario‬

‭ ssential Woodworks (“Essential”) and Modern Furniture (“Modern”) are negotiating a friendly‬
E
‭acquisition of Essential by Modern. Both companies are part of the same supply chain in the‬
‭furniture industry, where Essential is Modern’s main supplier. Mark Rogers works for Essential’s‬
‭investment banking team and is evaluating Modern’s current offer: $7 plus 0.50 shares of Modern‬
‭stock per share of Essential stock. Rogers estimates that the two companies will result in‬

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‭ conomies of scale with a net present value of $120 million. He uses the information in Exhibit 1 to‬
e
‭calculate the takeover premium.‬

‭Exhibit 1‬

‭Essential‬ ‭Modern‬
‭Pre-merger stock price‬ ‭12‬ ‭16‬
‭Number of shares outstanding (millions)‬ ‭20‬ ‭60‬
‭Pre-merger market value (millions)‬ ‭240‬ ‭960‬
‭‬

I‭n a meeting, Rogers updates his supervisor on his research and mentions that Essential’s‬
‭management approached Modern regarding the acquisition after one of Modern’s competitors‬
‭attempted a hostile takeover of Essential.‬

‭15.‬ B
‭ ased on the type of acquisition between Essential and Modern, which of the following‬
‭stages of the industry life cycle is the furniture industry least likely in?‬

‭ .‬ G
A ‭ rowth.‬
‭B.‬ ‭Shakeout.‬
‭C.‬ ‭Decline.‬

‭16.‬ G
‭ iven Exhibit 1 and the information given in the case, the takeover premium if Essential‬
‭accepts Modern’s offer is closest to:‬

‭ .‬ 6
A ‭ 8.50.‬
‭B.‬ ‭190.00.‬
‭C.‬ ‭308.50.‬

‭17.‬ I‭f Modern proposed an all-cash offer of $15 per share of Essential stock, compared to the‬
‭mixed offer, the post-merger value with this cash offer would most likely be:‬

‭ .‬ h
A ‭ igher.‬
‭B.‬ ‭the same.‬
‭C.‬ ‭lower.‬

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‭18.‬ T
‭ he situation Rogers describes to his supervisor is most likely an example of which of the‬
‭following post-offer takeover defence mechanisms?‬

‭ .‬ P
A ‭ ac-man defence‬
‭B.‬ ‭White knight defence‬
‭C.‬ ‭White squire defence‬

‭Questions 19-22 relate to Quantitative Methods.‬

‭Sunil Manan Case Scenario‬

‭ unil Manan, research director at a hedge fund, is reviewing the regression results involving‬
S
‭monthly return of UVS Telecom against the monthly return of NASDAQ and the difference between‬
‭the monthly returns on long-term treasury notes and short-term borrowing rate set by the Federal‬
‭Reserve (YS). The multiple regression model uses data of previous 203 months. Manan tests for‬
‭and confirms the presence of conditional heteroskedasticity. He then runs a similar regression but‬
‭it is corrected for conditional heteroskedasticity by using robust standard errors. Table 4 gives the‬
‭results:‬

‭Table 4: Regression model summary output: UVS Telecom‬

‭Variable‬ ‭Coefficient‬ ‭t‭-‬ statistic‬ ‭p‬‭-value‬

‭Constant‬ ‭-0.0085‬ ‭-0.0120‬ ‭0.99‬

‭NASDAQ‬ ‭0.4465‬ ‭6.150‬ ‭< 0.01‬

‭YC‬ ‭1.2504‬ ‭4.530‬ ‭< 0.01‬

‭ anan wants to test the null hypothesis that the coefficient on YC is equal to 1 against the‬
M
‭alternative hypothesis that it is not equal to 1. He also wants to determine whether the model has‬
‭serial correlation. He uses the t-distribution values given below in Table 5.‬

