FinQuiz Level2Mock2016Version6JunePMSolutions

CFA Level II Mock Exam 6 Solutions (PM)
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CFA Level II Mock Exam 6
June, 2016
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FinQuiz.com 6th Mock Exam 2016 (PM Session)
Questions Topic Minutes

1-6 Ethical and Professional Standards 18
7-12 Corporate Finance 18
13-24 Financial Reporting and Analysis 36
25-30 Equity Investments 18
31-42 Fixed Income 36
43-48 Derivatives 18
49-54 Alternative Investments 18
55-60 Portfolio Management 18
Total 180

Questions 1 through 6 relate to Ethical and Professional Standards
Lucid Advisory (LA) Case Scenario

Lucid Advisory (LA) is an investment firm providing investment banking and brokerage
services. In the current year, LA established an in-house research department. In addition, LA
recently adopted the CFA Institute Research Objectivity Standards (ROS) and is now developing
policies and procedures to better comply with the standards.
In a report to LAs existing clients and prospects, senior research analyst, Carl Nuvez, explains
why the CFA Institute-ROS were adopted and lists down three objectives the firm intends to
achieve by adhering to the standards:
Objective 1: To design investment processes in a manner such that client interests are placed
above the interests of the firm and its employees.
Objective 2: Require covered employees to undertake trading activities which align their
interests with those of their clients.
Objective 3: To provide general disclosures of actual and potential conflicts of interests which
are easy to follow and understand.
Three months ago, LAs investment banking department participated in the market making of
Edge Corps stock earning a fee of $100,000. The activity was headed by Janet Morris, LAs
senior investment banker and the firms compliance officer had taken stringent measures to
avoid all cross department conflicts by barring research analysts from participating.
Three months later, Nurez assigns Samantha Dale to cover the stock of Edge Corp. Given LAs
past relationship with Edge Corp, Nurez restricts Dale from participating in conference calls
where Edge Corp management is present as well as restricts communication with company
personnel to emails. He believes such an action will prevent potential conflicts of interests.
After a detailed evaluation of Edge Corp, Dale rates the stock as a hold based on an uncertainty
of the companys future direction. She issues the report with the recommendation on June 1.
On June 2, Edge Corps management publically announces its intention to take the company
global starting with Paris, France where a building has been acquired for production purposes.
On the same day Dale revises the recommendation to buy and issues a detailed
recommendation to clients and prospects. On June 4th, she seeks approval from LAs compliance
department and purchases Edge Corp shares for her investment portfolio.

After leaving Dale to cover Edge Corp, Nurez drafts policies which aim to address the
responsibilities required by LAs research analysts and other covered employees with respect to
the CFA Institute-ROS. He mandates employees to attest annually, either in writing or orally,
their adherence to the Policy. In addition the drafted policies require employees to update any
issued recommendations every thirty calendar days.
1. Which of the following explanations will Nurez most likely provide for implementing the
CFA-Institute ROS? To:
A. fulfill a legal requirement.

B. provide an appropriate working environment for their investment professionals.
C. implement standards which are more superior in quality relative to the CFA
Institute Code and Standards.
Correct Answer: B
Reference:
CFA Level II, Volume 1, Study Session 1, Reading 3, LOS a
One of the motives of implementing the CFA Institute-ROS is to provide an appropriate

working environment for a firms investment professionals - one that promotes ethical
behavior and facilitates compliance with the CFA Institute Code and Standards.
A is incorrect. Investment firms are not legally obliged to comply with standards. The
CFA Institute encourages firms to adopt the CFA Institute-ROS.
C is incorrect. The CFA Institute-ROS are designed to complement, not replace the CFA
Institute Code and Standards. Therefore, it is incorrect to assume that the former set of
standards is more superior in quality.
2. Which of the following most likely represents an objective of the CFA Institute-ROS?
A. Objective 1
B. Objective 2
C. Objective 3
Correct Answer: A

Reference:
Objective 1 represents a valid objective of the CFA Institute-ROS. Firms are encouraged
to develop policies and procedures which aim to prepare research reports, make
investment recommendations, and take investment actions; and develop policies,
procedures and disclosures that always place the interests of investing clients before their
employees or firms interests.
Objective 2 does not represent an objective of the CFA Institute-ROS.
Objective 3 incorrectly represents an objective of the CFA Institute-ROS. Policies and

procedures should aim to facilitate full, fair, meaningful, and specific disclosures of
potential and actual conflicts of interest of the firm or its employees to its actual and
prospective clients.
3. In restricting Dales ability to communicate with Edge Corps management, has Nurez
violated any CFA Institute-ROS?
A. No.
B. Yes, to the extent of participation in conference calls only.
C. Yes, to the extent of participation in conference calls and mode of
communication.
Correct Answer: C
Reference:
CFA Level II, Volume 1, Study Session 1, Reading 3, LOS b
In order to conduct quality research and develop a reasonable and adequate basis,
research analysts need the ability to communicate with the subject company management.
Therefore restricting Dales ability to participate fully in conference calls and limiting the
mode of communication, Nurez is in violation of the CFA Institute-ROS.

4. Is Dale required to disclose LAs market making of the Edge Corp stock in her research
report?
A. Yes.
B. No, because she is not involved.
C. No, because she issues the report three months later.
Correct Answer: A
Reference:
Given that Dale is covering a company which has been subject to a market making
activity she is required to make a disclosure of LAs relationship with Edge Corp in her
report. This disclosure is required to be made regardless of the fact that this activity was
carried out in the past.
5. By purchasing Edge Corps stock for her investment portfolio, has Dale violated the CFA
Institute-ROS?
A. No.
B. Yes, she is front running client trades.
C. Yes, she has engaged in a personal trade.
Correct Answer: A
Reference:

Dale is not violating the CFA Institute-ROS when purchasing Edge Corps share for her
investment portfolio. This is because an exception to the recommended five-day
restricted trading period can be made in response to the announcement of the expansion
plan by the company. In addition, clients are informed about the announcement and
change in recommendation as well as given an adequate time to trade.
The CFA Institute-ROS requires firms to implement policies and procedures that
adequately prevent front running of client trades. Establishing restricted periods of thirty
calendar days before and five calendar days after issuing the research report are
recommended. However, exceptions are permitted on the announcement of significant
news or events by the subject company if investing clients are given the adequate notice
and the ability to trade. Dale has not attempted to front-run client trades.
C is incorrect. Given that Dale has pre-cleared her investment by seeking prior approval
from LAs compliance department she is not in violation of these standards in this
respect.
6. Are Nurezs drafted policies with respect to the attestation of adherence and issuing
updates concerning research reports consistent with the requirements and
recommendations of the CFA Institute-ROS?
Attestation of Issuing
Adherence? Updates?
A. No No
B. Yes No
C. No Yes
Correct Answer: A
Reference:

Both of Nurezs drafted policies fail to comply with the requirements and
recommendations of the CFA Institute-ROS.
Covered employees are required to attest annually in writing their understanding of and
adherence to the Policy. The standards do not make any reference to oral attestation.
Firms are recommended to issue reports and recommendations at least quarterly, with
additional updates when there is an announcement of significant news or events by, or
that might impact, the subject company. The standards do not provide a specific timeline
with respect to issuing updates.

Questions 7 through 12 relate to Corporate Finance
Legume Inc. Case Scenario

Legume Inc. is a grower and wholesaler of grains, lentils and rice. Ralph Gonzales, the CEO,
along with Marion Boyce and Frank Icke, two senior executives, are meeting to discuss
corporate policy reforms. The individuals present three recommendations during the meeting.
Recommendation 1: At present 30% of our employees are providing external field assistance to
self-employed farmers several of whom are our direct competitors. Legume must discourage this
practice by obliging employees to sign a noncompete agreement.
Recommendation 2: Legumes capital budgeting department has a tendency to pitch project

ideas with heavy budgets and average expected returns on capital. To minimize the unnecessary
wastage of internally generated funds, project managers should be permitted to solely utilize
financial leverage as a source of project funding. By engaging in loan agreements with rigid
covenants, managers will have less freedom to unwisely spend cash.
Recommendation 3: The proposed enactment of the Safe Food Act will bring drastic changes to
conventional farming practices. Under the act farmers will be required to monitor their usage of
pesticides and eventually convert to organic farming techniques. Legume is expected to
experience a significant increase in operating costs and reduced profitability for the foreseeable
future as farmers adapt to the act. A policy is required to address the risks faced by the company.
Also on the board agenda is the proposed acquisition of Miller Grains, a grower and wholesaler
of grains. The boards main incentives behind the transaction are to increase market presence and
achieve economies of scale. Icke is concerned that the transaction may pose an anti-trust
challenge and collects market share data on all competitors in the grains industry for the purpose
of analysis (Exhibit 1).
The board concludes their meeting by analyzing Uta, a potential target for a friendly merger with
Legume. The board is debating on which payment method should be recommended to the
management of Uta. Details concerning the potential offers and Legumes and Utas pre-merger
details have been collected by the board (Exhibits 2 and 3).
Based on the data presented in Exhibits 2 and 3, the directors conclude:
The price paid for the targets shares is lower in Offer 2 and so this method should be
recommended to Utas management.

