CFA Institute CFA Level II Chartered Financial Analyst CFA-Level-II Exam Practice Test

Shirley Nolte, CFA, is a portfolio manager for McHugh Investments. Her portfolio includes 5,000 shares of Pioneer common stock (ticker symbol PNER), which is currently trading at $40 per share. Pioneer is an energy and petrochemical business that operates or markets its products in the United States, Canada, Mexico, and over 100 other countries around the world. Pioneer's core business is the exploration, production, and transportation of crude oil and natural gas. Pioneer also manufactures and markets petroleum products, basic petrochemicals, and a variety of specialty products.

Nolte would like to fully hedge her exposure to price fluctuations in Pioneer common stock over the next 90 days. She determines that the continuously compounded risk-free rate is 5%. She also gathers some information on exchange-traded options available on Pioneer stock. This data is shown in Exhibit 1.

From this data, she determines that the put option deltas are equal to:

* 1 -month put option delta = -0.46.

* 3-month put option delta = -0.36.

* 6-month put option delta - - 0.29.

* 9-month put option delta = -0.17.

She also concludes that the 9-month put option is mispriced relative to the 9-month call option, and an arbitrage opportunity is possible, but that the 3-month put option is correctly priced relative to its comparable call option. She also estimates the gamma of the 3-month call option to be 0.023.

In an unrelated transaction, Nolte is also considering the purchase of a put option on a futures contract with an exercise price of $22. Both the option and the futures contract expire in six months. The call price is $1 and the futures price today is $20.

The gamma of the 3-month $40 call option on Pioneer stock is most likely:

Sharon Foster, 56, is an executive at a large Biotech firm. Foster plans to retire in five years, to travel and spend time with her grandchildren. Foster is in excellent health, although her husband died several years ago. Foster's only significant asset is her employer's 401(k) retirement plan. Her salary is more than adequate to cover her living expenses until she retires, but she does not anticipate that she will accumulate any additional savings beyond her retirement account. The balance in her account currently is $3.2 million, but Foster estimates that by the time she retires the account will have grown to $4.5 million. She expects that her pretax living expenses, including a liberal travel budget, will be $150,000 per year, beginning when she retires. She is willing to take risk to achieve her financial goals. Her retirement account is currently invested 80% in stocks and 20% in bonds. Foster estimates her post-retirement income tax rate to be 35%, which is about the same as her current tax rate.

As she is starting to plan her retirement, Foster has turned to her longtime friend, Don Welch, CFA, who is a portfolio manager at Scientific Investments, LLC . Welch is considering three different mutual funds for Foster's account. All three are well-diversified funds of large capitalization stocks. The expected returns and standard deviations of each fund are shown below in Exhibit 1. Welch assumes a risk-free rate of return of 3.0%.

Welch believes in stock market efficiency, but he also believes that individual securities are mispriced by the market from time to time. He has recently reviewed research related to the Treynor-Black (TB) model of security selection and portfolio optimization. Welch refers to a prospectus from Fund D, which uses the TB framework in developing its portfolios. In discussing their use of the TB model, the prospectus cites an example where an active portfolio of five stocks is combined with a passive, index portfolio. The portfolio weights of the stocks are in Exhibit 2.

Welch further notes that the beta of the active portfolio is 0.90, although the standard deviation of the portfolio's returns is high. Of the five stocks shown in the portfolio, three have positive alphas, and two have negative alphas. A footnote to the sample data states that the sample assumes that the analysts* alpha forecasts are perfect.

Welch is reviewing Foster's account, together with the mutual fund data, in an attempt to develop a long-term investment plan for Foster.

In preparing an investment policy statement for Foster, which of the following best describes her post-retirement risk tolerance?

Chester Brothers, LLC, is an investment management firm with $200 million in assets under management. Chester's equity style is described to clients as a "large cap core" strategy. One year ago, Chester instituted a new compensation plan for its equity portfolio managers. Under this new plan, each portfolio manager receives an annual bonus based upon that manager's quarterly performance relative to the S&P 500 index. For each quarter of aut-performance, the manager receives a bonus in the amount of 20% of his regular annual compensation. Chester has not disclosed this new plan to clients. Portfolio managers at Chester are not bound by non-compete agreements.