‭Table 5‬

‭DF‬ ‭p ‭=
‬ 0.05‬ ‭p ‭=
‬ 0.025‬

‭120‬ ‭1.658‬ ‭1.980‬

‭200‬ ‭1.653‬ ‭1.972‬

‭Infinity‬ ‭1.645‬ ‭1.960‬

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‭19.‬ R
‭ egarding conditional heteroskedasticity, the most appropriate conclusion is that the‬
‭variance of the error term is correlated with:‬

‭ .‬ b
A ‭ oth the dependent and the independent variables.‬
‭B.‬ ‭the dependent variable only.‬
‭C.‬ ‭the independent variable only.‬

‭20.‬ I‭f Manan assumes that the monthly yield spread is 1.35% and the monthly value of NASDAQ‬
‭is -1.05%, the predicted monthly return of UVS Telecom is‬‭closest‬‭to:‬

‭ .‬ 0
A ‭ .37%.‬
‭B.‬ ‭0.25%.‬
‭C.‬ ‭0.63%.‬

‭21.‬ T
‭ he value of the test statistic relating to Manan’s null hypothesis that the value of the‬
‭coefficient on YC is equal to 1 is‬‭closest‬‭to:‬

‭ .‬ 0
A ‭ .67.‬
‭B.‬ ‭0.91.‬
‭C.‬ ‭4.53.‬

‭22.‬ I‭f the standard error of the coefficient is 0.070 and the degrees of freedom is 200, the 95%‬
‭confidence interval for the coefficient on the NASDAQ is‬‭closest‬‭to:​‬

‭ .‬ 0
A ‭ .31 to 0.58.‬
‭B.‬ ‭-0.20 to 0.07.‬
‭C.‬ ‭0.04 to 0.31.‬

‭Questions 23-26 relate to Alternative Investments.‬

‭Delver Investment Management Case Scenario‬

‭ elver Investment Management, Inc., is a private equity firm that focuses on buyouts of publicly‬
D
‭traded companies and structures itself as a general partner in these deals. Carrie Roberts, a senior‬
‭analyst, has been asked by the chief investment officer to assist the marketing department in‬

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‭ eveloping marketing material and leaflets for soliciting institutional investments. Roberts‬
d
‭discusses the basic attributes of buyout investments with the marketing manager which would be‬
‭included in the promotional material:‬

‭Attribute 1‬‭: The target firms have steady and predictable‬‭cash flows.‬

‭Attribute 2‬‭: The target firms have significant asset‬‭base and established products.‬

‭ ttribute 3‬‭: The cash burn rate could be significant‬‭to ensure the viability of the‬
A
‭restructured company.‬

I‭t is decided that the leaflet should also list how Delver aligns its interests with those of the‬
‭managers of the companies it controls.‬

‭ urther, Roberts suggests that an example of a typical acquisition should be given to serve as an‬
F
‭illustration. The example involves Delver’s purchase of Skiffy, Inc. for $400 million. After the‬
‭acquisition, Skiffy’s new capital structure consists of USD200 million in debt, USD180 million in‬
‭preference shares, and USD20 million in common equity. Delver sells Skiffy after five years to a‬
‭strategic investor for USD710 million.‬

‭23.‬ ‭Which of the attributes of buyout investments is‬‭least‬‭likely‬‭correct?‬

‭ .‬ A
A ‭ ttribute 1.‬
‭B.‬ ‭Attribute 2.‬
‭C.‬ ‭Attribute 3.‬

‭24.‬ W
‭ hich of these clauses is most likely to be added in the leaflet that shows alignment of‬
‭Delver’s interests with the managers of the portfolio companies?‬

‭ .‬ E
A ‭ arn-outs.‬
‭B.‬ ‭Tag-along, drag-along rights.‬
‭C.‬ ‭Reserved matters.‬

‭25.‬ W
‭ hen Skiffy, Inc. is sold the part of its capital structure that will‬‭most likely‬‭have decreased in‬
‭size is?‬

‭ .‬ P
A ‭ reference shares.‬
‭B.‬ ‭Common equity.‬

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‭C.‬ ‭Debt.‬

‭26.‬ C
‭ ompared to the exit route chosen, the least likely alternate exit route for Skiffy, Inc‬
‭investment is a(n):‬

