MCQs i mess up once studying is finished Flashcards
1
Q
Which of the following return calculating methods is best for evaluating the annualized returns of a buy-and-hold strategy of an investor who has made annual deposits to an account for each of the last five years?
A
Geometric mean return.
B
Arithmetic mean return.
C
Money-weighted return.
A
A
Geometric mean return.
The geometric mean return compounds the returns instead of the amount invested.
2
Q
For a risky asset with volatile historical returns, which of the following measures of mean return will be most likely be highest?
A
Harmonic mean
B
Arithmetic mean
C
Geometric mean
A
B
Arithmetic mean
As long as the returns aren’t the same every year, the arithmetic mean always produces higher averages than the geometric mean. Analysts should be aware of this bias and identify whether returns are quoted on a geometric or arithmetic average.
2
Q
The nominal risk-free rate is best described as the sum of the real risk-free rate and a premium for:
A
maturity.
B
liquidity.
C
expected inflation.
A
C
expected inflation.
2
Q
Which of the following methods is the least likely recommended approach when dealing with outliers?
A
Do nothing and use the data without any adjustment.
B
Substitute the median for extreme values to stabilize the distribution.
C
Set a pair of boundaries and remove all observations that fall outside the boundaries.
A
B
Substitute the median for extreme values to stabilize the distribution.
There are three ways to deal with outliers:
No adjustments
Remove all outliers (trimmed mean)
Replace outliers with either an upper or lower limit (winsorized mean)
It is not appropriate to substitute the median for extreme values. This will create artificial stability that gives a misleading impression that the distribution is less volatile than it actually is.
2
Q
The return metric that most accurately evaluates the performance of a portfolio manager who does not exercise control over the timing of new contributions and withdrawals is the:
A
time-weighted return.
B
internal rate of return.
C
money-weighted return.
A
A
time-weighted return.
Time-weighted return, which is unaffected by the timing and amount of cash flows, is most appropriate for measuring the performance of a manager who does not control new contributions and withdrawals.
2
Q
he average return for Portfolio A over the past twelve months is 3%, with a standard deviation of 4%. The average return for Portfolio B over this same period is also 3%, but with a standard deviation of 6%. The geometric mean return of Portfolio A is 2.85%. The geometric mean return of Portfolio B is most likely:
A
less than 2.85%.
B
equal to 2.85%.
C
greater than 2.85%.
A
A
less than 2.85%.
2
Q
Which of the following statements is most accurate? Compared to analytical methods, Monte Carlo simulation:
A
provides more precision when valuing options.
B
provides more insight into causal relationships.
C
can be used to value a wider variety of options than analytical methods.
A
C
can be used to value a wider variety of options than analytical methods.
2
Q
The Black-Scholes-Merton option pricing model is most likely based on the assumption that the prices of underlying assets are:
A
t-distributed.
B
Chi-square distributed.
C
lognormally distributed.
A
C
lognormally distributed.
2
Q
Analysts performing bootstrap:
A
seek to create statistical inferences of population parameters from a single sample.
B
repeatedly draw samples of the same size, with replacement, from the original population.
C
must specify probability distributions for key risk factors that drive the underlying random variables.
A
Bootstrapping through random sampling generates the observed variable from a random sampling with unknown population parameters. The analyst does not know the true population distribution, but through sampling can infer the population parameters from the randomly generated sample.
B is incorrect because, when performing bootstrap, the analyst repeatedly draws samples from the original sample and not population, where each individual resample has the same size as the original sample and each item drawn is replaced for the next draw.
2
Q
An analyst takes a sample of an equity index’s monthly returns over a five-year period and determines that the the natural logarithm of this random variable follows a normal distribution. Based only on this information, it is most likely that:
A
the index’s monthly return data is normally distributed.
B
the index’s monthly return data is lognormally distributed.
C
there is not sufficient evidence to reach a conclusion about the distribution of the index’s monthly return data.
A
B
the index’s monthly return data is lognormally distributed.
If a random variable is lognormally distributed, it follows that its natural logarithm is normally distributed. It is also true that, if a random variable’s natural logarithm is normally distributed, the variable itself must be lognormally distributed.
3
Q
Which of the following methods is most appropriate to use when only some members of a finite population can be identified?
A
Systematic sampling
B
Simple random sampling
C
Stratified random sampling
A
A
Systematic sampling
Systematic sampling can be used when not all members of a population can be coded or even identified to be placed in groups. It involves selecting every Kth member of a population until the desired size of the sample is reached.
3
Q
Compared with bootstrap resampling, jackknife resampling:
A
is done with replacement.
B
usually requires that the number of repetitions is equal to the sample size.
C
produces dissimilar results for every run because resamples are randomly drawn.
A
B
usually requires that the number of repetitions is equal to the sample size.
For a sample of size n, jackknife resampling usually requires n repetitions. In contrast, with bootstrap resampling, we are left to determine how many repetitions are appropriate.
4
Q
A researcher would like to gather a sample of fifty people. He divides the range of the people’s heights into ten intervals of equal length and randomly selects two people from each interval. This is most likely an example of:
A
cluster sampling.
A researcher would like to gather a sample of fifty people. He divides the range of the people’s heights into ten intervals of equal length and randomly selects two people from each interval. This is most likely an example of:
A
23%
cluster sampling.
B
70%
stratified sampling.
C
7%
systematic sampling.
C
systematic sampling.
A
B
stratified sampling.
5
Q
The following table shows the significance level (a) and the p-value for two hypothesis tests.
Level of Significance p-Value
Test 1 0.02 0.05
Test 2 0.05 0.02
In which test should we most likely reject the null hypothesis?
A
Test 1 only
B
Test 2 only
C
Both Test 1 and Test 2
A
B
Test 2 only
The p-value is the smallest level of significance at which the null hypothesis can be rejected. If the p-value is less than the level of significance, the null is rejected.
In Test 1, the p-value exceeds the level of significance, whereas in Test 2, the p-value is less than the level of significance.
6
Q
A sample is taken from a normally distributed population with known variance. The observations in this sample are sorted according to an ordinal scale. To test a hypothesis regarding the sample mean, an analyst would most likely use a:
A
t-test.
B
z-test.
C
nonparametric test.
A
C
nonparametric test.
When data is ranked, such as when it has been sorted according to an ordinal scale, the assumptions of parametric tests (e.g., z-test, t-test) do not hold and a nonparametric test should be used.
Parametric tests require a stronger measurement scale.
7
Q
Which of the following statements is most likely an example of a null hypothesis for a one-sided test?
A
The equity risk premium is equal to 5.0%.
B
The equity risk premium is greater than 6.0%.
C
The equity risk premium is less than or equal to 7.0%.
A
C
The equity risk premium is less than or equal to 7.0%.
A hypothesis is a statement about a population parameter that can be tested with sample statistics. Hypothesis testing requires two mutually exclusive and collectively exhaustive statement — an alternative hypothesis that is the “hoped for” outcome and null hypothesis that must be accepted unless there is sufficient evidence to reject it.
If an analyst expects to observe that the equity risk premium is greater than 7.0%, this would be used as the alternative hypothesis and the corresponding null hypothesis would be that the equity risk premium is less than or equal 7.0%. Using a one-sided test, the test statistic will either be in the region of rejection region at the right tail or it will fall in the region to the left and it will be concluded that there is insufficient evidence to reject the null hypothesis.
A statement that the equity risk premium is greater than 6.0% is consistent with a one-sided test, but this would be the alternative hypothesis. A null hypothesis must include the point of equality. In this scenario, the null hypothesis would be that the equity risk premium is equal to or less than 6.0%.
8
Q
The level of significance of a hypothesis test is best used to:
A
calculate the test statistic.
B
define the test’s rejection points.
C
specify the probability of a Type II error.
A
B
define the test’s rejection points.
The level of significance is used to establish the rejection points of the hypothesis test.
9
Q
The power of a hypothesis test is most likely:
A
equivalent to the level of significance.
B
the probability of not making a Type II error.
C
unchanged by increasing a small sample size.
A
B
the probability of not making a Type II error.
The power of a hypothesis test is the probability of correctly rejecting the null when it is false. Failing to reject the null when it is false is a Type II error
10
Q
The probability of correctly rejecting the null hypothesis is most likely the:
A
p-value.
B
power of a test.
C
level of significance.
A
B
power of a test.
11
Q
A machine learning model that has been underfit will most likely:
A
treat noise in a training dataset as true parameters.
B
fail to recognize true relationships in a training dataset.
C
identify relationships in a training dataset that are not found in the validation dataset.
A
B
fail to recognize true relationships in a training dataset.
underfit models are overly simplistic and can fail to identify true relationships that are present in a training dataset.
By contrast, a model is described as overfit when it treats noise in the training dataset as true parameters, but it is unable to find the same relationships in the validation dataset.
12
Q
HTML code is most accurately classified as:
A
structured data.
B
unstructured data.
C
semistructured data.
A
C
semistructured data.
13
Q
The critical value for the chi-square test of independence is most likely determined by the:
A
number of observations in the sample.
B
number of rows and columns in the contingency table.
C
magnitude of the squared deviations between expected and observed frequencies.
A
B
number of rows and columns in the contingency table.
The critical chi-square value used in a test of independence is determined two factors. The first is the desired region of rejection on the right side of the chi-square distribution. The second factor is the test statistic’s degrees of freedom
14
Q
Which of the following statements is most accurate? For a financial system to be described as having complete markets, it:
A
may not be either informationally efficient and operationally efficient.
B
must be informationally efficient, operationally efficient, and allocationally efficient.
C
must be both informationally efficient and operationally efficient, but may not be allocationally efficient.
A
A
may not be either informationally efficient and operationally efficient.
A financial system is considered to have complete markets if the following conditions are met:
Investors can earn an appropriate risk-adjusted return in exchange for agreeing to move money from the present to the future
Creditworthy borrowers can easily obtain funds from lenders
Investors can reduce, trade, or eliminate risk by hedging
Currencies and commodities can be easily traded
If all of this can be done at a low cost, the financial system is said to be operationally efficient. If asset prices reflect all relevant available information, the financial system is said to be informationally efficient.
However, it is not necessary for a financial system to be either operationally or informationally efficient in order to be said to have complete markets.
15
Q
The Standard & Poor’s Depositary Receipts (SPDRs) is an investment that tracks the S&P 500 stock market index. Purchases and sales of SPDRs during an average trading day are best described as:
A
primary market transactions in a pooled investment.
B
secondary market transactions in a pooled investment.
C
secondary market transactions in an actively managed investment.
A
B
secondary market transactions in a pooled investment.
16
You have placed a sell market-on-open order—a market order that would automatically be submitted at the market’s open tomorrow and would fill at the market price. Your instruction, to sell the shares at the market open, is a(n):
A
execution instruction.
B
validity instruction.
C
clearing instruction.
B
validity instruction.
An instruction regarding when to fill an order is considered a validity instruction.
17
Tony Harris is planning to start trading in commodities. He has heard about the use of futures contracts on commodities and is learning more about them. Which of the following is Harris least likely to find associated with a futures contract?
A
Existence of counterparty risk.
B
Standardized contractual terms.
C
Payment of an initial margin to enter into a contract.
A
Existence of counterparty risk.
Harris is least likely to find counterparty risk associated with a futures contract. There is limited counterparty risk in a futures contract because the clearinghouse is on the other side of every contract.
18
Over the long-term, equity investors who do not believe that they possess superior information will most likely:
A
hold only cash until they acquire superior information.
B
have longer holding periods than information-motivated traders.
C
achieve returns that closely track the performance of a broad market index.
C
achieve returns that closely track the performance of a broad market index.
Equity investors who do not believe they have superior information will most likely passively hold a diversified portfolio such as one composed of stocks included in a broad market index (according to their representative weights). It is not necessary to eliminate all potential for earning an equity risk premium by holding cash until superior information can be acquired.
19
In an order-driven market, orders at the same price are most likely ranked according to the:
A
uniform pricing rule.
B
derivative pricing rule.
C
secondary preference rules.
C
secondary preference rules.
In order-driven markets, the highest priority is given to the most aggressively priced orders. For orders at the same price, order-driven market use secondary preference rules to establish trading priority. Precedence may be granted based on the time that the orders were received or whether the entire order size is displayed. While each market is free to use its own order-ranking criteria, the objective is to establish rules that increase liquidity.
The uniform pricing rule is used in call markets to determine a price at which all trades of a given security are executed in order to maximize trading volume.
20
Commercial banks are most likely different from non-financial corporations in their ability to issue which of the following types of money markets securities?
A
Commercial paper only
B
Certificates of deposit only
C
Both commercial paper and certificates of deposit
B
Certificates of deposit only
Both commercial banks and non-financial corporations issue commercial paper. However, only banks are able to issue certificates of deposit.
21
An investor who purchases both a corporate bond and a credit default swap based on that underlying asset has least likely used the financial system for which purpose?
A
Saving
B
Borrowing
C
Managing risk
B
Borrowing
By purchasing a corporate bond, the investor has saved. The investor used the financial system to move money from the present to the future.
In purchasing a credit default swap, the investor has mitigated risk. The swap is an insurance policy that pays out if the issuer of the underlying bond defaults on its obligations.
22
An investment bank leading a best efforts initial public offering most likely has:
A
no conflict of interest with the issuer.
B
a conflict of interest that creates an incentive to overvalue the issuer.
C
a conflict of interest that creates an incentive to undervalue the issuer.
A
no conflict of interest with the issuer.
Although this dynamic exists for underwritten offerings, it does not exist for best efforts offerings. In such cases, the investment bank acts only as a broker and is not obligated to purchase any unsold shares. This eliminates the potential for a conflict of interest.
23
Which of the following statements about exchange-traded funds is most correct?
A
Exchange-traded funds are not backed by any assets.
B
The investment companies that create exchange-traded funds are financial intermediaries.
C
The transaction costs of trading shares of exchange-traded funds are substantially greater than the combined costs of trading the underlying assets of the fund.
B
The investment companies that create exchange-traded funds are financial intermediaries.
24
The role of brokers is most accurately described as:
A
trading with clients in quote-driven markets.
B
finding buyers for infrequently-traded assets.
C
holding assets as inventory until a buyer can be found.
B
finding buyers for infrequently-traded assets.
25
Commodities that can be stored and delivered at low cost are most likely:
A
perishable with a high value-to-weight ratio.
B
nonperishable with a low value-to-weight ratio.
C
nonperishable with a high value-to-weight ratio.
C
nonperishable with a high value-to-weight ratio.
Commodities that can be stored and delivered at low cost are typically nonperishable items with high value-to-weight ratio. Examples include industrial diamonds, precious metals and high-value industrial metals.
26
Consider a mutual fund that invests primarily in fixed-income securities that have been determined to be appropriate given the fund’s investment goal. Which of the following is least likely to be a part of this fund?
A
Warrants.
B
Commercial paper.
C
Repurchase agreements.
A
Warrants.
27
Which of the following market structures most likely relies heavily on dealers as a source of liquidity?
A
Order-driven markets
B
Quote-driven markets
C
Continuous trading markets
B
Quote-driven markets
Dealers are the only source of liquidity in quote-driven markets
28
Minimum capital requirements can most effectively be imposed by:
A
insurers.
B
regulators.
C
counterparties.
B
regulators.
Minimum capital standards exist to minimize the potential for one company's failure to have a significant widespread negative impact on financial markets. In theory, counterparties could require minimum capital requirements as conditions of contracts, but governments and their regulatory agencies have more power to enforce compliance.
29
You are the manager of an ETF based on a price-weighted index. Over the past quarter, one of your stocks, Sunrise, Inc., has appreciated by 10%, while other index components have remained relatively flat. There were no stock splits. In order to minimize tracking error, you will most likely:
A
sell some Sunrise, Inc. shares.
B
buy additional Sunrise, Inc. shares.
C
maintain the current portfolio weights.
C
maintain the current portfolio weights.
In the absence of stock-splits, price-weighted indices do not rebalance based on price changes, because the weights adjust in concert with pricesC
30
When creating a security market index, the target market:
A
determines the investment universe.
B
is usually a broadly defined asset class.
C
determines the number of securities to be included in the index.
A
determines the investment universe.
The target market determines the investment universe and the securities available for inclusion in the index.
31
Commodity index values are based on:
A
futures contract prices.
B
the market price of the specific commodity.
C
the average market price of a basket of similar commodities.
A
futures contract prices.
32
A float-adjusted market-capitalization-weighted index weights each of its constituent securities by its price and:
A
its trading volume.
B
the number of its shares outstanding.
C
the number of its shares available to the investing public.
C
the number of its shares available to the investing public.\
“Float” is the number of shares available for public trading.
33
Which of the following statements regarding sector indexes is most accurate? Sector indexes:
A
track different economic sectors and cannot be aggregated to represent the equivalent of a broad market index.
B
provide a means to determine whether an active investment manager is more successful at stock selection or sector allocation.
C
apply a universally agreed upon sector classification system to identify the constituent securities of specific economic sectors, such as consumer goods, energy, finance, health care.
B
provide a means to determine whether an active investment manager is more successful at stock selection or sector allocation.
34
A price-weighted index is most likely to be reconstituted after one of its component firms:
A
is acquired.
B
pays a dividend.
C
executes a stock split.
A
is acquired
Indexes are reconstituted in order to continue to reflect the performance of a target market. Events such as bankruptcies, mergers, acquisitions, and de-listings may prompt index providers to replace an acquired firm with another representative firm.
While a price-weighted index must be rebalanced in order to adjust for stock splits, this does not necessitate a reconstitution.
35
Which index method will most likely result in a value tilt?
A
Price weighting
B
Fundamental weighting
C
Market capitalization weighting
B
Fundamental weighting
The value tilt is a key feature of fundamental weighting. Indexes created with this method heavily invest in stocks with high book-to-market ratios.
36
A unique feature of hedge fund indexes is that they:
A
are frequently equal weighted.
B
are determined by the constituents of the index.
C
reflect the value of private rather than public investments.
B
are determined by the constituents of the index.
Hedge funds are not required to report their performance to any party other than their investors. Therefore, each hedge fund decides to which database(s) it will report its performance. Thus, for a hedge fund index, constituents determine the index rather than index providers determining the constituents.
37
After inception, the value of the total return version of a security market index will most likely:
A
lags the value of the price return version of the index.
B
match the value of the price return version of the index.
C
exceed the value of the price return version of the index.
C
exceed the value of the price return version of the index.
At inception, the total return and price return versions of a security market index are both set to the same value. As constituent companies pay dividends, the total return version of the index will grow faster than the price return version.
38
In comparison to equity indexes, the constituent securities of fixed-income indexes are:
A
more liquid.
B
easier to price.
C
drawn from a larger investment universe.
C
drawn from a larger investment universe.
the fixed-income market has more issuers and securities than the equity market.
39
Security market indexes are used as:
A
measures of investment returns.
B
proxies to measure unsystematic risk.
C
proxies for specific asset classes in asset allocation models.
C
proxies for specific asset classes in asset allocation models.
Security market indexes play a critical role as proxies for asset classes in asset allocation models.
40
Which of the following is not a real estate index category?
A
Appraisal index.
B
Initial sales index.
C
Repeat sales index.
B
Initial sales index.
41
The goal of a broad market equity index is most likely to represent the performance of:
A
an entire asset class.
B
a collection of markets.
C
an entire economic sector.
A
an entire asset class.
A broad market index attempts to broadly represent an asset class (i.e., equity).
42
Which of the following index weighting methods requires the most frequent rebalancing?
A
Price weighting.
B
Equal weighting.
C
Market-capitalization weighting.
B
Equal weighting.
43
Uses of market indexes do not include serving as a:
A
measure of systemic risk.
B
basis for new investment products.
C
benchmark for evaluating portfolio performance.
A
measure of systemic risk.
Security market indexes are used as proxies for measuring market or systematic risk, not as measures of systemic risk.
44
A security market index represents the:
A
risk of a security market.
B
security market as a whole.
C
security market, market segment, or asset class.
C
security market, market segment, or asset class.
A security market index represents the value of a given security market, market segment, or asset class.
45
Security market indexes are:
A
constructed and managed like a portfolio of securities.
B
simple interchangeable tools for measuring the returns of different asset classes.
C
valued on a regular basis using the actual market prices of the constituent securities.
A
constructed and managed like a portfolio of securities.
46
company has arranged to sell their accounts receivable to a lender at a steep discount. In this arrangement, the company would pass the credit granting and collection process to the lender.
The arrangement is best described as:
A
Revolvers
B
Factoring
C
Committed line of credits
B
Factoring
47
Which of the following statements is most accurate?
A
Commodity indexes all share similar weighting methods.
B
Commodity indexes containing the same underlying commodities offer similar returns.
C
The performance of commodity indexes can be quite different from that of the underlying commodities.
C
The performance of commodity indexes can be quite different from that of the underlying commodities.
48
In comparison to equity indexes, the constituent securities of fixed-income indexes are:
A
more liquid.
B
easier to price.
C
drawn from a larger investment universe.
C
drawn from a larger investment universe.
49
When creating a security market index, the target market:
A
determines the investment universe.
B
is usually a broadly defined asset class.
C
determines the number of securities to be included in the index.
A
determines the investment universe.
50
With respect to efficient markets, a company whose share price changes gradually after the public release of its annual report most likely indicates that the market where the company trades is:
A
semi-strong-form efficient.
B
subject to behavioral biases.
C
receiving additional information about the company.
C
receiving additional information about the company.
51
In a market that is perfectly efficient except for transaction costs of 0.10% per trade, securities prices would most likely:
A
equal to their intrinsic value.
B
be at least 0.10% different from their intrinsic value.
C
be no more than 0.10% different from their intrinsic value.
C
be no more than 0.10% different from their intrinsic value.
In an efficient market, investors buy any undervalued securities and sell any overvalued securities, with the result that the market value of a security quickly becomes the intrinsic value. With transaction costs, the investor is limited at the margins -- buying a security undervalued by 0.10% does not present an arbitrage opportunity if transaction costs are twice that amount. There will be a band of efficiency, in which the value of the inefficiency is less than the transaction costs.
52
The existence of an earnings surprise anomaly is most appropriately interpreted as evidence that a market is:
A
weak-form efficient.
B
semi-strong-form efficient.
C
semi-strong-form inefficient.
C
semi-strong-form inefficient.
A market in which it is possible to consistently earn risk-adjusted profits (net of fees) based on earnings surprises cannot be considered semi-strong-form efficient.
According to the semi-strong form of the market efficiency hypothesis, prices reflect all historical market data and publicly-available information (for example, reported earnings compared to analysts’ prior estimates). The earnings surprise anomaly is observed when prices fail to quickly and fully reflect the portion of reported earnings that were not reflected in analysts’ estimates.
53
A security’s intrinsic value most likely:
A
does not fluctuate.
B
cannot be known with certainty.
C
is different for different investors.
B
cannot be known with certainty.
A security’s intrinsic value is how much investors would value it if they could produce an unbiased analysis of all relevant information. Because such an analysis is not possible, a security’s intrinsic value cannot be known with certainty.
54
The difference between a stock at the end of its first day trading on a secondary market after an initial public offering (IPO) and its issue price is most accurately described as:
A
an earnings surprise.
B
an information cascade.
C
the degree of underpricing.
C
the degree of underpricing.
In a relatively efficient secondary market, a stock will trade near its intrinsic value by the end of its first day of trading after an IPO. Due to the various pressures faced by the investment banks that underwrite IPOs, the issue price is often set at a level that is below its Day 1 closing price. The difference between these prices is known as the degree of underpricing.
55
Overconfidence bias is most likely attributable to:
A
a lack of information.
B
an inability to accurately process information.
C
a belief that markets are informationally efficient.
B
an inability to accurately process information.
Investors who exhibit overconfidence bias overestimate their ability to process information accurately. Overconfidence bias is not caused by a lack of information – even the most well-informed market participants may be overconfident.
56
Which of the following statements is most accurate? Arbitrage trading:
A
makes markets less efficient.
B
makes markets more efficient.
C
may increase or decrease market efficiency depending on the circumstances.
B
makes markets more efficient.
Markets are inefficient when assets with identical payoffs have different prices. Arbitrageur trading increases market efficiency by selling the overpriced assets and buying underpriced assets until it is no longer possible to earn risk-free profits. Any restriction on arbitrage trading makes markets less efficient.
57
With respect to rational and irrational investment decisions, the efficient market hypothesis requires:
A
only that the market is rational.
B
that all investors make rational decisions.
C
that some investors make irrational decisions.
A
only that the market is rational.
The efficient market hypothesis and asset-pricing models only require that the market is rational. Behavioral finance is used to explain some of the market anomalies as irrational decisions.
58
Which of the following statements is most accurate? Closed-end investment funds:
A
trade in the primary market.
B
may trade at a premium above net asset value per share.
C
trade at a discount to net asset value per share that is entirely attributable to illiquidity concerns.
B
may trade at a premium above net asset value per share.
While it is common for closed-end investment funds to trade at prices below their net asset value per share, they can (and, in some cases, do) trade at a premium.
Closed-end investment funds trade in secondary markets, not the primary market.
59
The practice of discovering a statistically significant relationship indicating the possibility of earning abnormal returns before establishing a hypothesis is most accurately described as:
A
data mining.
B
technical analysis.
C
identifying a time-series anomaly.
A
data mining
Data mining occurs when analysts repeatedly run tests of market data until a statistically significant relationship can be found and subsequently formulate a hypothesis for why this relationship might exist. This is the opposite order that these steps occur when following generally accepted research practices and can lead to the identification of apparent market anomalies with no compelling rationale for their existence.
60
If a market is semi-strong-form efficient, the risk-adjusted returns of a passively managed portfolio relative to an actively managed portfolio are most likely:
A
lower.
B
higher.
C
the same.
B
higher.
61
The level of a market's efficiency is most likely inversely related to:
A
the number of participants.
B
restrictions on foreign investment.
C
the ability for investors to take short positions.
B
restrictions on foreign investment.
62
If a researcher conducting empirical tests of a trading strategy using time series of returns finds statistically significant abnormal returns, then the researcher has most likely found:
A
a market anomaly.
B
evidence of market inefficiency.
C
a strategy to produce future abnormal returns.
A
a market anomaly.
63
Return on equity (ROE) is most likely calculated based on the book value of equity rather than the market value of equity because:
A
the market value of equity is too volatile.
B
management has more control over the book value of equity.
C
the book value of equity better reflects the company's intrinsic value.
B
management has more control over the book value of equity.
There are other formulas that relate earnings to a stock's market value, but ROE is frequently used when analysts want to directly measure management's performance.
64
Which of the following is incorrect about the risk of an equity security? The risk of an equity security is:
A
based on the uncertainty of its cash flows.
B
based on the uncertainty of its future price.
C
measured using the standard deviation of its dividends.
C
measured using the standard deviation of its dividends.
Some equity securities do not pay dividends, and therefore the standard deviation of dividends cannot be used to measure the risk of all equity securities.
65
Which of the following measures is the most difficult to estimate?
A
The cost of debt.
B
The cost of equity.
C
Investors’ required rate of return on debt.
B
The cost of equity.
The cost of equity is not easily determined. It is dependent on investors’ required rate of return on equity, which reflects the different risk levels of investors and their expectations about the company’s future cash flows.
66
Which of the following forms of equity is most likely to maximize an investor's potential to profit from a company's improved operating performance?
A
Putable common shares
B
Callable common shares
C
Cumulative preference shares
A
Putable common shares
Putable common shares can be sold back to their issuer at a pre-specified price. However, investors have no obligation to do so and there is no limit on the potential value of these shares.
Callable common shares provide only limited potential to profit from a company's improved operating performance. If the value of these shares rises above a pre-specified exercise price, the issuer has the right to repurchase them at a discount to their market price.
67
Emerging markets have benefited from recent trends in international markets. Which of the following is less likely to have been a benefit of these trends?
A
Emerging market companies do not have to worry about a lack of liquidity in their home equity markets.
B
Emerging market companies have found it easier to raise capital in the markets of developed countries.
C
Emerging market companies have benefited from the stability of foreign exchange markets.
C
Emerging market companies have benefited from the stability of foreign exchange markets.
The trends in emerging markets have not led to the stability of foreign exchange markets.
68
Which of the following statements is most accurate? Unlike sponsored depository receipts, unsponsored depository receipts:
A
do not pay dividends.
B
are not issued by the underlying company.
C
are not guaranteed payment in the event of bankruptcy.
B
are not issued by the underlying company.
The difference between sponsored and unsponsored depository receipts comes down to issuance.
Unsponsored depository receipts are issued by a depository bank of a company's stock in a foreign market.
By contrast, sponsored depository receipts (DRs) are issued directly by the underlying company in a foreign market.
Both types of depository receipts pay dividends. Similar to common stock, neither are guaranteed payment in the event of bankruptcy.
69
Which of the following statements is most accurate in describing a company’s book value?
A
Book value increases when a company retains its net income.
B
Book value is usually equal to the company’s market value.
C
The ultimate goal of management is to maximize book value.
A
Book value increases when a company retains its net income.
A company’s book value increases when a company retains its net income.
70
An equity's risk is most accurately characterized as the uncertainty surrounding expected:
A
total return.
B
market price.
C
free cash flows.
A
total return.
71
Which of the following securities issued by a French retailer would most likely trade in the company's domestic equity markets?
A
Global registered shares only
B
Global depository receipts only
C
Neither global registered shares nor global depository receipts
A
Global registered shares only
Global registered shares may trade simultaneously in multiple markets with prices quoted in local currencies. They provide the underlying securities for the issuers of global depository receipts.
72
An Australian mining firm has issued sponsored depository receipts. The responsibilities of the depository bank most likely include:
A
exercising voting rights.
B
processing dividend payments.
C
pricing the issue of new shares.
B
processing dividend payments.
73
A company is holding its annual shareholder meeting, at which candidates will be elected to serve on its seven-member board of directors. If the company uses the cumulative voting method, what is the maximum number of votes that an investor who holds 100 cumulative preference shares will most likely be able to cast for any single candidate?
A
0
B
100
C
700
A
0
Unless otherwise specified, preference shares do not provide investors with any voting rights.
74
When an investor purchases an American depository receipt, the underlying security they are buying is most likely a:
A
depository share.
B
unit of common stock.
C
sponsored depository receipt.
A
depository share.
Depository receipts are international claims on depository shares. These shares may act very similar to common stock, but they are a different type of security, designed specifically for foreign investment.
75
Which of the following is least likely to be cited as a justification for imposing restrictions on foreign investment?
A
Reducing the volatility of capital flows
B
Improving domestic equity market performance over the long-run
C
Providing opportunities for domestic investors to own shares of foreign companies
B
Improving domestic equity market performance over the long-run
Empirical evidence indicates that restrictions on foreign investment cause domestic equity markets to underperform over the long-term.
76
Global depository receipts (GDRs) are most likely:
A
issued in the United States.
B
denominated in US dollars.
C
unavailable to US investors.
B
denominated in US dollars.
Global depository receipts are not required to be denominated in US dollars, however, the majority are.
77
The type of equity voting right that grants one vote for each share of equity owned is referred to as:
A
proxy voting.
B
statutory voting.
C
cumulative voting.
B
statutory voting.
78
Which of the following is least likely to be a reason for a company to issue equity securities on the primary market?
A
To raise capital.
B
To increase liquidity.
C
To increase return on equity.
C
To increase return on equity.
79
Which of the following statements is least accurate in describing a company’s market value?
A
Management’s decisions do not influence the company’s market value.
B
Increases in book value may not be reflected in the company’s market value.
C
Market value reflects the collective and differing expectations of investors.
A
Management’s decisions do not influence the company’s market value.
A company’s market value is affected by management’s decisions. Management’s decisions can directly affect the company’s book value, which can then affect its market value.
80
he voting method that is most beneficial to shareholders with a small number of shares in a company is:
A
proxy voting.
B
statutory voting.
C
cumulative voting.
C
cumulative voting.
Cumulative voting is more beneficial to shareholders with a small number of shares. It allows these shareholders to apply all of their votes to elect one candidate on the board of directors, providing an opportunity for a higher level of representation than would be possible under statutory voting
81
The book value of the company is equal to
total assets minus total liabilities
82
With respect to Level III sponsored ADRs, which of the following is least likely to be accurate? They:
A
have low listing fees.
B
are traded on the NYSE, NASDAQ, and AMEX.
C
are used to raise equity capital in US markets.
A
have low listing fees.
The listing fees on Level III sponsored ADRs are high.
83
Which of the following equity securities are most likely traded on exchanges in the United States?
A=
American depository shares only
B
American depository receipts only
C
Both American depository shares and American depository receipts
B
American depository receipts only
American depository receipts (ADRs) are issued by company's based outside of the United States, but are denominated in US dollars and trade on American exchanges.
84
A company’s cost of equity is often used as a proxy for investors’:
A
average required rate of return.
B
minimum required rate of return.
C
maximum required rate of return.
B
minimum required rate of return.
Companies try to raise funds at the lowest possible cost. Therefore, cost of equity is used as a proxy for the minimum required rate of return.
