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In-depth Questions and Explanations
According to the Modigliani-Miller propositions (with taxes), if a company increases its debt level, its market value will most likely:
- decrease since the costs of financial distress are increasing.
- remain the same since the market value is unaffected by the capital structure.
- increase proportionally to the change in debt.
Explanation:
The Modigliani-Miller (MM) propositions assume perfect capital markets (ie, no arbitrage, no transaction or bankruptcy costs, and symmetric information) and assert that a company’s market value equals the present value of its future cash flows. Modigliani and Miller propose that, in the absence of taxes:
- A company’s capital structure does not affect its value (MM I without taxes); and
- A company’s cost of equity (re) is directly proportional to its debt-to-equity ratio (D/E), but WACC remains constant (MM II without taxes).
However, these propositions change when there are corporate taxes:
- The market value of a levered company is greater than the value of an unlevered but otherwise identical company; tax-exempt interest payments improve the levered company’s cash flows, increasing its value. The difference in value is the amount of the debt tax shield (tD), which is the product of a company’s tax rate (t) and value of debt (D) (MM I with taxes).
- A company’s re is directly proportional to D/E, adjusted by (1 − t). Greater leverage will increase the cost of equity, but at a slower pace due to taxes. The greater the tax rate (t), the slower the increase in re when D/E increases (MM II with taxes).
Therefore, with taxes, an increase in debt will proportionally increase a company’s value and reduce its WACC.
(Choice A) The MM propositions assume no cost of financial distress.
(Choice B) The market value would remain the same in the absence of taxes.
Things to remember:
The Modigliani-Miller (MM) propositions assume perfect capital markets (ie, no arbitrage, no transaction or bankruptcy costs, and symmetric information). When these propositions include corporate taxes, greater leverage will increase a company’s market value (MM I) and reduce its WACC (MM II).
If a professional organization has standards of conduct in addition to its code of ethics, the purpose of the standards is most likely to describe:
- shared principles.
- laws and regulations.
- acceptable behaviors.
Explanation:
| Instruments for compliance with professional ethics | ||
|---|---|---|
| Instrument | Owner | Describes |
| Code of ethics | Professional organization | Shared principles |
| Standards of conduct | Professional organization | Minimally acceptable behavior |
| Laws and regulations | Government | Legal limits of behavior |
A code of ethics is a professional organization’s statement of shared principles. Standards of conduct provide a guide to practicing the principles outlined in the code of ethics. Standards of conduct also clarify the minimally acceptable behaviors required to conform to the code of ethics. Although not addressed directly in standards of conduct, adherence to civil laws and regulations may be the minimally acceptable behavior in some cases.
Standards of conduct may be principle-based or rule-based. Principle-based standards are universally applicable to members of the profession and are based on the principles outlined in the code of ethics. Rule-based standards, while also relating to the principles in the code of ethics, are usually more narrowly applicable and specific to certain members or scenarios that may arise.
A code of ethics may or may not be accompanied by standards of conduct whereas standards of conduct exist only to enhance their associated code of ethics. CFA Institute has adopted both a code of ethics and standards of conduct (the “Code and Standards”); CFA charterholders and candidates are expected to know and comply with both.
(Choice A) Standards of conduct are used to describe minimally acceptable behaviors or practices, given the shared principles of the code of ethics. The code of ethics describes the shared principles.
(Choice B) Standards of conduct do not describe civil laws and regulations.
Things to remember:
Standards of conduct are used to clarify the minimally acceptable behaviors required to conform to the shared principles stated in a code of ethics; they do not address applicable civil laws and regulations.
At the end of 20X4, a hedge fund had $25 million in assets under management (AUM). The fund has the following fee structure, high-water mark, and 20X5 results:
| Selected Data | |
| Management fee (average assets) | 1% |
| Incentive fee (net of management fee) | 10% |
| Soft hurdle rate | 6% |
| High-water mark (millions) | $27 |
| Year-end fund assets 20X5 (millions) | $30 |
Assuming no inflows or outflows, the incentive fee (in $) earned by this hedge fund for 20X5 is closest to:
- 109,000
- 272,500
- 300,000
Explanation:
Hedge funds charge a management fee and an incentive fee. The management fee is calculated as a percentage of the total value of the fund’s assets under management (AUM). It is assessed each year regardless of profitability.
The incentive fee is levied against the fund’s annual gains, subject to certain conditions. It is calculated either gross or net of the management fee. The net calculation subtracts the management fee from AUM to arrive at an adjusted AUM that is used to calculate the fund’s profits.
The high-water mark represents the value of AUM, net of fees, at any time during the fund’s existence. To earn an incentive fee, the fund must exceed the high-water mark, the base from which the fee is calculated.
The hurdle rate is the minimum profit that the fund must earn (usually annually) before it receives an incentive fee. The hurdle rate can either be “soft,” meaning that the incentive fee is calculated based on the entire profit, or “hard,” meaning that the incentive fee is based on only the excess profit above the hurdle rate.
In this scenario, the fund generated net returns in 20X5 of 18.9% ( = (29.725 – 25) / 25 ), above the soft hurdle rate of 6%, and eclipsed the high-water mark of $27 million. Therefore, the fund earned an incentive fee of 10% of profits, net of the management fee on average assets of $27,500,000:
0.10 × (29,725,000 − 27,000,000) = $272,500.
(Choice A) $109,000 is the result of incorrectly assuming a hard hurdle rate is in effect.
(Choice C) $300,000 is the incentive fee if management fees are not deducted.
Things to remember:
Hedge funds charge both a fixed management fee and a variable incentive fee. The incentive fee is contingent on whether the fund earns a profit and may be subject to a high-water mark and hurdle rate.
In the short run, a company maximizing profit in a market with perfect competition produces at a quantity that most likely results in:
- economic profits equal to zero.
- marginal revenue equal to marginal cost.
- market price greater than marginal revenue.
Explanation:
A firm operating under perfect competition maximizes economic profit by producing and selling at the quantity where marginal revenue (MR) equals marginal cost (MC). Cost in this context includes opportunity costs (eg, the owners’ required return from the business). Perfectly competitive firms can earn economic profits in the short run, but even if economic profits are zero or negative, a firm may be earning an accounting profit.
MR, the incremental revenue from selling one additional unit, depends on the firm’s demand curve. In the case of perfect competition, the demand curve for any individual firm is a horizontal line at the market equilibrium price, since demand is perfectly elastic. Therefore, market price equals MR at all quantities (Choice C).
MC, the incremental cost to produce one additional unit, depends on the firm’s cost structure. Producing at a quantity greater than where MR = MC means that the incremental cost for each unit exceeds the incremental revenue generated by that unit and the firm generates a loss on each additional unit sold. Producing at a lower quantity means that the firm forgoes economic profit (in the short run) since the additional revenue from a unit sold would exceed the cost of the unit.
(Choice A) Perfectly competitive firms can earn economic profits in the short run. However, in the long-run, the positive economic profits will attract new firms, which will increase supply/lower price until economic profit is zero.
Note: Although this question specifically addresses perfect competition, the condition that firms optimally produce when MR = MC applies to all market structures. It is likely that the exam will have questions on this topic.
Things to remember:
Under perfect competition, a firm maximizes short-run economic profit by producing and selling at the quantity where marginal revenue (MR) equals marginal cost (MC). Since there is perfectly elastic demand, price also equals MR for all quantities. Short-run, but not long-run, economic profits are possible. However, a firm may earn an accounting profit even if economic profits are zero or negative.
An analyst observes the following market data for one American put option:
| Selected Data | |
| (in CAD) | |
| Stock price | 48 |
| Strike price | 50 |
| Option premium | 4 |
This option’s moneyness is best described as:
- in the money.
- at the money.
- out of the money.
Explanation:
Moneyness refers to the relationship between an option’s strike price and the underlying stock price and is indicative of the option’s intrinsic value. An option trading at the money or out of the money has no intrinsic value. An option trading in the money has intrinsic value:
- For an in-the-money call option, the underlying stock price is greater than the strike price. This gives the call owner the right to buy the stock at a price lower than the market price, which in turn gives the option intrinsic value.
- For an in-the-money put option, the strike price is greater than the underlying stock price. This gives the put owner the right to sell the stock at a price higher than the market price, which in turn gives the option intrinsic value.
In this scenario, the put option’s underlying stock price is less than its strike price. Therefore, the option is trading in the money. Note that the option’s premium is irrelevant to determining the option’s intrinsic value; it would, however, be relevant to determining the option’s profit at exercise.
(Choice B) If the stock price equals the strike price, the option is trading at the money (ATM). At expiration, an ATM option is economically equivalent to owning the underlying asset.
(Choice C) For a call option, if the stock price is less than the strike price, the option is trading out of the money (OTM) and has no intrinsic value. The same is true for a put option if the stock price is greater than the strike price.
Things to remember:
Moneyness refers to the relationship between an option’s strike price and the underlying stock price. If the stock price equals the strike price, the option is trading at the money. For a call (put) option, if the stock price is greater (less) than the strike price, the option is trading in the money. For a call (put) option, if the stock price is less (greater) than the strike price, the option is trading out of the money.
An analyst wants to use the asset-based valuation approach to determine the intrinsic value of a company’s stock and gathers the following data:
To reflect fair values, the analyst believes that the long-term assets should be adjusted down by 25% and the long-term debt should be adjusted up by 5%. If there are 500 million shares currently outstanding, and the company’s stock trades at $29 per share, then the stock is most likely:
- undervalued.
- fairly valued
- overvalued.
Explanation:
Analysts can use the asset-based valuation model to estimate the intrinsic equity value of a firm by subtracting the fair value of liabilities from the fair value of assets. The intrinsic stock price can be calculated by dividing the intrinsic equity value by the number of shares outstanding. If the market price of the stock is greater than its intrinsic value, then the stock is overvalued, and vice versa.
The stock is overvalued since its price is trading at 29, which is above its intrinsic value of 28.
