100% Free CFA Institute CFA-Level-II Practice Test Questions

Question 1

Natalia Berg, CFA, has estimated the key rate durations for several maturities in three of her $25 million bond portfolios, as shown in Exhibit 1.

At a fixed-income conference in London, Berg hears a presentation by a university professor on the increasing use of the swap rate curve as a benchmark instead of the government bond yield curve. When Berg returns from the conference, she realizes she has left her notes from the presentation on the airplane. However, she is very interested in learning more about whether she should consider using the swap rate curve in her work.

As she tries to reconstruct what was said at the conference, she writes down two advantages to using the swap rate curve:

Statement 1: The swap rate curve typically has yield quotes at 11 maturities between 2 and 30 years. The U .S . government bond yield curve, however, has fewer on-the-run issues trading at maturities of at least two years.

Statement 2: Swap curves across countries are more comparable than government bond curves because they reflect similar levels of credit risk.

Berg also estimates the nominal spread, Z-spread, and option-adjusted spread (OAS) for the Steigers Corporation callable bonds in Portfolio 2. The OAS is estimated from a binomial interest rate tree. The results are shown in Exhibit 2.

Berg determines that to obtain an accurate estimate of the effective duration and effective convexity of a callable bond using a binomial model, the specified change in yield (i.e., Ay) must be equal to the OAS.

Berg also observes that the current Treasury bond yield curve is upward sloping. Based on this observation, Berg forecasts that short-term interest rates will increase.

If the spot-rate curve experiences a parallel downward shift of 50 basis points:

A : all three portfolios will experience the same price performance.

B : Portfolio 1 will experience the best price performance.

C : Portfolio 3 will experience the best price performance.

Answer: A

Question 2

Susan Foley, CFA, is Chief Investment Officer of Federated Investment Management Co. (FIMCO), a large investment management firm that includes a family of mutual funds as well as individually managed accounts. The individually managed accounts include individuals, personal trusts, and employee benefit plans. In the past few months, Foley has encountered a couple of problems.
The Tasty IPO
Most portfolio managers of FIMCO have not participated in the initial public offering (IPO) market in recent years. However, recent changes to the compensation calculation at FIMCO have tied manager bonuses to portfolio performance. The changes were outlined in a letter that was sent out to clients and prospects shortly before the new bonus structure took effect. Carl Lee, CFA, is one portfolio manager who believes that investing in IPOs may add to his client's equity performance and, in turn, increase his bonus. While Lee's individual clients have done quite well this year, his employee benefit plans have suffered as a result of limited exposure to the strongest performing sector of the market. Lee has placed an order for all employee benefit plans to receive an allocation of the Tasty Doughnut IPO. Tasty is an over-subscribed IPO that Lee knew would make money for his clients. When he placed the order, Lee's assistant reminded him that one pension plan. Ultra Airlines, was explicitly prohibited from investing in IPOs in its investment policy statement, due to the under-funded status of the pension plan. Lee responded that the Tasty IPO would never actually be owned in Ultra's account, because he would sell the IPO stock before the end of the day and realize a profit before the position ever hit the books.
Another manager, Franz Mason, CFA, who manages accounts for about 150 individuals, is also interested in the Tasty IPO. Mason visits Lee's portfolio assistant and quizzes him about Lee's participation in the Tasty deal. Mason is sure that Lee would not have bought into Tasty unless he had done his homework. Mason places an order for 10,000 shares of the IPO. Mason returns to his desk and begins to allocate the IPO shares among his clients. Mason divides his client base into two groups: clients who are income-oriented and clients who arc capital gains-oriented. Mason believes those clients that are income-oriented are fairly risk averse and could not replace lost capital if the Tasty Doughnut deal lost money. Mason believes the capital gains-oriented accounts arc better able to withstand the potential loss associated with the Tasty IPO. Accordingly, Mason allocates his 10,000 share order of the Tasty IPO strictly to his capital appreciation clients using a pro rata allocation based on the size of the assets under management in each account.
FIMCO Income Fund (FIF)
Over the past three years, the FIF, with $5 billion in assets, has been the company's best performing mutual fund. Jane Ryan, CFA, managed the FIF for seven years, but resigned one year ago to start her own hedge fund. Under Ryan, the FIF invested in large cap stocks with reliable dividends. The fund's prospectus specifies that FIF will invest only in stocks that have paid a dividend for at least two quarters, and have a market capitalization in excess of $2.5 billion. Foley appointed FIMCO's next best manager (based on 5-year performance numbers) Steve Parsons, CFA, to replace Ryan. Parsons had been a very successful manager of the FIMCO Opportunity Fund, which specialized in small capitalization stocks. Six months after Parsons took over the helm at FIF. the portfolio had changed. The average market capitalization of FIF's holdings was $12.8 billion, as opposed to $21 billion a year ago. Over the same period, the average dividend yield on the portfolio had fallen from 3.8% to 3.1%. The performance of the FIF lagged its peer group for the first time in three years. In response to the lagging performance, Parsons purchased five stocks six months ago. Parsons bought all five stocks, none of which paid a dividend at the time of purchase, in anticipation that each company was likely to initiate dividends in the near future. So far, four of the stocks have initiated dividend payments, and their performance has benefited as a result. The fifth stock did not initiate a dividend, and Parsons sold the position last week. Largely due to the addition of the five new stocks, the FIF's performance has led its peer group over the past six months.
Before leaving FIMCO, Ryan had told Foley that above-average returns from both the management and client side could be gained from entering into the risk-arbitrage hedge fund market. Ryan had tried to convince FIMCO management to enter the risk-arbitrage market, but the firm determined that no one had the experience or research capability to run a risk-arbitrage operation. As a result, Ryan started the Plasma Fund LLC one month after leaving FIMCO. Foley remembers seeing Ryan at the annual FIMCO client dinner parly (before she left the firm) discussing the profits to be made from risk-arbitrage investing with several large FIF shareholders. Ryan mentioned that she would be opening the Plasma Fund to these FIMCO clients, several of whom made substantial investments in the first months of Plasma Fund's life. After Ryan resigned and left her office, Foley performed an inventory of firm assets signed out to Ryan. One of the copies of the proprietary stock selection software packages, FIMCO-SelectStock, assigned to Ryan was missing along with several of the SelectStock operating manuals. When Foley contacts Ryan about the missing software and manuals, Ryan states that the reason she took the SelectStock software was that it was an out of date version that FIMCO's information technology staff had urged all managers to discard.
Has there been any violation of CFA Institute Standards of Professional Conduct relating to either the change in the average holdings of the FIF during the first six months of Parsons's leadership, or in Parsons's subsequent investment in the non-dividend paying stocks?

