2004 CFA level 2 mock exam

Prepared for Jia Jia
4/5/2014
1


Answer for Alternative Investments – Mitchell
1.The value of the apartment building = net operating income / (discount

rate – growth rate) 
 Value = $540,000 / (8% - 3%) = $10,800,000.
2014 CFA Level II
"Private Real Estate Investments," by Jeffrey D. Fisher and Bryan D.
MacGregor
 Section 6.2
2.The cash flow is the difference between the net operating income and
the debt service. The equity is the difference between the market value
of the property and the mortgage on the property.
($700,000 – $600,000) / ($10,000,000 – $9,000,000) = 10%
2014 CFA Level II
"Private Real Estate Investments," by Jeffrey D. Fisher and Bryan D.
MacGregor
 Section 12
3.Applying a multiple to FFO and AFFO may not capture the intrinsic
value of real estate assets held by the REIT or REOC. Some properties
do not produce income and thus would not contribute to FFO but still
have value.
2014 CFA Level II
"Publicly Traded Real Estate Securities," by Anthony Paolone, Ian
Rossa O'Reilly, and David Kruth
 Section 6.3
4.Although buyout investments typically have steady and predictable
cash flows, venture capital investments do not.
2014 CFA Level II
"Private
Equity

Valuation,"
Jenkinson
 Section 2.3

by

Yves

Courtois

and

Tim

5.
Post-money valuation = $20,000,00 / (1 + 0.40)3 = $7,288,630
Pre-money valuation = $7,288,630–$5,000,000 = $2,288,630
Ownership fraction = $5,000,000 / $7,288,630 = 68.6%
2014 CFA Level II
"Private
Equity
Valuation,"
Jenkinson
 Appendix

by

Yves

Courtois

and

Tim

2


6.
A funds of funds tends to have lower survivor bias.
Statement 1 is incorrect because funds of funds tend to have average
performance because of diversification among strategies and managers.
Statement 3 is incorrect because funds of funds tend to have lower backfill
bias.
2014 Modular Level 2, Vol. 3, Reading 26, Section 3.2
“Investing in Hedge Funds: A Survey,” Keith H. Black
Section 11

3


Prepared for Jia Jia
4/5/2014
1


Answer for Corporate Finance – Kocher

1. According to best practices in corporate governance, Kocher can be
on the board of directors but should not be the chairman of the board of
directors. Furthermore, whether the retiring CEO's membership on the
board is replaced with an independent or non-independent director is

irrelevant because the board will have at least 75% representation from
independent members in either case.
2014 CFA Level II
 "Corporate Governance," by Rebecca Todd
McEnally and Kenneth Kim
 Sections 5.1.1, 5.1.2
2.Kocher is a member of the board of directors of HTF. Making Herman a

board member at BKT creates an interlocking directorship, which makes
Herman a non-independent board member.
2014 CFA Level II
"Corporate Governance," by Rebecca Todd McEnally and Kenneth
Kim
 Section 5.1.1
3.According to best practices in corporate governance, the audit and
nominating committees should be composed entirely of independent
board members. Upon becoming CEO, Kocher is no longer considered
an independent board member.
2014 CFA Level II
"Corporate Governance," by Rebecca Todd McEnally and Kenneth
Kim
 Sections 5.1.7, 5.1.8
4.The optimal capital structure will have the lowest weighted average
cost of capital (WACC). Using the data in Exhibit 1, the following can be
calculated:

Comparison of
the WACC
Proportion of
debt (WD)
Proportion of
equity (WE)
Pre-tax cost of
debt (kD)

Cost of equity
(kE)
Tax rate

Financing
Mix 1

Financing
Mix 2

0.40

Current
Financing
Mix
0.50

0.60

0.50

0.40

0.05

0.52

0.055

0.075

0.079

0.083

0.60

0.30
2


WACC = WD× kD
× (1 – 0.30) +
WE × kE

0.0590

0.0577
(given)

0.0563

Based on the WACC, the optimal financing mix is financing mix 2.
2014 CFA Level II
“Capital Structure,” by Raj Aggarwal, Pamela Peterson Drake, Adam
Kobor, and Gregory Noronha 
 Section 2.7
5.Dividend payout ratio = dividends/net income
Dividend per share = dividends/8 million shares