Things to remember:
Analysts can use the asset-based valuation model to estimate the intrinsic equity value of a firm by subtracting the fair value of liabilities from the fair value of assets. The intrinsic stock price can be calculated by dividing the intrinsic equity value by the number of shares outstanding.
Under IFRS, if a company has an asset with an indefinite useful life, the company is least likely to be required to disclose the:
- amortization method used.
- carrying value of the asset.
- reason(s) the asset’s useful life is considered indefinite.
Explanation:
Under IFRS, an intangible asset with an indefinite useful life is not amortized. Instead, it must be tested for impairment annually or more frequently if necessary. Since the asset is not amortized, there is no amortization method to be disclosed.
For intangible assets with indefinite lives, IFRS require two disclosures:
-
The carrying amount of the asset on the balance sheet
-
The reasons the useful life is considered indefinite, including factors that support the assessment (eg, legal rights, market stability, lack of foreseeable obsolescence)
(Choice B) IFRS require disclosure of the carrying amount for each class of intangible assets, including intangible assets with indefinite useful lives.
(Choice C) IFRS require a company to justify why the asset is considered to have an indefinite useful life.
Things to remember:
Under IFRS, an intangible asset with an indefinite useful life is not amortized, so there is no amortization method to be disclosed. For intangible assets with indefinite useful lives, IFRS require two disclosures: the carrying amount of the asset on the balance sheet and the reasons the useful life is considered indefinite, including the factors that support that assessment.
To test whether a mutual fund’s mean return differs from a model’s predicted mean return when the mutual fund’s standard deviation is unknown, the most appropriate method is to calculate a:
- chi-square statistic with n − 1 degrees of freedom.
- t-statistic using the sample mean and sample standard deviation.
- z-statistic with critical values from the standard normal distribution.
Explanation:
Hypothesis testing for a population mean, if the population standard deviation is unknown, requires the use of a t-test based on the t-distribution. The t-test involves:
- calculating a sample test statistic using a sample mean and standard deviation,
- referencing a confidence or significance level, and
- determining whether to reject the null hypothesis (Ha).
These tests are commonly applied in forward-looking return estimation applications when population parameters are unknown and sample data are used to make inferences.
The t-distribution accounts for the additional sampling variability introduced by estimating population variance from the sample. As the sample size increases, the t-distribution results should approach the population’s distribution. For smaller samples, using the t-distribution provides a reliable inference when evaluating whether the sample mean significantly deviates from the population mean.
(Choice A) A chi-square distribution is used to evaluate hypotheses concerning variances, not means. This distribution is inappropriate when testing the equality between a sample mean and a hypothesized population mean.
(Choice C) A z-test requires knowledge of the population standard deviation, which is usually unavailable, as in this case. This requirement makes z-testing an unsuitable method for most return-based hypothesis tests.
Things to remember:
Hypothesis tests for population means typically require the use of a t-test when the population standard deviation is unknown. This situation is common in return estimation when analysts are working with small sample data sets. The t-distribution accounts for the added uncertainty of estimating variability from small samples.
Portfolios on the efficient frontier most likely differ from those on the minimum-variance frontier in that efficient frontier portfolios:
- exclude portfolios with lower returns per level of risk.
- combine the risk-free asset with the optimal risky portfolio.
- maintain a lower risk-return tradeoff through passive management.
Explanation:
The minimum-variance frontier (MVF) includes all portfolios with the lowest possible risk (ie, standard deviation) for each level of expected return. The efficient frontier (EF) is a subset of the MVF and includes only portfolios offering the highest expected return for a given level of risk. These EF portfolios represent the most desirable risk-return combinations for rational, risk-averse investors.
In the image:
-
Portfolio F is the global minimum-variance portfolio (GMVP), the portfolio with the lowest possible risk on the MVF. The GMVP separates inefficient portfolios (eg, Portfolio G) from the efficient portfolios on the EF (eg, Portfolios E and C). Portfolio G provides lower returns for the same level of risk, compared with Portfolio E.
-
The efficient frontier (EF) is the portion of the MVF above Portfolio F, including Portfolios E and C. These portfolios dominate the inefficient portfolios below F because they provide better risk-return tradeoffs.
-
Portfolio C provides the same expected return as Portfolios A and B but with a lower standard deviation (risk), making it more efficient and attractive to a rational, risk-averse investor.
(Choice B) Combining the risk-free rate and the optimal risky portfolio describes the capital allocation line, which is unrelated to the distinction between the MVF and the EF.
(Choice C) Portfolios on the EF maximize returns for a given risk level, independent of active or passive management.
Things to remember:
The efficient frontier (EF) is a subset of the minimum variance frontier (MVF) that includes only portfolios offering the best risk-return tradeoffs. Inefficient portfolios, below the global minimum-variance portfolio (GMVP), offer lower returns for the same risk or higher risk for the same return. Rational investors prefer portfolios on the EF for their superior efficiency.
Compared with analytical duration, empirical duration is the more appropriate measure to estimate the impact of benchmark interest rate changes for a bond portfolio of:
- US agency bonds.
- global high-yield corporate bonds.
- highly rated European covered bonds.
Explanation:
Duration is a linear estimate of the change in a bond’s price given a change in its yield.
- Analytical duration (eg, modified duration) estimates price and yield changes given a change in benchmark interest rates, based on current market information.
- Empirical duration estimates a bond’s interest rate sensitivity using the correlations between benchmark yields and yield spreads based on historical data and statistical relationships with other factors (eg, credit, liquidity).
Empirical and analytical duration will be very similar for bonds that have similar risks as benchmark securities, but will differ for bonds with considerable spread risk, such as credit, liquidity, or country risk, etc. The more types of risk a bond is exposed to, besides interest rate risk, the more relevant its empirical duration will be. Empirical duration is particularly useful in predicting price changes during periods of financial stress (eg, flight to quality), as correlations among risky assets increase dramatically.
Global high-yield corporate bonds represent a wide variety of credit, country, and liquidity risks, in addition to interest rate risk, so empirical duration can be expected to be a more appropriate predictor of their prices than analytical duration.
(Choices A and C) US agency and highly rated (eg, AAA, AA+) European covered bonds carry little credit risk; therefore, both duration measures will be very similar.
Things to remember:
Empirical duration estimates a bond’s interest rate sensitivity using historical data and statistical relationships with other factors, quantifying the correlations between benchmark yields and yield spreads. Empirical duration is relevant for bonds with considerable spread risk, particularly during periods when benchmark yields and spreads may be correlated, as it can provide a more accurate measure of risk.
Passage
Compass Engineering's board of directors is deciding between cash dividends or a share repurchase program as a method to begin returning cash to shareholders. Liam Fischer, a member of the board, states that both cash dividends and share repurchases have certain advantages that should be considered:
| Advantage 1: | Share repurchases tend to be more flexible. Although dividends can be raised, lowered, or suspended, they appear to create an expectation among investors that the distribution will continue in the future. Share repurchases do not seem to create the same expectation. |
| Advantage 2: | If the tax rates for capital gains and dividends are the same, and the information content is the same, then shareholders' wealth will be greater with cash dividends since all shareholders receive cash. |
Alicia Wu, the chairman of the board, indicates that Compass should review the long-term trends in the country (the United Kingdom) before deciding.
After deliberation, the board favors a share repurchase program. Jessica King, another member of the board, is concerned about the effect of share repurchases on Compass' EPS. She collects the following data for 20X2:
In addition, King wonders what effect share repurchases have on companies' book values. She gathers data from three of Compass' peers who have made a share repurchase:
The board members then discuss the best approach for Compass to repurchase shares. King has identified two possible scenarios, both using the same amount to repurchase shares:
Scenario 1: Purchase shares using all cash on hand.
Scenario 2: Purchase shares with funds from an issuance of debt.
Wu states that her preference is to choose a method by which the company can control the process and execute it quickly. She also prefers a process that would allow Compass to discover the minimum price at which it can repurchase the desired number of shares.
Based on Scenario 1 and Exhibit 1, a share repurchase would cause Compass' 20X2 EPS to be closest to:
- £6.72
- £6.77
- £6.80
Explanation:
Share repurchases are a popular alternative to cash dividends for returning cash to shareholders. Repurchases allow companies to purchase shares currently being held by shareholders using one of several methods. Once repurchased, the shares are either held for reissue (ie, treasury shares) or retired (ie, canceled shares).
The repurchase leaves fewer shares for investors to hold (ie, shares outstanding), which often results in a change to a company's per-share financial ratios (eg, EPS). Like dividends, share repurchases are made using corporate cash, whether the cash is on hand or obtained through the issuance of new debt.
- When cash on hand is used, EPS always increases.
- When new debt is issued, the change in EPS depends on the company's after-tax cost of debt and its earnings yield.
In this question, Compass' EPS following the share repurchase would be £6.77, calculated below.
(Choice A) £6.72 results from incorrectly applying the company's tax rate to the cash used to repurchase shares, arriving at cash of £400 million [£500 million × (1 − 0.2)].
(Choice C) £6.80 incorrectly uses the company's share price instead of the purchase price to calculate the number of shares repurchased. Companies do not always repurchase shares at the market price.
Things to remember:
Share repurchases are a popular alternative to cash dividends. They often result in a change to a company's per-share financial ratios. When cash on hand is used for a repurchase, EPS will always increase. When new debt is issued instead, the change in EPS depends on a company's after-tax cost of debt and its earnings yield.
Passage
Tom Johnson, CFA, is a portfolio manager at Universal Advisors, a US-based wealth management firm that serves high-net-worth individuals and families. Universal's equity portfolio offering includes separately managed accounts (SMAs) in which clients own individual securities. Johnson manages the portfolio with an aggressive high-risk, high-reward strategy, investing mostly in small-cap growth stocks. To reduce transaction costs and to simplify trading and settlement, Universal buys only US-listed securities for client accounts.
