Overview for Questions #1-4 of 88 Question ID: 1626127

TOPIC: FINANCIAL STATEMENT ANALYSIS

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

Ali Saminder, CFA, has recently been hired by JJK Holdings, Inc. (JJK), a U.S.-based
financial services holding company. JJK has global operations in commercial and
investment banking alongside a significant wealth management division, JJK BMD.
Saminder is currently on a six-month rotation working in the risk management
division of JJK. She is seeking to become familiar with JJK's approach to risk
management and the maintenance of an adequate capital base.

Saminder has reviewed an internal document outlining JJK's approach to meeting

regulatory requirements and has made a note of two fundamental rules that she
believes are used to help analyze capital adequacy.

Rule 1: When assessing the tier 1 capital ratio, assets should be weighted
according to their risk, with riskier assets assigned a lower value than
risk-free assets such as cash.

Rule 2: Off-balance-sheet assets should be excluded from the asset base of the
bank when assessing capital adequacy.

The document provided to Saminder outlines JJK's approach to calculating regulatory

capital. Extracts from the document are shown in Exhibit 1.

Exhibit 1: Internal Memo—Regulatory Capital Calculation (extracts)

Tier 1 capital is defined in accordance with global regulatory standards and is

appropriately adjusted for intangible and deferred tax assets resulting from
losses carried forward.
Other tier 1 capital consists of irredeemable non-cumulative preferred stock
with a fixed divided of 4.3%.
Consistent with local regulatory standards, Tier 2 capital is comprised of
$18,047m of subordinated debt maturing in five years, and a convertible bond
issue convertible only at maturity at the end of 20X9 (convertible into common
stock).
JJK Holding has a target tier 1 ratio of 15% and total capital ratio of 20%.
20X8 year-end figures are forecast as follows:
 20X8 ($m)

Regulatory capital

Common equity tier 1 capital 87,390

Additional tier 1 capital 16,401

Tier 2 capital 25,447

Total assets 510,948

Risk-weighted assets 601,312

Saminder notes that the convertible bond is due for conversion in 20X9. She intends
to recalculate the 20X8 tier 1 ratio as if the bonds had been converted already.

Saminder has also reviewed an internal memo outlining some key trends over the last
three years that were labeled 'Possible concerns?' by a previous employee. However,
it was not clear from the document which trends if any were actual cause for concern.
The trends included in the documents are shown in Exhibit 2: Internal Memo—
Three-Year Trends.

Exhibit 2: Internal Memo—Three-Year Trends

20X5 20X6 20X7

$m $m $m

Assets under management1 139,398 118,957 108,086

Net outflows2 100,483 112,482 196,429

High quality liquid assets 111,432 127,352 198,393

Available stable funding 376,092 376,653 388,624

Required stable funding 327,043 301,275 303,182

1 Represents client assets managed by JJK BMD Trusts

2 30-day liquidity needs in a stress scenario

Question #1 of 88 Question ID: 1560269

Which of Saminder's fundamental rules is most likely to be accurate?

A) Only rule 1 is accurate.

B) Only rule 2 is accurate.
C) Neither rule is accurate.

Question #2 of 88 Question ID: 1560270

Using the forecasted data and explicit targets given in Exhibit 1: Internal Memo—
Regulatory Capital Calculation (extracts), Saminder is most likely to conclude that
JJK Holdings would:

A) meet its targeted tier 1 ratio and total capital ratio.

B) meet its targeted tier 1 ratio but not its targeted total capital ratio.
C) fail to meet either target.

Question #3 of 88 Question ID: 1560271

How are tier 1 capital and total capital most likely to change when Saminder makes
her stated adjustment for the convertible bonds?

A) Common equity tier 1 capital and total capital will both remain unchanged.
B) Tier 1 capital will increase and tier 2 capital will decrease.
C) Other tier 1 capital will decrease and total capital will remain unchanged.

Question #4 of 88 Question ID: 1626128

Using the data in Exhibit 2: Internal Memo—Three-Year Trends, which of the

following statements is most accurate?

The number of days JJK can withstand a stress-level-volume of cash outflows

A)
decreased by three days from 20X5 to 20X7.
B) The liquidity coverage ratio decreased in each of the two years.
The trend in net stable funding ratio indicates an increase from 20X5 to 20X7 in
C)
highly liquid funding available, compared to the level of funding required.
Overview for Questions #5-8 of 88 Question ID: 1630309

TOPIC: FINANCIAL STATEMENT ANALYSIS

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

Roleo is a large U.S. multinational with subsidiaries around the world and prepares its
financial statements in accordance with the U.S. GAAP. Among these subsidiaries is
Simlair Industries. Alex Dudda, CFA, is one of the equity analysts following Roleo.
Roleo has a defined benefit pension plan for its employees.

In preparing his research report, Dudda makes the following observations in the
working documents:

Defined Benefit Pension Plans

Dudda noted that the assumed higher expected rate of return on plan assets reduces
reported pension expense but does not affect the PBO, and thus increases the plan's
funded status.

Employee Share Option Scheme

Roleo also has an employee share option scheme. Just as there is a cost to Roleo for
its defined benefit scheme, the cost of Roleo's share option scheme will be charged as
an expense to the income statement and hence reduce retained earnings and equity
even if there is no cash outlay.

Question #5 of 88 Question ID: 1560264

Assume the country where Simlair is operating has been experiencing 30% annual
inflation over the past three years and that Simlair has a net monetary liability
position. Which of the following best describes the effect on Roleo's consolidated
financial statements?

A) A gain is recognized in the income statement.

B) A loss is recognized in the income statement.
C) A gain is recognized as a direct adjustment to the balance sheet.
Question #6 of 88 Question ID: 1560265

Assume that Simlair is a significantly integrated sales division of Roleo, and that Roleo
makes virtually all of the operating, investing, and financing decisions. The foreign
currency gains and losses that arise from the consolidation of Simlair should be
reported in:

A) shareholders’ equity.
B) operating cash flow.
C) net income.

Question #7 of 88 Question ID: 1630310

Dudda's statement about defined benefit pension plans is most likely:

A) correct.
B) correct about PBO but incorrect about funded status.
C) correct about funded status but incorrect about PBO.

Question #8 of 88 Question ID: 1626126

Dudda's comments regarding Roleo's employee share option scheme are most likely:

A) correct.
incorrect because the cost of issuing shares under an employee stock option
B) scheme will be taken directly to equity via OCI and hence not reduce retained
earnings.
incorrect as the cost of issuing shares under an employee stock option scheme will
C)
not reduce equity.

Overview for Questions #9-12 of 88 Question ID: 1561802

TOPIC: CORPORATE ISSUERS

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

Dan Andrews, CFA, is the equity analyst for a large pension fund. One of the fund's
holdings is Debian Corporation, based in Country A, an emerging market economy.
Debian recently divested a division, and wants to distribute the resulting proceeds to
its shareholders. Andrews collects the information on Country A, as shown in Exhibit
1.

Exhibit 1: Select Information on Country A

Country A is a rapidly growing emerging market economy. Its 20-year

benchmark currency–denominated sovereign debt currently offers an
attractive 8% yield. Current tax rates are investor friendly and are 12% for
both dividends and capital gains, while the corporate tax rate is 30%. The
standard deviation of equity returns is 19%; for bond returns, it is 12%.

Andrews discusses Debian's current dividend policy with Sarah Givens, a senior
economist with the fund. Givens makes the following statements:

Statement 1: Shareholders can plan their financial budget assuming a

specific dividend income. Higher dividends makes them less
reliant on uncertain income from their other investments, a
preference they exhibit while choosing which investments to
continue to hold.

Statement 2: Shareholders are acutely aware of their tax situations, and

always want to maximize their after-tax cash flows, if given a
choice.

The 20-year benchmark sovereign bond yield is currently 6%. Andrews plans on using
the international capital asset pricing model (ICAPM) to estimate Debian's cost of
capital. Givens states that the ICAPM prices two risk factors: (1) a benchmark market
index factor, and (2) a foreign currency–denominated, wealth-weighted market index.

Question #9 of 88 Question ID: 1561803

Regarding Debian's plan to distribute the cash flow from the divested business, which
of the following is the most likely course of action for the company?

