JUN18L1/S02PM

ETHICS

Question 1
Which of the following is the most accurate statement regarding candidates in the CFA Program according to the CFA
Institute Standards?
a) Candidates do not need to comply with the CFA Institute Standards until they are
awarded the CFA charter.
b) Candidates can claim only partial CFA designation if they have passed one or more
levels of the examinations.
c) To be a candidate a person must have both successfully registered for the CFA
Program and enrolled for one of the CFA examinations.
The CFA Institute Standards of Professional Conduct apply to both members and candidates, so choice A is not
correct. Partial designation is not permitted, so choice B is not correct. Choice C is a correct statement.

Question 2
Karren Black, CFA, is a portfolio manager. She has just taken over a sizeable portfolio of securities that a client
transferred from another portfolio manager. The portfolio has a large holding in a small company, Micro Engineering,
which is an illiquid stock. After doing research into the prospects of Micro Engineering, Black decides to sell the
holding in the company. Her sell orders push down the price of the stock. Black:
a) Has not violated Standard II(B): Market Manipulation.
b) Has violated Standard II(B): Market Manipulation, since she distorted the share
price of Micro Engineering.
c) Has violated Standard II(B): Market Manipulation, since she should have made
every effort to spread the sale orders across a number of brokers to reduce the
price impact of the trades.
Black had no intention of misleading the market, so she did not violate Standard II(B); therefore, the correct answer is
A.

Question 3
Isabella Maserati, CFA, an analyst, is writing a report on the Bermuda Railtrack Corporation (BRC). She is a friend of
the wife of the chief executive officer (CEO) of BRC, and when chatting about the report she is writing, the CEO's wife
says that her husband told her BRC is intending to cut the dividend paid to shareholders in BRC. An announcement
will be made the following week and it is expected to be badly received by investors. Maserati quickly finishes her
report with a “sell” recommendation based on the anticipated dividend cut.
Based on the CFA Institute Standards:
a) Maserati should not use the information from the CEO's wife because it is material
and nonpublic information.
b) Maserati should immediately disseminate the information to institutional clients and
individual investors on a fair basis.
c) The information that BRC is likely to cut the dividend is unconfirmed therefore
Maserati is free to use the information to internally justify her sell recommendation
but should not mention in the report that the dividend will be cut.
Maserati should be aware that the information is material and nonpublic and therefore not write the report, which may
cause others to act on the information.

Question 4
Robert Shoemaker, CFA, is an automotive analyst in the brokerage arm of an investment bank. He changes his
recommendation on Bayer Motors to a “sell” after looking at the unofficial computer-generated model on the Internet of
the new two-door sports model to be launched next year. He states that the new model is unattractive and therefore
forecasts that sales growth will slow down. Shoemaker's approach:
a) Violates the insider trading rules.
b) Reflects the misappropriation theory.
c) Reflects lack of distinction between facts and opinions.
According to Standard V(B), Shoemaker should clearly differentiate between facts and opinions.

Question 5
The corporate finance department of an investment bank recently obtained a mandate to underwrite a bond offering
from Endiron Corp. The director of the corporate finance department issues a circular requesting that all research
reports about Endiron should carry a favorable recommendation. Charlotte van Nistelroyen, CFA, the equity analyst
covering Endiron, is about to write a “sell” recommendation as a result of Endiron's current production capacity
constraints. According to the CFA Institute Standards:
 a) The investment banking company should put Endiron on a restricted list and only
disseminate factual information.
b) Van Nistelroyen has professional and commercial duties to her employer and
therefore should change the recommendation to a “buy.”
c) Van Nistelroyen, as an equity analyst, is free to write the research report without
any pressure since it is a bond issue not an equity issue.
A firewall should be used to separate the corporate finance and research departments and this would include putting
stocks on a restricted list if the corporate finance department is doing an issue for the company.

Question 6
A profession is characterized by participants who:
a) Are self-regulating.
b) Are highly regulated.
c) Agree to follow a code of ethics.
The three characteristics of a profession are that it is:
 Based on specialized knowledge.
 Based on service to others.
 Practiced by members who agree to adhere to a common code of ethics.

Question 7
The CFA Institute Code of Ethics specifically addresses all of the following except:
a) Competence.
b) Supervisory responsibilities.
c) Integrity of the investment profession.
Supervisory responsibilities are addressed in the Standards of Professional Conduct, not the Code of Ethics.

Question 8
Edward Winsore, CFA, based in California, manages the pension fund of a privately owned company, Brandsohn. The
proprietor, Christina Brandsohn, is pleased with the consistent outperformance over the benchmark. She offers
Winsore, as a token of gratitude, two tickets to a Broadway show and a weekend in New York, all expenses paid.
According to the CFA Institute Standards, Winsore should:
a) Reject the offer.
b) Pay for his travel but is free to accept the offer of accommodation and tickets.
c) Report the offer to his employer and if his employer agrees, he is free to accept the
offer.
Winsore will be in compliance with Standard I(B) if he discloses the gift to his employer, and as long as his employer
doesn't object, he can accept the offer.

Question 9
Pauline Krakowsky, CFA, is the marketing director of the high-net-worth division of Smoke Investment Advisory Firm.
In order to impress the retired chairman and cofounder of the publicly listed Lee Kok Soy Property Development, she
requests that the research department of the affiliated brokerage arm of Smoke write a favorable recommendation for
the listed company. Krakowsky hopes to win discretionary investment management business from Lee Kok Soy.
Krakowsky's request is:
a) In violation of the CFA Institute Standards.
b) A legitimate business practice and not inconsistent with the CFA Institute
Standards.
c) Not in violation of the CFA Institute Standards if the listed company operates in a
country with less strict regulations than the CFA Institute Standards.
The request is in violation of Standard I(B) as the research department is being asked to compromise the
independence and objectivity of an investment recommendation.

Question 10
The research department of a brokerage firm has just completed an updated report on Vroom Automobile Suppliers.
The report recommends a “sell” and is to be published and disseminated the next morning. According to the CFA
Institute Standards, Armand Guigiaro, CFA, an institutional broker at the firm:
a) Must make reasonable efforts to achieve immediate public dissemination of the
information.
b) Must wait until the official publication of the report and use an equitable system to
disseminate the information to all his clients.
 c) May only use the information for the benefit of his individual clients and immediate
family members before institutional clients are informed.
The best choice is B according to Standard III(B): Fair Dealing.

Question 11
Fumiko Kasawa, CFA, works for JMK Asset Management and has been managing a large family trust fund for four
years. The performance record of the trust looks impressive with the trust rising in value by an average of 28% per
annum over the past four years. Kasawa's colleague, Bruce Moore, CFA, who is head of marketing at JMK, decides to
use her performance record in a marketing presentation to another trust who is looking to change fund manager and is
considering appointing JMK as their new manager. Moore says, “… We have achieved an average return of 28% per
year over the past four years, illustrating our superior stock selection skills.”
Although the performance data is correct, he does not state that the good performance is partly due to the trust fund
holding a large block of shares in the family company, which has performed particularly well. The decision to hold
these shares was made by the trust, not by Kasawa. Which of the following statements is most accurate in describing
Moore's performance claim?
a) Moore has not violated the CFA Institute Standards since the performance claim is
correct.
b) Moore has not violated the CFA Institute Standards if he does not make any
guarantee over future performance.
c) Moore has violated the CFA Institute Standards since his statement misleads the
potential client on the results achieved.
Moore, although giving performance numbers that are factually correct, has not given a fair and accurate view of the
fund's performance; therefore, he has violated Standard I(C): Misrepresentation.

