PASSMAX
2021 LEVEL I CFA® EXAM
MOCK 2
SESSION 1: Solutions
(The Solutions for Session 2 begin on Page 29)
1
ETHICS (1-28)
1. Chan Liu, CFA, is the new research manager at the Pacific MicroCap Fund. Liu observed the following
activities after she published a research report on a thinly traded micro-cap stock that included a "buy"
recommendation:
• Pacific traders purchased the stock for Pacific's proprietary account and then purchased the same stock for all
client accounts; and
• Pacific marketing department employees disseminated positive, but false, information about the stock in
widely read internet forums.
Liu notes the stock's price increased more than 50% within a period of two days and was then sold for Pacific's
account. Which of the following steps is most appropriate for Liu to take to avoid violating the CFA Institute
Standards of Professional Conduct?
A. Remove her name from the micro-cap stock research report.
B. Publicly refute the false information posted on internet forums.
C. Report the observed activities to her employer.
Answer = C
Certain staff at Liu's employer appear to be engaged in front running, a violation of Standard VI(B)–Priority of
Transactions, and market manipulation, a violation of Standard II(B)–Market Manipulation. If Liu observes
these violations without taking steps to notify her employer, she will be in violation of Standard I(A)–
Knowledge of the Law. Liu should know that the conduct observed is likely a violation of applicable laws,
rules, and regulations as well as a violation of the CFA Institute Standards of Professional Conduct. Her first
step, therefore, should be to attempt to stop the behavior by bringing it to the attention of the employer through
a supervisor or the firm's compliance department. Inaction may be construed as participation or assistance in the
illegal or unethical conduct.
Source: "Guidance for Standards I-VII,"
**
2. Jan Loots, CFA, quit his job as a portfolio manager at an investment firm with whom he had a nonsolicitation agreement he signed several years ago. Loots received permission to take his investment
performance history with him and also took a copy of the firm's software-trading platform. Subsequently, Loots
sent out messages on social media sites announcing he was looking for clients for his new investment
management firm. Access to Loots's social media sites is restricted to friends, family, and former clients. Loots
least likely violated the CFA Institute Standards of Professional Conduct concerning his:
A. non-solicitation agreement.
B. investment performance history.
C. trading software.
Answer = B
The portfolio manager received permission to use his investment performance history from his prior employer.
The member violated his non-solicitation agreement by indicating his availability to new clients on several
social media sites accessible by clients of his former employer. This action is a violation of Standard IV(A)–
Loyalty because he did not act for the benefit of his former employer. In this case, the member may cause harm
to his former employer if his messages result in clients moving to his new business from his former employer.
The member also violated Standard IV(A) by taking his employer's property, the trading software.
Source: "Guidance for Standards I-VII,"
**
3. Sergio Morales, CFA, believes he has found evidence that his supervisor is engaged in fraudulent activity
involving a client's account. When Morales confronts his supervisor, he is told the client is fully aware of the
issue. Later that day, Morales contacts the client and after disclosing the fraudulent activity, he is told by the
client to mind his own business. Following the requirements of local law, Morales provides all of his evidence,
along with copies of the client's most recent account statements, to a government whistleblower program. Has
Morales most likely violated the CFA Institute Standards of Professional Conduct?
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A. No
B. Yes, concerning Duties to Employers
C. Yes, concerning Preservation of Confidentiality
Answer = A
Because Morales believes his supervisor and potentially the client are engaged in fraudulent activity and
following the requirements of local law, he has not violated Standard III(E)–Preservation of Confidentiality or
Standard (V)–Duties to Employers.
Source: "Guidance for Standards I-VII,"
**
4. Carlos Cruz, CFA, is one of two founders of an equity hedge fund. Cruz manages the fund's assets, and the
other co-founder, Brian Burkeman, CFA, is responsible for fund sales and marketing. Cruz notices the most
recent sales material used by Burkeman indicates assets under management are listed at a higher value than the
current market value. Burkeman justifies the discrepancy by stating recent market declines account for the
difference. To comply with the CFA Institute Standards of Professional Conduct, Cruz should least likely take
which of the following actions?
A. Provide a disclaimer in marketing materials indicating prices are as of a specific date.
B. Report the discrepancy to CFA Institute's Professional Conduct Program.
C. Correct the asset information and provide updates to prospective clients.
Answer = B
A violation of Standard I(A): Knowledge of the Law is likely to occur unless the asset base information is
corrected. Cruz has yet to violate any CFA Institute standards, so he need not report a violation. If Cruz does
not take action, however, he will be in violation of the standards and at that point would need to report this
violation under Standard I(A). The member should know his conduct may contribute to a violation of applicable
laws, rules, regulations, or the CFA Institute Standards of Professional Conduct related to the inaccurate sales
materials. Cruz should seek to have the information corrected and accurate information provided to prospective
clients. It may also be prudent to seek the advice of legal counsel
Source: "Guidance for Standards I-VII,"
**
5. Christina Ng, a Level I CFA candidate, defaulted on a bank loan she obtained to pay for her master's degree
tuition when her wedding cost more than expected. A micro finance loan company lent her money to pay off the
tuition loan in full, including penalties and interest. The micro finance loan company even extended further
credit to pay for her parents' outstanding medical bills. Unfortunately, her parents' health problems escalated to
the point that Ng had to take extensive time away from work to deal with the issues. She was subsequently fired
and consequently defaulted on the second loan. Because she was no longer employed, Ng decided to file for
personal bankruptcy. Do the loan defaults leading up to Ng's bankruptcy most likely violate Standard I(D):
Misconduct?
A. No
B. Yes, with regard to the first loan default
C. Yes, with regard to the second loan default
Answer = A
Although Ng's first loan default, which played a part in the subsequent bankruptcy, is a result of poor financial
choices (i.e., paying for higher wedding costs rather than her tuition loan), neither of the loan defaults or the
bankruptcy involves fraudulent or deceitful business conduct but rather unfortunate personal circumstances.
Therefore, she would most likely not be in violation of Standard I(D): Misconduct.
Source: "Guidance for Standards I-VII,"
**
6. Kim Klausner, CFA, monitors several hundred employees as head of compliance for a large investment
advisory firm. Klausner has always ensured that his company's compliance program met or exceeded those of
its competitors. Klausner, who is going on a long vacation, has delegated his supervisory responsibilities to Sue
Chang. Klausner informs Chang that her responsibilities include detecting and preventing violations of any
capital market rules and regulations and the CFA Institute Standards of Professional Conduct. Klausner least
likely violated the CFA Institute Standards of Professional Conduct by failing to instruct Chang to also consider:
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A. industry standards.
B. firm policies.
C. legal restrictions.
Answer = A
The requirement under Standard IV(C): Responsibilities of Supervisors does not include any reference to
industry standards. Standard IV(C) requires supervisors to instruct those subordinate to them to whom
supervision is delegated about detection methods to prevent violations of laws, rules, regulations, firm policies,
and the CFA Institute Code and Standards.
Source: "Guidance for Standards I-VII,"
**
7. When a client asks her how she makes investment decisions, Petra Vogler, CFA, tells the client she uses
mosaic theory. According to Vogler, the theory involves analyzing public and nonmaterial nonpublic
information, including the evaluation of statements made to her by company insiders in one-on-one meetings in
which management discusses new earnings projections not known to the public. Vogler also gathers general
industry information from industry experts she has contacted. Vogler most likely violates the CFA Institute
Standards of Professional Conduct because of her use of:
A. nonmaterial nonpublic information.
B. one-on-one meeting information.
C. industry expert information.
Answer = B
A violation of Standard II(A): Material Nonpublic Information is likely to occur when using information that is
selectively disclosed by corporations to a small group of investors, analysts, or other market participants.
Earnings estimates given in a one-on-one meeting would likely be considered material and nonpublic
information. Information made available to analysts remains nonpublic until it is made available to investors in
general. Under the mosaic theory, it is acceptable to use information from industry contacts as long as the
analyst uses appropriate methods to arrive at her conclusions. Additionally, it is acceptable to use nonmaterial
nonpublic information in her analysis; this use is not a violation of Standard II(A): Material Nonpublic
Information.
Source: "Guidance for Standards I-VII,"
**
8. Bailey Watson, CFA, manages 25 emerging market pension funds. He recently had the opportunity to buy
100,000 shares in a publicly listed company whose prospects are considered "above industry norm" by most
analysts. The company's shares rarely trade because most managers use a buy-and-hold strategy because of the
company's small free float. Before placing the order with his dealer, Watson allocated the shares to be
purchased according to the weighted value of each of his clients' portfolios. When it came time to execute the
trades, the dealer was able to purchase only 50,000 shares. To prevent violating Standard III(B): Fair Dealing, it
would be most appropriate for Watson to reallocate the 50,000 shares purchased by:
A. reducing each pension fund's allocation proportionately.
B. distributing them equally among all the pension fund portfolios.
C. allocating randomly but giving funds left out priority on the next similar type trade.
Answer = A
Standard III(B): Fair Dealing requires members and candidates to deal fairly and objectively with all clients.
Certain clients cannot be favored over other clients when their investment objectives and circumstances are
similar. Therefore, the most appropriate way to handle the reallocation of an illiquid share is to reduce each
client's proportion on a pro rata, or weighted, basis.
Source: "Guidance for Standards I-VII,"
**
9. Lin Liang, CFA, is an investment manager and an auto industry expert. Last month, Liang sent securities
regulators an anonymous letter outlining various accounting irregularities at Road Rubber Company. Shortly
before he sent the letter to the regulators, Liang shorted Road stock for his clients. Once the regulators opened
an investigation, which Liang learned about from his sources inside the company, Liang leaked this information
to multiple sources in the media. When news of the investigation became public, the share price of Road
4
immediately dropped 30%. Liang then covered the short positions and made $5 per share for his clients. Liang
least likely violated which of the CFA Institute Standards of Professional Conduct?
A. Priority of Transactions
B. Misconduct
C. Market Manipulation
Answer = A
The member has not violated Standard VI(B): Priority of Transactions because this standard concerns client
investment transactions having priority over member or candidate investment transactions and is not applicable
here. The member has engaged in information-based manipulation of Road stock in violation of Standard II(B):
Market Manipulation and Standard I(D): Misconduct. Members and candidates must refrain from "pumping up"
(or down, in this case) the price of an investment by issuing misleading positive (or negative) information for
their or their clients' benefit.
Source: "Guidance for Standards I-VII,"
**
10. Jennifer Ducumon, CFA, is a portfolio manager for high-net-worth individuals at Northeast Investment
Bank. Northeast holds a large number of shares in Baby Skin Care Inc., a manufacturer of baby care products.
Northeast obtained the Baby Skin Care shares when it underwrote the company's recent IPO. Ducumon has
been asked by the investment banking department to recommend Baby Skin Care to her clients, who currently
do not hold any shares of Baby Skin Care in their portfolios. Although Ducumon has a favorable opinion of
Baby Skin Care, she does not consider the shares a buy at the IPO price or at current price levels. According to
the CFA Institute Standards of Professional Conduct, the most appropriate action for Ducumon is to:
A. recommend the shares after additional analysis.
B. ignore the request.
C. follow the request as soon as the share price declines.
Answer = B
Ducumon's opinion of the Baby Skin Care shares must not be affected by internal pressure. If Ducumon
followed the request from the investment banking department at her company, she would be in violation of
Standard I(B): Independence and Objectivity. Ducumon must refuse to recommend the Baby Skin Care shares
until they are an attractive purchase based on fundamental analysis and market pricing.
Source: "Guidance for Standards I-VII,"
**
11. Rodney Rodrigues, CFA, is responsible for identifying professionals to manage specific asset classes for his
firm. In selecting external advisers or subadvisers, Rodrigues reviews the adviser's investment process,
established code of ethics, the quality of the published return information, and the compliance and integrated
control framework of the organization. In completing his review, Rodrigues most likely violated the CFA
Institute Standards of Professional Conduct with regard to his due diligence on:
A. internal control procedures.
B. adherence to strategy.
C. performance measures.
Answer = B
Standard V(A): Diligence and Reasonable Basis applies to the level of review necessary to select an external
adviser or subadviser and would at minimum include reviewing the adviser's adherence to its stated strategy.
Source: "Guidance for Standards I-VII,"
**
12. Solomon Sulzberg, CFA, is a research analyst at Blue Water Management. Sulzberg's recommendations
typically go through a number of internal reviews before they are published. In developing his
recommendations, Sulzberg uses a model developed by a quantitative analyst within the firm. Sulzberg made
some minor changes to the model but retained the primary framework. In his reports, Sulzberg attributes the
model to both the quantitative analyst and himself. Before the internal reviews of his reports are completed,
Sulzberg buys shares in one of the companies. After the internal review is complete, he fails to recommend the
purchase of the stock to his clients and erases all of his research related to this company. Sulzberg least likely
violated the CFA Institute Standards of Professional Conduct related to:
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A. Misrepresentation.
B. Record Retention.
C. Priority of Transactions.
Answer = A
The research analyst has not violated Standard I(C): Misrepresentation because he has not knowingly made any
misrepresentations related to investment analysis, recommendations, actions, or other professional activities.
The research analyst has correctly attributed the model to both the quantitative analyst and to himself because
he has revised the original model. Research developed while employed by a firm is the property of the firm, and
the analyst is in violation of Standard V(C): Record Retention because members and candidates must develop
and maintain appropriate records to support their investment analysis, recommendations, actions, and other
investment-related communications with clients and prospective clients. As a general matter, records created as
part of a member's or candidate's professional activity on behalf of his or her employer are the property of the
firm. The analyst also violated Standard VI(B): Priority of Transactions by taking advantage of his knowledge
of the stock's value before allowing his employer to benefit from that information
Source: "Guidance for Standards I-VII,"
**
13. Jackson Barnes, CFA, works for an insurance company providing financial planning services to clients for a
fee. Barnes has developed a network of specialists—including accountants, lawyers, and brokers—who
contribute their expertise to the financial planning process. Each of the specialists is an independent contractor.
Each contractor bills Barnes separately for the work he or she performs, providing a discount based on the
number of clients Barnes has referred. What steps should Barnes take to be consistent with the CFA Institute
Standards of Professional Conduct?
A. Inform potential clients about his arrangement with the contractors before they agree to hire him
B. List the consideration he receives from the specialists on monthly client invoices
C. Have his independent contractors approved by the insurance company
Answer = A
The referral arrangements should be disclosed to potential clients before entry into any formal agreement for
services and not after the fact. This disclosure allows potential clients to consider whether the arrangement
causes them any potential harm as a result of the arrangement (e.g., higher fees and potential conflicts of
interest).
