2017 Level II Mock Exam PM

The afternoon session of the 2017 Level II Chartered Financial Analyst® Mock
Examination has 60 questions. To best simulate the exam day experience, candidates
are advised to allocate an average of 18 minutes per item set (vignette and 6 multiple
choice questions) for a total of 180 minutes (3 hours) for this session of the exam.
Questions Topic Minutes

1–6 Ethical and Professional Standards 18

7–12 Quantitative Methods 18
13–18 Economics 18
19–24 Financial Reporting and Analysis 18
25–30 Equity 18
31–36 Equity 18
37–42 Fixed Income 18
43–48 Derivatives 18
49–54 Alternative Investments 18
55–60 Portfolio Management 18
Total: 180

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© 2017 CFA Institute. All rights reserved.
 
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2017 LEVEL II MOCK EXAM PM

Amanda Austin Case Scenario

Amanda Austin is the CEO and founder of Austin Research Consultants. The firm
advises investment banks on how to establish and sustain profit-making research divi-
sions. Her latest client is a newly established investment bank, Evergreen Investment
Bank (Evergreen). As part of her consultancy assignment, she has been asked to
implement policies and procedures to help Evergreen claim compliance with the CFA
Institute Research Objectivity Standards (CFA Institute ROS). Austin subsequently
drafts an Independence and Objectivity of Research Policy and Procedures Manual.
To ensure that all staff members understand Evergreen’s new research policies and
procedures, Austin holds a training session for the group to discuss the requirements
of the CFA Institute ROS. She starts off the session describing the objectives of the
standards. “The CFA Institute ROS helps firms implement and enforce policies and
procedures to eliminate analysts’ conflicts of interest, thereby ensuring their indepen-
dence and objectivity. Adopting the standards also supports self-regulation by creating
specific, measurable, and demonstrable standards as well as by providing a favorable
work environment that supports, and encourages ethical behavior by the analysts.”
Austin continues and informs Evergreen’s staff that once the policy and procedures
manual is finalized, she will communicate its availability to all of the firm's clients and
prospective clients to assure them that the firm is acting in an ethical and professional
manner. In addition, a hard copy of the manual will be sent to all research analysts
and their supervisors to ensure the implementation of and ongoing compliance with
the policy and procedures.
Austin proceeds to talk about the specifics of the CFA Institute ROS and discusses
Standard 6.0 Relationships with Subject Companies. In her draft policy, she made the
following suggestions for implementation:
Suggestion 1 Evergreen’s analysts should not promise a subject company a
specific target price or rating.
Suggestion 2 Only factual portions of the report should be sent to the subject
company prior to publication for verification.
Suggestion 3 Material gifts or entertainment provided by the subject company
should be accepted only if allowed by the firm’s policies.
Austin continues by explaining the new personal trading policies. She states that
Evergreen requires all employees to report all of their transactions, except for those
in diversified investment companies, that are subject to trading restriction periods
of 30 days before a report issuance and 5 days after an issuance, unless significant
news has been announced. In addition, those same employees can make trades that
are contrary to the firm’s investment recommendation only when under financial
duress; however, evidence of the duress must be supplied and approved in advance
by the compliance officer.
During the question and answer session, Ted Osram, one of Evergreen’s research
analysts, says to Austin, “I am often invited to appear on investment-related televi-
sion programs to discuss my recommendations. Should I fully disclose my spouse’s
shareholding in the company I am speaking about in addition to my own? I see from
your draft policy that I need to disclose only my personal investments and trading
when making public appearances.”
Christine Shera, a research analyst, states that she would like to discuss her last
research report as it relates to the CFA Institute ROS. She continues, “I recently
issued a research report on a company that was based on a report I received from a

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sell-side analyst whom I know to be thorough and competent. I liked her ideas, so
with her permission and acknowledgement, I replicated portions of her report. The
sell-side analyst’s report was so thorough I did not have to add much to my report.
But I did add my own recommendation, risk rating, and a time frame over which I
think her target price will be met. Her report was published just two days after she
visited the company’s management, and I sent my report to our clients only one day
after I received her report, so I know the information was timely.”
1 Austin’s description of the objectives of the CFA Institute ROS is least likely
correct with regard to the impact of:
A policies and procedures.
B self-regulation.
C the firm’s work environment.
2 Does Austin's communication plan for the Independence and Objectivity of
Research Policy and Procedures Manual most likely meet the requirements of
the CFA Institute ROS?
A Yes
B No, with regard to distribution to the analysts and their supervisors
C No, with regard to the availability to clients and prospective clients
3 Which of Austin’s suggestions regarding Standard 6.0 Relationships with
Subject Companies is most likely a CFA Institute ROS requirement rather than
a recommendation?
A Suggestion 1
B Suggestion 2
C Suggestion 3
4 Which of Evergreen’s personal trading polices is most likely stricter than
required or recommended by the CFA Institute ROS Standard 7.0 Personal
Investments and Trading?
A The types of transactions that need to be reported
B Trading contrary to the firm’s recommendation
C Trading restrictions for all employees
5 What is Austin’s most appropriate response to Osram’s question with regard to
the CFA Institute ROS requirements?
A “No, you are required to fully disclose any investments of the firm or what
you own personally only when a direct conflict of interest is present.”
B “You should disclose your spouse’s interests. I will revise the policy to reflect
this requirement.”
C “You need to make a disclosure regarding your spouse’s interests only when
you are actively marketing the company you are discussing.”
6 Which of the CFA Institute ROS did Shera most likely violate by issuing her last
research report?
A Standard 8.0 Timeliness of Research Reports and Recommendations
B Standard 11.0 Rating System
C Standard 3.0 Reasonable and Adequate Basis
 
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Garfield Case Scenario

Jordan Garfield, an analyst for a firm that specializes in international equities, is investi-
gating the behavior of HighTech Inc., a technology stock. He believes its returns should
be influenced by the return on the NASDAQ index, as many analysts suggest. Garfield
collects five years of monthly returns from 2005 to 2009 for the NASDAQ index.
Garfield estimates a simple linear regression using the NASDAQ return to explain
the variation in HighTech’s return. The summary output from this analysis is shown
in Exhibit 1.

