CFA Institute CFA-Level-II Exam Questions

Mary Montpicr is an equity analyst with World Renowned Advisors. The firm provides investment advice and financial planning services globally to institutional and retail clients. Shortly after the company opened an office in Malaysia, Montpier's supervisor in the New York office. Rick Reynolds, asked her to relocate, and Montpier agreed. The goal of the new Malaysian office is to serve as a source of international investment opportunities for U .S . clients. Montpier's main task is to cover small-cap stocks in the region and develop a network of contacts with other investment firms in the region.

Through her interaction with other analysts in Malaysia, Montpier learns that the use of material nonpublic information is common practice in analyst research reports and recommendations. Such practice is not prohibited by law in Malaysia. Montpier is encouraged by this knowledge because she recently observed several investment bankers meeting numerous times at an exclusive local country club with the CEOs of two Malaysian rival companies. It is public information that one of the companies is searching for potential acquisition targets. She has thought several times about issuing a recommendation on one of the companies but has not done so for fear of breaking the law. After learning of the Malaysian insider trading laws, Montpier recommends the stock of the acquisition target, which she had already established as a good investment through prior research.

Montpier has also learned that Malaysian law is very lax regarding outside consulting arrangements by investment professionals. It is common for analysts and portfolio managers to maintain ongoing consulting contracts with entities other than their primary employer. As a result of this, Montpier has begun financial service consultations for members of a local investment club. The club is developing an appropriate compensation package for her services, which to date have included financial planning activities and investment research. When Montpier established the relationship with the investment club, she informed them that she had a full-time job at World Renowned Advisers, which offers similar services.

After a year of consulting with the investment club, Malaysian law changed, requiring investment bankers, securities analysts, and portfolio managers to register with the Malaysian Securities Commission in order to engage in independent consulting practice. Since she is unaware of the change, Montpier does not file the proper registration forms and is later investigated, fined, and temporarily sanctioned by the Malaysian Securities Commission. Montpier is able to have the sanction, but not the fine, removed after appealing the Commission's ruling. Montpier's counterpart in the New York office is Jim Taylor, who has worked as an analyst at World Renowned Advisors for approximately seven years. Taylor researches health care and biotech stocks for the firm and participates in client meetings when managers are recommending stocks that Taylor covers. Taylor recently completed Level 1 of the CFA examination and is waiting for his results so he can register for the Level 2 examination.

In preparation for a client meeting, Taylor's supervisor, Jessica James, asks him to prepare a research report on attractive companies in the health care industry. Since Taylor is busy preparing for company conference calls, James tells him to "throw something together from the street." To meet James' request, Taylor obtains reports on Immune Healthcare and Remedy Corp., two companies that he has heard about but has not researched. Taylor takes the original reports he obtains from a third-party, adds some general industry information, and submits "strong buy" recommendations to James for the stocks. He does not credit the original authors in the report, which is a violation of copyright law. Taylor includes his qualifications in the report and mentions that he is a "Level 2 Candidate in the CFA Program." Although written procedures require James to review all analyst reports prior to release, time constraints often prevent her from reviewing the reports prior to distribution. James recommends the stocks to her clients, who then purchase them. Several months later, the clients are able to sell the Immune Healthcare and Remedy Corp. shares at annualized rates of return of 21% and 17%, respectively. James informs Taylor of the clients' successful investments and requests that he begin investigating potential biotech investments for the same group of investors.

To gain insight on biotech stocks, Taylor registers for an upcoming medical study, where he and others will be the subject of testing for the efficacy of several new drugs. On his application, Taylor indicates that he has the appropriate medical condition for the study and signs a confidentiality agreement, but he leaves the question about his occupation blank. During the study, Taylor learns that two of the new drugs on which Next Breakthrough Corp. is awaiting regulatory approval have serious negative side effects in patient testing. This information confirms existing research that Taylor has been working on in the health care sector. At the conclusion of the study, Taylor sends an e-mail to his clients recommending that they "sell" Next Breakthrough Corp. Over the next two weeks. Next Breakthrough releases information that the drugs in question have been held up by a regulatory agency pending additional investigation. The stock plunges over 30% on the news.

By not filing the proper registration forms with the Malaysian Securities Commission, did Montpier likely violate any CFA Institute Standards of Professional Conduct?

Jerry Sanders, CFA, has been asked to analyze the 20-year bonds of Marietta Tech, Inc., which are currently being held in a corporate bond portfolio managed by a colleague, and to recommend whether the bonds should be sold or held. The bonds currently have a yield spread of 1.55% over Treasuries.

