Notable Incorrect Exam Questions / Things to Remember

Calculation of Periodic Pension Cost (see problem 54 on Exam 4) Same for Question 55 on related topic SAME FOR 56

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Another stock (not in the portfolio), PSL, has a factor sensitivity of -0.9 to inflation and +1.2 to GDP growth rate. Last year, PSL's actual return was 8% (0.5% unexplained by the model). Inflation surprise, as well as GDP growth rate surprise, was +0.5%. PSL's expected return was closest to: A) 7.35%. B) 7.50%. C) 8.50%.

8 = E(R) + (-0.9 × 0.5) + (1.2 × 0.5) + (0.5) E(R) = 7.35% Answer is A REMEMBER: macroeconomic factor models have Expected Return (E(r)) as the intercept, with the suprise factors to the variables as what causes the deviations from the Expected Return.

Which of the following items in the statement of cash flows would be least appropriate to detect improper revenue recognition by Delicious? A) cash inflows from a reduction in receivables. B) cash inflows due to a reduction in inventories. C) cash inflows due to a higher net income.

A Improper revenue recognition (e.g., bill and hold sales) accounting results in an increase in sales (and increase in accounts receivable), increase in cost of goods sold (i.e., reduction in inventory) and an increase in net income.

I suggest instead that you take a look at the following term structure model, which calculates the change in the log of the short term interest rate over small increments of time (dt): dln(rt) = ϴtdt + σdzt Kahn's feedback in Exhibit 2 is most likely to be advocating the exclusion of: A) the segmented markets theory in favor of the Kalotay-Williams-Fabozzi (KWF) model. B) the preferred habitat theory in favor of the Vasicek model. C) the segmented markets theory in favor of the Cox-Ingersoll-Ross model.

A is Answer The Kalotay-Williams-Fabozzi (KWF) model assumes constant drift, no mean reversion, and constant volatility. The KWF differential equation describes the dynamics of the log of the short interest rate. 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

Soft- vs Hard-Catalyst Event Driven Approach

A soft-catalyst event-driven approach is an investment made before an event has been announced. A hard-catalyst event-driven approach is an investment made after a corporate event has been announced; this strategy seeks to take advantage of security prices that have not fully adjusted.

QUESTION ON OTHER SIDE; ANSWER BELOW Best's post-acquisition LTD is $8,000 million [= 7,700 million BV of Best + 300 million fair value (FV) of Gremlin debt]. Best's post-acquisition equity is equal to $7,300 million (= 5,800 million Best pre-acquisition equity + 900 million FV of shares used to acquire Gremlin + 600 million noncontrolling interest). Under U.S. GAAP, the noncontrolling interest is based on the full goodwill method (= 1,500 million FV of Gremlin × 40% noncontrolling interest). Thus, the long-term debt-to-equity ratio is 1.10 (= 8,000 million LTD / 7,300 million equity). Under both IFRS and GAAP, you cannot restate debt as fair value (only can account for acquisition of debt at fair value for subsidiary only), which is why it is 7,700 BV + 300 FV. Under GAAP, only can do Full Goodwill.

According to U.S. GAAP, Best's long-term debt-to-equity ratio, calculated immediately after the acquisition, is closest to: A) 1.07. B) 1.10. C) 1.12.

Accruals Ratio Formula

Accruals Ratio = Aggregate Accruals / Average NOA Balance Sheet Approach: Aggregate Accruals = NOA(t) - NOA(t-1) ---- NOA = (assets - cash*) - (liabilities - total debt) ---- *includes cash equivalents & marketable securities Cash Flow Approach: Aggregate Accruals = NI - (CFO + CFI)

West is meeting with a client to discuss inclusion of actively managed funds in that client's portfolio. To prepare for the meeting, West creates a presentation to illustrate the merits and risks of this change. West cannot recall the term that is used to capture the sum of active factor risk and active specific risk (where these two terms refer to variances rather than standard deviations). The term that West cannot recall is most likely: A) active total risk. B) active risk squared. C) alpha risk.

Active risk squared = active factor risk + active specific risk. (Note that the terms in this equation "active specific risk" and "active factor risk" refer to variances rather than standard deviations.) Answer is B

If Jacobs enters into a $10 million 4-year 4.50% annual-pay fixed-rate equity swap as the equity return payer, what is the value to Jacob of the swap after one year (immediately after settlement) if the index has increased from 1,054 to 1,103, the MRR term structure is as given below, and the 3-year annual-pay swap fixed rate is currently 5.0%? MRR 1-year: 4.10% 2-year: 4.70% 3-year: 5.29% A) -$136,885 B) -$464,982 C) -$602,555

Answer is A

Regarding Carson's question about mechanics of forward pricing, Walsinzki would most accurately state that forward prices are set such that: A) the market value of the contract at inception is 0. B)the forward price is higher than the spot price by the expected return on the underlying. C) the forward price is lower than the spot price by the dividend yield on the underlying.

Answer is A Forward prices are set so the market value of the contract at inception is zero. Using the cost of carry model, forward price equals spot price plus net cost of carry. For an equity forward contract, net cost of carry equals risk-free rate minus dividend yield.

When valuing a small stake in a private company using a P/E multiple from comparable public companies as the basis for valuation, we should apply appropriate discounts to reflect the unique characteristics of the private company investment. Regarding thestatement made by Lutge on valuation discounts, which of the following discounts would be appropriate in the scenario described? A) DLOM ONLY. B) DLOC ONLY. C) Both DLOM and DLOC ONLY.

Answer is A If the basis of valuation is public company comparable, a discount for a private company's lack of marketability (DLOM) would be appropriate. Because this particular valuation is based on comparable public company's multiples such as P/E (and not actual public company acquisition prices), no control premium is not embedded in the valuation. Accordingly, a DLOC should not be applied.

Ponder has a carry trade open involving the Bun (the currency of Bundovia). Ponder notices that Bundovia has a current account deficit and asks Satya about the impact of such a deficit on the value of the Bun. Satya states that the impact on the Bun depends on three factors: Factor 1: The expected size of the current account deficit in the future. Factor 2: The influence of exchange rates on domestic prices. Factor 3: The response of import and export demand to changes in import and export prices. How many of the factors identified by Satya regarding Bundovia's current account deficit are accurate? A) One factor only. B) Two factors only. C) All three factors.

Answer is A Only Factor 3 is correct. Factor 1 incorrectly specifies the size of expected future deficits rather than size of initial current account deficit. Factor 2 incorrectly specifies influence on domestic prices in general rather than domestic prices of traded goods (i.e., imports/exports).

Ganatra meets an old colleague, Riteish Shah, for lunch. Shah specializes in the insurance industry and makes the following statements: Statement 1: P&C insurers' liability duration is generally shorter than that of life insurance companies. Statement 2: Analysis of a life insurer's profitability includes analysis of its loss reserves. Which of Shah's statements about insurance companies is most accurate? A) Only Statement 1 is correct. B) Only Statement 2 is correct. C) Both statements are correct.

Answer is A Only Statement 1 is correct. P&C policies (and hence, claim liabilities) tend to be short-term, compared to relatively long-term life insurance policies. Statement 2 is incorrect because evaluation of loss reserves is important for P&C insurers' profitability. (Module 11.6, LOS 11.f)

For valuation purposes, Margulies prefers to use a metric that is representative of the current economic income of a REIT; meaning, one that represents the funds available for distribution. Based on Margulies's focus on current economic income, the most appropriate metric to use to value a REIT is: A) AFFO. B) NOI. C) FFO.

