The Association for Investment Management and Research (AIMRsm) does not endorse, promote, review,

or warrant the accuracy of the products or services offered by organizations sponsoring or providing
CFA® exam preparation materials or programs, nor does AIMR verify pass rates or exam results claimed
by such organizations.

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

SUPERVISOR

2002 CFA® Level II SASF Mock Exam

ANSWERS

Instructors:
Peter Chau, CFA
Patrick Collins, CFA
Don Davis, CFA
Jivendra Kale
Jim Keene, CFA
Terry Lloyd, CFA
Dion Roseman, CFA
Prof. John M. Veitch, CFA
Loren Walden, CFA
Brad Walters, CFA

The Security Analysts of San Francisco

SASF CFA®Level II 2002 Mock Exam

Saturday, May 11, 2002

Questions Topics Time Instructor

Item Set
1 – 10 Financial Statement Analysis SS # 5 15 minutes Brad
Walters
11 – 29 Equity Analysis SS # 9-13 27 minutes Terry Lloyd
30 – 39 Ethics SS # 1 & 2 15 minutes Loren
Walden
40 – 54 Debt Instruments SS #14 & 15 21 minutes Peter Chau
55 – 60 Quantitative Methods SS # 3 & 4 12 minutes J Veitch/J
Kale
Total 90 minutes
Essay
61 – 63 Economic Methods SS # 4 20 minutes John Veitch
64 Financial Statement Analysis SS # 6 & 7 18 minutes John Veitch
65 – 68 Basic Valuation SS # 8 20 minutes D Davis
69 Derivatives SS # 17 & 18 12 minutes John Veitch
70 – 75 Portfolio Management SS #20 20 minutes Patrick
Collins
Total 90 minutes

Please note that the distribution of questions on the SASF CFA Level I Practice exam
broadly reflects the weights placed on each subject area by the CFA Level I study guide.
There is no guarantee that the questions on the actual CFA exam will reflect these relative
weights.

2
The Association for Investment Management and Research (AIMRsm) does not endorse,
promote, review, or warrant the accuracy of the products or services offered by organizations
sponsoring or providing CFA® exam preparation materials or programs, nor does AIMR
verify pass rates or exam results claimed by such organizations.

3
Study Session #5 – Financial Statement Analysis
 2002 Brad Walters, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited
without permission.

1. A debt security in a held-to-maturity portfolio should be reported on the balance sheet

at__________________.

A. Market Value
B. Historical Cost
C. Present Value of future cash flows
D. Market Value less dividends and interest

2. A debt security in an available-for-sale portfolio should be reported on the balance sheet

at__________________.

A. Market Value
B. Historical Cost
C. Present Value of future cash flows
D. Market Value less dividends and interest

3. What ownership level is generally required to consolidate a subsidiary for financial

reporting purposes?

A. >20%
B. 20-50%
C. >50%
D. >60%

4. What degree of influence is generally required to consolidate a subsidiary for financial

reporting purposes?

A. Significant influence
B. No significant influence
C. Control
D. None of the above

5. Under the cost method of accounting for investments, market value changes in the value
of the investment are not recognized on the balance sheet until there is an actual:

A. Appraisal
B. Cash flow analysis
C. Transaction
D. Net present value calculation

4
6. The equity reported on consolidated financial statements is ____________ the equity
reported on the parent-company-only financial statements.

A. Less than
B. Greater than
C. Equal to
D. Sometimes less and sometimes more than

7. Reportable segments are defined as components of the enterprise that account for at least
_______ of any one of the following:
(1) Total revenues (before elimination of intersegment sales);
(2) Combined operating profit (of profitable segments), or its operating loss must exceed the
same required percentage of the combined operating loss of segments with losses;
(3) Combined identifiable assets of all segments.

A. 5%
B. 10%
C. 25%
D. 50%

8. Segment data are most useful for which of the following?

A. Information on segment liabilities

B. Information on segment profitability
C. Trend analysis
D. Segment cash flow analysis

9. Which of the following is the term given to the method of accounting for an acquisition
that requires writing-up assets to their fair value?

A. Pooling of interests method

B. Purchase method
C. Consolidation method
D. Direct cost method

10. Which of the following is the term given to the method of accounting for an acquisition
that may require recording goodwill on the balance sheet?

A. Pooling of interests method

B. Purchase method
C. Consolidation method
D. Direct cost method

5
Study Session #9 – Equity Investments
 2002 Terry Lloyd, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without
permission.

11. High product volume is typically associated with which strategy?

A. cost leadership
B. product differentiation
C. focus
D. diversification

12. Consolidation typically starts in which phase of a company’s life

A. pioneer
B. growth
C. mature
D. decline

13. All of the following, except one, are accounting elections a company can make that lead
to incomparability of financial statements between firms.

A. inventory methods (such as LIFO/FIFO)

B. accrual of accounts payable (as incurred or as paid)
C. depreciation methods (such as straight line/accelerated)
D. revenue recognition (such as evenly or completed contract)

[the correct answer is b; under accrual accounting, the obligations must be booked as they are
incurred]

14. Which of the following is a limitation of ratio analysis on a company’s financial

statements?

A. they are based on GAAP

B. they are backward looking
C. they do not provide industry context
D. all of the above

15. Economic Value Added differs from other valuation measures in that it recognizes the
cost of

A. options
B. equity
C. dividends
D. internal growth

6
16. The two-stage dividend discount model is best for which kind of firm?

A. firms in a high growth phase expected to decline to a lower rate and then a
constant rate
B. firms with growth rates at or below the nominal growth in the overall
economy
C. firms in a current high growth phase with an expectation of slowing
growth
D. firms whose dividend growth rates follow a linear or “H” pattern to a steady
rate

17. The constant, or “Gordon Growth,” model of estimating value based on cash flows relies
on all of the following assumptions except one.

A. the company’s business is mature or has “plateaued”

B. discretionary cash flow is growing at a steady rate
C. they buyer’s required rate of return is steady over the projection period
D. the terminal cash flow is at a constant multiple

[the correct answer is d; there is no terminal value in the calculation]

Study Session #10 & 11 – Equity Investments

 2002 Terry Lloyd, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without
permission.

18. Which of the following best describes the Free Cash Flows to the Firm?

A. it starts with net income and adds back interest, taxes and depreciation
B. it is taken from the operating cash flows section of the statement of cash flows
C. it measures the free cash flows to the firm after allowances for preferred
dividends and a reinvestment of capital
D. it is the GAAP operating income plus an add back for depreciation and
amortization

[the correct answer is c; it measures how much cash is available for distribution to the equity
holders after reinvestment and payments to debt and preferred holders]

19. What is the difference between dividends and cash flow?

A. nothing; it is a difference of terminology

B. it is a timing difference for accounting purposes between the year earned and
the year paid
C. it is the difference between what can be paid out and what is paid out
D. cash flow has interest added back

7
20. The price earnings ratio is increased by only which of the following?

A. the riskiness, or volatility of the company’s business

B. an increase in interest rates
C. the company’s growth rate
D. a higher payout ratio

[the correct answer is c; all the other factors will decrease the PE ratio]

21. Advantages of the price to sales ratio are all of the following, except:

A. revenue is harder (but not impossible) to manipulate than earnings

B. it is useful for money losing firms
C. revenues tend to be less volatile than GAAP earnings
D. all of the above

22. Which of the following will make the price to sales ratio higher?

A. a higher profit margin (gross or net)

B. higher risk factors
C. a lower growth rate
D. all of the above

23. All of the following are problems associated with using ratios for cross-border valuations,
except:

A. the differences in accounting for consolidations

B. the use of reserves to manipulate earnings
C. the use of inflation factors for fixed assets
D. they are all problems

Study Session #12 & 13 – Equity Investments

 2002 Terry Lloyd, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without
permission.

24. All of the following are traditional measures of performance except

A. basic earning power (EBIT /total assets)

B. return on assets (net income / total assets)
C. economic value added (economic performance – cost of capital)
D. return on equity (net income / equity)

[the correct answer is c; the others are incorrect]

8
25. Tobin’s Q is measured as:

A. market value of the firm’s equity divided by the replacement value of the
assets
B. the compound growth rate of earnings implied by the current share price
C. the firm’s current share price divided by the index for the firm’s industry
D. the market value of assets divided by the replacement value of the assets

26. The relationship between EVA and MVA is

A. there is no relationship
B. they are virtually the same thing
C. MVA = EVA / WACC
D. EVA = MVA / WACC

27. Cash Flow Return on Investment analysis indicates that the share is a buy if the indicated
return on the investment exceeds the current price using