Question 12
Which of the following statements is most accurate regarding verification of compliance with GIPS?
a) Verification must be done on a firm-wide basis, not just for specific composites.
b) Verification by a third party is required if a firm claims that it is GIPS compliant.
c) Verifiers are not expected to understand the methods by which valuations and
performance numbers are calculated.
Verification is strongly recommended but is not mandatory. If verification is done, it must be performed by a third party.
Verifiers must understand the methods and policies used to record performance calculation for performance purposes.

Question 13
Which of the following statements is least accurate with respect to GIPS regarding composites?
a) All actual fee-paying discretionary portfolios must be included in at least one
composite.
b) Firm composites must be defined to include portfolios with similar investment
objectives or strategies.
c) Composite performance calculation must equally weight the performance of the
portfolios in the composite.
Composites should be asset-weighted, not equally weighted, returns of the constituent portfolios.

Question 14
George Gekko, CFA, an investment manager with C. B. Asset Management, is a former classmate of a lawyer who is
working to assist Fortune Manufacturing in negotiations with the labor union to delay a pay raise. He is informed in
confidence that the negotiation appears to be progressing in favor of the labor union, which is demanding a 25%
immediate raise in pay. It can be inferred that the company will incur substantial additional labor costs for the current
year. According to the CFA Institute Standards, Gekko:
a) Must not use the nonpublic information to trade or cause others to trade.
b) May use the nonpublic information only after gaining approval from Fortune's
management.
c) Must announce the information publicly in order to achieve immediate public
dissemination of the information.
Choice A is the most appropriate according to Standard II(A): Material Nonpublic Information.

Question 15
Which of the following is most accurate with respect to the construction of composites?
a) Terminated portfolios must be excluded from past performance records.
b) If a discretionary, fee-paying portfolio is excluded from all of a firm's composites,
the reason must be disclosed.
 c) If portfolios have similar objectives and strategies and are investing in the same
asset classes, they would generally be included in the same composite.
Terminated portfolios should be included until the last measurement period that they are under management, so
choice A is not correct. GIPS specify only that all fee-paying discretionary portfolios should be included in a
composite, so choice B is not correct. Composites are a group of portfolios that have the same strategy or objective,
so choice C is the most accurate.

Question 16
Under GIPS, which of the following could be classified as a firm?
a) A legal firm that gives advice on investment of trust accounts.
b) A pension fund operating under the Employee Retirement Income Security Act
(ERISA).
c) A subsidiary of an investment management company that is a distinct business
unit.
The legal firm and pension fund are not classed as firms under GIPS. A firm must be an investment firm, subsidiary, or
division thereof that is presented to clients as a distinct business unit.

Question 17
Charles Fuller, CFA, manages the Western Charity Fund, and he receives a request from a potential donor for
information on the fund, including the current investment strategy and the holdings in the fund. Fuller's best course of
action is to:
a) Contact the trustees for permission to release the information.
b) Release the information since it is not material nonpublic information.
c) Release the information to the potential donor since Fuller is acting in the best
interests of the charity.
Standard III(E) requires that members preserve their clients' confidentiality and not release information to outside
parties even if it is not material nonpublic information. He has a fiduciary duty to the trustees of the fund and must get
their permission before releasing information about the fund.

Question 18
Which of the following is not included in the objectives of GIPS?
a) Charge clients reasonable levels of investment management fees.
b) Ensure accuracy and consistency in the presentation of performance.
c) Promote fair, global competition among all firms in the investment industry.
It is recommended that fees should be disclosed, but the Standards do not specify the amount that clients can be
charged.

Quantitative Methods

Question 19
There is a 20% probability that a stock will experience a decline in earnings, a 30% probability that it will not pay a
dividend, and a 15% probability that it will both report a decline in earnings and not pay a dividend. What is the
probability that the stock will either report a decline in earnings or not pay a dividend?
a) 35%
b) 50%
c) 65%
Apply the Addition Rule:
P(A or B) = P(A)+P(B)−P(AB) = 0.2+0.3−0.15=0.35

Question 20
The returns from a portfolio are normally distributed with a mean of 16% and a standard deviation of 8%. The
probability of a negative return occurring is closest to:
a) 0.5%.
b) 2.5%.
c) 5.0%.
Approximately 95.4% of returns are expected to occur between the mean plus or minus two standard deviations.
Therefore, approximately 2.5% of returns will be negative.

Question 21
A client has asked an investment manager to achieve a minimum return of 3% on his portfolio. Which of the following
three funds would be the best alternative using a safety-first approach?
 Expected Return Standard Deviation of Returns
A. 5% 2%
B. 8% 6%
C. 12% 8%
a) A
b) B
c) C
To select the best fund we need to maximize the SF Ratio = [E(RP) – RL]/σP
A: SFR = (5% – 3%) / 2% = 1
B: SFR = (8% – 3%) / 6% = 0.833
C: SFR = (12% – 3%) / 8% = 1.125

Question 22
Which of the following statements is least accurate with respect to a Monte Carlo simulation?
a) It does not require that returns are normally distributed.
b) It generates a large number of random samples from probability distributions.
c) It uses samples taken from historic data to calculate probabilities of certain events
occurring.
Using historic data to estimate future probabilities is historic simulation.

Question 23
Time-weighted rates of return calculate the:
a) Internal rate of return of the portfolio.
b) Geometric average of the returns for each subperiod, each period weighted by the
size of the fund.
c) Compound growth rate of $1 invested in the portfolio at the beginning of the
measurement period.
Time-weighted rates of return are calculated by compounding returns for each subperiod, each period weighted
equally. This gives the compound growth rate of $1 invested at the beginning of the period in the portfolio. For
example, for a one-year period, if the quarterly time-weighted return is 5%, $1 invested over one year would be worth
$1(1.05)4 = $1.22 at the end of the year.

Question 24
An analyst is collecting data on the performance of hedge funds. He does not include funds that are no longer
operating. His analysis is likely to exhibit:
a) Data-mining bias.
b) Survivorship bias.
c) Data-snooping bias.
Funds that have closed (often due to bad performance and/or high risk) will not be included in the data, so the data
will tend to provide a distorted view of past performance of the funds.

