JUN18L1/EP05

TEMAS:
- ETHICS: Questions 1-18
- QUANTITATIVE METHODS: Questions 19-32
- ECONOMICS: Questions 33-44
- FINANCIAL REPORTING & ANALYSIS: Questions 45-68
- CORPORATE FINANCE: Questions 69-77
- PORTFOLIO MANAGEMENT: Questions 78-86
- EQUITY: Questions 87-98
- FIXED INCOME: Questions 99-110
- DERIVATIVES: Questions 111-116
- ALTERNATIVE INVESTMENTS: Questions 117-120
ETHICS:
Question #1
According to the Code of Ethics, a member reflects credit on the profession when a member:
A) practices in a professional and ethical manner.
B) consults with other members on a regular basis.
C) places the clients first.
Component four of the Code says that a member shall "Practice and encourage others to practice in a professional
and ethical manner that will reflect credit on members and the profession." Neither of the other choices are implied by
the Code.
Reading 2

Question #2
The first component of the Code of Ethics does NOT explicitly say that a CFA Institute member will act with which of
the following?
A) Solemnity.
B) Integrity.
C) Competence.
Component one mentions all of these except solemnity.
Reading 2

Question #3
All of the following are violations of Standard II(B) Market Manipulation EXCEPT:
A) exploiting differences in market inefficiencies.
B) securing a controlling interest in an equity security in order to influence the price of a related derivative instrument.
C) disseminating misleading information about the development of new products and technologies.
Standard II(B) Market Manipulation prohibits practices that distort prices or artificially inflate trading volumes with the
intent to mislead market participants. The Standard is not intended to prohibit legitimate trading strategies that exploit
differences in market inefficiencies.
Reading 3

Question #4
Which of the following statements is an acceptable reference to the CFA designation?
A) All members of our research team are CFA charterholders who passed their exams on their first tries.
B) Most of our portfolio managers are CFAs and are committed to the highest ethical standards.
C) Tom and Elizabeth are Chartered Financial Analysts.
The CFA or Chartered Financial Analyst designation must be used as an adjective, not as a noun. It is acceptable to
mention passing the exams on the first try if this is a statement of fact.
Reading 3

Question #5
A manager has pointed out that his firm has experienced significant expansion over the past few years. Until recently,
its Legal Department was responsible for the firm's compliance activities. Now, however, the legal and compliance
functions have been separated. A compliance officer has been formally designated and a comprehensive compliance
program has been put in place.
In order to function effectively, the compliance officer must have the authority:
A) which is consistent with the most senior partner or executive officer in the firm.
B) to affect, control, and guide employee behavior and to respond to employee misconduct.
C) to hire and fire personnel.
Compliance officers must be able to guide employee behavior and respond to employee misconduct, otherwise there
will be no effective compliance procedures in place. Unless the compliance officer can effectuate compliance
procedures, the compliance program has no chance of responding to or preventing violations of the Standards.
Reading 3

Question #6
Brendan Duval works as a research analyst for Toby Securities. Duval recommends changing a recommendation from
"sell" to "buy" on Dalton Company. His firm, which manages several mutual funds, may be interested in buying
Dalton's stock. He also manages the retirement account that his parents established with Toby. Duval wants to buy
shares of Dalton's stock because it is an appropriate investment for his parent's retirement account and obtains
approval from his employer to do so. Duval is also thinking about personally investing in Dalton stock. According to
CFA Institute Standards of Professional Conduct, which of the following best describes the priority of transactions?
Duval should give:
A) Toby's clients and his parent's account equal priority, followed by his employer, and then his personal account.
B) priority to Toby's clients and his employer concurrently, followed by his parent's retirement account, and finally his
personal account.
C) priority of transactions to Toby's clients, followed by his employer, then his parent's retirement account, and finally
his personal account.
According Standard VI(B) Priority of Transactions, Duval should give transactions for clients and employers priority
over his personal transactions. Because his parent's retirement account represents a client account at Toby, Duval
should treat this account just like any other firm account. His parent's retirement account should neither be given
special treatment nor disadvantaged because of an existing family relationship with Duval. If Duval treats his parent's
retirement account differently from other accounts at Toby, he would breach his fiduciary duty to his parents.
Reading 3

Question #7
John Hill, CFA, has been working for Advisors, Inc., for eight years. Hill is about to start his own money management
business and has given his two-week notice of his resignation from Advisors. A few days before his resignation takes
effect, on his lunch hour, he takes out a loan from a bank on behalf of his new business and uses the money to buy
some office equipment for his new business. Since he engaged in these transactions while still an employee of
Advisors, Hill violated Standard IV(A), Loyalty to Employer, by:
A) both taking out the loan and purchasing the office equipment.
B) neither of these actions.
C) engaging in a financial transaction, like taking out a loan, only.
The Standards of Practice under IV(A) expressly says that a departing employee is "generally free to make
arrangements or preparations to go into a competitive business before terminating the relationship with the
employee's employer provided that such preparations do not breach the employee's duty of loyalty." Neither of these
actions are in conflict with the interests of Advisors, and Hill performed them on his own time.
Reading 3

Question #8
Which one of the following constitutes the illegal use of material nonpublic information?
A) Trading on information your sister, the firm's attorney, told you over dinner.
B) Trading based on your analytical review of the firm's future prospects.
C) Trading immediately after attending the firm's annual shareholders' meeting.
Members may not trade on material nonpublic information; therefore, the information conveyed by the firm's attorney
may not be used by a member for trading purposes.
Reading 3

Question #9
Which of the following statements is most correct under the Code and Standards?
A) Consent from the employer is necessary to permit independent practice that could result in compensation or other
benefits in competition with the member's employer.
B) Members are prohibited from making arrangements or preparations to go into competitive business before
terminating their relationship with their employer.
C) CFA Institute members are prohibited from undertaking independent practice in competition with their employer.
Members are not prohibited from making arrangements or preparations to go into competitive business before
terminating their relationship with their employer. CFA Institute members are not prohibited from undertaking
independent practice in competition with their employer provided they have consent from their employer. Members
must provide notification to their employer describing the types of services to be rendered, the expected duration, and
compensation for the services.
Reading 3

Question #10
CFA Institute believes:
A) that firms should comply with all domestic laws and regulations and that these laws also govern behavior in foreign
markets, regardless of foreign laws and requirements.
B) that a minimum level of professional responsibility and conduct dictates that members be aware of and comply with
laws, rules, and regulations governing their conduct.
C) that a maximum level of professional responsibility and conduct dictates that members be aware of and comply
with laws, rules, and regulations governing their conduct.
CFA Institute's Code and Standards dictate a minimum level of conduct. Standards should not be based on ethics of
upper management and the board of directors of a company. Firms must comply with the strictest applicable
standards, whether they be foreign or domestic laws and regulations.
Reading 3

Question #11
Lucy Ackert and Chris Brown prepared the following information to be included in the promotional materials of their
employer, Lofton Securities.
 Lucy Ackert is one of five CFAs at Lofton Securities. She satisfied all requirements for the CFA designation in
1998.
 Chris Brown holds a CFA Level I designation, which he passed in 2001. He is registered to take the next
scheduled Level II examination.
Are the promotional materials prepared by Ackert and Brown fully consistent with the Standards of Professional
Conduct?
A) Ackert: Yes. Brown: No.
B) Ackert: No. Brown: Yes.
C) Ackert: No. Brown: No.
Neither statement is fully consistent with Standard VII(B), Reference to CFA Institute, the CFA Designation, and the
CFA Program. The CFA designation must always be used as an adjective and never as a noun as Ackert used in her
promotional description. Correct use of the CFA designation would be: "Lucy Ackert is one of five CFA charterholders
at Lofton Securities." No designation exists for someone who has passed Level I of the CFA examination. Thus,
Brown's statement saying that he "holds a CFA Level I designation" represents incorrect use. A correct statement
would be: "Chris Brown passed Level I of the CFA examination in 2001."
Reading 3

Question #12
Sue Parsons, CFA, works full-time as an investment advisor for the Malloy Group, an asset management firm. To help
pay for her children's college expenses, Parsons wants to engage in independent practice in which she would advise
individual clients on their portfolios. She would conduct these investment activities only on weekends. She is currently
only in the preparation stage and has not started independent practice yet. Which of the following statements about
Standard IV(A), Loyalty to Employer, is most accurate? Standard IV(A):
A) requires Parsons to obtain written consent from both Malloy and the persons from whom she undertakes
independent practice.
B) requires Parsons to notify Malloy in writing about her intention to undertake an independent practice.
C) does not require Parsons to notify Malloy of preparing to undertake independent practice under the current
conditions.
Standard IV(A), Loyalty to Employer, requires that Parsons obtain written consent only from her employer before she
undertakes independent practice that could result in compensation or other benefit in competition with Malloy. It is not
required to get permission from your employer when only preparing to go into independent practice.
Reading 3

