JUN18L1/S02AM

ETHICS

Question 1
Giles Stafford, CFA, is the chief investment officer of a small investment management firm in a country that already
has strict regulations on the way that performance is reported. In most cases the regulations are stricter than the
Global Investment Performance Standards (GIPS®), and he decides that since he is complying with the local
regulations he will claim GIPS compliance. Which of the following statements best describes the situation?
a) As long as the local regulations are generally stricter, satisfying the local
regulations is sufficient to claim GIPS compliance.
b) Stafford must ensure that all the requirements of GIPS are followed before his firm
can claim compliance. If there are differences between the local laws and the GIPS,
the differences must be disclosed.
c) If the country where Stafford is working cannot be persuaded to use the GIPS as its
national standard for presenting performance, then a firm operating in that country
cannot claim GIPS compliance.
Stafford must meet the local laws and regulations but must make full disclosure of the conflict in the compliant
presentation.

Question 2
ABC Investment Managers decides to calculate and present performance in compliance with GIPS. Which of the
following is most accurate?
a) ABC Investment Managers must wait five years before they can claim GIPS
compliance and in the meantime build up five years of compliant data.
b) ABC Investment Managers may present noncompliant data for the past five years
as long as they disclose that it is noncompliant and all future data is compliant with
GIPS.
c) ABC Investment Managers must present five years' historic data (or data from
inception of the firm or composites if their existence is less than five years) that is
compliant with GIPS.
Five years of compliant data must be presented. Each subsequent year ABC must add compliant data until they have
built up to providing 10 years' data.

Question 3
Thomas Jewitt, CFA, works for MidWest Brokerage, a firm that specializes in providing brokerage services to private
clients. Occasionally he refers his clients to MidWest's personal financial planning department, a subsidiary of
MidWest brokerage, for which he receives referral fees. He does not disclose this arrangement to his clients. Which of
the following statementsbest describes Jewitt's actions?
a) Jewitt has violated the CFA Institute Standards because he has not disclosed the
arrangement to his clients.
b) Jewitt is in compliance with the CFA Institute Standards because this is an internal
arrangement within MidWest.
c) Jewitt has violated the CFA Institute Standards; under the Standards, he is not
permitted to receive fees for internal referrals.
Jewitt has violated Standard VI(C) since the Standard does not distinguish between third-party and internal
arrangements. All referral fees are permitted but must be disclosed to clients. Even though it is not a regular
occurrence he still needs to disclose the arrangement to his clients at the time of referral.

Question 4
Valery de Picarde, CFA, is the director of a major Karamba-owned investment management firm's branch in Indopulo.
Karamba is known as the world's center of investment management with securities laws stricter than the CFA Institute
Code and Standards. In Indopulo, an emerging market, the local securities laws and regulations are embryonic. They
are very vague regarding the definition of insider trading and have no provision regulating soft dollars. De Picarde's
client is a citizen of Karamba but residing in and doing business in Indopulo. The client and de Picarde's business
dealings are under the jurisdiction of the laws of Indopulo.
Which is the most appropriate action for de Picarde to follow when dealing with this client?
a) De Picarde should follow the laws of Karamba since they are stricter that the laws
of Indopulo.
b) De Picarde does not need to comply with the laws of Karamba since the client is
not resident there, and can therefore take full advantage of soft-dollars
arrangements but not insider trading opportunities.
 c) As a CFA Institute member, de Picarde must comply with the CFA Institute Code
and Standards regarding insider trading and soft dollars, as they are stricter than
the laws of Indopulo.
According to Standard I(A) the rule of thumb is that members must comply with the stricter of the applicable laws (in
this case Indopulo's laws) and the Code of Standards.

Question 5
James Richards, CFA, who is a quantitative analyst at Chelsea Investments, a money management firm, has recently
been working on a quantitative risk management model for a convertible arbitrage strategy. Richards recently
attended a CFA Institute conference where he learned that High Finance, a competing investment advisory firm, is
also developing a similar model but approaching it from a different angle. He did not agree with the main assumptions
of the High Finance model although he admitted that its new methodology is innovative. Upon returning to his office,
Richards adopted High Finance's quantitative techniques but kept the original assumptions from his model. The
results are promising, and Jane Seamore, the CEO of Chelsea Investments, is pleased with Richards's research. She
appears in public seminars to present the new methodology and to win client mandates. Which of the following
complies with the CFA Institute Standards?
a) Richards or Seamore must credit High Finance for having developed the model.
b) Richards should not have misappropriated the quantitative techniques from High
Finance.
c) Seamore does not need to refer to either Richards or High Finance developing the
model in an oral presentation.
Standard I(C): Misrepresentation says Richards or Seamore must acknowledge the original source of the quantitative
techniques, although Richards can take credit for the final results. Richards is employed by Chelsea Investments;
therefore, the intellectual property of research work generally belongs to the employer, unless specified differently.

Question 6
Which of the following is most likely to influence whether an investment professional acts ethically?
a) Their character
b) Their work environment
c) Their home environment
Research has shown that situational influences often lead so-called good people to behave unethically. Situational
influences include the work environment and the culture of the employer.

Question 7
Which of the following actions is least likely to support an information barrier (firewall)?
a) Limit the number of people in the firm who have access to material nonpublic
information.
b) Place securities on a restricted list when the firm has access to material nonpublic
information.
c) Limit the number of major institutional clients who regularly receive “special
investment tips” prior to information being made public.
Firewalls are intended to block the dissemination of material nonpublic information. Choice C is still dissemination and
therefore in violation of Standard II(A).

Question 8
William Johnson, CFA, is a stock analyst covering the oil sector. Through his contacts in the oil industry, he has
accumulated and analyzed several pieces of nonpublic information. Although none of the information is material,
Johnson reached the conclusion that one of the companies he covers has discovered a new oil field, which will
probably have a major impact on future earnings. According to the CFA Institute Standards, Johnson:
a) Should urge the oil company to make the information public immediately.
b) Is allowed to use the information to make investment recommendations and
decisions.
c) Is not allowed to make investment recommendations or take actions based on this
information.
Each individual piece of information is nonmaterial so Johnson does not violate the Code and Standards; his action is
permissible under the “mosaic” theory.

Question 9
David Lovell, CFA, is a fund manager with BL Partners, which is an institutional fund management firm and does not
manage private client portfolios. Outside office hours, Lovell provides investment advice to a number of friends for
which Lovell is paid an advisory fee. The arrangement has been in place for several years. According to the CFA
Institute Standards:
 a) Lovell is prohibited from providing investment advice independently of the business
of his employer.
b) Lovell may continue with the arrangement as long as he does not recommend the
same stock to his friends as he purchases for clients of BL Partners.
c) Lovell is free to provide advice as along as he has provided details of the
arrangement to BL Partners and they have given consent to the arrangement.
Members are permitted to conduct independent activity, but they must provide details of the activity to their employer
and receive their consent.

Question 10
Which of the following concepts does the CFA Institute Code of Ethics not include?
a) Competence
b) Independent judgment
c) Verification of investment performance
Verification of investment performance is not covered in the CFA Institute Code of Ethics. It is recommended when a
firm claims compliance with GIPS.

