2010 Level II Mock Exam: Afternoon Session ANSWERS AND REFERENCES

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1 2010 Level II Mock Exam: Afternoon Session ANSWERS AND REFERENCES Trendwise Case Scenario Trendwise is an investment firm advising individual clients, as well as, offering a variety of mutual funds, including the Omega Fund (OF). OF has a large ownership stake in Cyclical Industries (CI). OF and CI have one director in common, Glenn Libra. At the April OF board meeting, portfolio manager Ileana Natali, CFA, stated that after conducting thorough research and analysis, she was firmly convinced the fund should sell its shares of CI. One director advised Natali, Don t sell CI. It s a great stock, isn t it Mr. Libra? Libra listened but did not respond. Hearing the director s comment, Natali decided not to sell the shares as planned. In the following weeks the stock price rose dramatically. One month later, Libra phoned Natali, requesting she vote OF s shares to reelect him to the CI board of directors. Natali then sent Libra an saying, I voted OF s shares for you, a step I feel is in the best interest of our fundholders. Natali continued, Please be aware we recently conducted a cost-benefit analysis and determined it is not worthwhile to vote all proxies. We are sending all clients a copy of our new proxy-voting policies which will explain, we may not vote all proxies in the future. Libra warned, Voting proxies is an integral part of the management of investments. A fiduciary who fails to vote proxies may violate CFA Standards. In response, Natali agreed to consult counsel and the CFA handbook regarding the new policies. The following week, Natali s supervisor asked her to evaluate a proposal from Brock Securities Brokerage (Brock). Brock recently proposed a soft dollar arrangement with Trendwise. Trendwise claims compliance with the CFA Institute Soft Dollar Standards. In her evaluation, Natali noted Brock proposes a higher commission rate than Trendwise pays its current brokerage firm. She also indicated Brock s fees are within a reasonable range. In addition, Natali indicated Brock could possibly provide better trade execution than Trendwise s present broker. Natali proposes to use Brock on a trial basis. In a memorandum to Trendwise s compliance officer, Natali states: I believe the proposed brokerage arrangement from Brock satisfies the two fundamental principles in the CFA Institute Soft Dollar Standards Trendwise must use in evaluating soft dollar arrangements: Principle 1: All client commissions paid to a broker are the property of the client.

2 Principle 2: Mutual funds, such as Omega, establish their own policies with respect to the use of certain brokers. I recommend we use Brock only for OF transactions. This will allow us to verify the quality of Brock s trade execution, and the soft dollar credits will decrease the research costs to OF s fundholders. After a one-year trial period, we will inform our directors of this new arrangement and report the results of the arrangement. If the directors decide to renew the contract, we will inform the fundholders. The following week Natali s supervisor sent her a memo asking if the following firm policies need any revisions to comply with the CFA Institute Research Objectivity Standards: Policy 1. Base compensation for analysts is determined from the quality of research performed. Year-end bonuses may be adjusted based on an analyst s work with investment banking and corporate finance teams. Policy 2. In their relationships with corporate issuers, analysts are prohibited from either directly or indirectly promising favorable reports, or threatening negative reports. Price targets may be agreed upon as long as the corporate issuer meets all disclosure requirements prior to the report being issued. Policy 3. In their relationships with corporate issuers, analysts are prohibited from sharing with or communicating to a subject company, prior to publication, any section of a research report. Policy 4. Ensure that covered employees do not share information about the subject company or security with any person who could have the ability to trade in advance of or otherwise disadvantage the firm s mutual funds. 1. With respect to her actions concerning Libra and Cyclical Industries (CI), Natali least likely violated the CFA Institute Standards of Professional Conduct concerning: A. Loyalty. B. Conflicts of interest. C. Independence and Objectivity. Answer: A Guidance for Standards I-VII 2010 Modular Level II, Vol. 1, pp , Study Session 1-2-a Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to specific situations.

3 A is correct because Natali s actions least likely impacted her employer. By changing her recommendation to keep CI and appease an important client she has violated both the Conflicts of Interest and Independence Standards, Standard VI (A) and Standard I (B). 2. In their discussion of the new proxy voting policy, whose statements are consistent with the CFA Institute Standards? A. Libra s only. B. Natali s only. C. Both Libra s and Natali s. Answer: C Guidance for Standards I-VII 2010 Modular Level II, Vol. 1, p. 50 Study Session 1-2-a Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to specific situations. C is correct because statements made by both Natali and Libra are consistent with the Standards. According to Standard III (A) (Loyalty, Prudence, and Care) voting proxies is an integral part of the management of investments and a fiduciary who fails to vote proxies may violate the Standard. The Standards of Practice Handbook also states that a cost-benefit analysis may show that voting all proxies may not benefit the client, so voting proxies may not be necessary in all instances. Members and candidates should disclose to clients their proxy-voting policies, which Natali has done. 3. Which aspect of Trendwise s duty to its clients is most likely to be violated by its proposed soft dollar arrangement with Brock? A. All soft dollar practices must be fully disclosed. B. Investment managers must at all times seek best trade execution. C. Commissions paid must be reasonable in relation to the research and execution services provided. Answer: A CFA Institute Soft Dollar Standards 2010 Modular Level II, Vol. 1, pp. 50, Study Sessions 1-2-a, 1-3-b Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to specific situations.

