Question #1 of 100

B) not a violation if the data can be gathered from several public sources.

Explanation

Since the security prices represent factual information that can be verified from several sources,
there is no violation. A violation may have occurred had the information been exclusively published
by the source. Whether or not the analyst has a subscription to the publication is not an issue. (Topic
1, LO A.1)

Question #2 of 100

A) Disclosing material nonpublic information would have an impact on the price of a security or be
of interest to a reasonable investor.

Explanation

All of these are true except that it is a violation for having received material nonpublic information.
The member can receive such information as part of their regular duties or by accident. Neither is
punishable in and of itself, and penalties only apply if the member trades or causes others to trade
on the information. The member may have certain duties, such as trying to disseminate the
information after receiving it. An analyst may use nonmaterialnonpublic information. (Topic 1, LO
A.2)

Question #3 of 100

A) Overstating an earnings projection in order to increase the price of a stock.

Explanation

Standard II(B), Market Manipulation, is not intended to prohibit transactions that are done in order to
minimize income taxes or trading strategies that are not intended to distort prices or artificially inflate
trading volume. Overstating earnings projections in order to increase the price of a stock is a direct
violation. (Topic 1, LO A.2)

Question #4 of 100

A) not violated the CFA Institute Standards.

Explanation

Standard I(B) requires members to maintain independence and objectivity. A visit by an analyst to an
out-of-the-way site may be paid for by a client company host as long as the analyst can maintain
objectivity. Members should encourage clients to limit the use of corporate aircraft, but exceptions
can be made if transportation would not otherwise be available or would be inefficient. (Topic 1, LO
A.1)

Question #5 of 100

C) invest a portion of the retirement plan in Bingham Company stock if the investment is prudent
and if he keeps the overall portfolio properly diversified.

Explanation

Standard III(A), Loyalty, Prudence, and Care, requires members to comply with their fiduciary duty.
Retirement plan managers owe their duty to the plan participants, not to the management of the
company sponsoring the plan. The fiduciary duty includes the obligation to diversify the plan's
investments, regardless of the quality of the sponsoring company's stock. Investing in the company's
stock is not prohibited. (Topic 1, LO A.3)

Question #6 of 100

C) 3.

Explanation

There are at least three misrepresentations. First, that Pyles is a portfolio manager, when he is really
a trainee. Second, that the firm can provide all of the services they will ever need. Third, that he can
guarantee a 75% return. (Topic 1, LO A.1)

Question #7 of 100

C) a violation because the advertisement implies the firm generated this return.

Explanation

Reporting the historical returns of all assets now in the fund introduces a survivorship bias. Also, the
advertisement is misleading because the fund just came into existence and has no historical record.
Thus, the firm has misled the public as to their performance history. (Topic 1, LO A.3)

Question #8 of 100

C) start the registration of her new company.

Explanation
The only action that will not breach Standard IV(A), Loyalty to Employer, is beginning the registration
process for the new company. (Topic 1, LO A.4)

Question #9 of 100

C) must disclose his plans to take on clients and obtain Oak Investments' consent, but he doesn't
need to do either regarding the preparations to begin his own business.

Explanation

According to Standard IV(A), Loyalty, members and candidates may undertake an independent
practice that could result in compensation or other benefits in competition with their employer if they
disclose to their employer the types of services that will be provided, the duration of services, and
the compensation. Members and candidates must also obtain consent from their employer (but not
from current clients) before engaging in independent practice. The other preparations that he has
made to begin his own business need not be disclosed and are not violations as long as they are
done on his own time and he doesn't actually begin soliciting new clients for the business until he
leaves his current employment. (Topic 1, LO A.4)

Question #10 of 100

C) support the sponsor's management during proxy fights.

Explanation

Members are required to act in the interest of their clients. In voting proxies, the client's interest must
prevail over management's interest. (Topic 1, LO A.3)

Question #11 of 100

D) a violation of the Standard concerning appropriateness and suitability of investment actions.

Explanation

Given the variety of accounts under her supervision, it is not likely the shares of a speculative
biotech firm would be suitable for all accounts. Placing such shares in all accounts indicates that she
has failed to consider the appropriateness and suitability of the investment for each account, and this
places her in violation of Standard III(C). (Topic 1, LO A.3)

Question #12 of 100

A) only if she had not used soft dollars to pay for the conference table.
Explanation

Standard III(A) requires members to act for the benefit of their clients and to place their clients'
interests above their own. Soft dollars may be used for client benefit if the practice is disclosed. It is
not required that each element of research purchased benefit each client involved; however, the
manager should seek to ensure that over time. All clients benefit from the use of research purchased
with client brokerage. Using soft dollars for the purchase of office furniture does not directly benefit
any client and is a violation. (Topic 1, LO A.3)

Question #13 of 100

C) decline in writing to accept the supervisory position until the firm adopts appropriate procedures.