Question 11
John Jameson, CFA, includes the following in his resume, “I passed each of the CFA exams at the first attempt, and
this success shows my superior analytical skills.” Jameson:
a) Is in compliance with the CFA Institute Standards.
b) Violates the CFA Institute Standards since he should not link the CFA exams to
claiming superior analytical skills.
c) Violates the CFA Institute Standards since he should not refer to the CFA exams
and can only state that he is a CFA charterholder.
Jameson is free to say he passed each exam at the first attempt (if it is true), but he should not use this to “over-
promise” his individual competency.

Question 12
Alan Duff, CFA, is a stock analyst with Grit and Sand securities broker. He has been concerned about the recent
financial situation of Liverpool Corporation and is about to write a report with a “sell” recommendation. While working
on his report, his wife, who happens to be looking for a new job, is called by her employment agency informing her
that Liverpool Corporation is interested in meeting her for a job interview the following day. She is excited by the
prospect of working for Liverpool Corporation but after discussing Liverpool Corporation with her husband she is
anxious to find out more about the financial stability of the company. Duff delays finalizing the report until after his
wife's interview in case she finds out any new information about the company's prospects. The following week he
issues a “buy” recommendation and revises the revenue, profit, and cash flow projections using some of the nonpublic
information that Mrs. Duff obtained in the interview process, which is based on an optimistic economic scenario.
Which of the following CFA Institute Standards is Duff least likely to violate?
a) Loyalty
b) Independence and Objectivity
c) Material Nonpublic Information
Duff has compromised his independence and objectivity in making the buy recommendation; using optimistic
economic scenarios as a basis for the recommendation does not suggest diligence and a reasonable basis. He has
also made use of the nonpublic information provided by his wife. Choice A is the best answer.

Question 13
Lee Min Chu is a senior partner of a small brokerage firm, Golden Sun Securities, which recently participated in a
large convertible bond offering. The offering company has been given a poor recommendation by the research
department in the past two quarters partly due to increasing competition. Anticipating a low level of interest from
Golden Sun's clients, Lee immediately calls his senior analyst, Jane Kwok, CFA, and instructs her to be more
optimistic with her recommendation because Golden Sun must offload its substantial participation in the offering.
Kwok is promised an increase in bonus for this recommendation upgrade. Kwok comes up with a more favorable
recommendation by revising some of the assumptions she made earlier.
Which of the following statements is most accurate?
a) Kwok is in compliance with the CFA Institute Standards.
b) Kwok violates the CFA Institute Standards because she did not maintain her independence and objectivity.
c) Kwok violates the CFA Institute Standards because she used material nonpublic information about the
convertible bond offering.
The best answer is B. Kwok does not maintain her independence when she is persuaded by Lee to change her
recommendation.
Question 14
Fiona Bergkamp, CFA, is an equity sales manager at an overseas branch of London-based Arval Securities. The
office is located in an emerging market. Initial public offerings (IPOs) are often heavily oversubscribed and Bergkamp
applies for shares for her own and clients' accounts and then allocates any shares received in the offering between
her own and client accounts on a pro rata basis. Which of the following best describes Bergkamp's action?
a) Bergkamp is violating Standard VI(B): Priority of Transactions.
b) Bergkamp is complying with the CFA Institute Code and Standards.
c) Bergkamp is violating Standard V(B): Communication with Clients and Prospective
Clients.
Bergkamp is in violation as Standard VI (B) since she should put her clients' interests ahead of her own. Ideally, she
should not apply for IPOs for her personal account.

Question 15
The CFA Institute Standards specify that when investment transactions are concerned:
a) Members' families who are clients must be treated separately from other clients.
b) Members should not invest in securities owned by clients to avoid conflicts of
interest.
c) Members must always put their clients' and employer's interests before their own
interests.
Clients' and employer's interests must always come first. However, family members who are also clients should be
given the same treatment as other clients. Members are permitted to make investments in securities held by clients
(although IPOs and private equity investment can create conflicts).

Question 16
Peter Amir, CFA, is managing a small-cap German equity fund and he has decided to sell the holding in Mercury
Trading. The low liquidity of Mercury Trading's shares means that selling the fund's shares is likely to drive down the
share price. He decides to sell his personal position ahead of the sale of the fund's shares. Amir is least likely to have
violated which of the following CFA Institute Standards?
a) Standard II(B): Market Manipulation
b) Standard VI(B): Priority of Transactions
c) Standard II(A): Material Nonpublic Information
Clients should come first and the fund's transaction should be executed first so Standard VI(B): Priority of
Transactions has been violated.
Also, Amir dealt on material nonpublic information for his own account since he knew the fund's sale order would
move the share price, so Standard II(A): Material Nonpublic Information has been violated.
Standard II(B): Market Manipulation has not been violated. The intention of the sale orders was not to manipulate
market prices.

Question 17
Joseph Marlot, CFA, is a research analyst covering ABC Foods Corporation. His wife has a sizeable holding in ABC
Foods shares. Marlot:
a) Must sell the shares immediately.
b) Must disclose the ownership of the shares by a member of his immediate family.
c) Does not need to disclose the ownership since it is his wife, not Marlot himself, who
owns the shares in ABC Foods.
he share ownership could reasonably be expected to affect Marlot's ability to make unbiased and objective
recommendations, and therefore it should be disclosed.

Question 18
Jeremy Horton, CFA, works in a small investment firm that specializes in managing portfolios investing in the
European equity markets. For discretionary clients who require exposure to non-European markets Horton relies on
an independent investment firm to research and make recommendations on which stocks to buy and sell. Which of the
following is the most accurate?
a) Horton has violated the CFA Institute Standards; he is plagiarizing the investment
firm's research by using it for his own clients' accounts.
b) Horton has violated the CFA Institute Standards by not doing his own research and
investigation into investments in the non-European markets.
c) Horton has not violated any of the CFA Institute Standards as long as he makes
reasonable efforts to check that the investment firm's research is objective and
sound.
Choice A is not accurate. Using a third party's research is plagiarism only if he repeats their research or
recommendations without attributing it to the other firm.
Horton is free to use third-party research if he has a reasonable basis for assuming the research is sound, so C is
correct.

QUANTITATIVE METHODS

Question 19
We are given the following data on a frequency distribution:
Interval Frequency
0 up to 10 5
10 up to 20 8
20 up to 30 10
30 up to 40 3
Which of the following statements is least accurate?
a) The relative frequency of the first class is 0.19.
b) The intervals will not include outlying observations.
c) The cumulative relative frequency of the second class is 0.50.
All observations will be included in one of the intervals, so B is not a correct statement. The relative frequency of the
first class is 5/26 = 0.19, the cumulative frequency of the second class is (5 + 8) / 26 = 0.5.

Question 20
An analyst is looking at the returns from two funds and calculates that Fund A has an average return of 10% per
annum with a standard deviation of returns of 12%. Fund B has an average return of 14% per annum with a standard
deviation of returns of 20%. The average risk-free rate was 5% per annum. Which of the following statements
is most accurate?
a) The returns from Fund B are both absolutely and relatively more disperse than Fund A's.
b) Fund A's returns are relatively less disperse than B's and Fund A has a more attractive Sharpe ratio.
c) The coefficient of variation of Fund A's returns is higher than Fund B's, although the Sharpe ratio is lower.
The coefficient of variation of A is 12% / 10% = 1.2, B = 20% / 14% = 1.4, so B's returns are both absolutely and
relatively more dispersed than A's.
The Sharpe ratio of A is (10% – 5%)/12% = 0.42, and of B is (14% – 5%) / 20% = 0.45. B has a better risk-adjusted
performance.