4 Critique company soft dollar practices and policies. A is correct because according the Soft Dollar Standards, once a manager decides to use soft dollar services, the manager should fully disclose to its clients its brokerage commission policies. Trendwise proposes to inform clients only at year s end which would not meet the Standards requirement. 4. In her statement about evaluating soft dollar arrangements, Natali is most likely correct with respect to: A. Principle 1. B. Principle 2. C. Both Principles 1 and 2. Answer: A CFA Institute Soft Dollar Standards 2010 Modular Level II, Vol. 1, pp Study Session 1-3-a Define soft dollar arrangements and state the general principles of the Soft Dollar Standards. A is correct as Natali stated Principle 1 correctly. According to the Soft Dollar Standards, I. General Principles, brokerage is the property of the client. 5. In response to her supervisors question regarding the firm s policies on research objectivity, Natali s best response would be: A. both policies 1 and 2 are consistent with the current Standards. B. both policies 1 and 2 are inconsistent with the current Standards and require changes. C. the policy on analyst compensation requires changes, but the policy regarding relationships with corporate issuers is consistent with current Standards. Answer: B CFA Institute Research Objectivity Standards 2010 Modular Level II, Vol. 1, p. 168 Study Session 1-4-b Critique company policies and practices related to research objectivity and distinguish between changes required and changes recommended for compliance with the Research Objectivity Standards. B is correct. Both policies 1 and 2 are inconsistent with the current Standards. According to the Research Objectivity Standards, firms must establish and

5 implement salary, bonus, and other compensation for analysts that do not directly link compensation to investment banking or other corporate finance activities on which the analyst collaborated (either individually or in the aggregate.) The Standards also state that research analysts are prohibited from directly or indirectly promising a subject company or other issuer a favorable report or specific price target, or from threatening to change reports, recommendations, or price targets. 6. To make the firm s policies consistent with CFA Institute Research Objectivity Standards, Natali should suggest the following regarding Policy 3 and 4: A. both policies 3 and 4 are consistent with the current Standards. B. both policies 3 and 4 are inconsistent with the current Standards. C. policy 3 requires changes, but policy 4 is consistent with current Standards. Answer: B CFA Institute Research Objectivity Standards 2010 Modular Level II, Vol. 1, pp Study Session 1-4-b Critique company policies and practices related to research objectivity and distinguish between changes required and changes recommended for compliance with the Research Objectivity Standards. B is correct. According to the Research Objectivity Standards, analysts are prohibited from sharing with, or communicating with or communicating to a subject company, prior to publication, any section of a research report that might communicate the research analyst s proposed recommendation, rating, or price target. It is recommended that the compliance or legal department receive a draft research report before sections are shared with the subject company. She also needs to change Policy 4 so that it is applicable to all clients, not just mutual funds.

6 Walter Speckley Case Scenario Walter Speckley is a high net worth individual who recently relocated from Europe to the United States. Speckley sold his European properties and will receive the 10 million proceeds 180 days from now. The terms of the sale require the funds to remain in escrow for an additional 180 days after receipt. He intends to invest the escrowed funds in a 180- day euro-denominated money market instrument. When the escrow period ends 360 days from now, Speckley intends to convert these funds to U.S. dollars and buy stock in the First Bank of Kanata (FBK), a small regional U.S. bank that he has identified as an attractive investment opportunity. FBK stock is priced in U.S. dollars and the company will pay a dividend of $5.00 per share 180 days from now. Speckley s investment objectives are to lock in: 1. the yield he will receive on his euro-denominated money market investment 180 days from now; 2. the exchange rate he will receive when he converts his funds from euros to U.S. dollars 360 days from now; and 3. the current purchase price of FBK stock. To accomplish these objectives, Speckley plans to use forward contracts. Exhibit 1 describes the transactions proposed by Speckley. Exhibit 1 Time-line of Events Now 180 Days from Now 360 Days from Now Cash transactions Property sale proceeds received ,000, Euro-denominated money market ,000,000 Investment matures investment Euros converted into U.S. dollars Dollars received FBK stock purchase (in U.S. dollars) Stock purchased Dividend paid on FBK stock --- $5.00 per share --- Derivatives transactions Euribor forward rate agreement Contract entered --- Contract matures Forward currency contract Contract entered --- Contract matures Forward contract on FBK stock Contract entered --- Contract matures

7 Speckley approaches Illing & Partners, a private investment bank, to obtain price quotes on the various forward contracts. Illing & Partners base their price quotes on the information in Exhibit 2. Exhibit 2 Spot Market Information 180-day Euribor 2.50% 360-day Euribor 3.50% 180-day U.S. yield 3.00% 360-day U.S. yield 3.00% Dollars per euro (spot) $1.25 Price per share of FBK stock $ Howard Dunn, an analyst at Illing & Partners, explains to Speckley that currency forward prices are determined in part by the current levels of domestic and foreign interest rates and the levels of domestic and foreign interest rates expected at the expiration of the forward contract. Dunn tells Speckley that he will receive fewer dollars when he converts his proceeds using the 360-day forward currency contract than he would receive at the current spot exchange rate. When Speckley asks why, Dunn replies: The forward exchange rate reflects that 360-day U.S. interest rates are lower than 360- day European interest rates. Speckley enters into a Euribor forward rate agreement, a short position in a currency forward contract to exchange dollars for euros, and a long position in a FBK forward contract. As the currency forward contract nears maturity, the market value of the long position is $149,000 and Speckley estimates that the probability that his counterparty will default at maturity is 25 percent. 7. Based on the information in Exhibits 1 and 2 and assuming a 360-day year, the price of a 360-day euro forward contract is closest to: A. $ B. $ C. $ Answer: A Forward Markets and Contracts, Don M. Chance 2010 Modular Level II, Vol. 6, pp Study Session c

