Mock Exam Level II 2003 Ans

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

SUPERVISOR
2003 CFA® Level II SASF Mock Exam
Instructors:
Peter Chau, CFA
Patrick Collins, Ph.D., CFA
Ed Cordisco, CPA
Don Davis, CFA
Jivendra Kale, Ph.D.
Terry Lloyd, CFA
Prof. John M. Veitch, Ph.D., CFA
Loren Walden, CFA, CFP
The Security Analysts of San Francisco

SASF CFA®Level II 2003 Mock Exam
Saturday, May 3, 2003
Questions Topics Time Instructor
Item Set
1 – 10 Ethics SS # 1 & 2 15 minutes Loren
Walden
11 – 14 Quantitative Methods SS # 3 6 minutes Jivendra
Kale
15 – 27 Debt Instruments SS #13, 14, & 15 20 minutes Peter Chau
28 – 43 Derivatives SS #16 & 17 24 minutes Peter Chau
44 – 49 Portfolio Management 12 minutes Patrick
Collins
50 – 55 Financial Statement Analysis SS # 5 9 minutes Ed
Cordisco
56 – 63 Economics SS # 4 16 minutes John Veitch
64 – 70 Quant. Methods & Economics SS # 3&4 14 minutes John Veitch
Total 116 minutes
Essay/Item Set
71 – 73 Basic Valuation SS # 8 15 minutes Don Davis
74 – 79 Equity Valuation SS # 9 12 minutes Terry Lloyd
80 – 87 Equity Valuation SS # 10 20 minutes Terry Lloyd
88 – 91 Equity Valuation SS # 11 & 12 8 minutes Terry Lloyd
92 - 96 Financial Statement Analysis SS #7 12 minutes John Veitch
Total 67 minutes
Please note that the distribution of questions on the SASF CFA Level II Practice exam
broadly reflects the weights placed on each subject area by the CFA Level II study guide.
There is no guarantee that the questions on the actual CFA exam will reflect these relative
weights.
SASF Level II Mock Exam 2003 Answers Page 2 of 43

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.

Study Session #1 & 2 – Ethics
 2003 Loren Walden, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited
without permission.
Each question in this section is 1½ minutes unless noted otherwise
1. Which of the following is an obstacle to and effective proxy voting Policy?
A. Lack of a clear policy and management support;

B. Perception that a policy is a difficult procedure;
C. Voting in the clients best interest;
D. All of the above.
2. Which of the following is not a sanction that AIMR can impose on a covered person?
A. Public censure
B. Private censure
C. Revocation of membership
D. None of the above
3. Which of the following can result in a summary suspension?
A. Felony conviction.
B. Permanent disbarment under securities law
C. Failure to cooperate with and AIMR investigation
D. All of the above
4. Which of the following is a complete description of the principals of the New Prudent
Investor Rule?
A. Diversification, Assessment of risk levels, Duty and Authority to Delegate as a prudent

investor would, Apply thorough analysis on soft dollar usage;
B. Diversification, Assessment of risk levels, Costs must be justified, Impartiality of
balancing income and growth, Apply thorough analysis on soft dollar usage;
C. Diversification, Assessment of risk levels, Duty and Authority to Delegate as a
prudent investor would, Impartiality of balancing income and growth, Duty and
authority to delegate as a prudent investor would.
D. Duty to front run clients, Duty to use soft dollars to purchase computer software, Duty to
favor one client over another, Duty to fail the exam if you choose this as your answer.
5. Which of the following are general fiduciary standards carried over from the Prudent
Person Rule to the new Prudent Investor Rule?

A. Care, Skill, Caution, Loyalty
B. Impartiality
C. Diversification
D. A and B only
Fink Quatronion, CFA is the senior portfolio manager at Clink LLC Investment Management,
a seven billion dollar firm. Clink focuses upon managing assets for pension funds of technology
companies located in the United States. Clink has adopted the AIMR Code and Standards. Fink
manages both the many research analysts as well as the portfolio managers at Clink.
One day, Billy Badly, a level II candidate for the Charter Financial Analyst designation, gets
called into Finks office. There are several things Fink is concerned about regarding Billy’s
conduct and has outlined them on a memo to help keep the meeting on track. The following is
the memo:
Memo of conduct problems for Billy Badly.
1. Purchased securities for his personal account that are under review for possible
consideration to sell for client accounts
2. Has delegated his research duties required under ERISA buy buying sector funds in
some of his client’s portfolios.
3. Has been working on a charity on weekends without disclosing this to his supervisor
in writing.
4. Does not review his account’s circumstances at least bi-annually.
5. Did not inform the firm in writing that he was bound by the code.
6. Assuming all of the items did occur, which of the items in the memo are clear violations
of AIMR’s Code and Standards?
A. None
B. 1,2,4,5
C. 1
D. 1,2,3,4
7. How could Fink Quatronion, CFA have done a better job and created an affirmative
defense?
A. He failed to have systems in place to avoid clear violations of the code. By having check
systems in place in writing he could avoid Billy type problems.
B. He could check all new hires for clues about integrity.
C. He should provide all employees a copy of the Code when they are hired and educate
them frequently about the code.
D. All of the above.

8. Under ERISA a fiduciary must do which of the following?
1. Have a written investment policy

2. Monitor performance
3. Never use plan assets for their own account
4. Never transact plan assets if a conflict of interest exists
5. Never get kickbacks
6. Never use soft dollars
A. 1,2,3,5 only
B. 1,3,5,6 only
C. l,2,3,4,5 only
D. 1,2,3,4,5,6
9. Under the Prudent Investor Rule each individual security is taken on its own merits.
A. True
B. False
C. Only if ERISA is the operating rule then it is true
D. Only if ERISA and the Prudent Expert rule is enforced
A large group of portfolio managers and analysts meet once a year for an investment
conference at a fancy hotel to get educated wined and dined by a brokerage firm. The host firm
pays for meals, entertainment, expensive wine, and the hotel suites. At this meeting, breakout
sessions are provided for the brokerage firm’s top clients with senior management of publicly
traded companies presenting at the conference.
At one of these breakout sessions, an analyst named Tommy Toy, CFA overhears the CEO of
Reardon Steel talking into his cell phone before the meeting begins. The CEO said “I can’t say
anything right now because I have a room full of Wall Street jerks breathing down my neck. But
if they want to buy our firm for that much money, get the board together and we will meet
tomorrow morning at corporate headquarters. Send the jet out to get me tonight.”
After hearing this conversation, Tommy gets his own cell phone out and proceeds to call
in an order to by several thousand shares of Reardon Steel for his personal account.
10. Which of the following is most true?
A. Tommy can trade all he wants in Reardon Steel for himself but not for his clients.
B. Tommy cannot trade on the overheard information because it came directly from a senior
officer who would be considered an insider.
C. Tommy cannot trade on the overheard conversation because of the subject matter of
the information.
D. The only violation that occurred is the brokerage firms offer to pay for the lodging.

Study Session #3 – Quantitative Methods
 2003 Jivendra Kale, Ph.D. All rights reserved. Reproduction in any form, in whole or in part, is prohibited
without permission.
Each question in this section is 2 minutes unless noted otherwise
A junior analyst has developed the following regression model to predict tire industry sales at
time t based on the variables in Table 1.
SALES t = 504.44 + 13.18 INDRUBt + 9.88CAPt + 11.66 INDTRt + 5.92 MILES t + 10.45 PERS t
t-values: (1.02) (0.67) (1.48) (0.83) (1.76) (1.13)
Number of observations: 36
Standard error of estimate: 1637.38
Unadjusted R2: 0.955
Table 1. Variable Descriptions

SALES Annual tire industry sales (in millions of dollars)
INDRUB Annual demand for replacement tires (Index: year 2000 = 100)
CAP Capacity utilization rate (annual percentage) for rubber and plastic
manufacturing
INDTR Annual industrial production of tires (Index: year 2000 = 100)
MILES Annual all-systems mileage (in billions of miles)
PERS Annual personal consumption of tires, tubes, and accessories (in
billions of dollars)
Variable Estimates for 2003

INDRUB 144.1
CAP 90.7
INDTR 143.9
MILES 2,359.8
PERS 36.6
Critical Values for Student’s t Distribution

Area in Upper Tail of Distribution
Degrees of Freedom 10% 5% 2.5%
29 1.311 1.699 2.045
30 1.310 1.697 2.042
31 1.309 1.696 2.040
36 1.306 1.688 2.028
11. The goodness of fit, or explanatory power, of a multiple regression equation is given by
A. The standard error of estimate for the regression
B. The F-statistic for the regression

C. The R2 for the regression
D. The t-values for the regression coefficients
12. What is the forecast of tire industry sales for 2003?