The board employs the data in the exhibits to calculate the gains Legumes shareholders should
expect from the proposed merger.
Exhibit 1:
Grains Wholesale & Grower Industry Market Share Data
Legume Miller Grains Uta AS Limited Ilium Corp

Market Share (%) 40 10 10 15 25
Exhibit 2:
Proposed Merger Offer Transaction Details
Offer 1 Offer 2
Mode of payment Cash Stock
Exchange ratio N/A 0.5:1
Cost of acquisition (millions) $960 $840
Present value of expected synergies (millions) $180 $180
Exhibit 3:
Pre-merger Financial Data
Legume Uta
Pre-merger stock price $18.00 $12.00
Number of shares outstanding (millions) 90 60
7. The implementation of Recommendation 1 will lead to an increase in:
A. residual costs.
B. bonding costs.
C. monitoring costs.
Correct Answer: B
Reference:

Bonding costs are costs incurred by managers to ensure shareholders that they are
working in their best interests. The cost of the proposed non-compete agreements is an
example of this agency cost.
A is incorrect. Residual costs are those incurred even when there is sufficient monitoring
and bonding because the latter two mechanisms are imperfect. There is no evidence to
indicate that the proposed bonding mechanism in the recommendation will be imperfect.
C is incorrect. Monitoring costs are incurred by owners to monitor the management of the
company and include expenses in generating the annual report, board of director
expenses and the cost of the annual meeting. The cost of non-compete agreements does
not fit within this agency costs category.
8. Recommendation 2 most likely reflects the:
A. pecking order theory.

B. free cash flow hypothesis.
C. Modigliani and Millers Proposition II.
Correct Answer: B
Reference:
Recommendation 2 reflects the free cash flow hypothesis which asserts that the more
financially leveraged a company is the less freedom managers have to take on more debt
or unwisely spend cash. Because project managers are wasting internally generated funds
on suboptimal projects, the implementation of the proposed recommendation will
discipline managers by forcing them to make informed choices when evaluating projects
for investment. Managers will be required to make interest and principal payments which
will reduce the companys free cash flow and opportunities to waste cash.
A is incorrect. The pecking order theory describes a hierarchy based on which managers
choose financing sources. The recommendation does not attempt to propose that project
managers rely on a financing hierarchy.
C is incorrect. The MM propositions are concerned with the impact of the choice of
capital structure on company value. Recommendation 2 does not address the impact of
project managers financing choices on Legumes capital structure.

9. The policy being proposed in Recommendation 3 will aim to reduce:
A. legal risk.
B. strategic policy risk.
C. legislative and regulatory risk.
Correct Answer: C
Reference:
CFA Level II, Volume 3, Study Session 9, Reading 27, LOS g
Legislative and regulatory risk is the risk that governmental laws and regulations that
directly or indirectly affect a companys operations will change and have the potential to
severely affect the companys continued profitability and even its long-term
sustainability. The enactment of the Safe Food Act will affect the companys operations
and have an adverse effect on the companys continued profitability.
A is incorrect. Legal risk arises due to the failure of managers to adequately manage ESG
factors which will lead to lawsuits and other judicial actions. Legume has not
demonstrated an inadequate management of ESG factors.
B is incorrect. Strategic policy risk is the risk that managers will enter into transactions or
incur other business risks that may not be in the best long-term interests of shareholders.
This risk is not applicable to the recommendation.
10. Based on the data presented in Exhibit 1, the proposed acquisition of Grains Miller will
most likely:
A. not pose an anti-trust challenge.

B. pose a definite anti-trust challenge as the HHI increases by more than 50 points.
C. pose a possible anti-trust challenge as the HHI increases by more than 100 points.
Correct Answer: B
Reference:

To determine whether the merger will evoke anti-trust challenges, the pre-merger HHI is
compared to the post-merger HHI.
Pre-merger HHI = (40)2+ (10)2 + (10)2 + (15)2 + (25)2 = 2,650
Post-merger HHI = (40 + 10)2 + (10)2 + (15)2 + (25)2 = 3,450
The pre-merger HHI is more than 1,800 points indicating that the industry is highly
concentrated. In addition, the change in HHI following the merger transaction is greater
than 50 (3,450 2,650 = 800) and so the merger will evoke a definite challenge by the
government.
11. Are the directors correct with respect to their conclusion derived regarding the
recommended mode of payment for the proposed merger?
A. Yes.
B. No, offer 1 should be the recommended method.
C. No, offer 2 should be recommended as it generates higher gains for Legumes
shareholders.
Correct Answer: B
Reference:
CFA Level II, Volume 3, Study Session 9, Reading 28, LOS k
Legume should recommend the mode of payment which generates the greatest gains for
Utas shareholders. Gains to the targets shareholders are measured in terms of premium
generated from the transaction.
Cash offer:
Target shareholders gain = Premium= PT VT = $960 million ($12.00 60) = $240
million
Stock offer:
Premium = PT VT = $840 million ($12.00 60) = $120 million
Given that the premium is the greatest in the cash offer (Offer 1), this is the mode of
payment which Legumes shareholders should recommend to Utas management.

12. Using the data in Exhibits 1 and 2, the stock offer will generate a gain for Legumes
shareholders equal to:
A. $60 million.
B. $120 million.
C. $1,800 million.
Correct Answer: A
Reference:
CFA Level II, Volume 3, Study Session 9, Reading 28, LOS k
Acquirers gains = S (PT VT) = $180 million [$840 million ($12.00 60 million)
= $60 million.

Questions 13 through 18 relate Financial Reporting and Analysis
Widget Inc. Case Scenario

Widget Inc. is a manufacturer of clocks and other timing apparatus operating in the U.S. The
manufacturer operates with two entities in its structure; SC Publishers (SCP), a publishing firm
situated in France and Widget-Mount, a special purpose vehicle. Widget Inc. has a 25% equity
stake in SCP giving it significant influence over the investees business activities.
Louis begins her analysis by evaluating SCPs financial statements. She tasks her subordinate
with collecting and translating selective financial statement information concerning the investee
for the fiscal years 2013 and 2014 (Exhibit 1).
Louis is concerned that the Widget Inc.s net profit margin growth is not organic and that the
main driver behind the growth is SCPs operating results. To determine if her suspicions hold
true, she calculates Widgets net profit margin growth excluding the income from the investee.
Louis then proceeds to conduct DuPont analysis to evaluate the sources behind the 31.14%
growth in return-on-equity (ROE). She has determined that there is one factor which has failed to
contribute to this growth. For the analysis, she will be evaluating Widget Inc. as a whole.
Louis would like to isolate Widget Inc.s market capitalization from that of the total company.
She recognizes that this is important in understanding the factors which influence share price as
the factors influencing stock valuation differ considerably from one stock exchange to the next.
She collects the necessary data to perform the calculations (Exhibit 2).
On January 15, 2014 Widget Inc. had sold $30 million worth of receivables to Widget-Mount.
Widget Inc had inappropriately treated the transaction as a sale on its balance when, in reality, it
was a securitization transaction.
Louis concludes her analysis by analyzing the reasons for the declining trend in SCPs operating
cash before interest and taxes to operating income ratio. She determines the reason for this trend
is that the accruals component dominates earnings and is rising in significance each year. When
discussing the issue with Tim Gabbins, her colleague, he states, The accruals trend observed
will eventually revert and the composition of SCPs earnings gives us an idea of the speed with
which this will occur.

Exhibit 1
Selective Financial Statement Information for Widget Inc. (2013-2014) in $ Millions
2014 2013
Income Statement Data
Revenue 100 85
EBIT 90 80
EBT 65 50
Profit from continuing operations 54 38
Share of SCPs income 15 12
Balance Sheet Data

Total assets 870 840
Shareholders equity 400 370
Exhibit 2
Market Capitalization Information Widget Inc. And SCP on December 31, 2014
Share Price (SCP) 12.50
Exchange rate (EURO:US$) 1.13
Shares held by Widget in SCP 50,000
Widget Incs total market capitalization $1,000,000
13. The translated financial statements, which the subordinate provides to Louis, are an
output to which stage of the financial analysis framework?
A. Input data collection

B. Processing the input data
C. Analysis and interpretation of input data
Correct Answer: B
Reference:
Translating the financial statements of SCP is part of the phase of the financial statement
analysis framework in which the input data is processed.

