IFT Question Bank

QUANTS
Basics of Multiple Regression and

Underlying Assumptions
Musfirah Jelani, CFA, works for Zara Pharma, a pharmaceutical company. She is forecasting
sales for one of their products. She collects data on the relationship an individual’s activity
levels and age have with the probability of developing Disease X. She judges activity levels
by using a 0-10 scale. She then runs a regression and develops the following model: YPROB = 0
– 0.04XACT + 0.008XAGE
1. Question 1
Q-Code: 23-L2-QM-BMRU-184399
Which of the following is most likely the dependent variable in the regression
equation?
o A
Probability
o B
Activity Levels
o C
Age
Incorrect
A is correct. The probability of developing Disease X is the dependent variable. This
variable is calculated using the values of the independent variables (activity levels and
age), their coefficients and the intercept value. The probability is therefore
“dependent” on the other inputs.
2. Question 2
Which of the following statements is least likely correct?
o A
The probability of developing Disease X is inversely correlated with an

individual’s activity levels.
o B
A one unit increase in XAGE results in YPROB increasing by 8%.

o C
YPROB is more sensitive to a one unit change in XACT than it is to a one unit
change in XAGE.
Incorrect
B is correct. A one unit increase in XAGE results in YPROB increasing by 0.8%.
Option A is a correct statement because the slope coefficient for XACT is -0.04, where
the minus sign implies a negative correlation. Option C is a correct statement because
the slope coefficient of XACT is -0.04 whereas the slope coefficient of XAGE is 0.008. The
magnitude of XACT’s slope coefficient is higher.
3. Question 3
Based on the scatter plots, which of the following assumptions is most likely violated?
o A
Homoskedasticity
o B
Linearity
o C
Normality
Incorrect
B is correct. The assumption of linearity is violated because XAGE and YPROB do not have
a linear relationship. The data points form a parabola:
4. Question 4
Based on the scatter plots, which of the following statements is most likely correct?
o A
The assumption of independence of errors is violated by the relationship

between YPROB and XAGE.
o B
The assumption of normality is violated by the relationship between

YPROB and XAGE.
o C
The assumption of the independence of independent variables is violated

because of the relationship between XAGE and XACT.
Incorrect
C is correct. The assumption of the independence of independent variables is
violated because of the relationship between XAGE and XACT. The assumption of
independence of independent variables is that there is no linear relationship
between two or more of the independent variables or combinations of the
independent variables. By looking at the scatter plot for XAGE and XACT, we can see that
these two independent variables have a linear relationship.
Mathew Davidson, CFA a quantitative analyst, is asked to assess the variation in the stock
returns of Bubbles Inc, a beverage company. Davidson runs a simple linear regression of
returns on Bubbles stock against the returns of the S&P index and inflation. He uses the last
five-year monthly data for his model. Before beginning his analysis, Davidson first ensures
that the five main assumptions of multiple linear regression are met. As part of this task, he
looks at scatter plots of the regression residuals (shown in Exhibit 1 and 2) and a Q-Q plot.
Exhibit 1: Residual vs. Predicted Value of Dependent
Variable Exhibit 2: Residual vs.

Factors (Independent
Variables)
1. Question 1
Which of the following is least likely an assumption of multiple linear regression?
o A
There is no exact linear relation between two or more of the independent

variables or combinations of the independent variables
o B
The observations are independent of one another, meaning the regression

residuals are uncorrelated across observations.
o C
The variances of the regression residuals are normally distributed.

Incorrect
C is incorrect. The correct assumption is that the variances of the regression
residuals should be the same across all observations (homoskedasticity). The five
main assumptions of multiple regression are as follows:
4. Linearity: The relationship between the dependent variable and the independent
variables is linear.
5. Homoskedasticity: The variance of the regression residuals is the same for all
observations.
6. Independence of errors: The observations are independent of one another.
This implies the regression residuals are uncorrelated across observations.
7. Normality: The regression residuals are normally distributed.
8. Independence of independent variables:
5a. Independent variables are not random.

5b. There is no exact linear relation between two or more of the independent
variables or combinations of the independent variables.
2. Question 2
Which of the following regression assumptions can least likely be assessed using a
scatterplot of the residuals against the dependent variable?
o A
Homoskedasticity
o B
Independence of errors
o C
Linearity
Incorrect
C is correct. The scatterplot of the residuals against the dependent variable can be
used to judge whether the assumptions of homoskedasticity and independence of
errors are met.
For homoskedasticity, we look at the variance of the residuals on the scatterplot. For
this assumption to be met, the variance has to be the same across observations. For
the independence of errors assumption, we see whether the residuals appear to
have any correlation with each other.
For linearity, we look at the scatterplot of the independent variables against the
dependent variable. If there is any nonlinear relationship, then this assumption has
been violated.
3. Question 3
Based on Exhibit 2, the assumption of homoskedasticity is most likely:
o A
not violated.
o B
violated due to the relationship of the residuals and the S&P 500 returns.
o C
violated due to the relationship of the residuals and inflation rates.

Incorrect
A is correct. The assumption of homoskedasticity is that the variance of the
regression residuals is the same for all observations. Exhibit 2 does not indicate
towards any pattern in the variance of the residuals, rather the variance stays the
same across observations for both independent variables.
4. Question 4
Which of the following statements regarding Q-Q plots is least likely correct?
o A
Q-Q plots help identify potential outliers.

o B
Q-Q plots can be used to determine whether the assumption of

homoskedasticity is met.
o C
Q-Q plots can be used to determine whether the assumption regarding

normality of regression residuals is met.
Correct
B is correct. Q-Q plots, or normal Q-Q plots, compare a model’s standardized
residuals to a theoretical standard normal distribution. It can therefore be used to
determine whether the residuals follow the normal distribution or not. This plot also
helps identify potential outliers, because some data points may fall significantly
above or below the theoretical normal distribution line.
Option B is an incorrect statement because the variance of the residuals is not
examined in a Q-Q plot, and the assumption of homoskedasticity has to do with the
variance of the residuals across observations.
Akio Jun, a quantitative analyst, works for Durham Investments which is considering selling
one of its investments, Onron. Onron Malaysia designs and produces high-quality electric
components. Lately there has been a decline in the company’s profitability due to an
increasing number of defective components. Jun is asked to write a research report on
Onron and give his recommendations. Consequently, Jun approaches the company and
analyzes the data relating to the defective components sent by them. Using his knowledge
of statistics, Jun runs a regression involving the number of defective components per hour
as a function of the air resistance and voltage. The regression results are given in Table
1: Table 1: Regression Results: Dt = b0 + b1Airt + b2Vt + εt
Standard
Coefficient
Error
Constant (b0) 0.0210 0.1230
Air resistance (b1) 0.0008 0.0013
Voltage (b2) 0.7979 0.4000
Number of observations in the regression 350
Critical t value at 5% significance (two-tail test that coefficient
1.96
equals zero)
R- Std. Error of
F Significance of F
squared Estimate
0.502 0.033 177.60 0.000
Jun tests the hypothesis that the coefficients for air resistance and voltage are significantly
different from zero, using a significance level of 5%. He also calculates the AIC and BIC for
the model.
1. Question 1
Q-Code: 21-L2-QM-MRIR-75869
Based on Table 1, the regression coefficient(s) most likely significantly different from
zero is (are) with respect to the coefficient(s) for:
o A
air resistance (b1) only.

o B
voltage (b2) only.

o C
both air resistance (b1) and voltage (b2).

Incorrect
B is correct. To determine whether the regression coefficients are significantly
different from zero, formulate the null hypotheses that the coefficients are equal to
zero. The alternative hypotheses are that the coefficients do not equal zero (two-
tailed tests). The appropriate test statistics, t, are calculated by dividing the estimates
of the coefficients by their respective standard error. For
b1, �=0.00080.0013=0.615. For b2, �=0.79790.4000=1.995 The critical t value at 5%
significance (two-tail test) = 1.96. The t-statistic for air resistance is less than 1.96,
whereas the t-statistic for voltage is greater than 1.96. Therefore, the null hypothesis
for b2 equal to zero is rejected, suggesting that the coefficient of voltage is
significantly different from zero.
2. Question 2
The results given in Table 1 most likely imply that:
o A
the variations in the independent variables explain half of the variation

in the defective components per hour.
o B
the predicted model has only a 50% probability of being correct.

o C
the F-statistic is not significant.

Incorrect
A is correct. The R2 indicates variations in the independent variables which explain
50.2% of the variation in the dependent variable. The F-statistic is highly
significant. R2 does not give the probability of a dependent variable prediction being
correct.
3. Question 3
Q-Code: 23-L2-QM-ERMF-186655
Which of the following is least likely a limitation of R-squared?
o A
The R2does not change when we add independent variables to the

model.
o B
The R2cannot provide information on whether the coefficients are statistically

significant.
o C
The R2cannot provide information on whether there are biases in the

estimated coefficients and predictions.
Incorrect
A is correct. The R2 does change when we add independent variables to the model.
The R2 increases, which would imply that the explanatory power is increasing,
however this increase may not be meaningful since it could be due to an overfitting
problem.
Options B and C are correct statements.
4. Question 4
Which of the following statements regarding statistics that assess model fit is most
likely correct?
o A
For AIC, a higher value implies a better model.

o B
For adjusted R2, a lower value implies a better model.
o C
The penalty for having more parameters is higher for the BIC formula
than the AIC formula.
Incorrect
C is correct. As compared to AIC, the penalty for having more parameters is greater
for BIC, because ln(n) is greater than 2 even for very small sample sizes.
AIC = nln (Sum of Square errors / n) + 2(k+1)
BIC = nln (Sum of Square errors / n) + ln(n)(k+1)
Option A is incorrect because for AIC (and BIC), a lower value implies a better model.
Option B is incorrect because for adjusted R2, a higher value implies a better model.
Beena Ameerali, an analyst, is evaluating the returns of Zextra Inc., an automotive parts
manufacturer based in U.K. She believes that the returns will be influenced by FTSE 100 and
the CNY/GBY exchange rate, since Zextra imports manufacturing inputs from China.
Ameerali runs multiple linear regression involving the monthly stock returns of Zextra on
monthly returns of the FTSE 100 Index and the CNY/GBP exchange rate changes. The
summary of the regression results is given in Table 2: Table 2: Regression Results: Zextra
monthly stock returns on FTSE 100 Index monthly returns and CNY/GBP changes 2012-
2016
Regression Statistics
Multiple R 0.7771
R-squared 0.6038
Standard error of estimate 0.0521
Observations 60
Degrees of Mean Sum of
ANOVA Sum of Squares(SS)
freedom (df) Squares (MSS)
Regression 2 0.2355 0.1178
Residual 57 0.1545 0.0027
Coefficients Standard Error t-Statistic p-value

Intercept 0.0003 0.0059 0.0511 0.9600
FTSE 100 return 1.1500 0.1521 7.5617 0.0000
CNY/GBP
0.2100 0.2467 0.8512 0.3889
change
1. Question 1
Based on Table 2, the value of the F-statistic is closest to:
o A
16.
o B
43.
o C
35.
Incorrect
B is correct. The formula for the F-statistic
is�= ��/��/[�−(�+1)]= 0.2355/20.1545/(60−3)=43.4417
2. Question 2
The most likely conclusion about the null hypothesis that the coefficient of CNY/GBP
change is zero, using a 5% level of significance, is:
o A
to not reject the alternative hypothesis.

o B
to not reject the null hypothesis.

o C
to reject the null hypothesis.

Incorrect
B is correct. The p-value is the smallest level of significance at which the null
hypothesis can be rejected. The null hypothesis for the CNY/GBP test statistic is that
the exchange rate change is not related to the return on Zextra stock. The p-value of
0.3889 is higher than 0.05, thus Ammerali will fail to reject the null hypothesis.
3. Question 3
Given that for a particular month, the FTSE 100 return is 7.2% and the CNY/GBP
exchange rate is 0.1200, the predicted value of Zextra return is closest to:
o A
8.31%.
o B
10.83%.
o C
11.39%.
Incorrect
B is correct. The information in Table 2 shows that the intercept is 0.0003, the slope
coefficient for X1 (FTSE 100 return) is 1.15 and the slope coefficient for X2 (CNY/GBP
exchange rate) is 0.2100. This means the model will be as follows: Y = 0.0003 +
1.15X1 + 0.2100X2. Using the values of X1 and X2 given in the question, we calculate the
following predicted value for Y:
Y = 0.0003 + 1.15(0.072) + 0.2100(0.1200) = 0.1083
4. Question 4
The standard error of the forecast for the dependent variable may be greater than
the standard error of the regression because:
o A
the prediction interval for the within-sample error is greater than that of the
dependent variable.
o B
of the combined effect of the model error and sampling error.

o C
the standard error of the forecast for the dependent variable cannot be
decreased but the standard error of the regression can.
Correct
B is correct. In the case that the independent variables are also forecasts, the
standard error of the forecast of the dependent variable will increase because now
there is the model error (same as regression model) and sampling error. When this
occurs, the prediction interval for within-sample error is less than that of the
dependent variable. Options A and C are incorrect statements.
Akio Jun, a quantitative analyst, works for Durham Investments which is considering selling
one of its investments, Onron. Onron Malaysia designs and produces high-quality electric
components. Lately there has been a decline in the company’s profitability due to an
increasing number of defective components. Jun is asked to write a research report on
Onron and give his recommendations. Consequently, Jun approaches the company and
analyzes the data relating to the defective components sent by them. Using his knowledge
of statistics, Jun runs a regression involving the number of defective components per hour
as a function of the air resistance and voltage. The regression results are given in Table
1: Table 1: Regression Results: Dt = b0 + b1Airt + b2Vt + εt
Coefficient Standard Error

Constant (b0) 0.0210 0.1230
Air resistance (b1) 0.0008 0.0013
Voltage (b2) 0.7979 0.4000
Number of observations in the regression 350
Critical t value at 5% significance (two-tail test that
1.96
coefficient equals zero)
R-squared 0.502
Significance of
F-statistic 177.60 0.000
F
VIFAIR 3.58 VIFVOL 2.42
Breusch-Godfrey F-statistic Critical F value
3.1790 2.9957
Jun determines whether there is serial correlation, multicollinearity or conditional
heteroskedasticity in the data. Jun discusses his analysis with his colleague, Robert Zhao,
who makes the following comment regarding the consequences of serial correlation: “The
presence of serial correlation in the error terms will affect the validity of estimates. Positive
serial correlation will impact our ability to conduct reliable statistical tests, since both the F-
statistic and t-statistics values will likely be overestimated.”
1. Question 1
Q-Code: 23-L2-QM-MMMR-186694
The Breusch-Godfrey test statistic most likely indicates that:
o A
the null hypothesis of no positive serial correlation should be rejected.

o B
the null hypothesis of no positive serial correlation should not be rejected.

o C
the results are inconclusive regarding the presence of serial correlation in the
regression model.
Incorrect
A is correct. The value of the Breusch-Godfrey F-statistic is given in Table 1 as 3.1790.
The critical value is given as 2.9957. The BG statistic value exceeds the critical value,
therefore the BG test rejects the null hypothesis of no positive serial correlation.
2. Question 2
Assume that the pairwise correlation between the independent variables is 0.018.
The regression results in Table 1 most likely indicate that:
o A
the R2 is spurious.
o B
the regression coefficients have inflated standard errors.
o C
multicollinearity does not exist.

Incorrect
C is correct. The VIF values for both independent variables are below 5, indicating no
multicollinearity. In addition, the pairwise correlation is low. For multicollinearity to
occur in a regression there should be two (or more) independent variables, as is the
case in this problem. Furthermore, the additional classic symptoms of
multicollinearity (high R2 and significant F-statistic, but not significant coefficients) are
not present.
3. Question 3
Conditional heteroskedasticity most likely occurs when the variance of the error term
is correlated with:
o A
both the dependent and the independent variables.

o B
the dependent variable only.

o C
the independent variable only.

Incorrect
C is correct. Conditional heteroskedasticity means that the variance of the error term
is correlated with the values of the independent variables.
4. Question 4
Zhao’s comment regarding the consequences of serial correlation is most likely:
o A
Correct
o B
incorrect with respect to validity of estimates.

o C
incorrect with respect to validity of tests.

Incorrect
A is correct. Serial correlation in the error terms will affect the estimates for
regression coefficient standard errors if one of the independent variables is a lagged
value of the dependent variable. Positive serial correlation affects the validity of the
statistical tests as F-statistic value and t-statistics values may be inflated.
Shanzay Abbad, a quantitative analyst, runs a regression of the monthly return for an
energy equity index for the previous 153 months against the monthly returns for NASDAQ
and the difference between the monthly returns on long-term U.S. government bonds and
short-term Federal Reserve borrowing rate (YC). The results of the regression are given in
Table 1. Table 1: Abbad’s Regression Results Excerpts
Variable Coefficient t-statistic p-value

Constant -0.0072 -0.019 0.98
NASDAQ 0.3782 6.005 <0.01
YC 1.0592 4.315 <0.01
R2 0.45
Durbin-Watson statistic 0.90
Breusch-Godfrey F-
1.95 P-value 0.042
statistic
Correlation between YC and NASDAQ 0.31
Breusch-Pagan statistic 0.036 P-value 0.8523
Abad reviews the data and concludes that there is no evidence of multicollinearity. She also
tests for serial correlation and heteroskedasticity, using a level of significance of 5%.
1. Question 1
Abbad’s conclusion that multicollinearity is not a problem, is most likely based on the
observation that the:
o A
correlation between YC and NASDAQ is low.

o B
model R2 is relatively high.

o C
model F-value is high and the p-values for the YC and NASDAQ are low.
Incorrect
A is correct. Multicollinearity occurs when two or more independent variables (or
combinations of independent variables) are highly (but not perfectly) correlated.
Correlation between independent variables may be a reasonable indication of
multicollinearity in cases in which the regression contains only two independent
variables. In the regression model, the correlation between the YC and the NASDAQ
variables is only 0.31.
2. Question 2
The best conclusion about serial correlation in the regression model is that the
regression residuals have:
o A
significant serial correlation.

o B
no significant serial correlation.

o C
inconclusive results regarding serial correlation.

Incorrect
A is correct. The p value for the BG F-statistic (0.042) is less than the significance level
of 0.05, which means we can reject the null hypothesis that there is no serial
correlation in the residuals; and conclude that serial correlation is present.
Additionally, the DW statistic is not close to 2, which also indicates the presence of
correlation in the residuals.
3. Question 3
Which of the following is most likely a limitation of using the Durbin-Watson test to
detect serial correlation?
o A
It does not incorporate the squared differences of successive residuals.

o B
It only applies to first-order serial correlation.

o C
It does not measure autocorrelation.

Incorrect
B is correct. The Durbin-Watson (DW) test is a measure of autocorrelation and
compares the squared differences of successive residuals with the sum of the
squared residuals. The major drawback of the DW test is that it only applies to first-
order serial correlation. The Breusch-Godfrey test is used instead, as it is more
robust.
4. Question 4
Using the information in Table 1, the residuals of the model are most likely:
o A
homoskedastic
o B
Hetroskesdastic
o C
neither homoskedastic nor heteroskedastic.

Incorrect
A is correct. The Breusch-Pagan (BP) test checks for heteroskedastic residuals in
models. In this case, the p-value of the BP statistic is 0.8523, which is higher than the
level of significance of 0.05. This means that the null hypothesis that there is no
heteroskedasticity is not rejected. The residuals are therefore considered
homoskedastic.
Richard Peters, CFA, is analyzing the monthly returns on the local stock market index, the
MDA500. This index tracks the performance of the 500 largest publicly traded companies in
his home country, Everland. Peters gathers monthly data on these 500 companies, using 25
years of data, as well as the inflation and GDP for each month. As part of his analysis, he
also collects information regarding which political group was in power for each data point.
Everland has three major political groups, Group A, Group B, and Group C, with elections
occurring every five years. Peters wants to further his analysis by investigating the
relationship between the monthly returns of the index and inflation. He introduces
interaction terms between inflation and the political group, to see how the relationship
differs with different governments. Peters’ data is shown in Exhibit 1. Exhibit 1
Table 1
Dummy Variables
Political Group Group A Group B
Group A 1 0
Group B 0 1
Group C 0 0
Table 2
Coefficient
Intercept 0.036
INFL -0.235
GDP 0.724
GRPA 0.052
GRPB -0.047
INFL_GRPA 0.004
INFL_GRPB -0.001
As part of his analysis, Peters seeks to identify any influential data points. He calculates the
studentized residuals and Cook’s D for each data point. Selected data is shown in Exhibit 2.
Exhibit 2
Table 3
Observation Studentized Residual Cook’s D
Observation 51 0.563 0.004
Observation 53 -1.397 0.037
Observation 55 -2.004 0.093
1. Question 1
Q-Code: 23-L2-QM-EXMR-186730
Based on Table 1 in Exhibit 1, the control group is most likely:
o A
Group A.
o B
Group B.
o C
Group C.
Incorrect
C is correct. The control group (or base group) is the category that is not assigned a
dummy variable. In this case, it is Group C.
2. Question 2
Given the data in Table 2, which of the following statements is least likely correct?
o A
The value 0.724 is a slope coefficient.

o B
GRPB is an interaction term.

o C
INFL_GRPB is a slope dummy variable.

Incorrect
B is correct. GRPB is an intercept dummy variable. When GRPB = 1 (i.e., when Group
B is in government), the coefficient for GRPB will be added to the intercept value.
Option A is correct because 0.724 is the slope coefficient for the independent
variable GDP. Option C is correct because INFL_GRPB is a slope dummy variable (also
called interaction term). When GRPB = 1, the coefficient for INFL_GRPB will be added
to the slope coefficient of INFL.
3. Question 3
Which of the following is least likely a correct interpretation of the data in Exhibit 1?
o A
If Group B is in government and INFL and GDP are both zero, then the
monthly return on MDA500 index would be -1.1%.
o B
If Group A is in government, the slope coefficient for INFL would be -0.231.

o C
The monthly return on the MDA500 index is generally higher when

Group B is in government compared to when Group A is in government.
Incorrect
C is correct. Generally, the monthly return on the MDA500 is lower when Group B is
in government compared to when Group A is in government.
Ret = 0.036 + 0.052GRPA – 0.047GRPB – 0.235INFL + 0.724GDP + 0.004INFL_GRPA –
0.001INFL_GRPB
When Group A is in power (GRPA = 1 and GRP B = 0):
Ret = 0.036 + 0.052(1) – 0 – 0.235INFL + 0.724GDP + 0.004INFL – 0
Ret = 0.088 – 0.231INFL + 0.724GDP
When Group B is in power (GRPA = 0 and GRP B = 1):
Ret = 0.036 + 0 – 0.047(1) – 0.235INFL + 0.724GDP + 0 – 0.001INFL
Ret = -0.011 – 0.236INFL + 0.724GDP
For the same values for INFL and GDP, the return when Group B is in government
will be lower than that of Group A because the intercept is lower and slope
coefficient for INFL is lower, whereas the slope coefficient for GDP is the same for
both.
Option A is a correct statement because in the situation that Group B is in
government and INFL and GDP are zero, the regression equation would simplify as
follows:
0.001INFL_GRPB
Ret = 0.036 + 0 – 0.047(1) – 0.235INFL + 0.724GDP + 0 – 0.001INFL
Ret = (0.036 – 0.047) – 0.236INFL + 0.724GDP
Ret = -0.011 – 0.236INFL + 0.724GDP
Ret = -0.11 – 0 – 0 = -0.011
Option B is a correct statement because if Group A is in government, then the
regression equation would simplify to the following:
0.001INFL_GRPB
Ret = 0.036 + 0.052(1) – 0 – 0.235INFL + 0.724GDP + 0.004INFL – 0
Ret = 0.088 – 0.231INFL + 0.724GDP
4. Question 4
Using the information in Exhibit 2 and a critical t-value of +/-1.960, which of the
observations are most likely influential based on the studentized residuals and Cook’s
D?
Studentized residuals Cook’s D
Option A Observations 52 and 55 Observation 55
Option B Observations 52, 53, 55 Observations 52 and 55
Option C Observations 52 and 55 None of the observations
o A
Option A
o B
Option B
o C
Option C
Incorrect
C is correct. To determine the outliers based on the studentized residuals, we must
compare the studentized residual for each observation with the critical t-value, which
is given as +/- 1.960. Observations 52 and 55 are the only observations with a higher
t-calc than t-crit, so they are considered the outliers.
When using Cook’s D, there are three criteria. If the calculated Cook’s D for an
observation is greater than 0.5, then the observation may be influential. If the Cook’s
D is greater than 1.0, then the observation is highly likely to be influential. According
to these two criteria, there are no influential observations in Table 3. However, the
third criterion is that an observation is highly likely to be influential if its Cook’s D is
greater than 2√(k/n), where k is the number of independent variables and n is the
total number of observations. For this question, the value of 2√(k/n) is 0.1265
(2√(2/500)). None of the observations is greater than this.
Afia Irfan, CFA, is an analyst examining the likelihood of a cosmetics company to go

bankrupt. She gathers data on 200 companies from the past 30 years and identifies which
companies have filed for bankruptcy. She also looks at data regarding the PE ratios and
product price points relative to those of competitors. She comes up with the following logit
model, where bankrupt = 1 and not gone bankrupt = 0, and the log likelihood statistics
(Table 1). Bankrupt = 0.456 + 0.346PE – 1.273PRICE
Table 1
Model Log-likelihood
Restricted: Intercept only -285.73
Unrestricted: Intercept, PE, PRICE -283.49
Irfan performs an LR test on her model using a critical chi-square value of 5.991. Eisha
Waqar, an intern who is shadowing Irfan, asks her about the LR test. Irfan makes the
following statements: Statement 1: The LR test is a joint test of unrestricted coefficients.
Statement 2: Rejecting the null hypothesis is a rejection of the smaller, restricted model in
favor of the larger, unrestricted model. Statement 3: The LR test performs best when
applied to large samples. While looking at Irfan’s data, Waqar commented on a data point
that seemed extreme compared to the others. Irfan responded by saying she had noticed
the outlier as well, but it was not an issue.
1. Question 1
o A
The intercept of 0.456 is the log odds of the probability of bankruptcy if PE

and PRICE are both zero.
o B
The coefficient of 0.346 for PE implies odds of 1.413.

o C
A one-unit change in PRICE results in a 28% increase in the probability of

bankruptcy, all other variables held constant.
Incorrect
C is correct. A one-unit change in PRICE will result in a 22% increase in the probability
of bankruptcy, all other variables held constant.
Coefficient of PRICE (log odds) = -1.273
Odds (elog odds) = 0.2799
Probability [Odds/(1 + Odds)] = 0.2799/1.2799 = 0.2187 = 22%
Option A is a correct statement. Option B is also correct: 0.346 represents the log
odds, so the non-log odds are elog odds = e0.346 = 1.413.
2. Question 2
Regarding her decision for the LR test, Irfan should most likely:
o A
reject the null hypothesis.

o B
not reject the null hypothesis.

o C
neither reject nor fail to reject the null hypothesis because she does not have
enough information to make an accurate decision.
Incorrect
B is correct. Irfan should not reject the null hypothesis because the calculated test
statistic is less than the critical value.
Test statistic: LR = -2 (log likelihood restricted model – log likelihood unrestricted
model) = -2 (-285.73 – – 283.49) = 4.48
Critical value = 5.991
4.480 < 5.991
3. Question 3
Which of the Irfan’s statements regarding the LR test is least likely correct?
o A
Statement 1
o B
Statement 2
o C
Statement 3
Incorrect
A is correct. The LR test is a joint test of restricted coefficients. Statements 2 and 3 are
correct statements.
4. Question 4
Which of the following is most likely the reason why the extreme data point is not an
issue?
o A
It is an outlier, not a high-leverage point.

o B
It does not tilt the regression line.

o C
It is not close to the regression line.

Correct
B is correct. Outliers and high-leverage points are problematic when they are distant
from the regression line, because in that case they “tilt” the line. If the extreme value
is close to the line, then it does not significantly impact the regression analysis.
Time-Series
1. Question 1
Q-Code: 21-L2-QM-TSAN-75897
Charlene Brett, a research analyst, regresses the natural log of Home Furnishings, a
home furniture and accessories manufacturer and retailer, against the natural log of
GDP. Brett then conducts the Dickey-Fuller test which establishes that the two series
have unit roots. Next, she uses the Engle–Granger approach, by testing the residuals
from the above regression and rejects the null hypothesis that the error term has a
unit root. The most likely conclusion that can be drawn from the result of the Engle–
Granger test is that the two time series are:
o A
cointegrated, and tests of the estimates of the intercept and slope are
therefore valid.
o B
not cointegrated, and tests of the estimates of the intercept and slope are
therefore valid.
o C
cointegrated and the estimates of regression coefficients are invalid.

Incorrect
A is correct. “If the (Engle–Granger) Dickey–Fuller test rejects the null hypothesis that
the error term has a unit root, then we conclude that the error term in the
regression is covariance stationary. Therefore, the two time series are cointegrated.
The parameters and standard errors from linear regression will be consistent and
will let us test hypotheses about the long-term relation between the two series.”
2. Question 2
Zarar Abadan, a research analyst considers a time series model to predict Systech
Corporation’s gross margin. He decides to use the first-order autoregressive model
AR(1). He reviews the results and notices that the autocorrelations of the residuals
from that model do not differ significantly from zero. The results of the regression
(without the autocorrelations) are reported in Table 4.
Table 4: Regression Results of AR(1) Model Gross Margin of Systech.
GPMt = b0 + b1GPMt-1 + ɛt
Coefficient Standard Error t-Statistic

Intercept (b0) 0.0654 0.0283 2.314
Lag 1 (b1) 0.6795 0.0516 13.1875
Number of observations 59
Durbin-Watson statistic 1.8545
Based on the regression results reported above, the mean-reverting level for the
model is closest to:
o A
0.1090.
o B
0.3205.
o C
0.2040.
Incorrect
C is correct. The mean reverting level for an AR(1) model: xt+1 = b0 + b1xt + ɛt is given
by: �� = �01−�1=0.06541−0.6795=0.204056
3. Question 3
Serena Anand, a finance professor explains to her students that nonstationarity or
heteroskedasticity would negatively affect the use of the AR(1) model. She asks the
students to test for the presence of each. Anand shares the results from an AR(1)
model of the unit root test for nonstationarity and of a test for the presence of
heteroskedasticity with her students. These are reported in Table 5.
Table 5: Unit Root Test for Nonstationarity and the Test for Heteroskedasticity
Unit root test statistic -12.5501

Unit root test critical value at the 5% level of significance -2.89
Heteroskedasticity test statistic 3.0145
Heteroskedasticity test critical value at the 5% level of significance 1.96
Based on the test results reported above, the best conclusion that can be drawn is
that:
o A
heteroskedasticity is present in the error term variance.

o B
there is a unit root.

o C
standard errors are reliable.

Incorrect
A is correct. Because the unit root test statistic -12.5501 is less than the critical value
of -2.89, the AR(1) model does not exhibit a unit root. The test for heteroskedasticity
suggests that the error terms are heteroskedastic, because the test statistic of
3.0145 is greater than the critical value of 1.96.
4. Question 4
For a log linear trend model, the slope coefficient is 5 and the intercept coefficient is
10. The predicted trend value at time t = 20 is closest to:
o A
110.
o B
5.92.
o C
62.34
Incorrect
B is correct. The equation for the log-linear trend model is:
ln yt = b0 + b1t, where t = 1, 2, …, T
therefore: yt = e b0 + b1t
y20 = e 10 +5(20) = 5.92
Log-linear trend models are used when linear trend models do not correctly model
the growth of a time series. Log-linear trend models work well in fitting a time series
with exponential growth (constant growth at a particular rate).
5. Question 5
In which of the following scenarios will a log-linear trend model be most likely used?
o A
When the variable grows at a constant rate.

o B
When the variable increases over time by a constant amount.

o C
The Durbin Watson statistic is significantly different from 2.0.

Incorrect
A is correct. When the variable grows at a constant rate, the log-linear model is most
appropriate. When the variable grows increases over time by a constant amount, a
linear trend model is most appropriate. A Durbin Watson statistic significantly
different from 2.0 suggests that the residual terms are correlated and it may be
appropriate to use an autoregressive model.
6. Question 6
For a linear trend model, the intercept is 2, trend coefficient is 0.5, and the error
term is expected to be zero. The predicted trend value in the 20th period is closest to:
o A
12.
o B
40.5.
o C
50.
Incorrect
A is correct.
In a linear trend model, the dependent variable changes at a constant amount with
time. The independent variable is time. The linear trend equation for a time-series is
given by:
yt = b0 + b1 t + εt, t = 1, 2,…, T
where:
yt = the value of the time series at time t (value of the dependent variable)
b0 = the y-intercept term
b1 = the slope coefficient or the trend coefficient
t = time, the independent or explanatory variable.
εt = a random-error term
In this case, the predicted trend value where t=20 is equal to:
2 + 0.5(20) + 0 = 12.
7. Question 7
Which of the following is least likely a requirement for a time series to be covariance
stationary?
o A
The expected value of the time series changes at a constant rate over
time.
o B
The time series’ volatility around its mean does not change over time.
o C
The covariance of the time series with leading or lagged values of itself is
constant.
Incorrect
A is correct. For AR models to work, the time series must be covariance stationary. A
time series is covariance stationary if it meets the following three conditions:
4. The expected value of the time series (the mean) must be constant and finite
in all periods (i.e., the time series should not trend upwards or downwards).
(This is why Statement A is not correct.)
5. The variance must be constant and finite in all periods (i.e., the time series’
volatility around its mean should not change over time). (Statement B)
6. The covariance of time series, past or future must also be constant and finite
in all periods (i.e., the covariance of the time series with leading or lagged
values of itself should be constant). (Statement C)
8. Question 8
Consider an AR(1) model with the following equation: xt = 2.5 + 0.2(xt-1)
If the current value of x is 4, the two-period-ahead forecast is closest to:
o A
2.5.
o B
3.3.
o C
3.16.
Incorrect
C is correct. One step ahead forecast = 2.5 + 0.2(4) = 3.3
Two step ahead forecast = 2.5 + 0.2(3.3) = 3.16
An autoregressive model (AR) is a time series regressed on its own past values and
represents relationships where current-period values are related to previous-period
values. When we use this model, we can drop the normal notation of y as the
dependent variable and x as the independent variable because we no longer have
that distinction to make. Here we simply use xt, such as in the equation in the
question: xt = 2.5 + 0.2(xt-1).
This is a first-order autoregression, AR(1), for the variable xt, because we only use the
most recent past value of xt to predict the current value of xt. By using a process
called chain rule forecasting, the next period’s value, predicted by the forecasting
equation, is substituted into the equation to give a predicted value two periods
ahead.
9. Question 9
The correlations of the error terms from the estimation of an AR(1) model using a
sample with 144 observations is presented in the following figure. Based on this
information which of the following statements is most appropriate?
(The critical two tail t-value at the 5% significance level and 142 degrees of freedom
is 1.98.)
Lag Autocorrelation
1 0.124
2 0.148
3 0.166
o A
The AR model is correctly specified.

o B
The AR model is not specified correctly because the autocorrelations of the
residuals for lag 2 are statistically different from 0.
o C
The AR model is not specified correctly because the autocorrelations of

the residuals for lag 3 are statistically different from 0.
Incorrect
C is correct. We can detect serially correlated errors by testing whether the
autocorrelations of the error terms (error autocorrelations) differ significantly from
0. If the model is correctly specified, none of the autocorrelations will be statistically
significant.
A three-step process is used to determine if an AR model has been correctly
specified:
4. Estimate a particular autoregressive model such as AR (1) and calculate the

error terms.
5. Estimate the autocorrelations of the residuals from the model, i.e., the
correlation between the error terms of one period and the error terms of
previous periods.
6. Perform the t-test to test whether the residual autocorrelations differ
significantly from 0.
Null hypothesis is: error autocorrelation at a specified lag equals 0.

Standard error of the residual correlation = 1/√T, where T is the number of
observations in the time series.
Test stat = residual autocorrelation / standard error
If the autocorrelations of the error term (error autocorrelations) differ significantly
from 0, then the model is not specified correctly.
For this question, we can start from step 3 since we are given the autocorrelations of
the residuals.
The standard error is 1/√(144) = 0.08333.
The t-stat for Lag 1 is 0.124 / 0.08333 = 1.488
Since the t-stat for Lag 3 is more than the critical value of 1.98 we cannot say that
autocorrelation of the residual for Lag 3 is statistically different from 0. Hence the
model is not specified correctly.
10. Question 10
For a regression model xt = 2.5 + 0.2 xt-1 , the mean reverting level is closest to:
o A
12.5.
o B
3.125.
o C
4.65.
Incorrect
B is correct. The mean reverting level can be computed as b0 / (1 – b1) = 2.5 / (1 – 0.2)
= 3.125.
A time series shows mean reversion if it tends to fall when its level is above its mean
and rise when its level is below its mean.
A classic example of a time series showing mean reversion is inflation data. For
example, if the long term expected inflation rate for a country is 2%, inflation tends
to come down when it is above 2% and tends to rise when it is below 2%.
11. Question 11
A time series that follows a random walk process has the following expression xt =
b0 + b1xt-1 + ∈t . Which of the following statements is least accurate?
o A
The expected value of the error term E(∈t) is 0 for a random walk with or
without drift.
o B
b(0) = 0 for a random walk without drift and b(0) ≠ 0 for a random walk with
drift.
o C
b(1) = 1 for a random walk without drift and b(1) ≠ 1 for a random walk
with drift.
Incorrect
C is correct. In either case (with or without a drift), b1 = 1.
A random walk is a time series in which the value of the series in one period is the
value of the series in the previous period plus an unpredictable random error.
Without a drift, b0 = 0, b1 = 1, and the error term has an expected value of 0. In a
random walk with a drift, b0 ≠ 0, b1 = 1, and the error term has an expected value of
0.
12. Question 12
An analyst is checking for unit root problem and has performed the Dickey Fuller
test. He found that the null hypothesis (g = 0) cannot be rejected. Which of the
following statements is most accurate?
o A
The time series does not have a unit root problem.

o B
The time series is covariance stationary.
o C
The time series has a unit root problem.

Incorrect
C is correct. For an AR (1) model to be covariance stationary, the absolute value of
the lag coefficient b1 must be less than 1. When the absolute value of b1 is 1, the time
series is said to have a unit root. If a time series has a unit root problem, then it is a
random walk and not covariance stationary.
We can detect the unit root problem by using the Dickey-Fuller test.
g1 = b1 – 1, so if g1 = 0 then b1 = 1
The null hypothesis is that g1 = 0, if this cannot be rejected (as in the case of this
question), then b1 – 1 = 0 so b1 = 1. Therefore, the series has a unit root problem.
13. Question 13
If a time-series model has a unit root problem then which of the following
transformations can most likely be performed to solve this problem?
o A
Log-linear transformation.
o B
First-differencing.
o C
Dickey Fuller transformation.

Incorrect
B is correct. A random walk time-series is not covariance stationary, so standard
regression analysis cannot be used to estimate it without transforming the data. First
differencing is the process used to transform a random-walk time series (i.e., one
with a unit root problem) to a covariance stationary time series. In this method, we
define a first differenced variable yt such that:
yt = xt – x(t-1) = εt
If the original series is a random walk, then the first-differenced series will yield b0 = 0
and b1 = 0, and the error terms will not be serially correlated. The first differenced
variable yt will be covariance stationary. The mean reverting level of the first-
differenced model is: (b-0)/(1- b1) = 0/1 = 0.
14. Question 14
Which of the following statements regarding seasonality is least likely correct?
o A
Seasonality can be detected by testing for significant serial correlation of the
residuals in a time-series model.
o B
Correcting seasonality should increase the value of R^2.

o C
To correct for seasonality, seasonal lag(s) need to be excluded from the

AR model.
Incorrect
Seasonality is common in financial data. If the error term of a time-series model
shows significant serial correlation at seasonal lags, it is said to have seasonality. A
time-series with seasonality is not covariance stationary. Seasonality can be
corrected by including a seasonal lag in the model. For instance, to correct
seasonality in the quarterly time series, modify the AR (1) model to an AR(4) model:
xt = b0 + b1 x(t–1) + b2 x(t-4) + εt
15. Question 15
The following table shows the autoregression output for Log-quarterly sales of a
retailer using an AR(1) model. The number of observations are 40. Which of the
following statements is most accurate?
(At a significance level of 5% and 38 degrees of freedom the critical t-value is 2.024.)
Residual Lag t-statistic

1 -0.45
2 -0.02
3 0.015
4 4.815
o A
Seasonality is present in the time series.

o B
Seasonality is not present in the time series.

o C
The AR model is specified correctly.

Incorrect
A is correct. The t-stat for Lag 4 is higher than the critical t-value. Thus, we can
conclude that seasonality is present in the time series.
We detect seasonality through autocorrelations in the data. In case of seasonality in
a quarterly time series, the fourth autocorrelation would differ significantly from
zero. In case of seasonality in a monthly time series, the 12th autocorrelation would
differ significantly from zero.
Seasonality is when the error term of a time-series model shows significant serial
correlation at seasonal lags. A time-series with seasonality is not covariance
stationary. Since seasonality means there is autocorrelation in the error terms, a
model with seasonality is incorrected specified (so option C is incorrect).
16. Question 16
The regression results for an ARCH(1) model are shown below. If the current period
squared error is 0.4356, the variance of the error terms in the next period
is closest to:
Coefficients p-value
Constant 5.6521 <0.001
Lag 1 0.3496 <0.001
o A
5.652.
o B
5.804.
o C
6.001.
Incorrect
B is correct. If the variance of the error in a time series depends on the variance of
the previous errors, then this condition is called autoregressive conditional
heteroskedasticity (ARCH). If a time-series model has significant ARCH(1), then we
can predict the next period error variance using the formula:
σ2t+1 = a0 + a1 ε2t
In this case, the p-value of a1 (the coefficient of the lagged variable) is less than 0.001
which means that it is statistically significant, so ARCH exists. We can use the above
formula to predict the variance of the error term in the next period: σ2t+1 = 5.6521 +
0.3496(0.4356) = 5.804.
17. Question 17
If linear regression is used to model the relationship between two time series and
the (Engle-Granger) Dickey-Fuller test rejects the null hypothesis that the error term
has a unit root, then we most likely:
o A
assume that the error term in the regression is covariance stationary.

o B
assume that the two time series are not cointegrated.

o C
cannot use the regression coefficients and standard errors in hypothesis

tests.
Incorrect
A is correct. If the test rejects the null hypothesis that the error term has a unit root,
then we can conclude that the error term in the regression is covariance stationary.
The two series are cointegrated, and the standard errors of linear regression will be
consistent. The regression coefficients and standard errors can be used in
hypothesis tests. However, we must proceed with caution because the regression
coefficients represent the long-term relationship between the variables and may not
be useful for short-term forecasts.
18. Question 18
Linear regression is least appropriate for modeling the relationship between two time
series when:
o A
neither series has a unit root.

o B
only one series has a unit root.

o C
both series have a unit root and are cointegrated.

Incorrect
B is correct.
The four possible scenarios based on whether the dependent variable, the
independent variable, or both have a unit root are listed below:
• If neither of the time series has a unit root, then we can safely use linear
regression.
• If only one of the two time series has a unit root, then we should not use
linear regression.
• If both time series have a unit root and they are cointegrated, we may safely
use linear regression.
• If both time series have a unit root, but they are not cointegrated, then we
cannot use linear regression.
Two time series are said to be cointegrated if a long-term financial or economic

(macro) relationship exists between the two variables or if they follow similar trends.
19. Question 19
Analyst Serena Miller wants to predict TechSol’s gross margin for the next period.
She is considering the best model for gross margin. Based on her observations of
the quarterly data over a 12 – year period, Miller believes that the current period’s
gross margin will be related to the previous-period value. Miller will most likely use a:
o A
first-order autoregressive model AR(1) along with autocorrelations.

o B
simple linear regression model.

o C
correlation test between sales and margin.

Incorrect
A is correct. Based on her belief, Miller will use a time-series model – AR(1) model
along with autocorrelations of the residuals from that model and examine the model
to check if it is correctly specified. If correctly specified, she will use it to predict
TechSol’s gross margin. If not then the time-series model is corrected for any
misspecifications, before it can be used to predict the gross margin.
20. Question 20
Which of the following statements is most accurate? When comparing two
autoregressive models:
o A
The model with the higher root mean squared error (RMSE) for out-of-sample
data is expected to produce better predictive power in the future.
o B
The model with the lower root mean squared error (RMSE) for in-sample data
is expected to produce better predictive power in the future.
o C
The model with the lower root mean squared error (RMSE) for out-of-
sample data is expected to produce the better predictive power in the
future.
Incorrect
C is correct. The model with the lower RMSE for the out-of-sample data will have
lower forecast error and will be expected to have better predictive power in the
future.
21. Question 21
Analyst 1: The coefficients of models estimated with shorter time series are usually
less stable than those with longer time series.
Analyst 2: If there has been a dramatic change in the underlying economic

environment, then historical data may not provide a reliable model.
o A
Analyst 1 is correct.
o B
o C
Both analysts are correct.

Correct
B is correct. Analyst 1 is incorrect. There is no clear-cut basis in economic or financial
theory for determining the sample period to estimate a time-series model. Typically,
one has to examine the graphs of the data to see if the time-series looks stationary
before estimation begins.
Lars Karel, a financial analyst at I-Worth Hedge Fund, is reviewing SUV Motors’ production
data and regression analysis provided by the company. Lately, due to certain faulty ignition
switches, SUV has recalled its vehicles from the market. Karel reviews the regression results
that show the number of faulty switches per hour as a function of the number of
mechanical rotations and the production rate of the assembly lines. He tests it for serial
correlation and multicollinearity and decides to conduct the Dickey-Fuller unit root test of
nonstationarity on each of the time series. Table 1 shows the results. Table 1: Results of
the Dickey-Fuller test for a unit root.
Value of Slope
Time Series Standard Error t-Statistic Significance of t
Coefficient
Faulty switches
0.0042 0.0029 1.4522 0.1105
per hour
Number of
-0.493 0.0958 -5.1450 0.000
rotations
Production rate
-0.613 0.0476 -12.8600 0.000
per hour
Reviewing the Dickey-Fuller test results, Karel’s supervisor comments, “Regression can be
safely used for testing the relationship between dependent and independent variables if:
I. none of the three time series has a unit root, or

II. all three series have a unit root but they are also cointegrated.”
1. Question 1
The most likely conclusion from the results of the Dickey-Fuller test assuming a 5%
level of significance is that:
o A
dependent variable has a unit root but the independent variables do
not.
o B
independent variables exhibit unit roots but the dependent variable does
not.
o C
none of the three series exhibit a unit root.
Incorrect
A is correct. The Dickey-Fuller tests a transformed version of
regression: ��−��−1= �0+�1��−1+��, �(��)= 0 where The null
hypothesis to test for unit root
is:�0: �1=0−�ℎ� �� ℎ��
��
Versus the alternative hypothesis:
�1: �1<0−�ℎ� �� ℎ��
��
Based on the t ratios and their significance levels in Table 1, we reject the null
hypothesis that the coefficient is zero for both number of rotations and rate (i.e.,
the independent variables). We do not reject the null for the dependent variable,
faulty switches per hour.
2. Question 2
Regarding his comments, Karel’s supervisor is most likely:
o A
correct.
o B
incorrect because only the independent variable series should be tested

for the possibility of a unit root.
o C
incorrect, because only the dependent variable series should be tested for
the possibility of a unit root.
Incorrect
A is correct. One possibility is that none of the time series has a unit root, therefore
we can safely use linear regression to test the relations between two time series
(dependent variable and the independent variables). Another possibility when
regression can be used safely is that all the time series have unit roots but they are
also cointegrated, then the regression coefficients and standard errors will be
consistent and can be used for hypothesis testing.
Shavir Adel, an analyst, investigates the time series behaviour of change in gross profit
margin of william pharma. The result of the time series regression are shown in Table
1. Table 1: Result of regression of ∆GPMt on Lagged (∆GPMt = b0 + b1∆GPMt-1 + εt)
R2 0.053
Standard error 0.15786
Observation 40
Durbin-Watson 2.097
Coefficient Standard Error t – Statistics Significance of t

Constant (b0) 0.137 0.121 1.130 0.154
Lagged ∆GPM (b1) 0.953 0.700 1.361 0.181
Adel tells his colleague, “This regression is a special case of a first-order autoregressive
(AR(1)) model; the results suggest that change in GPM is a random walk because the
estimated value for b0 does not appear to be significantly different from zero, and the
estimated coefficient on the first lag – b1 is close to 1.” Adel’s colleague, Zohair Danani
replies, “True, the ∆GPM series based on the previous period margins is indeed a random
walk.”
1. Question 1
Is Adel correct in his statements regarding the ∆GPM time series being a random walk
?
o A
incorrect because b1 should be close to 0.

o B
correct.
o C
incorrect because b0 should be close to -1.

Incorrect
B is correct. When modeled using a AR(1) model, as in the formula given in Table 1,
random walks will have an estimated intercept coefficient near zero and an
estimated slope coefficient on the first lag near 1. Therefore, Adel’s statement is
correct.
2. Question 2
If Danani is correct, the best forecast of the next period’s ∆GPM will most likely be the:
o A
predicted value from the above A(R) model in Table 1

o B
average GPM over different time series.

o C
current period’s ∆GPMt.

Incorrect
C is correct. If a time series is a random walk, the best forecast of xt that can be made
in period t – 1 is xt-1. So, the best forecast of the next period’s change in GPM is the
current period’s ∆GPMt.
Beena Sharma and Arshan Zubin, two analysts at MHD Securities, examine the relationship
of P/CF of Darius Aurvedic Medicine, (DrAM). Sharma applies the AR(1) model to P/CF time
series. In order to test whether the errors in the regression display first-order
autoregressive conditional heteroskedasticity ARCH(1), Sharma regresses the squared
residuals denoted as ɛ t 2, on lagged squared residuals. The results are given in Table 3. Table
3: Results of Regression of Squared Residuals, ɛt2, on Lagged Squared Residuals, ɛt-12
Coefficient Standard Error t Significance of t

Intercept (a0) 3.393 0.578 5.870 0
Lag 1 (a1) 0.214 0.025 8.405 0
R2 Standard Error Durbin-Watson

0.056 0.1093 1.994
Sharma and Zubin discuss the addition of more variables in the analysis. Zubin states:
“When we apply linear regression to two time series, at least one of the following conditions
must hold, in order to rely on the validity of the estimated regression coefficients.”
I. “The independent variable should not have a unit root but the dependent variable
should exhibit a unit root.
II. Both time series have a unit root, but are not cointegrated.”
1. Question 1
Based on the results of Table 3, the regression most likely has ARCH(1) errors
because:
o A
a0 is significantly different from zero.
o B
a1 is not significantly different from zero.

o C
a1 is significantly different from zero.

Incorrect
C is correct. “We can test whether a time series is ARCH by regressing the squared
residuals from a previously estimated time series model on a constant and one lag
of the squared residuals (as in Table 3). If the estimate of the slope (a1) of the
regression of the squared residuals on the lagged one period squared residuals is
statistically significantly different from 0, the time series is ARCH(1).”
2. Question 2
Based on the results given in Table 2, Sharma and Zubin should most likely model
P/CF by using the:
o A
generalized least squares model.

o B
AR(1) model.
o C
ARMA model.
Incorrect
A is correct. If ARCH exists, the standard errors for the regression parameters will
not be correct. Hence generalized least squares or methods that correct for
heteroskedasticity need to be used.
3. Question 3
Is Zubin correct regarding his Condition 1?
o A
No, because only the independent variable series should be tested for the
absence of a unit root.
o B
Yes.
o C
No, because in that case the estimated regression coefficients and

standard errors will be inconsistent.
Incorrect
C is correct. Both the independent variable and dependent variable needs to be
tested for the absence of unit roots. If Condition 1 holds the error term in the
regression will not be covariance stationary. Hence the regression coefficients and
standard errors will be inconsistent, giving invalid results.
4. Question 4
Is Zubin’s Condition 2 correct?
o A
Yes.
o B
No. because if both time series have unit roots then they should be
cointegrated for reliable estimation of regression coefficients.
o C
No, because none of the time series should have a unit root or exhibit
cointegration.
Correct
B is correct. If both the time series have a unit root, but they are cointegrated, the
error term in the linear regression will be covariance stationary. Hence the
regression coefficients and standard errors will be consistent and we can use them
for hypothesis tests.
Machine Learning
1. Question 1
Q-Code: 21-L2-QM-MALE-75957
Which of the following statements is least likely an advantage of machine learning?
Machine Learning programs:
o A
do not rely on restrictive assumptions.

o B
can handle problems with low number of variables only.

o C
can handle problems with high degree of non-linearity.

Incorrect
B is correct. This is an incorrect statement because machine learning techniques are
better than statistical approaches at handling problems with many variables (high
dimensionality).
ML programs have several advantages over other approaches:
• They do not rely on restrictive assumptions such as linear relationships,

normally distributed population data, etc. (Option A)
• They can handle problems with high dimensionality (a large number of
variables).
• They can handle problems with high degree of non-linearity. (Option C)
2. Question 2
Which machine learning technique most likely requires a labeled data set?
o A
Unsupervised Learning
o B
Supervised Learning
o C
Deep Learning
Incorrect
B is correct. Supervised learning requires a labeled data set, one that contains
matched sets of observed inputs and the associated output. Deep learning
algorithms can use both labeled as well as unlabeled data sets.
Unsupervised machine learning does not make use of labeled data.
3. Question 3
An analyst wants to use a machine learning algorithm for a given data. He notes
down a few of the features that the data has:
• It is not a complexity reduction problem

• It is a classification problem
• Data is labeled
• Data is not complex and does not have non-linearities.
Based on the features mentioned above, the most appropriate machine learning
technique and machine learning algorithm to use is:
A. Supervised Learning Classification KNN or SVM

B. Supervised Learning Regression CART, Random Forests or Neural Nets
C. Unsupervised Learning Classification CART, Random Forests or Neural Nets
o A
Option A
o B
Option B
o C
Option C
Incorrect
A is correct. If complexity reduction is not a problem and we have classification
problem with labeled data, we use classification algorithms, which are supervised
machine learning algorithms. For data, which is not complex and non-linear, we use
KNN or SVM. B is incorrect because we use CART, Random Forests or Neural Nets
when we have Complex non-linear data. C is incorrect, classification is a supervised
learning technique.
4. Question 4
Overfitting in a model is best described as:
o A
an issue where the model does not fit the training data.
o B
an issue where the model fits training data perfectly but does not work well
with in-sample data.
o C
an issue where the model fits training data perfectly but does not work
well with out-of-sample data.
Incorrect
C is correct. Typically, a machine learning algorithm that fits the training data
perfectly would not be good at predicting out-of-sample data.
The training sample or ‘in-sample’ data is the data that is used to train the model.
Validation samples are used to validate and tune the data. Test samples are used to
test the model’s ability to predict well on new data. These are also called ‘out-of-
sample’ data.
5. Question 5
An analyst created a ML model for classifying companies listed on JPX -Nikkei 400
index into two categories; companies with YoY increase in EPS and no YoY increase
in EPS. Data that she collects is labeled (Increase in EPS or No increase in EPS). After
training his model, he discovered that the model correctly classifies companies using
the training data, however, when he used new data the model did not perform well.
What is the most appropriate action that analyst should implement to address this
problem?
o A
Use the k-fold cross-validation technique.
o B
Use unsupervised learning.

o C
Shuffle the data randomly and then divided into k equal sub-samples, with k-
1 samples used as validation samples and one sample, the kth, used as a
training sample.
Incorrect
A is correct. K-fold cross-validation technique is used to estimate the model’s out-of-
sample error and then it is used to adjust the model accordingly. B is incorrect
because we do not use unsupervised learning with labeled data. C is incorrect
because it describes the K-fold cross validation techniques incorrectly, the correct
method should be: “Shuffle the data randomly and then divided into k equal sub-
samples, with k-1 samples used as training samples and one sample, the kth, used as
a validation sample.”
6. Question 6
Which of the following statements regarding model errors and overfitting is least
accurate?
o A
An optimal point of model complexity exists where the variance and bias
error curve intersect, and the total error is minimized.
o B
Variance error refers to how much the model’s result change in response to
new data.
o C
Overfitted models have low variance errors.

Incorrect
C is correct. Overfitted models have high variance errors. Options A and B are
correct statements.
The total out-of-sample error can be decomposed into:
Bias error: refers to the degree to which a model fits the training data. Underfitted
models have high bias errors.
Variance error: refers to how much the model’s result change in response to new
data. Overfitted models have high variance errors.
Base error: refers to errors due to randomness in the data.
7. Question 7
Which of the following best describes penalized regression?
o A
Penalized regression is a computationally efficient technique used in

prediction problems where the target variable is continuous.
o B
Penalized regression is a linear classifier that aims to seek the optimal

hyperplane that separates the observations into two sets of data points.
o C
Penalized regression is supervised learning technique most often used for

classification.
Incorrect
A is correct. Penalized regression is a computationally efficient technique used in
prediction problems where the target variable is continuous. A popular type of
penalized regression is LASSO. B is incorrect because it describes support vector
machine (SVM). C is incorrect because it describes K-nearest neighbor (KNN).
8. Question 8
A supervised machine learning algorithm that can be applied to predict a categorical
variable or a continuous target variable is:
o A
LASSO.
o B
Classification and Regression Tree (CART).

o C
K-Nearest Neighbor (KNN).

Incorrect
B is correct. Classification and regression tree (CART) can be applied to predict either
a categorical target variable, producing a classification tree, or a continuous target
variable, producing a regression tree.
Option A is incorrect because LASSO is a type of penalized regression, which is used
when the target variable is continuous, not categorical. Option C is incorrect because
KNN is used when the target variable is categorical.
9. Question 9
Which of the following statements are most likely correct with respect to the k-nearest
neighbor (KNN) algorithm?
o A
It is a powerful algorithm because it is non-parametric and makes no
assumptions about the distribution of the data.
o B
One advantage of KNN is that is relatively simple and defining what “similar”
or “near” means is a straightforward process.
o C
One drawback of KNN is that it cannot be used directly for multi-class

classification.
Incorrect
A is correct.
B is incorrect because the major challenge of KNN is defining what “similar” or “near”
means.
C is incorrect because an advantage of KNN is that it can be used directly for multi-
class classification. (In machine learning, multiclass classification is the task of
classifying instances into one of more than two classes.)
10. Question 10
Which of the following is not an unsupervised machine learning algorithm?
o A
Principal component analysis (PCA)

o B
K-means clustering
o C
K-Nearest Neighbor (KNN)

Incorrect
C is correct. K-Nearest Neighbor (KNN) is a supervised learning algorithm.
Unsupervised machine learning does not make use of labeled data. Several input
variables are used for analysis, but no output (or target variable) is provided.
Because labeled data is not provided, the ML program has to discover structure
within the data on its own. Unsupervised learning is useful for large complex data
set which is hard to visualize.
11. Question 11
A limitation of using the k-means clustering is that:
o A
it works well only with small data sets.

o B
the number of clusters in which to partition the data, must be decided
before k-means can be run.
o C
the centroids need to be adjusted manually, which introduces the chance of

human error.
Incorrect
B is Correct. A limitation of K-means clustering method is that the hyperparameter k
must be decided beforehand, which can be difficult to do.
12. Question 12
When using clustering, unsupervised learning algorithm, which of the following
is least likely an application of this algorithm:
o A
Portfolio diversification.
o B
Reduces large number of features to manageable set.

o C
Discovering patterns in high dimensional data.

Incorrect
B is correct. Reducing large number of features to a manageable set is an application
for Penalized regression not clustering. Options A and C are application of clustering.
13. Question 13
Considering deep learning networks (DLNs) and neural networks (NN) which of the
following statement is least accurate:
o A
Hidden layers have an activation function which acts like a dimmer switch. It
can increase or decrease the strength of the input.
o B
Neural networks (NN) with at least 25 hidden layers are known as deep
learning nets (DLNs).
o C
Hidden layers have a summation operator which multiplies each input value
by a weight and sums the weighted values to form the total net input.
Incorrect
B is correct. Neural networks with many hidden layers (at least 3 but often more than
20 hidden layers) are known as deep learning nets (DLNs).
14. Question 14
Neural networks have three types of layers of nodes which are connected by links.
The learning most likely takes place in:
o A
the input layer.

o B
the hidden layer.

o C
the output layer.

Incorrect
B is correct. In neural networks, learning takes place in the hidden layer through
improvements in the weights applied to nodes.
Neural networks have layers of nodes connected by links. The three types of layers
are:
• Input layer nodes that correspond to features

• Hidden layer(s) that feed the output node
• Output node that generates the predicted value
In neural networks, learning takes place in the hidden layer through improvements
in the weights applied to nodes. These improvements are undertaken with the aim
of reducing the total error.
15. Question 15
Which of the following statements is least accurate with respect to reinforcement
learning (RL)?
o A
Reinforcement learning involves an agent that should perform actions that

will maximize its reward over time, taking into consideration the constraints
of its environment.
o B
In an RL algorithm, learning takes place in the hidden layer through

improvements in the weights applied to nodes.
o C
RL algorithm learning occurs over time through millions of trials and errors.
Correct
B is correct. This statement is correct for neural networks, not reinforcement
learning. In reinforcement learning, the algorithm observes its environment, learns
by testing new actions, and reuses its pervious experiences.
Statements A and C are correct.
Jin Yang, manager at Forks Corporation, is interviewing two candidates for a position of a
business analyst at his firm. Yang knows from experience that the job role requires
candidates to have at least basic knowledge about Machine Learning (ML) and ML
algorithms. During the interview, he tests the knowledge of the candidates by asking them a
few questions and records the responses of both candidates. First, he asks the candidates
to define ML, for which the candidates’ responses are as follows:
Candidate 1: ML is a set of computer-driven approaches adapted to

extracting information only from linear, labelled data sets.
Candidate 2: ML is a set of computer-driven approaches aimed at

generating structure or predictions from data without human
intervention by finding a pattern and then applying the pattern.
Jin then asks the candidates to determine whether supervised machine learning or
unsupervised machine learning is more appropriate for identifying groupings of data with a
target variable. During the interview Jin also ask the candidates to identify an appropriate
type of ML Algorithm for the following hypothetical scenario: “We have a database of
corporate bonds, in which bonds are classified based on their credit rating. Along with credit
ratings, the database contains other detailed information about the bonds, which includes
details about the issuing company and the bond issue itself. Now, assume that a new bond
is issued in the market, but it has no credit rating. Which ML algorithm can be best used to
classify the implied credit rating for the new bond ?
1. Question 1
Which candidate gave the most accurate response?
o A
Candidate 1
o B
Candidate 2
o C
Both responses are accurate

Incorrect
B is correct. Candidate 2 gives the accurate definition of machine learning. A & C are
incorrect because Candidate 1’s response is incorrect. ML is not limited to extracting
information from linear, labelled data sets.
2. Question 2
Best response for Jin’s questions about supervised and unsupervised learning is:
o A
An unsupervised ML algorithm is used.

o B
A supervised ML algorithm is used.

o C
Both methods can be used.

Incorrect
B is correct. A supervised ML algorithm is meant to predict a target (Y) variable. A is
incorrect because unsupervised ML algorithm does not use labelled training data. C
is incorrect because the term “labelled training data” means the target (Y) is
provided.
3. Question 3
Most appropriate ML algorithm for the new bond in the case-based scenario is:
o A
K-means clustering
o B
K-Nearest Neighbour (KNN)

o C
Hierarchical clustering
Correct
B is correct. By nature, corporate bonds with similar issuer and issue characteristics
should be given a similar credit rating. So, by using KNN, we can predict the implied
credit rating of the new bond based on the similarities of its characteristics to those
of the bonds in our database.
Alice Cohen is a data analyst at an investment management firm, Central Funds Ltd. The
fund runs a high dividend yield fund for high net-worth clients. Cohen’s manager ask’s her
to classify the companies in the NASDAQ 100 index into two categories: companies with
dividend increase and companies with no dividend increase. Cohen gathers data gathers
data for training, validating and testing a machine learning model. Data consists of 500
observations of NASDAQ 100 companies. Each observation consists of 30 features and
labelled target. Cohen uses the data to train her ML model. Observing the results from her
model she finds out that the model is good when classifying the data in the training sample,
but it doesn’t perform well when using out of sample data.
1. Question 1
The problem that Cohen faced with classifying the out of sample data is best
described as:
o A
Overfitting and high variance error.

o B
Overfitting and high bias error.

o C
Underfitting and high bias error.

Incorrect
A is correct. Cohen’s model is good at correctly classifying using the training sample,
but it does not perform well using new data. The model is overfitted, so it has high
variance error.
2. Question 2
Which of the following actions can address the problem identified?
o A
Use unsupervised learning model.

o B
Use the k-fold cross-validation technique to estimate the model’s out of

sample error, and then adjust the model accordingly.
o C
Increase the model complexity.

Correct
B is correct. K-fold cross validation helps minimize both bias and variance errors. A is
incorrect because unsupervised ML models do not use labelled training data. C is
incorrect, because increasing model complexity results in higher variance error.
Big Data
1. Velocity of data refers to:
o A
the quantity of data.

o B
the speed at which data are created.

o C
the credibility and reliability of different data sources.
2. Incorrect
3. B is correct. Option A refers to Volume of data and option C refers to Veracity of
data.
4. Big data differs from traditional data because of a set of characteristics (3 V’s):
• Volume – refers to the quantity of data.
• Variety – refers to the array of available data sources.
• Velocity – refers to the speed at which data are created.
In addition to these three V’s, a fourth V is becoming increasingly important,

especially when using big data for drawing inferences or making predictions.
• Veracity – refers to the credibility and reliability of different data sources.

5. Question 2
Q-Code: 21-L2-QM-BDAP-75970
Which of the following is least likely a step in machine learning model building?
o A
Data collection.
o B
Data encryption.
o C
Data exploration.
Incorrect
B is correct. Options A and C are ML model building steps.
6. Question 3
Your colleague is describing a step involved in machine learning model building for
structured data. She tells you the following:
“This step involves cleaning and preprocessing the raw data. Cleaning may involve
adding missing values, fixing out-of-range values, etc. Preprocessing may involve
extracting, aggregating, and filtering a select set of columns.”
The step she is referring to is most likely:
o A
data exploration.
o B
data preparation and wrangling.

o C
data curation.
Incorrect
B is correct.
A is incorrect because data exploration involves exploratory data analysis, feature
selection and feature engineering. C is incorrect because data curation is a step in
machine learning model building for unstructured data. It entails gathering relevant
text data from different sources via web spidering programs.
7. Question 4
Jack Ryan, an analyst at AMC Corporation, is working to develop a ML model to
identify potential investors for AMC’s equity mutual fund. While working on cleansing
the data, he finds out that the income for some individuals is stated as negative. This
error in Data is best described as an:
o A
invalidity error.
o B
incompleteness error.
o C
inaccuracy error.
Incorrect
A is correct. Income cannot be negative, which makes the data sets with negative
income meaningless.
An incompleteness error occurs when data is missing, for example, if the names of
some individuals were not present in the data set. An inaccuracy error occurs when
the data presented is not a measure of true value. An example would be if the data
shows “don’t know” in the ‘Credit Card’ column for a particular individual. This does
not measure true data because an individual either has a credit card or does not (the
answer can only be yes or no).
8. Question 5
Feature extraction is best described as:
o A
aggregating two or more variables into one variable, in order to consolidate

similar variables.
o B
converting variables in the dataset into appropriate types.

o C
creating new variables from the existing ones in the data.
Incorrect
C is correct. We can extract a new variable from the existing ones for ease of
analyzing and using for training the ML model.
Option A is incorrect as this refers to aggregation and option B is incorrect because it
refers to conversion. All three transformations (aggregation, conversion, and
extraction) are part of the data wrangling (preprocessing) step of data analysis of
structured data.
9. Question 6
When normalizing the textual data which of the following points should be covered:
o A
lemmatization.
o B
removing html tags.

o C
removing white spaces.

Incorrect
A is correct. Lemmatization is the process of converting inflected forms of a word
into its morphological root. Other options refer to text cleansing.
10. Question 7
Which of the following statements is most accurate?
o A
Bag-of-words is essentially a collection of a distinct set of tokens from

all the texts in a sample data set.
o B
Tokenization is part of the text cleansing process.

o C
Confusion matrix is the output produced by preparing and wrangling textual

data.
Incorrect
A is correct. Other options are false statements.
Option B is incorrect because tokenization is part of text wrangling (preprocessing).
Option C is incorrect because confusion matrixes are used in performance
evaluation during the model training step of model building.
11. Question 8
Feature engineering is best described as:
o A
a process of creating new features by changing or transforming the

existing ones.
o B
a process of selecting pertinent features from the dataset for ML model

training.
o C
a process of combining two features into one consolidated one.

Incorrect
A is correct. It is the definition of feature engineering. Option B describes feature
selection; option C is incorrect.
12. Question 9
Nancy Hopkins, an analyst, is collecting data from the workers of Star Mall. In her
survey she has a free response field where she asks the worker to enter their job
responsibilities. Which of the following visualization techniques will be most
appropriate for her to use?
o A
Box plots
o B
Word clouds
o C
Scatter plots
Incorrect
B is correct. The data in the free response field will be text based and for this word of
clouds offer an appropriate starting point for exploratory analysis.
13. Question 10
Which of the following is least likely a method of feature selection?
o A
Term frequency
o B
Chi-squared test
o C
N-grams creation
Incorrect
C is correct. Creating n-grams is feature engineering technique. Term frequency and
using the chi-squared test are feature selection methods.
14. Question 11
Statement 1: The main problem with overfitted models is that they are unlikely to
perform well on out-of-sample data.
Statement 2: Model tuning involves managing the trade-off between model bias
error and model variance error.
Which of the statements are most likely correct?
o A
Statement 1 only
o B
Statement 2 only
o C
Both Statement 1 and Statement 2

Incorrect
C is correct. Both statements are correct.
Overfitting is when a model is complex and fits the training data too well. It is then
unlikely that the model will perform well on out-of-sample data.
Model bias is an error associated with underfitting, and model variance is an error
associated with overfitting. Model tuning is the involves managing the trade off of
these two errors.
15. Question 12
An analyst is evaluating the performance of a model through error analysis.
Actual Training Labels

Class “1” Class “0”
Class “1” TP = 49 FP = 9
Predicted Results
Class “0” FN = 12 TN = 30
Based on the confusion matrix, the model’s accuracy metric is closest to:
o A
0.61.
o B
0.79.
o C
0.84.
Incorrect
B is correct.
Accuracy is the percentage of correctly predicted classes out of total predictions.
Accuracy = (TP + TN)/(TP + FP + TN + FN)
In this scenario: Accuracy = (49 + 30)/(49 + 9 + 30 + 12) = 0.79
16. Question 13
In machine learning model training, which of the following is least likely a factor for
method selection?
o A
Receiver Operating Characteristic (ROC)

o B
Size of dataset
o C
Type of data
Incorrect
A is correct. Receiver Operating Characteristic (ROC) is technique used for measuring
model performance. Other options are factors on which model selection is based on.
17. Question 14
Which of the following statements is most likely correct with respect to different term
frequency (TF) measures?
o A
Inverse document frequency is calculated as 1/DF, where DF is document

frequency.
o B
‘TF – IDF’ is calculated as TF x IDF, where TF is term frequency and IDF is

inverse document frequency.
o C
Document frequency is number of times a given word appears in the whole
corpus divided by the total number of words in the corpus.
Incorrect
B is correct. TF – IDF is calculated as TF × IDF. A high value indicates that a word
appears more frequently within a smaller number of documents, i.e. these words
have good predictive power and are important.
A is incorrect because IDF if calculated as log(1/DF). This is a relative measure of how
unique a term is across the entire corpus.
C is incorrect because document frequency is the number of sentences that contain
a particular word divided by the total number of sentences. A high DF indicates high
word frequency in the text. The definition in option C is that of term frequency at
collection level.
18. Question 15
When dealing with text-based data, “cleansing” most likely involves:
o A
removing html tags, punctuations, most numbers, and white spaces.

o B
lowercasing, removing stop words, stemming or lemmatization, creating bag-

of-words (BOW) and documentation term matrix (DTM).
o C
using statistics such as term frequency, bar charts, and word clouds.
Incorrect
A is correct. B refers to the preprocessing of text-based data. C refers to exploratory
data analysis (EDA) of text data, which occurs after cleansing and preprocessing.
19. Question 16
Which of the following is least likely correct with respect to feature selection for text-
based data?
o A
For text data, tokens represent the features.

o B
Commonly used feature selection methods are term frequency (TF),

document frequency (DF), chi-squared test, and mutual information
(MI).
o C
Feature selection of text data involves systematically altering,
decomposing or combining existing features to produce more
meaningful features.
Incorrect
C is correct. This statement describes the feature engineering step of data
exploration.
Options A and B are correct statements.
ABQ Corporation, a multinational conglomerate, is planning to expand its portfolio by

investing in the United States’ car wash industry. Vince Gilligan, an analyst at ABQ
Corporation, and his team have been assigned to work and develop a machine learning
model for tagging potential customers in order to project sales. Gilligan asks one of his data
scientists, Steve Gomez, to perform a preliminary assessment of the data cleansing and
preprocessing tasks. While speaking to Gilligan about data preparation, Gomez makes the
following statement: “For manually entered data, data cleansing is a vital task that must be
performed on raw data, because manually entered data can have incomplete, duplicated,
erroneous, or inaccurate values. Whereas Automated data, which is generated by systems,
does not need data cleansing and it can be used directly to train the ML model.” As part of
the assessment Gilligan extracts a sample of data for manual examination, he calls in
Gomez for a discussion.
S. No. ID Name Gender Owns a car Make of car Income ($) State
1 1 Mr. Mike Male Yes Chrysler 68,000 NY
2 3 Mrs. Skyler Female Yes Jeep 26,000 CO
3 4 Mr. Hank Male Yes Jeep 50,000
4 7 Mr. Walter Male Yes Pontiac 14,000 NH
5 11 Mrs. Marie Female Yes Volkswagen -23,000 TX
6 12 Ms. Jane Female No N/A 20,000 CA
Gilligan adds: “We should not consider the data for the “make of car” as it wouldn’t add
much meaning to the ML model.”
1. Question 1
Gomez’ statement about data preparation is most likely:
o A
Correct.
o B
Incorrect because of his comment about the manually entered data.

o C
Incorrect because of his comment about the automated data.

Incorrect
C is correct. The comment about the errors in manually entered data is correct. The
comment about the automated data is incorrect because automated data can have
similar errors. These errors can be caused because of server errors and software
bugs.
2. Question 2
The data shown for Mr. Hank has an error best described as:
o A
Invalidity error
o B
Incompleteness error
o C
Duplication error
Incorrect
B is correct. This is an incompleteness error because the data in the field: “State” is
missing.
3. Question 3
The data shown for Mrs. Marie most likely has an:
o A
Invalidity error
o B
Inaccuracy error
o C
Incompleteness error
Incorrect
A is correct. For Mrs. Marie, the income is shown as a negative number. Income
cannot be negative, which makes this information meaningless. Hence, it’s an
invalidity error.
4. Question 4
Gilligan’s comment about excluding ‘the make of the car’ from analysis is most likely
beneficial for the ML model because:
o A
Selecting fewer features increases ML model complexity and training time.

o B
Selecting fewer features decreases ML model complexity and training

time.
o C
Selecting fewer features increases the amount of computing power required,

which in turn increase costs and training time.
Correct
B is correct. Feature selection is used to reduce the number of features in the
dataset because it is essential to identify and remove unneeded, irrelevant, and
redundant features. This results in lower ML model complexity and lower training
time.
Carol Smith, Chief Technology Officer at Finza Ltd, is meeting with two of the recently hired
data scientists James Riley and Justin Huff to assess their knowledge about big data projects.
She starts the meeting by saying that there are three steps involved in data exploration:
Exploratory data analysis (EDA), feature selection and feature engineering. She asks Riley to
comment on EDA. Here are some of the comments from Riley’s reply: Comment 1: “The
objective of EDA includes finding patterns and relationship in data” Comment 2: “A
commonly used visualization technique for structured data is word clouds” Carol then asks
Huff to explain the relationship between model fitting errors and number of features. Huff
replies: “A dataset with a small number of features can lead to underfitting, and a dataset
with a large number of features can lead to overfitting.” Then Carol tests both scientists,
Riley and Huff, on confusion matrix. He asks them about the precision ratio, both answer
him correctly. At the end of the meeting Carol gives out the following confusion matrix and
asks Riley and Huff to calculate the F1 score.
Actual Training Results

Class “1” Class “0”
Predicted Class “1” TP = 30 FP = 9
Results Class “0” FN = 5 TN = 16
1. Question 1
Which of the Riley’s comment is the least accurate?
o A
Comment 1
o B
Comment 2
o C
Both are accurate.

Incorrect
B is correct. Word clouds are commonly used as a visualization technique for text
based unstructured data. Common visualization techniques for structured data are
histograms, bar charts, box plots, etc. Comment 1 is a correct statement.
2. Question 2
Huff’s reply to Carol’s question is most likely:
o A
Correct
o B
Incorrect, because small number of features lead to over fitting and vice
versa.
o C
Incorrect, because there is no relation between model fitting errors and

number of features in a data set.
Incorrect
A is correct. Huff’s reply is a true statement.
3. Question 3
With regards to Carol’s question about Precision ratio. What is the most likely answer
that they would had given? Precision ratio is the:
o A
ratio of correctly predicted positive classes to all actual positive classes.

o B
ratio of correctly predicted positive classes to all predicted positive

classes.
o C
None of the above.

Incorrect
B is correct. It is the correct explanation of the precision ratio. Option A explains the
Recall ratio.
4. Question 4
Based on the confusion matrix that Carol gives out at the end of the meeting, The F1
score is closest to:
o A
0.8131
o B
0.7692
o C
0.8108
Incorrect
C is correct. F1 score is the harmonic mean of precision and recall ratios.
F1 score = (2 * P * R)/(P + R)
P = TP/(TP + FP) = 30/(30+9) = 0.7692
R = TP/(TP + FN) = 30/(30+5) = 0.8571
F1 = (2 x 0.7692 x 0.8571) / (0.7692 + 0.8571) = 0.8108
ECONOMICS
Currency Exchange Rates

1. Question 1
Q-Code: 23-L2-EC-CERD-198125
Marian Smith is the CFO of a large manufacturing firm based in Germany. She is
responsible for overseeing exposure to price risk in both the commodity and
currency markets. She finds out that the USD/Euro bid ask price quoted by Dealer A
is 1.1645/1.1650. The firm has to make a large payment to a US based supplier.
Smith calls up Dealer A with specific details of the transaction and asks to verify the
USD/Euro quote. Dealer A calls her back later with a revised USD/Euro bid–offer
quote of 1.1643/1.1652.
Which of the following would be the best reason for the revised USD/Euro dealer
quote of 1.1643/1.1652?
o A
Lower volatility in the USD/Euro market

o B
A request for a much larger transaction

o C
Lesser popularity of the currency pair involved

Incorrect
B is correct. The larger the transaction size, the wider the bid-offer spread.
A is not correct because lower volatility is likely to result in lower bid offer spread.
C is not correct because USD/EUR is not amongst the less popular pairs.
2. Question 2
An analyst is considering the following three transactions involving Indian rupee
(INR), United States dollar (USD), and Chilean Peso (CLP):
• Transaction 1: Buy INR 5 million against the USD at 15:30 Mumbai time.
• Transaction 2: Sell INR 100 million against the CLP at 2:30 Mumbai time.
• Transaction 3: Buy CLP 50 million against the USD at 14:30 Santiago time.
Which transaction will most likely have the widest bid-offer spread under normal
market conditions?
o A
Transaction 1.
o B
Transaction 2.
o C
Transaction 3.
Incorrect
B is correct. INR/CLP is the least liquid among the given currency pairs. The
transaction is for a larger amount that occurs outside the normal trading hours.
3. Question 3
The following are spot rate quotes in the interbank market:
USD/EUR 1.5559/1.5563
JPY/USD 82.17/82.20
CAD/USD 0.9643/0.9647
SEK/USD 7.1739/7.1742
What is the bid–offer on the JPY/CAD cross rate implied by the interbank market?
o A
85.1774/85.2414
o B
79.2365/79.2983
o C
1.0366/1.0370
Incorrect
Solution: A is correct. To calculate the JPY/CAD rate, we have to multiply the JPY/USD
and USD/CAD rates.
But we are not given the USD/CAD rate directly, so we have to invert the CAD/USD
quotes to get this rate. Given the CAD/USD quotes of 0.9643/0.9647, we take the
inverse of each and interchange bid and offer, so that the USD/CAD quotes are
(1/0.9647)/(1/0.9643), or 1.0366/1.0370.
Multiplying the JPY/USD and USD/CAD we get:
Bid: 85.1774 = 82.17 × 1.0366
Offer: 85.2414 = 81.89 × 1.0370
4. Question 4
Given the following bid-ask quotes, what is the potential arbitrage profit based on an
initial position of GBP 2 million?
USD/GBP: 1.2350 – 1.2360
GBP/CHF: 0.8285 – 0.8290
USD/CHF: 1.0250 – 1.0300
o A
GBP 0
o B
GBP 647
o C
GBP 13,280
Incorrect
B is correct.
Calculate the USD/GBP cross rates based on the quoted GBP/CHF and USD/CHF
rates:
USD/GBP = USD/CHF * CHF/GBP
Bid: 1.0250 * (1/0.8290) = 1.2364
Ask: 1.030 * (1/0.8285) = 1.2432
Compare the cross-rate bid and ask rates to the quoted ones:
Cross-rates: 1.2364 – 1.2432
Quoted rates: 1.2350 – 1.2360
These rates are in terms of USD/GBP, and we are starting out with GBP 2 million, so
we will benefit most from selling GBP at the higher bid rate, then buying back GBP at
the lower ask rate. The transactions will be as follows:
Selling GBP 2 million at 1.2364 USD/GBP → GBP 2,000,000 * 1.2364 USD/GBP = USD
2,472,800.
Buying GBP at 1.2360 USD/GBP → USD 2,472,800 ÷ 1.2360 USD/GBP = GBP
2,000,647.25.
The arbitrage profit is the value of the ending position minus the value of the initial
position:
2,000,647 – 2,000,000 = 647 GBP
5. Question 5
If a dealer quoted a bid–offer of 85.2711/85.2719 in JPY/CAD as compared to
85.1774/85.2414 implied by the interbank market, computed in the question above,
you would:
o A
not make any arbitrage profits.
o B
make arbitrage profits, buying CAD in the interbank market and selling
it to the dealer.
o C
make arbitrage profits, buying CAD from the dealer and selling it in the
interbank market.
Incorrect
B is Correct. The implied interbank cross rate for JPY/CAD is 85.1774/85.2414.
The dealer’s quote is 85.2711/85.2719 which lies entirely to the right of the interbank
rate, i.e., we have a ‘DBi G IO’ situation. Hence, an arbitrage opportunity exists. We
can buy the base currency (CAD) from the interbank market at 85.2414 and sell to
the dealer at 85.2711, to make an arbitrage profit of JPY 0.03 per CAD.
6. Question 6
Brendan Rosner manages a global equity fund based in Hong Kong. He is evaluating
stocks from Japan and New Zealand to add to the portfolio. As part of his evaluation,
he is also considering the impact of interest rates, exchange rates and inflation in
these countries. He has gathered the following currency and market rates:
Country Currency Spot Exchange Rate **

Hong Kong HKD NA
JAPAN JPY 14.07 / 14.08
New Zealand NZD 0.1800 / 0.1900
** Number of foreign currency units per one HKD
If a dealer’s bid-side quote for JPY/NZD is 78.45, then a profit on a HKD 100,000,000
investment in the triangular arbitrage opportunity is closest to:
o A
HKD 291,193.
o B
HKD 362,473.
o C
HKD 5,862,926.
Incorrect
A is correct. Given that there is a triangular arbitrage opportunity, compare the
dealer’s bid rate with the interbank offer rate. Dealer JPY/NZD bid = 78.45 (given).
Interbank JPY/NZD offer = JPY/HKD offer x HKD/NZD offer = 14.08 x 1/0.18 = 78.22.
Therefore, buy NZD (sell JPY) in the interbank market and sell NZD (buy JPY) in the
dealer market. On a HKD 100,000,000 investment, buy NZD at 0.18 in the interbank
market = 100,000,000 x 0.18 = NZD18,000,000.
Sell NZD to the dealer at 78.45 = 18000,000 x 78.45 = JPY1,412,100,000.
Sell JPY in the interbank market at 14.08 = 1,412,100,000/14.08 = HKD100,291,193.
Hence profit = HKD(100,291,193-100,000,000) = HKD291,193.
7. Question 7
The following information is provided:
Spot (USD/EUR) 1.6014
180-day MRR (USD) 2.75%
180-day MRR (EUR) 1.50%
The forward premium (discount) for a 180-day forward contract for USD/EUR is:
o A
0.0197
o B
0.0099
o C
-0.0099
Incorrect
8. Question 8
The DKK/USD spot rate is 6.9900/7.0000. The forward points on a six-month forward
contract are 100/120. If you want to sell USD in the forward market, the relevant rate
is:
o A
7.0000.
o B
7.0020.
o C
7.0120.
Incorrect
A is correct. You want to sell USD (base currency). This means the dealer will buy
Hence the relevant rate is the bid rate. The forward rate will be 6.9900 + 100/10,000
= 7.0000.
9. Question 9
Sherman Capital, an investment fund based in New York, hedged a long exposure to
the Australian dollar by selling AUD 10 million forward against the USD; the all-in
forward price was 6900 (USD/AUD). Three months prior to the settlement date,
Sherman wants to mark this forward position to market. The bid–offer for the
USD/AUD spot rate, the three-month forward points, and the three-month MRRs
(annualized) are as follows:
Spot rate (USD/AUD) 0.6825/0.6830
Three-month points –12.1/–10.0
Three-month MRR (AUD) 5.37%
Three-month MRR (USD) 2.50%
The mark-to-market value for Sherman’s forward position is closest to:
o A
−USD 80,000.
o B
+USD 77,503.
o C
+USD 79,503.
Incorrect
Solution: C is correct. Sherman sold AUD 10 million forward to the settlement date
at an all-in forward rate of 0.6900 (USD/AUD). To mark this position to market, the
fund would need an offsetting forward transaction involving buying AUD 10 million
three months forward to the settlement date.
For the offsetting forward contract, because the AUD is the base currency in the
USD/AUD quote, buying AUD forward means paying the offer for both the spot rate
and the forward points. This scenario leads to an all-in three-month forward rate of
0.6830 − 0.0010 = 0.6820.
On the settlement day, Sherman will receive USD 6,900,000 (AUD 10,000,000 ×
0.6900 USD/AUD) from the original forward contract and pay out USD 6,820,000
(AUD 10,000,000 × 0.6820 USD/AUD) based on the offsetting forward contract. The
result is a net cash flow on the settlement day of 10,000,000 × (0.6900 − 0.6820) =
+USD 80,000. This is a cash inflow because Sherman sold the AUD forward and the
AUD depreciated against the USD. This USD cash inflow will occur in three months.
To calculate the mark-to-market value of the original forward position, we need to
calculate the present value of this USD cash inflow using the three-month USD
discount rate (we use USD MRR for this purpose):
USD80,000 / 1 + 0.025(90/360) = +USD79,503
10. Question 10
A UK-based fixed-income asset manager is deciding how to allocate money between
UK and USD.
USD/GBP spot rate (mid-market) 1.15
One-year forward points (mid-market) +1.70
One-year GBP deposit rate 1.25%
One-year USD deposit rate 2.75%
Based on the above data, which of the following statements is not true?
o A
Based on uncovered interest rate parity, over the next year, the expected
change in the USD/GBP is closest to 1.5%.
o B
There is no arbitrage condition that forces uncovered interest rate parity to

hold.
o C
If the asset manager completely hedged the currency risk associated

with a one-year USD deposit using a forward rate contract, the one-year
all-in holding return, in GBP, would be closest to 2.75%.
Incorrect
Solution: C is correct. According to covered interest rate parity, a fully hedged USD
investment would provide the same return as the GBP investment:1.25%. Under this
parity condition, an investment in a foreign money market instrument that is
completely hedged against exchange rate risk should yield the exact same return as
an otherwise identical domestic money market investment.
11. Question 11
Which of the following statements is least accurate about forward rate parity?
o A
Forward rate parity holds if both covered and uncovered interest rate parity
hold.
o B
Forward rate is an accurate predictor of expected spot rate because
uncovered interest rate parity always holds.
o C
Forward rate parity assumes that the investors are risk neutral.
Incorrect
B is correct. The uncovered interest rate parity relationship is not enforced by
arbitrage and assumes that investors are risk neutral, which is not the case. As a
result, uncovered interest rate parity is often violated and the forward rate is a poor
predictor of expected spot rate.
12. Question 12
A US-based fixed-income investment manager is deciding how to allocate her
portfolio between US and Japan. (US is the domestic currency.) US’s one-year deposit
rate is 2.5%, considerably higher than Japan’s at 1%, but the US dollar is estimated to
be roughly 5% overvalued relative to the Japanese yen based on purchasing power
parity. If real interest rates in Japan and US were equal, then under the international
Fisher effect, the inflation rate differential between Japan and US would be closest
to:
o A
1.5%
o B
5%
o C
2.5%
Incorrect
A is correct. If the real interest rates were equal, then the difference in nominal
yields would be explained by the difference in inflation rates (2.5% – 1%).
13. Question 13
According to the ex-ante PPP, the expected change in the spot exchange rate should
equal:
o A
the expected difference between domestic and foreign inflation rates.

o B
the nominal interest rate spread.

o C
the forward premium or discount.
Incorrect
Solution: A is correct. the ex-ante version of PPP states that ‘expected’ changes in
spot exchange rates are driven by ‘expected’ inflation differentials:
Over short time horizons, nominal exchange rate movements appear random.
However, over longer time horizons, nominal exchange rates tend to gravitate
toward their long-run PPP equilibrium values.
14. Question 14
If all the key international parity conditions are held at all times, then the expected
percentage change in the spot exchange rate would equal all, except which of the
following?
o A
the forward premium or discount (expressed in percentage terms)

o B
the real yield spread between countries

o C
the difference between expected national inflation rates

Incorrect
Solution: B is correct. If all the key international parity conditions held at all times,
then the expected percentage change in the spot exchange rate would equal:
• the forward premium or discount (expressed in percentage terms)

• the nominal yield spread between countries
• the difference between expected national inflation rates
It would then be impossible for a global investor to earn consistent profits on

currency movements.
15. Question 15
According to the theory and empirical evidence of purchasing power parity (PPP),
which of the following would not be true if PPP holds in the long run?
o A
Over shorter horizons nominal exchange rate movements may appear
random, however, over longer time horizons they tend to gravitate toward
their long-run PPP equilibrium values.
o B
Low-inflation countries should tend to see their currencies depreciate

over time.
o C
PPP appears to be a valid framework for assessing long-run fair value in the
FX markets, even though the path to PPP equilibrium may be slow.
Incorrect
Solution: B is correct. According to PPP, low-inflation countries should see their
currencies appreciate (at least, over the longer term) in order to re-equilibrate real
purchasing power between countries.
16. Question 16
L.O.: e Q-Code: 21-L2-EC-CERD-74352

The current EUR/USD exchange rate is 1.1234. The Eurozone inflation rate is 5%. The
US inflation rate is 2%. According to the relative version of PPP, the percent change
in the spot exchange rate %ΔSEUR/USD will be closest to:
o A
3%.
o B
-3%.
o C
2%.
Incorrect
A is correct. According to the relative version (also called the ex-ante version) of PPP,
the percentage change in the spot exchange rate will completely be determined by
the difference between the foreign and domestic inflation rates.
17. Question 17
Which of the following statements is most likely true?
o A
If forward rates are unbiased predictors of future spot rates, then

covered and uncovered interest rate parity hold.
o B
Uncovered interest parity assumes that investors are risk-takers.

o C
By combining the relative purchasing power parity with the international

Fisher equation, we get the covered interest parity.
Incorrect
A is correct. The forward rates will be an unbiased predictors of future spot rates, if
covered and uncovered interest rate parity hold. B and C are incorrect statements.
18. Question 18
Which of the following is not true about FX carry trades?
o A
They can be profitable when uncovered interest rate parity does not hold.
o B
They involve taking long positions in a high yielding currency and a short
position in a low yielding currency.
o C
Carry trade returns are less peaked, with thinner tails.

Incorrect
Solution: C is correct. Carry trade strategies involve leverage which increases
volatility of returns. Hence, during turbulent economic times, such carry trades can
yield significant losses if the higher yielding currency depreciates substantially. Due
to the potential of high losses, carry trade returns are more peaked, with fatter tails
relative to normal distribution and negative skewness.
19. Question 19
A Tokyo-based asset manager enters into a carry trade position based on borrowing
in yen and investing in one-year UK MRR.
Today’s One-Year Spot Rate One Year

Currency Pair Spot Rate Today
Libor Later
JPY 0.10% JPY/USD 142.45 142.05
GBP 1.50% USD/GBP 1.1500 1.1512
After one year, the all-in return to this trade, measured in JPY terms, would be
closest to:
o A
+1.22%.
o B
+3.23%.
o C
+1.32%.
Incorrect
Solution: A is correct. To calculate the all-in return for a Japanese investor in a one-
year GBP MRR deposit, we must first calculate the current and one-year-later
JPY/GBP cross rates as follows:
Current JPY/GBP spot rate = 142.45*1.1500 = 163.8175
One year later JPY/GBP spot rate = 142.05*1.1522 = 163.5280
Assuming an initial position of, for example, 1000 yen (JPY 1000), the investor will
obtain JPY 1000 × 1/JPY 163.8175 = GBP 6.1044. After one year, the investment will
be worth GBP 6.1044 × 1.015 = GBP 6.1960. Converting back to yen in one-year
results in GBP 6.1960 × JPY 163.5280/AUD = JPY 1013.214. Paying off the yen loan
results in a profit of JPY 1013.214 – (JPY 1000 × 1.001) = JPY 12.21. In percentage
terms, this is 1.22% since our investment was 1000 JPY.
20. Question 20
Which of the following is the most likely consequence of a current account surplus in a
country according to balance of payments approach?
o A
Currency depreciation over time.

o B
Currency appreciation over time.

o C
Decline in imports and rise in exports.

Incorrect
Solution: B is correct. A current account surplus indicates high demand for the
domestic currency which would cause the currency to appreciate, over time the
currency would lose its competitiveness resulting in a decline in exports and rise in
imports, making the surplus hard to maintain.
21. Question 21
Andrew Peters is forecasting USD/CAD exchange rates using a balance of payments
analysis. He observes that Canada has a current account surplus while the United
States is running a current account deficit. He makes the following statement, “The
USD/CAD exchange rate is expected to increase in the short run.” Is Peters’
statement correct?
o A
Yes.
o B
No, the USD/CAD exchange rate is expected to decrease in the short run.
o C
No, the USD/CAD exchange rate is expected to increase in the long run.
Incorrect
C is correct. When a country is running a current account surplus, its currency is
expected to strengthen in the long run. The impact of a current account surplus or
deficit on the exchange rate takes place in the long run. Investment or financing
decisions are the dominant factor in determining exchange rate movements in the
short to intermediate run.
22. Question 22
In general, the correlation between equity market returns and changes in exchange
rates: is
o A
highly positive over time.

o B
highly negative over time.

o C
not stable in the short term and tends to converge toward zero in the
long run.
Incorrect
C is correct. Correlations between equity returns and exchange rates are unstable in
the short term and tend toward zero in the long run.
23. Question 23
Sue Mathew, a currency strategist is examining two countries—A and B. Country A
has a low-yield safe haven currency while the Country B has a high-yield currency
whose value is likely to fluctuate based on global economic growth rate. Mathew
notes that because of the high yield on the Country B ’s bonds, international
investors have recently been reallocating their portfolios more heavily toward its
Consequently, Country B has been experiencing boom-like conditions, which
would most likely lead to:
o A
depreciation in Country B’s currency value in the near term.

o B
an increase in inflation expectations in Country B.
o C
an increase in the risk premium for the Country B.

Incorrect
B is correct. Given the increase investor interest in Country B and the boom-like
conditions in the country, it is most likely that its inflation is increasing in the near
term and the risk premium is decreasing. Consequently, Country B’s currency will
appreciate.
24. Question 24
According to Mundell- Fleming Model, exchange rate of a country with capital
controls would most likely appreciate as a result of?
o A
expansionary monetary and expansionary fiscal policies.

o B
restrictive monetary and expansionary fiscal policies.

o C
restrictive monetary and restrictive fiscal policies.

Incorrect
Solution: C is correct. When capital mobility is low, trade flows will determine
exchange rate movements rather than capital flows. According to Mundell- Fleming
Model, the effect of monetary and fiscal policy changes on the currency of a country
with low capital mobility is summarised in the table below:
Low Capital Mobility
Expansionary Restrictive
Monetary Policy Monetary Policy
Expansionary Fiscal
Domestic currency depreciates Indeterminate
Policy
Domestic currency
Restrictive Fiscal Policy Indeterminate
appreciates
25. Question 25
According to Mundell- Fleming Model, what would be the most likely impact of
expansionary fiscal and expansionary monetary policies on the currency of a country
with high capital mobility?
o A
The domestic currency would appreciate.
o B
They would have an indeterminate effect on the domestic currency.

o C
The domestic currency would depreciate.

Incorrect
Solution: B is correct. According to Mundell- Fleming Model, the effect of monetary
and fiscal policy changes on the currency of a country with high capital mobility is
summarised in the table below
High Capital Mobility
>
Expansionary Restrictive
Monetary Policy Monetary Policy
Expansionary Fiscal Domestic currency
Indeterminate
Policy appreciates
Restrictive Fiscal Domestic currency
Indeterminate
Policy depreciates
26. Question 26
A currency strategist examines a country that has a high degree of capital mobility
and a floating-rate currency regime. Although the current outstanding volume of
government debt is low, as a percentage of GDP, it is rising sharply as a result of
expansionary fiscal policy. Moreover, it is likely to increase further based on the
projections for the government debt-to-GDP ratio. Based on the Mundell–Fleming
and portfolio balance models, which of the following is the most likely implication for
the country’s exchange rate?
o A
The exchange rate is likely to appreciate over the short run.

o B
As the government debt becomes harder to finance and, assuming there is

no change in monetary policy over the long term, the fiscal response will lead
to currency appreciation as yields rise.
o C
A decrease in country’s risk premium in the short run.

Incorrect
Solution: A is correct. The country has low debt to GDP ratio. Hence, expansionary
fiscal policy will lead to higher interest rates and higher real rates relative to other
countries. This should lead to currency appreciation.
27. Question 27
Which of the following statements is not true about a currency crisis?
o A
Most of the currency crisis episodes were anticipated by key credit

rating agencies and economists who typically change their forecasts
prior to a crisis.
o B
Countries with relatively sound economic fundamentals can fall victim to

currency crisis episodes.
o C
It has been difficult to establish a good early warning system for currency
crisis.
Incorrect
Solution: A is correct. Currency crises often catch most market participants and
analysts by surprise. Hence, it would be incorrect to say that most of the currency
crisis episodes were anticipated by key credit rating agencies and economists.
28. Question 28
Which of the following will not be classified as a pull factor for capital flows?
o A
a decrease in inflation and inflation volatility

o B
more-flexible exchange rate regimes

o C
search for higher interest rates by global investors

Incorrect
Solution: C is correct. Search for higher interest rates by global investors will be
classified as a push factor for capital flows. Push factors are not determined by
domestic economic policies but by international capital mobility. On the other hand,
pull factors represent favorable developments inside a country that attract foreign
flows.
29. Question 29
If a country is facing an unwanted surge in capital inflows leading to an overvaluation
of its currency, then which of the following is the most appropriate action that the
country’s central bank can take?
o A
Allow the currency to appreciate.

o B
Book highly leveraged long position in the high-yielding domestic currency

and short position in the low-yielding foreign currency.
o C
Directly intervening and limiting currency transactions.

Incorrect
C is correct. If the excessive inflows have resulted in currency overvaluation, then
government or central bank can use capital controls and direct intervention in the
foreign exchange market by preventing banks from conducting currency
transactions in which their currency is sold (as was done by Malaysia in the Asian
financial crisis).
30. Question 30
Early warning system is least likely to indicate an impending crisis when there is:
o A
broad money growth and the ratio of M2 to bank reserves tend to rise.
o B
restricted flow of capital.

o C
inflation tends to be significantly higher.

Incorrect
B is correct. Prior to a currency crisis, the capital markets have been liberalized to
allow the free flow of capital.
31. Question 31
Which of the following is most likely a good warning system for an impending
currency crisis?
o A
A system that has a strong record of predicting an actual crisis, but also
generates a lot of false signals.
o B
A system that includes a wide variety of economic indicators, including

those for which data is available after a significant lag.
o C
A system that starts flashing well in advance of an actual currency crisis

and which incorporates a wide range of symptoms that crisis prone
currencies might display.
Incorrect
C is correct. Option A and B describe negative factors that reduce the effectiveness
of a warning system.
Three months ago, a dealer sold USD 5 million forward against the EUR for a 90-day term at
an all-in rate of 1.0876. Today, the dealer wants to use an FX swap to roll this position
forward for another three months. The current spot rate and forward points for the
USD/EUR currency pair are given below: Spot rate (USD/EUR)1.0619/1.0620 One month
13.01/13.04 Two month 33.1/33.4 Three month 49.1/49.4 Four month 62.8/63.4 Five month
79.4/80.2 Six month 94.3/95.2
1. Question 1
The current all-in four month bid rate for delivery of EUR against the USD is closest
to
o A
1.0682.
o B
1.0688.
o C
63.8600.
Incorrect
A is correct. All-in four-month bid rate for EUR (the base currency) is equal to: 1.0619
+ (62.80/10,000) = 1.06818.
2. Question 2
The cash flow that will be realized by the dealer on the settlement date will most
likely be:
o A
an outflow of 111,041.
o B
an outflow of 111,262.
o C
an inflow of 111,041.
Incorrect
A is correct. Three months ago, the dealer sold USD 5 million at an all-in rate of
1.0876.
This is equivalent to receiving 5,000,000 / 1.0876 = EUR 4,597,278.4 on settlement
day.
Today the dealer will buy USD 5 million at a spot rate of 1.06195 to settle the
maturing USD forward contract, so that USD amounts net to zero on settlement day.
This is equivalent to selling 5,000,000/1.06195 = EUR 4,708,319.60
The dealer will pay EUR 4,708,319 on settlement day.
(Exam tip: with an FX swap use the mid-market rate. In this case 1.06195 represents
the mid-market rate.)
These two transactions can be combined as:
5,000,000 / 1.0876 – 5,000,000 / 1.06195 = 111,041
Since the USD appreciated against the euro during the course of the forward
contract, the dealer incurs an outflow.
3. Question 3
The all-in rate that the dealer will use today to sell the USD six months forward
against the EUR is closest to:
o A
1.06689.
o B
1.07147.
o C
1.07152.
Incorrect
C is correct. EUR is the base currency in this example. Selling the USD is equivalent to
buying the EUR, hence the offer side of the market must be used. All-in forward price
= 1.0620 + (95.2/10,000) = 1.07152.
Michael Brennan, is a financial advisor based in South Africa. He advises select high net
worth individuals, and is analyzing two emerging countries, India and South Africa. The data
collected by Brennan is presented below: Mid-market spot rate INR/ZAR: 4.89 One-year
Indian deposit rate: 8.5% One-year South African deposit rate: 7.2%
1. Question 1
Based on uncovered interest rate parity, the expected change in the INR/ZAR rate
is closest to:
o A
a decrease of 1.3 percent.
o B
an increase of 1.3 percent.

o C
An increase of 2.0 percent.

Incorrect
B is correct. According to the uncovered interest rate parity, the expected
appreciation (depreciation) of the INR/ZAR rate is equal to the interest rate
differential between India and South Africa (8.5% and 7.2%) = 8.5 – 7.2 = 1.3%
appreciation of INR/ZAR rate.
2. Question 2
If the analyst expects future INR/ZAR spot rate to equal the forward rate, he is least
likely assuming that:
o A
uncovered interest rate parity holds.

o B
investors are risk neutral.

o C
spot rates follow a random walk.

Incorrect
C is correct. The expected future spot rate is equal to the forward rate if we assume
that uncovered interest rate parity holds. We also assume that investors are risk
neutral. Spot rates do not follow a random walk as current interest rate spreads
determine expected exchange rate movements.
3. Question 3
The INR/ZAR spot rate one year from now is forecasted to be 4.89. This
forecasting least likely assumes that:
o A
spot rates follow a random walk.

o B
uncovered interest rate parity holds.

o C
it is not necessary for uncovered interest rate parity to hold.

Incorrect
B is correct. If uncovered interest rate parity holds, then current spot rate will not be
a predictor of future spot rates unless interest rate differential is equal to 0. If the
current INR/ZAR spot rate is the best predictor of future spot rates, then the
assumption is that exchange rate movements follow a random walk.
4. Question 4
Brennan recommends a client to invest in a 1-year Indian deposit. He also
recommends hedging the currency exposure to INR using a forward rate contract.
The one-year all-in holding return would be closest to:
o A
0 percent.
o B
7.2 percent.
o C
8.5 percent.
Correct
B is correct. Since the exposure to INR is completely hedged, the return would be
what an investment in ZAR would earn, that is, 7.2 percent. This is based on covered
interest rate parity that states that an investment in a foreign money market
instrument that is completely hedged should give the same return as an otherwise
domestic money market investment.
An analyst is evaluating the relative merit of investing in three countries: Norway(NOK),

United Kingdom (GBP), and Switzerland(CHF). He has collated data on their exchange rates
and interest rates presented below. Use the following information to answer questions 24-
26.
Country One year Libor Currency pair Spot rate

NOK 1.05% NOK/GBP 10.5800/10.5900
GBP 0.56% CHF/GBP 1.2510/1.2550
CHF -1.25% NOK/CHF 8.4610/8.4650
1. Question 1
Assuming covered interest rate parity holds, the all-in return on a one-year
investment to a Swiss investor whose currency exposure to the NOK is fully hedged
is closest to:
o A
0.0 percent.
o B
-1.25 percent.
o C
1.05 percent.
Incorrect
B is correct. As per covered interest rate parity, an investment in a foreign money
market instrument (NOK here) that is completely hedged should give the same
return as an otherwise domestic money market investment (CHF).
2. Question 2
Using the midpoint of the bid-offer quote, assuming uncovered interest rate parity
holds, the expected value of CHF/GBP six months from now is closest to:
o A
1.2163.
o B
1.2285.
o C
1.2417.
Incorrect
C is correct. If uncovered interest rate parity holds, then expected spot rate six-
months from now is equal to six-month forward exchange rate. Bid-offer quote
midpoint of CHF/GBP = (1.251+1.255)/2 = 1.253
Se = 1.253 (1+ (-0.0125/2 )) / (1 + 0.0056 / 2) = 1.2417
3. Question 3
Assume uncovered interest rate parity holds. The expected movement in the
NOK/GBP pair one year from now is closest to:
o A
0.00 percent.
o B
0.49 percent.
o C
1.05 percent.
Correct
B is correct. If uncovered interest rate parity holds, then the expected movement in
the spot exchange rate is equal to the interest rate differential = 1.05 – 0.56 = 0.49
percent.
Maev, an emerging market country, is issuing high yield bonds in a bid to attract foreign
investment. The booming economy has been successful in receiving capital inflows from
global funds.
1. Question 1
In the near term, the capital inflows to Maev will least likely result in:
o A
an increase in risk premia.

o B
an increase in inflation expectations.

o C
an increase in real currency value.

Incorrect
A is correct. A booming economy will attract investors and in the near-term cause
the risk premium to decrease.
2. Question 2
Given the excessive capital inflows, Maev’s policy makers are most likely to face which
of the following situations?
o A
Depreciation of the currency value.

o B
Increase in property prices.

o C
Limited investments in risky projects.

Incorrect
B is correct. Excessive capital inflows lead to an unwarranted appreciation of the
currency value, excessive investments in risky projects and financial asset or
property market bubble.
3. Question 3
If capital inflows lead to an unwanted appreciation in the real value of its currency,
Maev’s government would most likely:
o A
implement capital controls.

o B
liberalize fiscal policy.

o C
buy its currency in foreign markets.

Incorrect
A is correct. To reduce unwanted appreciation of its currency, Maev would most
likely impose capital controls to counteract the surging capital inflows.
Economic Growth
1. Question 1
Q-Code: 23-L2-EC-EGID-198209
Which of the following statements is not true according to endogenous growth
model?
o A
The economy does not converge to a steady-state rate of growth that is

independent of saving/investment decisions.
o B
Increasing capital will result in diminishing marginal returns.

o C
Spending on R&D has positive externalities that benefit the whole economy.
Incorrect
B is correct. Unlike the neoclassical model, which assumes diminishing marginal
returns to capital, the endogenous growth models assume investment in capital can
have constant returns. Thus, increasing the saving rate can permanently increase the
rate of economic growth.
2. Question 2
Which of the following factors is least likely to contribute to economic growth?
o A
Free trade
o B
Restrictions on capital flow

o C
Well-developed legal and regulatory system

Incorrect
Solution: B is correct. Restrictions on trade and capital flow is one of the factors
limiting economic growth in developing countries. Other factors limiting growth
include the following:
• Low saving and investment

• Poorly developed financial markets
• Weak and corrupt legal systems; poor law enforcement
• Lack of property rights
• Political instability
• Poor public education and health services
• Tax and regulatory policies which discourage entrepreneurship
• Restrictions on trade
3. Question 3
Which of the following factors is least likely when reviewing projected equity and GDP
growth forecasts?
o A
Extrapolating historical equity returns factors in changes in economic

conditions, valuation changes, and the potential for economic growth.
o B
Long-term real GDP growth rates tend to be far less volatile, especially for
developed economies.
o C
Countries with prudent monetary policies, inflation rates fluctuate less than
stock prices.
Incorrect
A is correct. Extrapolating historical equity returns does not factor in changes in
economic conditions, valuation changes, and the potential for economic growth.
High volatility makes equity returns difficult to predict based on their own history.
Long-term real GDP growth rates tend to be far less volatile, especially for developed
economies because long-term potential growth is driven by slowly evolving
fundamental economic forces. Similarly, for countries with prudent monetary
policies, inflation rates are much less volatile than stock prices. Hence, one could
reasonably place much higher confidence in forecasts of long-term real and nominal
GDP growth than in equity market return forecasts based on historical equity
returns.
4. Question 4
Using the Grinold-Kroner framework, equity market returns can be attributed to:
o A
dividend yield and expansion/contraction of the price-to-earnings ratio
o B
dividend yield, expansion/contraction of the price-to-earnings ratio and

nominal GDP growth only.
o C
dividend yield, expansion/contraction of the price-to-earnings ratio,

nominal GDP growth and change in shares outstanding.
Incorrect
C is correct. Using the Grinold-Kroner framework, equity market returns can be
attributed to (1) dividend yield, (2) expansion/contraction of the price-to-earnings
ratio, (3) nominal GDP growth, and (4) change in shares outstanding.
5. Question 5
Country X is an advanced economy with USD150,000 of capital available for each
worker and thus a high capital-to-labor ratio. In contrast, Country Y is a developing
country with only USD15,000 of capital available for each worker. Which of the
following statements is least accurate about the two countries?
o A
An increase in business investment in both countries results in capital

deepening.
o B
Addition to capital has a bigger impact on growth in Country X

compared to Country Y.
o C
An increase in spending on university research will cause an upward shift in

the production function in both countries.
Incorrect
Solution: B is correct. Addition to capital has a bigger impact on growth in Country Y
compared to Country X. Country Y operates at a low level of capital per worker so
diminishing returns to capital are small. Hence, any addition to capital has a bigger
impact on growth in Country Y. Country X operates at high capital-to-labor ratio, so
additions to capital have little impact on growth because of diminishing returns.
6. Question 6
Which of the following statements is true regarding natural resources?
o A
Relationship between natural resources and growth is complex.

o B
Ownership of natural resources is important, access is not.
o C
Presence of natural resources can never limit growth.

Incorrect
Solution: A is correct. Even though countries with more natural resources are
expected to grow faster, this is not always the case and the relationship between
natural resources and growth is complex.
B is not correct because access to natural resources is important, ownership is not.
Some countries such as Japan and South Korea have grown rapidly but have few
natural resources. Whereas, countries like Venezuela and Saudi Arabia have not
grown much although they have large oil reserves.
C is not correct because for some countries, the presence of natural resources may
even limit growth. This can happen for two reasons:
• Countries rich in natural resources may fail to develop the economic

institutions necessary for growth.
• Countries may suffer from Dutch disease, where currency appreciation
makes other segments of the economy, particularly manufacturing, globally
uncompetitive.
7. Question 7
Which of the following is least accurate about factors affecting growth rate of labor
supply?
o A
An increase in the working age population (age 16-64) is considered positive.

o B
Labor growth due to an increasing labor force participation represents a

permanent trend.
o C
In advanced countries, the long-term trend in average working hours has

been towards a shorter work-week.
Incorrect
B is correct. Growth due to an increasing labor force participation represents a
temporary trend as the participation rate cannot keep increasing indefinitely.
8. Question 8
Consider an economy with per capita income growing at a constant 38% rate and
with a 19% saving rate, an output-to-capital ratio of 0.6515, a depreciation rate of
9%, and a 1% labor force growth. If the savings rate increases to 22%, the new
growth rate of per capita income using endogenous growth model will be closest to:
o A
4.33%
o B
6.33%
o C
5.33%
Incorrect
Solution: A is correct. Using the endogenous growth model, the new growth rate of
per capita will be calculated using the following equation:
∆ye/ye = ∆ke/ke = sc – δ – n = 0.6515*0.22-0.09-0.01=4.33%
9. Question 9
Beginning in steady-state equilibrium, an economy’s saving rate suddenly increases
from 20% of income to 25% of income. Other key parameters describing the
economy are as follows:
1. Growth rate of TFP = 0.025

2. Income share of capital = 0.33
3. Depreciation rate = 0.11
4. Labor force growth rate = 0.01
According to the new classical model, the steady-state output-to-capital ratio

is closest to:
o A
0.6293
o B
0.1573
o C
0.5892
Incorrect
Solution: A is correct. To calculate output to capital ratio, according to the new
classical model, we will use the following equation:
Output per unit of capital =Y / k = (1/s) = [ (θ / 1 -α) + δ + n] = (1/0.25)[(0.025/ (1 –
0.33) + 0.11 +0.01]
10. Question 10
Which of the following is not a criticism of the neo classical model?
o A
Steady state growth rate is considered unrelated to saving and investment

rate.
o B
TFP progress is regarded as endogenous to the model.

o C
According to the model, if capital stock rises faster than labor productivity
then return on investment will decline.
Incorrect
B is correct. TFP progress is regarded as exogenous to the model. It provides no
quantifiable prediction of the rate or form of TFP change.
11. Question 11
Which of the following statements is least accurate about GDP growth?
o A
Real GDP per capita grows if the real GDP grows at a faster rate than the
population.
o B
GDP growth in the large, developed economies has generally slowed over the
last few decades.
o C
GDP for developing countries is generally growing at a slower rate than

developed countries.
Incorrect
C is correct. GDP for developing countries is generally growing at a faster rate than
developed countries.
12. Question 12
Statement 1: Poor countries will only converge to the income levels of the richest
countries if they make appropriate institutional changes.
Statement 2: Convergence to the same level of per capita output and same steady
state growth rate is possible if countries have the same saving rate, population
growth rate and production function.
Which of the above statements refers to the concept of conditional convergence?
o A
Statement 1
o B
Statement 2
o C
Both Statements 1 and 2

Incorrect
Solution: B is correct. Statement 2 refers to conditional convergence which implies
that convergence is conditional on the countries having the same saving rate,
population growth rate and production function. If these conditions hold, the model
implies convergence to the same level of per capita output as well as the same
steady state growth rate.
Statement 1 refers to the concept of club convergence. The basic premise is that
lower-income members of the club are converging to the income levels of the richest
countries. This implies that the countries with the lowest per capita income in the
club grow at the fastest rate.
13. Question 13
Which of the following is least likely supported by empirical evidence?
o A
Some of the poorer countries are converging rather than diverging to

the income levels of the developed countries.
o B
Only rich and middle-income countries that are members of the club are
converging to the income level of the richest countries of the world.
o C
Countries in the non-convergence trap do not implement necessary

institutional reforms.
Incorrect
Solution: A is correct. Empirical evidence suggests that some of the poorer
countries are diverging rather than converging to the income levels of the developed
countries. This leads us to the concept of club convergence: only rich and middle-
income countries that are members of the club are converging to the income level of
the richest countries of the world. Countries with the lowest per capita income in the
club grow at the fastest rate.
Countries outside the club may fall into a non-convergence trap. These are countries
which do not implement necessary institutional reforms and their income levels are
moving further away from the income levels of developed countries.
14. Question 14
Which of the following is a least likely outcome of opening up the economy?
o A
Countries can focus on industries in which they have a comparative

advantage.
o B
Companies have access to a larger, global market resulting in economies of

scale.
o C
Increased competition from global markets, resulting in lower

productivity of local companies.
Incorrect
Solution: C is correct. Increased competition from global markets, forces companies
to produce better products, improve productivity, and keep costs low.
15. Question 15
According to endogenous growth model, a more open trade policy:
o A
has no effect on the rate of economic growth.

o B
will permanently raise the rate of economic growth.

o C
will temporarily raise the rate of economic growth.

Incorrect
B is correct. In contrast to the neoclassical model, endogenous growth models
predict that a more open trade policy will permanently raise the rate of economic
growth.
16. Question 16
Country Z lacks significant natural resources. Which of the following channels will
be least effective in overcoming this challenge to bolster long-term growth?
o A
Deepening the capital base

o B
Making investments in technology

o C
Maintaining a low rupee exchange rate

Incorrect
C is correct. Maintaining a low currency exchange rate is a policy aimed at
maintaining demand for the country’s exports. It might boost long-term capacity
growth indirectly, however, by encouraging adoption of leading-edge technology.
However, it would not be expected to be as powerful as capital deepening and/or
investment in technology.
17. Question 17
Country A is a developed country with a high level of capital per worker. Which of the
following factors would most likely have the greatest positive impact on the per capita
GDP growth of Country A?
o A
Saving and investment

o B
Free trade
o C
Technology
Incorrect
Solution: C is correct. Technological progress can help developed countries, like
Country A, increase productivity and thereby increase per capita GDP. Most
developed countries have low trade barriers; thus, freer trade is likely to have only
an incremental impact on per capita GDP growth. Also, because the country already
has a high capital-to-labor ratio, increased saving/investment is unlikely to increase
the growth rate substantially unless it embodies improved technology.
18. Question 18
The relative shares of labor and capital in Country C, are approximately 0.6 and 0.4,
respectively. According to Solow growth accounting function, all else equal, a 1%
increase in capital will increase output by:
o A
0.4%.
o B
0.6%.
o C
0.2%.
Incorrect
Solution: A is correct. A 1% increase in capital will increase output by 0.4%. The
(Solow) growth accounting equation is as follows:
ΔY/Y = ΔA/A + αΔK/K + (1 – α) ΔL/L
or
Growth rate of output = rate of technological change + α (growth rate of capital) + (1
– α) (growth rate of labor).
The elasticities of capital and labor in the growth accounting equation are the
relative shares of capital (α) and labor (1 − α) in national income and are estimated
from the GDP accounts.
19. Question 19
Which of the following is a least likely outcome of technological progress?
o A
It allows an economy to produce more output with the same amount of

input.
o B
It helps an economy overcome some of the limits of diminishing marginal

returns of capital.
o C
It results in a downward shift in the production function.

Incorrect
Solution: C is correct. Technological progress results in an upward shift in the
production function.
20. Question 20
South Africa has a rapidly growing economy. The country has recorded an average
growth rate of 9 percent over the last few years. The labor input and total factor
productivity data for South Africa is given below.
Growth in hours Growth in labor Growth in Growth due to capital
worked (%) productivity (%) TFP (%) deepening (%)
2.4 7.0 3.3 3.7
Given the data above, the long-term sustainable growth rate in potential GDP
is closest to:
o A
7.0 percent.
o B
9.0 percent.
o C
9.4 percent.
Incorrect
C is correct.
Growth rate in potential GDP = 2.4 % + 7.0% = 9.4%
21. Question 21
In 1960, the real GDP per capita in dollars of India was USD 83.81. In 2013, the per
capita GDP of India was USD 1,498.87. The annual growth rate in per capita GDP for
India over the period 1960 – 2013 is closest to:
o A
5.47 percent.
o B
5.59 percent.
o C
5.61 percent.
Incorrect
B is correct.
The annual per capita GDP growth rate for India over the period 1960-2013 was
5.59%. Growth rate = [(1498.87/83.81)^(1/53)] -1 = 5.59%.
22. Question 22
Annabelle Gracias, an analyst, is analyzing Donican’s economy. Gracias concludes
that eliminating high tariffs on foreign imports will boost Donican’s economy. She
reasons that this will decrease the country’s physical capital stock, improve
productivity and employment, and increase spending on plant and equipment.
Gracias is least likely correct with respect to:
o A
employment.
o B
physical capital stock.

o C
productivity.
Incorrect
B is correct.
Tariffs increase the price of imported goods. If a country introduces tariffs, foreign
countries will not import goods (including capital goods) because they will be
uncompetitive. By eliminating tariffs, there will be an increase in capital goods
coming in from abroad, which will increase the country’s physical capital stock.
23. Question 23
An equity analyst is determining the long-term equity returns for Sweden. The P/E
multiple of the Swedish stock market is at an all-time high of 20.18, a growth rate of
5 percent. The corporate profits to GDP ratio is around its historical average.
Macroeconomic forecasts available to the analyst are listed below:
• Projected long-term real growth rate: 2.10%

• Long-term inflation rate: 0.75%
Based on the macroeconomic forecasts and data available, the long-term equity
returns are closest to:
o A
0.00 percent.
o B
2.10 percent.
o C
2.85 percent.
Incorrect
C is correct.
Equity market appreciation = nominal GDP = 2.1 + 0.75 = 2.85%
P/E and profit share of GDP will be close to zero in the long run.
24. Question 24
A fixed income analyst employed by JP Connors, receives a macroeconomic
forecasting report from a trusted source. The report predicts the GDP growth to be
lower by 3 percent next year. Based on the forecast, the fixed-income analyst
recommends that the company increase its fixed income investments. The reason
for this recommendation is most likely the anticipation of:
o A
lowering of short-term interest rates by the central bank.

o B
upward pressure on inflation.

o C
narrowing output gap.

Incorrect
A is correct.
Central bank may lower interest rates to stimulate economic growth. This will lead to
increase in bond prices.
25. Question 25
Nate Conway is a fixed income analyst, while John Fleming is an equity analyst at an
investment firm. They meet with economist David Pearce to discuss the importance
of potential GDP growth to equity and fixed income investors. Their comments are
as follows:
• Conway: “All else equal estimated potential GDP growth is directly related to
the credit risk of sovereign bonds.”
• Fleming: “In the long run, GDP growth rate, earnings to GDP ratio and price-
to-earnings multiple all contribute to stock market price performance.”
• Pearce: “Potential GDP is used to gauge inflationary pressures. A positive
output gap and actual growth rate higher than the sustainable growth rate
puts upward pressure on inflation, which may lower bond prices.”
Based on the commentary above, the analyst who is most likely correct is?
o A
Conway.
o B
Fleming.
o C
Pearce.
Incorrect
C is correct.
A positive output gap (actual GDP minus potential GDP) and actual GDP growth rate
above the potential growth rate puts upward pressure on inflation. This results in
higher interest rates and lower bond prices. A is incorrect because potential GDP
growth is inversely related to credit risk. B is incorrect because in the long run, only
GDP growth rate drives stock market performance.
26. Question 26
Neru is a developing country with a free trade policy. To boost economic growth, the
central bank has recently liberalized its financial markets and allowed foreign direct
investment in select industries. The economic data of Neru is presented below:
Growth due to capital deepening 1.7% Growth in labor productivity 3.4%

Population growth rate 1.3% Growth in capital 6.2%
Share of labor in GDP 40%
Based on the economic data given above and the growth accounting equation,
the most appropriate conclusion is that GDP growth is driven by:
o A
labor.
o B
capital.
o C
TFP.
Incorrect
B is correct.
Share of capital is α = 0.6 because share of labor is 1- α = 0.4 (given).
ΔA/A = 3.4% – 1.7% = 1.7%; αΔK/K = 0.6 x 6.2 = 3.72%; (1 − α) ΔL/L = 0.4 x 1.3 = 0.52%
GDP growth is driven by capital as it is greater than growth due to labor or TFP.
27. Question 27
Which of the following statements about capital deepening is least likely correct?
Capital deepening:
o A
can be a source of sustained growth in the economy if the marginal

product of capital is less than marginal cost.
o B
increases so long the growth rate of capital is greater than the growth rate of
labor.
o C
cannot be a source of sustained growth if the economy is in steady state.
Incorrect
A is correct.
Capital deepening cannot be a source of sustained growth in economy. The capital-to-
labor ratio increases as long as the growth rate of capital is higher than the growth
rate of labor. If the economy has reached its steady state, then capital deepening
cannot provide sustained growth in the economy. Only when the marginal product
of capital is greater than its marginal cost and the economy is below the steady state
can capital deepening cause a in raise per capita growth.
28. Question 28
Dustin Cranor, an economics student at Phyx University, is writing a thesis on what
promotes economic growth in a country. He discusses the following factors and their
impact on the increase in per capita GDP with a fellow student:
• Investment in the country’s infrastructure.

• Better education and healthcare system.
• Relaxing immigration policies.
Which of the following factors are least likely to increase the rate of per capita GDP?
o A
Better education and healthcare system.

o B
Investment in the country’s infrastructure.

o C
Relaxing immigration policies.

Incorrect
C is correct.
Relaxing immigration policies will boost population growth which will increase the
growth rate of the economy but does not affect the rate of increase in per capita
GDP. Education improves the quality of human capital, and investment in
infrastructure can raise the growth of per capita GDP.
29. Question 29
Neon is a country with an aging population. The country’s population and growth
rate of labor input have been steadily declining. The country has recently relaxed its
immigration policies to increase labor participation rate. The labor input and total
factor productivity data for Neon is given below.
Growth in labor Growth in Growth due to capital Growth in
productivity (in %) TFP (in %) deepening (in %) GDP (in %)
0.3 -0.8 1.1 -0.1
Assume population growth net of immigration is 1 percent for the period 2005-2015.
Using the data given above and the labor productivity growth accounting equation,
the estimated growth rate in potential GDP is closest to:
o A
-0.1 percent.
o B
0.3 percent.
o C
1.3 percent.
Incorrect
C is correct.
Growth rate in potential GDP = growth rate of labor force + growth rate in labor
productivity = 1% + 0.3% = 1.3%.
30. Question 30
Analyst 1: Non – ICT spending can lead to capital deepening and thus have less
impact on potential GDP growth.
Analyst 2: But ICT spending through their network externalities can increase GDP
growth rate.
o A
o B
o C

Incorrect
C is correct. Non-ICT spending may result in capital deepening, therefore will not
influence potential GDP growth. In contrast, an increase in ICT investments in the
economy, may increase potential GDP growth through their externalities.
31. Question 31
Jane Rutledge is a Level II candidate in the CFA program. Rutledge made the
following notes while studying growth theories in economics.
• As per the classical model, the growth in real GDP per person is temporary as
the population explosion will bring it back to its subsistence level.
• As per the neoclassical model, the long-term growth in GDP depends
exclusively on capital deepening investment. The theory also states that
marginal returns to capital will make growth sustainable in the long term.
• As per the endogenous growth model, a higher saving rate is key to a
permanently higher growth rate.
Rutledge’s notes related to which growth theory is least likely correct?
o A
Classical model.
o B
Neoclassical model.
o C
Endogenous growth theory.

Incorrect
B is correct.
Exogenous technological progress is a key tenet of the neo-classical model. As per
the model, long-term growth is not solely dependent on capital deepening
investment as it eventually leads to diminishing marginal returns to capital.
32. Question 32
The labor cost, TFP growth, and labor force growth data for St. Lucia are given below:
Labor cost in total factor

TFP growth (%) Labor force growth (%)
cost (%)
52.3 3.5 1.5
The steady state growth rate in the neoclassical model for St.Lucia is closest to:
o A
6.7 percent
o B
8.2 percent
o C
8.8 percent
Incorrect
B is correct.
Steady-state growth rate = (3.5%/0.523) + 1.5% = 8.2%
33. Question 33
Sharlene Kibblesmith is estimating the growth rates using different models for Palau,
a developing nation. Using the labor productivity growth accounting equation, she
estimates the long-term growth rate in potential GDP to be 5.9 percent. As per the
neoclassical model, her estimate of Palau’s steady state growth rate is 8.4 percent.
Which of the following best explains the reason for the difference in growth rates
between the two methods?
o A
Palau’s economy is operating below the steady state and capital

deepening can increase productivity growth and growth in potential
GDP until it reaches steady state.
o B
Palau has a high per capita income and will grow at a faster rate before
converging with developed countries.
o C
Palau’s economy is operating at the steady state and capital deepening will
increase marginal product of capital and growth in potential GDP.
Incorrect
A is correct. The growth rate in potential GDP (5.9%) is below the steady state growth
rate (8.4%) which means that the economy is operating below the steady state and
capital deepening can increase per capita growth. B is incorrect because Palau will
only grow at a faster rate before convergence if it has a low per capita income. C is
incorrect because the difference in growth rates imply that the economy is not
operating at the steady state.
34. Question 34
David Wolf, a portfolio manager, is comparing the growth rates of Peru, a developing
country, with that of Germany, a developed nation, using the Solow growth
accounting equation. Peru’s per capita income is expected to grow at a higher rate
than that of Germany for some time. Wolf believes both countries will have the same
per capita growth rate in the long term since the neoclassical model assumes that all
countries have access to the same technology. This convergence theory between
Peru and Germany is best described as:
o A
conditional convergence.
o B
club convergence.
o C
absolute convergence.
Incorrect
C is correct. Absolute convergence means that developing countries will eventually
catch up with the advanced countries and have the same per capita output.
Conditional convergence requires countries to have same saving rate, production
function, and population growth rate. Club convergence is restricted to rich and
middle-income countries.
35. Question 35
Justin Marshall is an emerging market analyst evaluating the economic prospects of
two countries, Russia and Colombia. Marshall decides to invest in Russia based on
the following reasons:
• Russia is developed enough to be considered as part of the developed

nations, whereas Colombia is not. Its growth prospects are higher as it has a
lower per capita income than other developed nations.
• Russia is keen on adopting proven technology from other developed
countries.
• Russia is more open to foreign direct investment and technological progress
than Colombia.
Marshall’s reasoning for buying Russian stocks is most consistent with which
economic model?
o A
Classical.
o B
Endogenous.
o C
Neoclassical.
Incorrect
C is correct.
The first reason describes club convergence, while the second reason is a source of
convergence. Neoclassical model states technological progress as the only way to
sustain growth in potential GDP per capita.
36. Question 36
The finance minister of Samoa is discussing with the country’s economic advisor the
impact of the following three policies on per capita income and sustainable long
term growth rate:
• Higher rates of savings and investment.
• Higher spending on R&D and knowledge capital.
• Implementing new technologies.
The chief economic advisor concurs that these policies will not result in diminishing
marginal returns to capital and will permanently increase the growth rate. The
proposed policies are most consistent with which growth model?
o A
Classical.
o B
Neoclassical.
o C
Endogenous.
Incorrect
C is correct.
The Endogenous model does not assume diminishing marginal returns to
capital and increasing the saving rate increases the economic growth rate
permanently.
A is incorrect because the classical model assumes that population growth rises
when the level of per capita income rises above the subsistence income. But the
labor input faces diminishing marginal returns, and the
increase in output eventually declines to zero. B is incorrect as the model assumes
higher capital spending results in diminishing marginal returns and a temporary
increase in growth rate.
37. Question 37
Jason Chiu, an emerging market analyst, has been closely following China and Brazil
over the past decade. His evaluation of the two economies shows that per capita
income of China is slowly converging with that of developed countries, whereas
Brazil’s is not. Which of the following factors least likely explain the reason for non-
convergence of Brazil’s economy?
o A
Brazil has relatively high exports as a percentage of GDP compared to

China.
o B
China has more foreign direct investment than Brazil.

o C
Business investment as a share of GDP is higher in China than Brazil.

Incorrect
A is correct.
Brazil may be a relatively closed and inward-oriented economy if the per capita
income has not converged yet. B and C indicate the reasons for Chinese economy’s
convergence with developed countries.
38. Question 38
Country X is a developed country with a high level of capital per worker. Which of the
following factors will most likely cause the highest increase in GDP growth in Country
X?
o A
Saving and Investment

o B
Free Trade
o C
Improved Higher Education System

Incorrect
C is correct. Developed countries generally have a developed primary and secondary
education system, and so would benefit most from improving their post-secondary
education systems, as this will likely encourage innovation and technological
advances. This will in turn drive economic growth.
Country X already has a high level of capital per worker, so it can be assumed that
the level of savings and investment is already substantial. A further increase will not
have as great an impact on economic growth as that of increased technology from
an improved higher education system.
Developed countries generally have low trade barriers, and so freer trade will have a
relatively small impact on GDP growth in Country X.
Alex Salmon, a professor of economics, is explaining the concept of capital deepening and
determinants of economic growth using a developed country and a developing country as
examples. The economic conditions of both the countries are listed below:
• Denmark is a developed country with $90,000 of capital available per worker.

• Mexico is a developing country with $7,500 of capital available per worker.
Salmon asks his students to analyze the impact of certain factors on the growth rate of
potential GDP.
1. Question 1
If business investment is increased in both the countries, capital deepening occurs.
What will be the most likely effect on potential GDP growth rate ?
o A
Growth rate of potential GDP of Mexico will be higher than that of

Denmark.
o B
Growth rate of potential GDP of Denmark will be higher than that of Mexico
o C
Impact on growth rate of potential GDP is the same for both the countries.
Incorrect
A is correct.
Since Mexico has low capital per worker and small diminishing returns to capital,
additional investment will have a greater impact on potential GDP growth rate than
Denmark.
2. Question 2
Which of the following factors will have a greater impact on the potential GDP
growth rate of Denmark?
o A
An increase in business investment.

o B
An increase in R&D spending and investment in ICT goods.

o C
An increase in business investment, and non-ICT capital spending.