Exhibit 1 Garfield’s First Regression Model Summary Output Regression of

HighTech Returns on NASDAQ Index Returns, 2005–2009
Coefficient Standard Error p-Value

Intercept 0.001795002 0.007209589 0.804260285

NASDAQ return 1.086005661 0.130620835 0.000000000

Degrees of
ANOVA Freedom (DF) Sum of Squares (SS) Mean Square (MS)

Regression 1 0.214743645 0.214743645

Residual 58 0.180181024 0.003106569
Total 59 0.394924669
Multiple R 0.737399823
R-squared 0.543758499
Standard error of
estimate
Observations 60

Garfield presents the regression results to the investment committee with the
following three conclusions:
1 The regression intercept is statistically significant.
2 The model explains more than half of the variation in HighTech’s returns.
3 The NASDAQ index return and the HighTech return are positively correlated.
The committee asks Garfield whether he can use the model to predict the return
on HighTech’s stock. Ram Gupta, a committee member, asks:
“What would HighTech’s return be in a month when the return on the
NASDAQ index is 0.05633?”
Another committee member, Riko Samora, thinks that the simple regression model
omits important factors that might affect HighTech’s performance. Samora believes
that because more than 40% of HighTech’s customers are in Tokyo, the value of the
Japanese currency should influence HighTech’s sales and that the model’s significance
would considerably improve if Garfield considers this fact.
Following Samora’s suggestion, Garfield runs a multiple linear regression adding
the change in the JPY/USD exchange rate as a second independent variable. The results
from this regression are shown in Exhibit 2.

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Exhibit 2 Garfield’s Second Regression Model Summary Output Regression

of HighTech Returns on NASDAQ Index Returns and JPY/USD
Changes, 2005-2009
Standard
Coefficient Error t-Statistic p-Value

Intercept 0.000214 0.007127649 0.030025 0.976152

NASDAQ return 1.122096 0.130216256 8.617173 0.000000
JPY/USD change 0.2864262 0.291700144 0.981919 0.330289

Degrees of Sum of Mean Square

ANOVA Freedom (DF) Squares (SS) (MS)

Regression 2 0.224426149 0.112213075

Residual 57 0.170498519 0.002991202
Total 59 0.394924669
Multiple R 0.753840729
R-squared 0.568275844
Adjusted 0.553127628
R-squared
Standard error of 0.054691883
estimate
Durbin–Watson 2.02
(DW)
Observations 60

Garfield presents the new results to Samora, who asks him two questions:
1 Are the results of this second regression significant?
2 Do you suspect that the model has problems with multicollinearity or serial
correlation?
Garfield responds to the Samora’s questions by examining the F-, t-, and DW
statistics in the regression output to see whether they are significant.
7 The standard error of estimate of the regression model shown in Exhibit 1 is
closest to:
A 0.0031.
B 0.1802.
C 0.0557.
8 Which of Garfield’s conclusions to the investment committee about the findings
from his first model (Exhibit 1) is least likely correct? Conclusion:
A 1
B 2
C 3
9 In response to Gupta’s question about predicting HighTech’s return, Garfield’s
prediction (in decimal form) will be closest to:
A 0.06118.
B 0.04333.
 
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C 0.06297.
10 Using the results shown in Exhibit 2, the value of the F-statistic is closest to:
A 9.63.
B 37.51.
C 16.76.
11 Based on the results of the regression model shown in Exhibit 2, the best
conclusion Garfield can make about a hypothesis that the coefficient JPY/USD
change is zero is to:
A reject the alternative hypothesis.
B reject the null hypothesis.
C fail to reject the null hypothesis.
12 In preparing his response to Samora’s second question, Garfield’s most appro-
priate conclusion is that the model:
A has multicollinearity but not serial correlation.
B has serial correlation but not multicollinearity.
C does not have either multicollinearity or serial correlation.

CapFX Partners Case Scenario

Alexandra Beauregard was recently hired as an analyst at CapFX Partners, a United
States based currency trading firm that maintains offices in major financial centers
around the world. Beauregard assists CapFX foreign currency strategist Robert
Thibodeaux. The firm executes trades for clients and manages a foreign currency
investment fund. Beauregard is meeting with Thibodeaux to discuss the characteristics
of the foreign exchange markets.
Thibodeaux explains that knowing what establishes a currency’s real long-term
equilibrium value helps investors manage risk exposure.
“To better serve our clients and maximize the performance of our investment
fund we need to be able to filter out the short term noise in exchange rates
so that we can better understand their likely direction over the long term.”
He notes that the International Monetary Fund (IMF) uses a three-pronged
approach to assess the long-run equilibrium value of exchange rates.
“Of the three, I prefer the approach that is based on several economic factors
including trends in a country’s net foreign asset position and terms of trade.”
Beauregard has concerns about the firm’s experiences during currency crises.
She recalls reading a study produced by the IMF that an impending currency crisis is
signaled by numerous economic variables. She makes the following statements with
regard to some of these variables:
1 Trade balances exhibit substantial decline prior to the crisis.
2 A country has distinctive economic growth patterns ahead of the crisis.
3 Inflation is significantly higher in the pre-crisis period.
Thibodeaux notes that while fundamental-based models are useful in explaining
longer-term trends in exchange rates, they are of limited value when it comes to
explaining short-term trends. He explains:
“Technical analysis, as well as order flow, sentiment, and positioning indi-
cators have been more successful for short-term exchange rate forecasting,”

