SASF Mock Exam Level II 2002 Ans

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DO NOT OPEN THIS EXAM COVER SHEET UNTIL INSTRUCTED TO DO SO BY EXAMINATION SUPERVISOR

2002 CFA® Level II SASF Mock Exam

ANSWERS

Instructors:Peter Chau, CFAPatrick Collins, CFADon Davis, CFAJivendra KaleJim Keene, CFATerry Lloyd, CFADion Roseman, CFAProf. John M. Veitch, CFALoren Walden, CFABrad Walters, CFA

The Security Analysts of San Francisco

SASF CFA® Level II 2002 Mock Exam

Saturday, May 11, 2002

Questions Topics Time Instructor

Item Set

1 – 10 Financial Statement Analysis SS # 5 15 minutes Brad Walters

11 – 29 Equity Analysis SS # 9-13 27 minutes Terry Lloyd

30 – 39 Ethics SS # 1 & 2 15 minutes Loren Walden

40 – 54 Debt Instruments SS #14 & 15 21 minutes Peter Chau

55 – 60 Quantitative Methods SS # 3 & 4 12 minutes J Veitch/J Kale

Total 90 minutes

Essay

61 – 63 Economic Methods SS # 4 20 minutes John Veitch

64 Financial Statement Analysis SS # 6 & 7 18 minutes John Veitch

65 – 68 Basic Valuation SS # 8 20 minutes D Davis

69 Derivatives SS # 17 & 18 12 minutes John Veitch

70 – 75 Portfolio Management SS #20 20 minutes Patrick Collins

Total 90 minutes

Please note that the distribution of questions on the SASF CFA Level I Practice exam broadly

reflects the weights placed on each subject area by the CFA Level I study guide. There is no

guarantee that the questions on the actual CFA exam will reflect these relative weights.

The Association for Investment Management and Research (AIMRsm) does not endorse, promote, review, or warrant the accuracy of the products or services offered by organizations sponsoring or providing CFA® exam preparation materials or programs, nor does AIMR verify pass rates or exam results claimed by such organizations.

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Study Session #5 – Financial Statement Analysis 2002 Brad Walters, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.

1. A debt security in a held-to-maturity portfolio should be reported on the balance sheet at__________________.

A. Market ValueB. Historical CostC. Present Value of future cash flowsD. Market Value less dividends and interest

2. A debt security in an available-for-sale portfolio should be reported on the balance sheet at__________________.

A. Market ValueB. Historical CostC. Present Value of future cash flowsD. Market Value less dividends and interest

3. What ownership level is generally required to consolidate a subsidiary for financial reporting purposes?

A. >20%B. 20-50%C. >50%D. >60%

4. What degree of influence is generally required to consolidate a subsidiary for financial reporting purposes?

A. Significant influenceB. No significant influenceC. ControlD. None of the above

5. Under the cost method of accounting for investments, market value changes in the value of the investment are not recognized on the balance sheet until there is an actual:

A. AppraisalB. Cash flow analysisC. TransactionD. Net present value calculation

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6. The equity reported on consolidated financial statements is ____________ the equity reported on the parent-company-only financial statements.

A. Less thanB. Greater thanC. Equal toD. Sometimes less and sometimes more than

7. Reportable segments are defined as components of the enterprise that account for at least _______ of any one of the following:

(1) Total revenues (before elimination of intersegment sales);

(2) Combined operating profit (of profitable segments), or its operating loss must exceed the same required percentage of the combined operating loss of segments with losses;

(3) Combined identifiable assets of all segments.

A. 5%B. 10%C. 25%D. 50%

8. Segment data are most useful for which of the following?

A. Information on segment liabilitiesB. Information on segment profitabilityC. Trend analysisD. Segment cash flow analysis

9. Which of the following is the term given to the method of accounting for an acquisition that requires writing-up assets to their fair value?

A. Pooling of interests methodB. Purchase methodC. Consolidation methodD. Direct cost method

10. Which of the following is the term given to the method of accounting for an acquisition that may require recording goodwill on the balance sheet?

A. Pooling of interests methodB. Purchase methodC. Consolidation methodD. Direct cost method

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Study Session #9 – Equity Investments 2002 Terry Lloyd, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.

11. High product volume is typically associated with which strategy?

A. cost leadershipB. product differentiationC. focusD. diversification

12. Consolidation typically starts in which phase of a company’s life

A. pioneerB. growthC. matureD. decline

13. All of the following, except one, are accounting elections a company can make that lead to incomparability of financial statements between firms.

A. inventory methods (such as LIFO/FIFO)B. accrual of accounts payable (as incurred or as paid)C. depreciation methods (such as straight line/accelerated)D. revenue recognition (such as evenly or completed contract)

[the correct answer is b; under accrual accounting, the obligations must be booked as they are incurred]

14. Which of the following is a limitation of ratio analysis on a company’s financial statements?

A. they are based on GAAPB. they are backward lookingC. they do not provide industry contextD. all of the above

15. Economic Value Added differs from other valuation measures in that it recognizes the cost of

A. optionsB. equityC. dividendsD. internal growth

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16. The two-stage dividend discount model is best for which kind of firm?

A. firms in a high growth phase expected to decline to a lower rate and then a constant rate

B. firms with growth rates at or below the nominal growth in the overall economy

C. firms in a current high growth phase with an expectation of slowing growth

D. firms whose dividend growth rates follow a linear or “H” pattern to a steady rate

17. The constant, or “Gordon Growth,” model of estimating value based on cash flows relies on all of the following assumptions except one.

A. the company’s business is mature or has “plateaued”B. discretionary cash flow is growing at a steady rateC. they buyer’s required rate of return is steady over the projection periodD. the terminal cash flow is at a constant multiple

[the correct answer is d; there is no terminal value in the calculation]

Study Session #10 & 11 – Equity Investments 2002 Terry Lloyd, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.

18. Which of the following best describes the Free Cash Flows to the Firm?

A. it starts with net income and adds back interest, taxes and depreciationB. it is taken from the operating cash flows section of the statement of cash flowsC. it measures the free cash flows to the firm after allowances for preferred

dividends and a reinvestment of capitalD. it is the GAAP operating income plus an add back for depreciation and

amortization

[the correct answer is c; it measures how much cash is available for distribution to the equity holders after reinvestment and payments to debt and preferred holders]

19. What is the difference between dividends and cash flow?

A. nothing; it is a difference of terminologyB. it is a timing difference for accounting purposes between the year earned and

the year paidC. it is the difference between what can be paid out and what is paid outD. cash flow has interest added back

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20. The price earnings ratio is increased by only which of the following?

A. the riskiness, or volatility of the company’s businessB. an increase in interest ratesC. the company’s growth rateD. a higher payout ratio

[the correct answer is c; all the other factors will decrease the PE ratio]

21. Advantages of the price to sales ratio are all of the following, except:

A. revenue is harder (but not impossible) to manipulate than earningsB. it is useful for money losing firmsC. revenues tend to be less volatile than GAAP earningsD. all of the above

22. Which of the following will make the price to sales ratio higher?

A. a higher profit margin (gross or net)B. higher risk factorsC. a lower growth rateD. all of the above

23. All of the following are problems associated with using ratios for cross-border valuations, except:

A. the differences in accounting for consolidationsB. the use of reserves to manipulate earningsC. the use of inflation factors for fixed assetsD. they are all problems


24. All of the following are traditional measures of performance except

A. basic earning power (EBIT /total assets)B. return on assets (net income / total assets)C. economic value added (economic performance – cost of capital)D. return on equity (net income / equity)

[the correct answer is c; the others are incorrect]

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25. Tobin’s Q is measured as:

A. market value of the firm’s equity divided by the replacement value of the assets

B. the compound growth rate of earnings implied by the current share priceC. the firm’s current share price divided by the index for the firm’s industryD. the market value of assets divided by the replacement value of the assets

26. The relationship between EVA and MVA is

A. there is no relationshipB. they are virtually the same thingC. MVA = EVA / WACCD. EVA = MVA / WACC

27. Cash Flow Return on Investment analysis indicates that the share is a buy if the indicated return on the investment exceeds the current price using

A. the nominal rates of growthB. the historical rates of growthC. the firm’s weighted average cost of capitalD. the market-wide discount rate

28. Market Value Added (MVA) is calculated as

A. the market value of the firm’s debt and equity less the book values for those items

B. the implied value for the firm’s equity using a weighted average cost of capital

C. basically the increase in equity before the payment of dividendsD. the changes in market prices for the firm’s debt and equity securities over a

period

[the correct answer is a; the others are incorrect]

29. Which of the following is true for estimating the income of zero income stocks, such as ecommerce companies?

A. projected results will follow a bimodal distributionB. industry statistics will provide a baseline for evaluationC. a “buildup” approach for the discount rate will provide a reasonable estimate

for evaluating discount ratesD. the sensitivity of the growth and discount rates has less impact than on

established companies

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Study Session #1 & 2 – Ethics 2002 Loren W. Walden, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.