Incorrect
B is correct. Capital deepening has limited impact on the growth rate of potential
GDP for a developed country. Technological progress has a greater impact on the
growth rate of the developed countries.
3. Question 3
If Mexico removes restrictions on foreign investment, then the most likely impact is:
o A
a shift in the production function and increase in growth of potential GDP.

o B
a movement along the production function and increase in growth of

potential GDP.
o C
insignificant growth of potential GDP because of diminishing returns.
Correct
B is correct. The effect of capital deepening through foreign investment is the same
as the effect of an increase in business investment. Only technological progress
results in a shift in the production function. Diminishing returns is small at low levels
of capita to labor, hence higher level of foreign investment will increase the potential
GDP growth rate of Mexico.
Use the data given below to answer next two questions: The key attributes of an
economy are given below:
• Savings rate: 35 percent of income

• Depreciation rate of capital: 0.15
• Growth rate of labor force: 0.02
• Income share of capital: 0.30
• Growth rate of TFP: 0.03
1. Question 1
Given the data above, the steady state growth rate of per capita income is closest to:
o A
2.85 percent.
o B
4.29 percent.
o C
10 percent.
Incorrect
B is correct.
Steady state growth rate of per capita income = 0.03/(1 – 0.3) = 4.29%
2. Question 2
Given the data above, the steady state output-to-capital ratio is closest to:
o A
0.551.
o B
0.608.
o C
0.709.
Correct
B is correct.
Steady state output-to-capital ratio = 1/0.35 x [0.03/(1 – 0.3) + 0.15 + 0.02] = 0.608
Use the following data to answer next 2 questions. Consider an economy with the
following growth parameters:
• Growth rate of per capita income: 4.29 percent

• Savings rate: 35 percent of income
• Output-to-capital ratio: 0.608
• Depreciation rate of capital: 0.15
• Growth rate of labor force: 0.02
1. Question 1
If the savings rate decreases to 30 percent, then the new steady state growth rate of
per capita income using the endogenous growth model will be closest to:
o A
1.24 percent.
o B
1.28 percent.
o C
4.28 percent.
Incorrect
A is correct.
In the endogenous growth model, growth rate of per capita income = (0.30)(0.608) –
0.15 – 0.02 = 1.24 percent
2. Question 2
According to the endogenous growth model, if the savings rate increases to 38
percent, calculate the impact of the higher savings rate on per capita income and
compare it with 4.29% (using the neoclassical model). How much higher will be the
per capita income after 5 years?
o A
1.81 percent.
o B
6.1 percent.
o C
9.5 percent.
Incorrect
C is correct.
Step 1: Calculate the steady state growth rate = (0.38)(0.608) – 0.15 – 0.02 = 6.10
percent
Step 2: Increase in growth rate due to higher saving rate = 6.10 – 4.29 = 1.81 %
Step 3: Calculate cumulative impact of faster growth rate = exp (0.0181 x 5) = 1.095.
So, because of a higher savings rate of 38%, per capita income will be 9.50%
higher than it would have been with the lower savings rate of 35%.
Output per
Total Growth Labor cost
Physical hour worked in
Year hours worked in TFP as percentage
capital stock 2015 adjusted for
(millions) (in %) of total factor cost
PPP
2005 $3,000 26,000 -0.7 60.00 39.6
2015 $4,100 32,000 -1.5 59.60 40.0
Assume the average growth rate in TFP over 10 years is -0.34 percent and the labor share of
output given by the average labor cost as a percentage of total factor cost is 59.8 % for
2005-2015.
1. Question 1
The potential growth rate of Cypriot economy using the growth accounting method
is closest to:
o A
2.2 percent.
o B
2.4 percent.
o C
2.5 percent.
Incorrect
A is correct.
Growth rate in capital = [(4100/3000)^(1/10)] – 1 = 3.2%
Labor input = Growth rate in total hours worked = [(32,000/26,000)^(1/10)] – 1= 2.1%
Share of capital = 1- 0.598 = 0.402
Growth in potential GDP = 0.402 x 0.032 + 0.598 x 0.021 + (-0.0034) = 2.2%
2. Question 2
The amount of growth that can be attributed to labor is closest to:
o A
0.84 percent.
o B
1.26 percent.
o C
1.29 percent.
Incorrect
B is correct.
Growth attributed to labor = 0.598 x 0.021 = 1.26%
3. Question 3
The potential GDP growth rate of Cyprus using the labor productivity method
is closest to:
o A
2.0 percent.
o B
2.1 percent.
o C
2.2 percent.
Incorrect
C is correct.
Growth in labor force = [(32,000/26,000)^(1/10)] – 1= 2.1%
Growth in labor productivity per hour worked = [(40/39.6)^(1/10)] – 1 = 0.1%
Growth in potential GDP = 2.1 + 0.1 = 2.2%
Economics Regulation
1. Question 1
Q-Code: 23-L2-EC-ECOF-198246
Which of the following issues that regulators try to address are related to
informational frictions?
o A
moral hazard.
o B
positive externalities.
o C
negative externalities.
Incorrect
Solution: A is correct. Informational frictions result in a variety of issues that
regulators try to address. These issues include:
• Moral hazard: incentive conflicts that arise from the delegation of decision-
making to agents or from contracts which will affect the behavior of one
party to the detriment of the counterparty.
• Adverse selection: private information in the hands of some market
participants which affects the consumption of goods and services.
2. Question 2
Prudential supervision is primarily concerned with:
o A
ensuring that the optimal amount of a public good is produced.

o B
stability of the financial system.

o C
promoting competition.
Incorrect
B is correct. Prudential supervision focuses on promoting financial stability and
reducing system-wide risks.
3. Question 3
Which of the following statements regarding commerce related issues that need
regulatory intervention is least accurate?
o A
Environmental issues such as pollution arise at the local level only.

o B
Absence of patents and copyrights diminish the incentive for R&D.

o C
Misuse of private and public information by internet companies needs to be

prevented.
Incorrect
Solution: A is correct. Environmental issues such as pollution tend to be both at a
regional level as well as a global level. International mechanisms are required to
facilitate the coordination and acceptance of responsibilities among national
governments.
4. Question 4
Which of the following policies will be least likely implemented to regulate commerce?
o A
Subsidies to encourage domestic production.

o B
Antitrust laws to block mergers and acquisitions.

o C
Allowing price collusion.

Incorrect
C is correct.
Regulators keep a check on price collusion as it is anti-competitive behavior.
5. Question 5
Financial markets are regulated in order to:
o A
protect intellectual property.

o B
prevent failures of financial systems.

o C
promote international trade.

Incorrect
B is correct. Financial markets are regulated to prevent financial systems from failing
and to avoid financial crises.
6. Question 6
In response to antitrust issues, regulators are least likely to:
o A
lift monetary sanctions.
o B
ask certain companies to divest portions.

o C
change operating practices or change marketing practices.

Incorrect
Solution: A is correct. Regulators may impose monetary sanctions in response to
antitrust issues.
7. Question 7
Which of the following is least likely to be classified as anti-competitive behavior?
o A
Predatory pricing.
o B
Pricing discrimination.
o C
Geographic divestiture of business segments.

Incorrect
C is correct.
Divestiture of business segments along with monetary sanctions are steps taken by
regulators to resolve antitrust issues.
8. Question 8
Plif, a leading ecommerce fashion retailer, merges with its largest competitor, Tyn.
The merged entity because of economies of scale, slashes prices of its products by
more than 80% to increase sales. The antitrust risk associated with the given
business strategy is most likely:
o A
exclusive pricing.
o B
predatory pricing.
o C
fair dealing.
Incorrect
B is correct.
Engaging in predatory pricing is anticompetitive behavior and hence may be subject
to antitrust laws.
9. Question 9
Which of the following is least likely a distinctive feature of independent regulators
compared to government agencies?
o A
Independent regulators rely on government funding.

o B
They have a higher degree of autonomy in decision-making.

o C
They are, to an extent, immune from political pressure.

Incorrect
Solution: A is correct. The major distinction between government agencies and
independent regulators is that independent regulators typically do not rely on
government funding. This gives them a degree of autonomy in decision-making.
They are also, to an extent, immune from political pressure.
10. Question 10
Dodd Frank Act is an example of a/an:
o A
administrative regulations or administrative law.

o B
statute.
o C
judicial law.
Incorrect
Solution: B is correct. Dodd-Frank Act in the United States is an example of a statue
which is a law enacted by a legislative body.
11. Question 11
‘Interpretation of courts’ can be classified as:
o A
statues.
o B
administrative law.
o C
judicial law.
Incorrect
C is correct. Regulations can be classified as reflecting laws enacted by legislative
bodies (statutes), rules issued by government agencies or other regulators
(administrative regulations or administrative law), and interpretations of courts
(judicial law).
12. Question 12
Statement 1: Independent regulators are given legal authority by the government to
enforce new statutes.
Statement 2: SROs can issue administrative regulations related to the new statutes
using government funding.
Which of the following statements is correct?
o A
Statement 1
o B
Statement 2
o C
Both statements are correct.

Incorrect
Solution: A is correct. Self-regulating bodies cannot issue administrative regulations
related to the new statutes using government funding. They are meant to be
independent from government and immune to its influence.
13. Question 13
Which of the following situations can most likely lead to ‘race to the bottom’?
o A
Regulatory capture
o B
Regulatory competition
o C
Regulatory arbitrage
Incorrect
B is correct. Regulatory competition can lead to a “race to the bottom”, where
countries continually reduce their regulatory standards to attract as many
companies as possible.
14. Question 14
Assume that a stricter regulatory act is repealed and replaced with a simpler act that
allows banks to increase their leverage. The new regulation is likely to have a positive
impact on the profitability of the banking industry. This is an example of regulatory:
o A
capture.
o B
arbitrage.
o C
competition.
Incorrect
A is correct.
Changes in regulations which enhance the interests of the regulated entities (banks
in this case) is an example of regulatory capture.
15. Question 15
After fresh deposits of iron ore were discovered along the Ghana/Togo border, a
number of iron and steel manufacturing plants were set up in both the countries.
This was expected to boost their per capita GDP. The government of Ghana is
planning to pass a clean water and air act to control pollution in the area. However, a
possible outcome of the government action could be the relocation of the
manufacturing plants to Togo. This is least likely because of:
o A
regulatory arbitrage.
o B
regulatory capture.
o C
regulatory competition.
Incorrect
B is correct. “Regulatory differences across jurisdictions can lead to shifts in location
and behavior of entities because of regulatory competition and regulatory arbitrage.”
16. Question 16
Suzy Kilner, a global equity analyst is studying the regulatory norms of two potential
emerging markets: Sulny and Drizny. Kilner makes an interesting observation:
Sulny’s insider trading rules have not been amended since 1992 leaving several
loopholes, whereas Drizny’s market regulator recently made several amendments to
close the gap in insider trading rules. Drizny’s rules are stringent. Kilner believes
investors are likely to exploit the regulatory differences between the two countries to
their benefit because of:
o A
A. regulatory competition.
o B
o C
externalities.
Incorrect
B is correct.
Differences in regulations across jurisdictions with less stringent regulations lead to
17. Question 17
The Basel Committee on Banking Supervision and The International Organization of
Securities Commission were established to reduce:
o A
o B
o C
both A) and B).

Incorrect
C is correct. As most governments have recognized the importance of global
regulatory cooperation and coordination, the Basel Committee on Banking
Supervision and the International Organization of Securities Commission were
established to reduce regulatory competition and regulatory arbitrage.
18. Question 18
According to Coase Theorem, the allocation of property rights will be efficient if
o A
an externality can be traded and there are no transaction costs.

o B
an externality cannot be traded and there are no transaction costs.

o C
an externality can be traded and there are transaction costs.

Incorrect
Solution: A is correct. “Coase Theorem”, which states that if an externality can be
traded and there are no transaction costs, then the allocation of property rights will
be efficient and the resource allocation will not depend on the initial assignment of
property rights.
19. Question 19
East Side is a popular residential neighborhood of Cago, a city in Durnsia. A few
years ago, the municipal commission of the city granted licenses for restaurants to
be opened in the neighborhood. Now, residents want all of them closed by a certain
time because of the noise pollution. The municipal commission has designed a
system in which the restaurants bid on rights to stay open until midnight each
month. Consequently, the winning bidder receives the right to close at midnight.
Violation of the regulation results in payment of a fine. The trading of closing hours’
rights results in optimum noise pollution levels. This practice to control noise
pollution is most consistent with:
o A
the Coase theorem.

o B
regulatory capture.
o C
Incorrect
A is correct. According to the Coase theorem, trading on an externality without any
transaction costs results in efficient allocation of the property rights.
20. Question 20
The risk of faltering economy infecting other, healthier economies is most likely
referred to as:
o A
regulatory capture.
o B
financial contagion.
o C
systemic risk.
Incorrect
B is correct. Financial contagion is a situation in which financial shocks spread from
their place of origin to other regions; or in other words, a faltering economy infects
other, healthier economies.
21. Question 21
Which of the following is not an example of a regulatory tool used to intervene in
financial markets?
o A
Short-selling restrictions
o B
Black-out periods
o C
Minimum capital requirements for banks

Incorrect
Solution: B is correct. Blackout periods are established by companies in response to
concerns about insider trading. During this period, insiders are banned from trading
on the company’s stock (these periods often precede earnings announcements and
continue for a short while afterward). Thus, blackout periods are not a tool used by
regulators to intervene in the financial services sector.
22. Question 22
An analyst makes the following statements regarding the analysis of regulations:
Statement 1: The regulatory burden refers to the private costs of regulation less the
private benefits of regulation.
Statement 2: Regulatory costs and benefits are more difficult to assess on a
prospective basis than a retrospective basis, which is why analysts often conduct an
after-the-fact analysis.
Which statement is most likely correct?
o A
Statement 1 is correct.
o B
o C

Incorrect
B is correct. Statement 1 is incorrect because it defines the net regulatory burden.
The regulatory burden is simply the costs of regulation for the regulated entity.
23. Question 23
Which of the following statements is least accurate about regulatory cost benefit
analysis?
o A
Regulators should only consider implementation costs of regulation.

o B
Retrospective analysis allows for a more informed assessment of whether

any changes need to be made to the regulation.
o C
New regulations can be first tested in a sandbox environment.

Incorrect
Solution: A is correct. Regulators should consider both the implementation costs of
regulation as well as the indirect costs. Indirect costs refer to the way in which
economic decisions and behaviour are altered and market allocation changed.
Sometimes there may be costs that were unanticipated.
24. Question 24
Statement 1: Regulatory filings and consultations in response to proposed
regulations identify at least some of the “unintended consequences” prior to the
implementation of the regulations.
Statement 2: Unintended consequences are reflective of underlying policy risk and
may result in high unanticipated costs.
Which of the above statements is correct about unintended consequences of

regulation?
o A
Statement 1
o B
Statement 2
o C

Incorrect
Solution: C is correct. Statement 1 is correct because regulatory filings, in response
to proposed regulations, often identify at least some of the unintended
consequences prior to the implementation of the regulation. Statement 2 is correct
because the cost of unintended consequences, including both indirect costs and
unanticipated implementation costs, can be high.
25. Question 25
An equity analyst is responsible for the manufacturing sector in a Country A. The
regulatory authorities are preparing new rules to reduce carbon emissions by
manufacturing companies. What is likely to be of least concern to the analyst when
evaluating the impact of the new rules on companies?
o A
Risk of fines and ban on certain activities as a result of non-compliance.

o B
Changes to operating costs to ensure compliance with the new regulation.

o C
Health care cost savings in the society as a result of reduced pollution.

Incorrect
Solution: C is correct. Options C relate to cost–benefit analysis carried out by the
regulatory authority.
26. Question 26
Regulation Q imposed a ceiling on the interest rates paid by banks for various types
of deposits. After regulation Q was imposed, the demand for money market
funds most likely:
o A
increased.
o B
decreased.
o C
remained unchanged.
Incorrect
A is correct. Regulation Q set a ceiling on the interest rates paid by banks for various
types of deposits, which resulted in investors’ shifting funds to money market funds.
David Moketsi, an economist at Beacon Capital, is analysing the regulatory environment in

Country X and Country Y. Sarah Jones, an associate at Beacon, is assisting him in the
analysis. Research conducted by Jones reveals that the regulator in Country X is dominated
by individuals who seem to be keen on enhancing the interests of the regulated entities.
Some of the recent regulatory actions include restricting potential competition and price
controls. On the other hand, the regulator in Country Y is amending regulations to attract
foreign investors. In this regard, some proposals under consideration include tax benefits,
duty-free import of production-related materials and zero VAT on local materials sourced.
Some of the statements made by Jones in her report on the two countries are listed
below: Statement 1: Free market mechanisms cannot be used to control externalities, such
as pollution, facing the countries. Statement 2: Governments can intervene in markets
through the use of price mechanisms only. Statement 3: A cost-benefit analysis should be
conducted before any new regulation is implemented. Subsequently, Moketsi and Jones met
the equity research team of Beacon to brief the analysts on the findings of the research.
One of the points discussed in the meeting was that the government in Country X is
preparing new rules on carbon emissions by industrial companies. These rules aim at
limiting the age and exhaust emissions of the equipment used by industrial companies.
1. Question 1
Regulatory environment in Country X is most likely an example of:
o A
o B
o C
regulatory capture.
Incorrect
C is correct. According to the regulatory capture theory, the regulator is often
dominated by individuals who are closely connected with the industry they should
be regulating. In such situations, the regulator might be more interested in
enhancing the interests of the regulated entities rather than society.
2. Question 2
Which of the following statements is not correct?
o A
Statement 1
o B
Statement 2
o C
Neither A) nor B)
Incorrect
C is correct. Statement 1 is not correct because free market mechanisms can be
used to control externalities such as pollution. The is consistent with Coase Theorem
which theorem states that if an externality can be traded and there are no
transaction costs, then the allocation of property rights will be efficient and the
resource allocation will not depend on the initial assignment of property rights.
Statement 2 is not correct because, in addition to price mechanisms, governments
can intervene in markets through:
• restricting some activities (for example, insider trading and short selling)
• mandating some activities (for example, capital requirements for banks)
• providing public goods (for example, national defense and transportation
infrastructure)
• financing private projects that the government believes will benefit society
3. Question 3
Regulatory initiatives taken by Country Y most likely signify:
o A
arbitrage
o B
competition
o C
capture
Incorrect
B is correct. Regulatory competition refers to a situation where regulators compete
with each other to provide a regulatory environment designed to attract certain
entities. Regulatory competition can lead to a “race to the bottom”, where countries
continually reduce their regulatory standards to attract as many companies as
possible.
4. Question 4
A cost benefit analysis of implementing new regulation takes into account:
o A
implementation cost.
o B
indirect cost.
o C
Both A) and B).

Incorrect
C is correct. Regulators should consider both the implementation costs of regulation
(for example, cost of hiring cost of hiring additional compliance attorneys) as well as
the indirect costs. Indirect costs refer to the way in which economic decisions and
behavior are altered and market allocation changed. Sometimes there may be costs
that were unanticipated.
5. Question 5
What is most likely to be of greatest concern to analysts when evaluating the impact
of the new rules on industrial companies?
o A
Health care cost savings due to improved air quality.

o B
Increase in capital expenditure and operating costs of industrial

companies to comply with the new regulation.
o C
The costs considered by the regulator when conducting cost benefit analysis
for the new regulation.
Correct
B is correct. The analysts would need to analyze the impact of the proposed
regulations on the performance of companies.
A and C relate to cost–benefit analysis carried out by the regulatory authority.
FSA
Intercorporate Investments
1. Question 1
Q-Code: 23-L2-FR-ININ-198287
Which of the following statements is least accurate about IFRS 9?
o A
The terms for available-for-sale and held-to-maturity no longer appear in IFRS

9.
o B
The new categories of measurement are amortized cost, FVPL and FVOCI.
o C
It has the same approach to loan impairment.

Incorrect
Solution: C is correct. IFRS 9 has a different approach to loan impairment. With the
new standard, we move from the incurred loss model to the expected credit loss
model. Therefore, we not only consider historical and current information about
loan performance, but also consider forward-looking information.
2. Question 2
Which of the following statements regarding IFRS 9 is correct?
Statement 1: This accounting standard has led to a significant convergence between

IFRS and US GAAP in terms of reporting for investments in financial assets.
Statement 2: This standard replaced IAS 39 and was effective for annual periods
beginning on or after 1st January 2019.
o A
Statement 1
o B
Statement 2
o C
Both statements 1 and 2

Incorrect
A is correct. Statement 1 is correct. Statement 2 is incorrect because IFRS 9 was
effective for annual periods beginning on or after 1st January 2018.
3. Question 3
Which of the following measurement approaches will not be used to measure equity
instruments under IFRS 9?
o A
Amortized costs
o B
FVOCI
o C
FVPL
Incorrect
Solution: A is correct. Equity instruments are measured at FVPL or FVOCI. They
cannot be measured at amortized cost.
Debt instruments are measured at amortized costs, FVOCI or FVPL depending on the
business model.
4. Question 4
An investment is least likely to be considered an associate company if the investor
has:
o A
significant influence over the investee’s business activities.

o B
control over the investee’s business activities.

o C
20 – 50% ownership or voting power of the investee.

Incorrect
Solution: B is correct. An investment is considered an “associate company” when the
investor has (or can exercise) significant influence, but not control, over the
investee’s business activities. Significant influence is presumed with 20 – 50%
ownership or voting power of the associate (investee).
5. Question 5
The equity method is not used to account for:
o A
associates.
o B
joint ventures.
o C
business combinations.
Incorrect
C is correct. The equity method is used to account for investments in associates and
joint ventures. Both IFRS and US GAAP now require business combinations to be
accounted for using the acquisition method, which replaces the purchase method.
6. Question 6
Capricorn, Inc., is a diversified manufacturing company based in UK. In 2015, it held a
19% ownership interest in Gabole Limited and was considered to have significant
influence. To account for its investment in Gabole, the method most likely used by
Capricorn was:
o A
the equity method.

o B
fair value through profit or loss.

o C
available-for-sale.
Incorrect
A is correct. Although Capricorn had less than 20% ownership interest in Gabole, it
was considered to have significant influence, which required the equity method.
7. Question 7
Company A recently acquired a 55% stake in Company B. Which of the following
methods will Company A use to account for its investment in Company B?
o A
Equity method
o B
Purchase method
o C
Acquisition method
Incorrect
C is correct. When the parent company has a controlling interest usually (at least) a
50% ownership stake and control over the subsidiary, the acquisition method is
used.
8. Question 8
Company A owns 40% of the voting shares in Company B and is able to control
Company B. Under U.S. GAAP which of the following methods is most appropriate to
use?
o A
Equity method.
o B
Proportionate consolidation method.

o C
Acquisition method.
Incorrect
C is correct. It is possible to control with less than a 50% ownership interest. In this
case, the investment is still considered controlling and the acquisition method would
be most appropriate.
9. Question 9
Which of the following statements is least likely correct regarding the equity method?
o A
Under both IFRS and US GAAP, companies must disclose assets, liabilities,
and results of equity method investments.
o B
The investor’s ownership in the investee company is presented as a single

line item because equity method is effectively a one-line consolidation.
o C
The percentage a company owns in another company is more important

than its level of influence on operations when categorizing an
investment as either an associate or a financial asset.
Incorrect
C is correct. The level of influence the investing company has on the investee’s
operations is more important than the percentage ownership when categorizing
investments in financial assets. The general range for an investment in associates is
20% to 50%, but this does not need to be strictly followed. An investing company
may own less than 20% in another company, but if it has significant influence on the
investee, it is considered to have invested in an associate and must use the equity
method to account for it. Conversely, if a company owns 25% of a company but does
not have significant influence on its operations, the investment is not considered an
associate. Therefore, the level of influence is more important than the percentage
ownership when classifying investments in financial assets. Both A and B are correct
statements.
10. Question 10
Fivestar Corp. purchases a 30% interest in Sherwood for US$300,000 on 1 January
2019. Sherwood reports income and dividends as follows:
Income Dividends
2019 US$150,000 US$25,000
2020 225,000 50,000
2021 310,000 95,000
Total US$685,000 US$170,000
The investment in Sherwood that appears on Fivestar’s balance sheet as of the end
of 2021 is:
o A
US$815,000
o B
US$454,500
o C
US$934,000
Incorrect
Solution: B is correct.
Value of investment = beginning value + share of profits – share of dividends
Value of investment on balance sheet = US$300,000 + 0.3*685,000 – 0.3*170,000 =
454,500.
11. Question 11
Assume that Quart Co. acquires 30% of the outstanding shares of Redwood Co for
US$100,000. At the acquisition date, book values and fair values of Redwood’s
recorded assets and liabilities are as follows:
Book Value Fair Value

Current assets US$15,000 US$15,000
Plant and equipment 151,000 203,000
Land 135,000 147,000
Total Assets US$301,000 US$365,000
Book Value Fair Value
Liabilities 125,000 125,000
Net assets US$176,000 US$240,000
Quart Co. believes that the value of Redwood Co. is higher than the book value of its
identifiable net assets. The goodwill is determined as:
o A
US$28,000
o B
US$47,200
o C
US$31,600
Incorrect
A is correct.
Purchase price US$100,000

Proportionate share in Redwood’s assets:
52,800
30% of book value of Redwood (30% × US$176,000)
Excess purchase price US$47,200
Attributable to net assets (fair value of assets – book value of assets)
Plant and equipment (30% × [US203,000–��151,000]) US$15,600
Land (30% × [US147,000–��135,000]) 3,600
Goodwill (residual) US$28,000
12. Question 12
On 1 January 2018, Lancewood Company acquired 30% of Wartford Inc. common
shares for the cash price of €450,000. It is determined that Lancewood has the ability
to exert significant influence on Wartford’s financial and operating decisions. The
following information concerning Wartford’s assets and liabilities on 1 January 2018
is provided:
Wartford, Inc.
Book Value Fair Value Difference
Current assets €90,000 €90,000 €0
Plant and
1,700,000 2,000,000 300,000
equipment
Total Assets €1,790,000 €2,090,000 €300,000
Liabilities 700,000 700,000 0
Net assets €1,090,000 €1,390,000 €300,000
The plant and equipment are depreciated on a straight-line basis and have 10 years
of remaining life. Wartford reports net income for 2018 of €150,000 and pays
dividends of €60,000. Investment in the associate at the end of 2018 will be reported
at:
o A
€468,000
o B
€477,000
o C
€486,000
Incorrect
A is correct.
Using the amortization rule, the investment in associate will be calculated mas
follows:
Purchase price €450,000

Lancewood’s share of Wartford’s net income (30% × €150,000) 45,000
Dividends received (30% of €60,000) (18,000)
Excess purchase price attributable to plant and equipment = 30% *
300,000 = €90,000
(9,000)
Amortization of excess purchase price attributable to plant and
equipment (€90,000 ÷ 10 years)
31 December 2018 balance in investment in Wartford €468,000
13. Question 13
Under which of the following, the option to account for equity method investment at
fair value is available to all investing entities?
o A
IFRS
o B
US GAAP
o C
Both IFRS and US GAAP

Incorrect
Solution: B is correct. Both IFRS and US GAAP give the investor the option to account
for their equity method investment at fair value. Under US GAAP, this option is
available to all entities; however, under IFRS, its use is restricted to venture capital
organizations, mutual funds, unit trusts, and similar entities, including investment-
linked insurance funds.
14. Question 14
Under which of the following, an impairment loss is recognised in the income
statement?
o A
IFRS
o B
US GAAP
o C

Incorrect
C is correct. Under both IFRS and US GAAP, an impairment loss is recognized in the
income statement.
15. Question 15
On 1 January 2017, Orange Grove Company acquired a 20% interest in Crystal
Company for €900,000 and used the equity method to account for its investment.
The book value of Crystal’s net assets on that date was €3,900,000. All fair values of
assets and liabilities were equal to book values except for a building. The building
was undervalued by €45,000 and has a 20-year remaining life. The company used
straight-line depreciation for the building. Crystal paid €4,300 in dividends and
reported net income of €30,000. During the year, Crystal sold inventory to Orange
Grove. At the end of the year, there was €9,000 profit from the upstream sale in
Crystal’s net income. The inventory sold to Orange Grove by Crystal had not been
sold to an outside party.
The investment in Crystal on 31 December 2017 will be reported at:
o A
€902,890
o B
€904,610
o C
€895,390
Incorrect
Solution: A is correct. Prior to calculating the investment value, the equity income is
calculated as follows:
The unrealized profit of €1,800 is subtracted because the sale has not been
confirmed by a third party yet.
Orange Grove’s share of Crystal’s reported income (20% × €30,000)
Amortization of excess purchase price attributable to the building, ((20% * €45,000)
÷ 20)
Unrealized profit (20% × €9,000)
Equity income 2017
Investment in Crystal is calculated as:
Investment in Crystal on 31 Dec., 2011 = Initial purchase price + Orange Grove’s
share of net income – dividends = €900,000 + €3,750 – €860 = €902,890.
16. Question 16
Lotte Company owns 20% of Acme Company; it uses the equity method of
accounting. Amortization of excess purchase price, related to undervalued assets at
the time of the investment, is €6,500 per year. During 2019, Lotte sold €85,000 of
inventory to Acme for €135,000. Acme resold €108,000 of this inventory during 2019.
The remainder was sold in 2020. Acme reports income from its operations of
€710,000 in 2019 and €750,000 in 2020.
The equity income to be reported as a line item on Lotte’s 2019 and 2020 income
statements will be:
o A
€133,500 for 2019 and €145,500 for 2020

o B
€135,500 for 2019 and €143,500 for 2020

o C
€136,500 for 2019 and €147,500 for 2020

Incorrect
Solution: A is correct.
In this case, there downstream sale of inventory from Lotte to Acme. Let’s calculate
the unrealized profit first.
Lotte’s profit on the sale of inventory to Acme = €135,000 − 85,000 = €50,000
Acme sells 80% (€108,000/135,000) of the goods purchased from Lotte; 20% is
unsold. 80% of the profit is realized.
Total unrealized profit = €50,000 × 20% = €10,000
Lotte’s share of the unrealized profit = €10,000 × 20% = €2,000
The equity income for 2019 is calculated as follows:
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Lotte’s share of Acme’s reported income (20% × €710,000) €142,000

Amortization of excess purchase price (6,500)
Unrealized profit (20% × €10,000) (2,000)
Equity income 2019 €133,500
Equity income for 2020 is calculated as:
Lotte’s share of Acme’s reported income (20% × €750,000) €150,000
Amortization of excess purchase price (6,500)
Realized profit (20% × €10,000) 2,000
Equity income 2012 €145,500
17. Question 17
Which of the following is least likely a challenge faced by analysts in equity method
accounting?
o A
Appropriateness of the equity method for investors.

o B
Restrictions on dividends.
o C
Non-disclosure of assets, liabilities, and the results of equity method

investments.
Incorrect
Solution: C is correct. Both IFRS and US GAAP require companies to disclose assets,
liabilities, and the results of equity method investments. This information is
presented in the footnotes to the financial statements.
A and B are challenges faced by analyst in equity method accounting.
18. Question 18
Under the US GAAP, after the business combination, none of the earlier companies
continue to exist and a new legal entity is formed in case of:
o A
Merger
o B
Consolidation
o C
Acquisition
Incorrect
Solution: B is correct. In case of consolidation, after the combination, none of the
earlier companies continue to exist and a new legal entity is formed.
Company A + Company B = Company C
19. Question 19
On 1 July 2014, La Chateaux, headquartered in France acquired Mt. St. Michaels SA, a
ski resort in the Alps region of France. Chateaux paid €22 million for 100% of the
company. The following shows selected data from the financial statements of Mt. St.
Michaels at acquisition in € thousands.
Total assets (*) 52,400

Total liabilities 29,600
Share capital 15,000
Retained earnings 7,800
(*) The 30 June 2014 Statement of Financial Position reflects the fair value of the
identifiable assets and liabilities of Mt. St. Michaels at acquisition.
Under the acquisition method, the Mt. St. Michaels purchase price allocation most
likely resulted in which of the following for La Chateaux?
o A
A gain of €800,000.
o B
An increase in retained earnings of €7,800.

o C
A loss of €800,000.
Incorrect
A is correct. The acquisition was a bargain purchase for La Chateaux:
Price paid for 100% €22 million

Fair value of the net assets (€ thousands)
Share capital + Retained earnings = 15,000 + 7,800 22,800
Negative goodwill in thousands –€800
Negative goodwill is recognized immediately as a gain in profit or loss.
20. Question 20
Soweto Corp contributes USD935,000 for an 85% interest in Nyala Corp. The
identifiable net assets have a fair value of USD1,000,000. The fair value of the entire
entity is determined to be USD1.1 million. The partial and full goodwill will be
determined as:
o A
USD85,000 as partial goodwill and USD100,000 as full goodwill

o B

o C
Incorrect
A is correct. IFRS permits partial and full goodwill, while US GAAP only allows full
goodwill.
IFRS – Partial Goodwill

Fair value of consideration $935,000
85% of Fair value of identifiable net
850,000
assets
Goodwill recognized $85,000
IFRS and US GAAP Full Goodwill
Fair value of entity $1,100,000
Fair value of identifiable assets 1,000,000
Goodwill recognized $100,000
21. Question 21
Which of the following is least accurate about combination balance sheet post 100%
acquisition?
o A
The book values of assets and liabilities of the acquiring entity are added to
the fair value of the assets and liabilities of the acquiree.
o B
Stock is measured at fair value under both IFRS and US GAAP.

o C
At the acquisition date, retained earnings of both the acquirer and the
acquiree are included in the combined entity.
Incorrect
C is correct. At the acquisition date, only the acquirer’s retained earnings are
included in the combined entity. The earnings of the acquiree are included in the
consolidated income statement and retained earnings only in post-acquisition
periods.
22. Question 22
Under which of the following methods, the non-controlling interest is measured
using either the full goodwill or partial goodwill method?
o A
IFRS
o B
US GAAP
o C

Incorrect
Solution: A is correct. Under IFRS, the non-controlling interest is measured using
either the full goodwill or partial goodwill method. Under US GAAP, the parent must
use the full goodwill method.
23. Question 23
On 1 January 2019, ABC Co. acquired 90% of the outstanding shares of Target Co. in
exchange for shares of ABC Co.’s no par common stock with a fair value of €170,000.
The fair market value of Target’s shares on the date of the exchange was €190,000.
Below is selected financial information from the two companies immediately prior to
the exchange of shares:
The value of goodwill and the value of the non-controlling interest at the acquisition
date under the full goodwill method will be:
Goodwill Non-Controlling Interest

A. €45,000 €24,500
B. €71,000 €11,000
C. €80,000 €19,000
o A
Option A.
o B
Option B.
o C
Option C.
Incorrect
C is correct. Full goodwill method is required under US GAAP and optional under
IFRS.
Fair value of the subsidiary’s shares is given as €190,000.
Goodwill = total fair value of the subsidiary – the fair value of the subsidiary’s
identifiable net assets = €190,000 – €110,000 = €80,000
The value of the non-controlling interest under full goodwill method = non-
controlling interest’s proportionate share of the Target’s fair value = 10% * 190,000 =
€19,000
24. Question 24
Using data given in Question 17, the value of goodwill and the value of the non-
controlling interest at the acquisition date under the partial goodwill method will
be
Goodwill Non-Controlling Interest

A. €45,000 €24,500
B. €71,000 €11,000
C. €80,000 €19,000
o A
Option A.
o B
Option B.
o C
Option C.
Incorrect
Solution: B is correct. The partial goodwill method is permitted only under IFRS.
Goodwill = Purchase price – parent’s proportionate share of the subsidiary’s net
identifiable assets
Goodwill = €170,000 – 90% of 110,000 = €71,000
Value of the non-controlling interest = proportionate share of the fair value of the
subsidiary’s identifiable net assets = 10% of €110,000 = €11,000
25. Question 25
The cash-generating unit of a German company has a carrying value of €1,200,000,
which includes €250,000 of allocated goodwill. The recoverable amount of the cash-
generating unit is determined to be €1,100,000, and the estimated fair value of its
identifiable net assets is €1,000,000. According to IFRS, the impairment loss would
be:
o A
€100,000
o B
€200,000
o C
€250,000
Incorrect
The unit is impaired since the carrying value is more than the recoverable value.
Impairment loss = recoverable amount – carrying value.
Impairment loss of €100,000 is reported on the income statement and the goodwill
is reduced to €150,000.
26. Question 26
A reporting unit of a US corporation has a fair value of USD1,500,000 and a carrying
value of USD1,725,000 that includes recorded goodwill of USD225,000. The
estimated fair value of the identifiable net assets of the reporting unit at the
impairment test date is USD1,400,000. Under US GAAP, the impairment loss will be:
o A
S225,000
o B
$125,000
o C
$100,000
Incorrect
Solution: B is correct.
Under US GAAP, the impairment loss is calculated using a two-step approach as
outlined below:
Step 1: Determine if there is an impairment: is fair value < carrying value?
Since the fair value of the reporting unit is less than its carrying book value, a
potential impairment loss has been identified. Fair value of unit: 1,500,000<1,725,000
Step 2: Calculate the impairment loss
An impairment loss of $125,000 is reported on the income statement.

27. Question 27
Which of the following methods is most likely to report the lowest leverage?
o A
Equity Method
o B
Acquisition method (partial goodwill)

o C
Acquisition method (partial goodwill)

Incorrect
Solution: A is correct. The following table compares the effect of equity method and
acquisition method on ratios:
Acquisition method Acquisition method

Equity method
(partial goodwill) (full goodwill)
Higher (full Higher (full
Sales Lower
consolidation) consolidation)
Net income Same Same Same
Assets Lower (net assets) Higher (all assets) Higher (all assets)
Liabilities Lower Higher (all liabilities) Higher (all liabilities)
Slightly higher
Equity Net assets Net assets relative to partial
goodwill method
Lower (less favorable Lower (less favorable
Net profit Higher (most
because revenue is because revenue is
margin favorable)
higher) higher)
Higher (slightly better
Lower (most
Leverage Higher (less favorable) than partial goodwill
favorable)
method)
Return on Lower than equity
Higher (most Lowest (least
equity and method but higher than
favorable) favorable)
return on assets full goodwill method
28. Question 28
Analyst 1: The sponsor usually maintains the decision-making power and voting
control over the SPE.
Analyst 2: The equity owners of an SPE usually receive a rate of return that is tied to
the performance of the SPE.
o A
o B
o C
Both analysts are incorrect.

Incorrect
C is correct. Both statements are incorrect. The sponsor does not usually have voting
control over the SPE. The activities of an SPE are specifically detailed in governing
documents created at the origination of the SPE. Under US GAAP, the structure of
the SPE transfers the risks and rewards from the equity owners to the variable
interest owners. In return, the equity owners usually receive a fixed rate of return.
29. Question 29
Analyst 1: One potential benefit of a VIE is lower risk since the assets and liabilities of
the VIE are isolated in the event the sponsor experiences financial difficulties.
Analyst 2: The organizational form of a VIE must be either a partnership or a joint

venture and there are no permanent limits imposed on the decision-making powers
of the VIE’s management. Which analyst is most likely correct?
o A
o B
o C
Both analysts are incorrect.

Incorrect
A is correct. Analyst 1 is correct. Risk reduction is a potential benefit of forming a VIE.
Analyst 2 is incorrect. The organizational form can be a corporation, partnership,
joint venture or trust. Sometimes permanent limits are imposed on the decision-
making powers of the VIE management.
Two members of the treasury division of Berken AG, a Germany-based electronics

manufacturing firm, are reviewing Berken’s portfolio of investments. They are particularly
interested in the investment income reported by MDMarkt during the year and whether the
investments should be considered impaired. Berken reports under IFRS. The following
tables give the year end (31 December 2015) selected financial information and investment
information at purchase date for MDMarkt. (Values are in € thousands except for per share
data.)
Classification at purchase Associated company

Amount owned by Berken 1.5 million shares
Total number of shares outstanding 5.0 million shares
Market value on 1 January 2015 €40.00 per share
Market value on 31 December 2015 €37.85 per share
Net earnings of investee company in 2015 €12,500
Dividends paid by investee company in 2015* €0.60 per share
*
Dividends maintained at historic levels Additional investment information of MDMarkt at
the date of purchase (31 January 2010). All data in € thousands except per share data.
Price paid €21 per share
Total net book value of MDMarkt €95,450
Excess of fair market value of plant and equipment above book value €5,570
Useful life remaining on plant and equipment 10 years
MDMarkt uses straight-line depreciation
At 31 December 2015
Book value of investment on Berken’s statement of financial position €62,600
1. Question 1
Which of the following statements regarding impairment of investment in MDMarkt
at the end of 2015 is most likely correct? The investment in MDMarkt may:
o A
be impaired due to the recent decline albeit in the share price that has led to
the market value being lower than its book value
o B
not be impaired because the goodwill at acquisition has not been fully
written off.
o C
not be impaired because the dividends have been maintained at historic
levels.
Incorrect
C is correct. Under IFRS there must be an objective proof of impairment due to one
or more events that happened after realization of the initial investment. The loss
event impacting future cash flows has to be reliably measured. Goodwill is included
in the investment carrying amount and hence not tested separately for impairment.
It’s not known whether the decline in MDMarkt’s share price is permanent.
Therefore, if the dividends have been maintained at historic levels then the
investment should not be considered impaired.
2. Question 2
In 2015, the equity income (in € thousands) contributed by MDMarkt to Berken’s
earnings is closest to:
o A
3,583.
o B
3,750.
o C
2,079.
Incorrect
A is correct. Because of MDMarkt’s classification as an associated company, Berken
would use the equity method. Berken owns 30% (1.5 mil shares/5.0 mil shares) of
MDMarkt.
Percentage of MDMarkt’s net income (in € thousands) = 30% x 12,500 = 3,750.
Less amortization of the excess value of tangible assets (in € thousands) = 30% x
5,570/10 = 167.10.
Investment income from MDMarkt (in € thousands) = 3,582.90.
3. Question 3
The amount of goodwill in the MDMarkt investment included in the purchase price
is closest to:
o A
0.
o B
€2,865,000.
o C
€1,194,000.
Incorrect
C is correct. Under the equity method goodwill is calculated at the purchase date and
included in the carrying amount of the investment.
Acquisition calculation
Price per share € 21.00
Number of shares × 1,500,000
Total price paid for 30% € 31,500,000
30% of net book value of MDMarkt € 28,635,000 (0.30 × €95,450,000)
Excess purchase price paid € 2,865,000
Attributed to plant and equipment € 1,671,000 (0.30 × €5,570,000)
Goodwill € 1,194,000
On 31 December 2015, Normandy PLC, a UK-based company, paid ₤400 million to acquire a
50% stake in Asquire Co. The purchase price was in excess of the fair value of Asquire’s net
assets, attributable to previously unrecorded patents with an economic life of four years.
The fair value of Asquire’s assets and liabilities other than patents was equal to their book
values. Normandy and Asquire both comply with IFRS. Normandy believes that both
companies’ 2016 financial results excluding merger adjustments will be similar to 2015. The
following table gives the selected data of both companies at 31 December 2015 (in ₤
millions).
Normandy PLC Asquire Co.

Total current assets 310 200
PP&E, net 1,860 1,220
Investment in Asquire 400 Na
Total assets 2,570 1,420
Current liabilities 135 115
Long-term debt 700 525
Total equity 1,735 780
Net income 70 5
1. Question 1
The current ratio of Normandy will most likely be highest if the purchase is reported
under:
o A
consolidation with full goodwill.

o B
the equity method.

o C
consolidation with partial goodwill.

Incorrect
B is correct. Under the equity method, current ratio = ₤310 / ₤135 = 2.30, Using
consolidation (either full or partial goodwill), current ratio = ₤510 / ₤250 = 2.04.
2. Question 2
The long-term debt to equity ratio of Normandy on 31 December 2015, will most
likely be lowest if the purchase was reported under:
o A
the equity method.

o B
consolidation with partial goodwill.

o C
consolidation with full goodwill.

Incorrect
A is correct. Under the equity method, long-term debt to equity ratio of Normandy =
₤700/₤1,735 = 0.4035. There is no goodwill, therefore it does not matter if full or
partial goodwill method is used. Using the consolidation method, long-term debt to
equity ratio = (700+525)/(1,735+400) = 0.5738. Equity includes ₤400 million non-
controlling interest under either consolidations.
3. Question 3
Based on Normandy’s forecast, return on beginning equity in 2016, for Normandy
will be most likely:
o A
different under equity method, but same under either of the

consolidation.
o B
same under all the three methods.

o C
different under all the three methods.

Incorrect
A is correct. Net income is the same under all the three methods. Beginning equity
under the equity method is ₤1,735 million. Under either of the consolidations
beginning equity includes ₤400 million of non-controlling interest = ₤1,735 + ₤400 =
₤2,135. Therefore, return on beginning equity is highest under equity method
Employee Compensation
1. Question 1
Q-Code: 23-L2-FR-ECPE-198405
Companies typically pre-fund:
o A
defined contribution (DC) plans.

o B
defined benefit (DB) plans.

o C
other post-employment benefits (OPB) plan.

Incorrect
Solution: B is correct. Companies typically pre-fund the defined benefit plans by
contributing funds to a pension trust. Regulatory requirements to pre-fund vary by
country.
Companies typically do not pre-fund other post-employment benefits plan
obligations.
2. Question 2
Which of the following statements regarding defined benefit (DB) pension plans
is least likely correct?
o A
The company’s obligation is defined in each period, but future benefits

are linked to performance of plan assets.
o B
The amount of the future benefits estimated in the current period are
determined by a formula.
o C
In a DB plan investment risk is borne by the company.

Incorrect
A is correct. In a DB plan amount of future benefit depends upon a formula and is
estimated in the current period. B & C are correct statements.
3. Question 3
Which of the following statements is least accurate regarding pension fund
obligations?
o A
Under IFRS, the obligation is called ‘the present value of the defined benefit
obligation (PVDBO)’.
o B
Under US GAAP, the obligation is called ‘the projected benefit obligation

(PBO)’.
o C
To calculate pension obligations, companies need to make assumptions

about future compensation increases and discount rates only.
Incorrect
Solution: C is correct. To calculate pension obligations, companies need to make
several assumptions including future compensation increases and levels, discount
rates and expected vesting. Any changes in the assumptions will change the
estimated pension obligation. If the change increases the obligation, it is called an
actuarial loss. If the change decreases the obligation, it is called an actuarial gain.
4. Question 4
The finance manager of Company A while commenting on its defined benefit plan’s
funded status and the amount recorded on the balance sheet, mentioned that the
current service cost change from last quarter has primarily resulted from a higher
percentage of employees that are expected to leave before the full vesting period of
7 years. Based on this explanation about the current service cost change, the
present value of obligation has most likely:
o A
increased.
o B
stayed the same.

o C
decreased
Incorrect
Solution: C is correct. The present value of the DB obligation would decrease if a
higher percentage of employees is expected to leave before the full 7-year vesting
period. If the employee leaves before meeting the vesting requirement, she may be
entitled to none or a portion of the benefits earned up until that point. In measuring
the DB obligation, the company considers the probability that some employees may
not satisfy the vesting requirements and uses this probability to calculate the current
service cost and the present value of the obligation.
5. Question 5
The projected benefit obligation (PBO) is defined as:
o A
actuarial present value of all future pension benefits earned to date based on
current salary levels.
o B
actuarial present value of all future pension benefits earned to date

based on expected future salary increases.
o C
actuarial future value of all post-retirement healthcare benefits earned to

date.
Incorrect
B is correct. The projected benefit obligation (PBO) is defined as the actuarial present
value of all future pension benefits earned to date based on expected future salary
increases.
6. Question 6
Which of the following statements about defined benefit and defined contribution
pension plans is least accurate?
o A
A company with a defined benefit plan will report on its balance sheet the net
difference between the fair value of the pension fund assets and the present
value of the pension liability.
o B
Accounting for a defined contribution plan is complicated because

many investment options are available to the employees.
o C
Accounting for defined benefit plan is complicated because of the required

actuarial assumptions.
Incorrect
B is correct. Accounting for defined benefit plan is more complicated than
accounting for defined contribution plans. The remaining two statements are
correct.
7. Question 7
Which of the following is least likely a characteristic of defined contribution plans?
o A
The future value of the benefits to the employee depends on how well the
investments perform.
o B
Future pension payments represent a liability for the employer.

o C
The employee bears the investment risk.

Incorrect
Solution: B is correct. The employer’s contributions are recorded as an expense on
the income statement, in case of a defined contribution plan. At the end of the
reporting period, if there are any unpaid expenses, they are shown as a liability.
In a defined benefit (DB) pension plan, future pension payments represent a liability
for the employer and need to be estimated. In these plans, the pension benefit is
defined and generally depends on factors like years of service and compensation
level at retirement.
8. Question 8
As of 31 December 2020, the present value of the Proton Corp’s defined benefit
obligation is €6,185 and the fair value of the pension plan assets is €6,665. In
addition, the present value of available future refunds and reductions in future
contributions is €226. The amount Proton would report as a pension asset or liability
on its 2020 balance sheet will be:
o A
Net pension asset of €226

o B
Net pension asset of €480

o C
Net pension liability €254

Incorrect
Solution: A is correct. Since plan assets are greater than DBO, the plan is
overfunded. The net pension asset number is subject to a ceiling which is the
present value of future economic benefits. In this case, ‘economic benefit’ refers to
refunds from the plan or reductions of future contributions.
The overfunded amount of 6,665 – 6,185 = 480 is more than the ceiling of €226; the
company will therefore report a net pension asset of 226.
9. Question 9
Assume that the following information is provided about a company reporting under
IFRS:
• PVDBO at start of year = 160

• FVPA at start of year = 140
• Discount rate = 11%
• Actual return on assets = 17
• Service costs = 9
• Increase in pension obligation due to changes in actuarial assumptions = 5
Under IFRS, total periodic pension cost will be closest to:
o A
14.6
o B
17.8
o C
10.2
Incorrect
A is correct. The components of pension costs can be calculated as:
10. Service cost = 9 (given)

11. Net interest income/expense = net pension liability or asset × interest rate
= (160 – 140) x 11% = 2.2
12. Remeasurements: Net return on plan assets = actual return – (plan assets ×
interest rate) = 17 – (140 x 11%) = 6
Since the actual return on plan assets is more than (beginning plan assets x Interest
rate), the impact on pension costs will be negative.
Actuarial losses = 5 (given)
An actuarial loss will have a positive impact on pension costs.
Remeasurements = (-1.6) + 5 = 3.4
Total periodic pension cost = 9 + 2.2 + 3.4 = 14.6
10. Question 10
The following information is available for a company’s defined benefit pension plan.
Contributions $1.0 million
Reported total pension costs $0.9 million

Based on the above information, assuming no tax, which of the following statements
is most accurate?
o A
There is a reduction in the overall pension obligation of $200,000.

o B
There is a reduction in the overall pension obligation of $100,000.

o C
The company has effectively borrowed $200,000.

Incorrect
B is correct. Since the contributions exceed the total pension costs of the period, the
excess can be economically interpreted as a reduction of the pension obligation. This
is similar to loan repayment in excess of scheduled principal payment.
11. Question 11
A company has one employee with a current annual salary of $200 which will remain
unchanged. At the end of three years a lump sum pension payment will be made
based on the formula: number of years worked x final annual salary x 0.25. The
discount rate is 11%. The closing obligation at the end of Year 2 will be:
o A
$90.09
o B
$45.05
o C
$100.00
Incorrect
12. Question 12
Under US GAAP, the term ‘corridor’ in the corridor approach used to recognise
actuarial gains and losses in the P&L refers to the:
o A
11 percentage range
o B
10 percentage range
o C
9 percentage range
Incorrect
Solution: B is correct. Under US GAAP, If the cumulative amount of unrecognised
actuarial gains and losses becomes too large (i.e., exceeds 10 percent of the greater
of the defined benefit obligation or the fair value of plan assets), then the excess is
amortised over the expected average remaining working lives of the employees
participating in the plan and is included as a component of periodic pension cost in
P&L. The term “corridor” refers to the 10 percent range, and only amounts in excess
of the corridor must be amortised.
13. Question 13
Under which of the following methods, the expected annual increase in
compensation over the employee service period can have a significant impact on the
defined benefit obligation?
o A
US GAAP
o B
IFRS
o C
Both US GAAP and IFRS

Incorrect
Solution: C is correct. Under both IFRS and US GAAP, the assumed rate of increase
in compensation—the expected annual increase in compensation over the employee
service period—can have a significant impact on the defined benefit obligation.
14. Question 14
Which of the following is least accurate regarding impact of some key estimates on the
balance sheet and the periodic pension cost?
Impact on Periodic
Assumption Impact on Balance Sheet
Cost
Periodic pension costs
A. Higher discount rate. Higher obligation.
will typically be higher.
Higher rate of
B. Higher obligation. Higher service costs.
compensation increase.
Not applicable for IFRS.
Higher expected return Lower periodic pension
C. No effect
on plan assets. expense under US
GAAP.
o A
Option A.
o B
Option B.
o C
Option C.
Incorrect
Solution: A is correct. As a result of higher discount rate, the obligation on balance
sheet would be lower. Furthermore, periodic pension costs will typically be lower
because of lower opening obligation and lower service costs.
15. Question 15
Analyst 1: Changes in actuarial assumptions and past service costs fully and
immediately affect the income statement.
Analyst 2: Changes in projected benefit obligation (PBO) and plan assets fully and
immediately affect the balance sheet.
o A
o B
o C

Incorrect
B is correct. Changes in the projected benefit obligation (PBO) and plan assets
immediately affect the funded status (difference in PBO and plan assets) and the full
amount of the change is reflected on the balance sheet when the change occurs.
However, changes in actuarial assumptions and past service costs are recognized in
the income statement over time thereby smoothing pension expense.
16. Question 16
An increase in the assumption for discount rate from 6% to 7%, all else equal
would most likely result in lower:
o A
total liabilities.
o B
net income.
o C
cash flow from operating activities.

Incorrect
Solution: A is correct. A higher discount rate will reduce the present value of the
pension obligation (liability). In most cases, a higher discount rate will decrease the
interest cost component of the net periodic cost because the decrease in the
obligation will more than offset the increase in the discount rate (except if the
pension obligation is of short duration). Therefore, periodic pension cost would have
been lower and reported net income higher.
Cash flow from operating activities should not be affected by the change.
17. Question 17
When comparing the pension disclosures of different companies, which of the
following points should least likely be considered?
o A
The values of the net pension liabilities disclosed on the balance sheet are
net amounts.
o B
The cash flow information for both companies may not be comparable.
o C
The discount rates for both companies may not be comparable.

Incorrect
C is correct. The discount rates used by the companies do not need to be compared.
The present values of the pension obligation calculated using the discount rates are
comparable, as the discount rate accounts for the different levels of risk in each
company.
A is incorrect because comparing the net amounts makes it difficult to judge the
difference in the scale of the companies being compared. For example, the net
pension liability of two companies may be USD 5 million. However, one company
could have a pension liability of USD 100 million and assets of USD 95 million, while
the other company could have a liability of USD 25 million and assets of USD 20
million. This difference is scale could lead to significant differences in financial ratios,
such as the debt-to-equity ratio. Therefore, this fact needs to be considered when
comparing companies.
B is incorrect because some pension-related cash flows may be classified as
financing activities in IFRS and operating activities under US GAAP. This needs to be
considered when comparing companies.
18. Question 18
Which of the following is a least likely assumption used to estimate benefit
obligations?
o A
The discount rates used to estimate pension obligations are generally based
on high-quality corporate bonds.
o B
Assumption regarding the expected return on pension plan assets is relevant

for US GAAP only.
o C
Post-employment health care plans usually assume that the health care
costs will grow at an increasing rate in future.
Incorrect
C is correct. Usually the assumption is that the health care costs will taper off to
some lower, constant rate at some year in the future. That future inflation rate is
known as the ultimate health care trend rate.
19. Question 19
Holding all else equal, which of the following assumptions would least likely result in a
lower benefit obligation and a lower periodic cost in case of post-employment health
care plans?
o A
A lower assumed near-term increase in health care costs.

o B
A lower assumed ultimate health care cost trend rate.

o C
A later year in which the ultimate health care trend rate is assumed to
be reached.
Incorrect
Solution: C is correct. An earlier year in which the ultimate health care cost trend
rate is assumed to be reached will result in a lower benefit obligation and a lower
periodic cost.
20. Question 20
Selected data for Sheffield Enterprises is given below. All amounts are in millions of
US dollars.
Based on the above information, total periodic cost of Sheffield Enterprises would
be:
o A
$-1
o B
$11
o C
$-13
Incorrect
Solution: B is correct. The calculation would be as follows:
Ending pension liability = 141 – 147= -6
Beginning pension liability = 127 – 135 = -12
Total periodic cost = ∆Net pension liability + Employer contributions = (-6 – -12) + 5 =
$11
21. Question 21
The following information is presented about a company that uses IFRS. All amounts
are in millions of US dollars.
Based on the above information, which of the following statements is correct?
o A
A 5% rate is used to calculate the net interest expense.

o B
Actual return on plan’s assets is 6%.

o C
Service cost and Net Interest expense is reported in P&L while

remeasurements are shown in OCI.
Incorrect
Solution: C is correct.
Components shown under P&L include –
• Service costs: 300

• Net interest expense: 300
Components shown under OCI include –
• Remeasurements: -150
A is not correct because net interest expense is 6% as calculated below:

Net interest expense = Net pension liability at the start of the year x Interest rate
300 = (25,000-20,000) x Interest rate
Interest rate = 0.06 = 6%
B is not correct because actual return on plan’s asset is 6.5% as calculated below:
Actual rate of return on plan assets = Actual return / Plan assets = 1,300 / 20,000 =
6.5%
22. Question 22
Using the following data, what is the retirement benefit paid for the year?
Change in benefit obligation 2019

Employer contributions 4,000
Current service cost 750
Past service cost 500
Discount rate for liabilities 0.07
Pension obligation at the start of the year 245,000
Pension Obligation at the end of the year 244,050
o A
-950
o B
-6,200
o C
-19,350
Incorrect
C is correct. Paying retirement benefits decreases the pension obligation and is
therefore one of the values that contributes to the change in the pension obligation
from the start of the year to the end of the year. The other items that cause this
change are the current service cost, past service cost, and interest cost. Since we
know the value for all of these, as well as the beginning and ending values for the
pension obligation, we can calculate the benefits paid using algebra:
Pension obligation at the start of the year 245,000

+ Current service cost 750
+ Past service cost 500
+ Interest cost (discount rate*pension obligation at the start of
17,150
the year)
– Benefits paid (plug) -19,350
Pension Obligation at the end of the year 244,050
245,000 + 750 + 500 + 17,150 + x = 244,050

x = – 19,350
Since paying the retirement benefits decrease the pension obligation, it is a negative
number.
23. Question 23
The following information is presented about a company. All amounts are in millions
of US dollars
2019
Employer contributions 4,000
Current service costs 700
Past service costs 450
Discount rate for liabilities 9%
Pension obligation at start of year 157,000
Pension obligation at end of year 155,877
Actuarial loss 1,255
Plan assets at start of year 125,000
Plan assets at end of year 119,811
Actual return on plan assets 9,200
Expected rate of return on plan assets 0.11
Which of the following statements is correct?
o A
Pension cost of $4,030 will be reported in P&L under US GAAP.

o B
Pension cost of $6,255 will be reported in OCI under US GAAP.

o C
Pension cost of $1,080 will be reported in P&L under IFRS.

Incorrect
Solution: B is correct. Calculations are as follows:
Pension cost in P&L under US GAAP = Current service costs + Interest expense on
pension obligation – Expected return on plan assets = 700 + 0.09 x 157,000 – 0.11 x
125,000 = $1080
Pension cost in OCI under US GAAP = Past service costs + Actuarial loss – Difference
between expected and actual return on assets = 450 + 1,255 – (9,200 – 0.11 x
125,000) = $6,255
Pension cost in P&L under IFRS = Current service cost + Past service cost + Net
interest expense = 700 + 450 + 0.09 x 32,000 = 4,030
Pension cost in OCI under IFRS = Actuarial loss – Net return on plan assets = 1,255 –
(9,200 – 0.09 x 125,000) = 3,305
24. Question 24
Based on information from Tristar’s 2019 annual report (currency in ₤ millions), an
analyst determines that the company’s total pension cost was ₤527. The company
also disclosed that it made a contribution of ₤607. Tristar reported cash inflow from
operating activities (CFO) of ₤5,231 and cash outflow from financing activities (CFF) of
₤1,911. The company’s effective tax rate was 27.3 percent. The analyst intends to
adjust CFO and CFF to reflect the difference between the company’s contribution
and the total pension cost. These adjustments will be:
o A
An increase in cash outflow from financing activities of ₤58.6.

o B
A decrease in cash inflow from operating activities of ₤58.6.

o C
An decrease in cash outflow from financing activities of ₤58.6.

Incorrect
(Company contribution – Total pension cost) x (1 – Tax rate) = (607 – 527) x (1 – 0.273)
= 58.6
Since the company contribution is more than the economic pension expense, this
excess after tax should be viewed as a form of repayment. Interpreting the excess
contribution as similar to a repayment of borrowing (financing use of funds) rather
than as an operating cash flow would increase the company’s cash outflow from
financing activities by ₤58.6, from ₤1,911 to ₤1,969.6, and increase the cash inflow
from operations by ₤58.6, from ₤5,231 to ₤5,289.6.
25. Question 25
Which of the following is least likely correct regarding share-based compensation?
o A
Share-based compensation given by a company is an expense that reduces

earnings even if no cash is involved
o B
Under both IFRS and U.S. GAAP, fair value of share-based compensation is
reported as an expense.
o C
Issuing stock options requires no cash outlay, and typically a company

is not likely to face a cash outflow when options are exercised.
Incorrect
C is correct. Issuing stock options involves no cash outlay initially, but when options
are exercised the company forgoes issuing new shares at the current market price. A
& B are correct statements.
26. Question 26
Which of the following types of stock grants addresses employees’ concern that
share price is beyond their control?
o A
Outright grants
o B
Restricted grants
o C
Performance shares
Incorrect
Solution: C is correct. Performance shares are determined by performance
measures other than change in share price. For example, accounting earnings or
return on assets. It addresses employees’ concern that share price is beyond their
control and should not be used for assessment.
27. Question 27
Which of the following statements regarding stock grants is most accurate?
o A
Restricted grants are reported at fair value of the stock and the
compensation expense is allocated over the course of the service
period.
o B
Outright grants are reported at fair value of the stock on the grant date and
the compensation expense is recorded as a one-time expense.
o C
The compensation of performance shares is determined by change in share

price.
Incorrect
A is correct. Restricted grants require employees to return ownership of the shares if
certain conditions are not met. They are reported at fair value at the grant date and
the compensation expense is allocated over the course of the service period.
B is incorrect because the compensation expense for outright grants is allocated
over the service period, it is not a one-time expense. The first part of the statement
is correct; outright grants are reported at fair value of the stock on the grant date.
C is incorrect because the compensation of performance shares is determined by a
performance factor other than change in share price, such as accounting earnings or
return on assets.
28. Question 28
The date on which the employees can first exercise the stock options is referred to
as:
o A
grant date.
o B
vesting date.
o C
exercise date.
Incorrect
Solution: B is correct. The vesting date is the date that employees can first exercise
the stock options.
29. Question 29
A company awards 900,000 stock options to its executives on 1 July 2021. The
estimated cost of each option is $0.40. The options require a service period of 4
years after the grant date before vesting. The stock option expense for 2021:
o A
$90,000
o B
$45,000
o C
$360,000
Incorrect
B is correct. The expense for the year = 900,000 (½0.40/4)(½)=45,000
We divide by 4 because the options have a service period of 4 years. Since the
options are granted in the middle of 2021, we multiply by ½ to allocate the expense
to the second half of 2021.
30. Question 30
In 2021, Company B used a lower volatility assumption of 19% compared to 21% for
2020 for its option grants. Hence, its 2021 net income is most likely to be:
o A
lower.
o B
higher.
o C
the same.
Incorrect
Solution: B is correct. Lower volatility reduces the fair value of an option and thus
the reported expense. Using the 2020 volatility estimate would have resulted in
higher expense and thus lower net income.
The table below shows the impact of an increase in an input value or assumption:
Impact if there is an increase in input value or

Input or Assumption
assumption
Exercise price Higher exercise price leads to a lower option value
Higher stock price volatility leads to higher option
Stock price volatility
value
Higher time to expiration leads to higher option
Estimated life of each award
value
Estimated dividend yield Higher dividend yield leads to a lower option value
Risk free rate Higher risk-free rate leads to a higher option value
31. Question 31
Current pension obligation for an average fully vested participant in Plan A with 10
years of prior service is illustrated below:
• Current annual salary: €90,000

• Years to retirement: 15
• Retirement life expectancy: 20 years
Current plan assumptions and other features:
• Benefit: Annual payments for life equal to 1% of the employee’s final salary
for each year of service beyond the date of the plan’s establishment
• Annual compensation increase: 6%
• Discount rate: 4%
• Compensation increases are awarded on the first day of the service year; no
adjustments are made to reflect the possibility that the employee may leave
the firm at an earlier date.
If the annual compensation rate is lowered to 5%, the annual unit credit for the
average participant would decrease by an amount closest to:
o A
S3,437.
o B
$3,885.
o C
$5,728.
Incorrect
Solution: A is correct. The calculations are as follows:
Current Revised
Assumption Assumption
Current Salary $90,000 $90,000
Years Until Retirement 15 15
Years of Service (includes prior 10) 25 25
Retirement life expectancy 20 20
Annual compensation increases 6% 5%
Discount Rate 4% 4%
Final year’s estimated earnings* $203,481.36 $178,193.84
Estimate annual payment for each of the 20
$50,870.34 $44,548.46
years**
Value at the end of year 15 (retirement date) of
$691,344.51 $605,428.12
the estimated future payments***
Annual unit credit**** $27,653.78 $24,217.12
*Because there are now 15 years until retirement, there are 14 years until retirement from the
end of Year 1. The final year’s estimated earnings, estimated at the end of Year 1, are as follows:
Current year’s salary × [(1 + Annual compensation increase)Years until retirement]
**The estimated annual payment for each of the 20 years (retirement life expectancy) is
(Estimated final salary × Benefit formula) × Years of service
***The value at the end of Year 15 (retirement date) of the estimated future payments is the PV
of the estimated annual payment for each of the 20 years at the discount rate of 4%.
****The annual unit credit = Value at retirement/Years of service.
32. Question 32
Two analysts are discussing share-based compensation and make the following
comments regarding stock appreciation rights and phantom stock:
Analyst 1: With a phantom share plan, compensation is based on the performance of

the firm’s actual shares.
Analyst 2: Stock appreciation rights do not have a dilution effect on existing

shareholders.
o A
Only Analyst 1 is correct.
o B
Only Analyst 2 is correct.

o C

Correct
B is correct. Stock appreciation rights do not cause dilution to the existing
shareholders since no shares are actually issued. The payoff of phantom stocks is
based on the performance of hypothetical stock instead of the firm’s actual shares.
Western Motors has made the following changes in their DB pension plan:
• A 100-basis point increase in the assumed annual compensation increase.

• The vesting period has been changed from three years to four years.
• The discount rate has been raised from 4.5% to 5.5%.
Two analysts at SARS Investments are reviewing the year-end financial statements of
Western Motors in order to analyze the impact of the changes which became effective on 1
January 2015, on the company’s employment costs. Western Motors reports under IFRS.
Analyst 1: Change in the annual compensation increase will increase the service costs,
reported as an expense in P&L. Analyst 2: The increase in vesting period will result in an
actuarial loss.
1. Question 1
Regarding the discussion between the two analysts about the changes in the
pension plan of Western Motors, who is most likely accurate?
o A
Analyst 1.
o B
Analyst 2.
o C
Both.
Incorrect
A is correct. An increase of 100 basis points in the annual compensation will
increase the service costs and lead to a higher obligation. B is incorrect because an
increase in vesting period will result in an actuarial gain, not loss.
2. Question 2
L.O.: d Q-Code: 21-L2-FR-ECPE-75398

An increase of 100 basis points in the discount rate will most likely result in:
o A
higher obligation and higher periodic pension costs.
o B
lower obligation and lower periodic pension costs.

o C
higher obligation and lower service costs.

Incorrect
B is correct. A higher discount rate will result in a lower obligation and lower periodic
pension costs. Section 2.3.3. LO.d.
3. Question 3
If Western Motors reported under US GAAP, the past service costs arising due to
changes in pension plan would most likely be recognized in:
o A
P&L.
o B
OCI and amortized to P&L over employees’ service lives.

o C
OCI and not amortized subsequently to P&L.

Correct
B is correct. Under US GAAP, current service costs are mentioned in P&L and past
service costs are recognized in OCI in the period in which the change causing these
costs occurs. These costs are amortized to P&L over the average lives of the
employees over time.
Paula is a junior analyst at RCI Trust & Investments. She has been given the following
information about Steve Horne, an employee who has started working at Grate Cement.
Paula has been asked by her supervisor to calculate the pension liability arising from Horne.
Pension Plan Details and Assumptions Employee Details

Annual wage increase 4.50% Current salary $40,000
Discount rate 6.00% Date hired 1-Jan-15
Expected retirement
Pension Plan Benefit Payments Date 31-Dec-20
Estimated final salary $49,847

Estimated annual Estimated final salary
Annual payments are paid at year end and
payment for each of the x 1.5% x years of
continue for the remainder of the retiree’s 25 years service = $4,486.23
life Estimated years in
25
retirement
1. 1
2. 2
1. Answered
2. Review
1. Question 2
The pension expense in Year 2 arising from Horne’s employment is closest to:
o A
$430.
o B
$8,000.
o C
7,570.
Correct
B is correct. PV of the 4,486.23 annuity for 25 years at 6% is USD57,349.08. Hence
annual unit credit per service year = 57,349.08/6 = 9,558.18. Year 2 Opening
obligation 9,558.18/(1.06)5 = 7,142.43. Interest cost = 6% x 7,142.43 = 428.55. Year 2
current service cost = 9,558.18/(1.06)4 = USD7,570.97. Pension expense =
428.55+7,570.97 = USD7,999.52.
Carly is an intern at Gravity Investments. She collects selected information from Note F of
the 2015 Annual Report of Gourmet Foods given in the table below. Maurice, an analyst at
Gravity, asks Carly to use the data to calculate the net periodic pension cost and the total
periodic pension cost for Gourmet Foods for 2015. Gourmet Foods presents its financial
statements in accordance with US GAAP.
($ thousands)
Start-of-year pension obligations 82,500
Start-of-year plan assets 70,052
End-of-year pension obligations 84,116
End-of-year plan assets 72,284
Current service cost 1,170
Interest cost 6,188
Actual return on plan assets 6,836
Expected return on plan assets 5,359
Benefits paid to retired employees 5,742
Employer’s contributions 1,138
Amortization of past service costs 375
1. Question 1
The 2015 periodic pension cost (in $ thousands) that Gourmet Foods reported on its
income statement is closest to:
o A
7,358.
o B
2,374.
o C
1,999.
Incorrect
B is correct. Under US GAAP, the periodic pension cost is calculated as follows:
$ thousands
Current service cost 1,170
Interest cost on the obligation 6,188
Less expected return on plan assets –5,359
Plus amortization of past service costs 375
Periodic pension cost 2,374
2. Question 2
Gourmet Foods’ 2015 total periodic pension cost (in $ thousands) is closest to:
o A
1,138.
o B
616.
o C
522.
Incorrect
C is correct. “The total periodic pension cost is the change in the net pension asset or
liability excluding the effect of the employer’s periodic contribution to the plan.”
($ Pension Pension Net Pension

thousands) Obligations Assets Liability
End of year 84,116 72,284 11,832
Less start of
82,500 70,052 12,448
year
Change in net pension liability = 11,832 – 12,448 = -616
Total periodic pension cost = change in net pension liability + employer’s
contribution
= -616 + 1,138 = 522
Alternative Calculation:
Service cost 1,170
Interest cost 6,188
Less actual return on plan assets –6,836
Total periodic pension cost 522
Sally Gables has recently been appointed as the CFO of Rhine Industries, a large public
limited company which prepares its financial statements in accordance with IFRS. Gables is
reviewing the company’s pension plan which has a funding deficit during 2015 due to rising
pension costs, coupled with the pension assets effected from poor investment
performance. Rhine has made changes to the plan to control pension costs which were
reported as plan amendments in the year made. Information regarding the company’s
pension plan as of December 31, 2015 is given below:
Values in € Millions 31 Dec 2015

Employer contributions 84.00
Employee contributions 1.70
Current service cost 73.20

Plan amendments (230.00)
Actuarial gain 285.70
Plan assets at start of year 5,036.00

Plan assets at end of year 4,272.10
Benefit obligation at start of year 4,649.00
Benefit obligation at end of year 4,399.90
Actual return on plan assets -15.50%

Discount rate used to estimate plan liabilities 5.60%
1. Question 1
The benefits paid (in € millions) in 2015 by Rhine’s pension plan are closest to:
o A
84.00
o B
68.60.
o C
1.70.
Incorrect
B is correct. Benefits paid can be determined either from focusing on the change in
pension plan assets or from the change in the benefit obligation over the year, as
follows:
(€ millions) Calculations
From the change in plan assets:
Assets at start of year 5,036.0
Actual return on assets –781.0 –15.5% × 5,036.0
Employer contributions 84
Benefits paid –X To be solved for
Asset at end of year 4,272.1
Solve for X: €68.60
Alternatively, from the change in the benefit obligation (In € millions)

Benefit obligation at start of year 4,649.0
Current service cost 73.2
Plan amendments –230.0
Interest cost 260.3 5.6% × 4,649
Benefits paid –X To be solved for
Actuarial gain –285.7
Benefit obligation at end of year 4,399.9
Solve for X: €68.60
2. Question 2
The poor investment performance of the pension assets in 2015 most likely caused
the periodic pension costs (in €-millions) reported in the P&L to be:
o A
lower by €781.
o B
higher by €781.
o C
not affected.
Incorrect
C is correct. Under IFRS, the components of periodic pension cost reported in P&L
are: the service cost and the net interest expense or income (calculated by
multiplying the net pension liability or net pension asset by the discount rate used to
measure the pension liability). The actual return (negative in 2015) has no effect on
the periodic pension cost reported in P&L. The actual return on plan assets will affect
the net return on plan assets (part of the remeasurement component) which is
recognized in OCI and not subsequently amortized to P&L.
3. Question 3
Rhine’s contribution to the pension plan in 2015 relative to its total pension cost
(excluding income tax effects, in €-millions) can be best interpreted as a:
o A
financing cash inflow of €515.

o B
investing cash inflow of €84.

o C
operating cash outflow of €599.

Incorrect
A is correct. The company’s contribution of €84 is €514.8 less than the total periodic
pension cost of €598.8 million, and from an economic perspective, can be thought of
as a source of financing (borrowing).
In millions.
End of year net pension asset €4,272.10 –

(liability) (€127.8) €4,399.90
€5,036.0 –
Start of year net pension asset €387.0 €4,649.0
Net change in funding status over
Year –€514.8
Less Employer contribution –€84.0
Total periodic pension cost –€598.8
WalterGre is a retailer that provides a defined benefit pension plan for its employees. It
reports under US GAAP. Rudy Horne is an equity analyst, who is reviewing WalterGre’s
pension plan and its assumptions. Following table gives the assumptions of WalterGre’s
defined benefit plan:
2015 2014
Expected long-term rate of return on plan assets 6.0% 5.3%
Discount rate 4.75% 4.25%
Estimated future salary increases 4.50% 4.00%
Inflation 3.00% 3.20%
1. 1
2. 2
3. 3
4. 4
1. Answered
2. Review
1. Question 4
L.O.: e Q-Code: 21-L2-FR-ECPE-75411

Compared to pension assumptions used in 2014, which of the following
assumption pairs used in 2015, is most likely inconsistent?
o A
Discount rate, estimated future salary increases.

o B
Inflation, estimated future salary increases.

o C
Expected long-term rate of return on plan assets, discount rate.

Correct
B is correct. The company increased its estimate of future salary increases in 2015,
but lowered its inflation estimate. Usually salary increases are in line with rise in
inflation. Section 2.4.1. LO.e.
Selena Gabriel, an analyst at Gemini Investments, has been given the responsibility of
reviewing TBZ bank’s compensation plans, specifically the assumptions of the plan and their
impact on earnings. The following data collected by Gabriel gives the compensation plans’
assumptions over the last two years.
2015 2014
Risk-free rate 4.00% 3.50%
Expected life 4 years 3 years
Dividend yield 1.5% 0.0%
Expected volatility 30% 28%
1. Question 1
Compared to 2015 financial statements, if TBZ had used the 2014 expected volatility
assumptions to value its employee stock options, it would have most likely recognized:
o A
higher compensation expense.

o B
lower compensation expense.

o C
lower net income.
Incorrect
B is correct. A lower volatility assumption decreases the stock option value reducing
the compensation expense, thus resulting in higher earnings.
2. Question 2
A longer expected life of stock options and a higher risk-free rate in 2015, compared
to 2014, would have most likely impacted TBZ’s financial statements by showing a:
o A
higher compensation expense.

o B
higher earnings.
o C
lower deferred compensation liability.

Incorrect
A is correct. A higher risk-free rate and longer estimated life of the stock options
increase the value of options, increasing compensation expense and lowering net
income.
3. Question 3
Compared to its 2014 assumptions, TBZ’s earnings in 2015 were most
favorably affected by the change in:
o A
expected life.
o B
risk-free rate.
o C
dividend yield.
Incorrect
C is correct. A higher dividend yield reduces stock option value lowering
compensation expense and thus impacting earnings favorably.
RBJ Bank has included stock options as an annual executive compensation since 2012. In
January 2015, the bank introduced a restricted stock grant program for all non-executive
employees who had already been with the company for three or more years. The following
are the highlights of the restricted stock grant program:
• The fair value of the company’s stock on the grant date was $6.0 million.
• The restricted stock grants require a vesting period of three years.
The average volatility of the company’s stock had been in the range of 35%–39% during
2012–2014, but has dropped to the 15% – 20% since 2015.
1. Question 1
For the year ending 2015, stock-based compensation expense from the stock grant
program ($ millions) will be closest to:
o A
2.0.
o B
6.0.
o C
3.0.
Incorrect
A is correct. The compensation expense for restricted stock grants is the fair market
value of the shares on the grant date, and this amount is allocated over the service
period: 6/3=2.0 million.
2. Question 2
Given the recent changes in the volatility of the bank’s stock, RBJ’s compensation
expense for which employee category will be most likely affected?
o A
Only executive.
o B
Only non-executive employees.

o C
Both executives and non-executives.

Incorrect
A is correct. Only the executive stock option plan is affected by volatility of the
company’s stock. The volatility affects the initial valuation of the stock options
granted. The initial valuation of the options determines the expense recognized.
Compensation expense for stock grants is based on the fair market value of the
stock on the day of the grant and is not affected by the stock’s volatility.
Multinational Operations
1. Question 1
Q-Code: 23-L2-FR-MUOP-198512
Rupert Co. sells goods to a customer in the United Kingdom for £10,000 on 10
October 20X1, with payment to be received in British pounds on 10 February
Rupert’s functional and presentation currency is the euro. Spot exchange rates
between the euro (€) and British pound (£) are as follows:
10 October 20X1 £1 = €1.150

31 December 20X1 £1 = €1.173
10 February 20X2 £1 = €1.169
Rupert’s fiscal year end is 31 December.
Which of the following statements is least accurate about effect of the foreign
currency transaction on the financial statements?
o A
The company will report a realized gain of €230 in the income statement
for 20X1.
o B
The company will report a realized loss of €40 in the income statement for
20X2.
o C
The total change from the transaction date to the settlement date is €190.
Incorrect
Solution: A is correct. The company will report an unrealized gain of £10,000 × (€1.173
– €1.15) = €230 in the 20X1 income statement. This will result from the change in
value of the accounts receivable from the date of sale to the balance sheet date, i.e.,
from 10th Oct to 31st Dec.
The change in value of the accounts receivable that occurs from the balance sheet
date to the settlement date, i.e., from 31st Dec to 10th Feb is recorded as a foreign
currency transaction gain or loss in the 20X2 income statement. So the company will
report a transaction loss of £10,000 × (€1.169 – €1.173) = -€40.
The total change from the transaction date to the settlement date = £10,000
×(€1.169 – €1.15) = €190. This was accounted by showing a gain of €230 in 20X1 and
a loss of €40 in 20X2.
2. Question 2
Statement 1: Both IFRS and US GAAP require FX gains and losses to be reported in
net income, even if they have not yet been realized.
Statement 2: Both IFRS and US GAAP indicate where on the income statement these
should be placed.
Which of the above statements is correct?
o A
Statement 1
o B
Statement 2
o C
Both Statements 1 & 2

Incorrect
Solution: A is correct. Statement 2 is not correct because neither standard indicates
where on the income statement these should be placed. The two most common
placement treatments are:
• As component of other operating income/expense.

• As component of non-operating income/expense, in some cases as part of
financing cost.
The calculation of profit margins is affected by where the FX gains/losses are

reported.
3. Question 3
If the functional currency strengthens against the foreign currency, then which of the
following transactions will incur a loss?
o A
Import purchase.
o B
Export sales.
o C
Both import purchase and export sales.

Incorrect
B is correct. The exporter is exposed to FX risk as the functional currency may
strengthen against the foreign currency. This will decrease the amount of functional
currency that the exporter will receive. On the other hand, strengthening of the
functional currency benefits an import purchase transaction.
4. Question 4
Two analysts make the following statements after the US dollar weakens against the
Mexican peso. (Assume both of the following transactions occur between balance
sheet dates.)
Analyst 1: If an American company is exporting their products to Mexico, they have

an asset exposure and will therefore experience an unrealized loss.
Analyst 2: If a Mexican company is importing supplies from the US, they have a
liability exposure and will therefore experience an unrealized gain.
Which analyst is most likely correct?
o A
Analyst 1
o B
Analyst 2
o C
Neither analyst
Incorrect
B is correct. Since the Mexican company is importing goods from the US, they will be
paying in US dollars. Since the US dollar has weakened against the peso, they have to
pay fewer USD than if the currency had not weakened.
Analyst 1 is incorrect because the American company will experience a gain. Since it
is exporting products to Mexico, it will receive its payment in Mexican pesos. The
peso has strengthened against the dollar, so it will experience an unrealized gain.
5. Question 5
If the foreign subsidiary’s functional currency is different from the parent’s
presentation currency, which method must be used?
o A
Current rate method

o B
Temporal method
o C
Historical method
Incorrect
Solution: A is correct. If the foreign subsidiary’s functional currency is different from
the parent’s presentation currency, the current rate method must be used. If the
foreign subsidiary’s functional currency is same as the parent’s presentation
currency, the temporal method must be used.
6. Question 6
Which of the following procedures for translation of the foreign entity’s foreign
currency financial statements into the parent’s presentation currency is not correct
under current rate method?
o A
All assets and liabilities are translated at the current exchange rate at the
balance sheet date.
o B
Stockholders’ equity accounts are also translated at current exchange

rates.
o C
Revenues and expenses are translated at the exchange rate that existed
when the transactions took place.
Incorrect
B is correct. Under current rate method, stockholders’ equity accounts are translated
at historical exchange rates.
7. Question 7
Under temporal method, expenses related to non-monetary assets are translated at
the:
o A
current exchange rate.

o B
average exchange rate.

o C
the exchange rates used to translate the related assets.

Incorrect
Solution: C is correct. Under temporal method, expenses related to non-monetary
assets, such as cost of goods sold (inventory), depreciation (fixed assets), and
amortization (intangible assets), are translated at the exchange rates used to
translate the related assets.
Under current rate method, revenues and expenses are translated at the exchange
rate that existed when the transactions took place. For practical reasons, an average
exchange rate is often used.
8. Question 8
Which of the following statements is least accurate?
o A
In the temporal method, monetary assets and liabilities are translated at the
current exchange rate.
o B
In the current rate method, stockholder’s equity accounts are translated at

historical exchange rates.
o C
In the temporal method, non-monetary assets and liabilities measured

at their current value on the balance sheet are translated at historical
exchange rates.
Incorrect
C is correct. In the temporal method, generally monetary assets and liabilities are
translated using current rates and non-monetary assets and liabilities are translated
using historical rates. However, there is an exception for non-monetary assets and
liabilities measured at their current value on the balance sheet. These are translated
at the exchange rate at the date when the current value was determined. Statements
A and B are correct.
9. Question 9
Analyst 1: The preferred functional currency for subsidiaries that are mostly
independent of the parent is the local currency.
Analyst 2: For highly integrated subsidiaries (regardless of local conditions), or for

subsidiaries (of companies reporting under US GAAP) operating in high-inflation
environments, the parent’s reporting currency should be used as the functional
currency.
o A
o B
o C

Incorrect
10. Question 10
Annual inflation rates and selected exchange rates between the Turkish lira (TL) and
US dollar during the 2000–2001 period were as follows:
o A
($631)
o B
($436)
o C
Nil
Incorrect
A is correct. The historical cost of the property is translated at the current exchange
rate, which results in a new translated amount at each balance sheet date.
11. Question 11
Using the data in question and assuming no other assets or liabilities, the cumulative
translation gains or losses that would be reported under temporal method on 31
December 2001 would be:
o A
($631)
o B
($436)
o C
Nil
Incorrect
Solution: C is correct. The historical cost of land is translated using the historical
exchange rate, which results in the same translated amount at each balance sheet
date.
12. Question 12
A US firm owns a foreign subsidiary in India. In 2014, sales were INR 10,000,000 and
the INR/USD exchange rate was 60. In 2015, the sales remained constant at INR
10,000,000 but the exchange rate was 65. What will be the impact of the change in
the value of the USD on the parent company’s translated sales?
o A
Sales will increase by 7.69%.

o B
Sales will decrease by 7.69%.

o C
Sales will decrease by 9.64%.

Incorrect
B is correct. While sales were flat at INR 10,00,000 in local currency terms, after
translation the parent firm would report sales of USD 153,846.15 for 2015 = (INR
10,000,000 / 65) versus sales of INR 166,666.66 for 2014 = (INR 10,000,000 / 60). This
represents a decline of 7.69%.
13. Question 13
Which of the following is not correct, under temporal method, if foreign currency
strengthens relative to parent’s presentation currency?
Net Monetary Liability Exposure Net Monetary Asset Exposure

A ↑Revenues ↑Revenues
B ↑Shareholder’s equity ↓Shareholder’s equity
C ↑Liabilities ↑Liabilities
o A
Option A.
o B
Option B.
o C
Option C.
Incorrect
Solution: B is correct. Under temporal method, if foreign currency strengthens
relative to parent’s presentation currency, shareholder’s equity will decrease in case
of net monetary liability exposure because of lower net income due to a transaction
loss. The reverse is true if there is a net monetary asset exposure. The relationship is
summarised below:
Temporal Method, Net Temporal Method Net

Monetary Liability Monetary Asset
Exposure Exposure
↑Revenues ↑Revenues
↑Assets ↑Assets
Foreign currency strengthens
↑Liabilities ↑Liabilities
relative to parent’s
↓Net income ↑Net income
presentation currency
↓Shareholder’s equity ↑Shareholder’s equity
Translation loss Translation gain
14. Question 14
Which of the following is not correct, under temporal method, if foreign currency
weakens relative to parent’s presentation currency?
Net Monetary Liability Exposure Net Monetary Asset Exposure

A ↓Revenues ↓Revenues
↓Assets ↓Assets
B
C ↓Net Income ↑Net income

o A
Option A.
o B
Option B.
o C
Option C.
Incorrect
Solution: C is correct. Under temporal method, if foreign currency weakens relative
to parent’s presentation currency, shareholder’s equity will increase in case of net
monetary liability exposure because of higher net income due to a transaction gain.
The reverse is true if there is a net monetary asset exposure. The relationship is
summarised below:
Temporal Method, Net Temporal Method Net

Monetary Liability Exposure Monetary Asset Exposure
↓Revenues ↓Revenues
Foreign currency
↓Assets ↓Assets
weakens relative
↓Liabilities ↓Liabilities
to parent’s
↑Net income ↓Net income
presentation
↑Shareholder’s equity ↓Shareholder’s equity
currency
Translation gain Translation loss
15. Question 15
Which of the following is not correct, under current rate method, if foreign currency
strengthens relative to parent’s presentation currency?
o A
Liabilities will decrease.

o B
Shareholder’s equity will increase.

o C
There will be positive translation adjustment.

Incorrect
Solution: A is correct. The relationships are summarised in the table below:
Current Rate Method

↑Revenues
↑Assets
Foreign currency strengthens ↑Liabilities
relative to parent’s presentation ↑Net income
currency ↑Shareholder’s equity
Positive translation adjustment
↓Revenues
↓Assets
Foreign currency weakens
↓Liabilities
relative to parent’s presentation
↓Net income
currency
↓Shareholder’s equity
Negative translation adjustment
16. Question 16
Under which translation method, many of the ratios of foreign currency financial
statements are preserved?
o A
Current rate method

o B
Temporal method
o C
Both current and temporal methods

Incorrect
Solution: A is correct. Many of the ratios of foreign currency financial statements are
preserved when the current rate method is used for translation. On the other hand,
if we use the temporal method for translating, then most of these ratios are
distorted.
17. Question 17
Which of the following ratios will most likely be affected by translation under the
current rate method?
o A
Net profit margin.

o B
Debt/Assets ratio.
o C
Fixed asset turnover ratio.

Incorrect
C is correct. All pure income statements and balance sheet ratios are unaffected by
translation under the current rate method. The fixed asset turnover ratio is not a
pure ratio; it consists of an income statement measure (sales, translated at the
average rate) and a balance sheet measure (fixed assets, translated at the current
rate).
18. Question 18
Which of the following is not true in a hyper inflationary environment?
o A
IFRS and US GAAP differ substantially in their approach to translating the

foreign currency financial statements of a subsidiary.
o B
US GAAP requires that the financial statements be translated using the

current rate method.
o C
IFRS require financial statements to be first restated for inflation and then
inflation adjusted financial statements be translated at the current exchange
rate.
Incorrect
Solution: B is correct. US GAAP requires that the financial statements be translated
using the temporal rate method.
19. Question 19
Which method ensures that companies avoid a “disappearing plant problem in a
country with high inflation?
o A
Temporal method
o B
Current rate method

o C
Both temporal and current rate methods

Incorrect
A is correct. Requiring the temporal method ensures that companies avoid a
“disappearing plant problem” that exists when the current rate method is used in a
country with high inflation. In a highly inflationary economy, as the local currency
loses purchasing power within the country, it also tends to weaken in value in
relation to other currencies. Translating the historical cost of assets such as land and
buildings at progressively weaker exchange rates causes these assets to slowly
disappear from the parent company’s consolidated financial statements.
20. Question 20
If a multinational corporation needs to use both the current rate and the temporal
methods of translation at a single point in time, its consolidated financial statements
can reflect:
o A
a net translation gain or loss that is included in the determination of net

income.
o B
a separate cumulative translation adjustment reported on the balance sheet

in stockholders’ equity.
o C
Both A) and B).

Incorrect
Solution: C is correct. Under both IFRS and US GAAP, a multinational corporation
may need to use both the current rate and the temporal methods of translation at a
single point in time. This situation will apply when some foreign subsidiaries have a
foreign currency as their functional currency (and therefore are translated using the
current rate method) and other foreign subsidiaries have the parent’s currency as
their functional currency (and therefore are translated using the temporal method).
As a result, a multinational corporation’s consolidated financial statements can
reflect simultaneously both a net translation gain or loss that is included in the
determination of net income (from foreign subsidiaries translated using the
temporal method) and a separate cumulative translation adjustment reported on
the balance sheet in stockholders’ equity (from foreign subsidiaries translated using
the current rate method).
21. Question 21
In 2014, BUE GmbH, a German company set up a wholly owned subsidiary, Serena
Inc., in Argentina. Serena sells all its production to the parent company. BUE reports
under IFRS. Throughout 2014, Argentina experienced high rates of inflation,
averaging 30% per year with no signs of decreasing. The accounting method used
this year (2016) to account for Serena in the consolidated financial statements as
compared to prior years is most likely:
o A
the temporal method as was used in the past.
o B
the current method is used after restating nonmonetary items for

inflation.
o C
the temporal method is used after restating all accounts for the general price
index.
Incorrect
B is correct. Since Serena sells all its production to the parent company, therefore, in
previous years its functional currency would normally be euro (parent’s currency)
and it would have used temporal method to account for its financial statements.
Since 2013 it has operated in a high inflationary environment exceeding the 100%
indicator of hyperinflation over three years. Therefore, in 2016, under IFRS, the
nonmonetary items should be restated for inflation and then Serena’s financial
statements should be translated using the current exchange rate method.
22. Question 22
Which of the following statements about the effect of multinational operations on a
company’s effective tax rate is not correct?
o A
Countries have established various laws and practices to prevent aggressive

transfer pricing practices.
o B
It is not possible for an analyst to obtain information about the tax

impact of multinational operations.
o C
Whether and when a multinational company also pays income taxes in its
home country depends on the specific tax regime.
Incorrect
B correct. An analyst can obtain information about the tax impact of multinational
operations from companies’ disclosure on effective tax rates.
23. Question 23
Sanafil is a French pharmaceutical company with subsidiaries in Europe and the U.S.
It has recently set up a wholly owned subsidiary in South America where the tax rate
is 12%. There is a proposal in France to reduce the corporate tax rate from the
current 33% to 25.5%. The average tax rates for the eurozone countries and United
States where Sanafil has presence is 34% and 35% respectively. France operates
under a tax treaty with all countries in which it has subsidiaries, such that it will owe
taxes on foreign earned income to the extent that the French rate exceeds the
foreign rate. The pre-tax income earned by Sanafil in 2016 in France is €350 million
and in South America is €207 million. If the tax reduction proposal had been in effect
in 2016, the increase in Sanafil’s net income (in € millions) would have been closest to:
o A
26.
o B
16.
o C
42.
Incorrect
C is correct. The proposed change in tax rates would have affected pre-tax income
earned in France and pre-tax income in South American subsidiary, because of lower
tax rates. Income earned from subsidiaries in the Eurozone and U.S. are taxed at
higher rates and not subject to tax in France.
Tax Effect as Under Proposal

Sanafil Difference
Reported (33%) (25.5%)
French earnings before
€350 115.50 89.25 €26.25
taxes (EBT) in millions
South American EBT in
€207 68.31 52.79 €15.52
millions
Total in millions €41.77
24. Question 24
Which of the following statements is least accurate for an entity with operations in
multiple countries with different tax rates ?
o A
Its effective tax rate is not affected by the transfer prices it sets.
o B
Its effective tax rate will be lower if it sets a transfer price such that a higher
portion of its profit is allocated to lower tax rate jurisdictions.
o C
Generally multinational companies have to pay income taxes in the country

in which the profit is earned.
Incorrect
A is correct. Multinational operations affect a company’s effective tax rate because of
the ability to set transfer prices.
25. Question 25
Which of the following statements regarding disclosures on the effects of foreign
currency is not correct?
o A
Companies often make important disclosures about foreign currency effect

on sales growth in the MD&A.
o B
Multinational companies disclose major sources of foreign exchange risk.

o C
Disclosures about the effects of currency fluctuations do not include

sensitivity analyses.
Incorrect
C is correct. Disclosures about the effects of currency fluctuations often include
sensitivity analyses.
26. Question 26
Two multinational companies, A and B have reported the same sales growth rate.
Growth in sales of A came from changes in volume and price. On the other hand,
growth in sales from B came from changes in exchange rate. All else equal, the most
appropriate conclusion is that:
o A
Company A’s growth is more sustainable than Company B.

o B
Company B’s growth is more sustainable than Company A.

o C
Both companies have sustainable growth rates.

Incorrect
A is correct. Growth in sales that comes from changes in volume or price is more
sustainable than growth in sales that comes from changes in exchange rates.
Candall Engineering, a Chicago-based company that sells electricity generating engines has a
Chinese subsidiary, Able Motors. The subsidiary was created on 31 December 2014 and
Candall Engineering decided to use the U.S. dollar as its functional currency. Thomas
Robinson, CFO of Candall Engineering was asked the following questions by the Board of
Directors regarding the impact of exchange rates on the financial statements of Able Motors
and the consolidated financial statements of Candall Engineering at the 2015 year-end
presentation:
• What were the reasons for using the U.S. dollar as the functional currency?
• If the functional currency was changed to Chinese yuan for Able Motors would there
be any translation effects for Candall?
• How would the financial statement ratios of the parent company be impacted if the
functional currency was changed?
1. Question 1
Which of the following is least likely a reason for using the U.S. dollar as Able Motors’
functional currency ?
o A
Able Motors has autonomy over its decision-making involving

operations, investment and financing.
o B
Cash flows of Able Motors directly affect the cash flows of Candall.
o C
Transactions with Candall are a large proportion of Able Motors’ activities.

Incorrect
A is correct. The Chinese yuan will be selected as the reporting currency if all
operating, financing and investing decisions are based in the local currency. B & C
are reasons for using the parent’s currency as the functional currency.
2. Question 2
If the functional currency of Able Motors is changed, the consolidated financial
statements for Candall Engineering would report:
o A
realized gains and losses on nonmonetary assets and liabilities.

o B
unrealized gains and losses on nonmonetary assets and liabilities.

o C
realized gains and losses on monetary assets and liabilities.

Incorrect
B is correct. If the functional currency is changed to the Chinese yuan, the current
rate method will be used instead of the temporal method. Under the current rate
method, gains and losses arising from translation will be realized only when the
subsidiary is sold.
3. Question 3
If the functional currency is changed from the US dollar to the Chines Yuan, the
financial statements ratios most likely impacted are:
o A
fixed asset turnover.

o B
cash ratio.
o C
receivables turnover.
Incorrect
A is correct. If the Chinese yuan is selected as the functional currency, the current
rate method will be used, and the current exchange rate will be the rate applied to
translate all assets and liabilities. Sales are translated at the average rate under both
current rate and temporal methods, but fixed asset will be translated at the current
rates instead of the historical rates. Therefore, fixed asset turnover will most likely
be affected. Cash ratios and receivable turnover will not be impacted.
Thomas Robinson, CFO of Candall Engineering, reviews the financial statements of the
Chinese subsidiary, Able Motors, established for consolidation on 31 December 2014. The
U.S. dollar is the functional currency of Able Motors. Able Motors uses the FIFO inventory
accounting method. The purchases of CNY750 million of inventory and sale of that inventory
happened evenly in 2015. The table below gives Able Motors’ 31 December 2015 balance
sheet (in millions CNY) and relevant exchange rate information.
Cash 337.50
Accounts receivable 245.00
Inventory 192.50
Fixed assets 250.00
Accumulated depreciation (25.00)
Total assets 1,000.00
Accounts payable 192.50
Long-term debt CNY437.50
Common stock 250.00
Retained earnings 120.00
Total liabilities and shareholders’ equity 1,000.00
USD/CNY
Rate on 31 December 2014 0.14
Average rate in 2015 0.15
Weighted average rate for inventory purchases 0.15
Rate on 31 December 2015 0.16
1. Question 1
The amounts reported on Able Motors’ financial statements at 31 December 2015,
after translating inventory and long-term debt of Able Motors in millions U.S. dollars
will be closest to:
o A
31 for inventory and 70 for long-term debt.

o B

o C

Incorrect
B is correct. The temporal method is used to translate the subsidiary’s accounts.
Under the temporal method, long-term debt (monetary liability) is translated at the
current (year-end) rate. Therefore, the translated amount is 437.50 x 0.16 = USD 70
million. Inventory (nonmonetary assets) is translated at historical exchange rates.
Hence, we should use the weighted average rate for inventory purchases which is
0.15. Inventory amount = 192.50 x 0.15 = USD 28.875 or approximately USD 29
million.
2. Question 2
The amount of Able Motors’ retained earnings after translating into the parent
currency (in millions U.S. dollar) will be closest to:
o A
20.
o B
18.
o C
19.
Incorrect
B is correct. The translated balance sheet is shown below. Step 1 is to calculate total
assets which equal USD153.58. Hence total liabilities plus shareholder equity will
also equal $153.58. The liabilities plus common stock is 30.80 + 70.00 + 35.00 =
135.80. Retained earnings = 153.58 – 135.80 = 17.78.
Account CNY Rate $/CNY US$

Cash 337.50 0.16 54.00
Accounts receivable 245.00 0.16 39.20
Inventory 192.50 0.15 28.88
Fixed assets 250.00 0.14 35.00
Accumulated depreciation (25.00) 0.14 (3.50)
Total assets 1,000.00 153.58
Accounts payable 192.50 0.16 30.80
Long-term debt 437.50 0.16 70.00
Common stock 250.00 0.14 35.00
Retained earnings 120.00 To balance 17.78
Total liabilities &
1,000.00 153.58
shareholders’ equity
3. Question 3
If the functional currency of Able Motors’ was changed to Chinese yuan, the balance
sheet exposure in CNY millions would be closest to:
o A
370.
o B
1,000.
o C
250.
Incorrect
A is correct. If the functional currency was changed, the current rate method would
be used and the balance sheet exposure would be equal to net assets = 1,000 –
192.50 – 437.50 = CNY370.00 million.
Arcander AG is a German multinational corporation. It uses the euro as its presentation

currency and reports under IFRS. Electrolox is a Malaysian subsidiary of Arcander and has
experienced mild inflation rates. Electrolox uses the FIFO method to record its inventory.
The table below gives selected financial information for Electrolox.
Selected financial data for Electrolox 31 Dec 2015 (MYR Millions)

Cash 138.65
Accounts receivable 255.00
Inventory 554.60
Fixed assets 1,819.00
Accumulated depreciation (227.40)
Total assets 2,540.00
Long-term debt 222.00
Common stock 688.00
Retained earnings 1,425.00
Total liabilities & equity 2,540.00
Total revenues MYR5,200
Net income 488.00
Exchange rate at specific times € per MYR
Rate when first 1,200 of fixed assets were acquired 0.212
Rate when remaining fixed assets were acquired 0.226
Rate when long-term debt was issued 0.220
31 December 2014 0.240
Weighted average rate when inventory was acquired 0.242
Average rate in 2015 0.244
31 December 2015 0.248
1. Question 1
If Electrolox used euro as its functional currency for 2015, instead of MYR, then it
is most likely that Arcander’s consolidated:
o A
fixed asset turnover will be higher.

o B
fixed asset turnover will be lower.

o C
receivables will be higher.

Incorrect
A is correct. If euro is the functional currency of Electrolox, the temporal method
must be used. Monetary assets such as receivables and revenues would be the same
under either accounting method. With the temporal method, fixed assets are
translated at historical rates rather than current rates. Fixed assets were purchased
when euro was stronger (MYR was weaker), so at historical rates the translated value
of fixed assets will be relatively low. Therefore, the revenues/fixed assets ratio will be
higher.
2. Question 2
If MYR is the functional currency for Electrolox, any unrealized translation gain/loss
when the parent consolidates will most likely be:
o A
reported as part of net income.

o B
reported directly to equity as part of cumulative translation

adjustment.
o C
not reported until the entity is sold.

Incorrect
B is correct. When the current rate method is used, all currency gains and losses are
reported as cumulative translation adjustment to shareholders’ equity.
3. Question 3
Arcander’s consolidated gross profit margin for 2015 would be highest if Electrolox
used the inventory accounting method of:
o A
FIFO with euro as its functional currency.

o B
LIFO with euro as its functional currency.

o C
FIFO with MYR as its functional currency.

Incorrect
A is correct. If euro is the functional currency, the temporal method will be used.
Under the temporal method, cost of sales is translated using historical rates. Since
the euro has consistently weakened against MYR, the cost of sales will be lower and
gross profit margin higher when an earlier exchange rate is used to translate
inventory, as compared to using the current exchange rate. Since prices are rising,
FIFO will result in lower cost of sales and higher gross profit margin compared to
using the LIFO method.
4. Question 4
If the current rate method is used to translate Electrolox financial statements, the
consolidated financial statements of Arcander will most likely include Electrolox’s:
o A
€50.02 million in accounts payable.

o B
negative translation adjustment to shareholder equity.

o C
€1,269 million in revenues.

Incorrect
C is correct. Under the current rate method, revenue = MYR5,200 x 0.244 = €1,268.80
million. Accounts payable will be translated at current rate = MYR205 x 0.248 =
€50.84 million. Electrolox will have a net asset balance sheet exposure under the
current method. MYR has been strengthening against the euro, the translation
adjustment will be positive.
5. Question 5
If euro is the functional currency for Electrolox in 2015, Arcander may reduce its
balance sheet exposure to exchange rates by:
o A
issuing MYR33.35 million of long-term debt to buy fixed assets.

o B
selling MYR 33.35 million of fixed assets.

o C
issuing MYR33.35 million of notes payable for investment in government

securities.
Incorrect
B is correct. If euro is the functional currency, then the temporal method is used. The
balance sheet exposure = 138.65 + 255 – 205 – 222 = -MYR33.35 or a net monetary
liability of MYR33.35 million. If fixed assets (non-monetary) are sold which are
nonmonetary, cash will increase, and the net monetary liability is wiped out. This
implies that balance sheet exposure is removed. Issuing debt will increase the net
monetary liability.
6. Question 6
If Electrolox’s financial statements are translated into euro using the temporal
method, Arcander will most likely include:
o A
€137.54 million in inventory.

o B
€394.30 million in fixed assets.

o C
€53.30 million in long-term debt.

Correct
B is correct. Under the temporal method, inventory and fixed rates are translated at
historic rates. Long-term debt is translated at year-end (current) rates. Fixed assets =
1200 x 0.212 + 619 x 0.226 = €394.29 million.
Henrik Kraus, chief financial officer of Altia AB, is preparing the company’s 2016 annual
report. Kraus is particularly interested in the transactions and disclosures related to Altia’s
foreign operations. Altia is a Norway-based furniture and home accessories manufacturer
and retailer, which reports under International Financial Reporting Standards (IFRS). It has a
presence in Norway, the eurozone and the United States. The stores in the eurozone and
the United States are operated through a wholly owned subsidiary in each region. The sales
numbers are presented below.
Exhibit 1: Altia AB Sales for the Years Ended 31 December

Consolidated (NOK millions) Parent Only (NOK millions)
2016 2015 2016 2015
Sales 35,200 31,890 5,478 5,518
The relevant currency exchange rates are shown in Exhibit 2. The functional currency for the
eurozone subsidiary is the euro (EUR). The functional currency for the US subsidiary is the
USD. The current rate method is used to translate the financial statements of both
subsidiaries.
Exhibit 2: Exchange Rates
NOK per EUR NOK per USD
Beginning 2015 8.35 6.07
Average 2015 8.60 6.10
End of 2015 8.80 6.13
Average 2016 8.90 7.42
End of 2016 9.10 8.71
The number of stores operated in each region is shown in Exhibit 3.
Exhibit 3: Number of Stores by Region
Year Eurozone Norway United States Total
2015 360 105 85 550
2016 420 106 85 611
Kraus makes the following notes:
• In 2015, the sales per store, in NOK, were the same for both US and Norwegian
stores.
• The sales per US store in USD remained constant in 2016.
• The eurozone region sales figures (in millions) were NOK19,400 in 2015 and
NOK22,640 in 2016.
1. Question 1
L.O.: i Q-Code: 21-L2-FR-MUOP-75431

The growth rate in sales per store in the eurozone region between 2015 and 2016 in
local currency (EUR) is closest to:
o A
6.16%.
o B
-3.4%.
o C
4.0%.
Incorrect
B is correct.
2015 2016
European sales (given) (in millions) NOK19,400 NOK22,640
Exchange rate (average rate used
NOK8.60/EUR NOK8.90/EUR
for sales under current method)
Sales in millions EUR2,256 EUR2,544
Number of stores 360 420
Sales/Store in millions EUR6.27/Store EUR6.06/Store
Growth rate (6.06 – 6.27)/6.27 –3.35%
Section 5.1. LO.i.
2. Question 2
Using Exhibits 1, 2, and 3 and Kraus’ notes about the US operations, the change in
sales reported for the US region (in NOK from 2015 to 2016) due to change in the
NOK/USD exchange rate in 2016 is closest to:
o A
NOK 966.50 million.

o B
NOK 732.28 million.

o C
NOK 8.62 million.

Incorrect
A is correct. The number of stores in U.S. are same in both years: 85. Average sales
per US store in 2015 is the same as average sale per Norwegian store. USD sales are
the same for both years. But when sales are converted to NOK, the change in value
is due to the change in exchange rate over the period.
Calculations NOK (millions)

Number of stores in the
85
United States (Exhibit 1)
Average sales/US store in
2015
NOK5,518/105 stores = 52.55/Store
(same as the Swedish stores in
2015)
Sales/US store (in USD
millions) based on (NOK52.55/Store)/(NOK6.10/USD)
average exchange rate in = USD8.615/Store
2015
Total USD sales (in USD
millions) in 2015 and 85 stores × (USD8.615/Store)
2016 (same both years in = USD732.275
USD)
Total USD sales in 2015 in
USD732.275 × (NOK6.10/USD) = 4,467.00 million
NOK
Sales in USD in 2016 (the
same as 2015), converted at USD732.275 × (NOK7.42/USD) = 5,433.50 million
the 2016 average rate
Increase in sales because of change in exchange rate 966.50 million
Top Invest is a London-based private equity firm which provides financing for CQX Tours Plc.
CQX uses International Financial Reporting Standards (IFRS) in the preparation of its
financial statements. CQX, a relatively new company, specializes in arranging flights and
vacation packages to Mediterranean locations and prices its tourist packages competitively.
It sells most of its flights and vacation packages in Britain in British pounds (GBP). Costs are
incurred in multiple currencies. A few additional points related to CQX are as follows:
• Wage costs are in GBP.

• Property lease costs are normally priced in US dollars (USD).
• At year-end (31 December), CQX had a large outstanding payable in euros related to
fees that were incurred evenly over the final quarter. The company paid the full
amount on 01 March as per the due date.
The table below gives the USD to GBP and EUR to GBP exchange rates during 2015.
Selected Exchange Rate Data
GBP/USD GBP/EUR
1-Jan-15 0.65
30-Jun-15 0.71
31-Dec-15 0.69 0.74
01-Mar-16 0.72
Average, 1 July-31 December 2015 0.7215
Average, 1 October-31 December 2015 0.73
1. Question 1
Operating income for CQX as a result of the change in the USD to GBP exchange rate
during 2015 would most likely:
o A
increase because of the positive effect on selling costs.

o B
decrease because of the negative effect on operating costs.

o C
increase because of the positive effect on revenues.

Incorrect
B is correct. CQX incurs lease costs in USD. During the year, the USD appreciated
relative to the GBP (from GBP0.6500/USD to GBP0.6900/USD), thereby making
purchases (costs) in USD costlier for CQX and thus decreasing operating income.
2. Question 2
Regarding CQX’s large payable at year-end (31 Dec) in euros, the most likely effect on
CQX’s financial statements would be:
o A
deferral of any currency effects until the payable is paid on its due date in
March.
o B
reporting an unrealized exchange loss at year-end.

o C
adjustment of the payable to reflect the change in exchange rate when

payment is made.
Incorrect
B is correct. The EUR strengthened against the GBP (GBP0.7300/EUR to
GBP0.7400/EUR), and CQX would report an unrealized loss (from holding a liability in
an appreciating currency) in net income. The payable would be originally recorded
when the fees were incurred during the final quarter but revalued at year-end to
GBP0.7400. This results in an increase in a liability leading to a loss.
3. Question 3
The functional currency of CQX is most likely:
o A
EUR.
o B
USD.
o C
GBP.
Incorrect
C is correct. The functional currency is the currency of the primary economic
environment in which an entity operates. CQX’s functional currency is most likely
GBP. The company sets its prices in GBP based on competition in Britain; it is
financed by a British private equity firm, and it receives its revenues primarily in GBP.
Green Fields is a British retailer based in the U.K. It has recently acquired 100% of Sargus, a
Greek company that produces and packages fruits and vegetables. Sargus has long-term
debt outstanding from a Greek bank that financed the 2014 purchase of agriculture land
which will now be part of Green Fields. Sargus incurs all costs related to operating and
cultivation of its products in EUR. After the acquisition, all of Sargus’ revenue in GBP comes
from sales in Britain by Green Fields. The financial reporting of Green Fields is presented
under IFRS. The GBP/EUR rate was 0.70 at the time of acquisition in June 2016 and was 0.72
at year-end 2016. Green Fields uses the temporal method for its translation of Sargus. The
following table gives the selected balance sheet data related to the Sargus acquisition.
30 June 2016 (Acquisition 31 December 2016 (year-

EUR thousands
date) end)
Cash & accounts receivable 3,300 3,600
Inventory 1,700 1,900
Net fixed assets 13,000 12,564
Total assets 18,000 18,064
Current liabilities 3,000 3,007
Long-term debt 8,600 8,350
Share capital 4,200 4,200
Retained earnings 2,200 2,507
Total liabilities &
18,000 18,064
shareholders’ equity
1. Question 1
If the temporal method is used to translate Sargus’ financial statements into the
consolidated financial statements of Green Fields, the functional currency of Sargus
is most likely:
o A
EUR.
o B
GBP.
o C
USD.
Incorrect
B is correct. The functional currency of Sargus currently appears to be GBP. Sargus
receives revenues from Green Fields, in GBP. Even though Sargus incurs most costs
and its financing (long-term debt) in EUR, under IFRS, Factors 1 and 2 (dealing with
revenues and sales prices) rank higher than Factors 3 and 4 (dealing with operating
and financing costs) when determining functional currency. Under IFRS, when the
functional currency of the subsidiary is the same as the parent, the temporal method
should be used to translate the subsidiary’s financial statements.
2. Question 2
On 31 December 2016, the most likely effect of the change in GBP/EUR exchange rate
on the consolidated financial statements of Green Fields arising due to its acquisition
of Sargus is:
o A
a translation adjustment reported in other comprehensive income.

o B
a translation loss reported in net income.

o C
a translation gain reported in shareholders’ equity.

Incorrect
B is correct. Green Fields is using the temporal method for its translation of Sargus,
and the initial exposure is a net liability exposure (monetary liabilities of EUR8,300
exceed the monetary assets of EUR3,300). The EUR appreciated against the GBP
during the six-month period (from GBP0.70/EUR to GBP0.72/EUR). The effect of
having a net liability position in a strengthening currency will be a translation loss
which under the temporal method, is reported in net income.
3. Question 3
By choosing the temporal method, rather than the current rate method, for
translating Sargus financial statements in GBP, the ratio least likely effected will be
the:
o A
current ratio.
o B
receivables turnover ratio.

o C
net profit margin.

Correct
B is correct. The accounts receivable turnover ratio is calculated as sales/average
accounts receivable. Under both the current method and the temporal method,
sales are translated at the average exchange rate and accounts receivable are
translated at the current exchange rate. Therefore, this ratio would not be affected
by the method of translation.
BFSA AG is a Belgium-based manufacturer and retailer of audio-visual devices. In 2014 it

sold 40% of its products in the US. BFSA also aimed to establish operations in lower tax
jurisdictions, and in 2015, set up subsidiaries in Ireland and Latvia which have the lowest
corporate tax rates in Europe, 12.5% and 15% respectively. The corporate tax rate in
Belgium is 33% in US is 35%. The following table gives the selected data of BFSA AG in EUR
millions.
€ millions 2015 2014

Earnings before tax 144.64 180.00
Net earnings after tax 115.00 126.00
1. Question 1
An analyst will most likely use the information regarding the change in exchange rates
between US dollar and EUR affecting the sales growth:
o A
to evaluate the management’s historical performance.

o B
to determine exchange rate gains and losses reported in net income.

o C
to affirm why the audio division’s organic growth was only 12%.
Incorrect
A is correct. Sales growth for a multinational is impacted not only by changes in
volume and price but also by changes in the exchange rates between the reporting
currency and the currency in which sales are made. Management has control over
growth in sales resulting from greater volume or higher price, but cannot control
exchange rate changes. An analyst will therefore consider the foreign currency effect
on sales growth to forecast future cash flows and to evaluate a management team’s
historical performance.
2. Question 2
The best explanation regarding the geographic mix of BFSA’s profit in 2015 compared
with the 2014 profit distribution is that more profits came from:
o A
domestic (Belgian) operations.

o B
Irish and Latvian operations.

o C
US operations.
Correct
B is correct. The 2015 effective tax rate on earnings is lower than in 2014 (see the
following table), implying that more profits were earned in a lower tax jurisdiction.
(€ millions) 2015 2014

Earnings before taxes 144.64 180.00
Net earnings after tax 115.00 126.00
Income taxes 29.65 54.00
Effective tax rate (Income taxes/EBT) 20.50% 30.00%
Analysis of Financial Institutions
1. Systemic risk is best described as:
o A
a situation where financial shocks in a particular economy or region spreads

out and affects others.
o B
risk of failure of the financial system as a result of the failure of a major

financial institution.
o C
the undiversifiable risk inherent to the entire market.

2. Incorrect
3. B is correct. Systemic risk is “a risk of disruption to financial services that is (i) caused
by an impairment of all or parts of the financial system and (ii) has the potential to
have serious negative consequences for the economy as a whole.” A describes
financial contagion and C is systematic risk.
4. Question 2
Q-Code: 21-L2-FR-ANFI-75475
Banks have systemic importance because:
o A
financial assets are measured at fair value instead of historic cost.

o B
of high regulation which can potentially harm businesses by placing

limitations on capital.
o C
serving as intermediaries creates financial inter- linkages across all

types of entities which can be negatively affected even if one bank fails.
Incorrect
C is correct. Banks serve as intermediaries between and among providers and
recipients of capital. This leads to the formation of financial inter-linkages across all
types of entities, including households, banks, corporations, and governments. This
network across entities means that the failure of one bank will negatively affect
other financial and non- financial entities. Hence, the larger the bank, the greater its
potential impact on the entire financial system. Thus, banks have systemic
importance.
5. Question 3
The following tables contain information regarding the ratings and weights assigned
to Bank XYZ by three different analysts using the CAMELS approach.
Analyst A Rating Weights

Capital Adequacy 1.0 1
Asset Quality 3.0 1
Management Capabilities 2.0 1
Earnings 1.0 1
Liquidity 4.0 1
Sensitivity to Market Risk 3.0 1
Analyst B Rating Weights

Asset Quality 2.0 1
Earnings 1.0 1
Liquidity 2.0 3
Analyst C Rating Weights

Asset Quality 2.0 2
Earnings 1.0 2
Liquidity 1.5 1
Which analyst has assigned Bank XYZ with the best score?
o A
Analyst A
o B
Analyst B
o C
Analyst C
Incorrect
C is correct. Analyst C assigned Bank XYZ with the lowest score, which means it
received the best CAMELS score from this analyst. The calculations are as follows:
Analyst A: (1 + 3 + 2 + 1 + 4 + 3) / 6 = 14/6 = 2.33
Analyst B: (5 + 2 + 1 + 1 + 6 + 3) / 9 = 18/9 = 2
Analyst C = (1.5 + 4 + 2 + 2 + 1.5 + 2.5)/8 = 13.5/8 = 1.6875
6. Question 4
The objectives of Basel III are most likely to:
o A
govern banks globally with a framework that improves transparency and

allows banks to have flexible stable funding requirement relative to its
liquidity over a 180-day period.
o B
improve the banking sector’s ability to absorb shocks, enhance risk

management and governance, and reinforce transparency and
disclosures.
o C
specify the amount that a bank must hold in high- quality liquid assets to
cover its liquidity needs in a 90- day liquidity stress scenario.
Incorrect
B is correct. Basel III is the enhanced framework succeeding Basel I and Basel II. The
objectives of the Basel III are: “to improve the banking sector’s ability to absorb
shocks arising from financial and economic stress, whatever the source, improve risk
management and governance, and strengthen banks’ transparency and disclosures.”
7. Question 5
The three highlights of the Basel III framework are:
o A
minimum capital, minimum liquidity, and stable funding.

o B
maximum percentage of risk-weighted assets, minimum one-year deposits,

and minimum cash.
o C
minimum cash and securities, maximum one-year deposits, maximum asset

write-downs.
Incorrect
A is correct. Three important highlights of Basel III are the minimum capital
requirement, minimum liquidity, and stable funding. Basel III specifies the minimum
percentage of its risk-weighted assets that a bank must fund from its equity. This
limits financial leverage such that a bank is able to withstand loan losses (asset write-
downs). Minimum liquidity requires that a bank must hold enough high-quality liquid
assets to cover its liquidity needs in a 30-day liquidity stress scenario. This
requirement ensures that a bank has enough cash to cover a partial loss of funding
sources (e.g. customers’ deposits, other borrowings). A minimum amount of stable
funding relative to the bank’s liquidity needs over a one-year horizon is also
required. Stability of funding is based on the deposit tenor and depositor type (e.g.
funds from consumers’ deposits are considered more stable than funds raised in the
interbank markets).
8. Question 6
Capital adequacy is best described as:
o A
corporate loans as a percentage of common stock.

o B
risk-weighted assets as a proportion of retained earnings.

o C
proportion of a bank’s assets funded with capital.

Incorrect
C is correct. Capital adequacy for banks is described in terms of the proportion of
the bank’s
assets funded with capital.
9. Question 7
Common Equity Tier 1 Capital includes:
o A
common stock, issuance surplus, retained earnings, accumulated other

comprehensive income, and certain adjustments.
o B
instruments that are subordinate to deposits and other debt obligations, do

not have a fixed maturity, and pay any type of dividends or interest.
o C
instruments that are subordinate to depositors and to general creditors of

the bank and have an original minimum maturity of five years.
Incorrect
A is correct. Common Equity Tier 1 Capital includes common stock, issuance surplus
related to common stock, retained earnings, accumulated other comprehensive
income, and certain adjustments including the deduction of intangible assets and
deferred tax assets. Other Tier 1 Capital includes other types of instruments issued
by the bank that meet certain criteria. For example, instruments that are
subordinate deposits and other debt, have no fixed maturity and payment of
dividends and interest should be at the bank’s discretion. Tier 2 Capital includes
instruments that are subordinate to depositors and to creditors of the bank, have an
original minimum maturity of five years, and meet certain other requirements.
10. Question 8
Which of the following statements is least accurate? According to the minimum capital
requirements set forth in Basel III:
o A
Common Equity Tier 1 Capital should be at least 6.5% of risk- weighted

assets.
o B
Common Equity Tier 1 Capital should be at least 4.5% of risk- weighted

assets.
o C
Total Capital must be at least 8.0% of risk-weighted assets.

Incorrect
A is correct. Common Equity Tier 1 Capital must be at least 4.5% of risk- weighted
assets.
11. Question 9
The three major asset categories of a bank are:
o A
cash and liquid securities, loans, and government securities.

o B
cash and liquid financial instruments, securities issued by other

entities, and loans.
o C
cash and liquid financial instruments, loans to customers, and repurchase

agreements.
Incorrect
B is correct. The three major asset categories of a bank are: 1) Highly liquid financial
instruments – for example, T-Bills. 2) Investments in securities issued by other
entities – for example, a bond issued by another company. 3) Loans – Generally the
largest component of overall assets.
12. Question 10
Excerpt from Annual Report Disclosure of AVC Bank plc
At 31 Dec. 2017 At 31 Dec. 2016

($m) ($m)
Neither past
Strong credit quality $1,304,500 $1,325,600
due nor impaired
Good credit quality $274,700 $260,200
Satisfactory credit quality $275,375 $246,950
Past due but not impaired $12,000 $10,000
Impaired $25,510 $18,050
Total gross amount $1,892,085 $1,860,800
Impairment allowances $(10,500) $(7,440)
Total $1,881,585 $1,853,360
Does the change in the bank’s impairment allowances in 2017 reflect the change in
the credit quality of financial instruments (specifically the amount of impaired
assets)?
o A
No.
o B
Yes.
o C
Indeterminable.
Incorrect
B is correct. Yes, the change in bank’s impairment allowances in 2017 reflects the
change in the credit quality of financial instruments. The 10,500/7,440 = 41.13%
increase in the amount of impairment allowances in 2017 corresponds to the
25,510/18,050 = 41.33% increase in impaired assets. As a result, the amount of
impairment allowances as a percentage of impaired assets remained roughly
constant in both years (USD7,440/USD18,050 = 41.2% for 2016 and
USD10,500/USD25,510 = 41.2% for 2017).
13. Question 11
Which of the following is NOT a positive factor related to ‘management capabilities’
while determining the CAMELS’ score for this component? The bank has:
o A
a strong governance structure.

o B
sound measures to identify and control risk.

o C
restrictions on management communications.

Incorrect
C is correct. One of the positive factors contributing to an effective management is
transparency in management communications. Other factors related to
management capabilities are:
• Do we have a strong governance structure, whereby management is acting in

the best interests of shareholders?
• Is management properly complying with laws and regulations?
• Are the internal controls strong?
• Is the financial reporting quality good?
If all these other factors are also positive, then this would result in a good
CAMELS’ score for this component.
14. Question 12
High quality earnings most likely means:
o A
accounting estimates are unbiased and earnings are sustainable.

o B
accounting estimates are unbiased and the return on invested capital is equal
to the cost of capital.
o C
earnings are trending upwards with trading income as a proportion of

earnings greater than net interest income and service income.
Incorrect
A is correct. Generally, high- quality earnings mean that accounting estimates are
unbiased and the earnings are derived from sustainable rather than non-recurring
items. Banks’ earnings typically comprise (a) net interest income (the difference
between interest earned on loans minus interest paid on the deposits), (b) service
income, and (c) trading income. Of these three, trading income is typically the most
volatile. Thus, a greater proportion of net interest income and service income is
typically more sustainable than trading income.
15. Question 13
Which one of the following is a factor to consider while evaluating the liquidity
position of a bank?
o A
Estimating loan impairment allowances

o B
Concentration of funding
o C
Volatility of net interest income

Incorrect
B is correct. One of the liquidity-monitoring metrics described in Basel III is
concentration of funding. Concentration of funding refers to the proportion of
funding that is obtained from a single source. Excessive concentration of funding
exposes a bank to the risk that a single funding source could be withdrawn.
Estimating loan impairment allowances are important to determine whether
earnings are high quality. Volatility of net interest income is important for evaluating
the sustainability of earnings.
16. Question 14
The following table shows the components of Bank SBI’s highly liquid assets and net
cash outflows (in billions of dollars).
31 Dec 2017 31 Dec 2016 31 Dec 2015

High-Quality Liquid Assets 400 389 378
Net Cash Outflows 347 342 336
HQLA in excess of Net Outflows 53 47 42
Based on the table, SBI’s 2017 liquidity coverage ratio indicates:
o A
it can withstand cash outflows that are 20% higher than its 30- day liquidity
needs in a stress scenario.
o B
it can withstand a stress level volume of cash outflows for 34.5 days.
o C
inadequate liquidity.
Incorrect
B is correct. The following table calculates the Liquidity Coverage Ratios for Bank SBI.
31 Dec. 31 Dec.
In billions dollar 31 Dec. 2017
2016 2015
High-Quality Liquid Assets 400 389 378
Net Cash Outflows 347 342 336
HQLA in excess of Net
53 47 42
Outflows
Liquidity Coverage Ratio = 400/347 =
113.7% 112.5%
HQLA/Net Outflows 115.3%
The minimum LCR threshold is 100%; anything less would indicate an inability to
meet the liquidity needs. The three years’ LCR shows that SBI has adequate liquidity.
Its LCR has improved over the years. SBI’s 2017 LCR indicates it can withstand cash
outflows that are 15% higher than its 30-day liquidity needs in a stress scenario or,
equivalently, it can withstand a stress level volume of cash outflows for 34.5 days
(115% x 30 days). Either way, the LCR indicates adequate liquidity even in the
absence of any (likely) remedial management steps in an actual stress event.
17. Question 15
One limitation of CAMELS approach used to evaluate banks is that it fails to address a bank’s:
o A
sensitivity to market risk.

o B
competitive environment.
o C
management capabilities.
Incorrect
Solution: B is correct. The CAMELS approach has six components: (1) capital
adequacy, (2) asset quality, (3) management capabilities, (4) earnings sufficiency, (5)
liquidity position, and (6) sensitivity to market risk. Some attributes of a bank are not
addressed by this method, such as its competitive environment. A bank’s competitive
position relative to its peers may affect how it allocates capital and assesses risks.
18. Question 16
Which of the following trends would most likely indicate an improvement in sensitivity of
the bank to market risk?
o A
A downward trend in the total trading VaR and total trading and credit
portfolio VaR.
o B
An increase in liquidity coverage ratio and the net stable funding ratio.
o C
An increase in common equity Tier 1 capital ratio, Tier 1 capital ratio, and
total capital ratio.
Incorrect
Solution: A is correct. A downward trend in the two VaR measures, total trading VaR
(all market risk factors) and total trading and credit portfolio VaR, indicates an
improvement in bank’s sensitivity, or a reduction in its exposure, to market risk.
19. Question 17
Analyst 1: VaR statistics can be effective indicators of trends in intra-company risk taking.
Analyst 2: VaR is not as useful for assessing risk-taking activities between different
companies.
Which analyst is correct?
o A
Analyst 1
o B
Analyst 2
o C
Both Analysts 1 and 2

Incorrect
Solution: C is correct. The value at risk (VaR) disclosure is helpful for assessing a
bank’s exposure to market factors. VaR statistics can be effective indicators of trends
in intra-company risk taking. However, because of differences in calculation
assumptions across companies, VaR is not as useful for assessing risk-taking
activities between different companies.
20. Question 18
Southcity bank is very active in the 30-day reverse repurchase agreement market during
times when the bank experiences significant increases in retail deposits. This is most likely to
affect which of the following ratios:
o A
Tier 2 capital ratio

o B
Liquidity coverage ratio

o C
Net stable funding ratio

Incorrect
Solution: B is correct. Reverse repurchase agreements represent collateralized loans
between a bank and a borrower. A reverse repo with a 30-day maturity is a highly
liquid asset. It would directly affect the liquidity coverage ratio (LCR) which evaluates
short-term liquidity. LCR represents the percentage of a bank’s expected cash
outflows in relation to highly liquid assets.
21. Question 19
The bank will enjoy government support in times of economic distress if it has:
o A
above-average equity-based compensation and large asset write-downs.

o B
a mission to serve the community and borrowers affect the primary industry.
o C
a large size or is a SIFI.

Incorrect
C is correct. A bank that will receive government support in times of financial crisis, is
considered safe as compared to banks that will not receive government support.
Two factors are considered to determine whether government support will be
provided to banks – the size of the bank and the status of the country’s banking
system. If the bank is very large, then chances are that it is extremely important for
the economy and will therefore receive support. If it is categorized as a SIFI
(systemically important financial institution), then such a bank will likely receive
government support in the event of financial distress. SIFIs are institutions that
would pose a significant risk to the economy in the event of a failure. However, such
institutions face increased regulation in the post- crisis era.
22. Question 20
Tivari is a global bank with its head office in Nevari and NVS as its home currency.
Recently NVS strengthened against the functional currencies of its foreign
subsidiaries. The translation of balance sheet accounts at the end of an accounting
period may lead to currency translation adjustments that can:
o A
increase capital.
o B
reduce capital.
o C
have no impact.
Incorrect
B is correct. Currency exposure is an issue for large global banks. For example, if the
functional currency of a foreign subsidiary depreciates relative to the reporting
currency of the bank, then this results in a negative impact on the capital of the
bank.
23. Question 21
Sarah Khan is comparing two similar banks, Birchwood and Oakland. She is
assessing which bank would be more suitable for her client to invest in. The
following table compares some ratios of the two banks.
Birchwood Oakland
Common Equity Tier 1
Capital / Total risk- 12.52% 4.75%
weighted assets
Tier 1 Capital / Total risk-
16.60% 5.78%
weighted assets
Total Capital / Total risk-
17.12% 9.1%
weighted assets
Khan also notes that both Birchwood and Oakland’s pretax income increased by an
average of 4% in the past 5 years, but Birchwood’s provision for pretax losses had
decreased substantially over the years while Oakland’s has remained relatively
constant.
If all other financial information regarding the two banks is the same, which of the
following statements is most likely correct?
o A
If Khan’s client is investing in equity, they will prefer to invest in Birchwood.

o B
If Khan’s client is investing in fixed income, they will prefer to invest in

Birchwood.
o C
Khan should recommend Birchwood to her client regardless of whether they

buy the bank’s shares or bonds.
Incorrect
B is correct. Birchwood’s capital adequacy is higher than that of Oakland. All three
capital adequacy ratios are higher than the Basel III minimum capital requirements
(4.5% for Common Equity Tier 1 Capital, 6.0% for Tier 1 Capital, and 8.0% for Total
Capital). Oakland’s Tier 1 Capital ratio is lower than the minimum amount, and
overall its ratios are lower than Birchwood’s. This makes Birchwood the more
attractive investment to a fixed income investor.
Option A is incorrect because if all other financial information regarding the two
banks is the same, an equity investor would prefer to buy shares in Oakland because
its earnings appear to be more sustainable. Birchwood’s provision for pretax losses
has decreased substantially over the past 5 years, which would make the pretax
income appear higher than it would have if this provision remained constant.
However, Birchwood’s provision for pretax losses cannot decrease indefinitely, which
makes its earnings less sustainable than Oakland’s.
Since an equity investor and fixed income investor would have different preferences
when deciding between investing in these two banks, option C is incorrect.
24. Question 22
The most likely difference between a P&C insurance company and a L&H insurance
company is:
o A
P&C insurers’ claims are more variable and “lumpier”.

o B
P&C insurers’ policies are usually longer term relative to L&H insurers’
policies that are typically short term.
o C
L&H insurers’ claims are more unpredictable than P&C insurers’ claims.
Incorrect
A is correct. P&C insurers’ claims are more variable and “lumpier” because they occur
from accidents and other unpredictable events. L&H insurers’ claims are more
predictable because they correlate closely with stable actuarially based mortality
rates applied to large populations. P&C insurers’ policies are usually short term, and
the final cost will usually be known within a year of occurrence of an insured event,
whereas L&H insurers’ policies are usually longer term.
25. Question 23
A ‘soft’ pricing market for insurance premium is when:
o A
competition lessens and underwriting standards tighten.

o B
firms cut prices to get more business.

o C
premiums rise and insurers gain profitability.

Incorrect
B is correct. The property and casualty insurance business is cyclical. It is a price-
sensitive business, with many competitors unafraid to cut prices to obtain market
share. High competition leads to low profitability. There is pressure on the firms to
cut prices to get more business, which leads to a ‘soft’ pricing market. Due to this,
some firms that do not have enough capital to maintain losses exit the market.
When firms exit, the competition lessens and underwriting standards tighten,
creating a “hard” pricing market. The premiums rise, and the profitability also
improves. The higher premiums attract new firms to the industry. As more firms
enter, the competition once again goes up and the cycle repeats. IFT Notes.
26. Question 24
A low combined ratio (less than 100%) for the P& C insurance industry indicates:
o A
a soft insurance market where competitors exit the market because of

unprofitable underwriting.
o B
an underwriting loss.
o C
a hard insurance market, attracting new entrants because of higher

premium prices.
Incorrect
C is correct. When the industry’s combined ratio — the total insurance expenses
divided by the net premiums earned — is low, it indicates a hard insurance market,
attracting new entrants. This happens because the lower premium prices decrease
the total net premiums earned, and the combined ratio increases, indicating a soft
market. Competitors leave the market, either because they want to forgo
unprofitable underwriting or because of their own failure. For a single insurance
company, a combined ratio higher than 100% indicates an underwriting loss.
27. Question 25
The loss and loss adjustment expense ratio indicates:
o A
efficiency of money spent in obtaining new premiums.

o B
success in estimating risks insured.

o C
overall efficiency of an underwriting operation.

Incorrect
B is correct. Loss and loss adjustment expense ratio = (Loss expense + Loss
adjustment expense)/Net premiums earned. This ratio indicates the degree of
success an underwriter has achieved in estimating the risks insured. A lower ratio
shows greater success. Underwriting expense ratio = Underwriting expense/Net
premiums written. This measures the efficiency of money spent in obtaining new
premiums. A lower ratio indicates higher success. Combined ratio = Loss and loss
adjustment expense ratio + Underwriting expense ratio. This shows the overall
efficiency of an underwriting operation. A combined ratio of less than 100 is
considered efficient.
28. Question 26
Roma Harris, an analyst at a large wealth management firm, meets with her
supervisor to discuss adding financial institution’s equity securities to client
portfolios. She focuses on Emerald Insurance (Emerald), a property and casualty
company. To evaluate Emerald further, Harris compiles the information presented in
the Exhibit below.
Exhibit: Key Performance Ratios for Emerald Insurance
Ratio 2021 2020

Loss and loss adjustment expense 57.1% 59.2%
Underwriting expense 34.3% 32.9%
Combined 91.4% 92.1%
Dividend 2.7% 2.5%
Based only on the information in the Exhibit, in 2021 Emerald most likely:
o A
improved its ability to estimate insured risks.

o B
experienced a decrease in overall efficiency.

o C
was more efficient in obtaining new premiums.

Incorrect
Solution: A is correct. The loss and loss adjustment expense ratio decreased from
59.2% to 57.1% between 2020 and 2021. This ratio indicates the degree of success an
underwriter has achieved in estimating the risks insured. A lower ratio indicates
greater success in estimating
insured risks.
Jared Leto, an analyst at a large investments firm, is asked to assess SGV Bank as the firm is
considering investments in it. Leto applies the CAMELS approach to analyze the bank. He
begins the analysis by looking at the capital position. Leto compares the capital ratios with
the minimum capital requirements set forth in Basel III. The following table presents an
excerpt from SGV’s annual report containing disclosures about its capital position. The
excerpt shows amount of capital by tier, and risk- weighted assets.
Total Regulatory Capital and Risk-

Weighted Assets
31 Dec. 2016
31 Dec. 2017 ($m)
($m)
Regulatory Capital
Common equity tier 1
143,000 120,650
capital
Additional tier 1
22,380 21,320
capital
Tier 2 capital 36,450 34,100
Total regulatory
201,830 176,070
capital
Risk-weighted assets 1,100,000 850,900
1. Question 1
According to the Basel III minimum capital requirements, the total capital must be at
least:
o A
4.5% of RWAs.
o B
6.0% of RWAs.
o C
8.0% of RWAs.
Incorrect
C is correct. According to the Basel III minimum capital requirements, the total
capital must be at least 8.0% of risk-weighted assets. Common Equity Tier 1 Capital
must be at least 4.5% of risk- weighted assets and Total Tier 1 Capital must be at
least 6.0% of risk- weighted assets.
2. Question 2
Based on the table above, in 2017 SGV’s capital ratios most likely:
o A
strengthened.
o B
weakened.
o C
remained unchanged.
Incorrect
B is correct. The following table shows the capital ratios for the SGV Bank.
At 31 Dec. 2017 (%) At 31 Dec. 2016 (%)

Common equity tier 1 143,000/1100,000 = 120,650/850,900 =
ratio 13.0% 14.2%
165,380/1100,000 = 141,970/850,900 =
Tier 1 ratio
15.0% 16.7%
201,830/1100,000 = 176,070/850,900 =
Total capital ratio
18.3% 20.7%
SGV’s capital ratios weakened in 2017. Its Common Equity Tier 1 ratio decreased
from 14.2% of RWAs to 13.0% of RWAs. Its Tier 1 ratio also decreased from 16.7% to
15.0%, and its Total Capital Ratio decreased from 20.7% to 18.3%.
3. Question 3
The primary reason for the change in SGV’s capital ratios in 2017 most likely is:
o A
an increase in the amount of risk-weighted assets.

o B
a decrease in the amount of risk-weighted assets.

o C
an increase in the total regulatory capital.

