Most Recent CFA Institute CFA-Level-II Exam Questions & Answers

Stanley Bostwick, CFA, is a business services industry analyst with Mortonworld Financial. Currently, his attention is focused on the 2008 financial statements of Global Oilfield Supply, particularly the footnote disclosures related to the company's employee benefit plans. Bostwick would like to adjust the financial statements to reflect the actual economic status of the pension plans and analyze the effect on the reported results of changes in assumptions the company used to estimate the projected benefit obligation (PBO) and net pension cost. But first, Bostwick must familiarize himself with the differences in the accounting for defined contribution and defined benefit pension plans.

Global Oilfield's financial statements are prepared in accordance with International Financial Reporting Standards (IFRS). Excerpts from the company's annual report are shown in the following exhibits.

What was the most likely cause of the actuarial gain reported in the reconciliation of the projected benefit obligation for the year ended 2008?

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In 2001, Continental Supply Company was formed to provide drilling equipment and supplies to contractors and oilfield production companies located throughout the United States. At the end of 2005, Continental Supply created a wholly owned foreign subsidiary, International Oilfield Incorporated, to begin servicing customers located in the North Sea. International Oilfield maintains its financial statements in a currency known as the local currency unit (LCU). Continental Supply follows U .S . GAAP and its presentation currency is the U .S . dollar.

For the years 2005 through 2008, the weighted-average and year-end exchange rates, stated in terms of local currency per U .S . dollar, were as follows:

International Oilfield accounts for its inventory using the lower-of-cost-or-rnarlcet valuation method in conjunction with the first-in, first-out, cost flow assumption. All of the inventory on hand at the beginning of the year was sold during 2008. Inventory remaining at the end of 2008 was acquired evenly throughout the year.

At the beginning of 2006, International Oilfield purchased equipment totaling LCU975 million when the exchange rate was LCU 1.00 to SI. During 2007, equipment with an original cost of LCU 108 million was totally destroyed in a fire. At the end of 2007, International Oilfield received a LCU 92 million insurance settlement for the loss. On June 30, 2008, International Oilfield purchased equipment totaling LCU 225 million when the exchange rate was LCU 1.25 to $1.

For the years 2007 and 2008, Continental Supply reported International Oilfield revenues in its consolidated income statement of S375 million and $450 million, respectively. There were no inter-company transactions. Following are International Oilfield's balance sheets at the end of 2007 and 2008:

At the end of 2008, International Oilfield's retained earnings account was equal to $525 million and, to date, no dividends have been paid. All of International Oilfield's capital stock was issued at the end of 2005.

Assuming that International Oilfield's equipment is depreciated using the straight-line method over ten years with no salvage value, calculate the subsidiary's 2008 depreciation expense under the temporal method.

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Wendall Wayne is a fixed income portfolio manager with Skyline Investments. Until recently he has focused almost exclusively on residential mortgage-backed securities (MBS). However, two weeks ago he was given approval to begin purchasing asset-backed securities (ABS) and commercial MBS as well. Wayne has forecasted that interest rates will decrease by approximately 100 basis points over the next month.

Wayne first completes an analysis of two tranches (a PAC I tranche and a support tranche) from a collateralized mortgage obligation (CMO) that was issued 18 months ago. When the CMO was issued, the initial collar of the PAC I tranche was 150 - 400 PSA . He estimates the change in the average life of each tranche as the prepayment speed varies, assuming the prepayment speed stays at that speed until the tranche matures. The results are shown in Exhibit 1.

In his report, Wayne makes the following statements regarding the CMO:

Statement 1: The CMO is structured so that the support tranche has more extension risk, and the PAC I tranche has more contraction risk.

Statement 2: The cash flows of the PAC I tranche will be less affected by the change in interest rates I have forecast than the cash flows of the support tranche.

Wayne has pushed for approval to begin trading ABS because he is particularly interested in collateralized debt obligations (CDOs). However, he doesn't know a lot about them, so he first does some reading and prepares some key points related to CDOs to guide his analysis.

Statement 3: CDOs are typically collateralized by emerging market bond issues, home equity bank loans, and high-yield corporate bond issues.

Statement 4: One advantage of issuing a synthetic CDO versus a cash CDO is that credit risk is lower with a synthetic CDO because the junior note holders also sell a credit default swap.

Statement 5: Some CDOs include an equity tranche to provide payment and credit protection to the senior and mezzanine tranches, but for most issues, credit protection is provided by external credit enhancements.

Wayne wants to understand the distinction between amortizing and non-amortizing assets that are securitized by ABS transactions, as well as the appropriate spread measures to use for various types of fixed-income securities. He asks a colleague, Martin Freed, to explain to him the difference between the two and how the payment structure of the ABS is affected by whether the assets in the pool are amortizing or non-amortizing. Freed replies:

Statement 6: An auto loan is an example of an amortizing asset, and a credit card receivable is an example of a non-amortizing asset.

Statement 7: For amortizing assets, the composition of the loans in the asset pool doesn't change once the assets are securitized. For non-amortizing assets, the composition of the asset pool does change.

Freed also tells Wayne that the credit analysis of commercial mortgage-backed securities (CMBS) should focus on the credit risk of the property, not the borrower. Freed also says that two key ratios useful for assessing the credit risk of the property are the debt service coverage ratio (net operating income/debt service) and the loan-to-value ratio (current mortgage amount/current appraised value). Wayne concludes that both of the ratios Freed recommends for credit analysis of CMBS are positively related to credit risk: the higher the ratio, the more risky the loan.