A) Increase regular dividends.

B) Pay a special dividend instead of an increase in regular dividends.
C) Pay dividends instead of a stock repurchase to preserve flexibility.

Question #10 of 88 Question ID: 1561804

Regarding statements made by Givens, which of the following is most accurate?

Statement 1 is consistent with the bird-in-hand theory, while Statement 2 is

A)
consistent with the dividend irrelevance theory.
Statement 1 is consistent with the dividend irrelevance theory, while Statement 2 is
B)
consistent with tax minimization theory.
Statement 1 is consistent with dividend preference theory, while Statement 2 is
C)
consistent with tax aversion theory.

Question #11 of 88 Question ID: 1561805

What is the estimate of CRP to use in estimating Debian's required return on equity?

A) 2.00%.
B) 3.17%.
C) 0.38%.

Question #12 of 88 Question ID: 1561806

Givens's statement about the ICAPM is:

A) correct.
incorrect about the second factor because it is based on an equally weighted market
B)
index.
C) incorrect about the first factor because it is based on a global market index.

Overview for Questions #13-16 of

Question ID: 1560283
88
TOPIC: EQUITY VALUATION

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

Carl Warner, CFA, has been asked to review the financial information of Global Drug
World (GDW) in preparation for a possible takeover bid by rival competitor
Consolidated Drugstores International (Consolidated). GDW has produced impressive
results since going public via an initial public offering in 2008. Through a program of
aggressive growth by acquisition, GDW is currently seen as a major player and a
threat to Consolidated's own plans for growth and profitability. In preparation for his
analysis, Warner has gathered the following financial data from GDW's year-end
statements.

GDW Statement of Income for Year Ended May 31, 2018

Sales 4,052,173

Expenses

Cost of goods sold, general and operating expenses 3,735,397

Noncash charges 56,293

Interest on long-term debt 20,265

Other interest 5,223

3,817,178

Income before income taxes 234,995

Income taxes 70,499

Net income 164,497

Earnings per share 0.72

Partial GDW Balance Sheet on May 31, 2018

Assets

Current assets (excluding cash)

Accounts receivable 284,762

Inventories 490,755

Prepaid expenses 23,743

Total current assets (excluding cash) 799,260

Property, plant, and equipment 687,890

Other assets 236,417

Liabilities

Current liabilities (excluding notes payable)

Accounts payable and accrued liabilities 296,564

Other 100,039

Total current liabilities (excluding notes payable) 396,603

Long-term debt 262,981

Other liabilities 15,484

Additional Information

Risk-free rate 4.5%

WACC 7.5%

2018 working capital investment $7,325

2018 dividends $82,248

Beta 1.10

Investment in fixed capital in 2018 $143,579

Market risk premium 5%

Total equity May 31, 2017 $1,019,869

Principal repayment of long-term debt in 2018 $33,275

Notes payable issued in 2018 $5,866

2018 change in liabilities $27,409

Tax rate 30%

As part of his analysis, Warner needs to forecast the free cash flow to the firm (FCFF)
for 2019. The best information he has points to an increase in sales of 6%. The
earnings before interest and tax (EBIT) margin is not expected to change from the rate
of 6.4% achieved in 2018. Fixed capital spending is expected to be $36,470.
Investment in net working capital is expected to be $24,313. Moreover, Warner notes
that the only noncash charge is depreciation, which he estimates will be $60,000.

Warner has been asked to analyze the effect each of the following corporate events, if
taken during 2019, would have on GDW's free cash flow to equity (FCFE):
 20% increase in dividends per share.
Repurchase of 25% of the firm's outstanding shares using cash.
New common share offering that would increase shares outstanding by 30%.
New issue of convertible bonds that are not callable for five years and would
increase the level of debt by 10%.

Warner is also interested in valuing Betacorp, another acquisition possibility for

Consolidated. Warner notes that Betacorp is a mature, profitable company with
generous dividend payments, which has resulted in a volatile capital structure for the
company.

Question #13 of 88 Question ID: 1560284

By how much (in dollars) does GDW's FCFF exceed its free cash flow to equity (FCFE) in
2018?

A) $9,567.
B) $45,251.
C) $52,897.

Question #14 of 88 Question ID: 1560285

The 2019 estimate of FCFF is closest to:

A) $191,646.
B) $210,329.
C) $215,329.

Question #15 of 88 Question ID: 1560286

Which corporate event that Warner is analyzing is likely to have the largest effect on
FCFE in 2019?

A) Share repurchase.
B) Share offering.
C) Convertible bond issue.

Question #16 of 88 Question ID: 1560287

Which of the following approaches would Warner most appropriately use to value
Betacorp?

A) FCFF approach.
B) FCFE approach.
C) Dividend discount approach.

Overview for Questions #17-20 of

88 Question ID: 1560288

TOPIC: EQUITY VALUATION

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

Marie LeBlanc, CFA, is an analyst at Lee Nguyen Investments, an international equities

investment firm. LeBlanc has been asked to value two European cosmetics
companies, Schön AG and Hermosa S.A.

The beauty products industry is a mature industry with few competitors. One segment
that is growing is luxury skin care; while the cosmetics industry is expected to grow at
a steady rate of 3.5%, the luxury skin care segment is expected to grow at 5.5%.

Schön AG, based in Frankfurt, Germany, is the largest company in the luxury skin care
segment of the cosmetics industry. Schön is considered a very stable company within
the cosmetics industry and the luxury skin care segment. Schön's equity beta is 1.00.

LeBlanc collects selected financial information from Schön's income statement and
cash flow statement (for the last fiscal year) and from Schön's balance sheet (for the
last two fiscal year ends). The information is shown in Exhibit 1. Negative numbers are
indicated in parentheses. There is no preferred stock, and no long-term asset sales
occurred in 20X9.

Exhibit 1: Selected Schön Financial Information (€ millions except for rates and
ratios)
Income Statement 20X9 Balance Sheet 20X8 20X9

Revenue 4,250 Total current assets 2,408 2,577

EBITDA 1,461 Net PPE 3,794 4,150

Operating income 1,169 Notes payable 600 644

Interest expense 150 Long-term debt 2,020 2,070

Income tax rate 30% Total liabilities 3,210 3,378

Dividends 357 Total equity 2,992 3,349

Other Information 20X9

CF from operations 1,042

CF from investing (648)

Risk-free rate 2.50%

After-tax cost of debt 4.50%

Cost of equity 8.50%

Target D/E ratio 1.00

Hermosa S.A., based in Barcelona, Spain, is the third largest company in the luxury
skin care segment of the cosmetics industry. Hermosa is considered a growth
company within the cosmetics industry and the luxury skin care segment. Hermosa
has not issued bonds and all of Hermosa's debt is considered short and intermediate
term. For the fiscal year 20X9, FCFF is €143 million and FCFE is €136.23 million.
Hermosa pays no dividends. Hermosa's earnings are expected to grow at 14.0% for
three years and then at the expected overall rate of growth in the luxury skin care
segment. Hermosa's equity beta is 1.20. The risk-free rate is 2.5%. Hermosa's target
weight for debt is 25.0%. Hermosa has 200 million shares outstanding.

Elizabeth Nguyen, one of the partners at Lee Nguyen Investments, approaches

LeBlanc about a client interested in buying Hermosa S.A. Nguyen asks LeBlanc about
using the residual income method to value Hermosa.

Statement 1: Residual income models can be used with a variety of

inventory cost flow assumptions without any adjustments.

Statement 2: If the company has any special purpose entities that are
not consolidated, we need to adjust the reported financial
 statements, effectively consolidating the SPE, before
applying the residual income method.

Question #17 of 88 Question ID: 1560289

The free cash flow to equity for Schön AG for 20X9 is closest to:

A) €439 million.
B) €488 million.
C) €499 million.

Question #18 of 88 Question ID: 1560290

Assuming that the growth rate of Schön earnings is equal to the overall cosmetics
industry growth rate, the value of the firm is closest to:

A) €17.2 billion.
B) €33.6 billion.
C) €49.9 billion.

