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ExamWise® Volume 1 CFA 2008 Level I Certification With Preliminary Reading Assignments The Candidates Question And Answer Workbook For Chartered Financial Analyst

Authors Jane Vessey, CFA M. Afdal Pamilih, CFA David Stewart
Published by  
 

TotalRecall Publications, Inc.   1103 Middlecreek  Friendswood, TX 77546  281‐992‐3131   

 

    

TotalRecall Publications, Inc.
This Book Sponsored by The Center For Financial Certification, Inc.  Portions Copyright © 1999‐2008 by TotalRecall Publications, Inc.. Portions Copyright © 2005‐2006 by  Pegasus, Inc.. All rights reserved.  Printed in the United States of America. Except as permitted under  the United States Copyright Act of 1976, No part of this publication may be reproduced, stored in a  retrieval  system,  or  transmitted  in  any  form  or  by  any  means  electronic  or  mechanical  or  by  photocopying, recording, or otherwise without the prior permission of the publisher.  The views expressed in this book are solely those of the author, and do not represent the views of any  other party or parties.   Printed in United States of America, Canada, and England     Paper Back:  ISBN:   978‐1‐59095‐945‐9      UPC:    6‐43977‐93703‐2  EBook:    ISBN:   978‐1‐59095‐948‐0      UPC:    6‐43977‐93763‐6    The sponsoring editor for this book is Bruce Moran and the production supervisor is Corby R. Tate.   This  publication  is  not  sponsored  by,  endorsed  by,  or  affiliated  with  CFA  Institute™,  CFA®,  and  their  logo  are  trademarks  or  registered  trademarks  of  CFA  Institute.org  in  the  United  States  and  certain other countries. All other trademarks are trademarks of their respective owners. Throughout  this book, trademarked names are used. Rather than put a trademark symbol after every occurrence  of  a  trademarked  name,  we  used  names  in  an  editorial  fashion  only  and  to  the  benefit  of  the  trademark owner.  No intention of infringement on trademarks is intended.     The  CFA Institute™  does  not  endorse,  promote  or  review  the  accuracy  of  the  products  or  services  offered  by  organizations  sponsoring  or  providing  CFA®  Exam  preparation  materials  or  programs,  nor  does  CFA Institute™  verify  pass  rates  or  exam  results  claimed  by  such  organizations.  Any  warranty regarding the offered products or services is made solely by TotalRecall Publications, Inc.,  which are not in any way affiliated with CFA Institute™, the Institute of Chartered Financial Analysts  (ICFA),  or  the  Financial  Analysts  Federation  (FAF).  If  you  are  dissatisfied  with  the  products  or  services provided, please contact, TotalRecall Publications, Inc. 1103 Middlecreek, Friendswood, TX  77546 (888‐237‐7849). CFA® is a licensed service mark of CFA Institute™. Used by permission.    Disclaimer Notice: Judgments as to the suitability of the information herein for purchaser’s purposes  are  necessarily  the  purchaser’s  responsibility.  TotalRecall  Publications,  Inc.  and  The  Financial  Certification  Center,  Inc.  extends  no  warranties,  makes  no  representations,  and  assumes  no  responsibility as to the accuracy or suitability of such information for application to the purchaser’s  intended purposes or for consequences of its use.  

 

     This book is dedicated to our fantastic children Adam and Julia who we love very much.  

Jane Vessey & M. Afdal Pamilih
        This Study Guide is dedicated to the widow(er)s and orphans of the “Silent Spring”.  Those who have  sacrificed  loved  ones  to  the  obscurity  of  quiet  study  and  endured  weekend  sacrifice  above  and  beyond  the  call  of  continuing  education.    On  the  alter  of  a  profession’s  highest  accreditation  these  unsung heroes have sacrificed time with their spouse, shopping with Mom, and pitch and catch with  Dad.    These  patient  supporters  have  endured  tense  attitudes,  unfinished  chores,  extra  duties,  and  received the respect and appreciation of all who have studied throughout the “Silent Spring”.  In particular, never ending thanks to:  Carol Lee, Mary Elizabeth, Sophia Victoria, David Todd II 

David Stewart

 

    

ExamWise® Volume 1 CFA 2008 Level I Certification With Preliminary Reading Assignments The Candidates Question And Answer Workbook For Chartered Financial Analyst BY Authors Jane Vessey, CFA M. Afdal Pamilih, CFA David Stewart
Jane Vessey
Jane  Vessey  manages  a  training  company  in  the  United  Kingdom  specializing  in  financial  analysis  and  investment.    She  is  a  visiting  lecturer  at  Cass  Business  School  teaching  classes  in  asset  management and valuation. She also teaches a CFA®   revision course at ISMA (the business school at  Reading  University)  and  is  an  associate  at  a  leading  London  financial  training  company  where  she  teaches  courses  covering  investment  management  and  related  topics.    She  has  developed  online  training programs for students taking the CFA examinations and teaches CFA courses for UKSIP (the  UK Society of Investment Professionals).   Jane  graduated  in  Mathematics  from  Oxford  University,  United  Kingdom,  and  is  a  CFA  charter  holder.  She has some eighteen years experience working in the investment industry,  starting out as  an equity analyst before becoming an investment manager.  She was based in London and Tokyo and  took responsibility for managing equity portfolios invested in the Japanese and other Asian markets.  In 1990, Jane moved to Indonesia and established and ran an investment management operation on  behalf  of  Mees  Pierson.    She  took  responsibility  for  all  areas  of  the  business,  including  investment,  operations, marketing and administration.  While in Asia, Jane was involved in providing training to  capital market participants and state officials and teaching in courses provided by local universities. 

 

    

M. Afdal Pamilih
Afdal  has  18  yearsʹ  experience  working  in  the  finance  industry.  He  started  his  career  with  J.P.  Morgan,  and  then  with  County  NatWest  Government  Securities,  in  New  York  specializing  in  the  development  of  quantitative  products  for  foreign  exchange  and  fixed  income  markets.  After  returning  to  Indonesia  in  1989  he  was  responsible  for  the  development  of  investment  services  and  subsequently treasury management for leading banks in Jakarta.   Afdal has developed web‐based training programs for the CFA examinations and has wide teaching  experience,    including  instructing  at  the  School  of  Management,  University  of  Surrey,  United  Kingdom.  He  obtained  a  MSc  in  Mathematics  from  the  University  of  Texas  at  Arlington  and  holds  the  Chartered Financial Analyst (ʺCFAʺ) qualification.         

David Stewart:
David Stewart has extensive experience in venture capital and business structural reorganizations. As  president  of  a  private  client  broker  dealer  firm,  he  has  business  valuation  and  project  valuation  experience on the venture capital side and portfolio management on the asset management side. His  analysis,  commentary,  books,  and  study  guides  have  appeared  in  the  financial  management,  securities, and exam prep industries.   David  has  collaborated  with  experts  in  the  field  to  produce  the  2001  through  2006  editions  of  this  study guide. His extensive research into the CFA exam program and past exam histories, field work,  and  consistent  review  of  CFA  Institute  information  allows  him  and  his  co‐authors  to  deliver  high  quality and up to date information. 

 

    

About the Book:
ExamWise  Volume  1  For  CFA  Level  I  Concept  Check  Q&A  Workbook  With  Preliminary  Reading  Assignments is designed to give you plenty of practice questions to test your readiness for the CFA  exam.  It  offers  400+  concept  check  questions  based  18  exam  study  sessions  that  cover  the  Learning  Outcome Statements and their associated CFA Assigned Readings. For additional practice, there is an  accompanying free download test engine that generates multiple mock exams similar in design and  difficulty to the real CFA exam. The questions and explanations have references to the page number  in the related Reading and to the related LOS.  Use this workbook to test your understanding of the basic concepts covered in the CFA Readings and  identify your strengths and weaknesses. Then you can move on to more advanced study materials to  sharpen your weakest knowledge areas.   This book is divided into Study Sessions (1 – 18) that cover the 76 Learning Outcome Statements and  the  associated  Assigned  Readings.  Appendix  A  (Exhibits  1  –  4),  is  a  collection  of  exhibits  and  flow  charts  for  condensed  reference  and  review,  including  examples  of  accounting  statements,  puts  and  calls, PE breakdown, and financial ratios.   

The 18 2008 CFA Level I Study Sessions breakout is as follows: Ethical and Professional Standards
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. Study Session 1: Ethical and Professional Standards  Study Session 2. Quantitative Methods: Basic Concepts  Study Session 3. Quantitative Methods: Application  Study Session 4. Economics: Microeconomic Analysis  Study Session 5. Economics: Market Structure and Macroeconomic Analysis   Study Session 6. Economics: Monetary and Fiscal Economics  Study Session 7. Financial Statement Analysis: Introduction   Study Session 8. Financial Statement Analysis: Income Statement, Balance Sheet, Cash  Study Session 9. Financial Statement Analysis: Inventories, Assets, Taxes, and Debt   Study Session 10. Financial Statement Analysis: Techniques, Apps, & International  Study Session 11. Corporate Finance 

Investment Tools

Portfolio Management
12. Study Session 12. Portfolio Management 

Asset Valuation
13. 14. 15. 16. 17. 18. Study Session 13. Analysis of Equity Investments: Securities Markets  Study Session 14. Analysis of Equity Investments: Industry and Company Analysis  Study Session 15. Analysis of Fixed Income Investments: Basic Concepts  Study Session 16. Analysis of Fixed Income Investments: Analysis and Valuation  Study Session 17. Derivative Investments  Study Session 18. Alternative Investments Equity Investments: Securities Markets 

 

    

Online Information:
1. What is CFA Institute http://www.cfainstitute.org/aboutus/index.html 2. CFA Program: 3. The Code of Ethics (Full Text) http://www.cfainstitute.org/cfaprogram http://www.cfainstitute.org/centre/ethics/code/

The Standards of Professional Conduct Standard I: Fundamental Responsibilities Standard II: Relationships with and Responsibilities to the Profession Standard III: Relationships with and Responsibilities to the Employer Standard IV: Relationships with and Responsibilities to Clients and Prospects Standard V: Relationships with and Responsibilities to the Public 4. Why The CFA Designation Matters to You: Individual Investor FAQ http://www.cfainstitute.org/aboutus/investors/articles/cfamatters.html 5. Soft Dollar Standards http://www.cfainstitute.org/centre/ethics/softdollar/

6. CFA Institute-PPSTM AIMR Performance Presentation Standards http://www.cfapubs.org/doi/ref/10.2469/faj.v57.n2.2433 7. Global Investment Performance Standards http://www.cfainstitute.org/centre/ips/

Click the picture and link to a free CFA Candidates online glossary.

 

    

List of Chapters
Study Session 01: Ethical and Professional Standards: Study session 02: Quantitative Methods: Study Session 03: Quantitative Methods: Study Session 4: Introduction Study Session 04: Economics: Study Session 05: Economics: Study Session 06: Economics: Study Session 7: Introduction Study Session 07: Financial Statement Analysis: Study Session 08: Financial Statement Analysis: Study Session 09: Financial Statement Analysis: Study Session 10: Financial Statement Analysis: Study Session 11: Corporate Finance: Study Session 12: Portfolio Management: Study Session 13: Equity Investments: Study Session 14: Equity Investments: Study Session 15: Fixed Income Investments: Study Session 16: Fixed Income Investments: Study Session 17: Derivative Investments: Study Session 18: Alternative Investments: Terminology: Appendix A: Download Instructions 14 34 60 84 112 136 160 184 198 222 248 274 300 330 354 378 402 426 450 474 501 503 526

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..............................................................................................................................................................................................................................................................................................Table of Contents   IX  Table of Contents About the Book:........................................................................................60 Reading 11: Hypothesis Testing ........................................................................................................................................................................................................................................34 Reading 7: Statistical Concepts and Market Returns ....60 Reading 9: Common Probability Distributions ...................... VI Online Information:............84 Supply.............................................................................14 Reading 4: Global Investment Performance Standards (GIPS) .............85 Price changes and demand and supply.........................................................................................................................................88 Impact of changes in demand and supply ......................................................34 Reading 5: The Time Value of Money ............................................91 Taking the Nation’s Economic Pulse CH 7 .......84 Introduction..................................................................................................................................................................................................14 Study session 02: Quantitative Methods: 34 Basic Concepts ..................................................................................14 Reading 2: “Guidance” for Standards I–VII.34 Reading 6: Discounted Cash Flow Applications .................................................................................60 Reading 12: Technical Analysis ............................................................................................................................................60 Reading 10: Sampling and Estimation..............................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................84 Consumer choice and the Law of Demand..........................14 Reading 3: Introduction to the Global Investment Performance Standards (GIPS) ..............60 Study Session 4: Introduction 84 Introductory Readings....................................................................................................................85 Producer choice and the Law of Supply ................ Demand..................... VII Study Session 01: Ethical and Professional Standards: 14 Reading 1: Code of Ethics and Standards of Professional Conduct ...................................................................................34 Study Session 03: Quantitative Methods: 60 Application ......................... and the Market Process CH 5........................................................................................88 Supply and Demand: Applications and Extensions CH 4............90 Elasticity and the incidence of tax ...............................34 Reading 8: Probability Concepts...................................87 Shifts in supply .....................................90 Introduction....................90 Resources ...................92   ...............86 Shifts in demand .......................................................................................................................................................................................................................

........................... 160 Reading 28: Monetary Policy.............................................................. 92 Working with Our Basic Aggregate Demand/ Aggregate Supply Model CH 10............................. 100 Introductory Readings Concept Check Questions ............................................................................................. 160 Reading 25: Money......................... 112 Reading 16: Organizing Production............................................................... 136 Reading 22: Monitoring Cycles..................................................................................................... Interest....... 104 Introductory Readings Concept Check Answers..... 184 Introduction ... 108 Study Session 04: Economics: 112 Microeconomic Analysis..................................................................................................................................................................................................................... 160 Reading 27: Fiscal Policy ......................................................................... Real GDP.................................. and the Price Level ................................... 112 Reading 15: Markets in Action........................................................................................................................................................................................................... 100 Introduction .................... 112 Study Session 05: Economics: 136 Market Structure and Macroeconomic Analysis....................................................... 136 Reading 20: Monopolistic Competition and Oligopoly.. Banks............................................. 96 Keynesian Foundations of Modern Macroeconomics CH 11................................................................................. 136 Reading 19: Monopoly........... 136 Reading 21: Demand and Supply in Factor Markets........................................ 136 Reading 23: Aggregate Supply and Aggregate Demand ............................................................................................................................................................................................................. 112 Reading 14: Efficiency and Equity.................................................................... 160 Reading 24: Money.................................................... 112 Reading 13: Elasticity ................................... 184 Measuring Business Income .............................................. 112 Reading 17: Output and Costs .......................................................................................................................................... 160 Reading 26: Inflation.........................X   Table of Contents  Introduction ....................................................................................................................................................................... 96 Aggregate demand .................................. 136 Study Session 06: Economics: 160 Monetary and Fiscal Economics ........................................................................................................................................................................................................................................................................................................................................................................................................ 96 Introduction ............................. 136 Reading 18: Perfect Competition..................................................... 100 Keynesian economics........................ 184   .................................................................................. 160 Study Session 7: Introduction 184 Introductory Readings ........................................................................................ Jobs......... and the Federal Reserve........................................................................ 92 Gross domestic product.................................................................. and the Price Level .............................................................................................................................

.....................193 Introduction Concept Check Answers ....................................192 Treasury stock................................................188 Current Liabilities and the Time Value of Money....................................198 Study Session 08: Financial Statement Analysis: 222 The Income Statement.............................................................................................................................................................................................................................................................................................192 The Corporate Income Statement and the Statement of Stockholders’ Equity ..187 Inventory.............................................................................................191 Common stock ................................................190 Liabilities...............................................................................................................................................................192 Introduction Concept Check Questions................................................................................................................................................................................................191 Accounting for dividends ............................192 Introduction...............185 Income statement......... and Cash Flow Statement .................................................................................198 Reading 30: Financial Reporting Mechanics .............................................................................................................................................222 Reading 32: Understanding the Income Statement .........................................................190 Contributed Capital ..........................................................................................................................................................................187 Effect of inventory accounting method.....................................................................187 Inventory cost ................................................................................................................................185 Balance Sheet ..........................................................................................................................................................................................191 Preferred stock .......198 Reading 31: Financial Reporting Standards .................................................222 Reading 33: Understanding the Balance Sheet.........................................192 Retained earnings ......191 Contributed capital ...............................................................Table of Contents   XI  Accounting methods....................................................................................................................................................................................................................................................................................187 Introduction.............................................................................................191 Stock issuance ..................................................................................................................................................................................................................................................................192 Accounting for stock dividends and stock splits................................................198 Reading 29: Financial Statement Analysis: An Introduction ..........191 Introduction...............................................................................................................................................190 Introduction.................195 Study Session 07: Financial Statement Analysis: 198 An Introduction.....................186 Inventories ..........................................................................................................................................................185 Introduction...................................................................................................................... Balance Sheet....................................................................................................................................................................................................................................................................................................184 Financial Reporting and Analysis ...............222   ...........................................................................................

............... 248 Reading 38: Analysis of Income Taxes ............................ 248 Part II—Analysis of Depreciation and Impairment....................... 248 Reading 35: Analysis of Inventories ................................................................................ 248 Part I—The Capitalization Decision....................... 248 Reading 40: Leases and Off-Balance-Sheet Debt ............... 330 Study Session 13: Equity Investments: 354 Securities Markets ........................ 222 Study Session 09: Financial Statement Analysis: 248 Inventories................................................................................ 300 Reading 48: The Corporate Governance of Listed Companies: ............................................................................................. 354 Reading 55: Market Efficiency and Anomalies .................................................................................... 354 Study Session 14: Equity Investments: 378 Industry and Company Analysis................................................ 300 Reading 46: Working Capital Management............................................................................................................................................. 248 Study Session 10: Financial Statement Analysis: 274 Techniques.................. 248 Reading 36: Analysis of Long-Lived Assets: .. 330 Reading 51: An Introduction to Asset Pricing Models ... 300 Reading 47: Financial Statement Analysis ................................................ Deferred Taxes.................................................XII   Table of Contents  Reading 34: Understanding the Cash Flow Statement ........................................................................... 300 Study Session 12: Portfolio Management: 330 Reading 49: The Asset Allocation Decision.......................... Long-Term Assets.....................................................................................................................................................and Off-Balance Sheet Debt ............................................................................................................................................................................................................. 274 Reading 41: Financial Analysis Techniques................................................................... 300 A Manual for Investors........................................................................................................................................... 378   .............................................................................................. 248 Reading 37: Analysis of Long-Lived Assets: ............................................ 248 Reading 39: Analysis of Financing Liabilities ................. 274 Study Session 11: Corporate Finance: 300 Reading 44: Capital Budgeting ................................................................................................................ 354 Reading 54: Efficient Capital Markets ................... 274 Reading 42: Financial Statement Analysis: Applications .... Applications................................... 378 Reading 56: An Introduction to Security Valuation: Part I .... 300 Reading 45: Cost of Capital.......................................................................................................................... 354 Reading 53: Security-Market Indexes .............. and International Standards Convergence ................................................................................................................................................................................................................ 274 Reading 43: International Standards Convergence ............... 354 Reading 52: Organization and Functioning of Securities Markets ........................................... and On............................... 330 Reading 50: An Introduction to Portfolio Management..........................

..................................................................................................450 Reading 72: Futures Markets and Contracts ...........................450 Reading 71: Forward Markets and Contracts .....................................................................378 Reading 59: Company Analysis and Stock Valuation...................................................................................................................................................................................................................................................402 Reading 63: Risks Associated with Investing in Bonds .........426 Reading 68: Yield Measures..........................................................................................................................426 Reading 67: Introduction to the Valuation of Debt Securities ............378 Study Session 15: Fixed Income Investments: 402 Basic Concepts .........................................................................................................................................402 Reading 65: Understanding Yield Spreads.......402 Reading 64: Overview of Bond Sectors and Instruments ..................450 Reading 75: Risk Management Applications of Option Strategies ....................................................................................................................378 Reading 60: An Introduction to Security Valuation: Part II........................................................................................................................................378 Reading 58: Equity: Concepts and Techniques....................................................................402 Reading 66: Monetary Policy in an Environment of Global Financial Markets ........................ Spot Rates.........402 Reading 62: Features of Debt Securities .426 Reading 69: Introduction to the Measurement of Interest Rate Risk .....................426 Study Session 17: Derivative Investments: 450 Reading 70: Derivative Markets and Instruments ..................................................................................402 Study Session 16: Fixed Income Investments: 426 Analysis and Valuation...............................................................474 Terminology: Appendix A: Download Instructions     ....................378 Reading 61: Introduction to Price Multiples ................................................................................................450 Reading 73: Option Markets and Contracts........................................................................................................450 Study Session 18: Alternative Investments: 474 501 503 526 Reading 76: Alternative Investments ....... and Forward Rates ...450 Reading 74: Swap Markets and Contracts .......Table of Contents   XIII  Reading 57: Industry Analysis...............................................................

  The principles and guidance presented in the CFA Institute Standards of Practice Handbook (SOPH)  form  the  basis  for  the  CFA  Institute  self‐regulatory  program  to  maintain  the  highest  professional  standards  among  investment  practitioners.  Having  a  global  standard for reporting investment performance minimizes the potential for ambiguous or misleading  presentations.    Reading 1: Code of Ethics and Standards of Professional Conduct  Reading 2: “Guidance” for Standards I–VII  Reading 3: Introduction to the Global Investment Performance Standards (GIPS)  Reading 4: Global Investment Performance Standards (GIPS)        . The guidance reviews the  purpose  and  scope  of  each  standard.  presents  recommended  procedures  for  compliance.  and  provides examples of the standard in practice.  “Guidance”  in  the  SOPH  addresses  the  practical  application of the Code of Ethics and Standards of Professional Conduct.  The  Global  Investment  Performance  Standards  (GIPS)  facilitate  efficient  comparison  of  investment  performance  across  investment  managers  and  country  borders  by  prescribing  methodology  and  standards  that  are  consistent  with  a  clear  and  honest  presentation  of  returns.14   Study Session 01:   Study Session 01: Ethical and Professional Standards:   The  readings  in  this  study  session  present  a  framework  for  ethical  conduct  in  the  investment  profession by focusing on the CFA Institute Code of Ethics and Standards of Professional Conduct as  well as the Global Investment Performance Standards (GIPS®).

 CFA.  Vasco must comply with Talia’s law.   B.  Vasco should not worry about Rasen’s law. Vasco must only comply with the Code and Standards  regarding insider trading and soft‐dollar arrangements. if any at all.  Blanc must refuse the invitation as it may jeopardize her investment judgment.  B.  The private client is a fee‐paying client of Blanc’s firm. a portfolio manager. CFA. Talia is known as the world’s centre of investment management with securities laws stricter  than  the  CFA  Institute  Code  and  Standards.  Blanc may accept the invitation if she reports it in writing to CFA Institute citing the full  monetary value of the vacation.  As a CFA Institute member.        2. is invited to spend a three‐ week vacation valued at $10. is the director for a major Talia‐owned investment management firm branch in  Rasen.  an  emerging  market.  the  local  securities  laws  and  regulations  are  lenient. Tracy Blanc.  Blanc may accept such an invitation as long as she reports it in writing to her employer  and gains their approval.  Blanc is recommended to donate the monetary value of the vacation to a charity of her  choice. According to Standard IV(B) – Disclosure of  Additional Compensation Arrangements:  A.  D.      .  C. it is an early stage emerging market and the  law enforcement will be lax.  As an expression of gratitude.  C.  Jason Vasco.  Vasco only has to comply with Rasen’s law and therefore can take the fullest advantage  of soft‐dollar arrangements.  In  Rasen.Ethical and Professional Standards   1  1. Which of the following is  most accurate?  A.  and  Vasco  is  governed  by  Talia’s  laws.000 with her spouse in a luxurious resort owned by a wealthy private  client after she skillfully protected the value of the client’s capital during a severe market downturn.  D.  They  are  very  vague  in  the  definition of insider trading and have no provision regulating soft‐dollars.

....  the  local  securities  laws  and  regulations  are  lenient.... 15‐17......... Vasco should not worry about Rasen’s law..    ...... C.........  The private client is a fee‐paying client of Blanc’s firm... Reference: CFA® Program Curriculum..... C...  and  Vasco  is  governed  by  Talia’s  laws. If there is no objection she is free to accept the invitation... According to Standard IV(B) – Disclosure of  Additional Compensation Arrangements:  A. in this case Talia’s law is the strictest.. is invited to spend a three‐ week vacation valued at $10. Vasco must comply with Talia’s law.. a portfolio manager......  Jason Vasco.. Blanc may accept the invitation if she reports it in writing to CFA Institute citing the full monetary value of the vacation. pp. Talia is known as the world’s centre of investment management with securities laws stricter  than  the  CFA  Institute  Code  and  Standards.      2.. Correct Answer:  C ... Vasco only has to comply with Rasen’s law and therefore can take the fullest advantage of softdollar arrangements. Correct Answer:  A  LOS: Reading 2‐b  Standard I (A) stipulates that in foreign jurisdictions members must comply with the stricter of the applicable laws and the Code of Standards.. Blanc may accept such an invitation as long as she reports it in writing to her employer and gains their approval.. Blanc must refuse the invitation as it may jeopardize her investment judgment.... 75‐76.. B... CFA... CFA. D.  They  are  very  vague  in  the  definition of insider trading and have no provision regulating soft‐dollars..... Tracy Blanc......000 with her spouse in a luxurious resort owned by a wealthy private  client after she skillfully protected the value of the client’s capital during a severe market downturn. if any at all.... D.. B.. Reading 2‐b  Blanc needs to report in writing the additional compensation so her supervisor and the firm can assess whether it is potentially a conflict of interest... is the director for a major Talia‐owned investment management firm branch in  Rasen..... Volume 1.... pp.  In  Rasen. it is an early stage emerging market and the law enforcement will be lax. Vasco must only comply with the Code and Standards regarding insider trading and soft-dollar arrangements. Reference: CFA® Program Curriculum.....2   Study Session 01:   1. Volume 1..  As an expression of gratitude. As a CFA Institute member.. Which of the following is  most accurate?  A........  an  emerging  market..... Blanc is recommended to donate the monetary value of the vacation to a charity of her choice..

  has  just  been  offered  an  exciting  new  position  with  Walton  Asset  Management and decides that he will resign from his current position with Trust Asset Management. must disclose the ownership of the shares by a member of his immediate family. He is least likely to violate the Code and Standards. Under Standard VI(A). C. C. experience in pricing unlisted securities which he gained while attending training courses which were paid for by Trust Asset Management. D. does not need to disclose the fact that his son owns the shares of Bourgogne Vineyard Corporation. must sell the shares immediately. B. Morgon:  A. if he takes:   A.  Joseph  Morgon.  is  a  research  analyst  covering  the  Bourgogne  Vineyard  Corporation.  Before he resigns he decides to ensure that he uses some of the skills and materials he has developed  at Trust Asset Management.  Morgon’s parents bought $50 worth of Bourgogne Vineyard Corporation shares for his two‐year old  son on his birthday.Ethical and Professional Standards   3  3.  Kevin  Dudman. must file a report with the SEC.       4.  CFA. internal contact information on Trust Asset Management‘s major clients which is available from other eternal sources. computer models developed to identify mispriced securities developed by Dudman and a colleague at Trust Asset Management. stock market analysis prepared by Dudman when he was working at Trust Asset Management. B. Disclosure of Conflicts.  CFA.   . D.

.... Client contact details should not be taken from his employer.. D ... must sell the shares immediately............. computer models developed to identify mispriced securities developed by Dudman and a colleague at Trust Asset Management.. internal contact information on Trust Asset Management‘s major clients which is available from other eternal sources.......  has  just  been  offered  an  exciting  new  position  with  Walton  Asset  Management and decides that he will resign from his current position with Trust Asset Management...  Kevin  Dudman.....        4.............. D...... pp. 69‐74..... Volume 1....4   Study Session 01:   3. B... LOS: Reading  2‐b  Correct Answer:  The share ownership is not likely to be material and therefore will not reasonably affect Morgon’s ability to make unbiased and objective recommendation according to Standard VI(A) Disclosure of Conflicts......  Morgon’s parents bought $50 worth of Bourgogne Vineyard Corporation shares for his two‐year old  son on his birthday..    . experience in pricing unlisted securities which he gained while attending training courses which were paid for by Trust Asset Management............ must file a report with the SEC....... C............ does not need to disclose the fact that his son owns the shares of Bourgogne Vineyard Corporation...  is  a  research  analyst  covering  the  Bourgogne  Vineyard  Corporation... so D is the correct answer.. Under Standard VI(A)..  CFA.....  Before he resigns he decides to ensure that he uses some of the skills and materials he has developed  at Trust Asset Management. Morgon:  A......... 89‐94...... must disclose the ownership of the shares by a member of his immediate family..... pp.....  Joseph  Morgon... although he is not prohibited from collecting client information from outside sources. C... D.... Reference: CFA® Program Curriculum... He is least likely to violate the Code and Standards.............. However skills and experience gained at Trust Asset Management can be used in his new job.  CFA. Volume 1. if he takes:   A. Disclosure of Conflicts... stock market analysis prepared by Dudman when he was working at Trust Asset Management................ LOS: Reading  2‐b  Models and research which he worked on when employed by Trust Asset Management belong to Trust Asset Management.. Correct Answer:  D ...... Reference: CFA® Program Curriculum. B............

  Greenback:  A. Greenback lives on  the  same  street  as  the  CFO  of  Brown  Appliances.  did not violate the Code and Standards because he used mosaic theory to arrive at his  recommendation.    .  is  the  research  analyst  responsible  for  following  Brown  Appliances  Company.Ethical and Professional Standards   5  5.  B.  This  fact  has  not  yet  been  made  public  by  Brown  Appliances.  CFA.  D.  Upon  returning  to  his  office.  violated the Code and Standards because he did not have a reasonable and adequate  basis for his recommendation.  This  analysis  suggests  the  stock  should be  rated  a  “sell”  because  the  market  outlook  for  the firm’s new products is bleak compared with that of the closest competition.  C.  Wimpy  Greenback.  Greenback’s wife overheard the wife of the Chief Financial Officer of Brown Appliances complaining  that  her  husband  had  been  working  late  due  to  a  hostile  takeover  threat  from  a  foreign  appliances  group.  was in full compliance with the Code and Standards.  During  a  recent  neighborhood  gathering.  Greenback  released  a  strong  “buy”  recommendation  to  the  public  based  on  this  new  information.  violated the Code and Standards by failing to distinguish between facts and opinions in  his recommendation.

 pp.  Greenback:  A.  During  a  recent  neighborhood  gathering...  is  the  research  analyst  responsible  for  following  Brown  Appliances  Company.. states that members must have a reasonable and adequate basis for a recommendation.....  This  fact  has  not  yet  been  made  public  by  Brown  Appliances............ if a tender offer to Brown Appliances follows........... C.. This may well be a misappropriation of material nonpublic information as stated in Standard V(A) Prohibition against Use of Material Nonpublic Information...    ...  Greenback  released  a  strong  “buy”  recommendation  to  the  public  based  on  this  new  information.... was in full compliance with the Code and Standards. violated the Code and Standards because he did not have a reasonable and adequate basis for his recommendation...........  Upon  returning  to  his  office. Reference: CFA® Program Curriculum... B. Greenback lives on  the  same  street  as  the  CFO  of  Brown  Appliances.. 80‐84....... LOS: Reading  2‐b  Standard V(A) Diligence and Reasonable Basis...... Correct Answer:  D ... D.......... Greenback should have reinvestigated the company’s situation and not only relied on unofficial information.........6   Study Session 01:   5...  Wimpy  Greenback.  This  analysis  suggests  the  stock  should be  rated  a  “sell”  because  the  market  outlook  for  the firm’s new products is bleak compared with that of the closest competition.... Volume 1...... violated the Code and Standards by failing to distinguish between facts and opinions in his recommendation.  Greenback’s wife overheard the wife of the Chief Financial Officer of Brown Appliances complaining  that  her  husband  had  been  working  late  due  to  a  hostile  takeover  threat  from  a  foreign  appliances  group. did not violate the Code and Standards because he used mosaic theory to arrive at his recommendation..  CFA.

  C.  immediately re‐rate the stock to a “buy” since the firm’s overall interest supersedes that  of the client. to a “hold”  recommendation) since little harm is done by being a bit more positive.  increase the rating by no more than one increment (in this case.  Fiona Griffiths.  The  firm’s  equity  brokerage  unit  is  about  to  publish  a  “sell”  recommendation on Kia Telcom due to an unexpected announcement of cost overruns. the best course of action for the equity brokerage unit is to:  A.Ethical and Professional Standards   7  6.  Griffiths  understands  the  local  environment  so  she  is  able  to  influence  the  allocation  process so that she can personally subscribe to the maximum she can afford and then allocate the rest  to her clients. Griffiths is in compliance with the Code and Standards since her clients are satisfied. is an equity sales manager at a London‐based Tiger Securities branch in an  emerging market. Griffiths violates the Code and Standards since she does not maintain client. B. C.  has  decided  to  compete  for  the  advisory  and  underwriting  bond  offering  of  Kia  Telcom.  The fixed‐income corporate finance department of Golden Brothers. The head of  fixed‐income  investment  banking  has  asked  the  head  of  the  equity  brokerage  unit  to  change  the  recommendation from “sell” to “buy” before distributing the research report to clients.  place Kia Telcom on a restricted list and publish only factual information about the  company.  Which  of  the  following  describes  Griffiths’  situation?  A. while the firm’s overall  interest is served. Griffiths violates the Code and Standards due to the priority she gives to transactions. According to  the Code and Standards.  assign a more senior analyst to decide if the stock deserves a higher rating for the sake of  objectivity since less senior analysts may err in judgment. Her clients never complain because they have almost always profited from investing in  the  emerging  market  over  the  last  couple  of  years. D. CFA.   . Griffiths violates the Code and Standards since she lacks independence and objectivity. Initial public offerings are often oversubscribed making it difficult to ensure a fair  allocation.  a  ‘hot’  telecommunications  company.  D. confidentiality.        7.  B. an investment banking firm.

...... Volume 1..... B. an investment banking firm.......... increase the rating by no more than one increment (in this case....  a  ‘hot’  telecommunications  company...........  Which  of  the  following  describes  Griffiths’  situation?  A... Reference: CFA® Program Curriculum....... the best course of action for the equity brokerage unit is to:  A.. Griffiths violates the Code and Standards since she does not maintain client. Her clients never complain because they have almost always profited from investing in  the  emerging  market  over  the  last  couple  of  years...... Correct Answer:  A .  The fixed‐income corporate finance department of Golden Brothers....  Fiona Griffiths...8   Study Session 01:   6... D......... Volume 1.    ... confidentiality... 21‐25... B.  The  firm’s  equity  brokerage  unit  is  about  to  publish  a  “sell”  recommendation on Kia Telcom due to an unexpected announcement of cost overruns............ C.. while the firm’s overall interest is served...... According to  the Code and Standards... Griffiths violates the Code and Standards due to the priority she gives to transactions........ regardless of whether the clients are pleased with her services.... to a “hold” recommendation) since little harm is done by being a bit more positive. is an equity sales manager at a London‐based Tiger Securities branch in an  emerging market. since she puts her personal investment ahead of her clients... assign a more senior analyst to decide if the stock deserves a higher rating for the sake of objectivity since less senior analysts may err in judgment.  has  decided  to  compete  for  the  advisory  and  underwriting  bond  offering  of  Kia  Telcom.LOS: Reading  2‐a  In this case................ pp... D... C.. pp.......... 94‐99....... B....    7..  Griffiths  understands  the  local  environment  so  she  is  able  to  influence  the  allocation  process so that she can personally subscribe to the maximum she can afford and then allocate the rest  to her clients........ Griffiths is in compliance with the Code and Standards since her clients are satisfied. LOS: Reading  2‐b  Correct Answer:  Griffiths is in violation as Standard VI(B) Priority of Transactions....... Griffiths violates the Code and Standards since she lacks independence and objectivity..... CFA.. place Kia Telcom on a restricted list and publish only factual information about the company.............. immediately re-rate the stock to a “buy” since the firm’s overall interest supersedes that of the client...... Initial public offerings are often oversubscribed making it difficult to ensure a fair  allocation..... any action to accommodate the interest of the investment banking department that may compromise the independence and objectivity of the brokerage research efforts can violate Standard I(B) and the Code of Ethics. The head of  fixed‐income  investment  banking  has  asked  the  head  of  the  equity  brokerage  unit  to  change  the  recommendation from “sell” to “buy” before distributing the research report to clients...... Reference: CFA® Program Curriculum.

 Jonathan Beecham.  elaborated on the technical features of Pluto’s standard valuation method used to  identify the undervaluation.  avoided the meeting with Beecham in the first place because the founding partners of  Pluto came from Vulcan.  Which  of  the  following  statements  best  describes the action Anderson should have taken? Anderson should have:  A. Beecham has been a client of Vulcan Investments for years.  B.  Anderson’s  actions  violated  the  Code  and  Standards.  given Beecham a longer time period to take advantage of the offer price when switching  his account to Pluto. objectives.  At  the  beginning  of  their  meeting.  works  for  Pluto  Capital.  Anderson  sympathized  with  his  situation.  a  newly  established  investment  counseling  firm.  but is now considering switching his account to Pluto Capital because he has been disappointed by  Vulcan’s  underperformance  following  the  takeover. a prospective client of the firm.  C.Ethical and Professional Standards   9  8.  Victoria  Anderson. and tolerance for risk before making  any investment recommendation.  determined Beecham’s investment needs.  D. Anderson then promises Beecham that she  can  buy  the  stock  for  his  account  at  the  current  price  if  he  switches  the  account  within  48  hours. is  meeting with Anderson for the first time.  CFA.  then  immediately  explains  to  Beecham  that  she  has  discovered  a  highly undervalued stock that offers large potential gains.  The  founding  partners  of  Pluto  Capital  came  from  Vulcan  Investments  which  was  recently  taken over by a large financial services group.    .

LOS: Reading  2‐b  Prior to recommending any investments........ is  meeting with Anderson for the first time.... Beecham has been a client of Vulcan Investments for years..  then  immediately  explains  to  Beecham  that  she  has  discovered  a  highly undervalued stock that offers large potential gains... 60‐64.. B.10   Study Session 01:   8..........    .... and tolerance for risk as stated in Standard III(C) Suitability...  Victoria  Anderson.... Anderson should determine Beecham's investment needs. and tolerance for risk before making any investment recommendation..  works  for  Pluto  Capital.. D. Correct Answer:  D ......  a  newly  established  investment  counseling  firm.. C....  The  founding  partners  of  Pluto  Capital  came  from  Vulcan  Investments  which  was  recently  taken over by a large financial services group..... Reference: CFA® Program Curriculum.  At  the  beginning  of  their  meeting...  Anderson’s  actions  violated  the  Code  and  Standards. given Beecham a longer time period to take advantage of the offer price when switching his account to Pluto... objectives. determined Beecham’s investment needs. elaborated on the technical features of Pluto’s standard valuation method used to identify the undervaluation.......... objectives.......  Anderson  sympathized  with  his  situation.... avoided the meeting with Beecham in the first place because the founding partners of Pluto came from Vulcan..... Anderson then promises Beecham that she  can  buy  the  stock  for  his  account  at  the  current  price  if  he  switches  the  account  within  48  hours..  but is now considering switching his account to Pluto Capital because he has been disappointed by  Vulcan’s  underperformance  following  the  takeover........ Jonathan Beecham. Volume 1.  CFA. pp...  Which  of  the  following  statements  best  describes the action Anderson should have taken? Anderson should have:  A..... a prospective client of the firm.....

Ethical and Professional Standards   11  9.  Ken  Janzen,  CFA,  is  an  economist  at  a  large  bank  and  he  has  never  made  direct  investment  decisions.  Jenzen  is  the  latest  winner  of  a  well‐publicized  portfolio  management  competition  in  a  national newspaper. On the recommendation of his friends, he is launching an investment fund. In  the prospectus he tells the prospective clients, “The fund has no long‐term track record as yet, but the  investment  manager  has  shown  considerable  skills  in  managing  hypothetical  portfolios.  In  a  competition  the  manager  has  demonstrated  a  portfolio  total  return  above  26  percent  per  year  annualized, and that is more than 12 percent above the benchmark for the same period.” He managed  to  raise  a  significant  amount  of  money  from  retail  investors  who  are  interested  in  investing  in  the  fund. Has Janzen violated the Code and Standards?  A.  B.  C.  D.  Yes, because the statement misrepresents Janzen’s track record.  Yes, because he cannot quote performance for a hypothetical portfolio.   Yes, because the statement about return ignores the risk preferences of his clients.  No, because the statement is a true and accurate description of Janzen’s track record. 

 

12   Study Session 01:   9.  Ken  Janzen,  CFA,  is  an  economist  at  a  large  bank  and  he  has  never  made  direct  investment  decisions.  Jenzen  is  the  latest  winner  of  a  well‐publicized  portfolio  management  competition  in  a  national newspaper. On the recommendation of his friends, he is launching an investment fund. In  the prospectus he tells the prospective clients, “The fund has no long‐term track record as yet, but the  investment  manager  has  shown  considerable  skills  in  managing  hypothetical  portfolios.  In  a  competition  the  manager  has  demonstrated  a  portfolio  total  return  above  26  percent  per  year  annualized, and that is more than 12 percent above the benchmark for the same period.” He managed  to  raise  a  significant  amount  of  money  from  retail  investors  who  are  interested  in  investing  in  the  fund. Has Janzen violated the Code and Standards?  A. B. C. D. Yes, because the statement misrepresents Janzen’s track record. Yes, because he cannot quote performance for a hypothetical portfolio. Yes, because the statement about return ignores the risk preferences of his clients. No, because the statement is a true and accurate description of Janzen’s track record. D ........................................................................................... LOS: Reading  2‐b 

Correct Answer: 

Although Janzen’s experience in managing investments is only based on his winning a hypothetical portfolio management competition, he does not misrepresent his capabilities and experience as described in Standard III(D) Performance Presentation. Whether it is appropriate for an investor to subscribe to his investment fund is a different matter. The role of the Code and Standards is to guide self-regulation of CFA Institute members, not to certify the merit of an investment. Reference: CFA® Program Curriculum, Volume 1, pp. 64‐67. 

 

Ethical and Professional Standards   13  10.  Martha  Pierpont,  CFA,  works  for  the  securities  custody  department  of  North  Pole  Trust  Bank.  She  makes  a  reciprocal  referral  fee  arrangement  with  Robert  Underhill,  CFA,  an  adviser  at  BestAdvice.com.  She  does  not  disclose  the  referral  arrangement  but  Underhill  does  so  by  inserting  one clause in BestAdvice.com’s investment advisory agreement that includes “… from time to time  referral fees may be arranged with a number of selected securities custodians.” Clients of BestAdvice  regularly use North Pole’s services and pay referral fees. Which of the following is most accurate?  A.  B.  C.  D.        11.  Charles Chaplane, who is not a member of CFA Institute, is a senior partner of a small brokerage  firm,  Blue  Moon  Securities,  which  recently  participated  in  a  large  stock  offering.  The  offering  company has been given an unfavorable recommendation by his research department in the past two  quarters  due  to  lacklustre  performance.  Chaplane  immediately  calls  his  junior  analyst  John  Blumenberg, CFA, and instructs him to upgrade his recommendation. Blumenberg comes up with a  more  favorable  recommendation  within  a  short  period  of  time.  Blumenberg  is  least  likely  to  have  violated the Standards because he failed:  A.  B.  C.  D.  to avoid a conflict of interest.   to maintain independence and objectivity.  to make a fair statement of investment performance.  to exercise due diligence and thoroughness in making an investment recommendation.  Only Pierpont complies with the Code and Standards.  Only Underhill complies with the Code and Standards.  Both Pierpont and Underhill comply with the Code and Standards.  Neither Pierpont nor Underhill comply with the Code and Standards. 

 

14   Study Session 01:   10.  Martha  Pierpont,  CFA,  works  for  the  securities  custody  department  of  North  Pole  Trust  Bank.  She  makes  a  reciprocal  referral  fee  arrangement  with  Robert  Underhill,  CFA,  an  adviser  at  BestAdvice.com.  She  does  not  disclose  the  referral  arrangement  but  Underhill  does  so  by  inserting  one clause in BestAdvice.com’s investment advisory agreement that includes “… from time to time  referral fees may be arranged with a number of selected securities custodians.” Clients of BestAdvice  regularly use North Pole’s services and pay referral fees. Which of the following is most accurate?  A. B. C. D. Only Pierpont complies with the Code and Standards. Only Underhill complies with the Code and Standards. Both Pierpont and Underhill comply with the Code and Standards. Neither Pierpont nor Underhill comply with the Code and Standards. D ........................................................................................... LOS: Reading  2‐b 

Correct Answer: 

The best choice is D since any referral fee arrangement that a client ultimately pays must be disclosed in terms of the nature of the consideration or the benefit together with the estimated monetary value, by both the payer and recipient of the fee. See Standard VI (C) Referral Fees. Reference: CFA® Program Curriculum, Volume 1, pp. 99‐101.      11.  Charles Chaplane, who is not a member of CFA Institute, is a senior partner of a small brokerage  firm,  Blue  Moon  Securities,  which  recently  participated  in  a  large  stock  offering.  The  offering  company has been given an unfavorable recommendation by his research department in the past two  quarters  due  to  lacklustre  performance.  Chaplane  immediately  calls  his  junior  analyst  John  Blumenberg, CFA, and instructs him to upgrade his recommendation. Blumenberg comes up with a  more  favorable  recommendation  within  a  short  period  of  time.  Blumenberg  is  least  likely  to  have  violated the Standards because he failed:  A. B. C. D. to avoid a conflict of interest. to maintain independence and objectivity. to make a fair statement of investment performance. to exercise due diligence and thoroughness in making an investment recommendation. C ........................................................................................... LOS: Reading  2‐b 

Correct Answer: 

The best answer is C, because there is no evidence to suggest that performance presentation is relevant to the question. Reference: CFA® Program Curriculum, Volume 1, pp. 64‐67. 

 

Ethical and Professional Standards   15  12.  Patricia  Lualua,  CFA,  is  a  portfolio  manager  of  Raven  Asset  Management.  Recently  she  won  a  mandate  from  the  Flemish  Widows  pension  fund  trustees  to  manage  the  investments  of  the  fund.  One  of  the  Flemish  Widows  trustees  privately  mentions  that  Lualua  should  direct  her  trades  to  Churner Securities, which is owned by a relative of one of the trustees. Lualua, for fear of losing the  account, directs 50% of the trades to Churner Securities. She is pleased to find that Churner’s quality  of  execution  is  good  and  the  emerging  market  research  quality  is  excellent.  Although  Flemish  Widows does not invest in emerging markets, Lualua finds the research useful for the other funds she  manages.  Lualua decides not  to  inform  anyone regarding  the situation.  According  to  the  Code  and  Standards:  A.  B.  C.  D.  Lualua should stop trading with Churner Securities.  Lualua may continue trading with Churners Securities.  Lualua should disclose this arrangement to Flemish Widows.  Lualua should disclose this arrangement to the CFA Institute. 

 

16   Study Session 01:   12.  Patricia  Lualua,  CFA,  is  a  portfolio  manager  of  Raven  Asset  Management.  Recently  she  won  a  mandate  from  the  Flemish  Widows  pension  fund  trustees  to  manage  the  investments  of  the  fund.  One  of  the  Flemish  Widows  trustees  privately  mentions  that  Lualua  should  direct  her  trades  to  Churner Securities, which is owned by a relative of one of the trustees. Lualua, for fear of losing the  account, directs 50% of the trades to Churner Securities. She is pleased to find that Churner’s quality  of  execution  is  good  and  the  emerging  market  research  quality  is  excellent.  Although  Flemish  Widows does not invest in emerging markets, Lualua finds the research useful for the other funds she  manages.  Lualua decides not  to  inform  anyone regarding  the situation.  According  to  the  Code  and  Standards:  A. B. C. D. Lualua should stop trading with Churner Securities. Lualua may continue trading with Churners Securities. Lualua should disclose this arrangement to Flemish Widows. Lualua should disclose this arrangement to the CFA Institute. C ........................................................................................... LOS: Reading  2‐b 

Correct Answer: 

Under most securities laws this situation is acceptable but under Standard III(A), Loyalty, Prudence and Care, Lualua’s trading relationship does not put her client’s interest first. Lualua should disclose the arrangement to the Board of Trustees of Flemish Widows and let the Board give the direction. Reference: CFA® Program Curriculum, Volume 1, pp. 48‐53. 

 

Ethical and Professional Standards   17  13.  Carlina Paparazzi, a fund manager with Abbotswood Advisors, has just been given the authority  to manage a newly acquired client which has a retirement benefit plan, when she realizes that a US  Government Bond belonging to the account matures the next day. The bond comprises 5% of the total  assets.  Abbotswood  Advisors  is  still  in  the  midst  of  a  discussion  with  the  client  regarding  the  formulation of a new investment policy and portfolio objectives. Looking at what the current market  has  to  offer,  there  are  a  number  of  attractive  opportunities.  One  opportunity  that  stands  out  is  a  corporate bond of a major oil company that went out of favor due to an environmental accident that  occurred the week before. She has followed the oil company for a number of years and knows that its  fundamentals are sound. The prospect of an improved credit rating in the next six months is not yet  reflected in the current price. Her supervisor asks Paparazzi to invest the proceeds in the corporate  bond. Paparazzi prefers however to invest them in 3‐month Treasury Bills, albeit with a much lower  yield, until the new investment policy and objectives are formulated. What is the best course of action  for Paparazzi?  A.  Invest in the Treasury Bills until the new investment policy and objectives are  established.  B.  Split the investment between the corporate bond and the Treasury Bills to diversify the  risk.  C.  Revert to the client for a decision and do nothing until the client’s direction is received.  

D.  Follow her supervisor’s direction as the corporate bond opportunity will benefit the  overall performance of the fund. 

 

18   Study Session 01:   13.  Carlina Paparazzi, a fund manager with Abbotswood Advisors, has just been given the authority  to manage a newly acquired client which has a retirement benefit plan, when she realizes that a US  Government Bond belonging to the account matures the next day. The bond comprises 5% of the total  assets.  Abbotswood  Advisors  is  still  in  the  midst  of  a  discussion  with  the  client  regarding  the  formulation of a new investment policy and portfolio objectives. Looking at what the current market  has  to  offer,  there  are  a  number  of  attractive  opportunities.  One  opportunity  that  stands  out  is  a  corporate bond of a major oil company that went out of favor due to an environmental accident that  occurred the week before. She has followed the oil company for a number of years and knows that its  fundamentals are sound. The prospect of an improved credit rating in the next six months is not yet  reflected in the current price. Her supervisor asks Paparazzi to invest the proceeds in the corporate  bond. Paparazzi prefers however to invest them in 3‐month Treasury Bills, albeit with a much lower  yield, until the new investment policy and objectives are formulated. What is the best course of action  for Paparazzi?  A. Invest in the Treasury Bills until the new investment policy and objectives are established. B. Split the investment between the corporate bond and the Treasury Bills to diversify the risk. C. Revert to the client for a decision and do nothing until the client’s direction is received. D. Follow her supervisor’s direction as the corporate bond opportunity will benefit the overall performance of the fund. Correct Answer:  A ........................................................................................... LOS: Reading  2‐b 

Regardless of whether it is the best investment decision, choices C or D will violate Standard III(C), Suitability, because the overall investment policy and objectives are not yet established. Choice A is not correct because the client pays a fee to hire expertise in investment decision making. So the best choice is B, where the client’s interest is protected, as a Treasury Bill is a cash equivalent and is risk-free, as are the maturing Treasury Bonds. Reference: CFA® Program Curriculum, Volume 1, pp. 60‐64. 

 

Ethical and Professional Standards   19  14.  Muhammad  Taqdir,  CFA,  is  an  investment  manager  whose  clients  are  high‐net  worth  individuals. Taqdir is a member of a local charity organization that supports children with asthma.  During  a  meeting  at  the  charity,  Taqdir  recommends  that  the  organization  sends  a  letter  to  Xara  Corporation  requesting  they  make  a  donation  to  the  charity.  Taqdir  knows  of  Xara  Corporation’s  involvement  in  this  cause  from  previous  discussions  with  a  colleague  in  the  office.  The  chief  executive  and  owner  of  Xara  Corporation  is  a  client  of  the  firm.  The  charity,  citing  Taqdir’s  recommendation, sent the letter and received a substantial donation. According to the CFA Institute  Code and Standards:  A.  Taqdir has done his best since the organisation received a substantial donation. 

B.  Taqdir should not have disclosed the identity of the chief executive without his prior  approval.  C.  Taqdir should have informed the chief executive of Xara that he is going to receive a  letter from the organization.  D.  Taqdir should have requested the approval of his colleague before disclosing the name of  the chief executive of Xara. 

 

20   Study Session 01:   14.  Muhammad  Taqdir,  CFA,  is  an  investment  manager  whose  clients  are  high‐net  worth  individuals. Taqdir is a member of a local charity organization that supports children with asthma.  During  a  meeting  at  the  charity,  Taqdir  recommends  that  the  organization  sends  a  letter  to  Xara  Corporation  requesting  they  make  a  donation  to  the  charity.  Taqdir  knows  of  Xara  Corporation’s  involvement  in  this  cause  from  previous  discussions  with  a  colleague  in  the  office.  The  chief  executive  and  owner  of  Xara  Corporation  is  a  client  of  the  firm.  The  charity,  citing  Taqdir’s  recommendation, sent the letter and received a substantial donation. According to the CFA Institute  Code and Standards:  A. Taqdir has done his best since the organisation received a substantial donation. B. Taqdir should not have disclosed the identity of the chief executive without his prior approval. C. Taqdir should have informed the chief executive of Xara that he is going to receive a letter from the organization. D. Taqdir should have requested the approval of his colleague before disclosing the name of the chief executive of Xara. Correct Answer:  B............................................................................................ LOS: Reading  2‐b 

Regardless of the fact that that the organization finally received the substantial donation, Tariq has violated the preservation of confidentiality under Standard III(E), Preservation of Confidentiality, in disclosing the name of the chief executive and owner of Xara without prior knowledge of both the chief executive and his colleague. Reference: CFA® Program Curriculum, Volume 1, pp. 67‐69. 

 

  CFA.  is  scheduled  to  visit  the  corporate  headquarters  of  Venus  Industries.000. hotel room.  Which  of  the  following  actions  would  be  the  best  course  for  Maggio  to  take  under  the  Code  and  Standards?  A.  Reject the golf outing offer but accept the reimbursement of the travel expenses since  they are legitimate business‐related expenses. including the cost of meals.  Accept the expenses‐paid trip and disclose the value of the trip in the report.  Marco  Maggio.  The location of Venus Industries is within a 15‐minute drive of a prestigious golf course. Marco Maggio learns that Venus is offering Maggio an extension of his stay that  weekend and invites him for a day of golf with all expenses paid.  Accept both the expenses‐paid trip and the golf outing as more information can often be  extracted from the company in a more leisurely environment.  Maggio expects to use the information obtained there to complete his research report on Venus stock.  B.  C. On arrival at  the Venus premises. but it is at  Maggio’s discretion to take the golf outing offer without disclosing it as it occurs outside  working hours.  Pay for all travel expenses.Ethical and Professional Standards   21  15. The total cost for the weekend is about $2.    . including costs of meals and incidental items and politely  reject the golf outing offer. and air transportation back to  Venus Industries.  D. Venus Industries also offers to pay  for all the expenses for the trip.

.....  The location of Venus Industries is within a 15‐minute drive of a prestigious golf course. Volume 1.. D.....000.... Reject the golf outing offer but accept the reimbursement of the travel expenses since they are legitimate business-related expenses.....    ....  Which  of  the  following  actions  would  be  the  best  course  for  Maggio  to  take  under  the  Code  and  Standards?  A.....  Maggio expects to use the information obtained there to complete his research report on Venus stock...22   Study Session 01:   15....  Marco  Maggio.... and air transportation back to  Venus Industries...  is  scheduled  to  visit  the  corporate  headquarters  of  Venus  Industries. but it is at Maggio’s discretion to take the golf outing offer without disclosing it as it occurs outside working hours. Venus Industries also offers to pay  for all the expenses for the trip. for his own travel expenses and not accept the golf outing.. Correct Answer:  A .. pp......... LOS: Reading  2‐b  Maggio risks violating Standard I(B) Independence and Objectivity because accepting any significant gift may impede his independence and objectivity. B. Pay for all travel expenses...  CFA..... hotel room...... Reference: CFA® Program Curriculum.. Accept both the expenses-paid trip and the golf outing as more information can often be extracted from the company in a more leisurely environment.. C.. Accept the expenses-paid trip and disclose the value of the trip in the report.............. He should pay.... On arrival at  the Venus premises..... Marco Maggio learns that Venus is offering Maggio an extension of his stay that  weekend and invites him for a day of golf with all expenses paid. 21‐29..... including the cost of meals. The total cost for the weekend is about $2.. including costs of meals and incidental items and politely reject the golf outing offer....... whenever possible..

  To  make  it  more  attractive to Freud.  may accept the additional compensation subject to the approval of his employer as  required by Standard IV(B) Additional Compensation Arrangements.  One  of  his  clients  in  Monaco  offers  him  bonus  compensation  beyond  that  provided  by  his  firm  if  the  portfolio  performance  exceeds  the  agreed  benchmark.  is free to accept the additional compensation in the tax‐free account. his client will send the bonus compensation to a tax‐free account in a tax haven.  D. as long as the  account is not under the jurisdiction of either Monaco or Austria.  should turn down the additional compensation offer because it violates Standard IV(B)  Additional Compensation Arrangements.  Freud:  A.Ethical and Professional Standards   23  16.  C.  Simon Freud.  B. CFA.    .  should report the situation to the compliance officer of the CFA Institute according to  Standard I(B) Independence and Objectivity.  Austria. is a private‐client investment manager at Super Echo investment firm based  in  Vienna. it will therefore also be  outside the jurisdiction of the Code and Standards.

.  To  make  it  more  attractive to Freud. is a private‐client investment manager at Super Echo investment firm based  in  Vienna. CFA... The tax-free account is a separate issue and will have to be viewed in light of tax rules and regulations...........  Simon Freud.. D..... Correct Answer:  C . B.. as long as the account is not under the jurisdiction of either Monaco or Austria...........  Austria.  One  of  his  clients  in  Monaco  offers  him  bonus  compensation  beyond  that  provided  by  his  firm  if  the  portfolio  performance  exceeds  the  agreed  benchmark.... his client will send the bonus compensation to a tax‐free account in a tax haven.. Reference: CFA® Program Curriculum.............    ..... C.  Freud:  A.......... should report the situation to the compliance officer of the CFA Institute according to Standard I(B) Independence and Objectivity. may accept the additional compensation subject to the approval of his employer as required by Standard IV(B) Additional Compensation Arrangements.. it will therefore also be outside the jurisdiction of the Code and Standards. should turn down the additional compensation offer because it violates Standard IV(B) Additional Compensation Arrangements...... 75‐76.. LOS: Reading  2‐b  Standard IV(B) Additional Compensation Arrangements does not prohibit the acceptance of additional compensation as long as approval from the employer is obtained......... Volume 1......24   Study Session 01:   16...... is free to accept the additional compensation in the tax-free account....... pp..

 On a recent trip to see a bank  that  he  covers.  This  information  has  not  been  made  public. CFA.   . Luny should request his supervisor’s approval. Luny should refrain from taking any action on the smaller bank’s stock until the bank has made the tender offer information public.  he  was  presented  with  a  rosy  outlook  for  the  bank’s  earnings  in  the  next  two  years  which  is  above  the  consensus  expectations. B. Luny is entitled to take advantage of the information as he did not misappropriate it.Ethical and Professional Standards   25  17. Luny should encourage the bank to disclose the tender offer information to the public but is free to take advantage of the information in the meantime. C. D.  When  probed  further  about  the  assumptions.  Luny  feels  very  lucky to receive this unexpected tip and rushes back to his office to revise his projections and advise  his major clients to buy the smaller bank’s stock. is a bank analyst with London Fog Securities. What should Luny have done instead?  A.  the  CFO  inadvertently mentioned that serious discussions are taking place for a tender offer of a smaller well‐ managed  bank  that  Luny  also  covers.  Joseph Luny.

..  Luny  feels  very  lucky to receive this unexpected tip and rushes back to his office to revise his projections and advise  his major clients to buy the smaller bank’s stock... Luny should request his supervisor’s approval. CFA............... C.......  When  probed  further  about  the  assumptions.... On a recent trip to see a bank  that  he  covers.. D...... Volume 1..    ......  Joseph Luny...  he  was  presented  with  a  rosy  outlook  for  the  bank’s  earnings  in  the  next  two  years  which  is  above  the  consensus  expectations....... 36‐45.. Correct Answer:  C .. Luny is entitled to take advantage of the information as he did not misappropriate it................ Luny should encourage the bank to disclose the tender offer information to the public but is free to take advantage of the information in the meantime.  the  CFO  inadvertently mentioned that serious discussions are taking place for a tender offer of a smaller well‐ managed  bank  that  Luny  also  covers. pp..  This  information  has  not  been  made  public.... If it is not appropriate to encourage public dissemination of the information he can only communicate the information to his supervisor or compliance department........ is a bank analyst with London Fog Securities. LOS: Reading  2‐b  Under Standard II(A) Material Nonpublic Information Lung should not act or cause others to act on this information .26   Study Session 01:   17... Luny should refrain from taking any action on the smaller bank’s stock until the bank has made the tender offer information public..... Reference: CFA® Program Curriculum... B... What should Luny have done instead?  A......

  Marianne  Warner.  Her  husband  holds 25  percent  of  the shares  of  Gurita  Corporation.Ethical and Professional Standards   27  18.  Warner violates the Code and Standards for failing to disclose the conflicts of interest.  C.  a  computer  services  company.    .  is  a  portfolio  manager  at  Creative  Investment  Management  and  in  charge  of  managing several  discretionary  portfolios.  B. Warner believes that the current market price is too high and immediately advises her  husband  to  sell  half  of  his  shares.  The  share  price  skyrocketed  and  the  value  of  her  husband’s holding went up from $1 million prior to the public offering to $8 million at the current  market price.  D.  In  line  with  the  high  sector  growth.  Warner violates the Code and Standards for possessing material non‐public information.  She  also  recommends  he  put  the  proceeds  into  one  of  the  discretionary portfolios she is currently managing.  Gurita  Corporation  went  public  earlier  in  the  year.  CFA. Which one is the best answer?  A.  Warner does not violate the Code and Standards.  Warner violates the Code and Standards for failing to disclose additional compensation  arrangements.

..... pp... Warner does not violate the Code and Standards.. Warner believes that the current market price is too high and immediately advises her  husband  to  sell  half  of  his  shares.  She  also  recommends  he  put  the  proceeds  into  one  of  the  discretionary portfolios she is currently managing.  CFA. 36‐45........ LOS: Reading  2‐b  Choice B would apply if the advice was given when one or more of the portfolios contain Gurita shares.  In  line  with  the  high  sector  growth. B.  a  computer  services  company.  Gurita  Corporation  went  public  earlier  in  the  year...... Volume 1............ Warner violates the Code and Standards for possessing material non-public information..  is  a  portfolio  manager  at  Creative  Investment  Management  and  in  charge  of  managing several  discretionary  portfolios.. D. C..... Correct Answer:  A .....................  The  share  price  skyrocketed  and  the  value  of  her  husband’s holding went up from $1 million prior to the public offering to $8 million at the current  market price.. Warner violates the Code and Standards for failing to disclose the conflicts of interest..28   Study Session 01:   18......    .. There is no mention of material nonpublic information or additional compensation so Warner has not violated any of the Standards. Warner violates the Code and Standards for failing to disclose additional compensation arrangements................ Reference: CFA® Program Curriculum.....  Marianne  Warner.. Which one is the best answer?  A.  Her  husband  holds 25  percent  of  the shares  of  Gurita  Corporation......

  the  product  recall  is  planned  to  be  a  quiet  affair. Seller should inform CFA Institute of the violation of the Code and Standards so he can clear himself of the possible misrepresentation. Seller should do nothing as it may jeopardize the success of the issue. CFA.  The  Professional  Conduct  staff  under  the  direction  of  CFA  Institute  are  least  likely  to  make  an  enquiry into a member’s conduct when:   A.  However  Seller  is  aware  that  recently a competitor’s product recall received a large amount of adverse publicity.   . Seller should inform his supervisor and let him/her deal with the situation since Seller himself should not jeopardize the success of the issue.   C.  D.  the media reports on a member whose professional conduct appears to have been  unethical.  Jonathan Seller. According to the Code and Standards:  A. Seller should revise the preliminary prospectus to include the omitted information to avoid any possible misrepresentation.Ethical and Professional Standards   29  19.         20.  Since  the  number  of  items  affected  is  relatively  small. D. Seller found out that the prospectus has concealed an  impending  product  recall  due  to  a  quality  control  error. works for an investment bank that is acting as the principal underwriter for  an issue of stock of a large tire manufacturer.  they perform random checks on members’ professional conduct.  they receive a written complaint regarding a member’s professional conduct.  members self‐disclose on their Professional Conduct Statement that they are involved in  litigation regarding their investment advice. B. C. The preliminary  prospectus has been distributed.  B.

...... Seller should revise the preliminary prospectus to include the omitted information to avoid any possible misrepresentation..30   Study Session 01:   19. B. Correct Answer:  D ...    .. Reference: CFA® Program Curriculum... Correct Answer:  B........ or whenever a candidate is suspected of comprising their professional conduct during an examination........ written complaints... works for an investment bank that is acting as the principal underwriter for  an issue of stock of a large tire manufacturer..... B is the best answer...... media or other public sources providing information............... D...... the media reports on a member whose professional conduct appears to have been unethical... members self-disclose on their Professional Conduct Statement that they are involved in litigation regarding their investment advice..... they receive a written complaint regarding a member’s professional conduct............ p.Reading 1‐a  There is no mention of CFA Institute performing random checks on members’ (or candidates’) behavior........... CFA.. Reading 2‐b  Standard V requires that members shall make reasonable and diligent efforts to avoid any material misrepresentation in any research report or investment recommendation.......... Seller should inform CFA Institute of the violation of the Code and Standards so he can clear himself of the possible misrepresentation. C........ 80‐81.......    20......... C....  However  Seller  is  aware  that  recently a competitor’s product recall received a large amount of adverse publicity....  the  product  recall  is  planned  to  be  a  quiet  affair. B.  Jonathan Seller... Volume 1......... Seller should do nothing as it may jeopardize the success of the issue........ D........... they perform random checks on members’ professional conduct........ Seller found out that the prospectus has concealed an  impending  product  recall  due  to  a  quality  control  error.  Since  the  number  of  items  affected  is  relatively  small... pp...... The circumstances that might prompt an enquiry are self-disclosure by a member........ Volume 1................. Seller should inform his supervisor and let him/her deal with the situation since Seller himself should not jeopardize the success of the issue...... According to the Code and Standards:  A.. The preliminary  prospectus has been distributed...... 9.... Reference: CFA® Program Curriculum.....  The  Professional  Conduct  staff  under  the  direction  of  CFA  Institute  are  least  likely  to  make  an  enquiry into a member’s conduct when:   A...

  Remuneration levels of investment professionals.  Deneuve may implement the new model without informing her private clients since they  would be unlikely to understand the model.  D.  Which of the following is not a concept covered by the CFA Institute Code of Ethics?  A.  Independent judgment.  the  valuation  model  produces  favorable  results  particularly when applied to certain industries.  D.  Tamara Deneuve. but not to others.  Deneuve has the sole right to any proprietary model she has developed.        22. Together  with her colleagues.  B. According to the Code and  Standards:  A.  C.    .  B.  Deneuve should not implement the model since it can only be applied to certain  industries. she has developed a new proprietary valuation model for emerging markets in  Asia. is an investment manager in charge of Asian equity portfolios.  Integrity and diligence. Deneuve has decided to implement  the new model to those industries but use the usual model for the others.Ethical and Professional Standards   31  21.  Competence.  C.  Back  testing  using  12‐month  earnings  data.  Deneuve must inform her clients prior to implementing the model. CFA.

