CFA Institute 2020 Mock Exam A - Afternoon Session

1
2020 Level II Mock Exam (A) PM

The afternoon session of the 2020 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 multiple
choice questions) for a total of 180 minutes (3 hours) for this session of the exam.
THE FOLLOWING INFORMATION RELATES TO

QUESTIONS 1–6
Forster Investment Advisors (Forster) is a small asset management firm managing funds
for both retail and institutional clients. Forster also undertakes investment banking
activities, including market making, but only for the shares of a few companies that
it follows closely.
Forster’s finance director, who also serves as the firm’s compliance officer, has
given notice that he will retire in one month’s time. Forster’s managing director asks
Terry McGuinn, CFA, if he would be interested in being the compliance officer after
the finance director retires. McGuinn, an independent compliance consultant whose
clients mostly include pension funds, agrees to meet the managing director to discuss
the position.
At the meeting, McGuinn is told, “Forster adopted the CFA Institute Code and
Standards 10 years ago. The outgoing finance director assured us at the time that we
adopted the Code and Standards that all of Forster’s policies and procedures met the
requirements most of the recommendations as well. As a result, we mention com-
pliance with the Code and Standards in all of our marketing material. We encourage
you to implement new changes, but the implementation will need to be coordinated
through the human resources department.” After agreeing on written specific duties
and responsibilities for the role, McGuinn accepts the offer to act as Forster’s com-
pliance officer on a part-time consultancy basis.
On his first day as the new compliance officer, McGuinn immediately reviews
a draft response to a request for proposal (RFP) to be submitted the next day to a
potential pension fund client. The proposal is identical to another RFP sent out three
months ago and includes Forster’s organizational chart, an in-depth description of
its investment process and the occasional use of third-party research providers, and
a guarantee of a minimum 5% investment return and return of principal through a
guaranteed structured savings product, underwritten by an investment-grade life insur-
ance company. McGuinn approves the RFP document without making any changes.
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2 2020 Level II Mock Exam (A) PM
That same day, Colleen Collins, a research analyst, approaches McGuinn, con-
cerned that she may be in possession of insider information. Collins relates that she
was at a party the night before and overheard a conversation between two CEOs of
competing, publicly listed manufacturing companies. The CEOs discussed, but did
not express their opinions on, the validity of a recent article published in an online
industry newsletter, which was speculating on the benefits of a merger between their
two companies. The newsletter is available by subscription only. One of these com-
panies is on Forster’s recommended buy list.
Following this conversation, McGuinn feels it is necessary to enhance Forster’s
rules and procedures when dealing with possible insider information. He recommends
the following changes to the company’s policies and procedures:
Recommendation 1: Stop market-making activities when in possession of mate-
rial nonpublic information.
Recommendation 2: Regularly review employee and proprietary trading.
Recommendation 3: Require all employees to attend an annual refresher course
on how to identify and handle material nonpublic information.
After reviewing how Forster chooses and retains its stockbrokers every year,
McGuinn makes several changes in the policy. The following guidelines are imple-
mented and communicated to clients. Stockbroker selection must be based on the
brokers’ ability to:
Guideline 1: provide accounting software.
Guideline 2: execute client transactions efficiently.
Guideline 3: obtain invitations to investment conferences for loyal clients.
After undertaking investigations based on an anonymous report, McGuinn con-
firms that several Forster fund managers were witnessed being wined and dined over
the past few weeks by large brokerage firms trying to get Forster’s business. The same
employees have not notified him about these dinners, a violation of Forster’s internal
policies. McGuinn notifies the employees in writing that they have been violating the
company policy. In the letter of notification, he requires the employees to abide by
the policy in the future.
1 Is McGuinn’s proposed compliance officer structure most likely consistent with
the CFA Institute Code and Standards?
A No, with regard to authority and responsibility.
B Yes.
C No, with regard to policies and procedures.
2 Which item in the request for proposal (RFP) is leastlikelyconsistent with
Standard I(C)–Misrepresentation?
A Guaranteed investment return
B The firm’s organizational structure
C Use of third-party research providers
3 Did Collins most likely receive insider information as defined by the CFA
Institute Code and Standards?
A No, because the information is considered non-material.
B Yes.
C No, because the information is considered public.
4 Which of McGuinn’s recommendations is least appropriate to implement as
per recommended procedures for compliance of Standard II(A)–Material
Nonpublic Information?
2020 Level II Mock Exam (A) PM 3
A Recommendation 1
B Recommendation 2
C Recommendation 3
5 Which guideline with regard to choosing stockbroking services is most likely
consistent with Standard III(A)–Duty to Clients?
A Guideline 2
B Guideline 3
C Guideline 1
6 With regard to the fund managers under investigation, the most appropriate
additional action McGuinn should take is to:
A monitor their future actions.
B report the misconduct up the chain of command.
C require a statement stating the behavior will cease.

