FinQuiz Level2Mock2016Version2JuneAMQuestions PDF

CFA Level II Mock Exam 2 – Questions (AM)
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CFA Level II Mock Exam 2
June, 2016
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FinQuiz.com – 2nd Mock Exam 2016 (AM Session)
Questions Topic Minutes

1-6 Ethical and Professional Standards 18
7-12 Quantitative Methods 18
13-18 Economics 18
19-24 Corporate Finance 18
25-36 Financial Reporting and Analysis 36
37-48 Equity Investments 36
49-54 Fixed Income 18
55-60 Derivatives 18
Total 180

Questions 1 through 6 relate to Ethical and Professional Standards
Octagon Investments (OCTIN) Case Scenario
Pamela Santos Lopez is a portfolio manager at Octagon Investments (OCTIN), a large

money management in New York, USA. Lopez works as a research analyst at the firm
and is responsible for conducting and writing research reports on the stocks of
telecommunication firms. Lopez has been asked by her supervisor to write a report on the
stocks of two telecommunication firms: FibreOptics Inc. and BlueTech Inc. FibreOptics
Inc. is one of OCTIN’s clients and OCTIN makes a market in FibreOptics’s shares. After
reviewing the firm’s publicly available financial statements and notes to financial
statements, as well as talking to key executives at competing firms, Lopez wrote a
thorough research report about the company. Before including her recommendation,
Lopez forwarded the report to the investment banking department through the
compliance department, to view the balance sheet information provided, as well as to
identify any potential conflicts of interests. After the revisions were made, Lopez added
her recommendation and released the reports to her clients.
After releasing the report, Lopez was called for a media interview by one of her very
close friends who hosted a financial talk show on a well-known local channel. During the
interview, Lopez disclosed all information about the firm. In addition, she stated that
although her recommendation was to ‘buy’ the stock, each investor should view his or
her own circumstances before purchasing it. During the interview, Lopez did not mention
that OCTIN made a market in FibreOptics’ shares, but she disclosed this fact clearly in
the research report and also disclosed to the audience and the interviewer that the report
was available to all members of the audience at minimum cost.
Lopez had followed BlueTech Inc. for a while now, and had considerable knowledge
about the firm’s financial performance. Even so, before adding an appropriate price target
for the firm’s stock in her report, Lopez decided to contact the firm’s CEO to discuss key
information concerning BlueTech’s product and industry expansion strategy. Lopez
provided him with a copy of her report and asked to collect it the next day after he had
made the necessary additions. After receiving the report the next day, Lopez reviewed it,
revised her price target, and made the report available to her clients.
Lopez’s supervisor reviewed her research reports and assessed them for quality of
research and the adequacy of the basis for the recommendations made. As part of Lopez’s
regular performance review, her supervisor checked the accuracy of her
recommendations over time. OCTIN’s compensation policies included measurable

criteria, and these criteria were made available to clients and prospective clients. OCTIN
made the following extract from its compensation policy manual available to clients:
“An analyst’s compensation is not directly linked with OCTIN’s investment banking
activities on which the analyst collaborated. However, if OCTIN’s aggregate investment
banking revenues increase by more than 20% in a year, the firm’s research analysts’
compensation is increased by 3%.”
In addition to the disclosure made about its compensation policies, OCTIN also records
the following in its policy manual:
• OCTIN enforces quiet periods of 20 calendar days from issuance for IPOs and at least
10 calendar days from the issuance for secondary offerings.
• Restricted periods of at least 30 calendar days before and five calendar days after
report issuance are enforced.
Lopez is also covering the stock issued by Droplet Inc. (DRPI). Lopez provided a
comprehensive analysis of the firm’s current and pro-forma financial statements in her
report and included a ‘buy’ recommendation for the stock. After making the report
available to all her clients and waiting for a week, Lopez decided to re-balance her
diversified stock portfolio. To effectively achieve this objective, Lopez had to sell the
Droplet Inc. stock, which had risen in value during the current quarter.
1. With respect to the research report on FibreOptics Inc., has Lopez most likely
violated the CFA Institute Research Objectivity Standards?
A. No.
B. Yes, because the investment banking department is prohibited from
modifying a research report on their own authority.
C. Yes, communication with the investment banking department is prohibited
because OCTIN makes a market in FibreOptics’ shares and this creates a
potential conflict of interest.

2. With regards to the research report on BlueTech Inc., has Lopez most likely
violated the CFA Institute Research and Objectivity Standards?
A. Yes.
B. No, only if she first provides a draft report to the compliance department,
justifies the revised price target, and the compliance department approves
all changes made to the report.
C. No, only if she provides that portion of the research report to FibreOptics
Inc. that contains factual information that can be verified by the CEO.
3. With regards to her media interview, did Lopez most likely violate the CFA
Institute Research and Objectivity Standards?
A. Yes
B. No, because she disclosed all facts clearly in the research report
C. No, because she disclosed all facts clearly in the research report and made
the report available to all those who were interested
4. With respect to research analyst compensation, is OCTIN most likely in

accordance with the CFA Institute Research and Objectivity Standards?
A. Yes.
B. No, because analysts’ compensation is dependent on the firm’s investment
banking revenues.
C. No, because the disclosure made to clients and prospects is inadequate.
5. With regards to its policy manual, is OCTIN most likely in accordance with the
CFA Institute Research and Objectivity Standards?
A. Yes.
B. Only with respect to the quiet periods.
C. Only with respect to the restricted periods.

6. With regards to her trade in the stock of Droplet Inc., has Lopez most likely
violated the Research and Objectivity Standards?
A. No.
B. Yes, because she traded contrary to her published recommendation.
C. Yes, because she is prohibited to trade in a security that she covers.