..... Together  with her colleagues.... This falls under Standard V(B) Communication with Clients and Prospective Clients..... 83‐87. Deneuve must inform her clients prior to implementing the model........  Back  testing  using  12‐month  earnings  data.... Her clients must be informed in advance and given sufficient time to evaluate and decide whether such changes have a significant impact to their situation......... Deneuve may implement the new model without informing her private clients since they would be unlikely to understand the model..  Tamara Deneuve. Deneuve has decided to implement  the new model to those industries but use the usual model for the others. CFA.. but not to others...  the  valuation  model  produces  favorable  results  particularly when applied to certain industries.... According to the Code and  Standards:  A.    ............... Deneuve should not implement the model since it can only be applied to certain industries.. Reference: CFA® Program Curriculum.... B.... Correct Answer:  A . is an investment manager in charge of Asian equity portfolios..... C..... Volume 1..... pp.... LOS: Reading  2‐b  The application of a new valuation model may constitute a significant change to the investment process. D.32   Study Session 01:   21.... Deneuve has the sole right to any proprietary model she has developed............. she has developed a new proprietary valuation model for emerging markets in  Asia...

.... D .. C.. Competence....      .......... Independent judgment................ 12‐14.... Volume 1.... D...  Which of the following is not a concept covered by the CFA Institute Code of Ethics?  A.............. LOS: Reading  1‐c  Correct Answer:  Remuneration of investment professionals is not explicitly covered in the Code of Ethics. Integrity and diligence......... Reference: CFA® Program Curriculum.... pp. Remuneration levels of investment professionals.... B... Disclosure of compensation is stipulated in Standard IV(B) Additional Compensation Arrangements and in Standard VI(C) Referral Fees.....Ethical and Professional Standards   33  22.................

g.. or any  other type of security or investment.  The time value of money concept is one of the main principles of financial valuation. and internal rate of return) are the basic tools  used to support corporate finance decisions and estimate the fair value of fixed income. This session introduces two main building blocks of the quantitative analytical  tool kit: (1) the time value of money and (2) statistics and probability theory. and which will be used throughout the remainder of  the CFA curriculum. The calculations  based on this principle (e. the basic concepts of statistics and probability theory constitute the essential tools used in  describing  the  main  statistical  properties  of  a  population  and  understanding  and  applying  various  probability concepts in practice. future value. present value. equity.  Similarly.34   Study Session 02:   Study session 02: Quantitative Methods: Basic Concepts   This introductory study session presents the fundamentals of those quantitative techniques that are  essential in almost any type of financial analysis.    Reading 5: The Time Value of Money  Reading 6: Discounted Cash Flow Applications  Reading 7: Statistical Concepts and Market Returns  Reading 8: Probability Concepts          .

  B.  B.0833.000    .  D.  D.        2.  0.  The following income streams will be paid from an investment:  End year 1   End year 2   End year 3     At the end of year 3 the investment will have no remaining value.  C.  An analyst states “ ….260.9230.692.  $38.721.   This means that the analyst believes that the probability of it increasing the dividend is closest to:   A.580.    0.   $39.  $15.  $43.Quantitative Methods: Basic Concepts   35  1.0769.  0.000  $10.9166.  0.  $46.000  $25. the odds against the company increasing its dividend are twelve to one”.  C. If the discount rate is 8% the  present value of the investment is closest to:  A.

433 + $7.....08)2 (1... there is a one in thirteen chance it will happen. LOS: Reading  8‐c  Correct Answer:  Odds against of twelve to one..........      2............    .... $46.. $43. 197‐198... LOS: Reading  5‐d  PV = $15...580......  An analyst states “ …......... D.........0769. means the probability is 1/(12 + 1) = 0..9230...000 $25.. pp... B..721....... 0. A .. 320‐321. $39.... 0................ C..... Reference: CFA® Program Curriculum.. the odds against the company increasing its dividend are twelve to one”.08)3 = $13..08 (1.9166........692..000 $10............0769..000 At the end of year 3 the investment will have no remaining value... 0.. Volume 1... Volume 1..... D..............   This means that the analyst believes that the probability of it increasing the dividend is closest to:   A....000 + + 1.000 $25...000 $10.938 = $43..36   Study Session 02:   1..... 0..260.....889 + $21..0833.....  The following income streams will be paid from an investment:  End year 1 End year 2 End year 3 $15.... pp.. $38...... If the discount rate is 8% the present value of the investment is closest to: A... Correct Answer:  C ........... B.... C...260 Reference: CFA® Program Curriculum.

  16.  14.04%.08%. 22.  15.  B. New cash of $2  million is then invested in the fund and the fund increases in value to $15 million at the end of the  second year.Quantitative Methods: Basic Concepts   37  3.  A portfolio increases in value from $10 million to $12 million over the first year.  If  a  credit  card  company  charges  interest  at  a  rate  of  15%  compounded  monthly. The money‐weighted and time‐weighted rates of return are closest to (respectively):  A.  C.  12.  B.  then  the  effective annual rate of interest is closest to:  A.4%.  13.5%.  D.  C.8%.1%.5%. 22.0%.  10.        4.  D.  14.     .8%. 13. 27.  12.4%.86%.03%.

...1%. 15..86%.. New cash of $2  million is then invested in the fund and the fund increases in value to $15 million at the end of the  second year..0125) − 1 = 16.. 14.... 14......4%..... Volume 1...8%....5%... 182‐183.03%..........39% Reference: CFA® Program Curriculum.. 27......... A .... B...4%............ C. C. The time-weighted return is the geometric average of the returns in each period............08%.......04%. 222‐223... 12.............20)(1..... D.... 2 15 (1....... 13. pp... D . 22..... LOS: Reading  5‐c  m Correct Answer:  = (1 + 0. 13. Volume 1....5%..0%.. D.0714) = (1 + r ) 2 so r = 13.......38   Study Session 02:   3.8%......... R = 12. 16.8%........ The money‐weighted and time‐weighted rates of return are closest to (respectively):  A...........  then  the  effective annual rate of interest is closest to:  A..       4...........  If  a  credit  card  company  charges  interest  at  a  rate  of  15%  compounded  monthly....08% 12 r ⎞ ⎛ EAR = ⎜1 + S ⎟ − 1 ⎝ m⎠ Reference: CFA® Program Curriculum.. LOS: Reading  6‐c   Correct Answer:  10 + = The money-weighted return is calculated by solving (1 + R ) (1 + R )2 So.... pp..  A portfolio increases in value from $10 million to $12 million over the first year. 22........    ........ 12.. 10. B...

  Y should be accepted and X rejected.        Both projects should be accepted.  D.  from  each investment as shown below.  Holding period yield.  Which is the lowest yield on a 90‐day Treasury bill?  A.0  9. The cost of X is $2 million and the cost of Y is $10 million.  Bank discount yield. Which should be accepted for investment?  End of Year  1  2    A.1  1.8  Y  3.0  6.  C.  Both projects should be rejected.  C.  A  manager  is  offered  two  investments  projects  X  and  Y  with  net  cash  flows.  Effective annual yield.    .  in  $  million.  B.  Money market yield.Quantitative Methods: Basic Concepts   39  5.  X  1.  X should be accepted and Y rejected.  D.  B. The cost  of capital for X is 10% and for Y is 8%.

... Volume 1..........1 1....  Y should be accepted and X rejected....10 2 3........ and the money market yield being based on the purchase price.. 214‐216..40   Study Session 02:   5....  X should be accepted and Y rejected........  Both projects should be rejected.. Reference: CFA® Program Curriculum.  A  manager  is  offered  two  investments  projects  X  and  Y  with  net  cash  flows........ B...... The cost  of capital for X is 10% and for Y is 8%..... whereas the bank discount yield is based on the maturity value....      6..  B.. This is a result of the compounding in the effective annual yield calculation..  in  $  million.............08 2 t =0 t = −10 + Both investments have positive NPVs so they should both be accepted..08 1..... Holding period yield... LOS: Reading  6‐d  Correct Answer:  The holding period yield is not an annualized figure.. Money market yield..  D.. C.............  C..  X 1..    .. pp..  Which is the lowest yield on a 90‐day Treasury bill?  A....... Bank discount yield......0 A ...0 9.................... Reference: CFA® Program Curriculum..49 1.. The cost of X is $2 million and the cost of Y is $10 million..8 Y 3.  from  each investment as shown below.    Correct Answer:  Both projects should be accepted. The highest will be the effective annual yield.... followed by the bank discount yield.10 1.. Which should be accepted for investment?  End of Year  1  2  A.......... 229‐233. Effective annual yield.........1 1. followed by the money market yield.. so for 90-day paper it will be the lowest yield..0 + = 0..LOS: Reading  6‐a  N NPV (X) = ∑ NPV (Y) = ∑ N t =0 (1 + r ) (1 + r ) CFt CFt t = −2 + 1... pp. Volume 1.......49 1... B..... D.......0 9..8 + = 0.....

  D.  What  is  the  probability  of  a  customer. ordering neither potatoes nor rice?  A. chosen at random.86%.  D.  then  the  effective annual rate of interest is closest to:  A.24.  The  probability  of  a  customer  in  a  restaurant  ordering  potatoes  is  40%.    .  0.  0.  If  a  credit  card  company  charges  interest  at  a  rate  of  15%  compounded  monthly.04%.10.  C.  C.  10.00.14.Quantitative Methods: Basic Concepts   41  7.  0.  B.        8.  14.  the  probability  of  them  ordering  rice  is  60%  and  the  probability  of  them  ordering  both  is  10%.03%.  15.  16.  B.08%.  0.

...    .....  The  probability  of  a  customer  in  a  restaurant  ordering  potatoes  is  40%........ pp.  then  the  effective annual rate of interest is closest to:  A. pp.. D......  If  a  credit  card  company  charges  interest  at  a  rate  of  15%  compounded  monthly......08% 12 r ⎞ ⎛ EAR = ⎜1 + S ⎟ − 1 ⎝ m⎠ Reference: CFA® Program Curriculum.......1 = 0..... 0. C..42   Study Session 02:   7......... 0.10.. 0. D....00.....9 The probability of a customer ordering neither is 1 – 0.......        8.................... 325‐326.......  What  is  the  probability  of  a  customer........ chosen at random.. B. D ... B... 16.... Volume 1..1 Reference: CFA® Program Curriculum...9 = 0..08%.......... 15......... LOS: Reading  5‐c  m Correct Answer:  = (1 + 0........... 14... 182‐183. C...24.. B.......04%....... 0.86%.6 – 0......14....... Volume 1..4 + 0.....03%.......... 10.....LOS: Reading  8‐e  Correct Answer:  Use the general rule of addition to calculate the probability that a customer orders either potatoes or rice: P(A or B) = P(A) + P(B) – P(A and B) = 0...0125) − 1 = 16.......  the  probability  of  them  ordering  rice  is  60%  and  the  probability  of  them  ordering  both  is  10%. ordering neither potatoes nor rice?  A.

  0.   B.        10.  If P(A|B) = P(A) then the events A and B are:  A.12.  A shop which sells matches knows that 14 out of 20 boxes of matches will contain 100 matches  exactly.  mutually exclusive.08.  B.06.  0.Quantitative Methods: Basic Concepts   43  9.   exhaustive.  independent.  equally likely to occur.  0.    .09.  0.   D. the remainder will contain more than 100 matches. The probability of a customer picking up  a box of matches that contains more than 100 matches. and then picking up a second box containing  more than 100 matches is closest to:  A.   C.  C.  D.

D.... pp.  If P(A|B) = P(A) then the events A and B are:  A.08.......... Volume 1. 323‐324................. 0............ B. 0.. Volume 1....... which says that: P(A and B) = P(A) P(B|A) = 6/20 × 5/19 = 0.....08 Reference: CFA® Program Curriculum......... B.        10..  A shop which sells matches knows that 14 out of 20 boxes of matches will contain 100 matches  exactly.......    ... C. LOS: Reading  8‐f  Correct Answer:  Two events are independent if the occurrence of one event does not affect the probability of the other event occurring............. B. 0..06.......09................... B..... equally likely to occur.......... The probability of a customer picking up  a box of matches that contains more than 100 matches... C.. mutually exclusive........ p. 327..12..... exhaustive.. independent.... 0.........LOS: Reading  8‐e  Correct Answer:  Use the general rule of multiplication.........44   Study Session 02:   9.. D....... Reference: CFA® Program Curriculum............. and then picking up a second box containing  more than 100 matches is closest to:  A........ the remainder will contain more than 100 matches.......

  B. $28.  C.  D.        12.  12.68%.  C.  $24. $23.Quantitative Methods: Basic Concepts   45  11.50.    If  mortgage  payments  are  made  monthly.64.  12.55%.  12.00.  A  mortgage  has  an  annual  quoted  interest  rate  of  12  percent. then the effective annual interest rate is closest to:  A.  An investor puts $50.  D.  11.  B.  $23.000 into a mutual fund at the end of each quarter and his purchase prices  are $20.40%.  $24.36%.12.  $23.    . The average price that he pays per share is closest to:  A. $25.

..50............55%...... then the effective annual interest rate is closest to:  A.68%....000 into a mutual fund at the end of each quarter and his purchase prices  are $20. LOS: Reading  5‐c  m Correct Answer:  The effective annual rate (EAR) is given by: ⎛ r ⎞ EAR = ⎜1 + S ⎟ − 1 ⎝ m⎠ where m rs = = number of compounding periods per year quoted annual interest rate EAR = (1.... 272..    .40%. $23.....00..... 179‐180........ C..36%......... 12...............12....... Volume 1.........68% Reference: CFA® Program Curriculum... D....... $23......... $24........... The average price that he pays per share is closest to:  A..01)12 .. pp. C... XH = n n ⎛ 1 ∑⎜ ⎜ i =1 ⎝ X i ⎞ ⎟ ⎟ ⎠ = 4 1 1 1 ⎞ ⎛ 1 + + ⎟ ⎜ + ⎝ 20 25 28 23 ⎠ = 4 = $23.......1692 Reference: CFA® Program Curriculum. D ... 12... $25... $28....  A  mortgage  has  an  annual  quoted  interest  rate  of  12  percent. B.    If  mortgage  payments  are  made  monthly...... $24. LOS: Reading  7‐d  Correct Answer:  The harmonic mean is the average price on a per share basis... D...    12...1 = 12..... 12.......46   Study Session 02:   11........... Volume 1... 11....... B..  An investor puts $50......64 0. $23.64......... B........ p.

492.  D.1%.000.        14.500.    .  The geometric mean rate of return is closest to:  A.000 earns a return of 5% compounded continuously for 8 years.  The future  value is closest to:  A.000.477.000.  $1.  C.  B.400.2%.  $1.Quantitative Methods: Basic Concepts   47  13. and at the end of the third year it  has risen to $115 million.  B.  The  value  of  a  portfolio  starts  at  $100  million.000.  3.7%.  6.  4.  C.  $1.  A deposit of $1.8%.  4.  $1.  D.000. at the end of the second year it has risen to $105 million.  at  the  end  of  the  first  year  it  has  fallen  to  $80  million.

7183  Reference: CFA® Program Curriculum..... pp. D.492..... at the end of the second year it has risen to $105 million.. 4....8%.825 Note: to find the programmed value of e on your CFA Institute-approved financial calculator.. C.... Volume 1.......000....095) 1/3 – 1 = 0....000... 3. $1........000 earns a return of 5% compounded continuously for 8 years..  The geometric mean rate of return is closest to:  A........ C..... $1....    ....400....48   Study Session 02:   13. Volume 1.1%...... 269‐270...........000........80 x 1........0476 Reference: CFA® Program Curriculum........ B... use the keystrokes: HP‐12C  BA II Plus    1  g   ex   1  2nd  [ex]  2.7%............ LOS: Reading  8‐d  Correct Answer:  FV N = PV e rS × N The future value is given by = $1.  The  value  of  a  portfolio  starts  at  $100  million.........313 x 1. and at the end of the third year it  has risen to $115 million.....(1 + R n ) − 1 = (0.....  The future  value is closest to:  A....500..05×8 = $1.000.. pp..............000 .. 6. D..... $1...    14. 491...... 171‐182.000..... C ... B.......... $1... C ... LOS: Reading  7‐d  Correct Answer:  R G = = (1 + R 1 )(1 + R 2 ).  at  the  end  of  the  first  year  it  has  fallen  to  $80  million......2%......477...7183  2.000 e 0. 4.  A deposit of $1.

  D.  There  is a  competition  in which  there are  six  contestants  and you  need  to  pick  winners  for  1st.  C.0   5.  The mean.0  6.0  5.  B.Quantitative Methods: Basic Concepts   49  15.  120.0  6. median and mode are closest to:    A.0  5.            Mean    5.0  5.4  5. how many ways can they be selected?   A.0    .        16.0          Median   5.  720.0          Mode   6.  2nd and 3rd places.  36.4  5.  D.4  5.  B.  The following information was collected on the average numbers of hours worked per day by the  15 employees of a shop over the last month:   5  6  5  5  8  4  4  2  4  7  6  7  7  5      6  20.  C.

.......... 5..0 B.  There  is a  competition  in which  there are  six  contestants  and you  need  to  pick  winners  for  1st............  120............  The following information was collected on the average numbers of hours worked per day by the  15 employees of a shop over the last month:   5 58 4 4 6 7 6 54 2 7 7 5 The mean.... Reference: CFA® Program Curriculum.  2nd and 3rd places. LOS: Reading  7‐d  ∑ w i Xi w Mean = X = ∑ i = [1(2) + 3(4) + 4(5) +3(6) +3(7) +1(8)]/15 = 5........ 5... The mode is the most frequently occurring observation..................      16...0 6...... p.....    Correct Answer:  C ....50   Study Session 02:   15.... LOS: Reading  8‐n  This requires the permutation formula since the order of the r objects matters......4 C.......  B.0 5..  36.. 5.. how many ways can they be selected?   A. which is 5..0 6..  720.. 5........  n! Number of ways = ( n − r )! = 6!/(6 – 3)! = 120 Reference: CFA® Program Curriculum... which is 5.....0 6.............................  C......... pp.    .....4 5.. Volume 1...... 255‐263.. median and mode are closest to: Mean Median A.. Volume 1......... 356......0 5. so apply: 20.0 Correct Answer:  6 Mode C ....  D..4 The median is the middle observation....0 D.4 5..0 5...

   the probability that two or more events will occur concurrently.  B.  It is always lower than the time‐weighted rate of return.  C.    .  It is the internal rate of return.  the probability that an event will happen more than once.  C.  Conditional probability refers to:  A.  Which  of  the  following  statements  is  most  accurate  regarding  a  money‐weighted  rate  of  return  for a portfolio?  A.  D.Quantitative Methods: Basic Concepts   51  17.  It is the geometric average of the periodic rates of return.  B.  D.  the probability of a particular event occurring given that another event has already  occurred.  the probability that one of two mutually exclusive events will occur.  It is the arithmetic average of the periodic rates of return.        18.

 Volume 1.... It is the internal rate of return. It is the geometric average of the periodic rates of return................. the probability that one of two mutually exclusive events will occur. C.......    ...... pp. It is always lower than the time-weighted rate of return......................... p. It is ‘conditional’ on the other event............ D.. B... Reference: CFA® Program Curriculum................ It is the arithmetic average of the periodic rates of return... 322.......... the probability of a particular event occurring given that another event has already occurred. C and D refer to arithmetic and geometric time-weighted rates of return... Reference: CFA® Program Curriculum........... A ............... LOS: Reading  8‐d  Correct Answer:  Conditional probability is the probability of an event occurring given another event has already occurred.. C..52   Study Session 02:   17................. 221‐229. LOS: Reading  6‐c  Correct Answer:  B will not be true if there have been cash flows into the portfolio before superior performance..........  Conditional probability refers to:  A........ the probability that two or more events will occur concurrently......... Volume 1... the probability that an event will happen more than once. D. B.... D .......        18......  Which  of  the  following  statements  is  most  accurate  regarding  a  money‐weighted  rate  of  return  for a portfolio?  A....

000 Beginning value $100.   .  29.  28.Quantitative Methods: Basic Concepts   53  19.000 $100. The dispersion of returns relative to the mean is lower for stock A than stock B.200.  The following data is provided on the quarterly performance of a fund.000  $1.500.000 Ending value The time‐weighted return for the year is closest to:  A.000 $1.000.  D.600.000 $1. D.000 ($200.000 $1.500.7%.        6.  B.000  $1.1%.000)  $300.  61.6%.   Which of the following statements is the most accurate?  A.200. The standard deviation of stock A is double that of stock B.  Stock  A  has  a  coefficient  of  variation  of  30%  and  stock  B  has  a  coefficient  of  variation  of  60%.000 Cash inflow at beginning $1. B. The variance of stock A is double that of stock B. The dispersion of returns relative to the mean is higher for stock A than stock B.500.      1st Quarter 2nd Quarter $1.000 20. C. if the mean returns of both stocks are the same. if the mean returns of both stocks are the same.4%.  3rd Quarter  4th Quarter $1.500.  C.

.300...000 ($200..500...800.800.000 ...1%. 3rd Quarter $1....$1..  The following data is provided on the quarterly performance of a fund. 6......500..000  $1.2909 = 29.500...$1....000 Beginning value $100..100. 223‐226.000 Ending value The time‐weighted return for the year is closest to:  A. 29.000 Cash inflow at beginning $1...1538) x (1..$1.1538) x (0.000 = -11..... HPR = ($1..09% Q2..000 $100...000 $1. Volume 1..000 = 9...      1st Quarter 2nd Quarter $1....8889) –1 = 0.600..    .....300.38% Q3..300...500..300.000)/$1..000 4th Quarter  $1..000  $300.500.54   Study Session 02:   19.6%...4%. 28...000  Correct Answer:  C .200. D. LOS: Reading  6‐c  The first step is to calculate the returns for each quarter: Q1.000)/$1..000)/$1.38% Q4....000 .000 .000 = 15.000) $1.....$1. B.000 ..... HPR = ($1..000 = 15..1% Reference: CFA® Program Curriculum. HPR = ($1.000..7%..200. pp.000 $1..600.100. C. 61...........000)/$1. HPR = ($1..0909) x (1..500..11% Then calculate the geometric average to get the time-weighted return: (1.....200..

... Volume 1................. The standard deviation of stock A is double that of stock B..   Which of the following statements is the most accurate?  A... The coefficient of variation measures the dispersion of returns relative to the mean return........... The variance of stock A is double that of stock B. if the mean return is the same the standard deviation of stock A is half that of B....LOS: Reading  7‐h  CV = s X X 100 Answers C and D are incorrect since.... D.... The dispersion of returns relative to the mean is lower for stock A than stock B...... Correct Answer:  A... C..... B...... if the mean returns of both stocks are the same.. Reference: CFA® Program Curriculum.......  Stock  A  has  a  coefficient  of  variation  of  30%  and  stock  B  has  a  coefficient  of  variation  of  60%..... pp.. if the mean returns of both stocks are the same.Quantitative Methods: Basic Concepts   55  20.... The dispersion of returns relative to the mean is higher for stock A than stock B............    ...... 292‐294....

  33.0%.3%.  D.  60.  42.0%.    .   The  shop  knows  that  3%  of  the  pens  supplied  by  Mountain  Pens  are  defective  and  5%  of  the  pens  supplied by Valley Pens are defective.  The pens in the shops are mixed together.  B.  A shop buys pens from two manufacturers. If a pen is chosen at  random and found to be defective what is the probability that it was supplied by Mountain Pens?  A.3%.  55.56   Study Session 02:   21. 55% from Mountain Pens and 45% from Valley Pens.  C.

000 at the end of each year for the next ten years. the value of the investment at the end of ten years will be closest to:  A.  A person invests $10.   .708. B. if the investment earns 6%  interest annually.708. $134. D.350. $139. C. $131.808. $149.Quantitative Methods: Basic Concepts   57  22.

... LOS: Reading  8‐m  Correct Answer:  P(A 1 | B) = Apply Bayes’ formula: P(A 1 )P(B | A 1 ) P(A 1 )P(B | A 1 ) + P(A 2 )P(B | A 2 ) define A1 .....  A shop buys pens from two manufacturers.. 60.. D.......45 × 0.... 42.0%.    ..55 × 0.58   Study Session 02:   21....  The pens in the shops are mixed together..........3%.. 55% from Mountain Pens and 45% from Valley Pens.3%...Mountain Pens supply the pen A2 ....... 349‐353. C..05) = 0..Valley Pens supply the pen B ...03) + (0... Volume 1......... 55........ B......423 Reference: CFA® Program Curriculum. B. 33..............03 (0....0%....   The  shop  knows  that  3%  of  the  pens  supplied  by  Mountain  Pens  are  defective  and  5%  of  the  pens  supplied by Valley Pens are defective. pp.the information that the pen is defective P(A 1 | B) = 0....55 × 0.. If a pen is chosen at  random and found to be defective what is the probability that it was supplied by Mountain Pens?  A..

00 N = 10.    Explicit use of annuity formula: Calculator keystrokes for:  HP‐12C  f CLEAR FIN 10000 CHS PMT BA II Plus  2nd [QUIT] 2nd [CLR TVM] 10000 +/.... use the annuity formula or a financial calculator: This is an annuity type question.807...708....808.............00 = $10.. Volume 1...000 at the end of each year for the next ten years.000 (1 + 0....807..  A person invests $10.. $131....... Or use a financial calculator..06 = $10..000.708. A..PMT = -10... if the investment earns 6%  interest annually.00 6 I/Y 10 N CPT FV I/Y = 6.808 Reference: CFA® Program Curriculum.. pp..000 × 13..00 FV = 131.. the value of the investment at the end of ten years will be closest to:  A.00 FV FV = 131..Quantitative Methods: Basic Concepts   59  22... $149............95 0.95 A = $10.LOS: Reading  5‐d  Correct Answer:  This is a question asking for the future value of an annuity.... C.00 6.000 r = 6% = 0. D.. $134.06 N = 10 FVN = A (1 + r )N 1 r   6 i 10 -10.... $139..06) 1 10 n 10......... B....... 183‐185.      ....350.1808 = $131.......000....

  Hypothesis testing is a closely related topic. It is important that analysts  properly  understand  the  assumptions  and  limitations  when  applying  these  tools  as  mis‐specified  models or improperly used tools can result in misleading conclusions. Probability theory and calculations are  widely  applied  in  finance.    Reading 9: Common Probability Distributions  Reading 10: Sampling and Estimation  Reading 11: Hypothesis Testing  Reading 12: Technical Analysis      . This session presents the techniques that can be applied  to accept or reject an assumed hypothesis (null hypothesis) about various parameters of a population.  in  the  field  of  investment  and  project  valuation  and  in  financial risk management.  can  be  observed. you will also learn about the fundamentals of technical analysis.  rather  than  the  whole  population.  Furthermore.  for  example.60   Study Session 03:   Study Session 03: Quantitative Methods: Application   This  study  session  introduces  the  discrete  and  continuous  probability  distributions  that  are  most  commonly used to describe the behavior of random variables..g.  this  session  teaches  how  to  estimate  different  parameters  (e.  mean  and  standard  deviation)  of  a  population  if  only  a  sample.  Finally.

  A standard normal distribution with low standard deviation will be less peaked than a  standard normal distribution with higher standard deviation.Quantitative Methods: Applications   61  1.  Which of the following statements regarding normal distributions is most accurate?   A. the returns  of a portfolio containing these securities are normally distributed.  D.  C. This is an  example of:  A.        .  stratified random sampling.  cluster sampling.  An analyst is selecting a sample from the orders received from a firm’s customers.  B.  If the returns on individual securities in a portfolio are normally distributed. The orders are  time stamped and he decides to include in the sample every 5th order received by the firm.   systematic random sampling.  C.        2.  B.   The normal distribution is a good model for the distribution of asset prices.  simple random sampling.   The mean and standard deviation of the standard normal distribution are both 1.  D.

.. B....... stratified random sampling. Statement D is accurate.. the returns of a portfolio containing these securities are normally distributed. A standard normal distribution with low standard deviation will be less peaked than a standard normal distribution with higher standard deviation................        2........ cluster sampling.. so statements B and C are not correct....  An analyst is selecting a sample from the orders received from a firm’s customers. pp............. D ..... D.......................... C..    .. D. If the returns on individual securities in a portfolio are normally distributed.. 422‐423....  Which of the following statements regarding normal distributions is most accurate?   A............................. Reference: CFA® Program Curriculum.......... Correct Answer:  D .. LOS: Reading  10‐b  Correct Answer:  Systematic random sampling is when we select every kth member of a population.... Volume 1.. pp.. The orders are  time stamped and he decides to include in the sample every 5th order received by the firm.. often used when we cannot number or label the members of a population............ Reference: CFA® Program Curriculum...... Volume 1... B........ C. systematic random sampling...... 389‐397........ simple random sampling... The normal distribution is a good model for the distribution of asset prices... By definition a standard normal distribution has a mean of 0 and standard deviation of 1....... LOS: Reading  9‐f  The normal distribution is a good model for many asset returns but not prices.. The mean and standard deviation of the standard normal distribution are both 1..62   Study Session 03:   1.... This is an  example of:  A..

 If  the rejection point for a one‐tailed test with 19 degrees of freedom is 1.  A company is analyzing the days that employees take off as sick leave each year and is concerned  that the number of days that employees are taking off has risen above the past average number of 4. if the population is approximately normally  distributed.729 at the 5% significance level  we can conclude that:  A.  the mean number of days is still 4 days or less at the 5% significance level.5 with a standard deviation of 1.  B.  population statistic.  C.  C.  we should use the z‐test.  A hypothesis is a statement about a:  A.  D.  B.5 days.Quantitative Methods: Applications   63  3.  It  is  assumed  that  the  population  is  approximately  normally  distributed.  population parameter.  using the t‐statistic is not valid for a small sample. not the t‐test.  sample parameter.  A  sample  of  20  employees is taken and the mean number of days taken is 4.  the mean number of days is more than 4 days at the 5% significance level.    .0  days.  D.  sample statistic.          4.

. using the t-statistic is not valid for a small sample....... t 19 = x −µ 4..... We use data from a sample to test whether we should accept or reject the hypothesis.. sample statistic...729 at the 5% significance level  we can conclude that:  A... we should use the z-test. pp... B... D .... If  the rejection point for a one‐tailed test with 19 degrees of freedom is 1.... 456‐457..  A  sample  of  20  employees is taken and the mean number of days taken is 4...335 n This is within the confidence interval so we do not reject the null hypothesis. C...............  A company is analyzing the days that employees take off as sick leave each year and is concerned  that the number of days that employees are taking off has risen above the past average number of 4.... C.......0  days. Volume 1..    .............49 s 1.. population statistic............      4...0 0..5 − 4... Volume 1...5 with a standard deviation of 1.. D....LOS: Reading  11‐e  Correct Answer:  Set the null hypothesis as H0: µ ≤ 4...................64   Study Session 03:   3........LOS: Reading  11‐a  Correct Answer:  A hypothesis is a statement about a population parameter.5 days. Reference: CFA® Program Curriculum.... if the population is approximately normally distributed....  It  is  assumed  that  the  population  is  approximately  normally  distributed. not the t-test....... 466‐474.... the mean number of days is still 4 days or less at the 5% significance level....... D................ Reference: CFA® Program Curriculum....5 20 0. sample parameter.0 We can use the t-test since we are assuming the population is normally distributed..... C .... population parameter.5 = = = 1... pp.. B............. the mean number of days is more than 4 days at the 5% significance level.  A hypothesis is a statement about a:  A.....

  The standard error of the sample mean is closest to:  A.  B.28.  D.    .  The mean of the distribution is zero.  Lognormal distributions are frequently used to reflect the distribution of stock returns.Quantitative Methods: Applications   65  5.10.  C.   0.  Which of the following statements regarding lognormal distributions is most accurate?  A.  D.  The standard deviation of a population is 25 and a sample of 50 observations is taken from the  population.  0.  10.  Y is a lognormal distribution if LnY is normally distributed.  B.54.  C.        6.  The distribution is bell shaped.00.  3.

.. C .. B........... C ..........54............ 10......... 3.. 0......... D....    .... Volume 1..07 = 3........ σx = σ n Reference: CFA® Program Curriculum.. is not correct.00...... Y is a lognormal distribution if LnY is normally distributed......28......... Reference: CFA® Program Curriculum.. D. the lower bound is zero.. 400‐406............        6... is not correct.... Lognormal distributions are frequently used to reflect the distribution of stock returns... LOS: Reading  9‐j  Correct Answer:  A. B........ pp......... B...10.. The distribution is bell shaped.............. 429. C.....  The standard deviation of a population is 25 and a sample of 50 observations is taken from the  population.54.. they are frequently used to show the distribution of stock prices..........  The standard error of the sample mean is closest to:  A... they are positively skewed distributions. The mean of the distribution is zero.. Volume 1..LOS: Reading  10‐e  Correct Answer:  The standard error of the sample mean is given by = 25/7.... C.....  Which of the following statements regarding lognormal distributions is most accurate?  A... 0. is not correct........... D...66   Study Session 03:   5.. p.......

  D.  31.  it is approximately a normal distribution.  B.  B.  the standard error tends to one as the size of the samples increases. The  probability of the stock market falling by more than 2% in a year is closest to:  A.  The  Central  Limit  Theorem  states  that  if  the  sampling  distribution  of  the  sample  mean  is  calculated using samples of equal size from a population that is not normal. then:  A.   the mean of the distribution will be smaller than the population mean.  2.  15.9%.  D.3%.  4.  C.  A stock market rises by an average of 10% a year and the standard deviation of returns is 6%.        8.  C.7%.Quantitative Methods: Applications   67  7.6%.    .  the dispersion of the distribution is more than the dispersion of the population.

or equal if n = 1. B... D.. The  probability of the stock market falling by more than 2% in a year is closest to:  A... it is approximately a normal distribution.......... B..... the standard error tends to zero as the sample size increases....6%.68   Study Session 03:   7.. the mean of the distribution will be smaller than the population mean. A ....... is not correct....... Reference: CFA® Program Curriculum....... Volume 1.. D. then:  A. 4.3% will be below -2% and 2. A . pp... pp... Therefore 2...    ........... the standard error tends to one as the size of the samples increases....... A is correct. C......9%......7%...  A stock market rises by an average of 10% a year and the standard deviation of returns is 6%...3% will be above 22%..6% lie outside this range....... the distribution will be approximately normal although the underlying population may not be normally distributed......3%. 15..... D... C.......4% of observations fall between the mean plus or minus two standard deviations so 4......... the dispersion is less than that of the population.... the mean of the distribution will be the same as the population mean........ LOS: Reading  10‐f  Correct Answer:  B...... is not correct..        8...LOS: Reading  9‐g  Correct Answer:  A fall of 2% is two standard deviations from the mean.. 389‐393..... C. 428‐431............ 31.... is not correct.... Volume 1. 2... 95........................... the dispersion of the distribution is more than the dispersion of the population.  The  Central  Limit  Theorem  states  that  if  the  sampling  distribution  of  the  sample  mean  is  calculated using samples of equal size from a population that is not normal.... Reference: CFA® Program Curriculum.

  C.    .  Hypothesis test  a one‐tailed test  a one‐tailed test  a two‐tailed test  a two‐tailed test  Test statistic  t‐test  z‐test  t‐test  z‐test  look‐ahead bias. and should the z‐test or t‐test be used?     A.  data‐snooping bias.  Historic  analysis  suggests  that  stocks  trading  on  a  low  price/book  value  have  tended  to  outperform the market.  Hypothesis  testing  is  used  to  determine  the  mean  return  of  mutual  funds  in  a  single  period.  B.  B.  survivorship bias.  data‐mining bias.  D.        10.  D.  If the analysis has not included companies that have gone bankrupt then the  analysis could be biased due to:  A.  C.  A  sample of 25 funds is taken and the null hypothesis is defined as the mean is equal to 12%.Quantitative Methods: Applications   69  9.  Is this an  example of a one or two‐tailed test.

.... Volume 1....  Hypothesis  testing  is  used  to  determine  the  mean  return  of  mutual  funds  in  a  single  period........ the companies that went bankrupt would have been trading on low price/book multiples.... and this would have lowered the average performance of the low price/book value stocks............. 444‐446...... The z-test should only be used for large samples... B...... data-mining bias..........LOS: Reading  11‐a and 11‐e  If there is no direction (greater or less than) in the null hypothesis it is two-tailed... Give the sample size of less than 30 funds the t-test should be used.... pp..        10...... C... Reference: CFA® Program Curriculum......... Volume 1.......  A  sample of 25 funds is taken and the null hypothesis is defined as the mean is equal to 12%......... C. Reference: CFA® Program Curriculum................70   Study Session 03:   9...... survivorship bias... D.... pp.... data-snooping bias.. Hypothesis test a one-tailed test a one-tailed test a two-tailed test a two-tailed test Test statistic t-test z-test t-test z-test Correct Answer:  C ....  If the analysis has not included companies that have gone bankrupt then the  analysis could be biased due to:  A.... B. 458 and 466‐474. and should the z‐test or t‐test be used?   A..........  Historic  analysis  suggests  that  stocks  trading  on  a  low  price/book  value  have  tended  to  outperform the market. C . LOS: Reading  10‐k  Correct Answer:  It has been argued that if all companies had been included........ D.. look-ahead bias..............  Is this an  example of a one or two‐tailed test..    ...........

000 per month and he decided to look at a sample 100 workers to see if this is correct.  D.   The  sample  mean  is  $5.  C.018  with  a  standard  deviation  of  80.  In hypothesis tasting a p‐value of 0.    If  he  sets  the  null  hypothesis  as  the  population mean is $5.  reject the null hypothesis at both the 1% and 5% significance level.  not reject the null hypothesis at the 1% significance level but reject it at the 5%  significance level.  there is extremely strong evidence that H0 should be rejected.1 indicates that:   A.1 of observing a sample value at least as extreme as the value  observed.  B.000 he should:  A.  An  analyst  is  studying  the  monthly  income  of  workers  at  a  factory.    He  is  told  that  the  mean  income is $5. assuming H0 is rejected.  not reject the null hypothesis at the 5% significance level but reject it at the 1%  significance level. assuming H0 is correct.  there is extremely strong evidence that H0 should not be rejected.  there is a probability of 0.    .   D.         12.   C.1 of observing a sample value at least as extreme as the value  observed.   not reject the null hypothesis at both the 1% and 5% significance level.Quantitative Methods: Applications   71  11.  there is a probability of 0.  B.

.. C.  In hypothesis tasting a p‐value of 0.....96 (the critical value for the 5% significance level) so we can reject the hypothesis at the 5% significance level.018  with  a  standard  deviation  of  80......1 of observing a sample value at least as extreme as the value observed.. assuming H0 is correct.....LOS: Reading  11‐e  Correct Answer:  Z = (5018-5000)/8 = 2.... D.        12................ Reference: CFA® Program Curriculum...... not reject the null hypothesis at both the 1% and 5% significance level.. not reject the null hypothesis at the 5% significance level but reject it at the 1% significance level...........  An  analyst  is  studying  the  monthly  income  of  workers  at  a  factory.1 indicates that:   A..... reject the null hypothesis at both the 1% and 5% significance level... C... 465‐466........ D........ there is a probability of 0..... LOS: Reading  11‐c  The p-value is the probability of observing a value as extreme or more extreme than the value observed.... Reference: CFA® Program Curriculum.......... C ................. 466‐474....... there is extremely strong evidence that H0 should be rejected. Correct Answer:  C .. This is less than 2.. However it is more than 1.... there is extremely strong evidence that H0 should not be rejected..25.1 of observing a sample value at least as extreme as the value observed.000 per month and he decided to look at a sample 100 workers to see if this is correct.    ..001 or less.....    If  he  sets  the  null  hypothesis  as  the  population mean is $5..000 he should:  A.......... B....    He  is  told  that  the  mean  income is $5........... not reject the null hypothesis at the 1% significance level but reject it at the 5% significance level... pp.. for it to be extremely strong evidence it would need to be 0..... Volume 1.. assuming H0 is rejected........ Volume 1. B..........72   Study Session 03:   11. pp. there is a probability of 0.........58 (the critical value for the 1% significance level) so there is no evidence to reject the null hypothesis at the 1% level....   The  sample  mean  is  $5.

   the null hypothesis is rejected and the results are not consistent with a mean of 1.4%  the null hypothesis is not rejected and the results are not consistent with a mean of 1.  D.  the mean for a single non‐normally distributed population.  the mean for a single normally distributed population.  Given that t0.4% in line with the risk taken on by the fund and wish to decide at the 10% significance  level whether the results are consistent with a population mean return of 1.4%  A.  B.4%.  A chi‐square test statistic ( χ ) could be used for hypothesis tests for  2 the null hypothesis is rejected and the results are consistent with a mean of 1.Quantitative Methods: Applications   73  13.  You expected the fund to have achieved  a return of 1.  You are analyzing the monthly returns from a fund over the last year and calculate that the mean  return was 1.  C.25% with a sample standard deviation of 1.4%.  the variance for a single non‐normally distributed population.  D.  the variance for a single normally distributed population.05.  C.796 you can conclude that:  A.11=  1.   the null hypothesis is not rejected and the results are consistent with a mean of 1.    .  B.4%.        14.0%.

. B.      14..25 − 1.... Reference: CFA® Program Curriculum. We need to apply the t-test because it is a small sample..11=  1...4% the null hypothesis is not rejected and the results are not consistent with a mean of 1. the null hypothesis is rejected and the results are consistent with a mean of 1..... It is always 0 or a positive number and has different distributions based on the number of degrees of freedom.... pp..4 0....29 1.... D....LOS: Reading  11‐e  Correct Answer:  Set the null hypothesis as H0: µ = 1..........74   Study Session 03:   13. the null hypothesis is rejected and the results are not consistent with a mean of 1.. 466‐474............... the null hypothesis is not rejected and the results are consistent with a mean of 1..  You are analyzing the monthly returns from a fund over the last year and calculate that the mean  return was 1....4%. LOS: Reading  11‐f  Correct Answer:  A chi-square test statistic is used to test for variance when we have a normally distributed population....05..... Reference: CFA® Program Curriculum.......................4%. C. the variance for a single non-normally distributed population.0 12 n This is within the confidence interval so the null hypothesis is not rejected and the results are consistent with the mean return being 1.. t n −1 = x −µ 1.25% with a sample standard deviation of 1.. D...........52 s 0............  A chi‐square test statistic ( χ ) could be used for hypothesis tests for  2 A...4%... Volume 1....0%. the mean for a single normally distributed population... C...... the mean for a single non-normally distributed population.......4% in line with the risk taken on by the fund and wish to decide at the 10% significance  level whether the results are consistent with a population mean return of 1...... B. 482‐484...........4% B.......4%..... pp..4%.15 = =− = −0....796 you can conclude that:  A.........    ......  Given that t0... B.. Volume 1........  You expected the fund to have achieved  a return of 1.. the variance for a single normally distributed population...

  C.  B.  simple random sampling.0 and 40.0 and 30.  systematic sampling.0.    .  the  number  taken  proportional  to  the  size  of  the  subpopulation.1 and 37.  B.2 and 34.  between 15.  structured sampling.  stratified random sampling.  D.  C.0. The 95% confidence interval for the population mean is closest to:  A.  Large  samples  are  taken  from  a  normal  population.  between 12.9.  D.  When  selecting  a  sample  a  population  is  first  divided  into  subpopulations  and  then  random  samples  are  taken  from  each  subpopulation. This is an example of:  A.  between 20.  the  sample  mean  is  25  and  the  sample  standard deviation is 5.8.  between 15.        16.Quantitative Methods: Applications   75  15.

 pp. The 95% confidence interval for the population mean is closest to:  A..0.. B. D.  the  number  taken  proportional  to  the  size  of  the  subpopulation.................... between 20....96 standard deviations.............. Reference: CFA® Program Curriculum. This is 25 ± (1. D............ systematic sampling......... simple random sampling.. Volume 1.....76   Study Session 03:   15..    .....2 and 34. B......... 433‐435......... stratified random sampling... C.9.. D .... 422‐425...8.....0............... between 12....... C.... between 15... pp..  Large  samples  are  taken  from  a  normal  population........0 and 40.. Reference: CFA® Program Curriculum...        16... LOS: Reading  10‐b  Correct Answer:  Stratified random sampling ensures that different subdivisions within a population are represented in the sample.....  When  selecting  a  sample  a  population  is  first  divided  into  subpopulations  and  then  random  samples  are  taken  from  each  subpopulation. between 15.... LOS: Reading  10‐f  Correct Answer:  The 95% confidence interval is given by sample mean plus or minus 1. This is an example of:  A.. structured sampling...96 × 5) = 25 ± 9..1 and 37...... Volume 1.......2 and 34.......  the  sample  mean  is  25  and  the  sample  standard deviation is 5.8 which is between 15. B........0 and 30.8............

  a smaller standard error of the sample means.        18.  C.  a larger dispersion in the distribution of the sample means.  D.  the mean of the sampling distribution of the sample mean being equal to the population  mean.  B.  Skew      Often used to describe asset  prices  returns  prices  returns  positively skewed     positively skewed    negatively skewed     negatively skewed.  the sampling distribution of the sample mean being approximately a normal distribution.      .Quantitative Methods: Applications   77  17.  D.  C.  If a very large sample size is used it is least likely to lead to:  A.  Which of the following describe lognormal distributions?    A.  B.

.............. D......... Reference: CFA® Program Curriculum........ so B is the correct answer...78   Study Session 03:   17.......... Reference: CFA® Program Curriculum.  Which of the following describe lognormal distributions?  A.......... The bound of zero means the distribution is often used to model asset prices..... D. 428‐431. Skew positively skewed positively skewed negatively skewed negatively skewed...... However a large sample size will lead to sample means being close to the population mean and therefore less disperse. Volume 1....... C. pp..... a larger dispersion in the distribution of the sample means............ a smaller standard error of the sample means............ B....... Volume 1. C........... LOS: Reading  9‐j  A lognormal distribution is bounded by zero on the left and has a long tail on the right so it is positively skewed....... B............    ..... Often used to describe asset prices returns prices returns Correct Answer:  A .............        18........ pp..... the mean of the sampling distribution of the sample mean being equal to the population mean. 400‐406.  If a very large sample size is used it is least likely to lead to:  A.....LOS: Reading  10‐e  Correct Answer:  A large sample size will lead to a smaller standard error of the sample mean since the standard error is equal to the population standard deviation divided by the square root of the sample size.............. the sampling distribution of the sample mean being approximately a normal distribution....... B.. The central limit theorem says that the sampling distribution of the sample mean is close to a normal distribution if the sample size is large (greater than thirty)..... The mean of the sample means will be the same as the mean of the population....

  the standard deviation of returns.Quantitative Methods: Applications   79  19.  An  investment  manager  is  managing  a  diversified  portfolio  of  international  equities  and  the  performance benchmark is the MSCI World index.  B.   D.  the absolute deviation of returns relatives to the MSCI World Index.  the standard deviation of the sampling distribution of sample mean.  C.  the risk that the value of the portfolio falls below a critical level.  the standard deviation of the sample divided by the standard deviation of the  population.  the average standard deviation of each sample.  C.    . Shortfall risk for the portfolio refers to:  A.        20.  D.   B.  the standard deviation of the sample minus the standard deviation of the population.  the standard deviation of returns relatives to the MSCI World Index.  The standard error of the sample mean is:  A.

.... the average standard deviation of each sample..... the standard deviation of the sampling distribution of sample mean...    ....... the standard deviation of the sample divided by the standard deviation of the population... B.................... Shortfall risk for the portfolio refers to:  A..... B....... pp................. the absolute deviation of returns relatives to the MSCI World Index...... pp.        20....... it can be reduced by minimizing the probability that the return falls below a certain minimum level.....  The standard error of the sample mean is:  A......80   Study Session 03:   19... Volume 1. Volume 1..... The central limit theorem says that this is equal to the population standard deviation divided by the square root of the sample size.......... B. Reference: CFA® Program Curriculum..... B.... D....... 428‐431..LOS: Reading  10‐e  Correct Answer:  The standard deviation of a sample mean is the standard error............  An  investment  manager  is  managing  a  diversified  portfolio  of  international  equities  and  the  performance benchmark is the MSCI World index............. the standard deviation of returns relatives to the MSCI World Index...... C............ the standard deviation of returns.. 397‐ 400. Reference: CFA® Program Curriculum.... the standard deviation of the sample minus the standard deviation of the population........ D. the risk that the value of the portfolio falls below a critical level.. C................... LOS: Reading  9‐i  Correct Answer:  Shortfall risk is the risk that the value of a portfolio falls below a certain level..

  The sample mean is 6.48 and 6.  A  client  wishes  to  protect  the  value  of  his  capital.  The 99% confidence level is closest to:  A.39.  D.95 and 6.52.61 and 6.  Asset  A  B  C  D    A.  B.  Expected Return  25  15  10  8  Standard Deviation    12  8  6  5    .        22.55.  C.  Portfolio D.Quantitative Methods: Applications   81  21.  between 5.  D.  Portfolio C.  between 5.  B.    Which  of  the  following  portfolios  will  be  optimal from a safety‐first analysis?  between 4.  Portfolio B.  C.05.  between 5.  Portfolio A.  A  sample  of  100  observations  is  taken  from  a  normally  distributed  population  with  a  standard  deviation of 2.45 and 7.

.52............05.......  The 99% confidence level is closest to:  A...48 and 6......................48 and 6...... between 5..55............ C...... pp.. which is the point estimate of the population mean population standard deviation sample size = reliability factor....82   Study Session 03:   21.  A  sample  of  100  observations  is  taken  from  a  normally  distributed  population  with  a  standard  deviation of 2. D.. LOS: Reading  10‐j  Correct Answer:  x ± zα / 2 The confidence interval is given by where σ n x σ n = = = sample mean...95 and 6. between 5.45 and 7..... between 4.... between 5. the point where α/2 of the probability is in the right tail The 99% confidence level is 6 ± (2...39.61 and 6..58 x 2)/10 which is between 5.... 433‐439....52.  zα / 2   .. B.  The sample mean is 6.. Reference: CFA® Program Curriculum.. B.. Volume 1.

.LOS: Reading  9‐i  σP where σP = portfolio standard deviation Calculate the S F Ratio for each portfolio: S F Ratio(A) = 25/12 = 2..600 A has the highest S F Ratio and is the correct answer..... Portfolio B.......... Portfolio C..........08 S F Ratio(B) = 15/8 = 1..        . Reference: CFA® Program Curriculum.    Which  of  the  following  portfolios  will  be  optimal from a safety‐first analysis?    Asset  A B C D A..........  A  client  wishes  to  protect  the  value  of  his  capital..... Portfolio A.. B..........Quantitative Methods: Applications   83  22. 397‐400.. Expected Return  25 15 10 8 Standard Deviation    12 8 6 5 Correct Answer:  ( ) S F Ratio = [E R P − R L ] RP RL = portfolio return = threshold level A.... C..................... pp...667 S F Ratio(D) = 8/5 = 1.......... Volume 1..... Portfolio D.875 S F Ratio(C) = 10/6 = 1..... D..

84   Study Session 04:   Study Session 4: Introduction Introductory Readings Economics:  Private  and  Public  Choice. 10  “Keynesian Foundations of Modern Macroeconomics. Sobel.  Gwartney.” Ch. 2003)  “Supply. Demand. Macpherson (South‐Western. Candidates should know what type of factors  cause shifts in the supply and demand curves and movements along the curves and understand  the concept of market equilibrium.” Ch.  James  D. and the Market Process. The law of supply says that a higher  price means producers produce more of the product.  Stroup.           . and David A.  Richard  L. 3  “Supply and Demand: Applications and Extensions” Ch. 11    Supply. and the law of demand says that consumers  buy less of a good if the price rises. Demand.” Ch.  Russell S.  10th  edition.” Ch. and the Market Process CH 5 Introduction This chapter is centered on the laws of supply and demand. 7  “Working with Our Basic Aggregate Demand/Aggregate Supply Model. 4  “Taking the Nation’s Economic Pulse. and vice versa.

  which  is  the  excess  of  sales  revenue  over  the  production  costs.  The  Law  of  Demand  states  that  there  is  an  inverse  relationship  between  the  price  of  a  product  and  the  amount  or  quantity  of  it  that  consumers  are  willing  to  purchase.  Price  Law of Demand Demand Quantity    A consumer surplus is the difference between the maximum price that consumers are willing to  pay and the price that they actually pay.  The  Law  of  Supply  states  that  there  is  a  direct  relationship between the price of a product and the amount of it that is offered for sale. this is a net gain to the buyers of the good.Introductory Readings   85  Consumer choice and the Law of Demand Consumers are forced to make choices regarding how they spend their income in order to get the  most  value  for  their  money.  Producer choice and the Law of Supply All  economic  participants  in  an  economy  are  aiming  to  generate  profit.      .

 If demand is inelastic it means that a change in price only has  a small impact on the quantity demanded.86   Study Session 04:   Price  Law of Supply Supply                       Quantity Price changes and demand and supply Consumers buy less of a product as the price increases because of the availability of substitutes.  If  the  demand  for  a  product  is  elastic  it  means  a  small  price  change  will  lead  to  a  large  change  in  demand. The  availability of substitutes is a major factor in deciding the sensitivity to the quantity demanded to a  change  in  price.  Similarly a supply curve is elastic when the quantity supplied is very responsive to a change in price  (a flat curve) and inelastic when quantity supplied is not very responsive to a change in price (a steep  curve). Unitary elastic means that a  percent change in quantity demanded leads to a percent change in price.  In  the  diagram  below  when  the  price  moves  from  P1  to  P2.    . so prices move from Q1 to Q2.  the  quantity  demanded falls sharply from Q1 to Q2.

 It  is important to differentiate between changes in demand (a shift of the demand curve) and changes  in quantity demanded (a movement along the same demand curve).        .  changes in price or availability of competing products.Introductory Readings   87  Shifts in demand A shift in the demand curve will be a result of a change in demand due to factors other than price.  changes  in  taxes  on  the  product. and changes in expectations of future prices.  Factors  that  lead  to  a  shift  include  increases  in  consumer  income.

  Similarly  an  unanticipated  surge  in  demand  for  a  product will initially push up prices but longer‐term supply will be increased.  High prices will tend to lead to an excess supply illustrated by the points a and b. but in the long  run  demand  will  respond  to  the  price  change.  technology  improvements. which will decrease the equilibrium price  and increase the equilibrium quantity.  and  producers  will  increase  prices  until  equilibrium is reached. which will increase the equilibrium price and  decrease the equilibrium quantity. The following are examples of factors that  could  lead  to  a  change  in  supply  –  changes  in  resource  costs.  Decrease in supply – the supply curve shifts to the left. which will decrease both the equilibrium  price and quantity.  demand  will  exceed  supply.  illustrated  by  points  c  and  d.88   Study Session 04:   Shifts in supply A change in supply indicates a shift in the supply curve. in the short run.  It  is  important to differentiate between short run (an insufficient time period for decision makers to fully  adjust to changes in market conditions) and long run (a sufficient time for decision makers to make  adjustments).  An unanticipated cut in supply will. lead to a sharp increase in price. changes in taxes on the producers of the product.    .  On  the  other  hand  if  prices  are  too  low.   Increase in supply – the supply curve shifts to the right.  natural  disasters which limit supply of a product.   Decrease in demand – the demand curve shifts to the left.   Equilibrium  is  defined  as  a  state  of  balance  between  forces  such  as  supply  and  demand. which will increase both the equilibrium  price and quantity. producers will tend  to  lower  prices  until  supply  and  demand  are  in  balance.  Impact of changes in demand and supply Increase in demand – the demand curve shifts to the right.

    .Introductory Readings   89  The invisible hand principle says that market prices act as an inducement to individuals to pursue  productive activities that also promote the economic well being of society.

90   Study Session 04:  

Supply and Demand: Applications and Extensions CH 4
Introduction
This  chapter  examines  some  of  the  applications  of  supply  and  demand  analysis  covered  in  the  previous Reading. First we look at the impact of wage rates, interest rates and foreign exchange on  supply and demand. Then we look at the impact of government action, including price controls on  markets,  and  of  black  markets  which  are  operating  outside  the  legal  system.  Finally  we  consider  taxation and how it relates to elasticity of supply and demand. 

Resources
The  first  step  in  a  firm’s  production  process  is  the  purchase  of  resources.  Resources  include  raw  materials,  labor  etc.  Resource  markets  generally  have  downward‐sloping  demand  curves  and  upward‐sloping supply curves. There is a close link between the markets for the end‐product and the  resources  used  to  make  the  product.  For  example,  when  the  price  of  a  resource  increases,  costs  increase leading to a reduction in supply and higher prices for the end‐product.  The loanable funds market refers to the market that coordinates the borrowing and lending decisions  of firms and households. Participants in the market include commercial banks, and stock and bond  markets. The interest rate is the price of loanable funds.   The demand curve will slope downwards to the right since firms and households will borrow more  at low interest rates. On the other hand, low interest rates will make it less attractive to save so the  supply curve will be upward sloping to the right. Market forces will drive interest rates to a level, E,  where the quantity of funds demanded will equal the quantity of funds supplied.  

The interest rate is important because it is the link between the price of something today with its price  in the future. 

 

Introductory Readings   91  The  foreign  exchange  market  is  the  market  in  which  different  currencies  are  bought  and  sold.  Exchange rates between currencies are very important since they determine the price of all goods and  services  that  are  traded  in  international  markets.  They  will  also  influence  decision  makers  who  are  looking at producing goods in different countries, although other issues such as transport costs, legal  issues will be factors to consider before a decision is made to move production overseas.  A price ceiling is a legal restriction that establishes a maximum price that a good can be sold at. If the  price  ceiling  is  set  below  the  equilibrium  price  it  will  increase  demand  and  reduce  the  quantity  supplied creating a shortage of the good. Non‐price factors (e.g. waiting lists) will determine who is  able to buy the product. Suppliers will be tempted to reduce the quality of the good supplied if they  cannot increase prices.  Price floors establish a minimum price that can be charged for a good. If the price is fixed above the  equilibrium price then a surplus of the good will appear.  The  minimum  wage  is  an  example  of  a  price  floor,  and  has  led  to  the  substitution  of  machines  or  more highly‐skilled workers for low‐paid workers. Also employers will have little incentive to offer  non‐wage benefits to workers on the minimum wage.   A black market is a market that operates outside the legal system, either the sale of illegal goods or  goods  at  illegal  prices  or  terms.  Black  markets  are  characterized  by  higher  profit  margins  for  suppliers who do not get caught (to compensate the supplier for the higher risk), defective products  and violence (to settle disputes). The point is made that a legal system that allows for settlement of  disputes is essential for the smooth operation of markets.  Tax incidence refers to how the burden of a tax is distributed between buyers and sellers and related  parties (the actual incidence). This will often be quite different to the statutory incidence which is the  legal  assignment  of  the  responsibility  to  pay  the  tax.  It  can  be  shown  that  the  actual  incidence  is  independent of its statutory incidence, i.e. whether it is imposed on the buyer or the seller.  Looking at the example of when a tax is imposed on the seller of a product, this will shift the supply  curve up by the amount of the tax. The intersection of the demand curve and supply curve will move,  splitting  the  tax  burden  between  the  buyer  and  seller.  The  reduction  in  overall  trade  (and  loss  of  benefit of this trade to both parties) results in a deadweight loss; this is the loss over and above the  actual payment of tax to the government. 

Elasticity and the incidence of tax
In the case that demand is inelastic and supply elastic the burden of tax will largely fall on the buyer  (e.g.  when  oil  prices  rise).  Conversely  when  demand  is  relatively  elastic  compared  to  supply,  the  sellers will bear the largest burden.  If either demand or supply is relatively inelastic fewer trades will be eliminated so a rise in tax will  result in a relatively small deadweight loss. 

 

92   Study Session 04:  

Taking the Nation’s Economic Pulse CH 7
Introduction
The focus of this chapter is on the measurement of GDP as the most commonly quoted measure of  economic performance. Candidates need to know how to calculate GDP using both the expenditure  and the resources cost‐income approaches. They also need to be familiar with the differences between  GDP and GNP, and how to switch between nominal and real GDP given the rate of inflation. At the  end of the chapter we look at alternative measures for the performance of the economy. 

Gross domestic product
Gross  domestic  product  (GDP)  is  defined  as  the  total  market  value  of  all  final  goods  and  services  produced  within  a  country’s  borders  during  a  specific  time  period.  GDP  is  a  broad  measure  of  current  production  of  goods  and  services,  and  GDP  calculations  exclude  second‐hand  goods,  intermediate goods, and financial transactions.  There are two main approaches to measuring GDP:  19. 1.  Expenditure approach, where GDP is the sum of:  Consumption (C) Gross private investment (Ig) Government expenditure (G) Net Exports (NX) The expenditure approach is commonly stated as:    GDP = C + Ig + G + NX  Gross  private  investment  includes  depreciation  expense;  gross  investment  is  the  sum  of  net  investment (In) plus depreciation. Net exports (NX) is equal to exports minus imports (X – IM), and  NX  can  be  either  positive  or  negative.  If  exports  are  higher  than  imports,  NX  will  be  positive  and  added to GDP; if imports are higher than exports, NX will be negative and subtracted from GDP.  20. 2.  Cost resource‐income approach, where GDP is the sum of:  Wages, salaries, self-employed income Rents, profits, and interest Indirect business taxes Depreciation Net income of foreigners Net income of foreigners can be positive or negative. If foreigners bring in more investment income  into a country than the residents of the same country pay abroad, then net income will be positive.  GDP calculated by the expenditure approach and GDP calculated by the cost‐income approach must  be equal.   

 

Introductory Readings   93 

Example Int-1 Calculating GDP
  The fictitious country of Euphoria has the following expenditure and income categories  and amounts (in millions):  • Imports $95 • Net investment $100 • Wages and salaries $295 • Government expenditure $70 • Depreciation $25 • Indirect business taxes $60 • Issuance of corporate bonds $35 • Self-employed income $95 • Exports $150 • Rents, profits, and interest $140 • Net income of foreigners -$40 • Consumption expenditure $325 The trick to calculating GDP is to identify expenditure versus cost‐income components.  To use the GDP expenditure approach, we must first compute two preliminary items:          Ig = net investment + depreciation = $100 + $25 = $125  NX = exports – imports = $150 – $95 = $55  GDP = C + Ig + G + NX  GDP = $325 + $125 + $70 + $55 

  GDP = $575  To use the GDP cost‐income approach, sum up all cost‐income components:    GDP  =  wages  and  salaries  +  self‐employed  income  +  rents,  profits,  and    interest + depreciation + indirect business taxes + net income of foreigners    GDP = $295 + $95 + $140 + $25 + $60 + (‐$40)    GDP = $575  Notice  that  GDP  is  equal  using  either  approach.  The  issuance  of  bonds  is  a  financial  flow, which is excluded from GDP calculations. (Assume that the asset financed by the  bond flotation has already been counted under gross business investment).   

 

94   Study Session 04:   GDP counts the value of goods and services produced inside a nation by residents of that nation and  by foreigners living there, too. Whereas, GNP counts the value of goods and services produced by the  citizens of a country, whether they are living in the country itself or living abroad. GDP and GNP will  be equal only when net income of foreigners is zero.  GDP  is  measured  in  the  U.S.  in  dollars.  In  simple  terms,  GDP  is  the  sum  of  price  multiplied  by  quantity (P × Q) of all final goods and services produced. Quantity represents real production within  an  economy;  if  quantity  (or  output)  changes,  then  economic  activity  reported  by  GDP  will  change.  However, GDP can change, even if there is no change in output, if prices by themselves change.  Nominal  GDP  measures  economic  activity  by  multiplying  current  prices  with  current  output;  nominal GDP can increase because of either increasing prices and/or increasing output. Whereas, real  GDP  measures  economic activity  by  multiplying  historical  prices referenced  to  a  particular year  by  current  output;  because  prices  are  held  constant,  real  GDP  can  only  change  because  of  output  changes.  When newspapers or television report GDP forecasts, they almost always mean real GDP.  Inflation is the increase in prices over time, and there are two main ways in which inflation can be  measured. The Consumer Price Index (CPI) measures narrow price changes in a typical “basket” of  goods bought by consumers, captured in the consumption component of GDP calculations. The GDP  deflator  measures  broad  price  changes  across  all  categories  of  economic  activity,  captured  by  consumption, investment, government, and net exports.  Both CPI and the GDP deflator are referenced to a base year, which is assigned a value of 100.0. As  inflation rises, so does the index value of the CPI or the GDP deflator.  The  Equation  below  is  used  to  calculate  real  GDP  when  we  are  given  nominal  GDP  and  the  GDP  deflator for any given year: 

Equation Int-1
 

real GDPperiod t = nominal GDPperiod t ×

GDP deflatorbase year GDP deflatorperiod t

  

Recall that the GDP deflator in the base year is equal to 100.0. Therefore, real GDP will always equal  nominal GDP in the base year. 

 

Introductory Readings   95 

Example Int-2 Calculating real GDP
  • • • Given the following information:  Nominal GDP in 2005 = $11,381.2 billion GDP deflator in 2005 = 121.4 GDP base year is 1986 Calculate real GDP in 2005: 

real GDPperiod t = nominal GDPperiod t ×

GDP deflatorbase year GDP deflatorperiod t

= $11,381.2 billion × = $9,375.0 billion

100.0 121.4

    

Although  GDP  attempts  to  capture  a  nation’s  economic  activity,  some  activities  will  elude  statisticians and will be excluded from any measure. Such excluded activities include:  • Leisure and human costs; • Unreported and illegal activities, such as the underground economy; • Value of unpaid household production, including chores; • Harmful side effects of production, including pollution of air, water, soil; and • Quality and variety of product improvements which occur through innovation. GDP and GNP are the broadest measures of output. However, there are several alternative measures  of economic performance:  • National income (NI) is the earnings of all resource owners, which is the sum of employment compensation (salaries), rents, corporate profits, interest, and self-employment income. However, not all of this income is available for personal use. • Personal income (PI) adjusts NI by subtracting corporate profits and social insurance taxes and adding transfer payments and dividends. PI can be spent on consumption, saving, or paying of personal taxes. • Disposable income (DI) strips away personal taxes from PI. Out of the five output measures, DI is the narrowest. DI can either be consumed or saved.

 

96   Study Session 04:  

Working with Our Basic Aggregate Demand/ Aggregate Supply Model CH 10
Introduction
We now look at the effects of changes in aggregate demand and supply on other economic indicators,  such as growth, prices and employment. First of all we examine the factors that change supply and  demand  and  then  differentiate  between  the  short‐run  and  long‐run  impact  of  anticipated  versus  unanticipated  changes  on  the  economy.  We  also  consider  the  self‐correcting  mechanisms  that  will  help stabilise the economy. 