A. $19,330.154 million
B. $504.440 million
C. $19.330 million
D. $1,637.38 million
13. What is the 95% confidence interval for the forecast of tire industry sales for 2003?
A. $17,692.774 to 20,967.534 million
B. -$1,637.380 to 1,637.380 million
C. -$2,839.090 to 3,847.970 million
D. $15,986.624 to 22,673.684 million
14. Which is a symptom of multicollinearity?

A. Low R2 but statistically significant coefficients
B. Large R2 but statistically insignificant coefficients
C. Regression coefficients hardly change when independent variables are dropped from the
regression equation
D. High standard error of estimate for the regression
Study Session #13 & 14 – Fixed Income – Credit and Valuation

 2003 Peter Chau, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without
permission.
Alicia Quan is an analyst for a mutual fund that owns some high-yield bonds issued by AQT
Corporation. The following table shows AQT’s simplified balance sheet. Amounts are in millions
of dollars.
Total assets 1,000 Current liabilities 200

Long-term debt 300
Equity 500
The long-term debt includes high-yield bonds, some of which are owned by the mutual fund.
AQT is planning to embark on a new project that requires additional capitalization of $200
million. It is not clear how AQT plans to fund the new project. It may issue more stocks and
possibly more bonds. Alicia is concerned that, if AQT decides to issue additional bonds, the
higher debt ratios would cause the existing high-yield bonds to go down in value. The high-yield

bonds include a negative covenant that puts a limit on additional indebtedness unless certain
ratios are met. One such ratio is the long-term debt to total capitalization, which must be less
than 45%.
15. If AQT were to fund the new project by issuing additional bonds, the long-term debt to
total assets ratio would be
A. 16.7%
B. 41.7%
C. 50.0%
D. 58.3%.
16. If AQT were to fund the new project by issuing stocks, the long-term debt to equity ratio
would be
A. 30.0%
B. 42.9%
C. 60.0%
D. 71.4%.
17. Alicia is confident that the following cannot happen
A. AQT funds the new project using all stocks

B. AQT funds the new project using all bonds
C. AQT funds the new project using stocks and bonds
D. AQT funds the new project using stocks and syndicated bank loans.
18. Alicia is concerned that the high-yield bonds may drop in value if the new project is
capitalized in a way that is detrimental to existing bondholders. She can hedge this risk
by
A. shorting Treasury bond futures

B. buying put options on AQT stocks
C. monitoring closely the news from AQT corporate headquarters
D. none of the above.
19. To understand the interest rate risk of the high-yield bonds, Alicia would need
A. the modified duration

B. the effective duration
C. the convexity or effective convexity
D. the nominal spread or zero-volatility spread.

Answers to Item Set B
15. B. Long-term debt = 300 + 200 = 500. Total assets = 1000 + 200 = 1200.
16. B. Long-term debt = 300. Equity = 500 + 200 = 700
17. B. If AQT funds the new project using all bonds, then long-term debt = 300 + 200 = 500,
total capitalization = 300 + 200 + 500 = 1000, and long-term debt to total capitalization =
500 / 1000 = 50%. This would violate the negative convenant.
18. D. A is definitely incorrect. Alicia is trying to hedge a credit risk event, not an interest
risk event. Therefore Treasury bond futures would not help. B is tempting. Prices of high-
yield bonds usually move in the same direction as the same company’s stocks. A put
option on the company stock would then move in the opposite direction and provide
some hedge. (Of course, finding the proper hedge ratio is still a problem.) In this case,
however, the new funding may hurt the bondholders and hence benefit the shareholders.
A put option would then lose when the high-yield bonds lose. This is no hedge. C is
always a good idea. However, it does not provide a hedge. By the time the news comes
out, the market may have reacted.
19. B. C is out since convexity does not help if one does not know the duration. D is out;
spreads do not measure interest rate risk. A may be an acceptable answer if the high-yield
bond is noncallable. However, since many corporate issues are callable, B is always a
safe answer.
Study Session #15 – Fixed Income – Structured Securities

permission.
Abdul Ramaswamy’s department has been analyzing the company’s investments in mortgage-
backed securities using nominal spreads and zero-volatility spreads. Some of the elements which
may enter the calculations for these spreads are:
(i) yield of a Treasury instrument with maturity equal to the weighted average remaining
maturity of the mortgage pool underlying the MBS,
(ii) yield of a Treasury instrument with maturity equal to the average life of the MBS,
(iii) spot rates for the entire Treasury yield curve,
(iv) expected cash flows for the MBS through its maturity,
(v) market price of the MBS.
20. To calculate the zero-volatility spread,
A. (i), (iv), and (v) are needed

B. (ii), (iv), and (v) are needed

C. (iii), (iv), and (v) are needed
D. (v) is not needed.
21. The expected cash flows described in (iv)
A. have already accounted for expected prepayment and therefore accounted for the
embedded prepayment option in the MBS
B. have already accounted for expected prepayment but have not accounted for the
embedded prepayment option in the MBS
C. have not accounted for prepayment
D. are the same as the cash flows from the MBS with no prepayment.
Abdul wants to use more sophisticated techniques, such as option-adjusted spreads (OAS), to
analyze the MBS.
22. OAS is superior to nominal spreads or zero-volatility spreads because
A. it is calculated using a Monte Carlo model

B. it is calculated using a binomial model
C. it properly accounts for the embedded prepayment option in the MBS
D. it makes use of the entire Treasury yield curve and interest rate volatility.
23. The zero-volatility spread may be thought of as
A. a constant spread over the entire yield curve

B. an extreme case of an OAS in which the volatility is assumed to be zero
C. a spread that does not change with volatility
D. both A and B.
Abdul decides to use a Monte Carlo model to analyze the MBS. He uses an interest rate volatility
of 10% and obtains an OAS of 50 bp for a FNMA certificate. Later, he realizes that an interest
rate volatility of 12% is more appropriate.
24. As the assumed volatility goes up, the value of the embedded prepayment option in the
FNMA certificate
A. goes up
B. goes down
C. may go up or down
D. stays constant if the Monte Carlo model is properly calibrated to the interest rate
volatility.

25. If Abdul had used the old OAS of 50 bp but the new 12% volatility to value the FNMA
certificate, he would find that the model value of the FNMA
A. is higher than the market price of the FNMA

B. is lower than the market price of the FNMA
C. may be higher or lower than the market price of the FNMA
D. equals the market price of the FNMA if the Monte Carlo model is properly calibrated
to the interest rate volatility.
Abdul has some experience with OAS in her work analyzing callable and putable bonds. After
analyzing a few MBS, Abdul feels that she understands a lot more about OAS.
26. The OAS of an MBS
A. is always higher than the zero-volatility spread

B. is always lower than the zero-volatility spread
C. may either be larger or lower than the zero-volatility spread
D. may not be compared with the zero-volatility spread because they are calculated using
two different methods.
27. The OAS of a callable bond
A. goes up when the assumed volatility goes up

B. goes down when the assumed volatility goes up
C. is always independent of the assumed volatility
D. is independent of the assumed volatility if the binomial model is properly calibrated
to the interest rate volatility.
Answers to Item Set D
20. C. Take the expected cash flows and discount them at the appropriate spot rates plus a
constant spread. This will result in a certain PV. Using trial and error, change the spread
until this PV equals the market price. This spread is the zero-volatility spread.
21. B. The embedded prepayment option manifests itself as different cash flows under
different interest rate conditions. One therefore need many cash flow scenarios to fully
appreciate the option-like characteristics. A single set of expect cash flows simply will
not do.
22. C.