A. the nominal rates of growth

B. the historical rates of growth
C. the firm’s weighted average cost of capital
D. the market-wide discount rate

28. Market Value Added (MVA) is calculated as

A. the market value of the firm’s debt and equity less the book values for
those items
B. the implied value for the firm’s equity using a weighted average cost of capital
C. basically the increase in equity before the payment of dividends
D. the changes in market prices for the firm’s debt and equity securities over a
period

[the correct answer is a; the others are incorrect]

29. Which of the following is true for estimating the income of zero income stocks, such as
ecommerce companies?

A. projected results will follow a bimodal distribution

B. industry statistics will provide a baseline for evaluation
C. a “buildup” approach for the discount rate will provide a reasonable estimate
for evaluating discount rates
D. the sensitivity of the growth and discount rates has less impact than on
established companies

9
Study Session #1 & 2 – Ethics
 2002 Loren W. Walden, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited
without permission.
TOTAL OF 15 MINUTES FOR THIS ITEM SET

Jamie Howard, a CFA level II candidate, works as a consumer durables analyst for CD Advisors. The
firm specializes in managing individual portfolios for families and trusts. Recently, the firm has made a
strategic shift toward marketing to institutional investors, specifically corporate pension funds. As part of
Jamie’s duties as an analyst, she is required to review proxy issues for all of the companies she covers.
And, while CD Advisors does not vote on proxy issues, the firm believes that understanding all proxy
issues is important. Upon learning that the firm is trying to attract corporate pension accounts, Jamie
recalls that proxies must be voted for corporate pension accounts and informs her advisor of this rule.
Her advisor reminds her that while she is a CFA candidate, the firm itself has not adopted the AIMR Code
and Standards and is thus exempt from this rule.

30. Which of the following statements is/are TRUE?

A. Voting proxies for corporate pension accounts is required regardless of AIMR’s Code
and Standards because under ERISA, all proxies must be voted.
B. Voting proxies is required for all individual accounts as well as ERISA accounts
under AIMR’s Code and Standards.
C. Voting proxies can be delegated to a third party consultant.
A. Both A and C are true

Jamie is asked by the research director to cover EG, a large consumer products manufacturer located in
the U.K. She remembers that one of her graduate school classmates works as an analyst in London and
gives him a call. It turns out that he has just written an extensive report on EG and has given the stock a
strong buy rating. He offers to fax a copy to Jamie so that she may learn more about EG. After reviewing
his conclusions and getting basic information on the company from the EG company website, she too
concludes that the stock is a strong buy and writes a brief report including the model of her classmate.
She decides it is not necessary to do any further research because her friend works for a large investment
firm known for their thorough research. And, since the firm’s reports are widely disseminated and used,
she believes she does not need to get permission to incorporate the model into her work.

31. Which of AIMR’s Code and Standards have been violated?

A. Standard III Relationships and responsibilities to her employer because she did not
exercise sound judgment in her investment conclusions.
B. Standard IV Relationships with and responsibilities to clients and prospects because
she did not exercise diligence and thoroughness in her research recommendations.
C. Standard II Relationships with and responsibilities to the profession because she did
not get written permission to use her friend’s report and did not give written credit to
the source.
D. B and C only.

10
32. Which following statements is FALSE?
A. Under ERISA, a fiduciary must have a written investment policy.
B. Under ERISA, a fiduciary can outsource management responsibilities for the
management of the pension fund.
C. Under ERISA, a fiduciary must adhere to the basic principals of modern portfolio
theory.
D. None of the above because they are all true.

33. Which of the following is NOT an element of a “firewall” used to contain material non-public
information.

A. Control over interdepartmental communications.

B. Limit information dissemination of insider information to appropriate employees
only. Also known as “key access persons”.
C. Review of all employee trades against a restricted list.
D. None of the above because they are all key elements of a “firewall”.

Questions 5 though 9 are to be answered from the case below:

Thomas Whitman, CFA, is the senior portfolio manager for Red Tree Capital, a large independent
investment advisor that has $2 billion under management comprised of corporate pension accounts and
family trusts. The firm has adopted AIMR’s Code and Standards and all newly hired employees are given
a copy of the code and asked to sign a document stating that they have read the code. Thomas is
responsible for all junior portfolio managers and the trading staff as part of his duties.
One of his traders recently received a block trade order given to him by portfolio manager Jeff
Johnston, CFA. The following quote is Jeff speaking to the trader:
“I just got off the phone with our biotech analyst, Frederica Fortune. She said that Genetime is
ripe to be bought by a large pharmaceutical company and that it is a bargain at any price below $12! She
also said that even though she has only been covering the stock a short period, her meeting with
management yesterday was upbeat and she is confident that management is going places. The fact that it
is a single product company in early trial phase did not temper her views because she believes the product
has the potential to be a blockbuster. The stock is at $11, go ahead and buy $10 million dollars worth- up
to a price of $12. I am putting it in all of my accounts and will get the account numbers to you as the
orders fill.”
The trade takes several days to complete and then Jeff decides which portfolios will get each
day’s order fills at the end of the trading session. Since the large pension accounts require more shares,
he has directed the majority of the first trades to these pension accounts to fill the appropriate allocation.

34. Which of the following statements about AIMR’s Code and Standards is FALSE:
A. The responsibility to supervise employees belongs solely to management.
B. One of the criteria for deciding if a manger has a fiduciary duty is to determine if the
manager is receiving a fee from the client.
C. If a firm does not have supervisory procedures put in place, a CFA candidate should
decline, in writing, any promotions to supervisory level until the firm adopts written
procedures.
D. Overhearing a discussion by corporate executives about material non-public
information not pertaining to a tender offer does not invoke the insider-trading rule.

11
35. By recommending Genetime, Frederica likely violated which of the following standard(s)?
A. Fundamental Responsibilities, for not knowing or complying with the rules.
And, she violated relationships and responsibilities to clients and prospects for
not exercising diligence and thoroughness and using independent judgment.
B. Relationships and responsibilities to clients and prospects; for not exercising
diligence and thoroughness and for not using independent judgment. And, she
violated fair dealing because she should have given her analysis to all portfolio
managers of her firm at the same time to prevent front running of accounts.
C. Both A and B are correct.
D. Neither A nor B are correct.

36. Thomas Whitman, CFA violated the Code and Standards because he:

A. Failed to supervise employee actions.

B. Failed to educate his employees of the code and standards making sure that they
understand the rules.
C. Failed to have written standards put in place to prevent certain accounts from gaining
advantage over other accounts because of size.
D. All of the above.

37. Which of the following statements is FALSE.

A. AIMR code and standards prohibits block order transactions without having the
exact allocation predetermined and in writing.
B. Jeff Johnston should have predetermined which portfolios, if any, should own shares
of Genetime instead of giving a block order for all of his accounts.
C. Jeff Johnston violated his fiduciary duties of care skill and prudence by purchasing
Genetime.
D. Jeff Johnston violated his responsibility to clients because he did not understand the
risk potential of the investment in Genetime.

38. Frederica’s meeting with management violated the following rule:

A. Insider trading on material non-public information with regard to a tender offer.

B. Selective dissemination since one-on-one meeting with management can no longer
occur under the 1997 Securities and Exchange Act covering fair disclosure.
“Regulation F.D.”
C. Both A and B.
D. One on one private meeting can be an integral part of analysis, thus no rule was
broken.

Debbie Nottingham, CFA, is asked to sit on the Board of Directors of Pineapple Trust, a private
endowment with $100 million in assets. Pineapple Trust does not pay her for her work as she chooses to
donate her time. She does however accept Pineapple’s offer to pay for her first class travel expenses to
their annual meeting on Kauai. Debbie has informed her employer and Pineapple Trust, in writing, of the
entire scope of the relationship. Her employer has NOT adopted AIMR’s Code and Standards.

12
39. Debbie violated which if any of the following rules of the Code and Standards:

A. She should have paid for her own travel since the value is greater than $100 and the
location is accessible by commercial means.
B. She has a direct conflict with her employer due to the amount of time it can
reasonably be assumed it will take her to fulfill her responsibilities as a director.
Even though her firm has not adopted the code, she is bound by the code. The code
prohibits this type of conflict and thus she is bound by the higher standard and must
not accept the directorship.
C. Both A and B.
D. Neither A nor B.