Questions 7 through 12 relate to Quantitative Methods
Quarter Investment Advisory (QIA) Case Scenario
Quarter Investment Advisory (QIA) is a medium-sized, U.S. based, money management

firm. Scott Marshall works as a quantitative analyst at the equity department of the firm
and is currently preparing for his next meeting with QIA’s largest client in terms of
revenues. In the course of selecting appropriate investments for the client, Marshall is
analyzing the results of two sets of regression analysis:
Regression 1: A linear regression with the growth in Axxo Enterprises EPS as the
dependent variable and the company’s leverage, growth in inventories and
analyst following as the independent variables.
Regression 2: A first-order autoregressive model, with the net profit margin for Beta
Enterprises as the dependent variable.
Exhibits 1 and 2 display the results of the first regression.
Exhibit 1
Linear Regression Results
Coefficient t-Statistic
Intercept 0.0678 3.02
Debt/Equity ratio 0.4851 4.55
Growth in inventories 0.2932 8.90
Analyst following 0.5500 5.23
No. of observations 79
P-value for the F-statistic 0.01
Exhibit 2
Pairwise Correlations
D/E and Growth in inventories 0.88
Growth in inventories and analyst following 0.85
Analyst following and D/E 0.98

After a thorough analysis of the regression estimates and results, Marshall prepared the
following points for the meeting:
“Given the significance of the t-statistics (relative to a critical t-value of almost 2.0) along
with the significance of the F-statistic, multicollinearity does not seem to be a problem in
this multiple regression. However, the high pairwise correlations among the independent
variables suggest that there is a multicollinearity problem.”
Marshall then estimated the regression with a larger sample, a greater number of
observations and only one independent variable (growth in inventories) to test for serial
correlation. With 200 observations, Marshall determined that the correlation between the
regression residuals from one period and those from the previous period equaled 0.598.
He then added the following conclusion to his presentation to be made during the
meeting:
Conclusion 1: “The OLS standard errors in this regression will most likely significantly
underestimate the true standard errors.”
Conclusion 2: “Based on my analysis, each of the two variables’ time series—the growth
in EPS time series and the growth in inventories time series—has a unit
root. However, based on the Engle-Granger Dickey-Fuller test, the two
series are cointegrated. Hence, we can use linear regression to estimate the
short-term relation between the two series.”
Marshall then proceeded with his analysis of regression 2. Exhibit 3 displays the results
of this regression.
Exhibit 3
Autoregressive Model
Coefficient t-statistic
Intercept 0.036 2.56
Lag 1 0.768 4.99
Observations 60
Autocorrelations of the Residual
Lag Autocorrelation
1 0.0783
2 0.0893
3 0.1124
4 –0.0594

He concluded his presentation with the following remark:
“The AR model predicts that the net profit margin will increase if it is below 15.52% and
decrease if it is above this level.”
7. With respect to his point concerning regression 1, and a 5% significance level,

Marshall is most accurate with respect to his statement about:
A. the significance of t-statistics and the F-statistic.

B. the pairwise correlations.
C. neither the significance of the regression statistics nor the pairwise
correlations.
8. With respect to conclusion 1 about the modified regression 1 to be presented

during the meeting, and with a 5% significance level, Marshall is most likely:
A. correct.
B. incorrect, because the OLS standards errors will overestimate the true
standard errors.
C. incorrect, because the OLS standards errors might overestimate or
underestimate the true standard errors.
9. With respect to Conclusion 2 about the modified Regression 1 to be presented

during the meeting, Marshall is most likely:
A. correct.
B. incorrect, because the regression coefficients and standard errors produced
by linear regression would be inconsistent.
C. incorrect, because the use of error correction models rather than linear
regression models would be more suitable in this case.
10. At a 5% significance level, is the autoregressive model correctly specified?
A. No.
B. Yes, because the t-statistics are significantly different from 0.
C. Yes, because none of the autocorrelations is significantly different from 0.

11. Assuming the model is correctly specified, Beta Enterprises’ net profit margin for
the second quarter of 2009, assuming that the net profit margin for the last quarter
of 2008 was 25%, is closest to:
A. 21.1%.
B. 22.8%.
C. 26.70%.
12. With respect to his concluding remark, Marshall is most likely:
A. incorrect.
B. correct, only if the time series is covariance stationary.
C. correct, only if the DW statistic is 2.

Questions 13 through 18 relate to Economics
Black-Rock Investments (BRON) Case Scenario
Carlos Ford, a portfolio manager and an exchange rate specialist, has worked with Black-
Rock Investments (BRON), a capital management firm, for the past 15 years. Ford
resigned from BRON last year and now works as a currency manager and consultant for a
number of investment firms. Last week, Ford was invited by Michael Wagle, a friend and
a financial analyst, to advise him concerning an investment made in Canadian dollars.
During their conversation, Wagle presented him with the following information:
• C$/U.S.$ spot rate (mid-market): 0.856

• One-year Canadian deposit rate: 4.00%
• One-year U.S. deposit rate: 6.50%
Wagle added:
“I am not sure how the C$/US$ exchange rate will change in the future, but I would like
to generate an almost riskless profit on my one-year investment in Canadian dollars.
Would that be possible?”
After reviewing the data Wagle presented, Ford made the following comments:
Comment 1: “I expect the Canadian dollar to appreciate against the U.S. dollar over the
coming year. According to my analysis, and corroborating evidence, the
percentage change in the spot exchange rate will be 4.50%.”
Comment 2: “Given the current one-year forward points, and my own analysis, I
believe that the U.S. dollar will sell at a forward discount of 3.50%.”
In the course of their discussion on exchange rates and the effects of various factors on
their future movements, Ford made the following comments:
Statement 1: “For countries following an expansionary monetary policy along with a

fixed exchange rate policy, the actions taken by the central bank to
maintain the level of exchange rate will offset the effects of the policy.
However, in cases where countries are following an expansionary fiscal
policy, steps taken to maintain a fixed exchange rate will reinforce the
impact of the expansionary fiscal policy.”