Year

2009
2010
2011
2012

(1)
Net Income
($ millions)

(2)
Dividends
($ millions)

(2)/(1)
Dividend
Payout
Ratio

(2)/8.00 (million
shares)
Dividend Per
Share

10.40
8.20
12.50
13.70

3.12
2.46

3.75
4.11

0.30
0.30
0.30
0.30

0.39
0.31
0.47
0.51

In the table, the constant dividend payout ratio of 0.30 is evidence of a
constant dividend payout ratio policy. It cannot be a stable dividend
policy because the dividend per share has not been constant, and it
cannot be a residual dividend policy because project investment had not
been considered prior to paying the dividend (a problem noted by
Kocher in 2009 and 2010).
2014 CFA Level II
“Dividends and Share Repurchases: Analysis,” by Gregory Noronha and
George H. Troughton 
 Sections 4.1.1, 4.1.3
6.Total expected dividends paid = dividend × shares outstanding
 $0.50
× 8 million shares = $4.0 million
Expected earnings left for project investment (projected earnings minus
total expected dividends paid. Note: This figure will be the expected
equity contribution toward project financing):
 $14.25 million - $4.0
million = $10.25 million
3

Expected amount of capital available for project investment:

Using the current financing mix of 50% debt and 50% equity:

2014 CFA Level II
 "Capital Structure," by Raj Aggarwal, Pamela
Peterson Drake, Adam Kobor, and Gregory Noronha
 Section 3.2
"Dividends and Share Repurchases: Analysis," by Gregory Noronha and
George H. Troughton
 Sections 4.1.1, 4.1.3

Answer for Corporate Finance – Scott
1.Economic income = Change in market value plus the after-tax cash
flow.
Market value = Present value of future expected after-tax cash flows
Beginning market value, at beginning of Year 3 (assuming end-of-year
cash flows):

Ending market value at the end of Year 3:

Economic profit = (292,939 – 382,712) + 147,180 = 57,407
2014 CFA Level II
"Capital Budgeting," by John D. Stowe and Jacques R. Gagne
Section 8.2
2.Operating income before tax - Interest = Taxable income:
4


$102,750 – ($300,000 × 0.12) = $66,750
Accounting income or net income = Taxable income × (1 – Tax rate)
$66,750 × (1 – 0.40) = $40,050

2014 CFA Level II
"Capital Budgeting," by John D. Stowe and Jacques R. Gagne
Section 8.2
3.Ludlow's suggestion of considering alternate economic environments
is an example of scenario analysis.
2014 CFA Level II
"Capital Budgeting," by John D. Stowe and Jacques R. Gagne
Section 7.3.2
4.Because the schedule for the first year is equivalent to straight-line
depreciation (1/5 = 20%), the after-tax operating cash flow does not
change under straight line or MACRS accelerated depreciation.
2014 CFA Level II
"Capital Budgeting," by John D. Stowe and Jacques R. Gagne
Section 6.1
5.Ludlow's suggestion is an example of economic profit: EBIT × (1 – tax
rate) – $WACC. EBIT is earnings before interest and taxes.
2014 CFA Level II
"Capital Budgeting," by John D. Stowe and Jacques R. Gagne
Section 8.3.1
6.
EAA = 128,146/2.2832=56,126

EAA = 183,109/3.3522=54,624

The three-year project is preferred because it has a higher EAA.

5


LCML: The least common multiple, given 3 and 5, is 15. Compare the

NPV of each project, assuming each project is repeated for 15 years.
NPV (three-year project, 15 years):

NPV (five-year project, 15 years):

The three-year project is preferred because the NPV over 15 years is
higher.
2014 CFA Level II
"Capital Budgeting," by John D. Stowe and Jacques R. Gagne
Sections 7.1.1– 7.1.2

6


Prepared for Jia Jia
4/5/2014
1


Answer for Derivatives – Huang
1. The value of a long position in a forward contract at any time is