1.5 points per correct answer

Study Session #14, 15 & 16 – Debt Investments

 2002 Peter Chau, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without
permission.
TOTAL OF 21 MINUTES FOR THIS ITEM SET

Mohammad Farhad is a quantitative analyst in charge of monitoring the valuation and risk of a
portfolio consisting of Treasury bonds, AAA-rated callable and putable corporate bonds,
Treasury note and bond futures, and interest rate swaps.

The Treasury bonds have an aggregate face value of $1 billion and a current market value of
$1.05 billion. The modified duration is 8 years. Mohammad intends to compute the convexity as
well but has not completed his calculations.

The AAA-rated corporate bonds have an aggregate face value of $300 million and a current
market value of $300 million. Currently there are only callable bonds. Mohammad believes that
they will be called by the issuer if the yield curve drops (in a parallel fashion) by 120 basis points
(bp) or more. Based on fundamental analyses performed at another department, Mohammad
concludes that he does not need to be concerned about the credit risk of the AAA-rated corporate
bonds. However, because of their call features, these bonds obviously have interest-rate
sensitivities that may be different from those of non-callable bonds. The effective duration of the
corporate bonds is 3 years. Again, Mohammad intends to compute the effective convexity but
has not completed his calculations.

The holdings of Treasury note and bond futures, and of interest-rate swaps, are currently
minimal. However, Mohammad’s department intends to increase these holdings substantially as
part of a general strategy to manage interest-rate risk. The instruments under consideration are
10-year Treasury note futures and 5-year swaps that exchange a fixed rate for floating three-
month LIBOR.

13
40. The factors most likely to be important in analyzing the credit risk of the AAA-rated
callable corporate bonds are
A. borrower’s capacity to repay, political risk, long-term debt to equity ratio
B. negative pledge clause, regulatory issues, quality of management
C. coverage ratios, return on equity, limitation on asset sales
D. limitation on additional indebtedness, capitalization ratios, sources of
liquidity

41. If the yield curve shifts upward (in a parallel fashion) by 1 bp, the value of the entire
portfolio
A. will decrease by approximately $890,000
B. will decrease by approximately $930,000
C. cannot be determined from the currently known information
D. none of the above

42. For the purposes of risk management, Mohammad wants to see what happens if the yield
curve shifts (in a parallel fashion) by a large amount. If the yield curve shifts down by
100 bp, the value of the entire portfolio

A. will increase by more than $89 million

B. will increase by approximately $89 million
C. will increase by less than $89 million
D. cannot be determined from the currently known information

43. If the yield curve shifts up by 100 bp, the value of the entire portfolio

A. will decrease by more than $93 million

B. will decrease by approximately $93 million
C. will decrease by less than $93 million
D. cannot be determined from the currently known information

44. In order to compute the convexity of the Treasury bonds and the effective convexity of
the AAA-rated callable corporate bonds, Mohammad has available the following
resources:
i. a software program that implements a backward induction valuation methodology
within the binomial interest-rate tree framework,
ii. the current Treasury yield curve,
iii. the current Treasury rate volatility,
iv. the current AAA-rated non-callable, non-putable corporate bond yield curve, and
v. the current AAA-rated corporate bond rate volatility.
For the purposes of computing convexity of the Treasury bond, Mohammad needs to use:
A. i, and ii
B. i, ii and iii
C. ii and iii
D. more resources than the ones listed above

14
45. Refer again to the items in question 5. For the purposes of computing the effective
convexity of the AAA-rated callable corporate bonds, Mohammad needs to use

A. i and iv
B. i, iv and v
C. i, ii, iii, iv and v
D. more resources than the ones listed above

46. Mohammad is concerned about interest rates increasing sharply in the future, thereby
reducing the value of the portfolio. A reasonable strategy to mitigate such risk is to

A. take a long position in Treasury note futures and enter into a swap to receive
fixed and pay floating three-month LIBOR
B. take a short position in Treasury note futures and enter into a swap to receive
fixed and pay floating three-month LIBOR
C. take a long position in Treasury note futures and enter into a swap to pay fixed
and receive floating three-month LIBOR
D. take a short position in Treasury note futures and enter into a swap to pay
fixed and receive floating three-month LIBOR

47. Mohammad is interested in expanding the capabilities of his analytical tools to value
different interest-rate derivative instruments. He is considering the following:
i. use the Black-Scholes model to value Treasury note futures
ii. use the Black model to value options on Treasury note futures
iii. use the cash-and-carry arbitrage model to value Treasury note futures
iv. expand the arbitrage-free binomial model to handle interest-rate caps and floors
The following strategy makes sense

A. implement i, ii and iv
B. implement ii and iii
C. implement iii and iv
D. implement ii, iii and iv

Because of his brilliant work in analyzing the Treasury bond and AAA-rated callable corporate
bond portfolio, Mohammad Farhad has been promoted to oversee the analysis of mortgage-
backed securities and asset-backed securities as well. The mortgage-backed securities consist of
mostly FNMA pass-through certificates with an aggregate face value of $400 million and a
current aggregate market value of $410 million. The underlying mortgage pools have an original
maturity of 30 years, a current weighted average remaining maturity of 18 years, and a weighted
average coupon of 7%. Mohammad understands that prepayment is an important issue in
analyzing the mortgage-backed securities.

15
48. Mohammad estimates the prepayment rate of his FNMA pass-through certificates to be
120% PSA. Assuming that rate to persist for a year, the total principal prepayment for his
FNMA pass-through certificates over the next year is approximately

A. $24.0 million
B. $24.6 million
C. $28.8 million
D. $29.5 million

49. Mohammad’s boss plans to reinvest the cash flows (both interest and principal) from the
FNMA pass-through certificates in new FNMA pass-through certificates. Currently, these
instruments are priced at par and have underlying mortgage pools with an original
maturity of 30 years, a weighted average remaining maturity of 29.5 years, and a
weighted average coupon of 7%. Mohammed estimates that these new certificates are
likely to have a prepayment rate that is

A. higher than 120% PSA

B. approximately 120% PSA
C. lower than 120% PSA
D. not determinable using his available information

50. Mohammad wants to compare

i. the dollar amount of prepayment over the next year for $1 million face value of
his existing FNMA pass-through certificates, with
ii. the dollar amount of prepayment over the next year for $1 million face value of
the new FNMA pass-through certificates.
The most likely outcome is that

A. i is greater than ii
B. i is about the same as ii
C. i is less than ii
D. ii is close to zero

Mohammad’s boss also plans to add interest-only (IO) strips, principal-only (PO) strips, and
collateralized mortgage obligations (CMO) to the mortgage-backed portfolio. Mohammad wants
to explore the possible gains and losses on these instruments if interest rates move. He also wants
to build up his analytical tools to handle these instruments.

51. If interest rates go up, the greatest loss, per dollar of market value, will come from

A. FNMA pass-through certificates

B. IO strips of the FNMA pass-through certificates
C. a floater tranche of a CMO collateralized by FNMA pass-through certificates
D. an inverse floater tranche of a CMO collateralized by FNMA pass-
through certificates

16
52. If interest rates go down, the greatest gain, per dollar of market value, will come from

A. FNMA pass-through certificates

B. IO strips of the FNMA pass-through certificates
C. PO strips of the FNMA pass-through certificates
D. a planned amortization class (PAC) of a CMO collateralized by FNMA pass-
through certificates

53. Mohammad wants to implement a Monte Carlo simulation model because

i. backward-induction methods cannot be used to calculate option-adjusted
spreads
ii. analyses using nominal spread and zero-volatility spread have their limitations
iii. backward-induction methods cannot be used to value mortgage-backed
securities
iv. option-adjusted spread analysis is desirable

B. i, ii and iii
C. ii, iii and iv
D. i, iii and iv
E. ii and iv

54. Mohammad finished building a Monte Carlo simulation model in two days and started
computing the option-adjusted spread for the FNMA pass-through certificates. However,
in his haste, he put in an erroneously high market value and an erroneously high interest
rate volatility.

A. The two input errors tend to offset each other and the OAS is approximately
correct.
B. The two input errors compound and the OAS is too high.
C. The two input errors compound and the OAS is too low.
D. The erroneously high market value is irrelevant to the calculation of the OAS.

Mohammad’s boss bought $1 billion face value of inverse floaters and support tranches of a
CMO. Interest rates moved the wrong way and the portfolio lost many millions. However, the
losses did not appear on the books as a result of some creative accounting using a pyramid of
subsidiaries.

1.5 points per correct answer

17
Study Session #3 &4 – Quantitative Methods
 2002 Prof. John M. Veitch. All rights reserved. Reproduction in any form, in whole or in part, is prohibited
without permission.
TOTAL OF 12 MINUTES FOR THIS ITEM SET

A junior analyst has developed the following regression model to predict DSL subscription sales
based on consumer disposable incomes and computer sales.

