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CFA Level 1 Practice Questions for Equity Investments

CFA Level 1 Practice Questions for Equity Investments

1. Which of the following is the least accurate rationale to justify the use of price-to-book value (P/B) ratio as a measure of relative valuation of companies or common stocks?

A. P/B is a useful measure of value for firms that are not expected to continue as a going concern.

B. Compared to P/E, the P/B ratio is not influenced by such accounting effects as expensing a capital

investment as opposed to capitalizing it.

C. P/B is particularly appropriate to value companies primarily composed of liquid assets, for example,

those in the financial services industry.

It is incorrect to say that P/B correctly reflects a company’s value. The historical cost basis of assets in P/B ratio is a drawback, not a rationale for using it as a measure of relative valuation.

2. An analyst is creating a new stock market index that is not affected by stock splits. The index the analyst is least likely to develop is:

A. unweighted.

B. price-weighted.

C. value-weighted.

 A price-weighted index, such as the Dow Jones Industrial Average, requires adjustment for stock splits. It is computed by summing the prices of individual stocks and dividing by a divisor that is adjusted for

stock splits such that the index value is the same before and after the split.

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3. An analyst gathers the following information about a company:

The price-to-book (P/B) ratio of the company is closest to:

A. 2.31.

B. 3.50.

C. 4.20.

Number of issued and outstanding shares = 4 m 0.5 m = 3.5 m; (Issued Treasury Stock) BV per share

 = 4m shares (1.50) + \$20 m + \$5 m - \$10 m = \$21 m / 3.5 m sh. = \$6.00 Price-to-book value = \$21 / \$6.00 = 3.50 4. A call market is least likely characterized as a market: A. with bid-ask prices posted by dealers. B. where buy-sell orders are cleared at a single equilibrium price. C. with participation by a small number of active investors-traders.

In a call market traders/investors indicate their bids and asks for stocks and they are not posted by dealers. Also, a call market is not a dealer or quote-driven market.

5. The annual report of a company as at the end of its first year of its operation contains the following

data:

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The company’s ending inventories using LIFO are valued at \$1,500,000 and a footnote to financial statements reports inventories valued using FIFO would be \$1,900,000. The company’s tax rate is 30 percent. The FIFO adjusted price-to-book value of the company is closest to:

A. 3.93.

B. 4.00.

C. 4.08.

Inventory Adjustment = \$400,000 x 0.70 = \$280,000: (FIFO LIFO values) x (1-Tax rate) BV per share = \$1 m + \$10 m + \$4 m + \$0.28 m = \$15.28 / 2 m sh. = \$7.64. Price-to-book value = \$30 / \$7.64 = 3.93

6. An analyst gathers the following data about a company with a double-digit growth rate that is expected to continue for three more years:

The best estimate of the company’s value per share is closest to:

A. €48.68.

B. €50.68

C. €85.93

7. An equity fund manager gathers the following data in order to assess the investment potential of a company and its stock:

Based on the above information, which of the following statements most accurately describes the company and its stock? The company is a:

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A. growth company and its stock is a growth stock.

B. growth company and its stock is a speculative stock.

C. speculative company and its stock is a growth stock.

The company is a growth company since the spread between ROA and WACC is larger than the industry average and its dividend yield is 0% compared to the industry average of 1.2%. The company’s stock is a growth stock considering its under¬valuation. A speculative stock, on the other hand, would be

overvalued.

8. Free cash flow to equity is most accurately described as operating free cash flow adjusted for:

A. only interest payments to debt holders.

B. payments to both debt holders (interest and principal) and preferred stockholders.

C. both interest and principal payments to debt holders, but not payments to preferred stockholders.

Free cash flow to equity is derived after adjusting the operating free cash flow for payments to debt holders (interest and principal) as well as preferred stockholders.

9. Assuming efficient markets and a lack of access to superior analysts, which of the following is the least important activity in managing portfolios?

A. Minimizing total transaction costs.

B. Diversifying completely on a global basis.

C. Paying close attention to the monetary policy environment.

In efficient markets and without access to superior analysts, portfolio management calls for minimizing the transaction costs and diversifying completely on a global basis. Paying attention to the monetary policy and evaluating its implications for portfolio management is appropriate for portfolio managers with access to superior analysts.

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10. An analyst gathers the following data about a company in order to estimate its price/earnings (P/E)

ratio.

The P/E ratio is closest to:

A. 6.7 x.

B. 13.3 x.

C. 20.0 x.

Growth rate = g = RR x ROE = (1 - 0.40) x 15 = 9%; P/E1 = D1/E1 ÷ (k - g) = 0.40 ÷ (0.12 - 0.09) =13.33

11. For growth companies which of the following components of ROE is most likely to decline first?

A. Profit margin.

B. Financial leverage.

C. Total assets turnover.

For growth companies profit margin is one of the first ratios to decline due to increased competition and forced price cuttings.

12. Which of the following is least likely included in the assumptions of an informationally efficient

securities market?

A. A large number of profit-maximizing participants analyze and value securities.

B. New information regarding securities comes to the market in a predictable manner.

C. Profit-maximizing investors adjust security prices rapidly to reflect the effect of new information.

The assumption that the new information comes to the market in a predictable manner is an inaccurate statement. The correct assumption is that the new information comes to the market in a random

fashion.

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13. The index weighting that results in portfolio weights shifting away from securities that have increased in relative value (e.g., decrease in book-to-market) toward securities that have fallen in relative value whenever the portfolio is rebalanced is most accurately described as:

A. equal weighting.

B. fundamental weighting.

B is correct. Fundamentally weighted indices generally will have a contrarian “effect” in that the portfolio weights will shift away from securities that have increased in relative value and toward securities that have fallen in relative value whenever the portfolio is rebalanced.

14. According to the industry life-cycle model, an industry in the shakeout stage is best characterized as experiencing:

A. slowing growth and intense competition.

B. little or no growth and industry consolidation.

C. relatively high barriers to entry and periodic price wars.

A is correct. The shakeout stage is usually characterized by slowing growth, intense competition, and declining profitability. During the shakeout stage, demand approaches market saturation levels because few new customers are left to enter the market. Competition is intense as growth becomes increasingly dependent on market share gains.

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15. An investor uses the data below and Gordon’s constant growth dividend discount model to evaluate

a company’s common stock. To estimate growth, she uses the average value of the:

1) compounded annual growth rate over the period 20062011 and 2) sustainable growth rate for the year 2011.

 If her required return is 15%, the stock’s intrinsic value is closest to: A. \$23.71. B. \$25.31. C. \$30.14. Answer = B B is correct. V0 = D1/(r – g
 16. According to behavioral finance, observed overreaction in securities markets most likely occurs due to: A. loss aversion. B. gambler’s fallacy. C. disposition effect.

A is correct. According to loss aversion related arguments in behavioral theories, investors dislike losses more than they like comparable gains. Thus, such a behavioral bias can explain observed overreaction in

markets.

17. Companies pursuing cost leadership will most likely:

A. invest in productivity-improving capital equipment.

B. engage in defensive pricing when the competitive environment is one of high rivalry.

C. establish strong market research teams to match customer needs with product development.

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A is correct. Companies pursuing cost leadership must be able to invest in productivity-improving capital equipment in order to be low-cost producers and maintain efficient operating systems.

18. The following data pertain to a margin purchase of a stock by an investor.

If the stock is sold exactly one year after the purchase, the total return on the investor’s investment is closest to:

A. 14%.

B. 19%.

C. 22%.

19. A trader seeking to sell a very large block of stock, or a piece of urban real estate property, for her

client will most likely execute the trade in a(n):

A. brokered market.

B. order-driven market.

C. quote-driven market.

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A is correct. Instruments that are infrequently traded and expensive to carry as inventory (e.g., very

large blocks of stock, real estate properties, fine art masterpieces, and liquor licenses) are executed in brokered markets. Organizing order-driven markets for such instruments is not sensible because too few traders would submit orders to them.

20. Accounting standards and reporting requirements that produce meaningful and timely financial

disclosures are most critical for achieving which of the following efficiencies associated with a well-

functioning financial system?

A. Operational

B. Allocational

C. Informational

C is correct. Accounting standards and reporting requirements that allow meaningful and timely

financial disclosures reduce the costs of obtaining fundamental information and thereby allow analysts to form more accurate estimates of fundamental values. Liquid markets allow well-informed traders to

fill their orders at low costs. Well-informed traders make prices informationally efficient.

21. Arbitrage activity will most likely be higher in securities markets:

A. that are efficient.

B. with no restrictions on short selling.

C. with high information-acquisition costs.

B is correct. Short selling helps in price discovery. Arbitrageurs benefit from pricing discrepancies

(inefficiencies); therefore, arbitrage activity will be higher in markets with no restrictions on short

selling.

22. An analyst collects the following data on the return on equity (ROE) and the payout ratio for two

companies, M and N. Using a required return of 12.4% for both companies, she computes the justified

forward P/E ratios, which are also given below.

If Company M increases its dividend payout ratio to 40% and Company N decreases its dividend payout ratio to 30%, which of the following will most likely occur? The justified P/E ratio of:

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A. both companies would increase.

