Level 2 mock exam question and answers 2008

Level 2 Mock Exam - Part 1_2008
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1

Code of Ethics and Standards of Professional Conduct and Guidance for Standards I-VII, CFA
Institute
2008 Modular Level II, Vol. 1, pp. 70-71, 73, Example 5.
Study Session 1-2-a
demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by
applying the Code and Standards to specific situations
Neither is an acceptable reason for soliciting clients while at Portree. The clients belong to Portree
and Jun is not permitted to solicit their business until he leaves the firm. As indicated in the Readings
and Standards of Practice Handbook, even though Jun does not receive monetary compensation for
his services, he may be considered an employee because as an intern he receives compensation and
benefits in the form of work experience and knowledge.

2

Code of Ethics and Standards of Professional Conduct and Guidance for Standards I-VII, CFA
Institute
2008 Modular Level II, Vol. 1, p. 70.
Study Session 1-2-a
demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by
applying the Code and Standards to specific situations
Velez has acted appropriately and has not violated her duty of loyalty to Portree. According to the
Standard relating to Duty to Employer, a departing employee is generally free to make arrangements
or preparations to go into a competitive business before terminating the relationship with her
employer provided that such preparations do not breach the employee’s duty of loyalty. Specifically,
prior to leaving an employer, members must not contact existing clients or potential clients for the

purpose of soliciting their business for the new business.

3

Code of Ethics and Standards of Professional Conduct and Guidance for Standards I-VII, CFA
Institute
2008 Modular Level II, Vol. 1, p. 70.
Study Session 1-2-a
demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by
applying the Code and Standards to specific situations
Jun’s use of Fantine’s methods is acceptable. The Standards do not impose a prohibition on the use
of experience or knowledge gained at one employer from being used at another employer. According
to the Standards, “Once an employee has left the firm, the skills and experience that an employee
obtains while employed are not “confidential” or “privileged” information.”


4

Code of Ethics and Standards of Professional Conduct and Guidance for Standards I-VII, CFA
Institute
2008 Modular Level II, Vol. 1, pp. 105-107
Study Session 1-2-a
demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by
applying the Code and Standards to specific situations
Jun’s statement about passing the exams on the first try was merely factual, while his business card,
which he distributes to prospective clients, prematurely states that he is a CFA charterholder.

5

Code of Ethics and Standards of Professional Conduct and Guidance for Standards I-VII, CFA

Institute
2008 Modular Level II, Vol. 1, pp. 94-95, 98, Examples 8, 9
Study Session 1-2-b
recommend practices and procedures designed to prevent violations of the Code of Ethics and
Standards of Professional Conduct
Priority goes to clients over accounts in which Upsala personnel are beneficial owners.

6

Code of Ethics and Standards of Professional Conduct and Guidance for Standards I-VII, CFA
Institute
2008 Modular Level II, Vol. 1, pp. 69-70, 89
Study Session 1-2-a
demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by
applying the Code and Standards to specific situations
Whether or not Upsala’s compliance policy requires disclosure, Jun is obligated to comply with CFA
Institute Standards. The Standard relating to Loyalty to Employer requires that Jun disclose details of
the consulting work and receive written consent from Upsala before rendering service.

7

“Time Series Analysis,” Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and David E.
Runkel
2008 Modular Level II, Vol. 1, pp. 362-367
Study Session 3-13-d
discuss the structure of an autoregressive model of order p, calculate one- and two-period-ahead
forecasts given the estimated coefficients, and explain how autocorrelations of the residuals can be
used to test whether the autoregressive model fits the time series
Testing for correct specification of an autoregressive (AR) model requires a test to determine if the
correlations between the error term and several lagged error terms are statistically different from zero.

If the autocorrelations are significantly different from zero, the model is not correctly specified.

8

“Time Series Analysis,” Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and David E.
Runkel
2008 Modular Level II, Vol. 1, pp. 395-398
Study Session 3-13-l
explain autoregressive conditional heteroskedasticity (ARCH), and discuss how ARCH models can
be applied to predict the variance of a time series
To examine for the presence of heteroskedasticity, Nordique should test whether the variance of the
error in one period depends on the variance of the error in previous periods. This is accomplished by
regressing the squared residuals from the estimated model on the squared residuals lagged one period.


9

“Time Series Analysis,” Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and David E.
Runkel
2008 Modular Level II, Vol. 1, pp. 376-384
Study Session 3-13-i, j
discuss the implications of unit roots for time-series analysis, explain when unit roots are likely to
occur and how to test for them, and demonstrate how a time series with a unit root can be transformed
so that it can be analyzed with an autoregressive model;
discuss the steps of the unit root test for nonstationarity, and explain the relation of the test to
autoregressive time series models
The Dickey-Fuller test is used to test for the presence of a unit root. The model is of the form: (P/E)t
- (P/E)t-1 = b0 + g1 (P/E)t-1 + εt. The null hypothesis (H0: g1 = 0) is that the series has a unit root and is
not stationary. The alternate hypothesis (H1: g1 ≠ 0) is that the series does not have a unit root and is
stationary.

10

“Time Series Analysis,” Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and David E.
Runkel
2008 Modular Level II, Vol. 1, pp. 376-380
Study Session 3-13-i
discuss the implications of unit roots for time-series analysis, explain when unit roots are likely to
occur and how to test for them, and demonstrate how a time series with a unit root can be transformed
so that it can be analyzed with an autoregressive model
Beloit is concerned that a unit root exists. If she is correct, first differencing is a suggested solution,
i.e., re-estimate the regression using the form: [(P/E)t - (P/E)t-1 ] = b0 + b1 [(P/E)t-1 - (P/E)t-2 ] + εt.

