Question 1

Yi Tang updates several economic parameters monthly for use by the analysts and the portfolio managers at her firm. If economic conditions warrant, she will update the parameters even more frequently. As a result of an economic slowdown, she is going through this process now.
The firm has been using an equity risk premium of 5.6%, found with historical estimates. Tang is going to use an estimate of the equity risk premium found with a macroeconomic model. By comparing the yields on nominal bonds and real bonds, she estimates the inflation rate to be 2.6%. She expects real domestic growth to be 3.0%. Tang does not expect a change in price/earnings ratios. The yield on the market index is 1.7% and the expected risk-free rate of return is 2.7%.
Elizabeth Trotter, one of the firm's portfolio Managers, asks Tang about the effects of survivorship bias on estimates of the equity risk premium. Trotter asks, 'Which method is most susceptible to this bias, historical estimates, Gordon growth model estimates, or survey estimates?'
Tang wishes to estimate the required rate of return for Northeast Electric (NE) using the Capital Asset Pricing Model (CAPM) and the Fama-French three factor model. She is using the following information to accomplish this:
* The risk-free rate of return is 2.7%.

* The expected risk premiums arc:

* The beta coefficient in the CAPM is estimated to be 0.63.
* The betas (factor sensitivities) for the three Fama-French factors are 1.00 for the market factor, -0.76 for the size factor, and -0.04 for the book-to-markct factor.
Trotter also asks Tang about adjusted betas. She says, 'We use a formula for the adjusted beta where the adjusted beta = (2/3) (regression beta) + (1/3) (1.0). How do the adjusted betas compare to the original regression betas?'
Trotter has one final question for Tang. Trotter says, 'We need to estimate the equity beta for VixPRO, which is a private company that is not publicly traded. We have identified a publicly traded company that has similar operating characteristics to VixPRO and we have estimated the beta for that company using regression analysis. We used the return on the public company as the dependent variable and the return on the market index as the independent variable. What steps do I need to take to find the beta for VixPRO equity? The companies have different debt/equity ratios. The debt of both companies is very low risk, and I believe I can ignore taxes.'
The best response to Trotter's question about survivorship bias is:

Options :

A : historical estimates.

B : Gordon model estimates.

C : survey estimates.

Answer: A

Question 2

Erich Reichmann, CFA, is a fixed-income portfolio manager with Global Investment Management. A recent increase in interest rate volatility has caused Reichmann and his assistant, Mel O'Shea, to begin investigating methods of hedging interest rate risk in his fixed income portfolio.
Reichmann would like to hedge the interest rate risk of one of his bonds, a floating-rate bond (indexed to LIBOR). O'Shea recommends taking a short position in a Eurodollar futures contract because the Eurodollar contract is a more effective hedging instrument than a Treasury bill futures contract.
Reichmann is also analyzing the possibility of using interest rate caps and floors, as well as interest rate options and options on fixed income securities, to hedge the interest rate risk of his overall portfolio.
Reichmann uses a binomial interest rate model to value 1-year and 2-year 6% floors on 1-year LIBOR, both based on $30 million principal value with annual payments. He values the 1-year floor at $90,000 and the 2-year floor at $285,000.
Reichmann has also heard about using interest rate collars to hedge interest rate risk, but is unsure how to construct a collar.
Finally, Reichmann is interested in using swaptions to hedge certain investments. He evaluates the following comments about swaptions.
* If a firm anticipates floating rate exposure from issuing floating rate bonds at some future date, a payer swaption would lock in a fixed rate and provide floating-rate payments for the loan. It would be exercised if the yield curve shifted down.
* Swaptions can be used to speculate on changes in interest rates. The investor would buy a receiver swaption if he expects rates to fall.
What would be the most appropriate way for Reichmann to construct an interest rate collar to hedge the fixed-rate portion of the portfolio using the 2-year 6% floor and a 2-year 12?p?

Options :

A : Buy the floor and buy the cap.

B : Buy the floor and sell the cap.

C : Sell the floor and buy the cap.