Statement 2: “For an emerging economy, a uniformly expansionary fiscal/monetary

policy mix will be bearish for its currency, and a uniformly restrictive
fiscal/monetary policy mix will be bullish.”
Ford then talked about the Taylor Rule used by many central banks in determining the
appropriate policy rate as a function of their neutral rate, their inflation and output targets,
and the observed deviations from those targets. Ford stated that the Taylor rule also
provided valuable insights in determining exchange rates. When he used the example of
the euro-dollar exchange rate, Wagle posed the following questions:
Question 1: “How will an increase in the inflation gap in the euro area relative to the
inflation gap in the United stated affect the U.S. dollar?”
Question 2: “How will an increase in the output gap in the euro area relative to the
output gap in the United Stated affect the U.S. dollar?
13. Assuming Ford’s comments are accurate, Ford should most likely advice Wagle to
invest in:
A. a fully currency-hedged Canadian money market instrument.

B. an unhedged Canadian money market instrument.
C. either a fully currency-hedged Canadian money market instrument or a
U.S. money market instrument.
14. Assuming Ford’s comments are accurate and uncovered interest rate parity holds,
Ford should most likely advice Wagle to invest in:
A. A fully currency-hedged Canadian money market instrument.

B. an unhedged Canadian money market instrument.
C. either a fully currency-hedged Canadian money market instrument or a
U.S. money market instrument.

15. In equilibrium, if the forward exchange rate is an unbiased predictor of the spot
exchange rate then, in one year:
A. covered interest rate parity will hold.

B. the percentage change in the C$/US$ spot exchange rate will be –2.5%,
and the US$ will trade at a forward discount of 2.5%.
C. the US$ will trade at a forward discount of 2.5%, but the percentage
change in the spot exchange rate will depend on the number of risk-neutral
investors in the market.
16. Ford is most accurate with respect to:
A. Statement 1 only.
B. both statements 1 and 2.
C. neither Statement 1 nor Statement 2.
17. The best response to Wagle’s Question 1 is that the U.S. dollar will:
A. weaken versus the euro in real terms.

B. strengthen versus the euro in real terms.
C. strengthen versus the euro in nominal terms.
18. The best response to Wagle’s Question 2 is that the U.S. dollar will:
A. weaken versus the euro in real terms.

B. strengthen versus the euro in real terms.
C. strengthen versus the euro in nominal terms.

Questions 19 through 24 relate to Corporate Finance.
Moonwalk Electronics (MWE) Case Scenario
Sam Wilton worked as a financial analyst for a capital management firm for the past ten
years. Last year, Wilton was hired by Moonwalk Electronics (MWE), a U.S. based firm
that manufactures microchips, storage devices and other hardware components of
supercomputers. Wilton joined MWE as the head of the corporate finance department.
For his first assignment, Wilton evaluates the inflation assumptions, which are used to
project cash flows for MWE’s proposed projects. Stephen Collins, a project analyst at
MWE, informs Wilton, “Our in-house economic analyst had projected inflation to equal
2.5%. However with the latest monetary policy change, inflation has risen to 3.0%. Given
that the tax system does not adjust depreciation for inflation, MWE’s project estimates
should not be significantly affected.”
Wilton conducted the analysis of the proposed with his subordinate, Mona Lawson.
During the analysis she asked Wilton of the limitations associated with capital rationing.
Next, Collins requested Wilton to evaluate a project that required an initial investment in
fixed capital of $500,000 and working capital of $50,000. The project was expected to
generate sales of $350,000 each year, for the next 5 years. 70% of the investment in fixed
capital was depreciable, depreciated straight-line to zero. Cost of goods sold was
expected to be $100,000/year over the period under analysis. At the end of year 5, the
fixed assets would be sold for $200,000. The tax rate and required return applicable to the
project are 35% and 12% respectively.
When Wilton calculated the NPV of the project, he was not sure whether his estimate
reflected reality. To enhance the accuracy of his decision, Wilton decided to re-evaluate
the project under the following two scenarios:
Scenario 1: The portion of the investment in fixed capital that is depreciable should be
depreciated using an accelerated depreciation schedule, with 35% of the
value depreciated during the first two years, and 10% thereafter.
Scenario 2: The fixed capital would be sold for $100,000 at the end of the investment
horizon.

Collins was satisfied with the decision presented by Wilton. As another favor, Collins
presented Wilton with his own calculations for three projects that MWE had shortlisted
for investment purposes, and asked him to review them. Using MWE’s WACC for
measuring risk, Collins displayed the following results of his analysis.
Exhibit
Beta Decision
Project 1 0.8 Reject
Project 2 1.5 Accept
Project 3 1.2 Accept
*Company’s beta equals 1.2.
Collins then stated that he computed the economic income to make the accept/reject
decision for an investment in a specialized electronics equipment. Based on his analysis,
the project was feasible, and MWE should invest in the equipment. When Wilton
reviewed Collins work, he made the following comments:
Comment 1: “You should not use MWE’s WACC to discount the cash flows of the
respective projects. The project-specific required rates of returns,
calculated using project-specific betas, should be used instead. Doing so
will change your conclusions.”
Comment 2: “Economic income is based on the economic depreciation rather than

accounting depreciation. However, your approach to analyze the
investment in the equipment does not take into account the effect of
financing costs.”
19. Is Collins correct with respect to the impact of inflation on depreciation?
A. Yes.
B. No, the value of depreciation tax savings will increase.
C. No, the value of depreciation tax savings will be reduced.

20. The least appropriate response to Lawson’s query concerning capital rationing is
that the technique:
A. has the potential to violate market efficiency.