B. both companies would decrease.

C. Company M would increase but that of Company N would decrease.

A is correct. Dividend growth rate = (1 Payout ratio) × ROE; Justified forward P/E: P0/E1 = p/(r g). Using the new payout ratios, the justified forward P/Es, calculated below, of both firms would increase. Company M: New dividend growth rate = (1 0.4) x 12% = 7.2%; New Justified forward P/E = 0.4/(0.124

0.072) = 7.7x.

Company N: New dividend growth rate = (1 0.3) x 14% = 9.8%; New Justified forward P/E = 0.3/(0.124

0.098) = 11.5x.

23. A fund manager gathers the following data in order to assess a stock’s potential for a possible addition to her portfolio:

Which of the following is the most appropriate decision for the fund manager?

A. Do not invest in the stock.

B. Invest in the stock because the company’s ROE is greater than the required rate of return.

C. Invest in the stock because the required rate of return is greater than the company’s WACC.

A is correct. The company’s cost of equity is often used as a proxy for the investors’ minimum required

rate of return because it is the minimum expected rate of return that a company must offer its investors to purchase its shares in the primary market and to maintain its share price in the secondary market. Using the CAPM, the company’s cost of equity = 3.50% + 1.80(5.25%) = 12.95%, compared with the fund manager’s required rate of return of 13.60%. Therefore, the fund manager should not invest in the

stock.

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24. An observation that stocks with above average price-to-earnings ratios have consistently

underperformed those with below average price-to-earnings ratios least likely contradicts which form of

the market efficiency?

A. Weak form

B. Strong form

C. Semi-strong form

B is correct. The observation that stocks with high above-average price-to-earnings ratios have consistently underperformed those with below-average price-to-earnings ratios is a cross-sectional anomaly. It is a contradiction to the semi-strong form of market efficiency and weak-form market efficiency because all the information used to categorize stocks by their price-to¬earnings ratios is publicly available.

25. In securities exchange markets, a member who executes stop loss or stop buy orders when the specified price occurs is most likely a:

A. specialist.

C. commission broker.

The specialists (market makers) have two major functions. They act as brokers to match buy and sell orders, including special (stop loss or stop buy) orders.

26. An analyst gathers the following data for a company to estimate the expected growth rate of

dividends and use it as an input for valuing the company’s common stock.

The company’s expected growth rate is closest to:

A. 4.2%.

B. 6.3%.

C. 12.5%.

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g = RR x ROE; RR = (1 Payout Ratio) = 1 0.25 = 0.75 ROE = ROA x Financial Leverage; ROE = 10% x 1.67

= 16.67%; g = 0.75 x

16.67 = 12.5%

27. Which of the following statements about the short sale of a stock is least accurate?

A. The short seller must pay any dividends due to the lender of shares.

B. A stop buy order would enable a short seller to minimize potential losses.

C. Short sales involve time limits for returning the shares borrowed to the lender.

Describe the process of selling a stock short and discuss an investor’s likely motivation for selling short.

28. An analyst gathers the following data to determine the attractiveness of the company’s common

stock:

Using the constant growth dividend discount model, the stock’s intrinsic value is closest to:

A. \$12.82.

B. \$18.29.

C. \$19.57.

g = growth rate of dividends: [(3/2)1/6] - 1= 7%; Alternatively, PV = 2, FV = -3 n= 6, compute I/Y;

k = 9 +

 1.8 (17 – 9) = 23.4% V = 3(1.07) / (0.234-0.07) = 19.57 29 Value Line Index, an unweighted index, uses which of the following methods in the computation of

the holding period returns of underlying stocks?

A. Geometric mean.

B. Arithmetic mean.

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C. Value-weighted mean.

CFA Level 1 Practice Questions for Equity Investments

The Value Line Index, an un-weighted index, uses the geometric mean return approach.

30. The behavior of investors who put more money into a failure that they feel responsible for, rather

than into a success, is most accurately described as:

A. escalation bias.

B. confirmation bias.

C. overconfidence bias.

Escalation bias refers to the investor behavior of putting more money into a failure that they feel responsible for rather than into a success. This leads to the practice of “averaging down” by viewing the additional purchase as a “bargain” rather than considering the initial purchase as a mistake and selling the stock.

31. An analyst gathers the following data about a company:

Using the dividend discount model, the company’s dividend payout ratio is closest to:

A. 5%.

B. 30%.

C. 70%.

= / (k g); \$40 = \$2 / (0.12 -g); g= 7%; g = ROE x RR; RR = 7 / 10 = 0.70; Payout Ratio = 1 RR = 1 0.70 = 0.30 = 30%.

32. Which of the following attributes is least likely to be associated with the characteristics of a well

functioning securities market?

A. Market depth.

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C. Rapid adjustment of prices to new information.

Wide bid-ask spreads is not a characteristic of a well functioning market.

33. The best description of the measure of cash flow to use when estimating the total value of a firm is

the operating free cash flow:

A. prior to interest payments on debt.

B. prior to interest payments on debt but after deducting funds needed for capital expenditures.

C. after adjustment for payments to debt holders, but before dividend payments to common

stockholders.

The appropriate cash flow for estimating the total value of a firm is the operating free cash flow prior to interest payments on debt but after deducting funds needed for capital expenditures.

34. Which of the following is the least likely source of unreliability of a pricing anomaly?

A. Data mining.

B. Arbitrage activity.

Arbitrage activity is not a source of unreliability of an anomaly. Arbitrageurs attempt to take advantage of an anomaly and are not a source of its unreliability.

35. The best characterization of the strong-form of efficient market hypothesis (EMH) with respect to

the information set is that it encompasses:

A. both weak-form and semistrong-form hypotheses.

B. neither weak-form nor semistrong-form hypothesis.

C. the semistrong-form but not the weak-form hypothesis.

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The difference among the three forms of the EMH revolves around the information set included in each. The weak form includes public market information, the semistrong form includes all public information, and the strong form includes all public and private information. The strong form EMH encompasses both the weak-from and the semistrong form EMH.

36. Among a company’s price to earnings (P/E), price to sales (P/S), and price to cash flow (P/CF) ratios, it is most accurate to state that P/E ratios are generally more stable from period to period than:

A. P/S ratios but not P/CF ratios.

B. P/CF ratios but not P/S ratios.

C. neither P/S ratios nor P/CF ratios.

Discuss the rationales for, and the possible drawbacks to, the use of price to earnings (P/E), price to book value (P/BV), price to sales (P/S), and price to cash flow (P/CF) in equity valuation. Calculate and interpret P/E, P/BV, P/S, and P/CF.

37. The issue of differences in accounting conservatism between companies is best addressed when

companies are compared using which of the following ratios?

A. Price-to-earnings

B. Price-to-cash flow

C. Price-to-book value

Using price-to-cash flow rather than price-to-earnings addresses the issue of differences in accounting conservatism between companies (differences in quality of earnings).

 38. A continuous market most likely exists for a stock when: A. specialists or market makers attempt to derive new equilibrium prices in an orderly manner. B. new information about the company prospects is continuously released to market participants. C. trades occur at any time the market is open wherein stocks are priced either by auction or by dealers. Answer: C

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In a continuous market, trades occur at any time the market is open and the stocks are priced either by auction or by dealers. The dealers provide liquidity for investors by buying and selling the shares of stock for themselves.

39. Capital market efficiency is desirable, but there are limitations to achieving full market efficiency. Which of the following is least likely to be a limitation to achieving full capital market efficiency?

A. Survivorship bias

B. Limits of arbitrage

C. Cost of information

The three limitations for achieving full capital market efficiency are: 1) cost of information, 2) cost of trading, and 3) limits of arbitrage. Survivorship bias is not one of them.

40. A price-weighted index series is composed of the following three stocks:

If stock Z completes a three-for-one stock split at the end of Day 1, the value of the index after the split (at the end of Day 3) is closest to:

A. 29.9.

B. 31.7.

C. 32.3.

The price-weighted index is computed by totaling the current prices of the stocks in the index and dividing the sum by a divisor that has been adjusted for stock splits and changes in the sample over time. Index before the split = (10 + 20 + 60) / 3 = 30; New divisor: [(10 + 20 + 20) / X] = 30; X = 1.67 Index after the split = (12 + 19 + 22) / 1.67 = 31.7

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41. An analyst gathers the following information about a company:

The analyst expects the information above to accurately reflect the future. If the company wants to achieve a growth rate of 15% without changing its capital structure or issuing new equity, the company’s maximum dividend payout ratio (in %) is closest to:

A. 25.

B. 40.

C. 60.

ROE = ROA x Financial leverage; Retention ratio = growth rate / ROE; Payout ratio = 1 Retention ratio ROE = (10.0%)(2.5) = 25%; Retention ratio = 0.15/0.25 = 0.60; Payout ratio = 1 0.60 = 40.0%

42. A company has furnished the following information:

According to the dividend discount model and the other data given, the company’s stock is best described as a:

A. growth stock.

B. cyclical stock.

C. speculative stock.

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A speculative stock is (i) substantially overvalued and (ii) it sells at an extremely high P/E ratio. The computations for intrinsic value are: Implied dividend growth By accessing this mock exam, you agree to the following terms of use: rate = ROE x RR = 20% x 0.5 = 10%; Intrinsic value of the stock = €2.20 / (15%

– 10%) = €44.00 compared to the market price of €50. The stock's P/E is 30x versus the industry average of 20x.