Question #13
Which of the following most accurately states a limitation that the Fair Dealing standard imposes?
A) Before trading on her own portfolio, a CFA charterholder must wait for employer and client deals to be executed.
B) Clients should not be discriminated against when disseminating investment recommendations.
C) Referral fees may be disclosed after proceeding with an agreement for service.
Standard III(B) Fair Dealing states that the dissemination of information and recommendations to clients must be
handled fairly. The other choices are related to Standard VI(B) Priority of Transactions and Standard VI(C) Referral
Fees.
Reading 3

Question #14
Ted Willis received his CFA designation in 1998 and was employed as an investment counselor until 2003. During the
past several years, Willis has been out of work because of a serious illness. He also failed to pay his annual CFA
Institute dues during the current year. Willis has now recovered and accepted a position with an investment advisory
firm. His new business card says, "Ted Willis, CFA." As part of his job with his new firm, Willis uses PowerPoint® to
make presentations to groups of prospective clients. He obtained some of these PowerPoint® slides from web sites,
but removed the copyright notice before showing the slides to prospective clients.
Which of the following statements about Standard VII(B), Reference to CFA Institute, the CFA Designation, and the
CFA Program, and Standard I(C), Misrepresentation, is most accurate? Willis:
A) violated both Standard VII(B) and Standard I(C).
B) violated Standard VII(B) but he did not violate Standard I(C).
C) did not violate either Standard VII(B) or Standard I(C).
Willis violated Standard VII(B) because his right to use the CFA designation was suspended when he stopped paying
CFA Institute dues. Thus, he can no longer use the CFA designation on his business card. Willis also violated
Standard I(C) because he was guilty of plagiarism. He inappropriately used copyrighted material, which provided the
impression that such material was his own.
Reading 3
Question #15
Which of the following actions most likely violates Standard I(D) Misconduct?
A) A member pursues an employment opportunity with a competing firm, primarily as a means of securing a salary
increase from her current employer.
B) An analyst is arrested for trespassing while participating in an anti-abortion protest.
C) A Level I candidate submits a request to her employer for auto travel reimbursement using inflated mileage totals
Any activity that reflects adversely on a member's professional reputation, integrity, or competence is a violation of
Standard I(D) Misconduct. Standard I(D) is generally not intended to extend to legal transgressions resulting from acts
of civil disobedience in support of personal beliefs. A member can pursue an employment opportunity with a
competitor as long as the member abides by the Standards related to Duties to Employers.
Reading 3

Question #16
Which of the following is a CORRECT statement of a member's duty under the Code and Standards?
A) A member who trades securities in a foreign securities market where no applicable local laws or stock exchange
rules regulate the use of material nonpublic information may take investment action based on this information.
B) A member is required to comply only with applicable local laws, rules, regulations, or customs even though the
CFA Institute Code and Standards may impose a higher degree of responsibility or a higher duty on the member.
C) In the absence of specific applicable law or other regulatory requirements, the Code and Standards govern the
member's actions.
The Code and Standards represent a minimum level of guidance for members' actions, not a maximum level. The key
to remember here is that whether the local area does or does not have standards governing member's actions, one
must follow the stricter standard environment.
Reading 3

Question #17
Dick Bowden, a CFA charterholder, receives a free country club membership in exchange for financial advice he can
offer the firm. He should:
A) do nothing; it is his business where he spends his free time.
B) disclose the arrangement to his employer.
C) reject the country club membership since it is illegal under CFA Institute rules and regulations to accept outside
compensation.
Dick should disclose the arrangement to his employer under Standard IV(B), Additional Compensation Arrangements.
Reading 3

Question #18
Which of the following is least likely an appropriate use of the CFA designation?
A) Jeremy Salyers has earned the CFA designation by passing three exams, all three on his first attempts.
B) Jeremy Salyers, CFA.
C) Jeremy Salyers, as a CFA charterholder, expects to outperform the market because CFA charterholders have on
average outperformed their peers.
Members may not over-promise their performance as CFA charterholders. They may follow their name with the
designation and describe, factually, the requirements for becoming a charterholder.
Reading 3

QUANTITATIVE METHODS:
Question #19
A stated interest rate of 9% compounded quarterly results in an effective annual rate closest to:
A) 9.3%.
B) 9.4%.
C) 9.2%.
Quarterly rate = 0.09 / 4 = 0.0225.
Effective annual rate = (1 + 0.0225)4 − 1 = 0.09308, or 9.308%.
Reading 6

Question #20
Banca Hakala purchases two front row concert tickets over the Internet for $90 per seat. One month later, the rock
group announces that it is dissolving due to personality conflicts and the concert that Hakala has tickets for will be the
"farewell" concert. Hakala sees a chance to raise some quick cash, so she puts the tickets up for sale on the same
internet site. The auction closes at $250 per ticket. After paying a 10% commission to the site on the amount of the
sale and paying $10 in shipping costs, Hakala's one-month holding period return is approximately:
A) 139%.
B) 144%.
C) 44%.
The holding period return is calculated as: (ending price - beginning price +/- any cash flows) / beginning price. Here,
the beginning and ending prices are given. The other cash flows consist of the commission of 0.10 × $250 × 2 tickets
= $50 and the shipping cost of $10 (total for both tickets).
Thus, her one-month holding period return is: [(2 × $250) - (2 × $90) - $50 − $10] / (2 × $90) = 1.44, or approximately
144%.
Reading 7

Question #21
What is the yield on a discount basis for a Treasury bill priced at $97,965 with a face value of $100,000 that has 172
days to maturity?
A) 3.95%.
B) 2.04%.
C) 4.26%.
($2,035 / $100,000) × (360 / 172) = 0.04259 = 4.26% = bank discount yield.
Reading 7

Question #22
A Treasury bill, with 80 days until maturity, has an effective annual yield of 8%. Its holding period yield is closest to:
A) 1.72%.
B) 1.70%.
C) 1.75%.
The effective annual yield (EAY) is equal to the annualized holding period yield (HPY) based on a 365-day year. EAY
= (1 + HPY)365/t − 1. HPY = (EAY + 1)t/365 − 1 = (1.08)80/365 − 1 = 1.70%.
Reading 7

Question #23
A multivariate normal distribution that includes three random variables can be completely described by the means and
variances of each of the random variables and the:
A) correlations between each pair of random variables.
B) conditional probabilities among the three random variables.
C) correlation coefficient of the three random variables.
A multivariate normal distribution that includes three random variables can be completely described by the means and
variances of each of the random variables and the correlations between each pair of random variables. Correlation
measures the strength of the linear relationship between two random variables (thus, "the correlation coefficient of the
three random variables" is inaccurate).
Reading 10

Question #24
Student's t-Distribution
Level of Significance for One-Tailed Test
df 0.100 0.050 0.025 0.01 0.005 0.0005
Level of Significance for Two-Tailed Test
df 0.20 0.10 0.05 0.02 0.01 0.001
40 1.303 1.684 2.021 2.423 2.704 3.551
60 1.296 1.671 2.000 2.390 2.660 3.460
120 1.289 1.658 1.980 2.358 2.617 3.373
The average salary for a sample of 61 CFA charterholders with 10 years experience is $200,000, and the sample
standard deviation is $80,000. Assume the population is normally distributed. Which of the following is a 99%
confidence interval for the population mean salary of CFA charterholders with 10 years of experience?
A) $172,514 to $227,486.
B) $172,754 to $227,246.
C) $160,000 to $240,000.
If the distribution of the population is normal, but we don't know the population variance, we can use the Student's t-
distribution to construct a confidence interval. Because there are 61 observations, the degrees of freedom are 60.
From the student's t table, we can determine that the reliability factor for t α/2, or t0.005, is 2.660. Then the 99%
confidence interval is $200,000 ± 2.660($80,000 / √61) or $200,000 ± 2.660 × $10,243, or $200,000 ± $27,246.
Reading 11

Question #25
When sampling from a nonnormal distribution with an known variance, which statistic should be used if the sample
size is large and if the respective sample size is small?
A) t-statistic; t-statistic.
B) z-statistic; not available.
C) z-statistic; z-statistic.