Source: "Guidance for Standards I-VII,"
**
14. On a flight to Europe, Romy Haas, CFA, strikes up a conversation with a fellow passenger, Vincent Trujillo.
When Trujillo learns Haas is in the investment profession, he asks about the CFA designation. Haas tells him
the following about the CFA designation. Which statements would be the most accurate?
Statement 1: Individuals who have completed the CFA Program have the right to use the CFA designation.
Statement 2: The CFA designation is globally recognized, which is why it can be used as part of a firm's name.
Statement 3: CFA charterholders must satisfy membership requirements to continue using the designation.
A. Statement 1
B. Statement 3
C. Statement 2
Answer = B
According to Standard VII(B): Reference to CFA Institute, the CFA Designation, and the CFA Program,
Statement 3 is an accurate statement concerning the CFA designation.
Source: "Guidance for Standards I-VII,"
**
15. Wouter Duyck, CFA, is the sole proprietor of an investment advisory firm serving several hundred middleclass retail clients. Duyck claims to be different from his competitors because he conducts research himself. He
discloses that to simplify the management of all these accounts, he has created a recommended list of stocks
from which he selects investments for all of his clients based on their suitability. Duyck's recommended list of
6
stocks is obtained from his primary broker, who has completed due diligence on each stock. Duyck's
recommended list least likely violates which of the following CFA Institute Standards of Professional Conduct?
A. Diligence and Reasonable Basis
B. Fair Dealing
C. Misrepresentation
Answer = B
Standard III(B): Fair Dealing concerns the fair treatment of clients when making investment recommendations
or taking investment action, and there is no indication the adviser has discriminated against any clients in regard
to his recommendations because he invests all clients in the same universe of stocks. The adviser has violated
Standard I(C): Misrepresentation with his research, however, because it is not independently created but
actually information provided to him by his broker. In addition, the adviser has violated Standard V(A):
Diligence and Reasonable Basis because he has not made reasonable and diligent efforts to determine whether
the third party's research is sound.
Source: "Guidance for Standards I-VII,"
**
16. Abdul Naib, CFA, was recently asked by his employer to submit an updated document providing the history
of his employment and qualifications. The existing document on file was submitted when he was hired five
years ago. His employer notices the updated version shows Naib obtained his MBA two years ago, whereas the
earlier version indicated he had already obtained his MBA at the time of his hire. Because the position Naib was
hired for had a minimum qualification of an MBA, Naib is asked to explain the discrepancy. He justifies his
actions by stating: "I knew you would not hire me if I did not have an MBA, but I already had my CFA
designation. Knowing you required an MBA, I went back to school on a part-time basis after I was hired to
obtain it. I graduated at the top of my class, but this should not come as any surprise because you have seen
evidence I passed all of my CFA exams on the first attempt." Did Naib most likely violate the CFA Institute
Standards of Professional Conduct?
A. Yes, with regard to Misconduct
B. No
C. Yes, with regard to Reference to the CFA Designation
Answer = A
Naib knowingly misrepresented his qualifications at the time of his hire by stating he had obtained an MBA
when in fact he had not. This action reflects adversely on his professional integrity, violating Standard
I(D):Misconduct. Stating he passed his CFA exams in three consecutive years is not a violation of Standard
VII(B): Reference to CFA Institute, the CFA Designation, and the CFA Program if it is factual. There is no
evidence given to indicate he did not pass as claimed.
Source: "Guidance for Standards I-VII,"
**
17. Tonya Tucker, CFA, is a financial analyst at Bowron Consolidated. Bowron has numerous subsidiaries and
is actively involved in mergers and acquisitions to expand its businesses. Tucker analyzes a number of
companies, including Hanchin Corporation. When Tucker speaks with the CEO of Bowron, she indicates many
of the companies she has looked at would be attractive acquisition targets for Bowron. After her discussion with
the CEO, Tucker purchases 100,000 shares of Hanchin Corporation at $200 per share. Bowron does not have
any pre-clearance procedures, so the next time she meets with the CEO, Tucker mentions she owns shares of
Hanchin. The CEO thanks her for this information but does not ask for any details. Two weeks later, Tucker
sees a companywide e-mail from the CEO announcing Bowron's acquisition of Hanchin for $250 a share. In
regard to her purchase of Hanchin stock, Tucker least likely violated the CFA Institute Standards of
Professional Conduct concerning:
A. Priority of Transactions.
B. Loyalty.
C. Material Nonpublic Information.
Answer = C
There is no indication the analyst had access to material nonpublic information and was in violation of Standard
II(A): Material Nonpublic Information. Specifically, Tucker did not have information concerning any decision
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by Bowron to acquire Hanchin stock because she is not a part of Bowron's decision-making team that
determines the companies it plans to take over. The analyst had indicated numerous companies were viable
options for take over, and she did not single out any one company in particular. However, trading the stock of a
company the analyst recommended as an acquisition candidate does violate Standard IV(A): Loyalty because
she did not give her employer the opportunity to take advantage of her skill/recommendation prior to buying the
shares for her own portfolio. In addition, the analyst violated Standard VI(B): Priority of Transactions, which
requires that investment transactions for clients and employers must have priority over investment transactions
in which a member or candidate is the beneficial owner despite the fact that there are no stock pre-clearance
procedures at Bowron.
Source: "Guidance for Standards I-VII,"
**
18. Kelly Amadon, CFA, an investment adviser, has two clients: Ryan Randolf, 65 years old, and Keiko
Kitagawa, 45 years old. Both clients earn the same amount in salary. Randolf, however, has a large amount of
assets, whereas Kitagawa has few assets outside her investment portfolio. Randolf is single and willing to invest
a portion of his assets very aggressively; Kitagawa wants to achieve a steady rate of return with low volatility so
she can pay for her child's current college expenses. Amadon recommends investing 20% of both clients'
portfolios in the stock of very low-yielding small-cap companies. Amadon least likely violated the CFA
Institute Standards of Professional Conduct in regard to his investment recommendations for:
A. only Randolf's portfolio.
B. only Kitagawa's portfolio.
C. both clients' portfolios.
Answer = A
In Randolf's case, the investment may be appropriate given this client's financial circumstances and aggressive
investment position. This investment would not be suitable for Kitagawa because of her need for a steady rate
of return and her low-risk profile.
Source: "Guidance for Standards I-VII,"
**
19. Danielle Deschutes, CFA, is a portfolio manager who is part of a 10-person team that manages equity
portfolios for institutional clients. A competing firm, South West Managers, asks Deschutes to interview for a
position with its firm and to bring her performance history to the interview. Deschutes receives written
permission from her current employer to bring the performance history of the stock portfolio with her. At the
interview, she discloses that the performance numbers represent the work of her team and describes the role of
each member. To bolster her credibility Deschutes also provides the names of institutional clients and related
assets constituting the portfolio. During her interview, Deschutes most likely violated the CFA Institute
Standards of Professional Conduct with regard to:
A. her contribution to the portfolio's returns.
B. providing details of the institutional clients.
C. the stock portfolio's performance history.
Answer = B
Deschutes most likely violated Standard III(E): Preservation of Confidentiality by failing to preserve the
confidentiality of client records when she disclosed specific details about clients in the equity portfolio.
Source: "Guidance for Standards I-VII,"
**
20. Charles Mbuwanga, a Level III CFA candidate, is the business development manager for Sokoza Investment
Group, an investment management firm with high-net-worth retail clients throughout Africa. Sokoza introduced
listed Kenyan REITs (real estate investment trusts) to its line of investment products based on new regulations
introduced in Kenya to diversify its product offering to clients. The product introduction comes after months of
researching Kenyan property correlations with other property markets and asset classes in Africa. Sokoza
assigns Mbuwanga as part of the sales team that will introduce this product to its clients across Africa.
Mbuwanga subsequently determines most of Sokoza's clients' portfolios would benefit from having a small
Kenyan property exposure to help diversify their investment portfolios. By promoting the Kenyan REITs for
Sokoza's client portfolios as planned, Mbuwanga would least likely violate which of the following standards?
8
A. Independence and Objectivity
B. Suitability
C. Knowledge of the Law
Answer = A
There is no indication Mbuwanga's recommendation is based on any compensation package based on sales
targets. If he had a sales target as part of his responsibility to promote the new product, it could be conceived
that his independence and objectivity would be in question. Mbuwanga does, however, seem to be in violation
of Standard III(C): Suitability because although research with regard to correlation was undertaken, an analysis
based on each individual client's return and risk objectives was not done. He may also be in violation of
Standard I(A): Knowledge of the Law because he would need to determine whether the Kenyan REIT product
is allowable in each of the countries where his clients reside.
Source: "Guidance for Standards I-VII,"
**
21. Sheila Schleif, CFA, is an equity analyst at an investment banking division of Mokara Financial Group, a
full service financial group. Schleif uses a multifactor computer model to make stock recommendations for all
clients of Mokara. Schleif discovers the model contains an error. If the error were corrected, her most recent
buy recommendation communicated to all clients would change to a sell. Schleif corrects the error, changing the
buy to a sell recommendation, and then simultaneously distributes via e-mail the revision to all investment
banking clients who received the initial recommendation. A week later, Schleif sells the same shares she held in
her personal portfolio. Concerning her actions, Schleif most likely violated which of the following CFA Institute
Standards of Professional Conduct?
A. Priority of Transactions
B. Diligence and Reasonable Basis
C. Fair Dealing
Answer = C
The analyst violated Standard III(B): Fair Dealing by selectively distributing the revised recommendation only
to investment banking clients despite being responsible for making investment recommendations to all group
clients. Schleif should distribute the change in recommendation to all clients who received the initial
recommendation, not just those within the investment banking division of the group.
Source: "Guidance for Standards I-VII,"
**
22. Linda Chin, CFA, is a member of a political group advocating less governmental regulation in all aspects of
life. She works in a country where local securities laws are minimal and insider trading is not prohibited. Chin's
politics are reflected in her investment strategy, where she follows her country's mandatory legal and regulatory
requirements. Which of the following actions by Chin would be most consistent with the CFA Institute
Standards of Professional Conduct?
A. Continuing her current investment strategy
B. Following the CFA Institute Standards of Professional Conduct
C. Disclosing her political advocacy to clients
Answer = B
Standard I(A): Knowledge of the Law requires members and candidates to comply with the more strict law,
rules, or regulations and follow the highest requirement, which in this case would be the CFA Institute
Standards of Professional Conduct. Standard II(A): Material Nonpublic Information would also apply because
members and candidates who possess material nonpublic information that could affect the value of an
investment must not act or cause others to act on the information. Disclosure that she meets local mandatory
legal requirements—versus the more strict law, rules, or regulations mandate of the Standards of Professional
Conduct—would not excuse the member from following the Standards of Professional Conduct.
Source: "Guidance for Standards I-VII,"
**
23. Colleen O'Neil, CFA, manages a private investment fund with a balanced global investment mandate. Her
clients insist that her personal investment portfolio replicate the investments within their portfolios to assure
them she is willing to put her own money at risk. By undertaking which of the following simultaneous
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investment actions for her own portfolio would O'Neil most likely be in violation of Standard VI(B): Priority of
Transactions?
A. Sale of a listed US blue chip value stock
B. Purchase of a UK government bond in the primary market
C. Participation in a popular frontier market IPO
Answer = C
Standard VI(B): Priority of Transactions dictates members and candidates give their clients and employer
priority when making personal investment transactions. Even when clients allow or insist the manager invest
alongside them, the manager's transactions must never adversely affect the interests of the clients. A popular or
"hot" IPO in a frontier market is likely to be oversubscribed. In such cases, Standard VI(B) dictates that the
manager should not participate in this event to better ensure clients will have a higher probability of getting
their full subscription allotment, even though clients have allowed or dictated that she participate alongside
them.
Source: "Guidance for Standards I-VII,"
**
24. Millicent Plain has just finished taking Level II of the CFA examination. Upon leaving the examination site,
she meets with four Level III candidates who also just sat for their exams. Curious about their examination
experience, Plain asks the candidates how difficult the Level III exam was and how they did on it. The
candidates say the essay portion of the examination was much harder than they had expected and that they were
not able to complete all questions as a result. The candidates go on to tell Plain about broad topic areas that
were tested and complain about specific formulas they had memorized that did not appear on the exam. The
Level III candidates least likely violated the CFA Institute Standards of Professional Conduct by discussing:
A. specific formulas.
B. the examination essays.
C. broad topic areas.
Answer = B
Discussing the level of difficulty of the essay portion of the examination did not violate Standard VII(A):
Conduct as Members and Candidates in the CFA Program. Standard VII(A) and the Candidate Pledge were
violated by candidates when they revealed broad topic areas and formulas tested or not tested on the exam.
Source: "Guidance for Standards I-VII,"
**
25. Which of the following statements does not accurately represent the objectives of Global Investment
Performance Standards (GIPS)? The GIPS standards:
A. ensure consistent, accurate investment performance data in the areas of reporting, records, marketing, and
presentations.
B. obtain global acceptance of calculation and presentation standards in a fair, comparable format with full
disclosure.
C. promote fair competition among investment management firms in all markets by requiring common fee
structures.
Answer = C
One of the objectives of the GIPS standards is to promote fair competition among investment management
firms in all markets; this objective does not require unnecessary entry barriers or hurdles for new firms, such as
common fee structures.
Source: Global Investment Performance Standards (GIPS)
**
26. According the GIPS standards, for periods beginning on or after 1 January 2011, the aggregate fair value of
total firm assets most likely includes all:
A. fee-paying discretionary accounts.
B. fee- and non-fee-paying discretionary accounts.
C. fee- and non-fee-paying discretionary and non-discretionary accounts.
Answer = C
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For periods beginning on or after 1 January 2011, total firm assets must include the aggregate fair value of all
discretionary and non-discretionary assets managed by the firm. This includes both fee-paying and non-feepaying portfolios.
Source: Global Investment Performance Standards (GIPS)
**
27. Which of the following statements is least accurate with respect to GIPS compliance?
A. If a firm does not fully comply with GIPS, it must disclose why.
B. Compliance is voluntary.
C. Compliance is to be firm-wide, not just composite basis.
Answer = A
Only firms directly involved in the investment management process, may claim compliance. Furthermore, a
firm either fully complies with GIPS, or it doesn’t. The only exception to full compliance with GIPS is if it
conflicts with local laws; in that case, local laws must be followed with the conflict disclosed.
Source: Global Investment Performance Standards (GIPS)
**
28. Which of the following statements is least accurate with respect to the methodology involved when adhering
to GIPS?
A. A composite is simply the aggregation of all the portfolios managed by the firm, which share a similar
objective or strategy.
B. Give an exhaustive set of composites, all discretionary and non-discretionary portfolios of the firm must be
represented.
C. Only fee paying portfolios may be included in the composites.
Answer = B:
Only discretionary portfolios may be included in composites.