Question 21
Which of the following statements is the most accurate?
a) A Type II error is rejecting the null hypothesis when it is true.
b) The alternate hypothesis should always contain the equal sign.
c) The level of significance is the probability of rejecting the null hypothesis when it is true.
A Type I error is rejecting the null hypothesis when it is true. The null hypothesis should always contain the equal sign.
Choice C is correct.

Question 22
The change in polarity principle indicates that:
a) Once a resistance level on a chart has been broken it then becomes a support level.
b) After a double bottom has been formed on a chart the price is expected to move into an uptrend.
c) When a short-term moving average crosses a long-term moving average it indicates a new price
trend has been established.
The change in polarity principle is concerned with support and resistance levels and states that once a support level
has been breached it becomes a resistance level and vice versa.

Question 23
In hypothesis testing a p-value of 0.1 indicates that:
a) There is extremely strong evidence that H0 should be rejected.
b) There is a probability of 0.1 of observing a sample value at least as extreme as the value observed,
assuming H0 is correct.
c) There is a probability of 0.1 of observing a sample value at least as extreme as the value observed,
assuming H0 is rejected.
The p-value is the probability of observing a value as extreme or more extreme than the value observed, for it to be
extremely strong evidence it would need to be 0.001 or less.

Question 24
A normal distribution has a mean of 7 and a variance of 3. The z-value, or standardized normal random variable, of an
observation of 8 is closest to:
a) 0.33.
b) 0.58.
c) 1.73.
z = (X – u) / σ = (8 – 7) / 1.73 = 0.58; that is, this is the number of standard deviations of an observation above or
below the mean.

Question 25
Interest is compounded quarterly and $1.0 million is invested today and will be worth $1.2 million in one year's time.
The stated annual interest rate is closest to:
a) 17.82%.
b) 18.64%.
c) 20.00%.
If the stated annual rate is r and the number of periods is 4.

Question 26
You are analyzing the monthly returns from a fund over the last year and calculate that the mean return was 1.25%
with a sample standard deviation of 1.0%. You expected the fund to have achieved a return of 1.4% 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%. Given that t0.05,11 = 1.796 you can conclude that the null hypothesis is:
a) Not rejected and the results are consistent with a mean of 1.4%.
b) Rejected and the results are not consistent with a mean of 1.4%.
c) Not rejected and the results are not consistent with a mean of 1.4%.
Set the null hypothesis as H0: μ = 1.4%. We should apply the t-test because it is a small sample.

This is within the confidence interval, so the null hypothesis is not rejected and the results are consistent, with the
mean return being 1.4%.

Question 27
A portfolio increases in value from $10 million to $12 million over the first year. 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. The annualized money-
weighted and time-weighted rates of return are closestto (respectively):
a) 12.8%, 13.4%.
b) 12.8%, 22.5%.
c) 13.4%, 22.5%.
The money-weighted return is calculated by solving 10+2/(1+R)=15/(1+R)2
So, R = 12.8%.
The annualized time-weighted return is the geometric average of the returns in each period. The return in the first year
is ($12m - $10 m)/$10m = 20.00%
The return in the second year is ($15 million – $14 million) / $14 million = 7.14%
(1.20)(1.0714) = (1+r)2 so r=13.39%

Question 28
The forecast rate of return for a portfolio has the following probability distribution:
Rate of return Probability
–10.0% 0.10
0.0% 0.25
+10.5% 0.50
+25.0% 0.15
The variance of the rate of return is closest to:
a) 0.0095.
b) 0.0760.
 c) 0.0974.
The mean is:

The variance is:

Question 29
There is a 30% chance of a company's share price falling on any given day, and the chance of whether it falls or not is
assumed to be the same each day and independent of the previous day's performance. The probability, over four
days, of it falling on exactly one day is closest to:
a) 10.3%.
b) 25.0%.
c) 41.2%.
Apply the binomial probability distribution where we are solving for P(1).

Question 30
A Treasury bill has 170 days to maturity and is selling at $97,000 with a face value of $100,000. The bank discount
yield is closest to:
a) 1.42%.
b) 6.35%.
c) 6.55%.
The yield on a bank discount basis is given by:

Question 31
The following data are given on the number of shares whose share price rose over one month:
Share Price Rose Over One Month Share Price Fell Over One Month
Nonfinancial sector shares 38 24
Financial sector shares 10 12
What is the probability of randomly selecting a financial sector share that rose over the month?
a) 11.9%
b) 22.6%
c) 37.5%
The Rule of Multiplication for events, A and B, that are not mutually exclusive, is:

where A indicates a financial sector share and B indicates the share price rose.

Question 32
The standard deviation of a population is 25 and the size of a sample taken from the population is 40. The standard
error of the sample mean is closest to:
a) 0.253.
b) 0.625.
c) 3.956.

where σ is the population standard deviation and n is the sample size.

ECONOMICS
Question 33
If the market demand function for goods is given by QD = 35 – P, the consumer surplus when the price is 15
is closest to:
a) 200.
b) 360.
c) 400.
When P is 15, the quantity is 35 – 15 = 20
When Q is 0, P = 35
The consumer surplus is the area of the triangle bounded by P = 15 to 35 and Q = 0 to 20. Area = ½(base × height) =
½(20 × 20) = 200.

Question 34
A firm that is operating in monopolistic competition will make:
a) Economic profits in the short and long run.
b) Either economic profits or losses in the short run and economic profits in the long
run.
c) Either economic profits or losses in the short run and zero economic profit in the
long run.
Since monopolistic competition has low barriers to entry, if a firm is making economic profits, new competitors will
enter the market, which will drive prices down. Similarly, if firms are making economic losses, it will lead to firms
dropping out of the market and prices increasing until economic losses are eliminated. In both cases, firms will make
zero economic profit in the long run.

Question 35
Which of the following is an automatic stabilizer in terms of stimulating demand in a recession?
a) Progressive income tax
b) Increase in national defense spending
c) Increase in government infrastructure spending
Automatic stabilizers stimulate demand during a recession and restrain demand during an inflationary boom without
the government needing to change fiscal policy using legislation. Progressive income tax payments will fall in a
recession, which will help stabilize the economy.

Question 36
One-year interest rates are 2% in the United States and are 1% in Japan, and the spot rate of yen/US$ = 115. If there
is no arbitrage opportunity, the one-year yen/US$ forward rate is closestto:
a) 112.75.
b) 113.88.
c) 116.14.
There would be an arbitrage opportunity unless:

or yen113.875 = US$1.

Question 37
If the price elasticity of demand for a product is inelastic, it means that:
a) An increase in price does not lead to a reduction in the amount purchased.
b) Price and total expenditures on the product will move in the same direction.
c) A percent increase in price leads to a larger percent reduction in the amount purchased.
If sales are inelastic, the percent change in sales is less than the percent change in price, so the price change will
have a greater impact on total expenditures than the quantity change. This means that the price and total
expenditures on the product will move in the same direction.

Question 38
A country is an importer of goods with an elasticity of 0.4 (in the domestic market) and exporter of goods with an
elasticity of 0.5 (in the overseas market). If the country trade is balanced, a depreciation of its currency will tend to:
a) Leave the trade in balance.
b) Move the trade balance to deficit.
c) Move the trade balance to surplus.
If trade is balanced, we can apply the classic Marshall-Lern*er condition to check that the sum of the elasticities is
greater than one. Since 0.5 + 0.4 < 1, a depreciation of the currency will move the trade balance into deficit; the
increase in exports is insufficient to offset the increase in imports.