TOTAL OF 15 MINUTES FOR THIS ITEM SET

Jamie Howard, a CFA level II candidate, works as a consumer durables analyst for CD Advisors. The firm specializes in managing individual portfolios for families and trusts. Recently, the firm has made a strategic shift toward marketing to institutional investors, specifically corporate pension funds. As part of Jamie’s duties as an analyst, she is required to review proxy issues for all of the companies she covers. And, while CD Advisors does not vote on proxy issues, the firm believes that understanding all proxy issues is important. Upon learning that the firm is trying to attract corporate pension accounts, Jamie recalls that proxies must be voted for corporate pension accounts and informs her advisor of this rule. Her advisor reminds her that while she is a CFA candidate, the firm itself has not adopted the AIMR Code and Standards and is thus exempt from this rule.

30. Which of the following statements is/are TRUE?

A. Voting proxies for corporate pension accounts is required regardless of AIMR’s Code and Standards because under ERISA, all proxies must be voted.

B. Voting proxies is required for all individual accounts as well as ERISA accounts under AIMR’s Code and Standards.

C. Voting proxies can be delegated to a third party consultant.D. Both A and C are true

Jamie is asked by the research director to cover EG, a large consumer products manufacturer located in the U.K. She remembers that one of her graduate school classmates works as an analyst in London and gives him a call. It turns out that he has just written an extensive report on EG and has given the stock a strong buy rating. He offers to fax a copy to Jamie so that she may learn more about EG. After reviewing his conclusions and getting basic information on the company from the EG company website, she too concludes that the stock is a strong buy and writes a brief report including the model of her classmate. She decides it is not necessary to do any further research because her friend works for a large investment firm known for their thorough research. And, since the firm’s reports are widely disseminated and used, she believes she does not need to get permission to incorporate the model into her work.

31. Which of AIMR’s Code and Standards have been violated?

A. Standard III Relationships and responsibilities to her employer because she did not exercise sound judgment in her investment conclusions.

B. Standard IV Relationships with and responsibilities to clients and prospects because she did not exercise diligence and thoroughness in her research recommendations.

C. Standard II Relationships with and responsibilities to the profession because she did not get written permission to use her friend’s report and did not give written credit to the source.

D. B and C only.

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32. Which following statements is FALSE?

A. Under ERISA, a fiduciary must have a written investment policy.B. Under ERISA, a fiduciary can outsource management responsibilities for the

management of the pension fund.C. Under ERISA, a fiduciary must adhere to the basic principals of modern portfolio

theory.D. None of the above because they are all true.

33. Which of the following is NOT an element of a “firewall” used to contain material non-public information.

A. Control over interdepartmental communications.B. Limit information dissemination of insider information to appropriate employees

only. Also known as “key access persons”.C. Review of all employee trades against a restricted list.D. None of the above because they are all key elements of a “firewall”.

Questions 5 though 9 are to be answered from the case below:

Thomas Whitman, CFA, is the senior portfolio manager for Red Tree Capital, a large independent investment advisor that has $2 billion under management comprised of corporate pension accounts and family trusts. The firm has adopted AIMR’s Code and Standards and all newly hired employees are given a copy of the code and asked to sign a document stating that they have read the code. Thomas is responsible for all junior portfolio managers and the trading staff as part of his duties.

One of his traders recently received a block trade order given to him by portfolio manager Jeff Johnston, CFA. The following quote is Jeff speaking to the trader:

“I just got off the phone with our biotech analyst, Frederica Fortune. She said that Genetime is ripe to be bought by a large pharmaceutical company and that it is a bargain at any price below $12! She also said that even though she has only been covering the stock a short period, her meeting with management yesterday was upbeat and she is confident that management is going places. The fact that it is a single product company in early trial phase did not temper her views because she believes the product has the potential to be a blockbuster. The stock is at $11, go ahead and buy $10 million dollars worth- up to a price of $12. I am putting it in all of my accounts and will get the account numbers to you as the orders fill.”

The trade takes several days to complete and then Jeff decides which portfolios will get each day’s order fills at the end of the trading session. Since the large pension accounts require more shares, he has directed the majority of the first trades to these pension accounts to fill the appropriate allocation.

34. Which of the following statements about AIMR’s Code and Standards is FALSE:

A. The responsibility to supervise employees belongs solely to management.B. One of the criteria for deciding if a manger has a fiduciary duty is to determine if the

manager is receiving a fee from the client.C. If a firm does not have supervisory procedures put in place, a CFA candidate should

decline, in writing, any promotions to supervisory level until the firm adopts written procedures.

D. Overhearing a discussion by corporate executives about material non-public information not pertaining to a tender offer does not invoke the insider-trading rule.

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35. By recommending Genetime, Frederica likely violated which of the following standard(s)?

A. Fundamental Responsibilities, for not knowing or complying with the rules. And, she violated relationships and responsibilities to clients and prospects for not exercising diligence and thoroughness and using independent judgment.

B. Relationships and responsibilities to clients and prospects; for not exercising diligence and thoroughness and for not using independent judgment. And, she violated fair dealing because she should have given her analysis to all portfolio managers of her firm at the same time to prevent front running of accounts.

C. Both A and B are correct.D. Neither A nor B are correct.

36. Thomas Whitman, CFA violated the Code and Standards because he:

A. Failed to supervise employee actions.B. Failed to educate his employees of the code and standards making sure that they

understand the rules. C. Failed to have written standards put in place to prevent certain accounts from gaining

advantage over other accounts because of size.D. All of the above.

37. Which of the following statements is FALSE.

A. AIMR code and standards prohibits block order transactions without having the exact allocation predetermined and in writing.

B. Jeff Johnston should have predetermined which portfolios, if any, should own shares of Genetime instead of giving a block order for all of his accounts.

C. Jeff Johnston violated his fiduciary duties of care skill and prudence by purchasing Genetime.

D. Jeff Johnston violated his responsibility to clients because he did not understand the risk potential of the investment in Genetime.

38. Frederica’s meeting with management violated the following rule:

A. Insider trading on material non-public information with regard to a tender offer.B. Selective dissemination since one-on-one meeting with management can no longer

occur under the 1997 Securities and Exchange Act covering fair disclosure. “Regulation F.D.”

C. Both A and B.D. One on one private meeting can be an integral part of analysis, thus no rule was

broken.

Debbie Nottingham, CFA, is asked to sit on the Board of Directors of Pineapple Trust, a private endowment with $100 million in assets. Pineapple Trust does not pay her for her work as she chooses to donate her time. She does however accept Pineapple’s offer to pay for her first class travel expenses to their annual meeting on Kauai. Debbie has informed her employer and Pineapple Trust, in writing, of the entire scope of the relationship. Her employer has NOT adopted AIMR’s Code and Standards.

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39. Debbie violated which if any of the following rules of the Code and Standards:

A. She should have paid for her own travel since the value is greater than $100 and the location is accessible by commercial means.

B. She has a direct conflict with her employer due to the amount of time it can reasonably be assumed it will take her to fulfill her responsibilities as a director. Even though her firm has not adopted the code, she is bound by the code. The code prohibits this type of conflict and thus she is bound by the higher standard and must not accept the directorship.

C. Both A and B.D. Neither A nor B.

1.5 points per correct answer

Study Session #14, 15 & 16 – Debt Investments 2002 Peter Chau, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.


