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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)

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CFA Level II Mock Exam 2
June, 2016

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

FinQuiz.com – 2nd Mock Exam 2016 (AM Session)

Questions Topic Minutes


1-6 Ethical and Professional Standards 18
7-12 Quantitative Methods 18
13-18 Economics 18
19-24 Corporate Finance 18
25-36 Financial Reporting and Analysis 36
37-48 Equity Investments 36
49-54 Fixed Income 18
55-60 Derivatives 18
Total 180

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Questions 1 through 6 relate to Ethical and Professional Standards

Octagon Investments (OCTIN) Case Scenario

Pamela Santos Lopez is a portfolio manager at Octagon Investments (OCTIN), a large


money management in New York, USA. Lopez works as a research analyst at the firm
and is responsible for conducting and writing research reports on the stocks of
telecommunication firms. Lopez has been asked by her supervisor to write a report on the
stocks of two telecommunication firms: FibreOptics Inc. and BlueTech Inc. FibreOptics
Inc. is one of OCTIN’s clients and OCTIN makes a market in FibreOptics’s shares. After
reviewing the firm’s publicly available financial statements and notes to financial
statements, as well as talking to key executives at competing firms, Lopez wrote a
thorough research report about the company. Before including her recommendation,
Lopez forwarded the report to the investment banking department through the
compliance department, to view the balance sheet information provided, as well as to
identify any potential conflicts of interests. After the revisions were made, Lopez added
her recommendation and released the reports to her clients.

After releasing the report, Lopez was called for a media interview by one of her very
close friends who hosted a financial talk show on a well-known local channel. During the
interview, Lopez disclosed all information about the firm. In addition, she stated that
although her recommendation was to ‘buy’ the stock, each investor should view his or
her own circumstances before purchasing it. During the interview, Lopez did not mention
that OCTIN made a market in FibreOptics’ shares, but she disclosed this fact clearly in
the research report and also disclosed to the audience and the interviewer that the report
was available to all members of the audience at minimum cost.

Lopez had followed BlueTech Inc. for a while now, and had considerable knowledge
about the firm’s financial performance. Even so, before adding an appropriate price target
for the firm’s stock in her report, Lopez decided to contact the firm’s CEO to discuss key
information concerning BlueTech’s product and industry expansion strategy. Lopez
provided him with a copy of her report and asked to collect it the next day after he had
made the necessary additions. After receiving the report the next day, Lopez reviewed it,
revised her price target, and made the report available to her clients.

Lopez’s supervisor reviewed her research reports and assessed them for quality of
research and the adequacy of the basis for the recommendations made. As part of Lopez’s
regular performance review, her supervisor checked the accuracy of her
recommendations over time. OCTIN’s compensation policies included measurable

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

criteria, and these criteria were made available to clients and prospective clients. OCTIN
made the following extract from its compensation policy manual available to clients:

“An analyst’s compensation is not directly linked with OCTIN’s investment banking
activities on which the analyst collaborated. However, if OCTIN’s aggregate investment
banking revenues increase by more than 20% in a year, the firm’s research analysts’
compensation is increased by 3%.”

In addition to the disclosure made about its compensation policies, OCTIN also records
the following in its policy manual:

•   OCTIN enforces quiet periods of 20 calendar days from issuance for IPOs and at least
10 calendar days from the issuance for secondary offerings.
•   Restricted periods of at least 30 calendar days before and five calendar days after
report issuance are enforced.

Lopez is also covering the stock issued by Droplet Inc. (DRPI). Lopez provided a
comprehensive analysis of the firm’s current and pro-forma financial statements in her
report and included a ‘buy’ recommendation for the stock. After making the report
available to all her clients and waiting for a week, Lopez decided to re-balance her
diversified stock portfolio. To effectively achieve this objective, Lopez had to sell the
Droplet Inc. stock, which had risen in value during the current quarter.

1.   With respect to the research report on FibreOptics Inc., has Lopez most likely
violated the CFA Institute Research Objectivity Standards?

A.   No.
B.   Yes, because the investment banking department is prohibited from
modifying a research report on their own authority.
C.   Yes, communication with the investment banking department is prohibited
because OCTIN makes a market in FibreOptics’ shares and this creates a
potential conflict of interest.

Correct Answer: A

Reference:
CFA Level II, Volume 1, Study Session1, Reading 3, LOS b

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Lopez has not violated the Standards. This is because the Standards permit the
investment banking personnel to review a research report only to verity factual
information or to identify potential conflicts of interest. However, the compliance
department should act as an intermediary for all communications between the
research analyst and the investment banking department.

2.   With regards to the research report on BlueTech Inc., has Lopez most likely
violated the CFA Institute Research and Objectivity Standards?

A.   Yes.
B.   No, only if she first provides a draft report to the compliance department,
justifies the revised price target, and the compliance department approves
all changes made to the report.
C.   No, only if she provides that portion of the research report to FibreOptics
Inc. that contains factual information that can be verified by the CEO.

Correct Answer: B

Reference:
CFA Level II, Volume 1, Study Session 1, Reading 3, LOS b

Lopez has shared only those sections that contain facts that can be verified by the
firm’s CEO. If the compliance department receives a draft report, and approves all
changes made to the report that occur as a consequence of BlueTech Inc.’s
verification, Lopez will not violate any Standards.

3.   With regards to her media interview, did Lopez most likely violate the CFA
Institute Research and Objectivity Standards?

A.   Yes
B.   No, because she disclosed all facts clearly in the research report
C.   No, because she disclosed all facts clearly in the research report and made
the report available to all those who were interested

Correct Answer: A

Reference:
CFA Level II, Volume 1, Study Session 1, Reading 3, LOS b

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Covered employees who make public appearances should be prepared to make


full disclosure of all conflicts of interest, either their own or their firms’ about
which they know. Lopez should have disclosed the fact that OCTIN makes a
market in FibreOptics Inc.’s shares. By not doing so, she has violated the
Standards.

4.   With respect to research analyst compensation, is OCTIN most likely in


accordance with the CFA Institute Research and Objectivity Standards?

A.   Yes.
B.   No, because analysts’ compensation is dependent on the firm’s investment
banking revenues.
C.   No, because the disclosure made to clients and prospects is inadequate.

Correct Answer: A

Reference:
CFA Level II, Volume 1, Study Session 1, Reading 3, LOS b

OCTIN is in accordance with the standards. The firm does not directly link
analyst compensation with investment banking activities. Research analyst
compensation, in general, can be dependent upon firm’s investment banking
revenues, but firms should disclose the extent of this dependence.

5.   With regards to its policy manual, is OCTIN most likely in accordance with the
CFA Institute Research and Objectivity Standards?

A.   Yes.
B.   Only with respect to the quiet periods.
C.   Only with respect to the restricted periods.

Correct Answer: C

Reference:
CFA Level II, Volume 1, Study Session 1, Reading 3, LOS b

The Standards recommend quiet periods of 30 calendar days from issuance for
IPOs and at least 10 calendar days from issuance for secondary offerings. The
policy regarding restricted periods is in accordance with the Standards.

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

6.   With regards to her trade in the stock of Droplet Inc., has Lopez most likely
violated the Research and Objectivity Standards?

A.   No.
B.   Yes, because she traded contrary to her published recommendation.
C.   Yes, because she is prohibited to trade in a security that she covers.

Correct Answer: B

Reference:
CFA Level II, Volume 1, Study Session 1, Reading 3, LOS b

Lopez has violated the Standards by trading contrary to her published


recommendation. Although she has a legitimate reason for selling the security,
investors will be sent a mixed message that may cause concern and confusion.
Only in the case of ‘extreme financial hardship’ can an analyst trade contrary to
his/her recommendation.

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Questions 7 through 12 relate to Quantitative Methods

Quarter Investment Advisory (QIA) Case Scenario

Quarter Investment Advisory (QIA) is a medium-sized, U.S. based, money management


firm. Scott Marshall works as a quantitative analyst at the equity department of the firm
and is currently preparing for his next meeting with QIA’s largest client in terms of
revenues. In the course of selecting appropriate investments for the client, Marshall is
analyzing the results of two sets of regression analysis:

Regression 1: A linear regression with the growth in Axxo Enterprises EPS as the
dependent variable and the company’s leverage, growth in inventories and
analyst following as the independent variables.

Regression 2: A first-order autoregressive model, with the net profit margin for Beta
Enterprises as the dependent variable.

Exhibits 1 and 2 display the results of the first regression.