Vt= St – F(0,T)/(1 + r)(T – t)
where
S = the underlying price
F = the forward price
r = the risk-free rate
T = the time to expiration at contract initiation
t = the time elapsed since initiation
Then, Vt = 75 – 80/(1.06) 0.25 = –$3.84, but this is the value of the long

position. The value of the short position has the opposite sign and is
$3.84.
2014 CFA Level II
“Forward Markets and Contracts,” by Don M. Chance
Section 4.2
2.The formula for the price of a forward contract on an equity index is:
F(0, T) = S 0e-( δc)Te(rc) T
where
F(0,T) = the price of a forward contract initiated at time 0 and
expiring at time T
S0 = the spot price of the underlying
δc = the continuously compounded dividend yield
rc = the continuously compounded interest rate
T = 180/365 = 0.4932, which is the time to expiration of the contract
in years.
Then,

2014 CFA Level II
"Forward Markets and Contracts," by Don M. Chance
 Section 4.2
3.The formula for the forward exchange rate is:
F(0,T) = S0[(1 + r)T/(1 + rf)T]

2


where
F(0,T) = the forward exchange rate of a forward contract initiated at
time 0 and expiring at time T
S0 = the spot price
r = the domestic risk-free rate

rf= the foreign risk-free rate

The formula assumes the currency quote is dollars per yen. If the quote
is yen per dollar (as is the case here), then the forward price is S 0[(1 +
rf)T/(1 + r)T], so
F = 112(1.01/1.06) 9 0/365 = JPY110.67/USD.

Note that the continuous formula, F= S 0erf Te–rT, can be used. Converting
the given rates to continuous rates gives rf= ln(1.01) = 0.00995 and r =
ln(1.06) = 0.05827.
F = 112e(90/36 5)(0.0099 5–0.0582 7) = JPY 110.67/USD.
2014 CFA Level II
"Forward Markets and Contracts," by Don M. Chance
 Section 4.4
4.At expiration, if the market value of the contract is positive (Manager B
sold the yen at a higher price than she could sell it at expiration),
Manager B will only receive the agreed-on price if the other party does
not default.
2014 CFA Level II
"Forward Markets and Contracts," by Don M. Chance
 Section 5
5.The value of a futures contract before it has been marked to market
can be greater than or less than zero. The value is the gain or loss
accumulated since the last mark-to-market adjustment.
2014 CFA Level II
"Futures Markets and Contracts," by Don M. Chance
 Section 7.1.2
6.The futures price formula is f0(T) = S0 (1+r)T + FV(CB,0,T), where
FV(CB,0,T) represents the future value (FV) of the costs of storage
minus the convenience yield. Thus the convenience yield decreases the
futures price.
2014 CFA Level II
3

"Futures Markets and Contracts," by Don M. Chance
 Section 7.1.7

Answer for Derivatives – Speckley
1. The formula for the forward currency price is F(0,T) = [S0/(1 + rf )T]  (1

+ r)T
where
F(0,T) = the forward price at time 0 for a delivery date at time T
(which is one year, or 1, in this case)
S0 = the spot exchange rate
rf= the foreign interest rate
r = the domestic interest rate
In this item set, the domestic interest rate is the U.S. rate.
Using the information from Exhibit 2 gives the following:
F(0,T) = (1.25/1.035)  (1.030) = $1.244
2014 CFA Level II
"Forward Markets and Contracts," by Don M. Chance
 Section 4.4
2.
The price formula for a forward contract on an equity security is
F(0,T) = [S 0 – PV(D,0,T)] × (1 + r)T
= [ S0 × (1 + r)T ] – FV(D,0,T)
where
S0 = the current price of the equity
PV(D,0,T) = the present value of the dividend stream across the life
of the forward contract
(T) FV(D,0,T) = the future value of the dividend stream across the
life of the contract

Given the information in the problem and in Exhibits 1 and 2, the
contract is for one-year (T = 1) and the dividend occurs in 180 days (½
year). Putting the numbers into the formula gives the following:
F(0,T) = {100 – [5/(1 + 0.03) 0.5 ]} × (1 + 0.03)
4


