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Schweser Printable Answers - Session Asset Valuation: Valuation Concepts

Test ID#: 1362411

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Question 1 - #29272

Samuel Davidson, CFA, is an investment advisor for The Karazim Group (Karazim), a financial planning and investment firm catering to wealthy individuals in the United States. Davidson has called a client, Kelly Musch, to discuss increasing the international exposure in her portfolio. Since Musch is unfamiliar with foreign investments and their risk evaluation, she has expressed an interest in meeting with Davidson to discuss the matter. During the course of their discussion, she indicated an interest in German firms,

explaining to Davidson that her grandparents are originally from Germany and she is knowledgeable about the culture there. Consequently, she is more comfortable investing in Germany as opposed to other

countries. In preparation for the meeting Davidson gathered current data on Germany (Figure 1) to illustrate some issues relevant to international investments.

Figure 1: Current Data on Germany and the United States Current Exchange Rate 1 EUR = USD0.80

Expected Exchange Rate in

Three Months 1 EUR = USD0.85

German ST Capital

Gains/Dividend Tax Rate 15.00%

U.S. ST Capital Gains/Dividend

Tax Rate 28.00%

German Government Bond Yield

(non- US denominated) 11.00%

German Government Bond Yield

(AAA rated, US denominated) 8.50%

U.S. 10 year Treasury bond Yield 4.75%

U.S. AAA rated Corporate Bond

Yield 7.50%

Local Inflation Rate 5.75%

U.S. Inflation Rate 3.25%

Because she is in a high tax bracket, Musch is concerned about the tax ramifications of international investments. To illustrate how taxes work on a German investment, Davidson prepares an example that assumes that Musch buys 100 shares of KDR Corporation. KDR is currently trading in Germany at EUR28 per share. In his example, Davidson makes the simplifying assumption that there are no transaction costs.

The illustration assumes that Musch holds the shares for three months and receives a dividend of EUR 1.0.

After three months, Musch sells the shares at a price of EUR 30 per share.

During their discussion of the example Musch expresses her concerns that trading and execution costs were not included. Musch asks, “Are trading costs higher when investing in foreign markets?” Davidson says they can be, but that there are various ways to minimize execution costs. To help with the discussion, Davidson calls Karazim’s head equity trader, Jeffery Pyle, and puts him on a speakerphone. Davidson tells Pyle that he has a client in his office who is asking about execution costs when trading foreign investments. Davidson says, “I told her that there are various ways to reduce execution costs when trading foreign stocks including program trading, internal crossing, and indications of interest.” Pyle replies, “There are additional ways to reduce execution costs, including external crossing, overseas trades, and using futures contracts. We try to use a variety of methods to insure best execution for our clients.”

Musch thanks them for the explanation. While Pyle is on the phone, Musch asks, “I have also heard that American Depository Receipts are another way to invest in foreign stocks. Can you tell me about ADR’s?”

Pyle responds by listing five key features of ADR’s.

Level 1 ADR’s comply with SEC registration and reporting requirements, and thus enable the issuer to raise capital in the U.S.

1.

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Level 2 ADR’s can be listed on the New York Stock Exchange (NYSE) or the NASDAQ Exchange.

2.

One advantage to investing in ADR’s is that they are denominated in U.S. dollars and therefore eliminate the currency risk associated with foreign investments.

3.

Another advantage to investing in ADR’s is that they reduce administration and duty costs on international transactions.

4.

ADR’s are issued by foreign banks and consist of a bundle of shares in a foreign corporation that are being held in custody at a U.S. bank.

5.

After hearing Pyle’s explanation about ADR’s Davidson hangs up the phone and tells Musch, “I am not sure he is correct on all of his points, but hopefully you have a better idea how ADR’s work.”

The meeting between Musch and Davidson ends up lasting another hour. Davidson spends the remainder of the meeting discussing other means of international investing, including closed-end funds and

exchange-traded funds.

Part 1)

Musch was wondering how the Paris Bourse and Frankfurt DAX compare to the NYSE and NASDAQ exchange. Which of the following best

describe the markets questioned? The Paris Bourse and Frankfurt DAX are:

A)order-driven markets which are more similar to the NASDAQ exchange than the NYSE which is an price-driven market.

B)order-driven markets which are more similar to the NYSE than the NASDAQ exchange which is a price-driven market.

C)price-driven markets which are more similar to the NASDAQ exchange than the NYSE which is an order-driven market.

D)price-driven markets which are more similar to the NYSE than the NASDAQ exchange which is an order-driven market.

Your answer: A was incorrect. The correct answer was B) order-driven markets which are more similar to the NYSE than the NASDAQ exchange which is a price-driven market.

The Paris Bourse, Frankfurt DAX, and Tokyo Nikkei operate as order-driven markets. This is also referred to as an auction driven market, where the market matches the supply and demand for securities directly, and prices are determined by supply and demand. The U.S. NASDAQ is a price-driven market, where interested buyers and sellers submit bid and ask prices, and competition among market makers promotes the best prices. The NYSE is a combination of both an order-driven and price-driven system. Therefore, the NYSE more closely resembles the Paris Bourse and Frankfurt DAX than does the NASDAQ.