Explanation

Standard IV(C), Responsibilities of Supervisors, requires that if a member cannot discharge

compliance responsibilities because of a poor compliance system, the member should decline in
writing to accept supervisory responsibility until the firm adopts an adequate system. (Topic 1, LO
A.4)

Question #14 of 100

A) inform the clients of the change and tell them it is based upon an opinion and not a fact.

Explanation

According to Standard V(B), Hatfield must inform the clients of the change and tell them it is based
upon an opinion and not a fact. The SEC is not involved. Making an identical change in two
portfolios may be a violation of this standard if the needs of the clients are not identical. (Topic 1, LO
A.5)

Question #15 of 100

A) enables the referring party to determine the fair fee for the referral.

Explanation

Standard VI(C), Referral Fees, states, "Members and Candidates must disclose to their employer,
clients, and prospective clients, as appropriate, any compensation, consideration, or benefit received
from or paid to others for the recommendation of products or services."

Appropriate disclosure means telling the client or prospect, before agreeing to perform services, of
any benefit given or received for recommending the member's services. Such disclosure will help the
client evaluate any partiality shown in any recommendation of services and evaluate the full cost of
the services. The member should disclose the nature of the consideration or benefit (e.g., flat fee or
percentage basis, one-time or continuing benefit). The Standard does not require any benchmarking
information that clients or prospects could use to compare fees or to determine a fair rate. (Topic 1,
LO A.6)

Question #16 of 100

C) violated the Standards by not having a reasonable basis for making the purchase of Datagen.

Explanation

Standard V(A) requires members to have a reasonable and adequate basis for taking investment
actions. Overhearing a conversation does not provide adequate basis. It is not improper to use
overheard conversations that do not include inside information, nor is it improper to reference
another firm's report to substantiate adequate basis, if the other report is justified. (Topic 1, LO A.5)

Question #17 of 100

C) When members change employers, transferring the records supporting their investment
recommendations to the new employer is the member's responsibility.

Explanation

Records supporting investment actions and recommendations are the property of the firm. A
member cannot take these records or copies of them to a new employer without permission from the
original employer. The other statements are accurate. (Topic 1, LO A.5)

Question #18 of 100

A) violated the Standards by not disclosing her performance bonus.

Explanation

Standard VI(A) requires members to disclose all matters that could reasonably be expected to impair
the member's ability to make unbiased and objective recommendations. Compensation based on a
percentage of fees generated does not create an inherent bias. If, however, a performance bonus is
paid for investment results, it may unduly encourage the manager to take more risk than is proper
and prudent, and so the existence of the bonus opportunity must be disclosed to the client. (Topic 1,
LO A.6)

Question #19 of 100

D) Private equity investments.

Explanation

Venture capital, leveraged buyouts, mezzanine financing, and distressed debt are all categories of
private equity investments. (Topic 2.1, LO 1.2)

Question #20 of 100

C) Incorrect Correct

Explanation

Return computations for alternative investments must accommodate the underlying structures, such
as the size and timing of cash flows and leverage. Adjustments for higher order distribution moments
are not necessary for return computations.

Alternative investment valuation methodologies must account for nontraditional attributes associated
with this asset class, including:

 Short-term active trading that quickly trades securities based on short-term price changes.
 Transaction-based prices are not continuously observable, making data comparisons extremely
challenging.
 Many alternative investments have unique cash flow structures that make forecasting difficult.
 Appraisal-based valuation, which may differ from actual market-based valuation if it were
available, is necessary for certain alternative investments. (Topic 2.1, LO 1.4)

Question #21 of 100

C) Both I and II.

Explanation

Both of the analyst's statements are accurate. Liquid alternative investments typically do not provide
an incentive fee on profits to managers, which can discourage skilled managers. The two main types
of liquid alternative investment strategies are hedge fund replication and clones. Hedge fund
replication aims to obtain returns similar to those of hedge funds and uses simple factor-based
approaches or trading systems. (Topic 2.2, LO 2.4)

Question #22 of 100

D) internal rate of return that accounts for the timing of the investment's cash distributions and
withdrawals.
Explanation

The internal rate of return (IRR) is known as the dollar-weighted return (or money-weighted return) in
which returns are averaged over the investment's life depending on the timing of cash distributions
and withdrawals. The dollar-weighted return is the investment's IRR, taking into account all cash
inflows and outflows. (Topic 2.3, LO 3.4)

Question #23 of 100

A) mean.

Explanation

The shape of probability distributions are described by the moments of the distribution. The first raw
moment is the mean of the distribution, which is the expected value of the returns. (Topic 2.4, LO
4.1)

Question #24 of 100

B) 0.85. Hypothesis should not be rejected.

Explanation

The Jarque-Bera statistic for this fund equals:

The Jarque-Bera statistic for this fund (0.85) is less than the critical value (5.99). The statistic does
not lie in the rejection area to the right of 5.99. Therefore, we should not reject the hypothesis that
this fund"s returns follow a normal distribution. (Topic 2.4, LO 4.5)

Question #25 of 100

B) Semivariance is a downside risk measure.

