CFA II Practice Problem
Assume the country where International Oilfield is operating has been experiencing 30% annual inflation over the past three years. Which of the following best describes the effect on Continental's consolidated financial statements for the year ended 2016?
A gain is recognized in the income statement. The temporal method is required if the foreign subsidiary is operating in a highly inflationary environment, defined as cumulative inflation of more than 100% in a 3-year period. Compounded inflation of 30% annually for three years is approximately 120% (1.30 − 1). Under the temporal method, remeasurement gains and losses are recognized in the income statement. In this case, International Oilfield has a net monetary liability position (monetary liabilities of 600 million > monetary assets of 120 million). Holding net monetary liabilities denominated in a currency that is depreciating will result in a gain.
A monthly VaR
A monthly VaR cannot be annualized by simply multiplying by 12. The monthly return and standard deviation would need to be annualized and VaR recalculated. An assumption of a normal distribution is invalid if options were in the portfolio.
A regression exhibits conditional heteroskedasticity if
A regression exhibits conditional heteroskedasticity if the variance of the regression errors are not constant and are related to the regression independent variables. Clark's Finding 2 indicates that his regression exhibits conditional heteroskedasticity
AIC is a measure of
AIC is a measure of model parsimony, so a lower AIC indicates a better-fitting model. The term 2(k + 1) is the penalty assessed for adding independent variables to the model.
Given Mabry's assessment of the risks associated with BIC, which option strategy would be the most effective in deltaneutral hedging the risk of BIC stock?
Add put options to the portfolio as the put option delta moves closer to zero. To protect a portfolio against an expected decrease in the value of a long equity position, put options can be purchased (i.e., a protective put strategy). The number of puts to purchase depends on the hedge ratio, which depends on the option's delta. As a put option's delta moves closer to zero, the put becomes a less-effective hedging instrument, so we need to use more of them. Thus, we must add additional put options to the portfolio as the put option delta moves closer to zero
Agency cost when a company increases borrowing
Agency costs include equity holders' cost to monitor the firm's executives, management's bonding costs to assure owners that their best interests are guiding the company's actions, and residual losses that result even when sufficient monitoring and bonding exists. Adding additional debt reduces the agency costs to equity holders because less of their capital is at risk. The leverage effectively shifts some agency costs to bondholders. Additionally, managers have less cash to squander when higher leverage is employed because higher interest costs will restrict discretionary free cash flow.
AIC and BIC
Akaike's information criterion (AIC) and Schwarz's Bayesian information criteria (BIC) are also used to evaluate model fit and select the "best" model among a group with the same dependent variable. AIC is preferred if the purpose is prediction, BIC is preferred if goodness of fit is the goal, and lower values of both measures are better.
Extendible bond
An extendible bond is valued identically to a putable bond. Bond B would be identical to a 3-year putable bond where the underlying option is a European put option exercisable in 2 years at par.
If the Canadian dollar is expected to depreciate relative to the U.S. dollar and the Mexican peso, then nominal interest rates in Canada must be
Angle uses the uncovered interest rate parity relationship to forecast future spot rates. If the Canadian dollar is expected to depreciate relative to the U.S. dollar and the Mexican peso, then nominal interest rates in Canada must be higher than those in the United States and Mexico. The 13% nominal interest rate in Mexico is higher than the nominal interest rate in the U.S., so the nominal interest rate in Canada must be greater than 13%.
For an independent variable to be statistically significant, it must
As a general rule, any independent variable must have a t-statistic of 2 or more to be statistically significant.
In computing EVA , which of the following adjustments made by an analyst would be least appropriate? A) Add LIFO reserve to total capital. B) Expense R&D instead of capitalizing it. C) Eliminate deferred taxes and consider only cash taxes as an expense.
B R&D should be capitalized and amortized rather than expensing when incurred. The other adjustments are appropriate.
If the premium on Put D on November 1 is $3.18, which of the following has most likely occurred? Strike price is 30
BIC had a negative earnings surprise. The premium on Put D has risen from $2.31 to $3.18 and there is still time left until expiration. Therefore, the increase in value must have come from either a decrease in stock price, an increase in volatility, or both of these events. Choice A would be correct if the option was at expiration and the $3.18 represented only intrinsic value. Since we are not yet at the expiration date, the stock price must be above $26.82. A negative earnings surprise would most likely cause a drop in the market price of the stock. Since there is no indication of the exact amount of the drop in price, the premium observed is a possibility. A decrease in BIC volatility would reduce the put premium, not increase it.