14. By omitting SCPs performance, Widget Inc.s net profit margin growth will:
A. increase.
B. decrease.
C. remain the same.
Correct Answer: A
Reference:
CFA Level II, Volume 2, Study Session 7, Reading 21, LOS c
All $ figures are in millions.

Widget Inc.s net profit margin growth including SCPs earnings is equal to 20.7895%:
2014: $54/$100 = 0.5400

2013: $38/$85 = 0.4471
Net profit margin growth including SCPs performance = 0.5400/0.4471 1 = 20.7783%
Excluding SCPs earnings, the net profit margin growth will increase to 27.4926%.
2014: ($54 $15)/$100 = 0.3900

2013: ($38 $12)/$85 = 0.3059
Net profit margin growth excluding SCPs performance = 0.3900/0.3059 1 = 27.4926%
15. The factor which is not contributing to the growth in total ROE is most likely:
A. leverage.
B. efficiency.
C. profitability.
Correct Answer: A
Reference:

To determine which component failed to contribute to the growth in ROE, the growth in
each component will be calculated:
2014 2013
Net profit margin = Profit from 54.0% 44.7%
continuing operation/sales
Efficiency = Asset Turnover = 0.115 0.101
Sales/total assets
Leverage = Total assets/total equity 2.17 2.27
Given that financial leverage has declined, this factor has not contributed to the increase
in ROE.
16. Using the data in Exhibit 2, the pro rata market value that investors are placing solely on
Widget Inc.s operations is equal to:
A. 29.4%.
B. 37.5%.
C. 70.6%.
Correct Answer: A
Reference:
The pro rata market value being placed solely on Widget Incs operations is equal to
29.4%.
Value of SCP holding in US$ = 12.50 50,000 1.13 = $706,250
Implied value of Widget Inc. = $1,000,000 $706,250 = $293,795
Pro rata market value = $293,795/$1,000,000 = 29.38% or 29.4%
17. If Louis corrects Widget Inc.s financial statements to reflect the securitization
transaction, the absolute change in the companys total liabilities-to-equity will equal to:
A. 3.45%.
B. 6.38%.
C. 93.6%.

Correct Answer: B
Reference:
CFA Level II, Volume 2, Study Session 7, Reading 21, LOS e
Louis will correct Widget Inc.s financial statements by accounting for the securitization
transaction as that of financing. This will be achieved by increasing liabilities by the
proceeds received from the sale of receivables.
All $ calculations are in millions.
Reported liabilities-to-equity ratio = ($870 $400)/$400 = 1.175
Adjusted liabilities-to-equity ratio = ($870 $400 + $30)/$400 = 1.250
The absolute percentage change in the liabilities-to-equity ratio is 6.38%.
18. The composition of SCPs earnings, which Gabbins is referring to, will:
A. increase the speed of mean reversion.

B. decrease the speed of mean reversion.
C. have no impact on the speed of mean reversion.
Correct Answer: A
Reference:
CFA Level II, Volume 2, Study Session 7, Reading 20 & 21, LOS e & g
A high proportion of accruals relative to cash in earnings will increase the speed of mean
reversion.

Questions 19 through 24 relate to Financial Reporting and Analysis
Delta-Mono Case Scenario

Delta-Mono (DM) manufactures artillery equipment for the U.S. armed forces. The company
prepares and presents its financial statements in accordance with the U.S. GAAP.
DM maintains a post employment health care benefit plan. The plan was created at the beginning
of the year 2013. DMs investment officer, Daniel Pronzo, would like to compare the
reasonableness of the assumptions used to account for the plan in the companys financial
statements. Pronzo plans to accomplish this by comparing DMs assumptions with those of
Skylark, a competitor, and collects details relevant for the analysis (Exhibit 1).
Using the data collected Pronzo builds his analysis by estimating the impact of a 1% increase in
the initial inflation rate on financial leverage and return-on-equity. Details concerning the impact
on DMs post-employment benefits expense and obligation as well as relevant financial
statement information have been summarized (Exhibit 2).
Pronzo prepares a report to summarize the results of his findings. He concludes his report by
drawing a comparison between the characteristics of defined benefit plans (DBPs) and other
employment post benefit plans (OPBs). Excerpts from the report are as follows:
Pre-Funding Requirements:
Sponsor companies are not required to pre-fund OPBs as these plans are insured by the
U.S. government. In contrast, sponsors are legally obliged to pre-fund a DBP.
Future Obligations versus Future Benefits:
DBP sponsors need to estimate the amount of future obligations. This contrasts with
OBPs where the amount of future obligations is pre-specified.
The amount of future benefits is defined for both types of post-employment benefit
plans thus removing the need for estimation.

On January 1, 2014 DM sold an artillery machinery unit with a fair value of $2.00 million on a
finance lease. The lease was classified as a sales-type lease. On December 31, 2014, Jacqueline
Lee, DMs senior financial analyst, obtains relevant financial details concerning the lease from
the companys disclosures. Po believes the discount rate has been overestimated by 200 basis
points.
Lease receivable 1/1/2014 = $2.60 million

Annual lease payment (due January 1 of each year) = $0.65 million
Discount rate = 12%
Lease term = 5 years
Exhibit 1
Health Care Benefit Plan Assumptions & Account Balances
DM Skylark
Initial inflation rate (2013) 8% 5%
Long-term inflation rate 6% 5%
Year long-term inflation rate is attained 2018 2020
Accumulated benefit obligation (2012) $980,000 $1,800,000
Periodic expense for benefits (2012) $145,000 $621,000
Total assets $7,200,000 $10,450,000
Total equity $4,100,000 $7,246,000
Exhibit 2
Impact of 1% Increase in Initial Inflation Rate
DM Skylark
Change in obligations + 122,000 + 112,500
Change in expense + 52,480 + 37,980
19. If DM revises the year in which the long-term inflation rate is realized to 2017, which of
the following measures will increase?
A. Liabilities
B. Net profit margin
C. Asset turnover ratio
Correct Answer: B

Reference:
An earlier year in which the health care trend rate is assumed to be reached will reduce
reported pension obligation and periodic costs. This will:
increase reported net profit margins (due to an increase in net profits resulting
from a decline in periodic costs);
decrease reported liabilities; and
not affect asset turnover ratios which does not include liabilities or pension costs
in its computation.
20. Using the data in Exhibits 1 and 2, a 1% increase in the inflation rate will cause the
absolute percentage change in the financial leverage ratio (total assets/total equity) of:
A. DM to be higher.
B. Skylark to be higher.
C. both companies to be the same.
Correct Answer: A
Reference:
The initial financial leverage ratios of each company are as follows:
DM = $7,200,000/$4,100,000 = 1.756
Skylark = $10,450,000/$7,246,000 = 1.442
Following the increase in inflation rate, the revised ratios are as follows
DM = $7,200,000/($4,100,000 +$52,480) = 1.734

Skylark = $10,450,000/($7,246,000 + $37,980) = 1.435
Change in DMs financial leverage ratio = 1.734/1.756 1 = - 1.25%
Change in Skylarks financial leverage ratio = 1.435/1.442 1 = - 0.485%
The change in inflation rate will result in a greater decline (and higher absolute change)
in DMs financial leverage ratio.

21. Considering the Pre-funding Requirements excerpt from Ponzos report, he is most
accurate regarding the comments made on:
A. OPBs.
B. DBPs.
C. both OPBs and DBPs.
Correct Answer: B
Reference:
Ponzo is accurate regarding the pre-funding requirements specified for DBPs but not
OPBs. DBP sponsors will be required to fund the plan in advance. On the other hand,
OPB sponsors may not be legally required to pre-fund plans. This difference in
requirements occurs because governments partially insure DPB plans but not OPB plans.
22. Considering the Future Obligations versus Future Benefits except, Ponzo is least
accurate with respect to the comments made regarding:
A. DBPs; the amount of future obligations is pre-defined.

B. OPBs; the amount of future obligations is based on a plan formula.
C. OPBs; the amount of future benefits depends on plan specifications.
Correct Answer: C
Reference:
With respect to DBPs, the amount of future benefits is based on the plans formula and is
this defined. Lee is accurate with respect to this comment. However, Lee has also
accurately pointed out that the amount of future obligations must be estimated; the
relevant amount must be estimated in the current period.
With respect to OPBs, the amount of future benefit depends on plan specifications and
type of benefits. In addition, the amount of future obligations must be estimated in the
current period. Lee is inaccurate with respect to both her comments concerning OBPs.