Question 25
An analyst is reviewing mutual funds' performance. The funds have returned on average 2.5% per quarter, with a
standard deviation of 0.16%. The manager takes a sample of 50 funds over the past quarter and finds that the mean
return of this sample is 2.55%. Using the z-test, at the 0.01 and the 0.05 significance level is there evidence that the
returns from funds have changed from the average of 2.5%?
a) There is evidence that the returns from mutual funds have changed at both the 0.01
significance level and the 0.05 significance level.
b) There is evidence that the returns from mutual funds have changed at the 0.01
significance level, but there is no evidence they have changed at the 0.05
significance level.
c) There is no evidence that the returns from mutual funds have changed at the 0.01
significance level, but there is evidence that they have changed at the 0.05
significance level.
define H0 : μ = 0.0250
Ha: μ = 0.0250
This is a two-tailed test, so the critical values of z at the 0.01 significance level are ± 2.58, and at the 0.05 significance
level are ± 1.96. If the computed z-value lies outside these ranges, reject the null hypothesis and accept the
alternative. In this case, z falls outside the range at the 0.05 significance level, but inside the range at the 0.01
significance level.

Question 26
An investor puts $5,000 a year into a savings account at the beginning of each year for six years, earning 12%
compounding annually. How much will be in the account at the end of the six years?
a) $40,575
b) $42,148
c) $45,445
The future value of the payments is calculated using the annuity formula or a financial calculator.

Note that this is an equivalent to an annuity due, since the first payment is at the beginning of the year.

Question 27
Two investment managers have their performance analyzed. The first, A, achieves an average (arithmetic mean)
performance of 20%, with a standard deviation of 2%. The second, B, achieves an average performance of 12%, with
a standard deviation of 1.5%. Which of the following statements is the most accurate?
a) The coefficient of variation of A's returns is equal to that of B's.
b) The coefficient of variation of A's returns is lower than that of B's.
c) The coefficient of variation of A's returns is higher than that of B's.
The coefficient of variation is σ/μ. For A this is 2%/20% = 10.0, and for B = 1.5%/12%=12.5.

Question 28
Which of the following distributions exhibits kurtosis?
a) A lognormal distribution
b) The distribution of returns from a call option
c) A distribution that is approximately normal but is more peaked with fat tails
Kurtosis refers to a distribution that has a larger/smaller percentage of small deviations from the mean and a
higher/lower percentage of large deviations, compared to a normal distribution. A distribution that is more peaked with
fat tails exhibits leptokurtosis.

Question 29
A preference share pays an annual dividend of $5 and has a perpetual life. If an investor requires a return of 8% per
annum, how much would he be willing to pay for the share?
a) $62.50
b) $120.00
c) $125.00
Using the perpetuity formula:
PV = Dividend/Requiredrateofreturn = $5/0.08=$62.50PV=Dividend/Requiredrateofreturn=$5/0.08=$62.50

Question 30
Elliott wave theory is based on identifying waves:
a) Whose duration follows a Fibonacci sequence.
b) That fall into cycles corresponding to Fibonacci numbers.
c) That follow patterns based on the ratios of Fibonacci numbers.
Elliott wave theory identified waves where positive price movements took prices up to a Fibonacci ratio of previous
highs, and falls reverse prices by a Fibonacci ratio.

Question 31
When testing a hypothesis concerning the relative values of the variances of two normally distributed populations, the
appropriate test statistic is:
a) F-statistic.
b) t-test statistic.
 c) Chi-square statistic.
The F-test is used to test the variances of two populations assuming that they are normally distributed.

Question 32
An analyst is looking at data on the salaries paid by companies in the manufacturing sector. A sample of 500
employees is selected; the sample mean salary is $55,000 and the sample standard deviation is $8,000. The 95%
confidence interval for the population mean is closest to:
a) $54,076 up to $55,923.
b) $54,299 up to $55,701.
c) $54,642 up to $55,358.

Economics

Question 33
In which of the following markets are firms least likely to expand output until marginal revenue equals marginal cost?
a) Oligopoly
b) Monopoly
c) Monopolistic competition
Monopolists and firms in monopolistic competition will all maximize profits by expanding output until marginal revenue
equals marginal cost. An oligopolist does not necessarily do so; it may be part of a cartel that restricts output and fixes
prices.

Question 34
A low, risk-free interest rate in a country relative to other countries will tend to lead to the:
a) Indirect exchange rate increasing and there being a forward discount.
b) Indirect exchange rate decreasing and there being a forward discount.
c) Indirect exchange rate increasing and there being a forward premium.
A low risk-free interest rate in a country relative to other countries is compensation for the expected strength in the
currency. This means the indirect exchange rate is expected to increase, as a unit of local currency will buy a larger
amount of foreign currency. There will be a forward premium to reflect the lower interest rate and expected
appreciation of the currency.

Question 35
In a country, the nominal gross domestic product (GDP) was $250 billion, inflation was 5%, and the quantity of money
was $60 billion. The government increased the quantity of money to $63 billion. Using the quantity theory of money,
the velocity of circulation is likely to be closest to:
a) 3.97.
b) 4.17.
c) 25.43.
If the quantity of money were increased to $63 billion, it would not have an effect on the velocity of money, so it would
still be the nominal GDP divided by the money supply, or $250 billion divided by $60 billion, which is 4.17.

Question 36
A Keynesian macroeconomist believes that:
a) The short-run aggregate supply curve is horizontal.
b) A central bank should focus on keeping the quantity of money growing at a steady
rate.
c) Taxes should be kept at low levels since they create disincentives that decrease
potential GDP.
The Keynesian school of thought believes not only that money wage rates are slow to respond to a fall in aggregate
demand but also that prices of goods and services are sticky, so A is the correct answer. Choice B refers to
monetarists, and choice C refers to monetarists and classical economists.

Question 37
Which of the following organizations would be most likely to assist in resolving international monetary problems?
 a) World Bank Group
b) World Trade Organization
c) International Monetary Fund (IMF)
The IMF's role is to ensure the stability of the international monetary system.

Question 38
If GDP is at potential GDP and the central bank unexpectedly increases the quantity of money, leading to an increase
in GDP above potential GDP, then which of the following is most likely to happen first?
a) The price level starts to rise.
b) The money wage rate begins to rise.
c) Real GDP begins to decrease again.
This is an example of demand-pull inflation. The increase in the quantity of money increases aggregate demand,
which pushes the aggregate demand curve up to the right; the intersection with the short-run aggregate supply curve
is now at a higher price level. Subsequent effects will include an increase in money wage rates and then a decrease in
GDP back to potential GDP.

Question 39
If a government uses fiscal policies to stabilize the economy, when the economy is expanding rapidly, the appropriate
government action is most likely to be to:
a) Decrease interest rates.
b) Increase public spending.
c) Raise personal income taxes.
Raising personal income taxes would reduce consumption and slow the economy. Increasing public spending would
increase aggregate demand, which would stimulate rather than slow the economy.

Question 40
Which of the following conditions indicate that a firm benefits from economies of scale?
a) The average total cost curve is rising slowly.
b) Marginal costs are higher than variable costs.
c) Marginal costs are lower than average total costs.
Choice A is not correct: for a company with economies of scale, the average total cost curve is declining. Choice B is
not correct, since this does not mean that average total costs are falling. Economies of scale mean that long-run
average costs decline as output increases, so marginal costs are less than average total costs.