Exhibit 1
Linear Regression Results
Coefficient t-Statistic
Intercept 0.0678 3.02
Debt/Equity ratio 0.4851 4.55
Growth in inventories 0.2932 8.90
Analyst following 0.5500 5.23

No. of observations 79
P-value for the F-statistic 0.01

Exhibit 2
Pairwise Correlations

D/E and Growth in inventories 0.88

Growth in inventories and analyst following 0.85

Analyst following and D/E 0.98

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

After a thorough analysis of the regression estimates and results, Marshall prepared the
following points for the meeting:

“Given the significance of the t-statistics (relative to a critical t-value of almost 2.0) along
with the significance of the F-statistic, multicollinearity does not seem to be a problem in
this multiple regression. However, the high pairwise correlations among the independent
variables suggest that there is a multicollinearity problem.”

Marshall then estimated the regression with a larger sample, a greater number of
observations and only one independent variable (growth in inventories) to test for serial
correlation. With 200 observations, Marshall determined that the correlation between the
regression residuals from one period and those from the previous period equaled 0.598.
He then added the following conclusion to his presentation to be made during the
meeting:

Conclusion 1: “The OLS standard errors in this regression will most likely significantly
underestimate the true standard errors.”

Conclusion 2: “Based on my analysis, each of the two variables’ time series—the growth
in EPS time series and the growth in inventories time series—has a unit
root. However, based on the Engle-Granger Dickey-Fuller test, the two
series are cointegrated. Hence, we can use linear regression to estimate the
short-term relation between the two series.”

Marshall then proceeded with his analysis of regression 2. Exhibit 3 displays the results
of this regression.

Exhibit 3
Autoregressive Model
Coefficient t-statistic
Intercept 0.036 2.56
Lag 1 0.768 4.99
Observations 60
Autocorrelations of the Residual
Lag Autocorrelation
1 0.0783
2 0.0893
3 0.1124
4 –0.0594

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

He concluded his presentation with the following remark:

“The AR model predicts that the net profit margin will increase if it is below 15.52% and
decrease if it is above this level.”

7.   With respect to his point concerning regression 1, and a 5% significance level,


Marshall is most accurate with respect to his statement about:

A.   the significance of t-statistics and the F-statistic.


B.   the pairwise correlations.
C.   neither the significance of the regression statistics nor the pairwise
correlations.

Correct Answer: C

Reference:
CFA Level II, Volume 1, Study Session 3, Reading 10, LOS l

Multicollinearity may be a problem even when we do not observe the classic


symptom of insignificant t-statistics but a highly significant F-test. Also, very
high pairwise correlations among independent variables can indicate
multicollinearity, but is not a necessary condition. Multicollinearity may be a
problem even if correlations are low.

8.   With respect to conclusion 1 about the modified regression 1 to be presented


during the meeting, and with a 5% significance level, Marshall is most likely:

A.   correct.
B.   incorrect, because the OLS standards errors will overestimate the true
standard errors.
C.   incorrect, because the OLS standards errors might overestimate or
underestimate the true standard errors.

Correct Answer: A

Reference:
CFA Level II, Volume 1, Study Session 3, Reading 10, LOS k

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

With a large sample, the DW statistic is approximately equal to 2(1 – r). Hence,
DW statistic equals 2(1 – 0.598) = 0.804 With one independent variable and 200
observations, we can reject the null hypothesis of no correlation in favor of the
alternative hypothesis of positive serial correlation at the 0.05 significance level
because the DW statistic is far below dl (the dl for k=1 and n=100 is 1.65 and for
200 observations it would be even higher). This suggests that the OLS standard
errors will underestimate the true standard errors.

9.   With respect to Conclusion 2 about the modified Regression 1 to be presented


during the meeting, Marshall is most likely:

A.   correct.
B.   incorrect, because the regression coefficients and standard errors produced
by linear regression would be inconsistent.
C.   incorrect, because the use of error correction models rather than linear
regression models would be more suitable in this case.

Correct Answer: C

Reference:
CFA Level II, Volume 1, Study Session 3, Reading 11, LOS n

If both series have a unit root, but are cointegrated, the regression coefficients and
standard errors will be consistent and linear regression can be used. However, the
cointegrated regression estimates the long-term relation between the two series.
For measuring the short-term relation, other models, like error correction models,
should be used.

10.  At a 5% significance level, is the autoregressive model correctly specified?

A.   No.
B.   Yes, because the t-statistics are significantly different from 0.
C.   Yes, because none of the autocorrelations is significantly different from 0.

Correct Answer: C

Reference:
CFA Level II, Volume 1, Study Session 3, Reading 11, LOS e

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

For checking whether the model is correctly specified, we need to test the
autocorrelations for significance. In this case, standard error equals 1/√T = 1/√60
= 0.1291. The t-statistics for the autocorrelations is given by:

Lag 1: 0.0783/0.1291 = 0.606


Lag 2: 0.0893/0.1291 = 0.6917
Lag 3: 0.1124/0.1291 = 0.8706
Lag 4: –0.0594/0.1291 = –0.460

With 58 degrees of freedom and a 0.05 significance level, the critical value of the
t-statistic is about 2.0. None of the four autocorrelations has a t-statistic larger
than 2.0 in absolute value. Therefore, none of the autocorrelations differs
significantly from 0. The model is thus correctly specified.

11.  Assuming the model is correctly specified, Beta Enterprises’ net profit margin for
the second quarter of 2009, assuming that the net profit margin for the last quarter
of 2008 was 25%, is closest to:

A.   21.1%.
B.   22.8%.
C.   26.70%.

Correct Answer: A

Reference:
CFA Level II, Volume 1, Study Session 3, Reading 11, LOS d

Net profit margin for the first quarter of 2009: 0.036 + 0.768(0.25) = 22.8%. For
the second quarter of 2009: 0.036+0.768(0.228) = 21.11%

12.  With respect to his concluding remark, Marshall is most likely:

A.   incorrect.
B.   correct, only if the time series is covariance stationary.
C.   correct, only if the DW statistic is 2.

Correct Answer: B

Reference:
CFA Level II, Volume 1, Study Session 3, Reading 11, LOS f

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Mean reverting level: 0.036/(1-0.768) = 15.52%. All covariance-stationary time


series have a finite mean-reverting level.

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Questions 13 through 18 relate to Economics

Black-Rock Investments (BRON) Case Scenario

Carlos Ford, a portfolio manager and an exchange rate specialist, has worked with Black-
Rock Investments (BRON), a capital management firm, for the past 15 years. Ford
resigned from BRON last year and now works as a currency manager and consultant for a
number of investment firms. Last week, Ford was invited by Michael Wagle, a friend and
a financial analyst, to advise him concerning an investment made in Canadian dollars.
During their conversation, Wagle presented him with the following information:

•   C$/U.S.$ spot rate (mid-market): 0.856


•   One-year Canadian deposit rate: 4.00%
•   One-year U.S. deposit rate: 6.50%

Wagle added:
“I am not sure how the C$/US$ exchange rate will change in the future, but I would like
to generate an almost riskless profit on my one-year investment in Canadian dollars.
Would that be possible?”

After reviewing the data Wagle presented, Ford made the following comments:

Comment 1: “I expect the Canadian dollar to appreciate against the U.S. dollar over the
coming year. According to my analysis, and corroborating evidence, the
percentage change in the spot exchange rate will be 4.50%.”

Comment 2: “Given the current one-year forward points, and my own analysis, I
believe that the U.S. dollar will sell at a forward discount of 3.50%.”

In the course of their discussion on exchange rates and the effects of various factors on
their future movements, Ford made the following comments:

Statement 1: “For countries following an expansionary monetary policy along with a


fixed exchange rate policy, the actions taken by the central bank to
maintain the level of exchange rate will offset the effects of the policy.
However, in cases where countries are following an expansionary fiscal
policy, steps taken to maintain a fixed exchange rate will reinforce the
impact of the expansionary fiscal policy.”

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Statement 2: “For an emerging economy, a uniformly expansionary fiscal/monetary


policy mix will be bearish for its currency, and a uniformly restrictive
fiscal/monetary policy mix will be bullish.”

Ford then talked about the Taylor Rule used by many central banks in determining the
appropriate policy rate as a function of their neutral rate, their inflation and output targets,
and the observed deviations from those targets. Ford stated that the Taylor rule also
provided valuable insights in determining exchange rates. When he used the example of
the euro-dollar exchange rate, Wagle posed the following questions:

Question 1: “How will an increase in the inflation gap in the euro area relative to the
inflation gap in the United stated affect the U.S. dollar?”

Question 2: “How will an increase in the output gap in the euro area relative to the
output gap in the United Stated affect the U.S. dollar?

13.  Assuming Ford’s comments are accurate, Ford should most likely advice Wagle to
invest in:

A.   a fully currency-hedged Canadian money market instrument.


B.   an unhedged Canadian money market instrument.
C.   either a fully currency-hedged Canadian money market instrument or a
U.S. money market instrument.