Answer: C

Question 3

Henke Malfoy, CFA, is an analyst with a major manufacturing firm. Currently, he is evaluating the replacement of some production equipment. The old machine is still functional and could continue to serve in its current capacity for three more years. Tf the new equipment is purchased, the old equipment (which is fully depreciated) can be sold for $50,000. The new equipment will cost $400,000, including shipping and installation. If the new equipment is purchased, the company's revenues will increase by $175,000 and costs by $25,000 for each year of the equipment's 3-year life. There is no expected change in net working capital.
The new machine will be depreciated using a 3-year MACRS schedule (note: the 3-year MACRS schedule is 33.0% in the first year, 45% in the second year, 15% in the third year, and 7% in the fourth year). At the end of the life of the new equipment (i.e., in three years), Malfoy expects that it can be sold for $10,000. The firm has a marginal tax rate of 40%, and the cost of capital on this project is 20%. In calculation of tax liabilities, Malfoy assumes that the firm is profitable, so any losses on this project can be offset against profits elsewhere in the firm. Malfoy calculates a project NPV of-$62,574.
Suppose for this question only that Malfoy has forgotten to reflect a decrease in inventory that will result at the beginning of the project. The most likely effect on estimated project NPV of this error:

Options :

A : is to overestimate NPV.

B : is to underestimate NPV.

C : depends on whether the inventory is assumed to build back up to its previous level at the end of the project or the decrease in inventory is permanent.

Answer: B

Question 4

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 International Oilfield is a significantly integrated sales division and virtually all operating, investing, and financing decisions are made by Continental Supply, foreign currency gains and losses that arise from the consolidation of International Oilfield should be reported in:

Options :

A : shareholders equity.

B : operating cash flow.

C : net income.

Answer: C

Question 5

Paul Durham, CFA, is a senior manager in the structured bond department within Newton Capital Partners (NCP), an investment banking firm located in the United States. Durham has just returned from an international marketing campaign for NCP's latest structured note offering, a series of equity linked fixed-income securities or ELFS. The bonds will offer a 4.5% coupon paid annually along with the annual return on the S&P 500 Index and will have a maturity of five years. The total face value of the ELFS series is expected to be $200 million.

Susan Jacobs, a fixed-income portfolio manager and principal with Smith & Associates, has decided to include $10 million worth of ELFS in her fixed-income portfolio. At the end of the first year, however, the S&P 500 Index value is 1,054, significantly lower than the initial value of 1,112 set by NCP at the time of the ELFS offering. Jacobs is concerned that the four remaining years of the ELFS life could have similar results and is considering her alternatives to offset the equity exposure of the ELFS position without selling the bonds, Jacobs decides to offset her portfolio's exposure to the ELFS by entering into an equity swap contract. The LIBOR term structure is shown below in Exhibit 1.

After hearing of her plan, one of the other partners with Smith & Associates, Jonathan Widby, feels it is necessary to meet with Jacobs regarding her proposed strategy. Mr. Widby makes the following comments during the meeting:
'You should also know that I am quite bullish on the stock market for the near future. Therefore, as an alternative strategy, I recommend that you establish a long position in a 1 x 3 payer swaption. This strategy would allow you to wait and see how the market performs next year but will give you the ability to enter into a 2-year swap with terms that can be established today should the market have another down year.
If, however, you choose to proceed with your strategy, know that credit risk for an equity swap is greatest toward the end of the swap's life. Thus, analysts tracking your portfolio will not be happy with the added credit risk (hat your portfolio will be exposed to as the swap nears the end of its tenor. You should think about what credit derivatives you can use to manage this risk when the time comes.'
To offset any credit risk associated with the equity swap, Widby recommends using an index trade strategy by entering into a credit default swap (CDS) as a protection buyer. Widby's strategy would involve purchasing credit protection on an index comprising largely the same issuers (companies) included in the equity index underlying the swap. Widby suggests the CDS should have a maturity equal to that of the swap to provide maximum credit protection.
Evaluate, in light of the appropriate equity swap strategy for Jacobs's portfolio, Mr. Widby's comments regarding the credit risk and use of swaptions in Jacobs's portfolio.

Options :

A : Widby is correct only with respect to credit risk.

B : Widby is correct only with respect to the swaptions.

C : Widby is incorrect with respect to both credit risk and the swaptions.

Answer: C

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