When you are sampling from a: and the sample size is small, use a: and the sample size is large, use a:
Normal distribution with a known variance z-statistic z-statistic
Normal distribution with an unknown variance t-statistic t-statistic*
Nonnormal distribution with a known variance not available z-statistic
Nonnormal distribution with an unknown variance not available t-statistic*
*The z-statistic is theoretically acceptable here, but use of the t-statistic is more conservative.
Reading 11

Question #26
Student's t-Distribution
Level of Significance for One-Tailed Test
df 0.100 0.050 0.025 0.01 0.005 0.0005
Level of Significance for Two-Tailed Test
df 0.20 0.10 0.05 0.02 0.01 0.001
24 1.318 1.711 2.064 2.492 2.797 3.745
25 1.316 1.708 2.060 2.485 2.787 3.725
26 1.315 1.706 2.056 2.479 2.779 3.707
27 1.314 1.703 2.052 2.473 2.771 3.690
A random sample of 25 Indiana farms had a mean number of cattle per farm of 27 with a sample standard deviation of
five. Assuming the population is normally distributed, what would be the 95% confidence interval for the number of
cattle per farm?
A) 25 to 29.
B) 22 to 32.
C) 23 to 31.
The standard error of the sample mean = 5 / √25 = 1
Degrees of freedom = 25 − 1 = 24
From Student's t-table, t5/2 = 2.064
The confidence interval is: 27 ± 2.064(1) = 24.94 to 29.06 or 25 to 29.
Reading 11

Question #27
The variance of 100 daily stock returns for Stock A is 0.0078. The variance of 90 daily stock returns for Stock B is
0.0083. Using a 5% level of significance, the critical value for this test is 1.61. The most appropriate conclusion
regarding whether the variance of Stock A is different from the variance of Stock B is that the:
A) variances are not equal.
B) variance of Stock B is significantly greater than the variance of Stock A.
C) variances are equal.
A test of the equality of variances requires an F-statistic. The calculated F-statistic is 0.0083/0.0078 = 1.064. Since the
calculated F value of 1.064 is less than the critical F value of 1.61, we cannot reject the null hypothesis that the
variances of the 2 stocks are equal.
Reading 11

Question #28
Which of the following statements about hypothesis testing is least accurate?
A) The significance level is the probability of making a Type I error.
B) A Type I error is the probability of rejecting the null hypothesis when the null hypothesis is false.
C) A Type II error is the probability of failing to reject a null hypothesis that is not true.
A Type I error is the probability of rejecting the null hypothesis when the null hypothesis is true.
Reading 12

Question #29
A p-value of 0.02% means that a researcher:
A) can reject the null hypothesis at the 5% significance level but cannot reject at the 1% significance level.
B) can reject the null hypothesis at both the 5% and 1% significance levels.
C) cannot reject the null hypothesis at either the 5% or 1% significance levels.
A p-value of 0.02% means that the smallest significance level at which the hypothesis can be rejected is 0.0002,
which is smaller than 0.05 or 0.01. Therefore the null hypothesis can be rejected at both the 5% and 1% significance
levels.
Reading 12

Question #30
Which of the following would a technical analyst most likely interpret as a "buy" signal?
A) 20-day moving average crosses below a 100-day moving average.
B) 30-day moving average crosses above a 5-day moving average.
C) 10-day moving average crosses above a 60-day moving average.
When using moving averages to generate trading signals, a "golden cross" of a shorter-term average above a longer-
term average is a buy signal, while a "dead cross" under the longer-term average is a sell signal.
Reading 13

Question #31
According to research, heart attack is one of the leading causes of death worldwide with about 7.6 million casualties in
2013. The research also claimed that “male smokers are likely to experience heart attack 15 times more than those
who don't smoke and female smokers are likely to experience heart attack 12 times more than nonsmoking females.”
Furthermore, the National Statistics Office released data that 16% of females worldwide are smokers. Suppose you're
in a hospital, waiting for your turn for a medical checkup, and the female beside you is having a monthly maintenance
checkup following a heart attack, what are the chances that she is a smoker?
A) 69.57%
B) 16.24%
C) 27.61%
Using the Bayes' theorem,
P = (12 * 0.16 * x)/[(12 * 0.16 * x) + (x * 0.84)]
P = 69.57%

Question #32
The annual returns of the various stocks for 2008 are given in the table below:
Stock ABC DEF GHI JKL MNO PQR
Return 21% -10% 5% 13% -19% 5%
The range and standard deviation of the stock returns, assuming that they represent a population, are:
Range Std Dev
A. 40 32.9
B. 40 13.43
C. 28.16 40

A) Row A
B) Row B
C) Row C
The range is the difference between the highest and lowest value in the dataset [21 − (−19) = 40]. The standard
deviation is the average of the square root of the sum of squared deviations from the mean:
Std Dv.= σ = √ (21−2.5)2 +(−10−2.5)2 +(5−2.5)2 +(13−2.5)2 +(−19−2.5)2 +(5−2.5)2 / 6 = 13.43

ECONOMICS:
Question #33
If a change in consumer tastes causes a permanent downward shift in demand for hats, but there are no changes in
the cost of inputs to production of hats, the most likely market response would be:
A) a short-term movement along the supply curve to a lower equilibrium price, and a long-run shift in supply.
B) no change in the price of hats because the costs of production have not changed.
C) a short-run shift in the supply curve, causing a decline in the price of hats.
If the costs of production do not change, the supply curve for hats will not shift in the short run in response to a
decrease in demand. Instead, there will be a movement along the supply curve to a new, lower, equilibrium price,
followed by a long-run shift in the supply curve as producers exit the business.
Reading 14

Question #34
For a linear demand curve, at the price where elasticity is -2.0, reducing prices will:
A) increase total revenue and we are not at the point of maximum total revenue.
B) increase total revenue and we are at the point of maximum total revenue.
C) decrease total revenue and we are not at the point of maximum total revenue.
If the price elasticity of demand is -2.0, this indicates that the percentage change in quantity demanded is twice the
percentage change in price. Thus, a decrease in price will be more than offset by the increase in quantity, and total
revenue will increase. We are not at the point of maximum total revenue which is where elasticity is -1.0-the point of
unit elastic demand.
Reading 14

Question #35
The demand function for a good is QD = 2000 − 125P and its supply function is QS = −400 + 75P. At a price of $10,
the mark for this good exhibits:
A) an equilibrium.
B) excess supply.
C) excess demand.
At P = $10, QD = 2000 − 125(10) = 750 and QS = −400 + 75(10) = 350. Quantity demanded is greater than quantity
supplied this price, so the market exhibits excess demand.
Reading 14

Question #36
Which of the following is the most likely effect of a subsidy in the market for corn?
A) The supply curve for corn will shift to the right.
B) Marginal costs will be less than marginal benefit.
C) The equilibrium quantity of corn will decrease.
A subsidy causes a shift rightward in the supply curve (increase in supply at a given price level) by the amount of the
subsidy. The equilibrium quantity will increase and the price paid by buyers will decrease. Marginal cost will exceed
marginal benefit an deadweight loss will result from overproduction.
Reading 14

Question #37
Which of the following is least accurate regarding the allocative efficiency associated with price discrimination? Price
discrimination:
A) results in gains to the discriminating firm by selling to consumers with relatively inelastic demand.
B) leads to production where the sum of consumer surplus and producer surplus is greater than it would be otherwise.
C) leads to a decrease in allocative efficiency.
Allocative efficiency occurs when the quantity produced maximizes the sum of consumer and producer surplus. That
is, where marginal benefit equals marginal cost. Price discrimination reduces the allocative inefficiency that exists
when prices are greater than marginal cost by increasing output toward the quantity where price equals marginal cost.
Firms gain by selling to customers with inelastic demand while still providing goods to customers with more elastic
demand. This may even cause production to take place at a level where it would not take place otherwise.
Reading 15

Question #38
Which of the following is least likely to be considered a reason why regulation of monopolies is not effective?
A) Regulation shifts industry demand and increases prices.
B) Regulation reduces the incentive for firms to reduce costs.
C) Regulators do not know the firm's cost structure.
Regulation is not associated with a shift in industry demand.
Reading 15

Question #39
Which of the following is least likely a source of bias in CPI data?
A) Sample selection
B) Substitution
C) Quality changes
The three sources of bias associated with CPI data are: new goods, quality changes, and substitution.
Reading 17

Question #40
Firms' initial responses to an emerging economic contraction are most likely to be:
A) deferring maintenance of machinery.
B) laying off workers.
C) reducing overtime hours.
Early in an economic contraction, firms typically reduce output by using capital and labor less intensively than during
an expansion (e.g., by reducing overtime). When they believe a contraction is likely to persist, firms decrease capacity
by laying off workers and reducing their physical capital, often by deferring maintenance or not replacing worn-out
equipment.
Reading 17