23. D. A is obviously true. B is also true. The subtle point here is that discounting at a long-
term spot rate (as in the calculation of a zero-volatility spread) is equivalent to
discounting at a series of short-term future rates (as in the calculation of an OAS).
24. A. All options become more valuable with higher volatility.
25. B. When the volatility is increased to 12%, the embedded prepayment option is more
valuable. However, the FNMA is short such an option. Therefore the new model value of
the FNMA at 12% volatility is lower than the old model value at 10% volatility. The latter
must equal the market price, by definition of the OAS.
26. B. Think of the opposite case of 10. When volatility goes down, the OAS of a FNMA
goes up. In the extreme case when volatility goes to zero, the new OAS becomes the
zero-volatility spread. This must be higher than the old OAS.
27. B. Same reasoning as in an MBS. Like an MBS, a callable bond is short the embedded
call option. When volatility goes up, the embedded call option increases in value; hence
the model value of the callable bond decreases. To bring the model value back up to the
market price, one must decrease the OAS.
Study Session #16 – Derivatives – Futures and Swaps

permission.
Tim Lopez is an analyst at Wo Chong, a major manufacturer and wholesaler of tofu. The sale
price of tofu is very stable. However, the cost of production fluctuates with the cost of the
ingredients, mainly soybeans.
Tim wants to hedge the cost of production with soybean futures. He wants to run a regression of
the cost of production against soybean futures prices:
∆COSTt = a + b ∆SOYBEANt + et
∆COSTt = change in cost of production in $ per lb of tofu
∆SOYBEANt = change in soybean futures price in $ per bushel
Tim understands that the regression results will tell him if hedging will be effective or not.
28. For the hedging to be at least somewhat effective,
A. the coefficient a must not be zero

B. the coefficient b must be positive
C. the coefficient b must be negative
D. the coefficient b must not be zero.

Tim obtains the following regression results:
a = 0.0047, b = 0.0651, R2 = 0.28.
Based on the t statistics, the coefficient a is not significantly different from zero, but the
coefficient b is significantly different from zero.
Tim wants to hedge the production cost of 1,000,000 lbs of tofu. Each soybean futures contract is
for 5,000 bushels. The July contract is trading at 564.75 ($5.6475 per bushel).
29. Tim should
A. buy soybean futures contracts

B. sell soybean futures contracts
C. hold off because the regression results show hedging will not be effective
D. hold off because the regression results are inconclusive.
30. If Tim decides to hedge, the number of soybean futures contracts to buy or sell is
A. 1
B. 13
C. 325
D. 3,072.
Rightly or wrongly, Tim decides to hedge, and buys or sells the appropriate number of contracts.
A month later, he finds that production cost of tofu has gone up from $0.48 per lb to $0.50 per lb.
The July soybean futures contract is now trading at 594.75.
31. The cumulative mark-to-market cash flow over the month from the soybean futures
contract(s) is
A. negative $1,500
B. negative $19,500
C. positive $19,500
D. positive $921.60.
32. Wo Chong’s net gain or loss is
A. a gain of $19,500
B. a loss of $20,000
C. a gain of $500
D. a loss of $500.

Nisei Bank has a portfolio of floating rate loans indexed to the Prime rate. The Prime rate moves
more or less with LIBOR, but changes in jumps and less frequently. The bank’s earnings are
directly tied to the amount of interest it receives from its loans. The management of Nisei Bank
wants to stabilize its earnings, at least with respect to this portfolio of Prime based loans.
33. To stabilize its earnings, Nisei Bank can

A. enter into a swap to receive LIBOR and pay fixed
B. buy a strip of Eurodollar futures
C. sell a strip of Eurodollar futures
D. none of the above.
The portfolio of Prime based loans have a current aggregate balance of $400 million. The
balance will decrease over time as borrowers are required to make principal payments every
month. The average life of a loan is 10 years.
34. To best stabilize its earnings, Nisei Bank should

A. enter into a 5-year swap to receive LIBOR and pay fixed on a notional amount of
$400 million
B. enter into a 5-year swap to receive fixed and pay LIBOR on a notional amount of
$400 million
C. enter into a 5-year swap to receive LIBOR and pay fixed on a notional amount of
$800 million
D. D. enter into a 5-year swap to receive fixed and pay LIBORon a notional amount of
$800 million.
In 2003, Nisei Bank stepped right into the 20th century and discovered a wide variety of swaps
besides the plain vanilla swap.
35. To best stabilize its earnings, Nisei Bank should enter into
A. an accreting swap
B. an amortizing swap
C. a basis swap to receive LIBOR and pay Prime
D. a yield curve swap.
Answers to Questions
28. The correct answer is D. Either a positive or a negative b can work. Tim can buy or sell
depending on the sign of b. However, if b is zero, then there is no hedge.
29. The correct answer is A. In buying soybean futures, Tim is locking in the price at which
Wo Chong can buy soybeans. That is the hedge.
30. The correct answer is B. From the regression, b = 0.0651 bushels of soybeans per lb of
tofu. Tim wants to hedge 1,000,000 lbs of tofu, therefore he should hedge with 1,000,000

* 0.0651 or 65,100 bushels of soybeans. Each contract is for 5,000 bushels. Therefore he
needs 65,100 / 5,000 or 13.02 contracts. Round that to 13.
31. The correct answer is C. Remember that each contract covers 5,000 bushels. A price
change from 564.75 to 594.75 means an increase in price from $5.6475 per bushel to
$5.9475 per bushel. Since Tim is long 13 contracts, the cumulative mark-to-market cash
flow is positive. The amount is 13 * 5,000 * ($5.9475 − $5.6475) or $19,500.
32. The correct answer is D. Loss from increase in production cost of tofu = 1,000,000 *
($0.50 − $0.48) = $20,000.
Gain from futures = 13 * 5,000 * ($5.9475 − $5.6475) = $19,500.
Net position = $19,500 − $20,000 = −$500.
33. B. The bank receives Prime, which fluctuates and causes earnings instability. When
Prime goes down, earnings go down, as does LIBOR. If the bank is long Eurodollar
futures, the futures position gains when LIBOR goes down, thus providing a hedge.
34. B. Matching the notional balance of the swap with the aggregate balance of the loan
portfolio is important. This swap will only hedge the earnings for the first five years. A
naïve view of D might lead one to think that 5 years at $800 million is equivalent to 10
years at $400 million. It isn’t.
35. B. The amortizing swap will take care of the declining aggregate balance of the portfolio
quite nicely. The basis swap in C merely exchanges the instability from Prime for the
instability from LIBOR. However, it is very useful when combined with a fixed for
floating swap. See question 5.
Study Session #17 – Derivatives - Options

permission.
John Gambol is considering the purchase of JGD stocks and options for his company’s portfolio.
JGD stocks are currently trading at $100 per share. JGD options are available in European puts
and calls. The times to expiration are three months, six months, and nine months. Strike prices
are $90, 95, $100, $105 and $110. All combinations are possible for a total of 2 x 3 x 5 or 30
options.
36. The cheapest call option (lowest call premium) is
A. the three-month call with a strike price of $95

B. the three-month call with a strike price of $105
C. the nine-month call with a strike price of $95

D. the nine-month call with a strike price of $105.
37. If JGD stocks go up, the highest dollar payoff at expiration would come from
A. the call with a strike price of $95

B. the call with a strike price of $100
C. the call with a strike price of $105
D. the put with a strike price of $100.
Of course, it is now prior to expiration. John is interested in doing some day trades to take
advantage of short-term stock price movements.
38. If JGD stocks go down, the biggest dollar gain per option would come from
A. buying the six-month put with a strike price of $95