Relative to Bond B, the Geneva, Inc., bond is most likely to be:
Bond B and Geneva, Inc., bonds are of the same credit quality, but Geneva Inc.'s bond offers a lower OAS and, hence, offers lower compensation for taking the same credit risk. Hence, the Geneva, Inc., bond is overpriced. The difference in option feature is not relevant, as OAS is computed after adjusting for option risk.
For this question only, assume that Joplin is right about the credit risk of Dxon bonds. If the volatility estimate used in generating the interest rate tree is less than the true volatility, which of the following choices most accurately describes the impact on the calculated value of bond B and the estimated OAS of bond B?
Bond B is identical to a 3-year putable bond with the put option exercisable in Year 2. If the volatility estimate used to generate the interest rate tree is lower than the actual volatility, the value of the put option and, thus, the value of the putable bond would be underestimated. A lower volatility estimate would underestimate the OAS computed for the putable bond. When the assumed level of interest rate volatility is underestimated, the computed value of the bond using backward induction methodology will be too low; therefore, the OAS needed to force the model price to be equal to the market price will be lower as well.
Effective duration of callable and putable bond
Both callable and putable bonds have an effective duration that is less than or equal to the effective duration of an optionfree bond. When the underlying call option is deep out of money, the effective duration of a callable bond and that of an option-free bond will be same. As a result, the statement about effective duration is incorrect. Thomas's statement about one-sided down duration is correct. Due to the limited upside for a callable bond, the change in price of a callable bond for a decrease in interest rates is lower than the change in price for an option-free bond.
Acquisition method vs Equity method (Net income & ROA)
Both the acquisition method and equity method will report the same net income. The acquisition method (under either partial or full goodwill) will report higher assets than the equity method and hence ROA would be lower under the acquisition method compared to under the equity method
Indication of positive serial correlation
Clark finds that the correlation between the regression errors across time was very close to 1, indicating the presence of significant positive serial correlation.
Partial GW method
Compare the buying price (the price you paid for particular ownership) with the FV of the same ownership I.e. if acquire 60% - then have to compare with 60% of the fair value
Full GW method
Consider the value 100% ownership i.e. pro rata value if the company was acquired 100%. Compare buying price with current fair value.
Countries with stewardship code
Countries with stewardship code compel some investors, (e.g., institutional investors) to "comply or explain" investor corporate governance engagement with respect to the stewardship code.
Valuation dividend discount method vs free cash flow model
DDM is from the minority shareholder perspective FCF is from the majority shareholder perspective
Using the data found in Exhibit 1 and Exhibit 4, Delicious's implied P/E multiple without regard to its U.S. associate is closest to:
Delicious's implied value without its U.S. associate is €90,736 [€97,525 Delicious market cap − €6,789 share of associate's market cap ($32,330 × 30% × €0.70 / $ current exchange rate)]. Delicious's net income without associate is €6,147 (€6,501 net income − €354 pro-rata share of income from associate). Implied P/E = 14.8 (€90,736 Delicious implied value without associate / €6,147 Delicious net income without associate).
Earnings quality refers to
Earnings quality refers not only to compliance with GAAP but also to the persistence and level of earnings. The GAAP-compliant net income does not satisfy the minimum return requirement; hence, earnings are low (and therefore of low quality).
Wilrus asks Pilchard to assess the overall significance of her regression. To address the question, Pilchard calculates the R-square. She also decides to run a test of the significance of the regression as a whole. Determine the appropriate test statistic she should use to test the overall significance of the regression.
F-Statistic The F-statistic is used to test the overall significance of the regression, which is formulated with the null hypothesis that all three slopes simultaneously equal zero. Note that the adjusted R-square is not a test-statistic.
GW Impairment GAAP
FV vs Carrying Value Impaired if FV < CV
For an unconstrained optimization, a change in aggressiveness in active weights changes
For an unconstrained optimization, a change in aggressiveness in active weights changes both the active return and active risk proportionally, leaving the information ratio unchanged.
For firms in the initial growth phase
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 negative, and the profit margin is high.
Gamma
Gamma (Γ) is an options risk metric that describes the rate of change in an option's delta per one-point move in the underlying asset's price. Delta is how much an option's premium (price) will change given a one-point move in the underlying asset's price. To dynamically hedge a long stock position, long put options will be used. Long stock has zero gamma while long put has positive gamma. Portfolio gamma therefore would be positive. Underlying stock positions will not have Gamma because their Delta is always 1.00 (long) or -1.00 (short) and will not change. Positive Gamma means that the Delta of long calls will become more positive and move toward +1.00 when the stock price rises, and less positive and move toward 0 when the stock price falls.