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The discussion of short-term exchange rate forecasting continues with the fol-
lowing comments:
Beauregard: “Technical analysis is not likely to benefit our emerging
market trades because the currencies are thinly traded.”
Thibodeaux: “Utilizing trend following in our carry trade strategy should
protect us from experiencing losses in a market unwind.”
Beauregard: “Monitoring market sentiment by following the trend in
risk reversals should enable us to predict and confirm cur-
rency rate movements on our trades.”

Thibodeaux and Beauregard discuss some of CapFX’s recent trades using the cur-
rency quotes and rates provided in Exhibits 1 and 2. For all currency pairs provided
the notation used is, for example: USD/AUD: US dollars per Australian dollar.
■ Based on the data in Exhibit 1, a European client recently entered into a
one-year JPY/EUR carry trade based on the projected outlook for the two
currencies.
■ A Hong Kong based client producing electronic components, signed a long-
term contract to deliver components to a Canadian aircraft parts manufacturer.
The client wanted to estimate the hedging cost for a sale scheduled to close in
nine months. Based on the data presented in Exhibit 2, the client entered into a
nine-month (270-day) HKD/CAD forward contract.

Exhibit 1 Interbank Currency Quotes and Libor Rates

Currency Bid Offer Projected Spot in One-Year Libor
Pair (Spot) (Spot) One Year Rates

USD/AUD 0.7050 0.7083 0.7148 JPY 0.15%

USD/EUR 1.0851 1.0873 1.0984 USD 0.90%
JPY/USD 117.62 117.66 118.32 EUR 1.40%
AUD 1.75%

Exhibit 2 Interbank Currency Quotes and Libor Rates

270-Day Libor
Currency Pair Bid (spot) Offer (spot) (Annualized)

HKD/CAD 5.6019 5.6037 HKD 0.50%

CAD 2.16%

13 The approach preferred by Thibodeaux to assess the long-run equilibrium value

of exchange rates is best described as the:
A reduced-form econometric model.
B macroeconomic balance approach.
C external sustainability approach.
14 Which of Beauregard’s statements regarding a currency crisis is the most
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A Statement 3
B Statement 2
C Statement 1
15 Which of the comments about short-term exchange rate forecasting is the most
accurate? The comment by:
A Beauregard regarding their emerging market trades.
B Beauregard regarding monitoring market sentiment.
C Thibodeaux regarding their carry trade strategy.
16 Based on the data in Exhibit 1, the bid EUR/AUD cross-rate implied by the
interbank market is closest to:
A 0.6497.
B 0.6484.
C 0.7650.
17 Based on the data in Exhibit 1, the expected net investment return on a one-
year carry trade based on the JPY/EUR currency pair, measured in JPY terms, is
closest to:
A 2.86%.
B 3.10%.
C 3.01%.
18 Using Exhibit 2, the mid-market forward premium (discount) for a 270-day
forward contract for HKD/CAD is closest to:
A –0.0686.
B –0.0697.
C –0.0913.

Rhine AG Case Scenario

Claus Petersen, a pension fund equity analyst, is preparing an analysis of Rhine AG
(Rhine) for the upcoming quarterly fund meeting. Rhine is a German based manu-
facturer that operates three distinct divisions: Children’s Products (infant car seats,
strollers, cribs, etc.), Recreational Products (bicycles, bicycle trailers, etc.), and Home
Furnishings (contemporary furniture). All three divisions sell through retail outlets
around the world.
The company has been pursuing an aggressive growth strategy, achieved through
both foreign acquisitions and organic growth. Petersen is interested in determining
how well Rhine is allocating its resources between the three divisions and the effects
of the foreign acquisitions on overall performance. Exhibit 1 summarizes selected
divisional and corporate data for 2013 and 2012.

Exhibit 1 Rhine AG Selected Divisional and Corporate Data (in € millions)

Recreational
Total for 3 divisions Children’s Products Products Home Furnishings
2013 2012 2013 2012 2013 2012 2013 2012

Revenues 2,837.1 2,775.5 1,176.2 1,236.2 1,034.1 930.0 626.8 609.3

Gross profit 621.4 640.8 296.6 337.6 246.0 220.3 78.8 82.9
Operating profit 172.7 219.4 64.7 115.7 72.9 62.2 35.1 41.5

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Exhibit 1 (Continued)

Recreational
Total for 3 divisions Children’s Products Products Home Furnishings
2013 2012 2013 2012 2013 2012 2013 2012
Earnings before 136.6 170.0
taxes
Net earnings after 109.9 132.3
tax
Total Assets 2,498.0 2,479.5 1,270.9 1,249.6 961.5 948.5 265.6 281.4
Capital 32.7 42.3 22.1 30.0 6.7 8.6 3.9 3.7
expenditures
Proportion 100% 100% 67.6% 70.9% 20.5% 20.3% 11.9% 8.7%
of Capital
expenditures
Proportion of Total 100% 100% 50.9% 50.4% 38.5% 38.3% 10.6% 11.3%
assets