DSLt = 26.44 + 2.6 DISPINCt + .098 COMPUTERt

t-values: (9.02) (1.98) (1.56)

Number of observations: 34 Correlation between

Standard error of estimate: 21.96 DISPINC & COMPUTER: .864
Unadjusted R2: .83 Durbin-Watson statistic: 2.04
1
F-stat: 87.95

DSLt = DSL sales subscriptions (in 100’s of millions of dollars) in quarter t

DISPINCt = Average annual per capita disposable income (in thousands of $) in quarter t
COMPUTERt = PC and Mac sales (in 100’s of millions of $) in quarter t

Variable Estimates for 2003:Q1

DISPINCt 34.69
COMPUTERt 286.70

Critical Values for Student's t-Distribution

Degrees of Area in Upper Tail
Freedom 5% 2.5%
28 1.701 2.048
29 1.699 2.045
30 1.697 2.042
31 1.696 2.040
32 1.694 2.037

Critical Values for F-Distribution at 5% Level of Significance

Degrees of Freedom Degrees of Freedom (df) for the Numerator
for the Denominator 1 2 3
28 4.20 3.34 2.95
29 4.18 3.33 2.93
30 4.17 3.32 2.92
31 4.16 3.31 2.91
32 4.15 3.30 2.90

55. The goodness of fit, or explanatory power, of a multiple regression equation is given by
A. The standard error of estimate for the regression
B. The F-statistic for the regression
C. The R2 for the regression
D. The t-values for the regression coefficients

18
 56. What is the forecast of DSL subscription sales for 1st quarter of 2003?
A. $14,473 million
B. $3,97670 million
C. $144.73 million
D. $3.9767 billion

57. What is the 95% confidence interval for the forecast of DSL subscription sales for 2003?
A. $ 99.932 to 189.529 million
B. $ 362,543 to 423,272 million
C. $ 9,993 to 18,952 million
D. $3.62543 to 4.23272 billion

58. What problems does this regression suffer from?

A. Possible multicollinearity and serial correlation.
B. Possible multicollinearity but no serial correlation.
C. No multicollinearity but possible serial correlation.
D. None of the above problems.

59. Which statement is correct for the regression model?

A. Neither DISPINC nor COMPUTER matters for DSL sales because their t-
values are low.
B. One or both DISPINC or COMPUTER matters for DSL sales because their t-
values are low.
C. Neither DISPINC nor COMPUTER matters for DSL sales because the value
of the F-statistic is high.
D. One or both of DISPINC and COMPUTER matters for DSL sales
because the value of the F-statistic is high.

60. What other potential problems does this regression suffer from given the information
provided?
A. Spurious regression due to the relationship of Computer sales to DSL sales.
B. Spurious regression due to the use of real variables in the regression.
C. Spurious regressions due to the use of nominal variables in the regression.
D. None of the above problems.

2 points each correct answer

19
Study Session #4 – Economic Methods
 2002 Prof. John M. Veitch. All rights reserved. Reproduction in any form, in whole or in part, is prohibited
without permission.
TOTAL OF 20 MINUTES FOR THIS ITEM SET

“Pick up line 3, will you?” “Huh? Me?” It’s your first day at Stagecoach Bank’s foreign
exchange dealing room and your new boss is too busy to even talk to you. But the little light on
the bank of telephone buttons has been flashing impatiently.
“Yes, you,” your new boss replies. “Its Ralph from Diamonds-R-Us in London. He wants
clarification on our bid and offer quotes for Spanish in terms of South African. Here you are.”
she says, “These are your direct quotes. “Give it a shot,” she says, “Try not to lose too much of
the bank’s money.”

Exhibit 1 SPOT 3-MONTH FORWARD 1-YEAR FORWARD

SPANISH PESETA Pta 183.164-183.204/US$ Pta 182.976-183.036/US$ Pta 182.481-182.581/US$

SO. AFRICAN RAND ZAR 7.8600-7.8700/US$ ZAR 7.888-8.038/US$ ZAR 8.235-8.285/US$

Diamonds-R-Us plans to sell gems and receive revenue denominated in Spanish Pesetas (Pta)
which they need to convert into in South African Rand (ZAR). Ralph will realize net proceeds of
20 million Pta at the end of 90 days and wants to eliminate the risk that the exchange rate of the
ZAR will change adversely relative to the Pta during this 90-day period.
Work out the required bid or ask cross rates for him. Exhibit 1 shows the current exchange rates
between the ZAR, Pta, and the U.S. dollar (US$).

61. Describe the currency transaction that Omni should undertake to eliminate currency risk
over the 90-day period.

Source of Risk
Action to eliminate
Be Specific!

Ralph should sell 90-day forward Pta

Currency risk arises from the possibility
against 90-day forward ZAR delivery (sell
that the ZAR will appreciate against the
90-day forward Pta against USD and buy
Pta over the next 90-day period.
90-day forward ZAR against USD).
1 point
1 point

20
62. Calculate the following:

Thing to calculate Calculation

Ralph is looking to sell Pesetas for Rand. Home country is S. Africa.

ZAR/Pta cross Peseta is the foreign currency. So bank quotes Ralph their bid rate to
currency rate to value buy Pesetas, the foreign currency.
the Spanish revenue.
Cross Bid = Bid/Ask = [ZAR 7.888/US$]/[Pta 183.036/US$]
3 points
= ZAR 0.043095/Pta

By buying the 90-day forward Ralph has locked the Rand value of the
Current value of Peseta revenue. Current value of the Spanish revenue in ZAR is:
Spanish revenue in ZAR Value = ZAR/Pta Cross Bid 90-day forward x Pta 20 million
ZAR.
= ZAR 0.043095/Pta x 20,000,000 Pta
3 points
= ZAR 861,900

The forward bid premium is the percent difference between the 3-

month forward cross-bid rate and the current spot cross-bid rate
annualized:

Annualized forward Cross bid spot = Bid/Ask = [ZAR 7.8600/US$]/[Pta 183.204/US$]

premium or = ZAR 0.042903/Pta
discount at which
 f3bid
month  espot
bid
  360 
the ZAR is trading Forward Premium    
bid   100
versus the Peseta.  espot   90 
3 points
 0.043095  0.042903   360 
    90  100
 .042903
= 1.79%

(11 MINUTES)
Exhausted from your phone ordeal, you begin to slump in your chair. Immediately another trader
hands you the following list of information. “Give us some insight into the ZAR vs. the US$
exchange rate, won’t you?” he says.

21
 Financial Information
Base price level (2000) 100
Current US price level (2001) 105
Current South African price level (2001) 115
Current Spanish price level (2001) 123
Base Rand spot exchange rate (2000) ZAR 5.714/US$
Current Rand spot exchange rate (2001) ZAR 7.784/US$
Expected annual US inflation (2002) 2.2%
Expected annual South African inflation (2002) 6.6%
Expected annual Spanish inflation (2002) 3.6%
Expected US one-year interest rate (2002) 3.2%
Expected South African one-year interest rate (2002) 11.45%
Expected Spanish one-year interest rate (2002) 5.2%
The trader tells you tells you to use the concepts of purchasing power parity (PPP) and the
International Fisher Effect (IFE) to forecast spot exchange rates.
63. Calculate the following:

Thing to calculate Calculation

Current ZAR spot PSA2001 = 115, PUS2001 = 105, e2000 = US$ 0.175/ZAR = $1/5.714 ZAR
rate in USD that
would have been PPP Rate2001 = e2000 x [PUS2001/ PSA2001]
forecast by PPP. = US$ 0.175/ZAR x [105/115] = US$ 0.1598/ZAR
3 points

rSA2002 = .1145, rUS2002 = .032, e2001 = US$ 0.127/ZAR = $1/7.784 ZAR

Using the IFE, the
expected ZAR spot IFE Rate2002 = e2001 x [(1+ rUS2002)/(1 + rSA2002)]2
rate in USD two = US$ 0.127/ZAR x [1.032/1.1145]2
year from now.
3 points = US$ 0.1089/ZAR

πSA2002 = .066, πUS2002 = .022, e2001 = US$ 0.127/ZAR = $1/7.784 ZAR

Using PPP, the
expected ZAR spot PPP Rate2005 = e2001 x [(1+ πUS2002)/(1 + πSA2001)]2
rate in USD two
years from now. = US$ 0.127/ZAR x [1.022/1.066]2
3 points = US$ 0.1167/ZAR

(9 MINUTES)

22
Study Session #6 & 7 – Financial Statement Analysis
 2002 Prof. John M. Veitch, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited
without permission.
TOTAL OF 18 MINUTES FOR THIS ITEM SET

Dilbert Lay, CFA is an analyst following NextGen Telecomm. In reviewing NextGen's 2001
annual report, Dilbert discovers the following footnotes (1)-(3). Dilbert feels a more accurate
picture of NextGen’s Balance Sheet, Income Statement and Cash Flow Statement can be arrived
at by reversing these transactions.

