PASSMAX
2021 LEVEL I CFA® EXAM
MOCK 1
SESSION 1: Solutions
(The Solutions for Session 2 begin on Page 28)
1
ETHICS (1-28)
1. Vishal Chandarana, an unemployed research analyst, recently registered for the exam. After two months of
intense interviewing, he accepts a job with a stock brokerage company in a different region of the country.
Chandarana posts on a blog how being a CFA candidate really helped him get a job. He also notes how relieved
he was when his new employer did not ask him about being fired from his former employer. Which CFA
Institute Standards of Professional Conduct
did Chandarana least likely violate?
A. Loyalty to Employers
B. Reference to CFA Institute, the CFA Designation, and the CFA Program
C. Misconduct
Answer = B
There is no evidence Chandarana violated Standard VII(B)–Reference to CFA Institute, the CFA Designation,
and the CFA Program with regard to his being a CFA candidate. Specifically, Chandarana does not overstate his
competency or imply he will achieve superior performance as a result of his CFA designation. It does appear,
however, Chandarana did not act with integrity when he hid information that could potentially harm his new
employer's reputation, thus violating Standard I(D)–Misconduct and Standard IV(A)–Loyalty.
Source: "Guidance for Standards I–VII"
*
2. David Donnigan enrolled to take the Level II CFA examination in the current year, but he did not take the
exam. Donnigan advised his employer that he passed Level II. Subsequently, he registered to take the Level II
exam the next year. Which CFA Institute Standards of Professional Conduct did Donnigan least likely violate?
The standard related to:
A. referencing candidacy in the CFA Program.
B. duty to employer.
C. professional misconduct.
Answer = A
Because he registered to take the exam in the next year, Donnigan still qualifies to state he is a candidate in the
CFA Program. He would not, however, be authorized to reference that he is a Level III candidate and, if asked,
would need to specifiy that he is a Level II candidate.
Source: "Guidance for Standards I-VII,"
*
3. Ian O'Sullivan, CFA, is the owner and sole employee of two companies, a public relations firm and a
financial research firm. The public relations firm entered into a contract with Mallory Enterprises to provide
public relations services, with O'Sullivan receiving 40,000 shares of Mallory stock in payment for his services.
Over the next 10 days, the public relations firm issued several press releases that discussed Mallory's excellent
growth prospects. O'Sullivan, through his financial research firm, also published a research report
recommending Mallory stock as a "buy." According to the CFA Institute Standards of Professional Conduct,
O'Sullivan is most likely required to disclose his ownership of Mallory stock in:
A. the press releases only.
B. the research report only.
C. both the press release and the research report.
Answer = C
Members should disclose all matters that reasonably could be expected to impair the member's objectivity as
outlined in Standard I(B), and Standard VI(A).
Source: "Guidance for Standards I-VII,"
*
4. James Woods, CFA, is a portfolio manager at ABC Securities. Woods has reasonable grounds to believe his
colleague, Sandra Clarke, a I candidate, is engaged in unethical trading activities that may also be in violation
of local securities laws. Woods is not Clarke's supervisor, and her activities do not impact Woods or any of the
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portfolios for which he is responsible. Based on the Code and Standards, the recommended course of action is
for Woods to:
A. report Sandra Clarke to ABC's trading supervisor or compliance department.
B. not take any action because he is not directly involved.
C. report Sandra Clarke to the appropriate governmental or regulatory organization.
Answer = A
Under Standard 1(A) in situations where a member or candidate is aware of employer engagement in unethical
or illegal activity, it is recommended that they attempt to stop the behavior by bringing it to the attention of a
supervisor or the firm's compliance department.
Source: "Guidance for Standards I-VII,"
*
5. Madeline Smith, CFA, was recently promoted to senior portfolio manager. In her new position, Smith is
required to supervise three portfolio managers. Smith asks for a copy of her firm's written supervisory policies
and procedures but is advised that no such policies are required by regulatory standards in the country where
Smith works. According to the Standards of Practice Handbook, Smith's most appropriate course of action
would be to:
A. decline to accept supervisory responsibility until her firm adopts procedures to allow her to adequately
exercise such responsibility.
B. require the employees she supervises to adopt the CFA Institute Code of Ethics and Standards of
Professional Conduct.
C. require her firm to adopt the CFA Institute Code of Ethics and Standards of Professional Conduct.
Answer = A
According to guidance for Standard (IV(C), if a member cannot fulfill supervisory responsibilities because of
the absence of a compliance system or because of an inadequate compliance system, the member should decline
in writing to accept supervisory responsibility until the firm adopts reasonable procedures to allow the member
to adequately exercise such responsibility.
Source: "Guidance for Standards I-VII,"
*
6. Nicholas Bennett, CFA, is a trader at a stock exchange. Another trader approached Bennett on the floor of the
exchange and verbally harassed him about a poorly executed trade. In response, Bennett pushed the trader and
knocked him to the ground. After investigating the incident, the exchange cleared Bennett from any
wrongdoing. Which of the following best describes Bennett's conduct in relation to the CFA Institute Code of
Ethics or Standards of Professional Conduct? Bennett:
A. violated the standard relating to professionalism.
B. did not violate any of the Code of Ethics or Standards of Professional Conduct.
C. violated both the standard relating to professionalism and integrity of capital markets.
Answer = A
The CFA Institute Code of Ethics requires members to act with integrity, competence, diligence, respect, and in
an ethical and professional manner. The Standards of Professional Conduct relating to professional misconduct
state members and candidates must not commit any act reflecting adversely on their professional reputation,
integrity, or competence. Bennett's actions violated the Code of Ethics and StandardI(D)–Professionalism, but
not Standard II–Integrity of Capital Markets.
Source: "Guidance for Standards I-VII,"
*
7. According to the CFA Institute Code of Ethics and Standards of Professional Conduct, trading on material
nonpublic information is least likely to be prevented by establishing:
A. personal trading limitations.
B. selective disclosure.
C. firewalls.
Answer = B
3
Selective disclosure occurs when companies discriminate in making material nonpublic information public.
Corporations that disclose information on a limited basis create the potential for insider-trading violations. See
Standard II(A).
Source: "Guidance for Standards I-VII,"
*
8. During an on-site company visit, Marsha Ward, CFA, accidentally overheard the chief executive officer of
Stargazer, Inc. discussing the company's tender offer to purchase Dynamica Enterprises, a retailer of Stargazer
products. According to the CFA Institute Standards of Professional Conduct, Ward most likely cannot use the
information because:
A. it was overheard and might be considered unreliable.
B. she does not have a reasonable and adequate basis for taking investment action.
C. it relates to a tender offer.
Answer = C
Trading on the information is restricted given that it relates to a tender offer; it is clearly material, nonpublic
information as stated in Standard II(A).
Source: "Guidance for Standards I-VII,"
*
9. Adira Badawi, CFA, who owns a research and consulting company, is an independent board member of a
leading cement manufacturer in a small local market. Because of Badawi's expertise in the cement industry, a
foreign cement manufacturer looking to enter the local market has hired him to undertake a feasibility study.
Under what circumstances can Badawi most likely undertake the assignment without violating the CFA Institute
Code of Ethics and Standards of Professional Conduct?
A. He makes full disclosure to both companies.
B. He signs confidentiality agreements with both companies.
C. He receives written permission from the local company.
Answer = A
Making full and fair disclosure of all matters that could reasonably be expected to impair one's independence
and objectivity or interfere with respective duties to one's clients is required by Standard VI(A)–Disclosure of
Conflicts.
Source: "Guidance for Standards I–VII"
*
10. Which of the following is not a component of the CFA Institute Code of Ethics?
A. Promote financial integrity and seek to prevent and punish abuses in the financial markets.
B. Practice and encourage others to practice in a professional and ethical manner that will reflect credit on
themselves and the profession.
C. Place the integrity of the investment profession and the interests of clients above your own personal interests.
Answer = A
Punishing abuse in the financial markets is not one of the six components of the Code of Ethics.
Source: “Code of Ethics,”
*
11. Jiro Sato, CFA, deputy treasurer for May College, manages the Student Scholarship Trust. Sato issued a
request for proposal (RFP) for domestic equity managers. Pamela Peters, CFA, a good friend of Sato, introduces
him to representatives from Capital Investments, which submitted a proposal. Sato selected Capital as a
manager based on the firm's excellent performance record. Shortly after the selection, Peters, who had
outstanding performance as an equity manager with another firm, accepted a lucrative job with Capital. Which
of the CFA charterholders violated the CFA Institute Standards of Professional Conduct?
A. Both
B. Neither
C. Peters
Answer = B
Members should use reasonable care and judgment to maintain independence and objectivity, as stated in
Standard I (B). There is no indication of inappropriate behavior in the selection of the equity manager or in the
4
acceptance of employment with that manager; both decisions were based on the excellent performance records
of the manager and the member, respectively.
Source: "Guidance for Standards I-VII,"
*
12. Claire Jones, CFA, is an analyst following natural gas companies in the United States. At an industry energy
conference, the chief financial officer of Alpine Energy states that the company is interested in making strategic
acquisitions. At a separate event, Alpine's head of exploration commented that he is bullish on natural gas
production prospects within northeastern Pennsylvania. Jones is aware that Alpine currently has very little
exposure to this region. She also knows another company in her universe, Pure Energy, Inc. is based in
northeastern Pennsylvania and controls significant assets in the area. Pure Energy is highly leveraged, and Jones
believes it will need to raise additional capital or partner with another firm to move to the production phase with
their assets. Jones attempts to contact Alpine's chief executive officer with an unrelated question and is told he
is unavailable because he is on a business trip to northeastern Pennsylvania. Jones updates her research on Pure
Energy and then recommends the stock to Lisa Wong, CFA, a portfolio manager, who purchases significant
positions in client accounts. The following week, Pure Energy announces it has entered into an agreement to be
purchased by Alpine for a significant premium. Has either Jones or Wong most likely violated standards with
regard to the integrity of capital markets?
A. Yes, Jones' recommendation is based on insider information
B. No
C. Yes, both Jones and Wong have acted on insider information
Answer = B
Jones has used the mosaic theory to combine nonmaterial, nonpublic information with material public
information.
Source: "Guidance for Standards I-VII,"
*
13. Ron Dunder, CFA, is the CIO for Bling Trust (BT), an investment adviser. Dunder recently assigned one of
his portfolio managers, Doug Chetch, to manage several accounts that primarily invest in thinly traded microcap stocks. Dunder soon notices that Chetch places many stock trades for these accounts on the last day of the
month, toward the market's close. Dunder finds this trading activity unusual and speaks to Chetch, who explains
that the trading activity was completed at the client's request. Dunder does not investigate further. Six months
later, regulatory authorities sanction BT for manipulating micro-cap stock prices at month end in order to boost
account values. Did Dunder violate any CFA Institute Standards of Professional Conduct?
A. Yes, because he failed to reasonably supervise Chetch.
B. Yes, because he did not report his findings to regulatory authorities.
C. No.
Answer = A
The CFA Institute Code and Standard on Responsibilities of Supervisors, Standard IV (C), requires
members/candidates to take steps to detect and prevent violations of laws, rules and regulations. Dunder failed
in his supervisory role when he accepted Chetch's explanation of the unusual trading activity. Dunder should
have reviewed the client's goals and objectives, as well as records, to see whether the client in fact requested
month-end trading. Regardless of the explanation provided by Chetch, Dunder should have investigated further.
Source: "Guidance for Standards I-VII,"
*
14. Jefferson Piedmont, CFA, a portfolio manager for Park Investments, plans to manage the portfolios of
several family members in exchange for a percentage of each portfolio's profits. Because his family members
have extensive portfolios requiring substantial attention, they have requested that Piedmont provide the services
outside of his employment with Park. Piedmont notifies his employer in writing of his prospective outside
employment. Two weeks later, Piedmont begins managing the family members' portfolios. By managing these
portfolios, which of the following CFA Institute
Standards of Professional Conduct has Piedmont violated?
A. Conflicts of Interest
B. Additional Compensation
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C. Both Additional Compensation and Conflicts of Interest
Answer = C
According to Standard IV(B) and Standard VI(A), members should disclose all potential conflicts of interest,
should disclose the substantial time involved in managing family accounts and, when engaging in independent
practice for compensation, should not render services until receiving written consent from all parties.
Source: "Guidance for Standards I-VII,"
*
15. Carolina Ochoa, CFA, is the chief financial officer at Pantagonia Computing. Ochoa is currently the subject
of an inquiry by Pantagonia's corporate investigations department. The inquiry is the result of an anonymous
complaint accusing Ochoa of falsifying travel expenses for senior management related to a government
contract. According to the CFA Institute Code of Ethics and Standards of Professional Conduct, it is most
appropriate for Ochoa to disclose the allegations:
A. to CFA Institute when the investigation concludes.
B. on her Professional Conduct Statement.
C. to CFA Institute if the allegations are proven correct.
Answer = B
Members and candidates must self-disclose on the annual Professional Conduct Statement all matters that
question their professional conduct, such as involvement in civil litigation or criminal investigations or being
the subject of a written complaint.
Source: "Guidance for Standards I-VII,"
*
16. Ileana Inkster, CFA, was recently offered a senior management position within the trust department at a
regional bank. The department is new, but the bank has plans to expand it significantly over the next few
months. Inkster has been told she will be expected to help grow the client base of the trust department. She is
informed that the trust department plans to conduct educational seminars and pursue the attendees as new
clients. Inkster notices that recent seminar advertisements prepared by the bank's marketing department do not
mention investment products will be for sale at the seminar. The ads indicate attendees can "learn how to
immediately add $100,000 to their net worth." What should Inkster most likely do to avoid violating any CFA
Institute Standards of Professional Conduct?
A. Decline to accept the new position
B. Accept the position and inform senior management of inadequate compliance procedures
C. Accept the position and revise the marketing material
Answer = A
The prospective supervisor's first step should be to not take the position. Accepting the position with inadequate
procedures in place or improper marketing material would leave Inkster at risk of incurring a violation of
Standard IV(C)–Responsibilities of Supervisors. She could agree to be hired as an interim consultant with the
bank in order to implement adequate procedures before taking on any supervisory role.
Source: "Guidance for Standards I-VII,"
*
17. Beth Kozniak, a CFA candidate, is an independent licensed real estate broker and a well-known property
investor. She is currently brokering the sale of a commercial property on behalf of a client in financial distress.
If the client's building is not sold within 30 days, he will lose the building to the bank. A year earlier, another
client of Kozniak's had expressed interest in purchasing this same property. However, she is unable to contact
this client, and she has not discovered any other potential buyers. Given her distressed client's limited time
frame, Kozniak purchases the property herself and forgoes any sales commission. Six months later, she sells the
property for a nice profit to the client who had earlier expressed interest in the property. Has Kozniak most
likely violated the CFA Institute Standards of Professional Conduct?