QUESTIONS 7–12
Fiona O’Connor, CFA, who is based in Dublin, runs the asset management firm that
manages the assets for the Step Up Social Impact Private Equity Fund (the Fund), which
is registered in Ireland. The general partner of the Fund has asked O’Connor to meet
with Elise Jensen, CFA, a pension asset consultant, to find out whether Jensen will
pitch the Fund to her institutional clients looking for an environmental, social, and
governance (ESG) approach. Jensen specializes in working with continental European–
based pension funds, many of which are Swiss pension funds required by Swiss pen-
sion regulations to undertake an ESG assessment prior to making an investment. In
addition, all her clients have a relatively low risk profile, because they are small funds.
The few pension funds Jensen works with that do not require an ESG assessment still
include the desire for this type of evaluation in their investment mandate.
During an introductory meeting that lasts about an hour, Jensen asks O’Connor
to give an overview of the Fund. O’Connor makes the following three statements:
First, as you are aware, the Step Up Fund is a global social impact fund.
Therefore, we have allocated 85% of our investment portfolio to education
and health care. In addition, some of the companies we invest in offer
scholarships or free services to those who cannot afford their services. As
a result, our investment returns may not be as high as those of funds that
have a strict “for-profit” investment strategy, but we still track our Fund
against ESG indexes. We have also developed a set of “social impact” metrics
that aim to show the Fund has a positive impact on people’s lives. Details
of the investment strategy and how we select investments are clearly and
extensively described in our fund prospectus. In addition, investors are
notified prior to any changes being made in our investment process.
Second, let me explain how we select investments. I’ll give you the
prospectus, too, for your further reference, because it contains all the
details, and they’re quite extensive. We identify potential investments from
around the globe through our own analysts’ research within the education
and health care industries. We also use third-party agents to find potential
investments. If we make an investment in the companies they present to
us, we pay them a finder’s fee. One such agent we use is Make-a-Difference
Consultants, an asset consulting firm that has adopted the CFA Institute
Code and Standards.
Finally, I also want to disclose to you the compensation arrangements
for the asset management firm’s six investment analysts, all of whom report
to me directly. Two of the analysts work part-time, because they made
earlier commitments with other asset management firms before I found
them. But they do not work for other social impact funds, so I’m OK with
this arrangement because we consider them independent contractors. We
disclose this and other forms of management compensation to all clients
and potential clients. All the analysts are paid monthly and participate in the
firm’s year-end bonus program. The value of the bonus pool is determined
by how well the company has performed.
Prior to the end of the meeting, O’Connor invites Jensen to join her and one of
her analysts on an upcoming trip to Harare, Zimbabwe, to undertake an annual ESG
assessment for one of their social impact investments. The Fund has invested in a
private university for women that was founded a couple of years ago, with 40% of the
students coming from disadvantaged families. O’Connor adds, “This way, you can see
our investment process in action.” Jensen expresses interest in going to Zimbabwe as
part of her due diligence process and asks, “Who pays for my trip expenses?”
During their trip to Zimbabwe, O’Connor and Jensen meet with the university’s
chief financial officer and learn about the increasing success of the school and the
impact the school programs are having on their students. Jensen expresses her excite-
ment about the potential of the school and cannot wait to return home to present the
school as a potential investment to her clients. After returning home, Jensen makes
her first presentation to her smallest client, with assets totaling EUR20 million. She
makes the following statement:
I just got back from a due diligence trip to Zimbabwe with Fiona O’Connor,
the portfolio manager of the Step Up Fund, which has an ESG investment
mandate. We visited an amazing women’s university that has solicited
donations for a scholarship program for disadvantaged women. The school
is very well run, and with the new scholarship program, investment returns
are expected to increase, because they will no longer need to subsidize
tuition. I’ve been assured the other holdings within the Step Up Fund are
of equal caliber. I got to know O’Connor during the trip and feel she has
a good grasp of ESG issues. I really believe you should invest in the Step
Up Fund, because it meets your investment objectives. I would start with
a EUR5 million investment.
7 Based only on the information given, when providing investment advice to her
clients, Jensen should most likely adhere to which of the following to avoid vio-
lating Standard I(A): Knowledge of the Law?
A Irish legislation
B Swiss regulations
C CFA Institute Standards of Professional Conduct
8 Given O’Connor’s first statement about the asset allocation, expected returns,
and strategy of the Step Up Social Impact Private Equity Fund, does O’Connor
most likely violate the CFA Institute Standards?
A No
B Yes, with regard to Standard III(A): Loyalty, Prudence, and Care
C Yes, with regard to Standard V(B): Communication with Clients and

Prospective Clients
9 Given O’Connor’s second statement to Jensen, which further action should
O’Connor least likely take to comply with required or recommended proce-
dures for the CFA Institute Standards of Professional Conduct?
A Monitor the consultants’ compliance policy execution.
B Disclose the finder’s fee arrangement in the fund prospectus.
C Notify clients of the finder’s fee policy on a semiannual basis.
10 With regard to the asset management firm’s compensation arrangements for the
investment analysts as mentioned in O’Connor’s final statement, does O’Connor
most likely violate any CFA Institute Standards?
A No
B Yes, relating to the bonus pool
C Yes, relating to the part-time policy
11 To avoid violating any of the CFA Institute Standards of Professional Conduct,
how should O’Connor most likely reply to Jensen’s question regarding the trip to
Zimbabwe?
A My firm
B Your clients
C The Step Up Fund
12 During Jensen’s meeting with her client, did she most likelymake any inappro-
priate comments related to Standard III(C): Suitability?
A No
B Yes, with regard to due diligence
C Yes, with regard to due diligence and asset allocation

QUESTIONS 13–18
Brendan Dennehy works for Transon Investments, PLC, a Dublin-based hedge fund
with significant equity investments in technology companies in Asia, North America,
and Europe. Transon is concerned about the recent poor performance of one of the
fund’s Chinese investments, Winston Communications, an assembler of telecommu-
nications equipment. Transon’s chief of information technology (IT) is Sean Malloy.
Yesterday, Winston’s IT office sent Malloy data related to the assembly process and
a printout of an analysis of the number of defective assemblies per hour. Winston’s
IT people believe that the number of defective assemblies per hour is a function of
the outside air temperature and the speed (production rate) of the assembly lines.
Malloy recalls that Dennehy has had substantial training in statistics while working
on his MBA. He asks Dennehy to help him interpret the regression results supplied
by Winston.
Exhibit 1 Regression Results

Dt= b0 + b1Airt + b2Rt + εt
(continued)
Exhibit 1 (Continued)
Coefficient Standard Error
Constant (b0) 0.016 0.0942

Outside air temperature 0.0006 0.001
(b1)
Assembly line speed 0.5984 0.3
(b2)
Number of observations used in the regression 384
Critical t-value at 5% significance (two-tail test where 1.96
coefficient equals zero)
Standard Error of Durbin–Watson Significance