43. An investor opens a margin account with an initial deposit of \$5,000.

shares of a stock at \$30. His margin account has a maintenance margin requirement of 30%. Ignoring commissions and interest, the price (in \$) at which the investor receives a margin call is closest to:

He then purchases 300

A. 19.05.

B. 23.08.

C. 23.81.

Determine the stock price at which the investor receives a margin call by solving for the critical stock price, P, as: [(#of shares x P) Margin Loan] / (# of shares x P) = % of Maintenance Margin (300P \$4,000) / 300P = .30; P = \$4,000 / 210 = \$19.05

44. The following information is from a company’s most recent financial statements:

The company uses the LIFO inventory method. The footnotes to the financial statements indicate that if the company had used the FIFO method, the inventory balance would have been \$45 million higher than the amount reported on the

company’s most recent financial statements. If the company’s common stock is currently selling for \$59 per share, the company’s adjusted price-to book-value ratio is closest to:

A. 1.67.

B. 1.79.

C. 1.89.

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Adjusted book value equals shareholders' equity adjusted for equity claims that are senior to common stock and inventory method, and other adjustments related to pension and retirement plans. Dividing by the number of outstanding common shares results in the adjusted book value per share. Adj. price to book value ratio = Current stock price / Adj. book value per share Adj. book value per share = [\$325 \$40 + \$45(0.6)] / 10 = \$31.20

Adj. price to book value ratio = \$59 / \$31.20 = 1.89.

45. An investor gathers the following data for a company:

The company’s estimated dividend growth rate (in %) is closest to:

A. 8.0.

B. 10.0

C. 12.5.

ROE = Net income / Equity; Retention rate = 1 (Dividends / Net income); g = Retention rate x Return on equity Equity = \$200 million - \$120 million = \$80 million; ROE = \$10 million / \$80 million = 12.5%. Alternatively using the DuPont Model: ROE = Return on assets x Financial leverage or Profit margin x Total assets turnover x Financial leverage; Sales = NI / NPM = \$10 million / 0.02 = \$500 million; TAT = 500 / 200 = 2.5 Financial Leverage = 200 / 80 = 2.5

ROE = 2 x 2.5 x 2.5 = 12.5% Retention rate = 1 (\$2 million / \$10 million) = 80%; Growth rate = 12.5% x 80% = 10%.

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46. A company’s \$100 par perpetual preferred stock has a dividend rate of 7 percent and a required rate of return of 11 percent. The company’s earnings are expected to grow at a constant rate of 3 percent per year. If the market price per share for the preferred stock is \$75, the preferred stock is most appropriately described as being:

A. overvalued by \$11.36.

B. undervalued by \$15.13.

C. undervalued by \$36.36.

Value of perpetual preferred stock = Dividend / Investor’s required rate of return \$7/ 0.11 = \$63.64. The stock is overvalued by \$75.00 63.64 = \$11.36.

47. An equity analyst working for a growth oriented mutual fund has a tendency to misvalue the stocks

of popular companies that she has previously recommended and the fund already owns. Her behavior is

most likely consistent with which of the following biases?

A. Escalation bias

B. Prospect theory

C. Confirmation bias

Confirmation bias refers to the bias of looking for information that supports prior opinions and decisions, which leads to a tendency to misvalue the stocks of generally popular companies.

48. A company earned \$3 a share last year and just paid a dividend of \$2 a share. The company’s

dividends are expected to grow by 8 percent annually for the next two years. An investor with an 11 percent required rate of return expects to sell the stock at \$75 two years from now. The maximum amount the investor should be willing to pay for this company’s stock (in \$) today is closest to:

A. 58.68.

B. 64.71.

C. 66.63.

V = D1 / (1 + k) +D2 / (1 + k)2+ SP2 / (1 + k)2 The value of the stock:

= \$64.71

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49. In an efficient market, fundamental analysis most likely requires that the analyst must:

A. extrapolate historical data to estimate future values and take investment decisions.

B. do a superior job of estimating the relevant variables and predict earnings surprises.

C. use trading rules for detecting the price movements that lead to new equilibrium prices.

To take advantage of the long-run price movements in an efficient capital market the analyst must do a superior job of estimating the relevant variables and predict earnings surprises.

50. A large manufacturing company is in a competitive industry. It has above-average investment

opportunities and its return on investments has been above the required rate of return. The firm retains a large portion of earnings to fund its superior investment projects. The company is best characterized as a:

A. growth company.

B. cyclical company.

C. speculative company.

Growth companies are characterized by above-average investment opportunities that yield rates of return greater than the firm’s required rate of return. They also retain a large portion of their earnings to fund the superior investment projects and hence they tend to have low dividend payout ratios.

51. A security market with price continuity is most accurately characterized as a market in which:

A. assets can be bought or sold quickly with minimal transaction costs.

B. prices change rapidly from one transaction to the next in response to new information.

C. prices do not change much from one transaction to the next in the absence of new information.

Price continuity means that prices do not change much from one transaction to the next unless substantial new information becomes available.

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52. An analyst gathered the following information for a company whose common stock is currently priced at \$40 per share:

A severe cyclical contraction occurred in 2009 for a major segment of the company’s operations. What is the most accurate estimate of the stock's P/E ratio assuming the analyst uses the average ROE method for normalizing the firm's EPS?

A. 26.5

B. 32.8

C. 34.2

To normalize the EPS, multiply the current book value per share with the average ROE for the most recent full cycle. Normalized P/E = current market price / normalized EPS. Average ROE = (14 + 7 + 8 + 8)/4 = 9.25; Normalized EPS = Normalized ROE x 2009 BVPS = 0.0925 × 16.30 = \$1.51 Normalized P/E = \$40/1.51 = 26.5.

53. Which of the following most accurately describes the computation of nearly all bond market indices, U.S. and global?

A. Model priced

C. Market priced

Compare and contrast major structural features of domestic and global stock indices, bond indices, and composite stock-bond indices.

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54. An analyst gathers the following data about a company and the market:

Using the dividend discount model the company’s price per share (in \$) is closest to:

A. 16.00.

B. 16.82.

C. 18.28.

Dividend per share = Earnings per share x Payout ratio; k = E(Ri) = RFR + βi (RM

RFR); Vj = D1 / (k - g), where Vj = value of stock; D1 = D0 (1 + g); ks = the required rate of return; g = the constant growth rate of dividends. Most recent dividend (D0) = 2.00 (0.6) = 1.20

k = 4.20 + 5.60(1.50) = 12.60%; V = 1.20(1.051) / (0.126 0.051) = \$16.82 Note: The notation of E(Ri) in

p. 279 (Vol. 4) is the same as k in p. 142 (Vol. 5).

55. All else equal, a decrease in the expected rate of inflation will most likely result in a decrease in:

A. the real risk-free rate.

B. the nominal risk-free rate.

C. both real and nominal risk-free rates.

The nominal risk-free rate of return includes both the real risk-free rate of return and the expected rate of inflation. A decrease in inflation expectations would decrease the nominal risk-free rate of return, but would have no effect on the real risk-free rate of return.

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56. A security market in which all the bids and asks for a stock are gathered to arrive at a single price

that satisfies most of the orders is best described as a:

A. call market.

B. dealer market.

C. primary market.

A call market is a market in which all the bids and asks for a stock are gathered to arrive at a single price

where the quantity demanded is as close as possible to the quantity supplied.

57. Which of the following statements most accurately describes the weak-form Efficient Market

Hypothesis (EMH)? The weak-form EMH assumes that current security prices:

A. fully reflect all information from public and private sources.

B. fully reflect all security market information, including transactions by exchange specialists.

C. adjust rapidly to the release of all public information; that is, security prices fully reflect all

public information.

The weak-form EMH assumes that current stock prices fully reflect all security market information, including transactions by exchange specialists.

58. An analyst gathered the following information about a company:

If markets are in equilibrium, which of the following statements best describes the company’s price-to- earnings (P/E) ratio? The company’s P/E ratio based on the infinite period dividend discount model (DDM) is:

A. less than the company’s trailing P/E ratio.

B. the same as the company’s trailing P/E ratio.

C. greater than the company’s trailing P/E ratio.

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The trailing P/E ratio is computed as the current stock price divided by the current or trailing 12-months’ EPS. On the other hand, the P/E ratio based on the infinite period dividend discount model is computed as (D/E) / (k g). If markets are in equilibrium, the price per share reflects the value determined by the constant growth dividend. Using the constant growth model the stock's value is (\$2.40)(1.08) / 0.07 = \$37.03; The trailing P/E = 37.03 / 6 = 6.17. The DDM P/E is the dividend payout ratio divided by k-g = 0.4 / 0.07 = 5.71. Another way of computing DDM P/E is: Current Market Price/Expected 12-month earnings: 37.03/(6.00 x 1.08) = 5.71. (see p. 148)

59. An investor borrows the maximum amount allowed by the initial margin requirement of 40 percent

to purchase 100 shares of a stock selling at \$60 per share. If the investor sells the stock when its price

increases to \$70 per share, her return (%), before commissions and interest, will be closest to:

A. 16.7

B. 27.8

C. 41.7

Investor’s return = (Market value of the stock – Loan) / Investor’s Equity.