Question 39
If the central bank buys $1 million of securities from commercial banks and the money multiplier is 4, then the increase
in quantity of money is:
a) $0.25 million.
b) $1 million.
c) $4 million.
The increase in quantity of money is simply the money multiplier × the increased reserves (4 × $1million) that are now
available for lending.

Question 40
When a central bank lowers its official interest rate in response to a slowdown in gross domestic product (GDP)
growth, the expected impact will be to:
a) Increase aggregate demand and increase inflation.
b) Reduce the supply of loanable funds and increase inflation.
c) Increase the quantity of money and strengthen the domestic currency.
The first impact of a central bank lowering the official interest rate will be to reduce other short-term interest rates and
increase the quantity of money. In time, aggregate demand increases and inflation picks up, so A is the correct
answer.

Question 41
The following data has been provided regarding the output per worker in Nation A and Nation B:
Output per Worker per Day
Clothing Electronics
A 1 2
B 2 3
It is assumed that other production costs are constant in each country and transportation costs are low.
Which of the following statements is most accurate?
a) Both countries will gain if Nation A focuses on the production of clothing and Nation
B on the production of electronics.
b) Both countries will gain if Nation A focuses on the production of electronics and
Nation B on the production of clothing.
c) Only Nation B can gain from trade between the two countries because it is a lower-
cost producer of both clothing and electronics.
Although Nation B has the absolute advantage in the production of both products (i.e., it can produce both products
more cheaply in terms of man-hours), Nation A has a comparative advantage in the production of electronics. If Nation
A switched its workers to producing electronics and Nation B switched its workers to producing clothing, there would
be an expansion in total output and both countries would gain.

Question 42
Which of the following is the least accurate description of behavior in an oligopoly?
a) There are high barriers to entry protecting members of an oligopoly.
b) Advertising to promote brand names is not worthwhile in an oligopoly.
c) Firms are motivated to form cartels, which can generate economic profits for the participants.
Firms in an oligopoly will still advertise to win market share from their competitors.

Question 43
When a domestic currency depreciates, a direct exchange rate quote will:
a) Increase.
b) Decrease.
c) Not change.
The direct quote expresses the foreign currency as the base currency, so if the domestic currency depreciates, the
foreign currency will buy more of the domestic currency and the rate will increase.

Question 44
A company owns a piece of machinery and the fixed cost associated with the machine is $100,000 per year. Variable
costs associated with using the machine are $300,000 per year, and the annual revenue generated from using the
machine is $325,000 per year. The machine has no alternative use so the company should:
a) Stop using the machine since it is running at a loss.
b) Continue to operate the machine in the short and long term.
c) Continue to operate the machine in the short but not the long term.
Revenue is more than variable costs, but less than variable plus fixed costs. In the short term continue to use the
machine, but in the long term stop using the machine.

FINANCIAL REPORTING & ANALYSIS

Question 45
If a company has a very high net fixed asset turnover compared to its competitors, this could be explained by the fact
that the company:
a) Is using older, and in many cases fully depreciated, machinery.
b) Has bought a large amount of new machinery to support future growth.
c) Uses capital leases rather than operating leases for all of its machinery.

Choice B is not correct since it would imply that too many assets are being used for sales generated.
Choice C is not correct since it would imply that the asset value was potentially higher than its competitors.

Question 46
A company had 500,000 common shares and $3 million of a 6% convertible bond issue, which was outstanding
throughout the last accounting period. The convertible bond is convertible into 20 shares per $1,000. If the company's
net income was $5 million and the tax rate was 30%, the diluted earnings per share were closest to:
a) $8.93.
b) $9.15.
c) $10.25.
Diluted earnings per share

If no dilution, earnings per share would be $10.

Question 47
Under International Financial Reporting Standards (IFRS), interest paid and interest received by a company can be
classified as which types of cash flow?
Interest Paid Interest Received
A. Operating only Operating or financing
B. Operating or financing Operating or investing
C. Operating or financing Operating or financing
a) A
b) B
c) C
Under U.S. generally accepted accounting principles (GAAP), interest items must be classified as operating cash
flows, but under IFRS, interest paid can be classified as operating or financing; interest received can be classified as
operating or investing cash flows.

Question 48
If a company declares and pays a dividend of $10 million and pays interest of $25 million, it will, under U.S. GAAP:
a) Decrease the financing cash flow by $35 million.
b) Decrease the investing cash flow by $10 million and decrease the financing cash flow by $25 million.
c) Decrease the financing cash flow by $10 million and decrease the operating cash flow by $25 million.
Payment of dividends is included in financing cash flow. Interest payments are an operating cash flow.

Question 49
Restructuring costs would normally be classified under U.S. GAAP as:
a) An operating expense.
b) An extraordinary item.
c) An unusual or infrequent item.
Restructuring costs are usually classified as nonrecurring items but are part of a company's continuing operations.
Extraordinary items must be both unusual in nature and infrequent in occurrence, so it would normally be classified as
an unusual and infrequent item.

Question 50
A firm is using the percentage-of-completion method rather than the completed contract method to account for a major
construction project it is working on. Until the contract is completed, what impact will this have on its financial
statements?
a) Increase liabilities
b) Reduce total assets
c) Increase stockholders' equity
The percentage-of-completion method recognizes revenues and costs in proportion to the percentage of work
completed. Income is higher throughout the project, and liabilities will be lower as income is a larger offsetting item.

Question 51
Walton Publishing Inc. uses U.S. GAAP and has announced the following financial data:
$ million
Cash payment for salaries 30
Rent expense 6
Purchase of equipment 10
Repurchase of common stock 12
Cash collection from customers 85
Cash payment to suppliers 40
Depreciation expense 10
Sale of land 6
Cash flows from operating and investing activities are:
a) $9 million from operating, ($4 million) from investing.
b) $19 million from operating, ($4 million) from investing.
c) $19 million from operating, ($10 million) from investing.

$ million
Cash Flow from Operating Activities 85
Cash collection from customers (40)
Cash payment to suppliers (30)
Cash payment for salaries (6)
Rent expense 9
$ million
Cash flow from investing activities (10)
Purchase of equipment 6
Sale of land (4)

Question 52
Which of the following would be least likely to be included in the Statement of Changes in Shareholders' Equity?
a) Interest paid
b) Dividend declared
c) Conversion of convertible bonds
The statement of changes in shareholders' equity reflects changes in a company's net assets; this includes
comprehensive income and capital transactions with the owners. Interest paid is a cash flow, and would not be
reported as part of the statement of changes in shareholders' equity.

Question 53
A retailer and a property developer both purchase pieces of land. This is likely to be classified as which type of activity
by each company?
 Retailer Property Developer
A. Investing Investing
B. Investing Operating
C. Operating Investing
a) A
b) B
c) C
For most firms the purchase of land is an investing activity, but in the case of the property developer, this is likely to
have been purchased for development and resale to customers, so it is an operating activity.

Question 54
Under U.S. GAAP, when available-for-sale securities are owned by a company, an unrealized gain is:
Income Statement Balance Sheet
A. Recognized Recognized
B. Not recognized Recognized
C. Not recognized Not recognized
a) A
b) B
c) C
The unrealized gain is not recognized on the income statement but is recognized in shareholders' equity on the
balance sheet.