Incorrect
A is correct. The primary reason for the change in SGV’s capital ratios in 2017 was an
increase in the amount of risk-weighted assets. Total risk-weighted assets increased
from USD850,900 million to USD1,100,000 million.
Bareera Ali, an analyst at a securities firm, is asked to analyze the asset quality of ABM Bank,
headquartered in Netherlands. Ali evaluates the overall asset composition of ABM. She
analyzes the liquid assets, loan composition and investments in securities components of
the balance sheet. The following table presents the asset portion of the balance sheet of
ABM, which is prepared according to IFRS. Excerpts from ABM Bank’s Balance Sheet At 31
December
2017 (€ 2016 (€
Assets
million) million)
Cash and balances at central banks 40,000 30,920
Collection from other banks 1,660 1,800
Government debt certificates 9,900 8,870
Financial assets held for trading 73,480 70,175
Financial assets designated at fair value 7,740 7,370
Loans and advances to banks 27,340 28,220
Loans and advances to customers 269,230 288,540
Reverse repurchase agreements, non-
50,320 45,650
trading
Other financial investments 136,500 130,000
Assets held for sale 1,370 13,702
Total Assets 742,500 752,100
Note 1: Cash, Collections and Government certificates are considered highly liquid. Note 2: Assets held for
sale are long-term assets related to discontinued operations. Note 3: Investments in securities: financial
assets held for trading, financial assets designated at fair value, other financial investments.
1. Question 1
Did ABM’s balance sheet liquidity decrease or increase in 2017? (calculate the
proportion of total assets invested in liquid assets for 2016 and 2017).
The bank’s balance sheet liquidity:
o A
increased.
o B
decreased.
o C
neither, it remained unchanged.

Incorrect
A is correct. ABM’s balance sheet liquidity increased in 2017. In 2016, the proportion of
ABM’s balance sheet invested in highly liquid assets was 5.5%.
( 30,920 + 1,800 + 8,870 )mil / 752,100mil = 5.53%
In 2017, the proportion of ABM’s balance sheet invested in highly liquid assets was
7.00%.
( 40,000 +1,660 + 9,990) mil / 742,500 mil = 6.94% = 7.00%
2. Question 2
Did the percentage of investments to total assets change from 2016 to 2017?
o A
Yes, it decreased.
o B
Yes, it increased.
o C
No, it remained unchanged.

Incorrect
B is correct. Financial assets held for trading, financial assets designated at fair value,
and other financial investments are included in investments in securities. The
percentage of investments on ABM’s balance sheet increased in 2017. In 2016, the
percentage of investments to total assets was 27.6%
( 70,175 + 7,370 + 130,000 ) mil / 752,100 = 27.6%
In 2017, the percentage of investments to total assets was 29.3%
(73,480 + 7,740 + 136,500 ) mil / 742, 500 mil = 29.3%
3. Question 3
The proportion of the ABM’s assets that are loans are:
o A
45% in 2016 and 48% in 2017.

o B
50% in 2016 and 47% in 2017.

o C
48% in 2016 and 47% in 2017.

Incorrect
C is correct. In 2016, loans represented 48.2% [(28,220 + 288,540 + 45,650)/752,100 =
48.2%] of total assets, and in 2017, loans represented 46.7% [(27,340 + 269,230 +
50,320)/742,500 = 46.7%] of HSBC’s total assets.
Sam Hill is a recently hired junior analyst at Veron Securities. Hill and his supervisor, Ben
Bridges discuss some of the firm’s investments in banks and insurance companies. Bridges
asks Hill about the differences in the assessment of banks relative to the evaluation of non-
financial companies. In response Hill makes the following statements:
Statement 1: Financial institutions are more heavily regulated than non-financial

companies because of their greater systemic importance.
Statement 2: Assets of financial institutions are mostly financial assets, unlike those of
non-financial companies, which are mostly tangible assets. Financial assets are measured
at fair value for financial reporting purposes.
Statement 3: Generally, the insurance market has a larger proportion of cross-border

business than most banks.
Bridges asks Hill about Basel III, the international regulatory framework for banks. Hill
replies, “Basel III has three important features. First, it specifies the minimum percentage
of risk-weighted assets that a bank must fund with its capital. This requirement limits a
bank from taking excessive financial leverage which can lead to asset write-downs.
Second, Basel III specifies that a bank must hold enough cash and securities to cover its
liquidity needs over a six-month stress scenario. This ensures that a bank has sufficient
cash to cover a partial loss of funding sources or a cash outflow from off- balance- sheet
funding commitments. Third, a minimum amount of stable funding is required relative to
the bank’s liquidity needs over a one- year horizon. Consumers’ deposits are considered
more stable than interbank deposits.”
Bridges tells Hill that he uses the CAMELS approach for analyzing banks. He asks Hill about
some of the other factors relevant to the analysis of a bank which also apply to any
company and are not covered by the CAMELS approach. Hill responds that a bank’s
competitive environment, off-balance-sheet assets and liabilities, the different business
segments of a bank, risk factors given in a bank’s annual filing, currency exposures and
Basel III disclosures should be considered while analyzing a bank.
1. Question 1
Which of the following statements made by Hill regarding the differences between
financial and non-financial companies is least likely correct?
o A
Statement 1.
o B
Statement 2.
o C
Statement 3.
Incorrect
C is correct. Relative to banks, the overall insurance market has a smaller proportion
of cross- border business. The reinsurance business, however, is largely
international. The international aspect of the reinsurance business increases the
importance of the insurance sector to the global financial system. A & B are correct.
2. Question 2
Regarding the Basel III framework, which feature mentioned by Hill is least accurate?
o A
The minimum capital requirement.

o B
The minimum liquidity requirement.

o C
The stable funding requirement.

Incorrect
B is correct. According to the minimum liquidity requirement stipulated in Basel III, a
bank must hold enough high- quality liquid assets to cover its liquidity needs in a 30-
day liquidity stress scenario. A and C are correct.
3. Question 3
The off-balance-sheet items stated by Hill related to the other factors (besides
CAMELS’ approach) to consider for a bank or for any company are most likely:
o A
guarantees, unused committed credit lines, and letters of credit.

o B
the existence of VIE, benefit plans, and AUM.

o C
operating leases, and offshore guarantees.

Correct
B is correct. An analyst should review the existence of variable interest entities (VIE).
A variable interest entity may result in off-balance- sheet assets and liabilities for a
bank if the bank has an interest in the VIE but is not required to consolidate it. If the
VIE is not consolidated with the bank, its existence and certain financial information
must be disclosed. If non-consolidated, the reasons given for non- consolidation
should be examined for reasonableness, and the implications to the bank of various
scenarios affecting the VIE should be assessed. Benefit plans are another “off-
balance- sheet” item for investors to examine. Shortfalls in assets due to weak
market performance can cause increases in required contributions to plans. Interest
rate decreases, which will make plan obligations higher, can also cause rapid cash
drains for required contributions to plans. Finally, sometimes in banks, assets under
management (AUM) that generate management fees and are not consolidated with a
bank’s balance sheet accounts, should be analyzed. These drive returns for a bank
and therefore the size and growth or decline in assets under management should be
considered. A is incorrect because off- balance- sheet obligations such as
guarantees, unused committed credit lines, and letters of credit represent bank’s
trading activities. These are analyzed by the CAMELS approach. C is incorrect
because operating leases are a low- risk example of off- balance- sheet liabilities.
These can be easily accessed by investors in the lease footnotes.
Carly Johnson works as a junior analyst at DRB Investments. She meets with the senior
analyst, Tanya Ricci, to discuss the insurance companies under consideration for investment
by the firm. Ricci asks Johnson about the differences between P&C and L&H insurers.
Johnson states the following differences: Difference 1: P&C claims are more variable as they
arise from accidents or unpredictable events, whereas L&H insurers’ claims are more
predictable because they correlate with actuarial determined mortality rates. Difference
2: P&C companies invest in stable-return, low risk investments, whereas L&H seek the
higher returns offered by riskier investments. Difference 3: Due to their low-risk
investments, P&C companies have lower risk-based capital requirements as compared to
L&H insurers, which need a high equity cushion and can have higher capital requirements.
Ricci asks Johnson to calculate pre-tax operating margin, pre-tax operating return on assets,
and return on equity for three L&H insurers. The selected financial information for the three
insurers is presented in Table 1. Table 1: Financial Information for Three L&H Insurers
Year End 2017
In $(‘000) Insurer A Insurer B Insurer C

Total Revenues 4,442,000 4,350,900 4,230,950
Pre-tax Operating Profit 214,560 304,800 160,700
Average Assets 50,890,000 67,150,000 34,500,000
Average Equity 4,150,000 5,165,390 3,285,700
Riccialso asks Johnson to review key performance ratios for Avrey Bank, a bank in which
DRB invests. These ratios are presented in Table 2. Table 2: Key Performance Ratios For
Avrey Bank Key Performance Ratios for ABC Bank
2015 2016 2017
Common equity Tier 1 capital ratio 8.7% 9.8% 10.5%
Tier 1 capital ratio 9.6% 10.7% 11.7%
Total capital ratio 12.4% 12.2% 12.4%
Liquidity coverage ratio 103.2% 101.4% 99.1%
Net stable funding ratio 96.0% 94.6% 93.7%
Total trading VaR (all market risk factors) $9 $11 $13
Total trading and credit portfolio VaR $13 $16 $19
* Note: VaR amounts are in millions and are based on a 99% confidence interval and a single
day holding period.
1. Question 1
Which of the differences between P&C insurers and L&H insurers stated by Johnson
is incorrect?
o A
Difference 3.
o B
Difference 2.
o C
Difference 1.
Incorrect
A is correct. L&H claims are considered more predictable than those of P&C insurers,
therefore L&H insurers do not need as high an equity cushion and can have lower
capital requirements.
2. Question 2
Based on Table 1 and the performance ratios (pre-tax operating margin, pre-tax
operating return on assets & equity), Johnson should conclude that the insurer with
the best performance in 2017 was?
o A
Insurer A.
o B
Insurer B.
o C
Insurer C.
Incorrect
B is correct. Following table shows the calculation of performance ratios of the three
insurers.
For 2017 Insurer A Insurer B Insurer C

Pre-tax
214,560/4,442,000 = 304,800/4,350,900 = 160,700/4,230,950 =
Operating
4.83% 7.01% 3.80%
Margin
Pre-Tax
Operating 214,560/50,890,000 304,800/67,150,000 160,700/35,500,000
Return on = 0.42% = 0.45% = 0.45%
Avg. Assets
Pre-Tax
Operating 214,560/4,150,000 = 304,800/5,165,390 = 160,700/3,285,700
Return on 5.17% 5.90% = 4.89%
Avg. Equity
Insurer B shows higher performance ratios although the pre-tax operating return on
average assets are equal for both insurers B & C.
3. Question 3
Based on Table 2, Johnson should conclude that over the last three years, Avrey
Bank’s:
o A
liquidity position has increased.

o B
sensitivity to market risk has declined.

o C
capital adequacy has improved.

Incorrect
C is correct. Over the past three years, there has been an increase in the two VaR
measures—total trading VaR (all market risk factors) and total trading and credit
portfolio VaR. This trend indicates an increase in Avrey Bank’s exposure to market
risk. The two liquidity measures—the liquidity coverage ratio and the net stable
funding ratio—have decreased over the past three years, indicating a weakness in
Avrey Bank’s liquidity position. Trends in the three capital adequacy measures—
common equity Tier 1 capital ratio, Tier 1 capital ratio, and total capital ratio—
indicate an increase in capital adequacy. The total capital ratio has remained fairly
constant over the past three years, but the common equity Tier 1 capital ratio and
the Tier 1 capital ratio have increased.
Evaluating Quality of Financial

Reports
1. Question 1
Q-Code: 21-L2-FR-EQFR-75353
Company ABC’s financial statements adhere to generally accepted accounting
principles (GAAP). However, ABC understates earnings in periods when the company
is performing well and overstates earnings in periods when the company is
struggling. Based on this information, ABC’s financial statements can be best
categorized as:
o A
Non-GAAP compliant.
o B
GAAP compliant, but with earnings management.

o C
GAAP compliant and decision useful with sustainable and adequate returns.
Incorrect
B is correct. ABC’s financial statements are GAAP compliant but cannot be relied
upon to assess the past or future performance of a company.
2. Question 2
An equity analyst is currently reviewing the annual reports of two companies. She
makes the following observations about Company A and Company B:
Company A reports information that follows US GAAP without any deviations and is
relevant to analysts reviewing the company’s performance and prospects. Its return
on capital in the previous year was sufficient, but earnings do not appear to be
sustainable.
Company B reports information that follows US GAAP without any deviations and is
relevant to analysts reviewing the company’s performance and prospects. There is
evidence of an aggressive bias in accounting choices. Earnings appear sustainable
and last year’s return on capital was sufficient.
Based on these observations, which of the following conclusions is the analyst most
likely to make?
o A
Company A shows high reporting and earnings quality.

o B
Company B is displays higher reporting quality than Company A.

o C
Company B shows higher earnings quality than Company A.

Incorrect
C is correct. Since Company B’s earnings appear to be stable while Company A’s do
not, Company B shows higher earnings quality. Company B’s reporting quality is
lower than Company A’s as it uses aggressive accounting choices.
3. Question 3
The Beneish’s M-Score for TRS Corp. is -1.35. Using a -1.78 M-Score as the cutoff, TRS
can most likely be classified as a:
o A
manipulator, with the M-Score indicating a higher-than-acceptable

probability of earnings manipulation.
o B
non-manipulator, with the M-Score indicating a lower than 3.80% probability

of earnings manipulation.
o C
non-manipulator, with the M-Score indicating a lower than 6.80% probability

of earnings manipulation.
Incorrect
A is correct. The M-Score of -1.35 is greater than the cutoff -1.78, hence it indicates a
higher-than-acceptable (3.8%) probability of earnings manipulation.
4. Question 4
If the value of the Accruals variable in the Beneish model is greater than one, what
does that indicate? The value greater than one shows that accruals have:
o A
increased from the previous year and there is no probability of earnings

manipulation.
o B
increased from the previous year which could indicate earnings

manipulation.
o C
decreased, and earnings are high-quality.

Incorrect
B is correct. Accruals greater than one can indicate aggressive accounting policies
that have shifted current expenses to later periods. Thus, higher accruals could
indicate earnings manipulation.
5. Question 5
On 31 December 2014, the market capitalization of Sunkeaf Corporation was USD
2,450 million. The amount of goodwill on Sunkeaf’s balance sheet as of 31
December 2014, was USD 2,980 million. Goodwill and other intangible assets
represented over 50% of total assets in 2014. Based on this information, the least
likely conclusion is that:
o A
goodwill on the balance sheet is overvalued.

o B
a future write-off is likely.

o C
the company has grown organically over the years

Incorrect
C is correct. Because the goodwill amount exceeded the market cap of Sunkeaf in
2014, goodwill on the balance sheet is overvalued and so a future write-off is likely.
Given the large amount of goodwill on the balance sheet, the company has probably
grown through acquisitions, and not organically.
6. Question 6
Which of the following is least likely an effect of an aggressive, premature and
fictitious revenue recognition accounting choice in earlier periods?
o A
Overstated income.
o B
Understated assets.
o C
Overstated equity.
Incorrect
B is correct. An aggressive, premature and fictitious revenue recognition will result in
overstated income and overstated equity. This is because the revenue recognition
choices will increase revenues, which will in turn increase net income. This higher net
income will flow through to retained earnings, which will overstate equity. This
accounting choice will overstate assets (accounts receivable), not understate them.
7. Question 7
An analyst judges that Twister Inc. improperly recognized EUR60 million of revenue
and improperly capitalized EUR150 million of its cost of revenue. She then estimates
the effect of these two misstatements on net income, assuming a tax rate of 25%.
After adjusting the Twister, Inc. income statement for the two possible
misstatements, the decline in net income is closest to:
o A
EUR45 million.
o B
EUR67.5 million.
o C
EUR157.5 million.
Incorrect
Solution: C is correct. B is correct. The correction of the revenue misstatement would
result in lower revenue by EUR60 million, and the correction of the cost of revenue
misstatement would result in higher cost of revenue by EUR150 million. The result is
a reduction in pre-tax income of EUR210 million. Applying a tax rate of 25%, the
reduction in net income would be 210 × (1 − 0.25) = EUR157.5 million.
8. Question 8
In 2015, close examinations of the financial statements of Hybrid Autos by the
regulators indicated that the company showed a gradual increase in operating
income before interest and taxes in 2014 over 2013 due to gains from sale of
securities and sale of business unit. From an analyst’s perspective, with reference to
Hybrid Autos’ financials, which of the following statements is least likely correct?
o A
After-the-fact evidence of earnings management is not of great use in

anticipating earnings quality issues.
o B
Evaluating changes in operating earnings over time requires a careful

examination of the classification of items.
o C
The increase in operating income appears to be sustainable.

Incorrect
C is correct. The increase in operating income is due to ‘gains from sale of securities’
and ‘sale of business unit’. These items are not sustainable. A & B are true
statements.
9. Question 9
Analyst 1: Lower M-scores indicate an increased probability of earnings
manipulation.
Analyst 2: A GMI value greater than 1 indicates deteriorating gross margins.
o A
o B
o C

Incorrect
B is correct. Higher M-scores indicate an increased probability of earnings
manipulation.
10. Question 10
Which of the following is least likely one of the steps involved in evaluating the quality
of financial reports?
o A
Check for warning signs of possible issues with the quality of financial
reports.
o B
Compare the company’s accounting policies with each of the companies

in the industry.
o C
Learn about the company’s management.

Incorrect
B is correct. One of the general steps to evaluate the quality of a company’s financial
reports is to compare its accounting policies and ratios to those of its closest
competitors, not all the companies in the industry. Both option A and C are steps
involved in evaluating the quality of financial reports.
11. Question 11
Statement 1: Since companies are aware of the Beneish model and how M-scores
are calculated, some of them can present information in a way that will result in
lower M-scores.
Statement 2: The predictive power of the Beneish model is decreasing over time, so
analysts are not recommended to use it when evaluating a company’s earnings
quality.
Which of the statements are correct?
o A
Only Statement 1 is correct.

o B
Only Statement 2 is correct.
o C

Incorrect
A is correct. Statement 1 is correct. As a result of such practices, the predictive power
of the Beneish model has decreased over time. Statement 2 is incorrect, however,
because analysts are not discouraged from using the model to evaluate companies’
earnings quality. Instead, they are discouraged from relying solely on the results of
this model and are advised to use qualitative measures alongside quantitative ones
to assess earnings quality.
12. Question 12
1. A company’s reported pre-tax income of USD6.5 billion last year. This amount
includes USD1.0 billion of acquisition and divestiture-related expenses, USD0.3
billion of restructuring expenses, and USD0.9 billion of other non-operating
expenses. The acquisition and divestiture-related expenses as well as restructuring
expenses are non-recurring expenses, but other expenses are recurring expenses.
The company’s core pre-tax income last year is closest to:
o A
USD7.8 billion.
o B
USD4.3 billion.
o C
USD5.6 billion.
Incorrect
Solution: A is correct. Recurring or core pre-tax earnings would be USD7.8 billion,
which is the company’s reported pre-tax income of USD6.5 billion plus the USD1.0
billion of non-recurring (i.e., one-time) acquisitions and divestiture expenses plus the
USD0.3 billion of non-recurring restructuring expenses.
13. Question 13
An analyst compares Bigbuilder, Inc.’s financial statements with those of an industry
peer. Both firms have similar, above-average returns on equity (ROE). However,
Bigbuilder has a higher cash flow component of earnings. If the analyst applies the
mean reversion principle in her forecasts of the two firms’ future ROE, she should
forecast that the ROE for Bigbuilder is most likely to decline:
o A
at the same rate as the peer firm.
o B
more rapidly than that of the peer firm.

o C
more slowly than that of the peer firm.

Incorrect
Solution: C is correct. Based on the principle of mean reversion, the high ROE for
both firms should revert towards the mean. Bigbuilder has a higher cash flow
component to its return than the peer firm, however, so its high return on common
equity should last longer than that of the peer firm. The peer firm has a higher
accruals component, so it is likely to revert more quickly.
14. Question 14
Solane Corporation, a USA-based company reported US$30.0 million in costs related
to restructuring during fiscal year 2014 due to its decision to close a factory. Nearly
100 jobs were lost, and a portion of restructuring costs were associated with
employee severance payments. The reporting of restructuring costs was consistent
with GAAP. With respect to the restructuring costs, an analyst’s most likely concern is
that the company might:
o A
have overstated previous periods’ net incomes.

o B
overstate the current period’s net income.

o C
understate future periods’ net income.

Incorrect
A is correct. The restructuring charge was most likely the result of activities in the
past and should have been considered when evaluating past net incomes. Since it
was not considered, previous periods’ net incomes are higher than they should be,
while the current period’s net income is understated.
15. Question 15
ETL is a global communications company. The revenues of the company have been
growing steadily during 2013-2016 at an average rate of 15%. The operating profit
margins have improved slightly over this period. The following table shows the time
series account of its common-size asset portion of balance sheet.
2013 2014 2015 2016

Total current assets 15% 14% 13% 11%
Gross PP&E 31% 38% 46% 48%
Acc. depreciation 3% 6% 8% 10%
Net PP&E 28% 32% 38% 38%
Intangibles 55% 53% 49% 51%
Other assets 2% 1% 0% 0%
Total assets 100% 100% 100% 100%
The company has not changed their product focus or business strategy. Which of the
following statements is most likely correct with reference to the annual time-series
common-size asset portion of ETL’s balance sheet?
o A
There is an indication that the expenses have been overstated.

o B
Capitalization of costs is done instead of expense recognition.

o C
Rising revenues and decreasing asset turnover ratios indicate proper cost
capitalization.
Incorrect
B is correct. The buildup of costs in property, plant, and equipment indicate that
expenses were under-reported in the income statement. In view of slight
improvement in profit margins over the period 2013-2016, there’s a possibility that
capitalization of costs was done instead of expense recognition.
16. Question 16
Sustainable earnings refer to earnings that are:
o A
likely to persist in the future.

o B
likely to have higher growth than competitors.

o C
likely to be affected by business financing decisions.

Incorrect
A is correct. Sustainable earnings refer to earnings that can be expected to persist in
the future.
17. Question 17
Analyst 1: Earnings that have a significant accrual component are less persistent.
Analyst 2: Low-quality earnings are insufficient to cover the company’s cost of capital
and/or are derived from nonrecurring, one-off activities.
o A
o B
o C

Incorrect
18. Question 18
When earnings are largely comprised of accruals, mean reversion will occur:
o A
relatively faster than usual.

o B
relatively slower than usual.

o C
at the same rate as usual.

Incorrect
A is correct. Earnings consist of cash flows and accruals, and there is an inverse
relationship between accruals and cash flow. Mean reversion in earnings means that
extreme levels of earnings tend to revert to normal levels over time. If earnings are
high in a particular period due to a higher accrual component versus a cash
component, then it is likely that this high level of earnings is not sustainable and the
earnings will come back down to the mean level faster in the subsequent periods. So
when earnings are largely comprised of accruals, mean reversion will occur at a
faster rate. The opposite is true when earnings are relatively free of accruals.
19. Question 19
Which of the following statements about the earnings quality of a company
is least accurate?
o A
The objective of analyzing earnings is to understand the persistence and

sustainability of earnings.
o B
Bankruptcy prediction models are used to quantify the likelihood that a
company will default on its debt and/or declare bankruptcy.
o C
The higher the Z-score, the higher the probability of bankruptcy of a

company.
Incorrect
C is correct. The higher the Z-score, the lower the probability of bankruptcy of a
company.
20. Question 20
The following table shows selected data of Global Enterprise for the year ending 31
December:
$ millions 2014 2015 2016

Net income 5,470 5,660 5,800
Cash from operating activities 13,000 13,450 14,000
Which of the following statements is most likely accurate? Comparing cash from
operating activities with net income indicates:
o A
high earnings quality.

o B
low earnings quality.

o C
that earnings manipulation is taking place.

Incorrect
A is correct. During the period 2014-16, the cash flow to net income ratio has
consistently ranged in the 2.0 to 2.5 range. This is an encouraging sign and points
towards high earnings quality. However, this measure cannot be interpreted in
isolation. If cash operating activities exceed net income, then an analyst has to
further investigate the investing and financing activities of a company before
qualifying earnings as high quality.
21. Question 21
Which of the following most likely indicates that a company is boosting its operating
cash flow by selling receivables to a third party?
o A
A decrease in the company’s days’ sales outstanding.

o B
An increase in the company’s days’ sales outstanding.
o C
An decrease in a company’s days of payable.

Incorrect
A is correct. A decrease in the company’s days’ sales outstanding may indicate that
the company is boosting operating cash flow by selling receivables to a third party.
22. Question 22
Which of the following characteristics of high financial reporting quality, with regard
to the balance sheet, is most likely affected by the presence of off-balance items such
as operating leases and purchase contracts?
o A
Completeness
o B
Unbiased measurement
o C
Clear presentation
Incorrect
A is correct. Significant amounts of off-balance-sheet obligations lack completeness
as they understate a company’s leverage.
23. Question 23
Tim Morrison, an analyst at Trimark Investment, is considering adding Autofit Inc., a
manufacturer of automotive parts, to the portfolio. After analysing the financial
statements, Morrison is of the view that some of the inventory is obsolete due to
innovation. He is concerned that Autofit’s inventory is overstated. Morrison’s concern
about Autofit’s inventory suggests poor reporting quality, most likely resulting from a
lack of:
o A
completeness.
o B
unbiased measurement
o C
clear presentation.
Incorrect
B is correct. Morrison is concerned that innovations have made some of Autofit’s
inventory obsolete. This scenario suggests impairment charges for inventory may be
understated and that the inventory balance does not reflect unbiased measurement.
24. Question 24
Statement 1: Audit opinions are based on historical information and typically do not
provide information on a timely enough basis to be a useful source of information
about risk.
Statement 2: A change in the auditor, especially multiple changes in the auditor, can
be a signal of possible reporting problems.
o A
Only statement 1 is correct.

o B
Only statement 2 is correct.

o C

Incorrect
TechSol Inc. provides customized software for processing of financial transactions and
markets its services globally. It reports under US GAAP. TechSol’s CFO recently resigned
amidst allegations of massive financial fraud. The external auditors uncovered the following
misconduct in its financial reporting:
• fictitious customer accounts and fake invoices/billing for services not rendered.
• not recording losses on payments for services provided.
• FVPL securities reported at fair value showed overstatement of unrealized gains.
1. Question 1
The best characterization of TechSol’s financial reports as per the quality spectrum of
financial reports is:
o A
non-GAAP compliant, and poor quality.

o B
GAAP compliant, but with earnings management.

o C
GAAP compliant and decision useful with sustainable and adequate returns.
Incorrect
A is correct. TechSol financial statements are non-GAAP compliant and cannot be
relied upon to assess earnings quality. They are at the bottom of the quality
spectrum of financial reports with fictitious information.
2. Question 2
The most likely effect on the basic accounting equation of fictitious customer accounts
and fake invoices is:
o A
understated assets and understated equity.

o B
overstated assets and overstated equity.

o C
overstated income and understated expenses.

Incorrect
B is correct. An aggressive, premature and fictitious revenue recognition will result in
overstated income, overstated equity and overstated assets (accounts receivable).
3. Question 3
The most likely effect on the accounting equation of not reporting a bad debt expense
is:
o A
overstated accounts receivable.

o B
overstated liabilities.
o C
understated income.
Incorrect
A is correct. An understatement of bad debt expense leads to overstated assets
(accounts receivable) understated expenses, and overstated income and equity.
4. Question 4
The least likely effect on TechSol’s financial statements of showing overstatement of
unrealized gains from held for trading investment at fair value is:
o A
overstated income.
o B
overstated equity.
o C
overstated cash.
Incorrect
C is correct. The financial assets will be overstated along with overstatement of
income and equity.
RJT Corp. wanted to raise USD 60 million in capital by borrowing against its receivables. To
accomplish this, it created a special purpose entity with USD 5 million and had the SPE
borrow USD 60 million. These funds (USD 60 million) were used to purchase RJT’s
receivables.
1. Question 1
The removing of receivables from RJT’s balance sheet would most likely:
o A
improve the receivables turnover ratio.

o B
increase the days’ sales outstanding.

o C
increase the net profit margin.

Incorrect
A is correct. By selling receivables to a SPE, RJT’s receivables turnover ratio would
increase which would lower the days’ sales outstanding. Since the receivables were
not sold at a gain the net profit margin would not be affected.
2. Question 2
Which of the following is most likely to be affected by RJT’s sale of receivables to the
SPE?
o A
current ratio.
o B
debt to equity.
o C
DSO.
Incorrect
C is correct. DSO will decrease. With the sale of receivables, there is a decrease in
receivables but an increase in cash. Hence, current assets stay the same. The current
ratio and debt to equity on the unconsolidated balance sheet of RJT will be
unaffected by the sale.
Solar Technologies was involved in aggressive accounting practices such as recording
revenues based on bill-and-hold practices. Solar Technologies reported under US GAAP. The
table below gives the selected data from Solar’s statement of cash flows for the years 2014-
2015 (in $ thousands).
Operating Activities: 31 Dec 2014 30 Dec 2015

Net income (loss) (125,600) 55,800
Adjustments to net income
Depreciation & amortization 26,100 19,674
Restructuring, impairment, and other non-cash special
156,100 –
costs
: : :
Increase (decrease) in cash from changes in working
capital:
Receivables, net (7,600) (38,880)
Inventories (6,420) (49,130)
Account payable 8,100 (810)
: : :
Restructuring charge reversal (46,800)
: : :
Net cash provided by (used in) operating activities 7,800 (4,210)
1. Question 1
The most likely impact on the 2015 net income of Solar Technologies of reporting
restructuring/non-cash special charges and subsequently reversing the restructuring
charges will be:
o A
a false indication of improvements in performance.

o B
an inaccurate representation of operating expenses.

o C
a correct portrayal of growth in earnings.

Incorrect
A is correct. The reconciliation between the 2014 net income and operating cash
flows shows non-cash charges for restructuring, impairment, and other costs totaled
USD156.1 million. In 2015, the reversal of the restructuring charge was USD46.8
million. By inflating and subsequently reversing restructuring charges, the company’s
net income showed significant improvement.
2. Question 2
Regarding improper revenue recognition practices of Solar Technologies, the
items most likely affected on the statement of cash flows in 2015 will be:
o A
payables, net income, expenses.

o B
receivables, net income, inventory.

o C
receivables, payables, inventory.

Correct
B is correct. The items impacted on the statement of cash flows by improper
revenue recognition include net income, receivables, and inventories. Net income
and receivables would be overstated. The statement of cash flows, in which an
increase in receivables is shown as a negative number, highlights the continued
growth of receivables. In addition, Solar’s practice of recording sales based on bill-
and-hold led to an increase in the 2015 inventory.
In 2014 BestSound Plc. purchased shares of Inter Corp for USD 15 million and classified the
cash flow as an investing activity. In 2015 BestSound Inc. sold shares of Inter Corp for USD
14 million and classified the cash flow as an operating activity. BestSound’s reported
operating and investing cash flows for 2014 and 2015 are given below.
2014 2015
Cash flows from operating activities (USD millions) 100 110
Cash flows from investing activities (USD millions) -150 -145
1. Question 1
Had the purchase and sale of Inter Corp. shares been treated as an investing activity
in both years the change in operating cash would have been closest to:
o A
10%.
o B
24%.
o C
-4%.
Incorrect
C is correct. Had the cash flow been classified as an operating activity in 2015, the
cash flow from operations would have been 110 – 14 = 96. Hence, the change in
operating cash would have been (96 – 100) / 100 = – 4%.
2. Question 2
The most likely impact of the change in classification is that BestSound’s:
o A
2015 operating cash flow was overstated.

o B
2014 operating cash flow was understated.

o C
2015 investing cash flow was correctly stated.

Incorrect
A is correct. By showing the cash inflow as an operating cash flow in 2015,
BestSound is overstating operating cash flow. Since the purchase of Inter Corp.
shares was classified as an investing activity in 2014, the same classification should
have been retained in 2015.
Integration of FSA Techniques

1. The primary goal of financial statement analysis is to:
o A
document portfolio changes to comply with the Prudent Investor Rule.

o B
justify trading decisions to comply with the Code and Standards.

o C
facilitate an economic decision.

2. Incorrect
3. C is correct. The primary goal of financial statement analysis is to facilitate an
economic decision. Financial statement analysis may assist in documentation and
justification of trading decisions, however, these are not the primary purposes.
4. Question 2
Q-Code: 21-L2-FR-IFSA-78787
Amy Green, an analyst at a private equity firm, is performing a DuPont analysis of
Blackbrick Co. The following table contains data she has collected:
2021 2020 2019

Tax Burden 58.5% 59.2% 57.9%
Interest Burden 85.2% 83.7% 81.3%
EBIT Margin 13.4% 12.8% 12.2%
ROE 7.89% 7.56% 6.27%
Revenue $3.9 million $3.1 million $3.5 million
Total Equity $3.3 million $2.6 million $3.2 million
Total Assets $5.8 million $4.2 million $4.9 million
Which of the following is most likely a cause for the upward trend in Blackbrick’s ROE
over the three years?
o A
Increasing leverage
o B
Increasing asset turnover ratio

o C
Decreasing equity
Incorrect
A is correct. Blackbrick’s leverage has increased over the three-year period, which
has a positive effect on the company’s ROE.
The DuPont Analysis breaks ROE down as follows:
ROE = Tax Burden x Interest Burden x EBIT Margin x Asset Turnover x Leverage
ROE = (NI/EBT) x (EBT/EBIT) x (EBIT/Sales) x (Sales/Assets) x (Assets/Equity) = NI/E
The asset turnover ratio and leverage for the three-year period are:
2021 2020 2019

Asset Turnover 3.9/5.8 = 0.672 3.1/4.2 = 0.738 3.5/4.9 = 0.714
Leverage 5.8/3.3 = 1.75 4.2/2.6 = 1.62 4.9/3.2 = 1.53
B is incorrect because the asset turnover ratio has decreased over the years, which
lowers the ROE.
C is incorrect because the company’s level of equity has fluctuated over the three
years and increased very slightly. Overall, it has not decreased.
5. Question 3
A special purpose entity (SPEs) was conducted for the benefit of the sponsoring
entity which reports under IFRS. This SPE is most likely to be:
o A
consolidated on sponsoring entity’s financial statements.

o B
held off-balance sheet.
o C
consolidated on sponsoring entity’s financial statements only if it is a

“qualifying SPE.”
Incorrect
Solution: A is correct. Under IFRS, SPEs must be consolidated if they are conducted
for the benefit of the sponsoring entity. Further, under IFRS, SPEs cannot be
classified as qualifying. Under US GAAP, qualifying SPEs (a classification which has
been eliminated) do not have to be consolidated.
6. Question 4
Based on the following information alone, Company XYZ is most likely overallocating
capital to which one of its three segments?
Capex as a % of Assets as a % of
EBIT Margin (%)
Total Capex Total Assets
Segment A 30% 20% 15%
Segment B 25% 40% 12%
Segment C 45% 40% 10%
o A
Segment A
o B
Segment B
o C
Segment C
Incorrect
C is correct. Generally, the segment with the highest profitability (here indicated by
the highest EBIT margin) should be allocated the most capital per assets. The
following table shows the current capital allocation per assets for each segment:
Capex % / Assets % EBIT Margin (%)

Segment A 1.50 15%
Segment B 0.63 12%
Segment C 1.13 10%
According to these ratios, Segment A is the most profitable and is allocated the most
capital. Segment B is the second most profitable segment, however, it receives less
capital per assets than Segment C, which has a lower EBIT margin. This indicates that
Segment B is underallocated and Segment C is overallocated capital.
7. Question 5
During an inflationary period, which of the following method of inventory valuation
will a firm seeking to lower current tax liability select?
o A
Average cost.
o B
LIFO.
o C
FIFO.
Incorrect
B is correct. During an inflationary period, using LIFO would increase COGS, since the
most recent (highest cost) inventory would be sold. Therefore, earnings and taxes
would be lowest under LIFO.
8. Question 6
Company ABC has recently reduced the average useful life of their depreciable
assets. Assuming everything else remains constant, which of the following will most
likely occur?
o A
Net income will increase.

o B
Net income will decrease.

o C
Net income will remain the same.

Incorrect
B is correct. Depreciation expense increases as the depreciable life of an asset
decreases. Thus, net income will decline.
9. Question 7
Fairway Chemicals is a publicly traded company that complies with IFRS 9.
Information about Fairway’s investment portfolio for the years ended 31 December
2020 and 2019 is presented in the table below:
Exhibit: Fairway’s Investment Portfolio ($ Thousands)
Buffalo Corp. Acme AG Sourborn SA

Classification FVPL FVOCI Amortized cost
Cost $34,000 $51,000 $60,000
Market Value, 31
37,000 49,000 65,000
December 2020
Market Value, 31
36,000 48,000 67,000
December 2021
* All securities were acquired at par value.
Which of the following statements is least accurate based on the information given in
the above Exhibit?
o A
The balance sheet carrying value of the investment portfolio (in

USDthousands) at 31 December 2021 is closest to USD144,000.
o B
The balance sheet carrying value of the investment portfolio at 31 December

2021 would have been higher if Sourborn’s securities had been reclassified as
FVPL security.
o C
If Sourborn had been reclassified as FVPL security, the interest income

would have been higher.
Incorrect
Solution: C is correct. If Sourborn had been reclassified as FVPL security, the interest
income would remain unchanged. The coupon payment is recorded as interest
income whether securities are amortized cost or FVPL. No adjustment is required for
amortization since the bonds were bought at par.
A is not correct. Under IFRS 9, FVPL and FVOCI securities are carried at market value,
whereas amortized cost securities are carried at historical cost. USD36,000 + 48,000
+ 60,000 = USD144,000.
B is not correct. If Sourborn had been classified as a FVPL security, its carrying value
would have been the USD67,000 fair value rather than the $60,000 historical cost.
10. Question 8
Stellar Limited is a pharmaceutical company headquartered in India. It complies with
IFRS. In 2019, Stellar held a 15 percent passive stake in Oliver Limited. In December
2019, announced that it would be increasing its ownership to 50 percent effective 1
January 2020. At 31 December 2020, Stellar’s total assets balance would most likely be:
o A
highest if Stellar is deemed to have significant influence over Oliver.

o B
highest if Stellar is deemed to have control of Oliver.

o C
unaffected by the accounting method used for the investment in Oliver.

Incorrect
Solution: B is correct. When a company is deemed to have control of another entity,
it records all of the other entity’s assets on its own consolidated balance sheet.
11. Question 9
Stellar Limited reported sales of INR1 billion in 2020 while Oliver posted sales of INR
400 million in the same period. Assuming Stellar’s 50 percent ownership of Oliver
with control, the consolidated sales of Stellar in 2020 would be closest to:
o A
INR1.4 billion
o B
INR1.2 billion
o C
INR1.0 billion
Incorrect
Solution: A is correct. Under the assumption of control, Stellar would record its own
sales plus 100 percent of Oliver’s. INR1 billion + 400 million = IN1.4 billion.
12. Question 10
Statement 1: Net income is higher if the acquisition method is used as compared to
the equity method.
Statement 2: Net income is independent of the accounting method used for the
investment in an entity.
o A
Statement 1
o B
Statement 2
o C
Both statements are incorrect.

Incorrect
Solution: B is correct. Net income is not affected by the accounting method used to
account for active investments in other companies. “One-line consolidation” and
consolidation result in the same impact on net income; it is the disclosure that
differs.
13. Question 11
Company XYZ reported a net income of USD5 million in 2010. In reviewing the
annual report, an analyst notices that XYZ booked an expense of USD1 million for
cost of relocating its main office. Assuming a tax rate of 30%, what would normalized
earnings be for 2010?
o A
USD4.3 million.
o B
USD5.7 million.
o C
USD6.0 million.
Incorrect
B is correct. The company will increase 2017 earnings by the tax-adjusted value of
the USD1 million one-time expense (1 × (1 – 0.3) = USD0.7million). Therefore, the
normalized earnings would be USD5.7 million.
14. Question 12
Peter Saunders, an analyst at a private equity firm, is concerned with earnings
quality of Mystify Chemicals. He intends to calculate Mystify’s cash-flow-based
accruals ratio and the ratio of operating cash flow before interest and taxes to
operating income using the information in the exhibit below:
Exhibit: Earnings Quality Date of Mystify Chemicals ($ million)
2019 2020 2021

Earnings before Interest and Tax 3,646 5,190 5,956
Net income 2,741 3,913 4,101
Net cash flow provided by (used in)
3,513 4,133 4,517
operating activitya
(4,001) (2,996) (1,500)
investing activity
(2,567) (1,173) (999)
financing activityb
Average net operating assets 30,563 33,497 32,079
a
includes cash paid for taxes of: (905) (1,277) (1,855)
b
includes cash paid for interest of: (455) (611) (1,131)
The cash-flow-based accruals ratios from 2019 to 2021 indicate:
o A
improvement in earnings quality.

o B
deterioration in earnings quality.
o C
no change in earnings quality.

Incorrect
Solution: A is correct. The cash-flow-based accruals ratio = [NI − (CFO + CFI)]/(Average
NOA). The cash-flow-based accruals ratio falls from 11 percent in 2019 to 8 percent
in 2020, and then to 3 percent in 2021. The declining trend over the three-year
period signifies an improvement in earnings quality because it indicates that accruals
are not a large factor in the financial results.
15. Question 13
The ratio of operating cash flow before interest and taxes to operating income for
Mystify for 2021 is closest to:
o A
1.26
o B
1.07
o C
0.76
Correct
Solution: B is correct. Net cash flow provided by (used in) operating activity must be
adjusted for interest and taxes, as necessary, in order to be comparable to operating
income (EBIT). Reporting under IFRS, Mystify chose to classify interest expense as a
financing cash flow so the only necessary adjustment is for taxes.
The operating cash flow before interest and taxes = 4,517 + 1,855 = 6,372. Dividing
this by EBIT of 5,956 yields 1.07. The ratio over 1.0 indicates that earnings are
supported by cash flow.
Rabia Shah is an equity analyst at Birkshire Investments. She has been asked to determine
whether Bestway Industries is suitable for investment. On 1 January 2015, Bestway
purchased a 20% equity interest in UVL for USD 200 million and used the equity method to
account for the transaction. For 2015, UVL reports sales of USD 1,300 million, net income of
USD 110 million, and average assets of USD 700 million. Bestway reports investment in
associate company (UVL) of $220 million on 31 December 2015. The following table some
shows data related to Bestway.
Bestway Industries (in USD millions) 2013 2014 2015

Revenue 6,160 7,340 8,000
EBIT 560 740 980
Interest expense 19 26 35
Net income 350 450 550
Average total assets 3,934 4,194 4,500
Assets / Equity 2.00 2.10 2.15
* Note: Assume Bestway Industries’ assets/equity remains unchanged before and after the 20% equity
interest in UVL.
1. Question 1
L.O.: c Q-Code: 21-L2-FR-IFSA-75460

Bestway’s net profit margin for 2015, excluding the investment in UVL is closest to:
o A
6.6%.
o B
6.8%.
o C
7.9%.
Incorrect
A is correct. Net profit margin calculations are as follows: (550 – 20% x 110) / 8000 =
6.60%. LO.c, d.
2. Question 2
Bestway’s asset turnover ratio for 2015, excluding the investment in UVL is closest to:
o A
1.7.
o B
1.9.
o C
2.0.
Incorrect
B is correct. The average investment in UVL during 2015 is (200 + 220) / 2 = 210. The
asset turnover ratio excluding investment in UVL is calculated as follows: 8000/(4500
– 210) = 1.86.
3. Question 3
Based on the DuPont analysis, Bestway’s ROE over the 2013-2015 period, excluding
investments in UVL is best described as:
o A
stable.
o B
trending lower.
o C
trending higher.
Incorrect
C is correct. ROE can be calculated as: net profit margin x asset turnover x
leverage. ROE for “Bestway-only” (excluding investments in associates) over 2013-
2015 is calculated as follows:
2013 2014 2015

5.68 x 1.57 x 2.00 = 17.8 6.13 x 1.75 x 2.10 = 22.5 6.60 x 1.86 x 2.15 = 26.5
The ROE over the period 2013-2015 is trending higher.
4. Question 4
L.O.: d Q-Code: 21-L2-FR-IFSA-75463

Excluding investments in associates would result in the interest coverage ratio for
Bestway being:
o A
higher.
o B
the same.
o C
lower.
Correct
B is correct. The calculation for interest coverage is EBIT/interest expense, neither of
which is impacted by investments in UVL. LO.d.
Shania Turlington is a quantitative analyst at Layland Investments. Turlington has been

given the responsibility to investigate Premier Group, a UK-based global food and beverage
company. Turlington is curious about the company’s capital allocation decisions based on
product segments. Typically, the largest investments in assets will require a similar
proportion to capital expenditures. Turlington calculates the following ratios presented
below for the three product segments of Premier:
A. Segment Assets as a % Segment CapEx as a %

EBIT Margin
of Total Assets of Total CapEx
2015 2014 2015 2014 2015 2014
Best Nutrition 15.7 15.5 8.3 8.2 30.0 37.0
Marvelous Aids 23.3 23.2 26.0 33.0 6.6 4.6
Sweet Delight 16.5 16.2 65.7 58.8 63.4 58.4
1. Question 1
The product segment that most likely received capital expenditures allocations on a
growth basis during 2015 is:
o A
Sweet Delight.
o B
Best Nutrition.
o C
Marvelous Aids.
Incorrect
B is correct. The ratio of capital expenditure percentage to total asset percentage
should be calculated for each segment: if greater than 1, it indicates that a segment
is being allocated a greater proportion of capital expenditures than its proportion of
total assets and the company is therefore growing the segment. As shown below, the
ratio exceeds 1.0 for only the Best Nutrition segment. Ratio = % of Capital
Expenditures / % of Total Assets.
Segment Assets as a Segment CapEx as a

2015 Ratio
% of Total Assets % of Total CapEx
Best Nutrition 8.3 30.0 3.614
Marvelous
26.0 6.6 0.254
Aids
Sweet Delight 65.7 63.4 0.965
2. Question 2
L.O.: c Q-Code: 21-L2-FR-IFSA-75469

All else equal, based on the EBIT margins over the period 2014-2015, the capital
allocation decisions of Premier Group can be best described as:
o A
reasonable.
o B
not reasonable.
o C
according to long-term growth objectives.

Correct
B is correct. The EBIT margins over the 2014-2015 period were flat for all the three
product segments. The well-margined business segment of Marvelous Aids received
the lowest capital expenditures allocations based on the ratio of the proportion of
capital expenditures to the proportion of total assets, followed by Sweet Delight. The
lowest margined segment, Best Nutrition, received the highest capital expenditure
allocations. The capital allocation decisions do not appear to be reasonable. LO.c.
Cara is a Spanish company that has been pursuing an aggressive growth strategy. Cara runs
three distinct divisions: CaraDutti, OXY and Uno. All three divisions sell through retail outlets
around the world. Anna Peters, an equity analyst, is interested in determining how well Cara
is allocating its resources between the three divisions. The table below summarizes selected
divisional and corporate data for 2015 in € millions.
Total for
CaraDutti OXY Uno
three divisions
Revenues 3,550.00 1,475.00 1,295.00 780.00
Operating profit 216.00 81.00 91.00 44.00
Total assets 3,126 1,594.26 1,188.00 343.74
Capital expenditures 41.00 26.65 10.25 4.10
Proportion of capex 100% 65% 25% 10%
Prop. of tot. assets 100% 51% 38% 11%
Peters’ wants to determine the importance management is giving to each division by
reviewing the relationship between capital expenditures and assets. She assumes that
2015’s investment behavior is representative of future investment patterns. Cara’s operating
margin in 2014 was 7.85%.
1. Question 1
The division that is likely to become less significant in the future is:
o A
Uno.
o B
CaraDutti.
o C
OXY.
Incorrect
C is correct. Peters estimates the ratio of capital expenditure proportion to asset
proportion for each division.
Total
CaraDutti OXY UNO
Proportion of capital expenditures 65% 25% 10% 100.0%
Proportion of total assets 51% 38% 11% 100.0%
Ratio: Proportion of capital
expenditures to proportion of total 1.27 0.66 0.91 1.0
assets
This rato for OXY is significantly lower than 1 showing that Cara is allocating a
lower proportion of capital expenditures to that division relative to asset
proportions. If this trend continues, the OXY division will become less significant
over time.
2. Question 2
If CaraDutti, had been able to maintain its 2014 operating margin of 9.5% in 2015,
the company’s overall operating margin in 2015, compared to 2014, would have
been:
o A
higher.
o B
lower.
o C
the same.
Correct
B is correct. The calculations are shown below:
Apply the 9.5% margin to 2015 revenues for

0.095 × 1,475 140.125
division
Increase in 2015 operating profit for division,
140.125 –
had the 59.125
81.00
margin been maintained
Revised 2015 company operating profit with
216.00 +
increase in men & women apparel division’s 275.125
59.125
operating profit
Revised 2015 company operating margin 275.125/3,550 7.75%
2014 company operating margin 7.85%
Even if the division had maintained its operating margin in 2015, the overall
company operating margin would still have decreased (7.75% versus 7.85%).
Asma Abbas is examining Maple Industries liquidity ratios, which are given in the table
below. Even though the company’s current and quick ratios have improved, Abbas views the
changes in the company’s cash conversion cycle as indicative of a deterioration in the
company’s liquidity position.
Ratio 2015 2014 2013
Current ratio 2.50 2.35 1.26
Quick ratio 1.15 0.97 0.58
Accounts receivable turnover 6.30 6.58 6.61

Inventory turnover 4.09 4.23 4.42
Accounts payable turnover 6.18 6.26 6.07
Cash conversion cycle 88 days 84 days 78 days
Abbas is also analyzing the level of accruals in the company’s performance. She investigates
the balance sheet–based and cash flow–based accruals ratios (not shown) and asks her
supervisor for advice on additional analysis that should be done as a follow-up on this issue.
1. Question 1
Compared with 2013, the change in which working capital account was most
likely responsible for deterioration in liquidity?
o A
Accounts receivable.
o B
Accounts payable.
o C
Inventory.
Incorrect
C is correct. The CCC has increased since 2013, from 77.7 days to 88.0 days (see the
following table). The working capital account that had the largest effect on the
increase in CCC was inventory because the holding period has increased by 6.6 days.
2015 2013
Working Capital Days
Turnover Turnover Days
Account (365/Turnover)
Accounts receivable 6.30 57.9 6.61 55.2
Inventory 4.09 89.2 4.42 82.6
Accounts payable 6.18 59.1 6.07 60.1
Cash conversion
88.0 77.7
cycle
Cash conversion cycle = Days in sales + Days in inventory – Days in payables
2. Question 2
The best answer to Abbas’s query about further analysis is that she should conduct a:
o A
DuPont analysis.
o B
discounted cash flow analysis.
o C
cash flow ratio analysis.

Incorrect
C is correct. To determine whether the company is engaged in earnings
manipulation, the analyst should evaluate cash flow ratios.
Financial Statement Modeling

Shehla Yamani, an analyst at Dorset Investments, is developing sales and expense forecasts
of Chesston Chemicals. She collects financial data on Chesston given in the table below.
Income statement 2016 ($ millions)

Sales 9,925
Cost of goods sold (COGS) 5,955
Gross profit 3,970
Selling expenses 2,084
General and administrative expenses (G&A) 350
Depreciation and amortization expenses (D&A) 300
Operating profit 1,236
Interest expense 98
Earnings before taxes (EBT) 1,138
Income taxes (34%) 387
Net profit 751
Average balance sheet items
Total assets 8,270
Net debt 1,640
Total liabilities 4,570
Total equity 3,700
Using 2016 as the base year, the analyst expects:
• 2017 global GDP growth rate to be at 4.0%

• sales to grow 2% faster than projected nominal global GDP growth
• cost of goods sold ratio to decline 0.55% annually
• selling expenses to remain stable as a percentage of sales
• general and administrative and depreciation and amortization expenses to be fixed
• net debt to decline by USD140 million in 2017
Yamani, after completing the forecasts for Chesston’s income and expenses, considers
forecasting the balance sheet accounts specifically the accounts on the balance sheet that
can be most effectively forecasted from the income statement. Yamani then focuses her
attention on another company, Universe Plc. Universe operates in Countries X and Y. The
tax rate in Country X is 50%, and the tax rate in Country Y is 20%. Universe generates an
equal amount of profit before tax in each country in its first year. Relevant data is given
below:
(in € millions) X Y Total
Profit before tax 200 200 400
Effective tax rate 50% 20% 35%
Tax 100 40 140
Net Profit 100 160 260
1. Question 1
Q-Code: 21-L2-EQ-IACA-74612
Based on the data given above and Yamani’s sales and expense forecasts, Chesston’s
net profit estimate (in $ millions) for 2017 will be closest to:
o A
766.
o B
869.
o C
900.
Incorrect
B is correct.
2017 vs. 2016 Calculation 2017

Sales GDP + 2% = 6% increase 9,925 × 1.06 10,521
Percentage of sales, expected [(5,955/9,925) –
COGS 6,255
to decline 0.55% in 2017 0.0055)] × 10,521
Gross profit 4,266
Selling expenses Stable percentage of sales (2,084/9,925) × 10,521 2,209
G&A
No change 350
expenses
D&A
No change 300
expenses
Operating Profit 1,407
Rate on 2016 net debt
Interest expense = 98/1,640 = 6% 1,500 × 0.06 90
Debt to decline by €140 million
EBT 1,317
Income taxes 34% tax rate 1,317 × 0.34 448
Net profit 869
2. Question 2
The balance sheet accounts that can be most reliably forecasted from the income
statement are:
o A
property plant and equipment.

o B
inventory.
o C
net debt.
Incorrect
B is correct. A common way to forecast working capital accounts (i.e., inventory)
would be by using efficiency ratios, such as inventory turnover. Projections for long-
term assets and net debt, are not directly tied to income statement.
3. Question 3
Which of the following statements regarding Universe’s effective tax rate is most
likely correct, if the profit in Country X is stable but the profit in Country Y grows 12%
annually for the next three years?
o A
The effective tax rate will gradually decline because a higher proportion
of profit will be generated in the country with the lower tax rate.
o B
The effective tax rate will gradually rise because of higher profits earned in
Country Y.
o C
The effective tax rate will stay the same because higher profits of Country Y
will be netted off against lower profits of Country X.
Incorrect
A is correct. Universe’s effective tax rate of 35% will gradually fall because a higher
proportion of profit will be generated in the country with the lower tax rate.
Years (€ millions) 0 1 2 3
Profit before tax, Country X 200 200 200 200
Profit before tax Country Y 200 224 251 281
Combined profit before tax 400 424 451 481
Tax Country X 50% 100 100 100 100
Tax Country Y 20% 40.0 44.8 50.2 56.2
Combined tax 140.0 144.8 150.2 156.2
Combined effective tax rate 35.0% 34.15% 33.30% 32.47%
Net Profit 260.0 279.2 300.8 324.8
4. Question 4
Suppose the tax authorities in Country X allow some costs (e.g., accelerated
depreciation) to be taken earlier for tax purposes. Country X, as a result, reports a
50% reduction in taxes paid in the current year but an increase in taxes paid by the
same amount in the following year (and each year after that). Assume Country X has
stable profit before tax and Country Y shows 12% annual before-tax-profit growth.
The combined cash tax rate for the current and next three years is closest to:
o A
35%; 34.2%; 33.3%; 32.5%.

o B
22.5%; 34.2%; 33.3%; 32.5%.

o C
17.5%; 17%; 16.7%; 16.3%.

Correct
B is correct. The combined cash tax rate will be 22.5% in the current year and then
rebound in subsequent years. Only the rate for the current year will decline from a
tax deferral; in subsequent years, the deferral for a given year will be offset by the
addition of the amount postponed from the previous year. The combined cash tax
rate beginning with the second year will decline over time.
Years (€ millions) 0 1 2 3
Profit before tax, Country X 200 200 200 200
Profit before tax Country Y 200 224 251 281
Combined profit before tax 400 424 451 481
Tax per income statement 140 144.8 150.2 156.2
Tax Payment Country X 50 50 50 50
Postponed tax payment, Country X 50 50 50
Tax Country Y 20% 40 44.8 50.2 56.2
Combined tax 90 144.8 50.2 156.2
Cash tax rate 22.5 % 34/15% 33.3% 32.47%
effective tax rate 35% 34.15% 33.3 % 32.47%
Nigel Armstrong, an analyst at Rutherford Investment Bank, is analyzing the competitive

position of HWC Technologies, a manufacturer of smartphones and mobile phone
accessories. Shaun Dwight is Armstrong’s supervisor, who has asked him to evaluate HWC’s
profitability over the past four years by comparing it with its two main rivals that are located
in different territories with different tax regimes. Armstrong conducts the smartphone
industry analysis using Porter’s five forces framework. Excerpts from his analysis are given
below:
• Customer switching costs are low.

• HWC holds 21% of world market share; its two main competitors hold 12.5%, and
10.0% respectively.
• A high number of equipment suppliers. Intense competition among suppliers.
• Demand is highly sensitive to the economy.
• Large number of choices available.
• High capital requirement and advanced technologies’ cost, customer loyalty towards
existing brands, constant push to innovate and launch new products.
HWC’s cost of goods sold for last year (2015) was 29% of sales. To forecast HWC’s income
statement for 2016, Armstrong assumes an inflation rate of 7% on the cost of goods sold.
Armstrong’s forecasts of HWC’s price and volume changes are given below:
• Average price increase per unit is 4.00%

• Volume growth is negative 2.00%
As a regular practice, Armstrong takes note of his forecasts and later compares them to the
actual numbers. This gives him an idea of how accurate his projections are.
1. Question 1
Based on the analysis of the competitive environment under the Michael Porter
framework, HWC’s ability to generate above market returns on invested capital
is most likely based on:
o A
high barriers to entry.

o B
high bargaining power of suppliers.

o C
low bargaining power of customers.

Incorrect
A is correct. The industry has high barriers to entry which makes it costly for new
competitors to enter the market. Hence HWC is better able to defend its market
share and likely generate above market returns. The low customer switching costs
(suggesting a high threat of substitutes), little product differentiation and demand
sensitive to economy suggests high bargaining power of buyers. Furthermore, there
is intense rivalry amongst suppliers suggesting low bargaining power of suppliers.
2. Question 2
HWC’s operating profit margins over the forecast period, given the current
competitive environment, will least likely:
o A
increase.
o B
decrease.
o C
stay the same.

Incorrect
B is correct. The current favorable characteristics of the industry (high barriers to
entry, low bargaining power of suppliers and strong brand loyalty) along with HWC’s
dominant market share position, will likely result in HWC’s profit margins being at
least equal to or greater than current levels over the forecast horizon.
3. Question 3
HWC’s 2016 gross profit margin based on the information given above, is closest to:
o A
72%.
o B
71%.
o C
70%.
Incorrect
C. is correct. HWC’s 2016 gross profit margin incorporating the industry-wide 7%
inflation on cost of goods sold is calculated as follows:
Revenue growth = (1.04) × (0.98) – 1 = 1.92%
COGS increase = (1.07) × (0.98) – 1 = 4.86%
Forecasted revenue = Base revenue × Revenue growth increase
Forecasted revenue = 100 × 1.0192 = 101.92
Forecasted COGS = Base COGS × COGS increase
Forecasted COGS = 29 × 1.0486 = 30.41
Forecasted gross profit = 101.92 – 30.41 = 71.51
Forecasted gross profit margin = 71.51/101.92 = 70.16%.
4. Question 4
Q-Code: 23-L2-FR-FSMO-184921
By comparing his forecasts to the actual numbers, Armstrong is most likely attempting
to mitigate which of the following biases?
o A
Confirmation bias
o B
Illusion of control
o C
Overconfidence bias
Incorrect
C is correct. Overconfidence bias is a bias in which people demonstrate unwarranted
faith in their own abilities. Analysts can mitigate this is by recording their forecasts
and reviewing them regularly, identifying both the correct and incorrect forecasts
they have made.
Confirmation bias is the tendency to look for and notice what confirms prior beliefs
and to ignore or undervalue whatever contradicts them. Two approaches to
mitigating confirmation bias in the forecasting process are to speak to or read
research from analysts with a negative opinion on the security under scrutiny and to
seek perspectives from colleagues who are not economically or psychologically
invested in the subject security.
Illusion of control is a tendency to overestimate the ability to control what cannot be
controlled and to take ultimately fruitless actions in pursuit of control. This can be
mitigated by restricting modeling variables to those that are regularly disclosed by
the company, focusing on the most important or impactful variables, and speaking
only with those who are likely to have unique or significant perspectives.
Rajini Lal, an auto sector analyst at Turin Investments, is reviewing the historical efficiency
ratios of Core Automobiles to forecast the company’s working capital accounts. After
establishing the financial forecasts of Core, Lal estimates a terminal value based on the
company’s average price-to-earnings multiple (P/E) over the past five years. Lal knows that
the terminal value estimate is sensitive to key assumptions about the company’s future
prospects. She asks her colleague: “Suppose a technological development beyond our
financial forecast period was to effect Core adversely, then how should the terminal value
change?” Next, Lal evaluates FTI S.p.A., a publicly traded Italian company that manufactures
and sells automobiles and commercial trucks. FTI is a market leader in the manufacture and
sale of petrol sedans in the ‘A’ segment with two other competitors and has a strong brand
name along with a well-established distribution network. The capital costs are very high for
new entrants in the industry. But inexpensive imported models in the same segment may
become substitutes for FTI’s petrol sedans. Lal selects the return on invested capital as the
metric to assess the FTI’s profitability. Though the company has been introducing
electric/hybrid cars as far back as 2008, its year-end 2023 model is considered the most
innovative to date. The company’s projections are as follows:
• Competing new electric models will enter the market in 2025.

• Electric cars will not be a substitute for petrol sedans.
• Research and development costs in 2024 and 2025 will lead to improvement of the
electric vehicles.
1. Question 1
Lal ‘s method of forecasting the working capital accounts of Core will most likely be
described as?
o A
top-down approach.
o B
bottom-up approach.
o C
hybrid approach.
Incorrect
B is correct. Lal is using a bottom-up approach to forecast Core’s working capital
accounts by using the company’s historical efficiency ratios to project future
performance.
2. Question 2
Regarding Lal’s question about the technological development, the most
appropriate answer is to:
o A
lower the price-to-earnings multiple.

o B
decrease the required rate of return.

o C
increase the sustainable growth rate.

Incorrect
A is correct. Because a technological development may affect Core adversely beyond
the forecast horizon, the future growth or profitability of the firm will likely be lower
than the historical average. Hence the target multiple should reflect a discount to the
historical multiple to reflect this difference in growth and/or profitability. The choice
of the multiple used for terminal value should be consistent with the long-run
expectations for growth and required return.
3. Question 3
Based on Porter’s five forces framework, which of the following competitive factors
will likely have the greatest impact on FTI’s pricing power in the A segment petrol
sedans?
o A
Threat of new entrants.

o B
Threat of substitutes.
o C
Rivalry.
Incorrect
B is correct. Inexpensive, small imported vehicles are substitutes for petrol sedans
and may greatly impact FTI’s pricing power for its petrol vehicles.
4. Question 4
Given FTI’s projections, the gross profit margin of the firm’s electric motor vehicle
division in 2025 will most likely be impacted by:
o A
cannibalization by petrol sedans.

o B
competition.
o C
research costs.
Correct
B is correct. Competition from other electric car manufacturers is expected from
2025. This could result in lower demand for FTI’s electric sedans and affect their
gross profit margin.
FIXED INCOME
The Term Structure and Interest

Rate Dynamics
1. Question 1
Q-Code: 22-L2-FI-TSIR-145597
If you are given the 2-year, 3-year and 4-year spot rates, which of the following
forward rates can you calculate?
o A
The one-year forward rate two years from today, the one-year forward
rate three years from today and the two-year forward rate two years
from today.
o B
The one-year forward rate four years from today and the two-year forward
rate three years from today.
o C
The two-year forward rate three years from today and four-year forward rate
one year from today.
Incorrect
A is correct. The forward rates mentioned in Option A, f2,1, f3,1, f2,2 can be calculated
using the following equations.
[1 + z3]3 = [1 + z2]2 [1 + f2,1]1
[1 + z4]4 = [1 + z3]3 [1 + f3,1]1
[1 + z4]4 = [1 + z2]2 [1 + f2,2]2
B and C are incorrect because each requires the five-year spot rate z5.
2. Question 2
The measure that identifies shaping risk is least likely:
o A
key rate duration.

o B
three-factor model of yield curve sensitivities to parallel, steepness, and

curvature movements.
o C
effective duration.
Incorrect
C is correct. Key rate duration or sensitivities to parallel, steepness, and curvature
movements allow one to identify and manage shaping risk, which is the sensitivity to
changes in the shape of the yield curve in addition to the risk related to parallel
changes. Effective duration only addresses the latter.
3. Question 3
Richard Kors discusses a newly issued zero-coupon bond by CBOX Corporation with
his supervisor. It is rated A1/A+, with seven years to maturity priced to yield 8.50% to
maturity. This credit typically trades in line with high-quality banks andcors. Current
market rates are 8% for the seven-year risk-free spot rate, and the seven-year swap
spread is 0.50%. Kors’ supervisor wants to know if this bond is mispriced?
Kors best response is: The newly issued zero-coupon CBOX bond is:
o A
not mispriced.
o B
mispriced because of the difference between the swap rate and the spot
rate.
o C
mispriced because of the difference between the swap rate and bond yield.
Incorrect
A is correct. The CBOX bond is likely not mispriced because the swap rate (8% + 0.5%
= 8.5%) is equal to the bond’s yield to maturity. Also, the default risk rating of A1/A+
matches the default risk rating of high-quality commercial banks which is generally
A1/A+.
4. Question 4
Kiran Bindre a newly hired junior risk manager is asked to review credit spread
indicators that measure credit and liquidity risk for fixed income securities. Bindre
makes the following observations about credit risk measures.
I. Z-spread represents the difference between the yield on credit bonds and the
implied spot yield curve.
II. Libor-OIS (overnight index swaps) spread is the difference between Libor and
high quality corporate bonds’ yields.
III. TED (Treasury-eurodollar) spread represents the difference between Libor
and overnight indexed swap rates.
Which of Bindre’s observations is most likely correct?
o A
Observation 1.
o B
Observation 2.
o C
Observation 3.
Incorrect
A is correct. Z-spread is the constant basis point spread that would need to be added
to the implied spot yield curve to determine bond price. B & C are incorrect. TED
spread is the difference between Libor and T-bill yield of matching maturity, and
Libor-OIS spread is the difference between Libor and overnight indexed swap (OIS)
rate.
5. Question 5
Sam Hunt is asked to evaluate the impact of yield curve movements on fixed-income
securities. He constructs a yield curve factor model that describes three independent
yield curve movements. The yield curve movements are shown below.
Time to
1 Year 2 Years 3 Years 4 Years 5 Years
Maturity
Factor 1 0.55% 0.81% 1.19% 1.67% 2.23%
Factor 2 – 0.35 0.77 1.53 0.76 – 0.33
Factor 3 0.72 0.73 0.74 0.75 0.76
Based on the table above, the movements characterized by Factor 1, Factor 2, and
Factor 3 are most likely:
o A
steepness, curvature, and level.

o B
curvature, level, and steepness.

o C
level, steepness, and curvature.

Incorrect
A is correct. Factor 1 represents a change in steepness in the yield curve because the
changes in yield increase through each maturity point. Factor 2 shows change in
curvature because the changes in the short-term and long-term are different from
the middle term. Factor 3 represents a change in level because the changes in yield
are equal across all maturity points.
6. Question 6
Chris Bird, Director of Research at a securities firm, makes the following comments
regarding the term structure theories which provide an explanation of the term
structure shape to his team of fixed income analysts:
Comment 1: “The pure expectations theory states that the forward rate is an
unbiased predictor of the future spot rate. This theory is consistent with the
assumption that investors are risk averse as they are affected by uncertainty and
require a risk premium.
Comment 2: The liquidity preference theory assumes a liquidity premium to

compensate investors for taking more interest rate risk by investing in longer
maturity bonds. Therefore, this theory predicts an upward sloping yield curve
because of the liquidity premium, even if spot rates are expected to be unchanged.
Comment 3: A third explanation of the shape of the yield curve is the segmented
markets theory which asserts that yields are a function of supply and demand for
funds of a specific maturity. This is similar to the preferred habitat theory in
proposing that investors and borrowers having strong preferences for particular
maturities.”
Which of Bird’s comments regarding the theories of the term structure of interest
rates is least likely correct?
o A
III.
o B
II.
o C
I.
Incorrect
C is correct. Bird is incorrect regarding uncertainty and pure expectations theory.
According to this theory investors are unaffected by uncertainty and risk premiums
do not exist. Comments 2 & 3 are correct.
7. Question 7
Two portfolio managers are discussing a portfolio management strategy called riding
the yield curve.
Portfolio manager 1: “This strategy can enhance portfolio total return by buying
bonds with maturities longer than their investment horizon whenever the yield curve
is upward sloping and stable.”
Portfolio manager 2: “I agree, this strategy can continuously increase the portfolio
total return even if interest rates increase unexpectedly, because as the bonds roll
down the yield curve, they will appreciate in price.”
Regarding how investors can profit from riding the yield curve, which portfolio
manager is most likely correct?
o A
neither.
o B
Portfolio manager 1.
o C
Portfolio manager 2.
Incorrect
B is correct. Portfolio manager 1 is correct in his interpretation of increasing returns
from rolling down the yield curve. However, if rates unexpectedly rise more than
what is predicted by the forward curve, the trade is subject to significant interest rate
risk. Hence Portfolio manager 2 is incorrect.
8. Question 8
Tom Bailey, fund manager makes the following statements while giving a
presentation on spread measures in fixed income securities:
Statement 1: “The Z-spread uses the implied spot yield curve and adds the spread
necessary to discount the bond’s cash flows and derive its current market price. It is
a useful measure of risk for corporate bonds.
Statement 2: The TED spread is used for the valuation of government bonds and is
calculated as the difference between Libor and the yield on a T-bill of equal maturity.
Statement 3: The Libor-OIS spread incorporates an index rate which is typically the
rate for overnight unsecured lending between banks. The Libor-OIS spread serves as
an indicator of risk and liquidity of money market securities.”
Bailey is least likely correct regarding which spread measure?
o A
Z-spread.
o B
TED spread.
o C
Libor-OIS spread.
Incorrect
B is correct. The TED spread is a measure of perceived credit risk in the general
economy, it is not used in valuation of individual bonds. A & C are correct
statements.
9. Question 9
Aki Hiroshi, director research assigns Sally Jun, analyst to value a bond, issued by
AAA rated Japanese International Bank (JIB), maturing in 2.94 years, with a coupon
rate of 1.94% paid annually. Dealers are quoting the bond flat to swaps. Hiroshi
advises Jun to use simple interpolation to calculate the swap spread. Jun gathers the
following information:
Maturity (Years) 1 2 3 4
Off the run JGB yield (%) -0.26 -0.13 0.02 0.17
On the run JGB yield (%) -0.20 -0.04 0.11 0.28
Swap rate (%) 0.40 0.58 0.75 0.96
Based on the data given above, the spread for the credit and liquidity component of
the JIB bond’s yield to maturity is closest to:
o A
0.74.
o B
0.64.
o C
0.58.
Incorrect
B is correct. The swap spread represents the return that investors require for credit
and liquidity. Since dealers are quoting the bond flat to swaps or swaps + 0 basis
points there is no added spread to swaps. The swap spread is measured over the
“on-the-run” or most recently issued government security, in this case “on the run”
JGB (Japanese government bonds). Simple interpolation is used to calculate the swap
spread.
JGB yield for the maturity: -0.04 + 0.94 × {0.11 – (-0.04)} = 0.10.
The swap rate for the maturity: 0.58 + 0.94 × (0.75 – 0.58) = 0.7398 = 0.74 approx. The
difference represents the swap spread: 0.74 – 0.10 = 0.64.
10. Question 10
Canan Enver is evaluating a portfolio of zero-coupon bonds with maturities of 1, 5
and 10 years with $100 in each position. Enver is analyzing what happens as rates
change across the yield curve. He assumes the portfolio sensitivities to factors given
in Table 1. The portfolio has equal weightings in each key rate duration. Enver’s
supervisor asks him to examine the effect on the portfolio when the curve steepens.
Table 1: Factor Movements and Key Rate Durations
Year 1 5 10
Parallel 0 0 0
Steepness 1 0 -1
Based on Table 1 and the supervisor’s assumptions, which bond will outperform?
o A
The one-year bond.

o B
The five-year bond.

o C
The ten-year bond.

Incorrect
C is correct. The 10-year bond will gain the most from a change in steepness of the
yield curve. This is based on the steepness factors in Table 1. The 1-year rate is up by
1 unit and the 10-year rate is down by 1 unit.
11. Question 11
Consider a three-year loan beginning in two years. The two-year and five-year spot
rates are 5% and 11%, respectively. The five-year discount factor is closest to:
o A
0.5934.
o B
0.6632.
o C
0.9524.
Incorrect
A is correct. The five-year discount factor is the price one would pay today for $1 in
five years. This is calculated using the five-year spot rate:
1/[(1 + 0.11)5] = 0.5934
12. Question 12
Riley Scott, a fixed income analyst suggests a newly issued, five-year term US
Treasury zero-coupon note priced at USD64.99 ($100.00 face value) to his portfolio
manager for investment. The bond yields 9.00% to maturity. According to Scott some
investors may purchase this Treasury zero-coupon note today and hold it to
maturity, while others may buy the same Treasury note in two years and then hold it
for three years to maturity. Scott’s portfolio manager asks him to calculate the
forward rate that would cause investors to be indifferent about either purchasing
the Treasury zero-coupon note today or purchasing it in two years. Given the spot
rates z1 = 5%, z2 = 6%, z3 = 7%, z4 = 8%, z5 = 9%; the forward rate that would make an
investor indifferent between buying the Treasury note today or in two years
is closest to:
o A
9%
o B
7%
o C
11%
Incorrect
C is correct. The forward rate two years from now maturing in three years f2,3 that
would make an investor indifferent in purchasing the 5 year US Treasury note today
or two years from today is:
(1 + z5)5 = (1 + z2)2 (1 + f2,3)3
(1.09)5 = (1.06)2 (1 + f2,3)3
f2,3 = [(1.09)5/ (1.06)2]1/3 -1 = 11.047% ≈ 11.05%
13. Question 13
Rana Dabir, a quantitative analyst is evaluating whether a four-year 8% annual-
coupon Treasury bond priced to yield 9.72% to maturity is cheap (buy
recommendation), fairly valued (hold recommendation) or rich (sell
recommendation) based on arbitrage opportunities. Dabir has collected the
following data:
Year 1 Year 2 Year 3 Year 4

Spot rate 0.068 0.1020
Discount factor 0.7797
Forward rate: f2,1 0.112
Based on the data and the yield to maturity given above, Dabir should most likely:
o A
hold the Treasury bond.

o B
sell the Treasury bond.

o C
buy the Treasury bond.

Incorrect
B is correct. The quoted YTM of 9.72%, results in a bond price of 94.5146 [N = 4, I =
9.72, PMT = 8, FV = 100, CPT PV].
The bond price based on the spot rates is:
8 / 1.068 + 8 / (1.074)2 + 8 / (1.0865)3 + 108 / (1.102)4 = 93.895.
where:
Year 3 spot rate z3 is calculated as:
DF3 = 1 / (1 + z3)3
1 / 0.7797 = (1 + z3)3 => z3 = 8.65%.
Year 2 spot rate z2 is calculated as:
[1 + z3]3 = [1 + z2]2 [1 + f2,1)]
(1.0865)3 / (1.112) = [1 + z2]2 => z2 = 7.40%.
The quoted YTM 9.72% [bond price of 94.52] is more expensive than the YTM 9.92%
[bond price of 93.89] based on spot rates, hence the analyst should sell the bond.
14. Question 14
If there are positive yield changes in the short-term rate and the long-term rate but a
decline in the middle-term rate, then the movement is best known as a change in the:
o A
curvature of the curve.

o B
steepness of the curve.

o C
level of the curve.

Incorrect
A is correct. A unit positive change in the standard deviation of the factor causing
positive yield changes in the short-term rate and the long-term rate but a decline in
the middle-term rate is described a change in the curvature or ‘twist’ of the curve.
15. Question 15
If the one-year par rate is 3.00% and the two-year par rate is 3.65%, then the one-
year and two-year zero-coupon rates are:
o A
3.00%; 3.65%
o B
3.65%; 4.05%.
o C
3.00%; 3.66%
Incorrect
C is correct. The zero-coupon rates are determined by using the par yields and
solving for the zero-coupon rates, by bootstrapping. The one-year zero-coupon rate
is the same as the one-year par rate because of the assumption of annual coupons.
The two-year zero-coupon rate is determined by solving the following equation in
terms of one monetary unit of current market value, using z1 = 3%:
1 = 0.0365 / 1.03 + 1 +0.0365 / (1 + z2)2
Solving the equation for z2
1 – 0.0365 / 1.03 = 1.0365 / (1 + z2)2
(1 + z2)2 = 1.0365 / 0.964563
z2 = (1.0746)1/2 – 1
z2 = 3.6629%
16. Question 16
If a sovereign par curve implies a one-year discount factor of 0.9615, and a two-year
factor of 0.9070, then the swap rate at time T = 1 is closest to:
o A
3.50%
o B
5.00%
o C
4.00%
Incorrect
C is correct. The swap rate at time T =1 can be calculated from the formula:
S1 / (1 +Z1)1 + 1 / (1 +Z1)1 = 1
S1 / (1 +0.04)1 + 1/(1 + 0.04)1 = 1 -> S1 =4%
where:
DF1 = 1 / (1 + z1)1
1 / 0.9615 = (1 + z1)1 => z1 = 4.00%.
17. Question 17
A student makes the following statements:
Statement 1: A spot rate is the interest rate on a security that makes a single
payment at a future point in time.
Statement 2: The spot yield curve shows the spot rates for a range of maturities.
Statement 3: The spot rates on a spot yield curve are the annualized returns of
option-free, default-risk-free bonds with varying coupon rates.
Which of the above statements are most likely correct?
o A
Statement 1 only
o B
Statements 1 and 2
o C
Statements 2 and 3
Incorrect
B is correct. Both statements 1 and 2 are true statements. A spot rate is the interest
rate on a security that makes a single payment at a future point in time. The spot
rate, ZN, for a range of maturities (for example: N = 1, 2, 3…) is called the spot yield
curve or spot curve. The spot curve shows, for various maturities, the annualized
return on an option-free and default-risk-free zero-coupon bond with a single
payment of principal at maturity.
Statement 3 is incorrect because a spot curve shows the spot rates at different
maturities for a zero-coupon bond, not different bonds with different coupon rates.
18. Question 18
The relationship between the four-year spot rate, two-year spot rate and two-year
forward rate two years from now is given as:
o A
[1 + Z2]2= [1 + Z4]4[1 + f2,2]2

o B
[1 + Z4]4= [1 + Z2]2[1 + f2,2]2

o C
[1 + Z4]4 = [1 + Z2]2 [[1 + f4,2]2

Incorrect
B is correct.
According to the forward rate model:
[1 + ZB]B = [1 + ZA]A[1 + fAB-B]B-A
Therefore, the relationship between the four-year spot rate, two-year spot rate and
two-year forward rate two years from now can be expressed as:
[1 + Z4]4 = [1 + Z2]2 [1 + f2,2]2
19. Question 19
If the one-year spot rate is 3.00%, two-year spot rate is 4.00% and three-year spot
rate is 5.00%, then f1,2 is:
o A
greater than Z3.

o B
less than Z3
o C
equal to Z3.
Incorrect
Using the forward rate model:
[1 + z3]3 = [1 + z1)]1[1 + f1,2]2
(1 + 0.05)3 = (1 + 0.03)1 (1 + f1,2)2
f1,2 = 6.0145%
This is greater than Z3, 5.00%.
20. Question 20
The YTM can provide a poor estimate of expected return if:
o A
the yield curve is flat.

o B
there is no risk of default.

o C
the bond has one or more embedded options.

Incorrect
Solution: C is correct. The YTM can provide a poor estimate of expected return if the
bond has one or more embedded options (e.g. put, call, or conversion).
A is not correct because the YTM is generally a realistic estimate of expected return
only if the yield curve is flat.
B is not correct because the YTM can provide a poor estimate of expected return if
there is significant risk of default.
21. Question 21
When the spot curve is upward sloping, a later initiation date results in a forward
curve that is:
o A
a greater distance above the spot curve.

o B
closer to the spot curve.

o C
a greater distance below the spot curve.

Incorrect
Solution: A is correct. If the spot curve is upward sloping (downward sloping), a later
initiation date will result in a forward curve that is a greater distance above (below)
the spot curve.
22. Question 22
Suppose for a given portfolio that key rate changes are considered to be changes in
the yield on 1-year, 5-year, and 10-year securities. Estimated key rate durations are
KeyDur1 = 0.40, KeyDur2 = 0.65, and KeyDur3 = 0.81. The percentage change in the
value of the portfolio if a parallel shift in the yield curve results in all yields increasing
by 75 bps is closest to:
o A
‒1.39%.
o B
+1.39%.
o C
-2.30%.
Incorrect
Solution: A is correct. An increase in interest rates would lead to an decrease in
bond portfolio value: ‒0.40(0.0075) ‒ 0.65(0.0075) ‒ 0.81(0.0075) = -0.01395 = -1.39%
23. Question 23
In a bearish flattening; the:
o A
short -term bond yields rise more than the long-term bond yields.
o B
short-term rates fall more than the long-term bond yields.

o C
short -term bond and the long-term bond yields remain unchanged.
Incorrect
Solution: A is correct. During economic expansions, monetary authorities raise
benchmark rates to control inflation. This results in a bearish flattening; the short -
term bond yields rise more than the long-term bond yields.
During economic recessions, monetary authorities cut benchmark rates to stimulate
economic activity. This results in a bullish steepening; the short-term rates fall more
than the long-term bond yields
24. Question 24
Analyst 1: Portfolio concentrated in a single maturity is known as a bullet portfolio
while the one that combines short and long maturities is known as a barbell
portfolio.
Analyst 2: An investor may capitalize on an expected bullish flattening of the yield

curve by shifting from a barbell to a bullet position.
Which of the above statements in correct?
o A
Statement 1
o B
Statement 2
o C

Incorrect
Solution: A is correct. Fixed-income investors with long only investment mandates
may alternate between portfolios concentrated in a single maturity, known as a
bullet portfolio, and those with similar duration that combine short and long
maturities, known as a barbell portfolio.
Statement 2 is not correct because an investor expecting a bullish flattening of the
yield curve can shift from a bullet portfolio to a barbell portfolio.
25. Question 25
Which of the following statements is not correct?
o A
Flight to quality is most often associated with bearish flattening.

o B
Investors expecting rates to fall will generally extend portfolio duration.

o C
Investors expecting rates to rise will shorten portfolio duration.

Incorrect
Solution: A is correct. A flight to quality is most often associated with bullish
flattening, in which the yield curve flattens as long term rates fall by more than
short-term rates.
26. Question 26
The swap spread is defined as the spread paid by the:
o A
floating-rate payer over the rate of same maturity of the most recently issued
government security.
o B
fixed-rate payer over the rate of same maturity of the most recently
issued government security.
o C
fixed-rate payer over the investment grade corporate bonds of the same
maturity.
Incorrect
B is correct. The swap spread is defined as the spread paid by the fixed-rate payer
over the rate of same maturity of most recently issued (“on-the-run”) government
security.
27. Question 27
When the yield curve is downward-sloping, the market expectation it most
likely reflects is:
o A
falling inflation rates in the future.

o B
rising inflation rates in the future.
o C
strong economic growth in the future.

Incorrect
A is correct. A downward-sloping yield curve indicates a market expectation of falling
future inflation rates (because a premium for expected inflation is added into the
nominal yield) from a relatively high current level. B & C are incorrect because an
upward-sloping yield curve reflects market expectation of increasing future inflation
associated with strong economic growth.
28. Question 28
Which of the following statements regarding the YTM of a risk-free government bond
is most accurate? The YTM is an appropriate measure of the expected return of the
bond if the:
o A
interest rates are volatile and the bond is either putable or callable.
o B
coupons are reinvested at the original yield to maturity and the bond is
held till maturity.
o C
yield curve has a steep slope.

Incorrect
B is correct. The yield to maturity is the expected rate of return of a bond if certain
conditions are met. These are that the bond is held till maturity, all coupons and
principal are paid in full as they become due, and coupons are reinvested at the
original YTM. A & C are incorrect because the YTM is a poor estimate of expected
return if interest rates are volatile; yield curve is steeply sloped; there is risk of
default; or bond has embedded options (e.g., put, call).
29. Question 29
The par curve represents the yield to maturity on:
o A
coupon-paying corporate bonds priced at par.

o B
discount bonds.
o C
coupon-paying government bonds at par.

Incorrect
C is correct. The par curve indicates the yields to maturity on coupon-paying
government bonds, priced at par, for different maturities.
30. Question 30
Assume you have the following information: one-year spot rate is 5.00%, two-year
spot rate is 6.00% and the one-year forward rate one year from today is 7.01%. If the
spot rates one year from now reflect the current forward curve, the return of a two-
year, zero-coupon bond over a one-year holding period will be closest to:
o A
5.00%.
o B
6.00%.
o C
7.01%.
Incorrect
A is correct. The total return on a zero-coupon bond over a holding period of one-
year is the one-year rate if the spot rates evolve as implied by the current forward
rate curve.
31. Question 31
Assume the spot curve one year from today differs from today’s forward curve.
Consider the following information: one-year spot rate is 5.00%, two-year spot rate is
6.00% and the one-year forward rate one year from today is 7.01%. If the one-year
spot rate one year from today is 6.00%, the return of a two-year, zero-coupon bond
over a one-year holding period will be closest to:
o A
5.00%.
o B
6.00%.
o C
7.01%.
Incorrect
B is correct. At time 0, the price of a USD100-par, zero-coupon bond will be 100 /
1.062 = 88.9996. At time 1, the price of a USD100-par, zero-coupon bond will be 100 /
1.06 = 94.3396. Hence, the return of the two-year zero-coupon bond over the one-
year holding period will be 94.3396 / 88.9996 – 1 = 6%. In this scenario, the spot rate
one year from today does not reflect the forward rate curve at time 0. Consequently,
the one-year holding period return of a two-year bond will be different from the one-
year holding period return of a one-year bond.
32. Question 32
A bond is undervalued if the investor’s expectation about the future spot rates is:
o A
lower than the quoted forward rate.

o B
equal to the quoted forward rate.

o C
greater than the quoted forward rate.

Incorrect
A is correct. A bond is undervalued if the investor’s expectation about the future spot
rates is lower than the forward rate for the same maturity. This is because the
market is discounting payments of the bond at a higher rate than the
investor. Hence the market price is less than the bond’s intrinsic value. A bond is
overvalued if the expected future spot rates are higher than quoted forward rate.
33. Question 33
If at the end of Year 1, the one-year spot rate is higher than what is implied by the
current forward curve, the one-year holding period return on a two-year zero-
coupon bond will be:
o A
less than the one-period risk-free rate.

o B
equal to the one-period risk-free rate.

o C
more than the one-period risk-free rate.

Incorrect
A is correct. The return will be less than the one-period risk-free rate, because the
bond’s actual value at the end of year 1 will be less than what was projected at time
0. B & C are incorrect because if spot rates evolve as predicted by current forward
curve then bond’s return is the one-period risk-free rate. If projected spot rates are
lower than the current forward curve, the bond’s return will be more than the one-
period risk-free rate.
34. Question 34
If a yield curve is upward sloping and does not change level or shape, then buying a
bond with maturity longer than the investment horizon would provide a total return:
o A
greater than the return on a maturity-matching strategy.

o B
equal to the return on a maturity-matching strategy.

o C
lower than the return on a maturity-matching strategy.

Incorrect
A is correct. When the yield curve is upward sloping and does not change level or
shape, then buying a bond with with maturity longer than the investment horizon
would provide a total return greater than the return on a maturity-matching
strategy. This is because the bond is valued at lower yields and higher prices as it
nears maturity. This strategy is called ‘riding the yield curve’ or ‘rolling down the yield
curve’.
35. Question 35
The least likely trade that an active bond investor would make when the yield curve is
upward sloping is known as:
o A
rolling down the yield curve.

o B
riding the yield curve.

o C
the maturity-matching strategy.

Incorrect
C is correct. The yield curve trade that an active bond investor often makes when the
yield curve is upward sloping is known as riding the yield curve or rolling down the
yield curve, because the trade is based on buying a bond with a maturity longer than
the investment period and selling it before maturity to earn a higher total return
than the maturity-matching strategy.
36. Question 36
A forward contract value will decrease if:
o A
future spot rates are equal to the current forward rates.
o B
future spot rates are higher than the current forward rates.
o C
future spot rates are lower than the current forward rates.
Incorrect
B is correct. A forward contract value is expected to decrease if future spot rates are
higher than what is predicted by current forward rates. This is because cash flows
will be discounted at an interest rate that is greater than what was initially expected.
A forward contract value will increase if future spot rate is expected to be lower than
the prevailing forward rate.
37. Question 37
The swap rate reflects the:
o A
floating-rate leg of an interest rate swap.

o B
fixed-rate leg of an interest rate swap.

o C
average of the floating-rate and fixed-rate legs of an interest rate swap.

Incorrect
B is correct. The swap rate is the interest rate for the fixed-rate leg of an interest rate
swap.
38. Question 38
The least likely reason that the swap market is highly liquid is:
o A
due to counterparties making the swap contracts flexible and customized.

o B
due to multiple borrowers or lenders.

o C
due to providing the most efficient method of hedging interest rate risk.
Incorrect
B is correct. The swap market is highly liquid because it consists of counterparties
and not multiple borrowers or lenders, and provides the most efficient method to
hedge interest rate risk.
39. Question 39
If one-year forward rate five years from today is 9.00%, the least correct interpretation
of 9.00% is:
o A
the reinvestment rate that would make a buyer indifferent between investing
in a six-year zero-coupon bond or buying a five-year zero-coupon bond and
at maturity reinvesting the proceeds for one year.
o B
the rate that would make the investor indifferent between buying a
five-year bond or buying a six-year bond.
o C
the one-year rate that can be locked in today by investing in a six-year zero-
coupon bond instead of buying a five-year zero-coupon bond and at
maturity, reinvesting the proceeds in a zero-coupon instrument which has
one-year maturity.
Incorrect
B is correct. A and C are the true interpretations of 9.00%. It is the reinvestment rate
that would make a buyer indifferent between investing in a six-year zero-coupon
bond or buying a five-year zero-coupon bond and at maturity reinvesting the
proceeds for one year. Forward rate hence, is a type of breakeven interest rate. The
9.00% forward rate can also be interpreted as a rate that can be locked in by
extending maturity by one year by investing in a six-year zero-coupon bond.
40. Question 40
The swap spread is quoted as 90 bps. If the fixed payer in a four-year interest rate
swap is paying a rate of 3.05%, then the four-year government bond is yielding:
o A
3.95%.
o B
3.05%.
o C
2.15%.
Incorrect
C is correct. The fixed leg of the four-year fixed-for-floating swap is 3.05% and the
swap spread is 90 bps, then: govt. bond rate + 0.9% = 3.05%. government bond rate
= 2.15%.
41. Question 41
A USD 1 million Eny Corporation bond pays a semiannual coupon of 3.125% and has
2.5 years remaining to maturity. The treasury rates of two-year and three-year
maturities are 1.01% and 1.13%. If the swap spread for the same maturity as the
bond is 1.676%, then the yield to maturity on the bond is closest to:
o A
2.75%.
o B
2.81%.
o C
2.69%.
Incorrect
A is correct. By interpolation between the two treasury rates, the swap rate for 2.5
years is:
[1.01% + (180360)(1.13%−1.01%)] =1.07%, the swap spread is 1.676\%.
The yield to maturity on the bond is 1.070\% + 1.676\% = 2.746\%.
42. Question 42
o A
The swap spread helps an investor assess the time value, liquidity and credit
components of the yield to maturity of a bond.
o B
The Z-spread is less accurate than an interpolated yield, when interest

rate swap curves are steep.
o C
The Z-spread is the constant spread in basis points when added to the
implied spot yield curve gives the invoice price of the bond.
Incorrect
B is correct. The Z-spread is more accurate than a yield that is interpolated linearly,
especially with steep interest rate swap curves. A & C are accurate statements.
43. Question 43
The Z-spread of Bond X is 250 bps and the Z-spread of Bond Y is 190 bps. All else
equal, which statement is most accurate ?
o A
Bond Y is discounted at a higher rate than Bond X.
o B
Bond X is riskier than Bond Y.

o C
Bond Y will sell at a lower price than Bond X.

Incorrect
B is correct. The Z-spread of Bond X is 250 bps and the Z-spread of Bond Y is 190
bps. The higher Z-spread for Bond X implies it is riskier than Bond Y. The higher
discount rate will make the price of Bond X lower than Bond Y.
44. Question 44
An increase in the TED spread least likely indicates that the:
o A
perceived liquidity risk in the general economy is increasing.

o B
default risk on interbank loans is increasing.

o C
perceived liquidity risk is decreasing.

Incorrect
C is correct. TED spread is an indicator of perceived credit and liquidity risk. An
increase in the TED spread indicates greater perceived credit and liquidity risk, and
vice versa. An increase in the TED spread also indicates that the default risk on
interbank loans is increasing.
45. Question 45
The Libor-OIS spread reflects the:
o A
risk and liquidity of money market securities.

o B
differing supply and demand conditions.

o C
credit risk in the banking system.

Incorrect
A is correct. The Libor-OIS spread is an indicator of risk and liquidity of money
market securities. B is incorrect because the 10-year swap spread indicates the
differing supply and demand conditions. C is incorrect because the TED spread
indicates risk in the banking system.
46. Question 46
Compared to the pure expectations theory, the local expectations theory asserts
that:
o A
the buying a seven-year bond and holding it for five years is the same as
buying a five-year bond.
o B
the return for every bond over the short term is the risk-free rate.
o C
the return for every bond is the risk-free rate for that maturity, because
investors do not require risk premiums.
Incorrect
B is correct. The local expectations theory differs from the pure expectations theory
because it asserts that the expected return for every bond over the short-term
periods is the risk free rate, rather than contending that every bond yields the risk-
free rate for that specific maturity. Local expectations theory requires no risk
premiums for only short holding periods but considers risk premiums on longer
term investments.
47. Question 47
Which statement is least likely correct? The shape of the yield curve is typically upward
sloping as claimed by the liquidity preference theory because of the:
o A
liquidity premium required by lenders to compensate for interest rate risk.

o B
yield premium to account for the lack of liquidity in longer-dated debt

instruments.
o C
liquidity premium that increases with maturity.

Incorrect
B is correct. The shape of the yield curve is typically upward sloping as claimed by
the liquidity preference theory because of the liquidity premium required by lenders
to compensate for interest rate risk. The liquidity premium increases with maturity.
This is not to be confused with the yield premium required for the lack of liquidity
borne by the thinly traded bonds.
48. Question 48
The theory which asserts that investors limit investments to those maturity sectors
that match the maturities of their liabilities is best known as the:
o A
preferred habitat theory.

o B
segmented markets theory.

o C
unbiased expectations theory.

Incorrect
B is correct. The theory which asserts that investors limit investments to those
maturity sectors that match the maturities of their liabilities is best known as the
segmented markets theory. This theory is consistent with the presence of
asset/liability constraints of the investors which are either regulatory or self-
imposed. Investors hold debt securities that match their investment horizon to
avoid risks related to asset/liability mismatch.
49. Question 49
Which theory proposes that the term structure of interest rates is influenced by both
market expectations and institutional factors?
o A
Preferred habitat theory.

o B
Liquidity preference theory.

o C
Pure expectations theory.

Incorrect
A is correct. The preferred habitat theory asserts that investors and institutions will
accept additional risk in return for additional expected return. In this theory both
market expectations and institutional factors influence the term structure of interest
rates.
50. Question 50
A movement in which the yield curve shifts upwards or downwards is best known as
a:
o A
curvature movement.
o B
steepness movement.
o C
level movement.
Incorrect
C is correct. The level movement refers to an upward or downward shift in the yield
curve. Steepness refers to non-parallel shift in the yield curve and curvature is
movement in three segments of the yield curve (short-term, long-term, and middle-
term).
Sarah Miller, a quantitative analyst has been given the task of analyzing a newly issued, US
Treasury bond with a five-year maturity and an annual coupon of 9.00%. The bond was
issued at a price of 101.89 to yield 8.52%. Miller is evaluating this bond for investors who
will buy this bond with the intention of holding it to maturity. Her analysis is based on an
expectation that the forward rates are the future spot rates. Current spot rates and
extrapolated one year forward rates are provided in Table 1. Table 1: Spot and Forward
Interest Rates
Year Spot Rate Forward Rate

1 5.0%
2 6.0% 7.0%
3 7.0% 9.0%
4 8.0% 11.1%
5 9.0% 13.1%
Miller’s supervisor Kathy asks, “Suppose an investor purchases this five-year US Treasury bond at
101.89, to yield 8.52% to maturity. He holds the bond for two years, at which time the 1 year, 2 year
and 3 year spot interest rates are each assumed to equal 10.00%. Will this Treasury bond be
overvalued or undervalued?”
1. Question 1
Based on Table 1, and assuming Miller’s interest rate expectation materializes, the realized
return for the US Treasury bond if held to maturity is closest to:
o A
8.52%.
o B
8.90%.
o C
1.50%.
Incorrect
B is correct. The present value of the bond is 101.89. Since the forward rates are
assumed to be the future spot rates, the value of the bond at the end of Year 5 is
calculated as follows:
9(1.07)(1.09)(1.111)(1.131) + 9(1.09)(1.111)(1.131) + 9(1.111)(1.131) +9(1.131) +109 =
156.00.
The annualized realized return = (156.00 / 101.89) 1/5 – 1 = 8.89%.
2. Question 2
Based on Table 1, and Kathy’s assumptions of an investor who buys the five year US
Treasury bond but sells it after two years, it is best to conclude that the bond is:
o A
overvalued.
o B
undervalued.
o C
fairly valued.
Incorrect
A is correct. For any bond in which the expected future spot rates (10.0% for each of
the remaining three years of the bonds term) is higher than a quoted forward rate
for the same maturity (for example, the 9.0% one year rate two years forward
{“f(1,2)”} as implied by the current spot curve), the bond is overvalued vs. its intrinsic
value since the market is placing a lower discount rate on its cash flows (9.0%
forward rate today vs. 10.0% assumed future spot rate).
The Arbitrage-Free Valuation

Framework
1. Question 1
Q-Code: 21-L2-FI-AFVF-75131
Jeremy Kabelo, a newly hired fixed income analyst at a securities firm, makes the
following statements regarding valuation of option-free bonds:
Statement 1: Special programming skills are needed to properly calibrate a binomial

tree to match benchmark risk-free bond prices, which makes the binomial approach
quite costly to adopt.
Statement 2: Pathwise valuation is an alternative approach to backward induction in

a binomial tree.
Which of Kabelo’s statements is least likely correct?
o A
Statement 1
o B
Statement 2
o C

Incorrect
A is correct. To calibrate a binomial interest rate tree, Solver function in Excel is
typically used which is relatively easy to do. Therefore, a knowledge of special
programming techniques is not required and no great expense is incurred.
2. Question 2
The following are four interest rate paths and the possible forward rates along those
paths. Using pathwise valuation the present value for the second path for a three-
year zero-coupon bond in dollars is closest to:
Forward Rate Forward Rate

Path Rate Year 1
Year 2 Year 3
1. 1.000% 3.483 % 6.817%
2. 1.000% 3.483 % 5.050 %
3. 1.000% 2.580 % 5.050 %
4. 1.000% 2. 580 % 3.741 %
o A
91.08
o B
89.60
o C
90.04
Incorrect
A is correct. Using pathwise valuation the present value for the second path is
calculated as follows: 100/(1.01)(1.03483)(1.0505) =$91.08.
3. Question 3
Monte Carlo method is used for:
o A
confirming the security value given by the binomial lattice.

o B
simulating a significant number of interest rate paths to determine the

effect on the security value.
o C
determining the value of the security by using the least number of interest
rate paths.
Incorrect
B is correct. Monte Carlo method is used for simulating a very large number of
interest rate paths to determine the effect on the value of the security.
4. Question 4
Consider a 30-year mortgage-backed security with monthly fixed payments. Which of
the following steps are least likely involved in valuation with the Monte Carlo method?
o A
Simulate 500 one-month interest rate paths, under a volatility assumption

and probability distribution.
o B
Produce spot rates from the simulated interest rates and calculate cash flows
along each path.
o C
Determine the median of all the present values.

Incorrect
C is correct. Monte Carlo method involves the following steps for a monthly fixed
payment bond:
• Simulate numerous one-month interest rate paths under a volatility

assumption and probability distribution.
• Generate spot rates from the simulated interest rates.
• Determine cash flows for each interest rate path.
• Calculate the present value for each path.
• Calculate the average present value across all interest rate paths.
5. Question 5
To ensure that the Monte Carlo model is arbitrage-free and fits the current spot
curve a constant is added to all interest rates. The model is then known as:
o A
mean reversed.
o B
fitted to implied yield curve forward rates.

o C
drift adjusted.
Incorrect
C is correct. In order to produce the benchmark bond values equal to the market
prices, so that the Monte Carlo model fits the current spot curve and is arbitrage
free, a constant called a drift term is added. The model after using this technique is
said to be drift adjusted.
6. Question 6
The Monte Carlo method is least likely used for valuation of:
o A
option-free bonds.
o B
mortgage-backed instruments.
o C
securities whose cash flows are path dependent.

Incorrect
A is correct. Monte Carlo method is often used for valuation of a security with path
dependent cash flows, such as mortgage-backed securities.
7. Question 7
Andy Dimon, a fixed income analyst at a hedge fund, is responsible for pricing
individual securities and identifying arbitrage opportunities in the market. Dimon is
familiar with the process of stripping whereby individual cash flows of a government
bond are traded as zero-coupon securities. He therefore, evaluates government
bonds that have been stripped. Currently Dimon is assessing a 3% annual-pay
government bond maturing in three years quoted in the market at $102.85. Dimon
uses the data given below to value the bond:
Table 1: Par rates and Spot rates
Year 1 Year 2 Year 3

Par rate 1.00% 2.00% 3.00%
Spot rate 1.00% 2.01% 3.04%
Given the interest rates in Table 1 and the bond’s market price, the arbitrage
opportunity most likely identified by Dimon is:
o A
buying only year 1 strip and selling the years 2 and 3 strips.
o B
buying all the strips and selling the bond.
o C
buying the bond and selling all the strips.

Incorrect
B is correct. The value of the government bond using spot rates is calculated as
follows:
3 / 1.01 + 3 / 1.02012 + 103 / 1.03043 = 100.0031. Therefore, an arbitrage opportunity
exists whereby strips could be purchased for USD100.0031 and reconstituted into
the bond, which could be sold for USD102.85.
8. Question 8
Samina Khan senior analyst is explaining to her interns the valuation of bonds using
the binomial interest rate tree. She makes the following statements:
Statement 1: In the valuation process, the interest rate tree generates interest rate
dependent cash flows, and supplies interest rates to discount these cash flows.
Statement 2: The binomial interest rate tree is based on two assumptions: the first
is an interest rate model such as the lognormal model of interest rates and the
second is volatility of interest rates.
Statement 3: Volatility can be estimated by observing prices of interest rate

derivatives. The lognormal model is useful as it can have negative interest rates.
Which of Khan’s statements regarding binomial interest rate tree is least likely correct
?
o A
I.
o B
II.
o C
III.
Incorrect
C is correct. The lognormal model of interest rates insures two properties: non-
negativity of interest rates, and higher volatility at higher interest rates. A & B are
correct statements.
9. Question 9
Mike Davis, senior analyst, asks Maria Lopez, recently hired intern, to use a binomial
interest rate tree to calculate the value of a bond. Lopez evaluates a three-year,
$100 par value, 2.00% annual-pay coupon bond using the binomial interest rate tree
framework given in Table 2.
Table 2: Three-Year Binomial Interest Rate Tree
Time 0 Time 1 Time 2

1. 62%
1.000% 1.78%
1.20% 1.32%
0.98%
Using the data in Table 2 and the backward induction method, the value of the bond
is closest to:
o A
102.81.
o B
102.19.
o C
103.01.
Incorrect
B is correct. The value of the three-year bond is calculated as follows:
Value at Time 2
0.5×[1021.0178+1021.0178]+2=102.2162
0.5×[1021.0132+1021.0132]+2= 102.6711
0.5×[1021.0098+1021.0098]+2=103.0101
Value at Time 1
0.5 ×[102.21621.0162+102.67111.0162]+2=102.8105
0.5×[102.67111.012+103.01011.012]+2=103.6211
Value at Time 0. No coupon payment at Time 0.
0.5×[102.81051.01+103.62111.01]=102.1939.
10. Question 10
Juna Barette, senior portfolio manager at a security firm, discusses the Monte Carlo
method for pricing securities that are interest rate path dependent with the firm’s
research director, Cybil Humbe. Barette states, “I believe by using the Monte Carlo
method and increasing the number of simulations to (say) 1,500, will produce an
average present value across all scenarios equal to the true fundamental value of
the securities.” Humbe agrees and increases the number of paths while valuing a
benchmark bond. The result is a value that does not equal the market price of the
bond.
Humbe should most likely correct the problem that she has encountered when using
the Monte Carlo simulation by:
o A
decreasing the number of simulations.

o B
adding a constant to all interest rates on all paths
o C
changing the volatility assumption.

Incorrect
B is correct. Monte Carlo method produces a benchmark bond value equal to its
market value only by chance. A constant is added to all interest rates on all paths
such that the average present value of the benchmark equals its market value.
Changing volatility assumption or increasing/decreasing paths does not mean that
the model will give a value closer to the market value.
11. Question 11
Pathwise valuation calculates bond value by:
o A
backward induction using the interest rate paths specified by the binomial
lattice.
o B
calculating value for each possible interest rate path and averaging
these values across paths.
o C
simulating a large number of potential interest rate paths.

Incorrect
B is correct. Pathwise valuation calculates the value of a bond for each interest rate
path (from the list of potential interest rate paths specified by a binomial tree) and
takes the average of these values across paths.
12. Question 12
Jehan Abbas, fixed income trader, explains about the no arbitrage principle involved
in bond valuation when using a binomial interest rate tree to an intern. “The
arbitrage-free principle in a financial market is based on the following conditions:
I: Two risk-free securities with the same payoff and timing must sell for the same
price.
II: Any portfolio of securities must have the same price as the sum of the prices of
the individual securities in the portfolio.
III. Higher risk securities must give higher payoff than lower risk securities.”
Which of Abbas’ conditions regarding arbitrage-free valuation is least likely correct?
o A
I.
o B
II.
o C
III.
Incorrect
C is correct. The principle of no arbitrage applies to risk-free securities and
portfolios, not risky ones. Lack of dominance (I) and value additivity (II) must hold for
a market to be arbitrage free. The relationship between risk and return does not
apply to arbitrage-free principle.
13. Question 13
Sonia Batla, senior fixed income analyst, is interviewing Hina Abdullah for the post of
a junior analyst. Batla asks Abdullah to determine the value of a 3.5% annual-pay
coupon option-free bond of USD100 par value with two years remaining to maturity
using the following calibrated binomial interest rate tree.
Calibrated Binomial Interest Rate Tree
Time 0 Time 1 Time 2

2.0% 4.6% 8.2%
3.4% 6.1%
4.5%
The value of the two-year bond calculated by Abdullah is closest to:
o A
102.4
o B
101.0
o C
103.6
Incorrect
B is correct.
Value at Time 1:
0.5×[103.51.046+103.51.046]+3.5=102.4484.
0.5×[103.51.034+103.51.034]+3.5=103.5967.
Value at Time 0:
0.5×[102.44841.02+103.59671.02]=101.0025.
14. Question 14
Amal Hakim, senior quantitative analyst, discusses the pathwise valuation approach
with her supervisor. Hakim states, “In this type of valuation, you would specify all of
the possible interest rate paths that are specified by a binomial tree and value the
bond along each path. The value of the bond is then calculated as the average of the
values across all paths. For example, for the 3-year bond you would need to calculate
its value for 23 or 8 different paths.” Is Hakim most likely correct in her interpretation
of pathwise valuation?
o A
Yes.
o B
No, the values are weighted by the probability.

o C
No, she is incorrect about the number of paths needed to value a 3-year
bond.
Incorrect
C is correct. Valuing a 3-year bond requires 22 = 4 interest rate paths. The discount
rate for cash flows occurring in the first period is known with certainty and forms the
base of the interest rate tree. The one-year forward rates for one, and two years
from now are unknown and described by the branches of the tree. For a 2-year tree,
interest rates can increase or decrease from where they are after one year, so there
are uu, ud, du, and dd paths.
15. Question 15
Aki Hiroko, senior fixed income analyst, compares the Monte Carlo approach to the
binomial tree approach, while conducting a training session of junior analysts. “The
Monte Carlo approach is different than the binomial framework due to the following
reasons:
I: No calibration is required in the Monte Carlo approach, whereas the binomial tree
requires calibration.
II: The Monte Carlo approach is often applied when cash flows are path dependent,
whereas the binomial tree approach only allows one expected cash flow per node.
III: The Monte Carlo approach randomly generates interest rate paths and values the
security across those paths, whereas the binomial tree approach values the security
across all possible interest rate paths on the tree.
Hiroko is least likely correct with respect to:
o A
Reason I.
o B
Reason II.
o C
Reason III.
Incorrect
A is correct. Monte Carlo simulation randomly generates interest rate paths that will
correctly value benchmark bonds only by chance. A constant, known as a drift term,
is added to every interest rate on every simulated path to calibrate the simulation so
that the values estimated for benchmark bonds equal their market prices. B & C are
correct statements.
16. Question 16
Which of the following statements is least accurate about term structure models?
o A
All term structure models make simplifying assumptions about how rates
evolve over time.
o B
There are numerous interest rate models with varying assumptions.

o C
All models capture interest rate dynamics perfectly.

Incorrect
Solution: C is correct. No single model captures interest rate dynamics perfectly.
When choosing a term structure model, we must make a trade-off between
simplicity and accuracy.
17. Question 17
Which of the following models seek to describe the dynamics of the term structure
by using fundamental economic variables?
o A
Equilibrium term structure models

o B
Arbitrage-free term structure models

o C
Both A) and B)
Incorrect
Solution: A is correct. Equilibrium term structure models seek to describe the
dynamics of the term structure by using key economic variables that are assumed to
affect interest rates. Arbitrage-free term structure models use observed market
prices of a reference set of financial instruments, assumed to be correctly priced, to
model the market yield curve.
18. Question 18
Statement 1: Equilibrium term structure models require fewer parameters to be
estimated relative to arbitrage-free models.
Statement 2: Arbitrage-free models can model the market yield curve less precisely
than equilibrium models.
o A
Statement 1
o B
Statement 2
o C

Incorrect
Solution: A is correct. Equilibrium term structure models require fewer parameters
to be estimated relative to arbitrage-free models. Arbitrage-free models allow for
time-varying parameters due to which they can model the market yield curve more
precisely than equilibrium models.
19. Question 19
KWF model differs from Ho-Lee model in terms of:
o A
constant drift and volatility assumption.

o B
no mean reversion assumption.

o C
use the log of the short rate as the dependent variable.

Incorrect
Solution: C is correct. The KWF model is similar to the Ho-Lee model – it assumes
constant drift, no mean reversion, and constant volatility. However, we use the log of
the short rate as the dependent variable. The model takes the form:
d ln(rt) = θtdt + σdZ
20. Question 20
Which of the following is a multifactor model that takes into account short-, medium-
and long-term interest rates?
o A
Gauss+
o B
Vasciek
o C
KWF
Incorrect
Solution: A is correct. The Gauss+ model is a multi-factor interest rate model that is
widely used in valuation and hedging. The Gauss+ model takes into account short-,
medium-, and long-term interest rates.
21. Question 21
A lognormal model of interest rates insures which of the following?
o A
Higher volatility at higher rates.

o B
Constant volatility across high or low rates.

o C
Lower volatility at higher rates.

Incorrect
A is correct. A lognormal model of interest rates insures two properties: non-
negativity of interest rates and higher volatility at higher interest rates.
22. Question 22
The Vasicek model, unlike the CIR model:
o A
allows for volatility to be proportional to interest rates levels.
o B
avoids the possibility of negative interest rates.

o C
assumes that volatility does not rise with interest rates instead remains
constant over the analysis period.
Incorrect
C is correct. The Vasicek model, unlike the CIR model makes the assumption of
constant volatility over the analysis period for the calculation of interest rates. Under
the Vasicek model, it is theoretically possible for interest rate to be negative. The CIR
model allows increase in volatility with the level of interest rates.
23. Question 23
The estimated yield curve is most likely modeled accurately to match the observed
yield curve with the:
o A
Vasicek model.
o B
CIR model.
o C
Ho-Lee model.
Incorrect
C is correct. The Ho-Lee model provides the most accurate model for estimating the
yield curve to match the observed yield curve, because it allows the parameter to
vary deterministically with time.
24. Question 24
The arbitrage-free value of option-free bonds is the:
o A
sum of present values of the future values using par rates.

o B
sum of present values of the expected future values using the

benchmark spot rates.
o C
sum of the future values of the bond based on yield to maturity.

Incorrect
B is correct. The arbitrage-free value of an option-free bond is calculated by adding
the present values of the expected future cash flows of the bond using the
benchmark spot rates.
25. Question 25
The yield for a 3.5% coupon 5-year annual pay bond in Karachi (Bond X) is 2.8%. The
same bond sells for PKR 101.98 in Lahore. Is there an arbitrage opportunity and if so,
how can it be exploited?
o A
There is no arbitrage opportunity.

o B
There is an arbitrage opportunity which can be exploited by buying the bond

in Karachi and selling in Lahore.
o C
There is an arbitrage opportunity which can be exploited by buying the

bond in Lahore and selling in Karachi.
Incorrect
C is correct. Bond X’s price in Karachi is 103.22. (N = 5, I/Y = 2.8, PMT = 3.5, FV = 100,
CPT. PV = 103.22.) The market price in Lahore is 101.98. An arbitrage opportunity
exists. This can be exploited by buying bonds for 101.98 in Lahore and selling in
Karachi for 103.22, making 1.24 per 100 of bonds traded.
26. Question 26
Benchmark Par Curve
Maturity (Years) Par Rate Bond Price

1 1.00% 100
2 2.00% 100
3 3.00% 100
Bond A is 3-year 4% coupon annual-pay bond. It has the same risk and liquidity as
the benchmark and sells for $102.8286 today to yield 3%.
Calculate the spot rates from the given term structure. The spot rates for each year’s
cash flow are:
o A
1.00%, 2.00%, 3.00%.

o B
2.10%, 3.20%, 4.50%.

o C
1.00%, 2.01%, 3.04%

Incorrect
C is correct. 1-year spot rate r(1) is the same as 1-year par rate = 1% i.e. r(1) = 1.00%.
Using bootstrapping to calculate the 2-year spot rate r(2) and 3-year spot rate r(3).
For r(2):
100 = 2 / (1.01) + 102 / [1 + r(2)]2 => 100 – 2 / 1.01 = 102 / [1 + r(2)]2 => r(2) = 2.01%
Similarly for r(3):
100 = 3 / (1.01) + 3 / (1.0201)2 + 103 / [1 +r(3)]2 => r(3) = 3.04%.
27. Question 27
Benchmark Par Curve
Maturity (Years) Par Rate Bond Price

1 1.00% 100
2 2.00% 100
3 3.00% 100
Bond A is 3-year 4% coupon annual-pay bond. It has the same risk and liquidity as
the benchmark and sells for $102.8286 today to yield 3%.
Which of the following statements is most likely correct regarding the arbitrage-free
price of Bond A given the term structure above?
o A
Bond A’s cash flows must be discounted by its yield to maturity to determine
the arbitrage-free price.
o B
Bond A’s cash flows must be discounted by the spot rates to obtain the
arbitrage-free price.
o C
Bond A must be discounted by the yield to maturity of a three-year

benchmark bond to find the arbitrage-free price.
Incorrect
B is correct. The arbitrage-free price of Bond A is found by discounting each cash
flow of the bond by the spot rate of the same maturity as the date of the cash flow.
28. Question 28
An interest rate tree represents interest rates based on:
o A
an interest rate model and an assumption about volatility of interest
rates.
o B
both positive and negative interest rates.

o C
higher and lower forward rates determined by changing volatility at each

node.
Incorrect
A is correct. An interest rate tree is a representation of interest rates based on an
interest rate model and an assumption about interest rate volatility.
29. Question 29
The interest rate model is based upon:
o A
pathwise valuation.
o B
Pascal Triangle.
o C
a lognormal model of interest rates.

Incorrect
C is correct. The binomial interest rate tree structure is based on the lognormal
model.
30. Question 30
The method(s) most likely used to estimate interest rate volatility is (are):
o A
the historical volatility method only.

o B
the implied volatility approach only.

o C
the historical volatility method or the implied volatility approach.

Incorrect
C is correct. Interest rate volatility can be estimated using historical data. Interest
rate volatility can also be estimated using the implied volatility method.
31. Question 31
The equilibrium term structure models require the specifications of which two
terms?
o A
The drift term and the stochastic or volatility term

o B
The short-term rate and the long-term rate

o C
The term premium and the risk premium

Incorrect
A is correct. The equilibrium term structure models require the specification of a
drift term and the assumption for interest rate volatility. The CIR model and the
Vasicek model have two parts: (1) a deterministic part (sometimes called a “drift
term”), the expression in dt, and (2) a stochastic (i.e., random) part, the expression in
dz, which models risk.
32. Question 32
In place of the above, please add the following questions in the Practice Test:
Three-Year Binomial Interest Rate Tree
At which node, the interest rate will be close to the implied one-year forward rate
two years from now (as derived from the spot curve)?
o A
Node 2-2
o B
Node 1-2
o C
Node 1-1
Incorrect
A is correct. The implied forward rates represent a median value. Since Node 2–2 is
the middle node rate in Year 2, it will be close to the implied one-year forward rate
two years from now.
33. Question 33
Implied Values (in $) for Bond Z: A 4% coupon, three-year, annual pay bond
based on the above interest rate tree
Based on the information in the above exhibit, the bond price at Node 1–1
is closest to:
o A
93.4661
o B
98.2280
o C
95.8470
Incorrect
B is correct. The price of Bond Z at Node 1- 1 is calculated as follows:
(0.5 x 97.2222 + 0.5×99.0566 +5)/1.05= $98.2280
34. Question 34
The process of calibrating a binomial interest rate tree least likely involves:
o A
Fitting the interest rate tree to the current yield curve by selecting interest
rates to produce benchmark bond values given a volatility assumption.
o B
Finding the interest rates in the tree numerically by an iterative process.

o C
Changing volatility assumption at every node to determine forward

rates for valuation of a benchmark.
Incorrect
C is correct. Volatility is kept constant. Two rates at each node must be consistent
with the volatility assumption, the interest rate model, and the observed market
value of the benchmark bond. A & B are the steps involved in the construction of a
binomial interest rate tree.
35. Question 35
The following information relates to next 3 questions.
Two-Year Binomial Tree to Calibrate
Benchmark Par Curve
Maturity (Years) Par Rates Bond Price

1 1.00% 100
2 2.00% 100
3 3.00% 100
One-Year Spot Rates of Par Rates
Maturity (Years) One-Year Spot Rate

1. 00%
1.
2. 2.01 %
3. 3.04 %
One-Year Implied Forward Rates
Maturity (Years) Forward Rate

Current 1-year rate 1.000%
One-year rate, one-year forward 3.03%
One-year rate, two years forward 5.13%
Zero-coupon bond prices: P1 = 0.9901, P2 = 0.9610, P3 = 0.9141
Consider the binomial tree given above. Assume volatility is 15%, and the lower one-
year forward rate is 2.580%. The higher one-year forward rate using the lognormal
model of interest rates is closest to:
o A
3.00%.
o B
3.48%.
o C
4.05%.
Incorrect
B is correct. According to the lognormal model of interest rates the higher rate =
F1,2u = (F1,2d) x e2σ where σ = 15%;
F1,2u = 2.580% x e0.3 = 3.483%.
36. Question 36
Benchmark Par Curve

1 1.00% 100
2 2.00% 100
3 3.00% 100

1. 1.00%
2. 2.01 %
3. 3.04 %

If the lower one-year rate = 2.580%, and the higher rate = 3.48%, the correct price for
a two-year zero is closest to:
o A
0.9610.
o B
0.9901.
o C
0.9141.
Incorrect
A is correct. Given price of a zero based on the lower rate = 2.580\% and the higher
rate = 3.483\% the price is given by the following equation: [(0.5)(1/1.0258) + (0.5))(1 /
1.03483) / 1.01 = 0.9610. The price can also be calculated using the 2-year spot rate:
P2 = 1 / (1.0201)2 = 0.9610.
37. Question 37
Benchmark Par Curve

1 1.00% 100
2 2.00% 100
3 3.00% 100

1. 1.00%
2. 2.01 %
3. 3.04 %

If the volatility assumption is changed from 15% to 20%, the implied forward rates
will most likely:
o A
spread out on the tree.

o B
collapse to the implied forward rates from the yield curve.

o C
be unaffected by the volatility change.

Incorrect
A is correct. Implied forward rates are impacted by volatility change. If the volatility
assumption is changed to a higher value, say 20%, the possible implied forward
rates will spread out on the tree. If the assumed volatility is lowered from 15%, the
interest rates will collapse.
38. Question 38
If the binomial tree is correctly calibrated for benchmark bonds, it can be used to
price:
o A
option-free bonds.
o B
mortgage-backed securities.
o C
both option-free bonds and mortgage-backed securities.

Incorrect
A is correct. The interest rate tree is fit to the current yield curve by choosing
interest rates that result in benchmark bond value. By doing this, the bond value is
arbitrage free and will correctly price option-free bonds.
39. Question 39
An option-free bond that is valued using spot rates should give:
o A
the same value as pricing by using the binomial lattice.

o B
a value higher than the price given by a binomial interest rate tree.
o C
a value lower than the price given by using a binomial lattice

Incorrect
A is correct. An option-free bond when priced by discounting with spot rates
produces the same value as obtained by using the arbitrage-free binomial lattice.
Annis Qawan, director research ILT Investment Bank, makes the following comments
regarding calibration of the binomial interest rate tree to his team members: Comment 1:
“Calibrating an interest rate tree requires an iterative process and interest rates are
determined numerically. Comment 2: There are two possible rates – the upper and lower
rates. These rates must be consistent with the volatility assumption, the interest rate model,
and the observed market value of the benchmark bond. Comment 3: The cash flows of the
bond are discounted using the interest rate tree, and if this doesn’t produce the correct
price, then another benchmark bond is selected and the process is repeated.” Qawan then
asks Jawad Hamid, an analyst, to calculate the value of a bond using a binomial interest rate
tree and compare it to its value determined using spot rates. The bond he selects for the
comparison is non-benchmark, option-free, has three years to maturity and an annual-pay
coupon rate of 5%. The coupon rate is below the coupon rate of a benchmark bond of the
same maturity. The yield curve is currently downward sloping. Hamid’s analysis shows that
the spot rates generate a value equal to the market price of the bond, but the interest rate
tree methodology produces a higher value.
1. Question 1
Which of Qawan’s comments on calibrating a binomial interest rate tree is least
likely correct?
o A
Comment III.
o B
Comment II.
o C
Comment I.
Incorrect
A is correct. If the interest rates do not produce a correct price, then another pair of
forward rates are selected and the process is repeated. The benchmark bond is not
changed. B & C are correct comments.
2. Question 2
The bond value calculated by Hamid using the binomial interest rate will most
likely be:
o A
lower than the value from the spot rate methodology.
o B
equal to the value from the spot rate methodology

o C
higher than the value from the spot rate methodology.

Correct
B is correct. Both methodologies will produce the same result. The binomial tree is
based on implied one-year forward rates derived from spot rates and a no arbitrage
condition. Therefore an option-free bond should have the same value whether using
the spot rate curve or the binomial tree.
Valuation and Analysis of Bonds

with Embedded Options
1. Question 1
Q-Code: 21-L2-FI-VABE-75182
Li Min, fixed-income strategist, asks her intern to evaluate a three-year 5.25% annual
coupon bond callable at par ($100) in one year and two years from now using the
binomial interest rate tree depicted in Table 2.
Table 2. Binomial Interest Rate Tree at 10% Interest Rate Volatility

2.50% 3.87% 5.52%
3.17% 4.52%
3.70%
Using the above information, the value of the bond is closest to:
o A
$102.68.
o B
$101.85.
o C
$100.16.
Incorrect
A is correct. Valuation of the 3-year 5.25% annual coupon bond, callable at par in one
year and two years from today using the backward induction process is as follows:

R = 2.50 C = 5.25 C = 5.25 105.25
V = 102.683 R = 3.87 R = 5.52
V = 101.205 V = 99.744
Called at 100
C = 5.25 C = 5.25
R = 3.17 R = 4.52
105.25
V = 102.016 V = 100.698
Called at 100 Called at 100
C = 5.25
R = 3.70
105.25
V = 101.495
Called at 100
C = Annual coupon
R = One-year interest
rate 105.25
V = Value of the
callable bond
For example: Take the Year 2 V = $99.744, calculated as follows:
0.5×[105.251.0552+105.251.0552]=99.744.
Similarly, V = 100.698 in Year 2 (Middle box). Since this value is greater than USD100,
the bond will be called at USD100. Replacing USD100.698 with USD100 and
continuing with the backward induction process until Year 0.
2. Question 2
When interest rates fall, the effective duration of a putable bond is:
o A
exceeds that of an otherwise identical option-free bond.

o B
similar to that of an otherwise identical straight bond.

o C
less than that of a straight bond.

Incorrect
B is correct. When interest rates fall, the put option is out of the money. The
effective duration of a putable bond is similar to that of an otherwise identical
option-free bond.
3. Question 3
To measure the interest rate sensitivity of a callable or putable bond when the
embedded option is near the money:
o A
one-sided durations are used.

o B
two-sided effective duration is used.

o C
average price response to up- and down-shifts of interest rates is applied.

Incorrect
A is correct. One-sided durations—that is, the effective durations when interest rates
go up or down—are better at capturing the interest rate sensitivity of a callable or
putable bond than the the average price response to up- and down-shifts of interest
rates – (two-sided) effective duration, particularly when the embedded option is near
the money. When the embedded option is in the money, the price of the callable
bond has limited upside potential or price of putable bond has limited downside
potential.
4. Question 4
A callable bond is more sensitive to interest rate rises than to interest rate declines,
particularly when the call option is near the money. The one-sided duration for a 25
bps increase in interest rates is most likely:
o A
higher than a one-sided duration for a 25 bps decrease in interest rates.

o B
equal to a one-sided duration for a 25 bps decrease in interest rates.

o C
lower than a one-sided duration for a 25 bps decrease in interest rates.

Incorrect
A is correct. When the bond is immediately callable, a 25 bps increase in the interest
rate has a greater effect on the value of the callable bond than a 25 bps decrease in
the interest rate. When interest rates are high the call option will not be exercised.
No matter how far interest rates decline, the price of the callable bond cannot
exceed 100 because no investor will pay more than the price at which the bond can
be immediately called. In contrast, there is no limit to the price decline if interest
rates rise. Therefore, the one-sided up-duration is higher than the one-sided down-
duration.
5. Question 5
L.O.: k Q-Code: 21-L2-FI-VABE-75168

o A
Key rate durations measure the sensitivity of a bond’s price to changes in

certain maturities on the benchmark yield curve.
o B
Key rate durations help portfolio managers detect the “shaping risk” for
bonds.
o C
Key rate durations are calculated by assuming parallel shifts in the

benchmark yield curve.
Incorrect
C is correct. Effective duration is calculated by assuming parallel shifts in the
benchmark yield curve. In the calculation of key rate durations instead of shifting
the entire benchmark yield curve, only key points are shifted, one at a time. The
effective duration for each maturity point shift is then calculated separately. Key rate
durations help to identify the “shaping risk” for bonds—that is, the bond’s sensitivity
to changes in the shape of the yield curve.
6. Question 6
Table 4: Key Rate Durations of 30-Year Bonds Putable in 10 Years Valued at a 5% Flat
Yield Curve with 15% Interest Rate Volatility
Coupon Price (%
Total 3-Year 5-Year 10-Year 30-Year
(%) of par)
2 76.85 7.80 –0.12 –0.32 7.56 0.68
5 106.87 14.97 –0.02 –0.06 5.45 9.60
10 205.30 12.79 0.06 0.18 2.05 10.50
Using the information presented in Table 4, the 10% coupon bond compared to the
2% coupon bond, is most sensitive to changes in the:
o A
10-year rate.
o B
3-year rate.
o C
30-year rate.
Incorrect
C is correct. Compared to the low coupon bond, the 10% putable bond (high coupon)
is most sensitive to changes in the 30-year rate, because it is unlikely to be put and
thus behaves like an otherwise identical option-free bond.
7. Question 7
The effective convexity of a three-year 3.50% annual coupon bond callable at par one
year from now:
o A
is always positive.
o B
turns negative when the call option is out of money.

o C
turns negative when the call option is near the money.

Incorrect
C is correct. The effective convexity of the callable bond turns negative when the call
option is near the money, because the upside for a callable bond is much smaller
than the downside. When interest rates decline, the price of the callable bond is
capped by the price of the call option if it is near the exercise date. When interest
rates are high the value of the call option is low, the callable and straight bond
behave similarly from changes in interest rates – both have positive convexity.
8. Question 8
o A
Putable bonds always exhibit positive convexity.

o B
Putable bonds have greater upside potential than otherwise similar callable
bonds when interest rates fall.
o C
The upside for a putable bond is much larger than the downside when
the put option is out of money.
Incorrect
C is correct. A & B hold true for putable bonds. When the option is near the money,
the upside for a putable bond is much larger than the downside since putable bond
price is floored by the price of the put option near the exercise date. Putable bonds
have more upside potential than otherwise identical callable bonds when interest
rates decline, because put option is worthless, and putable bond is similar to straight
bond in terms of price change, whereas the call option is valuable which caps price
appreciation in callable bonds.
9. Question 9
The information below relates to next 2 questions.
Binomial Interest Rate Tree at 10% Interest Rate Volatility

3 Year Floating Rate Bonds issued by Cemex Corp.

One-year
Bond X Libor annually, set in arrears, capped at 5.00%
One-year
Bond Y Libor annually, set in arrears, floored at 3.25%
The value of Bond X is closest to:
o A
98.874% of par.
o B
99.684% of par.
o C
10.324% of par.
Incorrect
B is correct. Valuation of the Three-Year Libor Floater Capped at 5.00%.
Today Year 1 Year 2 Year 3

C = 3.3
C = 106.2
R = 6.2
105.0
V = 98.870
C =1.0
C = 106.2
R = 3.3
105.0
V = 99.407
C = 3.3
V = 99.684 R = 5.1 C = 105.1
R = 1.0 V = 99.905 105.0
C = 2.7
C = 1.0 C = 105.1
R = 2.7 105.0
V = 99.954
C = 2.7
R = 4.2 C = 104.2
V = 100
C = 104.2
C = Cash Flow (% of par)
R = One-Year Interest Rate (%)
V = Value of the Capped Floater (% of par)
For each scenario, we check whether the cap applies, and if it does, the cash flow is
adjusted. For example, in state uuu, Libor is higher than the 5.00% cap. Thus, the
coupon is capped at the 5.00 maximum amount, and the cash flow is adjusted
downward from the uncapped amount (106.2) to the capped amount (105.0). The
coupon is also capped for three other scenarios in Year 3.
For Year 2:[(105)/1.062 + (105)/1.062] x 0.5 =98.870
[(105)/1.051 + (105)/1.051] x 0.5 = 99.905
[(104.2) / 1.042 + (104.2) / 1.042] x 0.5 = 100
For Year 1: [(98.870 +3.3) / 1.033 + (99.905 + 3.3) / 1.033] x 0.5 = 99.407
[(99.905 +2.7) / 1.027 + (100 +2.7) /1.027] x 0.5 = 99.954
For Year 0: [(99.407 +1) / 1.01 +(99.954 +1) / 1.01] x 0.5 = 99.684
10. Question 10
3 Year Floating Rate Bonds issued by Cemex Corp.

One-year
Bond X Libor annually, set in arrears, capped at 5.00%
Bond Y One-year
Libor annually, set in arrears, floored at 3.25%
Both bonds have the same credit rating.
The value of Bond Y is closest to:
o A
100.000% of par.
o B
101.490% of par.
o C
102.493% of par.
Incorrect
C is correct. Valuation of the Three-Year Libor Floored Floater at 3.25%.

C = 3.3
R = 6.2 C = 106.2
V = 100
C =1.0
3.25
C = 106.2
R = 3.3
V = 100
C = 3.3
R = 5.1
V = 102.493
V = 100 C = 105.1
R = 1.0
C = 2.7
3.25
C = 1.0
3.25
C = 105.1
R = 2.7
V = 100.536
C = 2.7
3.25 C = 104.2
R = 4.2 C = 104.2
V = 100
R = One-Year Interest Rate (%)
V = Value of the Capped Floater (% of par)
For Year 2[(106.2) /1.062 +(106.2) /1.062] x 0.5 =100
[(105.1) /1.051 +(105.1) /1.051] x 0.5 =100
[(104.2) /1.042 +(104.2) /1.042] x 0.5 =100
For Year 1: {(100 +3.3) /1.033 + (100 +3.3) /1.033] x 0.5 = 100
{(100 +3.25) /1.027 + (100 +3.25) /1.027] x 0.5 = 100.538
For Year 0: [(100 +3.25) / 1.01 +(100.536 + 3.25)/ 1.01] 0.5 = 102.493
11. Question 11
Consider the following table for next 2 Questions.
Bond X: 4.25% Annual Coupon Callable Convertible Bond Maturing on 4 May

2020
Issue date 4 May 2015

At par denominated into bonds of USD 100,000
Issue Price each, and multiples of USD 1,000 each
thereafter
Conversion Period 4 June 2015 to 3 April 2020
Initial Conversion Price USD7.00 per share
Two years, three years and four years from now
at premium to par, where premium declines after
Issuer Call Price
the second year from 10% to 6% third year and
to 3% in fourth year
Market Information
Convertible Bond Price on 5 May
USD125,000
2016
Share Price on Issue Date USD5.00
Share Price on 5 May 2016 USD7.50
Using the initial conversion price of Bond X, the conversion ratio (in shares)
is closest to:
o A
14,286.
o B
20,000.
o C
17,900.
Incorrect
A is correct. Conversion ratio = (Bond X’s Par value) / (initial conversion price) =
100,000 / 7 = 14,285.71 = 14,286 shares.
12. Question 12
Bond X: 4.25% Annual Coupon Callable Convertible Bond Maturing on 4 May
2020
Issue date 4 May 2015

At par denominated into bonds of USD100,000
Issue Price
each, and multiples of USD1,000 each thereafter
Conversion Period 4 June 2015 to 3 April 2020
Initial Conversion Price USD7.00 per share
Two years, three years and four years from now
at premium to par, where premium declines after
Issuer Call Price
the second year from 10% to 6% third year and
to 3% in fourth year
Market Information
Convertible Bond Price on 5 May
USD125,000
2016
Share Price on Issue Date USD5.00
Share Price on 5 May 2016 USD7.50
The minimum value of Bond X on 5 May 2016, assuming a yield of 5% on an identical

non-convertible bond on that date, is given as:
o A
USD82,285.
o B
USD107,145.
o C
USD100,000.
Incorrect
B is correct. The minimum value of the convertible bond is given as:
Maximum (Conversion Value, Straight Bond Value)
The Conversion Value of Bond X on 5 May 2016 = Share Price x no. of shares
USD7.50 x 14,286 = USD107,145
The Straight Bond Value of Bond X, is given as:
Using the FC: N = 4, I/Y = 5, PMT = 4250, FV = 100,000; CPT PV = 97,340.54
Max (USD107,145, USD97,341) = USD107,145.
13. Question 13
Value of a callable convertible bond is given by:
o A
Value of straight bond + Value of call option on the issuer’s stock.

o B
Value of straight bond + Value of call option on the issuer’s stock – Value
of issuer call option.
o C
Value of straight bond + Value of call option on stock + Value of issuer call
option.
Incorrect
B is correct. Value of callable convertible bond = Value of straight bond + Value of call
option on the issuer’s stock -Value of issuer call option.
14. Question 14
On 1 June 2015 Company X issued a 5-year, 4% annual coupon convertible bond at
USD1,000 par with a conversion ratio of 25 ordinary shares, on 02 June 2016, given
the market price of Company X stock as USD54, the risk-return characteristics of the
convertible most likely resemble that of:
o A
a busted convertible.
o B
a straight bond without the conversion option.

o C
Company X’s common stock.