85
RJR Industries generates 80% of its revenues from manufacturing toys and 20% from publishing children's books. The company has included labor and material costs, depreciation, certain salaries, and other expenses that are directly related to sales in the amount reported as cost of goods sold. The company has most likely grouped the accounts by:
A
nature.
B
function.
behavior with output.
B
function.
86
All else equal, a higher share of debt in a company's capital structure will most likely affect its:
A
operating income.
B
degree of operating leverage.
C
ratio of net income to shareholders' equity.
C
ratio of net income to shareholders' equity.
Operating income is earnings before interest and tax, whereas net income is operating income less interest and taxes. Increasing the share of debt in a company's capital structure will affect net income through higher interest costs, but operating income will be unaffected. Financial leverage has no effect on operating leverage.
87
When conducting company analysis, which of the following is least relevant to determining a company’s business model?
A
Company annual report describing the firm’s product lines
B
Comments by management about competing products and substitutes
C
Industry white papers regarding the company’s product pricing strategy
B
Comments by management about competing products and substitutes
Competing products and substitutes are analyzed in Porter’s Five Forces. This analysis is usually performed to better understand a company’s industry and its competitive positioning. Management comments are unlikely to guide the analyst to better understand the company’s business model.
88
Lower industry concentration is usually associated with a high degree of competitive intensity unless the industry is most likely:
A
global.
B
service-oriented.
C
one with low product differentiation.
B
service-oriented.
Lower industry concentration, defined as many small competitors in the market, is usually associated with a high degree of competitive intensity unless the industry is service-oriented, is local in nature, or has high product differentiation.
89
An analyst is assessing the pricing power of an organic food manufacturer. The company's products, which have been sold exclusively in local specialty stores, will soon be carried by large retail chain stores. The analyst notes that the company's industry is characterized by heterogeneous product offerings and low fixed costs.
Which of the following factors most likely limits the company’s pricing power?
A
Fixed costs
B
Product offerings
C
New distribution channels
c
New distribution channel
While selling its products through large retailers will likely increase its sales volume, the company's its pricing power will be reduced below its current level as it sells to customers that have more bargaining power that the company’s current customer base (local specialty stores).
90
Which of the following is not a limitation of the cyclical/non-cyclical descriptive approach to classifying companies?
A
A cyclical company may have a growth component in it.
B
Business-cycle sensitivity is a discrete phenomenon rather than a continuous spectrum.
C
A global company can experience economic expansion in one part of the world while experiencing recession in another part.
B
Business-cycle sensitivity is a discrete phenomenon rather than a continuous spectrum.
Business-cycle sensitivity falls on a continuum and is not a discrete “either/or” phenomenon.
91
PESTLE analysis is a framework for identifying:
A
industry themes.
B
the level of industry concentration.
C
determinants of industry profitability.
A
industry themes.
PESTLE analysis is a framework for identifying “themes” or “narratives” that investors may take a perspective on and desire exposure to.
92
An alternative method of grouping companies by geography is least likely to be completed using:
A
location of head office.
B
geographic composition of revenue.
C
primary listing of its equity securities.
C
primary listing of its equity securities.
Classification by country is typically by the country where the issuer is incorporated, the country of the primary listing of its equity securities, the location of its headquarters, or market perception.
93
Which of the following is most likely a risk of executing a differentiation competitive strategy?
A
pricing premiums become too high
B
larger competitors outcompete on price
C
a desire for premium-ization among customers
A
pricing premiums become too high
The risks of a differentiation strategy include imitation by competitors, buyers becoming sophisticated and no longer demanding level of service, and pricing premiums becoming too high for customers to beat; such a strategy may also preclude high market share, as customers value exclusivity.
94
While modeling a manufacturing firm's income statement, an analyst makes the following comment about the factors that are expected to have the biggest impact on expenses: "COGS will increase, in part, due to higher prices for ingredients and packaging, as well as the higher cost of maintaining the company's production facilities. The primary driver of decreases in SG&A is a reduction in benefits paid to sales staff."
Is this comment most likely correct?
A
Yes
B
No, because benefits for sales staff are not included in SG&A
C
No, because factory maintenance costs are not included in COGS
A
Yes
his comment is correct.
COGS include the cost of raw materials used in products and the direct labor costs incurred to produce (e.g., salaries of production staff). Additionally, COGS include overhead costs attributable to production, such as the cost of maintaining facilities.
The SG&A expense includes any costs incurred to sell or deliver a company's products, such as salaries and benefits paid to sales staff.
95
An analyst is forecasting operating costs for a company with relatively high fixed costs, sensitivity to economic conditions, and commodity inputs with volatile pricing. The company does not follow a hedging strategy for commodity purchases but tries to buy when prices are low. Which of the following is most appropriate to use in forecasting operating costs? The analyst uses:
A
analyst discretion to forecast all operating costs.
B
management guidance to forecast all operating costs.
C
management guidance to forecast fixed operating costs and analyst discretion to forecast variable operating costs.
C
management guidance to forecast fixed operating costs and analyst discretion to forecast variable operating costs.
Management has an advantage in forecasting for objects that are subject to its actions (such as capital expenditures and inventories, which affect fixed costs). The analyst is likely to have an informational advantage when it comes to forecasting economic conditions and commodity prices, which affect revenues and variable costs.
96
A clothing company, which initially produced designer clothing, has increasingly entered into the mass market. Which of the following approaches to forecasting revenues is least appropriate?
A
Historical results
B
Analyst’s discretionary forecast
C
Historical base rates and convergence
A
Historical results
97
ABC Limited (ABCL) is currently profitable and is expected to remain so over the next five years. The company plans to retain all earnings over the next five years, forgoing any dividend payments and share repurchases. In the notes to the company's financial statements, ABCL’s management has stated its goal to maintain a 30% debt-to-capital ratio. Based on this information, it is most likely that, over the next five years, the company will:
A
take on additional debt.
B
maintain a constant level of debt.
C
use a portion of its profits to pay down debt.
A
take on additional debt.
ABCL is expected to be profitable over the next five years and all earnings will be retained rather than paid out as dividends. This will increase the amount of equity in the company's capital structure. In order to maintain a 30% debt-to-capital ratio, it will be necessary for the company to take on additional debt.
98
An analyst notes that a company’s capital expenditures do not follow a discernible pattern; the company seems to have periods of very low capital expenditures and periods of high capital expenditures. Management does not provide any guidance on capital expenditures. The analyst should develop a forecast of capital expenditures based on:
A
the company’s usage of PP&E capacity.
B
the industry’s average capital expenditures.
C
the company’s average capital expenditures.
A
the company’s usage of PP&E capacity.
Based on the company’s spending pattern, it most likely makes capital expenditures based on capacity needs as it grows. If it is approaching full usage of existing capacity, it will expand.
99
The asset-based value of the equity of a company is the
fair value (market value) of the assets minus the fair value of liabilities.
100
The market value of equity for a company can be calculated as enterprise value:
A
minus market value of debt, preferred stock, and short-term investments.
B
plus market value of debt and preferred stock minus short-term investments.
C
minus market value of debt and preferred stock plus short-term investments.
C
minus market value of debt and preferred stock plus short-term investments.
Enterprise value is calculated as the market value of equity plus the market value of debt and preferred stock minus short-term investments.
101
Which of the following is most likely used in a present value model?
A
Enterprise value.
B
Price to free cash flow.
C
Free cash flow to equity.
C
Free cash flow to equity.
102
A three-stage dividend discount model is the most appropriate for which of the following companies?
A
A company that is in the maturity phase
B
A young company entering the growth phase
C
An older company that has moved from a growth phase to a transition phase
B
A young company entering the growth phase
A three-stage dividend discount model is the most appropriate for a company that is fairly young and entering the growth phase.
A two-stage dividend discount model is suitable for an older company that has moved from the growth phase to the transition phase
a constant growth model is appropriate for a company that is in the mature phase of growth.
103
An analyst makes the following statement: “Use of P/E and other multiples for analysis is not effective because the multiples are based on historical data and because not all companies have positive accounting earnings.” The analyst’s statement is most likely:
A
inaccurate with respect to both historical data and earnings.
B
accurate with respect to historical data and inaccurate with respect to earnings.
C
inaccurate with respect to historical data and accurate with respect to earnings.
A
inaccurate with respect to both historical data and earnings.
The statement is inaccurate in both respects. Although multiples can be calculated from historical data, forecasted values can be used as well. For companies without accounting earnings, several other multiples can be used. These multiples are often specific to a company’s industry or sector and include price-to-sales and price-to-cash flow.
104
A price earnings ratio that is derived from the Gordon growth model is inversely related to the:
A
growth rate.
B
dividend payout ratio.
C
required rate of return.
C
required rate of return.
105
A disadvantage of the EV method for valuing equity is that the following information may be difficult to obtain:
A
Operating income.
B
Market value of debt.
C
Market value of equity.
B
Market value of debt.
According to the reading, analysts may have not have access to market quotations for company debt.
106
In the free cash flow to equity (FCFE) model, the intrinsic value of a share of stock is calculated as:
A
the present value of future expected FCFE.
B
the present value of future expected FCFE plus net borrowing.
C
the present value of future expected FCFE minus fixed capital investment.
A
the present value of future expected FCFE.
In the FCFE model, the intrinsic value of stock is calculated by discounting expected future FCFE to present value. No further adjustments are required.
107
The financial statement analysis framework includes the following steps:
Step 1: Articulate the purpose and context of the analysis
Step 2: Collect input data
Step 3: Process data
Step 4: Analyze/interpret processed data
Step 5: Develop and communicate conclusions/recommendations
Step 6: Follow-up
During which of these steps would an analyst most likely engage in discussions with a company's competitors?
A
Step 2
B
Step 4
C
Step 5
A
Step 2
During the process of collecting input data (Step 2), analysts gather information from a variety of sources such as a company's management, supplier, customers and competitors.
108
Subzero Corporation is currently involved in a legal dispute with one of its customers. The company’s legal counsel has advised that a potential loss from the dispute is probable but the amount of loss cannot be reasonably estimated. Subzero failed to adequately disclose the lawsuit in its financial statement notes. Subzero’s independent auditor will most likely issue:
A
a disclaimer of opinion.
B
a qualified audit opinion.
C
an unqualified audit opinion.
B
a qualified audit opinion.
109
US generally accepted accounting principles are currently developed by which entity?
A
The Securities and Exchange Commission.
B
The Financial Accounting Standards Board.
C
The Public Company Accounting Oversight Board.
B
The Financial Accounting Standards Board.
The FASB is responsible for the Accounting Standards Codification™, the single source of nongovernmental authoritative US generally accepted accounting principles.
110
Which of the following is least likely to result in changes to financial reporting standards?
A
New products
B
New companies
C
New types of transactions
B
New companies
111
Proxy statements are most likely:
A
required to be filed with regulators at least annually.
B
reported in a supplemental schedule to a company's audited financial statements.
C
distributed to provide shareholders with information about matters to be voted on at a company's annual meeting.
C
distributed to provide shareholders with information about matters to be voted on at a company's annual meeting.
112
The purpose of the International Organization of Securities Commissions (IOSCO) is most likely to:
A
regulate securities and capital markets.
B
issue international financial reporting standards.
C
provide guidance on regulating securities and capital markets.
C
provide guidance on regulating securities and capital markets.
113
A qualified audit opinion is most likely required:
A
for a company with related-party transactions.
B
when the scope of the auditing process has not been limited.
C
in financial statements for the quarter after a major accounting policy change is implemented.
C
in financial statements for the quarter after a major accounting policy change is implemented.
114
Which of the following best describes the role of financial statement analysis?
A
To provide information about a company’s performance
B
To provide information about a company’s changes in financial position
C
To form expectations about a company’s future performance and financial position
C
To form expectations about a company’s future performance and financial position
115
The financial statement analysis framework includes the following steps:
Step 1: Articulate the purpose and context of the analysis
Step 2: Collect input data
Step 3: Process data
Step 4: Analyze/interpret processed data
Step 5: Develop and communicate conclusions/recommendations
Step 6: Follow-up
During which of these steps would an analyst most likely produce a report with a company valuation and estimated earnings per share?
A
Step 3
B
Step 4
C
Step 5
C
Step 5
116
The role of financial statement analysis is best described as:
A
providing information useful for making investment decisions.
B
evaluating a company for the purpose of making economic decisions.
C
using financial reports prepared by analysts to make economic decisions.
B
evaluating a company for the purpose of making economic decisions.
The primary role of financial statement analysis is to use financial reports prepared by companies to evaluate their past, current, and potential performance and financial position for the purpose of making investment, credit, and other economic decisions.
117
A core objective of the International Organization of Securities Commissions is to:
A
eliminate systemic risk.
B
protect users of financial statements.
C
ensure that markets are fair, efficient, and transparent.
C
ensure that markets are fair, efficient, and transparent.
118
In cases when the auditor believes that a company’s financial statements are not fairly presented in accordance with applicable accounting standards, the financial statements will most likely contain:
A
a qualified audit opinion.
B
an adverse audit opinion.
C
an unmodified audit opinion.
B
an adverse audit opinion.
119
A qualified audit opinion is most likely required:
A
for a company with related-party transactions.
B
when the scope of the auditing process has not been limited.
C
in financial statements for the quarter after a major accounting policy change is implemented.
C
in financial statements for the quarter after a major accounting policy change is implemented.
120
ubzero Corporation is currently involved in a legal dispute with one of its customers. The company’s legal counsel has advised that a potential loss from the dispute is probable but the amount of loss cannot be reasonably estimated. Subzero failed to adequately disclose the lawsuit in its financial statement notes. Subzero’s independent auditor will most likely issue:
A
a disclaimer of opinion.
B
a qualified audit opinion.
C
an unqualified audit opinion.
B
a qualified audit opinion.
121
The purpose of the International Organization of Securities Commissions (IOSCO) is most likely to:
A
regulate securities and capital markets.
B
issue international financial reporting standards.
C
provide guidance on regulating securities and capital markets.
C
provide guidance on regulating securities and capital markets.
122
Which statement is most accurate? A common size income statement:
A
restates each line item of the income statement as a percentage of net income.
B
allows an analyst to conduct cross-sectional analysis by removing the effect of company size.
C
standardizes each line item of the income statement but fails to help an analyst identify differences in companies’ strategies.
B
allows an analyst to conduct cross-sectional analysis by removing the effect of company size.
123
a company chooses to change an accounting policy. This change requires that, if practical, the company restate its financial statements for:
A
all prior periods.
B
current and future periods.
C
prior periods shown in a report.
C
prior periods shown in a report.
124
All else equal, capitalizing expenses rather than expensing them will most likely:
A
increase total asset turnover.
B
reduce net cash flow from operating activities.
C
increase cash outflows from investing activities.
C
increase cash outflows from investing activities.
If costs were expensed, they would be recognized as an operating cash outflow. By capitalizing these costs, net cash flows from operating activities and cash outflows from investing activities are both increased.
125
Under IFRS, gains attributable to the sale of a business unit should most likely be:
A
included in other comprehensive income.
B
disclosed in a separate line on the income statement.
C
treated as an extraordinary item and reported on a net of tax basis.
C
treated as an extraordinary item and reported on a net of tax basis.
126
When calculating diluted EPS, which of the following securities in the capital structure increases the weighted average number of common shares outstanding without affecting net income available to common shareholders?
A
Stock options
B
Convertible debt that is dilutive
C
Convertible preferred stock that is dilutive
A
Stock options
When a company has stock options outstanding, diluted EPS is calculated as if the financial instruments had been exercised and the company had used the proceeds from the exercise to repurchase as many shares possible at the weighted average market price of common stock during the period. As a result, the conversion of stock options increases the number of common shares outstanding but has no effect on net income available to common shareholders
127
Under IFRS, a loss from the destruction of property in a fire would most likely be classified as:
A
continuing operations.
B
discontinued operations.
C
other comprehensive income.
A
continuing operations.
A fire may be infrequent, but it would still be part of continuing operations and reported in the profit and loss statement. Discontinued operations relate to a decision to dispose of an operating division.
128
Which of the following least accurately describes adjustments to a company's earnings per share to be made if it has outstanding convertible debt?
A
Add back after-tax interest paid on that convertible debt
B
Add the potential new shares to the total number of shares outstanding
C
Multiply the outstanding convertible debt by the percentage likely to convert
C
Multiply the outstanding convertible debt by the percentage likely to convert
129
In June of 20X6, a US company announced that it would immediately begin the process of splitting off its profitable European division. In November of 20X6, the company issued an update on this process, which it expected to be formally completed in the fourth quarter of 20X7. Net income attributable to the European division should most likely be:
A
excluded from the company's 20X6 income statement.
B
recorded as a separate line item in the company's 20X6 income statement.
C
included in net income from the company's continuing operations in its 20X6 income statement with details of the pending split-off disclosed in the notes.
B
recorded as a separate line item in the company's 20X6 income statement.
Under both IFRS and US GAAP, revenues from a business unit that will not impact a company's balance sheet in the future should be reported as income from discontinued operations in a separate line in the income statement.
130
Considered in isolation, which of the following events is least likely to produce a difference between a company’s basic and diluted earnings per share?
A
A stock split
B
The issuance of convertible debt
C
The issuance of convertible preferred stock
A
A stock split
131
Which of the following least accurately describes adjustments to a company's earnings per share to be made if it has outstanding convertible debt?
A
Add back after-tax interest paid on that convertible debt
B
Add the potential new shares to the total number of shares outstanding
C
Multiply the outstanding convertible debt by the percentage likely to convert
C
Multiply the outstanding convertible debt by the percentage likely to convert
132
The initial measurement of goodwill is most likely affected by:
A
an acquisition’s purchase price.
B
the acquired company’s book value.
C
the fair value of the acquirer’s assets and liabilities.
A
an acquisition’s purchase price.
133
For financial assets classified as available for sale, how are unrealized gains and losses reflected in shareholders’ equity?
A
They are not recognized.
B
They flow through retained earnings.
C
They are a component of accumulated other comprehensive income.
C
They are a component of accumulated other comprehensive income.
For financial assets classified as available for sale, unrealized gains and losses are not recorded on the income statement and instead are part of other comprehensive income. Accumulated other comprehensive income is a component of Shareholders’ equity
134
Which of the following would an analyst most likely be able to determine from a common-size analysis of a company’s balance sheet over several periods?
A
An increase or decrease in sales.
B
An increase or decrease in financial leverage.
C
A more efficient or less efficient use of assets.
B
An increase or decrease in financial leverage.
Common-size analysis (as presented in the reading) provides information about composition of the balance sheet and changes over time. As a result, it can provide information about an increase or decrease in a company’s financial leverage.
135
For financial assets classified as held to maturity, how are unrealized gains and losses reflected in shareholders’ equity?
A
They are not recognized.
B
They flow through retained earnings.
C
They are a component of accumulated other comprehensive income.
A
They are not recognized.
Financial assets classified as held to maturity are measured at amortised cost. Gains and losses are recognized only when realized.
136
At the beginning of the year, a company paid $1.2 million to purchase debt securities and classified these as available-for-sale. At the end of the year, the securities had a market value of $1.5 million. All else equal, if these financial assets had been classified as trading securities, the company's net income for the year would most likely have been:
A
lower.
B
the same.
C
higher.
C
higher.
Unrealized gains and losses on trading securities are included in the income statement.
By contrast, unrealized gains and losses on available-for-sale securities bypass the income statement and are instead included directly in shareholders’ equity.
137
For financial assets classified as trading securities, how are unrealized gains and losses reflected in shareholders’ equity?
A
They are not recognized.
B
They flow through income into retained earnings.
C
They are a component of accumulated other comprehensive income.
B
They flow through income into retained earnings.
138
For financial assets classified as available for sale, how are unrealized gains and losses reflected in shareholders’ equity?
A
They are not recognized.
B
They flow through retained earnings.
C
They are a component of accumulated other comprehensive income.
C
They are a component of accumulated other comprehensive income.
139
Compared to a company that uses the FIFO method, during periods of rising prices a company that uses the LIFO method will most likely appear more:
A
liquid.
B
efficient.
C
profitable.
B
efficient.
LIFO will result in lower inventory and higher cost of sales. Gross margin (a profitability ratio) will be lower, the current ratio (a liquidity ratio) will be lower, and inventory turnover (an efficiency ratio) will be higher.
140
Carrying inventory at a value above its historical cost would most likely be permitted if:
A
the inventory was held by a producer of agricultural products.
B
financial statements were prepared using US GAAP.
C
the change resulted from a reversal of a previous write-down.
A
the inventory was held by a producer of agricultural products.
141
Valmore Mills manufactures forest products that are used in the construction of residential homes. The company's inventory currently has a net realizable value in excess of its historical cost. Valmore Mills would most likely be required to carry its inventories at cost under:
A
US GAAP only.
B
both IFRS and US GAAP.
C
neither IFRS nor US GAAP.
C
neither IFRS nor US GAAP.
For most companies that adhere to IFRS, inventories must be carried at the lower of cost or net realizable value. Producers of commodities such as agricultural goods, forest products, and minerals are exempt from this requirement and may measure their inventories at net realizable value even if this exceeds historical cost. US GAAP make similar allowances for these types of companies.
142
Zimt AG uses the FIFO method, and Nutmeg Inc. uses the LIFO method. Compared to the cost of replacing the inventory, during periods of rising prices, the cost of sales reported by:
A
Zimt is too low.
B
Nutmeg is too low.
C
Nutmeg is too high.
A
Zimt is too low.
Zimt uses the FIFO method, so its cost of sales represents units purchased at a (no longer available) lower price. Nutmeg uses the LIFO method, so its cost of sales is approximately equal to the current replacement cost of inventory.
143
Since it was founded 50 years ago, XYZ Corp. has not had to write down its inventories, nor has the company ever pledged its inventories as security for any of its liabilities. In its financial statements for the most recent year, the company disclosed its cost of goods sold (COGS), the total carrying amount of its inventories at fair value less cost to sell, as well as its chosen inventory valuation method. XYZ Corp. has most likely:
A
met the disclosure requirements under IFRS.
B
disclosed more information than required by IFRS.
C
failed to meet the disclosure requirements under IFRS.
C
failed to meet the disclosure requirements under IFRS.
nternational Financial Reporting Standards require companies to disclose the following information:
Which inventory valuation method has been used
Amount of inventories recognized as an expense (COGS)
Carrying amount of inventory at carried fair value less selling costs
Total carrying amount of inventories as well as the carrying amount in classifications (e.g., raw materials, work in progress)
Additional disclosures are required regarding write-downs and any inventories that have been pledged as security for liabilities
In this example, XYZ Corp. has not met the requirement to report separate amounts for different categories of inventory.
144
Company A adheres to US GAAP and Company B adheres to IFRS. Which of the following is most likely to be disclosed on the financial statements of both companies?
A
Any material income resulting from the liquidation of LIFO inventory
B
The amount of inventories recognized as an expense during the period
C
The circumstances that led to the reversal of a write down of inventories
B
The amount of inventories recognized as an expense during the period.
Both US GAAP and IFRS require disclosure of the amount of inventories recognized as an expense during the period. Only US GAAP allows the LIFO method and requires disclosure of any material amount of income resulting from the liquidation of LIFO inventory. US GAAP does not permit the reversal of prior-year inventory write downs.
145
In a period of declining inventory unit costs and constant or increasing inventory quantities, which inventory method is most likely to result in a higher debt-to-equity ratio?
A
LIFO
B
FIFO
C
Weighted average cost
B
FIFO
146
Zimt AG wrote down the value of its inventory in 2017 and reversed the write-down in 2018. Compared to the results the company would have reported if the write-down had never occurred, Zimt’s reported 2018:
A
profit was overstated.
B
cash flow from operations was overstated.
C
year-end inventory balance was overstated.
A
profit was overstated.
The reversal of the write-down shifted cost of sales from 2018 to 2017. The 2017 cost of sales was higher because of the write-down, and the 2018 cost of sales was lower because of the reversal of the write-down. As a result, the reported 2018 profits were overstated. Inventory balance in 2018 is the same because the write-down and reversal cancel each other out. Cash flow from operations is not affected by the non-cash write-down, but the higher profits in 2018 likely resulted in higher taxes and thus lower cash flow from operations.
147
Corex, a producer of rare minerals used in various industrial processes, prepares its financial reports in accordance with IFRS. The company is most likely:
A
required to carry its inventory at the lower of cost or net realizable value.
B
permitted to carry its inventory at net realizable value even if this exceeds cost and there is not an active market for the minerals.
C
permitted to carry its inventory at net realizable value even if this exceeds cost, but only if the minerals trade in an active market.
B
permitted to carry its inventory at net realizable value even if this exceeds cost and there is not an active market for the minerals.
FRS allow mineral producers to report their inventories at their net realizable value even when this is greater than cost. (Most companies that adhere to IFRS must report inventories at the lower of cost or net realizable value, but producers of certain commodities are exempt from this requirement.)
If the products trade in an active market, a quoted market price may be used to determine fair value. Even if an active market does not exist, fair value can be established based on market determined prices, such as the price at which the most recent transaction was executed.
148
Beschlund Industries, which adheres to IFRS, is currently carrying inventory at its historical cost of €50,000. If the company determines that inventory's net realizable value is €45,000, the €5,000 loss in value:
A
must be included as part of the cost of goods sold.
B
must be reported separately from cost of goods sold.
C
may be included as part of cost of goods sold or reported separately.
C
may be included as part of cost of goods sold or reported separately.
149
A write down of the value of inventory to its net realizable value will have a positive effect on the:
A
balance sheet.
B
income statement.
C
inventory turnover ratio.
C
inventory turnover ratio.
Activity ratios (for example, inventory turnover and total asset turnover) will be positively affected by a write down to net realizable value because the asset base (denominator) is reduced. On the balance sheet, the inventory carrying amount is written down to its net realizable value and the loss in value (expense) is generally reflected on the income statement in cost of goods sold, thus reducing gross profit, operating profit, and net income.
150
Which of the following is a required financial statement disclosure for long-lived intangible assets under US GAAP?
A
The useful lives of assets
B
The reversal of impairment losses
C
Estimated amortization expense for the next five fiscal years
C
Estimated amortization expense for the next five fiscal years
Under US GAAP, companies are required to disclose the estimated amortization expense for the next five fiscal years. Under US GAAP, there is no reversal of impairment losses. Disclosure of the useful lives—finite or indefinite and additional related details—is required under IFRS.
151
An analyst is valuing equities issued by two companies in the retail sector. Company A is based in the United States and reports in accordance with US GAAP. Company B is based in France and reports in accordance with IFRS. Which of the following statements is most accurate?
A
Company A must report carrying amounts based on the cost model
B
Company A may report carrying amounts based on the revaluation model
C
Company B must report carrying amounts based on the revaluation model
A
Company A must report carrying amounts based on the cost model
The cost model requires companies to report carrying amounts that represent the difference between historical cost and accumulated depreciation or amortization.
Reported carrying amounts based on the revaluation model represent the fair value of an asset at the time of its revaluation less any depreciation or amortization that has accumulated since that date. While US GAAP requires the use of the cost method and does not allow the use of the revaluation method, IFRS permits companies to choose either of these methods.
152
Which of the following assets is most likely to be amortized?
A
Goodwill
B
Machinery with a 5-year expected useful life
C
A purchased patent, set to expire in 10 years
C
A purchased patent, set to expire in 10 years
To be amortized, assets must have the following attributes:
Long-term
Intangible
Finite life
Goodwill is an intangible asset with an infinite lifetime. Rather than being amortized, it is tested annually for impairment.
Tangible assets, such as machinery, are depreciated rather than amortized. Conceptually, depreciation and amortization are essentially the same. The main distinction is that depreciation applies to tangible assets and amoriztation is used to expense the cost of intangible assets.
153
Which of the following statements is most accurate? Under US GAAP, an impairment loss:
A
may only be reversed for assets held for sale.
B
may not be reversed under any circumstances.
C
may be reversed for both assets held for sale and assets held for use.
A
may only be reversed for assets held for sale.
Under US GAAP, impairment losses attributable to assets held for use cannot be reversed. However, reversals of impairment losses attributable to assets held for sale are permitted.
154
According to IFRS, all of the following pieces of information about property, plant, and equipment must be disclosed in a company’s financial statements and footnotes except for:
A
useful lives.
B
acquisition dates.
C
amount of disposals.
B
acquisition dates.
IFRS do not require acquisition dates to be disclosed.
155
Berkley Manufacturing collected $2.3 million in cash from a tenant renting one of its unused facilities. The company recognizes this as deferred revenue for accounting purposes and pays taxes based on the cash payment. This will most likely result in Berkley recording:
A
a deferred tax asset.
B
a deferred tax liability.
C
neither a deferred tax asset nor a deferred tax liability.
A
a deferred tax asset.
Because the rent received in advance is taxed on a cash basis, Berkley must include this in taxable income for the financial year received.
156
When both the timing and amount of tax payments are uncertain, analysts should treat deferred tax liabilities as:
A
equity.
B
liabilities.
C
neither liabilities nor equity.
C
neither liabilities nor equity.
The deferred tax liability should be excluded from both debt and equity when both the amounts and timing of tax payments resulting from the reversals of temporary differences are uncertain.
157
A company will most likely record a deferred tax liability when:
A
the carrying amount of an asset exceeds its tax base.
B
certain losses are deducted for accounting purposes but not for tax purposes.
C
certain revenues are recognized for tax purposes but not for accounting purposes.
A
the carrying amount of an asset exceeds its tax base.
When an asset's carrying value is greater than its tax base, a deferred tax liability is created. For example, depreciating an asset more rapidly for tax purposes than for accounting purposes will cause taxable income to be lower and the amount of tax paid will be less than what is implied by accounting net income.
Until the temporary difference is offset with higher tax payments in later periods, the company will carry a deferred tax liability on its balance sheet.
157
Which of the following is added to income tax payable to determine the company’s income tax expense as reported on the income statement?
A
Deferred tax assets
B
Deferred tax liabilities
C
Changes in deferred tax assets and liabilities
C
Changes in deferred tax assets and liabilities
The changes in deferred tax assets and liabilities are added to income tax payable to determine the company’s income tax expense (or credit) as it is reported on the income statement.
A and B are incorrect because it is the changes in deferred tax assets and liabilities that are added to income tax payable.
158
A company that has reported deferred tax assets in previous years records an increase to its valuation allowance in its latest financial statements. The most likely explanation for the use of this increase is that the company expects future taxable income to:
A
be higher than previously forecast.
B
offset the previously reported amount of its deferred tax asset.
C
be insufficient to utilize the previously reported amount of its deferred tax asset.
C
be insufficient to utilize the previously reported amount of its deferred tax asset.
A company reports a large amount of valuation allowance in its financial statements. The most likely implication of this valuation allowance in relation to future earnings prospects of the company is that the company does not expect to generate enough taxable profits to utilize the deferred tax assets.
158
Analysts should treat deferred tax liabilities that are expected to reverse as:
A
equity.
B
liabilities.
C
neither liabilities nor equity.
B
liabilities.
If the liability is expected to reverse (and thus require a cash tax payment) the deferred tax represents a future liability.
158
Which of the following will most likely result in the creation of a deferred tax liability?
A
Taxable temporary differences only
B
Deductible temporary differences only
C
Both taxable temporary differences and deductible temporary differences
A
Taxable temporary differences only
159
When accounting standards require an asset to be expensed immediately but tax rules require the item to be capitalized and amortized, the company will most likely record:
A
a deferred tax asset.
B
a deferred tax liability.
C
no deferred tax asset or liability.
A
a deferred tax asset.
160
Deferred tax liabilities should be treated as equity when:
A
they are not expected to reverse.
B
the timing of tax payments is uncertain.
C
the amount of tax payments is uncertain.
A
they are not expected to reverse.
161
In the current year, Michaels Company has a carrying amount of USD3,500,000 and tax base of USD5,000,000 for accounts receivable. Michaels will most likely recognize:
A
a deferred tax asset.
B
a deferred tax liability.
C
no deferred tax asset or liability.
A
a deferred tax asset.
because the carrying amount is less than the tax base for this asset, this difference is a temporary difference that will result in a deferred tax asset.
162
Which of the following statements about tax rates is correct?
A
The effective tax rate is typically used for forecasting cash flows.
B
The cash tax rate is relevant for projecting earnings on the income statement.
C
A company’s income tax expense equals the sum of current taxes plus the change in deferred tax assets and liabilities.
163
A company enters into a finance lease agreement to acquire the use of an asset for three years with lease payments of €19,000,000 starting next year. The leased asset has a fair market value of €49,000,000 and the present value of the lease payments is €47,250,188. Based on this information, the value of the lease liability reported on the company’s balance sheet at lease inception is closest to:
A
€47,250,188.
B
€49,000,000.
C
€57,000,000.
A is correct. Under the revised reporting standards under IFRS and US GAAP, a lessee must recognize an asset and a lease liability at inception of each of its leases (with an exception for short-term leases). The lessee reports a “right-of-use” (ROU) asset and a lease liability, calculated essentially as the present value of fixed lease payments, on its balance sheet. Thus, at lease inception, the company will record a lease liability on the balance sheet of €47,250,188.
A
€47,250,188.