‭ .‬ I‭PO.‬
A
‭B.‬ ‭Private equity firm.‬
‭C.‬ ‭Liquidation.‬

‭Questions 27-30 relate to Equity Investments.‬

‭Ginny Lyon Case Scenario‬

‭ inny Lyon is the director of research at Remy Capital which specializes in identifying overvalued‬
G
‭and undervalued securities. Lyon makes the following comments to the newly hired analysts:‬

‭ omment 1‬‭: “An active manager attempts to achieve‬‭positive excess risk-adjusted return.‬
C
‭But to detect mispricing is not easy; hence, it is important to understand the possible‬
‭sources of perceived mispricing.”‬

‭ omment 2‬‭: “Remy Capital invests in distressed securities‬‭representing companies in‬

C
‭financial distress. The valuation process involves identifying the investment and resale‬
‭value, in short,the liquidation value of such companies.”‬

‭ omment 3‬‭: “An analyst at Remy Capital is required‬‭to evaluate the reasonableness of the‬
C
‭expectations implied by the security’s market price by comparing the market’s implied‬
‭expectations with his own outlook.”‬

‭27.‬ ‭With respect to Comment 1, perceived mispricing is‬‭most likely‬‭the difference between:‬

‭ .‬ ‭estimated intrinsic value and market price.‬

A
‭B.‬ ‭intrinsic value and estimated value.‬
‭C.‬ ‭intrinsic value and market price.‬

‭28.‬ ‭The sources of perceived mispricing are most likely:‬

‭ .‬ t‭ rue mispricing or alpha and the error in the intrinsic value estimate.‬
A
‭B.‬ ‭true, unobservable intrinsic value and the error estimate.‬

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‭C.‬ ‭valuation estimate less the unobservable intrinsic value, and going-concern value.‬

‭29.‬ ‭With respect to Comment 2, which of the following statements is least likely correct?‬

‭ .‬ F
A ‭ or most companies, the going-concern value is greater than the liquidation value.‬
‭B.‬ ‭The value of nonperishable inventory if liquidated immediately is higher rather than its‬
‭value if it were to be sold over a longer time.‬
‭C.‬ ‭An analyst will typically forecast free cash flow of a financially sound company rather‬
‭than estimating its liquidation value.‬

‭30.‬ ‭According to Comment 3, analysts at Remy Capital use valuation techniques to:‬

‭ .‬ i‭nfer market expectations.‬

A
‭B.‬ ‭provide fairness opinions.‬
‭C.‬ ‭to value acquisitions.‬

‭Questions 31-34 relate to Portfolio Management.‬

‭Brie Lars Case Scenario‬

‭ rie Lars is a portfolio manager for Mega Inc., an appliance manufacturer. At the quarterly meeting‬
B
‭with the client, Brie explains that she uses multifactor models as a guide to asset allocation. In‬
‭particular she uses the arbitrage pricing theory (APT) to model asset return. She describes the‬
‭three main assumptions of the APT model:‬

‭Assumption 1‬‭: A factor model can be used to explain‬‭asset returns.‬

‭Assumption 2‬‭: No arbitrage opportunities are possible‬‭in a well-diversified portfolio.‬

‭ ssumption 3‬‭: Adding assets to a diversified portfolio,‬‭adds to factor risk and to its specific‬
A
‭risk.‬

‭ he explains that she evaluates different funds in the market and seeks to exploit arbitrage‬
S
‭opportunities among them. She presents an example of different portfolios using a one-factor‬
‭model that explains returns. The data is presented below:‬

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‭Exhibit 1: Portfolio information for a one-factor model‬

