HELPFUL ANSWER RATIONALES TOP QUESTIONS YOU MUST MASTER TO PASS THE LEVEL II CFA EXAM

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1 HELPFUL ANSWER RATIONALES TOP QUESTIONS YOU MUST MASTER TO PASS THE LEVEL II CFA EXAM

2 Top Questions You Must Master for the Level II CFA Exam Congratulations on getting through Level I and welcome to Level II. If you haven t had a chance to familiarize yourself with the differences in the exams and details why Level II is so much more difficult than Level I, check out the guide on How to Pass the Level II CFA Exam and get Ten Tips for succeeding. Then, here are some questions to test your knowledge of typical, fundamental topics that are likely to appear on the actual exam. Foreign Exchange FX) Market concepts first appear in Economics, but cross further into topics of Financial Reporting Analysis, Derivatives and Portfolio Management. A solid understanding of FX and lots of practice questions will pay off on exam day. Let s do a quick Level I FX recap: The A/B exchange rate convention, or PC/ BC, indicates the number of units of Currency A price currency) required to purchase one unit of Currency B base currency). Think of it in terms of any product. A $5/bag of chips reflects the price of a bag of chips base) in USD price). An increase to $6/bag means the bag denominator) increased in value. Likewise, if the current exchange rate is $2/ GBP; then one unit of GBP costs $2. If the exchange rate increases to $3/GBP; then one unit of GBP is more valuable appreciates) and costs $3. Alternatively, the USD has lost value depreciated) because it costs more to buy the same unit of GBP. Exchange rates are typically quoted using a bid-ask spread in terms of the base currency. The bid ask) is the price at which the dealer is willing to buy sell) the base currency. Calculating cross rates is straightforward; it s just a matter of eliminating the third currency mathematically A/B x B/C = A/C). The complexity arises in cross rate calculations with bid-ask spreads. Use the following information to answer questions 1 and 2: An analyst gathers the following spot rate quotes in the interbank market: CAD/USD: AUD/USD: The bid-ask on the AUD/CAD cross rate implied by the interbank market is closest to: A B C This question requires you to determine cross rates. A) is the correct answer. AUD/CAD bid = AUD/USD bid x USD/CAD bid USD/CAD bid = 1 / CAD/USD ask ) = 1/ = AUD/CAD bid = x = AUD/CAD ask = AUD/USD ask x USD/CAD ask USD/CAD ask = 1 / CAD/USD bid ) = 1/ = AUD/CAD ask = x = TIP: Remember the b/a ask price is the reciprocal of the a/b bid price and the b/a bid price is the reciprocal the a/b ask price.

3 2. If a deal quoted a bid-ask rate of in AUD/CAD, then a triangular arbitrage would involve buying: A. AUD in the interbank market and selling it to the dealer for a profit of CAD per AUD. B. CAD in the interbank market and selling it to the dealer for a profit of AUD per CAD. C. CAD in the interbank market and selling it to the dealer for a profit of AUD per CAD. B) is the correct answer. The AUD/CAD cross rate implied by the interbank market is look back at question #1). For an investor to make an arbitrage profit, the bid ask) price quoted by the dealer should be higher lower) than the ask bid) price in the interbank market. Since the bid price quoted by the dealer ) is higher than the ask price in the interbank market ), the investor can purchase CAD in the interbank market for AUD and sell it to the dealer for AUD , making a profit of AUD per CAD transacted. TIP: Pay attention to whether the question is asking from the perspective of the dealer or the investor. Financial Reporting and Analysis FRA) encompasses a variety of topics in Level II and accounts for 15% - 20% of the exam. Level II FRA begins with inventories and long-lived assets, which build on what you learned in Level I. Recognize if you need a Level 1 refresher; if so, invest the time. Intercorporate Investments covers a lot of ground, with many popular concepts; you can never be sure which will show up on exam day. The classification, measurement and disclosure of intercorporate investments, in particular, investments in financial assets is a must know as well the treatment of goodwill after an acquisition. You would be wise not to rush through these sections! Intercorporate Investments investments in other companies) can significantly impact a company s income statement and balance sheet. The classification of an investment is based on the degree of control or influence, not just percentage of the investment. The four categories are investments in financial assets, investments in associates, business combinations and joint ventures. Financial reporting treatment depends on the classification. The following questions look specifically at investments in financial assets. Use the following information to answer the next two questions. Consider the following information relating to Philip Materials PM) fixed income investment portfolio. All amounts are in EUR ). Purchase Price par value) Emmy Corp. PTCA Int l Pumi Co. Market Value, Dec. 31, 2010 Market Value, Dec. 31, 2011 Classification 50,000 40,000 38,000 Held to maturity 20,000 25,000 28,000 Available for sale 60,000 66,000 69,000 Held to maturity 3. The balance sheet carrying value of PM s investment portfolio at December 31, 2011, is closest to: A. 127,000. B. 135,000. C. 138,000. C) is the correct answer. Held-for-trading and available-for-sale securities are carried at market value, while held-to-maturity securities are carried at historical cost. Balance sheet carry value = 50,000 28,000 60,000 = 138,000.

