Mock 4

Question 1

Donald Smith, CFA, has been assigned by his employer to write a report for clients on Braden Corporation. Smith has 1,000 shares of Braden that he bought three years ago and has been discussing a consulting contract with Braden to write guidelines for their investor relations department. If Smith writes the report on Braden Corporation, he must disclose within the report:

A)
both his ownership of Braden shares and his prospective consulting work.
B)
and to his employer his prospective consulting work but not his ownership of Braden shares.
C)
his ownership of Braden shares but need only disclose his prospective consulting work to his employer.

Answer 1

A)
both his ownership of Braden shares and his prospective consulting work.

Both ownership of Braden stock and the possible consulting work present potential conflicts of interest for Smith and must be disclosed within the report to comply with Standard VI(A) Disclosure of Conflicts

Question 2

The CFA Institute Code of Ethics most likely requires members and candidates to:

A)
not engage in activity which compromises the integrity of CFA Institute.
B)
stay informed on applicable laws and regulations that pertain to their respective areas of business.
C)
act with competence, integrity, and in ethical manner when dealing with the public, clients, employers, employees, and other market participants.

Answer 2

C)
act with competence, integrity, and in ethical manner when dealing with the public, clients, employers, employees, and other market participants.

The first requirement of the Code of Ethics is that members and candidates “act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients, prospective clients, employers, employees, colleagues in the investment profession, and other participants in the global capital markets.” Knowing the applicable laws and regulations is required by Standard I(A) Knowledge of the Law. Standard VII(A) Conduct as Participants in CFA Institute Programs requires members and candidates not to compromise the integrity of CFA Institute.

Question 3

Craig Boone, CFA, a fixed-income trader, observes that one of the salesmen on the desk has been allocating his trades at the end of the day, giving better execution to large clients, a practice Boone suspects is illegal. The salesman tells Boone this is a common practice and that the firm’s senior management is aware of it. If Boone makes a personal record of the activity, takes it home for his personal files, and subsequently reveals it to regulatory authorities, he would:

A)
not be in violation of any Standards.
B)
be in violation of the Standards for disclosing confidential information.
C)
be in violation of the Standards for breaching his duty of loyalty to his employer.

Answer 3

A)
not be in violation of any Standards.

According to Standard IV(A) Loyalty, the interests of a member or candidate’s employer are secondary to protecting the interests of clients and the integrity of capital markets. In this circumstance, whistleblowing is justified. As long as his motivation is clearly not for personal gain, he may, according to the Standards, violate employer confidentiality in this case. While he is required to dissociate from the suspect activity by Standard I(A) Knowledge of the Law, he is not prohibited by the Standards from reporting it unless a stricter local law applies.

Question 4

Sanctions that may be imposed on members by CFA Institute include:

A)
public censure, suspension of membership, and fines.
B)
suspension of membership, revocation of CFA charter, and fines.
C)
public censure, suspension of membership, and revocation of CFA charter.

Answer 4

C)
public censure, suspension of membership, and revocation of CFA charter.

If a Professional Conduct Program inquiry finds that a member has violated the Code and Standards, CFA Institute may impose sanctions, which include public censure, suspension of membership in CFA Institute and use of the CFA designation, and revocation of a member’s CFA charter. CFA Institute does not impose fines.

Question 5

When a member or candidate knows that a client and coworker are violating regulatory rules and local law, the member or candidate is:

A)
not required to report any of the violations to authorities.
B)
required to report violations by the coworker but not the client.
C)
required to report the violations of the law and of the regulatory rules to the appropriate authority.

Answer 5

)
not required to report any of the violations to authorities.

The Standards strongly encourage, but do not require, members and candidates to report violations of relevant regulatory rules and laws.

Question 6

Susan Smart, CFA, is about to change her “buy” recommendation on RollinsCo to “sell.” RollinsCo had been growing rapidly over the past year, but Smart believes the growth potential is now gone. Smart sells the shares held in her discretionary client accounts and in her own personal account before issuing her report. According to the Standards that concern fair dealing and priority of transactions, Smart violated:

A)
both of these Standards.
B)
neither of these Standards.
C)
only one of these Standards.

Answer 6

A)
both of these Standards.

Smart violated both Standards. Smart violated Standard III(B) Fair Dealing because she did not deal fairly and objectively with all clients and prospects when disseminating investment recommendations, giving priority to some of the firm’s clients by trading for her clients first before issuing the report. She also sold her own shares before issuing the report, which violated Standard VI(B) Priority of Transactions. Smart did not give clients an opportunity to react to and benefit from her recommendation before she personally benefited from her research

Question 7

To be compliant with GIPS, a firm’s composites must comprise all:

A)
fee-paying accounts.
B)
discretionary accounts.
C)
discretionary accounts that are fee-paying.

Answer 7

C)
discretionary accounts that are fee-paying.