Footnote (1) During 2001, NextGen invested $50 million in a startup software company, called
NNG (Next NextGen). NNG immediately purchased a technology license from
NextGen for $20 million. In addition, NNG paid $25 million to hire twenty of
NextGen’s software engineers to develop software for use with the telecomm
equipment during the year. NNG has one employee and an office in a building
owned by NextGen.

Footnote (2) On December 31, 2000, NextGen raised the expected returns on its pension
investments by one percent up to 9.5% and lowered its inflation estimates by ½ %.

Footnote (3) NextGen sold Vodavox, a European telecomm, telecomm equipment valued at
$100 million which NextGen also financed. NextGen immediately sold off this
receivable from Vodavox for $100 million to a third party financial institution with
full recourse.

64. Indicate, for each of the three footnotes, the effect of Dilbert’s adjustments on the
financial ratios for NextGen shown in the template on the following page for:
i. the year 2001.
ii. the year 2002.

Note: Assume all financial information remains unchanged from 2001 through 2002, except that
referenced in the footnotes above.

Answer this Question using the Template provided on the next page.

23
Template for this Question

Effect on 2001 Ratio Effect on 2002 Ratio

Ratio (Circle One) (Circle One)

Footnote (1)
Operating Cash Flow / Sales Decrease No Effect

Net Income / Sales Decrease No Effect

Sales / Net Fixed Assets Decrease Increase

Footnote (2)
Operating Cash Flow / Sales Decrease/No Effect* Decrease/No Effect*

Net Income / Sales Decrease Increase

Sales / Net Fixed Assets No Effect No Effect

Footnote (3)
Operating Cash Flow / Sales No Effect No Effect

Net Income / Sales No Effect No Effect

Sales / Net Fixed Assets No Effect No Effect

1 point per correct answer

Footnote (1)
NextGen is using a shell company to essentially capitalize its Research & Development costs. Reversing
this transaction results in the following adjustments.
Operating Cash Flow / Sales: In 2001, operating cash flows must be adjusted down by the amount of the
technology license and software engineer expenses, $45 million. Cash Flows from Investment
would be raised by $50 million. Sales also fall by $45 million in reversing the transaction. In
2002, there is no effect because R&D is expensed in the year incurred.
Net income / Sales: In 2001, net income falls by the amount that sales fall. Since Sales is a larger number
than net income but both change by the same $ amount, the ratio for 2001 falls. The ratio for
2002 is unaffected.
Sales / Fixed Assets: In 2001, Sales fall by the $45 million. The investment in NNG is backed out, leaving
fixed assets $50 million lower. Thus the ratio falls for 2001 assuming that Sales are smaller than
Fixed Assets (If the opposite is true then the ratio rises). In 2002 the ratio will be higher as sales
are unaffected but fixed assets remain $50 million lower than previously.
Footnote (2)

24
Operating Cash Flow / Sales: In 2001, the change in pension assumptions lowers NNG’s pension
expense, which raises operating cash flows*. Reversing this change will lower operating cash
flow for 2001 and 2002 with no effect on sales in either year. Thus the ratio falls after adjustment
in both years.
* The direct effect of pension cost on operating cash flows is zero. If we assume that any changes
in pension cost immediately affect payment to pension liabilities then the original answer is
correct. If no immediate effect on pension financing cash flow then No Effect in both years.
Net income / Sales: Higher pension expense reduces net income in both years without affecting sales.
Again the ratio decreases in both 2001 and 2002.
Sales / Fixed Assets: Changes to the pension return assumptions do not affect fixed assets or sales. Hence
no effect on the ratio in either year.

Footnote (3)
This is a valid sale financed by NextGen, so sales revenue continues to be reported as before. Sale of
receivable with full recourse, however, means should bring the recievable back onto NextGen’s balance
sheet as an asset with offsetting liability.
Operating Cash Flow/Sales: As worded in the question the transaction would generate $100 million
operating cash with $100 million in CFF from sale of receivable. Bring receivable and associated
liability back on balance sheet changes CFF but not Operating Cash Flows. Hence correct answer
is No Change to ratio in either year.
Net Income/Sales: Sales are unaffected by the adjustment in both years. No expense items are involved
after adjustment, so net income is not affected in either year. We are assuming of course that
Vodavox doesn’t default on the obligation that would result in a charge against income in the year
of the default
Sales / Fixed Assets: The adjustment involves increasing accounts receivable and a liability account on
the balance sheet. It does not involve fixed asset category. Hence ratio is unchanged in both years.

Final Note: It is important to see that a same $ change in the numerator and
denominator does not mean the ratio remains unchanged. If Sales are $1000 and
Net Income is $200, then a fall of $50 in both sales and net income does change
the (Net income/Sales) ratio. Originally ratio was 200/1000 = 0.2 but after change
is 150/950 = 0.158, a decline in the ratio.

25
Study Session #8 – Basic Valuation
 2002 Don Davis, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without
permission.
The next four questions relate to the following Company (This material is an adaptation
of, and borrowed liberally from, the 1998 Level II CFA exam, Question 2.)

SASF Sample Company

Financial Statements: Yearly Data
Income Statement December December
2000 2001
Revenue $5,400 $7,760
Cost of goods sold 4,270 6,050
Selling, general, and admin. expense 690 1,000
Depreciation and amortization 40 50
Operating income (EBIT) $400 $660
Interest expense 0 0
Income before taxes $400 $660
Income taxes 110 215
Income after taxes $290 $445
Diluted EPS $0.84 $1.18
Average shares outstanding (000) 346 376

Financial Statistics December December

2000 2001
COGS as % of sales 79.07% 77.96%
SG&A as % of sales 12.78 12.89
Operating margin 7.41 8.51
Pretax income/EBIT 100 100
Tax rate 27.5 32.58

Balance Sheet December December

2000 2001
Cash and cash equivalents $50 $180
Accounts receivable 720 1,050
Inventories 430 690
Net property, plant, and equipment 1,830 3,550
Total assets $3,030 $5,470

Current liabilities $1,110 $1,750

Total liabilities $1,110 $1,750

Stockholders' equity 1,920 3,720

Total liabilities and equity $3,030 $5,470

Market price per share $30.00 $45.00

Book value per share $5.55 $9.89
Annual dividend per share $0.25 $0.40

26
 TOTAL OF 20 MINUTES FOR THIS ITEM SET

65. Using 2001 data only, calculate the 2001 ROE of this company (based on starting equity,
exclude issuances of new equity, assuming dividends are paid on average shares
outstanding), and break down the ROE into three components, per the duPont formula.
Show your work.

2001 ROE Formula Calculation

Starting Equity =
Starting Equity = 3,720 – 445 + (.40 x 376) = 3,425
Ending Equity – Net
Income + Dividends
ROE =
Net Income / Equity(t-1) = 445 / 3,425 = 13.0%
ROE = Net Income /
Equity(t-1) 1 point
2 points

DuPont
Formula
Components Component 1 Component 2 Component 3

ROE = Earnings / Sales x Sales / Assets x Assets / Equity

Formula
½ point ½ point ½ point

ROE = 445 / 7760 x 7760 / 5470 x 5470 / 3425 = 13.0%

Numbers
½ point ½ point ½ point

66. Based on 2001 data only, calculate the sustainable rate of growth. Show your work.

2001 ROE Formula Calculation

Retention Rate =
($1.18 EPS - $0.40 Dividend ) / $1.18 EPS = 66.1%
Sustainable Growth =
ROE x Retention Rate
ROE x Retention Rate = 13.0% x 66.1%
1 point = 8.6% Sustainable Growth
2 point

27
For the next year, it is projected that the SASF Sample Company will have the following
pattern:
VARIABLE ASSUMPTIONS
Revenue will rise 30% from 2001
Cost of goods sold (as % of sales) 2-year historical average
S, G & A expense (as % of sales) 2-year historical average
Depreciation and amortization 2% of 2001 property, plant, & equip.
Interest expense zero
Tax rate 34%
Shares outstanding no change