Source: Global Investment Performance Standards (GIPS)
QUANTITATIVE METHODS (29-45)
29. You have $50,000 to invest. Bank A offers 7% compounded semi-annually, while Bank B offers 6.6%
compounded continuously. Which Bank offers the more attractive opportunity and how much extra interest may
be earned?
Preferred Bank
Extra Interest earned
A.
Bank A
$88.67
B.
Bank B
$149.92
C.
Bank A
$149.92
Answer =C
Bank A: PV=50,000, N=2, I=3.5, CPT FV=53561.25 $INT=3561.25
Bank B: 50000e^.066 = 53411.33
$INT=3411.33
Extra Interest by BankA
149.92
Source: The Time Value of Money
**
30. The nominal (quoted) annual interest rate on an automobile loan is 10%. The effective annual rate of the
loan is 10.47%. The frequency of compounding periods per year for the loan is closest to:
A. weekly.
B. monthly.
C. quarterly.
Answer = B
Weekly:
[1 + (.10/52)]52 = (1+EAR)1 : EAR = 10.51%
Monthly: [1 + (.10/12)]12 = (1+EAR)1 : EAR = 10.47%
Quarterly: [1 + (.10/4)]4 = (1+EAR)1 : EAR = 10.38%
Source: The Time Value of Money
11
31. The minimum rate of return an investor must receive in order to accept an investment is best described as
the:
A. internal rate of return.
B. required rate of return.
C. expected return.
Answer = B
Internal Rate of Return (IRR) and Expected Return (ER) are the same: It’s the return that the investment’s CF
will translate into when measured relative to the investment’s price (i.e. cost). Therefore, the higher the CFs,
the higher the IRR or ER will be. Required Return is the minimum return that the investor would be satisfied
with, given the riskiness of the investment. Therefore, the higher the risk, the higher the required return will be.
Source: The Time Value of Money
**
32. Which of the following best describes the characteristic of a distribution that is negatively skewed and has a
negative excess kurtosis?
A. There is exists a higher than normal likelihood that a very large negative value will be observed.
B. While there are some large positive outlier values, most of the observations will have a negative deviation
from the mean.
C. While there are some large negative outlier values, their likelihood of occurrence is very rare.
Answer = C
Skew and Kurtosis are related to the outlier (extreme) observations. Skew is caused by the ‘value’ of these
outliers observations. Therefore, a negative skew implies that the values of the negative outliers are larger than
the values of the positive outliers. On the other hand, Kurtosis (and Excess Kurtosis, which is simply: Kurtosis
– 3) is caused by the ‘frequency’ of these outlier observations. Therefore, a negative Excess Kurtosis implies
that the outlier observations occur less often than normal. Put together, we can conclude that while the negative
outliers can be very large (i.e. negative skew), they do not occur that often (i.e. negative excess kurtosis).
Source: Statistical Concepts and Market Returns
**
33. The following information is available for a portfolio:
Asset Class
Weight in Portfolio(%)
Asset Class Return(%)
Correlation with Equities(%)
Equities
45
16
100
Mortgages
25
12
30
Cash and Equivalents
30
2
10
The return on the portfolio is closest to:
A. 10.0%.
B. 8.2%.
C. 10.8%.
Answer = C
The portfolio return is the weighted mean return and is calculated as follows:
Note that correlation had no impact on portfolio return. Instead, correlation (i.e. the co-movement of the assets)
will only affect the overall volatility (i.e. risk) of the portfolio.
Source: Statistical Concepts and Market Returns
**
34. Over the past four years, a portfolio experienced returns of –8%, 4%, 17%, and –12%. The geometric mean
return of the portfolio over the four-year period is closest to:
A. 0.99%.
B. –0.37%.
C. 0.25%.
Answer = B
[(1-.08)(1+.04)(1+.17)(1-.12)] = [ 1 + G ]4
12
[0.98512] = [ 1 + G ]4
[0.98512] 1/4 = [ 1 + G ]
[0.99626] = [ 1 + G ]
G = -.0037406 = -0.37%
Source: Statistical Concepts and Market Returns
**
35. There are 8 stocks on your BUY list, from which you would like to construct a 5-stock portfolio. How
many possible ways can you construct this portfolio?
A. 6720
B. 56
C. 336
Answer = B
Since the order in which the 5 stocks are arranged within a portfolio does not matter, the number of 5-stock
portfolios possible would be: 8!/[(3!)(5!)] = 56
Source: Probability Concepts
**
36. The variance of returns of Asset A is 625. The variance of returns of Asset B is 1,225. The covariance of
returns between Asset A and Asset B is 600. The correlation of returns between Asset A and Asset B is closest
to:
A. 0.47.
B. 0.29.
C. 0.69.
Answer = C
Step 1. [ σ(A) = (625)1/2 = 25 ] and [ σ(B) = (1225)1/2 = 35 ]
Step 2. Correlation = [ Cov(A,B) ] / [σ(A) x σ(B) ]
= [ ( 600 ) ] / [( 25 ) x ( 35 )]
= 0.6857
Source: Probability Concepts
**
37. There is a 30% probability that we’ll experience a recession. The probability that we’ll see an increase in
interest rates, given that a recession has occurred, is 21%. What is the probability that we’ll see both a
recession and a decrease in interest rates?
A. 79.0%
B. 38.0%
C. 23.7%
Answer = C
Step 1. P(i drop, GIVEN recession) = .79
Step 2. P(i drop AND recession) = .79 X .30 = .237
Source: Probability Concepts
**
38. Which of the following does not accurately describe a discrete uniform distribution?
A. There are a finite number of specified outcomes.
B. 95% of the observations are expected to fall within two standard deviations of the average.
C. The wider the range, the lower the probability of observing a specific value.
Answer = B
A discrete uniform distribution has countable numbers as its outcome (i.e. the outcomes are not continuous) and
each outcome is equally likely. The 95% confidence interval applies to a normal distribution.
Source: Common Probability Distributions
**
39. The following table represents the historic data for Stock X:
RETURN:
-2%
1% 5%
-10%
3%
13
FREQUENCY:
10
20
80
30
40
What is the probability that you’ll observe a return on Stock X that’s less than 3%?
A. 55.6%
B. 33.3%
C. 66.7%
Answer: B
Number of observations with values LESS than 3%: 10+20+30 = 60
Total number of observations: 180
P(R<3) = 60/180 = 33.33
Source: Common Probability Distributions
**
40. Which of the following is the least likely characteristic of the normal probability distribution? The normal
probability distribution:
A. has kurtosis of 3.0.
B. has the same value for mean, median, and mode.
C. is more suitable as a model for asset prices than for returns.
Answer = C
A normally distributed variable will exhibit the following characteristics:
i) Skew = 0 (i.e. the distribution is symmetric around the mean)
ii) Kurtosis = 3, and therefore Excess Kurtosis = (Kurtosis – 3) = (3 – 3) = 0
iii) The values will range from negative infinity to positive infinity. However, asset prices have a lower limit of
zero, thus making a normal distribution an unsuitable framework for analysis. While asset returns also have a
lower limit (equal to -100%), this lower limit is statistically indifferent form negative infinity.
Source: Common Probability Distributions
**
41. From a population that is normally distributed, a sample of 50 observations are drawn, resulting in a sample
mean and variance of 34 and 324 respectively. The 90% confidence interval for this random variable is closest
to:
A. 29.8 to 38.2
B. 4.3 to 63.7
C. 8.8 to 37.6
Answer =B
NOTE: The question asks for confidence interval for the random variable, not its average. Consequently, use
standard deviation (324)^0.5 or 18, and not the standard error.
Range-Low: 34-1.65(18) = 4.3
Range-High: 34+1.65(18) = 63.7
Source: Sampling and Estimation
**
42. Which of the following statements most accurately describes the potency of the central limit theorem?
A. If each sample taken from a population includes more than 30 observations, then the sample mean would be
normally distributed, even if the underlying population isn’t.
B. If the sample size is large enough, then the sample mean will equal to the population mean.
C. Given that the population variance is known, the population mean can be computed simply by drawing a
sufficiently large sample.
Answer =A
As per answer. Furthermore, standard error would represent the dispersion of the sample mean.
Source: Sampling and Estimation
**
43. Which of the following would not be deemed as a quality of a good estimator?
A. Consistent.
B. Robust.
C. Unbiased.
14
Answer =B
Robustness is not deemed as an estimator quality.
Source: Sampling and Estimation
**
44. If you suspect that the variance of the underlying population has increased, which of the following would
not be consistent with a proper hypothesis test?
A. The null should indicate that the variance has decreased.
B. The degrees of freedom would be defined as the sample size less one.
C. A very high sample variance relative to the hypothesized variance would result in a low value for the sample
statistic.
Answer =C:
The suspected claim should always be set up as the alternative hypothesis, this way if it is accepted, there is
conclusive evidence of its existence.
The sample statistic in this case is = [(n-1)(sample variance)]/(hypothesized variance)
Therefore, as the sample variance increases, the value for the test statistic will increase as well.
Source: Hypothesis Testing
**
45. Independent samples drawn from normally distributed populations exhibit the following characteristics:
Sample
Size
Sample Mean
Sample Standard Deviation
A
25
200
45
B
18
185
60
Assuming that the variances of the underlying populations are equal, the pooled estimate of the common
variance is 2,678.05. The t-test statistic appropriate to test the hypothesis that the two population means are
equal is closest to:
A. 1.90.
B. 0.29.
C. 0.94.
Answer = C
The t-statistic for the given information (normally distributed populations, population variances assumed equal)
is calculated as:
In this case, we have a paired (common) variance (s2p) = 2678.05.
Interpret: The hypothesis is that the two population means are equal (which should result in the zero difference
between them). However, our sample indicates that the difference between the sample means are 0.94 standard
deviations away from the hypothesis. Consequently, if the test statistic (i.e. the 0.94) should fall within the
critical values (not given in this question), then we would attribute this sample deviation from the hypothesis
due to chance (i.e. sample error) and thus not reject the hypothesis. On the other hand, if the test statistic ends
up being greater than the critical values, then we may conclude that the sample fell outside an acceptable range
for the hypothesis and thus we would reject it.
Source: Hypothesis Testing
15
ECONOMICS (46-62)
46. The aggregate demand and supply functions for the local market for pizza, along with some relevant data, is
as follows:
AD(Pizza) = 13,500 – 2,020 P(Pizza) + 0.07(Income) - 0.31 P(Cola)
AS(Pizza) = -4,000 + 1,219 P(Pizza) – 91(Wage)
Related Data
Price of a pizza:
$5/pizza
Aggregate monthly income:
$2,050
Price of cola per bottle:
$1.35/bottle
Wage rate paid to pizza personnel:
$10
The number of units of excess demand for pizza is closest to:
A. 2,358.
B. 1,471.
C. 2,072.
Answer = A
AD(Pizza) = 13,500 – 2,020 P(Pizza) + 0.07(Income) - 0.31 P(Cola)
= 13,500 – (2,020 × 5) + (0.07 × 2,050) – (0.31 × 1.35) = 3,543 units
AS(Pizza) = -4,000 + 1,219 P(Pizza) – 91(Wage)
= -4,000 + (1,219 × 5) - (91 × 10)
= 1,185 units
Excess ‘Demand’ = 3,543 – 1,185
= 2,358 units
Source: Topics in Demand and Supply Analysis
**
47. Which of the following statements is least accurate?
A. So long as price exceeds AVC, in the short term, the firm should continue to operate, even if it is not able to
cover all its total costs.
B. Revenue is maximized when marginal revenue equals to marginal cost.
C. Over the long term, firms operating in perfect competition should earn a zero economic profit.
Answer = B
Answer A is true: In the short term, if the price exceeds AVC, that excess may be used to offset part of the
firm’s fixed costs (which would be payable irrespective of whether the firm operates or shuts down).
Answer B is false: When MR = MC, it is ‘profit’ that is maximized (rather than revenue). In fact, revenue
would be maximized when marginal revenue becomes zero (i.e. selling an additional unit would no longer
contribute to revenue – therefore, revenue must have reached its maximum point.
Answer C is true: Economic profit refers to ‘excess’ profit, and in a perfectly competitive environment, firms
would only make a ‘normal’ profit, but zero excess profit.
Source: Topics in Demand and Supply Analysis
**
48. Which of the following would least accurately describe a good that had an income elasticity of 0.6?
A. An increase in consumer income would cause the demand curve to shift left.
B. It would be impossible for this good to be a Giffen good.
C. The good would be regarded as normal.
Answer = A
Since the income elasticity is positive, an increase in income would result in an increase in demand for the
good, and thus the demand curve would shift right.
Source: Topics in Demand and Supply Analysis
**
16
49. Which of the following best describes the cost behavior of a typical firm?
A. Average Variable Cost (AVC) is inversely related to the Average Productivity (AP) of workers.
B. When Marginal Cost (MC) is increasing, AVC must be increasing as well.
C. When Marginal Productivity (MP) begins to decrease, Total Costs will begin to increase at an decreasing
rate.
Answer = A
Answer A is true: As workers become more productive (make more units within the same number of hours), the
cost associated with each unit (AVC) should diminish.
Answer B is false: Even if MC is increasing, so long as the absolute value of MC is less than AVC, then AVC
would drop.
Answer C is false: When Marginal Productivity (MP) begins to decrease, Total Costs will begin to increase at
an ‘increasing’ rate.
Source: Topics in Demand and Supply Analysis
**
50. Which characteristic is a firm least likely to exhibit when it operates in a market with a downward sloping
demand curve, many competitors, and zero economic profits in the long run?
A. Differentiated product
B. Low barriers to entry
C. No pricing power
Answer = C
The characteristics of monopolistic competition include a large number of competitors, low pricing power, and
the production of differentiated products (through advertising and other non-price strategies), but these still
result in some pricing power. The ease of entry results in zero economic profits in the long run.
Source: The Firm and Market Structures
**
51. With its existing production facilities, a monopolist firm can produce up to 100 units. It faces the following
demand and cost schedules:
Output
Price
Total
(units)
($/unit)
Costs ($)
0
3,000
600
20
2,800
10,600
40
2,600
32,600
60
2,400
66,600
80
2,200
112,600
100
2,000
170,600
The optimal output level for this producer (in units) is closest to:
A. 20.
B. 60.
C. 100.
Answer = B
The optimal output level is 60 units because it produces the highest profit:
Output
Price
Total
Total
Profit
($/unit)
(units)
Revenue
Costs ($) ($)
($)
2,800
56,000
10,600
45,400
20
2,600
104,000
32,600
71,400
40
2,400
144,000
66,600
77,400
60
2,200
176,000
112,600 63,400
80
2,000
200,000
170,600 29,400
100
Source: The Firm and Market Structures
**
17
52. A firm in the market environment characterized by monopolistic competition will most likely:
A. continue to experience economic profit in the long run.
B. have a well-defined supply function reflecting its marginal and average costs.
C. have many competitors, each of which follows its own product differentiation strategy.
Answer = C
As the name implies, monopolistic competition is a hybrid market. The most distinctive factor in monopolistic
competition is product differentiation. Although the market is made up of many firms that compose the product
group, each producer attempts to distinguish its product from that of the others, and product differentiation is
accomplished in a variety of ways.