R2 the Estimate Statistic F-Statistic ofF
0.414 0.333 1.89 157.699 0

Durbin–Watson critical
1.63 1.72
values (5% significance)
Correlation between
outside air temperature 0.015
and assembly line speed
Using the data provided in Exhibit 1, Dennehy tests the hypothesis that the coef-
ficients for outside air temperature and assembly line speed are significantly different
from zero, using a significance level of 5%. Dennehy also uses the results given in
Exhibit 1 to evaluate the potential for multicollinearity in the data.
Finally, Dennehy would like to confirm that nonstationarity is not a problem. To
test for this he conducts Dickey–Fuller tests for a unit root on each of the time series.
The results are reported in Exhibit 2.
Exhibit 2 Results of the Dickey-Fuller Tests

Value of the Standard
Time Series Test Statistic Error t-Statistic Significance oft
Defective assemblies 0.0036 0.0023 1.591 0.1123

per hour
Outside air –0.423 0.0724 –5.846 0
temperature
Assembly line speed –0.586 0.043 –13.510 0
Dennehy tells Malloy about the Dickey-Fuller test results, stating:

“We can safely use regression to estimate the relationship between the dependent
variable and the independent variables if 1) none of the three time series exhibit a
unit root or 2) all three time series exhibit a unit root but they are also mutually
cointegrated.”
13 Based on Exhibit 1 and statistical tests, the best conclusion Dennehy can make
is that the regression coefficient is significantly different from zero with respect
to the coefficient(s) for:
A assembly line speed (b2) only.

B both outside air temperature (b1) and assembly line speed (b2).
C outside air temperature (b1) only.
14 The most appropriate interpretation of the results reported in Exhibit 1 is that:
A the F-statistic of the regression is not significant.
B predictions of defective assemblies per hour made using the regression have
only about a 41% chance of being correct.
C variations in the independent variables explain approximately 41% of the
variation in the defective assemblies per hour.
15 What is the most appropriate inference from the Durbin–Watson statistic
reported in Exhibit 1? The Durbin–Watson test:
A is inconclusive.
B rejects the null hypothesis of no positive serial correlation.
C fails to reject the null hypothesis of no positive serial correlation.
16 The results reported in Exhibit 1 are most accurately interpreted as indicating
that:
A the reported R2 is spurious.
B multicollinearity is not present.
C the regression coefficients have inflated standard errors.
17 Assuming a 5% level of significance, the most appropriate conclusion that can
be drawn from the Dickey–Fuller results reported in Exhibit 2 is that the:
A test for a unit root is inconclusive for the dependent variable.
B independent variables exhibit unit roots but the dependent variable does
not.
C dependent variable exhibits a unit root but the independent variables do
not.
18 Dennehy’s statement about the Dickey–Fuller test is best characterized as:
A incorrect, because only the independent variables series need to be tested
for the absence of a unit root
B incorrect, because only the dependent variable series needs to be tested for
the absence of a unit root.
C correct.

QUESTIONS 19–22
Sunjet Airlines Ltd. (Sunjet), a US-based “no frills” carrier, has the following existing
non-domestic operations.
■■ Nanuk Air Inc. (Nanuk) is a Canadian carrier that Sunjet purchased several
years ago. It provides service to remote mining operations in the Canadian
north. The company has been very profitable, and it recently financed a renewal
of its fleet of seaplanes with CAD-denominated long-term debt.
■■ Sunjet Mexico SA (SunMex) was established on 1 April 2016 to facilitate expan-
sion of the Sunjet network to six Mexican destinations. The company purchased
hangar assets in Mexico that were 100% financed with MXN-denominated
loans guaranteed by Sunjet, and operations began shortly thereafter. Although

most of SunMex’s revenues are generated in the US vacation travel market, the
company also serves domestic Mexican passengers. These MXN-denominated
sales amounted to approximately 10% of SunMex’s fiscal 2016–17 revenues, and
they are expected to remain below 15% in the future.
Today is 30 April 2017, one month after Sunjet’s fiscal year end, and the CEO,
Mark Napier, is meeting with the CFO, Lisa Cameron, to discuss the international
operations. Napier mentions that he will be meeting next week with the president
of SunMex to discuss the first year of operations. Cameron pulls out the draft year-
end results (Exhibit 1) and some exchange rate data (Exhibit 2). She notes that the
SunMex president’s bonus is tied to fixed asset turnover and net income targets. She
reminds Napier that the bonus thresholds are evaluated based on the translated USD-
denominated financial statements rather than the MXN-denominated ones, and she
promises to send the translated version once the results are finalized.
Exhibit 1 Summarized Draft Financial Statements for SunMex, Fiscal

2016–17 (MXN millions)
Cash and accounts receivable 47
Fixed assets (net) 370
Total assets 417
Current liabilities 33
Long-term debt 224
Common shares 160
Retained earnings 0
Total liabilities and shareholders’ equity 417
Sales 140
Depreciation expense 20
Other expenses 120
Tax expense 0
Net income 0
Exhibit 2 Selected Exchange Rates

USD per MXN CAD per USD
31 March 2017 0.0513 1.352

Average for fiscal 2016–17 0.0538 1.340
1 June 2016 0.0625 1.300
31 March 2016 0.0625 1.303
Average for fiscal 2015–16 0.0855 1.312
Nanuk, which prepares its translated statements using the current rate method,
is next on the agenda. Cameron reports that annual translated USD-equivalent sales
are up from 22.3 million last year to 23.7 million this year. Cameron reminds Napier
that one of the performance metrics in the bonus calculation for Nanuk’s president
is Nanuk’s sales growth determined in the local currency. Napier asks Cameron to
calculate that figure for the 2016–17 fiscal year.
Napier also asks Cameron what effect Nanuk’s translated statements will have on
Sunjet’s other comprehensive income for the current year.
19 Under which translation method for non-domestic operations will SunMex’s
fixed asset turnover most likelybe higher?
A The temporal method
B The current rate method
C There will be no difference.
20 On translation, SunMex’s USD-denominated net income most likely includes:
A a re-measurement gain of $2.526 million.
B a re-measurement loss of $1.792 million.
C no re-measurement gains or losses.
21 In the bonus calculation for Nanuk’s president, the sales growth that is to be
used isclosestto:
A 10.3%.
B 6.3%.
C 8.5%.
22 Thebestanswer to Napier’s question about the effect of Nanuk on Sunjet’s other
comprehensive income is that Nanuk’s:
A net asset exposure will generate a re-measurement gain.
B net liability exposure will generate a re-measurement gain.
C net asset exposure will generate a re-measurement loss.