Mohammad Farhad is a quantitative analyst in charge of monitoring the valuation and risk of a portfolio consisting of Treasury bonds, AAA-rated callable and putable corporate bonds, Treasury note and bond futures, and interest rate swaps.

The Treasury bonds have an aggregate face value of $1 billion and a current market value of $1.05 billion. The modified duration is 8 years. Mohammad intends to compute the convexity as well but has not completed his calculations.

The AAA-rated corporate bonds have an aggregate face value of $300 million and a current market value of $300 million. Currently there are only callable bonds. Mohammad believes that they will be called by the issuer if the yield curve drops (in a parallel fashion) by 120 basis points (bp) or more. Based on fundamental analyses performed at another department, Mohammad concludes that he does not need to be concerned about the credit risk of the AAA-rated corporate bonds. However, because of their call features, these bonds obviously have interest-rate sensitivities that may be different from those of non-callable bonds. The effective duration of the corporate bonds is 3 years. Again, Mohammad intends to compute the effective convexity but has not completed his calculations.

The holdings of Treasury note and bond futures, and of interest-rate swaps, are currently minimal. However, Mohammad’s department intends to increase these holdings substantially as part of a general strategy to manage interest-rate risk. The instruments under consideration are 10-year Treasury note futures and 5-year swaps that exchange a fixed rate for floating three-month LIBOR.

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40. The factors most likely to be important in analyzing the credit risk of the AAA-rated callable corporate bonds are

A. borrower’s capacity to repay, political risk, long-term debt to equity ratioB. negative pledge clause, regulatory issues, quality of managementC. coverage ratios, return on equity, limitation on asset salesD. limitation on additional indebtedness, capitalization ratios, sources of

liquidity

41. If the yield curve shifts upward (in a parallel fashion) by 1 bp, the value of the entire portfolio

A. will decrease by approximately $890,000B. will decrease by approximately $930,000C. cannot be determined from the currently known informationD. none of the above

42. For the purposes of risk management, Mohammad wants to see what happens if the yield curve shifts (in a parallel fashion) by a large amount. If the yield curve shifts down by 100 bp, the value of the entire portfolio

A. will increase by more than $89 millionB. will increase by approximately $89 millionC. will increase by less than $89 millionD. cannot be determined from the currently known information

43. If the yield curve shifts up by 100 bp, the value of the entire portfolio

A. will decrease by more than $93 millionB. will decrease by approximately $93 millionC. will decrease by less than $93 millionD. cannot be determined from the currently known information

44. In order to compute the convexity of the Treasury bonds and the effective convexity of the AAA-rated callable corporate bonds, Mohammad has available the following resources:i. a software program that implements a backward induction valuation methodology

within the binomial interest-rate tree framework,ii. the current Treasury yield curve,iii. the current Treasury rate volatility,iv. the current AAA-rated non-callable, non-putable corporate bond yield curve, andv. the current AAA-rated corporate bond rate volatility.

For the purposes of computing convexity of the Treasury bond, Mohammad needs to use:

A. i, and iiB. i, ii and iiiC. ii and iiiD. more resources than the ones listed above

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45. Refer again to the items in question 5. For the purposes of computing the effective convexity of the AAA-rated callable corporate bonds, Mohammad needs to use

A. i and ivB. i, iv and vC. i, ii, iii, iv and vD. more resources than the ones listed above

46. Mohammad is concerned about interest rates increasing sharply in the future, thereby reducing the value of the portfolio. A reasonable strategy to mitigate such risk is to

A. take a long position in Treasury note futures and enter into a swap to receive fixed and pay floating three-month LIBOR

B. take a short position in Treasury note futures and enter into a swap to receive fixed and pay floating three-month LIBOR

C. take a long position in Treasury note futures and enter into a swap to pay fixed and receive floating three-month LIBOR

D. take a short position in Treasury note futures and enter into a swap to pay fixed and receive floating three-month LIBOR

47. Mohammad is interested in expanding the capabilities of his analytical tools to value different interest-rate derivative instruments. He is considering the following:

i. use the Black-Scholes model to value Treasury note futuresii. use the Black model to value options on Treasury note futuresiii. use the cash-and-carry arbitrage model to value Treasury note futuresiv. expand the arbitrage-free binomial model to handle interest-rate caps and floors

The following strategy makes sense

A. implement i, ii and ivB. implement ii and iiiC. implement iii and ivD. implement ii, iii and iv

Because of his brilliant work in analyzing the Treasury bond and AAA-rated callable corporate bond portfolio, Mohammad Farhad has been promoted to oversee the analysis of mortgage-backed securities and asset-backed securities as well. The mortgage-backed securities consist of mostly FNMA pass-through certificates with an aggregate face value of $400 million and a current aggregate market value of $410 million. The underlying mortgage pools have an original maturity of 30 years, a current weighted average remaining maturity of 18 years, and a weighted average coupon of 7%. Mohammad understands that prepayment is an important issue in analyzing the mortgage-backed securities.

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48. Mohammad estimates the prepayment rate of his FNMA pass-through certificates to be 120% PSA. Assuming that rate to persist for a year, the total principal prepayment for his FNMA pass-through certificates over the next year is approximately

A. $24.0 millionB. $24.6 millionC. $28.8 millionD. $29.5 million

49. Mohammad’s boss plans to reinvest the cash flows (both interest and principal) from the FNMA pass-through certificates in new FNMA pass-through certificates. Currently, these instruments are priced at par and have underlying mortgage pools with an original maturity of 30 years, a weighted average remaining maturity of 29.5 years, and a weighted average coupon of 7%. Mohammed estimates that these new certificates are likely to have a prepayment rate that is

A. higher than 120% PSAB. approximately 120% PSAC. lower than 120% PSAD. not determinable using his available information

50. Mohammad wants to compare

i. the dollar amount of prepayment over the next year for $1 million face value of his existing FNMA pass-through certificates, with

ii. the dollar amount of prepayment over the next year for $1 million face value of the new FNMA pass-through certificates.

The most likely outcome is that

A. i is greater than iiB. i is about the same as iiC. i is less than iiD. ii is close to zero

Mohammad’s boss also plans to add interest-only (IO) strips, principal-only (PO) strips, and collateralized mortgage obligations (CMO) to the mortgage-backed portfolio. Mohammad wants to explore the possible gains and losses on these instruments if interest rates move. He also wants to build up his analytical tools to handle these instruments.

51. If interest rates go up, the greatest loss, per dollar of market value, will come from

A. FNMA pass-through certificatesB. IO strips of the FNMA pass-through certificatesC. a floater tranche of a CMO collateralized by FNMA pass-through certificatesD. an inverse floater tranche of a CMO collateralized by FNMA pass-

through certificates

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52. If interest rates go down, the greatest gain, per dollar of market value, will come from

A. FNMA pass-through certificatesB. IO strips of the FNMA pass-through certificatesC. PO strips of the FNMA pass-through certificatesD. a planned amortization class (PAC) of a CMO collateralized by FNMA pass-

through certificates

53. Mohammad wants to implement a Monte Carlo simulation model because

i. backward-induction methods cannot be used to calculate option-adjusted spreads

ii. analyses using nominal spread and zero-volatility spread have their limitationsiii. backward-induction methods cannot be used to value mortgage-backed

securitiesiv. option-adjusted spread analysis is desirable

B. i, ii and iiiC. ii, iii and ivD. i, iii and ivE. ii and iv

54. Mohammad finished building a Monte Carlo simulation model in two days and started computing the option-adjusted spread for the FNMA pass-through certificates. However, in his haste, he put in an erroneously high market value and an erroneously high interest rate volatility.

A. The two input errors tend to offset each other and the OAS is approximately correct.

B. The two input errors compound and the OAS is too high.C. The two input errors compound and the OAS is too low.D. The erroneously high market value is irrelevant to the calculation of the OAS.

Mohammad’s boss bought $1 billion face value of inverse floaters and support tranches of a CMO. Interest rates moved the wrong way and the portfolio lost many millions. However, the losses did not appear on the books as a result of some creative accounting using a pyramid of subsidiaries.

1.5 points per correct answer

16

Study Session #3 &4 – Quantitative Methods 2002 Prof. John M. Veitch. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.