23.Based on Lees concern regarding the discount rate, on December 31, 2014, DMs total
assets balance will be overstated by:
A. $0.11 million.
B. $0.38 million.
C. $0.54 million.
Correct Answer: A
Reference: CFA Level II, Volume 2, Study Session 5, Reading 17, LOS f
All $ figures are in million unless otherwise stated.
Using the CF function on the financial calculator, the present value of the lease
receivable balance on January 1, 2014 will increase to $2.7104 million following a
decrease in discount rate to 10%.
CF0 = $0.65; CF1 = $0.65; CF2 = $0.65; CF3 = $0.65; CF4 = 0.65; I/Y = 10%; NPV =
$2.7104
Interest @ 10% Lease Receivable

Lease Receivable Annual Lease Accrued in Reduction of 31/12/2014
1/1/2014 Payment Previous Year lease receivable
$2.7104 million $0.65 million $0 $0.65 million $2.0604 million
Therefore, on December 31, 2014 total assets will be overstated by $2.0604 ($2.600
$0.6500) = $0.1104 million.
24. The sales-type lease classification used by DM will imply that, relative to the lease
receivables balance on January 1, 2014, the fair value of the unit is most likely:
A. equal.
B. lower.
C. higher.
Correct Answer: B
Reference:
CFA Level II, Volume 2, Study Session 5, Reading 17, LOS f

The sales-type finance lease classification is used when the present value of lease
payments (that is, the lease receivables balance at the inception of the lease) is greater
than the fair value of the leased asset resulting in a profit on the transaction.

Questions 25 through 30 relate to Equity Investments
Blitz Technologies Case Scenario

Blitz Technologies is a bioengineering firm situated in Nemora, a developing country, with the
US$ as the reporting currency. A small province in the country has reported the emergence and
spread of a viral disease which is unheard of in the medical field. Although the symptoms of the
disease have been determined, the cities that will be affected and the external conditions and
circumstances which will exacerbate the present circumstances are highly uncertain and not
within the control of government authorities.
Blitzs CEO announces that the company will undertake research which will be aimed at finding
a cure, developing drugs for treatment and diagnostic equipment. The CEO tasks Carl Hendricks,
head of research and planning, to prepare a report which will detail the strategy and plan of
action necessary to deal with the state of affairs. Hendricks begins the report by stating, A
shaping strategy will be employed whereby fellow researchers from across the globe will be
engaged. Given that these individuals have successfully developed treatments for rare viral
diseases in the past, I am highly confident that as a team we will be able to achieve similar
results.
Nemoras bioengineering industry is one of the countrys most heavily regulated industries. A
growing population, changes in the external environment and demographics require industry
participants to remain actively involved in devising strategies for success. The most recent
government regulation has mandated participants to ensure any research report generated is
subject to a rigorous review procedure prior to public dissemination. Lyole Associates, a medical
research firm has identified the opportunity to be the first in the industry to offer review services.
Lyole will additionally provide its clients a unique access to highly qualified pharmacists and
medical professionals.
Sylvia Dwight is an equity analyst specializing in bioengineering firms. Dwight is undertaking

an investigation for the mere purpose of forecasting the impact of the new strategy on Blitzs
sales revenue. Blitz has a 38% share in an industry with a forecasted increase in annual revenue
of 5%. Dwight anticipates Blitzs sales revenue to grow 300 basis points higher than the industry
forecast as the company will be expected to employ superior technology in its research and
development processes which in turn is expected to enhance the efficacy of developed drugs.
In addition to the sales projections, Dwight is developing three alternative forecasts as outlined
below:
Forecast 1: Blitz will continue to enjoy the economies of scale it has experienced in the past.

Forecast 2: $3 million has been classified as research costs in the current years income
statement. Tax authorities do not recognize these expenses as part of taxable income.
The company is forecasted to recognize a further $7 million as research costs over
the coming two years. The tax rate is expected to remain constant at 30%.
Forecast 3: Profitability is forecasted to remain relatively stable as highlighted in the exhibit.
However, Blitz is expected to face an increase in:
I. working capital as manufactured drugs are not expected to be immediately sold until the
company secures the confidence of medical professionals; this will lead to a buildup in
finished goods inventory.
II. financial leverage as any new technologies acquired will be financed with debt.
Exhibit
Current and Future Financial Information Concerning Blitz Associates (In $ millions)
2014
2016 2015 (Current)
Sales 70 55 45
Cost of sales 25 15 10
Selling, general and 19 15 12
administrative expenses
Operating profit 26 25 23
Profit before taxes 17 14 14
25. In context of the proposed shaping strategy developed, the trap which Hendricks fallen
into can be best characterized as:
A. unexamined habits.
B. cultural mismatches.
C. misplaced confidence.
Correct Answer: C
Reference:

Hendricks has fallen into the misplaced confidence trap by demonstrating his assurance
with respect to Blitzs ability to control an unpredictable and uncertain environment. The
unpredictable environment calls for an adaptive strategy with short planning cycles which
constantly modify research with changing external factors.
26. Lyole Associates response to the new government regulation affecting the biotechnology
industry most likely demonstrates an attempt to:
A. position the company.

B. exploit industry change.
C. shape industry structure.
Correct Answer: A
Reference:
CFA Level II, Volume 4, Study Session 11, Reading 31, LOS d
Lyole Associates has recognized that presently there is no research firm offering the
services it will be giving to Berlitz. With a lack of suppliers (medical research report
review service providers), Lyole has positioned itself in an industry where these
competitive forces are weakest.
27. The approach used by Dwight to forecast Blitzs revenues is most likely characterized as:
A. hybrid.
B. top-down.
C. bottom-up.
Correct Answer: A
Reference:
Dwight is using a hybrid approach to forecast Blitzs revenues. By forecasting the

biotechnology industrys growth and Blitzs share in that growth, she is using the market
growth and market share (top-down) approach. By basing her projections on technology
adopted by the company and impact of technology on the efficacy of drugs, Dwight is
using the bottom-up approach. A combination of the two approaches is known as the
hybrid approach.

28. Using the information in the exhibit, is Dwight correct with respect to Forecast 1?
A. Yes.
B. No, operating costs have not been managed efficiently.
C. No, operating margins are positively correlated with sales.
Correct Answer: B
Reference:
All $ figures are in millions.
C is incorrect. Operating profits margins (operating profit/sales) are forecasted to be

negatively correlated with sales, decreasing with the rise in sales revenue. (2014: 51.1%;
2015: 45.4%; 2016: 37.1%).
Cost of sales as a percentage of sales is projected to increase from 22.2% ($10/$45) in

2014 to a forecasted 35.7% ($25/$70) in 2016. Selling, general and administrative
expenses as a percentage of sales are projected to increase from 26.7% ($12/$45) in 2014
to 27.1% ($19/$70) in 2016. The increase in costs demonstrates inefficiency in cost
generation.
29. Considering Forecast 2 in isolation and using the information in the exhibit, relative to
the companys reported taxes, cash taxes paid in the current year will be:
A. lower.
B. higher.
C. the same.
Correct Answer: B
Reference:
Profit before taxes (given) $17,000,000

Reported tax expense = ($17,000,000 30%) 5,100,000
Cash taxes paid = 0.30 ($17,000,000 + $3,000,000) 6,000,000
The cash taxes paid in the current year will be $900,000 higher.

30. Considering Forecast 3 in isolation, Blitzs return on invested capital (ROIC) will most
likely:
A. increase.
B. decrease.
C. remain the same.
Correct Answer: B
Reference:
ROIC = net operating profit less adjusted taxes/invested capital
Given that profits are expected to remain relatively constant, ROIC should be expected to
remain stable. However, invested capital which is calculated as operating assets less
operating liabilities, will increase due to a buildup of inventory. Therefore, this measure
is expected to decrease due to this factor.
Financial leverage (Forecast 2-ii) does not affect this measure of profitability.

Question 31 through 36 relate to Fixed Income
Stella Owens Case Scenario
Stella Owens is a fixed-income manager at Halo Analytics, a financial services firm providing
valuation and advisory services. Owens will be holding a seminar in which she aims to
demonstrate traditional theories of the term structure of interest rates. She intends to apply any
theories discussed to current and expected conditions in the bond market.
She begins her seminar by comparing the unbiased and local expectations theories by making the
following opening statement:
Statement 1: Both theories assume that the one-period return will always equal to the one-year
risk-free rate regardless of the maturity of the bond. However, economic reality is
considerably different from theoretical assumptions.
Next, Owens demonstrates how these traditional models can be used to explain the slope of the
current yield curve (Exhibit 1) and make projections for spot rates.
Exhibit 1: Current Yields

Maturity (Year) Yield (%)
1 22%
2 18%
3 15%
5 5%
15 2%
Based on the data collected and an expectation of deflation, Owens forecasts spot rates to decline
in the future. Her forecast for inflation is based on a recent announcement by monetary
authorities to cut down policy rates as part of a move to stimulate the national economy.
Owens concludes her seminar with a discussion of how modern term structure models describe
evolving interest rates. The manager summarizes the difference between the Cox-Ingersoll-Ross
(CIR) and Vasicek model, on the one hand, and the Ho-Lee model, on the other hand, in the form
of two statements:
Statement 2: The Ho-Lee model generates a term structure which most closely matches the
current term structure while the other two models generate poor estimates of the
current term structure.