A. No
B. Yes, she did not disclose her potential conflicts of interest to either client
C. Yes, she profited on the real estate to the detriment of her financially stressed client
Answer = A
6
Kozniak does not appear to have violated any CFA Institute Standards of Professional Conduct. Because she is
known in the market for investing and brokering property and both parties have worked with Kozniak in the
past, both parties would know of her interests. In addition, in both cases, she acts for her own account as a
primary investor, not as a broker. She buys the property for her own portfolio and then sells the property from
her own portfolio. Therefore, Kozniak did not violate Standard VI(A)–Disclosure of Conflicts. When she
purchased the property for her portfolio, she saved her client from losing the building to the bank and did not
charge a sales commission. Because the sale of the property to her other client did not take place until six
months after her purchase, and she was unable to contact the client who had earlier expressed interest prior to
her purchase, she cannot be accused of violating Standard III(A)–Loyalty, Prudence, and Care with either client.
Source: "Guidance for Standards I-VII,"
*
18. Mariam Musa, CFA, head of compliance at Dunfield Brokers, questions her colleague Omar Kassim, a CFA
candidate and a research analyst, about his purchase of shares in a company for his own account immediately
before he publishes a "buy" recommendation. He defends his actions by stating he has done nothing wrong
because Dunfield does not have any personal trading policies in place. The CFA Institute Standards of
Professional Conduct were most likely violated by:
A. only Kassim.
B. both Musa and Kassim.
C. only Musa.
Answer = B
Both Musa and Kassim violated the Standards of Professional Conduct. Musa violated Standard IV(C)–
Responsibilities of Supervisors by not ensuring policies were in place to prevent violations of the Standards of
Professional Conduct (in this case, Standard VI(B)–Priority of Transactions) by someone subject to her
supervision. As the head of compliance, Musa supervised Kassim and must meet her supervisory
responsibilities outlined in the Standards of Professional Conduct. Kassim violated Standard VI(B)–Priority of
Transactions because he did not give sufficient priority to Dunfield's clients before trading on his
recommendation.
Source: "Guidance for Standards I-VII,"
*
19. James Simone, CFA, the chief financial officer of a publicly listed company, seeks to improve the quality of
his company's communication with institutional fund managers. He holds an investor briefing with this group
the evening before the company earnings are announced. The company's quarterly earnings are broadcast in a
press release the next day before the market opens. The earnings information in the investor briefing is identical
to that in the press release. Did Simone most likely violate the CFA Institute Standards of Professional Conduct?
A. Yes
B. No, because the company releases information while the market is closed
C. No, because investor briefing and press release information are identical
Answer = A
Simone violated Standard II(A)–Material Nonpublic Information by giving institutional fund managers access
to material nonpublic information prior to public dissemination (i.e., the press release). By releasing earnings
results to a select group of institutional fund managers prior to a public press release, Simone allows the
institutional fund managers a time advantage over other investors not invited to the investor briefing.
Source: "Guidance for Standards I-VII,"
*
20. Diana Fairbanks, CFA, is married to an auditor who is employed at a large accounting firm. When her
husband mentions that a computer firm he audits will receive a qualified opinion, she thinks nothing of it. Later
that week, when she reviews a new client account, she notices there are substantial holdings of this computer
firm. When she does a thorough internet search for news on the company, she does not find anything about its
most recent audit or any other adverse information. Which of the following actions concerning the computer
stock should Fairbanks most likely take to avoid violating the CFA Institute Standards of Professional Conduct?
A. Complete a thorough and diligent analysis of the company and then sell the stock.
B. Sell the stock immediately because she has a reasonable basis for taking this investment action.
7
C. Take no investment action.
Answer = C
The information concerning the qualified opinion is material. It is also nonpublic because it has not been
released and is not available online, so the mosaic theory would not hold up in this case. As a result, she would
be in violation of Standard II(A)–Material Nonpublic Information if she took investment action based on this
information. She should also make reasonable efforts to achieve public dissemination of the information.
Source: "Guidance for Standards I-VII,"
*
21. Margie Germainne, CFA, is a risk management consultant who has been asked by a small investment bank
to recommend policies to prevent bank employees from front running client orders. These clients generally
invest in one or more of the bank's large cap equity unit trusts. To ensure compliance with the CFA Institute
Standards of Professional Conduct, Germainne should least likely recommend which of the following?
Employees should be restricted from trading:
A. equity-related securities.
B. without prior permission.
C. during established time periods.
Answer = A
Although Standard VI(B)–Priority of Transactions is designed to prevent any potential conflict of interest or the
appearance of a conflict of interest with respect to personal transactions, it does not ban employees from trading
securities. A ban on all equity-related securities could be excessively restrictive to employees and unnecessary
if appropriate personal transaction policies and procedures are in place.
Source: "Guidance for Standards I-VII,"
*
22. Molly Burnett, CFA, is a portfolio manager for a fund that only invests in environmentally friendly
companies. A multinational utility company recently acquired one of the fund's best-performing investments, a
wind power company. The wind power company's shareholders received utility company shares as part of the
merger agreement. The utility has one of the worst environmental records in the industry, but its shares have
been one of the top performers over the past 12 months. Because the utility pays a high dividend every three
months, Burnett holds the utility shares until the remaining two dividends are paid for the year then sells the
shares. Burnett most likely violated the CFA Institute Standard of Professional Conduct concerning:
A. Disclosure of Conflicts.
B. Suitability.
C. Independence and Objectivity.
Answer = B
The utility is not a suitable investment for a fund that only invests in companies with good environmental
records. Continuing to hold this investment, therefore, was a violation of Standard III(C)–Suitability.
Source: "Guidance for Standards I-VII,"
*
23. Johannes Meir, CFA, is a compliance officer for Family Estate Planning, LLC, a private wealth consulting
firm. Many of his colleagues have family members who have started their own retail businesses. Some of Meir's
colleagues have been asked by relatives to serve as non-executive directors or advisers to their companies. Meir
should most likely recommend which of the following policies to ensure compliance with the CFA Institute
Standards of Professional Conduct?
A. Require employees to declare all income sources annually
B. Require employees to declare all outside business interests
C. Prohibit employees from becoming directors or advisers
Answer = B
Standard VI(A)–Disclosure of Conflicts requires the disclosure of conflicts. For Meir to understand what
potential conflicts of interest employees may have with the firm and with their clients, he would need to know
the outside interests of each staff member. The staff members themselves may not know enough about the
company and its clients to disclose those interests that would present a potential conflict. Therefore, it may be
8
best to have all employees declare their outside business interests on an annual basis so Meir can make the
determination as to what outside business interests need to be disclosed to clients.
Source: "Guidance for Standards I-VII,"
*
24. Which of the following statements concerning requirements under Standard V(B)–Communication with
Clients and Prospective Clients is least likely accurate? This standard requires members and candidates to:
A. divulge the number of investment related personnel responsible for external communication.
B. distinguish between fact and opinion in the presentation of investment analysis and recommendations.
C. disclose the basic format and general principles of the investment process.
Answer = A
Standard V(B)–Communication with Clients and Prospective Clients does not limit the type or number of staff
responsible for external communication.
Source: "Guidance for Standards I-VII,"
*
25. Gabrielle Gabbe, CFA has been accused of professional misconduct by one of her competitors. The
allegations concern Gabbe's personal bankruptcy filing 10 years ago when she was a college student and had a
large amount of medical bills she could not pay. By not disclosing the bankruptcy filing to her clients, did
Gabbe most likely violate any CFA Institute Standards of Professional Conduct?
A. No
B. Yes, related to Misconduct
C. Yes, related to Misrepresentation
Answer = A
A personal bankruptcy does not necessarily constitute a violation of Standard I(C)–Misrepresentation or
Standard I(D)–Misconduct. If the circumstances of the bankruptcy involved fraudulent or deceitful business
conduct, then failing to disclose it may constitute a violation of the Standards of Professional Conduct.
Source: "Guidance for Standards I-VII,"
*
26. After a firm presents a minimum required number of years of GIPS- compliant performance, the firm must
present an additional year of performance each year, building up to a minimum of:
A. 10 years of GIPS-compliant performance.
B. 15 years of GIPS-compliant performance.
C. 5 years of GIPS-compliant performance.
Answer = A
After a firm presents a minimum of five years of GIPS-compliant performance, the firm must present an
additional year of performance each year, building up to a minimum of 10 years of GIPS-compliant
performance.
Source: Global Investment Performance Standards (GIPS)
*
27. According to the Global Investment Performance Standards (GIPS), firms must do all of the following
except:
A. adhere to certain calculation methodologies and make specific disclosures along with their performance.
B. provide investors with a comprehensive view of their performance only in terms of returns.
C. comply with all requirements of the GIPS standards, such as updates, guidance statements, and clarifications.
Answer = B
Firms must provide investors with a comprehensive view of their performance in terms of risk and returns, not
just returns.
Source: Global Investment Performance Standards (GIPS)
*
28. According to the Global Investment Performance Standards (GIPS), which of the following is not a part of
the verification process? Testing whether the:
A. firm has complied with all the composite construction requirements.
B. verification is undertaken by the compliance department in the absence of a third party.
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C. firm's processes and procedures are designed to calculate results in compliance with GIPS standards.
Answer = B
Source: Global Investment Performance Standards (GIPS)
QUANTITATIVE METHODS (29-45)
29. Which of the following statements is least likely accurate with respect to the determination of the required
rate of return on an investment?
A. The greater the rate of expected inflation, the greater will be the required rate of return.
B. The faster the growth rate of expected cash flows, the greater will be the required rate of return.
C. Investments with relatively lesser tax burdens, will generally command a lower required rate of return,
holding all other factors constant.
Answer = B
The growth rate is not directly tied in with the required rate of return.
Source: The Time Value of Money
*
30. Your friend is currently 40 years old and plans to retire when she turns 62. She expects her life expectancy
to be 90 years and the appropriate discount rate to hold steady at 6.78%. She plans to redeem $34,000 per year,
at the end of each year of retirement. Ignoring taxes and inflation, how much would she need to save at the end
of each year before retirement, in order to meet her retirement goal?
A. $421,578
B. $8,838
C. $5,417
Answer = B
PMT=34000; N=28; I=6.78%, CPT PV=421578
FV=421578; N=22; I=6.78%, CPT PMT = 8838
Source: The Time Value of Money
*
31. Jane Doe is currently 32 years old and plans to retire when she’s 69. Her life expectancy is 93 years. Her
current consumption expenditure is $43,000. Inflation is expected to average around 2.5% for the remainder of
her working years. If her goal is to have her real retirement income equal to 75% of her current expenditure,
and she can reasonably earn a 9% return on her savings, how much must she have accumulated on her
retirement date?
A. $825,466
B. $1,040,684
C. $780,508
Answer = C
i) PV=43000, N=37, I=2.5, CPT FV=107,214
ii) she requires 75% of that = 80410
iii) PMT=80410, N=24, I=9, CPT PV=780,508
Source: The Time Value of Money
*
32. Over a four year period, Mutual Fund A exhibited the following annual rates of return: 8, 11, 15, and -2.
Which of the following best approximates the:
Mean Absolute Deviation
Variance
A.
5.0
30.8
B.
5.0
39.5
C.
4.6
30.8
Answer =B
NOTE: Unless the question makes a distinction between a sample and a population, just assume that it’s a
population (therefore using n as the divisor when computing variance).
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i) compute average = (8+11+15-2)/4 = 8
ii) MAD = [ |8-8| + |11-8| + |15-8| + |-2-8| ] / 4 = 5
iii) var = [(8-8)^2 + (11-8)^2 + (15-8)^2 + (-2-8)^2 ] / 4 = 39.5
Source: Statistical Concepts and Market Returns
*
33. A pension fund manager is aware that 4.8% is the minimum return that needs to be achieved in order to
meet the fund’s future liabilities. Over the last 5 years, the arithmetic and geometric rates of return have
averaged around 9.4% and 7.8% respectively. If the variance of this performance has been 156 and the risk free
rate has remained steady at 3.6%, which of the following best approximates Coefficient of Variation:
A.
1.33
B.
1.33
C.
1.48
Answer =A
Standard deviation = (156)^0.5 = 12.5
CV=[12.5]/9.4 = 1.33
Source: Statistical Concepts and Market Returns
*
34. A descriptive measure of a population characteristic is best described as a:
A. parameter.
B. frequency distribution.
C. sample statistic.
Answer = A
Any descriptive measure (such as mean or variance) of a population is called a parameter, whereas descriptive
measures of a sample are referred to as statistics.
Source: Statistical Concepts and Market Returns
*
35. Event X and event Y are independent events. The probability of X is 0.2 [P(X) = 0.2] and the probability of
Y is 0.5 [P(Y) = 0.5]. The joint probability of X and Y [P(X, Y] is closest to:
A. 0.1.
B. 0.3.
C. 0.7.
Answer = A
Given that X and Y are independent, their joint probability is equal to the product of their individual
probabilities. In this problem, we calculate 0.2 × 0.5 = 0.1.
Source: Probability Concepts
*
36. After concluding that the economy has entered a recession, an analyst increases the probability that used car
sales will exceed 800,000 units. This probability may best be referred to as
A. a priori.
B. subjective.
C. empirical.
Answer =A.
A priori probability is established by observing current values for the conditional variables.
Source: Probability Concepts
*
37. A portfolio manager estimates the probabilities of the following events for a mutual fund:
• Event A: the fund will earn a return of 5%.
• Event B: the fund will earn a return below 5%.
The least appropriate description of the events is that they are:
A. dependent.
B. exhaustive.
11
C. mutually exclusive.
Answer = B
Events are exhaustive when they cover all possible outcomes. Mutually exclusive means that only one event can
occur at a time. Two events are dependent if the occurrence of one event does affect the probability of
occurrence of the other event. In this situation, Event A and B are both mutually exclusive (because they cannot
occur at the same time) and dependent (because if one event occurs, the probability of the other becomes zero).
However, the two events are not exhaustive because they do not cover the event that the fund will earn a return
above 5%.
Source: Probability Concepts
*
38. Stock H has a an expected return of 9.4% and a standard deviation of 12.76%. Assuming that the return on
this stock is normally distributed, what is the probability that you’ll earn “at least” 2% next year?
Use the following excerpt from the cumulative normal distribution table:
(d): -1.72
-1.18 -0.74 -0.58 +0.34 +1.02 +1.56 +2.75
N(d): .0427 .1190 .2297 .2810 .6331 .8461
.9406
.9970
A. 28.10%
B. 22.97%
C. 71.90%
Answer = C
d=(2-9.4)/12.76 = -.58, thus N(d) = .2810
P(R>2%) = 1-.2810 = 0.719
Source: Common Probability Distributions
*
39. Stock L is expected to generate a return of 2% per month for the first 6 months and then 4% for the
remaining 6 month period. Assuming that the investment cost $71.25 to begin with, what would be the
equivalent continuously compounded annual percentage rate for this stock?