‭Portfolio‬ ‭Expected return‬ ‭Factor sensitivity‬

‭A‬ ‭15.0%‬ ‭0.8‬
‭B‬ ‭16.0%‬ ‭1.0‬
‭C‬ ‭19.0%‬ ‭1.2‬

‭31.‬ ‭Which of Brie’s assumptions underlying APT is‬‭least‬‭likely‬‭correct?‬

‭ .‬ A
A ‭ ssumption 1.‬
‭B.‬ ‭Assumption 2.‬
‭C.‬ ‭Assumption 3.‬

‭32.‬ B
‭ ased on Exhibit 1, can an arbitrage portfolio be created with a combination of portfolios A, B‬
‭and C?‬

‭ .‬ N
A ‭ o.‬
‭B.‬ ‭Yes, the portfolio would earn an expected return of 1.0%.‬
‭C.‬ ‭Yes, the portfolio would earn an expected return of 17.0%.‬

‭33.‬ A
‭ ssuming that portfolio A and B’s returns are represented by a single-factor equation of‬
‭E(Rp) = RF + λ1βp, the value of λ1 is‬‭closest‬‭to:‬

‭ .‬ 0
A ‭ .05.‬
‭B.‬ ‭0.025.‬
‭C.‬ ‭0.010.‬

‭34.‬ ‭Based on its factor sensitivity, portfolio B can be best characterized as:‬

‭ .‬ a
A ‭ n arbitrage portfolio.‬
‭B.‬ ‭a market-neutral portfolio.‬
‭C.‬ ‭a pure factor portfolio.‬

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‭Questions 35-40 relate to Fixed Income.‬

‭Giyani Investment Advisers Case Scenario‬

‭ iyani Investment Advisers is a wealth management firm looking to increase its exposure in‬
G
‭fixed-income securities. Jai Aakash, the chief investment officer of the firm, would like to add‬
‭bonds with embedded options to the firm’s bond portfolio. Aakash decides to ask Rekha Datta, the‬
‭firm’s senior analyst, to select and analyze bonds for possible inclusion in the firm’s bond portfolio.‬

‭ atta first identifies two corporate bonds that are callable at par with similar maturity, credit quality‬
D
‭and call dates. To account for risk, Datta uses the option adjusted spread (OAS) approach for the‬
‭bonds, assuming an interest rate volatility of 20%. Results from Datta’s analysis are summarized in‬
‭Table 1.‬

‭Table 1. Summary Results of Rekha’s Analysis Using the OAS Approach‬

‭Bond‬ ‭OAS (in bps)‬

‭Bond A‬ ‭45.50‬
‭Bond B‬ ‭50.50‬

‭ ext Datta examines four bonds issued by Indigo Motors given in Table 2. These bonds mature in‬
N
‭four years and have the same credit rating. Bond D and Bond E though identical to Bond C, an‬
‭option-free bond, include an embedded option.‬

‭Table 2. Bonds Issued by Indigo Motors‬

‭Bond‬ ‭Coupon‬ ‭Special Provision‬

‭Bond C‬ ‭6.00% annual‬
‭Bond D‬ ‭6.00% annual‬ ‭Putable at par at the end of years 2 and 3‬
‭Bond E‬ ‭6.00% annual‬ ‭Callable at par at the end of years 2 and 3‬
‭Bond F‬ ‭Six-month Libor Semi-annually, set in arrears‬

‭ akash also wants Datta to determine the sensitivity of Bond C’s price to a 30 bps parallel shift of‬
A
‭the benchmark yield curve. The results of Datta’s calculations are shown in Table 3.‬

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‭Table 3. Summary Results of Rekha’s Analysis about the Sensitivity of Bond C’s Price to a Parallel‬
‭Shift of the Benchmark Yield Curve‬

‭Magnitude of the Parallel Shift in the Benchmark Yield Curve‬ ‭0 bps‬ ‭+30 bps‬ ‭–30 bps‬
‭Full Price of Bond C‬ ‭1005.5‬ ‭1004.5‬ ‭1006.5‬

‭ inally, Datta selects the two bonds issued by Galaxy International, given in Table 4. These bonds‬
F
‭are close to their maturity date and are identical, except that Bond G includes a conversion option.‬
‭Galaxy’s common stock is currently trading at USD135 per share.‬

