March Mock Exam PM - Answers

Block 1: Kostecka

Question
1 of 6
The account should be managed according to the clients investment goal of capital preservation and a
low risk tolerance. Under Standard III (A) Loyalty, Prudence, and Care, the first step for members and
candidates in fulfilling their duty of loyalty to clients is to determine the identity of the client to whom the
duty of loyalty is owed. Only when the daughter is granted legal responsibility over her fathers affairs by
the court does she become the client.

CFA Level 2
Guidance for Standards IVII, by CFA Institute
Standard III(A): Loyalty, Prudence, and Care; Standard III(C): Suitability

Question
2 of 6
Kostecka has not violated Standard III (A) Loyalty, Prudence, and Care as he has put his clients interests
first. However, by not dissociating himself from the illegally embezzled funds, Kostecka has violated
Standard I (A) Knowledge of the Law. By managing these funds, Kostecka benefits directly via
management fees and could be associating himself with suspicious financial transactions and potentially
violating anti money laundering regulations. In addition, by not dissociating himself from the embezzled
funds, Kostecka has also placed his firm in a position where it may suffer reputational harm so has
violated Standard IV (A) Duties to Employers (Loyalty). .

CFA Level 2
Guidance for Standards IVII, by CFA Institute
Standard I (A) Knowledge of the Law, Standard III (A) Loyalty, Prudence, and Care.
Standard IV (A) Duties to Employers (Loyalty)

Question
3 of 6
Kosteckas board service creates the opportunity to receive material nonpublic information involving
Jabbertalk and is a basic conflict of interest. As a result , according to Standard VI (A) Conflicts of
Interest, the directorship should be disclosed. Members and candidates must make full and fair disclosure
of all matters that could reasonably be expected to impair their independence and objectivity or interfere
with respective duties to their clients, prospective clients, and their employer. Because the member has
not made any disclosure concerning his board membership, he is in violation of Standard VI (A).
Kostecka has also ignored his clients mandate of low risk tolerance and capital preservation and is in
violation of Standard III (C) Suitability. In addition, Nathoo has violated her fiduciary duty as a trustee of
the account as she failed to manage her fathers portfolio in accordance with his wishes.

CFA Level 2
Guidance for Standards IVII, by CFA Institute Standard III (C) Suitability, Standard VI (A) Conflicts of
Interest.
March Mock Exam PM - Answers

Question
4 of 6
Standard III (B) Fair Dealing requires members and candidates to deal fairly and objectively with all
clients when providing investment analysis, making investment recommendations, taking investment
action, or engaging in other professional activities. When Kostecka informs clients of the upcoming
investment recommendation by Forkson, he has treated all clients fairly because this disclosure is
provided to all of his current clients.

CFA Level 2

Guidance for Standards IVII, by CFA Institute

Standard III (B) Fair Dealing, Standard V (B) Communication with Clients and Prospective Clients,
Standard VI (B) Priority of Transactions

Question
5 of 6
Statements overstating the competency of an individual or imply, either directly or indirectly, that superior
performance can be expected from someone with the CFA designation are not allowed under Standard
VII (B) Reference to CFA Institute, the CFA Designation, and the CFA Program. The Standard
specifically states when referring to the CFA Institute, CFA Institute membership, the CFA designation, or
candidacy in the CFA Program, members and candidates must not misrepresent or exaggerate the
meaning or implications of membership in the CFA Institute, holding the CFA designation, or candidacy in
the CFA Program.

CFA Level 2

Guidance for Standards IVII, by CFA Institute

Standard VII (B) Reference to CFA Institute, the CFA Designation, and the CFA Program

Question
6 of 6
Kosteckas performance presentation of his firms composite performance is in compliance with Standard
III (D) Performance Presentation.

CFA Level 2

Guidance for Standards IVII, by CFA Institute

Standard III (D) Performance Presentation.
March Mock Exam PM - Answers

Block 2: KingFisher

Question
1 of 6

It is a violation of Standard VII(B): Reference to CFA Institute, the CFA Designation, and the
CFA Program to imply that the competencies of a CFA charterholder are superior to those of
others not holding the designation. It is not a violation, however, to factually state that
charterholders must annually renew their commitment to abide by the Code and Standards or that
each of the team members passed all three CFA exams on their first attempt.