164
Under US GAAP, a lessor’s reported revenues at lease inception will be highest if the lease is classified as:
A
a sales-type lease.
B
an operating lease.
C
a direct financing lease.
A
a sales-type lease.
A sales-type lease treats the lease as a sale of the asset, and revenue is recorded at the time of sale equal to the value of the leased asset.
165
an automobile manufacturer provides a defined-benefit pension plan to all of its employees. The company will most likely include pension costs attributable to its assembly line workers in which of the following categories on its income statement?
A
Cost of goods sold
B
Salaries and wages
C
Administrative expenses
A
Cost of goods sold
A manufacturing firm will count pension expenses attributable to production workers (as well as their salaries and other forms of compensation) toward inventory. This amount appears on the income statement as part of cost of goods sold as sales are recognized. Expenses incurred as compensation for employees who are not directly involved in the production process will be included with salaries or other administrative expenses.
166
Penben Corporation has a defined benefit pension plan. At 31 December, its pension obligation is €10 million and pension assets are €9 million. Under either IFRS or US GAAP, the reporting on the balance sheet would be closest to which of the following?
A
€10 million is shown as a liability, and €9 million appears as an asset.
B
€1 million is shown as a net pension obligation.
C
Pension assets and obligations are not required to be shown on the balance sheet but only disclosed in footnotes.
B
€1 million is shown as a net pension obligation.
The company will report a net pension obligation of €1 million equal to the pension obligation (€10 million) less the plan assets (€9 million).
167
Which of the following statements about a defined-benefit pension plan is least accurate?
A
The sponsor promises to make periodic payments to participants after retirement
B
If the plan is underfunded, a net pension liability will be recorded on the sponsor’s balance sheet
C
The value of benefits received by participants depends on the performance of the plan’s assets
C
The value of benefits received by participants depends on the performance of the plan’s assets
In a defined contribution plan, the pension ultimately paid by the plan depends on the performance of the plan’s assets. However, in a defined benefit plan, the pension ultimately paid by the plan is defined according to a benefit formula.
168
Which of the following is a difference between a stock grant and a stock option grant?
A
Whereas the fair value of stock grants is usually based on the market value at the date of the grant, the fair value of option grants must be estimated.
B
Companies account for stock grants by allocating compensation expense over the employee service period, whereas compensation expense for stock options is expensed immediately.
C
Compensation expense is determined based on the market value of a share of stock on the grant date, whereas the measurement date for the value of an option is when the employee exercises the option.
A
Whereas the fair value of stock grants is usually based on the market value at the date of the grant, the fair value of option grants must be estimated.
169
Which of the following is typically an objective of a share-based compensation plan?
A
Attracting new employees
B
Maximizing executive compensation
C
Alignment of employees’ interest with those of management
A
Attracting new employees
170
Which of the following conditions best explains why a company’s manager would obtain legal, accounting, and board level approval prior to issuing low-quality financial reports?
A
Motivation
B
Opportunity
C
Rationalization
C
Rationalization
Typically, conditions of opportunity, motivation, and rationalization exist when individuals issue low-quality financial reports. Rationalization occurs when an individual is concerned about a choice and needs to be able to justify it to herself or himself. If the manager is concerned about a choice in a financial report, she or he may ask for other opinions to convince herself or himself that it is okay.
171
Which technique most likely increases the cash flow provided by operations?
A
Stretching the accounts payable credit period
B
Applying all non-cash discount amortization against interest capitalized
C
Shifting classification of interest paid from financing to operating cash flows
A
Stretching the accounts payable credit period
172
Which of the following best describes an opportunity for management to issue low-quality financial reports?
A
Ineffective board of directors
B
Pressure to achieve some performance level
C
Corporate concerns about financing in the future
A
Ineffective board of directors
Opportunities to issue low-quality financial reports include internal conditions, such as an ineffective board of directors, and external conditions, such as accounting standards that provide scope for divergent choices
173
When earnings are increased by deferring research and development (R&D) investments until the next reporting period, this choice is considered:
A
non-compliant accounting.
B
earnings management as a result of a real action.
C
earnings management as a result of an accounting choice.
B
earnings management as a result of a real action.
Deferring research and development (R&D) investments into the next reporting period is an example of earnings management by taking a real action.
174
Financial reports of the lowest level of quality reflect:
A
fictitious events.
B
biased accounting choices.
C
accounting that is non-compliant with GAAP.
A
fictitious events.
Financial reports span a quality continuum from high to low based on decision-usefulness and earnings quality. The lowest-quality reports portray fictitious events, which may misrepresent the company’s performance and/or obscure fraudulent misappropriation of the company’s assets.
175
Earnings that result from non-recurring activities most likely indicate:
A
lower-quality earnings.
B
biased accounting choices.
C
lower-quality financial reporting.
A
lower-quality earnings.
176
An analyst is reviewing a company to look for warning signs of information manipulation. Which of the following would most likely qualify as a warning sign that the analyst should investigate further?
A
Inventory turnover is increasing
B
Net income is consistently below cash provided by operations
C
The company’s revenue growth is significantly higher than its competitors
C
The company’s revenue growth is significantly higher than its competitors
177
Bias in revenue recognition would least likely be suspected if:
A
the firm engages in barter transactions.
B
reported revenue is higher than the previous quarter.
C
revenue is recognized before goods are shipped to customers.
B
reported revenue is higher than the previous quarter.
Bias in revenue recognition can lead to manipulation of information presented in financial reports. Addressing the question as to whether revenue is higher or lower than the previous period is not sufficient to determine if there is bias in revenue recognition.
178
A trend analysis of a company's financial statements with values stated in absolute currency terms is most likely to be effective:
A
at providing insights about a mature company.
B
at identifying structural changes that a company has experienced.
C
during periods of structural change in the macroeconomic environment.
A
at providing insights about a mature company.
Trend analysis is most valuable for analyzing mature companies and during periods of relative stability in macroeconomic conditions and the competitive landscape.
179
Which of the following is the least likely to be listed among the limitations of ratio analysis?
A
Companies may use different accounting methods
B
Companies may report results in different currencies
C
Companies may have operations in different industries
B
Companies may report results in different currencies
180
In order to assess a company’s ability to meet its short-term obligations, which of the following ratios would an analyst most likely examine?
A
Payables turnover
B
Defensive interval ratio
C
Working capital turnover
B
Defensive interval ratio
Liquidity ratios measure the company’s ability to meet short-term obligations. Liquidity ratios include the current ratio, quick ratio, cash ratio, and defensive interval ratio.
181
A trend analysis of a company's financial statements with values stated in absolute currency terms is most likely to be effective:
A
at providing insights about a mature company.
B
at identifying structural changes that a company has experienced.
C
during periods of structural change in the macroeconomic environment.
A
at providing insights about a mature company.
182
The return on invested capital (ROIC) metric most likely incorporates:
A
the degree of financial leverage.
B
operating liabilities relative to operating assets.
C
the firm’s competitiveness relative to companies in other tax regimes.
B
operating liabilities relative to operating assets.
183
Which of the following is most likely to be among the recommendations for an analyst using the discounted cash flow approach to estimate a company's terminal value?
A
The forecast horizon should be based on the timing of the next inflection point
B
The terminal growth rate assumption should be based on the company's historical growth rate
C
The terminal year free cash flow projection should be adjusted based on the timing of the business cycle
C
The terminal year free cash flow projection should be adjusted based on the timing of the business cycle
When using the DCF method to estimate a company's terminal value, analysts should adjust their estimates of terminal year free cash flows to account for the timing of the business cycle. Using an estimate for a terminal year that coincides with the peak or trough of a cycle can lead to excessively high or low valuations. Cash flow estimates should be normalized before being incorporated into long-term projections.
The length of a forecast horizon should not be determined by the timing of inflection points, which are extremely difficult to predict.
184
Nigel French, an analyst at Taurus Investment Management, is analyzing Archway Technologies, a manufacturer of luxury electronic auto equipment, at the request of his supervisor, Lukas Wright. French is asked to evaluate Archway’s profitability over the past five years relative to its two main competitors, which are located in different countries with significantly different tax structures.
French notes that for the year just ended (2019), Archway’s COGS was 30 percent of sales. To forecast Archway’s income statement for 2020, French assumes that all companies in the industry will experience an inflation rate of 8 percent on the COGS. After putting together income statement projections for Archway, French forecasts Archway’s balance sheet items. He uses Archway’s historical efficiency ratios to forecast the company’s working capital accounts.
French’s approach to forecasting Archway’s working capital accounts would be most likely classified as a:
A
hybrid approach.
B
top-down approach.
C
bottom-up approach.
C
bottom-up approach.
French is using a bottom-up approach to forecast Archway’s working capital accounts by using the company’s historical efficiency ratios to project future performance.
185
Nigel French, an analyst at Taurus Investment Management, is analyzing Archway Technologies, a manufacturer of luxury electronic auto equipment, at the request of his supervisor, Lukas Wright. French is asked to evaluate Archway’s profitability over the past five years relative to its two main competitors, which are located in different countries with significantly different tax structures.
Which profitability metric should French use to assess Archway’s five-year historic performance relative to its competitors?
A
Current ratio
B
Operating margin
C
Return on invested capital
B
Operating margin
Operating (EBIT) margin is a pre-tax profitability measure that can be useful in the peer comparison of companies in countries with different tax structures.
186
Nigel French, an analyst at Taurus Investment Management, is analyzing Archway Technologies, a manufacturer of luxury electronic auto equipment, at the request of his supervisor, Lukas Wright. French is asked to evaluate Archway’s profitability over the past five years relative to its two main competitors, which are located in different countries with significantly different tax structures.
Based on his financial forecast for Archway, French estimates a terminal value using a valuation multiple based on the company’s average price-to-earnings multiple (P/E) over the past five years. Wright discusses with French how the terminal value estimate is sensitive to key assumptions about the company’s future prospects. Wright asks French:
“What change in the calculation of the terminal value would you make if a technological development that would adversely affect Archway was forecast to occur sometime beyond your financial forecast horizon?”
The most appropriate response to Wright’s question about the technological development is to:
A
increase the required return.
B
decrease the perpetual growth rate.
C
decrease the price-to-earnings multiple.
C
decrease the price-to-earnings multiple.
If the future growth or profitability of a company is likely to be lower than the historical average (in this case, because of a potential technological development), then the target multiple should reflect a discount to the historical multiple to reflect this difference in growth and/or profitability.
If a multiple is used to derive the terminal value of a company, the choice of the multiple should be consistent with the long-run expectations for growth and required retur
187
Which of the following statements is most accurate? Special purpose acquisition companies:
A
are pass-through entities.
B
raise equity capital through private placements.
C
place the proceeds of their equity issuance in trust.
C
place the proceeds of their equity issuance in trust.
A special purpose acquisition company (SPAC) is created as a vehicle to take a private company public. After raising equity capital in an initial public offering, the SPAC places the proceeds in a trust until a target company can be identified and acquired. SPACs are not pass-through entities.
188
Which of the following is most likely a disadvantage of using a private limited company structure rather than a public limited company structure as an organizational form for a business?
A
Taxation of retained earnings
B
Requirement to pay dividends
C
Restrictions on the number of shareholders
C
Restrictions on the number of shareholders
Many jurisdictions restrict the number of shareholders that private limited companies are allowed to have, which limits growth potential. By contrast, public limited companies (or corporations) face no such restrictions.
189
Dee’s Arbor Group Inc. (DAG Inc.) is a large international investor in timber and forest assets located on the North and South American continents. DAG Inc. is the general partner of DAG LP, a limited partnership that is the 100% owner of the timber and forest assets. DAG LP is controlled by DAG Inc. and its limited partners; the limited partners own a 20% stake in the partnership, while DAG Inc. holds the remaining majority stake.
DAG Inc.’s shares are listed on stock exchanges in the United States and Canada. DAG Inc. is organized as a special corporate form available in its jurisdiction in which it does not pay corporate income taxes so long as it distributes all of its net income as dividends to its shareholders and complies with other conditions. In the current and past fiscal years, DAG Inc. has complied with all of these conditions.
DAG Inc.’s shares are owned by various members of the Dee family, who hold several key senior management positions at DAG Inc. and DAG LP, and collectively they own 30% of the shares of DAG Inc. The remainder of DAG Inc.’s shares are owned by a variety of individual and institutional investors, none of whom own more than 5%.
Which of the following best describes the taxation of DAG Inc. and DAG LP?
A
DAG LP pays tax based on its pre-tax income.
B
Shareholders of DAG Inc. pay tax based on dividend income.
C
DAG Inc. pays tax based on its pre-tax income.
B
Shareholders of DAG Inc. pay tax based on dividend income.
DAG Inc. is organized as a special corporate form available in its jurisdiction in which it does not pay corporate income taxes. DAG LP, as a limited partnership, is a pass-through entity. DAG Inc. shareholders pay tax on dividend income.
190
The owners of Granville Precision Instruments are considering changing the company's structure from a general partnership to a corporation in order to raise new equity. From the perspective of the owners, which of the following is most likely a disadvantage of this potential change?
A
Their control over the company's operations will be reduced
B
The company's retained earnings will be subject to double taxation
C
They will be required to enter into contracts on behalf of the company
A
Their control over the company's operations will be reduced
191
From the corporate issuer’s perspective, the risk level of bonds compared to stocks is:
A
lower.
B
higher.
C
the same.
B
higher.
From the issuer’s perspective, bonds are riskier than stocks for the same reason bonds are safer than stocks for investors. Bonds increase risk to the corporation by increasing leverage. If the company is struggling and cannot meet its promised obligations to bondholders, bondholders have the legal standing to force certain actions upon the corporation, such as bankruptcy and liquidation.
192
Which of the following stakeholders are least likely to be positively affected by increasing the proportion of debt in the capital structure?
A
Senior management
B
Non-management employees
C
Shareholdera
B
Non-management employees
While leverage increases risk for all stakeholders, shareholders generally benefit through higher potential returns. Senior management typically benefits through equity-based compensation. For non-management employees, equity-based compensation is likely to be small to non-existent.
193
Which of the following board structures is most consistent with the stakeholder theory of corporate governance?
A
One-tiered board
B
Two-tiered board
C
Staggered board
B
Two-tiered board
Stakeholder theory is based on the idea that corporate governance should consider all stakeholders, not just shareholders. A two-tiered board structure includes a supervisory board, which is composed for non-executive directors representing a broader range of stakeholders, including employees, labor unions, and the general public.
194
Private lenders and bondholders most likely differ with respect to:
A
their payoff profiles.
B
their holding periods.
C
the priority of their claims.
B
their holding periods.
Private lenders (e.g., banks) initial loans with the intention of holding them until maturity. By contrast, bondholders generally have much shorter holding periods.
195
The existence of “stranded assets” is a specific concern among investors of:
A
energy companies.
B
health care companies.
C
property companies.
A
energy companies.
A specific concern among investors of energy companies is the existence of “stranded assets,” which are carbon-intensive assets at risk of no longer being economically viable because of changes in regulation or investor sentiment.
196
Which of the following represents a principal-agent conflict between shareholders and management?
A
Risk tolerance
B
Multiple share classes
C
Accounting and reporting practices
A
Risk tolerance
Shareholder and manager interests can diverge with respect to risk tolerance. In some cases, shareholders with diversified investment portfolios can have a fairly high risk tolerances because specific company risk can be diversified away
197
Which of the following is least likely to be included among the core objectives of corporate governance?
A
Managing incentives
B
Arranging checks and balances
C
Minimizing conflict between shareholders and directors
C
Minimizing conflict between shareholders and directors
The core of corporate governance is managing incentives and arranging a system of checks and balances for the purpose of minimizing and managing conflicts and potential conflicts between insiders and shareholders.
198
A credit committee formed in the aftermath of a bankruptcy most likely represents the interests of:
A
borrowers.
B
customers.
C
unsecured creditors.
C
unsecured creditors.
In certain jurisdictions, credit committees are formed to represent the interests of lenders, particularly unsecured creditors, during the bankruptcy process.
199
he CEO of a publicly-listed company makes the following statement: "By using proper governance mechanisms and control systems, it is possible to completely eliminate information asymmetry between principals and agents. However, it may be in the best interests of shareholders to maintain some level of information asymmetry relative to their agents."
This statement is most likely:
A
correct.
B
incorrect because any information asymmetry is detrimental to shareholders.
C
incorrect because it is not possible to completely eliminate information asymmetry between principals and agents.
C
incorrect because it is not possible to completely eliminate information asymmetry between principals and agents.
The CEO is incorrect in claiming that it is possible to completely eliminate information asymmetry. Governance mechanisms and control systems can reduce, but not eliminate, information asymmetry between shareholders and managers.
200
A control system that is weak with respect to the quantity and quality of corporate information is most likely to serve the interests of:
A
directors.
B
managers.
C
shareholders.
B
managers.
Control systems that limit the quantity and quality of information prevent directors from conducting proper scrutiny of a company’s operations. In such an environment, managers have more opportunities to make decisions that benefit their own interests at the expense of shareholders.
201
A say on pay provision is least likely to limit the discretion of:
A
directors.
B
managers.
C
shareholders.
C
shareholders.
Say on pay provisions allow shareholders the opportunity to express their views about executive compensation packages. The purpose of these provisions is to limit the discretion that managers and directors have to award themselves excessive compensation and benefits.
202
Which of the following represents a responsibility of a company’s board of directors?
A
Implementation of strategy
B
Enterprise risk management
C
Considering the interests of shareholders only
B
Enterprise risk management
The board typically ensures that the company has an appropriate enterprise risk management system in place.
203
Greg Young is the CEO of Dataport, a firm that provides analytical services to companies in the transportation sector. Young also serves at the Chair of Dataport's Board of Directors. Today, Young is meeting with Linda Marchman, Dataport's CFO and a fellow Board member, to discuss the company's corporate governance. During the course of their meeting, Young makes the following statement: "In my role as CEO, I act as an agent, not as a principal."
Young's claim is most likely:
A
correct.
B
incorrect because he does not act as an agent.
C
incorrect because he acts as both a principal and an agent.
C
incorrect because he acts as both a principal and an agent.
An agency relationship is defined by one party (the principal) engages another party (the agent) with the ability to control certain resources. The principal must trust the agent to make decisions related to those resources that are in the principal's best interest. In this example, Young is correct in claiming that, as Dataport's CEO, he is the agent of principals in the form of the company's shareholders. However, he is also a principal in this role. Specifically, as a CEO, he cannot operate the company single-handedly and has delegated decision-making authority to agents in the form of executives and managers.
204
Which of the following examples would be best described as a drag on liquidity?
A
Reduced line of credit
B
Early payment to creditors
C
Delinquent account receivable
C
Delinquent account receivable
205
Two analysts are discussing the costs of external financing sources. The first states that the company’s bonds have a known interest rate but that the interest rate on accounts payable and the interest rate on equity financing are not specified. They are implicitly zero. Upon hearing this, the second analyst advocates financing the firm with greater amounts of accounts payable and common shareholders equity. Is the second analyst correct in his analysis?
A
He is correct in his analysis of accounts payable only.
B
He is correct in his analysis of common equity financing only.
C
He is not correct in his analysis of either accounts payable or equity financing.
C
He is not correct in his analysis of either accounts payable or equity financing.
Although accounts payable do not charge an explicit interest rate, the cost of accounts payable is reflected in the costs of the services or products purchased and in the costs of any discounts not taken. Accounts payable can have a very high implicit cost. Similarly, equity financing is not free. A required return is expected on shareholder financing just as on any other form of financing.
206
Which of the following projects is most likely to be undertaken without a capital budgeting/allocation analysis?
A
New product safety requirements
B
Installation of pollution control systems
C
A new aircraft to be used by senior managers
C
A new aircraft to be used by senior managers
While projects that are undertaken to comply with regulations related to product safety and environmental standards are typically required by external agencies rather than internally driven, companies use capital allocation analysis to determine, for example, whether these changes impact the financial viability of their operations or if there are advantages to early adoption.
By contrast, pet projects such as a new corporate aircraft may be approved without the scrutiny of a typical capital allocation analysis.
207
Larissa Soroka, an analyst at ABC company, has been asked to prepare cash flow forecasts for two mutually exclusive investment projects related to new products. ABC’s management asks Soroka to include the cost of market research that was recently completed as well as the potential loss of revenue from existing products that could occur if either project is undertaken.
When preparing the cash-flow forecasts for both projects, Soroka should include:
A
only the cost of the market research.
B
only the loss of revenue from existing products.
C
both the market research cost and the loss of revenue from existing products.
B
only the loss of revenue from existing products.
Capital allocation analysis should include only incremental cash flows associated with a new investment. The loss of revenue from existing products is an incremental negative effect that should be included in the analysis. The market research costs in this case are a sunk cost because the research has already been completed and therefore does not affect cash-flow estimates, no matter whether ABC undertakes either of these projects or neither of them.
208
Which of the following is true of the growth stage in a company’s development?
A
Cash flow may be negative or positive.
B
Cash flow is positive and growing quickly.
C
Cash flow is negative, by definition, with investment outlays exceeding cash flow from operations.
A
Cash flow may be negative or positive.
209
An analyst made the following statement:
“All else equal, if Modigliani and Miller's assumptions hold, adding more debt to TWP's capital structure will result in a higher asset beta."
Is the analyst’s claim in the statement most likely correct?
A
Yes
B
No, because adding debt will result in a lower asset beta
C
No, because adding debt will have no effect on the asset beta
C
No, because adding debt will have no effect on the asset beta
The asset beta is a measure of business risk, or the systematic risk that cannot be diversified away. Assuming no change in a company's business risk, changes to its capital structure will have no effect on its asset beta. Rather, the higher risk associated with an increase in a company's financial leverage would be captured by an increase in its equity beta. As a result of this change, shareholders are exposed to greater risk and will demand a higher return on equity, but (all else equal) the asset beta will remain constant.
210
Which of the following is least likely to be true with respect to agency costs and senior management compensation?
A
A well-designed compensation scheme should eliminate agency costs.
B
Equity-based incentive compensation is the primary method to address the problem of agency costs.
C
High cash compensation for senior management, without significant equity-based performance incentives, can lead to excessive caution and complacency.
A
A well-designed compensation scheme should eliminate agency costs.
A well-designed management compensation scheme can reduce, but not eliminate, agency costs.
211
Which of the following mature companies is most likely to use a high proportion of debt in its capital structure?
A
An electric utility
B
A mining company with a large, fixed asset base
C
A software company with very stable and predictable revenues and an asset-light business model
A
An electric utility
An electric utility has the capacity to support substantial debt, with very stable and predictable revenues and cash flows. The software company also has these attributes, but it would have been much less likely to have raised debt during its development and may have raised equity. The mining company has fixed assets, which it would have needed to finance, but the cyclical nature of its business would limit its debt capacity
212
Which of the following is the closest example of a one-sided network?
A
An online employment website
B
A social network for model train collectors
C
A website for home improvement contractors
B
A social network for model train collectors
A social network for model train collectors involves a single group of users and thus is closest to a one-side network. The others involve two user groups: employers and job-seekers in A, and homeowners and contractors in C.
213
Which of the following statements is most accurate? A company that markets and sells goods produced by other firms:
A
is a value added reseller.
B
receives licensing royalties.
C
has a contract manufacturing arrangement.
C
has a contract manufacturing arrangement.
Contract manufacturers produce that are marketed and sold by other firms that specialize in functions such as design and R&D.
A value added reseller distributes its own products while also providing complex services, such as customization, installation, and after-sales support.
Under a licensing arrangement, a company receives royalties for allowing other firms to manufacture and sell products that use its intellectual property.
214
A bundling pricing strategy is best suited to complementary products that have:
A
low profit margins and low marketing costs.
B
high profit margins and low marketing costs.
C
high profit margins and high marketing costs.
C
high profit margins and high marketing costs.
A bundling pricing strategy is particularly effective for selling complementary products with high incremental profit margins and high marketing costs relative to the cost of the product. For example, phone, internet, and cable television services.
215
hich of the following businesses is least likely to have network effects?
A
A telephone company
B
A price comparison website for travel airfares
C
A resume preparation service for online job seekers
C
A resume preparation service for online job seekers
The resume preparation service benefits from the network effects on various online job sites, but the service is not the source of those network effects.
The other businesses (A and B) become more valuable to their customers as they attract users. The telephone network is very useful because most people are on it. An airfare price comparison website is valuable to airlines because it has many shoppers and valuable to shoppers because it features prices for multiple airlines and routes.
216
Network effects are least likely to be an explicit consideration for a company that uses which of the following pricing strategies?
A
Dynamic pricing
B
Freemium pricing
C
Penetration pricing
A
Dynamic pricing
A dynamic pricing strategy is executed by charging different prices based on fluctuating demand, such as peak and off-peak rates. This strategy can be employed by many different types of companies and does not give explicit consideration to network effects. By contrast, both the freemium penetration pricing strategies are based on sacrificing revenues during an initial period in order to gain users and develop network effects.
217
A firm will most likely rely on estimates of opportunity cost if it uses:
A
cost-based pricing.
B
penetration pricing.
C
value-based pricing.
C
value-based pricing.
A value-based approach sets prices according to the value that a customer receives. Often, this involves estimating the opportunity cost of not making the purchase. For example, customers will be willing to pay a high price for a product or service that helps them avoid potentially catastrophic losses.
218
Over the long run, in an industry with perfect competition, the firm should most likely determine its optimal output quantity based on:
A
minimum efficient scale.
B
short-run average total cost.
C
marginal cost and marginal revenue.
A
minimum efficient scale.
To maximize long-run profit under perfect competition, a firm should operate at the minimum efficient scale point. On the other hand, the short-run (instead of long-run) profit is determined where marginal cost equals marginal revenue.
219
Deep River Manufacturing is one of many companies in an industry that make a food product. Deep River units are identical up to the point they are labeled. Deep River produces its labeled brand, which sells for $2.20 per unit, and “house brands” for seven different grocery chains which sell for $2.00 per unit. Each grocery chain sells both the Deep River brand and its house brand. The best characterization of Deep River’s market is:
A
oligopoly.
B
perfect competition.
C
monopolistic competition.
C
monopolistic competition.
There are many competitors in the market, but some product differentiation exists, as the price differential between Deep River’s brand and the house brands indicates.
220
Which of the following statements is most accurate? Firms operating in monopolistically competitive markets:
A
face low barriers to entry and high barriers to exit.
B
are able to exercise a limited amount of pricing power.
C
sell highly differentiated products that are not close substitutes for products offered by their competitors.
B
are able to exercise a limited amount of pricing power.
Monopolistically competitive markets are characterized by low barriers to both entry and exit. Firms that operating in these markets offer products that are close substitutes for each other.
221
Two firms, Alpha and Beta, operate in a duopoly market. Alpha, the industry's dominant firm, sets its output level. After observing Alpha's decision, Beta chooses its optimal output level. This dynamic gives Alpha a first-mover advantage. These actions are most likely consistent with the:
A
Nash model.
B
Cournot model.
C
Stackelberg model.
C
Stackelberg model.
The Stackelberg model assumes that firms make decisions sequentially. The leader firm makes its decision first. Then the follower firm makes its decision after observing the leader firm’s decision.
222
A firm in a perfectly competitive market is operating at a point where marginal revenue is less than marginal cost. The firm should most likely:
A
increase production to return to profitability.
B
decrease production to return to profitability.
C
minimize losses in the short run by maintaining current production levels until prices allow for a return to profitability over the long run.
B
decrease production to return to profitability.
223
Companies most likely have a well-defined supply function when the market structure is:
A
oligopoly.
B
perfect competition.
C
monopolistic competition.
B
perfect competition.
A company in a perfectly competitive market must accept whatever price the market dictates. The marginal cost schedule of a company in a perfectly competitive market determines its supply function.
224
What most likely happens in a monopolistically competitive industry as the market moves toward a long-run equilibrium?
A
New entrants come in and take away customers, reducing economic profits for incumbents
B
The number of incumbents will be reduced as larger companies acquire smaller competitors
C
The long-run level of output will approach the quantity produced by a perfectly competitive market
A
New entrants come in and take away customers, reducing economic profits for incumbents
225
Under conditions of perfect competition, a company will break even when market price is equal to the minimum point of the:
A
average total cost curve.
B
average variable cost curve.
C
short-run marginal cost curve.
A
average total cost curve.
226
One disadvantage of the Herfindahl–Hirschmann Index is that the index:
A
is difficult to compute.
B
fails to reflect low barriers to entry.
C
fails to reflect the effect of mergers in the industry.
B
fails to reflect low barriers to entry.
227
A company doing business in a monopolistically competitive market will most likely maximize profits when its output quantity is set such that:
A
average cost is minimized.
B
marginal revenue equals average cost.
C
marginal revenue equals marginal cost.
C
marginal revenue equals marginal cost.
228
A firm that increases its quantity produced without any change in per-unit cost is experiencing:
A
economies of scale.
B
diseconomies of scale.
C
constant returns to scale.
C
constant returns to scale.
Output increases in the same proportion as input increases occur at constant returns to scale.
229
In an industry comprised of three companies, which are small-scale manufacturers of an easily replicable product unprotected by brand recognition or patents, the most representative model of company behavior is:
A
oligopoly.
B
perfect competition.
C
monopolistic competition.
B
perfect competition.
The credible threat of entry holds down prices and multiple incumbents are offering undifferentiated products.
230
According to the Cournot model, a company operating in an oligopoly market most likely sets its output level assuming that which of the following will not change?
A
Its competitors' prices
B
Its competitors' output
C
Aggregate industry-level demand
B
Its competitors' output
in an oligopoly, the industry is concentrated among relatively few firms. Unlike a pure monopoly where there are no competitors and pure competition where firms are price takers, the key challenge in an oligopoly is understanding the interactions with other producers. The Cournot model provides a framework for managing interactions between firms in this type of setting.
231
Over the long run, in an industry with perfect competition, the firm should most likely determine its optimal output quantity based on:
A
minimum efficient scale.
B
short-run average total cost.
C
marginal cost and marginal revenue.
A
minimum efficient scale.
To maximize long-run profit under perfect competition, a firm should operate at the minimum efficient scale point. On the other hand, the short-run (instead of long-run) profit is determined where marginal cost equals marginal revenue.
The minimum efficient scale point is the lowest point on the long-run average total cost (LRAC). It is not determined by the short-run average total cost (SATC).
232
A firm operating in a perfectly competitive market will most likely shut down production in the short run if marginal revenue is less than:
A
average total cost.
B
average fixed cost.
C
average variable cost.
C
average variable cost.
233
Two firms, Alpha and Beta, operate in a duopoly market. Alpha, the industry's dominant firm, sets its output level. After observing Alpha's decision, Beta chooses its optimal output level. This dynamic gives Alpha a first-mover advantage. These actions are most likely consistent with the:
A
Nash model.
B
Cournot model.
C
Stackelberg model.
C
Stackelberg model.
234
Which of the following statements is most accurate? Firms operating in monopolistically competitive markets:
A
face low barriers to entry and high barriers to exit.
B
are able to exercise a limited amount of pricing power.
C
sell highly differentiated products that are not close substitutes for products offered by their competitors.
B
are able to exercise a limited amount of pricing power.
235
Which of the following statements is most accurate? Compared to its concurrent business cycle, a typical credit cycle:
A
peaks later.
B
has a shorter duration.
C
has a steeper trajectory.
C
has a steeper trajectory.
236
Which of the following most likely to be interpreted as an indicator of a future economic expansion?
A
Higher trade sales
B
Higher weekly manufacturing hours
C
Lower average unemployment duration
B
Higher weekly manufacturing hours
237
Current economic statistics indicating little change in services inflation, rising residential building permits, and increasing average duration of unemployment are best interpreted as:
A
conflicting evidence about the direction of the economy.
B
evidence that a cyclical upturn is expected to occur in the future.
C
evidence that a cyclical downturn is expected to occur in the future.
B
evidence that a cyclical upturn is expected to occur in the future.
Rising building permits—a leading indicator—indicate that an upturn is expected to occur or continue.
Increasing average duration of unemployment—a lagging indicator—indicates that a downturn has occurred,
the lack of any change in services inflation—also a lagging indicator—is neither negative nor positive for the direction of the economy.
Taken together, these statistics indicate that a cyclical upturn may be expected to occur.
238
An increase in new capital goods orders and a decrease in the weekly number of initial unemployment insurance claims are most accurately characterized as:
A
leading indicators of an economic expansion.
B
coincident indicators of an economic expansion.
C
a leading and a lagging indictor, respectively, of an economic expansion.
A
leading indicators of an economic expansion.
Increases in new orders for capital goods and decreases in unemployment insurance claims are both leading indicators of an economic expansion.
239
The inventory–sales ratio is most likely to be rising:
A
as a contraction unfolds.
B
partially into a recovery.
C
near the top of an economic cycle.
C
near the top of an economic cycle.
Near the top of a cycle, sales begin to slow before production is cut, leading to an increase in inventories relative to sales.
240
The characteristic business cycle patterns of trough, expansion, peak, and contraction are most likely:
A
periodic.
B
recurrent.
C
of similar duration.
B
recurrent.
The stages of the business cycle occur repeatedly over time.