Petersen’s preferred method to determine which division is becoming less significant

over time is to review the relationship between capital expenditures and total assets
by operating division. He plans to base his conclusion on the assumption that 2013’s
investment behavior is representative of future investment patterns.
Petersen knows that revenues in the Children’s Products division have suffered
due to declining birth rates in Europe and North America, but believes if Rhine can
maintain the operating margin for this division that overall company profitability
shouldn’t be affected.
Corinna Berg, another analyst with the fund reminds Petersen that during 2013
the US dollar weakened against the Euro by 4% and that 50% of the sales in the
Recreational Products division are sold in the United States.
Petersen recalls that some of the recent global expansion was aimed at establish-
ing operations in Ireland, because its statutory corporate tax rate is lower than the
German rate of 29.8%. If Petersen assumes that other tax credits were the same in
2013 as 2012, he can analyze changes in Rhine’s effective tax rate to determine if the
geographic mix of the company’s profits has changed in 2013.
Petersen finally examines the company’s liquidity ratios (Exhibit 2). Even though
the company’s current and quick ratio have improved, his interpretation of the changes
in the company’s cash conversion cycle is that the company’s liquidity position has
deteriorated.

Exhibit 2 Rhine AG Selected Ratios

Ratio 2013 2012 2011

Current ratio 2.31 2.17 1.16

Quick ratio 1.06 0.89 0.53
Accounts receivable turnover 5.82 6.08 6.11
Inventory turnover 3.78 3.91 4.09
Accounts payable turnover 5.71 5.78 5.60
Cash Conversion Cycle 95 days 90 days 84 days
 
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Worried that the balance-sheet-based and cash-flow based accruals ratios (not
shown) raise some concerns about the possible use of accruals to manage earnings,
Petersen asks Berg, for advice on what further type of analysis he should do as a
follow-up on this issue.
19 Using Petersen's preferred method and 2013 divisional data, the best conclusion
Peterson can make about which division will potentially become less significant
in the future is that it will be:
A home furnishings.
B recreational products.
C children's products.
20 If the children's products division had been able to maintain its 2012 operating
margin in 2013, the company’s overall operating margin in 2013, compared to
2012, would have been:
A higher.
B the same.
C lower.
21 Which of the following is the most appropriate use of Berg’s reminder about the
US versus euro exchange rate in 2013? Peterson should use the information:
A to determine the exchange gains or losses included in net income.
B to confirm that the division's organic growth was less than 11.2%.
C when evaluating management's historical performance.
22 The best conclusion Petersen can make about the geographic mix of Rhine’s
profit in 2013 is that compared with 2012 the mix is:
A more international.
B about the same.
C more domestic.
23 Compared with 2011, the change in which working capital account most likely
had the largest effect on Petersen’s observed deterioration in liquidity?
A Accounts payable
B Accounts receivable
C Inventory
24 Berg’s best answer to Petersen’s question about further analysis is that he should
conduct a:
A Cash flow ratio analysis.
B DuPont analysis.
C Discounted cash flow analysis.

Chan Mei Yee Scenario

Chan Mei Yee is valuing McLaughlin Corporation common shares using a free cash
flow approach. Yee assembled information about McLaughlin from several sources.
She begins her analysis by determining free cash flow to the firm (FCFF) and free
cash flow to equity (FCFE) for the 2012 fiscal year, using the financial statements in
Exhibits 1 and 2. McLaughlin’s fiscal year ends 31 December.

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Exhibit 1 McLaughlin Corporation Selected Financial Data (in millions,

except per share amounts)
For Year Ending 31 December 2012

Revenues $6,456
Earnings before interest, taxes, depreciation, and amortization 1,349
(EBITDA)
Depreciation expense 243
Operating income 1,106
Interest expense 186
Pretax income 920
Income tax (32%) 294
Net income $626

Number of outstanding shares (millions) 411

2012 Earnings per share $1.52
2012 Dividends paid (millions) $148
2012 Dividends per share $0.36
2012 Fixed capital investment (millions) $535

Cost of equity 12.0%

Weighted average cost of capital 9.0%

Exhibit 2 McLaughlin Corporation Consolidated Balance Sheets (in

millions)
as at 31 December
2012 2011

Assets
Cash and cash equivalents $32 $21
Accounts receivable 413 417
Inventories 709 638
Other current assets 136 123
Total current assets 1,290 1,199

Current liabilities $2,783 $2,678

Long-term debt 2,249 2,449
Common stockholders’ equity 1,072 594
Total liabilities and stockholders’ equity $6,104 $5,721

Yee plans to perform two different valuations of McLaughlin, which she calls the
“base case” valuation and the “alternative” valuation. Critical assumptions for each
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Base case valuation

■ 2013 FCFF will be $600 million.

■ Beyond 2013, FCFF will grow in perpetuity at 4 percent annually.
■ The market value and book value of McLaughlin’s long-term debt are approxi-
mately equal.

Alternative valuation

■ 2013 earnings per share (EPS) will be $1.80.

■ EPS will grow forever at 6 percent annually.
■ For 2013 and beyond:
● Net capital expenditures (fixed capital expenditures minus depreciation) will
be 30 percent of EPS.
● Investments in working capital will be 10 percent of EPS.
● 60 percent of future investments will be financed with equity and 40 percent
will be financed with debt.
Yee is also concerned about the effects on McLaughlin’s 2013 FCFE of the following
three possible financial actions by McLaughlin during the year 2013.
■ Increasing common stock cash dividends by $110 million.
■ Repurchasing $60 million of common shares.
■ Reducing its outstanding long-term debt by $100 million.
Melissa Nicosia, Yee’s supervisor, reviews McLaughlin’s valuations. Specifically,
Nicosia makes the following three statements:
1 The free cash flow valuation approach is superior to the discounted dividend
valuation approach because the company’s dividends have been substantially
different from its FCFE.
2 Because the company’s capital structure seems unstable, the FCFE valuation
approach is superior to the FCFF valuation approach.
3 If there is a change in control at McLaughlin, the discounted dividend valuation
approach would be superior to a free cash flow valuation approach.

