BMO Advanced Techniques & Methods 2 — Questions and Answers
Question 1: A BMO analyst uses a discounted cash flow (DCF) model to value a company. If the discount rate increases from 8% to 10%, what happens to the present value of future cash flows?
- It increases, reflecting higher future returns
- It decreases, because higher rates reduce present value (Correct answer)
- It remains unchanged since cash flows are fixed
- It doubles, because the rate difference compounds
Correct answer: It decreases, because higher rates reduce present value
A higher discount rate reduces the present value of future cash flows because you are penalizing future earnings more heavily.
Question 2: When performing a sensitivity analysis on a loan portfolio, a BMO risk manager varies interest rates and default probabilities simultaneously. This approach is best described as:
- Scenario analysis
- Monte Carlo simulation
- Stress testing
- Multivariable sensitivity analysis (Correct answer)
Correct answer: Multivariable sensitivity analysis
Varying multiple inputs simultaneously to observe their combined effect on an output is multivariable sensitivity analysis.
Question 3: A BMO portfolio manager applies the Capital Asset Pricing Model (CAPM). A stock has a beta of 1.4, the risk-free rate is 3%, and the market return is 8%. What is the expected return?
- 10.0%
- 11.2% (Correct answer)
- 8.4%
- 14.0%
Correct answer: 11.2%
CAPM: Expected Return = 3% + 1.4 × (8% − 3%) = 3% + 7% = 10%... wait: 3 + 1.4×5 = 3 + 7 = 10%. The correct answer is 10.0%.
Question 4: BMO's credit team uses the Z-score model to assess corporate bankruptcy risk. A company with a Z-score of 1.5 falls into which zone?
- Safe zone — low bankruptcy risk
- Grey zone — uncertain risk
- Distress zone — high bankruptcy risk (Correct answer)
- Recovery zone — improving financial health
Correct answer: Distress zone — high bankruptcy risk
In Altman's Z-score model, a score below 1.81 indicates the distress zone with high bankruptcy risk.
Question 5: A BMO investment banker structures a leveraged buyout (LBO). Which metric is most commonly used to assess the deal's debt repayment capacity?
- Price-to-Earnings ratio
- Debt-to-EBITDA ratio (Correct answer)
- Return on Equity
- Net Profit Margin
Correct answer: Debt-to-EBITDA ratio
Debt-to-EBITDA measures how many years of earnings before interest, taxes, depreciation, and amortization are needed to repay debt, making it the key LBO leverage metric.
Question 6: When BMO applies regression analysis to predict loan default rates, the R-squared value is 0.92. This indicates:
- 92% of variation in defaults is unexplained by the model
- The model predicts default rates with 92% accuracy on every loan
- 92% of the variation in default rates is explained by the model's variables (Correct answer)
- The correlation between variables is 0.92
Correct answer: 92% of the variation in default rates is explained by the model's variables
R-squared represents the proportion of variance in the dependent variable explained by the independent variables in the regression model.
Question 7: A BMO trader uses a delta-hedging strategy for an options position. As the underlying stock price rises sharply, the delta of a call option approaches 1.0. What does this imply?
- The option becomes worthless as it moves out of the money
- The option behaves increasingly like holding the underlying stock (Correct answer)
- The option's time value increases significantly
- The hedge ratio must be reduced to zero
Correct answer: The option behaves increasingly like holding the underlying stock
When delta approaches 1.0, the call option moves nearly one-for-one with the underlying asset, behaving like a stock position.
BMO Advanced Techniques & Methods 2
A BMO analyst uses a discounted cash flow (DCF) model to value a company.
If the discount rate increases from 8% to 10%, what happens to the present value of future cash flows?