Correct Answer: A

Reference:
CFA Level II, Volume 1, Study Session 4, Reading 13, LOS e & f

Given the interest rate differential of 2.50%, the U.S. dollar should depreciate by
2.50% relative to the Canadian dollar. However, the current forward discount is
3.50%. Hence, Ford should advice Wagle to invest in a hedged Canadian money
market instrument. This will remove all risk, and Wagle will be able to earn a
return greater than the domestic return of 6.50%.

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

14.  Assuming Ford’s comments are accurate and uncovered interest rate parity holds,
Ford should most likely advice Wagle to invest in:

A.   A fully currency-hedged Canadian money market instrument.


B.   an unhedged Canadian money market instrument.
C.   either a fully currency-hedged Canadian money market instrument or a
U.S. money market instrument.

Correct Answer: B

Reference:
CFA Level II, Volume 1, Study Session 4, Reading 13, LOS e & f

If uncovered interest rate parity holds, then the expected change in the spot
exchange rate of 4.50% will be realized (in reality, there is a range of outcomes
around this expected change). If this is the case, Wagle will be better off investing
in an unhedged Canadian money market instrument, because the Canadian dollar
will appreciate by more than is given by the interest rate differential of 2.50%
(even more than the current forward premium of 3.50%).

15.  In equilibrium, if the forward exchange rate is an unbiased predictor of the spot
exchange rate then, in one year:

A.   covered interest rate parity will hold.


B.   the percentage change in the C$/US$ spot exchange rate will be –2.5%,
and the US$ will trade at a forward discount of 2.5%.
C.   the US$ will trade at a forward discount of 2.5%, but the percentage
change in the spot exchange rate will depend on the number of risk-neutral
investors in the market.

Correct Answer: B

Reference:
CFA Level II, Volume 1, Study Session 4, Reading 13, LOS e & f

If forward rates are unbiased predictors of future spot exchange rates, then the
change in the spot exchange rate will be equal to the forward premium or
discount. The forward discount in this case is equal to the interest rate differential
of –2.50%. This is equivalent to saying that the uncovered interest rate parity will
hold.

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

16.  Ford is most accurate with respect to:

A.   Statement 1 only.
B.   both statements 1 and 2.
C.   neither Statement 1 nor Statement 2.

Correct Answer: B

Reference:
CFA Level II, Volume 1, Study Session 4, Reading 13, LOS m

Both statements are correct.

17.  The best response to Wagle’s Question 1 is that the U.S. dollar will:

A.   weaken versus the euro in real terms.


B.   strengthen versus the euro in real terms.
C.   strengthen versus the euro in nominal terms.

Correct Answer: A

Reference:
CFA Level II, Volume 1, Study Session 4, Reading 13, LOS l.

An increase in the inflation gap in the euro area relative to the output gap in the
United States will strengthen the euro versus the U.S. dollar in real terms.

18.  The best response to Wagle’s Question 2 is that the U.S. dollar will:

A.   weaken versus the euro in real terms.


B.   strengthen versus the euro in real terms.
C.   strengthen versus the euro in nominal terms.

Correct Answer: A

Reference:
CFA Level II, Volume 1, Study Session 4, Reading 13, LOS l.

An increase in the output gap in the euro area relative to the output gap in the
United States will strengthen the euro versus the U.S. dollar in real terms.

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Questions 19 through 24 relate to Corporate Finance.

Moonwalk Electronics (MWE) Case Scenario

Sam Wilton worked as a financial analyst for a capital management firm for the past ten
years. Last year, Wilton was hired by Moonwalk Electronics (MWE), a U.S. based firm
that manufactures microchips, storage devices and other hardware components of
supercomputers. Wilton joined MWE as the head of the corporate finance department.
For his first assignment, Wilton evaluates the inflation assumptions, which are used to
project cash flows for MWE’s proposed projects. Stephen Collins, a project analyst at
MWE, informs Wilton, “Our in-house economic analyst had projected inflation to equal
2.5%. However with the latest monetary policy change, inflation has risen to 3.0%. Given
that the tax system does not adjust depreciation for inflation, MWE’s project estimates
should not be significantly affected.”

Wilton conducted the analysis of the proposed with his subordinate, Mona Lawson.
During the analysis she asked Wilton of the limitations associated with capital rationing.

Next, Collins requested Wilton to evaluate a project that required an initial investment in
fixed capital of $500,000 and working capital of $50,000. The project was expected to
generate sales of $350,000 each year, for the next 5 years. 70% of the investment in fixed
capital was depreciable, depreciated straight-line to zero. Cost of goods sold was
expected to be $100,000/year over the period under analysis. At the end of year 5, the
fixed assets would be sold for $200,000. The tax rate and required return applicable to the
project are 35% and 12% respectively.

When Wilton calculated the NPV of the project, he was not sure whether his estimate
reflected reality. To enhance the accuracy of his decision, Wilton decided to re-evaluate
the project under the following two scenarios:

Scenario 1: The portion of the investment in fixed capital that is depreciable should be
depreciated using an accelerated depreciation schedule, with 35% of the
value depreciated during the first two years, and 10% thereafter.

Scenario 2: The fixed capital would be sold for $100,000 at the end of the investment
horizon.

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Collins was satisfied with the decision presented by Wilton. As another favor, Collins
presented Wilton with his own calculations for three projects that MWE had shortlisted
for investment purposes, and asked him to review them. Using MWE’s WACC for
measuring risk, Collins displayed the following results of his analysis.

Exhibit
Beta Decision
Project 1 0.8 Reject
Project 2 1.5 Accept
Project 3 1.2 Accept
*Company’s beta equals 1.2.

Collins then stated that he computed the economic income to make the accept/reject
decision for an investment in a specialized electronics equipment. Based on his analysis,
the project was feasible, and MWE should invest in the equipment. When Wilton
reviewed Collins work, he made the following comments:

Comment 1: “You should not use MWE’s WACC to discount the cash flows of the
respective projects. The project-specific required rates of returns,
calculated using project-specific betas, should be used instead. Doing so
will change your conclusions.”

Comment 2: “Economic income is based on the economic depreciation rather than


accounting depreciation. However, your approach to analyze the
investment in the equipment does not take into account the effect of
financing costs.”

19.  Is Collins correct with respect to the impact of inflation on depreciation?

A.   Yes.
B.   No, the value of depreciation tax savings will increase.
C.   No, the value of depreciation tax savings will be reduced.

Correct Answer: C

Reference:
CFA Level II, Volume 3, Study Session 8, Reading 23, LOS b

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Collins is incorrect with respect to his statement. Given that the tax system does
not adjust depreciation for inflation, an increase in the inflation rate will reduce
the value of depreciation tax savings.

20.  The least appropriate response to Lawson’s query concerning capital rationing is
that the technique:

A.   has the potential to violate market efficiency.


B.   may prohibit managers from overspending their budgets.
C.   cannot be used when a company’s capital budget is limited.

Correct Answer: C

Reference:
CFA Level II, Volume 3, Study Session 8, Reading 23, LOS c

Capital rationing is typically used when a company’s capital budget has a size
constraint, which may force the company to allocate funds amongst less profitable
projects.

Capital rationing has the potential to misallocate a society’s resources. The


technique may violate market efficiency if society’s resources are not allocated
where they will generate the best returns.

Capital rationing may be classified as either hard or soft. Under hard capital
rationing, managers cannot go beyond a fixed capital budget. On the other hand,
under soft capital rationing, managers may be allowed to over-spend their budgets
only if funds are allocated profitably.

21.  The project that Collins requested Wilton to evaluate has an NPV closest to:

A.   $256,016.
B.   $265,950.
C.   $293,870.

Correct Answer: A

Reference:
CFA Level II, Volume 3, Study Session 8, Reading 23, LOS a

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Initial outlay: 500,000+50,000 = $550,000


Depreciation each year: 500,000×0.70/5 = $70,000
Annual cash flow: (350,000 – 100,000)(1–0.35) + 0.35($70,000)
= $187,000/year for 5 years.
Terminal cash flow: 200,000 + 50,000 –0.35(200,000 –150,000) = $232,500
Discounted value: –550,000 + [$187,000 / (1.12)5] + [$232,500 / (1.12)5] =
–550,000 + 674,093 + $131,923 = $256,016

With a positive NPV, MWE should accept the project.

22.  How will reevaluating the project under Scenario 1 most likely affect the ultimate
decision?

A.   The decision will change.


B.   The decision will remain the same.
C.   The impact of the revaluation on the outcome of the project cannot be
ascertained.

Correct Answer: B

Reference:
CFA Level II, Volume 3, Study Session 8, Reading 23, LOS a

The project has a positive NPV. Shifting to an accelerated depreciation method


will increase the present value of the tax savings, and will increase the NPV.
Hence, the decision will remain the same: accept the project.

23.  How will re-evaluating the project under Scenario 2 most likely affect the ultimate
decision?

A.   The decision will change.


B.   The decision will remain the same.
C.   The impact of the revaluation on the outcome of the project cannot be
ascertained.