Marietta Tech, Inc. designs, manufactures, and markets specialty trucks and truck bodies mounted on new truck chassis produced by others, including concrete mixers, refuse bodies, fire and emergency vehicles, defense trucks, cut-away and dry freight van bodies, refrigerated units, stake bodies, and other specialized trucks. Marietta also manufactures fiberglass wind deflectors, armored trucks, shuttle buses, and cargo vans. Marietta's customers are located in the United States and Canada.

Exhibit 1: Selected Financial Data for Marietta Tech, Inc. (in thousands of $)

At lunch Sanders discusses the credit analysis of various types of bonds with Elizabeth Yan, who was just hired as a bond analyst. Yan makes the following statements:

Statement 1: An analysis of the issuer's business and operating risks is important to the analysis of corporate bond credit risk but not important for the credit analysis of asset backed securities (ABS).

Statement 2: The unique bond covenants in a municipal bond's trust indenture require an additional level of credit analysis not necessary in a corporate credit analysis.

After lunch Sanders asks Tatiana Petrovich in the municipal bond department for her opinion on the most important factors in the risk assessment of tax-backed municipal debt. Petrovich identifies three factors:

1. Ameasure of debt burden, such as debt-per-capita in the tax jurisdiction.

2. An evaluation of tax collection rates and intergovernmental revenue ability.

3. Analysis of the municipality's budgetary policies as an indication of financial discipline.

Sanders first analyzes Marietta's 2008 EBIT-to-interest expense and EBITDA-to-interest expense and compares them to the median ratios from Exhibit 2. Relative to the BBB medians for the respective ratios:

Ryan Hendricks serves as a security analyst for Investment Management, Inc. (IMI), which employs the Treynor-Black model to evaluate securities and to make portfolio recommendations. IMI uses the capital asset pricing model (CAPM) to determine the degree to which securities may be mispriced relative to IMFs forecasts.

Hendricks evaluates the common shares of Computer Software Associates (CSA), a small company specializing in a unique computer software market niche. Hendricks obtains the following market model results for CSA, using monthly returns for the past 60 months:

Hendricks uses the adjusted beta method to derive his forecasts for companies' future betas. In deriving his forecast for any company beta, Hendricks uses the following first-order autoregressive formula:

forecast beta = 0.33 + 0.67 x (historical beta) (2)

Hendricks derives required returns for individual securities using the CAPM after making appropriate adjustments using his adjusted beta formula in equation (2).

IMI provides Hendricks with the following capital market forecasts to use as inputs for the CAPM.

IMI asks Hendricks to make decisions to take long and short positions in individual securities for IMl's actively managed portfolio, IMI-Active. Specifically, Hendricks is asked to examine CSA and Millennium Drilling (MD), an oil and gas drilling company specializing in deep sea drilling. After a thorough examination of the prospects for each company, Hendricks derives the following alpha forecasts for CSA and MD.

Hendricks forecasts that the unsystematic variance (the variance of the market model regression error) for MD will be more than double that of CSA .

After determining the appropriate allocations across securities within the IMI-Active portfolio, Hendricks derives the portfolio predictions shown in Exhibit 3.

IMI forecasts that the total standard deviation for the S&P500 returns will equal 20%. After examining the historical forecasting abilities of Hendricks, IMI determines that Hendricks has demonstrated perfect forecasting ability in regards to CSA stock, but imperfect forecasting abilities in regards to MD stock. IMI finds that the correlation between the realized alphas for MD and the forecast MD alphas provided by Hendricks equals 0.50.

Referring to the Treynor-Black model, Hendricks makes the following statements:

Statement 1: All else equal, the Treynor-Black model increases the weight to the active portfolio as its unsystematic risk increases.

Statement 2: The Treynor-Black model is based on the premise that only a limited number of stocks should be included in the actively managed portfolio.

Using the Treynor-Black model, IMI must select optimal combinations of the S&P500 market index and the IMI-Active portfolio. The optimal combination is expected to lie along a capital allocation line with intercept and slope:

MPT Associates (MPTA) is an investment advisory firm that makes asset allocation and stock selection recommendations for its clients. MPTA currently manages three portfolios: X, Y, and Z. Portfolio X is the mean-variance efficient market portfolio. Portfolio Y is the portfolio of risky assets with minimum variance. Portfolio Z consists exclusively of 90-day Treasury bills. The three portfolios have the following characteristics:

Expected return for Portfolio X =15%

Standard deviation of returns for Portfolio X = 20%

Expected return for Portfolio Y = 7%

Standard deviation of returns for Portfolio Y = 5%

Expected return on Portfolio Z = 5%

Recently, MPTA was contacted simultaneously by two clients: Danielle Burk and Derek Kitna. Burk and Kitna have known each other since college and are both currently working for the same company.