Explanation

Semivariance considers how much variability exists for downside outcomes only. It just looks at
negative deviations and provides an estimate of the degree of variability regarding losses. (Topic
2.5, LO 5.1)

Question #26 of 100

D) Autoregressive conditional heteroskedasticity model.

Explanation

Autoregressive conditional heteroskedasticity models (ARCH) forecast volatility using historical data
while assigning greater weight to more recent data. (Topic 2.5, LO 5.2)

Question #27 of 100

A) M2 method.

Explanation

The M2 is a risk-adjusted measure of the portfolio return. Using leverage, the portfolio standard
deviation is adjusted to the point where it equals the standard deviation of the market index. The
M2 equals the expected return on the leveraged portfolio that has the same standard deviation as the
market index. (Topic 2.5, LO 5.4)

Question #28 of 100

D) non-diversifiable and idiosyncratic components.

Explanation

Asset pricing models are helpful tools for separating the total risk of an investment into its non-
diversifiable (i.e., systematic) and diversifiable (i.e., idiosyncratic, unsystematic) components. The
models assume that investors should receive compensation for non-diversifiable risk but not for
diversifiable risk. (Topic 2.6, LO 6.2)

Question #29 of 100

B) 1%.

Explanation

The idiosyncratic return equals the fund return minus the ex post CAPM benchmark return:

0.10 − [0.05 + 0.80(0.10 − 0.05)] = 0.10 − 0.09 = 0.01 = 1%

(Topic 2.6, LO 6.2)

Question #30 of 100

C) The momentum risk factor.

Explanation
The Fama-French three-factor model is an empirical multifactor asset pricing model where SMB is
the size factor equal to the difference in returns between portfolios of small and big firms (Rs - Rb),
and HML is the book-to-market factor equal to the difference in returns between portfolios of high
and low book-to-market firms (Rh - Rl).

E(Ri) - Rf = β1(Rm − Rf) + β2E(SMB) + β3E(HML)

(Topic 2.6, LO 6.3)

Question #31 of 100

B) The model uses two different currencies and a common risk-free interest rate.

Explanation

The currency option pricing model prices an option that gives the right to exchange S units of one
currency for S* units of another currency. It uses two different risk-free interest rates that correspond
to the two currencies exchanged. A simplifying assumption of these option pricing models is that the
underlying securities do not pay dividends or other cash distributions. (Topic 2.6, LO 6.7)

Question #32 of 100

D) Rho Vega

Explanation

Rho measures the sensitivity of the option price to changes in the risk-free interest rate. Vega
measures the sensitivity of the option price to changes in the price volatility of the underlying
security. Theta measures the sensitivity of the option price to changes in time to expiration. Gamma
measures the rate of change in delta to changes in the price of the underlying security. (Topic 2.6,
LO 6.8)

Question #33 of 100

B) fails to take into account the impact of kurtosis.

Explanation

The CAPM assumes a normal return distribution, which means that skewness and kurtosis are not
accounted for in the model. As a result, a pricing model that does account for non-normal
distributions will very likely produce a different expected return than the CAPM. (Topic 2.7, LO 7.4)
Question #34 of 100

D) improperly specified, and the true ex post alpha equals −1%.

Explanation

The model is improperly specified because it does not derive the correct required return for the fund.
The true ex post alpha equals the difference between the fund's return and the required return:

ex post alpha = 13% − 14% = −1%

(Topic 2.8, LO 8.3)

Question #35 of 100

C) Asset classes contain only an alpha driver or a beta driver.

Explanation

Asset classes, such as bonds or equities, contain both alpha drivers and beta drivers. For example,
index funds (beta drivers) and hedge funds (alpha drivers) are available for both bonds and equities.
The other statements are true. (Topic 2.8, LO 8.6)

Question #36 of 100

C) Spurious correlation is the lack of a linear relationship between two variables.

Explanation

Spurious correlation indicates that there is a relationship between variables, but it is idiosyncratic,
coincidental, and limited to just a small set of observations. (Topic 2.8, LO 8.9)

Question #37 of 100

B) level of significance is higher and the standard error is lower.

Explanation

The slope parameter of a regression equation can be evaluated for statistical significance by
comparing its t-statistic (the estimate of the parameter divided by the standard error) to the critical
value associated with the level of significance. The higher the level of significance, the lower the
critical value, which makes it more likely that the t-statistic will exceed this value. If the standard error
is lower, the denominator of the t-statistic calculation is lower, which makes the statistic higher.
(Topic 2.9, LO 9.1)
Question #38 of 100

B) Fund replication analysis.

Explanation

Hedge fund replication is a process of identifying an investment strategy that mimics a particular
fund's returns. In fund replication, a model is derived that uniquely identifies specialized factors for
each fund. In the fund replication method, a model is used to identify factors for a specific fund rather
than market-wide factors for a broad cross-section of funds. In the fund replication method, a fund's
return is explained by a specialized set of market-based (as opposed to market-wide) factors. (Topic
2.9, LO 9.5)

Question #39 of 100

A) Paper lots.