Question 41
If a company is unable to expand the size of its production facilities it means that as more and more units of a variable
resource are used output will eventually:
a) Decrease and marginal costs will increase toward average total costs.
b) Increase at a decreasing rate and marginal costs will exceed average total cost.
c) Increase at a decreasing rate and average fixed costs will increase as a percentage
of total cost.
The law of marginal diminishing returns states that as more and more units of a variable resource are allocated to
production they will eventually increase output at a decreasing rate. Mathematically, as the marginal costs increase,
they will become higher than the average total cost, thereby increasing the average total cost.

Question 42
If the price of a product falls by 10% and demand rises by 20%, the price elasticity of demand isclosest to:
a) –2.0 and elastic.
b) –2.0 and inelastic.
c) –0.5 and elastic.
Price elasticity is (% change in quantity / % change in price) which is (20 / (–10) = –2. If the demand changes by more
than the price, then demand is elastic.

Question 43
An export subsidy on a product will, in the exporting country, increase:
a) The producer surplus.
b) The consumer surplus.
c) Government revenues.
An export subsidy is a payment for every unit of export, so government revenues fall, so choice C is not correct. The
producers have an incentive to export rather than sell domestically, which can have the effect of increasing domestic
prices and reducing the consumer surplus. The producer receives the subsidy plus the overseas price, so it will tend
to increase the producer surplus.

Question 44
In a perfectly competitive market, demand for a firm's products is:
a) Unitary elastic.
b) Perfectly elastic.
c) Perfectly inelastic.
The demand curve is horizontal, so perfectly elastic.

Financial Reporting and Analysis

Question 45
Using the periodic method rather than the perpetual method for calculating the cost of sales under last in, first out
(LIFO), when unit costs of a product are rising, it will:
a) Not affect the cost of sales.
b) Tend to lead to a lower cost of sales.
c) Tend to lead to a higher cost of sales.
Using the periodic method will take the cost of the latest inventory purchased, which will be the highest amount (as
prices are rising). The perpetual method will take lower costs if new inventory is purchased during the accounting
period.

Question 46
The following information is provided on a company's purchases and sales of a product.
Beginning inventory was 50 units at a cost of $10, ending inventory 70 units.
Purchases Sales
First quarter 30 units @ $10 20 units @ $12
Second quarter 30 units @ $12 30 units @ $15
Third quarter 40 units @ $14 40 units @ $17
Fourth quarter 50 units @ $15 40 units @ $18
Under first in, first out (FIFO), the company's gross profit from this product for the year and, under LIFO, the inventory
value at the end of the period (using the periodic method) are:
Gross Profit (FIFO) Inventory Value (LIFO)
A. $650 $700
B. $650 $1,030
C. $1,440 $1,030
a) A
b) B
c) C
Total sales = $2,090
COGS under FIFO will be for first 130 units purchased:
= (80 × $10) + (30 × $12) + (20 × $14) = $1,440
Gross profit = $650
Under LIFO, the inventory at the end of the period will be the first items recorded, the starting inventory plus 20 units
@ $10, which is $700.

Question 47
A company will derecognize an asset if:
a) The asset is fully depreciated.
b) The asset has no further use or disposal value.
c) It is impossible to reliably estimate the fair value of the asset.
Derecognition occurs when an asset is not expected to provide any future benefits through use or disposal, so B is the
best answer.

Question 48
Under U.S. generally accepted accounting principles (GAAP), a reversal of impairment is:
a) Not permitted.
b) Permitted if the asset is held for use.
 c) Permitted if the asset is held for sale.
Impairment of assets that are held for use cannot be reversed; however, if the asset is held for sale, it can be
reversed, so C is correct. (Under International Financial Reporting Standards [IFRS], reversals are permitted for all
assets.)

Question 49
The general journal contains all business transactions:
Ordered Step in Accounting System
A. By account First
B. By account Second
C. Chronologically First
a) A
b) B
c) C
The general journal is the first step in the accounting system flow when business transactions are recorded in date or
chronological order. It is the general ledger that shows the same entries as the general journal, but they are ordered
by account. This is the second step in the accounting system flow.

Question 50
If interest rates rise after a company has issued debt and they are accounting for the debt on an amortized cost basis,
then:
a) The higher interest rate will lead to a higher interest expense on the income
statement.
b) The market value of the debt declines, which can be reflected in the balance sheet
as a gain on investments.
c) The higher interest rate will not be reflected in either the income statement or
balance sheet of the company.
If interest rates rise after a company has issued debt, then there is an economic impact, but it is not reflected in the
financial statements of the company (using an amortized cost basis). The effective interest rate is used throughout the
life of the debt.

Question 51
If a lease is classified as an operating lease rather than as a finance lease, this will lead to the lessee reporting higher:
a) Investing cash flows.
b) Financing cash flows.
c) Operating cash flows.
The total lease payment will be recorded as an operating cash outflow. With a finance lease it will be recorded as
partly operating and partly financing cash outflow.

Question 52
Which of the following is least likely to be important to decision makers when they look at financial statements?
a) Comparability
b) Straightforwardness
c) Understandability
Information that is useful, even if it is complex, should not be excluded, so B is the best answer.

Question 53
The following information is provided regarding a company's operations in the last fiscal year. The company does not
pay tax and uses U.S. GAAP.
Cash collected from customers $500,000
Cash paid for new plant and equipment $200,000
Cash paid to suppliers $150,000
Cash paid for salaries $120,000
Cash paid for rent $60,000
Depreciation expense $30,000
Cash paid for interest costs $80,000
Cash dividends paid $20,000
Cash raised from bond issue $400,000
The cash flow from operations was:
a) $90,000.
b) $150,000.
c) $170,000.
Cash flow from operations

Question 54
The cash flow from financing, using the data for the company provided in the previous question, was:
a) ($420,000).
b) $300,000.
c) $380,000.
Cash flow from financing
= Cash raised from bond issue – Cash dividends paid
= $400,000 – $20,000
= $380,000

Question 55
If an analyst wishes to calculate ratios using current values, they should use ratios based on LIFO, rather than FIFO,
for which of the following ratios?
a) Gross profit margin
b) Debt-to-equity ratio
c) Return on total capital
Use LIFO for income-related ratios and FIFO for balance sheet ratios.

Question 56
A company has 100,000 call options outstanding with an exercise price of $40 per share. The average share price
over the last accounting period was $55 and at the end of the period was $60. When calculating diluted earnings per
share, using the treasury stock method, the number of potential shares created by the option is closest to:
a) 27,273.
b) 33,433.
c) 66,567.
The number of shares issued on exercise is 100,000. This would raise $4 million in cash, which would buy back
72,727 shares, giving net new shares of 27,273.

Question 57
A company increases its accounts receivable and its inventory levels. The impact will be to increase or decrease,
respectively, its operating cash flows:
Accounts Receivable Inventory Levels
A. Increase Increase
B. Decrease Increase
C. Decrease Decrease
a) A
b) B
c) C
The company will have more money owing from customers and more money tied up in inventories.

Question 58
Related revenues and expenses should be recognized in the same time period under the:
a) Accrual concept.
b) Matching principle.
c) Economic earnings principle.
The matching principle says that related revenues and expenses should be recognized in the same time period.