11

“Time Series Analysis,” Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and David E.
Runkel
2008 Modular Level II, Vol. 1, p. 367
Study Session 3-13-e
explain mean reversion, and calculate a mean-reverting level
If the process is mean reverting, the market P/E will move toward the mean-reverting level over
time. If it is currently above its mean reversion level, the P/E will tend to fall, suggesting that
underweighting stocks would be appropriate.

12

“Time Series Analysis,” Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and David E.
Runkel
2008 Modular Level II, Vol. 1, pp. 367-368
Study Session 3-13-d

discuss the structure of an autoregressive model of order p, calculate one- and two-period-ahead
forecasts given the estimated coefficients, and explain how autocorrelations of the residuals can be
used to test whether the autoregressive model fits the time series
The one-month forecast is 0.332 + (0.975 x 22.50) = 22.27. The two-month forecast is 0.332 + (0.975
x 22.27) = 22.04.


“Analysis of Intercorporate Investments,” Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried
2008 Modular Level II, Vol. 2, pp. 10, 13, 24-26, 33-34
Study Session 5-21-b, d
calculate and analyze the effect of marketable securities classification on the financial statements and
financial ratios under SFAS 115;
distinguish, given various ownership and/or control levels and relevant accounting standards, whether
the cost method, equity method, proportionate consolidation method, or consolidation method should
be used and analyze and contrast the earnings effects of using the cost method, equity method,
consolidation method, and proportionate consolidation method on a company’s financial statements
and financial ratios
The appropriate components of ACI’s net income derived from the equity investments in Exhibit 1
(amounts in millions) are as follows:
13

Investment

Method of Accounting

Columbus
De Soto
Marco
De Vaca
Viking

Total

Consolidation
Equity Method
Available-for-Sale1
Cost
Available-for-Sale

Amount Included in
ACI’s Income
(0.60 x 65) = $39.0
(0.30 x 85) = 25.5
3.0
2.0
0.5
$70.0

Source
Net Income
Net Income
Dividends
Dividends
Dividends

Note 1: With a majority owner controlling Marco, there is no indication that ACI exhibits the degree
of control consistent with a 30% stake; the Marco investment has been accounted for by Fanner as an
available-for-sale security.

14

“Analysis of Intercorporate Investments,” Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried
2008 Modular Level II, Vol. 2, p. 13-15
Study Session 5-21-b
calculate and analyze the effect of marketable securities classification on the financial statements and
financial ratios under SFAS 115
A reclassification from held-to-maturity to available-for-sale would not change the 2007 pre-tax
income for ACI. Under held-to-maturity, interest that is received would be included in income but
changes in market value of the securities would be ignored. Under available-for-sale, interest would
once again be included, but only realized rather than unrealized gains would appear in income. Thus,
as no gains were realized during the year, there would be no change.


“Analysis of Intercorporate Investments,” Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried
2008 Modular Level II, Vol. 2, p. 10-24
Study Session 5-21-c
calculate and analyze the mark-to-market investment return on a marketable securities portfolio under
SFAS 115
The analyst should track investment performance on a mark-to-market return basis, measuring
the actual investment performance for each period (page 21). ACI has five investments classified
under SFAS 115 (marketable securities where the company does not have the ability to exercise
significant influence or control): Marco, De Vaca, Viking, Cortez and Da Gama. De Vaca does not
have a market value and hence is accounted for under the cost method. It is not possible to calculate a
mark-to-market return for it. Calculation of the mark-to-market return includes interest and dividend
income plus realized and unrealized gains and losses; see page 21 and 22 for sample calculations and
definition. The four qualifying securities and calculations of the mark-to-market portfolio return are
as follows: (Note there were no realized gains or losses during the year.) The equity securities were
purchased January 1, 2007, their cost basis is therefore equal to the opening market value. The debt
securities were purchased during the year so their cost basis is also equal to their opening market
value.)
15

Fixed Maturities
Interest or Dividend Income
Cortez
$3
$2
De Gama
Marco
Viking
Market Valuation
Adjustment
Cortez
($4)
De Gama
($5)
Marco
Viking
Mark-to-Market Return, in $ millions

Equities

Total

$5
$3
$0.5

$3.5

($9)

($10)
$20

$10
$9.5


16

“Analysis of Intercorporate Investments,” Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried
2008 Modular Level II, Vol. 2, pp. 24, 35-36
“Mergers, Acquisitions, and Other Intercorporate Investments,” Thomas R. Robinson, Paul Munter,
and Julia Grant
2008 Modular Level II, Vol. 2, pp. 77-78, 88-91
Study Sessions 5-21-d, 5-22-f
distinguish, given various ownership and/or control levels and relevant accounting standards, whether
the cost method, equity method, proportionate consolidation method, or consolidation method should
be used and analyze and contrast the earnings effects of using the cost method, equity method,
consolidation method, and proportionate consolidation method on a company’s financial statements
and financial ratios;
identify situations when companies should apply the equity and consolidation methods of accounting
for investments
If ACI loses control over Columbus, Columbus will be treated under the equity method instead of
under the consolidation method. The equity method is one-line consolidation, the net income and
common equity are the same but the reported revenues, assets and liabilities would decrease.

17

“Analysis of Intercorporate Investments,” Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried
2008 Modular Level II, Vol. 2, pp. 13, 26-27

Study Session 5-21-b, d
calculate and analyze the effect of marketable securities classification on the financial statements and
financial ratios under SFAS 115;
distinguish, given various ownership and/or control levels and relevant accounting standards, whether
the cost method, equity method, proportionate consolidation method, or consolidation method should
be used and analyze and contrast the earnings effects of using the cost method, equity method,
consolidation method, and proportionate consolidation method on a company’s financial statements
and financial ratios
The litigation will preclude ACI from using the equity method. If De Soto is then classified under
available-for-sale, book value per share could decrease because equity will not be increased by ACI’s
share of De Soto’s income in excess of dividends.