Question #41
The spot exchange rate for CHF/EUR is 0.8342 and the 1-year forward quotation is −0.353%. The 1-year forward
exchange rate for EUR/CHF is closest to:
A) 1.2029.
B) 0.8313.
C) 1.2022.
The forward rate for CHF/EUR is 0.8342 × (1 − 0.00353) = 0.8313. The 1-year forward EUR/CHF exchange rate is 1 /
0.8313 = 1.2030.
Reading 20

Question #42
A currency exchange rate that is set today for an exchange to be made 90 days in the future is best described as a:
A) forward exchange rate.
B) real exchange rate.
C) spot exchange rate.
A forward exchange rate is a currency exchange rate for an exchange to be made in the future. Forward rates are
quoted for various future dates (e.g., 30 days, 60 days, 90 days, or one year).
Reading 20

Question #43
In a fractional reserve banking system, commercial banks:
A) Must hold reserves equal to 100% of their loans.
B) Are permitted to hold reserves of less than 100% of their loans.
C) Are permitted to hold reserves of less than 100% of their deposits.
A fractional reserve banking system means that banks need to keep only a fraction of their deposits as cash and other
reserves. The rest are available to lend to customers.

Question #44
The central bank increases the quantity of money and credit in the economy in:
A) An expansionary monetary policy.
B) A contractionary monetary policy.
C) An expansionary fiscal policy.
The first choice is correct. The statement properly describes an expansionary monetary policy. The second choice is
incorrect. A contractionary monetary policy happens when the central bank decreases the quantity of money and
credit in the economy. The third choice is incorrect. An expansionary fiscal policy happens when the government
spends more than the tax it collects.

FINANCIAL REPORTING & ANALYSIS:

Question #45
A firm's internal controls are most accurately described as:
A) outside the scope of an audit report under IFRS and U.S. GAAP.
B) a responsibility of the firm's board of directors.
C) directly affecting the firm's financial reporting quality.
Weak internal controls provide an opportunity for low-quality or even fraudulent financial reporting. A firm's
management, not its board of directors, is responsible for ensuring the effectiveness of a firm's internal controls. Under
U.S. GAAP, auditors are required to state an opinion on a firm's internal controls.
Reading 21

Question #46
The best description of the general ledger is that it:
A) is where journal entries are first recorded.
B) sorts the entries in the general journal by account.
C) groups accounts into the categories that are presented in the financial statements.
Information flows through an accounting system in four steps:
1. Journal entries record every transaction, showing which accounts are changed by what amounts. A listing of all the
journal entries in order by date is called the "general journal."
2. The general ledger sorts the entries in the general journal by account.
3. At the end of the accounting period, an initial trial balance is prepared that shows the balances in each account. If
any adjusting entries are needed, they will be recorded and reflected in an adjusted trial balance.
4. The account balances from the adjusted trial balance are presented in the financial statements.
Reading 22

Question #47
Sampson Corp. had 500,000 shares of common stock outstanding at the beginning of the year. The average market
price was $20.
 On April 1, Sampson issued 100,000 shares of $1000 par value 10 percent preferred stock.
 On July 1, Sampson issued 200,000 warrants to purchase 10 shares of common stock each at $22 per share.
 On October 1, Sampson repurchased 60,000 of common stock as treasury stock for $15 per share.
The weighted average common shares outstanding Sampson should use to compute basic earnings per share (EPS)
was:
A) 515,000.
B) 485,000.
C) 600,000.
Only the October 1 transaction affects the weighted average common shares outstanding because the April 1
transaction would not affect the number of shares outstanding and the July 1 transaction involves warrants which
would not be included in the basic EPS calculation. The computation for basic EPS is [(500,000 × 12) − (60,000 × 3)] /
12 = 485,000.
Reading 24

Question #48
Selected financial ratios from Mulroy Company's common-size income statements are as follows:
20X1 20X2 20X3
Gross profit margin 22% 24% 26%
Operating profit margin 18% 20% 22%
Pretax margin 15% 14% 13%
Net profit margin 11% 10% 9%
Relative to sales, it is most likely that Mulroy's:
A) operating expenses are increasing.
B) income tax expense is increasing.
C) nonoperating expenses are increasing.
Nonoperating expenses are equal to the difference between operating profit and pretax profit. Based on the given
profit margins, Mulroy's nonoperating expenses increased from 3% of sales in 20X1 to 9% of sales in 20X3. Because
gross profit margin is increasing, cost of goods sold is decreasing as a percentage of sales. Other operating expenses
and income tax expense, as a percentage of sales, were stable over the period shown.
Reading 24

Question #49
When the market value of an investment in a debt security is less than its carrying value, how should the investor
report the investment on the balance sheet if the security is classified as held-to-maturity and what amount should be
reported if the security is classified as available-for-sale?
Held-to-maturity Available-for-sale
A) Fair value Fair value
B) Amortized cost Fair value
C) Amortized cost Amortized cost
Held-to-maturity securities are reported on the balance sheet at amortized cost while available-for-sale securities are
reported at fair value. Amortized cost includes the amortization of a premium or discount that was created when the
security was purchased.
Reading 25

Question #50
When using the indirect method for computing cash flow from operating activities, a change in accounts payable will
require which of the following?
A) A negative adjustment to net income regardless of whether accounts payable increases or decreases.
B) A positive (negative) adjustment to net income when accounts payable increases (decreases).
C) A negative (positive) adjustment to net income when accounts payable increases (decreases).
A decrease in accounts payable represents an outflow. Hence, a negative adjustment will be required. Conversely, an
increase represents an inflow and a positive adjustment.
Reading 26

Question #51
An examination of the cash receipts and payments of Xavier Corporation reveals the following:
Cash paid to suppliers for purchase of merchandise $5,000
Cash received from customers 14,000
Cash paid for purchase of equipment 22,000
Dividends paid 2,000
Cash received from issuance of preferred stock 10,000
Interest received on short-term investments 1,000
Wages paid 4,000
Repayment of loan to the bank 5,000
Cash from sale of land 12,000
Under U.S. GAAP, Xavier's reported cash flow from operations will be:
A) $5,000.
B) $6,000.
C) -$5,000.
Cash flow relating to operating activities includes cash paid to suppliers, cash received from customers, interest
received, and wages paid. -5,000 + 14,000 + 1,000 + -4,000 = 6,000.
Reading 26

Question #52
Maverick Company reported the following financial information for 2007:
in millions
Beginning accounts receivable $180
Ending accounts receivable 225
Sales 11,000
Beginning inventory 2,000
Ending inventory 2,300
Purchases 8,100
Beginning accounts payable 1,600
Ending accounts payable 1,200
Calculate Maverick's cost of goods sold and cash paid to suppliers for 2007.
Cost of goods sold Cash paid to suppliers
A) $7,800 million $7,100 million
B) $3,800 million $8,500 million
C) $7,800 million $8,500 million
Cost of goods sold is equal to $7,800 million ($2,000 million beginning inventory + $8,100 million purchases - $2,300
million ending inventory). Cash paid to suppliers is equal to $8,500 million (-$7,800 COGS - $300 million increase in
inventory - $400 million decrease in accounts payable). Alternate solution: Cash paid to suppliers is equal to $8,500
million (-$8,100 million purchases - $400 decrease in accounts payable).
Reading 26

Question #53
How would the collection of accounts receivable most likely affect the current and cash ratios?
Current ratio Cash ratio
A) No effect Increase
B) No effect No effect
C) Increase Increase
Collecting receivables increases cash and decreases accounts receivable. Thus, current assets do not change and
the current ratio is unaffected. Because the numerator of the cash ratio only includes cash and marketable securities,
collecting accounts receivable increases the cash ratio.
Reading 27

Question #54
The most likely effect of a write-down of inventory to net realizable on a firm's total asset turnover is:
A) a decrease.
B) no change.
C) an increase.
Total asset turnover is revenue divided by total assets. Writing down inventory to NRV decreases total assets and has
no effect on revenue. As a result, total asset turnover increases.
Reading 28

Question #55
Given the following inventory data about a firm:
 Beginning inventory 20 units at $50/unit
 Purchased 10 units at $45/unit
 Purchased 35 units at $55/unit
 Purchased 20 units at $65/unit
 Sold 60 units at $80/unit
What is the inventory value at the end of the period using LIFO?
A) $1,225.
B) $1,575.
C) $3,450.
Ending inventory equals 20 + 10 + 35 + 20 − 60 = 25 of the first units purchased equals:
(20 units)($50/unit) + (5 units)($45/unit) =
$1,000 + $225 = $1,225
Reading 28