B. buying the six-month put with a strike price of $100
C. buying the six-month put with a strike price of $105
D. buying the six-month call with a strike price of $95.
39. If JGD stocks go up, the biggest return on investment would come from
A. buying the JGD stock

B. buying the three-month call with a strike price of $95
C. buying the three-month call with a strike price of $100
D. buying the three-month call with a strike price of $105.
John soon finds that day trading has its rewards, but comes with risks as well. His next strategy is
to buy or write options but hold the position until expiration.
40. If JGD stocks go up, the following option strategy would gain
A. short an JGD three-month put with a strike price of $95

B. long a bull spread
C. short a bear spread
D. all of the above.
41. If JGD stocks go up substantially, the following option strategy would have the most gain
A. long a straddle
B. long a strangle
C. long a butterfly spread
D. long a bull spread

42. If JGD stocks go down substantially, the following option strategy would gain
A. long a straddle, long a strangle, or long a butterfly spread

B. short a straddle, short a strangle, or short a condor spread
C. long a straddle, long a butterfly spread, or long a condor spread
D. long a strangle, short a butterfly spread, or short a condor spread.
43. If JGD stocks stay within a narrow range, the following option strategy would gain
A. long a straddle, short a strangle, or long a bull spread

B. long a straddle, long a butterfly spread, or short a condor spread
C. short a straddle, short a butterfly spread, or short a condor spread
D. short a strangle, long a butterfly spread, or long a condor spread.
Answers
36. B. The cheapest call is the one that is the most out-of-the-money and the closest to
expiration.
37. A. Most in-the-money call. The put is out-of-the-money.
38. C. This is another question about the delta of options. The call delta is positive; so D is
out since the stock goes down. The put delta always negative; but since the stock goes
down, that implies a gain. The magnitude of the put delta increases as the option gets
more in-the-money. The deepest in-the-money put is C.
39. D. The return on investment is the increase in option value divided by the option cost.
From question 4, we know that the increase in option value is higher for the more in-the-
money calls. However, the in-the-money calls cost a lot more. Therefore the return on
investment is not as great as that of the out-of-the-money calls. If one were to rank the
return on investment from lowest to highest, it would be A, B, C, and D.
40. D. A short put position gains since the put remains unexercised. A long bull spread gains.
A short bear spread is identical to a long bull spread.
41. A. C can be eliminated easily since a long butterfly spread loses when stock prices go up
at lot. D can be eliminated because a bull spread gives up the extreme upside potential. A
straddle gains more than a strangle in extreme price movements. If this were not so, a
strangle would dominate a straddle in that it would have a better return at any stock price.
Another way of looking at this is the following. A straddle involves buying an at-the-
money call and an at-the-money put. A strangle involves buying an out-of-the-money call
and an out-of-the-money put. The straddle obviously costs more than the strangle, and
therefore should have better upside potential.

42. D. When stocks go down a lot, a long straddle gains, a long strangle gains, a short
butterfly spread gains, and a short condor spread gains.
43. D. When stocks trade within a narrow range, a short straddle gains, a short strangle gains,
a long butterfly spread gains, and a long condor spread gains.
Study Session #18 – Portfolio Management

 2003 Patrick Collins, Ph.D., CFA. All rights reserved. Reproduction in any form, in whole or in part, is
prohibited without permission.
Each question in this section is 2 minutes unless noted otherwise
Consider the following information:
Year Investment X Investment Y

1 4% -6%
2 -10% 8%
3 8% 12%
4 14% -2%
Risk Free Rate: 2%
44. The Covariance of Investment X and Investment Y is:
A. -32.60
B. -21.00
C. +144.82
D. -103.50
Answer: B.
Covariance = 1/nΣ(xi – xavg)(yi – yavg), where
Average of x = 4%
Average of y = 3%
[(4-4)(-6-3)+(-10-4)(8-3)+(8-4)(12-3)+(14-4)(-2-3)] / 4 =
[(0) + (-70) + (36) + (-50)] / 4 = -84 / 4 = -21.00
45. The Standard Deviations of Investments X and Investment Y are:
A. 8.83 and 10.56

B. 6.44 and 4.71
C. 5.52 and 7.28
D. 8.83 and 7.28

Answer: D.
Standard Deviation = [Σ(xi – xavg)2 / n]1/2
Investment X:
{[(4-4)2 + (-10-4)2 + (8-4)2 + (14-4)2] / 4}1/2 =
{[(0) + (196) + (16) + (100)] / 4}1/2 = (78)1/2 = 8.83
Investment Y:
{[(-6-3)2 + (8-3)2 + (12-3)2 + (-2-3)2] / 4}1/2 =
{[(81) + (25) + (81) + (25)] / 4}1/2 = (53)1/2 = 7.28
46. The correlation of Investment X and Investment Y is:
A. -0.3267
B. -0.8144
C. +0.0161
D. -0.6599
Answer: A.
r = Covxy / (SDx)(SDy)
r = -21.00 / (8.83)( 7.28) = -21.00 / 64.28 = -0.3267
47. The expected rate of return of a portfolio consisting of 40% Investment X and 60%
Investment Y is:
A. 3.3%
B. 3.8%
C. Cannot be answered with data provided
D. 3.4%
Answer: D.
E(Rp) = E(Rx)(%x) + E(Ry)(%y) =
(.04)(.4) + (.03)(.6) = (.016) + (.018) = .034 = 3.4%
48. The standard deviation of a portfolio consisting of 40% Investment X and 60%
Investment Y is:
A. 21.44
B. 13.89
C. 3.88
D. 4.63

Answer: D.
SDp = [(%x)2(SDx)2 + (%y)2(SDy)2 + 2(%x)(%y)(COVxy)]1/2
SDp = [(.4)2(8.83)2 + (.6)2(7.28)2 + 2(.4)(.6)(-21.00)]1/2
SDp = [(.16)(77.97) + (.36)(52.99) + (-10.08)]1/2
SDp = [12.48 + 19.08 – 10.08]1/2 = 4.63
Consider the Following Information:
Beta Estimated Return Estimated Standard

Deviation
Investment A .9 8.5% 16%
Investment B 1.1 10.5% 24%
Variance of the Market: .0289

Return of the Market: 11%
Risk Free Rate: 3%
49. The Alpha of Investment B is:
A. +.02%
B. -.02%
C. +1.8%
D. +4.02%
Answer: 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(Return of the Market – Risk
Free Rate).
Required Return of B = .03 + 1.1(.11 - .04)
Required Return of B = .03 + .077 = 10.7%
Alpha = 10.5% - 10.7% = -.02% Investment B’s Alpha is negative.
Study Session #5 – Accounting – Mergers

 2002 Ed Cordisco, CPA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without
permission.
Below is selected data from String Corporation’s acquisition of Cord Corporation on January 1,
2001. On that date, String acquired, for cash, all of the outstanding $5 par value voting stock of

Cord for $100,000. Cord’s Property Plant & Equipment has a fair market value of $50,000 in
excess of cost. Both companies continue to operate separately. Listed below are selected
separate and consolidated Balance Sheet and Income Statement accounts.
Balance Sheet Account

String Cord Consolidated
Cash $ 20,000 $ 10,000 $ 30,000
Accounts Receivable 27,000 24,000 45,000
Investment in Cord 100,000 - -0-
Property & Equip 120,000 100,000 270,000
Accounts Payable 18,000 16,000 28,000
Stockholders’ Equity 249,000 118,000 317,000
Income Statement Account

Revenues $350,000 $250,000 $560,000
Cost of goods sold 252,000 195,000 420,000
Gross Profit 98,000 55,000 140,000
50. Which one of the following accounting methods would be appropriate to account for this
business combinations?
A. Pooling Method
B. Purchase Method
C. Cost Method
D. Equity Method
51. What is the primary difference between the Pooling Method and the Purchase Method
accounting for a business combination?
A. The Pooling Method values the assets and liabilities at Fair Market Value.
B. The Purchase Method combines net income for the entire year.
C. The Purchase Method values the assets and liabilities at Fair Market Value.
D. Goodwill is only created using the Pooling Method.
52. Assume both companies are located in a foreign country where the International
Accounting Board Standards (IASB) apply for the purchase method.
A. In-process Research & Developments costs are treated as an asset.