18

“Analysis of Intercorporate Investments,” Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried
2008 Modular Level II, Vol. 2, pp. 25-26
Study Session 5-21-d
distinguish, given various ownership and/or control levels and relevant accounting standards, whether
the cost method, equity method, proportionate consolidation method, or consolidation method should
be used and analyze and contrast the earnings effects of using the cost method, equity method,
consolidation method, and proportionate consolidation method on a company’s financial statements
and financial ratios
De Soto must be classified according to the equity method. According to the equity method, securities
are carried on the balance sheet at cost plus an adjustment for the investor’s share of the investee’s
income, less an adjustment for cash dividends received by the investor. Thus, $125.0 million cost +
(25.5 million income share - 5.0 dividends received) = $145.5 million.


19

“Analysis of Multinational Operations,” Gerald I White, Ashwinpaul C. Sondhi, and Dov Fried
2008 Modular Level II, Vol. 2, pp. 163-165
Study Session 6-26-b
distinguish among the local currency, the functional currency, and the reporting currency
The functional currency will be the Euro for Catlette since the all-current method is used and the U.S.
dollar for Heren (temporal method).

20

“Analysis of Multinational Operations,” Gerald I White, Ashwinpaul C. Sondhi, and Dov Fried
2008 Modular Level II, Vol. 2, pp. 166-168
Study Session 6-26-c, d
compare and contrast the all-current (translation) method and the temporal (remeasurement) method;
analyze and evaluate the effects of the all-current and temporal methods on the parent company’s
balance sheet and income statement
Unrealized non-monetary gains are ignored when the temporal method is used. All other gains are
reported on the income statement.

21

“Analysis of Multinational Operations,” Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried
2008 Modular Level II, Vol. 2, pp. 163-165
Study Session 6-26-c, d, k
compare and contrast the all-current (translation) method and the temporal (remeasurement) method;
analyze and evaluate the effects of each on the parent company’s balance sheet and income statement;
illustrate and analyze alternative accounting methods for subsidiaries operating in hyperinflationary
economies
Garrison is using the all-current method for Catlette. The all-current method is most appropriate when
the subsidiary (Catlette) is a self-contained independent operating entity.

22

“Analysis of Multinational Operations,” Gerald I White, Ashwinpaul C. Sondhi, and Dov Fried
2008 Modular Level II, Vol. 2, pp. 166-168
Study Session 6-26-c, d
compare and contrast the all-current (translation) method and the temporal (remeasurement) method;
analyze and evaluate the effects of each on the parent company’s balance sheet and income statement
All gains and losses are reported as a cumulative translation adjustment in equity when the all-current
method is used.
“Analysis of Multinational Operations,” Gerald I White, Ashwinpaul C. Sondhi, and Dov Fried
2008 Modular Level II, Vol. 2, pp. 166, 173
Study Session 6-26-g
translate a subsidiary’s balance sheet and income statement into the parent company’s currency, using
the all-current method and the temporal method
Under the all-current method, all assets would be translated at the year-end (current) rate of 0.75:

23

Cash and receivables
Inventory
Fixed Assets
Total Assets
*Rounded to 1,667

50 divided by 0.75 =
200 divided by 0.75 =
1,000 divided by 0.75 =
1,250 divided by 0.75 =

66.667

266.667
1,333.333
1,666.667*


24

“Analysis of Multinational Operations,” Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried
2008 Modular Level II, Vol. 2, pp. 171-174
Study Session 6-26-g, h
translate a subsidiary’s balance sheet and income statement into the parent company’s currency, using
the all-current method and the temporal method;
analyze how the translation of a subsidiary’s financial statements will affect the subsidiary’s financial
ratios
Catlette’s income statement will be translated using the average exchange rate:
Sales
CGS
Gross Profit

1,000 divided by 0.78 =
700 divided by 0.78 =

1,282.051
897.436
384.615

Gross margin: 30.0% (note the same result can be obtained using pre-translation data).

25

“Corporate Governance,” Rebecca Todd McEnally and Kenneth Kim
2008 Modular Level II, Vol. 3, pp. 193, 200-201
Study Session 9-34-a
explain corporate governance, discuss the objectives and the core attributes of an effective corporate
governance system, and evaluate whether a company’s corporate governance has those attributes
Directors’ identification with managers’ interest rather than those of the shareholders is a source of
conflict, which may call into question the directors’ objectivity.

26

“Corporate Governance,” Rebecca Todd McEnally and Kenneth Kim
2008 Modular Level II, Vol. 3, p. 202
Study Session 9-34-d
describe the responsibilities of the board of directors, and explain the qualifications and core
competencies that an investment analyst should look for in the board of directors
All three listed board responsibilities are valid components of an effective corporate governance
system.

27

“Corporate Governance,” Rebecca Todd McEnally and Kenneth Kim
2008 Modular Level II, Vol. 3, pp. 231-232
Study Session 9-34-g
discuss the valuation implications of corporate governance
Dexter is not concerned about incomplete, misleading, or materially misstated financial statements,
i.e., accounting risk.

28

“Capital Structure and Leverage,” Raj Aggarawal, Cynthia Harrington, Adam Kobor and Pamela P.

Peterson
2008 Modular Level II, Vol. 3, pp. 126-129
Study Session 8-32-i, k, l
discuss the effect of taxes on the MM propositions, the cost of capital, and the value of a company;
explain and diagram the static trade-off theory of the optimal capital structure;
compare the implications of the MM propositions, the pecking order theory of capital structure, and
the static trade-off theory of capital structure
Assuming static trade-off theory of capital structure holds the value of a levered firm is maximized
at its optimal debt-to-equity ratio which is the case when the weighted average cost of capital are
minimized.