Aggregate demand
There are, in fact, three separate curves: aggregate demand, short‐run aggregate supply, and long‐run  aggregate supply  The aggregate demand (AD) curve is a downward‐sloping curve, with the price level (P) plotted on  the vertical axis and real GDP (Y) plotted on the horizontal axis. There are six factors that will shift  AD to the right (AD1), also known as an increase in aggregate demand:  • Increase in real wealth • Decrease in real interest rates • Increased optimism in the economy • Higher expected inflation in the future • Higher incomes abroad, thereby boosting exports • Domestic currency depreciation, thereby boosting exports and restricting imports The opposite of these factors will cause the AD curve to shift to the left, also known as a decrease in  aggregate  demand  (AD2).  The  diagram  below  depicts  the  shape  of  the  original  aggregate  demand  curve (AD0) and the shifted curves. 
Price level Aggregate Demand

AD2

AD0

AD1

Real GDP

 

Introductory Readings   97  The  short‐run  aggregate  supply  (SRAS)  curve  is  an  upward‐sloping  curve,  with  the  price  level  (P)  plotted on the vertical axis and real GDP (Y) plotted on the horizontal axis. There are five factors that  will shift SRAS to the right (SRAS1), also known as an increase in short‐run aggregate supply:  • Increase in the stock of capital • Technological improvements • Reduction in input prices • Lower expected inflation in the future • Favourable shocks, such as good weather The opposite of these factors will cause the SRAS curve to shift to the left, also known as a decrease in  short‐run aggregate supply (SRAS2). The diagram below depicts the shape of the original short‐run  aggregate supply curve (SRAS0) and the shifted curves. 
Price level Short-run aggregate supply

SRAS2

SRAS0

SRAS1

Real GDP

The long‐run aggregate supply (LRAS) curve is a vertical curve, with the price level (P) plotted on the  vertical  axis  and  real  GDP  (Y)  plotted  on  the  horizontal  axis.  There  are  two  factors  that  will  shift  LRAS to the right (SRAS1), also known as an increase in long‐run aggregate supply:  • Increase in the stock of capital • Technological improvements Observe that these factors are common to SRAS, which means that whenever the LRAS curve shifts,  the SRAS curve will move with it in the same direction. The opposite of these factors will cause the  LRAS curve to shift to the left, also known as a decrease in long‐run aggregate supply (LRAS2). The  diagram  below  depicts  the  shape  of  the  original  long‐run  aggregate  supply  curve  (LRAS0)  and  the  shifted curves. 

 

98   Study Session 04:  
Price level Long-run aggregate supply LRAS2 LRAS0 LRAS1

YF2

YF0

YF1

Real GDP

The  LRAS  curve  plays  a  significant  role  in  regulating  the  macro  economy:  the  position  of  LRAS  determines the level of economic activity corresponding to full employment (YF0). Full employment  can only be achieved when an economy is operating somewhere along the LRAS curve.  An  unanticipated  change  in  macroeconomics  suggests  that  people  are  caught  off  guard  by  the  change, but over time, the market will react to it. When people initially react to unanticipated changes  in  either  AD  or  SRAS,  then  output  can  change,  but  only  in  the  short  run.  (Remember  that  LRAS  represents the limit of production in the economy in the long run.)  Consider an unanticipated increase in government expenditure, a component of AD. If the AD curve  shifts upwards, then the new short‐run equilibrium will occur at the intersection of the new AD curve  and  the  original  SRAS  curve.  Thus,  output  (Y)  and  price  level  (P)  will  be  higher  in  the  short  run.  However,  the  economy  is  now  operating  beyond  its  capacity,  which  exerts  pressure  on  resource  prices.  As  resource  prices  increase,  SRAS  will  shift  to  the  left  until  equilibrium  is  restored  along  LRAS. Thus, output (Y) is restored to full employment and the price level is higher. In the long run,  unanticipated changes in AD result in changes to the price level only. 
Price level PLR PSR P0 E0 SRAS1 SRAS0 AD0 AD1 LRAS0

ELR eSR

YF YSR

 

Introductory Readings   99  Unanticipated changes in SRAS will only affect the short‐run position of the SRAS curve itself; there  will  be  no  affect  on  aggregate  demand.  Consider  an  economy  dependent  on  agriculture,  and  an  unexpected warm summer boosts the economy’s main crop. In the short run, the favorable boost in  production will shift the SRAS curve to the right, leading to a lower price level but a higher level of  output.  However,  the  economy  is  operating  beyond  its  long‐run  capacity,  and  there  is  upward  pressure  on  resource  prices.  As  resource  prices  increase,  SRAS  will  shift  to  the  left  until  long‐run  equilibrium is restored along the LRAS curve. In the long run, unanticipated changes in SRAS result  in neither a change to the price level nor change in output. 
LRAS0 Price level

eSR P0 PSR E0 AD0 SRAS0 SRAS1

YF

YSR

Market  economies  respond  when  they  operate  at  an  output  level  above  or  below  full  employment  (along  the  LRAS  curve).  There  are  two  self‐correcting  mechanisms  that  tend  to  restore  long‐run  equilibrium:  • Changes in resource prices affect the SRAS curve. We have discussed this in the previous LOS. For example, when output is higher than full employment, increasing resource prices tends to decrease SRAS, causing higher price levels and eventually restoring the economy to full employment. • Changes in real interest rates affect the AD curve. For example, when output is higher than full employment, real (inflation-adjusted) interest rates will increase as the demand for money increases. Higher real interest rates depress business investment, which is a component of AD. Thus, there is a tendency for AD to automatically decrease, which can help restore the economy to its full employment level of output. The third self‐correcting mechanism relates to consumption expenditure, which is a large component  of  AD.  (Consumption  represents  approximately  65  percent  of  GDP  in  most  developed  economies.)   Compared  with  other  components  of  AD,  consumption  is  the  most  stable  component  of  GDP.  The  inherent  stability  of  consumption  expenditure  helps  to  mitigate  changes  to  other  less  stable  components of GDP, such as net exports (tied to the exchange rate) and business investment (tied to  interest rates and fickle business sentiment). 

 

  Keynesians  are  followers  of  John  Maynard  Keynes. recessions tended to be short lived as the economy automatically reverted to  long‐run output and employment through the SRAS mechanism discussed in the previous Reading. The aggregate expenditure curve is shown as the AE  curve in the graph below. and even when GDP  is zero. there will be autonomous expenditure.  and  NX.  However.  The  model  distinguishes  between  autonomous  verses  induced  expenditure.  The  classical  school  assumed  that  the  economy  operated  mostly  at  or  near  its  long‐run level of output. SRAS adjustments are too slow.  even  when  disposable  income is equal to zero.  whereas  induced  expenditure  is  a  function  of  income. with reduced output and widespread unemployment.   Keynesian economics The distinction between classical and Keynesian economics stems from the assumptions made on the  length  of  recessions.  In  a  simplified  economy  consisting  of  consumers. He believed that the government  should  run  a  budget  deficit  in  order  to  stimulate  demand  and  bring  the  economy  back  to  full  employment.  The Keynesian model explains the output level at which an economy can operate. According to the Keynesians.  Keynes  (hence  Keynesians)  believed  that  the  economy  could  get stuck in prolonged recession. Total expenditure is an upward sloping function of GDP (output).100   Study Session 04:   Keynesian Foundations of Modern Macroeconomics CH 11 Introduction In this section we explore the main principles of Keynesian theory which was developed by a British  economist  to  explain  the  prolonged  unemployment  in  the  1930s. in the absence of  either an explicit SRAS or LRAS curve.)    Autonomous  expenditure  has  no  relationship  with  levels  of  income.  consumption  expenditure  increases  as  disposable  income  increases  (induced).  G. and the government can only restore long‐run output and employment  levels by boosting AD.    . the economy will maintain a level of consumption by drawing down assets  (autonomous). This chapter examines the rationale behind his thinking including the importance of the  expenditure multiplier. if indeed they  operate at all.  Keynes  focused  on  demand  rather  than  supply  and  the  role  of  the  government’s fiscal policy in taking an economy out of recession.  total  expenditure  is  equal  to  consumption  expenditure.  a  British  economist  of  the  early  20th  century.  I. Keynesians  do not believe that adjustments to SRAS will restore equilibrium.  (Recall  the  major  components  of  expenditure:  C. Rather.  For  example.  it  has  had  a  major  influence  on  subsequent  economic  thinking.  Writing  during  the  Great  Depression. they believe that recessions  stem from a deficiency of AD.

 Note that MPC + MPS = 1.  if  people  consume  less  than  is  planned. In the graph below.  The  marginal  propensity to consume (MPC) is additional consumption related to an additional unit of disposable  income.  when  real  GDP  Planned  AE  <  Planned  AE  >  is  equal  to  planned  Output  Output  GDP GDP aggregate  increased decreased Real GDP  expenditure. where planned  aggregate  expenditure  is  equal  to  actual  output.  businesses  decrease their production. Businesses increase production to meet  the  unanticipated  expenditure.  In  response. therefore. resulting in lower output.  which  boosts  output.        Planned aggregate    expenditur Unplanne   e (AE inventor 45‐degree  d   buil ‐u AE = GDP y line   d p Unplanne   inventor d   reductio y   Actual AE n   Keynesian  macro‐ Keynesian  equilibrium  (Planned  equilibrium  occurs  AE Y) along  the  45‐degree  line.  then  businesses  inventories  will  be  unexpectedly  increased.Introductory Readings   101  Businesses  plan  for  a  certain  level  of  expenditure. is shown in the Equation Int‐2 below:  Keynesian equilibrium Equation Int-2   marginal propensity to consume = Δ consumption expenditure             Δ disposable income  where Δ is uppercase Greek letter delta meaning change.  then  businesses inventories will be depleted faster than expected.    .  Alternatively. we can define the marginal propensity to save (MPS) as 1  – MPC. Recall that disposable income  can be either consumed or saved.  and  they  build  inventories  to  meet  consumption  expenditure.  If  people  consume  more  than  is  planned. businesses wish to operate along a 45‐degree line.   The MPC is a number greater than zero but less than one (0 < MPC <1).

MPC MPS   Example Int-3 Marginal propensity to consume and expenditure multiplier When  disposable  income  is  $150. if some of the increase in autonomous expenditure is saved rather than  spent.  then  the  total  effect  of  the  government’s  increased  expenditure would be a $10 × 4 = $40 increase in total output (Y).0.80). $157. Intuitively. people had a tendency to consume more of the autonomous increase (MPC = 0.  consumption  expenditure  is  $120. The expenditure multiplier is positively related to the MPC and negatively  related to MPS.  If.25  expenditure multiplier = The  expenditure  multiplier  explains  the  total  increase  in  output  caused  by  an  initial  change  in  autonomous expenditure. then  the new expenditure multiplier would be:  expenditure multiplier = 1 1 1 = = = 5  1 .MPC 1 .  If  the  government  increased  autonomous  expenditure  by  $10.25 Note that the MPS = 1 – MPC = 1 – 0. consumption expenditure is $157.  which  yields  an  expenditure  multiplier  of  4.50 − $120 $37. exp.  Use Equations Int‐2  and Int‐3.75   ∆ disposable income $200 − $150 $50 1 1 1 = = = 4      1 .  Assume  that  the  MPC  =  0.5 = = = 0. as shown below:  Equation Int-3     expenditure multiplier = 1 1 =      1 . respectively:  marginal propensity to consume  = ∆ consump. Calculate the marginal  propensity to consume and the expenditure multiplier. the effect of the autonomous stimulus on the economy will be reduced.80 0.75 0. however.  and  when  disposable income is $200.75.50.102   Study Session 04:   The expenditure multiplier is related to the MPC and MPS.0.20   .MPC 1 .75 = 0.

  which  would  reverberate  throughout  the  economy  via  the  expenditure  multiplier. resulting in a multiplied increase in output (Y) until planned aggregate expenditure  equals output.Introductory Readings   103  If  the  government  increased  autonomous  expenditure  by  $10.  then  the  total  effect  of  the  government’s increased expenditure would be a $10 × 5 = $50 increase in total output (Y).    .  The decrease in aggregate demand causes a decline in output and employment levels.  Alternatively. inflation pressures would emerge.  Keynesians believe that private investment is the most volatile component of aggregate expenditure. The economy’s  built‐in  stabilizers  might  not  be  enough  to  offset  the  decline  in  AD. which reverberates throughout the entire economy by the multiplier effect.  an  increase  in  business  confidence  would  result  in  an  autonomous  increase  in  investment  expenditure.  so  Keynesian  believe  that  the  government ought to increase expenditure to restore full employment.  In terms of the Keynesian model. If output expands beyond full employment. an increase in autonomous expenditure would shift the actual AE  curve upwards.  An  unexplained  decline  in  business  confidence  results  in  an  autonomous  decrease  in  private  investment.

    3.  If the GDP deflator in a country has risen from 100 in 1985. B. a fall of 3.     elastic. C. C.  A natural disaster will often cause:   A.9%. to 130 in 2005 and nominal GDP has  risen from $85 billion to $125 billion then the change in real GDP over the period is closest to:   A.1%. with a steep demand curve. D.104   Study Session 04:   Introductory Readings Concept Check Questions 1. elastic.   . C.  It is noticed that a small change in price has a big impact on demand for a product. D. B. a move to the left along the supply curve.1%. with a flat demand curve. B. This means  the demand is:   A. an increase of 13. with a steep demand curve. inelastic. inelastic.     a shift in the supply curve to the left. a shift in the supply curve to the right. an increase of 62. with a flat demand curve.     2.5%. a move to the right along the supply curve. D. an increase of 17.

B. C. I.   5. All of the above.  IV. III and IV only.  A significant change in the exchange rate. GNP and GDP are both the same.  A. Rising inflation. but different terms are used in different countries.  II. I and III only. C.  An increase in real interest rates. Real interest rates will decline. D. which of the following will act as a  self‐correcting mechanism?  A.  When economic output is less than the economy’s potential.   GNP is GDP less depreciation costs. GNP is calculated using the expenditure approach and GDP using the income approach. D. Fiscal stimulus. D.  III.  New technology increasing productivity. B. GNP is GDP less the income of foreigners in the country plus the income earned by the country’s citizens overseas. C.  A change in inflationary expectations.  Which of the following would cause a shift in aggregate demand?  I.  Which  of  the  following  statements  is  CORRECT  regarding  gross  national  product  (GNP)  and  gross domestic product (GDP)?  A. B.   .Introductory Readings   105  4. Real resource prices will rise.   II only.   6.

33 billion. adjusting interest rates is the primary tool that should be used to stimulate aggregate demand. B.  If the marginal propensity to consume (MPC) is 0.106   Study Session 04:   7. adjusting money supply is the primary tool that should be used to stimulate aggregate demand. B.         8. macroeconomic policy should focus on maintaining aggregate expenditures at the level that leads to full employment . $4. market forces are sufficient to ensure that the economy operates at the full employment level in the long term. $3. D. C.28 billion.7 and investment spending is increased by $3  billion then the additional income generated is closest to:  A.00 billion   . C.  The Keynesian model implies that:  A. $10. D.00 billion. $7.

Introductory Readings   107    .

this will lead to a flat demand curve.108   Study Session 04:   Introductory Readings Concept Check Answers 1. C.  A natural disaster will often cause:   A. inelastic. This means  the demand is:   A. This will in turn increase the equilibrium price. B.    A  Demand is elastic since it is highly responsive to a change in price. D. with a steep demand curve. B. A  Correct Answer: 2.  The supply curve shifts to the left as supply is decreased. elastic. elastic. a move to the right along the supply curve. C.   Correct Answer: 1. D. a shift in the supply curve to the right. inelastic.   . a shift in the supply curve to the left. with a flat demand curve. a move to the left along the supply curve.  It is noticed that a small change in price has a big impact on demand for a product. with a steep demand curve. with a flat demand curve.     2.

  Which  of  the  following  statements  is  CORRECT  regarding  gross  national  product  (GNP)  and  gross domestic product (GDP)?  A.9%.Introductory Readings   109  3. but different terms are used in different countries. C. an increase of 13.  If the GDP deflator in a country has risen from 100 in 1985. GNP is calculated using the expenditure approach and GDP using the income approach. B. an increase of 62. GNP and GDP are both the same. to 130 in 2005 and nominal GDP has  risen from $85 billion to $125 billion then the change in real GDP over the period is closest to:   A. GNP is GDP less the income of foreigners in the country plus the income earned by the country’s citizens overseas.    .15 billion This is an increase of 13.  B  Real GDP (2004) = $125 billion x (100/130) = $96. C. D.1%. GNP is GDP less depreciation costs. B.5%.1%.     4. D. an increase of 17.   Correct Answer: 3.1%   a fall of 3. B  Correct Answer: 4.

  II.  New technology increasing productivity.   Correct Answer: 5. C. III and IV only.110   Study Session 04:   5.  A change in inflationary expectations. I and III only.  A significant change in the exchange rate.   .  IV. B. B.  The main self-correcting mechanisms will be the fall in real interest rates and resource prices (including labor costs). Rising inflation. D.  When economic output is less than the economy’s potential. All of the above.    C  Item II would lead to a shift in the supply curve. D. B  Correct Answer: 6. Real resource prices will rise. which of the following will act as a  self‐correcting mechanism?  A.  III. Fiscal stimulus.  An increase in real interest rates. I.  A.  Which of the following would cause a shift in aggregate demand?  I. Real interest rates will decline.     6. II only. C.

    D      8. B. C. Therefore the additional income is $3 billion x 3.33.28 billion. B. C.33 or $10 billion.  If the marginal propensity to consume (MPC) is 0.33 billion.7 and investment spending is increased by $3  billion then the additional income generated is closest to:  A.00 billion. adjusting interest rates is the primary tool that should be used to stimulate aggregate demand.  The Keynesian model implies that:  A. $4.00 billion D  Correct Answer: 8. market forces are sufficient to ensure that the economy operates at the full employment level in the long term. D.  The expenditure multiplier is 1/(1 – 0. adjusting money supply is the primary tool that should be used to stimulate aggregate demand.7) or 3. D. $10.   Correct Answer: 7.   .Introductory Readings   111  7. $3. $7. macroeconomic policy should focus on maintaining aggregate expenditures at the level that leads to full employment .

 which  measures  the  dependency between  demand  and  supply  and  the  impact  of  changes  in  either  on  the  equilibrium price level.  One of the main concepts related to the equilibrium between demand and supply is elasticity.  Understanding  these  concepts  enables  analysts  to  differentiate among various companies on an individual level. A second key concept is efficiency. and to determine their attractiveness  for an investor. which is a measure of the firm’s “optimal”  output  given  its  cost  and  revenue  functions.     Reading 13: Elasticity  Reading 14: Efficiency and Equity  Reading 15: Markets in Action  Reading 16: Organizing Production  Reading 17: Output and Costs            .112   Study Session 04:   Study Session 04: Economics: Microeconomic Analysis   This study session focuses on microeconomic concepts and how firms are affected by these concepts.

    .  D.  normal profit.  Economic profit is total revenue less:   A.  opportunity costs.  D.  C.  B.  horizontal.        2.  linear and passes through the origin.  B.  C.  an upward sloping curve.  explicit costs.Economics: Microeconomic Analysis   113  1.  implicit costs.  The momentary supply curve of agricultural crops is generally:     A.      vertical.

. Reference: CFA® Program Curriculum. D.... vertical... D . 26‐27...............LOS: Reading  16‐a  Correct Answer:  Economic profit is after opportunity costs which include both explicit and implicit costs...........  Economic profit is total revenue less:   A..............114   Study Session 04:   1................................. C......... pp. Normal profit is included in implicit costs.......... Generally producers cannot rapidly change their output so supply is inelastic and the supply curve is vertical......... 94‐95.... A .. an upward sloping curve.... pp......... Volume 2.... Volume 2.. Reference: CFA® Program Curriculum...  The momentary supply curve of agricultural crops is generally:   A.. opportunity costs........ linear and passes through the origin.......    ...LOS: Reading  13‐a  Correct Answer:  The quantity of agricultural goods available will depend on decisions on planting of the crop made some time previously... normal profit..... B.... B. implicit costs.. horizontal..        2........ explicit costs............... D......... C..

  Which of the following are examples of implicit and explicit opportunity costs?    A.  B.  C.Economics: Microeconomic Analysis   115  3.  D.  create a surplus of the good.  increase value for buyers.  C.  Making a market in a good illegal is most likely to:    A.  reduce the quantity traded.  reduce costs for suppliers.  D.  Implicit cost   Utility expenses                 Explicit cost  Rental costs   Accounting depreciation  Salary costs  Bank interest  Interest foregone      Dividend payments   Economic depreciation     .  B.        4.

C.... B....... Explicit costs are paid for in money. reduce the quantity traded.... D........ Implicit cost Utility expenses Interest foregone Dividend payments Economic depreciation Explicit cost Rental costs Accounting depreciation Salary costs Bank interest Correct Answer:  D . such as bank interest... p... Reference: CFA® Program Curriculum.............. C..... utilities.. D.........    .......... This will lead to a move in the equilibrium point to the left....... Volume 2...... 81‐84........ B. LOS: Reading  15‐d  Correct Answer:  Making a market illegal is likely to push up costs for suppliers (if there is a penalty on suppliers) and/or reduce value for buyers (if there is a penalty on buyers).... reduce costs for suppliers.... these are often related to use of capital and use of owner’s resources........... pp...116   Study Session 04:   3... rental expense............ Volume 2..... Interest forgone and economic depreciation are both forms of implicit costs................ Reference: CFA® Program Curriculum.... salaries......... increase value for buyers......LOS: Reading  16‐a  Implicit costs are when there is no payment made but another action has been foregone... reducing quantities traded.  Making a market in a good illegal is most likely to:    A.......... C . 92‐95        4..  Which of the following are examples of implicit and explicit opportunity costs?  A... create a surplus of the good......................

  The average fixed cost curve.  Which of the following curves is least likely to be U‐shaped?   A.  Demand for the service will decline.  B.        6.  The average variable cost curve.  C.    .  The average total cost curve.  D.  A black market in the service will develop.  C. which of  the following is least likely to happen?   A.  If a government puts a price ceiling on a service which is below the equilibrium price.Economics: Microeconomic Analysis   117  5.  There will be as shortage of supply of the service.  The service providers’ producer surplus will decline.  B.  D.   The marginal cost curve.

... The service providers’ producer surplus will decline... There will be as shortage of supply of the service. 60‐66...... Reference: CFA® Program Curriculum. or increase... C. pp........ The average fixed cost curve. C ...  If a government puts a price ceiling on a service which is below the equilibrium price. The average total cost curve...    . reducing the producer surplus. pp...... Volume 2......... B...... The average fixed cost decreases steadily as output increases............. Volume 2............. A black market in the service will develop.... D.. D... LOS: Reading  17‐c  Correct Answer:  The average total.. 129‐134...118   Study Session 04:   5.....” is the correct choice.... A black market may well develop to fulfill demand................ marginal and variable costs decrease at low outputs and increase at high outputs......... C......... so “Demand for the service will decline.. The average variable cost curve..... A .......................... they are U-shaped......        6.... Demand for the service will decline......... Reference: CFA® Program Curriculum... The marginal cost curve.. B.. Demand will be unchanged.  Which of the following curves is least likely to be U‐shaped?   A.......LOS: Reading  15‐a  Correct Answer:  The price ceiling will lead to a drop in supply..... which of  the following is least likely to happen?   A.......

  horizontal.  linear and passes through the origin.   Technology and labor are usually considered to be which type of resources?    A.  vertical.  If the supply of a product is unit elastic it means that the supply curve is:  A.  D.  C.        8.  Technology   Long‐run    Long‐run    Short‐run    Short‐run    Labor  Long‐run  Short‐run  Long‐run  Short‐run    .  B.  an upward sloping curve.Economics: Microeconomic Analysis   119  7.  D.  C.  B.

.   Technology and labor are usually considered to be which type of resources?  A....... B...... 122‐123..... linear and passes through the origin... pp........................... C... so the supply curve is a straight line and passes through the origin......120   Study Session 04:   7............. horizontal.. Volume 2.. Reference: CFA® Program Curriculum.. Technology Long-run Long-run Short-run Short-run Labor Long-run Short-run Long-run Short-run B.. p...LOS: Reading  13‐a  Correct Answer:  Unit elastic means that the percentage change in price equals the percentage change in quantity supplied................. B....................... an upward sloping curve.... D .........    .......... 25...  If the supply of a product is unit elastic it means that the supply curve is:  A............. D...... Reference: CFA® Program Curriculum...... C........ D....        8........LOS: Reading  17‐a  Correct Answer:  Technology cannot usually be varied in the short run so is considered a long-run resource... vertical.. Labor is usually a variable input so is a short-run resource...... Volume 2....

  D.        10.  C.   The cost of capital and labor are lower than for corporations.    .  The entire wealth of owners is at risk.  Proprietorships in the U.  C.  increasing supply.  They are owned by one or more people. are generally characterized by which of the following?  A.   Profits are taxed at the proprietorship and owner level.  B.  B.  D.Economics: Microeconomic Analysis   121  9  When a government introduces a subsidy on an agricultural product.  marginal cost on the original supply curve falling below marginal benefit.  creating overproduction.  shifting the supply curve downwards to the right. in the domestic market this  is least likely to have the effect of:  A.S.

....... B..... A ...... creating overproduction and a deadweight loss............... B..S.......... D . Volume 2.. so B is not correct.  Proprietorships in the U.... so A is correct.LOS: Reading  14‐e  Correct Answer:  A proprietor has unlimited liability.......... The entire wealth of owners is at risk..... D... Reference: CFA® Program Curriculum. pp...... pp............ C.. shifting the supply curve downwards to the right... They are owned by one or more people....122   Study Session 04:   9.. The cost of capital and labor are lower than for corporations..... in the domestic market this  is least likely to have the effect of:  A......... 101‐102....    ......  When a government introduces a subsidy on an agricultural product.... if a proprietorship cannot pay its debts then the parties owed money can claim the assets of the proprietor. 79‐80........... LOS: Reading  15‐d  Correct Answer:  A subsidy is a payment by the government to producers.. are generally characterized by which of the following?  A... Profits are only taxed once as the owner’s income so C is not correct. A subsidy increases supply so original marginal cost rises above marginal benefit.. C.... The cost of capital is usually higher than that of a corporation so D is not correct.. Reference: CFA® Program Curriculum..... Profits are taxed at the proprietorship and owner level. Proprietorships can only be owned by a single person.....        10. The supply curve is the marginal cost curve and the demand curve the marginal benefit curve.. increasing supply.............. Volume 2........ D............. creating overproduction...... marginal cost on the original supply curve falling below marginal benefit.........

  a substitute good.  It is most likely that the good  is:  A.  D.  a luxury item.  an inferior good.  administrative costs reduce the impact of transferring wealth between different parties.  C.  B.  a normal good.  people should be treated fairly and their property rights respected.  It is noted that the income elasticity of a good is slightly negative.  B.  all participants should have the same income to maximize the benefits gained from the  economic pie.        12.  D.  the state should not own property to ensure all participants have equal access to goods  and services.    .  C.Economics: Microeconomic Analysis   123  11.  Followers of utilitarianism are most likely to believe that:  A.

........ D... 49‐50.... Reference: CFA® Program Curriculum....... for inferior goods demand moves in the opposite direction to income... A and C are part of the symmetry principle.LOS: Reading  13‐a  Correct Answer:  Income elasticity measures the change in demand when income changes...... B......    ... Volume 2..... B...... D.... However.... C . and B is an argument against utilitarianism............ For most goods this is positive..  Followers of utilitarianism are most likely to believe that:  A...... pp..... Volume 2.............. a luxury item.... people should be treated fairly and their property rights respected...........        12..124   Study Session 04:   11... Reference: CFA® Program Curriculum...... all participants should have the same income to maximize the benefits gained from the economic pie...... Correct Answer:  D .... these are goods typically bought by people on low incomes. an inferior good....... a normal good..... LOS: Reading  14‐f  Utilitarianism says that all participants should have the same income as this maximizes the combined marginal benefit of consuming goods so D is correct...  It is most likely that the good  is:  A....... administrative costs reduce the impact of transferring wealth between different parties.............  It is noted that the income elasticity of a good is slightly negative............. C... as when incomes rise.. pp............ 21‐22...... C... the state should not own property to ensure all participants have equal access to goods and services.... spending on goods usually rises. a substitute good..

        14.  B.   benefit certain producers of the product.  D.  C.  the price of the good less the marginal cost of the unit.Economics: Microeconomic Analysis   125  13.  benefit consumers of the product.    .    increase the marginal cost of production of the good.  B.  The value of one more unit of a good is least accurately described as:   A.   lead to the marginal cost being higher than marginal benefit.  its marginal benefit.  the maximum price consumers are willing to pay for it.  C.  D.  the price paid for the unit plus the consumer surplus from it.  When a government imposes a quota on a product it is most likely to:   A.

..... Volume 2........ the maximum price consumers are willing to pay for it. B............... The marginal cost will decline as supply drops and consumers will face shortages and higher prices so A.... increase the marginal cost of production of the good.        14.. D....... B........... LOS: Reading  14‐b  Correct Answer:  The value is the same as the marginal benefit... which is the most consumers are willing to pay to buy another unit of the good... the price of the good less the marginal cost of the unit.. B......... its marginal benefit............ benefit consumers of the product......... LOS: Reading  15‐c  Correct Answer:  A quota is likely to create a supply shortage. so B is the best answer.  When a government imposes a quota on a product it is most likely to:   A.... 77‐81. which pushes up the price creating extra profits for producers who are allocated the quota. C....... pp............ not consumer.....    ........... B.......... Reference: CFA® Program Curriculum........ C........ The price of the good less the marginal cost of the unit is the producer. benefit certain producers of the product.... The consumer surplus for each good is the value or marginal benefit less the price... surplus.... the price paid for the unit plus the consumer surplus from it.. D.  The value of one more unit of a good is least accurately described as:   A. Volume 2............... C and D are not correct...126   Study Session 04:   13.... 38‐40.... pp...... lead to the marginal cost being higher than marginal benefit.. Reference: CFA® Program Curriculum........

350  B. 25%.  D.  10%  90%  10%  90%                  Herfindahl‐Hirschman Index                  470  470  2.  C.     .  The law of diminishing returns implies that   A.  total profits diminish as output increases.  marginal product is eventually higher then average product when sufficient units of a  variable resource are added.  D.  The four  firm concentration ratio and Herfindahl‐Hirschman Index are:    Four firm concentration ratio   A. 25% 10% and 10%.  marginal product is initially upward sloping then downward sloping as quantities  increase.  as more units of a variable resource are added marginal product eventually decreases.Economics: Microeconomic Analysis   127  15.  B.  An industry has five participants with market shares of 30%.  C.350  2.        16.

..... 25% 10% and 10%........... D.... 126‐127.................... Reference: CFA® Program Curriculum... 25%... marginal product is initially upward sloping then downward sloping as quantities increase. 10% D.. pp.........LOS: Reading  16‐g  Four-firm concentration ratio is (30% + 25% + 25% + 10%) = 90% Herfindahl-Hirschman Index is 302 + 252 + 252 + 102 = 2350 Reference: CFA® Program Curriculum.......... B...........  The law of diminishing returns implies that   A..........  An industry has five participants with market shares of 30%.350 2..     . as more units of a variable resource are added marginal product eventually decreases......128   Study Session 04:   15...... C..... Volume 2... marginal product is eventually higher then average product when sufficient units of a variable resource are added......... total profits diminish as output increases........ Correct Answer:  C ........ pp...... Volume 2......350 D ..... LOS: Reading  17‐c  The law of diminishing returns sates that marginal product starts to decline as quantities increase due to technological constraints.. 10% B.............  The four  firm concentration ratio and Herfindahl‐Hirschman Index are:  Four firm concentration ratio A.... 105‐106.... 90% C.......... 90% Correct Answer:  Herfindahl-Hirschman Index 470 470 2......        16...............

000 per annum.000.000.0 units  205.      $80.000.Economics: Microeconomic Analysis   129  17.000 per annum).   The economic profit of the manufacturing company is closest to:  A.000  5. who also owns the factory. Labor  24  25  26  Total Production  5.  D. D.000.350  When labor increase from 25 to 26 per day the marginal and average product are closest to:    A. B.  marginal product            150 units   150 units   200 units   350 units           average product  150. is charging an annual rent of only $25.000 in a similar business.0 units    .000 and economic depreciation  is $40.  A manufacturing company has sales of $1 million per annum and explicit costs of $700.  Company  ABC  provides  the  following  information  on  labor  (workers  per  day)  and  total  production (units output per day).  B.  Interest forgone is $20. C.0 units  207.200  5.  The owner could earn a normal annual profit of $50.8 units  208. $130.000 $120.   He also does not charge for  his time (wages would be $60.  C.000 for the  factory whereas the rent he could receive in the open market is $75.       18.000 $180.  The  owner of the company.

000 ..000 .... Reference: CFA® Program Curriculum.8 units C....$40..000.. A ....$ 50........ is charging an annual rent of only $25...$50.......$60.200 which equals 150 units......350 When labor increase from 25 to 26 per day the marginal and average product are closest to: marginal product average product A.0 units Correct Answer:  B......  The  owner of the company.. D..000 in a similar business..    18......... this is 5........... which is 5....000 $180....... Volume 2....   The economic profit of the manufacturing company is closest to:  A...0 units D..000 (normal profit lost).. 200 units 208. C..130   Study Session 04:   17.....000. who also owns the factory....000 (wages foregone) ......... 93‐96....$20. 150 units 150......LOS: Reading  16‐a  Correct Answer:  The economic profit is therefore $1..  Interest forgone is $20..  Company  ABC  provides  the  following  information  on  labor  (workers  per  day)  and  total  production (units output per day)... $130. B.   He also does not charge for  his time (wages would be $60...000. 124‐129... pp......000 (additional implicit cost of rental) ......000 ....000 per annum. $80....    .$700.000 and economic depreciation  is $40....  A manufacturing company has sales of $1 million per annum and explicit costs of $700..000 per annum)..000..... LOS: Reading  17‐b  The marginal product is the increase in total product for one additional unit of labor.000 for the  factory whereas the rent he could receive in the open market is $75.. Volume 2. 150 units 205.  The owner could earn a normal annual profit of $50.000...8 Reference: CFA® Program Curriculum.200 5.... Average product is total product divided by the quantity of labor employed.000 ..... This equals $80.....000 5...350 divided by 26 equals 205. 350 units 207.    Labor  24  25  26  Total Production 5...........000.0 units B..................350 – 5.000 $120... pp...

  be the point where the marginal society benefit equals the marginal society cost.  an inefficient quantity being produced.Economics: Microeconomic Analysis   131  19.   overproduction of the good. if a good has external benefits it is least likely to lead to:  A.  maximize the sum of the consumer and producer surpluses.        20.  B.  C.  a deadweight loss.  D.    be the quantity to which free market forces drive production.  B.  D.   disregard external benefits and external costs to the consumer and producer respectively.  C.  The efficient quantity produced of a good is least likely to:  A.  In the market economy.    .    a social loss.

...... This is a loss to society as a whole.... a deadweight loss.. a social loss. D..... Reference: CFA® Program Curriculum...    ... C . disregard external benefits and external costs to the consumer and producer respectively.. this inefficient production level leads to a deadweight loss... maximize the sum of the consumer and producer surpluses..LOS: Reading  14‐e  Correct Answer:  External costs and benefits will distort the quantity produced and consumed so the efficient quantity is unlikely to be produced if they are disregarded. 46‐48..  The efficient quantity produced of a good is least likely to:  A...................... Volume 2..... Reference: CFA® Program Curriculum.... if a good has external benefits it is least likely to lead to:  A....... Volume 2..................... B.. C.... D ........ pp. an inefficient quantity being produced... This will lead to underproduction of the good........LOS: Reading  14‐e  Correct Answer:  External benefits refer to benefits that accrue to people other than a consumer of a good so the demand curve for the good does not reflect all the benefits that accrue... C........ be the quantity to which free market forces drive production........... 43‐46... pp............................. D.. be the point where the marginal society benefit equals the marginal society cost... which is a social loss...        20.......... B.  In the market economy....132   Study Session 04:   19..... overproduction of the good............

  We also ignore  minus signs.  2.  0.  The  elasticity  of  demand  is  closest to:  A.  2.  The price of ABC Financial News is increased from $2.Economics: Microeconomic Analysis   133  21.  0.000  units.  If the price of televisions produced by manufacturer is increased by 10% from $500 to $550 then  demand  is  forecast  to  fall  by  20%.  C.22.  B.  1.45.  B. this leads to an increase in the  sales  of  a  competing  financial  magazine  .        22.81.  1.  D.33.  up  from 100.  XYZ  Finance.50.  1.000  copies  a  week.  from  100.000 copies a week.22.04.  which  now  sells  120.  C. we are measuring the magnitude of elasticity.    . The cross elasticity of demand is closest to:   A.  D.000  units  to  80.00 to $2.    Note: percentages are calculated on the average price and average quantity.  2.50.25.

........ we are measuring the magnitude of elasticity. 0. 2. B......  from  100.... Volume 2....  If the price of televisions produced by manufacturer is increased by 10% from $500 to $550 then  demand  is  forecast  to  fall  by  20%..  The  elasticity  of  demand  is  closest to:  A.. D..50..000  units  to  80.. C. 13‐14..33.. 2..33 % ∆P 50 / 525 Note: percentages are calculated on the average price and average quantity.......    . 2....... Reference: CFA® Program Curriculum..000  units.................. this is ∆Q / Q ave %∆Q Dem 20/90 = = 2.22...134   Study Session 04:   21...... pp....... We also ignore minus signs.. C .. LOS: Reading  13‐b  Correct Answer:  Price elasticity of demand where QDem = quantity demanded P = price = % ∆Q Dem % ∆P %∆QDem = percentage change in quantity demanded........45..........

...81.000  copies  a  week. The cross elasticity of demand is: %∆Q Dem 20 / 110 0... C. 1.....  up  from 100.......25. LOS: Reading  13‐a  Correct Answer:  Cross elasticity of demand = %∆Q Dem %∆PC where QDem = quantity demanded PC = price of substitute or complement %∆Q Dem = percentage change in quantity demanded....1818 = = = 0.. Volume 2. 1.. The cross elasticity of demand is closest to:   A....        ....22.... 0.  XYZ  Finance...... D. this leads to an increase in the  sales  of  a  competing  financial  magazine  ..81 %∆PC $0.. 1.........000 copies a week....  which  now  sells  120. B..Economics: Microeconomic Analysis   135  22.04..50... 19‐21....... A.....00 to $2....25 0....  The price of ABC Financial News is increased from $2..............50 $2.....2222 Reference: CFA® Program Curriculum...... pp.

 and how to forecast changes in the business cycle and the impact  on. among other things.    Reading 18: Perfect Competition  Reading 19: Monopoly  Reading 20: Monopolistic Competition and Oligopoly  Reading 21: Demand and Supply in Factor Markets  Reading 22: Monitoring Cycles. price levels and profitability.  Among the most important of these market forms are monopoly and perfect competition. Jobs.  or  a  particular  industry. although  monopolistic competition and oligopoly are also covered.  The  readings explain the business cycle.  The  study  session  then  introduces  the  macroeconomic  concepts  that  have  an  impact  on  all  firms  in  the  same  environment.136   Study Session 05:   Study Session 05: Economics: Market Structure and Macroeconomic Analysis   This  study  session  first  compares  and  contrasts  the  different  market  structures  in  which  firms  operate.  a  group  of  related  countries. and the Price Level  Reading 23: Aggregate Supply and Aggregate Demand          .  The  market  environment  influences  the  price  a  firm  can  demand  for  its  goods  or  services.  be  it  a  country. The study session concludes by describing how  an economy’s aggregate supply and aggregate demand are determined.

  C.        .  the level of unemployment after allowing for cyclical conditions in the labor markets.  the level of unemployment after allowing for cyclical and frictional conditions in the  labor markets.  the money wage rate multiplied by the price level.  the money wage rate divided by the inflation rate.        2.  D.   the amount of goods that an hour’s work can buy.  the level of unemployment after allowing for frictional and structural conditions in the  labor markets.  when unemployment is zero.   C.  D.  B.  B.  Full employment is:  A.  the growth in wages adjusted for productivity.  The real wage rate is:  A.Economics: Microeconomic Market Structure and Macroeconomic Analysis   137  1.

....... pp................. the growth in wages adjusted for productivity.. when unemployment is zero.......  Full employment is:  A........ Volume 2. pp.. C ....... B......    .......... C...... or the quantity of goods that an hour’s work can buy.. Correct Answer:  D .... LOS: Reading  22‐c  Full employment is the level of employment after allowing for the normal/natural rate of unemployment caused by frictional and structural factors..........         2............... the level of unemployment after allowing for cyclical and frictional conditions in the labor markets....... the level of unemployment after allowing for cyclical conditions in the labor markets............... Reference: CFA® Program Curriculum... 297‐300... the money wage rate divided by the inflation rate. D... Reference: CFA® Program Curriculum.....138   Study Session 05:   1.. Volume 2............ the money wage rate multiplied by the price level....... D... the level of unemployment after allowing for frictional and structural conditions in the labor markets.....  The real wage rate is:  A... 292‐293...... B............ C........ the amount of goods that an hour’s work can buy.... LOS: Reading  22‐b  Correct Answer:  The real wage is simply the money wage rate divided by the price level......

  A market in which there are only a small number of producers of a good.  B.  D.  C.  B.  One of the reasons single‐price monopolies are said to be inefficient is because:   A.  A firm which has to decide which price will maximize profits.   prices are kept below production costs.        4.  C.   D.  costs are not minimized.Economics: Microeconomic Market Structure and Macroeconomic Analysis   139  3.  An industry where there are high barriers to entry for firms looking to enter the business.  Which of the following is the least accurate description of a monopoly?  A.  prices are below marginal revenue.    .  excess goods are produced.  A producer of a good for which there are no attractive substitutes.

..        4...140   Study Session 05:   3........... prices are below marginal revenue.... prices are kept below production costs...... C .. B........ pp....... An industry where there are high barriers to entry for firms looking to enter the business.. Reference: CFA® Program Curriculum........  Which of the following is the least accurate description of a monopoly?  A..... C... so price also exceeds marginal cost............ pp.......... Volume 2...... D. LOS: Reading  19‐b  Correct Answer:  In a single-price monopoly a shortage of goods is produced.. For a monopoly price exceeds marginal revenue.. 176‐181....... costs are not minimized................. Reference: CFA® Program Curriculum......  One of the reasons single‐price monopolies are said to be inefficient is because:   A.. B.    ... C............... A firm which has to decide which price will maximize profits..................... costs are not minimized... D......... A market in which there are only a small number of producers of a good............... A . A producer of a good for which there are no attractive substitutes. excess goods are produced.... 181‐186....... Volume 2...LOS: Reading  19‐a  Correct Answer:  A monopoly is a firm or market where there is only one producer of a product..

  C.  D. will depend on  the industry.  B. if it is not a natural monopoly.  D.Economics: Microeconomic Market Structure and Macroeconomic Analysis   141  5.  When firms are price takers the short‐run market supply curve is:  A.  Abolish licensing requirements that limit entry to the industry.  horizontal.  whether it slopes upwards or downwards to the right.  Reduce barriers and quotas that are acting as a barrier to foreign firms competing in the  industry.  Which of the following would be the least sensible regulatory step to consider in order to increase  resource allocation of a monopoly?  A.  B.  C.  slopes downwards to the right.    .  Regulate that the monopoly firm must reduce prices to the marginal cost.  Break up the monopoly into smaller companies. or is horizontal.        6.  slopes upwards to the right.

.... C.. pp. 198‐190. pp............ Reference: CFA® Program Curriculum..... B...................... D..... horizontal..... it would be better to use the average total cost....        6............ whether it slopes upwards or downwards to the right..... slopes upwards to the right....... B.142   Study Session 05:   5.... 156‐160........... D...... slopes downwards to the right.......... Break up the monopoly into smaller companies............ if it is not a natural monopoly... LOS: Reading  18‐c  Correct Answer:  Firms will increase supply if the price rises so the supply curve slopes upwards to the right.  Which of the following would be the least sensible regulatory step to consider in order to increase  resource allocation of a monopoly?  A............. will depend on the industry.... B.... or is horizontal..... Reference: CFA® Program Curriculum..... Abolish licensing requirements that limit entry to the industry.. Regulate that the monopoly firm must reduce prices to the marginal cost..... (Note – the long-run supply curve will not necessarily slope upwards to the right)......... B..... Volume 2..LOS: Reading  19‐e  Correct Answer:  Regulating that a monopoly must price their product at the marginal cost would lead to the monopoly making losses.... Reduce barriers and quotas that are acting as a barrier to foreign firms competing in the industry.... C.. Volume 2.........  When firms are price takers the short‐run market supply curve is:  A..    ........

        8.  Which of the following statements regarding a monopoly is least accurate?  A.  D.  B.  There are high barriers to entry.  C.Economics: Microeconomic Market Structure and Macroeconomic Analysis   143  7.  The demand curve is horizontal.  There are no substitutes for a product.  Foreign exchange rate  increase  increase   decrease   decrease                   Expected inflation rate  increase  decrease  increase   decrease    .  There is a single seller of a well‐defined product.  C.  D.  B.  What is the impact of an increase in foreign exchange rate (strengthening of local currency) and  an increase in the expected inflation rate on aggregate demand?      A.

. The demand curve is horizontal.. B.......... There are high barriers to entry.......... B..... LOS: Reading  23‐b  An increase in the foreign exchange rate will decrease aggregate demand since net exports will decline..................... 322‐325.        8. D.... D................ There is a single seller of a well-defined product.. It is downward sloping............. C..... There are no substitutes for a product.........    .. Volume 2................... Reference: CFA® Program Curriculum....  Which of the following statements regarding a monopoly is least accurate?  A.... Reference: CFA® Program Curriculum...... as price increases demand will fall................... An increase in the expected inflation rate increases aggregate demand as people choose to buy goods today before prices rise. B.. C.........144   Study Session 05:   7... 178‐81....... Volume 2.. Foreign exchange rate increase increase decrease decrease Expected inflation rate increase decrease increase decrease Correct Answer:  C ........  What is the impact of an increase in foreign exchange rate (strengthening of local currency) and  an increase in the expected inflation rate on aggregate demand?    A.. pp............. pp......LOS: Reading  19‐a  Correct Answer:  The demand curve for a monopoly is the market demand curve.

  the inflation rate is very high.  A significant rise in the real wage rate is most likely to indicate that:  A.  C.  D.  C.Economics: Microeconomic Market Structure and Macroeconomic Analysis   145  9.  B.  Price takers    Yes   Yes   No    No            Firms in monopolistic competition  Yes  No  Yes  No  productivity is rising.  B.    .  D.  the aggregate hours worked has risen.  the employment rate has dropped sharply.  Long‐run economic profits can be made by:    A.        10.

................. the aggregate hours worked has risen..... Therefore in the long run they will make zero economic profits.... Volume 2.. pp.................. LOS: Reading  20‐b  Correct Answer:  Price takers and firms in monopolistic completion are operating in markets where there are no barriers to entry and exit..... D. D.. C.. the employment rate has dropped sharply....... 292‐293... A ..... B.. pp. LOS: Reading  22‐b  Correct Answer:  When real wages rise.......... Price takers Yes Yes No No Firms in monopolistic competition Yes No Yes No D ...... Volume 2.......................................... the inflation rate is very high.......  Long‐run economic profits can be made by:  A...............  A significant rise in the real wage rate is most likely to indicate that:  A... C. Reference: CFA® Program Curriculum.... productivity is rising.. Reference: CFA® Program Curriculum...    ................ 212‐213. it usually coincides with an increase in productivity...        10........ B......146   Study Session 05:   9....

        12.  B.  D.  C.  D.  An increase in the quantity of capital in an economy is likely to:  A.  average variable cost.  B.  A profit maximizing firm in monopolistic competition will expand output until marginal revenue  equals:  A.  market price.  shift only the short‐run aggregate supply curve to the right.  C.  have no effect on the aggregate supply curves.  shift both the short‐run and long‐run aggregate supply curves to the right.Economics: Microeconomic Market Structure and Macroeconomic Analysis   147  11.    .  marginal cost.  average total cost.  shift only the long‐run aggregate supply curve to the right.

. Volume 2.............. have no effect on the aggregate supply curves......    .......... average total cost. pp. marginal cost.........        12...... D.......... average variable cost.... Volume 2..... D.... D ... shift only the long-run aggregate supply curve to the right.  An increase in the quantity of capital in an economy is likely to:  A. 316‐319. 210‐212.148   Study Session 05:   11. pp.. market price.......  A profit maximizing firm in monopolistic competition will expand output until marginal revenue  equals:  A............ B..... C...........................LOS: Reading  23‐a  Correct Answer:  The larger the capital base the more productive the labor force and the higher the output shifting both supply curves to the right...... shift only the short-run aggregate supply curve to the right.............. C....... B.... shift both the short-run and long-run aggregate supply curves to the right.................. Reference: CFA® Program Curriculum........ LOS: Reading  20‐b  Correct Answer:  Output will be expanded until marginal revenue equals marginal cost............ B.. Reference: CFA® Program Curriculum......

  C.  The lowest possible cost is most likely to be found in a market which is:  A.  Classical economists believe:  A.   technological change is a strong influence on aggregate demand.    .  D.        14.Economics: Microeconomic Market Structure and Macroeconomic Analysis   149  13.   an oligopoly.  money wage rates are slow to change in a recession.  B.  D.  fiscal policy can be used to stimulate aggregate demand.  B.   in perfect competition.  a monopoly.  in monoplolistic competition.  C.   the government should use monetary policy to stimulate demand in a recession.

....  The lowest possible cost is most likely to be found in a market which is:  A.        14.    ...... and the economy is effective at self regulation.. pp..... 335.. B................. 214‐215... D.. LOS: Reading  23‐d  Correct Answer:  Classical economists believe technological change is the main driver of aggregate demand and supply.... in perfect competition. Also monopolies and oligopolies set prices above an efficient point which reduces quantity and increases average costs... C. C ..... Reference: CFA® Program Curriculum... LOS: Reading  20‐b  Correct Answer:  In monopolistic competition firms produce below the efficient amount which increases costs. B... in monoplolistic competition....... an oligopoly.150   Study Session 05:   13. p.. C ........... a monopoly........... Volume 2. Reference: CFA® Program Curriculum....  Classical economists believe:  A.................. the government should use monetary policy to stimulate demand in a recession........... C... D....................... money wage rates are slow to change in a recession.................. technological change is a strong influence on aggregate demand........... fiscal policy can be used to stimulate aggregate demand.............. Volume 2.........

  9.3%.  If the CPI price index was 75 last year and 82 this year.  C.2%.  B.        16.  B.  D.  a large number of participants.    .  8.  identical products.Economics: Microeconomic Market Structure and Macroeconomic Analysis   151  15. then the annual inflation rate is closest to:  A.5%.  7.  C.  A price‐taker market is least likely to be characterized by:  A.  each participant has a small market share.  high entry barriers.  D.0%.  8.

...33% Reference: CFA® Program Curriculum... pp......... 150‐151. Reference: CFA® Program Curriculum... each participant has a small market share......... There are no restrictions or barriers to entry................ then the annual inflation rate is closest to:  A......LOS: Reading  18‐a  Correct Answer:  A price-taker market is one with perfect competition............ high entry barriers...152   Study Session 05:   15. 300‐304..........  A price‐taker market is least likely to be characterized by:  A..... identical products.....2%...75)/75] x 100 = 9... Volume 2. LOS: Reading  22‐d  Correct Answer:  The inflation rate is [(82 ................ 9.. 8.. a large number of participants........ C.3%...... D .. 7.....    ...... p.................5%.......  If the CPI price index was 75 last year and 82 this year. B.. 8..... D......        16. Volume 2......... B.......0%......... D........ C. B..

  Retired workers.  People looking for a job.  D.  Which of the following groups of people is least likely to be included in the labor force?  A.  B.        18.  C.  People waiting to start a new job within two weeks.  D.  marginal cost.  market price.  average total cost.  B.  A profit maximizing price taker will expand output until marginal revenue equals:  A.  average variable cost.Economics: Microeconomic Market Structure and Macroeconomic Analysis   153  17.    .  Part‐time workers.  C.

... B. marginal cost..    ............... it does not include retired workers.  A profit maximizing price taker will expand output until marginal revenue equals:  A. C.....LOS: Reading  22‐a  Correct Answer:  The labor force includes all the employed and unemployed. average total cost................154   Study Session 05:   17. LOS: Reading  18‐b  Correct Answer:  Output will be expanded until Price = Marginal revenue = Marginal cost...  Which of the following groups of people is least likely to be included in the labor force?  A..................... C......................... Volume 2.............. average variable cost............ Reference: CFA® Program Curriculum.............. Reference: CFA® Program Curriculum.. D...... D..        18... People looking for a job....... market. which is a purely competitive.... 151‐152.. pp....... 287‐288. Volume 2... A .. B...... Retired workers.... market price... Part-time workers........ People waiting to start a new job within two weeks.. B..... pp... Marginal revenue always equals market price in a price taker.......

        20.  Output  increase   increase   decrease  decrease            Prices  increase   decrease  increase   decrease    .  If a monopoly uses price discrimination it is least likely to have the effect of:   A.  C.  finding the single price that will maximize the quantity sold.  minimizing the consumer surplus.  B.  Firms acting in collusion in an oligopoly would generally attempt to:     A.  producing the quantity which is similar to that produced in a perfectly competitive  market.  bringing the market demand curve close to the marginal revenue curve.  D.  C.  D.  B.Economics: Microeconomic Market Structure and Macroeconomic Analysis   155  19.

...... C.... D.... minimizing the consumer surplus...156   Study Session 05:   19... finding the single price that will maximize the quantity sold... Volume 2.. 220‐222................ bringing the market demand curve close to the marginal revenue curve and producing a higher quantity.....    ........ B.. B.. 191‐196... bringing the market demand curve close to the marginal revenue curve. By definition price discrimination is not a single-price monopoly so answer B is not accurate Reference: CFA® Program Curriculum.....        20............. producing the quantity which is similar to that produced in a perfectly competitive market.... D.................. LOS: Reading  19‐c  Correct Answer:  Price discrimination has the effect of transferring the consumer surplus to the monopoly.... pp. pp................  Firms acting in collusion in an oligopoly would generally attempt to:   A. C...................LOS: Reading  20‐a  Correct Answer:  Collusion is usually with the intention of increasing economic profit for the participants by limiting output and raising pierces. Output increase increase decrease decrease Prices increase decrease increase decrease C . Volume 2...................................  If a monopoly uses price discrimination it is least likely to have the effect of:   A............... B........ Reference: CFA® Program Curriculum....

        22. It explains why:  A.  C.  D.  Which of the following is a characteristic of monopolistic competition?   A.  Firms cannot sell products above the market price.  the opportunity to make large profits will tempt new members to join the cartel.  Firms produce identical products.  B.  D.   Firms have downward sloping demand curves.Economics: Microeconomic Market Structure and Macroeconomic Analysis   157  21.  The market is purely competitive. the easier it is to maintain price‐fixing agreements.     .  cartels can be maintained as long as there are only a small number of members.  the more players in a cartel.  C.  members of a cartel are tempted to cheat on other members of the cartel.  B.  The prisoners’ dilemma can be applied to price‐fixing in an oligopoly.

......... Reference: CFA® Program Curriculum........ C ..... B...... The market is purely competitive... B and D are all characteristics of a price-taker or a perfectly competitive market.. Firms have downward sloping demand curves.. Firms cannot sell products above the market price.... Firms produce identical products.. pp............. 208‐210...........    ........158   Study Session 05:   21............LOS: Reading  20‐a  Correct Answer:  A. C....... D.....  Which of the following is a characteristic of monopolistic competition?   A..... Volume 2...

..... C..... pp....Economics: Microeconomic Market Structure and Macroeconomic Analysis   159  22... Volume 2...... members of a cartel are tempted to cheat on other members of the cartel...... cartels can be maintained as long as there are only a small number of members.... It explains why:  A..... the easier it is to maintain price-fixing agreements... B.......LOS: Reading  20‐d  Correct Answer:  Game theory shows that Nash equilibrium is reached when participants cheat........ 226‐234...  The prisoners’ dilemma can be applied to price‐fixing in an oligopoly.......... D.. although this is not the best outcome for participants. the more players in a cartel............ Reference: CFA® Program Curriculum........... A......        .. the opportunity to make large profits will tempt new members to join the cartel.....

 and this study  session  describes  circumstances  when  this  may  lead  to  inflation  and  the  transmission  mechanisms  between the monetary sector and the real part of the economy. highlighting the special role of the central bank within an economy. Supply and  demand for resources. Interest. It examines the functions of money  and how it is created. Finally.160   Study Session 06:   Study Session 06: Economics: Monetary and Fiscal Economics   This study session focuses on the monetary sector of an economy. Banks. Real GDP. such as labor and capital. the goals and implications of  fiscal  and  monetary  policy  are  explored  by  examining  some  of  the  main  models  of  macroeconomic  theory (Keynesian. and the Price Level  Reading 26: Inflation  Reading 27: Fiscal Policy  Reading 28: Monetary Policy        . and monetarist). classical. and goods are strongly interrelated.     Reading 24: Money. and the Federal Reserve  Reading 25: Money.

         2.  monetary policy should be constantly adjusted to reflect levels of aggregate demand.  long term GDP growth is only affected by technological change.  C.   D.   D.  aggregate demand will be less than expected when the Fed raises interest rates.  A monetarist is most likely to believe that:   A.   inflation will fall and real GDP will fall below potential GDP.Economics: Monetary and Fiscal Economics   161  1. compared to the shift with an  unanticipated policy change.  the government should adopt expansionary fiscal policies when real GDP is below  potential GDP.       .  the supply curve shifts more sharply to the left.  steady money growth will allow the economy to operate at full employment.  B.  C.  It is important the Fed’s policies to control inflation have credibility when faced with the prospect  of rising inflation since it is more likely that:    A.  inflation will fall without an increase in unemployment.  B.

........... long term GDP growth is only affected by technological change. compared to the shift with an unanticipated policy change.. aggregate demand will be less than expected when the Fed raises interest rates. LOS: Reading  28‐b  Correct Answer:  Monetarists believe that the economy is self regulating and it will normally operate at full employment if the pace of money growth is kept steady......... If the policy is not anticipated demand is still expected to increase at a higher rate and money wage rates continue to rise at a higher rate. B....... D..............  It is important the Fed’s policies to control inflation have credibility when faced with the prospect  of rising inflation since it is more likely that:    A.. 468‐470... Correct Answer:  A ........  A monetarist is most likely to believe that:   A...... pp....... so the supply curve moves to the left slowing GDP.. the government should adopt expansionary fiscal policies when real GDP is below potential GDP... the supply curve shifts more sharply to the left.... LOS: Reading  28‐d  If the Fed’s policies are anticipated then wage rates will grow more slowly reflecting the expectations of lower aggregate demand so inflation can be reduced without a move towards recession or increased unemployment............ steady money growth will allow the economy to operate at full employment....... Volume 2.......................................... B.. D.......... Reference: CFA® Program Curriculum..... C. B. C........ inflation will fall and real GDP will fall below potential GDP...........    .. monetary policy should be constantly adjusted to reflect levels of aggregate demand... Reference: CFA® Program Curriculum....... pp.162   Study Session 06:   1. Volume 2...........         2... 477‐479.. inflation will fall without an increase in unemployment.

Economics: Monetary and Fiscal Economics   163  3.  reduce its outstanding debt.  increase business tax rates.  the velocity of money.        4.  When the government adopts a counter cyclical fiscal policy in response to a threat of recession  the government might:  A.  prices.  D.  employment.  reduce the size of the budget deficit (or increase the surplus).  The quantity theory of money says that an increase in money supply will lead to an increase in:  A.  increase infrastructure spending.  C.  B.  D.  output.  C.    .  B.

............. the velocity of money. B................... C..... reduce its outstanding debt.. reduce the size of the budget deficit (or increase the surplus).......... LOS: Reading  25‐c  Correct Answer:  The quantity theory of money says a change in money supply will lead to the same change in price levels.......... Volume 2..        4.  The quantity theory of money says that an increase in money supply will lead to an increase in:  A.......... B.. pp... Reference: CFA® Program Curriculum.. pp.......... prices........... since velocity and output are unaffected by the quantity of money. increase business tax rates..... Volume 2....... C ... Reference: CFA® Program Curriculum....... employment..164   Study Session 06:   3............. D... 386‐389..... output............  When the government adopts a counter cyclical fiscal policy in response to a threat of recession  the government might:  A.. C...... This is derived from MV = PY.... A ......    ..... increase infrastructure spending.. D............LOS: Reading  24‐e  Correct Answer:  A countercyclical policy attempts to move the economy in the opposite direction to the business cycle and therefore ahead of a recession the policy would be aimed at stimulating demand...... 361‐364.........

  C.  B.Economics: Monetary and Fiscal Economics   165  5.  D.  Which of the following is least likely to be an impact of higher inflation if the higher inflation was  anticipated?  A.  Decision‐makers spend more time forecasting the impact of inflation and less time in  productive activities.  C.  the interest rate level that will attract individuals to place a greater proportion of their  wealth on deposit with banks.  D.  B.  The demand for money is:  A.  a measure of consumers’ willingness to increase productivity for additional  remuneration.  A reduction of investment by businesses.  Real GDP will fall below potential GDP.  the amount of money drawn out of cash and savings accounts over one year.  An increase in effective tax rates.   the amount of money that people wish to hold in cash and highly liquid assets.        6.    .

. the amount of money drawn out of cash and savings accounts over one year............. Decision-makers spend more time forecasting the impact of inflation and less time in productive activities..... a measure of consumers’ willingness to increase productivity for additional remuneration.. but anticipated inflation should not do so as resource costs will rise in anticipation of higher prices........ Correct Answer:  B.... A reduction of investment by businesses.. 376‐380..166   Study Session 06:   5......... Reference: CFA® Program Curriculum.LOS: Reading  25‐a  The demand for money is simply the amount of money that people wish to hold in cash and highly liquid assets.............. the interest rate level that will attract individuals to place a greater proportion of their wealth on deposit with banks....................... B... D.... D. C. Correct Answer:  B........ LOS: Reading  26‐d  Unanticipated inflation will reduce real GDP below potential GDP........... An increase in effective tax rates.... pp..............  Which of the following is least likely to be an impact of higher inflation if the higher inflation was  anticipated?  A.. B.....    ..... the amount of money that people wish to hold in cash and highly liquid assets.... Reference: CFA® Program Curriculum...  The demand for money is:  A.. so the aggregate demand and aggregate supply curves will both shift together....................... 412‐414...        6...... C....... pp....... Volume 2.......... Real GDP will fall below potential GDP... Volume 2..

  are most likely to be:      A.    .  A move by government to adopt a more expansionary monetary policy in response to the threat  of an economic slowdown will.  be ineffective in increasing output since decision‐makers will adjust their expectations to  reflect the policy.  inancial innovation            increase     increase   decrease   decrease                     Rising interest rate  increase  decrease  increase   decrease  D.  C.  be ineffective since it will be too early to adjust policy.  B.  C.  D.S.  B.         8.  tend to stabilize the economy as output responds to the change in policy. in the long run:  A.  have no effect on the economy.Economics: Monetary and Fiscal Economics   167  7.  The impact on demand for money (M1) of financial innovation and rising interest rates in the U.

.......... Reference: CFA® Program Curriculum...........168   Study Session 06:   7.. Correct Answer:  D .......        8...... Reference: CFA® Program Curriculum................ D....... in the long run:  A....... so the only impact will be a rise in prices. which give zero interest........ pp......... LOS: Reading  25‐b  In the long run decision-makers would have time to adjust their policies................  are most likely to be:    A..... B. new products such as credit card and ATMs have reduced the demand for M1..... inancial innovation increase increase decrease decrease Rising interest rate increase decrease increase decrease Correct Answer:  D .......... 376‐380.. As interest rates rise the opportunity cost of holding money in currency or checking accounts. have no effect on the economy... increases and money is placed in interest bearing securities such as savings accounts. pp..... D...... This decreases the demand of money..LOS: Reading  25‐a  Financial innovation tends to reduce the demand for money...... be ineffective in increasing output since decision-makers will adjust their expectations to reflect the policy. Volume 2....... tend to stabilize the economy as output responds to the change in policy. Volume 2. be ineffective since it will be too early to adjust policy..................S........    .....  A move by government to adopt a more expansionary monetary policy in response to the threat  of an economic slowdown will... 386‐387.......... B... C..  The impact on demand for money (M1) of financial innovation and rising interest rates in the U..... C..

  According to the quantity theory of money if the GDP of a country is $50 billion and the velocity  of circulation is 8.  B.  D. which will increase money supply.    .  $400 billion.  In the case that households increase their holdings of currency and reduce the balances in their  checking accounts by an equal amount.  to increase money supply since the currency is available for immediate use. which will tend to reduce the money  supply.  there will be no impact on money supply.        10.  the impact on the money supply will be:  A.  $6.  to reduce the amount that can be loaned by banks.  C.  D. then the quantity of money is:   A.200 billion.  $160 billion.  $3.25 billion.  C.  B.Economics: Monetary and Fiscal Economics   169  9. since the increased holdings in currency will  offset the reduction in checking accounts. and the Federal Reserve does not take any offsetting action.  to reduce banks’ required reserves.

...... C.... C...... which will increase money supply.  the impact on the money supply will be:  A............. 387‐389. pp. 348‐352... there will be no impact on money supply..... to increase money supply since the currency is available for immediate use...... A ......  In the case that households increase their holdings of currency and reduce the balances in their  checking accounts by an equal amount..  According to the quantity theory of money if the GDP of a country is $50 billion and the velocity  of circulation is 8. then the quantity of money is:   A... Reference: CFA® Program Curriculum.25 billion. B.. Correct Answer:  C ....... Reference: CFA® Program Curriculum....... since the increased holdings in currency will offset the reduction in checking accounts. LOS: Reading  25‐c  Correct Answer:  Use MV = GDP......... and the Federal Reserve does not take any offsetting action. to reduce banks’ required reserves.......... D.............. $6... pp... so M = $50 billion/8 = $6.... which will tend to reduce the money supply... D............. Volume 2.........    .... $3.......170   Study Session 06:   9.. to reduce the amount that can be loaned by banks.200 billion.................... $400 billion. B........        10... which will reduce the money supply.... Volume 2.. If the balances in checking accounts are reduced then it will not directly affect the money supply but it will reduce the amount of reserves that the banks need to keep and also reduce the amount that they can loan.25 billion.....LOS: Reading  24‐a  Checking accounts and currency are included in money supply....... $160 billion..........

  D.        12.  B.  Treasury‐bill rate.  the monetary base.   the federal funds rate.  Interest rates  increasing    increasing     decreasing    decreasing               Quantity of money  increasing  decreasing  increasing  decreasing    .Economics: Monetary and Fiscal Economics   171  11.  When aggregate demand drops sharply the Keynesian feedback rule is most likely to lead to the  Fed:    A.  B.  D.  C.  Intermediate targets of the Fed’s monetary policy are least likely to include:   A.  C.  M1.

... Interest rates increasing increasing decreasing decreasing Quantity of money increasing decreasing increasing decreasing C .......LOS: Reading  28‐a  Correct Answer:  Intermediate targets give the Fed information on whether the monetary policy is having the desired effect....... the federal funds rate.... Treasury-bill rate.. C.... C .  Intermediate targets of the Fed’s monetary policy are least likely to include:   A..... Reference: CFA® Program Curriculum.... pp................... M1....... Volume 2......  When aggregate demand drops sharply the Keynesian feedback rule is most likely to lead to the  Fed:  A........ Volume 2....... D......... the monetary base..... M2 and/or the monetary base) and the federal funds rate.... B..... pp....        12.................. LOS: Reading  28‐c  Correct Answer:  The Fed would decrease the interest rate and increase the quantity of money in order to shift the aggregate demand curve back to the right........ D....... 470‐472..    ................ C... Typically these targets will be monetary aggregates (M1...... 462‐463.... B.............. Reference: CFA® Program Curriculum.....172   Study Session 06:   11.............

  C.  Interest rates.  C.  Progressive corporate tax.  Inflation rates.  B.  fixed‐rule policy.  D.        14.  Exchange rates.    .  Which of the following is an automatic stabilizer?  A.Economics: Monetary and Fiscal Economics   173  13.  This is most likely to be an example of a:   A.  B.  discretionary policy.  After analysis of the economic environment the Fed decides not to change its monetary policy in  response to a demand‐driven slowdown in the economy.  feedback‐rule policy.  stabilization policy.  D.