Question #19 of 88 Question ID: 1560291

The estimated value of Hermosa stock using FCFE valuation is closest to:

A) €19.70.
B) €21.40.
C) €22.10.

Question #20 of 88 Question ID: 1560292

Regarding LeBlanc's statements to Nguyen:

A) both statements are correct.
B) neither statement is correct.
C) only one statement is correct.

Overview for Questions #21-24 of

88 Question ID: 1560293

TOPIC: FIXED INCOME

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

Rafael Dias joined Banco Apice S.A. last year as a junior bond analyst.

Gabriela Gomes, Dias's immediate supervisor, provides him with a binomial interest
rate tree with a 20% volatility assumption as shown in Exhibit 1.

Exhibit 1: Binomial Interest Rate Tree

Guilherme da Silva, one of the bond traders at Apice, provides Dias with information
about several trades currently being evaluated. Exhibit 2 shows data about two of the
bonds.

Exhibit 2: Selected Information on Potential Trades

Characteristic Bond A Bond B

Maturity 3 years 2 years

Option Callable at par at t = 1 year Putable at par at t = 1 year

Coupon 2% 1.50%

Par Value $100 $100

Da Silva asks Dias the following questions:

Question 1: Which bond in Exhibit 2 is most likely to exhibit negative

convexity?

Question 2: For a given decline in interest rate, which bond is most likely to
have lower upside potential?

Question 3: If interest rates rise, which bond is most likely to see its
effective duration increase?

Question #21 of 88 Question ID: 1560294

The price of Bond A in Exhibit 2 is most accurately described as being sensitive to

shifts in:

A) the one-year par rate only.

B) the three-year par rate only.
C) both the one-year and three-year par rates.

Question #22 of 88 Question ID: 1560295

The most accurate answers to Da Silva's Question 1 and Question 2 are:

Question 1 Question 2

A) Bond A Bond A

B) Bond A Bond B

C) Bond B Bond A
Question #23 of 88 Question ID: 1560296

Using the rates in Exhibit 1 and the information in Exhibit 2, the value of Bond A is
closest to:

A) $90.63.
B) $95.68.
C) $99.28.

Question #24 of 88 Question ID: 1560297

In answer to Da Silva's Question 3, the bond whose effective duration is most likely to
increase if interest rates rise is:

A) Bond A
B) Bond B
C) neither Bond A nor Bond B.

Overview for Questions #25-28 of

88 Question ID: 1560303

TOPIC: DERIVATIVES

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

Randy Carson is the chief information officer of Zion Investments, LLC, an

independent investment company. Carson has asked Jane Walsinzki, a senior
derivatives analyst for Zion, for information on several outstanding contract positions.
Walsinzki prepares a report outlining relevant information about the various
derivatives.

Walsinzki's report first identifies that the firm has a payer position in a two-year,
semiannual, 3.25% fixed interest rate swap with a notional of $15 million. The second
settlement just occurred. Current 180-day and 360-day MRR are 3.25% and 3.50%,
respectively.
The report also identifies a two-year, semi-annual USD-for-EUR currency swap with a
notional of €1 million. When the swap was initiated, the USD and EUR fixed rates were
3% and 2%, respectively. The exchange rate has changed from €/$ 0.9091 at inception
to €/$ 0.8929 currently.

Furthermore, the report outlines that the firm holds a call option on a Eurodollar
futures contract. This position was established to hedge another position of the firm,
but Walsinzki could not identify the position that was being hedged.

Finally, Carson asks Walsinzki about the mechanics of forward pricing.

Question #25 of 88 Question ID: 1560304

The value of the interest rate swap is closest to:

A) $32,200.
B) $47,500.
C) $63,300.

Question #26 of 88 Question ID: 1560305

The fixed USD payment in the currency swap is closest to:

A) $16,500.
B) $17,900.
C) $33,000.

Question #27 of 88 Question ID: 1560306

The call option on Eurodollar futures is most likely being used to hedge:

A) a floating rate liability.

B) a long position in a floating rate note.
C) a long position in a fixed rate bond.
Question #28 of 88 Question ID: 1560307

Regarding Carson's question about mechanics of forward pricing, Walsinzki would

most accurately state that forward prices are set such that:

A) the market value of the contract at inception is 0.

the forward price is higher than the spot price by the expected return on the
B)
underlying.
the forward price is lower than the spot price by the dividend yield on the
C)
underlying.

Overview for Questions #29-32 of

88 Question ID: 1626129

TOPIC: ALTERNATIVE INVESTMENTS

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

Mateo Durand, a student at HEC Paris, has been asked to prepare a presentation on
commodities and commodity derivatives for his Trading course. Durand has a basic
understanding of commodity derivatives, but would like a practitioner's perspective,
and so has arranged an interview with commodities trader Elena Laurent.

During the informational interview, Durand first asks Laurent, "Could you explain the
various types of participants in commodity futures markets? I've heard about hedgers,
speculators, and arbitrageurs, but I'm not sure I really understand the difference."

In response, Laurent makes three statements:

Statement 1: "Hedgers may not be accurate predictors of the future supply and
demand for the commodity they deal in."

Statement 2: "Speculators can earn guaranteed profits by providing insurance to

hedgers."

Statement 3: "Arbitrageurs may use storage facilities to exploit mispricing

between commodity spot prices and futures prices."

Laurent begins to quiz Durand. She asks him: "If you were going to calculate the total
return of a fully collateralized commodity futures contract, which of these expressions
would you use?"

Equation 1: collateral return + spot price return + roll return

Equation 2: spot price return + direct storage costs – convenience yield

Equation 3: spot price return + roll return + convenience yield – collateral return

Durand continues his questioning:

"I understand that the original purpose of futures markets was for producers and
consumers to hedge physical raw materials. Could you explain the various theoretical
bases for commodity futures markets' long-run behavior?"

In response, Laurent makes three explanatory statements:

Statement 4: "In Insurance Theory, commodity consumers who are short the
physical good are motivated to buy the commodity for future
delivery to hedge their consumption price risk exposure."

Statement 5: "The Hedging Pressure Hypothesis describes scenarios when

producers along with consumers seek to protect themselves from
commodity market price volatility by entering into price hedges to
stabilize their projected profits and cash flow."

Statement 6: "The Theory of Storage focuses on supply and demand dynamics

of commodity inventories, including the concept of convenience
yield."

To wrap up their conversation, Laurent poses a hypothetical situation to Durand:

"Suppose that a refinery operating on the US Gulf Coast wishes to enter into a swap
that will hedge against adverse changes in the price difference between highly liquid
Brent Crude Oil futures contracts and very illiquid Gulf of Mexico crude oil futures
contracts. What kind of commodity swap would the refinery want to enter into?"

After the interview, Laurent agrees to meet with Durand the following week to discuss
more topics related to commodities and commodity derivatives.

Question #29 of 88 Question ID: 1626130

Regarding Laurent's statements about the various types of participants in commodity

futures markets, Laurent was least accurate in making:
A) Statement 1.
B) Statement 2.
C) Statement 3.

Question #30 of 88 Question ID: 1626131

Durand should state that the total return of a fully collateralized commodity futures
contract can most accurately be calculated using Laurent's:

A) Equation 1.
B) Equation 2.
C) Equation 3.

Question #31 of 88 Question ID: 1626132

Regarding the primary theories of futures returns, Laurent was least accurate in
making:

A) Statement 4.
B) Statement 5.
C) Statement 6.

Question #32 of 88 Question ID: 1626133

Regarding Laurent's hypothetical question, the refinery is most likely to enter into:

A) an excess return swap.

B) a basis swap.
C) a variance swap.

Overview for Questions #33-36 of

Question ID: 1626139
88
TOPIC: PORTFOLIO MANAGEMENT

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

Rose Dongen is the chief risk officer at Molenaar Asset Management. Dongen is
concerned about the risk metrics the firm is currently using, so she meets with Dan
Kuiper, the firm's portfolio manager, and Dirk Schipper, the head trader. Kuiper
explains that the firm has been using a Value at Risk (VaR) metric over the past year,
and it seems to communicate downside risk very well. Kuiper makes the following
statements:

Statement 1: A 5% VaR measures the maximum loss with a 95% confidence

level.