Source: The Firm and Market Structures
**
53. Which of the following statements concerning the Herfindahl–Hirschman Index (HHI) is most accurate?
A. The HHI is a useful measure of potential barriers to entry.
B. An HHI of 0.05 would be analogous to having the market shared equally by 20 firms.
C. The HHI is usually unaffected by mergers among the top market incumbents.
Answer = B
-HHI measures how concentrated an industry is. For instance, the more that an industry is dominated by a few
large firms (which may have resulted from a series of mergers), the higher the HHI will be.
-HHI = Sum of (individual firm market share)2
Therefore, if there were 20 firms, each with and equal market share of 5% (1/20), then:
HHI = 20 x (0.05)2 = 0.05
-Note that HHI would reach its upper limit of 1.0, if the industry was dominated by just one firm: HHI = (1) 2 =
1. Furthermore, HHI only looks at the existing firms within an industry (whereas entry barriers only affect
‘potential’ firms entering into the industry).
Source: The Firm and Market Structures
**
54. Which of the following is most likely to cause a shift to the right in the aggregate demand curve?
A. Increase in taxes
B. Decrease in real estate values
C. Boom in the stock market
Answer = C
A right shift in the aggregate demand curve implies that holding price constant, consumers are demanding more
goods, which may result from:
i) Decrease in taxes (and therefore an increase in disposable income)
ii) Increase in wealth (via increase in real estate values and/or stock prices).
Source: Aggregate Output, Prices, and Economic Growth
**
55. Which of the following will most likely cause the short-run aggregate supply (SRAS) curve to shift to the
right?
A. Increase in business taxes
B. Increase in the supply of human capital
C. Increase in nominal wages
Answer = B
A rightward shift in SRAS may be interpreted as follows: Holding price constant at P(o), the economy is now
able to produce more output, a scenario which would unfold if the supply of human capital were to increase. A
rightward shift in SRAS may equivalently be viewed as a downward shift. In this case, the interpretation would
be as follows: Holding output levels constant at Y(o), price levels in the economy are decreasing, which are
likely to occur if costs were to decrease (either through lower taxes or lower nominal wages)
Source: Aggregate Output, Prices, and Economic Growth
**
18
56. The unemployment rate is best described as the ratio of unemployed to:
A. total population of people who are of working age.
B. labor force.
C. labor force minus frictionally unemployed.
Answer = B
Employment, or its inverse, unemployment, is a broad concept, the specifics of which are as follows:
i) Labor Force: represents the number of individuals who are either employed or seeking employment.
Consequently, groups that are neither employed nor seeking employment (for example, full-time students,
retirees, children, stay-at-home parents) would not be counted as part of the labor force, even though they may
make up a significant proportion of the population.
ii) Employed: are the number of individuals who are currently working. This measure includes both full-time
and part-time workers.
iii) 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).
iv) 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.
v) 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).
Source: Understanding Business Cycles
**
57. Which of the following is most consistent with real business cycle (RBC) models? The arguments and
recommendations of RBC models suggest that:
A. monetary variables have a major impact on GDP growth.
B. persons are unemployed because their asking wages are too high.
C. governments should intervene when the economy is in contraction.
Answer = B
As suggested particularly by the earliest RBC models, a person is unemployed because he or she is asking for
wages that are too high, or in other words, this person’s utility function is maximized by having more leisure
(e.g., free time to visit museums, watch games on TV, and enjoy time with friends) and less consumption
(which could be increased by giving up some leisure and finding a job).
Source: Understanding Business Cycles
**
58. Which of the following factors is least likely to cause an increase in the equilibrium amount of money
demand by an economy?
A. A rise in prices.
B. Financial innovation.
C. An increase in real GDP.
Answer = B
Financial innovation means that individuals need to hold less cash on hand. However, all the other factors
would induce individuals to hold more money on hand.
Source: Monetary and Fiscal Policy
**
59. An analyst argues that if the central bank were to reduce the money supply, the short term result would be a
reduction in the amount of investments made by business, as well as a reduction in exports. Is the analyst
correct with respect to her statement about:
Reduced Investment
Reduced exports
A.
YES
NO
B.
NO
NO
19
C.
YES
YES
Answer = C
A reduction in the money supply would mean a rise in interest rates. This would directly cause the amount of
investment to drop. As well, the higher interest rates would cause an appreciation of the home currency, and
thus causing exports to fall.
Source: Monetary and Fiscal Policy
**
60. An expansionary fiscal policy is most likely associated with:
A. an increase in capital gains tax rates.
B. crowding out of private investments.
C. an increase in government spending on social insurance and benefits.
Answer = B
Expansionary fiscal policy occurs either through an increase in discretionary government spending or a decrease
in taxes. In both cases, more spending power is transmitted into the economy. However, for the government to
finance its increase in spending, it must borrow more, which in turn leads to less capital being available for
private borrowers (i.e. they are ‘crowded out’). Rises in government spending on social insurance and benefits
is a form of automatic stabilizer and not due to discretionary fiscal expansion.
Source: Monetary and Fiscal Policy
**
61. Which of the following statements is least accurate with respect to the impact of subsidies?
A. The result would be an overproduction of the underlying good.
B. The market price of the underlying good would decrease.
C. The allocative inefficiency would be very similar to that of minimum wage laws.
Answer = C.
A subsidy artificially lowers the cost of production (to the producer, but not society). Therefore, supply is
increased and market price falls. However, since the extra output is being produced at a cost to society (once
the tax subsidy is paid for) that is greater than the benefit placed on it, a deadweight loss occurs. Minimum
wage on the other hand results in underproduction, the opposite of subsidies.
Source: International Trade and Capital Flows
**
62. A country having a current account deficit most likely will still be able to consume more output than it
produces by:
A. restricting foreign direct investment.
B. adjusting interest rates to stimulate higher domestic savings.
C. increasing its net foreign liabilities.
Answer = C
The current account deficit implies that a country is buying more from abroad than foreigners are buying from
them; in other words, imports are exceeding exports. To illustrate, suppose that exports = $100 whereas imports
= $120. This would imply that the domestic country is spending $20 more than what they are taking in from
their trading partners. As a result, the domestic country would have to borrow that $20 from the very same
trading partners it is buying from. In the process, the liabilities owed to foreigners would increase. The other
way to get the extra $20 required, would be to encourage (rather than restrict) foreign direct investment into the
home country.
Source: Currency Exchange Rates
FINANCIAL REPORTING (63-90)
63. The financial statement that would be most useful to an analyst in understanding the changes that have
occurred in a company's retained earnings over a year is the statement of:
A. financial position.
B. comprehensive income.
20
C. changes in equity.
Answer = C
The statement of changes in equity reports the changes in the components of shareholders’ equity over the year,
which would include the retained earnings account.
Source: Introduction to Financial Statement Analysis
**
64. The use of estimates in financial reporting is best described as:
A. acceptable despite the risk of manipulation by management.
B. a factor that reduces the understandability of financial statements.
C. avoidable through sophisticated accounting and auditing techniques.
Answer = A
-Estimates are necessary in order to produce financial statements that reflect the economics of the underlying
business. For example, when a firm purchases a long term asset, an estimate must be made about its useful life
so that its cost may be depreciated over that period.
-Nevertheless, management may use this discretion to manipulate earnings. For example, by overestimating the
life of the asset, the depreciation expense recognized each year would be reduced (thus causing an increase in
reported earnings).
Source: Introduction to Financial Statement Analysis
**
65. The least likely reason that a security analyst needs to understand the accounting process is to:
A. prevent earnings manipulation by management.
B. make adjustments to reflect items not reported in the financial statements.
C. aid in the assessment of management's judgment in accruals and valuations.
Answer = A
Understanding the accounting process may assist an analyst in identifying earnings manipulation, but it will not
prevent the manipulation of earnings by management. It is important for an analyst to understand the accounting
process so that they can make adjustments for items not reported and aid in the assessment of management's
judgment of accruals and valuations.
Source: Financial Reporting Standards
**
66. Under the International Accounting Standards Board's (IASB's) Conceptual Framework, one of the
qualitative characteristics of useful financial information is that different knowledgeable users would agree that
the information is a faithful representation of the economic events that it is intended to represent. This
characteristic is best described as:
A. comparability.
B. verifiability.
C. understandability.
Answer = B
Under the IASB’s Conceptual Framework, verifiability means that different knowledgeable and independent
users would agree that the information presented faithfully represents the economic events that it is intended to
represent
Source: Financial Reporting Standards
**
67. In the beginning of 2017, Mega Corp. had 18 million shares outstanding. On March 1 st, it repurchased 2
million shares and on November 1st, it issued an additional 5 million shares. On June 30 th, the company
implemented a 2:1 stock split. If net income for the year was $28 million, which of the following would best
represent the EPS that would be reported by Mega Corp.?
A. $0.814
B. $0.836
C. $0.748
Answer =B:
i) restate pre-June 30th number of shares outstanding on a post split basis:
21
Jan.1: 36 million and March 1st: 32 million.
ii) weighted average number of shares: 36M(2/12)+32M(8/12)+37M(2/12) = 33.5M
iii) EPS = 28M/33.5M = .836
Source: Understanding the Income Statement
**
68. A retailer provides credit cards only to its most valued customers who pass a rigorous credit check. A credit
card customer ordered an item from the retailer in May. The item was shipped and delivered in July. The item
appeared on the customer's July credit card statement and was paid in full by the due date in August. The most
appropriate month in which the retailer should recognize the revenue is:
A. July.
B. May.
C. August.
Answer = A
The appropriate time to recognize revenue would be in the month of July because the risks and rewards have
been transferred to the buyer (shipped and delivered), the revenue can be reliably measured, and it is probable
that the economic benefits will flow to the seller (the rigorous credit check was completed). Neither the actual
payment date nor the credit card statement date is relevant here
Source: Understanding Income Statements
**
69. Peel Co. reported a total net income of $82 million for 2017. It’s weighted average number of shares
outstanding for the year was 35 million. On September 1 st, Peel Co. issues 2 million preferred shares. Each
preferred share is entitled to a dividend payment of $2.00; alternatively, each share may be convertible into 3.5
common shares. Which of the following would best represent the diluted EPS reported by Peel Co. for 2017?
A. $2.12
B. $2.20
C. $2.37
Answer =B:
Weighted average number of shares = 35M + [(4/12)*(2M*3.5)] = 37.33M
DEPS = 82M/37.33M = 2.20
Source: Understanding the Income Statement
**
70. Other comprehensive income is least likely to include gains or losses on:
A. the sale or disposal of discontinued operations.
B. the translation of foreign currency–denominated subsidiary financial statements.
C. derivative contracts accounted for as hedges.
Answer = A
The items that are typically included as part of OCI are as follows:
1. Foreign Currency Translation Gains/Losses.
2. Certain cost components associated with a Defined Benefit Plan.
3. Unrealized Gains/Losses on Derivatives used for Hedging.
On the other hand, gains or losses on the disposal of discontinued operations are reported separately near the
bottom of the income statement and are included in net income, not other comprehensive income.
Source: Understanding the Income Statement
**
71. The current ratio for an industry is 3.2. Data for a firm in the industry is presented below:
£ ‘000s
Cash
200
Accounts receivable
350
Inventory
1,250
Accounts payable
300
Taxes payable
200
Installment loan payable, due in three equal
600
22
annual payments on June 30.
Using the current ratio, when compared with the industry, the firm is best described as being:
A. as liquid.
B. less liquid.
C. more liquid.
Answer = B
Current ratio = Current assets ÷ Current liabilities
Current assets:
Current liabilities:
£ ‘000s
£ ‘000s
Cash
200
Accounts payable
300
Accounts receivable
350
Taxes payable
200
Inventory
1,250
Loan payable, first
200
installment
Total
1,800
Total
700
The higher the current ratio the more liquid the company. Thus, with a current ratio of 2.6 (1,800 ÷ 700), the
company is less liquid than the industry, with a current ratio of 3.2.
Source: Understanding Balance Sheets
**
72. An analyst argues that when using the LIFO method for inventory accounting is used during a period of
rising prices, the amount of purchases should not change, however, cash flow from operations should increase.
Is the analyst correct with respect to:
Purchases
CFO
A.
YES
YES
B.
YES
NO
C.
NO
NO
Answer = A:
While the amount paid to vendors should not be influenced by the accounting method used, the use of LIFO
will cause COGS to increase, taxable earnings to decrease, tax payable to decrease, and therefore operating cash
flows to increase.
Source: Understanding the Cash Flow Statement
**
73. You note the following item’s from Mega Corp.’s financial statements:
Net Income
$845,000
Depreciation
61,000
Gain on Sale of Division
75,000
Increase in Receivables
38,000
Decrease in Inventory
43,000
Increase in Payables
82,000
Increase in Gross PPE
211,000
Decrease in Bank notes
50,000
Dividends
95,000
Which of the following best estimates the Free Cash Flow to Equity?
A. $562,000
B. $657,000
C. $868,000
Answer = B.
FCFE = NI + DEP – Gain – Change in WC - CAPX – Debt payments
=845000+61000-75000-[(38000 – 430000) – (82000)] – 211000 – 50000
=657000
Source: Understanding the Cash Flow Statement
**
23
74. In 2021, a software company recorded unearned revenue related to a software license that it will recognize
as revenue during 2022. Ignoring income taxes, this recognition of the software revenue will most likely have
which of the following effects on cash from operations in 2022?
A. No effect
B. A decrease
C. An increase
Answer = A
The company received the cash in 2021 when it recorded the unearned revenue and it was a part of the cash
from operations in that year. In 2022, the revenue is earned but there is no cash exchanged and hence no effect
of the cash from operations.
Source: Understanding the Cash Flow Statement
**
75. You notice that the cash flows for Mega Corp. have been increasing at a very substantial rate. In which of
the following instances, would you expect this pattern to most likely continue?
A. The cash flows have been increasing due to the high quality reputation of the company’s products.
B. The cash flows have been increasing due to the issuance of new longer term debt, as opposed to the
commercial papers which the company relied upon previously.
C. The cash flows have been increasing due to the sale of non-operating assets.
Answer = A:
The most important source of cash flow is operations. If a company’s operating cash flows are not healthy, then
the company’s future will be bleak.