Statement 3: Unlike the CIR and Ho-Lee model, the Vasicek model assumes constant volatility
over the analysis period.
After concluding the seminar, Owens explores the presence of arbitrage opportunities for a three-
year, 8% annual coupon-paying bond issue. The issue is trading in three different exchanges.
Based on their exchange-quoted prices, she determines the profit (loss) generated on an arbitrage
strategy within each exchange (Exhibit 2). Owens uses the data in Exhibit 1 as part of a
bootstrapping process to generate spot rates (Exhibit 3).
Exhibit 2
Calculated Arbitrage Profit/(Loss) in Exchanges
NASDAQ LSE NORDIC
Arbitrage profit/ (loss)* 8.5000 5.1808 (7.590)
*Profit or loss is per 100 of par value
Exhibit 3
Spot Rates
Maturity Rate (%)
1 25
2 22
3 19
4 17
5 14
31. With respect to Statement 1, Owens is most likely:
A. correct.
B. incorrect; local expectations theory does not incorporate risk neutrality in the
short- or long-term.
C. incorrect; local expectations theory predicts that the one-period return for long-
term bonds is higher than the risk-free rate.
Correct Answer: A
Reference:
CFA Level II, Volume 5, Study Session 14, Reading 43, LOS i

A is correct. Both unbiased and local expectations theories assume risk-neutrality in the
short-term. This implies that the one-period return on either short- or long-term securities
is equal to the one-period risk free rate. Unbiased theory asserts that every security is
risk-free and must earn the relevant risk-free rate. The local expectations theory contends
that the expected return for every bond over the short-term is the risk-free rate. Therefore,
one would expect the one-period return to equal to the one-year risk-free rate under both
theories.
B is incorrect. See above.
C is incorrect. Regardless of bond maturity, applying the local expectations theory will
result in the one-period return being equal to the one-year risk free rate.
32. By referring to economic reality being different from theoretical assumptions, Owens is
implying that, relative to long-dated bonds, short-dated bonds are least likely associated
with higher:
A. demand.
B. actual prices.
C. actual returns.
Correct Answer: C
Reference:
CFA Level II, Volume, Study Session 14, Reading 43, LOS i
Market evidence has demonstrated that the need for liquidity and the ability to hedge risk
essentially ensure that the demand for short-term securities will exceed that for long-term
securities. Therefore, both the yields and actual returns on short-dated securities are lower
than those for long-dated securities. Therefore, short-dated securities quote higher actual
prices.
33. Combining Owens forecast for inflation and spot rates suggests that she most likely
believes liquidity premiums:
A. are present.
B. are nonexistent.
C. cannot be determined due to conflicting forecasts.
Correct Answer: A

Reference:
The yield curve presented in Exhibit 1 is downward sloping. Combining the current yield
curve with Owens expectation of deflation suggests that she believes liquidity premiums
to be present. According to the liquidity preference theory, a downward sloping yield
curve could still be consistent with the existence of liquidity premiums if one of the
factors underlying the shape of the yield curve is an expectation of deflation.
34. Owens second statement is most likely:
A. correct.
B. incorrect; the Ho-Lee model does not attempt to describe the current yield curve.
C. incorrect; all three models require short-term rates to follow a certain path and
thus the estimated yield curve does not match the observed curve.
Correct Answer: A
Reference:
CFA Level II, Volume 5, Study Session 14, Reading 43, LOS j
The Ho-Lee model can be calibrated to market data by inferring the form of the time-
dependent drift term from market prices; this means that the model can precisely generate
the current term structure.
On the other hand, both the Vasicek and CIR models require the short-term rate to follow
a certain process. Therefore, the estimated yield curve may not match the observed yield
curve.
35. With respect to Statement 3, Owens is most likely correct with respect to:
A. all three models.

B. the CIR model only.
C. the Vasicek model only.
Correct Answer: A
Reference:

The CIR model makes volatility proportional to the square root of the short-term rate,
which allows for volatility to increase with the level of interest rates.
Interest rates are calculated under the Vasicek model by assuming that volatility remains
constant under the period of analysis.
The Ho-Lee model allows volatility to vary with time.
36. Using the data in Exhibits 2 and 3, which of the following statements most accurately
presents the current market price of the security in the relevant exchange?
A. NASDAQ: 67.3638
B. LSE: 72.5744
C. NORDIC: 68.2738
Correct Answer: C
Reference:
Based on the spot rates, the no-arbitrage price of the three-year 10% issue is 75.8638.
8 8 108
No-arbitrage price = + + = 75.8638
1.25 (1.22 ) (1.19 )3
2
Based on the arbitrage profit/(loss) quoted in exhibit 2, the current market prices are:
NASDAQ = 75.8638 + 8.5000 = 84.3638
LSE = 75.8638 + 5.1808 = 81.0446
NORDIC = 75.8638 7.590 = 68.2738

Questions 37 through 42 relate to Fixed Income
Luciana Waldwick Case Scenario

Luciana Waldwick is a fixed income analyst serving Yalt Advisors, an asset management firm.
YA offers a fixed income fund which is invested in a wide range of securities including
corporate bonds and asset-backed securities (ABS). Waldwick is particularly interested in a
residential mortgage-backed security (RMBS) which has a senior-subordinate tranche structure.
Each bond class in the structure has been downgraded by Lynch & Morry (L&M), a credit rating
agency
Waldwick expands her analysis by studying the similarities and differences between the credit
analysis required for ABSs and corporate debt. She draws the following conclusions:
Conclusion 1: Unlike corporate debt, the complex cash flow structure of ABS tranches renders
the structural model an inapplicable valuation tool as it assumes a constant
riskless rate of interest.
Conclusion 2: Credit rating agencies use the same rating scales for ABSs and corporate bonds.
In her correspondence with a credit analyst at L&M, the latter informs her that the issuer of the
ABS has entered into an agreement with the rating agency whereby the firm would receive its
agreed upon service fee of $40,000 in return for generating the credit rating.
Interest rates in the market have recently declined which has increased the probability of
borrowers exercising the prepayment option embedded in their mortgage loans. The expected
yield-to-maturity (YTM) quoted on the junior tranche is 8.5% and the yield curve is sloping
steeply downwards. Based on the recent changes, Waldwick concludes:
Conclusion 3: Given the current shape of the yield curve and the revised probability of
refinancing, the expected rate of return will not equal to 8.5% and coupon
payments will be reinvested at a rate which differs from the YTM.
Waldwick also analyzes the implication of the shape of the yield curve for nominal yields,
expected inflation and economic growth. In addition, she intends to use key rate duration to
measure the impact of the curve steepening on the price sensitivity of fund assets. She justifies
her choice by listing the strengths of the risk measure:
Strength 1: Captures shaping risk

Strength 2: Measures parallel yield curve shifts

Strength 3: Models the price sensitivity of bonds with embedded options
In her professional studies, Waldwick learned how the forward rate can be interpreted as a
breakeven rate. She intends to use the forward rate model to determine how the rate agreed on
today for a two-year loan made five years from today can be viewed as the breakeven rate. For
her analysis, she assumes a hypothetical rising spot rate curve (Exhibit) and arrives at the
following conclusion:
Conclusion 4: The no-arbitrage forward rate, f(5,2), of 5.45% can be viewed as the breakeven
rate if the investor is indifferent between:
I. buying a seven-year zero-coupon bond at 4.50% or

II. investing in a five-year zero-coupon bond at 3.60% and at maturity reinvesting
the proceeds for two more years at 1.00%.
Exhibit:
Spot Rates for Forward Rate Model
Maturity Rate (%)
S(2) 1.00%
S(3) 2.50%
S(4) 3.00%
S(5) 3.60%
S(6) 3.90%
S(7) 4.50%
37. With respect to her conclusions concerning the similarities and differences of the credit
analysis of ABSs and corporate bonds, Waldwick is least accurate with respect to:
A. Conclusion 1 only.
B. Conclusion 2 only.
C. both conclusions 1 and 2.
Correct Answer: A
Reference:

Waldwick is inaccurate with respect to Conclusion 1 but accurate with respect to

Conclusion 2. While she has correctly stated that structural models assume a constant
riskless rate of interest and cash flows of ABSs are complex (due to the presence of
embedded options) her conclusion is incorrect because she asserts that structural models
are inapplicable for valuation.
38. Which of the following conflicts is particularly associated with the process used by the
agency to generate credit ratings?
A. Agency
B. Incentive
C. Stability versus accuracy
Correct Answer: B
Reference:
The model being used by L&M is an issuer- pays model as the credit rating agency is
being paid by the issuer of the RMBS to generate a credit rating. A limitation of using
this model is the inherent incentive conflicts. By being compensated by the issuer, rating
agencies may have an incentive to generate a credit rating which will gain more business
rather than an objective rating.
39. With respect to Conclusion 3, Waldwick is most accurate with respect to her comments
regarding the:
A. expected rate of return only.