Statement 2: Parametric VaR is more suitable than historical VaR if we expect

fundamental changes in the economy.

Kuiper states that the expected return of the firm's portfolios over the next year is
11.20%, with annual standard deviation of 14.80%. Currently, the firm has $332 million
in assets under management.

Dongen makes the following statements regarding using a backtesting approach to

evaluate investment strategies:

Statement 1: Backtesting uses the real-life investment process to test the risk-
return tradeoff of an investment strategy.

Statement 2: Backtesting fully accounts for randomness in data.

Schipper makes the following statements regarding Monte Carlo simulation:

Statement 1: We can use a Monte Carlo simulation, however if the asset

returns are correlated a multivariate distribution should be
specified.

Statement 2: Monte Carlo simulation is a proxy for actual investing.

Question #33 of 88 Question ID: 1560339

Regarding Kuiper's Statement 1 and Statement 2:

A) only Statement 1 is accurate.

B) only Statement 2 is accurate.
C) both statements are accurate.

Question #34 of 88 Question ID: 1560340

The 5% annual $VaR using the parametric approach is closest to:

A) $44 million.
B) $56 million.
C) $150 million.

Question #35 of 88 Question ID: 1626140

Regarding Dongen's two statements about backtesting:

A) Both statements are correct

B) Statement 1 is correct while statement 2 is incorrect.
C) Statement 1 is incorrect while statement 2 is correct.

Question #36 of 88 Question ID: 1626141

Regarding Schipper's two statements:

A) Only statement 1 is correct.

B) Only statement 2 is correct.
C) Both statements are correct.

Overview for Questions #37-40 of

Question ID: 1626142
88

TOPIC: PORTFOLIO MANAGEMENT

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

Brendan Mollie is a summer intern at Faver Asset Management. He is currently

learning about the various economic forecasts used at Faver. As part of his
orientation, Sean McDermott, the chief economist at Faver, provides Mollie with the
firm's forecasts for three countries as shown in exhibit 1.

Exhibit 1: Forecasts For Subject Countries

Real GDP GDP Expected Unemployment

Country
growth volatility Inflation Rate

East Farnia 2.1% 3% 1.2% 5.0%

West
1.3% 4% 3.2% 4.2%
Farnia

Soth
3.2% 4% 1.1% 3.6%
Farnia

McDermott tells Mollie that the inter-temporal rate of substitution in East Farnia is
0.9368.

Mollie asks McDermott the following questions:

Question 1: What do we mean by the inter-temporal rate of substitution?

Question 2: What factors are associated with an investor having a higher inter-
temporal rate of substitution?

Question #37 of 88 Question ID: 1626143

Using the information in Exhibit 1, which country is expected to have the lowest real
risk-free rate?

A) East Farnia.
B) West Farnia.
C) South Farnia.

Question #38 of 88 Question ID: 1626144

The real risk-free rate in East Farnia is closest to:

A) 2.1%.
B) 3.3%.
C) 6.8%.

Question #39 of 88 Question ID: 1626145

Regarding Mollie's Question 1, the inter-temporal rate of substitution is best defined

as:

the rate at which a consumer is willing to substitute risky assets for default-free
A)
assets.
the rate at which a consumer is willing to substitute consumption in the present for
B)
consumption in the future.
the rate at which a consumer is willing to substitute consumption in the future for
C)
consumption in the present.

Question #40 of 88 Question ID: 1626146

Regarding Mollie's Question 2, one factor that is positively related to an investor's

inter-temporal rate of substitution is:

A) expected future price of a risky asset.

B) current income level.
C) real rate of return.

Overview for Questions #41-44 of

88 Question ID: 1626147

TOPIC: ETHICAL AND PROFESSIONAL STANDARDS

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

Carol Blackwell, CFA, has been hired into the research department of Blanchard
Investments. Blanchard's manager, Thaddeus Baldwin, CFA, has worked in the
securities business for more than 50 years. On Blackwell's first day at the office,
Baldwin gives her an incomplete research report on Tops Groceries, Inc., to finish up.

Upon researching Tops, information about the financial instability of Tops Groceries'
largest customer surfaces. Blackwell revises the research report by lowering the
earnings projections. The day the report is to be released, Blackwell learns that
Baldwin has replaced the lower, revised earnings projections with his earlier
estimates.

Baldwin realizes that many of the firm's practices and policies would benefit from a
compliance check. Baldwin wants Blackwell to ensure that the policies and procedures
at the firm are in compliance.

During a local society luncheon, Blackwell is seated next to CFA candidate Lucas
Walters, who has been assigned the task of creating a compliance manual for
Borchard & Sons, a small brokerage firm. Walters asks for her advice.

When Walters returns to work, he is apprised of the following situation: Borchard &
Sons purchased 25,000 shares of CBX Corp. for equity manager Quintux Quantitative
just minutes before the money manager called back and said it meant to buy 25,000
shares of CDX Corp. Borchard then purchased CDX shares for Quintux, but not before
shares of CBX Corp. declined by 1.5%. The broker is holding the CBX shares in its own
inventory.

Borchard proposes three methods for dealing with the trading error.

Method 1: Quintux directs additional trades to Borchard worth a dollar value

equal to the amount of the trading loss.

Method 2: Borchard receives investment research from Quintux in exchange for

Borchard covering the costs of the trading error.

Method 3: Borchard transfers the ordered CBX shares in its inventory to

Quintux, which allocates them to all of its clients on a pro-rata basis.

Question #41 of 88 Question ID: 1626148

Blackwell's most appropriate course of action to remain in compliance with the Code
and Standards is to:
A) include a disclosure indicating that lower earnings estimates are available.
follow up the first report with a second report emphasizing lower earnings
B)
projections.
remove her name from the report if they release the report with higher earnings
C)
estimates.

Question #42 of 88 Question ID: 1626149

When updating the proxy-voting policy to conform to CFA Institute recommendations,

which of the following recommendations is least appropriate for Blanchard to adopt?

A) Determine the economic impact of non-routine proxy votes.

B) Follow the same proxy-voting procedures regardless of the nature of the proposal.
If the proxy voter’s preference differs from the preference of a client who has
C)
delegated his voting powers, go with the client’s preference.

Question #43 of 88 Question ID: 1626150

If Walters wants the manual to satisfy the requirements and recommendations of the
Code and Standards, which of the following instructions is least appropriate to include
in the section on fair dealing?

Whenever possible, disseminate investment recommendations to all clients at the

A)
same time.
Execute all clients’ requested trades promptly and without comment, regardless of
B)
the company’s opinion on the stock being traded.
Members of the investment-policy committee should not discuss possible changes
C) in investment recommendations with anyone else in the firm until after an official
decision has been made.

Question #44 of 88 Question ID: 1626151

Which method for dealing with the trading error is most consistent with the Code and
Standards?
A) Method 1.
B) Method 2.
C) Method 3.

Overview for Questions #45-48 of

88 Question ID: 1626117

TOPIC: QUANTITATIVE METHODS

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

Ernie Smith and Jamal Sims are analysts with the firm of Madison Consultants.
Madison provides statistical modeling advice to portfolio managers throughout the
United States and Canada.

Sims has been assigned the task of valuing the U.S. stock market. He decides that the
sales data should be transformed. He takes the natural log of the data and uses it in
the following model:

∆ln salest = b0 + b1 ∆ln salest − 1

Parameter estimates for the autoregressive model and the actual data for the two
most recent months are shown in Exhibit 1.

Exhibit 1: U.S. Autoregressive Model

Intercept 0.052

Lag 1 coefficient 0.684

Actual sales one month ago (–1) 6,270

Actual sales two months ago (–2) 6,184

Smith and Sims originally modeled Canadian retail sales using the equation Xt = b0 +
b1Xt–1 + b2Xt–12 but now believe that Canadian retail sales may be more appropriately
modeled with an ARCH process.

Smith states that, in order to find out, he would take the residuals from the original
autoregressive model for Canadian retail sales and then square them.

Sims states that these residuals would then be regressed against the Canadian retail
sales data using the following equation: et = b0 + b1Xt, where e represents the residual
terms from the original regression and X represents the Canadian retail sales data. If
b1 is statistically different from zero, then the regression model contains an ARCH
process.

