Level II of CFA® Program Mock Exam 1 – Solutions (PM)

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Level II of CFA® Program

Mock Exam 1
June, 2019

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

FinQuiz.com – 1st Mock Exam 2019 (PM Session)

Questions Topic Minutes

1-12 Ethical and Professional Standards 36
13-18 Quantitative Methods 18
19-24 Financial Reporting and Analysis 18
25-36 Equity Investments 36
37-48 Alternative Investments 36
49-54 Fixed Income 18
55-60 Portfolio Management 18
Total 180

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

Questions 1 through 6 relate to Ethical and Professional Standards

Alpha and Beta Associates (A&B) Case Scenario

Alpha and Beta Associates (A&B) is a small U.S. based investment management firm
that provides asset management services to private wealth clients. Ryan Becker is the
chief investment officer (CIO) at A&B who oversees a team of portfolio managers and
research analysts at the firm. Becker has just assigned two clients to Adam Levin, a
portfolio manager. When Levin reviewed the clients’ IPS, he determined that Client A
was in the later stage of his life and wanted to minimize risk and increase cash flow
certainty. Client B, on the other hand, was young, had no dependents, and had a job in a
stable industry. After a comprehensive analysis of the clients, and a meeting with each of
them, Levin made the following statements to the clients with regards to appropriate
investment opportunities:

Client A: “Since your risk tolerance is low you should shift a portion of your
investments from equity to bank-sponsored fixed certificates of deposit.
This will ensure that your principal is ‘guaranteed’ up to the insured
limit.”

Client B: “Even though you can tolerate significant risk, I would still advise you to
invest at least a portion of your investment in agency CMOs, like ‘interest-
only strips’. These derivatives are ‘guaranteed’ by the U.S. government
and hence, limit your risk.”

Levin is evaluating the future of the technology sector and is trying to pick stocks that
would promise above-average returns. For this, he followed business news and read
publications in financial and technology journals. Levin recently read an article published
in ‘The Capital Markets’. The article was written by Walter Laws, a financial journalist
and a technology industry analyst. The article stated that technology stocks were going to
outperform the market over the next quarter, and that this trend was expected to continue
in the near future. Levin decided to use this information in his own paper, so he contacted
Laws’ firm to get a copy of the original article. He then included the complete study in
his paper and cited only Walter Laws.

After writing his paper, Levin met with Becker to discuss the future of the utilities sector.
Levin knew that Becker is a senior analyst, and has gained considerable trust and respect
in his field. During a discussion with Levin, Becker stated that due to changes in the
market and industry structure, he believes the major utilities giants will see a drastic drop
in earnings in the coming quarter. Becker continued by stating that he was going to
change his ‘buy’ recommendation to ‘sell’ and was going to express his opinion in an
interview on a global news channel the next day. After his talk with Becker, Levin

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

decided to ask his brother, who worked in the utilities industry for ten years, to advise
him on buying or selling utilities stocks. He stated that Levin should follow the ‘sell’
recommendation, since he believed that the industry was going to see a downfall. Levin
quickly sold 10,000 utilities shares that he held in his own portfolio.

Levin is responsible for the management of two equity funds: The Beta Fund and The
Equatic Fund. Both funds have 5% of their worth invested in the stock of QUIN
Technologies, but their investment guidelines indicate this to be an excessive amount.
Because QUIN’s stock has low liquidity in the stock market, Levin decided to trade
portions of the stock back and forth between the two funds so as to increase liquidity.
Due to his trading, Levin managed to bring the amount invested within the guidelines of
the two funds.

Levin recently attended a seminar where he met his friend John Ryder, a mutual fund
portfolio manager. While talking to Ryder, Levin found out that one of his new clients is
also an investor in Ryder’s fund. He stated that this meant that they now share a
responsibility to the client.

1. With respect to his comments to his clients, is Levin most likely in violation of the
Standard I(C) ‘Misrepresentation’ of the Standards of Professional Conduct?

A. No.
B. Only with respect to Client A.
C. Only with respect to Client B.

Correct Answer: C

Reference:
Level II of CFA Program Volume 1, Study Session 1, Reading 2, LOS a

Levin is not in violation with respect to Client A. Bank-sponsored certificates are

insured by the government so using the term ‘guaranteed’ in this context is not
inappropriate.

Levin is in violation with respect to Client B. Although the underlying mortgages

are guaranteed by the government, the interest stream on the IOs is not, which
changes when interest rates in the market change.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

2. With respect to the inclusion of the article in his paper, is Levin most likely in
violation of Standard I(C), Misrepresentation?

A. No.
B. Yes, because he did not mention ‘The Capital Markets’ in references.
C. Yes, because he did not make efforts to determine whether the study was
comprehensive and not misrepresented.

Correct Answer: A

Reference:
Level II of CFA Program Volume 1, Study Session 1, Reading 2, LOS a

Levin is not in violation. Since Levin has obtained the complete study from the
original author, he need only cite that author and not the intermediary.

3. With respect to trading utilities shares, did Levin violate Standard II(A), Material
Nonpublic Information?

A. No.
B. Yes, because he traded on Becker’s advice before it became public.
C. Yes, because he traded on his brother’s advice before it became public.

Correct Answer: B

Reference:
Level II of CFA Program Volume 1, Study Session 1, Reading 2, LOS a

Levin violated the Standard because he traded on Becker’s change of opinion.

Becker is a renowned analyst, and his appearance on the TV channel where he
would discuss the changed recommendation is bound to have a material impact on
the stock. On the other hand, Levin’s brother is not a reliable source, so trading on
his advice is not a violation.

4. With respect to the Beta and Equatic Funds, has Levin most likely violated
Standard II(B), Market Manipulation?

A. Yes.
B. No, because he was working in the best interest of his clients.
C. No, because he did not manipulate the market with the intentions of
profiting from the trading.

Correct Answer: A

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

Reference:
Level II of CFA Program Volume 1, Study Session 1, Reading 2, LOS a

Even though Levin’s trading will benefit the fund’s participants, his actions are
leading to an artificial distortion of trading volume, and, in turn, the price of the
stock.

5. With respect to his statement to Ryder, is Levin most likely correct?

A. No.
B. Yes, because both Ryder and Levin have a duty of loyalty to the client.
C. Yes, because both Ryder and Levin need to work together toward the
management of the client’s needs.

Correct Answer: A

Reference:
Level II of CFA Program Volume 1, Study Session 1, Reading 2, LOS b

Ryder is incorrect. Ryder’s responsibility is to manage the fund according to the

IPS of the fund. His actions should not be influenced by the needs of any
particular fund investor.

6. Which of the following about proxy voting policies is most likely in accordance
with the Standards of Professional Conduct?

A. An investment manager can vote with management on non-routine

governance issues without consulting the client.
B. An investment manager need not vote all proxies if a cost-benefit analysis
indicates that voting all proxies is not beneficial.
C. Although proxies have economic value to a client, voting proxies is not an
integral part of the management of investments.

Correct Answer: B

Reference:
Level II of CFA Program Volume 1, Study Session 1, Reading 2, LOS b

An investment manager need not vote all proxies if a cost-benefit analysis

indicates that voting all proxies may not benefit the client. Options A and C are
incorrect.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

Questions 7 through 12 relate to Ethical and Professional Standards

Quench Beverages (QB) Case Scenario

Quench Beverages (QB) is a manufacturer and distributor of various types of beverages.

QB is situated in the country of Lexcorn. The country’s regulations concerning securities
trading are relatively relaxed compared to its neighboring countries. QB has recently
hired Mona Smith, CFA, to provide advisory services for its investment portfolio.

On her first day at work, Smith relies on a research report prepared by her brother, who
works at an equity research firm, to purchase the stock of Line plc. She purchases the
report at a discount from the price quoted in the market. After considerable research on
research providers, Smith comes to the conclusion that her brother has the most expert
insight on manufacturers such as Line plc. However, to avoid the appearance of any
conflict, she tells colleagues that she will be relying on a leading expert report to make
purchases of the Line plc stock for her clients’ portfolios. Local regulations do not
require disclosures by investment advisors in this regard.

Immediately after making the stock allocation, Smith is contacted by her previous client,
Rice Growers. The company’s CEO is extremely pleased with the annual performance
achieved by Smith when she was managing the company’s portfolio as their investment
advisor. The CEO offers Smith a fully paid trip to the Bahamas. The trip funding also
includes hotel accommodation and tickets to a beach cruise. After checking with local
laws and firm policies, Smith accepts the offer and puts in an application for a holiday in
writing. She discloses details of the trip to her supervisor on her return.

On her first day back on the job, Smith receives a letter from Line plc’s CEO inviting her
to visit the company’s manufacturing facility. The purpose of the visit is purely
educational and is undertaken to learn more about the strength of the company’s
operating and governance structures as well as reaffirm her reasons for selecting the Line
plc stock for clients’ portfolios.

During her visit, Smith overhears two production managers discussing plans for
organizing a union strike for demanding an increase in wages. The conversation stops as
soon as the managers realize that an outsider is present.

Smith returns to her desk and shares the news with her brother who tells her that a
production strike of any scale has the potential to shrink Line plc’s market share
especially given the fact that it operates in a fiercely competitive market. He instructs
Smith to sell the stock and immediately issues a flash report with a sell rating.

QB’s management is extremely pleased with Smith’s performance as investment advisor.

She is requested to prepare a brochure which includes an introduction and explains her
performance results. Smith prepares the following statements:

Statement 1: “The CFA Program is a rigorous course of study which equips candidates
such as me with top-of-the-line portfolio management skills.”

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

Statement 2: “The current year has been an exceptional performance year for me and QB.
If we continue to have access to top quality research, I can foresee a
replication of the performance achieved for many years to come.”

‘O Hara Traders is one of QB’s competitors. The firm’s CEO, Paul Jones, contacts Smith
after learning about her exemplary performance from QB’s brochure. He offers Smith a
part-time investment advisor position which will involve managing the firm’s recently
established investment portfolio for a fee. Smith responds by stating that she will need to
think over the offer.

Smith feels that more emphasis should be placed on drafting policies which address the
conflict between local laws and the Code and Standards as well as how individuals
should deal with situations in which there is a violation of law. She drafts the following
two policies:

Policy 1: Investment professionals should always comply with the strictest regulations
even if it contradicts with the Code and Standards.

Policy 2: If an employee has come to know that an impending client activity, which is yet
to materialize, is illegal, he or she should bring up the matter with a regulatory
authority.

7. In order to comply with requirements and recommendations of the CFA Institute

Standards of Professional Conduct, Smith’s best course of action with respect to
relying on her brother’s report would be to:

A. avoid purchasing the stock as it constitutes a conflict of interest.

B. seek permission from her employer prior to relying on the report.
C. provide a written disclosure of the fees offered and her relationship with
her brother to QB.

Correct Answer: C

Reference:
Level II of CFA Program Volume 1, Study Session 1, Reading 2, LOS b

C is correct. Because of her relationship with the report writer, the discount offered
to Smith by her brother may constitute a conflict of interest requiring disclosure.
The discount may be perceived by her client and employer (both QB) as a special
favor bestowed upon Smith because she is related to the report writer. Therefore, to
eliminate any doubt, best practice would dictate that she discloses her relationship
with the report writer and the discounted fees offered by him to QB. Standard VI
(A) Disclosure of Conflicts requires members and candidates to make full and fair
disclosure of all matters that could reasonably be expected to impair their
independence and objectivity. All actual and potential conflicts of interest should be
disclosed.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

A is incorrect. Smith can purchase the stock as long as she makes the necessary
disclosure. There is considerable evidence to indicate that she did not select her
brother’s research report just because of her relationship to him but rather has
undertaken thorough and independent investigation prior to selecting the research
report for purchase. Therefore, Smith has grounds to rely on the report’s
recommendation and purchase the Line plc stock for QB’s portfolio.

B is incorrect. Smith is not required to seek permission from her employer prior to
purchasing the stock.

8. By accepting the trip, Smith is most likely in violation of the standards relating to:

A. loyalty.
B. knowledge of the law.
C. additional compensation arrangements.

Correct Answer: C

Reference:
Level II of CFA Program Volume 1, Study Session 1, Reading 2, LOS a

C is correct. Smith is in violation of Standard IV (B) Additional Compensation

Arrangements because she accepted the trip offer from Rice Growers without
obtaining written consent from Rice Growers and QB. The standard prohibits
members and candidates from accepting benefits, gifts, compensation, or
consideration that competes with or might reasonably be expected to create a
conflict of interest with their employer’s interest unless they obtain a written
consent from all the parties involved. Rice Growers is a former client and the
acceptance of the trip may be perceived as Smith still maintaining loyalties with
the client.

A is incorrect. Although Smith has been dishonest with her employer when
concealing the fact that the trip was funded by her former client, such conduct
does not injure the firm, deprive it of profit, and/or deprive it of her skills and
abilities, and is thus not a violation of Standard IV (A) Loyalty.

B is incorrect. There are is a lack of information concerning local (Lexcorn)

regulations which cover acceptance of trips from external parties. Thus, any
conflict between the Code and Standards and local laws on this matter cannot be
determined. Therefore, Smith is not in violation of Standard I (A) Knowledge of
the Law.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

9. In context of the discussion concerning the Line plc’s production strike plans,
which of the following individuals is most likely in violation of the standard
relating to material and nonpublic information?

A. Smith only.
B. Smith’s brother only.
C. Both of the siblings.

Correct Answer: C

Reference:
Level II of CFA Program Volume 1, Study Session 1, Reading 2, LOS a

C is correct. Smith is in violation of the standards relating to the material and

nonpublic information because she shared material information regarding the
production strike with her brother and thus caused him to act on the information.
Because the production strike was being privately discussed between production
managers, Smith should have known that the information is material and
nonpublic. Standard II (A) requires that members and candidates who possess
material and nonpublic information that could affect the value of the investment
should not act or cause others to act on the information. Even though Smith was
initially not aware of the impact of the production strike, she had sufficient data to
conclude that the information is material and nonpublic.

Smith’s brother is also in violation of the standard relating to material and

nonpublic information because he acted on the information by issuing a sell
rating.

10. Which of Smith’s statements is most likely in violation of the CFA Institute
Standards of Professional Conduct?

A. Statement 1 only.
B. Statement 2 only
C. Both of the statements.

Correct Answer: A

Reference:
Level II of CFA Program Volume 1, Study Session 1, Reading 2, LOS a

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

A is correct. Smith’s first statement is in violation of the CFA Institute Standards

of Professional Conduct because she has incorrectly referred to herself as a
candidate of the CFA program when she is actually a member of the program and
eligible to use the ‘CFA’ marks after her name. Standard VII (B) Reference to
CFA Institute, the CFA Designation and the CFA Program prohibits members and
candidates from misrepresenting membership in CFA Institute, holding the CFA
designation, or candidacy in the CFA Program. Smith’s untrue statement is
construed as misrepresentation. The standards do not prohibit individuals from
giving their opinion on the CFA Program and its quality as such conduct is not
covered by the standards.

Smith’s second statement is not in violation of the CFA Institute Standards of

Professional Conduct because she is not attempting to make performance
guarantees but is merely making a performance prediction which is contingent on
the availability of sound research.

11. Can Smith accept Jones’ offer without violating Standard IV Duties to
Employers?

A. Yes, as long as she receives consent prior to acceptance.

B. Yes, as long as she refuses to accept any compensation.
C. No, she cannot accept independent assignments which compete with her
employer.

Correct Answer: A

Reference:
Level II of CFA Program Volume 1, Study Session 1, Reading 2, LOS b

A is correct. Standard IV (A) Loyalty recommends members and candidates to

not undertake independent practice for compensation until they receive consent
from their employer to all the terms of the agreement. Giving investment advice
to ‘O Hara Traders represents competing practice for which members and
candidates must receive employer consent prior to engagement.

12. Which of the following statements most accurately explains whether the two
policies drafted by Smith are consistent with the CFA Institute Code and
Standards?

A. Policy 1 is consistent; applicable law is the one which imposes a higher

degree of responsibility.
B. Policy 1 is inconsistent; members and candidates must not engage in any
conduct that constitutes a violation of the Code and Standards.
C. Policy 2 is consistent; members and candidates should disclose illegal
activities to a concerned authority to avoid violating Code and Standards.

Correct Answer: A

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

Reference:
Level II of CFA Program Volume 1, Study Session 1, Reading 2, LOS a, b

A is correct. Policy 1 is consistent with the Code and Standards. Standard I (A)
Knowledge of the Law requires members and candidates to comply with the
stricter law, rule or regulation. Members and candidates must comply with
applicable laws or regulations related to their professional activities. Applicable
law is the law which governs the member’s or candidate’s conduct. The stricter
law is considered as the applicable law.

Policy 2 is inconsistent with the recommendation of the Standard I (A)

Knowledge of the Law. CFA Institute strongly encourages members and
candidates to report potential violations of the Code and Standards. Furthermore,
the Code and Standards do not compel members and candidates to report
violations to their governmental or regulatory organizations unless such
disclosure is mandatory under applicable law. Therefore, if a member or
candidate has reasonable grounds to believe that an imminent client activity is
unethical or illegal, he or she should discuss the matter with the internal
compliance department for guidance or the supervisor and only make disclosure
to a regulatory organization if the disclosure is mandatory.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

Questions 13 through 18 relate to Quantitative Methods

Quality Investment Advisory (QIA) Case Scenario

Quality Investment Advisory (QIA) is a U.S. based asset management firm providing
financial advice and portfolio management services to both private wealth and
institutional clients. Rob Wallace works as the chief portfolio manager at QIA’s
headquarters in Chicago, USA. Wallace is currently managing a $5 million portfolio of
John Mackintosh, one of the firm’s oldest high net worth private wealth clients. The
portfolio invests a significant portion in the stocks of emerging markets, like those of
Russia and Brazil. To estimate the returns to the Brazilian stock investments, Wallace
specified a regression model with the dependent variable measuring the Brazilian stock
returns and the independent variables measuring the percentage increase in the Brazilian
Gross Domestic Product (GDP) and the returns to a broad-based Brazilian market index.
Exhibit 1 displays the results to estimating this regression.

Exhibit 1
Regression Analysis Results
Coefficient Standard Error
Intercept 0.0095 0.013
Annual % increase in GDP 0.667 0.337
Annual return to Brazilian market index 2.245 0.245

ANOVA
Regression Sum of Squares 0.9436
Residual Sum of Squares 0.3426
Observations 60

While talking to Mackintosh about the results of the regression, Wallace made the
following comment:

Comment: “The interpretation of the slope coefficient of annual % increase in GDP is

that for every 1 unit increase in GDP, we would expect returns to increase
by 0.667 units. The coefficient value of 0.667 will remain constant even if
we remove the second independent variable.”

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

When Mackintosh inquired about the effect of changes in market return on the return to
his Brazilian investment, Wallace stated that if we compare the returns to the investment
at the beginning of a year with those at the end of the year during which time market
return has increased by 1%, we would expect the returns to the investment to increase by
2.245%. However, he stated that to ensure that this holds true, we would have to calculate
the F-statistic using data of the sum of squared residuals and the regression sum of
squares.

After his meeting with Mackintosh, Wallace met Colin Edwards, a statistician at QIA’s
headquarters. Edwards has been working with Wallace toward the management of the
U.S. stock portfolio of an institutional fund worth $25 million. In applying regression
analysis to financial data, Edwards specified a multiple regression model to determine
whether an increase in the U.S. literacy rate and a change in the technology industry’s
competitive structure have any effect on technology stocks’ P/E multiples. While
discussing the violations of regression assumptions with Wallace, Edwards stated that
although heteroskedasticity does not affect the consistency of regression parameter
estimates, it does however lead to mistakes in inference. Wallace stated that serial
correlation, however, did affect the consistency of parameter estimates, but only if at least
one of the independent variables is a lagged value of the dependent variable.

Wallace questioned Edwards about machine learning (ML) and its major forms. Edwards
replied with the following statements.

i) Machine learning involves several approaches by which computer programs are

used to learn from experience to improve performance.
ii) Supervised learning and unsupervised learning are two distinct classes of ML.
The distinction between these categories is whether the technique makes or does
not make use of labelled training data.
iii) Unsupervised learning analyzes X variable and there is no Y target variable set.

13. Which of the following about the regression on Brazilian stock returns is most
accurate using a critical value of 2.00 for the t-test statistics?

A. The Brazilian stock returns are very closely related to the annual return to
the Brazilian market index.
B. The Brazilian stock returns are closely related to the annual % increase in
GDP.
C. The Brazilian stock returns are unrelated to the annual return to the
Brazilian market index and to the annual % increase in GDP.

Correct Answer: A

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

Reference:
Level II of CFA Program Volume 1, Study Session 3, Reading 8, LOS c

We have to check the coefficients for significance.

The t-statistic for annual % increase in GDP: 0.667/0.337 = 1.979

The t-statistic for annual return to Brazilian market index = 2.245/0.245 = 9.163
Df = 60 – 3 = 57, at 0.05 significance level, critical t-statistic = 2.00

Hence, only the coefficient on the annual return to Brazilian market index is
significant. Therefore, we can conclude that the stock returns are closely related to
the Brazilian stock market index returns.

14. Using the information provided in Exhibits 1 and 2, the F-statistic is closest to:

A. 2.754.
B. 78.49.
C. 79.87.

Correct Answer: B

Reference:
Level II of CFA Program Volume 1, Study Session 3, Reading 8, LOS g

RSS
F-statistic = k (0.9436/2)/(0.3426/57) = 78.49
SSE
[n k
1 ]

15. With respect to his comment, Wallace will most likely be correct only if the:

A. second independent variable is uncorrelated with the annual % increase in

GDP.
B. intercept and the second independent variable are uncorrelated with the
annual % increase in GDP.
C. residuals of the regression represent the expected net effect on Brazilian
stock returns of a 1 unit increase in annual GDP after removing that part of
GDP that is correlated with the market index return.

Correct Answer: A

Reference:
Level II of CFA Program Volume 1, Study Session 3, Reading 8, LOS b
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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

The coefficient on annual % increase in GDP will remain constant (even if the
second variable is removed) only if the second variable (annual return to Brazilian
market index) is uncorrelated with the annual % increase in GDP. Options B and
C are incorrect.

16. With respect to the effect of changes in market return on the return to the
Brazilian investment, Wallace is least accurate with respect to:

A. the comparison of returns only.

B. neither the comparison of returns nor the F-statistic.
C. both the comparison of returns and the F-statistic.

Correct Answer: C

Reference:
Level II of CFA Program Volume 1, Study Session 3, Reading 8, LOS b & g

Wallace is incorrect with respect to the comparison of returns. The returns to the
investment will not increase by 2.245% because the annual % increase in GDP
might also change and will also impact the returns. Therefore, Wallace should
interpret 2.245 as the expected increase in stock returns for a 1-unit increase in
market index returns holding % increase in GDP constant.

Wallace is also incorrect with respect to the F-statistic. Even if we assume that the
% increase in GDP is held constant, to determine whether the coefficient on the %
increase in the Brazilian market index is significantly different from 0, we need to
perform a t-test. The F-test is viewed as a test of a regression’s overall
significance; this statistic is not used to test the significance of one independent
variable in a multiple regression model.

17. With respect to the violations of regression assumptions, are Edwards and
Wallace most likely correct?

A. Only Edwards is correct.

B. Only Wallace is correct.
C. Both Edwards and Wallace are correct.

Correct Answer: C

Reference:
Level II of CFA Program Volume 1, Study Session 3, Reading 8, LOS k

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

Edwards is correct. Heteroskedasticity does not affect the consistency of the

regression parameter estimators. It does, however, lead to mistakes in inference.

Wallace is correct. If one of the independent variables is a lagged value of the

dependent variable, then serial correlation will cause the estimates to be
inconsistent.

18. Is Edwards’ statements correct regarding Machine Learning and its forms?

Edwards is:

A. correct regarding all three statements.

B. incorrect regarding statement iii) only.
C. incorrect regarding statements ii) and iii).

Correct Answer: A

Reference:
Level II of CFA Program Volume 1, Study Session 3, Reading 8, LOS p

Edwards is correct with respect to all three statements.

Machine learning involves several approaches by which computer programs are

used to learn from experience to improve performance.

Supervised learning and unsupervised learning are two distinct classes of ML.
Supervised ML makes use of labelled training data whereas unsupervised does
not make use of labelled training data.

Unsupervised learning analyzes X variable and there is no Y target variable set. In

unsupervised ML there is no target to which we match the feature set.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

Questions 19 through 24 relate to Financial Reporting Analysis

Silvan Miller Case Scenario

Silvan Miller is an independent financial analyst evaluating 2017 financial statements of

Grecco, a textile manufacturer. Miller is of the opinion that Grecco’s financial statements
contain numerous discrepancies and so aims to evaluate their financial reporting quality.
As a starting point, Miller summarizes his findings based on a preliminary analysis:
Finding 1: Grecco realized $30 million in profits on the sale of a spare spinning unit,
originally purchased for manufacturing purposes. The gain is believed to be reported as
part of continuing operations and is a material amount.

Finding 2: The amount of bad debt expenses reported during the year is most likely
understated by $2 million.

Next, Miller collects data on Grecco’s reported net income and net cash provided by
operations for the fiscal years 2014 to 2016 (Exhibit). Miller strongly believes that the
relationship between the two items is another potential source of financial misreporting.

Exhibit (in $ millions)

2014 2015 2016
Net income 150 250 380
Net cash provided by
operating activities 70 90 100

Miller has heard of the concept of mean reversion in earnings. He wonders how this
concept applies to the data collected in the exhibit.

In an attempt to learn more about Grecco’s financial reporting quality, Miller engages in
a discussion with Octavia Taylor, another independent financial analyst who has followed
Grecco and other textile manufacturers for a considerable number of years. In a
discussion with Miller, she shares her perceptions concerning the reporting quality of the
current year’s financial statements:

Opinion 1: The operating expenses reported in the current year are nearly 50% less
compared to what was reported in the financial year 2016. I strongly believe
that this difference can only be attributed to a deliberate misclassification of
operating expenses as non-operating on the income statement.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

Opinion 2: In the notes to its financial statements, the management discloses two bill-
and-hold sales arrangements with two of Grecco’s major customers. Under the
arrangement, goods have been shipped to a central warehouse belonging to
Grecco. The goods will be shipped to the customers when demanded.
Revenue related to the transactions has been recorded in the current year’s
income statement.

19. Based only on the notes collected by Miller, Grecco’s financial statements are
most likely classified as:

A. Unsustainable earnings.
B. non-GAAP compliant.
C. GAAP compliant, decision useful, sustainable and will help generate
adequate returns.

Correct Answer: A

Reference:
Level II of CFA Program Volume 2, Study Session 6, Reading 18, LOS a & b

A is correct. Based on Finding 1, profits realized from the sale of a spinning unit
are generally not recurring and therefore unsustainable. Furthermore, by reporting
this non-recurring item as part of continuing operations, a portion of Grecco’s
profit from continuing operations is unsustainable.

Reporting bad debt expense as part of continuing operations will inflate profits in
the current year. However, this inflation in profits is one-time and unsustainable.

B is incorrect. The notes do not indicate a departure from GAAP.

C is incorrect. The notes indicate that the financial statements are neither decision
useful nor sustainable because of the earnings management believed to have
occurred. Therefore, low quality earnings will fail to provide an adequate level of
return on investment.

20. If Note 2 is correct, the least likely impact of an understatement of bad debt
expenses is an overstatement of the:

A. net profit margin.

B. asset turnover ratio.
C. days of sales outstanding.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

Correct Answer: B

Reference:
Level II of CFA Program Volume 2, Study Session 6, Reading 18, LOS h

B is correct. An understatement of bad debt expense will overstate the reported

accounts receivable, which is an asset, and lead to an understated asset turnover
ratio (Sales/Total Assets).

A is correct. An understatement of bad debt expense will overstate profits and the
net profit margin (net profit/sales).

C is incorrect. Accounts receivable turnover is represented by the formula

[accounts receivable/(total credit sales/number of days)]. An understated reported
bad debt expense will overstate accounts receivable and the days of sales
outstanding measure.

21. Based on the data collected in the Exhibit, Miller can conclude that Grecco’s
earnings are characterized by a high degree of:

A. persistence.
B. discretionary accruals.
C. non-discretionary accruals.

Correct Answer: B

Reference:
Level II of CFA Program Volume 2, Study Session 6, Reading 18, LOS e

B is correct. Between 2014 and 2015, net income increased by about 67% and
between 2015 and 2016, this increase was 152%.

During the same time, net cash provided by operating activities increased by 29%
between 2014 and 2015 and increased by 11% between 2015 and 2016.

The rapid growth in net income is unmatched by the growth in net cash provided
by operating activities. A decline in the growth of operating cash inflows could
suggest that Grecco is reporting a large number of discretionary accruals with the
intent to distort reported earnings.

A is incorrect. Because the accelerated growth in Grecco’s net income compared

to the declining growth in net cash provided by operating activities suggests the

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

presence of discretionary accruals, the relative size of the accruals component of

earnings will be larger relative to the cash component. Earnings with a larger
component of accruals are less persistent.

C is incorrect. Non-discretionary accruals result from normal transactions and

would have not created the difference in growth between the two items.

22. Based on the data collected in the Exhibit, Miller will conclude that the speed of
mean reversion will be:

A. slow.
B. rapid.
C. indeterminable based on the information provided.

Correct Answer: B

Reference:
Level II of CFA Program Volume 2, Study Session 6, Reading 18, LOS g

B is correct. When the growth in net income exceeds that of operating cash
inflows, earnings will have a larger accrual component which may hasten the
earnings’ reversion to the mean; this is even more likely when the accrual
elements are outliers relative to the normal amount of accruals in a company’s
earnings as is the case with Grecco.

23. A possible objective behind the misclassification of expenses (Opinion 1) is to:

A. overstate net income.

B. understate tax expense.
C. overstate operating profit.

Correct Answer: C

Reference:
Level II of CFA Program Volume 2, Study Session 6, Reading 18, LOS h

C is correct. Operating expenses are deducted from a company’s gross profit and
used to determine operating profit. Therefore, misclassifying operating expenses
as non-operating expenses can be construed as an attempt to overstate operating
profit.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

A is incorrect. Net income is not affected by the classification of operating

expenses as non-operating as the expenses will be deducted either way to arrive at
the final income figure.

B is incorrect. Similarly, the profit before tax figure is not affected if operating
expenses are reported correctly or misclassified as non-operating. Hence, the tax
expense figure will be the same regardless of how these expenses are reported.

24. Considering Opinion 2, Grecco’s current year’s earnings are most likely:

A. overstated.
B. understated.
C. correctly stated.

Correct Answer: A

Reference:
Level II of CFA Program Volume 2, Study Session 6, Reading 18, LOS f

The bill-and-hold arrangement clearly demonstrates an attempt by Grecco to

accelerate the recognition of revenues. Revenue associated with the transaction
can only be recognized when the respective goods are delivered to the customer.
The decision to accelerate revenue recognition will lead to an overstatement of
Grecco’s earnings.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

Questions 25 through 30 relate to Equity Investments

Beth Hofer Case Scenario

Beth Hofer is an equity analyst that has been assigned the task of evaluating the financial
performance of two construction firms: Sturdy Constructions (STUCON), and Walnut
Constructions Company Limited (WALCO). Exhibits 1 and 2 display information about
the financial vitals of STUCON that Hofer has accumulated for valuation purposes.

Exhibit 1
STUCON’s financial information for
years ending 31 December (in $ thousands)
2010 2011
Income before taxes 105.34 121.65
Depreciation expense 55.11 59.43
Impairment of intangibles 23.74 15.46
Interest expense 17.20 22.06
Income resulting from the reversal of
14.54 11.88
restructuring charges
*STUCON is taxed at a rate of 35%. STUCON’s preferred dividends for the
year 2011 were $9,000 and STUCON issued $10,000 worth of preferred
stock during the same year.

Exhibit 2: Additional Information

2010 2011
Cash 155.34 234.45
Accounts receivable 95.65 135.12
Inventory 67.75 99.45
Gross Fixed assets-No sale during the
680.43 720.04
year
Accounts payable 60.20 70.06
Current portion of long-term debt 123.33 145.85
Notes payable 55.74 75.49
Long-term debt 75.47 80.54

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

After his analysis of STUCON’s financial performance, Hofer proceeded with the
valuation of Walnut Constructions. Hofer believes that the market values of construction
companies are close to their intrinsic values, and hence, is planning to base her estimation
on a market-based metric. WALCO’s current earnings per share is $4.29. Exhibit 3
presents the trailing P/E multiples of WALCO’s peer-group companies, along with other
relevant data.

Exhibit 3
Trailing P/E ratios for WALCO’s peer-group
Long-term
Company Trailing P/E EPS Growth Current ratio Debt/Equity
Forecast
AB 34.56 12% 1.19 1.00
BC 25.23 15% 1.35 1.02
CD 106.98 22% 0.55 3.56
DE 30.64 10% 0.98 1.98
EF 27.99 9% 0.67 2.35

Hofer then met with Julius James, a construction industry analyst at her investment firm.
After reviewing the data Hofer had gathered for valuation purposes, James made the
following comments:

Statement 1: “Ignoring the effects of risk and growth, WALCO’s appropriate intrinsic
value based on the trailing P/E multiples of its peer-group and its current
EPS level is $193.39.”

Statement 2: “To address the impact of long-term earnings growth prospects on P/E,
you should estimate each company’s PEG ratio using the growth forecasts
provided. Stocks with lower PEGs are more attractive than stocks with
higher PEGs.”

As their discussion about P/E multiples continued, Hofer stated that equity market indices
have also been used as comparison assets to determine over or undervaluation of stocks.
She stated that according to the Yardeni model, higher expected corporate bond yields
imply a lower justified market P/E and higher expected long-term growth results in a
higher justified P/E. James agreed, and added that the Fed model did not account for the
effect of changes in corporate profits since it did not consider the earnings growth rate in
its prediction of future market returns.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

25. STUCON’s free cash flow to the firm for the year 2011 is closest to:

A. $55.
B. $65.
C. $67.

Correct Answer: B

Reference:
Level II of CFA Program Volume 4, Study Session 11, Reading 30, LOS c & d

FCFF=Net income +NCC+Int(1 – tax rate) – FCInv – WInv + Preferred dividends

= [121.65(1–0.35)]+ 59.43+15.46 – 11.88+[22.06(1 – 0.35)] – (720.04-
680.43) – (135.12-95.65) – (99.45 – 67.75)+(70.06 -60.20)+9
=$64.50

26. STUCON’s free cash flow to equity for the year 2011 is closest to:

A. $57.
B. $76.
C. $98.

Correct Answer: C

Reference:
Level II of CFA Program Volume 4, Study Session 11, Reading 30, LOS c & d

FCFE =FCFF – Int(1 – tax rate)+Net borrowing – preferred dividends + Net

issuance of preferred stock
FCFE: $64.50 – [$22.06(1–0.35)] + $47.34* – $9 + $10 = $98.5

*
▪ Notes payable increased by 75.49 – 55.74 = 19.75
▪ Long-term debt increased by 80.54 – 75.47 = 5.07
▪ Current portion of long-term debt increased by 145.85-123.33 =22.52
Net borrowing = 19.75 + 5.07 +22.52 = 47.34

27. STUCON most likely used most of its FCFE to:

A. pay cash dividends to preferred stock holders.

B. increase its balance of cash and cash equivalents.
C. increase its net borrowing and issue new shares of preferred stock.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

Correct Answer: B

Reference:
Level II of CFA Program Volume 4, Study Session 11, Reading 30, LOS g

STUCON has used most of its free cash flow to equity to increase its cash balance
($79.11). Issuance of shares of preferred stock is not a use of FCFE. Net
borrowing is a use of FCFF.

28. With respect to Exhibit 3, which of the following companies appears to be the
most undervalued relative to its peers?

A. Company BC
B. Company DE
C. Company EF

Correct Answer: A

Reference:
Level II of CFA Program Volume 4, Study Session 11, Reading 31, LOS r

Company BC appears to be most undervalued because of lowest PEG ratio

(25.23/15=1.68).

29. James is most accurate with respect to:

A. Statement 1 only.
B. Statement 2 only.
C. both Statements 1 and 2.

Correct Answer: B

Reference:
Level II of CFA Program Volume 4, Study Session 11, Reading 31, LOS j & k

Statement 1 is incorrect. James has used the mean P/E to calculate an intrinsic
value for WALCO, although the data clearly shows that Company CD is an
outlier. James should have used the median P/E value or inverse price ratios since
these measures mitigate the effect of outliers on the valuation conclusion.

Statement 2 is correct.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

30. With respect to the Yardeni and Fed model, are Hofer and James most likely
correct?

A. Only Hofer is correct

B. Both Hofer and James are correct
C. Neither Hofer nor James is correct

Correct Answer: C

Reference:
Level II of CFA Program Volume 4, Study Session 11, Reading 31, LOS h

Hofer is incorrect. The Yardeni model defines the P/E ratio in terms of the current
corporate bond yields and expected long-term growth.

James is incorrect. The Fed model does not incorporate the expected growth rate
in earnings. However, the justified P/E predicted by the model is affected by
small changes in interest rates and/or corporate profits (which determine earnings
yields).

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

Questions 31 through 36 relate to Equity Investments

Dave Mitchell Case Scenario

Dave Mitchell is member of the portfolio management team that manages the domestic
equity investments of a large U.S. pension fund. Mitchell just met with Chris Hann, the
head of the pension committee, to discuss certain lucrative investment opportunities in
the utilities industry. While talking to Mitchell, Hann stated that since the pension fund
had an expected time horizon of 20 years, he wanted the fund to be invested in securities
that offered attractive long-term returns. Mitchell shortlisted four firms in the utilities
industry and presented their prospects to Hann. Exhibit 1 displays this information.

Exhibit 1
U.S. Utilities

Consensus Dividend
Yield Payout
Company Growth Beta Ratio (%)
Forecast (%) (%)
Quarx 4.35 0.37 7.8 80
Zeto 11.67 0.73 4.1 66
FinX 16.91 0.54 2.31 35
Alpha 16.33 0.65 5.7 40

In addition to U.S. utilities, Mitchell is also evaluating the attractiveness of the

telecommunication industry for inclusion in the pension fund and has narrowed down his
selection to two large-cap telecommunication firms. Exhibit 2 presents selected
information on the stocks of the two firms.

Exhibit 2
U.S. Telecommunication Stocks Per Share Dividends ($)
Period Virtual Communications WiLine Communications
3Q 2009 0.45
4Q 2009 0.89 0.45
1Q 2010 0.87
2Q 2010 0.56 0.95
*Both stocks are currently selling for $50/share

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

After his analysis, Mitchell made the following comments to Hann:

Statement 1: “Based on the trailing dividend yield of the two companies, I believe that
compared to Virtual Communications, investing in WiLine
Communications will reflect a greater orientation to the growth investment
style.”

Statement 2: “With regards to its relation to fundamentals, stocks that have higher betas
should pay higher dividend yields.”

Mitchell just read an article on the market-based valuation of companies. The article
stated the use of enterprise value based multiples when applying the method of
comparables and calculated the enterprise value for Hybrid Energy (HYEN), a renowned
firm of the U.S. energy sector, selling for a current price of $45.09/share. Exhibit 3
displays financial information that the article presented.

Exhibit 3
HYEN’s financial information (in $ millions)
for the year ended 31 December
Item 2010 Item 2010
Cash and cash Preferred stock;
1,020 1.5
equivalents 25 million shares
Short-term Common stock;
105 11.50
investments 230 million shares
Accounts payable 1,593 Minority interest 55
Current portion
45 Total equity 3,258
of long-term debt
Long-term debt 750 Retained earnings 2,184
*Long-term debt has a market value of $890 million. Preferred Stock is selling
for $35. Preferred dividends equaled $12 million.

The article compared HYEN with its competitors based on the EV/EBIT measure. It then
ranked companies based on their EV/EBIT and total invested capital/EBIT values.
Mitchell noticed that the ranking differed significantly based on the measure used to rank
the companies. He decided to use the financial information to compare the companies
using the EV/sales measure.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

31. Which of the following companies should Mitchell most likely invest the pension
fund in?

A. FinX
B. Alpha
C. Quarx

Correct Answer: B

Reference:
Level II of CFA Program Volume 4, Study Session 11, Reading 31, LOS d

The pension fund should be invested in Alpha. Alpha offers the greatest
combination of dividend yield and expected growth—22.03%. In addition, the
low dividend payout ratio suggests that its dividend is subject to low risk. The
pension fund has a long time horizon and should focus on ‘total return’. Alpha is
thus the best choice.

32. Mitchell is most accurate with respect to:

A. Statement 1 only.
B. Statement 2 only.
C. neither Statement 1 nor Statement 2.

Correct Answer: A

Reference:
Level II of CFA Program Volume 4, Study Session 11, Reading 31, LOS d

Statement 1 is correct. The trailing dividend yield of Virtual Communications is

(0.45+0.89+0.87+0.56)/50 = 5.54% and of WiLine Communications is
(0.45+0.95)/50=2.8%. Since WiLine’s dividend yield is lower, investment in
WiLine will be consistent with a greater growth orientation.

Statement 2 is incorrect. Higher betas result in higher required rates. However, it

is not necessary for companies to increase dividends as reinvested earnings can
generate capital gains to compensate investors.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

33. HYEN’s enterprise value in 2010 is closest to:

A. $11,170.7 million.
B. $12,135.7 million.
C. $12,190.7 million.

Correct Answer: A

Reference:
Level II of CFA Program Volume 4, Study Session 11, Reading 31, LOS n

Total value of common equity: 230m ×$45.09 = $10,370.70 million

Total value of debt: = $890 million
Total value of preferred stock: 25m x $35 = $875 million
Minority Interest = $55 million
Cash and Cash equivalents = $1,020 million

Enterprise value: 10,370.70+890+875+55-1,020 = $11,170.7 million.

34. With regard to the article, which of the following is most accurate?

A. Depreciation and amortization is a major expense for companies in the

energy sector.
B. Energy sector companies have significantly different capital structures.
C. Energy sector companies differ in their investments in marketable
securities and cash balances.

Correct Answer: C

Reference:
Level II of CFA Program Volume 4, Study Session 11, Reading 31, LOS m

The writer of the article has compared companies using the EBIT measure in the
denominator. EBIT would be the appropriate choice if neither depreciation nor
amortization is a major expense for the companies being compared. The
difference in rankings based on TIC and EV indicates that there is a variation
among energy companies in cash, cash equivalents, or marketable securities.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

35. If HYEN’s net income in 2010 was $900 million, and its interest, taxes,
depreciation and amortization expenses were $65 million, $250 million, $421 and
$12 million respectively, its EV/EBITDA ratio will be closest to (Assume EV of
$11,362.95):

A. 6.22.
B. 6.89.
C. 6.91.

Correct Answer: B

Reference:
Level II of CFA Program Volume 4, Study Session 11, Reading 31, LOS n

EBITDA: 900+65+250+421+12= $1,648 million

EV/EBITDA = $11,362.95/1,648 = 6.89

36. Mitchell’s preference to use the EV/Sales ratio rather than the P/S as a basis for a
valid comparison of the companies is most likely because:

A. energy companies generally do not issue preferred stock.

B. the companies differ in their use of debt in their capital structures.
C. market prices of energy companies vary significantly from intrinsic
values.

Correct Answer: B

Reference:
Level II of CFA Program Volume4, Study Session 11, Reading 31, LOS m

The price to sales ratio fails to recognize differences in the capital structures of
companies. EV/S is an alternative sales-based ratio that is particularly useful
when comparing companies with diverse capital structures.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

Questions 37 through 42 relate to Alternative Investments

A-Typical Investments (ATYP) Case Scenario

A-Typical Investments (ATYP) is an asset management firm that specializes in

alternative investments including hedge funds, private equity and real estate. Sean Lee is
the CEO of ATYP. Lee has assigned Tom Roy, an assistant portfolio manager, the task of
valuing three commercial real estate properties that ATYP has shortlisted for acquisition.
Exhibit 1 displays key information about the three properties.

Exhibit 1
Selected Property Data
Property 1 Property 2 Property 3
Gross potential rent $2,500,000 $2,000,000 $3,000,000
Expense Reimbursement
$400,000 $250,000 $0
revenue
Other income $200,000 $20,000 $350,000
Vacancy loss $415,000 $189,000 $234,000
Operating expenses $80,000 $455,000 $1,110,000
*For each of the properties, property management expenses are 10% of effective
gross income.

To gain further insight into the valuation metrics of the properties, Roy approached
Jessica Stone, a research analyst at ATYP, to provide him with details about the income-
producing potential of each of the above properties. Stone presented the following
information:

• The net operating income of Property 2 is expected to remain constant for the next
two years, at the end of which, it is expected to see a one-time jump of 15%. After
that, no further growth is expected.
• If ATYP invests in Property 2, it should hold it for two years. The terminal cap rate
for the property is 13% and the discount rate is 10%.
• Property 1 is currently being renovated due to which it has a higher than typical
vacancy rate. If we purchase the property, ATYP would have to complete the
renovations. However, if it were already renovated, it would have an NOI of $5
million next year, which is expected to increase by 4.5% per year thereafter. Even
though next year’s NOI is lower, from year 2 onwards, the NOI will revert to its
stabilized value. The IRR for such an investment, after renovation, is 16%.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

After reviewing Roy’s work, Lee is considering the purchase of Property 3. The property
has an appraised value of $16 million. Roy wants to maximize ATYP’s return on equity,
and is hence, evaluating various financing alternatives with regards to the investment in
the property. Lee instructed Roy to get rates that lenders in the market are willing to
accept to grant loans for commercial real estate. Roy presented Lee with the following
quote:

“An interest-only loan at 9.5% as long as the LTV ratio does not exceed 70%, and the
DSCR is at least 1.35. The balance of the loan will be due after 7 years.”

Roy decided to take the loan and invest in the property. Lee was not sure how the return
on equity of this leveraged investment compared to an all-cash purchase. To get a
complete understanding on various approaches to valuing real estate, Roy read an article
on “Private Real Estate Investments”, published in a financial journal. The article
presented the following information of a commercial property:

“The property has a going-in capitalization rate of 6.5% and a terminal capitalization rate
of 5.0%. Investors require a total return of 9.5% from the investment. Mortgage rates in
the market to finance the purchase of the property are 6.0%. Market rents and property
values are expected to increase at a rate of 3.0% for the foreseeable future, and equity
investors are willing to accept a 5.0% additional return to take on the risk of the
investment.”

After reading the article, Roy approached Lee and made the following comments:

Statement 1: “The cap rates on properties are useful indicators about their income
growth potential. These rates are somewhat analogous to the P/E multiple
for a stock—stocks with greater earnings potential have higher multiples,
just like properties with greater income potential have lower cap rates.”

Statement 2: “The cap rate that investors are willing to accept is based on the current
NOI and does not depend on how income might change in the future. The
discount rate, on the other hand, is based on current and future NOI, and
hence, takes into account how future NOI might change.”

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

37. Based on the information provided in Exhibit 1 and the information provided by
Stone, the value of Property 2 using the discounted cash flow method, is closest
to:

A. $12,826,902.
B. $12,949,820.
C. $41,521,424.

Correct Answer: A

Reference:
Level II of CFA Program Volume 6, Study Session 15, Reading 42, LOS g

NOI: $1,417,900=2,000,000+250,000+20,000 – 189,000 – (10%×2,081,000) –

455,000

Property value at end of 2 years: 1,417,900(1.15)/0.13 = $12,542,961.54

Value:
N=2 FV=$12,542,961.54 PMT=1,417,900 I = 10%
CPT PV

The current value of the property is: $12,826,902

38. The price that ATYP should be willing to pay for property 1 is closest to:

A. $39,495,483.
B. $41,182,140.
C. $43,428,439.

Correct Answer: B

Reference:
Level II of CFA Program Volume 6, Study Session 15, Reading 42, LOS g

First year’s NOI: 2,500,000+400,000+200,000 –415,000 –(10%×2,685,000) –

80,000 = $2,336,500

Value: [2,336,500+{5,000,000(1.045)/(0.16-0.045)}]/1.16
=[2,336,500+45,434,782.61]/1.16
= $41,182,140.18

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

Explanation:
NOI of the building - if already renovated:
year 1 = $5million
year 2 = $5million x 1.045 = $5.2250 million
year 3 = $5.2250 million x 1.045 = $5.4601 million
..

NOI of the building - without renovation (the current condition):

year 1 = $5million $2,336,500
year 2 = $5million x 1.045 = $5.2250 million
year 3 = $5.2250 million x 1.045 = $5.4601 million

39. The equity dividend rate for property 3, assuming the property is purchased at its
appraised value, is closest to:

A. 13.13%.
B. 15.75%.
C. 16.32%.

Correct Answer: A

Reference:
Level II of CFA Program Volume 6, Study Session 15, Reading 42, LOS m

NOI: $1,694,400 = 3,000,000+350,000+0 – 234,000 – (10%×3.116,000)

–1,110,000

Mortgage payment: Based on LTV: 70% of 16 million: $11,200,000

Based on DSCR, mortgage payment: 1,694,400/1.35 = $1,255,111.11 and loan

amount:1,255,111.11/0.095 = $13,211,696

The lower loan amount is what can be borrowed.® $11,200,000 since it is <
$13,211,696.

The first year cash flow is the NOI less the mortgage payment: $1,694,400 –
($11,200,000×9.5%) = $630,400

Equity: 16,000,000 – 11,200,000 = $4,800,000

The equity dividend rate is: 630,400/4,800,000 = 13.13%

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

40. If property 3 can be sold after 5 years for $18 million, financial leverage is most
likely to:

A. positively affect the investor.

B. negatively affect the investor.
C. have no affect on the return to an investor.

Correct Answer: A

Reference:
Level II of CFA Program Volume 6, Study Session 15, Reading 42, LOS m

If no loan was taken, the IRR would be:

PV = –16 million
PMT = NOI = 1,694,400
N= 5
FV = 18 million
IRR: 12.536754%

The investor earns 12.536754% before adding the loan, and the loan is at 9.5%, so
the investor will benefit from the spread.

41. With regards to the article, and considering each in isolation, which of the
following statements is most accurate?

A. The risk premium for the property is not fully reflected in the discount rate
used.
B. The implied growth rate is greater than the actual growth in market rents
and property values.
C. The article most likely assumes that interest rates are going to rise in the
future and property values will increase at a lower rate.

Correct Answer: A

Reference:
Level II of CFA Program Volume 6, Study Session 15, Reading 42, LOS f

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

The implied growth rate is: Discount rate – going in cap rate = 9.5%-6.5% =
3.0%. Market rents and property values are also expected to increase by 3.0%.
Since the terminal capitalization rate is less than the going-in rate, this suggests
that either interest rates will fall or the property values and NOI will increase at an
even faster rate in the future.

Option A is correct. The discount rate (9.5%) is 3.5% greater than the mortgage
rate. However, equity investors require a 5% risk premium. Hence, the risk
premium is not fully reflected in the discount rate used.

42. Roy is most accurate with respect to:

A. Statement 1 only.
B. Statement 2 only.
C. both statements 1 and 2.

Correct Answer: A

Reference:
Level II of CFA Program Volume 6, Study Session 15, Reading 42, LOS f

Statement 1 is correct. The cap rate is analogous to the price-earnings multiple for
a stock, except that it is the reciprocal. Just as stocks with greater earnings growth
potential tend to have higher price-earnings multiples, properties with greater
income growth potential have higher ratios of price to current NOI and thus lower
cap rates.

Statement 2 is incorrect. Even though the cap rate is based on current NOI, the
rate that investors are willing to accept depends on how they expect the income to
change in the future and the risk of that income. These expectations are said to be
implicit in the cap rate.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

Questions 43 through 48 relate to Alternative Investments

Wing Financials (WING) Case Scenario

Wing Financials (WING) is an asset management firm operating several branches all
over the U.S. Wing Alternatives (WIA) is one of the firm’s independent subsidiaries that
specializes in the pricing and valuation of alternative investments including private and
publicly traded real estate, hedge funds, and private equity funds. Nicolas Gordon is a
private equity analyst at WIA with considerable experience in evaluations of private
equity funds. Recently, Gordon was invited to deliver a lecture on private equity
valuation in The University of Financial Management (UFM), Illinois, USA. During the
lecture, Gordon made the following comments contrasting valuation in venture capital
and buyout settings:

Statement 1: “Since venture capital firms have the objective of generating high returns
from a limited number of investments, they typically conduct a full blown
due diligence of the target firm before investing in it. This includes
strategic, commercial, financial, legal, environmental, and tax
considerations. On the other hand, buyout firms are more likely to focus
their analysis on the financial and legal aspects of the deal.”

Statement 2: “Variable revenue to the general partner of buyout firms comprises of

carried interest, transaction fees and monitoring fees. However, for the GP
of VC firms, carried interest is generally the main source of variable
revenue.”

After his visit to UFM, Gordon met Randy Thom, a newly hired research analyst at WIA.
Thom wanted to learn about various private equity fund structures, and asked Gordon to
strengthen his conceptual understanding of PE funds’ operations. To explain the
workings of a PE fund, Gordon presented him with the following example:

“The private equity fund has a committed capital of $450 million. The fund made its first
and only investment of $50 million a year ago and just exited the investment. The general
partner of the fund received $5 million from the deal since he was entitled to a carried
interest of 25%.”

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

Thom then posed the following questions to Gordon:

Question 1: “From what I understand, there must be instances when there is a conflict
of interest between GPs and their LPs. How can these conflicts of interest
be prevented?”

Question 2: “I have heard that the performance of PE funds is affected by fees and
profit shares. How can we measure their impact on fund performance?”

Gordon answered:

Answer 1: There are various private equity terms that can prevent such conflicts of
interest. These include tag-along, drag-along rights, no-fault divorce and
crossover co-investments.

Answer 2: Their impact can be measured by comparing the gross IRR measure with
the net IRR measure of the private equity fund. In addition to this,
comparing the NAV before distributions with the NAV after distributions
can also reflect the impact that profit sharing has on fund performance.”

Gordon is evaluating the performance of three venture capital funds. Exhibits 1-3 display
selected information about the funds.

Exhibit 1
Commit
ted Capital
Gross
Capital Called Net IRR Report
Fund Vintage IRR
($ Down (%) Date
(%)
millions (%)
)
Dec
A 2003 15 95% 18.34 12.45
2010
Dec
B 2008 35 35% 1.5 (0.56)
2010
*Term for Fund A is 2012 and for Fund B is 2018.

Exhibit 2
Fund DPI RVPI
A 1.35 1.43
B 0.12 1.55

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

Exhibit 3
Fund C Performance Information ($ millions) for the year 2010

Capital called down 15

Cumulative Paid in capital 125
Operating results 115
Management fees 2% of cumulative capital called-down
Beginning NAV after distributions 187.34
Carried interest 15.67
Distributions 100
*The total distributions till date equal $189 million.

43. Gordon is most accurate with respect to:

A. Statement 1 only.
B. Statement 2 only.
C. both statements 1 and 2.

Correct Answer: B

Reference:
Level II of CFA Program Volume 6, Study Session 15, Reading 44, LOS c

Statement 1 is incorrect. Buyout firms typically conduct full blown due diligence
before investing in the target firm. Venture capital firms, on the other hand, tend
to conduct primarily a technology and commercial due diligence; financial due
diligence is limited as portfolio companies have no or very little operating history.

Statement 2 is correct. Variable revenue to the general partner (GP) at buyout

firms comprises of carried interest, transaction fees, and monitoring fees. Variable
revenue to the GP at VC firms is generally comprised of carried interest.

44. With respect to the example Gordon presented to Thom, which of the following
distribution mechanisms does the fund most likely follow?

A. Deal-by-deal waterfalls
B. Total return waterfalls (threshold 20%)
C. Either deal-by-deal or total return waterfalls (threshold 20%)

Correct Answer: C

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

Reference:
Level II of CFA Program Volume 6, Study Session 15, Reading 44, LOS c

Under the deal-by-deal method, the GP receives carried interest after each
individual deal. Since the GP received $5 million from the deal, the profit must be
25% (x) = 5---x = $20 million. Hence, the entire proceeds of the sale are $70
million. Under the first alternative of the total return method, the GP would
receive nothing. Under the second alternative, the exit value of $70 million
exceeds 20% of the invested value of $50 million. The GP is thus entitled to
receiving $5 million. Hence, the fund may be following either of the two
distribution waterfall methods.

45. Gordon is most accurate with respect to:

A. Answer 1.
B. both Answers 1 and 2.
C. neither Answer 1 nor Answer 2.

Correct Answer: C

Reference:
Level II of CFA Program Volume 6, Study Session 15, Reading 44, LOS f, h and i

Answer 1 is incorrect. Although the no-fault divorce clause protects LPs since it
allows them to remove a GP without cause as long as 75% of them approve the
removal, a crossover co-investment is a classic example of a conflict of interest. A
tag-along, drag-along right protects the management from any potential future
acquirer.

Answer 2 is incorrect. Although the comparison of gross IRR with net IRR does
reflect the impact of fees and profit sharing, the comparison of NAV before and
after distributions indicates the impact of carried interest and distributions on the
ending value of a fund.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

46. Using the information presented in Exhibits 1 and 2, which of the following about
Funds A and B is most accurate?

A. Fund B’s GP has not yet been able to increase the value of the investment
portfolio as is evident from the gross and net IRRs of the fund
B. An RVPI of 1.43 for Fund A indicates that it is a profitable fund very
close to termination
C. The GP of Fund A has a greater ability to raise funds in the market than
does the GP of Fund B

Correct Answer: B

Reference:
Level II of CFA Program Volume 6, Study Session 15, Reading 44, LOS i

An RVPI of 1.43 indicates that the residual value remains high at 1.43 times
capital drawn down which is a good signal about the profitability of the fund (it is
close to termination since the fund terminates in 2 years).

Fund B is still a young fund and is most likely still experiencing the J-curve
effect, as is evident from the gross and net IRRs. However, the residual value of
1.55 indicates that despite the fund being in its early years, the GP has managed to
increase the value of the investment portfolio.

47. The ending NAV for the year 2010 of Fund C is closest to:

A. $199.17.
B. $299.17.
C. $314.84.

Correct Answer: A

Reference:
Level II of CFA Program Volume 6, Study Session 15, Reading 44, LOS i

NAV before distributions: 187.34+15-2.5+115 = $314.84

NAV after distributions: $314.84-15.67-100=$199.17

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

48. The DPI and RVPI for Fund C are closest to:

A. 0.800 and 2.518 respectively.

B. 1.512 and 1.593 respectively.
C. 2.312 and 2.393 respectively.

Correct Answer: B

Reference:
Level II of CFA Program Volume 6, Study Session 15, Reading 44, LOS i

DPI: 189/125 = 1.512

RVPI: 199.17/125 = 1.5934

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

Questions 49 through 54 relate to Fixed Income

Westgate Associates Case Scenario

Westgate Associates is a global wealth management firm managing Thelta, a fixed

income fund. Leon Davis is fund manager of Thelta.

Davis is seeking to expand Thelta investments. However, any selected security must pass
through the following screens prior to its inclusion:

1. The minimum credit rating must be investment grade.

2. Investment universe should comprise solely of local issuers.
3. Quoted interest rate should be a minimum of 5%.
4. Investment horizons of fund investors are long-term and must be considered.

Next, Davis collects data on recent yield changes at particular maturity points on the
yield curve and key rate durations of Thelta (Exhibit 1). He intends to use this data to
analyze the yield curve for changes in:

i. curvature,
ii. level, and
iii. steepness.

Exhibit 1:
Maturity 2 4 6 8 10 12
ΔYield + 220 + 195 + 8 bps + 85 bps + 110 + 95 bps
bps bps bps
Key rate 3.6 6.5 7.9 8.2 12.4 13.8
duration

Davis would like to ensure that the yields of the chosen securities have a minimum
impact on portfolio volatility. For this purpose, Davis is attempting to analyze the
volatility of interest rates using the:

I. volatility term structure and

II. Cox-Ingersoll-Ross model.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

In addition, Davis seeks to include zero-coupon default-free securities in the fund’s

investment portfolio. The securities being analyzed and the expected one-period and total
holding period returns are summarized in the exhibit below (Exhibit 2).

Exhibit 2: One-period and Holding Period Returns

For Zero-Coupon Securities
Maturity One-Period Total Holding
Security (Years) Return Period Return
A 1 3.5% 3.5%
B 2 3.5% 4.0%
C 7 3.5% 6.2%
D 12 3.5% 8.3%
E 15 3.5% 10.1%

49. By passing new investments through the defined screens, Davis’ security
selection will be most likely consistent with the:

A. preferred habitat theory.

B. liquidity preference theory.
C. segmented markets theory.

Correct Answer: C

Reference:
Level II of CFA Program Volume 5, Study Session 12, Reading 34, LOS j

Davis’ security selection for Thelta will be consistent with the segmented markets
theory. With clients’ time horizons being long-term, the fund will be restricted to
securities with a long-time horizon.

A is incorrect. The preferred habitat theory states that will investors have strong
preferences for particular maturity ranges. Higher returns in other maturity ranges
may encourage shifting portfolio assets outside their preferred range. The time
horizon of investors restricts the fund’s investments to long-term securities.

B is incorrect. The liquidity preference theory claims that in order to lend long-
term investors need to be offered a premium to compensate for the higher
liquidity risk. There is nothing in the case which may suggest that the investment
process will result in decisions being made in accordance with this theory.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

50. Based on the data in Exhibit 1, Davis will conclude that the yield curve has
undergone a change in:

A. level only.
B. steepness only.
C. level and curvature.

Correct Answer: C

Reference:
Level II of CFA Program Volume 5, Study Session 12, Reading 34, LOS l

The short-term and long-term rates have both increased indicating a change in
level. However, the change in the intermediate rate is almost negligible relative
the short- and long-term rates. The latter situation indicates a change in curvature.

51. Using the data in Exhibit 1, which of the following interest rate changes has the
highest effect on the value of the portfolio?

A. 2 year.
B. 10 year.
C. 12 year.

Correct Answer: B

Reference:
Level II of CFA Program Volume 5, Study Session 12, Reading 34, LOS l

Pr ice
Duration
Yield

Δ in Price (Maturity, 2 years) = – 3.6 × 2.2% = – 7.92%

Δin Price (Maturity, 10 years) = – 12.4 × 1.10% = – 13.64%
Δin Price (Maturity, 12 years) = – 13.8 × 0.95% = – 13.11%

The security with the highest price sensitivity as measured by duration will
maximize the impact of yield changes on portfolio returns.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

52. Using term structure volatility, Davis will conclude that the volatility of short-
term rates is:

A. higher and linked to inflation.

B. higher and linked to monetary policy.
C. lower and linked to economic activity.

Correct Answer: B

Reference:
Level II of CFA Program Volume 5, Study Session 12, Reading 34, LOS m

The volatility term structure shows that the volatility of the short rates is higher
relative to long-term rates and is linked to uncertainties in the monetary policy.

A is incorrect. The volatility of long-term rates is more closely linked to

uncertainties in inflation. The volatility of short-term rates is linked to
uncertainties in monetary policy.

C is incorrect. The volatility of long-term rates is lower and more closely linked
to uncertainty in real economic activity.

53. Using the Cox-Ingersoll-Ross model, Davis will conclude that with the level of
interest rates, volatility will:

A. increase.
B. decrease.
C. remain unchanged.

Correct Answer: A

Reference:
Level II of CFA Program Volume 5, Study Session 12, Reading 34, LOS k

The Cox-Ingersoll-Ross model includes a volatility term which follows the

random normal distribution and makes volatility proportional to the square root of
the short-term rate and allows volatility to increase with the level of interest rates.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

54. A shortcoming of the term structure theory used by Davis to arrive at the forecasts
in Exhibit 2 is that:

A. economic reality is not captured.

B. investors are assumed to be risk neutral.
C. the independence of yields at different maturities is not considered.

Correct Answer: A

Reference:
Level II of CFA Program Volume 5, Study Session 12, Reading 34, LOS j

Davis is using the local expectations theory to derive the forecasts in exhibit 2.

This is evident from the one-period holding return for each security, regardless of
maturity, being equal to the one-period risk-free rate of 3.5% (the return of
security A). Furthermore, total holding period returns are higher relative to the
one-period return due to the inclusion of risk premiums (returns increasing with
maturity). A shortcoming of this theory is that it fails to accurately represent
economic reality; this is because it has been observed that short holding-period
returns on long-term bonds typically exceed that for long-term bonds.

B is incorrect. The pure expectations theory assumes investors are risk-neutral

while the local expectations theory acknowledges the existence of risk for longer
holding periods.

C is incorrect. This statement reflects a limitation of the liquidity preference

theory. The theory simply argues for the existence of a liquidity premium. For
example, a downward sloping term structure can still be consistent with the
existence of liquidity premiums as can an upward sloping yield curve.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

Questions 55 through 60 relate to Portfolio Management

Dave Gilbert Case Scenario

Dave Gilbert is a portfolio manager and economic analyst at Western Alliance, a wealth
management firm operating in Regine, a country with an emerging market. In an effort to
diversify his clients’ holdings, Gilbert has decided to allocate fixed-income securities to
their portfolios. He decides to consider risky corporate bonds as potential asset classes
and identifies four bond issues each with a different maturity (Exhibit 1). Prior to
allocation, Gilbert decomposes the value of each issue into two components, the risk
neutral present value and discount for risk. The latter represents the covariance between
the intertemporal rate of substitution and the future price of the investment one year from
today.
Exhibit:
Potential Bond Issues for Client Portfolios
Risk Neutral Discount for
Bond Issue Present Value* Risk*
A 0.8943 0.045
B 0.9021 0.061
C 0.7654 - 0.034
D 0.8993 0.000
*Per $1 of Par Value

After collecting the data in the exhibit, Gilbert aims to address the following questions:

Question 1: Which bond issue carries a positive risk premium?

Question 2: Which bond issue can be classified as a one-period default-free bond?

Question 3: Which bond issue will be least suitable for those investors who expect their
labor income to shrink in the future due to poor economic conditions?

After making the allocations, Gilbert proceeds to explore the relationship between the
real GDP growth and real default-free interest rate in Regine’s economy. In the current
year, Regine’s stocks have been included in a global emerging market index following
significant technological progress. In a few years, the country’s economic growth is
expected to converge with its steady state projected growth. The current real GDP growth
rate exceeds that observed in developed markets such as U.S. and Japan.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

Gilbert concludes his study by exploring the factors which help to explain the observed
upward sloping nominal yield curve. He believes the slope may indicate a preference for
one bond maturity over the other.

55. The most appropriate response to Question 1 is bond issue:

A. A.
B. B.
C. C.

Correct Answer: C

Reference:
Level II of CFA Program Volume 6, Study Session 17, Reading 49, LOS a

A negative covariance term will result in a positive risk premium. Based on the
pricing formula (below) a negative covariance term will result in a lower current
market price today. A lower price today will result in a higher required return
over time according to the present value model (below).
~
Et Pt ~ ~
Pricing formula = Pt,s cov Pt 1,s 1
,m t ,1
1,s 1
1 lt 1

i
N
E CF i t s

Present value model = P t = å t

s 11 t ,s pit ,s
l qt ,s

56. The most appropriate response to Question 2 is bond issue:

A. A.
B. C.
C. D.

Correct Answer: C

Reference:
Level II of CFA Program Volume 6, Study Session 17, Reading 49, LOS a

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

For a one-period default-free bond, the covariance term (or discount for risk) is
zero because the future price is a known constant and the covariance of a random
quantity with a constant is zero. Given that issue D is the only security with a zero
risk discount factor it is classified as a one-period default-free bond.

57. The most appropriate response to Question 3 is bond issue:

A. B.
B. C.
C. D.

Correct Answer: C

Reference:
Level II of CFA Program Volume 6, Study Session 17, Reading 49, LOS a

Bond issue D will be least suitable for investors who expect their income to shrink
due to poor economic conditions. This is because a decline in income corresponds
to a decline in consumption today which in turn increases the marginal utility of
future consumption the intertemporal rate of substitution. In addition, poor
economic conditions are associated with declining asset payouts for risky
securities leading to declining asset prices. Investors will be exposed to declining
asset prices and higher risk of bond defaults.

58. Based on the real GDP growth information presented with respect to Regine’s
economy, the analyst should expect:

A. a negative relationship between real GDP growth and real default-free

interest rates.
B. real default-free interest rates to be higher in Regine relative to developed
economies.
C. real default-free interest rates to be lower in Regine relative to developed
economies.

Correct Answer: B

Reference:
Level II of CFA Program Volume 6, Study Session 17, Reading 49, LOS c

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

B is correct. The higher rate of real GDP growth in Regine relative to developed
world economies suggests that emerging market economy should be characterized
with higher real default-free interest rates. The higher rate of economic growth
will occur because Regine is below its steady state of growth and so it will grow
faster to catch up (as has been anticipated).

A is incorrect. Real GDP growth rates are positively related to real default-free
interest rates. An increase in the real GDP growth will lead to an increase in real
default-free interest rate. An increase in real GDP growth rate will increase
expected future income which, in turn, will increase the availability of goods and
services in the future relative to today. Consequently, individuals will have less
incentive to save for future consumption and so a higher real rate of interest is
needed to induce saving for future consumption.

59. Based on Gilbert’s growth expectations, which of the following statements most
accurately characterizes investors’ behavior?

A. Individuals are less motivated to save today.

B. Marginal utility is expected to increase in the future.
C. Investor income is expected to decline in the future.

Correct Answer: A

Reference:
Level II of CFA Program Volume 6, Study Session 17, Reading 49, LOS c

A is correct. Gibert expects Regine’s real GDP to increase in the future. Real
GDP growth is always positively related to real default-free interest rates. An
increase in real GDP growth will reduce individuals need to save for future
consumption because they will have more goods and services available to them in
the future as a result of higher expected future income.

B is incorrect. Individuals are expected to be wealthy in the future. A rise in

financial wealth will increase consumption in the future relative to today which in
turn will reduce the marginal utility of future consumption.

C is incorrect. See above.

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 Level II of CFA® Program Mock Exam 1 – Solutions (PM)

60. Based on the observed slope of the yield curve and combining expectations of
interest rates and bond risk premiums, Gilbert will most likely conclude that:

A. short-dated bonds are more reliable hedges relative to long-dated bonds.

B. short-dated bonds carry lower risk premiums relative to long-dated bonds.
C. interest rates are expected to rise if expectations concerning bond risk
premiums and interest rates are both considered.

Correct Answer: A

Reference:
Level II of CFA Program Volume 6, Study Session 17, Reading 49, LOS d

A is correct. An upward sloping yield curve indicates that short-term bonds have
lower yields and expected returns relative to long-dated bonds. One reason which
may explain the difference in expected return is that the former are valued for
their ability to pay more during bad economic times. In this respect, short-dated
bonds can be seen as being less positively correlated with bad times than long-
dated bonds. This leads to short-dated bonds serving as more reliable hedges.

B is incorrect. Given that short-dated bonds are seen as more reliable hedges
against bad economic times and have a less positive (or more negative)
correlation with bad times than long-dated bonds, bond risk premiums should be
higher for the latter.

C is incorrect. When expectations concerning bond risk premiums and future

interest rates are combined, an upward sloping yield curve does not necessarily
embody an expectation of interest rate increases. The yield curve may imply a
combination of expected rate increases and risk premiums, or expected rate cuts
that are more than offset by the existence of positive risk premiums.

This preference will drive the expected returns down prices of these favorable
instruments up.

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