67. Construct a 2002 projected income statement and EPS for the SASF Sample Company
using the percent-of-sales forecasting method based on the above 2001 data and the
assumptions above.
Projected INCOME STATEMENT 2002
Numbers Calculations
Revenue 1 point $10,088 30% growth x 2001 revenues

Cost of Goods Sold 1 point
Selling, General &
Administrative 1 point
Depreciation 1 point
7,920 78.51% average x 2002 projected revenues
1,296 12.84% average x 2002 projected revenues
69 2% of 2001 property, plant, and equipment

Operating Income 803

Interest Expense 0 given

Income Before Taxes 803

Taxes 1 point 273 34% of Income before taxes

Net Income 530

Earnings per Share 1 point $1.41 Income after tax divided by 376,000 shares

68. Based on the sustainable growth, the projection assumptions in the income statement
above are not realistic. What are the two least likely projection parameters to be valid?
Parameters least likely
to be valid Reason
With a 30% level of projected revenues, and only an 8.6%
Zero Interest Cost sustainable growth rate, there will be a need for more debt
1 point (i.e.: 0 interest cost assumption is not valid). 1 point
AND/OR
With a 30% level of projected revenues, and only an 8.6%
No Change in Shares
sustainable growth rate, there will be a need for more equity
outstanding
(i.e.: no change in shares outstanding is not valid). 1 point
1 point

28
Study Session #17 & 18 – Derivatives
 2002 Prof. John M. Veitch. All rights reserved. Reproduction in any form, in whole or in part, is prohibited
without permission.
TOTAL OF 12 MINUTES FOR THIS ITEM SET

Lara Mundell Smith, CFA has been reviewing current equity call prices for SemiCon and has
noticed several discrepancies between several options prices and the basic option pricing
relationships. She bets you lunch at Aqua that you won’t be able to identify three of these
discrepancies.

Closing Prices on SemiCon Ltd Equity Call Options

May 3, 2002

Expiration Month
Close Strike May June July August
13.64 12.50 1.02 1.95 2.12 2.54
13.64 15.00 0.35 0.70 0.55 1.12
13.64 17.50 0.20 0.58 0.83 1.34

69. Identify three different apparent pricing discrepancies in the above table. Identify which
of the following basic option-pricing relationships each discrepancy violates.
[Note: the fact that options contracts do not always trade at the same time as the underlying stock
should not be identified as one of the discrepancies.]

Describe Discrepancy What options-pricing relationship violated?

May call is near expiration and in the money. Its value

should reflect at least its intrinsic value i.e. difference
May call with $12.50 strike is undervalued between current price minus strike ($13.64 - $12.50 =
2 points $1.14). Hence this call is undervalued.
2 points

Call options with same strike price but longer

July call at $15.00 strike is undervalued.
(alternatively June call at $15.00 is
overvalued.)
2 points
August call with $17.50 strike is
overvalued. (alternatively August call at
$15.00 is undervalued.)
2 points
maturities should be more valuable. Hence July call
should sell for more than June call. Table shows that
July call is selling for $0.55, less than the June call
selling at $0.70. Hence July call is undervalued.
2 points
Call options with same maturity but higher strike price
that are more out of the money should sell for less.
Why? A larger movement in underlying stock price is
needed for the higher strike price option to pay off.
Table shows that August $17.50 call is selling for more
than the August $15.00 call. Hence August $17.50 call
is overvalued.
2 points

29
Study Session #20 – Portfolio Investments
 2002 Patrick Collins, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited
without permission.
TOTAL OF 20 MINUTES FOR THIS ITEM SET

You are given the following information regarding the historical returns on two assets, X and Y:

Year Investment X Investment Y

1 6% -3%
2 -10% 8%
3 3% 15%
4 17% -6%
5 4% 1%

70. Calculate the Covariance of Investment X and Investment Y

Covariance Formula Calculation

of X and Y Average of x = 4%
Average of y = 3%
Covariance =
(1/n)Σ(xi – xavg)(yi – yavg) [(6-4)(-3-3)+(-10-4)(8-3)+(3-4)(15-3)+(17-4)(-6-3)+(4-4)(1-3)] / 5 =
1 point [(-12) + (-70) + (-12) + (-117) + (0)] / 5 =
-211 / 5 = -42.20
2 point

71. Calculate the Standard Deviation of Investment X and Investment Y

Standard
Deviation Formula Calculation
Investment X:
{[(6-4)2 + (-10-4)2 + (3-4)2 + (17-4)2 + (4-4)2] / 5}1/2 =
SDX =
Investment
[Σ(xi – xavg)2 / n]1/2 {[(4) + (196) + (1) + (169) + (0)] / 5}1/2 =
X
1 point (74)1/2 = 8.60
1 point

∗∗∗Correction∗∗
SDY = Investment Y:
Investment {[(-3-3)2 + (8-3)2 + (15-3)2 + (-6-3)2 + (1-3)2] / 5}1/2 =
[Σ(yi – yavg)2 / n]1/2
Y
1 point {[(36) + (25) + (144) + (81) + (4)] / 5}1/2 =
(50.8)1/2 = 7.62 1 point

30
72. Calculate the correlation of Investment X and Investment Y

Correlation Formula Calculation

of X and Y

ρXY = ∗∗∗Correction∗∗
Covxy /(SDx)(SDy) ρXY = -42.20 / (8.60)( 7.62) = -42.2 / 61.32 = -0.644
1 point 1 point

73. Calculate the expected return and standard deviation of a portfolio consisting of 30%
Investment X and 70% Investment Y.

Portfolio of
30% X and
70% Y Formula Calculation

E(Rp) =
Expected E(Rp) =
Portfolio (.04)(.3) + (.03)(.7) = (.012) + (.021) = .033 =
E(Rx)(%x) + E(Ry)(%y)
Return 3.3%
1 point
1 point

SDp = ∗∗∗Correction∗∗SDp =

Portfolio [(%x)2(SDx)2 + (%y)2(SDy)2 [(.3)2(8.60)2 + (.7)2(7.62)2 + 2(.3)(.7)(-42.2)]1/2

Standard = [(.09)(73.96) + (.49)(58.06) + (-17.72)]1/2
+ 2(%x)(%y)(COVxy)]1/2
Deviation
1 point = [6.66 + 28.45 – 17.72]1/2 = 4.17
2 points

74. Explain why a portfolio consisting of 30% investment X and 70% investment Y produces
a lower standard deviation than a portfolio consisting of 70% Y and 30% risk-free asset.

Answer:

By definition the variance of the risk free asset is zero. Therefore the variance of 70%
Investment Y and 30% risk free equals 70%(7.13) or 4.99 vs. 3.72. The lower variance of a
portfolio consisting of two assets each of which have high variance is caused by the negative
covariance (or correlation) between X and Y.
2 points

31
Consider the following information:

Beta Estimated Return Estimated Standard

Deviation
Investment A .8 12.5% 23%
Investment B 1.1 14.5% 28%

Variance of the Market: .0324

Return of the Market: 14%
Risk Free Rate: 4%

75. Calculate the Alpha of Investment B and determine an appropriate trading strategy for
Investment B.

Formula Calculation
Alpha is the difference between
Estimated Return and Required
Return (as determined by the Required Return of B = .04 + 1.1(.14 - .04)
Security Market Line under the = .04 + .11 = 15%
Alpha for Capital Asset Pricing Model)
Estimated Return of B = 14.5%
Investment B
Required return of Investment B = Alpha = 14.5% - 15% = -.05%
Risk Free Rate + 1 point
Beta(Market Return – Risk-Free
Rate) 1 point

Assuming that trading costs and taxes are not prohibitive, the portfolio manager
Trading
may wish to sell investment B if the portfolio currently owns it; or may wish to
Strategy for
short sell it given a reasonable expectation
Investment B
2 points

32
SASF Mock Exam CFA Level II 2002 Answer Key
It is difficult to compare your results on this practice exam with what your results are likely to be
on the actual CFA Level II exam. Each correct multiple-choice answer (Questions 1 – 69)
carries the value of 1.5 points. The total points on each short answer question (Questions 71 –
85) are equal to the number of minutes assigned to that question.
The SASF Level II mock exam thus has a total of 180 possible points. The following guide may
help you in identifying your areas of weakness.
60% 108 points correct out of 180 points
70% 126 points correct out of 180 points
80% 144 points correct out of 180 points
90% 162 points correct out of 180 points
If you scored 70% correct or below then you should go back and review the sections on which
you performed poorly. If you scored over 80% on the Mock exam it is likely that you are well
prepared for the actual CFA Level II exam. Please note that the Ethics section is a section on
which you MUST do well in order to pass the Level II exam. If you do not do well on the Ethics
section there is a possibility that you will not pass the exam even if you performed well on all the
other sections!!
ALL UNANSWERED QUESTIONS SHOULD BE COUNTED AS WRONG IN TOTALING UP YOUR SCORE.