Incorrect
C is correct. The conversion price = par value/conversion ratio = USD 1000/25 = USD
40 per share.
On 02 June 2016, the stock price of Company X = USD 54. The share price of USD 54
is well above the conversion price of USD 40. The risk-return characteristics of the
convertible bond are similar to those of the underlying stock of Company X. When
the underlying share price is well below the conversion price, the convertible bond is
described as “busted convertible” and exhibits mostly bond risk–return
characteristics, hence A & B are incorrect.
15. Question 15
At very high interest rates, the effective duration of a:
o A
callable bond significantly exceeds that of an otherwise identical straight

bond.
o B
callable bond is similar to that of an otherwise identical straight bond.

o C
callable bond is lower than an identical straight bond because the call option
is deep in the money.
Incorrect
B is correct. The effective duration of a callable bond cannot exceed that of a straight
bond. At high interest rates, the call option is out of money, so the bond will unlikely
be called. Therefore, the effect of an interest rate rise on a callable bond is very
similar to an otherwise identical straight bond, and the two bonds in such an interest
rate scenario will have similar effective durations. A & B are incorrect because, when
interest rates fall, the call option moves into money limiting the price
appreciation of the callable bond. Consequently, the call option reduces the effective
duration of the callable bond relative to that of the straight bond.
16. Question 16
Trudie Wilder, CFO, asks Bret Ruttie, recently hired quantitative analyst, about
valuation approaches of callable bonds. Ruttie responds by making the following
statements:
• Statement I: “One approach is to use a binomial interest rate tree and then
use a process of backward induction to determine the value of a default-free
bond.
• Statement II: To value risky bonds, option-adjusted spread (OAS) is used;
OAS is a constant spread that, when added to all the one-period forward
rates on the interest rate tree, makes the value of the bond equal to its
market price.
• Statement III: OAS may be used as a relative value measure. An OAS greater
than the OAS of bonds with similar characteristics and credit quality shows
that it is most likely underpriced. However, if interest rate volatility increases,
then the OAS and thus relative cheapness of a callable bond will increase.”
Which of Ruttie’s statements is least likely correct ?
o A
Statement I.
o B
Statement II.
o C
Statement III.
Incorrect
C is correct. “OAS is often used as a measure of value relative to the benchmark. An
OAS lower than that for a bond with similar characteristics and credit quality
indicates that the bond is likely overpriced (rich) and should be avoided. A larger OAS
than that of a bond with similar characteristics and credit quality means that the
bond is likely underpriced (cheap).” If interest rate volatility increases, then the OAS
and the relative cheapness of a callable bond will decrease. A & B are correct
statements.
17. Question 17
Ann Georgiou, portfolio manager asks Libby Kareblo, junior fixed income analyst,
about the advantages of holding convertible bonds in a portfolio to investors.
Kareblo explains, “The first advantage is a higher coupon rate for investors than
similarly rated option-free bond. The second advantage is that the convertibles will
generally increase in value if the underlying common stock price increases.” Is
Kareblo most likely correct regarding the two advantages of investing in convertibles?
o A
Yes.
o B
No, she is incorrect regarding the increase in value.

o C
No, she is incorrect regarding the higher coupon rate.

Incorrect
C is correct. Convertible bondholders participate in the upside potential because of
the conversion option when the underlying common stock rises above the
conversion price. Therefore, they accept a lower coupon rate than on similarly rated
option-free bonds.
18. Question 18
Greet Wilder, head of research, discusses convertible bonds that were issued by
Haldrone Corporation with a call option and a conversion price of ₤6.00 with his
team members. Haldrone’s common stock is currently trading at ₤5.625 and has
been rising steadily for two months. Wilder asks one of the analysts, “Will you
convert the bonds if the common stock price rises above the conversion price or wait
and continue to receive the coupon payments?” The analyst responds, “I’ll wait
because the share price may trend further upwards.” Wilder interjects, “No,
bondholders will likely not be able to wait, since there’s a mechanism in Haldrone
bonds to protect existing shareholders.” The mechanism that Wilder refers to is most
likely a(n):
o A
call option.
o B
conversion period.
o C
adjusted conversion price.

Incorrect
A is correct. Haldrone’s convertible bonds are callable, therefore it has an incentive
to call the bond when the underlying share price increases above the conversion
price in order to avoid paying further coupons. This is called forced conversion
because it forces bondholders to convert their bonds into shares.
19. Question 19
Shams Lakhani, fund manager DLB Asset Management Company, during a
presentation to portfolio managers, makes the following comments comparing the
valuation of convertible bonds with callable bonds:
Comment 1: “Value of a convertible bond is equal to the value of an otherwise

identical straight bond minus the value of a call option on the issuer’s stock. Hence, it
is similar to the value of a callable bond.
Comment 2: The valuation procedure of a convertible is similar to the valuation of a

bond with embedded options. Its value is determined using an interest rate tree
based on the given yield curve and interest rate volatility assumptions. Backward
induction process is applied to calculate the bond’s present value after determining
whether the embedded options will be exercised at each node.
Comment 3: Convertible bonds are more complex than callable bonds because the
analyst must consider factors that may affect the issuer’s common stock, including
dividend payments and the issuer’s actions, plus market conditions and exogenous
reasons that affect the value of the issuer’s common stock and the bond.”
Which of Lakhani’s comments is least likely correct?
o A
1.
o B
2.
o C
3.
Incorrect
A is correct. Value of convertible bond = Value of straight bond + Value of call option
on the issuer’s stock. Comments 2 & 3 are correct.
20. Question 20
Akash Bhavin analyzes Bond T, a three year 4.75% annual-pay coupon bond putable
at 98 one year and two years from now. He assumes 15% interest rate volatility and,
using yields on par bonds, constructs the binomial interest rate tree given in Table 4.
Table 4: Binomial Interest Rate Tree

4.20% 5.51% 7.14%
4.08% 5.29%
3.92%
Using the interest rate tree given in Table 4, the value of the putable bond
is closest to:
o A
97.965.
o B
99.986.
o C
101.236.
Incorrect
B is correct. The value of the three year 4.75% annual coupon bond, putable at 98
one year and two years from now is calculated using the interest rate tree given in
Table 4 and the backward induction process.

C = 4.75
C = 4.75
R = 4.20 R = 7.14
R = 5.51 104.75
V = 99.986 V =97.769
V = 98.089
Put at 98*
C = 4.75 C = 4.75
R = 4.08 R = 5.29 104.75
V = 100.781 V =99.487
C = 4.75
R = 3.92 104.75
V = 100.799
C = annual coupon
R = one-year interest
rate 104.75
V = value of the
putable bond.
*The bond will be put in year 2 because the present value of the bond’s future cash
flows is lower than the put price of 98.
21. Question 21
Shermeen Ojas, portfolio manager, is evaluating a 5-year putable bond recently
purchased by a client. She calculates the current and the expected values of the
bond if market interest rates were to rise or fall by 30 basis points (bps). Ojas then
uses the estimated values of the bond given in Table 5 to determine the effective
duration.
Table 5: Value of 5-year Putable Bond
Change in interest rates +30 bps No change -30 bps

Value of bond 96.890 98.875 100.699
The effective duration calculated by Ojas is closest to:
o A
6.4.
o B
7.0.
o C
3.1.
Incorrect
A is correct. The effective duration of the bond is given by the following Equation (3)
�� = ��–
��+2×(Δ ��)×��0= 100.699−96.8902×0.0030×98.875=6.42.
22. Question 22
Pal Lakshay, senior fixed income portfolio manager, while discussing the effective
duration and convexity of bonds with his colleagues makes the following comments:
Comment I: “The effective duration of a callable or a putable bond cannot be greater

than that of an otherwise identical option-free bond.
Comment II: The effective convexity of a callable bond is always positive whereas the
effective convexity of a putable bond turns negative when the put is near the money.
Comment III: The option-free bonds have low positive convexity.”
Which of Lakshay’s three comments is least likely correct?
o A
Comment I.
o B
Comment II.
o C
Comment III.
Incorrect
B is correct. Putable bonds always exhibit positive convexity. Conversely, the
effective convexity of a callable bonds turns negative when the call option is near the
money.
23. Question 23
o A
The value of a floored floater is equal to the value of a straight bond

minus the value of the embedded floor.
o B
A floor provision in a floating-rate bond benefits the investor.
o C
The term ‘set in arrears’ means that the coupon rate is determined at the
start of a period but is paid at the end of that period.
Incorrect
A is correct.
Value of capped floater = Value of straight bond – Value of embedded cap
Value of floored floater = Value of straight bond + Value of embedded floor
Both options B and C are correct statements. Since a floored floater prevents the
coupon rate from going below a specific rate, the investor benefits because they are
protected from receiving lower coupon payments. A capped floater, on the other
hand, protects the issuer because it prevents the coupon rate from going above a
specified rate, so they do not need to pay out very high coupons.
24. Question 24
All else equal, as the yield curve slopes downward, value of the put option in a
putable bond most likely:
o A
increases.
o B
decreases.
o C
remains unchanged.
Incorrect
Solution: B is correct. All else being equal, the value of the put option decreases as
the yield curve moves from being upward sloping, to flat, to downward sloping.
25. Question 25
Consider a four-year 5% bond putable in Year 3. Its value should be exactly the same
as that of a:
o A
three-year 5% bond extendible by one year.

o B
four-year 5% bond extendible by one year.

o C
one-year 5% bond extendible by three years.
Incorrect
Solution: A is correct. Putable and extendible bonds are equivalent, except that their
underlying option-free bonds are different. The value of a four-year 5% bond putable
in Year 3 should be exactly the same as that of a three-year 5% bond extendible by
one year. Otherwise, there would be an arbitrage opportunity.
26. Question 26
Statement 1: The issuer must redeem the convertible bond for cash in the case of a
hard put.
Statement 2: In the case of a soft put, the investor has the right to exercise the put
but the issuer chooses how the payment will be made.
o A
Statement 1
o B
Statement 2
o C

Incorrect
Solution: C is correct. The put options can be hard puts (must be redeemed in cash)
or soft put (issuer can choose to redeem the convertible bond for cash, common
stock, subordinated notes, or a combination of the three).
27. Question 27
Value of callable putable convertible bond is equal to:
o A
Value of straight bond + Value of call option on the issuer’s stock – Value
of issuer call option + Value of investor put option.
o B
Value of straight bond – Value of call option on the issuer’s stock – Value of
issuer call option + Value of investor put option.
o C
Value of straight bond – Value of call option on the issuer’s stock – Value of
issuer call option – Value of investor put option.
Incorrect
Solution: A is correct. The value of callable putable convertible bond is equal to:
Value of straight bond + Value of call option on the issuer’s stock – Value of
issuer call option + Value of investor put option.
28. Question 28
When the underlying share price is well below the conversion price, the price of the
convertible bond is least likely affected by:
o A
interest rate movements.

o B
the issuer’s credit spreads.

o C
issuer’s common stock price movements.

Incorrect
Solution: C is correct. When the underlying share price is well below the conversion
price, the convertible bond exhibits mostly bond risk–return characteristics. In this
case, the price of the convertible bond is mainly affected by interest rate movements
and the issuer’s credit spreads.
29. Question 29
All else equal, as the yield curve slopes upward, value of the call option in callable
bonds most likely:
o A
decreases.
o B
increases.
o C
remains unaffected.
Incorrect
A is correct. When the yield curve is upward sloping, the one-year forward rates are
higher and the opportunities for the callable bond issuer to call the bond are
fewer. Hence the value of the call option decreases. Value of call option in callable
bonds increases as yield curve flattens or inverts.
30. Question 30
L.O.: a Q-Code: 21-L2-FI-VABE-75137
A call option that can only be exercised on predetermined dates is best known as
a(n):
o A
American-style callable bond.

o B
Bermudan-style call option.

o C
European-style call option.

Incorrect
B is correct. A Bermudan-style call option can be exercised only on a preset
schedule dates after the end of the lockout period. These dates are given in the
bond’s indenture. The issuer of a European-style callable bond can only exercise the
call option on a single date at the end of the lockout period. An American-style
callable bond is continuously callable from the end of the lockout period until the
maturity date. Section 2.1.1. LO.a.
31. Question 31
An embedded option in which the holder can keep the bond for a number of years
after maturity is best known as a(n):
o A
Bermudan call option.

o B
put option.
o C
extension option.
Incorrect
C is correct. An embedded option in which at maturity, the bondholder (an
extendible bond investor) has the right to keep the bond for a number of years after
maturity, possibly with a different coupon is known as an extension option.
32. Question 32
An acceleration provision and a delivery option are most likely unique to:
o A
sinking fund bonds.

o B
extendible bonds.
o C
hybrid bonds.
Incorrect
A is correct. A sinking fund bond (sinker), requires the issuer to make principal
repayments where each payment is a certain percent of the original principal
amount. The issuer sets aside funds over time to retire the bond issue, thereby
lowering credit risk. Such a bond may include the following options: call option, an
acceleration provision and a delivery option.
33. Question 33
From an investor’s perspective, the value of a call option most likely:
o A
increases the value of a callable bond relative to the straight bond.

o B
decreases the value of a callable bond relative to the straight bond.

o C
neither increases nor decreases the value of the callable bond relative to the
straight bond.
Incorrect
B is correct. For a callable bond, the investor is long the bond but short the call
option. The call option from an investor’s perspective, lowers the value of the
callable bond relative to the value of the straight bond. Value of callable bond =
Value of straight bond – Value of call option.
34. Question 34
If the value of a 10% coupon, annual-pay straight bond with five years remaining to
maturity is USD102.50, and the value of a callable bond of similar terms is
USD102.00, the value of the call option is given by:
o A
0.
o B
USD102.50 – USD102.00.
o C
USD102.00 – USD102.50.
Incorrect
B is correct. Value of issuer call option = Value of straight bond – Value of callable
bond = USD102.50 – USD102.00 = USD0.50.
35. Question 35
Relative to a straight bond, a putable bond most likely has:
o A
a higher value because of the put option.

o B
a lower value because of the put option.

o C
the same value.

Incorrect
A is correct. For a putable bond, an investor is long the bond and long the put option.
Hence the value of the putable bond relative to the value of the straight bond is
higher because of the put option. Value of putable bond = Value of straight bond +
Value of investor put option.
36. Question 36
A wealth manager has identified two four-year annual coupon government bonds,
Bond X and Bond Y with similar terms. Bond X is callable at par three years from
today and Bond Y is callable and putable at par three years from today. Compared to
Bond Y, value of Bond X is:
o A
higher.
o B
lower.
o C
the same.
Incorrect
B is correct. Relative to Bond Y, Bond X will have a lower value than Bond Y because
it does not have a put option.
37. Question 37
Consider a bond callable at 100. The bond is least likely to be called if:
o A
value of the bond’s future cash flows is higher than 100.
o B
value of the bond’s future cash flows is lower than 100.

o C
value of the bond’s future cash flows is close to 100.

Incorrect
B is correct. Because the issuer borrows money, it will exercise the call option when
the value of the bond’s future cash flows is higher than the call price or if the price is
very close to the call price.
38. Question 38
Table 1: Equivalent Forms of a Yield Curve
Maturity (Years) Par Rate (%) Spot Rate (%) One-Year Forward Rate (%)
1 1.00 1.00 1.00
2 2.00 2.01 3.03
3 3.00 3.04 5.13
Assume zero volatility and the term structure given in Table 1. The value of a three-
year 4.50% default-free annual coupon bond callable at par one year and two years
from now is closest to:
o A
USD103.50
o B
USD103.90
o C
USD103.00
Incorrect
A is correct. Value of a callable default-free three-year 4.50% annual coupon bond is
given below. The bond is callable at par one year and two years from now at zero
volatility. Using the one-year forward rates given in Table 1:
Year
Today Year 1 Year 2
3
104.
Cash Flow 4.50 4.50
50
Discount 5.13
1.00% 3.03%
Rate %
Value of 99.40+4.501.0303=1
100+4.501.01=103.4653 104.501.0513=99
Callable 00.8444
≅103.50 .4007
Bond Called at 100
Not called
39. Question 39
For a three-year bond putable at par one year and two years from today, an investor
will most likely exercise the put option when the:
o A
value of the bond’s future cash flows is lower than 100.

o B
value of the bond’s future cash flows is higher than 100.

o C
bond is trading at premium to par.

Incorrect
A is correct. The decision to exercise the put option is made by the investor. He will
exercise the put option when the value of the bond’s future cash flows is lower than
100 (put price).
40. Question 40
Table 1: Equivalent Forms of a Yield Curve
Maturity (Years) One-Year Forward Rate (%)

1 1.00
2 3.03
3 5.13
Based on the one-year forward rates given in Table 1, the value of a three-year 4.5%
annual-coupon default-free bond, putable at par one year and two years from today
at zero volatility is closest to:
o A
USD103.
o B
USD104.
o C
USD105.
Incorrect
C is correct. Value of a bond with 4.5% annual coupon putable at par two years and
one year from today at zero volatility is given as:
Year
Today Year 1 Year 2
3
Cash 104.
4.50 4.50
Flow 50
Disco
5.13
unt 1.00% 3.03%
%
Rate
Value
104.501.0513=99
of the 101.43+4.501.01=1 100+4.501.0303=101.4268≅10
.4007
Putable 04.88 1.43 Not put
Put at 100
Bond
41. Question 41
Assume a flat yield curve. If interest rate volatility increases, the value of a callable
bond:
o A
increases.
o B
decreases.
o C
stays the same.

Incorrect
B is correct. Value of a callable bond = Value of a straight bond – Value of the call
option. All else equal an increase in volatility increases the chances of the call option
being exercised by the issuer. As value of the call option increases, value of the
callable bond decreases.
42. Question 42
Assume a flat yield curve. If interest rate volatility increases, the value of a putable
bond:
o A
increases.
o B
decreases.
o C
stays the same.

Incorrect
A is correct. Value of the putable bond = Value of the straight bond + Value of the put
option. All else equal a higher volatility increases the value of the put and hence the
value of the putable bond. Value of a straight bond is unaffected by interest rate
volatility.
43. Question 43
A bond with an issuer option is a(n):
o A
callable bond.
o B
putable bond.
o C
extendible bond.
Incorrect
A is correct. A callable bond has an embedded call option which is an issuer option—
that is, the right to exercise the option at the discretion of the bond’s issuer. The call
provision allows the issuer to redeem the bond before its intended maturity. A
putable bond has an embedded put option which is an investor option. An
extendible bond has an extension option which allows the bondholder the right to
keep the bond for a number of years after maturity, with a different coupon.
44. Question 44
All else equal, a put option provides a hedge against:
o A
falling interest rates.

o B
rising interest rates.

o C
a change in shape of the yield curve.

Incorrect
B is correct. If interest rates start rising, bond investor would like their principal back
so they can invest their money at a higher rate. Investing in a bond with an
embedded put option makes this possible. All else being equal, the value of the put
option decreases as the yield curve moves from being upward sloping, to flat, to
downward sloping as opportunities to put the bond decline.
45. Question 45
Table 2: Binomial Interest Rate Tree at 10% Interest Rate Volatility
Based on the implied forward rates of Table 1

Table 3: Valuation of a Default-Free Three-Year 4.50% Annual Coupon Bond Callable
at Par One Year and Two Years from Now at 10% Interest Rate Volatility

Value of the callable bond V0 = USD103.465 C = 4.50 C = 4.50
Value of a straight three-year 4.50% annual V= Node 2-1 V 104.50
coupon bond = USD104.306 100.085 = ?
C = 4.50
C = 4.50
V= 104.50
V = 99.448
101.454
C = 4.50
Node 2-3 V 104.50
=?
104.50
Given the one-year forward rates in Table 2, the value of the callable three-year
4.50% annual coupon bond at Node 2-3 is closest to:
o A
USD99.870; bond will not be callable at par.

o B
USD100.33; bond will be callable at par.

o C
USD98.670. bond will be callable at par.

Incorrect
B is correct. At Node 2-3 V = 0.5 x [(104.5 / 1.04160) + (104.50 / 1.04160)] =
USD100.326. The bond price exceeds par hence the bond is callable at par. The bond
value is reset from USD100.326 to USD100.000.
46. Question 46
L.O.: f Q-Code: 21-L2-FI-VABE-75154


Year
3
Value of a straight three-year 4.50% annual coupon V= Node 2-1 V 104.50
bond = USD104.306 100.085 =?
C = 4.50
C = 4.50
V=
V = 99.448 104.50
101.454
C = 4.50
Node 2-3 V 104.50
=?
104.50
Assuming no change in the initial setting except that volatility changes from 10% to
20% in Table 2, the new value of the same three-year 4.50% annual coupon callable
bond from Table 3 is:
o A
more than 103.465.

o B
less than 103.465.

o C
equal to 103.465.
Incorrect
B is correct. Value will be less than 103.465. A higher interest rate volatility increases
the value of the call option. Value of the callable bond = value of the straight bond –
value of call option. A higher call option value will consequently reduce the value of
the callable bond since it is subtracted from the straight bond value. Section 3.5.1.
LO.f.
47. Question 47
L.O.: f Q-Code: 21-L2-FI-VABE-75155


Year
3
bond = USD104.306 100.085 =?
C = 4.50
C = 4.50
V=
V = 99.448 104.50
101.454
C = 4.50
Node 2-3 V 104.50
=?
104.50
Using Table 2, the value at Node 2-1 (Table 3) of the three-year 4.50% annual coupon
bond putable at par in one year and two years from now is closest to:
o A
USD98.40 putable at par.

o B
USD99.40 not putable at par.

o C
USD100.33 putable at par.

Incorrect
A is correct. Given the one-year forward rates in Table 2, from Table 3 the three-year
4.50% annual coupon bond (putable at par one year and two years), is putable at
Node 2-1.
At Time 2, value at Node 2-1 = USD0.5\ \times \ [(104.5/1.06205)+\
(104.50/1.06205)]=USD98.395. The bond is at a discount to par so it will be putable at
par at Node (2, 1). Bond value will reset to 100. Section 3.5.2. LO.f.
48. Question 48

Year
3
bond = USD104.306 100.085 =?
C = 4.50
C = 4.50
V=
V = 99.448 104.50
101.454
C = 4.50
Node 2-3 V 104.50
=?
104.50
Assume nothing changes in the initial setting of the three-year 4.50% annual coupon
putable bond valued at 104.96, except the bond is now putable at 96 instead of
100. A similar straight bond is valued at 104.31. The new value of the putable bond
is closest to:
o A
USD100.00.
o B
USD104.96.
o C
USD104.31.
Incorrect
C is correct. The put price of 96 is too low for the put option to be exercised in any
scenario. Therefore, it will not be equal to its previous value of 104.96. The value of
the put option is zero. Value of the putable bond is equal to the value of the straight
bond which is USD104.31.
49. Question 49
One of the approaches used to value risky bonds is to raise the one-year forward
rates derived from the default-free benchmark yield curve by a fixed spread at zero
volatility known as the:
o A
swap spread.
o B
Libor-OIS spread.
o C
Z-spread.
Incorrect
C is correct. The Z-spread or zero-volatility spread is a fixed spread added to the
one-year forward rates derived from the default-free benchmark yield curve to value
risky bonds. A is incorrect, because swap spread is the spread paid by the fixed-rate
payer of an interest rate swap over the rate of recently issued government
security. B is incorrect because the Libor-OIS spread which is the difference between
Libor and the OIS rate is used as an indicator of risk and liquidity of money market
securities.
50. Question 50
For risky bonds with embedded options, the constant spread when added to one-
year forward rates on the interest rate tree, makes the arbitrage-free value of the
bond equal to its market price is best known as:
o A
option-adjusted spread.
o B
TED spread.
o C
swap spread.
Incorrect
A is correct. Option-adjusted spread is that constant spread when added to the one-
year forward rates of the binomial lattice makes the arbitrage-free price of a risky
bond with embedded options equal to its market price. B & C are incorrect. The TED
spread is an indicator of credit risk in the economy. Swap spread is explained above.
51. Question 51
Consider the interest rates given in Table 2. The price of a three-year 4.50% annual
coupon risky callable bond (callable at par one year and two years) is 103.00 at 10%
interest rate volatility. If the one-year forward rates in Table 2 are raised by an OAS
of 30 bps, the price of the callable bond is 102.90. The correct OAS that justifies the
given market price of 103 is:
o A
more than 30 bps.

o B
equal to 30 bps.
o C
less than 30 bps.

Incorrect
C is correct The three-year 4.50% annual coupon callable risky bond at 10% interest
rate volatility is given as 103.00. If the bond’s price is given, the OAS is found by the
trial and error method. At 30 bps which is added to the one-year forward rates in
each state of the binomial interest rate tree, the price is lower at 102.90. Because of
the inverse relationship between a bond’s price and its yield, this means that the
discount rates are too high. Hence the OAS should be lower than 30 bps.
52. Question 52
A portfolio manager is analyzing three 10-year 5.0% annual coupon callable bonds of
equal risk. The bonds differ only in the OAS but are similar in characteristics and
credit quality.
Bond A OAS = 30 bps

Bond B OAS = 25 bps
Bond C OAS = 27 bps
Which bond is the most underpriced?
o A
Bond A.
o B
Bond B.
o C
Bond C.
Incorrect
A is correct. Bond A has the highest OAS compared to Bond B and Bond C, so it is
the most underpriced (cheap). Lower OAS for bonds with similar characteristics and
credit quality (Bonds B & C) indicate that they are possibly overpriced.
53. Question 53
If interest rate volatility increases from 10% to 20%, for a 20-year 5% annual coupon
bond, callable in five years, the OAS for the bond:
o A
increases.
o B
decreases.
o C
is unaffected.
Incorrect
B is correct. As interest rate volatility increases the OAS of the callable bonds
decreases and vice versa.
54. Question 54
The most appropriate duration measure for bonds with embedded options is:
o A
effective duration.
o B
yield duration measure.

o C
modified duration.
Incorrect
A is correct. Effective duration works for bonds with embedded options and for
straight bonds. Therefore, it is used by practitioners regardless of the type of bond
being analyzed. Yield duration measures, such as modified duration, can be
used only for option-free bonds because these measures assume that a bond’s
expected cash flows do not change when the yield changes.
55. Question 55
Bond A has the following characteristics:
Time to maturity 5 years from now

Coupon 4.75% annual
Type of Bond Callable at par one year from today
Current price (% of par) 101.25
Price (% of par) when shifting the
102.00
benchmark yield curve down by 30 bps
Price (% of par) when shifting the
100.74
benchmark yield curve up by 30 bps
The effective duration for Bond A is closest to:
o A
0.60
o B
2.10
o C
5.20
Correct
B is correct. The effective duration for Bond A =(102.00 – 100.74) / (2 x 0.003 x
101.25) = 2.074.
Sienna Miller, CIO of a hedge fund, is interviewing Kumar for the post of a fixed income
analyst, and asks him to evaluate two bonds. Information on the bonds is given in Table
1: Table 1: Bond Information
Bond Maturity Coupon Type of Bond

Callable at par in one year &
C&N Corp. Bond (1) Three years 4.5% annual
two years from now
Putable at par in one year &
PBX Co. Bond (2) Three years 4.5% annual
two years from now
Miller questions Kumar on how to determine the value of these bonds. Kumar responds by
stating, “For both bonds 1 & 2, the value of the bond is calculated by subtracting the value of
the embedded option from the value of the straight bond.” Miller next states, “”Interest rate
volatility and the shape of the yield curve may also affect the values of Bonds 1 & 2. Assume
the following situations: I: Interest rate volatility increases and the yield curve remains flat.
II: Interest rate volatility remains at the current 10% level and the yield curve flattens further
with rates rising in the 0 – 1 year maturity and declining in the 2-year maturity and above.”
Miller inquires, about the impact on both bonds under each volatility and interest rate
scenario.
1. Question 1
The embedded option in both bonds (listed in Table 1), is most likely known as:
o A
Bermudan-style.
o B
European-style.
o C
American-style.
Incorrect
A is correct. In a European-style callable/putable bond, the call/put option can only
be exercised on a single date at the end of the lockout period. An American-style
callable bond is continuously callable from the end of the lockout period until the
maturity date. A Bermudan-style embedded option can be exercised only on a
predetermined schedule of dates after the end of the lockout period, as described
for Bond 1 and Bond 2.
2. Question 2
Is Kumar correct about the valuation of bonds with embedded option?
o A
Yes.
o B
No, he is incorrect about the valuation of Bond 1.

o C
No, he is incorrect about the valuation of Bond 2.

Incorrect
C is correct. Value of a callable bond (Bond 1 in this case) = Value of straight bond –
Value of call option. Value of a putable bond (Bond 2 in this case) = Value of straight
bond + Value of put option. Kumar is incorrect about the valuation of Bond 2.
3. Question 3
If Situation I occurs, it is most likely that the value of Bond 1:
o A
and value of Bond 2 will fall.

o B
will fall and value of Bond 2 will rise.

o C
will rise and value of Bond 2 will fall.

Incorrect
B is correct. All else being equal, the call option increases in value with interest rate
volatility. As interest rate volatility increases in a flat yield curve environment, the
value of the callable bond decreases. All else being equal, the put option increases in
value with interest rate volatility, therefore with a flat yield curve as interest rate
volatility increases, the value of the putable bond increases.
4. Question 4
If Situation II occurs, it is most likely that the value of Bond 1:
o A
will rise more rapidly than the straight bond value and Bond 2 value will rise
less rapidly than the straight bond value.
o B
and Bond 2 will rise less rapidly than the straight bond value.
o C
will fall and value of Bond 2 will rise more rapidly than the straight bond
value.
Correct
B is correct. All else being equal, as the yield curve flattens, the value of call option in
Bond 1 increases. Although Bond 1 increases in value, but the increase in the call
option results in a lower value than a straight bond. As the yield curve flattens, the
value of the put option in Bond 2 declines, therefore the value of the putable bond
will not rise as much as a straight bond.
Peter Han is a portfolio manager for a fixed-income fund that invests in corporate bonds,
including convertible bonds. One of the convertible bonds in the fund was issued on 3
March 2016 by Shou Heavy Industries. Each bond has a par value of CNY1,000,000. The
initial conversion price was CNY1,500. At the convertible bond issuance date, Shou’s
common stock was trading at CNY1,080. The bonds have a threshold dividend of CNY100
and a change of control conversion price of CNY500. On 4 March 2017, the market
conversion price for Shou bonds was CNY1,600 and its common shares closed at CNY995.
The next day, Shou, paid a dividend (never previously paid) to common shareholders of
CNY150 per share.
1. Question 1
The dividend paid to Shou’s common stock holders will least likely affect the bond’s:
o A
conversion ratio.
o B
conversion price.
o C
change of control conversion price.

Incorrect
C is correct. The conversion price is adjusted downwards increasing the conversion
ratio if the annual dividend payments are above the threshold dividend to
compensate convertible bondholders.
2. Question 2
The conversion ratio of the Shou bonds on the date of issuance was closest to:
o A
925.93.
o B
666.67.
o C
2,000.
Incorrect
B is correct. The conversion ratio on issuance date = face value of each bond/ initial
conversion price = CNY1,000,000/CNY1,500 = 666.67 shares. Each CNY1,000,000
converts into 666.67 common shares.
3. Question 3
On 4 March 2017, the risk-return characteristics of Shou’s bonds most likely resemble
those of:
o A
shares of common stock.

o B
busted convertibles.
o C
putable bond.
Correct
B is correct. On 4 March 2017, the market conversion price of the bonds was
CNY1,600. Therefore, the market conversion premium ratio = (CNY1,600/CNY995) – 1
= 60.80%. The underlying common stock is below the market conversion price, and
the embedded call option is far out of money. Hence Shou bonds will resemble
option-free bonds, also known as busted convertibles.
Tom Bailey, a quantitative analyst, is asked to evaluate bonds with embedded options that
are currently perceived to be mispriced. He gathers data on a group of comparable bonds
that have the same market liquidity. Table 3: Bond Features and Prices
Bond I Bond II Bond III

Remaining maturity 3 years 3 years 3 years
Credit rating AA AA AA
Coupon rate 5.00% 5.00% 5.00%
Optionality Callable option-free Putable
Price 102.282 102.114 102.397
Bailey’s supervisor tells him that the research desk has just circulated an interest rate
forecast according to which the interest rate volatility is expected to decrease and the yield
curve, which is currently flat, is expected to become upward sloping. He asks Bailey to
consider the impact of these expected changes on the values of the bonds given in Table 3.
1. Question 1
Assuming Bond II is correctly priced, given the information in Table 3, is Bond I
mispriced?
o A
No.
o B
Yes.
o C
Lack of sufficient information to determine mispricing.

Incorrect
B is correct. The three bonds have the same credit rating, coupon rate and the same
remaining maturity, but they are trading above par. Therefore, the coupon rate of a
par bond with the same credit rating and maturity must be lower than 5.00%. Bond II
is a straight bond, while Bond I is a callable bond. All else equal the price of Bond I
will be capped relative to the price appreciation of Bond II because of the call option
at lower interest rates. Hence its price should likely be lower than the price of Bond
II. Sections 3.2-3.3. LO.b.
2. Question 2
If the interest rate volatility changes in the way forecasted, which bond in Table 3
will most likely experience the largest decrease in price?
o A
Bond I.
o B
Bond II.
o C
Bond III.
Incorrect
C is correct. The value of a straight bond is unaffected by interest rate volatility. The
value of the call option and put option decrease with a decrease in interest rate
volatility. Hence the value of the callable Bond I will increase whereas the value of
the putable Bond III will decrease.
3. Question 3
If the shape of the yield curve changes as forecasted, and price of Bond II does not
change, the price of Bond III will most likely:
o A
decrease.
o B
increase.
o C
not change.
Correct
B is correct. As the yield curve moves from flat to upward sloping, the value of the
put option increases. Since the value of the putable Bond III is equal to the value of
an otherwise identical straight bond plus the put option value, it will increase too.
Andy Sloan, chief investment officer at Puth Investments, a firm specializing in fixed- income
portfolio management, would like to add bonds with embedded options to the firm’s bond
portfolio. He asks Su Crane, one of the firm’s senior analysts, to analyse and select bonds for
the firm’s bond portfolio. Crane first chooses two corporate bonds that are callable at par
and uses the option adjusted spread (OAS) approach to analyse the bonds, assuming an
interest rate volatility of 15%. The following Table 6 presents the results of her
approach. Table 6: Crane’s Analysis Using OAS Approach
Bond* OAS
Bond S 28.5 bps
Bond T 33.6bps
*Both bonds have the same maturity credit ratings and call dates. Crane then selects the following
four bonds issued by Dragnet Industries listed in Table 7. Table 7: Dragnet Industries’
Bonds
Bond Coupon Maturity Special Provision
Bond P 5.00% annual 3 years option- free bond
Callable at par in one
Bond Q 5.00% annual 3 years
year & two years
Putable at par in one
Bond R 5.00% annual 3 years
year & two years
One- year Libor
Bond V 3 years
annually, set in arrears
Note: These bonds have the same credit quality. To value the Dragnet Industries’ bonds, Crane
uses constructs the binomial interest rate tree presented in Table 8 with an interest rate
volatility of 10%. Table 8
2.00% 3.90% 5.50%
3.20% 4.50%
3.70%
Finally, Sloan wants Crane to determine the sensitivity of Bond Q’s price to a 30 bps parallel
shift of the benchmark yield curve. Crane calculates Bond Q’s price as 103.245% of par for a
30 bps parallel shift down in interest rates, and 102.639% of par for a 30 bps shift up in
interest rates.
1. Question 1
Based on Table 6, compared to Bond S, Bond T is most likely:
o A
underpriced.
o B
overpriced.
o C
fairly priced.
Incorrect
A is correct. If two bonds have the same characteristics and credit quality, they
should have the same OAS. If this is not the case, the bond with the largest OAS (i.e.,
Bond Y) is likely to be underpriced (cheap) compared to the bond with the smallest
OAS (Bond X).
2. Question 2
The effective duration of Bond V is closest to:
o A
higher than 3.
o B
higher than or equal to 2.

o C
lower than or equal to 1.

Incorrect
C is correct. Because the effective duration of a floater is close to the time to next
reset and the reset for Bond V is annual, the effective duration of Bond V, a floating-
rate bond is lower than or equal to 1.
3. Question 3
Using Table 7, if interest rates increase, the bond whose effective duration will
lengthen is most likely:
o A
Bond P.
o B
Bond Q.
o C
Bond R.
Correct
B is correct. The effective duration of Bond P, an option-free bond changes very little
in response to interest rate movements. For a callable bond (Bond Q here), as
interest rates rise, a call option moves out of the money, which increases the bond
value and lengthens its effective duration. For a putable, as interest rates rise, a put
option moves into the money, limiting the price depreciation of the putable bond
and shortening its effective duration. Thus Bond Q’s effective duration will lengthen
if interest rates rise.
Bella Hadim, a fixed-income analyst has been assigned to value two floating-rate bonds
issued by Dymax Inc. given in Table 9. Both bonds have a maturity of three years and the
same credit quality. Table 9
One-year Libor annually, set in arrears, capped

Bond I
at 4.00%
One-year Libor annually, set in arrears, floored
Bond II
at 3.00%
Using the binomial interest rate tree given below, Hadim calculates the value of the Dymax
bonds.
2.50% 4.63% 5.33%
3.43% 3.95%
2.93%
Hadim’s analysis for the 4.5% capped floater is shown below: Table 10: Valuation of Bond
I.
Today Year 1 YEar 2 Year 3
C = 4.63 4.00 R = C
5.33 V = 98.737 = 105.33 104.00
C =2.5 R = 4.63 C
V = 98.794 = 105.33 104.00
C = 4.63 4.00 R =
R = 2.50 3.95 V = 100 C = C = 103.95
3.43
C = 2.5 R = 3.43
C = 103.95
V = 100
C = Cash Flow
(% of par) R =
One-Year Interest
C = 3.43 R = 2.93
Rate (%) V = C = 102.93
V = 100
Value of
the Capped
Floater (% of par)
C = 102.93
1. Question 1
Using Table 10, the value of Bond I is closest to:
o A
100.00% of par.
o B
99.41% of par.
o C
97.83% of par.
Incorrect
B is correct. From Table 10:
For Year 0: [(98.794+2.5)1.025+(102.5)1.025]×0.5=99.412% �� .
2. Question 2
Using Table 9, the value of Bond II is closest to:
o A
100.5% of par.
o B
101.4% of par.
o C
99.97% of par.
Incorrect
A is correct. Valuation of Bond II floored at 3.00%.

C = 4.63
R = 5.33 C = 105.33
V = 100
C =2.5
3.00
C = 105.33
R = 4.63
V = 100
C = 4.63
R = 3.95
V = 100.504
V = 100 C = 103.95
R = 2.50
C = 3.43
C = 2.5
3.00
C = 103.95
R = 3.43
V = 100.033
R = One-Year Interest Rate C = 3.43
C = 102.93
(%) R = 2.93
103
V = Value of the Capped V = 100.068
Floater ( % of par)
C = 102.93
103
Tom Holland, chief investment officer Zavier Investment Advisors during his meeting with
the analysts discusses the impact of weakening economic activity. The equity market values
are predicted to decline in the coming year and the negative GDP growth rate of the
previous quarters is not expected to improve. Holland wants the investors to consider
adding more fixed- income securities to their portfolios and limiting their equity exposure.
Holland observes, “Because of low government yields we should consider investment- grade
corporate bonds over government securities. According to the consensus forecast among
economists, the central bank is expected to lower interest rates in their upcoming meeting.”
After the meeting, Zandya Coleman, a fixed-income analyst selects the following four fixed-
rate investment- grade bonds issued by Bliss Paper Company for investment (Exhibit
1). Exhibit 1: Bliss Paper Company’s Fixed-Rate Bonds
Bond Annual Coupon Type

*
Bond X 2.0% Straight bond
Bond Y 2.0% Callable at par without a lockout period
Bond Z 2.0% Putable at par one and two years from now
Bond S 2.0% Convertible bond: currently out of money
*Note: All bonds have a remaining maturity of three years. Coleman finds that demand for
consumer credit is relatively strong, despite other poor macroeconomic indicators. As a
result, she believes that volatility in interest rates will increase. Coleman also reads a report
from Thomson Crew, a reliable financial and economic information provider, forecasting
that the yield curve may invert in the coming months.
1. Question 1
Based on Exhibit 1, Bond X is most likely trading at a current price higher than the
price of:
o A
Bond Y.
o B
Bond Z.
o C
Bond S.
Incorrect
A is correct. Bond Y (callable) most likely has a current price that is less than Bond X
(straight or option free) because investors are short the call option and must be
compensated for bearing call risk. Bond S (convertible) most likely has a current
price that is greater than Bond X because investors are paying for the embedded
conversion option which has time value associated with it. Similarly, Bond Z, most
likely trades at a premium relative to Bond X because of the put option.
2. Question 2
Assuming the interest rates forecast is proven accurate, the bond with the smallest
price increase is most likely:
o A
Bond X.
o B
Bond Y.
o C
Bond Z.
Incorrect
B is correct. According to the consensus economic forecast interest rates will
decrease. With interest rates decreasing, all bond prices should rise ignoring any
price impact resulting from any embedded options. When interest rates fall, the call
option in Bond Y (callable) becomes valuable, causing an opposing effect on price.
The put option of putable bonds, by contrast, increases in value when interest rates
rise rather than decline.
3. Question 3
If the forecast of the interest rate volatility proves accurate, the bond with the
greatest price increase is most likely:
o A
Bond Y.
o B
Bond Z.
o C
Bond S.
Incorrect
B is correct. An increase in interest rate volatility will cause the values of the put and
call options in Bond Z and Bond Y to increase. Bond Z (putable) would likely
experience a price increase due to the increased value of the put option whereas
Bond Y (callable) would experience a price decrease because of the increased value
of the call option. The price of Bond S, an out-of- the-money convertible, should be
minimally affected by changes in interest rate volatility.
4. Question 4
If Thomson Crew’s forecast comes true, the value of the embedded option will most
likely increase in:
o A
Bond Y.
o B
Bond Z.
o C
Both Bond Y and Z.

Incorrect
A is correct. All else being equal, the value of a put option decreases as the yield
curve moves from being upward sloping to flat to downward sloping (inverted).
Alternatively, a call option’s value increases as the yield curve flattens and increases
further if the yield curve inverts. Hence if the yield curve became inverted, the value
of the embedded option in Bond Y (Callable) would increase.
5. Question 5
Based on Exhibit 1, if the forecast for interest rates and equity returns are proven
accurate, which bond’s option is most likely to be exercised?
o A
Bond Y.
o B
Bond Z.
o C
Bond S.
Incorrect
A is correct. If interest rates are lowered, the yields on Bliss’s bonds are likely to
decrease and Bond Y (callable) may be called. B is incorrect because if the equity
market declines, Bliss’s stock price will likely decrease and Bond S’s (convertible)
conversion option would likely not be exercised. Because Bond S is currently trading
out of the money, it will likely trade further out of the money once the stock price
decreases. C is incorrect because Bond Z (putable) is not likely to be exercised in a
decreasing interest rate environment.
Julianne Maurice, a fixed-income analyst for Chariot Investments, Inc. collects data on three
corporate bonds, given below.
Bond Annual Coupon Type Price

Callable at par one year & two
Bond S 4.5% 101.300
years from now
Bond T 4.5% Option-free 102.400
Putable at par one year & two
Bond U 4.5% 103.200
years from now
Note: Each bond has a maturity of three years remaining and a credit rating of BBB+.
1. Question 1
If benchmark yields fall, which bond would most likely exhibit a decline in effective
duration?
o A
Bond S.
o B
Bond T.
o C
Bond U.
Incorrect
A is correct. Bond S is a callable bond and the effective duration of a callable bond
decreases when interest rates fall. This is because an interest rates decline may
result in the call option moving into the money, which limits the price appreciation of
the callable bond. The price of Bond S is 101.300 and it is callable at par in one year
and two years. Thus, the call option is already in the money and would likely be
exercised in response to increases in the bond’s price.
2. Question 2
For Bond S, one-sided:
o A
up-duration will be lesser than one-sided down-duration.

o B
up-duration will be greater than one-sided down-duration.

o C
up-duration and one-sided down duration will be equal.
Incorrect
B is correct. For Bond S (callable), an (say 30 bps) increase in the interest rate has a
greater effect on the value of the callable bond than a (30 bps) decrease in the
interest rate. This is because the callable bond is more sensitive to interest rate rises
than to interest rate declines For the option-free bond one-sided up-duration and
one-sided down-duration will be about equal. For putable bonds, one-sided down
duration is greater than one-sided up duration.
3. Question 3
The key rate duration which is the largest for Bond T is:
o A
one-year key rate duration.

o B
two-year key rate duration.

o C
three-year key rate duration.

Incorrect
C is correct. For Bond T (an option-free bond) an option-free bond the longest key
rate duration will be in the year of its maturity because the largest cash flow
(payment of both coupon and principal) occurs in that year.
4. Question 4
The bond which has most likely the lowest effective convexity is:
o A
Bond S.
o B
Bond T.
o C
Bond U.
Incorrect
A is correct. All else being equal, a callable bond will have lower effective convexity
than an option-free bond when the call option is in the money. Similarly, when the
call option is in the money, a callable bond will also have lower effective convexity
than a putable bond if the put option is out of the money. Bond S (callable) is
currently priced higher than its call price of par value, which means the embedded
call option is in the money. The put option embedded in Bond U is not in the money;
the bond is currently priced above par value. Thus, the effective convexity of Bond S
will likely be lower than the option-free and the putable bond.
Credit Analysis Models

1. Question 1
Q-Code: 21-L2-FI-CRAM-75287
Consider a 3- year, 3.00% annual payment bond that is priced at 103 (per 100 of par
value). It has an annual default probability of 1.25% (the hazard rate) and a recovery
rate of 40%. Assuming 10% volatility the credit valuation adjustment for the bond is
2.2542. Using the government par curve in Exhibit 9 and the binomial interest rate
tree in Exhibit 10 of LM04 (curriculum), the value for the corporate bond assuming
no default (VND) is 104.4152. The fair value is 102.1610 and the yield to maturity is
2.247%. The yield on the 3- year benchmark bond is 1.50%. The expected exposure
for date 1 and date 2 are 104.1542 and 102.9417. If the default probability is doubled
to 2.50%, and the recovery rate is kept at 40%, what is the change in the credit
spread?
(LM04 (2023) refers to 2022 Reading 31)
o A
151 bps.
o B
76.6 bps.
o C
74.7 bps.
Incorrect
B is correct. The VND remains the same at 104.4152. The calculations for the CVA of
the bond given an annual default probability of 2.50% and a recovery rate of 40% are
given below:
Expected exposures for date 1 and date 2: 104.1542 and 102.9417. Expected
exposure for date 3 is 103.
The calculations for the loss given default LGD are:
104.1542 × (1 – 0.40) = 62.4925
102.9417 × (1 – 0.40) = 61.7650
103 × (1 – 0.40) = 61.8000
The calculations for the POD for date 2 and date 3 are:
2.5% × (100% – 2.5%) = 2.4375%
2.5% × (100% – 2.5%)2 = 2.3766%
Expected Discount CVA Per Year

Date LGD POD
Exposure Factor (DF) (LGDxPODxDF)
1 104.1542 62.4925 2.5000% 1.002506 1.5662
2 102.9417 61.7650 2.4375% 0.985093 1.4831
3 103.0000 61.8000 2.3766% 0.955848 1.4039
CVA = 4.4532
The fair value of the bond = VND – CVA =104.4152-4.4532 = 99.9620. The YTM of the
bond is: N = 3, PV = -99.9620, PMT = 3.00, FV = 100, I/Y CPT = 3.013%. The credit
spread over the 1.5% benchmark yield of comparable maturity = 3.013% – 1.500% =
1.513%.
The credit spread before doubling the default probability is: 2.247%-1.500% =
0.747%. By doubling the default probability, the credit spread changes to: 1.513% –
0.747% = 0.766% or 76.6 basis points.
2. Question 2
If payments are not made according to the original schedule, a bond default is
triggered and bond payments are accelerated in case of:
o A
Hard bullet covered bonds.

o B
Soft bullet covered bonds.

o C
Conditional pass-through covered bonds.

Incorrect
Solution: A is correct. In case of hard bullet covered bonds, if payments are not
made according to the original schedule, a bond default is triggered and bond
payments are accelerated.
Soft bullet covered bonds are similar to hard bullet, but the bond default and
payment acceleration is delayed to a new final maturity date, which is usually up to a
year after the original maturity date.
In case of conditional pass-through covered bonds, if all bond payments have not
been made, the bonds are converted into pass-through securities after the original
maturity.
3. Question 3
Which of the following statements is least accurate about covered bands?
o A
The underlying asset pool in covered bonds is dynamic.

o B
Rating agencies often assign a credit rating to covered bonds that is
several notches below that of the issuing financial institution.
o C
When evaluating covered bonds, though the dual recourse principle is

important.
Incorrect
Solution: B is correct. Given the additional credit enhancements, recovery rates tend
to be high and default probabilities low, making covered bonds a relatively safe
credit asset. As a result, rating agencies often assign a credit rating to covered bonds
that is several notches above that of the issuing financial institution.
4. Question 4
If the underlying collateral is homogeneous and granular while the risk horizon is
medium term, then which of the following credit analysis approaches will be used?
o A
Book
o B
Portfolio
o C
Loan-by-loan
Incorrect
Solution: B is correct. If the underlying collateral is homogeneous and granular while
the risk horizon is medium term, then we will use the portfolio-based approach. For
example, Auto ABS.
5. Question 5
Analyst 1: The term structure of credit spreads typically is flat or slightly upward
sloping for high-quality investment-grade bonds.
Analyst 2: High-yield bonds can have a more upwardly sloped term structure of
credit spreads than investment-grade bonds or even an inverted curve.
Which of the above analyst is correct?
o A
Analyst 1
o B
Analyst 2
o C

Incorrect
Solution: C is correct. For investment grade bonds, the probability of default is low;
hence, credit spreads tend to be low. The credit term structure tends to be flat or
slightly upward sloping (due to the possibility of credit migration in the long term).
For high-yield securities, the greater likelihood of default usually results in steeper
credit spread curves. We could also have a downward sloping yield curve if the POD
is currently high but is expected to come down in the future.
6. Question 6
Analyst 1: Environmental, social, and governance (ESG) considerations may also play
a role in credit risk assessment.
Analyst 2: Estimated probabilities of default (POD) and loss given default (LGD) do
not incorporate potential ESG impacts.
Which of the above analysts is correct?
o A
Analyst 1
o B
Analyst 2
o C
Neither Analyst 1 nor Analyst 2

Incorrect
Solution: A is correct. Environmental, social, and governance (ESG) considerations
also affect credit risk assessment. For example, companies that pollute the
environment may face fines, companies with poor labor practices may face
consumer boycotts, and companies with weak governance may engage in fraudulent
accounting. These potential impacts should be incorporated in POD and LGD.
7. Question 7
Tamara Green is an intern at an investment bank. Her supervisor asks her if she
knows what granularity and homogeneity are in the context of analyzing asset-
backed securities. Green makes the following statements, “Granularity refers to the
degree to which the underlying debt characteristics within a structured financial
instrument are similar across individual obligations. Homogeneity refers to the
number of obligations in the overall structured financial instrument. The appropriate
approach to evaluate asset-backed securities depends on the granularity,
homogeneity, asset type, and tenor of the underlying.”
Green is most likely correct with regards to:
o A
granularity.
o B
homogeneity.
o C
the factors that determine what approach to use to evaluate ABS.

Incorrect
C is correct. The other statements are incorrect because she swapped the definitions
of the two terms. Granularity refers to the number of obligations in the overall
structured financial instrument. Homogeneity refers to the degree to which the
underlying debt characteristics within a structured financial instrument are similar
across individual obligations.
8. Question 8
Statement 1: The unique feature of covered bonds is that they give recourse to the
issuer in addition to the predetermined underlying collateral.
Statement 2: The three major credit analysis approaches used for ABS are portfolio,
loan-by-loan, and value-to-book.
Which of the above statements is most likely correct?
o A
Statement 1
o B
Statement 2
o C
Neither statement
Incorrect
A is correct. Statement 2 is incorrect because the three major credit analysis
approaches used for ABS are the portfolio approach, loan-by-loan approach, and
book approach.
9. Question 9
Which of the following is least likely correct?
o A
If a company refinances a near-term bond with a longer-term bond, the
credit spread curve becomes steeper because the credit spread widens.
o B
High-yield bonds generally have steeper credit spread term structures than
investment grade bonds.
o C
If there are issuer- or industry-specific factors that are likely to increase the
POD in the future, then this will result in a steep upward sloping term
structure.
Incorrect
A is correct. This statement is incorrect because recently issued bonds are traded
more frequently than older bonds and are therefore more liquid. Bonds with higher
liquidity have narrower credit spreads, so refinancing by issuing a newer bond will
lead to a flatter credit spread term structure.
10. Question 10
Statement 1: Credit spreads are more sensitive to changes in the hazard rate (annual
probability of default) than to changes in the recovery rate.
Statement 2: Rating agencies use ‘notching’ to address differences in the hazard rate.
Which of the above statements is most likely correct?
o A
Statement 1 only
o B
Statement 2 only
o C

Incorrect
A is correct. Statement 2 is incorrect because notching is used to account for
differences in the recovery rate. For example, if a bond was previously assumed to
have a recovery rate of 50%, but is now considered to have a recovery rate of 35%,
this decrease can be reflected by a downgrading of the rating on the bond, such as a
change from a rating of BB to BB-.
11. Question 11
Statement 1: The quoted margin of a floating-rate bond is a fixed rate that is added
to the benchmark rate which helps establish the coupon payment.
Statement 2: If the market value of a floating rate bond is less than the par value,
then the discount margin is less than the quoted margin.
Statement 3: The discount rate for floaters is similar to the credit spread for fixed-
coupon bonds.
Which of the above statements is least likely correct?
o A
Statement 1
o B
Statement 2
o C
Statement 3
Incorrect
B is correct. Statement 2 is incorrect because if the market value of a floating rate
bond is less than the par value, then the discount margin is greater than the quoted
margin.
The discount margin is the margin above the benchmark rate, which is used to
discount the cash flows to get the market value of the bond.
• If market value = par value → DM = QM

• If market value < par value → DM > QM
• If market value > par value → DM < QM
12. Question 12
When explaining how the structural credit model works, your colleague says the
following, “Under the structural credit model, debt and equity can be thought of in
terms of options. Using this analogy, we can say that debtholders own the assets of
the company and have written a call option to the shareholders. Similarly, equity is a
long position in a call option on the assets of the company, with a strike price equal
to the par value of debt.”
She is most likely correct with respect to her comment regarding:
o A
equity.
o B
debt.
o C
both debt and equity.
Incorrect
C is correct.
Suppose a company at time 0 has assets = A, and liabilities = a zero-coupon bond
with a par value of K and maturity T. The value of assets at time T is uncertain and is
denoted by A(T).
The values for debt and equity at time T are denoted by D(T) and E(T) and can be
expressed as:
D(T) + E(T) = A(T)
E(T) = Max[A(T) – K,0]
D(T) = A(T) – Max[A(T) – K,0]
The first equation is based on the balance sheet equation: Assets = Liabilities +
Equity
The second equation indicates that equity is a long position in a call option on the
assets of the company, with a strike price K. The value of equity goes up when the
asset value goes up. Also, because of the limited liability assumption, equity does not
take on negative values. This payoff is similar to a call option.
The third equation indicates that debtholders own the assets of the company and
have written a call option to the shareholders. If asset value falls below K, the value
of equity falls to zero and the debtholders own the remaining assets.
13. Question 13
The credit analysis approach for short-term structured finance instruments such as
credit cards ABS, is most likely:
o A
portfolio.
o B
book.
o C
loan-by-loan.
Incorrect
B is correct. If the risk horizon is short term and the underlying collateral is
homogeneous and granular we use the book approach. For example, for credit card
ABS using this approach, we will look at the entire book of credit card loans and will
use statistical factors such as delinquency rates to evaluate the credit quality of the
entire book.
14. Question 14
Which of the following is not a key driver of the term structure of credit spreads?
o A
Duration of the on-the-run government bonds.
o B
Expectations of economic growth and inflation.

o C
Company-value model and industry-specific analysis.

Incorrect
A is correct. Duration and maturity of the most liquid on-the-run government bonds
is an important concern when analyzing the term structure of credit spreads. But it is
not a key driver of credit spreads’ term structure. To determine credit spreads it is
necessary to select the appropriate risk- free or benchmark rates. A frequently
traded government security with the nearest maturity to an outstanding corporate
bond is a logical benchmark choice. But, the duration and maturity of the most liquid
or on- the- run government bonds rarely match that of corporate bonds so
interpolation between yields of government securities with the closest duration is
done. Since this may not be appropriate for less- liquid maturities, the benchmark
swap curve based on interbank rates is often substituted for the government
benchmark for off- the- run maturities. B & C are drivers of credit spreads curve,
along with credit quality, market supply/demand, and financial conditions.
15. Question 15
A bank disburses loans to Company A and Company B. Company A has higher
default risk (POD = 3%), but the value of the collateral is high relative to the amount
borrowed (LGD per 100 of par value = 20). Company B has lower default risk (POD =
1%), but the value of the collateral is very low relative to the amount borrowed (LGD
per 100 of par value = 90). All else equal, compared to Company A, Company B most
likely has:
o A
lower credit risk.

o B
higher credit risk.

o C
higher liquidity risk.

Incorrect
B is correct. Default risk addresses the likelihood of an event of default. Credit risk, a
broader term, considers both the default probability and the expected loss if default
occurs. For example, it is possible that the default risk on a collateralized loan is high
while the credit risk is low, especially if the value of the collateral is high relative to
the amount that is owed. Expected loss for Company A = 3% x 20 = 0.6. Expected loss
for Company B = 1% x 90 = 0.9. Based on expected losses, Company B has higher
credit risk.
16. Question 16
Gori Khan is a portfolio manager considering an investment grade 3-year floater for
purchase. The floater pays annually the 1-year benchmark rate plus 0.40% quoted
margin and trades at 101.650 per 100 of par value. The annual probability of default
for the first two years is 0.50% and the recovery rate 30%. For the final year the
probability of default is 0.60% and the recovery rate is 20%. Assuming no default and
10% volatility, the fair value of the floater is 100.002. The discount margin DM,
assuming no default is most likely (no calculations required):
o A
higher than the quoted margin.

o B
lower than the quoted margin.

o C
equal to the quoted margin.

Incorrect
B is correct. The discount margin is the margin above the benchmark rate, which is
used to discount the cash flows to get the market value of the bond.
• If market value = par value → DM = QM

• If market value < par value → DM > QM
• If market value > par value → DM < QM
The discount margin DM is lower than the quoted margin because the floater is
priced at a premium.
17. Question 17
Consider an investment grade 3-year floater that pays annually the 1-year
benchmark rate plus 0.40% quoted margin. The annual probability of default for the
first two years is 0.50% and the recovery rate 30%. For the final year the probability
of default is 0.60% and the recovery rate is 20%. The floater is priced at 100.0130.
The VND for the floater is 101.1773 using the binomial interest rate tree for 10%
interest rate volatility. The following table shows the value of the floater paying the
1- year benchmark rate plus 0.40% assuming no default and 10% volatility. Should
the floater be purchased based on an expectation of 10% volatility of interest rates?
Exhibit 10 of the curriculum: 1- Year Binomial Interest Rate Tree for 10% Volatility
Date 0 Date 1 Date 2 Date 3
100.7719 100.3857
1.9442% 3.7026% 104.1026
Coupon = 2.3442
101.1773 100.3882
-0.2500% Coupon = 0.1500 3.0315% 103.4315
Coupon = 1.9918
100.7769
1.5918% 100.3903
2.4820% 102.8820
Discount factors:
D1: 1.002506
D2: 0.985093
D3: 0.955848
o A
No, because it is over-valued.

o B
Yes, because it is under-valued.

o C
Yes, because it is fairly-valued.
Incorrect
C is correct. To calculate the fair value of the floating-rate bond paying the
benchmark rate plus 0.40%, first calculate the CVA.
The expected exposure to default loss are calculated below:
For date 3: [(104.1062 x 0.25 ) + ( 103.4315 x 0.50 ) + ( 102.8820 x 0.25 ) ] = 103.4619
For date 2: [(100.3857 x 0.25 ) + ( 100.3882 x 0.50 ) + ( 100.3903 x 0.25 )] + [(2.3442 x
0.5 ) + ( 1.9918 x 0.5 ) ] = 102.5561
The calculations for LGD are:
Date 1: 100.9244 x ( 1 – 0.30 ) = 70.6471
Date 2: 102.5561 x ( 1 – 0.30 ) = 71.7893
Date 3: 103.4619 x ( 1 – 0.20 ) = 82.7695
The calculations for the POD for date 2 and date 3 are
0.50% (100% – 0.50%) = 0.4975%
0.60% (100% – 0.50% )2 = 0.5940%

Date LGD POD
1 100.9244 70.6471 0.5000% 1.002506 0.3541
2 102.5561 71.7893 0.4975% 0.985093 0.3518
3 103.4619 82.7695 0.5940% 0.955848 0.4699
CVA = 1.1758
The fair value of the floater is VND – CVA = 101.1773-1.1758 = 100.0015
Because the floater appears to be fairly priced therefore it should be purchased.
18. Question 18
The fair value of a 3-year 3% annual-pay corporate bond is 102.1610, and the 3- year
par yield for the comparable maturity government bond is 1.50%. The annual credit
spread over the benchmark bond is:
o A
78.25 bps.
o B
45.15 bps.
o C
74.71 bps.
Incorrect
C is correct. The yield to maturity (YTM) for the corporate bond given a fair value of
102.1610 is: PV = 102.1610, PMT = 3, N=3, FV = 100, CPT I/Y = 2.2471%. Therefore, the
credit spread over the benchmark bond is 0.7471% (= 2.2471% – 1.5000%). An
annual spread of 74.71 basis points per year for two years.
19. Question 19
The VND assuming no default for a 3-year, 3% annual payment corporate bond is
104.4152 and the CVA is 2.2542. If it is priced at 103, should this bond be purchased
?
o A
Yes, because it is under-valued.

o B
No, because it is over-valued.

o C
Yes, because it is fairly-valued.

Incorrect
B is correct. The fair value of the bond is VND – CVA. . Given that the bond is trading
at 103, it should not be purchased because it is over-valued.
20. Question 20
Consider a 3- year, 3.00% annual payment bond that is priced at 103 (per 100 of par
value). It has an annual default probability of 1.25% (the hazard rate) and a recovery
rate of 40%. Assuming 10% volatility calculate the credit valuation adjustment for the
bond. Use the government par curve in Exhibit 9 and the binomial interest rate tree
in Exhibit 10 of LM04 (curriculum). The value for the corporate bond assuming no
default (VND) is 104.4152.
Exhibit 9 LM04 -Par Curve for Annual Payment Benchmark Government Bonds,
Spot Rates, Discount Factors, and Forward Rates
Maturity Coupon Rate Price Discount Factor Spot Rate Forward Rate
1 -0.25% 100 1.002506 -0.2500%
2 0.75% 100 0.985093 0.7538% 1.7677%
3 1.50% 100 0.955848 1.5166% 3.0596%
Exhibit 10 of LM04 1- Year Binomial Interest Rate Tree for 10% Volatility
The following table shows the VND Calculations using the 1-Year Binomial Interest
Rate Tree for 10% Volatility
Date 0 Date 1Date 2 Date 3

99.3225 103
100.6884 Coupon 3.00
104.4152 Coupon 3 99.9694 103
101.6199 Coupon 3.00
100.5055 103
o A
2.2542.
o B
2.5042.
o C
2.8709.
Incorrect
A is correct. The VND for the bond is 104.4152. The calculations for the bond values
using the binomial interest rate tree are:
103/1.037026 = 99.3225
103/1.030315 = 99.9694
103/1.024820 = 100.5055
{(0.5 x 99.3225) + ( 0.5 x 99.9694)] + 3 / 1.019442 = 100.6884
{(0.5 x 99.9694) + ( 0.5 x 100.5055)] + 3 / 1.015918 = 101.6199
{(0.5 x 100.6884) + ( 0.5 x 101.6199)] + 3 / 1 – 0.0025 = 104.4152
The calculations for the CVA of the bond given an annual default probability of 1.25%
and a recovery rate of 40% are given below:
Expected exposures for date 1 and date 2:
[( 0.5 x 100.6884 ) + ( 0.5 x 101.6199)] + 3 = 104.1542
[(0.25 x 99.325) + ( 0.5 x 99.9694 ) + ( 0.25 x 100.5055)] + 3 = 102.9417
104.1542 × (1 – 0.40) = 62.4925
102.9417 × (1 – 0.40) = 61.7650
103 × (1 – 0.40) = 61.8000
1.25% × (100% – 1.25%) = 1.2344%
1.25% × (100% – 1.25%)2 = 1.2189%
Expected Discount Factor CVA Per Year

Date LGD POD
Exposure (DF) (LGDxPODxDF)
0
1 104.1542 62.4925 1.2500% 1.002506 0.7831
2 102.9417 61.7650 1.2344% 0.985093 0.7511
3 103.0000 61.8000 1.2189% 0.955848 0.7200
CVA = 2.2542
21. Question 21
Simon Ryker is a fixed-income analyst at Ace Securities. He has been asked to assess
a high-yield bond for possible inclusion into the firm’s diversified portfolio. Ryker
will most likely use the:
o A
structural model.
o B
reduced-form model.
o C
BSM model.
Incorrect
B is correct. Structural models require data which is usually with the managers of the
company, their commercial bankers and the credit rating agencies. Therefore, they
can be used for internal risk management, for banks’ internal credit risk measures,
and for publicly available credit ratings. Reduced- form models take the input values
from financial markets. Therefore, they are typically used by financial analysts trying
to value debt securities. The information required is easily available to external
parties. BSM is an option pricing model used by credit ratings agencies to estimate
credit parameters.
22. Question 22
The least likely advantage of the reduced-form models over the structural models is:
o A
the inputs are observable variables, including historical data.

o B
the economic reasons for default are explained.

o C
the default intensity is estimated using regression analysis on company-

specific variables and macroeconomic variables.
Incorrect
B is correct. A disadvantage to reduced- form models is that they, unlike structural
models, do not explain the economic reasons for default. Also, reduced- form
models assume that default comes as a “surprise” and can occur at any time. Default
is rarely a surprise because the issuer usually has been downgraded many times
before the final event occurs. A & C are advantages of the reduced-form models.
23. Question 23
Bond X is 4-year 5% annual-pay bond which is expected to undergo a credit ratings
downgrade from its current A rating. Its credit spread will change along with the
ratings change. With a credit spread migration, Bond X’s expected return will be
reduced. The least likely reason for the decrease in the expected return due to credit
spread migration is:
o A
the probabilities of change are symmetrical around the current rating.

o B
the probabilities for change are skewed toward a downgrade rather than an
upgrade.
o C
the increase in the credit spread is greater for downgrades than the decrease
in the spread for upgrades.
Incorrect
A is correct. The probabilities of change are not symmetrical but skewed toward a
downgrade rather than an upgrade. B & C are correct reasons for the reduction in
the expected return of Bond X.
24. Question 24
L.O.: c Q-Code: 21-L2-FI-CRAM-75278

Bond Y is a 5-year, 6% annual-pay BBB-rated bond. It will have a modified duration of
3.5 at the end of the year. The following table (reproduced from Exhibit 7 of LM04)
shows the one-year corporate transition matrix. The representative credit spreads
are also shown. Based on the representative one- year corporate transition matrix
and assuming no default,
what is the expected return on the bond over the next year? (Hint: Find the
adjustment in bps to the bond’s yield to maturity (YTM) over the next year).
Representative One- Year Corporate Transition Matrix (entries are %)
From/To AAA AA A BBB BB B CCC,CC,C

BBB 0.02 0.30 4.80 85.50 6.95 1.75 0.45
Credit Spread 0.60% 0.90% 1.10% 1.50% 3.40% 6.50% 9.50%
The expected return is Bond Y’s YTM:
o A
minus 0.65%.
o B
minus 0.78%.
o C
minus 0.82%.
Incorrect
C is correct. Bond Y is a BBB- rated corporate bond with a modified duration of 3.5 at
the end of the year. For each possible transition, the expected percentage price
change as the
product of the modified duration and the change in the spread is calculated below:
From BBB to AAA – 3.5 x ( 0.60% – 1.50% ) = + 3.15 %

From BBB to AA – 3.5 x ( 0.90% – 1.50% ) = + 2.10 %
From BBB to A – 3.5 x ( 1.10% – 1.50% ) = + 1.40 %
From BBB to BB – 3.5 x ( 3.40% – 1.50% ) = – 6.65.%
From BBB to B – 3.5 x ( 6.50% – 1.50% ) = – 17.50 %
From BBB to CCC,CC,C – 3.5 x ( 9.50% – 1.50% ) = – 28.00 %
The expected percentage change in bond value for a BBB- rated corporate bond is
found by multiplying each expected percentage price change for a possible credit
transition by its respective transition probability and summing the products:
(0.0002 × 3.15%) + (0.003 × 2.10%) + (0.048 × 1.40%) + (0.8550 × 0%) + (0.0695 × –
6.65%) + (0.0175 × –17.50%) + (0.0045 × –28.00%) = –0.8203%
The expected return on Bond Y over the next year is its yield to maturity minus
0.82%, assuming no default. Section 3.
25. Question 25
Tarra Smith is a young stock broker who has a FICO credit score of 750. Her credit
score last year was 765. Which of the following factors can least explain the
downgrade?
o A
She applied for a new car loan and was declined from her local bank.
o B
She does not check her FICO score monthly.

o C
Her bank lowered her limit on credit card from USD2,000 to USD1,000, for
the same average monthly balance.
Incorrect
B is correct. Self- checking one’s credit score has no impact. Self-checking is deemed
to be a “soft inquiry” and is not factored into the calibration of the FICO score. The
car loan is a new type of credit usage and thus does not have any late payments,
since it was denied it has a negative impact on the score. The credit card debt- to-
limit ratio is a component of the debt burden. A lower limit for the same average
balance increases the ratio and weakens the credit score.
26. Question 26
Consider a 2-year, zero-coupon corporate bond. The assumed recovery rate is 40%
and probability of default POD for each date is 1.30%. The government bond yield
curve is assumed to be flat at 3.00%. Default is assumed to occur at year-end on date
1, and date 2. The exposure on date 2 is 100. The credit valuation adjustment or CVA
is:
o A
1.46
o B
1.35.
o C
2.50.
Incorrect
A is correct. The following table gives the calculation of the CVA. The CVA is the value
of the credit risk in present value terms. LGD stands for the loss given default, POD
for the probability of default on the given date, POS for the probability of survival as
of the given date, DF for the discount factor, and PV for the present value.
Expected PV of
Dt( Exposure Recovery LGD POD POS
Loss (7) DF(8) Expected Loss
1) (2) (3) (4) (5) (6)
LGD xPOD (9)
1/1.03
97.0874× 1-
100/1.03 58.25 58.2524×1.3 = 0.7573×0.970
1 0.4 1.30% 0.013 =
= 97.0874 24 0% 0.9708 87= 0.7352
=38.8350 98.70%
= 0.7573 7
1.3%( 98.70%
1- - 1/1.032
60.00 0.013) 1.2831 = 0.76986×0.94
2 100 40.0000 0.76986
00 = %= 0.9426 26= 0.7257
1.2831 97.4169 0
% %
CVA
1.4609
=
27. Question 27
Consider a one-year 5% annual pay corporate bond priced at par. The credit agency’s
data set on the historical default experience for 1- year corporate bonds issued by
companies having the same business profile as the issuer reveals that 1% of such
bonds default. The average recovery rate is 40%. The government bond yield curve is
flat at 3.00%. The probability of default is closest to:
o A
1%.
o B
99%.
o C
3%.
Incorrect
C is correct. The probability of default, is the probability that a bond issuer will not
meet its contractual obligations on schedule. In credit risk modeling risk-
neutral probabilities of default are used instead of actual (or historical) default
probabilities. The recovery rate = 40%. If default occurs at end of year the investor
receives = 105×40% = 42. Therefore, let the risk- neutral default probability be P*-
0 The probability of survival is 1 – P*. Given that the corporate bond is priced at 100,
solving for the risk-neutral probability of default P*. 100 = [105x (1- P*)] + (42xP*) /
1.03 => 3.1746%
28. Question 28
o A
Expected exposure to default loss is the expected amount that may be lost if
default occurs, before factoring in recovery.
o B
Recovery rate is percentage of the loss recovered from a bond in

default.
o C
The loss given default for a one-year 5% annual pay corporate bond
priced at par, with an assumed recovery rate of 40% is 60.
Incorrect
C is correct. The loss given default for a one-year 5% annual pay corporate bond
priced at par, with an assumed recovery rate of 40% = 105(1- 40%) = 63.
Connie Yeo is a fixed-income analyst at KMS Mutual Fund. She is analyzing the following
securities for investment by her firm.
Fixed-
Income Features
Securities
Zero- coupon, 3- year corporate bond with a par value of 100.
The estimates obtained from the research department for risk-
Bond X neutral probability of default (the hazard rate) for each date for
the bond and the recovery rate are 1.25%, and 30%
respectively.
Similar features as Bond X, except a 4% annual payment
Bond Y
corporate bond.
She performs the analysis by assuming no interest rate volatility and that the government
bond yield curve is flat at 2.5%. To understand the effect on the bond’s fair value Yeo
increases the recovery rate and the probability of default. She increases both by 20% of
their existing estimates and calculates the bond’s fair value again.
1. Question 1
If Bond X trades at 92, under the original estimates of recovery rate and probability
of default it is:
o A
over-valued.
o B
under-valued.
o C
fairly-valued.
Incorrect
A is correct. First calculate the credit valuation adjustment CVA. The CVA is the value
of the credit risk in present value terms. LGD stands for the loss given default, POD
for the probability of default on the given date, POS for the probability of survival as
of the given date, DF for the discount factor, and PV for the present value.
The price of the default free 3-year zero-coupon bond is 100xDF Year 3 = 100 x
0.9286 = 92.86. The fair value of Bond X = (92.8600 – 2.4072) = 90.4528. At 92, it is
over-valued.
2. Question 2
The fair value of Bond X under new estimates of the recovery rate and probability of
default is closest to:
Expected PV of
D
Recove Loss (7) Expected
t Exposure
ry LGD POD Loss (9)
(1 (2) POS (6) LGDxP DF (8)
(3) (4) (5) LGDxPODx
) OD DF
0
100/1.025 1- 1/1.025
34.265 60.91
1 2
= 1.50% 0.015= 0.9137 = 0.8914
3 61
95.1814 98.50% 0.9756
1.5%(1
- 98.5%-
1.4775% 1/1.0252
100/1.025 35.122 62.43 0.015) 0.9225×0.95
2 = = 0.9225 =
= 97.5610 0 90 18= 0.8780
1.4775 97.0225 0.9518
% %
1.5%(1 97.0225
- %-
1/1.0253 0.9314×0.92
36.000 64.00 0.015)2 1.4553% 86=
3 100 0.9314 =
0 00 = =
0.9286 0.8649
1.4553 95.5672
% %
CVA = 2.6343
o A
89.60.
o B
94.33.
o C
90.23.
Incorrect
C is correct. With the change in estimates, the recovery rate = 30%x1.20 = 36%, and
the probability of default = 1.25%x1.20 = 1.50%. The calculation of CVA is as follows:
PV of
Expected
Dt Recover Expected Loss
Exposure Loss (7)
(1 y LGD (9)
(2) POD (5)POS (6) LGDxPO DF (8)
) (3) (4) LGDxPODxD
D
F
0
100/1.0252 60.916 1-0.015= 1/1.025
1 34.2653 1.50% 0.9137 0.8914
= 95.1814 1 98.50% = 0.9756
1.5%(1- 98.5%-
100/1.025 62.439 0.015)= 1.4775% 1/1.0252 0.9225×0.9518
2 35.1220 0.9225
= 97.5610 0 1.4775 = = 0.9518 = 0.8780
% 97.0225%
1.5%(1-
97.0225%
0.015)2 0.9314×0.9286
64.000 -1.4553% 1/1.0253
3 100 36.0000 = 0.9314 =
0 = = 0.9286
1.4553 0.8649
95.5672%
%
CVA = 2.6343
There is no change in exposures. Changes in the hazard and recovery rates do not
a?ect the value of the default free bond. So, it is the same as in the previous question
= 100/1.0253 = 92.86. Value of CVA increases from 2.4072 to 2.6343. The fair value of
Bond X decreases to = 92.86 — 2.6343 = 90.2257.
3. Question 3
The fair value of Bond Y under the original estimates of the recovery rate and
probability of default is closest to:
o A
103.0.
o B
101.7.
o C
104.3.
4. Question 4
Bond Y trades at 109. If the bond is purchased at this price and it defaults on Date 2,
the rate of return to the investor would be closest to:
o A
-28%.
o B
-32%.
o C
-44%.
Incorrect
C is correct. If default occurs on Date 2, the internal rate of return (IRR) is: CF0 = -109,
CF1 = 4, CF2 = 31.6390 (recovery at date 2), IRR CPT = -44.26%.
Paula Anderson, a junior analyst is asked to analyze a 3-year 3.5% annual pay corporate
bond that is trading at 103.5 (per 100 of par value). She performs the credit analysis
assuming an upward- sloping yield curve and volatile interest rates. The following table
shows the data on annual payment benchmark government bonds. (This is reproduced
from Exhibit 9 of R37). She constructs a binomial interest rate tree (reproduced from Exhibit
10 of R37) based on an assumption of future interest rate volatility of 10%. Par Curve for
Annual Payment Benchmark Government Bonds, Spot Rates, Discount Factors, and
Forward Rates
Coupon
Maturity Price Discount Factor Spot Rate Forward Rate
Rate
1 -0.25% 100 1.002506 -0.2500%
2 0.75% 100 0.985093 0.7538% 1.7677%
3 1.50% 100 0.955848 1.5166% 3.0596%
Anderson uses an annual default probability of 2.0% (the hazard rate) and a recovery rate
of 50%.
1. Question 1
Based on her analysis, the fair value of the bond is closest to?
o A
106.0.
o B
102.9.
o C
104.2.
Incorrect
B is correct. The VND for the bond using the binomial interest rate tree are:
103.5 / 1.037026 = 99.8046
103.5 / 1.030315 = 100.4547
103.5 / 1.024820 = 100.9933
[(0.5 x 99.8046) + (0.5 x 100.4547)] + 3.5 / 1.019442 = 101.6533
[(0.5 x 100.4547) + (0.5 x 100.9933)] + 3.5 / 1.015918 = 102.5910
[(0.5 x 101.6533) + (0.5 x 102.5910)] + 3.5 / (1 – 0.0025) = 105.8869VND
The calculations for the CVA of the bond given an annual default probability of 2.00%
and a recovery rate of 50% are given below:
Expected exposures for date 1 and date 2: [(0.5 x 101.6533) + (0.5 x 102.5910)] + 3.5
= 105.6222
[(0.25 x 99.8046) + (0.5 x 100.4547) + (0.25 x 100.9933)] + 3.5 = 103.9268
Exposure for date 3 = 103.50.
105.6222 × (1 – 0.50) = 52.8111
103.9268 × (1 – 0.50) = 50.4634
103.5 × (1 – 0.50) = 51.7500
2.00% × (100% – 2.00%) = 1.96%
2.00% × (100% – 2.00%)2 = 1.9208%

Date LGD POD
0.
1. 105.6222 52.8111 2.000% 1.002506 1.0589
2. 100.4286 50.4634 1.9600% 0.985093 0.9743
3. 103.5000 51.7500 1.9208% 0.955848 0.9501
CVA = 2.9833
Fair value of the bond = VND – CVA = 105.8869 – 2.9833 = 102.9036.
2. Question 2
What is the credit spread of the 3-year, 3.5% annual-pay corporate bond over a
comparable government bond? The credit spread is closest to:
o A
200bps.
o B
90 bps.
o C
100 bps.
Incorrect
C is correct. The VND as calculated in Q#5 = 105.8869 or using the DF (3.5 x
1.002506) + (3.5 x 0.985093) + (103.5 x 0.955848) = 105.8869 . The fair value of this
bond (Q#5) = 102.9. The YTM is:CF0 = -102.9, CF1 = 3.5, CF2 = 3.5, CF3 = 103.5, IRR
CPT = 2.485%. The YTM of a theoretical comparable- maturity government bond with
the same coupon rate as the corporate bond is: CF0 = 105.8869, CF1-CF2 = 3.5, CF3 =
103.5. IRR CPT = 1.480%. The credit spread = 2.485%-1.480% = 1.005% or 100.5bps.
3. Question 3
Anderson decreases the recovery rate and the probability of default by 20% of their
existing estimates and determines the bond’s fair value again. The new fair value
is closest to:
o A
103.00
o B
104.00
o C
102.60.
Incorrect
A is correct. For the 3-year 3.5% corporate bond, the VND remains at 105.8869.
Calculations with the new recovery rate 0.5(1-0.20) = 40% and annual probability of
default 2(1-0.2) = 1.60% are as follows:
Using the binomial interest rate tree, values on date 2 are 99.8046, 100.4547 and
100.9933 and values on date 1 are 101.6533 and 102.5910
Expected exposures for date 2 and date 1:
[(0.25 x 99.8046) + (0.5 x 100.4547) + (0.25 x 100.9933)] + 3.5 = 103.9268
[(0.5 x 101.6533) + (0.5 x 102.5910)] + 3.5 = 105.6222
Expected exposure for date 3 = 103.50
105.6222 × (1 – 0.40) = 63.3733
103.9268 × (1 – 0.40) = 62,351
103.5 × (1 – 0.40) = 62.1000
1.60% × (100% – 1.60%) = 1.5744%
1.60% × (100% – 1.60%)2 = 1.5492%

Date LGD POD
0
1 105.6222 63.3733 1.6000% 1.002506 1.0165
2 103.9268 62.3561 1.5744% 0.985093 0.9671
3 103.5000 62.1000 1.5492% 0.955848 0.9196
CVA = 2.9032
Fair value of the bond = VND – CVA = 105.8869 – 2.9032 = 102.9837.
Kelly Rowland, an analyst at ANB Investment Bank is evaluating a 3 – year A-rated floating
rate note. The issuer is also A-rated. The bond’s coupon is the one-year benchmark rate plus
1%. Rowland’s supervisor Linda Brett has asked her to make a recommendation regarding
the existing position of the bank in the FRN. The estimates obtained from the research
department for risk- neutral annual probability of default (the hazard rate) and the recovery
rate are 1.50%, and 40%. The market price of the FRN is 102.30. Rowland uses the following
information for carrying out the credit analysis on the FRN. Par Curve for Annual Payment
Benchmark Government Bonds, Spot Rates, Discount Factors, and Forward Rates
Discount Forward
Maturity Coupon Rate Price Spot Rate
Factor Rate
1 -0.25% 100 1.002506 -0.2500%
2 0.75% 100 0.985093 0.7538% 1.7677%
3 1.50% 100 0.955848 1.5166% 3.0596%
Rowland constructs a binomial interest rate tree (reproduced from Exhibit 10 of R31) based
on an assumption of future interest rate volatility of 10% and calculates the fair value of the
FRN. Rowland believes that
the issuer of the FRN which is in the manufacturing sector will face a decline in the
profitability next year. She increases the probability of default estimate from 1.50% in Year 1
to 2.00% in Years 2, and 3 and recomputes the fair value of the FRN. Rowland shows her
calculations to Brett. After reviewing Rowland’s work, Brett feels that the ratings of the
issuer will undergo a change.
1. Question 1
Based on the fair value of the FRN calculated, Rowland’s recommendation
should most likely be to:
o A
hold the FRN.

o B
sell the FRN.

o C
add the FRN to the existing position.

Incorrect
B is correct. The following table shows the valuation of the FRN, assuming no default,
which has a quoted margin of 1%.
Date 0 Date 1 Date 2 Date 3

101.9300 100.9643
104.7026
1.9442% 3.7026%
VND Coupon = 2.9442
102.9435 Coupon = -0.25 100.9706
104.0315
-0.2500% +1.00 = 0.75 3.0315%
Coupon = 2.5918
101.9423 100.9758
103.4820
1.5918% 2.4820%
The expected exposure to default loss are calculated below:
For date 1: [ 101.9300 x 0.5) + (101.9423 x 0.50)] + 0.75 = 102.6862
For date 2: [100.6943 x 0.25) + (100.9706 x 0.5) + (100.9758 x 0.25)] + [(2.9442 x 0.5) +
(2.5918 x 0.5)] = 103.7383
For date 3: [(104.7026 x 0.25) + (104.0315 x 0.5) + (103.4820 x 0.25)] = 104.0619
The calculations for LGD are:
Date 1: 102.6862 x (1 – 0.4) = 61.6117
Date 2: 103.7383 x (1 – 0.4) = 62.2430
Date 3: 104.0619 x (1 – 0.4) = 62.4371
The calculations for the POD for date 2 and date 3 are
1.50%(100% – 1.50%) = 1.4775%
1.50%(100% – 1.50%)2 = 1.4553%

Date LGD POD
0
4.
102.6862 61.6117 1.50000% 1.002506 0.9265
2. 103.7383 62.2430 1.4775% 0.985093 0.9059
3. 104.0619 62.4371 1.4553% 0.955848 0.8685
CVA = 2.7009
The fair value of the floater is VND – CVA = 102.9435 -2.701= 100.2425. Because the
market price of 102.3 is greater than the estimated fair value, the analyst should
recommend selling the FRN.
2. Question 2
Based on Rowland’s new estimate of the probability of default, assuming no default,
which of the following statements regarding the fair value of the FRN is correct ?
o A
The fair value of the FRN will increase 100.44.

o B
CVA will decrease to 2.600.

o C
The fair value will decrease to 99.66.

Incorrect
C is correct. The changing of the annual probability of default will not affect VND of
the FRN which remains 102.9435. The expected exposures, loss given default, and
discount
factors are also unaffected by the changing probability of default. The following is
the completed credit valuation adjustment table:

Date LGD POD
0
1 102.6862 61.6117 1.5000% 1.002506 0.9265
2%(1-0.015)
2 103.7383 62.2430 0.985093 1.2079
= 1.97%
2%(1-
0.015)(1-
3 104.0619 62.4371 0.955848 1.1522
0.02) =
1.9306%
CVA = 3.2866
By increasing the annual default probability for year 2 and Year 3, the CVA increases
to 3.2866 and the fair value falls to 102.9435 – 3.2866 = 99.6569.
3. Question 3
Based on the research department assumption about the probability of default and
Rowland’s own assumption, Brett most likely expects the issuer to be:
o A
downgraded from A to BBB by the credit agencies.

o B
placed on watch with a negative outlook.

o C
upgraded from A to AA.

Correct
B is correct. The credit rating agencies usually make incremental changes as seen in
a transition matrix provided in Exhibit 7 of the reading. The bond appears to be
overvalued, according to Rowland’s and the firm’s assessment of the probability of
default and the recovery rate than that of the agencies. Therefore, it is likely that the
credit rating agencies put the issuer on a negative watch. A is incorrect because the
rating agencies rarely jump an issuer all the way from A to BBB. C is incorrect
because the bond is perceived to be overvalued so Rowland and Brett do not expect
a credit upgrade. According to Exhibit 7 of the reading an A- rated issuer has an
87.50% probability of remaining at that level, a 0.05% probability of moving up to
AAA, a 2.50% probability of moving up to AA, an 8.40% probability of moving down to
BBB.
Credit Default Swaps

1. Question 1
Q-Code: 21-L2-FI-CDSW-75259
Consider two sports car manufacturers, Alpine and Delfino. The credit quality of
Alpine is expected to improve over the next quarter and that of Delfino is anticipated
to weaken over the same time period. An investor can benefit from this scenario by:
o A
going short both Alpine and Delfino CDS contracts.

o B
going short an Alpine CDS and long a Delfino CDS.

o C
going long an Alpine CDS and short a Delfino CDS.

Incorrect
C is correct. In the CDS market, because the credit protection buyer promises to
make future payments, he/she is regarded as being short and the credit protection
seller who receives payments till a credit event is triggered, is considered as being
long. If the credit quality on an underlying debt improves, the credit protection seller
benefits. On the contrary if the credit quality deteriorates, the credit protection
buyer benefits. Because the credit quality of Alpine is expected to improve and
Delfino is expected to weaken, an investor should take a long position in Alpine CDS
and a short position in the Delfino CDS.
2. Question 2
Q-Code: 23-L2-FR-CDSW-197996
An investor believes that a company will undergo a leveraged buyout (LBO)
transaction. In this pursuit, it will issue large amounts of debt and use the proceeds
to repurchase all of the publicly traded equity. In anticipation of this corporate
action, which equity-versus-credit trade an investor would most likely execute?
o A
Buy the stock and buy credit protection.

o B
Sell the stock and sell credit protection.

o C
Buy stock and sell credit protection.

Incorrect
Solution: A is correct. The investor might consider buying the stock and buying
credit protection. Both transactions will be profitable if the LBO occurs because the
stock price will rise as the company repurchases all outstanding equity while the CDS
price will rise as its spread widens to reflect the increased probability of default.
3. Question 3
An investor buys $10 million of six-year protection, and the CDS contract has a
duration of five years. The company’s credit spread was originally 600 bps and
widens to 750 bps. The investor (credit protection buyer) would:
o A
benefit from the change in credit spread.

o B
lose from the change in credit spread.

o C
remain unaffected from the change in credit spread.

Incorrect
Solution: A is correct. The investor owns protection and is therefore short the credit
exposure. The credit quality of the underlying deteriorates as the credit spread
widens. Hence, the value of the credit protection he owns increases.
4. Question 4
Assume a high-yield company’s 10-year credit spread is 700 bps and the duration of
the CDS is 7 years. Assume high-yield companies have 6% coupons on their CDS. The
approximate upfront premium required to buy 10-year CDS protection would
be closest to:
o A
7% of notional.
o B
1% of notional.
o C
0%.
Incorrect
Solution: A is correct. A good approximation of the present value of a stream of
payments can be made by multiplying the payment rate by the duration:
Upfront premium ≈(Credit spread-Fixed coupon)*Duration
≈(700bps-600bps)*7 = 7% of notional
5. Question 5
A German company files for bankruptcy, triggering various CDS contracts. It has two
series of senior bonds outstanding: Bond X trades at 30% of par, and Bond Y trades
at 50% of par. Investor A owns €10 million of Bond X and owns €10 million of CDS
protection. Investor B owns €10 million of Bond Y and owns €10 million of CDS
protection. Investor B would:
o A
prefer to cash settle his CDS contract.

o B
prefer to physically settle his CDS contract.

o C
be indifferent between cash and physical settlement.

Incorrect
Solution: A is correct. Investor B would prefer a cash settlement because he owns
Bond Y, which is worth more than the cheapest-to-deliver obligation. He will receive
the €7 million payout [(1 – 30%) × €10 million] on his CDS contract and can sell the
bond for €5 million, for total proceeds of €12 million. If he were to physically settle
his contract, he would receive only €10 million, the face amount of his bond.
6. Question 6
Palmer Securities adheres to ISDA (International Swaps and Derivatives Association)
protocols for credit default swap (CDS) transactions. All contracts must conform to
ISDA specifications. A portfolio manager at a wealth management fund intends to
discuss investment opportunities with a strategist at Palmer. Before the fund can
engage in trading CDS products with Palmer, it must satisfy compliance
requirements.
To satisfy the compliance requirements, the fund is most likely required to:
o A
set a notional amount.

o B
sign an ISDA master agreement.

o C
post an upfront payment.

Incorrect
Solution: B is correct. To satisfy the compliance requirements, the wealth fund must
sign an ISDA master agreement with Palmer. The ISDA master agreement is a
document that lays down the rules that all CDS contracts must conform to and other
guidelines for the functioning of the CDS market. All parties to a CDS sign the
agreement.
7. Question 7
Malika Kamran, chief credit analyst at IFT Investments, reviews MIDA Corporation’s
five-year bond currently yielding 7.50%. Kamran notices that a comparable five-year
CDS contract has a credit spread of 4.0%. Since Libor is 2.50%, Kamran considers a
basis trade to take advantage of the pricing difference between the MIDA’s bonds
and CDS.
The basis trade that would most likely take advantage of the current pricing difference
is:
o A
purchase the 5-year comparable CDS and go long the 5-year MIDA bond.
o B
purchase the 5-year comparable CDS and short the 5-year MIDA bond.
o C
purchase the 5-year synthetic CDO and sell the 5-year CDS.
Incorrect
A is correct. The 5-year MIDA bond and the comparable CDS imply different credit
spreads. Credit risk is cheap in the CDS market (4.0%) compared to the bond market
(5.0% = 7.50% – 2.50%).
Therefore, an investor should buy protection in the CDS market at 4.0%, and go long
the MIDA bond, thereby earning 5.0% for assuming the credit risk.
8. Question 8
Brad Newman, chief credit analyst is interviewing Penny Kimmel, an analyst.
Newman questions Kimmel, “Suppose an investor sells five-year CDS protection on
Company X with the premiums paid quarterly over the next five years. What is the
probability of survival for Company X, assuming a constant hazard rate of 3% per
quarter?”
The probability of survival through the second quarter is closest to:
o A
94.09%.
o B
5.91%.
o C
96.04%.
Incorrect
A is correct. The probability of survival through the first quarter is 97%, and the
conditional probability of survival through the second quarter is also 97%. The
probability of survival through the second quarter = 97% × 97% = 94.09%.
9. Question 9
Brian Miller, chief investment officer Greer Advisors, which specializes in derivatives,
buys USD600 million of protection on the CDX HY index (100 constituents). Miller
believes that the creditworthiness of a few of the components will improve, hence he
takes a position on a portion of the credit risk in each. For ASIX Glass, he sells USD5
million of single-name CDS protection. The credit quality of ASIX subsequently
improves.
Greer Advisors’ net notional exposure to ASIX Glass is closest to:
o A
USD2.6 million.
o B
USD1.0 million.
o C
USD0.5 million.
Incorrect
B is correct. Greer Advisors is short USD6 million notional (USD600 million/100)
through the index CDS and is long USD5 million notional through the single-name
CDS. His net notional exposure is USD1 million.
10. Question 10
Shehla Muneer, director research, makes the following three comments regarding
the credit curve to the analysts covering the CDS market for various bonds.
Comment I: “The credit curve is similar to the term structure of interest rates, but it
applies to non-government borrowers and considers credit risk.
Comment II: The curve is impacted by various factors, with hazard rates being the
most important.
Comment III: Downward-sloping curves are less common, because they are a result
of longterm stress in the financial markets.”
Which of Muneer’s comments is least likely correct ?
o A
I
o B
II
o C
III
Incorrect
C is correct. Downward-Sloping credit curves imply a greater probability of default in
earlier years. They are less common, and usually occur due to severe near-term
stress in the financial markets.
11. Question 11
Angela owns some bonds issued by Alcarta Corp. She has become concerned about
a default in the long-run but is not worried about default in the short-term. Alcarta’s
two-year CDS trades at 300 bps, and the five-year CDS trades at 500 bps. Which of
the following curve trades would best hedge her risk?
o A
Going short (buying protection) in the five-year CDS, and going long
(selling protection) in the two-year CDS.
o B
Going long (selling protection) in the five-year CDS, and going short (buying
protection) in the two-year CDS.
o C
Going short in the five-year CDS, while taking no position in the two-year CDS.
Incorrect
A is correct. Angela anticipates steepening of curve, and can hedge the default risk
by positioning herself short (buying protection) in the five-year CDS while going long
in the two-year CDS (selling protection). B is incorrect because Angela is concerned
about default in the long-run. C is incorrect because going short one CDS is more
expensive and riskier than a curve trade.
12. Question 12
In a CDS contract, the party that agrees to make a series of fixed periodic payments
to the counterparty over the contract term in return for a promise to be
compensated by the counterparty in case of default is best known as:
o A
the credit protection buyer.

o B
the credit protection seller.

o C
an option seller.
Incorrect
A is correct. A CDS contract has a credit protection buyer and the credit protection
seller. The credit protection buyer makes a series of fixed payments to the seller
over the contract life in return for a promise to be compensated by the protection
seller for credit losses resulting from a default.
13. Question 13
A company’s 10-year CDS trades at a credit spread of 600 bps, and the 5-year CDS
trades at a credit spread of 350 bps. Suppose the 10-year spread widens by 120 bps,
whereas the credit spread of the 5-year CDS remains unchanged. The change in the
credit curve suggests that:
o A
the company’s longer-term creditworthiness has improved.

o B
the company’s longer-term creditworthiness has deteriorated.

o C
the company has become riskier than before in the short term.
Incorrect
B is correct. The credit curve change shows that the company is not any riskier than
before in the short term (5 years). However, its longer-term (10 year)
creditworthiness has deteriorated.
14. Question 14
An upward-sloping credit curve most likely indicates:
o A
a greater possibility of default in later years.

o B
a greater possibility of default in earlier years.

o C
that the probability of default will remain unchanged through time.

Incorrect
A is correct. An upward-sloping credit curve indicates a greater probability of default
in later years. B is incorrect because a downward-sloping curve reflects default
probability in earlier years. C is incorrect because a constant probability of default
will result in flattening of the credit curve.
15. Question 15
The upfront payment at the start of the CDS contract is paid by the protection buyer
to the protection seller if:
o A
the upfront payment is less than zero.

o B
value of premium leg is greater than the value of protection leg.

o C
the present value of protection leg is greater than present value of

premium leg.
Incorrect
C is correct. Upfront payment is defined as: Present value of protection leg – Present
value of premium leg. If the difference between the present value of protection leg
and present value of premium leg is greater than zero, then the protection buyer
pays the protection seller at the initiation date of the CDS contract. If the difference
is less than zero, the upfront payment is made by the protection seller to the
protection buyer.
16. Question 16
Consider a company with a constant hazard rate of 3% per quarter. An investor sells
5-year CDS protection on the company with payments made quarterly over the life
of the CDS contract. The conditional probability of survival for the second quarter,
and the probability of default (sometime) during the first two quarters are closest to:
Conditional probability of survival Probability of default during first

for 2nd quarter two quarters
A. 3%. 97%
B. 97% 6%
C. 94%. 12%.
o A
Option A.
o B
Option B.
o C
Option C.
Incorrect
B is correct. The conditional probability of survival for the second quarter is 97%,
because the hazard rate is constant at 3% each quarter. The probability of survival is
97%, in the first quarter and the conditional probability of survival through the
second quarter is also 97%. The probability of survival through the second quarter =
97% × 97% = 94.09%. Hence, the probability of default sometime during the first two
quarters =1 – 94.09% = 5.91%.
17. Question 17
The most common settlement method for CDS following a credit event declaration
is:
o A
cash settlement.
o B
physical settlement.
o C
bond delivery.
Incorrect
A is correct. Cash settlement is the most common settlement method for CDS
contracts. Physical settlement of CDS involving actual delivery of debt instrument is
uncommon.
18. Question 18
A company files for bankruptcy, triggering CDS contracts. It has two series of senior
bonds outstanding: Bond P, which is trading at 40% of par, and Bond Q, which is
trading at 50% of par. The recovery rate for both CDS contracts is closest to:
o A
50%.
o B
40%.
o C
60%.
Incorrect
B is correct. The recovery rate is 40% for both CDS contracts, since Bond P is the
cheapestto-deliver obligation.
19. Question 19
The three main types of credit events are:
o A
bankruptcy, voluntary restructuring, issuance of equity.

o B
IPO, liquidation, litigation.

o C
bankruptcy, involuntary restructuring, failure to pay.
Incorrect
C is correct. The three types of credit events are: bankruptcy, failure to pay,
involuntary restructuring.
20. Question 20
KLD Corp. issues bonds with a credit spread of 700 bps. A 10-year CDS against these
bonds bears an annual coupon rate of 5%. Which of the following statements is least
likely correct ?
o A
The protection buyer agrees to make annual payments of 5% over the life of
the CDS.
o B
The protection seller promises to make annual payments amounting to

5% over the life of the contract.
o C
The protection buyer will make an upfront payment to the protection seller
because the standard rate is lower than the CDS credit spread.
Incorrect
B is correct. A 5% coupon rate implies that the protection buyer agrees to make
annual payments of 5% over the life of the contract. If the CDS coupon rate (5%) is
lower than the credit risk of the entity (7%), the protection buyer makes an upfront
payment to the protection seller. A & C are correct statements.
21. Question 21
An advantage of an index CDS is that it permits investors to take positions on:
o A
the credit risk of a particular bond issuer.

o B
ETFs.
o C
the credit risk of a combination of borrowers.

Incorrect
C is correct. An index CDS allows investors to take positions on the credit risk of a
group of borrowers (companies). B is incorrect because CDS are written on debt
instruments whereas exchange-traded funds are combinations of equities of
different companies. Although an index CDS is traded in the same way ETFs are
traded. A is incorrect because CDS on one particular bond issuer is called a single-
name CDS.
Sam Bright, chief investment officer M&R Investment Bank, is reviewing the bank’s
fixedincome portfolio, specifically IJI bond – a ₤5 million five-year senior unsecured bond. A
few months after the purchase of the IJI bond, Bright had purchased a ₤5 million CDS with a
standardized coupon rate of 5%. The reference obligation of the CDS is the IJI bond. Bright
asks Dave Roberts, credit risk analyst, about the settlement protocol on IJI bonds if the
borrower defaults on its interest payments. Robert collects the following information on the
IJI bonds currently outstanding: Bond I: A three-year senior unsecured bond trading at 30%
of par Bond II: A five-year senior unsecured bond trading at 40% of par Bond III: A five-year
subordinated unsecured bond trading at 20% of par A month later, IJI fails to make a
scheduled interest payment on the outstanding subordinated unsecured obligation after a
grace period; but no bankruptcy is filed. Bright asks Roberts to determine if IJI experienced
a credit event.
1. Question 1
If IJI experienced a credit event, the recovery rate for the CDS contract is
o A
30%.
o B
40%.
o C
20%.
Incorrect
A is correct. Bond I is the cheapest-to-deliver obligation, trading at 30% of par, so the
recovery rate for the CDS contract is 30%. Although Bond III trades at a lower dollar
price, it is subordinated and, therefore, does not qualify for coverage under the
senior CDS.
2. Question 2
If IJI experienced a credit event, the settlement preference would most likely be:
o A
a physical settlement.
o B
a cash settlement
o C
indifferent between a cash or physical settlement.

Incorrect
B is correct. A cash settlement would be likely preferred by M&R. M&R owns Bond II
(trading at 40% of par), which is worth more than the cheapest-to-deliver obligation
(Bond I trading at 30% of par). Therefore, M&R can cash settle for ₤3.5 million [= (1 –
30%) × 5 million] on its CDS contract and sell Bond II it owns for ₤2 million, for total
proceeds of ₤5.5 million. If M&R were to physically settle the contract, only ₤5 million
would be received, the face amount of the bonds and they would deliver Bond II. A is
incorrect because if M&R were to phyically settle the contract, they would receive
only ₤5 million, which is less than the amount obtained from a cash settlement. C is
incorrect because M&R would receive more if they were to cash settle, so they would
not be indifferent.
3. Question 3
Which of the following statements is most likely correct? Roberts conclusion is:
o A
IJI experienced a credit event.

o B
IJI did not experience a credit event because it did not file for
bankruptcy.
o C
IJI did not experience a credit event because it still has to make its principal
payment.
Incorrect
A is correct. “IJI experienced a credit event when it failed to make the scheduled
coupon payment on the outstanding subordinated unsecured obligation. Failure to
pay, a credit event, occurs when a borrower does not make a scheduled payment of
principal or interest on any outstanding obligations after a grace period, even
without a formal bankruptcy filing.”
Jenna May, a fixed-income portfolio manager at Crossby Advisors, asks Asa Hideaki, a
derivatives analyst, to determine if an upfront payment would be required and if so
calculate the premium amount on a 5-year CDS on BJA Industries. Hideaki collects the
information for the CDS given in Table 1. Table 1: Selected Information on 5-Year CDS on
BJA Industries
Credit Spread 300 bps

Duration 3 years
Coupon Rate 1%
May purchases the 5-year CDS on BJA Industries bond. After buying the 5-year CDS, the
credit spread for BJA widens by 250 basis points. May wants to unwind its CDS position on
BJA Industries by entering into new offsetting contracts.
1. Question 1
Based on Table 1, the upfront premium as a percent of the notional required to buy
the 5-year CDS on BJA Industries is closest to:
o A
2%.
o B
6%.
o C
9%.
Incorrect
B is correct. ??????? ??????? = (?????? ?????? − ????? ??????) × ????????. ??????? ???????
???????? ?? ?? ???? for 5 − ???? ??? ?? ??? = [(300 − 100) × 3 = 6% ?? ?ℎ? ????????.
2. Question 2
If May enters into new offsetting contracts after purchasing the CDS on BJA, the firm
would most likely:
o A
gain from the CDS position.

o B
lose from the CDS position

o C
neither gain nor lose from the CDS position

Incorrect
A is correct. Crossby Advisors purchased protection, hence are economically short
and benefit from an increase in the company’s spread. Because after purchasing the
protection, the credit spread widened by 250 basis points. Therefore, the firm
realizes a gain by entering into a new offsetting contract (sells the protection for a
higher premium to another party). A loss to the credit protection buyer would be if
the credit spread decreases.
3. Question 3
The price change in the 5-year CDS on BJA debt, after widening of the credit spread is
closest to:
o A
2.5%
o B
3.5%
o C
7.5%.
Incorrect
C is correct. %Change in CDS price = change in spread in bps x duration = 250 × 3 =
7.5%.
Akio Hiroshi, chief credit analyst at NIPO Investments, reviews ASCS Corporation’s five-year
bond currently yielding 6%. Hiroshi notices that a comparable five-year CDS contract has a
credit spread of 3.75%. Since Libor is 2.0%, Hiroshi considers a basis trade to take advantage
of the pricing difference between the ASCS’s bonds and CDS.
1. Question 1
Based on the information above, 5-year ASCS bond’s credit spread is:
o A
2.00%.
o B
2.25%.
o C
4.00%.
Incorrect
C is correct. The credit spread = ASCS bond yield – Libor = 6.0% − 2.0% = 4.0%.
2. Question 2
The basis trade that would most likely take advantage of the current pricing
difference is:
o A
purchase the 5-year comparable CDS and go long the 5-year ASCS bond.
o B
purchase the 5-year comparable CDS and short the 5-year ASCS bond.
o C
purchase the 5-year synthetic CDO and sell the 5-year CDS
Incorrect
A is correct. The 5-year ASCS bond and the comparable CDS imply different credit
spreads. Credit risk is cheap in the CDS market (3.75%) compared to the bond
market (4.0%).
Therefore, an investor should buy protection in the CDS market at 3.75%, and go
long the ASCS bond, thereby earning 4.0% for assuming the credit risk.
3. Question 3
Based on the basis trade, for ASCS, if convergence occurs in the bond and CDS
markets, the trade will capture a profit closest to:
o A
0.25%.
o B
2.25%.
o C
1.75%.
Incorrect
A is correct. The credit risk is cheap in the CDS market relative to the bond market. If
the CDS and the bond are both purchased, and convergence occurs, the profit
captured by trade will be the differential in the two markets 4.0% − 3.75% = 0.25%.
DERIVATIVES
Pricing and Valuation of Forward

Commitments
1. Question 1
Q-Code: 21-L2-DV-PVFC-74225
Which of the following is least likely a feature of currency swaps? Currency swaps:
o A
involve an exchange of notional amounts at the start and at the expiration of

the swap.
o B
involve payments that are in different currency units on each leg of the swap.
o C
have payments which are netted at each leg.

Incorrect
C is correct. Options A and B represent features of currency swaps.
2. Question 2
Which of the following is not true about equity swaps?
o A
The underlying reference instrument for the equity leg can be an individual
stock, a published stock index, or a custom portfolio.
o B
The equity leg cash flow can be with dividends

o C
All the interest rate swap nuances exist with equity swaps that have a fixed or
floating interest rate leg.
Incorrect
Solution: B is correct. The equity leg cash flow can be with or without dividends.
3. Question 3
Suppose a company has issued fixed-rate bonds to the investors and is now
concerned about a decline in interest rates. It can create a synthetic floating-rate
bond by entering a:
o A
receive-fixed, pay floating interest rate swap

o B
receive-floating, pay fixed interest rate swap

o C
receive-fixed, receive floating interest rate swap

Incorrect
A is correct. By entering a receive-fixed, pay floating interest rate swap the firm can
create a synthetic floating-rate bond. The two fixed rate payments (receiving fixed as
part of the swap contract and paying fixed to the bond investors) cancel out and the
firm has effectively created a synthetic variable-rate loan.
4. Question 4
Which of the following is not true about dirty price of the bond?
o A
It is also referred to as the full price of the bond.

o B
It is calculated as the quoted price plus interest accrued since the last coupon
date.
o C
It is the clean price without the interest accrued since the last coupon
date.
Incorrect
C is correct. The quoted price is the clean price without the interest accrued since the
last coupon date.
5. Question 5
The following spot rates are given:
1-Month USD MRR is 2.55%, 3-Month USD MRR is 2.61%, 6-Month USD MRR is 2.69%,
and 1-Year USD MRR is 2.75%.
Given these four spot rates in the MRR term structure, how many FRA rates can be
calculated?
o A
8 FRA rates
o B
6 FRA rates
o C
10 FRA rates
Incorrect
B is correct. Based on the four MRR spot rates given, we can compute six separate
FRA rates as follows: 1 × 3, 1 × 6, 1 × 12, 3 × 6, 3 × 12, and 6 × 12 FRA rates.
6. Question 6
If the forward contract price is lower than the equilibrium price:
o A
the forward contract is purchased and the underlying is sold.

o B
the forward contract is sold and the underlying is purchased.

o C
the forward contract and the underlying are both purchased.

Incorrect
Solution: A is correct. To make an arbitrage profit, we sell at the higher price and
buy at lower price. If the forward contract price is lower than the equilibrium price,
we purchase the forward contract and sell the underlying. Whereas, if the forward
contract price is higher than the equilibrium price, we will sell the forward contract
and purchase the underlying.
7. Question 7
A UK company needs to borrow 100 million US dollars for four years for its American
subsidiary. The company decides to issue GBP-denominated bonds in an amount
equivalent to USD 100 million. The company then enters into a four-year currency
swap with annual reset and exchanges the notional amounts at initiation and at
maturity.
At initiation, the exchange rate was 0.75 USD/GBP. The notional amount is USD 100
million and GBP 133.33 million. The fixed rates are 2.7930% for USD and 0.6488% for
GBP.
Six months have passed since the company entered into this currency swap contract.
The spot exchange rate for USD/GBP is now 0.73 and the present value factors are
as follows:
Years to Maturity US discount factors UK discount factors

0.5 0.9880 0.9985
1.5 0.9629 0.9940
2.5 0.9367 0.9876
3.5 0.9094 0.9793
The current value of the currency swap is closest to:
o A
USD -82,015,000.
o B
USD 3,727,000.
o C
USD 9,717,000.
Incorrect
B is correct. The calculation is shown below:

0.5 0.9880 0.9985
1.5 0.9629 0.9940
2.5 0.9367 0.9876
3.5 0.9094 0.9793
Sum 3.7970 3.9594
Value of currency swap = Va = FBa – StFBb
where FB is the fixed-rate bond value in its own currency, St is the exchange rate at
Time t, ‘a’ is the price currency, and ‘b’ is the base currency.
The value of a fixed-rate bond (FB) = notional amount x [(fixed rate x sum of present
value factors) + present value factor of last period]
FBUSD = 100,000,000 x [(0.02793 x 3.7970) + 0.9094] = 101,545,021
FBGBP = 133,333,333 x [(0.006488 x 3.9594) + 0.9793] = 133,998,478
VUSD = FBUSD – S0.5FBGBP = USD 101,545,021 – (0.73 USD/GBP)(GBP 133,998,478) = USD
3,726,132
8. Question 8
A UK company needs to borrow 100 million US dollars for four years for its American
subsidiary. The company decides to issue GBP-denominated bonds in an amount
equivalent to USD 100 million. The company then enters into a four-year currency
swap with annual reset and exchanges the notional amounts at initiation and at
maturity. Assume the USD/GBP spot exchange rate is 0.75 and the present value
factors are as follows:

1 0.9756 0.9965
2 0.9500 0.9911
3 0.9232 0.9837
4 0.8954 0.9744
The fixed annual payments in both currencies are closest to:
o A
USD 651,518 and GBP118,272.

o B
USD2,793,000 and GBP865,067.

o C
USD648,800 and GBP3,724,000.

Incorrect
B is correct. To calculate the fixed payment amounts, we need to determine the fixed
rates for each currency, then multiply these rates by their respective notional
amount. To compute the fixed rates, we first need to calculate the sum of the
present value factors for each currency:

1 0.9756 0.9965
2 0.9500 0.9911
3 0.9232 0.9837
4 0.8954 0.9744
Sum 3.7451 3.9457
Fixed rate = (1 – d4) / (sum of discount factors)
USD fixed rate = (1 – 0.8954) / (3.7451) = 2.7930%
GBP fixed rate = (1 – 0.9744) / (3.9457) = 0.6488%
GBP notional amount = USD100 million / (0.75 USD/GBP) = 133.33 million GBP
USD fixed payments = USD100,000,000 x 0.027930 = USD2,793,000
GBP fixed payments = GBP133,333,333 x 0.006488 = GBP865,067
9. Question 9
o A
Entering a receive-fixed, pay-floating interest rate swap is the same as

being short a fixed rate bond and long a floating bond.
o B
In an interest rate swap, the fixed swap rate is equal to one minus the final
discount factor, all divided by the sum of all the discount factors.
o C
The pricing of an interest rate swap is done such that at initiation, the value
of the fixed leg and the value of the floating leg is equal.
Incorrect
A is correct. The statement is incorrect because entering a receive-fixed, pay-floating
interest rate swap is the same as being long a fixed bond and short a floating-rate
bond. This is because when you are long a fixed-rate bond, you pay the price upfront
and receive coupon payments based on the agreed upon fixed rate. Therefore, you
receive fixed payments. Being short a floating-rate bond means you receive an
upfront payment, then pay periodic coupons based on a floating rate. Therefore, a
combination of being long a fixed-rate bond and short a floating-rate one is similar
to entering into a receive fixed, pay-floating interest rate swap.
Both options B and C are correct statements. Option B describes the swap pricing
equation: rFIX = (1 – dn) / (d1 + d2 + d3 + … + dn), where di is the discount factor of the
given period. Option C describes a rule of pricing an interest rate swap, whereby the
price is determined such that at initiation, the value of the swap is zero.
10. Question 10
Based on market quotes on the US dollar Libor, the three-month and six-month
rates are currently at 1.00% and 1.25% respectively. The 3×6 FRA fixed rate,
assuming a 30/360-day count convention, is closest to:
o A
0.374%.
o B
0.990%.
o C
1.496%.
Incorrect
C is correct. Based on the given information, L(90) = 1.00% and L(180) = 1.25%.
Therefore, the 3×6 FRA rate is [((1+(0.0125×180/360))/(1+(0.0100×90/360))) -1 ] /
(90/360) = 1.496%.
11. Question 11
Six months ago a party entered a receive-fixed, pay-equity three-year annual reset
swap in which the fixed leg is based on a 30/360 day count. The fixed rate at the time
of the swap was 2.2%, the equity was trading at 100, and the notional amount was
₤5,000,000. Now all spot interest rates have fallen to 2.0% (a flat term structure), and
the equity is trading for 103. Calculate the fair value of this equity swap. The table
below gives the present value factors based on the new spot rates of 2.0% applied to
the fixed cash flow of (2.2%x5 mil) ₤110,000.
Date (in years) PV Factors Fixed Cash Flow PV of Fixed Cash Flow
0.5 0.9901 110,000 108,911
1.5 0.9707 110,000 106,777
2.5 0.9517 5,110,000 4,863,187
Total 5,078,875
o A
-₤82,474.
o B
-₤71,125.
o C
-₤283,000.
Incorrect
B is correct. The fair value of this equity swap is 5,078,875 less 5,150,000 [=
(103/100) 5,000,000],or a loss of ₤71,125.
12. Question 12
Suppose an investor entered into a receive-equity index and pay-fixed swap with a
quarterly reset, 30/360 day count. The notional amount is ₤10,000,000, pay-fixed
(1.4% annualized, or 0.35% per quarter). Assuming an equity index return of –5.0%
for the quarter (not annualized), the equity swap cash flow in thousands will be:
o A
₤350.
o B
-₤535.
o C
₤535.
Incorrect
B is correct. ₤10,000,000(-0.05-0.0035) = -₤535,000.
13. Question 13
Suppose a year ago Company X entered a ₤10,000,000 five-year receive-fixed Libor-
based interest rate swap with annual resets (30/360 day count). The fixed rate in the
swap contract entered one year ago was 2.30%. The current discount factors are
given in Table 1.
Table 1
Maturity ( Years ) Present value Factors

1 0.9901
2 0.97787
3 0.9654
4 0.9385
The value (in thousands) for the party receiving the fixed rate will be closest to:
o A
₤275.
o B
₤390.
o C
-₤275.
Incorrect
A is correct. The sum of present values = 3.87187.
V = (FS0 − FSt)ΣPVt,ti = (0.023 – 0.0159)(3.87187) = 0.02749
0.02749 x ₤10 mil = ₤274,900.
14. Question 14
Suppose we are pricing a four-year Libor-based interest rate swap with annual resets
(30/360 day count). The estimated present value factors, are given in Table 1 below:
Table 1
Maturity ( Years ) Present value Factors

1 0.9901
2 0.97787
3 0.9654
4 0.9385
The Fixed rate of the swap is:
o A
1.5%.
o B
1.6%.
o C
1.4%.
Incorrect
B is correct. Sum of present value factors is 0.9901+0.97787+0.9654+0.9385 =
3.87187. Fixed swap rate = rFIX = (1− d) / (sum of all the present values) = (1 – 0.9385) /
3.87187 = 0.015884 = 1.588%.
15. Question 15
You enter into a one-year equity swap with quarterly settlement. You pay the
S&P500 return and the counter party pays fixed annualized rate of 4%. At the end of
the first quarter the S&P500 index increases by 4%. Which of the following
statements is most likely true about cash flow at the end of first quarter?
o A
You will need to make a payment to the counterparty.

o B
You will receive a payment from the counterparty.

o C
There will be no net cash flow.

Incorrect
A is correct. The 4% is an annualized rate. The quarterly rate is 1%. At end of the first
quarter you need to pay 4% based on the S&P500 return and you should receive 1%.
The net impact is that you need to pay 3%.
16. Question 16
Which of the following statements is most likely accurate? In the carry arbitrage
model:
o A
an instrument is bought or sold along with a forward position in that

instrument.
o B
the law of one price does not hold.

o C
the portfolio is created with no liabilities and a net positive cash flow today.
Incorrect
A is correct. In the carry arbitrage model, an instrument is bought or sold along with
a forward position in that instrument.
17. Question 17
Suppose that a bond futures contract is based on an underlying French bond quoted
at €106 that has accrued interest of €0.063. The euro-bond futures contract matures
in three months. At contract expiration, the bond will have an accrued interest of
€0.190. There are no coupon payments due until after the futures contract expires.
The current risk-free rate is 0.20%. The conversion factor is 0.75. The equilibrium
euro-bond quoted futures price based on the carry arbitrage model will be closest
to:
o A
€150.
o B
€130.
o C
€140.
Incorrect
C is correct. QF0(T) = [1/CF(T)]{FV0,T[B0 + AI0] – AIT – FVCI0,T} = [1/ 0.75]{(1.002)^3/12[106
+ 0.063] − 0.19 − 0} = €141.2345.
18. Question 18
Suppose an investor entered a receive-floating 6 × 9 FRA at a rate of 0.85%, with
notional amount of GBP1,000,000 at Time 0. The 6 × 9 FRA rate is quoted in the
market at 0.85%. After 90 days the three-month GBP Libor is 1.01% and the six-
month GBP Libor is 1.11%, which is used as the discount rate to determine the value
after 90 days. The new 3 x 6 FRA rate is found as 1.21%. Assuming the appropriate
discount rate is GBP Libor, the value of the original receive-floating 6 × 9 FRA will be
closest to:
o A
GBP1,200.
o B
GBP895.
o C
GBP600.
Incorrect
B is correct. V90(0,180,90) = 1,000,000 × [(0.0121−0.0085)(90 / 360)] / [1+0.0111(180 /
360)] = GBP895.033.
19. Question 19
The three-month GBP Libor and the six-month GBP Libor based on the current
market quotes is 0.39% and 0.52% respectively. Assume a 30/360-day count
convention. The 3 × 6 FRA fixed rate will be closest to:
o A
0.65%.
o B
0.52%.
o C
0.78%.
Incorrect
A is correct. FRA(0,90,90) = {[ 1+0.0052( 180 / 360 ) 1+0.0039( 90 / 360 ) ] − 1} × 4 =
0.0064937 ≅ 0.65%.
20. Question 20
A stock trading at €50, pays a €1.00 dividend in three months. The price of the
forward contract on this stock expiring in six months will most likely decrease if
there is a(n):
o A
increase in dividend.
o B
increase in expected future stock price.

o C
increase in risk-free interest rate.

Incorrect
A is correct. Being a carry benefit, the increase in dividend will decrease the forward
price. The expected stock price does not influence the forward price. An increase in
the risk-free rate will increase the forward contract price.
21. Question 21
The continuously compounded dividend yield on a broad based stock index is 4.88%,
and the current stock index level is 1,300. The continuously compounded annual
interest rate is 5.8%. Based on the carry arbitrage model, the nine-month futures
price will be closest to:
o A
1,300
o B
1,408
o C
1,309
Incorrect
C is correct. Based on the carry arbitrage model forward price is F0(T) = S0e(rc-γ)T.
Future value of the underlying adjusted for the dividend payments = 1,300e(0.0580–
0.0488)(9/12)
= 1,309.
22. Question 22
Assume an investor bought a one-year forward contract with price F0(T) = 110. Six
months later, at Time t = 0.5, the price of the stock is S0.5 = 115 and the interest rate
is 4%. The value of the existing forward contract expiring in six months will be closest
to
o A
-7.
o B
5.
o C
7.
Incorrect
C is correct. F0(T) = 110, S0.5 = 115, r = 4%, and T – t = 0.5, the six-month forward
price at Time t is equal to Ft(T) = FVt,T(St) = 115(1 + 0.04)0.5 = 117.2775. Value of the
existing forward entered at Time 0 valued at Time t using the difference method is:
Vt(T) = PVt,T[Ft(T) – F0(T)] = (117.2775 – 110)/(1 + 0.04)0.5 = 7.136.
23. Question 23
The unique issues influencing the pricing of forward and futures fixed-income
contracts based on the carry arbitrage model are:
o A
accrued interest, conversion factor adjustment, choosing cheapest-to-

deliver bonds.
o B
quoted price, coupon frequency, choosing least expensive bonds.

o C
dirty price, bond maturity, price of eligible bonds.

Incorrect
A is correct. Fixed-income forward and futures contracts have certain unique issues
that are considered when applying the carry arbitrage model. First, fixed-income
securities are quoted without accrued interest. But full price is paid when buying the
bond so the accrued interest is included in forward/futures contracts’ pricing.
Second a conversion factor adjustment is used to make all deliverable bonds roughly
equal in price. Third, when multiple bonds can be delivered for a particular maturity
of a futures contract, a cheapest-to-deliver bond is usually chosen after the
conversion factor adjustment.
24. Question 24
Suppose an investor buys a one-year equity futures contract and there are now
three months to expiration. Today’s futures price is 111.30. There are no other cash
flows. The futures contract value after marking to market, will be closest to:
o A
100.
o B
0.00.
o C
111.30.
Incorrect
B is correct. Futures contracts are daily marked to market, such that the resulting
profits and losses, are received or paid at each daily settlement. Hence, the equity
futures contract value is zero after settlement.
25. Question 25
The one-year forward price of an underlying which pays a dividend in six months is
given by:
o A
the future value of the underlying less the future value of carry
benefits.
o B
the future value of the underlying plus the future value of carry benefits.
o C
the future value of the underlying plus the future value of carry costs.
Incorrect
A is correct. The forward price is the future value of the underlying plus the future
value of the carry costs minus the future value of the carry benefits. In this case no
carry costs are given and the carry benefit is the dividend payments in six months.
Hence the no-arbitrage forward price is the future value of the underlying less the
future value of the carry benefits..
26. Question 26
The forward value at time t for a long forward contract initiated at time 0 is:
o A
the future value of the difference in forward prices.

o B
the present value of the difference in forward prices.

o C
equal to the spot price at time t

Incorrect
B is correct. Vt(T) = Present value of difference in forward prices = PVt,T[Ft(T) − F0(T)].
27. Question 27
If F0(T) > FV(S0), an arbitrageur would:
o A
conduct a reverse carry arbitrage strategy.

o B
purchase the forward contract and sell the underlying short.

o C
sell the forward contract and purchase the underlying.
Incorrect
C is correct. Unless F0(T) = FV(S0), there is an arbitrage opportunity. If F0(T) > FV(S0),
then an arbitrage opportunity exists, forward contract is sold and the underlying is
purchased. A & B are incorrect. “If F0(T) < FV(S0), then forward contract would be
purchased and underlying is sold short.” This is known as reverse carry arbitrage.
28. Question 28
The no-arbitrage forward price of an underlying which has no storage cost and no
convenience yield is:
o A
the future value of the spot price compounded by the risk-free rate over
time T.
o B
the future value of the spot price using the discount rate which is relevant for
the underlying instrument.
o C
the same as the spot price.

Incorrect
A is correct. F0(T) = Future value of underlying = FV(S0).
29. Question 29
At the forward or futures contract initiation date the price negotiated is such that the
value of the contract is:
o A
less than zero.

o B
equal to zero.
o C
more than zero.

Correct
B is correct. The forward price or futures price is negotiated between parties such
that market value of the forward or futures contract at the initiation date is zero.
James Miller, a fund manager at a bank’s treasury department, considers long forward
contracts on Parma Inc’s (PIC) shares. The stock is currently trading at USD102 and the
annual compounded risk free rate is 4%. The company recently declared a dividend of USD2
a share and the payment is to be received in two months. James decides to go long 3-month
forward contracts on 1,000 shares. After one month, the share price is USD110 a share
whereas the risk free rate remains the same. James is concerned about the value of the
forward position. He is also concerned about how the value of the position could be
impacted due to changes in the stock’s price, the risk free rate and the dividend payments.
1. Question 1
The forward price at the inception of the contract is closest to:
o A
$100.9850
o B
$100.9985
o C
$100.9880
Incorrect
B is correct. The forward price is calculated as (102 × 1.043/12) − (2 × 1.041/12) =
100.9985.
2. Question 2
After one month, the value of the forward position is closest to:
o A
$7,641
o B
$7,650
o C
$7,666
Incorrect
C is correct. After one month, the new forward price is calculated as 110 × 1.042/12 − 2
× 1.041/12 = 108.7149. The forward position’s value is 1000 × (108.7149 −100.9985) /
1.042/12 = USD7,666.08.
3. Question 3
If James had entered into a futures contract instead of the forward contract, the
value of his position after one month would have most likely been:
o A
Higher
o B
Lower
o C
Same
Incorrect
B is correct. Futures contracts are marked to market daily and after marking to
market the value of the contract becomes zero. Hence compared to the value of the
forward contract, James’s position after one month would have been lower under a
futures contract.
4. Question 4
Which of the following will most likely result in an increase in the value of a short
forward position?
o A
Increase in spot price

o B
Increase in interest rates

o C
Increase in dividend paid

Incorrect
C is correct. An increase in dividend paid will cause the forward price to decline
which will increase the value of a short forward position. A and B will result in an
increase in forward price hence a decrease in the value of a short forward position.
Magna Corp. plans to take out a three-month loan of USD1,000,000 in three months’ time to
meet its working capital needs. The company’s CFO, Adam Sand CFA, was concerned about
an increase in interest rates during that time. Therefore, he had entered into a pay-fixed
forward rate agreement three months ago with a notional principal of USD1,000,000. The
LIBOR rate summary is presented below:
Rate three months ago Current rate

1 month LIBOR 1.00% 1.20%
Adam would like to evaluate the company’s current position on the FRA
1. Question 1
The forward rate at which the company had initiated its FRA is closest to:
o A
1.19%
o B
1.24%
o C
1.31%
Incorrect
B is correct. Three months ago the company must have entered into a 6 x 9 FRA. The
relevant rates are therefore the 6 month LIBOR and 9 month LIBOR three months
ago. The forward rate is calculated as ( [1+(0.0115 * 9/12 )] / [1+(0.0110 * 6/12)]− 1) ×
4 =1.243%.
2. Question 2
The interest amount actually paid at the maturity of the loan will be based on the
difference between the fixed rate of the contract as established on the initiation date
and the:
o A
the 3 month LIBOR 3 months from now

o B
the 3 month LIBOR 6 months from now

o C
the 6 month LIBOR 3 months from now.

Incorrect
A is correct. The interest actually paid would be based on the 3 month LIBOR in three
months i.e. when the loan is taken out.
3. Question 3
The current forward rate for a notional loan beginning in three months with three
months to maturity is closest to:
o A
1.40%
o B
1.15%
o C
1.35%
Incorrect
A is correct. The relevant rates are the current 3 month LIBOR and the current 6
month LIBOR. The forward rate is calculated as ([1+(0.0135 x 6 / 12)] / [1+(0.0130 x 3
/ 12)]− 1) × 4 =1.395%.
4. Question 4
The current value of the company’s position on the FRA is closest to:
o A
$400
o B
$405
o C
$397
Incorrect
C is correct. The increase in the forward rate over the three month period would
result in a gain on the position. The profit would be due at loan maturity and
therefore its current value would be calculated by discounting it to the present using
the 6 month LIBOR. The value on the FRA is calculated as:
{[(0.0140 × 3 /12 ) − (0.0124 × 3 / 12 )] × 1,000,000}/[1 + (0.0135 × 6 / 12 )] = 397.3.
Alan Joe, an avid fixed income investor has a large portfolio of corporate and government
bonds. Joe’s portfolio consists of floating as well as fixed rate bonds. Anticipating an
increase in interest rates, Alan had entered into a three year interest rate swap. He had
consequently entered into an interest rate swap on a notional principal of $100,000 for
three years with semi-annual payments. The LIBOR term structure at that time produced
the following discount factors:
Time Discount factor

0.5 0.9759
1 0.9506
1.5 0.9248
2 0.8985
2.5 0.8737
3 0.8480
One year later, the discount factors are:
TIme Discount factor
0.5 0.9731
1 0.9461
1.5 0.9192
2 0.8917
Alan would like to evaluate his current position on the swap.
1. Question 1
In order to hedge against an increase in interest rates, Alan had most likely entered
into a:
o A
receive-fixed, pay-floating swap

o B
receive-floating, pay-fixed swap

o C
receive-fixed, pay-fixed swap

Incorrect
B is correct. Alan had entered into a receive-floating, pay-fixed swap to hedge against
an increase in interest rates.
2. Question 2
The swap rate at the initiation of the contract was closest to:
o A
5.56%
o B
2.78%
o C
5.85%
Incorrect
A is correct. The swap would consist of a long floating rate bond and a short fixed
rate bond. The value of the fixed rate bond for each dollar should be equal to that of
the floating rate bond i.e. $1 per each dollar. Hence the fixed swap rate is calculated
as: Fixed rate x (0.9759+0.9506+0.9248+0.8985+0.8737+0.8480) +1(0.8480) = 1 Fixed
rate = (1 – 0.8480)/5.4715 Fixed rate = 2.78%, or 5.56% on an annual basis.
3. Question 3
The current swap rate is closest to:
o A
5.96%
o B
5.81%
o C
2.90%
Incorrect
B is correct. The fixed swap rate is calculated as: Fixed rate x
(0.9731+0.9461+0.9192+0.8917) + 1(0.8917) = 1 Fixed rate = (1-0.8917) / 3.73 Fixed
rate = 2.904%, or 5.81% on an annual basis.
4. Question 4
The current value of the swap to Alan is closest to:
o A
$490
o B
-$466
o C
$466
Incorrect
C is correct. the value of the swap is calculated as 100,000 x (0.0581−0.0556) / 2 ×
3.73 = $466.25.
Valuation of Contingent Claims

1. Question 1
Q-Code: 21-L2-DV-VACC-80680
Which of the following is most likely correct?
o A
Theta is generally negative for options.

o B
Vega is the change in a portfolio for a given small change in calendar time,
holding everything else constant.
o C
The rho of a call is negative, and the rho of a put is positive.

Incorrect
A is correct. Theta is generally negative for options because as calendar time passes,
time to maturity decreases, and the value of an option decreases.
B is incorrect because it states the definition of theta. Vega is the change in a given
portfolio for a given small change in volatility, holding everything else constant.
C is incorrect because rho is positive for a call option and negative for a put option.
2. Question 2
Which of the following statements is incorrect?
o A
Delta of an option gives the change in the option value for a given small
change in the value of stock, holding everything else constant.
o B
All else constant, option gamma is the change in a given option delta for a
given small change in stock value.
o C
Vega of an option is always negative since an increase in volatility

reduces both put and call values.
Incorrect
C is correct. The vega of an option is always positive as an increase in volatility, leads
to an increase in the call and put option values. A & B are correct statements.
3. Question 3
Which of the following statements regarding delta hedging of an option is incorrect ?
o A
A delta neutral portfolio means that portfolio delta is set to zero.

o B
A portfolio of put options with a delta of -1,000, can be hedged by selling

1,000 shares of the underlying stock.
o C
The optimal number of hedging units = – Portfolio delta divided by the delta
of the hedging instrument.
Incorrect
B is correct. If the portfolio consists of put options, hedging will involve buying
shares, not shorting.
4. Question 4
A portfolio delta is 2,500. This portfolio needs to be hedged with call options. The call
options have a delta of 0.5. A delta neutral portfolio is most likely attained by:
o A
buying 10,000 call options.

o B
selling 5,000 call options.

o C
selling 2,500 call options.