Answer is A REMEMBER: FFO is popular among data providers but AFFO focuses on ECONOMIC INCOME Adjusted funds from operations (AFFO) is intended to serve as a useful representation of current economic income. AFFO is also known as cash available for distribution (CAD) or funds available for distribution (FAD).

Upon analyzing a particular bank's offering of a 2-year forward contract on a risk-free, 5-year, zero coupon bond, Hellens states that "the quoted forward price of $0.8608 per $1 is higher than it should be under the forward pricing model and, hence, arbitrage profits could be made." Maturity (years) | Spot Rate (%) 1 | 0.25 2 | 0.36 3 | 0.90 5 | 1.49 7 | 2.27 10 | 2.94 20 | 3.52 30 | 4.00 Hellens's claim regarding the 2-year forward contract on the 5-year, risk-free, zero coupon bond is most accurately described as: A) incorrect, as the quoted price is roughly in line with the forward pricing model. B) incorrect, as the quoted price is much lower than the forward pricing model would suggest. C) correct.

Answer is A The trouble I had here is the terminology... when referring to a forward rate, the "2-year forward" means a forward contract that STARTS in 2 years (NOT MATURES IN 5 YEARS). The "5-Year" part is the maturity.

Schipper makes the following statements regarding Monte Carlo simulation: Statement 1:We can use a Monte Carlo simulation, however if the asset returns are correlated a multivariate distribution should be specified. Statement 2:Monte Carlo simulation is a proxy for actual investing. Regarding Schipper's two statements: A) Only statement 1 is correct. B) Only statement 2 is correct. C) Both statements are correct.

Answer is A When individual asset returns are correlated, it is crucial to specify a multivariate distribution in a Monte Carlo simulation. Rolling-window backtesting (not Monte Carlo simulation) is a proxy for actual investing.

Point 1: Unlike the structural model, reduced form models do not explain why default occurs. Point 2: A key input into the reduced form model is the default intensity, which is the probability of default over the next time period. Default intensity is estimated using option pricing models. Which of Lowenstadt's points in Exhibit 1 is correct? A) Only point 1 is accurate. B) Only point 2 is accurate. C) Neither point is accurate.

Answer is A While structural models provide economic rationale regarding why default occurs (i.e., when AT < K), reduced form models do not. Default intensity is typically estimated using regression models (not option pricing models).

Walsinzki's report first identifies that the firm has a payer position in a two-year, semiannual, 3.25% fixed interest rate swap with a notional of $15 million. The second settlement just occurred. Current 180-day and 360-day MRR are 3.25% and 3.50%, respectively. The value of the interest rate swap is closest to: A) $32,200. B) $47,500. C) $63,300.

Answer is A new 180-day discount factor = 1 / [1 + (0.0325 × 180 / 360)] = 1 / 1.01625 = 0.9840. new 360-day discount factor = 1 / [1 + (0.035 × 360 / 360)] = 1 / 1.035 = 0.9662. sum of the discount factors = 0.9840 + 0.9662 = 1.9502 new SFR = [(1 - 0.9662) / 1.9502] × (360/180) = 3.47% value (payer) = (0.0347 - 0.0325) × (180 / 360) × (1.9502) × ($15,000,000) = $32,178.30.

Defined Benefit Pension Plans Dudda noted that the assumed higher expected rate of return on plan assets reduces reported pension expense but does not affect the PBO, and thus increases the plan's funded status. Dudda's statement about defined benefit pension plans is most likely: A) correct. B) correct about PBO but incorrect about funded status. C) correct about funded status but incorrect about PBO.

Answer is B Assuming a higher expected rate of return on plan assets (under U.S. GAAP) reduces reported pension expense but does not affect the PBO nor the fair value of plan assets -- and therefore does not affect the funded status of the plan.

Janet Grange, CFA, a junior analyst makes the following statements about the industry: Statement 1: There is considerable economy of scale for R&D expense as evidenced by larger R&D expenditures (as a proportion of revenues) for larger companies. Statement 2: Firms with commodity-type inputs that can pass higher material costs on to their customers often hedge their future input costs by using forward contracts or other derivative securities. Regarding the statements made by Grange, it is most accurate to state that: A) both statements are correct. B) both statements are incorrect. C) only one statement is correct.

Answer is B Economies of scale in R&D expense are evidenced by lower R&D expense as a proportion of sales for larger companies. Firms with commodity-type inputs that cannot easily pass on higher input costs to their customers often hedge their future input costs by using forward contracts or other derivative securities. (If the input costs can be passed on to the customer, the producer does not have a pricing risk that needs to be hedged.)

Furthermore, the report outlines that the firm holds a call option on a Eurodollar futures contract. This position was established to hedge another position of the firm, but Walsinzki could not identify the position that was being hedged. The call option on Eurodollar futures is most likely being used to hedge: A) a floating rate liability. B) a long position in a floating rate note. C) a long position in a fixed rate bond.

Answer is B Eurodollar futures contracts are cash settled contracts on MRR. Futures prices are inversely related to MRR. Call options on Eurodollar futures increase in value when interest rates fall, and hence, can be used to hedge a floating rate asset. It's essential to differentiate Eurodollar futures options from other types of interest rate options: General Interest Rate Options: For options directly on interest rates (not through futures), a call option increases in value when rates rise because you're betting directly on the rate itself increasing. Eurodollar Futures Options: With Eurodollar futures options, you're dealing with the futures price, which moves inversely to the rate. Thus, a call option increases in value when rates fall because the futures price is rising.

In Jackman's binomial interest rate tree, the probability of an up movement is least likely to be equal to: A) exactly 50%. B) (1 + Rf​ - D) / (U​ - D). C) 1 - the probability of a down move.

Answer is B For a binomial interest rate tree, the probability of an up movement = the probability of a down movement = 0.5. In a binomial stock price tree, the risk-neutral probability of an up move can be calculated based on the risk-free rate, the size of an up movement, and the size of a down movement: πU = (1 + Rf - D) / (U - D).

Gillis received an invitation from the new finance minister of Binaria, one of the EM nations included in her portfolio. The minister has proposed a number of fiscal reforms that he hopes will help support Binaria's weakening currency. Because of its remote location, Binaria will pay all travel expenses of the attendees, as well as lodging in government-owned facilities in the capital city. As a further inducement, attendees will also receive small bags of uncut emeralds (because emeralds are a principal export of Binaria), with an estimated market value of $500. According to CFA Institute Standards of Professional Conduct, Gillis may accept the invitation to attend the conference in Binaria without violating the Standards: A) so long as she pays her own travel expenses and refuses the gift of emeralds. B) so long as she refuses the gift of emeralds. C) because she would be the guest of a sovereign government.

Answer is B Standard I(B). Attending the conference would be appropriate, but Gillis must avoid any situation that would affect her independence in order to properly comply with Standard I(B) − Professionalism: Independence and Objectivity. Since Binaria is remotely located, it is reasonable for the government to pay her travel expenses. However, the gift of emeralds must be refused. The fact that the host is a sovereign government does not matter—the obvious objective is to give the analysts a favorable bias toward the currency and the proposed reforms. (Module 42.1, LOS 42.a)

When formulating the proxy voting policy, which of the following is least appropriate for Burton to include? A) Determine the economic impact of non-routine proxy votes. B) Treat all proposals equally as far as proxy voting goes. C) If the client preference differs from the proxy voter's preference, defer to client wishes.