Question 55
If a company makes write-downs due to impairments of long-lived assets, this will:
Cash from Operations Total Asset Turnover
A. Decrease Increase
B. No change Decrease
C. No change Increase
a) A
b) B
c) C
Impairment is a noncash item so it will not affect cash from operations. Impairment write-downs will lead to reduction
in asset values and therefore an increase in the total asset turnover.

Question 56
A company enters into a lease agreement to make lease payments of $5,000 at the end of each year for the next
three years. It is treated as a finance lease and the discount rate used is 8%. The asset is depreciated using the
straight-line method. The principal repayment in the first year will be closest to:
a) $1,031.
b) $3,800.
c) $3,969.
The present value of the lease is $12,885.
The interest expense in the first year will be 8% of $12,885 which is $1,031.
Deduct this from the lease payment of $5,000 to arrive at the principal repayment of $3,969.
Depreciation is only included if calculating the total expense.

Question 57
Which of the following would be a warning sign that a company is adopting aggressive revenue recognition methods?
a) A decrease in asset turnover
b) A decrease in receivables turnover
c) A decrease in days of sales outstanding
A decrease in receivables turnover suggests that revenues are being recorded prematurely (or are fictitious). A
decrease in asset turnover indicates a fall in sales as proportion of assets and a decrease in days of sales outstanding
indicates customers are paying more promptly; neither directly indicates aggressive revenue recognition.

Question 58
Under U.S. GAAP, companies:
 a) Recognize only net liabilities associated with defined-benefit pension schemes on their balance sheet.
b) Recognize net liabilities or assets associated with defined-benefit pension schemes on their balance sheet.
c) Do not recognize net liabilities associated with defined-benefit pension schemes if the pensions are funded
through a separate legal entity.
Liabilities, or assets, are recognized on the balance sheet.

Question 59
A firm reported a decline in deferred tax liabilities. This could be the result of:
a) An increase in the tax rate.
b) A slowdown in the firm's capital spending program.
c) An increase in provisions for doubtful debts not recognized for tax purposes.
Increasing the tax rate will increase deferred tax items so A is not correct. An increase in provision for doubtful debts
would increase deferred tax assets so C is not correct. A slowdown in capital spending (impacting depreciation) could
explain a decline in deferred tax liabilities.

Question 60
A company builds new operating facilities and pays for the construction with new borrowings. Under U.S. accounting
rules the firm should usually:
a) Capitalize the interest costs of the new borrowing.
b) Expense the interest costs associated with the borrowing.
c) Expense or capitalize the costs associated with the new borrowing depending on
the company's internal policy.
When specific borrowing can be identified to pay for the building work, then the interest costs of that borrowing are
usually capitalized.

Question 61
A company buys a piece of machinery for $100,000, and it estimates the life of the machine to be four years after
which it will have a salvage value of $10,000. Using the double-declining-balance method of depreciation what will be
the depreciation charge in the fourth year?
a) $2,500
b) $5,625
c) $6,250
Depreciation expense will be:
Year 1 ½ × ($100,000) = $50,000
Year 2 ½ × ($100,000 – $50,000) = $25,000
Year 3 ½ × ($100,000 – $75,000) = $12,500
Year 4 ½ × ($100,000 – $87,500) = $6,250 but this is reduced to $2,500 since at this point the value of
the machinery has reached its salvage value.

Question 62
An increase in deferred tax liabilities in a financial year:
a) Equals taxes payable less income tax expense in that year.
b) Reflects when the carrying amount of a liability has increased above its tax base
c) Is an accrual of income tax expense for the year, which is expected to be paid in future years.
Choice A is not correct: the increase in liability is income tax expense less taxes payable.
When the carrying amount of a liability has increased above its tax base it increases the deferred tax assets.

Question 63
When a bond issuer makes a coupon payment for a bond that was issued at a discount it will, under U.S. GAAP:
a) Overstate operating cash flows and understate financing cash flows.
b) Understate operating cash flows and overstate financing cash flows.
c) Overstate operating cash flows and understate investing cash flows.
The low coupon payment will be counted as a cash flow from operations, although it can be argued that the interest
component should be seen as a larger cash outflow from operations and the increase in principal as a financing cash
inflow.

Question 64
Computer Retailers Inc. provided the following data regarding its scanner purchases and sales over the year.
 January 1 Beginning inventory of 120 scanners at cost of $70 each.
 March 1 Purchase of 500 scanners at cost of $65 each.
  September 1 Purchase of 200 scanners at cost of $60 each.
 December 31 Ending inventory of 200 scanners.
Which of the following statements is most accurate regarding the use of the periodic method for last in, first out (LIFO)
and first in, first out (FIFO) to account for inventories over the year? The ending inventory under LIFO is:
a) $13,600, which is lower than under FIFO.
b) $13,600, which is higher than under FIFO.
c) $12,000, which is higher than under FIFO.
Under LIFO the ending inventory of 200 scanners, 120 @ $70 and 80 @ $65 = $13,600. This is higher than under
FIFO ($12,000). Since the prices of scanners are falling, the cost of goods sold (COGS) will be lower under LIFO, and
net income will be higher.

Question 65
Which of the following statements is most accurate regarding the straight-line depreciation method?
a) It compensates for the rising repair costs as an asset ages.
b) It is the most frequently used method of depreciating assets in the United States.
c) It is often used to reduce the tax burden immediately after an asset is purchased.
Choices A and C refer to accelerated depreciation methods.

Question 66
In a sales-type lease, the sales revenue reported at the beginning of the lease on the lessor's financial statements is:
a) The present value of the lease payments.
b) The present value of the lease payments less the carrying value of the asset being leased.
c) The present value of the lease payments plus the present value of the residual value of the asset
being leased.
The sales revenue reported at the beginning of the lease on the lessor's financial statements is the present value of
payments they will receive from the lease agreement. The COGS is the carrying value of the asset.

Question 67
A deferred tax asset:
a) Will increase when income tax rates increase.
b) Will increase if a valuation allowance is increased.
c) Is created when the carrying amount of an asset in the financial statements is higher than its tax base.
A deferred tax asset (or liability) will increase when income tax rates rise, so choice A is correct.
When a valuation allowance is increased, the value of the deferred tax asset falls. When the carrying amount of an
asset in the financial statements is higher than its tax base, it will increase a deferred tax liability.

Question 68
Under IFRS, which of the following statements is most accurate?
a) Reversals of write-downs of inventory values are permitted.
b) The cumulative effect of a change in inventory valuation method is reflected in the current
year's income statement.
c) Reductions in values of inventory are carried straight through to stockholders' equity and not
reported as an expense.
Inventory write-downs are recognized as an expense; changes in inventory valuation methods should be recognized
retrospectively. Reversals are permitted, so A is the correct answer.