241
The relative strength of an economic trend, as measured by the proportion of economic indicators moving in the same direction, is most likely provided by a:
A
Paasche index.
B
diffusion index.
C
Laspeyres index.
B
diffusion index.
A diffusion index reflects the proportion of indicators that are moving in a pattern that is consistent with the overall index. It serves to summarize the common elements of a group of data points.
Paasche and Laspeyres indexes are used to assess price inflation.
242
Based on typical labor utilization patterns across the business cycle, productivity (output per hours worked) is most likely to be highest:
A
at the peak of a boom.
B
into a maturing expansion.
C
at the bottom of a recession.
C
at the bottom of a recession.
At the end of a recession, firms will run “lean production” to generate maximum output with the fewest number of workers.
243
In a recession, companies are most likely to adjust their stock of physical capital by:
A
selling it at fire sale prices.
B
not maintaining equipment.
C
quickly canceling orders for new construction equipment.
B
not maintaining equipment.
Physical capital adjustments to downturns come through aging of equipment plus lack of maintenance.
244
An economic peak is most closely associated with:
A
accelerating inflation.
B
stable unemployment.
C
declining capital spending.
A
accelerating inflation.
245
During the contraction phase of a business cycle, it is most likely that:
A
inflation indicators are stable.
B
aggregate economic activity relative to potential output is decreasing.
C
investor preference for government securities declines.
B
aggregate economic activity relative to potential output is decreasing.
The net trend during contraction is negative.
246
Which of the following is most likely to increase after an increase in aggregate real personal income?
A
Equity prices
B
Building permits for new private housing units
C
The ratio of consumer installment debt to income
C
The ratio of consumer installment debt to income
Aggregate real personal income is a coincident indicator of the business cycle, and the ratio of consumer installment debt to income is a lagging indicator. Increases in the ratio of consumer installment debt follow increases in average aggregate income during the typical business cycle.
247
An analyst writes in an economic report that the current phase of the business cycle is characterized by accelerating inflationary pressures and borrowing by companies. The analyst is most likely referring to the:
A
peak of the business cycle.
B
contraction phase of the business cycle.
C
early expansion phase of the business cycle.
A
peak of the business cycle.
Accelerating inflation and rapidly expanding capital expenditures typically characterize the peak of the business cycle. During such times, many businesses finance their capital expenditures with debt to expand their production capacity.
248
The least likely goal of a government’s fiscal policy is to:
A
redistribute income and wealth.
B
influence aggregate national output.
C
ensure the stability of the purchasing power of its currency.
C
ensure the stability of the purchasing power of its currency.
Ensuring stable purchasing power is a goal of monetary rather than fiscal policy. Fiscal policy involves the use of government spending and tax revenue to affect the overall level of aggregate demand in an economy and hence the level of economic activity.
249
The delay attributable to the time required for a government's fiscal policies to take effect after being enacted is most accurately described as the:
A
action lag.
B
impact lag.
C
recognition lag.
B
impact lag.
250
Which of the following is the most likely example of a tool of fiscal policy?
A
Public financing of a power plant.
B
Regulation of the payment system.
C
Central bank’s purchase of government bonds.
A
Public financing of a power plant.
Public financing of a power plant could be described as a fiscal policy tool to stimulate investment.
251
A contractionary fiscal policy will always involve which of the following?
A
Balanced budget
B
Reduction in government spending
C
Fall in the budget deficit or rise in the surplus
B
Reduction in government spending
Note that a reduction in government spending could be accompanied by an even bigger fall in taxation, making it be expansionary.
252
Given an independent central bank, monetary policy actions are more likely than fiscal policy actions to be:
A
implementable quickly.
B
effective when a specific group is targeted.
C
effective when combating a deflationary economy.
A
implementable quickly.
Monetary actions may face fewer delays to taking action than fiscal policy, especially when the central bank is independent.
253
Which statement regarding fiscal policy is most accurate?
A
Cyclically adjusted budget deficits are appropriate indicators of fiscal policy.
B
To raise business capital spending, personal income taxes should be reduced.
C
An increase in the budget surplus is associated with expansionary fiscal policy.
A
Cyclically adjusted budget deficits are appropriate indicators of fiscal policy.
Cyclically adjusted budget deficits are appropriate indicators of fiscal policy. These are defined as the deficit that would exist if the economy was at full employment (or full potential output).
254
In a country with a marginal propensity to consume of less than 1, the effect of an equivalent increase in taxes and government spending will most likely be:
A
no change in total spending.
B
a decrease in aggregate output.
C
an increase in aggregate demand.
C
an increase in aggregate demand.
When a country's marginal propensity to consume is less than 1, an increase in taxes and government spending will result in a net increase in aggregate spending due to the balanced budget multiplier effect.
255
Which role is a central bank least likely to assume?
A
Lender of last resort.
B
Sole supervisor of banks.
C
Supplier of the currency.
B
Sole supervisor of banks.
The supervision of banks is not a role that all central banks assume. When it is a central bank’s role, responsibility may be shared with one or more entities.
256
Which of the following statements is most accurate? Fiat money:
A
must be backed by gold reserves.
B
is based on the convertibility principle.
C
derives its value from a government decree.
C
derives its value from a government decree.
Countries that adhered to the gold standard issued bank notes that could be redeemed for a specified amount of gold. However, in the first half of the 20th century, countries largely abandoned the gold standard in favor of fiat money, which cannot be convertible into any other commodity. It is not backed by gold reserves, but rather derives its value from a government decree.
257
Eastland is a large country with a developed, diversified economy. After experiencing a minor recession last year, the country's economy is currently expanding at close to its underlying real trend trend growth rate of 2.4% and inflation is near the central bank's 2% target rate. Over the past six months, Eastland's fiscal policy has tightened significantly. This tightening is most likely attributable to:
A
political pressure.
B
automatic stabilizers.
C
monetary accommodation.
B
automatic stabilizers.
In general, fiscal policy is relatively difficult to implement significant changes to fiscal policy over the short term due to political concerns. When politicians are able to make fiscal policy changes relatively quickly, loosening is far more common than tightening. When fiscal tightening does occur, it is most often due to automatic stabilizers. For example, fiscal policy will automatically tighten as the need for unemployment benefits decreases during an economic recovery.
Monetary accommodation involves the loosening of monetary policy to support loose fiscal policies in response to an economic downturn.
258
The least likely limitation to the effectiveness of monetary policy is that central banks cannot:
A
accurately determine the neutral rate of interest.
B
regulate the willingness of financial institutions to lend.
C
control amounts that economic agents deposit into banks.
A
accurately determine the neutral rate of interest.
The inability to determine exactly the neutral rate of interest does not necessarily limit the power of monetary policy.
259
Under which combination of monetary and fiscal policy is public sector spending most likely to increase as a proportion of the economy?
A
Easy monetary policy and easy fiscal policy
B
Tight monetary policy and easy fiscal policy
C
Easy monetary policy and tight fiscal policy
B
Tight monetary policy and easy fiscal policy
aggregate economic output will increase due to the additional public spending from an expansionary fiscal policy. However, the impact of tight monetary policy will be lower private sector demand. The net effect will be an increase in government spending as a proportion of GDP.
260
An applicable conclusion drawn from the Geopolitical Risk Index (GPR) is that:
A
high geopolitical risk results in tangible macroeconomic effects.
B
recurring geopolitical risk events lead to reduced corporate investment.
C
the adverse impact of actual events is greater over time than that of the threat of such events.
A
high geopolitical risk results in tangible macroeconomic effects.
A is correct. The GPR index creators found that high levels of geopolitical risk reduce US investment, employment, and price level of the stock market.
B is incorrect because firms reduce investment in the wake of idiosyncratic events, which would be unlikely to repeat.
C is incorrect because the threat of an event was shown to have a larger impact over time than that of the actual events thems
261
Which of the following international trade bodies was the only multilateral body governing international trade from 1948 to 1995?
A
World Trade Organization (WTO).
B
International Trade Organization (ITO).
C
General Agreement on Tariffs and Trade (GATT).
C
General Agreement on Tariffs and Trade (GATT).
262
Which of the following actions by a country is most likely a form of geopolitical cooperation?
A
Acting as a conduit for trade
B
Engaging in rules standardization
C
Opting to use soft power over military retaliation
B
Engaging in rules standardization
B is correct. Political cooperation is associated with anything related to agreements of rules and standardization, with countries working together towards some shared goal. A cooperative country is one that engages and reciprocates in rules standardization.
A is incorrect because acting as a conduit of trade, like Panama, involves non-cooperatively using a country’s geographic location as a lever of power in broader international dynamics.
263
The free exchange of currency across borders is most accurately classified as which type of geopolitical tool?
A
Financial
B
Economic
C
National security
A
Financial
264
Which of the following statements is most accurate? The process of globalization:
A
requires the harmonization of rules.
B
is independent of political cooperation.
C
cannot be advanced without the support of state actors.
B
is independent of political cooperation.
While globalization can be facilitated and accelerated by political cooperation, it is an independent process that can be driven even without government support or harmonized rules. Non-state actors can advance the process of globalization through exchanges of products, technologies, ideas, etc.
265
Exogenous risks are best described as those that:
A
are known and evolve and expand over a period of time.
B
evolve around set dates, such as elections, new legislation, or other date-driven milestones, such as holidays or political anniversaries.
C
are sudden or unanticipated and impact either a country’s cooperative stance, the ability of non-state actors to globalize, or both.
C
are sudden or unanticipated and impact either a country’s cooperative stance, the ability of non-state actors to globalize, or both.
266
Which of these actions would do the most to increase geopolitical risk?
A
Increase capital flows
B
Restrict foreign currency exchange
C
Engage in trade of goods and services
B
Restrict foreign currency exchange
B is correct. Restricted foreign currency exchange—a characteristic of anti-globalization—would likely reduce political and economic cooperation and thus increase geopolitical risk.
267
Which of the following organizations helps to keep global systemic risk under control by preventing contagion in scenarios such as the 2010 Greek sovereign debt crisis?
A
World Bank Group (World Bank).
B
World Trade Organization (WTO).
C
International Monetary Fund (IMF).
C
International Monetary Fund (IMF).
From an investment perspective, the IMF helps to keep country-specific market risk and global systemic risk under control. The Greek sovereign debt crisis on 2010, which threatened to destabilize the entire European banking system, is a recent example. The IMF’s mission is to ensure the stability of the international monetary system, the system of exchange rates and international payments which enables countries to buy goods and services from each other.
268
In the context of geopolitical relationships, regionalism is most accurately characterized as a practical approach that falls between the extremes of:
A
autarky and globalization.
B
bilateralism and multilateralism.
C
anti-globalization and cooperation.
B
bilateralism and multilateralism.
A bilateral approach to political, economic, financial, and cultural dealings with the rest of the world involves one-at-a-time agreements with only one other partner.
By contrast a truly multinational approach pursues cooperation on a global scale.
Regionalism is a practical approach that falls in the middle of the spectrum between these two extremes.
269
n example of a geopolitical multi-tool for furthering national interests is:
A
cabotage.
B
armed conflict.
C
nationalization of key export industries.
A
cabotage.
A is correct. Cabotage is the right to transport passengers or goods within a country by a foreign firm. Many countries—including those with multilateral trade agreements—impose restrictions on cabotage across transportation subsectors, meaning that shippers, airlines, and truck drivers are not allowed to transport goods and services within another country’s borders. Allowing cabotage requires coordination on areas like physical security and economic coordination, a highly multilateral (multi-tool) process.
270
The use of voluntary export restraints is an economic tool that is most closely associated with which geopolitical model?
A
Autarky
B
Hegemony
C
Bilateralism
A
Autarky
Voluntary export restraints (VERs) are implemented unilaterally to advance a county's economic interest. This tool falls in the non-cooperation/nationalism quadrant of the geopolitical risk assessment framework, which is aligned with the autarky model.
271
The role of the International Development Association (IDA) is most accurately described as:
A
resolving global economic imbalances.
B
facilitating the coordination of trade policies.
C
lending to countries with developing economies.
C
lending to countries with developing economies.
The IDA operates as a not-for-profit bank, providing low-interest or no-interest loans to countries with limited access to international debt markets. It is closely affiliated with the World Bank.
272
Which of the following statements is most accurate? A country's geophysical resource endowment:
A
Geophysical resource endowments shape the dynamics of engagement between state actors.
B
A country's geophysical resource endowment is defined as its access to tradable commodities that are necessary for sustainable growth.
C
All else equal, a larger geophysical resource endowment contributes to internal political stability.
A
Geophysical resource endowments shape the dynamics of engagement between state actors.
273
Which of the following international trade organizations has a mission to help developing countries fight poverty and enhance environmentally sound economic growth?
A
World Bank Group (World Bank).
B
World Trade Organization (WTO).
C
International Monetary Fund (IMF).
A
World Bank Group (World Bank).
A is correct. The World Bank’s mission is to help developing countries fight poverty and enhance environmentally sound economic growth. The World Bank helps to create the basic economic infrastructure essential for creation and maintenance of domestic financial markets and a well-functioning financial industry in developing countries.
274
Which of the following statements is most accurate? The process of globalization:
A
requires the harmonization of rules.
B
is independent of political cooperation.
C
cannot be advanced without the support of state actors.
B
is independent of political cooperation.
275
In determining the impact of tariffs on national welfare, the most accurate definition of a small country is one that:
A
has a lower per capita GDP than its trading partner.
B
must accept the market price for the good or service being traded.
C
does not enjoy a comparative advantage in the good or service being traded.
B
must accept the market price for the good or service being traded.
The impact of a tariff on national welfare depends on the importing country's relative size. If a country is sufficiently large, tariffs on imports may increase the national welfare. However, imposing a tariff will always reduce the national welfare of a small country. In the context of this analysis, a country is considered to be small if it is a price taker, meaning that it does not have the ability to influence the market price of a good or service.
276
A country is most likely to implement countervailing duties in response to a trading partner's use of:
A
tariffs.
B
import quotas.
C
export subsidies.
C
export subsidies.
Export subsidies are payments made by governments to domestic firms with the objective of stimulating exports. Firms have an incentive to sell their products internationally, increasing the country's share of the global market. Trading partners often response by imposing countervailing duties on subsidized exports.
277
Which of the following international trading arrangements most likely involves the lowest level of integration between member states?
A
Free trade area
B
Economic union
C
Common market
A
Free trade area
278
Which of the following factors best explains why regional trading agreements are more popular than larger multilateral trade agreements?
A
Minimal displacement costs.
B
Trade diversions benefit members.
C
Quicker and easier policy coordination.
C
Quicker and easier policy coordination.
279
In a country that has adopted the US dollar as its medium of exchange, the central bank most likely:
A
must ensure the same interest rate on US dollar deposits as in the United States.
B
cannot use monetary policy to facilitate the growth of international trade and capital flows.
C
must maintain sufficient foreign exchange reserves to monetize the full amount of domestic government debt.
B
cannot use monetary policy to facilitate the growth of international trade and capital flows.
Countries that use a dollarization regime forego the ability to conduct independent monetary policy. This lack of independence makes it impossible for central banks to monetize government debt.
280
A requirement to obtain government approval for transactions involving certain types of assets is most accurately classified in which category of capital restrictions?
A
Price controls
B
Quantity controls
C
Administrative controls
C
Administrative controls
In the context of capital restrictions, administrative controls include measures such as requiring government approval for transactions involving certain types of assets.
Price controls typically take the form of taxes on certain types of transactions or mandatory reserve requirements.
Quantity controls involve limits on or requiring approvals for new or existing loans from foreign lenders.
281
A fixed exchange rate regime in which the monetary authority is legally required to hold foreign exchange reserves backing 100% of its domestic currency issuance is best described as:
A
dollarization.
B
a currency board.
C
a monetary union.
B
a currency board.
With a currency board, the monetary authority is legally required to exchange domestic currency for a specified foreign currency at a fixed exchange rate. It cannot issue domestic currency without receiving foreign currency in exchange, and it must hold that foreign currency as a 100% reserve against the domestic currency issued. Thus, the country’s monetary base (bank reserves plus notes and coins in circulation) is fully backed by foreign exchange reserves.
282
A company based in Switzerland collects revenues in Swiss francs (CHF) and makes purchases from suppliers based in the Eurozone. All else equal, the real exchange rate (in CHF/EUR) is least likely to increase as a result of an increase in:
A
Swiss inflation.
B
Eurozone inflation.
C
the nominal spot CHF/EUR exchange rate.
A
Swiss inflation.
From the equation above, all else equal, the real CHF/EUR exchange rate will:
Increase due to increases in either Eurozone inflation or the nominal spot CHF/EUR exchange rate.
Decrease as a result of higher Swiss inflation.
283
Which of the following is not a condition of an ideal currency regime?
A
Fully convertible currencies.
B
Fully independent monetary policy.
C
Independently floating exchange rates.
C
Independently floating exchange rates.
An ideal currency regime would have credibly fixed exchange rates among all currencies. This would eliminate currency-related uncertainty with respect to the prices of goods and services as well as real and financial assets.
284
A country with a trade deficit will most likely:
A
have an offsetting capital account surplus.
B
save enough to fund its investment spending.
C
buy assets from foreigners to fund the imbalance.
A
have an offsetting capital account surplus.
A trade deficit must be exactly matched by an offsetting capital account surplus to fund the deficit. A capital account surplus reflects borrowing from foreigners (an increase in domestic liabilities) and/or selling assets to foreigners (a decrease in domestic assets). A capital account surplus is often referred to as a “capital inflow” because the net effect is foreign investment in the domestic economy.
285
Which of the following statements is most accurate? In a country that has adopted a fixed parity regime, the central bank:
A
cannot act as a lender of last resort.
B
will allow the exchange rate to float within a band around one or more currencies.
C
must maintain sufficient foreign currency reserves to back to entire monetary base.
B
will allow the exchange rate to float within a band around one or more currencies.
Fixed parity regimes allow the domestic currency to float within a band of ± 1% around the target exchange rate with either a single foreign currency or a basket of foreign currencies.
Unlike a currency board system, a fixed parity regime does not require the central bank to back the entire monetary base with foreign reserves. Some discretion is allowed in setting the target level of foreign exchange reserves.
Although monetary policy independence is limited under fixed parity regimes, central banks may still act as the lender of last resort.
286
If the base currency in a forward exchange rate quote is trading at a forward discount, which of the following statements is most accurate?
A
The forward points will be positive.
B
The forward percentage will be negative.
C
The base currency is expected to appreciate versus the price currency.
B
The forward percentage will be negative.
The base currency trading at a forward discount means that 1 unit of the base currency costs less for forward delivery than for spot delivery; i.e., the forward exchange rate is less than the spot exchange rate. The forward points, expressed either as an absolute number of points or as a percentage, are negative.
287
A Japanese company seeking to hedge the exchange rate risk attributable to a large USD-denominated payment expected from an American customer in six months would most likely:
A
sell USD in the spot market.
B
buy JPY in the forward market.
C
buy USD in the forward market.
B
buy JPY in the forward market.
Because the Japanese company is expecting a payment denominated in USD, it has long USD exposure. If the company does not hedge this exposure, it will suffer in the event that the USD depreciates relative to the JPY over the next six months. This exposure can be hedged by entering a forward contract to sell USD and buy JPY.
288
The bond issue trading at the highest bid–offer spread is most likely a:
A
recently issued sovereign bond.
B
seasoned investment-grade corporate bond.
C
recently issued investment-grade corporate bond.
B
seasoned investment-grade corporate bond.
Bonds of less frequent corporate issuers or more seasoned bonds of frequent issuers are rarely traded, leading dealers to quote bid–offer spreads of at least 10–20 basis points or more for small sizes.
The most recently issued, or on-the-run, developed market sovereign bonds are typically the most liquid fixed-income securities, with primary dealers making active markets in large size with bid–offer spreads equal to a fraction of a basis point. Among corporate issuers, recently issued corporate bonds from frequent issuers of higher credit quality usually exhibit the greatest liquidity and tightest bid–offer spreads.
289
A bond issued internationally, outside the jurisdiction of the country in whose currency the bond is denominated, is best described as a:
A
Eurobond.
B
foreign bond.
C
municipal bond.
A
Eurobond.
A bond denominated in Japanese Yen and issued in the UK (Euroyen bond)
A bond denominated in US dollars and issued in France or the UK (Eurodollar bond)
A bond denominated in Swiss francs and issued in Singapore (Euroswiss bond)
290
Institutional investors have expressed concern about increased credit risk due to Digistrype’s planned expansion outside of its core business. Digistrype’s CFO would prefer to fund the expansion using debt, despite an expectation of lower market interest rates in the next few years. The CFO is also considering removing the conversion feature because of a concern about the possible share dilution if the bonds are converted to equity and a belief that DILO shares are significantly undervalued.
Which of the following is the best contingency feature Digistrype could add to mitigate its own concerns regarding lower interest rates?
A
Add a call provision to the proposed new debt.
B
Add a put provision to the proposed new debt.
C
Add a step-up coupon to the proposed new debt.
A
Add a call provision to the proposed new debt.
A call provision gives Digistrype the right to redeem all or part of the bond prior to maturity if interest rates decline, so new debt could be issued at a lower cost.
291
When issuing debt, a company may use a sinking fund arrangement as a means of reducing:
A
credit risk.
B
inflation risk.
C
interest rate risk.
A
credit risk.
A sinking fund arrangement is a way to reduce credit risk by making the issuer set aside funds over time to retire the bond issue.
B and C are incorrect because a sinking fund arrangement has no effect on inflation risk or interest rate risk.
292
If you purchased a pure discount bond, you would most likely earn income from:
A
coupon payments only.
B
excess of maturity value over purchase price only.
C
both coupon payments and excess of maturity value over purchase price.
B
excess of maturity value over purchase price only.
A pure discount bond sells at a discount and accrues value up to maturity.
Pure discount bonds are also known as zero-coupon bonds since they do not pay coupon payments. They only have one cash flow, which is the repayment of principal at maturity.
293
A Swedish company recently issued a bond denominated in US dollars. The price of the bond is least likely impacted by:
A
US interest rates.
B
the exchange rate.
C
Swedish interest rates.
C
Swedish interest rates.
The currency denomination of a bond’s cash flows determines which country’s interest rates affect the bond’s price. The price of the USD-denominated bond will be affected by US interest rates as well as the exchange rate between the US dollar and the Swedish krona.
294
In major developed bond markets, newly issued sovereign bonds are most often sold to the public via a(n):
A
auction.
B
private placement.
C
best-efforts offering.
A
auction.
295
An investor purchases a 5-year, 4.5% annual coupon bond with a face value of $1,000 at par and is promised level payments of $200.37 in each of the first four years of the bond's life as well as a larger payment of $350.37 at maturity. This bond is most likely considered a:
A
bullet bond.
B
fully amortized bond.
C
partially amortized bond.
C
partially amortized bond.
A partially amortized bond makes fixed period payments until maturity, at which time any remaining unamortized principal is repaid. In this example, the $150 difference between the final payment at maturity and the level annual payments represents the amount of principal that was not amortized over the course of the bond's lifetime.
A bullet bond makes only interest payments prior to maturity, at which point the full amount of the bond's principal is repaid. In this case, annual payments would have been $45 for the first 4 years and $1,045 ($1000 principal + $45 interest) would have been paid at the end of the 5th year.
296
Compared to public offerings, private placements most likely provide issuers with the advantage of:
A
greater liquidity.
B
lower disclosure requirements.
C
access to a larger pool of institutional investors.
B
lower disclosure requirements.
297
bond issued by a local government authority, typically without an explicit funding commitment from the national government, is most likely classified as a:
A
sovereign bond.
B
quasi-government bond
C
non-sovereign government bond.
C
non-sovereign government bond.
Bonds issued by levels of government below the national level—such as provinces, regions, states, cities, and local government authorities—are classified as non-sovereign government bonds.
These bonds are typically not guaranteed by the national government.
297
Which of the following best describes a negative bond covenant? The requirement to:
A
insure and maintain assets.
B
comply with all laws and regulations.
C
maintain a minimum interest coverage ratio.
C
maintain a minimum interest coverage ratio.
Negative covenants enumerate what issuers are prohibited from doing. Restrictions on debt, including maintaining a minimum interest coverage ratio or a maximum debt usage ratio, are typical examples of negative covenants.
298
Agency bonds are issued by:
A
local governments.
B
national governments.
C
quasi-government entities.
C
quasi-government entities.
Agency bonds are issued by quasi-government entities. These entities are agencies and organizations usually established by national governments to perform various functions for them.
299
A sovereign government would most likely be motivated to issue floating-rate debt in order to:
A
eliminate interest rate risk.
B
reduce its own exposure to interest rate risk.
C
reduce investors' exposure to interest rate risk.
C
reduce investors' exposure to interest rate risk.
300
characteristic of negotiable certificates of deposit is:
A
they are mostly available in small denominations.
B
they can be sold in the open market prior to maturity.
C
a penalty is imposed if the depositor withdraws funds prior to maturity.
B
they can be sold in the open market prior to maturity.
301
A non-sovereign bond issued to fund public goods and services in the non-sovereign’s limited jurisdiction that is repaid from local tax cash flows is referred to as:
A
a GO bond.
B
a revenue bond.
C
an agency bond.
A
a GO bond.
A is correct. General obligation bonds are used to fund public goods and services in the non-sovereign’s limited jurisdiction and are repaid from local tax cash flows.
302
wing Corp. is a large corporation that has an existing relationship with Sycamore Bank. Ewing is seeking short-term financing from a committed line of credit; however, Sycamore will offer only an uncommitted line of credit. Which of the following best supports Sycamore’s decision?
A
Sycamore will receive an upfront commitment fee on the uncommitted line of credit.
B
Sycamore will require less bank capital for the uncommitted line than for the committed line of credit.
C
Sycamore can form a syndicate to reduce the amount of committed capital needed under an uncommitted line of credit.
B
Sycamore will require less bank capital for the uncommitted line than for the committed line of credit.
B is correct. Committed lines require more bank capital than uncommitted lines, although commitments of less than a year (usually 364 days) minimize a bank’s capital requirement.
A is incorrect because Sycamore will receive an upfront commitment fee on a committed line of credit.
303
An investment vehicle based on cash flows from an underlying pool of mortgages offering tranches that carry a high level of prepayment risk is most likely a:
A
mortgage pass-through security.
B
collateralized mortgage obligation.
C
commercial mortgage-backed security.
B
collateralized mortgage obligation.
Collateralized mortgage obligations (CMOs) are a form of mortgage-backed security (MBS) that redistributes cash flows among tranches, which give investors the ability to choose their desired level of cash flow risk. Note that, because of how a CMO is structured, prepayment risk cannot be reduced or eliminated - only redistributed.
Mortgage pass-through securities are not divided into tranc
304
Which of the following measures is most appropriate to use to estimate the impact of a 0.25% increase in interest rates at all maturities on bond's price in terms of units of currency?
A
Money duration only
B
Modified duration only
C
Either Macaulay duration or modified duration
A
Money duration only
Money duration measures the price change in units of the currency in which a bond is denominated given a change in its yield-to-maturity.
Macaulay duration indicates the point in time when a coupon reinvestment and price effects of a change in yield-to-maturity offset one another.
The modified duration measure estimates the impact of a parallel yield curve shift in percentage terms.
305
Compared to an option-free, fixed-rate security, a floating-rate note most likely carries:
A
less interest rate risk in any interest rate environment.
B
less interest rate risk only when interest rates are rising.
C
greater interest rate risk in any interest rate environment.
A
less interest rate risk in any interest rate environment.
Interest rate risk is defined as the risk that a bond's value will be affected by fluctuating interest rates. Because their coupon rates are periodically reset to prevailing market rates, floating-rate notes (FRNs) carry minimal interest rate risk. As a result, FRNs typically trade close to their par value. Although prices of FRNs may change in response to a change in the credit quality of their issuer, these securities carry less interest rate risk than plain vanilla fixed-rate securities in any interest rate environment.
306
Which of the following statements about asset-backed securities and covered bonds is most accurate?
A
Covered bonds usually have lower credit risk and higher prepayment risk than an otherwise similar ABS
B
Asset-backed securities have a static pool of underlying assets while covered bonds are backed by a dynamic cover pool
C
Asset-backed securities offer investors recourse to the underlying assets while covered bonds offer recourse to the issuing financial institutio
B
Asset-backed securities have a static pool of underlying assets while covered bonds are backed by a dynamic cover pool
In contrast to asset-backed securities (e.g., mortgage-backed securities) that are backed by a static pool of underlying loans that expose investors to prepayment risk, cover pool sponsors must replace any prepaid or non-performing assets in the cover pool to ensure sufficient cash flows until the maturity of the covered bond.
307
Compared to a multiple-price auction process for a sovereign bond issue, a single-price auction is most likely to result in:
A
a wider range of bids a lower cost of funds.
B
a narrower range of bids a lower cost of funds.
C
a narrower range of bids a higher cost of funds.
A
a wider range of bids a lower cost of funds.
A single-price auction requires all bonds in the issue to be purchased for the same price. In other words, those who submit bids with lower yields can benefit from higher-yield (lower price) bids. This dynamic tends to reduce the issuer's borrowing costs because participants can submit low-yield competitive bids that have a high likelihood of being accepted while knowing that the yield they actually receive is likely to be higher.
By contrast, in a multiple-price auction, participants are required to pay the specific price that they have bid. This structure incentivizes a narrower range of bids.
308
Which of the following is a benefit to a bank that makes short-term loans and issues asset-backed commercial paper?
A
The bank receives commercial paper when the ABCP is issued.
B
Capital costs are reduced by providing undrawn backup liquidity instead of holding the short-term loans to maturity.
C
The bank purchases a liquid, short-term note with interest and principal payments from a short-term loan portfolio to which it would otherwise not have direct access.
B
Capital costs are reduced by providing undrawn backup liquidity instead of holding the short-term loans to maturity.
B is correct. The bank will reduce capital costs by providing undrawn backup liquidity instead of holding the short-term loans to maturity.
309
Which of the following is a source of wholesale funds for banks?
A
Demand deposits
B
Money market accounts
C
Negotiable certificates of deposit
C
Negotiable certificates of deposit
C is correct. Wholesale funds available for banks include central bank funds, interbank funds, and negotiable certificates of deposit.
A and B are incorrect because demand deposits (also known as checking accounts) and money market accounts are retail deposits, not wholesale funds.
310
All else equal, which of the following factors would most likely reduce the repo rate for a repurchase agreement?
A
Lengthening the maturity
B
Using widely-available collateral
C
Requiring physical delivery of collateral
C
Requiring physical delivery of collateral
Requiring collateral delivery gives the lender possession of collateral in case of default and greater assurance of repayment, resulting in a lower repo rate.
Widely-available collateral is less valuable than collateral that has scarcity value. Using more common collateral is associated with a higher repo rate.
Repo rates tend to rise as maturity lengthens.
311
Agency bonds are issued by:
A
local governments.
B
national governments.
C
quasi-government entities.
C
quasi-government entities.
C is correct. Agency bonds are issued by quasi-government entities. These entities are agencies and organizations usually established by national governments to perform various functions for them.
312
Which of the following statements describing a par curve is incorrect?
A
A par curve is obtained from a spot curve.
B
All bonds on a par curve are assumed to have different credit risk.
C
A par curve is a sequence of yields-to-maturity such that each bond is priced at par value.
B
All bonds on a par curve are assumed to have different credit risk.
All bonds on a par curve are assumed to have similar, not different, credit risk. Par curves are obtained from spot curves, and all bonds used to derive the par curve are assumed to have the same credit risk, as well as the same periodicity, currency, liquidity, tax status, and annual yields.
A par curve is a sequence of yields-to-maturity such that each bond is priced at par value.
313
A fixed-income portfolio manager is looking to value a one-year US dollar–denominated floating-rate note that has quarterly payments based on 90-day MRR plus 80 bps. Assume the following information:
90-Day MRR: 2.5%
Quoted Margin: 80 bps
Discount Margin: 100 bps
Face Value: USD100
Without doing any calculation, this floating-rate note is priced at:
A
a premium.
B
a discount.
C
par.
B
a discount.
This FRN is priced at a discount, because the quoted margin is less than the discount (required) margin.
314
In an upward-sloping yield curve environment, the arbitrage-free price of a bond calculated using spot rates would most likely be:
A
Less than the arbitrage-free price calculated using forward rates.
B
the same as the arbitrage-free price calculated using forward rates.
C
greater than the arbitrage-free price calculated using forward rates.
B
the same as the arbitrage-free price calculated using forward rates.
Forward rates are calculated in an arbitrage-free way so that they will be equivalent to spot rates.
The same price would be calculated regardless of whether forward rates or spot rates are used to discount cash flows.
315
A company has issued a floating-rate note with a coupon rate equal to the three-month MRR + 65 bps. Interest payments are made quarterly on 31 March, 30 June, 30 September, and 31 December. On 31 March and 30 June, the three-month MRR is 1.55% and 1.35%, respectively. The coupon rate for the interest payment made on 30 June is:
A
2.00%.
B
2.10%.
C
2.20%.
C
2.20%.
