CFA Institute CFA-Level-II Dumps - Pass CFA Level II Chartered Financial Analyst Exam in 2026

Charles Connor, CFA, is a portfolio manager at Apple Investments, LLC . Apple is a U .S .-based firm offering a wide spectrum of investment products and services. Connor manages the Biogene Fund, a domestic equity fund specializing in small capitalization growth stocks. The Biogene Fund generally takes significant positions in stocks, commonly owning 4.5-5% of the outstanding shares. The fund's prospectus limits positions to a maximum of 5% of the shares outstanding. The performance of the Biogene Fund has been superior over the last few years, but for the last two quarters the fund has underperformed its benchmark by a wide margin. Connor is determined to improve his performance numbers going forward.

The Biogene prospectus allows Connor to use derivative instruments in his investment strategy. Connor frequently uses options to hedge his fund's exposure as he builds or liquidates positions in his portfolio since Biogene's large positions often take several weeks to acquire. For example, when he identifies a stock to buy, he often buys call options to gain exposure to the stock. As he buys the stock, he sells off the options or allows them to expire. Connor has noticed that the increased volume in the call options often drives the stock price higher for a few days. He has seen a similar negative effect on stock prices when he buys large amounts of put options.

The end of the quarter is just a few days away, and Connor is considering three transactions:

Transaction A: Buying Put Options on Stock A

The Biogene Fund owns 4,9% of the outstanding stock of Company A, but Connor believes the stock is fully valued and plans to sell the entire position. He anticipates that it will take approximately 45 trading days to liquidate the entire Biogene position in Stock A

The Biogene Fund owns 5% of the outstanding stock of Company B . Connor believes there is significant appreciation potential for Stock B, but the stock price has dropped in recent weeks. Connor is hoping that by taking an option position, there will be a carryover effect on ihe stock price before quarter end.

Transaction C: Selling the Biogene Fund's Entire Position in .Stock C

Connor believes that Stock C is still attractive, but he is selling the stock with the idea that he will repurchase the position next month. The motivation for the transaction is to capture a capital loss that will reduce the Biogene Fund's tax expense for the year.

Apple has an investment banking department that is active in initial public offerings (IPOs). George Arnold, CFA, is the senior manager of the IPO department. Arnold approached Connor about Stock D, a new IPO being offered by Apple. Stock D will open trading in two days. Apple had offered the IPO to all of its clients, but approximately 20% of the deal remained unsold. Having read the prospectus, Connor thinks Stock D would be a good fit for his fund, and he expects Stock D to improve his performance in both the short and long term. Connor is not aware of any information related to Stock D beyond that provided in the prospectus. Connor asked to purchase 5% of the IPO, but Arnold limited Biogene's share to 2%, explaining:

"With Biogene's reputation, any participation will make the unsold shares highly marketable. Further, we may need Biogene to acquire more Stock D shares at a later date if the price does not hold up."

Connor is disappointed in being limited to 2% of the offering and suggests to Arnold in an e-mail that, given the 2% limitation, Biogene will not participate in the IPO . Arnold responded a few hours later with the following message:

"I have just spoken with Ms. D, the CFO of Stock D . Although it is too late to alter the prospectus, management believes they will receive a large contract from a foreign government that will boost next year's sales by 20% or more. I urge you to accept the 2%---you won't be sorry!"

After reviewing Arnold's e-mail, Connor agrees to the 2% offer.

By executing Transaction A, Connor is:

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Amie Lear, CFA, is a quantitative analyst employed by a brokerage firm. She has been assigned by her supervisor to cover a number of different equity and debt investments. One of the investments is Taylor, Inc. (Taylor), a manufacturer of a wide range of children's toys. Based on her extensive analysis, she determines that her expected return on the stock, given Taylor's risks, is 10%. In applying the capital asset pricing model (CAPM), the result is a 12% rate of return.

For her analysis of the returns of Devon, Inc. (Devon), a manufacturer of high-end sports apparel, Lear intends to use the Fama-French model (FFM). Devon is a small-cap growth stock that has traded at a low market-to-book value in recent years. Lear's analysis has provided a wealth of quantitative information to consider. The return on a value-weighted market index minus the risk-free rate is 5.5%, the small-cap return premium is 3.1%, the value return premium is 2.2%, and the liquidity premium is 3.3%. The risk-free rate is 3.4%. The market, size, relative value, and liquidity betas for Devon are 0.7, -0.3, 1.4, and 1.2, respectively. In estimating the appropriate equity risk premium, Lear has chosen to use the Gordon growth model.

Lear's assistant, Doug Saunders, presents her with a report on macroeconomic multifactor models that includes the following two statements:

Statement 1: Business cycle risk represents the unexpected change in the difference between the return of risky corporate bonds and government bonds.