B. may prohibit managers from overspending their budgets.
C. cannot be used when a company’s capital budget is limited.
21. The project that Collins requested Wilton to evaluate has an NPV closest to:
A. $256,016.
B. $265,950.
C. $293,870.
22. How will reevaluating the project under Scenario 1 most likely affect the ultimate
decision?
A. The decision will change.

B. The decision will remain the same.
C. The impact of the revaluation on the outcome of the project cannot be
ascertained.
23. How will re-evaluating the project under Scenario 2 most likely affect the ultimate
decision?
A. The decision will change.

B. The decision will remain the same.
C. The impact of the revaluation on the outcome of the project cannot be
ascertained.
24. Wilton is most accurate with respect to:
A. Comment 1 only.
B. both comments 1 and 2.
C. neither Comment 1 nor Comment 2.

Questions 25 through 30 relate to Financial Reporting and Analysis.
Smart Investments (SMIN) Case Scenario
Nicolas Brack is a stock analyst who works for Smart Investments (SMIN) a firm that
invests in the stocks of large, multinational firms. At present, Brack is working with
James Richardson, a private wealth client and a successful entrepreneur with a stock
portfolio worth $15 million. Richardson has asked Brack to invest a part of his portfolio
in the stocks of firms with high-growth prospects. Given the constraints in Richardson’s
investment policy statement, Brack short-listed the stocks of two firms as possible
investment opportunities: Click Products Inc. and Eminent Products Inc. Exhibits 1 and 2
present financial data that Brack accumulated to aid his analysis.
Exhibit 1
Click Products Inc. (US$ Millions)
31 December 2011 2010
Sales $575 $521

Revenue of Financial
$64 $52
Products
Cost of goods sold $489 $412
Net Profit $79 $71
Inventories $135 $110
Total current assets $378 $285
Total assets $650 $595

*The company is taxed at a rate of 25%.

Exhibit 2
Click Products Inc. Selected Notes to Financial Statements
Note 5. Summary of Accounting Policies

A. Inventories
The company uses the lower of cost or market for recording inventories. Cost is
determined using the last-in, first-out method. If the FIFO method had been used,
inventories would be $59 million and $46 million higher than reported at Dec 31, 2011
and 2010 respectively.
Brack is aware that in a few years, all U.S. reporting companies are expected to fully
adopt the International Financial Reporting Standards in presenting their financial
performance. Since IFRS does not allow the LIFO method of recording inventories,
Brack decided to estimate the firm’s key financial ratios after a restatement of Click
Products Inc.’s financial statements to the FIFO method. After writing a comprehensive
report on the firm, Brack called a meeting with Richardson. During the meeting, Brack
presented the following observations:
Observation 1: Under the periodic inventory system, the amount of goods available for
sale allocated to cost of sales and ending inventory may be quite different
using the FIFO method compared to the weighted average cost method.
Under a perpetual inventory system, however, the amounts are similar.
Observation 2: Under the FIFO method, the firm’s net profit margin and gross profit
margin would be higher. However, the absolute percentage difference
relative to the margins under LIFO will be less for the net profit margin
than for the gross profit margin.
Observation 3: Relative to FIFO, the firm appears to be less profitable, less liquid, and
more highly leveraged under LIFO. Hence, the company’s value increases
after restating the financial statements to the FIFO method.
Brack then presented financial information of Eminent Products Incorporated. Exhibit 3

displays this information.

Exhibit 3
Eminent Products Inc.
Financial Statement Information
under LIFO (as of 31 Dec 2011)
No. of units purchased 15,500
No. of units sold 17,000
Cost per unit sold $120
Sales price $250
Cost of goods sold $1,995,000
Brack concluded his meeting with the following statement:
“I believe a part of Eminent Product Inc.’s gross profit is due to LIFO liquidation. The
amount of LIFO liquidation can be estimated by calculating the decrease in the LIFO
reserve on the balance sheet. This is the amount by which cost of sales will be lower due
to LIFO liquidation.”
25. With regards to observation 1, Brack is most accurate with respect to:
A. the periodic inventory system only.

B. the perpetual inventory system only.
C. both the periodic and the perpetual inventory system.
26. Is Brack most likely correct with respect to observation 2, and how does the 2011
net profit margin of Click Products Inc. compare under the LIFO and FIFO
methods?
A. Yes, and the net profit margin under FIFO is 1.53% higher.
B. Yes, and the net profit margin under FIFO is 2.04% higher.
C. No, and the net profit margin under FIFO is 3.07% higher.
27. Click Products Inc.’s 2011 return on assets under FIFO accounting is:
A. 0.35% lower than under LIFO accounting.

B. 0.72% higher than under LIFO accounting.
C. 0.94% higher than under LIFO accounting.

28. Which of the following about Brack’s observation 3 and his comment about LIFO
liquidation is most accurate?
A. The observation is inaccurate but the comment is accurate

B. Both the observation and the comment are accurate
C. Neither the observation, nor the comment is accurate
29. Click Products Inc.’s 2011 inventory turnover under FIFO is closest to:
A. 2.45.
B. 2.72.
C. 3.13.
30. Eminent Products Inc.’s 2011 gross profit margin due to LIFO liquidation is
closest to:
A. $45,000.
B. $180,000.
C. $195,000.