8 Calculate and interpret the price and the value of 1) a forward contract on a fixed income security, 2) a forward rate agreement (FRA), and 3) a forward contract on a currency. The formula for the forward currency price is: F(0,T) = [ S 0 / ( 1 + r f ) T ] ( 1 + r ) T where F(0,T) = the forward price at time 0 for a delivery date at time T (which is one year, or 1, in this case) S 0 = the spot exchange rate r f = the foreign interest rate r = the domestic interest rate. In this item set, the domestic interest rate is the U.S. Substituting in the information from Exhibit 2: F(0,T) = ( 1.25 / ) ( 1.030) = Based on the information in Exhibits 1 and 2 and assuming a 360-day year, the price of a 360-day forward contract on FBK stock is closest to: A. $ B. $ C. $ Answer: A Forward Markets and Contracts, Don M. Chance 2010 Modular Level II, Vol. 6, pp Study Session b Calculate and interpret the price and the value of an equity forward contract, assuming dividends are paid either discretely or continuously. The price formula for a forward contract on an equity security is: F(0,T)= [ S 0 PV(D,0,T) ] ( 1 + r ) T = [ S 0 ( 1 + r ) T ] FV(D,0,T) where S 0 = the current price of the equity PV(D,0,T) = the present value of the dividend stream across the life of the forward contract ( T ) FV(D,0,T) = the future value of the dividend stream across the life of the contract Given the information in the problem and in Exhibits 1 and 2, the contract is for one-year (T = 1) and the dividend occurs in 180 days (½ year). Substituting this into the formula: F(0,T) = [ 100 { 5 / ( ) 0.5 } ] ( ) = [ 100 ( ) ] [ 5 ( ) 0.5 ] = $97.93

9 9. Dunn s explanation of the currency forward price is most likely: A. correct. B. incorrect because forward exchange rates are not affected by current domestic and foreign interest rates. C. incorrect because forward exchange rates are not affected by domestic and foreign interest rate expectations. Answer: C Forward Markets and Contracts, Don M. Chance 2010 Modular Level II, Vol. 6, pp Study Session a Explain how the value of a forward contract is determined at initiation, during the life of the contract, and at expiration C is correct because currency forward prices are determined by the current exchange rate, the current domestic and foreign interest rates and the maturity of the contract. 10. Dunn s explanation of the difference between the 360-day forward exchange rate and the current spot exchange rate is most likely: A. correct. B. incorrect because the forward exchange rate will also depend upon inflation expectations. C. incorrect because the forward exchange rate will be higher than the spot rate when U.S. interest rates are lower than European interest rates. Answer: A Forward Markets and Contracts, Don M. Chance 2010 Modular Level II, Vol. 6, pp Study Session c Calculate and interpret the price and the value of 1) a forward contract on a fixed income security, 2) a forward rate agreement (FRA), and 3) a forward contract on a currency. The exchange rate on forward currency contracts is determined by: F 0 (T) = [ S 0 / ( 1 + r f ) T ] ( 1 + r ) T where F 0 (T) = the current price of the forward contract expiring at time T S 0 = the current spot exchange rate r f = the foreign interest rate r = the domestic interest rate.

10 When domestic interest rates (U.S. in this item set) are lower than foreign interest rates, the forward exchange rate will be lower than the spot exchange rate; this is based on the assumption that the exchange rate is quoted as the amount of domestic currency required to purchase 1 unit of foreign currency. 11. The credit risk of the currency forward contract from Speckley s perspective is closest to: A. $0. B. $37,250. C. $149,000. Answer: A Forward Markets and Contracts, Don M. Chance 2010 Modular Level II, Vol. 6, pp Study Session d Evaluate credit risk in a forward contract, and explain how market value is a measure of the credit risk to a party in a forward contract. Speckley is short the Euro forward which has a positive market value. The long counterparty stands to lose $149,000 if Speckley defaults. 12. Based on the information in Exhibits 1 and 2 and assuming a 360-day year, the rate on a Euribor forward rate agreement (FRA) that meets Speckley s needs is closest to: A. 2.22%. B. 3.00%. C. 4.44%. Answer: C Forward Markets and Contracts, Don M. Chance 2010 Modular Level II, Vol. 6, pp Study Session c Calculate and interpret the price and the value of 1) a forward contract on a fixed income security, 2) a forward rate agreement (FRA), and 3) a forward contract on a currency The formula for an FRA rate is: FRA(0,h,m) = 1 + L 0 (h+m)( h+m / 360 ) L 0 (h) ( h / 360 ) (360/m)

11 where FRA(0,h,m) is the rate on an FRA contracted at time 0 expiring at time h for an investment period lasting from h to h+m and L 0 (h) is the h-period Euribor rate at time 0. In Speckley s case, h = m = 180. Using this and the information in Exhibit 2: FRA(0,180,180) = [ { ( ) / ( [ 1 / 2 ]) } - 1 ] 2 =