Finally, Wayne is trying to determine the most appropriate spread measure for valuing callable corporate bonds and high-quality home equity loan ABS. He plans to choose from the following measures: the zero-volatility spread, the OAS from the binomial model, and the OAS from the Monte Carlo model.

Regarding the CMO, are Wayne's statements correct?

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Mary Carr is 62 years old, in good health, and will retire in four years from her position as the CEO and chairman of the board of a large professional services firm, Appleton Professional Services, which is located in the midwestern United States. Carr has approached Tim Houlis, her financial planner, for help in preparing an investment policy statement and accompanying asset allocation. Jack Timmons is Houlis' assistant.

In a lunch meeting with Houlis and Timmons, Carr reveals that she is thinking of moving this year to be closer to Appleton's largest client. She is concerned about developing an investment plan now given that she will no longer have contact with Houlis if she does move. Houlis reassures her that this is not a problem. He states that a properly constructed investment policy statement can be readily implemented by her new financial advisor. Timmons states that the investment policy statement is a long-term document that should be changed only if the outlook for equities versus bonds and other assets changes.

Carr's parents were successful business people who owned a series of small firms. Their success, however, did not come without challenges. Twice they had to liquidate businesses in which they were the primary shareholders. As a child, Carr became accustomed to the uncertainties of the entrepreneurial world. When she graduated from college, her parents provided her with the funds to purchase Appleton Professional Services. Appleton was a small firm at that point, but Can-has grown it into one of the larger firms in its industry, even though the professional services industry is cyclical and is susceptible to economic recessions. Appleton went public eight years ago and Carr retained a majority shareholder position when it did. Over time she has sold some of the stock but still has a controlling position in the firm.

Despite the business difficulties Carr's parents experienced, they were able to amass a sizeable fortune in their later years. Including her inheritance and holdings in Appleton stock, Carr has a portfolio with a current value of $6,000,000, most of which is invested in Appleton and other domestic and international equities. Carr has instructed Houlis and Timmons to grow her portfolio over time, focusing on capital appreciation and achieving long-term return goals. She would like to leave her children a sizeable inheritance.

Carr is single with two children. Her oldest child, Mark, is 25 years old and financially independent. Her youngest son, John, is a junior in college at a prestigious liberal arts college in New England. The tuition payment for his last year of college of approximately $40,000 is due at the end of this year. She has no mortgage on her house. Carr is an avid bird watcher and gifts $50,000 a year to a local environmental group. She is concerned with the destruction of bird habitat, so she does not want to invest in highly-polluting industries or firms that are involved in real estate development.

When she retires, Carr will receive a lump-sum, after-tax distribution of approximately $500,000 from her firm. She will also begin collecting an annual pension payment equal to her current salary. The pension payment is indexed to inflation. She will be covered under Appleton's health insurance plan in retirement. Carr spends $ 170,000 a year on vacations and living expenses, which is about equal to her current salary at Appleton.

Houlis estimates that Carr is taxed at an effective marginal rate of 30% on capital gains and income. Houlis estimates an inflation rate of 3% for the rest of Carr's life expectancy, which he projects at 20 years or more, given her good health.

With regard to generating adequate liquidity for Carr's portfolio, Timmons states that she need not invest entirely in income-generating assets. Instead, Carr can generate income from stock dividends, bond coupons, and the sale of assets. By being willing to generate income through the sale of assets, Carr would be able to broaden the types of securities available to her for investment. Timmons states that the problem with most assets that produce income (e.g., dividend paying stocks) is that their expected return is usually lower. He states that the advantage of his approach is that Carr could pursue higher return assets, such as small company stocks.

Timmons' approach to generating liquidity can be best characterized as a:

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Charles Mabry manages a portfolio of equity investments heavily concentrated in the biotech industry. He just returned from an annual meeting among leading biotech analysts in San Francisco. Mabry and other industry experts agree that the latest industry volatility is a result of questionable product safety testing methodologies. While no firms in the industry have escaped the public attention brought on by the questionable safety testing, one company in particular is expected to receive further attention---Biological Instruments Corporation (BIC), one of several long biotech positions in Mabry's portfolio. Several regulatory agencies as well as public interest groups have heavily criticized the rigor of BIC's product safety testing.

In an effort to manage the risk associated with BIC, Mabry has decided to allocate a portion of his portfolio to options on BIC's common stock. After surveying the derivatives market, Mabry has identified the following European options on BIC common stock:

Mabry wants to hedge the large BIC equity position in his portfolio, which closed yesterday (June 1) at $42 per share. Since Mabry is relatively inexperienced with utilizing derivatives in his portfolios, Mabry enlists the help of an analyst from another firm, James Grimell.

Mabry and Grimell arrange a meeting in Boston where Mabry discusses his expectations regarding the future returns of BIC's equity. Mabry expects BIC equity to make a recovery from the intense market scrutiny but wants to provide his portfolio with a hedge in case BIC has a negative surprise. Grimell makes the following suggestion:

"If you want to avoid selling the BIC position and are willing to earn only the risk-free rate of return, you should sell calls and buy puts on BIC stock with the same market premium. Alternatively, you could buy put options to manage the risk of your portfolio. I recommend waiting until the vega on the options rises, making them less attractive and cheaper to purchase."

If the premium on Put D on November 1 is $3.18, which of the following has most likely occurred?

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