A junior analyst has developed the following regression model to predict DSL subscription sales based on consumer disposable incomes and computer sales.

DSLt = 26.44 + 2.6 DISPINCt + .098 COMPUTERt

t-values: (9.02) (1.98) (1.56)

Number of observations: 34 Correlation betweenDISPINC & COMPUTER: .864Standard error of estimate: 21.96

Unadjusted R2: .83 Durbin-Watson statistic: 2.041F-stat: 87.95

DSLt = DSL sales subscriptions (in 100’s of millions of dollars) in quarter tDISPINCt = Average annual per capita disposable income (in thousands of $) in quarter tCOMPUTERt = PC and Mac sales (in 100’s of millions of $) in quarter t

Variable Estimates for 2003:Q1

DISPINCt 34.69COMPUTERt 286.70

Critical Values for Student's t-Distribution

Degrees of Area in Upper Tail Freedom 5% 2.5%

28 1.701 2.04829 1.699 2.04530 1.697 2.04231 1.696 2.04032 1.694 2.037

Critical Values for F-Distribution at 5% Level of Significance

Degrees of Freedom Degrees of Freedom (df) for the Numerator for the Denominator 1 2 3

28 4.20 3.34 2.9529 4.18 3.33 2.9330 4.17 3.32 2.9231 4.16 3.31 2.9132 4.15 3.30 2.90

55. The goodness of fit, or explanatory power, of a multiple regression equation is given by

A. The standard error of estimate for the regressionB. The F-statistic for the regressionC. The R2 for the regressionD. The t-values for the regression coefficients

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56. What is the forecast of DSL subscription sales for 1st quarter of 2003?

A. $14,473 millionB. $3,97670 millionC. $144.73 millionD. $3.9767 billion

57. What is the 95% confidence interval for the forecast of DSL subscription sales for 2003?

A. $ 99.932 to 189.529 millionB. $ 362,543 to 423,272 millionC. $ 9,993 to 18,952 millionD. $3.62543 to 4.23272 billion

58. What problems does this regression suffer from?

A. Possible multicollinearity and serial correlation.B. Possible multicollinearity but no serial correlation.C. No multicollinearity but possible serial correlation.D. None of the above problems.

59. Which statement is correct for the regression model?

A. Neither DISPINC nor COMPUTER matters for DSL sales because their t-values are low.

B. One or both DISPINC or COMPUTER matters for DSL sales because their t-values are low.

C. Neither DISPINC nor COMPUTER matters for DSL sales because the value of the F-statistic is high.

D. One or both of DISPINC and COMPUTER matters for DSL sales because the value of the F-statistic is high.

60. What other potential problems does this regression suffer from given the information provided?

A. Spurious regression due to the relationship of Computer sales to DSL sales.B. Spurious regression due to the use of real variables in the regression.C. Spurious regressions due to the use of nominal variables in the regression.D. None of the above problems.

2 points each correct answer

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Study Session #4 – Economic Methods 2002 Prof. John M. Veitch. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.


“Pick up line 3, will you?” “Huh? Me?” It’s your first day at Stagecoach Bank’s foreign exchange dealing room and your new boss is too busy to even talk to you. But the little light on the bank of telephone buttons has been flashing impatiently.

“Yes, you,” your new boss replies. “Its Ralph from Diamonds-R-Us in London. He wants clarification on our bid and offer quotes for Spanish in terms of South African. Here you are.” she says, “These are your direct quotes. “Give it a shot,” she says, “Try not to lose too much of the bank’s money.”

Exhibit 1 SPOT 3-MONTH FORWARD 1-YEAR FORWARD

SPANISH PESETA Pta 183.164-183.204/US$ Pta 182.976-183.036/US$ Pta 182.481-182.581/US$

SO. AFRICAN RAND ZAR 7.8600-7.8700/US$ ZAR 7.888-8.038/US$ ZAR 8.235-8.285/US$

Diamonds-R-Us plans to sell gems and receive revenue denominated in Spanish Pesetas (Pta) which they need to convert into in South African Rand (ZAR). Ralph will realize net proceeds of 20 million Pta at the end of 90 days and wants to eliminate the risk that the exchange rate of the ZAR will change adversely relative to the Pta during this 90-day period.

Work out the required bid or ask cross rates for him. Exhibit 1 shows the current exchange rates between the ZAR, Pta, and the U.S. dollar (US$).

61. Describe the currency transaction that Omni should undertake to eliminate currency risk over the 90-day period.

Source of RiskBe Specific!

Action to eliminate

Currency risk arises from the possibility that the ZAR will appreciate against the Pta over the next 90-day period.

1 point

Ralph should sell 90-day forward Pta against 90-day forward ZAR delivery (sell 90-day forward Pta against USD and buy 90-day forward ZAR against USD).

1 point

19

62. Calculate the following:

Thing to calculate Calculation

ZAR/Pta cross currency rate to value the Spanish revenue.

3 points

Ralph is looking to sell Pesetas for Rand. Home country is S. Africa. Peseta is the foreign currency. So bank quotes Ralph their bid rate to buy Pesetas, the foreign currency.

Cross Bid = Bid/Ask = [ZAR 7.888/US$]/[Pta 183.036/US$]

= ZAR 0.043095/Pta

Current value of Spanish revenue in ZAR.

3 points

By buying the 90-day forward Ralph has locked the Rand value of the Peseta revenue. Current value of the Spanish revenue in ZAR is:

ZAR Value = ZAR/Pta Cross Bid 90-day forward x Pta 20 million

= ZAR 0.043095/Pta x 20,000,000 Pta

= ZAR 861,900

Annualized forward premium or discount at which the ZAR is trading versus the Peseta.

3 points

The forward bid premium is the percent difference between the 3-month forward cross-bid rate and the current spot cross-bid rate annualized:

Cross bid spot = Bid/Ask = [ZAR 7.8600/US$]/[Pta 183.204/US$]

= ZAR 0.042903/Pta

= 1.79%

(11 MINUTES)

Exhausted from your phone ordeal, you begin to slump in your chair. Immediately another trader hands you the following list of information. “Give us some insight into the ZAR vs. the US$ exchange rate, won’t you?” he says.

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Financial InformationBase price level (2000) 100Current US price level (2001) 105Current South African price level (2001) 115Current Spanish price level (2001) 123Base Rand spot exchange rate (2000) ZAR 5.714/US$Current Rand spot exchange rate (2001) ZAR 7.784/US$Expected annual US inflation (2002) 2.2%Expected annual South African inflation (2002) 6.6%Expected annual Spanish inflation (2002) 3.6%Expected US one-year interest rate (2002) 3.2%Expected South African one-year interest rate (2002) 11.45%Expected Spanish one-year interest rate (2002) 5.2%

The trader tells you tells you to use the concepts of purchasing power parity (PPP) and the International Fisher Effect (IFE) to forecast spot exchange rates.

63. Calculate the following:

Thing to calculate Calculation

Current ZAR spot rate in USD that would have been forecast by PPP.

3 points

PSA2001 = 115, PUS

2001 = 105, e2000 = US$ 0.175/ZAR = $1/5.714 ZAR

PPP Rate2001 = e2000 x [PUS2001/ PSA

2001]

= US$ 0.175/ZAR x [105/115] = US$ 0.1598/ZAR

Using the IFE, the expected ZAR spot rate in USD two year from now.

3 points

rSA2002 = .1145, rUS

2002 = .032, e2001 = US$ 0.127/ZAR = $1/7.784 ZAR

IFE Rate2002 = e2001 x [(1+ rUS2002)/(1 + rSA

2002)]2

= US$ 0.127/ZAR x [1.032/1.1145]2

= US$ 0.1089/ZAR

Using PPP, the expected ZAR spot rate in USD two years from now.

3 points

SA2002 = .066, US

2002 = .022, e2001 = US$ 0.127/ZAR = $1/7.784 ZAR

PPP Rate2005 = e2001 x [(1+ US2002)/(1 + SA

2001)]2

= US$ 0.127/ZAR x [1.022/1.066]2

= US$ 0.1167/ZAR

(9 MINUTES)

21

Study Session #6 & 7 – Financial Statement Analysis 2002 Prof. John M. Veitch, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.