12 Sofiya Prutko Case Scenario Sofiya Prutko, CFA, is a partner at Fedir Investments, a firm that acts as a private conduit for issuing securities backed by non-conforming residential mortgages. Fedir has assembled an $80 million pool of 30-year, fixed-rate mortgages with unusually high loanto-value ratios and intends to privately place the securities created from this pool. Prutko s task is to determine the best structure for the securities. As part of that process, she has scheduled a series of meetings with current and potential investors. Her first meeting is with an endowment fund manager who may purchase a portion of the securities if they meet his needs. During the meeting, Prutko is asked about the pool s characteristics and its estimated cash flows. She explains that the pool has a WAC of 7.10 percent and a WAM of 356 months and that, under current market conditions, prepayments are expected at 310 PSA. Later in the discussion, she presents a table showing pool cash flow estimates for a different prepayment assumption. An incomplete part of that table appears in Exhibit 1. Exhibit 1 Mortgage Pool Monthly Cash Flow Estimate Months From Now Outstanding Balance Mortgage Payment Net Interest Scheduled Principal 24 $47,563,831 $327,321 $281,419 $45,901 Prepayment The endowment fund manager explains that one of his primary concerns is that market interest rates will rise, leading to prepayment rates that are much lower than currently expected. He also explains that he wants a relatively long-term investment (average life greater than 5 years) and does not want to receive any cash flow from it for a number of years. Prutko s second meeting is with the manager of a public pension fund that invests in a wide variety of fixed income securities. The manager is currently concerned about credit risk but states that, Although I m concerned because some non-agency issuers have more credit risk than Fannie Mae and Freddie Mac, credit enhancement can be used to achieve a credit rating equal to that of Fannie and Freddie securities. Prutko describes the credit risk characteristics of Fedir s securitizations relative to agency securities and adds, in addition, for each $100 in mortgage principal, we issue only $95 in par-value securities, retaining $5 as an equity position. After meeting with these two individuals and others, Prutko decides to separate the pool into two $40 million pools. The first pool is used to back a pair of interest-only and principal-only stripped securities with a $38 million par value. The second pool is used to back a CMO structure with two $12 million sequential planned amortization class (PAC) tranches, PAC-A and PAC-B, and one $14 million support tranche. Interest rates at new issue suggest that prepayments will occur at 310 PSA and the initial PAC collar is

13 PSA for PAC-A and PSA for PAC-B. Each strip security and CMO tranche is privately placed, as was originally desired. 13. Given the 310 PSA prepayment assumption, the current prepayment rate of the pool is closest to a CPR of: A. 2.5%. B. 18.6%. C. 41.3%. Answer: A Mortgage-backed sector of the bond market, Frank J. Fabozzi, CFA 2010 Modular Level II, Vol. 5, pp Study Session d Compare and contrast the conditional prepayment rate (CPR) with the Public Securities Association (PSA) prepayment benchmark. During the first 30 months of a pool s life, t PSA level 4 CPR 6%* * 6%* *3.10 6%*.1333* % 2.5% where t is the number of months since the mortgages were originated. Since the WAM is 356, 4 months have elapsed. 14. Given a single monthly mortality prepayment assumption of percent and the other information about the 24 th month of the pool s life that is provided in Exhibit 1, the expected prepayment amount is closest to: A. $1,014,735. B. $1,020,780. C. $1,021,766. Answer: B Mortgage-backed sector of the bond market, Frank J. Fabozzi, CFA 2010 Modular Level II, Vol. 5, pp Study Session c Calculate the prepayment amount for a month, given the single monthly mortality rate. The (expected) prepayment amount = (Pool balance scheduled principal payment) single monthly mortality (SMM). $1,020,780 = ($47,563,831 - $45,901)

14 15. The endowment fund manager s concern about the impact of movements in market interest rates is best described as a concern about: A. extension risk. B. contraction risk. C. prepayment risk. Answer: A Mortgage-backed sector of the bond market, Frank J. Fabozzi, CFA 2010 Modular Level II, Vol. 5, pp Study Session f Explain the factors that affect prepayments and the types of prepayment risks. Prepayment risk includes contraction risk (the risk that the prepayment rate will rise resulting in a shortening of the security s life) and extension risk (the risk that the prepayment rate will fall, resulting in a lengthening of the security s life.) The investor has expressed a clear concern about falling prepayment rates indicating a concern about extension risk. This is also, generically, a concern about prepayment risk but is better described as extension risk. 16. The pension fund manager s statement about the credit risk of non-agency mortgage-backed securities is most likely: A. correct. B. incorrect, with respect to the use of credit enhancement. C. incorrect, with respect to the credit risk of non-agency issuers. Answer: A Mortgage-backed sector of the bond market, Frank J. Fabozzi, CFA 2010 Modular Level II, Vol. 5, pp Study Session k Compare and contrast agency and nonagency mortgage-backed securities. The pension fund manager s statement is true because most private label issuers do have more credit risk than FNMA or FHLMC and credit enhancement (in a variety of forms, such as third party default protection or overcollateralization) can be used to increase the credit rating of an issue to the level of Fannie and Freddie securities.