Fames Rogers, CFA, and Karen Pierce, CFA, are both portfolio managers affected by the new policy. Rogers out-performed the S&P 500 index in each of the last three quarters, largely because he began investing his clients1 funds in small cap securities. Chester has recently been citing Rogers's performance in local media advertising, including claims that "Chester's star manager, James Rogers, has outperformed the S&P 500 index in each of the last three quarters." The print advertising associated with the media campaign includes a photograph of Rogers, identifying him as James Rogers, CFA . Below his name is a quote apparently attributable to Rogers saying "as a CFA chartcrholdcr I am committed to the highest ethical standards."

A few weeks after the advertising campaign began, Rogers was approached by the Grumpp Foundation, a local charitable endowment with $3 billion in assets, about serving on their investment advisory committee. The committee meets weekly to review the portfolio and make adjustments as needed. The Grumpp trustees were impressed by the favorable mention of Rogers in the marketing campaign. In making their offer, they even suggested that Rogers could mention his position on the advisory committee in future Chester marketing material. Rogers has not informed Chester about the Grumpp offer, but he has not yet accepted the position.

Pierce has not fared as well as Rogers. She also shifted into smaller cap securities, but due to two extremely poor performing large cap stocks, her performance lagged the S&P 500 index for the first three quarters. After an angry confrontation with her supervisor, Pierce resigned. Pierce did not take any client information with her, but when she left she did take a copy of a Pierce has not fared as well as Rogers. She also shifted into smaller cap securities, but due to two extremely poor performing large cap stocks, her performance lagged the S&P 500 index for the first three quarters. After an angry confrontation with her supervisor, Pierce resigned. Pierce did not take any client information with her, but when she left she did take a copy of a computer model she developed while working al Chester, as well as the most recent list of her buy recommendations, which was created from the output of her computer valuation model. Pierce soon accepted a position at a competing firm, Cheeri Group. On her first day at Cheeri, she contacted each of her five largest former clients, informing them of her new employment and asking that they consider moving their accounts from Chester to Cheeri. During both telephone conversations and e-mails with her former clients, Pierce mentioned that Chester had a new compensation program that created incentives for managers to shift into smaller cap securities.

Cheeri has posted Pierce's investment performance for the past five years on its Web site, excluding the three most recent quarters. The footnotes to the performance information include the following two statements:

Statement 1: Includes large capitalization portfolios only.

Statement 2: Results reflect manager's performance at previous employer.

Assuming Rogers would like to accept the offer to serve on the Grumpp investment advisory committee, Rogers's obligations under the CFA Institute Standards require that he:

Mike Zonding, CFA, is conducting a background check on CFA candidate Annie Cooken, a freshly nudled MBA who applied for a stock-analysis job at his firm, Khasko Financiar.vZoftding does not like to hire anyone who does not adhere to the Code and Standards' professional conduct requirements.

The background check reveals the following:

(i) While doing a full-time, unpaid internship at Kale Investments, Cooken was reprimanded for working a 30-hour-a-week night job as a waitress.

(ii) As an intern at Lammar Corp., Cooken was fired after revealing to the FBI that one of the principals was embezzling from the firm's clients.

(iii) Cooken performed 40 hours of community service in relation to a conviction on a misdemeanor drug possession charge when she was 16 years old.

(iv) On her resume, Cooken writes, "Recently passed Level 2 of the CFA exam, a test that measures candidates' knowledge of finance and investing."

During the interview, Zonding asks Cooken several questions on ethics-related issues, including questions about the role of a fiduciary and Standard III(E) Preservation of Confidentiality. He asks her about her internship at Kale Investments, specifically about the working hours. Cooken replies that the internship turned out to require more time than she originally planned, up to 65 hours per week.

Zonding subsequently hires Cooken and functions as her supervisor. On her third day at the money management boutique firm, portfolio manager Steven Garrison hands her a report on Mocline Tobacco and tells her to revise the report to reflect a buy rating. Cooken is uncomfortable about revising the report.

To supplement the meager income from her entry-level stock-analysis job, Cooken looks for part-time work. She is offered a position working three hours each Friday and Saturday night tending bar at a sports bar and grill downtown. Cooken does not tell her employer about the job.

During her first week, Cooken has lunch with former MBA classmates, including Taira Basch, CFA, who works for the compliance officer at a large investment bank in town. Basch arrives late, explaining, "What a day, it's only noon and already I have worked on the following requests:

1. A federal regulator called and wanted information on potentially illegal activities related to one of the firm's key clients.