Equity = 100 x 60 x 0.4 = \$2,400; Loan = 100 x 60 x 0.6 = \$3,600 Market value of the stock = (70 x 100) =

\$7,000;

Investor’s return = (7,000 3,600) / \$2,400) 1 = 41.667%. Alternatively, Return = Profit/Investment = 100 x (70-60)/2,400 = 41.667%

60. Data that helps to compute expected growth rates of companies are furnished below:

Which of the following best describes the expected growth rate of Company 1? The expected growth rate of Company 1 compared to Company 2 is:

A. lower.

B. higher.

C. the same.

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ROE = Return on assets x Financial leverage; Retention rate = 1 (Payout ratio); g = Retention rate x Return on equity Company 1: ROE = 12% x 1.6 = 19.2%; g = (1 0.375) x 19.2 = 12% Company 2: ROE = 10% x 2.0 = 20.0%; g = (1 0.400) x 20.0 = 12%

61. An investor buys a stock on margin. Assume that the interest on the loan and the dividend are

both paid at the end of the holding period. The data related to the transaction are as follows:

The investor’s total return on this investment over the margin holding period is closest to:

A. 15.6%.

B. 16.7%.

C. 21.4%.

62. In futures markets, contract performance is most likely guaranteed by:

A. clearing houses.

B. regulatory agencies.

C. the futures exchanges.

Clearing houses arrange for financial settlement of trades. In futures markets, they guarantee contract

performance.

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63. An equity fund manager is considering a market index as benchmark for his portfolio and he has the

following preferences:

• the index should have a contrarian “effect”;

shares held by controlling shareholders should not be excluded;

dividends should be included in the weighting of constituent securities; and

the weights of constituent securities should not be arbitrarily determined by the index provider.

Which of the following weightings of indices best meets the fund manager’s preferences?

A. Equal.

B. Fundamental.

Fundamental weighting satisfies the fund manager’s preferences. Fundamental indices use a single measure, such as total dividends, to weight the constituent securities. Fundamentally weighted indices generally will have a contrarian “effect” in that the portfolio weights will shift away from securities that have increased in relative value and toward securities that have fallen in relative value whenever the portfolio is rebalanced. All shares are included in a fundamental weighted index.

64. Which of the following is the most accurate characterization of momentum anomalies? Momentum

anomalies:

A. relate to long-term price patterns.

B. relate to short-term price patterns.

C. are consistent with weak-form market efficiency.

Momentum anomalies relate to short-term price patterns, typically resulting from investor overreaction in response to the release of unexpected public information.

65. The advantages to an investor owning convertible preference shares of a company most likely

 include: A. less price volatility than the underlying common shares. B. preference dividends that are fixed contractual obligations of the company.

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 C. an opportunity to receive additional dividends if the company’s profits exceed a pre-specified level. Answer = A

Convertible preference shares tend to exhibit less price volatility than the underlying common shares because the dividend payments are known and more stable

66. A company has issued only one class of common shares and it does not pay dividends on them. It has

also issued two types of preference shares one that is putable and the other callable and both have a

non-cumulative feature. Which of these securities will most likely offer the lowest expected return to the investor?

A. Common shares.

B. Putable preference shares.

C. Callable preference shares.

Putable preference shares are less risky than their callable counterparts. They give the investor the option to put the shares back to the company. Because of the lower risk they will provide a lower expected rate of return. Common shares are the most risky, whether or not they are dividend paying, and are likely to offer the highest expected return.

67. An industry experiencing slow growth, high prices, and volumes insufficient to achieve economies of

scale is most likely in the:

A. mature stage.

B. shakeout stage.

C. embryonic stage.

An embryonic industry is one that is just beginning to develop and is characterized by slow growth, high prices, volumes not yet sufficient to achieve meaningful economies of scale, developing distribution channels, and low brand loyalty as there is low customer awareness of the industry’s product.

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68. Which of the following industries is most likely characterized by low barriers to entry, fierce

competition, fragmented structure, and weak pricing power?

A. Restaurants.

B. Proprietary drugs.

C. Credit card processing.

Explain the effects of industry concentration, ease of entry, and capacity on return on invested capital and pricing power.

Restaurants industry is characterized by low barriers to entry because anyone with a modest amount of capital and some culinary skill can open a restaurant. The industry, however, is fragmented which can lead to fierce competition and weak pricing power.

69. A fund manager compiles the following data on two companies:

Based on the information provided, the most accurate conclusion is that Company A’s stock is more attractive relative to that of Company B’s because of its:

A. smaller P/E ratio.

B. greater financial leverage.

C. higher dividend growth rate.

From the computations shown below Company A’s stock is more attractive because of its smaller P/E ratio than Company B’s stock.

70. An investor wants to determine the intrinsic value of the common stock for a company with the

following characteristics:

The firm maintains a constant dividend payout ratio

Goodwill and patents account for 40% of the firm’s assets

• The firm’s revenues and earnings are highly correlated with the business cycle

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Further, the investor focuses on the firm’s capacity to pay dividends rather than expected dividends. Considering the above, the investor will most likely use which of the following valuation models?

A. Asset-based valuation model.

B. Free-cash-flow-to-equity model.

C. Gordon dividend growth model.

Free-cash-flow-to-equity (FCFE) is a measure of the firm’s dividend-paying capacity which should be reflected in the cash flow estimates rather than expected dividends. Analysts must make projections of financials to forecast future FCFE and thus the constant growth assumption as in the Gordon growth model is not an issue. An asset-based valuation model is not appropriate considering the high proportion of intangibles (goodwill and patents) in the firm’s assets.

71. An investor considering the enterprise value approach to valuation gathers the following data:

The value per share of the company’s common stock is closest to:

A. \$13.43.

B. \$22.35.

C. \$22.90.

First, compute the enterprise value (EV) from EBIDTA x EV/EBITDA multiple. Then determine market capitalization (value of equity) using the following expression (see p. 297). Finally, compute the value per share. EV = Market capitalization + MV of preferred stock + MV of debt Cash and investments Market capitalization = EV MV of Preferred stock MV of debt Cash and investments Value per share = Market capitalization/Number of outstanding shares

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72. An analyst attempting to value the shares of a company has gathered the following data:

Using the Gordon growth model, the intrinsic value per share is closest to:

A. \$36.96.

B. \$46.15.

C. \$49.49.

g = b x ROE; b = earnings retention rate = (1 Dividend payout ratio) D1 = D0 (1+ g); V0 = D1 / (r g) b = 1 0.40 = 0.60; g =0.60 x 12 = 7.2%; D1 = 3.60 (1.072) = \$3.86; V0 = 3.86 / (0.15 0.072) = \$49.49

73. The type of efficiency that exists in an economy that uses resources in such a way that they are most

valuable is best described as:

A. operational.

B. allocational.

C. informational.

Economies that use resources in such a way that they are most valuable are allocationally efficient.

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74. A market has the following limit orders standing on its book for a particular stock:

If a trader submits an immediate-or-cancel limit buy order for 700 shares at a price of \$20.50, the most likely average price the trader would pay is:

A. \$20.35.

B. \$20.50.

C. \$20.58.

The limit buy order will be filled first with the most aggressively priced limit sell order and will be followed by filling with the higher priced limit sell orders that are needed up to and including the limit buy price until the order is filled. Average price = [(200 x \$20.20) + (300 x \$20.35) + (200 x \$20.50)] / 700 = \$20.35

75. Which of the following statements is most accurate with respect to rebalancing and reconstitution of

security market indices?

A. Equal weighted indices require frequent rebalancing.

B. Turnover within an index results from a reconstitution but not from rebalancing.

C. A price-weighted index requires rebalancing more than a market-capitalization-weighted index.

After an equal weighted index is constructed and the prices of constituent securities change, the index is no longer equally weighted. Therefore, maintaining equal weights requires frequent adjustments (rebalancing) to the index.

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76. The data for four stocks in an index are as follows:

Assuming the beginning value of the float-adjusted market-capitalization-weighted equity index is 100, the ending value is closest to:

A. 109.1.

B. 110.9.

C. 111.3.

In float-adjusted market-capitalization weighting, the weight on each constituent security is determined by adjusting its market capitalization for its market float. Per computations shown below, the ending value of the index so computed equals 109.1. (654,900 ÷ 600,000)

77. If a securities market is efficient, it is most likely that:

A. security prices would react only to the “unexpected” elements of information.

B. investors would prefer active investment strategies to passive investment strategies.

C. the time frame for price adjustment allows many traders to earn profits with little risk.

In an efficient market, prices should be expected to react only to the “unexpected” or “surprise” element of information releases. Investors process the unexpected information and revise expectations

accordingly.

78. A financial analyst utilizing his analytical expertise and up-to-date information buys a company’s

stock. His close friends, who lack information or expertise, imitate the financial analyst’s action and buy

the stock. Which of the following statements concerning this behavioral bias is most accurate?

A. It improves market efficiency.

B. It is identical to representativeness.

C. It is inconsistent with rational behavior.

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This behavioral bias is an example of an information cascade wherein the transmission of information is from those participants who act first and whose decisions influence the decisions of others. The behavior of informed traders acting first and uninformed traders imitating the informed traders is consistent with rationality. The imitation trading by the uninformed traders helps the market incorporate relevant information and improves market efficiency.