25 McLaughlin’s FCFF ($ millions) for 2012 is closest to:

A $418.
B $485.
C $460.
26 Assuming 2012 FCFF equals $500 million, McLaughlin’s FCFE ($ millions) for
2012 is closest to:
A $574.
B $174.
C $114.
27 Using Yee’s base case valuation assumptions and the FCFF valuation approach,
the year-end 2012 value per share of McLaughlin common stock is closest to:
A $29.20.
B $12.78.
C $23.73.

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28 Using Yee’s alternative valuation assumptions and the FCFE valuation approach,
the year-end 2012 value per share of McLaughlin’s common stock is closest to:
A $24.17.
B $18.00.
C $22.80.
29 The most likely combined effect of the three possible financial actions identified
by Yee will reduce McLaughlin’s 2013 FCFE ($ millions) by:
A $100.
B $270.
C $160.
30 Which of Nicosia’s three statements pertaining to McLaughlin’s valuation is the
most accurate? Statement:
A 2
B 3
C 1

Mary Barton Case Scenario

Mary Barton is a junior equity analyst for an investment company. She is currently
working on two of their funds; a large US-based equity fund and a smaller private
equity fund.
The large US-based fund uses discount models to estimate the value of stock
prices. For this fund, a difference in price of one dollar or more between the market
and estimated prices indicates that the shares are mispriced for the fund’s investment
purposes. The fund is allowed to take either long or short positions in those identified
as misvalued. Barton’s manager, George Eckhart, asks her to evaluate the stocks of
two companies for possible inclusion in that fund: XRail Company (XRL) and Z-Tarp
Limited (ZTL), (see Exhibit 1).

Exhibit 1 Selected Stock Data for XRL and ZTL and Additional Market
Information
XRL ZTL
EPS ($) DPS ($) EPS ($) DPS ($)

2015 3.15 1.77 5.62 2.53

2014 3.08 1.52 4.98 2.24
2013 2.99 1.36 4.73 2.13
2012 2.77 1.21 4.50 2.02
2011 2.52 0.90 4.20 1.89

Current market price $77.23 $93.05

Return on assets 27.4% 25.8%
Return on common equity 31.6% 32.8%
Beta 0.94 1.20
Required rate of return on 8.84% 10.48%
common equity

(continued)
 
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Exhibit 1 (Continued)

Additional information:

Risk-free rate 2.94%

Equity risk premium for common shares 6.28%
US economy real growth rate 3.70%
US inflation rate 2.00%

Note: DPS is dividends per share and EPS is earnings per share

Barton begins her analysis by looking at XRL. After doing some research, she con-
cludes that a reasonable growth estimate for the company is the sustainable growth
rate using the most recent year’s retention ratio, and calculates a price for XRL using
this information. She makes the following note:
■ it will not be possible to use the Gordon growth model for her analysis of XRL.
Barton and Eckhart discuss the impact of a company’s growth rate on its future
stock price. Barton determines XRL’s growth rate of earnings for the period from 2011
to 2015 and compares it to the current nominal growth rate of the US economy. She
concludes that XRL is likely to be in the transition stage of growth.
Next Eckhart asks Barton to calculate the intrinsic value of ZTL shares using the
Gordon model to determine if it meets the fund’s investment objectives. He suggests
that rather than using the sustainable growth rate, she should use the growth rate of
dividends over the past five years.
Eckhart tells Barton that he has heard rumors that ZTL is contemplating selling
one of its major manufacturing facilities. He believes that if that should happen, the
company would pay a series of special dividends in each of the three years following
the sale. Barton asks him how she could best incorporate such a possibility into the
valuation of the shares.
Turning to the private equity fund, Eckhart informs Barton that the fund is
considering buying a controlling interest in a closely held company, H-Tron (HTR),
which pays infrequent dividends that are well below the free cash flow from equity.
HTR has healthy cash flows with significant growth potential and holds patents on a
key innovation in electronics technology. Eckhart believes the value of these patents
is not fully reflected in HTR’s balance sheet. He asks her how HTR’s common equity
should be valued given these circumstances. Barton states that she will assess which
valuation method will be the most suitable.
Finally, Eckhart asks Barton to value HTR’s non-callable perpetual preferred stock
as a potential investment for the fund. The stock, currently privately held, pays a fixed
annual dividend of $7.50. After performing some industry analysis, Barton decides to
use an equity risk premium of 6% in valuing the stock.
31 Using the data in Exhibit 1, Barton’s note about the use of the Gordon growth
model to value XRL is most likely:
A correct because the required return on equity is less than the expected
growth rate.
B incorrect because the sustainable growth rate is greater than the US econo-
my’s growth rate.
C incorrect because the required return on equity is greater than the US econ-
omy’s growth rate.
32 Barton's conclusion that XRL is in the transition phase is best described as:

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A correct.
B incorrect, because the company is in the supernormal growth phase.
C incorrect, because the company is in the mature phase.
33 Using the data in Exhibit 1 and following Eckhart’s suggestions regarding the
valuation of ZTL, the most appropriate conclusion that Barton should make
about the ZTL shares is that the fund should:
A take a long position in ZTL.
B not add ZTL to the portfolio.
C take a short position in ZTL.
34 Eckhart’s best response to Barton’s question about the valuation of ZTL consid-
ering the potential sale of its manufacturing facility would be to use:
A the H-model to reflect the change in dividends.
B the Gordon growth model to incorporate the decrease in firm value after the
sale.
C a spreadsheet model that incorporates the special dividends.
35 Based on the information Eckhart provides to Barton about HTR, the most suit-
able method for her to use in determining the fair value of its common equity is
to discount future:
A forecasted future dividends.
B free cash flow to equity.
C residual income.
36 Barton’s estimate of the fair value for HTR’s preferred stock is closest to:
A $125.
B $84.
C $81.