Questions 31 through 36 relate Financial Reporting and Analysis
Fixen Enterprises Case Scenario
Eric Strauss is an investment analyst working for the acquisition and investment
department of Fixen Enterprises, a large firm that manufactures metallic fixtures, bolts
and spare parts used in heavy duty construction equipment. Last year, on January 1, 2009,
Fixen invested $750,000 in the debt securities issued by YLX Associates. The securities
had a 7.0% stated rate on par value, payable annually. The par value of the securities was
$715,000 and the market interest rate when the bonds were purchased was 6.0%. On 31
December 2009, the fair value of Fixen’s investment is $835,000. Strauss is assessing the
impact on Fixen’s financial statements of treating this investment as either held-to-
maturity, fair value through profit or loss (particularly held for trading) or available-for-
sale. Fixen’s analysis is based on the applicable IFRS standard(IAS 39) and US GAAP
standard as of December 2012. After a thorough analysis, Strauss formulated the
following conclusions:
Conclusion 1: Interest income reported in the income statement would be exactly the
same under all three classifications and would equal $45,000.
Conclusion 2: On 31 December 2009, the reported value on the balance sheet would be
the same whether the securities are classified as held for trading or
available-for-sale.
Strauss met with Sam Richards, Fixen’s chief executive officer, and presented his
conclusions during the meeting. After reviewing his work, Richards posed the following
question:
“If we decide to sell the securities tomorrow for $839,000, how will this gain be
recognized in our income statement?”
Strauss responded with the following statement:
“If the securities are initially classified as held-to-maturity or available-for-sale, the gain
on sale will be similar and would equal $89,000.”

Richards added by making the following comments:
1. Under IFRS, held-to-maturity, available for sale and held for trading investments are
all initially recognized at fair value. However, in case of held-to-maturity and
available-for-sale securities, transaction costs are included in the initial reported value
whereas, for held-for-trading securities, transaction costs are not included at initial
recognition.
2. For foreign available-for-sale debt and equity securities, the treatment of foreign
exchange gains and losses is different under IFRS and U.S. GAAP. Whereas under
U.S. GAAP, the entire change in fair value is reported in other comprehensive
income, under IFRS, the amount attributable to foreign exchange gains or losses is
recognized in the profit and loss account.
On January 1 2009, Fixen also acquired a 25% ownership interest in Block Associates for
$7,000,000. Exhibit 1 displays information concerning Block Associates assets and
liabilities as of January 1 2009.
Exhibit 1
Block Associates
BV of current assets $2,384,000
BV of plant and equipment $16,500,000
FV of plant and equipment $18,000,000
Liabilities $5,500,000
During the year, Block reported net income of $3,000,000 and paid dividends of $90,000.
The plant and equipment are depreciated on a straight line bases and have a 20 year
remaining life.
When reviewing the performance of this investment, Richards posed the following
question to Strauss:
“If Fixen sold $50,000 of inventory to Block Associates for $110,000 during 2009, and
Block Associates resold $80,000 of this inventory during the same year, how will this
affect the equity income reported on Fixen’s 2009 income statement?”

31. Strauss is most accurate with respect to:
A. Conclusion 1 only.
B. Conclusion 2 only.
C. both conclusions 1 and 2.
32. With respect to his response to Richards’s questions, Strauss is most likely:
A. correct.
B. incorrect, because the gain on sale will be similar and would equal
$94,050.
C. incorrect, because for a held-to-maturity security the gain on sale will be
$89,000, but for an available-for-sale security, the gain on sale will be
$4,000.
33. Richards is most accurate with respect to:
A. Comment 1 only.
B. both comments 1 and 2.
C. neither Comment 1 nor Comment 2.
34. Under the equity method, on 31 December 2009, Fixen’s financial statements will
include an investment in Block Associates closest to:
A. $7,708,750.
B. $7,727,500.
C. $8,102,500.
35. Under the equity method, which of the following about Fixen’s investment in
Block Associates is most accurate?
A. On 31, December 2009, the reported balance in investment in Block

Associates on Fixen’s financial statements will include goodwill of
$3,654,000
B. If Fixen had purchased Block Associates for $3 million, the difference
between the fair value of Block Associates’ net assets and the cost of the
investment would be excluded from the carrying amount of the investment
C. The amount of excess purchase price is systematically amortized by
reducing the carrying amount of the investment and by reducing Fixen’s
share of Block Associates’ profits

36. The best response to Richards question regarding Block Associates is that the
equity income will include unrealized profit of:
A. $2,045.
B. $2,727.
C. $4,091.

Questions 37 through 42 relate to Equity Investments
Stock Investments Incorporated (STIN) Case Scenario
Stock Investments Incorporated (STIN) is an equity management firm that offers stock
research, analysis and management services to its clients. Jenna Thomson is an equity
analyst at STIN who is currently updating her forward-looking valuation estimates of two
corporate entities: ABC Foods and White Enterprises. Thomson has yet to decide which
valuation model to use for the two companies. To support her decision, she gathered
some information about them, including:
ABC Foods: The firm has regularly paid dividends to its equity investors and
has been profitable since the year of initiation. The firm has
followed a fixed dividend payout policy since the past five years
even though earnings have been volatile and are expected to be for
the near future. The board of directors just announced that they
were going to adopt a fixed dividend policy from next year
onwards.
White Enterprises: The firm operates in a fast-growing sub-sector of the industry and
has no history of paying dividends. The firm is expanding
operations and is expected to have negative free cash flows for the
coming seven years, after which they are expected to turn positive.
For the same reasons, the company’s leverage is expected to
change significantly.
Thomson decided to use the dividend discount valuation model for ABC Foods, and the
free cash flow to equity model with a 15 year forecast horizon for White Enterprises to
capture the point at which expected FCFE turns positive.
Thomson is planning to purchase the stock of Glee Products Incorporated (GPI) currently
trading at a price of $150/share. The company has a forward dividend yield of 5% and a
beta of 1.34. Thomson expects the dividend yield to stay constant over time. As an
alternative to the stock investment, Thomson is considering the purchase of YLS
Enterprises stock, with a market price of $60/share. She decides to use the next year’s
announced dividend of $2.5/share, and a published beta of 0.9 for valuation purposes.
Based on her own valuations, Thomson believes that the stock is trading at a 30%
premium from intrinsic value. The risk free rate and the equity risk premium equal 4.5%
and 9% respectively.