CFA Level 2

"CFA Institute Guidance for Standards IVII," CFA Institute

Standard VII(B): Reference to CFA Institute, the CFA Designation, and the CFA Program

Question
2 of 6

Standard III(B): Fair Dealing accommodates the differentiation of services to clients as long as
such services are not offered selectively. The different service levels should be disclosed to
clients and prospective clients and should be available to everyone. A requirement to disclose all
conflicts of interest would not violate Standard VI(A): Disclosure of Conflicts, nor would the
outline of all compensation arrangements violate Standard IV(B): Additional Compensation
Arrangements.

CFA Level 2

"CFA Institute Guidance for Standards IVII," CFA Institute

Standard III(B): Fair Dealing; Standard VI(A): Conflicts of Interest; Standard IV(B): Additional
Compensation Arrangements

Question
3 of 6

Kingfisher's proposed general principles related to Capital Market Integrity properly address in
principle Standard II(A): Material Nonpublic Information and Standard II(B): Market
Manipulation. Standard II(A) does not disallow the possession of insider information but does
disallow using the information to take unfair advantage of the general investing public. Standard
II(B) requires the prohibition of market manipulationthat is, dissemination of false or
March Mock Exam PM - Answers

misleading information and transactions that deceive or would be likely to mislead market
participants by distorting the price-setting mechanism of financial instruments.

CFA Level 2

"CFA Institute Guidance for Standards IVII," CFA Institute

Standard II(A): Material Nonpublic Information; Standard II(B): Market Manipulation

Question
4 of 6

Which of Kingfisher's proposed requirements to ensure Duties to Clients is least appropriate to

prevent violations of CFA Institute Standards of Professional Conduct? The requirement calling
for a(n):

investment plan.
diversified portfolio.
periodic review.

Question not answered

Standard III(A): Loyalty, Prudence, and Care requires a client's portfolio to be managed by
investment guidelines agreed on with the client. Some clients' investment objectives may not
allow for a diversified portfolio across all asset classes available. Therefore, it may violate
Standard III(A) to include all asset classes available.

CFA Level 2

"CFA Institute Guidance for Standards IVII," CFA Institute

Standard III(A): Loyalty, Prudence and Care

Question
5 of 6

It is recommended that firms develop and use measurable criteria for assessing the quality of
research to help comply with Standard V(A): Diligence and Reasonable Basis. Therefore, the
research recommendations need to be assessed to determine their validity over time. Did the
process and the analyst's view lead to the right recommendation? If over time recommendations
consistently prove to be wrong, perhaps the research processes need to be changedor the
analysts themselves.
March Mock Exam PM - Answers

CFA Level 2

"CFA Institute Guidance for Standards IVII," CFA Institute

Standard V(A): Diligence and Reasonable Basis

Question
6 of 6

Task 1 is insufficient in that Standard IV(C): Responsibilities of Supervisors requires supervisors

to enforce non-investment-related policies as well as investment-related policies.

CFA Level 2

"CFA Institute Guidance for Standards IVII," CFA Institute

Standard IV(C): Responsibilities of Supervisors

Block 3: National Plastics

Question
1 of 6

If Haines acquires National, it would be a vertical merger because they are both in the same production
chain. It is an example of backward integration because Haines is closer to the consumer than the
packaging manufacturer.