Correct Answer: B

Reference:
CFA Level II, Volume 3, Study Session 8, Reading 23, LOS a

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Terminal year cash flow will be:


$100,000+50,000 – 0.35(–50,000) = $167,500
This will decrease NPV by:
PV of difference: [(232,500 – 167,500)/(1 + 0.12)5]= $36,883
The NPV is still positive so the decision remains the same.

24.  Wilton is most accurate with respect to:

A.   Comment 1 only.
B.   both comments 1 and 2.
C.   neither Comment 1 nor Comment 2.

Correct Answer: C

Reference:
CFA Level II, Volume 3, Study Session 8, Reading 23, LOS e & h

Comment 1 is incorrect. The conclusions will not change. With a lower beta of
0.8, Project 1 is rejected. Using a higher beta of 1.2 will confirm our conclusion
even more. With a higher beta of 1.5, Project 1 is accepted. Using a lower beta of
1.2, will, once again, confirm our conclusion. Project 3’s beta equals the beta of
the company, so the decision will remain unchanged.

Comment 2 is incorrect. Interest expenses are ignored when computing economic


income. However, the effects of financing costs are captured in the discount rate
used to find the PV of the stream of economic income.

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Questions 25 through 30 relate to Financial Reporting and Analysis.

Smart Investments (SMIN) Case Scenario

Nicolas Brack is a stock analyst who works for Smart Investments (SMIN) a firm that
invests in the stocks of large, multinational firms. At present, Brack is working with
James Richardson, a private wealth client and a successful entrepreneur with a stock
portfolio worth $15 million. Richardson has asked Brack to invest a part of his portfolio
in the stocks of firms with high-growth prospects. Given the constraints in Richardson’s
investment policy statement, Brack short-listed the stocks of two firms as possible
investment opportunities: Click Products Inc. and Eminent Products Inc. Exhibits 1 and 2
present financial data that Brack accumulated to aid his analysis.

Exhibit 1
Click Products Inc. (US$ Millions)
31 December 2011 2010

Sales $575 $521


Revenue of Financial
$64 $52
Products
Cost of goods sold $489 $412

Net Profit $79 $71

Inventories $135 $110

Total current assets $378 $285

Total assets $650 $595


*The company is taxed at a rate of 25%.

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Exhibit 2
Click Products Inc. Selected Notes to Financial Statements

Note 5. Summary of Accounting Policies


A. Inventories
The company uses the lower of cost or market for recording inventories. Cost is
determined using the last-in, first-out method. If the FIFO method had been used,
inventories would be $59 million and $46 million higher than reported at Dec 31, 2011
and 2010 respectively.

Brack is aware that in a few years, all U.S. reporting companies are expected to fully
adopt the International Financial Reporting Standards in presenting their financial
performance. Since IFRS does not allow the LIFO method of recording inventories,
Brack decided to estimate the firm’s key financial ratios after a restatement of Click
Products Inc.’s financial statements to the FIFO method. After writing a comprehensive
report on the firm, Brack called a meeting with Richardson. During the meeting, Brack
presented the following observations:

Observation 1: Under the periodic inventory system, the amount of goods available for
sale allocated to cost of sales and ending inventory may be quite different
using the FIFO method compared to the weighted average cost method.
Under a perpetual inventory system, however, the amounts are similar.

Observation 2: Under the FIFO method, the firm’s net profit margin and gross profit
margin would be higher. However, the absolute percentage difference
relative to the margins under LIFO will be less for the net profit margin
than for the gross profit margin.

Observation 3: Relative to FIFO, the firm appears to be less profitable, less liquid, and
more highly leveraged under LIFO. Hence, the company’s value increases
after restating the financial statements to the FIFO method.

Brack then presented financial information of Eminent Products Incorporated. Exhibit 3


displays this information.

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Exhibit 3
Eminent Products Inc.
Financial Statement Information
under LIFO (as of 31 Dec 2011)
No. of units purchased 15,500
No. of units sold 17,000
Cost per unit sold $120
Sales price $250
Cost of goods sold $1,995,000

Brack concluded his meeting with the following statement:

“I believe a part of Eminent Product Inc.’s gross profit is due to LIFO liquidation. The
amount of LIFO liquidation can be estimated by calculating the decrease in the LIFO
reserve on the balance sheet. This is the amount by which cost of sales will be lower due
to LIFO liquidation.”

25.  With regards to observation 1, Brack is most accurate with respect to:

A.   the periodic inventory system only.


B.   the perpetual inventory system only.
C.   both the periodic and the perpetual inventory system.

Correct Answer: C

Reference:
CFA Level II, Volume 2, Study Session 5, Reading 16, LOS a

The observation is correct. Under a periodic inventory system, the amount of cost
of goods available for sale allocated to cost of sales and ending inventory may be
quite different using the FIFO method compared to the weighted average cost
method. Under a perpetual inventory system, the amount of allocation is similar
under the two methods.

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

26.  Is Brack most likely correct with respect to observation 2, and how does the 2011
net profit margin of Click Products Inc. compare under the LIFO and FIFO
methods?

A.   Yes, and the net profit margin under FIFO is 1.53% higher.
B.   Yes, and the net profit margin under FIFO is 2.04% higher.
C.   No, and the net profit margin under FIFO is 3.07% higher.

Correct Answer: A

Reference:
CFA Level II, Volume 2, Study Session 5, Reading 16, LOS e

The observation is correct. The absolute percentage difference is less for net profit
margin than for the gross profit margin because of income taxes on the increased
income reported under FIFO.

Net profit margin: NI/total revenue


Under LIFO: 79/575+64 = 12.36%
Under FIFO:NI: 79+13 (increase in LIFO reserve) –3.25(increase in taxes due
to reduction in COGS) = $88.75
Net profit margin: 88.75/575+64 = 13.89%

27.  Click Products Inc.’s 2011 return on assets under FIFO accounting is:

A.   0.35% lower than under LIFO accounting.


B.   0.72% higher than under LIFO accounting.
C.   0.94% higher than under LIFO accounting.

Correct Answer: B

Reference:
CFA Level II, Volume 2, Study Session 5, Reading 16, LOS e

Return on assets under LIFO: NI/average total assets: 79/(650+595/2) = 12.69%

Return on assets under FIFO: 88.75/ [(650+59 – 14.75)+(595+46 – 11.5)/2] =


13.41%

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

28.  Which of the following about Brack’s observation 3 and his comment about LIFO
liquidation is most accurate?

A.   The observation is inaccurate but the comment is accurate


B.   Both the observation and the comment are accurate
C.   Neither the observation, nor the comment is accurate

Correct Answer: C

Reference:
CFA Level II, Volume 2, Study Session 5, Reading 16, LOS e

Although the company appears to be less profitable, less liquid, and more highly
leveraged under LIFO, yet, LIFO will increase the company’s value because the
cash flows are higher in earlier years due to lower taxes.

The decrease in LIFO reserve is indicative of aLIFO liquidation but is not


sufficient to determine the exact amount of the LIFO liquidation.

29.  Click Products Inc.’s 2011 inventory turnover under FIFO is closest to:

A.   2.45.
B.   2.72.
C.   3.13.

Correct Answer: B

Reference:
CFA Level II, Volume 2, Study Session 5, Reading 16, LOS e

Inventory turnover under FIFO: COGS/avg. inventory: (489 – 13)/[(135+59


+110+46)/2]=2.72

30.  Eminent Products Inc.’s 2011 gross profit margin due to LIFO liquidation is
closest to:

A.   $45,000.
B.   $180,000.
C.   $195,000.

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Correct Answer: A

Reference:
CFA Level II, Volume 2, Study Session 5, Reading 16, LOS e

Sales = No. of units sold × Sale price


= 17,000 × $250 = $4,250,000
COGS = $1,995,000
Margin = $ 4250,000 – $1,995,000
= $2,255,000

The COGS should have been $2,040,000(17,000×120) and the gross profit should
have been = $4,250,000 – $2,040,000 = $2,210,000.

Hence, the profit due to LIFO liquidation is the difference of


= $2,255,000 – $2,210,000
= $45,000.

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Questions 31 through 36 relate Financial Reporting and Analysis

Fixen Enterprises Case Scenario

Eric Strauss is an investment analyst working for the acquisition and investment
department of Fixen Enterprises, a large firm that manufactures metallic fixtures, bolts
and spare parts used in heavy duty construction equipment. Last year, on January 1, 2009,
Fixen invested $750,000 in the debt securities issued by YLX Associates. The securities
had a 7.0% stated rate on par value, payable annually. The par value of the securities was
$715,000 and the market interest rate when the bonds were purchased was 6.0%. On 31
December 2009, the fair value of Fixen’s investment is $835,000. Strauss is assessing the
impact on Fixen’s financial statements of treating this investment as either held-to-
maturity, fair value through profit or loss (particularly held for trading) or available-for-
sale. Fixen’s analysis is based on the applicable IFRS standard(IAS 39) and US GAAP
standard as of December 2012. After a thorough analysis, Strauss formulated the
following conclusions:

Conclusion 1: Interest income reported in the income statement would be exactly the
same under all three classifications and would equal $45,000.