Explanation

Land banking is the process of buying lots for the purpose of developing later. Stromberg is banking
land. However, the type of lot she is investing in is not a land bank. Land is categorized based on the
level of existing improvements that have been made. Stromberg is investing paper lots. Paper lots
are vacant but have zoning approval for development. In the case of blue top lots, the process of
development has begun, including rough grading of the property and interim drainage and erosion
controls. Finished lots are ready for construction with all development fees paid. (Topic 3.1, LO 10.2)

Question #40 of 100

A) The time it takes to switch between alternative crops.

Explanation

Three factors drive the value of an option to produce alternative crops:

 The correlation (or lack of) between the profitability of each alternative crop.
 The volatility of the profitability of each alternative crop.
 The current closeness of the profitability of each alternative crop.

Because crops have relatively short growing cycles, the time to switch to alternative crops is typically
short and, thus, is not a critical concern. (Topic 3.1, LO 10.4)
Question #41 of 100

A) Futures contracts.

Explanation

Unlike forward contracts, futures contracts are standardized, are traded on an organized exchange,
and offer transparent pricing and clearinghouse security. (Topic 3.2, LO 11.1)

Question #42 of 100

B) Inelastic supply.

Explanation

An example of inelastic supply is when the supply of a good does not immediately respond to a
change in the price of the good. (Topic 3.2, LO 11.3)

Question #43 of 100

A) Prices steadily increase in future delivery months.

Explanation

In a market in contango, prices steadily increase in future months, which is a reflection of carrying
costs and creation of negative spreads. Both contango and backwardation refer to the slope of the
term structure of forward prices. (Topic 3.2, LO 11.4)

Question #44 of 100

B) Commodity prices have very low correlation with the prices of capital assets.

Explanation

Capital assets are tangible assets. The reason for the lack of correlation between the two is that
commodity prices are driven by different economic fundamentals than capital assets such as stocks
and bonds. (Topic 3.3, LO 12.1)

Question #45 of 100

A) The underlying commodities are inefficiently priced.

Explanation
In order to earn superior alpha, the commodities trader takes on commodity exposure in order to
speculate on idiosyncratic (not systematic) movements in the underlying commodity prices. (Topic
3.3, LO 12.2)

Question #46 of 100

B) $10,000 500

Explanation

Commodity-linked notes (CLNs) cash flows include interest over the life of the instrument and a
payment at maturity, each of which may be tied to the value of a commodity or basket of
commodities. In some cases, the principal value of the CLN is protected, which puts a floor on the
downside exposure of the commodity-linked final payment. This is effectively a call option that allows
for upside participation with limited downside risk. CLN investors accept lower coupon payments on
the debt instrument in exchange for receiving the upside potential from commodity prices. In this
case, the option premium is calculated as:

$500,000 × (7% − 5%) = $500,000 × 2% = $10,000

The strike price for the call option is 500. (Topic 3.3, LO 12.3)

Question #47 of 100

B) The term structure of forward rates is backwardated.

Explanation

The roll yield, or roll return, is the return that results from changes in the basis of a futures contract.
The basis changes for two reasons: (1) Passage of time. As the time to maturity shortens, the
futures price and basis converges (i.e., rolls up or down) to the spot price, generating a return.
(2) Changes in cost of carry. The basis is determined by the cost of carry (i.e., interest rates,
dividends, storage costs, and convenience yield). Therefore, changes in the cost of carry directly
impact the basis. Roll yield is earned in backwardated and contango markets since it is driven by
changes in the basis rather than the shape of the term structure. (Topic 3.3, LO 12.4)

Question #48 of 100

C) discounted cash flow model.

Explanation
A discounted cash flow approach is typically used to value intellectual property (IP) investments.
However, the value is similar to an out-of-the-money option, and the growth rate is generally
negative as a result of expiring patents, obsolescence, and so forth. Thus, the value of an IP
investment is:

VIP,0 = (p × CF1)/(r − g)

(Topic 3.4, LO 13.4)

Question #49 of 100

D) results when interest rates have fallen and then fall again, resulting in fewer borrowers
refinancing after the second or subsequent decline(s) in rates.

Explanation

The path that interest rates take affects prepayments. If rates have fallen significantly and then fall
even further, the level of prepayments will likely be lower the second time around. Many borrowers
will have already refinanced after the first drop in rates. This occurrence is referred to as refinancing
burnout. Prepayments are, therefore, difficult to predict even under an explicit interest rate forecast.
(Topic 3.5, LO 14.4)

Question #50 of 100

B) Interest rates generally only affect mortgage-backed security investors due to their impact on
prepayment speeds.