15 17. According to the information that Prutko provided to the pension fund manager, the kind of credit enhancement that Fedir provides is best described as: A. wrapping. B. overcollateralization. C. excess spread accounts. Answer: B Asset-backed sector of the bond market, Frank J. Fabozzi, CFA 2010 Modular Level II, Vol. 5, pp Study Session d Distinguish among the various types of external and internal credit enhancements. Overcollateralization in a structure refers to a situation in which the value of the collateral exceeds the amount of the par value of the outstanding securities issued (p. 451) Wrapping refers to a third party guarantee from a monoline insurer. Excess spread accounts require security structures that do not pay out all incoming interest to the security holders, allowing the establishment of a spread account where excess interest payments are stored and can be used to cover future defaults, if needed. 18. Which type of CMO tranche would most likely meet the endowment fund manager s desired investment maturity and cash flow characteristics? A. An accrual tranche. B. A sequential-pay tranche. C. A planned amortization class tranche. Answer: A Mortgage-backed sector of the bond market, Frank J. Fabozzi, CFA 2010 Modular Level II, Vol. 5, pp Study Session h Distinguish among the sequential pay tranche, the accrual tranche, the planned amortization class tranche, and the support tranche in a CMO. Of the three, the accrual tranche typically receives principal only after all sequential-pay and/or planned amortization class tranches have been paid off, meeting the investor s need for a long-term security. Further, until its principal repayment begins, the accrual tranche does not pay interest but accrues it to principal, meeting the investor s need to not receive any cash flow for a number of years.

16 Lisa Jaworski Case Scenario Lisa Jaworski is an equity portfolio manager for Thornhurst Investments, a large investment management company based in Charlotte, North Carolina. Thornhurst currently uses the Capital Asset Pricing Model (CAPM) to evaluate securities and meanvariance portfolio optimization to construct equity portfolios. Jaworski is meeting with two assistant portfolio managers, Yaodong Bi and Niyati Ahuja. Bi and Ahuja have been asked to do some research on ways to improve on the methods currently being used by Thornhurst to evaluate securities and develop portfolios. Jaworski begins the meeting by outlining some issues relating to the CAPM. She makes the following statements: Statement 1 One of the reasons I am uncomfortable using the CAPM is that it makes some very restrictive assumptions such as: investors pay no taxes on returns and no transaction costs on trades, investors have unique views on expected returns, variances and correlations of securities, and investors can borrow and lend at the same risk-free rate of interest. Statement 2 We are also faced with a problem that our mean-variance optimization models can generate unstable minimum-variance efficient frontiers. Consequently, we face considerable uncertainty regarding recommendations we make to our clients on asset allocation. I attribute the instability to our use of: a short sales constraint, and historical betas. Bi suggests that multifactor models provide a better way to model stock returns. He develops two models on a whiteboard while stating: There are two ways to model stock returns using the following multifactor model: Model 1 In this model, stock returns ( ) are determined by surprises in economic factors such as GDP growth and the level of interest rates. Model 2 Here, stock returns ( ) are determined by factors that are company attributes such as price-earnings ratio and market capitalization.

17 While the interpretation of the intercept is similar for both models, the factor sensitivities are interpreted differently in the two models. Ahuja notes that a multifactor Arbitrage Pricing Model (APT) provides a much better basis than the CAPM for calculating expected portfolio returns and evaluating portfolio risk exposures. In order to illustrate the advantages of the multifactor APT model, Ahuja provides information for two portfolios Thornhurst currently manages. The information is provided below in Exhibit 1. The current risk-free rate is 2 percent. Exhibit 1 Factor Sensitivities and Risk Premia Factor Factor Sensitivities Risk Risk Factor Portfolio A Portfolio B Benchmark Premium (%) Confidence Risk Inflation Risk Business Cycle Risk Ahuja makes the following statement: Statement 3 We can tell from Exhibit 1 that Portfolio A is structured in such a manner that it will benefit from an expanding economy and improving confidence because the factor sensitivities for confidence risk and business cycle risk exceed the factor sensitivities for the benchmark. Portfolio B has very low factor sensitivities for confidence risk and business cycle risk but moderately high exposure to inflation risk, therefore Portfolio B can be referred to as a factor portfolio for inflation risk. Jaworski wants to examine how active management is contributing to portfolio performance. Ahuja responds with the following statement: Statement 4 Our models show that Portfolio A has annual tracking error of 1.25 percent and an information ratio of 1.2 while Portfolio B has annual tracking error of 0.75 percent and an information ratio of Which assumption of the CAPM is most likely incorrect in Jaworski s Statement 1? The assumption regarding: A. borrowing and lending. B. taxes and transaction costs. C. expected returns, variances and correlations.

18 Answer: C Portfolio Concepts, Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and David E. Runkle 2010 Modular Level II, Vol. 6, p. 404 Study Session e Explain the capital asset pricing model (CAPM), including its underlying assumptions and the resulting conclusions C is correct. This statement is incorrect. The CAPM assumes that investors have identical views on expected returns, variances and correlations of securities. 20. Is Jaworski s Statement 2 most likely correct? A. Yes. B. No, she is incorrect about the short sales constraint. C. No, she is incorrect about the use of historical betas. Answer: B Portfolio Concepts, Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and David E. Runkle 2010 Modular Level II, Vol. 6, pp Study Session i Discuss reasons for and problems related to instability in the minimum-variance frontier. B is correct. Jaworski is wrong. One of the reasons for an unstable minimumvariance efficient frontier is the absence of a short sales constraint. That is unconstrained mean variance optimization models produce inherently unstable efficient frontiers. The solution is to impose a no short sales constraint. 21. With regard to the statement on multifactor models, Bi is most likely incorrect with respect to the: A. intercept value. B. factor sensitivities. C. description of the factors. Answer: A Portfolio Concepts, Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and David E. Runkle