STIN releases a financial journal every month that provides an industry-wise analysis of
stock investments and makes investment recommendations. Thomson has been asked to
write a research report on Chemico (CHMO) for the journal, and to present a ‘buy’, ‘sell’,
or ‘hold’ recommendation. In preparing the report, Thomson gathers the following
information about Chemico’s vitals:
• The current dividend is $1.00.

• Thomson expects an initial two-year growth of 15% per year in earnings and
dividends.
• Thomson expects Chemico to grow at a rate of 8.0% as a mature company, and
expects the company to take 12 years for this transition.
• The required rate of return is 10%.
After performing the necessary calculations, Thomson stated that the stock was
overvalued and hence, presented a ‘sell’ recommendation. Before publishing the article,
Debbie Denise, an equity portfolio manager at STIN, reviewed Thomson’s analysis.
Denise was greatly impressed by Thomson’s work and solicited her advice for her
personal stock investments. One of Denise’s investments was in the stock of UPS Inc..As
a favor to Denise, Thomson agreed to help and accumulated the following information:
• The company has a shareholder’s equity of $5 million.

• The company just earned a net income of $1 million and paid $200,000 in dividends.
• The total number of shares outstanding is 50,000.
• UPS Inc.’s beta is 1.1, the risk-free rate is 4.5% and the risk premium is 8.0%
• Dividends are expected to grow at a constant rate.
Denise then read the report on Chemico. She made the following comment to Thomson:
“I believe that your estimate of the initial growth is too optimistic. A growth rate of 10%
is more in line with the company’s fundamentals.”
37. Thomson’s selection of a valuation model is most appropriate for:
A. ABC Foods.
B. White Enterprises.
C. neither ABC Foods nor White Enterprises.

38. The capital gains yield for the stock of Glee Products Incorporated is closest to:
A. 6.70%.
B. 11.56%.
C. 16.56%.
39. Which of the following about Thomson’s valuation of the YLS Enterprises stock
is most accurate?
A. Thomson is most likely using a lower dividend yield than implied by

market prices.
B. Thomson is using a growth rate estimate that is 1.25% lower than that
implied by market prices.
C. Thomson is using a 1.25% higher required return estimate or a 1.25%
lower growth estimate than is implied by market prices.
40. Which of the following about Chemico’s stock is most accurate?
A. A two-stage DDM model is appropriate for valuation, with the first stage
representing 1.24% of total value and the second stage representing
98.76% of total value.
B. A three-stage DDM model is appropriate for valuation, with the second
and third stage representing 97.46% of total value.
C. A three-stage DDM model is appropriate for valuation, with the first stage
representing 1.24% of total value and the second stage representing
97.46% of total value.
41. Chemico stock has a value closest to:
A. $76.66.
B. $84.11.
C. $87.84.
42. Assuming Denise’s comment about Chemico’s stock is accurate, which of the
following will be most consistent with the revised estimate?
A. A revised transition period of 15 years

B. A revised initial growth stage of 1 year
C. A revised transition period of 9 years

Questions 43 through 48 relate to Equity Investments
Randy McCrea Case Scenario
Randy McCrea, an equity portfolio manager, is working as a consultant analyst for a

number of investment management firms. McCrea’s most recent assignment involves the
analysis of Trunol Inc. and Depinol Inc., both operating in the oil extraction and
exploration industry of the market. Due to the nature of its business, Trunol reports
considerable amortization expenses in its financial statements that are expected to
continue for some years. No other unusual expenses are reported in Trunol’s financial
statements or notes to financial statements. McCrea is using the P/E multiple to value the
company’s stock. Exhibit 1 displays information that Trunol made public as of April
2010.
Exhibit 1
Trunol EPS
Measure Full year 2009 1st Quarter of 2009 1st Quarter of 2010
Reported EPS $5.67 $1.34 $1.78
Core EPS $4.95 $1.44 $1.51
*Core EPS makes adjustments for amortization charges
Depinol Inc. operates in a specific sub-sector of the oil exploration industry. When
assessing the performance of this sector, and the firm in specific, McCrea made the
following observations:
Observation 1: P/E’s are negatively related to the recent earnings growth rate but
positively related to the anticipated future growth rate.
Observation 2: The company has seen considerable increase in its total assets over the
past five years, with liabilities increasing at a much slower rate. Depinol’s
current financial statements, however, include a large asset write-down.
In preparing a report on the valuation of the two firms, McCrea made the following
comments:
Statement 1: “Inverse price ratios are commonly used by practitioners when discussing
valuation. Although the inverse price ratio of P/S and P/CF are rarely
used, the inverse ratio of P/D is much more commonly used, especially in
discussing index valuation.”

Statement 2: “The DDM approach supplies accurate valuations if a company pays cash
dividends. If, however, the company engages in share repurchases, the
model cannot be adjusted to account for their effect on the per-share
growth rates of dividends.”
McCrea is also valuing The In-State Corporation (ISC), a U.S. based insurance company.
McCrea knows that the P/BV multiple is appropriate for valuing financial institutions,
and hence, is planning to determine the multiple’s value for ISC. The closing price for
ISC was $56.00/share as of 31 December 2009. Exhibit 1 presents selected information
from the firm’s financial statements.
Exhibit 1
In-State Corporation ($ in millions) financial information as of Dec 31, 2009
Item Value
Common Stock, $0.01 par value, 1.0 billion shares authorized and 500
5
million issued
Additional paid-in-capital 1,052
Retained income 12,837
Treasury stock, (200 million) 10,384
Accumulated other comprehensive income 326
Total liabilities 105,293
After computing a comprehensive estimate of value, McCrea decided to meet with one of
his clients over lunch to discuss the security selection process. During lunch, the client
made the following comment:
“I am trying to use the P/E peer- group comparison approach to determine over/under
valuation of an electronics stock I own. The problem is that the peer group I selected
includes a company that has a very large multiple relative to others due to high-growth
prospects, and maybe, a little mispricing. In addition, one of the companies has a very
low multiple. I am not sure how this could affect the average, or in other words, the
benchmark that I would use.”
While advising his client, McCrea made the following comment:
“I suggest you remove the effect of outliers from the benchmark used.”