A. 14.72%
B. 15.80%
C. 20.83%
Answer = B
(1+EAR) = (1.02)6 x (1.04): EAR = 17.12
Ln(1.1712) = 15.80%
Source: Common Probability Distributions
*
40. The trustees of an endowment fund have indicated to you that they require at least the rate of inflation on
their portfolio in order to meet their expenditure needs. You come across four possible portfolios which may be
suitable for this client:
Portfolio K
Portfolio M Portfolio N
Expected Return:
15
22
18
Standard Deviaion:
9
16
9
If you determine that the long term average rate of inflation will be 3%, which of these portfolio’s would be
most suitable for this client?
A. Portfolio M
B. Portfolio N
C. Portfolio K
Answer = B
Choose the portfolio with the highest safety first ratio (i.e. the one with the most number of standard deviations
above the minimum required rate of return):
K = (15-3)/9 = 1.33
M = (22-3)/16 = 1.18
N = (18-3)/9 = 1.67
Source: Common Probability Distributions
12
*
41. From a sample of observations, you wish to determine the odds of the population average falling within a
specified range. Which of the following would be inconsistent with this exercise?
A. Within 1.96 standard errors of the sample mean, there is a 95% chance that the range would include the
population average, assuming that the sample size is large.
B. It is not imperative that the population variance be known in order to construct a confidence interval.
C. For a given confidence interval, the confidence range will become tighter as the degrees of freedom declines.
Answer = C
As the degrees of freedom (or sample size less one) decreases, the range will have to be expanded (i.e. margin
of error is increased) in order to cover the same confidence interval.
Source: Sampling and Estimation
*
42. When examining a sample in order to make an inference about the underlying population, which of the
following would most likely be deemed as a proper practice?
A. When looking at historical data, use only data that would have been available on the date of the observation,
not the date of the test.
B. Repeatedly run tests among the various variables until a relationship is found.
C. Only examine the historical data for the stocks which still remain in existence on the day of the test.
Answer = A
When conducting a test, one should only use data that would have been available to market participants in real
time. This avoids a testing pitfall referred to as “Look ahead bias”. Repeatedly running tests among the various
variables until a relationship is found is referred to as “data-mining”, and it basically amounts to searching for a
coincidence. Survivorship bias results when only examine the historical data for the stocks which still remain in
existence on the day of the test. Therefore, the sample results are biased upwards as the losing stocks are
excluded from the test. One should not change test parameters (i.e. sample period selection) in order to suit the
hypothesis.
Source: Sampling and Estimation
*
43. Which of the following statements is least accurate when conducting hypothesis tests concerning population
variance(s)?
A. An F-distribution must be used when conducting tests concerning the equality between two population
variances?
B. A chi-squared distribution has (n-1) degrees of freedom.
C. The distribution for sample variance is normally distributed.
Answer = C
The distribution for sample variance is “lognormal”, meaning that the lowest it can go to is zero (i.e. you cannot
have negative variance), while its upside is unlimited.
Source: Hypothesis Testing
*
44. In hypothesis testing, Type I error may be minimized if:
Sample size
Level of Significance
A.
Decreases
Decreases
B.
Decreases
Increases
C.
Increases
Decreases
Answer = C
Type I error: probability of rejecting the null when it’s true. This probability is equal to the level of
significance. As the level of significance increases, there is a greater likelihood that the null will be rejected.
On the other hand, as sample size increases, the standard error will decrease, meaning that the sample is very
representative of the population, i.e. there’s less likelihood that the null will get rejected if in fact it’s true.
Source: Hypothesis Testing
13
45. A portfolio manager claims that on average, his portfolio earn a return that’s in excess of 13%. A
compliance officer requires conclusive evidence of such a claim before allowing it to be publicized. Therefore,
she selects 18 portfolios, from which she compute an average return of 14.2% and a standard deviation of
16.8%. If she requires a 5% level of significance, which of the following would be her best course of action?
(The following is an excerpt from a Student’s t-Distribution):
Tail:
.025
.025
.05
.05
Df:
17
18
18
17
t-critial: 2.110
2.101
1.734
1.740
A. Refuse the publication of such a claim as the sample statistic of 0.303 is less that the t-critical of 1.740.
B. Allow the publication of such a claim since even the sample average return is in excess of the return that the
manager is claiming to have earned.
C. Refuse the publication of such a claim as the sample statistic of 0.071 is less than that of t-critical of 1.734
Answer =A:
Since the officer seeks conclusive evidence, the claim should be set up as the alternative hypothesis, this way if
the null is rejected (with a 95% margin of error), then she would have conclusive evidence that the alternative
statement is true.
The appropriate t-critical is 1.740.
The standard error of the sample mean = 16.8/(18)^(1/2) = 3.96
The sample statistic is (14.2-13.0)/[3.96] = 0.303
The officer cannot reject the null, and therefore, there is no conclusive evidence that the returns are in excess of
13%.
Source: Hypothesis Testing
ECONOMICS (46-62)
46. Which of the following is least likely a cause behind the increase in the price elasticity of a product?
A. An increase in the price of inputs.
B. An increase in the proportion of consumers’ income that’s spent on the product.
C. A longer evaluation period.
Answer = A
An increase in the price of inputs simply indicates that the price per unit should increase; however, elasticity
describes the percentage change in quantities sold relative to that percentage increase in price.
Source: Topics in Demand and Supply Analysis
*
47. Which of the following is not an accurate description of labour productivity in the short term?
A. Total product will always increase as more units of labour are added.
B. Starting with just one unit of labour, the marginal product of labour should at first decrease and then increase
as more units of labour are added.
C. As long as marginal product is above the average product, the average product will be increasing.
Answer = B
Starting with just one unit of labour, the marginal product of labour should at first increase and then decrease as
more units of labour are added. At first, the additional labour units would mean each labourer can specialize,
thus producing more units per labourer. As more workers are added, operations become less efficient.
Source: Topics in Demand and Supply Analysis
*
48. If the price of wazzus were to increase, the impact on total revenue when:
Demand is Inelastic
Demand is Elastic
A.
Increase
Increase
B.
Increase
Decrease
C.
Decrease
Increase
Answer = B
14
Inelastic demand implies that the total revenue goes in the direction of the price change, as the percentage
change in quantity is less than the percentage change in price. If demand is elastic, the drop in quantity would
dominate total revenue.
Source: Topics in Demand and Supply Analysis
*
49. Which of the following statements with respect to Giffen and Veblen goods is least accurate?
A. Giffen goods are "inferior," whereas Veblen goods are "high-status" goods.
B. Both types of goods violate the fundamental axioms of demand theory.
C. Both types of goods demonstrate the possibility of a positively sloping demand curve.
Answer = B
-Giffen Goods are a form of inferior good: when its price drops, real income (i.e. the consumer’s purchasing
power) increases, and therefore the quantity demanded decreases. As a result, price and quantity demanded
move in the same direction (i.e. the demand curve is positively sloped). These sequence of events are in line
with Demand Theory.
-Veblen Goods also exhibit a positively sloped demand curve; however, for a different reason: As the price of
the good is artificially increased, a sense of prestige becomes associated with the good, and hence, demand for it
increases. This is a violation of Demand Theory.
Source: Topics in Demand And Supply Analysis
*
50. Which of the following statements is least accurate with respect to the behavior of the marginal cost curve in
the short term?
A. If wages were to increase, there would be a movement up the marginal cost curve.
B. At higher levels of output, the law of diminishing returns would imply an increase in marginal cost as more
units are produced.
C. Even if average cost curve is decreasing, it is still quite possible for the marginal cost curve to be increasing.
Answer = A
The marginal cost curve is directly tied with the marginal productivity curve. At low levels of production, and
increase in production may bring specialization to the process, causing marginal productivity to increase and
marginal cost to decrease. However, at higher level of production, in the short term, plant capacity cannot be
increased. Therefore, added labor is not as productive, causing marginal costs to increase. Even if MC is rising,
if the value is still below ATC, then ATC will decrease. If input costs were to increase, the MC curve would
shift up for a given quantity, meaning a higher price is required in order to supply that amount.
Source: The Firm and Market Structures
*
51. Which of the following is the least likely outcome when a monopoly firm adopts first-degree (i.e. perfect)
price discrimination because of customers' differing demand elasticities?
A. The monopolist shares the total surplus with consumers.
B. The output increases to the point at which price equals the marginal cost.
C. The price for a marginal unit decreases to less than the price for other units.
Answer = A
Perfect price discrimination occurs when the monopoly firm charges each consumer the most that they are
willing to pay for its good. As a result, whatever surplus (i.e. value added) the consumer may have had from
purchasing that good, would now go to the monopoly firm; in other words, the monopoly firm captures the
entire consumer surplus. At the same time though, being able to charge each consumer the most that he/she is
willing to pay, would also imply that the firm would keep reducing its price in order to attract new consumers
who don’t place as high a value on the firm’s good. The firm will keep reducing its price (and thus sell more
units) until the price finally reaches the firm’s marginal cost. Beyond that point, the revenue brought in by
selling an incremental unit would fall short of the marginal cost of making that unit.
Source: The Firm and Market Structures
*
15
52. Six companies in an industry have the following market shares:
Corp.
A
B
C
D
E
F
Mkt.
30
25
16
12
10
7
(%)
If Companies D and F merge into a new Company, G, the industry's three-company concentration ratio would
be closest to:
A. 72%.
B. 74%.
C. 71%.
Answer = B
The concentration ratio for the top three companies would be 74%:
A (30%) + B (25%) + G (12% + 7%).
Source: The Firm and Market Structures
*
53. The following data pertain to the total output in units and average selling prices in an economy that
produces only two products, X and Y:
Product X
Product Y
Year
Output (units) Price/unit
Output (units) Price/unit
2011
2,800
€9
2,000
€47
2012
3,000
€11
1,800
€52
If the implicit price deflator for GDP in 2011 was 100, for 2012 it is closest to:
A. 106.2.
B. 106.8.
C. 113.4.
Answer = C
As of end of 2012:
Product X
Product Y
Total basket
Nominal GDP (at current prices): [3,000 x €11] + [1,800 x €52] = €126,600
Real GDP (at base year prices):
[3,000 x €9] + [1,800 x €47] = €111,600
GDP Deflator = Nominal GDP / Real GDP = €126,600 / €111,600 = 1.134
Therefore, current price levels in 2012 are 1.134 times higher than what they were in 2011 (the base year). In
other words, price levels have gone up 13.4% (i.e. inflation). Consequently, if the inflation index was 100 in
2011, it would be 1.134 times higher in 2012:
Index = 100 x 1.134 = 113.4
Source: Aggregate Output, Prices, and Economic Growth
*
54. Which of the following statements least accurately describes the various theories on the business cycle?
A. The Neoclassical theory stipulates that over the long term, real variables such as unemployment and output,
will be affected by shocks to the economy.
B. The Austrian School of Thought attributes fluctuations in the business cycle to government interventions in
the economy.
C. Kenesian theory stipulates that prices and wages are unlikely to react to changes in supply and demand
conditions for very long periods of time.
Answer = A
The main theories behind the behavior of business cycle are as follows:
1. Neoclassical: assumes that the economy will quickly adjust to shocks, and thus not allow for any long term
fluctuation in real variables such as output or unemployment.
2. Austrian School of Thought: stipulates that fluctuations in the business cycle are caused because of
government interventions in the economy.
16
3. Keynesian: While the Neoclassical and the Austrian schools of thought stipulate that the markets will be
quick to adjust to any new shocks and thus require little or no intervention on the part of the government,
Keynesian economists point out that wage and prices take a very long time to adjust, thus resulting in a
disequilibrium for long periods of time.
Source: Understanding Business Cycles
*
55. Which of the following definitions of Employment is most accurate?
A. The Labor Force Participation Rate measures the Labor Force relative to the working age population, rather
than the population as a whole.
B. The unemployment figure includes individuals who have given up looking for work.
C. The Unemployment Rate figure compares the number of people who are unemployed relative to the total
working age population.
Answer = A
A. Labor Force Participation Rate = Labor Force ÷ Working Age Population
This measure represents the proportion of the working age population (i.e. the 16-65 age group) that is currently
in the labor force (i.e. currently have a job or seeing one).
B. Unemployed: are the number of individuals who do not currently work but are actively seeking employment.
A person is deeded unemployed if they have been seeking employment for more than 4 months, or have found a
job but have not yet begun their tenure (i.e. frictional unemployment).
C. Unemployment rate = Unemployed ÷ Labor Force
This measure represents the proportion of the labor force that is unemployed. This is the segment of the labor
force that wants to work but cannot currently find work.
Source: Understanding Business Cycles
*
56. Which of the following would be most useful as a leading indicator to signal the start of an economic
recovery?
A. An increase in aggregate real personal income (less transfer payments)
B. A decrease in average weekly initial claims for unemployment insurance
C. The narrowing of the spread between the 10-year Treasury yield and the federal funds rate
Answer = B
-A decrease in the Average weekly initial claims for unemployment insurance implies that less people are being
laid off as a result of production beginning to pick up at firms (a situation which is common at the start of an
economic recovery).
-An increase in real income does not occur until much later after the economic recovery has commenced (it
takes time for economic expansion to translate into an increase in wealth for most households).
-Since the federal funds rate (which is an extremely short term interest rate) is generally lower than longer term
yields, a narrowing of spreads is an indication that the federal funds rate must be increasing (i.e. closing the gap
between short or long term rates). However, short term rates generally increase when the economy is
overheating, not when it’s just beginning its recovery.
Source: Understanding Business Cycles
*
57. Which of the following is not typically a role of a central bank?
A. Serve as a banker of last resort to commercial banks and the government.
B. Manage the value of the domestic currency in the FX markets.
C. Regulate the payment system.
Answer = B
The primary roles of central banks are as follows:
a) Issue currency (i.e. print money).
b) Serve as a banker of last resort to commercial banks and the government. For instance, if commercial banks
cannot obtain overnight loans from other commercial banks, then they may go to the central bank in order to
borrow the required amount of capital.
17
c) Regulate the payment system. For instance, when John Doe issues a check from his account with Bank A to
pay Sally Smith who has an account with Bank B, the presence of the central bank would ensure that funds do
get transmitted from Bank A to Bank B.
On the other hand, the central banks for most nations, do not actively engage if FX management.
Source: Monetary and Fiscal Policy
*
58. According to the Fisher effect, an increase in expected inflation will most likely increase:
A. both nominal and real interest rates.
B. the nominal interest rate.
C. the real interest rate.
Answer = B
As per Fisher: Nominal rate = Real rate + Inflation
Therefore, an increase in Inflation will only cause nominal rates to increase. Real variables (such as real GDP
growth or Real interest rates) are affected by factors other than price levels (i.e. inflation).
Source: Monetary and Fiscal Policy
*
59. Suppose that the required reserve ratio is 8% and the central bank purchases $100,000 worth of Treasury
securities in its open market operations. Which of the following is least likely to result following this
operation?