CORPORATE FINANCE

Question 69
A company has a target capital structure of 60% debt and 40% equity. If the company raises debt of less than $5
million, then its after-tax cost of debt is 5%. If the new debt issued is above $5 million, its after-tax cost of debt is 5.5%.
The first break point in the cost of capital raised due to the change in the cost of debt is closest to:
a) $5.00 million.
b) $8.33 million.
c) $12.5 million.
Break point

Question 70
Machinemakers Inc. is producing 500,000 machines per annum and the machines are sold at $100 each. Fixed costs
are $10 million, not including interest payments of $15 million. Variable costs are $40 per machine.
The operating breakeven point is closest to:
a) 166,667 machines.
b) 300,000 machines.
c) 416,667 machines.
Operating breakeven is when Q = F / (P – V) = 10,000,000 / (100 – 40) = 166,667 machines

Question 71
The managers of a company are reviewing a project that will cost $12 million. The cash flows from the project will be
$5 million at the end of the first year and $10 million at the end of the second year. Thereafter, the company may not
have similar projects available to invest in. The cost of capital is 10%. The managers should:
a) Reject the project since the profitability index is less than one.
b) Accept the project since the profitability index is greater than one.
c) Accept the project since the internal rate of return is above the cost of capital.
In this example, we cannot apply the internal rate of return (IRR) method since the question indicates that cash flows
will not be able to be reinvested in similar projects with the same IRR. The net present value (NPV) method gives:
NPV=−$12+$5/(1.10)+$10/(1.10)2=$0.81
or use a financial calculator.
The profitability index of 1 + NPV/initial investment is greater than 1 so the project should be accepted.

Question 72
A company decides to use a banker's acceptance to borrow over a one-month period and is quoted an all-inclusive
rate of 8%. The cost of credit is closest to:
a) 7.95%.
b) 8.05%
c) 8.70%.
Cost = Interest/Net Proceeds × 12 = [insert image equation]

Question 73
Burwood Company has a common stock price of $30. The current reported earnings per share are $2 and dividends
per share are $0.80. The return on equity is 12%. The cost of equity is closest to:
a) 6.66%.
b) 9.87%.
c) 10.06%.
The growth rate is the earnings retention rate multiplied by the return on equity (ROE). This is 7.2%.
Next year's dividends will be $0.80 × 1.072 = $0.858

Question 74
Which one of the following is considered good corporate governance in regard to the role of the board of directors and
committees of a company?
a) It is important that committees frequently report directly to shareholders, without
referring to the board of directors.
b) The board of directors delegates responsibilities to various committees but retains
ultimate responsibility to its shareholders.
c) Independent nonexecutive directors are usually prohibited from sitting on
committees but are represented on the board of directors.
Responsibilities can be delegated to committees, but the board still keeps overall responsibility to the shareholders of
the company. Committees are set up to focus on specific functions and report to the board on a regular basis.
Independent directors are frequently asked to chair committees involved in areas where there may be conflict of
interest. In some countries, regulations state certain committees can only be made up of independent directors.

Question 75
A company has negotiated trade discounts with its supplier and has negotiated terms of 1/10 net 40. If the company's
cost of borrowing funds is 12%, the company should pay how many days after each purchase?
a) 10 days
b) 11 days
c) 40 days
The cost of trade credit will reduce after the 11th day and will be lowest on the 40th day.
Cost of trade credit if pays on the 40th day is.

is still higher than the borrowing cost, so the company should pay at the end of the discount period.

Question 76
When sales are rising, the expected returns to stockholders are increased by a company having:
a) High operating leverage and low financial leverage.
b) Low operating leverage and high financial leverage.
c) Both high operating leverage and high financial leverage.
High operating leverage and financial leverage will increase the expected returns to stockholders but will also increase
the risk of the returns.

Question 77
An analyst is looking at the ranking of two mutually exclusive projects and finds that although project A has a higher
IRR, project B has a higher NPV. This is most likely to be explained by which of the following?
a) Project B is a larger project than project A.
b) The analyst has made a mistake; the project with the higher IRR will have a higher NPV.
c) Project B is a longer-term project than A, and a high discount rate has been used to calculate the NPV.
A larger project could well have a higher NPV despite there being a lower return, so A is the best answer. A high
discount rate would reduce the NPV for a long-term project, so C is not correct.

PORTFOLIO MANAGEMENT

Question 78
When a firm uses derivatives to change the payoff profile of its risk outcomes, this is referred to as:
a) Risk shifting.
b) Self-insuring.
c) Risk transfer.
Risk shifting is when a firm changes the probability distribution of returns, so A is the correct answer. Self-insurance
refers to a company taking on a risk as it judges it too expensive to hedge or insure against using external means.
Risk transfer is when risk is passed on to another party, usually by buying insurance.

Question 79
The investment policy statement:
a) Is relevant only to individual investors.
b) Should outline an investor's objectives and constraints.
c) Must focus on the investment manager's philosophy and decision-making process.
A policy statement helps the investor specify realistic goals and in setting the goals become more aware of the risks of
investing. It is a valuable way of communicating with the portfolio manager. It also helps set the benchmark against
which performance can be measured.

Question 80
Which of the following is not an assumption of the capital asset pricing model (CAPM)?
a) Investors have the same time horizon.
b) Investors are influenced by both rational and irrational factors.
c) Investors wish to maximize the risk/return utility of their investments.
The CAPM assumes that investors are rational and utility maximizers. Behavioral finance and technical analysis have
moved away from traditional capital market theory and say that investors are influenced by rational and irrational
factors.

Question 81
Which of the following statements is the most accurate?
a) Beta is a measure of unsystematic risk.
b) Betas are always greater than or equal to 1.
c) A stock with a beta that is higher than the market is expected to provide a return
that is higher than the market, when the market return is above the risk-free rate.
Choice A is not correct; beta is a measure of market or systematic risk. Choice B is not correct; betas can be negative.
Question 82
A U.S. investor is considering international diversification. Which of the following statements best describes his
position?
a) Markets that have a high correlation with U.S. market returns will generally generate higher returns.
b) Higher returns can usually be achieved by investing internationally for the same level of risk as
investing solely in the U.S. market.
c) Higher returns from international investment may compensate for the additional risk of including
overseas securities in a portfolio.
A U.S. investor, by investing in markets that provide returns that have a low correlation with the U.S. market returns,
can usually achieve higher returns for the same level of risk.

Question 83
The stock analyst in your firm has completed his forecasts for Kensington Corp. and Paddington Inc. The current
share prices are $85 and $56, respectively, and he forecasts that a year from now the share prices will have risen to
$102 and $60, respectively. Each stock will make a dividend payment of $2 at the end of the year. The betas of the
stock are 1.5 and 0.9, the expected market return over the next year is 15%, and the risk-free rate is 6%. Which of the
following is correct on the basis of the analyst's forecast?
Kensington Corp. Paddington Inc.
A. Overvalued Overvalued
B. Undervalued Undervalued
C. Undervalued Overvalued
a) A
b) B
c) C
Using the CAPM, the estimated return for Kensington Corp. is:
6%+1.5(15%−6%) = 19.5%
The analyst is forecasting a return of 22.4% (from capital gain plus dividend) so the stock looks undervalued.
The estimated return for Paddington Inc. is:
6%+0.9(15%−6%) = 14.1%
The analyst is forecasting a return of 10.7%, so the stock looks overvalued.

Question 84
Which type of fund is likely to have the most concentrated portfolio?
a) A leveraged buyout fund
b) An open-end equity fund
c) An exchange-traded fund
A leveraged buyout fund would usually make a small number of large investments whereas equity funds and ETFs
would be more diversified, so A is the best answer.