Answer is B Standard III(A) Loyalty, Prudence, and Care. Unusual proposals, such as hostile takeovers and executive changes, may require more review than routine matters such as renewing stock-repurchase agreements. Money managers should provide a means to review complex proxies. Establishing evaluation criteria and disclosing the firm's proxy voting policies and procedures to clients are basic elements of a proxy-voting policy. Client wishes regarding proxy voting should always be followed.

Miller makes two statements concerning cost of capital as shown below: Statement 1: In some less-developed countries that lack corporate debt markets, businesses have to rely on bank lending known as the shadow banking system. Statement 2: Countries that follow common law-based legal systems offer lower risk premiums compared to countries with civil law-based legal systems. Miller has made two statements, the shadow banking system, and the other concerning the characteristics of common law-based and civil law-based legal systems. Are Miller's statements correct? A) Only Statement 1 is correct. B) Only Statement 2 is correct. C) Both Statements 1 and 2 are correct.

Answer is B Statement 1 is incorrect. Shadow banking system relies on unregulated, non-bank sources. Statement 2 is correct. Countries that follow common law-based legal systems offer stronger protection to investors, leading to lower risk premiums compared to countries with civil law-based legal systems.

An analyst is considering the effects of income reported under the equity method on certain financial ratios. For a firm that reports equity income as non-operating income (not included in EBIT), removing equity income from the financial statements would most likely result in: A) an increase in the tax burden term in the extended Du Pont decomposition of ROE. B) an increase in the asset turnover ratio. C) a decrease in the interest coverage ratio.

Answer is B Tax Burden = NI/EBT Asset Turnover Ratio = Sales/Avg Assets Interest Coverage Ratio = EBIT/Interest Removing the effects of the income reported under the equity method involves removing the income and the equity asset reported on the balance sheet. The decrease in total assets will increase the asset turnover ratio. The tax burden term is net income divided by earnings before tax so that the decrease in net income from removing the equity income will decrease the term. Neither interest expense nor operating earnings (EBIT) are affected by the appropriate adjustments, so the interest coverage ratio is unaffected. (Module 13.2, LOS 13.b)

Regarding Mollie's Question 1, the inter-temporal rate of substitution is best defined as: A) the rate at which a consumer is willing to substitute risky assets for default-free assets. B) the rate at which a consumer is willing to substitute consumption in the present for consumption in the future. C) the rate at which a consumer is willing to substitute consumption in the future for consumption in the present.

Answer is B The intertemporal rate of substitution is the ratio of the marginal utility of future consumption to the marginal utility of current consumption. As such, this measure represents the rate at which the consumer is willing to substitute current consumption for 1 unit of consumption in the future. Note that in most scenarios, the inter-temporal rate of substitution is less than 1, meaning that individuals generally prefer present consumption over future consumption.

Stan Loper is unfamiliar with the Black-Scholes-Merton (BSM) option pricing model and plans to use a two-period binomial model to value some call options. The stock of Arbor Industries pays no dividends and currently trades for $45. The up-move factor for the stock is 1.15, while the down factor is 0.87, and the risk-free rate is 4%. He is considering buying two-period European style options on Arbor Industries with a strike price of $40. The delta of these options over the first period is 0.83. Loper is curious about the effect of time on the value of the calls in the binomial model, so he also calculates the value of a one-period European style call option on Arbor stock with a strike price of 40. The difference in value between the European 40 calls and otherwise identical American 40 calls is closest to: A) -$1.43. B) $0.00. C) $1.92.

Answer is B The possibility of early exercise is not valuable for call options on non-dividend paying stocks, so the value of the American call is the same as the value of the European call, and the difference in value is zero.

Additionally, because of the rise in the value of Clear's stock price, in 20X5 there was a tax windfall from the employee incentive stock option scheme. Due to its employee incentive stock option plan only, if Clear had presented its financial statements under U.S. GAAP, it would have reported: A) the same net income but higher stockholders' equity. B) higher net income but the same stockholders' equity. C) lower net income and lower stockholders' equity.

Answer is B Under U.S. GAAP, a tax windfall would reduce tax expense in the income statement and hence result in a higher net income. Tax windfalls would go directly into equity via OCI under IFRS. Either way, the stockholders' equity would be the same.

The endogenous growth theory predicts that the Tiberian GDP growth rate is most likely to: A) settle at a long-run steady state because of diminishing marginal productivity of capital. B) continue to increase because technological advances will be shared by many sectors of the economy. C) decline because the current GDP growth rate is not sustainable.

Answer is B Under the endogenous growth theory, the Tiberian GDP growth rate can continue to increase because technological advances will be shared by many sectors of the economy. Increasing R&D investment, for example, results in benefits not just to the firm making the investment but also to other firms. As these benefits flow to other firms, the economy becomes more productive and the long-term economic growth rate can continue to increase. A is neoclassical growth theory

Stan Loper is unfamiliar with the Black-Scholes-Merton (BSM) option pricing model and plans to use a two-period binomial model to value some call options. The stock of Arbor Industries pays no dividends and currently trades for $45. The up-move factor for the stock is 1.15, while the down factor is 0.87, and the risk-free rate is 4%. He is considering buying two-period European style options on Arbor Industries with a strike price of $40. The delta of these options over the first period is 0.83. Loper is curious about the effect of time on the value of the calls in the binomial model, so he also calculates the value of a one-period European style call option on Arbor stock with a strike price of 40. The value of the one-period 40 call on Arbor stock is closest to: A) $6.65. B) $6.86. C) $7.15.

Answer is B. Make a tree but only out 1 year rather than the full 2.

"Active bond managers will seek to outperform the market by anticipating interest rate movements that are not in line with current spot and forward rates. For example, the price of a 1-year forward contract on a 1-year, zero coupon, risk-free bond will remain unchanged if the future 1-year spot rate in one year is equal to the current 2-year spot rate. If it is not, there may be an opportunity for active managers to outperform the market." Lindstrom's comment in Exhibit 2 on active bond management is most likely: A) correct. B) incorrect, as the forward price will be unchanged if the 1-year spot rate occurring in one year is equal to the current 1-year forward rate one year from now [f (1,1)]. C) incorrect, as the forward price will be unchanged if the 1-year spot rate occurring in one year is equal to the current 1-year spot rate.

Answer is B. Spot rates should evolve in line with the current forward rates.

Smart then directs his attention to a particular T-bond futures contract. The cheapest-to-deliver is a 2.50% semi-annual coupon bond that last paid a coupon two months ago. The bond trades at $103.14 (clean price) and has a conversion factor of 0.8125. The futures contract matures in 3 months. The current 3-month risk-free rate is 0.25%. The no-arbitrage T-bond futures price is closest to: A) 102.74. B) 114.59. C) 126.25.

Answer is C

Recommendation: My research indicates that the slope coefficients of your regression changed significantly after the passage of Regulation Fair Disclosure, which took place in the middle of your 3-year sample period. Your regression pools across two distinct sample periods. Therefore, I recommend correcting your current regression equation for model misspecification. Regarding Lockhart's recommendation, the most likely form of model misspecification to which he refers is: A) stationarity model misspecification. B) time-series model misspecification. C) functional form model misspecification.

Answer is C All 4 of the attached are considered "Functional Form Model Misspecifications

Lowenstadt makes the following statement regarding this analogy and how it can be used to value equity and debt: Statement 1: Holding the company's equity is economically equivalent to owning a European call option on the company's assets. Lowenstadt's Statement 1 is best described as: A) incorrect, as he should have instead stated American call option. B) incorrect, as he should have instead stated European put option. C) correct.