Statement 2: Confidence risk represents the unexpected change in the level of real business activity.

Lear is also attempting to determine the most appropriate method for determining the required return for Densmore, Inc. (Densmore), a closely held company that is considering a debt issue within the next year. The company has not previously issued debt securities to the public, relying instead on bank financing. She realizes that there are a number of models to consider, including the CAPM, multifactor models, and build-up models.

Lear's choice of the Gordon growth model is an example of which of the following types of estimates of the equity risk premium?

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Sharon Foster, 56, is an executive at a large Biotech firm. Foster plans to retire in five years, to travel and spend time with her grandchildren. Foster is in excellent health, although her husband died several years ago. Foster's only significant asset is her employer's 401(k) retirement plan. Her salary is more than adequate to cover her living expenses until she retires, but she does not anticipate that she will accumulate any additional savings beyond her retirement account. The balance in her account currently is $3.2 million, but Foster estimates that by the time she retires the account will have grown to $4.5 million. She expects that her pretax living expenses, including a liberal travel budget, will be $150,000 per year, beginning when she retires. She is willing to take risk to achieve her financial goals. Her retirement account is currently invested 80% in stocks and 20% in bonds. Foster estimates her post-retirement income tax rate to be 35%, which is about the same as her current tax rate.

As she is starting to plan her retirement, Foster has turned to her longtime friend, Don Welch, CFA, who is a portfolio manager at Scientific Investments, LLC . Welch is considering three different mutual funds for Foster's account. All three are well-diversified funds of large capitalization stocks. The expected returns and standard deviations of each fund are shown below in Exhibit 1. Welch assumes a risk-free rate of return of 3.0%.

Welch believes in stock market efficiency, but he also believes that individual securities are mispriced by the market from time to time. He has recently reviewed research related to the Treynor-Black (TB) model of security selection and portfolio optimization. Welch refers to a prospectus from Fund D, which uses the TB framework in developing its portfolios. In discussing their use of the TB model, the prospectus cites an example where an active portfolio of five stocks is combined with a passive, index portfolio. The portfolio weights of the stocks are in Exhibit 2.

Welch further notes that the beta of the active portfolio is 0.90, although the standard deviation of the portfolio's returns is high. Of the five stocks shown in the portfolio, three have positive alphas, and two have negative alphas. A footnote to the sample data states that the sample assumes that the analysts* alpha forecasts are perfect.

Welch is reviewing Foster's account, together with the mutual fund data, in an attempt to develop a long-term investment plan for Foster.

In preparing an investment policy statement for Foster, her time horizon would most likely be described as:

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The board members for Kazmaier Foods have gathered for their quarterly board of directors meeting. Presiding at the meeting is the Chairman and CEO for Kazmaier, Phil Hinesman. The other eight members of the board are also present, including Allen Kazmaier, the brother of Kazmaier's founder; Elaine Randall, Executive Vice President for Emerald Bank, which Kazmaier uses to obtain short-term financing; and Bill Schram, Kazmaier's President and Chief Operating Officer. Each of the directors was elected to serve on the board for a 4-year term. They were elected two at a time over the past three years. With the exception of Hinesman, Allen Kazmaier, Randall, and Schram, board members had no ties to Kazmaier prior to joining the board and had no personal relationships with management. In addition to the regular board meetings, the five independent board members get together annually, in a meeting separate from the regular board meetings, to discuss the company's operations.

Item 1 on the board meeting agenda is a discussion about the importance of corporate governance and how Kazmaier can improve its corporate governance system. Hinesman begins the discussion by saying, "A strong system of corporate governance is important to our shareholders. Studies have shown that, on average, companies with strong corporate governance systems have higher measures of profitability than companies with weak corporate governance systems." Randall adds her comment to the discussion: "The lack of an effective corporate governance system increases risk for our investors. If we do not have the appropriate checks and balances in place, our investors may be exposed to the risk that information used to make decisions about our firm is misleading or incomplete, as well as the risk that mergers or acquisitions the firm enters into will benefit management at the expense of shareholders."

After a lengthy discussion, the board agrees on five separate recommendations that will enhance its current system of corporate governance. One of these recommendations is to change the function and structure of the board's audit committee. Currently the audit committee consists of Matthew Bortz, David Smith, and Ann Williams---three independent directors who each have backgrounds in finance and accounting. The board agrees that one more member should be added to the committee and that the committee should expand its list of responsibilities.