CFA Level II

"Mergers and Acquisitions," Rosita P. Chang and Keith M. Moore

Section 2
March Mock Exam PM - Answers

Question
2 of 6

FCFF = NI + NCC + Int(1 Tax rate) FCInv WCInv

NI Net income 156

+ Int(1 + Net interest after
47 (1 0.32) 32
Tax rate) tax
+ NCC + Non-cash charges Depreciation expense 61
Capital
FCInv (1,203 1,130) + 61 134
expenditures
Changes in net (315 696) (295
WCInv (6)
working capital 670) = 6

Free cash flow to

FCFF =121
firm
Change in net working capital excludes changes in cash and cash
equivalents.
CFA Level II

Mergers and Acquisitions, Rosita P. Chang and Keith M. Moore

Section 7.1.1

Free Cash Flow Valuation, Jerald Pinto, Elaine Henry, Thomas Robinson, and John Stowe
Section 3.1

Question
3 of 6
Year Free Cash Flow Present Value (PV) PV
(FCF) of FCF at 10.5% ($ millions)
($ millions)
2013 170 170/(1.105) 154
2
2014 165 165/(1.105) 135
3
2015 180 180/(1.105) 133
4
2016 195 195/(1.105) 131
PV of FCF 553
Terminal growth rate 5%
Terminal value, 2016

= 3,722.73

4
Terminal value at start of 2013 3,723/(1.105) 2,497
Enterprise value 3,050
Less debt after acquisition 650
Maximum value of equity 2,400
Maximum price per share (60 million shares) 2,400/60 = $40
March Mock Exam PM - Answers

CFA Level II
Mergers and Acquisitions, Rosita P. Chang and Keith M. Moore
Section 7.1.1
Free Cash Flow Valuation, Jerald Pinto, Elaine Henry, Thomas Robinson, and John Stowe
Section 4.3

Question
4 of 6

Shares of Zenith outstanding after merger (millions)

Original from Zenith 100

Issued in acquisition 14.4 0.24 share acquirer/share target 60

Total shares 114.4

Value of shares post-merger = $53/share 114.4 = $6,063 million

Value of shares post-merger in terms of pre-acquisition values, synergies, and

cash paid
($ millions)
Value pre merger of Zenith 5,000 $50/share 100 million shares
Value pre merger of
1,500 $25/share 60 million shares
National
+ Synergies +X Currently unknown

Cash paid 1,380 $23/share 60 million shares

Value of all shares post
6,063 Value from above
merger
Synergies 943 Solve for X
Note: Value to Nationals shareholders post-merger is the actual amount paid for the takeover.
CFA Level II

Mergers and Acquisitions, Rosita P. Chang and Keith M. Moore Section 7.2

Question
5 of 6

See Exhibit 2 in "Mergers and Acquisitions" reading; an HHI greater than 1,800 indicates that an
industry is highly concentrated. Should the HHI in a highly concentrated industry change by 50
or more, a governmental challenge to a particular business combination is very likely. In this
instance, the industry is highly concentrated and the HHI changes by 90, making Whelan's
second conclusion incorrect. A government challenge is likely.

CFA Level II "Mergers and Acquisitions," Rosita P. Chang and Keith M. Moore Section 6.2
March Mock Exam PM - Answers

Question
Initial market reaction is an important barometer for the value investors place on the gains from
merging as well as an indication of future returns.

CFA Level II

"Mergers and Acquisitions," Rosita P. Chang and Keith M. Moore

Sections 7.2, 9

Block 4: Sagara

Question
1 of 6

Substantive law focuses on the rights and responsibilities of entities and relationships among
entities. A well-developed legal system of substantive and procedural laws and respect for
property rights are likely to encourage growth, not limit it. Factors that limit growth include
restrictions on imports and low rates of saving.

CFA Level II

"Economic Growth and the Investment Decision," Paul Kutasovic

Section 2.7 "Economics of Regulation," Chester S. Spatt Section 2.1

Question
2 of 6

The stated conclusion is accurate in its entirety. The CobbDouglas function exhibits constant
returns to scale, which means that if all inputs are increased at the same percentage, then output
rises at that percentage. Diminishing marginal productivity exists with respect to each individual
input (if the other input is held constant). Continued growth in per capita output is possible even
in the steady state as long as there is ongoing technological progress (increases in TFP).

CFA Level II

"Economic Growth and the Investment Decision," Paul Kutasovic

Sections 4.1, 4.2

March Mock Exam PM - Answers

Question
3 of 6

In the Dutch disease scenario, currency appreciation driven by strong export demand for
resources makes other segments of the economy, in particular manufacturing, globally
uncompetitive. She is also incorrect regarding direct ownership of the rubber plantations by
foreigners; access to natural resources is essential but ownership is not.