..... fixed-rule policy.......... They include unemployment benefits........... Reference: CFA® Program Curriculum. stabilization policy......174   Study Session 06:   13........ 452‐455........ Inflation rates........ progressive corporate and personal taxes.... B. D ................ C..... discretionary policy............... D.  This is most likely to be an example of a:   A...........  Which of the following is an automatic stabilizer?  A...... Volume 2.    ....... Volume 2. pp..        14. feedback-rule policy... 467‐468..LOS: Reading  27‐e  Correct Answer:  Automatic stabilizers will tend to expand a budget deficit during a recession and contract a budget deficit in a boom...... Progressive corporate tax................ D....... B....... Interest rates....... Exchange rates..... pp............ LOS: Reading  23‐b  Correct Answer:  Discretionary policies respond to the state of the economy after taking into account all of the available information so C is the best answer.. Reference: CFA® Program Curriculum...........  After analysis of the economic environment the Fed decides not to change its monetary policy in  response to a demand‐driven slowdown in the economy.. C . C..

  C.  B.  D.  Traveler’s checks.  B.  The demand for money curve shows that the quantity of money demanded is:   A.  positively related to GDP growth.  Checking deposits.  C.  Which of the following is least likely to be included in M1?  A.  Issued checks.        16.  inversely related to interest rates.  positively related to interest rates.  Currency.    .Economics: Monetary and Fiscal Economics   175  15.  inversely related to GDP growth.  D.

. Volume 2. C................... Reference: CFA® Program Curriculum. inversely related to GDP growth.................. Traveler’s checks. pp... pp... not a form of money.... Volume 2......        16..... Checking deposits....... D .....    ............. B... positively related to GDP growth..... positively related to interest rates.......... inversely related to interest rates.... Checks are a promise to pay..... 302‐305.... C......  Which of the following is least likely to be included in M1?  A............176   Study Session 06:   15........... Currency.. B... B... traveler’s checks and checking deposits. Reference: CFA® Program Curriculum............... 376‐380....... D...  The demand for money curve shows that the quantity of money demanded is:   A...............LOS: Reading  25‐a  Correct Answer:  Demand for money measures the relationship between interest rates and the amount of money that people want to hold. LOS: Reading  24‐b  Correct Answer:  M1 is made up of currency. D............. Issued checks.

        18. when a customer puts $100.000    $9.  If banks retain 5% of new deposits in reserves and lend out 95%.  Loans              Deposits  $2.  C.000    $2.000.Economics: Monetary and Fiscal Economics   177  17. it will lead to a potential increase in loans and deposits of:    A.500.  increasing budget deficits to stimulate growth will be financed by higher total savings  rates.  increasing budget deficits to stimulate growth has no effect on economic activity.000  $9.900.000     $9.  increasing budget deficits to stimulate growth will be lead to a decline in net exports.500.000       .  D.  D.500.  the effect of increasing budget deficits to stimulate growth will be dampened by the  negative impact of higher real interest rates on private spending.000.000  on deposit with a bank.000  $1.  B.400.  The crowding‐out model says:  A.000  $2.000.  C.000  $9.  B.

178   Study Session 06:   17......................000 The potential deposit expansion multiplier is 1/0..........000 + $95.... C..    .750 as reserves and lends out $90...000 A ..... Volume 2...............000..000(1/0..000. D...... Correct Answer:  D .. the effect of increasing budget deficits to stimulate growth will be dampened by the negative impact of higher real interest rates on private spending. Loans $1.000 $9. D..000.......  If banks retain 5% of new deposits in reserves and lend out 95%... If we continue the exercise we can see that the total increase in deposits is $100. this will crowd out private investment.000 $2..000. = $100...000 $9........... increasing budget deficits to stimulate growth will be lead to a decline in net exports. Reference: CFA® Program Curriculum.....        18.. This money is in turn placed on deposit at another bank (after being used as payment in a transaction) and the next bank keeps $4......000 $9..500. B.. less the original $100.......400....000  on deposit with a bank.000 $2..05 = 20....500............000..........000. pp.250 + …....... increasing budget deficits to stimulate growth has no effect on economic activity.  The crowding‐out model says:  A.000.000 $9... pp. LOS: Reading  27‐b  A budge deficit decreases savings supply and therefore increases the real interest rate. 444‐445.. C..500.... The increase in loans will be $2....000. 356‐359.......05) = $2. B...... Volume 2..000 as reserves and can lend out $95....... when a customer puts $100.. Reference: CFA® Program Curriculum. increasing budget deficits to stimulate growth will be financed by higher total savings rates.000 Deposits $2.............000 + $90.900. LOS: Reading  24‐d  Correct Answer:  The bank keeps $5. it will lead to a potential increase in loans and deposits of:  A.250.

  C.  different generations are likely to pay different proportions of any fiscal imbalance.Economics: Monetary and Fiscal Economics   179  19.  the difference between the current year’s forecast tax revenues and social security  obligations.        20.  C.  B.    .  at the natural unemployment rate any anticipated inflation rate is possible.  B.  unemployment and inflation are inversely related.  an increase in aggregate demand lowers unemployment and increases inflation.  D.  D.  the imbalance between the amount of tax collected from the younger generation and the  amount collected from the older generation in any one calendar year.  the difference between the present value of expected tax revenues and social security  obligations.  A generational imbalance created by fiscal policy refers to:  A.  unemployment and expected inflation are inversely related.  The slope of the long‐run Phillips curve shows that:  A.

.... an increase in aggregate demand lowers unemployment and increases inflation.......    .... pp............... the difference between the present value of expected tax revenues and social security obligations.... D..... LOS: Reading  27‐c  The generational imbalance refers to how the load of the fiscal imbalance will be spread among different generations... 416‐417.... D.. In the U..... the imbalance between the amount of tax collected from the younger generation and the amount collected from the older generation in any one calendar year.... at the natural unemployment rate any anticipated inflation rate is possible. Volume 2.. B. pp....  The slope of the long‐run Phillips curve shows that:  A.. Correct Answer:  A . Reference: CFA® Program Curriculum.. Volume 2......... C......180   Study Session 06:   19....... 445‐447.......................S............. Reference: CFA® Program Curriculum......        20........ unemployment and inflation are inversely related..... C. C ...  A generational imbalance created by fiscal policy refers to:  A............ B...... it looks likely that part of the imbalance will have to be paid for by future generations..... It is vertical since GDP equals potential GDP when inflation is anticipated and unemployment is at its natural rate....LOS: Reading  26‐e  Correct Answer:  The LRPC is the relationship between inflation and unemployment when the inflation rate equals the expected rate........... the difference between the current year’s forecast tax revenues and social security obligations..... different generations are likely to pay different proportions of any fiscal imbalance... unemployment and expected inflation are inversely related................

  the division of the fiscal imbalance between the different generations.  Which  of  the  following  is  the  most  accurate  description  of  what  generational  accounting  measures?    A.  2006 inflation rate     2.  C.7%  3.Economics: Monetary and Fiscal Economics   181  21.  life expectancy and pension costs of each generation.  the tax burden and benefits taken by each generation.  D.  D.  present value of a government’s obligation to pay benefits and the present value of its tax  revenues.         22.0%  3.  C.0%  3.1%     .  The year‐end price data for a country was:   Year‐end  2005  2006  2007    Price level  110  113  117  The annual inflation rate in 2006 and the compound annual rate for the 2005‐2007 period were  closest to:      A.1%  6.5%                  2005‐2007 annual rate   3.7%  2.2%  7.  B.  B.

...... B... Reference: CFA® Program Curriculum..........    ... the division of the fiscal imbalance between the different generations..... present value of a government’s obligation to pay benefits and the present value of its tax revenues....... Volume 2..... B............. LOS: Reading  27‐c  Correct Answer:  Generational accounting is the method used to measure tax (income and social security) paid by each generation versus the social security benefit they receive in retirement...... D refers to fiscal balances across all generations and C refers to the generational imbalance............ pp...  Which  of  the  following  is  the  most  accurate  description  of  what  generational  accounting  measures?  A........ the tax burden and benefits taken by each generation... D.. C.............. life expectancy and pension costs of each generation... 445‐447..182   Study Session 06:   21..

...Price level last year × 100 Price level last year   113 110 × 100 = 2............5% 3....1% B.....027)(1.  The year‐end price data for a country was:   Year‐end  2005  2006  2007    Price level  110  113  117  The annual inflation rate in 2006 and the compound annual rate for the 2005-2007 period were closest to: 2006 inflation rate 2005-2007 annual rate A..........7% 6.....2% C.. 2......1%     Reference: CFA® Program Curriculum.5% 113   Inflation rate 2006 = Inflation rate 2007 = The compound annual rate is  (1.        .... 3.. 400‐401...0% D.1% Correct Answer:    A.........7% 110   117 113 × 100 = 3..... 2... Volume 2.. pp. 3...........035) 1 = 3....0% 7.7% 3......... LOS: Reading  26‐a  Inflation rate = Price level this year .......Economics: Monetary and Fiscal Economics   183  22..

” Ch. pp. 246–258  “Inventories. 5. 12.” Ch. rather than accounting simply on a cash basis.” Ch.  (Houghton  Mifflin.      .  and  Marian  Powers. that  revenues are recognized when they are earned and expenses when they are incurred rather than  when  they  are  actually  paid.13.184   Study Session 7 Introduction  Study Session 7: Introduction Introductory Readings Financial  Accounting. 412–426  “Contributed Capital. pp.  The  matching  rule  states  that  revenues  must  be  assigned  to  the  periods  when  the  services  are  performed  or  the  goods  are  sold.” Ch.” Ch.  8th  edition. pp.  Accounts  are  likely  to  need  adjustment.  this  is  generally  regarded  as  unsatisfactory  since  revenues  are  often  earned  in  a  different  period  from  which  the  payments  are  received. 8  “Current Liabilities and the Time Value of Money.  Although  revenues  and  expenses  can  be  accounted  for  on  a  cash  basis  for  tax  purposes.  Belverd  E. 584‐591  Measuring Business Income Introduction This  section  looks  at  the  concept  of  net  income  which  is  used  to  measure  a  company’s  profitability.” Ch. 543‐553  “The Corporate Income Statement and the Statement of Stockholders’ Equity.  and  expenses  must  be  assigned  to  the  period  in  which they produce the revenue.  Jr.. and  expenses  paid  in  a  different  period  from  which  they  are  incurred.  Needles. pp.  For  example  transactions  may occur in one accounting period but the benefits may spread over more than one accounting  period.  i. 3  “Financial Reporting and Analysis.  Accrual  accounting  refers  to  methods  that  accountants  use  to  apply  the  matching  rule. A fiscal year refers to the twelve‐month period used  by a company (which in many cases is not the same as the calendar year). 9. 2004)  “Measuring Business Income.  Candidates  need  to  be  familiar  with  the  accrual  basis  of  accounting  and  the  matching principle and why they are used.  Accounting methods Financial statements are prepared at the end of regular accounting periods to make comparisons  between different accounting periods easier.e.

      .  Property.g. whichever is longer. These assets are depreciated to allocate the cost of the assets over the period when they  are used. whichever is longer.  Contributed Capital – the par value of issued stock plus the amounts paid‐in in excess of the par  value. rather than distributed to  stockholders.  Retained Earnings – earnings that have been retained by the company.  Intangible Assets – long‐term assets with no physical substance – e. We will refer to balance sheet and income statement items throughout the  rest  of  the  Financial  Statement  Analysis  notes  so  it  is  essential  you  are  comfortable  with  the  structure.  Current  Liabilities  –  obligations  due  to  be  paid  or  performed  within  one  year. patents. or within the normal operating cycle of the business.  Investments  –  assets  that  are  not  used  in  the  normal  operation  of  the  business  and  are  not  expected to be converted into cash within one year.  Long‐Term Liabilities – debts that are due to be paid out in more than one year or beyond the  normal operating cycle.Introductory Readings   185  Financial Reporting and Analysis Introduction In this section Candidates learn the definition of each category or component on the balance sheet  and income statement. presentation and contents of financial statements.  or  within  the  normal operating cycle of the business.  Plant  and  Equipment  –  long‐term  assets  used  in  the  continuing  operation  of  the  business. goodwill.  Balance Sheet The major categories of a balance sheet are as follows:  ASSETS  Current Assets  Investments  Property. Plant and Equipment  Intangible Assets      LIABILITIES  Current Liabilities  Long‐term Liabilities    STOCKHOLDERS’ EQUITY  Contributed Capital   Retained Earnings  Current Assets – cash and other assets which can reasonably be expected to be realized in cash or  used within one year.

  Operating  Expenses  –  costs  other  than  the  cost  of  goods  sold.  these include interest income and interest expenses.186   Study Session 7 Introduction  Income statement The components of a multi‐step income statement are as follows:    –    =  –    =   +/‐  =   –    Net Sales  Cost of Goods Sold  Gross Profit  Operating Expenses  Income from Operations  Other Revenue and Expenses  Income before Income Taxes  Income Taxes  =   Net Income  Net Sales – gross proceeds from sales.    .  Other  Revenue and  Expenses –  revenues and  expenses  that are not  a  result  of  operating activities.  often  broken  down  into  selling  expenses and general and administrative expenses.  Cost of Goods Sold – amount paid for the goods that were sold. less sales returned and discounts offered.

 This means that the cost of goods held in inventory is associated with those that have been  purchased most recently. The four most commonly used methods  are shown below.  Last-In. The  cost of inventory will include the costs of raw materials used.  These  methods  make  different assumptions on the order in which items are sold. Reading 39.  The  valuation  method  used  to  value  inventory  is  critical since it will decide the COGS and gross profit of the company and the value of inventory on  the balance sheet. cost of labor and overhead costs.  When  assigning  costs  to  items  that  are  sold. There are three components to  inventory cost:  • Invoice price less purchase discounts.  This might be used by an art dealer where there are high priced items for sale that are all unique.Introductory Readings   187  Inventories Introduction Inventory  is another  short‐term  asset appearing  on the  balance sheet  and  the cost  of inventory  will  also  affect  the  income  statement. Allocation of these costs is difficult so they are usually expensed.    .  the  cost  of  goods  held  in  inventory  are  associated  with  those  that  have  been  purchased  the earliest. • Applicable taxes and tariffs.  such  as  storage  costs.  Inventory Inventory is a current asset and consists of goods held for sale in the normal course of business.  should  also  be  included  in  the  cost  of  inventory.  Specific Identification Method This method can be used when it is possible to match units left in inventory with a specific purchase.  different  methods  can  be  used. First-Out Method (LIFO) The  assumption  under  LIFO  is  that  the  cost  of  goods  sold  is  associated  with  the  most  recently  purchased.  There  are  four  methods  of  accounting  for  inventory  and  the  candidate needs to understand the impact on the balance sheet and income statement of the method  used. The  cost  of  goods  sold  (COGS)  is  measured  as  the  cost  of  goods  available  for  sale  less  the  value  of  inventory  at  the  end  of  the  accounting  period.  First-In.  Average-Cost Method Under  this  method  inventory  is  priced  at  the  average  cost  of  items  available  for  sale  during  the  period. • Freight or transportation including insurance costs when in transit. First-Out Method (FIFO) This is based on the assumption that the cost of goods sold is associated with the earliest purchases in  inventory.  Inventory cost Inventory cost is the price or consideration paid to acquire an asset. This Reading is covered in more detail in Study Session 9. It  could  be  argued  that  other  costs.

585.00   COGS        = $250.00  Last‐In. Specific Identification Method  This requires additional information.285.50 = $225.28   less January 31st inventory           = $1.00  = 250 × $5.00 )       COGS             = $1.00 per unit.00  Average‐Cost Method  Average unit cost of goods available for sale          = Cost of goods available for sale/units available          = $1.00  Effect of inventory accounting method In the above example.00   January 31st inventory   = Costs of goods available for sale – COGS          = $1.000.320.00  less January 31st inventory   = (200 × $5.50 each.  the  current  value of costs is used.335. then Cost of Goods Sold (COGS)   =  50 × $4. where prices are rising. If we are told that the specific cost of the 50 units sold was $4.585.00) ‐‐ $225 = $1.50 per unit and on January 20th it purchases 70 additional units at a cost of $6.585.188   Study Session 7 Introduction  Example Int-1   Calculating cost of inventory On December 31st a company holds 200 units in inventory with an assigned total value of $1. First‐Out Method (LIFO)  In this case the 50 units sold are those that were purchased last at a cost of $6.00  First‐In.000 + (30 x $5. the inventory value recorded is higher    .00 )           = $1.00 per  unit.  so  LIFO  will  give  the  lowest  gross  margin.00  less January 31st inventory  = (150 × $5. we can see that LIFO gives the highest COGS and FIFO  the  lowest  COGS. looking at the balance sheet.00 ) + (30 × $5.585/(200 + 30 + 70) = $5. or $5.00    COGS         = $265. First‐Out Method (FIFO)  In this case the 50 units sold are those that were purchased first at a cost of $5.50) + (70 x $6. On January 10th it purchases 30 additional units at a cost of $5.00 per unit Cost of goods available  = $1.  Costs of goods available   = $1.50 ) + (70 × $6. 50 units are sold over the month so 250 units are left in inventory at the end of January.360.00 ) + (30 × $5.00 per unit.28  Cost of goods available  = $1.00  = $300.50 ) + (20 × $6. However.  For  income  statement  items  LIFO  is  generally  considered  the  best  method  since  it  more  closely  follows  the  matching  rule.

00 $500.  then  the  inventory  should  be  written  down  to  the  lower‐of‐cost‐or‐market.50    100 $2. perhaps due to a decline in price  levels  or  obsolescence.  There are two methods for doing this:  Item-by-Item Method Cost and market values are computed for each item in inventory.Introductory Readings   189  under FIFO than LIFO.00 $1.350.00 $600.  When the replacement cost of inventory falls below the historic cost.00    .00  Inventory at the lower of cost or market  Major Category Method  Category 1  Item a  Item b  Total  Category 2  Item c  Item d  Total    Quantity  100 100 Total Cost  $400.  Example Int-2   Calculating inventory values Item‐by‐Item Method    Category 1  Item a  Item b  Category 2  Item c  Item d  Quantity  Cost per  Unit  Market  Value per  Unit  Lower of  Cost or  Market  $400.00  $800.00 $500.00    100 $200.00  $350.00 $350.00 $4.00  100 $600.00 $900.00 $1.00 $600.  Major Category Method  Total cost and total market values are computed for each category of goods.00      100 $4.00  $800.00 $3.00 Total  Market  Value  Lower of  Cost or  Market    $450.00  Inventory at the lower of cost or market  $800.50  100 $5.400.00 $1.00 $100. In this case FIFO could be considered a better method since inventory values  are closer to current values.00 $5.00  100 $6.00 $500.00 $100.

  These  items  include:  • Income taxes – a company’s managers will usually only know the profits after the year-end so an estimated figure must be used.   .  Current liabilities can be broken down into:  (i) Definitely Determinable Liabilities • • • • • • • • • Accounts payable Bank loans and commercial paper Notes payable Accrued liabilities Dividends payable Sales and excise tax payable Current portion of long-term debt Payroll liabilities Unearned revenues (ii) Estimated Liabilities The  existence  of  a  liability  is  clear  but  often  the  amount  will  not  be  known  until  later. whichever is longer.190   Study Session 7 Introduction  Current Liabilities and the Time Value of Money Introduction We  now  move  on  to  look  at  the  liability  side  of  the  balance  sheet. Current liabilities are liabilities that are expected to be paid within a  year. • Property tax payable – these are usually paid to the local governments in the U. Long‐term liabilities are due after one  year  or  operating  cycle.  Liabilities A liability is a legal obligation to make a future payment of assets.. • Vacation pay liability – not all employees will collect vacation pay so this should also be recorded as an estimated liability. or within a normal operating cycle.  Generally. or perform a service in the future.  as a result of a past transaction. • Product warranty liability – whilst a warranty or guarantee is outstanding on a product there is a liability and a firm should estimate how much the warranty is likely to cost.  An  example  is  when  a  sale  is  made  but  there  remains a liability to service the item sold.  Liabilities are usually valued at the amount of money need to pay the debt or the value of goods or  services  to  be  delivered.  Candidates  need  to  be  able  to  differentiate  between  current  liabilities  and  long‐term  liabilities  and  know  how  to  treat  liabilities  when the amount or likelihood of payment is uncertain.  perhaps  based  on  past  experience.  Whilst  in  some  cases  the  amount  is  definitely  known  in  other  cases  an  estimate  is  made.S. and the assessment dates are unlikely to match a firm’s year-end.  current  liabilities  are  paid  from  the  current  assets  or  from  the  proceeds  of  current  operations  whereas  long‐term  liabilities  represent  the  financing  of  long‐term  assets. Therefore an estimated figure should be used.

 usually in terms of both dividends and claim on assets in the  case  of  liquidation.  Paid‐in Capital in excess of par value. 2.Introductory Readings   191  (iii)Contingent liabilities A contingent liability is not an existing liability but a potential liability in the sense that it depends on  the outcome of a future event that arises because of a past transaction.  the  issuer will record a cash dividend payable item as a liability. and prior to payment.  Date  of  record  –  when  ownership  of  the  stock  entitles  the  owner  to  receive  the  dividend.  Common stock This is the residual equity which means that the holders have the last claim on assets in the case that  the  company  goes  into  liquidation.  Dividends  may be paid to stockholders which means that part of the stockholders’ equity. Different types of  preferred stock are:  Cumulative preferred stock – if a dividend is missed then it accumulates and must be paid before a  dividend can be paid to common stock holders. Preferred Stock – par value.  We  also  look  at  payments  to  stockholders  in  the  form  of  cash  dividends  or  repurchase  of  stock  and  the  impact  on  the  balance  sheet. amount authorized and amount issued and outstanding.  After this. 2. 3.  Callable preferred stock – the issuer can redeem the stock at a pre‐specified price.  It  is  usually  the only  stock  that  carries  voting  rights. is  being paid out to stockholders.  Contributed Capital Introduction Candidates are  expected  to  know  the  breakdown  of contributed  capital and  the  difference between  preferred  stock  and  ordinary  stock. amount authorized and amount issued and outstanding.  Contributed capital This is made up of three components:  1.  Dividends  are  revisited  in  Study Session 13.  Accounting for dividends There are three dates to consider:  1. 3.  Dividends  are  often  quoted  as  a  percentage  of  par  value  and  in  this  sense  the  characteristics of preferred stock are similar to those of a fixed‐income instrument.  Convertible preferred stock – can be exchanged into common stock.  Date of payment – the date the dividend is paid. and the liability is settled.  It  should  be  entered  in  the  accounts  if  it  is  both  (i)  probable  and  (ii)  can  be  reasonably  estimated.    . Date  of  declaration  –  when  the  directors  declare  that  a  dividend  is  going  to  be  paid.  Potential  liabilities  that  do  not  meet  these  conditions  should  be  referred  to  in  the  notes  to  the  accounts.  Preferred stock This has preference over common stock. usually earnings.  Common Stock – par value. the stock is ex‐dividend. No accounting entries are needed.

 to the ‘Paid‐in Capital in Excess of Par Value’ account.  This  does  not  involve  a  cash  payment  and  leads  only  to  a  transfer  of  funds  from  retained  earnings  to  the  contributed  capital  account. It is the profits (or losses) since inception less any dividends  paid to stockholders or transfers to contributed capital. or deficit.  The  amount  transferred  is  determined  by  the  market  value of the shares issued.  The  motivation  is  usually  to  reduce  the  market price and increase liquidity of the shares.  Retained earnings Retained  earnings  are  the  part  of  stockholders’  equity  that  represents  the  stockholders’  claim  on  assets generated by the firm’s earnings.  The Corporate Income Statement and the Statement of Stockholders’ Equity Introduction Here  we  consider  stock  dividends  and  stock  splits  which  are  corporate  actions  that  do  not  affect  a  company’s income or asset value.    . usually in the stock market.  Treasury stock This is stock that has been bought back by the issuer. rights to dividends etc.  It is treated as stock that has been issued but is no longer outstanding.  No‐par stock – the proceeds of the issue are credited to the Common Stock account.192   Study Session 7 Introduction  Stock issuance Par value stock – the par value is credited to the Common Stock (or Preferred Stock) account and any  surplus.  Stock splits This  is  when  a  corporation  increases  the  number  of  issued  shares  and  reduces  the  par  value  accordingly. or debited to the ‘Discount  on Capital Stock’ account respectively. and therefore does not have  voting rights. and not been resold  or retired.  Again  this  does  not  involve  a  cash  payment.  Accounting for stock dividends and stock splits Stock dividends This  is  a  distribution  of  shares  to  existing  common  stockholders  in  proportion  to  the  size  of  their  holding.

lower net income and higher inventory balances.  When inventory costs are increasing due to inflation. C.     2. higher net income and lower inventory balances. D. lower net income and lower inventory balances. when they are paid. once they can be reasonably estimated. B.  In a firm’s financial statements expenses should be recorded:   A. D. the decision to use LIFO rather than FIFO  will lead to:  A.Introductory Readings   193  Introduction Concept Check Questions 1.     when they occur. in the same period that related revenues are recorded.   . C. B. higher net income and higher inventory balances.

C. D. B. the firm has issued stock where the dividends are linked to Treasury bill yields. the firm has repurchased its own stock. On the declaration date reduces stockholders’ equity by the size of the dividend payable.   . C. the firm has invested in Treasury notes or Treasury bonds.  A stock dividend:  A. D.     4.     Has no impact on the financial statements. Transfers an amount from retained earnings to contributed capital. the firm has issued preferred shares.  If  Treasury  stock  is  included  in  a  firm’s  balance  sheet  as  part  of  stockholders’  equity  it  means  that:   A. B.194   Study Session 7 Introduction  3. Reduces the par value of stock outstanding.

C. when they occur.  When inventory costs are increasing due to inflation.   . in the same period that related revenues are recorded.  In a firm’s financial statements expenses should be recorded:   A. D  Correct Answer 1:   The matching rule says that related revenues and expenses should be recorded in the same accounting period. higher net income and lower inventory balances. higher net income and higher inventory balances. B. D. B. A  Correct Answer 2:   COGS will be higher under LIFO reducing net income. the decision to use LIFO rather than FIFO  will lead to:  A. Ending inventory will be lower since it will include ‘old’ inventory bought at lower prices. D. when they are paid.Introductory Readings   195  Introduction Concept Check Answers   1. once they can be reasonably estimated. C. lower net income and lower inventory balances. lower net income and higher inventory balances.       2.

has no impact on the financial statements.  A stock dividend:  A. D is not true since no cash is paid out. C  Correct Answer 3:   B refers to a stock split. the firm has repurchased its own stock. reduces the par value of stock outstanding. Correct Answer 4:   B  the firm has issued preferred shares. the firm has issued stock where the dividends are linked to Treasury bill yields.       4. Treasury stock refers to repurchased stock. This is likely to have happened because the managers believed the stock was undervalued in the market or as a defense against a takeover. on the declaration date reduces stockholders’ equity by the size of the dividend payable. B. D.       . C. 3. C. transfers an amount from retained earnings to contributed capital.196   Study Session 7 Introduction  3. the firm has invested in Treasury notes or Treasury bonds. D.  If  Treasury  stock  is  included  in  a  firm’s  balance  sheet  as  part  of  stockholders’  equity  it  means  that:   A. B.

Economics: Monetary and Fiscal Economics   197          .

     Reading 29: Financial Statement Analysis: An Introduction  Reading 30: Financial Reporting Mechanics  Reading 31: Financial Reporting Standards      . as provided in the assigned readings. and statement of changes in owners’ equity). notes to  those  statements. as well as the implications of alternative accounting methods  for financial analysis and valuation.  Candidates  are  expected  to  be  familiar  with  the  overall  analytical  framework  contained in the study session readings.  The  final  reading  in  this  study  explores  the  role  of  financial  reporting  standard‐setting  bodies  worldwide and the International Financial Reporting Standards framework promulgated by one key  body. For the purpose of Level I  questions  on  financial  statement  analysis.  A  general  framework  for  addressing most financial statement analysis tasks is also presented.  The  second  reading  illustrates  this  process.  A  company’s  financial  statements  are  the  end‐products  of  a  process  for  recording  the  business  transactions  of  the  company.  introducing  such  basic  concepts as the accounting equation and accounting accruals.  when  a  ratio  is  defined  and  calculated  differently  in  various texts.  including  the  principal  financial  statements  (the  income  statement. balance sheet. Variations in ratio definitions are part of the nature of practical financial analysis.  underscoring the critical role of the analysis of financial reports in investment decision making.  the  International  Accounting  Standards  Board.  The  first  reading  introduces  the  range  of  information  that  an  analyst  may  use  in  analyzing  the  financial  performance  of  a  company.  Note:   New rulings and/or pronouncements issued after the publication of the readings in Study Sessions 7  through  10  in  financial  statement  analysis  may  cause  some  of  the  information  in  these  readings  to  become  dated.198   Study Session 07:   Study Session 07: Financial Statement Analysis: An Introduction The  readings  in  this  study  session  discuss  the  general  principles  of  the  financial  reporting  system.  The presentation of financial information to the public by a company must conform to the governing  set of financial reporting standards applying in the jurisdiction in which the information is released. et al.  and  management  discussion  and  analysis  of  results.  The  movement  towards  worldwide  convergence of financial reporting standards is also introduced. cash flow statement. candidates should use the definitions given in the CFA Institute copyrighted readings  by Robinson.

  business transactions in date order.  When  a  firm  records  an  allowance  for  uncollectible  receivables  as  a  deduction  against  the  receivables account this is:  A.  a non‐recurring item.    .  D.  account balances.    business transactions by account.   a contra account.  an extraordinary item.Financial Statement Analysis: Introduction   199  1.  B.        2. usually prepared at the end of each accounting period.  C. usually prepared on a daily basis.  B.  account balances.  A general journal records all:  A.  C.  D.  an adjunct account.

....        2.. B... usually prepared on a daily basis......... B. D.... account balances... pp.. an extraordinary item.......  A general journal records all:  A... they are recorded in date order......... business transactions in date order........ Reference: CFA® Program Curriculum.. business transactions by account... D... is a contra account... account balances....200   Study Session 07:   1.. Volume 3.......... A ... a contra account.. pp.. Volume 3....... 68‐69.. a non-recurring item. to a new estimate of its net realizable value.......    ........................................LOS: Reading  30‐g  Correct Answer:  The general journal is the fist step in the flow of information through a financial reporting system....... C............. B........  When  a  firm  records  an  allowance  for  uncollectible  receivables  as  a  deduction  against  the  receivables account this is:  A... Reference: CFA® Program Curriculum. usually prepared at the end of each accounting period.. an adjunct account. LOS: Reading  30‐b  Correct Answer:  An account which reduces the value of an asset... It is where all transactions are recorded showing which accounts they affect. 38‐39.............. C................

  C.    .Financial Statement Analysis: Introduction   201  3.  D.        4.  B.  comprehensive income.  operating income.  Detail.  net income.  Materiality.  C.  B.  pre‐tax income.  Income that is independent of a firm’s capital structure is:  A.  D.  Which of the following is least likely to be important to an analyst when using financial reports?    A.  Relevance.  Consistency.

.. 109‐110......    ........................... LOS: Reading  29‐b  Correct Answer:  Operating income is revenues less costs of goods sold................ A ......... Therefore it is prior to interest costs which reflect the cost of debt financing. C...... 13..... D.. B... Relevance. Volume 3........................ pp.202   Study Session 07:   3...........  Which of the following is least likely to be important to an analyst when using financial reports?  A.. and research and development............... net income... comprehensive income. Consistency..LOS: Reading  31‐e  Correct Answer:  If the financial reports are to be relevant and timely it is not practical for them to include every detail of the financial data.... operating income................. pre-tax income... Reference: CFA® Program Curriculum.. B... SGA.....  Income that is independent of a firm’s capital structure is:  A.... Detail......        4.. Reference: CFA® Program Curriculum... p. Materiality. C ..... Volume 3.......... C..... D...

  C.  increase by $15.  Two  firms  buy  new  photocopiers.000.000.000.  How will the purchases be classified?    A.  D.    The  cost  of  the  goods  is  recorded  as  $35. payment will not be  received  for  30  days.  C.  decrease by $50.Financial Statement Analysis: Introduction   203  5.000 of goods but under credit terms given to customers.  B.        6. and the second firm is a bank planning to use the photocopier in its head  office.    The  first  firm  is  a  retailer  of  office  equipment  and  the  photocopier will be resold.  investing activity  operating activity    operating activity    operating activity      .  Retailer        Bank  investing activity  investing activity  financing activity  operating activity  decrease by $35.  A company sells $50.  As  a  result  of  this  transaction  assets will:   A.  D.000.000.  increase by $50.  B.

increase by $50. decrease by $50.000 and decrease inventory by $35.... D..............000 are recorded.... For the bank the photocopier will be a long-term asset to support its operations so it will be an investing activity...  Two  firms  buy  new  photocopiers..000..000 of goods but under credit terms given to customers. Reference CFA® Program Curriculum..............    The  cost  of  the  goods  is  recorded  as  $35.......  As  a  result  of  this  transaction  assets will:   A........... a net increase in assets of $15.LOS: Reading  30‐a  The purchase will be part of the day-to-day activity of the retailer so it will be classed as an operating activity..........    ... and the second firm is a bank planning to use the photocopier in its head  office. payment will not be  received  for  30  days................. pp.....000. 36‐37..204   Study Session 07:   5...    The  first  firm  is  a  retailer  of  office  equipment  and  the  photocopier will be resold.......... C...000. Volume 3........000 and COGS of $35. C ..... 50-58... B. Reference: CFA® Program Curriculum......000......... C....... decrease by $35..000... D......  How will the purchases be classified?  A............. increase by $15.........  A company sells $50.. Volume 3.. B....000.... pp.       6. LOS: Reading  30‐d  Correct Answer:  The accounting entries will be to increase accounts receivable (an asset) by $50.. Retailer investing activity operating activity operating activity operating activity Bank investing activity investing activity financing activity operating activity Correct Answer:  B..000. Additionally revenue of $50............

  C.    These are  likely  to  be  classified as  which types of activity?     A.        8.  The company must provide a discussion on whether there will be any impact from the  new standards on the financial statements.  At present a company is not obliged to comment on new standards until they are actually  implemented.  When  new  accounting  standards  are issued  which  will  be  implemented  in  the  future.  A manufacturing company receives dividends on a long‐term investment it has made in another  company’s  shares  and  pays a  dividend  to  its  own stockholders.  B.  which  of  the following best describes the requirements of a company under International Financial Reporting  Standards (IFRS)?   A.  The company must provide detailed information on the likely impact of the standards on  the financial statements.  D.  The company must disclose whether the new standards will or will not apply to its  financial statements.Financial Statement Analysis: Introduction   205  7.  C.  B.  D.  Receives dividend  Pays dividend  Investing  Investing      Investing  Financing  Investing   Financing  Financing    Financing      .

.. the conclusions can be anything from ‘does not apply’ to ‘management is still evaluating the impact’ to ‘the impact of adoption is discussed’.... Reference: CFA® Program Curriculum............ pp...... Volume 3..... B... The company must disclose whether the new standards will or will not apply to its financial statements. 127‐128. At present a company is not obliged to comment on new standards until they are actually implemented..  A manufacturing company receives dividends on a long‐term investment it has made in another  company’s  shares  and  pays a  dividend  to  its  own stockholders..206   Study Session 07:   7.... C... 36‐37....... Volume 3..... pp..        8......... Paying dividends to its own stockholders is a financing activity.......... will be an investing activity. LOS: Reading  31‐h  Companies are expected to provide a discussion on the impending regulations.... Receives dividend Investing Investing Financing Financing Pays dividend Investing Financing Investing Financing Correct Answer:  B. C... D............. The company must provide a discussion on whether there will be any impact from the new standards on the financial statements....................... Reference: CFA® Program Curriculum. if this is not the company’s main business... The company must provide detailed information on the likely impact of the standards on the financial statements.............................................    These are  likely  to  be  classified as  which types of activity?   A..  When  new  accounting  standards  are issued  which  will  be  implemented  in  the  future..... D....................  which  of  the following best describes the requirements of a company under International Financial Reporting  Standards (IFRS)?   A.. Correct Answer:  D .LOS: Reading  30‐a  Receiving dividends from a long-term investment.....    .. B..

  B.  income statement as an expense.  B.  balance sheet as a liability.  income statement as a revenue.  A bank lends money and receives interest from the borrowers.Financial Statement Analysis: Introduction   207  9.  Receives interest   Financing    Financing    Investing    Pays interest  Operating  Financing  Financing  Operating  balance sheet as an asset.  C.        10.  These activities are likely to be classified as which types of activity?     A. it also takes deposits on which it  pays interest.  D.S.  Under U.  Operating      .  D. GAAP minority interest appears in the:  A.  C.

...... it is reported as a liability under U...... B. balance sheet as a liability. B.        10....... C............ it also takes deposits on which it  pays interest... income statement as an expense..S.... balance sheet as an asset.............. pp............  Under U... 38‐40........    .... Receives interest Financing Financing Investing Operating Pays interest Operating Financing Financing Operating Correct Answer:  D ........ LOS: Reading  30‐b  Correct Answer:  Minority interest refers to equity held by other investors in a subsidiary that is consolidated in the accounts........... D. GAAP and is a balance sheet item............LOS: Reading  30‐a  A bank’s business is taking deposits and making loans so these are both operating activities. Volume 3.... income statement as a revenue... GAAP minority interest appears in the:  A. 36‐37......... Reference: CFA® Program Curriculum. C. pp...........S......................  These activities are likely to be classified as which types of activity?   A. Volume 3. Reference: CFA® Program Curriculum...............208   Study Session 07:   9................... B..  A bank lends money and receives interest from the borrowers... D..

  D.  a regulatory body with responsibility for ensuring that companies adhere to International  Financial Reporting Standards.  B.  The International Accounting Standards Board (IASB) is:  A.  B.  C.  responsible for developing international financial reporting and accounting standards  outside the U.  responsible for ensuring that investors receive financial information from companies that  best assists them in making investment decisions.  contributed capital less retained earnings.   net book value.  C.  a residual claim.  a standard‐setting body which was set up to harmonize accounting standards  internationally.  total assets less total liabilities.Financial Statement Analysis: Introduction   209  11.  Owners’ equity is least likely to be referred to as:  A.S.        12.  D.    .

... responsible for ensuring that investors receive financial information from companies that best assists them in making investment decisions. D ...... p......... B.............. LOS: Reading  30‐c  Correct Answer:  Owners’ equity is total assets less total liabilities.. One of its objectives is to achieve convergence in accounting standards..        12. a standard-setting body which was set up to harmonize accounting standards internationally................ a residual claim. 101..........    ... so A is the best answer. C..... pp............... D....  The International Accounting Standards Board (IASB) is:  A....S....................... Volume 3. responsible for developing international financial reporting and accounting standards outside the U........... net book value....... Reference: CFA® Program Curriculum...  Owners’ equity is least likely to be referred to as:  A..S.. LOS: Reading  31‐b  The IASB is a standard-setting organization responsible for developing international financial reporting and accounting standards in major countries including the U. Reference: CFA® Program Curriculum.. B.. Correct Answer:  A . a regulatory body with responsibility for ensuring that companies adhere to International Financial Reporting Standards.....210   Study Session 07:   11..... Owners’ equity is also referred to as a residual claim since it is what remains after all the liabilities are settled... contributed capital less retained earnings........... Volume 3..... which is net book value.... total assets less total liabilities... This is equivalent to contributed capital plus retained earnings..... D.... C................. 40‐43.

  C.  income statement.  Whenever possible fair values of assets should be used.  Which of the following statements is most accurate in describing the measurement of assets and  liabilities?    A.  Information about directors’ compensation is most likely to be included in a firm’s  A.  B.  D.        14.  auditor’s report.  A company is permitted to use a number of different methods to calculate asset and  liability values.  proxy statement.Financial Statement Analysis: Introduction   211  13.  A company must select whether to use historical or current cost methods and apply the  same method to all assets and liabilities.  Management’s Discussion and Analysis.   D.  B.  C.     .  Assets should generally be stated at historical cost and liabilities at present value.

D............... p... Whenever possible fair values of assets should be used.. current cost..... D................ 25.. A company must select whether to use historical or current cost methods and apply the same method to all assets and liabilities. stock options and major stockholders.. income statement. Correct Answer:  C ..... so C is the best answer..... B.... LOS: Reading  31‐d  Companies can use different combinations of historical cost... proxy statement................... auditor’s report...        14.. p.....  Information about directors’ compensation is most likely to be included in a firm’s  A....... Reference: CFA® Program Curriculum... C.............. They provide information on board members and management... Volume 3.......... executive compensation... B.. Management’s Discussion and Analysis....... A company is permitted to use a number of different methods to calculate asset and liability values....212   Study Session 07:   13.. Assets should generally be stated at historical cost and liabilities at present value.... B........... Volume 3.. C.  Which of the following statements is most accurate in describing the measurement of assets and  liabilities?    A...... Reference: CFA® Program Curriculum.....LOS: Reading  29‐e  Correct Answer:  Proxy statements relate to shareholder meetings......    .... realizable value... present vale and fair value............. 113.............

 GAAP includes standards established by a number of different organizations.  B. GAAP?   A.  The target is to replace U. GAAP by International Financial Reporting Standards by  2012.  B.  U.Financial Statement Analysis: Introduction   213  15.   D.  Which of the following statements is least accurate regarding U.  U.         16.S.  These  are  likely  to  be  classified  as  which  types  of  activity?     A.S.S.  A  manufacturing  company  records  a  depreciation  expense  associated  with  the  purchase  of  machinery  and  the  company  pays  income  tax.  D.  Depreciation  Financing    Operating    Investing    Income tax  Operating  Financing  Financing  Operating  Operating      .  Relevance and reliability are considered primary qualities in the U.S.  C. GAAP has a hierarchical structure with standards issued by the FASB holding the  highest position. GAAP framework.S.  C.

.............. D..... B.... GAAP has a hierarchical structure with standards issued by the FASB holding the highest position.... 118‐119.......LOS: Reading  30‐a  Correct Answer:  Depreciation is a cost of using machinery which is likely to be used to manufacture goods for sale.. U....S. GAAP framework. Volume 3...    ....... since it results from the operations of the company. pp. B.............  Which of the following statements is least accurate regarding U. pp............ GAAP?   A. D.. Correct Answer:  D ..S....................S................ Depreciation Financing Operating Investing Operating Income tax Operating Financing Financing Operating D ...... 36‐37..........S.... The target is to replace U. C. not to replace one with the other.......... GAAP and IFRS.......... GAAP includes standards established by a number of different organizations......  A  manufacturing  company  records  a  depreciation  expense  associated  with  the  purchase  of  machinery  and  the  company  pays  income  tax......... GAAP by International Financial Reporting Standards by 2012. Volume 3... therefore it is an operating item...S....... Reference: CFA® Program Curriculum....S.. C...  These  are  likely  to  be  classified  as  which  types  of  activity?   A.....214   Study Session 07:   15... U. LOS: Reading  31‐b  The objective is to harmonize U..        16.. Relevance and reliability are considered primary qualities in the U.... Paying income tax is an operating item. Reference: CFA® Program Curriculum..

        18.  B.  C.    .  D.  issue of new shares.  net assets.  C.  there is a difference between the timing of cash movements and the recognition of a  revenue or expense.  B.  D.  net income.  The Statement of Changes in Owners‘ Equity would be least likely to include information on:  A.  there is uncertainty whether revenue is going to be realized or an expense paid.  there is an adjustment to values of assets and liabilities on the balance sheet to reflect fair  values.  Accruals appear in financial statements when:  A.Financial Statement Analysis: Introduction   215  17.  dividends distributed.  a company uses a cash–based accounting method.

net income.............. This may be before or after the cash is received or paid which gives rise to accrual entries... D........... net assets....................        18............ LOS: Reading  29‐b  Correct Answer:  The Statement of Changes in Owners‘ Equity contains information on the composition and changes in owners’ equity over the reporting period........... 65‐67... issue of new shares............. this would be in the balance sheet.216   Study Session 07:   17. pp..... dividends distributed...  Accruals appear in financial statements when:  A............... Correct Answer:  D .... A . p..... Volume 3.LOS: Reading  30‐e  Accrual accounting requires that revenue is recognized when it is earned and expenses when they are incurred.. C.. B. Reference: CFA® Program Curriculum....... It would not explicitly include information on net assets.......  The Statement of Changes in Owners‘ Equity would be least likely to include information on:  A... Reference: CFA® Program Curriculum..... there is an adjustment to values of assets and liabilities on the balance sheet to reflect fair values... B.. This would include information on new shares issued and retained income.. a company uses a cash–based accounting method........ C............ D. there is uncertainty whether revenue is going to be realized or an expense paid...... there is a difference between the timing of cash movements and the recognition of a revenue or expense....    ....... Volume 3......... 19........

  Many nonquantifiable items are not included in the financial statements.  Which of the following is least likely to be a constraint in preparing useful financial statements?  A.  Rules‐based   Rules‐based    Principles‐based  Principles‐based    .  C.  IFRS    FASB  Rules‐based   Principles‐based  Rules‐based   Principles‐based  The time taken to ensure information is accurate.Financial Statement Analysis: Introduction   217  19.    The requirement to include information regardless of whether it is relevant or not.  B.  C.  D.  B.  Historically  the  approaches  of  the  International  Financial  Reporting  Standards  (IFRS)  and  the  Financial Accounting Standards Board (FASB) have been best described as:     A.  D.        20.  The cost of providing information that is accurate and useful.

........... Volume 3.. pp............. The requirement to include information regardless of whether it is relevant or not..  Which of the following is least likely to be a constraint in preparing useful financial statements?  A..    .......... Reference: CFA® Program Curriculum.. This difference in approach has created a barrier to establishing a single coherent framework for financial reporting..............  Historically  the  approaches  of  the  International  Financial  Reporting  Standards  (IFRS)  and  the  Financial Accounting Standards Board (FASB) have been best described as:   A.. 110‐111........ 122‐123..... is not useful and does not automatically need to be included in financial statements..... C......... The cost of providing information that is accurate and useful.......218   Study Session 07:   19................. Many nonquantifiable items are not included in the financial statements... The time taken to ensure information is accurate................... LOS: Reading  31‐d  Correct Answer:  Information that is not relevant......................... D is the best answer.....................        20.LOS: Reading  31‐g  IFRS adopt a principles–based approach which gives more flexibility on the preparation of financial reports. Reference: CFA® Program Curriculum. Volume 3.. D. D .. pp.... D. IFRS Rules-based Rules-based Principles-based Principles-based FASB Rules-based Principles-based Rules-based Principles-based Correct Answer:  C ... The FASB has been rules-based which means there are specific rules for each element or transaction.. C.. B.... B. in terms of being out of date or would not influence decision makers.......

Financial Statement Analysis: Introduction   219  21.           $28 million    $6 million  $35 million    $2 million    $3 million  $155 million.  $64 million.  The following information is provided on a company:  Retained earnings at beginning of year  Estimated income for year     Estimated revenue for year   Repurchase of stock over year   Estimated dividends paid over year     The estimated retained earnings at end of year are:  A.  C.  $32 million.        22.  $220 million    $35 million  $345 million    $60 million    $20 million    .  B.  D.  B.  The following information is provided on a company  Retained earnings at end of previous year     Net income over year  Contributed capital at year‐end  Dividends paid over year   Expenses over year     Owners’ equity at year end will be:  A.  $63 million.  $215 million.  D.  $67 million.  $255 million.  C.  $525 million.

....220   Study Session 07:   21............ pp.. $215 million..... 40‐46.$20 million = £215 million The repurchase of stock affects paid-up equity rather than retained earnings... LOS: Reading  30‐c  Estimated retained earnings at end of year = retained earnings at beginning of year + net income – dividends paid = $220 million + $35 million ... $525 million..... Reference: CFA® Program Curriculum...    ....... B............. $155 million..............  The following information is provided on a company:  Retained earnings at beginning of year $220 million Estimated income for year $35 million Estimated revenue for year $345 million Repurchase of stock over year $60 million Estimated dividends paid over year $20 million The estimated retained earnings at end of year are: A. D......... $255 million........ C.... Correct Answer:  B. Volume 3............

.... 40‐46....... C.......... Correct Answer:  D ... $32 million.  The following information is provided on a company  Retained earnings at end of previous year   $28 million  Net income over year  Contributed capital at year‐end  Dividends paid over year   Expenses over year   Owners’ equity at year end will be: A. D. B...... LOS: Reading  30‐c    $6 million  $35 million    $2 million    $3 million  Owners’ equity = contributed capital + retained earnings = $35 million + $28 million + ($6 million – $2 million) = $67 million Reference: CFA® Program Curriculum...............        .......................... Volume 3........ $64 million..... $67 million.... pp.Financial Statement Analysis: Introduction   221  22..... $63 million......

 the chapter  details  its  purpose.222   Study Session 08:   Study Session 08: Financial Statement Analysis: The Income Statement.    Reading 32: Understanding the Income Statement  Reading 33: Understanding the Balance Sheet  Reading 34: Understanding the Cash Flow Statement            . Additional  analyst tools such as the earnings per share calculation are also described. and Cash Flow Statement   Each reading in this study session focuses on one of the three major financial statements: the balance  sheet.  pertinent  ratios. Balance Sheet. the income statement. For each financial statement.  and  common‐size  analysis. and the statement of cash flows.  Understanding  these  concepts  allows  a  financial  analyst  to  evaluate  trends  in  performance  over  several  measurement  periods and to compare the performance of different companies over the same period(s).  construction.

  A manufacturing company acquires a smaller competitor.  C.  B.  the firm prefers to hold marketable securities rather than cash. & Cash Flow   223  1.  the firm has a large number of ‘other short‐term assets’ in the balance sheet. The acquirer combines the inventory of  the  two  companies  which  will  be  sold  to  generate  future  sales.  C.  B.  the firm has higher inventory levels compared with the rest of the industry.  No effect.  No effect.        2.  This  is  most  likely  to  have  the  following effect on the acquiring company’s cash flows:     A.  Operating cash flow    No effect             Financing cash flow  Understated.  Overstated    Understated  Understated  D.  Overstated.  If  a  firm’s  quick  ratio  is  above  the  industry  average  but  the  cash  ratio  is  below  the  industry  average this might be explained by:  A.      ..Financial Statement Analysis: Income Statement. Balance Sheet.  D.  the firm has extended to their customers more favorable credit terms than their  competitors.

.. the firm has higher inventory levels compared with the rest of the industry......    ..... it will be recorded as an investment activity..... the firm has a large number of ‘other short-term assets’ in the balance sheet.......LOS: Reading  34‐e  The acquirer will not be recognizing the cost of the inventory as an operating cash outflow........... D...... C....... No effect............ pp.......... Volume 3... LOS: Reading  33‐i  Correct Answer:  The quick ratio includes cash..... 279-283. C...  If  a  firm’s  quick  ratio  is  above  the  industry  average  but  the  cash  ratio  is  below  the  industry  average this might be explained by:  A...... Therefore cash flow from operations will be overstated. Correct Answer:  B.... Volume 3. B.. D .. Reference CFA® Program Curriculum...... No effect....224   Study Session 08:   1... or customers owing money....... 239‐240.. the firm prefers to hold marketable securities rather than cash............ There is no direct impact on cash flow from financing activities.......... B. The acquirer combines the inventory of  the  two  companies  which  will  be  sold  to  generate  future  sales...       2.  A manufacturing company acquires a smaller competitor......... Operating cash flow No effect Overstated Understated Understated Financing cash flow Understated... The relatively high quick ratio therefore indicates high levels of receivables.............. pp.. Reference: CFA® Program Curriculum.. Overstated... the firm has extended to their customers more favorable credit terms than their competitors...... D...............  This  is  most  likely  to  have  the  following effect on the acquiring company’s cash flows:   A...... marketable securities and receivables in the numerator whereas the cash ratio only includes cash and marketable securities...........

  GAAP  which  of  the  following  is  the  least  accurate  statement  concerning  extraordinary items? An extraordinary item:  A.  Which of the following ratios are correctly described as liquidity and solvency ratios?    A.  is not part of operating income. Balance Sheet.  B.  D. & Cash Flow   225  3.  C.S.        4.  D.  Under  U.  B.  is included in comprehensive income.Financial Statement Analysis: Income Statement.  is reported net of tax.  must be both unusual and infrequent.  C.  Liquidity     cash  current               Solvency  current  debt to equity  financial leverage  quick ratio  debt to equity  financial leverage      .

................. 239‐240.226   Study Session 08:   3................ below discontinued operations.........        4.... C ..............  GAAP  which  of  the  following  is  the  least  accurate  statement  concerning  extraordinary items? An extraordinary item:  A.................. 168...... Reference: CFA® Program Curriculum.. C.. pp....  Which of the following ratios are correctly described as liquidity and solvency ratios?  A. D.................................... and net of tax.............    ..... is reported net of tax. Volume 3. B........ p... D... B... must be both unusual and infrequent... Reference: CFA® Program Curriculum.... LOS: Reading  33‐i  Liquidity ratios measure a company’s ability to meet its short-term obligations.. C....... solvency ratios measure the ability to meet long-term and other obligations... Volume 3. is not part of operating income........... is included in comprehensive income. Therefore it will impact on net income and is not reported separately in comprehensive income.. Liquidity cash current debt to equity financial leverage Solvency current debt to equity financial leverage quick ratio Correct Answer:  B....LOS: Reading  32‐g  Correct Answer:  An extraordinary item will be reported separately on the income statement.  Under  U....S..

  D.  Weighted average cost method.Financial Statement Analysis: Income Statement.  B.  B.  increase operating cash flows.    .  decrease operating cash flows.  C. & Cash Flow   227  5.  LIFO.  D.  If a company decides to change from a policy of leasing plant and equipment through operating  leases to purchasing its own plant and equipment this will:   A.  C.  increase investing cash flows.  Which inventory accounting method usually gives a valuation of inventory that is closest to its  economic value?   A.  Lower of cost or market.  have no impact on operating cash flows.  FIFO.        6. Balance Sheet.

..... increase operating cash flows........... B..    .LOS: Reading  34‐a  Correct Answer:  Lease rentals are classified as an operating cash flow and the purchase of equipment is classified as an investing cash flow... The decision to switch from leasing to purchasing plant and equipment will increase operating cash flows but decrease investing cash flows. Reference: CFA® Program Curriculum. decrease operating cash flows. Volume 3......... A ...... FIFO........ LOS: Reading  32‐d  Correct Answer:  Since FIFO leaves the most recently purchased goods in inventory the valuation will usually be the closest to current values...  Which inventory accounting method usually gives a valuation of inventory that is closest to its  economic value?   A......  If a company decides to change from a policy of leasing plant and equipment through operating  leases to purchasing its own plant and equipment this will:   A.... 265‐273..... 157‐161............... B...        6. D... pp............... C........ B.. increase investing cash flows.............. have no impact on operating cash flows.................. Weighted average cost method.................. LIFO.. pp..... Reference: CFA® Program Curriculum............... D....... Lower of cost or market. C........228   Study Session 08:   5... Volume 3......

  D.Financial Statement Analysis: Income Statement.  C.  efficiency of use of assets     .  B.  B.  total assets.  profitability.   contingency accounting.  Using  common‐size  statement  analysis  of  the  balance  sheet  of  a  company  will  help  identify  changes in:  A.  D. & Cash Flow   229  7.  financial leverage.  the matching principle.        8.  When a company recognizes a warranty expense in the same accounting period as the sale of a  good this is an application of:  A.  the cost recovery method.  C.  accrual accounting. Balance Sheet.

..230   Study Session 08:   7..... pp.. Reference: CFA® Program Curriculum.. profitability.. B.... efficiency of use of assets C .. the matching principle..... C....... LOS: Reading  33‐i  Correct Answer:  Common-size statement analysis of the balance sheet will help identify changes in ratios which use balance sheet items..    .. but in common-size statements assets will always be 100%................ contingency accounting..... accrual accounting................. 162.............. LOS: Reading  32‐c  Correct Answer:  Under matching principles expenses should be recognized in the same period as the associated revenues. Volume 3........ B.. D.. p............ 239‐240....... C.... Volume 3...  Using  common‐size  statement  analysis  of  the  balance  sheet  of  a  company  will  help  identify  changes in:  A... B...................... D. this includes financial leverage which is assets/equity. so the company should recognize estimated warranty expenses in the same period as the sale............ financial leverage..............        8..... total assets.......... Reference: CFA® Program Curriculum. Total assets will also be read off the balance sheet. the cost recovery method.............  When a company recognizes a warranty expense in the same accounting period as the sale of a  good this is an application of:  A....

000.  information on changes in stockholders’ equity.    a detailed breakdown of cost of goods sold and other expenses.  B.000.000 is agreed.000  $750.000  $1.  C.  Installment method   $0    $750.  C.  D.000      . & Cash Flow   231  9.Financial Statement Analysis: Income Statement.000 and agrees to pay further installments of $600.        10. The profit that will be recognized as a result of the down payment.  The purchaser makes a down payment of  $1. Balance Sheet.000 per year at the end of each of the next  five years.  B.  D.  details on income from joint ventures and associates.500.  The Comprehensive Income Statement contains:   A. using the installment  method and cost recovery method is closest to:     A.000                Cost recovery method   $0  $0  $750.  The sale of a property which cost $3.000  $750.  details of income from subsidiaries.

.....000 Cost recovery method $0 $0 $750...... details of income from subsidiaries.......000 and agrees to pay further installments of $600.... 185‐186.... Volume 3........ a detailed breakdown of cost of goods sold and other expenses........000... information on changes in stockholders’ equity.......... Installment method $0 $750... Volume 3. details on income from joint ventures and associates. C. The profit that will be recognized as a result of the down payment.. B..... pp. B.000.... LOS: Reading  32‐l  Correct Answer:  Comprehensive income is the change in stockholders’ equity as a result of net income and other revenue and expense items that have been excluded from the income statement. D.  The Comprehensive Income Statement contains:   A.000 $750..$3......000 $1..............000 equals 50%... The profit recognized from the down payment is 50% x $1.....000 .. Reference: CFA® Program Curriculum...... 152‐154.....000 is agreed.....000..000. using the installment  method and cost recovery method is closest to:   A...... Reference: CFA® Program Curriculum......... equals $750........... pp.....  The purchaser makes a down payment of  $1.500........... pension liability adjustments......000 $750.500.. C. Cost recovery method: no profit is recognized until the costs have been recovered.........232   Study Session 08:   9...000. unrealized gains and losses on derivatives contracts and investments.000 per year at the end of each of the next  five years....000)/$3.... These items include foreign currency translation adjustments..................500..  The sale of a property which cost $3. D..000 Correct Answer:  B..000.        10. B.. LOS: Reading  32‐b  Installment method: the profit to sales ratio is ($4...    .

000 and its expected operating costs are $3.  I.  D.  $600.  C.  Jones Construction takes on a new project which it anticipates will take two years to complete.S.000.000.800. Balance Sheet.’s cash flow from investing was (ref. If it is using the percentage‐of‐ completion method to recognize revenue then the operating income recorded in the first year will be:  A.000.000. Question 41):  A.  D.W.000 and receives payments of $2.    .  $1.  ($12 million).  C. & Cash Flow   233  11.        12.  $200.  B.  $0.000. It  agrees a total contract price of $4.000. Inc.800.  ($6 million).  ($19 million).Financial Statement Analysis: Income Statement.000.   ($9 million).  B.000. In the first  year it incurs costs of $1.

....000.000 ...’s cash flow from investing was (ref... ($6 million)....W..  Jones Construction takes on a new project which it anticipates will take two years to complete.. C.000 and its expected operating costs are $3....... D............000. ($19 million). In the first  year it incurs costs of $1....000... C .....        12. $200.800. Question 41):  A..000 Costs = $1......000.000 x $4........ It  agrees a total contract price of $4....S.. Inc...$1..800......000.000... 271‐273.............000...............000.....400... C .....000.. LOS: Reading  32‐b  Correct Answer:  The revenue in the first year is: $1.000 = $2.......800..... 148‐152...LOS: Reading  34‐a  Correct Answer:  Cash flow from investing activities Cash flow from investing activities Purchase of land  Sale of equipment    (15) 6 (9) Reference: CFA® Program Curriculum.000 $3.......000 = $600.800...800. pp.. B.000 Operating income = $2... B.... D. Volume 3... C.....000. $1......... Volume 3.234   Study Session 08:   11.....000 Reference: CFA® Program Curriculum.400. ($9 million)....... pp.... $0. If it is using the percentage‐of‐ completion method to recognize revenue then the operating income recorded in the first year will be:  A.  I..............000 and receives payments of $2...... $600. ($12 million)..    ...

  C.  A U. consultancy company discovers that a transaction that took place last year was incorrectly  recorded and in fact a client paid an additional $10. Balance Sheet.  adjust the reported income in the previous year’s accounts. Inc. & Cash Flow   235  13.  recognize the $10.  B.  ($23 million).    .  adjust the retained earnings in the previous year’s balance sheet.S.  ($35 million).000 as an extraordinary profit in the current year.  I.  ($12 million).’s cash flow from financing was (ref.  D. The company should:   A.000 of fees over that recorded as a bonus based on  the benefits he received from the consultancy provided in that period.S.  B.W. Question 41):  A.  D.        14.  ($20 million).  increase the income received in the current year’s accounts.  C.Financial Statement Analysis: Income Statement.

.........236   Study Session 08:   13.... adjust the retained earnings in the previous year’s balance sheet.. ($20 million).........S.... The company should:   A.... Although it is a non recurring item it is not an extraordinary item. consultancy company discovers that a transaction that took place last year was incorrectly  recorded and in fact a client paid an additional $10.. ($12 million).... D.... The adjustment should be reported in the current year’s income statement...  I...S... adjust the reported income in the previous year’s accounts. Volume 3....LOS: Reading  32‐g  Correct Answer:  Adjustments to prior years’ accounts through adjustment to the retained earnings is only to be used for accounting errors....’s cash flow from financing was (ref..000 of fees over that recorded as a bonus based on  the benefits he received from the consultancy provided in that period................ ($35 million)...... pp. C ......... 273‐275......... Question 41):  A...........000 as an extraordinary profit in the current year.... Inc.........LOS: Reading  34‐a  Correct Answer:  Cash flow from financing activities Cash flow from financing  Retirement of common stock  Dividend payment    (12) (8) (20) Reference: CFA® Program Curriculum. B.... 169‐170.... recognize the $10. increase the income received in the current year’s accounts............ pp...... C........ ($23 million)..... C. D. B.................        14..... Volume 3. Reference: CFA® Program Curriculum.W....    . B.....  A U................

  extending the payment period for customers. Balance Sheet.  B.  over 5 years.  Bishop  Steel  Manufacturing  reported  little  change  in  net  income  whereas  the  operating  cash  flows rose sharply.  C.  B.Financial Statement Analysis: Income Statement.        16.  at the time of disposal.  using inventory to meet their customers’ orders and minimizing raw material purchases.  selling land that was not being used for a substantial sum of money. This might be explained by the company:  A.     .  D.  when the impairment of the assets takes place.  raising cash through the issue of long term bonds.  The costs of long‐lived assets are usually allocated:  A.  C.  D. & Cash Flow   237  15.  over a period that is chosen by the firm.

... extending the payment period for customers.238   Study Session 08:   15........ B............... C........ This might be explained by the company:  A........ at the time of disposal......... using inventory to meet their customers’ orders and minimizing raw material purchases. Reference: CFA® Program Curriculum. when the impairment of the assets takes place................ C is not correct since the sale of land would be classified as an investment cash flow... Volume 3......        16................... that assets are depreciated. over 5 years............. raising cash through the issue of long term bonds..LOS: Reading  34‐e  Correct Answer:  A is not correct since this would increase receivables and reduce operating cash flow.............. D ....  The costs of long‐lived assets are usually allocated:  A. pp.......... or useful life. C ... 162‐167.. D is correct since this would raise cash from the sale of inventory... C...... Reference: CFA® Program Curriculum.... D..... 279‐281..    ... B is not correct since the issue of bonds would be classified as a financing cash flow... Volume 3.  Bishop  Steel  Manufacturing  reported  little  change  in  net  income  whereas  the  operating  cash  flows rose sharply.... B.. pp.... LOS: Reading  32‐d   Correct Answer:  Usually the management has discretion over the period.. over a period that is chosen by the firm. D................... selling land that was not being used for a substantial sum of money......

  Which of the following is least likely to be included in the Statement of Stockholders’ Equity?  A. adjust for  non‐operating items included in net income and then adjust for changes in the balance of  operating asset and liability accounts. adjust for all non cash expenses/revenues.  Cumulative foreign exchange adjustments.   C.  Capital leases.  The  indirect  method  of  reporting  cash  flows  calculates  operating  cash  flow  by  which  of  the  following methods?  A.  Retained earnings.Financial Statement Analysis: Income Statement.  D. Balance Sheet.   D.  Additional paid in capital above the par value of common stock.   B. & Cash Flow   239  17.  Start with cash collections for the period and deduct cash outflows incurred in collecting  this cash.  Start with cash collections for the period and deduct cash outflows incurred in collecting  this cash.        18.  C.    .  Start with net income for the period and adjust for all non cash expenses/revenues and  adjust for non‐operating items included in net income.  B. and then adjust for changes in the balance of operating asset and liability accounts.  Start with net income for the period.

.... Start with net income for the period........... Additional paid in capital above the par value of common stock... Retained earnings................. Reference: CFA® Program Curriculum...... C.... Capital leases........... LOS: Reading  34‐d  The indirect method starts at the net income figure and makes adjustments whereas the direct method works through the cash items staring with cash collections.. Volume 3........................... pp.... Correct Answer:  D . Cumulative foreign exchange adjustments. adjust for nonoperating items included in net income and then adjust for changes in the balance of operating asset and liability accounts... Start with net income for the period and adjust for all non cash expenses/revenues and adjust for non-operating items included in net income. All the other items appear as part of shareholders’ equity....... LOS: Reading  33‐h  Correct Answer:  Capital leases are reported in the assets and liabilities section of the balance sheet.. 226‐230.. B....................... adjust for all non cash expenses/revenues..... Reference CFA® Program Curriculum...240   Study Session 08:   17... Start with cash collections for the period and deduct cash outflows incurred in collecting this cash.......... B....    .  The  indirect  method  of  reporting  cash  flows  calculates  operating  cash  flow  by  which  of  the  following methods?  A........ D....... D. Start with cash collections for the period and deduct cash outflows incurred in collecting this cash..... C. A ........... Volume 3... and then adjust for changes in the balance of operating asset and liability accounts. 265-271.  Which of the following is least likely to be included in the Statement of Stockholders’ Equity?  A.....       18............ pp.

  $30.000).  C.  ($100. Balance Sheet.  ($170. question 28):  A.  D.000).  B.  ($85.000).  ($115.000).    .  ($15.  The cash flow from financing in 2007 for North Company is (ref.000.  B.  ($70. question 28):    A. & Cash Flow   241  19.  $130.        20.  D.  C.000).000.  The cash flow from investments in 2007 for North Company is (ref.000).Financial Statement Analysis: Income Statement.

242   Study Session 08:   19.  The cash flow from investments in 2007 for North Company is (ref. question 28):    A. B. C. D. ($85,000). ($70,000). $30,000. $130,000. C ..........................................................................................LOS: Reading  34‐a 

Correct Answer: 

Investing cash flows 
Sale of old machine 

30 30

Net from investment 
   

Reference: CFA® Program Curriculum, Volume 3, pp. 271‐273.        20.  The cash flow from financing in 2007 for North Company is (ref. question 28):  A. B. C. D. ($170,000). ($115,000). ($100,000). ($15,000). B...........................................................................................LOS: Reading  34‐a 

Correct Answer: 

Financing cash flows: 
Bank notes  Dividends paid 

  (100) (15) (115)

Net from financing 
 

Reference: CFA® Program Curriculum, Volume 3, pp. 273‐275. 