Which of the following correctly analyzes Grimell's comments regarding earning the risk-free rate by selling calls and buying puts, and regarding waiting for the option vegas to increase?
Grimell is incorrect in both of his statements. Using put-call parity, Mabry could create a position in which he would earn the risk-free rate of return but he would need to sell calls and buy puts with the same strike price, not the same premium. As the vega (volatility relative to price) of an option increases, it would become more sensitive to changes in the volatility of the underlying asset. Therefore, the price would likely rise, not fall.
Compared to the temporal method, which of the following best describes the impact of the current rate method on International Oilfield's gross profit margin percentage for 2016 when stated in U.S. dollars? The gross profit margin would be:
Higher Compared to the temporal method, the current rate method will result in a higher gross profit margin percentage (higher numerator) when the local currency is depreciating as is the case in this scenario (the exchange rate has risen from LCU 1 per $1 to LCU 1.25 per $1; thus, it costs more LCUs to buy $1 which is the result of a depreciating LCU). Under the temporal method, COGS is remeasured at the historic rate; thus, COGS is not impacted by the depreciating currency. Under the current rate method, COGS is translated at the average rate; thus, COGS is lower because of the depreciating currency. Lower COGS results in a higher gross profit margin percentage.
The following are two key observations about Adjusted R^2 when adding a new variable to a regression:
If the coefficient's t-statistic > |1.0|, then Adj R^2 increases. If the coefficient's t-statistic < |1.0|, then Adj R^2 decreases. Importantly, the following should be noted: ■ Unlike in simple regression, there is no neat interpretation of the adjusted R2 in a multiple regression setting in terms of percentage of the dependent variable's variation explained. ■ The adjusted R2 does not address whether the regression coefficients are significant or the predictions are biased; this requires examining residual plots and other statistics. ■ R2 and adjusted R2 are not generally suitable for testing the significance of the model's fit; for this, we explore the ANOVA further, calculating the F-statistic and other goodness-of-fit metrics
If the neoclassical theory holds then the sustainable growth rate of output of G* is
If the neoclassical theory holds then the sustainable growth rate of output of G* is the same as the long-term growth rate of capital.
Carve-out transaction
In a carve-out transaction, a new entity is created in a similar manner to the spin-off transaction. The main difference is that a minority of shares is sold to the public while the majority portion of the new shares are held by the parent company (they are not distributed to existing shareholders).
Information ratio, unlike the Sharpe ratio, is affected by
Information ratio, unlike the Sharpe ratio, is affected by an allocation to cash or by the use of leverage.
REITs vs REOCs
Investment in both public REOCs and public REITs enjoy high liquidity, as shares of both trade on a stock exchange. Tax advantages favor REITs as REOCs are not tax-advantaged. REOCs are more reliant on capital appreciation due to their ability to reinvest cash flows, while REITs tend to have higher current income (i.e., yield).
Which country is most likely to benefit from capital deepening?
Krosse Krosse is a developing nation with the highest α (share of capital in GDP) among all the countries. A high value of α indicates that the next unit of capital added will increase output almost as much as the previous unit of capital. Developing nations with a high α are more likely to benefit from capital deepening, which should result in an increase in productivity
Based on the information provided, which developing country is most likely to achieve convergence in growth rates and standard of living with their developed counterparts?
Krosse is more likely to achieve convergence because Krosse is showing more willingness towards opening up the economy to trade and financial flows than is Procken; Krosse's international trade as a proportion of GDP is higher than Proken's, and comments by Krosse's representative indicate that inflow of foreign capital would be welcome. Finally, comments by Procken's representative indicate an inward-oriented policy, which could hinder convergence.
For this question only, assume that the population growth rate is the same for Krosse and Procken. A possible cause for the difference in growth rate of labor is that relative to Procken, Krosse has:
Krosse's labor growth rate is greater than that of Procken's. Labor growth can be accomplished by (1) an increase in the labor force participation rate, (2) an increase in average hours worked, (3) additional supply of labor by immigration, or (4) a higher population growth rate. We are told that the population growth rate is equal for the two countries. The only choice that allows for higher labor growth rate is then higher average hours worked.
LIBOR-OIS Spread
LIBOR-OIS spread: Calculated as the difference between LIBOR and the overnight indexed swap rate. It is considered a good indicator of the risk and liquidity inherent in the money markets
By claiming that Knowledge Technologies is "not a sustainable business model," Sampson CEO Drew Smith would most likely estimate Knowledge Technologies's value using:
Liquidation value If the company's business model is not sustainable, the liquidation value is more appropriate than its value as a going concern (which could be negative). Balance sheet value is an accounting concept, not a valuation concept.