29

“Dividends and Dividend Policy,” George H. Troughton and Catherine E. Clark
2008 Modular Level II, Vol. 3, pp. 165-170
Study Session 8-33-j
compare and contrast the following dividend policies: residual dividend, longer-term residual
dividend, dividend stability, and target payout ratio
A longer-term residual approach as used by TML S.A. is defined to pay out a (more) stable cash
dividend to shareholders and allocate a (more) flexible amount to share repurchases (see p. 168).
Hence, TML S.A. already experiences stable cash dividends (based on sustainable earnings) and
additional share repurchases (as a mean to distribute temporary earnings), and the management is
most likely to keep everything as it is.

30

“Dividends and Dividend Policy,” George H. Troughton and Catherine E. Clark
2008 Modular Level II, Vol. 3, pp. 168-170
Study Session 8-33-k

calculate a company’s expected dividend using the variables in the target payout approach
Formula to be applied is: Expected dividend = Last dividend + (Expected increase in earnings x
Target payout ratio x Adjustment factor) where
Adjustment factor = 1 / period to adjust dividend
The expected dividend = €0.50 + (€3.0 - €2.5) x 0.40 x 1 / 5 = €0.54

31

“Competitive Strategy: The Core Concepts,” Michael E. Porter
2008 Modular Level II, Vol. 4, pp. 169-174
Study Session 11-41-a, b
analyze the competitive advantage and competitive strategy of a company and the competitive forces
that affect the profitability of a company and discuss the two fundamental questions determining the
choice of competitive strategy;
explain how competitive forces determine industry profitability
Industry rivalries have increased the cost of doing business and reduced profits industry-wide. Porter
(p. 169) says “the first fundamental determinant of a firm’s profitability is industry attractiveness,”
which is evaluated using the five forces (p. 170) of industry rivalry, buyer power, supplier power,
threat of substitutes and threat of new entry. The vignette says that new entry and substitute
products are not a concern. However, competition for customers and suppliers has reduced industry
profitability (customers are paying less and costs for programming are rising). The vignette also
indicates that revenues are cyclical in nature. With regard to its position within the industry,
Svensoft’s previous strategy of focusing on the financial services industry has been rendered invalid
by the entry of major competitors into this segment.

32

“Competitive Strategy: The Core Concepts,” Michael E. Porter
2008 Modular Level II, Vol. 4, pp. 174-178
Study Session 11-41-a, c

analyze the competitive advantage and competitive strategy of a company and the competitive forces
that affect the profitability of a company and discuss the two fundamental questions determining the
choice of competitive strategy;
analyze basic types of competitive advantage that a company can possess and the generic strategies
for achieving a competitive advantage, the risks associated with each of the generic strategies,
the difficulties and risks of simultaneously using more than one of the generic strategies, and the
difficulties in sustaining a competitive advantage with any generic strategy
Svensoft’s plan to increase reliability constitutes a differentiation strategy.


33

“Industry Analysis,” Jeffrey C. Hooke
2008 Modular Level II, Vol. 4, pp. 191-192
Study Session 11-42-a
discuss the key components that should be included in an industry analysis model
External factors such as technology, government, social changes, demographics and foreign
influences are not discussed.

34

“Industry Analysis,” Jeffrey C. Hooke
2008 Modular Level II, Vol. 4, pp. 192-197
Study Session 11-42-b, c
illustrate the life cycle of a typical industry;
analyze the effects of business cycles on industry classification (i.e., growth, defensive, cyclical)
The high customer penetration, along with slowing growth prospects, indicate that the industry is
mature. That revenue declines and expands at greater-than-GDP rates indicates that it is a cyclical
industry.

35

“Industry Analysis,” Jeffrey C. Hooke
2008 Modular Level II, Vol. 4, pp. 212-213
Study Session 11-42-f
explain factors that affect industry pricing practices
The entry of broader based competitors into the financial services market, with the ability to
differentiate on both features and cost, is reducing segmentation. However, the increased competition
is raising wages and reducing revenue for existing players and makes it difficult for new players to
emerge.

36

“A Note on Asset Valuation,” George H. Troughton
2008 Modular Level II, Vol. 4, pp. 5-7
“International Asset Pricing,” Bruno Solnik and Dennis McLeavey
2008 Modular Level II, Vol. 6, pp. 433-436
Study Sessions 10-36, 18-70-b
explain how the classic works on asset valuation by Graham and Dodd and John Burr Williams are
reflected in modern techniques of equity and fixed income valuation;
state the assumptions of the domestic capital asset pricing model (CAPM), explain the extension of
the domestic CAPM to an international context (the extended CAPM), and describe the additional
assumptions needed to justify the extended CAPM
Most valuation models are based on discounting future cash flows, as Kennant realizes. On p. 5,
Troughton refers to the stock valuation process espoused in Graham and Dodd and states, “That
epic work stressed a philosophy of investing centered on the concept of ‘intrinsic value’.” Another
work by John Burr Williams proposes estimating the intrinsic value of common stock by calculating
the present value of all future dividends per share (p. 7). Contrary to Kennant’s belief, the modern
portfolio theory applies to portfolios as well as for valuing individual stocks in the framework of
CAPM (pp. 434-436).

37

“The Equity Valuation Process,” John D. Stowe, Thomas R. Robinson, Jerald E. Pinto, and Dennis W.
McLeavey
2008 Modular Level II, Vol. 4, pp. 27-31
Study Session 10-37-g
contrast absolute valuation models to relative valuation models
Both statements are correct definitions of the valuation models.