B. Amortization of goodwill, if any, is not amortized.
C. Assets and liabilities are recorded at net book value.
D. Goodwill is not created.

53. The financial ratios under the purchase method and pooling method will be affected in
the following way.
A. The fixed asset turnover ratio will increase under the pooling method.
B. The fixed asset turnover ratio will decrease under the pooling method.
C. The use of pooling method, under IASB, will result in a more consistency of
financial ratios.
D. The use of the purchase method under USGAAP and IASBGAAP will result in a more
consistency of financial ratios.
54. At year end December 31, 2001 what was the amount of inter-company sales from String
to Cord?
A. 27,000
B. 6,000
C. 12,000
D. 40,000
55. At year end December 31, 2001, what was the amount of inter-company Cord’s payable
to String for inter-company purchases?
A. 27,000
B. 6,000
C. 12,000
D. 40,000
Study Session #4 – Economics

 2003 Prof. John M. Veitch, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited
without permission.
Each question is 2 minutes unless noted otherwise.
You are given the following information about the Turkey and the U.S.:
Spot Rate in 1995
Turkish lira per US$ e1995 = l 59,650/US$
Price Level Index in 2000 (Base Year 1995 = 100)
PTurkey2000 = 1521.6
PUS2000 = 112.7
56. Using the above information, the PPP spot exchange rate for the US$ in terms of Turkish
lira in 2000 was closest to:

A. l 90,763,440/US$
B. l 907,634/US$
C. l 805,354/US$
D. l 6,722,555/US$
PP Rate2000 = e1995 x [PTurkey2000 / PUS2000] = l 59,650/US$[1521.6/ 112.7]

= l 805,354.39/US$
Use the following information in the next four questions
Junior Johnson, an international fixed income analyst, is given the following information
regarding the current spot rate and interest rates for the U.S. and Australia:
Table I
Current Spot Rate
Australian$/US$ AU$ 1.620/US$
Annual Interest Rate 3-month Gov’t 2-Year Gov’t
Australia 4.80% 4.68%
U.S. 1.22% 1.65%
57. The 3-month forward exchange rate between the Aussie dollar and the US dollar implied
by the information in Table I is closest to:
A. AU$ 1.565/US$
B. AU$ 1.677/US$
C. US$ 1.645/AU$
D. AU$ 1.634/US$
Take Australia as home country given the way the exchange rate is quoted.
Covered Interest Parity Condition requires:
AU 3-month return = Hedged 3-month US Return
[1+rAU/4) = 1/e0 x (1+rUS/4) x f3-month
(1 + .0480/4) = (1/1.620) x (1.0122/4) x f3-month
Solving for the 3-month forward from above yields f3-month = 1.620 x (1.0120/1.0031) = 1.634
58. Using the information in Table I above, Junior Johnson’s expected future spot exchange
rate for the US$ in terms of AU$ for two years in the future is closest to:
A. AU$ 1.668/US$

B. AU$ 1.677/US$
C. AU$ 1.718/US$
D. AU$ 1.737/US$
Australia is the Home Country and the EXR given is in Direct terms so that formula can be applied
in straightforward way. To construct a two-year in the future forecast you must adjust the annualized
interest rates to take into account the two-year forecast horizon.
Forecast Rate2005 = EXR2003 x [1+rAU]2/[1+rUS]2
Forecast Rate2005 = AU$1.62/US$ x [1.0468/1.0165]2 = AU$ 1.7180/US$
According to a poll of forecasters by The Economist magazine the expected inflation rate for the
U.S. is 1.8% this year and 1.5% next year, while the expected inflation rate for Australia is 2.7%
this year and 2.5% next year.
59. Using this information instead, Johnson’s expected future spot exchange rate for the US$
in terms of AU$ for two years in the future is closest to:
A. AU$ 1.635/US$
B. AU$ 1.650/US$
C. AU$ 1.689/US$
D. AU$ 1.718/US$
Using inflation differentials leads to a forecast for a smaller depreciation in the AU$ than does
using the interest rate differentials
Forecast Rate2005 = EXR2003 x {[1+πAU]2003 [1+πAU]2004}/{[1+πUS]2003 [1+πUS]2004}
Forecast Rate2005 = AU$ 1.620/US$ x {(1.027)(1.025)} /{(1.018)(1.015)}= US$ 1.650/AU
60. Johnson’s supervisor decides that the best forecast for the Aussie dollar/US$ exchange at
the end of two years is AU$ 1.635/US$. Using this forecast and the information from
Table I, the expected US$ total return from a two-year investment in Australia
government bonds is closest to:
A. 3.72%
B. 8.57%
C. 7.44%
D. 5.04%
Expected Return calculated as

Expected US return = e2003 x (1 + AU return)2 x (1/E[e2005])
Expected US return = AU$1.62/US$ x (1.0468)2 x (1/(AU$1.635/US$) = 1.0857
i.e. 8.57% total return over two years
61. It is two years later. The actual exchange rate runs out to be AU$1.69/US$. The actual
total return from a two-year investment in Australia government bonds is closest to:
A. 3.72%
B. 8.57%
C. 7.44%
D. 5.04%
Actual Return calculated as

Actual US return = e2003 x (1 + AU return)2 x (1/e2005)
Actual US return = AU$1.62/US$ x (1.0468)2 x (1/(AU$1.69/US$) = 1.0504
i.e. 5.04% total return over two years
Use the following table in answering the next two questions.

SPOT 3-MONTH FORWARD 1-YEAR FORWARD
PHILLIPINE PESO P 54.700-54.850/US$ P 54.9625-55.1625/US$ P 55.4990-55.7990/US$
JAPANESE YEN ¥ 117.130-117.180/US$ ¥ 116.975-117.075/US$ ¥ 116.690-116.840/US$
62. The exchange rate at which a Japanese bank will buy Phillipine pesos spot is closest to:
A. ¥ 2.1355/peso
B. ¥ 2.1413/peso
C. ¥ 0.4683/peso
D. ¥ 2.1422/peso
63. The value of the rate at which a Japanese bank will sell Phillipine pesos on the three-
month-forward is closest to:
A. ¥ 2.1301/peso
B. ¥ 0.4716/peso
C. ¥ 2.1224/peso
D. ¥ 2.1206/peso

ANSWER KEY Spot 3-month Forward 1-Year Forward
bid ask bid ask bid ask
Japan Yen/US$ 117.13 117.18 116.975 117.075 116.69 116.84
Phillipines Peso/US$ 54.7 54.85 54.9625 55.1625 55.499 55.799
Yen/Peso 2.1355 2.1422 2.1206 2.1301 2.0913 2.1053

Wrong answers
Indirect Peso/Yen 0.468283 0.466803 0.471575 0.469464 0.478182 0.475000
bid-bid 2.1413 2.1283 2.1026
ask-ask 2.1364 2.1224 2.0939
ask-bid 2.1422 2.1301 2.1053
Study Session #3 & 4 – Quantitative Methods & Economics

without permission.
Each question is 2 minutes unless noted otherwise.
The next two questions use the following table

Firm A Firm B Firm C
Revenues Euros US$ Euros
Costs Yen Euros US$
Assets Euros Euros US$
Liabilities Yen US$ Euros
Assume all three firms report their financial statements in US$.