Incorrect
B is correct. To arrive at a delta neutral portfolio NH = – Portfolio delta / DeltaH = -
2,500/0.5 = -5,000 = selling 5,000 call options.
5. Question 5
Which of the following statements is most likely correct ?
o A
If a portfolio is delta hedged there is no gamma risk.

o B
Gamma has the smallest value when an option is at the money.

o C
Gamma risk arises if there is an abrupt change in the price of the

underlying.
Incorrect
C is correct. Gamma risk arises when there is large jump in the value of the
underlying. Gamma measures “the risk that remains once the portfolio is delta
neutral” hence A is incorrect. Gamma has the largest value when the option nears at
the money, hence B is incorrect.
6. Question 6
Which of the following statements is least accurate ?
o A
Implied volatility provides an understanding of the investors’ opinions on

volatility of the underlying.
o B
If an option’s implied volatility is higher than an investor’s volatility

expectations, the investor will consider the option to be overvalued.
o C
Implied volatility is not comparable for options with different exercise

prices and expirations.
Incorrect
C is correct. Implied volatility can be used to compare the value of different options
with different exercise prices and expirations. A & B are correct statements.
7. Question 7
Which of the following statements is least likely correct with respect to foreign
exchange options?
o A
The discount rate is the risk-free rate in the base currency’s country.
o B
The value of a foreign exchange call option is equal to the foreign exchange
component minus the bond component.
o C
The volatility is the volatility of the log return of the spot exchange rate.
Incorrect
A is correct. The discount rate for a foreign exchange option is the risk-free rate in
the price or foreign currency’s country. For example, if the underlying is the
USD/GBP spot rate, the US interest rate would be the discount rate and the UK
interest rate would be the carry rate.
Option B is not the correct answer because it is a true statement:
Value of FX call option = foreign exchange component – bond component
Value of FX put option = bond component – foreign exchange component
Option C is also a correct statement.
8. Question 8
Which of the following statements is least likely correct regarding options on futures?
o A
A fiduciary call is a call option and the present value of the exercise price.
o B
The option value obtained through the Black model has two components, a
futures component and a bond component.
o C
For call options, the futures price is adjusted by –N(–d1) and the
exercise price is adjusted by +N(–d2).
Incorrect
C is correct. For call options, the futures price is adjusted by +N(d1) and the exercise
price is adjusted by –N(d2). For put options, the futures price is adjusted by –N(–d1)
and the exercise price is adjusted by +N(–d2). Options A and B are correct
statements.
9. Question 9
When calculating the value of a put option on a futures contract, the present value of
the strike price is most likely adjusted by:
o A
-N(d1).
o B
N(d2).
o C
N(-d2).
Incorrect
C is correct. The formula for the value of a put on a futures contract is as follows:
p = e–rT[XN(–d2) – F0(T)N(–d1)]
where F0(T) = the futures price at Time 0 that expires at Time T,
X = exercise price.
e–rT = present value term
For put options, the futures price is adjusted by –N(–d1) and the exercise price is
adjusted by +N(–d2).
10. Question 10
A company is planning to borrow 1,000,000 USD for a period of six months. It
intends to take out this loan three months from now. Currently, six-month LIBOR is
0.30% and the 3 x 9 FRA rate is 0.40%. The company is concerned that interest rates
may rise, so it purchases a call option that expires in three months and has an
exercise rate of 0.36%. When calculating the value of the interest rate call option, ‘tj-
1 + tm’ closest to:
o A
90 days.
o B
180 days.
o C
270 days.
Incorrect
C is correct. Under the standard market model, the interest rate call value is given
by:
c = (AP)e−r (tj−1 + tm) [FRA(0, tj−1, tm) N(d1) − RXN(d2)]
where:
AP = Accrual period (using the n/360 convention)
FRA(0,tj-1,tm) = FRA rate at Time 0 that expires at Time tj-1 and is based ‘m’ year Libor
RX = Exercise rate
‘tj-1 + tm’ is 270 days because the FRA expires in 3 months (90 days) and has a maturity
of 6 months (180 days).
11. Question 11
A receiver swaption value can be interpreted as:
o A
swap component minus the bond component.

o B
bond component minus the swap component.

o C
bond component plus the swap component.

Incorrect
B is correct. For receiver swaptions, the swap component is (AP)PVA(RFIX)N(–d1) and
the bond component is (AP)PVA(RX)N(–d2). The receiver swaption model value is
simply the bond component minus the swap component. The payer swaption model
value is the swap component (AP)PVA(RFIX)N(d1) minus the bond component
(AP)PVA(RX)N(d2).
12. Question 12
A non-dividend-paying stock is currently trading at €110. A call option has one year
to mature, the periodically compounded risk-free interest rate is 3%, and the
exercise price is €110. Assume a single-period binomial option valuation model,
where u = 1.25 and d = 0.65. Using the expectations approach, the risk-neutral
probability of an up move is closest to:
o A
0.63
o B
0.37
o C
0.55
Incorrect
A is correct. The risk-neutral probability of an up move = π = (1 + r – d) / (u – d) = (1 +
0.03– 0.65) / (1.25 – 0.65) = 0.63
13. Question 13
Which of the following is not an assumption of the BSM model?
o A
The underlying instrument is liquid, easily traded.

o B
Early exercise is allowed.

o C
No-arbitrage opportunities are available.

Incorrect
Solution: B is correct. BSM assumes that all options are European-style, early
exercise is not allowed. Options A and C are assumptions of BSM.
14. Question 14
The following information is given: S = 100, X = 100, r = 6%, T = 1.0, and σ =25%,
d1=0.365 and d2=0.115. The value of the put option using BSM would be closest to:
o A
7.02
o B
12.33
o C
9.35
Incorrect
Solution: A is correct. The calculations will be as follows:
p = e–rTXN(–d2) – SN(–d1) = e–0.06100N(–0.115) – 100N(–0.365)=42.59-35.57=7.02
15. Question 15
Suppose you are a speculative investor in London. On 01-June, you want to profit
from anticipated regulatory changes. On 01 July, you intend to borrow 10,000,000
pounds to fund the purchase of an asset, which you expect to resell at a profit three
months after purchase, say on 01 October. The current three-month LIBOR is 0.65%.
The appropriate FRA rate over the period of 01 July to 01 October is currently 0.75%.
You are concerned that rates will rise, so you want to hedge your borrowing risk by
purchasing an interest rate call option with an exercise rate of 0.70%.
In using the Black model to value this interest rate call option, what would the
underlying rate be?
o A
0.65%
o B
0.70%
o C
0.75%
Incorrect
Solution: C is correct. A forward or futures price is used as the underlying in using
the Black model. This approach is unlike the BSM model in which a spot price is used
as the underlying.
16. Question 16
The discount factor used in pricing this option would be over what period of time?
o A
01 June–01 July
o B
01 June–01 October
o C
01 July–01 October
Incorrect
Solution: B is correct. The option is being priced on 01 June. An option expiring 01
July when its payoff will be determined, but the payment will be made on 01
October. Thus, the expected payment must be discounted back from 01 October to
01 June.
17. Question 17
Which of the following statement is least accurate about vega?
o A
Vega is based on an observable parameter which is objective.

o B
Vega is high for options that are at or near the money.
o C
Vega is high for options that are short dated.

Incorrect
Solution: A is correct. Vega is based on an unobservable parameter, future volatility,
which is subjective.
18. Question 18
Suppose an options trader has only one option position i.e. a short call option. He
also holds some stock such that the portfolio is delta hedged. As a result of buying
call option, the gamma will:
o A
decrease.
o B
increase.
o C
stay neutral.
Incorrect
Solution: B is correct. Buying options (calls or puts) will always increase net gamma.
19. Question 19
Suppose an options dealer offers to sell a two-month at-the-money call on the index
option at 17% implied volatility and a one-month in-the-money put on the stock at
23%. An option trader believes that based on the current outlook, index volatility
should be closer to 23% and stock volatility should be closer to 19%. To benefit from
this view, the option trader should:
o A
buy the index call and sell the stock put.

o B
sell the index call and buy the stock put.

o C
sell the index call and sell the stock put.

Incorrect
Solution: A is correct. The trader should buy the index call and sell the stock put. The
trader expects the index volatility to rise and the stock volatility to fall. Therefore, the
index call option’s value is expected to rise and the stock put option’s value is
expected to fall.
20. Question 20
Table 1: Two-Year Binomial Interest Rate Lattice by Year
T=0 T=1 T=2

Rate =
3.9670% c++ =
0.00717
Value =
0.9626 Rate =
3.8900% c+ = ?
Value =
Rate =
0.9705 Rate
3.2450% c+- =
= 3.0380% c
0.0
=?
Value = 0.9750
Rate = 2.5600%
c– = ?
Rate =
2.2600% c— =
0.0
Using Table 1, the value of a call option at T = 0 with €1,000,000 notional principal is
closest to:
o A
€4,000.
o B
€3,000.
o C
€1,700.
Incorrect
C is correct. At T = 0, c = PVrf,0,1[πc+ + (1 – π)c–] = 0.9705[0.5 × 0.003451 + (1 −
0.5)0.0] = 0.001675. Multiplying by 1,000,000 gives 1,675 which is approximately
€1,700.
21. Question 21
According to the no-arbitrage approach, an investor can synthetically replicate a long
put option by:
o A
short selling the underling and using a portion of the proceeds to buy put
options.
o B
short selling the underlying and lending a portion of the proceeds.
o C
buying the underlying with partial financing.

Incorrect
B is correct. For a long put position, the underlying is sold short and a portion of the
proceeds is lent. To hedge a long put position h units of the underlying asset S are
traded.
22. Question 22
Consider a one-year put option with a strike price of USD100. The underlying stock is
currently trading at USD100 and does not pay any dividends. At the end of one year
the stock price will either be at USD125 or USD69. The periodically compounded
risk-free interest rate = 5.0%. Assuming a single-period binomial option valuation
model, the hedge ratio is closest to:
o A
0.55.
o B
-0.55.
o C
0.65.
Incorrect
B is correct. The hedge ratio = p+ − p− / s+− s−. S+ = 125, S– = 69. p+ = (0,100 − 125) =
0. p– = (0,100 − 69) = 31 Hence h = 0−31 / 125−69 = −0.554.
23. Question 23
A non-dividend paying stock is trading at €100. A European call option on this stock
has two years to mature. The periodically compounded risk-free interest rate is 3%,
the exercise price of the option is €100. The up factor is 1.25, and the down factor is
0.80. The riskneutral probability of an up move is 0.51. The call option value is closest
to:
o A
€13.80.
o B
€14.20.
o C
€14.50.
Incorrect
A is correct. At T=2, c++ = ???(0,?2? − ?) = ??? [0,156.25 − 100] = 56.25 c-+ = c+- =???(0,??? −
?) = ???[0,100 − 100] = 0 c– = ???(0,?2? − ?) = ???[0,64 − 100] = 0 c = PV[E(c2)] = PV[π2c++ +
2π(1 – π)c+– + (1 – π)2c– –] = 1/(1.03)2 [0.51256.25 + 2 × 0.51 × 0.49 × 0 + 0.4920] =
13.7908.
24. Question 24
A non-dividend paying stock is trading at €100. The risk-free rate is 3.00%. A two-
year European call option with a strike price of €100 is trading for €14.00. Using put-
call parity, value of a two-year European put option with a strike price of €100 is
closest to:
o A
€9.00.
o B
€8.26.
o C
€10.0.
Incorrect
B is correct. The put option value can be computed simply by applying put–call
parity: p = c + PV(X) – S = 14 + 100/(1 + 0.03)2 – 100 = 8.259. Thus, the current put
price is €8.26.
25. Question 25
Suppose you are given the following information: S0 = €100, X = €100, u = 1.25, d =
0.80, n = 2 (time steps), r = 3.00% (per period). The stock is not expected to pay
dividends. The risk-neutral probability is 0.51. The tree below shows that price of a
two-period Europeanstyle option should be 8.15
The early exercise premium for a similar American style put option is closest to:
o A
2.30.
o B
1.40.
o C
0.40.
Incorrect
B is correct. At T = 1, when a down move occurs because of early exercise option
(American-style) p = 100 – 80 = 20.00 instead of 17.1262. Hence the value of put at T
= 0 = 9.51. The early exercise premium = 1 / (1.03) × [0.51 × 0 + 0.49 × 20] − 8.15 =
9.51 − 8.15 = 1.36.
26. Question 26
A non-dividend-paying stock is currently trading at USD50. A European call option
has one year to mature, the periodically compounded risk-free interest rate is 7%,
and the exercise price is USD50. Assume this option can be priced using a single-
period binomial option valuation model, where u = 1.25 and d = 0.80. The market
price of the option is USD8. Determine whether there is an arbitrage opportunity
and if so, how can this opportunity be exploited?
o A
There is no arbitrage opportunity.
o B
An arbitrage profit can be made by selling options for $8 and buying

underlying shares.
o C
An arbitrage profit can be made by buying options for $8 and selling

underlying shares.
Incorrect
B is correct. We can use the binomial model to calculate the value of the call option:
S+ = 50(1.25) = 62.50
S- = 50(-0.80) = 40
c+ = Max(0, S+ – X) = 62.50 – 50 = 12.50
c- = Max(0, S- – X) = 0
h = [c+ – c-]/[S+ – S-]

h = [12.50 – 0]/[62.50 – 40] = 12.5/22.5 = 0.55
c = hS + PV(-hS- + c+)
c = 0.55(50) + [(-0.55*40) + 0]/1.07 = 27.50 – 20.56 = 6.94
Using the binomial model, it can be shown that the arbitrage-free value of the call
option is USD7. Since the option is trading for USD8, it is overpriced. An arbitrage
profit can be made by selling the overpriced options and buying an appropriate
number of underlying shares.
27. Question 27
The underlying instrument for interest rate options is most likely the:
o A
exercise rate.
o B
spot rate.
o C
futures rate.
Incorrect
B is correct. The underlying instrument for interest rate options is the spot rate.
28. Question 28
Which of the following statements is most likely correct?
o A
Interest rate options’ valuation follows the expectations approach.
o B
A put option on interest rates will be in the money when the spot rate is
above the exercise rate.
o C
A call option on interest rates will be in the money when the spot rate is
below the exercise rate.
Incorrect
A is correct. “Option valuation follows the expectations approach taken one period at
a time.” B & C are incorrect. A put option on interest rates will be in the money when
the exercise rate is above the spot rate, and for in the money call option the spot
rate will be above the exercise rate.
29. Question 29
The following information relates to next 2 questions.
Table 1: Two-Year Binomial Interest Rate Lattice by Year
T=0 T=1 T=2

Rate =
3.9670% c++ =
0.00717
Value =
0.9626 Rate =
3.8900% c+ = ?
Value =
Rate =
0.9705 Rate
3.2450% c+- =
= 3.0380% c
0.0
=?
Value = 0.9750
Rate = 2.5600%
c– = ?
Rate =
2.2600% c— =
0.0
An analyst is valuing two-year European-style call options on the periodically
compounded one-year spot interest rate. Assume the notional amount of the
options is €1, the call exercise rate is 3.25% of par, and the RN probability is 50%.
Using Table 1, the values of c+ and c– at T = 1 are closest to:
o A
c+ = 0.0035, c- = 0.0000.
o B
c+ = 0.0005,c- = 0.0040.
o C
c+ = 0.0050, c- = 0.0006.
Incorrect
A is correct. c+ = PV1,2[πc++ + (1 – π)c+–] = 0.9626 [0.5 × 0.00717 + (1 − 0.5)0.0] =
0.003451. c– = PV1,2[πc+– + (1 – π)c– –] = 0.9750 [0.5 × 0.0 + (1 − 0.5)0] = 0.0.
30. Question 30
The multi-period binomial model can be used to value:
o A
both path-dependent and path-independent options

o B
path-independent options only.

o C
path-dependent options only.

Incorrect
A is correct. The multi-period binomial model can be used to value both path-
independent and path-dependent options.
31. Question 31
Which of the following statements is most likely true? The value of a call option can
be calculated as the present value of the expected terminal option payoffs where the
discount rate is:
o A
the required return for the underlying stock and the expected payoff is based
on the risk neutral probability.
o B
the risk-free rate and the expectation is based on the risk neutral
probability.
o C
the required return for the underlying stock and the expected future cash
flows are based on the actual probability of the underlying stock going up or
down in value.
Incorrect
B is correct. The value of a call option can be described as the present value of the
expected terminal option payoffs where the discount rate is the risk-free rate and
the expectation is based on the risk neutral probability.
32. Question 32
Which of the following is not an assumption of the BSM model?
o A
The underlying follows geometric Brownian motion.

o B
The underlying has a constant volatility.

o C
Short-selling of the underlying is not allowed.

Incorrect
C is correct. BSM assumes that short selling is allowed. Options A and B are
assumptions of BSM.
33. Question 33
Call option value based on the BSM model is given as:
o A
the bond component minus the stock component.

o B
the stock component minus the bond component.

o C
the stock component plus the bond component.

Incorrect
B is correct. The BSM model has two components: the stock component and the
bond component. The stock component is given by SN(d1) and the bond component
is e–rTXN(d2). The call value is given by the stock component minus the bond
component. The put value based on the BSM model is the bond component – e–rTXN(-
d2) minus the stock component – SN(-d1).
34. Question 34
o A
A put option can be interpreted as lending that is partially financed with a

short position in shares.
o B
A call option be interpreted as short-selling the underlying stock and

using the proceeds to buy zero-coupon bonds.
o C
A call option can be interpreted as a leveraged position in the underlying

stock.
Incorrect
B is correct. The BSM model put value is equal to the cost of a portfolio of bonds
bought with proceeds from short selling of the underlying. A & C are correct
statements.
35. Question 35
Suppose a stock is trading on the Singapore Stock Exchange at SGD 60. A portfolio
manager believes that the stock price will rise in the next three months and decides
to buy threemonth call options with exercise price at SGD 62. The risk-free
government securities are trading at 1.74%, and the stock is yielding SGD 0.35%. The
stock volatility is 30%. Which of the following statements regarding the application of
the BSM model to value calls is correct? The BSM model inputs (underlying, exercise,
expiration, risk-free rate, dividend yield, and volatility) are:
o A
60, 0.35%, 1.74%, 0.25, 62, 0.30.

o B
60, 62, 0.25, 0.0174, 0.0035, 0.30.

o C
62, 0.25, 0.0035, 0.0174, 0.30, 60.

Incorrect
B is correct. The spot price of the underlying is SGD60. The exercise price is SGD62.
The expiration is 0.25 years (three months). The risk-free rate is 0.0174. The dividend
yield is 0.0035. The volatility is 0.30.
36. Question 36
A Pakistani importer has to pay fixed euro (€) amounts each quarter for goods. The
spot price of the currency pair is 117.60 PKR/€. If the exchange rate rises to 120
PKR/€ then euro would have strengthened because it would take more rupees to
buy one euro. The importer feels that the rupee will depreciate in the following
months. Hence, he considers buying an at-the-money spot euro call option to
protect against this rise. The Pakistani riskfree rate is 6.00% and the European risk-
free rate is 1.00%. What is the underlying price, the risk-free rate and the carry rate
to use in the BSM model to get the euro call option value?
o A
117.60, 6.00%, 1.00%.

o B
1/117.60, 1.00%, 0.00%.
o C
117.60, 1.00%, 6.00%.

Incorrect
A is correct. The underlying is the spot FX price of 117.60 PKR/€. The risk-free rate is
the Pakistani rate, 6.00%, and the carry rate is the European rate of 1.00%.
37. Question 37
The FTSE 100 Index (a spot index) is presently at 6,690 and the 0.25 expiration
futures contract is trading at 6,702. Suppose further that the exercise price is 6,690,
the continuously compounded risk-free rate is 0.16%, time to expiration is 0.25, and
the dividend yield is 4.0%. Based on this information and volatility, N(d1) = 0.526,
N(d2) = 0.488. The statement that is most accurate under the Black model to value a
European call option on the futures contract is:
o A
The call value is the present value of the difference between the futures
price of 6,702 times 0.526 and the exercise price of 6,690 times 0.488.
o B
The call value is the present value of the difference between the futures price
of 6,702 times 0.526 and the underlying price times 0.474.
o C
The call value is the present value of the difference between the exercise
price of 6,690 and the futures price of 6,702.
Incorrect
A is correct. Black’s model for call options can be expressed as c = e–rT [F0(T)N(d1) – XN
(d2)], where F0(T) = the futures price at Time 0 that expires at Time T = 6,702, X =
exercise price = 6,690.
38. Question 38
For an interest rate call option on three-month Libor with one year to expiration, the
FRA that expires in one year is 1.20%, the current three-month Libor is 0.84% and the
call exercise rate is 0.90%. In applying the Black model to value this interest rate call
option, the underlying rate is:
o A
0.84%.
o B
0.90%.
o C
1.20%.
Incorrect
C is correct. The underlying rate is the FRA rate that expires in one year = 1.20%.
Barry Todd is a valuations specialist at BCI Capital with a specific focus on derivatives. He is
valuing an American call option on Air Blitz Ltd. (ABL) with an exercise price of USD25 and
expiry in two years. The stock is currently trading at USD45. The stock is due to pay a
dividend of USD2 in one year’s time. The stock’s up move factor is 1.264 and the down move
factor is 0.679. The annual risk free rate is 3%.
1. Question 1
The risk neutral probability of an up move is closest to:
o A
0.60
o B
0.54
o C
0.44
Incorrect
A is correct. The risk neutral probability is calculated as 1.03−0.679 / 1.264−0.679 =
0.6.
2. Question 2
The call option’s value after an up move at year 1 is closest to:
o A
USD30.15
o B
USD31.43
o C
USD29.43
Incorrect
B is correct. As indicated in the figure below, the call option’s value after an up move
at year 1 is USD31.4257. Using the RN probability of 0.6 for an up move and discount
rate of 3%, the binomial option valuation lattice is as follows:
At year 1 after an up move, the option value as per the expectations approach is
USD30.1539. Because this is an American call option, its value is influenced by the
early exercise option. The stock value at Time 1 is calculated by subtracting the
present value of dividends from the current, S0 = USD45 value of the stock. Present
value of dividends at Time 0 = 2/1.03 = USD1.94175. Therefore, stock value at Time 1
= S+ = [(45-1.94175) X1.264] = 54.43. The early exercise value assumes the option is
exercised right before the stock goes ex-dividend and the investor receives the
dividend. If the call is not exercised the call buyer will not receive this dividend.
Hence, the early exercise value is 54.43 + 2 – 25 = USD31.43.
3. Question 3
The hedge ratio at year 1 after a down move is closest to:
o A
0.6990
o B
0.7050
o C
0.6850
Incorrect
A is correct. The hedge ratio is calculated as c+− c− / S+− S−=11.9550 − 0 / 36.9550 −
19.8516 = 0.6990.
4. Question 4
The call option’s current value is closest to:
o A
USD20.27
o B
USD21.01
o C
USD20.00
Incorrect
B is correct. The option’s current value is USD21.0107. Using the RN probability of 0.6
for an up move and discount rate of 3%, the binomial option valuation lattice is as
follows:
Note: The calculation of the call option’s value after an up move at year 1 was shown
in the solution to a previous question.
5. Question 5
Assuming that the given option was a European option, its current value would have
been:
o A
higher.
o B
same.
o C
lower.
Incorrect
C is correct. Because the European option would not have the choice of an early
exercise, its value would be lower than the American option.
Julia Bond, CFA, an analyst at Premium Investments is valuing a two year European call
option on the periodically compounded one year spot rate. The exercise rate is 2.5% and the
risk neutral probability is 50%. The binomial interest rate lattice is given below:
1. Question 1
The rate at the top most node at year 2 is:
o A
The two year spot rate at the beginning of year

o B
The one year spot rate at the beginning of year

o C
The one year spot rate at the end of year 2.

Incorrect
C is correct. The binomial interest rate tree shows the one-year spot rates in year 2.
2. Question 2
The current option value is closest to:
o A
$0.0031
o B
$0.0027
o C
$0.0024
Correct
B is correct. At year 2, the possible option values are:
c++= Max(0, 0.0325-0.025) = 0.0075
c+-= Max(0, 0.027-0.025) = 0.002
c—= Max(0, 0.0226-0.025) = 0
At year 1, we have:
c+= 0.9713(0.5 x 0.0075 + 0.5 x 0.002) = 0.004614
c–= 0.9761(0.5 x 0.002 + 0.5 x 0) = 0.000976
At year 0 the call option value is:
c = 0.9742 (0.5 x 0.004614 + 0.5 x 0.000976) = $0.002723.
Tim John and Bill Adams are analysts at Primus Capital. The have recently been assigned the
task of valuing options on equities in the market by the Chief Investment Officer. As
beginners, they valued options based on binomial models assuming discrete price changes
of the underlying. However, they are now evaluating using other option valuation models.
Tim and Bill discuss the characteristics, valuation methodologies and assumptions of option
valuation models before presenting their conclusions to the investment committee.
Specifically they discuss the Black –Scholes-Merton (BSM) model and the Black model. They
observe the following: Tim: The BSM model assumes that the underlying follows the
Brownian motion, implying that the return of the underlying is normally distributed. Bill: I
disagree. I believe the underlying’s return follows a lognormal distribution. Tim: The BSM
model assumes that all trades can be done free of any transaction costs. Bill: In addition, it
also assumes that short selling of the underlying instruments and full use of proceeds is
permitted. Tim: The BSM model assumes that options are American-style. Bill: I disagree.
The BSM model assumes the options are European-style. In addition, it also assumes that
the risk-free rate is non-constant. Tim: The BSM model can be described as having two
components; a bond and a stock component. For call options, the model can be seen as the
stock component minus the bond component. Bill: I agree, and for put options the model
can be seen as the bond component minus the stock component. Tim: I recently used the
BSM model to value the options of J&I Corp. My calculations of the parameters showed d1 =
0.333, d2 = 0.033, N(d1) = 0.633, N(d2) = 0.515. Bill: What was the trading strategy matching
the payoff of an option suggested by you? Tim: The modified Black model used for valuing
swaptions uses the fixed rate on a forward interest rate swap as the underlying. Bill: I
believe the swap rate and the exercise rate are both expressed as percentages and not
decimals.
1. Question 1
Regarding the return distribution of the underlying,:
o A
Tim is incorrect and Bill is correct.

o B
Tim is correct and Bill is incorrect.
o C
Both Tim and Bill are incorrect.

Incorrect
A is correct. The BSM model assumes that the underlying follows the geometric
Brownian motion, implying that the return of the underlying is lognormally
distributed. Hence Tim is incorrect and Bill is correct.
2. Question 2
Regarding transaction costs and short selling,:
o A
Tim is incorrect and Bill is correct.

o B
Both Tim and Bill are incorrect.

o C
Both Tim and Bill are correct.

Incorrect
C is correct. The BSM model assumes there are no transaction costs and that short
selling with full use of proceeds is permitted. Hence both Tim and Bill are correct.
3. Question 3
With regards to option style and risk free rate,:
o A
Tim is correct about option style, Bill is incorrect about option style but
correct about risk free rate.
o B
Tim is incorrect about option style, Bill is correct about option style but
incorrect about risk free rate.
o C
Tim is incorrect about option style, Bill is correct about option style and risk
free rate.
Incorrect
B is correct. The BSM model assumes that options are European-style i.e. early
exercise is not allowed. In addition, it also assumes that the continuously
compounded risk-free interest rate is known and constant. Hence, Tim is incorrect
about option style. Bill is correct about option style but incorrect about risk-free rate.
4. Question 4
With regards to the BSM model being interpreted as having two components:
o A
Only Tim is correct.

o B
Both are correct.

o C
Both are incorrect.

Incorrect
B is correct. Under the BSM model, a call option can be seen as the stock component
minus the bond component and the put option can be seen as the bond component
minus the stock component. Hence, both Tim and Bill are correct.
5. Question 5
The trading strategy most likely suggested by Tim that replicates call option payoffs
for a buyer is:
o A
buy 0.633 shares of stock and short sell 0.515 shares of zero-coupon
bonds.
o B
buy 0.515 shares of stock and short sell 0.633 shares of zero-coupon bonds.
o C
buy 0.633 shares of zero-coupon bonds and short sell 0.515 shares of stock.
Incorrect
A is correct. The BSM model for call options is N(d1)S –N(d2)e–rTX and for put options
is – N(–d1)S +N(–d2)e–rTX. For call options, the model can be seen as buying N(d1)
shares of the stock and short selling N(d2) shares of the bond. For put options, the
model can be seen as short selling N(-d1) shares of the stock and buying N(-d2)
shares of the bond. Hence the call option is the same as buying 0.633 shares of the
stock and short selling 0.515 shares of the bond..
6. Question 6
With regards to the modified Black model for valuing swaptions:
o A
Tim is correct and Bill is also correct.

o B
Tim is correct and Bill is incorrect.
o C
Both are incorrect.

Correct
B is correct. In the modified Black model for valuing swaptions, the underlying is the
fixed rate on a forward interest rate swap and both the swap rate and the exercise
rate are expressed as decimals and not percentages. Hence, Tim is correct and Bill is
incorrect.
ETHICS
Code of Ethics and Standards of

Professional Conduct
1. Question 1
Q-Code: 21-L2-ES-CESP-74852
According to the CFA Institute Code of Ethics, which one of the following is incorrect?
Members and Candidates must:
o A
Act with integrity, competence, diligence, and respect and in an ethical

manner with the public, clients, prospective clients, employers, employees
and other participants in the global capital markets.
o B
Place the integrity of the investment profession and the interests of

clients at par with their own interests.
o C
Use reasonable care and exercise independent professional judgment when

conducting investment analysis, making investment recommendations,
taking investment actions and engaging in other professional activities.
Incorrect
B is correct. According to the CFA Code of Ethics: “Place the integrity of the
investment profession and the interests of clients above their own personal
interests” and not at par with their own interests. The Code of Ethics.
2. Question 2
According to the CFA Institute Code of Ethics, which of the following statements
is least likely correct? Members and Candidates must:
o A
place the integrity of the investment profession and the interest of clients
above their own personal interests.
o B
maintain and improve their professional competence and strive to

create a competitive environment for other investment professionals.
o C
use reasonable care and exercise independent professional judgment when

conducting investment analysis, making investment recommendations,
taking investment actions, and engaging in other professional activities.
Incorrect
B is correct. The Code of Ethics does not talk about creating a competitive
environment. The focus is on maintaining and improving the professional
competency of self and others in the investment profession. The Code of Ethics.
3. Question 3
Which of the following is not a Standard of Professional Conduct?
o A
Efficiency of capital markets.

o B
Professionalism.
o C
Duties to clients.
Incorrect
A is correct. It is Integrity of Capital Markets, not Efficiency of Capital Markets.
Standards of Professional Conduct.
4. Question 4
Which one of the following is a Standard of Professional Conduct?
o A
Duties to Capital Markets

o B
Equity Analysis, Recommendations, and Actions

o C
Conflicts of Interest
Incorrect
C is correct. B is incorrect because it is Investment Analysis, Recommendations, and
Actions. A is incorrect because it is Duties to Clients and Duties to Employers.
Standards of Professional Conduct.
5. Question 5
Which one among the following is not a Standard of Professional Conduct?
o A
Duties to Employers.
o B
Responsibilities as a CFA Institute Member or CFA Candidate

o C
Communication with Employers.

Incorrect
C is correct. Communication with clients and prospective clients is a substandard
under Investment Analysis, Recommendations, and Actions. Standards of
Professional Conduct.
6. Question 6
is correct? Members and Candidates must:
o A
Promote the integrity and efficiency of the global capital markets for the
ultimate benefit of society.
o B
Promote the integrity and efficiency of the global capital markets for the
ultimate benefit of investors.
o C
Promote the integrity and viability of the global capital markets for the
Incorrect
C is correct. Refer to the Code of Ethics.
7. Question 7
o A
Use independence and exercise discretion when conducting investment

analysis, making investment recommendations, taking investment actions,
and engaging in other professional activities.
o B
Use reasonable care and exercise independent professional judgment

when conducting investment analysis, making investment
recommendations, taking investment actions, and engaging in other
professional activities.
o C
Use independence and objectivity when conducting investment analysis,

making investment recommendations, taking investment actions, and
engaging in other professional activities.
Incorrect
B is correct. Refer to the Code of Ethics.
8. Question 8
The Standards of Practice Handbook is most likely to require a member to disclose
which of the following to clients and prospective clients?
o A
Guidelines of CFA Institute Standards of Professional Conduct

o B
The important limitations and risks of the investment process

o C
A one-time investment loss that occurred after disclosure of certain risks of

investment
Incorrect
B is correct. According to Standard V(B) Communication with Clients and Prospective
Clients members should inform their clients about the significant limitations and
risks associated with the investment process. Standards of Professional Conduct.
9. Question 9
According to the Standards of Practice Handbook, which of the following statements
about Performance Presentation is least accurate? The Standard related to
performance presentation requires members and candidates:
o A
to ensure that the investment performance information is fair, accurate, and
complete.
o B
to deal fairly and objectively with all clients when providing investment
analysis, making investment recommendations, or taking investment
action.
o C
to avoid misrepresenting past performance to clients and prospective clients.

Incorrect
B is correct. Refer to Standard III(D) Performance Presentation. Standards of
10. Question 10
According to the Standards of Practice Handbook, members are most likely required
to disclose to their clients:
o A
ownership of stock in companies they recommend to clients.

o B
information on the Professional Conduct Statement.

o C
the screening steps used to select stocks.

Incorrect
A is correct. Refer to Standard VI(A) Disclosure of Conflicts. Standards of Professional
Conduct.
11. Question 11
According to the Standards of Practice Handbook, a member has to protect the
interests of his firm, refraining from any conduct that would deprive it of profit, or
his skills and ability. If a member fails, he violates the CFA Institute Standards of
Professional Conduct related to:
o A
Duties to Clients.
o B
Loyalty.
o C
Responsibilities of Supervisors.
Incorrect
B is correct. Refer to Standard IV(A) Loyalty. Standards of Professional Conduct.
12. Question 12
Which of the following statements is most accurate according to the Standards of
Practice Handbook? Members and Candidates must:
o A
deal fairly and objectively with the fee-paying clients when providing
investment recommendations, taking investment action, or engaging in other
professional activities
o B
ensure that anyone under their supervision complies only with the Code and
Standards
o C
not accept gifts, benefits or compensation if it creates a conflict with

their employer’s interest unless they obtain a written consent from all
parties involved.
Incorrect
C is correct. A is incorrect because they must deal fairly and objectively with all
clients, not just fee-paying clients. B is incorrect they must comply with applicable
laws, not just domestic laws. Standards of Professional Conduct.
13. Question 13
A failure to reveal information about a client involved in illegal activities is most likely a
violation of:
o A
Preservation of confidentiality.
o B
Loyalty, prudence and care.

o C
Disclosure of conflicts.
Incorrect
A is correct. Members and Candidates must reveal information when required by the
law, or when the client is involved in illegal activities. Standards of Professional
Conduct.
14. Question 14
Practice Handbook? Members and Candidates:
o A
who possess nonmaterial nonpublic information that could affect the value
of an investment must not act or cause others to act on the information
o B
who possess material nonpublic information that could affect the value
of an investment must not act or cause others to act on the
information.
o C
who possess nonmaterial public information that could affect the value of an
investment must not act or cause others to act on the information
Incorrect
B is correct. Refer to Standard II(A) Material Nonpublic Information. Standards of
15. Question 15
o A
may engage in practices to boost the liquidity of an illiquid stock.

o B
must not engage in practices to artificially inflate trading volume

o C
are not prohibited from creating rumor campaigns on blogs and social media
outlets with the intent of pumping prices.
Incorrect
B is correct. Refer to Standard II(B) Market Manipulation. Standards of Professional
Conduct.
16. Question 16
Which Standard requires members and candidates responsible for managing a
portfolio to a specific mandate, strategy, or style, to make investment
recommendations or take investment actions that are consistent with the stated
objectives and constraints of the portfolio?
o A
Standard III(C) Suitability.
o B
Standard V(A) Diligence and Reasonable Basis.

o C
Standard III(A) Loyalty, Prudence and Care.

Incorrect
A is correct. Refer to Standard III(C) Suitability. Standards of Professional Conduct.
17. Question 17
o A
Act with honesty, efficiency, thoroughness, and in an ethical manner with the
public, clients, prospective clients, employers, employees and other
participants in the global capital markets.
o B
Refrain from encouraging others to act in a professional and ethical manner

that will reflect credit on the employer and the profession.
o C
Promote the integrity and viability of the global capital markets for the
Incorrect
C is correct. A is incorrect because the Code of Ethics talks about integrity,
competence, diligence, and respect. B is incorrect because members and candidates
must not only practice themselves but also encourage others to practice in a
professional and ethical manner that will reflect credit on themselves and the
profession. The Code of Ethics.
18. Question 18
o A
must keep information about current, former, and prospective clients

confidential if it concerns illegal activities on the part of the client or
prospective client unless disclosure is required by the law.
o B
must disclose information about current, former, and prospective
clients if it concerns illegal activities on the part of the client or
prospective client irrespective of whether disclosure is required by the
law.
o C
must keep information about current, former, and prospective clients

confidential if it concerns illegal activities on the part of the client or
prospective client unless clients or prospective clients permit disclosure.
Incorrect
B is correct. Refer to Standard III(E) Preservation of Confidentiality. Standards of
19. Question 19
Which Standard relates to distinguishing between fact and opinion in the
presentation of investment analysis and recommendations?
o A
Standard V(C) Record Retention.

o B
Standard V(A) Diligence and Reasonable Basis.

o C
Standard V(B) Communication with Clients and Prospective Clients.

Incorrect
C is correct. Refer to Standard V(B) Communication with Clients and Prospective
Clients. Standards of Professional Conduct.
20. Question 20
A member gets verbal consent from his employer before accepting a 7-day vacation
for him and his family at his client’s private villa in southern Spain, including travel in
a private jet as it is in a remote location. This was in appreciation for the outstanding
performance of his client’s portfolio. Did the member violate any Standard?
o A
No
o B
Yes, Standard IV(A) Loyalty.

o C
Yes, Standard IV(B) Additional Compensation Arrangements.

Incorrect
C is correct. The member failed to obtain written consent and a gift such as is this
might potentially create a conflict of interest. Standards of Professional Conduct.
21. Question 21
Which Standard requires Members and Candidates to disclose to their employer,
clients, and prospective clients, as appropriate, any compensation, consideration, or
benefit received from or paid to others for the recommendation of products or
services?
o A
Standard VI(C) Referral Fees.

o B
Standard IV(B) Additional Compensation Arrangements

o C
Standard IV(A) Loyalty.

Incorrect
A is correct. Refer to Standard VI(C) Referral Fees. Standards of Professional Conduct.
22. Question 22
Which Standard requires Members and Candidates to make full and fair disclosure
of all matters that could reasonably be expected to impair their independence and
objectivity or interfere with respective duties to their clients, prospective clients, and
employer?
o A
Standard VI(A) Disclosure of Conflicts.

o B
Standard IV(A) Loyalty.

o C
Standard I(B) Independence and Objectivity.

Incorrect
A is correct. Refer to Standard VI(A) Disclosure of Conflicts. Standards of Professional
Conduct.
Guidance for Standards I–VII

1. Question 1
Q-Code: 21-L2-ES-GUID-74868
Cory Griffin, a Level II candidate, works as an investment advisor for Trust Mutual
Fund. He specializes in commodities and informs his clients that the energy prices
are going to rise due to political turmoil in the Middle East. He informs his broker at
Xylan Mercantile to invest long in oil futures for him. Griffin should:
o A
disclose his personal transaction.

o B
manage his personal account separately.

o C
refrain from any personal transaction as long as he is employed by Trust.

Incorrect
A is correct. According to Standard VI(A) Disclosure of Conflicts, Griffin should
disclose this personal transaction.
2. Question 2
Klaus Matthias, CFA, works at Meinhard Capital, an investment and brokerage firm
where he supervises a team that develops and markets fixed income funds to cater
to different high net worth clients internationally. Recently, due to the popularity of
Islamic products he has asked his team to develop an Islamic Fund to market to his
clients in the Middle East. The team includes three individuals who are all candidates
in the CFA Program. After some research, they come up with a product that seems
marketable to this specific niche. Before distribution of the fund, Matthias is worried
whether the Fund is suitable for all Islamic investors. Matthias should:.
o A
not launch the fund because it is not suitable for all Islamic investors.
o B
launch the fund but clearly acknowledge areas where the fund may not
be suitable for certain clients
o C
launch the fund because there will always be differences in cultural and
religious laws around the world.
Incorrect
B is correct. Refer to Standards I(A) Knowledge of the Law and III(C)
Suitability. Members and candidates should understand that a single product
cannot be suitable for all Islamic investors. The best way to deal with this situation is
to clearly define which Islamic laws and regulations are being followed in the
creation of the product and the types of investors for whom this fund will be
suitable.
3. Question 3
Nargis Dilawez, CFA, works as an independent research analyst and uses various
online social media sites to make announcements, recommendations and analysis of
various securities. She is a resident of Country S where there is no law against
posting of comments and opinions, but since her views are read globally she is
worried about regulators in certain countries who impose restrictions and
requirements on online communications. According to the Standards, Dilawez
should:
o A
continue to post her comments since her resident country does not impose
any regulatory restrictions.
o B
discontinue immediately and wait for the restrictions to ease in the

nonresident countries.
o C
seek guidance from appropriate, knowledgeable, and reliable sources to

diligently follow legal and regulatory trends affecting her professional
responsibilities.
Incorrect
C is correct. According to Standard I(A) Knowledge of the Law Dilawez should adopt
the stricter law.
4. Question 4
Wynona Fritz works for Brady Brokerage as a fixed income analyst. She is also
registered to take the Level III examination. After analyzing both the qualitative and
quantitative aspects of Saber Inc., Fritz concludes that the company is not correctly
rated by the credit rating agency and should be downgraded due to the leverage in
its capital structure. A senior manager from the investment banking department
informs her that Saber Inc. has chosen Brady Brokerage as one of the firms to
underwrite and market their new bond issue. Fritz is concerned that her report will
cause the company to terminate their relationship with Brady and affect her
employment. According to the Standards, Fritz should:
o A
dissociate from the report, the underwriting, and the client.

o B
be independent and objective in her analysis based solely on the

company’s fundamentals.
o C
change her recommendation about the credit rating to remove the conflict.
Incorrect
B is correct. Fritz should be independent and objective in her report. Alternatively,
Brady Brokerage could place Saber Inc. on a restricted list and issue only factual
information. Standard I(B) Independence and Objectivity.
5. Question 5
Jessica Morales works as an investment adviser for Chris Crosby, a middle-aged, risk
averse investor. As per the investment policy statement, Morales invests in low-risk,
high-income equities for Crosby keeping in mind his current needs and objectives.
Recently Crosby’s mother passed away leaving him with a significant inheritance.
Morales continues to invest as before without any change in the investment strategy.
According to the CFA Institute Standards of Professional Conduct, Morales should:
o A
stay abreast of changes in the client’s net worth and accordingly update
the investment policy to reflect changes in investment objectives.
o B
consider the long term aspect of Morales’ investments and continue with the
current strategy.
o C
keep changing the asset allocations in line with market changes.

Incorrect
A is correct. Refer to Standard III(C) Suitability.
6. Question 6
Christie Tania, CFA, works as a fixed income manager for Mastermind Invest Capital.
She finds an error in the performance results of one of her accounts as the report is
about to be released to the client. The correction of the error will show an
underperformance of the account compared to the selected benchmark. The client is
not satisfied with Mastermind and had previously indicated that the account will be
terminated if it did not meet the requisite returns. According to the CFA Institute
Standards, Tania should:
o A
not send the report and wait till account shows an improvement in results.
o B
inform the appropriate individuals that the report needs to be updated

before releasing it to the client.
o C
not correct the error and send it.

Incorrect
B is correct. According to Standard III(A) Loyalty the client needs to be informed with
the updated result of the underperformance of his account. Withholding information
is not in the best interest of the client.
7. Question 7
Bernhard Investment and Brokerage Company, has recently changed its stock
selection method based on fundamental analysis to technical analysis. After testing
it in-house under various scenarios, the new method seems more appropriate to the
investments done by Bernhard. Kurt Ludwig, CFA, a portfolio manager with
Bernhard feels that his clients will not understand the change and decides not to
inform them. The most appropriate action Ludwig should take to avoid a violation of
the Code and Standards is:
o A
to communicate the change of method to his clients and prospective

clients.
o B
to communicate to only those clients who have a previous knowledge of

technical analysis.
o C
not to inform of the change because it might lead the clients to challenge the
new method of stock selection.
Incorrect
A is correct. Ludwig must disclose to his clients the change in the process of
selection. Refer to Standard V(B) Communications with Clients and Prospective
Clients.
8. Question 8
Dave Daisuke, CFA, works in the corporate finance department of Advile Securities.
He receives a non-cash compensation for every referral he makes to the brokerage
department. This arrangement is an accepted norm within the company but the
clients are not informed because no cash is given out within the firm for
interdepartmental referrals. According to the CFA Institute Standards,
the most appropriate action to take for the firm to avoid a violation is to:
o A
adjust the non-cash compensation in the salaries of the personnel including

Daisuke who are referring clients to the brokerage department.
o B
disclose to clients at the time of a referral, the referral arrangements
within Advile’s departments.
o C
stop the referral policy to remove any conflicts of interest.

Incorrect
B is correct. Disclosure to clients is important even if the referrals result in a noncash
compensation. Refer to Standard VI(C) Referral Fees
9. Question 9
Lauren Crawley is enrolled to take the Level I exam. As he tries hard to remember a
formula to complete a question, he notices that the person in front of him gets up to
drink water and a piece of paper slips from his pocket and falls on Crawley’s table. In
order to avoid a violation of the CFA Institute Standards of Professional Conduct,
the least appropriate action taken by Crawley is to:
o A
remove it without looking at it and call the proctor.

o B
immediately call the proctor to her table and have the paper removed.
o C
look at the paper and then remove it before anyone else notices it.
Incorrect
C is correct. Refer to Standard VII(A) Conduct as Participants in CFA Institute
Programs.
10. Question 10
Anna Becker is employed by Jergen Investment Management Company (JIMC).
Becker is a Level II candidate and is the only CFA candidate employed by JIMC.
Becker is given supervisory responsibilities of the compliance department and asked
to review the firm’s compliance policies and procedures, which she finds inadequate.
She voices her concerns during a meeting with the CEO, who tells her to submit her
recommendations in a report but these will not be implemented since the firm is
undergoing a change in structure and no compliance changes will be entertained till
then. According to the Code and Standards, Becker should:
o A
decline to accept supervisory responsibilities.

o B
accept supervisory responsibilities and lay down the compliance policies and
procedures for future.
o C
wait till a new structure is implemented and then review the entire firm.
Incorrect
A is correct. According to Standard IV(C) Responsibilities of Supervisors, a member or
candidate should decline in writing to accept supervisory responsibilities until
reasonable compliance procedures are laid down by a firm for her to assume and
exercise responsibility
11. Question 11
Cory Crawford works as a fixed-income portfolio manager focusing on investment
grade bonds at Doonesbury Capital. His clients are primarily risk-averse, retired
pensioners. Crawford’s firm has introduced a bonus system to reward those
portfolio managers who achieve a return higher than their respective
benchmarks. Crawford, who is also a Level I candidate, purchases certain high-yield
bonds in order to increase the return of his clients’ portfolio. No change in the
objective or strategy has been suggested by Crawford. Crawford has least
likely violated the Standard related to:
o A
Suitability.
o B
Disclosure of Conflict.
o C
Priority of Transactions
Incorrect
C is correct. Crawford doesn’t own the same securities as his clients therefore he
least likely violates Standard VI(B) Priority of Transactions. According to Standard
VI(B) Priority of Transactions, investment transactions for clients and employers
must have priority over investment transactions in which a Member or Candidate is
the beneficial owner.
He violates Standard VI(A) Disclosure of Conflicts by failing to inform his clients of the
change in his compensation arrangement (i.e., a bonus system to reward those
portfolio managers who achieve a return higher than their respective benchmarks)
with his employer which causes a conflict between his compensation and the clients’
IPS. According to Standard VI(A) Disclosure of Conflicts, Members and Candidates
must make full and fair disclosure of all matters that could reasonably be expected
to impair their independence and objectivity or interfere with respective duties to
their clients, prospective clients, or employer. Members and Candidates must ensure
that such disclosures are prominent, are delivered in plain language, and
communicate the relevant information effectively.
He violated III(C) Suitability because he is managing a fixed-income portfolio focusing
on investment grade bonds and his clients are primarily risk-averse, retired
pensioners. This implies that the high-yield bonds are not suitable for his risk averse
clients. According to Standard III (C) Suitability, when “Members and Candidates are
responsible for managing a portfolio to a specific mandate, strategy, or style, they
must make only investment recommendations or take only investment actions that
are consistent with the stated objectives and constraints of the portfolio”.
12. Question 12
Rhonda Gates, CFA, works as a senior analyst covering basic materials and mining
industry at Marcel Investments. After a thorough and independent research, Gates
concludes that the stock of Riley Mining is overpriced and recommends selling it to
take profits. She informs all the department heads of Marcel of her
findings. Thomas Toffler, head of trading, after being informed about Riley’s stock
immediately places a sell order on behalf of the firm and is able to trade
aggressively. The next day Gates’ report is sent to all clients and the sales
force. Toffler least likely violated which of the following Standards?
o A
Loyalty, Prudence and Care.

o B
o C
Fair Dealing.
Incorrect
C is correct. Standard III(A) Loyalty, Prudence and Care has been violated because
Toffler did not place his clients’ interests before his employer’s interests. Standard
VI(B) Priority of Transactions has been violated. Toffler would have avoided the
conflict by waiting until his clients had the opportunity to receive and assimilate
Gates’ report. The report was sent out to all clients at the same time; hence Standard
III(B) Fair Dealing is not violated.
13. Question 13
Ratti Sonali, a Level III candidate, works as a trader at Rupali Investments. While
working on trades for high net-worth clients, she notices a decline in the portfolio
value due to certain investments made by the portfolio manager. She informs her
supervisor Ashok Rajan, who also supervises the portfolio manager. Rajan tells her
not to concern herself with the portfolio manager’s performance. Sonali then speaks
to the compliance officer who tells her that the high net worth client portfolio is
successful and the portfolio manager is very competent. The
Standard least likely violated is:
o A

o B
Misrepresentation.
o C
Responsibilities of Supervisors
Incorrect
B is correct. Standards III(A) Loyalty, prucence, and care and IV(C) Responsibility of
Supervisors have been violated since both the supervisor and compliance officer did
not investigate Sonali’s concerns. Standard IV (C) Responsibility of Supervisors
requires that Members and Candidates must make reasonable efforts to ensure that
anyone subject to their supervision or authority complies with applicable laws, rules,
regulations, and the Code and Standards. Standard I(C) Misrepresentation is not
violated because the question does not provide enough information to infer that
amy misrepresentations relating to investment analysis or recommendations is
made. As per Standard I(C) Misrepresentation, Members and Candidates must not
knowingly make any misrepresentations relating to investment analysis,
recommendations, actions, or other professional activities. A misrepresentation is
any untrue statement, or omission of fact, or any statement that is otherwise false or
misleading.
14. Question 14
Shehroze Parvan, CFA, manages a balanced fund at McCoy Securities. He recently
joined the company after working for ten years at Russell Securities. McCoy hired
Parvan because of his proven track record at Russell. The new advertising material
that Parvan develops for the clients of McCoy carries his past performance which he
achieved at Russell as an endorsement of his knowledge and skills in investing.
However, the performance results at the end include a qualifier stating, “These
results were achieved by Parvan at Russell Securities.” Has Parvan violated any
Standard?
o A
Yes, relating to Misconduct.

o B
Yes, relating to Performance Presentation.

o C
No.
Incorrect
C is correct. No violation has occurred. It is acceptable to share past performance as
long as a clear disclaimer is provided that this performance was achieved at another
firm
15. Question 15
L.O.: a Q-Code: 21-L2-ES-GUID-74882

Ankit Aacharya, CFA, while making the marketing material for his firm Aakash Capital
writes in the brochure, “Aakash Capital is committed to achieving excellent
performance for its clients. It hires the most eligible personnel in the field of
investment management. Most of the employees have either completed the CFA
Program or are enrolled as candidates in the CFA Program. As a CFA charterholder, I
am the most qualified to manage client investments.” Aacharya most likely violated
the Standard with improper references to the:
o A
CFA Designation.
o B
CFA Program.
o C
CFA Institute.
Incorrect
A is correct. CFA Institute and CFA Designation were improperly referenced. Refer to
Standard VII(B) Reference to CFA Institute, the CFA Designation, and the CFA
Program.
16. Question 16
Rasmussen Hadley, CFA, writes in an independent blog about the findings of his
research on various companies. He also works as an analyst with Brooklyn
Brokers. He has written permission from his employer and appropriate regulator to
give his opinion about various securities in his blog. Hadley, however uses the
pseudonym Sam Smith, CFA, to hide his identity on the internet. Does Hadley violate
the Standards?
o A
No.
o B
Yes, related to reference to CFA Designation.

o C
Yes, related to loyalty.

Incorrect
B is correct. Hadley cannot use the CFA designation tagged to a pseudonym or online
profile name used to hide his identity. He is free to use a pseudonym but without
the CFA designation. Refer to Standard VII(B) Reference to CFA Institute, the CFA
Designation, and the CFA Program.
17. Question 17
Sylvia Lancaster, a CFA candidate, is hired by Trevor Securities as a junior
analyst. James Brokovich is the director of research at Trevor and feels that
Lancaster should cover equities in emerging markets because of their rapid
growth. Lancaster reads various brokerage reports on the subject and talks to other
analysts of the company. Brokovich also arranges for her to meet with an old friend,
Bryan Lee, who is on the board of various East Asian companies. Lancaster is then
asked to submit a report on the companies in the consumer durables industry of
East Asia. Due to shortage of time, Lancaster finalizes her report based on her
conversation with Lee and the brokerage reports, and gives her “buy”
recommendations on Malaysian stocks from the consumer durables
industry. Lancaster does not give reference of the brokerage reports as sources in
her report. The Standard least likely violated by Lancaster is:
o A
Diligence and Reasonable Basis.

o B
Misrepresentation.
o C
Conflicts of Interest.
Incorrect
C is correct. Lancaster has violated Standard I(C) Misrepresentation by not citing the
brokerage reports as sources and Standard V(A) Diligence and Reasonable Basis
because of her lack of independent research in the preparation of her report.
18. Question 18
Lara Whitman, CFA, worked for Rapid Results Brokerage Company (RRBC) as a
trader. She recently resigned her position as a trader to join another competing
investment and brokerage firm. Whitman did not sign any non-compete agreement
while at RRBC that would have prevented her from soliciting former clients.
Whitman, however, had saved her client list and records while working at RRBC, in
her personal computer at home as a second copy. She accesses this file to contact
her former clients in her new job. The Standard most likely violated is:
o A
Loyalty.
o B
Duties to Clients
o C
Communications with Clients and Prospective Clients.

Incorrect
A is correct. Standard IV(A) Loyalty is most likely violated. A member cannot take
records or work performed on behalf of the firm in paper copy or electronically
without permission to another firm. In this case she cannot use the firm’s records of
clients without the firm’s permission.
19. Question 19
Julie Grosky, CFA, works for Harvest Mutual Fund where she manages a fixed income
fund. In a hastily compiled performance review, Grosky reports to her clients that
her fund has exceeded the benchmark by 0.20%. Stuart Brennan is a client of
Harvest, who writes back to inform Grosky that the fund actually underperformed
the benchmark. Grosky incorrectly blames the error on a computer program newly
implemented at Harvest. Grosky least likely violated the Standard relating to:
o A
Misrepresentation.
o B
Misconduct.
o C
Independence and Objectivity.

Incorrect
C is correct. Standard I(B) Independence and Objectivity involves members and
candidates not accepting any gifts or benefits that could be expected to compromise
their independence and objectivity. Since no benefits were received Grosky has least
likely violated I(B). Grosky most likely violated the Standards I(C) Misrepresentation,
and I(D) Misconduct because she knowingly misrepresents the cause of the error.
20. Question 20
Bryan Lee, CFA, works as a fund manager for Westlink Securities which historically
has focused on US equities. Due to his past experience, Lee is also knowledgeable
about emerging markets. After discussing the matter with the Chief Investment
Officer (CIO) of Westlink, he decides to extend his fund’s investment universe to
include equities from emerging markets. The firm’s marketing and promotional
literature is updated to reflect the change in investment strategy. Has Lee violated
any Standard?
o A
No.
o B
Yes relating to Communications with Clients and Prospective Clients.

o C
Yes, relating to Professionalism.

Incorrect
B is correct. Westlink and Lee’s current clients need to be informed along with the
prospective clients, of the change in the fund’s mandate since they might have
objections concerning the Fund’s new allocations. Hence Standard V(B)
Communications with Clients and Prospective Clients is most likely violated.
Significant risks and limitations of the new investments should also be disclosed
along with their impact on the fund as a whole.
21. Question 21
Siri Shekar, CFA, manages a balanced fund at Starlight Investments. She realizes that
the fund’s holdings in the stock of GYI Company are excessive, and selling the stock
will not be easy since it is thinly traded. Shekar is also a regular participant in various
social media sites as well as internet chat rooms where she mentions that GYI is
going into expansion. The company has not yet announced any expansion plans.
Shekar believes that this will build interest in the stock and she will be able to get rid
of some of her stock’s overweight position. Shekar least likely violated the CFA
Institute Standards of Professional Conduct related to:
o A
Market Manipulation.
o B
Material Nonpublic Information.

o C

Incorrect
B is correct. A is incorrect because Shekar was trying to artificially boost the price of
the GYI’s stock in order to sell her holdings. C is incorrect because there is no basis
for her statements in the social media sites. Standard II(A) Material Nonpublic
Information, Standard II(B) Market Manipulation, Standard V(A) Diligence and
Reasonable Basis.
22. Question 22
Nick Nader, CFA, works as a trader for Trust Investment Bank. During lunch he
receives a phone call from a longtime friend Chris Sandler, who is a trader at SYI
Securities. Sandler talks about various market rumors and tells Nader about a
software company which is going through merger talks with another company in the
same industry. Nader has a large purchase order from his portfolio manager for this
stock. He searches various internet reports and the software company’s website but
finds no such news of the merger. Upon returning to his desk he places the order
aggressively and completes it by the next day before the company releases any
information. Has Nader violated any Standard?
o A
No.
o B
Yes, related to Material Nonpublic Information.
o C
Yes, Independence and Objectivity.

Incorrect
A is correct. Nader did not violate any Standard. There are always rumors in the
market, before an official release by the company. Unless Nader knew that Sandler
was in a business relationship with the merger companies, there was no reason to
suspect that he was receiving nonpublic material information.
23. Question 23
Shazi Agnimukha, a CFA candidate, writes in her blog after taking the Level II exam of
the CFA program. She posts that the derivatives part of the exam was very easy while
the ethics questions were difficult and time consuming. She further writes that a
question from ethics was not properly structured and she was confused by the
language. Agnimukha further describes a question in the Fixed Income portion in
detail and asks if anyone can explain it to her. Agnimukha has most likely violated the
Standard related to:
o A
Conduct as Participants in the CFA Program.

o B
o C
Professionalism.
Incorrect
A is correct. Agnimukha has violated the Standard VII(A) Conduct as Participants in
the CFA Institute Programs by sharing exam content, undermining the validity and
integrity of the exam and CFA institute programs.
24. Question 24
Raul Devgan, CFA, is a portfolio manager for Khadri Investments. He manages a high
growth equity fund known as SmartMoney. Devgan reports the performance of
SmartMoney in its quarterly newsletter and states, “SmartMoney was able to surpass
its benchmark, S&P BSE by 0.20%. However, this type of performance should not be
expected from the fund always.” Adrik Vanyusha is a client of Devgan and follows the
performance of SmartMoney closely. Upon receiving the newsletter, he immediately
contacts Devgan and informs him that the fund never exceeded its benchmark but in
reality had underperformed. Devgan recalculates the results after the complaint,
which confirm Vanyusha’s claim. He sends Vanyusha the correct results and blames
the discrepancy on typographical error. Devgan least likely violates the Standard
relating to:
o A
Misconduct.
o B
Misrepresentation.
o C

Incorrect
C is correct. The Standard relating to Standard I(B) Independence & Objectivity has
not been violated because Devgan has not received any gifts, benefits or
consideration to compromise his independence and objectivity
1. Question 1
Vladmir Seriozha, CFA, is fixed-income analyst at Rasputin Securities and describes
the investment strategy of securities in a report to the firm’s clients which is based
on scenarios of certain declines in interest rates. The report explains the interest
rate model which shows the increase in securities’ valuations as rates decline. The
model does not capture the risks of investment if the rates rise. Seriozha informs all
the existing clients about the model’s weakness in capturing the risks related to
investments in case of an increase in interest rates, but the promotional material for
new clients does not carry this disclosure. Seriozha has most likely violated the
Standard related to:
o A

o B

o C
Duties to Clients.
Incorrect
A is correct. Standard V(B) Communications with Clients and Prospective Clients has
been violated. Seriozha has not run the downside risks and has not explained the
limitations of his model with respect to a change in rates contrary to the one he has
reported. Members and Candidates must adequately disclose the market-related
risks and limitations contained in their investment products and recommendations
especially in their investment process.
2. Question 2
Preet Khadri, CFA, works for Eminent Capital as an investment advisor. She meets
with a college classmate at a dinner who offers to pay Khadri a compensation for
selling the stock of her company Zoratri Inc., to her clients. Khadri does not mention
this arrangement to her clients or employer, and sells the shares of Zoratri to her
clients where appropriate. Khadri has least likely violated the Standard related to:
o A
Suitability.
o B
o C
Additional Compensation Arrangement.

Incorrect
A is correct. Khadri is in violation of Standard VI(A) Conflicts of Interest by failing to
disclose to her clients that she is receiving additional compensation for promoting
and selling Zoratri’s shares. Khadri has also not informed her employer of the
additional benefits received for recommending Zoratri’s stock. Therefore, her
employer cannot evaluate her loyalty and objectivity. She also failed to disclose the
additional compensation arrangement.
3. Question 3
TriStar Money Management wants to invest in emerging market on behalf of its high-
net-worth clients and hires Brent Emory, an independent consultant to solicit
proposals from various advisers. Emory after considerable due diligence provides a
list of managers based on their successful performance in the emerging market, but
promotes Asian Tigers as the most competent. TriStar selects Asian Tigers as the
new manager from Emory’s list and further reviews the selected new manager to
ensure that Asian Tigers is the appropriate investment manager for its clients.
During the review, TriStar discovers that Emory was being paid by Asian Tigers to
promote their services. Even though Emory was being paid by both parties, TriStar’s
investigation proves that the recommendation was objective and appropriate. Emory
has least likely violated the Standard related to:
o A
Referral Fees.
o B
Priority of Transactions.
o C
Additional Compensation Arrangements.

Incorrect
B is correct. No violation of Standard VI(B) Priority of Transactions is committed by
Emory.
4. Question 4
Ankit Tivari, CFA, is an investment adviser who works for Best Securities. He has two
clients: Raveena Ahisma, a 55 year-old widow with two college going children, and
Agneya Adya, a 35-year old journalist who works for a local newspaper. Both her
clients are employed and earn a substantial salary. Adya is very aggressive with his
investments and wants to invest in high risk securities for a higher return, whereas
Ahisma wants to invest in low risk, large cap securities to achieve a constant income
for her children’s education. Tivari recommends investing a quarter of their
portfolios in derivatives that have a potential to earn high returns despite their
volatility. Did Tivari violate any Standard while choosing investments for his clients?
o A
Yes, for both his clients.

o B
Yes, only in Ahisma’s case.

o C
Yes, only in Adya’s case.

Incorrect
B is correct. Tivari has violated Standard III(C) Suitability by not identifying the risks
and objectives of Ahisma and selecting an aggressive investment for both clients
which is only suitable for Adya, since the two clients have different financial
objectives and circumstances.
5. Question 5
Catherine Czcibor, CFA, works as a portfolio manager for a local investment
counseling firm. She is also a member of her son’s school committee to help raise
funding for a program for gifted children in music. Czcibor discusses an arrangement
with her supervisor in which she will donate a certain percentage of her fees from
clients referred to her by the school staff and parents. She gets a written approval
from her firm. The school’s board also approves Czcibor’s plan and agrees to
announce it in their upcoming parent teacher meeting along with sending a
newsletter to all the parents and staff. When Czcibor starts getting the school
referrals, she clearly discusses the referral arrangement with her new clients and the
distribution of her donation to the school. Has Czcibor violated any CFA Institute
Standards of Professional Conduct?
o A
Yes, related to conflicts of interest

o B
Yes, related to additional compensation arrangements

o C
No.
Incorrect
C is correct. Czcibor has not violated VI(C) Referral Fees because she obtained
permission from her employers, the school, and the clients.
6. Question 6
Isaac Dobrogost, a candidate in the CFA Program, works as an investment advisor for
Zenith Mutual Fund. He is invited by one of his clients, Sahara Inc. (SI), a
manufacturing company, to meet with the finance director along with a few large
stakeholders of SI. In the meeting Dobrogost finds out that the company is going
through a lean period and will announce a decrease in earnings in their next quarter
financial results. Can Dobrogost use this information to change the rating of the
company from “buy” to “sell”?
o A
No
o B
Yes, because this information is given directly by the company.

o C
Yes, because it has been disseminated to the other stakeholders as well.

Incorrect
A is correct. If the information is not publicly disseminated by the company and
Dobrogost uses it, then it becomes material nonpublic information, hence a violation
of Standard II(A). A small group of stakeholders does not qualify as the public. He
cannot use the information.
7. Question 7
Izzy Zubeika, CFA, works for Topworth Mutual Fund and is a portfolio manager for an
aggressive growth equity fund. She is planning to sell a large portion of her
investment to meet the medical costs of her ailing husband. Zubeika wants to sell
her stake in Royal Beverages, but her firm has recently upgraded the stock from
“hold” to “buy”. Nevertheless after receiving approval from her employer she informs
her broker to conduct the trade. Has Zubeika violated any CFA Institute Standards of
Professional Conduct?
o A
Yes related to Market Manipulation

o B
Yes, related to Priority of Transactions.

o C
No.
Incorrect
C is correct. No violation has occurred because she has received approval from her
employer. Standard VI(B) Priority of Transactions does not limit transactions of
employees which are different from the current recommendations as long as they
do not disadvantage the current clients.
8. Question 8
Su Ming Li, CFA, works as a portfolio manager for Peoples Investment Bank. She is
asked to analyze certain East Asian equities by her firm, for the purpose of
purchasing them. Li talks to Peter Wang, a friend and one of the owners of Dragon
Brokerage and Investment Company. He informs her that the East Asian equities are
doing very well due to a boom in their respective economies. After thoroughly
investigating these equities, she purchases them for her accounts wherever they are
suitable. Soon after she gets a call from Dragon to join the firm as a managing
partner. Li accepts the offer and resigns from her current job. The week before
joining Dragon, she purchases 1500 shares of East Asian equities for her personal
account. Once Li begins working at Dragon, she purchases a large block of shares of
East Asian equities and allocates them to accounts. Does Li’s purchase of shares for
her personal account violate the CFA Institute Standard of Professional Conduct?
o A
No, she bought the shares before beginning work at Dragon.

o B
Yes, relating to Suitability.

o C
Yes, relating to Priority of Transaction.

Incorrect
C is correct. Li may have violated the Standard relating to Priority of Transactions
when purchasing the shares for her account. She has accepted Dragon’s offer to join
as managing partner, has discussed the shares with Wang, and knows, or should
know, that she will purchase them for at least some Dragon clients once she begins
work at Dragon. Her purchase ahead of Dragon clients might be front-running. Best
practice would be to delay her private account purchase until after she purchases for
clients.
9. Question 9
Kaori Kazuya and Albert Farnsworth are both candidates in the CFA Program. Kazuya
is registered for the Level II exam and Farnsworth has passed the Level III exam of
the CFA program. Farnsworth is awaiting his CFA charter. Kazuya works for Metro
Investments and her business cards reads, “Kaori Kazuya, CFA Level II candidate”
whereas Farnsworth works as an analyst at Sarosky Wealth Management and does
not put any CFA designation on his business cards. But at the end of his reports, he
does give a reference that, “Albert Farnsworth has passed all three levels of the CFA
Program and will be eligible for the CFA charter upon completion of the required
work experience.” Who most likely violated the Standards?
o A
Both.
o B
Kazuya has violated the Standards, but not Farnsworth.

o C
Only Farnsworth violated the Standards

Incorrect
B is correct. Kazuya violates Standard VII(B) Reference to CFA Institute, the CFA
Designation, and the CFA Program, by using an improper designation on her
business cards. Farnsworth reference is proper according to Standard VII(B)
Reference to CFA Institute, the CFA Designation, and the CFA Program.
10. Question 10
Kayla Donovan, CFA, works as a portfolio manager for MacBrady Securities & Co.
Some of her wealthy and large clients hold long positions on Swift Delivery, which is
a courier service. After analyzing her own company’s research reports and
information available on various internet sites about Swift, as well as Swift’s
company website she concludes that the stock is expected to rise sharply on the
back of strong quarter-end earnings about to be released in an earnings report in a
few days. She informs all MacBrady’s clients since some of them will be at a distinct
advantage once the quarter-end earnings are reported. Donovan also runs a popular
blog as an independent analyst for which she has approval from her employer,
where she mentions her predictions about various stocks including observations
about Swift’s stock. She discloses to her clients about her blog which they regularly
visit. Has Donovan violated any CFA Institute Standards of Professional Conduct?
o A
Yes, relating to Market Manipulation.

o B
Yes, relating to Priority of Transactions

o C
No.
Incorrect
C is correct. Kayla Donovan has not violated any Standard. Donovan has not caused
the price of Swift to move up she has only given her opinion based on research.
Further, she informed MacBrady’s clients prior to her internet broadcast and has
approval from her employer to run her blog.
11. Question 11
Roza Hernandez is a trust officer for Rize Trust Co. Hernandez uses Ricardo Drez, a
broker, for trust account brokerage transactions. He gives Hernandez a lower price
for her personal purchases than Hernandez’s trust accounts. Hernandez is most
likely violating the Standard related to:
o A
Duty of Loyalty to Clients.

o B
Fair Dealing.
o C
Suitability.
Incorrect
A is correct. Hernandez is violating her duty of loyalty to her trust accounts by using
Drez, because he gives her favorable terms for her personal account.
12. Question 12
Robert Blake is on the board of directors of Rice Industries and receives free tickets
at the end of each quarter for his entire family to travel to any city of their choice in
Europe for his services to the board. Blake does not disclose this information to his
employer since it is not a monetary compensation. Has Blake violated any CFA
Institute Standards of Professional Conduct?
o A
No.
o B
Yes, he has to inform his employer of the benefit he receives.

o C
Yes, because he has bought stock of Rice for some of his clients where
appropriate.
Incorrect
B is correct. Blake has violated Standard IV(B) Additional Compensation
Arrangements by failing to disclose to his employer benefits received in exchange for
his services on the board.
13. Question 13
A group of CFA charterholders under the name Research CFA, present online
research on several popular stocks. Barry Marlow, a candidate in the CFA program, is
an analyst at Drew Hedge Fund. He is under pressure by his firm executives to
present his research report and recommendations on certain stocks. Marlow reads
the research report by Research CFA and uses material in his report discussed in the
online research. The least likely violation under the CFA Institute Standards of
Professional Conduct is:
o A
Reference to CFA Institute, CFA Designation, and the CFA Program.

o B

o C
Disclosure of Conflicts.
Incorrect
C is correct. Research CFA has violated Standard VII(B) Reference to CFA Institute, the
CFA Designation, and the CFA Program by using CFA designation inappropriately.
Marlow violated Standard V(A) Diligence and reasonable basis.
14. Question 14
Sara Petrowski, a CFA candidate, works as an analyst at Topline Brokers. She reads in
the Financial Times a study on the financial markets issued by Ace Research. She
uses material from the study in her research report and gives recommendations to
her clients. Petrowski does not cite the newspaper as a source since it is merely a
conduit of the original information. Has Petrowski violated the CFA Institute
o A
Yes, she has misrepresented the information.

o B
No, the newspaper is not the original source

o C
Yes, duty to her clients.

Incorrect
A is correct. Petrowski has violated Standard I(C). She should get the complete study
from its original author Ace Research review it and acknowledge it in her report
instead of simply plagiarizing the report.
15. Question 15
Janis David is the head of the research department at BAW, Inc. a brokerage firm.
She has decided to change her recommendation of the Cooper & Ginto Mines from
sell to buy. She informs the other executives of the firm orally before a report is
prepared and sent to all customers. David’s actions are in line with the firm policy.
Roger Little, one of the junior analysts at BAW immediately buys Cooper & Ginto
stock for himself and informs some of his contacts who are also BAW’s clients for
whom it is appropriate. David has most likely violated the CFA Institute Standards of
o A
o B

o C
Loyalty.
Incorrect
A is correct. David has violated Standard IV(C) by failing to supervise the actions of
those accountable to her. She did not set up procedures to prevent the
dissemination of or trading on the information.
16. Question 16
Syed Ali works for an investment bank and is involved in the underwriting of Apex
Inc. The chief accountant of Apex informs Ali that the information in the financial
statements filed with the regulator by Ali overstate sales and understate expenses.
Ali seeks the advice of the legal counsel of the firm who states that it will be difficult
for the regulator to prove that Ali was involved in any wrongdoing. Ali
has least likely violated the CFA Institute Standards of Professional Conduct related to:
o A
Misrepresentation.
o B
Misconduct.
o C
Fair Dealing.
Incorrect
C is correct. Ali has clearly misrepresented some important information. By not
being honest, he is also violating the standard with regards to misconduct.
17. Question 17
Hari Ram and his few colleagues are planning to leave Greysons Inc., a local
investment bank, to form their private consultancy. Ram has found out that one of
his clients has undertaken a request for proposal to hire a new investment adviser.
The RFP has been sent to Greysons and all of its competitors but its submission
period will end before Ram’s and his colleagues’ resignations become effective.
Nevertheless, Ram and the departing colleagues decide to respond to the client’s
request. They have most likely violated the CFA Institute Standards of Professional
Conduct relating to:
o A
Loyalty.
o B
Conflict of Interest.
o C
Duties to Clients
Incorrect
A is correct. By responding to the client’s RFP, the group of employees is competing
directly with the employer, hence Standard IV(A) Loyalty is violated.
18. Question 18
Richard Swanson, an analyst at Azwitz Securities, covers the oil industry. He, along
with other analysts, has just visited Prell Refineries, an exploration and production
company. Based on his own assessment and calculation of the drilling on site,
Swanson has concluded that the company has abundant oil reserves. This view is not
shared by the other analysts who have visited the site. Swanson writes in his
research report that Prell is in fact sitting on vast oil reserves and makes a buy
recommendation. Has Swanson violated any of the CFA Institute Standards of
o A
No.
o B
Yes, Communication with Client and Prospective Clients.

o C
Yes, Diligence and Reasonable Basis.

Incorrect
B is correct. Standard V(B) Communication with Client and Prospective Clients has
been violated, because Swanson’s assessment is an opinion not a fact. He did not
distinguish between opinion and fact.
19. Question 19
Romana Zahoor works for a local brokerage firm and is a CFA candidate. She plans
to issue a buy recommendation for the stock of Basics. Before issuing the
recommendation, she buys the stock for herself through her sister’s account.
Zahoor most likely violates the Standard of:
o A
o B
Fair Dealing
o C
Suitability.
Incorrect
A is correct. Zahoor has violated Standard VI(B) Priority of Transactions by taking
advantage of her knowledge of the stock and buying it for herself rather than her
client
20. Question 20
Eileen Connors is a chief trader for Ascot Investments, a money management firm.
She has been told recently by her most lucrative client Shelby Company that if the
performance of its accounts did not improve they will be forced to change their
money managers. Connors has purchased certain securities a few days back, whose
price has gone up significantly. She has failed to allocate these trades due to her
busy schedule. After the threat from Shelby, she decides to allocate the profitable
trades to Shelby’s account, while spreading the losing trades to other Ascot’s
accounts. Has Connors violated any Standard?
o A
Yes, related to Fair Dealing.

o B
No.
o C
Yes, related to Diligence and Reasonable Basis

Incorrect
A is correct. Connors has violated Standard III(B) Fair Dealing by failing to deal fairly
with all her clients in taking these investment actions.
21. Question 21
Penelope Cox is employed by Jameason Investment, and provides investment advice
to the trustees of SYU University in order to recommend investments that would
generate capital appreciation in endowment funds. Cox has been given internal
reports by the trustees that highlight the expansion of the university. Cox is
approached by Bradley Cooper, a local philanthropist who is considering a generous
contribution to SYU and another university in the area, but he would like to see the
expansion plans of SYU before making the donation. Cox knows that he does not
want to speak to the trustees hence she gives a copy of the internal report to
Cooper. Has Cox violated the Code and Standards?
o A
No
o B
Yes, preservation of confidentiality.

o C
Yes, loyalty
Incorrect
B is correct. Cox was given the internal reports by the trustees; because the
information was confidential Cox should have refused to divulge it to Cooper.
Therefore by handing the internal reports to him Cox violates Standard III(E)
Preservation of Confidentiality.
22. Question 22
Carla Simone, a CFA candidate and a research analyst, follows firms in the beverage
industry. She has been recommending the purchase of Citrus, because of its
introduction of a popular new drink for athletes and exercise enthusiasts. Simone’s
husband has inherited from a relative, the stock of Citrus worth $3.5 million. Simone
has been asked to write a follow up report on Citrus. She writes the report and gives
a strong buy recommendation. The report does not mention her husband’s
ownership of the stock. Has Simone violated the CFA Institute Standards?
o A
No.
o B
Yes, disclosure of conflicts

o C
Yes, independence and objectivity.

Incorrect
B is correct. Simone must disclose her husband’s ownership of the stock to avoid
violation of Standard VI(A) Disclosure of Conflicts.
23. Question 23
Babar Ahmed is a trader at Cooper & Baines, a local brokerage firm. He trades
frequently in the stock of Zelle, despite the fact that Zelle is not on the
recommended list of securities of Cooper. Ann Miller is the supervisor and
compliance officer of Ahmad. Part of her compensation is based on the trading
revenues of Cooper. She notices the large volume of trade of Zelle, but does not
investigate it. Has Miller violated the CFA Institute Standards?
o A
Yes, conflict of interests.

o B
No.
o C
Yes, responsibilities of supervisors.

Incorrect
C is correct. Yes Miller violates Standard IV (C) Responsibilities of Supervisors, by not
investigating the purchase of the stock and her failure to supervise the trader’s
activities.
24. Question 24
XYZ, an investment firm, manages pension plans of various large companies. XYZ
mainly uses Greatson, Inc. for most of its trading activity. This is because the CEOs of
the two companies are close friends. Greatson is more expensive than the other
brokerage firms offering the same brokerage services. Its research and execution
are average compared to the other brokerage firms. But Greatson absorbs XYZ’s rent
in exchange for the brokerage business given to it by XYZ. Has XYZ violated any CFA
o A
Yes, relating to loyalty, prudence, and care.

o B
No.
o C
Yes, relating to misconduct.

Incorrect
A is correct. Refer to Standard III(A) Loyalty, Prudence and Care.
1. Question 1
Tracy Chapman works as a proctor for the administration of the CFA examination in
her city. She reviews a copy of the Level III exam on the evening prior to the exam
and discloses information to two candidates who use it to prepare for the exam.
Chapman and the two candidates have least likely violated the CFA Institute
Standards of Professional Conduct, related to:
o A
Conduct that compromises the integrity, validity or security of CFA Institute

programs.
o B
Suitability.
o C
Attempt to circumvent security measures established by the CFA Institute

Incorrect
B is correct. Refer to Standard VII(A) Responsibilities as a CFA institute member or
CFA candidate.
2. Question 2
Christina Lucci, a CFA candidate, who is a portfolio manager of a growth mutual
fund, maintains an account in her sister’s name at several brokerage firms with
which her fund’s clients also do business. Whenever an eagerly awaited equity IPO is
announced, she instructs the brokers to buy it for her sister’s account. Because such
issues are scarce, her clients are unable to receive any new shares.
Lucci most likely violates the CFA Institute Standards of Professional Conduct related
to:
o A
Priority of Transactions.
o B
Disclosure of Conflicts
o C

Incorrect
A is correct. Refer to Standard VI(B) Priority of Transactions.
3. Question 3
Stefan Ericsson, a CFA candidate is an analyst working for publicly traded companies
to electronically promote their stocks. He has also set up a website to market his
research capabilities as an independent analyst. Ericsson posts a buy
recommendation on his website for each company that he has a contractual
relationship with and fails to disclose this in the research reports he issues or
statements in the internet chat rooms. Ericsson least likely violated the CFA Institute
Standards of Professional Conduct related to:
o A
Misrepresentation.
o B
o C
Fair Dealing.
Incorrect
C is correct. Refer to Standard I(C) Misrepresentation.
4. Question 4
Brendon Frazer, a CFA candidate, is an analyst with ITI, an investment and brokerage
company. ITI requires him to give a recommendation and research report every
month on a different company. He is also enrolled in a university where he takes
night classes to earn an MBA. Frazer has informed his employer of his enrollment in
the university. Due to excessive workload, he finds it difficult to complete his
research report on a technology company on time. In order to save time he develops
his report based on a few articles he read recently about the company and gives his
‘buy’ recommendation. Frazer gives the reference of the articles in his report. Is
Frazer’s report and recommendation in compliance with the CFA Institute Standards
of Practice?
o A
No
o B
Yes, because he gives reference of the articles

o C
Yes, because the technology company is suitable for some clients of ITI.
Incorrect
A is correct. Refer to Standard V(A) Diligence and Reasonable Basis.
5. Question 5
Nancy Keene recently left Kay Investments to join another competing firm. She left
her former employer after 10 years without any non-compete agreement, and did
not solicit any of her clients during the transition period. After joining the new firm,
she wants to contact her former clients because she developed close ties with them
after earning strong returns for their portfolios. Keene knows that many will follow
her to the new employer. Is Keene in violation of CFA Institute Standards of
o A
Yes, because she cannot contact her former clients.

o B
No, because she does not use any material from her former employer.
o C
Yes, because of loyalty to her former employer.

Incorrect
B is correct. Refer to Standard IV(A) Duties to Employers.
6. Question 6
Phillip Cochran, a CFA charterholder, is a portfolio analyst with Frazier Trust, and
manages the portfolio of Dennis Quad. Although Cochran receives a salary from his
employer, Quad tells him that “any year my portfolio exceeds a rate of return of 16%
before tax; you can fly to Paris at my expense and use my apartment for a week”.
Cochran fails to inform his employer of the arrangement and his vacation in Paris
the following year. Cochran most likely violated the CFA Institute Standards of
o A
Additional Compensation Arrangement.

o B
Suitability.
o C

Incorrect
A is correct. Refer to Standard IV(B) Additional Compensation Arrangements.
7. Question 7
Selma Hyek, a senior executive of Avery Capital, issues a performance report for the
accounts that showed capital appreciation for the years 1990 to 2006. Avery Capital
claims compliance with GIPS standards. Returns are not calculated in accordance
with the GIPS standards, because the composites are not asset weighted. Hyek most
likely violates the CFA Institute Standards of Professional Conduct relating to:
o A
Performance Presentation.
o B
Integrity of Capital Markets

o C
Record Retention.
Incorrect
A is correct. Refer to Standard III(D) Performance Presentation.
8. Question 8
Steve Tylor, a CFA candidate and a technology analyst with Rock Brokers, is invited by
SuperTech to participate in a technology conference at SuperTech’s expense.
SuperTech has also invited a few other analysts from different companies to the
same conference. It arranges and pays for Tylor’s airfare and accommodation for
two nights. The trip is strictly for business purposes and Tylor is not offered any
lavish hospitality by SuperTech. Tylor informs his employer of the arrangement and
is given permission to attend the conference. By accepting this invitation, has Tylor
violated the CFA Institute Standards of Professional Conduct?
o A
No.
o B
Yes, because it creates a conflict of interest.

o C
Yes, because it compromises Tylor’s independence and objectivity.

Incorrect
A is correct. Refer to Standard I(B) Independence and Objectivity. Tylor did not
violate Standard I(B) because his independence and objectivity are not being
compromised. There is no indication in the question that SuperTech is a client of
Tylor’s employer. SuperTech also does not offer to pay for more than the basics, and
Tylor’s employer is aware and has approved of the arrangement.
9. Question 9
Steve Miller is enrolled as a candidate in the CFA Program. He works as an assistant
manager in Trust Investment Bank. He enjoys drinking liquor during his lunch
break. Miller’s colleagues have noticed that he is visibly intoxicated after the lunch
break and is not in a position to make rational investment decisions. Miller most
likely violates the Standard of:
o A
Misconduct.
o B
Knowledge of the Law.

o C
Incorrect
A is correct. Refer to Standard I(D) Misconduct
10. Question 10
Franz Beckenbaur, CFA, is a trader for Lee Inc., an investment and brokerage firm. He
receives compensation for referrals from the firm’s portfolio and financial planning
division. He usually refers clients from his previous employer and does not have a
non-compete arrangement with them. Beckenbaur uses his own personal material
to contact them and informs them duly of the referral arrangement. Has Beckenbaur
violated any Standard?
o A
No, because he discloses to his former clients the referral arrangement.

o B
Yes, because he has a duty of loyalty to his clients

o C
Yes, because of a breach of loyalty to his former employer.

Incorrect
A is correct. Refer to Standard VI(C) Referral Fees.
11. Question 11
Penelope Gonzales is employed as a part-time analyst with Cooper Associates, an
institutional asset manager. She is paid a flat fee to complete a study of the
technology industry within a certain time span. She is also given unlimited access to
Cooper’s files and data. Gonzales can use the office facilities of Cooper during
normal working hours. Towards the conclusion of her report, she is offered a job at
Noblex, which is an IT firm. Gonzales submits a copy of her report along with
recommendations to her new employer. Has Gonzales violated any Standard?
o A
No.
o B
Yes, loyalty.
o C
Yes, misrepresentation.
Incorrect
B is correct. Refer to Standard IV(A) Loyalty.
12. Question 12
Leila Salman works for a firm that advertises its past performance in various
periodicals. Salman discovers that some accounts have left the firm recently and the
returns of these accounts are not included in the promotional material. The
omission has led to inflated performance returns. Salman is asked to use the same
material while soliciting clients. By doing so, Salman will least likely be violating the
CFA Institute Standard of:
o A

o B
Misrepresentation.
o C
Incorrect
A is correct. Refer to Standards I(A) Knowledge of the Law, I(C) Misrepresentation and
III (D) Performance Presentation
13. Question 13
Janice McDowell, CFA, is the chief investment officer of Zenith Investment Bank and
wants to improve the diversification of one of its balanced funds in order to improve
its returns. The investment policy statement of the fund mentions low risk
investments in large-cap equities, government bonds of AA ratings and corporate
bonds of high investment grade ratings. However, a new IPO offering of a small
pharmaceutical company with high growth potential, promises high returns since the
issue is being offered at a discount. He immediately allocates some portion of the
issue to his fund, without exceeding the limit on the equity exposure of this fund.
McDowell has least likely violated the CFA Institute Standards of Professional Conduct
relating to:
o A
Loyalty, prudence and care

o B
Suitability.
o C
Fair dealing.
Incorrect
C is correct. The Standards related to III(A) Loyalty, Prudence, and Care and III(C)
Suitability are violated. The IPS mentions low risk securities, and describes the asset
classes. Therefore investment in the pharma stock may not be suitable for this
portfolio.
14. Question 14
Alan Clay, candidate in the CFA Program, works for a large money manager. He
recently applied for an analyst position at Rodham & Winston, an investment bank
and was hired by them. Before leaving his current employer, he copies the firm’s
software that he developed, which he believes is his property. Clay feels that his
software is one of a kind and will help him in his new job. Has Clay violated any
Standard?
o A
No, the software was developed exclusively by him

o B
Yes, with respect to loyalty.

o C
Yes, because he failed to inform his new employer that the model was
developed for his previous employer
Incorrect
B is correct. Clay violated Standard IV(A) Loyalty because he misappropriated her
firm’s property without permission
15. Question 15
Avi Sharon is an analyst for Ariel Investment Management. He recommends the
purchase of ABC company’s stock after conducting due diligence on the company
and has published a research report that is well accepted by the company’s
management. The business managers of ABC invite him for further discussions. They
sponsor his air ticket and accommodations at an expensive hotel. Sharon, as per the
policy of Ariel, discusses the travel and stay arrangements with his employer and is
given permission. He further meets with the CFO in a dinner arranged by ABC and
gives full disclosure to his employer upon his return. According to the Standards of
Practice Handbook, has Sharon violated any CFA Institute Standard?
o A
Yes, with respect to Disclosure of Conflicts

o B
Yes, with respect to Additional Compensation Arrangements.

o C
No
Incorrect
C is correct. Sharon disclosed his travel and accommodation arrangements to his
employer and had only accepted them after being given permission by his firm. His
actions on return do not cause conflicts of interest between his company and ABC,
because he makes a full disclosure of his dinner with the CFO to his employer.
16. Question 16
Zion mutual fund advertises in its marketing brochures that all the fund managers at
Zion are CFA charterholders, and hence achieve better performance results. Which
CFA Institute Standard of Professional Conduct is most likely violated?
o A
Reference to CFA Institute, CFA Designation, and the CFA Program.

o B
Professional misconduct.
o C
Misrepresentation.
Incorrect
A is correct. There is improper reference to the CFA Designation that the charter
holders achieve better performance results. Refer to Standard VII(B).
17. Question 17
Ann Haley posts on her Twitter account that her Level III of the CFA exam went very
well. She further adds that although the exam was difficult and very tiring she still
managed to do fairly well by effectively managing time. Has Haley
violated any Standard?
o A
No.
o B
Yes, with respect to her conduct as participant in the CFA Program.

o C
Yes, with respect to reference to the CFA Program.

Incorrect
A is correct. Haley did not violate Standard VII(A) Responsibilities as a CFA Institute
Member or CFA Candidate.
18. Question 18
Signa is a local wealth management firm that mostly employs either CFA
charterholders or candidates in the CFA Program as its employees. Hence it uses the
name Signa, Chartered Financial Analysts, Inc. as the firm’s name. Which Standard
did Signa most likely violate?
o A
Reference to the CFA Designation.

o B
Misrepresentation
o C

Incorrect
A is correct. Signa has violated Standard VII(B) Reference to the CFA Designation by
using it inappropriately as the company’s name. The designation is only meant for
individuals and must not be used as a firm’s name.
19. Question 19
Shiraz Ahmed is a trader at an investment management firm. He is also involved in
the buy-side trades of an aggressive equity fund managed by the firm. During a
recent decline in the market many securities of the aggressive equity fund show a
marked decline in value, but the performance of the fund does not show a change in
return. Ahmed at once mentions it to his supervisor and the compliance officer, who
tell him that the fund is doing well and he should concentrate on his job at the
trading desk instead of asking irrelevant questions. The CFA Institute Standard that
is least likely violated is:
o A
Professional Misconduct
o B
o C

Incorrect
C is correct. According to Standard IV(C) Responsibilities of Supervisors, the
supervisor and the compliance officer have the responsibility to investigate Ahmed’s
concerns. Also see Standard I(D) Misconduct.
20. Question 20
Chang Li is head of sales at an investment bank. Li while reviewing the marketing
material of the bank realizes that some of the information contained there-in is out
of date. The marketing material is generated from the results provided by the bank’s
mutual funds and Li has no control over it. He continues to provide the material to
his sales team without updates. Did Li violate any Standard?
o A
Yes, with respect to misrepresentation.

o B
No, because he has no control over the marketing material.

o C
Yes, with respect to disclosure of conflicts.

Incorrect
A is correct. Li has violated Standard I(C) Misrepresentation by presenting out-of-
date information to clients.
21. Question 21
Greg Lou has been asked by his firm, Binkley Investment Management, to find an
adviser for one of its funds which invests in derivatives and complex securities. Lou
selects 12 firms based on their annual total return performance and finalizes on the
adviser with the highest annual total return. Which CFA Institute Standards of
Professional Conduct did Lou violate?
o A

o B
Professional Misconduct
o C

Incorrect
C is correct. Lou violated Standard V(A) Diligence and Reasonable Basis by not
conducting sufficient review of potential firms.
22. Question 22
Samina Haq a CFA candidate, works for Superior Trust Company. While reviewing the
performance of one of the trust funds, she finds out that the trust fund has on an
average performed at 5% for the last three years yet the brochure of her fund
advertises an annual compound growth rate of 20%, which happened only in the
past year. It also boasts of a consistent increment in the investment value above the
entire market which also took place during last year. Haq’s highest priority in avoiding
a violation of the CFA Institute Standards of Professional Conduct is to:
o A
correct the performance calculation and length of time.
o B
continue with the advertisement since it did rise above the market
o C
use the firm’s average rate of return in her marketing material for all
accounts.
Incorrect
A is correct. According to Standard III(D) Performance Presentation Haq needs to
correct the calculation and length of time specifying the performance of her trust
fund.
23. Question 23
Weinberg Inc., a global asset management company, has a large position in Wessner
Pharma. The trading volume of this stock is low. In order to boost the liquidity of the
stock, multiple trading desks at Weinburg start buying and selling Wessner shares
from each other. The CFA Institute Standard most likely violated by Weinberg is:
o A
o B
Misconduct.
o C
Acting on Non Public Information.

Incorrect
A is correct. Refer to Standard II(B) Market Manipulation. Weinberg created an
appearance of greater liquidity of stock through its trading strategy and was able to
manipulate the market.
24. Question 24
Norman Bates, CFA works as an analyst for Angle Investments. She has been asked
to cover investments in the Asian markets for their high rate of return. The trip is
sponsored by Sia, an investment and brokerage firm. Bates knows that Sia charges
commission at a higher rate than the other brokerage facilities used by her firm.
Nevertheless she convinces the trading desk at Angle to give more business to Sia so
she can take the trip. Bates is most likely violating the CFA Institute Standard of
o A

o B
Loyalty, Prudence, and Care.
o C

Correct
B is correct. Bates is violating Standard III(A) Loyalty, Prudence and Care. He should
have weighed the benefits of the trip against the commission charged by Sia. He
should have also determined whether best execution and prices could be received
from Sia.
1. Question 1
Mary Burnette supervises a team of research analysts at Brigham Money Managers.
One of her team member Siri Desai, an auto analyst, follows various websites and
blogs for research purposes on the auto industry. Desai while browsing through the
internet comes across a report by an independent research analyst on the hybrid car
introduced by Koyota Motor Company. Based on that report she gives a
recommendation of ‘buy’ in her research report without giving reference of her
source. Burnette is under a deadline by her firm to compile the reports and to
implement the recommendations. She does not review Desai’s work and sets up a
meeting with the portfolio managers to discuss the execution strategy based on the
research reports submitted by her team. Burnette least likely violated the CFA
Institute Standard of:.
o A
o B

o C
Disclosure of Conflicts
Incorrect
C is correct. Burnette has violated Standard IV(C) Responsibilities of Supervisors by
neglecting to review thoroughly Desai’s report and her recommendations. It is
Burnette’s responsibility to set up appropriate procedures; these are documented,
communicated and followed by the personnel working for her. She has also violated
Standard of Diligence and Reasonable basis.
2. Question 2
Raza Jaffery works as an independent analyst for the medical equipment industry.
His reports are based on an analysis of customer interviews, manufacturers, on-site
company visits, and secondary research from other analysts. Jaffery does not
maintain any records or files for the information he collects but he mentions the
source of his research in his reports. If the clients need information on the specific
web sites, Jaffery always provides them with the relevant information.
Jaffery most likely violated which of the following Standards?
o A
Record Retention.
o B

o C
Misrepresentation.
Incorrect
A is correct. Refer to Standard V(C) Record Retention. Jaffery must carefully
document and maintain copies of all information that goes in his reports in order to
avoid violation of Standard V(C).
3. Question 3
Cora Bentley works for an investment counseling firm. She is approached by a new
client Sue Grey for financial advice. Bentley very enthusiastically explains to her how
she can increase her return by investing in a few small-cap stocks that are selling at a
discount in the market. Has Bentley committed a violation of the CFA Institute
Standards?
o A
No.
o B
Yes, Bentley should have explained her qualifications, her education, and
experience and the meaning of her CFA Designation.
o C
Yes, Bentley should have determined Grey’s needs, objectives, tolerance

and risk before making any recommendations.
Incorrect
C is correct. Bentley should determine whether the investment is suitable to the
client’s financial situation. She should make an inquiry into the risk and return
objectives of the client before making any recommendations. Refer to Standard III(C)
Suitability.
4. Question 4
Robert Brown is an analyst at Lazarus Investment Bank, which is one of the
underwriters of Coolidge Inc. Brown discovers that the company has not given
accurate earnings figures. The actual figures are much lower than the numbers
presented. The preliminary prospectus has been distributed. Brown talks to his
supervisor, who casually dismisses the matter. Brown requests his manager to
assign him to another project. His action most likely conforms to which Standard?
o A

o B
Misrepresentation.
o C
Difference between fact and opinion.

Incorrect
A is correct. Brown’s actions are in line with Standard I(A) Knowledge of the Law.
5. Question 5
An independent analyst recommends a stock based on a 5-minute pre-market talk
show by a reputed analyst, on the TV that morning. The recommendation is least
likely a violation of:
o A

o B
Suitability.
o C
Fair Dealing.
Incorrect
C is correct. There is no evidence of discrimination among clients. However, by
recommending the stock without due diligence, the analyst has violated Standard
V(A) Diligence and Reasonable Basis, and Standard III (C) Suitability
6. Question 6
Martina Bart, CFA, is working as a portfolio manager at a large global investment
manager. Most of her clients are residents of a conservative country called Inara,
where the new government has introduced a new law barring equity holdings in
tobacco companies. Bart’s clients have significant exposure to tobacco companies
through international funds in their portfolio because of the handsome returns they
have earned in the past. Three months have passed, Bart is unaware of the change
in law and takes no action. According to the Standards, his inaction is:
o A
is a violation of the Standards as members should stay informed of the
changes in applicable laws.
o B
not a violation of the Standards since the exposure is through international

funds and not domestic tobacco companies.
o C
not a violation since it is a recommended procedure and a member cannot

be expected to keep track of the laws of all the countries his clients are from.
Incorrect
A is correct. If it is illegal to hold stocks of tobacco companies, Bart should have
taken steps to stay informed of the applicable laws. Standard I(A) Knowledge of the
Law.
7. Question 7
BU Airlines has taken INR 1.1 billion of debt and is unable to service it. The stock
prices have been falling and some investors are accumulating the stock in the hope it
will rise soon. Most investors are unaware of the health of the loss-making airline.
The research team at Emitus Investment Management, covers the stock and wants
to publish an adverse opinion on the stock. The firm’s policy does not permit
dissemination of a negative opinion about a client, as it was the underwriter when
BU went public two years ago. The best course of action is:
o A
defy the firm’s orders and issue an adverse opinion as loyalty to clients takes
precedence.
o B
to put BU on a restricted list.

o C
issue a favorable report for now as the airline industry is volatile and the
company may turn around.
Incorrect
B is correct. The recommended course of action would be to put BU Airlines on a
restricted list and disseminate only factual data. Standard I(B) Independence and
Objectivity.
8. Question 8
Lunu Mbasa is an independent analyst who writes a popular financial blog on stock
selection. He is hired by an investor relations firm to publish a research report on
FKart, an online lifestyle firm, on his blog. Mbasa will be paid a fixed fee plus a
monthly voucher that can be redeemed on the site if any investor buys the stock
based on his report. There is no disclaimer about the arrangement in his blog post.
This arrangement is least likely a violation of:
o A
Disclosure of conflicts.
o B

o C
Suitability.
Incorrect
C is correct. Refer Standard I(B) Independence and Objectivity and VI(A) Disclosure of
Conflicts.
9. Question 9
Pratik Mathew, a candidate registered for the Level II exam copies important
concepts ad formulas from difficult topics such as Economics, Quantitative Methods
and Derivatives daily from the CFA Institute curriculum and posts them on his
Facebook page. He had paid for the online version of the curriculum. He does not
attribute the source of his post. Mathew is most likely in violation of:
o A
Misrepresentation.
o B
Misconduct.
o C
Responsibilities as a CFA Institute Member or CFA Candidate.

Incorrect
A is correct. Refer Standard I(C) Misrepresentation.
10. Question 10
Inventure Advisors hires ten research analysts at the entry level from a reputed
management school. One of the recruits, Smith, has served a three-day jail term
after being convicted for drug abuse, while still in school, that was not disclosed at
the time of recruitment. He has since reformed after being to a rehabilitation center.
However, Smith had provided references, who would have acknowledged this
incident if the firm had done the background check. Who is most likely in violation of
Standard I(D) Misconduct?
o A
Smith, for not revealing the offence at the time of recruitment.
o B
The firm for not conducting the background check.

o C
Both Smith and the firm.

Incorrect
C is correct. It is recommended that firms check reference of potential employees.
According to Standard I (D) Misconduct, “Members and Candidates must not engage
in any professional conduct involving dishonesty, fraud, or deceit or commit any act
that reflects adversely on their professional reputation, integrity, or competence”.
The recommended procedures for compliance with Standard I (D) says the employer
should do background (reference) checks of employees to ensure they have not had
a brush with the law in the past and are eligible to work in the investment
profession.
11. Question 11
Sanjay Babu is a research analyst at Waterhouse Investment Management firm. He
covers Sat Corp, a technology services firm. Babu, during a visit to the firm to
interview the business heads about future growth prospects, overhears a
conversation between the CFO and VP-HR in the adjoining room, that the market
regulator of India is privately interrogating the CEO’s involvement in an insider
trading case of Sat Corp. What is the best course of action for Babu to take?
o A
Issue a sell recommendation as the stock will fall once the information is
public
o B
Encourage Sat Corp. to make the information public

o C
Communicate the information to his research team members so that they do

not make any investment recommendation on the firm
Incorrect
B is correct. C is incorrect because when public dissemination is not possible,
members must communicate only to the designated supervisory or compliance
personnel and not to their teams. Standard II(A) Material Nonpublic Information.
12. Question 12
The Food Safety and Standards Authority of India (FSSAI) was investigating the
presence of dangerous substances in a popular baby cereal, manufactured by Selet
Limited. Selet is a publicly listed company with operations around the world. The
tests results showed the presence of harmful chemicals above permissible limits that
could mean product recalls and a temporary ban on production. The results of the
test have not been made public as yet. Tara, a lead scientist at one of Selet’s labs,
confides the results to Raul, a research analyst who covers Selet and manages Tara’s
portfolio. She asks him to sell her holdings in Selet. If Raul acts on Tara’s information
only for her portfolio, he would most likely violate which of the following Standards?
o A
Fair Dealing.
o B

o C
Incorrect
B is correct. Raul must not act on the information passed by Tara and must
encourage her and her firm to achieve public dissemination. Standard II(A) Material
Nonpublic Information.
13. Question 13
Alex Karachanis, CFA, is an independent financial advisor with a roster of over 100
clients. Along with advisory services, he also facilitates in executing the trades for his
clients and manages their portfolio. Adonia Papadakis signed up Alex in November
2013 to advise and manage her portfolio. After detailed discussions on Adonia’s
circumstances and return requirements, it was agreed that only large cap equity
investments will be made. In mid-2013 Alex felt that large cap stocks were
excessively overvalued and shifted 50% of the portfolio to small-cap stocks. Over the
next six months, small-cap stocks significantly outperformed large cap stocks. It is
now January 2014 and Adonia has just received her account statement for 2013. She
is very happy with the performance of her portfolio. Which Standard did Alex least
likely violate?
o A
o B
Communication with Clients and Prospective Clients

o C

Incorrect
A is correct. Standard III(D) Performance Presentation is not violated as Alex sends a
quarterly itemized statement of the funds and securities in his custody, and the
transactions that occurred during this period. Standard V(B) Communication with
Clients and Prospective Clients is violated because Alex should have discussed the
change with the client before moving to small cap stocks. Standard III(A) Loyalty,
Prudence, and Care is violated because small cap stocks might not correspond to
client’s risk profile.
14. Question 14
Riya, CFA, a portfolio manager has two high net worth clients: Rita and Anita. The two
clients are sisters and except a few asset classes, their portfolio holdings are the
same. The sisters have received USD200,000 each in inheritance. Both, Rita and
Anita, have expressed interest in taking exposure in risky international equities,
especially China. Anita also plans to buy a new house in the next 3-4 months and
needs to make a down payment of USD450,000. Riya is aware of Anita’s plans and
her needs for liquidity. After a thorough research, Riya identifies a fund that has the
potential to earn good returns in the next three years, and recommends it to Rita for
investment. Has Riya violated any Standard by not recommending the fund to Anita?
o A
Yes, Standard III (B) Fair Dealing.

o B
No.
o C
Standard III (C) Suitability.

Incorrect
B is correct. Anita’s circumstances have changed and the down payment takes
precedence. She cannot invest any surplus in risky investments now. Since the stock
was not suitable, Riya did not recommend the fund. So, she did not violate any
standard.
15. Question 15
Roland Andrade manages a small-cap, growth fund called Equity Opportunity Series
– Growth. He purchases the stock of a large-cap dividend paying company as it will
bring stability to the fund. After the purchase, the stock has the highest holding in
the fund. Which Standard did Andrade most likely violate?
o A
Suitability.
o B

o C
Loyalty, Prudence, and Care

Incorrect
A is correct. A large-cap dividend paying company is usually not growth-focused. By
choosing this stock for the fund, Andrade has violated Standard III (C) Suitability as it
does not fit the fund’s investment mandate.
16. Question 16
Ind Bank has recently started advisory services at its new branch in Nhasi located in
an affluent neighborhood of high net worth individuals. To promote its services, the
bank conducts a marketing drive and in one month signs up many clients. Ent Nes,
an advisor at the bank, is meeting with a new client at the latter’s home. The client
wants to know if anyone from the community are Nes’ clients and whether any
private equity (PE) investments have been made. Nes boasts of the business he has
garnered in the past month and says a few people have recently made PE
investments, but does not reveal their names. Has Nes violated any Standard?
o A
No.
o B
Loyalty.
o C
Incorrect
A is correct. The assets managed by a firm is presented to clients, and is not
confidential. Since no names or confidential details of the clients were disclosed,
Standard III(E) is not violated.
17. Question 17
Vishal Kachru, CFA, works as a research analyst with HDC Investments. On Saturdays,
he gives lectures on leadership and brand building for three hours at a management
school nearby. He is compensated well for this activity as an independent lecturer.
Kachru ensures that he schedules this class only when he is not required at
work. Did Kachru violate any Standard?
o A
Yes, Standard IV (A) Loyalty by not informing his employer of this

engagement and compensation.
o B
No, because it does not affect the responsibilities to his employer.

o C
Yes, Standard VI (C) Disclosure of Conflicts.

Incorrect
B is correct. Since it does not interfere with his responsibilities at work, there is no
violation.
18. Question 18
Andrea Whistler, CFA is a research analyst at Awesome Investments. Among the list
of stocks she covers is home e-tailer Fabnish, which was issued a buy
recommendation recently. Whistler is also a passionate home décor blogger in her
spare time. To promote their newly launched home décor section, Fabnish has
approached Whistler to do an objective post on home improvement using the
products on their site. She will be compensated through vouchers for this activity
that can be redeemed on the site. Whistler does not inform her employer of this
activity as it does not interfere with her work commitments. Did any violation take
place?
o A
Yes, she should have informed her employer of the additional

compensation.
o B
No, because there was no conflict of interest.

o C
No, because she was loyal to her employer.

Incorrect
A is correct. Since Fabnish is a client covered as part of their research analysis, there
is a conflict of interest. She was paid for her engagement which she should have
disclosed to her employer. Standard IV(B) Additional Compensation Arrangements.
19. Question 19
Aidan Ackermann, CFA, is recently hired as a banking analyst at Becker Investments.
One of the mandates given by his supervisor Abigail Wohlers, is to improve the
online presence of Becker among social media platforms. Ackermann posts regularly
on the company’s Facebook page and Twitter on the various services offered by
Becker as well as snippets of the companies on his research list. He shares his
buy/sell/hold recommendation in a brief manner on Twitter before the report is
released to all clients. Wohlers is least likely to have violated the Standard relating to:
o A
Fair Dealing.
o B
o C
Incorrect
C is correct. By not educating Ackermann of the compliance procedures for social
media, and not supervising what was being posted online, Wohlers has violated
Standard IV(C) Responsibilities of Supervisors. Ackermann also violated Standard
III(B) Fair Dealing.
20. Question 20
Dan Belkin works for Benedict Advisors. The firm advises and manages the portfolio
of clients with various mandates. To cater to the increasing number of requests for
diversification by including international equities, Belkin has been assigned the task
of selecting a sub-adviser who specializes in this area. The selection must be made
within the next six weeks. Belkin shortlists ten names from a database of fund
managers who focus on this region. He eliminates those with a high expense ratio
and a high turnover rate, and narrows the list to five. Due to shortage of time, Belkin
has a brief interaction with each of the five fund managers to understand how they
calculate returns, and does not go into their stock selection or due diligence process.
He chooses the one with highest total returns in the past two years. In selecting the
manager with highest returns, Belkin is most likely in violation of the CFA Standards
relating to:
o A

o B

o C
Loyalty.
Incorrect
A is correct. He is in violation of Standard V(A) Diligence and Reasonable basis
because he did not make reasonable efforts to analyze all aspects such as stock
selection process, fees, investment philosophy, assets under management, or
experience before selecting an adviser. Belkin is also in violation of Standard III(C)
Suitability by not analyzing if the chosen manager’s services are appropriate for the
firm’s clients and if the fee structure is low relative to the services offered.
21. Question 21
Ashwin Kaushal, CFA develops a stock screening model using several parameters,
while he is employed at Reliable Investments Inc. He documents the assumptions
made regarding the model and the reasoning behind using parameters such as
shareholding pattern, performance of the stock relative to index, and comparing it
with peers. The success of the model lands him a job as the head of research at
Trust Advisors. Kaushal takes all the documents related to the model developed by
him. Did Kaushal violate any Standards?
o A
Yes, the Standard relating to Conflicts of Interest.

o B
Yes, the Standard relating to Loyalty.

o C
No, there was no violation.

Incorrect
B is correct. The documents related to the screening model and the model are a
property of Reliable Investments and not that of Kaushal’s because they were
developed using the resources of the company while employed there. Standard IV(A)
Loyalty.
22. Question 22
Eli Sorkin, is a research analyst covering the electronics industry. One of the
companies he follows closely is Canc Inc. as they often come up with innovative
products. When they release a wireless printer, he thinks it is a breakthrough and
after thorough research, strongly recommends the stock. A fortnight after the report
is released, Sorkin inherits $1million worth of Canc stock from a distant uncle. Sorkin
is asked to write a follow-up report on Canc. What is the least appropriate action for
Sorkin to take?
o A
Disclose the stock ownership to his employer.

o B
Do nothing as sufficient time has passed since the report was released.
o C
Disclose Ask his employer to assign further coverage of the stock to another
analyst.
Correct
B is correct. Sorkin must disclose his ownership of the Canc stock to his employer
and in his follow-up report. But the best course of action to avoid any conflict of
interest would be to ask his employer to assign the stock to another analyst.
Standard VI(A) Disclosure of Conflicts.
Application of the Code and
Standards
Sienna Bakers, CFA, is a research analyst with Redding Securities, a division of the Redding
Group. Redding is a full-service investment management firm. The Redding Group and its
divisions have adopted the CFA Institute Code of Ethics and Standards of Professional
Conduct. Bakers is presently writing a report on Sunbend Chemicals (Sunbend), a producer
of specialty chemicals. In the past, two board members of Redding had worked at key
positions at Sunbend. Further, Redding has an appropriate firewall between the investment
banking division, and the research division, set up when it served as an underwriter for
Sunbend’s debt offering few years ago. Bakers after thoroughly researching Sunbend,
determines a “Buy” recommendation for accounts with low risk tolerance for the coming
months. Her report mentions the main factors which led her to the new rating, a change
from her previous “hold” recommendation. There is no mention of Redding’s previous
relationships with Sunbend as they do not apply anymore. The report after being approved
by the Research Director is sent to all clients with a low risk profile as well as to Redding’s
portfolio management division. Carrie Daly, CFA, a portfolio manager for Redding’s portfolio
management division, worked with Bakers in the research department as an analyst few
years back. Daly is now responsible for institutional clients with a low risk mandate. Based
only on Bakers’ recommendation, Daly reviews all her accounts which are discretionary and
decides to purchase Sunbend’s stock where suitable. Daly determines the total number of
shares that need to be purchased for her accounts. Trades are fully executed by the end the
day and the shares are allocated according to Redding’s Trade Allocation Policy. Daly as a
matter of policy has a high priority on purchase for pension funds. She follows the policy
and purchases it for pension funds first then buys it on a pro rata basis for all other
accounts. All clients are charged the same commission.
1. Question 1
Q-Code: 21-L2-ES-APCS-75037
Regarding the report on Sunbend, the CFA Institute Standards of Professional
Conduct most likely violated by Bakers is:
o A
o B
Suitability.
o C
Communication with Clients and Prospective Clients.

Incorrect
A is correct. Redding’s previous business relationships needs to be disclosed in the
initial research report in order to maintain independence and objectivity. No board
members are currently employed by Sunbend and a firewall exists, but it does not
eliminate the need for the client to assess the potential conflict of interest between
Sunbend and the firm and the reason for the recommendation. Standard VI(A)–
Disclosure of Conflicts requires charterholders and candidates to disclose all matters
that could reasonably be expected to impair their objectivity or interfere with duties
to clients and prospects. Therefore, Bakers violated Standard VI(A).
B is incorrect because Standard III(C)–Suitability requires members and candidates to
determine if an investment is suitable to a client’s financial situation and consistent
with the client’s written objectives, and constraints. Baker’s research report is
distributed to only those clients with the appropriate risk profile.
C is incorrect because Standard V(B)–Communication with Clients and Prospective
Clients requires members and candidates to use reasonable judgment in identifying
which factors are important to their investment analyses, recommendations, or
actions and to include those factors in communications with clients and prospective
clients. Baker mentions the main factors in her report.
2. Question 2
Was Daly’s purchase of the Sunbend stock for her clients consistent with the CFA
o A
Yes.
o B
No, because she worked in the research department.

o C
No, because she purchased based on Baker’s recommendation

Incorrect
C is correct. Daly bought the stock based solely on Bakers’ recommendation thus
failed to comply with Standard V(A)–Diligence and Reasonable Basis. Even though
she worked in the research department and is likely familiar with the firm’s
methodology, Standard V(A) requires that she make a reasonable and diligent effort
to determine whether the research is sound, with reasonable assumptions and
objective recommendation.
B is incorrect because her prior experience at Redding’s research department does
not alleviate her responsibility to exercise diligence, independence, and
thoroughness in analyzing investments, making investment recommendations and
taking investment actions.
3. Question 3
Does Daly’s manner of purchase of Sunbend’s shares comply with the CFA Institute
o A
Yes, because all accounts are discretionary.
o B
Yes, because the same commission fee is charged for all accounts.
o C
No.
Incorrect
C is correct. Redding’s trade allocation policy does not treat all clients fairly. Daly has
violated her duty to her clients by giving priority to the pension fund over all other
accounts. According to Standard III(B) members and candidates must deal fairly and
objectively with all clients when providing investment analysis, making investment
recommendations, taking investment action.
Kim Edwards, a portfolio manager for WFG Mutual Funds, buys GTI Manufacturers, a
building materials company, for one of its large cap growth portfolio. Reviewing the trade,
Lea Miller, the bank’s compliance director, is concerned about GTI’s stock purchase asks
Edwards to provide justification. Edwards gives the following reason: Following on the “Buy”
recommendation of the research report issued by WFG’s Research Department, GTI
Manufacturers was purchased due to its potential for higher return given its present low
stock value. While its purchase – a small cap value stock in a large cap growth portfolio
appears to be questionable, it is consistent with the overall objectives, constraints and
context of the fund. The portfolio even after the inclusion of GTI, maintains its large cap
growth category. After the month end report is sent to the clients, Edwards receives a
written query from one of his clients. The client questions the purchase of GTI for the large
cap growth portfolio. He expresses his dissatisfaction as the purchase is not consistent with
his Investment Policy Statement. Edwards reviews the client’s investment policy and writes a
response. She also invites the client to a meeting she is scheduling at the end of the next
week with Tina, the analyst who prepared the recommendation. Edwards is satisfied with
GTI’s return potential over the next two weeks. She asks Tina to meet with several new
prospects. This will help attract new clients as they will come in direct contact with the
analysts who are responsible for the stocks’ recommendations. Tina meets with the
potential clients and explains the thorough research and analysis followed by the research
department.
1. Question 1
By including GTI’s stock in the large cap growth fund, has Edwards violated any CFA
o A
Yes, with respect to Suitability.

o B
Yes, with respect to Loyalty.

o C
No.
Incorrect
C is correct. Edwards has not violated the Code and Standards since the investment
is suitable in the context of the client’s total portfolio. According to the Standard III
(C) – Suitability, members and candidates when in charge of managing a portfolio to
a specific mandate, strategy, or style, must make only investment recommendations
or take only investment actions that are consistent with the stated objectives and
constraints of the portfolio. While the purchase of a small cap value stock in a large
cap growth mandate appears to be questionable, it fits with the overall objects and
constraints of the portfolio. Additionally, even after the purchase, the portfolio
continues to remain in the large cap growth category.
2. Question 2
After receiving the client’s query, Edwards should most likely:
o A
invite the client to review and revise his investment policy statement.
o B
advise him that the purchase is reviewed by the firm’s compliance director.
o C
sell GTI’s shares from the portfolio.

Incorrect
A is correct. Standard III(C)–Suitability requires members in an advisory relationship
to regularly update the client’s investment policy statement to reflect any changes in
the client’s circumstances. Updating the investment policy statement should be done
at least annually. One or more factors could change without the investment
manager’s knowledge, hence necessitating a regular review and update. B is
incorrect, because a review by the firm’s compliance director does not address the
client’s concerns. C is incorrect because liquidating the stock position in the portfolio
does not address the client’s concerns and may not be appropriate.
3. Question 3
During the meeting, whose actions most likely violated the Code and Standards?
o A
Edwards.
o B
Tina.
o C
neither.
Incorrect
C is correct. Neither Edwards nor Tina has violated the CFA Institute Standards of
Professional Conduct during the meeting with Edwards’ potential clients. By getting
Tina to meet with several new prospects Edwards is aiming to grow her client base.
By discussing her research approach, Tina has not given preferential treatment to
these potential clients. Tina only discussed the research process and did not disclose
her most current research.
Dave Rhett, CFA is a portfolio manager at a large securities and brokerage firm. Rhett
manages institutional and high net-worth clients. The firm resides and operates in a country
with its own stringent securities and brokerage laws and regulations enforced and regulated
by a Securities and Exchange Regulator. These laws, rules and regulations though strict are
less exacting than the Code and Standards. The firm follows the country’s laws to the letter
and has only on rare occasions been reviewed and investigated for potential violations. One
of Rhett’s clients calls and tells him that he will give 5% to him as a reward for achieving a
15% capital appreciation of his portfolio next year. This will be additional to the
compensation provided to Rhett by her firm. The client explains that it will be only for next
year. Rhett tells his supervisor about the arrangement who feels as this is only a one-time
benefit he does not need to seek the permission of the investment director. Rhett then calls
the client and accepts his offer. Paula Harding, CFA, is a research analyst at the firm covering
the petroleum sector. Harding is scheduled to visit the corporate headquarters of Carbade
Industries, a petroleum production and refining company. Harding is glad for the
opportunity because Carbade has shown attractive growth in the last quarter and she
expects to use the information she obtains there to complete her research report. Harding
learns that Carbade plans to pay for the costs of meals, accommodation, and air
transportation. Harding knows that the area does not have any proper hotels or inns and
commercial transportation charges are higher than normal fare because of lack of traffic on
that particular route. Harding is also covering another petroleum production and marketing
company, Totally Petro. She owns a substantial stock position in Totally Petro which is fully
disclosed to her firm. Harding is preparing a “buy” recommendation on Totally Petro.
1. Question 1
Which of the following is a correct statement under the Code and Standards?
o A
A member or candidate is required to comply only with the applicable laws,

rules and regulations, even though the Code and Standards may impose
stricter degree of responsibility on the member or candidate.
o B
A member or candidate is required to comply with the Code and

Standards when they are stricter than the applicable laws and
regulations.
o C
A member or candidate is required to comply only with the Code and
Standards in all instances even in the presence of local rules and regulations
governing the securities market.
Incorrect
B is correct. The firm does business in a locality where the applicable laws, rules and
regulations are less strict than the Code and Standards. According to Standard I(A) –
Knowledge of the Law, Members and Candidates must understand and comply with
all applicable laws, rules, and regulations (including the CFA Institute Code of Ethics
and Standards of Professional Conduct) of any government, regulatory organization,
licensing agency, or professional association governing their professional activities.
In the event of conflict, Members and Candidates must comply with the more strict
law, rule, or regulation. Hence member must adhere to the Code and Standards
which are more strict than the local laws.
2. Question 2
Did Rhett violate any CFA Institute Standards of Professional Conduct by accepting
the 5% reward?
o A
Yes, he needed to obtain written permission of his employer before

accepting the compensation arrangement.
o B
No, he obtained the supervisor’s consent.

o C
Yes, the additional compensation resulted in conflicts with the interests of

other clients.
Incorrect
A is correct. This involves Standard IV (B) – Additional Compensation Arrangements.
The arrangement described which involves Rhett to be compensated beyond the
compensation provided by his firm, on the basis of an account’s performance—is not
a violation of the Standards as long as Rhett discloses the arrangement in writing to
his employer and obtains permission prior to entering into the arrangement. Thus,
by failing to obtain a written consent from his employer, Rhett violated Standard
IV(B).
3. Question 3
Which of the following actions should Harding most likely take to comply with the
Code and Standards?
o A
Accept the expense-paid trip but disclose the value to her employer.
o B
Accept the travel expense paid trip and mention the amount in report.
o C
Pay for all travel expenses, including costs of meals and

accommodation.
Incorrect
C is correct. To comply with Standard I(B)– Independence and Objectivity it is best to
avoid a conflict of interest whenever possible. Therefore, Harding should pay for all
her expenses.
Disclosing the amount in the report or to employer will not help in avoiding the
conflict of interest.
4. Question 4
According to the Code and Standards, which of the following disclosures should
be most likely included in Harding’s report? Harding should mention that:
o A
she frequently buys petrol from Totally Petro.

o B
she holds a substantial common stock position in Totally Petro.

o C
her sister-in-law works in the crude oil exploration industry.

Correct
B is correct. This involves Standard VI(A) – Disclosure of Conflicts, according to which
members and candidates must make full disclosure of all matters that could
reasonably be expected to impair their independence and objectivity or interfere
with their duties to clients, prospective clients, and employer. Harding’s ownership in
the stock of the company for which she is writing a recommendation is known to her
employer. To prevent any conflict, she should disclose in her research report of her
ownership in the stock of Totally Petro. The use of a firm’s products, does not
require disclosure. The relationship between the analyst and the company through a
relative is so tangential that it does not create a conflict of interest necessitating
disclosure.
ALTERNATE INVESTMENTS
Introduction to Commodities and

Commodity Derivatives
1. Question 1
Q-Code: 21-L2-AI-CCDI-73886
An investor earns a 3.1% price return on a commodity futures contract position and
a 2.9% roll return after holding this position for one year. The required initial
collateral was 20% of the position at a risk-free rate of 3% per year. Her total
annualized return excluding leverage was:
o A
3.60%.
o B
6.00%.
o C
6.60%.
Incorrect
C is correct. Total return = Price return + Roll return + Collateral return
The investor holds the contracts for one year, so the price return of 3.1% and the roll
return of 2.9% are annualized figures. The collateral return = 3% per year × 20%
initial collateral investment = 0.6%. Total return (annualized) = 3.1% + 2.9% + 0.6% =
6.60%.
2. Question 2
Roll returns are generally positive when the futures market is:
o A
in backwardation.
o B
in contango.
o C
flat.
Incorrect
A is correct. Roll returns are generally positive (negative) when the futures market is
in backwardation (contango) and zero when the futures market is flat.
3. Question 3
Analyst 1: Some commodity futures price curves can rapidly shift from contango to
backwardation or vice versa.
Analyst 2: The shape of a commodity futures price curve reflects future supply and
demand of the underlying commodity(ies) only.

o A
Analyst 1
o B
Analyst 2
o C
Neither Analyst 1 nor Analyst 2

Incorrect
Solution: A is correct. During periods of market stress or fundamental structural
change in market conditions, some commodity futures price curves can rapidly shift
from contango to backwardation or vice versa. Analyst 2 is incorrect because the
shape of a commodity futures price curve reflects both long-term industry factors as
well as market expectations of future supply and demand of the underlying
commodity(ies).
4. Question 4
An arbitrageur has two active positions in the commodity futures markets— one for
cotton and the other for natural gas. The calendar spread on the cotton contract is
quoted at −70 cents per pound, and the calendar spread on the natural gas contract
is +$0.95 per million BTU (British thermal units). Based on this information, we can
say that:
o A
only the spreads of these commodities, and not the individual prices, can be
traded in commodity markets.
o B
the cotton futures market is in a state of contango and the natural gas
futures market is in a state of backwardation.
o C
the cotton futures market is in a state of backwardation and the natural gas
futures market is in a state of contango.
Incorrect
B is correct. The spread is the difference between the current spot price for a
commodity and the futures contract price. Futures markets in a state of contango
will have futures prices that exceed the spot price resulting in negative spread for
these markets. Conversely, in a state of backwardation, the spread is positive.
5. Question 5
Informed investors typically:
o A
provide insurance to hedgers.

o B
seek to take advantage of futures mispricing.

o C
take advantage of futures mispricing attributable to a lack of

information in the marketplace.
Incorrect
Solution: C is correct. Informed investors mainly keep commodity futures markets
efficient by capitalizing on mispricing attributable to a lack of information in the
market.
6. Question 6
Statement 1: Commodities are always physical goods.
Statement 2: Commodity investment takes place mainly through derivatives.
o A
Statement 1
o B
Statement 2
o C
Both statements 1 and 2

Incorrect
B is correct. The most common way to invest in commodities is through derivatives.
Statement 1 is incorrect because although most commodities are physical goods,
certain newer classes, such as electricity or weather, are intangible.
7. Question 7
The DBLC Index is unique in that it:
o A
rebalances annually.
o B
uses the production weighted method.
o C
has a rolling methodology that is optimized on roll return.

Incorrect
C is correct. The following passage is from the curriculum: “The most notable/unique
feature of [DBLCI] is its rolling methodology. Instead of focusing on nearterm
contracts, it is optimized based on the time value of maximized
backwardation/minimized contango for the contracts that fall within the next 12
calendar months. As an example, a June 2014 copper futures contract may be at 1%
backwardation versus May 2014 copper contract. But if the July 2014 copper contract
is at a 3% backwardation (1.5% per month, or 3% divided by two months) versus the
1% backwardation per month on the June 2014 contract, then the DBLCI will roll to
the July 2014 contract in preference to the June 2014 contract. Therefore, one could
argue the DBLCI takes an active decision with regards to roll return positioning as
compared with the other indexes.”
Option A is incorrect because though the DBLCI rebalances annually, so do the S&P
GSCI and BCOM, so it is not a unique quality of the index.
Option B is incorrect because the DBLCI uses a fixed weighting method.
8. Question 8
Which of the following statements about commodity indexes is least likely correct?
o A
Frequent rebalancing can lead to underperformance in a trending market

because the outperforming assets are sold but continue up in price, whereas
the underperforming assets are purchased but still drift lower.
o B
One of the roles of commodity indexes is as a broad indicator

(macroeconomic or forecasting purposes).
o C
The major commodity indexes have a high correlation with each other
and traditional asset classes.
Incorrect
C is correct. The major commodity indexes have a high correlation with each other
and a very low correlation with traditional asset classes.
9. Question 9
Which of the following statements is most likely correct with respect to variance and
volatility commodity swaps?
o A
Variance commodity swaps are where two parties agree to exchange

payments based on the difference between observed and expected volatility
in the price of a commodity.
o B
In a commodity variance swap, if the difference between the observed

variance and the variance established at the outset of the contract is positive,
the variance swap seller benefits.
o C
In a commodity volatility swap, if the volatility is higher than expected,

the volatility buyer benefits.
Incorrect
C is correct. Option A is incorrect because it states the definition of a commodity
volatility swap. A commodity variance swap is where two parties agree to periodically
exchange payments based on the proportional difference between an
observed/actual variance in the price levels of a commodity, and some fixed amount
of variance established at the outset of the contract.
Option B is incorrect because in a commodity variance swap, if the difference
between the observed variance and the variance established at the outset of the
contract is positive, the variance swap buyer benefits.
If the difference is negative, the variance swap seller benefits.
10. Question 10
Which of the following statements about commodities is most likely correct?
o A
Softs include corn, wheat, rice, and soy.

o B
The availability of precious metals such as gold, silver, platinum is generally

affected by weather.
o C
The storage of industrial metals is easy, but transport can be expensive.

Incorrect
C is correct. Option A is incorrect because softs are cash crops, which include cotton,
coffee, sugar, cocoa, etc. The examples in option A (corn, wheat, rice, and soy) are
those of grains.
Option B is incorrect because weather has effectively no impact on the availability of
precious metals due to their long storability.
11. Question 11
In a trending market, production-weighted S&P GSCI will have an opportunity to
outperform fixed-weight scheme indexes such as TR/CC CRB and RICI due to:
o A
higher rebalancing costs.

o B
frequent rebalancing.
o C
lower rebalancing costs.

Incorrect
C is correct. S&P GSCI will most likely outperform TR/CC CRB and RICI due to lower
rebalancing costs. This is because the higher (lower) futures prices usually coincide
with higher (lower) physical prices. TR/CC CRB and RICI have a fixed-weighting
scheme and will incur higher costs due to frequent rebalancing in a trending market.
12. Question 12
A portfolio manager of a large pension plan is seeking 4% of exposure of plan assets
amounting to USD 90 million to commodities index S&P GSCI for a period of three
years. Consequently, he enters into a swap contract with a global bank. According to
the swap terms, the payments received (net of fee paid) or made (plus fee charged)
by the swap buyer to the bank will be based on the change in the index level over
consecutive valuation dates multiplied by the notional amount of $90 million. This
type of swap is best known as a(n):
o A
total return swap.

o B
excess return swap.
o C
basis swap.
Incorrect
A is correct. The total return swap in commodities involves a party receiving
payments based on the change in the level of an index level over two consecutive
valuation dates multiplied by the notional amount of the swap.
13. Question 13
An oil refining company treasurer goes long a swap for a certain quality of Brent
crude with a reference price of USD90 per barrel. According to the swap terms the
company treasurer will pay the swap dealer a premium of USD15 for transferring
risk to the dealer. At the end of every month the company will receive a payment if
Brent crude is above the strike price of USD90. This is an example of a(n):
o A
total return swap.

o B
excess return swap.

o C
basis swap.
Incorrect
B is correct. This type of swap is known as an excess return swap. In a total return
swap either party might receive payment. In a basis swap, payments are based on
the difference between two related but not perfectly correlated reference prices of
commodities.
14. Question 14
Long-only commodity portfolio strategies that involve overweighing of agriculture,
livestock, precious metals and softs may expect to earn:
o A
positive roll return.

o B
negative roll return.

o C
flat roll return.

Incorrect
B is correct. “Indexes and long-only strategies that overweight agriculture, livestock,
precious metals, and softs should expect to see negative roll returns (or roll yields).
Energy commodities (apart from natural gas) have the opportunity for more positive
roll return.” Exhibit 14.
15. Question 15
Roll return is positive when futures markets are in:
o A
backwardation.
o B
contango.
o C
either backwardation or contango.

Incorrect
A is correct. Positive roll return is associated with periods of backwardation.
16. Question 16
The price of which commodity least likely reflects the demand for industrial
production activity?
o A
Platinum.
o B
Copper.
o C
Coffee.
Incorrect
C is correct. The price of industrial (base) metals, specifically copper indicates the
direction of industrial production. Industrial demand for silver, platinum, and
palladium make up about 50% demand for these precious metals. Demand for softs,
such as coffee is linked to global wealth.
17. Question 17
An investor has USD120 of exposure in soybean futures. The near contract is worth
USD10, but the far contract is worth USD11. To keep the post-roll exposure close to
the pre-roll exposure, he will most likely conduct the following transactions:
o A
buy 12 near contracts and sell 11 far contracts.
o B
sell 12 near contracts and buy 11 far contracts.

o C
buy 12 near contracts and buy 12 far contracts

Incorrect
B is correct. The investor original has USD120 / USD10 = 12 contracts, but the far
contract is worth USD11 of exposure. Therefore, for the investor to roll forward his
contracts and maintain a constant level of exposure, he needs to sell 12 near
contracts and buy 11 far contracts.
18. Question 18
The total return on a fully collateralized commodity futures contract is given as the:
o A
spot price return plus the roll return plus the collateral return.
o B
spot price return minus the annualized spot return standard deviation plus
the collateral return.
o C
collateral return minus the roll return.

Incorrect
A is correct. The total return on commodity futures contract are the price return plus
the roll return plus the collateral return.
19. Question 19
Under the Theory of Storage, what is the relationship between convenience yield and
the level of inventory?
o A
The level of inventory does not impact convenience yield.

o B
As inventory becomes more abundant, convenience yield rises.

o C
As inventory becomes scarce, convenience yield rises.

Incorrect
C is correct. Convenience yield is low when inventories are abundant but rises when
stock diminishes due to demand exceeding supply raising concerns about the future
availability of the commodity.
20. Question 20
In which situation is the Hedging Pressure Hypothesis similar to the Insurance
Theory?
o A
When commodity producers selling forward exceed commodity

consumers needed to complete the market resulting in the futures
price curve in backwardation.
o B
When price protection demanded by commodity producers equal the needs

of the commodity consumers, and the hedging needs of the buyer offset
those of the seller.
o C
When there is an imbalance in the demand for price insurance where the
buyers exceed the sellers causing the futures markets to be in contango.
Incorrect
A is correct. According to the Hedging Pressure Hypothesis, hedging pressure occurs
when both producers and consumers enter into price hedges to protect themselves
from market price volatility. If commodity producers exceed the commodity
consumers, then the imbalance in demand for price protection will cause the futures
prices to be lower to provide for sufficient discount for the speculators who will take
on the price risk. The futures price curve will represent backwardation and the
situation will be similar to Keynes’ Insurance Theory.
21. Question 21
Which of the following statements is least accurate? According to the Insurance
Theory:
o A
producers sell their commodities in the futures markets to hedge sales

prices, making their revenues more certain.
o B
the futures curve is in backwardation “normally” because the producers

constantly sell forward to lock in prices, resulting in lower prices in future.
o C
the spot price is higher than the futures price because the producers
take on the price risk.
Incorrect
C is correct. According to the Insurance Theory, the futures price is lower than the
spot price to induce the buyer (speculator) who takes on the price risk in exchange
for the insurance he provides to the commodity seller (producer). A & B are true
according to the Insurance Theory.
22. Question 22
o A
Physical-settled commodity futures contracts require that the title of the

commodity be transferred to the buyer.
o B
Cash-settled commodity futures contracts ensure a convergence of the

futures and spot market.
o C
As opposed to commodity spot prices, futures prices can be global,

standardized and act as a reference price for forward contracts.
Incorrect
B is correct. Physical delivery ensures a convergence of the futures and spot market
which may not take place in cash-settled futures contracts. A & C are correct
statements.
23. Question 23
When the near-term futures contract price is higher than the longer-term futures
contract price for the same commodity, the calendar spread is:
o A
positive and commodity futures markets are in backwardation.

o B
negative and commodity futures market are in contango.

o C
positive and the futures markets are in contango.

Incorrect
A is correct. When near-term futures contract price is higher than the longer-term
futures price, the calendar spread associated with the futures market is positive and
the markets are in backwardation. If the near-term futures contract price is less than
the longer-term futures contract price for the same commodity, then the futures
market for that commodity is in contango.
24. Question 24
The difference between spot and futures prices is known as:
o A
basis.
o B
calendar spread.
o C
net futures price.

Incorrect
A is correct. The difference between spot price and futures price is called basis. The
price difference between the near-term futures price and the longer-term futures
price is known as the calendar spread.
25. Question 25
Which of the following statements regarding participants of the commodity futures
markets is correct?
o A
Hedgers speculate on market direction and volatility with the expectation of

making a profit.
o B
Exchanges often provide insurance to hedgers.

o C
Traders and investors provide liquidity and price discovery for futures
markets.
Incorrect
C is correct. Traders and investors bet on market direction or volatility. They provide
liquidity and price discovery. Exchanges are responsible for establishing trading rules
and infrastructure, and analysts develop products based on the information
communicated by exchanges.
26. Question 26
One of the differences in valuation of commodities as opposed to financial assets is
that commodities:
o A
incur transportation and storage costs.

o B
provide periodic income.

o C
generate future cash flows.

Incorrect
A is correct. Commodities do not generate future cash flows or provide regular
income. But they incur transportation and storage costs which are an important
consideration while determining their future price.
27. Question 27
Valuation of commodities most likely requires:
o A
discounting future cash flows.

o B
discounting of future prices where future prices are susceptible to

supply and demand and expected price volatility of the commodities.
o C
a thorough fundamental analysis.