QUESTIONS 23–28
Joseph Cioffi and Amanda Yu, interns in the financial institutions division of an
investment firm, are cleaning up outstanding issues in a few files.
They start by examining the investment allocation and returns on the investment
portfolio for NANLife Group, a life and health insurance company, using data Cioffi
prepared (Exhibit 1).
Exhibit 1 Investment Allocation and Returns, NANLife Group, in $ Millions

Investment portfolio as of 31 December 2018 2017
Loans and deposits 8,800 9,000

Debt securities 141,000 130,800
Equity securities 40,250 34,000
Derivative financial instruments 130 90
Total financial investments 190,180 173,890
(continued)
Investment portfolio as of 31 December 2018 2017

Investment properties 4,900 4,600
Total investment portfolio 195,080 178,490
Investment returns for the year ending 31

December 2018 2017
Interest income 6,610 5,850

Dividend income 820 750
Rental income 175 170
Investment income 7,605 6,770
Gains (losses) on fixed-income investments 300 (125)
Gains (losses) on other investments 1,540 1,665
Total investment returns 9,445 8,310
Cioffi asks, “Why does NANLife have a much larger portion of its investment
portfolio in equity securities compared with the property and casualty company we
were working on yesterday?”
Yu replies, “NANLife can take greater risks with its investments for two reasons:
First, its claims are relatively more predictable, and second, the claims have a shorter
duration.”
Before moving on Cioffi comments,
“It was interesting to learn about the insurance industry when working on
the NANLife file. Unlike the banking industry, it does not have to follow
international standards for capital adequacy, but as a US-based insurer,
NANLife still has some US requirements to meet. The company also pre-
pares its financial statements using statutory accounting rules that differ
from both US GAAP and IFRS.”
Next, they turn their attention to a commercial bank file that still required some
work on the assessment of earnings quality, using summary earnings information
prepared by Yu (Exhibit 2).
Exhibit 2 Selected Earnings Information from Bank File, in $ Thousands

2018 2017 2016 2015 2014
Interest income 640,400 614,000 606,300 607,300 599,000

Interest expense 225,800 231,700 246,600 260,300 262,700
Net interest income 414,600 382,300 359,700 347,000 336,300
Trading income 3,200 5,140 6,600 (900) 15,430

Other income 135,400 125,200 116,500 117,200 100,300
Total income net of 553,200 512,640 482,800 463,300 452,030

interest expense
2018 2017 2016 2015 2014
Provision for credit 8,400 13,800 9,900 10,500 7,090

losses
Earnings before taxes 117,600 95,800 91,600 78,800 87,211
Yu states,
“We have to finish the CAMELS (capital adequacy, asset quality, manage-
ment capabilities, earnings sufficiency, liquidity position, and sensitivity
to market risk) analysis on this file. In my preliminary review of the bank’s
earnings information, I assigned a score reflecting high quality of earnings,
based on the following points:
■■ The trading income is volatile, but it is a small portion of the earnings.

■■ Net interest income has been growing at a constant rate over the period.
■■ The proportion of total income from net interest income has been stable in the
most recent years.”
Cioffi replies,
“I think we need to dig a little deeper. We need to look at the estimates
that are used to determine earnings and whether the bank is using them
to manage earnings before taxes (EBT). The provision for credit losses is
an estimate where management can exercise wide discretion. Let’s look at
what portion of the 2018 increase in EBT comes from the change in that
estimate.”
23 The average return on fixed-income assets for NANLife in 2018 is closest to:
A 4.6%.
B 4.8%.
C 5.1%.
24 From 2017 to 2018, the risk related to the investment allocation for NANLife is
bestdescribed as having shown:
A no change.
B a decrease.
C an increase.
25 Yu’s reply to Cioffi’s question concerning the higher portion of equity securities
in NANLife’s investment portfolio is bestdescribed as correct with respect to:
A both reasons.
B only the first reason.
C only the second reason.
26 Cioffi’s comments about the regulatory requirements for NANLife are best
described as:
A correct.
B incorrect with respect to accounting rules.
C incorrect with respect to capital adequacy requirements.

27 Using Exhibit 2, which of Yu’s points in support of the CAMELS score she
assigns for earnings quality is least accurate? The point concerning:
A trading income volatility.
B growth in net interest income.
C net interest income proportion.
28 Based on Exhibit 2, the proportion of the increase in the 2018 earnings before
taxes that comes from the change in the provision for credit losses is closest to:
A 4.6%.
B 7.1%.
C 24.8%.

