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

Question 1

Trent Black is a government fixed-income portfolio manager and on January 1, he holds $30 million of fixed-rate, semi-annual pay notes. Black is considering entering into a 2-year $30 million semi-annual pay interest rate swap as the fixed-rate payer. He must first determine the swap rate. Black notes the following term structure:

Black is also evaluating receiver and payer swaptions on the same $30 million interest rate swap. The swaptions are European-style swaptions that mature in 240 days. Black anticipates a decline in interest rates and would like to use the swaptions to profit from his interest rate forecast.
Black is also concerned about the potential credit risk inherent in both interest rate swaps and swaptions, so he consults Marcus Coleman, a contract specialist in the legal department. Coleman advises Black that:
Statement 1: The fixed rate payer in any plain vanilla interest rate swap is exposed to potential credit risk at the initiation of the swap but the floating rate payer is not.
Statement 2: The long position is exposed to potential credit risk in a payer swaption at initiation but the short
position in a payer swaption is not.
On May I after 120 days. Black is asked to determine the value of the 2-year, $30 million swap. The term structure after 120 days is:

Is Coleman correct with respect to the credit risk of swaps and swaptions?

A : Correct on both statements.

B : Only correct on Statement 1.

C : Only correct on Statement 2.

Answer: C

Question 2

Lena Pilchard, research associate for Eiffel Investments, is attempting to measure the value added to the Eiffel Investments portfolio from the use of 1-year earnings growth forecasts developed by professional analysts.
Pilchard's supervisor, Edna Wilms, recommends a portfolio allocation strategy that overweights neglected firms. Wilms cites studies of the 'neglected firm effect,' in which companies followed by a small number of professional analysts are associated with higher returns than firms followed by a larger number of analysts. Wilms considers a company covered by three or fewer analysts to be 'neglected.'
Pilchard also is aware of research indicating that, on average, stock returns for small firms have been higher than those earned by large firms. Pilchard develops a model to predict stock returns based on analyst coverage, firm size, and analyst growth forecasts. She runs the following cross-sectional regression using data for the 30 stocks included in the Eiffel Investments portfolio:
Ri = b0 + b,COVERAGEi + b2 LN(SIZEi) + b3(FORECASTi) + ei
where:
Ri = the rate of return on stock i
COVERAGEi = one if there are three or fewer analysts covering stock
i, and equals zero otherwise
LN(SIZEi) = the natural logarithm of the market capitalization
(stock price times shares outstanding) for stock i,
units in millions
FORECASTi = the 1-year consensus earnings growth rate forecast for stock i

Pilchard derives the following results from her cross-sectional regression:

The standard error of estimate in Pilchard's regression equals 1.96 and the regression sum of squares equals 400.
Wilrus provides Pilchard with the following values for analyst coverage, firm size, and earnings growth forecast for Eggmann Enterprises, a company that Eiffel Investments is evaluating.

Pilchard derives the ANOVA table for her regression. In her ANOVA table, the degrees of freedom for the regression sum of squares and total sum of squares should equal:

A : 3 and 30, respectively.

B : 4 and 29, respectively.

C : 3 and 29, respectively.

Answer: C

Question 3

Yi Tang updates several economic parameters monthly for use by the analysts and the portfolio managers at her firm. If economic conditions warrant, she will update the parameters even more frequently. As a result of an economic slowdown, she is going through this process now.
The firm has been using an equity risk premium of 5.6%, found with historical estimates. Tang is going to use an estimate of the equity risk premium found with a macroeconomic model. By comparing the yields on nominal bonds and real bonds, she estimates the inflation rate to be 2.6%. She expects real domestic growth to be 3.0%. Tang does not expect a change in price/earnings ratios. The yield on the market index is 1.7% and the expected risk-free rate of return is 2.7%.
Elizabeth Trotter, one of the firm's portfolio Managers, asks Tang about the effects of survivorship bias on estimates of the equity risk premium. Trotter asks, 'Which method is most susceptible to this bias, historical estimates, Gordon growth model estimates, or survey estimates?'
Tang wishes to estimate the required rate of return for Northeast Electric (NE) using the Capital Asset Pricing Model (CAPM) and the Fama-French three factor model. She is using the following information to accomplish this:
* The risk-free rate of return is 2.7%.

* The expected risk premiums arc:

* The beta coefficient in the CAPM is estimated to be 0.63.
* The betas (factor sensitivities) for the three Fama-French factors are 1.00 for the market factor, -0.76 for the size factor, and -0.04 for the book-to-markct factor.
Trotter also asks Tang about adjusted betas. She says, 'We use a formula for the adjusted beta where the adjusted beta = (2/3) (regression beta) + (1/3) (1.0). How do the adjusted betas compare to the original regression betas?'
Trotter has one final question for Tang. Trotter says, 'We need to estimate the equity beta for VixPRO, which is a private company that is not publicly traded. We have identified a publicly traded company that has similar operating characteristics to VixPRO and we have estimated the beta for that company using regression analysis. We used the return on the public company as the dependent variable and the return on the market index as the independent variable. What steps do I need to take to find the beta for VixPRO equity? The companies have different debt/equity ratios. The debt of both companies is very low risk, and I believe I can ignore taxes.'
The best response to Trotter's question about survivorship bias is:

A : historical estimates.

B : Gordon model estimates.

C : survey estimates.