4 4. Compared to PM s reported earnings before taxes in 2011, if PTCA Int l were instead classified as held for trading, earnings before taxes would most likely be: A. The same. B. 8,000 higher. C. 3,000 higher. C) is the correct answer. When securities are classified as held for trading, unrealized gains and losses are included in income. During 2011, there was an unrealized gain of 3,000 28,000-25,000) on PTCA Int l. Intercorporate Investments can also be complex because the required financial reporting treatment under U.S. GAAP and IFRS does not always align; be sure to understand the differences when measuring goodwill. For noncontrolling minority) interests, U.S. GAAP requires the full goodwill method and IFRS permits both the full and partial goodwill methods. 5. Which of the following is least likely if a parent uses the full goodwill method as opposed to the partial goodwill method to account for an acquisition? A. Return on assets and return on equity will be lower under the full goodwill method. B. Net income and shareholders equity are the same under both methods. C. The net profit margin will be the same under both methods. B) is the correct answer. Total assets and total equity are higher under the full goodwill method; hence, ROE and ROA are lower. Net income and retained earnings are the same under both methods, but total shareholders equity is higher under the full goodwill method. The income statement is the same under both. TIP: Do not read the question too fast; pay attention to what the question is specifically asking least vs. most likely, etc.) and watch out for tricky distractors. FRA also includes employee compensation, multinational operations and builds upon Level I financial reporting quality and financial statement techniques. The following questions highlight some must know concepts from employee compensation and multinational operations. 6. Consider the following information $000): Beginning pension obligation 2,225 Ending pension obligation 3,655 Benefits paid 170 Beginning fair value 1,850 Actual return on plan assets 250 Ending fair value 2,510 Given that there are no actuarial gains or losses for the period, periodic pension cost is closest to: A. $580. B. $770. C. $1,350. C) is the correct answer. This question requires a number of calculations to determine the final calculation of periodic pension cost. Ending net pension liability Beginning net pension liability Employer contributions Periodic pension cost = Ending pension obligation - Ending fair value = Beginning pension obligation Beginning fair value = Ending fair value Beginning fair value Actual return on plan assets benefits paid = Ending net pension liability beginning net pension liability Employer contributions 3,655 2,510 = 1,145 2,225 1,850 = 375 2,510 1, = 580 1, = 1,350 TIP: Many candidates are overwhelmed by pension calculations. Memorize the formulas and practice lots of questions if you find this section daunting.

