CFA Institute CFA-Level-II Exam Questions

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;

Delicious Candy Company (Delicious) is a leading manufacturer and distributor of quality confectionery products throughout Europe and Mexico. Delicious is a publicly-traded firm located in Italy and has been in business over 60 years.

Caleb Scott, an equity analyst with a large pension fund, has been asked to complete a comprehensive analysis of Delicious in order to evaluate the possibility of a future investment.

Scott compiles the selected financial data found in Exhibit 1 and learns that Delicious owns a 30% equity interest in a supplier located in the United States. Delicious uses the equity method to account for its investment in the U .S . associate.

Scott reads the Delicious's revenue recognition footnote found in Exhibit 2.

Exhibit 2: Revenue Recognition Footnote

____________________________________________________________________________

in millions___________________________________________________________________

Revenue is recognized, net of returns and allowances, when the goods are shipped to customers and collectability is assured. Several customers remit payment before delivery in order to receive additional discounts. Delicious reports these amounts as unearned revenue until the goods are shipped. Unearned revenue was 7,201 at the end of 2009 and 5,514 at the end of 2008.

Delicious operates two geographic segments: Europe and Mexico. Selected financial information for each segment is found in Exhibit 3.

At the beginning of 2009, Delicious entered into an operating lease for manufacturing equipment. At inception, the present value of the lease payments, discounted at an interest rate of 10%, was 6300 million. The lease term is six years and the annual payment is 669 million. Similar equipment owned by Delicious is depreciated using the straight-line method and no residual values are assumed.

Scott gathers the information in Exhibit 4 to determine the implied "stand-alone" value of Delicious without regard to the value of its U .S . associate.

When applying the financial analysis framework to Delicious, which of the following is the best example of an input Scott should use when establishing the purpose and context of the analysis?

Tamara Ogle, CFA, and Isaac Segovia, CAIA, are portfolio managers for Luca's Investment Management (Luca's). Ogle and Segovia both manage large institutional investment portfolios for Luca's and are researching portfolio optimization strategies.

Ogle and Segovia begin by researching the merits of active versus passive portfolio management. Ogle advocates a passive approach, pointing out that on a risk-adjusted basis, most managers cannot beat a passive index strategy. Segovia points out that there will always be a need for active portfolio managers because as prices deviate from fair value, active managers will bring prices back into equilibrium. They determine that Treynor-Black models permit active management within the context of normally efficient markets.

Ogle decides to implement Treynor-Black models in her practice and starts the implementation process. In conversations with her largest client's risk manager, Jim King, FRM, she is asked about separation theorem in relation to active portfolio management. She responds that separation theorem more properly relates to asset prices deviating from and gravitating toward their theoretical fair price. King next asks Ogle about the differences between the Sharpe ratio and the information ratio and the difference between the security market line (SML) and the capital market line (CML).

After reallocating her client portfolios based on using the Treynor-Black model, Ogle discusses the results with Segovia. Ogle states that she is satisfied with the current methodology, but given her preference for passive management, she is still concerned about relying on analyst's forecasts. Segovia tells Ogle that he will research methods for modifying the Treynor-Black model to account for analyst forecasts.

The optimal portfolio for an investor under the Treynor-Black model:

Martha Garret, CFA, manages fixed income portfolios for Jones Brothers, Inc. (JBI). JBI has been in the portfolio management business for over 23 years and provides investors with access to actively managed equity and fixed-income portfolios. All of JBI's fixed-income portfolios are constructed using U .S . debt instruments. Garret's primary portfolio responsibilities are the Quasar Fund and the Nova Fund, both of which are long fixed-income portfolios consisting of Treasury securities in all maturity ranges. The Quasar Fund holdings as of March 15 are provided in Exhibit 1. A comparison of key rate durations for the Quasar Fund and Nova Fund is provided in Exhibit 2.

Of particular importance to Garret and her colleagues is the degree of interest rate risk exposure unique to each portfolio under JBI's management. Driving the increased awareness of the portfolios' interest rate exposure is the double digit growth in assets under management that JBI's fixed-income portfolios have experienced in the last five years. Interest in the company's fixed-income portfolios continues to grow and as a result, all portfolio managers are required to attend weekly meetings to discuss key portfolio risk factors. At the last meeting, Miranda Walsh, a principal at JBI, made the following comments:

"The variance of daily interest rate changes has been trending higher over the last three months leading us to believe that a period of high volatility is approaching in the next twelve to eighteen months. However, the reliability is questionable since the volatility estimates were derived using an option pricing model, which assumes constant interest rates."

"Also, the Treasury spot rate curve currently has a similar shape to the yield curve on Treasury coupon securities, which, according to the market segmentation theory of interest rate term structure, indicates a relatively high level of demand from investors for intermediate term securities. Overzealous trading by investors unwilling to move into other maturity ranges may create mispricing and opportunities for arbitrage."

After the meeting, Walsh and JBI's other principals met to discuss a new international portfolio opportunity. At Walsh's suggestion, the principals selected Garret as the lead portfolio manager for the new fund, which will be titled the Atlantic Fund. One of the other portfolio managers, Greg Terry, CFA, suggested to Garret that she utilize the LIBOR swap curve as a benchmark for the Atlantic fund rather than using local government yield curves. Terry justifies his suggestion by claiming that "the lack of government regulation in the swap market makes swap rates and curves directly comparable between different countries despite fewer maturity points with which to construct the curve as compared to a government yield curve. Furthermore, credit risk in the swap curves of various countries is similar, thus avoiding the complications associated with different levels of sovereign risk embedded in government yield curves.'' Intrigued by the idea of using the swap curve, Garret has her assistant begin gathering a range of current and forward LIBOR rates.

Assume that Bond A is currently callable at 105 and will be callable at 103 in six months. If the yield curve experiences a negative butterfly shift over the next month, which of the following results is most likely to be observed?