79. Returns from a depository receipt are least likely impacted by which of the following factors?

A. Exchange rate movements

B. Analysts' recommendations

C. The number of depository receipts

The price of each depository receipt (and returns in turn) will be affected by factors that affect the price of the underlying shares, such as company fundamentals, market conditions, analysts’ recommendations, and exchange rate movements. The number of depository receipts issued affects their price, but does not impact the returns.

80. Firms with which of the following characteristics are most likely candidates for a management

A. High dividend payout ratios

B. Large amounts of overvalued assets and low debt levels

C. Large amounts of undervalued assets and high levels of cash flow

Companies with large amounts of undervalued assets (which can be sold to reduce debt) and which generate high levels of cash flow (which is used to make interest and principal payments on the debt) are likely candidates for MBO transactions.

81. An industry experiencing intense competitive rivalry among incumbent companies is best

characterized by:

A. differentiated products and low exit barriers.

B. a small number of competitors and low fixed costs.

C. customers basing purchase decisions largely on price.

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The factor that most influences customer purchase decisions is likely to also be the focus of competitive rivalry in the industry. In general, industries where price is a large factor in customer purchase decisions tend to be more competitive than industries in which customers value other attributes more highly.

82. Industry analysis is least useful to those who are engaged in:

A. a top-down investment approach.

C. indexing and passive investing strategies.

Indexing and passive investing strategies would not engage in over- or underweighting of industries, industry rotation, or timing investments in industries. Therefore, industry analysis is not useful to such investors or portfolio managers.

83. An analyst gathers the following information about a company:

Using asset-based valuation approach, the estimated value per share is closest to:

A. \$ 9.57.

B. \$10.29.

C. \$11.00.

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84. A stock selling at \$50 has a P/E multiple of 20 on the basis of the current year’s earnings. An analyst estimates that next’s earnings per share will be 10% higher and that the stock should be valued on a forward looking basis at the industry average P/E of 18. Based on the analyst’s assessment, it is most likely that the stock is currently:

A. overvalued.

B. fairly valued.

C. undervalued.

A. thinks that the stock is overvalued.

B. wants to limit the loss on a long position.

C. wants to limit the loss on a short position.

 C is correct. Investors who have entered into a short sale will incur losses if the stock begins to increase in value. A stop-buy order helps limit the loss on a short position because it becomes valid when the

stock price rises above the specified stop price.

86. The type of voting in board elections that is most beneficial to shareholders with a small number of

shares is best described as:

A. statutory voting.

B. voting by proxy.

C. cumulative voting.

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C is correct. Cumulative voting allows shareholders to direct their total voting rights to specific candidates, as opposed to having to allocate their voting rights evenly among all candidates. Thus, applying all of the votes to one candidate provides the opportunity for a higher level of representation on the board than would be allowed under statutory voting.

87. An investor gathered the following data in order to estimate the value of the company's preferred stock:

The value of the company's preferred stock is closest to:

A. \$52.17.

B. \$74.53.

C. \$96.92.

88. An investor gathers the following data.

To estimate the stock's justified forward P/E, the investor prefers to use the compounded annual earnings growth and the average of the payout ratios over the relevant period (i.e., 20082011). If the investor uses 11.5% as her required rate of return, the stock's justified forward P/E is closest to:

A. 10.

B. 12.

C. 21.

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C is correct. P0/E1= p/(r g) Earnings growth rate (g) over the period 20082011 = 2.50(1 + g)3 = 3.20; g

= 8.6%. Payout ratio (p) computation (for example, 2011) = 1.92/3.20 = 0.60. Average payout ratio = (0.60 + 0.50 + 0.70 + 0.64)/4 = 0.61. P0/E1= p/(r g) = 0.61/(0.115 0.086) = 0.61/0.029 = 21.0.

89. An investor evaluating a company's common stock for investment has gathered the following data.

Using the two-stage dividend discount model, the value per share of this common stock in 2012 is closest to:

A. \$28.57.

B. \$31.57.

C. \$38.70.

B is correct. Dividend per share (2012) = \$2.50 (0.6) = \$1.50.

22 V2012 = 1.50(1.25)+ 1.50(1.225)+ 1.50(1.25)(1.05)× 12

1.12 1.12(0.12−0.05) 1.12 = \$1.67 + \$1.87 + \$28.03 = \$31.57.

 90. Which of the following is least likely to be directly reflected in the returns on a commodity index?

A. Roll yield

B. Changes in the spot prices of underlying commodities

C. Changes in the futures prices of commodities in the index

B is correct. Commodity index returns reflect the changes in future prices and the roll yield. Changes in the underlying commodity spot prices are not reflected in a commodity index.

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91. A trader who has bought a stock at \$30 is concerned about a downside movement in the stock and

would like to place an order that guarantees selling it at \$25. Which of the following will most likely help

the trader achieve her objective? (GTC = Good-till-cancelled)

A. “GTC, stop 25, market sell” order

B. “GTC, stop 25, limit 25 sell” order

C. “put option buy” market order with a strike price of 25

C is correct. Option contracts can be viewed as limit orders for which execution is guaranteed at the

strike price. Therefore, a “put buy” order at a strike price of 25 will guarantee selling the stock at 25.

92. A trader who buys a stock priced at \$64 on margin with a leverage ratio of 2.5 and a maintenance

margin of 30% will most likely receive a margin call when the stock price is at or falls just below:

A. \$36.57.

B. \$44.80.

C. \$54.86.

C is correct.

Debit balance 64 × 0.61 −maintenance margin % = 1 −0.3 = \$54.86

93. Compared to its market-value-weighted counterpart, a fundamentally weighted index will least likely

have a:

 A. value tilt. B. contrarian “effect.” C. momentum “effect.”

C is correct. Momentum “effect” is a characteristic of a market-value-weighted index, not a fundamentally weighted index.

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94. A U.S. institutional money manager prefers to invest in depository instruments of non-domestic

equity securities that are privately placed in the U.S. and not subject to the foreign ownership and

capital flow restrictions. The type of security that is most appropriate for this investor is:

A. global registered shares.

B. global depository receipts.

C. American depository shares.

B is correct. Global depository receipts (GDRs) meet the investor preferences. They are not subject to

the foreign ownership and capital flow restrictions that may be imposed by the issuing company’s home

country because they are sold outside of that country. GDRs cannot be listed on U.S. exchanges, but they can be privately placed with the institutional investors based in the United States.

95. An equity analyst follows two industries with the following characteristics.

Based on the above information, the analyst will most appropriately conclude that compared to the firms in Industry 2, those in Industry 1 would potentially have:

A. larger economic profits.

B. over-capacity problems.

C. high bargaining power of customers.

A is correct. The economic profit (the spread between the return on invested capital and the cost of

capital) tends to be larger in industries with differentiated products, greater pricing power, and high switching costs to customers. Industry 1 has these features. Firms in Industry 2, on the other hand, have little pricing power (undifferentiated products and rapid shifts in market shares indicating intense

rivalry), which is indicative of potentially smaller economic profits.

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96. The Gordon growth model is most appropriate for valuing the common stock of a dividend-paying company that is:

A. young and just entering the growth phase.

B. experiencing a higher than the sustainable growth rate.

C. mature and relatively insensitive to the economic fluctuations.

C is correct. The Gordon growth model is most appropriate for valuing common stock of a dividend- paying company that is mature and relatively insensitive to the business cycle or economic fluctuations.

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CFA Level 1 Practice Questions for Fixed Income Investments

CFA Level 1 Practice Questions for Fixed Income Investments

1. If market interest rates rise, the price of a callable bond, compared to an otherwise identical option-

free bond, will most likely decrease by:

A. less than the option-free bond.

B. more than the option-free bond.

C. the same amount as the option-free bond.

A callable bond’s value is equal to an option-free bond less the value of the call option. As interest rates rise, the value of the call option decreases by a decreasing amount relative to the straight bond. The option-free bond also declines in value as interest rates rise, but this is offset by the decline in the value of the call option. Therefore, the price of a callable bond decreases by less than a comparable option- free bond.

2. A U.S. investor who purchases an option-free bond with a 7 percent coupon rate, maturing in 20

years, and issued by a U.S.-based company is most likely exposed to:

A. volatility risk and credit risk.

B. event risk and interest rate risk.

C. volatility risk and yield curve risk.

The investor faces event risk in a corporate bond and interest rate risk in a long-dated, fixed coupon

bond.

3. All else equal, an increase in expected yield volatility is most likely to result in an increase in the price

of a(n):

A. putable bond.

B. callable bond.

C. option-free bond.

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An increase in expected yield volatility increases the price of an embedded option. The price of a putable bond will increase because the price of the putable bond is equal to the price of an option-free bond plus the value of the put option.

4. An analyst is evaluating the two bonds below:

Compared with Bond A, Bond B most likely will have:

A. less interest rate risk and more reinvestment risk.

B. less reinvestment risk and more interest rate risk.

C. more interest rate risk and more reinvestment risk.

Since both securities have essentially the same maturity, all else the same, the bond with the lower coupon rate will have a higher sensitivity to changes in interest rates. The higher the yield on the bond, the more the reinvestment risk, because the investor must be able to reinvest at the same yield.