Question 85
If international securities are added to an investment opportunity set that previously included only domestic assets, the
efficient frontier is likely to move:
a) Downward and flatten.
b) Upward and extend to the left.
c) Downward and extend to the left.
As the number of available asset classes increases, assuming they are not perfectly correlated, new portfolios can be
constructed that have a higher return for the same level of risk; this raises the efficient frontier. There will be a new
minimum variance portfolio, so the efficient frontier will also extend further to the left.

EQUITY

Question 86
In an order-driven system with order precedence hierarchy, there are three sell orders, shown in the table below:
Order Limit Price Time Placed
Order A $22.85 9.15 am Displayed
Order B $22.85 9.10 am Hidden
Order C $23.15 9.10 am Displayed
Which order will usually be executed first?
a) Order A
 b) Order B
c) Order C
The first rule is price priority, so for a sell order the lowest price is executed first (A or B), and the next gives
preference to displayed over hidden orders, which is A. The time placed is the third priority.

Question 87
A fundamental index will:
a) Tend to overweight stocks with high price-earnings ratios.
b) Usually perform well compared to a market capitalization–weighted index when
value stocks are outperforming growth stocks.
c) Lead to index tracking funds needing frequent rebalancing to increase weightings in
stocks that have outperformed and reduce weightings in stocks that have
underperformed.
A fundamental index will tend to favor value stocks over growth stocks, so B is correct. A tracker fund will need
to reduce holdings in stocks that have outperformed as the outperformance will have increased their market value in
the fund, while their fundamental value will be unchanged.

Question 88
If a market is weak-form efficient but semi-strong-form inefficient, this supports the use of:
a) Technical analysis.
b) Passive investment.
c) Fundamental analysis.
Technical analysis would not consistently generate superior returns if a market is weak-form efficient. If it is semi-
strong-form inefficient, there is the opportunity for fundamental analysts to generate superior returns using publicly
available information, so choice C is correct.

Question 89
Which of the following would be the most likely to explain why a firm's price-to-sales (P/S) ratio is higher than its
competitors'?
a) The firm is highly geared relative to its competitors.
b) The firm has a high asset backing per share relative to its competitors.
c) The firm uses aggressive revenue recognition policies relative to its competitors.
High gearing would tend to reduce the market capitalization of the firm relative to its sales, leading to a lower P/S ratio,
so choice A is not correct.
Aggressive sales recognition would reduce the price investors are willing to pay for sales and will lead to a lower P/S
ratio, so choice C is not correct.
If the firm has high asset backing, this would increase the value of the company and might lead to a higher P/S ratio,
so B is the best answer.

Question 90
An example of an execution instruction(s) on an order:
a) Is a specified limit price.
b) Is a good-till-canceled instruction.
c) Are instructions to settle using a specified custodian.
A limit order is a common type of execution order, so A is the correct answer. Validity instructions are concerned with
the timing of an order, so choice B is a validity order. Choice C refers to settlement instructions.

Question 91
The market for a stock is currently $76.90 bid, $77.35 offer. If a new buy order is placed at $77.05, the order is said to:
a) Take the market.
b) Make a new market.
c) Be behind the market.
The buy order is higher than the current bid price of $76.90, so it makes a new market. The offer price is still higher
than $77.05, so the order will not be executed and it will not take the market.

Question 92
A company has an earnings retention ratio of 60%, dividends are expected to grow by 3% per annum, and the
investors' required rate of return is 8%. The theoretical forward price earnings ratio is closest to:
a) 5.0.
b) 8.0.
 c) 12.5.
P/E = D/[E(k−g)] = 0.4/(0.08−0.03) = 8.0

Question 93
The voting rights of a sponsored depository receipt (DR) are held by the:
a) Depository bank.
b) Investors in the DR.
c) Common shareholders in the company.
If it is a sponsored issue, the voting rights pass to the investors in the DR; if it is an unsponsored issue, the depository
bank retains the voting rights.

Question 94
An analyst forecasts that a company will pay a dividend of $3.50 for the next three years and dividends will grow at
4% thereafter. If investors' required rate of return is 8%, the value of the company is closest to:
a) $64.19.
b) $81.26.
c) $100.02.
Discount back the first three years' dividends at 8% to get $3.24, $3.00, and $2.78.
Thereafter, apply the dividend discount model (DDM) to give value of the shares at the end of the third year as
3.50(1.04) / (0.08 – 0.04) = $91 which discounts back to $72.24.
The value of the company = $3.24 + $3.00 + $2.78 + $72.24 = $81.26.

Question 95
The law of one price supports the use of price multiples based on:
a) Comparables.
b) Fundamentals.
c) Future expectations.
The law of one price is the rationale for multiples based on comparables. A fundamentals-based P/E is often related to
future expectations using a discounted cash flow model such as the Gordon growth model.

Question 96
Which of the following industries in the United States is likely to have the highest barriers to entry?
a) Restaurants
b) Auto manufacturing
c) Convenience stores
Auto manufacturing requires huge capital to build a plant, plus expertise and a dealer network that act as barriers to
entry. However, it is relatively easy to set up a convenience store or restaurant.

Question 97
Which of the following preference shares issued by a company is likely to offer the highest dividend to an investor?
a) Putable preference shares
b) Callable preference shares
c) Noncallable and nonputable preference shares
Callable preference shares are the most risky for the investor since the issuer has the right to buy the shares back at a
prespecified price; therefore, they will tend to carry the highest dividend.

FIXED INCOME

Question 98
As yields increase, the rate of decline in the price of a bond starts to slow. It is likely that the bond:
a) carries a bank guarantee.
b) contains an embedded put option.
c) contains an embedded call option.
As yields rise, the price of bonds declines, but the price decline of bonds with embedded put options will be less than
that of option-free bonds. Investors will be looking to exercise their put options, so the price will stabilize close to the
put price.
Guarantees do not affect the price behavior of bonds in this manner.

Question 99
The following data have been gathered:
 Years to Maturity Spot Rate (semiannual bond basis)
1 8.54%
2 7.50%
3 6.07%
4 5.56%
The one-year forward yield three years from now is closest to:
a) 2.02%.
b) 4.04%.
c) 6.53%.
This is a negatively sloping spot-yield curve, so it is to be expected that the forward rate would be lower.

Question 100
A straight bond without any call features has a remaining life of three years, has a 12% coupon rate payable annually,
and a yield to maturity of 10.5% (yields and spot rates all on annual basis). If the 1- and 3-year spot rates are 8.0%
and 10.7% respectively, then the 2-year spot rate is closest to:
a) 9.0%.
b) 9.4%.
c) 10.5%.
The following relationship must hold:
Price using yield-to-maturity calculation = price of bond using spot rates

Question 101
If an investor in a collateralized mortgage obligation (CMO) is willing to accept high prepayment risk but wants a high
expected return, he is most likely to select:
a) A planned amortization class (PAC) support tranche.
b) A later-paying PAC tranche.
c) An earlier-paying PAC tranche.
A PAC tranche has a predictable life, as long as prepayments stay within the PAC collar, whereas the support tranche
will take the prepayment risk within the range of the collar. The additional risk should lead to a higher expected return.

Question 102
A bond is traded at par and yields 9.5% to maturity. The term to maturity is 20 years, the modified duration is 8.8, and
the convexity is 124. If the yield to maturity rises by 150 basis points, the new bond price will be closest to:
a) 86.8.
b) 88.2.
c) 114.6.
Approximate percentage price change due to duration

Approximate percentage change due to convexity effect

Trading at par, the price of the bond is 100.