A. At a maximum, the money supply will increase by $1,250,000.
B. At a maximum, the amount of new loans should increase by $1,150,000.
C. The federal funds rate should increase.
Answer = C
The money supply will expand by 100000/.08 = 1250000
Eventually, the total amount in reserves that must be held by the banking system would be the $100,000.
Therefore, a total of 1150000 in new loans may be made.
With more money in the banking system, the federal funds rate should decrease.
Source: Monetary and Fiscal Policy
*
60. A small country has a comparative advantage in the production of pencils. The government establishes an
export subsidy for pencils to promote economic growth. Which of the following will be the most likely result of
this policy?
A. The increase in the domestic producer surplus will exceed the sum of the subsidy and the decrease in the
domestic consumer surplus.
B. As new domestic producers enter the pencils market, supply will increase and domestic prices will decline.
C. Although domestic producers will receive a net benefit, the policy will give rise to inefficiencies that cause a
deadweight loss to the national welfare.
Answer = C
Export subsidy involves the domestic government paying domestic producers a set amount for every unit of
good that they export (i.e. sell abroad). This may induce overproduction for the good and thus result in
inefficiency (as resources are now being directed from making other goods). Furthermore, the price of the good
sold in the domestic market may not decrease as the subsidy (which is in effect a cost reduction) is only
applicable for the units that are sold abroad.
Source: International Trade and Capital Flows
*
61. Which of the following is least likely a reason why nations might impose capital flow restrictions?
A. To control the value of their currency.
B. To manage the nation’s debt level.
C. To control domestic interest rates.
Answer = B
Nations primarily impose capital restrictions for the following reasons:
a) To control the value of their currency.
18
b) To control domestic interest rates.
c) Generate revenue for the government.
d) Permit the development of the domestic industries.
Source: International Trade and Capital Flows
*
62. Which of the following statements would always have to hold for a nation that’s paying a higher yield
(interest rates)?
A. They must be experiencing a higher rate of inflation.
B. Their currency would be trading at a forward discount.
C. Their GDP growth must be higher than that of their trading partners.
Answer = B
In order for there to be equilibrium between that nations, any extra yield earned in one country would have to be
offset by a discount on the forward rate on their currency, such that the total risk free return earned from all
countries would be the same (after currency conversion). While this ‘Interest Rate Parity’ condition always
holds, a higher yield would not necessarily imply higher inflation or higher GDP growth.
Source: Currency Exchange Rates
FINANCIAL REPORTING (63-90)
63. Notes to financial statements most likely include:
A. a discussion of significant trends, events and uncertainties that affect the operating results.
B. supplementary information about accounting policies, methods and estimates.
C. an auditor's opinion as to the fair presentation of the financial statements.
Answer = B
-The notes to the financial statements include all the accounting methods (and estimates) that were used in
arriving at the figures that are presented in the financial statements.
-Management Discussion and Analysis (MDA), as well as the auditor’s opinion are distinct segments of the
financial report that’s presented to shareholders (i.e. they are not simply grouped along with the notes).
Source: Introduction to Financial Statement Analysis
*
64. Interim reports most likely:
A. are issued semi-annually or quarterly.
B. include a full set of financial statements and notes.
C. are audited.
Answer = A
-Annual Reports are issued once a year and they include a full set of audited financial statements and notes.
However, in between the publication of these annual reports, interim reports (which aren’t necessarily audited)
are provided semi-annually or quarterly, depending on applicable regulatory requirements.
Source: Introduction to Financial Statement Analysis
*
65. For an item to be recognized on the financial statements, it must be:
A. transparent and its associated amount reliable.
B. probable that an economic benefit will flow and its amount is reliable.
C. probable that an economic benefit will flow and its contents are transparent.
Answer =B:
For an item to be recognized on the financial statements , its amount must be reliable and it must be highly
likely that this economic flow will take place.
Source: Financial Reporting Standards
*
66. Which of the following statements is most accurate with respect to the jurisdiction underlying financial
reporting?
19
A. The requirement to prepare financial reports in accordance with specified accounting standards is
the responsibility of standard-setting bodies.
B. Standard-setting bodies have authority because they are recognized by regulatory authorities.
C. Regulatory authorities are typically private sector, self-regulated organizations.
Answer = B
Accounting standards are set by non-governmental (i.e. private) entities, such as the Financial Accounting
Standards Board (FASB) in the U.S. However, government regulators (such as the SEC in the U.S.) mandate
that publicly listed companies comply with these accounting standards.
Source: Financial Reporting Standards
*
67. The following data is available on a company for the current year:
Metric
(£’000)
Comprehensive income
246,000
Dividends paid
60,000
Ending retained earnings
821,000
Opening retained earnings
580,000
The company will most likely report other comprehensive income (OCI) (in £'000) as a:
A. gain of 301,000.
B. gain of 186,000.
C. loss of 55,000.
Answer = C
Step 1. Ending Retained Earnings = Beginning RE + (NI – DIV)
821,000 = 580,000 + (NI – 60,000)
Therefore, NI = 301,000
Step 2. Comprehensive Income (CI) = NI + OCI
246,000 = 301,000 + OCI
Therefore, OCI = (-55,000)
Source: Understanding Income Statements
*
68. According to the International Financial Reporting Standards (IFRS), which of the following conditions
should be satisfied to report revenue from the sale of goods on the income statement?
A. Goods have been delivered to the customer.
B. Costs can be reliably measured.
C. Payment has been received.
Answer = B
The IFRS conditions that should be met to recognize revenue from the sale of goods include that the costs
incurred can be reliably measured, that the economic benefits will flow to the entity, and that the significant
risks and rewards of ownership have been transferred, which is normally when the goods have been delivered.
The actual receipt of any payment is not a condition for revenue recognition.
Source: Understanding Income Statements
*
69. Mega Corp. just got awarded a construction contract that’s expected to last for 3 years. The cumulative
amount of the billing will be $14 million. However, the firm expected to incur a cost of $5.5 million in Year 1,
$3.0 million in Year 2, and $1.5 million in Year 3. If all these amounts are deemed as reliable, and the
collection of all billings is deemed to be highly certain, which of the following would best represent the
profit/loss recognized by Mega Corp. in Year 1?
A. $2.2 million.
B. $7.7 million.
C. -$5.5 million.
Answer = A:
Since the amounts are “reliable” and “probable”, the percentage of completion method may be used:
20
Total cost = 5.5+3.0+1.5 = 10.0
Year 1 Revenue = 14million*(5.5/10) = 7.7M
Profit = 7.7M-5.5M = 2.2M
Source: Understanding the Income Statement
*
70. Which of the following items is unlikely to cause the equity value in a firm to increase?
A. Issuance of new common shares.
B. Issuance of new preferred shares.
C. The collection of cash from prior period credit sales.
Answer =C:
The equity increased when the sales was recognized, not when the cash was collected.
Source: Understanding the Balance Sheet
*
71. Which of the following statements is most accurate?
A. A classified balance sheet arises when in an auditor's opinion the financial statements materially depart from
accounting standards and are not presented fairly.
B. Non-controlling interest on the balance sheet represents a position the company owns in other companies.
C. Treasury stock is non-voting and receives no dividends.
Answer = C
-Classified Balance Sheet implies that the current accounts are distinguished from non-current (i.e. long term)
accounts.
-Qualified opinion implies that the auditor believes that the firm’s financial statements are not entirely
compliant with generally acceptable accounting standards (such as GAAP or IFRS).
-Non-controlling interest (i.e. Minority Interest) represents the portion of the equity in the parent firm’s
subsidiaries that the parent does not own.
-Treasury stocks are previously issued stocks that have been repurchased by the firm and therefore are no longer
in circulation. As a result, these shares are neither entitled to dividends nor voting rights.
Source: Understanding Balance Sheets
*
72. During 2019, the following events occurred at a company:
1 It purchased a customer list for $100,000, which is expected to provide equal annual
benefits for the next four years.
2 It recorded $200,000 of goodwill in the acquisition of a competitor. It is estimated that the
acquisition would provide substantial benefits for the company for at least the next 10
years.
3 It spent $300,000 on media placements announcing that the company had donated
products and services to the community. The CEO believes the firm’s reputation was
enhanced substantially and that the company will likely benefit from it for the next five
years.
Based on those events, the amortization expense that the company should report in 2020 is closest to:
A. $85,000.
B. $25,000.
C. $45,000.
Answer = B
The customer list is the only identifiable intangible asset, and it should be amortized on a straight-line basis
over its expected future life: $100,000/4 = $25,000/year. Goodwill is an unidentifiable intangible and should be
tested for impairment but not amortized. All advertising and promotion costs, such as the media placements, are
typically expensed. If the reputation of the company has been enhanced as the CEO suggests, it is an internally
generated intangible that is not recorded on the balance sheet and is thus not amortized.
Source: Understanding Balance Sheets
*
73. Which of the following statements is least accurate with respect to the various cash flow metrics?
21
A. In a year that includes a heavy amount of borrowing, FCFF will exceed FCFE.
B. FCFE is produced after deducting for payments made to preferred shareholders.
C. FCFE is produced after deducting for payments made to debt holders.
Answer = A
FCFF measures cash “available” for distribution to all capital providers, not amount raised from them. On the
other hand, FCFE measures cash available to “common” equityholders, after deducting payments to preferreds
and debt. On the other hand, money raised from debt and preferreds, is technically cash available to the owners.
Source: Understanding the Cash Flow Statement
*
74. Mega Corp. recently reported the following items on its financial statements:
2018
2017
Shareholders’ Equity:
428
345
Accounts receivable:
89
70
Accounts payable:
74
62
Inventory:
94
112
Depreciation:
52
48
During 2018, no stock was issued or repurchased; however, a dividend of 22 was declared and paid. The
operating cash flow for 2018 is closest to:
A. $168
B. $146
C. $157
Answer = A.
The change in SHE is equal to the retained earnings for the year:
(428-345) = NI – 22: NI=105
Therefore, OCF = 105 +52 – [(89-74+94)-(70-62+112)] = 168
Source: Understanding the Cash Flow Statement
75. Dividends received are most likely classified as which type of cash flow under both IFRS and US GAAP?
A. Investing.
B. Financing.
C. Operating
Answer = C
The complete list of distinction between IFRS and US GAAP when it comes to items on the Statement of Cash Flows
are as follows:
-Dividends Received:
i) US GAAP deems dividend income as an operating item.
ii) IFRS allows firms to classify dividend income either as an operating item or an
investing item (since dividend income is earned on investments).
-Dividend Paid:
i) US GAAP deems dividend payments by the firm as a financing item.
ii) IFRS allows firms to classify dividend payments either as an financing item or an
operating item.
-Interest Income:
i) US GAAP deems interest income as an operating item.
ii) IFRS allows firms to classify interest income either as an operating item or an
investing item (since interest income is earned on investments).
-Interest Expense:
i) US GAAP deems interest expense as an operating item.
ii) IFRS allows firms to classify interest expense either as an operating item or a
financing item (since interest is accrued on debt, a financing item).
Source: Understanding Cash Flow Statements
*
22
76. The following financial data is available for a company:
Return on assets (ROA) 4.8%
Total asset turnover 1.92
Financial leverage 1.75
Dividend payout ratio 48.1%
The company’s sustainable growth rate is closest to:
A. 4.00%.
B. 4.40%.
C. 4.78%.
Answer = B
Step 1. ROE = NI/E = (NI /A) x (A/E) = (ROA) x (Leverage) = (4.8%) x ( 1.75) = 8.4%
Step 2. g = ROE x (1 – Dividend Payout) = 8.4% x (1 - .481) = 4.36
Source: Financial Analysis Techniques
*
77. The following data are available on a company:
Metric
Current Year (¥
millions)
Cash
114
Inventory
462
Marketable securities
23
PPE (net)
677
Receivables
231
Current liabilities
390
Liquidity ratios in prior year
Cash ratio
0.37
Current ratio
2.19
Quick ratio
0.97
The value of the company's liquidity ratio that decreased the most in the current year, compared with the prior
year, is the:
A. cash ratio.
B. quick ratio.
C. current ratio.
Answer = C
-Current Ratio = [ (Cash + Mktble Secs + AR + Inv) / (Current Liability) ] = [ (114 + 23 + 231 + 462) / (390) ]
= 2.13
Change Year over Year = 2.13 – 2.19 = (-0.06)
-Quick Ratio = [ (Cash + Mktble Secs + AR) / (Current Liability) ] = [ (114 + 23 + 231) / (390) ] = 0.94
Change Year over Year = 0.94 – 0.97 = (-0.03)
-Cash Ratio = [ (Cash + Mktble Secs) / (Current Liability) ] = [ (114 + 23) / (390) ] = 0.35
Change Year over Year = 0.35 – 0.37 = (-0.02)
Source: Financial Analysis Techniques
*
78. Mega Corp. uses the LIFO method to account for its inventory. Recently, it reported the following results
(in millions):
2018
2017
Sales
648
612
COGS
432
389
Operating costs 18
15
Inventory
72
61
LIFO Reserve 50
34
The tax rate is 32%.
23
Had Mega Corp. used the FIFO method of accounting, its gross profit margin in 2018 would have been closest
to:
A. 30.9%
B. 35.8%
C. 32.7%
Answer = B.
COGS(fifo) = COGS(lifo) – (Change in LR) = 432 - (50-34) = 416
Gross profit mgn = (648 – 416)/648 = 35.8%
Note that Gross margin is Sales – COGS. On the other hand, Operating mgn deducts operating costs as well.
As well, note the order of the financial statements: 2018 is stated before 2017. Had you read it the other way
around, variables which you thought were decreasing, were actually increasing.
Source: Inventories
*
79. A company has operated at full capacity throughout the year, and a review of its inventory records for that
period indicates that the following costs were incurred:
Fixed production overhead
$500,000
Direct material and direct labor
$300,000
Storage costs during production
$25,000
Abnormal waste costs
$30,000
The total capitalized costs to inventory during the year are closest to:
A. $855,000.
B. $825,000.
C. $800,000.
Answer = B
-Inventory book value incorporates (i.e. capitalizes) all expenditures that were directly incurred in order to get
the inventory to its finished state. Subsequently, these amounts are recognized as an expense (on the income
statement as COGS) when the inventory units are sold.
-However, we exclude from inventory book value: (i) all expenditures incurred after the inventory reaches its
finished state) and (ii) any waste (i.e. costs of defective units). These items are instead immediately recognized
as expense on the current income statement.
-Therefore, the total amount capitalized = $500,000 + $300,000 + $25,000 = $825,000.
Source: Inventories
*
80. A company incurs the following costs related to its inventory during the year:
Cost
¥ Millions
Purchase price
100,000
Trade discounts
5,000
Import duties
20,000
Shipping of raw materials to manufacturing facility
10,000
Manufacturing conversion costs
50,000
Abnormal costs as a result of waste material
8,000
Storage cost prior to shipping to customers
2,000
The amount charged to inventory cost (in millions) is closest to:
A. ¥177,000.
B. ¥175,000.
C. ¥185,000.
Answer = B
Include in inventory cost (i.e. book value) all expenditures necessary to get it to its finished state. All costs
incurred afterwards (and costs related to defects/waste) are expensed as incurred.