Question 59
When a company receives payment for a service from a customer before the service has actually been provided, this
gives rise to:
 a) Accrued revenue recorded as an asset.
b) Deferred revenue recorded as an asset.
c) Deferred revenue recorded as a liability.
The cash received prior to the service being provided will lead to a liability to provide the service in the future; this is
recorded as unearned or deferred revenue.

Question 60
A company has sales of $300,000, gross profit of $120,000, and operating profit of $50,000. If the average total assets
are $170,000, and average inventory is $25,000, then inventory turnover and total asset turnover are closest to:
Inventory Turnover Total Asset Turnover
A. 4.8 times 1.8 times
B. 7.2 times 1.8 times
C. 7.2 times 3.4 times
a) A
b) B
c) C

Question 61
Internationally, an unqualified auditor's report indicates that the auditor:
a) Is unwilling to express an opinion about the financial statements.
b) Verifies that the financial statements give a true and fair view of the company's
performance and financial position.
c) Has verified that the financial statements are in compliance with accounting
standards but believes they present a misleading view of the company's financial
position.
An unqualified opinion indicates that financial statements give a true and fair view of the company's performance and
financial position; this is a “clean” opinion.

Question 62
Rapid Growth Inc. has just a made a major acquisition in order to grow its business, whereas its major competitor has
grown internally. Compared to its competitor, which of the following financial items for Rapid Growth Inc. are likely to
be lower, which would distort comparison with its competitor?
a) Intangibles
b) Return on assets
c) Book value per share
Rapid Growth Inc.'s acquisition will lead to an increase in its asset value and book value, reflecting the purchase of
intangibles such as staff expertise, brand names, research, and probably goodwill (assuming they have not been
written off). Its competitor will have expensed similar items and therefore will have a smaller asset base. This will tend
to lead to Rapid Growth Inc. reporting a lower return on assets.

Question 63
Firms that capitalize rather than expense costs will have:
a) More volatile earnings.
b) Higher debt-to-equity ratios.
c) Higher cash flow from operations.
Net cash outflow will be the same but will be allocated to cash flow from investing rather than from operating activities
if expenses are capitalized.

Question 64
A company provides five-year warranties on its products and recognizes a fixed percentage of sales as a warranty
expense in its financial statements. For tax purposes a warranty expense can be recognized only when it is an actual
expenditure, and this usually occurs toward the end of the five-year period. This will give rise to a:
a) Deferred tax asset.
b) Deferred tax liability.
 c) Tax loss carryforward.
Taxable income will be higher than pretax income, leading to prepayment of tax and therefore a deferred tax asset.

Question 65
If the market interest rate is lower than the coupon rate of a bond when it is issued:
a) Each coupon payment will be more than the interest expense and will
therefore reduce the discount on the issuer's balance sheet.
b) Each coupon payment will be less than the interest expense and will
therefore increase the discount on the issuer's balance sheet.
c) Each coupon payment will be more than the interest expense and will
therefore reduce the closing premium on the issuer's balance sheet.
The interest expense is based on the market rate at the time of issue (the effective rate), multiplied by the balance
sheet liability. Although the bond will be issued at a premium, the interest expense is less than the coupon payment,
and the difference will reduce the premium. This is referred to as amortization of the premium.

Question 66
Manufacturers Corp. provides the following data:
Machinery and Equipment 2017
Gross investment $345 million
Accumulated depreciation $165 million
Depreciation expense $ 26 million (straight-line method)
The average age of the machinery is closest to:
a) 6.3 years.
b) 6.9 years.
c) 13.3 years.
$ 165 million / $ 26 million = 6.35

Question 67
A company constructs a new factory and finances the factory partly from borrowings and partly using retained
earnings. In line with U.S. accounting rules, during the construction period the firm will usually:
a) Expense the interest costs associated with the borrowing.
b) Capitalize only the interest costs associated with the borrowing.
c) Capitalize the interest costs associated with the borrowing and the cost of the
equity used.
Although somewhat inconsistent, only interest costs are capitalized.

Question 68
Treating a lease as an operating lease rather than a capital lease will usually lead to which of the following financial
ratios being lower for the lessee company?
a) Interest cover
b) Return on assets
c) Debt-to-equity ratio
With an operating lease, the lease does not impact on the balance sheet, lowering short- and long-term debt levels, so
C is correct. Interest expense is lower, increasing interest cover (earnings before interest and taxes [EBIT] is also
lower, but usually proportionately less so), and return on assets is higher since assets are lower.

Corporate Finance

Question 69
When a company's sales increase, if other factors are held constant, then the operating risk will usually:
a) Decrease.
b) Stay the same.
c) Increase.
As sales increase the proportion of fixed costs versus variable costs will generally decrease which will decrease
operating leverage.

Question 70
An analyst evaluates a project and finds that there are multiple internal rates of return (IRRs). This is most likely to be
explained by:
a) The project has a number of cash outlays followed by cash inflows during its life.
 b) This is an attractive project with a positive net present value (NPV) for all positive
discount rates.
c) The analyst has made a mistake; there is only one discount factor that makes the
NPV of the cash flows equal to zero.
Cash outlays followed by inflows can lead to multiple IRRs, so choice A is correct. A project can have no IRR; this will
happen when the NPV is positive (or negative) for all discount rates, so graphically there is no point of intersection
with the x-axis. Choice B is incorrect.

Question 71
A company has bonds outstanding that have a coupon rate of 8% and are trading on a yield to maturity of 12%. The
company's marginal tax rate is 30%. The company's target debt-to-equity ratio is 35%, and the after-tax cost of equity
is 15%. The weighted-average cost of capital (WACC) based on the target capital structure is closest to:
a) 12.69%.
b) 13.29%.
c) 14.22%.
WACC = (D/D+E)*(1-T)*Kd + (E/D+E)*Ke
WACC = (0.26)*(1-30%)*12% + (0.74)*15%
WACC = 13.29%

Question 72
An environmental, social, and governance (ESG) approach that leads to a focus on investing in companies that
address problems of water shortage is which type of investment approach?
a) Thematic investing
b) Negative screening
c) Best-in-class investing
This is an example of thematic investing, which considers a single factor, in this case water shortages. Best-in-class
approaches look to identify companies that score well on ESG factors in different industries. Negative screening refers
to excluding certain sectors.

Question 73
An analyst forecasts that a company is about to take on a project with an NPV of $100 million. Following the
announcement of the project, the company's market capitalization rises by only $50 million. This might be explained
by which of the following?
a) The analyst is using a higher discount factor in his calculation than other analysts.
b) The market capitalization would not be expected to increase until the cash flows are
received.
c) The profitability of this project signals that the profitability of future projects will be
lower than previously expected.
If the analyst used a higher discount factor than other analysts, this would reduce his forecast for the project NPV, so
choice A is not correct. The market capitalization would be expected to reflect to some extent the increase in the value
of the company, so B is not a good answer. Choice C is the most likely explanation; if the profitability of the new
project is lower than expected, this could reduce the forecast profitability of other projects and therefore the full $100
million increase in NPV does not get added to the market capitalization.