B. reinvestment rate only.
C. both expected rate of return and reinvestment rate.
Correct Answer: C
Reference:
CFA Level II, Volume, Study Session 14, Reading 43, LOS a

Waldwick is accurate with respect to her comments regarding expected rate of return and
reinvestment rate. The YTM of 8.5% may be a poor estimate of the expected rate of
return as the yield curve has a steep slope and the issue has embedded prepayment
options. The steeply (downward) sloping yield curve implies that coupons will not be
expected to be reinvested at the YTM.
40. Considering nominal yields, the current shape of the yield is least likely associated with a
forecast of:
A. lower future inflation.

B. strong economic growth.
C. risk premiums decreasing with an increase in maturity.
Correct Answer: B
Reference:
CFA Level II, Volume, Study Session 14, Reading 43, LOS b
Incorporating nominal yields, which incorporate a premium for expected inflation, a

downward sloping yield curve will be interpreted as reflecting a market expectation of
decreasing inflation and weaker economic growth. In addition, a downward sloping yield
curve may also imply that risk premiums are decreasing with maturity.
41. Conclusion 4 is most accurate with respect to the:
A. forward rate used.

B. reinvestment rate specified in ii.
C. maturity of the bond specified in i.
Correct Answer: C
Reference:
CFA Level II, Volume, Study Session 14, Reading 43, LOS b

Waldwick has accurately specified the maturity of the zero-coupon bond in strategy i.
The two-year forward rate five years from today can be viewed as the breakeven rate if
the investor is indifferent between:
I. investing in a 7-year zero coupon bond or

II. investing in a 5-year zero-coupon bond and at maturity reinvesting the proceeds
for two more years.
Waldwick is least accurate with respect to the reinvestment rate used.

Using the forward model, the no-arbitrage forward rate has inaccurately been calculated.
The correct forward rate is 6.78% (see below):
!"#(%) ' !.,-('

[1 + f(5,2)]2 = )
= = 1.14029
!"#(() !.,./)
f(5,2) = 6.7844% or 6.78%
With respect to strategy ii, the proceeds received from the zero-coupon bond five years
from today will be reinvested at the two year forward rate five years from today. This rate
should equal 6.78%.
42. Which of the following strengths most likely justifies Waldwicks choice of key rate
duration as a risk measure?
A. Strength 1 only.
B. Strengths 1 and 2 only.
C. Strengths 1, 2 and 3.
Correct Answer: C
Reference:
CFA Level II, Volume, Study Session 14, Reading 45, LOS k
All three strengths justify Waldwicks choice of the key rate duration as a risk measure.
In addition to capturing parallel yield curve shifts, key rate durations reflect the
sensitivity of the bonds price to changes in specific maturity points on the benchmark
yield curve and, in this way, help managers and identify the shaping risk for bonds (the
sensitivity to changes in the shape of the yield curve).
In addition, key rate durations can be used to evaluate the price sensitivity of bonds with
embedded options.

Questions 43 through 48 relate to Derivatives
Alexei Orlov Case Scenario

AlxeiOrlov is the head of risk management at Marix Limited, a manufacturer of sporting
equipment. Marix is seeking to expand its business and client base by constructing
manufacturing facilities in different parts of the country. The company will need to borrow $2.5
million in a years time to fund the project. Orlov decides to engage in a one-year, quarterly
paying interest rate swap with Green Associates. The notional principal of the swap is $2.5
million and annual swap rate is 3.80%.
Orlov next collects data concerning the economy. A positive economic outlook accompanied by
economist projections of stable interest rates encourages Orlov to consider terminating the swap
position three months from today by engaging in a 0.25 1 swaption with Green Associates as
the counterparty on the original swaps initiation date.
Orlov calls a meeting which is attended by Marixs senior risk managers. Kelly Diop, a risk
manager, questions Orlovs choice of counterparty to which the latter responds, Engaging in a
terminating swaption with Green Associates, as opposed to another dealer, will help eliminate
credit risk.
During the meeting Orlov also discusses the other possible uses of swaptions.
Use 1: Swaptions can be used by arbitrageurs to exploit interest rate movements.
Use 2: Swaptions can be used by hedgers desiring to limit losses in a particular direction or, in
other words, those who require unilateral payoffs.
Use 3: Swaptions provide parties with the flexibility needed to remove interest rate uncertainty
from the underlying swap.
Orlov demonstrates how the swaption will be valued using the projected LIBOR term structure at
expiration and details concerning the swaption (Exhibits 1 and 2 respectively).
Diop believes that an analysis of company expansion on Marixs stock price is essential. Using
economic forecasts, she projects that if the company succeeds in increasing its market presence
following an expansion the share price should increase. However the extent of the percentage
increase is highly contingent on these two forecasts materializing. She recommends the purchase
of a one-year European call option to speculate on stock price movements.

For her analysis, Diop has assumed three possible scenarios for the share price. Each of the three
scenarios is equally likely in occurrence. She aims to calculate delta for each scenario and a
probability weighted average new call by combining the delta from each scenario. Details
relevant to her analysis and the scenarios are summarized in an exhibit (Exhibit 3). She will be
using the Black-Scholes-Merton (BSM) model to value the call option by incorporating the 4%
dividend yield on the stock.
Exhibit 1:
Current LIBOR Structure
90-day 3.5%
180-day 4.9%
270-day 5.7%
360-day 6.9%
Exhibit 2:
0.25 1 Receiver Swaption
Settlement details Up-front cash payment
Notional principal $2.5 million
Payment frequency Quarterly
Term Nine months
Floating leg payment basis LIBOR
Exhibit 3:
Scenarios and Details Concerning Option Valuation
Scenario 1 Scenario 2 Scenario 3

Projected underlying price $65 $70 $88
Exercise price $65.00

Current underlying price $65.00
Option price $8.50
N(d1) 0.7356
N(d2) 0.2644
Orlov concludes the meeting by stating that the BSM model is subject to assumptions which
limit the usefulness of the analysis.

43. With respect to the reason underlying his choice of Green Associates as counterparty to
the swaption, Orlovs statement is most likely:
A. accurate.
B. inaccurate; credit risk can only be mitigated.
C. inaccurate; credit risk can only be eliminated if the counterparty is not the same as
that to the original swap.
Correct Answer: B
Reference:
Even if the swaption is entered into with the original swap counterparty, credit risk is not
eliminated. The original swap will require Marix to pay the fixed rate and receive the
floating rate. The receiver swaption will require Marix to pay the floating rate, LIBOR, in
exchange for the receipt of fixed payments. While the floating rates on the interest rate
swaption and original swap will offset each other, the fixed rates are not equal and credit
risk exists to the extent of the net fixed payment. Therefore, credit risk is mitigated but
not eliminated.
44. With respect to his identification of the use of swaptions, Orlov is least accurate with
respect to:
A. Use 1
B. Use 2
C. Use 3
Correct Answer: B
Reference:

Swaptions call for bilateral payoffs in which both parties are equally exposed to gains and
losses. Therefore, swaptions cannot be used to achieve unilateral payoffs.
Swaptions can be used to speculate on interest rates. Therefore, this represents a valid use
of swaptions.
Swaptions give parties the flexibility to not engage in the swap if movements in swap
market rates are more favorable or otherwise choose not to engage in the swap at a later
date. Therefore, this represents a valid use of swaptions.
45. Using the data in Exhibits 1 and 2 and assuming the projection concerning the LIBOR
term structure materializes, the up-front cash payment at swaption expiration is closest to:
A. $8,644.
B. $25,300.
C. $58,800.
Correct Answer: B
Reference:
Discount Factor
Maturity (Days) Rate (%)
90 3.5% 0.9913
180 4.9% 0.9761
270 5.7% 0.9590
Annual fixed rate = [(1 0.9590)/(0.9913 + 0.9761 + 0.9590)] 360/90 = 5.6042%
Given that Green Associates is the counterparty to the swap and swaption, floating rate
payments are eliminated.
The original swap will require Marix to pay a fixed rate of 4.2500% while the swap
underlying the swaption will generate fixed payments for the company based on a fixed
rate of 5.6042%. Netting these two rates, at each settlement date Marix will receive
$8,643.75 = (5.6042% - 4.2500%) 90/360 $2,500,000
The present value of this payment stream is equal to $25,295.00 [$8,643.75 (0.9913 +
0.9761 + 0.9590)] or $25,300.