Sixty days after entering into the equity index futures contract, the value to the short party under the futures contract as compared to the value under an otherwise identical forward contract would most likely be:
Lower Given the decrease in the index level, the value of the short party's position in a forward contract should be positive. Because the futures contracts are marked to market, the value to the short (or long) party only reflects the change in futures price since the last mark to market. Hence, the value of the futures contract should be lower than the value of the forward contract.
Market fragmentation & as a response
Market fragmentation occurs when the number of venues trading the same instrument increases. As a response, algorithms are used to aggregate liquidity and route orders to the venues that have the best price and market depth.
Maximum drawdown vs Redemption Risk
Maximum drawdown is most commonly defined as the worst peak-to-trough decline in a portfolio's returns, or the worstreturning month or quarter for a portfolio. Maximum drawdown is an important risk measure for hedge funds. Redemption risk is a measure for open-end funds of the percentage of a portfolio could be redeemed at peak times.
Miller and Modigliani Proposition II (without taxes) states that
Miller and Modigliani Proposition II states that the cost of equity is a linear function of a company's debt/equity ratio.
Regarding the financial statement information provided in the analyst's report, the quality of financial statements has improved least for:
NavTech NavTech recently has decided to capitalize much of its research and development expense, thereby deferring much of its R&D expense (rather than immediately recognizing R&D as expense on the income statement). This is an example of aggressive accounting, especially if revenues cannot be matched directly with R&D expense. By reducing the investment return assumption on its pension investments, Sampson is moving to a more conservative approach. By capitalizing its leases (treating as finance leases rather than operating leases), Aerospace Communications more clearly reports its liabilities and assets.
Neoclassical growth theory concludes that capital accumulation affects the
Neoclassical growth theory concludes that capital accumulation affects the level of output but not the long-run growth rate.
Assuming International Oilfield is a significantly integrated sales division and virtually all operating, investing, and financing decisions are made by Continental Supply, foreign currency gains and losses that arise from the consolidation of International Oilfield should be reported in:
Net income Assuming International Oilfield is an integrated sales division and Continental Supply makes virtually all of the decisions, the functional currency is likely the presentation currency. Thus, the temporal method is used. Under the temporal method, remeasurement gains and losses are reported in the income statement
If BioTLab establishes a dividend and issues additional debt, the most likely effect on FCFF will be:
No effect If BioTLab established a dividend there would be no impact on either FCFF or FCFE. Changing the company capital structure by increasing debt will not impact FCFF, although it will initially increase FCFE by the amount of debt issued and then reduce FCFE thereafter by the after-tax interest expense.
Option-Adjusted Spread (OAS)
OAS = Z-spread - Option value (in basis points per year). The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is then adjusted to take into account an embedded option. Typically, an analyst uses Treasury yields for the risk-free rate. The spread is added to the fixed-income security price to make the risk-free bond price the same as the bond. The option-adjusted spread (OAS) measures the difference in yield between a bond with an embedded option, such as an MBS or callables, with the yield on Treasuries. Embedded options are provisions included with some fixed-income securities that allow the investor or the issuer to do specific actions, such as calling back the issue. Using historical data and volatility modeling, OAS considers how a bond's embedded option can change the future cash flows and thus the overall value of the bond.
Positive correlation causes
Positive serial correlation causes the standard errors to be too small, which then causes the t-statistics to be too large (biased upward).
Investment balance using equity method
Previous ending investment balance + equity income - dividend
Which of the following statements regarding the delta of the BIC options is correct? (Assume that the largest delta is defined as the delta furthest from zero.)
Put F has the largest delta of all the BIC options. An option that is deep in-the-money will have the largest delta. Call options that are deep in-the-money will have a delta close to one, while put options that are deep in-the-money will have a delta close to -1. Options that are out-of-the-money will have deltas close to zero. Put F is the option that is deepest in-the-money, and therefore has the largest delta (even though it is negative, the change in the price of Put F given a change in the price of BIC stock will be larger than any of the other options). Call C is the deepest out-of-the-money option, and thus has the smallest delta
When remeasuring International Oilfield's 2016 financial statements into the presentation currency, which of the following ratios is not affected by changing exchange rates under the temporal method?