The client then posed the following question:
“In using multiples in an investing strategy, what problems should an investor be aware
of?”
McCrea continued with a discussion of the various issues faced by investors when using
ratios in an investment setting.
43. The trailing P/E multiple that closely reflects Trunol’s underlying earnings as of
April 2010, if the share price equals $56.78/share, is closest to:
A. 9.293.
B. 11.311.
C. 11.471.
44. Based on the observations made by McCrea about Depinol, which of the
following will be the most appropriate EPS value to use in calculating the firm’s
P/E multiple?
A. Historical core EPS that adjusts for the large write-down

B. Historical average EPS, with no adjustment for the write-down
C. EPS calculated using the average return on equity and BVPS with an
adjustment for the write-down
45. McCrea is most accurate with respect to:
A. Statement 1 only.
B. Statement 2 only.
C. neither Statement 1 nor Statement 2.
46. The price-to-book-value per share for ISC is closest to:
A. 4.38.
B. 7.30.
C. 28.44

47. If McCrea’s client that he met over lunch follows his advice, which of the
following would be the most likely consequence of doing so?
A. The arithmetic mean would increase, the harmonic mean would decrease,
and the median may increase or decrease
B. The arithmetic mean would decrease, the harmonic mean would increase,
but the median would remain constant
C. The arithmetic mean and the harmonic mean would decrease, but the
median would remain constant
48. The best response to the client’s question is that an investor should be aware of
the:
A. look-ahead bias.
B. screening bias.
C. survivorship bias.

Questions 49 through 54 relate to Fixed Income.
Juan Dwight Case Scenario
Juan Dwight is a fixed income analyst serving a research firm. The firm has hired three
junior analysts each of which will be reporting to Dwight. During their first day at work,
Dwight conducts a training session where he aims to accomplish the following four tasks:
Task 1: Explain the forward pricing model and how the model can be used to eliminate
potential arbitrage opportunities.
Task 2: Explore the relationship between yield-to-maturities, expected rate of returns on

bonds, and spot rates.
Task 3: Evaluate the pricing of a bond based on the relationship between quoted forward
rates and expected future spot rates.
Task 4: Analyze spread measures.
For his first task, Dwight collects information on three zero-coupon investment strategies
(A, B and C) with respective prices, maturities and purchase dates (Exhibit 1).
Exhibit 1:
Details Concerning Three Zero-Coupon Securities
Purchase
Discount Maturity Date (Years
Security Factor (Years) from Today)
A 0.97087 1 0
B 0.90703 2 0
C 0.79383 3 0
For his second task, Dwight shares his observations regarding the relationship between
rates of return. His observations use data from Exhibit 1.
Observation 1: “The yield-to-maturity of each default-free issue is a reasonable estimate

of its expected rate of return.”

Observation 2: “The yield-to-maturity of a two-year bond with an embedded call option

should equal to that quoted for security B.”
For his third task, Dwight collects expected future spot rates, forward rates and current
spot rates for three zero-coupon risk-free securities; D, E and F (Exhibit 2).
Exhibit 2:
Expected Future Spot Rates, Current Spot
Rates And Quoted Forward Rates for D, E and F
Maturity Expected Quoted
Point Future Spot Forward Current
Security (Years) Rate Rate Spot Rate
D 1 7% 9% 11%
E 2 15% 12% 7%
F 3 18% 14% 7%
The analyst concludes her analysis by analyzing the average percentage change in three
spread measures observed between the years 2005 to 2010 (Exhibit 3).
Exhibit 3:
Average Percentage Change in Spread Measures (2005 to 2010)
Spread Percentage Change
I-spread + 5.5%
TED spread + 7.8%
LIBOR-OIS spread - 6.2%
49. In order to eliminate the potential for arbitrage profits, an investor seeking to
invest in a one-year zero coupon bond two years from today should expect a
payoff which is equivalent to that of security:
A. A.
B. B.
C. C.

50. Using the information in Exhibit 1, relative to the forward yield curve the position
of the spot curve will be:
A. lower.
B. higher.
C. the same.
51. Dwight is least accurate regarding:
A. Observation 1.
B. Observation 2.
C. both his observations.
52. Based on the data in Exhibit 2 and assuming projections are realized, which of the
following conclusions is most valid?
A. Security E is undervalued.
B. Security D is being discounted at a lower rate by the market relative to the
investor.
C. The return on Security F will be more than the one-period risk-free interest
rate.
53. Using the data in Exhibit 2, an investor with a three year investment horizon can
realize arbitrage profits from rolling down the yield curve if:
A. Security E is purchased.
B. Security F is purchased.
C. the slope of the yield curve changes to upward sloping.
54. Using the data in Exhibit 3, the percentage change in the TED spread indicates a
(n):
A. increase in Treasury bill rate.