19 2010 Modular Level II, Vol. 6, pp , Study Session j Discuss and compare macroeconomic factor models, fundamental factor models, and statistical factor models. A is correct. Model 1 is a macroeconomic factor model. In this model the intercept value is the expected return on the stock. Model 2 is a fundamental factor model. In fundamental factor models the factor sensitivities are standardized, thus the intercept is not interpreted as anything more than a regression intercept that ensures that expected asset specific risk equals zero (see page 431). It is not interpreted as the expected return for the stock as in the macroeconomic factor model. 22. Based on the information in Exhibit 1, the expected return for portfolio A is closest to: A. 8.4% B. 10.2% C. 12.2% Answer: C Portfolio Concepts, Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and David E. Runkle 2010 Modular Level II, Vol. 6, pp Study Session l Discuss the arbitrage pricing theory (APT), including its underlying assumptions and its relation to the multifactor models, calculate the expected return on an asset given an asset s factor sensitivities and the factor risk premiums, and determine whether an arbitrage opportunity exists, including how to exploit the opportunity. C is correct. The expected return for portfolio A is calculated as: E(R A ) = 2% % % % = 12.21% 23. Is Ahuja s Statement 3 most likely correct? A. Yes B. No, she is incorrect about Portfolio A C. No, she is incorrect about Portfolio B. Answer: C Portfolio Concepts, Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and David E. Runkle 2010 Modular Level II, Vol. 6, pp ,

20 Study Session l, m Discuss the arbitrage pricing theory (APT), including its underlying assumptions and its relation to the multifactor models, calculate the expected return on an asset given an asset s factor sensitivities and the factor risk premiums, and determine whether an arbitrage opportunity exists, including how to exploit the opportunity. Explain the sources of active risk, define and interpret tracking error, tracking risk, and the information ratio, and explain factor portfolio and tracking portfolio. C is correct. Ahuja is incorrect about Portfolio B. Factor portfolios by definition will have a factor sensitivity of 1 to a particular factor and zero sensitivity for all other factors. For Portfolio B to be a factor portfolio for the inflation risk factor it must have factor beta of 1 to inflation risk and zero for the other factors. 24. Based on Statement 4 by Ahuja, an appropriate conclusion is that the portfolio that has benefited the most from active management is: A. portfolio B because of tracking error. B. portfolio A because of the information ratio. C. portfolio B because of the information ratio. Answer: B Portfolio Concepts, Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and David E. Runkle 2010 Modular Level II, Vol. 6, pp Study Session m Explain the sources of active risk, define and interpret tracking error, tracking risk, and the information ratio, and explain factor portfolio and tracking portfolio. B is correct. Portfolio A has the highest information ratio. The information ratio provides the mean active returns per unit of active risk.

21 Brigitte Langlois Case Scenario Brigitte Langlois, a fixed income securities analyst for Cunard Securities, is responsible for evaluating and monitoring the creditworthiness of companies whose bonds are held in Cunard's High Yield International Corporate Bond Fund. Langlois bases her buy and sell decisions on a multivariate bankruptcy prediction model that estimates the probability that a company will face insolvency within the next 18 months. As inputs into the model, Langlois uses adjusted, rather than reported, accounting data to calculate a company's liquidity, solvency, and profitability ratios. Langlois and her research assistant, Barclay Kingston, are preparing a research report on Duban Inc., a U.S. based company, and Kerwin Corporation, Duban s recently acquired Swedish affiliate, to determine whether either company's intermediate-term bonds would be suitable investments for Cunard's bond fund. Langlois assigns Kingston several tasks: I want you to analyze Duban s long-term solvency because I am concerned about its obligation to provide pension benefits. Because Duban uses U.S. GAAP while Kerwin uses International Financial Reporting Standards (IFRS), I want you to prepare an analysis of their financial statements. Langlois provides Kingston with information about Duban s pension plan, which is shown below in Exhibit 1.

22 Exhibit 1 Duban Inc. Selected Footnote Disclosure Pension Plan Information (in U.S. $ millions) Reconciliation of Pension Benefit Obligation (PBO) Opening Balance $1,606 $1,296 Service Cost Interest Cost Plan Amendments 237 Benefits Paid (148) (145) Participant Contributions 8 6 Closing Balance $1,699 $1, Reconciliation of Plan Assets Opening Balance $507 $592 Return on Plan Assets (41) (21) Employer Contributions Participant Contributions 8 6 Benefits Paid (148) (145) Closing Balance $443 $507 Other Information Unrecognized Prior Service Cost Unrecognized Actuarial Loss Expected Return on Plan Assets Amortization of Unrecognized Prior Service Cost Amortization of Unrecognized Loss Langlois continues to outline Kingston s tasks: I would like you to compute the effect of the consolidation of Kerwin on Duban s profitability. As outlined in Exhibit 2, since the acquisition by Duban, Kerwin s performance has improved dramatically, but I think they should still be considered a Swedish based company for our investment purposes for the following reasons: They sell all of their output in Sweden, in kronas. Although they purchase some components from Duban, all of the labor and other costs are incurred in Sweden. They are able to finance all of their working capital needs from local sources. Selected information from Duban s financial statements and Management s Discussion and Analysis relating to its investment in Kerwin, is shown below in Exhibit 2.