Johnson instructs Francois Martin, a CFA Level II candidate and new equity analyst at the firm, to conduct research on Vent Industries, a French wind turbine manufacturer. Vent is dually listed on exchanges in France and in the US. Martin, a French national who recently moved to the US, is already familiar with the company since he has been following it personally for the past two years.
After completing due diligence on Vent, Martin is thoroughly impressed by the investment prospects and suggests that Johnson add the US-listed shares of Vent to client portfolios. Johnson, as the sole decision-maker, reviews Martin's research and financial models but wants to think about the suggestion before reaching a conclusion.
Martin is so impressed with Vent's investment prospects that he wants to buy it for his personal account. For guidance, Martin references Universal's publicly available personal transaction disclosure, which states only the following:
"Investment personnel are subject to policies and procedures regarding their personal trading."
Needing more detail, Martin checks with the firm's compliance officer, who informs him that the firm does have policies and procedures designed to prevent potential conflicts of interest related to personal trading. Universal does not require that employees obtain preclearance before trading, but the firm's policies do require:
- a two-day blackout period before and after client trades, and
- a quarterly report by its investment decision-making personnel on transactions and holdings.
Based on this information, Martin immediately places an order to buy Vent shares listed in France through his personal French brokerage account, which he established prior to joining Universal. Three days later, Johnson decides to invest for clients in the US-listed shares of Vent and places the order through Universal's trading desk.
Johnson is a board member for a local hospital endowment; for this, he receives modest compensation. Universal has approved Johnson's board participation and compensation. Johnson is considered to be a thoughtful and successful investor. The other board members, unhappy with the fees and performance of the endowment's existing income-oriented large-cap equity manager, asked Johnson a year ago if he would be willing to manage the equity portion of the endowment. Johnson responded by stating:
"The hospital provides so much to this community, I would be happy to manage the endowment's equity portfolio. It won't even take much time; I will manage the endowment portfolio as an exact replica of Universal's equity portfolio."
The next month, without informing Universal, Johnson began managing the endowment portfolio as a mirror image of Universal's equity strategy.
Recently, Johnson evaluated the investment prospects of an upcoming IPO for a small-cap biotech firm. The company does innovative cancer research, but it is still years away from profitability. After conducting thorough due diligence, Johnson has concluded this is a great investment opportunity; he would like the hospital endowment to participate, believing the other board members would be excited about the company's cancer research.
Johnson speaks to Universal's lead underwriter and requests that 5% of the firm's IPO allotment be allocated to the endowment. A few days later, when the IPO is priced and allocated, Universal receives 95,000 shares and the endowment receives 5,000 shares.
Do Universal's personal transaction disclosure policies comply with CFA Institute's required and recommended procedures?
- No.
- Yes, since no disclosure is required.
- Yes, since they meet the minimum disclosure requirements.
Explanation:
"Investment transactions for clients and employers must have priority over investment transactions in which a Member or Candidate is the beneficial owner."
Standard VI(B) Priority of Transactions stipulates that once a firm has established a policy on personal investing, specific reporting of personal holdings and securities transactions of investment personnel is required to ensure the policy is enforced. Since the policy's overriding goal is to address client concerns regarding personal securities transactions and any conflicts of interest for the firm's employees, enforcement procedures must also be established.
Key elements of the enforcement requirements include:
- Initial disclosure of holdings in which an employee has beneficial ownership (eg, for self, trust, spouse)
- Holdings disclosure, at least annually
- Duplicate transaction confirmations and periodic statements provided to the employer
- Preclearance procedures before the employee can trade
(Choice B) Standard VI(B) stipulates that duplicate transaction confirmations and periodic statements be provided, but it does not specify how frequently. Transaction confirmations should be done at the time of trade to ensure adequate supervision of activity, but quarterly holdings disclosure is adequate and common in most circumstances.
(Choice C) A blackout period is a recommended (not required) policy, and each firm has discretion regarding the period's duration. Although the minimum period is not specified, a blackout of two days before and after a client trade is likely adequate to minimize market impact and prevent a conflict of interest and/or front-running of client trades.
Things to remember:
The key requirements of Standard VI(B) for investment personnel include trade preclearance and reporting personal holdings and securities transactions.
Passage
Chao Li is a vice president at Tailwind Capital, a private equity (PE) firm. He is currently raising £100 million for Tailwind Fund A. Li meets with An Heng, an associate at Insular Insurance Co., a potential institutional investor. In their meeting, Li explains the general structure of PE funds to Heng:
Statement 1: The limited partners (LPs) and the general partner (GP) in a private equity fund participate in managing the fund.
Statement 2: The GP is entitled to carried interest, which is typically a percentage of the fund's profits after management fees.
Statement 3: PE funds are closed-end funds, so LPs can redeem their investments only at specified times.
Heng says, "I understand there are costs associated with investing in PE, such as significant performance fees, dilution costs whenever the PE firm starts new funds, and annual audit costs. And I know that there are some agency risks involved with investing in a PE fund. Is there a governance provision that would address GP gross negligence?"
Subsequently, Li raises the full £100 million for Fund A. One of the fund's investments is ModernWare, an online services company. The initial investment is £20 million: £13 million in debt, £2 million in preferred equity, and £5 million in the PE fund's equity. Tailwind plans to sell ModernWare 5 years from now and plans to reduce the debt balance by £10 million by the time of exit. The promised return for the preferred equity holders is 15%.
Several years after the fund's inception, Tailwind exits two investments: StoneWare and BronzeWare (Exhibit 1). Carried interest to the GP is accrued on a deal-by-deal basis and equals 20% of the profits from each exit. The hurdle rate is 10%. When a deal's IRR is above the hurdle rate, carried interest is accrued; when a deal's IRR is below the hurdle rate, a clawback penalty amount is accrued if there is a loss.
Twelve years after the fund's inception, Li meets with Heng again to review Fund A's performance, shown in Exhibit 2.
Which of Li’s statements on Tailwind's fund structure is incorrect?
- Statement 1
- Statement 2
- Statement 3
Explanation:
Statement 1: The limited partners (LPs) and the general partner (GP) in a private equity fund participate in managing the fund.
Statement 2: The GP is entitled to carried interest, which is typically a percentage of the fund's profits after management fees.
Statement 3: PE funds are closed-end funds, so LPs can redeem their investments only at specified times.
PE funds are typically structured as limited partnerships in which the GP (ie, fund manager) acts as an agent on behalf of the LPs (ie, investors). The GP actively manages the fund and is responsible for all debts (ie, unlimited liability). The LPs commit capital to the GP, and their liabilities are limited to their invested amounts. Statement 1 is incorrect since LPs are not actively involved in managing the fund.
(Choice B) In exchange for managing funds, GPs charge management fees, some transaction fees, and carried interest.
(Choice C) PE funds are closed-end funds since existing investors are restricted from redeeming their shares for long periods of time. In addition, new investors can be restricted from entering the fund during certain windows.
Things to remember:
A private equity fund consists of a general partner (GP) (ie, fund manager) and limited partners (ie, investors). The GP is entitled to management fees and carried interest in exchange for managing the fund. However, the GP is responsible for all the fund's debt (ie, unlimited liability), whereas the limited partners' liabilities are limited to their invested amounts.
Passage
Botan Saito is a portfolio manager for Spire Financial. Spire's investments are largely domestic, and Saito plans to diversify Spire's holdings by adding investments in international markets. Saito identifies three countries that he will research further. He collects the following economic data for each country, using average year-on-year growth rates:
During his research, Saito realizes that numbers are not fully explaining the economic differences in these countries. He further researches institutional economic information, shown in Exhibit 2:
Country 2 is planning to implement new policies that create a more open trade policy. Saito expects that this will result in a higher permanent steady-state GDP growth rate.
Saito is interested in how economic factors will ultimately impact each country's stock market. He notes that Country 3's:
- GDP growth is slightly above the country's steady-state GDP growth rate in 20X4;
- earnings-to-GDP ratio was above the country's historical average in 20X4; and
- price-to-earnings ratio of the country's publicly traded stocks was below its historical average in 20X4.
Saito is also interested in how potential GDP will affect each country's bonds. He arrives at the following conclusions:
Conclusion 1 Actual GDP growth relative to a country's potential GDP growth rate is an important factor in central bank decision-making and the likelihood of changes to the central bank's policies.
Conclusion 2 A decrease in a country's potential GDP growth rate increases the likelihood that the credit ratings on its sovereign debt will be downgraded.
Saito wishes to identify how capital deepening will affect each country's per capita output growth. Based on the neoclassical model, which of the following factors is most appropriate for Saito to consider?
- Capital-to-labor ratio
- Steady-state GDP growth
- Average hours worked per worker
Explanation:
Capital deepening is an increase in a country's capital per worker (ie, capital-to-labor ratio). When workers gain more capital, they traditionally become more productive. However, the neoclassical model of economic growth states that the per capita production function, which measures capital per worker against output per worker, exhibits diminishing marginal returns. Therefore, when a country has a greater capital-to-labor ratio, it will likely see a smaller per capita output increase from capital deepening than if it had a lesser capital-to-labor ratio, all else equal.
(Choice B) Steady-state GDP growth considers several factors, including capital growth, labor growth, capital and labor as a percentage of total factor cost, and total factor productivity. Therefore, this measure would not be the most appropriate to identify how capital deepening will affect each country's growth in output per capita.
(Choice C) Average hours worked per worker affects the factor of labor, not capital, when calculating economic output. Therefore, this measure would not be the most appropriate to use when specifically identifying how capital deepening will affect each country's growth in output per capita.
Things to remember:
Capital deepening is an increase in a country's capital per worker. In the neoclassical model, the per capita production function has diminishing returns. Therefore, a country with a greater capital-to-labor ratio will likely see a smaller output increase from capital deepening than a country with a lesser capital-to-labor ratio.