Conclusion 2: On 31 December 2009, the reported value on the balance sheet would be
the same whether the securities are classified as held for trading or
available-for-sale.

Strauss met with Sam Richards, Fixen’s chief executive officer, and presented his
conclusions during the meeting. After reviewing his work, Richards posed the following
question:

“If we decide to sell the securities tomorrow for $839,000, how will this gain be
recognized in our income statement?”

Strauss responded with the following statement:

“If the securities are initially classified as held-to-maturity or available-for-sale, the gain
on sale will be similar and would equal $89,000.”

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Richards added by making the following comments:

1.   Under IFRS, held-to-maturity, available for sale and held for trading investments are
all initially recognized at fair value. However, in case of held-to-maturity and
available-for-sale securities, transaction costs are included in the initial reported value
whereas, for held-for-trading securities, transaction costs are not included at initial
recognition.

2.   For foreign available-for-sale debt and equity securities, the treatment of foreign
exchange gains and losses is different under IFRS and U.S. GAAP. Whereas under
U.S. GAAP, the entire change in fair value is reported in other comprehensive
income, under IFRS, the amount attributable to foreign exchange gains or losses is
recognized in the profit and loss account.

On January 1 2009, Fixen also acquired a 25% ownership interest in Block Associates for
$7,000,000. Exhibit 1 displays information concerning Block Associates assets and
liabilities as of January 1 2009.

Exhibit 1
Block Associates
BV of current assets $2,384,000
BV of plant and equipment $16,500,000
FV of plant and equipment $18,000,000
Liabilities $5,500,000

During the year, Block reported net income of $3,000,000 and paid dividends of $90,000.
The plant and equipment are depreciated on a straight line bases and have a 20 year
remaining life.

When reviewing the performance of this investment, Richards posed the following
question to Strauss:

“If Fixen sold $50,000 of inventory to Block Associates for $110,000 during 2009, and
Block Associates resold $80,000 of this inventory during the same year, how will this
affect the equity income reported on Fixen’s 2009 income statement?”

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

31.  Strauss is most accurate with respect to:

A.   Conclusion 1 only.
B.   Conclusion 2 only.
C.   both conclusions 1 and 2.

Correct Answer: C

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

Conclusion 1 is correct. Interest income under all three classifications would be


$45,000that is the carrying value of $750,000 multiplied by the market interest
rate in effect when the bonds were purchased (6%).

Conclusion 2 is correct. On 31 December 2009, the bonds will be reported at their


fair value of $835,000 under both classifications.

32.  With respect to his response to Richards’s questions, Strauss is most likely:

A.   correct.
B.   incorrect, because the gain on sale will be similar and would equal
$94,050.
C.   incorrect, because for a held-to-maturity security the gain on sale will be
$89,000, but for an available-for-sale security, the gain on sale will be
$4,000.

Correct Answer: B

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

Carrying value: $750,000 – (interest payment-interest income) = 750,000 –


(50,050 – 45,000) = $744,950

For held-to-maturity, gain on sale is: $839,000 –carrying value = 839,000-


744,950 = $94,050

For available-for-sale, the gain on sale is: $94,050= (839,000 – 835,000) +


$90,050 (removed from other comprehensive income).

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

33.  Richards is most accurate with respect to:

A.   Comment 1 only.
B.   both comments 1 and 2.
C.   neither Comment 1 nor Comment 2.

Correct Answer: A

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

Comment 2 is incorrect. Although for foreign debt securities, this distinction is


correct, for equity securities, under IFRS and U.S. GAAP, the gain or loss that is
recognized in other comprehensive income arising from changes in fair value
includes any related foreign exchange component.

Comment 1 is correct.

34.  Under the equity method, on 31 December 2009, Fixen’s financial statements will
include an investment in Block Associates closest to:

A.   $7,708,750.
B.   $7,727,500.
C.   $8,102,500.

Correct Answer: A

Reference:
CFA Level II, Volume 2, Study Session 6, Reading 18, LOS a& c

Beginning net assets: $13,384,000


Plus: Net income: $13,384,000 + 3,000,000 = $16,384,000
Less: Dividends: $16,384,000 – 90,000 = $16,294,000 (2009 ending net assets)
Fixen’s share of recording assets (25%) = $16,294,000 × 0.25 = $4,073,500
Plus: Unamortized excess purchase price: $7,000,000 – (0.25 × $13,384,000)] –
[{0.25 × ($18,000,000 – $16,500,000)}/20] = $3,654,000 – 18,750 = $3,635,250
Investment in Block Associates: $4,073,5000 + $3,635,250 = $7,708,750

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

35.  Under the equity method, which of the following about Fixen’s investment in
Block Associates is most accurate?

A.   On 31, December 2009, the reported balance in investment in Block


Associates on Fixen’s financial statements will include goodwill of
$3,654,000
B.   If Fixen had purchased Block Associates for $3 million, the difference
between the fair value of Block Associates’ net assets and the cost of the
investment would be excluded from the carrying amount of the investment
C.   The amount of excess purchase price is systematically amortized by
reducing the carrying amount of the investment and by reducing Fixen’s
share of Block Associates’ profits

Correct Answer: B

Reference:
CFA Level II, Volume 2, Study Session 6, Reading 18, LOS a & c

Option A is incorrect. Goodwill: 7,000,000 – (25% ×13,384,000) –(1,500,000 ×


0.25)= $3,279,000

If Fixen had acquired Block Associates for $3 million, Fixen’s share of the fair
value of Block Associate’s net assets would have been greater than the cost of the
investment (negative goodwill), and the difference would have been excluded
from the carrying amount of the investment. Instead, it would be included as
income.

The amount of excess purchase price is not necessarily amortized (as is the case
with goodwill). Hence, Option C is incorrect.

36.  The best response to Richards question regarding Block Associates is that the
equity income will include unrealized profit of:

A.   $2,045.
B.   $2,727.
C.   $4,091.

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Correct Answer: C

Reference:
CFA Level II, Volume 2, Study Session 6, Reading 18, LOS c

Fixen’s profit on sale: 110,000 – 50,000 = $60,000


Block Associates sells 80,000/110,000 = 72.73% with 27.27% unsold.

Unrealized profit: 0.2727 (60,000) = $16,363.64


Fixen’s share of unrealized profit: 16,363.64 (0.25) = $4,090.91

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Questions 37 through 42 relate to Equity Investments

Stock Investments Incorporated (STIN) Case Scenario

Stock Investments Incorporated (STIN) is an equity management firm that offers stock
research, analysis and management services to its clients. Jenna Thomson is an equity
analyst at STIN who is currently updating her forward-looking valuation estimates of two
corporate entities: ABC Foods and White Enterprises. Thomson has yet to decide which
valuation model to use for the two companies. To support her decision, she gathered
some information about them, including:

ABC Foods: The firm has regularly paid dividends to its equity investors and
has been profitable since the year of initiation. The firm has
followed a fixed dividend payout policy since the past five years
even though earnings have been volatile and are expected to be for
the near future. The board of directors just announced that they
were going to adopt a fixed dividend policy from next year
onwards.

White Enterprises: The firm operates in a fast-growing sub-sector of the industry and
has no history of paying dividends. The firm is expanding
operations and is expected to have negative free cash flows for the
coming seven years, after which they are expected to turn positive.
For the same reasons, the company’s leverage is expected to
change significantly.

Thomson decided to use the dividend discount valuation model for ABC Foods, and the
free cash flow to equity model with a 15 year forecast horizon for White Enterprises to
capture the point at which expected FCFE turns positive.

Thomson is planning to purchase the stock of Glee Products Incorporated (GPI) currently
trading at a price of $150/share. The company has a forward dividend yield of 5% and a
beta of 1.34. Thomson expects the dividend yield to stay constant over time. As an
alternative to the stock investment, Thomson is considering the purchase of YLS
Enterprises stock, with a market price of $60/share. She decides to use the next year’s
announced dividend of $2.5/share, and a published beta of 0.9 for valuation purposes.
Based on her own valuations, Thomson believes that the stock is trading at a 30%
premium from intrinsic value. The risk free rate and the equity risk premium equal 4.5%
and 9% respectively.

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

STIN releases a financial journal every month that provides an industry-wise analysis of
stock investments and makes investment recommendations. Thomson has been asked to
write a research report on Chemico (CHMO) for the journal, and to present a ‘buy’, ‘sell’,
or ‘hold’ recommendation. In preparing the report, Thomson gathers the following
information about Chemico’s vitals:

•   The current dividend is $1.00.