The combined effect of both duration and convexity: 100 – 13.20 + 1.395 = 88.195.

Question 103
When interest rates change, it is observed that the price of a callable bond with a coupon of 4% moves as follows:
 Rates Down 50 Basis Points Rates Up 50 Basis Points
Price + 5% Price – 4%
The bond is most likely to have:
Convexity Yield
A. Positive Less than 4%
B. Positive More than 4%
C. Negative More than 4%
a) A
b) B
c) C
The bond has positive convexity since the gain is more than the loss for an equal move in interest rates. The bond's
coupon is probably less than market yields, meaning it is unlikely to be called in the near future. As yields fall, the
bond is more likely to be called and starts to exhibit negative convexity.

Question 104
An investor buys a bond at 103 with a 5% annual coupon and a four-year life. The investor estimates that they can sell
the bond at a yield to maturity of 4% after two years and in the meantime can reinvest coupons at 3%. Based on these
assumptions, the estimated horizon or realized yield is closest to:
a) 4.30%.
b) 4.95%.
c) 12.17%.
FV of coupons: 5.15 + 5.00 = 10.15
Bond horizon price using ytm of 4%: 51.04+105(1.04)2 = 101.89
Horizon yield: (total future cash / bond price)1/n−1 = (112.04 / 103)1/2−1 = 4.30%

Question 105
Which of the following factors is least likely to affect the yield spread of a bond?
a) The coupon rate of the bond
b) The expected liquidity of the issue
c) The economic and business outlook
Unless there is a change in the ability of the issuer to pay the coupon on the bonds at maturity, the coupon rate does
not directly affect the yield spread.

Question 106
A low repo rate on a repurchase agreement is most likely to be explained by which of the following?
a) The collateral has a low credit rating.
b) The counterparty has a low credit rating.
c) Delivery of the collateral to the lender is required.
The interest rate in a repurchase agreement is the repo rate. Delivery of collateral would lower the repo rate. A low
credit rating of either the collateral or counterparty would increase the risk and therefore increase the repo rate.

Question 107
Using the weighted average duration of bonds in a portfolio to estimate the change in price of a bond portfolio when
interest rates change assumes:
a) The yield curve makes a nonparallel shift.
b) The convexity of the price-yield curve is positive.
c) There is an equal change in yields for all bond maturities.
When there are nonparallel shifts in the yield curve, using a single duration measure is not accurate.

Question 108
The main risk for an investor with a negative duration gap is:
a) Market price risk.
b) Lower interest rates.
c) Higher interest rates.
The duration gap is the Macaulay duration minus the investment horizon. When the investment horizon is longer than
the Macaulay duration, then the main risk is lower interest rates affecting the reinvestment of the coupons.

Question 109
In the United States, which of the following is most likely to be unsecured debt?
a) Collateral trust bonds
b) General mortgage bonds
c) Subordinated debenture bonds
In the United States, unsecured debt is referred to as debenture bonds, whereas collateral trust bonds have collateral
pledged to ensure payments are made on the debt and general mortgage bonds have property pledged as security for
the debt.

DERIVATIVES

Question 110
Which of the following combinations of factors will tend to lead to the highest price of a call option?
a) A low strike price, low volatility, and low interest rates
b) A low strike price, high volatility, and a long time to expiry
c) A low strike price, high interest rates, and a short time to expiry
The profit on a call option will be determined by the difference between the stock price and the strike price: the lower
the strike price, the higher the potential profit, so B is the correct answer.
A longer time to expiry gives the holder a longer period in which the shares can move above the strike price, so the
option will be worth more. High volatility and high interest rates also increase the value of call options.

Question 111
When futures prices and interest rates are moving in opposite directions, holding a long futures position:
a) Is less attractive than holding an equivalent long forward position.
b) Is more attractive than holding an equivalent long forward position.
c) Has exactly the same payoff as holding an equivalent long forward position.
Futures prices are marked to market daily, so when prices are negatively correlated with interest rates, the profits on a
futures position can be reinvested at a declining rate of interest (or losses funded at higher rates), so in this
environment forwards are preferable to futures.

Question 112
The spot price of a share is $20, the risk-free rate is 2%, and the future value of the dividends to be paid on the share
over the next nine months is $1. The price of a forward on the share that expires in nine months' time is closest to:
a) $19.01.
b) $19.30.
c) $20.99.
The forward price is the spot price compounded at the risk-free rate over the life of the contract minus the future value
of any dividends.
The forward price is $20(1.02)3/4 – $1 = $19.30

Question 113
An investor deposits an initial margin of $100,000 for a futures trade. On the first day, he loses $5,000 on the trade;
the next day he loses a further $20,000. If the maintenance margin is $80,000, then:
a) He will receive a margin call on the second day to pay a variation margin of $5,000.
b) He will receive a margin call on the second day to pay a variation margin of $25,000.
c) He will receive margin calls on the first day to pay a variation margin of $5,000 and on the
second day to pay a variation margin of $20,000.
A variation margin must be paid if the investor's equity falls to below the maintenance margin requirement, and he
must bring the equity in his account back to the initial level. In this case, the equity falls to below $80,000 on the
second day, so he must make up the difference of $25,000 in variation margin.

Question 114
The clearinghouse of a futures exchange is least likely to do which of the following?
a) Act as counterparty to each transaction on the exchange
b) Make margin calls to members holding futures positions
c) Act as market maker in futures contracts traded on the exchange
The clearinghouse does not intentionally take positions in futures or act as market maker.

Question 115
A call option on a stock has a strike price of $30. The stock is trading at $34, and the price of the call option is $5. The
option is:
a) $4 in-the-money.
 b) $1 out-of-the-money.
c) $4 out-of-the-money.
The call option is in-the-money since the strike price is below the stock price, and the difference between the two
prices is $4.

ALTERNATIVE INVESTMENTS

Question 116
High-water marks in hedge fund fee calculations mean performance fees are:
a) Not charged twice for the same performance.
b) Capped when they reach the high-water mark.
c) Paid only when the return exceeds a hurdle rate.
High-water marks are established when the net asset value has reached a high point; performance fees are not
charged again until after the fund has reached the previous high, so choice A is correct.

Question 117
Early stage financing from a venture capital company is usually used for:
a) Market research of a new product idea.
b) Product development and initial marketing of a product.
c) Preparing the company to start commercial production and sales.
Choice A refers to angel investing. Choice B is seed-stage financing.

Question 118
A mortgage real estate investment trust (REIT) in the United States is least likely to be characterized by which of the
following?
a) It is a comparable investment to a bond.
b) It holds a diversified portfolio of real estate investments.
c) It is illiquid since there is no organized market for the REIT shares.
Choice C is not correct; REITs are closed-end investment companies that are traded on stock exchanges.

Question 119
Which of the following is least likely to be a characteristic of hedge funds?
a) They usually attempt to hedge out all market risk.
b) The managers are often compensated by incentive fees.
c) They have the flexibility to use derivatives and leverage.
Many hedge funds (e.g., global macro funds) deliberately take on market risk.

Question 120
The roll yield for a long-only investor in commodity futures:
a) Can be positive if the convenience yield is high.
b) Is negative when the commodity futures market is in backwardation.
c) Will be higher when the commodity futures market is in contango rather than backwardation.
When the convenience yield is high, the market will be in backwardation, with the futures price below the spot,
producing a positive roll yield.