Incorrect
B is correct. Valuation of commodities is not based on forecasting future cash flows
as the case is in financial assets but is based on forecasting the supply, demand and
volatility of the physical item. Commodities also require valuation by technical
analysis rather than fundamental analysis.
28. Question 28
Which of the following best describes the life cycle for crude oil and gasoline?
o A
Straight-through production to consumption.

o B
Input-output production life cycle.

o C
Seasonal production.
Incorrect
B is correct. Crude oil is extracted which is used as an input for producing refined
products such as gasoline and heating oil. Hence crude oil undergoes various
processing steps depending upon its quality and the demand for the various refined
products. A & C are incorrect. Natural gas has a life cycle characteristic which is
straight-through consumption. Grains have seasonal production.
29. Question 29
o A
The timing to maturity in livestock decreases with size.

o B
Farmers and consumers trade grain futures with the delivery months
matching the different growing cycle times of grains.
o C
Ranchers trade cattle futures to hedge against meat commitments from live
cattle but not young cattle.
Incorrect
B is correct. Grain futures have contract delivery maturities that match their growing
cycle. A is incorrect because timing to maturity is dependent upon the animal size, as
size increases so does maturity of the livestock. C is incorrect because ranchers can
hedge both young cattle and live cattle.
30. Question 30
The quality of which of the following commodity sectors is most likely affected by
storage?
o A
Softs.
o B
Industrial metals.
o C
Grains.
Incorrect
A is correct. Storability affects the quality and weight of softs (cash crops). Most
industrial metals can be stored for long periods therefore the quality is unlikely to be
affected by weather. Grains are grown in specific seasons and are stored till the next
season, hence not expected to cause a significant harm to quality.
Sia Xander, a commodity analyst at BGB Commodity Fund Managers, is asked to research
energy prices. She reviews the spot and future prices of West Texas Intermediate crude oil
on the close of 31 May 2017 presented in Exhibit 1. Exhibit 1: Spot and Future Prices WTI
Crude Oil as of 31 May 2017
Price per barrel

Spot price $51.11
NOV-2017 $51.64
FEB-2018 $51.79
MAY-2018 $51.90
Xander knows that as sanctions are lifted from Iran, the world crude oil production is
expected to increase, and likely add to the current surplus of 2 million barrels. Xander’s next
assignment is to examine the industrial metals for investment by one of BGB’s funds. She
makes the following notes shown in Exhibit 2. Exhibit 2: Investment Characteristics of
Industrial (Base) Metals
• GDP growth
Factors that affect • Politics
industrial product prices • Environmental pollution concerns
• Flexible can be stored for longer time periods

• Difficult to cut back production when supply exceeds demand
Product life cycle • Time lag involved between planning capacity expansion and
beginning production
• Valuation is impacted by storage and transportation costs

Valuation • Valuation is based on discounted cash flows
1. Question 1
Based on Exhibit 1, the futures market for WTI crude oil is most likely:
o A
in backwardation.
o B
in contango.
o C
flat.
Incorrect
B is correct. When the spot price is less than the futures price, the situation is called
contango. In the futures market “when the near-term futures contract price is lower
than the longer-term futures contract price, the futures market for the commodity is
in contango.” The near-term futures contract price of WTI crude oil is lower than the
longer-term futures price, hence the market is in contango.
2. Question 2
Regarding the world crude oil production, the convenience yield for crude oil
will most likely:
o A
decrease.
o B
increase.
o C
remain unchanged.
Incorrect
A is correct. Convenience yield is the benefit derived from physically holding a
commodity instead of going long in the respective futures contract. An increase in
expected supply of the commodity will lower the convenience yield.
3. Question 3
Based on Exhibit 2, which of Xander’s notes about the investment/valuation
characteristics of industrial metals is least appropriate?
o A
Demand dependent upon GDP growth, politics, and pollution concerns.

o B
Product life cycle flexible and production cut backs difficult.

o C
Valuation based upon future cash flows.

Incorrect
C is correct. Commodities do not generate cash flows. Hence unlike traditional asset
classes like stocks and bonds, valuation of commodities is not based upon future
cash flows but on discounted future prices. A & B are correct statements.
Sam Brown, fund manager at DLN Investments, a firm specializing in commodity trading, is
evaluating the performance of one of its funds. Brown compares the fund’s sectors’ returns
with the return components of the S&P Goldman Sachs Commodities Index (GSCI). Brown
finds that for the energy subindex of S&P GSCI (from 1982 – 2014), the spot return is 7.2%,
the roll return is 2.55% and the collateral return is 5.26%. While examining the roll return of
various S&P GSCI subindexes, Brown makes the following observations:
I. Roll return of energy subindex is positive when futures contract prices are in
backwardation.
II. Roll return on the livestock subindex is negative when spot livestock prices have
been higher than future prices.
III. Roll return is sector dependent therefore sector diversification will significantly
impact an investor’s overall roll return of a diversified commodity futures portfolio.
Brown discusses commodity sectors’ returns with his colleague Mira Jones. Jones comments
that the commodity futures returns are based on three theories. Brown agrees and makes
the following statements:
I. “The insurance theory proposes that the producer hedges his sales price risk by
using commodity futures market to lock in prices hence the futures price curve is
typically in backwardation.”
II. The hedging pressure perspective assumes a flat commodity curve if the two forces
of sellers and buyers seeking price protection are equal.
III. Finally, the theory of storage focuses on a direct relationship between the level of
inventories and the convenience yield.”
1. Question 1
The excess return of the energy subindex of S&P GCSI, is closest to:
o A
15.01%.
o B
9.75%.
o C
12.46%.
Incorrect
B is correct. The excess return = Spot return + Roll Return = 7.2% + 2.55% =
9.75% (Excess over Government T-bills, the collateral)
2. Question 2
Which of Brown’s observations regarding roll return is least likely correct?
o A
I.
o B
II.
o C
III.
Incorrect
B is correct. When future prices are lower than spot prices, the market is in
backwardation. Roll return is positive for futures market in backwardation.
3. Question 3
Which of Brown’s descriptions of the futures return theories is least likely correct?
o A
The description of the insurance theory.

o B
The description of the hedging pressure hypothesis.

o C
The description of the theory of storage.

Incorrect
C is correct. The Theory of Storage gives the futures price as:
Futures price = Spot price of the physical commodity + Direct storage costs (such as
rent and insurance) – Convenience yield. The convenience yield is inversely related to
inventories. If inventories are abundant, convenience yield is low and vice versa. A &
B are correct descriptions.
Keira White, a portfolio manager for an insurance company, has been given the mandate to
add commodities to the company’s current investment mix of stocks and bonds. White
considers two funds, the CGT Commodity Fund and the VX Fund. The CGT Fund has access
to storage facilities and capitalizes on mispricing between the spot and futures prices of
commodities. The VX Fund tries to outperform by trading when the pricing is right, it
attempts to benefit from an information advantage. It acts as an insurance provider in
return for an expected profit. White chooses the CGT Commodity Fund and its asset
allocations are given in Exhibit 1. Exhibit 1: CGT Commodity Fund’s Investment Mix
Commodity Sector Allocation (%)

Energy 36%
Grains 31%
Industrial Metals 33%
1. Question 1
The CGT Fund is most likely described as:
o A
a hedger.
o B
an arbitrageur.
o C
a speculator.
Incorrect
B is correct. Commodity arbitrage involves an ability to inventory physical
commodities and to seek mispricing between the commodity spot and the futures
price. A is incorrect because hedgers trade in the market to hedge their exposures
related to the commodity. C is incorrect because speculators “seek to outperform
the hedger by buying or selling futures contracts in conjunction with—or opposite
from—the hedger.”
2. Question 2
The VX Fund is most likely characterized as:
o A
an arbitrageur.
o B
a speculator.
o C
a hedger.
Incorrect
B is correct. Speculators seek to outperform the other participants by stepping in
when the pricing is right and provide insurance to hedgers in return for an expected
profit.
3. Question 3
The factor that most likely affect the supply and demand of all sectors of the CGT
Fund is:
o A
weather.
o B
disease.
o C
politics.
Incorrect
C is correct. Politics affect the demand/supply of all three sectors – energy, grains
and industrial metals. Industrial metals are not impacted by weather. Disease will
impact only the grain sector.
Priya Patel, a commodity trader at a global investment firm, is reviewing the futures prices
of the following commodities shown in Exhibit 1. Exhibit 1: Selected Commodity Futures
Prices
Copper
Cotton price US Gasoline
Month price US
cent/pound Price USD/gallon
cent/pound
July 2.5645 0.7716 1.6107
September 2.5775 0.7449 1.5884
December 2.5950 0.7322 1.4350
Patel is informed by Arun Roshan, an analyst at the firm, that according to a recent report,
cotton future prices will stay lower as the producers because of a bumper harvest continue
to lock in their prices to make their revenues more predictable. Next, Patel calculates the
total return of a trade executed by the firm involving a fully collateralized long futures
position in a nearer to expiration soybean futures contract at the quoted futures price of
939.2 (US cents/bushel). Three months later the entire position was rolled forward when the
near-term price was 941.4 and the farther-term futures price was 945.6. The collateral
earned a 0.50% annualized rate during the three-month period between the time that the
initial long position was taken and the rolling of the contract.
1. Question 1
Which futures market is most likely in contango?
o A
Copper.
o B
Cotton.
o C
Gasoline.
Incorrect
A is correct. When the near-term futures contract price is lower than the longer-term
futures contract price, the futures markets are in a state of contango. Copper is the
only one in Exhibit 1 which has a near-term futures price lower than the farther term
futures contract price, therefore the copper futures market is in contango.
2. Question 2
Based on Exhibit 1, which commodity’s roll return will most likely be negative?
o A
Gasoline.
o B
Copper.
o C
Cotton.
Incorrect
B is correct. Roll returns are generally negative when the futures market is in
contango. Because the copper futures market is in contango, its roll return will most
likely be negative.
3. Question 3
Based on the conclusion of a report on cotton, the shape of the cotton futures curve
in Exhibit 1 is best described by the:
o A
insurance theory.
o B
theory of storage.
o C
hedging pressure hypothesis.

Incorrect
A is correct. The shape of the futures price curve according to the insurance theory is
normally in backwardation as the case is in the cotton futures market. “Keynes, in his
1930 tome A Treatise on Money, proposed that producers use commodity futures
markets for insurance by locking in prices and thus make their revenues more
predictable. A commodity producer is long the physical good and thus would be
motivated to sell the commodity for future delivery to hedge its price.”
4. Question 4
The three-month total return on the soybean futures trade is closest to:
o A
0.23%.
o B
0.81%.
o C
-0.10%
Incorrect
C is correct. Total return = price return + roll return + collateral return.
Price return =(Current price – Previous Price) / Previous price = 941.4 – 939.2 / 939.2
= 0.00234 = 0.23%
Roll return = 100% position rolled = ( 941.4 – 945.6 / 941.4 ) x 100% = -0.446%
Collateral return = ( 3 / 12 ) x 0.50% = 0.125%
Total return = 0.23% – 0.45% + 0.125% = -0.095%
Overview of Real Estate

Investments
1. Question 1
Q-Code: 21-L2-AI-PREI-73751
Which of the following is most likely correct for investment in REIT shares? Investment
in shares of REITs, compared with direct investment in property:
o A
involves larger outlay due to indivisibility of real estate property.

o B
offers liquidity and diversification.

o C
requires expertise in property management.

Incorrect
B is correct. Investment in REITs allows real estate property to remain undivided but
the ownership on the property to be divided. This results in relatively high liquidity.
REITs also enable diversification due to purchase of ownership interests in multiple
properties. A & C are correct regarding private ownership in real estate properties.
2. Question 2
A person investing in commercial real estate should be least concerned about risks
due to:
o A
changes in business conditions.

o B
inflation in strong economic conditions.

o C
leverage.
Incorrect
B is correct. Real estate investments offer some inflation protection in the form of
rent increases and higher real estate value when inflation is high. A & C are risk
factors linked to investing in commercial real estate.
3. Question 3
The least likely reasons for including real estate frr investments in a portfolio of stocks
and bonds is:
o A
providing a hedge against inflation.

o B
risk reduction because of diversification.

o C
lower after-tax returns on real estate investments.

Incorrect
C is correct. Private real estate investments may receive a favorable tax treatment
compared with other investments. Because of this, real estate investments may
result in a higher after-tax return compared with after-tax return of other
investments. A & B are motivations for investing in real estate.
4. Question 4
Commercial real estate properties least likely include:
o A
industrial and warehouse properties.

o B
office buildings.
o C
timberland.
Incorrect
C is correct. Timberland is a unique category of real estate. A & B are included in the
category of commercial real estate properties.
5. Question 5
Residential properties most likely include:
o A
multi-family properties.
o B
farmlands.
o C
timberland.
Incorrect
A is correct. Residential properties include single-family houses and multi-family
properties.
6. Question 6
Which of the following is not a characteristic of real estate investment?
o A
Heterogeneity and fixed location.

o B
High unit value.

o C
Low transaction costs.

Incorrect
C is correct. Investment in Real estate involves high transaction costs compared to
investments in stocks and bonds. A & B are characteristics of real estate investment
that differentiate it from other asset classes.
7. Question 7
Q-Code: 21-L2-AI-PTRE-73791
Which of the following is least likely a type of publicly traded real estate security?
o A
An equity REIT share.

o B
A REOC share.
o C
Bank debt.
Incorrect
C is correct. Equity REITs and REOCs are types of publicly traded real estate
securities, whereas bank debt is an example of private debt.
8. Question 8
Which of the following is not an investment characteristic of REITs?
o A
Volatile revenue streams.

o B
High income distributions.
o C
Exemption from income taxes at corporate level.

Incorrect
A is correct. REITs regulations require income to be mainly from rents and
interest. Because of the contractual nature of income (except for hotel REITs) the
revenue streams are stable. B & C are investment characteristics of REITs.
9. Question 9
The most likely advantage of investing in REITs compared with publicly traded REOCs
is:
o A
operating flexibility.
o B
exemption from double taxation of income.

o C
free to change capital structure.

Incorrect
B is correct. REITs are typically exempt from double taxation of income. A & C are
advantages of investment in REOCs.
10. Question 10
Which of the following assets offers the most liquidity and the lowest investment
requirement in real estate investments?
o A
Direct investment in a property.

o B
Public REITs.
o C
Private REOCs.
Incorrect
B is correct. Publicly traded equity real estate securities, whether equity REITs or
REOCs offer the most liquidity and lower investments than either direct investments
in properties or investments in private REOCs.
11. Question 11
Which of the following statistics is most likely relevant for office, hotels and multi-
family REITs?
o A
Sales per square foot.

o B
Job creation trends.

o C
Industrial production.
Incorrect
B is correct. Job creation trends are typically reflected in: increased demand for
office space, increased demand for multi-family residential properties, and a greater
demand for hotel rooms.
12. Question 12
When analyzing retail REITs, analysts are least likely to consider trends in:
o A
population growth.
o B
GDP growth.
o C
retail sales growth.

Incorrect
A is correct. While analyzing retail REITs the first three economic factors that analysts
consider are GDP growth rates, retail sales growth and job creation.
13. Question 13
Which factor is least likely significant when evaluating equity REITs composed of multi-
family residential properties?
o A
Condominium construction in the region.

o B
State of regional economy.

o C
State of the global economy.

Incorrect
C is correct. A and B should be considered in analyzing multi-family residential
properties. High construction activity implies high anticipated demand which will
impact rental income. The state of the regional economy is likely to be correlated
with rental income. The state of the global economy will have a lower correlation
with the dynamics of a particular region.
14. Question 14
If the gross rent is USD25 per square foot and operating expenses are USD10 per
square foot, the net rent for an office building (per square foot) is equivalent to:
o A
USD15.
o B
USD35.
o C
USD25.
Incorrect
A is correct. In a gross lease the owner pays the operating expenses whereas a net
lease requires the tenant to pay the operating expenses. Hence the net rent = USD25
– USD10 = USD15 per square foot.
15. Question 15
The demand for which type of commercial real estate is most likely dependent upon
consumer spending:
o A
retail.
o B
industrial and warehouse.

o C
office.
Incorrect
A is correct. Retail space demand largely depends upon trends in consumer
spending. B is incorrect because industrial/warehouse demand is incumbent on
economy and economic growth. C is incorrect because demand for office properties
is driven by job growth.
16. Question 16
Which of the following statements regarding types of lease is not true?
o A
Triple-net leases require each tenant to pay its share of the common area
maintenance (CAM) and repair expenses, property taxes and building
insurance costs.
o B
In a ‘gross lease’, the owner is responsible for operating expenses.

o C
The risk of operating expenses being higher than expected is borne by

the tenant in a gross lease.
Incorrect
C is correct. The risk of operating expenses being higher than expected is borne by
the owner in a gross lease and the tenant in a net lease.
17. Question 17
The least likely reason for due diligence is:
o A
to lower the risk of acquiring a property with unexpected legal or physical

problems.
o B
to protect the seller against a lower price or cancellation of the

transaction by the buyer.
o C
to ascertain that there are no legal or unanticipated problems before lending

funds on a property.
Incorrect
B is correct. Due diligence is done to lower the risk of the buyer or lender against
any legal, environmental, physical and other unanticipated issues with the property
that could negatively affect the value. If such issues are identified, the buyer can
either renegotiate a lower price or walk away from the deal.
18. Question 18
Ross Williams, a portfolio manager for United Pension Fund, is considering an
investment in a multi-family building but is concerned that the building might have
structural issues. Which due diligence item would be most appropriate to address his
concerns regarding the multi-family building?
o A
Property survey.
o B
Review of service and maintenance agreement.

o C
Physical / engineering inspection.

Incorrect
C is correct. Physical / engineering inspection is done to ascertain that there are no
structural issues with the property and to check the condition of the building
systems, structures, foundation and adequacy of utilities.
19. Question 19
Which of the following statements is not true about due diligence?
o A
Due diligence should include an analysis of all the cash flow drivers and
liabilities.
o B
Qualitative factors must also be considered in the due diligence.

o C
Indirect investors are not required to perform due diligence on REITs

and REOCs
Incorrect
C is correct. Indirect investors should also perform due diligence on REITS and
REOCs. This enables them to determine whether the share valuation is appropriate
prior to making investment decisions. A lot of information about public companies
can be found in public filings of annual audited financial statements, quarterly
reports, and investor presentations.
20. Question 20
Appraisal-based indices may:
o A
overestimate the volatility of real estate returns.

o B
underestimate the volatility of real estate returns.

o C
create a “noisy” effect on the index returns.

Incorrect
B is correct. Since appraisals do not occur frequently, the data for the value of a
property will appear smoother than the actual value over time. This means that
appraisal-based indexes may understate volatility because the data in the indexes
will not capture all of the fluctuations in value.
Transaction-based indices include random elements therefore can be noisy.
21. Question 21
The two types of real estate indices are:
o A
appraisal-based indices and transaction-based indices.

o B
momentum-based indices and performance-based indices.

o C
total return indices and current income indices.

Incorrect
A is correct. The two types are: appraisal-based indices and transaction-based
indices.
22. Question 22
Which of the following is not a transaction-based index?
o A
NCREIF Property Index

o B
Repeat Sales Index

o C
Hedonic Index
Incorrect
Solution: A is correct. A popular appraisal-based index in the United States is the
NCREIF Property Index. The return of this index is calculated as:
NCREIF Return = (NOI – Capital Expenditures + Δ Market Value) / Beginning Market
Value.
23. Question 23
Compared to transaction-based index, appraisal based index is most likely to:
o A
have more volatility.
o B
lead a transaction-based index.

o C
have a lower correlation with other asset classes being reported.

Incorrect
Solution: C is correct. An appraisal-based index will tend to have less volatility and
lag a transaction-based index. Due to the lag, such indexes also tend to have lower
correlation with other asset classes.
Tim Jones, a seasoned investor in equity and fixed income securities, is interested in adding
real estate to his portfolio. With no previous real estate experience, Jones seeks professional
advice from AMZ, a real estate investment advisory firm. Jones asked the following
questions regarding real estate investments in the introductory meeting with Kate Miller, an
analyst at AMZ. Question 1: Which form of real estate investment would be best suited for
me in terms of portfolio diversification? Question 2: How efficient is real estate market
compared to the stock and bond markets? Question 3: Which factors should be taken into
consideration when using real estate investment indices? A few days later, Jones meets his
friend, Mathew Paul, who has invested in commercial real estate. Paul tells Jones that it is an
opportune time to invest in industrial and hotel REITs and makes the following two
statements. Statement 1: Increasing consumer spending and business formation trends
will positively affect revenues of industrial and hotel REITs. Statement 2: Hotel REITs’
revenue streams are protected from changes in demand because there are long-term
leases on hotel rooms.
1. Question 1
Q-Code: 23-L2-AI-REIN-196141
As a response to Question 1, which form of real estate investment is best suited for
Jones?
o A
Mortgage REITs
o B
Publicly traded REITs

o C
Direct investment in real estate through a joint venture

Incorrect
B is correct. Adding equity real estate investments to a traditional portfolio will
provide better diversification benefits than adding debt real estate investments such
as Mortgage REITs or MBS. Debt investments in real estate, are similar to other fixed-
income investments, such as bonds, and can be highly sensitive to changes in
interest rates.
Within equity real estate investments, publicly traded REITs are a lot more liquid as
compared to direct ownership of real estate. Also, the properties are professionally
managed and no real estate management expertise is required on the part of the
investor.
2. Question 2
Equity investors in real estate can gain from:
o A
Rent
o B
price appreciation.
o C
both A) and B)
Incorrect
C is Correct. Returns for real estate equity investors have two components: rent and
appreciation of property value. They take on more risk and, therefore, expect a
higher rate of return than debt investors.
3. Question 3
As a response to Question 2, compared to stock and bond markets, real estate
market is:
o A
less efficient.
o B
more efficient.
o C
equally efficient.
Incorrect
A is correct. As each property is unique and the volume of real estate transactions is
low, estimates of value or appraisals are used for price determination rather than
transaction prices. This makes the real estate market less efficient as compared to
the stock and bond markets. Investors who have superior information and skill at
evaluating properties may have an advantage in exploiting market inefficiencies.
4. Question 4
Which of the following statements would be least accurate when responding to
Question 3?
o A
Appraisal based indexes suffer from appraisal lag which underestimates

volatility.
o B
Appraisal based indexes tend to have lower correlation with other asset
classes.
o C
Transaction based indexes are preferred because they are not noisy.
Incorrect
C is correct. Transaction-based indexes tend to lead appraisal-based indexes, but
they can be noisy because statistical techniques are used to estimate the index. So,
there may be random upward or downward movements in the index.
5. Question 5
Which statement of Paul is not correct?
o A
Statement 1
o B
Statement 2
o C

Correct
B is correct. There are no long-term leases on hotel rooms to protect hotel REITs’
revenue streams from changes in demand. Hotel room demand fluctuates with
economic activity and business and consumer confidence
Investments in Real Estate

Through Publicly Traded
Securities
1. Question 1
Consider the following selected financial information of a Health Care REIT:
Net income $250,000

Depreciation and amortization $100,000
Non-cash rents $25,500
Recurring maintenance-type capital
$75,500
expenditures
Shares outstanding 70,000
Expected annual dividend per share next
$3.80
year
Dividend growth rate in years 2 and 3 5%
Dividend growth rate (after year 3
4.5%
into perpetuity)
Property subsector average P/FFO multiple 15x
Property subsector average P/AFFO
19x
multiple
The values of the Health Care REIT (per share basis) by applying relative valuation
subsector averages of P/FFO and P/AFFO are closest to:
o A
$54,$40.
o B
$75,$68.
o C
$75,$75.
Incorrect
B is correct. Funds from operations (FFO) = Net Income + Depreciation &
amortization = USD250,000 + USD100,000 = USD350,000, FFO / Share = 350,000 /
70,000 = USD5.0 Applying the property subsector multiple P/FFO = 15 x 5 =
USD75/share. Adjusted funds from operations = FFO – non – cash rent – recurring
maintenance – type capital expenditures = USD350,000 – USD25,500 – USD75,500 =
USD249,000,AFFO / shares = USD249,000 / 70,000 = USD3.56. Applying the property
subsector average P/AFFO multiple of 19 x 3.56 = USD67.64 / share.
2. Question 2
Which of the following is not a common feature of private and public real estate
investments?
o A
Potential inflation hedge

o B
Diversification benefits to stock and bond portfolios
o C
Direct ownership of real estate

Incorrect
C is correct. Direct ownership is possible through private real estate investments.
3. Question 3
Compared with private real estate, public real estate investments have:
o A
lower volatility.
o B
high equity market correlation in short term.

o C
wider variety of strategies and fewer restrictions.

Incorrect
B is correct. Public real estate investments, including equity REITs and REOCs, have
high equity market correlation in short term. A and C are characteristics of private
real estate i.e. direct investments.
4. Question 4
An increase in the capitalization rate will most likely result in NAV of REITs to:
o A
increase.
o B
decrease.
o C
remain unchanged.
Incorrect
B is correct. An increase in the capitalization rate will most likely result in NAV of the
REITs to decrease. The capitalization rate is used to estimate the market value of real
estate, which is then used to calculate NAV.
5. Question 5
Which of the following combinations of real estate investments is least suited for
investors whose primary objective is capital growth?
o A
Equity REITs
o B
REOCs
o C
Direct investment in income producing properties

Incorrect
A is correct. Constraints with REITs prevent them from reinvesting retaining earnings,
resulting in limited growth opportunities. If the investment objective is maximum
growth, REOCs and direct property investment are most appropriate. REOCs and
direct investors are free to invest in any kind of real estate or related activity and to
reinvest as much of their income as they deem appropriate for their objectives.
6. Question 6
Which of the following companies would be most suited for investors seeking broad
diversification?
o A
A company that owns office properties in Durban, Cape Town and

Johannesburg.
o B
A company with a mix of multi-family and retail properties in urban and

suburban markets.
o C
A company that owns warehouses in Singapore.

Incorrect
B is correct. A company with a mix of assets, multifamily and retail, with exposure to
urban and suburban markets offers the best diversification.
A is incorrect because the company owns only one asset type, office properties.
Furthermore, the economic activity correlation may be high among urban cities with
exposure to global trade and the financial sector.
C is incorrect because the company has only one type of asset, warehouse rentals, in
one market.
7. Question 7
Which of the following is least likely an advantage of investing in REITs?
o A
REITs can easily fund growth through retained earnings.

o B
REIT and passthrough structures avoid corporate income taxation.

o C
Share prices and transaction history are readily available.

Incorrect
A is correct. The main disadvantage for REITs is the lack of retained earnings. REITs
often need to access capital markets for equity and debt to fund growth. B and C are
advantages of investing in REITs.
8. Question 8
Businesses are organized as REOCs, as opposed to REITs, if they:
o A
are located in countries that have a tax-advantaged REIT regime in place.

o B
do not engage to a large extent in the development of for-sale real estate

properties.
o C
offer other non-qualifying services, such as brokerage and third-party

property management.
Incorrect
C is correct. Businesses are organized as REOCs, as opposed to REITs, if they offer
other non-qualifying services, such as brokerage and third-party property
management.
It could also be the case if they are located in countries that do not have a tax-
advantaged REIT regime in place or if they engage to a large extent in the
development of for-sale real estate properties.
9. Question 9
Samar Hammad, an equity analyst is being interviewed by Jawad Ahmed, research
director of an investment firm that caters for high-net worth clients. The firm is
planning to add publicly traded real estate investments to their clients’ portfolios
where applicable. Ahmed asks Hammad to give the advantages of using price to
funds from operations (P/FFO) multiples and price to adjusted funds from
operations (P/AFFO) multiples in the valuation of real estate investment trusts (REITs)
and real estate operating companies (REOCs). Hammad responds as follows:
Advantage 1: P/FFO and P/AFFO multiples are broadly accepted in evaluating

shares across global stock markets and industries.
Advantage 2: FFO estimates are easily available through market data providers
facilitating the calculation of P/FFO multiples.
Advantage 3: P/FFO adjusts for the impact of recurring capital expenditures

making comparison easier between properties.
Which of the advantage mentioned by Hammad is least likely correct ?
o A
1.
o B
2.
o C
3.
Incorrect
C is correct. P/FFO does not adjust for the impact of recurring capital expenditures
needed for the smooth operation of the property. P/AFFO adjusts for the effect of
recurring capital expenditures but wide variations in assumptions are incorporated
into the estimation of AFFO.
10. Question 10
Which of the following represents a disadvantage of public REITs compared to direct
investment in an income-producing property?
o A
Higher tax rate on dividends

o B
Real estate portfolio can be diversified by geography and property type.

o C
No property management skills or expertise are required.

Incorrect
A is correct. If one invests in public REITs, they may have to pay relatively high taxes
on the dividends they receive since dividends are taxed at high current income tax
rates. B & C are advantages of investing in public REITs.
11. Question 11
The three most common drivers of P/FFO and P/AFFO are:
o A
growth expectations, risk of the underlying asset and risk associated

with company’s capital structure.
o B
required return, leverage and earning power of the assets.

o C
current stock prices, gains and losses from property sales, and deferred
taxes.
Incorrect
A is correct. The three main drivers of P/FFO, P/AFFO and multiples of most REITS
and REOCs are: expectation of growth in FFO/AFFO, risk associated with the
underlying real estate, and capital structure risk which includes access to capital.
12. Question 12
Which of the of the following statements is most likely true for publicly traded REIT
shares?
o A
REIT shares generally trade at discount to NAVPS.

o B
REIT shares generally trade at premium to NAVPS.

o C
REIT shares can trade at a discount or a premium relative to NAVPS.

Incorrect
C is correct. REIT shares can trade at a discount or at premium relative to NAV. One
of the reasons NAV estimates trade at premiums/discounts to stocks is that the stock
market focuses on short term changes in income and asset values whereas the
property market valuations are focused on long term.
13. Question 13
The purpose of adjusting net earnings to obtain FFO and AFFO in the analysis of
REITs is to have a(n):
o A
accounting estimate of economic income dependent upon cash and non-cash
rents.
o B
revenue based measure of economic income that includes all non-cash

charges.
o C
cash flow based measure of sustainable economic income.

Incorrect
C is correct. The net earnings are adjusted to obtain FFO and AFFO to obtain a more
feasible measure of economic income that is not dependent upon non-cash
accounting estimates and non-cash charges.
14. Question 14
AFFO is defined as FFO less:
o A
non-cash rent, capital expenditures related to maintenance and leasing

commissions.
o B
non-cash rent, capital expenditures and depreciation.

o C
non-cash rent, capital expenditures and debt restructurings.

Incorrect
A is correct. AFFO is obtained by deducting non-cash rent, maintenance-type capital
expenditures and leasing costs from FFO.
15. Question 15
FFO is obtained from net earnings after excluding:
o A
interest expense, depreciation and amortization, and including deferred tax

charges.
o B
general and administrative expenses, corporate overheads, and interest

expense.
o C
depreciation, deferred tax charges, gains or losses from property sales

and debt restructuring.
Incorrect
C is correct. FFO is described as net earnings excluding depreciation, deferred tax
expenses, and gains or losses from property sale and debt restructuring.
16. Question 16
In the context of calculating the adjusted NOI, the term ‘non-cash rents’ refers to:
o A
the difference between the average contractual rent over the leases’
terms and the cash rent actually paid.
o B
rental payments which made are made in advance.

o C
estimated increase in rental income over the next period.

Incorrect
A is correct. Non-cash rents are removed from NOI estimates because “these are the
result of the accounting practice of “straight lining” the rental revenue from long-
term leases.” “The amount of this deduction is the difference between the average
contractual rent over the leases’ terms and the cash rent actually paid.”
17. Question 17
The following financial information relates to a REIT:
NOI $125 million

Cash and equivalents + Accounts Receivable
$75 million
+ Prepaid
Market value of debt outstanding $450 million
Other Liabilities $65 million
Market cap rate 6.5%
Shares outstanding 105 million
Book value per share $8.00
The REITs NAVPS is closest to:
o A
USD10.
o B
USD14.
o C
USD8.
Incorrect
B is correct. The NAVPS estimates values by capitalizing NOI, adding cash
equivalents, accounts receivable and prepaid, deducting market value of debt and
other liabilities and dividing the remaining value by the shares outstanding. NOI /
market cap rate = 125 million / 0.065 = 1,923.077 + 75 – 450 – 65 = USD1,483.077
million / 105 million = USD14.1245.
18. Question 18
Compared to book value per share, net asset value per share is a superior measure
of the net worth of a company because it considers:
o A
the cost model which accurately represents assets’ and liabilities’ values.
o B
current market values instead of accounting book values.

o C
the depreciated value of assets.

Correct
B is correct. NAVPS is often used to value REIT or REOCs. This method considers the
market value rather than the accounting book value of assets and liabilities.
Huang Li is an accounts manager at KYL capital, a wealth management firm. He wants to

diversify his clients’ portfolios by adding publicly traded real estate securities where
appropriate. His current portfolios are largely comprised of domestic equity and corporate
bonds. Li mentions his intention to invest in publicly traded real estate to his colleague,
Adrian Wang, who responds: “You should also consider direct real estate investments in
your portfolio because such investments will likely result in current income and capital
appreciation. However, they may impact portfolio risk because of high correlation with
existing investments.” Peter Chang, the fund’s chief investment officer, recommends
investing in securities that provide cash flows from sales of developed or improved
properties. Chang asks Li about the economic factors that affect the value of REITs of
different property subtypes. Li makes the following comments about the major economic
drivers of value of various types of equity REITs:
1. Job creation is an important economic factor that affects the value of office REITs
more than it affects the value of industrial and storage REITs.
2. Retail sales growth is more important for the value of industrial REITs than for
storage and office REITs.
• Population growth is less of a driver of value for multi-family REITs than for office
and retail REITs.
Keya Mitul, an alternative investments research analyst at KYL, has been assigned to assist
Li in his plans to include publicly traded real estate in some of his clients’ portfolios. She
chooses three large REIT holdings and justifies their selection based on the current
economic cycle. Exhibit 1 presents Mitul’s compilation of REIT holdings. Exhibit 1: REIT
Holdings and their Economic Justification
REIT Property Subtype Justification
This sector is primarily driven by job creation as it employs a
I Industrial
large labor force.
The current rise in GDP growth rate is favorable for all
property subtypes including retail REITs. The better-than-
II Retail
average retail sales growth further improves the prospects of
this sector.
Besides GDP growth rate, this sector is highly sensitive to
local demographic trends. New job creation and new business
III Storage
start-up activity in the area has increased the demand for
storage.
Mitul next calculates and reports net asset value per share (NAVPS), instead of book value
per share (BVPS), as the relevant valuation measure and provides the following explanation
for her preferred approach: I: NAVPS provides the fundamental benchmark for the value of
a REIT. Discounts in the REIT share price from NAVPS show potential undervaluation and
premium in the REIT share price from NAVPS reflect overvaluation. II: NAVPS includes the
value added by the management of the REIT. III: NAVPS shows the current market value of
the property rather than the values based on historical cost. Mitul collects financial data for
all three types of property REITs to calculate NAVPS. Exhibit 2 shows the data for REIT
I. Exhibit 2: Selected financial data for REIT I
Pro forma cash Net operating income (NOI) for last 12 months $280 million
Cash and equivalents $40 million
Land held for future development $60 million
Accounts receivable $20 million
Prepaid/other assets (excluding intangibles) $6 million
Total debt $1,430 million
Other liabilities $168 million
Shares outstanding 60,000,000
Estimated growth in NOI in next 12 months 4.00%
Capitalization rate 6.50%
1. Question 1
Q-Code: 23-L2-AI-IRTS-184966
Regarding direct real estate investments, Wang is least likely correct with respect to:
o A
high correlation with existing investments.

o B
current income generation.

o C
current income generation.

Incorrect
A is correct. Wang is correct in that direct real estate investment will likely result in
income and capital appreciation but incorrect regarding high correlation with
existing investments which constitute of stocks and bonds. Real estate returns may
provide diversification benefits because they are not highly correlated with other
asset classes such as, stocks and bonds. Therefore, adding to a portfolio may lower
the risk of the portfolio.
2. Question 2
The type of publicly traded real estate securities suggested by Chang is most likely a:
o A
REIT.
o B
REOC.
o C
MBS.
Incorrect
B is correct. Real estate operating companies (REOCs) generate cash flows from sales
of developed or improved properties rather than from recurring lease or rental
income.
3. Question 3
Which of Li’s comments regarding REITs is least appropriate:
o A
I.
o B
II.
o C
III.
Incorrect
C is correct. Population growth drives the demand for multi-family, storage and
health care facilities. Hence the value of the multi-family REITs depends upon
population growth. Retail REITs depend more upon retail sales growth and the value
of office REITs is more likely driven by job creation.
4. Question 4
Which of Mitul’s justification regarding the three REIT property subtypes is least
likely correct?
o A
REIT I.
o B
REIT II.
o C
REIT III.
Incorrect
A is correct. The GDP growth rate is the top economic driver in all sectors. The value
of an industrial REIT is also affected by retail sales growth. B &C correctly indicate the
economic drivers of retail and storage REITs.
5. Question 5
Which of Mitul’s explanations regarding her preference for NAVPS is least
likely correct?
o A
I.
o B
II.
o C
III.
Incorrect
B is correct. The value added by management is not included in NAVPS. A & B are
correct statements.
6. Question 6
Using the information in Exhibit 2, the NAVPS of REIT I is closest to:
o A
$44.30
o B
$50.13.
o C
$52.93.
Correct
B is correct.
(US$ millions)
Next year’s NOI estimate 280 × 1.04 291.2
Capitalized value of operating real estate
291.2 / 0.065 4,480
Other assets 40 + 60 + 20 + 6 126
Minus liabilities 1,430 + 168 1,598
NAV
4,480 + 126 – 1,598 3,008
NAVPS 3,008/60 $50.13
Capitalized value of operating real estate = NOI/Discount rate
Other assets = Cash and cash equivalents + Undeveloped land + Accounts receivable +
Prepaids
Liabilities = Total debt + Other liabilities
NAV = Operating assets + Other assets – Liabilities
NAVPS = NAV / Number of common shares
Rob Schneider, a portfolio manager at an investment management firm specializing in real

estate investments, gives reasons for not investing in real estate operating companies
(REOCs) to the chief investment officer, Aaron Perez:
I. REOCs are more restricted in their choice of capital structures and degree of
financial leverage than REITs.
II. Compared to REITs, REOCs do not have high income payouts and yields but can have
higher retention ratios.
III. REOCs are more constrained in their real estate investment choices and income
distribution.
Perez then questions Schneider about the valuation approaches used in REITs and REOCs.
Schneider makes the following statements regarding the NAVPS approach and the dividend
discount model (DDM) approach: 1: NAVPS usually gives a value that is higher than the
current share price of the REIT or REOC because it reflects the rental average income
retained by the property management company. 2: NAVPS is based on capitalizing the
rental streams – the NOI, after certain adjustments that accounts for the upcoming income
growth expectations. DDM uses published estimates of dividends and assumes a long-run
dividend growth rate for the terminal value. 3: The discount rate used in DDM is based on
CAPM derived from the broader public equity market. Perez asks Schneider to review a
research report on an office REIT for potential investment. The report presents relative
valuation measures, such as the ratio of price to funds from operations (P/FFO). Selected
information is shown in Exhibit 1. Exhibit 1: Selected Information for an Office Equity
REIT.
Property net operating income $200 million
General and administrative expenses $20 million
EBITDA $180 million
Depreciation and amortization $10 million
Net interest expense $49 million
Net income available to common $121 million
Non-cash (straight-line) rent adjustment $5 million
Recurring maintenance-type capital expenditures and leasing commissions $10 million
Price per share $42
1. Question 1
Which of Schneider’s reasons of not investing in REOCs is most likely correct?
o A
I.
o B
II.
o C
III.
Incorrect
B is correct. REOCs have more operating flexibility compared to REITs. REOCs are not
restricted in their choice of real estate investments, unless limitations are imposed
either in their articles of incorporation or the market. Compared with REITs, REOCs
can retain more of their income for re-investment when opportunities exist. REOCs
are free to use a wider range of capital structures and debt ratios. However, REITs
provide higher income payouts and yields because of their high income
distributions.
2. Question 2
Which of Schneider’s statements regarding the two valuation approaches is least
likely correct?
o A
Statement 1.
o B
Statement 2.
o C
Statement 3.
Incorrect
A is correct. NAVPS does not necessarily give a higher intrinsic value of the property.
It does not reflect the average income retained but shows the net operating income
of the last 12 months of the property after adjusting it for non-cash rents and
incorporating estimated upcoming growth. This value is then capitalized at a
comparable property’s capitalization rate. Value of assets is then added and
liabilities deducted to obtain the NAV, which divided by the shares outstanding gives
the NAVPS. B & C are correct statements.
3. Question 3
The P/FFO for the office REIT is closest to:
o A
14x.
o B
21x.
o C
19.2x
Incorrect
C is correct. First FFO (Funds from operations) is calculated by adding back
depreciation and amortization to net income.
FFO = USD121 + USD10 = USD131 million. FFO per share = 131 / 60 = 2.183. P/FFO =
42 / 2.183 = 19.24x.
4. Question 4
The P/AFFO for the office REIT is closest to:
o A
23.8x.
o B
21.8x.
o C
15.7x.
Correct
B is correct. First AFFO (Adjusted funds from operations) is calculated. AFFO is
calculated from FFO by deducting non-cash rent, capital expenditures for
maintenance and leasing costs. AFFO = USD131 – USD5 – USD10 = USD116 million.
AFFO per share = USD116 / 60 = USD1.93. P/AFFO = 42 / 1.93 = 21.76x.
CORPORATE ISSUERS
Analysis of Dividends and Share
Repurchases
1. Question 1
Q-Code: 21-L2-CF-DSRB-73992
It is expected that senior executives of Arwin Industries will exercise their stock
options which will result in the dilution of earnings per share. Arwin wants to offset
the dilution effect and increase leverage without issuing new debt. To achieve these
objectives, it will most likely:
o A
repurchase shares.
o B
pay stock dividends.

o C
pay a special dividend.

Incorrect
A is correct. A share repurchase will offset eps dilution and increase the debt ratio.
2. Question 2
SZL Inc., has maintained a regular dividend of $1.05 for the last five years despite
incurring restructuring costs. Given no change in its long term prospects, the
dividend policy followed by SZL is best known as:
o A
constant dividend payout.

o B
stable dividend policy.

o C
residual dividend policy.

Incorrect
B is correct. SZL follows a stable dividend policy, by paying regular dividends of
$1.05, which are not dependent upon short-term fluctuations in earnings.
3. Question 3
Roland Tyres paid USD0.60 on earnings of USD2.50 last year. The company
anticipates earnings of $3.30 this year. It has a 35% target payout ratio and uses a 5-
year adjustment period. The expected dividend for the current year is closest to:
o A
$0.80.
o B
$0.61.
o C
$0.71.
Incorrect
C is correct. Using the target payout adjustment model, expected dividend = Last
Dividend + [(Expected earnings x Target Payout ratio – Previous dividend) x
Adjustment factor] = USD0.60 + [{(3.30 x 0.35) – 0.6)} x (1/5)] = USD0.711.
4. Question 4
Liz Caybern, a fashion apparel company follows a residual dividend policy. It has
USD100 million in current earnings, a target capital structure of 20% debt and 80%
equity, and a prospective capital expenditure of USD80 million. The implied payout
ratio is closest to:
o A
64%.
o B
36%.
o C
0%.
Incorrect
B is correct. The residual dividend policy is based on paying out dividends from
internally generated funds after financing the current year’s capital expenditures.
Liz’s current earnings = USD100 million. Expected capital expenditure is USD80
million. Internal financing from retained earnings according to target capital
structure = 80% x 80 = USD64 million. Residual cash flow = dividend = USD100 –
USD64 = USD36 million. Implied payout ratio = 36/100 = 36%.
5. Question 5
Solstar, a telecommunication service provider is considering a 2 million common
share repurchase program. The company plans to carry out the buyback through its
surplus cash. Solstar’s current stock price is $35. Th company’s chief financial officer
wants to accomplish the share repurchases in the most cost-effective manner. Which
of the following share repurchase methods is least likely to be cost-effective?
o A
Fixed price tender offer.

o B
Open market share repurchases.

o C
Dutch auction tender offer.

Incorrect
A is correct. A fixed price tender offer can be accomplished quickly, but the company
usually has to offer a premium which raises the cost. Open market repurchases are
typically made opportunistically, with cost a more important consideration than
speed. These can be timed to exploit prices that are perceived to be below intrinsic
value. Dutch auctions generally enable a company to do the buyback at a lower price
than with a fixed price tender offer.
6. Question 6
TKK Industries is considering a share repurchase using surplus cash of €200 million.
TKK has earnings of €150 million and has 10 million shares outstanding. Its stock is
currently trading €100. TKK’s investment bankers suggest a premium of €10 to the
current market price for the share repurchase program being contemplated.
The most likely impact on EPS if Takemiya uses the surplus cash to repurchase shares
at €110 per share is:
o A
EPS will increase by 12% as a result of share repurchase.

o B
EPS will decrease by 18% as a result of share repurchase.

o C
EPS will increase by 22% as a result of share repurchase.

Incorrect
C is correct. Current EPS (before repurchase) = (€150 million net income)/(10 million
shares) = €15.00. If TKK repurchases shares, net income is unchanged at €150 mil-
lion. After share repurchase at €110, shares are reduced to approximately 1.82
million shares (€200,000,000/€110). Hence shares outstanding after repurchase = 10
– 1.82 = 8.18 ≌ 8.2 million . Thus, after the share repurchase, EPS should be (€150
million)/(8.2 million) = €18.29 = €18.3 approximately. EPS would increase by 22% as a
result of the share repurchase.
7. Question 7
A firm’s price-to-earnings ratio (P/E) is 10.5. The firm has decided to repurchase
shares using borrowed funds that have an after-tax cost of 6%. After the repurchase,
the earnings per share (EPS) will most likely:
o A
increase.
o B
decrease.
o C
remain unchanged.
Incorrect
A is correct. Convert P/E to the earnings yield (E/P) 1 / 10.5 = 9.5%. Because the after-
tax cost of debt is lower than the earnings yield (i.e., 6% < 9.5%), the EPS will increase
after the repurchase.
8. Question 8
The market price of a company’s share is USD11 per share with a price-to-book value
of 0.80. It has 20 million shares outstanding and announces a buyback of 10% of its
shares. If the buyback is accomplished at USD11 per share, the book value per share
after the buyback is closest to:
o A
USD10.
o B
USD11.
o C
USD14.
Incorrect
C is correct. The pre-buyback book value per share (BVPS) is USD11 / 0.80 =
USD13.75
Because the company’s market price per share is less than the BVPS, its BVPS should
increase after the share buyback.
Pre-buyback book value of equity = 20 million * 13.75 = USD275 million
Post-buyback book value of equity = USD275 million – ( 2 million * 11 ) = USD253
million
Post-buyback shares outstanding: 18 million shares outstanding (10% less)
Post-buyback BVPS = USD253 million / 18 million share = USD14.05
As per the calculation, the post-buyback BVPS is USD14.05.
9. Question 9
Techo Ltd. and Windows Inc. operate in the same industry.
Techo Ltd. Windows Inc.

Share Price $53 $53
Shares outstanding before buyback 12 million 12 million
Book Value $475million $950 million
Both companies announce a $5 million share buyback. Which of the following
statements is most likely true about the book value per share (BVPS) for the two
companies?
o A
The BVPS does not change for either company.

o B
The BVPS increases for Techno but decreases for Windows.

o C
The BVPS increases for Windows but decreases for Techo.

Incorrect
C is correct.
Share buyback for both companies = USD5 million / USD53 per shares = 94,340
shares.
Remaining shares for both companies = 12 million – 94,340 = 11.906 million.
Current BVPS of Techo Ltd. =USD475 million / 12 million = USD39.583.
The market price per share of USD53 is greater than the BVPS of USD39.593.
Book value after repurchase: USD475 million – USD5million = USD470 million
BVPS = USD470 / 11,906 = USD39.476
Change in BVPS = Decreased by USD0.107
This is expected. When the market price is greater than BVPS, a share repurchase
will reduce the BVPS.
Windows Inc’s current BVPS = USD950 million / 12 million = USD79.16.
The market price per share of USD53 is less than the BVPS of USD79.16.
Book value after repurchase: USD950 million – USD5 million = USD945 million
BVPS = USD945 million / 11,906 million = USD79.37
As expected the BVPS increases.
10. Question 10
If dividends are taxed at a higher rate than capital gains, shareholders of Company X
would most likely prefer that the company:
o A
pays cash dividends.

o B
repurchase shares.
o C
pays a special cash dividend only.

Incorrect
B is correct. In an environment where dividends are taxed at a higher rate than
capital gains, shareholders would prefer share repurchases because they would
have a tax advantage over cash dividends.
11. Question 11
The following information relates to taxation of dividends under the split-rate tax
system.
Pretax dividends USD100

Tax on retained earnings 35%
Tax on dividends 25%
Shareholder tax rate 32%
The effective tax rate on dividend is:
o A
32%
o B
35%
o C
49%.
Incorrect
C is correct. Dividends after tax = 100 (1 – 0.25) = USD75 After-tax dividend to
shareholder. [(1 – 0.32) x 75] = USD51. Effective tax rate on dividend = [25% + (75 x
0.32)%] = 49%.
12. Question 12
o A
In developed markets, the fraction of companies paying cash dividend has

increased over time.
o B
More companies in Europe distribute earnings by paying cash dividends than

share repurchases.
o C
Dividend payout ratios have increased in most developed markets over
time.
Incorrect
C is correct. In most developed markets, fraction of companies paying cash
dividends has declined but payout ratios have increased over time.
13. Question 13
All else equal a higher dividend payout ratio most likely means:
o A
lower dividend coverage ratio, and higher risk of a dividend cut.

o B
higher dividend coverage ratio, and higher risk of a dividend cut.

o C
no change in the dividend coverage ratio and lower risk of a dividend cut.
Incorrect
A is correct. A higher dividend payout implies a lower dividend coverage ratio that
may indicate all else equal, a higher risk of a dividend cut.
14. Question 14
If the dividend payout of Company Z is 56%, its dividend coverage ratio is closest to:
o A
56%.
o B
1.8 x.
o C
1.5x.
Incorrect
B is correct. Dividend coverage ratio = Net income/Dividends = inverse of dividend
payout ratio = 1/0.56 = 1.786x.
15. Question 15
Consider the following data of TPX Industries in millions.
Cash flow from operations $600

FCInv (capital expenditures) $174
Net borrowing $380
Dividends paid $160
Stock repurchases $730
The FCFE coverage ratio of TPX is closest to:
o A
5.00x.
o B
1.10x.
o C
0.91x.
Incorrect
C is correct. FCFE = CFO – FCInv + Net borrowing = 600 – 174 + 380 =USD806mil.
FCFE coverage ratio = FCFE/[Div. + Repurchases] = 806 / [160 + 730] = 0.906 .
16. Question 16
CSV Papers has a FCFE coverage ratio less than 1. This may be interpreted as:
o A
CSV’s liquidity position is increasing.

o B
cash or marketable securities of the company are increasing.

o C
CSV is drawing down its liquidity by paying out more funds to

shareholders than it can afford.
Incorrect
C is correct. FCFE coverage ratio is defined as FCFE/[Dividends + Share repurchases].
If the ratio is less than 1, the company’s liquidity is decreasing as it is paying out
more than it can afford.
17. Question 17
Which of the following equations is least likely correct?
o A
Dividend payout ratio = Dividends/(Net Income)

o B
Dividend coverage ratio = (Net Income)/Dividends

o C
FCFE coverage ratio = FCFE/(Dividends + Net Income)
Incorrect
C is correct. The first two equations, the dividend payout ratio and its inverse
(dividend coverage ratio), are correct. The FCFE coverage ratio is FCFE/(Dividends +
Share repurchases).
This is a more comprehensive measure of dividend safety than the first two ratios. If
this ratio is 1, the company is returning all available cash to its shareholders. If the
ratio is significantly greater than 1, the company is building up its cash reserves. If
the ratio is significantly less than 1, the company is paying out more than it is
earning. This is not sustainable; it will deplete the cash reserves and the company
will have to raise new equity. Hence, a ratio of less than 1 suggests that a company
will probably cut its dividend.
18. Question 18
A major concern to shareholders of Company A is that management might invest in
negative NPV projects. This potential overinvestment problem can be partially
controlled through:
o A
increase in dividend payouts.

o B
decrease in dividend payouts.

o C
constant dividend payouts.

Incorrect
A is correct. Negative NPV projects may increase the size of the company and thus
be better for managers, but they will generate negative economic returns. This
potential overinvestment problem can be partially controlled through high dividend
payouts. If most of the free cash flow is paid out, managers would be constrained in
their ability to overinvest by undertaking negative NPV projects.
19. Question 19
Twister Inc., with debt and a debt ratio of South African Rand (ZAR) 40 million and
40%, respectively, plans a share repurchase program involving ZAR 6 million or 10%
of the market value of its common shares. Assuming nothing else changes, financing
the repurchases using cash on hand would result in debt ratio of:
o A
43%
o B
40%
o C
74%
Incorrect
Solution: A is correct. Assuming nothing else changes, if Twister uses cash on hand to
make the share repurchase, the debt ratio would increase to 43% (ZAR 40 million/
ZAR 94 million = 0.425 or 43%).
20. Question 20
If dividends are taxed at a higher rate than capital gains, low dividend payout
companies that invest in profitable growth opportunities, would most likely have
higher share price. This argument is supported by which dividend theory?
o A
The tax argument.

o B
Dividend policy is irrelevant.

o C
Bird in hand argument.

Incorrect
A is correct. In some countries, the tax on dividends is higher than the tax on capital
gains. In such countries investors will prefer companies that pay low dividends and
invest in profitable growth opportunities.
21. Question 21
Alan D’Cruz owns 50,000 shares of Matrix Manufacturing Company at the prevailing
market price of USD149.5 a share. Matrix declares a 15% stock dividend to all
shareholders as per record as of 31st December. The market price of the stock and
D’Cruz’s ownership value in the company (in US dollars) given the following
information is closest to:
Shares outstanding 1 billion

Earnings per share (EPS) USD6.9
o A
USD149.5 and USD7.5 million respectively.

o B
USD130 and USD8.6 million respectively.

o C
USD130 and USD7.5 million respectively.

Incorrect
C is correct.
Stock Price = USD149.5 / 1.15 = USD130
Ownership Value = Shares owned * Stock Price
Ownership Value = (50,000*1.15) * Rs. 130 = USD7,475,000
22. Question 22
Santa Inc.’s common shares currently trade at a very low price and there is a risk of
the company being delisted from the stock exchange. Which of the following would
be the most appropriate action to consider?
o A
Stock dividend.
o B
Reverse stock split.

o C
Stock split.
Incorrect
B is correct. A reverse stock split would increase the price per share of the stock.
23. Question 23
While planning company prospects, Sanjay makes two statements:
Statement 1: “A significant apprehension of implementing a stock split is that it

increases the company’s price-to-earnings ratio.”
Statement 2: “A stock dividend will increase share price, given all the other factors
remain constant.”
Are these two statements about the effects of the stock dividend and stock
split correct?
o A
No.
o B
Statement 1 is correct but Statement 2 is incorrect.

o C
Statement 2 is correct but Statement 1 is incorrect.

Incorrect
A is correct. A stock dividend will decrease the price per share and earnings per
share. A stock split will reduce the price and earnings per share proportionately,
leaving the price-to-earnings ratio constant.
24. Question 24
Stock splits and stock dividends are most likely to:
o A
increase the debt/equity ratio.

o B
have no impact on the debt/equity ratio.

o C
decrease the debt/equity ratio.

Incorrect
B is correct. Stock splits and stock dividends do not impact financial leverage ratios.
25. Question 25
A two-for-one stock split will most likely impact the:
o A
earnings per share.

o B
price to earnings ratio.

o C
dividend payout ratio.

Incorrect
A is correct. A two-for-one stock split will double the number of shares, thus
reducing the EPS to half of its pre-split value. P/E will remain unchanged because the
price also reduces by half and exactly cancels out the effect of the reduced EPS. The
dividend payout ratio remains unchanged because the same proportion of earnings
will still be used after the split.
26. Question 26
According to MM, assuming perfect capital market, symmetric information, no taxes
and no transaction costs, dividend policy is:
o A
relevant.
o B
irrelevant.
o C
dependent upon company’s investment and financing decisions.

Incorrect
B is correct. According to MM, a company dividend policy should have no impact on
its cost of capital or on shareholder wealth, hence dividend policy is irrelevant given
perfect capital market assumptions, ignoring taxes or transaction costs and no
asymmetric information.
27. Question 27
“Homemade dividends” refers to a scenario where shareholders who need income:
o A
create their own dividend policy by selling shares to generate cash flow.
o B
demand higher dividends from the company.

o C
put pressure on a company to issue more stock dividends.

Incorrect
A is correct. Homemade dividend is a concept used by MM in their argument for
irrelevance of dividend policy. If a shareholder can do what a company does at no
cost, i.e. create dividends by selling his shares, then he can always alter the dividend
policy to suit his needs.
28. Question 28
According to the “bird in the hand” argument, dividends are:
o A
riskier than share repurchases.

o B
riskier than reinvestment of earnings.

o C
less risky than capital gains.

Incorrect
C is correct. According to “bird in hand” argument, while assuming perfect capital
market conditions, investors prefer dividends to capital gains from reinvesting
earnings, because they view dividends to be less risky.
29. Question 29
Which of the following statement is least accurate? If dividends are taxed at a higher
rate than capital gains, taxable investors should prefer companies that:
o A
give low dividends and reinvest earnings in profitable projects.

o B
distribute earnings through share repurchases in the absence of growth

opportunities.
o C
pay high dividends and have low growth opportunities.

Incorrect
C is correct. If dividends are taxed at a higher rate than capital gains, taxable
investors should prefer low dividend payout companies with profitable growth
opportunities.
30. Question 30
Companies in which industry are most likely to pay a special dividend as a means of
distributing more earnings during periods of strong profitability? Companies in the:
o A
Consumer staples industry.

o B
Cyclical industry.
o C
Technology.
Incorrect
B is correct. Firms in the cyclical industry (e.g., automakers) will use a special
dividend to share profits with shareholders when times are good but maintain the
flexibility to conserve cash when profits are down.
31. Question 31
A large-cap company has decided to decrease its dividends despite declaring year-
end profits. The dividend cut follows its announcement regarding investments in
profitable future projects. All else equal, such a decision by the company will most
likely lead to:
o A
an increase in share price because of increased scrutiny by investors.
o B
a decrease in share price because of increased scrutiny by the investors.

o C
a decrease in shareholders’ wealth.

Incorrect
A is correct. If a profitable company with high future cash flows and lucrative
opportunities announces a decrease in dividends, this is likely to be perceived as
positive information. As the information is absorbed by the market, the share price
will most likely rise.
32. Question 32
Which of the following statements is least likely correct? A dividend declaration might:
o A
decrease the gap between the market price of a stock and its intrinsic value.
o B
help overcome information asymmetry between investors and the company.

o C
increase information asymmetry between managers and shareholders.

Incorrect
C is correct. A dividend declaration conveys information to the market. A dividend
declaration can cause a reduction in the gap between the market price and intrinsic
value of a stock. It also may reduce the information asymmetry between company
management and outsiders.
33. Question 33
Company X has a corporate income tax rate of 30%, and 70% of its dividend income
received from investments in other companies is exempted from taxes. What is the
company’s effective tax rate on dividends?
o A
9%
o B
21%
o C
30%
Incorrect
A is correct. 70% of dividend income is exempted from taxation, the effective tax
rate on dividends is 0.30(1.00 – 0.70) = 0.09.
34. Question 34
The factor that least likely affects a company’s dividend policy is its:
o A
investment opportunities.
o B
human capital.
o C
flotation costs.
Incorrect
B is correct. Investment opportunities, future volatility of earnings, financial
flexibility, taxes, flotation costs and contractual/legal restrictions are the factors that
affect dividend policy.
35. Question 35
Consider the following information:
Net income before taxes $100

Corporate tax rate 30%
Net income after tax $70
Dividend (assuming 100% payout) $70
Shareholder tax on dividend (at 15%) $10.50
Net dividend to shareholder $59.50
Based on the above information the double tax rate on dividend distributions is:
o A
45.0%.
o B
59.5%.
o C
40.5%.
Incorrect
C is correct. The double tax rate on dividend distributions = (USD30 + USD10.50) /
100 = 40.5% or (USD100 – USD59.5) / USD100 = 40.5%.
36. Question 36
Under the dividend imputation tax system, when earnings are distributed to
shareholders in the form of dividends, shareholders receive:
o A
no credit for taxes paid at the corporate level.

o B
50% credit for taxes paid at the corporate level.

o C
credit for taxes the corporation has paid on distributed earnings.

Incorrect
C is correct. Under the dividend imputation tax system, shareholders receive a full
tax credit known as franking credit for the taxes the corporation has paid on the
distributed earnings.
37. Question 37
Consider the following information regarding dividend imputation tax system:
Marginal tax rate of the shareholder = 45%.
Pretax income S100

Corporate tax rate (35%) 35
Net income after tax 65
Dividend (100% payout) 65
Shareholder tax on pretax income 45
Less tax credit for corporate payment 35
Tax due from shareholder 10
The effective tax rate on dividend is:
o A
45%.
o B
10%.
o C
35%.
Incorrect
A is correct. Under the tax imputation system if the shareholder’s marginal tax rate is
higher than the company’s, the shareholder pays the difference between the two
rates. The effective tax rate is then the tax paid at the corporate level plus the
difference i.e. 35% + 10% = 45%.
38. Question 38
The taxation system in which the retained corporate earnings are taxed at a higher
rate than the earnings distributed as dividends is known as:
o A
tax imputation system.

o B
split-rate tax system.

o C
double taxation.
Correct
B is correct. Under the split-rate tax system, corporate earnings are taxed at a higher
rate than the dividends. Earnings distributed as dividends are still taxed twice, but
the low tax rate on dividends mitigates that tax deduction.
APN Textiles manufactures synthetic blended yarn, and is listed on the local stock exchange.
The company began its operations in 2001, and paid its first dividend in 2006. Demand for
APN’s yarn was strong till a fire at the factory in July 2010 destroyed its finished goods
inventory substantially. In the following year sales of yarn in APN’s price range were affected
by a decline in demand. The company responded by reducing inventory and repaying its
outstanding long-term debt, which was fully paid off in 2012. Earnings and dividends grew
steadily but dividends were discontinued soon after the fire, followed by a downtrend in
sales. Exhibit 1 shows the history of the company’s earnings per share (EPS) and dividends
per share (DPS) since 2006. Exhibit 1: APN’s Earnings and Dividend History for Years
Ending 2006 – 2015.
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
EPS(INR) 4.50 4.90 5.17 5.40 5.54 2.80 2.60 3.80 5.20 5.95
DPS(INR) 1.80 1.94 2.07 2.14 2.19
APN’s sales recovered in 2015, and the company decided to reinstate its dividends in 2016.
Sunil Anand, CFO APN wants to ensure against a future cut in dividends and determines
dividends with a target payout adjustment model using a five-year period to adjust toward
the target. Exhibit 2 shows his estimates and payout plan. Exhibit 2: Anand’s Estimates of
Future Earnings and Proposed Payout Plan
Earnings Dividends
2016 ₹7.10 per share ₹2.83 per share
2017 ₹8.77 per share
Proposed Long-Run Dividend Policy Beginning in 2017
Long-run target payout 33%
Adjustment factor 0.25 per year
Anand also reviews the company’s past share price behavior (2006 – 2010) and finds that
when the shares went ex-dividend, they fell by about ₹0.635 per ₹1.00 of dividend paid. The
results of last year’s survey on a sample of company’s investors shows that APN’s investors’
tax rate on capital gains was 20% but taxes on dividends varied. Anand wonders about the
marginal tax rate on dividends for those trading the shares around the ex-dividend date for
the share price period he reviewed.
1. Question 1
The dividend policy followed by APN until the fire occurred is best known as a:
o A
constant dividend payout policy.

o B

o C

Incorrect
A is correct. From the period 2006 – 2010, the company paid out approximately 39%-
40% of its annual earnings as dividends indicating a constant dividend payout policy.
2006 2007 2008 2009 2010

EPS(INR) 4.50 4.90 5.17 5.40 5.54
DPS(INR) 1.80 1.94 2.07 2.14 2.19
DPS/EPS (%) 40.0 39.6 40.0 39.7 39.5
2. Question 2
Using Anand’s estimates and proposed dividend policy in Exhibit 2, the company’s
2017 dividends per share will be closest to:
o A
₹1.62
o B
₹3.36
o C
₹2.85
Incorrect
C is correct. Using Anand’s proposed stable dividend policy modeled along the lines
of a target payout ratio based on long-term expected earnings, the 2017 dividend
per share is Expected Dividend = Previous dividend + [{Expected earnings x Target
payout Ratio) – Previous Dividend} x Adjustment Factor}.
2.83 + {{8.77 x 0.33) – 2.83} x 0.25] = ₹2.85 per shares.
3. Question 3
According to the results of the survey on capital gains taxes and Anand’s analysis of
share price behavior on ex-dividend dates, the marginal tax rate on dividend income
for the those trading the company’s shares is closest to:
o A
50.8%.
o B
49.2%.
o C
21.3%.
Correct
B is correct. Using the equation Pw – Px = D (1 – TD) / (1 – TCG).Pw – Px = ₹0.635; TCG =
20% D = ₹1.00 (assumed).. 0.635 = 1 x (1 – TD) / (1 – 0.20) => TD = (0.635) x (1 – 0.2)
=>TD = 0.492 or 49.2%.
Renaissance Industries is selling one of its divisions for €50 million cash. Jeremy Li, chief
investment officer contemplates what would be best for Renaissance’s shareholders:
I. a repurchase of 1 million of Renaissance’s common stock in the open market, or

II. to pay a special dividend of €50 million.
Renaissance’s common stock is trading at €50. Li discusses the possible effects of each of
his choice with the chief financial officer of Renaissance.
1. Question 1
If Renaissance conducts a share buyback, the most likely signal to investors will be
that the company:
o A
is lowering its debt ratio.

o B
has many new profitable investment opportunities.

o C
considers its shares to be undervalued in the market.

Incorrect
C is correct. Management sometimes may view its shares to be undervalued in the
marketplace. Therefore, it conducts a share buyback to give either a price support or
signal to investors that it considers its shares a good investment.
2. Question 2
The tax environment in which Renaissance’s shareholders will most likely prefer a
share repurchase instead of a cash dividend is one where:
o A
the capital gains tax rates are higher than the dividend tax rates.
o B
the capital gains tax rates are lower than the dividend tax rates.
o C
the tax rate is the same for both capital gains and dividends.
Correct
B is correct. Shareholders will prefer share repurchases over cash dividend in
jurisdictions where the tax rates on dividends is higher than the capital gains tax
rates.
Preeti Lal, finance director and Arun Sharma, chief investment officer of Rupex Polyester,
are discussing the firm’s dividend policy ahead of the board meeting. Reviewing the past
dividends (See Exhibit 1), Lal notices that external borrowing at higher rates was required
for profitable investments due to more earnings paid out as dividends than retained.
Sharma comments that if dividends in 2013 and 2014 had been reduced by ₹0.6 million and
₹0.5 million there would have been no need for additional borrowing at expensive interest
rates. Both agree that based on project finance requirements at the time, the company had
known that much of the earnings were going towards dividend payments. Exhibit 1: Rupex
Polyester Past Dividend Record (5 million shares outstanding)
Year Net Income (₹ millions) Dividends (₹ millions)

2013 10.00 4.00
2014 8.00 3.20
2015 11.75 4.70
2016 12.90 5.16
2017* 13.40* N/A
Estimated value After deciding on incorporating project investment needs into the dividend
*
policy, Lal and Sharma prepare a proposal to the board for a new dividend policy of paying
an annual dividend of ₹0.60 a share for the foreseeable future.
1. Question 1
Based on Exhibit 1 the dividend policy followed by the firm prior to 2017
is best described as a:
o A

o B
constant dividend payout policy.

o C

Incorrect
B is correct. The firm follows a constant dividend payout policy, as indicated from
Exhibit 1. A constant ratio of 40% of earnings was paid out as dividends. It is not a
stable dividend policy because the dividend per share had not been constant. It is
not residual because project investment needs were not considered prior to making
dividend payments.
Net Income Dividend

Year Payout Ratio
(₹ millions) (₹ millions)
2013 10.00 4.00 4/10 = 40%
2014 8.00 3.20 3.2/8.0 = 40%
2015 11.75 4.70 11.75/4.70 = 40%
2016 12.90 5.16 12.90/5.16 = 40%.
2. Question 2
Based on the firm’s current financing mix of 50/50 D/E and the estimated 2017
earnings, the expected capital available for investments under the proposed
dividend policy is closest to:
o A
₹20.8 million.
o B
₹10.4 million.
o C
₹5.2 million.
Incorrect
A is correct. Total expected dividends to be paid under the new proposal: 0.60 x 5 =
₹3 million The equity contribution for project financing = earnings remaining after
paying out dividends = 13.40 – 3 = ₹10.40million. The expected amount of capital
available for investments = [ 1 + %Debt Financing / %Equity Financing ] x the equity
portion from expected earning remaning = [ 1 + 50% / 50% ] x 10.4 = 20.8 million.
Bryan Seacrest, director research SKL Fund Managers, is discussing various issues involved
with investments in dividend paying companies with his junior analysts. Seacrest asks
Julianna Miguel, a recently hired analyst, the following question: “One of our clients owns
50,000 shares of Y-Electric Company which currently trades at €30 a share. Y-Electric attracts
tax-exempt clientele. Our client has instructed us to reinvest all dividends received in buying
additional shares for her portfolio. Y-Electric has just paid a €1.50 dividend hence what is
our client’s new share ownership after reinvesting of dividends at the ex-dividend price?”
Miguel responds that the new share ownership after accounting for the increase due to
reinvestment of dividends would approximately be 52,600. Seacrest asks his team about the
effective tax rate of another client of SKL. The client has a personal tax rate of 30% but he
invests in dividend paying companies that have a 35% corporate tax rate. Joe Saldana, a
junior analyst, calculates the investor’s effective tax rate. The discussion then turns to the
signaling effect of dividends to investors. Seacrest asks his team about the information
content of the dividend action involving TRC Industries’ recent announcement of a quarterly
dividend rate cut. Finally, Seacrest explains the factors associated with the high dividend
payout ratio of the companies in SKL’s High Dividend Yield Fund. These are: low growth
prospects, low tax rates on dividends and high flotation costs on new equity issues.
1. Question 1
Does Miguel correctly give the new share ownership of the client after reinvesting of
dividends?
o A
No, after reinvestment the shares owned increase to 52,500.

o B
Yes.
o C
No, after reinvestment the shares owned increase to 52,400.

Incorrect
B is correct. Because the clientele for Y-Electric are tax exempt investors hence the
tax rate is zero for dividends and capital gains. Amount of dividend received = 50,000
x 1.5 = €75,000. After dividends are paid the share price should decline by the
amount of the dividend to €30 – €1.50 = €28.50. SKL will purchase €75,000 / €28.50 =
2,632 (approximately) additional shares. This increases her total shares owned to .
2. Question 2
The effective tax rate calculated by Saldana on the pretax income distributed in
dividends is closest to:
o A
65.0%.
o B
54.5%.
o C
45.5%.
Incorrect
B is correct. The effective tax rate can be computed as: 1 – (1 – 0.35)(1 – 0.30) = 0.545
or 54.5% effective tax rate.
3. Question 3
All else equal, TRC’s dividend cut announcement will most likely affect the stock price
because it will signal:
o A
negative information regarding the company’s future profitability.

o B
positive information regarding the company’s future growth prospects.

o C
positive information regarding the company’s overvaluation in the market.

Incorrect
A is correct. All else equal, a dividend cut would convey negative information about
the company’s future earnings. If a company is overvalued then managers would not
have any incentive to increase or decrease a dividend because increased scrutiny of
such an action would result in a downward price adjustment.
4. Question 4
Does Seacrest correctly state the factors associated with companies with a high
dividend payout ratio?
o A
No, incorrect regarding high flotation costs.

o B
Yes.
o C
No, incorrect regarding low growth prospects.

Incorrect
A is correct. Flotation costs make it more expensive for companies to raise new
equity capital than internal funds. Hence, companies generally avoid establishing a
level of dividends that would result in new equity issuance for financing of projects.
High flotation costs would result in setting up low payout ratios.
Sami Lallani is an equity analyst at Tressler Securities He is reviewing the dividend policy of
Waltham Chemicals which represents a gradual adjustment to a target dividend payout
ratio. Last year Waltham’s reported earnings of USD1.50 a share and paid a dividend of
USD0.375 a share. The company projects earnings per share of USD2.00 for this year and a
target payout ratio of 30%. It uses a five-year adjustment period for its dividend. Lallani
estimates the dividend per share for this year. Finally Lallani’s supervisor questions him
about the type of dividend policy followed by SON Inc., a large utility company. SON has
been maintaining a dividend of US$ 1.12 for several years despite considerable variability in
its earnings due to restructuring costs. Lallani recalls from a recent report that he read on
SON, that the company expects no long-term changes in its prospects.
1. Question 1
The dividend per share estimated by Lallani for Waltham Chemicals is closest to:
o A
US$0.42.
o B
US$0.40.
o C
US$0.35
Incorrect
A is correct. Using Waltham Chemicals stable dividend policy modeled along the lines
of a target payout ratio based on long-term expected earnings, this year’s dividend
per share is:
Expected dividend = Previous dividend + [{(Expected earnings x Target pauout ratio)
– previous dividend] x adjustment factor].
Adjustment period = 5 years. Therefore adjustment factor per year = 1/5 = 0.2
0.375 + [{(2.00 x 0.3) – 0.375} x 0.20] = USD0.42 per Share
2. Question 2
The most appropriate answer to the supervisor’s question about the dividend policy
followed by SON is: SON follows a
o A
constant dividend payout ratio.

o B

o C
constant dividend payout ratio and a stable dividend policy.

Correct
B is correct. SON has been paying a regular dividend irrespective of the short-term
volatility in earnings, based on the long-term forecast of sustainable earnings in line
with the stable dividend policy. SON neither pays a consistent dividend payout ratio
nor pays dividends from the remaining amount of internally generated funds after
financing of the current year’s capital expenditure according to the target capital
structure. Hence B and C are incorrect.
Arun Manan, treasurer at Carthwright Paper & Packages Inc. a manufacturer of paper and
packaging material is considering either to use surplus cash or borrow funds to repurchase
shares in the open market. Manan wants to know the effect on earnings per share from
using each option given as follows: Option I: The company uses the entire surplus cash of
€20 million to repurchase shares at the market price. Option II: The company borrows funds
at the after-tax rate of 5.5% to repurchase 500,000 shares of stock at the prevailing market
price Carthwright has 20 million shares outstanding and earnings are €3.00 a share. The
company’s stock is trading at €40 a share.
1. Question 1
If Manan chooses Option I, the earnings per share is closest to:
o A
€3.10.
o B
€3.50.
o C
€2.90.
Incorrect
A is correct. At current market price, number of shares repurchased will be
= €20,000,000 / €40 = 500,000 shares.The company will have (20 million shares –
500,000 shares = 19,500,000 shares). Total earnings before the buyback = 20,000,000
x 3.00 = €60,000,000.
Total earnings after the buyback are the same because the company uses idle
(nonearning) cash to purchase the shares, but the number of shares outstanding is
reduced. EPS increases to €3.10 approx. (€60 million / 19.5 million shares = €3.08).
2. Question 2
If Manan chooses Option II, the earnings per share will most likely:
o A
remain the same.

o B
decrease.
o C
increase.
Incorrect
C is correct. The company’s earnings yield (E/P) is USD3/USD40 = 0.075 = 7.5%. When
the earnings yield is greater than the after-tax cost of borrowed funds (5.5%), EPS
will increase if shares are repurchased using borrowed funds.
Geti Amman, an equity analyst at CoreStat Consultants, a company providing consultancy
services in corporate finance, investments and trading to institutions and corporates.
Amman has been asked to determine the effect on various financial metrics of three
companies which are considering a repurchase of shares. All three companies are clients of
the firm. Amman gathers the following information for each of the three companies given
below:
Client I: SCI Corp. (A chemicals manufacturer)

A share repurchase accomplished by borrowing money just enough to
repurchase 100,000 shares.
Shares outstanding before buyback 4.10 million
Earnings per share before buyback US$5.00
Share price at time of buyback US$40.00
After-tax borrowing rate 5.00%
Client II: Telsar Automobile Company.

A share repurchase of 1,000,000 shares
Shares outstanding before buyback 15 million
Current share price US$30.00
Total assets at the time of buyback US$1,000 million
Total liabilities at the time of buyback US$500 million
Client III: Delvage Inc. (A consumer goods company)

A share repurchase of 200,000 shares at the current market price
Shares outstanding before buyback 3.2 million
Earnings per share before buyback US$6.25
P/E 8
Book value per share before buyback US$45
1. Question 1
Client I’s earnings per share after the buyback will be closest to:
o A
US$4.95.
o B
US$5.12.
o C
US$5.08.
Incorrect
C is correct. Total earnings before buyback: USD5.00 × 4,100,000 shares = USD20.5
million
Total amount of borrowing: USD40 × 100,000 shares = USD4,000,000
After-tax cost of borrowing: USD4,000,000 × 0.05 = USD200,000
Number of shares outstanding after buyback: 4,100,000 – 100,000 = 4,000,000
EPS after buyback: (USD20,500,000 – USD200,000) / 4,000,000 shares = USD5.075
The P/E before the buyback is USD40/USD5.075 = 7.9; thus, the E/P is 12.66%. Th
after – tax cost of debt is 5%; therefore, EPS will increase.
2. Question 2
After the buyback, the book value per share of Client II will most likely:
o A
remain the same.

o B
decrease.
o C
increase.
Incorrect
C is correct. Before buyback book value per share = (Assets – Liabilities) / shares
outstanding = (1000 – 500)mil / 15 mil = 500 / 15 =USD33.33. The book value of
equity after buyback will be reduced to USD500 million – USD30 million (1 mil shares
at the prevailing market price) = USD470 million, and the number of shares will be
reduced to 14 million; USD470 million / 14 million = USD33.57 book value per share.
If the prevailing market price is less than the book value per share at the time of the
buyback, book value per share increases.
3. Question 3
If Client III repurchases 200,000 shares at the prevailing market price, the book value
per share is closest to:
o A
$50.00.
o B
$44.67.
o C
$51.33.
Correct
B is correct. The prevailing market price is USD6.25(8) = USD50.00 per share. The
buyback would reduce equity by USD10 million. Book value of equity before the
buyback is USD144 million. Book value of equity after the buyback would be USD144
million − USD10 million = USD134 million. The number of shares outstanding after
the buyback would be 3 million. Thus, book value per share after the buyback would
be USD134 million / 3 million = USD44.67.
Jason Stewart, chief financial officer SNB Willer, a global beverage company is interviewing
Rana Abidi, a finance manager. Stewart asks Abidi the following questions: Question 1.
“Which method of share repurchase provides the maximum flexibility to a company in
terms of no legal obligation to complete the repurchase program?” Abidi replies, “It’s the
Dutch auction method.” Question 2. “A company with 10 million shares outstanding trading
at USD50 a share has USD70 million of surplus cash. It is considering whether to use the full
amount for paying a special cash dividend or repurchasing shares at the prevailing market
price. It can either pay special cash dividend of USD7 per share or repurchase USD70 million
worth of shares. When would the wealth of a shareholder in distributing the USD70 million
be equivalent under the two options?” Abidi responds, “When the company’s book value per
share is equal to the prevailing market price.”
1. Question 1
Is Abidi correct in her response to Question 1?
o A
Yes.
o B
No, maximum flexibility is provided by the open market share

repurchase method.
o C
No, maximum flexibility is provided by the fixed price tender offer share
repurchase method.
Incorrect
B is correct. Open market repurchases provide the maximum flexibility for a
company because there is no legal obligation to undertake or complete the
repurchase program. A company may not follow through with the repurchase
program due to unexpected need for liquidity, acquisitions, or capital expenditures.
Fixed price tender offer and Dutch auction method provide speed as they can be
accomplished in a short time period.
2. Question 2
Is Abidi’s response to Question 2 most likely correct?
o A
Yes.
o B
No, a shareholder’s wealth would be equivalent under the two

alternatives, when a company’s book value per share is less than $50.
o C
No, a shareholder’s wealth would be equivalent when tax consequences
and/or information content are the same for both alternatives.
Incorrect
C is correct. For the two options to be equivalent with respect to shareholders’
wealth, the amount of cash distributed, the taxation, and the information content
must be the same for both options.
Corporate Governance and ESG

Considerations in Investment
Analysis
1. Question 1
Q-Code: 21-L2-CF-CGIA-74200
Which type of ownership structure is most likely to result in a principal-agent conflict?
o A
Dispersed ownership and concentrated voting power

o B
Dispersed ownership and dispersed voting power.

o C
Concentrated ownership and concentrated voting power.

Incorrect
B is correct. A dispersed ownership and dispersed voting power structure has weak
shareholders and strong managers. The shareholders lack power to exercise control
over managers which can result in principal-agent conflicts. The managers may use
the company’s resources to pursue their own interests at the expense of
shareholders.
2. Question 2
Which of the following situations will most likely cause a conflict between directors
and shareholders?
o A
An independent board.
o B
The board members do not have consulting agreements with the company.
o C
Generous remuneration paid to directors irrespective of firm’s

performance.
Incorrect
C is correct. Generous compensation paid to directors can create director-
shareholder conflict. Excessive compensation may cause directors to align their
interests with the management instead of the investors.
3. Question 3
Aquasafe Inc. has concentrated ownership, given that the family owns 60% of the
shares. It has concentrated voting power such that each ownership share has equal
voting rights. The potential conflict between or among shareholders and managers
of Aquasafe can best be described as:
o A
voting caps.
o B
a principal-agent problem.
o C
a principal-principal problem.
Incorrect
Solution: C is correct. In this ownership structure, the controlling shareholders have
power over both management and minority shareholders. The conflict in this
structure exists between the controlling shareholders and the minority
shareholders. The controlling owners may be able to use the company’s resources to
pursue their own benefit at the expense of minority owners. This conflict is referred
to as a principal-principal problem.
4. Question 4
Which of the following stakeholders will have the least significant influence on
corporate governance of a company?
o A
Banks (that have lending relationship with the business)

o B
Managers and Board of Governors

o C
Debtors of the company

Incorrect
C is correct. Option A and B are important stakeholders to consider when making
corporate governance policies.
5. Question 5
Company X has a two-tier board structure. Its board most likely consists of:
o A
executive and non-executive directors.

o B
a supervisory board that oversees a management board.

o C
directors that sit on boards of at least two companies.

Incorrect
B is correct. A describes the structure of on-tier board. C is a false statement.
6. Question 6
Emma Fin, an analyst, is looking at corporate governance polices of two companies,
which are from the same sector. She finds out that company A has more effective
corporate governance policies as compared to company B. Considering both
companies are identical in all other aspects, which of the following conclusion is
most appropriate?
o A
Risk premium and cost of capital for Company A will be higher than Company
B.
o B
Risk premium will be lower, and cost of capital will be higher for Company A
as compared to Company B.
o C
Risk premium and cost of capital will be lower for company A and higher
for Company B.
Incorrect
C is correct. Lower risk premium and lower cost of capital are benefits of good
corporate governance.
7. Question 7
Under which of the following voting sharing structures, a potential conflict of interest
may exist between minority shareholders and the company’s founders and
management?
o A
Straight voting share structure

o B
Dual class voting share structure

o C
Both A) and B)
Incorrect
Solution: B is correct. Under dual-class share structures, company founders and
management have shares with more voting power. This is generally considered
negative because it can benefit one group of shareholders over another.
8. Question 8
An analyst is evaluating the board of directors of Orange Dairy which was founded
by the Samson family and is publicly traded. Orange’s 11-member board of directors
has a chairperson, who is not the CEO, and one independent director. The Samson
family accounts for four of the five no non-independent directors. All these family
members have served on the board for at least 15 Women represent five of the
board’s directors and the age of directors is ranging from 30 to 65 years old.
Which of the following is least likely a sign of effective corporate governance at

Orange Dairy?
o A
Chairperson of the Board who is not the CEO

o B
Tenure of the board of directors

o C
Women representation on the board

Incorrect
Solution: B is correct. The tenure of the family board members is likely to be
considered a negative attribute because it far exceeds the typical 10 years. The CEO
and chairperson roles are separate (no CEO duality), which can be considered a sign
of effective corporate governance. Similarly, the board appears to be diverse in
terms of age and gender, which is typically considered a positive attribute.
9. Question 9
Which of the following is least likely correct about identifying a company’s ESG
factors?
o A
The proprietary method approach may involve an analyst researching a

company’s annual reports, regulatory filings, and news reports.
o B
ESG data providers may give a company an ESG score and/or ranking.
o C
Obtaining ESG data from not-for-profit industry organizations is more

costly than using ESG data providers.
Incorrect
C is correct. Obtaining ESG data from not-for-profit industry organizations is less
costly than using ESG data providers. The three approaches of identifying a
company’s ESG factors are as follows:
4. Proprietary research: involves the use of own judgment or their firm’s proprietary
tools to identify ESG information.
5. ESG data providers: involves the use of information supplied by ESG data
providers, such as MSCI or Sustainalytics.
6. Not-for-profit industry organizations and initiatives: involves the
consideration of not-for-profit initiatives that provide data and insights on
ESG issues. This approach can be more cost effective as compared to
approach 2.
10. Question 10
Statement 1: From a fixed income analyst’s perspective, ESG integration is used to

both identify potential opportunities and mitigate downside risk, whereas from an
equity analyst’s perspective, it is only to mitigate downside risk.
Statement 2: The process of identifying ESG factors requires more time and money
for a fixed income analyst than it does for an equity analyst.
Statement 3: Equity analysts may integrate ESG factors into their analyses by
adjusting financial model variables such as cost of capital.
o A
Statement 1 and Statement 3

o B

o C
Statement 3 only
Incorrect
C is correct. Statement 3 is correct: one way equity analysts may modify their models
to reflect ESG factors is by adjusting the cost of capital for a company or project.
Statement 1 is incorrect because from a fixed income analyst’s perspective, ESG
integration is used to mitigate downside risks, while equity analysts may use it to
both identify potential opportunities and mitigate downside risk.
Statement 2 is incorrect because the process of identifying ESG factors is similar;
there are no substantial difference in the amount of time or money spent by equity
and fixed income analysts.
11. Question 11
Which of the following is least likely a characteristic of green bonds?
o A
Greenwashing is a risk associated with green bonds.

o B
Such bonds generally trade at a discount to comparable conventional

bonds.
o C
Relative to conventional bonds, green bonds have low liquidity.

Incorrect
B is correct. Green bonds generally trade at a premium over comparable
conventional bonds (which implies a lower cost of capital).
12. Question 12
Which of the following is least accurate about ESG information?
o A
Companies usually report information and metrics that are inconsistent.

o B
Different companies may report different levels of information.

o C
ESG disclosures are involuntary.

Incorrect
Solution: C is correct. ESG disclosures are voluntary which provides additional
challenge for analysts.
13. Question 13
Statement 1: Corporate governance considerations are reasonably consistent
across most companies and industries.
Statement 2: Environmental and social considerations are also reasonably

consistent across industries.
Which of the above statements is not correct?
o A
Statement 1
o B
Statement 2
o C

Incorrect
B is correct. Environmental and social considerations differ greatly across industries.
For example, environmental and social concerns for the energy sector will be very
different from the concerns for the banking sector.
14. Question 14
An analyst is researching an equity investment in Fort International, a global cement
producer. She intends to identify ESG factors impacting Fort and estimate the equity
valuation for the company. Fort’s cement production is energy intensive and relies
on coal. Most of Fort’s cement capacity is located in developing economies, where it
currently faces few environmental regulations. The analyst believes that the
company faces significant long-term risk due to regulatory changes regarding
greenhouse gas emissions in the developing economies. These changes will have a
negative impact on Fort’s cement capacity and its production costs. The analyst
integrates ESG factors into the equity valuation of This approach is most likely to
impact equity valuation by:
o A
raising the discount rate.

o B
increasing revenues.
o C
reducing operating cost.

Incorrect
Solution: A is correct. Fort faces significant long-term environmental risk factors. The
imposition of stricter regulation on greenhouse gas emissions in the developing
countries will result in stranded assets. The analyst should increase the discount rate
for Fort to account for the higher environmental risk.
Sophie Cohen, an Analyst, is analyzing the board of governors of Kamel Knitwear Ltd. The
Board of Kamel Knitwear Ltd. consists of 12 board members, 8 of which are independent
board members. The chairperson the board is also the CEO of the company. The directors
come from a diverse background and their age ranges between 35 to 78 years old. Cohen
further evaluates the company’s corporate governance policies. She finds out that the
company has been doing very good for the past few years, and this good performance is
also reflecting on the generous renumeration paid to the CEO and the directors. This high
compensation plan for the CEO has also increased the pay differential between the CEO and
the average worker. Through her contacts in the industry she gathers the data for CEO’s
salary and average worker salary, from which she derives an industry average for the ratio
of “CEO’s salary to average worker salary”. She discovers that the industry average has
remained somewhat stable, whereas, the ratio has been on the uptrend for Kamel,
consequently ending up higher than the industry average.
1. Question 1
Based on the analysis of board of governor, to improve the effectiveness of the
board most appropriate action for Cohen to propose is:
o A
Increase the number of non-independent board members

o B
Make the board composition less diverse

o C
Make sure that the chairperson of the board is an independent

member.
Incorrect
C is correct. This is the case of CEO duality, where the CEO of the company also
serves as the chairperson on the board. Chairpersons role of monitoring and
oversight is more likely to be compromised if CEO is the chairman too, as compared
to an independent chairperson.
2. Question 2
Based on Cohen’s findings about the increasing remuneration which of the following
statements is most likely correct:
o A
With better performance, remuneration of the CEO should increase but not
for the directors.
o B
With better performance, remuneration of the directors should increase but

not for the CEO.
o C
If the remuneration for both directors and CEO are linked with company
performance and strategy, then it sends a positive signal about the
company’s remuneration policy to the stakeholders.
Incorrect
C is correct, it gives the accurate definition for companies’ remuneration policy. A
and B are incorrect statements.
3. Question 3
Based on Cohen’s findings about the increasing remuneration which of the following
statements is most likely correct:
o A
Better performance is a result of CEO’s efforts because of which he is entitled

to get higher increments in remuneration as compared to average worker.
o B
If the ratio of CEO’s pay to the average worker’s pay is higher than the
industry average than it is a cause of concern for the stakeholders.
o C
Rising ratio of CEO’s pay to average worker’s pay sends a positive signal
about the company’s remuneration policy to the stakeholders.
Correct
B is correct. Higher ratio than the industry average shows that the incentives are not
appropriately distributed amongst the management. In evaluating a company’s
executive remuneration, investors typically consider whether the company’s
remuneration policies and practices provide appropriate incentives for management
to drive the value of a corporation.
Cost of Capital: Advanced

Alexandria Sanchez is estimating the cost of capital of RedEagle Co. RedEagle has issued
both debt and common equity. Sanchez begins by assessing the general state of the market
as well as the financial condition of the company. She notes that generally credit spreads
are narrow and the volatility of interest rates is low. The corporate tax rate is 25%. With
regards to the company itself, its profitability, cash flow generation and interest coverage
ratio are moderate compared to its peers. Sanchez then begins her estimation of the cost of
capital. She collects information regarding RedEagle’s current debt and equity levels. Exhibit
1 contains information regarding RedEagle’s current capital structure.
Exhibit 1
Capital Structure Selected Information
Single debt issue: 8% coupon
rate, maturing in 5 years,
semiannual payments. Straight
Debt 30%
unsecured debt, B credit
rating, thinly traded (no
reliable YTM).
Preferred Equity 0%
Common Equity 70% Actively traded
Sanchez also gathers information related to two liquid, B-rated bonds with semiannual
coupon payments, shown in Exhibit 2. She uses this information to estimate a YTM for
RedEagle’s debt.
Exhibit 2
Current Price (per 100 of par
Maturity Coupon rate
value)
Bond 1 2 years 3% 98.00
Bond 2 6 years 7% 107.60
Sanchez uses the bond yield plus risk premium method (BYPRP) to calculate RedEagle’s
cost of equity. She estimates a risk premium of 3.5% that compensates for the additional
risk of issuing equity compared to debt. While reviewing her work, Sanchez’s manager asks
her about the advantages and disadvantages of using this approach to estimate the cost of
equity. Sanchez responds with the following: “An advantage of this approach is that
estimating a company’s cost of debt provides a starting point estimate of the return
demanded by that company’s debt investors. A disadvantage is that the risk premium is
often estimated using historical data, however, historical data might not be appropriate if
the risk premiums are not stationary.”
1. Question 1
Q-Code: 23-L2-CF-CCAT-184935
An increase in which of the following would most likely decrease RedEagle’s cost of
capital?
o A
Interest coverage ratio

o B
Credit spreads
o C
Volatility of interest rates

Incorrect
A is correct. The interest coverage (IC) ratio is a debt and profitability ratio that
indicates how easily a company can pay interest on its outstanding debt. A higher
interest coverage ratio means a company is in a relatively better position to pay
interest on its outstanding debt. Therefore, if RedEagle’s IC ratio were to increase,
this would lower the cost of debt, leading to a lower cost of capital.
An increase in credit spreads and the volatility of interest rates would increase the
cost of debt, leading to a higher cost of capital.
2. Question 2
Using the information in Exhibits 1 and 2, RedEagle’s cost of debt is closest to:
o A
4.77%.
o B
5.13%.
o C
7.32%.
Incorrect
B is correct. The cost of debt will be an estimate of the YTM on RedEagle’s debt. To
estimate the YTM on RedEagle’s debt, we need to calculate the YTMs for both bonds
in Exhibit 2.
Bond 1: N = 4, PV = -98, PMT = 1.5, FV = 100, CPT I/Y
I/Y = 2.026%
YTM = 2.026% x 2 = 4.052%
Bond 2: N = 12, PV = -107.6, PMT = 3.5, FV = 100, CPT I/Y
I/Y = 2.748%
YTM = 2.748% x 2 = 5.496%
The YTM for debt with 2 years to maturity is 4.052% and the YTM for debt with 6
years to maturity is 5.496%. We can use these two data points to estimate the YTM
on debt with five years to maturity (RedEagle’s debt). This can be done using linear
interpolation:
Difference between YTM for bonds with 6 years to maturity and 2 years to maturity:
5.496 – 4.052= 1.444
Difference in YTM per year: 1.444/(6 – 2) = 0.361
RedEagle’s bond has 5 years to maturity, which is 3 years more than the bond with 2
years to maturity:
4.052 + (0.361*3) = 5.135
3. Question 3
Sanchez’s response about the bond yield plus risk premium approach is most
likely correct with respect to:
o A
the advantage.
o B
the disadvantage.
o C
both the advantage and the disadvantage.

Incorrect
C is correct. Sanchez’s response regarding both an advantage and disadvantage of
the bond yield plus risk premium approach is correct. Additional disadvantages are
that the BYPRP approach can only be used if a company has traded debt, the
determination of the risk premium is relatively arbitrary and if a company has
multiple traded debt securities, it is not clear which bond yield to use.
4. Question 4
Assuming RedEagle’s cost of debt is 6%, RedEagle’s cost of capital is closest to:
o A
3.8%.
o B
7.7%.
o C
8.0%.
Incorrect
C is correct. The cost of capital is calculated as follows: wacc = wdrd(1 – t) + were
The weightages of debt and equity as well as the tax rate are given in the case
information, and the cost of debt is provided by the question. The cost of equity
needs to be calculated.
The case provides information required to calculate the cost of equity using the
bond yield plus risk premium approach:
re = rd + risk premium = 6% + 3.5% = 9.5%
Therefore: wacc = wdrd(1 – t) + were = 0.30(0.06)(1 – 0.25) + (0.70)(0.095) = 0.08
Jeremy Adams, CFA is an equity analyst who deals primarily with companies in the chemical
and pharmaceutical industry. He is currently estimating the cost of equity for MDA Ltd., a
public chemical manufacturing company, and is being shadowed by an intern, Awais
Ahmed. Adams explains to Ahmed that his first step is to decide which method to use to
estimate the equity risk premium. He says, “I generally prefer forward-looking approaches
to historical approaches. ERPs estimated using historical approaches are more likely to be
inflated due to biases such as the survivorship bias. In addition to that, compared to
forward-looking approaches, they are also more subject to behavioral biases such as the
recency bias.” He decides to use the Grinold-Kroner model. He gathers the relevant
information (shown in Exhibit 1) and performs the calculation.
Exhibit 1
Yield on 10-year government bonds 2.8%
Dividend yield 3.1%
Expected growth rate in P/E 0.6%
Expected inflation 1.8%
Real GDP growth rate 2.2%
Expected revenue growth rate 3.1%
Expected change in shares outstanding -0.5%
As part of another project, Adams is estimating the cost of equity of Atlantic
Pharmaceuticals, a private pharmaceutical company headquartered in the US. Adams asks
Ahmed what he knows about estimating the cost of equity of private companies. Ahmed
responds with the following comments: Comment 1: The required rate of return for private
companies often comprises of a size premium, industry risk premium, and a specific-
company risk premium. Comment 2: The cost of equity can be estimated using either the
expanded capital asset pricing model (CAPM) or the bond yield plus risk premium (BYPRP)
model. Comment 3: Estimating the cost of equity for private companies is more challenging
than it is for public companies. During his calculation, Adams also wants to account for the
additional risk Atlantic Pharmaceuticals takes on through its exposure to international
markets, given that it makes 28% of its sales in India. He collects the following data in order
to calculate a country risk premium:
Exhibit 2
Sovereign country Standard deviation of Standard deviation of
Country
yield spread equity returns bond returns
India 2.5% 3.8% 2.1%
USA 1.3% 1.9% 1.2%
1. Question 1
Which of Adams comments regarding the limitations of historical approaches is most
likely correct?
o A
His comment regarding survivorship bias.

o B
His comment regarding recency bias.

o C
Neither of his comments were correct.

Incorrect
A is correct. Historical biases are more likely to be subject to data biases such as the
survivorship bias. This bias is present in equity market data when poorly performing
or defunct companies are removed from index membership, so that only relative
winners remain represented in index performance. This can inflate the estimated
equity risk premiums. Historical approaches are not more susceptible to the recency
bias than forward-looking approaches. Surveys, which are a type of forward-looking
approach, can be more subject to this bias as respondents may place more
relevance on recent events.
2. Question 2
Using the information in Exhibit 1, the equity risk premium for MDA Ltd. is closest to:
o A
4.4%.
o B
7.5%.
o C
10.0%.
Incorrect
A is correct. The equity risk premium (ERP) formula is as follows:
ERP = [DY + Δ(P/E) + i + g + ΔS] – E(rf)
where:
DY = dividend yield
Δ(P/E) = expected change in the P/E ratio
i = inflation
g the expected growth in real earnings per share (real GDP growth is a common
proxy)
ΔS = expected change in shares outstanding
E(rf) is the expected risk-free rate (long-term government bond yield is a common
proxy)
ERP = 3.1 + 0.6 + 1.8 + 2.2 – 0.5 – 2.8 = 4.4%
3. Question 3
Which of Ahmed’s comments regarding estimating the cost of equity for private
companies is most likely correct?
o A
Comment 1 and Comment 2

o B

o C

Incorrect
C is correct. Comment 2 is incorrect because the cost of equity is generally estimated
by using either the expanded CAPM or a build up approach that involves adding
relevant risk premia to the risk-free rate, such as a size premium and specific-
company risk premium. The BYPRP model involves starting with the company’s cost
of debt and adding an equity risk premium. Both comments 1 and 3 are correct
statements.
4. Question 4
Q4: Using the information in Exhibit 2 and the Damodaran model, the country risk
premium that Adams should use for Atlantic Pharmaceuticals is closest to:
o A
0.53%.
o B
0.61%.
o C
2.17%.
Correct
B is correct. Using the Damodaran model, the country risk premium (CRP) is:
CRP = sovereign yield spread x [volatility of the local country’s equity market] /
[volatility of the local country’s bond market]
CRP = (0.025 – 0.013) x (0.038/0.021) = 0.0217 = 2.17%
Adjusting this premium for the exposure Atlantic Pharmaceuticals has to India: 0.28
x 0.0217 = 0.61%.
Corporate Restructuring
Nicholas Green, CFA, an investment analyst, is evaluating the potential effects of the
recently announced acquisition of Spartan Rubber Ltd. by MedTech Corp., a medical
equipment manufacturing company. Spartan is a supplier of MedTech’s, and MedTech is
acquiring it for €45/share. Spartan’s stock is currently trading at €44/share, and Green’s
valuation places it at €42/share. MedTech’s major motivation behind the acquisition is the
potential cost synergies. It estimates that the acquisition will eventually lead to €250 million
lower operating costs each year, though only 30% will be realized in first year, 68% in
second, and 100% from the third year onwards. MedTech also estimates one-time costs of
€150 million each year for the next two years. In addition to realizing synergies, MedTech
also seeks to benefit from the acquisition of Spartan in other ways. As they work on this
project, one of Green’s colleagues, Angela Kim, comments that the majority of acquisitions
fail to create meaningful value for acquirers. She gives the following reasons: Reason 1: The
synergies realized may be less than what was expected. Reason 2: The acquiring company
may have paid too high a premium when purchasing the target company. Reason 3: The
target may not perform as well as was predicted due to integration issues. As part of his
analysis, Green forecasts the expected revenues and operating expenses for MedTech and
Spartan for the next three years without the effect of the acquisition announcement. His
projections are shown in Exhibit 1. He then uses these forecasts to estimate the projected
operating income for MedTech after the acquisition.
Exhibit 1: MedTech and Spartan projected revenues and operating expenses (EUR millions)
MedTech
Revenues 10,465 11,568 11,955
Operating Expenses 3,548 3,963 4,167
Spartan
Revenues 2,415 2,873 3,168
Operating Expenses 1,187 1,498 1,876
1. Question 1
Q-Code: 23-L2-FR-CRST-184947
The takeover premium that MedTech is paying for Spartan stock is closest to:
o A
2.27%.
o B
4.76%.
o C
7.14%.
Incorrect
C is correct. The takeover premium is the amount by which the per-share takeover
price exceeds the unaffected price expressed as a percentage of the unaffected price
and reflects the price of control, or the control premium—the amount shareholders
require to relinquish their control of the company to the acquirer. The formula for
the takeover premium is as follows:
Takeover premium = (deal price – unaffected stock price of the target) / unaffected
stock price of the target
(45 – 42)/42 = 7.14%
Since the current market price may be influenced by rumors regarding the
acquisition, the estimated value of Spartan’s share price will be used rather than the
market price.
2. Question 2
Q-Code: 23-L2-CF-CRST-184948
Which of the following is most likely a potential motivation of MedTech’s acquisition of
Spartan?
o A
Securing resources
o B
Increase management focus

o C
Increase Liquidity
Incorrect
A is correct. A company-specific motivation for acquisitions (and investment actions
in general) is securing resources. Spartan is a supplier to MedTech, and by buying a
supplier, MedTech can lock in this resource. Acquisitions do not provide increased
management focus or liquidity. In fact, by adding in a new segment or function,
upper management has to divide its focus further. Acquiring a company drains
liquidity rather than increasing it.
3. Question 3
Which of Kim’s reasons for acquisitions failure to create value is most likely correct?
o A
Reason 1 and Reason 3

o B
Reason 1 and Reason 2

o C
All three reasons

Incorrect
C is correct. All three reasons are correct.
4. Question 4
Based on the information given in the case and Exhibit 1, MedTech’s forecasted
operating income (in € millions) after the acquisition for the first three years
is closest to:
o A
8,000, 9,000 and 9,500.

o B
8,100, 9,000 and 9,300.

o C
8,100, 9,100 and 9,100.

Correct
B is correct. The calculations are shown in the following table:
Revenues
MedTech 10,465 11,568 11,955
Spartan 2,415 2,873 3,168
Combined Revenues 12,880 14,441 15,123
Operating Expenses
MedTech 3,548 3,963 4,167
Spartan 1,187 1,498 1,876
Cost synergies (75) (170) (250)
One-time costs 150 150 0
Combined Op Ex 4,810 5,441 5,793
Operating Income (Rev –
8,070 9,000 9,330
OpEx)
HighFashion, a clothing brand, is planning to outsource its HR function to an external

provider in an effort to improve operational efficiency and profitability and bring it to a level
that is comparable to its competitors. Current financial data for HighFashion and four
competitors are given in Exhibit 1.
Exhibit 1: Financial data for HighFashion and competitors (in USD million)
Total Assets Revenues EBIT
Company 1 348,485 84,265 31,495
Company 2 56,480 6,548 1,769
Company 3 219,647 75,672 26,128
Company 4 143,495 26,648 6,028
HighFashion 102,497 30,125 6,025
HighFashion has two business units: apparel and accessories. The company’s management
is considering spinning off the accessories unit. Mark Soresi, an analyst, is given the task of
valuing the individual business units and comparing them to comparable companies to
evaluate whether the spin-off would add value to stakeholders. He compiles financial
information related to the comparable companies and both of HighFashion’s business units
(shown in Exhibit 2). Exhibit 2
Table 1
HighFashion Business Revenue (USD Market Value (USD Book Value (USD
Unit millions) million) million)
Apparel 525 1,935 1,279
Accessories 115 330 248
Consolidated 630 2,265 1,527
Table 2
Median P/Sales of comparables (Apparel unit) 2.5
Median P/Sales of comparables (Accessories
1.5
unit)
1. Question 1
HighFashion’s decision to outsource one of its functions is most likely an example of
which of the following restructuring activities?
o A
Investment activity
o B
Divestment activity
o C
Restructuring activity
Incorrect
C is correct. Outsourcing is an example of a restructuring activity, as it does not
involve altering the size or scope of the company but improves the cost structure
with the intention of improving profitability.
2. Question 2
For HighFashion to reach the average EBIT margin of its competitors, it would most
likely have to decrease its operating expenses (in USD millions) by:
o A
3,013.
o B
10,042.
o C
16,426.
Incorrect
A is correct. Average EBIT margin = 30%
HighFashion EBIT margin = 6,025/30,125 = 20%
For HighFashion’s EBIT margin to be 30%, its EBIT needs to be 9,038 (= 0.30 x 30,125).
Given that revenue – operating expenses = EBIT, and assuming that the revenue
stays the same, operating expenses need to decrease by: 9,038 – 6,025 = 3,013.
3. Question 3
Which of the following statements regarding divestments is least likely correct:
o A
Divestment action is generally not profitable when a company has a

conglomerate discount.
o B
The valuation of the business segments is often the most significant factor
when deciding between selling a segment or spinning it off.
o C
Typically, unsustainable financial leverage prompts a corporate issuer to sell

one or more of its businesses for cash and use these proceeds to reduce its
leverage.
Incorrect
A is correct. A conglomerate discount is when the combined value of the segments
as stand-alone businesses is greater than their value as one company. In this type of
situation, divestment action adds value to stakeholders. Options B and C are correct
statements.
4. Question 4
Given the information in Exhibit 2, spinning off the accessories unit would most likely:
o A
decrease stakeholder value.

o B
increase stakeholder value.

o C
neither increase nor decrease stakeholder value.

Incorrect
A is correct.
Value of apparel unit on its own: 2.5 x 525 = 1,312.50
Value of accessories unit on its own: 1.5 x 115 = 172.5
Combined value of both units as separate entities: 1,312.50 + 172.50 = 1,485
Current consolidated value of both units (from Table 1): 2,265
Since the value of the two units as part of one company is higher than their
individual values, spinning off the accessories unit would decrease stakeholder
value.
EQUITY
Equity Valuation: Applications

and Processes
1. Question 1
Q-Code: 21-L2-EQ-EVAP-74530
“The value of an asset given a theoretically complete understanding of its investment
characteristics” is known as the:
o A
intrinsic value.
o B
liquidation value.
o C
market value.
Incorrect
A is correct. Intrinsic value of an asset is the value given a hypothetically complete
understanding of its investment characteristics.
2. Question 2
“Fair market value” is most accurately described by which of the following
statements?
o A
The value at which the asset is traded in the market.

o B
The price at which an asset changes hands between a willing buyer and
a willing seller when neither party is under compulsion to trade.
o C
Value of an investment to a particular buyer based on his/her needs and

expectations.
Incorrect
B is correct. The fair market value is the price at which an asset changes hands
between a willing buyer and a willing seller when neither party is under compulsion
to trade.
3. Question 3
o A
An investment is expected to yield abnormal positive returns when its market

price is higher than its intrinsic value.
o B
When market prices accurately reflect all information, investors would be

motivated to incur the costs of information gathering.
o C
Active management seeks to earn excess risk adjusted returns by way

of investment analysis.
Incorrect
C is correct. The purpose of active management is to seek excess risk adjusted
returns by way of investment analysis. An investment is NOT expected to yield
abnormal positive returns when its market price is higher than its intrinsic value.
When market prices accurately reflect all information, investors would NOT be
motivated to incur the costs of information gathering.
4. Question 4
Active managers try to identify mispricing which is the difference between:
o A
estimated intrinsic value and intrinsic value.

o B
intrinsic value and market price.

o C
estimated intrinsic value and market price.

Incorrect
B is correct. True mispricing is the difference between the asset’s true but
unobservable intrinsic value and its market price that contributes to excess risk-
adjusted return (alpha) sought by active managers.
5. Question 5
Which of the following statements is most likely accurate?
o A
The going concern assumption implies that a business will continue its
activities for at least ten years.
o B
The liquidation value of a company is the value of the company assigned by

its liquidators during bankruptcy.
o C
Generally, the value of a company if it continues operation is different

from its value if it were to be dissolved immediately.
Incorrect
C is correct. Generally, the going concern value of a company is different from its
liquidation value. This is due to the collective value of assets and human capital
managing those assets. The going concern assumption implies that the business is
expected to continue operation for the foreseeable future; there is no time limit. The
liquidation value of a business is if it were to be dissolved and its assets sold
individually.
6. Question 6
Which measure of value is most relevant for the analyst of a Core Equity Fund which
selects companies that are expected to generate significant positive free cash flow
from core business operations over a multiyear investment horizon?
o A
Liquidation value
o B
Going-concern value
o C
Investment value
Incorrect
Solution: B is correct. The emphasis on future free cash flows implies that going-
concern value is relevant.
7. Question 7
Sarah Bilgrami, an equity analyst at SIQ Securities, has been given the responsibility
to initiate coverage on Larkson Group. Bilgrami discusses the different equity
valuation and security selection techniques with her boss, Uzma Nizami. Based on
her understanding of the discussion, she makes the following notes:
• Note 1: An appropriate valuation model along with forecasts which are on

average correct are important for intrinsic value estimation. For active
security valuation to be effective the manager’s expectations must be in line
with the consensus expectations.
• Note 2: The sustainable growth rate of a company is based on the
assumption of growth through internally generated funds and approximates
the average growth rate of dividends over a long time.
• Note 3: For companies with changing leverage, FCFF is a better valuation
approach than FCFE.
Which of Bilgrami’s notes regarding valuation approaches and security selection

is least accurate?
o A
Note 1.
o B
Note 2.
o C
Note 3.
Incorrect
A is correct. The intrinsic value calculation must be based on accurate forecasts
along with an appropriate valuation model. The quality of forecasts is important to
the investment process. For active security valuation to be consistently successful,
the manager’s expectations must differ from consensus expectations. B & C are
correct statements.
8. Question 8
o A
Equity valuation is used by analysts to extract market expectations reflected

in stock prices.
o B
An investment bank can utilize equity valuation to offer a fairness opinion on

a merger.
o C
Equity valuation is not relevant when determining share-based

compensation.
Incorrect
C is correct. Equity valuation is used to value share-based compensation of
employees.
9. Question 9
Elle McGuire, an analyst at a local investment bank is researching International Paper
and Packaging Industry (IP&P). The company specializes in producing and
distributing paper and packaging material from raw wood, pulp and recycled paper.
McGuire’s operational analysis indicates that the external economic environment
controls much of the IP&P’s profitability and success. As the product is not unique
success lies in cost management and pricing the product at or close to the industry
average. McGuire finds that IP&P has increased its profit margins over the years by
controlling its costs through acquisition of efficient machinery and software. The
company’s competitive strategy based on McGuire’s operational analysis can
be best described as:
o A
focus.
o B
differentiation.
o C
cost leadership.
Incorrect
C is correct. IP&P’s competitive strategy is best described as cost leadership, since it
has been able to control costs and improve profit margins. A cost leadership strategy
if implemented successfully lowers costs and improves profitability while pricing the
products at or near industry average. The product is not unique so differentiation is
not feasible. The company has not adopted a focus, such as a particular type of
paper or packaging material.
10. Question 10
Which of the following is an indication of poor earnings quality?
o A
The company does not use off-balance sheet financing.

o B
The company reports operating and non-operating income separately.

o C
The company recognizes revenue when orders are received but holds
back goods for future delivery.
Incorrect
C is correct. Companies may recognize revenue early and hold back stock for
delivery to boost revenues and expenses, thus a sign of a possible problem with a
company’s earnings quality. Use of off-balance sheet financing such as leasing does
not appear on the balance sheet, hence the assets and liabilities are not properly
reflected. Separation of operating gains from non-operating gains is an indication of
good quality earnings.
11. Question 11
Which of the following indicators least likely represents poor financial reporting
quality?
o A
Not assuming long depreciable lives for assets.

o B
Using special purpose entities to remove assets from the balance sheet.
o C
Capitalizing expenses to delay their recognition.

Incorrect
A is correct. Using aggressive estimates and assumptions such as long depreciable
lives, may indicate an attempt to either boost current income or hide problems with
performance in the current period. Using SPEs to remove risky assets from the
balance sheet and capitalizing expenses that otherwise have to be expensed are
signs of poor financial reporting.
12. Question 12
Which of the following questions is not relevant to understanding a company’s
business model?
o A
How profitable are the industries in which the company operates?

o B
What is an appropriate discount rate to use in valuation of the

company?
o C
What is the company’s competitive strategy?

Incorrect
B is correct. Analysis related to discount rate and cash flows are part of equity
valuation models. The valuation models are chosen once the industry and
competitive analysis have been completed and company performance has been
forecasted.
13. Question 13
Company A operates in three unrelated industries with differing rates of growth:
cement (60% of earnings), life sciences (30% of earnings), and tobacco (10% of
earnings). The company has finalized the terms to acquire 80% of the outstanding
shares of Company B, an actively traded cement company, in an all-stock deal. Which
of the following is most likely to be appropriate to consider in Company A’s valuation
of Company B?
o A
Blockage factor
o B
Lack of marketability discount

o C
Control premium
Incorrect
Solution: C is correct. A control premium may be reflected in the value of a stock
investment that would give an investor a controlling position. Company A acquired
80% of the outstanding stock of Company B; more than 50% is considered a
controlling ownership position.
14. Question 14
Which of the following is a relative valuation method?
o A
Discounted cash flow valuation
o B
Asset based valuation

o C
Price to sales valuation

Incorrect
C is correct. Price to sales multiple valuation is a relative valuation method.
Discounted cash flow and asset based valuation are absolute valuation methods.
15. Question 15
An analyst has to value Titan, a fast-growing company, that is rapidly gaining market
share. It is not expected to be profitable for several more years. The company does
not expect to pay dividends for an extended period of time. Certain larger
competitors will become interested in acquiring Titan because of its excellent growth
prospects. Which valuation model would be suitable to estimate the value of Titan?
o A
P/E relative valuation

o B
Free cash flow

o C
Dividend discount
Incorrect
Solution: B is correct. Free cash flow model is suitable for valuation of this company
because negative earnings would make the use of P/E relative valuation difficult.
Furthermore, it is not possible to use dividend discount model since the company
does not expect to pay dividend in the foreseeable future.
16. Question 16
Sarah Connors and Jenny O’Brien are junior analysts at QPM Securities, who are
valuing Key Safety Components (KSC), a publicly traded auto parts manufacturer.
Connors mentions that KSC usually trades at a considerable discount to its peers,
and makes the following statements regarding its valuation:
Statement 1: KSC’s currently trades at USD34 per share, which is below its value
calculated using free cash flow approach.
Statement 2: If KSC spins off its unrelated printing and publishing division, the
discount will most probably disappear.
Statement 3: The method of comparables, and the method on forecasted
fundamentals should be used to check whether its P/E trades below the market
multiple.
Which statement most likely relates to a sum-of-the-parts approach?
o A
Statement 1.
o B
Statement 2.
o C
Statement 3.
Incorrect
B is correct. A sum-of-parts valuation approach sums the estimated values of each of
a company’s businesses/segments as if each segment were an independent going
concern. Statement 2 describes such a valuation approach. If a company operates in
unrelated businesses compared to companies with narrower focuses, then the
market applies a discount (conglomerate discount) to its stock. Since the division is
unrelated to the core operations of KSC, the value might be unlocked via a spin-off.
Statement 1 mentions the free cash flow approach and Statement 3 describes the
relative valuation method.
17. Question 17
In which of the following scenarios is sum-of-parts valuation most useful?
o A
When a company owns different subsidiaries in the same business segment.

o B
When the company is going into liquidation and dissolving its individual
business segments.
o C
When the company operates in different business segments each with

its unique characteristics.
Incorrect
C is correct. Sum of parts is most useful when the company operates in different
business segments each with its unique characteristics.
18. Question 18
Which of the following is the least appropriate rationale for conglomerate discounts?
o A
The company’s allocation of capital to different business divisions may not
maximize shareholders’ wealth.
o B
The company may have diversified in order to hide poor operating

performance.
o C
The liquidation value of business segments is less than their going

concern value.
Incorrect
C is correct. The most common explanations for conglomerate discounts are that the
company’s allocation of capital to different business divisions is inefficient since the
overall value does not increase, and that the company may have diversified in order
to hide poor operating performance. The liquidation value being less than going
concern value is NOT a reason for the application of conglomerate discounts.
19. Question 19
When performing equity valuation, an analyst should take into account which of the
following criteria for selection of a valuation model?
o A
The characteristics of the business being valued.

o B
The purpose for which the valuation is performed.

o C
Both A and B.
Incorrect
C is correct. The analyst should take into account both the characteristics of the
business and purpose of valuation when selecting a valuation model.
20. Question 20
Analysts who work at brokerage houses are referred to as:
o A
Sell-side analysts
o B
Buy-side analysts
o C
Corporate analysts
Incorrect
Solution: A is correct. Sell-side analysts work at brokerage firms; their research
reports are distributed to retail and institutional clients.
21. Question 21
Statement 1: Analysts contribute to the efficient functioning of capital markets.
Statement 2: Analysts benefit suppliers of capital.
o A
Statement 1
o B
Statement 2
o C

Incorrect
Solution: C is correct. Both statements are correct. As part of the valuation activities,
analysts collect, organize, analyse, and communicate corporate information. They
play an important role in financial markets by:
• Benefiting suppliers of capital by monitoring management performance.

• Helping clients make better buy/sell decisions.
• Contributing to the efficient functioning of capital markets.
Ginny Lyon is the director of research at Remy Capital which specializes in identifying
overvalued and undervalued securities. Lyon makes the following comments to the newly
hired analysts: Comment 1: “An active manager attempts to achieve positive excess risk-
adjusted return. But to detect mispricing is not easy; hence, it is important to understand
the possible sources of perceived mispricing.” Comment 2: “Remy Capital invests in
distressed securities representing companies in financial distress. The valuation process
involves identifying the investment and resale value, in short,the liquidation value of such
companies.” Comment 3: “An analyst at Remy Capital is required to evaluate the
reasonableness of the expectations implied by the security’s market price by comparing the
market’s implied expectations with his own outlook.”
1. Question 1
With respect to Comment 1, perceived mispricing is most likely the difference
between:
o A
estimated intrinsic value and market price.

o B
intrinsic value and estimated value.

o C
intrinsic value and market price.

Incorrect
A is correct. Perceived mispricing is the difference between the manager’s estimate
of intrinsic value and observed market price.
2. Question 2
The sources of perceived mispricing are most likely:
o A
true mispricing or alpha and the error in the intrinsic value estimate.
o B
true, unobservable intrinsic value and the error estimate.

o C
valuation estimate less the unobservable intrinsic value, and going-concern

value.
Incorrect
A is correct. The sources of perceived mispricing are: true mispricing which is the
difference between the unobservable intrinsic value and the market price; and the
error in the estimate of intrinsic value given as the difference between the valuation
estimate and the true but unobservable intrinsic value.
3. Question 3
With respect to Comment 2, which of the following statements is least likely correct?
o A
For most companies, the going-concern value is greater than the liquidation
value.
o B
The value of nonperishable inventory if liquidated immediately is higher

rather than its value if it were to be sold over a longer time.
o C
An analyst will typically forecast free cash flow of a financially sound company
rather than estimating its liquidation value.
Incorrect
B is correct. Liquidation value is based on the value of a company’s assets if it were
dissolved and the assets were sold individually. It is used to measure the value of
distressed securities. The liquidation value of nonperishable inventory if disposed-off
immediately is typically lower than the value of inventory if it could be sold over a
longer time-period.
4. Question 4
According to Comment 3, analysts at Remy Capital use valuation techniques to:
o A
infer market expectations.

o B
provide fairness opinions.

o C
to value acquisitions.
Incorrect
A is correct. Market prices show the investors’ expectations about the future
performance of companies. An analyst can use valuation models to determine the
reasonableness of the expectations implied by the market price by comparing it with
its intrinsic value based on his own expectations.
Barera Tahir an equity analyst is presently evaluating three companies that are retailers of
furniture and home furnishings. By evaluating the characteristics of the furniture and
furnishing industry Tahir finds that there are few barriers to entry, low product substitution
costs for customers, and a large number of wholesale suppliers. Further there is high intra-
industry rivalry among retailers. Tahir, while conducting her analysis of one of the
companies, Ashley Furniture & Furnishings, discovers that in the last earnings report, the
company recognized revenues early by recording sales prior to acceptance by customers. It
also included non-recurring items such as a litigation settlement in its favor that resulted in
higher earnings. As part of his valuation model, Tahir uses an appropriate discount rate for
free cash flows and estimates a horizon value at the end of ten years.
1. Question 1
Which of the following characteristics of the furniture and home furnishing industry
is least likely to affect its profitability negatively?
o A
the number of suppliers.

o B
the substitution costs.
o C
rivalry among retailers.

Incorrect
A is correct. The large number of wholesale suppliers will limit their ability to raise
input prices, hence positively affect industry profitability. B & C would negatively
affect the profitability of the industry.
2. Question 2
Based on Ashley Furniture’s last earning report, the most likely conclusion about its
reported earnings will be:
o A
unbiased.
o B
biased downward.
o C
biased upward.
Incorrect
C is correct. By reporting early revenues and including one-time inflows, the earnings
report of Ashley Furniture will show an upward bias relative to its core earnings.
3. Question 3
Which valuation model is Tahir most likely using?
o A
Absolute value model.

o B
Relative value model.

o C
Breakup value model.

Incorrect
A is correct. Tahir uses the absolute valuation model that is applied to estimate an
asset’s intrinsic value. One of the most important types is the discounted cash flow
models applied by Tahir.
Discounted Dividend Valuation

1. Question 1
Q-Code: 21-L2-EQ-DDVA-74679
Sarah Hamid discusses different equity valuation and security selection approaches
with her boss, Ali Hussain. Hussain makes the following comments:
i. A company’s sustainable growth rate is based on an assumption of growth

through internally generated funds. It is useful as it approximates the average rate
growth rate of dividends over a long horizon.
ii. Free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) are both
effected by a change in the company’s financial leverage.
iii. Abnormally high ROEs are not likely to persist due to competition, changes in
demand or innovations in technology.
Which comment is least likely accurate?
o A
Comment related to sustainable growth.

o B
Comment related to free cash flow.

o C
Comment related to ROE.

Incorrect
B is correct. Changes in financial leverage effects free cash flow to equity not free
cash flow to the firm.
2. Question 2
E-For-Life, a beverage company, sells vitamin water and other vitamins and minerals
enhanced beverages. It paid a $1.00 dividend last year that is expected to grow at
15% annually for the next three years. At the end of Year 3, the dividend is expected
to be 30% of EPS and the trailing P/E to equal 15. The terminal value of E-For-Life
stock is closest to:
o A
$52.
o B
$49.
o C
$76.
Incorrect
C is correct.
Time Dt or Vt
1 D1 = 1.00(1.15)= 1.15
2 D2 = $1.00 ( 1.15 )2 = $ 1.323
3 D3 = $1.00 ( 1.15 )3 = $ 1.521
V3 = 15 x ( 1.521 / 0.3 ) = $ 76.05
3. Question 3
Berry Berry Ltd. currently pays a dividend of USD5. The current growth rate is 15%
which is expected to decline linearly to a perpetual growth rate of 5% over the next
10 years. The cost of equity is 10%. The current value of the stock is closest to:
o A
USD165.
o B
USD145.
o C
USD155.
Incorrect
C is correct. Using the H Model, the value
is 5×(1+0.05)/(0.1−0.05)+5×(10/2)×(0.15−0.05)/0.1−0.05) = $155.
4. Question 4
Airmiles Ltd. paid a dividend of USD2 last year. Its earnings and dividends are
expected to grow by 20% for the next three years after which growth is expected to
decline linearly to 5% over 6 years. The company’s cost of equity is 9%. Its current
value is closest to:
o A
$107.5.
o B
$115.6.
o C
$65.2.
Incorrect
A is correct. Using the three-stage DDM, the cash flows are:
Year 1 2 3
Dividend 2.4 2.88 3.46
Value using H 3.46 x (1 + 0.05) / (0.09 – 0.05) + (3.46x(6 / 2)
Model x (0.2 – 0.05) / (0.09 – 0.05) = 129.75
Total 2.4 2.88 133.21
Present Value at
2.20 2.42 102.86
9%
Total PV $107.48
5. Question 5
Lothric Co. recently paid a dividend of USD8 which has been growing at a rate of
15%. The growth is expected to decline linearly to 5% over the next 5 years and
remain at that level indefinitely. The stock is currently trading at USD125. The
implied cost of equity is closest to:
o A
12.8%.
o B
14.6%.
o C
13.3%.
Incorrect
C is correct. Using the H Model, the required return is calculated as ( 8 / 125 ) x [ 1.05
+ ( 5 / 2 (0.15 – 0.05)] + 0.05 = 13.32\%.
6. Question 6
Mandose Electrical has grown at an average rate of 9% over the last ten years. The
company’s ROE is 15% and it pays 20% of its earnings as dividends. The sustainable
growth rate is closest to:
o A
8%.
o B
12%.
o C
15%.
Incorrect
B is correct. The retention ratio is b = 1 – 0.2 = 0.8. The sustainable growth rate is
ROE x b = 15% x 0.8 = 12%.
7. Question 7
The following data relates to Ingrain Chemicals:
Retention ratio 60%

Net profit margin 8%
Asset turnover 1.5
Equity/Total Assets 0.8
The company’s sustainable growth rate is closest to:
o A
9.6%.
o B
15.0%.
o C
9.0%.
Incorrect
C is correct. The company’s ROE is given as Net profit margin x Total asset turnover x
Total assets/equity. Hence ROE is 8% x 1.5 x (1/0.8) = 15%. Sustainable growth rate is
ROE x Retention ratio = 15% x 0.6 = 9.0%.
8. Question 8
ABC Ltd. is currently trading at USD40/share. The analyst estimates its intrinsic value
as USD30 using relative valuation and USD45 using DDM. The stock is:
o A
Overvalued according to DDM and undervalued according to relative

valuation.
o B
Overvalued according to relative valuation and undervalued according

to DDM.
o C
Overvalued according to relative valuation and fairly valued according to

DDM.
Incorrect
B is correct. Since the value according to relative valuation is lower than the stock
price, the stock is overvalued. But the intrinsic value according to DDM is higher than
the stock price, hence the stock is undervalued.
9. Question 9
Uzma Bukhari, director research at MNZ Investment Bank, informs Zehra Rabbani,
senior equity analyst, that Pascal Enterprises is contemplating selling one of its major
manufacturing facilities. If that happens, the company will pay a series of special
dividends in each of the three years following the sale. Bukhari asks Rabbani how
she would incorporate that possibility in the valuation of Pascal’s shares.
The best response to Bukhari’s query about Pascal’s valuation in view of the possible
sale of its manufacturing facility is to use:
o A
the Gordon growth model to measure the decline in firm value after the sale.
o B
a spreadsheet model that would value the special dividend pattern.

o C
a two-stage model to incorporate the change in dividends.

Incorrect
B is correct. Gordon growth model and multistage models are based on “stylized”
patterns of dividends growth. But spreadsheet models can value any assumed
dividend pattern easily.
10. Question 10
Lehman and Darry Co. currently pays no dividends. It is expected to have earnings of
USD10 per share in ten years’ time. Its expected dividend payout ratio in ten years
will be 60% and dividends are expected to grow at a stable rate of 4% thereafter. The
cost of equity is 8%. The value of the stock today is closest to:
o A
USD150.
o B
USD109.
o C
USD75.
Incorrect
C is correct. Dividend in year 10 is $10 x 0.6 = $6 per share. Using the Gordon growth
model, Vn = Dn + 1 / r – g the value in year 9 = 6 / (0.08 – 0.04) = USD150. The present value
is the value of stock today (using FC) = USD75.04. [N = 9; 1 / Y = 8; PMT = o; FV =
150;CPT PV].
11. Question 11
Della Simms is valuing the stock of General Chemical, a leading global company
specializing in the manufacture of PTA. Simms compiles the data shown below to
conduct a justified (fundamental) P/E analysis.
Expected long run dividend growth rate 4.0%

Dividend payout ratio 32%
General Chemical’s stock’s beta 0.856
General Chemical’s current EPS $20.54
Required return on equity 7.2%
Market data
Risk-free rate 2.50%
Expected market return 8.00%
Using the data given above, General Chemical’s justified trailing P/E is closest to:
o A
10.4.
o B
10.0.
o C
22.1.
Incorrect
A is correct. The justified trailing P/E is: (1 – b)(1 + g)/(r – g) = (0.32)(1.04)/(0.072 – 0.04)
= 10.40.
12. Question 12
Amina Inam, CFA, is an analyst for an equity firm and is covering Quality Tables, a
furniture manufacturing company. Quality Tables recently issued a dividend of €3
and Inam believes that this dividend will grow at a rate of 10% for the next 5 years.
After that, she expects the growth to slow to 4% per year, indefinitely. One share in
Quality Tables is currently trading at €49.50 and Inam estimates its return on equity
to be 11%. Given this information, the current value of a Quality Tables share
is closest to:
o A
€47.14.
o B
€57.15.
o C
€71.71.
Incorrect
B is correct. The analyst expects the dividend to grow at 10% for the next 5 years and
then 4% forever after that. Starting with €3, this is what the dividends are predicted
to be over the next few years:
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

3(1.1) = 3.30(1.1) = 3.63(1.1) = 3.99(1.1) = 4.39(1.1) = 4.83(1.04)
3.30 3.63 3.99 4.39 4.83 = 5.02
We can use the Gordon growth model once the growth rate is sustainable, so year 6
onwards. Using the Gordon Growth model and the predicted value of the dividend in
year 6, we get the present value of all year 6 onwards future dividends, at year 5:
Value of future dividends from year 6 and onwards = 5.02/(0.11 – 0.04) = 71.71
Since the €71.71 is at year 5, we can add that to the year 5 predicted dividend when
calculating the present value of all the dividends. The following calculations show the
computation of the present value of the dividends using a discount rate of 11%:
Value of Quality Tables stock = PV of future dividends = (3.3/1.11) + (3.63/1.112) +
(3.99/1.113) + (4.39/1.114) + (4.83 + 71.71)/1.115 = 57.15
This calculation can also be done using the cash flow keys on a financial calculator.
(Recommended approach on the exam)
CF0 = 0, CF1 = 3.3, CF2 = 3.63, CF3 = 3.99, CF4 = 4.39, CF5 = 4.83 + 71.71, I = 11, CPT
NPV = 57.15
13. Question 13
Trimax mining is a profitable company that is expected to pay a $5 dividend next
year. Because it is depleting its mining properties, the best estimate is that dividends
will decline forever at a rate of 3%. The required rate of return on Trimax stock is
11%. The value of Trimax shares is closest to:
o A
$35.71
o B
$62.50
o C
$34.64
Incorrect
Solution: A is correct. For Trimax, the value of the stock is,
V0 = 5/[ 0.11 − (−0.03)] = 5/0.14
= 35.71.�ℎ��ℎ��35.71 valuation for
the stock.
14. Question 14
The perpetual preferred stock of York Company has a par value of $50 per share and
pays an annual dividend of 4.5%. York estimates a capitalization rate at 5%. The
current market price of York Company preferred stock is most likely:
o A
$42
o B
$45.
o C
$90
Incorrect
Solution: B is correct. The value of a non-callable, fixed-rate, perpetual preferred
stock is:
Vo = 50*0.045 / 0.05 =$45
15. Question 15
For a security with a current dividend of 2,��25, and an
expected short-term growth rate of 11% linearly declining over 10 years to 5%, the
expected rate of return would be closest to:
o A
15.8%
o B
11.2%
o C
13.2%
Incorrect
A is correct. Expected return for the H-model would be calculated using the following
equation:
r = (Do / Po[(1 + gL )+ H (gs – gL)] + gL
r = ( 2 /25)[(1 + 0.05) + 5(0.11 – 0.050}] + 0.05
=15.8%
16. Question 16
In which phase of the life cycle, the company reaches an equilibrium wherein
investment opportunities on average just earn their opportunity cost of capital?
o A
Growth phase
o B
Transition phase
o C
Maturity phase
Incorrect
Solution: C is correct. In maturity, the company reaches an equilibrium in which
investment opportunities on average just earn their opportunity cost of capital.
Return on equity approaches the required return on equity. The earnings growth,
the dividend payout ratio, and the return on equity stabilize at levels sustainable in
the long term.
17. Question 17
Company B has an ROA of 11 percent, but it retains two-thirds of earnings and has
an equity multiplier of 1.25. Its sustainable growth rate is closest to:
o A
9.17%
o B
4.58%
o C
5.87%
Incorrect
A is correct. Company B’s sustainable growth is expressed as:
g = (2/3) × 11% × 1.25 = 9.17%.
18. Question 18
The dividend growth rate implied in the stock price of Company A is 5% which is
greater than the growth rate of 3% assumed by the analyst. This suggests that
Company A stock is most likely:
o A
overvalued.
o B
undervalued.
o C
Fairly valued.
Incorrect
Solution: A is correct. The dividend growth rate implied in the stock price of
Company A (i.e., 5%) is greater than the growth rate assumed by the analyst (i.e., 3%),
suggesting that Company A is overvalued.
19. Question 19
The stock of Casa Inc. currently trades at USD80. Its recent earnings and dividends
are USD10 and USD6 respectively. The required rate of return is 9%. The implied
constant growth rate in dividends is closest to:
o A
1.2%.
o B
1.3%.
o C
1.4%.
Incorrect
C is correct. Using the Gordon growth equation:
[6(1+g)] / [0.09-g] = 80
6 + 6g = 7.2 – 80g
86g = 1.2
g = 1.40%
20. Question 20
Delta Inc. has the following earnings and dividend history:
2009 2010 2011 2012

Earnings per share $4.00 $5.50 $6.05 $6.66
Dividend per share $2 $2 $2 $2
o A
A dividend discount model is not suitable for valuation as dividends do

not follow earnings.
o B
A dividend discount model is suitable for valuation because dividends are

stable.
o C
A dividend discount model is not suitable for valuation as dividend payout

ratio is low.
Incorrect
A is correct. Dividend discount model cannot be applied because there is no relation
between earnings and dividends. Option B is incorrect because constant dividends
do not warrant an application of a dividend discount model if there is no
understandable relationship of dividends with earnings. Option C is incorrect
because a low payout ratio does not invalidate the application of a dividend discount
model.
21. Question 21
CRG is in the manufacturing industry. The company has found it difficult to pay
dividends over the years due to debt financing requirements. Moreover, even
though the company has been profitable over the last few years, its free cash flows
have been negative owing to large capital investment requirements. The debt
retirement over the years has made its capital structure quite volatile. Which of the
following is least likely true with respect to identifying a model to value the company?
o A
A dividend discount model is unsuitable.

o B
A free cash flow based model is unsuitable because free cash flows have
been negative despite profits.
o C
A free cash flow to equity model is suitable because the company’s

capital structure is volatile.
Incorrect
C is correct. Options A and B are true statements. Option C is not a true statement,
and hence the correct answer.
22. Question 22
A residual income model is least suited for:
o A
Companies with poor dividend-paying histories.

o B
Companies with negative free cash flows within the forecast period.
o C
Companies with poor quality of accounting disclosures.