QUESTIONS 29–32
Ouse Inc., based in England, is a private company that produces and retails skin care
products, primarily soaps and lotions. Catherine Ferguson and her sister co-founded
the company 10 years ago because of their shared interest in developing plant-based
products that are not tested on animals. Initially the two sisters owned all the shares,
but two years ago they implemented performance-based compensation for the top
five senior managers, and as part of this process, the managers now own a combined
10% of the equity.
The company is looking to expand its equity base to help fund a new production
facility and support growth plans. Ferguson, who is responsible for the company’s
financial management, is meeting with Haji Malik, a financial consultant, to explore
Ouse’s equity financing options. Ferguson asks if they were to go public, could they
have a share structure similar to a company like Facebook, where the co-founders
could retain voting control of the company through the issuance of multi-voting
ordinary (common) shares.
Malik informs her that the dual class shares she has described are not permitted
in the United Kingdom. He states that before Ouse considers going public, there
are other options available. He suggests they look for private equity investment. He
mentions being familiar with a private equity fund that runs a socially responsible
investment (SRI) pool that could potentially be interested in Ouse. He says in order
to qualify to be included in the SRI pool, a company needs to demonstrate positive
attributes in all areas of ESG (environmental, social, and governance) considerations.
Ferguson is very interested in being associated with an SRI fund and asks how
Ouse could qualify for the investment. Malik explains that the private equity fund
he is thinking of uses data provided by the company and looks for other information
from industry organizations, news reports, and environmental groups.
Ferguson explains to Malik that Ouse is implementing a new initiative to reduce
the packaging associated with their products. The company will stock the majority
of their products in bulk containers in their retail outlets. Customers will purchase
refillable bottles, available in three different sizes, to be used for future purchases.
This change will attract customers interested in reducing their plastic footprint. The
company also expects the change to reduce shipping, packaging, and handling costs,
both at the distribution centers and in the retail stores. The numerous individual bottles
that would have been packaged for shipping and then unpacked and shelved at the
stores will be replaced with larger bulk containers. Malik notes that when announced,
analysts will use this information in their valuation of Ouse.
29 The change in ownership structure that occurred two years ago most likely
addressed which of the following issues associated with family-owned
businesses?
A Poor transparency
B Interlocking directorships
C Ability to attract quality management
30 If Ouse were to go public with the share structure similar to Facebook that
Ferguson asked about, which governance issue would most likely arise?
A Voting cap restrictions
B Principal–agent problem
C Principal–principal problem
31 Which of the following approaches to identifying a company’s ESG factors best-
describes the one used by the private equity fund that Malik mentions?
A ESG data providers
B Proprietary methods
C Not-for-profit initiatives
32 Analysts interested in incorporating ESG factors into their analysis will most
likely adjust for the announcement of the changes arising from Ouse’s new
packaging initiative by:
A increasing the risk premium.
B increasing the company’s fair value.
C modifying only the qualitative ESG analysis.

QUESTIONS 33–36
Mary Barton is a junior equity analyst for an investment company. She is currently
working on a large US-based 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 $1 or more between the market and estimated
prices indicates that the shares are mispriced for the fund’s investment purposes. The
fund is allowed to take either long or short positions in shares identified as misvalued.
Barton’s manager, George Eckhart, asks her to evaluate the stocks of two companies
for possible inclusion in that fund: XRail Company (XRL) and Z-Tarp Limited (ZTL).
Selected data for the stocks are shown in Exhibit 1.
Exhibit 1 Selected Stock Data for XRL and ZTL and Additional Market
Information
XRL ZTL
EPS ($) 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 4.5 2.02
2011 2.52 0.9 4.2 1.89
Current market price $77.23 $93.05
Return on assets 27.40% 25.80%
Return on common equity 31.60% 32.80%
Beta 0.94 1.2
Required rate of return on 8.84% 10.48%
common equity
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 the 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 with 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 growth model to determine whether 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. If that should happen, he believes that 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.
33 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.
34 Barton’s conclusion that XRL is in the transition phase is best described as:
A correct.
B incorrect, because the company is in the supernormal growth phase.
C incorrect, because the company is in the mature phase.
35 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.
36 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.

QUESTIONS 37–42
Halstead Capital Advisors is an investment advisory firm that specializes in taxable
fixed-income investing. Its clients consist of medium sized foundations and endow-
ments who select outside managers such as Halstead after having formulated their
investment policy and asset allocation targets.
Halstead’s chief investment strategist, Charles Scott, and quantitative analyst,
Catherine Bird, are meeting to discuss a research report that Bird is producing. The
report will address various fixed-income investing topics, including investment strat-
egies, credit spreads, and yield curve movements.
Bird is evaluating two US Treasury instruments. The first is a newly issued 7.00%
coupon bond with a 5-year maturity issued at a price of $101.15 ($100.00 face value)
with a yield to maturity of 6.72%. The second is newly issued zero-coupon bond with a
5-year maturity issued at a price of $71.30 ($100.00 face value) with a yield to maturity
of 7.00%. Current US Treasury spot rates and extrapolated forward rates are provided
in Exhibit 1. Bird expects that the future path of interest rates will follow that which
is implied by the forward curve.
Exhibit 1 Spot and Forward Interest Rates

Maturity Spot Forward Rates (1 year) Forward Rates (n – 1 year)
(Years) Rates (n – 1 years forward) (1 year forward)
(n) r(n) f(n – 1,1) f(1,n – 1)
1 3.00% 3.00% 3.00%

2 4.00% 5.01% 5.01%
3 5.00% 7.03% 6.01%
(continued)
Maturity Spot Forward Rates (1 year) Forward Rates (n – 1 year)

(Years) Rates (n – 1 years forward) (1 year forward)
(n) r(n) f(n – 1,1) f(1,n – 1)
4 6.00% 9.06% 7.02%
5 7.00% 11.10% 8.02%
Scott reminds Bird to include an update on credit instruments. He provides details

on a bond issued by Coores, rated A1/A+, with 5 years to maturity priced to yield
7.30%. At the time that the Coores bond was priced, the 5-year risk-free spot rate was
7.00%, and the 5-year swap spread was 0.30%.
Bird proposes to review other credit spread indicators that measure credit and
liquidity risk for money market securities, general creditworthiness of individual debt
issuers, and counterparty risk. Bird offers the following statements about measures
of credit risk:
Statement 1 The TED spread represents the difference between Libor and
overnight bank lending rates.
Statement 2 The Libor–OIS spread represents the difference between Libor
and corporate bond spreads.
Statement 3 The Z spread represents the constant basis point spread that is
added to the implied spot yield curve to measure the price of
credit risky bonds.
Scott asks Bird to evaluate the impact of yield curve movements on fixed-income
securities. Bird constructs a yield curve factor model in which a change in the yield
curve contains three independent factors. The yield curve movements are contained
in Exhibit 2.
Exhibit 2 Yield Curve Movements