Answer is C European call on assets is the correct analogy for equity under the structural model for credit analysis. Equity Analogy -- Call Option Analogy: hold european call option on company's assets -- Put Option Analogy: Long net assets of company and long a put Risky Debt Investor Analogy: Value of Risk Free Debt - Value of put option (aka CVA) (minus bc you are short the put option)

Which of the following would least likely lead to a higher persistence factor for Heritage? A) Heritage does not pay any dividends. B) Luxury residential builders have enjoyed a high persistence factor historically. C) Heritage has a high level of ROE as compared to its peers.

Answer is C Higher persistence factors will be associated with the following: -- Low dividend payouts -- Historically high residual income persistence in the industry Lower persistence factors will be associated with the following: -- High return on equity (counterintuitive; it is bc high ROE relative to peers is often a sign of manipulated earnings) -- Significant levels of nonrecurring items -- High accounting accruals

McDermott tells Mollie that the inter-temporal rate of substitution in East Farnia is 0.9368. The real risk-free rate in East Farnia is closest to: A) 2.1%. B) 3.3%. C) 6.8%.

Answer is C Real risk-free rate = [1/ E(mt)] - 1 = (1 / 0.9368) - 1 = 0.0675 = 6.75% or M(t) = P(0); therefore: Real Risk Free rate = [1 - P(0)] / P(0)

Saminder has reviewed an internal document outlining JJK's approach to meeting regulatory requirements and has made a note of two fundamental rules that she believes are used to help analyze capital adequacy. Rule 1: When assessing the tier 1 capital ratio, assets should be weighted according to their risk, with riskier assets assigned a lower value than risk-free assets such as cash. Rule 2: Off-balance-sheet assets should be excluded from the asset base of the bank when assessing capital adequacy. Which of Saminder's fundamental rules is most likely to be accurate? A) Only rule 1 is accurate. B) Only rule 2 is accurate. C) Neither rule is accurate.

Answer is C Rule 1 is incorrect because riskier assets are assigned a higher weighting. Risk-free assets such as cash are typically assigned a weighting of zero, because their risk-free nature means that they do not need to be supported by capital. Riskier assets require more capital funding, hence the higher weighting and risk adjusted value. Rule 2 is also incorrect because off-balance sheet assets also require capital funding and hence should be included using the same risk weighting approach.

With respect to the balance sheet accrual ratio, which of the following, other things equal, would most likely lead to an increase in the ratio for a growing company? A) Extending the time the firm takes to pay its suppliers. B) A significant build-up of cash. C) A build-up of inventory.

Answer is C See next slide for formula. The balance sheet accrual ratio is the year-over-year increase in net operating assets divided by average net operating assets. An increase in payables (a liability) will tend to decrease (reduce the change in) net operating assets, while an increase in inventory will tend to increase (increase the change in) net operating assets. Cash is not an operating asset and does not affect the ratio. (Module 13.5, LOS 13.e)

At the beginning of 20X8, Konker formed a qualified special purpose entity (QSPE) and sold a portion of its accounts receivables to the QSPE. Under U.S. GAAP, QSPE was exempt from consolidation requirements. The total amount of accounts receivables sold to the QSPE was $13.5 million. Yoakam has noted in his research that the Financial Accounting Standards Board (FASB) eliminated qualified special purpose entities. When FASB retroactively eliminated the allowance of QSPEs created for the securitization of receivables, the most likely impact on Konker's financial statements would have been: A) an increase in equity and an increase in interest expense. B) no change in assets but an increase in financial leverage ratios. C) an increase in financial leverage ratios and a decrease in the interest coverage ratio.

Answer is C The elimination of the securitization of receivables as an off-balance-sheet item would result in Konker having to report the transaction as securitized borrowing, replacing the receivables on the balance sheet, and reporting a liability equal to the proceeds of the securitization transaction. The impact on Konker's balance sheet would be an increase in assets, and an increase in liabilities. The change in equity from reporting the transaction in this way is likely to be small. Financial leverage would increase, and the consequent increase in interest expense from the liability would decrease the interest coverage ratio. (Module 13.5, LOS 13.d)

Stamper provides Puldo with the process used by the firm to evaluate credit risk as shown in Exhibit 1. Exhibit 1: Key Underlying Principles 1.) The probability of default multiplied by the recovery rate given default is equal to the expected loss. 2.) The sum of expected losses for each period is equal to the cumulative valuation adjustment. 3.) Given the market price of a credit risky bond, the estimated risk-neutral probabilities of default and recovery rates are positively correlated. In Exhibit 1, which of the underlying principles outlined by Stamper is most accurate? A) Principle 1. B) Principle 2. C) Principle 3.

Answer is C The expected loss is (the probability of default) × (loss given default), not the recovery rate. Credit valuation adjustment (CVA) is the sum of the present value of the expected loss for each period. In general, given the market price (and hence the implied credit spread), the estimated risk-neutral probabilities of default and recovery rates are positively correlated.

Employee Share Option Scheme Roleo also has an employee share option scheme. Just as there is a cost to Roleo for its defined benefit scheme, the cost of Roleo's share option scheme will be charged as an expense to the income statement and hence reduce retained earnings and equity even if there is no cash outlay. Dudda's comments regarding Roleo's employee share option scheme are most likely: A) correct. B) incorrect because the cost of issuing shares under an employee stock option scheme will be taken directly to equity via OCI and hence not reduce retained earnings. C) incorrect as the cost of issuing shares under an employee stock option scheme will not reduce equity.

Answer is C The expense of the employee stock options is recorded as compensation expense in the income statement and hence will reduce net income and eventually the retained earnings. However, there is an offsetting increase (same amount) in the paid-in capital and hence no overall impact on equity.

Smart is also interested in using the BSM model to price European and American call and put options. He is concerned, however, about whether the assumptions necessary to use the model are realistic. The assumptions he is particularly concerned about are: - The volatility of the option value is known and constant. - Stock returns are normally distributed. - The continuous risk-free rate is known and constant. Are the BSM assumptions listed correctly? A) No, because stock prices are assumed to be normally distributed. B) No, because the expected return on the stock is assumed to be known and constant. C) No, because the volatility of the return on the underlying stock is assumed to be known and constant.

Answer is C The first assumption listed in the vignette should read, "The volatility of the return on the underlying stock is known and constant." The other listed assumptions are correct. Price, volatility and cont. compounded yield assumptions all should be based on UNDERLYING (i.e. the stock)

Which of the following is the most appropriate test for cointegration? A) Breusch-Pagan. B) Durbin-Watson. C) Engle-Granger.

Answer is C: Engle-Granger = Dickey Fuller To test whether two variables are cointegrated, we regress one data series on the other and examine the residuals for a unit root using the Dickey-Fuller/Engle-Granger test. If we reject the null hypothesis, the error terms of the two data series are covariance stationary and cointegrated. The regression results will be valid. Essentially the time series is cointegrated if the error term from regressing one on the other is covariance stationary and t-tests are reliable

Use of Soft Dollars (Question 43 of Exam 1) Did Luna violate the CFA Institute Standards of Professional Conduct by using soft dollar commissions to pay TIM's software subscription costs to StockCal and/or Add-Invest? A) Both StockCal and Add-Invest software services may be paid for with soft dollars. B) Neither StockCal nor Add-Invest software may be paid for with soft dollars. C) It is acceptable to use soft dollars to pay for the StockCal software but not the Add-Invest software.