Question 74
Cumulative voting systems:
a) Allow shareholders to appoint a proxy to vote on their behalf.
b) Can assist smaller shareholders use their votes to get a director elected to the
board.
c) Allow shareholders to carry votes forward from one annual general meeting to the
next meeting.
With cumulative voting, as opposed to straight voting, shareholders can vote all of their shares for one director. With
cumulative voting it is easier for small investors to combine their votes to elect a director to represent their interests.

Question 75
A company's net operating cycle is longer than its competitors'. This could be explained by the company:
a) Paying suppliers in cash on receipt of goods.
b) Giving generous credit terms to its customers.
c) Introducing an effective method of inventory control.
The net operating cycle or cash conversion cycle = Number of days of receivables + Number of days of inventory –
Number of days of payables. Giving generous credit terms will extend the number of days of receivables and could
explain a relatively long net operating cycle.

Question 76
The recommended method for adjusting for flotation costs associated with raising new capital when evaluating a
project is to:
a) Ignore flotation costs since they are usually quite a small cost.
b) Deduct the flotation costs from the cash flows generated by the project.
c) Adjust the cost of capital to account for the increased cost of external capital.
The flotation costs for equity and also for debt, in many markets outside the United States, are too large to be ignored.
It is more rigorous to adjust the cash flows for flotation costs rather than adjusting the cost of capital, since the
reduction to the present value of the cash flows due to using a higher cost of capital will not usually equal the present
value of the costs.

Portfolio Management

Question 77
If an investor has steep indifference curves, it is likely to indicate that the investor:
a) Is aggressive.
b) Is conservative.
c) Has a long time horizon.
Steep utility or indifference curves show that the investor requires a large additional return to compensate for taking on
more risk, indicating a low tolerance for risk.

Question 78
An entrepreneur is about to retire and sell his business for a substantial sum of money (in excess of his retirement
needs), but up to now he has never invested in the capital markets and has always made his own financial decisions.
He is considering using a portfolio manager for the first time. The portfolio manager is most likely to consider that he
has a:
a) Low ability to take risk and low willingness to take risk.
b) Low ability to take risk and high willingness to take risk.
c) High ability to take risk and low willingness to take risk.
On the basis of the information supplied in the question, the entrepreneur has more assets than his future liabilities,
suggesting he has the ability to take risk, but his lack of familiarity with investing and delegating decisions to a portfolio
manager suggests he may be less willing to take risk.

Question 79
If an investment manager is concerned that the stock market is going to decline, which of the following would be
the most appropriate strategy for an equity portfolio?
a) Ensure that the beta of the portfolio is less than 1.
b) Ensure that the standard deviation of the portfolio is less than the market standard
deviation.
c) Ensure that the standard deviation of the portfolio is more than the market standard
deviation.
The manager will wish to reduce the sensitivity of his portfolio to the market, which is the systematic risk or beta of the
portfolio. The market beta is 1, so if he reduces the beta below 1, he would expect his portfolio to fall by less than the
market. Reducing the standard deviation of the portfolio will reduce its volatility but not necessarily the beta of the
portfolio.

Question 80
Risk assessment questionnaires are usually designed to assess a client's:
a) Ability to take risk.
b) Willingness to take risk.
c) Risk-adjusted return requirements.
Willingness to take risk is generally more difficult to assess, so questionnaires are used to gauge the investor's
psychology and attitude to risk.

Question 81
Systematic risk:
a) Is measured by beta.
 b) Is zero for the market.
c) Can be largely diversified away if more than 20 stocks are held in a portfolio.
Systematic risk is the market risk that is measured by beta. It cannot be diversified away by buying more and more
stocks in a market.

Question 82
Which of the following describes a factor that would be included as a constraint in an individual investor's policy
statement?
a) A high marginal income tax rate
b) A requirement for capital appreciation
c) A need to receive income from her investments
Risk and return items would be part of the objectives rather than constraints.

Question 83
Investments along the capital market line (CML) are generally:
a) Less risky than the market portfolio.
b) Not optimal since they lie below the efficient frontier.
c) Combinations of the risk-free asset and the market portfolio.
The CML is the tangent from the point representing the risk-free asset to the efficient frontier. Points along the tangent
will represent combinations of the risk-free asset and the market portfolio. They can be more or less risky than the
market portfolio according to whether the portfolio has borrowing or not.

Question 84
There is a risk that an employee in a securities firm makes a mistake when giving instructions for payment to a
counterparty's account. This is an example of:
a) Credit risk.
b) Market risk.
c) Operational risk.
Operational risks are those that arise from the people and processes in an organization, so C is the correct answer.

Question 85
The objective of tactical asset allocation is to:
a) Ensure that the portfolio's asset weightings are in line with the policy portfolio.
b) Construct a policy portfolio that will meet the long-term risk/return objectives of a client.
c) Identify opportunities to increase returns by forecasting market moves in the short term.
The strategic asset allocation that sets the policy portfolio is derived from the investment policy statement (IPS) and
the long-term capital market conditions. Tactical asset allocation leads to deviations away from the policy allocation
based on short-term forecasts for security returns.

Equity

Question 86
Time series analysis:
a) Supports the weak form of the efficient market hypothesis.
b) Supports the semi-strong form of the efficient market hypothesis.
c) Does not support either the weak form or semi-strong form of the efficient market hypothesis.
An example of anomalies discovered by time series analysis is the January effect, which shows that certain U.S. (and
other market) stocks tend to outperform in January, although more recent data suggest this anomaly has disappeared.
Other anomalies include the turn-of-the-month effect, the day-of-the-week effect, the weekend effect, and the holiday
effect. These anomalies indicate that markets are not semi-strong-form efficient. Momentum studies suggest that the
markets are not weak-form efficient, so choice C is correct.

Question 87
Which of the following statements regarding short sales using borrowed securities is mostaccurate?
a) The potential gains on a short sale are unlimited.
b) The lender of the securities is still the legal owner of the stock.
c) The borrower will repay the amount of dividends paid on the borrowed securities to the lender
of the securities.
The potential losses are unlimited, and the potential gains are limited to 100%, so choice A is not correct. The lender
of the securities is no longer the legal owner; the borrower is simply committed to returning the securities in the future,
so choice B is not correct. Dividends must be repaid to the lender, so C is the correct answer.

Question 88
Commodity indices are usually based on:
a) Prices of commodity producers' shares.
b) Spot prices for one or more commodities.
c) Futures prices for one or more commodities.
Commodity indices are usually based on the price of futures contracts.

Question 89
An investor buys 1,000 shares at a price of $60. The initial margin is 40%, and the maintenance margin is 30%. At
what share price does the investor receive a margin call?
a) $27.69
b) $51.43
c) $54.00
The initial margin is 40% × $60,000 = $24,000, and he borrows $36,000. His equity is 1,000P– $36,000, and the
margin call is when this equals 30% × 1,000P, or P = $51.43.