Time to Maturity 1 year 2 years 3 years 4 years 5 years
Factor 1 0.75% 1.10% 1.62% 2.27% 3.03%

Factor 2 –0.47% 1.03% 2.05% 1.02% –0.45%
Factor 3 0.98% 0.99% 1.00% 1.01% 1.02%
37 Using the information provided in Exhibit 1 and assuming that Bird’s interest
rate expectation materializes, the realized return for an investor who buys and
holds to maturity the US Treasury 7.00% coupon bond would most likely be:
A less than the yield to maturity.
B equal to the yield to maturity.
C greater than the yield to maturity.
rate expectation materializes, the year one holding period return for the Zero
Coupon bond is closest to:
A 5.01%.
B 3.00%.
C 7.00%.
rate expectation materializes, the forward rate at which an investor would be
indifferent to purchasing the US Treasury zero coupon note today or one year
from today isclosest to:
A 8.02%.
B 7.02%.
C 11.10%.
40 Using the information provided about the Coores bond and assuming that there
are no unusual factors affecting either the government or corporate debt mar-
kets, is Coores bond likely mispriced?
A Yes, because of the difference between the swap rate and the yield to
maturity.
B Yes, because of the difference between the swap rate and the spot rate.
C No.
41 Which of Bird’s statements regarding measures of credit risk is most likely
correct?
A Statement 2
B Statement 3
C Statement 1
42 Given the sample yield curve change shown in Exhibit 2, Factor 1, Factor 2 and
Factor 3 are most likely:
A steepness, curvature, and level.
B level, steepness, and curvature.
C curvature, level, and steepness.

QUESTIONS 43–48
Vladimir Kozorez is chief investment officer of MegaArb Associates (MAA), a multi-
asset-class arbitrage hedge fund he recently launched. He has hired Ludvig Nils, an
analyst with a deep and broad background in security analysis but no experience in
arbitrage investing. At their first research meeting, Kozorez, who is mentoring Nils,
makes the following comments regarding arbitrage using derivative contracts.
Comment 1 A forward commitment is a derivative instrument in the form
of a contract that provides the ability to lock in a price or rate
at which one can buy or sell the underlying instrument at some
future date or exchange an agreed-on amount of money on a
series of dates.
Comment 2 There is a difference between the pricing and the valuation of for-
ward commitments. Pricing involves determining the appropriate
forward commitment price or rate, typically after it has been
initiated. Valuation involves determining the appropriate rate of
the forward commitment when initiating the contract.
Comment 3 The two fundamental rules of arbitrage are that one does not use
any of one’s own money in a transaction, and one does not take
any price risk.
Kozorez asks Nils to evaluate a carry arbitrage trade for a S&P 500 Index forward
contract. He believes the contract may be mispriced. The index is currently trading at
1,900, and the forward contract expiring in one year is priced at 1,863. The index has
a continuously compounded dividend yield of 2.50%, and the one-year continuously
compounded interest rate is 0.75%. Kozorez believes that at the time of the contract’s
expiration, the index will be trading at 1903.
Nils sets out to evaluate arbitrage opportunities using forward rate agreements
(FRAs). Kozorez makes the following comments to Nils regarding FRAs: “An FRA
has two counterparties, a fixed-rate receiver that is short Euribor and a floating-rate
receiver that is long Euribor. The party that is long a 3 × 9 FRA must make a Euribor
deposit in three months and earns the Euribor rate for the subsequent six months.”
Nils also analyzes a US Treasury futures contract that he plans to use to hedge
a corporate bond’s interest rate risk. He researches the characteristics of Treasury
futures and observes the following characteristics.
Characteristic 1 The underlying deliverable bond in a US Treasury futures
contract consists of a basket of bonds from which the short
position can deliver the cheapest bond.
Characteristic 2 Eligible deliverable bonds can have various maturities and
coupon rates, and the seller will receive the futures price
adjusted by a conversion factor to account for any accrued
interest.
Characteristic 3 Long and short positions are marked to market each day.
Therefore, the contract’s market value at the end of each day
is zero.
Kozorez has a position in Spanish sovereign bonds that he wants to hold during
the next year because he believes euro rates will rally as the European Central Bank
continues with its quantitative easing program. He is less hopeful, however, about the
EUR currency, which he wants hedged back to USD. Kozorez asks Nils to evaluate
this hedging strategy. The US risk-free rate is 0.27%, and the eurozone risk-free rate
is 0.94%. Nils also uses the data in Exhibit 1 for his analysis.
Exhibit 1 Foreign Exchange Rates

USD/EUR EUR/USD
Spot 1.1156 0.8964

Forward 1.1104 0.9006
Lastly, MAA has a number of fixed-rate investments, which Kozorez is looking

to hedge against rising rates. He asks Nils to review interest rate swap contracts.
Nils determines that MAA should enter into a receive-floating, pay-fixed swap. He
recognizes that this arrangement will require an exchange of cash flows at initiation,
and he sets out to calculate the arbitrage-free amount of the cash flows. Based on his
work on other types of derivative instruments, he realizes that he could synthetically

create a swap contract through either a portfolio of underlying instruments or a
portfolio of forward contracts.
43 Which of the comments made by Kozorez regarding arbitrage is least likely
correct?
A Comment 2
B Comment 3
C Comment 1
44 Does Nils’s stock index evaluation most likely identify an arbitrage opportunity?
A Yes, there is a reverse carry arbitrage opportunity.
B Yes, there is a carry arbitrage opportunity.
C No, the forward is fairly priced.
45 Kozorez’s comments to Nils regarding FRAs are most likely:
A correct regarding counterparties and correct regarding their transactions.
B correct regarding counterparties and incorrect regarding their transactions.
C incorrect regarding counterparties and incorrect regarding their
transactions.
46 Which characteristic observed by Nils regarding Treasury futures is least likely
correct?
A Characteristic 1
B Characteristic 2
C Characteristic 3
47 Based on the data in Exhibit 1, using covered interest rate arbitrage, Nils’ evalu-
ation reveals that the USD/EUR forward rate is most likely:
A below fair value.
B above fair value.
C at fair value.
48 Which of Nils’ determinations in his analysis of the interest rate swap contracts
is least likely correct?
A Exchange of cash flows
B The structure of the swap
C The equivalency to using instruments or forwards