64. An appreciation of the Euro against the US$ is likely to result in the greatest increase in
the Return on Assets of which of the above three firms?
A. Firm A
B. Firm B
C. Firm C
D. All the firms are equally sensitive.
65. An appreciation of the Euro against the US$ is likely to result in the greatest decrease in
the Debt/Equity ratio of which of the above three firms?
A. Firm A
B. Firm B
C. Firm C
D. All the firms are equally sensitive.
Questions 66. – 70. use the following regression results.

You are given the following International CAPM regression results for the U.S.$-
denominated returns of a German multinational, SOP.
E(RSOP) = 0.032 + 1.245 RPW + 1.367 SRP¥ + 0.89 SRP€ + 0.45 SRP£
(0.015) (0.056) (0.987) (0.097) (0.109)
2
R = 0.346 N = 120
66. Which is the least significant currency exposure that this firm faces based on the results
of the above regression?
A. Japanese Yen exposure

B. Eurozone (Germany) Euro exposure
C. British Pound exposure
D. U.S. $ exposure.
67. Based on the results of the ICAPM regression, which of statement is correct?
A. A 1% appreciation of the Euro has no significant effect on the German firm’s

value denominated in Euros.
B. A 1% appreciation of the Euro has no significant effect on the German firm’s value
denominated in US$.
C. A 1% appreciation of the Euro has a +1% effect on the German firm’s value
denominated in Euros.
D. A 1% appreciation of the Euro has a -1% effect on the German firm’s value
denominated in Euros.
68 Which is the most valid interpretation of the R2 of this ICAPM regression?
A. R2 is low indicating the model does not explain the firm’s returns adequately.
B. R2 is high indicating the model explains the majority of the firm’s returns.
C. R2 indicates the systematic risk in the firm’s returns.
D. R2 indicates the idiosyncratic or diversifiable risk in the firm’s returns.
69. Under ICAPM’s assumption regarding the behavior of international capital markets, what
is the least likely source of problems in the residuals of the regression?
A. Problems arising from omitting an important currency risk premium in the regression.
B. Heteroscedasticity due to changing volatility in foreign exchange markets.
C. Serial correlation arising from market inefficiency.
D. Multicollinearity due to the correlation between the world risk premium and the
currency risk premiums.

A U.S. Investor evaluating the German multinational SOP using its estimated ICAPM regression
and the following information.
– Currency risk premiums (SRP) are relative to the US$.
– Expected return on World market is 8.2%.
Japan Germany U.K. U.S.

Risk-free Rate 0.02% 2.55% 3.59% 1.22%
Stock Market
-5.8% +2.8% +1.5% +9.2%
Return
SRP$,i -1.50% 3.34% 1.43%
70. SOP’s expected US$ return based on the ICAPM regression and the information given
above is closest to
A. 12.17%
B. 13.04%
C. 13.82%
D. 14.70%

Study Session #8 – Basic Valuation
 2003 Don Davis, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without
permission.
Time allocated is given in each question.
THE QUESTIONS IN THIS SECTION ARE BASED ON THE FOLLOWING DATA:
Sample Company Financial Statements

Yearly Data ($000 except per share data)
Income Statement December December
2000 2001
Revenue $3,480 $5,400
Cost of goods sold 2,700 4,270
Selling, general, and admin. expense 478 665
Depreciation and amortization 30 40
Operating income (EBIT) $272 $425
Interest expense 22 25
Income before taxes $250 $400
Income taxes 60 110

Income after taxes $190 $290
Diluted EPS $0.60 $0.84

Shares outstanding (000)
Average 317 346
Year End 320 360
Balance Sheet December December

2000 2001
Cash and cash equivalents $460 $ 50
Accounts receivable 540 720
Inventories 300 430
Net Goodwill 50 43
Net property, plant, and equipment 710 1,787
Total assets $2,060 $3,030
Current liabilities $760 $860

Long Term Debt: 300 350
Deferred Taxes 60 80
Stockholders' equity 940 740
Total liabilities and equity $2,060 $3,030
LIFO Reserve 10 15
Accumulated Goodwill Amort 10 17
Year End Market price per share $21.00 $23.00

Annual dividend per share $0.20 $0.40
Other Assumptions to use:

• Use Book Values to determine the cost of capital.
• Assume no short term debt
• Assume no operating leases or non-operating income
• Assume a 4% risk-free rate
• Assume an equity market risk premium of 6%.
• Assume that Sample’s beta is 1.1
• Assume that Sample’s marginal pre-tax cost of long term debt is 6%
• Assume that the marginal tax rate is 35%
First two questions are based on the “Economic Value Added” methodology.
(Total 15 minutes)
USE THE FOLLOWING TEMPLATE IN ANSWERING THIS QUESTION
Thing to calculate Calculation
Cash Operating Taxes: Tax expense: $ 110

Adj: (a) (Incr) in Deferred Taxes ( 20)
Add: (b) Tax benefit of Int Exp 9
Total $ 99
71. Calculate 2001 Net (a) Since deferred taxes went up, it means cash taxes paid was lower than
tax expense.
Operating Profit After
(b) = ($25 * 35%)
Tax, the intermediate step
used to determine EVA. NOPAT: EBIT (Oper. Profit): $ 425
Add back Goodwill Amort. 7
(3 minutes) Add: Incr. in LIFO reserve 5
Adjusted EBIT (Adjusted Oper Profit) $ 437
Less: Cash Operating Taxes 99
NOPAT: $ 338

USE THE FOLLOWING TEMPLATE IN ANSWERING THIS QUESTION
Cost of Debt: 6% (1-.35) = 3.90%

Cost of Equity: 4% + ( 1.1 (6%) ) = 10.60%
Equity Capital:
2000: 2001:
Book Value of Equity $ 940 $1,740
Deferred Taxes 60 80
LIFO Reserve 10 15
Accum Goodwill Amort 10 17
72. Calculate the Total Equity Capital $1,202 $1,852
adjustment for capital that
must be made to Net Concept of EVA is based on INVESTED capital, and so includes add-
Operating Profit to arrive backs to book value of equity.
at EVA.
Weighting: 2000: 2001: Average:
(6 minutes) Debt: $ 300 = 20.0% $ 350 = 15.9% 18.0%
Equity: 1,202 = 80.0% 1,852 = 84.1% 82.0%
Total Invested
Capital $1,502 = 100.0% $2,202 = 100.0% 100.0%
Weighted Average Cost of Capital: 9.39%
Adjustment: subtract Wtg Avg Cost of Capital *Year End Capital
= (9.39%) ($2,202) = ( 207)
Result: EVA (not asked for) $ 131
2000: 2001
Yr End Shares 320 360
x Yr End Stock Price $21 $23
Market Value of Equity $6,270 $8,280
73. Calculate the Market
Value Added in 2001.
Book Value of Debt: 300 350
(Assume that book value
Total Market Value: $6,570 $8,630
of debt equals market
Difference $2,060
value of debt.)
Invested Capital
(6 minutes)
(From Question 2. Above) 1,502 2,202
Difference $ 700
Market Value Added: $1,360

Scoring:
The entire question has a value of 21, proportion it as follows:
Question 71:
Correct Cash Operating Taxes 1
Correct Adjusted EBIT 1
Correct Final Result (NOPAT) 1
Question 72:
Correct Cost of Equity 2
Correct Weighted Avg Cost of Capital 2
Correct Adjustment for Capital 2
Question 73:
Correct Market Value 2
Correct Invested Capital 2
Correct Final Result (MVA) 2
Note: no points deducted if answer is off by 1 due to rounding.
Reference: Peterson & Peterson, Pages 12-24