23 Exhibit 2 Selected Information from Duban s 2009 Financial Statements and Management s Discussion and Analysis Concerning Duban s Investment in Kerwin Sweden is an important foreign market for Duban Inc. On 1 January 2009, we made an investment in Kerwin Corporation in expectation of strong consumer demand. As indicated in the following table, as a result of Duban s involvement in the Swedish operations Kerwin's 2009 net sales increased by 25 percent compared with 2008 sales. In addition, Kerwin's 2009 net income increased by 40percent compared to the prior year. Kerwin: Selected Financial Data (in SEK millions) Net sales 56,000 44,800 Net income 5,000 3,600 Monetary assets 13,000 12,000 Non-monetary assets 32,500 28,000 Monetary liabilities 18,000 17,500 Equity 27,500 22,500 USD/SEK Exchange Rate Year-end rate, 31 December $0.140 = 1SEK $0.127 = 1SEK *Average rate during year $0.132= 1SEK $0.141= 1SEK 25. Based on Exhibit 1, funded status of Duban s pension plan under U.S. GAAP for 2009 ($ millions) would be closest to a liability of: A B. 1,256. C. 1,831. Answer: B Employee Compensation: Post-Retirement and Share-Based, Elaine Henry, CFA and Elizabeth Gordon 2010 Modular Level II, Vol. 2, pp Study Session 6-22-g

24 Evaluate the underlying economic liability (or asset) of a company s pension and other post-employment benefits. The pension liability is calculated as follows: Plan Assets 443 Less: PBO (1,699) Funded Status - (deficit) (1,256) 26. Based on Exhibit 1, the pension expense ($ millions) that would be reported on Duban's 2009 income statement under U.S. GAAP would be closest to: A B C Answer: B Employee Compensation: Post-Retirement and Share-Based, Elaine Henry, CFA and Elizabeth Gordon 2010 Modular Level II, Vol. 2, pp Study Session 6-22-c, d Describe the components of a company s defined-benefit pension expense. Explain the impact of a defined benefit plan s assumptions on the defined benefit obligation and periodic expense. The pension expense is calculated as follows: Service Cost 86 Interest Cost 147 Expected Return on Plan Assets (46) Amortization of Unrecognized Prior Service Cost 23 Amortization of Unrecognized loss 15 Pension Expense Based on Exhibit 1, the underlying economic pension expense ($ millions) for Duban for 2009 would be closest to: A B C Answer: C Employee Compensation: Post-Retirement and Share-Based, Elaine Henry, CFA and Elizabeth Gordon

25 2010 Modular Level II, Vol. 2, pp Study Session 6-22-h Calculate the underlying economic pension expense (income) and other postemployment expense (income) based upon disclosures. The economic pension expense is calculated as follows: Service Cost 86 Interest Cost 147 Actual Return on Plan Assets 41 Economic Pension Expense 274 Alternative calculation: the change in the net funded position plus the employer s contributions. ( ) ( ) = $ Langlois description of Kerwin s operations most likely classifies the U.S. dollar as the: A. local currency. B. functional currency. C. presentation currency. Answer: C Multinational Operations, Timothy Doupnik 2010 Modular Level II, Vol. 2, pp Study Session 6-23-a Distinguish among presentation currency, functional currency, and local currency. Langlois describes the krona as the functional currency for Kerwin the sales prices and costs are primarily determined in Sweden and Kerwin is able to finance its operations locally. Therefore the U.S. dollar is not the functional currency, but the presentation currency. 29. If the Swedish krona is chosen as Kerwin s functional currency, Kerwin s 2009 return on equity ratio (%) after translation, using the year-end balance for equity, will be closest to: A B C Answer: A Multinational Operations, Timothy Doupnik 2010 Modular Level II, Vol. 2, pp , 183, 185

26 Study Session 6-23-d, e Calculate the translation effects, evaluate the translation of a subsidiary s balance sheet and income statement into the parent company s currency, and analyze the differential effect of the current rate method and the temporal method on the subsidiary s financial ratios. Analyze how using the temporal method versus the current rate method will affect the parent company s financial ratios. If the functional currency is the SEK, then Duban should use the current rate method to translate Kerwin. The equity will include the initial investment, current retained earnings and the required translation adjustment to bring the balance sheet back into balance following translation. ROE = Net Income/Total Equity (year-end balance) Net Income 5,000 x = 660 Translate at average rate Total Equity o Initial Equity 22,500 x = 2,858 Translate at historical rate (Jan 2009) o Increase in Retained Earnings 5,000 x = 660 Translate at average rate o Translation Adjustment 332 To balance the balance sheet (see following calculation) Total Equity 3,850 ROE 660/3,850 = 17.1% Translation Adjustment: Translation Translated Value Translated Net Assets (1) (27,500) x ,850 Less Translated Initial Equity 22,500 x ,858 Less Translated Increase in Retained Earnings 5,000 x Translation adjustment: amount needed to balance the balance sheet 332 (1) Net Assets = Net Non-monetary assets + Monetary assets Monetary liabilities = 13, ,500 18,000 = 27,500 OR Net assets = Equity = 27, With the changes in the krona indicated in Exhibit 2, compared to using the current rate method, net income under the temporal method, will most likely be: A. lower. B. higher. C. the same. Answer: A Multinational Operations, Timothy Doupnik 2010 Modular Level II, Vol. 2, pp ,

27 Study Session 6-23-d, e Calculate the translation effects, evaluate the translation of a subsidiary s balance sheet and income statement into the parent company s currency, and analyze the differential effect of the current rate method and the temporal method on the subsidiary s financial ratios. Analyze how using the temporal method versus the current rate method will affect the parent company s financial ratios. Under the temporal method the balance sheet exposure is limited to monetary assets and liabilities. Kerwin has a net liability exposure on its balance sheet (monetary liabilities exceed monetary assets) therefore the strengthening of the Swedish krona against the U.S dollar will result in a negative translation adjustment. This negative translation adjustment will be included in Duban s net income under the temporal method decreasing net income.