‭Table 4. Bonds Issued by Galaxy International‬

‭Bond‬ ‭Type of Bond‬

‭Bond G‬ ‭Convertible bond with a conversion price of USD165‬
‭Bond H‬ ‭Identical to Bond G except that it does not include a conversion option‬

‭35.‬ ‭Based on Table 1, Bond A relative to Bond B, is‬‭most‬‭likely‬‭:‬

‭ .‬ o
A ‭ verpriced.‬
‭B.‬ ‭fairly priced.‬
‭C.‬ ‭underpriced.‬

‭36.‬ ‭The effective duration of Bond F is:‬

‭ .‬ ‭lower than or equal to 1.0‬

A
‭B.‬ ‭lower than or equal to 4.0‬
‭C.‬ ‭lower than or equal to 0.5‬

‭37.‬ ‭In Table 2, the bond whose effective duration will shorten if interest rates rise is:‬

‭ .‬ B
A ‭ ond C‬
‭B.‬ ‭Bond D‬
‭C.‬ ‭Bond E‬

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‭38.‬ ‭The effective duration of Bond C is‬‭closest‬‭to:‬

‭ .‬ 3
A ‭ 3.15‬
‭B.‬ ‭3.315‬
‭C.‬ ‭0.3315‬

‭39.‬ ‭The value of Bond G is equal to the value of Bond H:‬

‭ .‬ p
A ‭ lus the value of a call option on Galaxy’s bond.‬
‭B.‬ ‭plus the value of a call option on Galaxy’s common stock.‬
‭C.‬ ‭minus the value of a call option on Galaxy’s common stock.‬

‭40.‬ ‭The minimum value of Bond G is equal to the:‬

‭ .‬ l‭esser of the conversion value of Bond G and the current value of Bond H.‬
A
‭B.‬ ‭greater of the conversion value of Bond G and the current value of Bond H.‬
‭C.‬ ‭greater of the current value of Bond H and a call option on Galaxy’s common stock.‬

‭Questions 41-44 relate to Derivatives.‬

‭Magna Corp. Case Scenario‬

‭ agna Corp. plans to take out a three-month loan of USD1,000,000 in three months’ time to meet‬
M
‭its working capital needs. The company’s CFO, Adam Sand CFA, was concerned about an increase‬
‭in interest rates during that time. Therefore, he had entered into a pay-fixed forward rate agreement‬
‭three months ago with a notional principal of USD1,000,000. The LIBOR rate summary is presented‬
‭below:‬

‭Rate three months ago‬ ‭Current rate‬

‭1 month LIBOR‬ ‭1.00%‬ ‭1.20%‬
‭3 month LIBOR‬ ‭1.05%‬ ‭1.30%‬
‭6 month LIBOR‬ ‭1.10%‬ ‭1.35%‬
‭9 month LIBOR‬ ‭ 1.15%‬ ‭1.35%‬

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‭Adam would like to evaluate the company’s current position on the FRA.‬

‭41.‬ ‭The forward rate at which the company had initiated its FRA is‬‭closest‬‭to:‬

‭ .‬ 1
A ‭ .19 %‬
‭B.‬ ‭1.24%‬
‭C.‬ ‭1.31%‬

‭42.‬ ‭The forward rate at which the company had initiated its FRA is‬‭closest‬‭to:‬

‭ .‬ t‭ he 3 month LIBOR 3 months from now‬

A
‭B.‬ ‭the 3 month LIBOR 6 months from now‬
‭C.‬ ‭the forward rate‬

‭43.‬ T
‭ he current forward rate for a notional loan beginning in three months with three months to‬
‭maturity is‬‭closest‬‭to:‬

‭ .‬ 1
A ‭ .4 %‬
‭B.‬ ‭1.15 %‬
‭C.‬ ‭1.35 %‬

‭44.‬ ‭The current value of the company’s position on the FRA is‬‭closest‬‭to:‬

‭ .‬ U
A ‭ SD 400‬
‭B.‬ ‭USD 405‬
‭C.‬ ‭USD 397‬

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