The coupon rate that applies to the interest payment due on 30 June is based on the three-month MRR rate prevailing on 31 March. Thus, the coupon rate is 1.55% + 0.65% = 2.20%.
316
The rate interpreted to be the incremental return for extending the time-to-maturity of an investment for an additional time period is the:
A
add-on rate.
B
forward rate.
C
yield-to-maturity.
B
forward rate.
The forward rate can be interpreted to be the incremental or marginal return for extending the time-to-maturity of an investment for an additional time period.
The add-on rate (bond equivalent yield) is a rate quoted for money market instruments, such as bank certificates of deposit, and indexes, such as MRR, Libor and Euribor.
Yield-to-maturity is the internal rate of return on the bond’s cash flows—the uniform interest rate such that when the bond’s future cash flows are discounted at that rate, the sum of the present values equals the price of the bond. It is the implied market discount rate.
317
Matrix pricing allows investors to estimate market discount rates and prices for bonds:
A
with different coupon rates.
B
that are not actively traded.
C
with different credit quality.
B
that are not actively traded.
318
Changes in the required margin for a floater usually come from:
A
shifts in the yield curve.
B
changes in credit risk.
C
increases or decrease in inflation.
B
changes in credit risk.
B is correct. The required margin is the yield spread over or under a reference rate, reflecting the credit risk of an issuer. Changes in the required margin typically come from a change in the issuer’s credit risk.
319
The spread component of a specific bond’s yield-to-maturity is least likely impacted by changes in:
A
its tax status.
B
its quality rating.
C
inflation in its currency of denomination.
C
inflation in its currency of denomination.
C is correct. The spread component of a specific bond’s yield-to-maturity is least likely impacted by changes in inflation in its currency of denomination
320
The holding period for a bond at which the coupon reinvestment risk offsets the market price risk is best approximated by:
A
duration gap.
B
modified duration.
C
Macaulay duration.
A
duration gap.
When the holder of a bond experiences a one-time parallel shift in the yield curve, the Macaulay duration statistic identifies the number of years necessary to hold the bond so that the losses (or gains) from coupon reinvestment offset the gains (or losses) from market price changes.
The duration gap is the difference between the Macaulay duration and the investment horizon. Modified duration approximates the percentage price change of a bond given a change in its yield-to-maturity.
321
An analyst gathers the following information on three otherwise equivalent 10-year, option-free bonds:
Bond A: 0% coupon rate
Bond B: 2% coupon rate for the first 5 years, 6% coupon rate for the last 5 years
Bond C: 4% coupon rate
All else equal, which of these bonds most likely exposes investors to the highest level of interest rate risk?
A
Bond A
B
Bond B
C
Bond C
A
Bond A
A bond's interest rate risk exposure (as measured by its duration) is inversely related to its coupon rate.
In this example, the zero-coupon bond will have the greatest interest rate risk because all its cash flows are paid at maturity in 10 years.
The other bonds have less interest rate risk because some of their cash flows occur before maturity.
322
An investor purchases a bond at a price above par value. Two years later, the investor sells the bond. The resulting capital gain or loss is measured by comparing the price at which the bond is sold to the:
A
carrying value.
B
original purchase price.
C
original purchase price value plus the amortized amount of the premium.
A
carrying value.
323
Holders of which of the following categories of debt most likely have the lowest priority claim to a borrower's assets?
A
Second lien debt
B
Senior unsecured debt
C
Senior subordinated debt
C
Senior subordinated debt
In order of highest to lowest priority of claims, the rankings of debt categories is:
First lien loan - Senior secured
Second lien loan - Secured
Senior unsecured
Senior subordinated
Subordinated
Junior Subordinated
Of the possible answer choices, senior subordinated debt has the lowest priority claim.
324
The carrying value of a bond purchased at a price below par is equal to the original purchase price:
A
minus the accumulated premium amortization.
B
minus the accumulated discount amortization.
C
plus the accumulated discount amortization.
C
plus the accumulated discount amortization.
C is correct. A bond purchased at a discount will have its price “pulled to par” as it approaches maturity. Its carrying value at time t is equal to its purchase price plus the accumulated discount amortization.
325
Which of the following statements about Macaulay duration is correct?
A
A bond’s coupon rate and Macaulay duration are positively related.
B
A bond’s Macaulay duration is inversely related to its yield-to-maturity.
C
The Macaulay duration of a zero-coupon bond is less than its time-to-maturity.
B
A bond’s Macaulay duration is inversely related to its yield-to-maturity.
B is correct. A bond’s yield-to-maturity is inversely related to its Macaulay duration: The higher the yield-to-maturity, the lower its Macaulay duration and the lower the interest rate risk. A higher yield-to-maturity decreases the weighted average of the times to the receipt of cash flow, and thus decreases the Macaulay duration.
A bond’s coupon rate is inversely related to its Macaulay duration: The lower the coupon, the greater the weight of the payment of principal at maturity
326
The “second-order” effect on a bond’s percentage price change given a change in yield-to-maturity can be best described as:
A
duration.
B
convexity.
C
yield volatility.
B
convexity.
327
An investor’s well-diversified portfolio has $200,000 in cash. The investor aims to invest in short-term, one-year Large-Cap Company bonds, prior to using the cash to invest in an upcoming IPO. There are currently two Large-Cap Company bonds on the market to purchase, both with one-year maturities. One of the bonds, Bond A, is a non-callable bond, while Bond B is a callable bond. As a fixed-income analyst, you are asked to conduct an analysis.
A colleague asks whether you also considered looking at the key rate durations when comparing the interest rate risks of Bond A and Bond B. Would research into key rate durations for Bond A and Bond B help you make a better decision about the interest rate risk of the two bonds?
A
Yes
B
No
C
Inconclusive
B
No
B is correct. Since both bonds mature in one year, key rate duration analysis would not give you any additional insight, since both bonds would undergo the same shift in the curve.
328
An investor purchases an annual coupon bond with a 6% coupon rate and exactly 20 years remaining until maturity at a price equal to par value. The investor’s investment horizon is eight years. The approximate modified duration of the bond is 11.470 years. The duration gap at the time of purchase is closest to:
A
–7.842.
B
3.470.
C
4.158.
C
4.158.
C is correct. The duration gap is closest to 4.158. The duration gap is a bond’s Macaulay duration minus the investment horizon. The approximate Macaulay duration is the approximate modified duration times one plus the yield-to-maturity. It is 12.158 (= 11.470 × 1.06).
329
The relative importance of convexity in estimating the expected impact of a yield curve shift on a bond's price is most likely greater if:
A
the yield curve steepens.
B
the shift is relatively large.
C
the shift is relatively small.
B
the shift is relatively large.
Convexity is a second-order measure of a bond's sensitivity to interest rate risk. For relatively small yield curve shifts, convexity has much less explanatory power than duration, which is a first-order measure. However, for larger yield curve shifts, the impact of convexity is far greater.
330
Holders of which of the following categories of debt most likely have the lowest priority claim to a borrower's assets?
A
Second lien debt
B
Senior unsecured debt
C
Senior subordinated debt
C
Senior subordinated debt
In order of highest to lowest priority of claims, the rankings of debt categories is:
1. First lien loan - Senior secured
2. Second lien loan - Secured
3. Senior unsecured
4. Senior subordinated
5. Subordinated
6. Junior Subordinated
Of the possible answer choices, senior subordinated debt has the lowest priority claim.
331
A callable bond is most likely to exhibit positive convexity:
A
in any interest rate environment.
B
if its yield is above the exercise rate.
C
if its yield is below the exercise rate.
B
if its yield is above the exercise rate.
a callable bond exhibits positive convexity if its yield is above the exercise rate and negative convexity if its yield is below the exercise rate.
332
An analyst has proposed that the duration of a fixed-income portfolio be calculated as the weighted average of the duration of its constituent securities. The primary limitation of this proposed approach is most likely that a bond's duration measure is based on the assumption that:
A
bonds do not contain embedded options.
B
parallel yield curve shifts are rarely observed.
C
changes in the yield curve are shape-preserving.
C
changes in the yield curve are shape-preserving.
Interpreting price changes based on duration assumes a parallel shift in the yield curve because the yield for all securities in the portfolio must change by the same amount. This is referred to as a shape-preserving shift because the yield curve may move up or down, but its shape does not change.
333
An investor’s well-diversified portfolio has $200,000 in cash. The investor aims to invest in short-term, one-year Large-Cap Company bonds, prior to using the cash to invest in an upcoming IPO. There are currently two Large-Cap Company bonds on the market to purchase, both with one-year maturities. One of the bonds, Bond A, is a non-callable bond, while Bond B is a callable bond. As a fixed-income analyst, you are asked to conduct an analysis.
What impact would a “flight to safety” (i.e., government bond yields falling and credit spreads widening) have on the analytical duration estimate of Bond A?
A
Decreased duration
B
Increased duration
C
No impact
C
No impact
C is correct. There would be no impact on the analytical duration estimate. However, an empirical duration estimate would be impacted. A flight to safety would result in an increase in the bond price due to the falling benchmark yield being offset by widening credit spread. This would lead to a lower empirical duration than analytical duration.
334
Which of the following covenants is least likely to be included in the indenture of a high-yield bond issue?
A
An affirmative covenant requiring the issuer to carry at least $50 million of secured debt on its balance sheet
B
An affirmative covenant requiring the issuer to repurchase its debt from lenders at par in the event of an acquisition
C
A negative covenant limiting the percentage of earnings that can be used for dividend payments and/or stock buybacks
A
An affirmative covenant requiring the issuer to carry at least $50 million of secured debt on its balance sheet
Covenants that address the amount of secured debt that a high-yield issuer can carry on its balance sheet are relatively common. However, these covenants typically establish a maximum allowable amount of secured debt rather than specifying a minimum required level.
335
hich of the following is most likely a significant risk of relying on credit ratings provided by agencies?
A
Rating agencies use different rating scales
B
Credit ratings may not capture all relevant risks
C
Market pricing of risk lags changes to credit ratings
B
Credit ratings may not capture all relevant risks
336
tedsmart Ltd and Fignermo Ltd are alike with respect to financial and operating characteristics, except that Stedsmart Ltd has less publicly traded debt outstanding than Fignermo Ltd. Stedsmart Ltd is most likely to have:
A
no market liquidity risk.
B
lower market liquidity risk.
C
higher market liquidity risk.
C
higher market liquidity risk.
C is correct. Market liquidity risk refers to the risk that the price at which investors transact may be different from the price indicated in the market. Market liquidity risk is increased by (1) less debt outstanding and/or (2) a lower issue credit rating. Because Stedsmart Ltd is comparable to Fignermo Ltd except for less publicly traded debt outstanding, it should have higher market liquidity risk.
337
An investor with a constraint against holding speculative grade bonds is most likely concerned with a bond's:
A
default risk.
B
credit migration risk.
C
expected loss given default.
B
credit migration risk.
Credit migration risk, also known as downgrade risk, is the possibility that a rating agency will downgrade a bond's credit rating. An investor with a constraint against holding speculative grade bonds can only hold investment grade bonds. They will most likely be concerned about the risk a bond that currently carries an investment grade rating being downgraded to speculative grade.
338
Credit risk of a corporate bond is best described as the:
A
risk that an issuer’s creditworthiness deteriorates.
B
probability that the issuer fails to make full and timely payments.
C
risk of loss resulting from the issuer failing to make full and timely payments.
C
risk of loss resulting from the issuer failing to make full and timely payments.
339
Which of the following variables is most useful for estimating the likelihood of default?
A
Credit rating
B
Recovery rate
C
Seniority ranking
A
Credit rating
340
Which of the following statements is most accurate? Ratings agencies:
A
anticipate event risk well.
B
rarely change ratings once they have been issued.
C
base their ratings on material, non-public information.
C
base their ratings on material, non-public information.
341
An issuer credit rating usually applies to a company’s:
A
secured debt.
B
subordinated debt.
C
senior unsecured debt.
C
senior unsecured debt.
342
An analyst who researches a bond's covenants in an effort to estimate recovery rates is most likely attempting to quantify the bond's:
A
default risk.
B
loss severity.
C
default probability.
B
loss severity.
343
In contrast to high-yield credit analysis, investment-grade analysis is more likely to rely on:
A
spread risk.
B
an assessment of bank credit facilities.
C
matching of liquidity sources to upcoming debt maturities.
A
spread risk.
A is correct. Most investors in investment-grade debt focus on spread risk—that is, the effect of changes in spreads on prices and returns—while in high-yield analysis, the focus on default risk is relatively greater.
344
The risk that the price at which investors can actually transact differs from the quoted price in the market is called:
A
spread risk.
B
credit migration risk.
C
market liquidity risk.
C
market liquidity risk.
345
The factor considered by rating agencies when a corporation has debt at both its parent holding company and operating subsidiaries is best referred to as:
A
credit migration risk.
B
corporate family rating.
C
structural subordination.
C
structural subordination.
346
Which of the following statements about the US municipal bond market is least likely correct?
A
Municipal bonds are issued by both cities and states
B
Municipal bond yields do not include a credit risk premium
C
Municipal borrowers may issue bonds on behalf of private entities
B
Municipal bond yields do not include a credit risk premium
n the United States, bonds issued by state and city governments and their agencies are called municipal bonds. These issuers often borrow on behalf of private entities (e.g., hospitals). The municipal sector represents approximately 10% of the overall US bond market.
However, it is incorrect to claim that municipal bond yields do not include a credit risk premium.
347
Upon a bankruptcy affecting a covered bond, the first available safeguards to protect against potential losses are the:
A
ringfenced loans.
B
unencumbered assets of the issuer.
C
assets added by the collateral manager during ramp-up.
A
ringfenced loans.
The correct answer is A. In the case of bankruptcy covered bond investors, they have dual recourse with the first safeguard being the ringfenced loans in the cover pool that underlie the covered bond transaction.
348
Which investor tranche plays a key role in determining CLO viability?
A
Senior
B
Equity
C
Mezzanine
B
Equity
The correct answer is B. Investors in equity tranches take on equity-like risks with the potential to earn returns comparable to equities. Moreover, these
349
Which of the following statements is most accurate? Unlike other types of asset-backed securities, a collateralized debt obligation (CDO):
A
has a collateral manager.
B
does not have an equity tranche.
C
does not require the creation of a special purpose entity.
A
has a collateral manager.
A CDO issues debt through a special purpose entity and uses the proceeds to purchase assets that are expected to generate a portfolio return in excess of the cost of debt. The portfolio of assets is created and overseen by a CDO manager, also known as a collateral manager. The CDO structure involves several different types of tranches that offer different levels of expected returns. The most senior tranches are relatively low-risk, low-return, while the residual (equity) tranche offers the highest expected return for investors with higher levels of risk tolerance.
350
AR&C Limited leases private jets to corporations in North America for a fixed term of five years. AR&C retains ownership of the jets. The corporations make equal interest payments each month. If a customer defaults, AR&C can repossess the jet. AR&C has been in business for approximately fifteen years and has a B3 credit rating, meaning that its debt is non-investment grade. AR&C has CAD500 million in leases on its balance sheet, which it wants to securitize into ABS.
Determine which of the following is the best next step for AR&C.
A
AR&C issues and sells securities backed by the pool of leases.
B
AR&C sets up a separate legal entity to which it sells the CAD500 million in leases.
C
AR&C discontinues servicing the leases, shifting this responsibility to a special purpose company.
B
AR&C sets up a separate legal entity to which it sells the CAD500 million in leases.
The correct answer is B. In order for these assets (leases) to be securitized, they must be held in a separate legal entity structure distinct from AR&C. The separate legal entity structure ensures that if AR&C, the originator of the leases, files for bankruptcy, the leases backing the ABS that are issued by the separate legal entity are secure there, thus AR&C’s creditors cannot have any claim on them.
351
In credit card receivable ABS, principal cash flows can be altered only when the:
A
lockout period expires.
B
excess spread account is depleted.
C
early amortization provision is triggered.
C
early amortization provision is triggered.
C is correct. In credit card receivable ABS, the only way the principal cash flows can be altered is by triggering the early amortization provision. Such provisions are included in the ABS structure to safeguard the credit quality of the issue.
352
Which commercial mortgage-backed security characteristic causes a CMBS to trade more like a corporate bond than a residential mortgage-backed security?
A
Call protection
B
Internal credit enhancement
C
Debt-service-coverage ratio level
A
Call protection
353
An investment vehicle based on cash flows from an underlying pool of mortgages offering tranches that carry a high level of prepayment risk is most likely a:
A
mortgage pass-through security.
B
collateralized mortgage obligation.
C
commercial mortgage-backed security.
B
collateralized mortgage obligation.
Collateralized mortgage obligations (CMOs) are a form of mortgage-backed security (MBS) that redistributes cash flows among tranches, which give investors the ability to choose their desired level of cash flow risk. Note that, because of how a CMO is structured, prepayment risk cannot be reduced or eliminated - only redistributed.
Mortgage pass-through securities are not divided into tranches.
354
Which of the following statements about securitization’s impact on economies and financial markets is correct?
A
Securitization decreases overall liquidity in the financial system.
B
Securitization provides an alternative means of funding business operations beyond traditional financing.
C
Securitization allows companies to directly access the financial markets and purchase loans that will be held on their balance sheet.
B
Securitization provides an alternative means of funding business operations beyond traditional financing.
The correct answer is B. An important benefit of securitization is that it provides an alternative means of funding business operations beyond traditional financing tools, such as bonds, preferred equity, and common equity.
355
Which of the following benefits of securitization is most likely to be important for investors?
A
Increased efficiency
B
Reduced liquidity risk
C
The ability to tailor interest rate and credit risk exposures
C
The ability to tailor interest rate and credit risk exposures
356
If interest rates increase, an investor who owns a mortgage pass-through security is most likely affected by:
A
credit risk.
B
extension risk.
C
contraction risk.
B
extension risk.
B is correct. Extension risk is the risk that when interest rate rise, fewer prepayments will occur. Homeowners will be reluctant to give up the benefit of a contractual interest rate that is lower. As a result, the mortgage pass-through security becomes longer in maturity than anticipated at the time of purchase.
357
In a securitization, the special purpose entity (SPE) is responsible for the:
A
issuance of the asset-backed securities.
B
collection of payments from the borrowers.
C
recovery of underlying assets from delinquent borrowers.
A
issuance of the asset-backed securities.
A is correct. In a securitization, the special purpose entity is the special legal entity responsible for the issuance of the asset-backed securities. The servicer, not the SPE, is responsible
358
Which of the following statements related to securitization is correct?
A
Time tranching addresses the uncertainty of a change in interest rates.
B
Securitizations are rarely structured to include both credit tranching and time tranching.
C
Junior and senior bond classes differ in that junior classes can be paid off only at the bond’s set maturity.
A
Time tranching addresses the uncertainty of a change in interest rates.
A is correct. Time tranching is the creation of bond classes that possess different expected maturities so that prepayment risk can be redistributed among bond classes. When loan agreements provide borrowers the ability to alter payments, in the case of changing interest rates, this prepayment risk increases because borrowers tend to pay off/extend part or all of their loans based on the interest rates movement.
359
The role of a special purpose vehicle (SPV) in the securitization process is most likely to:
A
originate the loans.
B
issue asset-backed securities to investors.
C
collect principal and interest payments from borrowers.
B
issue asset-backed securities to investors.
360
For an issuer, which of the following outcomes is most likely after offering a credit card ABS?
A
Increased cost of funding
B
Increased income from fees
C
Increased cost of default risk
B
Increased income from fees
The correct answer is B. A credit card ABS generates additional fee income.
361
n action affecting the cash flow received by a credit card ABS holder during its revolving period is the:
A
early repayment of principal by cardholders.
B
card’s floating-rate cap exceeding the periodic rate.
C
triggering of an ABS rapid amortization provision.
C
triggering of an ABS rapid amortization provision.
The correct answer is C. Triggering rapid amortization provisions accelerates and alters principal cash flows. Noteholders will receive their investments earlier, which they can then reallocate to other investments offering more attractive risk/return characteristics.
362
A characteristic of solar loans that makes them attractive to potential solar ABS investors is their:
A
universal availability to any homeowners.
B
ability to combine multiple liens to mitigate default risk.
C
flexibility in allowing either purchase or rental of solar systems.
B
ability to combine multiple liens to mitigate default risk.
The correct answer is B. Default risk minimization adds to investment appeal, and solar loans provide opportunities for overcollateralization. Normally, solar ABS are collateralized by the underlying debt: mortgages, loans, or receivables. These loans can be further collateralized by a lien pledged on the installed systems, on the property itself, or both.
A is incorrect as solar loans are typically extended only to prime borrowers who own their homes and have good payment records.
C is incorrect as the loans enable property owner purchase of installed systems instead of rental that is transacted through solar leases.
363
Which of the following statements about CDOs is correct?
A
The collateral pools for CDOs are static.
B
The proceeds to pay the CDO bond classes can only come from interest payments from collateral assets.
C
A CDO is a leveraged transaction, where equity tranche holders use borrowed funds to generate a return above the funding cost.
C
A CDO is a leveraged transaction, where equity tranche holders use borrowed funds to generate a return above the funding cost.
The correct answer is C. A CDO is a leveraged transaction, where equity tranche holders use borrowed funds (i.e., the bond classes issued) to generate a return above the funding cost.
364
Which of the following metrics is most likely to be used as an indicator of the potential credit performance of commercial mortgage-backed securities?
A
Loan-to-value ratio
B
Debt-to-equity ratio
C
Interest coverage ratio
A
Loan-to-value ratio
The loan-to-value ratio and the debt-service-coverage ratio are key indicators of potential credit performance.
365
securitization benefits investors by:
A
providing more direct access to a wider range of assets.
B
reducing the inherent credit risk of pools of loans and receivables.
C
eliminating cash flow timing risks of an ABS, such as contraction and extension risks.
A
providing more direct access to a wider range of assets.
366
For a CMO that includes Planned Amortization Class (PAC) tranches, if the prepayment rate is within the anticipated range, which of the following tranches most likely protects investors from prepayment risk?
A
PAC tranche
B
Senior tranche
C
Support tranche
C
Support tranche
The correct answer is C. If the prepayment rate is within the specified range, all prepayment risk is absorbed by the support tranche. This provides greater predictability of the size and timing of cash flows paid to investors in the PAC tranches.
367
The tranches in a collateralized mortgage obligation that are most likely to provide protection for investors against both extension and contraction risk are:
A
planned amortization class (PAC) tranches.
B
support tranches.
C
sequential-pay tranches.
A
planned amortization class (PAC) tranches.
A is correct. PAC tranches have limited (but not complete) protection against both extension risk and contraction risk. his protection is provided by the support tranches.
368
The role of a special purpose vehicle (SPV) in the securitization process is most likely to:
A
originate the loans.
B
issue asset-backed securities to investors.
C
collect principal and interest payments from borrowers.
B
issue asset-backed securities to investors.
369
n a securitization, the collateral is initially sold by the:
A
issuer.
B
depositor.
C
underwriter.
B
depositor.
B is correct. In a securitization, the loans or receivables are initially sold by the depositor to the special purpose entity that uses them as collateral to issue the ABS.
A is incorrect because the SPE, often referred to as the issuer, is the purchaser of the collateral rather than the seller of the collateral.
370
Which of the following benefits of securitization is most likely to be important for investors?
A
Increased efficiency
B
Reduced liquidity risk
C
The ability to tailor interest rate and credit risk exposures
C
The ability to tailor interest rate and credit risk exposures
The correct answer is C. Securitization provides a direct conduit between borrowers and investors. It also allows investors to tailor interest rate and credit risk exposures to suit their specific risk, return, and maturity needs.
371
The longest-term tranche of a sequential-pay CMO is most likely to have the lowest:
A
average life.
B
extension risk.
C
contraction risk.
C
contraction risk.
372
An investment vehicle based on cash flows from an underlying pool of mortgages offering tranches that carry a high level of prepayment risk is most likely a:
A
mortgage pass-through security.
B
collateralized mortgage obligation.
C
commercial mortgage-backed security.
B
collateralized mortgage obligation.
373
If interest rates increase, an investor who owns a mortgage pass-through security is most likely affected by:
A
credit risk.
B
extension risk.
C
contraction risk.
B
extension risk.
374
Which of the following statements related to securitization is correct?
A
Time tranching addresses the uncertainty of a change in interest rates.
B
Securitizations are rarely structured to include both credit tranching and time tranching.
C
Junior and senior bond classes differ in that junior classes can be paid off only at the bond’s set maturity.
A
Time tranching addresses the uncertainty of a change in interest rates.
A is correct. Time tranching is the creation of bond classes that possess different expected maturities so that prepayment risk can be redistributed among bond classes. When loan agreements provide borrowers the ability to alter payments, in the case of changing interest rates, this prepayment risk increases because borrowers tend to pay off/extend part or all of their loans based on the interest rates movement.
375
The feature of a covered bond transaction most likely shared with both CDOs and non-mortgage ABS is its:
A
specified LTV cutoff.
B
multiple tranches for the cover pool.
C
distinct maturity and settlement dates.
C
distinct maturity and settlement dates.
376
Collateralized mortgage obligations are designed to:
A
eliminate contraction risk in support tranches.
B
distribute prepayment risk to various tranches.
C
eliminate extension risk in planned amortization tranches.
B
distribute prepayment risk to various tranches.
B is correct. CMOs are designed to redistribute cash flows of mortgage-related products to different bond classes or tranches through securitization. Although CMOs do not eliminate prepayment risk, they distribute prepayment risk among various classes of bondholders.
377
An investor in a private equity fund is concerned that the general partner can receive incentive fees in excess of the agreed-on incentive fees by making distributions over time based on profits earned rather than making distributions only at exit from investments of the fund. Which of the following is most likely to protect the investor from the general partner receiving excess fees?
A
high hurdle rate
B
clawback provision
C
lower capital commitment
B
clawback provision
B is correct. A clawback provision requires the general partner in a private equity fund to return any funds distributed (to the general partner) as incentive fees until the limited partners have received their initial investments and the contracted portion of the total profits
378
Identify the fee approach that most directly encourages private equity fund managers to invest selectively, not just quickly. Management fees:
A
based on committed capital
B
combined with an incentive fee
C
based on a fixed percentage of assets under management
A
based on committed capital
The correct answer is A. Private equity funds typically calculate their management fee based on committed capital, which is the total amount that the limited partners have promised to fund future investments, rather than based on assets under management. The committed-capital basis for management fees is an important distinction from hedge funds, whose management fees are typically based on assets under management. Having committed capital as the basis for management fee calculations reduces the incentive for GPs to deploy the committed capital as quickly as possible to grow their fee base and thus allows the GPs to be selective about deploying capital into investment opportunities.
379
Assets developed through a public–private partnership typically involve:
A
long-lived fixed assets intended for public use.
B
ownership capital used in the early life cycle of a venture.
C
commercial real estate where private business activity is the primary cash flow source.
A
long-lived fixed assets intended for public use.
A is correct. In a public–private partnership (PPP), both governments and private investors are involved in funding and completing long-lived fixed assets intended for public use and/or to provide essential services.
380
An investor seeks a current income stream as a component of total return and desires an investment that historically has low correlation with other asset classes. The investment most likely to achieve the investor’s goals is:
A
timberland.
B
collectibles.
C
commodities.
A
timberland.
is correct. Timberland offers an income stream based on the sale of timber products as a component of total return and has historically generated returns not highly correlated with other asset classes.
381
Which of the following biases most likely cause hedge fund index returns to be overstated?
A
Backfill bias only
B
Survivorship bias only
C
Both backfill bias and survivorship bias
C
Both backfill bias and survivorship bias
Both survivorship and backfill biases result in the overstatement of the value of hedge fund indices.
Survivorship bias results from including only current investment funds. Thus, funds that have failed are not included in the index.
Backfill bias results from including previous return data for funds that have since entered the index.
382
Investments that rely on prices computed using internal models are most likely to be categorized by GAAP accounting rules as:
A
Level 1 assets
B
Level 2 assets
C
Level 3 assets
C
Level 3 assets
GAAP categorizes investments into three buckets:
Level 1 pricing uses exchange-traded, publicly-traded prices.
Level 2 pricing relies on outside broker quotes.
Level 3 pricing uses values computed using internal models.
383
A common problem for the “mark-to-model” valuation of private equity funds is most likely:
A
a violation of accounting rules.
B
an understatement of portfolio risk.
C
an understatement of interim portfolio return.
B
an understatement of portfolio risk.
384
A large drawdown of a hedge fund causes a significant amount of investors to request redemption of outstanding shares of the fund. Which of the following will most likely occur to the hedge fund?
A
Liquidation of its assets in proportion to the redemption requests
B
Investment of the redemption fees from the redeeming investors in order to hedge against a larger drawdown
C
Forced liquidation, thus resulting in the remaining investors to redeem their shares, causing full liquidation and closure of the fund
C
Forced liquidation, thus resulting in the remaining investors to redeem their shares, causing full liquidation and closure of the fund
A large amount of investors redeem shares, causing a forced liquidation of the fund, which results in an even bigger drawdown. The liquidation causes a magnification of the losses, leading to redemption requests from the remaining investors, thus fully liquidating and closing the fund.
385
Which of the following statements regarding private equity performance calculations is true?
A
The IRR calculation involves the assumption of two rates.
B
The money multiple calculation relies on the amount and timing of cash flows.
C
Because private equity funds have low volatility, accounting conventions allow them to use a lagged mark-to-market process.
A
The IRR calculation involves the assumption of two rates.
A is correct. The determination of an IRR involves certain assumptions about a financing rate to use for outgoing cash flows (typically a weighted average cost of capital) and a reinvestment rate assumption to make on incoming cash flows (which must be assumed and may or may not actually be earned).
386
The difference between mezzanine-stage financing and later-stage financing is most likely based on:
A
size.
B
timing.
C
the operating activities that they support.
Mezzanine financing is distinguished by its timing. Specifically, mezzanine investments are meant to serve as bridge financing for firms that are preparing to go public in an initial public offering.
387
The most likely effect on a portfolio’s diversification when exposure to direct lending commences is that it:
A
decreases.
B
remains the same.
C
increases.
A
decreases.
A is correct. While private capital can have overall positive contributions to diversification, direct lending can involve a large capital commitment to a single borrower, with increased concentration risk and reduced diversification. Investors attempt to protect against the risk of direct lending by having the debt itself classified as senior and secured with protective covenants in place to benefit from the associated higher interest rates while reducing non-diversifiable specific risk associated with a single borrower.
388
A feature that private debt and public debt share in the setting of their investment returns is their:
A
relationship to benchmark interest rates.
B
need for specialized investment knowledge.
C
opportunity for illiquidity premiums in market crises.
A
relationship to benchmark interest rates.
A is correct. For both public debt and private debt, return on debt capital tends to follow and change with the benchmark interest rate environment.
389
Which of the following is most likely to participate in early-stage financing?
A
Founders
B
Angel investors
C
Strategic investors
C
Strategic investors
C is correct. Strategic investors typically join in at early-stage to later-stage financing.
390
Anchor Inc. is a newly formed business that has not yet begun producing or selling any products. The company first needs to raise funds to be able to perform some initial market research regarding their product ideas. Any investments that the company receives during this formative stage would most accurately be classified as:
A
an angel investment.
B
seed-stage financing.
C
early-stage financing.
B
seed-stage financing.
Seed-stage investments, or seed capital, typically support activities such as product development and initial market research.
391
Angel investments in start-up companies are most likely made in the:
A
idea stage.
B
seed stage.
C
early stage.
A
idea stage.
392
Which of the following statements about the private equity market is most accurate?
A
Returns on private equity investments are often overstated
B
The level of activity in private equity has grown steadily in recent decades
C
Private equity firms will not sell their positions in portfolio companies to other private equity firms
Returns on private equity funds are overstated due to self-reporting and biases such as survivorship bias and backfill bias.
393
An advantage of REITs is:
A
low non-cash depreciation expenses.
B
more transparency than private real estate markets.
C
lower correlation with the public equity markets compared to private real estate.
B
more transparency than private real estate markets.
The correct answer is B. An advantage of REITs is more transparency than private real estate markets.
394
Which of the following relates to a benefit when owning real estate directly?
A
Taxes
B
Capital requirements
C
Portfolio concentration
A
Taxes
A is correct. When owning real estate directly, there is a benefit related to taxes. The owner can use property non-cash depreciation expenses to reduce taxable income and lower the current income tax bill. In fact, accelerated depreciation and interest expense can reduce taxable income below zero in the early years of asset ownership, and losses can be carried forward to offset future income. Thus, a property investment can be cash-flow positive while generating accounting losses and deferring tax payments. If the tax losses do not reverse during the life of the asset, depreciation-recapture taxes can be triggered when the property is sold.
395
A direct private real estate investor can reduce taxable income using:
A
double taxation.
B
cash depreciation expenses.
C
tax-deductible interest expenses.
C
tax-deductible interest expenses.
The correct answer is C. Direct private real estate owners can reduce their taxable income using non-cash property depreciation expenses and tax-deducible interest expenses.
396
Airports and railways are most accurately classified as:
A
utility assets.
B
social infrastructure assets.
C
economic infrastructure assets.