CFA Level II

"Economic Growth and the Investment Decision," Paul Kutasovic

Section 4.5

Question
4 of 6

N'Diarra's understanding of classical growth theory is correct, as is her understanding of its

implications. Classical growth theory holds the view that the growth rate of real GDP per person
is temporary because of population explosion. Her description of endogenous growth theory is
not accurate. She references a steady state rate of growth and diminishing marginal returns,
which are tenets of neoclassical growth theory.

CFA Level II

"Economic Growth and the Investment Decision," Paul Kutasovic

Sections 5.1, 5.2, 5.3

Question
5 of 6

Banantoumou's concern is an example of regulatory capture. Regulated companies' efforts to

fight particular regulations tend to attract more public attention than when the companies are
sympathetic to the contemplated regulations. Even more fundamentally, academics have argued
that regulation often arises to enhance the interests of the regulated, often called the "regulatory
capture" theory. For example, regulatory actions and determinations can restrict potential
competition and coordinate the choices of rivals.

CFA Level II

"Economics of Regulation," Chester S. Spatt Section 2.2.1

March Mock Exam PM - Answers

Question
6 of 6

Some independent regulators are SROs empowered to enforce the law. They do not typically rely
on government funding.

CFA Level II

"Economics of Regulation," Chester S. Spatt Section 2.1

Block 5: Treadway

Question
1 of 6

To calculate cash collections from customers, the revenue figure on the statement of earnings is adjusted
for the large decreases in unearned revenue (both short-term and long-term) and the increase in
accounts receivable.

(A$ thousands)

Revenue as reported 711,200

Decrease in short-term unearned revenue 12,500 21,250 -8,750

Decrease in long-term unearned revenue 6,500 13,500 -7,000

Increase in accounts receivable 35,700 33,500 -2,200

Cash collected from customers 693,250
CFA Level II

Evaluating Financial Reporting Quality, Scott Richardson and Irem Tuna Section 4.1.1.2
March Mock Exam PM - Answers

Question
2 of 6

Investments in associates are accounted for using the equity method. Only the dividends received
from associate companies would be cash, not the amount reported as income from investments in
associates. When using the equity method to account for an investment, the investment account
on the balance sheet increases by the amount of accrued investment income recognized and
decreases by the amount of dividends received. Therefore, analysis of the balance sheet account
changes will solve for dividends (the cash).

(A$ thousands)
Opening balance investment account 42,300

Plus investment income recognized (from Statement of Earnings) +1,200

Deduct dividends received: Solve for X X

Closing balance investment account 42,700

Solving for X, dividends, and cash received = A$800 thousand

CFA Level II

"Intercorporate Investments," Susan Perry Williams

Section 5.1

Question
3 of 6

The decrease in unearned revenue could be an indication of early revenue recognition as amounts
previously deferred are brought into income and not replaced with new deferred revenues on the
balance sheet. An increase in days sales in receivables could be an indicator of early revenue
recognition, but for CCCL the ratio did not change significantly (18.1 days in 2012 to 18.3 days
in 2013 using year-end receivables). Deferred tax assets can arise from differences in revenue
recognition for taxes and financial statement purposes (they would rise with increases in
unearned revenue) but there is no indication that revenue is the reason for the increase in
deferred tax assets (in fact unearned revenue decreased). The deferred tax assets most likely arise
from the loss carryforwards generated from earlier losses.

CFA Level II

"Evaluating Financial Reporting Quality," Scott Richardson and Irem Tuna

Section 4.1.1.2
March Mock Exam PM - Answers

Question
4 of 6

In 2013, CCCL started capitalizing the discount offered (from selling the handsets at a lower
price) instead of recording it in the period it is incurred. This change in the policy would increase
net income (by lowering expenses) and cash from operations. The amounts capitalized would be
recorded as cash outflows for investing activities, compared with cash from operations if they
were expensed.