 

Financial Statement Analysis: Income Statement, Balance Sheet, & Cash Flow   243  21.  W.S. Inc uses U.S. GAAP and supplied the following financial data:    $ million  Cash payment for salaries  Purchase of land  Cash payment for interest  Retirement of common stock  Cash collection from customers  Cash payment to suppliers  Depreciation expense  Dividend payment  Sale of equipment    Cash flow from operating activities was:  A.  B.  C.  D.  $36 million.  $39 million.  $46 million.  $49 million.  23   15    3  12  115  43  10  8  6 

 

244   Study Session 08:   21.  W.S. Inc uses U.S. GAAP and supplied the following financial data:  $ million Cash payment for salaries Purchase of land Cash payment for interest Retirement of common stock Cash collection from customers Cash payment to suppliers Depreciation expense Dividend payment Sale of equipment Cash flow from operating activities was: A. $36 million. B. $39 million. C. $46 million. D. $49 million. Correct Answer:  C ..........................................................................................LOS: Reading  34‐a  23 15 3 12 115 43 10 8 6

  Cash flow from operating activities
Cash collection from customers  Cash payment to suppliers  Cash payment for salaries  Cash payment for interest   

$ million 115 (43) (23) (3) 46

Reference: CFA® Program Curriculum, Volume 3, pp. 265‐271. 

 

Financial Statement Analysis: Income Statement, Balance Sheet, & Cash Flow   245  22.  North Company uses U.S. GAAP and provides the following financial statements: 

2007 Income statement (in $’000)
Sales  COGS  Depreciation  Interest expense  Gain on sale of old machinery Income before taxes  Income tax expense  Net income after taxes   Balance sheet (in $’000)   Assets:  Cash  Accounts receivable Inventory  Property,  plant  &  Total assets    Liabilities:  Accounts payable Bank notes  Deferred taxes Common stock Retained Earnings Total liabilities Total dividends of $15,000 were paid.  end  895 260 500 300 1,955 beg  100 200 800 500 1,600  5,400 (4,600) (200) (55) 30 575 (175) 400

370 0 90 1,000 495 1,955

350 100 40 1,000  110 1,600 

Old machinery was sold; the machinery had already been fully depreciated.  The cash flow from operations in 2007 is:    A.  B.  C.  D.  $580,000.  $830,000.  $880,000.  $910,000. 

 

246   Study Session 08:   22.  North Company uses U.S. GAAP and provides the following financial statements: 

2007 Income statement (in $’000) 
Sales  COGS  Depreciation  Interest expense  Gain on sale of old  Income before taxes  Income tax expense  Net income after taxes                Total dividends of $15,000 were paid. 

 
  Assets:  Cash 

Balance sheet (in $’000)  end 2007 895 260 500 300 1,955 beg 2007    100  200  800  500  1,600      370 0 90 1,000 495 1,955 350  100  40  1,000  110  1,600 

 5,400    (4,600)     (200)    (55)    30    575    (175)    400                               

Accounts receivable  Inventory  Property, plant &  Total assets    Liabilities:  Accounts payable  Bank notes  Deferred taxes  Common stock  Retained Earnings  Total liabilities 

Old machinery was sold; the machinery had already been fully depreciated.  The cash flow from operations in 2007 is:    A. B. C. D. $580,000. $830,000. $880,000. $910,000. C ..........................................................................................LOS: Reading  34‐a 

Correct Answer: 

 

Financial Statement Analysis: Income Statement, Balance Sheet, & Cash Flow   247  Cash flow from operations: Net income Adjust for Depreciation Gain on sale of machinery Deferred taxes Change in accounts receivable Decrease in inventory Change in accounts payable Net from operations

400 200 (30) 50 (60) 300 20 880

Reference: CFA® Program Curriculum, Volume 3, pp. 265‐271.   

 

248   Study Session 09:  

Study Session 09: Financial Statement Analysis:
Inventories, Long-Term Assets, Deferred Taxes, and Onand Off-Balance Sheet Debt
The  readings  in  this  study  session  examine  specific  categories  of  assets  and  liabilities  that  are  particularly susceptible to the impact of alternative accounting policies and estimates. Analysts must  understand the effects of alternative policies on financial statements and ratios, and be able to execute  appropriate adjustments to enhance comparability between companies. In addition, analysts must be  alert to differences between a companyʹs reported financial statements and economic reality.  The description and measurement of inventories require careful attention because the investment in  inventories is frequently the largest current asset for merchandizing and manufacturing companies.  For these companies, the measurement of inventory cost (i.e., cost of goods sold) is a critical factor in  determining gross profit and other measures of company profitability. Long‐term operating assets are  often  the  largest  category  of  assets  on  a  companyʹs  balance  sheet.  The  analyst  needs  to  scrutinize  managementʹs  choices  with  respect  to  recognizing  expenses  associated  with  the  operating  assets  because of the potentially large impact such choices can have on reported earnings.  A  companyʹs  accounting  policies  (such  as  depreciation  choices)  can  cause  differences  in  taxes  reported in financial statements and taxes reported on tax returns. The reading “Analysis of Income  Taxes” discusses several issues that arise relating to deferred taxes.  Both  on‐  and  off‐balance‐sheet  debt  affect  a  companyʹs  liquidity  and  solvency,  and  have  consequences  for  its  long‐term  growth  and  viability.  The  notes  of  the  financial  statements  must  be  carefully  reviewed  to  ensure  that  all  potential  liabilities  (e.g.,  leasing  arrangements  and  other  contractual  commitments)  are  appropriately  evaluated  for  their  conformity  to  economic  reality.  Adjustments to the financial statements may be required to achieve comparability when evaluating  several companies, and may also be required to improve credit and investment decision‐making. 

Reading 35: Analysis of Inventories  Reading 36: Analysis of Long‐Lived Assets:    Part I—The Capitalization Decision 

Reading 37: Analysis of Long‐Lived Assets:    Part II—Analysis of Depreciation and Impairment 

Reading 38: Analysis of Income Taxes  Reading 39: Analysis of Financing Liabilities  Reading 40: Leases and Off‐Balance‐Sheet Debt 

 

Financial Statement Inventories, Assets, Taxes & Debt   249  1.  When  a  company  reports  a  large  LIFO  reserve,  has  it  (1)  been  using  LIFO  or  FIFO  to  calculate  inventory balances and has it (2) overstated or understated the value of inventory compared with the  current market value?     A.  B.  C.  D.        2.  The average age of Manufacturers Corporation’s machinery is lower than other companies in the  same industry. Which of the following is the least likely to explain this?  A.  B.  The company has just made major write downs of impaired assets.  The company uses a shorter depreciation life for machinery than its competitors.  Inventory balances     LIFO   FIFO   LIFO   FIFO                   Overstated/understated  overstated   overstated   understated   understated 

C.  The company has just finished a major capital expenditure program to replace  machinery.   D.  The company has just acquired another manufacturing company and is making use of its  machinery, at the time of acquisition the depreciation on this machinery was set at zero.   

 

250   Study Session 09:   1.  When  a  company  reports  a  large  LIFO  reserve,  has  it  (1)  been  using  LIFO  or  FIFO  to  calculate  inventory balances and has it (2) overstated or understated the value of inventory compared with the  current market value?   Inventory balances A. LIFO B. FIFO C. LIFO D. FIFO Correct Answer:  Overstated/understated overstated overstated understated understated C .......................................................................................... LOS: Reading  35‐c 

The LIFO reserve is reported by companies using LIFO. Accounting using LIFO usually leads to an understatement of the inventory balance compared with current values, so information on the LIFO reserve is provided. Reference: CFA® Program Curriculum, Volume 3, pp. 308‐315.      2.  The average age of Manufacturers Corporation’s machinery is lower than other companies in the  same industry. Which of the following is the least likely to explain this?  A. The company has just made major write downs of impaired assets. B. The company uses a shorter depreciation life for machinery than its competitors. C. The company has just finished a major capital expenditure program to replace machinery. D. The company has just acquired another manufacturing company and is making use of its machinery, at the time of acquisition the depreciation on this machinery was set at zero. Correct Answer:  A ......................................................................................... LOS: Reading  37‐d 

average age =

accumul. depreciati on depreciat. expense

Impairment of assets would lead to lower current depreciation charges; this will lead to a higher average asset life. B, C and D will lead to lower average age. Reference: CFA® Program Curriculum, Volume 3, pp. 402‐404. 

 

Financial Statement Inventories, Assets, Taxes & Debt   251  3.  A company has just issued a bond with covenants. Which of the following clauses is least likely  to be included in the bond covenants?  A.  B.  A cap on leverage ratios at specified dates over the life of the bond.  A requirement that return on capital should exceed a specified percentage. 

C.  A restriction on dividend payments to shareholders if they would reduce stockholders’  equity below a specified level.  D.  A requirement that no future debt can be issued that ranks higher than the original bonds  giving the holders a prior claim on assets.         4.  Which of the following statements is most accurate regarding cash flow impact for a lessee of a  capital lease?  A.  B.  Total cash outflow each year is the same as the lease payment.  All of the rental payments are treated as cash flow from operations. 

C.  The rental payments are partly allocated as cash flow from operations and partly as cash  flow from investing.  D.  The present value of the lease payments is classified as an investing cash outflow at the  beginning of the lease. 

 

 521‐524........... C...... 500.............. Which of the following clauses is least likely  to be included in the bond covenants?  A.....LOS: Reading  39‐e  Covenants tend to focus on clauses that restrict leverage..... B..252   Study Session 09:   3.... pp................. p......... since the asset is not purchased.. Correct Answer:  B.. issuance of new debt or spending (on dividends or investment) that would limit the funds available to repay bond holders....  A company has just issued a bond with covenants.. Volume 3....... Reference: CFA® Program Curriculum.    . The rental payments are partly allocated to cash flow from operations and partly to cash flow from financing. other than lease payments... D.. The rental payments are partly allocated as cash flow from operations and partly as cash flow from investing...        4................. A cap on leverage ratios at specified dates over the life of the bond..... The present value of the lease payments is classified as an investing cash outflow at the beginning of the lease.... All of the rental payments are treated as cash flow from operations... C.......... A restriction on dividend payments to shareholders if they would reduce stockholders’ equity below a specified level. LOS: Reading  40‐b  There is no cash outflow at the beginning of the lease....  Which of the following statements is most accurate regarding cash flow impact for a lessee of a  capital lease?  A......... Therefore a return on capital requirement is least likely to be specified........................... B...... D.... Total cash outflow each year is the same as the lease payment.. A requirement that no future debt can be issued that ranks higher than the original bonds giving the holders a prior claim on assets..... A requirement that return on capital should exceed a specified percentage.......... Correct Answer:  A .... Volume 3.. Reference: CFA® Program Curriculum.

  calculate the present value of restoring the land to its original state and deduct this from  the carrying value of the assets.Financial Statement Inventories.  The company should.   revise the value of the asset and record the gain as an unusual item. an increase in the value of assets cannot be recognized until they are  sold.  calculate the undiscounted cost of restoring the land to its original state and depreciate  this cost over the life of the mine. Taxes & Debt   253  5.S.  GAAP:  A.  A mining company is required by regulation to restore land to its original state when mining has  finished. Under SFAS 143 the company is required to:  A. Assets. under U.  B.  B.  C.  not do anything.  calculate the present value of restoring the land to its original state at the end of each  year and recognize the difference from the previous year is an accretion expense.  revise the value of the asset and record the gain as ‘other income’.S.  revise the value of the asset and record the gain as an extraordinary income.        6.   D.  A U.  D.     .  C.  calculate the present value of restoring the land to its original state and recognize this as  an expense in the first year of operation of the mine. company reviews the value of its fixed assets and finds that an asset that had been written  down due to impairment in the previous accounting period now has a carrying value less than the  future cash flows expected to be received from the use of the asset.

.    .. B is not correct...... C.  A U...... revise the value of the asset and record the gain as an extraordinary income..... the cost should be discounted.....  A mining company is required by regulation to restore land to its original state when mining has  finished.......... LOS: Reading  37‐d  Correct Answer:  Under U..... C...... 402‐406.... pp.LOS: Reading  37‐e  A is not correct... B........... GAAP an increase in the value of an asset cannot be recognized until sale and also previous impairments cannot be restored. present value should be added to the asset value.. the cost should be added to the asset value and be depreciated over the useful life of the mine. not do anything..... Under SFAS 143 the company is required to:  A. calculate the present value of restoring the land to its original state and deduct this from the carrying value of the assets......... calculate the present value of restoring the land to its original state at the end of each year and recognize the difference from the previous year is an accretion expense........ revise the value of the asset and record the gain as an unusual item. company reviews the value of its fixed assets and finds that an asset that had been written  down due to impairment in the previous accounting period now has a carrying value less than the  future cash flows expected to be received from the use of the asset........... an increase in the value of assets cannot be recognized until they are sold.....  GAAP:  A.... Volume 3. Correct Answer:  D ...S...... B....... calculate the undiscounted cost of restoring the land to its original state and depreciate this cost over the life of the mine...........254   Study Session 09:   5.........S..S...... D.....        6.. under U.. calculate the present value of restoring the land to its original state and recognize this as an expense in the first year of operation of the mine.. Volume 3...... 408‐411........... Reference: CFA® Program Curriculum.. pp.... Reference: CFA® Program Curriculum...... D .....  The company should.. D........ C is not correct...... revise the value of the asset and record the gain as ‘other income’...

 a product and management expertise of another  company should:  A.  restate prior years’ accounts.   not make any retroactive adjustment.  capitalize the cost of purchasing the rights to use a name and expense the cost of the right  to use a product and management expertise. Taxes & Debt   255  7.  If  a  company  decided  to  change  the  estimated  life  of  an  asset  that  is  already  owned  by  the  company it must:  A. Assets.  capitalize the cost of purchasing these rights.    .  B.Financial Statement Inventories.   calculate the cumulative effect of the change and report net of taxes.  A franchisee who buys the rights to use a name.  expense the costs of purchasing these rights.        8.  C.   C.  D.  B.  D.   disclose it as a change in accounting principle.  capitalize the cost of purchasing the rights to use a name and a product and expense the  cost of the right to use management expertise.

......... D. expense the costs of purchasing these rights. Reference: CFA® Program Curriculum. a product and management expertise of another  company should:  A.... D...... not make any retroactive adjustment........... C.......... C.. B....256   Study Session 09:   7........ p....... LOS: Reading  36‐b  All the costs of purchase should be capitalized... 394‐397.... calculate the cumulative effect of the change and report net of taxes...... 360................ Correct Answer:  B............ capitalize the cost of purchasing the rights to use a name and a product and expense the cost of the right to use management expertise...  If  a  company  decided  to  change  the  estimated  life  of  an  asset  that  is  already  owned  by  the  company it must:  A.. disclose it as a change in accounting principle..... capitalize the cost of purchasing the rights to use a name and expense the cost of the right to use a product and management expertise.......... only current and future depreciation expense will be affected........ B......... B..... C and D are not correct since changing an estimate of life of an asset is not a change in accounting principle. Volume 3...... LOS: Reading  37‐b  Correct Answer:  A........... pp....    ....  A franchisee who buys the rights to use a name.. Reference: CFA® Program Curriculum............        8. Since this is only a change in accounting estimate there is no need to make retroactive adjustments....... restate prior years’ accounts............... capitalize the cost of purchasing these rights.. Volume 3.

 then the Cost of Goods Sold  under FIFO is:   A.  C.  $75 million.        10. the increase in LIFO reserve over the same  period is $5 million.  $25 million.  B.  $85 million. and the closing inventory under LIFO is $80 million.  an increase in the value of deferred tax liabilities.  Tax rates are reduced at the beginning of a company’s financial year.  If the Cost of Goods Sold under LIFO is $20 million.  an extraordinary gain which is stated net of tax on the income statement.  C.  B.  $15 million. In the company’s financial  statements the tax rate reduction will lead to:  A.  a restatement of prior years’ accounts.  D.    . Taxes & Debt   257  9. Assets.Financial Statement Inventories.  D.  a reduction in the value of deferred tax assets.

..........258   Study Session 09:   9..... an increase in the value of deferred tax liabilities.... pp. C... $75 million.......... COGS under FIFO = $20 million ..............................LOS: Reading  38‐g  Correct Answer:  The lower tax rate reduces the value of the tax benefit when the deferred tax asset is realized...... Volume 3......... an extraordinary gain which is stated net of tax on the income statement.. B.. $25 million............... $15 million... D................ and the closing inventory under LIFO is $80 million.  Tax rates are reduced at the beginning of a company’s financial year...... 312‐315.$5 million = $15 million Reference: CFA® Program Curriculum.....        10. Volume 3.... $85 million... then the Cost of Goods Sold  under FIFO is:   A... the increase in LIFO reserve over the same  period is $5 million. A ........ 427‐432...    ..........  If the Cost of Goods Sold under LIFO is $20 million.... a reduction in the value of deferred tax assets.... B... pp....... In the company’s financial  statements the tax rate reduction will lead to:  A.. a restatement of prior years’ accounts. B......... C.. LOS: Reading  35‐b  Correct Answer:  COGS under FIFO = COGS under LIFO – increase in LIFO reserve... D.............. Reference: CFA® Program Curriculum...

  $58.  C.000 at the end of each year.  $5.500.  A  company  enters  into  an  agreement  to  lease  equipment  (treated  as  a  capital  lease)  over  two  years and will pay lease payments of $50.000.000.  B. Taxes & Debt   259  11.  C.  $30.100 with a face  value  of  $1. Assets.  Market rates are 5% per annum and a 6% semi annual coupon bond is issued at $1.Financial Statement Inventories.  If  an  investor  buys  1.000  bonds  at  issue  and  receives  a  coupon  payment  after  six  months how much of this coupon payment will be recorded as principal repayment by the issuer?  A.  B.  $46.000.000.  $44.  $2.  D.        12.    .500.  $50.582.000.296. If the discount rate used is 8%  the closing liability at the end of the first year is closest to:  A.  $5.  D.

so the remainder is principal repayment of $2.. 521‐523................. D. 466‐471....... Volume 3.......000.......500..  Market rates are 5% per annum and a 6% semi annual coupon bond is issued at $1..000  bonds  at  issue  and  receives  a  coupon  payment  after  six  months how much of this coupon payment will be recorded as principal repayment by the issuer?  A..133) and principal repayment..000......        12. Volume 3.. The first lease payment is divided between interest (8% x $89. D..260   Study Session 09:   11.....5% multiplied by $1.  A  company  enters  into  an  agreement  to  lease  equipment  (treated  as  a  capital  lease)  over  two  years and will pay lease payments of $50.. $5. $44.. $46.. Reference: CFA® Program Curriculum..... B........    ....... $2. Reference: CFA® Program Curriculum..... $5...163........ Therefore the liability is reduced by $42....582... $58...000..500.. $30.............296.....000...... If the discount rate used is 8%  the closing liability at the end of the first year is closest to:  A...... B....500...000. B........000 at the end of each year..... $50.... C..LOS: Reading  39‐a  Correct Answer:  The coupon paid will be 3% multiplied by $1.000..... pp...000......500.. A . which is $89...867 to $46... which is $27... C..100.....100 with a face  value  of  $1.... The interest the investor earns is 2...000.296.... LOS: Reading  40‐b  Correct Answer:  At the beginning of the lease period the liability will be the present value of the lease payments... which is $30..  If  an  investor  buys  1..000. pp.....163 = $7..

  If a deferred tax liability is very unlikely to be paid then it should be treated as:  A.    .  a long‐term liability.  A firm agrees to buy a certain amount of oil from an oil producer at the market price each  year for the next five years.        14.  B.  An oil producer has the option to sell a certain amount of oil to another firm at a fixed  price each year for the next five years.  D.  C.  D.  Which of the following is an example of a take‐or‐pay contract?  A.  B.  stockholders’ equity. Assets. Taxes & Debt   261  13.  an extraordinary item.  An oil producer has the option to sell a certain amount of oil to another firm at the  market price each year for the next five years.  A firm has the option to buy a certain amount of oil from an oil producer at the market  price each year for the next five years.  a short‐term liability.  C.Financial Statement Inventories.

....        14. 439‐440.............. C. a long-term liability............. LOS: Reading  40‐c  A take-or-pay contract is a firm commitment.......... pp..... LOS: Reading  38‐d  Correct Answer:  If the factors that created the deferred tax liability are unlikely to be reversed..........262   Study Session 09:   13.... Volume 3.... at either a fixed or market price.... and can provide security of supply of a raw material for the buyer and security of income for the seller............ A firm agrees to buy a certain amount of oil from an oil producer at the market price each year for the next five years......... B....... D.. 532‐533. An oil producer has the option to sell a certain amount of oil to another firm at a fixed price each year for the next five years...  Which of the following is an example of a take‐or‐pay contract?  A. These contracts are an example of off-balance-sheet financing since future commitments are not treated as debt........................ than it is considered part of stockholders’ equity. Reference: CFA® Program Curriculum. C. Correct Answer:  A ......... An oil producer has the option to sell a certain amount of oil to another firm at the market price each year for the next five years..... Volume 3..... B.......    ......... not an option... Reference: CFA® Program Curriculum... D......  If a deferred tax liability is very unlikely to be paid then it should be treated as:  A...... stockholders’ equity. B........... pp...... A firm has the option to buy a certain amount of oil from an oil producer at the market price each year for the next five years.... an extraordinary item...... a short-term liability.

  Off‐balance‐sheet financing is significant.  the sum of the lease payments.Financial Statement Inventories.  Minimum lease payments for the next five years must be disclosed in the company’s  accounts. which of the following statements is least accurate?  A.  the present value of lease payments.  If a company actively uses operating leases.  C. Assets.  D.  the present value of lease payments plus the present value of the residual value.  B.  D.  In  a  direct  financing  lease  the  sale  value  reported  at  the  beginning  of  the  lease  on  the  lessor’s  financial statements is:  A.  C.  Return on assets should be adjusted downwards to give a clearer view of the company’s  efficiency.  B.  Total cash flow is understated. Taxes & Debt   263  15. there is no sale value reported.  zero.    .        16.

.264   Study Session 09:   15...... Volume 3. Total cash flow is understated........... Volume 3......... C.. D... Reference: CFA® Program Curriculum... Reference:  CFA® Program Curriculum.    ...... which of the following statements is least accurate?  A.... LOS: Reading  40‐d  Correct Answer:  With a direct financing lease only financing or interest income is reported.  If a company actively uses operating leases.. zero.. Return on assets should be adjusted downwards to give a clearer view of the company’s efficiency................... There is no ‘manufacturing’ profit and no sale is recorded.. Minimum lease payments for the next five years must be disclosed in the company’s accounts...... pp....... there is no sale value reported.......... 541‐543.... the present value of lease payments........... LOS: Reading  40‐b  Correct Answer:  Total cash flow is not understated but cash flow from operations is lower than if the lease were capitalized........ D...... the present value of lease payments plus the present value of the residual value...........  In  a  direct  financing  lease  the  sale  value  reported  at  the  beginning  of  the  lease  on  the  lessor’s  financial statements is:  A. A .......... pp...... 550‐551...... Off-balance-sheet financing is significant. B.... C .................. the sum of the lease payments.. C............ B.............        16.

 The company will record the gross investment in the machine as:   A. Taxes & Debt   265  17.        18.  the sum of the minimum lease payments plus the residual value of the machine.  B.  D.  B.  A company manufactures a machine and agrees to lease the machine under a sales‐type capital  lease agreement.  C.  the sum of the present values of the minimum lease payments.  gain in economic terms. Assets.  When market interest rates decline.    .Financial Statement Inventories.  D.  lose in economic terms.  the debt on the balance sheet is automatically adjusted to current market value so the  economic loss will be reflected as an accounting loss. a company that has fixed‐rate debt outstanding will:  A.  C.  the debt on the balance sheet is automatically adjusted to current market value so the  economic gain will be reflected as an accounting gain.  the sum of the minimum lease payments.  the sum of the present values of the minimum lease payments plus the present value of  the residual value of the machine.

...... LOS: Reading  39‐f  The debt on the balance sheet reflects the market rate at issuance and therefore if market interest rates decline the market value of the debt will increase which leads to an economic loss...... D...  When market interest rates decline.. C.. C........ the debt on the balance sheet is automatically adjusted to current market value so the economic loss will be reflected as an accounting loss.266   Study Session 09:   17................... Volume 3................. Volume 3...... the sum of the minimum lease payments.......... the difference between the gross investment and net investment is the interest component of the revenue represented by unearned income.. B. lose in economic terms.......... Correct Answer:  C ....... the sum of the minimum lease payments plus the residual value of the machine............... Correct Answer:  A ... Reference: CFA® Program Curriculum....... B.... Reference: CFA® Program Curriculum.. the debt on the balance sheet is automatically adjusted to current market value so the economic gain will be reflected as an accounting gain...... 489‐493.... LOS: Reading  40‐d  Net investment looks at the present value of the payments.. gain in economic terms....... pp...    .  A company manufactures a machine and agrees to lease the machine under a sales‐type capital  lease agreement.... 547‐550..... the sum of the present values of the minimum lease payments plus the present value of the residual value of the machine..... the sum of the present values of the minimum lease payments......... The company will record the gross investment in the machine as:   A.        18..... D. pp..... a company that has fixed‐rate debt outstanding will:  A......................

 this is most likely to  be explained by:  A.  it is a growing company with rising capital expenditure.  B.Financial Statement Inventories. Assets.  An analyst notices that a company’s net deferred tax liability has declined.  The financial ratios for a company.  the company has made a profit. will be as follows:    A.  B.    .  a new tax law has increased tax rates.  C. which uses operating leases compared to a company that uses  capital leases. Taxes & Debt   267  19.        20.  D.  C.  Interest cover  lower   lower   higher   higher                     Return on assets  lower  higher   lower   higher  the company has written down asset values due to impairment.

...  The financial ratios for a company... the company has written down asset values due to impairment..LOS: Reading  37‐a  A would not reduce deferred tax liabilities........ D........ pp..... Volume 3...    ...... Return on assets will be higher since assets will be lower...... will be as follows:  A.. this is most likely to  be explained by:  A............... it is a growing company with rising capital expenditure... 425‐452................. the company has made a profit...... C. pp............. 521‐524......... LOS: Reading  40‐b  Correct Answer:  Interest cover will be higher as interest payments will be lower.....        20.............. which uses operating leases compared to a company that uses  capital leases........268   Study Session 09:   19............. Reference: CFA® Program Curriculum.. B..  An analyst notices that a company’s net deferred tax liability has declined.. B. Volume 3.. Reference: CFA® Program Curriculum...................... a new tax law has increased tax rates... C...... Correct Answer:  D .. Interest cover lower lower higher higher Return on assets lower higher lower higher D ..... B is not correct since this would increase deferred tax liabilities C is not correct since this would to lead to increasing deferred tax liabilities if accelerated tax depreciation methods are used for tax reporting...........

Financial Statement Inventories.36    2. Assets.53    .19  2.  D.  The following financial data is provided by Sportswear Corporation:  $ million (using LIFO)  2006  Inventory  Current assets  LIFO reserve      2007  125 350 55 160 1700 105 300 45 110 1450 Current liabilities  COGS    The current ratios using FIFO are closest to:    A.14      2007  1.  B. Taxes & Debt   269  21.13  1.84  2.  2006    1.73      3.  C.32      2.

.73 2.. 312‐315........ 3.......... Volume 3........... Reference: CFA® Program Curriculum...36 1... pp.. Current ratio is current assets /current liabilities = 345/110 and 405/160 respectively which equal 3.14 and 2............53 respectively....  The following financial data is provided by Sportswear Corporation:  $ million (using LIFO)   2006  Inventory  Current assets  LIFO reserve      2007  125 350 55 160 1700 105 300 45 110 1450 Current liabilities  COGS  The current ratios using FIFO are closest to: 2006 2007 A..19 D.......13 B..... LOS: Reading  35‐d  Adjust current assets by adding the LIFO reserve to get current assets under FIFO of 345 in 2006 and 405 in 2007...270   Study Session 09:   21.. 2.53 Correct Answer:  D ......... 1.32 1...14 2...84 C.........    ..... 2....

  A new machine is purchased at a cost of $10.800.  $10.200.  $1.000.  The deferred tax expense in year 2 will be:  A.  D.  $600.Financial Statement Inventories.000.  B.  The company.400. Assets.  Annual revenues of $40. in its financial reports.    .  The following information is given regarding a company’s activities:  Tax rate is 30%.  C. Taxes & Debt   271  22.  $11.  The only expense is depreciation.  For tax purposes the machine is depreciated using the straight‐line method over two years with the  same salvage value.000 are generated from the new machine. depreciates the machine by using the straight‐line  method over four years and the salvage value is estimated to be $2.

. A new machine is purchased at a cost of $10. C.. Annual revenues of $40.....    ....800 $600 Reference: CFA® Program Curriculum.272   Study Session 09:   22....000 are generated from the new machine..... B..... $1.400.....000  $11...000.. 425‐470. $600...000  $36. A .. depreciates the machine by using the straight-line method over four years and the salvage value is estimated to be $2.. $10..000 $2.............000 $36. D..200.000 $10....000  $4..  The deferred tax expense in year 2 will be:  A.. The company...000  $10..000 $11.000.800.. The only expense is depreciation...800        Year 1 $40..800 Year 1 $40.. in its financial reports. For tax purposes the machine is depreciated using the straight‐line method over two years with the  same salvage value.... LOS: Reading  38‐f  Financial statement reporting – straight-line Revenue Depreciation Pre‐tax income   Tax expense of which:  Taxes payable Deferred tax  Correct Answer:    Tax reporting – straight-line depreciation over two   Revenue  Depreciation  Taxable income  Taxes payable          Year 2  $40.....400    $10.000 $38..........800   $600  Year 2  $40. $11..... Volume 3.400 $10....000  $2....000  $38.  The following information is given regarding a company’s activities:  Tax rate is 30%.... pp...000 $4.

 Assets.Financial Statement Inventories. Taxes & Debt   273            .

  Such adjustments are often needed to put companies’ reported results on a comparable basis.  cross‐sectional  analysis.274   Study Session 10:   Study Session 10: Financial Statement Analysis: Techniques.  trend  analysis. and the international convergence of accounting standards.    Reading 41: Financial Analysis Techniques  Reading 42: Financial Statement Analysis: Applications  Reading 43: International Standards Convergence        .  The first reading presents the most frequently used tools and techniques used to evaluate companies.  The  reading  also  discusses analyst  adjustments  to  reported  financials.S.  and  the  screening  of  potential  equity  investments.  there  are  still  significant  variations  between  generally  accepted  accounting  principles from one country to another. financial statement analysis  applications. Although there has been much progress in harmonizing accounting standards globally. Applications.  and  ratio  analysis.  accounting  standards. as  this  reading  discusses.  including  common  size  analysis. and International Standards Convergence   The readings in this study session discuss financial analysis techniques.  credit  risk.  This  study  session  concludes  with  a  reading  on  convergence  of  international  and  U.  The  second  reading  then  shows  the  application  of  financial  analysis  techniques  to  major  analyst  tasks  including  the  evaluation  of  past  and  future  financial  performance.

  If the debt‐to‐capital ratio has decreased for a firm this is most likely to be explained by:  A.  C.    EBITDA is more sensitive to the gearing of the company.  B.  the book value of debt has not changed but the market value of long‐term debt has  decreased.  B.Financial Statement Techniques.        2.  EBITDA does not take into account the cost of using fixed assets. and International Standards Convergence   275  1. Applications.  C.  D.  the firm has just completed a new issue of equity to finance its expansion. which of the following would support this preference?   A.  D.  the book value of debt has not changed but the market value of long‐term debt has  increased.  EBITDA gives a better indication of profits available to equity shareholders.  EBITDA is a more volatile number than earning per share.  the firm has switched from using long‐term debt to using more short‐term borrowing to  finance its activities.     .  Some  analysts  prefer  to  use  EBITDA  rather  than  earnings  per  share  to  value  a  company’s  performance.

.... 593‐597.. since it is before interest.......... which of the following would support this preference?   A.  If the debt‐to‐capital ratio has decreased for a firm this is most likely to be explained by:  A.........        2.... pp.. B.. A would lead to an increase in total equity so would explain a fall in the debt-to-capital ratio.......... Volume 3. EBITDA is a more volatile number than earning per share... EBITDA is more sensitive to the gearing of the company...... Usually total interest bearing debt is used in the calculation of capital so D is not correct... and is not directly sensitive to the level of gearing...... 610‐613.... B and C are not correct since the book value of debt is used in the calculation.    ........  Some  analysts  prefer  to  use  EBITDA  rather  than  earnings  per  share  to  value  a  company’s  performance..... B..... D.LOS: Reading  41‐g  Correct Answer:  Usually earnings per share are more volatile than EBITDA. the book value of debt has not changed but the market value of long-term debt has decreased................... D...... Since EBITDA is before depreciation and capital expenditure it does not take into account the cost of using fixed assets. EBITDA does not take into account the cost of using fixed assets.... EBITDA is profit available to all providers of capital.276   Study Session 10:   1....... C.. C....... Reference: CFA® Program Curriculum.. Reference: CFA® Program Curriculum....... C .. so might be used of compare companies with very different levels of fixed asset investment.. Correct Answer:  A ..... the book value of debt has not changed but the market value of long-term debt has increased... Volume 3.... the firm has switched from using long-term debt to using more short-term borrowing to finance its activities.... since they are after interest which is effectively a fixed charge.. LOS: Reading  41‐d  Debt-to-capital ratio is total debt divided by total debt plus shareholders’ equity..... pp.............................. the firm has just completed a new issue of equity to finance its expansion................ EBITDA gives a better indication of profits available to equity shareholders.

 amortization is still used.  is charged directly to stockholders’ equity and does not impact on the income statement.  is not permitted.  leads to a reduction in net income in the period when the impairment is recognized.  C.  B.  An analyst is evaluating the impact of changes in oil prices on an airline’s profitability.  The analysts  are most likely to use which type of analysis?    A.  D.  Airline  scenario   scenario        Retailer  scenario  sensitivity   scenario  sensitivity   sensitivity     sensitivity       .  it charged as a valuation allowance against the acquired assets.  B.Financial Statement Techniques.  Under International Financial Reporting Standards (IFRS) impairment of goodwill:  A.        4.  D. another  analyst is projecting the cash flows for a retailer based on different economic forecasts. Applications.  C. and International Standards Convergence   277  3.

... Volume 3...... D....................... Reference: CFA® Program Curriculum. Airline scenario scenario sensitivity sensitivity Retailer scenario sensitivity scenario sensitivity C ...... Under IFRS goodwill must be checked annually for impairment. B..... LOS: Reading  43‐b  Correct Answer:  Impairment reduces income in the year it is recorded.......    . is not permitted..... C.............. so would be applicable to measuring the sensitivity of the airlines profits to an oil price move.. C .... it charged as a valuation allowance against the acquired assets. reduces the value of net asset and reduces stockholder’s equity. is charged directly to stockholders’ equity and does not impact on the income statement. LOS: Reading  41‐h  Correct Answer:  Sensitivity analysis will give a range of possible outcomes if a variable changes.....  An analyst is evaluating the impact of changes in oil prices on an airline’s profitability............... so this would accommodate using different economic forecasts to predict cash flows for the retailer... Volume 3...... Reference: CFA® Program Curriculum....... B........ 685‐689..................        4.....  The analysts  are most likely to use which type of analysis?  A.... In scenario analysis forecasts are made based on specific assumptions or outcomes... another  analyst is projecting the cash flows for a retailer based on different economic forecasts....  Under International Financial Reporting Standards (IFRS) impairment of goodwill:  A.. leads to a reduction in net income in the period when the impairment is recognized..... D......... amortization is not permitted. pp....278   Study Session 10:   3....... pp....... amortization is still used........ 622‐623......... C.

  2.  the company has switched to using LIFO accounting rather than FIFO accounting in an  inflationary environment.  B.        6.  The  gross  profit  margin  of  a  company  has  declined  relative  to  its  competitors.  D.00.67. Applications.  C. and International Standards Convergence   279  5.  C.  National Telecoms Corporation’s interest coverage is closest to (ref.11.11.  the company’s credit quality has declined pushing up the interest rate on short‐term  debt.  1.  B.  the company has increased its marketing efforts and hired additional marketing  executives.  6.  the company has recognized losses on plant and equipment that has become obsolete.Financial Statement Techniques.    . financial data in question 34):   A.  2.  D.  This  could  be  explained by:  A.

... C... the company’s credit quality has declined pushing up the interest rate on short-term debt........ the company has recognized losses on plant and equipment that has become obsolete..... Interest expense. Correct Answer:  D .. the company has increased its marketing efforts and hired additional marketing executives.00. the company has switched to using LIFO accounting rather than FIFO accounting in an inflationary environment... 1........ C......67 45 Correct Answer:  Interest coverage = EBIT interest expense Reference: CFA® Program Curriculum............ LOS: Reading  41‐d  = 120 = 2.        6.    . B.. 6... D... pp............ financial data in question 34):   A............................ C ......... 2....... LIFO accounting would increase the cost of inventory sold thereby reducing the gross margin.... 593‐597.. B. losses on sale of plant and equipment and marketing expense are not part of COGS...... 597‐601...............280   Study Session 10:   5.  The  gross  profit  margin  of  a  company  has  declined  relative  to  its  competitors...........11. pp... 2..  National Telecoms Corporation’s interest coverage is closest to (ref.... Volume 3..... Reference: CFA® Program Curriculum..... Volume 3...11.........  This  could  be  explained by:  A.......67... LOS: Reading  41‐d  Gross profit margin is (revenue – COGS)/revenue. D.............

 This could be explained by:  A.   investors will tolerate a higher debt‐to‐equity relative to other companies in the sector.   the company has sold unprofitable business units and used the proceeds to reduce debt. It is generally the case that:  A.  C.  the company’s financial risk is lower than that of other companies in the sector.  the company has become less risky and therefore a higher return on total invested capital  is required.        8.  C. and International Standards Convergence   281  7.  The return on total capital of a company has increased.Financial Statement Techniques.    .  A company has a low fixed asset base relative to its sector average.  D.  D. Applications.  its sales variability is higher than that of other companies in the sector.  B.  operating profits will be relatively volatile compared to other companies in the sector.  the company’s operating profit has been deteriorating as competitive pressure increases.  B.  the company has increased borrowing to expand its operating capacity but this has not  yet been reflected in a rise in earnings.

........ D...282   Study Session 10:   7...... operating profits are less sensitive to changes in sales revenue........ the company’s operating profit has been deteriorating as competitive pressure increases......... pp......... 597‐601..... Reference: CFA® Program Curriculum.. LOS: Reading  41‐d  The total capital will have been reduced by the repayment of debt. the company has sold unprofitable business units and used the proceeds to reduce debt.........e.... C........ thereby increasing the return on total capital....... operating profits will be relatively volatile compared to other companies in the sector... B......... Correct Answer:  B.. D ......... This could be explained by:  A..................... D. the company’s financial risk is lower than that of other companies in the sector. It is generally the case that:  A. i.... One of the measures of financial risk is the debt-to-equity ratio... Reference: CFA® Program Curriculum....  The return on total capital of a company has increased....... LOS: Reading  41‐d  Correct Answer:  A low fixed asset base generally leads to lower operating leverage...... Volume 3... Investors will usually accept greater financial risk if operating risk is lower.    ..  A company has a low fixed asset base relative to its sector average............ B.............. the company has increased borrowing to expand its operating capacity but this has not yet been reflected in a rise in earnings... investors will tolerate a higher debt-to-equity relative to other companies in the sector. C.. Volume 3......... its sales variability is higher than that of other companies in the sector.... the company has become less risky and therefore a higher return on total invested capital is required.        8. 593‐594....... pp......

  lower interest costs as a percentage of sales.  higher financial leverage.  C.4% 4.2% 1.  A company provides the following information:       Return on equity  Return on total assets  Total asset turnover    The numbers could be explained by:    A.5% 1.  lower interest costs as a percentage of operating profit.        10.Financial Statement Techniques.9% 4.  D.  A major competitor of a company has the same net profit margin and total asset turnover as the  company.  B.  C.7   . and International Standards Convergence   283  9.  Financial leverage    increased    increased    decreased    decreased            Net profit margin  increased  decreased  increased  decreased  a lower tax rate.  B. Applications.  2006  8.5 2007  9.  D. The competitor’s return on equity is higher. this is explained by the competitor having:   A.

  A major competitor of a company has the same net profit margin and total asset turnover as the  company.......7 Correct Answer:  B............... Financial leverage increased increased decreased decreased Net profit margin increased decreased increased decreased 2006  8. a lower tax rate..      10.... C.. 84‐89... LOS: Reading  41‐d  Correct Answer:  Return on equity = net profit margin x total asset turnover x financial leverage Reference: CFA® Program Curriculum............. Return on assets = net profit margin x total asset turnover.. lower interest costs as a percentage of operating profit...... B.......... B..284   Study Session 10:   9... The competitor’s return on equity is higher.4% 4.... this is explained by the competitor having:   A... higher financial leverage.. pp......2% 1....... lower interest costs as a percentage of sales.........5 2007  9.. so financial leverage must have increased.9% 4...... LOS: Reading  41‐f  Return on equity = return on assets x financial leverage....................... C.... Reference: CFA® Program Curriculum..... pp. D....... D........    ............. B. Return on equity has increased when return on assets fell...............  A company provides the following information:     Return on equity  Return on total assets  Total asset turnover  The numbers could be explained by:  A... 597‐601..... If return on assets fell and total asset turnover increased in must be because net profit margins fell.. Volume 3.......... Volume 3.5% 1........

  this  is  most  likely  to  mean that:  A.  unless the firm has a heavy capital expenditure program it could pay off its debt from  retained cash flow in about four years.   D.25.Financial Statement Techniques.    .  B.  the cash flows required to pay interest on the debt are approximately a quarter of the  firm’s total cash flows.  B.  Which  of  the  following  is  least  likely  to  be  a  limitation  of  using  ratio  analysis  to  evaluate  the  financial performance of a company?   A.  A company’s operations may be diverse and it is not always easy to find companies that  can provide useful industry comparisons.   D.   C. and International Standards Convergence   285  11. Applications. after capital expenditure.  Ratios are more applicable for equity analysis and are less useful for credit analysis.        12.  There are potential inconsistencies between the signals different ratios are giving about a  company’s financial health.  the firm could pay off its debt from retained cash flow in about three months.  Ratios based on financial statements using different accounting methods may not be  comparable.  C.  the firm could increase debt financing by a factor of four times and still have sufficient  cash flow to cover interest payments on the debt.  When  Moody’s  calculates  that  a  firm’s  retained  cash  flow  to  debt  is  0.

the firm could increase debt financing by a factor of four times and still have sufficient cash flow to cover interest payments on the debt..286   Study Session 10:   11.. Correct Answer:  A . 572‐573.............. less dividends........ Reference: CFA® Program Curriculum. after capital expenditure... 649‐652    . LOS: Reading  41‐b  Ratios are widely used by both equity analysts and credit analysts so A is not correct. Volume 3......... Ratios based on financial statements using different accounting methods may not be comparable.......  When  Moody’s  calculates  that  a  firm’s  retained  cash  flow  to  debt  is  0... the cash flows required to pay interest on the debt are approximately a quarter of the firm’s total cash flows.  Which  of  the  following  is  least  likely  to  be  a  limitation  of  using  ratio  analysis  to  evaluate  the  financial performance of a company?   A................. B..... pp. C..  this  is  most  likely  to  mean that:  A. If cash flows and debt remains stable and there were no capital expenditures then the company could pay off its debt from retained cash flow in 1/0....... Volume 3....... C.............. Ratios are more applicable for equity analysis and are less useful for credit analysis..... C and D are all potential limitations of using ratios for financial analysis..........25........ D........... Correct Answer:  B.... D... B...... or 4 years. A company’s operations may be diverse and it is not always easy to find companies that can provide useful industry comparisons. Reference: CFA® Program Curriculum.....25.... pp.....        12........ B............... There are potential inconsistencies between the signals different ratios are giving about a company’s financial health.... LOS: Reading  42‐c  Retained cash flow is defined as operating cash flow before working capital changes... unless the firm has a heavy capital expenditure program it could pay off its debt from retained cash flow in about four years........... the firm could pay off its debt from retained cash flow in about three months......

  U.  C. and International Standards Convergence   287  13.  B.        14. GAAP  and International Financial Reporting Standards (IFRS) are:     A.Financial Statement Techniques.  When a firm cannot confidently forecast the outcome.  B. GAAP                IFRS  percentage of completion  revenue if contract costs can be recovered  completed contract    revenue if contract costs can be recovered   completed contract      completed contract      percentage of completion  percentage of completion    .  D.  lower financial leverage.  a lower interest burden. in terms or total revenues and costs.  A firm has a higher return on equity to its competitors. Applications.  a lower tax burden. this is least likely to be explained by:   A.  higher asset turnover. of a  construction project the appropriate accounting treatments for recognizing revenue under U.  D.S.S.  C.

.....S.. a lower interest burden. this is least likely to be explained by:   A...... GAAP completed contract completed contract percentage of completion percentage of completion   Correct Answer:  B........ Volume 3....... lower financial leverage. Volume 3.. D........... C... LOS: Reading  41‐f  IFRS percentage of completion revenue if contract costs can be recovered completed contract revenue if contract costs can be recovered A. C.. Reference: CFA® Program Curriculum........S.... using DuPont analysis........ in terms or total revenues and costs...... pp. GAAP...        14.... Correct Answer:  Return on equity..  A firm has a higher return on equity to its competitors. of a  construction project the appropriate accounting treatments for recognizing revenue under U. D ......... can be decomposed into total asset turnover x leverage x tax burden x interest burden x EBIT margin. GAAP  and International Financial Reporting Standards (IFRS) are:   U............. LOS: Reading  43‐b  Under IFRS.    ..... 684............ 604‐609.. Reference: CFA® Program Curriculum......S.288   Study Session 10:   13.. higher asset turnover................ the completed contract method must be used... D......... revenue can be recognised to the extent that contract costs can be recovered. p..... B..... B.......... Therefore lower financial leverage would tend to reduce return on equity. Under U....  When a firm cannot confidently forecast the outcome............... a lower tax burden............

  held‐for‐trading securities and available‐for sale securities only.  D. available‐for sale securities and held‐to‐maturity securities.  C.  Under  International  Financial  Reporting  Standards  (IFRS)  unrealized  gains  on  which  type  of  marketable securities are recorded in the income statement?   A.  B.  and  who  has  written  off  a  large  amount  of  uncollectible  receivables.    .  held‐for‐trading securities.  A company has employed a new financial controller who has installed a new system to improve  the  efficiency  of  inventory  management.        16.  D. Applications.Financial Statement Techniques.  This is likely to:    A.  C.  B.  available‐for‐sale securities only.  Inventory turnover    increase  increase  decrease  decrease                  Receivables turnover  increase  decrease  increase  decrease  held‐for‐trading securities only. and International Standards Convergence   289  15.

.... held-for-trading securities only....... held-for-trading securities................ available-for sale securities and held-to-maturity securities.. by reducing the number of days goods were held as inventory..... D........... held-for-trading securities and available-for sale securities only. C........................... available-for-sale securities only. Volume 3... 586‐589.. Available-for sale securities are recorded at market value but any unrealized gains flow straight through to shareholders’ equity........ Writing off receivables would reduce the denominator in the receivables turnover. Inventory turnover increase increase decrease decrease Receivables turnover increase decrease increase decrease Correct Answer:  A ....... Volume 3..  and  who  has  written  off  a  large  amount  of  uncollectible  receivables..... Reference: CFA® Program Curriculum.............290   Study Session 10:   15.... Only unrealized gains on held-for-trading securities are recorded in the income statement...  Under  International  Financial  Reporting  Standards  (IFRS)  unrealized  gains  on  which  type  of  marketable securities are recorded in the income statement?   A. B...................... pp..    . C....        16........... thereby increasing receivables turnover....... D... 681‐683...  This is likely to:  A..... Reference: CFA® Program Curriculum.LOS: Reading  43‐a  Correct Answer:  Unrealized gains are not recognized for held-to-maturity securities... A .... B..... LOS: Reading  41‐d  More efficient management of inventory would be expected to increase the inventory turnover....  A company has employed a new financial controller who has installed a new system to improve  the  efficiency  of  inventory  management.......... pp....

  C.  D.  South Inc.  The quick ratio is closest to:   0.  Maintaining working capital at current levels whilst achieving steady revenue growth.  1.13.  B.07.110 Total  610   .    Reducing the fixed assets used in the business.  1.55.  1. and International Standards Convergence   291  17.  Which  of  the  following  actions  would  be  least  likely  to  improve  a  firm’s  working  capital  turnover?   A.  D.  C.        18. Applications.   Current assets  Cash and cash equivalents  Receivables  Inventories  Other current assets  ($ ‘000) Current liabilities  ($ ‘000) 25  420  120  45  40  Short term debt  650  Accounts payable  350  Taxes payable  70  Other current liabilities  Total      A.’s breakdown of current assets and liabilities is as follows:  Reducing inventory levels.Financial Statement Techniques.82.  Tightening credit terms given to customers.  B.  1.

..... 1. D... C....... C .... 590‐593............ 583‐589...... C..  Which  of  the  following  actions  would  be  least  likely  to  improve  a  firm’s  working  capital  turnover?   A......... pp. Volume 3...........13 610 Reference: CFA® Program Curriculum.. Increasing revenue collection from customers would reduce receivables and as long as the cash collected was not held in cash equivalents this would improve the ratio.................. Tightening credit terms given to customers. pp..... Volume 3.. Reducing the fixed assets used in the business.. 1.292   Study Session 10:   17......... Fixed assets are not part of working capital so reducing fixed assets would not directly affect working capital turnover... for example reducing inventory levels would improve the ratio.. B.’s breakdown of current assets and liabilities is as follows:  Current assets  Cash and cash equivalents  Receivables  Inventories  Other current assets  ($ ‘000) 40 650 350 70 Current liabilities Short term debt Accounts payable Taxes payable Other current liabilities ($ ‘000)  25  420  120  45  Total  A. 1.. Reference: CFA® Program Curriculum...........55... LOS: Reading  41‐d  Correct Answer:  Working capital turnover is revenue/average working capital.........07. B..... Maintaining working capital at current levels whilst achieving steady revenue growth....... D....... 1.  South Inc..    ....... Reducing inventory levels......... The quick ratio is closest to: 0.....      18...82..... Reducing working capital by.........13........... where working capital is current assets less current liabilities.... LOS: Reading  41‐d  Quick ratio = cash + market securities + receivables current liabilities = 690 = 1.......110 Total 610  Correct Answer:  B...

 this could be explained by:   A.  the company maintains high inventory levels in order to meet customer orders promptly.  B.  Operating profit margin.  the company runs a just‐in‐time manufacturing system.  C.Financial Statement Techniques.  the resources of the company tied up in inventory are relatively high compared with its  competitors.  Total asset turnover.  B.     .  Which of the following ratios is least likely to be used to measure profitability?  A. Applications.   Return on assets.        20.  D.   a significant proportion of the company’s inventory is obsolete.  D.  Return on common equity.  A computer manufacturing company has very short days of inventory on hand compared with  its competitors. and International Standards Convergence   293  19.  C.

294   Study Session 10:   19.  Which of the following ratios is least likely to be used to measure profitability?  A. B. C. D. Return on assets. Total asset turnover. Operating profit margin. Return on common equity. B.......................................................................................... LOS: Reading  41‐d 

Correct Answer: 

Total asset turnover is a measure of activity rather than profitability. Reference: CFA® Program Curriculum, Volume 3, pp. 597‐598.        20.  A computer manufacturing company has very short days of inventory on hand compared with  its competitors, this could be explained by:   A. the company runs a just-in-time manufacturing system. B. a significant proportion of the company’s inventory is obsolete. C. the company maintains high inventory levels in order to meet customer orders promptly. D. the resources of the company tied up in inventory are relatively high compared with its competitors. Correct Answer:  A ......................................................................................... LOS: Reading  41‐d 

Short DOH indicates high inventory turnover (cost of goods sold/inventory) so it is unlikely the inventory is obsolete and the resources of the company tied up in inventory is smaller than its competitors. A just-intime manufacturing system means that computers are manufactured in response to customer demand which will reduce inventory levels, so A is correct. Reference: CFA® Program Curriculum, Volume 3, pp. 583‐589. 

 

Financial Statement Techniques, Applications, and International Standards Convergence   295  21.  ABC Corporation provides you with the following information: 

Income statement  $  million 
Sales  COGS    Gross profit  SGA expenses  Op. profit 

Balance sheet  Average over period                $ million  90 Accounts payable  10 Short‐term bank notes  70 Long‐term debt           150   (70) Common stock    30 Retained earnings 
 

150  Cash  (75)  Accounts receivable  75  Inventory  (20)  Property, P & E  55  Depreciation 

30 25 60

50 115

Interest  expense          (15)  Investment  Tax 

(10)    30  Total assets 

Net income 
 

280 Total liabilities &  equity 

280

Inventory turnover is closest to:  A.  B.  C.  D.  0.47.  0.93.  1.07.  2.14. 

 

296   Study Session 10:   21.  ABC Corporation provides you with the following information: 

Income statement  $  million 
Sales  COGS    Gross profit  SGA expenses  Op. profit 

Balance sheet  Average over period                $ million  90 Accounts payable  10 Short‐term bank notes  70 Long‐term debt           150   (70) Common stock    30 Retained earnings 
 

150  Cash  (75)  Accounts receivable  75  Inventory  (20)  Property, P & E  55  Depreciation 

30 25 60

50 115

Interest  expense          (15)  Investment  Tax 

(10)    30  Total assets 

Net income 
Inventory turnover is closest to: A. 0.47. B. 0.93. C. 1.07. D. 2.14. Correct Answer: 

280 Total liabilities &  equity 

280

C ......................................................................................... LOS: Reading  41‐d 

Inventory turnover =

COGS 75 = = 1.07 average inventory 70

Reference: CFA® Program Curriculum, Volume 3, pp. 583‐586. 

 

Financial Statement Techniques, Applications, and International Standards Convergence   297  22.  National Telecoms Corporation provides the following information: 

Income statement  $ million 
Sales  COGS  Gross profit  SGA exp.  Op. profit  Interest exp.  Tax 

Balance sheet  Average over period    $ million  1,050 Cash  (780) Accounts  270 Inventory*  (150) Property, P&E  120 Depreciation  (45)   (25)   90 Accounts payable  170 Notes payable  200 Long‐term debt  650   (430) Common stock 
Retained earnings   

50 125 300 150 55 680 

Net income 
   

50 

Total assets 

680 

Total liabilities &  equity 

*Inventory is unchanged over the period 

National Telecoms Corporation’s cash conversion cycle is closest to:   A.  B.  C.  D.  58 days.  130 days.  153 days.  176 days. 

 

298   Study Session 10:   22.  National Telecoms Corporation provides the following information: 

Income statement  $ million 
Sales  COGS  Gross profit  SGA exp.  Op. profit  Interest exp.  Tax 

Balance sheet  Average over period    $ million  1,050  Cash  (780)  Accounts  270  Inventory*  (150)  Property, P&E  120  Depreciation  (45)    (25)    90 Accounts payable  170 Notes payable  200 Long‐term debt  650   (430) Common stock 
Retained earnings   

50 125 300 150 55 680 

Net income 

50 

Total assets 

680 

*Inventory is unchanged over the period National Telecoms Corporation’s cash conversion cycle is closest to: A. 58 days. B. 130 days. C. 153 days. D. 176 days. Correct Answer: 

Total liabilities &  equity

B.......................................................................................... LOS: Reading  41‐d 

Days of sales outstanding = 365/annual receivables turnover = 365/(1050/170) = 59 days Days of inventory on hand = 365/inventory turnover = 365/(780/200) = 94 days Days of payables = 365/payables turnover = 365/(780/50) = 23 days Cash conversion cycle = Receivables collection period + inventory processing period – payables payment period= 130 days Reference: CFA® Program Curriculum, Volume 3, pp. 583‐589. 

 

Financial Statement Techniques, Applications, and International Standards Convergence   299     

 

300   Study Session 11:  

Study Session 11: Corporate Finance:
  This study session covers the principles that corporations use to make their investing and financing  decisions.  Capital  budgeting  is  the  process  of  making  decisions  about  which  long‐term  projects  the  corporation should accept for investment, and which it should reject. Both the expected return of a  project and the financing cost should be taken into account. The cost of capital, or the rate of return  required for a project, must be developed using economically sound methods.  Corporate  managers  are  concerned  with  liquidity  and  solvency,  and  use  financial  statements  to  evaluate performance as well as to develop and communicate future plans. The final reading in this  study session is on corporate governance practices, which can expose the firm to a heightened risk of  ethical lapses. Although these practices may not be inherently unethical, they create the potential for  conflicts  of  interest  to  develop  between  shareholders  and  managers,  and  the  extent  of  that  conflict  affects the firm’s valuation.    

Reading 44: Capital Budgeting  Reading 45: Cost of Capital  Reading 46: Working Capital Management  Reading 47: Financial Statement Analysis  Reading 48: The Corporate Governance of Listed Companies:   
 

A Manual for Investors 

 

Corporate Finance   301  1.  A  company  has  trade  credit  which  is  2/10,  net  30.    The  company  pays  on  the  20th  day.    The  effective borrowing cost of not paying on the 10th day is closest to:  A.  B.  C.  D.        2.  A company has trade credit with its suppliers and receives a discount if it pays within a specified  number  of  days.  It  works  out  the  cost  of  trade  credit  is  50%  if  it  pays  on  the  net  day.      If  the  company’s short term cost of funds is 18% then the company should pay:  A.  B.  C.  D.    on the net day.  on the day or purchase.  on the last day of the discount period  just after the discount period has ended.  36.5%.  44.6%.  106.0%.  109.0%. 

 

302   Study Session 11:   1.  A  company  has  trade  credit  which  is  2/10,  net  30.    The  company  pays  on  the  20th  day.    The  effective borrowing cost of not paying on the 10th day is closest to:  A. B. C. D. 36.5%. 44.6%. 106.0%. 109.0%. D ......................................................................................... LOS: Reading  46‐d 

Correct Answer: 

The cost of trade credit is calculated as the implicit rate of return which is represented by the trade discount offer. Cost =

0.02 1+ 1 - 0.02

365 / 20

- 1 = 109%

Reference: CFA® Program Curriculum, Volume 4, pp. 120‐121.        2.  A company has trade credit with its suppliers and receives a discount if it pays within a specified  number  of  days.  It  works  out  the  cost  of  trade  credit  is  50%  if  it  pays  on  the  net  day.      If  the  company’s short term cost of funds is 18% then the company should pay:  A. B. C. D. on the net day. on the day or purchase. on the last day of the discount period just after the discount period has ended. C ......................................................................................... LOS: Reading  46‐d 

Correct Answer: 

The discount offers a higher return for the company compared to its borrowing rate so it should take advantage of the discount offered and pay on the last day of the discount period. Losing the discount is more costly than delaying payment to the net day. Reference: CFA® Program Curriculum, Volume 4, pp. 120‐121. 

 

Corporate Finance   303  3.  Which of the following is least likely to be a pull on liquidity for a company?   A.  B.  C.  D.        4.  A  company  is  offered  two  projects  with  the  net  cash  flows,  in  $  million,  from  each  project  as  shown below. The cost of project A is $2 million and the cost of project B is $10 million. The cost of  capital  for  project  A  is  10%  and  for  project  B  is  12%.  Which  of  the  projects  should  be  accepted  for  inclusion in the capital budget?  paying vendors early.   low liquidity positions.   uncollected receivables.  limited short‐term lines of credit.  

End of year  1  2  3 
A.  B.  C.  D. 

Project A  1.1  0.8  0.4 

Project B  2.0  4.0  7.0 

Both projects should be rejected.  Both projects should be accepted.  A should be accepted and B rejected.   B should be accepted and A rejected. 

 

.30) which is less than the cost.  in  $  million. Reference: CFA® Program Curriculum.........  Which  of  the  projects  should  be  accepted  for  inclusion in the capital budget?  End of year  1  2  3  A. uncollected receivables...... The cost of  capital  for  project  A  is  10%  and  for  project  B  is  12%...............66 + 0...............      4........... discounted at 10%. is $9......  Which of the following is least likely to be a pull on liquidity for a company?   A.LOS: Reading  46‐a  Correct Answer:  A pull on liquidity refers to payments that are made too early or when credit availability is limited forcing the company to pay out funds before they receive money from sales or other sources. Uncollected receivables or not a pull.. low liquidity positions...0 4..... A should be accepted and B rejected.. limited short-term lines of credit.. Volume 4.. discounted at 12%........ A .96 million (1.........  from  each  project  as  shown below.. 88‐89...19 + 4..... The present value of the cash flows for project B..0 7....96 million (1... pp. C...... Reference: CFA® Program Curriculum. pp...... 12‐14...79 + 3. LOS: Reading  44‐d  Correct Answer:  The present value of the cash flows for project A.... D.00 + 0.. but a drag...4  Project B 2.. C...... C . B.  A  company  is  offered  two  projects  with  the  net  cash  flows...... paying vendors early. therefore the project should be rejected..98) which is less than the cost............... B should be accepted and A rejected.1  0..... Volume 4... on liquidity...... The cost of project A is $2 million and the cost of project B is $10 million..304   Study Session 11:   3... is $1......... D..    . Both projects should be accepted...8  0.... B... Project A  1..0 Both projects should be rejected....... therefore the project should be rejected..

 it is least appropriate it  possesses:  A.        6.  D.67%.60. The cost of equity is closest to:  A.    .55%.  C.  independence.  5.46%.Corporate Finance   305  5.80 and dividends per share were $1.  7.  North  Company  has  a  common  stock  price  of  $72.  resources. The return on equity is 8%.  D.  political affiliation.  The  latest  reported  earnings  per  share  were  $4.33%.  7.  B.  7.  experience and expertise.  B.  To enable a board to act in the best long‐term interests of shareowners.  C.

............... LOS: Reading  48‐d  Correct Answer:  The major factors that enable a board to act in the best long-term interests of shareowners are independence. Reference: CFA® Program Curriculum........... 7.        6............67%.......... 164‐168. Volume 4. 7...33%......  To enable a board to act in the best long‐term interests of shareowners...685 +g= + 5.  North  Company  has  a  common  stock  price  of  $72...... pp. D........60 x 1........... political affiliation.... Next year’s dividends will be $1.. The cost of equity is closest to:  A.. B.60. experience and expertise. The return on equity is 8%..685 ke = D1 $1. 5.......... Political affiliation may work in the short term but may well be detrimental in the long term..... D..67% P $72 Reference: CFA® Program Curriculum... 54‐55.. C ......55%......... LOS: Reading  45‐h  Correct Answer:  The growth rate is the earnings retention rate multiplied by the ROE.... experience and expertise........... D .......... it is least appropriate it  possesses:  A.... independence.... 7...306   Study Session 11:   5.....33% = 7.0533 = $1. resources..  The  latest  reported  earnings  per  share  were  $4..... C..... and the resources to support the independent work. Volume 4...... pp.. C.33%......80 and dividends per share were $1.....    ......46%. this is 5. B..

 is:  A.  C.  C.Corporate Finance   307  7.  D.  7.  8.        8  The case that the board chair also holds the title of chief executive.3% based on  the $500.  acceptable.  Dealer’s commission would be 0.25% and backup line costs would be 0.85%  8.05%.    .000 issued. because the effectiveness of the chief executive would be enhanced by his or  her position as the chairperson of the board.15%  B.  unacceptable because combining the two positions may reduce the ability and  willingness of independent board members to exercise their independent judgment.  B.5%. because combining the two positions will save costs and hence enhance  shareholder value.50%  7.  acceptable.  The cost of borrowing is closest to:  A.  unacceptable because it is universally prohibited in all jurisdictions. from the corporate governance  point of view.  A firm is looking at borrowing for two months and could issue $500.000 nominal of commercial  paper at 7.  D.

....... C...... Volume 4...LOS: Reading  46‐g  Correct Answer:  cost = (interest + dealer’s commission + back-up costs)/net proceeds x 12 = [(0.. LOS: Reading  48‐c  Choice A is incorrect because there are some jurisdictions that allow the combining of the two positions......000 nominal of commercial  paper at 7........... because the effectiveness of the chief executive would be enhanced by his or her position as the chairperson of the board. is:  A. unacceptable because combining the two positions may reduce the ability and willingness of independent board members to exercise their independent judgment.......... because combining the two positions will save costs and hence enhance shareholder value.....5%..308   Study Session 11:   7. D.......... D.......  Dealer’s commission would be 0..075 x $500..9875 = 8.85% 8.............05%.. 7..... acceptable.003) x $500...50% 7.. 8.. pp..... C..25% and backup line costs would be 0... Volume 4..      8  The case that the board chair also holds the title of chief executive....0805/0.... Choice C is incorrect because it is not the effectiveness of the chief executive that is being questioned...    .15% $500.  A firm is looking at borrowing for two months and could issue $500...... pp. The main issue is whether the board’s independence would be compromised.. Correct Answer:  D ....15% D .075 + 0...... from the corporate governance  point of view.. Choice B is incorrect......000 – (0......... B.... B.... Reference: CFA® Program Curriculum............... 126‐127..0025 + 0.....3% based on  the $500.. acceptable.000 x 2/12) Reference: CFA® Program Curriculum.. unacceptable because it is universally prohibited in all jurisdictions.  The cost of borrowing is closest to:  A. 165‐166......000 issued..... because the saving in cost is not the main issue from the corporate governance point of view...........000 x 2/12] x 6 = 0.......

      .  D.  Debt to equity ratio.  The average accounting rate of return is attractive because it does not need a present  value calculation.  Quick ratio.  Interest coverage.        10  Which  of  the  following  statements  is  most  accurate  concerning  the  different  methods  for  evaluating projects?  A.  C.  The IRR method can give multiple answers if there are nonconventional cash flows.  B.  B.  If the profitability index is positive it indicates that a project should be accepted.Corporate Finance   309  9  Which of the following ratios would be useful in evaluating a company’s internal liquidity?  A.  C.  D.  The IRR method is preferred since it assumes reinvestment at the project’s cost of capital.  Equity turnover.

........ The average accounting rate of return is attractive because it does not need a present value calculation.. Quick ratio. Equity turnover. Interest coverage.........LOS: Reading  44‐e  When a project has nonconventional cash flows (such as more than one cash inflow over the project’s life) the IRR method can give more than one solution............ pp..... The IRR method can give multiple answers if there are nonconventional cash flows............. Volume 4... If the profitability index is positive it indicates that a project should be accepted....LOS: Reading  46‐a  Correct Answer:  Quick ratio = cash + marketable securities + receivables current liabilities The ratio measures the current assets that can be quickly liquidated to meet current liabilities.............310   Study Session 11:   9  Which of the following ratios would be useful in evaluating a company’s internal liquidity?  A........ pp.......... B................ andthe lack of adjustment for time value of money is a disadvantage of the AAR method....... 25‐28............. or multiple IRRs.... C.. Correct Answer:  A ... 89‐91. C.. Reference: CFA® Program Curriculum.. the IRR method discounts back at the IRR.. Reference: CFA® Program Curriculum............... The IRR method is preferred since it assumes reinvestment at the project’s cost of capital... A . B......    ..        10  Which  of  the  following  statements  is  most  accurate  concerning  the  different  methods  for  evaluating projects?  A...... D... Volume 4....... A profitability index of over 1 means a project should be accepted.. D................ Debt to equity ratio.........

  D.  sells the receivables to the factor who takes responsibility for collecting the receivables.0%.  This means that:   A.  The following financial information is given for a company:  Net profit margin   = 4%  Operating profit margin  = 16%  Equity turnover    Total asset turnover  = 3.  10.  In order to secure short‐term funding a company factors its accounts receivable.  receivables are being used as collateral for a loan.  51.  C.  D.        12.  B.  B.5  The return on equity is closest to:     A.8%.  it takes out protection from the factor against its customers defaulting on payment of  money owed.Corporate Finance   311  11.2  = 2.  there is insufficient information given to calculate the return on equity.    .   it pays over any receivables collected to the factor in return for short‐term funding.2%.  12.  C.