Explanation

The goal of a mortgage-backed security investor is to project the probabilities of payoffs for each
tranche in the collateralized mortgage obligation (CMO) structure. Different risks are relevant for
different structures. Generally speaking, structured residential mortgage products focus primarily on
prepayment speeds and interest rate risks. Commercial mortgage-backed securities and subprime
mortgage products, especially junior tranches of each, focus primarily on credit risks and expected
default rates. Interest rates affect prepayment speeds but are relevant to all investors, including
mortgage-backed security holders, for reasons other than simply the relationship between interest
rates and prepayment speeds. (Topic 3.5, LO 14.4)

Question #51 of 100

D) purchase of string of call options.

Explanation

Each step in the process towards owning a completed development project can be viewed as a call
option. For example, after the property has been purchased, the move to the construction phase
may be viewed as a call option. The developer has the option to spend additional funds to improve
the property or the developer can essentially walk away from further development. (Topic 3.6, LO
15.1)

Question #52 of 100

C) Use of excessive leverage leads to magnified losses.

Explanation

Disadvantages of private equity real estate funds include:

 Investors lose direct control over portfolio decisions including selling, leveraging, leasing, and
strategic portfolio decisions.
 Private equity lacks liquidity as investments are often purchased and held to liquidation. As in a
private equity stock fund, an exit strategy may not exist prior to liquidation of the fund.
 Fund performance is difficult to measure due to potentially incorrect underlying asset valuations.
As a result, investors may be unable to realize the level of performance reported by the fund.
(Topic 3.6, LO 15.3)

Question #53 of 100

C) Data smoothing results in the underestimation of the diversification benefits that arise from
including real estate in a traditional asset portfolio.

Explanation

Data smoothing reduces volatility and correlation with traditional assets, resulting in underestimated
systematic risk and overestimated benefits from diversifying with real estate. (Topic 3.6, LO 15.5)

Question #54 of 100

C) High watermark.

Explanation

A high watermark means that a fund manager cannot receive a profit-sharing or incentive fee until
the manager exceeds the highest net asset value for the fund during the reporting period. (Topic 4.1,
LO 16.2)
Question #55 of 100

A) Market risk.

Explanation

Directional strategies have some degree of systematic (i.e., market) risk exposure, which means that
the fund is impacted by movements in the financial markets. (Topic 4.1, LO 16.4)

Question #56 of 100

B) Liquidation bias.

Explanation

Liquidation bias occurs when a hedge fund is going to close and stops reporting results before
actually ceasing operations. Selection bias occurs when the manager selectively reports the fund's
results. Hazard rate bias occurs when a young hedge fund fails and stops reporting results at a
certain age (on average about 14 months). Backfill bias occurs when the fund reports its historical
results upon its initial reporting to a database service. (Topic 4.1, LO 16.7)

Question #57 of 100

C) Leverage risk.

Explanation

Leverage risk refers to magnifying the risk of concentrated positions using futures, swaps, and
forward markets. Macro funds with significant leverage may require additional capital if markets have
losses. (Topic 4.2, LO 17.2)

Question #58 of 100

C) avoid SEC registration requirements.

Explanation

Private commodity pools avoid SEC registration requirements by selling to institutional investors and
high net worth individuals. (Topic 4.2, LO 17.4)

Question #59 of 100

B) Seeger is the commodity pool operator, and Smith is the commodity trading advisor of
ComVentures.
Explanation

Commodity pool operators (CPOs) are the general partners in a commodity pool. CPOs typically hire
professional money managers, called commodity trading advisors (CTAs), to actively manage
commodity futures positions. (Topic 4.2, LO 17.4)

Question #60 of 100

B) 54.

Explanation

A weighted moving average (WMA) is an arithmetically declining average of more distant prices. The
WMA calculation is as follows:

(Topic 4.2, LO 17.6)

Question #61 of 100

B) $5.

Explanation

A long binary put option would be priced at $5 (difference of $50 payoff if the merger is successful
and the initial cost of $45) and pays a higher cash amount when the referenced price falls. The
hedge fund position is viewed as a long risk-free bond position with a face value of $50 and a short
binary put option with a price of $5 and an expected payout of $15 (= $50 − $35) in the event the
merger fails. (Topic 4.3, LO 18.1)

Question #62 of 100

C) Interlocking boards.

Explanation

When board members or managers serve on multiple firms and boards simultaneously it is referred
to as interlocking boards. This could result in shareholder conflicts of interest. For example, activist
investors may lead a class action lawsuit against a board of directors and CEO who receives
excessive compensation at the expense of existing shareholders. (Topic 4.3, LO 18.2)

Question #63 of 100

A) Naked call position.

Explanation

A naked call option position occurs when an investor is short a call option and does not own the
underlying asset. (Topic 4.3, LO 18.4)

Question #64 of 100

C) second derivative of an option's price with respect to the underlying price of the asset.

Explanation

Gamma is the second derivative of an option's price with respect to the underlying price of the asset
and it measures how delta changes with changes in the price of the underlying asset. (Topic 4.4, LO
19.2)

Question #65 of 100

A) ABS are generally considered too complex to be considered for arbitrage strategies.