PLEASE CONTACT INDIVIDUAL INSTRUCTORS IF YOU HAVE QUESTIONS ABOUT THEIR ANSWERS.

Answer Key
1. B 21. D 41. B 61. Item Set
2. A 22. A 42. D 62. Item Set
3. C 23. D 43. C 63. Item Set
4. C 24. C 44. B 64. Item Set
5. C 25. D 45. B 65. Item Set
6. C 26. C 46. D 66. Item Set
7. B 27. C 47. D 67. Item Set
8. C 28. A 48. C 68. Item Set
9. B 29. A 49. A 69. Item Set
10. B 30. D 50. A 70. Item Set
11. A 31. D 51. D 71. Item Set
12. C 32. D 52. C 72. Item Set
13. B 33. D 53. C 73. Item Set
14. D 34. A 54. C 74. Item Set
15. B 35. A 55. C 75. Item Set
16. C 36. D 56. A
17. D 37. A 57. C
18. C 38. D 58. B
19. C 39. D 59. D
20. C 40. D 60. C

33
Study Session #14 & 15 – Debt Investments ANSWER KEY
 2002 Peter Chau, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without
permission.

40. D. All the items listed are factors to consider in credit analysis. The question is: which
ones are more likely to be important? I would argue that return on equity is not that
important, although the components of ROE are important. I would also argue that
political risk and regulatory issues apply only to companies in particular sectors. The
factors in d are more generally applicable. My response is d. Final answer.

41. B. Value changes are based on market value, not face value.

42. D. Without applying a convexity adjustment, the increase in value of the total portfolio
for a 100 bp downward move is $93 million. The Treasury bonds have positive convexity,
and the callable corporate bonds have negative convexity as rates move down. The
combined effective convexity may be positive or negative. Therefore, one does not know
whether the convexity adjustment would be positive or negative.

43. C. Without applying a convexity adjustment, the decrease in value of the total portfolio
for a 100 bp upward move is $93 million. The callable corporate bonds have positive
convexity as rates move up. The combined effective convexity is therefore positive. The
value decrease is therefore less than $93 million.

44. B. The valuation model must be calibrated to both interest rate levels and volatility.

45. B. To value corporate bonds, the model should be calibrated to the corporate bond yield
curve and volatility.

46. D. A short position in Treasury note futures gains when interest rates go up. So does
engaging in a swap to pay fixed and receive floating three-month LIBOR. Strategy a is
obviously the opposite of what one wants to achieve. Strategies b and c have partially
offsetting positions.

47. D. The Black-Scholes model is used to value options, not futures. Using the Black model
to value options on futures is somewhat dubious, but the market does it anyway.

48. C. The mortgage pool is 12 years old (original maturity of 30 minus remaining maturity
of 18), way past the point at which the PSA prepayment curve flattens out. The annual
prepayment rate is therefore 6% * 120% or 7.2%. Multiply this by $400 million face
value (equal to principal balance) to get $28.8 million. This result is only approximate. A
more exact calculation would compute the prepayment month by month and account for
scheduled principal payments as well.

49. A. The 12-year-old mortgage pool has a PSA of 120%. Presumably, this pool has
experienced some burnout. A new pool, which has experienced no burnout, should have a
PSA of more than 120%. Note that the prepayment for the new pool in the next few years

34
 will still be low because of the age effect. However, this is already captured in the PSA
curve.

50. A. Even though the new pool has a higher PSA, the prepayment amount over the next
year from the seasoned pool should still be higher because of the age effect. Give
yourself partial credit for selecting d. Over the first year, the prepayment from the new
pool should still be small, but should have ramped up enough so that one can no longer
say it is close to zero.

51. D. An IO strip gains when interest rates go up. A floater tranche is relatively immune to
interest rate moves. A pass-through instrument may gain or lose, depending on whether
the instrument has a market value that is above or below par. The biggest loss is incurred
by an inverse floater. Remember Orange County?

52. C. PO strips gain when interest rates go down, mainly from increased prepayment. IO
strips lose for the same reason. A pass-through may gain or lose, but its gain, if any, can
never exceed that of the PO, since a pass-through is really a PO plus an IO. A PAC bond
is like a pass-through but with a much shorter, and more well-defined, average life.
Therefore, its interest rate sensitivity should be lower.

53. C. The main reason why one would go to a Monte Carlo model is because backward-
induction methods cannot be used to value instruments whose cash flows are history-
dependent; hence item iii must be included. Item i is patently false, since backward-
induction methods can be used to compute OAS of callable bonds. The correct answer
should contain item iii but not item i.

54. C. The OAS is a plug to make the model value match market price. OAS and model value
move in opposite directions: a higher OAS increases the discount rates and reduces the
model value, and vice versa. An artificially high market price therefore implies an
artificially low OAS. A FNMA pass-through has embedded in it a prepayment option that
is given up to the borrower. Option values always go up with volatility. The value of a
pass-through therefore goes down if volatility goes up. An artificially high volatility
depresses model value; hence OAS will have to be artificially low to compensate. The
two errors compound to give an overly low OAS.

35
 ADDITIONAL QUESTIONS/ANSWERS NOT INCLUDED ON
SASF MOCK EXAM 2002
Study Session #8 – Basic Valuation
 2002 Don Davis, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without
permission.

1. What is the unifying factor in all valuation approaches?

A. Cash Flow
B. Future Earnings
C. Intrinsic Value
D. Relative Value

2. Which form of analysis uses Monte Carlo techniques?

A. Sensitivity Analysis
B. Scenario Analysis
C. Simulation Analysis
D. Strategic Analysis

3. Which of the following is NOT a possible course of action for a company when
sustainable growth is less than actual growth?

A. Sell new equity

B. Increase leverage
C. Outsource manufacturing
D. Increase the dividend

4. Which of the following is NOT a potential flaw in the relative value approach to
valuation?

A. Difficulty in identifying comparable companies

B. Difficulty in determining a discount rate
C. Difficulty in “normalizing” ratios for accounting differences
D. Difficulty in determining the key ratios

5. List the three key assumptions of the discounted cash flow approach to valuation

A. CASH FLOWS CAN BE ESTIMATED WITH SOME RELIABILITY

B. CASH FLOWS MAY BE NEGATIVE NOW, BUT WILL BE POSITIVE
SHORTLY.
C. THE APPROPRIATE DISCOUNT RATE CAN BE ESTIMATED

36
 6. List 4 types of firms for which the discounted cash flow approach does not work well.

A. FIRMS IN TROUBLE
B. CYCLICAL FIRMS
C. FIRMS WITH UNUTILIZED ASSETS
D. FIRMS WITH PATENT OS PRODUCT OPTIONS

also correct: , any of: FIRMS IN THE PROCESS OF RESRUCTURING

FIRMS INVOLVED IN AQUIZITIONS
PRIVATE FIRMS

Study Session #9 – Equity Investments

 2002 Terry Lloyd, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without
permission.

7. All of the following, except one, are general strategies a firm can pursue.

A. cost leadership
B. product differentiation
C. focus
D. diversification

8. All of the following, except one, are standard phases in the business cycle

A. growth
B. defensive
C. cyclical
D. investment

9. Which of the following converts a firm’s balance sheet to a column of ratios?

A. common size analysis

B. internal liquidity
C. operating efficiency
D. constant growth

37
Study Session #10 & 11 – Equity Investments
 2002 Terry Lloyd, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without
permission.

10. Which of the following is the best dividend model for a small grocery chain that pays out
a relatively stable percentage of its excess income?

A. the two stage model

B. the H model
C. the Gordon Growth
D. the three stage model

[the correct answer is c; it is appropriate for a steadily growing firm with a steadily growing
dividend payout]

11. The price to book value ratio is increased by all of the following, except:

A. the payout ratio

B. the growth rate of the company’s earnings
C. the riskiness of the firm’s earnings
D. none of the above

[the correct answer is c; the other factors will increase the PE ratio]

12. The difference between the value of the firm and the value of the firm’s equity is:

A. nothing; it is only terminology

B. the value of the firm includes the value of the firm’s debt capital
C. the value of the equity is based only on dividends paid or payable
D. other stakeholders may have a claim on the firm’s assets

13. The price earnings ratio is increased by only which of the following?

A. the riskiness, or volatility of the company’s business

B. an increase in interest rates
C. the company’s growth rate
D. a higher payout ratio

[the correct answer is c; all the other factors will decrease the PE ratio]

38
Study Session #12 & 13 – Equity Investments
 2002 Terry Lloyd, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without
permission.