Answer: A

Question 4

Maria Harris is a CFA Level 3 candidate and portfolio manager for Islandwide Hedge Fund. Harris is commonly involved in complex trading strategies on behalf of Islandwide and maintains a significant relationship with Quadrangle Brokers, which provides portfolio analysis tools to Harris. Recent market volatility has led Islandwide to incur record-high trading volume and commissions with Quadrangle for the quarter. In appreciation of Islandwide's business, Quadrangle offers Harris an all-expenses-paid week of golf at Pebble Beach for her and her husband. Harris discloses the offer to her supervisor and compliance officer and, based on their approval, accepts the trip.
Harris has lunch that day with C. K. Swamy, CFA, her old college roommate and future sister-in-law. While Harris is sitting in the restaurant waiting for Swamy to arrive, Harris overhears a conversation between the president and chief financial officer (CFO) of Progressive Industries. The president informs the CFO that Progressive's board of directors has just approved dropping the company's cash dividend, despite its record of paying dividends for the past 46 quarters. The company plans to announce this information in about a week. Harris owns Progressive's common stock and immediately calls her broker to sell her shares in anticipation of a price decline.
Swamy recently joined Dillon Associates, an investment advisory firm. Swamy plans to continue serving on the board of directors of Landmark Enterprises, a private company owned by her brother-in-law, for which she receives $2,000 annually. Swamy also serves as an unpaid advisor to the local symphony on investing their large endowment and receives four season tickets to the symphony performances.
After lunch, Alice Adams, a client, offers Harris a 1 -week cruise as a reward for the great performance of her account over the previous quarter. Bert Baker, also a client, has offered Harris two airplane tickets to Hawaii if his account beats its benchmark by more than 2% over the following year.
Juliann Clark, a CFA candidate, is an analyst at Dillon Associates and a colleague of Swamy's. Clark participates in a conference call for several analysts in which the chief executive officer at Dex says his company's board of directors has just accepted a tender offer from Monolith Chemicals to buy Dex at a 40% premium over the market price. Clark contacts a friend and relates the information about Dex and Monolith. The friend promptly contacts her broker and buys 2,000 shares of Dex's stock.
Ed Michaels, CFA, is director of trading at Quadrangle Brokers. Michaels has recently implemented a buy program for a client. This buy program has driven up the price of a small-cap stock, in which Islandwide owns shares, by approximately 5?cause the orders were large in relation to the average daily trading volume of the stock. Michaels' firm is about to bring shares of an OTC firm to market in an
IPO. Michaels has publicly announced that, as a market maker in the shares, his trading desk will create additional liquidity in the stock over its first 90 days of trading by committing to minimum bids and offers of 5,000 shares and to a maximum spread of one-eighth.
Carl Park, CFA, is a retail broker with Quadrangle and has been allocated 5,000 shares of an oversubscribed IPO. One of his clients has been complaining about the execution price of a trade Park made for her last month, but Park knows from researching it that the trade received the best possible execution. In order to calm the client down. Park increases her allocation of shares in the IPO above what it would be if he allocated them to all suitable client accounts based on account size. He allocates a pro rata portion of the remaining shares to a trust account held at his firm for which his brother-in-law is the primary beneficiary.
Has Michaels violated Standard 11(B) Integrity of Capital Markets: Manipulation with respect to any of the following?

A : The buy program is a violation.

B : The liquidity activity is a violation.

C : There is no violation.

Answer: C

Question 5

Arnaud Aims is assisting with the analysis of several firms in the retail department store industry. Because one of the industry members, Flavia Stores, has negative earnings for the current year, Aims wishes to normalize earnings to establish more meaningful P/E ratios. For the current year (2008) and six previous years, selected financial data are given below. All data are in euros.

Aims wishes to estimate normalized EPS for 2008 using two different methods, the method of historical average EPS and the method of average rate of return on equity. He will leave 2008 EPS and ROI out of his estimates. Based on his normalized EPS estimates, he will compute a trailing P/E for 2008. The stock price for Flavia Stores is 26.50.
Aims is also looking at price-to-book ratios as an alternative to price-to-earnings ratios. Three of the advantages of P/B ratios that Aims recalls are:
Advantage 1: Because book value is a cumulative balance sheet account encompassing several years, book value is more likely to be positive than EPS.
Advantage 2: For many companies, especially service companies, human capital is more important than physical capital as an operating asset.
Advantage 3: Book value represents the historical purchase cost of assets, as well as accumulated accounting depreciation expenses. Inflation and technological changes can drive a wedge between the book value and market value of assets.
Aims used a constant growth DDM to establish a justified P/E ratio based on forecasted fundamentals. One of his associates asked Aims if he could easily establish a justified price-to-sales (P/B) ratio and price-to-book (P/B) ratio from his justified P/E ratio. Aims replied, 'I could do this fairly easily)
If I multiply the P/E ratio times the net profit margin, the ratio of net income to sales, the result will be the P/S ratio. If I multiply the P/E ratio times the return on equity, the ratio of net income to book value of equity, the result will be the P/B ratio.'
Aims's associate likes to use the price-earnings-to-growth (PEG) ratio because it appears to address the effect of growth on the P/E ratio. For example, if a firm's P/E ratio is 20 and its forecasted 5-year growth rate is 10%, the PEG ratio is 2.0. The associate likes to invest in firms that have an above-industry-average PEG ratio. The associate also says that he likes to invest in firms whose leading P/E is greater than its trailing P/E. Aims tells the associate that he would like to investigate these two investment criteria further.
Finally, Aims makes two comments to his associate about valuation ratios based on EBITDA and on dividends.
Comment 1: EBITDA is a pre-interest-expense figure, so I prefer a ratio of total equity value to EBITDA over a ratio of enterprise value to EBITDA .
Comment 2: Dividend yields are useful information because they are one component of total return. However, they can be an incomplete measure of return, as investors trade off future earnings growth to receive higher current dividends.
Is Aims correct in describing how we could transform a justified P/E ratio into a P/S ratio or a P/B ratio?

A : Yes.

B : No. He is correct about the P/S ratio but incorrect about the P/B ratio.

C : No. He is correct about the P/B ratio but incorrect about the P/S ratio.

Answer: A

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