QUESTIONS 49–54
Eric Silverman is a senior portfolio manager for the endowment of Sawyer University
based in California. Sawyer’s investment policy currently only allows allocations to
domestic equity and corporate bonds. The investment committee has tasked Silverman
with assessing the endowment’s foray into real estate investments. He is meeting with
two of his team members to discuss the assignment: Jenny Lin, a senior associate, and
Rohan Dua, a senior financial analyst.
The endowment’s investment committee has asked Silverman to consider the impli-
cations of direct real estate investments in the endowment portfolio. The committee’s
view is that such investments will likely generate income and capital appreciation but
have no significant impact on portfolio risk because of their high correlations with
the existing investments.
Silverman has asked Dua to carry out some preliminary research on commercial
real estate and to report on his findings. Dua reports that commercial real estate
property types include office properties, industrial and warehouse space, and retail
space. Dua indicates that demand for office space depends on employment growth,
whereas a strong economy drives demand for warehouse space. Demand for retail
space depends on the level of import and export activity.
Silverman and his team are evaluating an investment in an office property. They
propose to use three valuation methods: the discounted cash flow method (DCF), the
cost approach, and the sales comparison approach. There are four years remaining in
the property lease, and annual net operating income (NOI) from lease payments is
$750,000. When the lease rolls over in Year 5, there is expected to be a one-time 15%
increase in NOI. Information about the evaluation is provided in Exhibits 1 and 2.
Exhibit 1 Selected Information to Evaluate Subject Property

Discount rate 7.50%
Terminal cap rate 5.50%
Market value of land $2,500,000
Replacement building costs $20,000,000
Curable physical depreciation costs $500,000
Incurable physical depreciation costs $3,500,000
Cost of modernizing heating and cooling system $1,200,000
Exhibit 2 Sales Comparison Information to Evaluate Subject Property

Size Price
(square Age (per square
feet) (years) Condition foot)
Subject office property 12,000 7 Excellent

Comparable office property 1 8,000 10 Average $1,150
Comparable office property 2 14,000 4 Average $1,325
To adjust for age, the price per square foot (PSF) of the comparable property is
adjusted by 3% per year of age difference. The adjustment for the condition of the
office property is 14% for properties in average condition.
Silverman asks the group to provide some characteristics of the three valuation
methods. Lin responds, “the DCF method takes into account cash flows that are
relevant to investors and incorporates the cyclical nature of the real estate market.
The cost approach works best for newer properties, whereas the sales comparison
approach provides reliable value estimates in an active real estate market in which
there are numerous transactions.”
49 The investment committee’s view on direct real estate investment is least likely-
correct with regard to:
A income.
B portfolio risk.
C capital appreciation.
50 Is Dua most likelycorrect with regard to the factors that drive demand for differ-
ent commercial real estate property types?
A No, he is incorrect about retail space.
B Yes.
C No, he is incorrect about industrial and warehouse space.
51 Based on the information provided and Exhibit 1, the value of the office prop-
erty based on the DCF approach is closest to:
A $14,254,549
B $16,265,226
C $18,193,813
52 Using the cost approach, the estimated value of the office property based on
Exhibit 1 and other information provided is closestto:
A $14,800,000.
B $15,300,000.
C $17,300,000.
53 Based on Exhibit 2 and other information provided, the value of the office prop-
erty using the sales comparison approach is closest to:
A $16,834,500.
B $17,023,500.
C $13,875,000.
54 In her response to Silverman regarding the characteristics of the three valuation
approaches, Lin is least likely correct with respect to the:
A DCF approach.
B sales comparison approach.
C cost approach.

QUESTIONS 55–60
Pari Patel is a senior portfolio manager at Applegate Capital Management, an insti-
tutional hedge fund manager in San Francisco that offers a variety of strategies. Patel
oversees the management of the Applegate Hedged Alpha Fund, a mutual fund with
the objective of providing capital appreciation while minimizing downside risk. Justin
Flaherty is a junior analyst on Patel’s team.
Patel works closely with Applegate’s risk and compliance teams to ensure he
understands the inherent risks in the portfolio. Each morning, Patel receives a risk
report with a number of metrics to help him assess portfolio exposures and risks.
Patel is reviewing the daily risk report with Flaherty to discuss why value at risk
(VaR) is an important measure of risk. Flaherty makes the following three statements
regarding VaR:
Statement 1 VaR measures the minimum expected loss, rather than the maxi-
mum expected loss, in a portfolio.
Statement 2 VaR is used to estimate portfolio losses that are likely to occur at
a fixed point in time, rather than over a period of time.
Statement 3 VaR measures portfolio volatility in percentage terms.
Patel replies to Flaherty’s statements by focusing on specific aspects of VaR:
“Applegate’s process begins with a risk decomposition of the portfolio holdings, typ-
ically assumes normal distribution of risk factors, and then uses the expected return
and standard deviation for each risk factor to estimate the VaR. The VaR threshold is
converted to a z-distribution. We then calculate the expected return and volatility of
the portfolio and adjust to the desired time interval. Finally, we can obtain VaR and
convert it into a dollar amount by multiplying by the portfolio value.”
In reviewing the VaR report, Patel would like more insight on the average loss that
would occur if the VaR cutoff is extended and asks Flaherty to contact the risk team to
improve the reporting metrics. After discussing with his colleague on the risk team,
Flaherty responds that going forward they will add conditional VaR, incremental VaR,
and marginal VaR to the report.
In addition to VaR, the risk report includes other measures that assist Patel in
better understanding portfolio sensitivities. Patel uses option strategies within the
fund to manage exposures. Patel asks Flaherty to review sensitivity risk measures
to better understand the option exposure within the fund. Flaherty uses gamma to
understand how sensitive option prices are to an increase in volatility of the underlying
stock and delta to determine how large moves in the value of the fund positions will
affect associated option values.
Marcus Thompson oversees risk management at Applegate on a firm-wide basis.
Because of the use of leverage, Thompson pays particular attention to risk measures
to understand the sources and uses of cash and the risk of hitting leverage limits and
facing margin calls. He uses a number of metrics in his risk dashboard and communi-
cates to managers and firm leadership when actions need to be taken to mitigate risk.
Thompson frequently reviews Applegate’s strategies to identify those with greater-
than-expected tail risk. Doing so helps him understand potential capital allocation
requirements for meeting tail risk losses. He is asked to review the following three
newly proposed fund strategies and to assess potential tail risk and capital requirements:
Strategy 1: Long–short equity fund targeting an equity market beta of 0.2 based
on fundamental long and short equity research
Strategy 2: Long-only option strategy that uses technical analysis and momen-
tum to trade call and put options on a short-term basis
Strategy 3: Alternative income strategy focused on long credit positions com-
bined with selling insurance and writing options to generate premium income
55 Which one of Flaherty’s statements on VaR is most likely correct?