Incorrect
C is correct. Residual income model will give erroneous results for companies with
poor quality accounting disclosures such that the determinants of residual income
model (book value and ROE) are not predictable. Options A and B state the criteria
for the application of the residual income model.
23. Question 23
Terra’s shares are currently priced at USD40. In one year the company is expected to
pay a USD5 dividend and the expected stock price after one year is USD36. The
required return is 8%. Terra’s shares are most likely:
o A
overvalued.
o B
undervalued.
o C
fairly valued.
Incorrect
A is correct. The dividend after one year is USD5 and the stock price would be
USD36. The present value of the shares is therefore: 5 + 36 / 1.08 = 37.96. At USD40,
Terra shares appear to be overvalued.
24. Question 24
Tescon Motors is expected to pay annual dividends of USD5, USD6 and USD7 at the
end of year 1, year 2 and year 3 respectively. The expected stock price at the end of
three years is USD105. The required return is 9%. The intrinsic value of the stock
is closest to:
o A
USD96.
o B
USD113.
o C
USD133.
Incorrect
A is correct. The intrinsic value is calculated as 5 / (1.09) + 6 / (1.09)2 + (7 + 105) /
(1.09)3 = $96.1.
25. Question 25
Alpha Corp has the following earnings and dividend history; the trend is expected to
last forever:
2009 2010 2011 2012

Earnings per share $8.00 $9.20 $10.60 $12.20
Dividend per share $2.40 $2.76 $3.18 $3.66
The company’s required return on equity is 11%. Which of the following
is most likely true?
o A
The Gordon growth model cannot be applied because the growth rate is
higher than the required rate.
o B
The Gordon growth model cannot be applied because there is no relation

between dividend and earnings.
o C
The Gordon growth model cannot be applied because the payout ratio is
greater than the required return.
Incorrect
A is correct. The Gordon growth model cannot be applied when the growth rate
(15% in this case) is higher than the cost of equity (11% in this case). Options B & C
are incorrect, because payout rate is constant thus dividends and earnings are both
growing at a constant rate of 15% and the payout ratio if greater than the required
return does not imply that the GGM cannot be applied.
26. Question 26
The following information is given for Beta Corp.:
Recent earnings $6
Payout ratio 30%
Expected annual growth rate 5%
Cost of equity 10%
The intrinsic value of the stock is closest to:
o A
$38.
o B
$126.
o C
$63.
Incorrect
A is correct. The recent dividend is 6 x 0.3 = 1.8. D1 is therefore 1.8 x 1.05 = 1.89.
Using the Gordon growth model, the intrinsic value is 1.89 / 0.1 – 0.05 = $37.8
27. Question 27
Frost Co. paid a dividend of USD8 last year. Earnings are expected to grow annually
by 9%. The payout ratio is expected to stay constant. The company’s cost of equity is
12%. The intrinsic value of the stock is closest to:
o A
$67.
o B
$291.
o C
$267.
Incorrect
B is correct. As payout ratio is constant, the growth rate of dividends would be same
as growth rate of earnings. D1 is therefore 8 x 1.09 = 8.72. The intrinsic value is 8.72 /
0.12 – 0.09 = USD290.67
28. Question 28
Which of the following situations is best suited for a discounted dividend valuation?
o A
Valuing a technology start-up for financing.

o B
Valuing a large, profitable confectioner that started out on a small scale

but is now the largest player in the market for portfolio investment.
o C
Valuing a tire manufacturer for a possible takeover.

Incorrect
B is correct. A discounted dividend valuation is most suitable for valuing a mature
company as the company is likely to have a history of dividends and the valuation is
from a minority shareholder’s perspective. Start-ups do not have a dividend history
and dividend based models are not suitable for valuing acquisitions.
29. Question 29
Boswaq Ltd. currently trades at USD66 per share. The recent dividend was USD2 and
the required rate of return is 10%. Which of the following is true?
o A
The stock is undervalued if its actual growth rate is less than 6.76%.
o B
The stock is overvalued if its actual growth rate is greater than 6.76%.
o C
The stock is undervalued if its actual growth rate is greater than 6.76%.
Incorrect
C is correct. Using the Gordon growth equation 2 ( 1 + g ) / 0.1 – g = 66; 2 + 2g = 6.6 –
66g: 68g = 4.6:6.76%. The implied growth rate is 6.76% therefore if the actual growth
rate is greater than 6.76%, the stock is undervalued.
30. Question 30
Safeway Inc.’s shares currently trade at USD80. It is expected to have average
earnings of USD7 per share next year, and earnings are expected to grow by 6%. The
required rate of return is 10%. If price reflects value, then PVGO is closest to:
o A
USD5.8.
o B
USD10.0.
o C
USD8.0.
Incorrect
B is correct 80 = E / r + PVGO: 80 = 7 / 0.1 + PVGO : PVGO = $10.
31. Question 31
Bestway Inc.’s shares trade at USD65. Its expected average earnings are USD6 a
share and the required rate of return is 11%. The growth component of the leading
P/E is closest to:
o A
1.74x.
o B
1.94x.
o C
1.63x.
Incorrect
A is correct.
The leading P/E is calculated as: P0/E1 = [1/r] + [PVGO/E1]
where, 1/r captures the no-growth component of P/E and PVGO/E1 captures the
growth component of the P/E
PVGO is computed as: PVGO = P0 – E1/r = 65 – 6/0.11 = USD 10.45
The growth component of P/E can then be calculated as: 10.45/6 = 1.74x.
32. Question 32
Parma Ltd.’s recent annual earnings were USD8 a share and current annual dividend
per share is USD4.8. Its earnings and dividends are expected to grow by 8%. The
company operates in the technology sector therefore has a high beta of 1.7. The risk
free rate is 3% and the equity risk premium is 5%. The company’s stock trades at
USD115. Its justified leading P/E ratio is closest to:
o A
13.3.
o B
17.1.
o C
14.2.
Incorrect
B is correct. The payout ratio is 4.8/8 = 0.6; the retention ratio (b) is 1 – 0.6 = 0.4. The
required return is 3\% + (1.7 x 5\%) = 11.5\%. The justified leading P/E ratio is given as
(1 – b) / (r – g) = (1 – 0.4) / (0.115 – 0.08) = 17.14.
33. Question 33
Brigand Publishers has preferred stock outstanding which carries a dividend of 8%
per annum based on a par value of USD100. The dividends for its common stock are
expected to grow at 3% per annum. The company’s cost of preferred equity is 9%.
The value of its preferred stock is closest to:
o A
91.6.
o B
88.9.
o C
137.3.
Incorrect
B is correct. The value of preferred equity is calculated as DP/rP = 0.08 x 100 / 0.09 =
USD88.89/share.
34. Question 34
Which of the following is a potential weakness of the Gordon growth model ?
o A
It is not applicable for valuing stable and mature dividend-paying companies.

o B
It cannot be used to value broad equity market indices.

o C
The model cannot be applied to non-dividend paying stocks.

Incorrect
C is correct. A potential weakness of the Gordon growth model is that it is not
appropriate for non-dividend paying stocks. Options A & B are NOT a weakness, but
the conditions for the application of the GGM.
35. Question 35
Xantex Ltd. is experiencing high earnings growth. The company needs to make
significant capital investments to support earnings growth due to which its free cash
flows are negative and dividends are not declared. Which life-cycle phase is the
company most likely in?
o A
Growth phase.
o B
Transition phase.
o C
Mature phase.
Incorrect
A is correct. The growth phase is characterized by high earnings growth, high capital
investments and usually low or no dividends.
Amir Lakhani is a junior equity analyst at Ordingam Securities. He has been asked to
prepare a research report for Thomas Crown, PLC, a tourism company and give
recommendation about its stock. Thomas Crown, is a small-cap publicly traded company
that pays dividends regularly. Following is the 2015 year-end selected financial data of the
company in ₤ millions:
Net Income 90
Dividends 36
Total Assets 1,015
Common Stock (70 million shares outstanding) 600
Retained earnings 171
CAPM derived required rate of return 10.5%
Lakhani uses the Gordon growth model to calculate the intrinsic value of Thomas Crown.
Lakhani’s manager reviews the calculations and suggests that Lakhani should use the H-
model to account for the anticipated growth in revenues over the next six years. Lakhani
incorporates the following inputs into the H-model computations:
• A short-term growth rate of 18% and after six years, a 6% constant growth rate
• An addition of a small-firm risk premium of 1.5% to the rate of return on the stock
1. Question 1
Based on the Gordon growth model and the 2015 data collected by Lakhani, Thomas
Crown’s intrinsic value per share as of 2015 is closest to:
o A
₤15.72.
o B
₤9.21.
o C
₤10.33.
Incorrect
A is correct. Using the Gordon growth model, V0 = D0 (1 + g)/(r – g).
g = b × ROE
b = 1 – Payout ratio = 1 – (36 / 90) = 0.6
ROE = Net income / Shareholders’ equity = 90 / (600 + 171) = 11.67%
g = 0.6 × 11.67% = 7.00%.
D0 = ₤36 million / 70 million shares = ₤0.5143/share
V0 = 0.5143(1 + 0.07) / (0.105 – 0.07) = ₤15.72.
2. Question 2
Using Lakhani’s estimates for growth and required return on the stock, the intrinsic
value per share of Thomas Crown’s stock as of 2015 based on H-model is closest to ?
o A
₤15.6.
o B
₤12.2.
o C
₤9.01.
Correct
B is correct. The H-model is:
Vo = Do ( 1 + gL ) + DoH (gs – gL ) / r – gL
D0 = ₤36 million / 70 million = ₤0.5143/share
gS = Initial short-term dividend growth rate = 18%
gL = Normal long-term dividend growth rate = 6%
r = 10.5% + 1.5% = 12%
H = 6 / 2 = 3.
V0 = [0.5143(1.06) + 0.5143 x 3 (0.18 – 0.06)] / (0.12 – 0.06) = ₤12.17.
Karen Dobson, an equity analyst for an investment company, is currently evaluating the
stocks of two companies for possible selection in the company’s large-cap fund. Selected
data for the stocks is given below.
TLC GRS
EPS ($) DPS ($) EPS ($) DPS ($)
2016 4.50 2.70 7.65 3.83
2012 3.56 1.42 5.73 2.86
Current market price $110.30 $126.70
Return on common equity 25.00% 26.20%
Beta 0.95 1.22
Required rate of return on common
9.18% 10.93%
equity
Equity risk premium for common shares 6.50%
US GDP real growth rate 3.40%
US inflation rate 2.20%
Note: DPS is dividends per share and EPS is earnings per share.
Dobson calculates the sustainable growth rate using the most recent year’s retention ratio
for TLC. However, Dobson concludes that it is not feasible to apply the Gordon growth
model for TLC’s analysis. Dobson next estimates TLC’s growth rate of earnings over the
period 2012 to 2016 and compares it with the current US nominal GDP growth rate. Looking
at the dividend payout history Dobson finds that the payout ratio has gradually increased
over the last five years. Consequently, Dobson classifies TLC in the transition stage of
growth. Finally, Dobson calculates the intrinsic value of GRS using the Gordon growth model
based on 2016 data and the dividends’ growth rate over the past five years rather than the
sustainable growth rate.
1. Question 1
Based on the information given above, is Dobson correct in her conclusion about the
use of Gordon growth model to value TLC?
o A
Yes, because the required rate of return on equity is less than the
expected growth rate.
o B
Yes, because the sustainable growth rate is greater than the U.S. GDP growth
rate.
o C
Yes, because the required rate of return on equity is greater than the U.S.
GDP growth rate.
Incorrect
A is correct. Dobson decides that expected growth rate estimate for TLC is the
sustainable growth rate. The Gordon growth model is not applicable if r is less than
g. For TLC, r = 9.18% and sustainable growth rate ‘g’ is given by: b2016 x ROE2016 = (1 –
2.70/4.50) x 0.25 = 10.0%.
2. Question 2
Dobson’s classification of TLC in the transition phase is most likely:
o A
correct.
o B
incorrect, because the company is in the supernormal growth phase.

o C
Incorrect, because the company is in mature phase.

Incorrect
A is correct. It is reasonable to say that TLC is in a transition phase because the
dividend payout ratio has increased and the earnings growth rate is declining
towards the overall economy growth rate of 5.60% (3.4 + 2.2). TLC’s compound
earnings growth rate over 2012 – 2016 = (4.5 / 3.56)1/4 – 1 = 6%. The dividend payout
ratio has increased from nearly 40% in 2012 to 60% in 2016.
3. Question 3
If the fund is allowed to take either long or short positions in shares identified as
mis-valued, then based on the data above and Dobson’s method of valuation of GRS
shares, the most appropriate conclusion about selection of GRS shares is that the
large-cap fund should:
o A
take a short position in GRS.

o B
take no position in GRS

o C
take a long position in GRS.

Incorrect
A is correct. The dividend growth rate over the period 2012 – 2016 = (3.83/2.86)1/4 – 1
= 7.57% ≈ 7.6%. Using the Gordon growth model, GRS intrinsic value =
3.832016 (1.076)/(0.1093 – 0.076) = USD123.756. The current market price is
USD126.70 which is higher than the intrinsic value, hence GRS shares are overvalued
and a short position should likely be taken.
Selena Reddick works as senior analyst at Delacour Investments, which is considering

buying a controlling interest in HYT-Tech, a closely held company, that pays infrequent
dividends lower than the free cash flow from equity. HYT-Tech has robust cash flows with
positive growth potential and holds key patents which, according to Reddick, are not fully
reflected in HYT’s balance sheet. She asks Nicki Hernandez, a junior analyst, to select the
appropriate valuation method for its shares. Reddick also must value HYT’s privately held
non-callable perpetual preferred stock, as a potential investment. The stock pays a fixed
annual dividend of $9.50. Reddick decides to use an equity risk premium of 6% after
analyzing the stock for its valuation.
1. Question 1
Based on the information given above, the most appropriate method to value HYT’s
common equity is:
o A
the dividend discount model.

o B
the residual income model.

o C
the free cash flow to equity approach.

Incorrect
C is correct. The free cash flow to equity is the suitable approach when the investor
wants to take a control perspective and dividends are infrequent and they either
exceed or fall short of the free cash flow to equity.
2. Question 2
Using a 3.0% risk-free rate, Reddick’s estimate of HYT’s preferred stock value
is closest to:
o A
$316.0.
o B
$105.6.
o C
$30.5.
Correct
B is correct. The value of the non-callable fixed-rate perpetual preferred stock is
given by D / r = 9.50/ (0.03 + 0.06) = USD105.56.
Suroor Behram is a junior analyst at GK Asset Management Company in UK. She is analyzing
H&L, a clothing and accessories firm with global sales, headquartered in Sweden. Behram
estimates H&L’s sustainable growth rate based on the information given in Table 1.
Table 1: Selected financial information of H&L (€ millions) 2016

Sales 20,318
Net income 2,188
Dividends 656.4
Common shares outstanding 1,641
Total assets 21,439
Common Equity 14,505
Behram examines H&L’s growth potential and expects the expansion to follow three distinct
stages of growth. The growth rate of 18% in the first stage to last from 2017-2019, followed
by 10% from 2020-2022, and 6% beyond 2022. She also estimates 12% as the long-term
return on equity (ROE) for the stock, and 11.5% as its required rate of return. Based on
these estimates, she determines H&L’s intrinsic value using the DDM.
1. Question 1
Using the information given in Table 1, H&L’s sustainable growth rate is closest to:
o A
4.50%.
o B
10.00%.
o C
10.56%.
Incorrect
C is correct. Using the Prat method:
Sustainable growth rate = retention ratio x profit margin x asset turnover x financial
leverage
g = (2,188 – 656.40) / 2,188 x 2,188 / 20,318 x 20,318 / 21,439 x 21,439 / 14,505 =
10.56%
Alternatively, g = retention ratio x ROE = (1 – 656.4/2,188) x 2,188 / 14,505 = 10.56%.
2. Question 2
Based on Behram’s growth estimates and the information in Table 1, the terminal
value component of H&L’s intrinsic value at the end of 2016 is closest to:
o A
€8.77.
o B
€16.84.
o C
€7.86.
Incorrect
A is correct. Dividend2016 = €656.4 million/1,641 million = €0.40/share. The value of the
dividend when it enters its terminal growth stage.
Dividend Behavior during the Three Growth Periods

Period of growth Formula Value
First 0.40 × (1.18)3 0.6572
Second 0.6572 × (1.10)3 0.8747
Third All future growth at 6%
The present value of all future dividends beyond 2022 can be determined using the
growing perpetuity formula:
growing perpetuity formula.
V2022 = 0.8747 (1.06)/ (0.115 – 0.06) V2022 = €16.8579 = 16.86
The present value as of 2016 of this terminal value V2016 = 16.86/ (1.115)6 =
is: €8.77
3. Question 3
In the final stage of a three-stage model, Behram used an estimate of H&L’s dividend
growth rate of 6%, this is most likely based on the retention ratio of:
o A
70%.
o B
50%.
o C
40%.
Correct
B is correct. using the expression g = retention ratio x ROE. Hence retention ratio g /
ROE = 6% / 12% = 0.5 or 50%.
Indie Melanez, a domestic equity analyst who is evaluating a frozen foods/vegetables

company, Robins Eye, Inc. currently trading on NASDAQ at $33.33 per share. The
competition in the industry is high and it has been growing at the GDP rate for several years.
Robins Eye has achieved success in the rapidly growing vegetable/prepared food category,
which has been gaining about 1.5% of share annually within the broader frozen foods
industry. The company has expanded rapidly in recent years and its future sales growth
outlook exceeds 15%, with profit margins rising above the level of its competitors. Melanez
predicts short-term earnings growth of 18% in 2017 for Robins Eye, with the growth rate
linearly declining over the next four years. In Year 5, the long-term growth rate will be
equivalent to the current industry sustainable growth rate. Melanez terms the frozen foods
industry as mature. She uses the required return and industry’s dividend yield as inputs in
valuation. Selected financial information of the company is given in the table below for the
year ending December 2016.
Robins Eye Industry Average

Return on equity (%) 25 13
Earnings per share (EPS) ($) 3.00 n/a
Dividend payout ratio (%) 20 60
Required return (%) n/a 10
Trailing dividend yield (%) 1.8 2.7
1. Question 1
Which of the following growth stages best applies to Robins Eye?
o A
Growth.
o B
Transition.
o C
Mature.
Incorrect
A is correct. Robins Eye is in the growth stage because it is expanding rapidly and
enjoying the benefits of the a rapidly growing market. Robins Eye has shown profit
margins higher than its competitors and abnormally high earnings per share growth,
reflecting that the company is in its growth phase.
2. Question 2
Using the information given above and data in the table, the expected rate of return
based on the H-model is closest to:
o A
10.0%.
o B
7.6%.
o C
5.2%.
Incorrect
B is correct. The H-model is given by the following expression:
r = [D0 / P0] [(1 + gL) + H (gS – gL)] + gL
H = Half-life in years of the super-normal growth rate = 4 x 0.5 = 2.0
D0 = 3.00 × 0.20 = USD0.60
gL = Sustainable growth rate for the industry = ROE × (1-payout) = 0.13 × (1 – 0.60) =
5.20%
gs = Short-term growth rate of Robins Eye = 0.18
r = (0.6/33.33) [(1.052) + 2 (0.18 – 0.052)] + 0.052 = 7.55%.
3. Question 3
Using the Gordon growth model, Melanez’s industry assumptions and the data from
the table above, Robins Eye’s implied long-term dividend growth rate is closest to:
o A
7%.
o B
6%.
o C
5%.
Incorrect
A is correct. Using the Gordon growth model V0 = D0 (1 + g)/(r – g). let D0 / P0 = d
(dividend yield). r – g = d (1 + g). Hence r – d = g (1 + d). g = (r – d)/(1 + d). Therefore,
using the industry information g = (0.10 – 0.027) / 1.027 = 7.108%.
Bridgette Cooper is analyzing the investment potential of Betty Cook Cakes & Breads (BCCB).
She makes the following notes and assumptions for BCCB:
• The company last year paid a dividend of $3.00. BCCB has maintained a long
consistent history of dividend payments.
• A decline in earnings of 1% every year permanently.
• A required return of 8.0% for the company for a beta of 0.71.
Cooper then discusses different valuation approaches with her colleague, Betty Brown.
• Cooper: Free cash flow valuation is appropriate for investors who want to take a
control perspective. Also, free cash flow to equity represents cash flow that can be
distributed outside the company without impairing the company’s capital
investment.
• Brown: The Gordon growth model is based on future dividends that are expected to
be paid indefinitely. The model value is sensitive to small changes in the assumed
growth rate and required rate of return.
• Cooper: We can use the residual income approach as it’s not based on book values
and hence does not require that the clean surplus relationship holds.
1. Question 1
Regarding the discussion on valuation methods, which comment is least likely correct
?
o A
Comment regarding FCFE.

o B
Comment regarding Gordon growth model.

o C
Comment regarding residual income.

Incorrect
C is correct. The residual income approach is based on the book value of equity and
present value of future residual earnings. It requires that the clean surplus
relationship holds.
2. Question 2
Given Cooper’s notes, BCCB’s intrinsic value is closest to:
o A
$33.0.
o B
$42.9.
o C
$40.4.
Incorrect
A is correct. Using the Gordon growth model V0 = D0 (1 + g)/ (r – g). V0 = 3 (1- 0.01) /
{0.08 – (-0.01)} = USD33.00.
Zaina Dinshaw, a research analyst at Orix Securities, is valuing the stock of SLT Corporation,
a glass manufacturer. Its 2016 EPS was USD1.75 and forecasted EPS for 2017 is USD2.05.
However, Dinshaw disagrees with the EPS forecast and believes that earnings growth in
2017 and 2018 will be 19% each year and will fall sharply thereafter because of intense
competition. Hence earnings growth beyond 2018 will be only 3% per year. Dinshaw further
estimates SLT’s dividend payout ratio of 40% for the foreseeable future. Finally, based on
another model, Dinshaw determines the company’s required rate of return on equity as
14.5%. Selected information is given in Table 1.
Table 1: 31 December 2016 Market Data for SLT Corp. and Industry Averages
SLT Corp Industry Average
Market price USD25.45 n/a
Beta (relative to broad market index) 1.25 0.95
Market risk premium 6.50%
1. Question 1
Based on the EPS forecast of USD2.05 and information given in Table 1, present
value of growth opportunities (PVGO) as of 31 December 2016, is closest to:
o A
USD23.64.
o B
USD9.83.
o C
USD12.17
Incorrect
B is correct. Using the formula: V0 = E1 / r + PVGO. V0 = USD25.45, E1 = 2.05; the
required return on equity based on CAPM = 5% + 1.25 x 6.50% = 13.125%. Thus
PVGO = V0 – E1/r = 25.45 – 2.05/13.125% = USD9.83.
2. Question 2
Using a required return of 14.5%, earnings per share of USD1.75, and Dinshaw’s
growth estimates, the intrinsic value of SLT’s stock is closest to:
o A
$14.05.
o B
$6.80.
o C
$8.30.
Incorrect
C is correct. Using Dinshaw’s assumption and the two-stage dividend discount
model:
2017 2018 2019

USD1.75 × 1.19 = USD2.083 × 1.19 = USD2.48 × 1.03 =
Earnings
USD2.08 USD2.48 USD2.55
USD2.08 × 0.40 = USD2.48 × 0.40 = USD2.55 × 0.40 =
Dividends
USD0.83 USD0.99 USD1.02
Terminal value at USD1.02/(0.145 – 0.03)
2018 = USD8.87
Values to be USD8.87 + 0.99 =
USD0.83
discounted to 2016 USD9.86
Value = (0.83 / 1.145) + (9.86 / 1.1452) = $8.25
In January 2017, George Arnold, an equity analyst, is valuing a publicly listed company, HNG
Paints Limited, a UK- based paint, coatings, adhesives and sealants manufacturer. Selected
financial information for 2016 is given below:
Net income ₤400 million

Number of shares outstanding 100 million
Weighted average cost of capital 10.3%
Cost of debt, before tax 6.0%
Cost of equity capital 13%
Expected dividend growth rate:
Expected for 2017 12%
After 2017, dividend growth rate declines linearly over a 6-year period
The final and perpetual growth rate: 6%
Estimated earnings per share (EPS) in 2022 ₤6.40
Arnold’s colleague, Ross Edwards, asks, “You have used a sustainable growth rate of 6%,
following the supernormal growth period. Is that because the sustainable growth model
assumes the company will require:
i. external debt financing,
ii. financing by equity issuance, and
iii. increasing its return on equity?”

1. Question 1
Based on the H-model, the per share value of HNG Paints is closest to:
o A
₤28.34.
o B
₤45.33.
o C
₤29.71.
Incorrect
A is correct. The value per share given by the H-model is:
V0 = D0{(1 + gL) + H(gS – gL)} / ( r – gL). D0 = 400 mil x 0.4 / 100 mil = ₤1.60 per share; r =
cost of equity = 13%, H = half-life in years of supernormal growth = 6 / 2 = 3; gL =
long-term growth rate after year 2 = 6%; H = 6.0%; gS = initial short-term growth rate
= 12%;
V0 = 1.6 {(1.06) + 3(0.12 – 0.06)} / (0.13 – 0.06) = ₤28.34.
2. Question 2
Regarding the assumptions about sustainable growth, Edwards is most likely correct
with respect to:
o A
external debt capital financing.

o B
equity issuance.
o C
increasing ROE.
Incorrect
A is correct. The sustainable growth rate model assumes that the growth will be
financed with the external debt capital and only reinvested earnings will be used to
maintain a target capital structure. No additional common equity will be issued. The
ROE is assumed to be a constant during this period.
3. Question 3
Edwards further asked Arnold about the present value of growth opportunities
(PVGO) in 2022 when the perpetual growth period begins.
The PVGO value after perpetual growth begins will be closest to ?

o A
₤10.5.
o B
-₤10.5.
o C
₤49.2.
Correct
B is correct. The no-growth value per share in 2022 = 6.40/0.13 = ₤49.23. Perpetual
growth g = 6%
Value as a perpetual growing stream (i.e., using the Gordon growth model): V0 = D1 / (r
– g) = 6.40 x 0.40 (1.06) / (0.13 – 0.06) = ₤38.7657. PVGO = PVGrowth – PVNo Growth = 38.77 –
49.23 = – ₤10.46.
Free Cash Flow Valuation

1. Question 1
Q-Code: 21-L2-EQ-FCFV-74702
John estimates the equity value of Novelty Fibers using both FCFE and FCFF
approaches. Based on FCFE the value is estimated to be USD58 whereas using FCFF
the value is estimated to be USD65. The stock is currently trading at USD61. The
stock is:
o A
undervalued according to FCFE but overvalued according to FCFF.

o B
undervalued according to FCFF but overvalued according to FCFE.

o C
undervalued according to FCFF but fairly valued according to FCFE.

Incorrect
B is correct. The stock’s market price is higher than its FCFE value therefore it is
overvalued according to FCFE. Its market price is lower than the FCFF value therefore
it is undervalued according to FCFF.
2. Question 2
Analyst 1: Incorporating environmental, social, and governance (ESG) considerations
in valuation models can have a significant impact on company valuation.
Analyst 2: One way of incorporating qualitative ESG information is to adjust the cost
of equity by adding a risk premium.
o A
Analyst 1
o B
Analyst 2
o C
Both Analyst 1 and 2

Incorrect
Solution: C is correct. Incorporating environmental, social, and governance (ESG)
considerations in valuation models can have a significant impact on company
valuation. ESG factors can be quantitative or qualitative. Quantitative ESG
information is straight-forward to incorporate in a valuation model, for example, it
can be easy to estimate the fine resulting from environmental pollution.
In contrast, qualitative ESG information is more difficult to incorporate. One way of
doing this is to adjust the cost of equity by adding a risk premium. This method
however, requires judgment on part of the analyst to determine the amount of the
risk premium.
3. Question 3
Which of the following statements regarding non-operating assets is not true?
o A
Non-operating assets are usually segregated from the company’s operating

assets.
o B
They are valued separately.

o C
Their value is subtracted from the value of the company’s operating

assets to find firm value.
Incorrect
C is correct. Non-operating assets, such as excess cash and marketable securities,
noncurrent investment securities, and nonperforming assets, are usually segregated
from the company’s operating assets. They are valued separately and then added to
the value of the company’s operating assets to find total firm value.
4. Question 4
A potential problem with using net income as a proxy for FCFE is that it does not
account for:
o A
operating profit.
o B
fixed capital, working capital investment and net borrowings.

o C
Interest expense.
Incorrect
Solution: B is correct. Net income is a poor proxy for FCFE because it does not
account for fixed capital, working capital investment and net borrowings. This is
evident when we look at the following equation:
FCFE = NI + NCC – FCInv – WCInv + Net borrowing
5. Question 5
To calculate FCFE from FCFF:
o A
subtract after-tax interest expenses and add net new borrowing.

o B
add after-tax interest expenses and add net new borrowing.

o C
subtract after-tax interest expenses only.

Incorrect
Solution: A is correct. The following equation will be used:
FCFE = FCFF – Int(1 – Tax rate) + Net borrowing
6. Question 6
When forecasting FCFF and FCFE by forecasting the components of free cash flows,
which of the following assumptions are least likely made?
o A
Investments in fixed assets and working capital bear a constant relationship

to increase in sales.
o B
The growth rate for FCFF and FCFE will be constant.

o C
Capital structure remains constant.

Incorrect
B is correct. If one is forecasting FCFF and FCFE by forecasting their components,
then FCFF and FCFE will not grow at constant rates. That is the assumption of the
other method of free cash flow forecasting, where one uses historical growth rates
for FCFF and FCFE. Options A and C are correct because they both are assumptions
made using forecasts of the components of free cash flows to forecast FCFF and
FCFE.
7. Question 7
Robert Behr and Carrie Miller are discussing CTEC Mills’ announcement regarding a
dividend cut resulting in higher retained earnings. These funds will be used to
reduce the debt level over a four-year time period. Behr makes the following
observations regarding the company’s financial policy initiatives:
i. With a dividend cut, the return on equity (ROE) will increase.

ii. The free cash flow to the firm (FCFF) will be positively impacted since it will
increase due to a lower payout ratio.
iii. The free cash flow to equity (FCFE) will fall in the year when debt is repaid,
nevertheless it will increase in the following years.
Which of Behr’s comments is most accurate?
o A
Comment related to increase in ROE.

o B
Comment related to increase in FCFF due to lower payout ratio.

o C
Comment related to FCFE fall and subsequent rise in later years.

Incorrect
C is correct. Behr is correct with respect to his comment regarding the decline in
FCFE in the year when debt is paid down. However, in the later years, it will increase
because of the reduced interest expense.
8. Question 8
Babar Muhib asks his junior analyst Zulfi Hameed to use the highest and lowest
reasonable estimates for the single-stage FCFE growth model parameters: required
rate of return and sustainable growth. Hameed’s analysis is given as follows:
Table 1: Sensitivity Analysis to Model Parameters in Valuation of

Dunbar’s Common Shares
Per-Share Valuation Per-Share Valuation
Parameter
with Low Estimate with High Estimate
FCFE growth rate $35.89 $54.69
Equity risk premium $55.21 $35.81
Beta $50.00 $37.86
Note: The risk-free rate is 3.5% in all cases
Based on the analysis above, the parameter that causes the greatest sensitivity in
valuation of the firm’s common equity is:
o A
growth rate.
o B
equity risk premium.

o C
beta.
Incorrect
B is correct. When the high/low measure for each variable is tested individually for
sensitivity while holding all values at the base case level to calculate FCFE, equity risk
premium parameter produces the widest stock price range (using absolute values).
Valuation with Valuation with

Variables Valuation Range
Low Estimate High Estimate
Equity risk premium $55.21 $35.81 $19.40
Growth rate $35.89 $54.69 -$18.80
Beta $50.00 $37.86 $12.14
9. Question 9
Bashir Ahmed, senior analyst, instructs Munawar Maqsood, an intern, to calculate
the current intrinsic value of GTAM Textiles’ common equity using the single-stage
FCFE growth model for valuation based on the following information given in Table
1.
Normalized FCFE USD2.36

FCFE growth rate 0.06
Equity risk premium 0.075
Beta 1.15
Risk-free rate 3.5%
Using the data given above, the intrinsic value of the company calculated by
Maqsood is closest to:
o A
$38.5.
o B
$40.8.
o C
$19.50.
Incorrect
B is correct. The required return on equity is calculated using CAPM: r = 3.5% + 1.15 x
7.5% = 12.125%. According to the single-stage FCFE model, equity value = V0 = 2.36
(1.06)/(0.1213 – 0.06) = USD40.809.
10. Question 10
Saddiq Pipes has ambitious growth plans that will be financed by borrowing more
than it has in the past. The company intends to retire the debt within the next 10
years. Regarding the impact of this debt on the company’s valuation, the analysts
discussing Saddiq’s growth projections, make the following statements:
Statement i: Because the capital structure seems to be relatively unstable in the

future, it would be best to use free cash flow to equity (FCFE) since the value is more
direct.
Statement ii: I would prefer FCFF over FCFE. In forward-looking valuation, the
required return on equity may be more sensitive to changes in debt than changes in
weighted average cost of capital (WACC).
Statement iii: Whichever method we choose, the discount rate for future cash flows
should be the required return on equity because we are valuing common stock.
Which statement is most likely correct?
o A
Statement i.
o B
Statement ii.
o C
Statement iii.
Incorrect
B is correct. When the capital structure is expected to be relatively unstable, FCFF is
preferred. In a forward-looking scenario, required return on equity may be more
sensitive to changes in leverage than changes in WACC. The discount rate for FCFF is
WACC. The discount rate for FCFE is required return on equity.
11. Question 11
Sally Chau and Ross Lee are asked to calculate the free cash flow to the firm (FCFF) of
Widget Industries. They make the following statements:
• Chau: The advantage of starting from cash flow from operations (CFO) is that
we do not have to make adjustments for working capital.
• Lee: I suggest we use the company’s earnings before interest, taxes,
depreciation, and amortization (EBITDA) but remember to add in all the non-
cash charges on the income statement.
• Chau: Regardless of whether we begin with net income, CFO, or EBITDA, net
borrowing will have to be added.
The comment most likely correct regarding the calculation of FCFF is:
o A
adjustments to working capital.

o B
adding non-cash charges.

o C
adding net borrowing.

Incorrect
A is correct. CFO shows changes in working capital hence no adjustments is required.
EBITDA has non-cash charges of depreciation and amortization added to it. Net
borrowing is only added for FCFE calculation, not FCFF.
12. Question 12
Namrata Lal is a junior equity analyst evaluating QYS Industries and collects the
following financial data in € millions for year ending 31 December 2016:
Table 1: Income Statement Excerpts
EBITDA 545
Depreciation expense 120
Operating income 425
Interest expense 31.5
Income taxes 125.9
Net income 267.6
Table 2: Selected Balance Sheet Data
Net investment in fixed capital – for 2016 327.6

Net increase in working capital – for 2016 –3.6
2016 2015
Notes payable 40 30
Long-term debt 310.5 295.7
Common stock (100 million shares outstanding) 1,460 1,460
Lal uses a tax rate of 34%, instead of the company’s tax rate and estimates the FCFE.
Based on the data given above, the firm’s 2016 FCFE per share calculated by Lal
is closest to:
o A
€0.81.
o B
€1.01.
o C
€0.70.
Incorrect
A is correct. Using the expressions FCFF = EBITDA (1 – Tax rate) + Depreciation(Tax
rate) – FCInv – WCInv. FCFE = FCFF – Interest (1 – Tax rate) + Net borrowing. FCFF2016 =
545 (1 – 0.34) + 120 x 0.34 – 327.6 – (-3.6) = €76.5 million. To calculate FCFE, estimate
the net borrowings over 2016/15: (310.5 + 40) – (295.7 + 30) = €24.8 million. FCFE2016 =
76.5 – 31.5(1 – 0.34) + 24.8 = €80.51 million. Per share FCFE2016 = 80.51 mil/100 mil =€
0.8051.
13. Question 13
Given the following assumptions about GTEX Corporation the value of equity at 2016
year-end is closest to:
Free cash flow to the firm for 2017 USD387,000

FCFF’s annual growth rate in perpetuity 6%
GTEX’s debt holding at an interest rate of 7.0% per year USD860,000
GTEX’s weighted average cost of capital (WACC) 9.5%
GTEX’s cost of equity 12.0%
o A
USD5.6 million.
o B
USD10.9 million.
o C
USD10.2 million.
Incorrect
C is correct. Using the constant-growth FCFF model: Firm Value = FCFF1/(WACC – g);
FCFF2016 = 387,000/(0.095 – 0.06) = USD11,057,143. Equity Value = 11,057,143 –
860,000 = USD10,197,143.
14. Question 14
Sarah Bukhsh, senior analyst at JP Securities makes the following observations about
FCFF and FCFE:
i. One can rely solely on the cash flow from operations section of the cash flow
statement when determining FCFE.
ii. It is advisable to use FCFE rather than FCFF to value equity when a firm’s
capital structure is relatively stable as it’s simpler and direct.
iii. Compared to FCFF, FCFE is not suitable when a firm has low leverage and
positive FCFE.
Which of Bukhsh observations is most likely accurate?
o A
First.
o B
Second.
o C
Third.
Incorrect
B is correct. If a company’s capital structure is relatively stable, using FCFE is simpler
and more direct method of valuing equity than FCFF. A is incorrect because all
sections of cash flow statement are important to calculate FCFE. C is incorrect, FCFF
is preferred when a firm has significant leverage and negative FCFE.
15. Question 15
Richard Dudley is analyzing LARS Industries common stock. He estimates the
investor’s required return on equity as 11%, and from the company’s annual report
determines the expected payout ratio as 30%. Dudley gathers the following financial
data.
LARS Industries ($) values in millions

Net income $600 Investment in fixed capital $110
Depreciation $200 Investment in working capital $30
Tax rate 32% Net borrowing $96
Number of outstanding shares 100 million
Dudley’s Estimates
LARS’s
9.5% Dividend payout ratio 30%
ROE
Using the constant-growth FCFE approach, and the information given above, the
intrinsic value per share is closest to:
o A
$173.80.
o B
$185.35.
o C
$133.70.
Incorrect
B is correct. FCFE = NI + Depr – FCInv – WCInv + Net borrowing = 600 + 200 – 110 – 30
+ 96 = USD756 million. Sustainable growth g = b x ROE = (1 – 0.30) x 0.095 = 6.65%. r
= 11%. Equity value = 756 (1.0665)/(0.11 – 0.0665) = USD18,535 mil. Value per share =
18,535/100 = USD185.35.
16. Question 16
Sarah Sajjad research director at YELL Securities makes the following three
comments to her junior analyst about valuation approaches:
i. The free cash flow valuation approach should be used whenever a company’s
dividends are significantly different from its FCFE.
ii. If a company’s capital structure is relatively unstable, the FCFE valuation
approach is superior to the FCFF valuation approach.
iii. In case a company undergoes a change in control, then it’s better to apply the
discounted dividend valuation approach rather than a free cash flow
valuation approach.
Which of the three comments made by Sajjad is most likely correct?
o A
First.
o B
Second.
o C
Third.
Incorrect
A is correct. The first comment is correct, because free cash flow valuation (FCFE or
FCFF) should be used whenever the dividends are significantly different from the
company’s capacity to pay dividends. B & C are incorrect comments.
17. Question 17
John Doe is an analyst at Brickrock Capital. He is estimating the value of Horti Goods
Ltd., an appliance manufacturer. He develops free cash flow forecasts for the
company and wants to value it using FCFF and FCFE approaches. The best discount
rate to use is:
o A
weighted average cost of capital for FCFF and cost of equity for FCFE.
o B
weighted average cost of capital for FCFE and cost of equity for FCFF.
o C
cost of equity for both FCFE and FCFF.

Incorrect
A is correct. FCFF is discounted using WACC whereas FCFE is discounted using cost of
equity.
18. Question 18
An analyst forecasts FCFE for Trend Corp. for years 2016 through 2020. The EPS in
2020 is projected to be USD3.5, and the average trailing P/E for the industry at the
beginning of 2021 is 8. Expected EPS for 2021 is USD4. The terminal value at the end
of 2020 is closest to:
o A
USD28.
o B
USD32.
o C
USD30.
Incorrect
A is correct. Using the trailing earnings of USD3.5 and trailing P / E of 8, the terminal
value in year 2020 is 3.5 x 8 = USD28.
19. Question 19
Rob Lowe is valuing the equity of Vic Beverages. He estimates FCFE for 2016 by using
a constant-growth model. The estimated value for FCFE for 2015 is USD5. Lowe uses
FCFE growth rate of 5% and required rate of return of 10%. With these variables, the
estimated value per share for 2016 is USD105. Lowe then conducts a sensitivity
analysis by taking the base values of FCFE growth rate and required rate of return
and highest and lowest estimates of these variables based on economic and
competitive environment. The following table shows the results:
Sensitivity Analysis for Vic Beverages
Valuation
Base-Case Valuation with Valuation with
Variables with Base-
Estimate Low Estimate High Estimate
Case
FCFE growth rate 5% USD105 USD87 USD133
Required rate
of return on 10% USD105 USD131 USD88
equity
The most likely conclusion that can be drawn is:
o A
The company’s value is not sensitive to the input variables.

o B
The company’s value is sensitive to input variables.

o C
The company’s value is least sensitive to the range of estimate for FCFE
growth rate.
Incorrect
B is correct. The value of the company is sensitive to both the input variables of
growth rate and required rate of return on equity.
20. Question 20
Bellavine Co. generated FCFE of USD1,800 last year. The cash flow is expected to
grow at 8% for the next three years after which it will grow at 3% annually. The
market value of the company’s debt outstanding is USD2,500 and the value of its
cash and equivalents is USD500. The company’s cost of equity is 8% and its WACC is
5%. The value of equity using FCFE is closest to:
o A
USD40,480.
o B
USD42,980.
o C
USD42,480.
Incorrect
C is correct. The calculation is as follows:
1 2 3
FCFE 1,944.0 2,099.5 2,267.5
TV (g=3%, r=8%) 46,710.1
Total 1,944.0 2,099.5 48,977.6
PV (r=8%) 1,800.0 1,800.0 38,880.0
Equity value $42,480.0
21. Question 21
Sam White is developing cash flow forecasts for Forza Ltd. The cash flows for the
next three years are given below:

FCFF USD500 USD550 USD600
Cash flows are expected to grow forever at 5% annually after year 3. The company
has USD1500 outstanding in debt and has cash and equivalents equal to USD1,000.
The company’s cost of equity is 9% and the WACC is 6%. The value of equity using
the FCFF valuation approach is closest to:
o A
USD57,750.
o B
USD53,860.
o C
USD52,860.
Incorrect
B is correct. The calculation is as follows:
1 2 3
FCFF in $ 500.0 550.0 600.0
TV 63,000.0
Total 500.0 550.0 63,600.0
PV (6%) 471.7 489.5 53,399.8
Total PV 54,361.0
less: debt (1,500.0)
Add: cash and equivalents 1,000.0
Equity Value in $ 53,861.0
Note: According to the constant-growth FCFF model, the firm value at time period 3
is given by:
Firm value = FCFF3 (1+g)/WACC – g = 600 (1+0.05)/(0.06-0.05) = 63,000
22. Question 22
A two stage free cash flow model is most useful for:
o A
a company that is in a mature phase of its lifecycle with growth at a stable

rate expected for the foreseeable future.
o B
a company with a valuable patent due to expire in two years.

o C
a startup company.
Incorrect
B is correct. A company that has an exclusive patent will experience different growth
rates before and after the expiration of the patent, therefore a two stage model is
appropriate. A mature company will likely see growth at a constant rate whereas a
startup will go through multiple stages of growth.
23. Question 23
A potential problem with using EBITDA as a proxy for free cash flow is:
o A
EBITDA does not include depreciation expense.

o B
EBITDA does not reflect amounts related to working capital or fixed

capital investments.
o C
EBITDA is not the company’s net profit.

Incorrect
B is correct. EBITDA does not reflect the effects of working capital and fixed capital
investments as they do not appear on the income statement.
24. Question 24
An increase in dividends declared will most likely:
o A
decrease FCFE only.

o B
decrease FCFF and FCFE.

o C
have no effect on FCFE or FCFF.

Incorrect
C is correct. Dividends do not affect free cash flow. They are a distribution of free
cash flow and therefore a use of available cash.
25. Question 25
Which of the following statements about forecasting free cash flow is most likely true?
o A
FCFF and FCFE always grow at the same rate.

o B
Free cash flows can be forecasted either at a constant growth rate or

under a more complicated method where each component is forecasted
separately.
o C
When forecasting free cash flow to equity, firm’s target debt ratios are not
considered.
Incorrect
B is correct. Free cash flows can be forecasted at a constant growth rate or by
forecasting each component individually. Under constant growth rate the underlying
assumption is that all components grow at a constant rate. The growth rate used for
FCFE is usually different than that used for FCFF.
26. Question 26
Nexter Corp.’s financial details are given as follows:
Cash flow from operations: $1,500
Depreciation: $600
WC Inv: $200
FC Inv: $300
The company’s free cash flow to firm is closest to:
o A
$1,200.
o B
$1,600.
o C
$1,000.
Incorrect
A is correct. Cash flow from operations is calculated after subtracting WC Inv and
adding back depreciation. Therefore, the only adjustment that needs to be made is
to subtract FCInv. FCFF = 1,500 – 300 = $1,200.
27. Question 27
Sally Brook is analyzing Nova Electronics for valuation purposes. The financial
statements for the years 2015 and 2016 are given below:
Income Statement (in $ Millions) Balance Sheet (in $ Millions)

2016 2015 2016 2015
Sales 1,500 1,200 Cash 600 330
COGS 600 450 Accounts receivable 800 650
Gross Profit 900 750 Inventory 450 400
SG&A 250 200 Current Assets 1,850 1,380
Depreciation 100 80 PPE (Gross) 2,990 2,800
Interest expense 50 40 Acc. depreciation 220 120
Profit before tax 500 430 PPE (Net) 2,770 2,680
Taxes (30%) 150 129 Total Assets 4,620 4,060
Profit after tax 350 301
Accounts payable 950 860
Short term debt 1500 1310
Long term debt 780 850
Common Stock 500 500
Retained earnings 890 540
Total liabilities and equity 4,620 4,060
The FCFF and FCFE of the company in $ millions for 2016 are
FCFF FCFE
A. 185 270
B. 95 180
C. 150 150
o A
Option A.
o B
Option B.
o C
Option C.
Incorrect
A is correct. The workings in $ millions are as follows:
Net Income 350 Net Income 350

Add: depreciation 100 Add: After tax Interest [50 x 0.7] 35
less WC Inv [(800+450-
110 Add: Depreciation 100
950)-(650+400-860)]
less WC Inv[(800+450-950)-
less: FC Inv (2990-2800) 190 110
(650+400-860)]
Add: Net borrowing
120 less: FC Inv (2990-2800) 190
[(1500-1310)+(780-850)]
FCFE 270 FCFF 185
28. Question 28
To estimate FCFF from EBITDA (1-Tax rate) which of the following adjustments are
required?
o A
add after-tax interest expense and working capital investment.

o B
subtract fixed capital investment and working capital investment.

o C
add depreciation times tax rate, subtract fixed capital investment and
working capital investment.
Incorrect
C is correct. FCFF equals after-tax EBITDA plus depreciation times tax rate minus
investments in fixed capital and working capital.
29. Question 29
To calculate FCFF from CFO:
o A
add after-tax interest expense and subtract fixed capital investment.

o B
subtract working capital investment.

o C
subtract both fixed capital investment and working capital investment.

Incorrect
A is correct. After-tax interest expense should be added to and fixed capital
investment should be subtracted from CFO to obtain an estimate of FCFF.
30. Question 30
Which of the following adjustments is not required while calculating free cash flow to
equity from net income?
o A
Subtract after tax interest expense.

o B
Subtract the value of principal repayments.

o C
Subtract the increase in the value of receivables.

Incorrect
A is correct. The interest expense and its tax deduction are already accounted for in
the net income therefore no adjustment is needed to calculate FCFE. The value of
debt repayments and working capital investment is subtracted from net income to
calculate FCFE.
31. Question 31
The equity value of a firm is the present value of its operating assets:
o A
plus excess cash and minus market value of debt.

o B
minus market value of debt and cash

o C
plus market value of debt

Incorrect
A is correct. The value of equity is found by subtracting the market value of debt
from the value of operating assets and any excess cash and marketable securities.
32. Question 32
Which of the following statements about the free cash flow approach
is most likely correct ?
o A
FCFF represents cash flows available to equity and debt holders but not
preferred stockholders.
o B
FCFE represents cash flow available to equity shareholders after

dividends have been paid.
o C
FCFF represents cash flow generated by the operating assets of the

business.
Incorrect
C is correct. FCFF represents cash flow generated by the operating assets of the
business which is then used to pay debt holders, preferred stockholders and
common shareholders. Hence A is incorrect. B is incorrect because FCFE is the cash
flow available to common stock holders after all operating expenses, interest and
principal payments have been made, and investments in working and fixed capital
done. Dividends are the uses of FCFE.
Kurt Rogers is valuing MCL Corporation’s common equity using a free cash flow approach.
He gathers the following financial information about MCL given in Table 1 and Table
2. Table 1 (€ millions, except per share amounts)
For Year Ending 31 December 2016

Earnings before interest, taxes, depreciation, and amortization (EBITDA) 1,470
Depreciation expense 263
Interest expense 223
Income tax (34%) 335
Net income €649
Number of outstanding shares (millions) 445
2016 fixed capital investment (millions) 580
Cost of equity 14.0%
Weighted average cost of capital (WACC) 7.50%
Table 2: (€ millions)
As of 31 December 2016 2015

Cash and cash equivalents €34 €22
Total current assets €1,400 €1300
Long-term debt 2,409 2,650
Total liabilities and stockholders’ equity €6,605 €6,191
1. Question 1
Using the information given in Table 1 & Table 2, MCL’s 2016 FCFF (in € millions)
is closest to:
o A
501.
o B
533.
o C
577.
Incorrect
A is correct. FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv.
Working Capital 2016 2015 Increase

Investment (€ millions) (€ millions) (€ millions)
Current assets
1,400 – 34 = 1,366 1,300 – 22 = 1,278
excluding cash
Working capital –1,642 –1,620 –22
FCFF = 649 + 263 + 223(1-0.34) – 580 – (-22) = €501.18 million.
2. Question 2
Using the above information, MCL’s 2016 FCFE (in € millions) is closest to:
o A
260.
o B
113.
o C
595.
Correct
B is correct. FCFE = FCFF – Int(1 – Tax rate) + Net borrowing.
2016 2015 Net increase

Long-term debt ($) 2,409 2,650 –241
FCFE = 501.18 – 223 (1 – 0.34) + (-241) = €113 million.
Simon Lee while analyzing Country Foods’ stock, plans to perform two different valuations:
the “base case” valuation and the “comprehensive” valuation. The 2016 year-end book value
of the company’s debt is $4,445 million and it has 490 million shares outstanding. Country
Foods’ weighted average cost of capital is 9.50%, and cost of equity is 12%. Lee’s key
assumptions for each valuation case are given below: Base case valuation
• 2017 FCFF will be $800 million.

• After 2017, FCFF will grow annually at 5% in perpetuity.
• Country Foods’ market value and book value of long-term debt are approximately
equal.
Comprehensive valuation
• 2017 earnings per share (EPS) will be $2.05.

• EPS will grow forever at 6% annually.
• For 2017 and beyond:
o Net capital expenditures (fixed capital expenditures minus depreciation) will
be 35% of EPS.
o Investments in working capital will be 15% of EPS.
o 70% of future investments will be financed with equity and 30% will be
financed with debt.
Shams Lakha, an equity analyst is analyzing the impact on HTEX Industries’ 2017 FCFE of the
following three possible financial actions by the company during the year 2017:
• Increasing common stock cash dividends by $100 million.

• Repurchasing $50 million of common shares.
• Reducing its long-term debt outstanding by $90 million.
1. Question 1
Using the FCFF method and the base case valuation assumptions, the 2016 year-end
value per share of Country Foods’ common stock is closest to:
o A
$27.
o B
$14.
o C
$29.
Incorrect
A is correct. Using the single-stage FCFF model: FCFF = 800/(0.095 – 0.05) = $17,778
million. Equity value = Firm value – Market value of debt = 17,778 – 4,445 =
USD13,333 million. Value per share = 13,333/490 = USD27.21.
2. Question 2
Using the comprehensive valuation assumptions and the FCFE method, the 2016
year-end value per share of Country Foods’ common stock is closest to:
o A
$38.
o B
$24.
o C
$22.
Incorrect
C is correct. Per share FCFE2017 = NI – (1 – DR)(FCInv – Dep) – (1 – DR)(WCInv) = 2.05 – (1
– 0.3)(0.35×2.05) – (1 – 0.3)(0.15 x 2.05) = $1.3325. FCFE will grow at the same rate as
EPS = 6% (given). Value per share2016 = 1.3325/(0.12 – 0.06) = $22.208.
3. Question 3
The combined effect of the three possible financial actions will most likely reduce the
company’s 2017 FCFE ($ millions) by:
o A
90.
o B
60.
o C
240.
Incorrect
A is correct. Increasing common stock dividends by USD100 million will not affect
FCFE, it’s a use of FCFE. Repurchasing $50 million of common shares will not affect
FCFE, it’s a use of FCFE. The debt repayment will reduce the FCFE by the full amount
of USD90 million.
Raj Aakash works as an analyst and is valuing the stock of Merk Steel. Aakash makes the
following assumptions for his FCFE model:
• A growth rate of 20% per year over the next three years (2017 through 2019) and a
5% constant growth rate beyond 2019
• An estimate of FCFE of $1.05 per share for 2017
• A small-firm risk premium of 2% to be added to the rate of return on the stock of
13%
Aakash’s boss, Faiyaz Rohan makes the following comments regarding valuation models:
I. The H-model is applied when the dividend growth begins at a high rate and falls
linearly throughout the abnormal growth period till it reaches a normal growth rate
at the end.
II. The FCFE model doesn’t consider the investment and financing policies of a
company. Free cash flow is not impacted by the firm’s dividend payout policy, but
any fresh common equity issuance can impact the cash flow available to
stockholders.
III. Additional borrowings will reduce FCFE in the year the debt is issued, leading to a
decrease in the equity value of a firm.
1. Question 1
Using Aakash’s 2017 assumptions for FCFE per share, the equity value of Merk’s
stock as of 2016 is closest to:
o A
USD14.77.
o B
USD13.28.
o C
USD10.55.
Incorrect
B is correct. The required rate of return = 13% + 2% = 15%.
2017 2018 2019

$1.05(1.2)2 = $1.51
FCFE per share $1.05
$1.05(1.2) 1.51(1.05)/(0.15 –
for (Aakash’s
= $1.26 0.05)
the year est.)
= $15.86
Present value $1.05/1.15 $1.26/1.152 (1.51+15.86)/1.153

(2016) of FCFE = $0.913 = $0.953 = $11.42
V0 = 0.91 + 0.95 + 11.42 = USD13.28.

2. Question 2
Which of the following comments made by Rohan regarding valuation models is most
likely correct?
o A
Comment I.
o B
Comment II.
o C
Comment III.
Incorrect
A is correct. Rohan is correct with respect to the H-model which “is a variant of the
two-stage model in which growth begins at a high rate and declines linearly
throughout the super-normal growth period until it reaches a normal growth rate at
the end.” FCFE considers the investment and financing policies, and it is not effected
by common stock issuance and dividends payments. Additional debt increases FCFE
in that year.
Market-Based Valuation: Price
and Enterprise Value Multiples
1. Question 1
Q-Code: 21-L2-EQ-MBVP-79352
The comparison of which of the following price multiples is most likely to be affected
by accounting differences?
o A
P/CFO
o B
P/FCFE
o C
P/B
Incorrect
C is correct. Comparisons of P/E, P/B, and multiples based on EBITDA are the most
affected by accounting differences. On the other hand, comparisons of P/CFO and
P/FCFE are least affected by accounting differences.
2. Question 2
Asad Mehanti is analyzing the stock of SGT Tanneries. Mehanti collects the following
data to estimate the long-term growth rate in dividends in order to calculate the
terminal value of the stock:
Required rate of return 12 %

Trailing dividend yield 4.5%
Return on equity 13.5%
Using the above data, SGT’s expected long-term growth rate in dividends is closest to:
o A
6%.
o B
7%.
o C
9%.
Incorrect
B is correct. 0.045 = (0.12 – g)/(1 + g). 0.045 + 0.045g = 0.12 – g. Hence g = 7.18%. The
expected long-term growth rate in dividends is approximately 7%.
3. Question 3
An analyst is valuing the stock of Quality Tables, a furniture manufacturing company.
Quality Tables has a beta of 1.2, a dividend payout ratio of 0.3, and an earnings
growth rate of 0.05. The following regression has been estimated based on the
financial information of comparable companies in the industry:
Predicted P/E = 10.05 + (4.63 x DPR) – (0.10 x beta) + (13.45 x EGR)
If Quality Tables’ actual trailing P/E is 12, the stock is most likely:
o A
overvalued.
o B
fairly valued.
o C
undervalued.
Incorrect
B is correct. Using the cross-sectional regression of the P/E ratio, we can calculate
the predicted P/E for Quality Tables:
Predicted P/E = 10.05 + (4.63 x 0.3) – (0.1 x 1.2) + (13.45 x 0.05) = 11.99 ≈ 12
Since the predicted P/E and actual reported P/E are very similar, the stock is fairly
valued.
4. Question 4
Mujahid Ali is an intern at an equity research firm. His supervisor asks him to
calculate the forward P/E ratio for an apparel company, TYX Apparel. It is
12th September 2020 and the company’s stock is currently priced at $22.40. Ali
gathers the following values for TYX’s past and predicted earnings per share
(amounts are in dollars).
Year 31 March 30 June 30 September 31 December

2020 1.20 0.98 0.95E 1.1E
2021 1.2E 1.3E 1.4E 1.4E
TYX Apparel’s forward P/E for the next four quarters is closest to:
o A
4.48.
o B
4.92.
o C
19.69.
Incorrect
B is correct. Since it is currently 12th September, this calculation is taking place during
the third quarter of 2020. The quarter hasn’t ended yet, so we will include it in the
“next four quarters” when we calculate the forward P/E.
We already know TYX’s stock price, so we simply have to compute the total EPS over
the next four quarters:
EPS = 0.95 + 1.10 + 1.20 + 1.30 = 4.55
P/E = 22.40/4.55 = 4.92
5. Question 5
Alan Forester, CFA is an equity analyst who is valuing MedDev, a medical device
company. The following table shows the trailing P/E ratios for four comparable
companies in the same industry:
Comp 1 25.23
Comp 2 34.34
Comp 3 23.57
Comp 4 28.89
MedDev just reported an EPS of $3.56 and its stock is currently trading at $109.25
Using the method of comparables, Forester will calculate a share price closest to:
o A
$93.38.
o B
$99.71.
o C
$109.25.
Incorrect
B is correct. The mean P/E ratio of the comparable companies is:
(25.23 + 34.34 + 23.57 + 28.89) / 4 = 28.01
Based on this average P/E and MedDev’s EPS, MedDev’s share price should be: 28.01
* 3.56 = $99.71
6. Question 6
On July 13 2020, the P/E ratio for S&P 500 is 22.22. If the yield on 10-year T-bonds is
0.63%, according to the Fed model, an investor should most likely invest in:
o A
equity.
o B
fixed income.
o C
neither equity nor fixed income.

Incorrect
A is correct.
Based on the Fed model, stocks are overvalued if the market’s current earnings yield
is less than the 10-year Treasury bond yield. Earnings yield (E/P) is the inverse of the
P/E ratio.
On 13 July 2020, the P/E ratio is 22.22. This means the current earnings yield is
1/22.22, which is 4.5%. Since this yield is higher than the 10-year T-bond, using the
Fed model alone, an investor would be encouraged by this information to invest in
the equity market.
7. Question 7
An analyst makes the following comments regarding the Yardeni model:
Statement 1: The Yardeni model includes the consensus ten-year earnings growth
rate forecast for the market index.
Statement 2: According to the Yardeni Model, higher corporate bond yields result in
lower justified P/E and higher expected long-term growth results in a higher justified
P/E.
Statement 3: It addresses a concern of the Fed model by including the expected

growth rate in earnings when calculating the intrinsic value of a stock.
Which of the above statements are most likely correct?
o A

o B
Statement 2 only
o C

Incorrect
C is correct. Statement 1 is incorrect because one of the inputs of the Yardeni model
is the consensus five-year earnings growth rate forecast for the market index.
Statements 2 and 3 are correct.
8. Question 8
Which of the following is least likely a reason why an analyst would make an
adjustment to the reported book value when calculating the P/B ratio for a
company?
o A
To make the P/B ratio more useful for comparisons among different stocks
o B
To make the book value per share more accurately reflect the value of
shareholder’s investment
o C
To make the P/B ratio closer to the mean ratio in the industry
Incorrect
C is correct. Making the P/B ratio closer to the mean P/B ratio in the industry is not a
reason why analysts adjust the reported book value of a company, whereas both A
and B are correct and valid reasons.
9. Question 9
A firm’s return on equity is 12%, its required rate of return is 9%, and its expected
growth rate is 6%. It’s most recently reported book value is $3.4 million. What is the
firm’s justified price-to-book ratio based on fundamentals?
o A
0.50
o B
1.33
o C
2.00
Incorrect
C is correct. The formula to calculate P/E, derived from the Gordon growth model, is
as follows:
P0/B0 = (ROE – g) / (r – g)
Therefore, P0/B0 = (0.12 – 0.06)/(0.09 – 0.06) = 2.
10. Question 10
An analyst is valuing ABC Corp. She has estimated the value of ABC’s free cash flow
to equity (FCFE) to be $2.86 per share and its trailing CF to be $6.23. She also
assumes that FCFE will grow at a constant long-term rate of 5%. Given a required
rate of return of 9%, the justified P/CF ratio for ABC Corp. is closest to:
o A
5.35.
o B
11.48.
o C
12.05.
Incorrect
C is correct. The value per share is calculated using the following information:
V0 = [(1 + g) FCFE0] / (r – g)
Based on the information in the question:
ABC’s value per share = (1.05 * $2.86)/(0.09 – 0.05) = $75.08
Therefore, the P/CF ratio is calculated as follows:
P/CF = 75.08/6.23 = 12.05
11. Question 11
Your professor makes the following statements during your Finance Fundamental’s
class on enterprise multiples:
Statement 1: EV/Sales is preferred over P/S because P/S is not comparable for
companies that have different capital structures.
Statement 2: One drawback of using EV/EBITDA is that EBITDA overestimates cash

flow from operations if working capital is growing.
Which of the statements is most likely correct?
o A
Statement 1 only
o B
Statement 2 only
o C

Incorrect
C is correct.
Enterprise value to sales is preferred over price to sales. P/S has a weakness because
P represents the stock price of the company, whereas sales indicates the funds
available to all capital providers. This makes P/S not comparable for companies with
different levels of debt because more funds flow to equity investors of a company
with low debt. For a debt-financed company, not all sales belong to a company’s
equity investors. Some of the proceeds from the sales would be used to service the
debt. EV/S is a more appropriate ratio for comparing companies with different
capital structures.
Statement 2 is correct because EBITDA does overestimate cash flow from operations
if working capital is growing.
12. Question 12
Rami Yousuf compiles the following data of HLT Beverages to conduct a justified
(fundamental) P/E analysis to assess its stock.
Expected long run dividend growth rate 6.5%

Payout ratio 25%
HLT’s stock’s beta 0.82
Current EPS $20.65
Required return on equity 9.50%
He compares the stock’s justified forward P/E to a predicted P/E based on a cross-
sectional regression of stocks in the same industry as HLT. The estimated regression
is given as: Predicted P/E = 6.05 + (7.12 x DPR) – (0.44 x Beta) + (16.46 x DGR)
where DPR is the dividend payout ratio and DGR is the expected dividend growth
rate.
Compared to the justified forward P/E of HLT, the predicted P/E from the regression
analysis will be:
o A
lower.
o B
higher.
o C
the same.
Incorrect
B is correct. The justified forward P/E = 0.25 / (0.095 – 0.065) = 8.33. The predicted
P/E according to estimated regression = 6.05 + (7.12 x 0.25) – (0.44 x 0.82) + (16.46 x
0.065) = 8.54. The forward P/E predicted under the regression method is higher.
13. Question 13
o A
Momentum indicators are valuation indicators that relate price of a
company or a fundamental, such as earnings, to comparable companies
in the same industry.
o B
The rationale behind using earnings surprise is that positive surprises may be
associated with persistent positive abnormal returns, or alpha.
o C
Investing strategies based purely on technical momentum indicators are

inherently self-destructing, because once a useful technical rule (or price
pattern) is discovered, it ought to be invalidated when the mass of traders
attempt to exploit it.
Incorrect
A is correct. Momentum indicators are valuation indicators that relate price or a
fundamental such as earnings to its own past values or expected value. Options B and C
are true.
14. Question 14
Which of the following is least likely a limitation of screening tools and computerized
databases?
o A
The user lacks control in calculating the inputs such as EPS.

o B
Most databases do not have qualitative factors.

o C
Such tools have a high error rate which often eliminates potential
investments.
Incorrect
C is correct. Computerized screening does not have a high error rate. Options A and
B are true.
15. Question 15
The harmonic mean is most likely preferred over the arithmetic mean when
calculating P/E because:
o A
The arithmetic mean is more prone to the look-ahead bias.

o B
The harmonic mean inherently gives less weight to higher P/Es and
more weight to lower P/Es.
o C
The harmonic mean is generally higher than the arithmetic mean.

Incorrect
B is correct. Since the harmonic mean gives less weight to higher P/Es, the weightage
given to outliers is much less than when the arithmetic mean is used. Options A and
C are incorrect.
16. Question 16
The economic rationale underlying the method of comparables is the:
o A
law of one price.

o B
law of similar prices.

o C
law of minimum price.

Incorrect
Solution: A is correct. The economic rationale for the method of comparables is the
law of one price: identical assets should sell at the same price.
17. Question 17
Question 7Q-Code: 21-L2-EQ-MBVP-74725
An analyst is researching the valuation of Tristar Corp., a large manufacturer of

automotive parts. Current share price of Tomatsu is USD 19.5. The following Exhibit
supplies data on EPS, BVPS, and the company’s ROE.
Exhibit: Tomatsu (Currency in US Dollars)
Measure 2015 2016 2017 2018 2019 2020 2021

EPS 0.79 0.61 0.59 0.55 0.91 0.85 1.03
BVPS 2.95 2.89 2.81 2.95 3.5 4.01 4.55
ROE 26.8% 21.1% 21.0% 18.6% 26.0% 21.2% 22.6%
P/E based on that estimate of normalized EPS using average ROE would be:
o A
19.1x
o B
25.7x
o C
18.5x
Incorrect
Solution: A is correct. Average ROE over the 2015–21 period is (26.8% + 21.1% +
21.0% + 18.6% + 26.0% + 21.2% + 22.7%)/7 = 22.5%. Based on the current BVPS of
USD4.55, the method of average ROE gives 0.225 × USD4.55 = USD1.02 as
normalized EPS. The P/E based on this estimate is USD19.5/USD1.02 = 19.1.
18. Question 18
In Yardeni’s model, higher current corporate bond yields:
o A
result in a higher justified P/E.

o B
result in a lower justified P/E.

o C
have no effect on justified P/E.

Incorrect
Solution: B is correct. Yardeni obtained the following expression for the justified P/E
on the market:
P / E = 1 / CBY – b *LTEG
As per the Yardeni Model, higher corporate bond yields result in a lower justified P/E
and higher expected long-term growth results in a higher justified P/E.
19. Question 19
During the third quarter of 2021, the mean consensus earnings forecast for
Woodford plc for the fiscal year ending December 2021 was USD4.15. Of the 11
estimates, the low forecast was USD3.35, the high forecast was USD4.61, and the
standard deviation was USD0.33. If actual reported earnings for 2021 come in equal
to the high forecast, the measure of the earnings surprise for Woodford scaled to
reflect the dispersion in analysts’ forecasts would be:
o A
$3.81
o B
$1.39
o C
$13.97
Incorrect
B is correct. In this case, scaled earnings surprise would be (USD4.61 –
USD4.15)/USD0.33 = USD0.46/USD0.33 = 1.39.
20. Question 20
Which of the following statements is least accurate about standardized unexpected
earnings (SUE)?
o A
In this measure, the magnitude of unexpected earnings is scaled by a

measure of the size of historical forecast errors or surprises.
o B
The larger the size of historical size of forecast errors, the more
meaningful a given size of EPS forecast error.
o C
The denominator used to determine SUE is standard deviation of past

unexpected earnings over some period prior to time t.
Incorrect
Solution: B is correct. The smaller the size of historical size of forecast errors, the
more meaningful a given size of EPS forecast error. For instance, if a stock has an
earnings surprise
of 0.1��ℎ��
��0.4, then the earnings surprise is small relative to past forecast errors.
A and C are true statements. , the standardized unexpected earnings (SUE) scales
the unexpected earnings by a measure of the size of historical forecast errors or
surprises.
EPSt – E(EPSt) / σ[EPSt – E(EPSt)]
where:
Numerator = unexpected earnings at time t
Denominator = standard deviation of past unexpected earnings over some period
prior to time t.
21. Question 21
Statement 1 Relative-strength indicators compare an equity’s performance during a
period with the performance of some group of equities or its own past performance.
Statement 2: The rationale for using relative strength is that patterns of persistence
or reversal may exist in stock returns.
o A
Statement 1
o B
Statement 2
o C

Incorrect
Solution: C is correct. Relative-strength indicators compare a stock’s performance
during a period either with its own past performance or with the performance of
some group of stocks. The rationale for using relative strength that patterns of
persistence or reversal may exist in stock returns.
22. Question 22
If the inflation rates are equal but pass-through rates differ, the justified P/E should
be:
o A
lower for the company with the lower pass-through rate.

o B
higher for the company with the lower pass-through rate.

o C
lower for the company with the higher pass-through rate.

Incorrect
Solution: A is correct. if the inflation rates are equal but pass-through rates differ, the
justified P/E should be lower for the company with the lower pass-through rate.
23. Question 23
The price, earnings and growth data for companies in the shoe industry are given
below:
Earnings per
Earnings per
Company Share price share growth
share
forecast
Service Industries $8 $64 4%
Bafa Ltd. $5 $40 8%
Hush Pupples $6 $66 6%
Based on the P/E-to-growth (PEG) ratio, the stock that is the cheapest on a relative
basis is:
o A
Service Industries.
o B
Bafa Ltd.
o C
Hush Pupples.
Incorrect
B is correct. The P/E-to-growth ratios are given below:
Company Earnings Share price Growth P/E PEG (P/E / g)

Service Industries $8 $64 4% 8 2
Bafa Ltd. $5 $40 8% 8 1.00
Hush Pupples $6 $66 6% 11 1.83
Based on the PEG ratio, Bafa Ltd. appears to be the cheapest, since it has the lowest
PEG ratio.
24. Question 24
Bradman Co. is currently trading at USD30 per share. Its forecasted EPS for next year
is USD5. The company’s value based on a discounted dividend model is USD25 per
share. The company’s justified forward P/E is:
o A
6.
o B
5.
o C
4.
Incorrect
B is correct. The company’s value using DDM is USD25 per share. Its forecasted EPS
is USD5. Therefore, its justified forward P/E1 is 25/5 = 5.
25. Question 25
A possible drawback for using the P/E ratio for valuation purposes is that:
o A
the use of different accounting methods does not distort EPS values.
o B
it is an uncommon method for valuation.

o C
it can be meaningless if earnings are negative.

Incorrect
C is correct. Negative earnings result in a meaningless P/E ratio. A is incorrect
because the application of different accounting methods may distort EPS values. B is
incorrect because P/E ratio for valuation is widely used by investors.
26. Question 26
Compared to the P/E ratio, P/B is:
o A
not meaningful when EPS is zero.

o B
more meaningful when EPS is highly variable.

o C
not applicable for companies expected to go into liquidation.

Incorrect
B is correct. Book value of a company is generally more stable than earnings which
makes P/B ratios more meaningful. A & B are incorrect. P/B may be used when EPS is
zero or negative. P/B ratios have been used in valuation of companies expected to
go into liquidation.
27. Question 27
Bamboo Inc. paid a dividend of USD1 last year. The expected dividends for the next
four quarters are USD0.20, USD0.25, USD0.30 and USD0.05. The stock currently
trades at USD8. The leading dividend yield is closest to:
o A
10.0%.
o B
12.5%.
o C
2.5%.
Incorrect
A is correct. The next year’s dividend is equal to 0.2 + 0.25 + 0.3 + 0.05 = 0.8. The
leading dividend yield is therefore 0.8/8 = 10%.
28. Question 28
Tesma Ltd. reported earnings of $800 last year. Upon studying the notes to financial
statements, an analyst identifies the following items which were included in
earnings:
Sales from a new product launched $200
Gain on sale of a business segment $300
Restructuring expenses $100
The company’s earnings, adjusted for nonrecurring items, are closest to:
o A
USD800.
o B
USD400.
o C
USD600.
Incorrect
C is correct. Gain on sale of a business segment and restructuring charges are
nonrecurring items, hence not part of core earnings. Therefore, adjusted earnings
for nonrecurring items (assuming no taxes) are USD800 – 300 (gain on sale) + 100
(restructuring charges) = USD600. Sales of new product are expected to continue in
future therefore considered part of core earnings.
29. Question 29
Which of the following statements about earnings yield is most likely true?
o A
When comparing companies based on earnings yield, the company with

the highest earnings yield is the cheapest.
o B
When comparing companies based on earnings yield, the company with the
lowest earnings yield is the cheapest.
o C
Earnings yield can never be negative.

Incorrect
A is correct. The stock with the highest earnings yield is the cheapest and the one
with the lowest earnings yield is the most expensive. Earnings yield can be negative
for negative earnings.
30. Question 30
All else equal, the justified P/E of a stock based on forecasted fundamentals is:
o A
directly related to the stock’s required rate of return.
o B
inversely related to growth rate.

o C
inversely related to the stock’s discount rate.

Incorrect
C is correct. The justified P/E of a stock is inversely related to its required rate of
return (discount rate). Its positively related to growth rate(s).
31. Question 31
Boxer Inc.’s data is given below:
Number of Annual net Book value Current Value as

shares outstanding sales of equity share price per DCF
10,000 $150,000 $250,000 $45 $50
The company’s justified price to sales and price to book multiples are:
Justified Price to Sales Justified Price to Book

A. 3.33 2.00
B. 3.00 1.80
C. 2.00 3.33
o A
Option A.
o B
Option B.
o C
Option C.
Incorrect
A is correct. The sales per share is 150000 / 10000 = USD15 and book value per
share is 250000 / 10000 = USD25. The justified price is USD50 as per DCF. Justified
P/S = 50/15 = 3.33 and justified P/B = 50/25 = 2.
32. Question 32
A possible drawback of using cross-sectional regression to estimate P/E is that:
o A
the relationship between P/E and the fundamental variables remains

constant.
o B
the predictive power of the estimated P/E from regression can change
over time.
o C
the method shows valuation relationships for different stocks over different
time periods.
Incorrect
B is correct. The predictive power of results from regression at any point in time can
be expected to change, because distributions of multiples change over time. The
relationship between P/E and fundamentals may change over time. The method
does not capture relationships for a different stock and different time periods.
33. Question 33
The P/E ratios of companies in the aviation industry are given below:
Company P/E ratio

Delta Airlines 5.6
Air Magma 8.0
Industry average 7.0
Which of the following statements is most likely correct? All else equal
o A
Delta Airlines has higher earnings growth than the industry.

o B
Air Magma has higher-than-average expected earnings growth than the

industry.
o C
The industry’s risk is lower than Air Magma.

Incorrect
B is correct. Air Magma has higher-than-average expected earnings growth than the
industry, therefore its higher P/E multiple than the industry is justified. Delta airlines’
growth should be lower than the industry as its P/E is lower and the industry’s risk
must be higher than Air Magma as the industry P/E is less than that of Air Magma.
34. Question 34
Bottles Co. is trading at a P/E multiple of 5. The average industry P/E multiple is 6.
Based on a DCF valuation, its justified P/E based on forecasted fundamentals is 4.
Bottles Co. is:
o A
undervalued based on forecasted fundamentals but overvalued based on

method of comparables.
o B
overvalued based on forecasted fundamentals but undervalued based

on method of comparables.
o C
overvalue based on forecasted fundamentals but fairly valued based on

method of comparables.
Incorrect
B is correct. Bottles Co.’s P/E is less than the average industry P/E, hence the
company is undervalued based on method of comparables. Its P/E (based on market
price) is higher than the justified P/E based on DCF, therefore it is overvalued based
on forecasted fundamentals.
35. Question 35
The earnings estimate for Poongko Ltd. five years from now is USD2.5 per share. The
EPS in the sixth year is expected to be USD2.75. The average industry trailing P/E
ratio is 4. The terminal value in year five is closest to:
o A
USD10.0.
o B
USD11.0.
o C
USD10.5.
Incorrect
A is correct. The terminal value based on trailing P/E is 4 x 2.5 = USD10.
36. Question 36
Which of the following statements about EBITDA is most likely true?
o A
EBITDA is pretax operating cash flow to equity holders.

o B
EBITDA is pretax operating cash flow to equity and debt holders.

o C
Interest expense is added back to EBITDA to obtain cash flow from

operations.
Incorrect
B is correct. EBITDA represents pretax operating cash flow to both equity and debt
holders as interest cost and dividends are both paid out from EBITDA after
deducting tax.
37. Question 37
A possible drawback of using earnings plus noncash charges as cash flow is that:
o A
working capital investment is ignored.

o B
depreciation is not added back to earnings.

o C
interest expenses are ignored.

Incorrect
A is correct. When earnings plus noncash charges are used to define cash flow from
operations items such as working capital investment and noncash revenue are
ignored. B & C are incorrect because interest expenses are already deducted in net
income whereas depreciation charges are added back.
38. Question 38
The details for Boxter Ltd. are as follows:
Market value of equity: USD1,500
Market value of debt: USD900
Minority Interest: USD400
Cash and equivalents: USD200
EBITDA: USD100
The company’s EV/EBITDA ratio is closest to:
o A
26.
o B
28.
o C
30.
Incorrect
A is correct. EV is given by market value of debt + market value of equity + minority
interest – cash and equivalents. EV is therefore 1500 + 900 + 400 – 200 = $2600.
EV/EBITDA is USD2,600 / USD100 = 26.
39. Question 39
Which of the following is least likely a factor that makes relative valuation difficult on a
cross-border basis?
o A
Difference in interest rates.

o B
Differences in accounting methods.

o C
Differences in market values of a firm in the same industry but trading

in different countries.
Incorrect
C is correct. Differences in market values of individual companies in the same
industry but trading in different countries is a common factor and is unlikely to
create difficulty in relative valuations. The differences in interest rates and risks as
well as accounting methods across different countries for companies in the same
industry makes relative valuation difficult.
40. Question 40
An abnormally high return on a stock can be explained by:
o A
a negative earnings surprise.

o B
high standardized unexpected earnings.

o C
a sign of reversal in an upward trending price graph.

Incorrect
B is correct. All else equal high standardized unexpected earnings can indicate a
large positive earnings surprise resulting in high stock returns, hence A is incorrect. C
is incorrect because a reversal will indicate a decrease in price and returns.
41. Question 41
Which of the following statements about the central tendency measures applied to a
group of multiples is least likely true?
o A
Extreme outliers will affect arithmetic mean.

o B
For an equally weighted portfolio, harmonic and weighted harmonic

mean will not be equal.
o C
For an equally weighted portfolio, weighted average and arithmetic mean will
be equal.
Incorrect
B is correct. For an equally weighted portfolio, the harmonic and weighted harmonic
mean will be equal.
42. Question 42
The current share price of Slick Shoes common equity is SGD19.26. Sally Han, senior
equity analyst, mentions to Peter Lee that historically, the company has had a ratio
of enterprise value (EV) to sales of 0.90×. She asks Lee to determine whether Slick
Shoes common shares are appropriately priced. Slick Shoes has 60 million of
common shares outstanding. Lee collects the following data:
Selected information 2016 Cost (millions) 2016 Market Value (millions)

Sales 1,904
Cash 300
Total assets 2,593
Total debt 644 610
Common shareholders’
1,297
equity
Non-controlling interest 355
Total equity 1,652
Based on the information given above and using the EV/Sales ratio approach, the
company’s shares given the historic metric are most likely:
o A
overvalued.
o B
properly valued.
o C
undervalued.
Incorrect
A is correct. The company’s EV/S multiple = 0.90. With Sales = 1,904 million, EV = 0.90
x 1,904 = 1,713.60 million. EV = MV of common equity + MV of debt + Non-controlling
interest – cash and investments. EV = (price per share x 60 million) + 610 million +
355 million – 300 million. 1,713.60 = price x 60 + 665. Solving for price per share =
(1,713.60 – 665) /60 = 17.4767. Given the historic EV/S metric, the company’s shares
currently trading at SGD19.26 are overvalued by over 10%.
43. Question 43
Sonia Kohan, portfolio manager makes the following comments regarding the use of
EV/EBITDA approach to valuation.
I. It is more suitable than P/E for comparing companies with different debt ratios.
II. EBITDA underestimates cash flow from operations if working capital is growing.
III. EV/EBITDA is not frequently used for capital-intensive firms.
Which comment regarding the use of enterprise value method of valuation is most
likely correct?
o A
Comment III.
o B
Comment II.
o C
Comment I.
Incorrect
C is correct. EV/EBITDA is more appropriate than P/E for comparing companies with
different financial leverage and capital structures. EBITDA will overestimate cash flow
from operations when working capital is growing.
Jay Han, CFA, is an equity analyst with ICH Securities valuing Houndwell Electronic
Component Company, a Hong Kong-based electronics components’ manufacturer. As part
of his analysis, Han wants to compare his earnings and return forecasts for Houndwell with
the consensus forecasts. The company’s required return on equity is 11%. Han’s forecast at
31 December 2016:
• expected long-term return on equity (ROE) of 14%.

• long-term retention ratio of 65%.
Consensus forecast of analysts following Houndwell at 31 December 2016:
• 2016 EPS of HKUSD24 and 2017 EPS of HKUSD27.60.

• 2016 dividends per share (DPS) of HKUSD8.40 and 2017 DPS of HKUSD9.66.
• long-term earnings and dividends growth rate of 8.5% per year after 2017.
1. Question 1
Based on Han’s forecast and the information given above, the justified forward P/E
ratio for Houndwell common stock at 31 December 2016 is closest to:
o A
5.7.
o B
34.2
o C
18.4.
Incorrect
C is correct. g = ROE x b = 0.14 x 0.65 = 0.091. Justified forward P/E = Payout ratio / (r
– g) = 0.35 / (0.11 – 0.091) = 18.42.
2. Question 2
Based on the required return of 11%, the consensus analysts’ forecasts and the
single-stage (constant growth) residual income approach, Houndwell’s justified price-
to-book ratio at 31 December 2016 is closest to:
o A
6.30.
o B
2.20.
o C
1.83.
Incorrect
C is correct. The justified P/B ratio using a single stage (constant growth) residual
income approach is given by P/B = (ROE – g) / (r – g). From the consensus forecast,
the payout ratio is 8.4/24 = 9.66 / 27.60 = 0.35 in both years. Therefore, retention
rate = 1 – 0.35 = 0.65. The forecasted growth rate is 0.085. g = b x ROE: ROE = g / b =
0.085/0.65 = 13.08% and P/B = (0.1308 – 0.085) / (0.11 – 0.085) = 1.832.
Sam Hunt, asset manager at Rim Investments wants to increase his fund’s investments in
the transportation sector. Hunt believes that although the transportation industry is cyclical,
the industry’s profitability will increase relative to the FTSE100 index because of improved
economic activity. Hunt asks Sara Mills, an analyst, to calculate the trailing and forward
price/earnings multiples based on core earnings of NewTransit Corporation. Mills uses the
following data of NewTransit for calculations.
Current year EPS ₤4.50

Expected restructuring charge next year as a % of EPS 1.8%
Expected EPS growth next year vs. FTSE 100 1.14x
Most recent annual dividend ₤1.26
Current share price ₤48.00
Expected EPS growth rate of FTSE100 6%
Hunt asks Mills to consider the following three items while computing price multiples of
companies in the industry:
• No adjustments are necessary for business cycle influences as its impact on this
industry should be minimal.
• The accounting methods used by these companies may have differences and
adjustments need to be made.
• The companies that provide core earnings have already incorporated the necessary
adjustments for nonrecurring items.
1. Question 1
Which of Hunt’s notes regarding the computation of price multiples is most accurate ?
o A
The note regarding the business cycle.

o B
The note regarding the accounting method.

o C
The note regarding the nonrecurring items.

Incorrect
B is correct. Hunt’s note regarding the differences in the accounting method is
correct, since an analyst need to adjust EPS for differences in accounting methods of
companies that are being compared in order to make P/E multiples comparable. A &
C are incorrect because an analyst must consider and make necessary adjustments
for nonrecurring items and business cycle influences.
2. Question 2
Based on NewTransit’s information, the forward P/E multiple is closest to:
o A
9.8x.
o B
9.2x.
o C
10.2x.
Incorrect
A is correct. Next year’s EPS growth rate based on the relationship to FTSE100
expected EPS growth rate = 6% x 1.14 = 6.8%. Next year’s EPS = 4.50 (1.068) = ₤4.806.
Core EPS = ₤4.81+ expected restructuring charges = 4.81 + (4.81 x 1.8%) = ₤4.897. P/E
multiple = 48/core EPS = 48/4.9 = 9.8x.
Azmat Ahmed is using the method of comparables to value the common stock of JINSUN
Electronics. Based on the forward P/E ratios and a five-year estimated growth rate, Ahmed
finds that the industry’s P/E-to-growth (PEG) ratio is comparable to that of the company. He
discusses this finding with his boss Sania Abdullah, and suggests that the company is fairly
valued relative to the industry. Abdullah responds that caution must be exercised while
using PEG because it:
• does not factor in differences in risk between the industry and the company.
• does not adjust for differences in the duration of growth between the industry and
the company.
• does not assume a linear relationship between P/E and growth.
Abdullah also instructs Ahmed to consider EV/EBITDA as an alternative method of

valuation. Ahmed asks Abdullah if there are any drawbacks to this method.
1. Question 1
Which of the following comments about the comparison using the PEG ratio is least
likely accurate?
o A
Does not factor differences in risk.

o B
Does not adjust for differences in growth duration.

o C
Does not assume a linear relationship.

Incorrect
C is correct. PEG assumes a linear relationship between P/E and growth which in
theory (as shown by DDM) is not linear. PEG ignores differences in risk, and
differences in duration of growth, hence A & B are correct statements made by
Abdullah.
2. Question 2
Which of the following statements best answers Ahmed’s query about the drawbacks
of EV/EBITDA method ?
o A
EV/EBITDA cannot be used when EPS is negative.

o B
Compared with free cash flow to the firm, EBITDA overestimates the
cash flow from operations if working capital is growing.
o C
EV/EBITDA cannot be used in the valuation of capital-intensive businesses.

Correct
B is correct. A drawback of the EV/EBITDA metric, is that EBITDA will overestimate
cash flow from operations if working capital is growing. A is incorrect because
EBITDA is frequently positive when EPS is negative, hence EV/EBITDA is used instead
of the P/E multiple. C is incorrect because EV/EBITDA is used extensively in valuing
capital-intensive companies.
Ali Zaidi is evaluating stocks in the emerging market countries. Zaidi decides to calculate the
justified price-to-sales (P/S) and EV/EBITDA multiples for the Brazilian stocks, starting with
Braskim, and using the following selected financial data of the firm in millions BRL.
Cash & cash equivalents 2,000

Investments 815
Total sales 8,070
EBITDA 2,930
Net income 750
Market value of common equity 8,845
Market value of debt 3,538
Market value of preferred stock 2,021
Estimated dividend payout ratio 40%
Estimated earnings growth rate 7%
Estimated required rate of return 10%
While discussing the comparison of valuation multiples for companies across different
countries, Zaidi makes the following comments:
I. EV/EBITDA is more likely to be affected by differences in accounting standards than

P/CFO or Price to Free Cash Flow to Equity (P/FCFE).
II. All else equal when inflation rates are the same in two countries, the justified P/E
multiple should be higher for companies with a lower inflation pass-through rate.
III. All else equal, a company operating in a high inflationary environment will have
higher justified P/E multiples compared to a company in an environment with lower
inflation rates.
1. Question 1
Using the data given above, the justified P/S ratio of the company is closest to:
o A
2.70.
o B
1.33.
o C
14.32.
Incorrect
B is correct. E0/S0 = 750 / 8,070 = 0.093; 1 – b = 40% (given); g = 7% (given); r = 10%;
Justified P0 / S0 = (0.093 x 0.40 x 1.07) / (0.10 – 0.07) = 1.3268.
2. Question 2
Using the data above the EV/EBITDA ratio of the company is closest to:
o A
4.0.
o B
3.5.
o C
4.2.
Incorrect
A is correct. EV = 8,845 + 3,538 + 2,021- 2,000 – 815 = BRL 11,589 million. EV/EBITDA =
11,589 / 2,930 = 3.955.
3. Question 3
Which of the comments related to comparison of valuation multiples across different
countries is most likely correct ?
o A
Comment I.
o B
Comment II.
o C
Comment III.
Incorrect
A is correct. EV/EBITDA is more likely to be impacted by differences in international
accounting standards than P/CFO and P/FCFE. B is incorrect because when inflation
rates are equal, justified P/E multiple should likely be lower for the company with the
lower pass-through rate. C is incorrect because when inflation rates differ between
two countries, the company operating in a high inflationary environment will likely
have a lower justified P/E.
Saadia Saadat instructs Fayyaz Khan to use two multiples-based approaches: 1) the justified
price-to-book ratio (P/B) and 2) the ratio of enterprise value to EBITDA (EV/EBITDA) for
evaluating the stock of Centura, Ltd., an automotive parts manufacturer and supplier.
Centura’s revenues and earnings are cyclical, from both seasonal and business cycle effects.
Saadat while discussing the stock with Khan makes the following three statements
regarding relative valuation approaches:
I. It’s best to adjust for the countercyclical property called the “Molodovsky effect”
while evaluating Centura’s trailing P/E.
II. The P/E-to-growth (PEG) measure is more appropriate than P/E because it adjusts for
differences in duration of growth and risk between Centura and its peers.
III. Centura’s return on equity (ROE) is much higher than its peers. Therefore, based on
its justified P/B compared to its peers with the same P/B, Centura will appear
overvalued.
Saadat also suggests that Centura’s multiples should incorporate a 20% discount to account
for Centura’s small size and thin trading. Khan collects the following data:
($ millions)
Net income 40 Book value of equity 200
Interest 10 Market value of equity 380
Taxes 20 Long-term debt 226
Depreciation 140 Cash 74
Amortization 30 Required return on stock 12.0%
Earnings growth rate 6.5%
1. Question 1
Which of Saadat’s following statements regarding relative valuation approaches
is most likely correct?
o A
Adjusting P/E.
o B
PEG.
o C
Justified P/B.
Incorrect
A is correct. Centura is a cyclical company. “Empirically, P/Es for cyclical companies
are often highly volatile over a cycle even without any change in business prospects.
High P/Es on depressed earnings per share (EPS) at the bottom of the cycle and low
P/Es on unusually high EPS at the top of the cycle reflect the countercyclical property
of P/Es known as the Molodovsky effect.
2. Question 2
Using the information given above and the adjustment proposed by Saadat,
Centura’s justified P/B is closest to:
o A
3.49.
o B
1.16.
o C
1.96.
Incorrect
C is correct. ROE = 40 / 200 = 20%. Justified P0/B0 = (0.20 – 0.065) / (0.12 – 0.065) =
2.4545. Incorporating the 20% discount suggested by Saadat = 2.4545 (1 – 0.2) = 1.96.
3. Question 3
Using the information given above and incorporating the discount proposed by
Saadat, the EV/EBITDA multiple is closest to:
o A
2.2.
o B
1.8.
o C
2.0.
Correct
B is correct. EV = 380 + 226 – 74 = USD532 million. EBITDA = 40 + 10 + 20 + 140 + 30 =
USD240 million. EV/EBITDA = 532/240 = 2.22. Incorporating the discount: 2.22 (1 –
0.2) = 1.776.
Residual Income Valuation

1. Question 1
Q-Code: 21-L2-EQ-RIVA-74770
Which of the following items will not violate clean surplus accounting?
o A
Changes in market value of instruments classified as available-for-sale

o B
Foreign currency translation gains flowing directly to retained earnings

o C
Inventory write downs

Incorrect
C is correct. Inventory write downs are reported in the income statement therefore
do not violate clean surplus accounting. A & B will lead to violation of clean surplus
accounting, hence are incorrect.
2. Question 2
Which of the following is not true about application of residual income model?
o A
It can be used when a company is not paying dividends or if it exhibits an

unpredictable dividend pattern.
o B
It can be used if a company has negative free cash flow many years out but is
expected to generate positive cash flow at some point in the future.
o C
It cannot be used if a lot of uncertainty exists in forecasting terminal

values.
Incorrect
Solution: C is correct. The residual income model is most appropriate if a great deal
of uncertainty exists in forecasting terminal values.
3. Question 3
The following data is available to value Swanson Corp.’s Shares on 31 December
2020.
• ROE estimated at 15% for the next 3 years

• All earnings will be reinvested
• Cost of equity is 11%
• Book value at the start of 2021 is 17 per share
• After year 3, Swanson’s residual income will decay over time to zero with a
persistence factor of 0.4.
The intrinsic value of Swanson based on residual income would be closest to:
o A
19.27
o B
18.73
o C
19.73
Incorrect
4. Question 4
The following information is available for Boko Sugar Mills on 31 December 2021:
• Adjusted NOPAT = 325 million

• Total capital is 1,850 million and there is no debt
• Closing stock price on 31 December 2021 is 35
• Total shares outstanding 100 million
• Cost of equity is 15%
The economic value added (EVA) for Boko will be:
o A
47.5 million
o B
1,659 million
o C
-200 million
Incorrect
Solution: A is correct. EVA = NOPAT – (C% * TC) = 325 – 0.15 x 1850 = 47.5 million
5. Question 5
Which of the following statements is least accurate about Tobin’s q?
o A
The numerator includes the market value of total capital.

o B
The denominator uses total assets valued at the historical accounting

cost.
o C
All else equal, Tobin’s q is expected to be higher the greater the productivity
of a company’s assets
Incorrect
Solution: B is correct. The denominator uses total assets valued at replacement cost
rather than at historical accounting cost. Replacement costs take into account the
effects of inflation.
6. Question 6
Which of the following statements are most likely correct when valuing a company
using the residual income valuation method?
o A
One adjustment analysts must make is to exclude a company’s identifiable

intangibles from the balance sheet.
o B
Goodwill that is not on the balance sheet should be included in the

company’s book value.
o C
Under US GAAP, since R&D is generally expensed, the income statement has
to be adjusted upwards when valuing a company.
Incorrect
B is correct. Goodwill that a company has generated on its own (not through
acquisitions) is not recorded on the balance sheet, but when using the residual
income valuation method, its value is estimated and included in the company’s
valuation.
Option A is incorrect because, as is the case with goodwill, the balance sheet is
adjusted to include identifiable intangible assets.
Option C is incorrect because adjustments related to R&D are not this
straightforward. An analyst has to consider the productivity of the R&D expenses
before deciding how much of an adjustment to make to the income statement, if
any.
7. Question 7
Which of the following statements are most likely correct?
Statement 1: If a company’s management records restructuring charges every

period, then these charges should not be excluded when calculating its residual
income.
Statement 2: When using the residual income approach to value international

companies, an analyst only has to focus on the differences in accounting standards
used by the companies they are valuing and make adjustments accordingly.
o A
Statement 1 only
o B
Statement 2 only
o C
Neither statement
Incorrect
A is correct.
Statement 1 is correct because when a company’s management records
restructuring or unusual charges every period, they are considered normal operating
expenses and are not excluded in the residual income calculation.
Statement 2 is incorrect because in addition to adjustments related to different
accounting standards, availability of reliable earnings forecasts, violations of the
clean surplus, and quality of earnings also have to be considered when using the
residual income valuation method on international companies.
8. Question 8
Bill Harold, portfolio manager Titanium Funds, explains to his interns the pros and
cons of using the residual income approach:
I. A strength of the model is that it uses readily available accounting data and
focuses on economic profitability.
II. One of its limitations is that it is assumed that interest expense appropriately
reflects the cost of debt capital.
III. Another weakness of the model is that terminal values make up a significant
portion of the value of a firm’s equity.
Which comment is least likely accurate?
o A
The use of accounting data.

o B
The cost of debt capital reflected by interest expense.

o C
The terminal values making a large portion of equity value.

Incorrect
C is correct. Terminal values do not make up a major portion of the total present
value. This is a strength of the RI model. A & B are correct statements.
9. Question 9
Chris North, analyst at West Wind Investments, decides to use the residual income
(RI) model to evaluate the stock of Black Arrow, a Singapore-based sportswear and
casual wear manufacturer. North justifies the use of the RI model to his supervisor
saying that it minimizes the uncertainty in making assumptions about Black Arrow’s
future earnings and long-term dividend growth. Black Arrow’s common stockholders’
equity at 2016 year-end was SGD 2,045 million. The company has 85 million shares
outstanding. North estimates the following metrics for the company:
The long-term return on equity (ROE) 14%

The required rate of return 10%
Constant earnings growth rate 4%
Based on the above information, using the residual income model, the intrinsic value
per share of Black Arrow is closest to:
o A
$24.06.
o B
$40.10.
o C
$33.68.
Incorrect
B is correct. The residual income model is: Vn = Bo + ROE – r / r – g (Bo)
The book value per share is calculated as common shareholders’ equity/number of
shares outstanding = USD2,045 million / 85 million = USD24.06 (end of 2016, or
beginning of 2017). The intrinsic value per share = V0 = 24.06 + [(0.14 – 0.10) / (0.10 –
0.04)] x 24.06 = USD40.10.
10. Question 10
In late January 2017, Jawad Ahmed, equity analyst at Optus Securities, was valuing
TRX Corporation’s stock using the residual income model. He collected the following
data for the year ending December 2016:
Net income $620 million

Common stock (par plus paid-in-excess of par) $1,575 million
Retained earnings $1,578 million
Cost of equity capital 14%
Dividend & Earnings growth projections:
Expected for 2017 13%
After 2017, dividend growth rate declines linearly
4%
over a 6-year period to a perpetual growth rate
Estimated earnings per share (EPS) in 2022 $4.20
Based on the information given above, Ahmed’s estimate of the company’s residual
income per share for 2018 is closest to:
o A
$0.80.
o B
$1.10.
o C
$0.76.
Incorrect
B is correct. Residual income for 2016 = Net income (2016) – Equity charge at the
beginning of 2016.
Amounts in $ million 2017 2018

2016 growth: 13% – (13% –
Growth rate 13% 11.5%
4%)/6
2017: 620 x 1.13 = 700.60
Net income: 620 in 2013 700.60 781.17
2018: 700.60 x 1.115 = 781.17
Less Dividends 210.18 234.35 30% x net income
Increase in retained earnings 490.42 546.82
Starting equity 3,153.00 3,643.42 Start of 2017:1,575 + 1,578
Ending equity 3,643.42 4,190.24
Net income 781.17 From above
Less equity charge 510.08 Starting equity 3,643.42 x 14%
Residual income 271.09
Residual income per share $1.08436 Divide by 250 mil shares
11. Question 11
Salman Mir, senior analyst, while evaluating Cupola Industries, makes the following
statements to his junior analysts:
“In the residual income valuation approach the adjustments for off-balance sheet
items are necessary in order to get a reliable estimate of book equity. Some items
such as operating leases require adjustments to both the amount of equity and the
future earnings of Cupola. Furthermore, when using the residual income approach,
the analyst must ensure that the company’s “available for sale” investments effect
equity directly hence require making adjustments to the income statement. Finally,
no adjustments to book equity is required for nonrecurring items.”
Mir is most likely incorrect with respect to:
o A
adjustments for operating leases.

o B
adjustments for “available-for-sale securities”.

o C
adjustments for nonrecurring items.

Incorrect
A is correct. Operating leases may not affect equity because leases involve both off-
balance sheet assets that offset off-balance sheet liabilities, but can influence future
earnings. B & C are correct with respect to clean surplus violations adjustments and
nonrecurring items.
12. Question 12
Jill Jones is valuing two companies, X and Y, using the residual income model. The
price and valuation data are as follows:
Company X Y
Market price USD55 USD60
Value obtained from RI model USD50 USD65
Comparing the intrinsic value (obtained from the RI model) of the companies with
their respective market prices, which of the following statements
is most likely appropriate?
o A
X is undervalued and Y is overvalued.

o B
X is overvalued and Y is undervalued.
o C
X and Y both are undervalued.

Incorrect
B is correct. X’s market price is greater than its intrinsic value hence it is overvalued.
Y’s market price is less than it is intrinsic value therefore it is undervalued.
13. Question 13
Jackson Co. reported annual earnings of $1500. Its current book value of equity
is $10,000 and it has a cost of equity of 8%. The company’s WACC is 6%. The residual
income is closest to:
o A
$700.
o B
$900.
o C
$1500.
Incorrect
A is correct. The equity charge is calculated as 8% x USD10,000 = USD800. RI is
therefore 1500 – 800 = USD700.
14. Question 14
A possible drawback of using a residual income model to value equity is that the:
o A
terminal value forms a small portion of total value.

o B
model cannot be applied when cash flows are volatile.

o C
accounting data can be manipulated by management.

Incorrect
C is correct. A potential drawback of RI model is that it relies on accounting data
which can be manipulated. A is not a drawback but a strength of the RI model. B is
incorrect because RI model can be used when cash flows are unpredictable.
15. Question 15
A difference between valuation derived from residual income models and DCF
models can be explained by:
o A
the difference in nature of models.

o B
the difference in underlying assumptions.

o C
the fact that compared to DCF models, value recognition is different in RI

models.
Incorrect
B is correct. The three models yield different results when underlying assumptions
are different. The nature of models does not impact the difference in output.
Recognition of value in RI models is earlier than in DDM but the total present value
whether using RI models or expected dividends or expected free cash flow should be
consistent.
16. Question 16
Which of the following factors most likely explains higher residual income
persistence? A company has:
o A
very high accounting accruals.

o B
extremely high return on equity.

o C
low dividend payout.

Incorrect
C is correct. Low dividend payout by a company leads to high RI persistence levels.
High return on equity and high accounting accruals tend to be associated with lower
persistence levels for RI.
17. Question 17
Goodway Comms. has a P/B ratio of 3.5. the company’s long-term ROE is 12% and its
current book value per share is USD10. The cost of equity is 9%. The implied growth
rate is:
o A
7.8%.
o B
6.5%.
o C
9.2%.
Incorrect
A is correct. The P/B ratio of 3.5 implies a price of 3.5 x 10 = USD35. The implied
growth rate can be found as; r – BV(ROE – r) / (V – BV) = 9% – 10(12% – 9%) / (35 – 10)
= 7.8%.
18. Question 18
Belma Corp. has a year-end book value per share of USD18, and cost of equity of 8%.
The company’s ROE of 12% is expected to continue for the foreseeable future.
Earnings are expected to grow at 10% and the payout ratio will remain at current
levels. Belma’s residual income per share for the 5th year is closest to:
o A
$6.8.
o B
$1.1.
o C
$0.5.
Incorrect
B is correct. The residual income in the coming year is estimated as (0.12 – 0.08) x 18
= USD0.72. RI in year 5 = (RI in year 1) x ((1.1)4 = USD1.054.
19. Question 19
Northern Airways has a current book value of $15 per share. The company’s
expected long-term ROE is 15% and its cost of equity is 11%. The company maintains
a dividend payout ratio of 70% and has constant earnings growth. The intrinsic value
of equity is closest to:
o A
$24.
o B
$26.
o C
$9.
Incorrect
A is correct. The growth rate is ROE x retention ratio = 15% x 30% = 4.5%. The
present value of future residual income is calculated as (0.15 – 0.11) x 15 / (0.11 –
0.045). The value of equity is therefore USD15 + USD9.23 = USD24.2.
20. Question 20
The required rate of return on equity for Dexter Labs is 8% and its recent ROE is 9%.
ROE is expected to persist at the same level for the foreseeable future. Based on this
information:
o A
the justified P/B is less than 1.

o B
the justified P/B is equal to 1.

o C
the justified P/B is greater than 1.

Incorrect
C is correct. As ROE is greater than the cost of equity, residual income is positive
therefore justified P/B ratio is greater than 1, assuming constant growth.
21. Question 21
Lara Jones is determining the intrinsic value of Lucky Autos using the residual
income models. The book value per share is currently at USD10.00 and forecasted
EPS for the next two years is USD1.50 and USD2.00 respectively after which the
company will cease to exist. The company is expected to pay a dividend of USD0.80
per share in the coming year and a liquidating dividend of USD12.70 in year 2. The
cost of equity is 9%. The stock’s intrinsic value is closest to:
o A
$10.5.
o B
$12.6.
o C
$11.4.
Incorrect
C is correct. The calculation is as follows:
Year 1 2
Beginning BV per share 10 10.7
EPS 1.5 2
Less: Dividend per share 0.8 12.7
Ending BV per share 10.7 0
Per-share equity charge (9%) 0.9 0.96
RI 0.6 1.037
PV of RI 0.55 0.87
The intrinsic value using the residual income model is B0 + total PV of RI = 10 + 0.55 +
0.87 = USD11.42.
22. Question 22
Which of the following statements about residual income models is most likely true?
o A
Book value is a small percentage of the stock’s overall value in RI models.

o B
Residual income valuation is relatively less sensitive to terminal value

compared to other models.
o C
Residual income models use the T-bill offer rate as discount rate.
Incorrect
B is correct. Residual income valuation is less sensitive to terminal value because
book value typically forms a significant percentage of the stock’s intrinsic value.
23. Question 23
Which of the following is least likely a use of residual income models?
o A
To develop budgets for management.

o B
To determine executive compensation.

o C
To test for goodwill impairment.

Incorrect
A is correct. RI models are not used for developing budgets but are used for
measuring goodwill impairment and determining managerial remunerations.
Harold Lee is analyzing the stock of Sanhua Electronics. As part of his analysis, Lee wants to
determine the intrinsic value using the residual income valuation approach. He collects the
following data:
In HK$ millions
Net income for 2016 120,000
Total stockholders’ equity on 31 Dec 2016 857,000
Total stockholders’ equity on 31 Dec 2015 785,000
Required return on equity 13%
Before applying the residual income approach Lee contemplates whether adjustments
should be made to Sanhua’s financial statements. Consequently, he examines three
possible items that could result in violations to clean surplus accounting:
I. Investments in securities classified as available-for-sale.

II. Foreign currency transactions arising from export sales and import purchases.
III. Foreign currency translation adjustments from the consolidation of subsidiary
companies.
1. Question 1
Sanhua’s residual income (in HK$ millions) is closest to:
o A
17,950.
o B
8,590.
o C
13,270.
Incorrect
A is correct. Residual income = Net income – Equity charge. Residual income =
120,000 – (0.13 x 785,000) = HK$17,950 million.
2. Question 2
Which of the following three items considered by Lee can least likely result in
violations of clean surplus accounting?
o A
Item I.
o B
Item II.
o C
Item III.
Correct
B is correct. Foreign transactions in the ordinary course of business, (due to import
purchase or export sale) are accounted for on both the income statement and
balance sheet at fair value, and hence do not violate clean surplus accounting. Any
unrealized change in the market value of investments in available-for-sale securities,
goes directly to stockholders’ equity rather than the income statement. This causes a
clean surplus accounting violation. Foreign currency translation adjustments also
bypass the income statement.
Hiran Divit is evaluating the stock of Gemini International Ltd., an apparel company listed on
the BSE 500 using the residual income approach. Divit feels that the consensus forecast is
too pessimistic for residual income prospects after 2016. During a recent conference call,
Gemini’s management discussed their plan to improve future profitability. Their plan
specifically involved increasing the Economic Value Added (EVA) by taking the following
three strategic steps:
I. Increase debt ratio to the optimal level.

II. Improve administrative functions to eliminate inefficiencies.
III. Reduce interest expense through equity issuance and repay debt.
Divit’s supervisor asks, “Why do you prefer the residual income model over other
approaches?”
1. Question 1
Which of the following three strategic steps will least likely lead to a higher EVA for
Gemini?
o A
Step I.
o B
Step II.
o C
Step III.
Incorrect
C is correct. EVA = NOPAT – (C% x TC), where NOPAT is net operating profit after
taxes, C% is the cost of capital and TC is the total capital. Interest costs do not impact
NOPAT as it’s a pre-interest measure. Further, replacing debt with equity issuance
increases the firm’s cost of capital thereby lowering its EVA.
2. Question 2
Divit’s most appropriate response to his supervisor’s question is?
o A
No adjustment is required to book value of common equity for

nonrecurring items.
o B
No adjustment is required to book value of equity for off-balance sheet
items.
o C
The interest expense appropriately captures the cost of debt in the residual
income approach.
Incorrect
A is correct. While it is important to adjust earnings for non-recurring items these
adjustments do not need to be made to the book value of equity because they are
already incorporated in the asset values. Adjustments are required to the book value
of equity for off-balance sheet items. The cost of debt is reflected by interest
expense in the RI model, which is a weakness of the model because of changing
market conditions, interest expense may not be a good estimate of the company’s
cost of debt.
Sabeen Shah, equity analyst, and Gulbano Murad, her research assistant, are valuing the
common stock of Inca Industries using a residual income valuation approach. Murad
assembles the relevant basic information given below:
Current book value per share $16.00

Required rate of return for common stock 12.00%
Forecasted data Yr 1 Yr 2 Yr 3 Yr 4
Earnings per share USD6.00 USD6.00 USD5.40 USD5.50
Residual income per share USD3.90 USD3.30 USD2.30 USD2.30
Note: After year 4, the residual income is expected to be zero. After completing the valuation, Shah
revises the approach with the help of the following alternative information.
Current book value per share $16.00
Required rate of return for common stock 12.00%
Forecasted data Yr 1 Yr 2 Yr 3 Yr 4
ROE 45% 35% 30% 25%
Dividends per share $1.05 $1.05 $1.05 $1.05
Note: After year 4, the residual income is expected to be zero.
1. Question 1
Using the basic information given above and the residual income valuation model,
the value per share of Inca Industries is closest to
o A
$33.48
o B
$25.21
o C
$17.48.
Incorrect
B is correct. Using the residual income model :
= 16.00 + 3.90 / 1.12 + 3.30 / 1.12 + 2.30 / 1.12 + 2.30 / 1.12 = $25.21. Using a
2 3 4
financial calculator: CF0 = 16, CF1 = 3.9, CF2 = 3.3, CF3 = 2.3, CF4 = 2.3; I = 12; NPV
CPT = 25.21.
2. Question 2
Using the alternative information, the residual income of Inca industries for Year 1
is closest to:
o A
$4.35.
o B
$3.26.
o C
$5.28.
Incorrect
C is correct. The formula for residual income is RIt = Et – rBt-1 = (ROEt – r) × Bt-1, RI1 =
(0.45 – 0.12) × 16.00 = USD5.28.
3. Question 3
Using the alternative information, and the residual income valuation model, the
value per share of Inca Industries is closest to:
o A
$35.25.
o B
$31.49.
o C
$40.57.
Correct
B is correct. Based on alternative information:
Year t 1 2 3 4
Bt-1 16.00 22.15 28.85 36.46
Et = ROEt × Bt–1 7.20 7.75 8.66 9.12
Dt 1.05 1.05 1.05 1.05
Bt = Bt–1 + Et – Dt 22.15 28.85 36.46 44.53
ROEt 45% 35% 30% 25%
(ROEt – r) 33% 23% 18% 13%
RIt = (ROEt – r) × Bt-1 5.28 5.10 5.19 4.74
Sally Waldon, senior analyst, makes the following two observations about residual income
models to her intern, Jamie Dunn: Observation 1: The single-stage residual income model
assumes that ROE will not exceed the cost of equity indefinitely. Observation 2: In residual
income models the terminal value often represents a relatively small percentage of total
value. Dunn voices his concerns as reflected in the following two statements: Statement I:
The residual income approach gives two values for a given stock since it uses two different
methods for computing capital charge. The equity charge method leads to a higher
valuation because it results in a higher residual income than the total capital charge
method. Statement II: The economic value added (EVA) is more appropriate than the
residual income approach because it uses just one method for computing capital charge
which is the product of the cost of capital and the total capital.
1. Question 1
Which of the following observations made by Waldon is most likely accurate ?
o A
Observation 1.
o B
Observation 2.
o C
Neither observation.
Incorrect
B is correct. Waldon is correct in her second observation because in residual income
models the terminal value may not be a large component of total value. This could
be because ROE may fade over time towards the cost of equity. Her first observation
is incorrect because the single-stage RI model assumes that excess ROE over cost of
equity will persist indefinitely..
2. Question 2
L.O.: a Q-Code: 21-L2-EQ-RIVA-74780

Which of Dunn’s statements regarding residual income approach and EVA is most
likely correct ?
o A
Statement I.
o B
Statement II.
o C
Neither statement.
Incorrect
C is correct. The residual income approach does provide for two methods for
computing capital charge: 1) the equity charge method and 2) the total capital charge
method; however, both approaches give the same residual income. It is also correct
that the economic value added uses only one method for capital charge – cost of
capital times total capital. But, it is not superior to the residual income approach for
equity valuation because EVA’s focus is not equity valuation. It is used for measuring
internal corporate performance and determining executive compensation. Hence
both statements are incorrect.
In early January 2017 Ali Shiraz, an analyst, was evaluating the stock of Cross Pipes by using
the residual income model. As part of his valuation, Shiraz calculated the terminal value of
Cross Pipes for 2026 arising from treating 2026’s residual income as a perpetuity. His
estimates of the share price are given below:
Forecasted residual income per share at end of 2026 USD6.40

Estimated return on equity (ROE) in 2026 18%
Residual income stream beyond 2026 Perpetuity
Growth rate beyond 2026 0%
Cost of equity 13%
Dividend payout 30%
Sarah, Shiraz’s supervisor, questioned his valuation at the beginning of 2017 consisting of a
terminal value based on perpetuity and suggested that rather than using a perpetuity,
residual income should fade over time. Sarah proposed a persistence factor of 0.60. Sarah
further made the following three observations regarding her preference for the use of the
residual income model for valuation over other available methods:
I. The model uses the cost of debt capital which can be determined using the interest
expense.
II. The model can be used when cash flows are unpredictable.
III. The terminal value does not constitute a large portion of the value and hence the
impact arising from the uncertainty of terminal value forecasts is low.
1. Question 1
Using the information given above, and comparing Shiraz’s perpetuity approach to
terminal value with Sarah’s approach, Sarah’s assumption leads to a value at the
beginning of 2017 that is approximately:
o A
USD10.5 lower than Shiraz’s method.

o B

o C

Incorrect
A is correct. (Note: end of 2016 = beginning of 2017 and end of 2026 = beginning of
2027. The years stated below represent the end of that year, i.e. TV2026 is the terminal
value at the end of 2026.)
Shiraz’s assumption of the terminal value: TV2026 = RI2027/r = 6.40/0.13 = USD49.23.
Sarah’s assumptions: Estimated growth rate in 2027 = Retention rate x ROE = (1 –

0.3) x 0.18 = 12.6%. Residual Income 2027 = RI2026 x (1 + g) = 6.40 x (1.126) = USD7.206.
TV2026 = ��( 1+�−�). TV2026 = 7.206(1+0.13−0.6)=$13.5962 .
Sarah’s vs Shiraz’s assumptions: Difference in TV2026 = 13.60 – 49.23 = -USD35.63. PV

of Difference = -35.63/ (1.13)10 = -USD10.496. Sarah’s estimate will be lower by $10.5.
(This is the difference at the end of 2016 = beginning of 2017.)
2. Question 2
The least appropriate observation made by Sarah regarding the use of residual
income model is:.
o A
III.
o B
II.
o C
I.
Incorrect
C is correct. “The residual income model uses accounting income estimates and
assumes that the cost of debt capital is properly reflected by interest expense, but
because of changing market conditions, interest expense may not be a good proxy
for the company’s cost of debt capital.” The other two statements are correct with
respect to the residual income model.
Private Company Valuation

Jamie Lee, M&A analyst at SVL Hedge Funds, is evaluating Sigma Software for a potential
acquisition. First, Lee assesses Sigma’s normalized operating income after tax. Selected data
from Sigma’s income statement for the year ended December 2016 and additional
estimates determined by Lee are given in tables 1 and 2. Sigma’s tax rate is 32%.
Table 1
Gross revenues HKUSD4,500,000
Cost of goods sold HKUSD1,575,000
SG&A expenses HKUSD1,620,000
Depreciation & amortization HKUSD380,000
Table 2
The cost of goods sold ratio should be at 40%.
SG&A includes CEO’s compensation of HKUSD500,000. According to Lee’s research
CEO’s compensation is HKUSD250,000 for similar sized firms.
The SG&A expenses include USD40,000 of depreciation and USD160,000 of operating
expenses relating to warehouses which will be kept by the current owners and are not a
part of Sigma’s core operations that are being considered for acquisition.
Lee estimates depreciation and amortization at 10.56% of gross revenues for pro forma
estimates. He thinks the current tax rate of 32% is appropriate.
Cathy Han, a senior analyst, suggests the use of excess earnings method (EEM) for valuing
Sigma and makes the following three comments:
• EEM estimates the earnings before deducting amounts that reflect the required
returns to current and fixed assets.
• EEM is frequently used for pricing private enterprises.
• EEM is particularly helpful for valuing Sigma since it values working capital, fixed
assets, and intangibles using separate discount rates.
1. Question 1
Q-Code: 21-L2-EQ-PCVA-74799
Based on the data in tables 1 & 2, the normalized operating income after taxes of
Sigma for the year 2016 is closest to:
o A
HK$717,300.
o B
HK$629,000.
o C
HK$1,014,800.
Incorrect
A is correct.
As reported Normalized
Gross revenues HK$4,500,000 HK$4,500,000
Cost of goods sold: normalized to 40% of gross revenues HK$1,575,000 HK$1,800,000
Gross profit HK$2,925,000 HK$2,700,000
SG&A expenses consist of HK$250,000 reduction in
CEO’s compensation and HK$200,000 reduction in
HK$1,620,000 HK$1,170,000
depreciation and operating expenses related to the
warehouses (40,000 + 160,000 = 200,000).
EBITDA HK$1,305,000 HK$1,530,000
Depreciation & amortization: normalized to 10.56% of
HK$380,000 HK$475,200
gross revenues
Earnings before interest and taxes HK$925,000 HK$1,054,800
Pro forma taxes at 32% HK$296,000 HK$337,536
Operating income after taxes HK$629,000 HK$717,264
2. Question 2
Which of the following comments of Han regarding the excess earnings method
is most likely correct? The comment relating to:
o A
required returns to current and fixed assets.

o B
EEM used for pricing entire private businesses.

o C
employing different discount rates for valuation.

Incorrect
C is correct. “The excess earnings method (EEM) allows for valuing working capital,
fixed assets, and intangible assets using different discount rates.” A is incorrect,
because, EEM involves determining earnings remaining after deducting required
returns to working capital and fixed assets. B is incorrect because EEM is rarely used
for valuing private businesses.
Brian White, a commodity analyst at Miller & Murray Consultants is valuing Green Acres, a
wheat and maize farmland. White opts for the guideline transactions method (GTM) using
2017 expected EBITDA. His estimates and some additional data are given below:
• Expected EBITDA for 2017 = $1,020,000.

• Three recent purchase transactions of similar companies indicate an average MVIC
(market value of invested capital) to EBITDA multiple of 7.0.
• As of 2016 year end, Green Acres has debt of $890,000 at an interest rate of 6%.
• No additional capital expenditures or borrowing are expected.
White makes the following three statements for his preference for the GTM approach for
valuation:
1. The GTM approach is suitable for valuing Green Acres because it is based on a
multiple that specifically relates to sales of entire companies.
2. Generally, appraisers accept the valuation from GTM approach because the
transactions data is readily available.
In the market approach, determination of MVIC for a private company will give the value of
equity by deducting the value of debt. Therefore, this approach is useful even for highly
leveraged or significantly volatile companies.
1. Question 1
The value of equity of Green Acres at the end of 2016 using White’s preferred
approach and estimates is closest to:
o A
$8,035,000.
o B
$6,250,000.
o C
$8,925,000.
Incorrect
B is correct. MVIC = EBITDA x multiple = USD1,020,000 x 7.0 = USD7,140,000. Value of
equity end of 2016 = MVIC – debt = USD7,140,000 – USD890,000 = USD6,250,000.
2. Question 2
Which of White’s statements regarding his preference for GTM approach
is most accurate ?
o A
I.
o B
II.
o C
III.
Incorrect
A is correct. White is correct in saying that the GTM uses a multiple that particularly
relates to sales of entire companies. B is incorrect, because information not subject
to public disclosure is limited. Hence, the GTM approach is not readily acceptable by
most appraisers. C is incorrect because current market values of debt may not be
available. Hence, for companies that are highly leveraged or have volatile future
expected performance, the valuation of equity by deducting the face value of debt
from MVIC may not be appropriate.
Linda Chang, M&A strategist at PNT investment consultant firm, is evaluating Aquafresh, a
small privately owned fish and shrimp farm using the capitalized cash flow method (CCM).
Chang takes the following steps:
• First, estimating the required rate of return on equity using the build-up method.
• Second, computing the firm’s weighted average cost of capital (WACC). Since current
market value of debt figures are not available, Chang uses the book values of debt
assuming the total debt value in the capital structure to be optimal.
The following tables contain Aquafresh’s 2016 year-end financial data and other inputs
compiled by Chang.
Table 1
Pre-tax cost of debt 9%
Total debt value weight in capital structure 25%
Tax rate 30%
Table 2:
10-year government bond yield 4.7%
Beta of publicly traded firms in the fish
0.81
farming industry
Equity risk premium 7.0%
Small stock risk premium 2.0%
Industry risk premium -1.2%
Aquafresh’s company-specific risk premium 1.0%
Long-term growth rate after 2017 6.0%
Gerald Huang, a senior equity analyst, reviews Chang’s analysis and based on a research
report on industry peers suggests 12.3% as an estimate of Aquafresh’s WACC. Chang uses
this rate to calculate Aquafresh’s equity value. Huang makes the following statements:
I. CCM is occasionally used for the valuation of large public companies, and rarely for
valuing private companies, such as Aquafresh.
II. The excess earnings method is more feasible because it provides an estimate of the
value of intangible assets by capitalizing future earnings remaining after deducting
required returns to working capital and fixed assets.
1. Question 1
Based on the method used by Chang for calculating the cost of equity and the data
in Tables 1 and 2, Aquafresh’s WACC is closest to:
o A
9.14%.
o B
11.70%.
o C
13.50%.
Incorrect
2. Question 2
Based on the WACC suggested by Huang, and the data given in Table 2, Aquafresh’s
capitalization rate is closest to:
o A
5.7%
o B
6.3%.
o C
7.5%.
Incorrect
B is correct. Capitalization rate = WACC – long-term growth rate = 12.3% – 6.0% =
6.3%.
Marina Nikolai is valuing AERD, an electronics and electrical parts private manufacturer and
supplier based in Germany. Nikolai is using the EV multiple approach and after a thorough
research finds that GTZ, a publicly traded company and a close competitor of AERD, is
currently valued at an EV/EBITDA (earnings before interest, taxes, depreciation, and
amortization) multiple of 6.7. Nikolai further makes an upward adjustment of 20% in the
EV/EBITDA multiple to reflect higher growth of AERD compared to GTZ. Nikolai compiles
AERD’s financial data given below and estimates 2017 EBITDA of €130.00 million.
€ millions 31 December 2016

EBITDA 120.0
Cash and short-term investments 62.5
Net fixed assets 63.0
Total assets 200.0
Notes payable 10.0
Long-term debt 37.5
Common equity 140.0
Nikolai’s supervisor feels that since one of their clients is considering a non-controlling
ownership interest in AERD, a discount for lack of control should be applied to the
computed entity value. Nikolai estimates a control premium of 25% for privately owned
firms similar to AERD.
1. Question 1
Using the data given above, Nikolai’s research, estimate and adjustment, AERD’s
value of equity based on the EV/EBITDA approach is closest to:
o A
€1,070 million.
o B
€1,045 million.
o C
€1,015 million.
Incorrect
A is correct. Adjusted EV/EBITDA multiple = 6.7 x 1.20 = 8.04. EV = EBITDA2017 x
Adjusted EV/EBITDA = 130 x 8.04 = 1,045.2 million. Value of equity = EV + Cash and
short-term investments – Long-term debt = 1,045.2 + 62.5 – 37.5 = €1,070.2 million.
2. Question 2
The discount for lack of control, based on Nikolai’s control premium is closest to:
o A
33%
o B
20%.
o C
80%.
Incorrect
B is correct. Discount for lack of control DLOC =
Tom Mathus has joined Pytheon, an investment firm. His first assignment is to value Calico,
a private firm which according to a recent research report shows that it was at risk of
bankruptcy last year. The report also includes cash flow projections, and last fiscal year’s
tangible assets and financial assets with their costs and market values. Mathus checks the
information update on Calico. He finds that the firm is in the development stage and SLR
Industries, is interested in acquiring Calico as it will provide revenue enhancement and cost
savings after operational control. Mathus’ superiors feel that his previous experience as a
bankruptcy analyst will be relevant for this appraisal. Mathus considers valuation based on
both liquidation and on a going concern premise. For its liquidation appraisal, Mathus
updates the fair values of the assets and liabilities and takes the difference (assets less
liabilities) as the equity value. Following are the three additional notes made by Mathus to
his appraisal indicating that the asset-based approach he employs:
I. reveals the value of the assets to a potential buyer, not the value to the company
itself;
II. is inappropriate for financial companies;
III. is relevant for companies in the early development stage or with limited tangible
value.
1. Question 1
The reason that Mathus’ prior experience will be most likely relevant in valuing Calico
is because his prior valuations:
o A
required assessing a company’s liquidation value and going concern

value.
o B
only required determining the liquidation value.

o C
focused on companies in early stages of development.

Incorrect
A is correct. For companies under bankruptcy protection, valuation of the businesses
and its assets may provide information as to how valuable a company is either as a
going concern or in liquidation. Therefore, companies in early stages of development
are typically valued using both an asset-based approach and the going concern
premise. Hence Mathus’ prior experience will be relevant in performing both types of
valuations.
2. Question 2
Regarding Mathus’ liquidation appraisal of Calico, his most relevant note is ?
o A
I.
o B
II.
o C
III.
Incorrect
A is correct. The asset-based approach is used for companies in liquidation, because
it assumes that the assets might be redeployed by potential buyers to higher valued
uses. That is one of the reasons why the going concern value might be less than the
liquidation value. B is incorrect because resource and financial companies might also
be valued using the asset-based approach. C is incorrect because asset based
approach is applied for companies with limited intangible value or in early stages of
development.
PORTFOLIO MGNT
Exchange Traded Funds:

Mechanics and Applications
1. Question 1
Q-Code: 21-L2-PM-ETFS-75742
ETF shares can only be created or redeemed through transactions in:
o A
Primary market.
o B
Secondary market.
o C
Over the counter.

Incorrect
A is correct. Primary market transactions are the only way that shares of the ETF can
be created or redeemed.
2. Question 2
An authorized participant (AP) can take advantage of an arbitrage opportunity by:
o A
Buying the ETF shares from the secondary market, that are trading at
discount to NAV, and exchanging it for the underlying basket of
securities.
o B
Buying the ETF shares from the secondary market, that are trading at
premium to NAV, and exchanging it for underlying basket of securities.
o C
Buying the underlying basket of securities, that are trading at a higher price
than ETF shares, and exchanging them for ETF shares.
Incorrect
A is correct. Assume that ETF shares are trading at $19.90, while the underlying
basket of securities is trading at $20. An AP can take advantage of this situation by
purchasing ETF shares from the secondary market for $19.90, exchanging them with
the ETF issuer for the underlying basket of securities, and selling the basket for $20,
to make a profit of $0.10.
3. Question 3
Which of the following statement is least accurate about the Exchange Trades Funds
(ETFs)?
o A
ETF shares are created/redeemed in kind.

o B
ETFs are less tax efficient as compared to mutual funds.

o C
ETFs are said to be tax fair as compared to mutual funds.

Incorrect
B is correct. ETFs are said to be tax fair and tax-efficient because they have certain
advantages regarding capital gains over mutual funds. A and C are correct
statements about ETFs.
4. Question 4
Which of the following statements is least accurate about authorized participants
(APs)?
o A
The AP creates new ETF shares by transacting in-kind with the ETF issuer.
o B
The transactions between AP and the ETF issuer are done in creation baskets.
o C
The AP can sell ETF shares in the secondary market to retail investors
only.
Incorrect
Solution: C is correct. The AP can sell ETF shares in the secondary market to both
retail and institutional investors.
5. Question 5
Two CFA candidates, Sophie and Finn, are having a discussion about the trading of
ETF shares they both make the following comments:
Sophie: ETFs trade in both primary and secondary market.
Finn: In the secondary market any pair of market participants can trade.
Which of the comments made by the two candidates is most likely correct?
o A
Sophie’s comment.
o B
Finn’s comment.
o C
Both are correct.

Incorrect
C is correct. In the primary market, OTC trades take place between the sponsor and
the AP. While any pair of market participants can trade in the secondary market.
6. Question 6
Tracking difference is calculated as:
o A
the difference between index returns and fund returns over a series of
rolling holding periods.
o B
the standard deviation of the differences between daily index returns and
daily ETF fund returns.
o C
the standard deviation of the differences between benchmark mutual fund

return and daily ETF fund returns.
Incorrect
A is correct. The best measure to evaluate an ETF is the tracking difference. It is
calculated as the difference between index returns and fund returns over a series of
rolling holding periods. A 12-month holding period is often used. Option B states the
calculation for tracking error, whereas option C is a false statement.
7. Question 7
ETF funds tracking the same underlying index can have very different index tracking
results. Which of the following will most likely result in offsetting cost?
o A
Fees and expenses.

o B
Regulatory tax requirements

o C
Asset manager operations

Incorrect
C is correct. ETF issuers often use strategies like security lending and dividend
capture to offset their operating costs.
8. Question 8
The bid-ask spread is most likely reduced by:
o A
bid-ask spread of underlying securities.

o B
discount related to likelihood of receiving offsetting ETF order.

o C
risk of hedging or carrying positions by the liquidity provider.

Incorrect
B is correct. Discount related to the likelihood of receiving an offsetting ETF order in
a short time frame reduce the spread.
9. Question 9
Quoted bid-ask spreads are positively related to which of the following factors?
o A
amount of competition among market makers for the ETF.

o B
amount of the ongoing order flow in the ETF.

o C
costs and risks for the ETF liquidity providers.

Incorrect
Solution: C is correct. Actual costs and risks for the liquidity provider are positively
related to spreads i.e., more costs and risks mean higher spreads. The spread is
compensation to the liquidity provider for bearing these costs and risks.
The spreads are negatively correlated to competition among market makers for the
ETF and the amount of the ongoing order flow in the ETF.
10. Question 10
Statement 1: NAV is usually a poor value indicator for ETFs holding foreign
securities.
Statement 2: Infrequently traded ETFs may have large premiums or discounts.
o A
Statement 1
o B
Statement 2
o C

Incorrect
Solution: C is correct. The major sources of ETF premiums and discounts are timing
difference and stale pricing.
Timing difference: NAV is usually a poor value indicator for ETFs holding foreign
securities due to differences in exchange closing times. For example, if a US traded
ETF holds European stocks, the NAV may be based on the market closing price in
Europe that occurred hours ahead of when the ETF stops trading on the US
exchange. Hence, Statement 1 is correct.
Stale pricing: Infrequently traded ETFs may also have large premiums or discounts.
For example, if an ETF last traded at 10.00 AM and the market closed at 4.00 PM, the
NAV may have significantly risen or fallen during that time due to market movement.
Hence, Statement 2 is also correct.
11. Question 11
Assuming arbitrage costs are minimal, new ETF shares would most likely be created by
the ETF sponsor when the share price of an ETF is trading at:
o A
a premium to its intraday NAV.

o B
a discount to its intraday NAV.
o C
par with its to its intraday NAV.

Incorrect
Solution: A is correct. When the share price of an ETF is trading at a premium to its
intraday NAV and assuming arbitrage costs are minimal, APs will buy the basket of
securities that the ETF tracks (the creation basket) and exchange it with the ETF
provider for new ETF shares (a creation unit). These new shares received by APs can
then be sold on the open market to realize arbitrage profits.
12. Question 12
ETFs have lower expense ratios as compared to mutual funds most likely because:
o A
They keep track record of individual investors.

o B
They require active managers to carry out security and macroeconomic

research.
o C
They do not bear the costs of communicating directly with individual

investors.
Incorrect
C is correct. ETF issuers do not have to bear the cost of communicating directly with
the individual investors, hence, they can charge a lower fee than the mutual funds.
13. Question 13
As a percentage of total cost, the management fee will most likely be a higher
percentage as compared to trading costs when we have:
o A
a longer holding period.

o B
short-term tactical trades.

o C
The management fee will always have a higher portion of the total cost.
Incorrect
A is correct. Trading costs are one-time costs and they decrease as a portion of the
total cost, hence, the portion of management fees increases for longer holding
periods.
14. Question 14
For a short term tactical investor which portion of the total cost is more significant?
o A
Management fees as a percentage of the total cost.

o B
Trading costs as a percentage of the total cost.

o C
Total cost as a whole.

Incorrect
B is correct. Trading costs are a more significant consideration for shorter-term
tactical ETF investors. Whereas, management fees are a more significant
consideration for longer-term buy-and-hold investors.
15. Question 15
Consider an ETF with a 0.10% annual fee, one-way commissions of 0.05%, and a bid–
ask spread of 0.10%. The round-trip trading cost would be closest to:
o A
0.20%
o B
0.15%
o C
0.10%
Incorrect
Solution: A is correct. Round-trip trading cost (%) would be calculated as follows:
= (One-way commission % × 2) + (½ Bid–ask spread % × 2)
= (0.05% × 2) + (½ × 0.10% × 2)
= 0.10% + 0.10%
= 0.20%
16. Question 16
Based on the information given in Question 15, the 3-month holding period cost
would be closest to:
o A
0.30%
o B
0.23%
o C
0.50%
Incorrect
Solution: B is correct. Holding period cost can be calculated as follows:
Holding period cost (%) = Round-trip trade cost (%) + Management fee for period (%).
Specific holding period costs can be calculated as follows:
3-month holding period cost (%) = 0.20% + 3/12 × 0.10% = 0.225%.
17. Question 17
Exchange-traded notes (ETNs) default risk is most likely an example of:
o A
fund closure risk.

o B
investor-related risk.
o C
counterparty risk.
Incorrect
C is correct. Exchange-traded notes (ETNs) are unsecured, unsubordinated debt
instruments. If the issuing bank declares bankruptcy, the ETNs issued by the bank
would effectively be worthless.
18. Question 18
Analyst 1: Fund closures do not create unexpected tax liabilities for the investor.
Analyst 2: A fund may not entirely shut down but undergo a ‘soft’ closure.
Which of the above analysts in correct?
o A
Analyst 1
o B
Analyst 2
o C
Incorrect
Solution: B is correct. Sometimes a fund may not entirely shut down but undergo a
‘soft’ closure. This includes scenarios like:
• Creation halts: The creation and redemption activities are stopped.

• Changes in investment strategy: Issuers can announce a change in the fund’s
underlying index and the fund may no longer meet the investor’s investment
objectives.
Analyst 1 is not correct because ETF issuers may decide to close an ETF and return
cash to investors which can create unexpected tax liabilities for the investor.
19. Question 19
The primary applications of ETF include:
• Portfolio efficiency
• Asset class exposure management
• Active and factor investing
Which of the following is least likely an example of the ‘portfolio efficiency’ application
of ETFs?
o A
Holding a small portion of funds in ETFs in anticipation of future cash

outflows
o B
Rebalancing using liquid ETFs with tight bid-ask spreads

o C
Investing in ETFs for broad portfolio diversification

Incorrect
C is correct. This is an example of using ETFs to gain core exposure to an asset or
sub-asset class, which is comes under asset class exposure management.
In Option A, a manager is expecting future cash outflows, so he/she invests in ETFs
rather than keeping cash idle or investing it directly in securities (which would be
relatively expensive and less easy to liquidate). This is an example of using ETFs in
efficient portfolio management.
Option B is also an example of efficiently managing a portfolio because using liquid
ETFs with tight bid-ask spreads when rebalancing allows the portfolio manager to
execute the rebalance in a single ETF trade and ensures the portfolio remains fully
invested according to its target weights.
20. Question 20
An application of using ETFs for active and factor investing is most likely:
o A
risk management.
o B
portfolio completion.
o C
transition management.
Incorrect
A is correct. Smart ETFs can be constructed in a way that manages the risk of a
portfolio. For example, ETFs based on the beta characteristics of the constituent
stocks can be used to adjust the portfolio’s beta, or ETFs can be used to manage
currency and/or duration risk.
Option B is incorrect because portfolio completion is an application of efficiently
managing portfolios with ETFs. Portfolio completion refers to filling gaps in strategic
exposure. (This includes temporary exposure to countries, sectors, industries,
themes, factors, etc.)
Option C is incorrect because it is also an application of using ETFs to efficiently
manage portfolios. The following is an excerpt from the curriculum: “Transition
management refers to the process of hiring and firing managers—or making
changes to allocations with existing managers—while trying to keep target
allocations in place. Since ETFs exist on most domestic, international, and global
equity benchmarks, a newly appointed transition manager can invest in an ETF to
maintain market exposure as she undergoes the process of selling the unwanted
positions of the manager she is replacing (the terminated manager).”
21. Question 21
Leveraged and inverse exposure, alternative weighting, and dynamic asset allocation
are most likely applications of:
o A
efficient portfolio management.

o B
asset class exposure management.

o C
active and factor investing.