Answer: C Standard III(A). Luna has violated the CFA Institute Standards of Professional Conduct - Standard III(A) Duties to Clients - Loyalty, Prudence, and Care. Client brokerage is the property or asset of the client and not TIM. Client brokerage should be used only for research products or services that are directly related to the investment decision-making process and not the management costs of the firm. In this case, Luna should disclose to TIM's clients that their brokerage may be used to purchase research. In addition, Luna should seek to ensure that Turn Byer is providing the best execution for TIM's clients. StockCal is clearly providing equity research products/services that aid TIM in the investment decision-making process and not the general operation or management costs of the firm. StockCal may therefore be properly paid for with client brokerage soft dollars, and this is not a violation of the Standards or Code. However, Add-Invest Software provides TIM's clients with portfolio accounting and performance measurement services and is not related to the investment decision-making process. Therefore, Luna is misusing client resources when she uses client brokerage to purchase Add-Invest Software. Add-Invest is clearly a business expense of TIM and should rightly be paid for by the firm and not the clients. The product or service received must provide proper assistance to the investment manager in following through with his investment decision-making responsibilities.

Question on other side!! Smith is correct. The first step in testing for an ARCH process is to take the residuals from the original autoregressive model and then square them. Sims is incorrect. The next step in determining whether an ARCH process exists is to regress the squared residuals from this period against the squared residuals from the previous period. If b1 is statistically different from zero, then we conclude that the regression model contains an ARCH process.

Are the comments of Smith and Sims on the construction of an ARCH model correct? A) Both comments are correct. B) Only Smith is correct. C) Only Sims is correct.

Statement 3: Conventional rolling-window backtesting may not fully account for the dynamic nature of financial markets or possible extreme downside risk. Statement 4: Compared to a historical simulation approach, Monte Carlo simulation is a more appropriate method to account for skewness, excess kurtosis, and tail dependence in a return distributions. Regarding Shepard's Statements 3 and 4: A) both statements are correct. B) only one statement is correct. C) neither statement is correct.

Asset return distributions often exhibit skewness and excess kurtosis (i.e., fat tails). Also, conventional rolling-window backtesting may not fully account for the dynamic nature of financial markets or possible extreme downside risk. Scenario analysis and simulation can provide a more thorough portrayal of investment strategy performance. This is accurate. Both Monte Carlo and historical simulation approaches are methods used to account for skewness, excess kurtosis, and tail dependence. This is incorrect, bc if the past data does have skewness and excess kurtosis, historical simulation may not be normally distributed. Answer is B

Statement 1: If asset returns do not follow a multivariate normal distribution, scenario analysis and simulation can provide a more complete picture of investment strategy performance. Statement 2: Scenario analysis can be used to analyze the performance and risk of investment strategies in different structural regimes. Regarding Shepard's Statements 1 and 2: A) only one statement is correct. B) neither statement is correct. C) both statements are correct.

Asset return distributions often exhibit skewness and excess kurtosis (i.e., fat tails). Since scenario analysis and simulations do not require specification of a multivariate normal distribution of asset returns, they can provide a more complete picture of investment strategy performance. Scenario analysis can be used to analyze the performance and risk of investment strategies in different structural regimes. Answer is C

The board also identified a need to address the financing of TorkSpark Plc., our wholly owned subsidiary in the U.K. In order to raise the 175 million GBP needed to fund an expansion of the operations, the board leveraged its relationship with the Lobman Starn banking group here in the United States. TorkSpark borrowed 250 million USD and set up a USD-GBP currency swap with a swap dealer based in Europe. Unfortunately, the dealer experienced some issues trying to hedge their position, so TorkSpark agreed to settle the swap at the PV of future payments only 170 days after origination. In order to hedge exposure to the currency swap described by the CFO, the swap dealer would least appropriately: A) borrow GBP. B) borrow USD. C) lend USD.

B TorkSpark has borrowed USD and thus should engage in a USD for GBP swap. At initiation, TorkSpark would exchange USD principal for GBP principal. During the life of the swap, TorkSpark would pay GBP interest and the swap dealer would pay USD interest. To hedge these flows, the dealer could enter into a GBP for USD swap. Alternately, the dealer could lend USD and borrow GBP.

Exhibit 1: VaR Calculations Portfolio EGF Internal Ref:0300201 5% VaR Inputs: - Mean annual return: 9.4% - Annual volatility: 14.2% Assumptions: - 250 trading days per year. - Risk factors are normally distributed. - Mean and volatility calculated using historical data over a 3-year lookback period. - The historical standard deviation has been adjusted upward to reflect the long-term expectations relative to the lookback period. 5% Annual VaR = [9.4% − (1.65 × 14.2%)] = -14% In Exhibit 1, the annual VaR is most accurately described as being calculated using: A) a historical simulation. B) the parametric method. C) a Monte Carlo simulation.

B.) 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. Historical: think actual returns Parametric: think mean and volatility (normal distribution) Monte Carlo: think thousands of iterations The 5% VAR calculation is calculated using the Z-Score! using the mean, vol, and 5% left tail z-score.

QUESTION ON OTHER SIDE!! See number 64 on Exam 4 for video that explains further. After two years, exposure = $5 + 105 / 1.02 = $107.94. Recovery rate (given in Exhibit 3) = 50%. Hence, recovery = 50% of $107.94 = $53.97. CF0 = -104.85, C01 = 5.0, C02 = $53.97. IRR = -25.83%

Based on the information in Exhibit 3, if the bond defaults 2 years after purchase, the IRR for the investment in the bond would be closest to: A) -16.67%. B) -18.43%. C) -25.83%.

While discussing international parity conditions with an intern, Stone makes the following statements. Statement 1: Absolute purchasing power parity extends the law of one price and states that a basket of goods should have the same price throughout the world. Absolute purchasing power parity is not widely used in practice to forecast exchange rates. Statement 2: Although relative purchasing power parity is useful as an input for long-run exchange rate forecasts, it is not useful for predicting short-run currency values. Are none right, one right, or both right?

Both are correct

Statement 1: A 5% VaR measures the maximum loss with a 95% confidence level. Statement 2: Parametric VaR is more suitable than historical VaR if we expect fundamental changes in the economy. Regarding Kuiper's Statement 1 and Statement 2: A) only Statement 1 is accurate. B) only Statement 2 is accurate. C) both statements are accurate.

Both statements are accurate. Five percent VaR is the minimum loss 5% of the time, or maximum loss with a 95% confidence level. Historical VaR is suitable only when past data is a good representation of the future. If we expect changes in the economic environment, updated parameters can be used with parametric VaR estimation to obtain robust estimates of VaR.

Current vs Quick Ratio Formula and Which Ratio Does not Change Under Current/Temporal Rate Methods?

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.

Over the past year, TorkSpark has also entered into a receiver swap, and has written call options on the stock of Perimeter, Inc., a Brazilian company listed on the NYSE. Additionally, TorkSpark has a long position in payer swaptions on a five-year interest rate swap. Garton believes that the expansionary fiscal and monetary policies will soon lead to an increase in interest rates. If Garton's expectations about interest rates turn out to be accurate, which of TorkSpark's positions is most likely to result in a gain to the firm? A) Receiver swap. B) Calls on Perimeter, Inc. C) Payer swaption.

