CFA Institute CFA-Level-II Exam Dumps

George Armor, CFA, is a new stock analyst for Pedad Investments. One tool that Pedad uses to compare stock valuations is the dividend discount model (DOM). In particular, the firm evaluates stocks in terms of "justified" multiples of sales and book value. These multiples are based on algebraic manipulation of the DDM. Over time, these multiples seem to provide a good check on the market valuation of a stock relative to the company's fundamentals. Any stock which is currently priced below its value based on a justified multiple of sales or book value is considered attractive for purchase by Pedad portfolio managers. Exhibit 1 contains financial information from the year just ended for three stable companies in the meat-packing industry: Able Corp, Baker, Inc., and Charles Company, from which Armor will derive his valuation estimates.

One of Pedad's other equity analysts, Marie Swift, CFA, recently held a meeting with Armor to discuss a relatively new model the firm is implementing to determine the P/E ratios of companies that Pedad researches. Swift explains that the model utilizes a cross-sectional regression using the previous year-end data of a group of comparable companies' P/E ratios against their dividend payout ratios (r), sustainable growth rates (g), and returns on equity (ROE). The resulting regression equation is used to determine a predicted P/E ratio for the subject company using the subject company's most recent year-end data. Swift has developed the following model, which has an R-squared of 81%, for the meat packing industry (16 companies):

Predicted P/E = 2.74 + 8.21(r) + 14.21(g) + 2.81(ROE)

(STD error) (2.11) (6.52) (9.24) (2.10)

After Swift presents the model to Armor, she points out that models of this nature are subject to limitations. In particular, multicollinearity, which appears to be present in the meat packing industry model, can create great difficulty in interpreting the effects of the individual coefficients of the model. Swift continues by stating that in spite of this limitation, models of this nature generally have known and significant predictive power across different time periods although not across different stocks.

Based on Exhibit 1, select the stock that is the most undervalued by applying the justified price-to-book value method.

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Joan Fisher and Kim Weatherford are economists responsible for modeling security returns for Quincy Portfolio Managers, which is located in the southwestern United States. Fisher is the firm's chief economist and Weatherford is her assistant.

Fisher has been busy over the past week modeling the macroeconomic data of an emerging market. The data for the past 24 months is shown in Exhibit 1.

Fisher ponders how she can run a regression that will model the data for this country in the most appropriate way. She decides to regress the macroeconomic values against a time variable. The resulting plot of the residuals is shown in Exhibit 2.

In addition to financial assets, Quincy Portfolio Managers also recommends the use of commodities as a portfolio diversifier. Weatherford has been examining price indices for silver in an attempt to determine whether silver returns are predictable. As an initial step, she uses an autoregressive first-order regression model on daily price data for silver over the past two years. The plot of the raw data and the results of the regression are shown in Exhibits 3 and 4.

Fisher and Weatherford later discuss fluctuations in gold prices. Although the arithmetic and geometric mean returns for gold were negative for much of the 1980s and 1990s, Fisher and Weatherford believe that gold should perform better in the future due to higher expected inflation. After appropriate transformation of the data, they use an autoregressive first-order regression model to examine the characteristics of gold returns, the results of which are shown in Exhibit 5.

Is the use of the Durbin Watson statistic in Weatherford's silver regression appropriate and, if so, how should it be interpreted?

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Viper Motor Company, a publicly traded automobile manufacturer located in Detroit, Michigan, periodically invests its excess cash in low-risk fixed income securities. At the end of 2009, Viper's investment portfolio consisted of two separate bond investments: Pinto Corporation and Vega Incorporated.

On January 2, 2009, Viper purchased $10 million of Pinto's 4% annual coupon bonds at 92% of par. The bonds were priced to yield 5%. Viper intends to hold the bonds to maturity. At the end of 2009, the bonds had a fair value of $9.6 million.

On July I, 2009, Viper purchased $7 million of Vega's 5% semi-annual coupon mortgage bonds at par. The bonds mature in 20 years. At the end of 2009, the market rate of interest for similar bonds was 4%. Viper intends to sell the securities in the near term in order to profit from expected interest rate declines.

Neither of the bond investments was sold by Viper in 2009.

On January 1,2010, Viper purchased a 60% controlling interest in Gremlin Corporation for $900 million. Viper paid for the acquisition with shares of its common stock.

Exhibit 1 contains Viper's and Gremlin's pre-acquisition balance sheet data.

Exhibit 2 contains selected information from Viper's financial statement footnotes.