Source: Understanding the Cash Flow Statement
**
76. An increase in which of the following ratios would most likely result in an increase in operating cash flows?
A. Days of sales outstanding
B. Quick ratio
C. Number of days of payables
Answer = C
-An increase in Days Sales Outstanding (DSO) implies that more of the firm’s sales are in Receivables (i.e. not
yet collected). Hence, CFO would be lower than reported Net Income.
-A higher Quick ratio simply means that the company has more in cash relative to its short term liabilities.
However, this does not tell us if that cash came from the current period’s operations (i.e. it could have come
from investing or financing activities as well).
- An increase in Days in Payables implies that the firm is taking longer to pay for its expenses, and as a result
would have more cash from operations than what net income would be reporting.
Source: Financial Analysis Techniques
**
77. The analytical tool that would be most appropriate for an analyst to use to identify the percentage of a
company's assets that are liquid is the:
A. current ratio.
B. common-size balance sheet.
C. cash ratio.
Answer = B
A common-size balance sheet expresses all balance sheet accounts as a percentage of total assets and would
provide insight into what portion of a company’s assets is liquid. On the other hand, cash and current ratios
measure liquidity relative to current liabilities, not relative to total assets
Source: Financial Analysis Techniques
**
78. By themselves, financial ratios are least likely to be sufficient in determining a company's:
A. past performance.
B. current financial condition.
C. creditworthiness.
24
Answer = C
Financial ratios alone are not sufficient to determine the creditworthiness of a company. Other factors must also
be considered, such as examining the entire operation of the company, meeting with management, touring
company facilities, and so forth.
Source: Financial Analysis Techniques
**
79. You extract the following data from Mega Corp’s financial statements:
2018
2017
Ending Inventory
345,000
315,000
LIFO Reserve
49,000
58,000
Tax rate is 32%.
Had Mega Corp. used the FIFO method, which of the following would have been the more likely results in
2018 for:
Pre-tax Income
Ending Inventory
A.
$9,000 higher
$354,000
B.
$9,000 lower
$394,000
C.
$9,000 higher
$394,000
Answer = B.
COGS(fifo) = COGS(lifo) – (change in LR)
But since LR decreased by 9000, GOGS-FIFO would be 9000 higher and therefore Pretax income (FIFO)
would be 9000 lower.
I(fifo) = I(lifo) + LR = 345000 + 49000 = 394000
Source: Inventories
**
80. The method a high end custom-built motorcycle manufacturer uses to value its inventory results in the
matching of the physical flow of the particular items sold, and the items remaining in inventory, to their actual
cost. Which of the following inventory valuation methods is the manufacturer most likely using?
A. FIFO
B. Weighted average cost
C. Specific identification
Answer = C
Specific identification is the inventory method that results in the matching of the physical flow of the particular
items sold and would be most suitable for high-end custom-built motorcycles that are not ordinarily considered
interchangeable. On the other hand, FIFO and WAC use an averaging approach to determine unit cost (i.e. they
simply divide total cost with total units). This results in units being assigned an average cost rather than the
actual amounts that were paid for each individual units.
Source: Inventories
**
81. A company values its ending inventory using the prices of its most recent purchases. The inventory
valuation method that the company is most likely using is:
A. FIFO.
B. Weighted average cost.
C. LIFO.
Answer = A
FIFO values ending inventory using the most recent costs of goods purchased.
Source: Inventories
**
82. The following information is available for a manufacturing company:
$ Millions
Cost of ending inventory computed using FIFO
4.3
Net realizable value
4.1
Current replacement cost
3.8
25
If the company is using International Financial Reporting Standards (IFRS) instead of US GAAP, its cost of
goods sold (in millions) is most likely:
A. $0.3 lower.
B. the same.
C. $0.3 higher.
Answer = A
Under IFRS, the inventory would be written down to its net realizable value ($4.1 million), whereas under US
GAAP, market value is defined as current replacement cost and thus would be written down to its current
replacement cost ($3.8 million). Therefore, the write-down (and as a result, COGS) will be $0.3M (4.1-3.8)
lower under IFRS.
Source: Inventories
**
83. A Canadian printing company that prepares its financial statements according to IFRS has experienced a
decline in the demand for its products. The following information (in Canadian dollars) relates to the company's
printing equipment as of the current fiscal year end:
Carrying value of equipment
500,000
Undiscounted expected future CF
550,000
Present value of expected future CF
450,000
Fair value
480,000
Costs to sell
50,000
Value in use
440,000
The impairment loss is closest to:
A. 0.
B. 60,000.
C. 70,000.
Answer = B
As per IFRS, assets must be reported at the lower of (i) Carry or (ii) Market
However, Market Value is the higher of:
a) Net Realizable Value = (Fair Value – Selling costs) = (480,000 – 50,000) = 430,000, or
b) Value in Use = 440,000
Consequently, Market Value will be set at 440,000.
And since market value (440,000) is less than the carry value (500,000), the asset will be deemed to be
impaired, and a subsequent impairment charge of 60,000 (500,000 – 440,000) must be recognized.
Source: Long-Lived Assets
**
84. An asset is purchased for $84,000. It has an estimated useful life of 10 years and a residual value of $16000.
If the company uses the 150% declining method of depreciation and the tax rate is 35%, which of the following
would best approximate the depreciation recorded for year 2?
A. $12,600
B. $6,800
C. $10,710
Answer = C
Normal Depreciation rate = 1/10 = 10%
150% Depreciation rate = 15%.
Year 1 Depreciation = 15% of 84000 = 12600
Year 2 Depreciation = 15% of (84000-12600) = 10710
Source: Long Lived Assets
**
85. Of the following depreciation methods, which one is most likely to result in a higher income during a
recession?
A. Units of production.
26
B. Straight Line.
C. Double Declining.
Answer = A
Under units of production, depreciation is tied to actual usage. Hence, as usage drops, as is the case in a
recession, depreciation will drop and earnings will be inflated.
Source: Long Lived Assets
86. Mega Corp. reports an ending net PPE of $485,000. Its accumulated depreciation at the beginning of the
year was $164,000. If the company uses the straight line method and the depreciation during the year was
$28,000, which of the following would best estimate the remaining life of the PPE?
A. 23.2 years.
B. 17.3 years.
C. 5.9 years.
Answer = B
Life remaining = Net PPE/Depreciation = 485000/28000 = 17.32
Source: Long Lived Assets
**
87. If a company has a deferred tax asset reported on its statement of financial position and the tax authorities
reduce the tax rate, which of the following statements is most accurate concerning the effect of the change? The
existing deferred tax asset will:
A. not be affected.
B. decrease in value.
C. increase in value.
Answer = B
Deferred Tax (be it an asset or a liability) = [before tax difference between financial and tax reporting] x (future
tax rate)
The reason we use the future tax rate is because deferred taxes will be either paid (if the firm currently has a
deferred tax liability) or received (if the firm currently has a deferred tax asset) in the future. Consequently,
when the future tax rate falls, the value of the deferred tax recognized today (be it an asset or liability) will fall
as well.
Source: Income Taxes
**
88. An analyst argues that an impairment charge would not be required until the sum of the discounted cash
flows declines below the carrying value of the asset. Furthermore, an impairment charge in the current period
would result in a reduction in deferred tax liability. Is the analyst correct with respect to:
Condition for impairment
Deferred tax liability
A.
NO
YES
B.
YES
NO
C.
NO
NO
Answer = A:
An impairment charge would be required once the carrying value exceeds the sum of the “un”discounted cash
flows. However, at that point, the impairment charge itself would equal to the excess of the carrying value
above the sum of the discounted cash flows. Since impairment is not a tax deduction, the taxes paid would
actually exceed the tax expense reported, resulting in a reduction in DTL.
Source: Income Tax
**
89. If a company issues bonds priced at a discount, which of the following is an unlikely outcome?
A. The interest expense would amount to the coupon payment plus the amortization of bond discount.
B. Operating cash flows would be understated relative to having issued bonds at par.
C. Net income would underestimate cash flow by the amount of the discount amortization.
Answer = B:
OCF is reduced by the amount of coupon payments, not interest expense. Since a discount bond is associated
with a relatively low coupon, the OCF will be overstated.
27
Source: Non-current (Long Term) Liabilities
**
90. If a loan with a book value of $165,000 is retired at $140,000, the impact would be as follows on:
Net income
Operating Cash Flow
A.
Loss of $25,000
- $140,000
B.
Loss of $25,000
No impact
C.
Gain of $25,000
No impact
Answer = C.
The retirement of debt is deemed as a financing cash outflow; furthermore, the gain loss on debt retirement is
non-cash, therefore, this transaction has no impact on OCF.
Source: Non-current (Long Term) Liabilities
28
PASSMAX
2021 LEVEL I CFA® EXAM
MOCK 2
SESSION 2: Solutions
29
CORPORATE FINANCE (1-18)
1. Which of the following is most likely a sign of a good corporate governance structure?
A. The chief executive position is separate from the chair position on the company’s board.
B. Independent board members comprise a minority proportion of the company’s board.
C. Independent board members are allowed to meet shareholders only in the presence of the entire board.
Answer = A
The Chief Executive Officer (CEO) is part of the management team that runs the firm. On the other hand, the
Chair of the Board is supposed to provide oversight over the management team. Consequently, it would be
improper to have the same person fulfill both roles.
Source: Introduction to Corporate Governance and Other ESG Considerations
2. 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. At
what discount rate would you be indifferent between accepting or rejecting the project?
A. 13.24%
B. 9.51%
C. 12.57%
Answer =B:
Indifference when PV = COST: 285000=10000/(K-.06): K=9.51
Source: Capital Budgeting
3. Which of the following statements is false with respect to the various project evaluation methods?
A. The discounted payback period decreases as the required rate of return increases.
B. The internal rate of return is simply the return that the project’s cash flows generate relative to the cost of the
project.
C. The payback period completely ignores the time value of money.
Answer = A
As the required rate of return increases, it takes longer for the present value of cash flows to recoup the
investment; thus discounted payback period increases.
Source: Capital Budgeting
4. A project would provide annual cash flows of $7200 for 18 years. It would cost $50,000 to implement this
project today. The required rate of return for this project is 5%. According to the IRR rule, which of the
following statements would be most accurate?
A. Accept the project since the IRR of 12.74% exceeds the required rate of return.
B. Accept the project since the IRR of 18.37% exceeds the required rate of return.
C. Reject the project since the required rate of return is less than the IRR of 12.74%.
Answer =A
PV=50000, PMT=7200, N=18 CPT I = 12.74
Source: Capital Budgeting
5. Mega Co. spent $28,000 last year to do an analysis for a new project. The project would require $571,000 in
property, plant, and equipment (all of which is required to be depreciated straight line over a 10 year period). In
addition, the required up front inventory would be $78,000, with vendors extending credit for up to 44% of that
amount. Once commenced, the project is expected to generate an earning before interest, tax, and depreciation
of $245,000. Interest expense each year is expected to be $22,500 while the tax rate is 35%. Which amount
may be regarded as the proper initial investment for this project?
A. $614,680
B. $649,000
C. $677,000
30
Answer =A:
The $28,000 is a sunk cost, the only relevant costs are those in the present and the future.
The full 571000 is regarded as a cost; however of the 78000 in inventory, the firm only has to pay 56% of that
or 43680. Thus, total initial investment is 614680.
Source: Capital Budgeting
6. Which of the following is least likely to be classified as an opportunity cost?
A. The incremental tax savings due to the higher depreciation associated with the new project.
B. The net realizable value of the office equipment had it not been used for the project.
C. The recent bid by a developer for the land which will eventually be used for the project.
Answer = A
We must distinguish between opportunity cost and incremental cash flow. The additional tax savings is an
incremental cash flow effect, while all the other items mentioned are opportunity costs.
Source: Capital Budgeting
7. Mega Corp. currently has a 12 year option free bond outstanding. The bond pays a coupon of 6.8% and is
currently priced at 97.5. Mega’s average and marginal tax rates are 28% and 34% respectively. The after tax
cost of debt is closest to:
A. 4.69%
B. 4.97%
C. 4.81%
Answer = A
YTM: FV=100, PMT=3.4, N=24, P=-97.5 CPT I = 3.556; YTM=7.11
A/T cost of debt = YTM(1-Tmgnl) = 7.11(1-.34) = 4.69
Source: Cost of Capital
8. Mega Corp. currently has $28million in non-convertible, non-redeemable preferred stock outstanding. The
stock pays a dividend of $0.68 and there are 5 million shares outstanding. Mega’s average and marginal tax
rates are 28% and 34% respectively. The after tax cost of the preferred is closest to:
A. 8.01%
B. 12.14%
C. 8.74%
Answer = B
Cost of preferred is just the dividend yield = 0.68 / (28M/5M) = 12.14%
Since dividends are paid with after tax earnings, the tax effect is already incorporated into the yield. (i.e. no
further tax adjustment is required)
Source: Cost of Capital
9. A 20-year $1,000 fixed-rate non-callable bond with 8% annual coupons currently sells for $1,105.94.
Assuming a 30% marginal tax rate and an additional risk premium for equity relative to debt of 5%, the cost of
equity using the bond-yield-plus-risk-premium approach is closest to:
A. 9.9%
B. 13.0%
C. 12.0%
Answer = C
Step 1. Find the YTM on the issuer’s bond:
FV = 1,000, PV = (-1,105.94), N = 20, PMT = 80, solve for i, which will equal 7%.
Step 2. The bond-yield-plus-risk-premium approach is calculated by adding a risk premium to the cost of debt
(i.e., the yield to maturity for the debt), making the cost of equity 12.00% (= 7% +5%).
Source: Cost of Capital
31
10. A company’s data are provided in the following table:
Cost of debt
10%
Cost of equity
16%
Debt-to-equity ratio (D/E)
50%
Tax rate
30%
The weighted average cost of capital (WACC) is closest to:
A. 13.0%.
B. 11.5%.
C. 14.0%.
Answer = A
Step 1. From [D/E = 0.5/1]  [A = D + E = 0.5 + 1 = 1.5]  [w(d) = 0.5/1.5 = 0.333] and [w(e) = 1/1.5 =
0.667]
Step 2. WACC = Wd(Rd)(1-t) + We(Re) = 0.333(10%)(1-.3) + (.667)(16%) = 13.0%
Source: Cost of Capital
11. Toro Co.’s capital structure is composed of 35% debt and 65% equity. The after tax costs of debt is 6.4%
up to $14million in debt, and 9.4% thereafter. The cost of equity is 8.7% up to $24million, and 13.4%
thereafter. At which amount of new capital, will the firm experience its initial increase in its marginal cost of
capital?
a) $40.0million
b) $28.4million
c) $36.9million
Answer = C
Breakpoint due to:
i) Debt: From [D=(.35)(Capital)]  [Capital = (D) / (0.35)]  14million/.35 = 40million
Therefore, if the firm were to raise more than $40M in capital, it would imply issuing more than $14M in debt,
in which case the cost of debt would jump from 6.4% to 9.4%. In other words, $40M in capital would trigger
the break even point for debt.
ii) Equity: From [E=(.65)(Capital)]  [Capital = (E) / (0.65)]  24million/.65 = 36.9million
Therefore, if the firm were to raise more than $36.9M in capital, it would imply issuing more than $24M in
equity, in which case the cost of equity would jump from 8.7% to 13.4%. In other words, $36.9M in capital
would trigger the break even point for equity.