2. A rival company's employee wanted information regarding employment opportunities at the firm.

3. A potential client contacted an employee and wanted detailed performance records of client accounts so he can decide whether to invest with the firm."

Basch goes on to say that she is responsible for developing a presentation on the differences between the Prudent Investor and the Prudent Man rules for managing trust portfolios. Basch explains to Cooken that the Prudent Investor rule requires a trustee to exercise five fiduciary standards in managing the assets of a trust account, including care, skill, caution, loyalty, and impartiality. She states that although there are many differences between the Prudent Man and the newer Prudent Investor rule, one element of continuity is the duty of the trustee to delegate investment authority in the event that the trustee lacks sufficient investment knowledge.

Toward the end of the lunch meeting, Basch suggests that in exchange for research published by Cooken and Khasko, Basch can have portfolio managers at her firm send clients that are too small for their firm to Khasko. Since Khasko specializes in clients with smaller portfolios, the arrangement sounds like a good idea to Cooken. Cooken tells Basch that she will think the arrangement over and get back with her next week with a decision.

According to CFA Institute Standards of Professional Conduct, which of the following statements is most accurate with regard to the arrangement proposed by Basch to Cooken?

Marie Williams, CFA, and David Pacious, CFA, are portfolio managers for Stillwell Managers. Williams and Pacious are attending a conference held by Henri Financial Education on the fundamentals of valuation for common stock, preferred stock, and other assets.

During the conference, the presenter uses an example of four different companies to illustrate the valuation of common stock from the perspective of a minority shareholder.

During the conference, the presenter uses an example of four different companies to illustrate the valuation of common stock from the perspective of a minority shareholder.

* Firm A is a noncyclical consumer products firm with a 50 year history. The firm pays a $1.80 dividend per share and attempts to increase dividends by 4% a year. Earnings and dividends have steadily increased for the past

20 years.

* Firm B is a technology firm. It has never paid a dividend and does not expect to in the near future. Furthermore, due to large investments in new factories and equipment, the firm is not expected to generate positive free cash flow in the foreseeable future.

* Firm C is an industrial firm with currently very little competition and a dividend growth rate of 9% a year. However, the profits in its product market have started to attract competitors and it is expected that Firm C's profits will slowly decline such that the dividend growth steadily falls each year until it reaches a growth rate of 4% a year.

* Firm D is a pharmaceutical firm that is currently enjoying high profits and paying dividends. However, the firm's strongest selling drug is coming off patent in three years. With no other drugs in the pipeline, the firm's dividend growth rate is expected to drop abruptly in three years and settle at a lower growth rate.

The next day, Pacious decides to put what he learned into practice. The stock he is valuing, Maple Goods and Services, currently pays a dividend of $3.00. The dividend growth rate is 25% and is expected to steadily decline over the next 8 years to a stable rate of 7% thereafter. Given its risk, Pacious estimates that the required return is 5%.

Williams analyzes the value of Mataka Plastics stock. Its dividend is expected to grow at a rate of 18% for the next four years, after which it will grow at 4%. This year's dividend is $5.00 and Williams estimates the required return at 15%.

From the seminar, Pacious learned that a firm's health can be gauged by the present value of its future investment opportunities (PVGO). Tackling a calculation, he uses the following example for Wood Athletic Supplies:

Stock price $90.00

Current earnings $5.50

Expected earnings $6.00

Required return on stock 15%

Pacious and Williams discuss the characteristics of firms in various stages of growth, where firms experience an initial growth phase, a transitional phase, and a maturity phase in their life. They both agree that the Gordon Growth Model is not always appropriate. Pacious makes the following statements.

Statement I: For firms in the initial growth phase, earnings are rapidly increasing, there are little or no dividends, and there is heavy reinvestment. The return on equity is, however, higher than the required return on the stock, the free cash flows to equity are positive, and the profit margin is high.

Statement 2: When estimating the terminal value in the three-stage dividend growth model, it can be estimated using the Gordon Growth Model or a price-multiple approach.

Which of the following best describes the appropriate valuation models for the Henri presentation scenarios?