...... Volume 4.... 10....... B.......5 The return on equity is closest to: A......  This means that:   A....8% Correct Answer:  return on equity Reference: CFA® Program Curriculum... there is insufficient information given to calculate the return on equity....8%.. 136‐145... C ...  The following financial information is given for a company:  Net profit margin = 4% Operating profit margin = 16% Equity turnover = 3. D......2%.......  In order to secure short‐term funding a company factors its accounts receivable............. C..... 12..... C. receivables are being used as collateral for a loan....312   Study Session 11:   11.............04 x 3. Reference: CFA® Program Curriculum.. This is different to when receivables are used as collateral for a loan which is an assignment of the accounts receivable..... Volume 4.........LOS: Reading  47‐a  = net profit margin x sales turnover x financial leverage = net profit margin x equity turnover = 0................ sells the receivables to the factor who takes responsibility for collecting the receivables... it pays over any receivables collected to the factor in return for short-term funding.................. it takes out protection from the factor against its customers defaulting on payment of money owed..... pp...    ..... 51............2 = 12......      12...... B........ pp... 125‐126..LOS: Reading  46‐g  Correct Answer:  When a company factors its accounts receivables it sells its receivables to the factor and transfers credit granting and collection to the factor.. D.. B..2 Total asset turnover = 2..0%...

  Which one of the following is least likely to be considered good corporate governance of a listed  company?  A.  tax rate.  C.   selling expenses.  The board members’ actions and decisions represent the best interests of shareowners.  depreciation.  D.Corporate Finance   313  13.  B.        14.  All shareowners have the same right to participate in the governance of the company.  Appropriate controls and procedures are in place covering management’s activities in  running the day‐to‐day operations of the company.  employees’ salaries.    .  with founding shareowners normally given the right to veto certain resolutions.  B.  The board and its committees are structured to act independently from management and  other parties that might influence the management.  D.  In proforma analysis which of the following items is usually considered to be a fixed rather than  a sales‐driven burden?  A.  C.

............. Unless there is a change in government tax rates the tax rate is assumed to be constant..... depreciation.. The board members’ actions and decisions represent the best interests of shareowners.. The board and its committees are structured to act independently from management and other parties that might influence the management........ pp.... Appropriate controls and procedures are in place covering management’s activities in running the day-to-day operations of the company...... Volume 4.        14.. employees’ salaries......... 183‐186.......  Which one of the following is least likely to be considered good corporate governance of a listed  company?  A....... Differentiating between economic and voting rights should be avoided.  In proforma analysis which of the following items is usually considered to be a fixed rather than  a sales‐driven burden?  A......... D...... all shareowners should have equal rights to participate in the governance of the company... Correct Answer:  D ........ with founding shareowners normally given the right to veto certain resolutions..LOS: Reading  48‐g  In a listed company............. All shareowners have the same right to participate in the governance of the company. pp............. selling expenses.. Volume 43................... B..... 149‐153.. LOS: Reading  47‐b  Correct Answer:  Income items with the exception of interest costs and tax are usually assumed to grow in line with sales. A .......... Reference: CFA® Program Curriculum....... C.. Reference: CFA® Program Curriculum.. tax rate.. B. C...    .............314   Study Session 11:   13............. D........

  1.  B.5 days.  C.  Islington Corporation provides you with the following information:   Income Statement  $  million  Sales on credit  COGS    298  (200)  Balance Sheet  Average over period                $ million        Cash  Accounts  Receivable  Inventory  Property.    .5 days.  5. P & E  Depreciation      Total Assets  50  60  Accounts Payable  Accrued Expenses  80  65  Gross Profit  SGA Expenses  Op.  73.0 days. Profit  98  (60)  38  100  375  (85)      500  Long‐term Debt     Common Stock    Retained Earnings    150    140  65    Interest  expense        (6)  Tax  Net Income    (13)  19  Total Liabilities &  500  Equity  The average receivables collection period for Islington Corporation is closest to:  A.4 days.Corporate Finance   315  15.  109.  D.

...... 73....0 days..316   Study Session 11:   15. B.5 days Reference: CFA® Program Curriculum... D.966 Average receivables collection period = 365/receivables turnover = 73..... Volume 4.... 1...... 109. Correct Answer:  C  ...5 days..LOS: Reading  46‐a  Receivables turnover = credit sales/average receivables = 298/60 = 4.....4 days.. 5.............................5 days... Profit  98  (60)  38  100  375  (85)      500  Long‐term Debt         150    Common Stock    Retained Earnings      140  65    Interest  expense        (6)  Tax  Net Income  (13)  19  Total Liabilities &  500  Equity  The average receivables collection period for Islington Corporation is closest to: A..    ....... pp.............  Islington Corporation provides you with the following information:   Income Statement  $  million  Sales on credit  COGS    298  (200)  Balance Sheet  Average over period                $ million        Cash  Accounts  Receivable  Inventory  Property. 89‐91..... P & E  Depreciation      Total Assets  50  60  Accounts Payable  Accrued Expenses  80  65  Gross Profit  SGA Expenses  Op. C....

2                    Net operating cycle  48.  D.2  144.  C.  B.2   144.9  53.  A company provides the following information     Credit sales   Cost of goods sold  Accounts receivable  Beginning Inventory  Ending Inventory  Accounts payable    The operating cycle and net operating cycle are closest to:    A.0  $125 million  $80 million  $15 million  $16 million  $22 million  $13 million    .  Operating cycle  108.1  84.2  108.Corporate Finance   317  16.9  89.

...9 B.......318   Study Session 11:   16.................  A company provides the following information   Credit sales   Cost of goods sold  Accounts receivable  Beginning Inventory  Ending Inventory  Accounts payable  $125 million  $80 million  $15 million  $16 million  $22 million  $13 million  The operating cycle and net operating cycle are closest to: Operating cycle Net operating cycle A.18 days . 144........$16) million = $86 million = 144..9 D. 144.(13/86) x 365 = 144.18 days Net operating cycle or cash conversion cycle = number of days of receivables + number of days of inventory – number of days of payables To calculate number of days of payables.LOS: Reading  46‐a  Operating cycle = number of days of receivables + number of days of inventory = (15/125) x 365 + (22/80) x 365 = 43...2 48.. 108.....0 Correct Answer:  D ..... 108..2 89..2 84.... 87‐95. we need to calculate purchases = $80 million + ( $22 . Volume 4..........2 53.8 + 100.........1 C..00 days Reference: CFA® Program Curriculum...............18 – 55.    .... pp..18 = 89..38 = 144....

63.34. Profit  Interest  expense  Tax  Net Income  98  (60)  38  (6)  (13)  19  100  375  (85)      500  Long‐term Debt    Common Stock  Retained Earnings    150    140  65    Total Liabilities &  500  Equity  The quick ratio is closest to:  A.  0.  0. P & E  Depreciation      Total Assets  Balance Sheet  Average over period                $ million  50  60  Accounts Payable  Accrued Expenses  80  65  Gross Profit  SGA Expenses  Op.  B.45.  C.  D.  0.  Islington Corporation provides you with the following information:   Income Statement  $  million  Sales on credit  COGS  298  (200)  Cash  Accounts  Receivable  Inventory  Property.    .76.  1.Corporate Finance   319  17.

.. P & E  Depreciation      Total Assets  Balance Sheet  Average over period                $ million  50  60  Accounts Payable  Accrued Expenses  80  65  Gross Profit  SGA Expenses  Op. 0........ C....LOS: Reading  46‐a  Quick ratio = (cash + marketable securities + receivables)/current liabilities = (50 + 60)/145 = 0...............  Islington Corporation provides you with the following information:   Income Statement  $  million  Sales on credit  COGS  298  (200)  Cash  Accounts  Receivable  Inventory  Property...34.............. Correct Answer:  C .. 1..45.    ... B...... Volume 4..... Profit  Interest  expense  Tax  Net Income  98  (60)  38  (6)  (13)  19  100  375  (85)      500  Long‐term Debt    Common Stock  Retained Earnings    150    140  65    Total Liabilities &  500  Equity  The quick ratio is closest to: A... pp.....76..320   Study Session 11:   17.. 89‐90..... 0....... 0.....63.....76 Reference: CFA® Program Curriculum... D........

  C.  National Telecoms Corporation provides the following information:  Income Statement 2007 $ million Credit Sales  COGS  Gross Profit  SGA exp.  176 days. Profit  Interest exp.      .  Tax  Net Income  Balance Sheet end 2007 Average over period $ million 1050    (780)      270    (150)      120    (45)    (25)       50    Cash  Accounts Receivable  Inventory  Property.Corporate Finance   321  18.  153 days.   Op.  58 days.  B. P & E  Depreciation       Total Assets   90 Accounts Payable  170 Notes payable   200 Long term debt  650   (430) Common Stock  Retained Earnings    50 125 300 150 55 680 680 Total Liabilities &  Equity  Dividends Paid  12  Inventory level unchanged from 2006 levels.   130 days.  D.  National Telecoms Corporation’s net operating cycle in 2007 is closest to:   A.

.............. 58 days........ Profit  Interest exp.......  National Telecoms Corporation’s net operating cycle in 2007 is closest to:   A...   Op...... B.....  Tax  Net Income  Balance Sheet end 2007 Average over period $ million 1050    (780)      270    (150)      120    (45)    (25)       50    Cash  Accounts Receivable  Inventory  Property...... pp.  National Telecoms Corporation provides the following information:  Income Statement 2007 $ million Credit Sales  COGS  Gross Profit  SGA exp.. 130 days.. 176 days.    ...... B..... C.................... Volume 4... LOS: Reading  46‐b  Correct Answer:  number of days of receivables = 365/annual receivables turnover =365/(1050/170) = 59 days number of days of inventory = 365/inventory turnover = 365/(780/200) = 94 days = number of days of receivables + number of days of inventory = 153 days Reference: CFA® Program Curriculum. P & E  Depreciation       Total Assets   90 Accounts Payable  170 Notes payable   200 Long term debt  650   (430) Common Stock  Retained Earnings    50 125 300 150 55 680 680 Total Liabilities &  Equity  Dividends Paid  12  Inventory level unchanged from 2006 levels.........322   Study Session 11:   18.. 89‐95.... 153 days... D.

25 million.  C. Tax Net Income $ million 1050 (780) 270 (150) 120 (45) (25) 50 It  is  assumed  that  sales  and  related  costs  are  growing  at  5%per  annum  and  there  is  no  change  in  capital structure. Profit Interest exp. Op.    .50 million. then National Telecom Corporation’s proforma net income in 2008 is closest to:  A.  National Telecoms Corporation provides the following information:  Income Statement  Credit Sales COGS Gross Profit SGA exp.  $ 54.00 million.  $ 56.  $ 52.  $ 51.Corporate Finance   323  19.  B.  D.00 million.

so profoma net income will be $54 million.. 164‐167. $ 52.. B... $ 56. LOS: Reading  47‐b  Operating profit will grow at 5% to $126 million.    ..00 million. Correct Answer:  C .... $ 51.....00 million..... Op....324   Study Session 11:   19.............33% so tax will be $81 million x 33... interest expense is assumed constant at $45 million and the tax ate is 33.... pp.......... Tax Net Income $ million 1050 (780) 270 (150) 120 (45) (25) 50 It is assumed that sales and related costs are growing at 5%per annum and there is no change in capital structure.. $ 54............. C...... D....... Volume 4......  National Telecoms Corporation provides the following information:  Income Statement Credit Sales COGS Gross Profit SGA exp...50 million... Reference: CFA® Program Curriculum.25 million.. Profit Interest exp.33% = $27 million.......... then National Telecom Corporation’s proforma net income in 2008 is closest to: A.

53  1.13  1.  B.  The  cost  of  a  project  is  $150  million  and  the  following  cash  flows  are  anticipated.Corporate Finance   325  20.  C.  Accept/reject  Reject   Reject  Accept  Accept                    PI  0.  Year  0  1  2  3  4  5  Total    Net Cash Flow  ($ million)  ‐150   25   50   55   40   60    The implied decision to accept or reject the project.  D. and the Profitability Index (PI) is closest to:     A.13  0.  the  cost  of  capital is 10%.70    .

...............3 37. Volume 4..70 Correct Answer:    C ..    .......  the  cost  of  capital is 10%.....7 41..3 41... Reject 0.13 B...13 D............3 27. Reject 0......... and the Profitability Index (PI) is closest to: Accept/reject PI A.53 C....  The  cost  of  a  project  is  $150  million  and  the  following  cash  flows  are  anticipated..3   19. Accept 1....9 Reference: CFA® Program Curriculum. 19.326   Study Session 11:   20...  Year  0  1  2  3  4  5  Total  Net Cash Flow ($ million) ‐150   25   50   55   40   60    The implied decision to accept or reject the project........ p................ Accept 1. LOS: Reading  44‐d  First of all calculate the present values of the cash flows: Year  0  1  2  3  4  5  Total  Net Cash Flow  ($ million)  ‐150  25  50  55  40  60   Discounted Net Cash Flow  ($ million)  ‐150.......0 22.

  preferred by investors because it demonstrates that the company aligns itself with the  investors’ interests.  C.        22.1%  12.  preferred by the tax office because it avoids imputation of income taxes for the  executives.  The following net income is anticipated.  The cost of a project is $150 million and it will be depreciated using the straight line method over  5 years with a zero salvage value.  not preferred from a corporate governance point of view because it might encourage the  executives to give compensation to themselves from short‐term share transactions.   Year  1  2  3  4  5    Net Income  ($ million) 4  20  22  20  – 5  The average accounting rate of return (AAR) of the project is closest to  A.2%  16.  not preferred by the capital markets regulatory body because it might encourage an  opportunity for insiders’ trading.Corporate Finance   327  21.  B.  D. This practice is:  A.  4.3%    .  board  members and other insiders prior to a public offering of its securities.  D.1%  8.  A  company  prohibits  itself  from  offering  shares  at  discounted  prices  to  management.  C.  B.

3% Reference: CFA® Program Curriculum.................. 4. LOS: Reading  44‐d  Average book value is ($150 million + $0million)/2 = $75 million Average net income is $(4 + 20 + 22 + 20 – 5)million/5 = $12.. Volume 4. p..2 million AAR = Average net income = $12............1% C.2% D..2 million Average book value $75 million = 16....328   Study Session 11:   21  The cost of a project is $150 million and it will be depreciated using the straight line method over  5 years with a zero salvage value.... 16. 12....    .3% Correct Answer:  D .................1% B....   Year  1  2  3  4  5  Net Income  ($ million)  4  20  22  20  – 5  The average accounting rate of return (AAR) of the project is closest to A... 18......  The following net income is anticipated....... 8.................

.. C................... 173‐175. This practice is:  A..... not preferred from a corporate governance point of view because it might encourage the executives to give compensation to themselves from short-term share transactions...... Reference: CFA® Program Curriculum..... LOS: Reading  48‐g  This is a preferred practice from a corporate governance point of view. preferred by investors because it demonstrates that the company aligns itself with the investors’ interests.      ........................... Volume 4.. D. B............. pp....  A  company  prohibits  itself  from  offering  shares  at  discounted  prices  to  management.. which indicates it is beneficial for the long-term interests of the investors. Correct Answer:  B ..Corporate Finance   329  22....  board  members and other insiders prior to a public offering of its securities... preferred by the tax office because it avoids imputation of income taxes for the executives.. not preferred by the capital markets regulatory body because it might encourage an opportunity for insiders’ trading.......

  The first reading discusses the asset allocation decision and the portfolio management process—they  are  an  integrated  set  of  steps  undertaken  in  a  consistent  manner  to  create  and  maintain  an  appropriate portfolio (combination of assets) to meet clients’ stated goals.  fixed income. Furthermore.    Reading 49: The Asset Allocation Decision  Reading 50: An Introduction to Portfolio Management  Reading 51: An Introduction to Asset Pricing Models        . The last two readings focus  on the design of a portfolio and introduces the capital asset pricing model (CAPM). derivatives. and alternative investments.  this  study  session  provides the critical framework and context for subsequent Level I study sessions covering equities. a centerpiece of  modern financial economics that relates the risk of an asset to its expected return.330   Study Session 12:   Study Session 12: Portfolio Management:   As  the  first  discussion  within  the  CFA  curriculum  on  portfolio  management. this study session provides the  underlying theories and tools for portfolio management at Levels II and III.

        2.  very similar.  The  asset  allocation  of  investors  between  equities  and  fixed  income  in  the  major  international  capital markets is:  A.  C.  is 1 if the asset is the market portfolio. since investors are using the same optimization models.  quite different.  B.   D.Portfolio Management   331  1.  very similar.  is the covariance of the asset with the market. since investors are making decisions in different economic and social  environments. since long term equity and fixed income returns have been consistent across  different markets.    lies between ‐1 and 1.  The beta of an asset:  A.  very similar.  is a measure of unsystematic risk.  D.  C.    .  B. since asset allocation is the most important step in portfolio construction in  all major markets.

 pp......... Volume 4.. is 1 if the asset is the market portfolio.... Correct Answer:  B. since investors are making decisions in different economic and social environments........ D.... pp............ since long term equity and fixed income returns have been consistent across different markets. have led to different weightings in equities and fixed income in portfolios in different countries........... lies between -1 and 1..    . it is a measure of systematic risk......... 223‐224.. D. quite different... Reference: CFA® Program Curriculum... Volume 4. very similar................ D.. C..............  The  asset  allocation  of  investors  between  equities  and  fixed  income  in  the  major  international  capital markets is:  A...... B.. is not correct because beta is the covariance divided by the variance of the market.LOS: Reading  49‐e  The different social and economic environments..... LOS: Reading  51‐d  Correct Answer:  A........332   Study Session 12:   1...        2... since investors are using the same optimization models.. B.... Reference: CFA® Program Curriculum......... B....... C ... is a measure of unsystematic risk............... C.... 264‐269....... very similar..... since asset allocation is the most important step in portfolio construction in all major markets..... is not correct since beta does not lie in any fixed range... in addition to political and tax issues. is the covariance of the asset with the market.  The beta of an asset:  A.......... is not correct.......... very similar. By definition the beta of the market itself is one.

  overvalued.  the  expected  market  return  over  the  next  year  is  15%  and  the  risk‐free  rate  is  5%.  correctly valued.  the question needs to provide data on the market risk premium to be able to decide  whether the stock is fairly valued.  C.’s stock is:  A.  Submitting regulatory reports to the appropriate authority.  B.  Forecasting market returns.  Mayfair Corp.  C.  You  note  that  the  beta  of  the  stock  is  0.  B.  Monitoring the portfolio.    .  D.  The  stock  analyst  in  your  firm  recommends  that  you  buy  shares  in  Mayfair  Corp.  The  current  share price is $26 and she forecasts that a year from now the share price will have risen to $30. There  is  no  dividend  payment  expected.  On  the  basis  of  the  analyst’s  forecast.  undervalued.   D.  Which of the following is least likely to be a step in the investment process?  A.  Asset allocation.8.        4.Portfolio Management   333  3.

.. B........’s stock is:  A.....8.. Volume 4......  The  stock  analyst  in  your  firm  recommends  that  you  buy  shares  in  Mayfair  Corp... Asset allocation........................ Forecasting market returns.. forecast future economic and market trends......8(15% − 5% ) = 13% The analyst is forecasting a return of 15.... C.. Correct Answer:  B. pp. Monitoring the portfolio.... D.. the question needs to provide data on the market risk premium to be able to decide whether the stock is fairly valued.. B....LOS: Reading  49‐a  Correct Answer:  The portfolio management process consists of 4 steps: construct the policy statement........... Submitting regulatory reports is not part of the investment decision-making process so D is the best answer............ 263‐266....... construct the portfolio and continually monitor and evaluate performance.......    ........  The  current  share price is $26 and she forecasts that a year from now the share price will have risen to $30........ overvalued...... correctly valued.....        4...... D .. Volume 4....  Which of the following is least likely to be a step in the investment process?  A... Reference: CFA® Program Curriculum. undervalued.... Reference: CFA® Program Curriculum...... 202‐203.  On  the  basis  of  the  analyst’s  forecast.......  Mayfair Corp........  You  note  that  the  beta  of  the  stock  is  0.4% so the stock looks undervalued. Submitting regulatory reports to the appropriate authority.... pp.. C...............334   Study Session 12:   3.LOS: Reading  51‐e  Using CAPM the estimated return is: R x = R f + β[E(R m ) − R f ] = 5% + 0........ There  is  no  dividend  payment  expected. D...  the  expected  market  return  over  the  next  year  is  15%  and  the  risk‐free  rate  is  5%...

  B.  has a higher expected return than the market.Portfolio Management   335  5.  is overvalued.  the standard deviation of a portfolio.  D.  the beta of a stock.        6.  B.  the risk‐free rate.  If a stock lies above the security market line (SML) this would indicate that the stock:  A.  D.    .  the risk aversion of an investor.  The characteristic line is used to estimate:  A.  C.  C.  has a lower expected return than the market.  is undervalued.

... LOS: Reading  51‐d  Correct Answer:  The characteristic line is the regression line of best fit through a scatter diagram of points representing a stock’s return against the market return.... has a lower expected return than the market..................LOS: Reading  51‐e  Correct Answer:  The stock is undervalued because the expected rate of return is higher than the required rate of return to compensate for its beta risk........    . C........ the risk-free rate...... Reference: CFA® Program Curriculum................ If a stock lies above the security market line (SML) this would indicate that the stock:  is overvalued........ B.....  The characteristic line is used to estimate:  A..... 267‐269... 263‐267..... is undervalued. has a higher expected return than the market... the beta of a stock. C......... Reference: CFA® Program Curriculum..    A.....        6........ pp..... D...................... pp..... the risk aversion of an investor.......... the slope gives the stock beta... Volume 4. Volume 4....... B. B. the standard deviation of a portfolio. D..........336   Study Session 12:   5. B.........................

  the point where the tangent from the risk‐free rate touches the efficient frontier.  D.0027.  0.  In capital market theory the Market Portfolio can be least accurately described as:  A.  C.        8. The index fund has a  variance of returns of 0.  0.0027.  A portfolio is 70% invested in an index fund and 30% in a risk‐free asset.  C.  B.  the portfolio which contains all risky assets in proportion to their market value.    .Portfolio Management   337  7.0019.  0.  D.  the portfolio where systematic risk has been completely diversified away.0039.  B.  it is the point where the Capital Market Line touches the efficient frontier. the variance for the total portfolio is closest to:  A.  0.0013.

Reference: CFA® Program Curriculum... Therefore the variance of the portfolio is: 2 2 σ 2 = w 1 σ1 + w 2 σ 2 + 2r12 w 1 w 2 σ1σ 2 port 2 2 = (0..... A ................. Volume 4.  In capital market theory the Market Portfolio can be least accurately described as:  A. B.. C.........338   Study Session 12:   7.. the point where the tangent from the risk-free rate touches the efficient frontier. the portfolio which contains all risky assets in proportion to their market value.........  A portfolio is 70% invested in an index fund and 30% in a risk‐free asset.. it is the point where the Capital Market Line touches the efficient frontier........0039. 0... B..LOS: Reading  51‐a  Correct Answer:  The variance and standard deviation of the risk-free asset are zero...... 259.        8..... 0....0013 2 Reference: CFA® Program Curriculum...... D.0019... the variance for the total portfolio is closest to:  A.... C.. 256‐258............................. D.0013.............0027. The index fund has a  variance of returns of 0...... A ............. the portfolio where systematic risk has been completely diversified away.... 0. 0..........0027.0027 = 0. Volume 4.. LOS: Reading  51‐b  Correct Answer:  A is not correct – it is the unsystematic risk that can be diversified away....    ......... pp............ p..........7 ) 0...

 Which of the following would be an appropriate course of action?  A.  Sell the international holdings and only hold U.  the investor is aggressive. stocks.  the investor has a long time horizon.S.  the investor has a short time horizon. based investment manager is concerned that the volatility of an international equity fund  he is managing is too high.  A U.  Increase the weighting in high beta stocks.S.  the investor is conservative.    .  If an investor has steep utility curves it is likely to indicates that:  A.  D.        10.  B.  C.  Consider investing in markets which have a low correlation with the existing assets in  the portfolio.  D.  Sell small capitalization stocks and concentrate the portfolio in a small number of big  market capitalization stocks.Portfolio Management   339  9.  C.  B.

....................        10....... the investor is conservative........ the investor is aggressive. stocks. B..... B............... Increase the weighting in high beta stocks.. Consider investing in markets which have a low correlation with the existing assets in the portfolio..S.....  A U............ Volume 4.... Reference: CFA® Program Curriculum.. Correct Answer:  C .. Which of the following would be an appropriate course of action?  A....S.. which is the standard deviation of returns...... B..... the investor has a short time horizon...... D...... the manager could include assets which have a low correlation with the existing assets in the portfolio........ C..... D. pp..... Volume 4... LOS: Reading  50‐f  In order to reduce volatility.  If an investor has steep utility curves it is likely to indicates that:  A.... the investor has a long time horizon... Sell the international holdings and only hold U...................... Sell small capitalization stocks and concentrate the portfolio in a small number of big market capitalization stocks.......... pp.......... based investment manager is concerned that the volatility of an international equity fund  he is managing is too high.....340   Study Session 12:   9..... 248‐249. Reference: CFA® Program Curriculum. C...........    ...LOS: Reading  50‐g  Correct Answer:  A steep utility curve shows that the investor needs to be compensated for taking a small amount of additional risk by receiving a significantly higher return. indicating he is conservative with a low appetite for risk... 256‐259.

        12.Portfolio Management   341  11.  71.0.  D.  Investors can borrow or lend at the risk‐free rate.  140.  Investors are not able to correctly anticipate inflation.   All investors have the same time horizon.  B.  C.    .  D.  50.  The correlation coefficient between the returns of two assets is 0.  Which of the following is a least accurate description of an assumption of Capital Market Theory?  A.4. The covariance of returns is closest to:  A.  Capital markets are in equilibrium.4.  C.  14.0.  B.6 and the standard deviations of  returns of the two assets are 7% and 12%.

C.. 236‐237.........0...... C................  Which of the following is a least accurate description of an assumption of Capital Market Theory?  A......342   Study Session 12:   11....4.. 14....  The correlation coefficient between the returns of two assets is 0..      12............ Investors are not able to correctly anticipate inflation........... pp.. or any inflation is fully anticipated........ 140.... Capital markets are in equilibrium.... D.......... B. Investors can borrow or lend at the risk-free rate....... 71..4 where: rxy = correlation between the returns of x and y standard deviation of returns of x standard deviation of returns of y σx = σy = Reference: CFA® Program Curriculum..6 × 7 × 12 = 50. D...    .......... 50.... Volume 4........... All investors have the same time horizon........0....... B.....................6 and the standard deviations of  returns of the two assets are 7% and 12%......... LOS: Reading  50‐d  Correct Answer:  rxy = cov ariance xy σxσy cov ariance = 0......... B.4... D ..LOS: Reading  51‐a  Correct Answer:  Capital Market Theory makes the assumption that there is no inflation or change in interest rates..... 254‐255. Reference: CFA® Program Curriculum.. pp. The covariance of returns is closest to:  A.. Volume 4...

    .6%.Portfolio Management   343  13.  1.  Probability   Return 0.  3.  1.20  0.2%.  C.  B.  C.   The efficient frontier represents portfolios that:  A.20  12%  15%  18%  The standard deviation of the returns is closest to:  A.  are equally attractive to an investor with a specified level of total risk tolerance.  D.9%.  are equally attractive to an investor with a specified level of systematic risk tolerance.  D.  offer the highest return for a given level of systematic risk.60  0.  The following data is provided on the expected return of an asset under different scenarios:  offer the highest return for a given level of total risk.3%.  B.  2.      14.

.......20  0.      14.. 1...18 − 0........20 x 12%) + (0.. LOS: Reading  50‐c  The expected return is (0.... pp.................. Correct Answer:  B......... are equally attractive to an investor with a specified level of total risk tolerance............. 2.....344   Study Session 12:   13.. D.. Volume 4. Volume 4..12 − 0... 3.    .   The efficient frontier represents portfolios that:  A... pp........... A ...... where σ 2 = 0..00036 σ = 0...9%..... B....01897 or 1. D.60 x 15%) + (0... are equally attractive to an investor with a specified level of systematic risk tolerance.. Reference: CFA® Program Curriculum.15) = 0..6%..2(0.. offer the highest return for a given level of total risk...15) + 0....... 1........... C.......................... 247‐249.  The following data is provided on the expected return of an asset under different scenarios:  Probability   Return  0.3%........... B...2%....9% 2 2 Reference: CFA® Program Curriculum.20 x 18%) = 15%.. offer the highest return for a given level of systematic risk....2(0..20  12%  15%  18%  The standard deviation of the returns is closest to: A. C.......... 230‐231...... LOS: Reading  50‐f  Correct Answer:  The efficient frontier represents the portfolios which offer the highest return for any given level of risk so A is correct.. The standard deviation is given by .60  0..

  D.  14.  covariance of the stock with the market and the variance of the market returns.  8.0%.5.5%.    .  11.0%.Portfolio Management   345  15.        16.  The beta of a stock can be computed from the:   A.  B.  6. The required rate of return from the stock is:  A.  C.5%.  B.  C.  correlation of the stock with the market and the variance of the stock returns.  correlation of the stock with the market and the market return.  D.  relative volatility of the stock returns to the market returns.  The expected return from a market is 12% and the risk‐free rate is 5% and a stock has a beta of  0.

. D.. pp..5(12% − 5% ) = 8.......... LOS: Reading  51‐d  Correct Answer:  The beta of an asset is the covariance of the assets returns with market returns divided by the variance of the market returns. 11............. LOS: Reading  51‐d  Correct Answer:  Using CAPM we can calculate the required return from the stock: R x = R f + β[E(R m ) − R f ] = 5% + 0........346   Study Session 12:   15..... pp...... Volume 4. The required rate of return from the stock is:  A........  The expected return from a market is 12% and the risk‐free rate is 5% and a stock has a beta of  0. correlation of the stock with the market and the market return..... D . covariance of the stock with the market and the variance of the market returns... correlation of the stock with the market and the variance of the stock returns.... D.. C...... B... 8.......... 267 ‐221.. B...... 6.. 14.......    ..5...... where: Rf = RM = i = the risk-free rate market return beta of stock Reference: CFA® Program Curriculum..5%........ Reference: CFA® Program Curriculum...  The beta of a stock can be computed from the:   A.. B.................. Volume 4..5%........0%....        16......................... relative volatility of the stock returns to the market returns........ 263‐267.0%. C...5% ..............

  relative  to  the  market  performance.  indicates the required rate of return of a stock given its standard deviation.  D.  The characteristic line:  A.  indicates the required rate of return of a stock given its systematic risk.  C.  is a regression line used to estimate a stock’s standard deviation.  a  stock  with  a  beta  of  0.  C.Portfolio Management   347  17.5  is  expected.  D.  B.  In  a  rapidly  rising  market.  is a regression line used to estimate a stock’s systematic risk.  Performance  outperform   outperform   underperform   underperform                       Direction   Same  Opposite  Same  Opposite    .        18. to:    A.  B.

is a regression line used to estimate a stock’s standard deviation............ Reference: CFA® Program Curriculum...... D. is a regression line used to estimate a stock’s systematic risk....... indicates the required rate of return of a stock given its systematic risk............. to:  A.. The slope of the line is the beta which measures systematic risk.........  The characteristic line:  A.... The positive beta means it will move in the same direction as the market..... LOS: Reading  51‐d  Correct Answer:  A low beta means the stock will move by less than the market if the market moves upwards by more than the risk-free rate. B......  In  a  rapidly  rising  market... indicates the required rate of return of a stock given its standard deviation.... 263‐266...... B... C..... D........ 267‐271. C.  relative  to  the  market  performance.. pp....... Volume 4. pp......... Performance outperform outperform underperform underperform Direction Same Opposite Same Opposite C .............................5  is  expected.... Reference: CFA® Program Curriculum........  a  stock  with  a  beta  of  0.................. LOS: Reading  51‐d  Correct Answer:  Systematic risk is often calculated by using regression analysis to examine the return of an asset against the return of the market.... Volume 4...348   Study Session 12:   17.....        18.    ......... A ............

  D.  provides the investor with the portfolio manager’s market outlook.  security market line is tangent to the efficient frontier.  provides details on the stocks that will be purchased for the portfolio.  investor utility curve is tangent to the security market line.  B.  B.  investor utility curve is tangent to the efficient frontier.  clarifies the investors’ objectives.        20.  C.  D.  The optimal portfolio for an investor is represented by the point where the:  A.    .  means that the investor takes responsibility for investment performance.  An investor policy statement is important because it:  A.Portfolio Management   349  19.  C.  investor utility curves intersect each other.

......... investor utility curve is tangent to the efficient frontier.. C. D. B.... 238‐249.... Volume 4..... A ......  The optimal portfolio for an investor is represented by the point where the:  A................    ... pp.. It also helps set the benchmark against which performance can be measured............ means that the investor takes responsibility for investment performance.350   Study Session 12:   19. Reference: CFA® Program Curriculum. It is a valuable way of communicating with the portfolio manager.. C .        20..... security market line is tangent to the efficient frontier........ clarifies the investors’ objectives.. investor utility curves intersect each other........ investor utility curve is tangent to the security market line.... 203‐206............ LOS: Reading  49‐b  Correct Answer:  A policy statement helps the investor specify realistic goals and in setting the goals become more aware of the risks of investing........................ D. Reference: CFA® Program Curriculum. provides the investor with the portfolio manager’s market outlook.LOS: Reading  50‐g  Correct Answer:  The utility curves represent the trade-off between risk and return....... C..........  An investor policy statement is important because it:  A....... provides details on the stocks that will be purchased for the portfolio........................... B.. pp........... The optimal portfolio will be where the highest utility curve touches the efficient frontier...... Volume 4....

  9.  C.    The  standard  deviation  of  the  combined  portfolio is closest to:    A.  D.  D.Portfolio Management   351  21.  and  70%  in  the  second  asset  that  has  a  variance  of  8.  2.  B.2.98%.  6.64%.  C.  B.        22. the assets have standard deviations of 4% and  8%.  Two assets have zero correlation.  and  the  correlation  between  the  two  assets  is  0.  6.7.    5.  the  variance  of  the  combined  portfolio is closest to:     A.  4.  24.3.  A portfolio is invested equally between two assets.    .  6.80%.00%.0.  If a portfolio is invested with 30% in the first asset that has a  variance  of  12.2.

....... 6...5)(0....  and  the  correlation  between  the  two  assets  is  0. the assets have standard deviations of 4% and  8%..5) (0.....352   Study Session 12:   21.98%.5) (0..08) 2 2 2 2 = 0. B..0004 + 0... Volume 4.....64%....08) + 2(0.......00%..  σj   . 4...0016 + 0.0498 where: σi = standard deviation of returns of asset i rij = standard deviation of returns of asset j wi = weighting of asset i in the portfolio = correlation between the returns of assets i and j Reference: CFA® Program Curriculum...3)(0.......80%.... C.......    The  standard  deviation  of  the  combined  portfolio is closest to:  A..... 6. A .04 ) + (0........04 )(0. pp.....00248 σ = 0..... LOS: Reading  50‐c  Correct Answer:  2 2 σ 2 = w 1 σ1 + w 2 σ 2 + 2r12 w 1 w 2 σ1σ 2 port 2 2 = (0....5)(0. D..00048 = 0... 24..... 238‐241....  A portfolio is invested equally between two assets.3....

. C....0............... B ..  the  variance  of  the  combined  portfolio is closest to:   A.7 ) 8 2 2 = 1..3) 12 + (0......... 238‐241..  If a portfolio is invested with 30% in the first asset that has a  variance  of  12......  and  70%  in  the  second  asset  that  has  a  variance  of  8. B. 9.......      ..2..... Volume 4.08 + 3.. 2....  Two assets have zero correlation.Portfolio Management   353  22...... pp........... D. 5. LOS: Reading  50‐c  Correct Answer:  Variance is given by: 2 2 σ 2 = w 1 σ1 + w 2 σ 2 + 2r12 w 1 w 2 σ1σ 2 port 2 2 = (0................92 =5 where: σi wi rij = = = standard deviation of returns of asset i weighting of asset i in the portfolio correlation between the returns of assets i and j Reference: CFA® Program Curriculum........7.2.. 6...

354   Study Session 13:   Study Session 13: Equity Investments: Securities Markets   This  study  session  addresses  how  securities  are  bought  and  sold  and  what  constitutes  a  well‐ functioning securities market. The reading on market indexes gives an understanding of how indexes  are constructed and calculated and the biases inherent in each of the weighting schemes used.  Some  of  the  most  interesting  and  important  work  in  the  investment  field  during  the  past  several  decades revolves around the efficient market hypothesis (EMH) and its implications for active versus  passive equity portfolio management. The readings on this subject provide an understanding of the  EMH  and  the  seemingly  persistent  anomalies  to  the  theory.  an  understanding  that  is  necessary  to  judge the value of fundamental or technical security analysis.     Reading 52: Organization and Functioning of Securities Markets  Reading 53: Security‐Market Indexes  Reading 54: Efficient Capital Markets  Reading 55: Market Efficiency and Anomalies    .

  B.      .  B.  the divisor increasing.  C.Equity Investments: Securities Markets   355  1.  C.        2.  it will provide greater liquidity in the secondary market.  it will reduce issuing costs.  the divisor decreasing.  it will avoid using an investment bank.  A corporation looking to raise funds may decide to do a private placement because:  A.  the issue can be sold at a higher price than if it was sold in a public offering.  there being no change in the divisor.  When a stock in the Dow Jones Industrial Average has a stock split this will lead to:  A.  D.  the divisor increasing if the stock is a high‐priced stock and falling if it is a low‐priced  stock.  D.

        2...... However the pricing will be lower than for a public offer since the purchasers will need to be compensated for the lack of liquidity in the secondary market............. the divisor increasing...... the divisor decreasing..... 9.. there is no immediate impact on the index so the divisor must also decrease.................. B. mainly since the requirement for lengthy registration documentation is reduced. Reference: CFA® Program Curriculum........... it will provide greater liquidity in the secondary market............................ B.. it will avoid using an investment bank.......... C. pp............. Volume 5.. Reference: CFA® Program Curriculum.. D....... Volume 5...  When a stock in the Dow Jones Industrial Average has a stock split this will lead to:  A... it will reduce issuing costs... the divisor increasing if the stock is a high-priced stock and falling if it is a low-priced stock....... C. A ... there being no change in the divisor...  A corporation looking to raise funds may decide to do a private placement because:  A....    . 42‐42.. the issue can be sold at a higher price than if it was sold in a public offering... B........... p..... LOS: Reading  52‐b  Correct Answer:  A private placement will have lower issue costs.356   Study Session 13:   1.................LOS: Reading  53‐a  Correct Answer:  When there is a stock split the stock price will fall................ D.

 the increase in the index over 2007 is closest  to:  A.  B.  D.  There are two stocks ABC and XYZ included in an unweighted index and the following data is  provided:    sell the stock when the price is falling.  deposit collateral when he borrows stock.00  $36.  C.  12.00  Price at end  $30.  B.25%.  11.  C.50%.000  50.        4.  A short seller of a stock will generally:  A.  Stock  ABC  XYZ    Number of shares  10.    .  D.000  Price at end  $25.Equity Investments: Securities Markets   357  3.  benefit from a rise in price of the stock.  8.33%.  benefit from the price fall when a stock goes ex‐dividend.00  $35.  12.75  If the index is computed using geometric averages.25%.

. Usually the lender of stock will require collateral as protection against the borrower failing to return the stock. 11....LOS: Reading  53‐a  An unweighted index is computed on the basis that an equal dollar amount is invested in each of stocks ABC and XYZ.. B........25%.. pp.....1225 = 12.... Volume 5....... D is not correct since he must pay the dividends to the lender of the stock. 12.. C ....000  Price at end  $25.358   Study Session 13:   3... 25‐26. the increase in the index over 2007 is closest to: A....00  Price at end  $30......20 x 1...... Volume 5.. C........ C....25%......... ABC rose by 20% and XYZ by 5% so the index performance is given by (1.... benefit from the price fall when a stock goes ex-dividend.. sell the stock when the price is falling...33%......  A short seller of a stock will generally:  A.............. 12....50%..... deposit collateral when he borrows stock.... 44‐46............ B. pp. Reference: CFA® Program Curriculum.. B is not correct since he will benefit when the price falls and he can buy back the stock at a cheaper price........... LOS: Reading  52‐f  Correct Answer:  A is not correct since he must sell on an uptick trade..... D... D.. benefit from a rise in price of the stock.. 8....................        4.05)1/2 – 1 = 0................. Reference: CFA® Program Curriculum..000  50......    .  There are two stocks ABC and XYZ included in an unweighted index and the following data is  provided:  Stock  ABC  XYZ  Number of shares  10..75  If the index is computed using geometric averages. Correct Answer:  C .....25%.....00  $36.00  $35.

39% (ii) 15.  investors allocate their funds to the companies that can make the best use of them.Equity Investments: Securities Markets   359  5.00%.  security prices adjust rapidly to the arrival of new information and therefore security  prices reflect all information about the security.  (i) 11.11% (ii) 15.  C. If the investor had (i) placed a market order  to buy the shares on the first day and then sold them on the last day (ii) a limit order to buy at $100  and sell at the end of the month.  D. his profit before transaction costs would be closest to:  A.’s shares  and is quoted $103 bid – 103½ ask. The share price then moves to $98 –  98½ before rising to $115 –115¾ at the end of the month.  An investor calls a broker on the first day of the month to find out the price of ABC Inc.11% (ii) 15.  (i) 12.  B.  (i) 12.    .  D.  An informationally efficient market is one where:  A.00%.  B. The shares are very liquid.39% (ii) 15.  C.        6.  security prices adjust slowly to the arrival of new information giving investors time to  take advantage of positive news.  (i) 11.75%.75%.  information is available on a timely basis to all investors.

...... (i) 11.        6........ $103 ½ and he will sell at the bid price of $115 making a profit of 11.. pp.. i. 25‐26...............11% (ii) 15. The shares are very liquid......00%.75%.11%....... security prices adjust rapidly to the arrival of new information and therefore security prices reflect all information about the security..............  An informationally efficient market is one where:  A.... Volume 5.......e.. Reference: CFA® Program Curriculum.............75%... If the investor had (i) placed a market order  to buy the shares on the first day and then sold them on the last day (ii) a limit order to buy at $100  and sell at the end of the month... Volume 5......11% (ii) 15... (ii) A limit order to buy at $100 will be executed and he will sell at $115 giving a profit of 15%. Correct Answer:  D ............. A ... The share price then moves to $98 –  98½ before rising to $115 –115¾ at the end of the month....... (i) 11. Reference: CFA® Program Curriculum.... D....39% (ii) 15.. pp.... 62‐63.00%.360   Study Session 13:   5....... B.. D.’s shares  and is quoted $103 bid – 103½ ask.. B... information is available on a timely basis to all investors.....    ...... C........ his profit before transaction costs would be closest to:  A.....  An investor calls a broker on the first day of the month to find out the price of ABC Inc.. (i) 12.LOS: Reading  52‐e  Correct Answer:  (i) If it is a market order he will pay the ask price to buy the shares.... security prices adjust slowly to the arrival of new information giving investors time to take advantage of positive news.......... investors allocate their funds to the companies that can make the best use of them. C.39% (ii) 15....... (i) 12..........LOS: Reading  54‐a  An informationally efficient market is one where security prices adjust very rapidly to the arrival of new information.....

  Buying on margin means that:  A.  C.  A call market refers to:  A.    .        8.  if an investor has bought shares on margin he will be required to keep a maintenance  margin with the broker.  a market where it is attempted to match all the bids and asks at a specified time.  B.  if an investor has bought shares on margin and the share price rises he will have made a  more attractive return on his investment than if he had fully paid for the shares. the investor may borrow 60% of the cost of buying  shares.Equity Investments: Securities Markets   361  7.  a market where all the trading is done by computer rather than on a trading floor. allowing him to leverage his transaction.  a market which specializes in providing derivatives trading.  D.  the returns from buying on margin will only be higher than paying in full for shares  when the share price moves significantly up or down.  if the margin requirement is 60%.  a market where trades are done by open outcry.  C.  B.  D. if the share price falls he will immediately receive a margin call.

.... if the share price falls he will immediately receive a margin call...LOS: Reading  52‐g  A is not true since if the margin requirement is 60% the investor can only borrow 40%......................    .... LOS: Reading  52‐c  Correct Answer:  In a call market all the bids and asks for a stock are collected and a stock price that will best match buyers and sellers is decided... Reference: CFA® Program Curriculum. B is not true since if the share moves down the losses will be higher if the investor has bought on margin.... 26‐29........... a market which specializes in providing derivatives trading............ a market where all the trading is done by computer rather than on a trading floor....... B.... Volume 5..... if an investor has bought shares on margin and the share price rises he will have made a more attractive return on his investment than if he had fully paid for the shares.. Reference: CFA® Program Curriculum.... C....... the returns from buying on margin will only be higher than paying in full for shares when the share price moves significantly up or down.. the investor may borrow 60% of the cost of buying shares..............        8.. pp... D is not true since if the maintenance margin is lower than the initial margin the investor will only receive a margin call after the shares have fallen to a level where the proportion of equity to the total value of stock is below the maintenance margin.... 15. if the margin requirement is 60%... a market where it is attempted to match all the bids and asks at a specified time... Volume 5....... a market where trades are done by open outcry............ if an investor has bought shares on margin he will be required to keep a maintenance margin with the broker.........362   Study Session 13:   7..  A call market refers to:  A...... C..... C is true due to the leverage effect.............. p.... D. allowing him to leverage his transaction. D.........  Buying on margin means that:  A... Correct Answer:  C ...... C ........ B...

  B.  D.  Which of the following is least likely to be a member of a U.        10.  17 ⅝ ‐ 18.  B.  C.  17 ⅝ ‐ 18 ¼. stock.Equity Investments: Securities Markets   363  9.  The quotations for the price of Brown and Co.S.  A registered trader.  C.  17 ¼ ‐ 17 ¾.    Dealer 1  Dealer 2  Dealer 3    Bid 17 ¾ 17 ½ 17 ⅝ Ask 18 ¼ 18 18 If Dealer 3 has excess inventory of Brown and Co.    . securities exchange?  A.  An underwriter.  17 ¼ ‐ 18 ¼.  A floor broker. changing his quote to which of the  following would be the most effective in reducing his inventory?   A.  D. are given by 3 dealers as shown below:    A specialist.

. securities exchange?  A.... Reference: CFA® Program Curriculum....... D.17 ¾.... 17 ....... changing his quote to which of the following would be the most effective in reducing his inventory? A. 2... An underwriter.. B.. 17 .............. A floor broker.....      10. 3....    ... and moving the bid price lower will mean he is unlikely to have to buy stock.. C........ Registered trader. A specialist................ pp. 17 ¼ . are given by 3 dealers as shown below:    Dealer 1  Dealer 2  Dealer 3  Bid  17 ¾  17 ½  17 ⅝  Ask 18 ¼ 18 18 If Dealer 3 has excess inventory of Brown and Co.. Reference: CFA® Program Curriculum... pp. Specialist........  Which of the following is least likely to be a member of a U....... 20‐23..18. Floor broker..... B... 17 ¼ .............. A registered trader......... Correct Answer:  D .... Commission broker.... C.... D... 24‐25...LOS: Reading  52‐e  Correct Answer:  The four major categories of membership are: 1.................. 4.... stock...  The quotations for the price of Brown and Co.... until the other dealers move their prices...364   Study Session 13:   9.....S.18 ¼.... Volume 5.LOS: Reading  52‐e  Moving the ask price lower than the other dealers will mean the dealer is able to sell stock...........18 ¼..... Volume 5.... C ...

  D.  short selling is not permitted.  overconfidence.  B.  When  investors  prefer  to  read  research  that  agrees  with  their  own  views.  rather  than  read  a  contrary opinion.        12.  individual stocks are traded at specified times.  C.  D.  escalation bias. this is referred to in behavioral finance as:  A.  stock prices are determined by auction.  dealers are making markets in stocks.  B.  A call market is one in which:  A.  prospect theory.  C.  confirmation bias.    .Equity Investments: Securities Markets   365  11.

.... Reference: CFA® Program Curriculum.... confirmation bias... Reference: CFA® Program Curriculum.. 14‐15. this is called confirmation bias. Volume 5......... Short selling may or may not be permitted in a call market............. LOS: Reading  52‐c  Correct Answer:  B and C are types of continuous market....... C...... individual stocks are traded at specified times....... short selling is not permitted.. D........ C........... overconfidence...... pp.  A call market is one in which:  A..... D ......... 83‐84.. prospect theory.......... In a call market the exchange usually sets the price and all trades are executed at a specified time at this price.  rather  than  read  a  contrary opinion....... pp.... B......... Volume 5. this is referred to in behavioral finance as:  A.. D ..    ...............366   Study Session 13:   11. stock prices are determined by auction.. LOS: Reading  54‐d  Correct Answer:  Research shows that investors seek out information that confirms their own views................ D..  When  investors  prefer  to  read  research  that  agrees  with  their  own  views..... escalation bias....... B............. dealers are making markets in stocks..        12.............

  only hold cash.  a short‐term random movement in a stock prices giving an opportunity to make a profit.  D.  C.  a predictable deviation between expected and actual returns for a stock.  If a market is perfectly efficient and a portfolio manager does not have superior analysts then the  portfolio manager should:  A.  A pricing anomaly is best described as:   A.  select a portfolio of securities at random.    .  a price move that reflects a factor that is specific to the individual stock.Equity Investments: Securities Markets   367  13.  D.  increase the systematic risk of the portfolio.  diversify away unsystematic risk and adjust the systematic risk of each portfolio to meet  clients’ objectives.  C.   out or underperformance of a stock against the market average performance.        14.  B.  B.

......................... Volume 5.... Volume 5. p... transaction costs and avoid holding illiquid stocks........ a short-term random movement in a stock prices giving an opportunity to make a profit..... only hold cash..... a predictable deviation between expected and actual returns for a stock.. B........... Reference: CFA® Program Curriculum..... C........ out or underperformance of a stock against the market average performance.. LOS: Reading  54‐c  Portfolio managers who do not have superior analysts should do the following: (i) Quantify their clients’ risk tolerance............ pp.....368   Study Session 13:   13... move..... 100.... (iv) Minimize costs including taxes........ Reference: CFA® Program Curriculum.........    ......... a price move that reflects a factor that is specific to the individual stock....... rather than a random. D....... 87‐89......  If a market is perfectly efficient and a portfolio manager does not have superior analysts then the  portfolio manager should:  A..  A pricing anomaly is best described as:   A...... C....... LOS: Reading  55‐b  Correct Answer:  A key element of an anomaly is that it is a predictable... diversify away unsystematic risk and adjust the systematic risk of each portfolio to meet clients’ objectives. B. B.......... increase the systematic risk of the portfolio. Correct Answer:  D ........... select a portfolio of securities at random... (ii) Construct a portfolio which has the appropriate risk profile and maintain this risk level on an ongoing basis.. (iii) Diversify to eliminate any unsystematic risk by investing globally...... D..        14.....

00.  C.99.  $49.  Data mining.000 shares at $50 and the initial margin is 60% and the maintenance margin  is 30%.        16.  $21.00.57.  Which  of  the  following  is  least  likely  to  be  a  reason  why  we  should  be  skeptical  of  claims  by  analysts to have discovered an anomaly?   A.  D.  B.  C.  Limited capital of arbitrageurs.  Nonsynchronous trading.  B.  D.  Survivorship bias. he/she will receive the first margin call when the stock price falls below:  A.  If an investor buys 1.    .  $28.Equity Investments: Securities Markets   369  15.  $14.

LOS: Reading  52‐g  Correct Answer:  The amount borrowed would be $20... Volume 5..... $14.........        16.000P ...00... We need to calculate when the value of the equity equals 30% of the total value of the stock. he/she will receive the first margin call when the stock price falls below:  A.30(1. $21.. LOS: Reading  55‐d  Correct Answer:  Limited capital can constrain the ability of arbitrageurs to take advantage of anomalies.    ....57............... D.. This is given by: 1...... C........ B. pp........ B........... C. $28.. Limited capital of arbitrageurs...... 100‐104. 26‐29.57 Reference: CFA® Program Curriculum............. Survivorship bias...... Data mining......  Which  of  the  following  is  least  likely  to  be  a  reason  why  we  should  be  skeptical  of  claims  by  analysts to have discovered an anomaly?   A.....  If an investor buys 1.......... C ..........000 shares at $50 and the initial margin is 60% and the maintenance margin  is 30%....000P) P = $28. D . but it is not a reason to be skeptical that they exist.000 = 0.370   Study Session 13:   15............... Volume 5...... pp..............000..$20..... D.00......99..... Reference: CFA® Program Curriculum... Nonsynchronous trading........... $49.

  C.  the percentage of the transaction value that must be paid for in cash.  the market value of the stock less the amount borrowed.  large capitalization stocks outperformed small capitalization stocks.  there were a small number of stock splits over the period.        18.  the market value of the stock less the amount paid in cash.  small capitalization stocks outperformed large capitalization stocks. This is  explained by:  A.  C.  The initial margin requirement for a stock purchase is:  A.  the percentage of the transaction value that can be borrowed. one is a value‐weighted index which increased by  12% whereas the other is an unweighted index which increased by 5% over the same period.  D.  Two indexes contain exactly the same stocks.  there were a large number of stock splits over the period.    .  D.Equity Investments: Securities Markets   371  17.  B.  B.

. 26‐29.......... the percentage of the transaction value that must be paid for in cash. B.  Two indexes contain exactly the same stocks.. B.... D ...  The initial margin requirement for a stock purchase is:  A.......        18.......... the market value of the stock less the amount borrowed..... the market value of the stock less the amount paid in cash... one is a value‐weighted index which increased by  12% whereas the other is an unweighted index which increased by 5% over the same period.................... Reference: CFA® Program Curriculum...........    ..LOS: Reading  53‐a  Correct Answer:  Stock splits will not affect either index since in the market-value-weighted index when there is a stock split the number of shares outstanding will increase but the share price will fall by a corresponding amount........................ D.... small capitalization stocks outperformed large capitalization stocks. C. Volume 5.. Volume 5. C... pp..372   Study Session 13:   17.. This is  explained by:  A. D......... there were a large number of stock splits over the period........... large capitalization stocks outperformed small capitalization stocks........... the percentage of the transaction value that can be borrowed.. In a value-weighted index companies with a larger market capitalization will have a higher weighting so D is the correct answer............................ D ......... Reference: CFA® Program Curriculum... An unweighted index will be computed on an equal amount of money invested in each stock regardless of price or market value......... pp..... rather than borrowed...LOS: Reading  52‐g  Correct Answer:  The initial margin is simply the percentage or proportion of the transaction value that must be paid for in cash. 44‐46. there were a small number of stock splits over the period.

Equity Investments: Securities Markets   373  19.  The performance of stocks that have announced a change in accounting methods.  C.  The performance of stocks with a low price/book value ratio.  The neglected firm effect.  B.        20.    .  B.  Using technical analysis.  D.  Minimizing total transaction costs.  D.  The January effect.  C.  Focusing on analyzing neglected companies.  The Efficient Market Hypothesis and the tests done to prove the Hypothesis imply doing which  of the following is the least useful for portfolio managers?  A.  Which of the following supports the semistrong‐form of the Efficient Market Hypothesis?  A.  Using analysts who have the ability to estimate economic variables that have an impact  on security prices.

. C. B......... 67‐79.. Correct Answer:  A .. B...... The neglected firm effect......... Reference: CFA® Program Curriculum.................. The January effect. Volume 5...  The Efficient Market Hypothesis and the tests done to prove the Hypothesis imply doing which  of the following is the least useful for portfolio managers?  A.. D......        20... Minimizing total transaction costs............. the neglected firm effect and the outperformance of low price/book value stocks are all anomalies of the semistrong-form of the EMH.....374   Study Session 13:   19...... The performance of stocks that have announced a change in accounting methods..................... LOS: Reading  54‐c  The weak-form of the Efficient Market Hypothesis implies that technical analysis based on past trading data does not have any value................ Focusing on analyzing neglected companies.. Studies find that analysts look at the true value of companies rather than the effects of a change in the way financial performance is reported... Using technical analysis.. The performance of stocks with a low price/book value ratio.. pp..... Volume 5....... 85.... Reference: CFA® Program Curriculum................ p.    .. D.. The performance of stocks that have announced a change in accounting methods supports the semistrong-form of the EMH... Using analysts who have the ability to estimate economic variables that have an impact on security prices......... LOS: Reading  54‐b  Correct Answer:  The January effect............. D ..........  Which of the following supports the semistrong‐form of the Efficient Market Hypothesis?  A... C...

  B.18.  125.  C.  A value‐weighted index is made up of two stocks. in order to diversify a portfolio that is invested in S&P 500 stocks.  B.000  6.  C.   Index  Russell Small‐Cap index  IFC Emerging Market index  Correlation with S&P 500  0.000  * after a 2 for 1 stock split  The base index is set at 100 on December 31st 2006.  D.67.392  On the basis of the data given. from  which index is it likely to be most effective to include stocks.  D.45. X and Y.000*  6.  106. The index on December 31st 2007 is closest to:  A.67.        22.000  December 31st 2007  Price  $15  $65  Shares  outstanding  20.Equity Investments: Securities Markets   375  21.  Based on  historic data the correlation between the S&P 500 and the Russell Small‐Cap index and  the IFC Emerging Market index are as shown in the table below. and which is the most important factor  in explaining the correlation figures?      A. and the following data is provided:  Include stocks from   Russell Small‐Cap index  Russell Small‐Cap index        Correlation explained by   Index construction  Index constituents  Index construction   Index constituents  IFC Emerging Market index   IFC Emerging Market index     Stock  X  Y  $25  $50  December 31st 2006  Price  Shares  outstanding  10.    .783  0.  98.  126.

......... B........   Index  Russell Small‐Cap index  IFC Emerging Market index  Correlation with S&P 500  0........ the most important factor in explaining low correlation is the different constituent stocks in the indexes... 56‐58.... in order to diversify a portfolio that is invested in S&P 500 stocks......... LOS: Reading  53‐c  A low correlation indicates that there are stronger diversification benefits..... Correct Answer:  D ....392  On the basis of the data given. D...... Volume 5. pp.......783  0. and which is the most important factor in explaining the correlation figures? Include stocks from Russell Small-Cap index Russell Small-Cap index IFC Emerging Market index IFC Emerging Market index Correlation explained by Index construction Index constituents Index construction Index constituents A.    ..........  Based on  historic data the correlation between the S&P 500 and the Russell Small‐Cap index and  the IFC Emerging Market index are as shown in the table below..... Reference: CFA® Program Curriculum.376   Study Session 13:   21........ Most of the major indexes (except for the Nikkei) are value weighted. C.. based on historic data..... from which index is it likely to be most effective to include stocks.... so including stocks from the IFC Emerging Market index would be most effective........

67..... 125.. D..  A value‐weighted index is made up of two stocks.        ..000  December 31st 2007  Price  $15  $65  Shares  outstanding  20. 31st 2006 is ($25 x 10.000) = $550...000) = $690.... C..... 106..Equity Investments: Securities Markets   377  22.000*  6.......45... B......000 Total market value on Dec. 44‐45.. The index on December 31st 2007 is closest to: A..........000 The index = ($690. LOS: Reading  53‐a  Correct Answer:  Total market value on Dec..... C ..18....000) x100 = 125.....000/$550.......000) + ($65 x 6. 126........000) + ($50 x 6....45 Reference: CFA® Program Curriculum.. X and Y...000  * after a 2 for 1 stock split The base index is set at 100 on December 31st 2006.......... and the following data is provided:    Stock  X  Y  December 31st 2006  Price  $25  $50  Shares  outstanding 10... pp... 98..000  6. 31st 2007 is ($15 x 20.... Volume 5.67..

 one of the most familiar and widely  used  tools  in  estimating  the  value  of  a  company.378   Study Session 14:   Study Session 14: Equity Investments: Industry and Company Analysis   This study session focuses on industry and company analysis and describes the tools used in forming  an opinion about investing in a particular stock or group of stocks.  These  techniques  provide  the  means  to  estimate  reasonable  price  for  a  stock.  The  readings  on  industry  analysis  are  an  important  element  in  the  valuation process.  The last reading in this study session focuses on price multiples.  and  introduces  the  application  of  four  commonly  used price multiples to valuation.    Reading 56: An Introduction to Security Valuation: Part I  Reading 57: Industry Analysis  Reading 58: Equity: Concepts and Techniques  Reading 59: Company Analysis and Stock Valuation  Reading 60: An Introduction to Security Valuation: Part II  Reading 61: Introduction to Price Multiples        .  This  study  session  begins  with  the  essential  tools  of  equity  valuation:  the  discounted  cash  flow  technique  and  the  relative  valuation  approach. Also  addressed is estimating a company’s earnings per share by forecasting sales and profit margins. providing the top–down context crucial to estimating a company’s potential.

00.  If  an  investor’s  required  rate  of  return  is  12%  and  a  company’s  stock  price  is  $45. then the stock  is:  A.  undervalued.  Availability of substitutes.  B.  D.  C.  the  next  dividend is estimated to be $3.Equity Investments: Industry and Company Analysis   379  1.  Which of the following would be a positive factor for producers’ profitability?  A.  fairly valued.    .  C.  D.60 and the growth rate of dividends is a constant 4.  overvalued.5%.  Weak supplier power.        2.    Low entry barriers.  information is needed on the dividend payout ratio to answer the question.  B.  Strong buyer power.

. information is needed on the dividend payout ratio to answer the question... C............ C ......    ........ B...5%..... Reference: CFA® Program Curriculum. this is a positive factor for the producers’ profitability......... undervalued. Strong buyer power means the buyers can demand low prices reducing profitability..............380   Study Session 14:   1....... Low entry barriers will increase competition.....  If  an  investor’s  required  rate  of  return  is  12%  and  a  company’s  stock  price  is  $45.... reducing profit margins..... fairly valued................. B..6/(0.......  Which of the following would be a positive factor for producers’ profitability?  A...... B....... pp. Availability of substitutes restrains producers who wish to raise prices...60 and the growth rate of dividends is a constant 4........ Volume 5... 141‐144.. C... Strong buyer power... Availability of substitutes....... then the stock  is:  A... Low entry barriers.. Reference: CFA® Program Curriculum. Volume 5.... if the price is $45 the stock is undervalued.. D.....00..        2....LOS: Reading  58‐e  Correct Answer:  Weak supplier power means that the suppliers to the industry are in a weak negotiating position and are unable to squeeze the producers’ profits. overvalued..12 – 0. D......045) = $48. LOS: Reading  60‐b  Correct Answer:  The stock price using the DDM should be 3........ Weak supplier power.. 177‐182............. pp.  the  next  dividend is estimated to be $3............

 After the third year dividends are forecast to grow at 4% per annum.  Which of the following factors is least likely to directly determine the level of competition in an  industry?  A.  Entry barriers.69.  An analyst forecasts a company will pay dividends of $2 in the first year. $3 in the second year  and $3.56.  D.  B.Equity Investments: Industry and Company Analysis   381  3.        4.  Availability of substitute products.  $36.    .    $39.05  $51.  B.  Bargaining power of buyers.81.  C. If an  investor’s required rate of return is 12% the value of the stock is closest to:  A.  D.  Unit labor costs.  C.  $37.50 in the third year.

.81...    ..12) (1...........  Which of the following factors is least likely to directly determine the level of competition in an  industry?  A...... $36. C .... pp. Value = D4 $3....... If an  investor’s required rate of return is 12% the value of the stock is closest to:  A...05 $51.. Unit labor costs.. $3 in the second year  and $3..04) = = $45.50 (k − g ) (0.. D...............50 + + = + + = $39.50(1....50 in the third year........... 141‐144........................... 176‐182. $37.. Value = P + D3 D1 D2 $2 $3 $45.. pp.... $39.04) The value of the stock today is the sum of the present values of the first three years’ dividends plus the present value of the end-year-three value..... B........ Entry barriers.12)3 Reference: CFA® Program Curriculum. D. B.05 2 3 2 (1 + k ) (1 + k ) (1 + k ) (1....... Volume 5. Availability of substitute products..... LOS: Reading  60‐b  Correct Answer:  First............ Reference: CFA® Program Curriculum....LOS: Reading  58‐e  Correct Answer:  Unit labor costs impact the profitability of an industry....50 + $3............. After the third year dividends are forecast to grow at 4% per annum..... Bargaining power of buyers......69... and although they indirectly affect how attractive a business is for participants they are not a direct factor determining competition...... Volume 5.... calculate the value of the stock at the end of year three..      4... C.. C.12) (1.56...12 − 0......382   Study Session 14:   3...  An analyst forecasts a company will pay dividends of $2 in the first year. B.....

  B.Equity Investments: Industry and Company Analysis   383  5.  A company is operating at the peak of the business cycle.  examining the specific variables that influence the earnings multiplier.  C.  Estimating a company earnings multiplier using macroanalysis involves:  A.  D.  examining the relationship between the historic earnings multiplier for the company and  company performance.  D.  examining the relationship between the company earnings multiplier and the market  earnings multiplier.  P/E using normalized earnings.    .  Leading P/E. including the  dividend payout ratio and required rates of return.        6.  Current P/E.  Trailing P/E.  C. Which of the following EPS calculations  is likely to give the highest P/E ratio?  A.  examining the relationship between the company earnings multiplier and the economy.  B.

.. hence the P/E will be higher on this basis............LOS: Reading  61‐a  Correct Answer:  Normalized earnings will calculate the earnings at the midpoint of the cycle so is likely to be lower than current/trailing earnings or prospective earnings. Trailing P/E..........384   Study Session 14:   5... examining the relationship between the company earnings multiplier and the market earnings multiplier........ Answer D refers to microanalysis.. examining the relationship between the company earnings multiplier and the economy.. C....... Reference CFA® Program Curriculum.. 205-210...... D .... Volume 5....................... including the dividend payout ratio and required rates of return........ C.....  Estimating a company earnings multiplier using macroanalysis involves:  A.. D. LOS: Reading  59‐b  Macroanalysis is estimating a P/E or earnings multiplier by looking at the relationship between the company and its market and industry........ B...... 160‐166.......... P/E using normalized earnings...............  A company is operating at the peak of the business cycle.. examining the specific variables that influence the earnings multiplier............. Which of the following EPS calculations  is likely to give the highest P/E ratio?  A........ B...       6..    ............. Leading P/E...... Reference: CFA® Program Curriculum.. pp. pp...... Volume 5. Current P/E.. examining the relationship between the historic earnings multiplier for the company and company performance......... Correct Answer:  B....... D.

Equity Investments: Industry and Company Analysis   385  7.  D.  how goods are transformed from raw materials through to the finished good and profits  are shared between firms along the chain.    .  A company whose earnings are very sensitive to the business cycle is a:  A.  growth company.  co‐opetition risks.  C.  B.  competition between rival firms in an industry.  the government’s ability to raise value added taxes.  cyclical stock.  D.  B.  C.  cyclical company.  growth stock.        8.  Value chain analysis in return expectations analysis is important because it studies:  A.

......... Reference: CFA® Program Curriculum.....LOS: Reading  59‐a  Correct Answer:  A cyclical company is one whose sales and earnings are very sensitive to the business cycle such as auto or steel companies... Co-opetition risks refer to risks....... growth company..... Volume 5.......... C............................ competition between rival firms in an industry..................    . C..        8. D .... pp...... 136‐140.. the government’s ability to raise value added taxes. Correct Answer:  D ..... LOS: Reading  58‐b  Value chain analysis in return expectations analysis looks at how returns are split between the participants in a value chain.................. 150‐151. B.  A company whose earnings are very sensitive to the business cycle is a:  A.... D....... growth stock.. Volume 5.........  Value chain analysis in return expectations analysis is important because it studies:  A........... A cyclical stock is defined differently. how goods are transformed from raw materials through to the finished good and profits are shared between firms along the chain... in the value chain and competition between rival firms is not referring to firms in the same value chain.. cyclical company.....386   Study Session 14:   7. D... not returns..... pp.. B............. co-opetition risks. Reference: CFA® Program Curriculum...... it is one which has a high beta so it has changes in rates of return which are larger than the changes in rates of return of the market.. cyclical stock.........