Therefore, combined, the firm would experience an increase in its cost of capital at both the 36.9M and 40M
levels of capital.
Source: Cost of Capital
12. Business risk most likely incorporates operating risk and:
A. interest rate risk.
B. sales risk.
C. financial risk.
Answer = B
Business risk combines the effects of sales risk and operating risk. Usually, companies in the same industry face
the same degree of business risk. For instance, most firms in the automotive industry are exposed to:
i) The same pricing pressures and uncertainty in unit sales (i.e. sales risk), and
ii) The same degree of operating risk, as most of their operating costs are fixed.
Source: Measures of Leverage
32
13. The following information is available for a firm:
Revenue
£800,000
Variable cost
400,000
Fixed cost
200,000
Operating income
200,000
Interest
60,000
Net income
140,000
The firm’s degree of total leverage (DTL) is closest to:
A. 1.43.
B. 2.86.
C. 2.00.
Answer = B
DTL is influenced by the presence of fixed costs (which includes both operating and financing). Consequently,
DTL may be measured as follows:
Earnings before fixed items = Rev-VC_________ = 800000 – 400000______________
= 2.86
Earnings after fixed items
Rev – VC – FC - Int
800000 – 400000 – 200000 – 60000
Source: Measures of Leverage
14. The unit contribution margin for a product is $20. A firm’s fixed costs of production up to 300,000 units is
$500,000. The degree of operating leverage (DOL) is most likely the lowest at which of the following
production levels (in units):
A. 200,000.
B. 100,000.
C. 300,000.
Answer = C
As production increases, the fixed cost gets spread out over more units. As a result, the fixed cost (which is the
cause of leverage), becomes less significant within the firm’s overall cost structure.
Source: Measures of Leverage
15. Financial risk is least likely affected by:
A. debentures.
B. long-term leases.
C. dividends.
Answer = C
Financial leverage (or risk) increases as the firm embarks upon fixed financing obligations (such as loans and/or
lease payments). On the other hand, dividends are neither obligatory (i.e. the firm is not required to pay them)
nor are they fixed (i.e. companies may increase or decrease dividend amounts are they see fit).
Source: Measures of Leverage
16. A vendor offers the following terms: 2/15, net 40. The opportunity cost of paying the due amount in 40
days is closest to:
A. 28.64%
B. 34.29%
C. 38.14%
Answer = B
Suppose the amount due is $100. If pay in 15 days, the balance due would be 98, whereas it would be 100 in 40
days. The holding period return is (2/98) = 2.04%. To annualize: (1+EAR) = (1.0204)^(365/25) : EAR =
34.29
Source: Working Capital Management
33
17. At the end of 2006, Mega Corp reported the following items:
Accounts Payable
$61,000
Accounts Receivable
97,000
Inventory
152,000
Income Tax Payable
81,000
Investments (Equity method)
75,000
Deferred Tax Assets
112,000
Bank Loans due on demand
68,000
Bonds Payable (due in 2008)
130,000
Unearned Revenues
28,000
Cash
42,000
For the year 2006, working capital is closest to:
A. $143,00
B. $53,000
C. $22,000
Answer = B.
Current assets: 97000+152000+42000
= 291000
Current liabilities: 61000+81000+68000+28000 = 238000
Working capital
= 53000
Source: Working Capital Management
18. For a 120-day US Treasury bill selling at a discount, which of the following measures would result in the
highest value for yield?
A. Money market yield (MMY)
B. Bond equivalent yield (BEY)
C. Discount-basis yield (DBY)
Answer = B
To illustrate these yield measures, suppose that a Treasury with 120 days left to maturity, is currently selling at
95. As a result, the dollar return (i.e. the discount) is locked in at 5 (as the 95 converges to 100 on the maturity
date). Therefore, the various yield measures may be computed as follows:
-MMY = (5 / 95) x (360 / 120) = 15.79%
-BEY = (5 / 95) x (365 / 120) = 16.01%
-DBY = (5 / 100) x (360 / 120) = 15.00%
Source: Working Capital Management
EQUITY (19-36)
19. A stop-buy order is most likely placed when a trader:
A. wants to limit the loss on a long position.
B. thinks that the stock is overvalued.
C. wants to limit the loss on a short position.
Answer = C
Suppose an investor shorts a stock at $100 (i.e. borrows the stock and then immediately sells it for $100). The
investor would now be obligated to repurchase that stock at a later date in order to return it to the party it
borrowed the stock from in the first place. Therefore, if the stock price were to appreciate, then the investor will
have to pay more for it than what he received when he originally shorted it. Consequently, to limit this potential
loss, the investor will set a price at which the stock will be repurchased at.
Source: Market Organization and Structure
34
20. You purchase 450 shares of Stock K, which is trading at $82.43. However, you only put down $20,000 and
finance the reminder with a broker loan charging a rate of 8%. Assuming that the interest is paid daily (i.e.
there is no accrued interest to add to the existing debt) and that the minimum margin is 35%, how low must the
price of Stock K fall before a margin call is made?
A. $28.85
B. $58.44
C. $56.27
Answer = B
Total cost = 450X82.43 = 37093.50
Initial Margin = 20,000; therefore Broker loan = 17093.50
Min P: .35 = [450P – 17093.50]/450P
Min P = 58.44
Source: Market Organization and Structure
21. Which of the following statements concerning the objectives of market regulation is least accurate?
Regulators:
A. set standards to ensure that all agents acting in the market are skilled.
B. ensure systems are in place to prevent fraud.
C. promote fair and orderly markets.
Answer = A
Regulators help solve agency problems by setting minimum standards of competence, not skill, for agents and
by defining and enforcing minimum standards of practice.
Source: Market Organization and Structure
22. The financial systems that are operationally efficient are most likely characterized by:
A. security prices that reflect fundamental values.
B. the use of resources where they are most valuable.
C. liquid markets with low commissions and order price impacts.
Answer = C
Operationally efficient markets are one in which trading is quick and cheap. Such markets are characterized as
being very liquid, in which the costs of trading-commissions, bid–ask spreads, and order price impacts—are
low. On the other hand, informational efficiency refers to the scenario in which security prices reflect
fundamental values (i.e. security price reflects all available information). Finally, allocative efficiency is the
term used to describe the scenario in which resources (like labor and capital) are directed towards where they
will be able to add the most value.
Source: Market Organization and Structure
23. An investor purchases 560 shares of ABC Corp. stock at $24 apiece. The initial required margin is 30%.
The broker loan rate has an EAR of 8%. If in 3 months, the position is liquidated when the stock is trading at
$28.50, which of the following would best approximate the return earned by the investor?
A. 43.8%
B. 58.0%
C. 10.8%
Answer = B
ROE= (Ending Equity – Beginning Equity)/(Beginning equity)
Beginning equity = 30% of (560*24) = 4032
(therefore, the original loan = 70% of (560*24) = 9408
Ending equity = Ending asset – Ending Liability
= [560*28.50] – [(9408)*(1.08)^0.25] = 6369
ROE = (6369/4032) – 1 = 58.0%
Source: Market Organization and Structure
35
24. The index weighting that results in portfolio weights shifting away from securities that have increased in
value relative to their earnings is most accurately described as:
A. float-adjusted market-capitalization weighting.
B. equal weighting.
C. fundamental weighting.
Answer = C
In a Fundamentally weighted index, the weights assigned to individual securities are based on some
fundamental driver of their valuation (such as the issuer’s sales or earnings). Therefore, if a stock’s P/E ratio
were to decrease, it would indicate that its earnings must have increased (relative to its stock price), and thus, it
would receive a larger weight in the index.
Source: Security Market Indices
25. Which of the following statements is most accurate with respect to rebalancing and reconstitution of security
market indices?
A. Turnover within an index results from a reconstitution but not from rebalancing.
B. A price-weighted index requires rebalancing more than a market-capitalization-weighted index.
C. Equal-weighted indices require frequent rebalancing.
Answer = C
Rebalancing involves changing the weight of an existing stock within the index. On the other hand,
reconstitution is when an existing stock is removed and/or a new stock is added to the index. Therefore:
-Both rebalancing and reconstitution will cause turnover (i.e. buying and selling) within the index.
-Whether the index is price or cap (price x number of shares) weighted, the weights will automatically adjust
with the changes in price of the constituent stocks. As a result, the indexes would not require any manual
rebalancing.
-In an equal weighted index, to maintain equal weights, the winning stocks (i.e. those with price appreciation)
would have to be sold and the losing stocks (i.e. those with price depreciation) would have to be purchased.
These adjustments would ensure that an equal dollar amount of exposure is maintained for each stock.
Source: Security Market Indices
26. Which of the following statements is least accurate with respect to the various weighing schemes that are
commonly used to compute index returns?
A. If any of the stocks included in a price weighted index should undergo a stock split, then the divisor will
drop.
B. A price weighted index has an upward bias with respect to the performance of the underlying basket of
stocks.
C. A value weighted index is dominated by the performance of very large corporations.
Answer = B
A price weighted index has a downward bias with respect to the performance of the underlying basket of stocks.
The logic: The stocks that do very well, generally end up splitting their stock and thus lose weight in the price
weighted index.
Source: Security Market Indexes
27. Which of the following statements regarding a commodity index is most accurate?
A. Commodity index returns differ from the changes in the prices of their underlying commodities.
B. Commodity indices commonly use an equal weighting method.
C. Commodity indices in the same markets will share similar risk and return profiles.
Answer = A
The performance of commodity indices can be different from their underlying commodities because the indices
consist of futures contracts on the commodities rather than the actual commodities. To illustrate, suppose that
oil was trading at 100 today while the futures price on a 1-year delivery contract was 103. To get exposure to
commodities, a trader would invest the 100 in a T-bill (assume yield is 5%), and then just long the futures
contract. Now suppose that on the expiry date, the price of oil is 110:
36
-The return from a direct investment in oil would have been 10% (buy at 100 today and sell at 110 in 1 year).
-The return from having a set up a futures position would be determined as follows:
i) The yield on the Treasury (5% of 100) = 5
ii) The spot return (spot price going from 100 to 110) = 10
iii) The roll yield (convergence between the future price of 103 and initial spot price of 100) = (-3)
Total return on position = 12 (or 12%).
We can see therefore how the commodity futures return differed from the return on the underlying asset itself.
Source: Security Market Indices
28. An observation that stocks with above average price-to-earnings ratios have consistently underperformed
those with below average price-to-earnings ratios least likely contradicts which form of market efficiency?
A. Weak form
B. Semi-strong form
C. Strong form
Answer = A
The observation that stocks with high above average price-to-earnings ratios have consistently underperformed
those with below average price-to-earnings ratios is a cross-sectional anomaly. It is a contradiction to the semistrong form of market efficiency and strong form market efficiency because all the information used to
categorize stocks by their price-to-earnings ratios is publicly available. It is not a contradiction to weak form
market efficiency.
Source: Market Efficiency
29. According to behavioral finance, observed overreaction in securities markets most likely occurs because of:
A. gambler's fallacy.
B. disposition effect.
C. loss aversion.
Answer = C
According to loss aversion–related arguments in behavioral theories, investors dislike losses more than they like
comparable gains. Thus, such a behavioral bias can explain observed overreaction in markets.
Source: Market Efficiency
30. Which of the following statements is most accurate in an efficient market?
A. Securities market prices fully reflect their fundamental values.
B. Active strategies will lead to excess risk adjusted portfolio returns.
C. Securities market prices respond over time to changes in economic information.
Answer = A
In an efficient market, the security price adjusts immediately to the release of new information. For instance, if
a company announces that they have discovered a new gold reserve which will become operational 3 years from
now, the market price will appreciate now in anticipation of the firm’s profits increasing in the future.
Market Efficiency
31. An analyst notes that XYZ Corp retains a patent on a very lucrative technology. This patent is not expected
to expire for another 15 years. However, the analyst is afraid that the market has priced in only good news into
the stock price, ignoring the fact that competitors are busy working on a technology which may compete with
that of XYZ Corp. Accordingly, how would you classify the following:
XYZ Corp.
XYZ Corp. Stock
A.
Growth
Growth
B.
Growth
Speculative
C.
Speculative
Growth
Answer = B
37
A growth company is one which exhibits a high growth rate in sales and earnings. However, if the stock of this
growth company is overpriced (by building in only good news), then the stock would be deemed as speculative,
as the announcement of a bad news would cause the stock price to fall dramatically.
Source: Overview of Equity Securities
32. The advantages to an investor owning convertible preference shares of a company most likely include:
A. an opportunity to receive additional dividends if the company's profits exceed a pre-specified level.
B. preference dividends that are fixed contractual obligations of the company.
C. less price volatility than the underlying common shares.
Answer = C
Convertible preference shares tend to exhibit less price volatility than the underlying common shares because
the dividend payments are known and more stable.
Source: Overview of Equity Securities
33. Which of the following is not an accurate depiction of how structural economic changes may affect
industries?
A. As the population ages, prospects for the retail sector should improve.
B. Technology has allowed corporate structures to become more decentralized.
C. Technology has allowed the consolidation of various sectors of the financial services industry.
Answer = A
As the population ages, it means that relatively, there are fewer younger people, the demographic group upon
which the retail sector relies so heavily upon. The older demographic groups save more than they spend.
Source: Introduction to Industry and Company Analysis
34. An industry experiencing slow growth, high prices, and volumes insufficient to achieve economies of scale
is most likely in the:
A. shakeout stage.
B. mature stage.
C. embryonic stage.
Answer = C
An embryonic industry is one that is just beginning to develop and is characterized by slow growth, high prices,
volumes not yet sufficient to achieve meaningful economies of scale, developing distribution channels, and low
brand loyalty because there is low customer awareness of the industry’s product.
Source: Introduction to Industry and Company Analysis
35. The Gordon growth model is most appropriate for valuing the common stock of a dividend paying company
that is:
A. experiencing growth that is higher than the sustainable growth rate.
B. mature and relatively insensitive to economic fluctuations.
C. young and just entering the growth phase.
Answer = B
The Gordon growth model is most appropriate for valuing common stock of a dividend paying company that is
mature and relatively insensitive to the business cycle or economic fluctuations.