CFA Level II

"Long-Lived Assets: Implications for Financial Statements and Ratios," Elaine Henry and
Elizabeth A. Gordon

Section 2

"Evaluating Financial Reporting Quality," Scott Richardson and Irem Tuna

Section 4.2.2

Question
The broadcast licenses were written down in 2011 but the write-down was reversed in 2013.
Therefore, during 2012 the intangible assets were understated, which would have understated
amortization expense for the year and increased profit. Thus, in 2012 net profit margin was
overstated.

CFA Level II

Financial Ratio List at beginning of Financial Reporting and Analysis Volume

"Long-Lived Assets: Implications for Financial Statements and Ratios," Elaine Henry and
Elizabeth A. Gordon

Section 4.1
March Mock Exam PM - Answers

Question
6 of 6

To determine the amount of customer acquisition costs capitalized, analyze the changes in
intangible assets as follows:

(A$ thousands)
Opening intangible assets, net 24,500
Add impairment loss reversal 12,500
Add new broadcast licenses from MM acquisition 5,500
Add brand name from MM acquisition 2,000
Capitalized customer acquisition cost: Solve for X X
Deduct amortization expense 7,250
Ending intangibles assets, net 43,250

Solving for X, capitalized customer acquisition cost = A$6,000 thousand

CFA Level II

"Long-Lived Assets: Implications for Financial Statements and Ratios," Elaine Henry and
Elizabeth A. Gordon

Sections 2, 4

"Intercorporate Investments," Susan Perry Williams

Section 6.2.1

Block 6: Ready Power

Question
1 of 6

($ millions)
COGS (FIFO) = COGS (LIFO) Increase in LIFO reserve*
17,729 35 = 17,694
*Increase in LIFO reserve = 1,442 1,407 = 35

CFA Level II

Inventories: Implications for Financial Statements and Ratios, Michael A. Broihahn

Section 3.1
March Mock Exam PM - Answers

Question
2 of 6

The LIFO reserve at the end of 2013 was $1,442 million, indicating that cumulative gross profits
would have been $1,442 million higher under FIFO. With a tax rate of 29% (Exhibit 3, Note 1.J),
the cumulative additional income tax expense would be $1,442 0.29 = $418 million, resulting
in an increase in retained earnings of $1,442 $418 = $1,024 million.

CFA Level II

"Inventories: Implications for Financial Statements and Ratios," Michael A. Broihahn

Section 3.1

Question
3 of 6
LIFO liquidation arises when the number of units sold exceeds the number of units purchased or
manufactured and thus a portion of the older inventory is sold off or liquidated.
CFA Level II
"Inventories: Implications for Financial Statements and Ratios," Michael A. Broihahn Section
3.2
CFA Level II
"Inventories: Implications for Financial Statements and Ratios," Michael A. Broihahn
Sections 2, 3

Question
4 of 6

Only Statement 2 is correct. In periods of rising inventory prices, as recently experienced by the
company, LIFO COGS is higher and average inventory is lower, which results in faster inventory
turnover and thus lower days of inventory on hand (DOH). Receivables and payables are not
affected by the choice of inventory method. The lower DOH will appear to shorten the operating
and cash conversion cycles.

CFA Level II

"Inventories: Implications for Financial Statements and Ratios," Michael A. Broihahn

Sections 2,3
March Mock Exam PM - Answers

Question
5 of 6

Net (depreciable) PP&E (excludes land) from Note 10: $5,311 $110 = $5,201 million Depreciation
expense from Note 1.F: $332 million

CFA Level II

Long-Lived Assets: Implications for Financial Statements and Ratios, Elaine Henry and Elizabeth A.
Gordon

Section 5

Question
6 of 6

Statement 3 is accurate. The company's liquidity position will decrease. The item in inventory is
replaced with a lease receivable, which is primarily long term, thereby reducing current assets.