  Use price to cash flow as the main relative measure using free cash flows in the  calculation.  Low return on equity for the company relative to the market.  Not attempt to value the company if there are concerns about the quality of the reported  accounts.    .  B.  B.         10.  C.  The company has a high beta.  Which  of  the  following  is  most  likely  to  lead  to  a  company’s  earnings  multiplier  being  higher  than the market multiplier?  A.  Which  would be an appropriate approach to take when valuing the company?  A.  C.  High earnings growth rates for the company relative to the market.  D.  Focus on price to book value since book value will not have been affected by any  manipulation of the accounts.  An analyst is valuing a company where he suspects that the management has been manipulating  the  accounts  by  capitalizing  expenses  that  should  have  been  treated  as  operating  expenses.  Use normalized earnings rather than current earnings in the price to earnings calculation.  D.  The risk of the company’s earnings is higher than the market.Equity Investments: Industry and Company Analysis   387  9.

Correct Answer:  B.. Low return on equity for the company relative to the market....  Which  of  the  following  is  most  likely  to  lead  to  a  company’s  earnings  multiplier  being  higher  than the market multiplier?  A.... C...... D.......................  An analyst is valuing a company where he suspects that the management has been manipulating  the  accounts  by  capitalizing  expenses  that  should  have  been  treated  as  operating  expenses.. 160‐166...... B... Higher risk means a higher required rate of return.......... 204‐210.. Focus on price to book value since book value will not have been affected by any manipulation of the accounts.... Volume 5... so D is the correct answer. Low return on equity implies low growth rates which would lead to a lower multiplier so C is not correct..388   Study Session 14:   9..... Reference: CFA® Program Curriculum... pp... Volume 5.. LOS: Reading  59‐b  Correct Answer:  High growth generally leads to a high multiplier........... and therefore a lower multiplier so B is not correct..    ......... Book value will also reflect a decision to capitalize rather than expense earnings.LOS: Reading  61‐a  Normalized earnings will look at earnings over a business cycle so will not resolve the issue of earnings manipulation. The company has a high beta......... Answer D is possible but analysts may not have the choice to ignore companies where they suspect that the accounts have been manipulated.. pp.......... A high beta would lead to a high required rate of return and therefore a lower multiplier so A is not correct... Use normalized earnings rather than current earnings in the price to earnings calculation..... D .. D... Use price to cash flow as the main relative measure using free cash flows in the calculation.. They will need to attempt to value them by adjusting the accounts and/or using cash flow methods.........  Which  would be an appropriate approach to take when valuing the company?  A....... B....................... High earnings growth rates for the company relative to the market.............. C... The risk of the company’s earnings is higher than the market.      10.. Cash flow will reflect the actual cash going in and out of the company so will be less subject to manipulation....... Not attempt to value the company if there are concerns about the quality of the reported accounts..... Reference: CFA® Program Curriculum...

81.  D.  9.  C.   Adjust book value for off‐balance‐sheet assets and liabilities.      12.13    5.65  0.  C. $  * Adjusted for non‐recurring items  2002  1.  Use tangible book value rather than total book value.Equity Investments: Industry and Company Analysis   389  11.12    2007  1. $   ROE* %  BVPS. book value per share ( BVPS) and return on equity (ROE):.37.00  0.03  32.    He  collects  the  following  data:  earnings  per  share (EPS).04    2003  2004  2.50  0.  33.22    2005  4.30  0.  Which of the following is least likely to be an adjustment made to book value in order to make it  better reflect the value of shareholders’ investment?    A.    Adjusted* EPS.33.00.00  The P/E of ABC commodities based on the average historical EPS is closest to:  A.  B.00  The current share price of ABC Commodities is $30.  7.  ABC  Commodities  is  sensitive  to  the  economic  cycle  and  an  analyst  decides  that  the  six  years  ending  2007  reflect  a  business  cycle  for  the  company.  B.30  0.  Use historic average of past book values over a business cycle.  10.  Adjust book value for differences in fair value and historic cost of assets.18    2006  3.    .25  0.  D.

. $   0....04 0..... C. $  * Adjusted for non-recurring items The current share price of ABC Commodities is $30..22 0........ B....... 210‐218...  ABC  Commodities  is  sensitive  to  the  economic  cycle  and  an  analyst  decides  that  the  six  years  ending  2007  reflect  a  business  cycle  for  the  company..30 2.18 0.. Use historic average of past book values over a business cycle. 7........    He  collects  the  following  data:  earnings  per  share (EPS).00 The P/E of ABC commodities based on the average historical EPS is closest to: A...81.00)/6 = 3... C...30 + 2....... 10. pp....13 0.00 P/E = 30........ Correct Answer:  2007 1.. reflecting retained earnings.... C ........LOS: Reading  61‐a  Correct Answer:  Since book value is a cumulative number.50 4.25 + 1.. 9.............00 = 10...33... Adjust book value for off-balance-sheet assets and liabilities.. 33.. 206‐210.....25 Adjusted* EPS......  2002 2003 2004 2005 2006   1........  Which of the following is least likely to be an adjustment made to book value in order to make it  better reflect the value of shareholders’ investment?  A.......... D. it is a more stable number than one year earnings.. Reference: CFA® Program Curriculum.........65 + 5.....00 Reference: CFA® Program Curriculum...65 5.... Adjust book value for differences in fair value and historic cost of assets.... so it is less likely that an average historic figure would be used.00  C ..37.... B.50 + 4.    .03 32.....00 0. pp...00/3.. Use tangible book value rather than total book value.......390   Study Session 14:   11.....00.. Volume 5......12 ROE* %    BVPS.... D...      12..... book value per share ( BVPS) and return on equity (ROE):..... Volume 5...30 3.....30 + 3. LOS: Reading  61‐b  The average EPS = (1.

57.        14.  3.  High exit costs.  If a company has an earnings retention ratio of 60%.  Excess industry capacity.  5.  B.  4.33.  C.  B.  8.  Which of the following factors will encourage new entrants to an industry?     A.  C.  High industry profitability.Equity Investments: Industry and Company Analysis   391  13.44.    .  D.  D.  A steep cost curve. earnings are growing at 5% per annum and  investors’ required rate of return is 12%.71. the P/E of the stock is closest to:  A.

C. pp.... the P/E of the stock is closest to:  A.. earnings are growing at 5% per annum and  investors’ required rate of return is 12%....  Which of the following factors will encourage new entrants to an industry?   A.    ...44..................... B...33... C ..... Excess industry capacity........................ 186‐188.... B. discourages new entrants.... 3. Reference: CFA® Program Curriculum....... LOS: Reading  60‐c  Correct Answer:    Reference: CFA® Program Curriculum... D .. Volume 5.........  If a company has an earnings retention ratio of 60%........................ High exit costs. 8........ 5................ D.. High industry profitability.......... A steep cost curve........ High exit costs.. Volume 5.57.. C.71.. 4.392   Study Session 14:   13.LOS: Reading  58‐e  Correct Answer:  High profitability will attract new entrants whereas a steep cost curve means it is difficult to enter the industry with small volumes..... and excess capacity means existing manufacturers may be willing to cut prices to deter new entrants.. D. 143‐144... pp....................      14. such as irreversibility of required capital investment.....

  P/S valuation methods can be used comparing companies with different cost structures.  Sales numbers are less subject to accounting manipulation.    .  D.  B.  Rapid accelerating growth.  B.  B.  D.        16.  C.  Which stage of the industry cycle is characterized by fast sales growth and high profit margins?  A.  P/S is viewed as an appropriate valuation method for cyclical companies.  Pioneering development.  Mature growth.  Which of the following is least likely to be a reason for using a price/sales (P/S) ratio to value a  company?  A.Equity Investments: Industry and Company Analysis   393  15.  Sales are generally more stable than earnings per share.  Market maturity.

...  Which stage of the industry cycle is characterized by fast sales growth and high profit margins?  A........... Reference: CFA® Program Curriculum. C....... Sales are generally more stable than earnings per share. D........ B.... Volume 5...  Which of the following is least likely to be a reason for using a price/sales (P/S) ratio to value a  company?  A.. P/S valuation methods can be used comparing companies with different cost structures...... Volume 5. pp...... Market maturity............. Reference: CFA® Program Curriculum.        16....... 137‐138... 218‐221..... D.... Rapid accelerating growth. D . LOS: Reading  58‐c  Correct Answer:  Rapid accelerating growth is the second stage when the industry is seeing rapid growth in sales and the potential for high profit margins because new entrants and therefore competition may be limited..........LOS: Reading  61‐a  Correct Answer:  P/S is not a good method for comparing companies with different cost structures because it doesn’t take into account a company’s profitability.................. D .394   Study Session 14:   15...... Mature growth.............. Sales numbers are less subject to accounting manipulation.... It is generally only useful for comparing companies operating in the same industry....................... P/S is viewed as an appropriate valuation method for cyclical companies... pp....    ...... B........................ B....... Pioneering development..

  An investor who follows an industry rotation strategy believes the economy has past its trough  and there is confirmation of recovery.  9.  D.  B.  Purchase stocks. Which strategy would he/she be likely to follow?  A.  Sell property.  Purchase bonds.  C.  C.Equity Investments: Industry and Company Analysis   395  17.  9.  B.  Sell commodities.  If the expected inflation rate in a country is 3% and the real risk‐free rate is 6% then the required  nominal risk‐free rate is closest to:  A.        18.  2.    .0%.  18.2%.0%.9%.  D.

.... D.. C ... 9............. 9............. pp.........................2%. pp.....  An investor who follows an industry rotation strategy believes the economy has past its trough  and there is confirmation of recovery....... C. Which strategy would he/she be likely to follow?  A..... Reference: CFA® Program Curriculum.... C........ 130‐132....LOS: Reading  58‐a  Correct Answer:  If the economy is in the recovery stage the best performance would be expected to come from cyclical stocks and commodities......03 – 1) = 9............... B. D.9%. Purchase stocks. 191‐193...................... Purchase bonds........0%. B.... 18.. and then property. LOS: Reading  60‐d  Correct Answer:  NRFR = [1 +RRFR] [1 + E(I)] – 1 where: NRFR = nominal risk-free rate RRFR = real risk-free rate E(I) = expected rate of inflation NRFR = (1.        18....... so B is the best answer.    . 2...06)(1...... B.. Volume 5... Volume 5.... Sell commodities....  If the expected inflation rate in a country is 3% and the real risk‐free rate is 6% then the required  nominal risk‐free rate is closest to:  A.......396   Study Session 14:   17........ Sell property........0%.18% Reference: CFA® Program Curriculum....

  Which  of  the  following  is  one  of  the  reasons  why  price  to  book  value  is  a  useful  valuation  measure?  A.  C.  A rise in the minimum wage increasing costs for fast‐food outlets.  Increasing demand for residential nursing care as the population ages.  Which  of  the  following  would  be  least  likely  to  be  a  result  of  structural  change  in  the  U.  D.Equity Investments: Industry and Company Analysis   397  19.  Book value is not usually distorted by the accounting methods used.  It is useful for comparing the value of stocks across industries.S.  B.    .  economy?  A.  D.  The move in population away from cities leading to stronger demand for catalogue and  online shopping.  C.  Book value has proved to be a good indicator of the market value of a company’s assets.  It can be used to value loss‐making companies.        20.  Rising consumer confidence leading to a surge in auto sales.  B.

... Reference: CFA® Program Curriculum...........................  Which  of  the  following  would  be  least  likely  to  be  a  result  of  structural  change  in  the  U. Volume 5.  Which  of  the  following  is  one  of  the  reasons  why  price  to  book  value  is  a  useful  valuation  measure?  A......... Book value is not usually distorted by the accounting methods used... so A is the best answer.......398   Study Session 14:   19... B..... The move in population away from cities leading to stronger demand for catalogue and online shopping... B.......LOS: Reading  61‐a  Correct Answer:  Loss making companies cannot be valued using current P/E and will often also have negative cash flow so P/B. Book value has proved to be a good indicator of the market value of a company’s assets..................... D..... D.        20......... It can be used to value loss-making companies..... Volume 5................ C...  economy?  A. pp.............    . LOS: Reading  57  Rising consumer confidence leading to a surge in auto sales would usually be the result of a cyclical move in the economy........ pp.. 125‐127.... 210‐218.. Increasing demand for residential nursing care as the population ages........... The other choices reflect longer-term structural changes in the economy........ Correct Answer:  A .. A .............S..... C.. Rising consumer confidence leading to a surge in auto sales... Reference: CFA® Program Curriculum... is a method that can usually be applied. A rise in the minimum wage increasing costs for fast-food outlets.... which is based on book value representing cumulative earnings and paid up capital... It is useful for comparing the value of stocks across industries..

  D.  the impact of monetary and fiscal policies on the market environment.  When  a  fund  manager  uses  top‐down  analysis  to  manage  equity  portfolios  he  is  least  likely  to  consider:  A.  sales per share are higher than for the average company.  impact of economic environment on different industries.  technical factors that will affect supply and demand for shares in the market.  B.  C.        22.Equity Investments: Industry and Company Analysis   399  21.  An analyst calculates the price to sales ratio for a company and finds it is significantly less than  the market average.  C.  B.    impact of industry environment on individual companies. this could be explained by:  A.  D.  the company has exhibited rapid sales growth relative to the market average.  sales growth has been consistent and the risk of sales growth faltering is small.  the company has a low profit margin relative to the average for the market.      .

... B. impact of economic environment on different industries. Individual companies are analyzed within the industries selected.. This will include analyzing each company’s past performance and forecasting its future prospects and then determining its value.... Volume 5........ The first step is to analyze alternative economies and securities markets. LOS: Reading  56  Correct Answer:  Top-down approaches usually focusing on fundamental rather than technical analysis. impact of industry environment on individual companies........ D.... the impact of monetary and fiscal policies on the market environment............. corporate and consumer expenditure..400   Study Session 14:   21... inflation. equities and cash in each market............. D .. C..    ... Analysts of economies will study a government’s fiscal and monetary policies. interest rates..... The next step is to use economic and market analysis to decide which industries will benefit and which will suffer in the expected environment.............. technical factors that will affect supply and demand for shares in the market...... 117‐121...... Reference: CFA® Program Curriculum......  When  a  fund  manager  uses  top‐down  analysis  to  manage  equity  portfolios  he  is  least  likely  to  consider:  A... The objective is to decide the country allocation and the allocation between bonds... pp.. and exchange rates.

.  An analyst calculates the price to sales ratio for a company and finds it is significantly less than  the market average.. B .... pp... Reference: CFA® Program Curriculum.......... D............Equity Investments: Industry and Company Analysis   401  22...... this could be explained by:  A.... B............ 218‐221.        .. Answers C and D would push up the P/S ratio.... sales per share are higher than for the average company.......LOS: Reading  61‐b  Correct Answer:  P/S is the same as P/E multiplied by the profit margin. the company has exhibited rapid sales growth relative to the market average... sales growth has been consistent and the risk of sales growth faltering is small.......... the company has a low profit margin relative to the average for the market.... so a low profit margin could explain a low P/S ratio....... C...... High sales per share are not going to necessarily lead to a low P/S ratio......... Volume 5.

  These  readings  combined  are  the  primary  building  blocks  for  mastering  the  analysis.  one  of  the  largest  and  fastest  growing  segments  of  global  financial  markets.      Reading 62: Features of Debt Securities  Reading 63: Risks Associated with Investing in Bonds  Reading 64: Overview of Bond Sectors and Instruments  Reading 65: Understanding Yield Spreads  Reading 66: Monetary Policy in an Environment of Global Financial Markets      .  valuation.  and  types  of  bonds.  Finally.  The  session  then  builds  by  describing  the  primary  issuers.402   Study Session 15:   Study Session 15: Fixed Income Investments: Basic Concepts   This  study  session  presents  the  foundation  for  fixed  income  investments.  the  study  session  concludes with an introduction to yields and spreads and the effect of monetary policy on financial  markets.  It  begins  with  an  introduction  to  the  basic  features  and  characteristics  of  fixed  income  securities  and  the  associated  risks.  sectors. and management of fixed income securities.

  The issuer cannot secure any of its assets to a new debt issue without giving equal  treatment to the existing debt holders.  D.  The issuer must submit periodic statements to the bond trustee.  Mortgage holders are not permitted to prepay mortgages ahead of the scheduled date.  A cap on a floater.  A floating rate security has a minimum coupon rate that must be paid if the reference  rate declines below a certain level.  C.      .  Which  of  the  following  is  least  likely  to  be  an  example  of  embedded  options  that  might  be  granted to bondholders?  A.  D.  Which of the following is an example of a negative covenant?  A.  C.        2.  The right to put the issue.  A floor on a floater.  B.  B.Fixed Income Investments: Basic Concepts   403  1.  Conversion privileges.

....... D.... A ..    . C........................ 242‐246. B. The right to put the issue..  Which  of  the  following  is  least  likely  to  be  an  example  of  embedded  options  that  might  be  granted to bondholders?  A.. LOS: Reading  62‐b  Correct Answer:  A cap on a floater is a benefit to the issuer if interest rates rise...        2............ Conversion privileges........... Reference: CFA® Program Curriculum.LOS: Reading  62‐a  A negative covenant is a restriction on the issuer to protect investors in the bond. An example is when unsecured debt holders are protected from the assets of the issuer being given as collateral in a subsequent debt issue..................... B.... Reference: CFA® Program Curriculum. 239......404   Study Session 15:   1.. D............ Volume 5. The issuer cannot secure any of its assets to a new debt issue without giving equal treatment to the existing debt holders.... C... not to the bondholders........................................... A floor on a floater. pp........  Which of the following is an example of a negative covenant?  A. p. A cap on a floater... Correct Answer:  D . A floating rate security has a minimum coupon rate that must be paid if the reference rate declines below a certain level......... Mortgage holders are not permitted to prepay mortgages ahead of the scheduled date.... The issuer must submit periodic statements to the bond trustee.... Volume 5.........

  D.  D.  C.  C.  An investor pays tax at a marginal rate of 40% and holds a tax‐exempt issue that has a yield of  6%.  B.  a sinking fund provision.  2.  a callable bond. The taxable‐equivalent yield is:  A.        4.0%.    .4%.  B.  15.  3.Fixed Income Investments: Basic Concepts   405  3.  10.6%.  a refundable bond.0%.  When the issuer of a bond agrees to retire a certain proportion of a bond issue each year.  a prepayment option. this is  an example of:  A.

 pp.......... D... C . a callable bond....... 2........  When the issuer of a bond agrees to retire a certain proportion of a bond issue each year...............06/0.. LOS: Reading  65‐i  Correct Answer:  taxable-equivalent yield = tax-exempt yield/(1 – marginal tax rate) = 0.. 3.. B........... The taxable‐equivalent yield is:  A. this is  an example of:  A. pp....... C.......0%..1 or 10% Reference: CFA® Program Curriculum................................. 251..6 = 0... 359‐361......... a refundable bond.................0%... C.... a prepayment option.. B... D ......LOS: Reading  62‐e  Correct Answer:  A sinking fund provision allows the issuer of a bond to retire a certain proportion of a bond issue each year..... a sinking fund provision... Reference: CFA® Program Curriculum..4%........ 10.. D.    ........ Volume 5......        4..... Volume 5...6%.... 15.406   Study Session 15:   3......  An investor pays tax at a marginal rate of 40% and holds a tax‐exempt issue that has a yield of  6%..

  Liquidity risk in bond markets can be measured by:  A.  C.  A floating‐rate note has the following coupon formula:  Six‐month Treasury bill rate + 60 basis points with a cap of 7% and a floor of 6.8%  6.Fixed Income Investments: Basic Concepts   407  5.5%  6.          6.  the bid‐ask spread.  price volatility.6%          5.5%  6.5%  5.1%    .  B.5%  7.   C. respectively?  A.5%  The 6‐month Treasury bill rates are as follows:    First reset date  Second reset date  Third reset date  Fourth reset date    6‐month  Treasury  bill rate  6.5%  7.  D.  recovery rates.0%  7.8%  6.  B.1%  What would be the coupon rates at the first and the second reset dates.  the slope of the yield curve.3%  6.  6.  D.

........      6......... C ......    . 6...........6% = 7.0%... D. pp.5% 6.........5% 7...1% C ...... the bid-ask spread....5%. D. Therefore it takes on the cap rate... 242‐246.........6% = 6....4% which is lower than the floor rate..6% 5......408   Study Session 15:   5........... LOS: Reading  62‐b  Correct Answer:  The coupon rate at the first reset date is 6..... Volume 5..... Reference: CFA® Program Curriculum........ 281‐283.5% + 0.. which is 7....5%  The 6‐month Treasury bill rates are as follows:    First reset date  Second reset date  Third reset date  6‐month  Treasury  bill rate  6.... B. the slope of the yield curve... Volume 5.........5%  5... respectively?  A...8%  6......  A floating‐rate note has the following coupon formula:  Six‐month Treasury bill rate + 60 basis points with a cap of 7% and a floor of 6... C..0% 7.5% 7. pp............. Reference: CFA® Program Curriculum... which is 6..8% + 0...3%  Fourth reset date  6..  Liquidity risk in bond markets can be measured by:  A.....1%  What would be the coupon rates at the first and the second reset dates....8% 6.... C... recovery rates. price volatility. LOS: Reading  63‐k  Correct Answer:  The bid-ask spread quoted by dealers reflects the liquidity of an issue. The coupon rate at the second reset date is 5........ Therefore it takes on the floor rate..........1% which is higher than the cap rate..5% 6. B......

  credit spread.  quality spread.  intermarket sector spread.  intramarket sector spread.  The  difference  in  yield  between  bonds  issued  by  industrial  companies  and  bonds  issued  by  information technology companies is an example of a:  A.  B.  D.  D.  Credit Card Receivables Asset‐Backed security.Fixed Income Investments: Basic Concepts   409  7.  Which one of the following is the least likely to be an example of a securitized bond?  A.  C.        8.  Mortgage‐backed security.  Mortgage bond.  Collateralized Mortgage Obligation.    .  C.  B.

Credit Card Receivables Asset-Backed security.... 305....... Mortgage-backed security...... C......... such as the use of bankruptcy-remote special purpose vehicles.....  The  difference  in  yield  between  bonds  issued  by  industrial  companies  and  bonds  issued  by  information technology companies is an example of a:  A..... D....... Volume 5. intramarket sector spread...... Industrial companies are in a distinct sector to information technology companies........ C..  Which one of the following is the least likely to be an example of a securitized bond?  A........ Volume 5..........    ... Reference: CFA® Program Curriculum...... The intramarket sector spread is the difference in yield between two bonds with the same maturity.......... D....................... quality spread....LOS: Reading  65‐e  Correct Answer:  The credit or quality spread is the difference in yield between Treasury securities and non-Treasury securities.. Mortgage bond..... p....        8... B.... A ... pp... intermarket sector spread....LOS: Reading  64‐e  Correct Answer:  Mortgage bonds are loans secured by mortgages to the company’s assets........... They are not structured with securitization techniques.... C ... in the same sector in a market...............410   Study Session 15:   7........... 355‐356.... Reference: CFA® Program Curriculum.... Collateralized Mortgage Obligation. credit spread... B......

    .  D.  MTNs have a maximum maturity of 10 years.  B.  it is a high‐grade bond.  the bond price has risen relative to that of an equivalent Treasury bond issue.Fixed Income Investments: Basic Concepts   411  9.  C.  Medium‐term notes (MTNs) differ from corporate bonds since:  A.  D.  MTNs are offered to investors on a continuous basis by the issuer or its agent.  C.  it is a low‐grade bond.  If the yield spread of a bond has widened it means that:  A.  the bond price has declined relative to that of an equivalent Treasury bond issue.        10.  MTNs have a maximum maturity of 5 years.  MTNs are not rated by any of the major credit rating organizations.  B.

.........  Medium‐term notes (MTNs) differ from corporate bonds since:  A..        10..................... LOS: Reading  64‐h  Correct Answer:  The unique feature of MTNs is that they are offered to investors on a continuous basis by the issuer or its agent........................ so the price has fallen.. D..... D ... pp.... B........ Reference: CFA® Program Curriculum..... Volume 5. LOS: Reading  63‐j  Correct Answer:  The credit or yield spread is the difference between the yield on the bond and the yield on a Treasury bond........... 322‐325....... MTNs are not rated by any of the major credit rating organizations.. D . pp.....412   Study Session 15:   9. MTNs are offered to investors on a continuous basis by the issuer or its agent........... relative to a Treasury bond........... D..... it is a high-grade bond......  If the yield spread of a bond has widened it means that:  A.........    ... MTNs have a maximum maturity of 10 years......... C... MTNs have a maximum maturity of 5 years....... it is a low-grade bond. C........... 277‐278. B... the bond price has declined relative to that of an equivalent Treasury bond issue...... If the spread has widened it means that the yield demanded by an investor in the bond has increased... Reference: CFA® Program Curriculum. Volume 5.. the bond price has risen relative to that of an equivalent Treasury bond issue........

  Accelerated sinking fund provision.  future economic activity. central banks find it most useful to derive information on:  A.  D.        12.  Interest rate cap.  Call option.  D.Fixed Income Investments: Basic Concepts   413  11.  C.  Put option.  B.  B.  From the equity markets.  Which  of  the  following  embedded  options  is  increasingly  valuable  to  an  investor  in  a  rising  interest rate environment?  A.    .  market expectations of interest rates.  ownership of equities by individuals.  international trade activity.  C.

... D...  Which  of  the  following  embedded  options  is  increasingly  valuable  to  an  investor  in  a  rising  interest rate environment?  A.......... Interest rate cap. future economic activity.. Reference: CFA® Program Curriculum. C. Accelerated sinking fund provision... Reference: CFA® Program Curriculum.. international trade activity..... C.......414   Study Session 15:   11.......  From the equity markets........ A ...............        12.....LOS: Reading  62‐e  Correct Answer:  From the investor perspective....... Put option........ B. The investor benefits from being able to sell back the bond at a specified price that is higher than the prevailing market price..... a put option is beneficial when interest rates rise. ownership of equities by individuals.................. Volume 5........ pp............... central banks find it most useful to derive information on:  A....... Call option...    . LOS: Reading  66‐b  Correct Answer:  Equity markets provide information on anticipated economic activity..... 379‐383.............. pp...... 252‐254.............. D.... market expectations of interest rates........ A .......... B. Volume 5..

  a special purpose vehicle.  5. If the yield declines by 50 basis points.25.  The legal entity that is used in asset securitization for bankruptcy remoteness is:  A.89.  0.  D.  D.  B.99.    . If the yield rises by 50 basis points.  an investment bank.Fixed Income Investments: Basic Concepts   415  13.  an indenture trustee.  C.  C.00. The duration of the bond is:  A.  1.  10.  A bond is initially priced at 97.        14.  a rating agency. the price increases to  99.50.  B.99. the price decreases to 94.50.

................. C .......99 x 0.. Volume 5.... 269‐271........  A bond is initially priced at 97........ so the assets used as collateral are separate from the firm that is requiring funding.... Volume 5.... a special purpose vehicle.... If the yield declines by 50 basis points....  The legal entity that is used in asset securitization for bankruptcy remoteness is:  A... B..416   Study Session 15:   13.... 5.        14...... D. an indenture trustee..... LOS: Reading  64‐i  Correct Answer:  A special purpose vehicle is the legal entity that the assets are sold to.005) = 5.99 – 94.... pp....... If the yield rises by 50 basis points.... 1.... D . 328‐329.99. pp.50.. LOS: Reading  63‐f  Correct Answer:  The duration = (99..25........... D.... The duration of the bond is:  A......... 0....99.. 10. an investment bank...    .....................89)/(2 x 97.... a rating agency.50.......... C.. C.... B... the price decreases to 94..... the price increases to  99....89..........00.... Reference: CFA® Program Curriculum.25 Reference: CFA® Program Curriculum..........

  A bond is initially priced at 97.   D.  an investor has the right to sell the bonds back to the issuer prior to maturity if the  market price has fallen below a prespecified level. If the par value of the bond is  $100.        16.  $500.  $10. the price decreases to 94.  $5.     .  D.  $1.  an issuer is required to retire a pre‐specified portion of a bond each year.000.  mortgagees are prepaid ahead of schedule and the cash received is set aside into a fund  which will be used to pay back investors at a later date.  B.99.Fixed Income Investments: Basic Concepts   417  15.000 then the dollar duration is:  A. the price increases to  99.250. If the yield rises by 50 basis points.  C.500.  A sinking fund provision refers to when:   A.89.   C.  an issuer has made an arrangement to buy back a bond at par in the case of deterioration  in the quality of collateral for a bond.  B. If the yield declines by 50 basis points.99.

... LOS: Reading  63‐f  Correct Answer:  The duration = (99..........        16.  A bond is initially priced at 97.....000.99 – 94... $10..418   Study Session 15:   15......89)/(2 x 97.... the price decreases to 94.99.. an issuer is required to retire a pre-specified portion of a bond each year. If the yield rises by 50 basis points... mortgagees are prepaid ahead of schedule and the cash received is set aside into a fund which will be used to pay back investors at a later date........ Correct Answer:  A .......25% x $100.    ....................... 269‐271..25 The dollar duration will be 5.. Reference: CFA® Program Curriculum...99...005) = 5.......... $1. If the yield declines by 50 basis points.000 then the dollar duration is:  A.... C.. Volume 5.......... Volume 5.250 Reference: CFA® Program Curriculum.. pp..  A sinking fund provision refers to when:   A.. C... D... D................... LOS: Reading  62‐d  A sinking fund requirement is usually put in place to reduce credit risk because the issuer has to retire a portion of the bond issue prior to maturity........ an issuer has made an arrangement to buy back a bond at par in the case of deterioration in the quality of collateral for a bond............. the price increases to  99. either by buying bonds in the market or providing cash for the trustee to call bonds using a lottery system.......... pp........ $500..500....000 = $5...... B. C . If the par value of the bond is  $100. 251‐255...... B.99 x 0.250...89... $5. an investor has the right to sell the bonds back to the issuer prior to maturity if the market price has fallen below a prespecified level.......

   B.  D.  B.  insignificant overnight interest rate moves following a policy announcement.  an increased level of implied volatility of the bond markets over the last few years.  A credible and transparent monetary policy of the ECB is reflected in:    A.Fixed Income Investments: Basic Concepts   419  17.  an investor cannot exercise an embedded put option whilst they are in a prespecified  nonrefunding period.  C.  the bonds can be called but the investor cannot be offered a replacement bond with a  similar yield.  the bonds cannot be called prior to the maturity date.  a strong euro against the dollar.  stable exchange rates.  Which a firm issues bonds that are nonrefundable this means that:    A.  the bonds cannot be redeemed using proceeds of another debt issue that has provided a  lower cost source of funds.  D.        18.     .   C.

.. C.... C.. Reference: CFA® Program Curriculum... a strong euro against the dollar.. Volume 5......... stable exchange rates........... 247‐251.......... B............. pp..........        18........ insignificant overnight interest rate moves following a policy announcement........ D... Reference: CFA® Program Curriculum.. the bonds cannot be called prior to the maturity date..............  A credible and transparent monetary policy of the ECB is reflected in:    A......... Correct Answer:  D ....... D.....LOS: Reading  62‐e  When a callable bond is issued it may have restrictions on when it can be called... the bonds can be called but the investor cannot be offered a replacement bond with a similar yield..... Volume 5..... C ....................... the bonds cannot be redeemed using proceeds of another debt issue that has provided a lower cost source of funds... an increased level of implied volatility of the bond markets over the last few years.    .... an investor cannot exercise an embedded put option whilst they are in a prespecified nonrefunding period......420   Study Session 15:   17.......... 379‐381...... pp... nonrefundable is such a restriction and means that the firm cannot issue a new bond on a lower yield to pay back the original bond holders..... LOS: Reading  66‐c  Correct Answer:  A credible and transparent policy means that market participants can forecast very accurately any policy announcements so there is little change in rates following an announcement.......... B..  Which a firm issues bonds that are nonrefundable this means that:    A..

  The right to prepay an amount above the scheduled principal repayment.  D.  the accrued interest component of the bond price.  the agreed bond price plus the accrued interest due to the seller of the bond.  C.  B.  The right to call the issue.  D.  the agreed bond price without accrued interest.  B.  C.  The clean price of a bond is:  A.  Which  of  the  following  is  least  likely  to  be  an  example  of  embedded  options  that  might  be  granted to the issuer of a bond?  A.    .Fixed Income Investments: Basic Concepts   421  19.  the agreed bond price for the bond less the accrued interest due to the buyer of the bond.  A floor on a floater.        20.  An accelerated sinking fund provision..

LOS: Reading  62‐b  Correct Answer:  A floor on a floater is a benefit to the holder of the bond if interest rates fall....... Volume 5.... Reference: CFA® Program Curriculum... 242‐246.. not to the issuer.. p............ the agreed bond price plus the accrued interest due to the seller of the bond...... A . The right to call the issue......... D..... An accelerated sinking fund provision. A ...........    .......... C. A floor on a floater..... LOS: Reading  62‐b  Correct Answer:  The clean price of a bond is the quoted price of a bond where the accrued interest is excluded.. Volume 5. Reference: CFA® Program Curriculum.........  The clean price of a bond is:  A...  Which  of  the  following  is  least  likely  to  be  an  example  of  embedded  options  that  might  be  granted to the issuer of a bond?  A...... The right to prepay an amount above the scheduled principal repayment...... D................ the agreed bond price for the bond less the accrued interest due to the buyer of the bond........................ the accrued interest component of the bond price......422   Study Session 15:   19....... B................... pp.... 246. the agreed bond price without accrued interest................... B..        20. C...

28.15% 7.000%.  The following information is given:    Issue 10‐year on‐the‐run Treasury  6% coupon 10‐year ABG Corporation Series J  5% coupon 10‐year IBN Limited 8.  D.  C.  3.        22.  0.85% 8.20.  3 basis points.00% The yield ratio between the 10‐year ABG Corp and the 10‐year Treasury is closest to:  A.83.0% coupon   Yield 6.78.15% 7.    .  B.  0.00% The absolute yield spread between IBN Limited and ABG Corporation bonds is:  A.  C.  The following information is given:    0.  D.0% coupon   Yield 6.Fixed Income Investments: Basic Concepts   423  21.015%.  Issue 10‐year on‐the‐run Treasury  6% coupon 10‐year ABG Corporation Series J  5% coupon 10‐year IBN Limited 8.  15 basis points.  1.  B.  1.85% 8.

. 3 basis points......15% or 15 basis points. Volume 5....  The following information is given:  Issue  10‐year on‐the‐run Treasury  6% coupon 10‐year ABG Corporation Series J  5% coupon 10‐year IBN Limited 8.015%....... 15 basis points.. Correct Answer:  D ... Do not use the coupon rates.. pp... D..    .85% 8.. 0................7...85% = 0..... 3....0% coupon  Yield 6.15% 7......0% . 352‐354..00% The absolute yield spread between IBN Limited and ABG Corporation bonds is: A............LOS: Reading  65‐e  The absolute yield spread = 8...000%....... C..... Reference: CFA® Program Curriculum....424   Study Session 15:   21..... B.......

.......78.....20. Volume 5. LOS: Reading  65‐e  The yield ratio 7. D..... 352‐354... Correct Answer:  D .      ...0% coupon Yield 6.... 1... pp..... 0...85% 8.83.. Reference: CFA® Program Curriculum......28......15% = 1.. B.....28..Fixed Income Investments: Basic Concepts   425  22.................... 1....85%/6... C....  The following information is given:  Issue 10‐year on‐the‐run Treasury  6% coupon 10‐year ABG Corporation Series J  5% coupon 10‐year IBN Limited 8. Again do not use the coupon rates......15% 7.... 0......00% The yield ratio between the 10-year ABG Corp and the 10-year Treasury is closest to: A..

426   Study Session 16:   Study Session 16: Fixed Income Investments: Analysis and Valuation   This study session illustrates the primary tools for valuation and analysis of fixed income securities  and markets.  specifically. interest rate and yield valuation and interest rate risk measurement and analysis. It begins with a study of basic valuation theory and techniques for bonds and concludes  with a more in‐depth explanation of the primary tools for fixed income investment valuation.     Reading 67: Introduction to the Valuation of Debt Securities  Reading 68: Yield Measures. and Forward Rates  Reading 69: Introduction to the Measurement of Interest Rate Risk      . Spot Rates.

  B.  D.  the market value of the portfolio will fall..        2.  the same as the maturity of the bond.    .  B.  If the duration of a bond portfolio is 5 and the average yield of bonds in the portfolio rises by 100  basis points then:  A.  the market value of the portfolio will rise by approximately 5%. the term to maturity of a bond.  C.  the market value of the portfolio will fall by approximately 5%. or equal to. or equal to.  we do not have sufficient information to calculate the impact on the market value of the  portfolio.  always positive and more than.  C.Fixed Income Investments: Analysis and Valuation   427  1. the term to maturity of a bond.  The Macaulay duration of a bond is:  A.      either negative or positive.  D. but by less than 5%.  always positive and less than.

.... the term to maturity of a bond. the term to maturity of a bond.......        2...  If the duration of a bond portfolio is 5 and the average yield of bonds in the portfolio rises by 100  basis points then:  A... the market value of the portfolio will fall by approximately 5%.. It is a measure of average time to the present value of cash flow receipts. or equal to... for the portfolio duration to be an indicator of the price move of the total portfolio..................... the same as the maturity of the bond............ 497.. the market value of the portfolio will rise by approximately 5%. the term to maturity of a bond. namely there should be a parallel shift in the yield curve.......    ..........LOS: Reading  69‐e  Correct Answer:  The unit of Macaulay duration is years. can take any number either positive or negative because it better measures the interest rate sensitivity of bonds and takes into account changes in cash flows due to interest rate changes.. pp....  The Macaulay duration of a bond is:  A. Mathematically it means that Macaulay duration will always be positive and less than.... always positive and more than............. but by less than 5%.............428   Study Session 16:   1...... p. D . C.. either negative or positive... Volume 5.. C.... steepened or flattened). we do not have sufficient information to calculate the impact on the market value of the portfolio... D... B.......... C . We need to know information on whether there was a parallel shift in the yield curve or the curve changed shape (e. B....... LOS: Reading  69‐f  Correct Answer:  The yield of each bond in the portfolio must rise by 100 basis points........ It is only the same as the maturity when it is a zero coupon bond. the market value of the portfolio will fall.............. so D is the correct answer... or equal to. or equal to... Volume 5.. Reference: CFA® Program Curriculum.... D. Other measures of duration such as effective duration......... always positive and less than...........g... 499‐501... Reference: CFA® Program Curriculum...

  D.  C.    .  B.        4.  B.  5.  10.  If the semiannual yield to maturity of a bond is 5%.  10. The modified duration is closest to:  A.77.  6.  6.6%.24.0%.66.  5.  The Macaulay duration of a semiannual bond with a 12% coupon is 6.3%.36.Fixed Income Investments: Analysis and Valuation   429  3.  10. the bond‐equivalent yield is closest to:  A.1%.0 and the yield to maturity  is 8%.  D.  5.  C.

 pp. Volume 5. B.... 10. B...... D.. C........ the bond‐equivalent yield is closest to:  A... Reference: CFA® Program Curriculum....0%..........  If the semiannual yield to maturity of a bond is 5%....36..0 and the yield to maturity  is 8%..04) = 5............1%...3%..66... D. 5..77 Reference: CFA® Program Curriculum.......6%. p.. B.............0/(1............... 6..  The Macaulay duration of a semiannual bond with a 12% coupon is 6. 5.........24.. C............. 5........... Volume 5.. The modified duration is closest to:  A... B.........LOS: Reading  69‐e  Correct Answer:  Semiannual bonds mean k = 2 Modified duration = Macaulay duration/[(1 + yield/k)] = 6....77..        4. 424‐425..    ......430   Study Session 16:   3.... 10..... 10.. LOS: Reading  68‐d  Correct Answer:  The bond-equivalent yield is simply double the semiannual yield...... 497........................... 6...

  $101.  The total dollar return from a bond is:  A.91.  the coupon income plus the reinvestment income plus the capital gain/loss on the bond.  An 8% bond makes semiannual coupon payments.Fixed Income Investments: Analysis and Valuation   431  5.        6.  D.42.    .  $96.  B.  D.27.  C.  B. If the yield to maturity  is 6% then the full price of the bond is closest to:  A. there are two further coupons to be paid and  the bond matures at $100 in 273 days (there are 182 days in a coupon period).  $98.  $103.  C.12.  the current yield multiplied by the price of the bond.  the coupon income plus the value of the quoted margin plus the capital gain/loss on the  bond.  the yield to maturity multiplied by the price of the bond.

... Multiplying by yield to maturity may be inaccurate since it assumes that coupons can be reinvested at the rate equivalent to the yield to maturity. D.    .........432   Study Session 16:   5..27..12.... If the yield to maturity  is 6% then the full price of the bond is closest to:  A........ the coupon income plus the reinvestment income plus the capital gain/loss on the bond. B......LOS: Reading  68‐a  Correct Answer:  The total dollar return is the coupon income plus the reinvestment income plus the capital gain/loss on the bond...91.... $101.42..03)1/2 + $104/(1........ there are two further coupons to be paid and  the bond matures at $100 in 273 days (there are 182 days in a coupon period)...  The total dollar return from a bond is:  A.. C .................... Volume 5....49 = $103. 42‐423.......... D .. C...... $98.....  An 8% bond makes semiannual coupon payments........... Reference: CFA® Program Curriculum.......... the coupon income plus the value of the quoted margin plus the capital gain/loss on the bond. B.........        6. $96. 392‐395.........03)3/2 = $3.. C.................94 + $99.... $103.......... pp....... LOS: Reading  67‐c  Correct Answer:  273 days is equivalent to 1 ½ coupon periods so: PV = $4/(1. the yield to maturity multiplied by the price of the bond........... pp.. the current yield multiplied by the price of the bond... D..42 Reference: CFA® Program Curriculum.... Volume 5.......

66%.  12.  modified duration.72%.        8.  C.Fixed Income Investments: Analysis and Valuation   433  7.  The appropriate duration measure to use for a high coupon callable bond is:  A.  effective duration.36%.  12.  D.  B.  C.  B.    .  11.  If the yield to maturity on an annual‐pay bond is 12% its bond‐equivalent yield is closest to:  A.  D.  12.  option‐adjusted duration.00%.  Macaulay duration.

.36%................... the cash flows might change as interest rates change........66%.......... LOS: Reading  68‐d  Correct Answer:  bond-equivalent yield = 2[(1+ yield on annual-pay bond)1/2 –1] = 11... option-adjusted duration... effective duration..... A ... Volume 5.66% Reference: CFA® Program Curriculum.... 11... 12....... C.... C..  If the yield to maturity on an annual‐pay bond is 12% its bond‐equivalent yield is closest to:  A.72%...... modified duration.. Macaulay duration.. 496....  The appropriate duration measure to use for a high coupon callable bond is:  A... B....00%. Volume 5..................    ... Reference: CFA® Program Curriculum. p...... B............... 431..434   Study Session 16:   7........ D.........LOS: Reading  69‐e  Correct Answer:  In a callable bond................ D. A ....... p....        8..... 12.................. The most appropriate duration measure is effective duration.. 12...

  reconstitution.  C.  C.  the  procedure is called:  A.  B.  D.        10.  negative convexity throughout the yield range.  bootstrapping.  A non‐callable bond has:  A.  hedging.  positive convexity throughout the yield range.  negative convexity at low yields and positive convexity at high yields.Fixed Income Investments: Analysis and Valuation   435  9.  positive convexity at low yields and negative convexity at high yields.  When  a  dealer  purchases  a  package  of  Treasury  strips  to  create  a  synthetic  Treasury  bond.  stripping.    .  D.  B.

.. D........................ B........... and a dealer can purchase a package of Treasury strips to create a synthetic Treasury bond.. D........436   Study Session 16:   9.. 484‐488........  the  procedure is called:  A.......... reconstitution............. negative convexity throughout the yield range. Volume 5.......... C.. negative convexity at low yields and positive convexity at high yields. C ..        10. Non-callable bonds have positive convexity throughout the yield range.... B...  When  a  dealer  purchases  a  package  of  Treasury  strips  to  create  a  synthetic  Treasury  bond.. Reference: CFA® Program Curriculum.. C.. 410....... hedging. Volume 5..... LOS: Reading  67‐f  Correct Answer:  Reconstitution occurs when a Treasury bond’s price is greater than its arbitrage-free value...  A non‐callable bond has:  A........    ............. positive convexity at low yields and negative convexity at high yields... would make the convexity negative in certain yield ranges.................... A .. bootstrapping.. such as a call option in a bond....... p. stripping....... LOS: Reading  69‐b  Correct Answer:  The presence of embedded options.......... pp... Reference: CFA® Program Curriculum...... positive convexity throughout the yield range.....

  C.  41.  D. the reinvestment income is  more important to produce the yield promised at the purchase date.49%.  B.  18.57%.5670.  Given the following information on a bond:  Duration  =  Convexity  Yields fall by:    The total estimated price change in percentage terms is closest to:  A.  For bonds bought at a premium.  250 basis points.  2.0935.    =    7.  The higher the coupon rate the more the bond is dependent on the reinvestment income  to produce the yield promised at the purchase date.  B.  For zero‐coupon bonds.  7.  Which of the following is the least accurate statement regarding reinvestment risk?  A.  D.        12. the reinvestment income is important to produce the yield  promised at purchase date.Fixed Income Investments: Analysis and Valuation   437  11.57%.    . rather than at a discount.  The longer the time to maturity the more the bond is dependent on the reinvestment  income to produce the yield promised at the purchase date.  21.92%.  C.

........ Correct Answer:  D .....49%..... C.....9175 = 2............... 18. the reinvestment income is more important to produce the yield promised at the purchase date....438   Study Session 16:   11..... D...57%....  Given the following information on a bond:  Duration = Convexity = Yields fall by: 7..........5670% x 0. 41... The longer the time to maturity the more the bond is dependent on the reinvestment income to produce the yield promised at the purchase date.5670.... B.... The higher the coupon rate the more the bond is dependent on the reinvestment income to produce the yield promised at the purchase date..025)2 x 100 Total estimated percentage price change Reference: CFA® Program Curriculum. D..... Volume 5. For zero-coupon bonds... The total estimated price change in percentage terms is closest to: A.... LOS: Reading  68‐c  Zero-coupon bonds have no reinvestment risk since they have no interim income from coupons to be reinvested.. 7..5684 = 21................... C. B. For bonds bought at a premium............... pp. LOS: Reading  69‐d  = 18. 2...025 x 100 Convexity adjustment: 41............        12.............  Which of the following is the least accurate statement regarding reinvestment risk?  A... the reinvestment income is important to produce the yield promised at purchase date........ 488‐492. pp.... 425‐430.. Correct Answer:  A .. 250 basis points......0935..    ..92%......57%... rather than at a discount.......4858 Estimated change using duration 7.. Volume 5.. 21.......0935 x (0.... Reference: CFA® Program Curriculum.

    .  For a large change in yields.Fixed Income Investments: Analysis and Valuation   439  13.1%.  B.  For a small change in yields.  D. the percentage price change is not the same for an increase  in yields as it is for a decrease in yields.        14.0%.5%. If the one‐ and two‐year spot rates are 6.  B.5%. the percentage price decrease is greater than the percentage  price increase.  14.  D.2%. the percentage changes are roughly the same.  C.  9.0% and  6.  For a large change in yields. whether the  yield increases or decreases.  An  option‐free  bond  has  a  remaining  life  of  three  years  and  carries  an  8%  annual  coupon  rate  payable annually and has a yield to maturity of 9%.  8.  7. respectively.  The percentage price change for a given yield change is not the same for all bonds.  Which of the following is least likely to be a characteristic of bonds with positive convexity?  A. then the three‐year spot rate is closest to:  A.  C.

.................. For a small change in yields. LOS: Reading  68‐h  Correct Answer:  The following relationship must hold.09)+8/(1. the percentage changes are roughly the same........ LOS: Reading  69‐c  For a large change in yields...  An  option‐free  bond  has  a  remaining  life  of  three  years  and  carries  an  8%  annual  coupon  rate payable annually and has a yield to maturity of 9%.... the percentage price decrease is greater than the percentage price increase..... 7....3032)1/3  z = 9.065)2+108/(1+z)3  97........2%.. D..... the percentage price change is not the same for an increase in yields as it is for a decrease in yields... For a large change in yields......... where the three-year spot rate is z: 8/(1..09)2+108/(1.......... Volume 5..0%.... pp..440   Study Session 16:   13...1%. For a large change in yields.............. The percentage price change for a given yield change is not the same for all bonds. Volume 5...... when a bond has positive convexity..0%  and 6... B. the percentage price increase is greater than the percentage price decrease........... Correct Answer:  B..5%...... C...........47 = 14.. whether the yield increases or decreases..  ... C .....06)+8/(1.. respectively...... C.. then the three‐year spot rate is closest to:  A..  Which of the following is least likely to be a characteristic of bonds with positive convexity?  A... If the one‐ and two‐year spot rates are 6..23%    Reference: CFA® Program Curriculum...87  1+z = (1..        14... 501‐503....... 8.... pp... 14..... B. 458‐461..... 9.... D.....60+108/(1+z)3  (1+z)3 = 108/82...    . Reference: CFA® Program Curriculum..09)3=8/(1...5%.

  C.  Longer duration of the CMO than the mortgage loans is possible and simply indicates the  sensitivity of the CMO to interest rate moves.  An  analyst  uses  a  model  to  calculate  effective  duration  and  finds  a  collateralized  mortgage  obligation (CMO) which has duration which is longer than the life of the underlying mortgage loans.  C.  D.         16. inputs should be taken  from a market source. it is observed that the price of a callable bond with a coupon of 5%  moves as follows:     Rates down 50 basis points  Price + 5%    The bond is likely to have    A.  B.  Which of the following statements is most accurate?  A.  When interest rates change.  The model looks to have produced an incorrect estimate of duration since CMOs would  be expected to have negative duration.  Effective duration is an inappropriate measure of duration to use since there are no  embedded options in a CMO.  B. such as dealers’ prices.  D.Fixed Income Investments: Analysis and Valuation   441  15.  It is inappropriate to use a model to estimate effective duration.  Convexity    Positive  Positive  Negative  Negative          Yield  Less than 5%  More than 5%  Less than 5%  More than 5%  Rates up 50 basis points  Price ‐ 3%    .

...........  When interest rates change...442   Study Session 16:   15....... pp. it is observed that the price of a callable bond with a coupon of 5%  moves as follows:   Rates down 50 basis points  Price + 5%  The bond is likely to have Convexity A............... 496‐499.. Positive B. Longer duration of the CMO than the mortgage loans is possible and simply indicates the sensitivity of the CMO to interest rate moves....... Negative Correct Answer:  Yield Less than 5% More than 5% Less than 5% More than 5% Rates up 50 basis points  Price ‐ 3%  B...... Reference: CFA® Program Curriculum.......... LOS: Reading  69‐c  The bond has positive convexity since the gain is more than the loss for an equal move in interest rates......  An  analyst  uses  a  model  to  calculate  effective  duration  and  finds  a  collateralized  mortgage  obligation (CMO) which has duration which is longer than the life of the underlying mortgage loans.... Negative D.... inputs should be taken from a market source............ such as dealers’ prices.. The model looks to have produced an incorrect estimate of duration since CMOs would be expected to have negative duration...... Reference: CFA® Program Curriculum........ As yields fall the bond is more likely to be called and starts to exhibit negative convexity........... Correct Answer:  D .. Positive C.......... The bond’s coupon is probably less than market yields meaning it is unlikely to be called in the near future..... D......  Which of the following statements is most accurate?  A.. It is inappropriate to use a model to estimate effective duration.. pp......... It is reasonable to use a model to calculate effective duration and effective duration can be positive (and longer then the maturity of the underlying loans) or negative depending on the structure and terms of the CMO.........LOS: Reading  69‐e  Effective duration is the correct method to use since cash flows from the CMO are influenced by interest rates.......    16..... Effective duration is an inappropriate measure of duration to use since there are no embedded options in a CMO......... 484‐487.    .... Volume 5..... C........ B..... Volume 5........

  7.  A zero‐coupon bond with two years remaining to maturity is currently trading at $82. the yield to maturity is closest to:  A.  6.8%.  D.  6.  13.65.  A bond without any embedded options has a remaining life of three years. If the  par value is $100.        18. carries an 8% coupon  rate payable annually. If the one‐ and three‐year spot rates are 8.  B.  9.5%.  11.  C.0%.Fixed Income Investments: Analysis and Valuation   443  17.  C.5%. and has a yield to maturity of 7%.0%  and 7.  B.0%. respectively.5%.0%. then the two‐year spot rate is closest to:  A.  9.  D.7%.0%.  8.    .

. D....... 398‐399.    ... LOS: Reading  68‐h  Correct Answer:  The following relationship must hold.    18.07)2 + 108/(1....08) + 8/(1+ z)2 + 108/(1......06 1 + z = (1. 6.65........ pp...... 6............ 11..8% annual yield Reference: CFA® Program Curriculum.21 x = 0..5%.65 = (1 + x )4 100 (1 + x )4 = 100 82. Volume 5.......... 13......0%. 458‐461. the yield to maturity is closest to:  A......LOS: Reading  67‐e  Correct Answer:  Let x be the semiannual yield we are looking for..45% Reference: CFA® Program Curriculum........................5%................ Volume 5.8%.....0%.. carries an 8% coupon  rate payable annually...0%..46 = 7. pp..... C..65 = 1.1337)1/2 z = 6... and has a yield to maturity of 7%.... C ........0%. If the  par value is $100. 8.. C.... 7.. then the two‐year spot rate is closest to:  A..... B...7%........... B.0%  and 7..  A bond without any embedded options has a remaining life of three years. where z is the two-year spot rate: 8/(1.... D..41 + 8/(1+z)2 (1 + z)2 = 8/7.. then: 82.444   Study Session 16:   17.. 9.. B.. If the one‐ and three‐year spot rates are 8.07)3 = 8/(1.07) + 8/(1.....0488 or 9... 9..07)3 14...... respectively..  A zero‐coupon bond with two years remaining to maturity is currently trading at $82......5%......

  the absolute change in dollar duration of a bond if there is a one hundred basis point  change in yield.  the option‐adjusted spread if a bond has embedded options.    .  the spread between spot and forward rates over the life of a bond.Fixed Income Investments: Analysis and Valuation   445  19.  the percentage change in dollar duration of a bond if there is a one hundred basis point  change in yield.  D.  D.  B.  B.  C.  the adjustment to the option‐adjusted spread as volatility changes.  The Z‐spread is:  A.        20.  the spread earned on a bond over the Treasury spot rate curve if it is held to maturity.  the percentage change in price of a bond if there is a one basis point change in yield.  the absolute change in price of a bond if there is a one basis point change in yield.  The price value of a basis point is:  A.  C.

......... D.... D .. pp...... B... LOS: Reading  68‐f  Correct Answer:  The Z-spread...... Volume 5...........  The Z‐spread is:  A..    . is the spread that must be added to the Treasury spot rate to give a discount rate which will make the discounted cash flows from a bond equal to its price...... yield... the percentage change in price of a bond if there is a one basis point change in yield.... C.. yield............. LOS: Reading  69‐i  The price value of a basis point is the absolute change in price of a bond if there is a one basis point change in yield... the adjustment to the option-adjusted spread as volatility changes. the absolute change in dollar duration of a bond if there is a one hundred basis point change in the percentage change in dollar duration of a bond if there is a one hundred basis point change in Correct Answer:  A .. D............... 445‐450........... Reference: CFA® Program Curriculum.446   Study Session 16:   19................... also called zero volatility or static spread..... the option-adjusted spread if a bond has embedded options.. the absolute change in price of a bond if there is a one basis point change in yield......... It is a special case of dollar duration............ the spread earned on a bond over the Treasury spot rate curve if it is held to maturity....... Reference: CFA® Program Curriculum. Volume 5...... B............ 504‐505.........  The price value of a basis point is:  A........ C.... pp...        20. the spread between spot and forward rates over the life of a bond.........

0  1.75%.5  1.0000  4.  5.Fixed Income Investments: Analysis and Valuation   447  21.  D.65  Price      100  Spot rate (BEY)  4.25%  7.0  1.  6.  5.  4.        22. the six‐month implied forward rate one and a half years from now is closest  to:  A.75%  6.00%.  B.  D.  Period  1  2  3    Years  0.  4.  C.  C.30  4.6606  The 6‐month forward rate.  The following data is collected:   Years to  0.  B.3000%.3535%.00%.  8.00%  7.5  Annual yield to  maturity (BEY)  4.25%  Based on the above data. one year from now is closest to:  A.0    Spot rate  5.3837%.  Given:    4.4803%.5  2.00  4.25%.  6.3000  4.    .5  1.

00%....75%...... C. the six‐month implied forward rate one and a half years from now is closest  to:  A....... 6..75%  6....  The following data is collected:  Years to  0..0    Spot rate  5.25%. pp.....035)3] – 1  The forward rate is 4..... 4....... 453‐458.... D.. 6..25%  Based on the above data............448   Study Session 16:   21.. Volume 5.00%  7.. 8.0  1.03625)4/(1 + 0. LOS: Reading  68‐h  Correct Answer:  = 4..00%.... D ..5  2.. B....0%  1f3 = [(1+ 0.........25%  7....5  1.......0%    Reference: CFA® Program Curriculum........    ...0% x 2 = 8...

.30  4.4803%...  Given:  Period  1  2  3  Years  0. Volume 5.... 4..6919% The 6-month forward rate.. one year from now is closest to: A...65  Price      100  Spot rate (BEY)  4......5  Annual yield to  maturity (BEY)  4.......LOS: Reading  68‐h  1f2 = (1 + z3)3/(1 + z2)2 -1 = (1...023303)3/(1.....3000%....00  4. 4...0000  4. 5..02150)2 -1 = 1... pp..0269 – 1 = 2..5  1...Fixed Income Investments: Analysis and Valuation   449  22. Correct Answer:  D ........0  1..3837% Reference: CFA® Program Curriculum.6919% = 5..... 453‐458..... is 2 x 2... B... C......3000  4. one year from now.. 5...6606  The 6-month forward rate.......3535%..........3837%....      . D....

 and the use of options in risk  management.      Reading 70: Derivative Markets and Instruments  Reading 71: Forward Markets and Contracts  Reading 72: Futures Markets and Contracts  Reading 73: Option Markets and Contracts  Reading 74: Swap Markets and Contracts  Reading 75: Risk Management Applications of Option Strategies      . futures.450   Study Session 17:   Study Session 17: Derivative Investments:   Derivatives—financial instruments that offer a return based on the return of some underlying asset— have become increasingly important and fundamental in effectively managing financial risk and  creating synthetic exposures to asset classes. and swaps). As in other security markets.   This study session builds the conceptual framework for understanding derivative investments  (forwards. derivative markets. arbitrage and market  efficiency play a critical role in establishing prices and maintaining parity. options.

  B.  C.Derivative Investments   451  1.  profit of $4.  profit of $3.        2.  the  option  price  is  $4  and  the  exercise  price  is  $23.  paid in equal parts when each swap payment is made.  At  the  expiration  of  the  option  the  stock  price  is  $30.  never paid.        .  C.  The  profit/loss of the option writer is a:  A.  D.  The  stock’s  current  price  is  $24.  loss of $4.  B.  The notional principal in a plain vanilla interest rate swap is:  A.  loss of $3.  A  trader  writes  a  European  call  option  on  a  stock.  paid at the time that the swap agreement is made.  D.  paid at the time that the swap agreement is signed and returned when the final swap  payment is made.

. Volume 6......... pp.452   Study Session 17:   1..... made.....  At  the  expiration  of  the  option  the  stock  price  is  $30.. profit of $3. 134‐138........................    . Reference: CFA® Program Curriculum. C. never paid..  the  option  price  is  $4  and  the  exercise  price  is  $23....... B......  The  stock’s  current  price  is  $24. C......        2....... D.... B...... Volume 6..................  The notional principal in a plain vanilla interest rate swap is:  A..... paid at the time that the swap agreement is signed and returned when the final swap payment is Correct Answer:  A ..... D.. profit of $4..........  The  profit/loss of the option writer is a:  A.. 151‐158....... B... LOS: Reading  75‐b  Correct Answer:  The writer has received the premium of $4 but the loss when the option is exercised is $30 minus $23 giving an overall loss of $3.. loss of $4..... paid in equal parts when each swap payment is made............ pp..  A  trader  writes  a  European  call  option  on  a  stock............... paid at the time that the swap agreement is made.................. LOS: Reading  74‐b  The notional principal is the amount on which the interest payments are calculated and does not change hands in an interest rate swap..... loss of $3....... Reference: CFA® Program Curriculum....

  The  company  should  consider  entering into:  A.  D.  The value of a put option at expiry is:  A.  a plain vanilla interest rate swap agreement where they take the receive‐fixed side of the  transaction.  C.    . minus the option premium.  a currency swap agreement where they take the pay‐fixed side   maximum of (i) zero and (ii) exercise price minus stock price.  maximum of (i) zero and (ii) stock price minus exercise price.  D.Derivative Investments   453  3.  maximum of (i) zero and (ii) exercise price minus stock price.  a plain vanilla interest rate swap agreement where they take the pay‐fixed side of the  transaction.  of the transaction.  maximum of (i) zero and (ii) stock price minus exercise price.  B.        4.  a currency rate swap agreement where they take the receive‐fixed side of the transaction.  C. minus the option premium.  B.  A  company  has  borrowed  to  finance  its  operations  using  floating‐rate  debt  but  it  is  now  concerned  that  short‐term  interest  rates  are  going  to  rise  sharply.

. maximum of (i) zero and (ii) exercise price minus stock price. C.. B...  The value of a put option at expiry is:  A....  The  company  should  consider  entering into:  A.. minus the option premium.. minus the option premium..    ..................... A .................. In that case he could theoretically buy the stock in the market and sell it at a higher price. Reference: CFA® Program Curriculum....        4........... LOS: Reading  74‐b  In a plain vanilla interest rate swap if the company pays a fixed rate of interest and receives a floating rate of interest. Correct Answer:  C ........LOS: Reading  73‐e  Correct Answer:  The holder of a put option will exercise the option if the exercise price is above the stock price..... offset the interest rate risk of its debt payments.. a currency swap agreement where they take the pay-fixed side of the transaction... pp................ maximum of (i) zero and (ii) stock price minus exercise price...... Volume 6... if the agreement is correctly structured..... the floating rate interest payment will... Volume 6......... 96‐99.... B.............. D... D. 134‐138. Reference: CFA® Program Curriculum........... pp..... C......... The option premium should only be taken into account if the profit/loss on the option is being calculated.. a plain vanilla interest rate swap agreement where they take the receive-fixed side of the transaction.... maximum of (i) zero and (ii) exercise price minus stock price..... a plain vanilla interest rate swap agreement where they take the pay-fixed side of the transaction..  A  company  has  borrowed  to  finance  its  operations  using  floating‐rate  debt  but  it  is  now  concerned  that  short‐term  interest  rates  are  going  to  rise  sharply........ If the stock price is higher than the exercise price he will let the option lapse worthless.......454   Study Session 17:   3.. a currency rate swap agreement where they take the receive-fixed side of the transaction. maximum of (i) zero and (ii) stock price minus exercise price.....

  reducing the volatility of his return.  increasing income.  C.  C.  When a trader writes a covered call this will often be with the objective of:  A.  Buy call options on the S&P Index.  D.Derivative Investments   455  5.    .  increasing his gain if the stock price rises above the exercise price plus the premium.  insuring his portfolio value.  Which of the following strategies would be consistent with this view?  A.  D.  B.  B.  An  investor  believes  that  the  S&P  Index  is  going  to  decline  sharply  over  the  next  two  years.  Write put options on the S&P Index.  Take a long position in futures on the S&P Index.  Enter into a two‐year equity swap to receive a fixed payment and pay an equity payment  based on the performance of the S&P index.        6.

... LOS: Reading  75‐b  Correct Answer:  Writing a covered call means that the trader will increase his income by the option premium.. LOS: Reading  74‐b  If the S&P Index falls the investor will receive both the fixed payment and an equity payment so this would be a viable strategy...... If the stock price rises above the exercise price his shares will be called and he will lose the capital gain he would have made if he had not written the option. Volume 6....... Take a long position in futures on the S&P Index........    ...................................... Enter into a two-year equity swap to receive a fixed payment and pay an equity payment based on the performance of the S&P index...... Correct Answer:  D . increasing his gain if the stock price rises above the exercise price plus the premium. insuring his portfolio value....... 138‐141... Buy call options on the S&P Index........  When a trader writes a covered call this will often be with the objective of:  A.. A ...........  An  investor  believes  that  the  S&P  Index  is  going  to  decline  sharply  over  the  next  two  years........... B.        6. pp...... Reference: CFA® Program Curriculum....... C. pp.....  Which of the following strategies would be consistent with this view?  A. increasing income. D... reducing the volatility of his return.. B......... D. Volume 6.......... Write put options on the S&P Index....456   Study Session 17:   5... Reference: CFA® Program Curriculum......... C........... 151‐158...................

  D.000 then he must deposit a variation margin of:  A.  C.        8.  D.  only if the stock price falls sharply below the exercise price.000  loss  on  the  trade.  only if the stock price rises sharply above the exercise price.  $1.  $5.  An  investor  deposits  an  initial  margin  of  $20.  If  the  maintenance  requirement is $15.  B.  C.000.000.  A trader sells both a call and a put option on a stock with the same exercise price and the same  expiration.  The  next  day  he  makes  a  further  loss  of  $2.  there is no requirement to pay a variation margin.000  for  a  futures  trade  and  the  next  day  makes  a  $2. he will make a profit on the transaction:  A.  if the stock price remains within a narrow range of the exercise price.000.000.  B.  if the stock price rises sharply or falls sharply.  $4.Derivative Investments   457  7.    .

.        8.. D....000  for  a  futures  trade  and  the  next  day  makes  a  $2.. pp..... B. C.... If the move is significant the loss made on either option would be greater than the premium income received. only if the stock price falls sharply below the exercise price...000 ($20. B...... D .000 .000......000).. Reference: CFA® Program Curriculum.........000 then he must deposit a variation margin of:  A..............$2....000. His strategy is profitable if the stock price does not move by more than the combined value of the premiums received away from the exercise price.  An  investor  deposits  an  initial  margin  of  $20.  The  next  day  he  makes  a  further  loss  of  $2... if the stock price remains within a narrow range of the exercise price..000..$2. D.... D . $4.. $5........ only if the stock price rises sharply above the exercise price............. Reference: CFA® Program Curriculum. C..... or if it moves down sharply the put option would be exercised...... if the stock price rises sharply or falls sharply. Volume 6...... pp.........458   Study Session 17:   7...... Volume 6.. 151‐158.....LOS: Reading  75‐a  Correct Answer:  This is a straddle (not explicitly covered in the readings) but the candidate can work out that if the stock price moves up sharply the call option would be exercised. LOS: Reading  72‐b  Correct Answer:  The variation margin only needs to be paid if the investor’s equity has fallen below the maintenance requirement..............    ...000 ...... This is not the case since the equity is still $16.  A trader sells both a call and a put option on a stock with the same exercise price and the same  expiration......000  loss  on  the  trade............ there is no requirement to pay a variation margin.... 55‐60.. he will make a profit on the transaction:  A........ $1..................000.....  If  the  maintenance  requirement is $15.