Passage
Herman Schmidt is a fund manager working at Rosige Zukunft LLC (RZ), a derivatives trading firm. RZ uses the carry arbitrage model to assess the value of bond forward contracts. Exhibit 1 contains information on several German government bonds that pay coupons once per annum and have five years remaining until maturity. Schmidt directs Hedwig Meyer, an RZ analyst, to price forward contracts on Bond A, Bond B, and Bond C. The 6-month risk-free rate is 1.50% and the 1-year risk-free rate is 2.00%.
Schmidt and Meyer discuss different methods for valuing interest rate and currency swaps. Exhibit 2 contains information on at-market EUR and CHF interest rate swaps, and the CHF/EUR exchange rate.
Schmidt has RZ initiate a fixed-for-fixed EUR/CHF currency swap, agreeing to pay 1.20% in CHF and receive 1.80% in EUR. RZ exchanges the swap notional with the counterparty at contract initiation, paying EUR 10 million and receiving CHF 10.5 million. Six months later, at-market 2.5-year fixed-for-fixed EUR/CHF currency swaps are quoted at 1.60% EUR for 1.40% CHF and the spot CHF/EUR exchange rate is 1.1000.
Schmidt anticipates that the equity of Dash Haber Ltd., a UK clothing retailer, will outperform versus expectations. He decides to use a 1-year, quarterly settled, equity-return-for-fixed-interest rate swap to gain long exposure to Dash Haber equity. Exhibit 3 contains information related to the swap:
All interest rates are annual compound rates and are based on a 360-day year.
Based on Exhibit 1, the no-arbitrage 6-month forward price of Bond A is most likely:
- less than its spot price.
- equal to its spot price.
- greater than its spot price.
Explanation:
The no-arbitrage forward price of an asset is the:
- future value of the asset's spot price, adjusted for the
- costs and benefits (ie, "carry" costs and benefits) of holding the asset to the forward contract expiration.
The forward price of a zero-coupon bond is just the future value of the bond's spot price since there are:
- no explicit carry costs, due to the opportunity cost of capital being captured in the future value of the spot price, and
- no carry benefits since a bondholder receives no periodic coupon payments.
As a result, CC0 and CB0 in the formula above both equal 0, reducing the calculation of the no-arbitrage forward price to:
In this scenario, the 6-month forward price of the 5-year zero-coupon bond (ie, Bond A) is calculated as:
F0 = 86.261 (1.015)0.5 = 86.906
If interest rates are positive, the no-arbitrage forward price of an asset with no holding costs or benefits is greater than the asset's spot price (Choices A and B). The spot/forward price difference reflects the opportunity cost of capital (eg, cost of financing a position in the asset) over the time to the forward contract expiration.
Things to remember:
The no-arbitrage forward price of an asset is the future value of the asset's spot price adjusted for the costs and benefits of holding the asset to the forward expiration. The forward price of an asset with no holding costs or benefits is above the asset's spot price by the opportunity cost of capital over the time to the forward expiration.
Passage
AussieParent Ltd, headquartered in Australia, is a multinational holding company that frequently engages in foreign currency transactions. AussieParent prepares its consolidated financial statements in accordance with IFRS. Its main subsidiary in Australia is Aussieteks, a distribution and logistics company.
On Dec 1 20X5, Aussieteks:
- purchased NZD 5,000,000 of supplies on credit from a New Zealand supplier, with payment due in 30 days in NZD, and
- sold and provided NZD 7,500,000 of services to a New Zealand customer on credit, with payment due in 60 days in NZD.
Aussieteks settles its payable on Dec 30 20X5 and collects its receivable on Jan 30 20X6. The company's fiscal year ends on December 31. The relevant exchange rates are shown in Exhibit 1 (NZD is the base currency):
AussieParent's Turkish subsidiary, Turkteks, began operations in 20X6 and primarily operates in Turkish lira (TRY). On May 30 20X6, Turkteks purchased inventory for TRY 50 million. Due to customer contract disputes, none of the inventory was sold in 20X6. By Dec 31 20X6, the general price index had increased by 65% since purchase, indicating hyperinflation. Economists expect the trend to continue for the next three years. The exchange rates for 20X6 were:
Separately, AussieParent consolidates the financial results of Nipponteks, its Japanese subsidiary, at the end of 20X6. Nipponteks primarily operates in AUD and has the following account balances on Dec 31 20X6 (all figures are in JPY):
-
Cash: 5,000,000
-
Receivables: 3,000,000
-
Payables: 5,850,000
-
Deferred income taxes: 1,150,000
The exchange rate on Dec 31 20X6 was AUD/JPY 0.0120, and the average exchange rate for 20X6 was AUD/JPY 0.0115.
Based on the rates in Exhibit 1, Aussieteks' foreign currency transaction gain (loss) on Jan 30 20X6 (in AUD) from collecting its accounts receivable is closest to:
- −7,500
- 22,500
- 30,000
Explanation:
Companies that purchase or sell goods or services in a foreign currency are exposed to transaction-based foreign exchange risk when settlement occurs after the initial transaction. When the settlement date occurs in a subsequent financial reporting period from the initial transaction date, companies must:
-
on the balance sheet date (eg, the end of the reporting period), remeasure the payable or receivable based on the FX rate on that date and recognize an unrealized transaction gain (loss) on the income statement, and
-
on the settlement date (which will occur in a subsequent recording period), recognize a transaction gain or loss based on changes in the FX rate from the last balance sheet date.
In this scenario, the initial sales transaction date is Dec 1 20X5, the balance sheet date is Dec 31 20X5, and the settlement date for collecting cash is Jan 30 20X6.
Aussieteks reported an AUD 30,000 FX gain on the balance sheet reporting date due to NZD appreciation. Then, Aussieteks experienced an AUD 7,500 translation loss due to NZD depreciation between Jan 1 20X6 and Jan 30 20X6.
(Choice B) AUD 22,500 is the entire net gain over both reporting periods. However, the value must be recorded, so a transaction gain (loss) must be recognized in both the period ending on the balance sheet date and the period ending on the settlement date.
(Choice C) AUD 30,000 is the unrealized transaction gain as of the balance sheet date of Dec 31 20X5.
Things to remember:
For foreign currency transactions settled in a later period, companies first remeasure the payable or receivable at the exchange rate as of the balance sheet date, recording an unrealized transaction gain or loss on the income statement. When the transaction is later settled, companies record a realized transaction gain or loss based on exchange rate changes since the last remeasurement.
Passage
Henri Pellatoir is an analyst for Q-Vex, Inc., a large Canadian manufacturer. Using quarterly financial data compiled over the last 15 years, Pellatoir wishes to project the company's gross profits. Exhibit 1 presents the historical data to be used in the analysis:
Pellatoir is using an AR(1) model for his analysis. Exhibit 2 shows the results of the regression model:
Pellatoir reviews the results of the analysis and determines that the model is misspecified. He makes a modification to the initial model, with results shown in Exhibit 3:
Pellatoir quickly establishes that the updated model does not have unit roots. Additional testing confirms that the updated model is properly specified and can be used to model the company's gross profit in future periods. After making the modifications to the model, Pellatoir is concerned about the presence of heteroskedasticity. He discusses this with another analyst, Zoe Arsenault, and she responds by stating that:
| Statement 1: | The presence of heteroskedasticity most likely will result in failure to reject a false null hypothesis. |
| Statement 2: | Autoregressive conditional heteroskedasticity (ARCH) regression models can estimate future error variances only if the null hypothesis of the ARCH test is rejected. |
Based on Exhibits 1 and 2, Pellatoir's most appropriate conclusion is that the model is misspecified since the:
- residuals are serially correlated.
- time series exhibits exponential growth.
- Durbin-Watson statistic differs significantly from 2.0.
Explanation:
Serial correlation occurs when the error terms of a regression are correlated, which is a violation of regression assumptions. When serial correlation is present, the t-statistics used for hypothesis tests on the regression coefficients will incorrectly appear to be significant. Models exhibiting serial correlation are misspecified and will require adjustments before any hypothesis testing can be performed.
For AR models, serial correlation is detected by performing a t-test on the autocorrelation of the residuals, in which the null hypothesis (H0) is that the autocorrelation t-statistic equals zero, indicating that serial correlation is not present.
Exhibit 2 lists the autocorrelation t-statistics. Each of these is compared against the model's critical t-value (given here as 2.00). On the fourth lag, the t-statistic is greater than the critical value (3.6023 > 2.00). H0 is rejected, and therefore the appropriate conclusion is that the residuals are serially correlated.
A common example of serial correlation is exponential growth: Values continuously grow at a particular rate, which implies the model has persistent rather than uncorrelated error terms. Exponential growth is present if the time series values in a graph increase or decrease at progressively higher rates. Exhibit 1 shows that profits were relatively unchanged or slightly lower over time, so the time series does not exhibit consistent exponential growth across the 15-year period (Choice B).
(Choice C) The Durbin-Watson (DW) hypothesis test checks for serial correlation by comparing the DW statistic with DW critical values. However, the DW test cannot be applied to AR models.
Things to remember:
A regression on a time series must be tested for different types of violations, such as serial correlation, before any meaningful hypothesis testing can be performed.
Passage
Yannes Bolger is a newly hired junior analyst at a derivatives trading firm, working on an interest rate option trading desk managed by Hidemi Okura. To assess Bolger's understanding of derivatives, Okura first asks him which combination of interest rate puts and calls is most similar to a pay-fixed, receive-floating forward rate agreement (FRA).