Question #56
A company acquires an intangible asset for $100,000 and expects it to have a value of $20,000 at the end of its 5-year
useful life. If the company amortizes the asset using the double-declining balance method, amortization expense in
year 4 of the asset's useful life is closest to:
A) $8,640.
B) $6,910.
C) $1,600.
Net book value at the end of year 3 is $100,000 × 3/5 × 3/5 × 3/5 = $21,600. DDB amortization in year 4 of 2/5 ×
$21,600 = $8,640 would amortize the asset below its salvage value, so amortization expense is the remaining $1,600
that will amortize net book value to $20,000.
Reading 29

Question #57
A building owned by a firm is most likely to be classified as investment property if:
A) the firm uses the building for its corporate headquarters.
B) space in the building is rented to other firms.
C) the building is a manufacturing plant or distribution center.
Under IFRS, investment property is an asset that is owned for the purpose of earning income from rentals, capital
appreciation, or both.
Reading 29

Question #58
If a lease is treated as a finance lease, as compared to being treated as an operating lease, the effect on the lessee's
current ratio and the debt/equity ratio will be an:
Current Ratio Debt/Equity Ratio
A) Decrease Increase
B) Increase Decrease
C) Increase Increase
With finance leases the lessee's assets, current liabilities, and long-term liabilities will be greater than if the lease was
an operating lease. With the debt to equity ratio, the liability is in the numerator, which results in an increase in the
ratio. With the current ratio, current liabilities are increased and are in the denominator which results in a decrease in
the ratio.
Reading 31

Question #59
Crawford Corp. and Vernon Corp. are lessors who have leased assets on identical terms to firms with similar credit
ratings. Crawford reports its lease as a sales-type lease and Vernon reports its lease as a direct financing lease. It is
most likely that:
A) Vernon reports under IFRS.
B) both firms report under U.S. GAAP.
C) Crawford retains the leased asset on its balance sheet.
For a lessor, under U.S. GAAP, a capital lease may be reported as either a sales-type or direct financing lease. This
distinction is not made for a financing (capital) lease under IFRS.
Reading 31

Question #60
Conditions that may cause firms to issue low-quality financial reports are best described as:
A) inappropriate ethical standards and failing to correct known reportable conditions.
B) unstable organizational structure and deficient internal controls.
C) opportunity, motivation, and rationalization.
The three conditions that often lead to low-quality financial reporting are opportunity, motivation, and rationalization.
Reading 32

Question #61
Joe Carter, CFA, believes Triangle Equipment, a maker of large, specialized industrial equipment, has overstated the
salvage value of its equipment. This would:
A) overstate earnings.
B) overstate liabilities.
C) understate earnings.
Overstating the salvage value reduces depreciation expense, which in turn increases earnings.
Reading 32

Question #62
The price to tangible book value ratio subtracts what components from equity?
A) Goodwill and intangible assets.
B) Intangible assets and property, plant and equipment.
C) Goodwill and property, plant and equipment.
Price to tangible book value is calculated by removing goodwill and intangible assets from equity. This adjustment
reduces assets and equity and produces a ratio that is not affected by differences in intangible asset values that may
result from how the assets were acquired.
Reading 33

Question #63
According to IFRS, which of the following is the least accurate treatment of inventory values?
A) Inventories are recorded at the higher of the original cost or the net realizable value.
B) Inventories are recorded at the lower of the original cost or the net realizable value.
C) Inventory write-downs are reversed, but only to the extent of the previous write-down.
According to IFRS, inventories are recorded at the lower of the original cost or the net realizable value. Reversals of
inventory write-downs are allowable to the extent of the previous write-down. Reversals of write-downs are not
allowable under U.S. GAAP.

Question #64
Which accounting equation embodies the principle that transactions are always recorded such that accounts balance
out?
A) Equity = Assets – Liabilities
B) Assets + Equity = Liabilities
C) Liabilities = Equity – Assets
The accounting equation shows that all assets are either financed through liabilities or equity. Transactions are
measured so that Assets = Liabilities + Equity. Manipulating the equation, we can get Equity = Assets – Liabilities.

Question #65
Right Inc. spent Php 10,000 monthly to develop a certain software for its own use. For the first four months, benefits of
the expenditure could not be estimated reliably. Over the remaining six months, the expenditures met the
capitalization criteria for identifiable intangible assets in accordance with IFRS.
What amount should Right, Inc. capitalize under U.S. GAAP and IFRS, respectively?
A) Php 60,000, Php 60,000
B) Php 100,000, Php 60,000
C) Php 100,000, Php 100,000
Under IFRS, Right can only capitalize the software expenditures that meet the capitalization criteria, which is 10,000 ×
6 months = 60,000.
Under U.S. GAAP, Emma will capitalize all expenditures incurred for software development for its own use, which is
the entire 10,000 × 10 months = 100,000.

Question #66
The reliability of projected profit margins based on past results is greatest if a company possess what characteristic?
A) Engaged in a commodities business
B) Large, diversified, and operating in mature industries
C) Operates in a single business segment
Having many different business segments, each possessing its own margins, allows a large, diversified company to
offset these margin changes against each other. The maturity of the industries they belong in also contribute to the
margins being more stable.

Question #67
The converged standards most likely follow which of the following approaches to revenue recognition?
A) Principles-based approach
B) Rules-based approach
C) Objectives-oriented approach
The converged standards provide a principles-based approach to revenue recognition.

Question #68
Which of the following costs is least likely capitalized as part of the cost of new machinery?
A) Site preparation costs.
B) Staff training costs.
C) Installation costs.
Staff training costs are not necessary to get the asset ready for its intended use and will be expensed.

CORPORATE FINANCE:
Question #69
Lane Industries has a project with the following cash flows:
Year Cash Flow
0 −$200,000
1 60,000
2 80,000
3 70,000
4 60,000
5 50,000
The project's cost of capital is 12%. The discounted payback period is closest to:
A) 3.4 years.
B) 3.9 years.
C) 2.9 years.
The discounted payback period method discounts the estimated cash flows by the project's cost of capital and then
calculates the time needed to recover the investment.
Cumulative
Discounted
Year Cash Flow Discounted
Cash Flow
Cash Flow
0 −$200,000 −$200,000.00 −$200,000.00
1 60,000 53,571.43 −146,428.57
2 80,000 63,775.51 −82,653.06
3 70,000 49,824.62 −32,828.44
4 60,000 38,131.08 5,302.64
5 50,000 28,371.30 33,673.98
discounted payback period =number of years until the year before full recovery +
Reading 35

Question #70
Axle Corporation earned £3.00 per share and paid a dividend of £2.40 on its common stock last year. Its common
stock is trading at £40 per share. Axle is expected to have a return on equity of 15%, an effective tax rate of 34%, and
to maintain its historic payout ratio going forward. In estimating Axle's after-tax cost of capital, an analyst's estimate of
Axle's cost of common equity would be closest to:
A) 8.8%.
B) 9.0%.
C) 9.2%.
We can estimate the company's expected growth rate as ROE × (1 − payout ratio): g = 15% × (1 − 2.40/3.00) = 3%
The expected dividend next period is then £2.40(1.03) = £2.47. Based on dividend discount model pricing, the
required return on equity is 2.47 / 40 + 3% = 9.18%.
Reading 36

Question #71
Which of the following is a key determinant of operating leverage?
A) The tradeoff between fixed and variable costs.
B) The competitive nature of the business.
C) Level and cost of debt.
Operating leverage can be defined as the trade off between variable and fixed costs.
Reading 37

Question #72
Which of the following is least likely a method by which firms repurchase their shares?
A) Exercise a call provision.
B) Tender offer.
C) Direct negotiation.
Call provisions are not relevant to common stock and are not considered a repurchase in any case. There are three
repurchase methods. The first is to buy in the open market. A company may repurchase stock by making a tender
offer to repurchase a specific number of shares at a price that is usually at a premium to the current market price. The
third way is to repurchase by direct negotiation. Companies may negotiate directly with a large shareholder to buy
back a block of shares, usually at a premium to the market price.
Reading 38

Question #73
An analyst who is evaluating a firm's working capital management would be least likely to be concerned if the firm's:
A) number of days of inventory is higher than that of its peers.
B) operating cycle is shorter than that of its peers.
C) total asset turnover is lower than its industry average.
A shorter operating cycle will lead to a shorter cash conversion cycle, other things equal, which is an indication of
better working capital management. Higher days inventory on hand, compared to peer company averages, will
lengthen the cash conversion cycle, an indication of poorer working capital management. Good working capital
management would tend to increase a firm's total asset turnover since a given amount of sales can be supported with
less working capital (less current assets).
Reading 39

Question #74
Which of the following is least likely to be considered a "best practice" regarding corporate governance?
A) A code of ethics that is audited and improved periodically.
B) Board members are limited to a six-year term.
C) Use of a third party to tabulate votes and retain voting records.
Anything beyond 2- or 3-year term limits on board membership has the potential to restrict the ability for shareholders
to change the composition of the board if its members are not acting in the shareholders' best interest.
Reading 40

Question #75
The following information relates to Gamma Corporation:
Number of units sold = 250,000
Contribution margin per unit = $30
Fixed operating costs = $1.2 million
A 20% increase in the number of units sold will increase the company’s operating income by:
A) 1.19%
B) 11.91%
C) 23.81%

This implies that a 1% change in units sold will result in a 1.1905% change in the company’s operating income.
Therefore, a 20% increase in the number of units sold will increase operating income by 23.81% (1.1905 × 20).