CFA Level II

"Long-Lived Assets: Implications for Financial Statements and Ratios," Elaine Henry and
Elizabeth A. Gordon Section 6.2.2

Block 7: Moyle

Question
1 of 6

Petsas' response to Moyle is correct. Futures and spot prices must converge at expiration. If they
do not, then it is possible to earn an arbitrage profit. If the spot price is greater than the futures
price, then one could earn an arbitrage profit by buying the futures contract and executing the
contract to purchase the underlying at the lower futures price and to sell it at the higher spot
price. If the futures price exceeds the spot price at expiration, then an investor could purchase the
asset at the spot price and enter into a short futures contract to sell it at the higher price, thus
locking in a profit.

CFA Level 2

"Futures Markets and Contracts," Don M. Chance Section 7.1.1

March Mock Exam PM - Answers

Question
2 of 6

The futures price is calculated as follows:

$3,508.6958 = 3,500(1.015)(2/12).

CFA Level 2

"Futures Markets and Contracts," Don M. Chance

Section 7.2.3

Question
3 of 6

p ++ = Max[0, X S++] = Max[0, 590 765.06] = 0

p + = Max[0, X S+ ] = Max[0, 590 655.76] = 0
p = Max[0, X S ] = Max[0, 590 562.08] = 27.92
S ++ = 609.90 1.12 1.12 = 765.06
S + = 609.90 1.12 0.96 = 655.76
S = 609.90 0.96 0.96 = 562.08

CFA Level 2
"Option Markets and Contracts," Don M. Chance
Section 6.2
March Mock Exam PM - Answers

Question
4 of 6

Iacocca is incorrect about the risk-free rate. Higher risk-free rates result in higher call option
prices and lower put option prices. She is correct about the impact of time to expiration and
volatility on put and call option prices.

CFA Level 2

"Option Markets and Contracts," Don M. Chance

Section 7.3

Question
5 of 6

Petsas is incorrect in stating that an interest rate swap is a combination of a long interest rate call
option and a long interest rate put option. A combination of the purchase of an interest rate call
option and the sale of an interest rate put option is equivalent to a plain vanilla interest rate swap
payment. Thus, if the underlying variable rate is below the exercise rate, the call is worthless and
the short put will require a net payment to the holder of the put. This scenario replicates the
situation in an interest rate swap in which the fixed payment (exercise rate) exceeds the variable
rate resulting in a net payment by the buyer of the swap.

CFA Level 2

"Swap Markets and Contracts," Don M. Chance

Section 4.1

Question
6 of 6
The appropriate present value factors are provided in the following table:

B0(90) 0.9922
B0(180) 0.9832
B0(270) 0.9728
B0(360) 0.9604
March Mock Exam PM - Answers

The fixed rate is calculated as follows:

The annualized rate = 0.0101 4 = 0.0404.

CFA Level 2

Swap Markets and Contracts, Don M. Chance

Section 4.2.1

Block 8: Metev

Question
1 of 6

Using data from Exhibit 3, the cost of equity (build-up method) = Risk-free rate + Equity risk
premium + Small stock risk premium + Industry risk premium + Company-specific risk
adjustment.
Cost of equity = 3.9 + 6.0 + 2.5 1.0 + 1.5 = 12.9%
WACC = Pre-tax cost of debt (1 T) (Debt weight) + Cost of equity (Equity weight)
WACC = 10.0 (1 0.25) (0.3) + 12.9 (0.7) = 2.25 + 9.03 = 11.28%
CFA Level II
"Private Company Valuation," Raymond D. Rath
Section 4.2.1
March Mock Exam PM - Answers

Question
2 of 6

Capitalization rate = (WACC Long-term growth rate) = 11.0% 5.0% = 6.0%

CFA Level II

"Private Company Valuation," Raymond D. Rath

Section 4.2.3

Question
3 of 6

to his first comment because the capitalized cash flow method is rarely used for the valuation of
public companies and it is more appropriate for valuing a private company such as RRBL.
Nenkov's second comment is correct because the excess earnings method involves estimating the
earnings remaining after deducting the amounts that reflect the required returns to working
capital and tangible assets. The residual amount of earnings (i.e., the excess earnings) is
capitalized to obtain an estimate of the value of intangible assets. Therefore, Nenkov's second
comment is correct.