5 7. An analyst gathered the following information regarding Lint Corporation: Retained earnings, January 1, 2011 Cumulative translation agreement CTA) on January 1, 2011 Net income, 2011 Dividends declared, December 31, 2011 Total assets, December 31, 2011 Total liabilities, December 31, 2011 Common stock $1.3 million $0.26 million $3.8 million $2.3 million $22.5 million $12.5 million $7 million For the year 2011, Lint Corporation will most likely recognize a translation: A. Gain of $200,000. B. Gain of $60,000. C. Loss of $60,000. C) is the correct answer. Ending retained earnings Ending CTA Translation gain/loss for the period = Beginning retained earnings Net income Dividends declared = Total assets Total liabilities Common stock Ending retained earnings Ending CTA Cumulative CTA 1.3m 3.8m 2.3m = $2.8 million 22.5m 12.5m -7m -2.8m = $0.2 million 0.2m 0.26m = -$60,000 Fixed Income valuation concepts that are definite must knows include arbitrage-free valuation, and valuation and analysis of bonds with embedded options. Make sure you are comfortable and understand how to construct, calculate and analyze binomial interest rate trees. A binomial interest rate tree is a visual representation of possible interest rates based on the interest rate model used and the interest rate volatility assumption. The binomial model assumes that the random variable interest rates) can take only two possible values in the next period and that the probability of realizing either value is equal 50%). Backward induction is the procedure for calculating the value of the bond, moving backward, from right to left, along the tree. The value of the bond at any given node depends on the: 1. Possible values of the bond one year from the node; 2 The coupon payment one year from that node; 3. The current one-year interest rate at that node. It is important to ensure the binomial interest rate tree has been calibrated to be arbitragefree in order to use the rates in the tree to value bonds with embedded options. Use the following information to answer the next two questions. Assuming an interest rate volatility of 10%, a three-period binomial interest rate tree is constructed. At every node, there is a 50% chance of moving to the higher interest rate node and a 50% chance of moving to the lower interest rate node: % % 3.50% % % % t = 0 t = 1 t = 2 8. Using the binomial tree, the arbitrage-free value of a three-year 6% coupon bond is closest to: A. $ B. $ C. $103.58

6 C) is the correct answer. Determine the bond value by applying backward induction. V 2,HH %) = $ , C = $6 V 2,HH = =$ ) ) 1 V 2,HL %) = $ , C = $6 V 2,HL = =$ ) ) 1 V 2,LL %) = $ , C = $6 V 2,LL = =$ ) ) 1 V 1,H %) = $ , C = $6 V 1,H = =$ ) ) 1 V 1,L %) = $ , C = $6 V 1,L = =$ ) ) 1 V %) = $ , C = $6 V 0 = =$ ) ) 1 The value of a callable putable) bond is calculated by applying the same backward induction methodology for an option free bond; except that at each node during the call put) period, the value of the bond equals the lower higher) of the value calculated through backward induction and the call put) price. It helps to remember for a callable putable) bond, the decision to exercise the call put) option is made by the issuer investor). Also know the following formulas; using the same information you could be asked for the: Value of issuer call option = Value of straight bond Value of callable bond Value of investor put option = Value of putable bond Value of straight bond 9. Using the binomial tree, the arbitrage-free value for the three-year 6% coupon bond callable at $100 any time after one year is closest to: A. $ B. $ C. $ C) is the correct answer. V 2,HH %) = $ , C = $6 V 2,HH = =$ ) ) 1 V 2,HL %) = $100, C = $6 V 2,LL %) = $100, C = $6 V 1,H %) = $100, C = $6 V 1,L %) = $100, C = $6 V %) = $ , C = $6 V 0 = =$ ) ) 1 TIP: If the question had asked instead about the putable bond, the put option would be exercised only at t=2, interest rate = %; V 2,HH = $100. The remaining t=2 and t=1 values would be the same as in question 4 and V 0 = $ The effective duration of a callable bond or a putable cannot exceed that of the straight bond: When interest rates are high low) relative to the bond s coupon, the embedded call put) option is out-of-the-money so the option is unlikely to be exercised. At high low) interest rates, the callable putable) and straight bonds have similar effective durations. When interest rates fall rise), the embedded option moves toward the money. The presence of the option reduces effective duration relative to the straight bond. 10. All other things remaining the same, which of the following bonds is most likely to have the highest effective duration: A. Straight bond. B. Callable bond. C. Putable bond. A) is the correct answer. The effective duration of a callable bond cannot exceed that of the straight bond. The effective duration of a putable bond also cannot exceed that of the straight bond. Good luck and stay on track. Remember, good preparation is essential to success. www.

The Term Structure and Interest Rate Dynamics Cross-Reference to CFA Institute Assigned Topic Review #35

Study Sessions 12 & 13 Topic Weight on Exam 10 20% SchweserNotes TM Reference Book 4, Pages 1 105 The Term Structure and Interest Rate Dynamics Cross-Reference to CFA Institute Assigned Topic Review #35