Question #76
Creole Inc. opened its business in January 2016. To kick off its operations, the company ordered and purchased raw
materials from its local suppliers Php 1,200,000 with terms 4/10, n/40. What is the annualized cost of not taking the
discount and just paying the invoice at its due date?
A) 56%
B) 64%
C) 72%
The terms 4/10, n/40 means that Creole gets a 4% discount if it pays within 10 days after the purchase. If Creole opts
not to do so, the company has 40 days from the date of purchase to pay for the raw materials.
Annualized cost of trade credit = {1 + [% discount /(1 – % Discount)]} ^ (365/Days past discount) – 1
Annualized cost of trade credit = [1 + (.04/.96)] ^ (365/30) – 1
Annualized cost of trade credit = 64.3236%

Question #77
Cash flows of project A and B are as follows:
Year Project A Project B
2007 (2,300.00) (1,700.00)
2008 1,600.00 900.00
2009 1,200.00 1,500.00
2010 900.00 534.86
If the crossover rate is 18%, Project B's IRR is closest to:
A) 35.32%.
B) 31.73%.
C) 33.47%.
Year Project A Project B Difference in Cash Flows between A and B
0 (2,300.00) (1,700.00) (600.00)
1 1,600.00 900.00 700.00
2 1,200.00 1,500.00 (300.00)
3 900.00 534.86** 365.14*
IRR 35.3245%
*To get the missing difference in cash flows, use the formula with IRR (crossover rate) at 18%.
l0=CF0+CF1/(1+IRR)+CF2/(1+IRR) 2 +CF3/(1+IRR) 3 CF3=365.14 l0=CF0+CF1/(1+IRR)+CF2/(1+IRR)2+CF3/(1+IR
R)3CF3=365.14
**To get Project B's missing cash flow, 900 – 365.14 = 534.86.
The IRR for Project B is 35.32%

PORTFOLIO MANAGEMENT:
Question #78
The top-down analysis approach is most likely to be employed in which step of the portfolio management process?
A) The planning step.
B) The execution step.
C) The feedback step.
Top-down analysis would be used to select securities in the execution step.
Reading 40

Question #79
The most appropriate measure of the increase in the purchasing power of a portfolio's value over a given span of time
is a(n):
A) holding period return.
B) real return.
C) after-tax return.
A real return is adjusted for the effects of inflation and is used to measure the increase in purchasing power over time.
Reading 42

Question #80
Gregg Goebel and Mason Erikson are studying for the Level I CFA examination. They have just started the section on
Portfolio Management and Erikson is having difficulty with the equations for the covariance (cov 1,2) and the correlation
coefficient (r1,2) for two-stock portfolios. Goebel is confident with the material and creates the following quiz for
Erikson. Using the information in the table below, he asks Erickson to fill in the question marks.
Portfolio J Portfolio K Portfolio L
Number of Stocks 2 2 2
Covariance ? cov1,2 = 0.020 cov1,2 = 0.003
Correlation coefficient r1,2 = 0.750 ? ?
Risk measure Stock 1 Std. Deviation1 = 0.08 Std. Deviation1 = 0.20 Std. Deviation1 = 0.18
Risk measure Stock 2 Std. Deviation2 = 0.18 Std. Deviation2 = 0.12 Variance2 = 0.09
Which of the following choices correctly gives the covariance for Portfolio J and the correlation coefficients for
Portfolios K and L?
Portfolio J Portfolio K Portfolio L
A) 0.011 0.833 0.056
B) 1.680 0.002 0.076
C) 0.011 0.002 0.076
The calculations are as follows:
Portfolio J covariance = cov1,2 = (r1,2) × (s1) × (s2) = 0.75 × 0.08 × 0.18 = 0.0108, or 0.011.
Portfolio K correlation coefficient = (r1,2) = cov1,2 / [ (s1) × (s2) ] = 0.02 / (0.20 × 0.12) = 0.833.
Portfolio L correlation coefficient = (r1,2) = cov1,2 / [ (s1) × (s2)1/2 ] = 0.003 / (0.18 × 0.091/2) = 0.003 / (0.18 × 0.30) =
0.056.
Reading 42

Question #81
The expected market premium is 8%, with the risk-free rate at 7%. What is the expected rate of return on a stock with
a beta of 1.3?
A) 17.4%.
B) 16.3%.
C) 10.4%.
RRStock = Rf + (RMarket − Rf) × BetaStock, where RR = required return, R = return, and Rf = risk-free rate, and (RMarket −
Rf) = market premium
Here, RRStock = 7 + (8 × 1.3) = 7 + 10.4 = 17.4%.
Reading 43

Question #82
Which of the following statements about systematic and unsystematic risk is most accurate?
A) Total risk equals market risk plus firm-specific risk.
B) The unsystematic risk for a specific firm is similar to the unsystematic risk for other firms in the same industry.
C) As an investor increases the number of stocks in a portfolio, the systematic risk will remain constant.
Total risk equals systematic (market) plus unsystematic (firm-specific) risk.
The unsystematic risk for a specific firm is not similar to the unsystematic risk for other firms in the same industry.
Unsystematic risk is firm-specific or unique risk.
Systematic risk of a portfolio can be changed by adding high-beta or low-beta stocks.
Reading 43

Question #83
An analyst gathered the following information regarding three portfolios. Which portfolio is most likely to plot below the
Markowitz efficient frontier?
 Portfolio Expected Return Standard Deviation
A 8% 13%
B 15% 16%
C 11% 20%

A) Row A
B) Row B
C) Row C
Portfolio C lies below the Markowitz efficient frontier because Portfolio B offers a higher return at lower risk.

Question #84
Regressing a stock's returns against the market's returns can be used to find:
A) A stock's beta.
B) The volatility of a stock's return.
C) The relative volatility of a stock's return.
The beta is the slope of a stock's characteristic line or regressions line (and the alpha is the intercept).

Question #85
Consider the following investors:
Investor A wants to invest in securities that make regular payments so that he can pay his daughter’s college tuition.
Investor B does not want to invest in stocks of Alpha Corp. (his employer), as he has access to material nonpublic
information about the company.
Which of the following is most accurate?
Investor A has: Investor B has:
A Liquidity constraints Unique needs and circumstances
B Time horizon constraints Unique needs and circumstances
C Liquidity constraints Legal and regulatory constraints
A) Row A
B) Row B
C) Row C
Investor A’s situation provides an example of a liquidity constraint.
Investor B is legally prohibited from investing in securities regarding which he has material nonpublic information.

Question #86
An assumption of the capital asset pricing model (CAPM) is:
A) Heterogeneous expectations.
B) Infinitely divisible assets.
C) Irrational individuals.
The CAPM assumes infinitely divisible assets. Other assumptions include risk-aversion, utility maximization, rational
individuals, frictionless markets, single holding period, homogeneous expectations, infinitely divisible assets, and price
takers.