Burk currently owns a $100,000 portfolio which she is holding in her Roth IRA retirement account. Her investment strategy is a passive approach. Her retirement portfolio has the following risk-return characteristics:

Expected return on Burk's portfolio = 10%

Standard deviation of returns on Burk's portfolio = 12%

Kitna requests advice from MPTA on the proper valuation of two stocks that he is considering. Kitna is interested in determining the fair value of shares of Long Drives, Inc. (LDI), a manufacturer of state-of-the-art golf clubs, and of Cell Chip Technologies (CCT), a manufacturer of cell phone chip processors. MPTA maintains a database of analyst forecasts and finds that the I -year consensus analyst forecast return for the CCT stock equals 15% and the LDI stock equals 13%.

After lengthy conversations with both Burk and Kitna, MPTA decides to advise both of them to use the capital market line, security market line, and capital asset pricing mode! as their primary analytical tools.

MPTA's senior executives are analyzing trends in asset pricing over the past several decades. They conclude that in the period 1998-1999, there was a bubble in stock prices. Stock prices subsequently corrected, however, from 2000-2001. They believe that the downward trend in stock prices from 2002-2003 was an overcorrection; that is, prices fell significantly below fundamental values.

MPTA executives have been discussing the use of the Treynor-Black model with the investment consultants, Benesh Associates. The advisors at Benesh recommend that each investor be allocated a combination of a passive portfolio and an actively managed portfolio, depending on the investor's risk and return preferences. In his presentation on the Treynor-Black model, David Benesh, the principal at Benesh Associates, makes the following statements:

Statement 1: With respect to the actively managed portfolio, the Treynor-Black model will allocate more funds to securities with large alphas and low systematic risk.

Statement 2; The capital asset pricing model assumes that short selling of securities is unrestricted and that unlimited borrowing at the risk-free rate is allowed. If these assumptions are violated, then the relationship between expected return and beta might not be linear. Unlike the theoretical capital asset pricing model, the Treynor-Black model avoids this problem because it does not consider short positions in securities.

In further discussion, Benesh recommends that MPTA consider subscribing to the investment newsletters of two independent equity analysts: Jack Nast and Elizabeth Tackacs. Their alphas, residual risk, and correlation between forecasted and realized alphas arc provided in the table below.

Regarding the statements made by Benesh on the Treynor-Black model, are both statements correct?

Fashion Inc. is a major U .S . distributor of high quality women's jewelry and accessories. The company's growth in recent years has been moderately above the industry average. However, competition is intensifying as a number of overseas competitors have entered this mature market. Although Fashion has been a publicly held company for many years, members of senior management and their families control 20% of the outstanding common stock. Martin Silver, the Chief Executive Officer, has been under intense pressure from both internal and external large shareholders to find ways to increase the company's future growth.

Silver has consulted with the company's investment bankers concerning possible merger targets. The most promising merger target is Flavoring International, a distributor of a broad line of gourmet spices in the United States and numerous other countries. In recent years, Flavoring's earnings growth rate has been above competitors' and also has exceeded Fashion's experience. Superior income growth is projected to continue over at least the next five years. Silver is impressed with the appeal of the company's products to upscale customers, its strong operating and financial performance, and Flavoring's dynamic management team. He is contemplating retirement in three years and believes that Flavoring's younger, more aggressive senior managers could boost the combined company's growth through increasing Fashion's operating efficiency and expanding Fashion's product line in countries outside the United States. Alan Smith, who is Silver's key contact at the investment banking firm, indicates that a key appeal of this merger to Flavoring would be Fashion's greater financial flexibility and access to lower cost sources of financing for expansion of its products in new geographic areas. Fashion has a very attractive performance based stock option plan. Flavoring's incentive plan is entirely based on cash compensation for achieving performance goals. Additionally, the 80% of Fashion's stock not controlled by management interests is very widely held and trades actively. Flavoring became a publicly held company three years ago and doesn't trade as actively.

Silver has asked Smith to prepare a report summarizing key points favoring the acquisition and an acceptable acquisition price. In preparing his report, Smith relics on the following financial data on Fashion, Flavoring, and four recently acquired food and beverage companies.

Based on pre-acquisition prices of $20 for Jones Foods, $26 for Dale Inc., S35 for Hill Brands, and $40 for Lane Co., the mean takeover premium for Flavoring would be closest to;