Quick ratio Both the numerator (cash + receivables) and denominator (current liabilities) of the quick ratio are remeasured at the current exchange rate under the temporal method. Inventories are ignored in the quick ratio. Since the same rate is used to remeasure both the numerator and denominator, the ratio does not change when stated in the presentation currency.
Reclassifying an amortized cost security to FVPL involves
Reclassifying an amortized cost security to FVPL involves stating the investment on the balance sheet at fair value and recognizing the difference in the fair value and the carrying value in the income statement
GW Impairment IFRS
Recoverable amount vs carrying value Impaired if RA < CV
Pilchard is asked whether her regression indicates that small firms outperform large firms, after controlling for analyst coverage and consensus earnings growth forecasts. Pilchard determines the appropriate hypothesis test to answer the question. Eiffel Investments uses a 0.01 level of significance for all hypothesis tests. Given the results of her regression, Pilchard should make which of the following decisions after controlling for analyst coverage and consensus earnings forecasts?
Reject the hypothesis that b ≥ 0, and conclude that small firms significantly outperformed large firms Pilchard should test the following null hypothesis: H : b ≥ 0. The alternative hypothesis is: H : b < 0 (a negative estimate for b supports the small firm effect). The test is a one-tail hypothesis test. The critical value at the 0.01 value for a one-tail test equals - 2.479 (area in lower tail equals 0.01; degrees of freedom equal 26). Exhibit 1 indicates that the t-statistic for the b estimate equals -2.50, which exceeds the critical value. Therefore, the null hypothesis that small firms do not outperform large firms, after controlling for COVERAGE and FORECAST should be rejected in favor of the alternative hypothesis that small firms outperform large firms (after controlling for COVERAGE and FORECAST).
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?
Review of the pension fund's guidelines related to developing the specific work product. The institutional guidelines related to developing the specific work product is an input source in the first phase (defining the purpose and context of the analysis). Audited financial statements are an example of an input in the data collection phase. Ratio analysis is an example of the output from the data processing phase
Sensitivity analysis indicates that the FCFE model's valuation of BioTLab's common stock is most sensitive to
Sensitivity analysis indicates that the FCFE model's valuation of BioTLab's common stock is most sensitive to the company's growth rate
ETF Counterparty & Settlement Risk
Some ETF legal structures expose investors to counterparty risk: the invested amount could be lost in the event of counterparty failure. Settlement risk is applicable for ETFs that use OTC derivative contracts, however ADRs are exchange-traded.
Spin-off transactions
Spin-off transactions involve creating a new entity out of a company's business line or one of its subsidiaries and then granting shares in the new entity to the existing shareholders of the parent company. The shareholders are then free to sell their shares in the spin-off company in the marketplace. Spin-offs are generally viewed as a favorable sign in the market because they often result in greater efficiency for the spin-off company and the parent company
Indicate whether the statements made by Diffle in his memo regarding the value of the embedded option and the effect of the volatility assumption are correct.
Statement 1: The value of the option embedded in the Hardin bonds can be derived by simply subtracting the interest rate tree value of the Hardin bonds from the interest rate tree value of the Bratton bonds. Statement 2: I am concerned that the 10% volatility assumption used to develop the interest rate tree might be too low. A higher volatility assumption would result in a lower value for the Hardin bonds. Statement 1 is correct. The value of the option would be the difference between the value calculated with no call feature (the Bratton bonds) and the value calculated assuming the bond is callable (the Hardin bonds). Recall that the vignette stated the Bratton and Hardin bonds were identical except for the call feature in the Hardin bonds. The option value would therefore be: 100.915 − 100.472 = 0.443. Statement 2 is also correct. Increased volatility would increase the value of the option, thus lowering the value of the callable bond.
Evaluate Swift's comments regarding multicollinearity and predictive power. Which of the following comments is correct?
Swift has correctly stated that if multicollinearity is present in a model, the interpretation of the individual regression coefficients becomes problematic. The existence of multicollinearity is generally signaled by a high R-squared value and low t-statistics on the regression coefficients. The t-stat for the coefficients for payout ratio, g, and ROE can be calculated as (8.21 / 6.52) = 1.26, (14.21 / 9.24) = 1.54, and (2.81 / 2.10) = 1.34, respectively. Note that all of these t-stats are well below the approximate critical value of 2, indicating they are statistically insignificant. With the high R-squared of 81% and insignificant t-stats, it appears that multicollinearity is indeed present in this model. Swift's comment regarding predictive power is incorrect. Cross-sectional regressions have unknown predictive power outside the specific sample and time period used to generate the regression.