EQUITY:
Question #87
The initial margin is the:
A) equity represented in the margin account at any time.
B) amount of cash that an investor must maintain in his/her margin account.
C) minimum amount of funds that must be supplied when purchasing a security on margin.
Margin is the amount of equity in the account at a given time. Initial margin is the amount of equity required initially to
execute an order.
Reading 45

Question #88
Which of the following weighting schemes will produce a downward bias on the index due to the occurrence of stock
splits by firms in the index?
A) Equal weighted price indicator series.
B) Price-weighted series.
C) Market-cap weighted series.
The price-weighting scheme sums the market price of each of the stocks contained in the index and then divides this
sum by the number of stocks in the index. Thus if a firm executes a stock split thereby reducing its share price, this will
cause a downward bias in the index.
Reading 46

Question #89
Which of the following statements on the forms of the efficient market hypothesis (EMH) is least accurate?
A) The semi-strong form EMH addresses market and non-market public information.
B) The weak-form EMH states that stock prices reflect current public market information and expectations.
C) The strong-form EMH assumes perfect markets.
The weak-form EMH assumes the price of a security reflects all currently available historical information. Thus, the
past price and volume of trading has no relationship with the future, hence technical analysis is not useful in achieving
superior returns.
The other statements are true. The strong-form EMH states that stock prices reflect all types of information: market,
non-public market, and private. No group has monopolistic access to relevant information; thus no group can achieve
excess returns. For these assumptions to hold, the strong-form assumes perfect markets - information is free and
available to all.
Reading 47

Question #90
An equity security that requires the firm to pay any scheduled dividends that have been missed, before paying any
dividends to common equity holders, is a:
A) participating preference share.
B) convertible preference share.
C) cumulative preference share.
Cumulative preference shares (cumulative preferred stock) must receive any dividends in arrears before the firm may
pay any dividends to common shareholders.
Reading 48

Question #91
Which of the following types of industries is typically characterized by above-normal expansion in sales and profits
independent of the business cycle?
A) Defensive.
B) Counter-cyclical.
C) Growth.
A growth industry is typically characterized by above-normal expansion in sales and profits independent of the
business cycle.
Reading 49

Question #92
When constructing a peer group of firms, an analyst should least appropriately consider the firms':
A) cost structures.
B) business cycle sensitivity.
C) industry classification.
A peer group should consist of firms that are alike in their principal lines of business, along with other similarities such
as cost structures and access to capital. Firms can be similar in business cycle sensitivity but dissimilar in terms of
their business activities (e.g., a firm in the home building industry and a firm in the heavy equipment manufacturing
industry).
Reading 49

Question #93
Day and Associates is experiencing a period of abnormal growth. The last dividend paid by Day was $0.75. Next year,
they anticipate growth in dividends and earnings of 25% followed by negative 5% growth in the second year. The
company will level off to a normal growth rate of 8% in year three and is expected to maintain an 8% growth rate for
the foreseeable future. Investors require a 12% rate of return on Day. The value of Day stock today is closest to:
A) $18.65.
B) $20.70.
C) $24.05.
First find the abnormal dividends:
D1 = $0.75 × 1.25 = $0.9375
D2 = $0.9375 × 0.95 = $0.89
D2 is the first dividend that will grow at a constant rate. We can use this dividend in the constant growth DDM to get a
value for the stock in period 1:
$0.89 / (0.12 - 0.08) = $22.25
Value of the stock today = ($22.25 + $0.9375) / 1.12 = $20.70.
Reading 50

Question #94
A company's payout ratio is 0.45 and its expected return on equity (ROE) is 23%. What is the company's implied
growth rate in dividends?
A) 4.16%.
B) 12.65%.
C) 10.35%.
Growth Rate = (ROE)(1 - Payout Ratio) = (0.23)(0.55) = 12.65%
Reading 50

Question #95
A stock is expected to pay a dividend of $1.50 at the end of each of the next three years. At the end of three years the
stock price is expected to be $25. The equity discount rate is 16 percent. What is the current stock price?
A) $19.39.
B) $24.92.
C) $17.18.
The value of the stock today is the present value of the dividends and the expected stock price, discounted at the
equity discount rate:
$1.50/1.16 + $1.50/1.162 + $1.50/1.163 + $25.00/1.163 = $19.39
Reading 50

Question #96
An analyst projects the following pro forma financial results for Magic Holdings, Inc., in the next year:
 Sales of $1,000,000
 Earnings of $200,000
 Total assets of $750,000
 Equity of $500,000
 Dividend payout ratio of 62.5%
 Shares outstanding of 50,000
 Risk free interest rate of 7.5%
 Expected market return of 13.0%
 Stock Beta at 1.8
If the analyst assumes Magic Holdings, Inc. will produce a constant rate of dividend growth, the value of the stock is
closest to:
A) $104
B) $19
C) $44
Infinite period DDM: P0 = D1 / (ke - g)
D1 = (Earnings × Payout ratio) / average number of shares outstanding
= ($200,000 × 0.625) / 50,000 = $2.50.

ke = risk free rate + [beta × (expected market return - risk free rate)]

ke = 7.5% + [1.8 × (13.0% - 7.5%)] = 17.4%.

g = (retention rate × ROE)

Retention = (1 - Payout) = 1 - 0.625 = 0.375.
ROE = net income/equity
= 200,000/500,000 = 0.4
g = 0.375 × 0.4 = 0.15.
P0 = D1 / (ke - g) = $2.50 / (0.174 - 0.15) = 104.17.
Reading 50

Question #97
The first decision that an index provider must make when conducting an index is most likely:
A) Security selection.
B) Allocation of weight to each security.
C) Identification of the target market.
When constructing a security market index, the first decision that must be made relates to which market, market
segment, or asset class the index should represent.

Question #98
If markets are semi-strong form efficient, technical analysis may lead to abnormal returns that are:
A) consistently positive.
B) zero on average.
C) consistently negative.
Technical analysis leads to positive abnormal returns if the market is weak form inefficient. In addition, a market that is
semi-strong efficient is also weak form efficient.

FIXED INCOME:
Question #99
An investor purchases a 5-year, A-rated, 7.95% coupon, semiannual-pay corporate bond at a yield to maturity of
8.20%. The bond is callable at 102 in three years. The bond's yield to call is closest to:
A) 8.9%.
B) 8.6%.
C) 8.3%.
First determine the price paid for the bond:
N = 5 × 2 = 10; I/Y = 8.20 / 2 = 4.10; PMT = 7.95 / 2 = 3.975; FV = 100; CPT PV = -98.99
Then use this value and the call price and date to determine the yield to call:
N = 3 × 2 = 6; PMT = 7.95 / 2 = 3.975; PV = -98.99; FV = 102; CPT I/Y = 4.4686 × 2 = 8.937%
Reading 53

Question #100
Holding other factors constant, the interest rate risk of a coupon bond is higher when the bond's:
A) yield to maturity is lower.
B) current yield is higher.
C) coupon rate is higher.
In this case the only determinant that will cause higher interest rate risk is having a low yield to maturity. A higher
coupon rate and a higher current yield will result in lower interest rate risk.
Reading 55

Question #101
Which of the following statements about an embedded call feature in a bond is least accurate? The call feature:
A) reduces the bond's capital appreciation potential.
B) increases the bond's duration, increasing price risk.
C) exposes investors to additional reinvestment rate risk.
A call provision decreases the bond's duration because a call provision introduces prepayment risk that should be
factored in the calculation.
For the investor, one of the most significant risks of callable (or prepayable) bonds is that they can be called/retired
prematurely. Because bonds are nearly always called for prepayment after interest rates have decreased significantly,
the investor will find it nearly impossible to find comparable investment vehicles. Thus, investors have to replace their
high-yielding bonds with much lower-yielding issues. From the bondholder's perspective, a called bond means not
only a disruption in cash flow but also a sharply reduced rate of return.
Generally speaking, the following conditions apply to callable bonds:
 The cash flows associated with callable bonds become unpredictable, since the life of the bond could be much
shorter than its term to maturity, due to the call provision.
 The bondholder is exposed to the risk of investing the proceeds of the bond at lower interest rates after the bond
is called. This is known as reinvestment risk.
 The potential for price appreciation is reduced, because the possibility of a call limits or caps the price of the bond
near the call price if interest rates fall.
Reading 55

Question #102
For a given bond, the duration is 8 and the convexity is 100. For a 60 basis point decrease in yield, what is the
approximate percentage price change of the bond?
A) 4.62%.
B) 4.98%.
C) 2.52%.
The estimated price change is -(duration)(∆YTM) + (½)(convexity) × (∆YTM) 2 = -8 × (-0.006) + (½)(100) × (-0.0062) =
+0.0498 or 4.98%.
Reading 55

Question #103
A bond portfolio consists of a AAA bond, a AA bond, and an A bond. The prices of the bonds are $1,050, $1,000, and
$950 respectively. The durations are 8, 6, and 4 respectively. What is the duration of the portfolio?
A) 6.00.
B) 6.67.
C) 6.07.
The duration of a bond portfolio is the weighted average of the durations of the bonds in the portfolio. The weights are
the value of each bond divided by the value of the portfolio:

portfolio duration = 8 × (1050 / 3000) + 6 × (1000 / 3000) + 4 × (950 / 3000) = 2.8 + 2 + 1.27 = 6.07.
Reading 55