= [100 × (1 + .03)] – [5 × (1 + .03) 0.5]
= $97.93
2014 CFA Level II
"Forward Markets and Contracts," by Don M. Chance
 Section 4.2
3.
The formula for the forward currency price is
F(0,T) = [S 0/(1 + rf)T]  (1 + r)T
where
F(0,T) = the forward price at time 0 for a delivery date at time T
(which is one year, or 1, in this case)
S0 = the spot exchange rate
rf = the foreign interest rate
r = the domestic interest rate
Thus, currency forward prices are determined by the current exchange
rate, the current domestic and foreign interest rates, and the maturity of
the contract but not expectations of future interest rates.
2014 CFA Level II
"Forward Markets and Contracts," by Don M. Chance
 Section 4.1
4.
The exchange rate on forward currency contracts is determined by
F0(T) = [S0/(1 + rf )T]  (1 + r)T
where
F0(T) = the current price of the forward contract expiring at time T

S0 = the current spot exchange rate
rf = the foreign interest rate
r = the domestic interest rate

or
F(0,T) = (1.25/1.035)  (1.030) = $1.244

5


When domestic interest rates (U.S. rates in this item set) are lower than
foreign interest rates, the forward exchange rate will be lower than the
spot exchange rate; this result is based on the assumption that the
exchange rate is quoted as the amount of domestic currency required to
purchase 1 unit of foreign currency. At the forward rate of USD1.244 per
EUR, Speckley will be able to purchase fewer dollars than at the spot
rate of USD1.25 per EUR.
2014 CFA Level II
"Forward Markets and Contracts," by Don M. Chance
 Section 4.4
5.Speckley is short the euro forward, which has a negative market value.
The long counterparty stands to lose $149,000 if Speckley defaults. But
Speckley faces no loss if the long counterparty defaults.
2014 CFA Level II
"Forward Markets and Contracts," by Don M. Chance, CFA
 Section 5
6.The formula for an FRA rate is:

where FRA(0,h,m) is the rate on an FRA contracted at time 0 expiring at
time h for an investment period lasting from h to h+m and L0(h) is the
h-period Euribor rate at time 0. In Speckley's case, h = m = 180. Using
this figure and the information in Exhibit 2 gives the following:

FRA(0,180,180) = ({[1 + 0.035]/[1 + 0.025( 1/2)]} – 1)  2 = 0.0444
2014 CFA Level II
"Forward Markets and Contracts," by Don M. Chance
 Section 4.3

Answer for Derivatives – Winters
1.

6


2014 CFA Level II
“Forward Markets and Contracts,” by Don M. Chance
 Section 4.2
2.According to put–call parity: Long bond + Long call = Long stock +
Long put
Bond = 98.04 = 100/1.0236 0/360 (must be calculated from option data
table)
Long call = $10.35 (given)
Long put = $9.25 (given)
Synthetic underlying stock = $99.14 = Long bond + Long call + Short put
(“+ Short put” is another way of expressing “– Long put”) = 98.04 + 10.35
– 9.25
2014 CFA Level II
“Option Markets and Contracts,” by Don M. Chance
 Section 5.5
3.Holding all other option factors constant, an increase in interest rates
causes call prices to increase and put prices to decline.
2014 CFA Level II
“Option Markets and Contracts,” by Don M. Chance
 Section 7.3
4.Gamma is a measure of the sensitivity of delta to a change in the stock
price. Gamma is largest for options that are at the money near maturity
because of the uncertainty about whether the option will expire (1) in the

money (delta is 1.0) or (2) out of the money (delta is 0.0).
2014 CFA Level II
“Forward Markets and Contracts,” by Don M. Chance
 Section 7.3.1
5.Swap 2 represents a $100,000 liability to Toye as the receiving
counterparty.
Index returns:
 S&P 500 = (1537.5/1500) – 1 = 2.5%
 Russell 2000 =
(913.5/900) – 1 = 1.5%
 NASDAQ = (2991.5/3100) – 1= –3.5%
Swap value = Notional amount × [– (Pay) return of the pay index +
(Receive) return of the receive index]
Swap 2 = –$100,000 = ($2,000,000) × (– 1.5% + –3.5%). The negative
value properly represents a liability.
2014 CFA Level II
“Swap Markets and Contracts,” by Don M. Chance
 Sections 4, 4.2.3