Explanation

The complexity of valuing asset-backed securities (ABS) makes them good candidates for arbitrage
strategies. (Topic 4.4, LO 19.4)

Question #66 of 100

A) Providing liquidity.

Explanation

If an institution starts selling a large quantity of stock in a short time period, the stock price will tend
to drop. A hedge fund manager that starts acquiring shares at depressed prices provides liquidity to
the market. (Topic 4.5, LO 20.1)

Question #67 of 100

B) Senior executives do not disclose the motives for personal transactions.

Explanation

One form of legal insider trading involves basing trades on the actions of senior executives. The
challenge in applying this strategy is that the motives of senior executives are unclear. (Topic 4.5,
LO 20.2)
Question #68 of 100

A) 0.15.

Explanation

The Fundamental Law of Active Management (FLOAM) states that the information ratio can be
separated into two components: the information coefficient and breadth. FLOAM is calculated as:

Breadth measures the number of independent forecasts. In this problem, breadth equals 60.

Using breadth and the information ratio given, we can solve for the information coefficient as follows:

(Topic 4.5, LO 20.3)

Question #69 of 100

C) 18%.

Explanation

Theoretical approaches to estimating the impact of diversification are based on the assumption that
all assets in the portfolio have equal weights, volatility, and amounts of systematic risk. Under these
assumptions, the standard deviation of the portfolio is calculated as:

(Topic 4.6, LO 21.1)

Question #70 of 100

B) FOFs use equally weighted portfolios.

Explanation

FOFs are most likely less biased than individual hedge funds because FOFs retain the returns of
liquidated funds in their track record and use actual weights, which are more reflective of
investments in practice. (Topic 4.6, LO 21.3)

Question #71 of 100

B) Investments in private equity funds are fundamentally different from investments in private equity
securities.

Explanation

While investments in private equity funds are indirect investments in multiple private equity portfolio
companies, an investment in a private equity security is a direct investment in a single private equity
portfolio company. Investors in private equity funds are indirectly investing in private equity portfolio
companies. The protection of limited partners' personal assets in a limited partnership fund structure
is known as the limited liability shield. The general partner (i.e., the private equity firm) bears any
surplus risk from the fund's investment strategies. The life expectancy of private equity funds is
typically 7-10 years. In a PIPE, an investor acquires a private equity position in a public firm, rather
than a public equity position in a publicly traded, private equity firm. (Topic 5.1, LO 22.1)

Question #72 of 100

A) Mezzanine financing is a niche market between story credits and the junk bond market.

Explanation

Mezzanine financing is used as a transitional financing vehicle to bridge financing gaps as a firm
grows and evolves. It may take the form of senior subordinated debt, convertible subordinated stock,
or convertible preferred stock. Bank loans are not generally part of mezzanine financing. Mezzanine
financing falls somewhere between junk bonds and story credits. Mezzanine debt fills the gap in
capital markets for financing available to middle market companies (i.e., firms with a market
capitalization of $200 million to $2 billion). (Topic 5.1, LO 22.3)

Question #73 of 100

B) The shares are trading at a 5.45% discount to NAV.

Explanation

The discount or premium as a percentage of NAV is calculated as follows:

Discount (premium) as a percentage of NAV = (market price / NAV) - 1

Discount (premium) as a percentage of NAV = (52 / 55) - 1 = 5.45%.

(Topic 5.1, LO 22.4)

Question #74 of 100

A) relied on traditional funding sources up to this point.

Explanation

Typically, start-up ventures cannot rely on traditional bank financing due to lack of sufficient
collateral. Negative cash flows are typical at the early stages and most of the firm's assets are
intangible, making it difficult to secure traditional bank financing. (Topic 5.2, LO 23.4)

Question #75 of 100

B) Early stage.

Explanation

BYG would be considered an early-stage venture capital investment. Early stage companies are in
the process of testing second-generation prototypes with customers. These companies also begin
marketing the product and establishing distribution channels. Early-stage companies begin the sales
process and attempt to create a market for its product. Financing during this stage is generally
$2,000,000 or more. (Topic 5.2, LO 23.4)

Question #76 of 100

C) Provision 2 is a clawback provision, and Provision 4 is a fund management covenant.

Explanation

A clawback provision grants the limited partners the ability to reclaim general partner incentive fees
at liquidation if they have experienced a loss of capital. Typical fund management covenants include
restrictions on the size of an investment in any one firm, restrictions on the use of debt, guidelines on
the payout of profits, and restrictions on making investments with other venture funds controlled by
the venture capitalist. (Topic 5.2, LO 23.4)

Question #77 of 100

B) Up to 1%.

Explanation

The fee for taking a firm private is usually up to 1% of the selling price for negotiating the transaction.
(Topic 5.2, LO 23.7)

Question #78 of 100

A) LBOs use less leverage.