Incorrect
C is correct. Factor exposure, risk management, leveraged and inverse exposure,
alternative weighting, active strategies within an asset class, dynamic asset allocation
and multi-asset strategies are all strategies that come under active and factor
investing using ETFs.
Roger Gold, chief investment officer at Airlift Securities is meeting with two recently hired
analysts, Maisie Sanders and Abraham McGill to assess their knowledge of exchange-traded
funds (ETFs). Gold starts the meeting by saying the ETFs rely on a creation or redemption
process that is carried out in an OTC primary market. He then askes Sanders and McGill to
briefly comment about the participants in the primary and the secondary market. The
analysts reply as follows:
Sanders: “Primary market consists of 2 participants, the ETF sponsor and the
authorized participants (exchange-traded). The AP creates new ETF shares by
transacting in-kind with the ETF issuer. Then these shares are sold by the AP in the
secondary market.”
McGill: “Both primary and secondary market consists of multiple participants. Any
participant can create or redeem shares in the OTC primary market by transacting
in-kind with the ETF issuer and then they can trade shares in the secondary market.”
Gold then states: “Arbitrage gap refers to the difference between the ETF price and NAV
which prompts the AP to create/redeem shares.”. Following his comment, he asks the
analysts to give an example of arbitrage opportunities that might exist. Lastly, Gold tests
analysts’ understanding of expense ratio and tracking error. He asks Sanders to give at least
two factors that result in lower expense ratio for ETFs as compared to mutual funds. He
asks McGill to determine which method is best suited to assess ETF’s performance, which
reflects the impact of portfolio rebalancing expenses and other fees.
1. Question 1
Which of the comments of the two analysts about the creation/redemption process
is most likely correct?
o A
Sanders’ comment
o B
McGill’s comment
o C
Both are incorrect.

Incorrect
A is correct. Sanders explanation about ETF mechanics is correct. McGill’s comment
is incorrect because only APs can create or redeem ETF share by transacting in kin
with the ETF sponsor.
2. Question 2
In response to Gold’s question on arbitrage opportunity analysts’ best response
should be:
o A
If ETF shares are trading at a premium to NAV, an AP can profit by purchasing

ETF shares and exchanging them for underlying basket of securities.
o B
If ETF shares are trading at a discount to NAV, an AP can profit by

purchasing ETF shares and exchanging them for underlying basket of
securities.
o C
If ETF shares are trading at a discount to NAV, an AP can profit by buying

underlying basket of securities and exchanging them for ETF shares.
Incorrect
B is correct. An AP can take advantage of this situation by purchasing ETF shares
from the secondary market (e.g. for USD24.90), exchanging them with the ETF issuer
for the underlying basket of securities, and selling the basket (e.g. for USD25), to
make a profit (e.g. USD0.10 in profit).
3. Question 3
For Gold’s question to Sanders about the expense ratio. Sanders’ response
should least likely include:
o A
ETFs usually follow an index-based portfolio management process which

does not require active managers doing extensive research.
o B
ETFs are based on a basket of underlying securities, which can include

depositary receipts.
o C
ETFs do not have to keep track of individual investor accounts.

Incorrect
B is correct. Options A and C are factors which contribute to lower expense ratio for
ETFs as compared to mutual funds.
4. Question 4
For Gold’s question to McGill about the tracking error. If McGill responded correctly,
his response should most likely have been:
o A
Tracking error
o B
Tracking differences
o C
The annualized standard deviation of the daily differential returns of the ETF
and its benchmark.
Incorrect
B is correct. The best measure to evaluate an ETF is the tracking difference, it
provides a more informative picture of the investment outcome for an investor in an
ETF. It is calculated as the difference between index returns and fund returns over a
series of rolling holding periods.
Nelson Jacobs recently invested in an ETF. Jacobs is new to investing in the ETF shares and
his knowledge about the ETF market is limited. He realizes his knowledge about the ETF
market is not the same his knowledge in conventional stock market. So, he decides to
consult a friend of his, Clara Hensley, to better understand the ETF market. She starts by
telling Jacobs that investing in ETFs introduces several unique risks because of their
structure, fund holdings, and underlying exposure. She then goes on to discuss different
types of risks that are involved, when investing in ETFs. Their conversation includes
discussion about counterparty, fund closure and investor-related risks. During the
discussion, Hensley states: “Much like the mutual funds, ETFs may lend their securities to
generate additional income. This exposes them to the risk of counterparty default.”.
1. Question 1
Based on the discussion between Jacobs and Hensley about counterparty risk. Which
of the following actions is least likely in line with lowering this risk?
o A
Reinvest the cash collateral into extremely short-term fixed-income

securities.
o B
Overcollateralize the lent securities.

o C
Lend securities to entities with low credit rating only.

Incorrect
C is correct. Cash collateral is usually reinvested into extremely short-term fixed-
income securities with minimal associated risk. Also, to minimize this risk securities
lent are generally overcollateralized, to 102% (domestic) or 105% (international).
2. Question 2
If Jacob decides to invest in the inverse ETFs, which risk factor is Hensley most likely
to warn him about, considering his lack of experience in investing in ETFs and his
lack of knowledge about risk and returns characteristics of ETFs?
o A
Counterpart risk
o B
Settlement risk
o C
Investor-related risks
Incorrect
C is correct. Leveraged and inverse ETFs are somewhat complex asset classes and
for a novice investor like Jacobs they introduce risks that are hard for novice
investors to understand. Investor-related risk is the risk that some ETF investors may
not fully understand how more complex ETFs will perform because of a lack of
understanding of sophisticated assets classes and strategies.
Using Multifactor Models

1. Question 1
Q-Code: 21-L2-PM-ITMM-75561
Which of the following statements about arbitrage pricing theory (APT)
is most likely true?
o A
APT represents an asset’s risk as a linear function of factors representing

unsystematic risk.
o B
The number of underlying factors in APT is fixed.

o C
A key assumption of APT is that there are many investable assets such
that asset specific risk can be diversified.
Incorrect
C is correct. APT explains an asset’s return based on factors representing systematic
risk only. It assumes that asset specific risk can be diversified away.
2. Question 2
An arbitrage opportunity is:
o A
a transaction that generates a risk-free return as a guaranteed pay-off.
o B
a transaction that is risk-free and requires no net investment of money

but earns an expected positive net profit.
o C
a transaction that earns a return in excess of the risk-free rate with minimal
risk.
Incorrect
B is correct. An arbitrage opportunity is an opportunity to conduct a transaction that
is risk-free and requires no net investment of money but earns an expected positive
net profit.
3. Question 3
The one year futures of DMX Co. are selling at USD11. The current stock price is
USD10 and the risk-free rate is 8%. There are no further costs or benefits of holding
the future contracts. John Harper is considering shorting futures. Which of the
following statements is most likely true?
o A
There exists an arbitrage opportunity as the transaction will yield a

return higher than the risk-free rate without assuming any risk.
o B
There is no arbitrage opportunity because the transaction does not yield a

return higher than the risk-free rate.
o C
There is no arbitrage opportunity because the transaction is not risk-free.

Incorrect
A is correct. Buying the stock and shorting the futures gives a guaranteed return of
10% i.e. 11/10 -1 = 10%. The RF rate is 8%. The transaction gives a pay-off, i.e. risk-
free. As the expected return is higher than the RF rate, an arbitrage opportunity
exists.
4. Question 4
The following table shows the factor sensitivities and expected returns of three well-
diversified portfolios each sensitive to the same factor:
Portfolio Factor Sensitivity Expected Return

A 0.5 6.5%
B -0.6 3.2%
C 0.7 7.1%
Assuming a single factor explains returns and no arbitrage opportunity exists, a risk-
free rate of 5%, the factor risk premium of Portfolio A is closest to:
o A
3.0%.
o B
5.1%.
o C
11.4%.
Incorrect
A is correct. Because the single factor explains returns, E(Rp) = RF + 0.5 x factor risk
premium (λ) given E(RA) = 0.065 = 0.05 + 0.5(λ). λ = (0.065 – 0.05)/0.5 = 0.03 = 3%.
5. Question 5
Belta Inc. has an expected return of 9%. The risk-free rate is 3%. The only factor
representing systematic risk is Factor X with an expected return of 5%. The
company’s sensitivity to Factor X is closest to:
o A
0.0.
o B
1.2.
o C
1.0.
Incorrect
B is correct. 9% = 3% + (Factor sensitivity x 5%). Factor sensitivity is therefore 1.2.
6. Question 6
Which of the following statements regarding multifactor models is most likely true?
o A
Fundamental factor models present sensitivities of the company to external

economic factors that affect its fundamentals.
o B
Factor analysis models and principal component models are instances of

fundamental factor models.
o C
Macro-economic factor model includes factors such as surprises in
interest rates and inflation.
Incorrect
C is correct. Macroeconomic models represent asset returns correlated to surprises
in some factors related to macroeconomic variables. These include interest rates,
inflation risk, business cycle risk, GDP growth etc.
7. Question 7
A potential difference between macroeconomic factor models and fundamental
factor models is that:
o A
macroeconomic factor models explain past returns whereas fundamental

factor models explain expected return.
o B
macroeconomic factor models use regression to estimate sensitivities

whereas fundamental factor models do not use regression.
o C
in macroeconomic models the factor is stated as a surprise whereas in

fundamental factor models the factor is stated as a return.
Incorrect
C is correct. In macro-economic models, the factor is stated as a surprise whereas in
fundamental factor models the factor is stated as a return.
8. Question 8
o A
Macroeconomic models are based on the principle that the returns to an

asset are correlated with surprises in macroeconomic factors such as GDP,
inflation, etc. Factor surprises are the independent variable in this model.
o B
Fundamental factor models often use more factors than

macroeconomic factor models. This gives them more explanatory power
which makes them superior to macroeconomic factor models.
o C
The factors of fundamental factor models for equities can be broadly

grouped into three categories: company fundamental factors, company
share-related factors, and macroeconomic factors.
Incorrect
B is correct. While fundamental factor models do have more explanatory power than
macroeconomic factor models, this does not make them superior. Both forms of
factor models have benefits and drawbacks.
The statements in options A and C are correct.
9. Question 9
Earnings growth will be classified as a:
o A
company fundamental factor.

o B
company share-related factor.

o C
macroeconomic factor.
Incorrect
Solution: A is correct. The factors of fundamental factor models for equities are
diverse, but they can be broadly grouped into the following three categories:
Type of factor Example

Company fundamental factors: related Earnings growth, earnings
to a company’s internal performance variability, earnings momentum, etc.
Market capitalization, price
Company share-related factors: related
multiples such as earnings yield,
to valuation measures
dividend yield, etc.
Macroeconomic factors: related to the CAPM beta, yield curve level
company’s industry sensitivity
10. Question 10
Real estate, timberland, farmland and energy are best suited for investment in which
of the following scenarios:
o A
High inflation/High growth

o B
Low inflation/High growth

o C
High inflation/Low growth

Incorrect
Solution: A is correct. Real assets, including real estate, timberland, farmland,
energy, are likely to benefit from high inflation/high growth scenario.
11. Question 11
Which of the following statements regarding multifactor models is most likely true?
o A
Multifactor models can be used to predict alpha in passively managed

portfolios.
o B
Factor models have sensitivity of -1 to a particular factor and 0 to all other

factors.
o C
Multifactor models can be used to replicate a benchmark’s risk

exposures for a passively managed portfolio.
Incorrect
C is correct. Multifactor models can be used to replicate risk exposures of a
benchmark for a passively managed portfolio when number of stocks in a
benchmark may be too high or investing in all stocks is not possible.
12. Question 12
Which of the following is least likely a benefit of using multifactor models in modeling
asset returns?
o A
Investors can better analyze their comparative advantage in bearing risk.

o B
Investors can achieve better-diversified portfolios.

o C
Investors can determine the optimum allocation between a risk-free

asset and market portfolio.
Incorrect
C is correct. Multifactor models do not provide an optimum allocation rather they
are used to understand the varying sources of risk in a portfolio. This can lead to
more efficient portfolios.
13. Question 13
Statement 1: A portfolio manager’s active return is the sum of factor tilts and
security selection.
Statement 2: An index fund that effectively meets its investment objective is
expected to have an information ratio of zero.
Which statement is correct?
o A
Statement 1
o B
Statement 2
o C

Incorrect
Solution: C is correct. Both statements are correct. Statement 1 is correct because a
portfolio manager’s active return is the sum of two components, factor tilts and
security selection. Factor tilt is the product of the portfolio manager’s factor tilts
(overweight or underweight relative to the benchmark factor sensitivities) and the
factor returns. Security selection reflects the manager’s skill to overweight securities
that outperform or underweight securities that underperform.
Statement 2 is correct because an index fund that effectively meets its investment
objective is expected to have an information ratio of zero, because its active return
should be zero.
14. Question 14
Which of the following will most likely have a comparative advantage in terms of
bearing business cycle risk?
o A
University endowment fund

o B
Private equity fund with a short-term investment horizon

o C
An investor who depends on income from salary

Incorrect
Solution: A is correct. A university endowment fund may have a comparative
advantage for bearing business cycle risk because of their long investment horizon.
A private equity fund with a shorter investment horizon may have a comparative
disadvantage in bearing business cycle risk. Similarly, an investor who depends on
income from salary will be more sensitive to business cycle risk relative to an
independent wealth investor.
15. Question 15
Active risk is due to:
o A
different-from-benchmark exposures relative to factors specified in the risk

model only.
o B
different-from-benchmark weights on individual assets only.

o C
both different-from-benchmark exposures to factors in the model and

different-from- benchmark weights of individual assets.
Incorrect
C is correct. Active risk has two components: 1) active factor risk which is the risk due
to portfolio’s different-from-benchmark exposures relative to factors specified in the
risk model and 2) asset selection risk which is the risk resulting from the portfolio’s
active weights of individual assets.
16. Question 16
The active risk decomposition of two portfolios, A and B is given below:
Portfolio Active Factor Active Specific

Industry Style factor
A 15 10 17
B 5 8 2
Note: Entries are in % squared
o A
Style factor contributed more to Portfolio B’s active risk than Portfolio
A.
o B
Portfolio B’s active risk is higher than that of portfolio A.

o C
The low active specific risk of portfolio B suggests a passively managed

portfolio.
Incorrect
A is correct. Style contributed 10/42 = 23.8% to portfolio A’s active risk and
8/15=53.3% to portfolio B’s active risk.
17. Question 17
The track record of three fund managers is given below:
Average Active return Tracking Error

Fund Manager A 5% 2%
Fund Manager B 2% 1%
Fund Manager C 6% 4%
Based on the data, which fund manager has the best risk-adjusted record?
o A
Fund Manager A.
o B
Fund Manager B.
o C
Fund Manager C.
Incorrect
A is correct. Fund Manager A’s IR (information ratio) is 5/2 = 2.5, Fund Manager B’s IR
is 2/1 = 2 and Fund Manager C’s IR is 6/4 = 1.5. Fund Manager A has the highest IR.
18. Question 18
An analyst constructs a macroeconomic factor model while comparing three
portfolios. She looks at their sensitivities to four factors: inflation, term structure,
unemployment, and GDP. The following table shows the factor sensitivities of each
portfolio.
Risk Factor Portfolio A Portfolio B Portfolio C

Inflation 1 0 1
Term Structure 0 1 1
Unemployment 0 1 1
GDP 0 1 1
If a portfolio manager wants to hedge against an existing long exposure to inflation

risk, he should most likely:
o A
take a long position in Portfolio A.

o B
take a short position in Portfolio A.

o C
take a long position in Portfolio B.

Incorrect
B is correct. Portfolio A is the factor portfolio for inflation risk because it has a
sensitivity of 1 to inflation and 0 to all other factors. Since the portfolio wants to
hedge against an existing long position, he should take a short position in this factor
portfolio.
19. Question 19
To achieve a higher information ratio, the active manager may assume:
o A
active factor risk only.

o B
active specific risk only.

o C
both A) and B).

Incorrect
C is correct. The active manager may assume active factor risk as well as active
specific risk to achieve a higher information ratio.
Brie Lars is a portfolio manager for Mega Inc., an appliance manufacturer. At the quarterly
meeting with the client, Brie explains that she uses multifactor models as a guide to asset
allocation. In particular she uses the arbitrage pricing theory (APT) to model asset return.
She describes the three main assumptions of the APT model: Assumption 1: A factor model
can be used to explain asset returns. Assumption 2: No arbitrage opportunities are possible
in a well-diversified portfolio. Assumption 3: Adding assets to a diversified portfolio, adds to
factor risk and to its specific risk. She explains that she evaluates different funds in the
market and seeks to exploit arbitrage opportunities among them. She presents an example
of different portfolios using a one-factor model that explains returns. The data is presented
below: Exhibit 1: Portfolio information for a one-factor model
Portfolio Expected return Factor sensitivity

A 15.0% 0.8
B 16.0% 1.0
C 19.0% 1.2
1. Question 1
Which of Brie’s assumptions underlying APT is least likely correct ?
o A
Assumption 1.
o B
Assumption 2.
o C
Assumption 3.
Incorrect
C is correct. “APT is based in part on the assumption that as assets are added to a
portfolio, the portfolio becomes well diversified and asset-specific risk is eliminated.”
Therefore, adding assets to a diversified portfolio should decrease its specific risk.
2. Question 2
Based on Exhibit 1, can an arbitrage portfolio be created with a combination of
portfolios A, B and C ?
o A
No.
o B
Yes, the portfolio would earn an expected return of 1.0%.

o C
Yes, the portfolio would earn an expected return of 17.0%.

Incorrect
B is correct. Portfolio B has a factor sensitivity of 1.0 and an expected return of
16.0%. A 50/50 portfolio combining portfolio A and portfolio C would also have a
factor sensitivity of 1.0 ((0.8 + 1.2)/2) but and expected return of 17.0% ((15% +
19%)/2). An arbitrage portfolio can be created by selling short portfolio B and
purchasing an equally weighted (50/50) portfolio of A and C, to give a net return of
17-16 = 1.0%.
3. Question 3
Assuming that portfolio A and B’s returns are represented by a single-factor
equation of E(Rp) = RF + λ1βp, the value of λ1 is closest to:
o A
0.05.
o B
0.025.
o C
0.010.
Incorrect
A is correct. Portfolio A’s return equation is: 15% = RF + 0.8λ1 and portfolio B’s return
equation is: 16% = RF + 1.0λ1. Using portfolio A’s equation, RF = 15% – 0.8λ1.
Substituting this in portfolio B’s equation gives:
16% = 15% – 0.8λ1 + 1.0λ1
0.2 λ1 = 0.01
λ1 = 0.05.
4. Question 4
Based on its factor sensitivity, portfolio B can be best characterized as:
o A
an arbitrage portfolio
o B
a market-neutral portfolio.
o C
a pure factor portfolio.

Incorrect
C is correct. A portfolio with a sensitivity of 1 to factor j and a sensitivity of 0 to all
other factors is called a pure factor portfolio for factor j.
Delta partners is an investment management firm which manages portfolios for high net-
worth individuals. The firm uses multifactor models to explain asset returns. In a meeting
with the investment committee, Simon William, a senior portfolio manager at the firm,
explains that he uses a four-factor model with factors for the market (denoted as RMRF),
market capitalization (small minus big, or SMB), book value effect (high minus low, or HML),
and momentum (winners minus losers, or WML). He has estimated the risk premiums for
these factors and estimated factor sensitivities for three portfolios, as shown in Exhibit
2. Exhibit 2: Factor risk premiums and portfolio sensitivities
Factor Portfolio Portfolio Portfolio

Factor
risk premium 1 sensitivities 2 sensitivities 3 sensitivities
RMRF 5.1% 0.8 1.0 0.9
SMB 1.4% 1.1 0.2 0.7
HML -0.8% 0.4 0.6 1.2
WML 0.5% 1.3 0.8 0.8
Simon further elaborates that he also uses different types of multifactor models. While
presenting a comparison of multifactor models to the investment committee, he states,
1. “In a macroeconomic factor model, the factors used are the surprises in economic
data relative to expectations.
2. In statistical factor models, an asset’s sensitivity to a factor is expressed using a
standardized beta, the value of the attribute for the asset minus the average value of
the attribute across all stocks divided by the standard deviation of the attribute’s
values across all stocks.”
1. Question 1
With regards to Simon’s explanation of the statistical factor model, he is most likely:
o A
correct.
o B
incorrect, because statistical factor models don’t use standardized

betas.
o C
incorrect, because the definition of standardized beta is incorrect.

Incorrect
B is correct. Standardized betas are used in fundamental factor models, not
statistical factor models.
2. Question 2
Based on the data in Exhibit 2, the portfolio with the highest expected return most
likely is:
o A
Portfolio 1.
o B
Portfolio 2.
o C
Portfolio 3.
Incorrect
A is correct. The expected portfolio return using a four-factor model is E(RP) = RF +
β1RMRF + β2SMB + β3HML + β4WML. The risk free rate is the same for all portfolios
therefore it doesn’t affect the relative returns. Portfolio 1’s return exclusive of the
risk free rate is (5.1% x 0.8 + 1.4 x 1.1% + -0.8% x 0.4 + 0.5% x 1.3) = 5.95% which is
higher than Portfolio 2’s 5.3% (5.1% x 1.0 + 1.4% x 0.2 – 0.8 x 0.6 + 0.5% x 0.8) and
Portfolio 3’s 5.01% (5.1% x 0.9 + 1.4% x 0.7 -0.8% x 1.2 + 0.5% x 0.8) (RF rate is the
same for all portfolios).
3. Question 3
The multifactor model given in Exhibit 2 is known as:
o A
The CAPM model.
o B
The Cahart model.

o C
The Fama French model.

Incorrect
B is correct. In the Carhart model, the excess return on the portfolio is explained as a
function of the portfolio’s sensitivity to a market index (RMRF), a market
capitalization factor (SMB), a book-value-to-price factor (HML), and a momentum
factor (WML).
4. Question 4
With regards to Simon’s explanation of the macroeconomic factor model, he is most
likely:
o A
incorrect, because the factors used are the absolute values of the
macroeconomic variables.
o B
correct.
o C
incorrect, because macroeconomic factor models are single-factor models.

Correct
B is correct. In a macroeconomic factor model, the factors used are the surprises in
economic data relative to expectations.
Greg Thompson and Marry Johnson are portfolio managers at Cimka Investments. They are
having a discussion on evaluating a portfolio’s risk adjusted performance and analyzing its
risk exposures. Greg states, “A portfolio’s performance can be measured using the
information ratio. During the year my portfolio achieved an active return of 2% and had a
variance of active returns equal to 36%, I believe the information ratio of 5.6 is quite
impressive”. He further adds, “Active return is the sum of each factor’s return multiplied by
the difference in the portfolio’s sensitivity to that factor and the benchmark’s sensitivity.
Active risk can be decomposed into total factor risk and active specific risk.” Mary then
presents a decomposition of the active risk of three portfolios under management given in
Exhibit 3. Exhibit 3: Decomposition of active risk
Portfolio 1 Portfolio 2 Portfolio 3

RMRF risk 10% 25% 10%
SMB risk 20% 15% 10%
HML risk 10% 20% 15%
WML risk 15% 15% 5%
Active specific risk 45% 25% 60%
Note: All figures are a percentage of total active risk squared.
1. Question 1
Greg’s statement about the information ratio of his portfolio is most likely:
o A
correct.
o B
incorrect, the information ratio is actually 0.33.

o C
incorrect, the information ratio is actually 0.50.

Incorrect
B is correct. Information ratio is measured as the active return divided by the
tracking error, which the is standard deviation of active returns. The tracking error of
Greg’s portfolio is The information ratio is therefore 2% / 6% = 0.33.
2. Question 2
With regards to Greg’s statement on active return and active risk, he is most
likely correct with regards to:
o A
active risk only.

o B
active return only.

o C
both active return and active risk.

Incorrect
A is correct. Greg is correct about active risk but incorrect about active return. The
active return consists of two parts: (1) the sum of each factor return x (portfolio’s
sensitivity to that factor – benchmark’s sensitivity) and (2) the active return resulting
from security selection. Greg did not include the effect of security selection.
3. Question 3
Based on the data provided in Exhibit 3, the total factor risk of Portfolio 1 is closest to:
o A
0.03%
o B
13.8%
o C
55.0%
Incorrect
C is correct. Total factor risk is the sum of the risk of each of the factors. For Portfolio
1, the total factor risk is 10% + 20% + 10% + 15% = 55%.
4. Question 4
Based on the data provided in Exhibit 3, which portfolio is likely to be
the most diversified?
o A
Portfolio 2.
o B
Portfolio 3.
o C
Portfolio 1.
Incorrect
A is correct. Diversification reduces a portfolio’s active specific risk; therefore, the
portfolio with the lowest active specific risk is likely to be the most
diversified. Portfolio 2 has the lowest active specific risk of 25%. Therefore, Portfolio
2 is likely to be the most diversified.
Ann Wiley, is a portfolio manager at Brooks Capital, a firm providing investment consulting
and portfolio management services to institutional clients. Wiley is meeting with a new
assistant, Paula Slater. Wiley begins the meeting with the following comment: Comment 1:
“We evaluate securities using multifactor models to determine the expected return and risk
of securities. Depending on our requirement, we choose one from the three types of
multifactor models: a macroeconomic factor model, a fundamental factor model, or a
statistical factor model. For macroeconomic factor models, the factors are the surprises in
the selected macroeconomic variables. For fundamental factor models, the factors are
cross-sectional differences in companies’ returns. In statistical factor models, we apply
statistical techniques, such as factor analysis or principal component analysis, to historical
securities’ returns to identify factors that best explain historical variances and covariances.”
Slater states: “What is the return generating process given by the arbitrage pricing theory
(APT) equation which is also a form of a multifactor model?” Wiley responds, “APT specifies
the appropriate number of factors to use in a multifactor model, helps identify those
factors, and gives the expected return of the asset being evaluated.” Wiley continues:
Comment 2: “Multifactor models are also used to explain the active risk of a portfolio. In
analyzing risk, using active risk squared can be decomposed into two components: active
factor risk and active specific risk. Active factor risk is due to portfolio’s different-from-
benchmark exposures relative to factors specified in the risk model. Active specific risk
measures the residual risk of the portfolio.”
1. Question 1
Wiley is least likely correct with respect to which type of multifactor model:
o A
macroeconomic factors models.

o B
fundamental factor models.

o C
statistical factor models.

Incorrect
B is correct. Wiley incorrectly states the fundamental factor model. In a fundamental
factor model, the factors are attributes of stocks or companies such as the book-
value-to-price ratio, market capitalization, the price-to-earnings ratio, and financial
leverage.
2. Question 2
Wiley’s response to Slater is most likely correct with respect to:
o A
number of factors.
o B
identity of the factors.

o C
expected return.
Incorrect
C is correct. The APT model gives us the intercept term which is the expected return
of the asset. The number and identity of factors are not specified by the APT model.
3. Question 3
In Comment 2, does Wiley correctly state the active factor risk and active specific risk?
o A
Yes.
o B
No, she is incorrect about active specific risk.

o C
No, she is incorrect active factor risk.
Incorrect
A is correct. Wiley correctly states the active factor risk and active specific risk. “Active
factor risk measures the factor exposures of the portfolio relative to its benchmark.
Active specific risk is the contribution to active risk squared due to each asset’s active
weight (actual weight in the portfolio minus weight in the benchmark) times its
residual risk (the variance of the asset’s returns left unexplained by the factors)—that
is, it measures the residual risk taken on by the portfolio.”
Yash Aggarwal, an equity portfolio manager for Southeast Investments, is meeting with
Satish Jha, senior analyst at the firm, to discuss ways to improve the current research
methods of evaluating securities. Jha begins by stating that multifactor models are very
useful in modeling stock returns. He adds, “We are currently using two types of multifactor
models that can explain stock returns: Ri = ai +bi1F1 + bi2F2 +..+biKFK + €i Model 1 In this model,
stock returns are determined by factors which are surprises in macroeconomic variables
such as GDP growth and the level of interest rates. Model 2 Here, stock returns are a linear
function of factors that are company or stock attributes such as price-earnings ratio and
market capitalization. The intercept ai is interpreted as the expected return to stock in both
models, the factor sensitivities bi are defined differently in the two models.” Aggarwal
observes, “A multifactor Arbitrage Pricing Model (APT) is also useful in explaining expected
portfolio returns and evaluating portfolio risk exposures.” She uses the information given
below in Exhibit 1 to illustrate the advantages of the multifactor APT model. The current
risk-free rate is 3 percent. Exhibit 1: Factor Sensitivities and Risk Premia
Factor
Risk Factor Factor Sensitivities Risk Premium
(%)
Portfolio X Portfolio Y Benchmark
Confidence Risk 0.90 0.05 0.60 5.0
Inflation Risk -0.20 -0.60 -0.33 -1.8
Business Cycle
1.37 0.10 1.00 5.8
Risk
Aggarwal then makes the following statement: “Exhibit 1 shows that Portfolio X will benefit
from a growing economy and improving confidence because the factor sensitivities for
confidence risk and business cycle risk are greater than the factor sensitivities for the
benchmark. Portfolio Y is a factor portfolio for inflation risk because of relatively high
exposure to inflation risk, and low factor sensitivities for confidence risk and business cycle
risk.” Aggarwal wants to know how active management is contributing to portfolio
performance. Jha responds, “Results from our analysis show that Portfolio X has annual
tracking error of 6% and an information ratio of 2.1 while Portfolio B has annual tracking
error of 0.65% and an information ratio of 0.8.”
1. Question 1
Regarding Jha’s explanation of the multifactor models, he is least likely correct about:
o A
description of models’ factors.

o B
intercept value.
o C
factor sensitivities.
Incorrect
B is correct. The intercept is not interpreted as an expected return by both models.
Model 1 is a macroeconomic factor model. In this model, the intercept value ai is the
expected return on the stock. Model 2 is a fundamental factor model. In
fundamental factor models, the factors are given as returns rather than
return surprises to predicted values so they do not generally have expected values of
zero. This changes the meaning of the intercept, which is no longer interpreted as
the expected return. A & C are correct statements.
2. Question 2
Based on the information given in Exhibit 1, the expected return of Portfolio X
is closest to:
o A
5.0%.
o B
15.8%.
o C
12.3%.
Incorrect
B is correct. The expected return of Portfolio A is given by the APT equation: E(Rp)
= RF + λ1βp,1 + … + λKβp,K
E(Rx) = 3% + (0.9 x 5%) + ( -0.2 x 1.8% ) + ( 1.37 x 5.8% ) = 15.806%.
3. Question 3
Is Aggarwal’s statement about portfolios shown in Exhibit 1 most likely correct?
o A
Yes.
o B
No, she is incorrect about Portfolio X.

o C
No, she is incorrect about Portfolio Y.

Incorrect
C is correct. Aggarwal is incorrect about Portfolio Y. “Factor portfolios by definition
will have a factor sensitivity of 1 to a particular factor and zero sensitivity for all other
factors. For Portfolio Y to be a factor portfolio for the inflation risk factor it must have
factor beta of 1 to inflation risk and zero for the other factors.”
4. Question 4
Based on Jha’s response about portfolio performance, the most likely conclusion is,
the portfolio that has benefited the most from active management is:
o A
portfolio Y because of tracking error.

o B
portfolio Y because of information ratio.

o C
portfolio X because of information ratio.

Incorrect
C is correct. Portfolio X has a higher information ratio. Therefore, it has performed
better in line with its chosen benchmark in terms of mean active returns per unit of
active risk.
Zara Kramer works as a portfolio manager at RCK Investments. She meets with Bill White,
the chief investment officer of a corporate pension fund, to discuss portfolio strategies and
techniques used in the management and risk assessment of the fund. White asks Kramer, “I
would like to understand the model that you use to choose stocks for the pension
portfolio?” Kramer responds, “At RCK, we typically use a multifactor model in which the
factors are price-to-earnings ratio (P/E), financial leverage, and market capitalization.”
Kramer adds, “We measure portfolio risk by using a risk model to decompose active risk into
the following two components – The first component is an ‘active factor risk,’ which is
systematic risk resulting from the differences in factor exposures between the portfolio and
the benchmark. The second component is the active specific risk which is expressed as the
individual asset’s active weight in the portfolio and the variance of returns unexplained by
the factors in the model.” Finally, Kramer explains the active return and performance
evaluation measures for the fund.
1. Question 1
The multifactor model described by Kramer is most likely a:
o A
macroeconomic factor model.

o B
fundamental factor model.

o C
statistical factor model.
Incorrect
B is correct. The multifactor model described by Kramer is a fundamental factor
model. In fundamental factor models, the factors are attributes of stocks or
companies. Fundamental factors that have been used are market capitalization, the
price- to-earnings ratio, book-value-to-price ratio and financial leverage.
2. Question 2
Is Kramer correct about the components of active risk?
o A
Yes.
o B
No, she is incorrect about the first component.

o C
No, she is incorrect about the second component.

Incorrect
A is correct. Kramer correctly explains the components of active risk. A portfolio’s
active risk squared can be decomposed into two components: (1) “active factor risk is
the contribution to active risk squared resulting from the portfolio’s different-from-
benchmark exposures relative to factors specified in the risk model” (or systematic
risk), and (2) active specific risk (or asset selection risk) is the contribution to active
risk squared measured by the portfolio’s active weights of individual assets and the
assets’ residual risk (also referred to as idiosyncratic risk).
Corgan Investments is an investment advisory and portfolio management firm that
specializes in equities in energy sector in various global markets. Brenda Fraser, senior
portfolio manager, is discussing management of the firm’s portfolios with a recently hired
analyst Patrick Ricoh. Fraser states, “We use factor models when analyzing regional energy
index expected returns.” Fraser continues, “Factor models are based on the arbitrage pricing
theory (APT), which works under three key assumptions: Assumption 1: A factor model
describes asset returns. Assumption 2: Investors can construct well-diversified portfolios
that eliminate factor risk. Assumption 3: No arbitrage opportunities are possible among
well-diversified portfolios.” Fraser adds: “Upon analysis of our three regional portfolios, I
have found that all the three portfolios show sensitivity to price-to-cashflow factor (P/CF) as
given in Exhibit 1. Information from Exhibit 1 shows the possibility of an arbitrage
opportunity that can be exploited by buying Portfolio III while selling short 40% of Portfolio I
and 60% of Portfolio II.” Exhibit 1. Portfolio Sensitivities to P/CF Factor
Portfolio Expected Return Factor Sensitivity

I 12.0% 0.9
II 13.3% 0.4
III 15.3% 0.6
Fraser concludes, “For our securities analysis we use a three-factor model, to compare the
mean expected return of the regional energy index with an individual security’s expected
return. The three factors are: Factor 1: P/CF factor that compares stocks of firms in the
highest P/CF quartile with the stocks of firms in the lowest P/CF quartile. Factor 2: A sector
excess return factor that compares local energy sector returns with the entire local equity
market (MKT). Factor 3: A capital investment factor.”
1. Question 1
Is Fraser correct in the description of APT ?
o A
Yes.
o B
No, she is incorrect with respect to Assumption 2.

o C
No, she is incorrect with respect to Assumption 3.

Incorrect
B is correct. The correct Assumption 2 of APT is, “There are many assets, so investors
can form well-diversified portfolios that eliminate asset specific risk” and not factor
risk.
2. Question 2
Is Fraser most likely correct in identifying existence of arbitrage opportunities among
the three portfolios?
o A
Yes.
o B
No, because Portfolio I has the highest factor sensitivity.

o C
No, because Portfolio III has the highest expected return.

Incorrect
A is correct. Fraser correctly spots the possibility of an arbitrage opportunity.
Portfolio III has the same factor sensitivity as a portfolio composed of 40% Portfolio I
and 60% Portfolio II. [( 0.4 x 0.9) + ( 0.6 x 0.4 ) ] = 0.6. Portfolio III has a higher
expected return than the combined return of Portfolios I & II = [( 0.4 x 12.0%) + ( 0.6 x
13.3%)] = 12.78% . Hence Portfolio III is currently undervalued with a higher expected
return.
3. Question 3
The three-factor model is most likely applied for:
o A
portfolio construction.
o B
return attribution.
o C
risk assessment.
Incorrect
A is correct. Corgan Investments most likely uses the three-factor model for portfolio
construction. By comparing the expected return of the security with the expected
return of its sector index, a portfolio would be constructed by selecting securities
with expected returns higher than the benchmark. The model is not being used for
risk or return attribution of a portfolio.
4. Question 4
The three-factor model described by Kramer is most likely a:
o A
macroeconomic factor model.

o B
statistical factor model.

o C
fundamental factor model.

Correct
C is correct. Corgan’s three-factor model is a fundamental factor model because it
considers such factors as P/CF, capital investment, and equity returns. There is no
reference to macroeconomic factors (e.g., interest rates, inflation risk, business cycle
risk, or credit spreads) and statistical factors (e.g., historical covariances).
Shania Peters, portfolio manager at a global investment firm focused on consumer staples’
stocks is conducting a workshop for new analysts at the firm. She explains that the firm uses
a three-factor model for portfolio construction by selecting securities after comparing them
to their respective sector index in their specific regions. Peters shares the following data
given in Exhibits 1 and 2 showing the regional sensitivities to the three-factor used in the
model and portfolios’ characteristics. She asks the participants to calculate the expected
return for the different regions, using 0.6% as the risk-free rate. Exhibit 1: Factor Model
and Portfolio Characteristics
Mean
Sector Tracking
Local Index β*P/S βMKT βDiv yield Information Ratio
Region Error
Return
North
9.0% 0.4 0.3 2.0 1.47 5.0%
America
Eurozone 7.5% 1.1 1.1 0.6 1.30 7.0%
China 6.5% 0.8 0.9 0.7 2.56 4.5%
Note: The three factors used in the model are: price-to-sales, market capitalization, and
*
dividend yield. Exhibit 2: Factor Values

Region P/S MKT Div Yld
North America 0.110 0.045 0.050
Eurozone 0.030 0.060 0.100
China 0.047 0.075 0.099
1. Question 1
Based on the information in Exhibits 1 & 2, the expected return for China sector
portfolio is closest to:
o A
17.0%.
o B
18.0%.
o C
16.3%.
Incorrect
B is correct. E(Rp ) = (0.8 x 0.047 ) + ( 0.9 x 0.075 ) + ( 0.7 x 0.099 ) + 0.006 = 18.04%
2. Question 2
Based on Exhibit 2, the portfolio that resembles the risk characteristics of an
aggressive equity manager is most likely:
o A
North America.
o B
China.
o C
Eurozone.
Incorrect
C is correct. The Eurozone portfolio has the highest tracking error. Tracking error is
active risk. An aggressive equity manager would be expected to have the highest
tracking error.
Measuring and Managing Market
Risk
1. Question 1
Q-Code: 21-L2-PM-MMMR-75601
Which of the following statements is least accurate regarding VaR?
o A
VaR gives the probability of the minimum amount that one can lose
over a certain period.
o B
VaR can be expressed either in currency units or as a rate of return.

o C
A 5% VaR of €2.0 million for one month is a loss of at least €2.0 million that
would be expected to occur over one month 5% of the time.
Incorrect
A is correct. “Value at risk is the minimum loss that would be expected a certain percentage of
the time over a certain period of time given the assumed market conditions.” It is NOT the
probability of a minimum amount that one can lose but a minimum loss that would
be expected over a certain period at a certain percentage of time. B and C are
correct statements regarding VaR.
2. Question 2
o A
A 5% VaR is a move of 2.33 standard deviations less than the expected value.
o B
One standard deviation downward movement is equal to 16% VaR.

o C
A higher confidence level will produce a lower VaR.

Incorrect
B is correct. A 16% VaR is a move of one standard deviation below the expected
value. A is incorrect because a 5% VaR is equal to a move of 1.65 standard deviations
below the expected value assuming normal distribution. C is incorrect because a
higher confidence level results in a higher VaR.
3. Question 3
o A
Market risk is the risk arising from changes in markets to which an

investment is exposed.
o B
The three elements of VaR are frequency, time horizon, and minimum
expected loss.
o C
If portfolio returns are normally distributed, a one standard deviation

downward move is equivalent to a 68% VaR.
Incorrect
C is correct. If portfolio returns are normally distributed, a one standard deviation
downward move is equivalent to a 16% VaR.

4. Question 4
Which of the following statements is least likely correct ?
o A
The parametric method of VaR estimation usually assumes a normal

distribution.
o B
A daily expected return of 0.0448% and daily standard deviation of 1.066%

results in the 5% VaR for a USD100 million portfolio of approximately USD1.7
million.
o C
The historical simulation method of VaR estimation like the parametric

method gives equal weights to all observations in a sample.
Incorrect
C is correct. Although the historical simulation method has a similar limitation of
equally weighing all observations like the parametric method, but it can adjust this
problem by allocating more weights to recent observations and less weights to ones
that are relatively distant in time. A and B are correct statements.
5. Question 5
Which of the following statements regarding the VaR estimation methods is most
likely correct?
o A
A primary advantage of using the parametric method that it can accurately

estimate VaR of a portfolio containing options.
o B
One of the disadvantages of the Monte Carlo simulation method is its

inability to process complex distributions.
o C
Compared to parametric method, Monte Carlo and historical simulation

methods more accurately measure VaR of portfolios containing options
and bonds with embedded options.
Incorrect
C is correct. Parametric method is difficult to use when portfolios consist of options
because of the non-normal distribution followed by options. Monte Carlo method
can use any distribution and the historical simulation method uses data that actually
happened hence these methods are not limited by the assumption of a normal
distribution. Hence, A and B are incorrect.
6. Question 6
A 5% historical simulation VaR of $850,000 is the:
o A
fifth percentile – a point on the distribution beyond which 5% of the

outcomes result in greatest gains.
o B
fifth percentile – a point on the resulting distribution past which 5% of

the outcomes end in larger losses.
o C
value that is 2.33 standard deviations below the expected value.

Incorrect
B is correct. A 5% historical simulation VaR of $850,000 is the fifth percentile of the
distribution – a point beyond which 5% of the observations result in larger losses.
7. Question 7
Assume a daily expected return of 0.0448% and daily standard deviation of 1.066%,
In dollars, which of the following values is closest to the annual 5% parametric VaR for
a $100 million portfolio?
o A
$16.6 million.
o B
$20.2 million.
o C
$1.7 million.
Incorrect
A is correct. The annual return and standard deviation are: 0.000448 x 250 = 0.112;
0.01066 x ( 250 )1/2 = 0.1686 Annual 5% VaR = [ 0.112 – (1.65 x 0.1686)](-
1)(USD100,000,000) = $16,619000
8. Question 8
Which of the following is least likely an advantage of using VaR as a risk measure?
o A
VaR is a relatively simple concept, hence decision makers are not required to
have a technical background to understand its implications.
o B
VaR is useful in comparing risk within a particular asset class.

o C
VaR can be used in capital allocation decisions of trading units or portfolios

by providing management with a benchmark.
Incorrect
B is correct. VaR can be used for comparing risk across asset classes, trading units
and portfolios by indicating which constituents are responsible for the most or least
risk to the overall risk. A & C are advantages of VaR.
9. Question 9
Which of the following is a limitation of VaR?
o A
Financial firms do not use VaR as it is not widely accepted by regulators.

o B
The use of normal distribution in VaR estimation methods most often
underestimates the likelihood of extreme events.
o C
VaR is unlikely to be affected by a trending or volatile regime.

Incorrect
B is correct. Because of its reliance on the normal distribution in parametric method
and sometimes in Monte Carlo simulation method, VaR underestimates the
frequency of extreme events occurring in the left tail of the distribution. A is
incorrect as VaR is widely accepted by SEC and bank regulators. C is incorrect as VaR
is affected by volatile and trending regimes.
10. Question 10
Which of the following statements is least likely correct regarding conditional VaR
(CVaR)?
o A
CVaR is also known as expected tail loss.

o B
CVaR gives the average of the losses beyond the VaR cutoff.
o C
CVaR is best obtained from the parametric method.

Incorrect
C is correct. Historical simulation or Monte Carlo methods are used for CVaR
calculation since the returns can be observed easily along the distribution. The
parametric method has a continuous distribution which require complex
mathematics for CVaR calculations. A and B are correct statements regarding CVaR.
11. Question 11
Suppose the current portfolio allocations of 60% in a stock index fund and 40% in a
long-term bond ETF are changed by increasing the investments in the stock index
fund, the effect on the portfolio VaR due to a change in position is measured by:
o A
incremental VaR.
o B
conditional VaR.
o C
relative VaR.
Incorrect
A is correct. Incremental Var (IVaR) measures the impact on the total VaR of the
portfolio if a position size is changed or a new asset is added relative to other
positions.
12. Question 12
The measure which gives the responsiveness of a portfolio to a change in one
underlying risk factor is best known as:
o A
VaR.
o B
hypothetical scenario analysis.

o C
sensitivity analysis.
Incorrect
C is correct. Sensitivity analysis is a risk measure which measures performance
based on changes in the underlying risk factors. A hypothetical scenario measures
the portfolio return based on a hypothetical change in markets.
13. Question 13
Relative to VaR, sensitivity risk measures typically account for:
o A
the probability of losses.

o B
the broader risk picture by giving probability of change in the underlying risk
factor.
o C
the change in asset value due to a change in the underlying risk factor.
Incorrect
C is correct. VaR gives a broader view of risk and losses by giving probability of
losses. Sensitivity risk measures do not account for probability of losses but give
the change in value as a result of a change in the underlying risk factor.
14. Question 14
Which of the following statements regarding sensitivity risk measures
is least accurate?
o A
Beta is used to measure equity exposure.
o B
Gamma of an option is similar to duration, as it examines the effect on

option value due to small changes in the underlying value.
o C
For larger yield changes convexity is added to duration to assess the change
in bond prices.
Incorrect
B is correct. Gamma is the second-order effect for options analogous to convexity of
a fixed-income security. It measures the sensitivity of the option delta to a change in
the underlying value. A & C are correct statements.
15. Question 15
Delta measure can be used to:
o A
understand the effect on option value due to change in volatility of the

underlying.
o B
estimate the price of an option as the underlying changes in value.

o C
Indirectly reflect the change in the value of the underlying.

Incorrect
B is correct. Delta can be used to estimate the new price of an option as the
underlying changes. Vega reflects the effect of volatility of the underlying on the
option value. Gamma indirectly reflect the change in underlying by measuring the
change in delta.
16. Question 16
Which of the following is correct about sensitivities?
o A
Option delta is a measure of an option’s sensitivity to changes in the

price of the underlying.
o B
Sensitivities can appropriately address volatilities of assets which is useful in

understanding different asset exposures.
o C
Duration is useful as it gives the change in the fixed-income portfolio value by
applying historical interest rates.
Incorrect
A is correct. B is incorrect because sensitivities do not typically differentiate assets
based on volatilities. C is incorrect because duration measures a 1bp change applied
to current rates.
17. Question 17
Parties that use leverage, such as banks and hedge funds, are least likely to:
o A
use single-factor stress tests.

o B
use multifactor scenario analyses.

o C
use stress tests to determine what market movements could impair their
capital.
Incorrect
Solution: B is correct. Parties that use leverage, such as banks and hedge funds, are
more likely to use single-factor stress tests rather than multifactor scenario analyses.
The focus on a single factor helps in assessing whether a given exposure is likely to
impair their capital under a given stress movement; these are pass/fail tests.
18. Question 18
Which of the following is least likely about scenario risk measures?
o A
They do not rely on history.

o B
They can be used to test a portfolio’s sensitivity to events that have never
occurred before.
o C
Hypothetical scenarios are likely to model asset correlations or

magnitude of movements correctly.
Incorrect
Solution: C is correct. Hypothetical scenarios do not use historical asset movements
as a reference, therefore, are likely to model asset correlations or magnitude of
movements incorrectly or unrealistically.
19. Question 19
Sensitivity risk measures do not:
o A
allow for a detailed assessment of portfolio risk.

o B
distinguish risk exposures by probabilities of the risk materializing.

o C
distinguish between risk exposures of difference portfolio securities.

Incorrect
Solution: B is correct. Sensitivities do not distinguish risk exposures by volatilities, or
probabilities of the risk materializing. For instance, even though a government bond
portfolio and a junk bond portfolio may have the same sensitivities to a 1% change in
interest rates, the junk bond portfolio is more likely to see spreads moving by 1%.
A and C are not correct because sensitivity risk measures allow for a detailed
assessment of portfolio risk and distinguish between risk exposures of difference
portfolio securities. For instance, duration allows to distinguish between risk
represented by a 2-year bond and a 5-year bond.
20. Question 20
Which of the following is least likely correct regarding constraints used in risk
budgeting?
o A
Banks more often apply limits on total economic capital or VaR.

o B
“a pension fund can set a limit on the overall surplus at risk, and then allocate
it among its different asset managers.”
o C
Portfolio managers may be allocated an ex post tracking error budget.

Incorrect
C is correct. Portfolio managers apply ex ante tracking error budget. A and B are
correct statements.
21. Question 21
Which of the following is true regarding position limits? Position limits help mitigate
risk by imposing limits on:
o A
gross size of long/short positions.

o B
investments expected to not exceed a certain threshold in a certain strategy.

o C
both gross size of long/short positions and investments expected to not

exceed a certain threshold in a certain strategy.
Incorrect
C is correct. Position limits address risk by applying limits on size of long/short
positions or on derivative activity, and limit investments in certain categories so as to
not breach a minimum while following a certain strategy.
22. Question 22
Which of the following statements is not true about economic capital of a business?
o A
It is the amount of capital a business needs to hold in order to survive losses

from its inherent risks.
o B
It is the maximum amount of capital that a company maintains.

o C
Once the overall economic capital of the business is defined, it is then

allocated among its business activities.
Incorrect
B is correct. It is the minimum amount of capital that a company must maintain. The
actual balance sheet capital should exceed the economic capital.
23. Question 23
Which of the following risk measures is least likely used by a defined benefit pension
plan?
o A
Interest rate and curve risk.

o B
Surplus at risk.
o C
Drawdown.
Incorrect
C is correct. Maximum drawdown also known as “the worst-returning month or
quarter for the portfolio is a risk measure used by hedge funds. A & B are correct.
24. Question 24
Which of the following factors least likely affect the types of risk measures used by
market participants?
o A
The degree of leverage of the market participant.

o B
The maximum past returns achieved by the business.

o C
Accounting or regulatory requirements.

Incorrect
B is correct. The past business returns do not influence the choice of risk measures.
A and C are correct factors.
25. Question 25
Which of the following is least likely a risk measure used by banks?
o A
VaR.
o B
Activity ratios.
o C
Duration measures and stress tests.

Incorrect
B is correct. Banks typically assess their liquidity gap, leverage ratios, economic
capital, VaR, duration analysis, and scenarios.
26. Question 26
Which of the following is least likely true? Economic capital is often used to:
o A
measure the amount of shareholders’ equity needed to compensate for tail

risk losses.
o B
measure the firm’s overall risk appetite.
o C
estimate shareholders’ equity required to meet losses for portfolios

with normal distribution.
Incorrect
C is correct. Economic capital measures the shareholders’ equity required to
overcome losses under stress market conditions. A and B are true statements.
Martin Cross, senior risk manager and Julia Bing, analyst at Gloria AMC are discussing the
VAR measure of risk management. Martin states, “It’s important to understand the three
points in the VaR concept. (1) VaR can be measured in either currency units or in percentage
terms, (2) it tells us how much one can lose, and (3) it references a time horizon, losses that
would be expected to occur a certain time.” Martin the asks Julia, “What does a VaR of $15
million at 5% for one month indicate?” Martin and Julia then talk about the advantages of
VaR as a risk management tool. Julia comments, “The advantages of VaR are: (1) it can be
used for performance evaluation, (2) it provides an estimate of losses during a worst-case
scenario, and (3) it is an objective method rather than a subjective method.” Martin next
calculates the VaR of one of the company’s equity funds; the Gloria Delta fund. He estimates
the dollar VaR at the 5% level using the parametric method with the following
inputs: Exhibit 1: Data for Gloria Delta fund
Portfolio Value $600 million

Daily Expected Return 0.05%
Daily Expected Volatility 1.20%
Martin and Julia then discuss other methods of estimating VaR. Martin states, “Historical
simulation to estimate VaR is useful however it has a limitation that mean and variance
estimates could be biased”. Julia says, “Monte Carlo method of estimating VaR has the
advantage that the number of necessary simulations is determined by the parameters”.
1. Question 1
L.O.: a Q-Code: 21-L2-PM-MMMR-75626

Which of the following statements made by Martin about VaR is least likely correct?
o A
VaR can be measured either in currency units or percentage terms.

o B
VaR represents the maximum loss.

o C
A VaR statement references a time horizon i.e. losses that would be expected
to occur over a given period of time
Incorrect
B is correct. VaR is a minimum loss not “how much one can lose.” A & C are correct
statements. Section 2.1. LO.a.
2. Question 2
L.O.: a Q-Code: 21-L2-PM-MMMR-75627
The VaR of $15 million at 5% for one month most likely means:
o A
There is a 5% chance of losing $15 million over one month.

o B
There is a 95% chance that the expected loss over the next month is less than
$15 million.
o C
The minimum loss that would be expected to occur over one month 5%
of the time is $15 million.
Incorrect
C is correct. 5% VaR means that the minimum loss over one month 5% of the time
would be $15 million. VaR does not represent the probability of occurrence of losses.
Section 2.1. LO.a.
3. Question 3
L.O.: d Q-Code: 21-L2-PM-MMMR-75628

Julia’s comments on the advantages of VaR are most likely correct with respect to:
o A
Losses in a worst-case scenario.

o B
performance evaluation.
o C
objective method.
Incorrect
B is correct. VaR can be used for risk adjustment of returns, required for
performance evaluation. VaR is a subjective method and does not give a worst-case
scenario. Losses can exceed VaR. Section 2.3. LO.d.
4. Question 4
L.O.: c Q-Code: 21-L2-PM-MMMR-75629

Using the inputs given in Exhibit 1, the daily 5% parametric VaR is closest to:
o A
$11.6 million.
o B
$12.4 million.
o C
$18.9 million.
Incorrect
A is correct. First, multiply portfolio standard deviation by 1.65; 0.012 x 1.65 = 0.0198.
Subtract this from the expected return; 0.0005 – 0.0198 = -0.0193. Taking the
absolute value = -0.0193 X (-1) = 0.0193. Multiplying this by the portfolio value gives a
VaR estimate of 0.0193 x 600 = $11.58 million. Section 2.2.1. LO.c.
5. Question 5
Regarding the alternative methods of estimating VaR, who is correct ?
o A
Martin only.
o B
Julia only.
o C
Neither Martin nor Julia.

Incorrect
C is correct. Neither Martin nor Julia is correct. Historical simulation does not require
the estimation of mean and variance and there is no industry standard on the
number of necessary simulations under the Monte Carlo method.
Vilma Atkinson is the head of risk at Preston Investments. She is having a discussion with
her assistant, Kyle Lee about the use of risk management tools in portfolio management.
She asks Kyle about the advantages and disadvantages of using scenario risk measures in
risk management along with VaR. Kyle states, “Scenario analysis can complement VaR as it
accounts for market liquidity, however, it carries a limitation that it has greater reliance on
historical market data than VaR.” Kyle further states, “An example of scenario analysis is
reverse stress test, where the most significant exposures of a portfolio are identified and
generate a hypothetical stress that adversely affects these exposures”. Vilma then discusses
option risk measures and how they can be used to assess the risk exposures of options
positions. Kyle states, “Delta measures the sensitivity of option value to the price of the
underlying and it ranges from 0 to +0.5. Gamma is a second-order effect that measures the
sensitivity of delta to price changes in the underlying. Vega is a first-order effect for options
reflecting the relationship between the option price and the volatility of the underlying.”
Later, Vilma asks Kyle to draft a risk management policy for the company’s balance fund,
which is designed primarily for investors with a low risk tolerance and a goal to limit the
likelihood of severe downside losses. Kyle drafts the following risk management policy: “The
balanced fund has a 10-day, 2% VaR limit of USD5 million and the fund will undertake
hedging activities if its cumulative 15 day loss ever exceeds USD10 million.” Vilma then asks
Kyle, “We have a diverse investor base including banks, corporations and long-only asset
managers. Which of these investors will prefer risk measures such as VaR expressed as a
percentage of assets and relative to a benchmark?”
1. Question 1
Is Kyle’s statement about scenario analysis correct?
o A
Yes.
o B
No, because scenario analysis doesn’t account for market liquidity better
than VaR.
o C
No, because scenario analysis does not need to rely on historical data.
Incorrect
C is correct. Since scenario analysis does not need to rely on history, it can be free of
the volatility and correlation behavior of recent market history, which may not be
representative of market stress conditions.
2. Question 2
Does Kyle give the example of scenario analysis correctly?
o A
Yes.
o B
No, because reverse stress test is not an example of scenario analysis.

o C
No, because he does not explain reverse stress test correctly.

Incorrect
A is correct. Kyle correctly explains the reverse stress test, which is an example of
hypothetical scenario analysis.
3. Question 3
Which option sensitivity measure does Kyle describe least accurately?
o A
Delta.
o B
Gamma.
o C
Vega.
Incorrect
A is correct. Call option deltas range from a value of 0 to a value of 1, whereas put
option deltas range from a value of 0 to a value of –1. The explanations of Gamma
and Vega are correct.
4. Question 4
Kyle’s risk management policy is least likely an example of:
o A
risk budgeting.
o B
scenario limits.
o C
stop-loss limits.
Incorrect
B is correct. A scenario limit establishes a limit on the loss for a given scenario, which
is not implemented by the policy drafted by Kyle. The 10-day, 2% VaR limit of $5
million is an example of risk-budgeting. The initiation of hedges above a certain loss
level is an alternative form of a stop-loss limit called drawdown control or portfolio
insurance.
5. Question 5
L.O.: j Q-Code: 21-L2-PM-MMMR-75635

Regarding Vilma’s question on risk measures by market participants, which answer
is most likely correct? The market participants that favor VaR expressed in percentage
terms are:
o A
banks.
o B
corporations.
o C
long-only asset managers.

Incorrect
C is correct. Long-only asset managers generally prefer to express VaR in percentage
terms and use a benchmark as a relevant risk measure. Banks and corporations
measure VaR more commonly in currency units and in absolute terms. Section 4.1.
LO.j.
Backtesting & Simulation
1. Question 1
Q-Code: 22-L2-PM-BTSI-151208
One method to evaluate investment strategies involves testing the strategy in a
hypothetical environment, specified by the user. This method is most likely known as:
o A
backtesting.
o B
a simulation.
o C
sensitivity analysis.
Incorrect
B is correct. A simulation is where a strategy or model is evaluated in a hypothetical
environment. Option A is incorrect because backtesting tests a strategy in an actual
historical environment, usually over a long period of time. It tells us how a strategy
would have performed if it had been implemented in the past. Option C is incorrect
because sensitivity analysis determines how changes in input variables affect a
target variable and risk profile.
2. Question 2
Which of the following statements regarding backtesting is least likely correct?
o A
Backtesting implicitly assumes that the future will be similar to the past.
o B
When deciding on the rebalancing frequency of a backtest, one should

consider transaction costs because the more frequent the rebalancing, the
higher the transaction costs.
o C
Longer time periods contain data that is non-stationary, which is why

investment managers prefer to backtest investment strategies over a
short period of time.
Incorrect
C is correct. While longer time periods do contain non-stationary data, this issue can
be minimized by supplementing the analysis of long-period backtests with a
historical scenario analysis of the discrete regimes within the long history (this
concept is covered in more detail later in the reading). Typically, investment
managers prefer to backtest strategies over as long a period as possible because a
larger sample size provides greater statistical confidence in the results.
Options A and B are incorrect because they are accurate statements.
3. Question 3
Which of the following statements is most likely correct with respect to rolling
windows? In this method:
o A
analysts construct a portfolio at the beginning of a period using data from a

historical in-sample period, then evaluate the portfolio using data from a
forecasted future period. This process is repeated as time moves on.
o B
analysts construct a portfolio using data from a historical, in-sample period,

then test the portfolio using data from the following period (this period was
not considered when the portfolio was created). Then, whether to rebalance
the portfolio and repeat the process is at the discretion of the analyst.
o C
analysts construct a portfolio based on historical, in-sample data, then

test it on the subsequent period (out-of-sample data). The portfolio is
then rebalanced, and the process is repeated for the subsequent period,
and so on.
Incorrect
C is correct. When backtesting with rolling windows, analysts construct a portfolio at
the beginning of the period using data from a historical in-sample period, e.g.,
January 2019 to December 2019 (12 months). The portfolio would then be evaluated
in the subsequent period, January 2020 (assuming monthly rebalancing). The data
from January 2020 was not considered when constructing the portfolio (out-of-
sample data). The results are recorded and then the portfolio is rebalanced using the
subsequent in-sample period, February 2019 to January 2020, and then the portfolio
would be tested using data from February 2020, and so on. The out-of-sample
period is essentially rolled over each period, and the new results are recorded.
Option A is incorrect because the portfolio is not tested in a forecasted future
period; rather, historical out-of-sample data is used. Option B is incorrect because
whether or not to repeat the process is not at the discretion of the analyst if they are
using rolling windows. By definition, the process has to be repeated because the in-
sample data and out-of-sample data are rolled over multiple periods, then the data
is consolidated.
4. Question 4
Which one of the following is least likely a metric or visual used in assessing
backtesting of a factor-based investment strategy?
o A
Sortino Ratio
o B
Distribution plots of factor returns

o C
A word cloud of text describing the characteristics of the factor

Incorrect
Solution: C is correct. A word cloud is not a visual used in assessing backtesting of a
factor-based investment strategy. A and Bare incorrect, because they are visuals and
metrics, respectively, used to assess backtests of factor-based strategies.
5. Question 5
Which of the following metrics reported in a backtest of an investment strategy
represents the maximum loss from a peak to a trough for an asset or portfolio?
o A
Maximum drawdown
o B
Sharpe Ratio
o C
Volatility
Incorrect
Solution: A is correct. Maximum drawdown is the maximum loss from a peak to a
trough for an asset or portfolio.
6. Question 6
Which of the following is least likely an example of look-ahead bias?
o A
An investor uses fundamentals in his model that were calculated using

macroeconomic data from a reputable, recently revised database.
o B
An investor compares the performance results of her backtested portfolio to

the historical performance of the current stocks in the S&P500 index.
o C
An investor uses only the results from backtesting to evaluate his
portfolio, as he believes that the past is an accurate predictor of the
future.
Incorrect
C is correct. A look-ahead bias is created by using information that was unknown or
unavailable during the historical periods over which the backtest is conducted. While
the investor in option C is incorrect, the past is not an accurate predictor of the
future which is why the results from backtesting are often supplemented with other
analysis, but this error is not a display of the look-ahead bias.
Option A is incorrect because this is an example of the look-ahead bias – since the
data being used in the model has been recently updated, the model contains
information that was not available in the period that it is being tested. Option B is
incorrect because the results are affected by the survivorship bias (which is a type of
look-ahead bias). By comparing her results to the performance of the current stocks
in the index, the investor is ignoring the poor-performing securities that were
removed from the index, but were present during the period she is testing her
portfolio in.
7. Question 7
Which of the following is most likely a way to reduce data snooping?
o A
Using point-in-time data

o B
Setting a lower hurdle than typical

o C
Using the rolling window method

Incorrect
C is correct. Two ways to mitigate data snooping is setting a much higher hurdle than
normal and using cross validation. The rolling window method is a form of cross
validation. Cross validation involves dividing data into training data and validation
data. In the rolling window method, the model is repeatedly trained then tested
using in-sample and out-of-sample data, respectively.
Option A is incorrect because using point-in-time data will not help to reduce data
snooping. It is useful in mitigating the survivorship bias and look-ahead bias. Option
B is incorrect because a using higher hurdle will minimize the bias, not a lower one.
8. Question 8
It is most appropriate to use historical scenario analysis when analyzing the results of
backtesting in which of the following cases?
o A
The model is being tested over a short time period.
o B
The government changed during the period, resulting in new economic

policies.
o C
Volatility remained relatively stable over the period.

Incorrect
B is correct. Historical scenario analysis is most appropriate when there are
significant economic changes during the time period being tested. This is more
common over longer time periods; significant changes are less likely over shorter
periods. Option B mentions a change to economic policies, this is significant enough
that an analyst would evaluate the model separately before and after the policies
change.
9. Question 9
Historical scenario analysis is a type of backtesting used to assess the performance
and risk of an investment strategy:
o A
in different structural regimes.

o B
at structural breaks.
o C
both A) and B).

Incorrect
Solution: C is correct. Historical scenario analysis is a type of backtesting used to
assess the performance and risk of an investment strategy in different structural
regimes and at structural breaks. Two common examples of regime changes are:
• Expansions and recessions

• High-and low-volatility regimes
10. Question 10
o A
The key difference between backtesting and historical simulation is

that in historical simulation, the sequence of the historical periods from
which data is gathered can be changed.
o B
With respect to historical simulation, since the number of simulations

required is usually greater than the size of the historical dataset, random
sampling without replacement is more common than random sampling with
replacement.
o C
Since the results from simulation analysis and backtesting are very similar,
analysts usually evaluate their investment strategies using either of the
methods in isolation.
Incorrect
A is correct. In backtesting, investment managers evaluate their investment
strategies by observing how it would have performed in a historical period. In
historical simulation analysis, results are constructed by randomly selecting returns
from many different historical periods without regard to time-ordering.
Option B is incorrect because the random sampling with replacement
(bootstrapping) is more frequently used than random sampling without
replacement. This is because, as Option B states, the number of simulations required
is usually greater than the size of the historical dataset, so it is not feasible to not
replace the data after each sample is drawn.
Option C is incorrect because the results from backtesting are usually supplemented
by simulation analysis. This is because backtesting implicitly assumes that the future
will be similar to the future, which is not necessarily the case. Simulations do not
have this assumption, so analyzing the results of both methods provides investment
managers with a more holistic result.
11. Question 11
Which of the following statements regarding Monte Carlo simulations is least
likely correct?
o A
A Monte Carlo simulation is only useful if the functional form of the statistical
distribution specified accurately reflects the true distribution of the
underlying data.
o B
Due to its simplicity, the multivariate normal distribution is often used in

investment research as the chosen functional form. However, the
multivariate normal distribution cannot account for negative skewness and
fat tails observed in factor and asset returns.
o C
If the underlying data is negatively skewed with fat tails, a Monte Carlo
simulation with a multivariate distribution assumption is likely to
overstate the downside risk of the portfolio being evaluated.
Incorrect
C is correct. If the underlying data is negatively skewed with fat tails, i.e. small gains
and few, extreme losses, a Monte Carlo simulation with a multivariate distribution
assumption will understate the downside risk of the portfolio being evaluated. This is
because a multivariate distribution does not account for negative skewness and fat
tails, so the data is treated as if the probability of losses and gains is the same, thus
ignoring part of the downside risk. Options A and B are incorrect because they are
true statements.
12. Question 12
The risk of a portfolio, Portfolio A, is measured using Monte Carlo simulations using
a multivariate normal distribution and Monte Carlo simulations using the skewed t-
distribution. If the value of the risk measure using both methods is the same, then
this could imply that the portfolio returns:
o A
follow a normal distribution.

o B
are negatively skewed.

o C
are positively skewed.

Incorrect
A is correct. If the returns of the portfolio were different using both methods, that
would suggest that return data is skewed and/or has fat tails. This is because when
Monte Carlo simulations are performed using the multivariate normal distribution,
skewness and fat tails are ignored. This issue is corrected when the multivariate
skewed Student’s t-distribution is used, so if the data had skewness then the results
from the simulations using this distribution would have been different from the
other simulations’ results.
13. Question 13
Which of the following is most likely one of the eight steps in implementing a
simulation?
o A
Use a random number generator to draw N random numbers for each

key decision variable.
o B
Evaluate results based on the rolling-window methodology.

o C
Define rebalancing frequency.
Incorrect
A is correct. The eight steps of implementing a simulation covered in this reading are
as follows:
4. Define the target variable. Typically, this variable is the return on an investment
strategy and its distribution.
5. Specify key decision variables. Typically, these variables are the returns of
each underlying asset and their weights in the overall portfolio.
6. Specify the number of trials (N) to run. Typically, researchers choose between
1,000 and 10,000 simulation runs. The greater the number of simulations the
more reliable the results.
7. Define the distributional properties of the key decision variables.
• In historical simulation, we draw from historical data.
• In Monte Carlo simulation, we can select and specify an appropriate
statistical distribution for each key decision variable.
5. Use a random number generator to draw N random numbers for each key
decision variable.
6. For each set of simulated key decision variables, compute the value of the
target variable.
7. Repeat steps 5 and 6 ‘N’ times.
8. We now get a set of N values of the target variable. We can then compute
typical metrics like mean return, volatility, Sharpe ratio, and the various
downside risk metrics such as CVaR and maximum drawdown.
Options B and C are incorrect because they are part of the backtesting process.
14. Question 14
Which of the following terms refers to random sampling with replacement, often
used in historical simulation?
o A
Inverse transformation
o B
Bootstrapping
o C
Sensitivity analysis
Incorrect
Solution: B is correct. Random sampling with replacement, also known as
bootstrapping, is often used in investment research. This is because the number of
simulations needed is often larger than the size of the historical dataset.
15. Question 15
Which of the following statements regarding sensitivity analysis is most likely correct?
o A
Sensitivity analysis fails to account for skewness and fat tails, which is why it
is often supplemented by a Monte Carlo simulation.
o B
Sensitivity analysis involves constructing results by randomly selecting

returns from many different historical periods without regard to time-
ordering.
o C
Sensitivity analysis can be performed using different distributions,

including ones that account for skewness and fat tails. It is often used in
addition to Monte Carlo simulations, which generally use the
multivariate normal distribution.
Incorrect
C is correct. Monte Carlo simulations often use the multivariate normal distribution,
which do not account for skewness and fat tails. Sensitivity analysis can be
performed using a distribution that does account for skewness and fat tails, such as
a multivariate skewed Student’s t-distribution.
Option A is incorrect because as mentioned above, the opposite is true.
Option B is incorrect because it describes historical simulation analysis. Sensitivity
analysis is a technique for assessing how changes in input variables affect a target
variable and risk profiles. It can be implemented to help managers better
understand the potential risks and returns of their investment strategies.
16. Question 16
Which of the following definitions most likely relate to sensitivity analysis?
o A
In this method, each key variable is assigned a statistical distribution, and

observations are drawn at random from that distribution.
o B
This method tests a strategy in an actual historical environment, usually over

a long period of time.
o C
It is a technique for assessing how changes in input variables affect a

target variable and risk profiles.
Incorrect
C is correct. Option A is incorrect because it describes a Monte Carlo simulation.
Option B is incorrect because it relates to backtesting.
Mary Becker is a senior analyst at a consulting firm and uses backtesting and simulation
techniques to assess equity strategies. This month, she is being shadowed by an intern,
Carlos Moreno. Becker and her team are currently developing a multifactor portfolio
strategy using seven factor portfolios. After a few days of observing the process, Moreno
asks her the following questions. Question 1: Why does your team use backtesting to assess
different strategies? Question 2: Why does your team not backtest over larger periods of
time? Becker answers his questions, and they continue with the backtesting process. They
run initial backtests on the seven factor portfolios to calculate performance statistics and
key metrics from each. They then design a risk parity portfolio and a benchmark portfolio.
Becker makes the following comments: Comment 1: Note that we do not adjust the weights
in the risk-parity portfolio; this is to avoid changing the proportion of risk contributed by
each factor. Comment 2: Generally, we use point-in-time data to avoid look-ahead biases.
Moreno also notes that before developing a model, Becker’s team separates the time
periods into in-sample and out-of-sample periods.
1. Question 1
The correct response to Question 1 is least likely:
o A
Backtesting helps evaluate whether a strategy would have produced

desirable results using historical data.
o B
Backtesting helps analysts understand the risk–return trade-off of an

investment strategy by approximating the real-life investment process.
o C
Backtesting is a technique that explores how a target variable and risk

profiles are affected by changes in input variables, which helps assess
whether an investment strategy should be accepted or rejected.
Incorrect
C is correct. Backtesting does not explore how a target variable and risk profiles are
affected by changes in input variables. Rather, this is a description of sensitivity
analysis which can be used to supplement the results of backtesting. Both options A
and B are objectives of using backtesting.
2. Question 2
The correct response to Question 2 is most likely:
o A
Long time periods can contain non-stationary data.

o B
The past is a poor predictor of the present.

o C
Backtesting over long time periods reduces the effectiveness of the test since
it increases the rebalancing frequency.
Incorrect
A is correct. One reason an analyst would avoid backtesting over long periods is that
a longer time period may contain regime changes, making the data non-stationary.
However, this issue can be overcome by supplementing the results with a historical
scenario analysis.
Option B is incorrect because while the past is not the most accurate predictor of the
future, it is also not a poor predictor, otherwise backtests would not be performed at
all. Option C is incorrect because the time period does not affect the rebalancing
frequency.
3. Question 3
Which of analyst’s comments is most likely correct?
o A
Comment 1 only
o B
Comment 2 only
o C
Both comments 1 and 2

Incorrect
B is correct. Comment 2 is correct. Point-in-time data is the most complete data for
any given time period and includes all companies that existed – the casualties as well
as the survivors. Using this data helps mitigates look-ahead biases.
Comment 1 is incorrect because the weights for each of the factors is adjusted each
period. A risk parity portfolio, by definition, has an equal amount of risk from each
factor. To ensure that the proportion of risk from each factor is maintained, the
weights are recalculated periodically.
4. Question 4
Which of the following statements regarding in-sample and out-of-sample data
is least likely correct?
o A
The model is trained in the out-of-sample data and tested in the in-
sample data.
o B
The in-sample data is also known as training data and out-of-sample data is
also known as validation data.
o C
Separating data into in-sample and out-of-sample data is also called cross
validation.
Incorrect
A is correct. Models are trained in in-sample data and tested in out-of-sample data.
The purpose of not using all of the available data to train the model is that the out-
of-sample data can then be used to assess how well the model works on data that
was not part of the training process.
Michael Davidson is an equity analyst at a private wealth management firm. One of his
clients, Harrold Wesley, asks Davidson to explain how he assesses his investment strategies.
Davidson explains the basics of the backtesting process and makes the following comments,
“Backtesting implicitly assumes that the past is likely to repeat itself. This assumption,
however, may not hold true, and the markets may exhibit extreme upside and downside
risks that have never been seen before. To mitigate this issue, we use point-in-time data
when backtesting.” To further explain his process to Wesley, Davidson shows him the risk
and return data of a risk parity portfolio he has developed, compared against a benchmark
portfolio. Exhibit 1
Return Std. Deviation Max drawdown

Risk Parity Portfolio 4.2% 1.4% 8.1%
Benchmark Portfolio 6.7% 3.8% 12.3%
Wesley then asks what the drawbacks of backtesting are. Davidson responds that among
other issues, a common mistake is to use revised macroeconomic data rather than data that
was available in the past, which biases results. Davidson explains that after evaluating a
strategy through backtesting, they then supplement their analysis with simulations,
specifically historical simulations and Monte Carlo simulations. Wesley asks for more
information regarding these processes, and he elaborates by making two statements.
Statement 1: Historical simulation construct results by selecting returns at random from
many different historical periods without regard to time-ordering. Statement 2: Monte Carlo
simulations do not draw from historical data, rather each key variable is assigned a
statistical distribution, and observations are drawn at random from that distribution.
1. Question 1
Davidson’s comments regarding an assumption and issue with backtesting are most
likely:
o A
correct.
o B
incorrect, because over long periods of time, this assumption holds true.
o C
incorrect, because using point-in-time data does not help to overcome
this issue.
Incorrect
C is correct. Backtesting assumes that the past is likely to repeat itself, but this
assumption may not always hold true. To get a more complete picture, analysts
often use simulation analysis along with backtesting.
Point-in-time data is the most complete data for any given time period and includes
all companies that existed – the casualties as well as the survivors. Analysts use this
data in backtesting to mitigate look-ahead biases. However, using this data does not
address the issue related to the assumption mentioned in the question.
2. Question 2
Based on Exhibit 1, which of the following statements is least likely correct?
o A
The risk parity portfolio outperformed the benchmark portfolio since its risk-
adjusted return is higher.
o B
The risk parity portfolio has lower downside risk than the benchmark
portfolio.
o C
While the standard deviation of the benchmark portfolio is higher than

that of the risk parity portfolio, the overall risk of the benchmark
portfolio is comparatively lower since it has a higher maximum
drawdown.
Incorrect
C is correct. A higher maximum drawdown implies higher downside risk, so the
benchmark portfolio is riskier than the risk parity portfolio, given the information in
Exhibit 1.
Option A is a correct statement. Even though the risk-adjusted return has not been
calculated, the data in Exhibit 1 shows that the return per unit of risk is higher for the
risk parity portfolio (4.2/1.4 = 3) compared to that of the benchmark portfolio
(6.7/3.8 = 1.8). Option B is a correct statement because the maximum drawdown, a
measure for downside risk, is lower for the risk parity portfolio than it is for the
benchmark portfolio.
3. Question 3
The bias mentioned by the analyst while explaining the drawbacks of backtesting
is most likely called:
o A
Survivorship bias
o B
Look-ahead bias
o C
Data snooping
Incorrect
B is correct. This is an example of a look-ahead bias. Look-ahead bias is created by
using information that was unknown or unavailable during the historical periods
over which the backtest is conducted.
Option A is incorrect because the survivorship bias refers to drawing conclusions
from data that only includes entities that have survived to that point. Option C is
incorrect because data snooping refers to making an inference after looking at
statistical results rather than testing a prior inference. The bias occurs when an
analyst selects data or performs analyses repeatedly until a significant result is
found.
4. Question 4
Which of the analyst’s statements regarding simulations is most likely correct?
o A
Only Statement 1
o B
Only Statement 2
o C

Incorrect
C is correct. Both statements are correct statements.
Suleiman Shaikh is a recently-hired equity analyst at Vitality Investments. His supervisor,

Andrea Watson, is explaining the process of backtesting and other supplementary
processes that help the team evaluate their investment strategies. Watson mentions that
some of the problems with backtesting are that it is subject to several biases. For example,
analysts may make an inference after looking at statistical results rather than testing a prior
inference. After showing Shaikh the basics of backtesting, Watson explains the different
ways the results from backtesting are supplemented. Her team often includes historical
scenario analysis in their process. Historical scenario analysis is a type of backtesting used
to assess the performance and risk of an investment strategy in different structural regimes
and at structural breaks. She shows Shaikh an example of the historical analysis for one of
their recent risk parity portfolios compared to a benchmark portfolio for two regime
changes: recession versus non-recession and high-volatility versus low-volatility regimes
Watson and her team also use historical and Monte Carlo simulations to supplement the
results of backtesting. In historical simulations, results are constructed by randomly
selecting returns from many different historical periods without regard to time-ordering.
Since the number of simulations required is usually greater than the size of the historical
dataset, a process involving random sampling with replacement is frequently used in
investment research. Shaikh asks what this process is called. Next, they discuss the use of
Monte Carlo simulations. Watson mentions that her team usually uses the multivariate
normal distribution. Shaikh inquires whether this distribution has any drawbacks and if so,
how they are overcome. Watson responds that the main drawback is that it cannot account
for the negative skewness and fat tails which may be observed in factor and asset returns.
One way to overcome this is to perform a sensitivity analysis by fitting the factor return data
to an alternative distribution then repeating the Monte Carlo simulation. She adds that a
distribution that accounts for skewness is the multivariate skewed Student’s t-distribution,
but this has one main drawback.
1. Question 1
The example Watson gave of a problem with backtesting is most likely an example of:
o A
cross validation.
o B
data snooping.
o C
survivorship bias.
Incorrect
B is correct. A common problem with backtesting is that an analyst may make an
inference after looking at statistical results rather than testing a prior inference. The
bias is called data snooping and occurs when an analyst selects data or performs
analyses repeatedly until a significant result is found. This issue can be mitigated by
setting a higher-than-typical hurdle rate and using cross validation (partitioning the
data into training data and validation data).
2. Question 2
Which of the following statements regarding Exhibits A and B is most likely correct?
o A
In terms of the Sharpe ratio, the risk-parity portfolio outperformed the

benchmark portfolio in economic scenarios and market volatility scenarios.
o B
The risk-parity portfolio is less robust to recession than the benchmark

portfolio, in terms of the Sharpe ratio.
o C
The risk-parity portfolio’s returns are more sensitive to volatility than

the benchmark portfolio’s returns.
Incorrect
C is correct. The Sharpe ratio is an indication of a portfolio’s risk-adjusted
performance. Exhibit B shows that the difference in the risk parity portfolio’s Sharpe
ratio in high-volatility conditions versus low-quality conditions (3.5 and 6) is greater
than the difference for the benchmark portfolio (4.5 and 4). This implies that the risk-
adjusted returns for the risk-parity portfolio are more sensitive to changes in
volatility than that of the benchmark portfolio.
Option A is incorrect because the risk-parity portfolio did not outperform the
benchmark portfolio in the high-volatility scenario. Option B is incorrect because the
risk-parity portfolio is more robust to recession than the benchmark portfolio since it
performed better in that scenario.
3. Question 3
The name of the process involving random sampling with replacement is most likely:
o A
backward induction.
o B
rolling windows.
o C
bootstrapping.
Incorrect
C is correct. This process is known as bootstrapping. When performing historical
simulations, the analyst applies their model to different time periods in the past,
regardless of the order. The analyst needs to decide whether they will re-use these
time periods in the simulation, i.e., sample randomly without replacement, or not.
Since the number of simulations required is usually greater than the size of the
historical dataset, random sampling with replacement (bootstrapping) is often used.
4. Question 4
The drawback of the skewed Student’s t-distribution that Watson refers to in her
response to Shaikh’s question is most likely that:
o A
it does not account for excess kurtosis.

o B
it is more likely to suffer from larger estimation errors.

o C
it requires the estimation of very few parameters.

Correct
B is correct. The main drawback of the multivariate skewed Student’s distribution is
that it requires the estimation of more parameters than a normal distribution, which
makes it more likely to suffer from estimation errors.
Option A is incorrect because this distribution accounts for both skewness and
excess kurtosis, while the multivariate normal distribution does not.
Option C is incorrect because this distribution requires more parameters to be fully
specified.
Economics and Investment

Markets
1. Question 1
Q-Code: 21-L2-PM-EIMA-75636
o A
Market value of an asset is impacted by the size of its cash flows only.
o B
Market values of an asset is impacted by discount rates only.

o C
Market value of an asset can be affected by interest rates, risk

premiums, size and magnitude of future cash flows.
Incorrect
C is correct. The market value of an asset can be affected by default-free interest
rates, risk premiums, the size and the magnitude of its future cash flows.
2. Question 2
Which of the following statements is least likely true?
o A
The higher the utility investors attach for current consumption relative to
future consumption, the higher the real rate.
o B
Marginal utility of consumption is lower during bad economic times.

o C
Investors increase their savings rate when uncertainty about future income
increases.
Incorrect
B is correct. Marginal utility of consumption is higher during bad economic times.
3. Question 3
Which of the following statements about covariance of risky assets is not correct?
o A
When the covariance is negative, the risk premium will be negative.

o B
When the covariance term is zero, the asset is risk free.

o C
When the covariance term is positive, the asset will have a rate of return less
than the risk-free rate.
Incorrect
Solution: A is correct. A negative covariance term for risky assets implies that asset
prices are lower and it results in a positive risk premium. The larger the negative
covariance term, the higher will be the risk premium and required return of an asset.
4. Question 4
o A
Equity markets always reflect the expectations of market participants hence

actual results are unlikely to affect market values.
o B
The effect of new information on asset values depends on whether that

information was built into market expectations or not.
o C
All else equal, positive earnings surprises are likely to bring down market
value because investors were not expecting the result.
Incorrect
B is correct. New information which is different from expectations affects asset
values.
5. Question 5
Which of the following will most likely lead to higher real risk-free interest rates?
o A
A low GDP growth forecast.

o B
Decrease in expected volatility in GDP growth.

o C
Increase in expected volatility in GDP growth.

Incorrect
C is correct. Interest rates are positively related to expected volatility in GDP growth
due to higher risk premiums when volatility is high.
6. Question 6
A decrease in forecasted GDP growth rate can lead to:
o A
higher long term interest rates.

o B
a decrease in marginal utility of future consumption.

o C
lower real government bond yields.

Incorrect
C is correct. Lower future GDP growth rates cause interest rates to decline and
marginal utility of future consumption to increase. Lower GDP growth rates lead to
lower real government bond yields.
7. Question 7
Suppose that an analyst estimates that the real risk-free rate is 1.5% and that
average inflation over the next year will be 3.25%. If the analyst observes the price of
a default-free bond with a face value of £100 and one full year to maturity as being
equal to £94.55, the implied premium embedded in the bond’s price for inflation
uncertainty would be closest to:
o A
1.014%
o B
2.514%
o C
4.264%
Incorrect
Solution: A is correct. The (approximate) implied premium can be calculated as
follows:
πt,s = 1.014% = (100/94.55) − (1 + 0.015 + 0.0325).
8. Question 8
Which of the following is least likely during recession?
o A
A rise in P/E.
o B
The spreads of corporate bonds can be expected to widen.

o C
The cyclical companies are likely to experience sharper decline in earnings

compared with non-cyclical companies.
Incorrect
Solution: A is correct. P/E is the ratio of the current share price to the earnings per
share generated by the company. During a slowdown, P/E values are low which
implies that investors are not willing a high price for the company’s earnings.
9. Question 9
Risk premiums for inflation uncertainty are:
o A
higher for short term bonds.

o B
higher for long term bonds.

o C
same for short term and long term bonds.

Incorrect
B is correct. All else constant longer term bonds have higher premiums for inflation
uncertainty.
10. Question 10
Suppose investors forecast an unanticipated decrease in real GDP growth and the
volatility of GDP growth for a particular country. The effect of such a forecast would
be for the coupon payments of an inflation-indexed bond issued by the government
of the country:
o A
to rise.
o B
to fall.
o C
to be indeterminate.
Incorrect
Solution: B is correct. The coupon payments would be expected to decrease,
reflecting a decrease in the real interest rate.
11. Question 11
Which of the following will most likely affect the yield spread between non-inflation-
adjusted and inflation-indexed bonds of the same maturity?
o A
a risk premium for future inflation uncertainty only.
o B
investors’ inflation expectations over the remaining maturity of the bonds.

o C
Both A) and B).

Incorrect
Solution: C is correct. The difference between the yield on a zero-coupon default-
free nominal bond and on a zero-coupon default-free real bond of the same
maturity is called the break-even inflation rate. The break-even inflation rate should
incorporate both investors’ inflation expectations over the remaining maturity and a
risk premium for uncertainty about future inflation,
12. Question 12
Long term government bonds are trading at 9%. The bond yield reflects an expected
inflation of 3% and premium for inflation uncertainty of 1%. The break-even inflation
rate embedded in the government bond yield is closest to:
o A
3%.
o B
1%.
o C
4%.
Incorrect
C is correct. The break-even inflation rate consists of expected inflation and risk
premium for uncertainty of inflation. Hence break-even inflation rate is equal to 3% +
1% = 4%.
13. Question 13
Which of the following statement is most likely true?
o A
Credit spreads tend to rise during bad economic periods and fall during
good economic periods.
o B
When credit spreads narrow, risk-free bonds will outperform risky bonds.
o C
Higher-rated bonds benefit more from falling credit spreads than lower-rated
bonds.
Incorrect
A is correct. During bad economic periods credit spreads rise and during good
economic periods credit spreads fall. Risky bonds benefit more from narrowing of
credit spreads than risk-free bonds. Hence, lower-rated bonds benefit more than
higher-rated bonds when credit spreads narrow.
14. Question 14
o A
Credit spread is the difference in yield on a corporate bond and government

bond with the same maturity.
o B
Credit spreads on low-rated bonds are always less than credit spreads
on high-rated bonds.
o C
Credit spreads increase in times of economic weakness because the

probability of default increases and recovery rate decreases when the
economy slows down.
Incorrect
B is correct. Credit spreads on high-rated bonds are always less than credit spreads
on low-rated bonds. For instance, the spread on BBB/Baa bonds is always higher
than the spread on AAA/Aaa rated bonds. This is because lower-rated bonds are
riskier, which leads to higher yields. The higher the yield on a bond, the higher the
credit spread (since credit spread is corporate bond yield minus government bond
yield).
The statements in option A and option C are correct.
Section 5.1.
15. Question 15
The current inflation rate is 3% while the central bank’s target rate of inflation is 2%.
The neutral real policy rate is 4%, the actual growth rate is 2.5% and the expected
GDP growth is 3.5%.
Given the above information, the policy rate is most likely:
o A
2%.
o B
7%.
o C
9%.
Incorrect
B is correct. Using the Taylor rule, we can calculate the policy rate as follows:
Policy rate = l + i + 0.5(i – i*) + 0.5(Y – Y*)
Where:
l = the level of real short-term interest rates that balance long-term savings and
borrowing in the economy
i = rate of inflation
i* = target rate of inflation
Y = actual GDP growth rate
Y* = expected GDP growth rate
Therefore, policy rate = 4 + 3 + 0.5(3-2) + 0.5(2.5-3.5) = 7%.
16. Question 16
Which of the following industries’ credit spread would most likely increase during
economic downturns?
o A
Consumer staples industry.

o B
Food industry.
o C
Automotive industry.
Incorrect
C is correct. The automotive industry is a cyclical industry hence spreads get affected
during economic downturns.
17. Question 17
Which of the following strategies will most likely require the highest equity risk
premium during economic downturns?
o A
Small-cap strategy.
o B
Mid-cap strategy.
o C
Large-cap strategy.
Incorrect
A is correct. Small-cap stocks tend to underperform large and mid-cap stocks during
an economic downturn. Hence investors demand a higher equity risk premium in
small stocks.
18. Question 18
o A
Equities are generally a good hedge for bad consumption outcomes.

o B
Relative to bonds, equities provide a better hedge against bad consumption

outcomes.
o C
Equity investors require a risk premium because equities are normally a

poor hedge against bad consumption outcomes.
Incorrect
C is correct. Equities generally do well in good economic times and bad in poor
economic times and therefore have poor consumption hedging ability. Hence equity
investors require an equity risk premium which is positive. Hence A is incorrect.
Bonds provide a better hedge against poor economic outcomes. Hence B is
incorrect.
19. Question 19
A cyclical industry will most likely show:
o A
a rise in earnings during good economic times and fall in earnings

during bad economic times.
o B
stable earnings in relation to business cycle.

o C
no relation between earnings and business cycle.

Incorrect
A is correct. Cyclical industries have earnings that are sensitive to the state of the
economy.
20. Question 20
o A
Valuation multiples tend to fall during economic expansion.

o B
Equity risk premium fall during good economic times.

o C
Credit spreads increase during good economic times.

Incorrect
B is correct. Equity risk premium fall during good economic times causing valuation
multiples to increase. Credit spreads narrow during good economic times.
21. Question 21
How is economic analysis useful for sector rotation strategies ?
o A
To determine impact of macro-economic factors on earnings of different

companies within an industry.
o B
To evaluate the relative performance of different types of sectors over

the business cycle.
o C
To take long-short bets on stocks within an industry.

Incorrect
B is correct. Economic analysis is useful in understanding the impact of the economic
cycle on sector performance and returns. It helps predict the timing of sector
downturns/upturns for reallocation. A and C are incorrect as these refer to within
sector strategies.
22. Question 22
Which of the following statements about real estate is most likely true?
o A
Real estate is not affected by business cycle because rental income remains
steady regardless of economic conditions.
o B
The required return on commercial real estate is likely to be close to

return on fixed income instruments as the nature of their cash flows is
similar
o C
The discount rate for real estate is likely to include a premium for lack
of liquidity.
Incorrect
C is correct. The discount rate for real estate includes a liquidity premium as it can
take time to enter or exit real estate at its fair value. Real estate returns also include
a premium for risk which is similar to an equity risk premium as their value is
affected by a host of economic factors. Real estate values are sensitive to economic
cycles.
Abe Harold, an equity analyst has recently joined Greenfield Advisers, a global economic
consulting firm that provides economic updates of the global economy, and forecasts the
macroeconomic variables impacting various financial markets. Cathy Huang, Harold’s
supervisor knows that he is still relatively new to macro forecasting models, therefore
discusses with him macroeconomic variables used in forecasting models. Huang first
questions him about the key components of a discount rate. Harold responds, “The
uncertainty about future cash flows is indicated in the discount rate which is composed of
three components: I. The return required by an investor on a real default-free fixed-income
security analogous to the expected return on an inflation-linked bond issued by a developed
economy government. II. The additional return required for investing in a real default-free
investment. III. The additional premium required to compensate for the uncertainty about
the asset’s future cash flows.” Huang then shows Harold some of the factors (refer to Exhibit
1) that influence a country’s economic cycle and how they affect policy interest rates and
fixed-income markets. Exhibit 1: Important Economic Observations
Country Factors
An aggregate increase in borrowing
China
Positive output gap
Volatile inflation expectations
USA
Increasing equity risk premiums
Increase in marginal utility from consumption
Japan
Increase in individual saving levels
Huang next asks Harold, about the relationship of current interest rates with inflation
expectations. Harold explains, “The difference between yields on a default-free real bond
and a default-free nominal bond of the same maturity reflects both future inflation
expectations of investors plus a risk premium for the uncertainty of future inflation.”
1. Question 1
Which of Harold’s responses regarding the discount rate’s components is least
likely correct?
o A
I.
o B
II.
o C
III.
Incorrect
B is correct. One of the key components of the discount rate is the additional return
required by investors from investing in nominal default-free investment that
is above the real default-free investment, because future nominal payments will be
affected by inflation.
2. Question 2
Based on Exhibit 1, which country should most likely have a policy rate above the
neutral rate?
o A
China.
o B
USA.
o C
Japan.
Incorrect
A is correct. China is experiencing an aggregate increase in borrowing and a positive
output gap, which implies that the economy is producing beyond its sustainable
capacity. Hence the policy rate should be above the neutral rate. Conversely if the
output gap is negative, the policy rate should be below the neutral rate.
3. Question 3
Is Harold’s response to Huang’s question about current rates and inflation
expectations most likely correct ?
o A
No, it is incorrect with regard to future inflation expectations.

o B
No, it is incorrect with regard to uncertainty of future inflation.

o C
Yes.
Incorrect
C is correct. Harold correctly states that the difference between the yields on a real
default-free bond and a nominal default-free bond of the same maturity is that the
nominal yield will incorporate the inflation expectations of investors over the
investment horizon of the two bonds, θt,s, plus a risk premium that will be required by
investors to compensate them primarily for uncertainty about future inflation, πt.
Sabeen Shah is an equity analyst at Saddat and Shafi Securities (SSS), a global investment
firm. Shah prepares a newsletter for the clients, which includes responses to commonly
asked questions, a commentary on the economic factors impacting the global financial
markets and investment recommendations based on economic forecasts. In the upcoming
newsletter, Shah responds to questions about economic factors that are driving P/E
multiples higher in USA. Shah writes that decreasing volatility in USA’s real GDP growth, a
rise in inflation expectations, and fall in equity risk premium are the possible contributors.
Shah’s colleague, Rabia Brohi covers commercial real estate for SSS. Brohi explains her
pricing model for valuing commercial real estate investments to Shah so that it can be
communicated to SSS’s clients. Shah reviews Brohi’s model which consist of the following
elements:
• Expected cash flows from rents with the sale or redevelopment option as leases
expire
• A risk premium that is analogous to the equity risk premium
• A risk premium to incorporate the credit risk of corporate bonds
• An actively traded securities’ equity risk premium
1. Question 1
Shah’s response regarding USA is least likely correct with respect to:
o A
decrease in volatility in GDP growth.

o B
rise in inflation expectations.

o C
fall in equity risk premium.

Incorrect
B is correct. The high P/E in USA could be due to a number of factors including an
increase in expectations of future real earnings growth, fall in interest rates and fall
in volatility in GDP real growth rate, a fall (not a rise) in inflation expectations, a fall in
equity risk premium etc.
2. Question 2
Which element of Brohi’s model is least likely correct ?
o A
The equity risk premium for actively traded securities.

o B
A risk premium similar to the equity risk premium.

o C
Expected cash flows from rents with the redevelopment option.

Incorrect
A is correct. The pricing of commercial real estate should include cash flows received
from rent payments with potential redevelopment value when the lease expires. The
discount rate for these cash flows should incorporate a risk premium for commercial
real estate which is closer to equity investments than fixed-income investments, a
liquidity risk premium to account for the illiquidity of a commercial real estate
investment, a credit risk premium, a real government bond yield plus a nominal
government bond yield.
Jeffery Chan is a fixed-income analyst at InfoCredit, a credit advisory and investment

management firm. During the weekly meeting with the investment committee, Chan feels
that the US Federal Reserve Board (Fed) will not likely raise the federal funds rate (FFR) by 25
bps for at least six months because of weak economic data. InfoCredit expects the monthly
non-farm payroll report to confirm the weakness in the economy by showing that US
created less than 98,000 jobs this month, in accordance with the consensus expectations.
The committee asks Chan what will happen to the short-dated bond prices if the payroll
report meets expectations. The committee discusses the GDP growth forecasts which is
expected to be weaker in the future but more volatile as the economy adjusts to a changing
interest rate environment. Chan believes these factors will cause downward pressure on
short-term government real rates. Chan forecasts the real one-year risk-free rate to be
0.25% and average inflation over the next year to be 1.25%. As part of his analysis, Chan
reviews the current price of a zero-coupon nominal Treasury bond with one year to maturity
trading at USD97.95 with a par value of USD100. Chan observes the difference in market
pricing compared to his forecasts.
1. Question 1
Will the bond prices change if the payroll report is consistent with the expectations ?
o A
No.
o B
Yes, the prices will rise.

o C
Yes, the prices will fall.

Incorrect
A is correct. Although InfoCredit forecasts lower non-farm payroll figures and weaker
economic data, but their expectation is in line with market consensus forecasts. This
information is anticipated and thus already reflected in asset prices. Prices would
more likely rise or fall if the information is different from what was expected i.e. a
surprise relative to what was anticipated.
2. Question 2
Is Chan most likely correct regarding the impact on short-term government real rates
?
o A
Yes.
o B
No, incorrect with respect to the impact due to growth.

o C
No, incorrect with respect to the impact due to volatility.

Incorrect
C is correct. Real default-free interest rates should be positively related to GDP
growth and positively related to the expected volatility of GDP growth. If there are
expected increases in GDP volatility then there would be upward pressure on short-
term default-free real rates, all else being held equal.
3. Question 3
The discrepancy in the default free bond’s price noted by Chan is most likely due to:
o A
the credit risk.

o B
inflation uncertainty.
o C
price risk.
Incorrect
B is correct. Short-term default-free interest rates tend to be very heavily influenced
by the inflation environment and inflation expectations over time. The greater
uncertainty about the real value of the bond’s payoff will cause investors to demand
a premium in compensation for this uncertainty and will cause the discrepancy in
bond pricing. The break-even inflation rate incorporates both premiums for
expectations about inflation and for the uncertainty of the future inflation
environment.
Sandy Murray, a senior credit analyst at HCR, a global investment firm, evaluates three
bonds from three different sectors in order to execute a short position for the firm’s fixed-
income fund. Murray reviews HCR’s economic outlook, which forecasts the GDP growth rate
to be weaker than expected and more volatile. All three bonds mature in five years and are
presented in Exhibit 1. Exhibit 1: Credit Market Outlook
Spread Credit
Economic Sector Debt/Capital Enterprise Value/EBITDA
to Treasuries(bps) Rating
Bond
Food 30% 8 200 A2
1
Bond Household
48% 7 240 Baa2
2 & Personal Products
Bond
Automobiles 44% 7.6 210 Baa1
3
Connie Li, a quantitative analyst at the firm, is developing a model that will use economic
inputs to provide an equity rotation strategy for equity funds. Li also decides to incorporate
a target equity risk premium into the model. She makes the following notes: Note I. The
equity premium should be positive and given the economic outlook quite large. Note II. The
type of product sold or service provided by a company will impact earnings and equity
performance. Note III. Equities demand a lower risk premium because of better
consumption-hedging properties than investment grade fixed income securities.
1. Question 1
Based on Exhibit 1 and HCR’s economic outlook, the bond most likely chosen for a
short position is:
o A
Bond 1.
o B
Bond 2.
o C
Bond 3.
Incorrect
C is correct. Bond 3 is in the cyclical industry, it has a lower debt/capital ratio and a
tighter spread than Bond 2, hence should be chosen for a short position given the
economic outlook for growth. Bond 1 & Bond 2 are in the consumer staples (non-
cyclical) industry. Higher-rated issues such as Bond 1 are likely to outperform in the
declining growth environment.
2. Question 2
Which of Li’s notes is least likely correct ?
o A
I.
o B
II.
o C
III.
Incorrect
C is correct. The note regarding equity with better consumption-hedging properties
is incorrect. Because of the cyclical nature of the economies and corporate profits,
equities are a bad hedge for bad consumption outcomes and that is why require
equity risk premiums. A & B are correct notes.
Analysis of Active Portfolio

Management
1. Question 1
Q-Code: 21-L2-PM-AAPM-75664
The Mambo Large-Cap Fund has yielded a return of 12.5% in the current year. The
fund is benchmarked to the large cap market index which yielded a return of 10.0%.
The fund manager however, took riskier bets during the year due to which the fund’s
beta relative to the index was 1.2. The fund’s alpha is closest to:
o A
2.5%.
o B
5.0%.
o C
0.5%.
Incorrect
C is correct. The alpha is calculated as the difference between the fund return and
risk adjusted benchmark return: 12.5% – 1.2(10%) = 0.5%.
2. Question 2
The return on the SEFCO equity fund is 30%. The benchmark equity index return is
27%. The return on the SEFCO bond fund is 8% whereas that on the fixed income
benchmark index is 9%. The strategic asset allocation is given as 60% equities and
40% bonds. The investor’s asset allocation is 65% equity and 35% bonds. The active
return attributable to security selection is closest to:
o A
1.6%.
o B
0.9%.
o C
2.5%.
Incorrect
A is correct. The return from security selection is calculated as (65%)(30% – 27%) +
(35%)(8% – 9%) = 1.60%.
3. Question 3
The most likely difference between the information ratio and sharp ratio is:
o A
Sharpe ratio can be measured ex-ante or ex-post but information ratio is only
measured ex-post.
o B
Sharpe ratio uses portfolio standard deviation as a measure of volatility

whereas information ratio relies on portfolio beta as a volatility measure.
o C
Adding cash to a portfolio does not change the Sharpe ratio but changes
the information ratio.
Incorrect
C is correct. Adding cash or leverage to a portfolio does not change the Sharpe ratio
but changes the information ratio. Both ratios can be measured ex-ante and ex-post
and both use standard deviation as a measure of volatility. Sharpe ratio uses
standard deviation of portfolio returns, i.e. total risk, and information ratio employs
standard deviation of active return, i.e. active risk.
4. Question 4
The CXY opportunity fund is a small-cap equity fund. The fund posted a return of
12% last year. The fund’s benchmark, the Cospy 100 Index yielded a return of 10.5%
during the same period. The standard deviation of the fund’s returns was 4.5%
whereas that of the benchmark’s return was 3.5%. The standard deviation of the
fund’s active return is 3% and the risk-free rate is 5%. Based on this information, the
fund’s Sharpe ratio and information ratio are closest to:
Sharpe Ratio Information Ratio

A. 1.56 0.5
B. 0.33 0.5
C. 1.56 1.5
o A
Option A.
o B
Option B.
o C
Option C.
Incorrect
A is correct. The Sharpe ratio is calculated as Rp – Rf / STDp = ( 12 – 5 ) / 4.5 = 1.56.The
information ratio is calculated as Rp – Rb / STD(Rp – Rb) = 12 – 10.5 / 3 = 0.5,
5. Question 5
The return and risk data for three funds and their benchmark is given below:
Benchmark Fund A Fund B Fund C

Average return 15% 17% 21% 11%
Standard
10% 9% 18% 5%
deviation
Sharpe ratio 1.10 1.44 0.94 1.40
Information ratio -0.15 0.09 0.12
Which fund would be best to combine with a passively managed portfolio ?
o A
Fund A.
o B
Fund B.
o C
Fund C.
Incorrect
C is correct. Fund C has the highest information ratio therefore combining it with the
passively managed portfolio will produce the highest Sharpe ratio.
6. Question 6
Freedom Frontier Fund is an actively managed fund with active risk of 11% and an
information ratio of 0.5. Its benchmark has a Sharpe ratio of 0.3 and standard
deviation of 8%. The optimal active risk is closest to:
o A
13.33%.
o B
13.60%.
o C
14.10%.
Incorrect
A is correct. The optimal active risk is given as STD(RA) = IR x STDB / SRB = 0.5 x 8% / 0.3
= 13.33%.
7. Question 7
Consider an investor choosing between two risky portfolios: a large-cap stock
portfolio and a small-cap stock portfolio. The following information is provided:
Large Cap Small Cap

Expected return 11.0% 14.4%
Expected volatility 15.5% 23.1%
Sharpe ratio 0.26 0.32
The amount of cash (in percentage terms) needed by an investor to reduce the risk
of a portfolio invested in the small-cap portfolio and cash to the same risk level as
that of the large-cap portfolio is closest to:
o A
67%
o B
33%
o C
24%
Incorrect
Solution: B is correct. We want to reduce the 23.1% volatility to 15.5% by adding
cash. The weight of small-cap stocks in the combined portfolio must therefore be
15.5/23.1 = 67%, leaving a 33% weight in risk-free cash. With that amount of cash,
the volatility of the combined portfolio will be 0.67(23.1%) = 15.5%, the same as the
large-cap portfolio.
8. Question 8
As a result of the addition of cash or leverage, the Sharpe Ratio will:
o A
increase.
o B
decrease.
o C
remain unchanged.
Incorrect
Solution: C is correct. The Sharpe ratio is unaffected by the addition of cash or
leverage in a portfolio.
9. Question 9
Statement 1: The information ratio is affected by the addition of cash or leverage in
a portfolio.
Statement 2: The information ratio of an unconstrained portfolio is unaffected by

the aggressiveness of active weights.
o A
Statement 1
o B
Statement 2
o C

Incorrect
Solution: C is correct. Unlike the Sharpe ratio, the information ratio is affected by
the addition of cash or leverage in a portfolio. Adding cash to a portfolio of risky
assets will usually cause the information ratio to decrease. Similarly, adding leverage
will usually cause the information ratio of the combined portfolio to increase.
The information ratio of an unconstrained portfolio is unaffected by the
aggressiveness of active weights. For instance, if the active security weights are all
multiplied by some constant ‘c’, then the expected active return becomes and the
active risk of the altered portfolio becomes. Information ratio of an actively managed
portfolio will remain unchanged as can be seen in the equation below:
IRc cR / cSTD(R ) = R / cSTD(R ) = IR
A A A A
10. Question 10
Which of the following is most likely correct?
o A
If the active weights are zero, then the value added is one.
o B
The transfer coefficient measures the degree to which the investor’s

forecasts are translated into active weights.
o C
Investors with higher information coefficients have a lower ability to forecast

returns.
Incorrect
B is correct. The transfer coefficient measures the degree to which the investor’s
forecasts are translated into active weights. The risk-weighted correlation between
optimal active weights and forecasted active returns is given by:
TC = COR(μi/σi , Δwi σi)
For instance, TC is high if both the forecasted active returns and active weights are
high.
A is incorrect because when active weights are zero, this means the weights are the
same as those of the benchmark. The value added will therefore be zero.
C is incorrect because a high information coefficient means the correlation between
forecasted returns and actual returns is also high. Therefore, if an investor has a
higher information coefficient, he/she has a higher ability to forecast returns.
11. Question 11
Information regarding four securities is shown below. Assume their active returns
are uncorrelated with each other and forecasts are independent from year to year.
Expected Active Active Return Benchmark

Security Active Weight
Return Volatility weight
A 3% 10% 5% 25%
B 5% 15% 10% 25%
C -2% 5% -3% 25%
D -6% 17% -12% 25%
Assuming the forecasted return on the benchmark portfolio is 10%, the forecasted
total return and active return of the managed portfolio are closest to:
o A
11.43% and 1.43%.

o B
10% and 1.43%.

o C
11.54% and 1.54%.

Incorrect
A is correct. The forecasted total return of the portfolio is the sum of portfolio
weights times total returns for each security. To calculate this, we first need to
calculate each security’s portfolio weight and total return forecast.
The portfolio weight for each security is its active weight plus its benchmark weight.
Similarly, the total expected return is each security’s expected active return plus its
benchmark return. The calculations are shown in the table below.
Security Portfolio Weight (%) Total Expected Return (%)

A 5 + 25 = 30 3 + 10 = 13
B 10 + 25 = 35 5 + 10 = 15
C -3 + 25 = 22 -2 + 10 = 8
D -12 + 25 = 13 -6 + 10 = 4
The forecasted total return of the portfolio is the sum of portfolio weights times total
returns for each security: (0.30)(0.13) + (0.35)(0.15) + (0.22)(0.08) + (0.13)(0.04) =
0.1143 = 11.43%.
The active return of the portfolio is the active return minus the benchmark return for
each security: 0.1143 – 0.1000 = 0.0142 = 1.43%.
Alternatively, the portfolio’s return can be calculated as the sum of active weights
times active returns for each security: (0.05)(0.03) + (0.10)(0.05) + (-0.03)(-0.02) + (-
0.12)(-0.06) = 0.0143 = 1.43%.
12. Question 12
A portfolio of 4 securities has an information coefficient of 0.50, transfer coefficient
of 1.00, active risk of 6%. Assuming the returns of the securities are uncorrelated, the
expected active return of the portfolio is closest to:
o A
3%.
o B
6%.
o C
12%.
Incorrect
B is correct. According to the basic fundamental law, the expected active portfolio
return is IC(ÖBR)sA.
Where IC is the information coefficient, BR is the breadth (or number of securities
with uncorrelated returns), and sA is the active risk of the managed portfolio.
In this case:
Expected active risk = 0.50 x (Ö4) x 0.06 = 0.05 x 2 x 0.06 = 0.06 = 6%
13. Question 13
Three investment managers are being evaluated for managing an equity fund. The
managers’ expected active returns and active weights for three securities are given
below. The risk of these stocks and their actual active returns are also given:
Manager 1 Manager 2 Manager 3

Active Active Active
E (RA) E (RA) E (RA) Risk Realized RA
wt. wt. wt.
Descon Co. 0.05 0.02 0.075 0.04 -0.05 0.02 0.15 0.06
Huda Co. -0.025 0.01 0.03 0.025 0.05 0.04 0.17 0.02
JJ Co. 0.03 0.04 -0.1 0.01 0.02 0.05 0.13 0.04
Suppose all three managers claim to be good at forecasting returns. According to the
full fundamental law of active management, which manager is the best at building
portfolios by anticipating future returns ?
o A
Manager 1.
o B
Manager 2.
o C
Manager 3.
Incorrect
(Note: You are unlikely to see questions with such lengthy calculations on the exam.
This question is designed to help you understand the concept. On the exam you can
expect most of the numbers to be provided to you, and may be required to do only a
small part of the calculations shown below.)
A is correct. The ability of the fund manager to accurately forecast active returns is
measured by the information coefficient. The IC is found as the correlation between
risk-adjusted active return expectation and risk-adjusted realized active returns:
Risk weighted forecasts [E (RA)/σ] RA/σ

Manager 1 Manager 2 Manager 3 Realized
Descon 0.13 0.27 0.13 0.40
Huda 0.06 0.15 0.24 0.12
JJ 0.31 0.08 0.38 0.31
IC 0.461 0.454 (0.248)

Manager 1 has the highest IC. Section 4.1. LO.c.
Calculations: (Rounded to two decimals)

Risk-adjusted realized active returns: 0.06/0.15 = 0.4; 0.02/0.17 = 0.12; 0.04/0.13 =
0.31
Risk weighted forecasts, Manager 1: 0.02/0.15 = 0.13; 0.01/0.17 = 0.06; 0.04/0.13 =

0.31
(Similar calculations for Managers 2 and 3.)
Information Coefficient Manager 1:

Use the Data mode in the calculator: Press 2nd Data, 2nd Clear work
Enter the following values
X01 = 0.13, Y01 = 0.40
X02 = 0.06, Y02 = 0.12
X03 = 0.31, Y03 = 0.31
To view the stats: Press 2nd Stat
Ensure calculator is in ‘LIN’ mode. You should see ‘LIN’ in the display, if you don’t see
this press 2nd Set repeatedly until you see ‘LIN’
Keep pressing the ‘Down’ arrows to see the stats. We are interested in the
correlation between the X and Y values which is the last stat to be displayed. But for
your understanding we have also explained the other stats that you will see before
you reach the correlation value
n = 3 denotes the number of paired observations
denotes the mean value of the X variable
Sx = 0.13 denotes the sample std deviation of X
σx = 0.11 denotes the population std deviation of X
You will also see the same stats for the Y variable
denotes the mean value of the Y variable
Sy = 0.14 denotes the sample std deviation of Y
σy = 0.17 denotes the population std deviation of Y
Next you will see the regression coefficients for a linear regression line between X
and Y
a = 0.19 denotes that the intercept coefficient
b = 0.51 denotes the slope coefficient
r = 0.46 denotes the correlation between the two variables. This is the value we are
interested in.
(Similar calculations for Manager 2 and Manager 3)
14. Question 14
Three investment managers are being evaluated for managing an equity fund. The
managers’ expected active returns and active weights for three securities are given
below. The risk of these stocks and their actual active returns are also given:
Manager 1 Manager 2 Manager 3

Active Active Active
E (RA) E (RA) E (RA) Risk Realized RA
wt. wt. wt.
Descon Co. 0.05 0.02 0.075 0.04 -0.05 0.02 0.15 0.06
Huda Co. -0.025 0.01 0.03 0.025 0.05 0.04 0.17 0.02
JJ Co. 0.03 0.04 -0.1 0.01 0.02 0.05 0.13 0.04
Suppose all three managers claim to be efficient in portfolio construction. According
to the full fundamental law of active management, which manager is the best at
building portfolios to make full use of their ability to correctly anticipate returns?
o A
Manager 1.
o B
Manager 2.
o C
Manager 3.
Incorrect
(Note: You are unlikely to see questions with such lengthy calculations on the exam.
This question is designed to help you understand the concept. On the exam you can
expect most of the numbers to be provided to you, and may be required to do only a
small part of the calculations shown below.)
B is correct. The ability of the fund manager to efficiently construct portfolios by

using their forecasted active returns is indicated by the transfer coefficient. The TC is
measured as the correlation between risk-adjusted forecasted active returns and
risk-adjusted actual active weights.
Risk weighted forecasts [E (RA)/σ] Risk adjusted weights [Act. wt. x σ]

Manager 1 Manager 2 Manager 3 Manager 1 Manager 2 Manager 3
Descon 0.13 0.27 0.13 0.0075 0.0113 (0.0075)
Huda 0.06 0.15 0.24 (0.0043) 0.0051 0.0085
JJ 0.31 0.08 0.38 0.0039 (0.0130) 0.0026
TC 0.476 0.910 0.569
Manager 2 has the highest TC. Section 4.3. LO.c.
Calculations:
Transfer coefficient Manager 1
Use the Data mode in the calculator: Press 2nd Data, 2nd Clear work
Enter the following values
X01 = 0.13, Y01 = 0.0075
X02 = 0.06, Y02 = -0.0043
X03 = 0.31, Y03 = 0.0039
To view the stats: Press 2nd Stat
Ensure calculator is in ‘LIN’ mode. You should see ‘LIN’ in the display, if you don’t see
this press 2nd Set repeatedly until you see ‘LIN’
Keep pressing the ‘Down’ arrows to see the stats. We are interested in the
correlation between the X and Y values which is the last stat to be displayed. But for
your understanding we have also explained the other stats that you will see before
you reach the correlation value
n = 3 denotes the number of paired observations
denotes the mean value of the X variable
Sx = 0.13 denotes the sample std deviation of X
σx = 0.11 denotes the population std deviation of X
You will also see the same stats for the Y variable
denotes the mean value of the Y variable
Sy = 0. 0060 denotes the sample std deviation of Y
σy = 0.0049 denotes the population std deviation of Y
Next you will see the regression coefficients for a linear regression line between X
and Y
a = 0.0013denotes that the intercept coefficient
b = 0.022 denotes the slope coefficient
r = 0.476 denotes the correlation between the two variables. This is the value we are
interested in.
(Similar calculations for Manager 2 and Manager 3)
15. Question 15
Given the information ratio (IR) for Fund A of 0.45 and the benchmark’s Sharpe Ratio
(SR) of 0.35, the combination of the benchmark portfolio and Fund A would produce
a SR of:
o A
0.57
o B
0.33
o C
0.80
Incorrect
Solution: A is correct. It would be calculated as follows:
SRP 2 = SRB 2 + IR2;
SRP = (0.1225 + 0.2025)0.5 = 0.57.
16. Question 16
Manager A invests in 40 securities and has an information coefficient of 0.3 and a
transfer coefficient of 0.7. Manager B invests in 60 securities and has an information
coefficient of 0.2 and a transfer coefficient of 0.9. Both fund managers are targeting
an active risk of 4%. Which of the following statements is most likely true ?
o A
Manager A has a higher active return than Manager B.

o B
Manager B has a higher active return than Manager A.

o C
Both Manager A and Manager B have the same active return.

Incorrect
B is correct. Manager A’s IR = TC x IC x ( B )1/2 = 0.7 x 0.3 x (40)1/2 = 1.33. Manager B’s IR
= 0.9 x 0.2 x (60)1/2 = 1.39. With active risk of 4%, Manager A’s active return is 1.33 x
4% = 5.3% and Manager B’s active return is 1.39 x 4% = 5.6%.
17. Question 17
Which of the following statements is most likely true about combining a benchmark
portfolio with an active portfolio?
o A
When given a choice, the fund manager with the highest information
ratio should be selected to manage the portfolio.
o B
When combining an active portfolio with a benchmark portfolio, the optimal

level of risk is given as the product of information ratio of the active portfolio
and Sharpe ratio of the benchmark portfolio.
o C
Selecting the portfolio with the highest Information ratio does not necessarily
ensure that the Sharpe ratio would be highest as well.
Incorrect
A is correct. When comparing different fund managers the one with the highest
information ratio should be selected.
18. Question 18
Two active management strategies involving individual stock selection with a
benchmark of 50 securities, and industrial sector selection with a benchmark of 12
sectors. The active security returns uncorrelated, and forecasts are independent. The
individual stock investor has an information coefficient of 0.06, while the industrial
sector investor has an information coefficient of 0.19. The expected information
ratio for each strategy, assuming each investor’s forecasts can be implemented
without constraints is closest to:
o A
IR(security selection) = 0.40; IR(industrial sector) = 0.70.

o B

o C

Incorrect
A is correct. IR of the unconstrained security selection strategy = IR = 0.06 x (50)1/2 =
0.42; IR of the industrial sector selection strategy = IR = 0.19 x (12)1/2 = 0.658.
19. Question 19
An investment manager is managing a portfolio with a benchmark consisting of 25
equity securities. The returns on these securities are uncorrelated, forecasts are
independent, and the investment manager is expected to exhibit skills as measured
by an information coefficient of 0.20. The portfolio active risk target is 4%. Under the
assumption that the security selection strategy is constrained, the transfer
coefficient would be 0.85. The expected active returns with and without constraints
are closest to:
o A
3.4% and 4%.

o B
4% and 3.4%.
o C
17% and 20%.

Incorrect
A is correct.
The expected active return with a transfer coefficient of 0.85 can be calculated using
the full fundamental law.
E(RA) = (TC)(IC)(√BR)sA
E(RA)= 0.85(0.20)(√25)(0.04) = 0.034 = 3.4%
The expected active return with no constraints can be calculated using the basic
fundamental law.
E(RA)* = IC(√BR)sA
E(RA)* = 0.20(√25)(0.04) = 0.04 = 4%
20. Question 20
o A
The fundamental law can have either cross sectional or time series
applications.
o B
If the returns of the securities in a portfolio are correlated and forecasts

are independent, then the breadth will be more than the total number
of securities in the portfolio.
o C
Calculating the expected return of an active management strategy in which

an investor either overweights or underweights credit exposure once per
quarter is an example of a time series application of the fundamental law.
Incorrect
B is correct. When the returns of the securities in a portfolio are uncorrelated, then
breadth can be assumed to be equal to the number of securities. If the returns are
correlated, however, then the breadth is lower than the number of securities in the
portfolio. The curriculum states the following rule of thumb which can be used to
approximate the breadth: BR = N/[1 + (N – 1)ρ]. Here, N is the number of securities
and ρ is the average correlation between the active security returns.
The statements in options A and B are correct.
21. Question 21
Which of the following statements about limitations of the fundamental law of active
management is least likely true?
o A
Active investors assume that they have superior skills compared to other
active managers.
o B
Calculating the ex-ante information ratio has a drawback that

managers tend to underestimate their ability to outperform the
market.
o C
The asset forecasts over time may not be truly independent.

Incorrect
B is correct. Managers tend to overestimate their ability to outperform the market
hence over estimate their ICs.
22. Question 22
Which of the following is most likely a limitation of the fundamental law?
o A
The fundamental law is not based on the mean-variance optimization

approach to relative performance.
o B
If uncertainty about forecasting ability is high, then the expected value added
will also be high.
o C
An investor’s forecasting ability varies across different segments, e.g.

they may be skillful in selecting stocks in one segment but have no
expertise in selecting stocks in another segment.
Incorrect
C is correct.
A is incorrect because the fundamental law is based on the mean-variance
optimization approach to relative performance, which means it has many of the
same limitations as the MVO approach.
B is an incorrect statement because a limitation of the fundamental law is that if
uncertainty about forecasting is high, then the expected value added will be low.
23. Question 23
Which of the following is least likely a limitation of the fundamental law?
o A
When using the time series application of the fundamental law, increasing
the rebalancing frequency may increase the realized information ratio.
o B
The fundamental law is more suitable for actively managed fixed-

income portfolios and less so for equity portfolios.
o C
Empirically, realized returns of stock selection are 45-91% of expected

returns predicted by the fundamental law.
Incorrect
B is correct. The fundamental law is more suitable for equity portfolios and less so
for actively managed fixed-income portfolios. Breadth can be easily determined for
equity portfolios because once systemic risk factors are removed, the remaining
risks are independent. In the case of actively managed fixed-income portfolios, most
bonds have some level of duration risk, credit risk, and optionality, so returns are
highly correlated and are difficult to separate.
Both options A and C are limitations of the fundamental law.
Diana Yeatz, is the chief financial officer of the Eckart Foundation, which finances college
education by providing grants and loans to students determined on the basis of merit and
need. Eckart has $1.4 billion in assets managed by external portfolio managers. Yeatz and
Ali Nathani, senior analyst at Eckart, are conducting the department’s quarterly review
process of evaluating active portfolio managers. Nathani collects the following information
for Eckart’s balanced funds, presented in Exhibit 1 and Exhibit 2. Exhibit 1. Selected Fund
Statistics
One-Year Returns Weights One-Year Total Return

Equity Bond Equity Bond
Fund A 15.0% 7.0% 69% 31% 12.52%
Fund B 11.0% 6.8% 66% 34% 9.57%
Benchmark 12.0% 7.0% 60% 40% 10.00%
Exhibit 2. Selected Fund Statistics
Fund A Fund B Benchmark
Five-year annualized return 13.5% 12.8% 10.25%
Standard deviation 14.4% 10.4% 9.60%
Active return 3.25% 2.55%
Active risk 7.00% 2.12%
Risk-free rate 5.5%
Yeatz reviews the fund information, and then asks Nathani to evaluate the managers. The
fund managers have the following characteristics: Manager 1: A fund made of stocks of
companies from the major developed markets. Its benchmark is the S&P Global BMI.
Manager 2: A fund with a total return objective of exceeding the return of the S&P Global
BMI. The fund can allocate upto 25% to cash. Manager 3: A fund that holds developed
countries’ sovereign bonds. Its benchmark is the S&P Global Developed Sovereign Bond
Index.
1. Question 1
Based on Exhibit 1, the performance attribution most likely shows that:
o A
Fund A overperformed through security selection and asset allocation.

o B
Fund B underperformed through asset allocation.

o C
Fund A and Fund B added value through security selection.

Incorrect
A is correct. Positive value added is generated by overweighting securities that have
returns greater than the benchmark and underweighting securities that have returns
less than the benchmark. Performance attribution systems can decompose the value
added into multiple sources. The most common decomposition is between value
added due to asset allocation and value added due to security selection. Fund A
overweighted the equity class ( 66% versus 60%) which performed better than the
bond class, and the equity portion of Fund A outperformed the equity benchmark
(15.0% versus 7.0%).
2. Question 2
Based on the information ratio calculated using Exhibit 2, which of the following
statements is most likely correct ?
o A
The manager of Fund B achieved the highest risk-adjusted returns.

o B
The manager of Fund A achieved the highest risk-adjusted returns.

o C
The managers of both the funds achieved the same return per unit of risk.
Incorrect
A is correct. The information ratio of an actively managed portfolio, IR, is calculated
by dividing the active return by active risk: IR = RP – Rb / STD ( RP – Rb )
IRFund A = (13.5 – 10.25 ) / 7 = 0.46 IRFund B = ( 12.8 – 10.25 ) / 2.12 = 1.20. The IRs
indicate that the manager for Fund B achieved the highest returns per unit of risk or
the highest risk-adjusted returns.
3. Question 3
Nathani is least likely to use the Sharpe ratio to evaluate the portfolio returns of:
o A
Manager 1.
o B
Manager 2.
o C
Manager 3.
Incorrect
B is correct. The Sharpe ratio is unaffected by the addition of cash or leverage in a
portfolio. Therefore, it would not be appropriate to use Sharpe ratio to evaluate a
portfolio where allocation to cash is a key investment decision.
Ling Mei, is the chief investment officer at Drexel Corp. responsible for the company’s
employees’ pension fund. She is interviewing Karl Seyfried for the post of an analyst. Mei
wants to determine whether Seyfried is familiar with the portfolio construction and
management process. Mei asks Seyfried about the fundamental law of active management.
Seyfried responds, “According to the fundamental law, the expected active return, is the
product of four key parameters: the transfer coefficient (TC), the information coefficient (IC),
breadth, and portfolio active risk. Managers with better ability to forecast returns or higher
IC will add more value over time. The transfer coefficient is low when there are constraints
over portfolio construction, and breadth is lower for positively correlated securities.” Mei
shares the following information (Exhibit 1) with Seyfried and asks him to evaluate the
portfolio managers. Exhibit 1. Portfolio Manager Comparison
Manager A Manager B
Based on monthly forecasts of commodity
prices and interest rates, the manager
Based on internal forecasts, the manager
allocates weights between a short-term US
may allocate weights to 20 developed
treasury bond fund and a commodity
countries using country-specific ETFs with
exchange-traded fund (ETF). The benchmark
quarterly rebalancing.
portfolio is 50% commodity and 50% US T-
bond.
Seyfried makes the following notes:
I. Manager A would improve its information ratio by rebalancing more frequently.

II. Manager B has a lower breadth than specified because of the likelihood of positive
correlation of country returns.
III. Because both managers have constrained portfolios, therefore information
coefficients will generally increase with aggressiveness of the strategy.
Mei questions Seyfried about practical limitations of the Fundamental Law of Active
Management. Seyfried answers as follows: 1: There is a lack of independence in
investment decisions. For example, almost all bonds have some form of credit risk and
duration risk, therefore returns are highly correlated in subtle ways. 2: When forecasts
are not independent or derivatives are used breadth is not equal to the number of
individual assets. 3: Most investors overestimate their forecasting skills and thus
overstate the information ratio.” Is Seyfried correct in his interpretation of the fundamental
law?
1. Question 1
Is Seyfried correct in his interpretation of the fundamental law?
o A
No, incorrect regarding lower TC of a constrained portfolio.

o B
No, incorrect regarding the four parameters of the fundamental law.

o C
Yes.
Incorrect
C is correct. Seyfried is correct in his response about the fundamental law. The law
states that the expected active return, E(RA), is the product of four key parameters:
the transfer coefficient, TC; the assumed information coefficient, IC; the square root
of breadth, BR; and portfolio active risk. Investors with higher IC will add more value
over time. TC is lower for constrained portfolios.
2. Question 2
Based on Exhibit 1 and the fundamental law of active management, which of the
notes of Seyfried is most likely correct ?
o A
I.
o B
II.
o C
III.
Incorrect
B is correct. BR is lower than the number of securities if their returns are positively
correlated. Although increasing the rebalancing frequency may increase the
information ratio, it will do so if the sequential active management decisions remain
independent. An unconstrained IR is invariant to the level of active risk, however the
IR for a constrained portfolio generally decreases with the aggressiveness of the
strategy.
3. Question 3
Is Seyfried most likely correct about the limitations of the fundamental law?
o A
Yes.
o B
No, incorrect about high correlation in fixed-income returns due to

credit risk and duration risk.
o C
No, incorrect about breadth being not equal to the number of individual
assets.
Incorrect
A is correct. Seyfried correctly states the limitations of the fundamental law.
Karlene Burnell is the new chief investment officer at Prost & Ingsol Foundation which
finances secondary school education. The foundation has €1 billion in assets managed by
outside portfolio managers. Burnell is responsible for selecting and evaluating portfolio
managers. Burnell is meeting with Ray Peterson, a newly hired member of her team, to
gauge his knowledge regarding manager selection and evaluation. She starts by asking,
“How is value added to a portfolio?” Peterson responds by making the following statements:
I. “Value is added when the portfolio return is greater than the benchmark return.
II. Positive value is added when securities with returns greater than the benchmark are
overweighted and those with lower than benchmark returns are underweighted.
III. Value added can be from asset allocation and security selection.”
Burnell then asks Peterson to review the information for Brye Investment Consultants and
include the information ratio. Exhibit 1: Brye Investment Consultants Selected Data
Fund average Benchmark
15.58 8.03
annual return (%) standard deviation (%)
Fund standard
8.9 Sharpe ratio 1.41
deviation (%)
Benchmark
average annual return 15.25 Active risk 1.38
(%)
Burnell comments, “The information ratio helps assess the active performance of a manger
for incurring the level of active risk and is useful in selecting managers.” She asks Peterson
about his understanding of the information ratio. Peterson remarks:
I. For any given asset class, the manger with the highest expected skill as measured by
the information ratio should be chosen.
II. The information ratio of a portfolio without constraints is unaffected if the active
weights deviate from the benchmark weights.
III. The information ratio of a combined portfolio will be unaffected if cash is added or
leverage is used.
1. Question 1
Is Peterson correct in his statements about “value added” ?
o A
Yes.
o B
No, incorrect with respect to value added from asset allocation and security
selection.
o C
No, incorrect with respect to overweighting / underweighting of securities

relative to benchmark.
Incorrect
A is correct. Peterson correctly explains value added. Value added or “active return”
of an actively managed portfolio is calculated by the difference between the return
on that portfolio and the return on the benchmark portfolio. Positive value added is
by overweighting the portfolio with securities that have returns greater than the
benchmark and underweighting securities that have returns less than the
benchmark. Value added can be from asset allocation and security selection.
2. Question 2
Based on the data given in Exhibit 1, the information ratio is closest to:
o A
0.38.
o B
0.24.
o C
0.04.
Incorrect
B is correct. The information ratio is calculated by dividing the active return (RA) by
the active risk. The active risk is the standard deviation of the difference between
portfolio return and the benchmark return STD(RP – RB). IR = RA / STD (Rp – RB ). IR = (
15.58 – 15.25 ) / 1.38 = 0.239.
3. Question 3
Regarding his remarks about the information ratio, Peterson is least likely correct with
respect to:
o A
I.
o B
II.
o C
III.
Incorrect
C is correct. Unlike the Sharpe ratio, the information ratio is affected by the addition
of cash or the use of leverage. The information ratio for such a combined portfolio
will generally be lower. However, the information ratio of an unconstrained portfolio
is unaffected by the aggressiveness of active weights. A and B are correct
statements.
Bill White, senior investment officer at Black Stone Investments is conducting a training
session of the new analysts hired by the firm. He asks one of the participants, Craig David,
to explain the difference between the Sharpe ratio and the information ratio as both are
useful tools in evaluating portfolio managers. David states, “The information ratio provides
benchmark relative expected or realized reward-to-risk measure, whereas the Sharpe ratio
gives an absolute expected or realized reward-to-risk measure. Sharpe ratios helps
understand the value added by the portfolio return in excess of the benchmark return for
assuming the risk of the portfolio. Although the Sharpe ratio is not affected by the addition
of cash or leverage, the information ratio is affected with the addition of either.” White then
explains the Fundamental Law of Active Management to her analysts and asks them if they
could interpret the correlation triangle. One of the analysts, Ariana Miller notes, “A manager
adds value if his forecasts correspond at least somewhat loosely to the realized active
returns. Further, if the portfolio manager is able to translate his forecasts of the best relative
returns into active weights, he will be able to achieve positive relative returns.” Finally, White
gives an example of the application of the Fundamental Law of Active Management by
evaluating the performance of Shenzua Investment Management Company. White states,
“Shenzua may be overstating its expected active return, because it rebalances frequently,
and alleges that its number of independent decisions is high. Some of Shenzua’s funds are
invested in economic regions where the same general analysis applies to all securities within
that region. That would mean that breadth is lower than stated. Furthermore, Shenzua
follows investment strategies for security selection that are not changed for several months.
It does not evaluate each security independently, therefore, the investment decisions are
not independent. This would again result in a lower breadth.”
1. Question 1
In his statements regarding the Sharpe ratio and the information ratio, David is least
likely correct with respect to:
o A
absolute value versus relative value.

o B
Sharpe ratio and portfolio return.

o C
The effect of cash or leverage.

Incorrect
B is correct. The Sharpe ratio is a measure based on the portfolio return in excess of
a riskless rate with the volatility of the portfolio return. The ratio provides a measure
of how much the investor is receiving in excess of a riskless rate for assuming the
portfolio risk.
2. Question 2
Is Miller correct in her interpretation of the fundamental law?
o A
Yes.
o B
No, incorrect with respect to translation of forecasted returns into active

weights.
o C
No, incorrect with respect to value added through forecasted returns

corresponding to realized returns.
Incorrect
A is correct. Both statements are correct. A manager adds value if his forecasts of
active returns correspond at least loosely to the realized active returns (information
coefficient). Furthermore, the manger must translate into active weight the securities
for which he has forecasted the best relative returns to generate positive relative
returns (transfer coefficient).
3. Question 3
Is White correct in his assessment of Shenzua overstating its expected active return?
o A
No, incorrect regarding the impact of investment decisions.
o B
Yes.
o C
No, incorrect regarding lower breadth for securities within the same region.
Incorrect
B is correct. Expected active return = (IC)(BR)1/2 x (Active risk). If the investment
decisions are not independent, or if individual securities are impacted by
assumptions or strategies that remain the same through multiple rebalancing
periods, then breadth will be lower reducing the information ratio and thus the
expected return.

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QUANTS

Basics of Multiple Regression and

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violated due to the relationship of the residuals and inflation rates.

Q-Q plots help identify potential outliers.

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air resistance (b1) only.

voltage (b2) only.

both air resistance (b1) and voltage (b2).

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the predicted model has only a 50% probability of being correct.

the F-statistic is not significant.

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The R2cannot provide information on whether the coefficients are statistically

The R2cannot provide information on whether there are biases in the

For AIC, a higher value implies a better model.

Coefficients Standard Error t-Statistic p-value

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to not reject the alternative hypothesis.

to not reject the null hypothesis.

to reject the null hypothesis.

of the combined effect of the model error and sampling error.

Coefficient Standard Error

the null hypothesis of no positive serial correlation should be rejected.

the null hypothesis of no positive serial correlation should not be rejected.

multicollinearity does not exist.

both the dependent and the independent variables.

the dependent variable only.

the independent variable only.

incorrect with respect to validity of estimates.

incorrect with respect to validity of tests.

Variable Coefficient t-statistic p-value

correlation between YC and NASDAQ is low.

model R2 is relatively high.

significant serial correlation.

no significant serial correlation.

inconclusive results regarding serial correlation.

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It only applies to first-order serial correlation.

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neither homoskedastic nor heteroskedastic.

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