Sims is also investigating the performance of 5-year European and British bonds
versus the actions of the U.S. Federal Reserve. He uses the U.S. Federal Funds rate.
The two regressions he uses are:

BYE,t = b0 + b1FFUS,t

BYB,t = b0 + b1FFUS,t

where: FF is the Federal Funds rate in the United States (US), and BY is the
bond yield in the European Union (E) and Great Britain (B).

Before he runs this regression, he investigates the characteristics of the dependent

and independent variables. He finds that the Federal Funds rate in the United States
and the bond yield in Great Britain have a unit root, but that the bond yield in the
European Union does not. Furthermore, the Federal Funds rate in the United States
and the bond yield in Great Britain are cointegrated, but the Federal Funds rate in the
United States and the bond yield in the European Union are not.

Question #45 of 88 Question ID: 1560249

The estimate of forecasted sales for the United States this month, using Sims's model,
is closest to:

A) $6,329.
B) $6,453.
C) $6,667.

Question #46 of 88 Question ID: 1560250

Are the comments of Smith and Sims on the construction of an ARCH model correct?

A) Both comments are correct.

B) Only Smith is correct.
C) Only Sims is correct.
Question #47 of 88 Question ID: 1626118

Is Sims's regressions of European and British bond yields on the U.S. Federal Funds
rate likely to produce valid results?

A) Neither Regression is valid.

B) Only Regression 1 is valid.
C) Only Regression 2 is valid.

Question #48 of 88 Question ID: 1560252

Which of the following is the most appropriate test for cointegration?

A) Breusch-Pagan.
B) Durbin-Watson.
C) Engle-Granger.

Overview for Questions #49-52 of

88 Question ID: 1560253

TOPIC: ECONOMICS

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

Frank Hoskins and Paul Lanning are economists for a large U.S. investment advisory
firm, Platinum Advisors. Hoskins and Lanning use their independent research on U.S.
stocks and international stocks to provide advice for the firm's network of advisors. As
the senior economist at Platinum, Hoskins is a partner in the firm and is Lanning's
supervisor. Lanning has worked for Platinum for four years. At a lunch meeting, the
two economists discuss the usefulness of economic theory, economic data, and the
resulting forecasts of the global economic and stock market activity.

Lanning is examining the historical record of economic growth in Petra. He has

gathered the data in Exhibit 1 to determine potential economic growth.

Exhibit 1: Economic Data for Petra from 20X1 to 20X7

Real GDP growth rate 3.9%

Growth rate in capital 1.4%

Growth rate in labor force 1.9%

Labor cost/total factor cost 0.52

Lanning then turns his attention to the countries of Alicia and Felicia. He notes that
the GDP growth rate in both countries is comparable. Alicia's capital to labor ratio is
USD 5,000. Felicia's capital to labor ratio is USD 2,800. Alicia has a relatively younger
labor force and the labor cost represents 35% of total factor cost. Both countries have
extensive restrictions on foreign direct investments in their economy.

It has long been Platinum's policy for its economists to use long-term economic
growth trends to forecast future economic growth, stock returns, and dividends in a
country. Lanning also examines the economy of Tiberia. Tiberia has a population of 11
million and is located in northern Africa. Its economy is diversified, and its main
exports are agricultural products and heavy machinery. The country's economy has
been growing at an annual rate of 6.2% for the past 10 years, in part because of
technological advances in the manufacturing of heavy equipment. These advances
involve the use of computer-operated welding machines that have made the
manufacturing process more efficient. Lanning is worried, however, that the current
GDP growth rate may not be sustainable and is considering advising Platinum's
portfolio managers to decrease their portfolio allocations to the country. Before doing
so, he will consult with Hoskins.

Question #49 of 88 Question ID: 1560254

Which country will experience a higher growth rate in potential GDP due to capital
deepening and due to removal of restrictions on inflow of foreign capital?

Capital deepening Removal of restrictions on inflow of capital

A) Alicia Felicia

B) Felicia Felicia

C) Felicia Alicia
Question #50 of 88 Question ID: 1560255

Petra's GDP growth rate attributable to growth in total factor productivity is closest to:

A) 0.6%.
B) 1.6%.
C) 2.2%.

Question #51 of 88 Question ID: 1560256

The classical growth theory predicts that Tiberia's long-run future GDP per capita is
most likely to:

A) decline due to diminishing marginal productivity of capital.

B) settle at subsistence level due to adjustments in the population.
remain unchanged from the current levels unless the government increases the
C)
budget deficit.

Question #52 of 88 Question ID: 1560257

The endogenous growth theory predicts that the Tiberian GDP growth rate is most
likely to:

settle at a long-run steady state because of diminishing marginal productivity of

A)
capital.
continue to increase because technological advances will be shared by many sectors
B)
of the economy.
C) decline because the current GDP growth rate is not sustainable.

Overview for Questions #53-56 of

Question ID: 1626119
88

TOPIC: FINANCIAL STATEMENT ANALYSIS

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

John Baragutti, CFA, works in the transaction services arm of HLBB, a large
accountancy firm with a substantial advisory business on the east coast of the United
States. He is currently advising on a potential M&A transaction between two airlines.
Tarpon Airlines, Inc. (Tarpon), which operates out of the east coast of the United
States, is the larger of the two companies and its board has entered into discussions
with the smaller Clear Air S.A. (Clear). Clear, based in France, would provide Tarpon
access to a significant number of landing slots in major European airports.

Baragutti is currently reviewing the income statement of Clear in order to address

some concerns raised by Tarpon's board. Merger discussions had initially progressed
rapidly after an initial review of Clear's last five years' income statements, which
revealed an operating profit margin that was in line with that of Tarpon. The board
has historically been extremely cautious about acquiring any potential target with a
profit margin lower than its own. However, further investigation has revealed
concerns regarding the treatment of pension costs in the income statement.

Tarpon runs only a defined contribution pension scheme for its employees and an
employee incentive stock option scheme. Clear, however, has a defined benefit
scheme that is currently overfunded. Additionally, because of the rise in the value of
Clear's stock price, in 20X5 there was a tax windfall from the employee incentive stock
option scheme. Extracts from the pension note included in Clear's annual report are
shown in Exhibit 1.

Exhibit 1: Pension Note (Extracts)

Present Value of
Fair Value of Plan
Defined Benefit
Assets
Obligations

€ million € million

As at 1 January As at 1
8,110 8,920
20X5 January 20X5

Current service Return on

170 145
cost plan assets

Employer
Past service cost 15 306
contributions

Interest cost 365 Benefits paid (202)

Benefits paid (202)

Remeasurement
218
(gains)/loss

As at 31
As at 31
8,676 December 9,169
December 20X5
20X5

Notes:

Pension benefit obligation has been calculated using the average yield on high-
quality corporate bonds with similar durations to the benefits in the scheme,
currently 4.5%.
Due to turbulent economic conditions in the eurozone, return on plan assets
was only 1.63%.
Remeasurement gains at the start of the year totaled €231 million.

Having never accounted for a defined benefit scheme, in its initial review, the board of
Tarpon did not consider the impact of the defined benefit plan on the operating
margin. As a result, Baragutti has been asked to address three issues.

First, Clear prepares its financial statements using IFRS whereas Tarpon reports under
U.S. GAAP. The board wants to gain an understanding of Clear's pension expense for
20X5 as computed under U.S. GAAP. Secondly, the disclosure of certain elements of
the pension cost has confused the board. Although the notes to the income statement
identify that the pension cost has an interest element, this has been included within
operating profit.

Finally, the board is concerned about future adjustments that may be required to deal
with the amortization of the remeasurement gains that have accumulated in Clear's
pension scheme. Baragutti intends to perform the following calculations to deal with
each issue independently:

Issue 1

Recalculate pension expense included in the income statement under U.S. GAAP.
Baragutti has observed that companies reporting pension expense under U.S. GAAP
have used an average of 3% for the expected return on plan assets and he intends to
apply this rate where applicable. He does not intend to amortize any of this year's
prior service cost.

Issue 2

Assuming IFRS, recalculate the local currency (€) operating margin excluding any
pension scheme interest element. The current income statement before Baragutti's
adjustments is shown in Exhibit 2.