7


6.The swaption should be exercised because it is in the money.
2014 CFA Level II
“Swap Markets and Contracts,” by Don M. Chance
 Sections 6.1–6.4

8


Prepared for Jia Jia
4/5/2014
1


Answer for Economics – Tremblay

1.The mid-market for CAD/USD is (1.2138 + 1.2259)/2 = 1.21985. The

mid-market forward premium (discount) is calculated as:

In this problem, we have:

2014 CFA Level II
"Currency Exchange Rates: Determination and Forecasting," by Michael
R. Rosenberg and William A. Barker
Section 2.2
2.The relative version of PPP states that the percentage change in the

spot exchange rate will be completely determined by the difference
between the foreign and domestic inflation rates. In this case,
thedifference in the inflation rates is 1.90%–2.30% =–0.4%. Subtracting
0.4% from the current bid gives the answer 1.2089. The calculation is
1.2138 – (0.004 × 1.2138) = 1.2089.
2014 CFA Level II

"Currency Exchange Rates: Determination and Forecasting," by Michael
R. Rosenberg and William A. Barker
 Section 3.1.4
3.It is cheaper to buy Canadian dollars indirectly through Brazilian reals
than directly with U.S. dollars. This creates a triangular arbitrage
opportunity:
US$1,000,000 × 2.3844 = BRL2,384,400
2,384,400 × 0.5250 = C$1,251,810
C$1,251,810/1.2259 = US$1,021,135
US$1,021,135 – US$1,000,000 = US$21,135 profit
2

2014 CFA Level II

"Currency Exchange Rates: Determination and Forecasting," by Michael
R. Rosenberg and William A. Barker
 Section 2.1
4.Baroque's comments describe the international Fisher effect. The
international Fisher effect states that the foreign-domestic nominal yield
spread will be solely determined by the foreign-domestic expected
inflation differential.
2014 CFA Level II
"Currency Exchange Rates: Determination and Forecasting," by Michael
R. Rosenberg and William A. Barker
 Section 3.1.5
5.Tremblay's first justification describes "club convergence." Her second
justification describes a second source of convergence–imitating or
adopting technology already widely used in the advanced countries.
Convergence is consistent with the neoclassical growth model.
2014 CFA Level II

"Economic Growth and the
Kutasovic
 Sections 5, 5.2.2, 5.4

Investment

Decision,"

by

Paul

6.The possibility for permanent higher growth in per capita output exists
within endogenous growth theories but not in neoclassical growth theory
nor in classical growth theory.
2014 CFA Level II

"Economic Growth and
Kutasovic
 Sections 5, 5.3

the

Investment

Decision,"

by

Paul

Answer forEconomics – Daltonia
1.The components of growth can be determined using Solow’s growth

accounting equation: ΔY/Y = ΔA/A + αΔK/K + (1 − α)ΔL/L
where:

ΔY/Y = GDP percentage growth

ΔA/A = percentage growth from total factor productivity
(TFP) 
 ΔK/K = percentage growth in capital

ΔL/L = percentage growth in labor

α = share of income paid to capital factor
1 – α = share of income paid to labor factor, also the elasticity of
output with respect to labor
3


TFP = Labor productivity growth – Growth in capital deepening = 1.7 –
2.3 = –0.6, which is given in Exhibit 1. Also given, 1 – α = 0.65 and α =

0.35
GDP growth = ΔY/Y = 3.75
Arising from the total of components below:
ΔA/A = growth due to TFP
−0.6
αΔK/K = growth due to capital
+ 2.13 = (0.35) × 6.1
(1 − α)ΔL/L = growth due to labor
+ 2.21 = (0.65) × 3.4
3.75 GDP growth
Growth due to labor of 2.21% is greater than the growth due to capital or TFP.
2014 CFA Level II
“Economic Growth and the
Kutasovic
 Sections 4.2-4.3

Investment

Decision,”

by

Paul

2.Pamuk’s conclusion is consistent with the endogenous growth model.
In the endogenous growth model, the economy does not reach a steady
growth rate equal to the growth of labor plus an exogenous rate of labor
productivity growth. Instead, saving and investment decisions can
generate self-sustaining growth at a permanently higher rate. This
situation is in sharp contrast to the neoclassical model, in which only a
transitory increase in growth above the steady state is possible. The

reason for this difference is because of the externalities on R&D,
diminishing marginal returns to capital do not set in.
2014 CFA Level II