Your portfolio has a 5% monthly VaR of $225,000 means
The $225,000 is a minimum loss that will be exceeded 5% of the time.
The degrees of freedom for the regression sum of squares (a.k.a., the explained sum of squares) equals
The ANOVA (Analysis of Variance) Table provides data on the sources of variation in the dependent variable (stock returns). The degrees of freedom for the regression sum of squares (a.k.a., the explained sum of squares) equals k, the number of independent variables: The total sum of squares equals the numerator of the sample variance formula for the dependent variable. Recall from Level I Quantitative Methods that the denominator of a sample variance equals N − 1. The denominator in the sample variance equals the degrees of freedom for the numerator (the total sum of squares). Therefore, the degrees of freedom for the total sum of squares in Pilchard's regression equals 30 − 1 = 29.
The P/E model is considered weak because
The P/E model is considered weak because accounting issues can impact earnings.
TED Spread
The TED spread is the difference between the three-month Treasury bill and the three-month LIBOR based in U.S. dollars. To put it another way, the TED spread is the difference between the interest rate on short-term U.S. government debt and the interest rate on interbank loans. The TED spread is the difference between the three-month LIBOR and the three-month Treasury bill rate. The TED spread is commonly used as a measure of credit risk, as U.S. Treasury bills are seen as risk-free. The TED spread often widens in periods of economic crisis, as the default risk widens; the spread narrows when the economy is more stable and defaults are less of a risk.
The accounting for an ownership interest of between 20% and 50% in an associate is handled using
The accounting for an ownership interest of between 20% and 50% in an associate is handled using the equity method. Under the equity method, the initial investment is recorded at cost and reported on the balance sheet as a noncurrent asset. Because the acquisition in this case is fully funded by cash, there will be no change to total assets for Hope.
The asset market approach focuses on
The asset market approach focuses on fiscal policy—not monetary policy.
The bootstrap effect will occur when
The bootstrap effect will only occur when Fashion's P/E ratio is higher than Flavoring's and Fashion's P/E post merger does not decline. At the current market price of $30.50, Fashion's P/E is 19.1, based on earnings per share of $1.60 ($80 million earnings / 50 million shares). At its current market price of $20 and earnings per share of $1.10 ($22 million earnings/20 million shares), Flavoring's stock's P/E is 18.2x. Therefore, the combined earnings per share after the merger would be higher if Fashion issued stock at the current price and bought Flavoring at $20 or less per share.
Assuming that on October 15, the closing price of BIC common stock is $40 per share, how would the delta of Put F have changed from June 1? (Strike price is at 50)
The delta on Put F will move closer to -1. As the option moves further into the money and as the expiration date approaches, the delta of a put option moves closer to -1.
Which of the following statements is most accurate regarding Diffle's calculation of duration and convexity?
The duration estimate for the Bratton bonds will reflect the projected percentage change in price for a 100-basis-point change in interest rates. The duration formula given will calculate the percentage change in price for a 100-basis-point change in yield, regardless of the actual change in rates used to derive BV and BV . The standard backward induction process would ensure that the derived values of BV and BV reflect any potential change in cash flows due to embedded options.
Statement 1: If relative purchasing power parity holds, we can say that uncovered interest rate parity also holds under certain conditions. What additional condition must be satisfied for Hohlman's Statement 1 to be valid?
The international Fisher relation must hold. If relative purchasing power parity holds, then inflation differentials drive future exchange rates. If the international Fisher relationship holds, then inflation differentials will be equal to interest rate differentials. Hence, when both relative purchasing power parity and the international Fisher relationship hold, uncovered interest rate parity should also hold. Covered interest rate parity always holds (by arbitrage) and is not a necessary additional condition. Real interest rate parity links the Fisher effect to the international Fisher relationship.
The objectives of regulators in financial markets include
The objectives of regulators in financial markets include (1) prudential supervision, (2) financial stability, (3) market integrity, and (4) economic growth. Low inflation is likely to be an objective of the central bank.
The optimal active risk for a constrained portfolio
The optimal active risk for a constrained portfolio = TC × optimal active risk for an unconstrained portfolio. Given that TC < 1 for constrained portfolio, the optimal active risk for a constrained portfolio will be lower than the optimal active risk for an unconstrained portfolio
The portfolio with the highest information ratio will have the
The portfolio with the highest information ratio will have the highest Sharpe ratio. Recall that the Sharpe ratio of the portfolio is computed as SR Port^2 = SR Bench^2 + IR Port^2 . Given that benchmark Sharpe ratio (SR ) is the same for all similar active portfolios, the active portfolio with the highest information ratio will also be the portfolio with the highest Sharpe ratio.