C Garton expects interest rates to rise. An increase in rates will lead to a gain for parties entering into a payer swap and payer swaptions because that party pays the (previously lower) fixed rate and receives the (higher) future floating rate. Rho is positive for equity call options; an increase in interest rate leads to a higher value of a call option. Because TorkSpark has written the option, it has a short position in the call, and thus would experience a loss due to an increase in the value of the call option.

Kelley believes that X-Sport's cost of capital should include specific company risk premium (SCRP) and makes the following notes: 1.) Qualitative factors affecting SCRP include corporate governance quality, use of leverage to finance assets, and customer and supplier concentration, among others. 2.) Firms with most of the assets represented by successful R&D would command a lower SCRP. Regarding Kelley's statements about specific company risk premium: A) only one of the statements is correct. B) both statements are correct. C) both statements are incorrect.

C is Correct Statement 1 is incorrect. Leverage is a quantitative factor and should not be listed in the list of qualitative factors. Statement 2 is incorrect. Assets represented by successful R&D would be intangible. Firms with mostly liquid, tangible, and fungible assets would command a lower SCRP.

Question on Other Side!! Questions 21 and 22 on Exam #2 REMEMBER!! - a 2 year bond will only need 2 periods of rates to discount back! any extra information is red herring Answer 1: C Answer 2: A

Calculate the value of the Bratton bonds using the interest rate tree. Bratton Bonds Value: A) 100.218. B) 100.378. C) 100.915. Hardin Bonds Value: A) 100.472. B) 100.915. C) 101.358.

As a call/put option moves further into the money, its delta approaches:

Call: 1 Put: -1 (out of the money it approaches 0)

similar to last slide on soft dollars/cash referrals

Client brokerage is strictly an asset of the client and must be used for the benefit of clients in research that will assist the investment manager in the investment decision-making process. Client brokerage cannot be used as a reward for bringing clients to TIM and to do so is a misappropriation of client assets. Cash referral fees are acceptable, so long as the referral arrangement is fully disclosed to the clients in advance of opening their accounts. The case mentions that this disclosure will be made. This disclosure allows the client to evaluate any potential conflict(s) of interest in the referral process.

Reese's statement: "Credit valuation adjustment is the sum of the expected loss for each period based on the risk-neutral probability of default." Reese's statement about credit valuation adjustment is most likely: A) correct. B) incorrect about the use of risk-neutral probability of default. C) incorrect about the sum of expected losses.

Credit valuation adjustment (CVA) is the sum of the present value of the expected loss for each period (and not simply just the sum of the expected losses). Answer is C

FOR CFA, CFI is = to FC Inv... would normally include CAPEX and gain on sale of LT assets (which would need to be subtracted out for FC inv)

Fact

Lower PEG is better than Higher PEG

Fact

The FCFF model is better than the FCFE model in valuing debt laden, cyclical companies, and companies with a changing capital structure.

Fact

A convertible bond had a coupon rate of 7.25%, a par value of $1,000, a conversion price of $55.56, and 10 years until maturity @ issuance. Two years after issuance, the bond became callable at 102% of par value. MediSoft's convertible bonds are now trading in the market for a price of $947 with an estimated straight value of $917. Currently, the stock is priced at $50 on the New York Stock Exchange and is expected to continue its annual dividend in the amount of $1.80 per share. Calculate the market conversion premium per share for MediSoft's convertible bonds. A) $2.61. B) $2.95. C) $5.56. The minimum value of the convertible bond today is closest to: A) $900. B) $917. C) $947.

First Question: Answer is A Second Question: Answer is B Minimum value of a convertible = Max (straight value, conversion value) Straight value = $917 (given) Conversion value = 18 × $50 = $900 Minimum value of the convertible = $917

For countries with high expected economic growth, it is most likely that: A) real risk-free rates will be low. B) the inter-temporal rate of substitution will be low. C) investors will save more.

For countries with high expected economic growth rates, real rates will be high. Investors will be less concerned about the future, and the inter-temporal rate of substitution will be low. Also, investors will want to increase current consumption and, hence, will borrow more and save less. Answer is B

What exchange rate is used for depreciation expense under temporal method

Historical Rate

Depreciation is based on...

Historical cost! not the net assets. Only changed if amount of original cost is destroyed or sold/bought

The most appropriate method of replicating a payer swap is to use a: A) zero-cost portfolio consisting of a long cap and a short floor with the same strike rate. B) short cap and long floor with strike rate equal to the swap fixed rate. C) long FRA with maturity equal to the swap tenor.

If the exercise rate on a cap and floor is same, a long cap and short floor can be used to replicate a payer swap. If the value of such long cap and short floor is same, their (common) exercise rate should be equal to the swap fixed rate. Answer C is wrong because there are multiple settlement periods so we would need multiple long FRAs Answer is A Video for this is great #66 of 88 on Exam 3

Netting Risk

In an FoF, the performance fees paid to outperforming individual underlying fund managers are not offset by losses in underperforming underlying funds, because the underlying funds are independent of one another. This results in netting risk: the FoF investor may have to pay performance fees to some managers - even when the investor is not earning a positive return in the FoF overall. Netting risk is not present in a multistrategy fund structure (and therefore it is an advantage of multistrategy funds over FoFs), because there is a single fund structure with multiple management teams. Returns of different fund strategies are offset against each other when performance fees are calculated.

QUESTION ON OTHER SIDE In the first regression, the Federal Funds rate in the United States has a unit root, but the bond yield in the European Union does not. So the former data series is not covariance stationary, but the latter is. In this case, the regression results will not be valid. In the second regression, both the Federal Funds rate in the United States and the bond yield in Great Britain have a unit root. So both data series are not covariance stationary. However, because they are cointegrated, the regression results will be valid. In Summary: - If neither data series has a unit root, the regression results are valid. - If only one data series has a unit root, the regression results are invalid. - If both data series have a unit root and they are cointegrated, the regression results are valid. - If both data series have a unit root and they are not cointegrated, the regression results are not valid.

Is Sims's regressions of European and British bond yields on the U.S. Federal Funds rate likely to produce valid results? A) Neither Regression is valid. B) Only Regression 1 is valid. C) Only Regression 2 is valid.

Question on other side!!! Given the exercise rate of 5%, the call option has a positive payoff for nodes C++ and C+-. The value of the option at node C++ can be calculated as: [Max (0, 0.083 − 0.05)] × $2,000,000 = $66,000 Similarly, the value at node C+- can be calculated as: [Max (0, 0.0504 − 0.05)] × $2,000,000 = $800 Value at node C+ = [(0.5 × 66,000) + (0.5 × 800)] / (1.0531) = $31,716 Value at node C- = [(0.5 × 800) + 0] / (1.0322) = $388 And the value at node C = [(0.5 × 31,716) + (0.5 × 388)] / (1.04) = $15,435 Answer is B

Jackman is also evaluating a two-year European interest rate call option with a strike rate of 5% and a notional principal of $2 million. Jackman wants to use a binomial tree as shown in Exhibit 1 to value the option. The value of the two-year interest rate call option is closest to: A) $7,717. B) $15,434. C) $18,415.

Li states that he would rather take the broad sample of 1,000 stocks with the highest trading volume and divide the sample into 10 groups of diverse characteristics. The intent is to select 1 stock from each group to long/short so as to diversify the portfolio composition and reduce risk. Li's suggested diversification problem could be best addressed using the: A) principal component analysis (PCA). B) K-Means clustering. C) LASSO.