B. increase in counterparty risk.
C. decrease in the liquidity of money market securities

Questions 55 through 60 relate to Derivatives.
Neon Strategists (NEST) Case Scenario
Mark Holmes works for an investment management firm that specializes in managing
funds invested in traditional stock and bond investments. Holmes has decided to leave his
current employer to work for Neon Strategists (NEST), a firm that specializes in using
combinations of derivative investment strategies to achieve above-average returns.
Holmes is doubtful of his expertise with derivative strategies, since he had only handled
traditional asset classes at his current employer. Before joining NEST, Holmes decided to
learn more about derivatives from Peter Stephenson, a specialist in the industry. On his
first day at Stephenson’s training program, Holmes learned about put and call options.
When talking about option strategies, Stephenson stated that an option could be created
using a combination of other securities. He stated the following ways to create a synthetic
position in a stock and a bond.
Synthetic stock position: Go long a call option and short a put option with the same
exercise priceas the call. In addition, lend money by investing in a bond with a face value
equal to the exercise price of the options and that matures on the options’ expiration day.
Synthetic bond position: Purchase a put option, and sell a call option with the same
exercise price as the put. In addition, issue a zero-coupon bond maturing on the options’
expiration day, and paying an amount equal to the exercise price.
To further illustrate alternative equivalent combinations involving options, Stephenson

presented the following information about a European put and call option:
• European put has an exercise price of $50 expires in 235 days.

• The underlying stock is priced at $57.
• The put sells for $2.67, and a call, with the same exercise price and time to expiration
as the put, sells for $9.25.
• The risk free rate is 4.0%.

Stephenson proceeded the session with an example of the stock of Runway Fashion
(RUFA), a leading fashion label in Ohio, USA. The stock was currently valued at
$150/share and it paid no dividends. The risk-free rate used in the analysis was 7.5%.
Stephenson demonstrated how to calculate the price of a European call option selling on
the stock. He stated:
“I believe that RUFA’s stock can either go up by 35% or go down by 20% during the
coming year.”
Holmes was glad that he joined the training program since he learned a lot from the
session. He was, however, still confused about the Black-Scholes-Merton Model, which
he found the most difficult to understand of all the option pricing models. When he
inquired about the interaction of the various inputs to the model, Stephenson made the
following comments about European options:
Comment 1: “Call option prices should be higher, the higher the underlying price and
the higher the risk-free rate. Put option prices, on the other hand, should be
lower, the higher the underlying price and the higher the risk-free rate.”
Comment 2: “Both put and call option prices increase with the increase in volatility and
time to expiration.”
After listening to his comments, Holmes posed the following question:
“When will a delta hedge work poorly?”
When the session was over, Holmes thanked Stephenson for his cooperation and set up
an appropriate time and day for the next session.
55. With respect to the creation of synthetic positions, Stephenson is most accurate
with respect to:
A. the synthetic stock position only.

B. both the synthetic bond position and the synthetic stock position.
C. neither the synthetic bond position nor the synthetic stock position.

56. Based on the information provided by Stephenson about the European call and
put, which of the following is most accurate?
A. No arbitrage opportunity exists using the European put and call options.
B. A risk-free gain can be realized by selling the call and buying the synthetic
call.
C. A risk-free gain can be realized by buying the call and selling the synthetic
call.
57. Given that Stephenson’s comment about RUFA’s stock is accurate, the cost ofthe
at-the-money option should be closest to:
A. $24.42.
B. $39.07.
C. $94.19.
58. If a European call option on RUFA’s stock is selling for $30, using 1,000 call
options, a risk-free profit of:
A. 15.50% can be earned with an investment of $65,454.

B. $6,002.18 can be earned without any net investment of money.
C. 17.75% can be earned without any net investment of money.
59. Stephenson is most accurate with respect to:
A. Comment 1 only.
B. Comment 2 only.
C. both comments 1 and 2.
60. The best response to Holmes’s question is that a delta-hedge works poorly when:
A. the option is in-the money and far from expiration.

B. the option is out-of-money and close to expiration.
C. there is more uncertainty about whether the option will expire in- or out-
of-money.

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CFA Level II Mock Exam 2 – Questions (AM)

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FinQuiz.com – 2nd Mock Exam 2016 (AM Session)

Questions Topic Minutes

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Questions 1 through 6 relate to Ethical and Professional Standards

Octagon Investments (OCTIN) Case Scenario

Pamela Santos Lopez is a portfolio manager at Octagon Investments (OCTIN), a large

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4. With respect to research analyst compensation, is OCTIN most likely in

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Questions 7 through 12 relate to Quantitative Methods

Quarter Investment Advisory (QIA) Case Scenario

Quarter Investment Advisory (QIA) is a medium-sized, U.S. based, money management

Exhibits 1 and 2 display the results of the first regression.

D/E and Growth in inventories 0.88

Growth in inventories and analyst following 0.85

Analyst following and D/E 0.98

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He concluded his presentation with the following remark:

7. With respect to his point concerning regression 1, and a 5% significance level,

A. the significance of t-statistics and the F-statistic.

8. With respect to conclusion 1 about the modified regression 1 to be presented

9. With respect to Conclusion 2 about the modified Regression 1 to be presented

10. At a 5% significance level, is the autoregressive model correctly specified?

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12. With respect to his concluding remark, Marshall is most likely:

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Questions 13 through 18 relate to Economics

Black-Rock Investments (BRON) Case Scenario

• C$/U.S.$ spot rate (mid-market): 0.856

Statement 1: “For countries following an expansionary monetary policy along with a

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Statement 2: “For an emerging economy, a uniformly expansionary fiscal/monetary

A. a fully currency-hedged Canadian money market instrument.

A. A fully currency-hedged Canadian money market instrument.

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A. covered interest rate parity will hold.

16. Ford is most accurate with respect to:

A. weaken versus the euro in real terms.

A. weaken versus the euro in real terms.

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Questions 19 through 24 relate to Corporate Finance.

Moonwalk Electronics (MWE) Case Scenario

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Comment 2: “Economic income is based on the economic depreciation rather than

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A. has the potential to violate market efficiency.

A. The decision will change.

A. The decision will change.

24. Wilton is most accurate with respect to:

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Questions 25 through 30 relate to Financial Reporting and Analysis.

Smart Investments (SMIN) Case Scenario

Sales $575 $521

Net Profit $79 $71

Inventories $135 $110

Total current assets $378 $285

Total assets $650 $595

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