38

“Discounted Dividend Valuation,” John D. Stowe, Thomas R. Robinson, Jerald E. Pinto, and Dennis
W. McLeavey
2008 Modular Level II, Vol. 4, pp. 325-328
“Equity: Concepts and Techniques,” Bruno Solnik and Dennis McLeavey
2008 Modular Level II, Vol. 4, pp. 141-144
Study Sessions 12-46-u, 11-40-g
estimate, using the DuPont model, a forecast for return on equity that can be used to estimate a
company’s sustainable growth rate;
evaluate two common approaches of equity analysis (ratio analysis and discounted cash flow models
including the franchise value model) and demonstrate how to find attractively priced stocks by using
either of these methods
The higher asset turnover is the primary reason for Fast Food’s higher ROE. See calculation of
DuPont analysis below.
NI / EBT
EBT / EBIT
EBIT / Sales
Sales / Assets

Assets / Equity
Return on equity

0.6667
0.5294
0.1417
0.6000
5.0000
0.1500

0.6643
0.4667
0.1500
0.8889
4.5000
0.1860

Tax burden
Tax rate
Net profit margin (Net income/ Sales)

3.0
33.3%
5.0%

4.7
33.6%
4.7%

39

“Competitive Strategy: The Core Concepts,” Michael E. Porter
2008 Modular Level II, Vol. 4, pp. 169-172
Study Session 11-41-a
analyze the competitive advantage and competitive strategy of a company and the competitive forces
that affect the profitability of a company and discuss the two fundamental questions determining the
choice of competitive strategy
Given that Belle Cuisine can source its ingredients from many suppliers, the effect of their bargaining
power is low (because they hardly have bargaining power), and confronted with few important
customers (selling 75% to five customers), the effect of its buyers’ bargaining power is high.

40

“Competitive Strategy: The Core Concepts,” Michael E. Porter
2008 Modular Level II, Vol. 4, pp. 169-172
Study Session 11-41-b
explain how competitive forces determine industry profitability
Buyer propensity to substitute increases intensity of rivalry.


41

“Competitive Strategy: The Core Concepts,” Michael E. Porter
2008 Modular Level II, Vol. 4, pp. 174-184
Study Session 11-41-d
explain the role of a generic strategy in the strategic planning process
Belle Cuisine exploits the special needs of a niche market, i.e., high quality food for clients at private
hospitals, by differentiating through branded quality products.

42

“Industry Analysis,” Jeffrey C. Hooke
2008 Modular Level II, Vol. 4, pp. 192-194
Study Session 11-42-b
illustrate the life cycle of a typical industry
A pioneering stage is characterized by many business failures.

43

“General Principles of Credit Analysis,” Frank J. Fabozzi
2008 Modular Level II, Vol. 5, p. 6
Study Session 14-55-a
distinguish among default risk, credit spread risk, and downgrade risk
Credit spread risk is correct because the major risk is expressed as the concern that the downgrade is
not fully reflected in the price of the bonds, which indicates the price will decline due to an increase
in the credit spread from the anticipated downgrade.

44

“General Principles of Credit Analysis,” Frank J. Fabozzi
2008 Modular Level II, Vol. 5, pp. 11-12
Study Session 14-55-c
calculate, critique, and interpret the key financial ratios used by credit analysts
Solvency ratios are a function of the nature of a company’s business. Therefore, it is inappropriate to
make direct comparisons between Barr and Park because they are in different industries.

45

“General Principles of Credit Analysis,” Frank J. Fabozzi
2008 Modular Level II, Vol. 5, pp. 12-13

Study Session 14-55-c
calculate, critique, and interpret the key financial ratios used by credit analysts
Total debt to capitalization equals current liabilities plus long-term debt, divided by long-term debt
plus current liabilities plus shareholders’ equity:
(5,199 + 7,436) / (7,436 + 5,199 + 2,449) = 12,635 / 15,084 = 83.8%.
The EBIT interest coverage ratio equals net income plus interest expense plus taxes, divided by the
interest expense: (1,221 + 580 + 263) / 580 = 2064 / 580 = 3.6.

46

“General Principles of Credit Analysis,” Frank J. Fabozzi
2008 Modular Level II, Vol. 5, pp. 14-17
Study Session 14-55-c
calculate, critique, and interpret the key financial ratios used by credit analysts
Funds from operations/total debt ratio is found by adding the non-cash items (depreciation and
amortization) to net income and dividing the sum by total debt (current liabilities plus long-term
liabilities), i.e., (1,841 + 1,320) / (8,314 + 12,013) = 3,161 / 20,327 = 15.6%.


47

“General Principles of Credit Analysis,” Frank J. Fabozzi
2008 Modular Level II, Vol. 5, pp. 27-29
Study Session 14-55-f
identify, explain, and interpret the typical elements of the corporate structure and debt structure of a
high-yield issuer and the impact of these elements on the risk position of the lender
Statement 1 is incorrect and Statement 2 is correct. The Tadd Group is more vulnerable to a rise
in short-term interest rates because they have a higher percentage of bank debt compared to Arc
Holdings’ bank debt and reset notes combined and because bank debt has a higher priority of claims
status than senior bonds.

48

“General Principles of Credit Analysis,” Frank J. Fabozzi
2008 Modular Level II, Vol. 5, pp. 27-29
Study Session 14-55-f
identify, explain, and interpret the typical elements of the corporate structure and debt structure of a
high-yield issuer and the impact of these elements on the risk position of the lender
The presence of zero (deferred) coupon bonds in the debt structure can impair the company’s ability
to improve its credit quality in the future as a burden is placed on future cash flows to meet the
deferred interest obligation.