14. All of the following are believed to be advantages of EVA except

A. it is simple to calculate
B. it is not subject to accounting “gimmickry”
C. it considers the cost of equity capital
D. it uses cash flow, not accrual accounting

[the correct answer is a; the others are incorrect]

15. Which of the following is calculated as a percentage

A. economic value added (EVA)

B. market value added (MVA)
C. cash flow return on investment (CFROI)
D. they are all calculated as a percentage

16. The primary advantage of using EVA as a tool to measure company performance over
other methods is

A. it forces the analyst to focus on true economic earnings by deducting the

cost of capital
B. it focuses on cash flow and not GAAP earnings
C. it is a straightforward calculation that can be applied easily to any company
D. the cost of capital is the same for all companies, making comparisons direct
among companies in different industries

39
Study Session #17 & 18 – Derivative Investments
 2002 Dion Roseman, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited
without permission.

17. Differentiate between spot and futures prices and explain the convergence between them.
(3 minutes)

18. Show that the implied repo rate is same as the cost of carry.
(4 minutes)

19. Discuss 3 characteristics of and motivations for swap that differentiate them from futures
(3 minutes)

20. Show and explain why put call parity must always hold (3 marks)
(3 minutes)

21. List 6 factors which affect option prices in real world (3 marks)
(3 minutes)

40
Study Session #19 – Alternative Investments
 2002 Jim Keene, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without
permission.

A wealthy Hong Kong family that you advise owns a 150,000 net rentable sq. ft. office building
at 350 California Street in San Francisco’s financial district built in 1972. The Class B building
is currently 92% leased and occupied to average credit quality local and regional tenants. The
full service leases expire evenly over the next five years starting in one year. The market is
approximately 86% occupied with no real signs of change in the next several years. The building
rental and expense information is as follows:

Average base rent/sq. ft./month $2.50

Fixed expenses/sq. ft./month (excluding real estate taxes) .50
Variable expenses/occupied sq. ft./month .60
Real estate taxes (current)/year $225,000

The building occupancy is expected to revert to the market occupancy evenly by the end of three
years. The building rents are at market and the market is expected to increase 3%/year for the
foreseeable future. Variable and fixed expenses (w/o real estate) are also expected to increase
3%/year. Real estate tax increases are limited to the lesser of 2%/year or inflation (unless the
property is sold and the real estate taxes are based on 1.5% of the sale price).

22. Based on this information, calculate the property’s expected cash flow for the next five
years.
(15 minutes)

23. Based on the following market rates of return, construct a discount rate to value the
property.

6 Month Treasury Bill 3.5%

10 Year Treasury Note 5.50%
10 Year AA Rate Corporate Bonds 6.5%
Emerging Markets Equities 14.0%
Venture Capital 18.0%

(5 minutes)

24. Based on the results from A and B, calculate a value for the property assuming a sale at
the end of five years (base on year 6 expected cash flow and assume a long-term growth
in cash flow on the property of 3%/year).

(7 minutes)

25. Your client is considering selling this property now and investing in a biotechnology
venture capital fund. Advise your client on the similarities and differences between the
two investments.
(3 minutes)

41
Study Session #19 – Alternative Investments ANSWER KEY
 2002 Jim Keene, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.

13. See excel spreadsheet below on cash flow projections.

350 CALIFORNIA STREET

Year 1 2 3 4 5

Rent Potential
Total square feet 150,000 150,000 150,000 150,000 150,000
occupancy % 92% 90% 88% 86% 86%
occupied sq. ft. 138,000 135,000 132,000 129,000 129,000
Annual rent/sq. ft. $30.00 $30.90 $31.83 $32.78 $33.77
Total rent $4,140,000 $4,171,500 $4,201,164 $4,228,853 $4,355,719

Expenses
Total sq. ft. 150,000 150,000 150,000 150,000 150,000
Occupied sq. ft. 138,000 135,000 132,000 129,000 129,000
Fixed expenses/sq. $6.00 $6.18 $6.37 $6.56 $6.75
ft./yr.
Total fixed $900,000 $927,000 $954,810 $983,454 $1,012,958
expenses
Var. exp./occupied $7.20 $7.42 $7.64 $7.87 $8.10
sq. ft./yr.
Total variable $993,600 $1,001,160 $1,008,279 $1,014,925 $1,045,373
expenses
Real estate taxes $225,000 $229,500 $234,090 $238,772 $243,547
Total expenses $2,118,600 $2,157,660 $2,197,179 $2,237,151 $2,301,878

Net operating cash $2,021,400 $2,013,840 $2,003,985 $1,991,703 $2,053,841

flow
14. The discount rate for an investment is based on its perceived level of risk compared to other options. As an asset class, single property
commercial real estate is much less liquid than domestic public equities and is subject to not only market risk, but also systematic risk
(that is, risk associated with the individual asset). On the other hand, it generates a reasonably reliable and steady cash flow with
protection from the length of the leases as well as its location in a long-term proven market area. Its risk lies somewhere between the 10
year 6.5% AA Corporate Bond discount rate and the 14% expected return on emerging market equities. Because the building is thirty
years old and older buildings require increasing capital expenditures relative to their operating cash flow capabilities, the risk should come
somewhere close to the emerging markets risk. Accordingly, using a discount rate anywhere in the 11 – 14% range is acceptable for
valuation judgment purposes.

42
15. See excel spreadsheet on valuation calculations.

Year 1 2 3 4 5 6
Rent Potential
Total square feet 150,000 150,000 150,000 150,000 150,000 150,000
occupancy % 92% 90% 88% 86% 86% 86%
occupied sq. ft. 138,000 135,000 132,000 129,000 129,000 129,000
Annual rent/sq. ft. $30.00 $30.90 $31.83 $32.78 $33.77 $34.78
Total rent $4,140,000 $4,171,500 $4,201,164 $4,228,853 $4,355,719 $4,486,391
Expenses
Total sq. ft. 150,000 150,000 150,000 150,000 150,000 150,000
Occupied sq. ft. 138,000 135,000 132,000 129,000 129,000 129,000
Fixed expenses/sq. ft./yr. $6.00 $6.18 $6.37 $6.56 $6.75 $6.96
Total fixed expenses $900,000 $927,000 $954,810 $983,454 $1,012,958 $1,043,347
Var. exp./occupied sq. ft./yr. $7.20 $7.42 $7.64 $7.87 $8.10 $8.35
Total variable expenses $993,600 $1,001,160 $1,008,279 $1,014,925 $1,045,373 $1,076,734
Real estate taxes $225,000 $229,500 $234,090 $238,772 $243,547 (1)
Total expenses $2,118,600 $2,157,660 $2,197,179 $2,237,151 $2,301,878 $2,120,080 (2)

Net operating cash flow $2,021,400 $2,013,840 $2,003,985 $1,991,703 $2,053,841 $2,366,310 (2)

Assumed discount rate 12% 13.5% (3)

Discount factor 1.12 1.254 1.405 1.574 1.762 2.138
Assumed discount rate 12.0%
Plus: Tax rate not included in year 6 1.5%
expenses
Less: Long-term growth rate -3.0%
Year 6 terminal capitalization rate 10.5%
$22,536,288
Present value of terminal value $12,787,695
Present value $1,804,821 $1,605,421 $1,426,397 $1,265,763 $1,165,405
$1,804,821 $1,605,421 $1,426,397 $1,265,763 $13,953,100
Present value $20,055,502

(1) The 1.5% tax rate is built into the 12% terminal value discount rate because the taxes are reassessed upon the sale.
(2) Excludes property taxes that are built into the terminal discount rate (12% plus 1.5% equals 13.5% terminal discount rate).
(3) Includes tax rate built into the terminal discount rate.

43
16. The similarities include:
• Both asset classes characterized by best managers adding significant value over worst managers (large dispersion of
performance)
• Both relatively illiquid
• Historical inflation hedges

The differences include:

• Real estate has operating cash flow; venture capital fund not expected to have much, if any
• Venture capital fund invests in numerous companies vs. one asset in real estate
• Venture capital has longer period of illiquidity (many years vs. many months to get money out)
• Expected returns higher for venture capital
• Venture capital commitment is drawn down over several years resulting in some time diversification
• Biotechnology start-ups would have no operating history as business; real estate would have some operating history

44