Question 90
If a stock has a high price-to-earnings (P/E) ratio relative to the market P/E, this is least likely to be explained by which
of the following?
a) Investors' required rate of return is higher for this stock than the market.
b) The expected growth rate of dividends is higher than the average in the market.
c) The quality of earnings is higher, leading to less uncertainty over the stock's
performance.
P/E = (D1/E1)/(k−g)
where:
 k = required rate of return
 D1/E1 = expected dividend payout ratio
 g = expected growth rate of dividends
A high g, or a low k, will lead to a higher P/E ratio. High quality of earnings would tend to reduce risk and therefore
reduce k.

Question 91
There are two shares, X and Y, making up a security market index, and the following information is given:
X: share price $50 20,000 shares outstanding
Y: share price $25 100,000 shares outstanding
Which of the following is most accurate?
a) If it is a price-weighted index, the index will rise more if X's share price rises by $10
than if Y's share price rises by $10.
b) If it is a price-weighted index, the index will rise more if X's share price rises by 10%
than if Y's share price rises by 10%.
c) If it is a market-capitalization-weighted index, the index will rise more if X's share
price rises by $10 than if Y's share price rises by $10.
Price-weighted index: X's share price rising by $10 has the same effect as Y's share price rising by $10. X's share
price rising by 10% means the index rises by (55 + 25) / (50 + 25) – 1 = 6.67%. Y's share price rising by 10% means
the index rises by (50 + 27.5) / (50 + 25) – 1 = 3.33%.
Market-capitalization-weighted index: X's share price rising by $10 means the index rises by (1.2 + 2.5) / (1 + 2.5) – 1
= 5.71%. Y's share price rising by $10 means the index rises by (1 + 3.5) / (1 + 2.5) – 1 = 28.57%. X's share price
rising by 10% means the index rises by (1.1 + 2.5) / (1 + 2.5) – 1 = 2.85%. Y's share price rising by 10% means the
index rises by (1 + 2.75) / (1 + 2.5) – 1 = 7.14%.

Question 92
A firm in the United States that is in the basic materials sector is most likely to be a:
a) Cyclical company.
b) Defensive company.
c) Noncyclical company.
Demand for basic materials will be dependent on the stage of the economic cycle, so it is a cyclical company.
Question 93
A preferred stock has a par value of $100, is trading at $90, and pays a 6% annual dividend. Assume that there is no
risk that the company will default on dividend payments. If an investor's required rate of return is 6.5%, the preferred
stock looks:
a) Attractive.
b) Expensive.
c) Fairly valued.
The value of the preferred stock, since it pays dividends in perpetuity, is $6 / 0.065 = $92.30. Therefore, at a price of
$90, the stock looks attractive.

Question 94
Enterprise value (EV) / earnings before interest, taxes, depreciation, and amortization (EBITDA) multiples are often
used rather than P/E ratios because:
a) EV/EBITDA is useful for comparing companies with similar financial leverage.
b) EBITDA avoids distortions due to different accounting treatment of depreciation and
amortization.
c) EV differentiates between the value of the firm belonging to shareholders and the
value belonging to debt holders.
EV/EBITDA is useful for comparing companies with different capital structures, so choice A is not correct. EV
combines the value of the company that belongs to debt and equity holders, so choice C is not correct. EBITDA is
profit before depreciation and amortization (and interest and tax), and it is not affected by different methods of
accounting for depreciation and amortization, so B is the correct answer.

Question 95
Which of the following would tend to increase a firm's long-term growth rate?
a) Increasing its profit margin
b) Reducing its financial leverage
c) Increasing the dividend payout ratio
The growth rate is earnings retention rate × return on equity (ROE). ROE is asset turnover × profit margin × financial
leverage. Therefore, increasing the profit margin is the only choice that increases, rather than decreases, the growth
rate.

Question 96
If the price to book value of a company is higher than the market and industry average, this could be explained by
which of the following?
a) The company has just purchased new machinery.
b) The company has significant off-balance-sheet liabilities.
c) It is a new company that has a small capital base, but it is expected to grow rapidly.
The purchase of new machinery would not immediately change the book value. Off-balance-sheet liabilities would
reduce the price to book value that investors are willing to pay. If it is a new company with good growth prospects,
investors may be willing to pay a high multiple of the current book value of assets.

Question 97
In behavioral finance, information cascades can explain:
a) The overconfidence of investors.
b) Serial correlation in stock returns.
c) Underreaction of stock prices to news.
Information cascades refer to the transmission of information from investor to investor, with the views of the first
investors to hear news being imitated by investors who hear news later. This can explain overreaction in stock prices
and serial correlation in stock returns.

Fixed Income

Question 98
The G-spread measures the yield spread of a bond over the appropriate:
a) Swap rate.
b) Government bond.
c) Government bond yield curve.
The G-spread (interpolated government bond spread) measures the difference between the yield on a bond and the
rate on a government bond with the same tenor or maturity. The Z-spread is the spread over the entire yield curve.
Question 99
The ratings methodology referred to as “notching” means the:
a) Maximum credit rating on a debt issue is the issuer's rating.
b) Credit ratings on debt issues can be above or below the issuer's rating.
c) Ratings on debt issues will be moved up and down as the issuer's creditworthiness
changes.
Issuer ratings are usually based on senior unsecured debt, so ratings for individual issues can be adjusted above or
below the issuer rating, reflecting their priority in the case of default.

Question 100
The price movements of a 10.5%, 20-year option-free bond are given in the following table:
Yield % Bond Price
7.00 137.3714
7.25 134.0390
7.50 130.8265
The approximate modified duration of the bond when the yield is 7.25% is closest to:
a) 9.77.
b) 13.24.
c) 17.75.

∆y = 25 basis points = 0.0025

Question 101
A bond has no embedded options; this means that when yields rise by 100 basis points, the fall in price of the bond is:
a) Less than the rise in price when rates fall by 100 basis points.
b) More than the rise in price when rates fall by 100 basis points.
c) The same as the rise in price when rates fall by 100 basis points.
If there are no embedded options, the bond will have positive convexity. This means that the gain is greater than the
loss for a given change in rates.

Question 102
When the issuer of a bond commits to retire a certain proportion of a bond issue each year, this is an example of a:
a) Callable bond.
b) Prepayment option.
c) Sinking fund provision.
A sinking fund provision commits the issuer of a bond to retire a certain proportion of a bond issue each year.

Question 103
Which of the following is the least likely to be a credit enhancement to a debt issue?
a) A letter of credit
b) A third-party guarantee
c) An early redemption option
Early redemption is not a credit enhancement.

Question 104
An investor forecasts that short-term rates are going to rise. He is most likely to consider purchasing:
a) An inverse floating-rate security.
b) A floating-rate security with the coupon set at a reference rate plus a quoted
margin, with a cap.
c) A floating-rate security with the coupon set at a reference rate plus a quoted margin
with no embedded options.
A floating-rate security with a typical coupon formula looks to be the best choice; a cap will put a limit on the coupon
received if rates rise. With an inverse note, the coupon will rise if interest rates fall.
Question 105
An investor forecasts that both market yields and interest rate volatility are going to rise by more than market
expectations. He is most likely to consider purchasing a:
a) Long-dated putable bond.
b) Short-dated putable bond.
c) Short-dated callable bond.
If interest rates rise, the short-dated bond will fall in price less than the long-dated bond, other factors held constant.
The rise in volatility will increase the value of both the call and put options, so a putable bond would outperform a
callable bond.