Issue 3

Baragutti prepares the following note containing two statements to advise the board
on the future amortization of actuarial gains and losses:

Statement 1

"Under IFRS, when cumulative remeasurement gains/losses are large

enough, they will be amortized through the income statement over the
average service life of the employees, reducing net income if net losses
are amortized, and increasing net income if net gains are amortized."

Statement 2

"Under U.S. GAAP, the amortization of net actuarial losses will increase
leverage (i.e., debt-to-equity ratio), whereas the amortization of net
actuarial gains will decrease leverage."

Exhibit 2: Income Statement (Extracts)

20X5

€ million

Revenue

Passenger 9,321

Cargo 456

Total 9,777

Employee costs 3,654

Depreciation, amortization 894

Aircraft operating lease costs 156

Fuel and oil costs 1,853

Engineering and other aircraft costs 542

Landing fees 1,458

Exchange rate losses 221

Ground equipment costs 765

Total operating costs 9,543

Operating profit 234

Fuel derivative losses 32

Finance costs 193

Finance income 89

Profit before tax 98

Note: Employee costs include the defined benefit pension expense for the period.

Question #53 of 88 Question ID: 1626120

Due to its employee incentive stock option plan only, if Clear had presented its
financial statements under U.S. GAAP, it would have reported:

A) the same net income but higher stockholders' equity.

B) higher net income but the same stockholders' equity.
C) lower net income and lower stockholders' equity.

Question #54 of 88 Question ID: 1626121

In dealing with Issue 1 as outlined, Baragutti is likely to calculate a pension expense

closest to:

A) €149 million.
B) €267 million.
C) €390 million.

Question #55 of 88 Question ID: 1626122

Using IFRS and Baragutti's suggested adjustments for Issue 2, he is likely to calculate
an adjusted operating margin closest to:
A) 2%.
B) 4%.
C) 6%.

Question #56 of 88 Question ID: 1626123

Which of Baragutti's statements on the amortization of actuarial gains and losses in

response to Issue 3 are most likely correct?

A) Both statements are correct.

B) Only statement two is correct.
C) Neither statement is correct.

Overview for Questions #57-60 of

88 Question ID: 1560273

TOPIC: FINANCIAL STATEMENT ANALYSIS

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

Jessica Goodfellow is an asset manager in The United Kingdom. In early 2021,

Goodfellow was investigating the Dorset engine, a product recently launched by
Sutton-Phelps Holdings PLC in a new class of twin-spool, high bypass turbofan
engines. As of 2021, the Dorset engine has only one direct competitor in its class: the
RAnx engine, developed by U.S.-based propulsion company RA Aviation Systems, LLC.
The Dorset engine has a few benefits over the RAnx engine; most notably, it has a 3%
fuel consumption advantage.

Janet Grange, CFA, a junior analyst makes the following statements about the
industry:

Statement 1: There is considerable economy of scale for R&D expense as

evidenced by larger R&D expenditures (as a proportion of
revenues) for larger companies.

Statement 2: Firms with commodity-type inputs that can pass higher

material costs on to their customers often hedge their future
 input costs by using forward contracts or other derivative
securities.

RA Aviation Systems reported their global sales of RAnx engines in US dollars.

Goodfellow converted these figures to pound sterling using the average USD/GBP
exchange rate for each year, and compiled the following table comparing sales of the
Dorset engine with sales of the RAnx engine, measured in millions of pound sterling.

Exhibit 1: Twin-spool, high bypass turbofan engine sales by year (in millions of £)

2018 2019 2020

Sutton-Phelps Dorset engine 12 84 2,177

RA Aviation RAnx engine 3,591 4,011 3,991

Question #57 of 88 Question ID: 1560274

Regarding the statements made by Grange, it is most accurate to state that:

A) both statements are correct.

B) both statements are incorrect.
C) only one statement is correct.

Question #58 of 88 Question ID: 1560275

The percentage of turbofan engine sales growth in this class in 2020 can be attributed
to the Dorset engine is closest to:

A) 1%.
B) 51%.
C) 101%.

Question #59 of 88 Question ID: 1560276

Goodfellow projects that the growth rate of the market for this turbofan engine class
will slow to 19% in 2021. She also expects the Dorset engine to improve its market
share by 9 percentage points. Based on these estimates, Goodfellow's estimate of
2021 Dorset engine sales should be closest to:

A) £2,591 million.
B) £2,732 million.
C) £3,251 million.

Question #60 of 88 Question ID: 1560277

Goodfellow's approach to modeling Sutton-Phelps's 2021 Dorset engine sales would

be best described as:

A) bottom-up.
B) hybrid.
C) time series.

Overview for Questions #61-64 of

88 Question ID: 1560298

TOPIC: FIXED INCOME

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

Jon Stevenson, CFA, is an experienced equity fund manager who has recently taken a
position with Lohsi Clearview, a UK-based hedge fund that has combined a wide range
of strategies to deliver impressive returns over the last five years. One of the fund's
strategies is to invest in high-credit-risk fixed income instruments. The fund has an
excellent track record of identifying bonds in this sector that subsequently
outperform the market.

Stevenson wishes to familiarize himself with the fund's strategies and has started by
looking at some of the techniques used in analyzing fixed income instruments. Exhibit
1 shows the firm's approach to analyzing credit risk.

Exhibit 1: Credit Analysis Tools

Credit Ratings

Before undertaking any level of detailed analysis, the credit rating from the three
major agencies should be obtained. Typically an instrument that is investment grade
according to all three agencies will not be worthy of further consideration.

Structural Models

An initial analysis using a simple structural model should be undertaken to calculate

the present value of the expected loss.

Reduced Form Models

Detailed analysis should be undertaken using the reduced form models used by the
fixed income team. This analysis should only be undertaken once the structural
model analysis has been completed.

Stevenson has no experience with structural models and is interested in learning

more. He finds an analysis that has been completed for a recent bond issue. The
results are shown in Exhibit 2.

Exhibit 2: IMC Bond Issue (ID 062014555612) Structural Model Results

Asset value At 1,200

Expected return on assets μ 0.04

Risk free rate r 0.02

Face value K 850

Time to maturity T−t 1.5

Return volatility σ 0.28

d1 1.26452

d2 0.92159

N(–d1) 0.1030

N(–d2) 0.1784

e1 1.35200

e2 1.00907

N(–e1) 0.0882
N(–e2) 0.1565

Expected loss 23.86

PV expected loss 23.51

Stevenson next turns his attention to DEP Bond, one of the fund's holdings. The bond
was purchased today, immediately after it paid its annual coupon. Stevenson obtains
the file for DEP and finds out that the bond was evaluated using a risk-neutral
probability of default (POD) as shown in Exhibit 3.

Exhibit 3: DEP Bond Issue (ID 071443274112)

Rating B Modified duration 2.80 POD 2.50%

Purchase price $104.85 Coupon (just paid) 5% Recovery rate 50%

Par value $100 Maturity 3 years Risk-free rate 2%

Question #61 of 88 Question ID: 1560299

Which of the credit analysis models shown in Exhibit 1 can only be used under the
assumption that the issuing company's assets trade in a frictionless market?

A) Structural models.
B) Reduced form models.
C) Both structural models and reduced form models.

Question #62 of 88 Question ID: 1560300

According to the structural model shown in Exhibit 2, the maximum amount an

investor holding the bond would pay to a third party to remove the risk of default
would be:

A) $0.65.
B) $22.86.
C) $23.51.
Question #63 of 88 Question ID: 1560301

Based on information in Exhibit 3, if Stevenson determines that the recovery rate

appropriate for DEP is 45%, the probability of default (POD) would most likely:

A) increase.
B) remain the same.
C) decrease.

Question #64 of 88 Question ID: 1560302

Based on the information in Exhibit 3, if the bond defaults 2 years after purchase, the
IRR for the investment in the bond would be closest to:

A) –16.67%.
B) –18.43%.
C) –25.83%.