LASSO is a feature-reduction algorithm; through optimization, LASSO automatically eliminates the least-predictive features. LASSO is not used for classification. K-means clustering partitions observations into k (k = 10 in this case) nonoverlapping clusters. PCA summarizes the information in a large number of correlated factors (features) into a much smaller set of uncorrelated factors and is used for dimension reduction and not for grouping or classification.

Liquidity Coverage Ratio and Net Stable Funding Ratio Formulas (for banks)

Liquidity Coverage Ratio = Highly Liquid Assets/Expected Cash Outflows* *1-month liquidity needs in stress scenario Net Stable Funding Ratio = available stable funding*/required stable funding** *think funding sources like liabilities, i.e. deposits, or equity ** think asset base (mortgages, gov't bonds, etc.)

Investment AB Framgang has been appointed by Olandig AB to manage Olandig's pension fund. Regarding Olandig's pension fund, Framgang is least likely to owe a duty of loyalty, prudence, and care to Olandig's: A) shareholders and management team. B) pension plan participants. C) pension plan beneficiaries.

Members and candidates that manage a firm's pension fund owe loyalty, prudence, and care to the participants and beneficiaries of the pension plan, rather than to the management team or the shareholders, according to Standard III(A)-Loyalty, Prudence, and Care.

Statement 1: N(d2) in the Black-Scholes Merton model is interpreted as the risk-neutral probability that a put option will expire in the money. Statement 2: A call option on a dividend-paying stock can be valued using the BSM if we reduce the current stock price by the present value of dividends expected over the life of the option. Regarding Statements 1 and 2 made by Widby, it would be most accurate to state that: A) both statements are correct. B) only Statement 1 is correct. C) only Statement 2 is correct.

N(d2) is interpreted as the risk-neutral probability that a call option will expire in the money. N(-d2) is interpreted as the risk-neutral probability that a put option will expire in the money. Statement 2 is correct as given. Answer is C

Proportionate Consolidation

Not the same as consolidation which is the same as the acquisition method. In the attached picture, proportionate consolidation is reflected under acquisition method. Total assets, liabilities, revenues, and expenses are higher under proportionate consolidation as compared to the equity method. However, net income and stockholders' equity are the same under either method. Accordingly, profit margin and return on assets are typically lower under proportionate consolidation than under the equity method. Return on equity will be same under either method. The following financial statements are provided for informational purposes only. The numbers in the acquisition method are derived as EPI + EP/BM LLC, except for the equity items.

Question 27 on Exam 3 - Good example of calculating FCFF

Note

Are structural models, reduced form models, or both used under the assumption that the issuing company's assets trade in a fricitionless market?

Only Structural models require that the company's assets trade in a frictionless arbitrage free market.

Residual Income (RI), Economic Value Added (EVA), Market Value Added (MVA)

RI = Net Income - Equity Charge --- Equity Charge = Equity* (or BV*) x Cost of Equity (or "r") *Equity should equal equity at the beginning of the year (end of last year) EVA = NOPAT - $WACC --- $WACC = Total Capital* x WACC *Total capital contains debt + equity and should reflect the beginning of year period (end of last year) MVA = market value of (total) capital − book value of (total) capital *Total capital contains debt + equity and is measured as of the latest period (not beginning/end of prior period) See questions 61-64 on Exam 1

Real Risk Free rate is positively related to...

Real risk-free rate is positively related to real GDP growth and to GDP volatility.

Make sure to use begin year (end of last year) book values

Remember

If Reese uses the risk-neutral probabilities of default to value the Pistar, Inc., bonds, she is most likely to conclude that the bond is: A) fairly valued. B) overvalued. C) undervalued.

Risk neutral probability of default is the probability of default implied in the current market price. If CVA is calculated using risk-neutral probability, the value of risky bond will be estimated to be equal to its market price. Answer is A

Which of the following is least appropriate regarding the use of standardized unexpected earnings? A) A given size forecast error is more meaningful the lower the size of historical forecast errors. B) SUE divides earnings surprise by the standard deviation of earnings. C) The economic rationale for examining earnings surprises is that positive surprises may lead to persistent positive abnormal returns.

SUE divides earnings surprise by the standard deviation of earnings surprise. Other statements are accurate. Important: positive earnings surprises can lead to PERSISTENT abnormal returns

In discussing these quotes, Surratt notes that the bid-ask spread is affected by many factors. She states that if an economic crisis were expected in the Asian markets, then the bid-ask spread of the currency quotes should widen. Castillo states that if a dealer wished to unload an excess inventory of yen, the typical response would be to lower her ask for the yen, thereby narrowing the bid-ask spread. Are Surratt and Castillo correct with regard to their statements concerning the currency bid-ask spreads? A) Only Surratt is correct. B) Only Castillo is correct. C) Both Surratt and Castillo are correct.

Surratt is correct. Market conditions affect currency spreads such that the bid-ask spread on foreign currency quotations increases as exchange rate volatility (uncertainty) increases. In this example, an economic crisis in the Asian markets would create uncertainty, thereby impacting the $/¥ and $/NT$ exchange rates and increasing the bid-ask spread. Castillo is incorrect. Bank and other currency dealer positions are not considered to directly impact the size of foreign currency spreads. In this example, it is true that the dealer would likely reduce her yen ask (selling price) if she wanted to unload an excess inventory of yen. However, the dealer would also probably reduce her bid (buying price) so that she did not buy any additional yen. The result would be that the spread would remain relatively unchanged

QUESTION ON OTHER SIDE!!! If the target of a merger has unused tax losses accumulated, the merged company can use the tax losses to immediately lower its tax liability, thus increasing its net income (Correct). The internet operation of The Daily is insignificant compared to the overall merger value. Any improvement in the cost structure of the internet operation will not have a significant impact on overall earnings. In addition, the high-growth characteristics of the internet segment would not warrant a cost restructuring of the operations (Incorrect). Answer is A

The acquistion terms call for an exchange of all outstanding shares of Daily for 1 million newly issued shares of Voyager. Michael Renner, the CFO of Voyager, defended the acquisition by stating that The Daily has accumulated a large amount of tax losses and that the combined company can benefit by immediately increasing net income after the merger. In addition, Renner states that the new Voyager will eliminate the inefficiencies of its internet operations and thereby boost future earnings. Based on Renner's comments defending Voyager's acquisition of The Daily, indicate whether his comments about net income and elimination of inefficiencies are most likely correct. A) Only Renner's comment that unused tax losses will immediately translate into higher net income is correct. B) Only Renner's comment that the elimination of inefficiencies within the internet operations will create additional value is correct. C) Both comments are correct.

Jared Sampson, CFA, is analyzing Gigatech, a large U.S.-based technology conglomerate. Sampson first starts out calculating economic value added (EVA) for Gigatech and notices that the firm uses last-in, first-out (LIFO) cost flow assumption. Regarding the LIFO cost flow assumption, which of the following is the most accurate adjustment to calculate EVA for Gigatech? A) While there is no adjustment needed to the NOPAT, the change in the LIFO reserve should be added to the invested capital. B) While there is no adjustment to the invested capital, the LIFO reserve should be added to NOPAT. C) The LIFO reserve should be added to the invested capital, and the change in the LIFO reserve should be added to NOPAT.

The correct adjustment is to add the LIFO reserve to the invested capital and add back the change in the LIFO reserve to NOPAT. The LIFO reserve is unique because it provides the necessary adjustment to reconcile LIFO inventory values to the more commonly used FIFO basis, which is often considered to reflect a more accurate representation of current market values. FIFO, being more straightforward and typically aligned with the actual flow of goods, doesn't require a similar adjustment figure to be reported in financial statements.