Inventory book value = 100,000 – 5,000 + 20,000 + 10,000 + 50,000 = 175,000
Source: Inventories
*
24
81. In the year following an expenditure, companies which expense (instead of capitalize) will exhibit a lower
profitability ratio and a lower leverage ratio. Is this statement accurate with respect to:
Profitability ratio
Leverage ratio
A.
YES
YES
B.
YES
NO
C.
NO
NO
Answer = C:
In the year that companies expense the expenditure, assets, earnings, and therefore equity will be relatively
lower. However, in the following year, while asset and equity values remain lower, earnings will be relatively
higher as the previous year’s expenditure is not being amortized in the current year, as would be the case under
capitalization. Therefore, in the year following the expenditure, the profitability ratio should be higher. On the
other hand, the lower remaining asset and equity value will translate into a higher leverage ratio.
Source: Long Lived Assets
*
82. A company purchased a warehouse for €35 million and incurred the following additional costs in getting the
warehouse ready to use:
• €2.0 million for repairs to the building's roof and windows
• €0.5 million to modify the interior layout to meet their needs (moving walls and doors, inserting and removing
partitions, etc.)
• €0.1 million on an orientation and training session for employees to familiarize them with the facility
The cost to be capitalized to the building account (in millions) is closest to:
A. €37.6.
B. €37.5.
C. €37.0.
Answer = B
-All costs incurred to get the asset ready for its intended use or to extend its life are capitalized (i.e. the amounts
are included in the book value of the asset). Therefore, the total amount capitalized would be:
35M + 2M + 0.5M = 37.5M
-Costs incurred to orient the employees does not directly extend the life of the asset, and as such, the 0.1M is
expensed immediately (i.e. it is not capitalized into the asset’s book value).
Source: Long-Lived Assets
*
83. A company that prepares its financial statements in accordance with International Financial Reporting
Standards (IFRS) is attempting to produce lighter and longer-lasting batteries for portable electronic devices.
The most appropriate accounting treatment for the related costs incurred in this project is to:
A. capitalize costs directly related to the development.
B. expense costs until technical feasibility has been established.
C. expense them as incurred.
Answer = B
Under IFRS, research and development costs are expensed until certain criteria are met, including that technical
feasibility has been established and the company intends to use the developed product.
Source: Long-Lived Assets
*
84. At the beginning of the year, a company purchased a fixed asset for $500,000 with no expected residual
value. The company depreciates similar assets on a straight line basis over 10 years, whereas the tax authorities
allow declining balance depreciation at the rate of 15% per year. In both cases, the company takes a full year's
depreciation in the first year and the tax rate is 40%. Which of the following statements concerning this asset at
the end of the year is most accurate?
A. The temporary difference is $25,000.
B. The tax base is $500,000.
C. The deferred tax asset is $10,000.
Answer = A
25
Step 1. Depreciation Expense recognized in Year 1:
Government: 15% of $500,000 = $75,000
GAAP: $500,000 over 10 years = $50,000
Since both the Government and GAAP will be recognizing a total expense of $500,000 over the life of the asset,
any difference in the amount recognized year to year, would be considered as temporary. In this case, as of the
end of Year 1, the temporary difference is $75,000 - $50,000 = $25,000
Step 2. Tax base is the amount that yet to be recognized as an expense for tax purposes. As of the end of Year 1,
only $75,000 of the $500,000 has been recognized; therefore, the unrecognized portion (i.e. the tax base) =
$425,000.
Step 3. In Year 1, from the Governments point of view:
i) The expense was $25,000 higher.
ii) Therefore, the taxable income was $25,000 lower.
iii) Therefore, the tax paid was $10,000 lower (40% of $25,000).
Since the firm paid a tax that was $10,000 lower than what it recognized as Tax Expense using GAAP, it would
owe this unpaid amount in the future. In other word, at the end of Year 1, it would recognize a Deferred Tax
Liability of $10,000 on its Balance Sheet.
Source: Income Taxes
*
85. Unused tax losses and credits that a company expects to use in future periods will most likely give rise to:
A. valuation allowances.
B. deferred tax liabilities.
C. deferred tax assets.
Answer = C
An asset is an item which provides a benefit to the firm. Unused tax losses and credits benefit the firm because
they may be used to lower the taxes that the firm would have to pay in the future. As a result, the firm would
recognize this pending benefit as a Deferred Tax Asset on its current balance sheet.
Source: Income Taxes
*
86. A company that prepares its financial statements in accordance with IFRS incurred and capitalized €2
million of development costs during the year. These costs were fully deductible immediately for tax purposes,
but the company is depreciating them over two years for financial reporting purposes. The company has a long
history of profitability, which is expected to continue. Which is the most appropriate way for an analyst to
incorporate the differential tax treatment in his analysis? He should include it in:
A. liabilities when calculating the company's current ratio.
B. equity when calculating the company's return-on-equity ratio.
C. liabilities when calculating the company's debt-to-equity ratio.
Answer = C
Since the cost recognized in the current period for tax purposes was higher, that would imply that the taxable
income (and therefore tax paid) was less than the tax expense reported under IFRS. As the firm did not pay the
full tax expense it was reporting, it would imply that the balance would be payable in the future. Consequently,
the firm would report a Deferred Tax Liability on the non-current portion of its balance sheet.
Source: Income Taxes
*
87. On January 1st, 2020, Mega Corp. issued $1 million in face value of a 5 year, 8% bond that’s callable at
101.5. If on December 31st, 2020, the bond was called back when market yields were 6%, which of the
following would best represent the gain or loss recognized on Mega Corp’s financial statement?
A. Loss of $15,000.
B. Gain of $15,000.
C. Loss of $55,197.
Answer = A:
26
Gain or Loss = (book value – amount paid to retire the debt) = (1000000-1015000)
Loss = 15000
Source: Non-current (Long Term) Liabilities
*
88. If a company issues bonds priced at a premium, which of the following is an unlikely outcome?
A. Part of the coupon payment would be deemed as a repayment of principal.
B. Interest expense should increase over time.
C. The total interest expense over the term of the bond would be equal to the difference between the total
coupon and principal amount paid and the amount that was raised.
Answer =B:
When a bond is issued at a premium, that premium is gradually paid down over time. Since interest expense is
simply = (initial yield)*(outstanding balance),
As the balance drops, so will the interest expense.
Source: Non-current (Long Term) Liabilities
*
89. Management could simply keep current net profit margins high, by using all of the following tactics except:
A. use a double declining method of depreciation as opposed to sum of the years’ digits.
B. estimate a long useful life for newly acquired assets.
C. estimate a high residual value for newly acquired assets.
Answer =A.
While both the double declining and Sum of the years’ digits results in the highest depreciation in the first year,
often times, the latte method results in the higher depreciation.
Source: Financial Reporting Quality
*
90. You note that while 2 companies have an equal ROE, their ROAs differ. The company with the higher
ROA, most likely has a:
A. lower leverage.
B. higher earnings retention.
C. lower earnings retention.
Answer = A.
ROE = ROA X Leverage. Therefore, ROA = ROE/Leverage.
For ROA to be higher, leverage must be lower.
Source: Financial Statement Analysis: Applications
*********
27
PASSMAX
2021 LEVEL I CFA® EXAM
MOCK 1
SESSION 2: Solutions
28
CORPORATE FINANCE (1-18)
1. Which of the following would least likely be deemed as necessary in order to establish a strong corporate
governance system?
A. Ready access for shareholder inquiries into corporate affairs.
B. Clearly defined rights, roles, and responsibilities for senior management.
C. The ability of the board to hire external consultants.
Answer = A
While a firm must be transparent, this will come eventually. However, many matters are regarded as material
nonpublic information, and the firm is not required to release this information to shareholders.
Source: Introduction to Corporate Governance and Other ESG Considerations
*
2. Which of the following least likely describes the concept of corporate governance?
A. It is particularly important when the company is closely held by a few controlling shareholders.
B. It defines the rights and responsibilities of the board, management, and shareholders.
C. It covers the structuring of incentive systems such that management’s interests are aligned with those of the
owners.
Answer = A
If the company were closely held, then shareholders would have a direct oversight over management. On the
other hand, if the shares were widely held by minority shareholders, then a strong corporate governance system
would be required to safeguard the interest of these otherwise powerless shareholders.
Source: Introduction to Corporate Governance and Other ESG Considerations
*
3. Which of the following statements most accurately describes the decision rule that is associated with the
Payback Period approach to project evaluation?
A. The Payback Period does not consider the total profit potential of a project.
B. The project would be accepted if the project’s Payback Period exceeds the ‘required’ Payback Period.
C. The higher the discount rate, the lower the Payback Period would be.
Answer = A
The Payback approach only looks at the cash flows earned prior to the cut-off period; thus ignoring all cash
flows beyond that point. The project would be rejected if the project’s Payback Period exceeds the ‘required’
Payback Period. In other words, it would be taking too long for the project to payback its initial cost. Finally,
the Payback approach looks at the undiscounted cash flows (and is therefore insensitive to changes in the
discount rate).
Source: Capital Budgeting
*
4. You are looking at 3 project proposals:
Project:
A
B
C
Cost:
50
130
20
NPV:
11
18
9
Which of the following statements would be least accurate?
A. If these projects were mutually exclusive, the company should choose B only.
B. If the company only had $130 million to invest, it should choose B.
C. Project C has the highest profitability index.
Answer = B
With $130 capital budget, the company has 2 choices:
i) Invest in B, in which case the NPV (i.e. the value added) would be 18, or
ii) Invest in A and C, in which case the combined NPV would be higher at 20 (11+9). Since these combined
projects will only require 70 in capital (50+20), the excess of 60 (130-70) should be distributed to shareholders
(either via dividends or share repurchase). Clearly then, the firm and its shareholders will be better off if
Project A and C are chosen (instead of Project C).
29
Source: Capital Budgeting
*
5. When computing the cash flows for a capital project, which of the following is least likely to be included?
A. Financing costs
B. Opportunity costs
C. Tax effects
Answer = A
When evaluating a project, look at how much cash flow it ‘generates’. Financing determines how that cash
flow is ‘distributed’. For instance, if the project was financed with debt, then the CF would be distributed as
interest, whereas if it
was financed with equity, the CF would be distributed in the form of dividends. While financing cost has no
direct impact on the project’s operating CF, it does nevertheless serve as the discount rate in order to find the
present value the project itself. However, the focus of this question was on project CF, rather than its valuation.
On the other hand, opportunity foregone as a result of undertaking a project and/or its tax effects, will have a
direct impact on the amount of CF that is generated.
Source: Capital Budgeting
*
6. If your company embarks on Project A today, the government will pay you $10,000 in one year and promise
to increase these payments by 6% per year indefinitely. However, this project will cost you $285,000 today. If
your required rate of return for this project is 9%, which of the following would best estimate its NPV?
A. +$38,387
B. -$13,333
C. +$48,333
Answer = C:
PV = 10000/(.09-.06) = 333333; NPV = 333333-285000 = 48,333
Source: Capital Budgeting
*
7. Which of the following statements is the most appropriate treatment of flotation costs for capital budgeting
purposes? Flotation costs should be:
A. incorporated into the estimated cost of capital.
B. expensed in the current period.
C. deducted as one of the project’s initial-period cash flows.
Answer = C
Floatation cost refers to the investment banking (i.e. underwriting) fees that are associated with issuing new
capital (in order to fund a new project). Like all other costs incurred up front for a project, floatation costs
should be incorporated into the project’s initial investment (i.e. cost). These upfront (i.e. capitalized) costs are
then eventually recognized as expense (on the firm’s income statement) over the project’s useful life.
Source: Cost of Capital
*
8. Which of the following statements is least accurate with the computation and use of a company’s weighted
average cost of capital (WACC)?
A. WACC reflects the overall risk of the company.
B. For debt and equity securities to maintain their market values, the company must earn a return on assets that
is equal to WACC.
C. WACC increases as the company takes on more projects.
Answer =C:
WACC would only increase if those new projects entailed more risk.
Source: Cost of Capital
*
30
9. Mega Corp. faces the following after tax capital cost schedule:
Debt
Equity
.
< $8.4 million: 4.6%
< $7.6 million: 8.4%
> $8.4 million: 6.2%
> $7.6 million: 10.9%.
The firm’s marginal tax rate is 32%, and its optimal capital structure is represented with 65% equity. If the firm
wished to raise $21 million in capital, its marginal cost of capital would be closest to:
A. 7.80%
B. 8.24%
C. 8.70%
Answer = C
65% of the 21million is equity = 13.65 → cost is 10.9%
35% of the 21 million is debt = 7.35 → cost is 4.6%
MCC (which is the WACC for incremental capital) = (.65)(10.9) + (.35)(4.6) = 8.70%
Source: Cost of Capital
*
10. Mega Corp. has the following capital structure:
Debt: $28 million face value currently trading at 94% of par and yielding 8.4%.
Preferred: $5 million par that’s currently trading at par and yielding 9.2%
Common: $52 million original issue, currently trading at 30% above the IPO price, resulting in an implied
required return of 12.8%.
Tax rate is 32%. The WACC is closest to:
A. 9.48%
B. 11.55%
C. 10.74%
Answer = C
i) [V = D + P + E] = (.94of28M) + (5M) +(1.3of52M) = 26.32 + 5 + 67.6 = 98.92
WEIGHTS = (.267)+(.051)+(.683)
ii) WACC = (.267)(8.4)(1-.32) + (.051)(9.2) + (.683)(12.8)
= 10.74
Source: Cost of Capital
*
11.
Income Statement
Millions ($)
Revenues
9.8
Variable operating costs
7.2
Fixed operating costs
1.5
Operating income
1.1
Interest
0.6
Taxable income
0.5
Tax
0.2
Net income
0.3
The degree of operating leverage (DOL) is closest to:
A. 1.1.
B. 2.4.
C. 1.7.
Answer = B
Operating leverage is caused by the presence of a fixed operating expenses. Consequently, DOL may be
measured as:
Earnings before fixed operating cost = __9.8 – 7.2__ = 2.36
Earnings after fixed operating cost
9.8 – 7.2 – 1.5
Source: Measures of Leverage
*
31
12. Which of the following is least likely to be a consequence of an increase in leverage employed by a firm?
A. It would be seen as a sign that management has a bearish outlook for the firm in the foreseeable future.
B. Only the firm’s risk potential would increase.
C. Only the firm’s return potential would increase.
Answer = A
When a firm issues capital (be it debt or equity), it is a signal that management sees many profitable
opportunities that need to be financed.
Source: Measures of Leverage
*
13. A cyclical company is most likely to face a higher:
A. Sales risk.
B. Financial risk.
C. Operating risk.
Answer = A
Sales risk refers to sales volatility, which is in turn affected by the number of units that are sold and the price at
which they are sold at. In cyclical industries (such as automotive sector), the sales risk can be quite high, with
strong sales experienced during periods of economic growth and declining sales during recessionary periods.