A : Both actions. The change in average holdings, and the purchase of non-dividend paying stocks, are violations of CFA Institute Standards.

B : The change in average holdings would not have been a violation of CFA Institute Standards if client notification had occurred before the change was initiated.

C : There is no violation regarding the change in average holdings, but the purchase of non-dividend paying stocks is a violation.

Answer: C

Question 3

Kevin Rathbun, CFA, is a financial analyst at a major brokerage firm. His supervisor, Elizabeth Mao, CFA, asks him to analyze the financial position of Wayland, Inc. (Wayland), a manufacturer of components for high quality optic transmission systems. Mao also inquires about the impact of any unconsolidated investments.

On December 31,2007, Wayland purchased a 35% ownership interest in a strategic new firm called Optimax for $300,000 cash. The pre-acquisition balance sheets of both firms are found in Exhibit 1.

On the acquisition date, all of Optimax's assets and liabilities were stated on its balance sheet at their fair values except for its property, plant, and equipment (PP&E), which had a fair value of $1.2 million. The remaining useful life of the PP&E is ten years with no salvage value. Both firms use the straight-line depreciation method.
For the year ended 2008, Optimax reported net income of $250,000 and paid dividends of $100,000.
During the first quarter of 2009, Optimax sold goods to Wayland and recognized $15,000 of profit from the sale. At the end of the quarter, half of the goods purchased from Optimax remained in Wayland's inventory.
Wayland currently uses the equity method to account for its investment in Optimax. However, given the potential significance of the investment in the future, Rathbun believes that a proportionate consolidation of Optimax may give a clearer picture of the financial and operating characteristics of Wayland.
Rathbun also notes that Wayland owns shares in Vanry, Inc. (Vanry). Rathbun gathers the data in Exhibit 2 from Wayland's financial statements. The year-end portfolio value is the market value of all Vanry shares held on December 31. All security transactions occurred on July 1, and the transaction price is the price that Wayland actually paid for the shares acquired. Vanry pays a cash dividend of $1 per share at the end of each year. Wayland expects to sell its investment in Vanry in the near term and accounts for it as held-for-trading.
Wayland owns some publicly traded bonds of the Rotor Corporation that it reports as held-to-maturity securities.
Which of the following best describes WaylancTs treatment of the intercompany sales transaction for the quarter ended March 31, 2009? Wayland should reduce its equity income by:

A : $2,625.