5. An analyst determined that if interest rates increase 120 basis points the price of a bond would be

\$89.70, but if interest rates decrease 120 basis points the price of that bond would be \$99.30. If the initial price of the bond is \$95.40, the approximate percentage price change for a 100 basis point change

in yield is closest to:

A. 2.5%.

B. 4.2%.

C. 8.4%.

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6. For an A- rated corporate bond that has deteriorating fundamentals, but is expected to remain

investment grade, the greatest risk is most likely:

A. default risk

B. liquidity risk

Credit spread risk is correct since the bond is expected to see a widening of spreads as a result of deteriorating fundamentals and a potential downgrade but still remaining investment grade.

7. The difference between nominal spread and zero-volatility spread will most likely be greatest for a

mortgage-backed security:

A. in an inverted yield curve environment.

B. in a steep upward-sloping yield curve environment.

C. with short maturity in a flat yield curve environment.

The difference between the Z-spread and the nominal spread is greater for issues in which the principal is repaid over time rather than only at maturity. In addition, the difference between the Z-spread and the nominal spread is greater in a steep yield curve environment.

8. A fixed income portfolio manager is evaluating investments in the mortgage market but is concerned

about prepayment risk. The security that will most likely minimize prepayment risk is:

A. a mortgage passthrough security.

B. a portfolio of interest-only mortgage loans.

C. tranche B of a collateralized mortgage obligation.

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A collateralized mortgage obligation or CMO, is structured to distribute prepayment risk among

different classes or tranches of bonds. Tranche A would be repaid first, followed by tranche B, then C,

etc.

9. An analyst is evaluating various debt securities issued by a company. likely to yield the lowest recovery in a bankruptcy is a:

A. mortgage bond

B. debenture bond.

C. collateral trust bond.

The type of security that is most

A debenture bond is unsecured and would be expected to recover less should the company file for bankruptcy, while mortgage and collateral trust bonds are secured by real property.

10. A U.S. investor has purchased a tax-exempt 5-year municipal bond at a yield of 3.86 percent which is

100 basis points less than the yield on a 5-year option-free

is 32 percent, then the yield ratio are closest to:

Treasury. If the investor’s marginal tax rate

A. 0.79

B. 1.26

C. 5.68

Yield ratio = (yield on tax-exempt bond) / (yield of US Treasury) =

3.86 / (3.86 + 100bp) = 3.86 / 4.86 = 0.79

11. An analyst has gathered the following information provided in the table below:

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Based on the information provided in the table, the current market price of a \$1,000 par value, option- free, 0 percent coupon corporate bond maturing in 5 years is closest to:

A. \$758.70.

B. \$781.20.

C. \$804.44.

12. An analyst gathered the following information about a portfolio comprised of three bonds:

Assuming there is no accrued interest, then the portfolio duration is closest to:

A. 5.55 years.

B. 5.76 years.

C. 6.82 years.

Portfolio value = (1.02 × 7 mil) + (0.94356 × 5 mil) + (0.88688 × 3 mil) = 14,518,440 Weight, Bond A = 7,140,000 / 14,518,440 = 0.492 Weight, Bond B = 4,717,800 / 14,518,440 = 0.325 Weight, Bond C =

2,660,640 / 14,518,440 = 0.183 Portfolio duration = (0.492 × 1.89) + (0.325 × 7.70) + (0.183 × 11.55) =

5.55

13. An analyst determines that a 5.50 percent coupon option-free bond, maturing in 7 years, would

experience a 3 percent decrease in price if market interest rates rise by 50 basis points. If market

interest rates instead fall by 50 basis points, the bond’s price would increase by:

A. exactly 3%.

B. less than 3%.

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C. more than 3%.

CFA Level 1 Practice Questions for Fixed Income Investments

The bond is option-free and will therefore exhibit positive convexity. An equal change in rates will produce a greater percentage gain when rates decrease than the percentage loss produced when rates

increase.

14. Holding all other factors constant, an increase in expected yield volatility will cause the price of a:

A. putable bond to increase.

B. callable bond to increase.

C. putable bond to decrease.

Increasing yield volatility increases the value of both put options and call options, which increases the value of a putable bond (which is long the put option) but decreases the value of a callable bond (which is short the call option.)

15. The table below summarizes the yields and corresponding prices for a hypothetical 15-year option-

free bond that is initially priced to yield 7%:

Using a 10 basis point rate shock, the duration for this bond is closest to:

A. 4.6 years.

B. 7.5 years.

C. 9.2 years.

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16. According to the market segmentation theory, an upward sloping yield curve is most likely due to:

A. investor expectations that short-term interest rates will fall in the future.

B. different levels of supply and demand for short-term and long-term funds.

C. an increasing yield premium required by investors for bearing interest rate risk.

The market segmentation theory asserts that the supply and demand for funds determine the interest rates for each maturity sector.

17. An 8 percent coupon bond with a par value of \$100 matures in 2 years and is selling at \$98.24 to

yield 9 percent. Exactly one year ago this bond sold at a price of \$95.03 to yield 10 percent. The bond

pays annual interest. The change in price attributable to the change in maturity is closest to:

A. \$1.50.

B. \$3.21.

C. \$4.97.

18. A fixed income portfolio manager owns a \$5 million par value non-callable bond. The bond’s

duration is 5.6 and the current market value is \$5,125,000. The dollar duration of the bond is closest to:

A. \$280,000.

B. \$287,000.

C. \$700,000.

A bond’s dollar duration is the expected price change given a 100 basis point

change in yield. In this case, dollar duration = 5.6 × 0.01 × \$5,125,000 = \$287,000.

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19. Two amortizing bonds have the same maturity date and same yield to maturity. The reinvestment

risk for an investor holding the bonds to maturity is greatest for the bond that is:

A. a zero-coupon bond.

B. a coupon bond selling at a discount to par.

C. a coupon bond selling at a premium to par value.

Because they have the same yield to maturity, we know that the bond selling for a premium has the higher coupon rate. Reinvestment risk refers to the risk that interest rates will decline causing the future income expected from reinvesting coupon payments to decline. The more coupon interest being paid, the greater the reinvestment risk.

21. If investors expect stable rates of inflation in the future, the pure expectations theory suggests that

the yield curve is currently:

A. flat.

B. inverted.

C. upward-sloping.

The pure expectations theory explains the term structure in terms of expected future short-term interest rates. Assuming that interest rates reflect a relatively stable real rate of interest plus a premium for expected inflation, stability in inflation expectations would mean unchanged future short-term interest rates and a flat yield curve.

22. A portfolio of option-free bonds is least likely to be exposed to:

A. volatility risk.

B. yield curve risk.

C. reinvestment risk.

Volatility risk is the risk that the price of a bond with an embedded option will decline when expected yield volatility changes. By definition, option-free bonds are not affected by volatility risk.

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23. An investor purchases a 5 percent coupon bond maturing in 3 years for \$102.80, providing a yield-to-

maturity of 4 percent. At what rate must the coupon payments be reinvested to generate the 4 percent

yield?

A. 0%

B. 4%

C. 5%

B is correct since the yield-to-maturity measure assumes that the coupon payments can be reinvested at an interest rate equal to the yield-to-maturity, in this case 4%.

24. The yield of a U.S. bond issue quoted on a bond-equivalent basis is 6.8 percent. The yield-to-

maturity on an annual-pay basis is closest to:

A. 6.69%.

B. 6.92%

C. 14.06%.

B is correct because the yield on an annual-pay basis is calculated as:

The yield on an annual-pay basis is always greater than the yield on a bond-equivalent basis because of

compounding.

25. Given the data in the table below, the price of a 3% coupon corporate bond maturing in 2 years is

closest to:

A. \$97.19.

B. \$98.12.

C. \$100.04.

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A is correct because the cash flows should be discounted using the appropriate spot rate plus spread :

25. Which of the following provides the most protection to a bondholder?

A. Call protection.

B. Refunding protection.

C. Sinking fund protection.

Call protection means the bond cannot be called from the bondholder by the issuer for any reason.

26. Which embedded option is most beneficial to a bond issuer?

A. A conversion privilege.

B. A floor on a floating rate bond.

C. An accelerated sinking fund provision.

An accelerated sinking fund provision gives the issuer an option to retire more than the sinking fund requirement. The other embedded options benefit bondholders.

27. The most relevant definition for duration is:

A. a security’s price sensitivity to changes in yield.

B. the first derivative of the security’s price with respect to yield.

C. the weighted-average time until receipt of the present value of cash flows.

This is the most relevant definition because users of duration are interested in a security’s price sensitivity to changes in yield.

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28. An endowment’s fixed income portfolio comprises three bonds whose market values, par values, coupon rates, and durations are given in the following table:

The portfolio’s duration is closest to:

A. 5.73.

B. 6.31

C. 6.85.

The duration of a portfolio is equal to the sum of the weighted durations of the individual bonds, with each weight equal to the market value of the bond divided by the market value of the portfolio, then

29. Jasper Corporation sold its receivables to a special purpose vehicle, JTL Corporation, created by

Jasper for that purpose. If JTL sells securities backed by the receivables, the credit rating associated with

those securities will most likely be based on the:

A. creditworthiness of JTL.

B. creditworthiness of Jasper.

C. collateral and credit enhancement mechanisms used.

The rating of asset-backed securities typically is independent of the issuer or originating firm’s credit; the rating depends on the collateral offered and the strength of any external or internal credit

enhancements.