She then asks Bolger to identify which of the strategies below is equivalent to being short an interest rate cap and long an interest rate floor, assuming both options are 1-year contracts based on the 3-month market reference rate (MRR), with quarterly settlement payments, 3% exercise rates, and $1 million notional amounts.
| Strategy 1: | Positions in two $1 million par value 1-year bonds that pay interest quarterly: long a floating-rate bond with a coupon rate based on the 3-month MRR, and short a 3% fixed-coupon bond. |
| Strategy 2: | A 1-year, $1 million notional, quarterly settled, receive-fixed, pay-floating interest rate swap with a 3% fixed-rate leg and a floating-rate leg based on the 3-month MRR. |
| Strategy 3: | Long a payer swaption on a 1-year, quarterly settled, $1 million notional swap with a 3% fixed-rate leg and a floating-rate leg based on the 3-month MRR. |
A corporate client contacts Okura for advice on structuring a debt offering. The client wants to borrow at a fixed cost for a specified maturity but expects interest rates to rise over the next few years. The client believes the bond market is underpricing interest rate options relative to the derivatives market. Therefore, the client asks how interest rate options might be used to achieve the preferred fixed-rate funding for the specified maturity while also reducing financing costs by taking advantage of the mispricing of embedded calls in the bond market.
Another client has requested a quote on a €10 million notional amount, 2-year, 4% European interest rate put. Okura asks Bolger to value the put option using the binomial interest rate tree shown in Exhibit 1.
Which of the following positions is most appropriately identified as being equivalent to a pay-fixed, receive-floating FRA?
- Short an interest rate call and long an interest rate put
- Long an interest rate call and short an interest rate put
- Long an interest rate cap and short an interest rate floor
Explanation:
A FRA is a forward contract on an interest rate, established between two counterparties: a buyer (long) who pays the fixed rate and receives the floating rate, and a seller (short) who pays the floating rate and receives the fixed rate. For FRAs held until expiration, there is a single cash settlement payment based on the difference between the FRA fixed rate and the MRR at expiration. At expiration:
- if MRR > FRA rate, the seller pays the buyer.
- if MRR < FRA rate, the buyer pays the seller.
FRAs are equivalent to simultaneous long and short interest rate calls and puts with exercise rates equal to the FRA fixed rate:
- Fixed-rate payer (ie, long) = long call and short put
- Fixed-rate receiver (ie, short) = short call and long put (Choice A)
The FRA fixed-rate payer receives a settlement payment if MRR > FRA rate; the greater the difference, the larger the payment. Conversely, if MRR < FRA rate, the fixed-rate payer makes a payment, which increases as the MRR declines more. This is the same payment pattern for an investor who is long calls and short puts on the MRR if both option exercise rates equal the FRA fixed rate:
-
If MRR > Exercise rate, the call is in the money and the investor receives a payment based on the rate difference.
-
If MRR < Exercise rate, the put is in the money and the investor makes a payment based on the rate difference.
(Choice C) An interest rate cap (floor) is a single derivative contract containing a portfolio of options known as caplets (floorlets) having a series of possible settlement payments. Therefore, being long an interest rate cap and short an interest rate floor is not equivalent to a FRA, which has a single settlement payment.
Things to remember:
FRAs are equivalent to simultaneous long and short interest rate puts and calls with exercise rates equal to the FRA fixed rate.
Passage
Karsten Knapp and Inna Schilling are financial advisors at Bloxx Investments, a wealth management firm. They are assessing the suitability of ETFs for existing clients who currently invest in mutual funds. Knapp is concerned that ETFs trading at a premium or discount to their NAV may affect clients' returns. He asks Schilling's opinion, and she makes the following statements:
| Statement 1: | Fixed income ETFs typically have lower premiums and discounts than equity ETFs. |
| Statement 2: | An index with an active futures market contributes to increased premiums and discounts of ETFs benchmarked to that index. |
| Statement 3: | The percentage of foreign securities held and the frequency of trading are factors that influence ETF premiums and discounts. |
Knapp and Schilling discuss the total costs of owning an ETF. Schilling explains that trading costs can be a significant portion of total costs, depending on the holding period. She gives Knapp an example based on PJW, an ETF that tracks the S&P 500 Index:
- Management fee: 0.30% per year
- Commission: 0.08% per trade
- Bid-offer spread of 0.14% on purchase and sale
- Holding period: 15 months
Schilling then says that ETFs have specific types of risk, and Knapp asks for more details. Schilling gives examples of events related to ETF risks, including "soft" closures.
Lastly, Knapp and Schilling discuss ETF applications and how ETFs can be used to increase the overall efficiency of a portfolio. Schilling tells Knapp that ETFs are often employed, for example, when an active manager moves the portfolio out of a certain asset class or factor that Bloxx's clients want to remain exposed to. This temporary gap can be offset by purchasing liquid ETFs and maintaining exposure to that asset class or factor.
Which of Schilling's statements about ETF premiums and discounts is correct?
- Statement 1
- Statement 2
- Statement 3
Explanation:
| Statement 1: | Fixed income ETFs typically have lower premiums and discounts than equity ETFs. |
| Statement 2: | An index with an active futures market contributes to increased premiums and discounts of ETFs benchmarked to that index. |
| Statement 3: | The percentage of foreign securities held and the frequency of trading are factors that influence ETF premiums and discounts. |
ETF premiums and discounts are implicit costs of trading ETFs and are calculated according to end-of-day or intraday NAV. If the ETF price is greater (less) than the NAV of the ETF's basket of securities, the ETF is trading at a premium (discount).
Factors that influence ETF premiums and discounts include:
-
Foreign securities held. The trading hours of foreign exchanges are typically different from the trading hours of the exchange where the ETFs are traded. This leads to situations where the NAV is a poor indicator of an ETF's fair value (eg, the ETF's exchange is open but the NAV is based on "old" prices for securities traded in a now-closed foreign exchange).
-
Frequency of trading. Differences in prices may occur if the securities held by the ETF are frequently traded but the ETF is not.
Therefore, ETFs holding foreign securities or trading infrequently typically have greater premiums or discounts relative to NAV.
(Choice A) Fixed income securities are traded over the counter, without continuous pricing. Fixed income ETFs are based on pricing indications from bond desks or pricing services, resulting in higher premiums/discounts than equity ETFs, which hold stocks continuously traded in exchanges.
(Choice B) Futures contracts allow investors to promptly hedge their positions on the underlying security, keeping the security's price closer to its fair value. Therefore, ETFs benchmarked to an index with an active futures market will be traded closer to their NAV, decreasing premiums and discounts.
Things to remember:
If an ETF's price is greater (less) than the NAV of its basket of securities, the ETF is trading at a premium (discount). ETFs holding foreign securities or trading infrequently typically have greater premiums or discounts relative to NAV.
Passage
Ellis Howard is a junior equity analyst for a university endowment fund. The fund's policy for evaluating equity investments is to use free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) to estimate a company's intrinsic value. Howard's supervisor asks about her methods for forecasting FCFF and FCFE from a company's reported net income. Howard replies:
| Method 1: | When determining changes in working capital, I do not include short-term notes payable as part of current liabilities. |
| Method 2: | When using net income to derive FCFF or FCFE, I do not normally add back deferred tax liabilities to net income. |
Howard is asked to evaluate Horizon ElectroCar as a potential investment. The company's selected financial information is shown in Exhibit 1:
The notes to the company's financial statements disclose the following information:
- The tax rate is 40%.
- In 20X1, Horizon spent SGD 1.0 million to repurchase common equity shares and borrowed SGD 1.3 million.
- There are no notes payable, and all debt is long term.
- The company classifies interest paid as cash from operations (CFO).
Howard estimated Horizon ElectroCar's per-share FCFE for 20X0 to be SGD 2.50. The applicable risk-free interest rate is 2%. Exhibit 2 shows Howard's estimates for the ranges of inputs used to value Horizon ElectroCar with a constant-growth FCFE model:
Howard is also evaluating Innovation Resources, which is located in Chad, where there has been high inflation in recent years. Relevant information concerning Chad and Innovation Resources is shown in Exhibit 3:
Finally, although Howard understands the endowment fund's rationale for valuing equity investments based on the company's free cash flow (FCF), she believes that other metrics can be adequate substitutes for FCF. She makes the following statements to support her position:
| Statement 1: | If a company makes no investment in fixed capital, then EBITDA can be used as a proxy for FCFF. |
| Statement 2: | CFO is the same as FCFE if the company's investment in PPE is equal to its net amount of borrowing. |
Which of Howard's methods concerning FCF forecasting is (are) appropriate?
- Only Method 1
- Both Method 1 and Method 2
- Neither Method 1 nor Method 2
Explanation:
| Method 1: | When determining changes in working capital, I do not include short-term notes payable as part of current liabilities. |
| Method 2: | When using net income to derive FCFF or FCFE, I do not normally add back deferred tax liabilities to net income. |
Estimating current and future FCFF and FCFE, starting from a company's net income, requires adjustments for investments in working capital and noncash charges.
Working capital includes a company's short-term assets and liabilities. However, FCFF is estimated from a company's operating cash flows, which excludes cash from financing activities. Notes payable are short-term liabilities that typically bear interest and are classified as cash from financing. Howard is correct to exclude them when calculating changes to working capital, so Method 1 is appropriate (Choice C).
Deferred tax liabilities and assets are examples of noncash items; they represent the difference between accounting tax expense and taxes actually paid and/or owed. Most deferred tax items result from timing differences, such as using straight-line depreciation for financial reporting and accelerated depreciation to determine actual taxes paid each year. Generally, the differences reverse over time; in those cases, an analyst should not adjust net income by the amount of the deferred asset or liability. Howard's Method 2 is also correct (Choice A).
Things to remember:
FCF estimates based on net income require adjustments for working capital investment and noncash charges. Notes payable are short-term liabilities, but if they are interest-bearing, they are excluded from working capital since they represent cash from financing, not from operations. Deferred tax assets and liabilities are noncash items, but analysts should use them to adjust net income only if they are not expected to reverse over time.
Passage
Sieger Financial Group functions as both a registered investment advisor and a broker-dealer, targeting high-net-worth (HNW) individuals and the mass affluent. To increase profit margins, Sieger aims to enhance the firm's competitive advantage by offering comprehensive wealth planning together with exclusive investment strategies that are not readily available to retail investors.