•   Thomson expects an initial two-year growth of 15% per year in earnings and
dividends.
•   Thomson expects Chemico to grow at a rate of 8.0% as a mature company, and
expects the company to take 12 years for this transition.
•   The required rate of return is 10%.

After performing the necessary calculations, Thomson stated that the stock was
overvalued and hence, presented a ‘sell’ recommendation. Before publishing the article,
Debbie Denise, an equity portfolio manager at STIN, reviewed Thomson’s analysis.
Denise was greatly impressed by Thomson’s work and solicited her advice for her
personal stock investments. One of Denise’s investments was in the stock of UPS Inc..As
a favor to Denise, Thomson agreed to help and accumulated the following information:

•   The company has a shareholder’s equity of $5 million.


•   The company just earned a net income of $1 million and paid $200,000 in dividends.
•   The total number of shares outstanding is 50,000.
•   UPS Inc.’s beta is 1.1, the risk-free rate is 4.5% and the risk premium is 8.0%
•   Dividends are expected to grow at a constant rate.

Denise then read the report on Chemico. She made the following comment to Thomson:

“I believe that your estimate of the initial growth is too optimistic. A growth rate of 10%
is more in line with the company’s fundamentals.”

37.  Thomson’s selection of a valuation model is most appropriate for:

A.   ABC Foods.
B.   White Enterprises.
C.   neither ABC Foods nor White Enterprises.

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Correct Answer: C

Reference:
CFA Level II, Volume 4, Study Session 11, Reading 34, LOS a

The dividend discount model is not appropriate as a valuation model for ABC
Foods. Although in the past, ABC Foods has followed a fixed dividend payout
policy (which means that dividends rise and fall with earnings), from next year
onwards, the firm is adopting a fixed dividend policy. Since valuation is a
forward-looking exercise, Thomson should incorporate the effect of changes in
dividend policy going forward (with a fixed dividend, there will be no meaningful
relation between dividends and earnings) and should not use the DDM for
valuation purposes.

The FCFE model is not appropriate for White Enterprises. Even though her model
incorporates a long forecast horizon to capture the point at which expected FCFE
turns positive, the uncertainty associated with such distant forecasts will be
considerable. In such a case, Thomson should feel more confident using another
approach (maybe residual income valuation).

38.  The capital gains yield for the stock of Glee Products Incorporated is closest to:

A.   6.70%.
B.   11.56%.
C.   16.56%.

Correct Answer: B

Reference:
CFA Level II, Volume 4, Study Session 11, Reading 34, LOS c& d

Total return = Dividend yield + Capital gains yield


4.5+1.34(9) = 5+x
16.56% – 5%=capital gains yield
11.56% =capital gains yield

Remember, the growth rate use in the Gordon growth dividend discount model is
the capital gains yield.

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

39.  Which of the following about Thomson’s valuation of the YLS Enterprises stock
is most accurate?

A.   Thomson is most likely using a lower dividend yield than implied by


market prices.
B.   Thomson is using a growth rate estimate that is 1.25% lower than that
implied by market prices.
C.   Thomson is using a 1.25% higher required return estimate or a 1.25%
lower growth estimate than is implied by market prices.

Correct Answer: B

Reference:
CFA Level II, Volume 4, Study Session 11, Reading 34, LOS d

Based on the market price, we can estimate the growth rate that the market is
estimating:

r= 4.5+ 0.9(9) = 12.6%


60 = 2.5/0.126-g
g = 8.433%

Since Thomson believes that the stock is trading at a 30% premium from intrinsic
value, she expects the growth rate to be:

46.1538 = 2.5/0.126 – g
g = 7.1833%

Although a higher required return estimate used by Thomson can support her
conclusion, she is using market-based data (publicly announced dividend, and
market-based information for the required return estimate) for her calculations.
The only difference between a market-based estimate and her own estimate will
be in the estimate of growth rates.

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

40.  Which of the following about Chemico’s stock is most accurate?

A.   A two-stage DDM model is appropriate for valuation, with the first stage
representing 1.24% of total value and the second stage representing
98.76% of total value.
B.   A three-stage DDM model is appropriate for valuation, with the second
and third stage representing 97.46% of total value.
C.   A three-stage DDM model is appropriate for valuation, with the first stage
representing 1.24% of total value and the second stage representing
97.46% of total value.

Correct Answer: B

Reference:
CFA Level II, Volume 4, Study Session 11, Reading 34, LOS i & l

Value Estimate:
D1 = 1(1.15) = 1.15
D2 = 1.15(1.15) = 1.3225
V2 (using the H-model) = [1.3225(1.08)/0.10 – 0.08] + [1.3225(6)(0.15 –
0.08)/0.10 –0.08] = 99.1875

Finding their present values at 10%


D1 = 1.04545
D2 = 1.09297
V2 = 81.973

Total value = $84.11156


Stage 1 represents 2.138/84.11 = 2.54% of total value and stages 2 and 3 represent
81.973/84.111 = 97.46% of total value.

41.  Chemico stock has a value closest to:

A.   $76.66.
B.   $84.11.
C.   $87.84.

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Correct Answer: B

Reference:
CFA Level II, Volume 4, Study Session 11, Reading 34, LOS l

Value Estimate:
D1 = 1(1.15) = 1.15
D2 = 1.15(1.15) = 1.3225
V2 (using the H-model) = [1.3225(1.08)/0.10 – 0.08] + [1.3225(6)(0.15 –
0.08)/0.10 –0.08] = 99.1875

Finding their present values at 10%


D1 = 1.04545
D2 = 1.09297
V2 = 81.973

Total value = $84.11156

42.  Assuming Denise’s comment about Chemico’s stock is accurate, which of the
following will be most consistent with the revised estimate?

A.   A revised transition period of 15 years


B.   A revised initial growth stage of 1 year
C.   A revised transition period of 9 years

Correct Answer: C

Reference:
CFA Level II, Volume 4, Study Session 11, Reading 34, LOS j

Since Denise expects initial growth to be lower, a longer growth period or a


shorter transition period would be most consistent with it. This is because slower
growth companies tend to have longer growth periods and shorter transition
periods.

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Questions 43 through 48 relate to Equity Investments

Randy McCrea Case Scenario

Randy McCrea, an equity portfolio manager, is working as a consultant analyst for a


number of investment management firms. McCrea’s most recent assignment involves the
analysis of Trunol Inc. and Depinol Inc., both operating in the oil extraction and
exploration industry of the market. Due to the nature of its business, Trunol reports
considerable amortization expenses in its financial statements that are expected to
continue for some years. No other unusual expenses are reported in Trunol’s financial
statements or notes to financial statements. McCrea is using the P/E multiple to value the
company’s stock. Exhibit 1 displays information that Trunol made public as of April
2010.
Exhibit 1
Trunol EPS
Measure Full year 2009 1st Quarter of 2009 1st Quarter of 2010
Reported EPS $5.67 $1.34 $1.78
Core EPS $4.95 $1.44 $1.51
*Core EPS makes adjustments for amortization charges

Depinol Inc. operates in a specific sub-sector of the oil exploration industry. When
assessing the performance of this sector, and the firm in specific, McCrea made the
following observations:

Observation 1: P/E’s are negatively related to the recent earnings growth rate but
positively related to the anticipated future growth rate.

Observation 2: The company has seen considerable increase in its total assets over the
past five years, with liabilities increasing at a much slower rate. Depinol’s
current financial statements, however, include a large asset write-down.

In preparing a report on the valuation of the two firms, McCrea made the following
comments:

Statement 1: “Inverse price ratios are commonly used by practitioners when discussing
valuation. Although the inverse price ratio of P/S and P/CF are rarely
used, the inverse ratio of P/D is much more commonly used, especially in
discussing index valuation.”

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Statement 2: “The DDM approach supplies accurate valuations if a company pays cash
dividends. If, however, the company engages in share repurchases, the
model cannot be adjusted to account for their effect on the per-share
growth rates of dividends.”

McCrea is also valuing The In-State Corporation (ISC), a U.S. based insurance company.
McCrea knows that the P/BV multiple is appropriate for valuing financial institutions,
and hence, is planning to determine the multiple’s value for ISC. The closing price for
ISC was $56.00/share as of 31 December 2009. Exhibit 1 presents selected information
from the firm’s financial statements.

Exhibit 1
In-State Corporation ($ in millions) financial information as of Dec 31, 2009
Item Value
Common Stock, $0.01 par value, 1.0 billion shares authorized and 500
5
million issued
Additional paid-in-capital 1,052
Retained income 12,837
Treasury stock, (200 million) 10,384
Accumulated other comprehensive income 326
Total liabilities 105,293

After computing a comprehensive estimate of value, McCrea decided to meet with one of
his clients over lunch to discuss the security selection process. During lunch, the client
made the following comment:

“I am trying to use the P/E peer- group comparison approach to determine over/under
valuation of an electronics stock I own. The problem is that the peer group I selected
includes a company that has a very large multiple relative to others due to high-growth
prospects, and maybe, a little mispricing. In addition, one of the companies has a very
low multiple. I am not sure how this could affect the average, or in other words, the
benchmark that I would use.”