Desna Securities Case Scenario

Susan Fujioka, a fixed-income portfolio manager at Desna Securities hires Ahti
Maalouf, an independent contractor who is an expert in fixed income valuation.
Fujioka provides him with copies of the spreadsheets she currently uses for valuation.
She asks him to help her build models that will allow her to more accurately identify
mispriced securities.
At their first meeting, Maalouf notes Fujioka currently values option-free bonds
by discounting their future expected cash flows using the zero-coupon yield curve. He
asks her why she hasn’t adopted the more flexible binomial interest rate tree frame-
work. She replies, “My approach will calculate the same values for option-free bonds
as those produced by a properly calibrated binomial tree. Further, it would require
special programming techniques to calibrate a binomial tree to match benchmark
risk-free bond prices, making implementation of that approach quite costly.”
Maalouf explains, “Valuation using a binomial interest rate tree is based on the
principle of no arbitrage. In order for there to be no arbitrage in a financial market,
three conditions must be met:”
Condition 1: If the risk of any security is higher than that of another, its
expected return must also be higher.
Condition 2: The price of any two risk-free securities with the same timing and
amount of payoffs must be the same.
Condition 3: The price of any portfolio of securities must equal the sum of the
prices of the individual securities in the portfolio.
 
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Maalouf provides Fujioka the zero-coupon yield curve in Exhibit 1 and asks her to
use her current approach to calculate the arbitrage-free value of an option-free, fixed-
rate, 4-year bond with a 3.5% coupon rate, annual payments, and a face value of 100.

Exhibit 1 Zero-Coupon Yield Curve

Maturity Yield

1 2.15%
2 3.45%
3 4.01%
4 4.40%

Using a different set of benchmark bond values, Maalouf constructs the calibrated
binomial interest rate tree shown in Exhibit 2. He shows Fujioka how to value a 3-year
option-free, fixed-rate bond with a 2.8% coupon rate, annual payments, and a face
value of 100 using this interest rate tree.

Exhibit 2 Calibrated Binomial Interest Rate Tree

Today Year 1 Year 2 Year 3

6.76%
4.56%

2.85% 5.11%

1.50% 3.45%

2.16% 3.86%

2.60%

2.92%

Maalouf explains, “An alternative to the calculations I just showed you is path-wise
valuation. In this variation, you would determine all of the possible paths interest
rates could take in our binomial tree and value the bond along each path. The value
of the bond is then calculated as the average of the values across all paths. For the
4-year bond you evaluated earlier, you would need to calculate its value for 24 or 16
different paths.”
Fujioka tells Maalouf that she has been reading about the use of Monte Carlo
forward-rate simulation for fixed income valuation. She asks Maalouf to further
explain this approach to her. Maalouf replies, “The Monte Carlo approach is quite
different from the binomial tree approach I’ve been describing to you. Some of these
differences include:”
Difference 1: The Monte Carlo approach does not require calibration, whereas
the binomial tree approach does.
Difference 2: The Monte Carlo approach is typically employed when cash
flows are path dependent, whereas the binomial tree approach only allows one
expected cash flow per node, regardless of the path of interest rates.

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Difference 3: The Monte Carlo approach randomly simulates a fixed number of

interest rate paths and values the security only across those paths, whereas the
binomial tree approach values the security across all possible interest rate paths
on the tree.

37 Is Fujioka most likely correct when comparing her approach to valuation with
the binomial interest rate tree framework?
A No, the values estimated by the two approaches will likely be different
B Yes
C No, she is incorrect regarding calibration of interest rate trees
38 Of the three conditions Maalouf claims are necessary for a market to be arbi-
trage free, he is least likely correct regarding:
A Condition 1.
B Condition 3.
C Condition 2.
39 The value Fujioka calculates for the four-year bond is closest to:
A 98.149.
B 96.764.
C 96.931.
40 The value Maalouf estimates for the three-year bond using the binomial tree in
Exhibit 2 is closest to:
A 100.623
B 100.908
C 103.708
41 Is Maalouf most likely correct in his description of path-wise valuation?
A No, the values on each path are weighted by their probability of occurrence
B Yes
C No, he is incorrect regarding the number of paths needed to value the four-
year bond
42 Of the three differences Maalouf describes between the binomial tree approach
to fixed-income valuation and the Monte Carlo simulation approach, he is least
likely correct regarding:
A Difference 3.
B Difference 2.
C Difference 1.

Messer Case Scenario

Athena Advisors Inc. offers portfolio replication services to pension funds and insurance
companies through the use of options. Clients are typically able to replicate market
exposures with smaller than normal investments of funds. Athena manages exposures
for its client, Wertfin Insurance Company, related to annuities indexed to the German
Blue Chip Equity Index. Athena portfolio manager Hannes Messer is meeting with
Wertfin’s risk manager Jens Szillat, who has asked to learn more about the principles
behind the option strategies being employed.
Szillat tells Messer, “I am somewhat familiar with option valuation models, however,
I would like to learn more about Athena’s methodologies with respect to the index
options you are managing for our portfolio.”
 