B : $7,500.

C : $15,000.

Answer: A

Question 4

Introduction
Rajesh Singh is the CFO of Goldensand Jewelry, Ltd, a London-based retailer of fine jewelry and watches. Singh has noticed that the price of gold has begun to increase. If economic activity continues to pick up, the price of gold is likely to accelerate its rate of increase as both the level of demand and inflation rates increase.
Implications of Rising Gold Price

Singh has become concerned about the cost implications for Goldensand if gold prices continue to rise. He has requested a meeting with Anita Biscayne, Goldensand's COO. In preparation for the meeting, Singh asked one of his staff, Yasunobu Hara, to prepare a regression analysis comparing the price of gold to the average cost of Goldensand's purchases of finished gold jewelry. Hara provides the regression results as shown in Exhibit 1.

Reviewing the regression results, Biscayne becomes concerned about the implications for the cost of finished jewelry to Goldensand if the price of gold continues to rise. To remain profitable, the cost of finished jewelry should not exceed $2,000.
Regression Concerns
Overall Concerns
Singh's principal concern about the regression is whether the time period chosen is a good predictor of the current situation. He makes the following statement:
Statement 1: We may have a problem with parameter instability if the relationship between gold prices and jewelry costs has changed over the past 30 years. Singh also focuses on the value of the slope coefficient. He expected it to be 4.0 based on his experience in the industry. Hara computes the appropriate test statistic and reports the following:
Statement 2: We fail to reject the null hypothesis that the slope coefficient is equal to 4.0 at the 5% level of significance.
Testing for Heteroskedasticity
Biscayne remarks that the dramatic increase in the price level over the past 30 years leads her to suspect heteroskedasticity in the regression results. She suggests to Singh that they should conduct a Breusch-Pagan chi-square test for heteroskedasticity by calculating the following test statistic:

Model Misspecification
Biscayne and Singh have various views on the potential for model misspecification and the effect of any such misspecification.
* Biscayne worries that the regression model is misspecified because it does not include a variable to measure the cost of the highly specialized labor used by manufacturing jewelers. She points out that the effect of omitting an important variable in a regression analysis is that the regression coefficients will be unbiased and inconsistent.
* Singh adds that another common consequence of misspecifying a regression analysis is creating undesired stationarity.
Multiple Regression
Hara conducts a series of regression analyses using all possible combinations of the suggested independent variables based on their average quarterly values. He returns with the following regression results as shown in Exhibit 3 for the equation which uses all suggested independent variables.

Hara is concerned about the equation described in Exhibit 3. He makes the following statement:
Statement 3: The Durbin-Watson statistic indicates the presence of positive autocorrelation at the 5% level.
Biscayne responds with the following statement:
Statement 4: An autocorrelation problem can be addressed by using the Hansen method to adjust the .

Is Biscayne correct regarding his statement concerning how to correct for autocorrelation?

A : No, because the White method is used to adjust the .

B : No, because the Hansen method adjusts the coefficient standard errors.

C : No, because the Hansen method is used to address the problem of multicollinearity.

Answer: C

Question 5

Henke Malfoy, CFA, is an analyst with a major manufacturing firm. Currently, he is evaluating the replacement of some production equipment. The old machine is still functional and could continue to serve in its current capacity for three more years. Tf the new equipment is purchased, the old equipment (which is fully depreciated) can be sold for $50,000. The new equipment will cost $400,000, including shipping and installation. If the new equipment is purchased, the company's revenues will increase by $175,000 and costs by $25,000 for each year of the equipment's 3-year life. There is no expected change in net working capital.
The new machine will be depreciated using a 3-year MACRS schedule (note: the 3-year MACRS schedule is 33.0% in the first year, 45% in the second year, 15% in the third year, and 7% in the fourth year). At the end of the life of the new equipment (i.e., in three years), Malfoy expects that it can be sold for $10,000. The firm has a marginal tax rate of 40%, and the cost of capital on this project is 20%. In calculation of tax liabilities, Malfoy assumes that the firm is profitable, so any losses on this project can be offset against profits elsewhere in the firm. Malfoy calculates a project NPV of-$62,574.
Suppose for this question only that Malfoy has forgotten to reflect a decrease in inventory that will result at the beginning of the project. The most likely effect on estimated project NPV of this error:

A : is to overestimate NPV.

B : is to underestimate NPV.

C : depends on whether the inventory is assumed to build back up to its previous level at the end of the project or the decrease in inventory is permanent.

Answer: B

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