“Economic Growth and
Kutasovic
 Section 5.3

the

Investment

Decision,”

by

Paul

3.Birol’s statement based on Mundell–Fleming model is inaccurate
because restrictive (not expansionary) fiscal policy, along with
expansionary monetary policy, would lead to capital outflows and cause
the currency to depreciate assuming high capital mobility.
2014 CFA Level II

“Currency Exchange Rates: Determination and Forecasting,” by
Michael R. Rosenberg and William A. Barker
 Sections 6.1, 6.2.2, 6.3
4.Suggestion 1 is an accurate description of a sterilized currency
intervention. If the currency is overvalued and inflation is a concern, a
sterilized intervention is necessary. Emerging market authorities would
sell domestic securities to the private sector to mop up any excess
liquidity created by its foreign exchange intervention activities. The end
result would be that the monetary base and the level of short-term
interest rates would not be altered by the intervention operation.

4


2014 CFA Level II

“Currency Exchange Rates: Determination and Forecasting,” Michael R.
Rosenberg and William A. Barker
 Section 7
5.Calculate the interbank implied cross rate for (DRN/EUR).
 Invert the
(EUR/USD) quotes. The 0.8045 bid becomes 1/0.8045 = 1.243 offer for
(USD/EUR). The 0.8065 offer becomes 1/0.8065 = 1.240 bid for
(USD/EUR).
Determine the interbank implied cross currency quotes for (DRN/EUR)
as follows:
Bid: 1.205(DRN/USD) ᵡ 1.24 (USD/EUR) = 1.4942 (DRN/EUR)
Offer: 1.210 (DRN/USD) ᵡ 1.243 (USD/EUR) = 1.504 (DNR/EUR).

2014 CFA Level II

“Currency Exchange Rates: Determination and Forecasting,” by
Michael R. Rosenberg and William A. Barker
 Section 2.1
6.To initiate a carry trade, a European investor will borrow in the lowest
interest rate currency, the euro (EUR). The cost will be 0.8%. He will
invest in the highest LIBOR rate currency, the DRN at 2.1%.

Sell

Sell
Invest at 2.1% DRN LIBOR:

5

Convert to EUR at projected spot:

Minus borrowing cost: 100,000×0.8%=EUR800
Ending balance = EUR101,065

Minus 100,000 beginning value = EUR1,065 profit
2014 CFA Level II

“Currency Exchange Rates: Determination and Forecasting,” by
Michael R. Rosenberg and William A. Barker
 Section 4.1

6


Prepared for Jia Jia
4/5/2014
1


Answer for Equity – Yee
1.

FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv
Net income (given) = $626; Non-cash charges (depreciation, given) =
$243; Interest expense (given) = $186; Tax rate = 294/920 = 32%; Fixed
capital investment (given) = $535

Working Capital
Investment

Current assets
excluding cash

Current liabilities

2012

 ($ millions)

Net
2011
increase

 ($ millions

 ($ millio
)
ns)

1,290 – 32 =
1,258

1,199 – 21
=1,178

2,783

2,678

–1,525

Working capital

–1,500 –25

FCFF = 626 + 243 + 186(1 – 0.32) – 535 – (–25) = 485.48 = $485 million

$418 is incorrect. It uses t not (1 – t).
FCFF = 626 + 243 + (186 × 0.32) – 535 – (–25) = 418.2 = $418 million
$460 is incorrect. It ignores working capital investment.
FCFF = 626 + 243 + 186 × (1 – 0.32) – 535 = 460.48 = $460 million
2014 CFA Level II
“Free Cash Flow Valuation,” by Jerald Pinto, Elaine Henry, Thomas
Robinson, and John Stowe
Section 3.1
2.FCFE = FCFF – Interest (1 – T) + Net borrowing
Given: 2012 FCFF base case estimate = $500; Interest expense = $186;
Tax rate = 32%

Long-term debt ($)

2012
2,249

2011
2,449

Net increase
–200

2