49

“Option Markets and Contracts,” Don M. Chance
2008 Modular Level II, Vol. 6, pp. 194-197
Study Session 17-64-d
explain how an option price, as represented by the Black-Scholes-Merton model, is affected by each
of the input values (the option Greeks);
As time to expiration increases the value of the call price also increases.

50

“Option Markets and Contracts,” Don M. Chance
2008 Modular Level II, Vol. 6, pp. 191-194
Study Session 17-64-f
explain the gamma effect on an option’s price and delta and how gamma can affect a delta hedge
Statement #1 is incorrect. Gamma is larger when there is more uncertainty about whether the option
will expire in- or out-of-the-money. Statement #2 is correct. Gamma measures the sensitivity of delta
to a change in the underlying. When gamma is large, delta changes rapidly and cannot provide a good

approximation of how much the option moves for each unit of movement in the underlying.


51

“Option Markets and Contracts,” Don M. Chance
2008 Modular Level II, Vol. 6, pp. 191-194
Study Session 17-64-a
calculate and interpret the prices of a synthetic call option, synthetic put option, synthetic bond, and
synthetic underlying stock and infer why an investor would want to create such instruments
The synthetic call (long put, long underlying and short bond) is more expensive than the market price,
thus the call is under-priced in the market. Using put-call parity, Baloo should buy the call in the
market and sell the synthetic call. Thus the correct arbitrage transaction (see put-call parity formula
below) is to buy the call and sell the put, short the equity, and buy the bond.
Put-call parity: co + X / (1 + r)T = po + So
co current price of call option with exercise price X, expiring in T years
X exercise price
r risk-free rate
po current price of put option with exercise price X, expiring in T years
So current equity price

52

“Option Markets and Contracts,” Don M. Chance
2008 Modular Level II, Vol. 6, pp. 168-173
Study Session 17-64-b
calculate and interpret prices of interest rate options and options on assets using one- and two-period
binomial models
Su= 52 x 1.15 = 59.8
Sd=52 x 0.8 = 41.6

P+ = 0
P- = 45 - 41.6 = 3.4
Π= (1 + 0.06 – 0.8) / (1.15 – 0.8) = 0.7429
P =(πp+ + (1 - π) x p - ) / (1 + r) = $0.83

53

“Swap Markets and Contracts,” Don M. Chance
2008 Modular Level II, Vol. 6, pp. 251-256
Study Session 17-65-e
calculate and interpret the fixed rate, if applicable, on an equity swap and the market values of the
different types of equity swaps during their lives
Fixed rate on swap = 4.99% (Given in vignette)
Market value of a swap:

=((723.86 / 757.09) - 0.9209 - 0.0499 x (0.9691+ 0.9209)) x 100,000,000 = -$5,910,000.

54

“Swap Markets and Contracts,” Don M. Chance
2008 Modular Level II, Vol. 6, pp. 251-252
Study Session 17-66-e
calculate and interpret the fixed rate, if applicable, on an equity swap and the market values of the
different types of equity swaps during their lives
This is the value of a swap as defined in the reference material.


55

“Portfolio Concepts,” Richard A. Defusco, Dennis W. McLeavey, Jerald E. Pinto, and David E.

Runkel
2008 Modular Level II, Vol. 6, pp. 378-388
Study Session 18-68-i, l
discuss and compare macroeconomic factor models, fundamental factor models, and statistical factor
models;
discuss the arbitrage pricing theory (APT), including its underlying assumptions and its relation to the
multifactor models, calculate the expected return on an asset given an asset’s factor sensitivities and
the factor risk premiums, and determine whether an arbitrage opportunity exists, including how to
exploit the opportunity
The model estimated in Exhibit 1 is a macroeconomic factor model. In macroeconomic factor models,
the factors are surprises in macroeconomic variables that significantly explain equity returns.

56

“Portfolio Concepts,” Richard A. Defusco, Dennis W. McLeavey, Jerald E. Pinto, and David E.
Runkel
2008 Modular Level II, Vol. 6, pp. 382-388
Study Session 18-68-l
discuss the arbitrage pricing theory (APT), including its underlying assumptions and its relation to the
multifactor models, calculate the expected return on an asset given an asset’s factor sensitivities and
the factor risk premiums, and determine whether an arbitrage opportunity exists, including how to
exploit the opportunity
The expected return on Portfolio P is:
E(Rp) = RF + λ1βp,GDP + λ2βp,INF = 4.5 + (3.0 x 1.0) + (-2.5 x 0.8) = 5.50%

57

“Portfolio Concepts,” Richard A. Defusco, Dennis W. McLeavey, Jerald E. Pinto, and David E.
Runkel
2008 Modular Level II, Vol. 6, pp. 382-388

Study Session 18-68-l
discuss the arbitrage pricing theory (APT), including its underlying assumptions and its relation to the
multifactor models, calculate the expected return on an asset given an asset’s factor sensitivities and
the factor risk premiums, and determine whether an arbitrage opportunity exists, including how to
exploit the opportunity
The expected return on an equal combination of Portfolios Q and R is:
E(Rp) = RF + λ1βp,GDP + λ2βp,INF
= 4.5 + [3.0 x (0.7 + 1.2) / 2] + [- 2.5 x (- 0.4 + 1.6) / 2) = 5.85%

58

“Portfolio Concepts,” Richard A. Defusco, Dennis W. McLeavey, Jerald E. Pinto, and David E.
Runkel
2008 Modular Level II, Vol. 6, pp. 398-406
Study Session 18-68-m
explain the sources of active risk, and define and interpret tracking error, tracking risk, and the
information ratio, and explain factor portfolio and tracking portfolio
Tracking risk is the square root of Active Risk Squared. Portfolio S tracking risk = 360.5 = 6.0%.
Portfolio T tracking risk = 400.5 = 6.3%.