Item 2 on the agenda for the board of directors' meeting is a report from Kazmaicr's Chief Financial Officer, Doug Layman. The following information was included in the material that was distributed to each board member before the meeting:

Current share price: $40.00

Shares outstanding: 56, 250,000

Estimated earnings: $112.5 million

Planned capital spending: $150 million

Target debt-to-equity ratio 1 to I

Cost of equity: 8.0%

Constant growth rate: 5.2%

Layman tells the board that his analysis indicates that, based on a constant-growth dividend discount model, the initiation of an $0.80 per share dividend would reduce the cost of equity by 1.2% and increase the value of the firm's stock, assuming that earnings, the cost of debt, and the constant growth rate don't change.

Item 3 on the agenda is the sale of Kazmaier's condiment packaging division to Sautter Packaging and Supply Company. Layman believes the sale will net the company $50 million, payable in cash. After discussing the pros and cons of selling the division, the directors agree that the sale is in the best interests of the company and its shareholders. The directors then move to a vote, and the sale of the condiment packaging division is approved unanimously. The committee then moves on to discuss what to do with the proceeds from the sale. Williams suggests that paying out the $50 million to shareholders as a special dividend would continue to give the firm flexibility in how it uses its excess cash. Smith tells the board that a share repurchase can be thought of as an alternative to a cash dividend, and that if the tax treatment between the two alternatives is the same, investors should be indifferent between the two. After debating the merits of special dividends and stock repurchases, Kazmaier's board authorizes the proceeds from the sale of the condiment packaging division to be used for the purchase of $50 million worth of outstanding shares.

An external agency recently included Kazmaier in a review of corporate governance systems to determine whether or not the structure of the board of directors was consistent with corporate governance best practices. The agency scored companies based on the following criteria:

Criterion 1: Composition of the board of directors.

Criterion 2: Chairman of the board of directors.

Criterion 3; Method of electing the board.

Criterion 4: Frequency of separate sessions for independent directors.

Each of the four criteria was weighted equally, with the firm receiving a positive mark for being in compliance with corporate governance best practice.

A month after the board meeting, the price of Kazmaier stock is still at $40 per share, and the sale of Kazmaier's condiment packaging division does not go through. In order to finance the approved share repurchase, Kazmaier is forced to borrow funds. Schram states, "I am concerned that the cost of the debt used to repurchase shares may cause a reduction in earnings per share."

Jennifer Nagy, a vice president in Kazmaier's finance division, tells Schram not to be concerned about using debt to finance the share repurchase because the rationale behind the repurchase is sound. Nagy then writes down some of the common rationales for share repurchases and hands them to Schram.

Rationale 1: Repurchasing shares can prevent the EPS dilution that comes from the exercise of employee stock options.

Rationale 2: Management can use a share repurchase to alter the company's capital structure by decreasing the percentage of equity.

Rationale 3: Like a dividend increase, a share repurchase is a way to send a signal to investors that Kazmaier's management believes the outlook for the company's future is strong.

How many of Nagy's rationales for a share repurchase are valid?

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Lena Pilchard, research associate for Eiffel Investments, is attempting to measure the value added to the Eiffel Investments portfolio from the use of 1-year earnings growth forecasts developed by professional analysts.

Pilchard's supervisor, Edna Wilms, recommends a portfolio allocation strategy that overweights neglected firms. Wilms cites studies of the "neglected firm effect," in which companies followed by a small number of professional analysts are associated with higher returns than firms followed by a larger number of analysts. Wilms considers a company covered by three or fewer analysts to be "neglected."

Pilchard also is aware of research indicating that, on average, stock returns for small firms have been higher than those earned by large firms. Pilchard develops a model to predict stock returns based on analyst coverage, firm size, and analyst growth forecasts. She runs the following cross-sectional regression using data for the 30 stocks included in the Eiffel Investments portfolio:

Ri = b0 + b,COVERAGEi + b2 LN(SIZEi) + b3(FORECASTi) + ei

where:

Ri = the rate of return on stock i

COVERAGEi = one if there are three or fewer analysts covering stock

i, and equals zero otherwise

LN(SIZEi) = the natural logarithm of the market capitalization

(stock price times shares outstanding) for stock i,

units in millions

FORECASTi = the 1-year consensus earnings growth rate forecast for stock i

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

The standard error of estimate in Pilchard's regression equals 1.96 and the regression sum of squares equals 400.

Wilrus provides Pilchard with the following values for analyst coverage, firm size, and earnings growth forecast for Eggmann Enterprises, a company that Eiffel Investments is evaluating.

Wilrus asks Pilchard to assess the overall significance of her regression. To address the question, Pilchard calculates the R-square. She also decides to run a test of the significance of the regression as a whole. Determine the appropriate test statistic she should use to test the overall significance of the regression.

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