CFA Level II

"Private Company Valuation," Raymond D. Rath

Section 4.2.3. 4.2.4

Question
4 of 6
Adjusted EV/EBITDA multiple = 7.2 (1.25) = 9.0
EV = EBITDA2013 Adjusted EV/EBITDA = 105.1 9.0 = 945.9
Value of equity = EV + Cash and short-term investments Long-term debt = 945.9 + 50.0 30.0
= 965.9
CFA Level II
"Market-Based Valuation: Price and Enterprise Multiples," Jerald Pinto, Elaine Henry, Thomas
Robinson, and John Stowe
Section 4
"Private Company Valuation," Raymond D. Rath
Section 4.2.3
March Mock Exam PM - Answers

Question
5 of 6

Statement 1 is correct because EBITDA is a pre-interest earnings figure, in contrast to earnings

per share, which is a post-interest figure. Thus the differences in financial leverage do not affect
EBITDA. Statement 2 is incorrect because EBITDA overestimates cash flow from operations if
working capital is growing. Therefore, only Statement 1 is correct.

CFA Level II

"Market-Based Valuation: Price and Enterprise Multiples," Jerald Pinto, Elaine Henry, Thomas
Robinson, and John Stowe

Section 4.1

Question
6 of 6

Discount for lack of control = 1 [1/(1+ Control premium)] = 1 [1/(1.30)] = 23.1%

CFA Level II

"Private Company Valuation," Raymond D. Rath

Section 4.5.1

Block 9: Richter

Question
1 of 6
The prepayment estimate provided for the SMM is 0.70%. For the one presented as a CPR, SMM=1 (1
1/12 1/12
CPR) , so a CPR of 8.50% implies that SMM=1 (1 0.085) =0.0074-0.74%. The pool has 17
months of seasoning, so a 220 PSA implies CPR = 17 0.2% 2.20 = 7.48%, which implies that SMM=1
1/12
(1 0.0748) =0.65%. The highest prepayment estimate of the three is the estimate of CPR = 8.50%.

CFA Level II

Mortgage-Backed Sector of the Bond Market, Frank J. Fabozzi

Section 3D
March Mock Exam PM - Answers

Question
2 of 6

Although mortgage rates are low, which would normally imply high rates of prepayment, they
have been low for some time. Therefore, any higher rate mortgage borrowers have already had
the opportunity to refinance at the current low (or even lower) rates. Newer borrowers borrowed
at these low (or lower) rates, so they will not have a refinancing incentive. This "burnout" effect
means that the current low mortgage rates are not expected to produce high rates of prepayment,
as stated. Furthermore, a poor economy will result in lower housing turnover, which will reduce
the rate of prepayment that would be caused by people moving to new houses.

CFA Level II

"Mortgage-Backed Sector of the Bond Market," Frank J. Fabozzi

Section 3F

Question
3 of 6

Based on the beginning balance of $117.54 million, WAC of 4.80%, WAM of 243 months, and
SMM of 0.70%, the expected cash flows of the pool for the next two months are as follows:

Principle and
Month Interest Principal Prepayment Balance
Interest
0 117,540,000
1 757,174 470,160 287,014 820,771 116,432,215
2 751,874 465,729 286,145 813,022 115,333,047
For Month 1 (Month 2), the principle and interest payment is the level (annuity) payment for a
principal balance of 117,540,000 (116,432,215) paid over 243 (242) months at a monthly rate of
0.40% (4.80%/12); the interest payment is 0.40% of the previous month's principal balance; the
scheduled principal payment is the difference between the principle and interest payment and the
interest payment; the expected prepayment is 0.70% of the previous month's principal balance
minus the scheduled principal payment; and the ending principal balance is the previous month's
principal balance minus the schedule principal payment minus the expected prepayment.

CFA Level II

"Mortgage-Backed Sector of the Bond Market," Frank J. Fabozzi

Section 3D
March Mock Exam PM - Answers

Question
4 of 6

If interest rates rise moderately, prepayment rates will decline moderately. The PAC tranche will
still be within its effective prepayment collar, so its cash flows will remain as promised or
planned. The tranche's value will be reduced only by the increase in the discount rate.