59

“Portfolio Concepts,” Richard A. Defusco, Dennis W. McLeavey, Jerald E. Pinto, and David E.
Runkel
2008 Modular Level II, Vol. 6, pp. 402-406
Study Session 18-68-m
explain the sources of active risk, define and interpret tracking error, tracking risk and the information
ratio, and explain factor portfolio and tracking portfolio
Comparing the components of Active Factor Risk, it is evident that with Industry factor risk equal to

2.0, Portfolio T is essentially industry neutral compared to the benchmark portfolio.

60

“Portfolio Concepts,” Richard A. Defusco, Dennis W. McLeavey, Jerald E. Pinto, and David E.
Runkel
2008 Modular Level II, Vol. 6, pp. 402-403
Study Session 18-68-m
explain the sources of active risk, define and interpret tracking error, tracking risk and the information
ratio, and explain factor portfolio and tracking portfolio
The information ratio is the ratio of mean active return to active risk. The higher the information
ratio, the better is the risk-adjusted performance of the portfolio. Because Portfolio T had a higher
information ratio, it experienced superior risk-adjusted performance.


CFA Institute 2008 Mock Exam 01 Q

Q1-6
Sang-Gyung Jun Case Scenario

Sang-Gyung Jun is enrolled in an MBA program and serves as an unpaid intern for Portree Investment Services.
During his internship, Jun's supervisor at Portree, Barbara Fantine, teaches him several stock valuation
techniques. Jun hopes his unpaid internship will eventually result in full-time employment with Portree, and he
enthusiastically recruits a number of wealthy clients, most of whom are family members. Fantine praises his
efforts, remarking that "these clients are the foundation on which you can build your career at Portree."

Despite his success, Jun's internship remains unpaid even after he receives his MBA degree and passes the CFA®
Level III examination. Jun seeks full-time employment with Upsala Financial Corp., which specializes in serving
high-net-worth individuals.

When interviewing for the position at Upsala, Jun informs his interviewer that "I need to obtain only one more
year of work experience before I will receive the CFA charter. I passed all three CFA examinations on the first try."
After the interview, Jun considers contacting the clients he has recruited at Portree to ask if they would become
his clients at Upsala.

When Fantine learns of Jun's plans to leave Portree, she informs Jun, "You are not permitted to use any of the
valuation techniques I have taught you because they belong to me."

Jun subsequently accepts the position at Upsala and informs Fantine. On the same day, Fantine receives news
about the departure of another Portree employee, Jasmine Velez, CFA. Velez is leaving to start an investment
firm that will directly compete with Portree. Velez has not contacted any potential clients, but during non-work
hours she has incorporated the new firm and obtained the necessary licenses.

On Jun's first day of work at Upsala, he receives and reviews a copy of the firm's compliance policy, excerpts of
which appear in Exhibit 1.

P.1 of 46


Exhibit 1
Upsala Financial Corp.
Compliance Policy

Independent Practice
Employees of Upsala may enter into independent practice only in business segments not already targeted by
Upsala, and only in roles clearly leading to improvements in employee skill and expertise that can be used
beneficially by Upsala.

Priority of trades
The interests of outside clients must be given priority over accounts registered in the name of Upsala itself.

Moreover, all personal trades by employees of Upsala firm will be pre-cleared in accordance with the firm's
compliance policies.

Jun also receives new business cards which read "Sang-Gyung Jun, CFA, Investment Consultant." Jun mails
letters of introduction with the business cards to contacts and potential clients.

Jun soon impresses his supervisor at Upsala with his knowledge of stock valuation techniques. He does not inform
his supervisor that he learned the techniques from Fantine at Portree.

Several months later, Jun receives an offer of part-time consulting work from a family friend who needs
assistance marketing investment services to high-net-worth individuals in Korea. Jun reviews the firm's policy on
independent practice and confirms that Upsala does not conduct business in Korea. Jun is convinced that the
consulting work will improve his skills and thus benefit Upsala. He accepts the consulting work, which requires
approximately three hours of late-night work on Mondays and Wednesdays. Jun then sends an email to his
supervisor informing him of the consulting offer, its requirements, duration, compensation, and the skills he
expects to develop from the work.

P.2 of 46


Question
According to CFA Institute Standards of Professional Conduct, may Jun solicit clients immediately following his
interview with Upsala?

Select exactly 1 answer(s) from the following:
A. Yes.

B. No, because he owes a duty of loyalty to Portree.

C. No, because he has not yet received an official offer from Upsala.

D. No, because he has not received written permission from either Upsala or Portree.

Question
When preparing to establish an investment firm, does Velez violate the CFA Institute Standard relating to Duty
to Employer?

Select exactly 1 answer(s) from the following:
A. No.

B. Yes, because she plans to compete directly with Portree.

C. Yes, because she incorporated the firm before leaving Portree.
D. Yes, because she uses the knowledge and skills acquired at Portree to develop a competing
business.

P.3 of 46


Question
When using the stock valuation methods at Upsala, does Jun violate any CFA Institute Standards of Professional
Conduct?

Select exactly 1 answer(s) from the following:
A. No.

B. Yes, because he does not have Fantine's permission.

C. Yes, because he does not have Portree's permission.

D. Yes, because he does not inform his supervisor of the source of the methods.

Question
Does Jun violate CFA Institute Standards of Professional Conduct with respect to his:

statement about passing

use of the

exams on the first try?

business card?

A.

No

No

B.

No

Yes

C.

Yes

No

D.

Yes

Yes

Select exactly 1 answer(s) from the following:
A. Answer A.