Explanation
LBOs use higher levels of leverage compared to venture capital deals. LBOs are generally
considered less risky than venture capital because they invest in more mature firms, have greater
certainty associated with the exit strategy, and the acquired company has an established
management track record. (Topic 5.2, LO 23.7)

Question #79 of 100

C) 120 basis points.

Explanation

Weighted average cost of capital with straight equity: (65% × 5.5%) + (35% × 24%) = 11.98%

Weighted average cost of capital with mezzanine financing: (65% × 5.5%) + (20% × 18%) + (15% ×
24%) = 10.78%

Cost differential = 11.98% − 10.78% = 1.20% or 120 basis points lower

(Topic 5.3, LO 24.1)

Question #80 of 100

B) Any party of interest may submit a reorganization plan to the bankruptcy court for approval.

Explanation

After filing the reorganization plan, the debtor firm has 60 days to convince creditors to accept this
plan. If one-half of the number and two-thirds of the value of each class of claimants accept the plan,
the firm seeks bankruptcy court approval of the plan. If the 60-day period lapses without an
approved plan, any party of interest (the firm's creditors) may submit a reorganization plan to the
bankruptcy court. If the debtor firm accepts the alternative plan, bankruptcy court approval is sought.
If the debtor firm rejects the alternative plan, the debtor firm submits a new plan and again begins
the negotiation process with creditors, or, alternatively, the bankruptcy court can force a cramdown
(the court confirms a reorganization plan in spite of claimant objections). (Topic 5.3, LO 24.2)

Question #81 of 100

A) the first statement only.

Explanation

Corporate capital structure is typically used to segment the risk of the corporation's assets across
investor types and may also be used to segment investor needs based on time horizon, taxation,
and return characteristics.
Tranching in structured products like a CDO allows issuers to redistribute credit risk by priority of
cash flows and principal payments. Tranching does not lower the overall level of credit risk of the
securities. (Topic 6.1, LO 25.2)

Question #82 of 100

D) An increase in market interest rates is likely to cause larger changes in the values of junior and
equity-only tranches compared to senior tranches.

Explanation

Tranches with longer durations (i.e., junior and equity-only) will be more affected by changes in
interest rates compared to tranches with shorter durations (i.e., senior tranches).
An accrual tranche receives no promised interest payments and is like a residual claimant with rights
to cash flows only after all other fixed-income tranches have been paid. Therefore, the value of the
accrual tranche is not likely to be impacted by changes in interest rates in either direction.

With an increase in interest rates, there is less incentive for borrowers to repay mortgages, thereby
leading to the slowing of prepayments. As a result, the value of the interest-only tranche will likely
increase now that the interest payment stream has been extended.

With an increase in interest rates, the value of principal-only tranches will likely decrease in value
due to the slowing of prepayments, so the PO investor is paid the face value later in the future,
thereby lowering its return. (Topic 6.1, LO 25.4)

Question #83 of 100

A) default risk.

Explanation

Default risk is the risk that the issuer of a bond (or the borrower of a loan) will not meet the
obligations of the issue. The borrower is deemed to be in default if it fails to make a scheduled
interest or principal payment. (Topic 6.2, LO 26.1)

Question #84 of 100

B) more complicated to model because both willingness and ability to pay must be considered.

Explanation

There are three reasons why sovereign credit derivatives are considered more complicated than
non-sovereign credit derivatives:
 Both the ability and the willingness of the sovereign entity to pay its obligations must be
modeled.
 The sovereign market is smaller than the corporate market, and there is a lack of empirical data.
 Credit models must incorporate additional macroeconomic factors not relevant to corporate
entities. (Topic 6.2, LO 26.3)

Question #85 of 100

D) Stock split.

Explanation

ISDA identified seven trigger events which trigger a payment from a credit protection seller to a
credit protection buyer:

 Bankruptcy.
 Failure to pay.
 Restructuring.
 Obligation acceleration.
 Obligation default.
 Repudiation/moratorium.
 Government intervention. (Topic 6.2, LO 26.4)

Question #86 of 100

A) have asymmetric payouts.

Explanation

Credit default swaps (CDSs), like credit options, have asymmetric payouts due to the contingent
nature of both types of instruments. A CDS only requires the credit protection seller to make a
payment if a trigger event occurs. CDSs do not require an initial payment by one party, while options
require the buyer to pay a premium. Options give the buyer the right to exercise, whereas CDSs
require the credit protection seller to make a payment. CDSs require a fixed periodic payment by the
credit protection buyer. Options only require the initial payment of the premium. (Topic 6.2, LO 26.5)

Question #87 of 100

C) excess earnings of the CDO collateral pool.

Explanation
The WAS over LIBOR measures the average income of the collateral used in the CDO trust above
LIBOR. Weighted average rating factor (WARF) measures the average credit rating of the collateral
used in the CDO trust. The CDO manager must monitor both WAS and WARF. Holders of the senior
tranche want to minimize WARF, while holders of the equity tranche want to maximize WAS. (Topic
6.3, LO 27.1)

Question #88 of 100

D) Synthetic CDOs using CDS.