CFA Level II

"Mortgage-Backed Sector of the Bond Market," Frank J. Fabozzi

Section 4E

Question
5 of 6

The reason described is related to seasoning, which is a characteristic of mortgage pools but not
a cause of path dependency.

CFA Level II

"Valuing Mortgage-Backed and Asset-Backed Securities," Frank J. Fabozzi

Section 4

Question
6 of 6

Security Z has the highest option-adjusted spread (OAS). The OAS is the spread measure that
takes into account the cost of the prepayment option embedded in MBS. A higher OAS implies a
higher expected return after accounting for the negative value of the prepayment option. The
nominal spread and zero volatility spread do not take into account the cost of the embedded
prepayment option.

CFA Level II

"Valuing Mortgage-Backed and Asset-Backed Securities," Frank J. Fabozzi

Section 4E
March Mock Exam PM - Answers

Block 10: Shah

Question
1 of 6

CFA Level II

Portfolio Concepts, Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and David E. Runkle

Section 2.2

Question
2 of 6

Shah is incorrect about average correlation and the number of securities required to achieve a
particular level of portfolio risk reduction. As the correlation between securities increases, the
number of securities required to achieve a particular level of portfolio risk decreases. Portfolio
risk is

For example, consider a situation in which the average correlation is 0.3. In this situation, the
minimum possible portfolio variance, when n is very large, is 0.32that is, 0.3 times the
variance of a single stock. To achieve a portfolio with only 110% of this minimum possible
portfolio variance, 25 stocks would be needed:

If the average correlation is 0.5, it can be shown that only 10 stocks are needed to achieve a
portfolio that is 110% of the minimum possible portfolio variance of 0.52:
March Mock Exam PM - Answers

That is, 25 stocks are needed to achieve a risk level of 110% of the minimum possible portfolio
risk when the correlation is 0.3. Ten stocks are needed to achieve a risk level of 110% of the
minimum possible portfolio risk when the correlation is 0.5.

CFA Level II

"Portfolio Concepts," Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and David E.
Runkle

Section 2.4

Question
3 of 6

Shah is correct that the risk and return of the new portfolio will be linear combinations of the risk
and return of the risk-free investment and the portfolio, respectively. The reason is because the
return and risk of the new portfolio is calculated as

E(Rp) = w1 E(R1) + (1w1) E(R2),

SD(Rp) = w1 SD(R1).

CFA Level II

"Portfolio Concepts," Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and David E.
Runkle

Section 2.5

Question
4 of 6

The multifactor model that Shah describes is a fundamental factor model. In fundamental factor
models, the factors are attributes of stocks or companies that are important in explaining cross-
sectional differences in stock prices. Among the fundamental factors that have been used are the
ratio of book value to price, market capitalization, the price-to-earnings ratio, and financial
leverage.

CFA Level II

"Portfolio Concepts," Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and David E.
Runkle

Section 4.1
March Mock Exam PM - Answers

Question
5 of 6

Shah correctly describes the two components of active risk. We can separate a portfolio's active
risk squared into two components: (1) active factor risk is the contribution to active risk squared
resulting from the portfolio's different-from-benchmark exposures relative to factors specified in
the risk model (or systematic risk), and (2) active specific risk (or asset selection risk) is the
contribution to active risk squared resulting from the portfolio's active weights on individual
assets as those weights interact with assets' residual risk (also referred to as idiosyncratic risk).

CFA Level II

"Portfolio Concepts," Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and David E.
Runkle

Section 4.6.2

Question
6 of 6

Shah is incorrect with respect to the P/E. He states that his firm ensures that the portfolio is tilted
toward low P/E stocks. The factor sensitivity of the portfolio to the P/E factor is negative (
0.25), indicating that it does invest in low P/E stocks. However, the benchmark's sensitivity is
0.35, indicating that stocks in the benchmark have lower P/Es than stocks in the portfolio. Thus,
the portfolio is not tilted toward low P/E stocks relative to the benchmark.

CFA Level II

"Portfolio Concepts," Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and David E.
Runkle

Section 4.6