Overview for Questions #65-68 of

88 Question ID: 1560313

TOPIC: DERIVATIVES

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

Stan Loper is unfamiliar with the Black-Scholes-Merton (BSM) option pricing model
and plans to use a two-period binomial model to value some call options. The stock of
Arbor Industries pays no dividends and currently trades for $45. The up-move factor
for the stock is 1.15, while the down factor is 0.87, and the risk-free rate is 4%. He is
considering buying two-period European style options on Arbor Industries with a
strike price of $40. The delta of these options over the first period is 0.83.

Loper is curious about the effect of time on the value of the calls in the binomial
model, so he also calculates the value of a one-period European style call option on
Arbor stock with a strike price of 40.
Question #65 of 88 Question ID: 1560314

The value of a two-period 40 call on Arbor Industries stock is closest to:

A) $6.65.
B) $8.86.
C) $9.21.

Question #66 of 88 Question ID: 1560315

The position in calls necessary to hedge a long position in 1,000 shares of stock over
the first period is closest to:

A) short 830 calls.

B) short 1,150 calls.
C) short 1,205 calls.

Question #67 of 88 Question ID: 1560316

The value of the one-period 40 call on Arbor stock is closest to:

A) $6.65.
B) $6.86.
C) $7.15.

Question #68 of 88 Question ID: 1560317

The difference in value between the European 40 calls and otherwise identical
American 40 calls is closest to:

A) –$1.43.
B) $0.00.
C) $1.92.
Overview for Questions #69-72 of
88 Question ID: 1560308

TOPIC: DERIVATIVES

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

Ben Smart heads the trading department for Blue Sigma. Smart is reviewing some of
the outstanding derivatives contracts. Specifically, Smart locates a long position in a
forward contract on 10,000 shares of Specialty Retail, Inc.

Smart then directs his attention to a particular T-bond futures contract. The cheapest-
to-deliver is a 2.50% semi-annual coupon bond that last paid a coupon two months
ago. The bond trades at $103.14 (clean price) and has a conversion factor of 0.8125.
The futures contract matures in 3 months. The current 3-month risk-free rate is
0.25%.

Smart is also interested in using the BSM model to price European and American call
and put options.

He is concerned, however, about whether the assumptions necessary to use the

model are realistic. The assumptions he is particularly concerned about are:

The volatility of the option value is known and constant.

Stock returns are normally distributed.
The continuous risk-free rate is known and constant.

Smart would like to value options on Rapid Repair, Inc., common stock, but Rapid pays
dividends, so Smart is uncertain about the effect on the value of the options. Smart
uses a two-period binomial model to value long positions in the Rapid Repair call and
put options without accounting for the fact that Rapid Repair pays dividends.

Question #69 of 88 Question ID: 1560309

Regarding the long forward position in Specialty Retail, Inc., the position is most likely
to lose value as a result of:

A) an increase in the risk-free rate.

B) an increase in the current stock price of Specialty Retail.
C) an extra dividend payment during the contract interval.
Question #70 of 88 Question ID: 1560310

The no-arbitrage T-bond futures price is closest to:

A) 102.74.
B) 114.59.
C) 126.25.

Question #71 of 88 Question ID: 1560311

Are the BSM assumptions listed correctly?

A) No, because stock prices are assumed to be normally distributed.

No, because the expected return on the stock is assumed to be known and
B)
constant.
No, because the volatility of the return on the underlying stock is assumed to be
C)
known and constant.

Question #72 of 88 Question ID: 1560312

When Smart failed to account for Rapid Repair dividends, did he likely overvalue the
calls or the puts?

A) The calls and the puts are overvalued.

B) Only the calls are overvalued.
C) Only the puts are overvalued.

Overview for Questions #73-76 of

Question ID: 1626134
88

TOPIC: ALTERNATIVE INVESTMENTS

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

Rita Larson, CFA, is an investment analyst for the Siprah family office. Larson is tasked
with evaluating two REITs currently being considered for investment. Exhibit 1
provides selected information for these REITs.

Exhibit 1: Selected REIT Information(in $ thousands, except number of shares

outstanding)

REIT M REIT N

Forecast Cash NOI $ 333.00 $ 288.00

FFO $ 182.20 $ 179.00

Cash & Equivalents $ 14.09 $ 15.91

Accounts Receivable $ 25.22 $ 33.44

Debt $ 118.92 $ 182.34

Other Liabilities $ 11.23 $ 9.90

Recurring maintenance type-capital expenditures $ 81.00 $ 32.00

Non-cash rents $ 45.00 $ 33.00

Shares outstanding 35,000 25,000

Larson has determined that similar REITs are trading at a P/FFO multiple of 9 and a
P/AFFO multiple of 12. Furthermore, Larson has determined the appropriate cap rate
to be 8%.

Larson's colleague Peter Mullins makes the following statements about the use of
multiples in REIT valuation:

Statement 1: Valuing REITs using multiples is considered relative valuation, while the
NAVPS approach would be viewed as an absolute valuation.

Statement 2: Compared to AFFO, FFO is considered a better indicator of the dividend

paying ability of a REIT. However, AFFO is a better indicator of a REIT's economic
income.

Statement 3: It is important to consider leverage differences between REITs while

using multiples based on FFO, while AFFO based multiples adjusts for leverage
differences.

Statement 4: REITs are more tax efficient than both REOCs and direct investments in
real estate
Question #73 of 88 Question ID: 1626135

The value of REIT M based on its P/AFFO multiple is closest to:

A) $19.27.
B) $46.85
C) $70.91

Question #74 of 88 Question ID: 1626136

The value of REIT N based on NAVPS is closest to:

A) $138.28.
B) $149.72.
C) $152.87.

Question #75 of 88 Question ID: 1626137

Regarding Mullin's Statements 1 and 2:

A) Only Statement 1 is correct.

B) Only Statement 2 is correct.
C) Both Statements are incorrect.

Question #76 of 88 Question ID: 1626138

Regarding Mullin's Statements 3 and 4:

A) Only Statement 3 is correct.

B) Only Statement 4 is correct.
C) Both statements are incorrect.
Overview for Questions #77-80 of
Question ID: 1560328
88

TOPIC: PORTFOLIO MANAGEMENT

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

Seva Wolff has just inherited $1.2 million. She meets with Roberta Gomez, her
financial advisor, about changes to her investment policy statement—and hence, her
portfolio—due to this major life event.

Gomez recommends that Wolff consider exchange-traded funds (ETFs) for her
portfolio and suggests that she can compile a list of ETFs suitable for Wolff.

Wolff is uncertain about this class of investment product and asks several questions.
In her response, Gomez makes the following statements:

Statement 1: ETFs represent shares in a portfolio. The fund manager must

disclose the holdings on an annual basis.

Statement 2: ETFs trade on both primary and secondary markets.

Statement 3: Market makers known as authorized participants keep ETF prices

in line with a fund's NAV per share through a process known as
creation/redemption. The costs of creation/redemption are borne
by all of the fund's shareholders.

Statement 4: Relative to traditional mutual funds, ETFs tend to distribute less in

capital gains to their shareholders.

Gomez then mentions that Wolff should consider other asset classes that form part of
a well-diversified portfolio. She says the expected return on an asset is affected by the
investor's intertemporal rate of substitution. She makes the following statements:

Statement 5: Typically, the covariance between a risk-averse investor's

intertemporal rate of substitution and the current asset price is
negative.

Statement 6: An investor's breakeven inflation rate is the expected future

inflation minus the risk premium for future inflation.

Question #77 of 88 Question ID: 1560329

Considering Gomez's Statements 1 and 2:

A) only Statement 1 is accurate.

B) only Statement 2 is accurate.
C) both statements are accurate.

Question #78 of 88 Question ID: 1560330

Considering Gomez's Statements 3 and 4:

A) only Statement 3 is accurate.

B) only Statement 4 is accurate.
C) neither statement is accurate.

Question #79 of 88 Question ID: 1560331

Gomez's Statement 5 is best described as:

A) correct.
incorrect about the covariance between the intertemporal rate of substitution and
B)
the current asset price.
C) incorrect about covariance being a factor in the pricing of securities.