Explanation

Synthetic CDOs using credit default swaps are often called correlation products because the credit
default swap (CDS) exposure is tied to the default of more than one bank loan. (Topic 6.3, LO 27.8)

Question #89 of 100

D) Schedule of interest payments received from the underlying collateral differs from the schedule
of interest payments on collateralized debt obligation securities.

Explanation

Differences in interest payment receipt periodicity is caused when the schedule of payments from
the underlying collateral does not match the schedule of payments to be made on the collateralized
debt obligation securities. (Topic 6.3, LO 27.8)

Question #90 of 100

A) With a U.S.-based structured product, investors may earn multiple different payouts.

Explanation

With a U.K.-based structured product, investors lose some upside returns in exchange for principal
protection. With a French-based structured product, afloor is the minimum return that is used to
calculate a payout to the investor. With a Swiss-based structured product, investors give up principal
protection in exchange for greater upside returns. (Topic 6.4, LO 28.4)

Question #91 of 100

D) Confirmation bias.

Explanation
Confirmation bias refers to instances where individuals more heavily weight information that agrees
with their beliefs while discounting information that disagrees with their beliefs. (Topic 7.1, LO 29.1)

Question #92 of 100

D) Bayou Management.

Explanation

Israel and Marino, the managers of Bayou, falsified financial records, used commission rebates from
a broker created by the firm (Bayou Securities) to hide losses, and created an accounting firm to
serve as the independent auditor. (Topic 7.1, LO 29.3)

Question #93 of 100

B) implementing well-designed operational systems to prevent errors.

Explanation

There are three primary sources of operational risk: operational errors, agency conflicts, and
operational fraud. Operational errors result from unintentional mistakes made while executing a
fund's strategy. Well-designed and implemented operational systems reduce as well as detect
operational errors. (Topic 7.2, LO 30.4)

Question #94 of 100

A) a long put, a short call, and a long position in the underlying stock.

Explanation

The combination of a put, a call, and an underlying asset can create a riskless hedge. The
relationship is:

put − call + stock = riskless bond

That is, a long position in a put, a short position in a call, and a long position in an underlying stock
removes risk. The long put removes the downside risk exposure from the long stock position. The
short call gives up the profit from potential increases in the underlying stock. (Topic 7.2, LO 30.6)

Question #95 of 100

B) Investment process risk is an idiosyncratic risk, and a key personnel clause allows asset
withdrawal if key personnel no longer make investment decisions for the fund.
Explanation

Investment process risk is the possible loss from lack of proper execution of the stated investment
strategy. A key personnel clause can be contained in the investor agreement that permits investors
to withdraw funds if key personnel are no longer making investment decisions for the fund. (Topic
7.3, LO 31.2)

Question #96 of 100

D) Legal counsel can assess a fund's current regulatory registrations and determine whether
pending civil, criminal, or regulatory proceedings have merit.

Explanation

Legal counsel should be utilized when assessing regulatory registrations and the merits of any
pending litigation. An outside auditor can provide verified information regarding a fund's accounting
and operations. The CFO reports performance to investors, but outside auditors verify the integrity of
this performance. Prime brokers, not outside auditors, are in the best position to assess the current
condition of a fund. Registration as an investment adviser is not an indicator of past malfeasance by
a fund. (Topic 7.3, LO 31.3)

Question #97 of 100

C) The U.S. investors will only pay taxes based on U.S. tax laws, while the Japanese investors will
only pay taxes based on Japan's tax laws.

Explanation

The master trust structure is tax neutral, meaning that there are no direct tax consequences at the
master trust level. A master trust is usually set up in a place that does not have corporate income
taxes, such as Bermuda, which allows any tax consequences associated with the hedge fund to flow
down to the tax code of the investor's home country. (Topic 7.3, LO 31.3)

Question #98 of 100

A) Omega-score.

Explanation

The omega-score was developed by Brown, Goetzmann, Liang, and Schwarz in 2008 and is an
excellent measure of operational risk of a fund. (Topic 7.3, LO 31.10)
Question #99 of 100

B) 33.

Explanation

The notional value of the futures contracts required to hedge the position is:

2,200,000 × 1.2 = $2,640,000

The number of contracts required to hedge the position is:

2,640,000 / (805 × 100) = 32.8 or 33 contracts (rounded)

(Topic 7.4, LO 32.4)

Question #100 of 100

C) The new investment model provides greater flexibility to seek alpha independent of the beta,
while traditional asset allocation provides little flexibility with respect to benchmarks.

Explanation

The problem with the traditional approach is that it provides little flexibility with respect to asset
allocations and benchmarks. Alpha opportunities are not central to the approach and, thus,
managers often find themselves seeking alpha in highly efficient markets such as bond and stock
markets rather than in alternative asset classes. The new investment model is more flexible than the
traditional model. In the new model, alpha is sought independently of beta. (Topic 7.4, LO 32.5)