The residual income approach
The residual income approach is most appropriate for firms that do not have dividend histories, have transparent financial reporting, and have negative free cash flow for the foreseeable future (usually due to capital demands).
"...I would suggest one area you could look at improving is the portion on term structure theories. Personally I would remove the theory stating that lenders and borrowers influence the shape of the yield curve and that the yield of each maturity sector is determined independently. I suggest instead that you take a look at the following equilibrium term structure model, which calculates the change in the short term interest rate (dr) over small increments of time (dt): dr = a(b-r)dt + sigma(r^0.5)dz It is a formula I personally use when modelling rates, typically with r = 3%, b = 8%, a = 0.40, σ = 20%."
The segmented markets theory and the preferred habitat theory both state that rates are influenced by lenders and borrowers, but it is the segmented markets theory that proposes that the maturity sectors are independent. The "b" term in the Cox-Ingersoll-Ross model is the mean reverting level for the short-term interest rate
If the gamma of Put E is equal to 0.081, which of the following correctly interprets the option's gamma?
The sensitivity of Put E's price to changes in BIC's stock price is very likely to change An option's gamma measures the change in the delta for a change in the price of the underlying asset. The gamma of an option is highest when an option is at-the-money since the probability of moving in or out of the money is high. Put E is close to being at-the-money and because it has a gamma of greater than zero, the sensitivity of Put E's price to changes in BIC's stock price (i.e., the delta) is likely to change. The higher the gamma, the greater the change in delta given a change in stock price.
How to calculate confidence interval
The standard error can be determined by knowing the formula for the t-statistic: t-statistic = (slope estimate − hypothesized value) / standard error Therefore, the standard error equals: standard error = (slope estimate − hypothesized value) / t-statistic The null hypothesis associated with each of the t-statistics reported for the slope estimates in Table 1 is: H : slope = zero. So, the standard error equals the slope estimate divided by its t-statistic: 0.2000 / 2.85 = 0.07. The confidence interval equals: slope estimate ± (t × standard error), where t is the critical t-statistic associated with the desired confidence interval (as stated in the question, the desired confidence interval equals 99%). Exhibit 3 provides critical values for a portion of the Student t-distribution. The appropriate critical value is found by using the correct significance level and degrees of freedom. The significance level equals 1 minus the confidence level = 1 − 0.99 = 0.01. The degrees of freedom equal N − k − 1, where k is the number of independent variables: 30 − 3 − 1 = 26 degrees of freedom. Note that the table provides critical values for one-tail tests of hypothesis (area in upper tail). Therefore, the appropriate critical value for the 99% confidence interval is found under the column labeled "0.005," indicating that the upper tail comprises 0.5% of the t-distribution, and the lower tail comprises an equivalent 0.5% of the distribution. Therefore, the two tails, combined, take up 1% of the distribution. The correct critical t-statistic for the 0.01 significance level equals 2.779. Therefore, the 99% confidence interval for the FORECAST slope coefficient is: 0.2000 ± 2.779(0.07) = (0.0055, 0.3945)
SWAP vs TED
The swap spread gives more information about supply and demand conditions in the market at a given maturity, whereas the TED spread more accurately reflects the level of risk in the banking system.
Under Standard V(A), specification of a price target is acceptable as long as
Under Standard V(A), specification of a price target is acceptable as long as the risk is appropriately disclosed. A research report can specify VaR as an appropriate risk metric, but the report should clarify that the quality of the VaR estimate depends on the quality of model inputs
Under the current rate method, gains and losses that occur as a result of the translation process
Under the current rate method, gains and losses that occur as a result of the translation process do not show up on the income statement but are instead accumulated in a balance sheet account called the cumulative translation adjustment account (CTA). The translation gain or loss in each year is calculated and added to the account, acting like a running total of translation gains and losses. The CTA is simply an equity account on the balance sheet.
the parametric method.
VaR has been calculated using the parameters (mean and standard deviation) of the portfolio and assuming a distribution for portfolio risk factors. A historical simulation would instead identify actual returns from the portfolio and identify the 5th percentile
Wash trading Layering Stuffing
Wash trading is a kind of market manipulation where the investor buys and sells the same financial instrument simultaneously, in order to simulate demand in the instrument by boosting trading volume. Placing a legitimate trade on one side of the market and several bogus orders on the other side of the market is known as layering. Entering large quantities of fictitious orders into the market and instantaneously canceling them is known as quote stuffing
When the expected future spot rate is equal to the forward rate (and covered interest parity holds—by arbitrage),
When the expected future spot rate is equal to the forward rate (and covered interest parity holds—by arbitrage), uncovered interest rate parity should hold as well. The international Fisher relationship links relative purchasing power parity to uncovered interest rate parity. Real interest rate parity links the Fisher effect to the international Fisher relationship.