30. A bond has a modified duration of 6.5 and convexity of -42.4. If interest rates decrease by 1.0

percent, the percentage change in the value of the bond will be closest to:

A. -6.92%.

B. +2.76%.

C. +6.08%.

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Describe the convexity measure of a bond and estimate a bond’s percentage price change, given the bond’s duration and convexity and a specified change in interest rates.

The percentage change in the bond’s value is equal to: (-Duration × Δy* × 100%) + (C × (Δy*)2 × 100%) = (-6.5 × -0.01 × 100%) + (-42.4 × (-0.01)2 × 100%) = +6.5% - 0.424% = +6.08.

31. An investor is considering the purchase of two bonds. One is a 5% coupon tax-exempt bond that

yields 4.5% while the other is a 7% coupon bond that is taxable and yields 6.0%. If the two bonds are alike in all other characteristics, the marginal tax rate that would make the investor indifferent between

the two bonds is closest to:

A. 25.0%.

B. 28.6%.

C. 33.3%.

The indifference point would be the tax rate that satisfies the equation: 6.0%×(1 T) = 4.5%. Solving for T, the marginal tax rate = 25%.

32. An investor is evaluating a diverse set of bonds from which he will select two issues. The investor’s objective is to find bonds with cash flows that will precisely match a known stream of future cash outflows. The pair of bonds most likely to meet the investor’s objective is a:

A. putable bond and a callable bond.

B. zero-coupon bond and a Treasury strip.

C. mortgage-backed-security and an asset-backed security.

Both the zero coupon and Treasury strip bonds have cash flows that can be estimated with certainty.

33. An analyst has gathered the following information:

Based on the arbitrage-free valuation approach, a \$1,000 face value bond that pays a 5 percent annual coupon and matures in 3 years has a current market value closest to:

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A. \$1,027.75.

B. \$1,028.67.

C. \$1,034.85.

CFA Level 1 Practice Questions for Fixed Income Investments

Each cash flow is discounted by the appropriate spot rate:

34. All U.S. Treasury coupon strips are:

A. zero-coupon securities.

B. issued directly by the U.S. Treasury.

C. created from pooled coupon payments of U.S. Treasury securities.

Describe how stripped Treasury securities are created and distinguish between coupon strips and principal strips.

Although the U.S. Treasury does not issue zero-coupon securities, it has created the STRIPS program through which securities that are stripped from the principal or interest payments of U.S. Treasury securities become direct obligations of the U.S. government.

35. A moral obligation bond is also known as:

A. a prerefunded bond.

B. a general obligation debt.

C. an appropriation-backed obligation

Some municipal bonds include a nonbinding pledge of additional tax revenue to make up any shortfalls; however legislative approval is required for the additional appropriation. These are known as moral obligation bonds. They are a form of general obligation debt, but most general obligation debt does not include such a pledge. In contrast, a prerefunded bond is backed by a trust of riskless securities that provide cash flows sufficient to pay the interest and principal payments of the bond.

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36. Corporate debt securities that are offered continuously to investors by an agent of the issuer are best described as:

A. range notes.

B. structured notes.

C. medium-term notes.

Describe the characteristics and motivation for the various types of debt issued by corporations (including corporate bonds, medium-term notes, structured notes, commercial paper, negotiable CDs, and bankers acceptances.)

37. An investment banking firm offers a corporation a binding bid to purchase an amount of new debt securities to be issued by the corporation with a specified coupon rate and maturity. The corporation can accept or reject this bid. This type of security distribution is best described as:

A. best efforts.

B. bought deal.

C. competitive bidding.

B is correct because bought deal underwriting occurs when an underwriter solicits securities from an issuer and the issuer accepts the offer.

38. A bond market analyst states, “The current term structure of interest rates is upward sloping which implies the market believes short-term interest rates will rise in the future.” Which theory of the term structure of interest rates does the analyst most likely believe?

A. Pure expectations theory.

B. Liquidity preference theory.

C. Market segmentation theory.

A is correct because under the pure expectations theory the only reason the yield curve will be upward

sloping is because market participants believe that short-term rates will rise in the future.

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39. An investor who has a 42% marginal tax rate is analyzing a tax-exempt bond that offers a yield of 3.74%. The taxable-equivalent yield of the bond is closest to:

A. 5.31%.

B. 6.45%.

C. 8.90%.

40.

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41. Jasper Corporation sold its receivables to a special purpose vehicle, JTL Corporation, created by Jasper for that purpose. If JTL sells securities backed by the receivables, the credit rating associated with those securities will most likely be based on the:

A. creditworthiness of JTL.

B. creditworthiness of Jasper.

C. collateral and credit enhancement mechanisms used.

The rating of asset-backed securities typically is independent of the issuer or originating firms credit; the rating depends on the collateral offered and the strength of any external or internal credit enhancements.

42. A bond has a modified duration of 6.5 and convexity of -42.4. If interest rates

decrease by 1.0 percent, the percentage change in the value of the bond will be closest to:

A. -6.92%.

B. +2.76%.

C. +6.08%.

43. The bond-equivalent yield (BEY) spot rates for U.S. Treasury yields are provided below.

On a BEY basis, the 6-month forward rate one year from now is closest to:

A. 2.10%.

B. 3.64%.

C. 4.21%.

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44. Holding all other characteristics the same, the bond exposed to the greatest level of reinvestment

risk is most likely the one selling at:

A. par.

B. a discount.

C is correct because a bond selling at a premium has a higher coupon rate and, all else the same, bonds with higher coupon rates face higher reinvestment risk. This is because the higher the coupon rate, the more dependent the bond’s total dollar return will be on the reinvestment of the coupon payments in order to produce the yield to maturity at the time of purchase.

45. A 6% 25-year bond with semiannual payments has a market price of \$850.00. The yield to maturity

of this bond is closest to:

A. 5.72%

B. 7.32%.

C. 7.91%.

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46. Which of these definitions of duration is most relevant to a bond investor? A bond’s duration is its:

A. half-life.

B. price sensitivity to yield changes.

C. first derivative of value with respect to its yield.

B is correct because bond investors are concerned about interest rate risk, and duration is a good measure of interest rate risk.

47. A bond has duration of 4.50 and convexity of -39.20. If interest rates increase by 0.5%, the

percentage change in the bond’s price will be closest to:

A. -2.35%.

B. -2.25%.

C. -2.15%.

A is correct because when convexity is known the percentage change in a bond’s price = (¬duration × ∆y

× 100) + (C × (∆y)2 × 100) = (-4.50×0.005×100)+(-39.20×0.0052×100) = -2.35.

48. A portfolio consists of four bonds with the following characteristics:

The duration of the portfolio is closest to:

A. 5.40.

B. 6.18.

C. 7.48.

C is correct because the duration of a portfolio is the weighted average of the bonds’ durations where

the weight for each bond is its contribution to the portfolio’s value or wbond=Valuebond/Valueportfolio and Durationportfolio=Σwbond×durationbond. In this case, value of the portfolio is 1.2+3.4+2.9+1.6 =

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9.1 million and the portfolio duration equals (1.2/9.1 × 3.2) + (3.4/9.1 × 7.6) + (2.9/9.1 × 12.4) + (1.6/9.1

× 1.5) = 0.4220 + 2.8396 + 3.9516 + 0.2637 = 7.48.

49. A 10-year bond is issued on January 1, 2010. Its contract requires that its coupon rate change over

time as shown in the following table:

This security is best described as an example of a:

A. step-up note.

B. floating-rate bond.

C. deferred coupon bond.

A is correct because a step-up note has contractually mandated changes in its coupon rate.

50. A 5-year floating-rate security was issued on January 1, 2006. The coupon rate formula was 1-year

LIBOR + 300 bps with a cap of 10% and a floor of 5% and annual reset. The 1-year LIBOR rate on January

1st of each year of the security’s life is provided in the following table:

During 2010, the payments owed by the issuer were based on a coupon rate closest to:

A. 4.5%.

B. 5.0%.

C. 6.5%.

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B is correct because LIBOR + 300 bps at the reset date equals 1.5% + 3.00% = 4.5%, which is below the floor of 5.00% so the coupon rate will be equal to the floor.

51. Which of these is the best example of an embedded option granted to bondholders?

A. A prepayment option

B. A floor on a floating rate security

C. An accelerated sinking fund provision

B is correct because the floor benefits the bondholder by keeping the coupon from falling below a certain threshold if market rates decline to very low levels.

52. A bond has a 10-year maturity, a \$1,000 face value, and a 7% coupon rate. If the market requires a

yield of 8% on the bond, it will most likely trade at a:

A. discount.

C. discount or premium, depending on its duration.

A is correct because when the required yield is higher than the coupon rate, the bond trades at a

discount to par.

53. When interest rates fall, the price of a callable bond will:

A. fall less than an option-free bond.

B. rise less than an option-free bond.

C. rise more than an option-free bond.

B is correct because when interest rates fall, the price of the embedded call option increases. Since,

price of a callable bond = price of option-free bond price of embedded call option, the price of the callable bond will not increase as much as an option-free bond since the price of the call option is increasing. As interest rates fall, the bond is more likely to be called, limiting the upside price increase

potential.