Source: Equity Valuation: Concepts and Basic Tools
36. Which of the following statements is least accurate? A firm’s free cash flow to equity (FCFE):
A. is significantly affected by the amount of dividends paid by the firm.
B. increases with an increase in the firm’s net borrowing.
C. is a measure of the firm’s dividend-paying capacity.
Answer = A
FCFE is the cash flow that’s available for distribution to shareholders after the firm makes the necessary
reinvestments back into the firm. Algebraically, FCFE = NI + Dep – WCInv – CAPX + Net borrowing.
38
Dividends therefore is the portion of FCFE that is distributed to shareholders. Consequently, the more FCFE
that the firm generates, the greater will be its capacity to payout dividends.
Source: Equity Valuation: Concepts and Basic Tools
FIXED INCOME (37-56)
37. Which of the following is least likely to be a type of embedded option in a bond issue granted to
bondholders? The right to:
A. put the issue.
B. call the issue.
C. convert the issue.
Answer = B
-Putable bonds grant the bondholder the right to put (i.e. sell) back the bond to the issuer for a pre-specified
exercise price.
-Convertible bonds grant the bondholder the right to convert the underlying bond into the issuer’s shares.
-On the other hand, Callable bonds grant the ‘issuer’ the right to call (i.e. buy) back its bonds at a pre-specified
price.
Source: Fixed Income Securities: Defining Elements
38. Which of the following descriptions of the various coupon structured bond is least accurate?
A. Payment-in-kind bonds result in an increase in credit risk over time.
B. In a capital inflation-indexed bond, the coupon payments would not be adjusted for inflation.
C. The price of floating rate bonds are less sensitive to interest rates than corresponding fixed rate bonds
Answer = B
Since [coupon payment] = [(coupon rate)x(principal)]
Any inflation adjustment to the principal would automatically translate to an equal inflation adjustment to the
coupon.
Source: Fixed Income Securities: Defining Elements
39. If you expect interest rates to rise, which of the following bonds would be most preferred?
A. Callable bonds.
B. Floaters with high caps.
C. Inverse floaters.
Answer = B
When interest rates rise, bond prices drop. This would be a drag on callable and convertible bonds. On the
other hand, the income on the inverse floater would drop while the income on the floater would increase. The
high caps would ensure that the coupon can appreciate quite a bit before it is capped.
Source: Fixed Income Securities: Defining Elements
40. Which of the following terms in a bond issue most likely helps to reduce credit risk?
A. Term maturity structure
B. Sinking fund arrangement
C. Floating rate note
Answer = B
A sinking fund arrangement is a way to reduce credit risk by making the issuer set aside funds over time to
retire the bond issue. By gradually reducing the principal amount over time, there will be a lower probability of
default on remaining balance that may be outstanding.
Source: Fixed-Income Markets: Issuance, Trading, and Funding
41. A 12-year annual pay bond pays an annual coupon of 7.2% and is currently priced at 102.8. The Bond
Equivalent Yield is closest to:
39
A. 6.85%
B. 6.74%
C. 6.91%
Answer = B
FV=100, PMT=7.2, N=12, PV= - 102.8, CPT I=6.85 (this is annual YTM)
(1+.0685) = (1+s.a.)^2: s.a. = 3.368
In the bond market, BEY = (6-month yield)X2 = 3.368X2 = 6.737
Source: Introduction to Fixed Income Valuation
42. Which of the following statements is least accurate with respect to the various bond spreads?
A. Option adjusted spread is higher for bonds with short call dates.
B. For bond with embedded puts, the OAS is greater than the static spread.
C. For straight bonds, the OAS is exactly identical to the static spread.
Answer = A
OAS is the spread after “adjusting” for options (i.e. stripping the spread due to the embedded option).
Therefore, the embedded option should have no effect on OAS.
OAS = Static spread – call spread (for callable bonds)
OAS = Static spread + put spread (for putable bonds)
Inflation is built into the benchmark, the spreads simply indicate the spread due to risks not inherent in the
benchmark.
Source: Introduction to Fixed Income Valuation
43. The government just issued a new class of TIPS at par. During the auction, the coupon was set at 3.8%.
The coupon is payable annually. If for the year, the applicable inflation rate come in at 1.4%, which of the
following represents the amount of coupon income generated for year one on a purchase of $140,000 in par of
these TIPS.
A. $5,394
B. $5,320.
C. $3,360
Answer = A
i) adjust principal for inflation: 140000(1.014) = 141,960
ii) Coupon = 3.8% of 141,960 = 5394.48
Source: Introduction to Fixed Income Valuation
44. If a bond is trading at a discount, which of the following would best represent the order from the highest
value to the lowest value.
A. Coupon, YTM, current yield.
B. Current yield, coupon, YTM.
C. YTM, current yield, coupon.
Answer = C
When a bond is trading at a discount, it has a built in capital gain (as the discount price converges to par).
Therefore YTM (which takes into account changes in price) will be the highest measure. While coupon rate is
coupon divided by 100, current yield is coupon/price. At discount price, current yield will exceed coupon.
Source: Introduction to Fixed Income Valuation
45. Currently, the yields on a 15 year zero coupon bond and a 15.5 year zero coupon bond are 7.4% and 7.2%
respectively. Which of the following best estimates the 6 month forward rate 15 years from now?
A. 2.84%
B. 7.30%
C. 1.29%
Answer = C
[1+(.074/2)]^30 X [1+(f/2)]^1 = [1+(.072/2)]^31
f=.0129 or 1.29%
40
Source: Introduction to Fixed Income Valuation
46. A two-year spot rate of 5% is most likely the:
A. yield to maturity on a zero-coupon bond maturing at the end of Year 2.
B. yield to maturity on a coupon-paying bond maturing at the end of Year 2.
C. coupon rate in Year 2 on a coupon-paying bond maturing at the end of Year 4.
Answer = A
A spot rate is defined as the yield to maturity on a zero-coupon bond maturing at the date of that cash flow.
Therefore, the spot rate captures the yield on just one cash flow due at a particular point in time. On the other
hand, yield to maturity (YTM) captures the yield on a series of cash flows over a term. We can think of YTM
as the weighted average yield of the individual spot rates encompassing the bond’s term.
Source: Introduction to Fixed-Income Valuation
47. Given two otherwise identical bonds, when interest rates rise, the price of Bond A declines more than the
price of Bond B. Compared with Bond B, Bond A most likely:
A. has a shorter maturity.
B. is callable.
C. has a lower coupon.
Answer = C
Bond A is more sensitive to interest rates (i.e. it has a higher degree of interest rate risk, or duration). This
occurs under the following conditions: i) Longer Maturity ii) Lower Coupon iii) Low yield levels
Source: Introduction to Fixed-Income Valuation
48. Consider a $100 par value bond, with an 8% coupon paid annually, maturing in 20 years. If the bond
currently sells for $96.47, the yield to maturity is closest to:
A. 8.37%.
B. 8.29%.
C. 7.41%.
Answer = A
FV=100; PMT =8, N=20, PV= (-96.47), Compute I=8.37
Source: Introduction to Fixed-Income Valuation
49. The one year and 2 year spot rates are 5.4% and 6.2% respectively. If the 6 month forward rate 2 years
from now and 2.5 years from now are 7.1% and 9.4% respectively, what should a 3-year zero coupon bond be
trading for today?
A. $81.63
B. $74.84
C. $81.91
Answer = A
Step 1. Compute the 3-year spot rate: [1+(r3)/2]^6 = [(1+.062/2)^4] x [(1+.071/2)] x [(1+.094/2)] : r3 =
6.88%
Step 2. Compute Price: FV=100, N=6, I=3.44%, CPT PV=81.63
Source: Introduction to Fixed Income Valuation
50. The type of residential mortgage least likely to contain a "balloon" payment is a(n):
A. fully amortizing mortgage.
B. interest-only mortgage.
C. partially amortizing mortgage.
Answer = A
A fully amortizing mortgage is least likely to contain a balloon payment because the principal is fully paid off
during the term of the loan (i.e. there is no principal left on the maturity date).
Source: Introduction to Asset-Backed Securities
41
51. Duration is most accurate as a measure of interest rate risk for a bond portfolio when the slope of the yield
curve:
A. stays the same.
B. increases.
C. decreases.
Answer = A
Duration measures the change in the price of a portfolio of bonds if the yields for all maturities change by the
same amount; that is, it assumes the slope of the yield curve stays the same.
Source: Understanding Fixed-Income Risk and Return
52. Which of the following most likely exhibits negative convexity?
A. A putable bond
B. A callable bond
C. An option-free bond
Answer = B
When yields decrease, it becomes increasingly likely that a callable bond will be repurchased at the prespecified strike price. Therefore, the price appreciation of the callable bond will begin to ‘decelerate’ (i.e. it
begins to exhibit negative convexity).
Source: Understanding Fixed Income Risk and Return
53. An investor is least likely exposed to reinvestment risk from owning a(n):
A. zero-coupon bond.
B. amortizing security.
C. callable bond.
Answer = A
-Reinvestment rate risk (RRR) is the uncertainty associated with the rate at which cash flows from the
underlying investment may be reinvested at. In particular, if interest rates were to decrease, then the cash flows
would have to be reinvested at yields that are lower than what they were when the investment was initially
purchased at, thus causing a drag on the overall return.
-RRR increases as cash flow ‘size’ and ‘frequency’ increases. In other words, the more frequent the cash flows
and/or the larger their amounts, then the more exposed the investor would become to the uncertain reinvestment
rate at that time.
-Since zero-coupon bonds pay no cash flow during their term, there would be no exposure to RRR.
Source: Understanding Fixed-Income Risk and Return
54. A bond with a par value of $100 matures in 10 years with a coupon of 4.5% paid semiannually; it is priced
to yield 5.83% and has a modified duration of 7.81. If the yield of the bond declines by 0.25%, the approximate
percentage price change for the bond is closest to:
A. 0.98%.
B. 1.95%.
C. 3.91%.
Answer = B
Approximate percentage price change = –[7.81 × (–0.0025)] = 0.01953 or 1.95%.
Source: Understanding Fixed-Income Risk and Return
55. Which of the following is least likely a component of the "Four Cs of Credit Analysis" framework?
A. Collateral
B. Covenants
C. Competition
Answer = C
The "Four Cs of Credit Analysis" framework includes capacity, collateral, covenants, and character.
Competition is not one of the components.
42
Source: Fundamentals of Credit Analysis
56. Which bonds most likely rank the highest with respect to priority of claims?
A. Senior unsecured bond
B. Subordinated debt
C. Second lien debt
Answer = C
The priority of claims are as follows:
i) Debts with Liens (these are backed up by collateral which is specifically pledged to repay this loan)
ii) Senior Unsecured (entitled to whatever collateral remains after the preceding liens are met).
iii) Subordinated (entitled to whatever remains after the preceding senior unsecured creditors are paid).
Source: Fundamentals of Credit Analysis
DERIVATIVES (57-68)
57. Which of the following statements best describes an advantage of a forward contract over a futures contract?
A forward contract:
A. is essentially free of default risk.
B. can easily be offset prior to expiration.
C. allows parties to enter into a customized transaction.
Answer = C
Unlike futures contracts, which have standardized features, forward contracts can be customized to suit the
needs of the parties involved.
Source:Derivative Markets and Instruments
58. A corporation issues five-year fixed-rate bonds. Its treasurer expects interest rates to decline for all
maturities for at least the next year. She enters into a one-year agreement with a bank to receive quarterly fixedrate payments and to make payments based on floating rates benchmarked on three-month LIBOR. This
agreement is best described as a:
A. futures contract.
B. forward contract.
C. swap.
Answer = C
Futures and Forward contracts only have one settlement date. On the other hand, swaps have a series of
settlement dates during the contract period. In this case, we have a 1-year swap with 4 settlement periods, which
makes it equivalent to a basket of 4 separate forward contracts.
Source: Derivative Markets and Instruments
59. Which of the following statements is least accurate with respect to the functioning of swaps?
A. At least one of the payments in a swap is determined by an uncertain variable.
B. To hedge the income on a portfolio of floating rate bonds, one should long an interest rate swap.
C. The exchange of notional principal is generally only required for currency swaps.
Answer = B
A portfolio of floating rate bonds would be generating a floating income. To fix this income, one should enter a
swap agreeing to deliver float in exchange for fixed. In swap convention, whoever pays fixed is deemed to be
long, therefore by receiving fixed, one is deemed to have shorted the swap.
Source: Derivative Markets and Instruments
43
60. Two parties agree to a forward contract on a non-dividend-paying stock at a price of $103.00. At contract
expiration, the stock trades at $105.00. In a cash-settled forward contract, the:
A. short pays the long $2.00.
B. short pays the long $103.00.
C. long pays the short $105.00.
Answer = A
From the Long position’s point of view, the obligation is to buy an asset (worth $105) but only pay the
previously agreed upon forward price ($103) for it. As a result, the long’s gain is $2, which the short would then
have to pay the long that amount.
Source: Basics of Derivatives Pricing and Valuation
61. A fund manager longs a 7X13 FRA with a fixed rate of 6.2% and a notional principal of $15 million.
Which of the following is inconsistent with this position?
A. The variable here is the 7 month LIBOR that’s expected to prevail in 13 months.
B. The manager expected LIBOR rates to exceed 6.2% on the FRA expiry date.
C. This contract will be cash settled seven months from today.
Answer = A
Today, the long enters into an agreement, stating that in 7 months, he will pay 6.2% in exchange for the 6
month LIBOR prevailing at that point in time.
Source: Basics of Derivatives Pricing and Valuation
62. Which of the following statements regarding swaps and forwards is not true?
A. A swap is really a series of forward contracts all incorporated into just one contract.
B. Unlike options, both swaps and forwards are contractual obligations.
C. A swap requires an upfront premium, whereas a forward does not.
Answer = C
Swaps do not require upfront premiums.
Source: Basics of Derivatives Pricing and Valuation
63. A 3-month put option on gold with an exercise price of $600/oz is currently trading at a premium of $15/oz.
What would the net profit or loss (per ounce) be for a short position if the gold price in 3 months is $550/oz.
A. Gain of $15.
B. Loss of $15.
C. Loss of $35.
Answer = C
rev=15, payout = 50, LOSS = 35
Source: Basics of Derivatives Pricing and Valuation
64. Which of the following combinations represents a long synthetic put position?
A. Long call, Long a zero coupon bond with a face value equal to the exercise price, Short the asset.
B. Long call, Short a zero coupon bond with a face value equal to the exercise price, Short the asset
C. Long call, Long a zero coupon bond with a face value equal to the exercise price, Long the asset
Answer = A
Put call parity refers to the equality between Portfolio 1, that’s long both a call and a bond (Fiduciary call) and
Portfolio 2, that’s long both the asset and a put (Protective put).