28 Brad Turner Case Scenario Brad Turner is the Chief Financial Officer of Foster Inc., a Canadian based manufacturing corporation that operates internationally. Foster has Cdn$20 billion in total assets, with excess cash to invest for a planned acquisition in two years. Information about Foster s equity portfolio and fixed income portfolio is provided in Exhibits 1 and 2, respectively. All securities were purchased on the first day of the current year. Foster adheres to International Financial Reporting Standards (IFRS) when accounting for its investments in the securities of other companies. Characteristic Classification Exhibit 1 Foster Inc. Equity Portfolio (at year end, Cdn$ thousands) Security Alton Inc. Barker Inc. Cosmic Inc. Darnell Inc. Associated Company Cost $100,000 $150,000 $250,000 $500,000 Market Value, end-of-year $97,000 $151,000 $257,000 $506,000 Dividends received during the year $1,000 $2,000 $3,000 $4,000 Foster s share of investee s net income for the year $5,000 $7,000 $10,000 $15,000 Note: Darnell Inc. has $2 billion in total assets. Foster owns 40 percent of Darnell s equity and has representation on Darnell s Board of Directors but does not have effective control. Characteristic Classification Exhibit 2 Foster Inc. Fixed Income Portfolio (at year end, Cdn$ thousands) Security Held-fortrading Availablefor-sale Availablefor-sale Eldon Inc. Fizz Inc. Gilt Inc. Harp Inc. Held-fortradinfor-salmaturity Available- Held-to- Held-tomaturity Cost $20,000 $35,000 $50,000 $60,000 Market Value, end-of-year $23,000 $45,000 $45,000 $64,000 Interest earned for the year $1,000 $2,000 $4,000 $5,000 Note: All fixed income securities were purchased at par value.

29 Turner is interested in understanding the effect of the investment portfolios on Foster s year-end financial statements. Foster is re-evaluating its investment strategy, including what would have been the effect if Foster had designated more of the securities as investments at fair value. Turner does not think the decline in market value of any of the securities is permanent, but when discussing it with his investment officer, Charlene Chen, she makes the following statement: I think the impairment in Gilt Inc. is permanent and we should recognize the impairment loss in net income. However, if it recovers next year we will be able to reverse the loss. For Turner s analysis, all tax effects are ignored. 31. The contribution of the equity portfolio to Foster s net income ($) for the year is closest to: A. 7,000. B. 18,000. C. 26,000. Answer: B Intercorporate Investments, Susan Perry Williams 2010 Modular Level II, Vol. 2, pp. 12, 20 Study Session 5-21-a, c Describe the classification, measurement, and disclosure under the International Financial Reporting Standards (IFRS) for 1) investments in financial assets, 2) investments in associates, 3) joint ventures, 4) business combinations, and 5) special purpose and variable interest entities (SPEs and VIEs). Analyze the effects on financial ratios of the different methods used to account for intercorporate investments. The sum of dividends for the first three investments (Alton, Barker & Cosmic) is reduced by the unrealized loss on the held-for-trading security (Alton); to this amount must be added Foster s share of Darnell s net income, as determined under the equity method. The result is: 1, , ,000 3, ,000 = $18, If at acquisition, all of the equity securities that were eligible to be designated as investments at fair value were so designated, the amount that the entire equity portfolio would contribute to Foster s net income ($) for the year is closest to: A. 11,000. B. 21,000. C. 26,000.

30 Answer: C Intercorporate Investments, Susan Perry Williams 2010 Modular Level II, Vol. 2, pp , 27 Study Session 5-21-a, c Describe the classification, measurement, and disclosure under the International Financial Reporting Standards (IFRS) for 1) investments in financial assets, 2) investments in associates, 3) joint ventures, 4) business combinations, and 5) special purpose and variable interest entities (SPEs and VIEs). Analyze the effects on financial ratios of the different methods used to account for intercorporate investments. Only the equity securities that were designated as available-for-sale (Barker and Cosmic) could have been designated at fair value and the unrecognized gains from those securities would then be included in income. Because Foster is a manufacturing company and not a venture capital or mutual fund company, it may not account for its significant influence in Darnell using fair value. Income would be equal to the dividends from Alton, Barker, and Cosmic plus the changes in market value for those same three securities plus the income from Darnell using the equity method. The result is 1, , ,000 3, , , ,000 = $26, Compared to its current classification, if Foster had classified its investment in Darnell as a joint venture and accounted for it in the preferred manner, the most likely effect on Foster s return on assets (ROA) is that ROA would be: A. no change. B. a decrease. C. an increase. Answer: B Intercorporate Investments, Susan Perry Williams 2010 Modular Level II, Vol. 2, pp , Study Session 5-21-a, c Describe the classification, measurement, and disclosure under the International Financial Reporting Standards (IFRS) for 1) investments in financial assets, 2) investments in associates, 3) joint ventures, 4) business combinations, and 5) special purpose and variable interest entities (SPEs and VIEs). Analyze the effects on financial ratios of the different methods used to account for intercorporate investments. The preferred method of accounting for a joint venture under IFRS is proportional consolidation.