Aryam Monge, founder of Sieger, is committed to strengthening client relationships by offering unique products, believing this approach will enhance the client base and revenue potential. She aims to increase the firm's revenue, factoring in both internal and external drivers. Regarding internal factors impacting revenues, she notes that the firm should:
-
adopt new technologies with lower cost structures.
-
incorporate ESG considerations into client portfolio management.
-
focus on the relevant client segment and monitor the efficiency of its efforts.
To expand business, Sieger has a referral network that includes several key industry partners:
| Partner 1: | Yuki Matsuda, CPA at Melun Tax, refers clients to Sieger in exchange for reciprocal referrals to her firm. |
| Partner 2: | Quan Nguyen, a representative at Duran Mutual, pays a fee to Sieger for referring Duran funds to Sieger's clients. |
| Partner 3: | Logan Anderson, client relationship advisor at Collity Trust, refers clients to Sieger's investment management services. In return, Sieger pays Collity 5% of the revenue earned from those clients in the first year. |
While reviewing Sieger's industry partners, Monge determines that Rinehart Financial Services, the current custodian for its clients' funds and securities, cannot satisfy the complex and globalized needs of Sieger's clients. She identifies three potential replacement custodians and one key service feature for each. Assume that the service feature specified for each custodian is not offered by the others.
| Custodian 1: | Enos Financial Services updates mutual fund price data the following day. |
| Custodian 2: | Perlberg Financial Services offers comprehensive consolidated monthly reports. |
| Custodian 3: | Orlandi Financial Services provides continuous access to financial data as a premium offering. |
For the industry partners that Sieger is considering, the difference that is an example of a retrocessive arrangement is most likely demonstrated by:
- Partner 1
- Partner 2
- Partner 3
Explanation:
A retrocession refers to a fee that a wealth adviser receives from a provider for recommending a particular product or products. An example is a mutual fund company compensating advisers who invest in the company's funds. This fee can create financial incentives to recommend specific investments.
Although retrocessions can enhance the adviser's income, they may also lead to conflicts of interest as clients might not be aware that their adviser is compensated for these recommendations. This can raise concerns about the objectivity of the advice provided, as advisers may prioritize funds that yield higher retrocession fees over those that align with the clients' best interests.
(Choice A) The transaction with Partner 1 is commonly known as a reciprocal referral agreement or referral partnership. In this arrangement, Melun Tax and Sieger refer clients to each other. This mutually beneficial agreement helps both parties expand their client bases through shared referrals.
(Choice C) The transaction with Partner 3 is an example of service fees, which are fixed charges related to an account's existence and maintenance. The 5% revenue payment from Sieger to Collity serves as compensation for referring clients, effectively representing a fee for connecting clients with investment management services.
Things to remember:
A retrocession often happens when a wealth adviser receives a fee from a mutual fund company for recommending its funds to clients. Although this practice can boost the adviser's income, it may create conflicts of interest as clients may not realize their adviser is incentivized to promote certain investments, potentially compromising the objectivity of the advice given.
Passage
Franco Rienzi manages a eurozone equity and fixed-income fund for a Zurich-based asset management company. Rienzi is meeting with Crista Vogel, an analyst working for the firm. Rienzi asks Vogel to evaluate long-run sustainable real GDP growth rates for European countries. Rienzi suggests that Vogel use historical growth rates from 1980 to the present. The two discuss the usefulness of historical data going that far back. During the discussion, Vogel makes the following statements:
| Statement 1: | Using data from 1980 to the present is appropriate since this time horizon includes multiple business cycles. This makes for a better estimate of long-run average GDP growth, which can then be used as a proxy for an economy's sustainable growth rate. |
| Statement 2: | Since most economic data series are rebased periodically, when multiple data sources are used it is essential to be certain that data calculated from different base periods are not being mixed. |
Rienzi and Vogel then discuss the state of the economy for individual eurozone countries. Part of the discussion addresses the long-run impacts of different mixes of tight and loose monetary and fiscal policy. Eventually, the conversation turns to negative interest rates, and Rienzi makes the following comments:
| Comment 1: | Negative policy rates result in very low or negative interest rates on cash equivalents, intended to stimulate growth through increased consumer spending by reducing returns on savings, and by encouraging businesses to increase investments since more projects are profitable at the lower rate. |
| Comment 2: | Reliable capital market forecasts can be made using models derived from analyzing the statistics on asset returns, interest rates, and GDP growth rates from around the globe for the numerous historical periods of negative rates. |
Returning to the topic of sustainable economic growth, Rienzi asks Vogel about economic models that estimate growth based on labor, capital, and technology. Vogel notes that increases in labor productivity are closely tied to real GDP growth rates, and she then identifies the key contributors to improvements in productivity.
Which of Vogel's statements is most likely correct?
- Only Statement 1
- Only Statement 2
- Both Statement 1 and Statement 2
Explanation:
Analysts should follow a disciplined approach when making economic or financial forecasts. This requires establishing an effective framework for developing capital market expectations. In part, this process involves determining both:
-
the approach, the method(s) and/or model(s), that will be used to estimate the variable of interest (eg, inflation, credit spreads), and
-
the information required (eg, money supply growth, coverage ratios).
The analyst should have a reasonable basis for both determinations.
In this scenario, the long time horizon suggested by Vogel is potentially problematic. Relationships among economic variables change over time. For example, regression coefficients quantifying the sensitivity between variables may differ for each sub period, which may all differ from the full-horizon relationship.
The existing institutional arrangements (eg, regulatory system, market structure) impact economic and financial conditions. Significant changes in the institutional environment (ie, a change in regime) can change relationships among economic variables. In this scenario, the full time horizon is not appropriate for eastern European countries. These were state-directed economies that transitioned to market-based economies. For such countries, it may be more appropriate to use data for the years after market-based institutions were mostly in place (Choices A and C).
Statement 2 is correct. Over time, the basis for generating economic data often changes (eg, new inflation formula, reclassifying expenditures as investment or consumption). A base-year is established and the index in question resets to 100.0. Data for previous periods is recalibrated to the new base period. This rebasing means that data from different sources may be incompatible if not calculated from the same base period.
Things to remember:
Analysts should follow a disciplined approach when making economic or financial forecasts. They should have a reasonable basis for their choice of method and/or model, data sources, and the time horizon from which the data sample is taken.
Passage
Harmonia Bank (HB) is a US community-oriented retail bank offering a comprehensive range of products. Diane Knab, HB's CIO, has primary responsibility for the bank's asset/liability (A/L) management activities and also manages the bank's liquidity, funding, and regulatory capital.
HB's head economist, Ivan Talf, CFA, is analyzing the rates curve for the upcoming quarterly meeting of the bank's asset/liability risk committee (ALRC). Talf expects the US Treasury yield curve to flatten as short-term interest rates, which have recently increased, become steady and long-term rates remain steady or decrease slightly. Knab confers with Talf and proposes a strategy to manage the changes in balance sheet risk during this anticipated interest rate movement.
HB's current equity-to-asset ratio is 20%, its liability portfolio duration is 2 years, and its asset portfolio duration is 3 years. Knab develops the following scenarios for balance sheet restructuring in order to compare the potential outcomes for the bank's regulatory capital and its market value of equity:
Knab knows the ALRC wants to minimize equity value volatility, so she develops the restructuring scenarios with this as a primary consideration.
Before the committee convenes its meeting, Knab and Talf discuss the scenarios within the context of HB's current 20% equity-to-asset ratio and its current asset and liability duration mismatch of 1 year. Knab makes the following statements based on a hypothetical 50-basis-point increase in interest rates:
| Statement 1: | When leveraged, banks increase equity value by taking in short-term deposits and investing in longer-duration loans and securities. |
| Statement 2: | Investing in common stock is likely to decrease the positive correlation between asset and liability returns. |
| Statement 3: | Generally speaking, when low interest rates begin to rise, it is uncertain how an asset-and-liability duration mismatch will affect equity returns. |
Shortly after their discussion, Knab presents her recommendations to the ALRC. The committee recommends modifying HB's overall risk exposure by:
- implementing a stock repurchase program, subject to regulatory approval and capital requirements,
- broadening the bank's loan portfolio by lending to smaller regional manufacturing companies, and
- reinvesting maturing floating-rate debt investments in a real estate portfolio of fixed-rate commercial mortgage-backed securities (CMBS) with maturities comparable to the current asset profile.
Based on Exhibit 1 and with all else equal, the change (in %) in HB's market value of equity in Scenario Z is closest to:
- −18.5
- 10.5
- 19.5
Explanation:
A bank's underlying investment strategy is primarily liability-driven investing (LDI). Changes in mark-to-market valuations for assets and liabilities are magnified by a leverage factor and can cause a change in the market value of the bank's equity. This change is a function of changes in both the:
- returns of the underlying assets and liabilities and the
- equity-to-asset ratio (ie, leverage ratio).
Leverage can magnify the positive (negative) effects of an increase (decrease) in asset values on equity value. Conversely, leverage can also magnify the negative (positive) effects of increasing (decreasing) liability values.
The change in HB's equity return is:
In Scenario Z, the combination of a 1.50% increase in asset value and a 0.50% decrease in liability value is magnified by an equity-to-asset ratio of 10.0% (or a 10x leverage assets-to-equity ratio) to increase HB's equity return by 19.5%.
(Choice A) A change of −18.5% results from incorrectly switching the changes in asset and liability returns.
(Choice B) A change of 10.5% results from mistakenly adding the liability component of return instead of subtracting it.
Things to remember:
The change in the market value of a bank's equity capital is a function of changes in the underlying asset and liability returns and the equity-to-asset ratio (ie, leverage ratio). Greater leverage magnifies these effects such that, if asset values increase (decrease), the return on equity will be higher (lower).