Study Session #9 – Industry & Company Analysis
 2003 Terry Lloyd, CPA, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited
without permission.
Competitive Strategies -Above average industry performance is in many ways determined by a

firm’s ability to employ a competitive advantage.
Cost leadership. The firm seeks to be the low cost provider in the
industry and seeks to achieve lower operating costs across all product
74. List and describe three
lines. Prices are set at or jut below the industry average. The product
types of competitive
should be homogeneous.
strategies that allow a firm to
obtain a competitive Differentiation. The firm focuses on product attributes that are
advantage. important to buyers. The firm can charge a premium price for these
benefits.
(1½ minutes) Focus. A focuser attempts to achieve cost leadership or product
differentiation within a product niche.
Cost leadership. The firm will not achieve cost leadership if

several firms are trying to be the cost leader, including foreign
75. Discuss the risks firms.
associated with each of the
three generic strategies. Differentiation. A change in customer preferences, or imitation
( 1½ minutes) by competitors, whose benefits are perceived to be greater than
the benefits offered by the subject firm.
Focus. The target segment ceases to be profitable.
76. List three ways that a

producer can achieve cost (1) economies of scale,
leadership (2) proprietary technology,
( 1½ minutes) (3) preferential access to raw materials/inputs (such as
lower rents paid for occupied space).
77. List three ways that a Differentiation:

producer can differentiate (1) product differentiation,
its product. (2) unique marketing strategies,
( 1½ minutes) (3) unique delivery methods

Industry Analysis
Any Three of the following
Industry classification by life cycle phase or by response to the various

stages in the business cycle.
External factor review of the issues that influence the fortunes of a
78. Discuss three factors given industry.
that should be included in Demand analysis of the prospective market demand based on
an industry analysis model. macroeconomic factors, industry classifications, and external factors.
( 3 minutes) Supply analysis, which evaluates prospective aggregate supply, based
on current capacity and planned capacity additions.
Profitability analysis, looking to prospective industry profitability,
using the factors listed above.
International competition and markets review, looking to potential
competition from offshore sources.
At the inception phase and new product or service is created. During

this phase, the product/service is being tested and marketed to buyers.
During the pioneer phase sales and profits are low (or even negative)
and the level of risk is high.
79. Illustrate the life cycle Next is the growth phase, when the product/service gains wider
of a typical industry. acceptance and sales and margins increase as some firms begin to
dominate. During the later stages of the growth phase new firms enter
( 3 minutes)
(through expiring protections such as patents).
In the maturity phase, the firms collectively push the industry
performance to average.
The industry eventually moves to decline, where firms have
diminishing profit margins, consolidation and overall
downsizing.segment ceases to be structurally attractive.

Study Session #10 – Equity – Valuation Models
without permission.
Discounted Dividend Valuation
80. An analyst has determined that the required rate of return for an equity investment in
shares of XYZ is 10.5%. If the risk free rate is 6% and XYZ’s beta is 1.2, calculate the
current equity premium.
This is a derivation of the risk premium from the CAPM and is solved algebraically:
R = Rfree + [β(Rmarket –Rfree)]
0.105 = 0.06 + [ 1.2(equity premium)] ; the equity premium = 0.0375

(2 minutes)
81. XYZ is not expected to pay a dividend until 10 years from now, at which time it is
expected to pay a dividend of $1.25 and to increase the dividend at a rate of 6%
thereafter. If the required rate of return is 7%, calculate the current value of XYZ.
$1.25
V0 = = $67.99
(0.07 - 0.06) x (1 + 0.07)9
It is discounted back for nine years since it is next year’s dividend that is discounted
back.
(2 minutes)
82. XYZ is a stable firm with earnings and dividends expected to grow at 4% indefinitely. If
the current dividend is $1.23 and the current value of XYZ is $17.00, calculate the
required return.

This is a variation Gordon Growth:
D1 $1.23 x (1.04)
r = +g= +.04 = $11.52%
Po $17.00
(2 minutes)
83. A firm has a net income of $1.8 million on sales of $40 million, average assets of $40
million, and stockholders’ equity of $25 million. If the firm distributes 30 percent of its
profits as dividends, calculate the Sustainable Growth Rate.
Sustainable growth = ROE x b [the retention rate]
1,800,000
g = ROE x b = x (1 - 0.30) =5.04%
25,000,000
(2 minutes)
84. If the required rate of return is 7%, calculate the value of a $100 par 5.5% fixed-rate
perpetual preferred share.
The formula for fixed rate preferred is the same as that of a stock with no expected
increase in dividends:
D ividend D ividend $100 x (0.055)

Vperpetual = = = = $78.57
Required Return r-0 0.07
(2 minutes)
Free Cash Flow Valuation
The Gray furniture company earned $3.50 per share last year. Investment in fixed capital was
$2.00 per share, depreciation was $1.60, and the investment in working capital was $0.50 per
share. Gray is currently operating at their target debt ratio of 40 percent, meaning 40 percent of
new working capital and fixed capital will be financed with new borrowings.
85. Calculate the value of Gray’s stock if the shareholders require a return of 14 percent on
their investment and the expected rate of growth in free cash flow to the equity is 4
percent per annum.

FCFEquity0 = NI – (1-DR)(FCInv – dep) – (1-DR)(WCInv) =
$3.50 – (1 - .4)($2.00 - $1.60) – (1 - .4)($0.50) = $2.96
$2.96 x (1.04)
Equity value per share = = $30.78
0.14 - 0.04
(4 minutes)
The Anderson Door Co. earned $30 million before interest and taxes on revenues of $80 million
last year. Capital expenditures were $20 million, and depreciation was $15 million. The
additions to working capital were $6 million. Anderson is currently operating at their target debt
ratio of 25 percent, and their tax rate is 40 percent. The shareholders require return of 15 percent
on their investment, the firm’s cost of debt is 8 percent, and the expected growth rate in firm cash
flows is 5 percent. The market value of debt is $25 million.
86. Calculate the value of the firm and the value of the firm’s equity.
FCFFirm0 =EBIT(1 – tax rate) + dep –FCInv – WCInv=

$30,000,000(1 – 0.40) + $15,000,000 - $20,000,000 - $6,000,000 =$7,000,000
After tax cost of debt = 0.08(1- 0.40) = 0.048 = 4.8%
WACC = (0.75 x 0.15) + (0.25 x 0.048) = 0.1245 =12.45%
$7,000,000 x (1.05)
Value of the firm = = $98,657,718
0.1245 - 0.05
Given that the firm has $25 million in outstanding debt, the aggregate value of equity is
$98,657,718 - $25,000,000 = $73, 657,718.
(4 minutes)

87. Describe how to use free cash flow to the firm (FCFFirm) models to value a firm’s
equity, and discuss when it is appropriate to use an FCFFirm model instead of an
FCFEquity model to value a firm’s equity.
FCFFirm models can be used to value a firm’s equity by first valuing the entire firm
and then subtracting the value of the debt. This approach should yield the same
estimate of equity value as an FCFEquity model if (1) consistent assumptions are made
about growth in the two approaches, and (2) the firm’s debt is correctly valued.
It is more appropriate to use an FCFFirm model to value a firm’s equity if the firm has
significant financial leverage or it is making substantial changes to its capital structure.
(2 minutes)
Study Session #11 & 12 – Equity – Applications & Special Issues

without permission.
Market-Based Valuation Price Multiples
The stock of Western Graphics Co. paid a dividend of $0.40 per share last year on earnings of
$1.00 per share. The firm’s earnings and dividends are expected to grow at 5% per year forever.
88. Calculate the justified trailing price to earnings multiple based on these forecasted
fundamentals for Western’s stock if shareholders require a return of 12% on their
investment.
Trailing P/E
Po (1 - b) x (1 + g) ($0.40/$1.00) x (1.05)
= = = 6.0
Eo r-g 0.12 - 0.05
(2 minutes)
An analyst is valuing an electric utility with a dividend payout ratio of 0.65, a beta of 0.56, and
an expected earnings growth rate of 0.032. A regression on other electric utilities produces the
following equation:
Predicted P/E = $8.57 + (5.38 x dividend payout) + (15.53 x growth) - (0.61 x beta).