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Messer replies, “The binomial valuation model can be applied to the 2-year
European style index call options we purchased one year ago. The applicable underlying
instrument is the German Blue Chip Equity price index, which excludes dividends.
Exhibit 1 shows the option’s characteristics at the time of purchase.”

Exhibit 1 Binomial Model Variables

u 1.15
d 0.90
π 0.52
Index price EUR 720
Strike price EUR 750
Hedge ratio 0.5697
1-Year Interest rate 3%
S– 648
c– 0

Messer explains, “Of course, with the index moving down 10% in the last twelve
months, the payoffs with these options could have been replicated without using
options.” Szillat responds, “My understanding is that the payoff would have been the
same as the call option if you had purchased 0.5697 index units and lent EUR 356.79
at the 1-year interest rate.”
Messer continues, “Twelve months ago, I noted that 2-year puts with a strike price
of EUR 750 cost EUR 38.48. Using the information in Exhibit 1 and today’s index value,
the binomial valuation model calculates the current price of the put as EUR 80.15. It
is actually trading now above that price at EUR 92.
Szillat responds, “I am curious whether you also use the Black–Scholes–Merton
(BSM) model for valuation. I understand the BSM and binomial models both have
the following three assumptions in common:
Assumption 1 Trading is possible at every instant.
Assumption 2 Volatility can be predicted with certainty.
Assumption 3 The annualized returns on the underlying follow a normal
distribution.
Szillat then asks, “How do you utilize the BSM model?”
Messer answers, “We use the BSM model to calculate estimates on a wide array
of comparative option variables, such as how much the option value will change for
a change in a particular parameter. For example, we can estimate how the rate of
change of an option price speeds up or slows down for a given change in the price of
the underlying index.”
Messer concludes, “We also use the BSM model to calculate the implied volatility.
The implied volatilities of the index options expiring in one year are shown in Exhibit 2.”

Exhibit 2 Implied Volatility Curve

Strike Price Implied Volatility

700 18.71
710 17.98
720 17.38

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Exhibit 2 (Continued)

Strike Price Implied Volatility

730 16.69
740 15.83
750 15.40
760 14.50
770 14.03
780 13.21
790 12.11
800 11.09

43 Using the binomial valuation method and the data in Exhibit 1, the price
Messer paid one year ago for the call option with a strike price of EUR750 is
closest to:
A EUR 51.54.
B EUR 47.57.
C EUR 102.08.
44 With respect to his assessment of replicating the option payoff, Szillat is least
likely correct about:
A lending EUR 356.79.
B using the one-year interest rate.
C purchasing 0.5697 index units.
45 Does the put option with a strike price of EUR 750 currently offer an arbitrage
opportunity?
A No, because the market has bid up the price of the put.
B No, because the put is deep in the money.
C Yes.
46 Which of Szillat’s assumptions is least consistent with the BSM model?
A Assumption 2
B Assumption 3
C Assumption 1
47 In describing how call option prices change, Messer is most likely referring to:
A delta.
B vega.
C gamma.
48 Which of the following would Messer most likely conclude from the implied
volatility data in Exhibit 2, if he excludes the effects of moneyness and time to
expiration?
A Using out-of-the-money options to hedge is more expensive than establish-
ing a long position with out-of-the-money options.
B Using out-of-the-money options to establish a long position is more expen-
sive than establishing a short position using out-of-the-money options.
C Using out-of-the-money options to establish either long or short positions is
more expensive than using at-the-money options.
 
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Wabash Case Scenario

Wabash Trading Advisors is a commodities trading and advisory firm with particular
emphasis in the grains and livestock markets. Their clients include major food com-
panies, financial institutions, and trading companies.
Tomas Gorski recently joined Wabash as a commodity analyst after several years
with another firm as an equity analyst. He meets with a senior commodity analyst at
Wabash, Pilar Moreno. She asks Gorski, “What differences are there between valuing
commodities and valuing equities? In response, Gorski makes the following statements:
Statement 1 Commodity valuation focuses on supply and demand, while
equity valuation focuses on discounted cash flows.
Statement 2 Commodities do not generate future cash flows beyond what can
be realized through their purchase and sale.
Statement 3 Equities and commodities are both considered financial assets.
Moreno explains to Gorski that Wabash does not participate in all of the commodity
sectors. We have intentionally chosen to avoid base metals, precious metals, and energy.
Gorski responds, “It makes sense to concentrate on commodities that have similar
characteristics. Even though metals and energy may require storage, they are non-
perishable and are not affected by weather. Livestock is perishable and can only be
stored for a very short period while grain can be stored longer.”
Moreno describes how some of Wabash’s clients hedge positions for critical com-
modities used in manufacturing. To illustrate, she shows Gorski data for a position
taken on behalf of Platte River Foods. The position is now close to expiration.

Exhibit 1 Platte River Foods

Initial Risk- Contract Price

Price Roll Collateral Free Longer
Return Return Required Rate Position Size Current Term

4% 1.50% 20% 1% $1,500,000 $750 $500

Moreno continues, “One of Wabash’s oldest clients, Fond du Lac, has been in
business for over 100 years and has developed sophisticated pricing models. Currently
their models predict that the price of corn is poised to more than double in the next
six months. Fond du Lac has purchased a large amount of corn in the spot market
and has taken delivery at its storage facilities. When the price increase occurs, they
intend to sell the corn in the spot market.”
Moreno asks Gorski to help her prepare a market overview to include in all client
presentations. Gorski collects the spot and futures prices of three commodities.