A Statement 1
B Statement 2
C Statement 3
56 Which estimation of VaR is Patel most likely describing?
A Historical simulation
B Monte Carlo
C Parametric
57 Which extension of VaR will most likely meet Patel’s needs?
A Conditional
B Incremental
C Marginal
58 Is Flaherty most likely correct in his use of sensitivity measures to assess the
impact of the option positions in the fund?
A Yes
B No, with regard to delta
C No, with regard to gamma
59 Which risk measure is Thompson least likely to use in his analysis?
A VaR
B Active share
C Gross exposure
60 Which of the strategies Thompson is asked to review is most likely to involve
significant tail risk and potential capital requirements?
A Strategy 1
B Strategy 2
C Strategy 3

CFA Institute 2020 Mock Exam A - Afternoon Session

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2020 Level II Mock Exam (A) PM

THE FOLLOWING INFORMATION RELATES TO

THE FOLLOWING INFORMATION RELATES TO

C Yes, with regard to Standard V(B): Communication with Clients and

THE FOLLOWING INFORMATION RELATES TO

Exhibit 1 Regression Results

Coefficient Standard Error

Constant (b0) 0.016 0.0942

Standard Error of Durbin–Watson Significance

0.414 0.333 1.89 157.699 0

Exhibit 2 Results of the Dickey-­Fuller Tests

Defective assemblies 0.0036 0.0023 1.591 0.1123

Dennehy tells Malloy about the Dickey-­Fuller test results, stating:

A assembly line speed (b2) only.

THE FOLLOWING INFORMATION RELATES TO

loans guaranteed by Sunjet, and operations began shortly thereafter. Although

Exhibit 1 Summarized Draft Financial Statements for SunMex, Fiscal

Exhibit 2 Selected Exchange Rates

31 March 2017 0.0513 1.352

THE FOLLOWING INFORMATION RELATES TO

Exhibit 1 Investment Allocation and Returns, NANLife Group, in $ Millions

Loans and deposits 8,800 9,000

Investment portfolio as of 31 December 2018 2017

Investment returns for the year ending 31

Interest income 6,610 5,850

Exhibit 2 Selected Earnings Information from Bank File, in $ Thousands

Interest income 640,400 614,000 606,300 607,300 599,000

Trading income 3,200 5,140 6,600 (900) 15,430

Total income net of 553,200 512,640 482,800 463,300 452,030

2018 2017 2016 2015 2014

Provision for credit 8,400 13,800 9,900 10,500 7,090

Earnings before taxes 117,600 95,800 91,600 78,800 87,211

■■ The trading income is volatile, but it is a small portion of the earnings.

C incorrect with respect to capital adequacy requirements.

THE FOLLOWING INFORMATION RELATES TO

THE FOLLOWING INFORMATION RELATES TO

2015 3.15 1.77 5.62 2.53

THE FOLLOWING INFORMATION RELATES TO

Exhibit 1 Spot and Forward Interest Rates

1 3.00% 3.00% 3.00%

Maturity Spot Forward Rates (1 year) Forward Rates (n – 1 year)

Scott reminds Bird to include an update on credit instruments. He provides details

Exhibit 2 Yield Curve Movements

Factor 1 0.75% 1.10% 1.62% 2.27% 3.03%

THE FOLLOWING INFORMATION RELATES TO

Exhibit 1 Foreign Exchange Rates

Spot 1.1156 0.8964

Lastly, MAA has a number of fixed-­rate investments, which Kozorez is looking

work on other types of derivative instruments, he realizes that he could synthetically

THE FOLLOWING INFORMATION RELATES TO

Exhibit 1 Selected Information to Evaluate Subject Property

Exhibit 2 Sales Comparison Information to Evaluate Subject Property

Subject office property 12,000 7 Excellent

THE FOLLOWING INFORMATION RELATES TO

55 Which one of Flaherty’s statements on VaR is most likely correct?

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Exhibit 1 Regression Results

Exhibit 2 Results of the Dickey-Fuller Tests

Dennehy tells Malloy about the Dickey-Fuller test results, stating:

Exhibit 1 Summarized Draft Financial Statements for SunMex, Fiscal

Exhibit 2 Selected Exchange Rates

Exhibit 1 Investment Allocation and Returns, NANLife Group, in $ Millions

Exhibit 2 Selected Earnings Information from Bank File, in $ Thousands

Exhibit 1 Spot and Forward Interest Rates

Exhibit 2 Yield Curve Movements

Exhibit 1 Foreign Exchange Rates

Lastly, MAA has a number of fixed-rate investments, which Kozorez is looking

Exhibit 1 Selected Information to Evaluate Subject Property

Exhibit 2 Sales Comparison Information to Evaluate Subject Property