Operating risk refers to the volatility of operating income, in which the greater the proportion of the firm’s
operating costs that are fixed, the more volatile its operating earnings will be (relative to changes in sales).
Financial risk is the volatility in earnings that’s caused by the presence of fixed financing costs (like interest,
leases, and preferred dividends).
Source: Measures of Leverage
*
14. The per unit contribution margin for a product is $12. Assuming fixed costs of $12,000, interest costs of
$3,000, and taxes of $2,000, the operating breakeven point (in units) is closest to:
A. 1,000.
B. 1,250.
C. 1,417.
Answer = A
The operating breakeven point refers to the number of units that need to be sold in order for operating profit (i.e.
EBIT) to equal to zero:
EBIT = Revenue – Variable Cost – Fixed Cost = 0;
EBIT = [(Contribution Margin) x (Q)] - Fixed Cost = 0
[ (12) x (Q)] – 12,000 = 0
Therefore, Q = 1,000 units.
Source: Measures of Leverage
*
15. The cash conversion cycle will decrease in all cases, except when:
A. Days in inventory decrease.
B. Receivables turnover increases.
C. Days in payables decreases.
Answer = C.
The cash conversion cycle(CCC) is equal to Days in Inventory + Days in Receivables – Days in Payables. CCC
is in effect the period of time for which the company has to pay its vendor before sales proceeds are collected
from its customers. Therefore, as the days in payable decreases, the CCC will increase.
Source: Working Capital Management
*
16. Mega Corp. issues $28 million in face value of 2 month commercial paper. The quoted rate is 6.82%,
however, the dealer’s commission is ¼% and the back up line cost is ½%. (All rates are applied to the face
value). The cost of issuing this commercial paper is closest to:
A. 7.05%
B. 7.57%
32
C. 7.66%
Answer = C
Cost = (interest and fees)/(proceeds raised)
Interest and fees = (.0682+.0025+.0050)(2/12)($28million) = 353267
Proceeds raised = $28million[1-(.0682)(2/12)] = 27681733
Holding period cost (for 2 months) = 353267/27681733 = 1.276
Annualize using BEY = 1.276X(12/2) = 7.66
Source: Working Capital Management
*
17. Which is most likely considered a “pull” on liquidity?
A. Obsolete inventory
B. Reduction in a line of credit
C. Increased difficulty in collecting receivables
Answer = B
A company’s liquidity may be adversely affected either because its receipts are delayed (i.e. drags) or because
its disbursements are made too soon (i.e. pulls).
1. Drags (delay of receipts): a) Overdue receivables: The larger this amount is or the more overdue that it is, the
higher will be the probability that the full amount of the receivables will not be collected (which would in turn
mean lower liquidity in the future). b) Obsolete inventory: Will take up space that could have been used to
store more liquid inventory. Furthermore, even though the obsolete inventory is not moving, it still incurs a
storage cost to the firm, thus reducing its liquidity. c) Tighter credit: With less credit available, interest costs
will increase, thus draining the amount of liquidity available to meet other short term obligations.
2. Pulls (pre-mature disbursements): a) Payments to vendors before due dates: Early payments mean that
liquidity dries up faster. This can be particularly troublesome if there was no discount afforded for early
payments. b) Preserving Lines of Credit: A firm may have to make payments on its lines of credit promptly in
order to appease its lenders (and thus, preserve its credit capacity).
Source: Working Capital Management
*
18. Which of the following operating ratios is inconsistent?
A. The accounts receivable turnover is the ratio of sales to average receivables.
B. The cash conversion cycle will decrease as the days in payables increases.
C. Days in inventory is the ratio of inventory to average credit sales.
Answer = C
-Accounts Receivable turnover = (Sales) / (Average Receivables).
-Cash Conversion Cycle = Day in Inventory + Days in Receivables – Days in Payables.
-Days in Inventory = Average Inventory / Average daily COGS
Source: Working Capital Management
EQUITY (19-36)
19. A trader who owns shares of a stock currently trading at $100 per share places a “GTC, stop $90, limit $85
sell” order (GTC means good till cancelled). Assuming the specified stop condition is satisfied and the order
becomes executed, which of the following statements is most accurate?
A. The trader faces a maximum realized loss of $15.
B. The order becomes a market order when the price falls below $85 and remains valid for execution.
C. The order will be executed at either $90 or $85.
Answer = A
The order becomes valid when the price falls to, or below, $90. The “limit $85 sell” indicates that the trader is
unwilling to sell below $85. Thus, the trader faces a maximum loss of $15 ($100 – $85).
Source: Market Organization and Structure
*
33
20. A Japanese exporter will sell U.S. dollars for Japanese Yen in the quote-driven currency markets. Which of
the following statements best describes her currency exchange transactions?
A. Her counterparties are dealers.
B. This currency exchange transaction takes place in organized exchanges.
C. She will pay commissions for exchange services.
Answer = A
In the quote-driven currency markets, dealers are counterparties to currency exchange transactions.
Source: Market Organization and Structure
*
21. Which of the following financial intermediaries is most likely to provide liquidity service to its clients?
A. Dealers
B. Brokers
C. Exchanges
Answer = A
The service that dealers provide is liquidity. Liquidity is the ability to buy or sell with low transaction costs
when investors want to trade. By allowing their clients to trade when they want to trade, dealers provide
liquidity to them.
Source: Market Organization and Structure
*
22. A market index contains the following two securities:
Stock Shares in Index Start-of-Period Price ($) End-of-Period Price ($) Dividend per Share ($)
A
600
40
37
2.00
B
500
50
52
1.50
The total return on an equal-weighted basis is closest to:
A. –1.75%.
B. 2.78%.
C. 2.25%.
Answer = C
Step 1. Compute Total Return for each Stock = [(P1 + D1) - (Po)] ÷ (Po)
Stock A: [(37+2) – 40] ÷ 40 = -2.5%
Stock B: [(52+1.5) – 50] ÷ 50 = 7.0%
Step 2. Equal Weighted Return = (0.5)(-2.5%) + (0.5)(7.0%) = 2.25%
Source: Security Market Indices
*
23. Which of the following statements is least accurate with respect to the different methodologies that are used
to compute index returns?
A. In a price weighted index, the weightings of each component stocks will not be affected should a stock in the
index undergo a stock split.
B. In a market cap weighted index, the number of shares a company has outstanding alone, is not a factor in
determining that stock’s weight in the index.
C. In a price weighted index, the divisor needs to be continuously adjusted for stock splits and the rotation of
stocks in the index.
Answer = A
In a price-weighted index, the weightings of each component stocks is based on the stock price. Thus, the
weights will be affected should a stock in the index undergo a stock split, as the price of the split stock will
drop.
Source: Security Market Indexes
*
24. Which of the following is not generally regarded as a risk associated with ETFs?
A. An ETF will be as volatile as the index it is designed to track.
B. Heavy selling of ETF shares may force the pool to realize accumulated capital gains.
C. The bid ask spreads on ETF’s may widen.
34
Answer = B
ETFs are structured so that the pool does not have to sell any assets. Instead, it exchanges pool assets for ETF
shares.
Source: Security Market Indices
*
25. An analyst argues that among all the forms of market efficiency, only the strong form and the semi-strong
form indicate that abnormal profits are not possible through the utilization of P/E, P/B, and earnings retention
data. Is the analyst correct with respect to:
Semi-Strong Form
Strong Form
A.
YES
YES
B.
YES
NO
C.
NO
YES
Answer = A
The strong form simply encompasses the semi-strong form, and the semi-strong form indicates that all publicly
available data (including the ratios mentioned in the question), are incorporated into the stock price. Therefore,
abnormal profits are not possible.
Source: Market Efficiency
*
26. Which of the following is least likely regarded as a limitation to achieving fully efficient markets?
A. Market participants must earn some profits if they are going to put in the effort to process new information
and thus price the stock correctly.
B. If short selling involves higher costs than outright purchases, then security prices may be biased upwards.
C. The more heavily regulated a market is, the more limited the trading becomes.
Answer = C
Regulations are not cited as a barrier to efficiency. In fact, some of the most heavily regulated markets (i.e. G7
nations), also happen to be regarded as the most efficient markets.
Source: Market Efficiency
*
27. Which of the following is not regarded as a problem that may prevent arbitrageurs from correcting
anomalies?
A. The market may be illiquid.
B. If two stocks of equal risk are exhibiting different expected returns, longing the underpriced and shorting the
overpriced may result in large losses if the divergence between the stocks continues.
C. It is unlikely that a trader will be able to identify two securities which are exactly identical in terms of risk.
Answer = A
Illiquidity should already be priced into the stock. Therefore, if an anomaly exists, it is not because of
illiquidity.
Source: Market Efficiency
*
28. Which of the following statements is most accurate?
A. Investors prefer to invest in callable common shares rather than putable common shares.
B. The issuing company is obligated to buy callable common shares at a predetermined price.
C. Putable common shares facilitate raising capital because of their appeal to investors over callable common
shares.
Answer = C
-Callable Common Shares: entitles the issuer to re-purchase the shares that it issued at some pre-determined
price. The issuer would of course only do this if the current market value of the stock were to exceed its call
price. This would be to the detriment of the investor as his shares are being called from him at a price that is
lower than what he might be able to get if shares were not callable. Not surprisingly then, callable common
shares are rare, and when they are issued, they would trade at a discount to comparable non-callable shares.
-Putable Common Shares: entitles the shareholder to sell the shares back to the issuer at some pre-determined
price. The shareholder might want to consider this option when the share price is trading below its put price.
35
For instance, if the put price was $30 and the share was trading at $22 in the market, then it would make more
sense for the shareholder to put (i.e. sell) the share back to the issuer at $30, rather than selling it in the market
for $22. Not surprisingly then, putable securities trade at a premium relative to their non-putable counterparts.
Putable common shares facilitate raising capital because of their appeal to investors over callable common
shares.
Source: Overview of Equity Securities
*
29. Returns from a depository receipt are least likely affected by which of the following factors?
A. Exchange rate movements
B. Analysts' recommendations
C. Number of depository receipts
Answer = C
Procedure for creating Depository Receipts (DRs):
Step 1. Place foreign (ex. Mexican) stocks in a trust.
Step 2. Trust issues DRs in the investor’s domestic market (ex. USA).
Therefore, the returns on the DRs are directly affected by the factors that affect the underlying stock, and
because DRs are denominated in US$ (whereas the underlying stock is denominated in MXN), changes in the
FX will also influence the returns. On the other hand, the number of DRs issued will not affect ‘returns’ as each
DR, no matter how many are outstanding, simply reflects the performance of the underlying issuer (and changes
in the FX).
Source: Overview of Equity Securities
*
30. Which of the following statements is least accurate with respect to the classification of companies and their
respective stocks?
A. Growth stocks are typically overvalued.
B. A growth company will generally have a relatively lower dividend yield.
C. The ROA of a growth company would have to be higher than its WACC.
Answer = A
Growth companies reinvest their earnings as opposed to paying dividends. This is because the return on their
investment opportunities (ROA) is higher than their cost of capital (WACC). Growth stocks are identified
when their intrinsic value is greater than their price, i.e. they are undervalued.
Source: Overview of Equity Securities
*
31. A corporate manager pursuing a low-cost strategy will most likely:
A. have strong market research teams for product development and marketing.
B. invest in productivity-improving capital equipment.
C. engage in offering products of unique quality or type.
Answer = B
A corporate manager pursuing a cost leadership strategy must be able to invest in productivity-improving
capital equipment for achieving cost controls and being able to offer products and services at lower prices than
the competition.
Source: Introduction to Industry and Company Analysis
*
32. Which of the following industry characteristics would you least likely prefer to see before investing in a
particular company?
A. There are high entry barriers into the industry.
B. There is a limited number of substitute products.
C. The industry product makes up a large proportion of the consumer’s budget.
Answer = C
If the industry product makes up a large proportion of the consumer’s budget, then consumers will be very
sensitive to the price charged. At the same time, the industry’s attractiveness increases if its buyers and
suppliers have limited bargaining power.
36
Source: Introduction to Industry and Company Analysis
*
33. Which of the following statement is least accurate with respect to how industry competitiveness is affected?
A. The closer the resemblance to a substitute product, the lower the potential revenues for an industry.
B. An industry which is void of a leading firm, will more likely be experiencing lower profitability.
C. The greater the number of buyers, the more their bargaining power will be.
Answer = C
If there are many buyers, then each individual buyer is deemed as relatively small, and thus weak in terms of
bargaining power.
Source: Introduction to Industry and Company Analysis
*
34. Stock U has a P/E of 15.4 and a dividend yield of 4.2%. If current dividends are $1.55 per share, which of
the following would best approximate the Earnings per Share for Stock U?
A. $36.90
B. $2.40
C. $0.65
Answer = B
1.55/P = .042: P=36.90
36.90/EPS = 15.4: EPS = 2.40
Source: Equity Valuation – Concepts and Basic Tools
*
35. Which of the following statements concerning different valuation approaches is most accurate?
A. The justified forward price-to-earnings ratio (P/E) approach offers the advantage of incorporating
fundamentals and presenting intrinsic value estimations.
B. One advantage of the three-stage dividend discount model (DDM) model is that it is equally appropriate to
young companies entering the growth phase and those entering the maturity phase.
C. It is advantageous to use asset-based valuation approaches rather than forward-looking cash flow models in
the case of companies that have significant intangibles.
Answer = A
A. Justified P/E = [Dividend Payout / (r – g)]. We can see then that justified P/E reflects the fundamental
drivers of stock valuations, namely:
(i) the required return (r): which reflects the risks associated with the stock, and
(ii) growth (g): which reflects the stock’s return potential.
B. Three stage models are suited for companies that are expected to experience different stages of growth (such
as young firms). On the other hand, mature companies are expected to remain on their current growth path and
therefore the constant growth model (which is a single stage model), would be more appropriate.
C. Asset based valuation is ideal if the fair value of the firm’s assets can easily be determined. On the other
hand, the value of intangible assets (ex. Patents and copyrights) is very unreliable (subjective) and as a result,
the asset based approach would not be well suited.
Source: Equity Valuation: Concepts and Basic Tools
*
36. Which of following statements is false with respect to stock valuation?
a) Holding initial cash flow and required return constant, the stock exhibiting a constant growth in cash flow
will be worth more than the stock exhibiting constant cash flows.
b) Holding growth constant, the stock with the lower required return will have a higher P/E relative to the stock
with the higher required return.
c) Valuation methods will not work if the stock is exhibiting a negative growth rate in its dividends.
Answer = C
A negative growth rate simply implies that the amount of the dividend payments is decreasing year over year.
Nevertheless though, so long as these dividend amounts are positive (albeit decreasing), they will translate into
a valuation for the stock.
Source: Equity Valuation: Concepts and Basic Tools
37
FIXED INCOME (37-56)
37. Which of the following bonds is most likely to trade at a lower price relative to an otherwise identical
option-free bond?