The carrying value of Viper's investment portfolio as of December 31, 2009 is closest to:

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Mike Diffle has been asked to evaluate the bonds of Hardin, Inc. The specific issue Diffle is considering has an 8% annual coupon and matures in two years. The bonds are currently callable at 101, and beginning in six months, they are callable at par. Bratton Corp, a competitor of Hardin's, also has bonds outstanding which are identical to Hardin's except that they are not callable. Diffle believes that the AA rating of both bonds is an accurate reflection of their credit risk. Diffle is wondering if the Bratton bonds might be a better investment than the Hardin bonds. Assume that the following 1-year interest rate tree is used to value bonds with a maturity of up to three years (this tree assumes interest rate volatility of 10%).

Also, assume that the appropriate spot rates for securities maturing in one, two, and three years are 7.25%, 7.5%, and 7.80%, respectively.

Diffle believes he should begin his analysis with the option-free Bratton bonds. He decides to consider two different approaches to valuing the Bratton Bonds---one that uses the current spot rate curve and another that uses the interest rate tree given above.

For the next step in his analysis, Diffle has decided to calculate the value of the Hardin bonds using the interest rate tree. His assumption is that the bond will be called ai any node of the tree where the calculated value exceeds the call price. Diffle summarizes the results of his bond valuation analysis in a memo to his supervisor, Luke Puldo. In this memo, Diffle makes the following statements:

Statement 1: The value of the option embedded in the Hardin bonds can be derived by simply subtracting the interest rate tree value of the Hardin bonds from the interest rate tree value of the Bratton bonds.

Statement 2: I am concerned that the 10% volatility assumption used to develop the interest rate tree might be too low. A higher volatility assumption would result in a lower value for the Hardin bonds.

After reviewing Diffle's analysis, Puldo notes that Diffle has not included any information on the option adjusted spread (OAS) for the Hardin bonds. Puldo suggests that Diffle should evaluate the OAS in order to get an idea of the liquidity risk of the Hardin bonds. Diffle counters that the OAS may not be very informative in this case, since he is uncertain as to the reliability of the interest rate volatility assumption.

To finish his analysis, Diffle would like to use his binomial model to evaluate the interest rate risk of both the Hardin bonds and the Bratton bonds. Diffle has shocked interest rates by 25 basis points throughout the interest rate tree he has been using to value the two bond issues. Using the new rates, Diffle has calculated values for the bonds assuming a 25-basis-point increase or decrease in rates. He plans to use these values as inputs into the following formulas for duration and convexity:

Calculate the value of the Bratton bonds using the interest rate tree.

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William Rogers, a fixed-income portfolio manager, needs to eliminate a large cash position in his portfolio. He would like to purchase some corporate bonds. Two bonds that he is evaluating are shown in Exhibit I. These two bonds are from the same issuer, and the current call price for the callable bond is 100. Assume that the issuer will call if the bond price exceeds the call price.

Rogers is also concerned about increases in interest rates and is considering the purchase of a putable bond. He ants to determine how assumed increases or decreases in interest rate volatility affect the value of the straight bonds and bonds with embedded options. After Rogers performs some analysis, he and his supervisor, Sigourney Walters, discuss the relative price movement between the two bonds in Exhibit 1 when interest rates change significantly

During the discussions, Rogers makes the following statements:

Statement 1: If the volatility of interest rates decreases, the value of the callable bond will increase.

Statement 2: The noncallable bond will not be affected by a change in the volatility or level of interest rates.

Statement 3: When interest rates decrease, the value of the noncallable bond increases by more than the callable bond.

Statement4: If the volatility of interest rates increases, the value of the putable bond will increase.

Walters mentors Rogers on bond concepts and then asks him to consider the pricing of a third bond. The third bond has five years to maturity, a 6% annual coupon, and pays interest semiannually. The bond is both callable and putable at 100 at any time. Walters indicates that the holders of the bond's embedded options will exercise if the option is in-the-money.

Rogers obtained the prices shown in Exhibit b using software that generates an interest rate lattice. He uses his software to generate the interest rate lattice shown in Exhibit 2.

Exhibit 2: Interest Rate Lattice (Annualized Interest Rates)

Using the information in the question and the following relevant portion of the interest rate and pricing trees, Rogers calculates the value of the callable bond at node B.

Corresponding portion of the interest rate tree:

Corresponding portion of the callable bond price tree:

The price of the callable bond at node B is closest to:

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