Passage
Sierra Capital Management (SCM) has managed institutional funds for the past 15 years but has never complied with GIPS®. Michael Butler, SCM's chief compliance officer, is planning to propose to the board of directors that the firm become GIPS-compliant, and he has created a list of how SCM would benefit from doing so:
| Benefit 1: | SCM's sales team will enhance its ability to secure new institutional business. |
| Benefit 2: | SCM can designate specific composites, pooled funds, or portfolios as GIPS-compliant. |
| Benefit 3: | SCM will avoid conflicts with local laws by adhering to GIPS reporting on performance calculation and presentation. |
Valora Dockins, CFA, the new portfolio manager of SCM's fixed-income funds, is also preparing for a meeting with the board of directors. Having managed the funds for just one year, Dockins wants to discuss her performance in the meeting and asks Harrison Jennings, a junior analyst, to calculate the funds' returns for the year. Jennings has all the monthly returns except for December and collects the necessary data to calculate the rate of return using the Modified Dietz methodology. The fixed-income funds allow external cash flows only on a weekly basis.
SCM also offers its investment strategies directly to ultra-high-net-worth clients as individual segregated accounts or through various wrap-fee sponsors. Dockins wants to calculate returns on her fixed-income strategies for these clients. However, the sponsors SCM works with charge a single bundled fee for both investment management and administrative services, making it impossible for SCM to isolate transaction costs from the bundled fee. Dockins asks Jennings to prepare a GIPS composite report for the accounts with bundled fees and consults with Butler to verify the fixed-income funds' compliance with GIPS standards.
Which of Butler's proposed benefits is most likely to benefit SCM?
- Benefit 1
- Benefit 2
- Benefit 3
Explanation:
The benefits of GIPS compliance for a firm are significant, particularly as the standards have become increasingly recognized and valued in the global investment industry. Benefits that a GIPS-compliant firm can enjoy include:
-
Competitive advantage: Compliance is helpful for winning institutional business, as noncompliance can reduce a firm's credibility.
-
Global recognition: Compliance helps firms compete globally by standardizing performance comparisons, enhancing market opportunities and reputation.
-
Internal improvements: Compliance requires a level of review and documentation that can improve management oversight.
(Choice B) SCM cannot designate specific composites, pooled funds, or portfolios as GIPS-compliant. The GIPS standards require all fee-paying, discretionary segregated accounts to be included in at least one composite, defined by mandate, objective, or strategy. Pooled funds must also be included if they meet the definition of "composite."
(Choice C) There may be unavoidable conflicts with GIPS and local laws. If GIPS conflict with local laws on performance calculation and presentation, SCM must adhere to local laws and disclose the conflict in its report. If GIPS are stricter than local laws but do not conflict with them, then SCM should adhere to GIPS.
Things to remember:
Being GIPS-compliant helps a firm strengthen its competitive position, improve its chances of securing institutional clients, and expand into international markets by adhering to a globally recognized standard for investment performance comparison. Compliance with GIPS can be seen as a vital tool for firms to strengthen internal controls and establish credibility and trust in the highly competitive investment management industry.
Passage
Harry Thomkins is a fixed-income portfolio manager at a US-based investment company. The company's mutual funds are available to US-domiciled investors only. Thomkins manages a domestic investment-grade corporate bond fund and an international bond fund. The international fund includes sovereign debt, investment-grade corporate bonds, and high-yield corporate bonds.
Thomkins meets with Elise Parsons, the firm's fixed-income strategist. Both Thomkins and Parsons expect US interest rates to generally increase across all maturities and market sectors. They discuss market expectations regarding the likelihood of the US Federal Reserve ("the Fed") raising its funds rate target by 50 basis points at the upcoming meeting of the Federal Open Market Committee. Exhibit 1 contains selected data on the current and expected fed funds targets and futures prices.
The discussion turns to potentially using Treasury futures to reduce the domestic investment-grade bond fund's interest rate risk relative to its benchmark. The duration of the fund currently matches the duration of its benchmark index. Thomkins decides to shorten the portfolio's duration to 7.50. Exhibit 2 shows information about the portfolio and Treasury futures.
Thomkins and Parsons consider the use of Treasury futures to achieve the desired target duration, and Parsons makes two statements identifying potential complications:
| Statement 1: | Achieving the targeted amount of interest rate risk reduction using Treasury futures requires that the yield spread of corporate over Treasury securities remains stable. |
| Statement 2: | The effectiveness of the duration reduction using Treasury futures can be undermined by a change in the cheapest-to-deliver (CTD) bond in the underlying basket of deliverable bonds. |
The international bond fund holds euro-denominated German government bonds. The bonds were purchased with EUR acquired for the spot exchange rate at the time of purchase. Thomkins now expects the EUR to depreciate and wants to hedge the currency exposure of those bonds using a cross-currency basis swap. Thomkins initiates a EUR/USD cross-currency swap with payment dates and an expiration date that exactly match the coupon dates and maturity date of the bond and with a notional amount that is the same as the bond's par value.
Based on Exhibit 1, the probability of a 50-basis point increase in the Fed funds rate target is closest to:
- 70%
- 83%
- 95%
Explanation:
Interest rates implied by Fed funds futures prices can be used to estimate the probability of policy rate target changes by the US Federal Reserve. No underlying term structure of funds rates provides a basis for arbitrage-free pricing of funds futures, meaning that a funds futures price reflects market participants' expectations for the level of the funds rate at the futures contract expiration.
Analysts use the interest rate implied by a futures price and the current effective Fed funds rate to estimate the probability of a forecasted change in the funds rate target. The estimated probability is based on expected changes market participants are pricing into the futures contract. The effective funds rate is either:
-
the stated target rate when a central bank has a point (ie, single-rate) target, or
- the midpoint of the stated range if a central bank uses a target range for its policy rate.
Using the information in Exhibit 1, the probability of a 50-basis point increase in the effective Fed funds rate is calculated as:
(Choice A) 70% results from using the high end of the current and forecasted target range for the funds rate.
(Choice B) 83% results from using the bottom end of the current and forecasted target range for the funds rate and inverting the numerator and denominator in the calculation.
Things to remember:
A Federal Reserve funds futures price reflects market participants' expectations of the level of funds at the futures contract expiration. Analysts use the interest rate implied by a futures price and the current effective funds rate to estimate the probability of a forecasted change in the funds rate target, based on expected changes market participants price into the futures contract.
Passage
Hirono Dashi is an equity portfolio manager for a UK-based investment company. Dashi meets with Tomas Szakacs, the firm's derivatives strategist, to discuss the use of equity and volatility derivatives to manage the risk of the European equity portfolio Dashi manages. In response to Dashi's questions regarding potential equity index swap strategies, Szakacs makes the following statements:
| Statement 1: | Portfolio cash holdings can be equitized by initiating a receive-equity, pay-fixed swap. |
| Statement 2: | Large-cap exposure can be decreased and small-cap exposure increased by initiating a swap where the portfolio is the equity-return payer on a large-cap index and equity-return receiver on a small-cap index. |
Dashi decides to reduce the systematic risk of her portfolio by using Euro Stoxx 50 futures. Exhibit 1 contains information regarding the equity portfolio and the futures contract:
The two discuss using a variance swap to hedge the tail risk of the long-only US equity portfolio managed by Dashi. She asks Szakacs about the potential gains and losses on variance swaps and, specifically, what the gain on the variance swap would be if realized volatility over the life of the contract is 22%, as she expects. Exhibit 2 contains information on the variance swap:
Dashi is concerned about the counterparty risk and liquidity of variance swaps. She asks Szakacs about using VIX futures instead of a variance swap to manage the tail risk. During the discussion, Szakacs makes the following comments about the relative advantages and disadvantages of going long VIX futures compared to buying a variance swap on the S&P 500:
| Comment 1: | If volatility increases, the linear payoff from going long VIX futures will generally be better than the convex payoff from buying variance swaps. |
| Comment 2: | Since the VIX futures curve is currently in backwardation, being long VIX futures will benefit from the roll as the contract approaches expiration. |
Which of Szakacs's statements regarding equity swaps is (are) correct?
- Only Statement 1
- Only Statement 2
- Both Statement 1 and Statement 2
Explanation:
Equity swaps are contracts in which the value of at least one leg reflects the return on an underlying equity, which may be a stock, a recognized index, or a custom portfolio. Equity-leg returns can be measured on a total-return or a price-change-only basis. The value of the other leg can be based on a floating or fixed interest rate, or on the return on a different equity.
Equity swaps are used to alter portfolio allocations or to alter the risk profile of the equity holdings. For asset allocation, swaps are used to synthetically create or reduce economic exposures, thereby adjusting asset class weights to a manager's targets. When initiating an equity swap:
- the equity return receiver creates long exposure or reduces short exposure and
- the equity return payer reduces long exposure or creates short exposure.
Equitizing cash is a common use of equity derivatives. Entering into a receive-equity return, pay-floating rate swap with a notional equal to the money amount to be equitized synthetically:
- creates a long equity position of that size through the returns on the equity leg and
- reduces cash holdings by an equal amount through the interest payments on the floating-rate leg.
Statement 1 is incorrect. While a receive-equity leg is the correct swap structure for equitizing cash, a pay-fixed leg is problematic. Reducing the portfolio's cash exposure requires a pay-leg on which the cash flows vary in line with changes in the income the portfolio collects on its cash (ie, a floating rate). Initiating an equity swap with a pay-fixed leg creates a mismatch between the fixed-rate payments the portfolio owes on the swap and the variable income it earns on cash holdings. Equitizing cash requires the pay-leg of the swap to be based on a floating rate (Choices A and C).
Things to remember:
Equity swaps are used to alter portfolio asset allocations or the risk profile of equity holdings in a portfolio. Initiating a swap as a return receiver creates long asset exposure or reduces short exposure. Initiating a swap as a return payer reduces long exposure or creates short exposure.
Question 7
Yotta Asset Management (YAM) is an investment fund management company responsible for advising and managing several mutual funds, hedge funds, and private wealth mandates. YAM takes its responsibilities to clients very seriously and so has introduced a written firm policy on the receipt of gifts in order to preserve loyalty to their clients and minimize conflicts of interest. The firm policy states:
"Managers must refuse to accept gifts or entertainment from service providers, potential investment targets, or other business partners of value more than $50. Total gifts received from one source in one three-month period received either in cash or benefit in kind cannot total more than $300. Employees must report in writing to their supervisors the acceptance within two business days of receipt of any gift or entertainment."