C
economic infrastructure assets.
There are two broad categories of infrastructure investments: economic infrastructure assets and social infrastructure assets. Social infrastructure assets (e.g., healthcare facilities) are used for human services, while economic infrastructure assets are vital for economic activity.
Economic infrastructure assets can be further divided into the following categories:
Transportation assets: Roads, bridges, tunnels, airports, ports, railways
Information and communication technology (ICT) assets: Telecommunication towers and data centers
Utility assets: Power plants, electricity transmission, gas storage, water treatment facilitie
397
REIT is considered to be “hybrid” if it invests in both:
A
equity REITs and mortgage REITs.
B
sole ownership and joint ventures.
C
direct and indirect property ownership.
A
equity REITs and mortgage REITs.
The correct answer is A. There are three main forms of REIT: (1) equity REITs that invest in properties outright or through partnerships and joint ventures, (2) mortgage REITs that underwrite loans to real estate (mortgages) or invest in MBS, and (3) hybrid REITs that invest in both of these types.
398
Which of the following types of infrastructure investments entails the lowest expected risk?
A
Greenfield
B
Brownfield
C
Secondary stage
C
Secondary stage
The correct answer is C. In the three groupings of the infrastructure development cycle—greenfield, operational secondary stage, and brownfield—the operational secondary-stage assets with an existing track record of generating steady, bond-like cash flows possess the lowest risk and offer the lowest return to the investors. Brownfield investments, redevelopment of existing infrastructure, are incrementally riskier, and greenfield projects are the riskiest.
399
Compared with similar fixed-income instruments, infrastructure debt:
A
has higher recovery rates.
B
experiences higher default rates.
C
has more fluctuation over the economic cycle.
A
has higher recovery rates.
The correct answer is A. Given the stable underlying nature of cash flows, infrastructure debt tends to experience lower default rates and higher recovery than similar fixed-income instruments, and it is less subject to fluctuation over the economic cycle.
400
Which of the following possible value drivers does not apply to both raw land and farmland investments?
A
Lease revenue
B
Sale of agricultural products
C
Price appreciation of property
B
Sale of agricultural products
B is correct. Raw land’s value is derived solely from lease revenue and price appreciation. Farmland, in contrast, also generates value from the production and sale of agricultural products.
401
Which of the following futures market price conditions would be most expected in a period of low commodity inventories?
A
Backwardation
B
Falling prices
C
Contango
A
Backwardation
A is correct. Low inventories of a specific commodity create incentives for market participants to own the physical commodity rather than a derivative contract. This incentive drives up spot prices relative to forward prices and can lead to spot prices being greater than forward prices (i.e., backwardation).
402
Which of the following statements is most correct if you observe that the correlation between farmland and inflation is significantly lower than the correlation between commodities and inflation (and that both correlations are positive)?
A
Commodities are expected to provide a better inflation hedge than farmland.
B
Farmland is expected to provide a better inflation hedge than commodities.
C
Differences in correlation do not provide any information that is useful in assessing whether an asset class is an inflation hedge.
A
Commodities are expected to provide a better inflation hedge than farmland.
A is correct. An effective hedge exhibits relatively high correlation relative to the risk exposure being hedged. Thus, the higher correlation between commodities and inflation implies that commodities provide a better hedge against inflation compared to farmland.
403
A hedge fund manager who attempts to profit by taking a long position in an issuer's convertible debt and shorting its equity is most likely pursuing a:
A
a relative value strategy.
B
a market neutral strategy.
C
an equity hedging strategy.
A
a relative value strategy.
This manager is pursuing a convertible bond arbitrage strategy, which involves taking long positions in convertible debt and shorting equity. This is an example of a relative value strategy.
404
Which of the following is a key building block of dApps?
A
Bitcoins
B
Smart contracts
C
Centralized exchanges
B
Smart contracts
The correct answer is B. Smart contracts are the building block of dApps. dApps are usually developed on the Ethereum blockchain network or other smart contract platforms that allow for peer-to-peer interaction using interoperable, transparent smart contracts that persist for the duration of the chain. These decentralized applications, or dApps, allow for transactions to take place—and to be recorded on the blockchain—without a central coordinating mechanism or centralized exchange.
405
Both event-driven and macro hedge fund strategies use:
A
long–short positions.
B
a top-down approach.
C
long-term market cycles.
A
long–short positions.
A is correct. Long–short positions are used by both types of hedge funds to potentially profit from anticipated market or security moves. Event-driven strategies use a bottom-up approach and seek to profit from a catalyst event typically involving a corporate action, such as an acquisition or a restructuring. Macro strategies seek to profit from expected movements in evolving economic variables.
406
An investor who wants to replicate the return on Bitcoins without the use of a digital wallet can best do so by:
A
investing in a cryptocurrency coin trust that holds Bitcoins.
B
investing in a listed cryptocurrency exchange stock.
C
buying Bitcoins from a centralized cryptocurrency exchange.
A
investing in a cryptocurrency coin trust that holds Bitcoins.
The correct answer is A. Investing in a cryptocurrency coin trust that holds Bitcoins is the best way to replicate the return on Bitcoins. Investing in a listed cryptocurrency exchange stock provides very indirect exposure that may not necessarily replicate the performance of Bitcoins because of a variety of company-specific factors, as well as the sensitivity to the general stock market environment. Buying Bitcoins from a centralized cryptocurrency exchange provides a direct exposure, but it would require a digital wallet.
407
A benefit of DLT favoring its use by the investment industry is its:
A
scalability of underlying systems.
B
ease of integration with existing systems.
C
streamlining of current post-trade processes.
C
streamlining of current post-trade processes.
C is correct. DLT has the potential to streamline the existing, often complex and labor-intensive post-trade processes in securities markets by providing close to real-time trade verification, reconciliation, and settlement, thereby reducing related complexity, time, and costs.
408
With respect to trading costs, liquidity is least likely to impact the:
A
stock price.
B
bid–ask spreads.
C
brokerage commissions.
C
brokerage commissions.
C is correct. Brokerage commissions are negotiated with the brokerage firm. \
A security’s liquidity impacts the operational efficiency of trading costs. Specifically, liquidity impacts the bid–ask spread and can impact the stock price (if the ability to sell the stock is impaired by the uncertainty associated with being able to sell the stock).
409
s the number of assets in an equally-weighted portfolio increases, the contribution of each new asset's variance to the portfolio's overall variance most likely:
A
increases.
B
approaches zero.
C
remains unchanged.
B
approaches zero.
410
The greatest diversification benefit is most likely achieved by selecting an asset with which of the following correlations with the current portfolio?
A
-1.00
B
0.00
C
1.00
A
-1.00
Adding assets with a correlation of 1 to your portfolio doesn't lower the volatility at all. These investments all move together.
Assets with a correlation of 0 are helpful. This is most commonly what investors are looking for. Finding independent companies can be a valuable way to lower the risk in your portfolio.
Correlations of -1, though, are ideal. As one company does poorly, the other company does well. The difficulty is that these are very difficult to come by. There aren't any companies with correlations of -1, but you might still get some that are negatively correlated.
411
Historical equity return data is most accurately described as:
A
positively skewed.
B
normally distributed.
C
exhibiting excess kurtosis.
C
exhibiting excess kurtosis.
Data on historical equity returns across countries and over many years reveal a negatively skewed distribution with more extreme events than would be expected under a normal distribution. This greater likelihood of outliers is known as excess kurtosis.
412
With respect to risk-averse investors, a risk-free asset will generate a numerical utility that is:
A
the same for all individuals.
B
positive for risk-averse investors.
C
equal to zero for risk seeking investors.
A
the same for all individuals.
A is correct. A risk-free asset has a variance of zero and is not dependent on whether the investor is risk neutral, risk seeking or risk averse
413
On the efficient frontier, increasing the standard deviation of a portfolio from 10% to 15% increases its expected return from 4.5% to 6.5%. The expected return on the efficient portfolio with a 20% standard deviation is most likely:
A
less than 8.5%.
B
equal to 8.5%.
C
greater than 8.5%.
A
less than 8.5%.
The top half of the minimum-variance portfolio is referred to as the efficient frontier. The frontier's slope decreases as standard deviation increases (moving right on the x-axis). In other words, there is a lower expected reward for taking additional risk as the standard deviation of the portfolio increases
414
Which of the following is least likely correct regarding investor indifference curves?
A
Indifference curves are continuous at all points
B
All points on any indifference curve have different utilities
C
An indifference curve plots combinations of risk-return pairs that an investor would accept to keep a set level of utility
B
All points on any indifference curve have different utilities
In fact, all points on an indifference curve have the same utility – an investor is essentially indifferent what point they are on the indifference curve.
Indifference curves are continuous at all points because there are theoretically an infinite number of various risk – return combinations that give the
415
Which of the following performance measures is consistent with the CAPM?
A
M2
B
Sharpe ratio.
C
Jensen’s alpha.
C
Jensen’s alpha.
C is correct. Jensen’s alpha adjusts for systematic risk
416
Which of the following performance measures does not require the measure to be compared to another value?
A
Sharpe ratio.
B
Treynor ratio.
C
Jensen’s alpha.
C
Jensen’s alpha.
C is correct. The sign of Jensen’s alpha indicates whether or not the portfolio has outperformed the market. If alpha is positive, the portfolio has outperformed the market; if alpha is negative, the portfolio has underperformed the market.
417
With respect to the capital asset pricing model, which of the following is least accurate?
A
The slope of the security characteristic line is an asset’s beta
B
The primary determinant of expected return of an individual asset is the market risk premium
C
An asset with negative beta will have an expected return for the asset that is less than the risk-free rate
B
The primary determinant of expected return of an individual asset is the market risk premium
The primary determinant of expected return of an individual asset is how well the asset correlates with the market (the asset’s beta).
418
The line depicting the total risk and expected return of portfolio combinations of a risk-free asset and any risky asset is the:
A
security market line.
B
capital allocation line.
C
security characteristic line.
B
capital allocation line.
B is correct. A capital allocation line (CAL) plots the expected return and total risk of combinations of the risk-free asset and a risky asset (or a portfolio of risky assets).
419
With respect to the security market line (SML), which of the following is most accurate?
A
The SML only applies to efficient portfolios
B
The slope of the SML is the market risk premium
C
The SML is a graphical illustration of the efficient frontier
B
The slope of the SML is the market risk premium
The SML is a graphical illustration of the CAPM.
the CAL or CML only apply to efficient portfolios. The SML applies to any security, efficient or not.
420
With respect to return-generating models, the slope term of the market model is an estimate of the asset’s:
A
total risk.
B
systematic risk.
C
nonsystematic risk.
B
systematic risk.
421
The sum of an asset’s systematic variance and its nonsystematic variance of returns is equal to the asset’s:
A
beta.
B
total risk.
C
total variance.
C
total variance.
C is correct. The sum of systematic variance and nonsystematic variance equals the total variance of the asset. References to total risk as the sum of systematic risk and nonsystematic risk refer to variance, not to risk.
422
With respect to capital market theory, which of the following assumptions allows for the existence of the market portfolio? All investors:
A
are price takers.
B
have homogeneous expectations.
C
plan for the same, single holding period.
B
have homogeneous expectations.
B is correct. The homogeneous expectations assumption means that all investors analyze securities in the same way and are rational. That is, they use the same probability distributions, use the same inputs for future cash flows, and arrive at the same valuations. Because their valuation of all assets is identical, they will generate the same optimal risky portfolio, which is the market portfolio.
423
The return metric that most accurately evaluates the performance of a portfolio manager who does not exercise control over the timing of new contributions and withdrawals is the:
A
time-weighted return.
B
internal rate of return.
C
money-weighted return.
A
time-weighted return.
Time-weighted return, which is unaffected by the timing and amount of cash flows, is most appropriate for measuring the performance of a manager who does not control new contributions and withdrawals.
The money-weighted return measure, which is an internal rate of return, will give a skewed indication of the manager's performance depending on factors that are beyond his or her control.
424
Investors can lend at the risk-free rate of 3.5%, but must pay 5.5% on any borrowed funds. Compared to a scenario in which all investors can borrow and lend at the risk-free rate, the capital market line most likely has:
A
the same slope at all levels of risk, but plots lower.
B
the same slope to the left of the market portfolio and a flatter slope to its right.
C
the same slope to the left of the market portfolio and a steeper slope to its right.
B
the same slope to the left of the market portfolio and a flatter slope to its right.
If all investors are able to borrow at the risk-free rate, the capital market line (CML) looks as it appears below: (same slope all throughout)
However, when non-government investors are unable to borrow at the risk-free rate, investors can expect lower returns as a result of having to pay a higher rate of interest on borrowed funds. As shown below, the CML becomes kinked and is flatter to the right of the market portfolio:
425
With respect to the pricing of risk in capital market theory, which of the following statements is most accurate?
A
All risk is priced.
B
Systematic risk is priced.
C
Nonsystematic risk is priced.
B
Systematic risk is priced.
B is correct. Only systematic risk is priced. Investors do not receive any return for accepting nonsystematic or diversifiable risk
426
With respect to capital market theory, an investor’s optimal portfolio is the combination of a risk-free asset and a risky asset with the highest:
A
expected return.
B
indifference curve.
C
capital allocation line slope.
B
indifference curve.
B is correct. Investors will have different optimal portfolios depending on their indifference curves. The optimal portfolio for each investor is the one with highest utility; that is, where the CAL is tangent to the individual investor’s highest possible indifference curve.
427
Which of the following client groups would most likely have the lowest risk tolerance for their portfolios?
A
Banks
B
Endowments
C
Defined benefit pension plan
A
Banks
428
Which of the following statements is most accurate? According to modern portfolio theory:
A
an asset's risk should be measured in relation to its non-systematic risk.
B
an asset's risk should be measured in relation to its non-diversifiable risk.
C
the priced risk of an asset is unaffected by holding it in a well-diversified portfolio.
B
an asset's risk should be measured in relation to its non-diversifiable risk.
According to modern portfolio theory, investors should not be rewarded for accepting risk that can be diversified away. This implies that an asset's risk should be measured in relation to its non-diversifiable risk, also known as systematic risk. Therefore, the priced risk of an asset is actually affected by holding it in a well-diversified portfolio.
429
A mutual fund which investors buy and sell on the open market (as opposed to investing directly with the fund) is most accurately described a(n):
A
no-load fund.
B
open-end fund.
C
closed-end fund.
C
closed-end fund.
Whether a fund is open/closed end depends on whether the fund managers are accepting new money. If they are, it is an open-end fund. If they are not, this is a closed-end fund.
How about load/no-load funds? That describes whether the fund charges a fee to purchase and/or redeem shares. If they do, it is a load fund. But if those transactions are free, the fund is a no-load fund.
The question is asking about buying and selling on the market. All mutual funds operate that way, but only closed-end funds disallow "investing directly with the fund."
430
Which of the following types of institutional investors most likely have the lowest risk tolerance?
A
Foundations
B
Non-life insurance companies
C
Defined benefit pension plans
B
Non-life insurance companies
Non-life (property and casualty) insurance companies need to be able to pay liabilities for claims on an ongoing basis. In order to be able to meet these obligations, their investments tend to be relatively short-term, liquid, and conservative.
431
Which of the following statements is most accurate? Unlike traditional asset managers, alternative managers are most likely willing to:
A
take short positions.
B
charge management fees.
C
invest in multiple asset classes.
A
take short positions.
Alternative asset managers are distinguished by their willingness to take short positions. Traditional investments are considered to be long-only, publicly traded investments in stocks, bonds, and cash. Many traditional asset managers are willing to invest in multiple asset classes. Although alternative managers typically charge an additional performance fee, both types of managers charge management fees based on the value of assets under management.
432
Which of the following categories most likely accounts for the largest share of the asset management industry's revenues?
A
Core
B
Alternatives
C
Active specialties
B
Alternatives
Although alternatives represent a relatively small share of assets under management, this category accounts for more than 40% of the revenues in the asset management industry.
433
Which of the following is most likely to trade at a premium or a discount?
A
Exchange traded funds
B
Open-end mutual funds
C
Closed-end mutual funds
C
Closed-end mutual funds
Because closed-end mutual funds do not accept new investments, shares of closed-end mutual funds can trade at a premium to or discount from net asset value depending on investor demand.
434
Which of the following mutual funds would most likely be characterized as a lifecycle fund?
A
Hybrid fund
B
Bond mutual fund
C
Stock mutual fund
A
Hybrid fund
Hybrid funds are considered a lifecycle fund because they can automatically reset the asset mix of stocks and bonds to best fit the investor's time frame.
A lifecycle fund, often referred to as a target-date fund, is a fund that manages the asset mix within the fund according to a selected time frame, typically a specific retirement date.
435
Compared to mutual funds, separately managed accounts most likely:
A
require a lower minimum investment.
B
allow investors to hold a broader range of asset classes.
C
give investors greater control over which assets are held.
C
give investors greater control over which assets are held.
Assets held in separately managed accounts are directly owned and controlled by the account's beneficiary, who retains the authority to determine which assets are held and the timing of transaction
436
Asset management firms are most commonly:
A
publicly traded.
B
privately owned.
C
part of large, diversified financial services firms.
B
privately owned.
The majority of private management firms are privately owned. Most of these firms are structured as limited liability corporations (LLCs) or limited liability partnerships (LLPs).
437
All else equal, adding a security with returns that are negatively correlated with those of an equally-weighted portfolio will most likely:
A
decrease the diversification ratio.
B
increase the diversification ratio.
C
not impact the diversification ratio.
A
decrease the diversification ratio.
The diversification ratio of an equally-weighted portfolio is the ratio of the portfolio's standard deviation to the average standard deviation of its components. Adding a security with negatively correlated returns will reduce the diversification ratio.
438
With respect to the portfolio management process, the asset allocation is determined in the:
A
planning step.
B
feedback step.
C
execution step.
C
execution step.
C is correct. The client’s objectives and constraints are established in the investment policy statement and are used to determine the client’s target asset allocation, which occurs in the execution step of the portfolio management process.
439
An equally weighted portfolio is composed of six securities with standard deviations of 17.0%, 11.4%, 16.9%, 9.0%, 12.1%, and 14.6%. If the returns of all six securities have correlations of less than 1.0 with the overall portfolio return of 13.5%, the diversification ratio is most likely:
A
less than 1.0.
B
equal to 1.0.
C
greater than 1.0.
A
less than 1.0.
The diversification ratio is the ratio of the standard deviation of returns for equally weighted portfolio’s returns divided by the average standard deviation of returns for the securities contained in the portfolio
440
A defined benefit plan with a large number of retirees is likely to have a high need for:
A
income.
B
liquidity.
C
insurance.
B
liquidity.
A is correct. Income is necessary to meet the cash flow obligation to retirees. Although defined benefit plans have a need for income, the need for liquidity typically is quite low. A retiree may need life insurance; however, a defined benefit plan does not need insurance.
441
George Hilton, age 54, holds a well-paying position as a real estate executive and has accumulated $2.25 million of investable assets. He intends to remain in his current position for 7 more years before limiting his work to part-time consulting. After leaving his full-time position, Hilton expects that his annual living expenses in excess of his consulting fees will be $60,000 initially and grow with inflation. Hilton considers himself to be a long-term investor and is willing to accept large fluctuations in the value of his portfolio. Which of the following most accurately characterizes Hilton’s ability and willingness to take on risk?
A
High ability to take risk, low willingness to take risk
B
Low ability to take risk, high willingness to take risk
C
High ability to take risk, high willingness to take risk
C
High ability to take risk, high willingness to take risk
442
In defining asset classes as part of the strategic asset allocation decision, pairwise correlations within asset classes should generally be:
A
equal to correlations among asset classes.
B
lower than correlations among asset classes.
C
higher than correlations among asset classes.
C
higher than correlations among asset classes.
C is correct. As the reading states, “an asset class should contain homogeneous assets… paired correlations of securities would be high within an asset class, but should be lower versus securities in other asset classes.”
443
A client who is a 34-year old widow with two healthy young children (aged 5 and 7) has asked you to help her form an investment policy statement. She has been employed as an administrative assistant in a bureau of her national government for the previous 12 years. She has two primary financial goals—her retirement and providing for the college education of her children. This client’s time horizon is best described as being:
A
long term.
B
short term.
C
medium term.
C
short term.
444
Tactical asset allocation is best described as:
A
attempts to exploit arbitrage possibilities among asset classes.
B
the decision to deliberately deviate from the policy portfolio.
C
selecting asset classes with the desired exposures to sources of systematic risk in an investment portfolio.
B
the decision to deliberately deviate from the policy portfolio.
B is correct. Tactical asset allocation allows actual asset allocation to deviate from that of the strategic asset allocation (policy portfolio) of the IPS. Tactical asset allocation attempts to take advantage of temporary dislocations from the market conditions and assumptions that drove the policy portfolio decision.
445
Which of the following typical topics in an investment policy statement (IPS) is most closely linked to the client’s “distinctive needs”?
A
Procedures.
B
Investment Guidelines.
C
Statement of Duties and Responsibilities.
B
Investment Guidelines.
B is correct. According to the reading, “The sections of an IPS that are most closely linked to the client’s distinctive needs are those dealing with investment objectives and constraints.” Investment Guidelines “[provide] information about how policy may be executed, including investment constraints.”
Procedures “[detail] the steps to be taken to keep the IPS current and the procedures to follow to respond to various contingencies.”
Statement of Duties and Responsibilities “detail[s] the duties and responsibilities of the client, the custodian of the client’s assets, the investment managers, and so forth.”
446
A 38-year-old single client earns an income that is sufficient to cover her immediate spending needs and set aside money for retirement. She intends to pay for the post-secondary educations of her two children - ages 6 and 10. Which of the following statements is most accurate?
A
Illiquid assets are unsuitable investments for this client
B
The client has a long-term time horizon and a high ability to take risk
C
The client has a medium-term time horizon and a low ability to take risk
B
The client has a long-term time horizon and a high ability to take risk
447
Which of the following factors is least likely to impact an investor's willingness to take risk?
A
Personality
B
Time horizon
C
Financial awareness
B
Time horizon
here is a distinction between investors' ability to take on risk and their willingness to do so. Ability to take risk has more to do with circumstances external to the individual and can be assessed based on relatively objective criteria such as time horizon and liquidity needs relative to asset base.
By contrast, willingness to take risk is more psychological and is often determined based on responses to personality questionnaires.
Time horizon affects an investor's ability to take risk. Financial awareness and personality affect an investor's willingness to take risk.
448
hich of the following is least likely to be placed in the appendices to an investment policy statement (IPS)?
A
Rebalancing Policy.
B
Strategic Asset Allocation.
C
Statement of Duties and Responsibilities.
C
Statement of Duties and Responsibilities.
C is correct. The major components of an IPS are listed in Section 2 of the reading. Strategic Asset Allocation (also known as the policy portfolio) and Rebalancing Policy are often included as appendices to the IPS. The Statement of Duties and Responsibilities, however, is an integral part of the IPS and is unlikely to be placed in an appendix.
449
A manager using the core-satellite approach is least likely to allocate the majority of a portfolio's assets to:
A
active investments.
B
passive investments.
C
low active risk investments.
A
active investments.
The core-satellite approach involves allocating the majority of a portfolio's assets to passive or low active investments (the "core") and placing the remaining funds in actively-managed "satellite" accounts.
450
A portfolio's investment policy statement specifies a policy weight of 15% for international equities with a corridor of +/- 5%. Based on the output of a proprietary model indicating that international equities are expected to outperform domestic equities over the next six months, the manager increases the portfolio's international equity allocation to 20%. This decision is most accurately characterized as an example of:
A
tactical asset allocation.
B
strategic asset allocation.
C
mean-variance optimization.
A
tactical asset allocation.
Tactical asset allocation involves decisions to deviate from policy weights - even if the new allocation is within an allowable range. Any deviation from a portfolio's strategic asset allocation increases its level of unwanted risk exposure.
451
Selma Witt is a high-ranking executive with Televek Industries. Witt's personal portfolio includes several thousand Televek shares, but she is prohibited from trading these securities during the week before the company's financial reports are scheduled to be released. Last year, Witt sold some of her other holdings to cover an expense associated with an unexpected emergency. The restriction on trading Televek shares should most appropriately be noted in which section of Witt's IPS?
A
Liquidity constraints
B
Unique circumstances
C
Legal and regulatory factors
C
Legal and regulatory factors
A restriction such as the one described in this example should be included in the legal and regulatory factors section of the IPS.
Liquidity constraints include expected or unanticipated needs to withdraw funds from a portfolio.
The unique circumstances category is used for any relevant factors that do not fit neatly into any of the other categories of constraints.
452
Which of the following biases least likely relates to the mental discomfort that occurs when new information conflicts with a set of initial beliefs?
A
Confirmation bias
B
Representativeness bias
C
Anchoring and adjustment bias
C
Anchoring and adjustment bias
Belief perseverance biases relate to cognitive dissonance, the mental discomfort when an investor is given new information that conflicts with prior beliefs. Biases in this category include:
Conservatism bias
Confirmation bias
Representativeness bias
Illusion of control bias
Hindsight bias
Anchoring and adjustment bias is a type of processing error bias.
453
un Park, CFA, works at a hedge fund. Most of Park’s colleagues are also CFA charterholders. At an event with recent university graduates, Park comments, “Most CFA charterholders work at hedge funds.” Park’s remark exhibits which behavioral bias?
A
Availability
B
Conservatism
C
Framing
A
Availability
A is correct. Park is extrapolating his observation based on a narrow range of experience (working at a hedge fund that employs many CFA charterholders) to the entire population of CFA charterholders. Using a narrow range of experience is a form of availability bias.
454
The halo effect, which may be evident in FMP’s assessments of a company with a history of high revenue growth, is a form of which behavioral bias?
A
Endowment
B
Representativeness
C
Regret aversion
B
Representativeness
B is correct. Representativeness refers to the tendency to adopt a view or forecast based on individual information or a small sample, as well to use simple classifications. The halo effect is an example of representativeness, because FMPs extend an overall favorable evaluation to an investment (e.g., a “good company”) based on one or few characteristics (e.g., a “visionary CEO”).
455
Momentum, can be partly explained by the following behavioral biases except:
A
availability.
B
home bias.
C
regret.
B
home bias.
456
Which of the following statements is most accurate? Investors who are subject to the endowment bias:
A
will exhibit herd behavior.
B
will sell off profitable positions too quickly.
C
have an emotional attachments to their assets.
C
have an emotional attachments to their assets.
Investors with endowment bias tend to hold on to securities they already own, especially inherited positions. They fail to sell off certain assets when they should. Feelings of disloyalty and concerns about tax issues emerge when they consider selling those securities. In short, emotional attachments can be a significant factor in their decision to sell or not to sell.
Herd behavior is a consequence of regret-aversion bias, not endowment bias.
457
Under-diversified portfolios are not a potential implication of which of the following behavioral biases?
A
Representativeness
B
Illusion of control
C
Confirmation
A
Representativeness
A is correct. Under-diversified portfolios are a consequence of both illusion of control and confirmation biases. Researchers have found that some investors prefer to invest in companies that they feel they have control over, such as the companies they work for, leading them to hold concentrated positions. Confirmation bias may lead to FMPs ignoring negative news, paying attention only to information confirming that a company is a good investment, which may result in large positions.
Representativeness bias is not typically associated with under-diversified portfolios.
458
Which of the following statements is most accurate?
A
Hindsight bias can be used to explain the price momentum of a stock
B
When a bubble is forming, investors’ “fear of missing out” is triggered by the loss-aversion bias
C
Status quo bias causes investors to overtrade because they constantly feel the need to make changes
A
Hindsight bias can be used to explain the price momentum of a stock
Answer choice A is accurate. When a stock price increases, investors are likely to feel they could have predicted the significant upward movement of the stock because the signs were "obvious" (i.e., hindsight bias). To remedy this regret, investors are likely to buy the stock, pushing the stock price even higher.
459
n the 1980s, Japan was viewed by many FMPs as the model economy. Although its growth began to decelerate sharply by 1990, it was not until the mid to late 1990s that FMPs’ GDP forecasts were consistently achieved. By taking several years to adapt their forecasts to the lower growth environment, FMPs exhibited which behavioral bias?
A
Mental accounting
B
Overconfidence
C
Conservatism
C
Conservatism
460
Which of the following statements is the most accurate?
A
Cognitive errors are usually caused by an investor’s intuition on a subconscious level
B
Traditional financial theories assume investors behave rationally while making decisions
C
While emotional biases are hard to detect, they can be corrected through better information and education
B
Traditional financial theories assume investors behave rationally while making decisions
nswer choice B is most accurate. Traditional economic and financial theories assume that investors behave rationally in their decision-making process. This assumption contradicts various researches studies.
461
All of the following are reasons that an apparent deviation from the efficient market hypothesis might not be anomalous except:
A
The abnormal returns represent compensation for exposure to risk.
B
Changing the asset pricing model makes the deviation to disappear.
C
The deviation is well known or documented.
C
The deviation is well known or documented.
C is correct. Bubbles and crashes are well-known and well-documented phenomena yet represent market anomalies.
462
Which of the following biases least likely relates to the mental discomfort that occurs when new information conflicts with a set of initial beliefs?
A
Confirmation bias
B
Representativeness bias
C
Anchoring and adjustment bias
C
Anchoring and adjustment biasBelief perseverance biases relate to cognitive dissonance, the mental discomfort when an investor is given new information that conflicts with prior beliefs. Biases in this category include:
Conservatism bias
Confirmation bias
Representativeness bias
Illusion of control bias
Hindsight bias
Anchoring and adjustment bias is a type of processing error bias.
463
The halo effect, which may be evident in FMP’s assessments of a company with a history of high revenue growth, is a form of which behavioral bias?
A
Endowment
B
Representativeness
C
Regret aversion
B
Representativeness
B is correct. Representativeness refers to the tendency to adopt a view or forecast based on individual information or a small sample, as well to use simple classifications. The halo effect is an example of representativeness, because FMPs extend an overall favorable evaluation to an investment (e.g., a “good company”) based on one or few characteristics (e.g., a “visionary CEO”).
464
Status quo bias is least similar to which of the following behavioral biases?
A
Endowment
B
Regret aversion
C
Confirmation
C
Confirmation
C is correct. Both endowment bias and regret-aversion bias often result in indecision or inertia—a typical outcome of status quo bias, in which people prefer to not make changes even when changes are warranted.
465
An example of a non-financial risk is:
A
market risk.
B
liquidity risk.
C
settlement risk.
C
settlement risk.
C is correct. Settlement risk is related to default risk but deals with the timing of payments rather than the risk of default.
466
The process of risk management includes:
A
minimizing risk.
B
maximizing returns.
C
defining and measuring risks being taken.
C
defining and measuring risks being taken.
C is correct. Risks need to be defined and measured so as to be consistent with the organization’s chosen level of risk tolerance and target for returns or other outcomes.
467
Which of the following statements is least likely correct regarding a firm’s proper risk management framework?
A
Risk governance deals with setting the firm’s overall risk tolerance
B
Financial risks such as market risk, liquidity risk, and credit risk comprise nearly all of the risks affecting firms
C
Risk tolerance sets forth which risks are acceptable and which are not, as well as how much risk the firm can be exposed to
B
Financial risks such as market risk, liquidity risk, and credit risk comprise nearly all of the risks affecting firms
Firms must consider both financial and non-financial risks. Both are usually important.
Firms have financial risks that come from exposure to markets. However, firms typically must also consider non-financial risks, such as regulatory risk, accounting risk, and tax risk.
468
Effective risk governance in an enterprise provides guidance on all of the following except:
A
unacceptable risks.
B
worst losses that may be tolerated.
C
specific methods to mitigate risk for each subsidiary in the enterprise.
C
specific methods to mitigate risk for each subsidiary in the enterprise.
C is correct. Risk governance is not about specifying methods to mitigate risk at the business line level. Rather, it is about establishing an appropriate level of risk for the entire enterprise. Specifics of dealing with risk fall under risk management and the risk infrastructure framework.
469
Which of the following scenarios is most likely an example of an adverse risk interaction?
A
US corporations issue more junk bonds because of low interest rates encouraged by easy monetary policy throughout the world. A few months later, credit spreads rise in the speculative debt markets.
B
A European investor purchases an out-of-the-money put in a foreign security. A few months later, equity markets decline in the option writer’s home country, causing this option writer to default on the put.
C
Speculators and retail investors throughout the world increase their exposure to foreign equities. A few months later, stock prices in emerging markets decline at the same time that stock prices in developed markets decline.
B
A European investor purchases an out-of-the-money put in a foreign security. A few months later, equity markets decline in the option writer’s home country, causing this option writer to default on the put.
Adverse risk interaction occurs when losses caused by one type of risk exacerbate losses caused by another type of risk.
470
An organization choosing to accept a risk exposure may:
A
buy insurance.
B
enter into a derivative contract.
C
establish a reserve fund to cover losses.
C
establish a reserve fund to cover losses.
C is correct. Risk acceptance is similar to self-insurance. An organization choosing to self-insure may set up a reserve fund to cover losses. Buying insurance is a form of risk transfer and using derivatives is a form of risk-shifting, not risk acceptance.