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54. A bond is selling for 98.2. It is estimated that the price will fall to 96.6 if yields rise 30 bps and that

the price will rise to 100.1 if yields fall 30 bps. Based on these estimates, the duration of the bond is

closest to:

A. 1.78.

B. 5.94.

C. 11.88.

55. The most direct disadvantage of investing in a callable security relative to an otherwise identical

option-free security is:

A. increased default risk.

B. lower interest payments.

C. decreased price appreciation potential.

C is correct because when interest rates decline, more borrowers will prepay, limiting the potential for the bond price to increase.

56. An investor fears that economic conditions will worsen and the market prices of her portfolio of

investment-grade corporate bonds will decrease more than her portfolio of government bonds. The

investor’s fear is best described as a fear of:

A. default risk.

C is correct because the when the market is willing to pay less for investing in risky bonds, the spreads on those bonds widens relative to default-free bonds. Thus the investor is concerned about credit spread risk.

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57. What type of risk does the bid-ask spread most closely measure?

A. Default risk

B. Inflation risk

C. Liquidity risk

C is correct because the size of the spread between the bid price and the ask price is the primary

measure of liquidity of the issue. Liquidity risk is the risk that the investor will have to sell a bond below

its indicated value. The wider the bid-ask spread, the greater the liquidity risk.

58. On January 1st of the year, an investor purchases \$100,000 in par value of a new Treasury Inflation

Protection Security (TIPS) issue that has a 2.5% coupon rate. The annual rate of inflation over the first

six months of the year is 4.0% and the annual rate of inflation for the second six months of the year is 3.0%. The amount of coupon interest paid to the investor after the second six months of the year is closest to:

A. \$1,275.

B. \$1,294.

C. \$1,339.

B is correct because the inflation-adjusted principal after the second six month period is \$100,000 × (1.02) × (1.015) = \$103,530 and \$103,530 × (2.5%/2) = \$1,294.

59. A level payment, fixed-rate, fully amortizing mortgage loan for \$220,000 is obtained with a term of

15 years, a mortgage rate of 6.0% with monthly compounding, and a monthly payment of \$1,856.49. Assuming that the borrower does not prepay or default, the principal that is repaid during the first 3 months is closest to:

A. \$660.

B. \$2,281.

C. \$3,667.

B is correct according to the table below showing the remaining principal balance after 3 monthly

payments.

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60. The primary motivation for creating a collateralized mortgage obligation (CMO) is best described as

the desire to redistribute which risk of investment in residential mortgages?

A. Default risk.

B. Liquidity risk.

C. Prepayment risk.

C is correct because the motivation for creating a CMO is to distribute prepayment risk among different classes of bonds.

61. Which of these embedded options most likely benefits the investor?

A. The floor in a floating-rate security

B. An accelerated sinking fund provision

C. The call option in a fixed-rate security

Identify common options embedded in a bond issue, explain the importance of embedded options, and identify whether such options benefit the issuer or the bondholder.

A is correct because the floor guarantees a minimum rate the investor will earn.

62. Consider two bonds that are identical except for their coupon rates. The bond that will have the

highest interest rate risk most likely has the:

A. lowest coupon rate.

B. highest coupon rate.

C. coupon rate closest to its market yield.

A is correct because a lower coupon rate means that more of the bond’s value comes from repayment of face value, which occurs at the end of the bond’s life.

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63. Duration is most accurate as a measure of interest rate risk for a bond portfolio when the slope of

the yield curve:

A. increases.

B. decreases.

C. stays the same.

C is correct because duration measures the change in the price of a portfolio of bonds if the yields for all maturities change by the same amount; that is, it assumes the slope of the yield curve stays the same.

64. An investor whose marginal tax rate is 33.5% is analyzing a tax-exempt bond offering a yield of

5.20%. The taxable-equivalent yield of the bond is closest to:

A. 3.90%.

B. 6.94%.

C. 7.82%.

C is correct because the Tax-equivalent yield = Tax-exempt yield/(1 Marginal tax rate) = 5.20%/(1 0.335) = 7.82%.

65. If the yield on a 5-year U.S. corporate bond is 7.39% and the yield on a 5-year U.S. Treasury note is

4.26%, the relative yield spread of the bond is closest to:

A. 3.13%.

B. 42.40%

C. 73.50%.

C is correct because the Relative yield spread = (Bond yield Reference yield)/Reference yield = (7.39% 4.26%)/4.26% = 73.50%.

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66. Consider a \$100 par value bond, with an 8% coupon paid annually, maturing in 20 years. If the bond

currently sells for \$96.47, the yield to maturity is closest to:

A. 7.41%.

B. 8.29%.

C. 8.37%.

C is correct because a security with a present value of 96.47, 19 interest payments of 8, and a 20th payment of principal plus interest (108) has a yield to maturity of 8.37%.

67. Consider two ten-year bonds, one that contains no embedded options and the other that gives its

owner the right to convert the bond to a fixed number of shares of the issuer’s common stock. The convertibility option in the second bond cannot be exercised for five years. The bonds are otherwise identical. Compared with the yield on the convertible bond, the yield on the option-free bond is most

likely:

A. lower.

B. higher.

C. the same.

B is correct because the convertibility option provides a benefit to the investor, who will accept a lower yield on the convertible bond compared with the option-free bond.

68. Using the U.S. Treasury spot rates provided below, the arbitrage-free value of a 2-year Treasury,

\$100 par value bond with a 6% coupon rate is closest to:

A. \$99.75.

B. \$105.65.

C. \$107.03.

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CFA Level 1 Practice Questions for Fixed Income Investments

69. Consider three bonds that have the same yield to maturity and maturity. The bond with the greatest

reinvestment risk is most likely the one selling at:

A. par.

B. a discount.

C is correct because yield to maturity is based on the assumption a bond is held to maturity, does not default, and has its coupon payments reinvested at the yield to maturity. The bond selling at a premium has the highest coupon rate and is expected to earn the most reinvestment income from reinvesting those coupon payments at the yield to maturity. If the reinvestment rate falls, this bond will suffer the greatest loss.

70. Using the U.S. Treasury forward rates provided below, the value of a 2½-year, \$100 par value

Treasury bond with a 5% coupon rate is closest to:

A. \$101.52.

B. \$104.87.

C. \$106.83.

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CFA Level 1 Practice Questions for Fixed Income Investments

71. If three bonds are otherwise identical, the one exhibiting the highest level of positive convexity is most likely the one that is:

A. putable.

B. callable.

C. option-free.

A is correct because when interest rates rise, a putable bond is more likely to be put back to the issuer by the investor, limiting the loss of value and giving the bond more positive convexity than an option- free bond. In contrast, a callable bond is likely to be called from the investor when interest rates fall, limiting the gain in value and giving the bond negative convexity.

72. The table below provides information about a portfolio of three bonds.

Based on this information, the duration of the portfolio is closest to:

A. 9.35.

B. 9.48.

C. 9.74.

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CFA Level 1 Practice Questions for Fixed Income Investments

73. The spread between the yields on a Ginnie Mae passthrough security and a comparable Treasury

security is best explained by:

A. credit risk.

B. prepayment risk.

C, reinvestment risk.

Mortgage-backed securities expose an investor to prepayment risk.

74. Which of the following provides the most flexibility for the bond issuer?

A. Put provision.

B. Call provision.

C. Sinking fund provision.

A call provision allows the issuer to repurchase the bond for any reason, assuming the call deferral period has ended and upon payment of any call premium.

75. An annual-pay bond has a yield to maturity of 5.00 percent. The bond-equivalent yield of the

annual-pay bond is closest to:

A. 4.94%.

B. 5.00%.

C. 5.06%.

The bond-equivalent yield of an annual-pay bond = 2 × [(1 + yield on annual-pay bond)0.5 1] = 2 × [(1 + 0.05)0.5 1] = 0.0494 = 4.94%

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CFA Level 1 Practice Questions for Fixed Income Investments

76. An analyst gathered the following information:

Annual Par Yield Theoretical Six-month Periods Years to Maturity Spot rate Forward Rates

BEY (%) BEY (%) BEY (%)

 1 0.5 3.00 3.00 3.00 2 1.0 3.30 3.30 3.61 3 1.5 3.50 3.51 3.91 4 2.0 3.90 3.92 5.15

The value of a single, default-free cash flow of \$50,000 at the end of Period 4 is closest to:

A. \$46,265.

B. \$46,299.

C. \$46,316.

The theoretical spot rates for Treasury securities represent the appropriate set of interest rates that should be used to value default-free cash flows. Therefore: \$50,000 / (1 + 0.0392/2)4 = \$46,264.80 ≈

\$46,265.

A. all points on the spot curve.

B. all points on the Treasury yield curve.

C. one point on the Treasury yield curve.

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The zero-volatility spread is a measure of the spread that the investor would realize over the entire Treasury spot rate curve if the bond is held to maturity.

78. If an institutional investor wants to borrow money for 30 days to finance a bond purchase, which of

these is most likely to be the lowest loan rate available?

A. Term repo rate

B. Call money rate

C. Broker loan rate

For institutional investors the term repo rate is less than the cost of bank financing (i.e., broker loan rate or call money rate.)

A. Z-spread minus the option cost.

B. Z-spread plus the cost of the option.

C. value of the security’s embedded option.

The Z-spread is the sum of the OAS and the option cost.

80. If interest rates are expected to decline, an investor can earn a higher coupon interest rate by