A. Convertible bond
B. Callable bond
C. Putable bond
Answer = B
A callable bond may be called away from the investor before the bond has matured. Clearly, this feature is
detrimental to the investor. As a result, the investor will pay a lower price for a callable bond. On the other
hand, the convertible and putable features are advantageous to the investor, thus compelling the investor to pay
a higher price for these bonds.
Source: Fixed-Income Securities: Defining Elements
*
38. Centro Corp. recently issued a floating-rate note (FRN) that includes a feature that prevents its coupon rate
from falling below a prespecified minimum rate. This feature in an FRN is most likely referred to as a:
A. collar.
B. floor.
C. cap.
Answer = B
An FRN with a floor on the coupon rate prevents the coupon rate from falling below a prespecified minimum
rate.
Fixed-Income Securities: Defining Elements
*
39. A BBB rated corporation wishes to issue debt to finance its operations at the lowest cost possible. If it
decides to sell a pool of receivables into a special purpose vehicle (SPV), its primary motivation is most likely
to:
A. receive a guaranty from the SPV to improve the corporation's credit rating.
B. allow the corporation to retain a first lien on the assets of the SPV.
C. segregate the assets into a bankruptcy-remote entity for bondholders.
Answer = C
A key motivation for a corporation to establish a SPV is to separate it as a legal entity. In the case of bankruptcy
for the corporation, the SPV is unaffected because it is not a subsidiary of the corporation. Given this
arrangement, the SPV can achieve a rating as high as AAA and borrow at lower rates than the corporation.
Source: Fixed-Income Securities: Defining Elements
*
40. In a repurchase agreement, the repo margin will be lower the:
A. higher the quality of the collateral.
B. lower the demand for the collateral.
C. higher the supply of the collateral.
Answer = A
A repurchase agreement is really a loan, in which the borrower posts the bond as a collateral and the lender
grants a loan. The higher the quality of the collateral, the more that the lender will be willing to lend. As a
result, the repo margin, which is the difference between the value of the collateral (which serve as the assets)
and the loan will diminish. Note that margin is really the borrower’s equity, where E=A-L. Again, as the
amount of the loan (L) increases, the margin (E) will diminish.
Source: Fixed-Income Markets: Issuance, Trading, and Funding
*
38
41. If a bank wants the ability to retire debt prior to maturity in order to take advantage of lower borrowing
rates, it most likely issues a:
A. callable bond.
B. putable bond.
C. convertible bond.
Answer = A
Callable bonds give issuers the ability to retire debt prior to maturity. The most compelling reason for them to
do so is to take advantage of potentially lower borrowing rates in the future.
Source: Fixed-Income Markets: Issuance, Trading, and Funding
*
42. Which of the following is least likely a short-term funding method available to banks?
A. Central bank funds
B. Syndicated loans
C. Negotiable certificate of deposits
Answer = B
A syndicated loan is a loan from a group of lenders, called the "syndicate," to a single borrower. Syndicated
loans are primarily originated by banks, and the loans are extended to companies but also to governments and
government-related entities. However, this question refers to the bank as the party that needs to raise short term
capital, in which case, the primary means would be through: Central Bank funds, Negotiable certificate of
deposits, and Interbank Funds.
Source: Fixed-Income Markets: Issuance, Trading, and Funding
*
43. Which of the following is most likely to cause an increase in the yield spread?
A. A rise in the general level of interest rates.
B. A rise in interest rate volatility while holding callable bonds.
C. A rise in interest rate volatility while holding putable bonds.
Answer = B
When interest rate volatility increases, option values (calls and puts) increase. But with a callable bond, the call
is short, meaning that the value of the callable bond would drop as the value of the call increases. And, as the
price drops, the bond’s yield (and therefore its spread above the benchmark yield) will increase.
Source: Introduction to Fixed-Income Valuation
*
44. Consider a $100 par value bond with a 7% coupon paid annually and 5 years to maturity. At a discount rate
of 6.5%, the value of the bond today is $102.08. One day later, the discount rate increases to 7.5%. Assuming
the discount rate remains at 7.5% over the remaining life of the bond, what is most likely to occur to the price of
the bond between today and maturity?
A. Decreases then remains unchanged
B. Decreases then increases
C. Increases then decreases
Answer = B
If the discount rate increases to 7.5% from 6.5%, the price of a bond decreases. At a discount rate of 7.5%, the
bond sells at a discount to face value. As a discount bond approaches maturity, it will increase in price over time
until it reaches par at maturity.
Source: Introduction to Fixed-Income Valuation
*
45. Which of the following is most likely a limitation of the yield to maturity measure?
A. It does not consider the capital gain or loss the investor will realize by holding the bond to maturity.
B. It assumes coupon payments can be invested at the yield to maturity.
C. It does not reflect the timing of the cash flows.
Answer = B
Yield to maturity does consider reinvestment income; however, it assumes that the coupon payments can be
reinvested at an interest rate equal to the yield to maturity. This is one of the limitations for the yield to maturity
39
measure because the investor is facing reinvestment risk (future interest rates may be less than the yield to
maturity at the time the bond is purchased).
Source: Introduction to Fixed-Income Valuation
*
46. An 8.2% coupon bond, has only one year remaining before it matures. The 6 month and one year spot rates
are 6.4% and 7.2% respectively. What is the arbitrage free value for this bond?
A. 94.74
B. 103.53
C. 100.96
Answer = C
P = 4.1/[1+(.064/2)]^1 + 104.1/[1+(.072/2]^2 = 3.9729 + 96.99 = 100.96
Source: Introduction to Fixed Income Valuation
*
47. Which of the following statements is least accurate with respect to Mortgage Backed Securities (MBS)?
A. Unlike other fixed income securities, the return on MBS can become severely suppressed if interest rates
should fall dramatically.
B. The accumulated amount of interest and principal payments are guaranteed, only their timing is not.
C. The interest on the MBS will be slightly less than the interest that’s actually paid by the homeowners.
Answer = B
Interest payments are based on the principal amount outstanding. Therefore, if the principal is repaid quicker
than anticipated, the accumulated interest payments will be less than expected.
Source: Introduction to Asset Based Securities
*
48. Assuming constant maturities, which of the following accurately depicts the security which would have the
highest degree of:
Interest rate risk
Reinvestment Rate risk
A.
Floating rate note
Residual CMO tranche
B.
MBS
Inverse floater
C.
Zero Coupon
MBS
Answer = C
For a given maturity, a zero coupon bond will always have the highest interest rate risk (i.e. its price is the most
sensitive to changes in yields). On the other hand, reinvestment rate risk increases with the frequency and size
of cash flows, as is the case with MBS.
Source: Introduction to Asset Based Securities
*
49. Consider a 5-year option-free bond that is priced at a discount to par value. Assuming the discount rate does
not change, one year from now the value of the bond will most likely:
A. increase.
B. decrease.
C. stay the same.
Answer = A
The bond is priced below its par value but will be worth exactly par value at maturity. Over time, assuming a
stable discount rate, the value of the bond must rise so that it is equal to par at maturity.
Source: Understanding Fixed-Income Risk and Return
*
50. A long-term bond investor with an investment horizon of 8 years invests in option-free, fixed-rate bonds
with a Macaulay duration of 10.5. The investor most likely currently has a:
A. positive duration gap and is currently exposed to the risk of lower interest rates.
B. negative duration gap and is currently exposed to the risk of higher interest rates.
C. positive duration gap and is currently exposed to the risk of higher interest rates.
Answer = C
40
The duration gap is the bond's Macaulay duration minus the investment horizon, which is positive in this case.
Since the investor’s horizon is short (relative to the bond’s Macaulay duration), it implies that the investor will
have to sell the bond before it matures. However, since the bond’s price is uncertain before its maturity date,
the investor will be exposed to interest rate risk. More specifically, if yields (interest rates) should increase,
then the price at which the bond will be sold at will decrease (thus reducing the return that the investor will
make).
Source: Understanding Fixed-Income Risk and Return
*
51. Which of the following is least likely a source of interest rate risk for a floating rate bond?
A. A rise in the required margin.
B. An extension in the coupon reset period.
C. A rise in LIBOR.
Answer = C
The coupon in the float will rise with LIBOR, thus causing price to remain close to par (as the coupon would
reflect prevailing rates). On the other hand, the margin embedded in the coupon rate is fixed. Therefore, if the
required margin were to increase, the bond’s overall coupon would be insufficient to compensate the investors,
thus causing the price to decrease. Furthermore, the longer the coupon reset period, the longer that the coupon
rate may fall out of line with prevailing LIBOR, thus causing the bond price to deviate from par.
Source: Understanding Fixed-Income Risk and Return
*
52. Holding all other characteristics the same, the bond exposed to the greatest level of reinvestment risk is most
likely the one selling at:
A. a premium.
B. a discount.
C. par.
Answer = A
A bond selling at a premium has a higher coupon rate and, all else being equal, bonds with higher coupon rates
face higher reinvestment risk. The reason is that the higher the coupon rate, the more dependent the bond's total
dollar return will be on the reinvestment of the coupon payments in order to produce the yield to maturity at the
time of purchase.
Source: Understanding Fixed-Income Risk and Return
*
53. A portfolio manager holds the following three bonds, which are option free and have the indicated
durations.
Bond
Par Value Market Value
Duration
Owned
Owned
A
$8,000,000 $12,000,000
3
B
$8,000,000 $6,000,000
7
C
$4,000,000 $6,000,000
6
The portfolio's duration is closest to:
A. 4.75.
B. 5.20.
C. 5.33.
Answer = A
Step 1. The total market value of the portfolio is 24M (12M+6M+6M). Par value is simply what the bonds will
be worth ‘when they mature’ and not what they are worth today.
Step 2. The portfolio's duration is a weighted average of the durations of the individual holdings:
(12/24) × (3.0) + (6/24) × (7.0) + (6/24) × (6.0) = 4.75.
Source: Understanding Fixed-Income Risk and Return
*
54. Credit spreads are most likely to narrow during:
A. economic contractions.
41
B. economic expansions.
C. a period of flight to quality.
Answer = B
Credit spreads are in effect the extra return that investors demand as compensation for bearing greater exposures
to credit risk. During economic expansions, the risk of issuers defaulting diminishes (i.e. credit risk decreases),
and as a result, investors will reduce the amount of return they demand (as compensation for risk) from these
issuers. On the other hand, during economic contractions (ex. Recessions), investors are more prone to sell their
corporate bonds and instead use their capital to invest in guaranteed Treasuries (i.e. flight to quality). During
such periods, the credit spreads on corporate bonds would increase (i.e. investors would have to be paid a higher
return to induce them to keep holding on to the corporate bonds).
Source: Fundamentals of Credit Analysis
*
55. Using the "Four Cs of Credit Analysis" framework, which of the following is the least likely factor to be
considered under the category of "capacity"?
A. History of fraud or malfeasance
B. Level of competition
C. Industry fundamentals
Answer = A
Any history of fraud or malfeasance is a major warning flag to credit analysis under the category of "character."
Source: Fundamentals of Credit Analysis
*
56. Compared with investment-grade bonds, the spread movements on high-yield bonds are influenced:
A. less by interest rate changes and exhibit a greater correlation with movements in equity markets.
B. more by interest rate changes and exhibit a greater correlation with movements in equity markets.
C. less by interest rate changes and exhibit a lower correlation with movements in equity markets.
Answer = A
High-yield bonds can be thought of as a hybrid between investment-grade bonds and equity securities. In other
words, their rank (in the event of issuer default) is below that of investment grade bonds, but higher than equityholders. Their spread movements are less influenced by interest rate changes than are investment-grade bonds
and they exhibit greater correlation with movements in equity markets.
Source: Fundamentals of Credit Analysis
DERIVATIVES (57-68)
57. Which of the following is unlikely to be a feature of an exchange traded derivative:
A. The exchange sets the underlying quantity and expiry date for each contract.
B. By setting margin accounts, the traders are responsible for clearing their gains and losses directly with each
other on a daily basis.
C. Exchange traded derivatives are more tightly regulated than their OTC counterparts.
Answer = B
The exchange (through its clearinghouse) will act as the counterparty for all sides of the trade. For example, if
Joe Buyer and Jane Seller enter into a derivative contract, the clearinghouse would effectively act as the seller
to Joe Buyer and as the buyer to Jane Seller. In effect, once the contract is entered into by Joe and Jane, each
will have to deal with the clearinghouse rather than each other. Thus, neither Joe nor Jane need concern
themselves with each other’s likelihood of default as the exchange will guarantee that the terms of the contract
will be met.
Source: Derivative Markets and Instruments
42
58. A corporation issues 5-year fixed-rate bonds. Its treasurer expects interest rates to decline for all maturities
for at least the next year. She enters into a 1-year agreement with a bank to receive quarterly fixed-rate
payments and to make payments based on floating rates benchmarked on 3-month LIBOR. This agreement is
best described as a:
A. swap.
B. futures contract.
C. forward contract.
Answer = A
A swap is a series of forward payments; specifically, an agreement between two parties to exchange a series of
future cash flows. The corporation receives fixed interest rate payments and makes variable interest rate
payments. Given that the contract is for 1 year and the floating rate is based upon 3-month LIBOR, at least 4
payments will be made during the year.
Source: Derivative Markets and Instruments
59. Which of the following statements is least accurate with respect to the distinguishing characteristics between
futures and a forward?
A. Both a futures and a forward would require an initial margin deposit.
B. The long position in either case would be obligated to buy the underlying asset at the futures price.
C. A futures contract is backed by a clearinghouse whereas a forward contract contains counterparty risk.
Answer = A
Futures contracts require initial margin deposits (this is how the clearinghouse is able to guarantee delivery). A
forward contract requires no such up front deposits and it is settled in its entirety on the expiry date. As a result,
forward contracts entail counterparty (or credit) risk.
Source: Derivative Markets and Instruments
60. If the implied volatility for options on a broad-based equity market index goes up, then it is most likely that:
A. the broad-based equity market index has gone up in value.
B. market interest rates have gone up.
C. the general level of market uncertainty has gone up.
Answer = C
One benefit of derivatives markets is information discovery. Implied volatility reveals information about the
risk of the underlying. Increases in implied volatility are an implication of increased market uncertainty.
Source: Derivative Markets and Instruments
61. You short 16 oil futures contracts with an initial futures price of $120 per barrel. Each contract is for 100
barrels. The initial and maintenance margins per contract are $1,600 and $1,150 respectively. At which of the
following prices would a margin call first go out?