46. Applying the BSM model to the stock option is most likely:
A. inappropriate as European options cannot be valued.

B. inappropriate if there are cash flows on the underlying.
C. appropriate given the existence of the dividend yield and type of option.
Correct Answer: C
Reference:
The BSM model can assumes that options are European and so it is well suited to valuing
the option in question.
Although the model assumes that there are no cash flows on the underlying, this
assumption can easily be relaxed.
47. Using delta as an approximation and the data in Exhibit 2, the probability weighted
average new call price is closest to:
A. $12.53.
B. $14.68.
C. $15.36.
Correct Answer: C
Reference:
To determine the probability weighted average new call price, the call price under each
scenario will need to be calculated.
New call price (Scenario 1) = $8.50 + (0.7356)($65 - $65) = $8.500

New call price (Scenario 2) = $8.50 + (0.7356)($70 $65) = $12.178
New call price (Scenario 3) = $8.50 + (0.7356)($88 $65) = $25.419
Probability-weighted average call price = (1/3)(8.500) + (1/3)($12.178) + (1/3)($25.419)
= $15.3657

48. Which of the following assumptions most likely underlies the BSM model?
A. Volatility is a model-driven variable.

B. The risk-free rate follows a random pattern.
C. Transaction costs are assumed to be negligible.
Correct Answer: C
Reference:
The BSM model assumes there are no transaction costs or taxes, the risk-free rate is
known and constant (interest rates are not allowed to be random), and volatility of the
underlying asset is known and constant. With respect to volatility, the BSM model
assumes that volatility is specified in the form of the standard deviation of the log return
and therefore need not be estimated or obtained from another source.

Questions 49 through 54 relate to Alternative Investments
Baltic Enterprises Case Scenario

Baltic Enterprises (BE) is an asset management firm which has traditionally invested in fixed
income and equity securities. Senior portfolio manager, Dennis Peterson would like to expand
the firms investment universe and is considering private equity and commodities as potential
candidates.
For the private equity investment, Peterson narrows his selection to two funds - Stark-X, a
venture capital (VC) fund, which finances start-up software houses such as Alpha Tech (AT) and
a buyout fund. Peterson is particularly concerned about the potential valuation issues faced when
appraising the value of an investment in venture capital funds.
In a meeting with Stark-Xs fund manager, Peterson inquires about the exit strategy the fund
intends to employ for its investors. The fund manager responds by informing Peterson that an
IPO has been favored as an exit route due to its numerous advantages.
Peterson is unable to decide between Stark-X and a buyout fund and decides to consult Ali Khan,
an asset manager serving BE. Khan proposes Peterson opt for the buyout fund. He supports his
proposal with the following justifications:
Justification 1: Buyout funds require a lower degree of due diligence relative to their VC
counterparts.
Justification 2: Buyout funds do not exhibit performance persistence.
Justification 3: The risk of buyout funds is relatively easier to measure due to their long
operating history.
After considerable deliberation, Peterson opts for Stark-X and investment in AT. The companys
management projects that it will raise $30 million from its IPO six years from today. To prepare
for its IPO AT will need to raise the requisite funds in two stages - today and four years from
today. BE will invest in AT at the beginning of the second stage. Details concerning the
investment have been summarized by Peterson:

Investment by first round investors = $8 million

BEs investment = $6 million
Percentage ownership of first round investors during first round = %
Dilution of ownership of first round investors =
Post-money value (T = 4) = $10 million.
Shares owned by company founders = 2 million
For BEs exposure to commodities, Peterson is exploring gasoline as a potential candidate. He

contacts his old friend, Peter Walsh, an expert in commodities, to shed some light on the
investment decision.
Walsh recommends, The global gasoline industry has been under considerable pressure from
environmental lobbyists over the past six months. If regulators respond to these pressures by
enacting stringent environmental regulations along with penalties for violation, the global price
of gasoline can significantly rise. I highly advise BE to undertake a long position in gasoline
futures. If the hoped for move materializes, it will be a win-win situation for the company.
49. Which of the following options can Peterson most likely explore to value BEs
investment in AT?
A. Relative value approach

B. Real option methodology
C. Discounted cash flow methodology
Correct Answer: A
Reference:

To determine the value of an investment in a venture capital fund, the real option
methodology can be used.
A is incorrect. The relative value or market approach cannot be used to value investments
in VC funds as Peterson will face difficulty in his pursuit for a comparable quoted
company operating in the same field as AT, which is in its start-up stage.
C is incorrect. The discounted cash flow approach is limited in its usefulness in the
valuation of VC investments. This is because there is significant uncertainty surrounding
projected future cash flows in VC transactions.
50. The advantages of an IPO as an exit route for Stark-X investors most likely includes:
A. cost effectiveness.
B. high exit valuation.
C. increased flexibility.
Correct Answer: B
Reference:
Going public via an IPO offers significant advantages including higher valuation
multiples. Therefore, Peterson can expect to receive a high valuation upon the exit of his
investment if Stark-X undertakes an IPO of AT.
However, an IPO comes at the expense of less flexibility and significant costs.
51. In context of his buyout fund investment proposal, Khan is least accurate with respect to:
A. Justification 1.
B. Justification 2.
C. Justification 3.
Correct Answer: B
Reference:
CFA Level II, Volume 5, Study Session 13, Reading 41, LOS c & f

Peterson is incorrect with respect to Justification 2. All private equity funds exhibit a
degree of performance persistence. Top performing funds continue to outperform while
poorly performing funds continue to generate poor performance or disappear.
Peterson is correct with respect to Justifications 1 and 3. Relative to VC funds, buyout

funds require a lower degree of due diligence as they are more established and have
relative stable cash flows. In addition, the risk of investing in a buyout fund is measurable
as they businesses which are relatively mature and have a long operating history.
52. The number of additional shares to be issued by ATs management to achieve BEs
desired ownership stake is closest to:
A. 1.6 million.
B. 3.8 million.
C. 4.6 million.
Correct Answer: C
Reference:
The following steps will be followed to determine the number of additional shares to be
issued to BE (y2):
Step 1: Determine the shares to be issued to the investors of the first round to achieve
their desired ownership fraction (y1)
y1 = x1[F1/(1 F1)] = 2,000,000[0.35/(1 0.35] = 1,076,923
Step 2: Determine the number of existing shares at the time of the second round (x2):
x2 = x1 + y1 = 2,000,000 + 1,076,923 = 3,076,923
Step 3: Determine y2:

y2 = x2[F2/(1 F2)]
where F2= I2/POST2 = $6,000,000/$10,000,000 = 0.60
y2 = 3,076,923[0.60/(1 0.60] = 4,615,384 or 4.6 million

53. ATs pre-money valuation four years from today is closest to:
A. $2 million.
B. $4 million.
C. $10 million.
Correct Answer: B
Reference:
All $ figures are in millions

Pre-money valuation four years from today (PRE2) = POST2 I2 = $10 $6 = $4 million
54. By acting on Walshs recommendation, BE will participate in the gasoline futures market
as a (n):
A. hedger.
B. speculator.
C. arbitrageur.
Correct Answer: B
Reference:
By following Walshs advice, BE will participate in the gasoline commodity market as a

speculator. Based on Walshs recommendation, he is advising Peterson to speculate on
the enactment of environmental regulation as well as an increase gasoline prices. By
undertaking a long position in gasoline futures, BE will be exposed to gains (if the
regulations are enacted) or losses (if the regulations are not enacted).
Walsh is not advising BE to participate in the commodity market as a hedger. This is
because the firm will increase, not mitigate its risk exposure, by undertaking a long
futures position.
Walsh is not advising BE to participate in the commodity market as an arbitrageur.

Arbitrageurs attempt to make riskless profits. However, given that the enactment of the
regulation is uncertain and a long exposure to gasoline futures is essentially a bet on
gasoline prices, BE will be exposed to substantial risks.