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Exhibit 2 Spot and Futures Prices

Corn Live Cattle Lean Hogs

Spot Price $369.25 $136.00 $81.23

3-Month Contract $372.50 $132.00 $83.41
6-Month Contract $378.75 $123.03 $78.92

49 Which of Gorski’s statements about the differences in the valuation of equities

and commodities is least likely correct?
A Statement 2
B Statement 1
C Statement 3
50 Gorski’s response to Moreno regarding metals, energy, livestock, and grains is
least likely correct with respect to:
A perishability.
B weather.
C storage.
51 The total return for the Platte River Foods hedge position is closest to:
A 5.5%.
B 5.7%.
V 5.3%.
52 In order to roll forward Platte River Foods’s current exposure and maintain its
dollar value, Moreno would:
A buy 2,000 near-term contracts and sell 3,000 of the longer-term contracts.
B sell 2,000 near-term contracts and buy 2,000 of the longer-term contracts.
C sell 2,000 near-term contracts and buy 3,000 of the longer-term contracts.
53 Fond du Lac would most likely be acting as a(n):
A speculator.
B arbitrageur.
C informed investor.
54 Based on the information presented in Exhibit 2, the commodity most likely in
contango is:
A lean hogs.
B live cattle.
C corn.

Citadel Case Scenario

Citadel Investment Partners is a global asset management firm offering a wide variety
of mutual funds to both institutional and individual investors. Simon Alexander is the
Chief Risk Officer at Citadel. He is responsible for risk oversight across the firm’s many
strategies, as well as communicating any risk issues with the portfolio management,
compliance, and executive teams. Alexander oversees a team of six analysts who are
responsible for the ongoing calculation and assessment of portfolio risk. Citadel uses
a variety of methods when estimating risk including value at risk (VaR), sensitivity
risk measures, and scenario risk measures.
 
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Jennifer Woolridge is a newly hired risk analyst, and Alexander is familiarizing

her with how the firm measures portfolio risk. In a conversation with Woolridge,
Alexander asks her what she has learned regarding the advantages of using VaR as a
risk management tool. Woolridge responds, “The advantages of VaR are: (1) it can be
used for performance evaluation, (2) it provides an estimate of downside exposure
during a worst-case scenario, and (3) it avoids subjectivity.”
Later that day, Woolridge receives an e-mail from Alexander asking her to estimate
the dollar VaR at the 5% level for the firm’s developing market equity fund. Woolridge
estimates VaR using the parametric method (assuming normal distribution) with the
following inputs:

Exhibit 1 Data for Developing Market Equity Fund

Portfolio Value $500 million
Daily Expected Return 0.04%
Daily Expected Volatility 1.30%

Alexander then asks Jun Lee, a senior risk analyst in the group, to explain to
Woolridge how Citadel employs scenario risk measures. Lee explains, “Scenario anal-
ysis complements VaR because it can better account for market liquidity. However,
a limitation of scenario analysis is that it has a greater reliance on historical market
data than does VaR.”
Lee then explains how the risk exposures of option positions may increase or
decrease overall portfolio risk. Lee and Woolridge discuss delta, gamma, and vega
as option sensitivity measures. Woolridge summarizes what she has learned to make
sure she has understood correctly: “Delta measures the sensitivity of an option to the
price of the underlying security and ranges from –0.5 to +0.5. Gamma is a second-
order effect that measures the sensitivity of delta to price changes in the underlying.
Vega is a first-order effect that measures the change in the volatility of an option to
the change in price of the underlying.”
Alexander receives a call from Sandra Patterson, Citadel’s CEO. Patterson expresses
her concern that the firm’s $500 million multi-asset fund has failed to protect investors
during a recent market decline. Alexander drafts an updated risk management policy
to present to the investment committee. The goal of this policy is to ensure that the
fund limits the likelihood of severe downside losses for investors.
“The multi-asset fund has a 5-day, 1% VaR limit of $10 million, and the fund
will undertake hedging activities, including the purchase of protective put
options, if its cumulative 30-day loss ever exceeds $15 million. In addition,
the magnitude of the hedge shall be designed to increase as losses increase.”
Following the investment committee’s approval, Patterson references the updated
risk management policy in her quarterly letter to investors. She states: “At Citadel, we
take risk management very seriously. In response to recent investor concerns about
volatility in our multi-asset fund, we have implemented a new policy. We limit fund
losses to 2% of assets with a 99% level of confidence, with additional measures to limit
total losses to 3% over a rolling 30-day period.”
55 Woolridge’s comments on the advantages of VaR are most likely correct
regarding:
A downside exposure.
B performance evaluation.
C subjectivity.

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56 Using the inputs in Exhibit 1, Woolridge’s estimate of VaR is most likely closest
to:
A $6.5 million.
B $18.9 million.
C $10.5 million.
57 Are Lee’s comments regarding scenario analysis most likely correct?
A No, with regard to market liquidity
B No, with regard to historical data
C Yes
58 Which option sensitivity measure does Woolridge most accurately describe?
A Vega
B Delta
C Gamma
59 Alexander’s risk management policy for the multi-asset fund is least likely an
example of:
A stop-loss limits.
B risk budgeting.
C scenario limits.
60 Patterson’s comments to Citadel’s investors are least likely accurate with regard
to her:
A use of confidence levels.
B discussion of limiting losses.
C implied percentage declines from dollar VaR limits.