A. $124.50
B. $115.50
C. $104.00
Answer = A
Loss per contract before a margin call goes out: 1600-1150=450
Per barrel, this translates to: 450/100=4.50
For a short, this loss would occur if the futures price appreciates by 4.50, to (120+4.50)=124.50
Source: Derivative Markets and Instruments
*
62. A call with a strike price of $52 is available on a stock that’s currently trading at $55. The call expires in 6
months and the risk free rate is 8%. The lower bound for this call is:
A. $6.85
B. $0
C. $4.96
Answer = C
43
The lower bound for a call is simply the present value of its intrinsic value at expiry:
PV of [S(T) – X] , which translates into: S(o) – PV(X) = (55) - [52/(1.08)^0.5] = 4.96
Source: Derivative Markets and Instruments
*
63. Mega Co. stock is currently trading at $190 per share. A call option on this stock, expiring in seven months
and with an exercise price of $200, is priced at $11.40. If the investor buys the call now, the net profit at expiry
if the stock price is trading at $215 would be closest to:
A. $13.60.
B. $3.60.
C. $15.00.
Answer = B
Step 1. Payoff at expiry = (215 – 200) = 15
Step 2. Profit = Payoff – Premium = 15 – 11.40 = 3.60
Source: Basics of Derivatives Pricing and Valuation
64. You enter a short position at $82 per contract. The initial margin and maintenance margin per contract are
at $11 and $7 respectively. If you should get a margin call for $5.60, what must have the futures price just
settled at, and what amount would the variation margin be for this contract?
Settlement Price
Variation margin
A.
$87.60
Greater than $4
B.
$87.60
Less than $4
C.
$76.40
Greater than $4
Answer = A
A margin call only goes out when there’s losses. For a short, that occurs when the futures price appreciates: 82
+ 5.60 = 87.60. The variation margin is the amount required to bring the margin level from below the
maintenance market back to its initial level. Therefore, the variation margin would be greater than $4.
Source: Basics of Derivatives Pricing and Valuation
65. Which of the following portfolios represents a synthetic long put option?
A. Long call, short bond, long the asset.
B. Short call, long bond, long the asset.
C. Long call, long bond, and short the asset.
Answer = C
According to the Put Call Parity: Call + Zero Coupon Bond = Put + Asset
Therefore, a synthetic put = Call + Bond - Asset
Source: Basics of Derivatives Pricing and Valuation
66. You short a call option when the price of the underlying asset is $52. The call has an exercise price of $50
and a premium of $3.50. If at expiry, the price of the asset has appreciated to $55, which of the following
represents the profit or loss on the trade?
A. -$0.50
B. +$0.50
C. -$1.50
Answer = C
A call is in the money when the asset price exceeds the strike price. However, since this is a short position, this
payoff is an outflow: 55-50 = 5.00. But the premium is an inflow, therefore the net loss = 3.50 – 5.00 = 1.50
Source: Basics of Derivatives Pricing and Valuation
67. Which scenario accurately describes the effect on put premium as a result of the following factors:
Increase in volatility of underlying asset
Increase in the risk free rate
A.
Increase
Increase
B.
Increase
Decrease
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C.
Decrease
Increase
Answer = B
All option values (calls and puts) appreciate when there is an increase in the volatility of the underlying asset
price; this is due to the limited downside and higher upside potential that comes with options. An increase in
the discount rate lowers the present value of the exercise price; but for a put, this is the payoff source.
Consequently, the put premium diminishes. Note: when analyzing the impact of interest rates, only look at its
effect on the PV of exercise price, NOT the price of the underlying asset.
Source: Basics of Derivatives Pricing and Valuation
68. When purchasing a futures contract, the initial margin requirement is best described as the:
A. amount needed to finance the purchase of the underlying asset.
B. minimum account balance required as prices change.
C. performance bond ensuring fulfillment of the obligation.
Answer = C
To ensure that the trader will be able to fulfill any losses which may be incurred on the underlying futures
contract, the exchange will require the trader to post a margin (i.e. deposit), from which losses will be deducted
from and gains will be added to. This adjustment to the margin account will take place at the end of each
trading day (i.e. daily settlement). By settling the gains and losses daily, the exchange ensures that losses do not
accumulate to levels that would impair the losing side’s ability to meet its obligations.
Source: Basics of Derivatives Pricing and Valuation
ALTERNATIVE INVESTMENTS (69-76)
69. The real estate index most likely to suffer from sample selection bias is a(n):
A. REIT index.
B. repeat sales index.
C. appraisal index.
Answer = B
Only properties that sell in each period and are included in the index and vary over time which may not be
representative of the whole market.
Source: Introduction to Alternative Investments
70. Which of the following investments most likely provides an investor with indirect equity exposure to real
estate?
A. Real estate limited partnerships
B. Commercial mortgage-backed securities
C. Real estate investment trusts
Answer = C
-Real estate investment trusts (REITs) provide investors with indirect equity real estate exposure. Since REITs
are securities (like stocks), they do not represent direct ownership of real estate. Instead, a REIT is backed by a
pool of real estate investments, the profits from which are flowed through to the holders of the REITs. But
again, a REIT is a security, rather than a direct physical ownership of a real estate property.
-Real Estate Limited Partnerships (RELPs) allow investors (which in this case would be the Limited Partners) to
have their capital directly invested by professional real estate managers (i.e. the General Partners), while
maintaining a limited liability exposure.
-Commercial mortgage-backed securities (CMBSs) provide investors with indirect investment opportunities in
real estate ‘debt’ (rather than equity interest in real estate).
Source: Introduction to Alternative Investments
45
71. Which attribute would a private equity firm most likely desire when deciding if a company is particularly
attractive as a leveraged buyout target?
A. Efficient management
B. Market value exceeds intrinsic value
C. Sustainable cash flow
Answer = C
Private equity firms look for companies that have strong cash flows and a significant amount of physical assets.
These physical assets can be used as collateral and borrowed against.
Source: Introduction to Alternative Investments
72. Concentrated portfolio strategies are attractive because of their:
A. ability to track market indices.
B. low risk.
C. potential to generate alpha.
Answer = C
Concentrated portfolio strategies focus on only a few securities, strategies, or managers. This focus reduces
diversification but may enable investors to achieve alpha (i.e. a return that is in excess of what would otherwise
be required for the level of risk undertaken).
Source: Introduction to Alternative Investments
73. Which of the following is most likely a private equity strategy?
A. Merger arbitrage
B. Quantitative directional
C. Venture capital
Answer = C
Venture capital is a private equity strategy in which private equity companies invest and get actively involved in
the management of portfolio companies. What’s distinct about venture capital is that the firms are generally in
their initial phases of growth.
Source: Introduction to Alternative Investments
74. Which of the following is most likely a private real estate investment vehicle?
A. Real estate limited partnership
B. Collateralized mortgage obligation
C. Real estate investment trust
Answer = A
-Real Estate Limited Partnerships (RELPs): Allow investors (which in this case would be the Limited Partners)
to have their capital managed by professional real estate managers (i.e. the General Partners), while maintaining
a limited liability exposure.
-Real Estate Investment Trusts (REITs): are similar to RELPs (i.e. diversified pool of real estate investments)
except that REITs issue shares (rather than Limited Partnerships). In other words, investors in RELPs are
regarded as ‘partners’ (which are private) whereas with REITs, they are regarded as ‘shareholders’ (which are
public).
-Collateralized mortgage obligations (CMOs): are considered as debt that is backed by real estate, rather than a
direct investment in real estate.
Source: Introduction to Alternative Investments
75. An alternative investments fund that employs leverage and takes long and short positions in securities is
most likely a:
A. hedge fund.
B. venture capital fund.
C. leveraged buyout fund.
Answer = A
46
-Hedge funds have the greatest flexibility in terms of what they may do in order to generate return. As a result,
they may take long and short positions in securities, and in order to amplify return opportunities, they will
employ leveraged strategies. On the other hand, venture capital funds and leveraged buyout funds have a ‘longonly’ approach, in which the managers purchase large blocks of shares of firms which they believe possess high
return opportunities.
Source: Introduction to Alternative Investments
76. A hedge fund that implements trades based on a top-down analysis of expected movements in economic
variables most likely uses a(n):
A. macro strategy.
B. event-driven strategy.
C. relative value strategy.
Answer = A
Macro strategies emphasize a top-down approach, and trades are made based on expected movements of
economic variables.
Source: Introduction to Alternative Investments
PORTFOLIO MANAGEMENT (77-90)
77. Which of the following institutional investors are most likely to have a low tolerance for investment risk and
relatively high liquidity needs?
A. Insurance company
B. Charitable foundation
C. Defined benefit pension plan
Answer = A
Insurance companies need to be relatively conservative and liquid given the necessity of paying claims when
due.
Source: Source: Portfolio Management: An Overview
*
78. Which of the following is least likely a part of the execution step of the portfolio management process?
A. Portfolio construction
B. Security analysis
C. Performance measurement
Answer = C
Performance measurement is a part of the feedback step of the portfolio management process. The execution
step includes asset allocation, security analysis, and portfolio construction.
Source: Source: Portfolio Management: An Overview
*
79. If Investor A has a lower risk aversion coefficient than Investor B, will Investor B's optimal portfolio most
likely have a higher expected return on the capital allocation line?
A. No, because Investor B has a lower risk tolerance
B. Yes
C. No, because Investor B has a higher risk tolerance
Answer = A
Investor A has a lower risk aversion (i.e. higher risk tolerance). Therefore, Investor A’s portfolio can be
expected to earn a higher return relative to Investor B (i.e. Investor B’s portfolio return can be expected to be
lower).
Source: Portfolio Risk and Return: Part I
*
47
80. A portfolio contains equal weights of two securities having the same standard deviation. If the correlation
between the returns of the two securities was to decrease, the portfolio risk would most likely:
A. remain the same.
B. increase.
C. decrease.
Answer = C
As correlation decreases, stock returns will become less in sync. As a result, the increasing degree of unrelated
movements will result in an offsetting effect between the stocks, thus lowering the overall volatility of the
portfolio.
Source: Portfolio Risk and Return: Part I
*
81. You devise the following probabilities for Stock M:
Probability(%): 22
30
28
20
E(Return):
9
-3
15
18
The expected standard deviation for Stock M is closest to:
A. 69.52%
B. 42.91%
C. 8.33%
Answer = C
i) E(R) = .22X9 + .30X-3 + .28X15 + .20X18 = 8.9
ii) var = .22(9-8.9)^2 + .30(-3-8.9)^2 + .28(15-8.9)^ + .20(18-8.9)
= .0022+42.48+10.42+16.56 = 69.5
iii) std. dvtn = 8.33
With a standard deviation questions, always expect variance to serve as a decoy answer.
Source: Portfolio Risk and Return: Part I
*
82. Which of the following is least likely an assumption of the capital asset pricing model (CAPM)?
A. Security prices are not affected by investor trades.
B. An investor can invest as much as he or she desires in any asset.
C. Investors are different only with respect to their unique holding periods.
Answer = C
One of the assumptions of the CAPM is that investors plan for the same single holding period.
Source: Portfolio Risk and Return: Part II
*
83. A portfolio with equal parts invested in a risk-free asset and the optimal risky portfolio will most likely lie
on:
A. the security market line.
B. a capital allocation line.
C. the efficient frontier.
Answer = B
A capital allocation line shows possible combinations of the optimal risky portfolio and the risk-free asset. The
security market line exhibits the relationship between the security’s beta and its required rate of return. Finally,
the efficient frontier represents all the efficient risky portfolios that are available.
Source: Portfolio Risk and Return: Part II
*
84. An asset has an annual return of 19.9%, standard deviation of returns of 18.5%, and correlation with the
market of 0.9. If the standard deviation of returns on the market is15.9% and the risk-free rate is 1%, the beta of
this asset is closest to:
A. 1.02.
B. 1.05.
C. 1.16
Answer = B
48
β= (ρi,m) x (σi/σm)
β= (0.90) × (0.185 / 0.159)
β= 1.047
Source: Portfolio Risk and Return: Part II
*
85. Which of the following is least likely evidence that individuals are risk averse?
A. Purchase of life insurance.
B. Of investments of equal risk, choosing the one with the higher expected return.
C. The avoidance of high risk stocks by most investors.
Answer = C
Risk aversion simply implies that investors require higher rates of return for higher risk assets. Therefore, risk
aversion does not imply the shunning of high risk stocks, just that they must offer a higher rate in order for
investors to purchase them.
Source: Basics of Portfolio Management and Construction
*
86. In a strategic asset allocation, assets within a specific asset class are least likely to have:
A. low paired correlations.
B. low correlations with other asset classes.
C. similar risk and return expectations.
Answer = A
i) The assets within a group would tend to exhibit similar risk and return characteristics, and as such, result in a
high degree of correlation amongst each other.
ii) On the other hand, the assets within a group would have almost no relation to the assets from another group;
this in turn would result in a low correlation among the different asset classes.
Source: Basics of Portfolio Management and Construction
*
87. A financial advisor gathers the following information about a new client:
-The client is a successful economics professor at a major university
-The client plans to work full time for seven years and then will work part time for 3 years before
retiring
-The client owns two homes and does not have any outstanding debt
-The client has accumulated retirement savings of approximately $ 2 million through their employer’s
retirement plan and will have anticipated retirement spending needs of $60,000 per year
-The client reads numerous financial publications and follows markets closely
-While concerned about the current health of the global economy, the client maintains that he is a longterm investor
Based on the above information, which of the following best describes this client?
A. low ability to take risk, but a high willingness to take risk
B. high ability to take risk, but a low willingness to take risk
C. high ability to take risk and a high willingness to take risk
Answer = C
The client is in a strong financial situation (stable job, no debt), has a reasonably long time horizon before
needing any liquidity (10 years), and reasonable retirement spending needs relative to total assets. These factors
indicate a high ability
to take risk. In addition, the client’s knowledge of financial markets, experience, and focus on the long term also
indicates a high willingness to take risk.
Source: Basics of Portfolio Planning and Construction
*
88. Which of the following is not a feature of an effective risk management framework:
A. Risk Identification and Measurement.
B. Risk Mitigation
49
C. Risk Modelling
Answer = C
An effective risk management framework should incorporate the following: 1. Risk Governance, 2. Risk
Identification and Measurement, 3. Risk Infrastructure, 4. Policies and Procedures, 5. Risk Mitigation,
6. Communication, 7. Strategic Analysis and Integration.
Source: Introduction to Risk Management
*
89. The belief that trends and patterns tend to repeat themselves and are, therefore, somewhat predictable best
describes:
A. arbitrage pricing theory.
B. technical analysis.
C. weak-form efficiency.
Answer = B
Technical analysts believe that trends and patterns tend to repeat themselves and are, therefore, somewhat
predictable.
Source: Technical Analysis
*
90. The following chart is best described as an example of which type of technical analysis chart?
A. A candlestick chart
B. A bar chart
C. A point and figure chart
Answer = A
The chart is an example of a candlestick chart. A candlestick chart provides four prices per data point entry: the
opening and closing prices and the high and low prices during the period (i.e., during a week). In a candlestick
chart, a vertical line represents the range through which the security price traveled during the time period. The
line is known as the wick or shadow. The body of the candle is shaded if the opening price was higher than the
closing price, and the body is clear if the opening price was lower than the closing price.
Technical Analysis
******
50