471
a company has a one-day 5% Value at Risk of $1 million, this means:
A
5% of the time the firm is expected to lose at least $1 million in one day.
B
95% of the time the firm is expected to lose at least $1 million in one day.
C
5% of the time the firm is expected to lose no more than $1 million in one day.
a
5% of the time the firm is expected to lose at least $1 million in one day.
A is correct. The VaR measure indicates the probability of a loss of at least a certain level in a time period.
472
A firm’s risk management committee would be expected to do all of the following except:
A
approving the governing body’s proposed risk policies.
B
deliberating the governing body’s risk policies at the operational level.
C
providing top decision-makers with a forum for considering risk management issues.
A
approving the governing body’s proposed risk policies.
A is correct. The risk management committee is a part of the risk governance structure at the operational level—as such, it does not approve the governing body’s policies.
473
A benefit of risk budgeting is that it:
A
considers risk tradeoffs.
B
establishes a firm’s risk tolerance.
C
reduces uncertainty facing the firm.
A
considers risk tradeoffs.
A is correct. The process of risk budgeting forces the firm to consider risk tradeoffs. As a result, the firm should choose to invest where the return per unit of risk is the highest.
474
The factors a risk management framework should address include all of the following except:
A
communications.
B
policies and processes.
C
names of responsible individuals.
C
names of responsible individuals.
C is correct. While risk infrastructure, which a risk management framework must address, refers to the people and systems required to track risk exposures, there is no requirement to actually name the responsible individuals.
475
Which of the following measures most likely captures the risk of large changes in the price of the underlying asset of a derivative?
A
Rho
B
Vega
C
Gamma
C
Gamma
Gamma reflects the risk of changes in delta as a second order risk, thus being the focus for large changes in the price of the underlying.
Vega measures the change in derivative prices for a change in volatility, while rho measures the sensitivity of derivative prices to changes in interest rates.
476
The process of risk management includes:
A
minimizing risk.
B
maximizing returns.
C
defining and measuring risks being taken.
c
defining and measuring risks being taken.
C is correct. Risks need to be defined and measured so as to be consistent with the organization’s chosen level of risk tolerance and target for returns or other outcomes.
477
Which of the following is the correct sequence of events for risk governance and management that focuses on the entire enterprise? Establishing:
A
risk tolerance, then risk budgeting, and then risk exposures.
B
risk exposures, then risk tolerance, and then risk budgeting.
C
risk budgeting, then risk exposures, and then risk tolerance.
A
risk tolerance, then risk budgeting, and then risk exposures.
A is correct. In establishing a risk management system, determining risk tolerance must happen before specific risks can be accepted or reduced. Risk tolerance defines the appetite for risk. Risk budgeting determine how or where the risk is taken and quantifies the tolerable risk by specific metrics. Risk exposures can then be measured and compared against the acceptable risk.
478
Which of the following is least likely correct with regard to the value at risk (VaR) measure?
A
It is a maximum extreme loss metric
B
It measures the size of the tail of the distribution of profits for an entity
C
It contains three elements – an amount stated in the units of currency, a time period, and a probability
A
It is a maximum extreme loss metric
VaR is a minimum extreme loss metric. VaR is interpreted as the minimum loss an entity can have with some probability.
VaR measures the size of the tail of the distribution of profits for an entity.
479
Which of the following statements is most accurate? If the covariance of returns between two assets is 0.0023, then:
A
the assets’ risk is near zero.
B
the asset returns are unrelated.
C
the asset returns have a positive relationship.
C
the asset returns have a positive relationship.
The covariance of returns is positive when the returns on both assets tend to be on the same side (above or below) their expected values at the same time.
480
afety-first rules are most likely to be used by investors who:
A
consider risk symmetrically.
B
are concerned about shortfall risk.
C
do not consider the correlations of returns on assets within a portfolio.
B
are concerned about shortfall risk.
481
The Black-Scholes-Merton option pricing model is most likely based on the assumption that the prices of underlying assets are:
A
t-distributed.
B
Chi-square distributed.
C
lognormally distributed.
C
lognormally distributed.
A key assumption of the Black-Scholes-Merton option model is that prices of underlying assets follow a lognormal distribution.
482
Analysts performing bootstrap:
A
seek to create statistical inferences of population parameters from a single sample.
B
repeatedly draw samples of the same size, with replacement, from the original population.
C
must specify probability distributions for key risk factors that drive the underlying random variables
A
seek to create statistical inferences of population parameters from a single sample.
A is correct. Bootstrapping through random sampling generates the observed variable from a random sampling with unknown population parameters. The analyst does not know the true population distribution, but through sampling can infer the population parameters from the randomly generated sample.
B is incorrect because, when performing bootstrap, the analyst repeatedly draws samples from the original sample and not population, where each individual resample has the same size as the original sample and each item drawn is replaced for the next draw.
483
Which of the following statements is most accurate? Compared to analytical methods, Monte Carlo simulation:
A
provides more precision when valuing options.
B
provides more insight into causal relationships.
C
can be used to value a wider variety of options than analytical methods.
C
can be used to value a wider variety of options than analytical methods.
Monte Carlo simulation can only provide statistical estimates, not precise valuations. And, unlike analytical methods, Monte Carlo simulation does not provide insight into the causal relationships between variables.
However, Monte Carlo simulation can be used to value many types of options that cannot be priced with analytical methods (e.g., Asian call options).
484
The weekly closing prices of Mordice Corporation shares are as follows:
Date Closing Price (€)
1 August 112
8 August 160
15 August 120
The continuously compounded return of Mordice Corporation shares for the period August 1 to August 15 is closest to:
A
6.90%.
B
7.14%.
C
8.95%.
A
6.90%.
A is correct. The continuously compounded return of an asset over a period is equal to the natural log of the asset’s price change during the period. In this case, ln(120/112) = 6.90%.
485
how to find annualized standard deviations?
find the annual variances and then do the square root
486
An analyst takes a sample of an equity index's monthly returns over a five-year period and determines that the the natural logarithm of this random variable follows a normal distribution. Based only on this information, it is most likely that:
A
the index's monthly return data is normally distributed.
B
the index's monthly return data is lognormally distributed.
C
there is not sufficient evidence to reach a conclusion about the distribution of the index's monthly return data.
B
the index's monthly return data is lognormally distributed.
If a random variable is lognormally distributed, it follows that its natural logarithm is normally distributed. It is also true that, if a random variable's natural logarithm is normally distributed, the variable itself must be lognormally distributed.
487
standard error formula
s / sqrt(n)
488
Which of the following methods is most appropriate to use when only some members of a finite population can be identified?
A
Systematic sampling
B
Simple random sampling
C
Stratified random sampling
A
Systematic sampling
Systematic sampling can be used when not all members of a population can be coded or even identified to be placed in groups. It involves selecting every kth member of a population until the desired size of the sample is reached.
Simple random sampling often involves coding each member of a population and then randomly selecting a sample from that population.
Stratified random sampling involves dividing the population into subpopulations based on one or more classification criteria and drawing samples from each group. All members of a population need to be able to be identified and coded or grouped for these methods to work.
489
Compared with bootstrap resampling, jackknife resampling:
A
is done with replacement.
B
usually requires that the number of repetitions is equal to the sample size.
C
produces dissimilar results for every run because resamples are randomly drawn.
B
usually requires that the number of repetitions is equal to the sample size.
B is correct. For a sample of size n, jackknife resampling usually requires n repetitions. In contrast, with bootstrap resampling, we are left to determine how many repetitions are appropriate.
490
An analyst uses the simple random sampling method to draw a sample of 30 stocks from an equally-weighted index with 500 constituents. The first stock sampled returned 10% in 20X2, and the mean 20X2 return of the analyst's entire sampled portfolio is 14%. If the index return in 20X2 was 16%, the absolute value of the analyst's sampling error is closest to:
A
2%.
B
4%.
C
6%.
A
2%.
The sampling error is the difference between the observed value and the value it was intended to estimate.
In this case, the observed value was the sample mean return, or 14%. The actual mean return for the population was 16%, so the sampling error was 2%.
491
The best approach for creating a stratified random sample of a population involves:
A
drawing an equal number of simple random samples from each subpopulation.
B
selecting every kth member of the population until the desired sample size is reached.
C
drawing simple random samples from each subpopulation in sizes proportional to the relative size of each subpopulation.
C
drawing simple random samples from each subpopulation in sizes proportional to the relative size of each subpopulation.
C is correct. Stratified random sampling involves dividing a population into subpopulations based on one or more classification criteria. Then, simple random samples are drawn from each subpopulation in sizes proportional to the relative size of each subpopulation. These samples are then pooled to form a stratified random sample.
492
A population has a mean of 15.5 and a variance of 0.25. A sample of 100 observations from this population has a mean of 14.8 and a standard deviation of 0.6. If the central limit theory holds, the variance of the distribution of the sample mean is closest to:
A
0.0025.
B
0.0250.
C
0.3600.
A
0.0025.
According to the central limit theory, the variance of the distribution of the sample mean is equal to the variance of the population divided by sample size. In this example:
0.25/100 = 0.0025
493
A chi-square test is most appropriate for tests concerning:
A
a single variance.
B
differences between two population means with variances assumed to be equal.
C
differences between two population means with variances assumed to not be equal.
A
a single variance.
A is correct. A chi-square test is used for tests concerning the variance of a single normally distributed population.
494
Calculated test statistic: 0.4893
Critical value rejection points: ±1.984
do we accept or reject the null hypothesis
Accept it
The calculated t-statistic value of 0.4893 falls within the bounds of the critical t-values of ±1.98, thus we have to accept the null hypothesis
495
The probability of correctly rejecting the null hypothesis is most likely the:
A
p-value.
B
power of a test.
C
level of significance.
B
power of a test.
B is correct. The power of a test is the probability of rejecting the null hypothesis when it is false.
496
If two populations are normally distributed and the population variances are unknown but can reasonably be assumed to be equal, which test formula will we use?
the complicated t-test that will
497
The power of a hypothesis test is most likely:
A
equivalent to the level of significance.
B
the probability of not making a Type II error.
C
unchanged by increasing a small sample size.
B
the probability of not making a Type II error.
B is correct. The power of a hypothesis test is the probability of correctly rejecting the null when it is false. Failing to reject the null when it is false is a Type II error. Thus, the power of a hypothesis test is the probability of not committing a Type II error.
498
In which of the following situations would a nonparametric test of a hypothesis most likely be used?
A
The sample data are ranked according to magnitude.
B
The sample data come from a normally distributed population.
C
The test validity depends on many assumptions about the nature of the population.
A
The sample data are ranked according to magnitude.
A is correct. A nonparametric test is used when the data are given in ranks.
499
F-test formula
F = variance 1 / variance 2
500
if the p-value is lower than the level of significance, what do we do?
we reject the null hypothesis
501
A pooled estimator is most likely used when testing a hypothesis concerning the:
A
equality of the variances of two normally distributed populations.
B
difference between the means of two at least approximately normally distributed populations with unknown but assumed equal variances.
C
difference between the means of two at least approximately normally distributed populations with unknown and assumed unequal variances.
B
difference between the means of two at least approximately normally distributed populations with unknown but assumed equal variances.
B is correct. The assumption that the variances are equal allows for the combining of both samples to obtain a pooled estimate of the common variance.
502
when do use the F-test
when we want to compare the variances of two samples
503
when do we use a chi-square test
when we want to see if a single sample variance differs from its population variance
504
Which of the following tests of a hypothesis concerning the population mean is most appropriate?
A
A z-test if the population variance is unknown and the sample is small
B
A z-test if the population is normally distributed with a known variance
C
A t-test if the population is non-normally distributed with unknown variance and a small sample
B
A z-test if the population is normally distributed with a known variance
505
The value of a test statistic is best described as the basis for deciding whether to:
A
reject the null hypothesis.
B
accept the null hypothesis.
C
reject the alternative hypothesis.
A
reject the null hypothesis.
A is correct. Calculated using a sample, a test statistic is a quantity whose value is the basis for deciding whether to reject the null hypothesis.
506
The critical value for the chi-square test of independence is most likely determined by the:
A
number of observations in the sample.
B
number of rows and columns in the contingency table.
C
magnitude of the squared deviations between expected and observed frequencies.
B
number of rows and columns in the contingency table.
The critical chi-square value used in a test of independence is determined two factors. The first is the desired region of rejection on the right side of the chi-square distribution. The second factor is the test statistic's degrees of freedom, which are calculated as
(r - 1) * (c - 1), where r and c are, respectively, the number of rows and columns in the contingency table.
The magnitude of the squared deviations between expected and observed frequencies determines the value of the calculated chi-square statistic that is compared to the critical value, which is unaffected by the number of observations in the sample.
507
Jill Batten is analyzing how the returns on the stock of Stellar Energy Corp. are related with the previous month’s percentage change in the US Consumer Price Index for Energy (CPIENG). Based on 248 observations, she has computed the sample correlation between the Stellar and CPIENG variables to be -0.1452. She also wants to determine whether the sample correlation is significantly different from zero. The critical value for the test statistic at the 0.05 level of significance is approximately 1.96. Batten should most likely conclude that the statistical relationship between Stellar and CPIENG is:
(the t-test = -2.30)
A
significant, because the calculated test statistic is outside the bounds of the critical values for the test statistic.
B
significant, because the calculated test statistic has a lower absolute value than the critical value for the test statistic.
C
insignificant, because the calculated test statistic is outside the bounds of the critical values for the test statistic.
A
significant, because the calculated test statistic is outside the bounds of the critical values for the test statistic.
outside the bounds of ±1.96, we reject the null hypothesis of no correlation and conclude that there is enough evidence to indicate that the correlation is different from zero.
508
Based on 30 years of quarterly data, an analyst calculates a sample correlation of 0.68 between real estate returns and inflation. The analyst hypothesizes a statistically significant relationship at the 5% level of significance between these two variables in the population. All else equal, reducing the number of observations in the sample will most likely increase the:
A
critical value of the t-statistic.
B
t-statistic's degrees of freedom.
C
likelihood of rejecting the null hypothesis.
A
critical value of the t-statistic.
The critical value of a t-statistic is determined by the degrees of freedom and the level of significance.
For a given level of significance, reducing the number of observations will reduce the number of degrees of freedom (n-2), which will result in a higher critical value for the t-statistic
This will also reduce the calculated value of the t-statistic, which will reduce the likelihood of rejecting the null hypothesis that the linear relationship between the two variables is not statistically significant.
509
When working with sample data taken from a population that is believed to be non-normally distributed, the most appropriate statistic to measure the strength of a linear relationship between two variables is the:
A
bivariate corelation coefficient.
B
Pearson correlation coefficient.
C
Spearman rank correlation coefficient.
C
Spearman rank correlation coefficient.
the Spearman rank correlation coefficient is used for non-parametric tests of correlation when working with data from a population that is believed to deviate significantly from an assumed normal distribution.
The Pearson (or bivariate) correlation coefficient is used to perform parametric tests if the population data is assumed to be normally distributed.
510
formula to find expected frequency
Eij = (total row i * total row j) / overall total
511
how to find the degrees of freedom in Tests Concerning Correlation
n - 2
512
in a regression, how do you calculate the standard error of the estimate?
sqrt(MSE)
MSE = mean sqaured error
The standard error of the estimate is the standard deviation of the regression residuals.
513
in a linear regression with one independent variable, the correlation (r) is calculated as
the square root of the coefficient of determination (R^2)
514
While preparing to run a simple linear regression model, an equity analyst makes the following statement: "The regression coefficients in a simple linear least squares model are the intercept, the independent variable, and the slope."
Is this statement most likely correct?
A
Yes
B
No, because the dependent variable is also a regression coefficient
C
No, because the independent variable is not a regression coefficient
C
No, because the independent variable is not a regression coefficient
When there is only one independent variable, the intercept and slope are referred to as the regression coefficients. Neither the independent variable nor the dependent variable is included in this category.
515
All else equal, an increase in which of the following will most likely result in a lower F-statistic?
A
Residual sum of squares
B
Number of observations
C
Mean regression sum of squares
A
Residual sum of squares
F = mean regression sum of square s/ mean squared error
F = (RSS/1) / (SSE/(n-2))
n is the number of observations
RSS is the regression sum of squares
SSE is the sum of squared errors, or residual sum of squares
a higher SSE will lower the F-test
516
Which of the following statements on
-value is most likely correct?
A
The p-value indicates the probability of making a Type II error
B
The lower the p-value, the weaker the evidence for rejecting the H0
C
The p-value is the smallest level of significance at which H0 can be rejected
C
The p-value is the smallest level of significance at which H0 can be rejected
517
Before running a regression model, an analyst states two of the underlying assumptions for linear regression analysis:
Assumption 1: The variance of the error term has an expected value of zero
Assumption 2: The independent variable is not random
What is the most accurate assessment of the analyst's description of the assumptions that must be satisfied to draw valid conclusions from a simple linear regression model?
A
Assumption 1 and Assumption 2 are both correct
B
Assumption 1 is correct and Assumption 2 is incorrect
C
Assumption 1 is incorrect and Assumption 2 is correct
C
Assumption 1 is incorrect and Assumption 2 is correct
Assumption 1 is incorrect. The homoskedasticity assumption states that the variance of the error term is the same for all observations. It does not imply that this measure has an expected value of zero.
Assumption 2 is correct. The assumption of linearity states that the dependent and independent variables are linearly related. This implies that the independent variable is not random. If it were, there would be no linear relationship with the dependent variable.
518
The independence assumption underlying a linear regression has most likely been violated if:
A
the error term is not normally distributed.
B
errors are correlated across observations.
C
the variance of the error term is not the same for all observations.
B
errors are correlated across observations.
In a linear regression, it is assumed that the pairs of observations for X and Y are uncorrelated with one another. Correlation of residual errors indicates that this assumption of independence has been violated.
519
An investor sells 20 out-of-the-money put contracts on Blacktree Minerals (BTM) stock. Each contract is for 1,000 shares of the underlying. The investor is most likely to incur losses if the price of BTM shares:
A
decreases.
B
remains unchanged.
C
increases.
A
decreases.
By selling put contracts, the investor agrees to buy the 20,000 shares of BTM in the future at a price fixed today if the option is exercised. The likelihood of incurring a loss from this position increases as the price of the underlying decreases.
520
An investor seeking to take a speculative position based on expected interest rate movements is considering the following positions:
Position 1: Long a six-month interest rate futures contract with a notional value of $10 million based on the 3-month market reference rate (MRR 3m, 6m).
Position 2: Short a forward rate agreement (FRA) with a notional value of $10 million based on the same 3-month MRR for a deposit to be made in six months.
Assuming that (MRR 3m, 6m) is set at 2.5% and the observed 3-month MRR is observed to be 2.4% when the contracts reach maturity in six months, Position 1 will most likely:
A
incur a loss.
B
realize a gain that is less than the gain earned Position 2.
C
realize a gain that is greater than the gain earned by Position 2.
C
realize a gain that is greater than the gain earned by Position 2.
If the 3-month reference rate is observed to be less than the set rate (2.4% vs. 2.5%), both a long interest rate futures position and a short FRA position will be profitable.
However, Position 2’s payoff will be the discounted value of the difference between the two deposits at maturity. By contrast, Position 1’s payoff will be for the full (undiscounted) amount.
521
Baywhite Financial is a broker-dealer and wealth management firm that helps its clients manage their portfolios using stand-alone derivative strategies.
Baywhite Financial seeks to gain a competitive advantage by making margin loans at fixed rates for up to 60 days to its investor clients. Since Baywhite borrows at a variable one-month market reference rate to finance these client loans, the firm enters into one-month FRA contracts on one-month MRR to hedge the interest rate exposure of its margin loan book. Which of the following statements best describes Baywhite’s interest rate exposure and the FRA position it should take to hedge that exposure?
A
Baywhite faces exposure to a rise in one-month MRR over the next 30 days, so it should enter into the FRA as a fixed-rate payer in order to benefit from a rise in one-month MRR above the FRA rate and offset its higher borrowing cost.
B
Baywhite faces exposure to a rise in one-month MRR over the next 30 days, so it should enter into the FRA as a fixed-rate receiver in order to benefit from a rise in one-month MRR above the FRA rate and offset its higher borrowing cost.
C
Baywhite faces exposure to a decline in one-month MRR over the next 30 days, so it should enter into the FRA as a fixed-rate receiver in order to benefit from a rise in one-month MRR above the FRA rate and offset its higher borrowing cost.
A
Baywhite faces exposure to a rise in one-month MRR over the next 30 days, so it should enter into the FRA as a fixed-rate payer in order to benefit from a rise in one-month MRR above the FRA rate and offset its higher borrowing cost.
As Baywhite faces exposure to a rise in one-month MRR over the next 30 days, it should enter into the FRA as a fixed-rate payer in order to benefit from a rise in one-month MRR above the FRA rate and offset its higher borrowing cost
522
Which of the following statements about derivatives market participants is most accurate?
A
Speculative transactions are inherently destabilizing to derivative markets
B
Speculative traders reduce the cost of modifying risk exposures in derivative markets
C
Hedgers are more beneficial to the functioning of derivative markets than speculators
B
Speculative traders reduce the cost of modifying risk exposures in derivative markets
Hedgers use derivatives markets to modify their risk exposures. On the opposite side of each hedging trade is a speculator who is willing to be compensated for accepting risk. Hedgers would not be able to accomplish their objectives without speculators acting as counterparties. The role of speculators is similar to insurers that take on diversified pools of risk in exchange for premiums.
523
An investor who expects interest rates to rise is considering using either an interest rate futures contract or a forward rate agreement (FRA) to establish a position that is consistent with this view. Which of the following positions will most likely increase in value due to rising interest rates?
A
Long interest rate futures or long FRA
B
Short interest rate futures or long FRA
C
Long interest rate futures or short FRA
B
Short interest rate futures or long FRA
Interest rate futures contracts are priced using the following formula:
Futures contract price = 100 - (100 * MRR)
Because the contract price is inversely related to the market reference rate, an investor who expects rates to rise will want to establish a short interest rate futures position.
By comparison, FRA positions are determined relative to the fixed-rate leg. A party that is long an FRA pays the fixed rate and receives the floating rate. Conversely, a short FRA position receives fixed and pays the floating reference rate. A long FRA position is consistent with the expectation of rising interest rates.
524
With respect to exchange-traded derivatives, which of the following is least accurate?
A
Exchange-traded derivatives are customized
B
The exchange guarantees all payments in the event of default
C
Full information on all transactions is disclosed to exchanges and regulatory bodies
A
Exchange-traded derivatives are customized
Exchange-traded derivatives are standardized, while OTC (over-the-counter) derivatives are customized.
Exchange markets have transparency, which means that full information on all transactions is disclosed to exchanges and regulatory bodies.
Derivatives exchanges use clearinghouses to provide a guarantee to the winning party that if the losing party fails to pay, the clearinghouse will pay the winning party. The clearinghouse accomplishes this by requiring a cash deposit from the participants to the contract.
525
Changes in the required margin for a floater usually come from:
A
shifts in the yield curve.
B
changes in credit risk.
C
increases or decrease in inflation.
B
changes in credit risk.
B is correct. The required margin is the yield spread over or under a reference rate, reflecting the credit risk of an issuer. Changes in the required margin typically come from a change in the issuer’s credit risk.
A and C are incorrect. Both risks, as “top-down” or macroeconomic risks, would be reflected in changes in the MRR, not in a spread such as the required margin.
526
Which of the following statements describing a par curve is incorrect?
A
A par curve is obtained from a spot curve.
B
All bonds on a par curve are assumed to have different credit risk.
C
A par curve is a sequence of yields-to-maturity such that each bond is priced at par value.
B
All bonds on a par curve are assumed to have different credit risk.
All bonds on a par curve are assumed to have similar, not different, credit risk.
Par curves are obtained from spot curves, and all bonds used to derive the par curve are assumed to have the same credit risk, as well as the same periodicity, currency, liquidity, tax status, and annual yields.
A par curve is a sequence of yields-to-maturity such that each bond is priced at par value.
527
how to find the bond equivalent yield of a banker's note?
1. The present value of the banker’s acceptance is calculated as
PV = FV * (1 - Days/year * DR)
2. Bond equivalent yield (AOR)
AOR = (365/Days) * (FV - PV)/PV
528
f a 10-year bond paying a market reference rate plus 60 basis points (bps) semiannually is selling at 100.57, the discount margin is most likely:
A
less than 60 bps.
B
equal to 60 bps.
C
more than 60 bps.
Since the bond is selling at a premium, the discount margin (the margin required by investors) will be less than the quoted spread of 60bps.
If the same bond were selling at par (100), the discount margin would be exactly 60 bps. If investors required a greater yield than the quoted spread (i.e., the discount margin were more than 60 bps), the bond would be selling at a discount.
529
Which of the following statements is most accurate? The yield spread for a corporate bond relative to an on-the-run US Treasury security of the same maturity:
A
cannot be negative.
B
must be negative if the corporate bond is trading above its par value.
C
may be negative if the corporate bond contains an embedded option.
C
may be negative if the corporate bond contains an embedded option.
it is possible that the yield spread is negative for a corporate bond with an embedded put option, which investors value because it grants the right to sell bonds back to their issuer if interest rates rise.
Investors may require less compensation for holding a putable corporate bond than an option-free US Treasury security of the same maturity (i.e., a negative yield spread).
530
An investor purchases a 20-year, 5% semiannual coupon government bond. Which of the following conditions are most likely required to hold in order to ensure that the return on this investment is equal to 5%.
Condition 1: The bond is held to maturity
Condition 2: Yield spreads are unchanged
Condition 3: Coupons payments earn a 5% yield as they are reinvested
Condition 1: The bond is held to maturity and Condition 3: Coupons payments earn a 5% yield as they are reinvested
Both Condition 1 and Condition 3 must hold in order to ensure that the investor's return is equal to 5%.
For an investor to earn a bond's yield-to-maturity, the following conditions must hold:
The bond is held to maturity
The issuer does not default
Coupons payments are reinvested and earn the same yield-to-maturity
It is possible to reinvest coupons at the same yield-to-maturity even if yield spreads change because a change in spreads does not necessarily result in a change in yield-to-maturity. Additionally, yield spreads are unlikely relevant in this example because the bond is issued by a government.
531
formula for treasury bill
Price = FV * (1 - (Days remaining / Days per year) * DR)
532
When underwriting new corporate bonds, matrix pricing is used to get an estimate of the:
A
required yield spread over the benchmark rate.
B
market discount rate of other comparable corporate bonds.
C
yield-to-maturity on a government bond having a similar time-to-maturity.
A
required yield spread over the benchmark rate.
533
ime Annualized Rate
6-month spot rate 3.5%
6-month future rate 6 months from now 3.7%
6-month future rate 12 months from now 3.9%
6-month future rate 18 months from now 4.1%
6-month future rate 24 months from now 4.3%
36-month spot rate (stated on a semiannual bond basis) 4.5%
The 6-month forward rate 30 months from now is closest to:
A
4.30%.
B
4.50%.
C
7.53%.
According to the arbitrage principle, investing at the 36-month spot rate should be identical to rolling over 6-a series of 6-month investments over the same period
C
7.53%.
534
Bond dealers most often quote the:
A
flat price.
B
full price.
C
full price plus accrued interest.
A
flat price.
A is correct. Bond dealers usually quote the flat price. When a trade takes place, the accrued interest is added to the flat price to obtain the full price paid by the buyer and received by the seller on the settlement date. The reason for using the flat price for quotation is to avoid misleading investors about the market price trend for the bond. If the full price were to be quoted by dealers, investors would see the price rise day after day even if the yield-to-maturity did not change. That is because the amount of accrued interest increases each day. After the coupon payment is made, the quoted price would drop dramatically. Using the flat price for quotation avoids that misrepresentation. The full price, flat price plus accrued interest, is not usually quoted by bond dealers. Accrued interest is included in the full price, and bond dealers do not generally quote the full price
535
The yield spread of a specific bond over the standard swap rate in that currency of the same tenor is best described as the:
A
I-spread.
B
Z-spread.
C
G-spread.
A
I-spread.
A is correct. The I-spread, or interpolated spread, is the yield spread of a specific bond over the standard swap rate in that currency of the same tenor.
The yield spread in basis points over an actual or interpolated government bond is known as the G-spread.
The Z-spread (zero-volatility spread) is the constant spread that is added to each spot rate such that the present value of the cash flows matches the price of the bond.
536
G-spread.
a yield spread above that of a government bond with the same maturity date
536
Which of the following statements describing a par curve is incorrect?
A
A par curve is obtained from a spot curve.
B
All bonds on a par curve are assumed to have different credit risk.
C
A par curve is a sequence of yields-to-maturity such that each bond is priced at par value.
B
All bonds on a par curve are assumed to have different credit risk.
B is correct. All bonds on a par curve are assumed to have similar, not different, credit risk. Par curves are obtained from spot curves, and all bonds used to derive the par curve are assumed to have the same credit risk, as well as the same periodicity, currency, liquidity, tax status, and annual yields. A par curve is a sequence of yields-to-maturity such that each bond is priced at par valu
536
how to calculate an implied spot rate
the geomtetric average of implied forward rates
537
the rate interpreted to be the incremental return for extending the time-to-maturity of an investment for an additional time period is the:
A
add-on rate.
B
forward rate.
C
yield-to-maturity.
B
forward rate.
B is correct. The forward rate can be interpreted to be the incremental or marginal return for extending the time-to-maturity of an investment for an additional time period.
The add-on rate (bond equivalent yield) is a rate quoted for money market instruments, such as bank certificates of deposit, and indexes, such as MRR, Libor and Euribor
537
Which of the following statements is most accurate? In an upward-sloping spot rate environment, the Treasury forward curve must be:
A
upward-sloping at all points.
B
located below the Treasury spot curve.
C
located above the Treasury spot curve.
C
located above the Treasury spot curve.
in an upward-sloping spot rate environment, forward rates will be higher than spot rates for the same maturities. Mathematically, if spot rates are successively higher at all maturities (i.e., the yield curve is upward sloping), the forward curve must be located above the spot curve.
537
The spread component of a specific bond’s yield-to-maturity is least likely impacted by changes in:
A
its tax status.
B
its quality rating.
C
inflation in its currency of denomination.
C
inflation in its currency of denomination.
C is correct. The spread component of a specific bond’s yield-to-maturity is least likely impacted by changes in inflation in its currency of denomination. The effect of changes in macroeconomic factors, such as the expected rate of inflation in the currency of denomination, is seen mostly in changes in the benchmark yield.
The spread or risk premium component is impacted by microeconomic factors specific to the bond and bond issuer, including tax status and quality rating.
537
n an upward-sloping yield curve environment, the arbitrage-free price of a bond calculated using spot rates would most likely be:
A
less than the arbitrage-free price calculated using forward rates.
B
the same as the arbitrage-free price calculated using forward rates.
C
greater than the arbitrage-free price calculated using forward rates.
B
the same as the arbitrage-free price calculated using forward rates.
Forward rates are calculated in an arbitrage-free way so that they will be equivalent to spot rates.
The same price would be calculated regardless of whether forward rates or spot rates are used to discount cash flows.
538
Changes in the required margin for a floater usually come from:
A
shifts in the yield curve.
B
changes in credit risk.
C
increases or decrease in inflation.
B
changes in credit risk.
B is correct. The required margin is the yield spread over or under a reference rate, reflecting the credit risk of an issuer. Changes in the required margin typically come from a change in the issuer’s credit risk.
539
Matrix pricing allows investors to estimate market discount rates and prices for bonds:
A
with different coupon rates.
B
that are not actively traded.
C
with different credit quality.
B
that are not actively traded.
540
A yield curve constructed from a sequence of yields-to-maturity on zero-coupon bonds is the:
A
par curve.
B
spot curve.
C
forward curve.
B
spot curve.
B is correct. The spot curve, also known as the strip, or zero, curve, is the yield curve constructed from a sequence of yields-to-maturity on zero-coupon bonds.
The par curve is a sequence of yields-to-maturity such that each bond is priced at par value. The forward curve is constructed using a series of forward rates, each having the same time frame.
540
Which of the following is least likely to be included as part of a corporate bond's yield spread?
A
Credit spread
B
Maturity premium
C
Liquidity premium
B
Maturity premium
A corporate bond's yield spread is the difference between the corporate bond yield and the benchmark rate.
A corporate bond's yield is calculated as the sum of the following components:
Real risk-free rate
Expected inflation
Maturity premium
Liquidity Premium
Credit Spread
The benchmark rate includes the following components:
Real risk-free rate
Expected inflation
Maturity premium
Therefore, the corporate bond's yield spread only includes the credit spread and a liquidity premium, but does not include a maturity premium.
541
The rate interpreted to be the incremental return for extending the time-to-maturity of an investment for an additional time period is the:
A
add-on rate.
B
forward rate.
C
yield-to-maturity.
B
forward rate.
B is correct. The forward rate can be interpreted to be the incremental or marginal return for extending the time-to-maturity of an investment for an additional time period.
The add-on rate (bond equivalent yield) is a rate quoted for money market instruments, such as bank certificates of deposit, and indexes, such as MRR, Libor and Euribor.