While advising his client, McCrea made the following comment:

“I suggest you remove the effect of outliers from the benchmark used.”

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The client then posed the following question:

“In using multiples in an investing strategy, what problems should an investor be aware
of?”

McCrea continued with a discussion of the various issues faced by investors when using
ratios in an investment setting.

43.  The trailing P/E multiple that closely reflects Trunol’s underlying earnings as of
April 2010, if the share price equals $56.78/share, is closest to:

A.   9.293.
B.   11.311.
C.   11.471.

Correct Answer: A

Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, LOS e

Since the amortization expenses are expected to continue for some years,
removing them from the EPS calculation would not reflect true value. Hence, in
this case, core EPS would not be appropriate. The EPS would be calculated as:

EPS = 5.67 – 1.34+1.78= $6.11


P/E = 56.78/6.11 = 9.293

44.  Based on the observations made by McCrea about Depinol, which of the
following will be the most appropriate EPS value to use in calculating the firm’s
P/E multiple?

A.   Historical core EPS that adjusts for the large write-down


B.   Historical average EPS, with no adjustment for the write-down
C.   EPS calculated using the average return on equity and BVPS with an
adjustment for the write-down

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Correct Answer: C

Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, LOS e

Since P/Es are negatively related to the recent earnings growth rate but positively
related to the anticipated future growth rate, Depinol is most likely a cyclical
company (reflecting the impact of rebounds in earnings). Also, since assets have
been increasing at a higher rate than liabilities, the book value per share of the
firm is most likely following a rising trend. To accurately reflect this change in
firm size, the method of average return on equity to calculate normalized EPS is
appropriate. However, an adjustment for the large write-down should be made;
otherwise current book value may not truly reflect the past rising trend.

45.  McCrea is most accurate with respect to:

A.   Statement 1 only.
B.   Statement 2 only.
C.   neither Statement 1 nor Statement 2.

Correct Answer: C

Reference:
CFA Level II, Volume 4, Study Session 11&12, Reading 34 & 36, LOSa&c

Statement 1 is incorrect. The inverse price ratio of the P/CF multiple, also called
the cash flow yield, is commonly used in evaluating securities.

Statement 2 is incorrect. The dividend discount model can be used for companies
that engage in share repurchases.

46.  The price-to-book-value per share for ISC is closest to:

A.   4.38.
B.   7.30.
C.   28.44

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Correct Answer: A

Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, LOS h

Book value = 5+1,052+12,837 – 10,384+326 = $3,836 million


Number of shares outstanding = 500 – 200 = 300 million
BVPS = 3,836/300 = $12.7867
P/BV = 56/12.7867 = 4.38

47.  If McCrea’s client that he met over lunch follows his advice, which of the
following would be the most likely consequence of doing so?

A.   The arithmetic mean would increase, the harmonic mean would decrease,
and the median may increase or decrease
B.   The arithmetic mean would decrease, the harmonic mean would increase,
but the median would remain constant
C.   The arithmetic mean and the harmonic mean would decrease, but the
median would remain constant

Correct Answer: B

Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, LOS q

The mean will most likely be biased upward because of the large outlier on the
upside. The harmonic mean tends to aggravate the impact of small outliers (those
close to zero) and hence, will most likely be biased downward. The median will
not be affected. Hence, by removing the effect of outliers, the arithmetic mean
will decrease, the harmonic mean will increase, but the median will remain
unaffected.

48.  The best response to the client’s question is that an investor should be aware of
the:

A.   look-ahead bias.
B.   screening bias.
C.   survivorship bias.

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Correct Answer: A

Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, LOS q

An issue concerning the use of ratios in an investing strategy is look-ahead bias.


Look-ahead bias is the use of information that was not contemporaneously
available in computing a quantity. This is especially true for multiples calculated
on a trailing basis.

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Questions 49 through 54 relate to Fixed Income.

Juan Dwight Case Scenario

Juan Dwight is a fixed income analyst serving a research firm. The firm has hired three
junior analysts each of which will be reporting to Dwight. During their first day at work,
Dwight conducts a training session where he aims to accomplish the following four tasks:

Task 1: Explain the forward pricing model and how the model can be used to eliminate
potential arbitrage opportunities.

Task 2: Explore the relationship between yield-to-maturities, expected rate of returns on


bonds, and spot rates.

Task 3: Evaluate the pricing of a bond based on the relationship between quoted forward
rates and expected future spot rates.

Task 4: Analyze spread measures.

For his first task, Dwight collects information on three zero-coupon investment strategies
(A, B and C) with respective prices, maturities and purchase dates (Exhibit 1).

Exhibit 1:
Details Concerning Three Zero-Coupon Securities

Purchase
Discount Maturity Date (Years
Security Factor (Years) from Today)
A 0.97087 1 0
B 0.90703 2 0
C 0.79383 3 0

For his second task, Dwight shares his observations regarding the relationship between
rates of return. His observations use data from Exhibit 1.

Observation 1: “The yield-to-maturity of each default-free issue is a reasonable estimate


of its expected rate of return.”

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Observation 2: “The yield-to-maturity of a two-year bond with an embedded call option


should equal to that quoted for security B.”

For his third task, Dwight collects expected future spot rates, forward rates and current
spot rates for three zero-coupon risk-free securities; D, E and F (Exhibit 2).

Exhibit 2:
Expected Future Spot Rates, Current Spot
Rates And Quoted Forward Rates for D, E and F
Maturity Expected Quoted
Point Future Spot Forward Current
Security (Years) Rate Rate Spot Rate
D 1 7% 9% 11%
E 2 15% 12% 7%
F 3 18% 14% 7%

The analyst concludes her analysis by analyzing the average percentage change in three
spread measures observed between the years 2005 to 2010 (Exhibit 3).

Exhibit 3:
Average Percentage Change in Spread Measures (2005 to 2010)
Spread Percentage Change
I-spread + 5.5%
TED spread + 7.8%
LIBOR-OIS spread - 6.2%

49.  In order to eliminate the potential for arbitrage profits, an investor seeking to
invest in a one-year zero coupon bond two years from today should expect a
payoff which is equivalent to that of security:

A.   A.
B.   B.
C.   C.

Correct Answer: C

Reference:
CFA Level II, Volume 5, Study Session 14, Reading 43, LOS b

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

An investor purchasing a one-year zero-coupon security two years from today


will not earn any arbitrage profits if the payoff is equivalent to a three-year zero-
coupon bond purchased at a cost of 0.79383. According to the forward pricing
model, arbitrage profits are eliminated if the two sides of the equation are in
balance:

P(T*+ T) = P(T*)F(T*, T)
P(2 + 1) = P(2) × F(2,1) or P(3) = P(2) × F(2,1)

50.  Using the information in Exhibit 1, relative to the forward yield curve the position
of the spot curve will be:

A.   lower.
B.   higher.
C.   the same.

Correct Answer: A

Reference:
CFA Level II, Volume 5, Study Session 14, Reading 43, LOS a

The discount factor, P(T), at each maturity will need to be converted into
corresponding spot rates, r(T).
1
r(T) = −1
P (T )1 / T
1
r(1) = − 1 = 3.00%
(0.97087 )1 / 1
1
r(2) = − 1 = 5.00%
(0.90703)1 2
1
r(3) = − 1 = 8.00%
(0.79383)1 3

Given that the spot rates are increasing with the passage of time, the forward yield
curve is upward sloping. An upward sloping forward yield curve implies that this
curve will be higher relative to the current (spot) yield curve.

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

51.  Dwight is least accurate regarding:

A.   Observation 1.
B.   Observation 2.
C.   both his observations.

Correct Answer: C

Reference:
CFA Level II, Volume 5, Study Session 14, Reading 43, LOS a

Dwight is incorrect with regard to both his observations. The yield curve is
steeply upward sloping as demonstrated by the discount factor declining with
maturity. Therefore, the yield-to-maturity (YTM) of the default-free issue is a
poor estimate of the expected rate of return on a bond.
The YTM of bonds with outstanding options at various maturities do not equal to
their corresponding spot rates. The YTM is related to spot rates, however, as the
yield should be some weighted average of spot rates used in the valuation of a
bond.

52.  Based on the data in Exhibit 2 and assuming projections are realized, which of the
following conclusions is most valid?

A.   Security E is undervalued.
B.   Security D is being discounted at a lower rate by the market relative to the
investor.
C.   The return on Security F will be more than the one-period risk-free interest
rate.