Part 2)

Given the information prepared by Davidson, what is the best estimate of the country risk premium for Germany?

A) 0.25%.

B) 1.25%.

C) 1.00%.

D) 3.00%.

Your answer: A was incorrect. The correct answer was C) 1.00%.

Calculation of the country risk premium using the US denominated bond yield is as follows:

German government bond yield (US dollar denominated) - U.S. 10 year T-bond yield

- Yield spread between comparably rated U.S. corporate and U.S. T-bond yields Country Risk Premium

Country Risk Premium = 8.50 – 4.75 – (7.50-4.75) = 8.50 – 4.75 – 2.75

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= 1.00 Part 3)

In Davidson’s investment example concerning KDR Corporation, the difference between the pre-tax return and the after tax return is:

A) 8.71%.

B) 13.02%.

C) 4.93%.

D) 1.43%.

Your answer: A was incorrect. The correct answer was C) 4.93%.

EUR dividend per share = EUR1*(1-0.15) = EUR0.85

Net USD dividend on 100 shares = EUR0.85*100*0.85USD/EUR = USD72.25 Tax credit in USD on 100 shares = EUR0.15*100*0.85USD/EUR = USD12.75

USD proceeds from sale of 100 shares = EUR30*100*0.85USD/EUR = USD2,550.00 Cost of 100 share in USD = EUR2,800*0.80USD/EUR = USD2,240.00

ST capital gains tax = (USD2,550 – USD2,240)*0.28 = USD86.80 Tax on gross dividend = USD85*0.28 = USD23.80

Total pre-tax return = (2,550 – 2,240 + 85.00)/2,240 = 0.1763

Total after-tax return = [(2,550 – 2,240 + 72.25) – 86.80 – 23.80 + 12.75]/2,240 = 0.1270 Impact of taxes on total return = 0.1763 – 0.1270 = 0.0493

Part 4)

Regarding the statements made concerning methods to reduce execution costs:

A) Davidson’s statement is incorrect, Pyle’s statement is correct.

B) Davidson’s statement is incorrect, Pyle’s statement is incorrect.

C) Davidson’s statement is correct, Pyle’s statement is correct.

D) Davidson’s statement is correct, Pyle’s statement is incorrect.

Your answer: A was incorrect. The correct answer was D) Davidson’s statement is correct, Pyle’s statement is incorrect.

Program trading reduces execution costs by trading large baskets of securities. Internal crossing networks minimize trading costs by simultaneously executing a buy and sell order for the same security between different clients within the firm. External crossing is similar to internal crossing, except clients are across an electronic crossing network. Other ways of potentially reducing execution costs are principal trades, agency trades, futures contracts, and indications of interest. Overseas trading is not a technique for lowering execution costs. Therefore, Davidson correctly identifies methods to reduce trading costs, while Pyle does not.

Part 5)

Which of the features concerning ADRs described by Pyle were CORRECT?

A) Features 1, 2, and 5.

B) Features, 2, 3, and 5.

C) Features 3 and 4.

D) Features 2 and 4.

Your answer: A was incorrect. The correct answer was D) Features 2 and 4.

Level 3 ADRs are the most prestigious and enable the issuer to raise capital and gain visibility in the U.S.

financial markets. Level 1 ADRs do not comply with SEC registration and reporting requirements, trade solely on the OTC market, and are often used to gauge interest for the firm’s securities in North America. Level 2 ADRs are listed on an exchange which includes either the NYSE or the NASDAQ. Therefore, Pyle’s Feature 2 is correct, but feature 1 is incorrect. ADRs are denominated in U.S. dollars, however, they do not eliminate currency risk – Pyle’s Feature 3 is incorrect. The primary advantage to investing in ADRs is that they reduce administration and duty costs on each transaction. Pyle’s Feature 4 is correct. ADRs are issued by U.S.

banks and consist of a bundle of shares of a foreign corporation that are being held in custody overseas. Pyle has his description backwards and his Feature 5 is incorrect.

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Part 6)

Davidson discussed foreign closed-end funds and exchange-traded funds (ETFs) with Musch. All of the following are correct statements regarding these investments EXCEPT:

A)portfolio managers do not have to worry about redemptions for shares of an international closed-end fund.

B)exchange-traded funds achieve international diversification with high levels of liquidity at a minimal cost.

C) open-end shares trade at their net asset value with no discounts or premiums.

D)the market value of closed-end country funds have historically had very low correlations with the U.S. stock markets.

Your answer: A was incorrect. The correct answer was D) the market value of closed-end country funds have historically had very low correlations with the U.S. stock markets.

Closed-end country funds have historically had periods where their returns are highly correlated with the U.S.

stock market, and this reduces the benefits of international diversification with these funds.

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