Questions 55 through 60 relate to Portfolio Management
Rocky Asset Management (RAM) Case Scenario

Rocky Asset Management (RAM) provides investment advisory and asset management services
to private-wealth clients and institutions. Benjamin Walker is a senior asset manager serving
RAM. In a conversation with Bram Cloet, an investment officer at RAM, Walker explains the
firms policies with respect to the portfolio management process of private wealth clients.
Policy 1: Since RAM only accepts private wealth clients with a specific risk appetite, a single
investment policy template has been designed for all existing and potential clients.
Policy 2: Many of our private wealth clients have short-term investment horizons and therefore
we prefer to develop short-run expected risk-return forecasts for asset classes.
Policy 3: Capital market expectations, investment objectives and constraints are combined to
develop target asset class weights for client portfolios.
Cloet requests Walker to elaborate on Policy 3 to which the latter responds, RAM prefers to
take a multi-period perspective in its strategic asset allocation process.
Following his discussion with Cloet, Walker proceeds to evaluate the notes he has taken during
his meetings with two potential clients, Jim Young and Sasha Heeren. The notes read as follows:
Jim Young:
65 years of age
Has explicitly stated that he would like to achieve an average annual return of 30%.
Is the co-owner of a law firm
His income comfortably covers his living expenses
Any excess income is used to save towards retirement
Upon retirement, he will transfer his ownership rights to his son, who is an associate at
the firm.
Sasha Heeren:
56 years of age
Current income covers living expenses
Needs $3 million in fifteen years time to fund her sons college education
Withdraws $20,000 from her portfolio to fund her mothers medical treatment at the end
of each year
Current investable assets are worth $1.3 million.

Subject to a tax rate of 35%
RAMs institutional clients comprise a small proportion of the client base and are being managed
by Neil Jans. Jans manages the policy portfolio of Box Inc.s defined benefit pension plan using
an active management mandate employing five distinct asset classes.
Jans would like to test the basic fundamental law on RAMs portfolio given that asset class
returns are uncorrelated with each other. The expected active returns, weights, volatilities are
summarized in the exhibit below (Exhibit).
Exhibit
Active Returns, Active Weights and Volatilities
Expected Active Active Return
Asset Class Return (%) Volatility (%) Active Weight (%)
1 10 20 8
2 20 40 17
3 -8 50 - 10
4 - 12 65 - 20
5 6 14 5
Based on the data collected, Jans arrives at the following conclusions:
Conclusion 1: Assuming an information coefficient of 0.60 and uncorrelated asset class returns,
the equation specified by the fundamental law of active management will be
satisfied using the information in the exhibit.
Conclusion 2: If the pairwise correlations between the asset classes are positive, the breadth of
the investment strategy will be less than five.
55. Which of the following policies is most consistent with standard portfolio management
process logic?
A. 1
B. 2
C. 3
Correct Answer: C

Reference:
CFA Level II, Volume 6, Study Session 18, Reading 56, LOS b, c & d
Policy 3 is most consistent with portfolio management process logic as strategic asset
allocation, which determines target asset class weights, is a product of capital market
expectations and the investment policy statement; the latter discusses the investors risk
and return objectives and constraints.
Policy 1 is not consistent with portfolio management process logic. Even if clients do
meet the risk appetite criteria established by RAM and are identical in this regard, their
time horizons and other constraints may not be alike. Thus each client must have a
distinct investment policy statement which provides details regarding his/her risk and
return objectives and constraints.
Policy 2 is not consistent with portfolio management logic. When forming capital market
expectations, it is important to use long-run forecasts of risk and return characteristics for
the various asset classes as a basis for choosing portfolios that maximize expected return
for given levels of risk.
56. The most appropriate response to Cloets question is that the multi-period perspective is:
A. relatively less costly to implement.

B. a relatively simple technique to implement.
C. able to address the liquidity and tax consequences associated with portfolio
rebalancing.
Correct Answer: C
Reference:
In contrast to the single-period perspective, a multi-period perspective to strategic asset

allocation addresses the liquidity and tax concerns that arise from rebalancing portfolios
over time.
A is incorrect. This approach is costlier to implement.
B is incorrect. Relative to the single-period perspective, the multi-period perspective is a

relatively complex technique as it considers serial correlations in returns as well as the
liquidity and tax consequences of portfolio rebalancing over multiple time periods.

57. Youngs return requirement can be described as:
A. average.
B. above average.
C. below average.
Correct Answer: B
Reference:
Youngs return requirement can be described as above average. Given that he his salary
more than offsets his living expenses and he has no immediate or long-term demand for
portfolio liquidity, he can demand an above average portfolio return. His stated return
requirement of 30% is too high and he will need to be educated by his manager in this
regard.
58. The pre-tax required return on Heerens portfolio should be closest to:
A. 6.82%.
B. 8.82%.
C. 10.49%
Correct Answer: C
Reference:
To generate $3 million in fifteen years time with an annual withdrawal requirement of

$20,000, Hessen would need to earn 6.8164% per year (see below) on an after-tax basis.
N = 15; PV = - 1,300,000; PMT = 20,000; FV = 3,000,000
CPT I/Y = 6.8164%
A post-tax return of 6.8164% would correspond to a pre-tax return of 10.4868%

[6.8164%/(1 0.35)].

59. The required return derived for Box Inc. is most likely:
A. subject to an inflation adjustment.

B. dependent on workforce characteristics.
C. dependent on the stage of life of individual participants.
Correct Answer: A
Reference:
The return requirement for defined benefit pension plans is equal to the return which will
fund pension liabilities on an inflation-adjusted basis.
B is incorrect. The risk tolerance of defined benefit pension plans depends on workforce
characteristics.
C is incorrect. The return requirement of defined contribution plans depends on the stage
of life of individual participants.
60. Is Jans correct with respect to his conclusions?
A. Yes
B. Only with respect to Conclusion 1.
C. Only with respect to Conclusion 2.
Correct Answer: C
Reference:

Jans first conclusion is incorrect. According to the basic fundamental law of active
management, expected active returns is calculated as follows:
E(RA )* = IC BR A
For the basic fundamental law to hold, both sides of the equation should equal.
Given the data in the exhibit, the expected active return, E(RA)*, is calculated as follows:
E(RA)* = (10%)(0.08) + (20%)(0.17) + (- 8%)(- 0.10) + (-12%)(- 0.20) + (6%)(0.05) =

7.7%
Expected active risk (A) = [0.082 20.02 + 0.172 40.02 + (- 0.10)2(50.0)2 + (-

0.20)2(65.0)2 + (0.05)2(14)2]1/2 = 15.5978%
The right hand side of the equation is greater than the left hand side (20.927% versus
7.7%, respectively):
Right hand side: IC BR A = 0.60 5 0.155978 = 0.209266 or 20.927%.
Jans second conclusion is correct. If the asset classes were positively correlated, the
breadth of the investment strategy will be lower than the number of securities in the
portfolio; that is, the breadth will be lower than 5.

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CFA Level II Mock Exam 6 Solutions (PM)

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FinQuiz.com 6th Mock Exam 2016 (PM Session)

Questions Topic Minutes

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Questions 1 through 6 relate to Ethical and Professional Standards

Lucid Advisory (LA) Case Scenario

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A. fulfill a legal requirement.

One of the motives of implementing the CFA Institute-ROS is to provide an appropriate

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Objective 2 does not represent an objective of the CFA Institute-ROS.

Objective 3 incorrectly represents an objective of the CFA Institute-ROS. Policies and

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Questions 7 through 12 relate to Corporate Finance

Legume Inc. Case Scenario

Recommendation 2: Legumes capital budgeting department has a tendency to pitch project

Based on the data presented in Exhibits 2 and 3, the directors conclude:

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Legume Miller Grains Uta AS Limited Ilium Corp

7. The implementation of Recommendation 1 will lead to an increase in:

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8. Recommendation 2 most likely reflects the:

A. pecking order theory.

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9. The policy being proposed in Recommendation 3 will aim to reduce:

A. not pose an anti-trust challenge.

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Pre-merger HHI = (40)2+ (10)2 + (10)2 + (15)2 + (25)2 = 2,650

Post-merger HHI = (40 + 10)2 + (10)2 + (15)2 + (25)2 = 3,450

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Questions 13 through 18 relate Financial Reporting and Analysis

Widget Inc. Case Scenario

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Balance Sheet Data

A. Input data collection

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All $ figures are in millions.

2014: $54/$100 = 0.5400

Net profit margin growth including SCPs performance = 0.5400/0.4471 1 = 20.7783%

2014: ($54 $15)/$100 = 0.3900

Net profit margin growth excluding SCPs performance = 0.3900/0.3059 1 = 27.4926%

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Value of SCP holding in US$ = 12.50 50,000 1.13 = $706,250

Implied value of Widget Inc. = $1,000,000 $706,250 = $293,795

Pro rata market value = $293,795/$1,000,000 = 29.38% or 29.4%

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All $ calculations are in millions.

Reported liabilities-to-equity ratio = ($870 $400)/$400 = 1.175

Adjusted liabilities-to-equity ratio = ($870 $400 + $30)/$400 = 1.250

The absolute percentage change in the liabilities-to-equity ratio is 6.38%.

A. increase the speed of mean reversion.

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Questions 19 through 24 relate to Financial Reporting and Analysis

Delta-Mono Case Scenario

Future Obligations versus Future Benefits:

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Lease receivable 1/1/2014 = $2.60 million