Question #104
Which of the following is most accurate about a bond with positive convexity?
A) Positive changes in yield lead to positive changes in price.
B) Price increases when yields drop are greater than price decreases when yields rise by the same amount.
C) Price increases and decreases at a faster rate than the change in yield.
A convex price/yield graph has a larger increase in price as yield decreases than the decrease in price when yields
increase.
Reading 55

Question #105
Becque Ltd. is a European Union company with the following selected financial information:
€ billions Year 1 Year 2 Year 3
Operating income 262 361 503
Depreciation & amortization 201 212 256
Capital expenditures 78 97 140
Cash flow from operations 303 466 361
Total debt 2,590 2,717 2,650
Dividends 70 70 72
Becque's three-year average debt-to-EBITDA ratio is closest to:
A) 4.6x.
B) 7.6x.
C) 3.6x.
EBITDA = Operating income + depreciation + amortization
Year 1: 262 + 201 = €463 billion
Year 2: 361 + 212 = €573 billion
Year 3: 503 + 256 = €759 billion
Debt/EBITDA ratio:
Year 1: 2,590 / 463 = 5.6x
Year 2: 2,717 / 573 = 4.7x
Year 3: 2,650 / 759 = 3.5x
Three-year average = 4.6x.
Reading 56

Question #106
If investors expect greater uncertainty in the bond markets, yield spreads between AAA and B rated bonds are most
likely to:
A) narrow.
B) slope downward.
C) widen.
With greater uncertainty, investors require a higher return for taking on more risk. Therefore credit spreads will widen.
Reading 56

Question #107
Recovery rates are greatest for classes of debt with the highest:
A) default rates.
B) loss severity.
C) priority of claims.
High default rates and loss severity are indicators of potential lower recovery rates. The highest priority of claims has
the lowest credit risk.
Reading 56

Question #108
Tony Ly is a Treasury Manager with Deeter Holdings, a large consumer products holding company. The Assistant
Treasurer has asked Ly to calculate the current yield and the Yield-to-first Call on a bond the company holds that has
the following characteristics:
 7 years to maturity
 $1,000 face value
 7.0% semi-annual coupon
 Priced to yield 9.0%
 Callable at $1,060 in two years
If Ly calculates correctly, the current yield and yield to call are approximately:
CY YTC
A) 7.80% 15.72%
B) 7.80% 15.82%
C) 7.78% 15.82%
To calculate the CY and YTC, we first need to calculate the present value of the bond: FV = 1,000, N = 14 = 7 × 2,
PMT = 35 =(1000 × 0.07)/2, I/Y = 4.5 (9 / 2), Compute PV = -897.77 (negative sign because we entered the FV and
payment as positive numbers).
Then, CY = (Face value × Coupon) / PV of bond = (1,000 × 0.07) / 897.77 = 7.80%.
And finally, YTC calculation: FV = 1,060 (price at first call), N = 4 (2 × 2), PMT = 35 (same as above), PV = -897.77
(negative sign because we entered the FV and payment as positive numbers), ComputeI/Y = 7.91 (semi-annual rate,
need to multiply by 2) = 15.82%.
Reading 53

Question #109
A zero-coupon bond matures three years from today, has a par value of $1,000 and a yield to maturity of 8.5%
(assuming semi-annual compounding). What is the current value of this issue?
A) $782.91.
B) $78.29.
C) $779.01.
The value of the bond is computed as follows:
Bond Value = $1,000 / 1.04256 = $779.01.
N = 6; I/Y = 4.25; PMT = 0; FV = 1,000; CPT → PV = 779.01.
Reading 53

Question #110
A semiannual-pay bond is callable in five years at $1,080. The bond has an 8% coupon and 15 years to maturity. If an
investor pays $895 for the bond today, the yield to call is closest to:
A) 9.3%.
B) 10.2%.
C) 12.1%.
YTC: N = 10; PV = -895; PMT = 80 / 2 = 40; FV = 1080; CPT → I/Y = 6.035 × 2 = 12.07%.
Reading 53

DERIVATIVES:

Question #111
Which of the following is typically equal to zero at the initiation of an interest rate swap contract?
A) Its value.
B) Neither its value nor its price.
C) Its price.
As with other derivatives, the price of an interest rate swap (the fixed rate specified in the contract) is typically set such
that the value of the swap is zero at initiation.
Reading 58

Question #112
Which of the following will increase the value of a call option?
A) An increase in the exercise price.
B) A dividend on the underlying asset.
C) An increase in volatility.
Increased volatility of the underlying asset increases both put values and call values. A higher exercise price or an
increase in cash flows on the underlying asset decrease the value of a call option.
Reading 58

Question #113
Consider a European call option and put option that have the same exercise price, and a forward contract to buy the
same underlying asset as the two options. An investor buys a risk-free bond that will pay, on the expiration date of the
options and the forward contract, the difference between the exercise price and the forward price. According to the
put-call-forward parity relationship, this bond can be replicated by:
A) buying the call option and writing the put option.
B) writing the call option and buying the put option.
C) writing the call option and writing the put option.
The put-call-forward parity relationship may be expressed as:
p0 - c0 = [X - F0(T)] / (1 + Rf)T
That is, at initiation of a forward contract on the underlying asset, buying a put option and writing a call option with
exercise price X will have the same cost as a risk-free bond which, at expiration of the forward and options, will pay
the difference between X and the forward price.
Reading 58

Question #114
A put option has a strike price of $65, and the stock price is $39 at expiration. The expiration day value of the put
option is:
A) $65.
B) $26.
C) $0.
A put option has an expiration day value of MAX (0, X-S). Here, X is $65 and S is $39.
Reading 59

Question #115
Linda Reynolds pays $2.45 to buy a call option with a strike price of $42. The stock price at which Reynolds earns
$3.00 from her call option position is:
A) $42.00.
B) $47.45.
C) $2.45.
To earn $3.00, the stock price must be above the strike price by $3.00 plus the premium Reynolds paid to buy the
option ($42.00+$3.00+$2.45).
Reading 59

Question #116
A stock is trading at $18 per share. An investor believes that the stock will move either up or down. He buys a call
option on the stock with an exercise price of $20. He also buys two put options on the same stock each with an
exercise price of $25. The call option costs $2 and the put options cost $9 each. The stock falls to $17 per share at the
expiration date and the investor closes his entire position. The investor's net gain or loss is:
A) $4 loss.
B) $3 loss.
C) $4 gain.
The total cost of the options is $2 + ($9 × 2) = $20.
At expiration, the call is worth Max [0, 17-20] = 0. Each put is worth Max [0, 25-17] = $8. The investor made $16 on
the puts but spent $20 to buy the three options, for a net loss of $4.
Reading 59

ALTERNATIVE INVESTMENTS:
Question #117
For an investment with negatively skewed returns, the most appropriate of the following risk measures is:
A) shortfall risk.
B) value at risk.
C) Sortino ratio.
The Sortino ratio uses downside deviation, and therefore will capture the effects of negative skewness better than
measures that use standard deviation. Value at risk (VaR) is a downside risk measure that estimates the potential loss
from outcomes in the left tail of the distribution of returns but uses standard deviation, as does shortfall risk.
Reading 60

Question #118
Real estate and private equity most likely share which of the following characteristics?
A) Commonly traded on an exchange.
B) Biases in historical returns on indexes.
C) Low management fees.
Private equity index returns may exhibit survivorship bias and backfill bias, while some real estate index returns may
exhibit sample selection bias. Neither asset class is considered to have low management fees. Private equity is not
typically traded on an exchange.
Reading 60

Question #119
The formative stage of venture capital investing when capital is furnished for market research and product
development is best characterized as the:
A) seed stage.
B) early stage.
C) angel investing stage.
In the seed stage of venture capital investing, capital is furnished for product development, marketing, and market
research. The angel investing stage is when investment funds are used for business plans and assessing market
potential. The early stage refers to investments made to fund initial commercial production and sales.
Reading 60

Question #120
Under which approach to valuing real estate properties is an analyst most likely to estimate a capitalization rate?
A) Cost approach.
B) Comparable sales approach.
C) Income approach.
The income approach estimates values by calculating the present value of expected future cash flows from property
ownership or by dividing the net operating income (NOI) for a property by a capitalization rate. The comparable sales
approach estimates a property value based on recent sales of similar properties. The cost approach is based on the
estimated cost to replace an existing property.
Reading 60