Question 106
The most appropriate measure of duration for a putable bond is:
a) Effective duration.
b) Modified duration.
c) Approximate modified duration.
When the cash flows are sensitive to interest rates, then modified duration should not be used.

Question 107
A medium-term note usually:
a) Is distributed on a best-efforts basis.
b) Is not traded in the secondary market.
c) Has a maturity of 5 to 10 years at the time of issue.
A medium-term note can have any maturity and is placed on a best-efforts basis rather than being underwritten.

Question 108
Which of the following bonds with the same duration would usually offer the lowest yield?
a) A corporate bond
b) An on-the-run sovereign bond
c) An off-the-run sovereign bond
Sovereign bonds are assumed to have zero credit risk, so they will trade on lower yields than corporate bonds. On-
the-run issues are more liquid than off-the-run issues, and there is increased demand for on-the-run issues, since they
are often used by traders to finance their activities. These two factors lead to their being traded on lower yields than
off-the-run issues.

Question 109
A mortgage holder has borrowed $250,000 through a nonrecourse mortgage loan to purchase a house. After three
years, there is an outstanding balance on the mortgage of $230,000. If the holder then defaults and the lender sells
the house for $150,000, the lender can claim a further:
a) $0.
b) $80,000.
c) $100,000.
It is a nonrecourse loan, so the lender has no further claim on the borrower's assets.

Derivatives

Question 110
ABC Investment Management has decided to make a long-term adjustment to their asset allocation and switch a
portion of their clients' portfolios from U.S. equities to Japanese equities, but they wish to keep their currency
exposure solely in U.S. dollars. This could be achieved by:
a) Entering into an equity swap to pay the return on the S&P 500 index and receive
the return on the Tokyo TOPIX index.
b) Entering into an equity swap to receive the return on the S&P 500 index and pay
the return on the Tokyo TOPIX index.
c) Entering into an equity swap to pay the return on the S&P 500 index and receive
the return on the Tokyo TOPIX index, combined with a series of forward sales of
yen to U.S. dollars.
The managers wish to pay the return on the S&P (which will offset the return on their underlying portfolio of U.S.
securities) and receive the return on the TOPIX index. There will be no exposure to the yen with these swaps, so there
is no need to do a forward trade on the currency (since we are told that the managers want to maintain their currency
exposure in U.S. dollars).
Question 111
The derivatives markets can help price discovery since:
a) Derivatives can be used to hedge risk.
b) Futures prices are a forecast of future spot prices.
c) Derivatives markets may be more liquid than spot markets.
Futures prices are mathematically linked to spot prices, so choice B is not correct. Hedging and risk management is a
purpose of derivatives, so choice A is not correct. Trading in derivatives requires less capital, and they may be more
liquid than the spot market in the underlying, so the derivatives markets may react more quickly to new information;
therefore, C is the best answer.

Question 112
A credit default swap allows an investor to:
a) Protect against the default of a bond they hold in their portfolio.
b) Swap the total return on a bond they hold in their portfolio for a fixed rate of interest.
c) Issue a security where the principal payoff of the security is reduced in the case of
a credit event.
In a credit default swap the buyer of protection makes periodic payments to the protection seller. The protection seller
only pays out in the case of a prespecified credit event (e.g. a bond default) occurring. Credit default swaps allow an
investor to buy ‘insurance’ against a default of a bond or bonds they hold in their portfolio.
Answer B refers to a total return swap and Answer C refers to a credit-linked note

Question 113
An investor purchases a put option for $5 with an exercise price of $80. The current price of the underlying asset is
$72. The breakeven point at expiry is an asset price of:
a) $75.
b) $85.
c) $88.
The value of the put at expiry must satisfy X – S = $5, where X = $80, for the value of the put to equal the option
premium.

Question 114
Which of the following is most likely to be a limit to arbitrage?
a) High market liquidity
b) High transaction costs
c) An inefficiently priced market
The inability to do both a long and short side of an arbitrage transaction or high transaction costs will limit the arbitrage
opportunities in a market, so B is the best answer. An inefficient market will potentially provide arbitrage opportunities.

Question 115
There is a European-style put option expiring in 90 days, the exercise price is 220, and the underlying is trading at
200. The risk-free rate is 3%. The lower bound on the option value isclosest to:
a) 18.38.
b) 18.52.
c) 21.63.
The lower bound is given by:

Alternative Investments

Question 116
At the beginning of the year, a hedge fund has assets of $200 million, and the fee structure is a management fee of
2% of the portfolio value at the end of the year plus a 20% incentive fee. The incentive fee is applied to the annual
gain in value, net of management fee, in excess of the previous high-water mark. The maximum value was two years
ago, when the value of the fund was $210 million. If the gross return over the year is 15%, the fee earned by the
manager isclosest to:
a) $7.68 million.
b) $8.60 million.
c) $9.68 million.
At the end of the year, the fund will be valued at $200 million × (1.15) = $230 million.
Management fee = 2% × $230 million = $4.6 million.
The new net value of the fund is $225.4 million, which is $15.4 million above the high-water mark, so the incentive fee
is 20% × $15.4 million = $3.08 million.
Total fee = $4.60 million + $3.08 million = $7.68 million.

Question 117
Which of the following is least likely to be given as a reason that using the Sharpe ratio to measure hedge funds' risk-
adjusted returns is misleading?
a) The securities held by hedge funds are not always priced using market prices.
b) Hedge funds that achieve poor performance or fail may not be included in the data.
c) The Sharpe ratio measures absolute performance rather than performance relative
to a benchmark.
Hedge funds target absolute, not relative, returns, so choice C is not a reason for not using the Sharpe ratio. Not using
market prices often leads to price smoothing, which will understate volatility used to calculate a Sharpe ratio, and
survivorship bias will reduce the validity of using Sharpe ratios.

Question 118
When a capitalization (cap) rate is used to value a commercial property, which of the following will lead to a higher cap
rate being used?
a) Rental income is forecast to grow rapidly.
b) It is a high-quality property for which there is strong rental demand.
c) The economic outlook is uncertain, leading to concerns over a potential
deterioration in the business environment.
The cap rate is a discount rate less the growth rate. A low-risk, stable, income-producing property will tend to be low
risk and therefore have a lower discount rate, whereas an uncertain business environment would increase risk and the
discount rate. High growth reduces the cap rate.

Question 119
Investing in commodities usually:
a) Provides an inflation hedge.
b) Is a defensive policy in times of low economic activity.
c) Provides returns that are highly correlated to equity markets.
Commodities tend to perform well in times of high inflation and are often purchased as an inflation hedge.

Question 120
The manager of a private equity fund is usually the:
a) Limited partner.
b) General partner.
c) Managing partner.
If it is set up as a partnership, the general partner is responsible for running the fund, and the limited partners are the
outside investors in the fund.