Dilbert Lay, CFA is an analyst following NextGen Telecomm. In reviewing NextGen's 2001 annual report, Dilbert discovers the following footnotes (1)-(3). Dilbert feels a more accurate picture of NextGen’s Balance Sheet, Income Statement and Cash Flow Statement can be arrived at by reversing these transactions.

Footnote (1) During 2001, NextGen invested $50 million in a startup software company, called NNG (Next NextGen). NNG immediately purchased a technology license from NextGen for $20 million. In addition, NNG paid $25 million to hire twenty of NextGen’s software engineers to develop software for use with the telecomm equipment during the year. NNG has one employee and an office in a building owned by NextGen.

Footnote (2) On December 31, 2000, NextGen raised the expected returns on its pension investments by one percent up to 9.5% and lowered its inflation estimates by ½ %.

Footnote (3) NextGen sold Vodavox, a European telecomm, telecomm equipment valued at $100 million which NextGen also financed. NextGen immediately sold off this receivable from Vodavox for $100 million to a third party financial institution with full recourse.

64. Indicate, for each of the three footnotes, the effect of Dilbert’s adjustments on the financial ratios for NextGen shown in the template on the following page for:

i. the year 2001.ii. the year 2002.

Note: Assume all financial information remains unchanged from 2001 through 2002, except that referenced in the footnotes above.

Answer this Question using the Template provided on the next page.

22

Template for this Question

RatioEffect on 2001 Ratio

(Circle One)Effect on 2002 Ratio

(Circle One)

Footnote (1)

Operating Cash Flow / Sales Decrease No Effect

Net Income / Sales Decrease No Effect

Sales / Net Fixed Assets Decrease Increase

Footnote (2)

Operating Cash Flow / Sales Decrease/No Effect* Decrease/No Effect*

Net Income / Sales Decrease Increase

Sales / Net Fixed Assets No Effect No Effect

Footnote (3)

Operating Cash Flow / Sales No Effect No Effect

Net Income / Sales No Effect No Effect

Sales / Net Fixed Assets No Effect No Effect

1 point per correct answer

Footnote (1)

NextGen is using a shell company to essentially capitalize its Research & Development costs. Reversing this transaction results in the following adjustments.

Operating Cash Flow / Sales: In 2001, operating cash flows must be adjusted down by the amount of the technology license and software engineer expenses, $45 million. Cash Flows from Investment would be raised by $50 million. Sales also fall by $45 million in reversing the transaction. In 2002, there is no effect because R&D is expensed in the year incurred.

Net income / Sales: In 2001, net income falls by the amount that sales fall. Since Sales is a larger number than net income but both change by the same $ amount, the ratio for 2001 falls. The ratio for 2002 is unaffected.

Sales / Fixed Assets: In 2001, Sales fall by the $45 million. The investment in NNG is backed out, leaving fixed assets $50 million lower. Thus the ratio falls for 2001 assuming that Sales are smaller than Fixed Assets (If the opposite is true then the ratio rises). In 2002 the ratio will be higher as sales are unaffected but fixed assets remain $50 million lower than previously.

Footnote (2)

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Operating Cash Flow / Sales: In 2001, the change in pension assumptions lowers NNG’s pension expense, which raises operating cash flows*. Reversing this change will lower operating cash flow for 2001 and 2002 with no effect on sales in either year. Thus the ratio falls after adjustment in both years.

* The direct effect of pension cost on operating cash flows is zero. If we assume that any changes in pension cost immediately affect payment to pension liabilities then the original answer is correct. If no immediate effect on pension financing cash flow then No Effect in both years.

Net income / Sales: Higher pension expense reduces net income in both years without affecting sales. Again the ratio decreases in both 2001 and 2002.

Sales / Fixed Assets: Changes to the pension return assumptions do not affect fixed assets or sales. Hence no effect on the ratio in either year.

Footnote (3)

This is a valid sale financed by NextGen, so sales revenue continues to be reported as before. Sale of receivable with full recourse, however, means should bring the recievable back onto NextGen’s balance sheet as an asset with offsetting liability.

Operating Cash Flow/Sales: As worded in the question the transaction would generate $100 million operating cash with $100 million in CFF from sale of receivable. Bring receivable and associated liability back on balance sheet changes CFF but not Operating Cash Flows. Hence correct answer is No Change to ratio in either year.

Net Income/Sales: Sales are unaffected by the adjustment in both years. No expense items are involved after adjustment, so net income is not affected in either year. We are assuming of course that Vodavox doesn’t default on the obligation that would result in a charge against income in the year of the default

Sales / Fixed Assets: The adjustment involves increasing accounts receivable and a liability account on the balance sheet. It does not involve fixed asset category. Hence ratio is unchanged in both years.

Final Note: It is important to see that a same $ change in the numerator and denominator does not mean the ratio remains unchanged. If Sales are $1000 and Net Income is $200, then a fall of $50 in both sales and net income does change the (Net income/Sales) ratio. Originally ratio was 200/1000 = 0.2 but after change is 150/950 = 0.158, a decline in the ratio.

24

Study Session #8 – Basic Valuation 2002 Don Davis, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.

The next four questions relate to the following Company (This material is an adaptation of, and borrowed liberally from, the 1998 Level II CFA exam, Question 2.)

SASF Sample CompanyFinancial Statements: Yearly DataIncome Statement December December

2000 2001Revenue $5,400 $7,760 Cost of goods sold 4,270 6,050Selling, general, and admin. expense 690 1,000Depreciation and amortization 40 50Operating income (EBIT) $400 $660 Interest expense 0 0Income before taxes $400 $660 Income taxes 110 215Income after taxes $290 $445

Diluted EPS $0.84 $1.18 Average shares outstanding (000) 346 376

Financial Statistics December December2000 2001

COGS as % of sales 79.07% 77.96%SG&A as % of sales 12.78 12.89Operating margin 7.41 8.51Pretax income/EBIT 100 100Tax rate 27.5 32.58

Balance Sheet December December2000 2001

Cash and cash equivalents $50 $180 Accounts receivable 720 1,050Inventories 430 690Net property, plant, and equipment 1,830 3,550Total assets $3,030 $5,470

Current liabilities $1,110 $1,750 Total liabilities $1,110 $1,750

Stockholders' equity 1,920 3,720

Total liabilities and equity $3,030 $5,470

Market price per share $30.00 $45.00 Book value per share $5.55 $9.89 Annual dividend per share $0.25 $0.40

25


65. Using 2001 data only, calculate the 2001 ROE of this company (based on starting equity, exclude issuances of new equity, assuming dividends are paid on average shares outstanding), and break down the ROE into three components, per the duPont formula. Show your work.

2001 ROE Formula Calculation

Starting Equity = Ending Equity – Net Income + Dividends

ROE = Net Income / Equity(t-1) 1 point

Starting Equity = 3,720 – 445 + (.40 x 376) = 3,425

ROE = Net Income / Equity(t-1) = 445 / 3,425 = 13.0%

2 points

DuPont FormulaComponents Component 1 Component 2 Component 3

FormulaROE = Earnings / Sales

½ pointx Sales / Assets

½ pointx Assets / Equity

½ point

NumbersROE = 445 / 7760 x

½ point7760 / 5470 x

½ point5470 / 3425 = 13.0%

½ point

66. Based on 2001 data only, calculate the sustainable rate of growth. Show your work.

2001 ROE Formula Calculation

Sustainable Growth = ROE x Retention Rate

1 point

Retention Rate = ($1.18 EPS - $0.40 Dividend ) / $1.18 EPS = 66.1%

ROE x Retention Rate = 13.0% x 66.1% = 8.6% Sustainable Growth

2 point

26

For the next year, it is projected that the SASF Sample Company will have the following pattern:

VARIABLE ASSUMPTIONS

Revenue will rise 30% from 2001Cost of goods sold (as % of sales) 2-year historical averageS, G & A expense (as % of sales) 2-year historical averageDepreciation and amortization 2% of 2001 property, plant, & equip.Interest expense zeroTax rate 34%Shares outstanding no change

67. Construct a 2002 projected income statement and EPS for the SASF Sample Company using the percent-of-sales forecasting method based on the above 2001 data and the assumptions above.