Swap curve is more commonly used among
Wholesale banks than retail banks; retail banks normally use the government yield curve.
Z-Spread
Z-spread: Calculated as the constant basis point spread added to the implied spot yield curve so that the discounted cash flows of a bond equal its market price. For a risky bond, the Z-spread is a more accurate measure of compensation for credit and liquidity risk than the swap spread.
As the uncertainty of the information coefficient increases, we are most likely to observe an increase in the:
active risks Active risk is comprised of the uncertainty from benchmark tracking risk and uncertainty about the true information coefficient (σ ). Hence, an increase in uncertainty about the information coefficient will increase active risk. The basic fundamental law relates expected active return to the information coefficient as follows: E(Ra) = IC/SigmaIC x BR^0.5 x SigmaA Hence, an increase in the uncertainty of the information coefficient leads to a decrease in the expected active return and a decrease in the information ratio.
The estimated loss under the condition that VaR has been exceeded is known as
conditional VaR.
Which of the following most accurately critiques the OAS discussion between Diffle and Puldo? Puldo is:
correct that the OAS will provide insight into the liquidity risk of the Hardin bonds, and Diffle is correct that different volatility assumptions would change the OAS. The OAS accounts for compensation for credit and liquidity risk after the optionality has been removed (i.e., after cash flows have been adjusted). Since in this case the credit risk of the bonds is similar, the OAS could prove helpful in evaluating the relative liquidity risk. OAS will be affected by different assumptions regarding the volatility of interest rates.
The FCFF model is better than the FCFE model in valuing
debt laden, cyclical companies, and companies with a changing capital structure.
Sixty days after the inception of the futures contract on the equity index, Norris has suggested an arbitrage strategy. Regarding the appropriateness of the strategy, the strategy is best described as:
inappropriate since the futures contract is overpriced. First, calculate the continuously compounded risk-free rate as ln(1.040811) = 4% and then calculate the theoretically correct futures price as follows: FP = S e = 1,015e = 1,025 Then, compare the theoretical price to the observed market price: 1,035 - 1,025 = 10. The futures contract is overpriced. To take advantage of the arbitrage opportunity, the investor should sell the (overpriced) futures contract and buy the underlying asset (the equity index) using borrowed funds. Norris has suggested the opposite.
If the expected growth rate in dividends for stocks increases by 75 basis points due to an improvement in economic conditions, who among the following would benefit the most? An investor who:
is long futures contracts on the equity index. An increase in the growth rate in dividends for stocks would increase the spot price of the equity index. As the spot price increases, the futures price for a given maturity also increases (holding interest rates constant). Higher dividends during the short period of time until maturity of the futures contract would have only a minimal negative impact on the futures price.
Rental price of capital
is the same as marginal cost of capital
In a steady state, marginal product of capital & marginal cost of capital
n steady state (i.e., in equilibrium), the marginal product of capital (MPK = αY/K) and marginal cost of capital (i.e., the rental price of capital, r) are equal; hence: αY/K = r.
High quality cash flow is most likely to be characterized by:
positive OCF that covers capital expenditures, dividends and debt repayments.
Primary Risk Management Measure - Steps Step 1: Identify the top 10 exposures for the portfolio. Step 2: Design a hypothetical global event that would simultaneously adversely affect each of the exposures. Step 3: Assess the impact on the portfolio. The primary risk management measure discussed in Exhibit 2 is most accurately described as:
reverse stress testing The description is of reverse stress testing, which is a form of scenario analysis, not sensitivity analysis. A Monte Carlo simulation would run many repeated scenarios.
Static trade-off theory of capital structure
static trade-off theory of capital structure, which states that a company should lever up to the point at which the additional increase in the costs of financial distress exceeds the additional increase in the tax shield from interest rate payments. Once this point is reached, adding more leverage to the company will decrease its value
the implications of an expansionary monetary policy in the U.S. under the Mundell-Fleming model predicts that
the implications of an expansionary monetary policy in the U.S. under the Mundell-Fleming model, which predicts a depreciation of the dollar
The international Fisher relationship links relative purchasing power parity to
uncovered interest rate parity.