    .  B.  B.  In the majority of cases the insured portfolio will outperform an equivalent uninsured  portfolio.  D.  an option where the underlying asset is a futures contract.  a futures contract where the holder has the option to buy a pre‐specified asset at an  agreed price at a future date.  C.  The probability of the insured portfolio achieving high positive gains is less than for the  uninsured portfolio.  a futures contract where the holder has an option at the delivery date to extend the  contract.  a futures contract where the holder agrees to buy a pre‐specified option at a future date.  C.  If put options are used to insure a portfolio which of the following statements is   most accurate?  A.  D.Derivative Investments   459  9.  An option on a futures is best described as:  A.        10.  There is a higher probability that the insured portfolio will achieve any given positive  return than the uninsured portfolio.  The insured portfolio will only report substantial losses in a small number of cases.

.. In the majority of cases the insured portfolio will outperform an equivalent uninsured portfolio...... C. LOS: Reading  75‐b  Correctly insuring a portfolio using put options should eliminate the possibility of a large loss since the portfolio value will not fall below the exercise price less the premium......... Reference: CFA® Program Curriculum.....460   Study Session 17:   9.. Reference: CFA® Program Curriculum...... B........  An option on a futures is best described as:  A................ The option holder has the right to enter into a futures contract (call option for a long position........ 162‐165.. put for a short position) at a fixed price.. Volume 6.. a futures contract where the holder has the option to buy a pre-specified asset at an agreed price at a future date..................... D............        10............ Volume 6.... B...... p. LOS: Reading  73‐b  An option on a futures is simply an option where the underlying asset is a futures contract............ Correct Answer:  A . pp............... Correct Answer:  C .. But if the return from the assets is positive the uninsured portfolio will outperform the insured portfolio because of the cost of the premium.............. The probability of the insured portfolio achieving high positive gains is less than for the uninsured portfolio........ a futures contract where the holder has an option at the delivery date to extend the contract. C.. an option where the underlying asset is a futures contract.... D.......... There is a higher probability that the insured portfolio will achieve any given positive return than the uninsured portfolio.. 94...  If put options are used to insure a portfolio which of the following statements is   most accurate? A.... The insured portfolio will only report substantial losses in a small number of cases..    . a futures contract where the holder agrees to buy a pre-specified option at a future date....

 He is  concerned that interest rates are going to fall and he wishes to put the money on 90‐day LIBOR on  receipt.  B.  profit if the stock price rises above the breakeven point of $70.  D.  An investor buys a call option at a premium of $10 on a stock which has a market price of $60.  short position in a 6 x 3 FRA. If  the exercise price is $62 the investor will make a:  A.  profit if the stock price rises above the breakeven point of $72.Derivative Investments   461  11. He should consider taking a:  A.  loss if the stock price rises above the breakeven point of $70.  B.  loss if the stock price rises above the breakeven point of $72.  D.  A corporate treasurer knows that his firm will receive a large cash inflow in 180 days’ time.        12.  short position in a 6 x 9 FRA.  C.  long position in a 6 x 3 FRA.  long position in a 6 x 9 FRA.  C.    .

.... long position in a 6 x 9 FRA... D....... Reference: CFA® Program Curriculum. C..... when S = $72 Reference: CFA® Program Curriculum............ B.............. D. Volume 6.. Volume 6.. pp.LOS: Reading  73‐e  Correct Answer:  Breakeven is when 0 = maximum [ 0................. If  the exercise price is $62 the investor will make a:  A..... C... 96‐100.....  A corporate treasurer knows that his firm will receive a large cash inflow in 180 days’ time........ pp............ (S – X)] – premium... that is a 180-day forward contract based on deposits that mature in 270 days.. profit if the stock price rises above the breakeven point of $72..... D ... LOS: Reading  71‐f  Correct Answer:  A short position will generate a profit if interest rates fall which will offset the loss from placing the cash inflow on deposit at a lower rate.. He is effectively locking in the rate he will receive in 180 days’ time. 40‐43.... profit if the stock price rises above the breakeven point of $70....... loss if the stock price rises above the breakeven point of $70............... B..... A 6 x 9 FRA is required. long position in a 6 x 3 FRA...............462   Study Session 17:   11.    ........... D ... short position in a 6 x 3 FRA.. He is  concerned that interest rates are going to fall and he wishes to put the money on 90‐day LIBOR on  receipt.............  An investor buys a call option at a premium of $10 on a stock which has a market price of $60... short position in a 6 x 9 FRA....        12...... He should consider taking a:  A...... loss if the stock price rises above the breakeven point of $72..

343.877.767.93 per bushel.$100  million  cash  inflow  and  it  decides  to  use  a  swap  agreement  to  gain  exposure to the market.000 bushels of wheat.  $2.232.  ABC  Asset  Management  is  running  a  fund  whose  returns  are  linked  to  the  performance  of  the  S&P  Index.123.  The trader posts an initial margin of $1.  C.000.500.  A trader sells one wheat futures contract.  It  has  a  U.        14.45 per bushel.S.  $8.  $5.  D. The payments are to be made quarterly with the first payment  on the last day in March and the payments will be based on the actual day count/365 basis.  C.100 the trader  would first receive a maintenance margin call at a wheat price closest to:  A. which is for 5.    .575.$100 million.  If the S&P Index rises by 10% in the quarter ending 31 March the first payment made by XYZ  will be closest to:    A.  $9.  B.  $4.  B.  D. at $4 per bushel.Derivative Investments   463  13. If the required maintenance margin is $1.92 per bushel.000.  $3.08 per bushel.  $11. It enters into a one‐year agreement with XYZ investment bank where XYZ  agree  to  pay  the  return  on  the  S&P  Total  Return  Index  and  ABC  will  pay  a  fixed  rate  of  5%  on  a  notional principal of U.  $5.S.

..100 the trader  would first receive a maintenance margin call at a wheat price closest to:  A.464   Study Session 17:   13. pp..... at $4 per bushel.45 per bushel... The payments are to be made quarterly with the first payment  on the last day in March and the payments will be based on the actual day count/365 basis.... LOS: Reading  72‐c  Correct Answer:  When he has made a loss of $400 he would receive a margin call.$100 million......877 XYZ pays $10......... $5...  If the S&P Index rises by 10% in the quarter ending 31 March the first payment made by XYZ will be  closest to:  A.. $11...............123 Reference: CFA® Program Curriculum...767....... which is for 5.. D...575..    14. B...232. Reference: CFA® Program Curriculum....S........ It enters into a one‐year agreement with XYZ investment bank where XYZ  agree  to  pay  the  return  on  the  S&P  Total  Return  Index  and  ABC  will  pay  a  fixed  rate  of  5%  on  a  notional principal of U.08 per bushel.000.. 55‐60. $2.. Volume 6. $4..343... LOS: Reading  74‐b  Correct Answer:  ABC will make a payment of $100m x 5% x 90/365 = $1......... $5... pp.  The trader posts an initial margin of $1.... Volume 6............877. C ..000 The net payment made by XYZ is $8. $9... C....232. $8................ C.......000....  A trader sells one wheat futures contract......$100  million  cash  inflow  and  it  decides  to  use  a  swap  agreement  to  gain  exposure to the market............. this is equivalent to a price rise of 8 cents.......93 per bushel.767.S. D. 138‐141...123..  It  has  a  U....000...... B. $3....000 bushels of wheat...500.  ABC  Asset  Management  is  running  a  fund  whose  returns  are  linked  to  the  performance  of  the  S&P  Index..    ...92 per bushel.......... since he sold the contract... B.. If the required maintenance margin is $1.

 it is impossible to terminate contracts.  A futures contract is a type of forward contract that has standardized contract terms.  Which of the following statements concerning futures and forward contracts is most accurate?  A.  B.  A forward contract is a type of futures contract that is traded on a recognized exchange.  go to the exchange and request an immediate cash settlement of the contract.  C.  Only forward contracts are guaranteed by a clearinghouse.  B.  Forward contracts tend to be more heavily regulated than futures contracts.  If  an  investor  has  taken  a  long  position  in  a  forward  contract  but  then  wishes  to  terminate  the  contract prior to expiry he can:  A.    .  do nothing.  C.Derivative Investments   465  15.  D.        16.  go back to the counterparty and take a long position in another contract with the same  expiry and underlying asset as the original contract.  take a short position in a new contract with same expiry and underlying asset as the  original contract.  D.

........ pp...... pp..... do nothing.... 33‐34....... Volume 6..... B.......        16........... C.......  Which of the following statements concerning futures and forward contracts is most accurate?  A.... Volume 6....... B................ Reference: CFA® Program Curriculum. C ...... D. C.....466   Study Session 17:   15.. D.........LOS: Reading  70‐a  Correct Answer:  A futures contract is a type of forward contract that has standardized contract terms and is traded on a regulated exchange....... it is impossible to terminate contracts... LOS: Reading  71‐b  Taking a short position will mean that they no longer have any net exposure to price movements in the underlying asset.. go to the exchange and request an immediate cash settlement of the contract. take a short position in a new contract with same expiry and underlying asset as the original contract.......... 9‐12. Reference: CFA® Program Curriculum.... A forward contract is a type of futures contract that is traded on a recognized exchange...................................... Only forward contracts are guaranteed by a clearinghouse.. go back to the counterparty and take a long position in another contract with the same expiry and underlying asset as the original contract............ Correct Answer:  C . Forward contracts tend to be more heavily regulated than futures contracts.............  If  an  investor  has  taken  a  long  position  in  a  forward  contract  but  then  wishes  to  terminate  the  contract prior to expiry he can:  A.    . A futures contract is a type of forward contract that has standardized contract terms..

  A dealer quotes on a 90‐day FRA.  a loss of $5.110 million. The payoff for the end user is closest to:  A.000.  a profit of $5.  Party X pays Yen 110 million. where the underlying is 180‐day dollar LIBOR. and Party X pays U. dollars 6 million.    .  Party X pays Yen 11.S.878.  The  U.  a loss of $4. At the end of the first year:  A.  D.000.  At expiration the rate on 180‐day LIBOR is 5%.S.  D.  a profit of $4.  Party  X  holds  U.  The  principal  is  $100  million.Derivative Investments   467  17.110 million.  Party Y pays Yen 110 million.  C.S.  C.S.878.  B. dollars 106 million.  dollars. with a notional principal of $1 million.  dollar  equals  Yen 110  when  the  agreement  is  signed and the fixed rates on U.S.  Party  Y  holds  Yen  and  wishes  to  exchange  these  for  U.S. and Party Y pays U.  Two  parties  X  and  Y  enter  into  a  ten‐year  fixed‐for‐fixed  currency  swap. dollars 6 million.S. and Party Y pays U. dollars is set at 6% and Yen at 1%.  dollars  and  wishes  to  exchange  these  for  Yen. at a rate of 4%.  Party Y pays Yen 11.  The end user takes a short position. and Party X pays U.S.  B. dollars 106 million.        18.

S...S... 40‐43..000....  dollars.. LOS: Reading  74‐b  Correct Answer:  Party X pays interest on the Yen borrowed which is: Yen 11. dollars 6 million. At the end of the first year:  A..... pp.......05(180 360 ) ⎦ Since the end user had a short position he must pay $4.. and Party Y pays U..... C.. A .S... D.000....... Volume 6.S....  Party  X  holds  U.....  At expiration the rate on 180-day LIBOR is 5%.  Party  Y  holds  Yen  and  wishes  to  exchange  these  for  U......000.. at a rate of 4%.. Party Y pays Yen 110 million. dollars is set at 6% and Yen at 1%.110 million...... Party X pays Yen 11.. D..... B........ Party Y pays Yen 11.025 ⎠ ⎣ 1 + 0..... Correct Answer:  The payoff is given by: B... Party Y pays interest on the U...000 million x 1% = Yen 110 million. where the underlying is 180‐day dollar LIBOR...  dollar  equals  Yen 110  when  the  agreement  is  signed and the fixed rates on U.468   Study Session 17:   17. with a notional principal of $1 million. and Party X pays U.878.....000.. dollars 6 million.. a loss of $4........S..... dollars 106 million..  The  U..... pp... and Party Y pays U..........110 million..05 − 0..  dollars  and  wishes  to  exchange  these  for  Yen.005 ⎞ $1.. The principals would be exchanged at the beginning of the agreement........ dollars 100 million x 6% = U.000 ⎢ ⎟ = $4.......878 to the dealer Reference: CFA® Program Curriculum. a profit of $5.000⎜ ⎝ 1.S. a profit of $4... dollars 6 million.878 ⎥ = $1.. Reference: CFA® Program Curriculum...  Two  parties  X  and  Y  enter  into  a  ten‐year  fixed‐for‐fixed  currency  swap.S.LOS: Reading  71‐g  ⎡ (0..  The end user takes a short position.S.... Party X pays Yen 110 million.04)(180 360) ⎤ ⎛ 0....      18..... 130‐134. The payoff for the end user is closest to: A... dollars borrowed which is: U......878..... C.. B.  A dealer quotes on a 90‐day FRA. Volume 6.S.. and Party X pays U.....S............... a loss of $5..S. dollars 106 million.....    ...  The  principal  is  $100  million..

Derivative Investments   469  19.  C.  D.  $14.  $6.  An investor writes a put option at a premium of $6 on a stock with an exercise price of $62.    .  D.  $8.  B.  $2.  C.  writing a put option on the stock index representing the underlying stock portfolio.  buying a call option on the stock index representing the underlying stock portfolio.  A portfolio insurance strategy for a diversified stock portfolio can be implemented by:  A.  B.  writing a covered call option on the stock index representing the underlying stock  portfolio.  buying a put option on the stock index representing the underlying stock portfolio.        20. If the  stock price is $70 at expiration the investor will make a profit of:  A.

.. B.... B.    ... $8. 154‐158... Volume 6. C....... Reference: CFA® Program Curriculum............. pp............. D........ If the  stock price is $70 at expiration the investor will make a profit of:  A. Reference: CFA® Program Curriculum. buying a call option on the stock index representing the underlying stock portfolio.......... $14.. A . so the investor makes a profit of the premium that he collected... Volume 6... LOS: Reading  75‐b  Correct Answer:  In the situation that the stock market index falls..................  An investor writes a put option at a premium of $6 on a stock with an exercise price of $62...... pp............. $6.................. B.... D...... writing a put option on the stock index representing the underlying stock portfolio.LOS: Reading  75‐a  Correct Answer:  The put option will lapse worthless since the exercise price is lower than the market price.. the losses on the underlying portfolio will be offset by the profits on the put option.. buying a put option on the stock index representing the underlying stock portfolio. writing a covered call option on the stock index representing the underlying stock portfolio........ $2.470   Study Session 17:   19...        20...............................  A portfolio insurance strategy for a diversified stock portfolio can be implemented by:  A... 162‐165................. C.

 and at the end of the second  year it is 9.  Annual  payments  will  be  made  in  arrears.  instruments available for risk management.  D.Derivative Investments   471  21.  The least likely benefit for an investor if a market includes financial derivatives is:  A.  D.5 million.  C.  B.        22.  price discovery.25%.  pays $1.  the  counterparty  agrees  to  pay  one  year  LIBOR.  The  swap  covers a  five year  period and  is  based  on  a  notional principal  of $100  million. The  one  year  LIBOR  rate at the time of agreement is 8.5 million. At the end of one year it is 9%.  receives $1.  trading efficiency.5%.  regulatory protection. The net payment that the pay‐fixed firm receives/pays at the end of the second year is:  A.  B.  A  firm  enters  into  a  plain  vanilla  interest  rate  swap  agreement  to  pay  a  fixed  rate  of  8%.    .  pays $1 million.  C.  receives $1 million.

..... Volume 6.... C ...... OTC derivatives often offer little regulatory protection. price discovery...    .. B............... Reference: CFA® Program Curriculum................... pp. 20‐22............. trading efficiency...472   Study Session 17:   21.... instruments available for risk management..... Although exchange-traded derivatives provide some regulatory protection.............. ability to hedge risk and market efficiency including low transaction costs are all benefits of derivatives. regulatory protection.. D.  The least likely benefit for an investor if a market includes financial derivatives is:  A. C....... LOS: Reading  70‐c  Correct Answer:  Price discovery.

. Reference: CFA® Program Curriculum. D... 134‐138........ pays $1.. pays $1 million.....Derivative Investments   473  22......  the  counterparty  agrees  to  pay  one  year  LIBOR. C ...... The  one  year  LIBOR  rate at the time of agreement is 8.25%..... and at the end of the second  year it is 9....  The  swap  covers a  five year  period and  is  based  on  a  notional principal  of $100  million..... The net payment that the pay‐fixed firm receives/pays at the end of the second year is:  A... Volume 6...LOS: Reading  74‐b  Correct Answer:  The payment received is $100 million x (9% ... B.....5%... receives $1....... C.... receives $1 million. pp....  Annual  payments  will  be  made  in  arrears.......8%) = $1 million......5 million.        .........5 million........ At the end of one year it is 9%....  A  firm  enters  into  a  plain  vanilla  interest  rate  swap  agreement  to  pay  a  fixed  rate  of  8%.

 closely held companies. private equity.g.  infrequent  valuations.  Although finding a single definition of an “alternative” investment is difficult. and implementation vehicles for investments in alternative assets. unique risks and opportunities associated with  them.  and  unique  legal  structures)  are  typically  associated  with  alternative investments.. distressed securities.  performance  measures for private equity and venture capital investments. certain features (e. and the relation between alternative investments and traditional investments. venture capital.       Reading 76: Alternative Investments      . differences between various hedge fund  strategies.   Each  one  of  these  categories  has  several  unique  characteristics. This study session discusses these features and how to evaluate their impact  on  expected  returns  and  investment  decisions  in  more  detail. and commodities.  hedge funds. methods for their valuation.  and  the  readings  discuss  valuation  methods  for  illiquid  assets  (such  as  direct  real  estate  or  closely  held  companies).  The  reading  provides an  overview  of  the major categories of alternative investments.  investors  are  increasingly  turning  to  alternative  investments. including real estate.  This  study  session  describes  the  common  types  of  alternative investments.  limited  liquidity.474   Study Session 18:   Study Session 18: Alternative Investments:   Due  to  diversification  benefits  and  higher  expectations  of  investment  returns.

  Entrepreneurs have strong management skills which increase the probability of  companies being successful.  B.  Investors expect to achieve higher investment returns than they receive from investing in  publicly listed securities.  first‐stage financing.  third‐stage financing.  D.  Capital provided to a company that is close to going public is:  A.  C.        .        2.Alternative Investments   475  1.  C.  Illiquidity is a feature of venture capital investment.  second‐stage financing.  D.  mezzanine financing.  Investors often need to make a long‐term commitment.  B.  Which of the following statements is the least accurate description of a characteristic of venture  capital investing?  A.

..476   Study Session 18:   1....... B.        2.. mezzanine financing.............. Investors often need to make a long-term commitment... D.... C. pp. C.. Illiquidity is a feature of venture capital investment... first-stage financing.......................... third-stage financing.......... 202‐204........    ........................ C .. Entrepreneurs have strong management skills which increase the probability of companies being successful....LOS: Reading  76‐g  Correct Answer:  Mezzanine or bridge financing is given to companies who are planning to go public in the near term......LOS: Reading  76‐g  Entrepreneurs often have weak management skills so the venture capitalist can help in providing direction and strategic guidance to the company. second-stage financing...................  Capital provided to a company that is close to going public is:  A...... Correct Answer:  C ..... Volume 6... pp.. 201‐202.. D..... Reference: CFA® Program Curriculum............ B...............  Which of the following statements is the least accurate description of a characteristic of venture  capital investing?  A. Volume 6.......... Investors expect to achieve higher investment returns than they receive from investing in publicly listed securities...... Reference: CFA® Program Curriculum..

  the shares are less liquid.  B.  a long/short fund.  One  of  the  reasons  that  the  shares  in  closely  held  companies  usually  trade  at  a  discount  to  publicly traded securities is:  A.  B.  C.  C.  investors often hold a majority stake.        4.  D.  A  hedge  fund  manager  specializes  in  taking  long  positions  in  companies  that  are  being  bid  for  and taking short positions in the acquiring company.Alternative Investments   477  3.  D.  investors often have a greater influence on the company’s management.  they have high market betas.    .  an event‐driven fund.  a futures fund.  a market‐neutral fund. He is likely to be managing a hedge fund that  is:  A.

.................. D..... investors often have a greater influence on the company’s management................ they have high market betas..... pp... Volume 6........ investors often hold a majority stake.... Reference: CFA® Program Curriculum.. pp......478   Study Session 18:   3...... C ...... in this case an acquisition. a market-neutral fund............ a long/short fund.......... He is likely to be managing a hedge fund that  is:  A..... C... so investors are compensated with a liquidity discount. A ...... LOS: Reading  76‐n  Correct Answer:  Closely held companies’ shares are often not publicly traded and lack marketability. Reference: CFA® Program Curriculum..... B....        4... LOS: Reading  76‐i  Correct Answer:  C is the best answer since the long and short positions are being taken as a result of specific events.... C.......... a futures fund... an event-driven fund.......... D.....  One  of  the  reasons  that  the  shares  in  closely  held  companies  usually  trade  at  a  discount  to  publicly traded securities is:  A.....    ..... B... 211‐213........... Volume 6.......  A  hedge  fund  manager  specializes  in  taking  long  positions  in  companies  that  are  being  bid  for  and taking short positions in the acquiring company...... 223‐224...... the shares are less liquid......

  the currency the fund is denominated in does not track the U.  D.  An investor in an Exchange Traded Fund (ETF) is exposed to tracking error risk.S.  D. this is the risk  that:  A.  The returns have low correlations with bond and equity returns.  C.  B.  the bid‐ask spread for shares in the ETF widens.  Which  of  the  following  is  the  least  accurate  description  of  a  characteristic  of  commodity  investment. based on historic data?   A.  C.Alternative Investments   479  5.    .  It offers inflation protection. dollar.  B.        6.  the fund does not closely replicate the performance of the index that it is following.  It produces attractive returns in periods of economic growth.  the ETF fails to make dividend payments to investors.  It has low volatility of returns.

.... dollar..........        6. B....... 225‐227...... the fund does not closely replicate the performance of the index that it is following... It offers inflation protection. D ..................  Which  of  the  following  is  the  least  accurate  description  of  a  characteristic  of  commodity  investment. It produces attractive returns in periods of economic growth... Reference: CFA® Program Curriculum................. D.....    ........ C..  An investor in an Exchange Traded Fund (ETF) is exposed to tracking error risk...480   Study Session 18:   5... Volume 6......... The returns have low correlations with bond and equity returns... LOS: Reading  76‐q  Correct Answer:  Historically commodities have exhibited higher volatility than equities. D.. Volume 6............ the bid-ask spread for shares in the ETF widens... LOS: Reading  76‐c  Correct Answer:  Tracking error is a measure of the deviations between ETF returns and the index returns...... C................. based on historic data?   A....... B. this is the risk  that:  A. B.......... pp................. 186‐187....... the currency the fund is denominated in does not track the U....... Reference: CFA® Program Curriculum....S....... It has low volatility of returns.. the ETF fails to make dividend payments to investors.... pp.

  B.  The potential to use hedge funds to diversify portfolios that hold other asset classes.    .  D.  D.  C.Alternative Investments   481  7.  Investors in hedge funds are least likely to be motivated by which of the following?   A.  Higher average returns provided by hedge funds compared to other investments.  Consistent returns across the different categories of hedge funds.        8.  The low volatility of returns from hedge funds compared to equity returns.  Trade sales are one of the most common methods of venture capital investors divesting  their holdings.  Trade sales are an unattractive exit strategy for most venture capitalists.  A trade sale is the first step in the public offering process.  Trade sales means that a venture capital investment is sold to another company  operating in the same industry.  Which  of  the  following  statements  regarding  trade  sales  of  venture  capital  investments  is  the  most accurate?  A.  B.  C.

............ Reference: CFA® Program Curriculum..........482   Study Session 18:   7...  Which  of  the  following  statements  regarding  trade  sales  of  venture  capital  investments  is  the  most accurate?  A.... Consistent returns across the different categories of hedge funds. fixed-income arbitrage versus global macro) have quite different performance records........... A ... C. Trade sales means that a venture capital investment is sold to another company operating in the same industry........................... A trade sale is the first step in the public offering process.... The low volatility of returns from hedge funds compared to equity returns....... C... Trade sales are one of the most common methods of venture capital investors divesting their holdings..... D.............. 217‐219........................    .............. D..... LOS: Reading  76‐i  Correct Answer:  Different types of hedge funds (e............ Reference: CFA® Program Curriculum.g. Volume 6........... p. B..LOS: Reading  76‐g  Trade sales refer to a venture capital investment being sold to or merged with another company.....  Investors in hedge funds are least likely to be motivated by which of the following?   A. Higher average returns provided by hedge funds compared to other investments... Trade sales are an unattractive exit strategy for most venture capitalists. pp.. Volume 6............ 204... B.. Correct Answer:  C .        8... The potential to use hedge funds to diversify portfolios that hold other asset classes..

  the managers are risk averse.  Which of the following is least likely to be used as a method of valuing real estate?  A.  C.  D.  B.  The prices of hedge funds are often smoothed because:  A.  D.  C.    .  they invest in over‐the‐counter instruments whose prices are based on estimates.        10.  they use arbitrage strategies.  Discounted cash flow approach.  they are actively dealing in derivative exchanges.  B.  Balance sheet approach.  Cost approach.  Income approach.Alternative Investments   483  9.

.......... they invest in over-the-counter instruments whose prices are based on estimates.. they use arbitrage strategies. they are actively dealing in derivative exchanges.......... pp..... 190‐198............. C .. 220‐221.. Volume 6.......... C...........LOS: Reading  76‐e  Correct Answer:  The methods that are covered in the text are the cost approach...............    .... Volume 6.        10.... C........... D ......... the managers are risk averse.............  Which of the following is least likely to be used as a method of valuing real estate?  A............ Cost approach....... B... Reference: CFA® Program Curriculum.. Discounted cash flow approach.. income approach and the discounted after-tax cash flow approach.....484   Study Session 18:   9.... Balance sheet approach. pp.. Reference: CFA® Program Curriculum.........  The prices of hedge funds are often smoothed because:  A.. sales comparison approach................. D...... B........... Income approach. D... LOS: Reading  76‐l  Correct Answer:  Over the counter instruments do not have market prices and the estimated values are often less volatile than exchange-traded instruments.

  D.    .  track the return from the stock market index.  B.  B.  C.  D.  The objective of a stock market index fund is to:   A.  generate a return which is independent of the stock market return.Alternative Investments   485  11.  outperform the return from the stock market index.  C.  purchase shares at the net asset value plus an initial charge.  purchase shares at a discount to the net asset value.  pay an annual management charge which is called a load.        12.   generate a return which is higher then the CPI index by investing in equities.  purchase shares at the net asset value.  Investors in a load open‐end fund:  A.

.. Reference: CFA® Program Curriculum.LOS: Reading  76‐a  Correct Answer:  An open-end investment company continues to buy and sell shares after the initial offering.................... B..... B.. pp. C.......... purchase shares at the net asset value. generate a return which is higher then the CPI index by investing in equities.... 180. A . Volume 6.. D.....  The objective of a stock market index fund is to:   A. Reference: CFA® Program Curriculum.......... perhaps by owning all the shares in the index with the same weighting as their representation in the index...486   Study Session 18:   11.    .        12............. pay an annual management charge which is called a load................... purchase shares at the net asset value plus an initial charge.... D ... purchase shares at a discount to the net asset value............... p........... 177‐180. D. generate a return which is independent of the stock market return..................... A managed or load fund is when the offering price is the NAV plus an initial charge called a front-end load. outperform the return from the stock market index.. Volume 6. track the return from the stock market index............ C........... LOS: Reading  76‐b  Correct Answer:  The objective of an index fund is to perform in line with a specified index.................  Investors in a load open‐end fund:  A.......

  Second‐stage financing.Alternative Investments   487  13.  Which  stage  of  venture  capital  financing  is  when  capital  is  provided  for  product  development  and research?  A.  Start‐up financing.  D.  Market capitalization rate  Valuation          lower    lower     higher    higher             lower  higher  lower  higher  Seed financing.    .  B.  A  property  which  is  considered  a  lower  risk  investment  than  another  property  investment.  First‐stage financing.  C.  assuming they both generate the same net operating income.  C.  D. will be likely to have a:    A.        14.  B.

. a low risk project will tend to have a low capitalization rate and therefore..  A  property  which  is  considered  a  lower  risk  investment  than  another  property  investment..............        14.................. D............ Seed financing. Second-stage financing........... C... a higher value. 193‐194...... Reference: CFA® Program Curriculum. pp.... First-stage financing.. will be likely to have a:  A....LOS: Reading  76‐g  Correct Answer:  Seed financing is the first stage of venture capital investing............ 201‐202........ C........ for equal net operating income......... pp.... Volume 6.......    ... Volume 6. B.... Market capitalization rate lower lower higher higher Valuation lower higher lower higher Correct Answer:  B..................488   Study Session 18:   13.  Which  stage  of  venture  capital  financing  is  when  capital  is  provided  for  product  development  and research?  A.... LOS: Reading  76‐f  The market capitalization rate reflects the investors’ required rate of return from the property........  assuming they both generate the same net operating income...... D...... A ....... Start-up financing...... Reference: CFA® Program Curriculum.. The product is still at the ‘idea’ stage.... for product development and market research.............. B.

  Investing in a hedge fund is least likely to be attractive because:  A.  B.    .Alternative Investments   489  15.  C.        16.  The after‐tax cash flow from a real estate investment adjusts the net operating income for all of  the following except:  A.  the fund will provide greater transparency than a traditional mutual fund.  the volatility of returns is lower than that of a fund investing in equities.  proceeds from sale of property.  cost of debt.  B.   D.  taxation on capital gains when the property is sold.  C.  the returns are higher than those available on equity funds.  depreciation expense less tax savings.  D.   the return from the fund is likely to have a low correlation with listed stocks and bonds.

....    ... depreciation expense less tax savings.....        16. B.. 193‐198.......... pp........... cost of debt.. The legal structure gives the fund managers not only the freedom to implement a variety of strategies but there are less stringent disclosure requirements than for traditional funds.......... LOS: Reading  76‐f  Correct Answer:  The net operating income (NOI) is before depreciation. proceeds from sale of property.....S.... C.... C ......... pp......... LOS: Reading  76‐j  Correct Answer:  The most common legal structure is limited partnership (in the U...... although the tax saving is included in the calculation...... Lack of transparency of hedge funds can be a major drawback for investors.. C..... the volatility of returns is lower than that of a fund investing in equities............. the fund will provide greater transparency than a traditional mutual fund........ B. 207‐210..... the return from the fund is likely to have a low correlation with listed stocks and bonds.................... the returns are higher than those available on equity funds......... Volume 6....... so no adjustment is made for the depreciation... Reference: CFA® Program Curriculum..... D.. and depreciation is a non-cash item....) or an offshore corporation......  The after‐tax cash flow from a real estate investment adjusts the net operating income for all of  the following except:  A.....  Investing in a hedge fund is least likely to be attractive because:  A.........490   Study Session 18:   15...... D..... taxation on capital gains when the property is sold.. Volume 6... C .. Reference: CFA® Program Curriculum..

  The role of venture capital investors is least likely to include:  A.S.  providing financing to small privately held companies. and internationally.  D. and internationally.  assisting companies to go public.  C.  D.S.  In the U. global funds refer to funds that:  A.    .  are only marketed outside the U.  making a market in the shares of their investments that have gone public.        18.S.   only invest outside the U.  B.  C.Alternative Investments   491  17.  invest in both the U.  are marketed in both the U.  assisting the companies that they invest in with strategic planning.  B.S.S.

.. 177...... and internationally. LOS: Reading  76‐b  Correct Answer:  ‘Global funds’ refer to funds that are investing in both the U....... p........ C. only invest outside the U.... are only marketed outside the U. and internationally..................S. C..... D...S. D ...... B.. invest in both the U.. providing financing to small privately held companies...... global funds refer to funds that:  A.S.  In the U......S.. pp..... are marketed in both the U..S..... 200‐202....LOS: Reading  76‐g  Correct Answer:  The role of venture capitalists is not just to provide finance but to also work with the management team to develop and expand the business.....    .....        18..... assisting the companies that they invest in with strategic planning..... D.............. C .. making a market in the shares of their investments that have gone public...... Volume 6..........  The role of venture capital investors is least likely to include:  A. Reference: CFA® Program Curriculum... B................492   Study Session 18:   17....... and international markets..... They would not normally be specialists or market makers.............. This would usually include assisting with a company going public as venture capitalists have experience dealing with underwriters and other financial institutions... Volume 6...........S..... assisting companies to go public. Reference: CFA® Program Curriculum..

50%  What would be the return for each of the classes of shares if an investor invests $1 for a period  of five years.  Fund A  32.  D.01%    .75%  0.30%  1.Alternative Investments   493  19.  B. the fees are shown in the table below:      Front‐end fees  Redemption fees  Annual expenses            Distribution fees  Management fees  Other expenses  Class A  4%  None    0.  C.46%  33.88%  37.08%  33.30%  0. assuming the fund grows by 8% annually?    A.08%            Fund B  34.20%  1.00%  0.24%  34.  A mutual fund has issued two classes of shares.20%  1.25%  Class B  None  5% in the first year but declining  by 1% point each year thereafter    0.88%  36. Each class holds the same underlying portfolio of  securities but the expense structures differ.46%  32.

...  A mutual fund has issued two classes of shares...08)5 x (1 – 0......LOS: Reading  76‐a    .30%  0... 33...20%  1.  $0...08)5 x (1 – 0.. the fees are shown in the table below:    Front‐end fees  Redemption fees  Annual expenses          Distribution fees  Management fees  Other expenses  Class A  4%  None    0.00%  0... pp.30%  1.. assuming the fund grows by 8% annually? Fund A Fund B A..88% B...08% 34...24%.......25%  Class B  None  5% in the first year but declining  by 1% point each year thereafter    0.......46% 36....494   Study Session 18:   19.. or a return of 32. 32..20%  1.. 33.. 32.... Each class holds the same underlying portfolio of  securities but the expense structures differ. or a return of 36.08% 37. 178‐180.   At the end of five years.....015)5 = $1.3246...    Reference: CFA® Program Curriculum....96 from the $1 will be available to invest....3624............46% 34...50%  What would be the return for each of the classes of shares if an investor invests $1 for a period of five years... $1 invested in the fund will be worth       Fund B:    At the end of 5 years..24% C.0125)5 = $1.75%  0..88% D.96 x (1..46%.... Volume 6...01% Correct Answer:  Fund A:   Due to the front‐end fee of 4%...  B.... $1 invested in the funds will be worth     $1 x (1.. only $0...

89%  8.75%  0.  D.25%  Class B  None  5% in the first year but declining  by 1% point each year thereafter    0.30%  0.19%  9.64%  8.  A mutual fund has issued two classes of shares.00%  0.  B.  C.30%  1. the fees are shown in the table below:      Front‐end fees  Redemption fees  Annual expenses            Distribution fees  Management fees  Other expenses  Class A  4%  None    0.Alternative Investments   495  20.40%            Fund B  8.19%  9.  Fund A  9.20%  1. Each class holds the same underlying portfolio of  securities but the expense structures differ.50%  What would be the return for each of the classes of shares if an investor invests $1 and redeems  his shares after two years.20%  1.40%  9.77%    .64%  9. assuming the fund grows by 8% annually?    A.

08)2 x (1 – 0....  $0..40% 8. 9.......50%  What would be the return for each of the classes of shares if an investor invests $1 and redeems his shares after two years...... pp...08)2 x (1 – 0.e... 9.20%  1..... i.75%  0..04) = $1.........19%.. Each class holds the same underlying portfolio of  securities but the expense structures differ.20%  1.... the fees are shown in the table below:    Front‐end fees  Redemption fees  Annual expenses          Distribution fees  Management fees  Other expenses  Class A  4%  None    0.40% 9..64%. Volume 6. 9......19% 8..... assuming the fund grows by 8% annually? Fund A Fund B A........64% B......LOS: Reading  76‐a    ...0125)2 = $1.....19% 8. 178‐180....   The investment in the fund after two years will be worth     $1 x (1.. 9... or a return of 9. so the investment in the fund after two years will be worth       Fund B:   After two years the redemption fee will be 4%..015)2 x (1 ‐ 0.. a decline of 1% point from 5%.0864 or a return of 8..0919........30%  0.64% D..89% C...25%  Class B  None  5% in the first year but declining  by 1% point each year thereafter    0.30%  1.496   Study Session 18:   20..96 x (1..    Reference: CFA® Program Curriculum...  A .  A mutual fund has issued two classes of shares.00%  0..77% Correct Answer:  Fund A:   There is no redemption fee..

40  2  0.000.    .  $710.20  5  0.  $346.Alternative Investments   497  21.000.  The  probability is based on the condition that the project has survived the previous year.000.  An  investor  is  looking  at  investing  $1  million  in  a  project.000.  $1.  $690.000.  $159.000  5%  $80.000  $60.  and  the  following  information has been collected.25  4  0.20  The expected net present value (NPV) of the project is closest to  A.400.35  3  0.  B. The figures are on an annual basis.   $620. However there is a  significant  risk  of  failure  and  the  probability  of  failure  in  any  year  is  given  in  the  table  below.      22.  $972.  Gross potential rental income   Estimated vacancy and collection losses  Insurance and taxes  Utilities  Repairs and maintenance  Depreciation  Interest on proposed financing    The net operating income (NOI) per annum is closest to  A.  $870.  D.  where  the  expected  payout  is  $10  million at the end of five years.400.  B.000  Year  Probability of failure  1  0.000  $70. The investor’s cost of equity for the project is 10%.  C.  $780.400.  An  investor  is  considering  purchasing  an  office  building  as  an  investment.000  $90.  D.000.  C.000  $30.

.000...000) ‐ $80.000.000 – (0.000 ‐ $60. LOS: Reading  76‐f  = gross potential rental income minus expenses = $1... D....000......  An  investor  is  considering  purchasing  an  office  building  as  an  investment.000  $90..... 193‐194..000  $30.... $780..000  $60.............000  Note the expenses for this calculation do not include depreciation (it is assumed that repairs will maintain the building in good condition indefinitely) and interest expense....  Gross potential rental income   Estimated vacancy and collection losses  Insurance and taxes  Utilities  Repairs and maintenance  Depreciation  Interest on proposed financing  $1... $710.. C....... Correct Answer:  NOI   D ....... pp..000.000. B... Volume 6..... $690..000 ‐ $30. $620.....000.000  The net operating income (NOI) per annum is closest to A.000  $70....000  5%  $80. The figures are on an annual basis.000    = $780...498   Study Session 18:   21.05 x $1......  and  the  following  information has been collected............. Reference: CFA® Program Curriculum.    ....000.

.187($5.25  4  0.... which is: (1 – 0. 205‐207...      ..  The  probability is based on the condition that the project has survived the previous year... $870...20) = 18. The investor’s cost of equity for the project is 10%... 1  0........  Year  Probability of failure  A..813(– $1 million) = $159. D..  where  the  expected  payout  is  $10  million at the end of five years.....25) (1 – 0....400... However there is a  significant  risk  of  failure  and  the  probability  of  failure  in  any  year  is  given  in  the  table  below..40) (1 – 0.. $972.......2 million    If the project fails the present value is: – $1 million..Alternative Investments   499  22.35) (1 – 0.......000. pp..... Volume 6.....    The expected NPV:    0. B..  An  investor  is  looking  at  investing  $1  million  in  a  project...400.20) (1 – 0.10)5 ‐ $1 million = $5..7%    If the project survives the present value is: $10 million/(1..2 million) + 0.... $159..LOS: Reading  76‐h  The probability that the project survives throughout the five years is given by the product of the individual probabilities it survives each year......400...... C...40  2  0....35  3  0.. $346...20  The expected net present value (NPV) of the project is closest to  Correct Answer:  A....20  5  0.....400    Reference: CFA® Program Curriculum..

500   Study Session 18:   2008 JUNE EXAM 15 February 2008   Second deadline for new CFA Program enrollments and exam registrations to be  received by CFA Institute   March 2008   Online sample exams available   17 March 2008   Final  deadline  for  new  CFA  Program  enrollments  and  exam  registrations  to  be  received by CFA Institute   17 March 2008   Final  deadline  for  disability  accommodation  requests  and  requests  for  religious  alternative dates to be received by CFA Institute   17 March 2008   Late April 2008   7 June 2008   June‐July 2008   Late July 2008   All test center change requests must be received by CFA Institute   Exam admission tickets available online   Exam date   and   8 June 2008   Exams graded   Exam results available online for Level I candidates   Exam date in Eastern Asia and Oceania  Late August 2008   Exam results available online for Level II and III candidates  2008 DECEMBER EXAM 17 March 2008   First  deadline  for  new  CFA  Program  enrollments  and  exam  registrations  to  be  received by CFA Institute   15 August 2008   Second deadline for new CFA Program enrollments and exam registrations to be  received by CFA Institute   15 September 2008  Final  deadline  for  new  CFA  Program  enrollments  and  exam  registrations  to  be  received by CFA Institute   15 September 2008  Final  deadline  for  disability  accommodation  requests  and  requests  for  religious  alternative dates to be received by CFA Institute   15 September 2008  All test center change requests must be received by CFA Institute   October 2008   Online sample exams available   Late October 2008   Exam admission tickets available online   6 December 2008   Exam date    and   7 December 2008        Exam date in Eastern Asia and Oceania  December 2008   January 2009   Exams graded   Exam results available online     .

 the  product is still at the ‘idea’ stage.  Leveraged buyouts (LBOs) – capital to fund a management group (a management buyout) or other  investors who wish to purchase a business or company.  Mutual fund – an open‐end investment company.  Load fund – a fund that makes an initial sales charge.  Investment company – a company that sell its own shares and uses the proceeds to buy stocks.  Mezzanine (or bridge) financing – venture capital provided for a company that expects to go public  in the near future.Terminology   501  Terminology: Appraisal – for real estate. bonds  or other financial instruments.  First‐stage financing – venture capital provided for initial commercial manufacture and sales.   Turnarounds  – capital provided to restructure a company that has problems.  Open‐end investment company – a company that offers new shares to investors and redeems shares  continuously. at the most.  Positive leverage – the return from a real estate investment is higher than the cost of debt. so the offering price is the net asset value plus  a load.  Real Estate Investment Trust (REIT) – a closed‐end investment company that invests in real estate  and mortgages on real estate. an investor  will achieve a higher rate of return if he/she uses leverage to purchase the property.  Market capitalization rate – divide a property’s net operating income by the appropriate market  capitalization rate to arrive at an estimate for its current market value.  No‐load fund – shares are sold at net asset value.  Income approach – the value of real estate is the present value of it future income.  It reflects the rate of return  required by investors in such a property. with no sales charge added. the process of estimating the current market value of a property. the  shares are then traded in the secondary market.  Seed financing – venture capital provided for product development and market research.  Real Estate Limited Partnership (RELP) – a real estate syndicate that invests in different types of real  estate.  Start‐up financing – venture capital provided for early stage product development and initial  marketing.      .  Closed‐end investment company – an investment company that issues a fixed number of shares. the cost of the land and  constructing the building at current prices.  Comparative sales approach – the value of a real estate is .

aspx   Thank you for reading our book     .502   Exhibit  FREE Author Collaberation: With the purchase of this book you also receive the following communications free! Now that you have purchased this product you have access to the Instructors/Authors that authored  this book.financialexams.         This is a free Feature for CFA Candidates of all levels.com/ContentPages/DrHarvey/tabid/71/D efault. http://www.  Send you questions to us and we will answer them for you.

Appendix A: 503 Appendix A: Exhibits Exhibit 1: Accounting Statements Exhibit 2: Puts and Calls Exhibit 3: PE Breakdown Exhibit 4: Ratios .

.Interest EBT . to pay bills..504 Exhibit Exhibit 1: Accounting Statements Income Stmt: Particular moment in the life of an asset Convert assets into profit to return to Inv or Stkhldrs Equity Income Statement Sales Balance Sheet Assets Profit Stk Eqty Investors Decisions Income Statement Assets come into Balance Sheet in SE to get to Assets Statement of Cash Flows Balance Sheet CFO Sales .Tax EAT Operating CA AR Inv FA CL AP CFI Investment Financing CFF LTD SE Inventory stored converted to product CEOs look at things from viewpoint of Cash Flow . Operation Cycle Sale CEO is always for looking something which will grow cash. Boeing could take years . Cash Collection Newspaper cycles daily.COGS Gross Margin Expenses EBIT . liquidity Acquire Inventory and A growing company never has cash enough collection to grow the inventory.

Appendix A: 505 Notes: .

Loss on the call is the amount the stock is over the call + strike. long put. Profit > X Profit Rec’d fm C 0 Loss 0 Loss X X+C stock price X X+P stock price Profit the short put is the amount more than the strike of the put. not to exceed the proceeds received from the put. long put and short put strategies. Short put will never have a value greater than zero. not to exceed the cost of the call. V<0 Value of the short call will be the amount over the strike the stock is trading. Profit < X+C Profit Rec’d fm C Short Put Profit of the short call is the amount under the strike + cost of the call (X+C). 0 cost of C 0 cost of P Loss Loss X X+C stock price X X+P stock price Short Call Loss > X+C. not to exceed the cost of the put. Profit Loss < X+P. S = Stock price. Short call will never have a value greater than zero. and short put strategies. Loss on the call is the amount the stock is under the call + strike. Profit < X Profit the long put is the amount under the strike and cost of the put. Long call will never have a value less than zero. Profit > X+C Profit Profit of the long call is the amount over the strike + cost of the call (X+C). S X Short Call Value Positive X S Short Put Value V<0 Value of the short put will be the amount less than the strike the stock is trading. not to exceed the proceeds received from the call. Long put will never have a value less than zero. Positive 0 negative 0 negative S X X S Interpret the profit/loss diagrams for the long call. (X = strike price. Long Call Long Put Loss < C. Loss > X. short call. Loss on the put is the amount the stock is over the strike. short call. C = cost of Call. Loss on the put is the amount the stock is less than the strike. .506 Exhibit Exhibit 2: Puts and Calls Interpret the diagrams that depict the expiration-day values of the long call. Long Put Value V>0 positive 0 negative 0 X negative Value of the long put will be the amount less than the strike that the stock is trading. P = cost of Put) Long Call Value Positive V>0 Value of the long call will be the amount over strike the stock is trading.

Appendix A: 507 Notes: .

Interest EBT .COGS Gross Margin .Expenses EBIT .508 Exhibit Exhibit 3: PE Breakdown Note: 3 Stage ROE Profit Margin * Total Asset Turnover * Financial Leverage NI * Sales * Total Assets Sales Total Assets Equity Editor’s Review: Income Statement Sales .Taxes EAT Bank happy What mgmt shareholders Gov’t happy Stockholders happy earns for (mgmt hides it’s perks if EAT is OK) .

Rf) β is # units of risk in the stock Stockholders want and pay for k.PriceNow PriceNow * Financial Leverage EBIT * Sls * Sls Assets Assets Equity Oper Total -Interest Financial * Tax Profit * Asset Expense * Leverage Retention Margin Turnover Rate Multiplier Rate EBIT * Sls Assets Int Equity Good f * Assets * (1 - Assets Note: tax ret (1-t) Bad side side P0 = D 1 k-g restate: k= D +g P = k = Rf + β(Rm .I ] (1-t) pending ratio Depr Inter tax sales per shr Exp adj (Retention) (ROE) k = Real Rate + Interest Prem + Risk Prem Tax * Interest * Oper’g * Asset Nominal rate should really multiply Reten Burden Profit Turnover Rate Margin k = Rf + β(Rm .Appendix A: 509 EAT = EBT .Rf) also k = (1+RR)(1+IP)(1+RP) real infl risk should be in equilibrium . k determines the P NI * EBT * EBT EBIT P0 = D 1 k-g WACC = (weke) + (wdkd) P0 = D 1 k-g T) Sls ReturnEstimated = Cash Div + PriceEnd .EBT(t) EAT = EBT(1-t) Expected EPS = Expected Sales/share We know last year’s P & P/E Can calc next year’s earnings then Proportion via P/E to get Pproj EOY Pproj EOY = (EProj EOY) (P/E) Earnings.D . DDM & ROE Calc P = Div / Earn E k–g Dividend pay-out k-g * Expected Net profit Margin Income Stmt: Next year’s projected [ (S) (EBDIT) .

inventory a.510 Exhibit Exhibit 4: Ratios calculate the financial ratios in each major category of analysis and discuss the uses of those ratios. structure of firm’s financial statements Internal Liquidity (Solvency): ability of firm to meet future short term obligations. compare near term obligations with current assets or cash flows Current Ratio: Current Assets Current Liabilities Quick ratio Acid Test Cash ratio Cash + mkt sec + AR CL CA .a. Common Size Statements: B/S in percent of Total Assets. I/S in percent of Sales Quickly compare two different size firms.CL not include.k. Quick Ratio Receivables Turnover Days Receivable Working Cap / Sales Avg collection: Net Annual Sales Avg Receivables 365 Avg Receivables Avg # of days to get paid higher % indicates more liquidity CA .Inv CL Cash + mkt sec CL even more conservative 365 Annual Turnover Working Capital = CA .CL Net Sales @ payable period: 365 Payables Turnover COGS @ AP (do they pay their bills) Annual Turnover Operating Performance: Operating Efficiency Ratios: Activity ratios: Inventory Turnover Turnover Total Asset Turnover Fixed Asset Turnover high or low relative to industry? Net Sales @ Tot Net Assets low: tie up too much assets utilization of fixed assets Net Sales @ Net Fixed Assets hi: old depr equipment How well management is operating the business How management uses its assets and capital sales per something @ Inventory period COGS @ Inventory 365 Inventory . same firm trends over time.

Pref. EBIT. % return on capital (How good is mgmt turning profits into sales) Note: Run down Income Statement and ratio to Sales (GP.COGS) relative cost price position in industry? (EBIT) variability is business risk indicator NI = EAT before tax profit margin Net Income – Preferred Dividend @ Common Equity DuPont System duPont formulation ROE = NI / Equity or EAT/Equity . C Stock Average Total Capital return on all capital (GP = Sls . EBT. Stock. EAT) EBIT: Mgmt earns Tax: Interest: EBT: Gross Profit Margin Operating Profit Margin Net Profit Margin EBT Margin Government earns Banker’s earn Stockholder’s earn Gross Profit Net Sales Operating Profit Net Sales Net Income Net Sales EBT Net Sales Common Size Income Statement lists all expense and income items as a % of sales (Inc Stmt: / Sls) (Bal: / Sls or Tot Assets) Return on Total Capital employed Return on Total Equity Return on Owners Equity Return on Equity (ROE): Net Income @ Total Equity ROE Net Income + Interest Expense Debt.Appendix A: 511 Equity Turnover excludes CL & LT Debt Net Sales Average Equity Avg collection period: Net Annual Sales Avg Receivables 365 Annual Turnover Receivables Turnover Operating Profitability: rate of profit on sales.

D/E = ½ (not D/E=1/3. easy mistake in a hurry) LTD = Long Term Debt LT Cap = Long Term Capital LTD / LT Cap Total Debt / Total Capital Interest Coverage NI + Tax + Int Exp EBIT Interest Expense Int Exp (Note: Look for this on the exam Cash Flow / LTD Cash Flow / Total Debt . firm value = 3.Equity Multiplier Profit Turnover Leverage Margin NI Sls * Sls Assets * Assets Equity Note:(Sls)(Assets) (Sls)(Assets) 4 Step ROE = NI = Tax Equity * Interest * Oper’g * Asset * Financial Reten Burden Profit Turnover Leverage NI * EBT EBT * EBIT EBIT Sls * Sls Assets * Assets Equity 5 Step Equation = Oper * Total Profit Margin EBIT Sls * Interest Financial * Tax Asset Expense * Leverage Turnover Rate Multiplier Sls Assets Int Assets * Assets Equity * Retention Rate (1 .512 Exhibit 3 Step ROE = NI = Net Equity * Asset * Financial a.a.T) Financial Risk: Uncertainty of returns to equity holders due to a firm’s use of fixed obligation debt securities Debt / Equity remember firm value is Db + Eq Db=1. Eq=2.k.

Appendix A: 513 Growth Analysis Retention rate earnings retained / total earnings (remember: growth = retention rate * ROE) ROE Total Asset Turnover Total Assets / Equity Net Profit Margin Sustainable growth rate see above. production methods Business Risk Coefficient of variation of operating income CV = σ/mean Standard Deviation of Operating Earnings (OE) Mean Operating Earnings Sales Volatility sd of sales mean sales need 5<Thru> 10 yrs to compute coef of variation Coefficient of Variation of Sales CV = σ/mean prime determinant of earnings variability Operating Leverage %∆OE / %∆Sls or Σ | [%∆OE] / [%∆Sls] | / N employment of fixed production costs direction of change not important. customers. calc from #’s not % . but relative size of the change is relevant OL = % change in operating earnings / % change in sales . operational performance note component of ROE see above. profitability see above. profitability g = retention * ROE retention rate = 1 – (Oper Inc after taxes) Risk Analysis: uncertainty of income flows for the total firm and for sources of capital Business Risk: Uncertainty of income caused by a firm’s industry Variability of sales due to products.

..............................................518 Changing the subcategories......523 Export your notes.................................................................................................521 Take the Simulated Exam .............................................................................................................................................................................................................................................................................................................................................................522 FlashCard Option ......................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................521 Simulated Exam ............................................................................................519 Reviewing an Adaptive Exam........................................................................................................................521 Checking your performance ...........517 Changing subjects ......................517 Telephone:........................................519 Take the Adaptive Exam ................................................................523 How to use a FlashCards ................................518 Using FinancialExams Quizzer options ..........523 Taking Notes ..............................................................................................................................................................................................................................................................................................................................................................................514 Practice Exam Features FinancialExam Features Using FinancialExams Quizzer In Brief ....516 FinancialExams Quizzer Features ...............523 Take notes from a study session.................................518 Printing questions ......................................521 Reviewing a Simulated Exam.....................................517 Online Help .....................................................................................................................................................................518 Setting up your printer ...........................................................................................................................................................................................517 Email:.........................................................................................................................................520 Starting a Study Session ....519 The Adaptive Exam .......................................................518 Changing the number of questions...................................................................................................................................................................................................................515 Study Session............................................................................................523 .....................................514 Practice Exams..................................................................520 Checking your score during a test ...............................................................................521 Checking your overall progress .............522 Starting a FlashCard Session.............................................519 How to take advantage of Adaptive testing: .........................................................

But now. you have no choices. it will force you to continually face them until you can demonstrate mastery over them. It has helped thousands of people achieve their certification goals. During this process. That’s right… two more times. Don’t be too disappointed if you don’t pass the first time. It can do the same for you. Keep in mind that any question answered incorrectly will be in the very next Study Session you take on that topic. achieve a minimum of 90% and 95% respectfully on each pass through before taking the Simulated Exam. Select the Category and Subcategories that you will be focusing on. 5) Take the Simulated Exam. The software is in control. Then it will find something else to haunt you with. The better you know the material. Once you are able to answer it correctly. To use this software successfully. that’s okay. The software has been gaining knowledge about your weaknesses and has just done everything in its power to make you fail this exam. . Do not clear the history again until all of the following steps have been completed. Once this software determines just what those weaknesses are. You will find that the number of Study Sessions and the amount of time necessary to achieve these scores will get smaller. the quicker the whole process becomes. 1) Spend some time getting familiar with the program. b) Achieve a minimum score of at least 85% on each and every subcategory topic before moving on to the Simulated Exam.) 3) After the four Adaptive Exams. correctly answered questions will begin to reappear. Aren’t you glad that wasn’t the real thing? 6) Clear your history and repeat the above steps two more times. If you want to bounce around a little between subcategories a little. Let this be your guide as to which subcategories to begin studying. When you have cycled through available questions. a) See and answer every question on that topic at least once. Spend some time getting to know this program. look at your Historical Analysis (the button is on the main screen). follow these simple steps. The program will remember where you left off. 4) Begin taking Study Sessions on selected topics. Start with your weakest and work your way up. (Note: You don’t have to take all four at one sitting. 2) Take four (4) Adaptive Exams. This will give you a graphical presentation of how you have done cumulatively in each category. clear the history (the button is on the main screen). You have two primary goals in Study Session mode. However. The rest of this document goes into more detail on using specific features of the FinancialExams Quizzer software. It is using its internal logic to determine your strengths and weaknesses on a topic-by-topic basis. it’s important that you don’t cheat yourself on this step.Practice Exam Features 515 Using FinancialExams Quizzer In Brief The FinancialExams Quizzer exam software is designed to identify your personal areas of weakness relative to passing specific exam objectives. When you’re ready to settle down to work. it will get shuffled to the bottom of the deck.

After you finish an exam. identify a resource. link to an available electronic book and view an explanation for the answer. The Simulated Exam is a timed test that presents a similar number of questions as the real exam. display the correct answer. In addition. FinancialExams Quizzer displays your score and the passing score required for the FinancialExams Quizzer test. The Adaptive Exam presents a fixed number questions with a maximum time allotment. questions you have answered correctly are not repeated until you have answered all the new questions. you can track your progress by displaying the number of questions you have answered with the Historical Analysis option. You may display the exam results of this specific exam from this menu. You may review each question. Study Session questions are selected from a single database for each session. Questions are chosen at random from the database. You can reset the progress tracking by clicking on the Clear History button. Questions that you have missed previously will reappear in later sessions and keep coming back to haunt you until you get the question correct. . A break from testing occurs at the mid-point of the exam. Practice Exams FinancialExams Quizzer also provides Adaptive and Simulated certification exams. In this way. You will start to memorize the correct answer that goes with the question concept. Each time a question is presented the answers are randomized so you will not memorize a pattern or letter that goes with the question. The Adaptive Exam is most helpful in identifying areas of weakness in the candidate’s knowledge of the exam objectives. dependent on the subcategory selected and the number of times each question has been previously answered correctly.516 Practice Exam Features Study Session FinancialExams Quizzer tests your knowledge as you learn about new subjects through interactive quiz sessions.

select Contents from the Help pull-down menu. 12. Easy to install Multiple choice Style questions Fill-in-the-blank Style questions Flash Card Style questions Hot Spot Style questions Drag/Drop/Mix/Match questions Answers randomized Print one question Cheat key or Flash Card option Instant question feedback Adaptive exam studies Skills assessment Historical analysis Resizable screen Most have Explanations References Statistical analysis Individual exam analysis Font selection Graphics User Notes creation Some Links to Electronic Book content 31. Each database contains 200 to 1200+ questions 3. 26. 21. 6.com CustomerService@BFQPress.com Telephone: Toll Free: International: Fax: (888) 992-3131 (281) 992-3131 (281) 482-5390 . 19. 16. 8. 25. 22. 9. 17. 27. 7.Practice Exam Features 517 FinancialExams Quizzer Features 1. 24. 28. 4. 11. 30. Easy to upgrade 5. 15. 14. 29. 32. Free version updates via email Online Help This manual installs on your PC along with the FinancialExams Quizzer. Additional help can be obtained via: Email: Support@BFQPress.com AskTheExpert@BFQPress. 20. 13. 18. To access it. 23. 10. Essay style questions Performance based questions Questions randomized Print a category of questions Single module studies Simulation exam studies Instant exam feedback 2.

Select Options from the View pull-down menu. Printing questions FinancialExams Quizzer allows you to print questions from your tests. Select the options for your printer. Setting up your printer FinancialExams Quizzer allows you to customize your print jobs. Changing the number of questions You can choose the number of questions presented in each quiz session. . To change exams: 1. Type a number of questions. 3. Select the Printing Options radial button. To select multiple subcategories. Select the exam for the test you want to run from the Select Exam window. in the Number of Questions field. You can take a test on any one or any combination of the subcategories. 1. select the desired general category from the Categories drop down list. To change the number of questions: 1. select the desired print option from the File pull-down menu in the Question window. hold down the CTRL key while clicking items in the list box. with or without the correct answer(s) marked. 2. Click the Change Exam button in the Main window. Click OK to change to the selected exam. 3. 2. between 1 and 250. Changing the subcategories Each FinancialExams Quizzer subject has a number of categories and subcategories. 2. The Printing Options window appears. 2. 4.518 Practice Exam Features Changing subjects FinancialExams Quizzer provides several practice exams to test your knowledge. all that are available will be displayed. 1. 3. Click on the box to the right of the Number of Questions field in the Main window. From the Subcategories frame. If the number of questions selected exceeds the number available in the chosen subcategory. To print the question(s). Click OK to exit and save changes. Select the desired subcategory from the list box. or the Cancel to keep the current exam.

There may be more than one correct answer. The following options are available: 1 2 3 4 Stop On Wrong Answers Enable Cheat Key Resizable Screen Font Setting To select an advanced option. The Adaptive Exam window appears. you should take the Adaptive exams. Clear the Historical Analysis Take four (4) adaptive exams in a row. your exam automatically ends. Go back to reviewing using the Study Sessions by Sub Category Repeat process until you are ready to pass the real exam. The Exam Preferences window appears. Before using Adaptive testing. Click the Start button. 4. View the historical analysis to identify your strength and weakness at the end of the four (4) adaptive exams. 2. 4. How to take advantage of Adaptive testing: 1. Click the Adaptive Exam radial button from the Main window. select Options from the View pull-down menu. 3. Before you learn about your subject using the Quizzer Study Sessions. This exam style does not simulate all of the exam environments that are found on certification exams. . You have a time limit in which to complete the adaptive exam. When the time limit has been reached. 5. This time varies from subject to subject. Click the circle to the left of the correct answer.Practice Exam Features 519 Using FinancialExams Quizzer options FinancialExams Quizzer provides a number of additional options to customize your test. Take the Adaptive Exam 1. Click the Next button to continue. 2. Adaptive Exam Adaptive testing is a time saving option used to identify the candidate’s strengths and weaknesses. clear historical Analysis. 3. You cannot choose specific subcategories for the Adaptive exam and once a question has been answered you cannot go back to a previous question. Study the contents after each adaptive exam. Text in the bottom left corner of the window instructs you to Choose the Best Answer (if there is only one answer) or Mark All Correct Answers (if there is more than one correct answer). although it is usually 15 to 25 questions in 30 minutes.

If you did not answer the question correctly. your answers. To see your answer. Starting a Study Session After you choose a subcategory to test yourself on. 3. To quit the test at any time. FinancialExams Quizzer displays your score and the passing score required for the test. If you have selected the Prompt on Wrong Answers option. Click the Correct Answer button. Reviewing an Adaptive Exam After you have taken an Adaptive exam. View the Explanation option To quit the test at any time. you can select Study Session from the Start pull-down menu. click the Try Again button. 3. 2. you may try to guess again or move to the next question. 1. you have the following choices: 1. Text in the bottom left corner of the window instructs you to Choose the Best Answer (if there is only one answer) or Mark All Correct Answers (if there is more than one correct answer). you can review the questions. click the Finish button. and the correct answers. 2. 2. Click the Next button to continue. Click the checkbox to the left of the correct answer. If you answered the question correctly.520 Practice Exam Features After the allotted time has elapsed. View the correct answer 4. Optionally. start the Study Session. FinancialExams Quizzer provides immediate feedback on your answer at the bottom of the window. and view an explanation for the answer (if available). . There may be more than one correct answer. To try again. You may only review your questions immediately after completing an Adaptive exam. To move to the next question after an incorrect guess. Click the Start button. click the Your Answer button. display the correct answer. click the Finish button. the exam exits to review mode. Display your exam results by selecting Details You may review each question. The Question window appears. To review your questions: 1. To start a study session: Select the Study Session radial button. click the Next Question button. a new question appears. After you have completed the Adaptive exam.

Practice Exam Features 521 Checking your score during a test The X% button displays the current percentage of questions that have been answered correctly. 1. 2. You have a fixed limit equal to that of the real exam to complete the Simulated Exam. Checking your performance Click the QID button. The number of times you have answered questions in that category correctly as a percentage of the total number of questions is displayed. 3. The Simulated Exam window appears. Take the Simulated Exam 1. To get detailed information on your performance on any subject. Click the X% button. There may be more than one correct answer. Checking your overall progress 1. Click the Start button. The Historical Analysis window appears. 2. click and hold the progress bar for that subject. you can take a simulated exam. FinancialExams Quizzer displays your progress in each test using a graphical progress bar. You cannot choose subcategories for a Simulated Exam. This exam simulates the exam environment that might be found on a certification exam. Click the circle to the left of the correct answer. When this time limit has been reached. Hold the cursor over the progress bar and a dialog box will open. your exam automatically ends. Click the Simulated Exam radial button from the Main window. Click OK to return to the test. A window appears displaying the number of questions that have been asked and the number of questions that have been answered correctly. Simulated Exam After you have learned about your subject using the Study Sessions. Click the Historical Analysis button from the Main window. FinancialExams Quizzer displays the performance details in the bottom left hand corner of the screen. A window appears. 3. 2. Text in the bottom left corner of the window instructs you to Choose the Best Answer (if there is only one answer) or Mark All Correct Answers (if there is more than one correct answer). . displaying the number of times you have been asked this question and the number of times you have answered this question correctly.

Display your exam results by selecting Details. and view an explanation for the answer (if available). 4. click the Finish button. 2. 4. To see your answer. The FlashCard option can be used as a review of all questions in the database. Use the FlashCard option to provide Positive Feed Back with Correct Answers. You have an unlimited time limit to think about each question. You should not view the answer until you have thought about the answer. Adaptive. FlashCard Option After you have learned about your subject using the Study Sessions. To quit the test at any time. To review which questions you have marked. . 1. you can review the questions. The Flash Card Option is very effect when used with Terminology or Glossary “Fill-in-the-Blank” style questions. and which you have not answered. your answers. Read the displayed question. and the correct answers. The FlashCard environment is very different and will help you more that you might believe on a certification exam. which you have answered. and Simulated exam go to the Thinking Option. After you have completed the Simulated Exam. click the Your Answer button. 2. Reviewing a Simulated Exam After you have taken a simulated exam. After the allotted time for testing. Hit the F4 Function key to display the correct answer. Click the Next button to continue. display the correct answer. Use this option a few days before the real exam to go through a lot of questions in a short period of time. You may only review your questions immediately after a Simulated Exam. 5. Think of the answer. check the Mark box in the upper left hand corner. 5. FinancialExams Quizzer displays your score and the passing score required for the test. the exam exits to review mode. Go to the next question. click the Review button.522 Practice Exam Features If you are unsure of the answer and wish to mark the question so you can return to it later. 3. You may review each question. Click the Correct Answer button. Read the Answer. To review your questions: 1.

Click OK to keep the note. Optionally. Think of the answer 3. Go to the next question. Click the Start button. Select the FlashCards Session radial button. you can select FlashCards Session from the Start pull-down menu. Pause a moment than hit the F4 function on your keyboard. Take notes from a study session Create your own information or reference. The notes will be permanently stored in the database for the subject you are studying. start FlashCards. Note: Some questions may ask for more than one answer: Bypass questions that state "Which of the Following" and "Select all that apply" etc. Did you get it correct? When you are ready to proceed Click the Next button to continue. you can export your notes to a standard text editor. 1. you may wish to write down notes about a particular question that you can use in later Study Sessions. (CheatKey) Review the displayed answer. The Question window appears. Click the Notes button from the Question window. Read the Answer 5. 3. 3. 2. How to use a FlashCards 1. . or Cancel to delete the note. Type your note. 1. If you would like to print or view your notes. To quit the test at any time.Practice Exam Features 523 Starting a FlashCard Session After you choose a subcategory to test yourself on. This is the time to THINK of the answer. Hit the F4 Function key to display the correct answer 4. FinancialExams Quizzer allows you to enter notes about each question. Note: You cannot take notes during a Simulated or Adaptive session until you have finished the exam and have entered the Review mode. 5. 4. Export your notes Click the Notes button from the Main window and export to Note Pad or any text editor you wish to use. You will find no answers to check or any visible area to type your answer into. click the Finish button. Taking Notes While you are taking your exam. Read the displayed question 2. You can also use this feature to record any comments you have about a particular question and send it in for review. 2.

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