Projected INCOME STATEMENT 2002

Numbers Calculations

Revenue 1 point $10,088 30% growth x 2001 revenues

Cost of Goods Sold 1 point 7,920 78.51% average x 2002 projected revenues

Selling, General & Administrative 1 point

1,296 12.84% average x 2002 projected revenues

Depreciation 1 point 69 2% of 2001 property, plant, and equipment

Operating Income 803

Interest Expense 0 given

Income Before Taxes 803

Taxes 1 point 273 34% of Income before taxes

Net Income 530

Earnings per Share 1 point $1.41 Income after tax divided by 376,000 shares

68. Based on the sustainable growth, the projection assumptions in the income statement above are not realistic. What are the two least likely projection parameters to be valid?

Parameters least likelyto be valid Reason

Zero Interest Cost 1 point

With a 30% level of projected revenues, and only an 8.6% sustainable growth rate, there will be a need for more debt (i.e.: 0 interest cost assumption is not valid). 1 point

AND/OR

No Change in Shares outstanding

1 point

With a 30% level of projected revenues, and only an 8.6% sustainable growth rate, there will be a need for more equity (i.e.: no change in shares outstanding is not valid). 1 point

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Study Session #17 & 18 – Derivatives 2002 Prof. John M. Veitch. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.


Lara Mundell Smith, CFA has been reviewing current equity call prices for SemiCon and has noticed several discrepancies between several options prices and the basic option pricing relationships. She bets you lunch at Aqua that you won’t be able to identify three of these discrepancies.

Closing Prices on SemiCon Ltd Equity Call OptionsMay 3, 2002

Close StrikeExpiration Month

May June July August13.64 12.50 1.02 1.95 2.12 2.5413.64 15.00 0.35 0.70 0.55 1.1213.64 17.50 0.20 0.58 0.83 1.34

69. Identify three different apparent pricing discrepancies in the above table. Identify which of the following basic option-pricing relationships each discrepancy violates.

[Note: the fact that options contracts do not always trade at the same time as the underlying stock should not be identified as one of the discrepancies.]

Describe Discrepancy What options-pricing relationship violated?

May call with $12.50 strike is undervalued2 points

May call is near expiration and in the money. Its value should reflect at least its intrinsic value i.e. difference between current price minus strike ($13.64 - $12.50 = $1.14). Hence this call is undervalued.

2 points

July call at $15.00 strike is undervalued. (alternatively June call at $15.00 is overvalued.)

2 points

Call options with same strike price but longer maturities should be more valuable. Hence July call should sell for more than June call. Table shows that July call is selling for $0.55, less than the June call selling at $0.70. Hence July call is undervalued.

2 points

August call with $17.50 strike is overvalued. (alternatively August call at $15.00 is undervalued.)

2 points

Call options with same maturity but higher strike price that are more out of the money should sell for less. Why? A larger movement in underlying stock price is needed for the higher strike price option to pay off. Table shows that August $17.50 call is selling for more than the August $15.00 call. Hence August $17.50 call is overvalued.

2 points

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Study Session #20 – Portfolio Investments 2002 Patrick Collins, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.


You are given the following information regarding the historical returns on two assets, X and Y:

Year Investment X Investment Y

1 6% -3%

2 -10% 8%

3 3% 15%

4 17% -6%

5 4% 1%

70. Calculate the Covariance of Investment X and Investment Y

Covariance of X and Y

Formula Calculation

Covariance = (1/n)(xi – xavg)(yi – yavg)

1 point

Average of x = 4%Average of y = 3%

[(6-4)(-3-3)+(-10-4)(8-3)+(3-4)(15-3)+(17-4)(-6-3)+(4-4)(1-3)] / 5 =

[(-12) + (-70) + (-12) + (-117) + (0)] / 5 =

-211 / 5 = -42.202 point

71. Calculate the Standard Deviation of Investment X and Investment Y

Standard Deviation Formula Calculation

Investment X

SDX = [(xi – xavg)2 / n]1/2

1 point

Investment X:{[(6-4)2 + (-10-4)2 + (3-4)2 + (17-4)2 + (4-4)2] / 5}1/2 =

{[(4) + (196) + (1) + (169) + (0)] / 5}1/2 =

(74)1/2 = 8.601 point

Investment Y

SDY = [(yi – yavg)2 / n]1/2

1 point

CorrectionInvestment Y:{[(-3-3)2 + (8-3)2 + (15-3)2 + (-6-3)2 + (1-3)2] / 5}1/2 =

{[(36) + (25) + (144) + (81) + (4)] / 5}1/2 =

(50.8)1/2 = 7.62 1 point

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72. Calculate the correlation of Investment X and Investment Y

Correlation of X and Y

Formula Calculation

XY = Covxy /(SDx)(SDy)

1 point

CorrectionXY = -42.20 / (8.60)( 7.62) = -42.2 / 61.32 = -0.644

1 point

73. Calculate the expected return and standard deviation of a portfolio consisting of 30% Investment X and 70% Investment Y.

Portfolio of 30% X and 70% Y Formula Calculation

Expected Portfolio Return

E(Rp) =

E(Rx)(%x) + E(Ry)(%y)1 point

E(Rp) =

(.04)(.3) + (.03)(.7) = (.012) + (.021) = .033 = 3.3%

1 point

Portfolio Standard Deviation

SDp =

[(%x)2(SDx)2 + (%y)2(SDy)2

+ 2(%x)(%y)(COVxy)]1/2

1 point

CorrectionSDp =

[(.3)2(8.60)2 + (.7)2(7.62)2 + 2(.3)(.7)(-42.2)]1/2

= [(.09)(73.96) + (.49)(58.06) + (-17.72)]1/2

= [6.66 + 28.45 – 17.72]1/2 = 4.172 points

74. Explain why a portfolio consisting of 30% investment X and 70% investment Y produces a lower standard deviation than a portfolio consisting of 70% Y and 30% risk-free asset.

Answer:

By definition the variance of the risk free asset is zero. Therefore the variance of 70% Investment Y and 30% risk free equals 70%(7.13) or 4.99 vs. 3.72. The lower variance of a portfolio consisting of two assets each of which have high variance is caused by the negative covariance (or correlation) between X and Y.

2 points

30

Consider the following information:

Beta Estimated Return Estimated Standard Deviation

Investment A .8 12.5% 23%

Investment B 1.1 14.5% 28%

Variance of the Market: .0324Return of the Market: 14%Risk Free Rate: 4%

75. Calculate the Alpha of Investment B and determine an appropriate trading strategy for Investment B.

Formula Calculation

Alpha for Investment B

Alpha is the difference between Estimated Return and Required Return (as determined by the Security Market Line under the Capital Asset Pricing Model)

Required return of Investment B =Risk Free Rate +

Beta(Market Return – Risk-Free Rate) 1 point

Required Return of B = .04 + 1.1(.14 - .04) = .04 + .11 = 15%

Estimated Return of B = 14.5%

Alpha = 14.5% - 15% = -.05%1 point

Trading Strategy for

Investment B

Assuming that trading costs and taxes are not prohibitive, the portfolio manager may wish to sell investment B if the portfolio currently owns it; or may wish to short sell it given a reasonable expectation

2 points

31

SASF Mock Exam CFA Level II 2002 Answer Key

It is difficult to compare your results on this practice exam with what your results are likely to be on the actual CFA Level II exam. Each correct multiple-choice answer (Questions 1 – 69) carries the value of 1.5 points. The total points on each short answer question (Questions 71 – 85) are equal to the number of minutes assigned to that question.

The SASF Level II mock exam thus has a total of 180 possible points. The following guide may help you in identifying your areas of weakness.

60% 108 points correct out of 180 points70% 126 points correct out of 180 points80% 144 points correct out of 180 points90% 162 points correct out of 180 points

If you scored 70% correct or below then you should go back and review the sections on which you performed poorly. If you scored over 80% on the Mock exam it is likely that you are well prepared for the actual CFA Level II exam. Please note that the Ethics section is a section on which you MUST do well in order to pass the Level II exam. If you do not do well on the Ethics section there is a possibility that you will not pass the exam even if you performed well on all the other sections!!