Does YAM's policy most likely comply with the CFA Institute's Asset Manager Code of Professional Conduct recommended practices?
- Yes.
- No, since cash gifts should not be permitted.
- No, since the quarterly limit on gifts and entertainment should not be greater than $100
Explanation:
The Asset Manager Code of Professional Conduct provides, in relevant part:
"Managers should consider creating specific limits for accepting gifts (eg, amount per time period per vendor) and prohibit the acceptance of any cash gifts."
The Code recommends that managers prohibit the acceptance of any cash gift. Since YAM's policy allows, although limits, cash gifts, if does not satisfy this recommendation. Although the recommended practice suggests limiting the gifts to nominal amounts, there is not a requirement nor is a specific amount suggested (Choices A and C).
Duri Jung, CFA, is a highly regarded sell-side analyst covering retail companies. She maintains close relationships with the companies she covers, attends technology conferences and seminars, and keeps up to date with the latest trends in the industry. She is one of three partners at a small boutique firm, Mosaic Insights.
Mosaic offers only one tier of service, which grants clients access to all of Mosaic's analysts' research and provides quarterly calls with the analysts. One of Jung's clients, Delta Investments, asks whether she would be willing to make a quarterly trip to their office to spend more time with Delta's analysts. Jung considers talking to her partners about adding a second, more expensive, tier of service. She suggests offering it only to clients that have expressed interest in similar office visits.
A representative for an industry conference contacts Jung to ask whether she would be interested in participating in a panel discussion about how technology will impact the retail sector and the way retail companies operate. Jung has not been asked to speak at a conference before and feels it would be a great opportunity to increase Mosaic's visibility.
Jun Song, CFA, the head of investor relations at Azalea Group, which Jung covers, arranges a conference call with a small number of sell-side analysts. On the call, Song tells the analysts that Azalea's chief financial officer plans to resign and that Azalea has begun the search for a new CFO. He adds that the news will be publicly announced tomorrow, but he wanted the analysts to have time to think about the information.
Jung believes that Azalea's external search for a new CFO will cause some investors to shift their holdings to Azalea's main competitor, Blossom Inc. Jung calls a portfolio manager at Delta and, without mentioning the announcement of Azalea's CFO resigning, suggests increasing Delta's investment in Blossom. The portfolio manager states that he is in the process of reducing his holdings in Blossom, and disregards Jung's recommendation.
The three partners at Mosaic are considering adding another partner to their firm, Joo-Won Kyung, CFA. Kyung's spouse manages a fund that has significant holdings in several of the companies that Kyung would cover at Mosaic. Kyung is also a director-at-large of her local CFA society and has been assigned with increasing the number of events for the society. She expects that the role will be a significant time commitment for the next several months.
With regard to offering a second tier of service, which of the following is Jung's most appropriate option under Standard III(B)?
- Offer the higher level of service as planned
- Continue offering only one level of service to clients
- Offer the higher level of service only if offered to all clients
Explanation:
"Members and Candidates must deal fairly and objectively with all clients when providing investment analysis, making investment recommendations, taking investment action, or engaging in other professional activities."
Standard III(B) Fair Dealing requires Members and Candidates to treat all clients fairly when recommending investments or undertaking investment actions on clients' behalf. Members and Candidates who issue investment recommendations must ensure they are disseminated in a way that provides all clients with a fair opportunity to act.
However, "fair" does not necessarily mean equal. The Standard allows firms to offer higher levels of service to clients willing to pay a premium (Choice B). However, these enhanced services:
-
must not disadvantage or negatively affect other clients, and
-
must be disclosed and made available to all clients and prospective clients.
In this scenario, Jung suggests offering a higher level of service only to clients that have previously expressed interest. However, her plan would violate the Standard if the higher tier of service were not offered to all of Mosaic's clients. Even if other clients have not expressed interest in receiving additional services from Jung, they might choose to do so if the additional services were offered to them. Failing to inform them denies them the opportunity to make that choice (Choice A).
Things to remember:
Standard III(B) Fair Dealing requires Members and Candidates to ensure their investment recommendations are fairly disseminated. Different levels of client services are allowed if those services do not disadvantage or negatively affect other clients and are disclosed and made available to all clients and prospective clients.
Irwin Tuason, a financial adviser at Velma Advisors, is evaluating three equity managers: Jawad All Cap Equity Strategies (JACS), Neoma All Cap Equity Strategies (NCES), and Foster Diversified Equity Strategies (FDES). These managers' factor exposures align with the expectations and constraints of Velma's investors, and all are benchmarked against the MSCI All Cap Index, offered through separately managed accounts:
After reviewing the portfolio comparison between JACS and NCES prepared by Velma analyst Alice Kittrell, Tuason wonders why NCES has a higher active risk than JACS despite having a similar active share.
Tuason believes this could be due to the varying investment objective functions and constraints applied to each. Kittrell provides these data:
For his evaluation, Tuason wants to know if these strategies exhibit the risk characteristics of well-constructed portfolios. Kittrell gathers the following information:
Lastly, Tuason asks Kittrell to calculate the expected compounded return of JACS with a leverage factor of 2 to assess the impact on the strategy's implementation limits.
Compared to JACS, NCES's higher active risk is most appropriately attributed to:
- concentrated sector bets.
- strong correlations among portfolio securities.
- differing security-level weights relative to those of the index.
Explanation:
Active share and active risk are metrics used to assess benchmark-relative risk and evaluate a manager's performance. While both provide insights into a manager's investment strategy, they capture different aspects of performance and risk. A manager can pursue active risk without significantly changing active share due to:
-
Concentrated sector bets: Sector concentration makes the portfolio more sensitive to sector-specific risks and volatility, increasing active risk without altering the proportion of holdings that differ from the benchmark.
-
Volatility of selected securities: If the selected securities have greater volatilities than those in the benchmark, they increase overall portfolio volatility and active risk. Active share measures the proportion of holdings that differ from the benchmark but not their volatility.
-
Weak correlations among portfolio securities: When securities do not move in tandem, their price movements offset each other less effectively, leading to a more unpredictable portfolio. This lack of synchronization amplifies the portfolio's active risk compared to a benchmark, even if the proportion of shares that deviate from the benchmark are similar (Choice B).
-
External market factors: Market conditions, economic events, or sector-specific developments can affect the performance of the securities in the portfolio differently from those in the benchmark. Such external factors can introduce additional volatility, leading to higher active risk regardless of the active share.
(Choice C) A similar active share indicates that a manager's security-level weights closely align with those of the benchmark index, suggesting minimal deviation from it.
Things to remember:
A manager can pursue active risk without significantly changing active share due to concentrated sector bets, high volatilities of selected securities, low or negative correlations among portfolio securities, and external market factors.
Natalie Brunner works for the capital introductions division of a large bank and is focused on introducing general partners (GPs) and limited partners (LPs) to form investment relationships. She attends a networking event for the purpose of generating new business and meets with a number of former clients and prospects.
In a conversation with a LP, Brunner makes the following statements about private equity exits:
| Statement 1: | Private equity exits usually take the form of public sales via IPOs, private sales, or (in some cases) liquidation. |
| Statement 2: | A GP-led secondary is a type of sale to a financial buyer in which a LP sells a partnership interest in a fund to another LP. |
| Statement 3: | When exiting via private sale, a manager can sell to a strategic buyer, another private equity fund via leveraged buyout, or to the existing management team in a management-led buyout. |
A new LP analyst, Sarah Davis, asks Brunner about the different phases of the private equity fund life cycle. Davis's firm is invested in a private equity fund, Pacific Coast Fund II, which is experiencing negative returns. The negative performance is confusing to Davis and her supervisor since the fund has made only one investment; however, no capital has been called yet.
Brunner meets a GP who is raising capital for their next fund. Brunner asks how the terms have changed, and the GP provides a reference sheet showing terms of the new fund versus the prior fund, as shown in Exhibit 1:
To conclude the event, Brunner meets a venture capital (VC) investor, Eric Halpern, who invests in start-ups and early-stage companies. They discuss the current market environment, and Halpern comments on his firm's typical target company:
| Comment 1: | Start-ups do not have an established product yet, so we focus on firms that have high growth potential or are disrupters in an established industry. |
| Comment 2: | We look for signs that companies are creating value, hitting financial milestones consistently, and maximizing profitability. |
Which of Brunner's statements is incorrect?
- Statement 1
- Statement 2
- Statement 3
Explanation:
Private equity exit strategies include IPOs, private sales, and liquidation. A GP-led secondary is a private sale of a specific asset or fund interest to a financial buyer. However, the financial buyer is typically another fund (ie, a continuation fund) or a GP not seeking to control the company. Brunner's Statement 2 refers instead to a traditional secondary transaction, which is the sale of a fund interest from a LP to another LP.
Strategic buyers may have different motivations than financial buyers, such as capitalizing on synergies or combining the business with another portfolio company. Private sales to strategic buyers take the form of management or leveraged buyouts (Choice C).
The best-known equity exit strategy is an initial public offering (IPO), which is when a private company is taken public through shares sold on a public exchange. An IPO is used to maximize valuations in a favorable equity market or stage a controlled exit process with multiple offering phases. IPO candidates are often large, established companies with good prospects for growth.
(Choice A) Liquidation is a less common form of exit and typically follows a bankruptcy or restructuring process. Liquidation is more commonly used by private equity strategies that specialize in distressed assets or special situations to create or recover value for the targeted asset.
Things to remember:
Private equity exit strategies include IPOs, private sales, and liquidation. Private sales may be through a financial buyer, such as a GP-led secondary, or to a strategic buyer, such as a management or leveraged buyout.
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