Cardoni demonstrates a simple merger arbitrage trade using the following deal information: - Essco Corp. offers to purchase Jayco Corp. in a stock-for-stock deal. - Deal terms include 1 share of Essco for 2.5 shares of Jayco. - Upon announcement of the deal, Essco's share price falls from $89 to $85, and Jayco's share price rises from $30 to $33. - If the merger fails, the share prices are expected to return to their pre-announcement levels. - The hedge fund manager establishes a merger arbitrage trade based on a position size of 50,000 shares in Jayco. Assuming Cardoni is using a hard-catalyst, event-driven approach, the maximum gain and the maximum loss of the Essco and Jayco merger-arbitrage trade are closest to: Maximum Gain | Maximum Loss A) $80,000 | $40,000 B) $50,000 | $200,000 C) $50,000 | $230,000

The manager establishes a long position in Jayco totaling 50,000 shares. Under a hard-catalyst event-driven approach, the manager will invest in the trade post- announcement. This will cost 50,000 × $33 = $1,650,000. The deal ratio is 1 share of Essco per 2.5 shares of Jayco; hence, the manager will short sell 50,000 / 2.5 = 20,000 shares of Essco at a post-announcement price of $85, raising 20,000 × $85 = $1,700,000 short proceeds. Therefore, the manager will earn a spread of $1,700,000 - $1,650,000 = $50,000 if the deal goes through. If the deal fails, prices are expected to revert to their pre-announcement levels. This means the manager will lose 50,000 × ($33 - $30) = $150,000 on the long position in Jayco shares. The manager will also lose 20,000 × ($89 - $85) = $80,000 on the short position in Essco shares, making total losses of $230,000.

Tomas Dench is an investment analyst working for the Onebridge University Endowment. The investment committee has recently decided to make an allocation to hedge funds for the first time. The committee has asked Dench to consider whether a direct investment, fund-of-funds (FoFs), or multistrategy fund would be the most appropriate approach. Key considerations in the decision are as follows: 1.) The internal investment staff at the endowment has no historical relationships with hedge fund managers. 2.) Operational risk caused by the allocation to hedge funds should be minimized. The allocation approach that is most appropriate for the endowment is: A) Direct investment. B) FoFs. C) Multistrategy funds.

The most appropriate approach for the endowment is to allocate the hedge funds through an FoF. The endowment does not have historical relationships with hedge fund managers. This suggests that the current investment staff does not have the expertise or experience to do due diligence of direct investments in hedge funds; hence, a direct approach is inappropriate. We are asked to minimize operational risk. The single fund structure of a multistrategy fund creates the greatest operational risk because fund failure would wipe out 100% of the investment. This would not occur for a diversified portfolio of hedge funds created under a direct investment program, or an FoF, which would spread investments across multiple individual hedge funds.

Question on other slide!! It is stated in the vignette that Weira has reached steady-state. In 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. r = (0.25)(4,500) / (18,750) = 0.06 or 6%

The rental price of capital in Weira (assuming Weira has reached a steady state) is closest to: A) 6%. B) 12%. C) 25%.

Swap Spread

The swap spread is the spread paid by the fixed-rate payer of an interest rate swap over the rate on an on-the-run government security with the same maturity as the swap.

QUESTION ON OTHER SIDE Question 1: C Question 2: A

To achieve the optimal level of active risk, what proportion of funds would Zhou allocate to the Lincoln fund? A) 53%. B) 82%. C) 151%. The highest Sharpe ratio that Zhou can achieve by combining the Lincoln fund and the Russell 2000 is closest to: A) 0.39. B) 0.42. C) 1.12.

Which of the following approaches would be least appropriate to measure the cost of capital of Maura Ltd.? A) Expanded CAPM. B) Extended CAPM. C) Country risk premium.

Two approaches to estimating the cost of equity of a foreign company are (1) country risk premium model and (2) the extended CAPM. Expanded CAPM is used for domestic private companies where additional risk premia (above those applicable for public companies) are applicable. (Module 17.2, LOS 17.d) Extended CAPM is the term for the overall branch of the 3 specific types of international/global CAPMs, including: -- International CAPM: includes global and currency 2-factor model -- Global CAPM: incorporates a global index and an additional local market factor to estimate ERP -- The country-spread model: estimates a country risk premium (CRP) (also called a country spread premium) for a specific emerging market.

Type I vs Type II Errors

Type 1 Error: Occurs when a hypothesis that is actually true is rejected, falsely indicating that an effect or relationship exists when it does not (false positive). (Heteroskedasticity & Serial Correlation - SE's too low, resulting in high T-Stat and Rejection of Null) Type 2 Error: Occurs when a hypothesis that is actually false is accepted, failing to detect an existing effect or relationship (false negative). (Multicollinearity, SE too high, resulting in low T-Stat and Failing to Reject the Null).

Compared to the temporal method, which of the following best describes the impact of the current rate method on the gross profit margin, assuming a depreciating local currency:

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.

QUESTION ON OTHER SIDE!! Build up Method = NO BETA (just risk premiums + risk free rate) ri = risk-free rate + equity risk premium + size premiumi + specific-company premiumi ri = 3.5% + 4.0% + 3.5% + 2.0% = 13.0%

Using the build-up method, Midwest News's required return on equity is closest to: A) 13.0%. B) 13.8%. C) 15.8%.

Swift is following Sigma, Inc., a chipmaker for wearable devices. Sigma has invested significantly in R&D since its inception and that expenditure is finally bearing fruit: the company is now profitable. Sigma correctly expenses the R&D expenditure when incurred. Relative to its competitors, Sigma pays a lower share of gross revenue to its independent contractors. However, Sigma does pay contractors annual bonuses based on their number of years of affiliation with the company. Which relative valuation multiple would Swift most appropriately use to value Sigma, Inc.? P/CF, P/B, or P/S?

We are told that the firm has significant investment in R&D, suggesting the existence of intangible assets that are not reflected in Sigma's book value; hence, the price-to-book value ratio may be misleading. Sigma's cost structure is different from that of its peers, so use of price-to-sales ratio may not be directly comparable. The price-to-cash-flow ratio is most appropriate here because cash flow is less prone to manipulation and less likely to be distorted by differences in accounting practices.

Question on other side!! A portfolio that has a sensitivity of 1.0 to one of the macroeconomic factors, and zero sensitivity to the remaining macroeconomic factors is called a factor portfolio. Portfolios D and E are factor portfolios. A portfolio that has factor sensitivities that equal the sensitivities of the benchmark is called a tracking portfolio. Portfolio Z has factor sensitivities that exactly match those of the S&P 500. (Module 36.3, LOS 36.e) (answer is A)

Which of these multi-factor portfolios are considered factor portfolios? A) Portfolios D and E. B) Portfolios D and Z. C) Portfolio Z only.

How to tell which country is most likely to benefit from capital deepening

Whichever country has the highest alpha (a) or share of capital (Cost of capital relative to total factor cost) When comparing multiple countries, a larger 𝛼α suggests a higher productivity of capital, making capital deepening a more effective strategy for boosting economic output in those countries.

For Justified Ratios, EVERYTHING can be derived from the GGM model. Just have to remember what the formulas are for Growth Rate, D(0) & E(1)

g = ROE x b D(0) = E(0) x (1-b) E(1) = B(0) x ROE