Correct Answer: B

Reference:
CFA Level II, Volume 5, Study Session 14, Reading 43, LOS c

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Security D is undervalued as the (realized) expected future spot rate is lower


relative to the quoted forward rate (7% vs. 9% respectively) which implies that
the market is discounting the bond’s payments at a higher rate than the investor.
Therefore, the market price is lower than the intrinsic value perceived by the
investor.

A is incorrect. Security E is overvalued as the (realized) expected future spot rate


is higher relative to the quoted forward rate (15% vs. 13% respectively) which
implies that the market is discounting the bond’s payments at a lower rate than the
investor. Therefore, the market price is higher than the intrinsic value perceived
by the investor.

C is incorrect. Since Security F’s (realized) expected future spot rate is higher
than quoted forward rate (18% vs. 14% respectively), the projected spot curve is
above the forward curve. Therefore, the return on Security F will be less than the
one-period risk-free rate.

53.  Using the data in Exhibit 2, an investor with a three year investment horizon can
realize arbitrage profits from rolling down the yield curve if:

A.   Security E is purchased.
B.   Security F is purchased.
C.   the slope of the yield curve changes to upward sloping.

Correct Answer: C

Reference:
CFA Level II, Volume 5, Study Session 14, Reading 43, LOS d

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Rolling down the yield curve will only be profitable if the yield curve is sloped
upwards and the forward curve is always above the current spot curve. When
observing the data in the exhibit, this is clearly not the case as at a maturity point
of one year, the forward rate is lower relative to the spot rate indicating the former
rate is not always higher relative to the latter rate.

A and B are incorrect. For this yield curve trade to be profitable, the trader should
buy bonds with maturities longer than the investment horizon as these would
allow the total return to exceed that of a maturity-matching strategy. A bond with
a longer maturity can be held for longer periods and allowed to appreciate in price
due to successively lower yields as it approaches maturity.

54.  Using the data in Exhibit 3, the percentage change in the TED spread indicates a
(n):

A.   increase in Treasury bill rate.


B.   increase in counterparty risk.
C.   decrease in the liquidity of money market securities

Correct Answer: B

Reference:
CFA Level II, Volume 5, Study Session 14, Reading 43, LOS h

An increase in the TED spread is a sign that lenders believe that the risk of default
on interbank loans is increasing and can be thought of as a measure of
counterparty risk.

A is incorrect. The TED spread is calculated as the difference between LIBOR


and the yield on a T-bill of matching maturity. A decrease in the Treasury bill rate
will lead to an increase in this spread measure.

C is incorrect. The LIBOR-OIS spread is an indicator of the liquidity of money


market securities.

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Questions 55 through 60 relate to Derivatives.

Neon Strategists (NEST) Case Scenario

Mark Holmes works for an investment management firm that specializes in managing
funds invested in traditional stock and bond investments. Holmes has decided to leave his
current employer to work for Neon Strategists (NEST), a firm that specializes in using
combinations of derivative investment strategies to achieve above-average returns.
Holmes is doubtful of his expertise with derivative strategies, since he had only handled
traditional asset classes at his current employer. Before joining NEST, Holmes decided to
learn more about derivatives from Peter Stephenson, a specialist in the industry. On his
first day at Stephenson’s training program, Holmes learned about put and call options.
When talking about option strategies, Stephenson stated that an option could be created
using a combination of other securities. He stated the following ways to create a synthetic
position in a stock and a bond.

Synthetic stock position: Go long a call option and short a put option with the same
exercise priceas the call. In addition, lend money by investing in a bond with a face value
equal to the exercise price of the options and that matures on the options’ expiration day.

Synthetic bond position: Purchase a put option, and sell a call option with the same
exercise price as the put. In addition, issue a zero-coupon bond maturing on the options’
expiration day, and paying an amount equal to the exercise price.

To further illustrate alternative equivalent combinations involving options, Stephenson


presented the following information about a European put and call option:

•   European put has an exercise price of $50 expires in 235 days.


•   The underlying stock is priced at $57.
•   The put sells for $2.67, and a call, with the same exercise price and time to expiration
as the put, sells for $9.25.
•   The risk free rate is 4.0%.

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Stephenson proceeded the session with an example of the stock of Runway Fashion
(RUFA), a leading fashion label in Ohio, USA. The stock was currently valued at
$150/share and it paid no dividends. The risk-free rate used in the analysis was 7.5%.
Stephenson demonstrated how to calculate the price of a European call option selling on
the stock. He stated:

“I believe that RUFA’s stock can either go up by 35% or go down by 20% during the
coming year.”

Holmes was glad that he joined the training program since he learned a lot from the
session. He was, however, still confused about the Black-Scholes-Merton Model, which
he found the most difficult to understand of all the option pricing models. When he
inquired about the interaction of the various inputs to the model, Stephenson made the
following comments about European options:

Comment 1: “Call option prices should be higher, the higher the underlying price and
the higher the risk-free rate. Put option prices, on the other hand, should be
lower, the higher the underlying price and the higher the risk-free rate.”

Comment 2: “Both put and call option prices increase with the increase in volatility and
time to expiration.”

After listening to his comments, Holmes posed the following question:

“When will a delta hedge work poorly?”

When the session was over, Holmes thanked Stephenson for his cooperation and set up
an appropriate time and day for the next session.

55.  With respect to the creation of synthetic positions, Stephenson is most accurate
with respect to:

A.   the synthetic stock position only.


B.   both the synthetic bond position and the synthetic stock position.
C.   neither the synthetic bond position nor the synthetic stock position.

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Correct Answer: A

Reference:
CFA Level II, Volume 5, Study Session 17, Reading 49, LOS a

Stephenson is correct regarding the synthetic stock position.

Stephenson is incorrect regarding the synthetic bond position; we need to invest in


a zero-coupon bond, not issue (lend) it.

56.  Based on the information provided by Stephenson about the European call and
put, which of the following is most accurate?

A.   No arbitrage opportunity exists using the European put and call options.
B.   A risk-free gain can be realized by selling the call and buying the synthetic
call.
C.   A risk-free gain can be realized by buying the call and selling the synthetic
call.

Correct Answer: C

Reference:
CFA Level II, Volume 5, Study Session 17, Reading 49, LOS a

Cost of synthetic call: 2.67 + 57 – 50/(1.04)0.6438 = $10.92

The call is underpriced. So buying the call and selling the synthetic call will yield
a risk-free profit.

57.  Given that Stephenson’s comment about RUFA’s stock is accurate, the cost ofthe
at-the-money option should be closest to:

A.   $24.42.
B.   $39.07.
C.   $94.19.

Correct Answer: A

Reference:
CFA Level II, Volume 5, Study Session 17, Reading 49, LOS b

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

S+ =150(1.35) = 202.5
S– =150(0.80) = $120
C+ =202.50 – 150 = 52.50
C– = 0

Up probability: 1.075 – 0.8/1.35 – 0.8 = 0.50


So, call option value: 0.5(52.50)/1.075 = $24.42

58.  If a European call option on RUFA’s stock is selling for $30, using 1,000 call
options, a risk-free profit of:

A.   15.50% can be earned with an investment of $65,454.


B.   $6,002.18 can be earned without any net investment of money.
C.   17.75% can be earned without any net investment of money.

Correct Answer: B

Reference:
CFA Level II, Volume 6, Study Session 17, Reading 49, LOSb

N = 52.50 – 0/202.5 – 120 = 0.6363636

Initial outlay: 636.3636(150)–1,000(30) = $65,454.54

One period later, portfolio value will be: 636.3636(202.5) – 1,000(52.50)


= $76,363.63

Or 636.3636(120) = $76,363.63

Return: ($76,363.63/$65,454.54) – 1 = 16.67%

Profit without net investment outlay: 16.67% –7.5% ($65,454.54) = $6,002.18

59.  Stephenson is most accurate with respect to:

A.   Comment 1 only.
B.   Comment 2 only.
C.   both comments 1 and 2.

Correct Answer: A

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CFA  Level  II  Mock  Exam  2  –  Solutions  (AM)  

Reference:
CFA Level II, Volume 6, Study Session 17, Reading 49, LOS d

Comment 1 is correct.

Comment 2 is incorrect. European put option prices can be either higher or lower
the longer the time to expiration.

60.  The best response to Holmes’s question is that a delta-hedge works poorly when:

A.   the option is in-the money and far from expiration.


B.   the option is out-of-money and close to expiration.
C.   there is more uncertainty about whether the option will expire in- or out-
of-money.

Correct Answer: C

Reference:
CFA Level II, Volume 6, Study Session 17, Reading 49, LOS f

A delta-hedge will work poorly when gamma is large. Gamma is larger when
there is more uncertainty about whether the option will expire in- or out-of-
money. That is, gamma will tend to be large when the option is at-the-money and
close to expiration.

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