B. Answer B.

C. Answer C.

D. Answer D.

P.4 of 46


Question
To make Upsala's statement on Priority of Trades consistent with CFA Institute Standards, Jun's most
appropriate recommendation is to replace the first sentence with:

Select exactly 1 answer(s) from the following:
A. The interests of clients must be given priority over accounts in which Upsala's employees are
beneficial owners.
B. The interests of outside clients must be given priority over family client accounts and accounts
registered in the name of Upsala itself.
C. The interests of outside clients must be given priority over family client accounts and accounts in
which Upsala's employees are beneficial owners.

D. The interests of outside clients must be given priority over family client accounts, accounts in
which Upsala's employees are beneficial owners, and the accounts registered in the name of Upsala
itself.

Question
When accepting the part-time consulting position, does Jun violate any CFA Institute Standards?

Select exactly 1 answer(s) from the following:
A. No.

B. Yes, because he does not have consent.

C. Yes, because he does not provide adequate disclosure to Upsala.

D. Yes, because the work requirements will interfere with his duties to Upsala.

P.5 of 46


Q7-12
Jacques Nordique Case Scenario

Jacques Nordique is a quantitative analyst at Brimford Investment Management. One of the firm's managing
partners asks Nordique to collect and analyze data as part of a project to explain and to forecast the behavior of
price/earnings (P/E) ratios. Nordique wants to examine time-series models of P/E behavior and begins by
collecting 15 years of monthly data on market P/E ratios.

After considering several different time-series models, Nordique estimates a regression equation of the form:

(P/E)t = b0 + b1 (P/E)t-1 + εt

and obtains the results shown in Exhibit 1. Nordique believes the time series is mean reverting and given the
estimated coefficients, he calculates the mean-reverting level of the market P/E ratio to be 13.3.

Exhibit 1
Regression Results
Dependent Variable is the Market Price/Earnings (P/E) Ratio
Regression Statistics
R-squared

0.959

F-statistic

4160.885

Standard Error of Estimate

0.988

Number of Observations

179

Durbin-Watson Statistic

2.115
Coefficients

Standard Error

Intercept

0.332

0.189

(P/E)t-1

0.975

0.015

Nordique shares his time-series results with his supervisor, Amy Beloit. She is interested in the implications for
stock-bond allocation, especially given that Brimford's investment strategists are neutral on the future direction
of interest rates. After reviewing the results, Beloit has two concerns about the time series estimated in Exhibit
1: (1) do the error terms exhibit heteroskedasticity; and (2) does the time series exhibit a unit root? Exhibit 2
contains critical values of several test statistics that may be relevant to the results that Nordique and Beloit are
interpreting.

P.6 of 46


Exhibit 2
Critical Values of Selected Test Statistics

t-statistic

Durbin-Watson Statistic

One-tailed Probabilities

α = 0.05, K = 1

Degrees of freedom

p = 0.05

p = 0.025

2

2.92

4.30

120+

1.66

1.98

dL = 1.65, dU = 1.69

P.7 of 46


Question
Given Nordique is correct about the mean reversion of the time series, his most appropriate action to determine if
the time series equation estimated in Exhibit 1 is correctly specified is to examine the:
Select exactly 1 answer(s) from the following:

A. Durbin-Watson statistic.

B. R-squared value and F-statistic.

C. autocorrelations between the error terms.

D. correlation between the squared error terms and the independent variable.

Question
To determine whether Beloit's first concern is valid, Nordique's most appropriate action would be to:
Select exactly 1 answer(s) from the following:
A. perform the Dickey-Fuller test.

B. re-estimate the model using a moving average.
C. regress the squared residuals from the equation estimated in Exhibit 1 on the squared
residuals lagged one period.
D. test whether the variance of the error in one period depends on the variance of the
error in successive time periods.

Question
Which of the following models is most appropriate to determine if Beloit's second concern is justified?
Select exactly 1 answer(s) from the following:
A. (P/E)t – (P/E)t–1 = b0 + g1 (P/E)t + εt.
B. (P/E)t - (P/E)t-1 = b0 + g1 (P/E)t-1 + εt.
C. (P/E)t - (P/E)t-1 = b0 + g1 [(P/E)t - (P/E)t-1] + εt.
D. (P/E)t - (P/E)t-1 = b0 + g1 [(P/E)t-1 - (P/E)t-2] + εt.

P.8 of 46

Question
If Beloit's second concern about the time-series results in Exhibit 1 is correct, Nordique's most appropriate action is to:
Select exactly 1 answer(s) from the following:
A. do nothing, because unit roots can be ignored when the Durbin-Watson statistic exceeds du..
B. do nothing, because unit roots are expected when using time-series data and will not affect the
specification of the equation.
C. re-estimate the regression using the form: (P/E)t = b0 + b1 (P/E)t-1 + b2 (P/E)t-2 + εt.
D. re-estimate the regression using the form: [(P/E)t - (P/E)t-1 ] = b0 +b1 [(P/E)t-1 - (P/E)t-2 ] +εt.

Question
If Nordique's claim about mean reversion is correct, which of the following recommendations is most appropriate?
Select exactly 1 answer(s) from the following:
A. Overweight stocks if the P/E is above its mean reversion level.

B. Underweight stocks if the P/E is above its mean reversion level.

C. Overweight stocks if the stock market is falling and underweight stocks if the stock market is rising.
D. Overweight stocks if the P/E is below its historical average, underweight stocks if the P/E is above
its historical average.

Question
If the model estimated in Exhibit 1 is correctly specified, and the market P/E ratio is 22.50 in June 2007, the
estimate of the market P/E ratio for August 2007 is closest to:
Select exactly 1 answer(s) from the following:
A. 21.39.

B. 21.91.

C. 22.04.
D. 22.27.

P.9 of 46