ALL UNANSWERED QUESTIONS SHOULD BE COUNTED AS WRONG IN TOTALING UP YOUR SCORE.

PLEASE CONTACT INDIVIDUAL INSTRUCTORS IF YOU HAVE QUESTIONS ABOUT THEIR ANSWERS.

Answer Key1. B 21. D 41. B 61. Item Set2. A 22. A 42. D 62. Item Set3. C 23. D 43. C 63. Item Set4. C 24. C 44. B 64. Item Set5. C 25. D 45. B 65. Item Set6. C 26. C 46. D 66. Item Set7. B 27. C 47. D 67. Item Set8. C 28. A 48. C 68. Item Set9. B 29. A 49. A 69. Item Set10. B 30. D 50. A 70. Item Set11. A 31. D 51. D 71. Item Set12. C 32. D 52. C 72. Item Set13. B 33. D 53. C 73. Item Set14. D 34. A 54. C 74. Item Set15. B 35. A 55. C 75. Item Set16. C 36. D 56. A17. D 37. A 57. C18. C 38. D 58. B19. C 39. D 59. D

32

20. C 40. D 60. C

33

Study Session #14 & 15 – Debt Investments ANSWER KEY 2002 Peter Chau, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.

40. D. All the items listed are factors to consider in credit analysis. The question is: which ones are more likely to be important? I would argue that return on equity is not that important, although the components of ROE are important. I would also argue that political risk and regulatory issues apply only to companies in particular sectors. The factors in d are more generally applicable. My response is d. Final answer.

41. B. Value changes are based on market value, not face value.

42. D. Without applying a convexity adjustment, the increase in value of the total portfolio for a 100 bp downward move is $93 million. The Treasury bonds have positive convexity, and the callable corporate bonds have negative convexity as rates move down. The combined effective convexity may be positive or negative. Therefore, one does not know whether the convexity adjustment would be positive or negative.

43. C. Without applying a convexity adjustment, the decrease in value of the total portfolio for a 100 bp upward move is $93 million. The callable corporate bonds have positive convexity as rates move up. The combined effective convexity is therefore positive. The value decrease is therefore less than $93 million.

44. B. The valuation model must be calibrated to both interest rate levels and volatility.

45. B. To value corporate bonds, the model should be calibrated to the corporate bond yield curve and volatility.

46. D. A short position in Treasury note futures gains when interest rates go up. So does engaging in a swap to pay fixed and receive floating three-month LIBOR. Strategy a is obviously the opposite of what one wants to achieve. Strategies b and c have partially offsetting positions.

47. D. The Black-Scholes model is used to value options, not futures. Using the Black model to value options on futures is somewhat dubious, but the market does it anyway.

48. C. The mortgage pool is 12 years old (original maturity of 30 minus remaining maturity of 18), way past the point at which the PSA prepayment curve flattens out. The annual prepayment rate is therefore 6% * 120% or 7.2%. Multiply this by $400 million face value (equal to principal balance) to get $28.8 million. This result is only approximate. A more exact calculation would compute the prepayment month by month and account for scheduled principal payments as well.

49. A. The 12-year-old mortgage pool has a PSA of 120%. Presumably, this pool has experienced some burnout. A new pool, which has experienced no burnout, should have a PSA of more than 120%. Note that the prepayment for the new pool in the next few years

34

will still be low because of the age effect. However, this is already captured in the PSA curve.

50. A. Even though the new pool has a higher PSA, the prepayment amount over the next year from the seasoned pool should still be higher because of the age effect. Give yourself partial credit for selecting d. Over the first year, the prepayment from the new pool should still be small, but should have ramped up enough so that one can no longer say it is close to zero.

51. D. An IO strip gains when interest rates go up. A floater tranche is relatively immune to interest rate moves. A pass-through instrument may gain or lose, depending on whether the instrument has a market value that is above or below par. The biggest loss is incurred by an inverse floater. Remember Orange County?

52. C. PO strips gain when interest rates go down, mainly from increased prepayment. IO strips lose for the same reason. A pass-through may gain or lose, but its gain, if any, can never exceed that of the PO, since a pass-through is really a PO plus an IO. A PAC bond is like a pass-through but with a much shorter, and more well-defined, average life. Therefore, its interest rate sensitivity should be lower.

53. C. The main reason why one would go to a Monte Carlo model is because backward-induction methods cannot be used to value instruments whose cash flows are history-dependent; hence item iii must be included. Item i is patently false, since backward-induction methods can be used to compute OAS of callable bonds. The correct answer should contain item iii but not item i.

54. C. The OAS is a plug to make the model value match market price. OAS and model value move in opposite directions: a higher OAS increases the discount rates and reduces the model value, and vice versa. An artificially high market price therefore implies an artificially low OAS. A FNMA pass-through has embedded in it a prepayment option that is given up to the borrower. Option values always go up with volatility. The value of a pass-through therefore goes down if volatility goes up. An artificially high volatility depresses model value; hence OAS will have to be artificially low to compensate. The two errors compound to give an overly low OAS.

35

ADDITIONAL QUESTIONS/ANSWERS NOT INCLUDED ONSASF MOCK EXAM 2002

Study Session #8 – Basic Valuation 2002 Don Davis, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.

1. What is the unifying factor in all valuation approaches?

A. Cash FlowB. Future EarningsC. Intrinsic ValueD. Relative Value

2. Which form of analysis uses Monte Carlo techniques?

A. Sensitivity AnalysisB. Scenario AnalysisC. Simulation AnalysisD. Strategic Analysis

3. Which of the following is NOT a possible course of action for a company when sustainable growth is less than actual growth?

A. Sell new equityB. Increase leverageC. Outsource manufacturingD. Increase the dividend

4. Which of the following is NOT a potential flaw in the relative value approach to valuation?

A. Difficulty in identifying comparable companiesB. Difficulty in determining a discount rate C. Difficulty in “normalizing” ratios for accounting differencesD. Difficulty in determining the key ratios

5. List the three key assumptions of the discounted cash flow approach to valuation

A. CASH FLOWS CAN BE ESTIMATED WITH SOME RELIABILITYB. CASH FLOWS MAY BE NEGATIVE NOW, BUT WILL BE POSITIVE

SHORTLY.C. THE APPROPRIATE DISCOUNT RATE CAN BE ESTIMATED

36

6. List 4 types of firms for which the discounted cash flow approach does not work well.

A. FIRMS IN TROUBLEB. CYCLICAL FIRMSC. FIRMS WITH UNUTILIZED ASSETSD. FIRMS WITH PATENT OS PRODUCT OPTIONS

also correct: , any of: FIRMS IN THE PROCESS OF RESRUCTURINGFIRMS INVOLVED IN AQUIZITIONSPRIVATE FIRMS

Study Session #9 – Equity Investments 2002 Terry Lloyd, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.

7. All of the following, except one, are general strategies a firm can pursue.

A. cost leadershipB. product differentiationC. focusD. diversification

8. All of the following, except one, are standard phases in the business cycle

A. growthB. defensiveC. cyclicalD. investment

9. Which of the following converts a firm’s balance sheet to a column of ratios?

A. common size analysisB. internal liquidityC. operating efficiencyD. constant growth

37


10. Which of the following is the best dividend model for a small grocery chain that pays out a relatively stable percentage of its excess income?