Therefore, a long put may be isolated by simply combining Portfolio 1 with a short asset position.
Source: Basics of Derivatives Pricing and Valuation
65. The intrinsic value of an option is always zero:
A. when it is out of the money.
B. at expiration.
C. when its time value is zero.
44
Answer = A
Intrinsic Value is the payoff that the option would yield if it was exercised immediately. Therefore, intrinsic
value would only exist if the payoff were to be positive (i.e. the option is in-the-money). On the other hand, if
the option were to be out-of-the-money, then the holder of the option would have no incentive to exercise, and
thus the intrinsic value would be zero.
Source: Basics of Derivatives Pricing and Valuation
66. Valuation of a swap during its life will least likely involve the:
A. use of replication.
B. investor's risk aversion.
C. application of the principle of no arbitrage.
Answer = B
A swap involves the exchange of as set of payment streams, such as fixed rate payments in exchange for
floating payments. However, this payment stream may easily be replicated with a set of bonds. Furthermore, at
inception, the fixed rate (i.e. the price) on the swap is set such that arbitrage would not be possible (i.e. it would
be efficiently priced). On the other hand, the value of the swap is not directly linked to investor’s level of risk
aversion. In other words, the swap price (or value) will be the same irrespective of whether the investor is
aggressive or conservative.
Source: Basics of Derivative Pricing and Valuation
67. Which of the following factors will cause the value of a European put option to decrease?
A. A rise in the strike price.
B. A decrease in the risk free rate of return.
C. An increase in volatility.
Answer = C
Upon exercise, the put holder will receive the strike price. Consequently, with a European put, the value of the
option would be dependent on the present value of this future payout. As a result, a higher discount rate will
result in a lower PV and thus, option valuation.
Source: Basics of Derivative Pricing and Valuation
68. Which of the following statements best describes changes in the value of a long forward position during its
life?
A. As interest rates go down, the value of the position goes up.
B. As the time to maturity goes down, the value of the position goes up.
C. As the price of the underlying goes up, the value of the position goes up.
Answer = C
A long forward is an obligation to purchase an asset in the future at a pre-set price (F). Consequently, if the
market price of the asset goes up, the fact that the purchase price was initially locked in at F would imply that
the investor would benefit (i.e. the long forward contract would not become more valuable). Specifically, the
payoff to the long forward on the expiry date would be: (Spot – F). Again, we can see that holding F constant,
as the spot price increases, the payoff (and therefore the value of the long forward contract) would appreciate.
Source: Basics of Derivative Pricing and Valuation
45
ALTERNATIVE INVESTMENTS (69-76)
69. Adding alternative investments to a portfolio of traditional investments will most likely result in a new
combined portfolio with returns and standard deviation that are, respectively:
Returns
Standard Deviation
A.
lower
lower
B.
higher
lower
C.
higher
higher
Answer = B
By adding alternative investments, the overall risk/return profile of the overall portfolio will potentially
improve. The overall risk will most likely drop, and the overall return will most likely rise.
Source: Introduction to Alternative Investments
70. If the price of a commodity futures contract is below the spot price, it is most likely that the:
A. convenience yield exceeds storage costs.
B. cost of carry exceeds the convenience yield.
C. roll yield is negative.
Answer = A
Futures Price (F) is the net cost of holding an asset until its future delivery date. Therefore, if holding costs
increase, F will increase (relative to the current spot price). ON the other hand, if the asset generates benefits
(be it income or convenience) while its being held, then this would reduce the cost of carry (and hence, F will
drop). Combined:
F = Spot + [Costs of Carry] – [Benefits of Carry]
As a result, if convenience yield (a benefit) were to exceed storage costs, then: F < S.
Source: Introduction to Alternative Investments
71. Investors in alternative assets who seek liquidity are most likely to invest in:
A. real estate investment trusts.
B. private equity.
C. hedge funds.
Answer = A
-REITs are required to distribute all earnings to their shareholders. And since REITs trade like stocks, the
shareholder may sell them at any time, if they were in need of additional liquidity.
-Private Equity (PE) and Hedge Funds (HF) can have long lock out periods during which investors cannot
redeem their capital. In the case of PE, investors would only get cash flows when the fund sells one of the
companies held within the fund.
Source: Introduction to Alternative Investments
72. Mutual Fund Q has an MER of 3.50%, however it has neither a front load nor a back load. Mutual Fund V
has an MER of 1.65%, and is only free of a front load. Both funds charge the MER at year end. If the
underlying assets for both funds are expected to earn 6%p.a over a 10 year period, what would the back end fee
have to be on V such that the investor would be indifferent between the 2 mutual funds?
A. 20.9%
B. 32.5%
C. 17.3%
Answer = C
Q: 100[(1.06)(1-.035)]^10 = 125.41
V: 100[(1.06)(1-.0165)]^10 = 151.64
(151.64-125.41) = 26.23
26.23/151.64 = 17.3%
Source: Introduction to Alternative Investments
46
73. Which of the following statements is least accurate with respect to hedge fund performance?
A. Most volatility measures for hedge funds are understated.
B. The Sharp measure for hedge funds as a group is generally overstated.
C. The correlation of hedge funds with traditional stocks and bonds are overstated.
Answer = C
Many hedge fund assets are infrequently traded. Thus, even when traditional stocks and bonds are exhibiting
high volatility, the price of the illiquid asset seems stable, but only because its not trading. The result is an
artificially low correlation.
Hedge funds specializing in emerging sectors or markets typically deal with illiquid securities. Therefore, short
selling would be very difficult.
Source: Introduction to Alternative Investments
74. A hedge fund manager charges a 1.5% base fee and an incentive fee equal to 25% of all returns in excess of
5%. If the underlying portfolio return equals 18%, which of the following best represents the net of fee
performance?
A. 11.50%
B. 12.85%
C. 13.25%
Answer = C
Starting with $1, without fees, ending value = 1.18
LESS: base fee = 1.5% of 1
0.015
Incentive = 25%(.18-.05)
0.0325
NET ending value
1.1325
RETURN = 13.25%
Source: Introduction to Alternative Investments
75. The value at risk of an alternative investment is best described as the:
A. minimum amount of loss expected over a given time period at a given probability level.
B. time period during which a fixed amount is lost at a given probability level.
C. probability of losing a fixed amount of money over a given time period.
Answer = A
For example, a 5%VaR of $10M implies that there is a 5% probability that the portfolio can lose $10M or more
within a given year. Alternatively, in one out of every 20 years (i.e. 1/20 = 5%), the portfolio can be expected to
lose over $10M.
PORTFOLIO MANAGEMENT (76-90)
76. Which of the following is least likely a part of the execution step of the portfolio management process?
A. Security analysis
B. Performance measurement
C. Portfolio construction
Answer = B
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: Portfolio Management: An Overview
77. In general, which of the following institutions will most likely have a high need for liquidity and a short
investment time horizon?
A. Banks
B. Defined benefit pension plans
C. Endowments
47
Answer = A
Banks have a short time horizon and high liquidity needs.
Source: Portfolio Management: An Overview
78. Which of the following statements regarding the investment objectives and constraints of endowment funds
is least accurate?
A. Their investment horizon is very long term.
B. Their ability to take risk is high.
C. Their liquidity needs are quite high.
Answer = C
Endowments provide continuous financial support (ex. Scholarships). The objective is to maintain the
purchasing power of the principal (i.e. increase the principal value in step with inflation) while generating
enough income in order to pay for their causes. Therefore, these funds must balance between their short term
spending needs and ensuring that the principal stays sufficient enough to finance their future funding
requirements. In fact, these funds are set up to have perpetual lives. In general, endowments exhibit the
following characteristics:
i) Horizon: Long term, as these funds are perpetual.
ii) Risk Tolerance: High, as the long time frame would give these funds the opportunity to recoup any losses
incurred in the intermediate term.
iii) Income Needs: Income must be sufficient enough to meet current spending commitments.
iv) Liquidity: Low, as these funds can simply meet their spending objectives through the income they generate
(i.e. there would be lesser need to liquidate any principal).
Source: Portfolio Management: An Overview
79. An investor purchases one share of stock for $85. Exactly one year later, the company pays a dividend of
$2.00 per share. This is followed by two more annual dividends of $2.25 and $2.75 in successive years. Upon
receiving the third dividend, the investor sells the share for $100. The money-weighted rate of return on this
investment is closest to:
A. 7.97%.
B. 8.63%.
C. 8.15%.
Answer = C
"Discounted Cash Flow Applications," Section 3.1
Money Weighted Return (MWR) is really the Internal Rate of Return (IRR): It’s the return that the cash flows
translate into when they are measured relative to the cost of the investment.
Using the cash flow (CF) function of a financial calculator: CF0 = –85, CF1 = 2, CF2 = 2.25, CF3 = 102.75;
and solving for IRR: IRR = 8.15%.
Source: Portfolio Risk and Return: Part I
80. Which of the following statements is least accurate with respect to the measurement of portfolio risk?
A. Standard deviation on its own does not reveal if the stock has more systematic or unsystematic risk.
B. As the correlation between the security returns decreases, the expected return for the portfolio will decrease.
C. A portfolio with a high beta does not automatically imply that its unsystematic risk is low.
Answer = B
Expected portfolio return is not affected by the correlation among its component securities.
Source: Portfolio Risk and Return: Part I
48
81. You wish to construct a portfolio made up of 2 securities;
Stock:
K
L
E(R):
12%
8%
Std. Dvtn: 14%
9%
Portfolio weight:
30%
70%
If the correlation between the two stock returns is +0.25, which of the following best approximates:
Portfolio E(R)
Portfolio std. dvtn.
A.
9.2
10.4
B.
9.2
8.4
C.
10.0
10.4
Answer = B
E(return) = .30(12) + .70(8) = 9.2
Portfolio VAR = (.3)^2(14)^2 + (.7)^2(9)^2 + 2(.3)(.7)(14)(9)(.25)
= 17.64+39.69+13.23 = 70.56
Portfolio S.D. = 8.4
Source: Portfolio Risk and Return: Part I
82. 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, then the most likely impact would be:
Portfolio Risk Portfolio Return
A.
No change
Decrease
B.
Decrease
Decrease
C.
Decrease
No Change
Answer = C
Correlation (or co-movement) between the securities only affects their combined (i.e. portfolio) volatility.
Return on the other hand, is simply the difference between the price at the beginning and the price at the end;
the co-movement in between would have had no impact on return.
Source: Portfolio Risk and Return: Part I
83. According to CAPM, if borrowing rates exceed the risk free lending rate, which of the following statements
would be “least” accurate?
A. There would no longer be a single identifiable market index.
B. Investors who borrow will find themselves earning a lower premium per each additional unit of risk that they
take.
C. The Markowitz efficient frontier would no longer be the same for all investors.
Answer = C
The Markowitz efficient frontier would still be the same for all investors, its just that it would no longer be the
case that all investors choose the same portfolio on the efficient frontier.
Source: Portfolio Risk and Return: Part II
84. Which of the following statements would not be true if the Capital Allocation Line was to become steeper?
A. The volatility of the optimal risky portfolio would now be higher.
B. Investors would yield a higher utility (end up on a higher utility curve)
C. The Sharp ratio (premium per unit of risk) would increase.
Answer = A
A steepening CAL may be due to an increase in the expected return of the optimal risky portfolio, while holding
its variance constant.
Source: Portfolio Risk and Return: Part II
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85. Stock K has a beta of 1.2 and an alpha of -0.9. The expected market return is 11.4% while the risk free rate
is currently 3.7%. Which of the following best estimates the expected rate of return on Stock K?
A. 11.13%
B. 12.94%
C. 12.04%
Answer = C
CAPM: 3.7+1.2(11.4-3.7) = 12.94
With alpha adjustment = 12.94 – 0.9 = 12.04%
Source: Portfolio Risk and Return: Part II
86. Stock A has a beta of 0.8 and an expected return of 12%, while Stock B has a beta of 1.4 and an expected
return of 17%. You have $8,400 in order to construct a portfolio. If the portfolio beta is 1.2, which of the
following statements must then hold true?
A. Your initial investment in Stock B is $5,628.
B. Your initial investment in Stock A is $5,628.
C. Your initial investment in Stock B is $2,800.
Answer = A
1.2= x0.8 + (1-x)1.4: x= .333
wb= .67*8400 = 5628
Source: Portfolio Risk and Return: Part II
87. Which of the following is most likely associated with an investor's ability to take risk rather than the
investor's willingness to take risk?
A. The investor has a long investment time horizon.
B. Safety of principal is very important to the investor.
C. The investor believes earning excess returns on stocks is a matter of luck.
Answer = A
Ability to take risk depends on objective factors such as level of wealth and/or income, as well as investment
horizon. For example, the longer the horizon, the greater will be the investor’s ability to take risk (as any losses
will likely be recovered over the long term). On the other hand, willingness to take risk is based upon the
investor’s psychological profile.
Source: Basics of Portfolio Planning and Construction
88. A portfolio manager decides to temporarily invest more of a portfolio in equities than the investment policy
statement prescribes because he expects equities will generate a higher return than other asset classes. This
decision is most likely an example of:
A. rebalancing.
B. tactical asset allocation.
C. strategic asset allocation.
Answer = B
-Strategic Asset Allocation (SAA) is the portfolio mix that is based on: (i) the investor’s objectives and
constraints, and (ii) the long term outlook for asset returns.
-Tactical Asset Allocation (TAA) represents short term deviations from SAA in order to exploit investment
opportunities.
-To illustrate the inter-relationship between the two, suppose that SAA is set at 60% stocks and 40% bonds,
with TAA capped at ±5%. If the portfolio manager felt that stocks were going to outperform in the short term,
then he may adjust the portfolio mix to 65% stocks and 35% bonds.
Source: Basics of Portfolio Planning and Construction
50
89. Which of the following is least accurate with respect to the components of an effective risk management
framework?
A. The Board would maintain oversight over the risk decisions made by management.
B. For a large organization, risk of each operating unit must be evaluated independently from the firm’s other
operating units.
C. A risk sub-committee should be created or a Chief Risk Officer appointed in order to specifically address
risk management issues at the firm.
Answer = B
Risk must be viewed in the context of its impact on the firm as a whole, rather than just individual operating
unit. To illustrate, suppose that a Company had 2 divisions: Export Co. and Import Co. While each unit alone
would be exposed to an incredible degree of FX risk, combined, their FX risk exposures would offset each other
and thus have little or no impact on firm’s value as a whole.
Source: Introduction to Risk Management
90. A stock is declining in price and reaches a price range wherein buying activity is sufficient to stop the
decline. This range is best described as the:
A. change in polarity point.
B. resistance level.
C. support level.
Answer = C
The support level is defined to be a low price range in which buying activity is sufficient to stop the decline in
price.
Source: Technical Analysis
51