Yield-to-maturity is the internal rate of return on the bond’s cash flows—the uniform interest rate such that when the bond’s future cash flows are discounted at that rate, the sum of the present values equals the price of the bond. It is the implied market discount rate.
542
Exceptions to the maturity effect exist for bonds that have:
A
long maturities, make small coupon payments, and trade at a discount.
B
short maturities, have high coupon rates, and trade at a discount.
C
long maturities, have high coupon rates, and trade at a premium.
A
long maturities, make small coupon payments, and trade at a discount.
A is correct. Exceptions to the maturity effect are rare and occur only for low-coupon (but not zero-coupon) long-term bonds trading at a discount.
B is incorrect because the maturity effect holds for bonds that have short maturities and high coupons.
543
A fixed-income portfolio manager is looking to value a one-year US dollar–denominated floating-rate note that has quarterly payments based on 90-day MRR plus 80 bps. Assume the following information:
90-Day MRR: 2.5%
Quoted Margin: 80 bps
Discount Margin: 100 bps
Face Value: USD100
Without doing any calculation, this floating-rate note is priced at:
A
a premium.
B
a discount.
C
par.
B
a discount.
This FRN is priced at a discount, because the quoted margin is less than the discount (required) margin.
544
Which of the following statements is most accurate? In an upward-sloping spot rate environment, the Treasury forward curve must be:
A
upward-sloping at all points.
B
located below the Treasury spot curve.
C
located above the Treasury spot curve.
C
located above the Treasury spot curve.
In an upward-sloping spot rate environment, forward rates will be higher than spot rates for the same maturities. Mathematically, if spot rates are successively higher at all maturities (i.e., the yield curve is upward sloping), the forward curve must be located above the spot curve.
545
Changes in the required margin for a floater usually come from:
A
shifts in the yield curve.
B
changes in credit risk.
C
increases or decrease in inflation.
B
changes in credit risk.
B is correct. The required margin is the yield spread over or under a reference rate, reflecting the credit risk of an issuer. Changes in the required margin typically come from a change in the issuer’s credit risk.
546
A limitation of calculating a bond portfolio’s duration as the weighted average of the yield durations of the individual bonds that compose the portfolio is that it:
A
assumes a parallel shift to the yield curve.
B
is less accurate when the yield curve is less steeply sloped.
C
is not applicable to portfolios that have bonds with embedded options.
A
assumes a parallel shift to the yield curve.
547
When the investor’s investment horizon is less than the Macaulay duration of the bond she owns:
A
the investor is hedged against interest rate risk.
B
reinvestment risk dominates, and the investor is at risk of lower rates.
C
market price risk dominates, and the investor is at risk of higher rates.
C
market price risk dominates, and the investor is at risk of higher rates
C is correct. The duration gap is equal to the bond’s Macaulay duration minus the investment horizon. In this case, the duration gap is positive, and price risk dominates coupon reinvestment risk. The investor risk is to higher rates.
548
The haircut on a repurchase agreement is most likely to be lower when:
A
the underlying collateral is in short supply.
B
the maturity of the repurchase agreement is long.
C
the credit risk associated with the underlying collateral is high.
A
the underlying collateral is in short supply.
A is correct. The haircut (the difference between the market value of the underlying collateral and the value of the loan) is a function of the supply and demand conditions of the collateral. The repo margin is typically lower if the underlying collateral is in short supply or if there is a high demand for it.
549
Which duration metric most accurately calculates the sensitivity of the security's value with respect to changes in the benchmark yield curve?
A
Effective duration
B
Modified duration
C
9
Macaulay duration
A
Effective duration
This describes effective duration.
Macaulay duration is calculated as the weighted average of the number of years until future payments.
Modified duration calculates the change in value with respect to changes in the yield to maturity.
550
A 15-year bond is selling for $107.98 at a yield of 4.75%. The approximate modified duration of this bond is 9.20. If the interest rates decrease to 4.55%, the approximate modified duration metric calculates that the price of this bond would most likely:
A
decrease by $1.99.
B
increase by $1.84.
C
increase by $1.99.
how do you answer this question?
C
increase by $1.99.
1. % price change = - Ann Modified duration * (change in %)
2. PV * (% price change) = $ change in Bond price
551
Which of the following is most appropriate for measuring a bond’s sensitivity to shaping risk?
A
Key rate duration
B
Effective duration
C
Modified duration
A
Key rate duration
A is correct. Key rate duration is used to measure a bond’s sensitivity to a shift at one or more maturity segments of the yield curve which result in a change to yield curve shape.
Modified and effective duration measure a bond’s sensitivity to parallel shifts in the entire curve.
552
An investor purchases a 12-year, 5.8% annual bond and intends to sell it after 10 years. The Macaulay duration of the bond is 8.97 years. If interest rates fall by 75 bps immediately after the purchase of the bond, the investor faces:
A
negative reinvestment risk.
B
no reinvestment risk.
C
positive reinvestment risk.
A
negative reinvestment risk.
A is correct. The investor has an investment horizon of 10 years, which is greater than the Macaulay duration of 8.97 years. Therefore, reinvestment risk dominates price risk.
B is incorrect because the investor faces reinvestment risk because the investment horizon is higher than the Macaulay duration.
C is incorrect because the investor faces negative coupon reinvestment risk, not positive coupon reinvestment risk, since the coupons will be reinvested at a lower interest rate.
553
The carrying value of a bond purchased at a price below par is equal to the original purchase price:
A
minus the accumulated premium amortization.
B
minus the accumulated discount amortization.
C
plus the accumulated discount amortization.
C
plus the accumulated discount amortization.
C is correct. A bond purchased at a discount will have its price “pulled to par” as it approaches maturity. Its carrying value at time t is equal to its purchase price plus the accumulated discount amortization.
554
A callable bond is most likely to exhibit positive convexity:
A
in any interest rate environment.
B
if its yield is above the exercise rate.
C
if its yield is below the exercise rate.
B
if its yield is above the exercise rate.
555
An analyst has proposed that the duration of a fixed-income portfolio be calculated as the weighted average of the duration of its constituent securities. The primary limitation of this proposed approach is most likely that a bond's duration measure is based on the assumption that:
A
bonds do not contain embedded options.
B
parallel yield curve shifts are rarely observed.
C
changes in the yield curve are shape-preserving.
C
changes in the yield curve are shape-preserving.
Interpreting price changes based on duration assumes a parallel shift in the yield curve because the yield for all securities in the portfolio must change by the same amount. This is referred to as a shape-preserving shift because the yield curve may move up or down, but its shape does not change.
If any of the constituent bonds contain embedded options, it would still be possible to use the portfolio's weighted-average effective duration as a measure of interest rate risk.
Although it is accurate that parallel interest rate shifts are rarely observed, this is not an assumption on which duration measures are based.
556
Empirical duration is likely the best measure of the impact of yield changes on portfolio value, especially under stressed market conditions, for a portfolio consisting of:
A
sovereign bonds of several AAA rated euro area issuers.
B
covered bonds of several AAA rated euro area corporate issuers.
C
AAA rated sovereign bonds, 25% AAA rated corporate bonds, and 50% high-yield (i.e., speculative-grade) corporate bonds, all from various euro area sovereign and corporate issuers.
C
AAA rated sovereign bonds, 25% AAA rated corporate bonds, and 50% high-yield (i.e., speculative-grade) corporate bonds, all from various euro area sovereign and corporate issuers.
Empirical duration is the best measure—better than analytical duration—of the impact of yield changes on portfolio value, especially under stressed market conditions, for a portfolio consisting of a variety of different bonds from different issuers, such as the portfolio described in Answer C. In this portfolio, credit spread changes on the high-yield bonds may partly or fully offset yield changes on the AAA rated sovereign bonds and spread changes on the AAA rated corporate bonds; this interaction is best captured using empirical duration. The portfolios described in Answers A and B consist of the same types of bonds from similar issuers—sovereign bonds from similar-rated sovereign issuers (A) and covered bonds from similar-rated corporate issuers (B)—so empirical and analytical durations should be roughly similar in each of these portfolios.
557
Holders of which of the following categories of debt most likely have the lowest priority claim to a borrower's assets?
A
Second lien debt
B
Senior unsecured debt
C
Senior subordinated debt
C
Senior subordinated debt
In order of highest to lowest priority of claims, the rankings of debt categories is:
1. First lien loan - Senior secured
2. Second lien loan - Secured
3. Senior unsecured
4. Senior subordinated
5. Subordinated
6. Junior Subordinated
Of the possible answer choices, senior subordinated debt has the lowest priority claim.
558
how to find the money duration from the macaulay duration
1. modified duration = mac duration / (1 + r)
2. money duration = ModDuration * PV Full
559
An investor purchases an annual coupon bond with a 6% coupon rate and exactly 20 years remaining until maturity at a price equal to par value. The investor’s investment horizon is eight years. The approximate modified duration of the bond is 11.470 years. The duration gap at the time of purchase is closest to:
A
–7.842.
B
3.470.
C
4.158.
C
4.158.
C is correct. The duration gap is closest to 4.158. The duration gap is a bond’s Macaulay duration minus the investment horizon. The approximate Macaulay duration is the approximate modified duration times one plus the yield-to-maturity. It is 12.158 (= 11.470 × 1.06).
Given an investment horizon of eight years, the duration gap for this bond at purchase is positive: 12.158 – 8 = 4.158. When the investment horizon is less than the Macaulay duration of the bond, the duration gap is positive, and price risk dominates coupon reinvestment risk.
560
Which of the following statements about duration is correct? A bond’s:
A
effective duration is a measure of yield duration.
B
modified duration is a measure of curve duration.
C
modified duration cannot be larger than its Macaulay duration (assuming a positive yield-to-maturity).
C
modified duration cannot be larger than its Macaulay duration (assuming a positive yield-to-maturity).
A bond’s modified duration cannot be larger than its Macaulay duration assuming a positive yield-to-maturity.
The formula for modified duration is:
MacDur / (1 + r)
561
Assuming no change in the credit risk of a bond, the presence of an embedded put option:
A
reduces the effective duration of the bond.
B
increases the effective duration of the bond.
C
does not change the effective duration of the bond.
A
reduces the effective duration of the bond.
A is correct. The presence of an embedded put option reduces the effective duration of the bond, especially when rates are rising. If interest rates are low compared with the coupon rate, the value of the put option is low and the impact of the change in the benchmark yield on the bond’s price is very similar to the impact on the price of a non-putable bond. But when benchmark interest rates rise, the put option becomes more valuable to the investor. The ability to sell the bond at par value limits the price depreciation as rates rise. The presence of an embedded put option reduces the sensitivity of the bond price to changes in the benchmark yield, assuming no change in credit risk.
562
A manufacturing company receives a ratings upgrade and the price increases on its fixed-rate bond. The price increase was most likely caused by a(n):
A
decrease in the bond’s credit spread.
B
increase in the bond’s liquidity spread.
C
increase of the bond’s underlying benchmark rate.
A
decrease in the bond’s credit spread.
A is correct. The price increase was most likely caused by a decrease in the bond’s credit spread. The ratings upgrade most likely reflects a lower expected probability of default and/or a greater level of recovery of assets if default occurs. The decrease in credit risk results in a smaller credit spread. The increase in the bond price reflects a decrease in the yield-to-maturity due to a smaller credit spread.
The change in the bond price was not due to a change in liquidity risk or an increase in the benchmark rate.
563
An investor’s well-diversified portfolio has $200,000 in cash. The investor aims to invest in short-term, one-year Large-Cap Company bonds, prior to using the cash to invest in an upcoming IPO. There are currently two Large-Cap Company bonds on the market to purchase, both with one-year maturities. One of the bonds, Bond A, is a non-callable bond, while Bond B is a callable bond. As a fixed-income analyst, you are asked to conduct an analysis.
What impact would a “flight to safety” (i.e., government bond yields falling and credit spreads widening) have on the analytical duration estimate of Bond A?
A
Decreased duration
B
Increased duration
C
No impact
C
No impact
C is correct. There would be no impact on the analytical duration estimate.
However, an empirical duration estimate would be impacted.
A flight to safety would result in an increase in the bond price due to the falling benchmark yield being offset by widening credit spread. This would lead to a lower empirical duration than analytical duration.
564
Company bonds, prior to using the cash to invest in an upcoming IPO. There are currently two Large-Cap Company bonds on the market to purchase, both with one-year maturities. One of the bonds, Bond A, is a non-callable bond, while Bond B is a callable bond. As a fixed-income analyst, you are asked to conduct an analysis.
A colleague asks whether you also considered looking at the key rate durations when comparing the interest rate risks of Bond A and Bond B. Would research into key rate durations for Bond A and Bond B help you make a better decision about the interest rate risk of the two bonds?
A
Yes
B
No
C
Inconclusive
B
No
B is correct. Since both bonds mature in one year, key rate duration analysis would not give you any additional insight, since both bonds would undergo the same shift in the curve.
565
The holding period for a bond at which the coupon reinvestment risk offsets the market price risk is best approximated by:
A
duration gap.
B
modified duration.
C
Macaulay duration.
C
Macaulay duration.
When the holder of a bond experiences a one-time parallel shift in the yield curve, the Macaulay duration statistic identifies the number of years necessary to hold the bond so that the losses (or gains) from coupon reinvestment offset the gains (or losses) from market price changes.
The duration gap is the difference between the Macaulay duration and the investment horizon.
Modified duration approximates the percentage price change of a bond given a change in its yield-to-maturity.
566
Money duration formula
AnnModDur * PV Full
567
A limitation of calculating a bond portfolio’s duration as the weighted average of the yield durations of the individual bonds that compose the portfolio is that it:
A
assumes a parallel shift to the yield curve.
B
is less accurate when the yield curve is less steeply sloped.
C
is not applicable to portfolios that have bonds with embedded options.
A
assumes a parallel shift to the yield curve.
A is correct. A limitation of calculating a bond portfolio’s duration as the weighted average of the yield durations of the individual bonds is that this measure implicitly assumes a parallel shift to the yield curve (all rates change by the same amount in the same direction).
In reality, interest rate changes frequently result in a steeper or flatter yield curve.
This approximation of the “theoretically correct” portfolio duration is more accurate when the yield curve is flatter (less steeply sloped). An advantage of this approach is that it can be used with portfolios that include bonds with embedded options. Bonds with embedded options can be included in the weighted average using the effective durations for these securities.
568
Which duration metric most accurately calculates the sensitivity of the security's value with respect to changes in the benchmark yield curve?
A
Effective duration
B
Modified duration
C
Macaulay duration
A
Effective duration
This describes effective duration.
Macaulay duration is calculated as the weighted average of the number of years until future payments.
Modified duration calculates the change in value with respect to changes in the yield to maturity.
569
An analyst has proposed that the duration of a fixed-income portfolio be calculated as the weighted average of the duration of its constituent securities. The primary limitation of this proposed approach is most likely that a bond's duration measure is based on the assumption that:
A
bonds do not contain embedded options.
B
parallel yield curve shifts are rarely observed.
C
changes in the yield curve are shape-preserving.
C
changes in the yield curve are shape-preserving.
Interpreting price changes based on duration assumes a parallel shift in the yield curve because the yield for all securities in the portfolio must change by the same amount. This is referred to as a shape-preserving shift because the yield curve may move up or down, but its shape does not change.
If any of the constituent bonds contain embedded options, it would still be possible to use the portfolio's weighted-average effective duration as a measure of interest rate risk.
Although it is accurate that parallel interest rate shifts are rarely observed, this is not an assumption on which duration measures are based.
570
For changes in yield-to-maturity, the convexity adjustment is most needed to account for the:
A
first-order effect on bond prices.
B
bond price risk due to small changes in yield-to-maturity.
C
non-linear relationship of bond prices and yield to maturity.
C
non-linear relationship of bond prices and yield to maturity.
C is correct. The convexity adjustment is a complementary risk measure to duration. It accounts for the second-order (non-linear) effect of yield changes on price. It is most useful for large yield changes, because duration provides a good approximation for small yield changes.
571
Which of the following is most appropriate for measuring a bond’s sensitivity to shaping risk?
A
Key rate duration
B
Effective duration
C
Modified duration
A
Key rate duration
A is correct. Key rate duration is used to measure a bond’s sensitivity to a shift at one or more maturity segments of the yield curve which result in a change to yield curve shape.
Modified and effective duration measure a bond’s sensitivity to parallel shifts in the entire curve.
572
Effective duration is most likely preferable to Macaulay duration for measuring the interest rate risk of bonds with embedded options because the Macaulay duration measure is based on the assumption that:
A
the yield curve is flat.
B
all yield curve movements are parallel shifts.
C
the timing and amount of future cash flows are known with certainty.
C
the timing and amount of future cash flows are known with certainty.
Since bonds with embedded options have uncertain cash flows, it is inappropriate to use Macaulay duration.
Effective duration, which calculates the sensitivity of the price of a bond with respect to changes in interest rates, is more appropriate.
573
The carrying value of a bond purchased at a price below par is equal to the original purchase price:
A
minus the accumulated premium amortization.
B
minus the accumulated discount amortization.
C
plus the accumulated discount amortization.
C
plus the accumulated discount amortization.
C is correct. A bond purchased at a discount will have its price “pulled to par” as it approaches maturity. Its carrying value at time t is equal to its purchase price plus the accumulated discount amortization.
574
The rating agency process whereby the credit ratings on issues are moved up or down from the issuer rating best describes:
A
notching.
B
pari passu ranking.
C
cross-default provisions.
A
notching.
A is correct. Recognizing different payment priorities, and thus the potential for higher (or lower) loss severity in the event of default, the rating agencies have adopted a notching process whereby their credit ratings on issues can be moved up or down from the issuer rating (senior unsecured).
575
An analyst who researches a bond's covenants in an effort to estimate recovery rates is most likely attempting to quantify the bond's:
A
default risk.
B
loss severity.
C
default probability.
B
loss severity.
Recovery rate is a measure of loss severity. It indicates how much of a security's value would be lost if the company defaults on its bond's obligations.
576
Adidas AG € in millions
Gross profit 12,293
Royalty and commission income 154
Other operating income 56
Other operating expenses 9,843
Operating profit 2,660
Interest income 64
Interest expense 166
Income before taxes 2,558
Income taxes 640
Net income 1,918
Additional information:
Depreciation and amortization: €1,214 million
Based on the information provided above, the EBITDA interest coverage ratio of Adidas AG is closest to:
what is the formula to find the interest coverage ratio?
(Operating Profit + Depreciation and Amortization) / Interest expense
577
expected loss formula
Probability of Default * LGD
577
Credit spread formula
Probability of Default * LGD
578
Which industry characteristic most likely has a positive effect on a company’s ability to service debt?
A
Low barriers to entry in the industry
B
High number of suppliers to the industry
C
Broadly dispersed market share among large number of companies in the industry
B
High number of suppliers to the industry
An industry with a high number of suppliers reduces the suppliers’ negotiating power, thus helping companies control expenses and aiding in the servicing of debt.
579
when we have credit spread and expected Loss information available to us, how do we compare two bonds
spread - Expected Loss
580
hich of the following is most likely a significant risk of relying on credit ratings provided by agencies?
A
Rating agencies use different rating scales
B
Credit ratings may not capture all relevant risks
C
Market pricing of risk lags changes to credit ratings
B
Credit ratings may not capture all relevant risks
It can be difficult, if not impossible, to capture all of the risks faced by an issuer in a credit rating. The risks of exposure to potential litigation or natural disasters can be significant, but are not necessarily reflected in a credit rating.
Changes to credit ratings lag market-based changes in the price of risk, not vice versa.
Although rating agencies use different rating scales, the rating categories are comparable. For example, Moody's A3 rating is equivalent to the A- rating used by S&P and Fitch.
581
A company issued a new series of bonds. In the event of default, the bondholders have the highest claim among general creditors to all of the company's assets that have not been specifically pledged as collateral. The newly-issued debt is most accurately categorized as:
A
unsecured debt.
B
second lien debt.
C
senior subordinated debt.
A
unsecured debt.
In the event of default, unsecured debtholders have a general claim to assets that have not been specifically pledged as collateral to back higher priority claims.
Second lien debt is backed by a specific asset (such as real property or personal property) as collateral.
The claims of senior subordinated debtholders are not backed by specific assets, but rank below the claims of unsecured debtholders.
582
As a company's financial position worsens, which of the following will most likely to occur first?
A
The market price of its debt will decrease
B
Rating agencies will downgrade its issues
C
The company will renegotiate the terms of its debt
A
The market price of its debt will decrease
Changes in a company's financial position are first reflected in adjustments to the market price of risk. In well-functioning markets, investors can react quickly to a deteriorating financial position by requiring a higher yield as compensation for holding the issuer's debt.
Credit rating agencies typically downgrade issuers after changes in the market price of risk have already been observed.
Debt restructuring, which involves negotiating changes to the terms of outstanding debt, is usually only done in order to avoid an impending bankruptcy. Market yields will already have adjusted before such action is taken.
583
A bond's bid-ask spread is most likely used as a measure of:
A
duration risk.
B
liquidity risk.
C
reinvestment risk.
B
liquidity risk.
Liquidity risk is the risk of not obtaining full value for securities sold.
A wider bid-ask spread indicates that bond dealers are requiring sellers to accept discounted prices for securities that are perceived as being relatively illiquid.
584
An investor with a constraint against holding speculative grade bonds is most likely concerned with a bond's:
A
default risk.
B
credit migration risk.
C
expected loss given default.
B
credit migration risk.
Credit migration risk, also known as downgrade risk, is the possibility that a rating agency will downgrade a bond's credit rating.
An investor with a constraint against holding speculative grade bonds can only hold investment grade bonds. They will most likely be concerned about the risk a bond that currently carries an investment grade rating being downgraded to speculative grade.
585
Credit risk of a corporate bond is best described as the:
A
risk that an issuer’s creditworthiness deteriorates.
B
probability that the issuer fails to make full and timely payments.
C
risk of loss resulting from the issuer failing to make full and timely payments.
C
risk of loss resulting from the issuer failing to make full and timely payments.
Credit risk is the risk of loss resulting from the borrower failing to make full and timely payments of interest and/or principal.
586
debt/capital formula
debt / (debt + capital)
587
Which of the following statements about the US municipal bond market is least likely correct?
A
Municipal bonds are issued by both cities and states
B
Municipal bond yields do not include a credit risk premium
C
Municipal borrowers may issue bonds on behalf of private entities
B
Municipal bond yields do not include a credit risk premium
In the United States, bonds issued by state and city governments and their agencies are called municipal bonds. These issuers often borrow on behalf of private entities (e.g., hospitals). The municipal sector represents approximately 10% of the overall US bond market.
However, it is incorrect to claim that municipal bond yields do not include a credit risk premium. Although municipal bond defaults are historically less common than for similarly-rated corporate bonds, they do occur and investors will require additional yield as compensation for this risk.
588
Stedsmart Ltd and Fignermo Ltd are alike with respect to financial and operating characteristics, except that Stedsmart Ltd has less publicly traded debt outstanding than Fignermo Ltd. Stedsmart Ltd is most likely to have:
A
no market liquidity risk.
B
lower market liquidity risk.
C
higher market liquidity risk.
C
higher market liquidity risk.
C is correct. Market liquidity risk refers to the risk that the price at which investors transact may be different from the price indicated in the market.
Market liquidity risk is increased by (1) less debt outstanding and/or (2) a lower issue credit rating.
Because Stedsmart Ltd is comparable to Fignermo Ltd except for less publicly traded debt outstanding, it should have higher market liquidity risk.
589
The process of moving credit ratings of different issues up or down from the issuer rating in response to different payment priorities is best described as:
A
notching.
B
structural subordination.
C
cross-default provisions.
A
notching.
A is correct.
Notching is the process for moving ratings up or down relative to the issuer rating when rating agencies consider secondary factors, such as priority of claims in the event of a default and the potential loss severity.
590
Upon a bankruptcy affecting a covered bond, the first available safeguards to protect against potential losses are the:
A
ringfenced loans.
B
unencumbered assets of the issuer.
C
assets added by the collateral manager during ramp-up.
A
ringfenced loans.
The correct answer is A. In the case of bankruptcy covered bond investors, they have dual recourse with the first safeguard being the ringfenced loans in the cover pool that underlie the covered bond transaction.
B is incorrect because while investors also have recourse to the unencumbered assets of the issuer, those serve as a subsequent safeguard.
C is incorrect because this post-transaction contribution is characteristic of the non-amortizing structure of a CDO (collateralized debt obligation).
591
Which commercial mortgage-backed security characteristic causes a CMBS to trade more like a corporate bond than a residential mortgage-backed security?
A
Call protection
B
Internal credit enhancement
C
Debt-service-coverage ratio level
A
Call protection
A is correct. With CMBS, investors have considerable call protection. An investor in an RMBS is exposed to considerable prepayment risk, but with CMBS, call protection is available to the investor at the structure and loan level. The call protection results in CMBS trading in the market more like a corporate bond than an RMBS. Both internal credit enhancement and the debt-service-coverage (DSC) ratio address credit risk, not prepayment risk.
592
Which investor tranche plays a key role in determining CLO viability?
A
Senior
B
Equity
C
Mezzanine
B
Equity
The correct answer is B. Investors in equity tranches take on equity-like risks with the potential to earn returns comparable to equities. Moreover, these residual tranche investors play a key role in whether a CLO is viable or not; the CLO structure has to offer competitive returns for this tranche. Facing these risk/return possibilities puts them in the position of the marginal, price-setting investors.
593
Which of the following is most likely an example of an internal credit enhancement used in securitizations?
A
Letter of credit
B
Overcollateralization
C
Planned amortization class tranches
B
Overcollateralization
The most common forms of internal credit enhancement include senior/subordinated structures, reserve funds, and overcollateralization.
A letter of credit is a type of external credit enhancement.
594
Which of the following statements about CDOs is correct?
A
The collateral pools for CDOs are static.
B
The proceeds to pay the CDO bond classes can only come from interest payments from collateral assets.
C
A CDO is a leveraged transaction, where equity tranche holders use borrowed funds to generate a return above the funding cost.
C
A CDO is a leveraged transaction, where equity tranche holders use borrowed funds to generate a return above the funding cost.
The correct answer is C. A CDO is a leveraged transaction, where equity tranche holders use borrowed funds (i.e., the bond classes issued) to generate a return above the funding cost.
595
The longest-term tranche of a sequential-pay CMO is most likely to have the lowest:
A
average life.
B
extension risk.
C
contraction risk.
C
contraction risk.
C is correct. For a CMO with multiple sequential-pay tranches, the longest-term tranche will have the lowest contraction (prepayments greater than forecasted) risk because of the protection against this risk offered by the other tranches.
The longest-term tranche is likely to have the highest average life and extension risk because it is the last tranche repaid in a sequential-pay tranche.
596
If a default occurs in a non-recourse commercial mortgage-backed security, the lender will most likely:
A
recover prepayment penalty points paid by the borrower to offset losses.
B
use only the proceeds received from the sale of the property to recover losses.
C
initiate a claim against the borrower for any shortfall resulting from the sale of the property.
B
use only the proceeds received from the sale of the property to recover losses.
B is correct. In a non-recourse CMBS, the lender can look only to the income-producing property backing the loan for interest and principal repayment. If a default occurs, the lender can use only the proceeds from the sale of the property for repayment and has no recourse to the borrower for any unpaid balance.
597
An investment vehicle based on cash flows from an underlying pool of mortgages offering tranches that carry a high level of prepayment risk is most likely a:
A
mortgage pass-through security.
B
collateralized mortgage obligation.
C
commercial mortgage-backed security.
B
collateralized mortgage obligation.
Collateralized mortgage obligations (CMOs) are a form of mortgage-backed security (MBS) that redistributes cash flows among tranches, which give investors the ability to choose their desired level of cash flow risk. Note that, because of how a CMO is structured, prepayment risk cannot be reduced or eliminated - only redistributed.
Mortgage pass-through securities are not divided into tranches.
Commercial mortgage-backed securities (CMBS) are structured to provide significantly less exposure to prepayment risk relative to that faced by investors who hold CMOs.
598
Which of the following statements about securitization’s impact on economies and financial markets is correct?
A
Securitization decreases overall liquidity in the financial system.
B
Securitization provides an alternative means of funding business operations beyond traditional financing.
C
Securitization allows companies to directly access the financial markets and purchase loans that will be held on their balance sheet.
B
Securitization provides an alternative means of funding business operations beyond traditional financing.
The correct answer is B. An important benefit of securitization is that it provides an alternative means of funding business operations beyond traditional financing tools, such as bonds, preferred equity, and common equity.
599
n a securitization, time tranching provides investors with the ability to choose between:
A
extension and contraction risks.
B
senior and subordinated bond classes.
C
fully amortizing and partially amortizing loans.
A
extension and contraction risks.
A is correct. Time tranching is the process in which a set of bond classes or tranches is created that allow investors a choice in the type of prepayment risk—extension or contraction—that they prefer to bear.
600
The role of a special purpose vehicle (SPV) in the securitization process is most likely to:
A
originate the loans.
B
issue asset-backed securities to investors.
C
collect principal and interest payments from borrowers.
B
issue asset-backed securities to investors.
The seller is the party who originates the loans.
The SPV the party who buys loans from the seller and sells asset-back securities to the investors.
The servicer is the party who collects principal and interest.
601
Which of the following statements about mortgage backed securities (MBS) and covered bonds is most accurate?
A
A covered bond has lower credit risk and higher prepayment risk than an otherwise similar MBS
B
An MBS has a static pool of underlying loans while a covered bond is backed by a dynamic cover pool
C
An MBS provides investors recourse to the underlying loans while recourse for a covered bond is limited to the issuer
B
An MBS has a static pool of underlying loans while a covered bond is backed by a dynamic cover pool
Because MBS are backed by a static pool of underlying loans, investors are exposed to prepayment risk. By contrast, covered bond issuers must replace any prepaid or non-performing assets in the cover pool to ensure sufficient cash flows over the security's lifetime.
602
The feature of a covered bond transaction most likely shared with both CDOs and non-mortgage ABS is its:
A
specified LTV cutoff.
B
multiple tranches for the cover pool.
C
distinct maturity and settlement dates.
C
distinct maturity and settlement dates.
The correct answer is C. As illustrated by their respective term sheets, all three types of ABS transactions have timing milestones designating due dates for investments (settlement date) and the end of their terms (maturity date).
603
n credit card receivable ABS, principal cash flows can be altered only when the:
A
lockout period expires.
B
excess spread account is depleted.
C
early amortization provision is triggered.
C
early amortization provision is triggered.
604
An excess spread account incorporated into a securitization is designed to limit:
A
credit risk.
B
extension risk.
C
contraction risk.
A
credit risk.
605
606
e inclusion of assets into a CLO collateral pool is completed:
A
during a subsequent ramp-up period.
B
prior to the close of the CLO transaction.
C
between ramp-up and loan maturity on meeting certain requirements.
C
between ramp-up and loan maturity on meeting certain requirements.
The correct answer is C. After the ramp-up period but before underlying collateral pool loans mature, the collateral manager may replace loans in the portfolio as long as the new asset meets the portfolio selection criteria.
A is incorrect because while additional assets are added to the collateral pool during a subsequent ramp-up period, loan replacements can still occur after the ramp-up period.
B is incorrect because a typical feature of CLO transactions is that the collateral portfolio is not finalized until after the transaction closes.
607
n a securitization, the collateral is initially sold by the:
A
issuer.
B
depositor.
C
underwriter.
B
depositor.
B is correct. In a securitization, the loans or receivables are initially sold by the depositor to the special purpose entity that uses them as collateral to issue the ABS.
A is incorrect because the SPE, often referred to as the issuer, is the purchaser of the collateral rather than the seller of the collateral.
C is incorrect because the underwriter neither sells nor purchases the collateral in a securitization. The underwriter performs the same functions in a securitization as it does in a standard bond offering.
608
n a securitization, the party that purchases the loans or receivables and uses them as collateral to issue ABS is the:
A
SPE.
B
seller.
C
servicer.
A
SPE.
The correct answer is A. The SPE is often referred to as the issuer in the prospectus because it is the entity that issues the securities to investors.
609
A characteristic of solar loans that makes them attractive to potential solar ABS investors is their:
A
universal availability to any homeowners.
B
ability to combine multiple liens to mitigate default risk.
C
flexibility in allowing either purchase or rental of solar systems.
B
ability to combine multiple liens to mitigate default risk.
610
An action affecting the cash flow received by a credit card ABS holder during its revolving period is the:
A
early repayment of principal by cardholders.
B
card’s floating-rate cap exceeding the periodic rate.
C
triggering of an ABS rapid amortization provision.
C
triggering of an ABS rapid amortization provision.
The correct answer is C. Triggering rapid amortization provisions accelerates and alters principal cash flows. Noteholders will receive their investments earlier, which they can then reallocate to other investments offering more attractive risk/return characteristics.
A is incorrect because typically during the revolving period, as credit cards are non-amortizing loans, the security holders receive only payments from the finance charges and fees the lender collects. Returned principal is reinvested in the collateral pool.