A. the two stage modelB. the H modelC. the Gordon GrowthD. the three stage model

[the correct answer is c; it is appropriate for a steadily growing firm with a steadily growing dividend payout]

11. The price to book value ratio is increased by all of the following, except:

A. the payout ratioB. the growth rate of the company’s earningsC. the riskiness of the firm’s earningsD. none of the above

[the correct answer is c; the other factors will increase the PE ratio]

12. The difference between the value of the firm and the value of the firm’s equity is:

A. nothing; it is only terminologyB. the value of the firm includes the value of the firm’s debt capitalC. the value of the equity is based only on dividends paid or payableD. other stakeholders may have a claim on the firm’s assets

13. The price earnings ratio is increased by only which of the following?

A. the riskiness, or volatility of the company’s businessB. an increase in interest ratesC. the company’s growth rateD. a higher payout ratio

[the correct answer is c; all the other factors will decrease the PE ratio]

38


14. All of the following are believed to be advantages of EVA except

A. it is simple to calculateB. it is not subject to accounting “gimmickry”C. it considers the cost of equity capitalD. it uses cash flow, not accrual accounting

[the correct answer is a; the others are incorrect]

15. Which of the following is calculated as a percentage

A. economic value added (EVA)B. market value added (MVA)C. cash flow return on investment (CFROI)D. they are all calculated as a percentage

16. The primary advantage of using EVA as a tool to measure company performance over other methods is

A. it forces the analyst to focus on true economic earnings by deducting the cost of capital

B. it focuses on cash flow and not GAAP earningsC. it is a straightforward calculation that can be applied easily to any companyD. the cost of capital is the same for all companies, making comparisons direct

among companies in different industries

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Study Session #17 & 18 – Derivative Investments 2002 Dion Roseman, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.

17. Differentiate between spot and futures prices and explain the convergence between them.

(3 minutes)

18. Show that the implied repo rate is same as the cost of carry.

(4 minutes)

19. Discuss 3 characteristics of and motivations for swap that differentiate them from futures

(3 minutes)

20. Show and explain why put call parity must always hold (3 marks)

(3 minutes)

21. List 6 factors which affect option prices in real world (3 marks)

(3 minutes)

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Study Session #19 – Alternative Investments 2002 Jim Keene, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.

A wealthy Hong Kong family that you advise owns a 150,000 net rentable sq. ft. office building at 350 California Street in San Francisco’s financial district built in 1972. The Class B building is currently 92% leased and occupied to average credit quality local and regional tenants. The full service leases expire evenly over the next five years starting in one year. The market is approximately 86% occupied with no real signs of change in the next several years. The building rental and expense information is as follows:

Average base rent/sq. ft./month $2.50Fixed expenses/sq. ft./month (excluding real estate taxes) .50Variable expenses/occupied sq. ft./month .60Real estate taxes (current)/year $225,000

The building occupancy is expected to revert to the market occupancy evenly by the end of three years. The building rents are at market and the market is expected to increase 3%/year for the foreseeable future. Variable and fixed expenses (w/o real estate) are also expected to increase 3%/year. Real estate tax increases are limited to the lesser of 2%/year or inflation (unless the property is sold and the real estate taxes are based on 1.5% of the sale price).

22. Based on this information, calculate the property’s expected cash flow for the next five years.

(15 minutes)

23. Based on the following market rates of return, construct a discount rate to value the property.

6 Month Treasury Bill 3.5%10 Year Treasury Note 5.50%10 Year AA Rate Corporate Bonds 6.5%Emerging Markets Equities 14.0%Venture Capital 18.0%

(5 minutes)

24. Based on the results from A and B, calculate a value for the property assuming a sale at the end of five years (base on year 6 expected cash flow and assume a long-term growth in cash flow on the property of 3%/year).

(7 minutes)

25. Your client is considering selling this property now and investing in a biotechnology venture capital fund. Advise your client on the similarities and differences between the two investments.

(3 minutes)

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Study Session #19 – Alternative Investments ANSWER KEY 2002 Jim Keene, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.

13. See excel spreadsheet below on cash flow projections.350 CALIFORNIA STREET

Year 1 2 3 4 5

Rent PotentialTotal square feet 150,000 150,000 150,000 150,000 150,000

occupancy % 92% 90% 88% 86% 86%occupied sq. ft. 138,000 135,000 132,000 129,000 129,000

Annual rent/sq. ft. $30.00 $30.90 $31.83 $32.78 $33.77 Total rent $4,140,000 $4,171,500 $4,201,164 $4,228,853 $4,355,719

ExpensesTotal sq. ft. 150,000 150,000 150,000 150,000 150,000

Occupied sq. ft. 138,000 135,000 132,000 129,000 129,000 Fixed expenses/sq.

ft./yr. $6.00 $6.18 $6.37 $6.56 $6.75

Total fixed expenses

$900,000 $927,000 $954,810 $983,454 $1,012,958

Var. exp./occupied sq. ft./yr.

$7.20 $7.42 $7.64 $7.87 $8.10

Total variable expenses

$993,600 $1,001,160 $1,008,279 $1,014,925 $1,045,373

Real estate taxes $225,000 $229,500 $234,090 $238,772 $243,547 Total expenses $2,118,600 $2,157,660 $2,197,179 $2,237,151 $2,301,878

Net operating cash flow

$2,021,400 $2,013,840 $2,003,985 $1,991,703 $2,053,841

14. The discount rate for an investment is based on its perceived level of risk compared to other options. As an asset class, single property commercial real estate is much less liquid than domestic public equities and is subject to not only market risk, but also systematic risk (that is, risk associated with the individual asset). On the other hand, it generates a reasonably reliable and steady cash flow with protection from the length of the leases as well as its location in a long-term proven market area. Its risk lies somewhere between the 10 year 6.5% AA Corporate Bond discount rate and the 14% expected return on emerging market equities. Because the building is thirty years old and older buildings require increasing capital expenditures relative to their operating cash flow capabilities, the risk should come somewhere close to the emerging markets risk. Accordingly, using a discount rate anywhere in the 11 – 14% range is acceptable for valuation judgment purposes.

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15. See excel spreadsheet on valuation calculations.

Year 1 2 3 4 5 6Rent Potential

Total square feet 150,000 150,000 150,000 150,000 150,000 150,000 occupancy % 92% 90% 88% 86% 86% 86%

occupied sq. ft. 138,000 135,000 132,000 129,000 129,000 129,000 Annual rent/sq. ft. $30.00 $30.90 $31.83 $32.78 $33.77 $34.78

Total rent $4,140,000 $4,171,500 $4,201,164 $4,228,853 $4,355,719 $4,486,391 Expenses

Total sq. ft. 150,000 150,000 150,000 150,000 150,000 150,000 Occupied sq. ft. 138,000 135,000 132,000 129,000 129,000 129,000

Fixed expenses/sq. ft./yr. $6.00 $6.18 $6.37 $6.56 $6.75 $6.96 Total fixed expenses $900,000 $927,000 $954,810 $983,454 $1,012,958 $1,043,347

Var. exp./occupied sq. ft./yr. $7.20 $7.42 $7.64 $7.87 $8.10 $8.35 Total variable expenses $993,600 $1,001,160 $1,008,279 $1,014,925 $1,045,373 $1,076,734

Real estate taxes $225,000 $229,500 $234,090 $238,772 $243,547 (1) Total expenses $2,118,600 $2,157,660 $2,197,179 $2,237,151 $2,301,878 $2,120,080 (2)

Net operating cash flow $2,021,400 $2,013,840 $2,003,985 $1,991,703 $2,053,841 $2,366,310 (2)

Assumed discount rate 12% 13.5% (3)Discount factor 1.12 1.254 1.405 1.574 1.762 2.138

Assumed discount rate 12.0%Plus: Tax rate not included in year 6

expenses1.5%

Less: Long-term growth rate -3.0%Year 6 terminal capitalization rate 10.5%

$22,536,288 Present value of terminal value $12,787,695

Present value $1,804,821 $1,605,421 $1,426,397 $1,265,763 $1,165,405 $1,804,821 $1,605,421 $1,426,397 $1,265,763 $13,953,100

Present value $20,055,502

(1) The 1.5% tax rate is built into the 12% terminal value discount rate because the taxes are reassessed upon the sale.(2) Excludes property taxes that are built into the terminal discount rate (12% plus 1.5% equals 13.5% terminal discount rate).(3) Includes tax rate built into the terminal discount rate.

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16. The similarities include: Both asset classes characterized by best managers adding significant value over worst managers (large dispersion of

performance) Both relatively illiquid Historical inflation hedges

The differences include: Real estate has operating cash flow; venture capital fund not expected to have much, if any Venture capital fund invests in numerous companies vs. one asset in real estate Venture capital has longer period of illiquidity (many years vs. many months to get money out) Expected returns higher for venture capital Venture capital commitment is drawn down over several years resulting in some time diversification Biotechnology start-ups would have no operating history as business; real estate would have some operating history

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SASF Mock Exam Level II 2002 Ans

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