Russell Larson, CFA, is an investment analyst for Sentry Properties, Inc., a group of wealthy investors that is currently interested in purchasing Riviera Terrace, a 60- unit apartment complex in Southeastern Florida. The current owners of Riviera Terrace have agreed to sell the property for $40,000,000. Larson estimates that Rivjera Terrace's net operating income for the first year after the sale is finalized will be $4,200,000, and it is expected to maintain its historic annual growth rate of 5%.

At Sentry's request, Larson will evaluate the investment in Riviera Terrace over a 5-year horizon using selling prices of $45,000,000 and S60,000,000.

During the due diligence process, Larson has determined that the average selling price for apartment complexes similar to Riviera Terrace is $1,250,000 per unit, with annual net operating income equal to $ 135,000 per unit. Larson has also determined that net operating income is typically 80% of gross income.

Larson has collected the following information to aid in his evaluation of Riviera Terrace.

* The property will be fully depreciated at a rate of S 1,250,000 per year over 32 years.

* Rental contracts are expected to be reissued on the date the sale is completed.

* Sentry has arranged to finance the investment with a 30-ycar, 7% interest-only loan, with monthly payments and a face value equal to 80% of the initial investment.

* Selling expenses will be 7% of the gross selling price.

* The capital gains tax rate is 15%, the tax on recaptured depreciation is 28%, and the tax rate on ordinary income is 40%.

* Sentry Properties' required return on equity is 20%.

* The interest rate on U .S . government bonds after adjustments for real estate based tax savings = 5.0%.

* The premium investors require for the illiquidity of real estate investments = 2.5%.

* The average real estate return net of appreciation = 1.25%.

* The real estate investment risk premium = 3.0%.

* The average internal rate of return for properties that are comparable to Riviera Terrace is 22%.

As part of the diligence process, Larson deems it to be appropriate to estimate the.market value of Riviera Terrace using capitalization rates based on the market extraction and built-up methods. One of the partners in Sentry Properties has also asked Larson to estimate the market value of Riviera Terrace using: (1) the direct income capitalization approach and (2) the gross income multiplier approach.

There are several indicators that the Florida real estate market may take a downward turn over the next five years. With this in mind, Larson determines that there is a reasonable chance that Sentry will have to terminate its investment in Riviera Terrace at the end of year 3 at the initial purchase price of $40,000,000. Under this scenario, he estimates the equity reversion after tax (ERAT) in year 3 to be $4,934,000. Cash flow after tax in years 1 and 2 are $1,676,000 and $1,802,000, respectively.

Under Larson's early termination scenario, and based on the internal rate of return (1RR) method of analysis, should he recommend that Sentry Properties invest in Riviera Terrace, assuming his estimate of ERAT is ccrect?

Austin Clark, CFA, has been asked to analyze White Goods Corporation, a $9 billion company that owns a nationwide chain of stores selling appliances and other electronic goods. As part of his analysis of the White Goods Corporation, Clark's supervisor, David Horvath, asks Clark to forecast White Goods' 2009 sales using multiple regression analysis. The following model was developed:

sales = 20.1 + 0.001 GDP+ 1,000.6 TR + 0.1 CC -3.2 PC -40.3 UR

t-values: (1.1) (2.3) (1.75) (3.2) (-0.48) (-0.9)

Number of observations: 76

Standard error estimate: 15.67

Unadjusted R2: 0.96

Regression sum of squares: 412,522

Error sum of squares: 17,188

Independent Variable Descriptions

GDP = gross domestic product

TR = average coupon rate on 5-year U .S . Treasury securities

CC = most recent quarter end consumer confidence index value

PC = previous year's sales of personal computers

UR = most recent quarter end unemployment rate

Variable Estimates for 2009

GDP =8,000

TR = 0.05

CC =97

PC = 60,000

UR = 0.055

Critical Values For Student's t-Distribution

Clark's supervisor asks him to prepare a report explaining the implications of the regression analysis results. Clark writes the following conclusions concerning regression analysis in his report:

Interpreting the results of regression analysis can be problematic if certain assumptions of the ordinary least squares framework are violated. The regression output for White Goods Corporation is unreliable for the following reasons:

Finding 1: The correlation between regression errors across time is very close to 1.

Finding 2: There is a strong relationship between the regression error variance and the regression independent variables.

Clark's two documented findings related to his examination of the regression errors should lead to the conclusion that Clark's regression equation exhibits strong evidence of: