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AdaptPrep CFA Mini-mock exam contest, 2018 Level II

Passage 1: Black (Reading 2)

Kevin Black, a trader with Holdfast Securities, was awarded his CFA charter after passing the
Level III exam last year and satisfying all other requirements for holding the designation.

One of Black's clients, Cynthia Redding, has given him written instructions to use Daybreak
Brokers to execute all trades from her account. Black believes that, although Daybreak Brokers
provide a reasonable level of service and no clients have complained about their commission
rates, Thompson Partners - a rival broker - offers better execution at a more attractive price.
Another of Black's clients, Albert Warren has a nondiscretionary account, meaning that Black
only executes orders from his client. However, because Warren has no preference about which
brokerage is used, Black directs all trades for this account to Daybreak Brokers.

Recently, Black noticed some irregularities that prompted him to review his file on Ian Clarkson,
a former client. Based on his analysis, Black has credible evidence that Clarkson has violated
securities laws. Unsure what to do with this information, Black consults Holdfast's policy on
client confidentiality, which prohibits sharing information about current and prospective clients
with unauthorized individuals. Black decides to draft a memo documenting his suspicions about
Clarkson's apparent illegal activities and shares it with his friend Blair Jacobson, one of
Holdfast's sell-side equity analysts. Jacobson, who does not work with any of Black's clients,
encourages his friend to discuss his suspicions with officers in Holdfast's compliance
department.

Three months ago, Jacobson initiated coverage of RC Industries (RCI). Several of the
assertions made in Jacobson's initial report were supported by the conclusions of three studies
conducted by a government agency. He maintained a detailed bibliography of sources, but no
copies of the government studies, which he accessed on the agency's website last week as he
prepared a follow-up report on RCI.

For the past month, Jacobson has been staying late after work as he prepares to write the Level
III CFA exam. In particular, Jacobson is having difficulty differentiating between various
behavioral biases and he shares this concern in an email to Black, who replies: "I wouldn't worry
about this too much about this. There was only one item set covering behavioral finance on the
Level III exam last year, and I found those questions pretty easy to answer."

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Question 1

According to the guidance for the Standards, Black should *most likely*:

A. use Thompson Partners to execute Redding's trades.

B. inform Redding of his belief about Thompson Partners.
C. continue using Daybreak Brokers to execute Redding's trades unless he is directed
otherwise.

Question 2

In using Daybreak Brokers to execute trades for Warren's account, has Black *most likely*
violated the Standards?

A. Yes
B. No, because this is a nondiscretionary account
C. No, because there is no directed brokerage arrangement

Question 3

Is Holdfast's policy on client confidentiality *most likely* consistent with the Standards?

A. Yes.
B. No, because the policy does not prohibit the sharing of information about former clients
C. No, because the Standards do not require information about prospective clients to be
kept confidential

Question 4

Has Black *most likely* violated the Standards by discussing his suspicions about Clarkson's
possible illegal activities with Jacobson?

A. Yes
B. No, because Jacobson is a Holdfast employee
C. No, because Black has an obligation to report suspected illegal activity

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Question 5

Has Jacobson *most likely* violated the Standards with respect to his retention of records
related to his report on RCI?

A. Yes
B. No, because he kept a bibliography of sources
C. No, because the studies were freely-available online

Question 6

In sharing information about last year's CFA exam with Jacobson, Black *most likely* violated
the Standards with respect to:

A. material nonpublic information only.

B. conduct as participants in CFA Institute programs only.
C. both material nonpublic information and conduct as participants in CFA Institute
programs.

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Passage 2: Gardner (Reading 10)

Mark Gardner, CFA, heads the investment research department of a wealth

management company. Gardner is an expert in statistical modelling and financial
statement analysis. The CFO asked Gardner to analyze JQL Airlines from an investor's
perspective. He reads through the company’s financial reports and learns that fuel cost
is a major component of its operating costs. He then tries to identify the factors that
drive fuel prices. He believes that fuel prices are a function of the demand for fuel and
describes the relationship with the following equation:

P i = b0 + b1 Di + εi

where:

P is fuel price (in USD per gallon) and D is the demand for fuel (in millions of barrels
per day, worldwide) of firm i.

b0 and b1 are the intercept and the slope coefficients, respectively.

εi is the error term.

Gardner uses the following assumptions for his linear regression model:

● Assumption 1: The independent variable ​D​i​ is not random.

● Assumption 2: The error term is correlated across observations.
● Assumption 3: The error term is normally distributed.

After Gardner runs the regression, he obtains the following results:

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Exhibit 1: Regression Results

Regression Statistics

Multiple R 0.8571

R2 0.7346

Adjusted R2 0.7269

Standard Error 1.0271

Observations 36

ANOVA

df SS MS F Significance F

Regression 1 99.2752 99.2752 94.1110 0.0000

Residual 34 35.8657 1.0549

Total 35 135.1409

Coefficients Standard Error t-Statistic

Intercept 23.6733 2.0602 11.4908

Demand -4.3398 0.4474 -9.7011

For 34 degrees of freedom, the critical value for a one-tailed t-test at the 1% significance
level is 2.441. Also, for 34 degrees of freedom, the critical value for a one-tailed t-test at
the 5% significance level is 1.691.

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Gardner shares this result with a colleague, Travis Robert, who is also working on the
same project. The modified regression equation, including refining costs, is given by:

P i = b0 + b1 Di + b2 Ri + εi

Robert includes one more independent variable, refining costs (in USD per gallon), in
the regression equation, denoted by Ri . After Robert runs the regression, he obtains
the following results:

Exhibit 2: Regression Result with Refining costs included as an independent variable

Regression Statistics

Multiple R 0.9580

R2 0.9178

Adjusted R2 0.9128

Standard Error 0.5802

Observations 36

ANOVA

df SS MSS F Significance
F

Regression 2 124.0327 62.0164 184.2372 0.0000

Residual 33 11.1082 0.3366

Total 35 135.1409

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Coefficients Standard
Erro​r

Intercept 5.4511 2.4226

Demand -1.0308 0.4612

Refining costs 0.2877 0.0335

For 33 degrees of freedom, the critical value for a one-tailed t-test at the 1% significance
level is 2.445. Also, for 33 degrees of freedom, the critical value for a one-tailed t-test at
the 5% significance level is 1.692.

Gardner asks Robert to test whether, as a group, the independent variables explain the
dependent variable.

Finally, Robert would like to test the hypothesis that fuel prices decrease as demand
increases. He wants to test this hypothesis at the 1% level of significance.

The critical value for a one-tailed t-test at the 1% significance level with 33 observations
is 2.445.

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Question 7

Which of the following models will *best* describe the fuel price?

A. P i = b0 + b1 D i + εi
B. P i = b0 + b1 Di + b2 Ri + εi
C. P i = b1 Di + b2 Ri + εi

Question 8

Based on Exhibit 1, which of the following is *most likely* correct?

A. The F-test is significant at the 1 percent significance level
B. The independent variable explains 86% of the variation in the dependent variable
C. The coefficient of demand is not statistically significant at the 1 percent significance level

Question 9

Which of Gardner's assumptions is *least likely* to be correct?

A. Assumption 1
B. Assumption 2
C. Assumption 3

Question 10

Gardner's regression model *most likely* suffers from which of the following specification
errors?

A. Nonstationarity is present
B. The functional form is incorrect
C. There is time-series misspecification

Question 11

Which of the following tests should Robert use for Gardner's request?

A. T-test
B. F-test
C. Durbin-Watson test

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Question 12

Based on Exhibit 2, what is the ​most appropriate​ null hypothesis and the ​most
appropriate​ conclusion regarding the magnitude of price change relative to the demand
(reflected by the coefficient b1 )?

A. Null Hypothesis: H 0 : b1 ≥ 0 ; Conclusion: Reject H 0

B. Null Hypothesis: H 0 : b1 = 0 ; Conclusion: Fail to reject H 0

C. Null Hypothesis: H 0 : b1 ≥ 0 ; Conclusion: Fail to reject H 0

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Passage 3: Empire Distribution (Reading 18)

Empire Distribution, based in the United Kingdom, sells pre-packaged meals to retailers
across Europe as well as in other countries through its subsidiaries. Its inputs are
sources from a network of suppliers located in various countries. The company issues
financial reports in accordance with IFRS and uses the UK pound (GBP) as its
functional currency.

On 1 January 2016, Empire was involved in the following transactions:

● Transaction A: Empire delivered EUR 150,000 of products to a German grocery

chain
● Transaction B: Empire accepted delivery of GBP 275,000 of vegetables from a
UK-based supplier
● Transaction C: Empire delivered EUR 460,000 of products to an French retailer
● Transaction D: Empire received USD 600,000 of packaging materials from a an
American supplier

Each of the transactions listed above was recorded on credit at the time of delivery and
settled in cash 90 days later, on 31 March 2016. Relevant currency exchange rates are
shown in Exhibit 1.

Exhibit 1: Spot USD and EUR exchange rates

1 Jan 2016 31 Mar 2016

USD/GBP 1.2862 1.2977

EUR/GBP 1.0911 1.1008

Paul Bird, Empire's CFO, is having a conference call with Sandra Herbert, President of
Farmer's Kitchen, Empire's American subsidiary and Gavin Henry, President of Oceania
Foods, Empire's Australian subsidiary. The three colleagues are reviewing financial data
for 2016, which ends today.

Bird and Herbert engage in a discussion of the similarities and differences between US
GAAP and IFRS with respect to disclosure requirements for companies with
multinational operations. In response to a question from Herbert, Bird replies,

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"Although US GAAP do require companies to identify the specific line item on the
income statement in which transaction gains or losses on foreign currency transactions
are recorded, Empire issues financial reports in accordance with IFRS, which impose no
such requirement."

Later in the conversation, Herbert makes the following claim: "In cases where a foreign
entity is disposed, US GAAP require disclosure of the value of the translation
adjustment that is transferred from the parent's balance sheet to its income statement.
However, this requirement does not exist under IFRS."

The conversation then turns to the Australian subsidiary's Empire has consolidated
Oceania's financial information as of the end of 2016 into its financial statements using
the current rate method. Key financial data for Oceania is reported in terms of
Australian dollars (AUD), which is the subsidiary's functional currency, is provided in
Exhibits 2. Relevant data on GBP/AUD exchange rates in 2016 appears in Exhibit 4.

Exhibit 2: Oceania's 2016 income statement

Sales 145,000,000

Cost of goods sold 115,000,000

Selling and administrative expenses 9,900,000

Exhibit 3: Oceania's balance sheet, as of 31 Dec 2016 (AUD)

Accounts receivable 11,800,000

Inventory 16,700,000

Property, plant, and equipment 360,800,000

Accumulated depreciation 41,200,000

Stockholders' equity 298,330,000

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Exhibit 4: GBP/AUD exchange rates

1 January 2016 0.6236

2016 average 0.6324

Historical weighted-average (inventory purchases) 0.6298

31 December 2016 0.6412

Later in the call, Bird and Henry discuss the potential impact on Empire's financial
statements if Oceania's results were consolidated using the temporal method. As the
colleagues are concluding their discussion, Henry mentions that Oceania is considering
selling an intangible asset that it is currently carrying at AUD 178,000 for an equivalent
amount of cash.

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Question 13

Based on the exchange rates quoted in Exhibit 1, Empire will *most likely* record a gain
attributable to which of the following?

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

Question 14

Is Bird's claim about disclosure requirements related to transaction gains *most likely* correct?

A. Yes
B. No, because IFRS do require specific line item disclosure of transaction gains
C. No, because US GAAP do not require specific line item disclosure of transaction gains

Question 15

Herbert's claim about disclosure requirements related to translation gains is *most likely*:

A. correct.
B. incorrect with respect to IFRS.
C. incorrect with respect to US GAAP.

Question 16

Upon being translated into its parent's presentation currency using the current rate method,
Oceania's gross profit margin for 2016 will be *closest* to:

A. 20.7%.
B. 21.0%.
C. 22.1%.

Question 17

All else equal, translating Oceania's financial information using the temporal method rather than
the current rate method would *most likely* have had what effect on Empire's ratios for 2016?

A. Gross margin would have been higher

B. Inventory turnover would have been lower
C. Receivables turnover would have been lower

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Question 18

Assuming that Empire continues to use the current rate method and Oceania executes the
proposed sale of intangible assets, the company's net asset balance sheet exposure would
*most likely* be:

A. a higher net asset balance sheet exposure.

B. the same net asset balance sheet exposure.
C. a lower net liability balance sheet exposure.

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Passage 4: Wei (Reading 32)

Charles Wei covers FanMaker (FMK), a manufacturer and distributor of residential and
commercial fans in developing markets. The company will be reporting its earnings for
the first quarter of 2017 tomorrow. Wei's supervisor, Meagan Ying, has asked him to
determine whether the company's stock is trading near its fair value using a
market-based valuation approach.

FMK's sales are cyclical - peaking in the summer months and surging during years with
above-average temperatures. Additionally, the company's success is influenced by the
business cycles of the companies in which it operates. Based on a review of historical
data shown in Exhibit 1, Wei concludes that FMK's stock, which is currently trading at
$64.78 per share, exhibits the Molodovsky effect.

Exhibit 1: Historical data for FMK

2011 2012 2013 2014 2015 2016

Earnings per share $3.02 $3.08 $3.24 $3.73 $3.61 $3.89

Average market price $45.68 $42.14 $55.29 $62.36 $63.87 $67.39

Book value per share $36.20 $39.22 $42.30 $45.54 $49.27 $52.88

Return on equity 8.34% 7.85% 7.66% 8.19% 7.33% 7.36%

Wei considers a stock to be fairly valued if it is trading within plus or minus 5% of its
justified price based on a forecast of earnings, which are expected by be $4.20 over the
next twelve months and grow at a long-term rate of 3.9% annually, and the historical
average P/E, which he calculates for FMK using data from Exhibit 1. The company's cost
of equity is currently 9.2%, reflecting a recent increase in financial and operational
leverage, and management maintains a 20% earnings retention ratio.

Having analyzed FMK using the company's own historical data and forecasts of its
future performance, Wei decides to compare certain metrics to those of other firms in
the industry. Before conducting this peer group analysis, Wei shows his preliminary
work to Ying, who makes the following statements:

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Statement 1: "Using either forward P/E ratios or earnings yields will produce a
consistent and meaningful ranking of comparable companies."

Statement 2: "The P/E-to-growth (PEG) ratio can be helpful when comparing

companies in the same industry because it accounts for differences in operating risk and
assumes a linear relationship between the P/E ratio and growth."

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Question 19

Wei's conclusion about FMK's stock is *most likely* based on having observed a pattern of:

A. countercyclical earnings.
B. low P/E ratios during recessions.
C. low P/E ratios during economic expansions.

Question 20

FMK's normalized P/E ratio using the company's historical average return on equity is *closest*
to:

A. 12.34.
B. 15.72.
C. 18.90.

Question 21

Based on his criteria, Wei *most likely* considers FMK to be:

A. overvalued.
B. fairly valued.
C. undervalued.

Question 22

FMK's forward P/E ratio is *most likely* greater than:

A. both its justified trailing P/E ratio and its justified forward P/E ratio.
B. its justified forward P/E ratio and less than its justified trailing P/E ratio.
C. its justified trailing P/E ratio and less than its justified forward P/E ratio.

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Question 23

Ying's claim in Statement 1 is *most likely*:

A. correct.
B. incorrect with respect to earnings yields.
C. incorrect with respect to forward P/E ratios.

Question 24

Is Ying's claim in Statement 2 *most likely* correct?

A. Yes
B. No, because the PEG ratio does not account for differences in operating risk
C. No, because the PEG ratio does not assume a linear relationship between P/E and
growth

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Passage 5: Pritchard (Reading 36)

Tracy Pritchard works as an analyst in the fixed-income branch of an investment bank.

Her department prices bonds trading in the market. Pritchard’s supervisor, Leslie
Matthews, requests that a bond issue be valued under different methods.

Matthews first requests that Pritchard calculate the arbitrage-free value of Bond A using
a yield-to-maturity curve. Bond A has a par value of $100, a coupon rate of 8.0%, and a
3-year maturity. The yield-to-maturity in year 1 is 4.0%, the yield-to-maturity in year 2
is 5.5%, and the yield-to-maturity in year 3 is 6.0%.

Exhibit 1: Yield to Maturity Par Rates for One-, Two-, and Three-Year Annual Pay
Option-Free Bonds

One-year Two-year Three-year

4.0% 5.5% 6.0%

Next, Matthews asks Pritchard to price Bond B, a 2-year bond with a par value of $100
and a coupon rate of 5.0% by using a binomial interest rate tree:

Exhibit 2: Binomial interest rate tree

Matthews asks for the present value of Bond B.

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Satisfied with the pricing work, Matthews then asks Pritchard to calibrate this binomial
tree to match a specific term structure. The one-year spot rate is 3.5% and the two-year
spot rate is 4.75%. The interest rate volatility is 20% per year.

After valuing these bonds with interest rate trees, Pritchard wants to understand their
general properties. Pritchard tells Matthews she has heard that interest rate trees
describe closely interrelated economic items. Matthews responds with the following
about them:

Property 1: Interest rate trees generate cash flows dependent on interest rates.

Property 2: Interest rate trees produce interest rates used to determine the present value
of cash flows.

Matthews asks Pritchard to consider another alternative to value bonds. Specifically, she
asks Pritchard to use pathwise valuation to price Bond C, a 2-year bond with a coupon
rate of 3% and par value of 100.

Here are the paths:

Exhibit 3: Interest Rate Paths

Path Time 0 Time 1

1 3.0% 3.6%

2 3.0% 3.6%

3 3.0% 2.7%

4 3.0% 2.7%

Pritchard, curious about the applications of pathwise valuation, asks Matthews about
the Monte Carlo method. She states the following:

Remark 1: Monte Carlo models are often used to value fixed-income securities whose
behavior depend on prepayments, such as mortgage-backed securities.

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Remark 2: Since increasing the number of paths in a Monte Carlo model increases its
statistical accuracy, it also implies that the model is closer to the fundamental value of a
security.

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Question 25

According to the term structure described in Exhibit 1, the arbitrage-free price of Bond
A is ​closest​ to:

A. $105.39.
B. $105.56.
C. $105.77.

Question 26

Using the interest rate binomial tree shown in Exhibit 2, the arbitrage-free price of Bond
B is ​closest​ to:

A. $100.50.
B. $101.00.
C. $104.25.

Question 27

When calibrating the binomial tree shown in Exhibit 2, the value of the interest rate in
the upper node of time 1 is ​closest​ to:

A. 4.92%.
B. 6.85%.
C. 7.35%.

Question 28

Which of the following is the ​most accurate​ assessment of Matthews’ statements

regarding interest rate trees?

A. Property 1 and Property 2 are both accurate

B. Property 1 is accurate and Property 2 is inaccurate
C. Property 1 is inaccurate and Property 2 is accurate

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Question 29

According to Exhibit 3, the arbitrage-free value of Bond C is ​closest​ to:

A. 98.67.
B. 99.86.
C. 102.23.

Question 30

Which of the following is the ​most accurate​ assessment of Pritchard’s statements

regarding the Monte Carlo method?

A. Remark 1 and Remark 2 are both accurate

B. Remark 1 is accurate and Remark 2 is inaccurate
C. Remark 1 is inaccurate and Remark 2 is accurate

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