Question #80 of 88 Question ID: 1560332

Gomez's Statement 6 is best described as:

A) correct.
incorrect, because breakeven inflation is equal to expected inflation plus a risk
B)
premium for inflation uncertainty.
incorrect, because breakeven inflation is equal to expected inflation minus actual
C)
inflation.
Overview for Questions #81-84 of
88 Question ID: 1626152

TOPIC: ETHICAL AND PROFESSIONAL STANDARDS

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

Connor Burton, CFA, is the managing partner for United Partners, a small investment
advisory firm that employs three investment professionals and currently has
approximately $250 million of assets under management. The client base of United
Partners is varied, and accounts range in size from small retirement accounts to a $30
million private school endowment. In addition to Burton's administrative
responsibilities as the managing partner at United, he also serves as an investment
advisor to several clients. Because United Partners is a small firm, the company does
not employ any research analysts but instead obtains its investment research
products and services from two national brokerage firms, which in turn execute all
client trades for United Partners. The arrangement with the two brokers has enabled
United to assure its clients that the firm will always seek the best execution for them
by having both brokers competitively bid for United's business.

A prospective client, Harold Crossley, has approached Burton about shifting some of
his personal assets under management from MoneyCorp to United Partners.

As a condition of moving his account to United Partners, Crossley insists that all of his
trades be executed through his brother-in-law, a broker for Security Bank. Security
Bank is a large, New York-based broker/dealer but is not one of the two brokerage
firms with which United currently does business. Burton contacts Crossley's brother-
in-law and determines that Security Bank's trade execution is competitive, but
Crossley's account alone would not generate enough volume to warrant any soft
dollar arrangement for research materials. However, Crossley's brother-in-law does
offer for Security Bank to pay a referral fee to Burton for directing any of United's
clients to Security Bank's retail banking division. To bring Crossley on as a client,
Burton agrees to the arrangement. Going forward, Burton will use Security Bank to
execute all of Crossley's trades.

United Partners currently has no formal policy on proxy voting. Burton wants to
develop a policy that conforms to the Code and Standards.

Several months later, Burton is invited to a road show for an initial public offering
(IPO) for SolutionWare, a software company. Security Bank is serving as lead
underwriter on SolutionWare's IPO. Burton attends the meeting, which is led by two
investment bankers and one software industry research analyst from Security Bank
who covers SolutionWare. Burton notes that the bankers from Security Bank have
included detailed financial statements for SolutionWare in the offering prospectus
and also disclosed that Security Bank provides a warehouse line of credit to
SolutionWare. After the meeting, Burton calls Crossley to recommend the purchase of
SolutionWare equity. Crossley heeds Burton's advice and tells him to purchase 5,000
shares.

Question #81 of 88 Question ID: 1626153

According to the CFA Institute Standards of Professional Conduct, the trading

arrangement between Burton and Security Bank is most likely:

a violation because the practice of directed brokerage violates the member’s duty of
A)
loyalty to the client.
a violation because although Security Bank’s execution is competitive, Burton will
B)
not be able to always obtain the best execution for his client.
C) not a violation because the brokerage is the property of the client.

Question #82 of 88 Question ID: 1626154

According to CFA Institute Standards of Professional Conduct, which of the following

statements best describes the circumstances under which Burton may enter into the
referral agreement with Security Bank? Burton may enter into the agreement:

A) under no circumstances.
B) only after receiving written permission from clients.
C) only after fully disclosing the referral arrangement to clients and prospective clients.

Question #83 of 88 Question ID: 1626155

When formulating the proxy voting policy, which of the following is least appropriate
for Burton to include?

A) Determine the economic impact of non-routine proxy votes.

B) Treat all proposals equally as far as proxy voting goes.
If the client preference differs from the proxy voter's preference, defer to client
C)
wishes.

Question #84 of 88 Question ID: 1626156

According to CFA Institute Standards of Professional Conduct, Burton's

recommendation to Crossley that he purchase shares of the SolutionWare initial
public offering is most likely:

in violation of Standard III(C) Suitability for not determining the appropriateness of

A) the investment for the portfolio and Standard I(B) Independence and Objectivity for
not making the investment recommendation to all of his clients at the same time.
in violation of Standard V(A) Diligence and Reasonable Basis for not thoroughly
analyzing the investment before making a recommendation and in violation of
B)
Standard III(C) Suitability for not determining the appropriateness of the investment
for the portfolio.
in violation of Standard V(A) Diligence and Reasonable Basis for not thoroughly
analyzing the investment before making a recommendation and in violation of
C)
Standard I(B) Independence and Objectivity for not making the investment
recommendation to all of his clients at the same time.

Overview for Questions #85-88 of

88 Question ID: 1626157

TOPIC: ETHICAL AND PROFESSIONAL STANDARDS

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

Matematicasa is a medium-sized asset management firm that uses various machine

learning techniques to make investment decisions. Last year, Matematicasa brought
Antonio Esposito, CFA, CPA, on-board. Espositio is admired in the investment
management industry for his use of machine learning techniques. At Matematicasa,
Esposito maintains an existing machine learning model called MDT that selects
investments based on a large amount of textual information from various online
sources, and recommends an optimal portfolio based on a client's selected
benchmark. Esposito uses the model exclusively for Matematicasa's insurance
company clients, but does not offer it to Matematicasa's family office customers.

Over the past several months, one of Matematicasa's insurance company clients has
begun raising concerns about underperformance of their portfolio versus its
benchmark. In response, Sofia Rossi, CFA (Esposito's supervisor, and Matematicasa's
head of research) requests that Esposito review the model. Esposito finds that this\e
machine learning model is incorrectly classifying text, resulting in inappropriate
investment recommendations.

After discovering the cause of the error, Esposito meets with Rossi to present his
findings. Esposito expresses his opinion that Matematicasa should correct the
problem immediately. However Rossi disagrees: she requests that Esposito update
the model at the end of the quarter during the normal upgrade cycle. Furthermore,
Rossi requests that Esposito keep the situation quiet for the time being, and assures
Esposito that appropriate disclosures to their senior management and to their clients
will be made at the end of the quarter, once they have had the opportunity to fix the
model.

After a few more weeks of customer complaints without action from Rossi (who still
refuses to disclose the error to customers), Esposito becomes disgruntled with
Matematicasa. Esposito agrees to a job interview with Algoritmo A.I. Sgr (AAIS), which
is Matematicasa's closest competitor. During his interview with AAIS's asset
management team, Esposito demonstrates a machine learning model called
AzionarioStella that Esposito has created in his spare time at home over the past
several months of evenings and weekends. Esposito first used historical data to tune
and back-test the model, and then put the model to work managing his personal
portfolio and then the portfolios of his siblings. The team at Algoritmo is excited by
Esposito's ideas and his model. The Algoritmo team offers Esposito a position on the
spot, and also expresses interest in licensing the AzionarioStella model from him.
Esposito accepts and resigns from Matematicasa that same day.

Question #85 of 88 Question ID: 1626158

In applying the MDT model exclusively to the accounts of Matematicasa's insurance

company clients, and not offering it to Matematicasa's family office customers, does
Esposito violate the CFA Institute Code and Standards?

A) No.
 Yes, because Esposito is obligated to disclose the existence of the model when
B)
speaking to high-net worth families
C) Yes, because the model may be suitable for some non-insurance clients.

Question #86 of 88 Question ID: 1626159

By not fixing the error in the MDT model promptly, did Esposito violate the CFA
Institute Code and Standards?

A) Yes.
B) No, because the Code and Standards does not specify a timeframe for fixing errors.
No, because it was Rossi’s responsibility as supervisor to ensure compliance with the
C)
Code and Standards.

Question #87 of 88 Question ID: 1626160

Following his unsuccessful attempts to convince Rossi that the model error needs to
be fixed immediately, and according to the CFA Institute Code and Standards, the
most appropriate next step that Esposito should take is to:

A) dissociate from Matematicasa.

B) alert Matematicasa’s senior management.
C) contact Matematicasa’s clients.

Question #88 of 88 Question ID: 1626161

With respect to his duties to his employer Matematicasa, did Esposito violate the CFA
Institute Code and Standards in developing his AzionarioStella model?

A) No.
Yes, because Esposito has an obligation to place his employer’s interests before his
B)
own interests.
Yes, because Esposito is depriving his employer of the advantage of his skills and
C)
abilities.