89. Calculate the predicted P/E on the basis of the values of the explanatory variables for the
company.
Predicted P/E = 8.57 + (5.38 x 0.65) + (15.53 x 0.032) – (0.61 x 0.56) = 12.2
(2 minutes)
A junior portfolio manager has been asked to consider price-to-cash flow for the analysis in
making a recommendation for an addition to the portfolio. She has gathered the following
information:
Recent Trailing P/CF Trailing P/FCFEquity Consensus Beta

Price CF per FCFEquit Year
Share y per Growth
Share Forecast
ABC $47.48 $2.00 23.90 $0.36 132.78 17.5% 1.22
XYZ $28.40 $1.36 20.88 $0.99 28.69 22.2% 1.36
90. Compare the valuation of XYZ with ABC and make a recommendation for an addition
to the portfolio.
XYZ appears to be undervalued relative to ABC. This conclusion is based on (1) XYZ
is selling at a P/CF of 20.88, which is 88% of the P/CF for ABC (23.9), and (2) the
P/FCFEquity for XYZ (28.69) is 22% of the P/FCFEquity for ABC (132.78). An
investor can buy XYZ’s cash flow for a lower multiple and gets higher expected
growth, based on consensus growth forecast of 22.2% for XYZ relative to 17.5% for
ABC.
(2 minutes)
Residual Income Valuation
91. Explain the relationship between the residual income (RI) approach to valuation and
dividend discount model (DDM) and free cash flow to equity (FCFEquity) alternatives.

In theory, the same value, or total present value, should be derived using expected
dividends, expected FCFEquity, or book value plus expected RI if the underlying
assumption are the same.
However, the recognition of value is different because FCFEquity and DDM models
forecast future cash flows while RIMs start with a balance sheet measure of equity and
the present value of expected future RI. An RIM can be used along with other models
to assess the consistency of results.
(2 minutes)
Study Session #6 & 7 – Financial Statement Analysis

without permission.
Use the following Footnote for the questions in this section
Pension Plan Footnote
The company has noncontributory defined benefit plans covering substantially all U.S. employees. The
benefits for these plans are based primarily on years of service and employees' pay near retirement. The
company's funding policy is consistent with the funding requirements of federal law and regulations.
The projected benefit obligation was determined using a discount rate of 9 percent at December 31, 2002
and 7.25 percent at December 31, 2001, and an assumed long-term rate of compensation increase of 5
percent. All quantities are in millions of $.
The Plan assets consist principally of common stocks and U.S. government obligations. The expected
rate of return on plan assets is 9.25%
( As of December 31, ) 2002 2001

Actuarial PV of:
Vested Benefit Obligation $5,743 $5,567
Accumulated Benefit Obligation 6,256 6,024
Projected Benefit Obligation 7,820 7,169
Fair Market Value of Plan Assets 5,788 6,197
Book Value of Plan Assets 5,678
( for the year of ) 2002 2001

Service Cost $389
Interest Cost 477
Benefits Paid 493 457

Employer Contributions 84 78
Actual Return on Plan Assets (89) (126)
92. Which one of the following quantities is the most appropriate measure of the firm’s
pension obligation in the event of the firm’s liquidation – VBO, ABO, PBO or Fair
Market Value of the Plan Assets? Provide a brief justification for your choice.
PBO takes into account expected future increases in worker salaries. If the firm is expected to be
liquidated this clearly overstates the pension obligation of the firm.
FMV of Plan Assets measures the ability to meet the pension obligation.
VBO measures the obligation that the firm has towards workers even if they leave the firm.
The most appropriate measure is the ABO as it captures the obligation to existing workers
based on their existing salary structure.
(1 minute)
93. Calculate the value of the Interest Cost for the firm’s pension plan during the year 2002.
Interest Cost = PBOBeginning x Discount Rate = $7,169 x .09 = $645

(1 minutes)
94. Calculate the value of the Service Cost for the firm’s pension plan during the year 2002.
PBOYear-end = PBOBeginning + Service Cost + Interest Cost – Benefits Paid

$7,820 = $7,169 + Service Cost + $645 - $493
Service Cost = 7820 – 7169 – 645 + 493 = $499
(2 minutes)
95. Calculate the value of the Reported Pension Expense for the firm’s pension plan during
the year 2002.

Pension Expense = Service Cost + Interest Cost – Expected Return on Plan Assets
= $499 + $645 – 6,197 x .0925 = $571
(2 minutes)
96. Calculate the value of the Actual Economic Pension Expense for the firm’s pension plan
during the year 2002.
Pension Expense = Service Cost + Interest Cost – Actual Return on Plan Assets
= $499 + $645 – (–89) = $1,233
(2 minutes)
95. Calculate the Book Value of Pension Assets for the firm’s pension plan on December 31,
2002.
BVend
= BVBegin + Expected Return on Plan Assets + Employer Contributions – Benefits Paid
= $5678 + $6,197 x .0925 + $84 – $493 = $5,842
(2 minutes)
96. Calculate the Minimum Liability Adjustment for the firm’s pension plan on December
31, 2002.

As ABO > FMVend of Plan Assets
MLA = ABO – FMVend of Plan Assets = $6,256 - $5,788 = $468
(2 minutes)

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

2003 CFA® Level II SASF Mock Exam

The Security Analysts of San Francisco

Saturday, May 3, 2003

Questions Topics Time Instructor

SASF Level II Mock Exam 2003 Answers Page 2 of 43

SASF Level II Mock Exam 2003 Answers Page 3 of 43

Each question in this section is 1½ minutes unless noted otherwise

1. Which of the following is an obstacle to and effective proxy voting Policy?

A. Lack of a clear policy and management support;

3. Which of the following can result in a summary suspension?

A. Diversification, Assessment of risk levels, Duty and Authority to Delegate as a prudent

SASF Level II Mock Exam 2003 Answers Page 4 of 43

Memo of conduct problems for Billy Badly.

SASF Level II Mock Exam 2003 Answers Page 5 of 43

1. Have a written investment policy

10. Which of the following is most true?

SASF Level II Mock Exam 2003 Answers Page 6 of 43

Each question in this section is 2 minutes unless noted otherwise

Table 1. Variable Descriptions

Variable Estimates for 2003

Critical Values for Student’s t Distribution

SASF Level II Mock Exam 2003 Answers Page 7 of 43

12. What is the forecast of tire industry sales for 2003?

14. Which is a symptom of multicollinearity?

Study Session #13 & 14 – Fixed Income – Credit and Valuation

Each question in this section is 1½ minutes unless noted otherwise

Total assets 1,000 Current liabilities 200

SASF Level II Mock Exam 2003 Answers Page 8 of 43

17. Alicia is confident that the following cannot happen

A. AQT funds the new project using all stocks

A. shorting Treasury bond futures

A. the modified duration

SASF Level II Mock Exam 2003 Answers Page 9 of 43

16. B. Long-term debt = 300. Equity = 500 + 200 = 700

Study Session #15 – Fixed Income – Structured Securities

Each question in this section is 1½ minutes unless noted otherwise

20. To calculate the zero-volatility spread,

A. (i), (iv), and (v) are needed

SASF Level II Mock Exam 2003 Answers Page 10 of 43

21. The expected cash flows described in (iv)

22. OAS is superior to nominal spreads or zero-volatility spreads because

A. it is calculated using a Monte Carlo model

23. The zero-volatility spread may be thought of as

A. a constant spread over the entire yield curve

SASF Level II Mock Exam 2003 Answers Page 11 of 43

A. is higher than the market price of the FNMA

26. The OAS of an MBS

A. is always higher than the zero-volatility spread

27. The OAS of a callable bond

A. goes up when the assumed volatility goes up

Answers to Item Set D

SASF Level II Mock Exam 2003 Answers Page 12 of 43

24. A. All options become more valuable with higher volatility.

Study Session #16 – Derivatives – Futures and Swaps

Each question in this section is 1½ minutes unless noted otherwise

28. For the hedging to be at least somewhat effective,

A. the coefficient a must not be zero

SASF Level II Mock Exam 2003 Answers Page 13 of 43

29. Tim should

A. buy soybean futures contracts

32. Wo Chong’s net gain or loss is