Each discretionary fee-paying account must be included in one, and only one, composite

Question 8

Tony Roberts, CFA, is part of a team that manages equities accounts. He believes that a teammate, who is not a CFA Institute member or candidate, takes actions that, while not illegal under local law, violate CFA Institute Standards of Professional Conduct. According to the CFA Institute Standards of Professional Conduct, Roberts:

A)
is required to dissociate from the team’s activities if they continue.
B)
is not required to act because the Code and Standards do not apply to non-members.
C)
must report the suspected violations of the Code and Standards first to his supervisor and then to CFA Institute.

Answer 8

A)
is required to dissociate from the team’s activities if they continue.

If Roberts suspects someone is engaging in activities that are illegal or violate the Code and Standards, Standard I(A) Knowledge of the Law requires him to dissociate from the activities if he cannot remedy the situation. In this situation, the teammate is acting within the applicable laws but is violating CFA Institute Standards of Professional Conduct. When the Code and Standards are stricter than applicable law, the Code and Standards apply to members and candidates. However, Roberts is not required by the Code and Standards to report violations of laws or the Code and Standards to CFA Institute or to governmental regulators, although it may be prudent or even required by law that he do so

Question 9

Judy Blush is a CFA candidate and is recommending the purchase of a mutual fund that invests solely in long-term U.S. Treasury bonds (T-bonds) to one of her clients. She states: “Because the U.S. government guarantees payment of both principal and interest on its bonds, risk of loss from investing in this fund is virtually zero.” Blush’s actions violated:

A)
the Standard on misrepresentation.
B)
the Standard on communication with clients.
C)
none of the Standards of Professional Conduct.

Answer 9

A)
the Standard on misrepresentation.

Government bonds are default risk free but are subject to price risk, particularly if the bonds are longer-term than the investor’s horizon. Thus, Blush misrepresented the nature of investing in the fund and therefore violated Standard I(C) Misrepresentation

Question 10

The Code of Ethics least likely states that members and candidates are required to:

A)
use their own judgement.
B)
obey all laws and the Standards of Practice.
C)
attempt to improve the competence of other investment professionals.

Answer 10

B)
obey all laws and the Standards of Practice.

Requirements for following laws and regulations are contained in the Standards (e.g., Standard I(A) Knowledge of the Law). The other choices are both explicitly required by the Code of Ethics

Question 11

Byron Bell, CFA, tells his assistant that Mary Mitchel, a client of his, confided to him that she is suffering from the early stages of Alzheimer’s disease and that she is planning to leave almost all of her sizable estate to Prather House, a support facility for Alzheimer’s patients. Bell directs his assistant to keep this information confidential. With respect to the Standard on preservation of confidentiality, Bell has:

A)
not violated the Standard.
B)
violated the Standard by sharing information about his client’s health but not about planned bequest to Prather House.
C)
violated the Standard both by sharing the information about his client’s health and about her planned bequest to Prather House.

Answer 11

A)
not violated the Standard.

Bell is permitted to share confidential client information with another firm employee who is also working for the client’s benefit, so sharing this information with his assistant is not a violation of Standard III(E) Preservation of Confidentiality

Question 12

The slope coefficient of a lin-log model describes a linear relationship between:

A)
relative changes in the dependent variable and relative changes in the independent variable.
B)
relative changes in the dependent variable and absolute changes in the independent variable.
C)
absolute changes in the dependent variable and relative changes in the independent variable.

Answer 12

C)
absolute changes in the dependent variable and relative changes in the independent variable.

In a lin-log model, the slope coefficient gives the absolute change in the dependent variable for a relative change in the independent variable

Question 13

In accrual accounting, the matching principle states that:

A)
an entity should recognize revenues only when received and expenses only when they are paid.
B)
transactions and events producing cash flows are allocated only to time periods in which the cash flows occur.
C)
expenses incurred to generate revenue are recognized in the same time period as the revenue.

Answer 13

C)
expenses incurred to generate revenue are recognized in the same time period as the revenue.

The matching principle holds that expenses should be accounted for in the same performance measurement period as the revenue they generate.

Question 14

Listed equity securities held as assets that do not convey significant influence in the investee company must be reported at fair value through profit and loss under:

A)
IFRS only.
B)
U.S. GAAP only.
C)
both IFRS and U.S. GAAP.

Answer 14

B)
U.S. GAAP only.

U.S. GAAP categorizes equity investment without significant control as trading securities, reported at fair value with profit and loss reported on the income statement. Under IFRS, firms can report equity securities in this manner, but may elect at the time of purchase to report an equity security at fair value through other comprehensive income.

Question 15

Which of the following statements about methods of calculating gross domestic product is most accurate?

A)
Except for a statistical discrepancy, the income and expenditure approaches to calculating GDP should result in the same value for economic output.
B)
Because it includes activity at all stages of production, the sum-of-value-added method results in a better estimate of GDP than the value-of-final-output method.
C)
Value-of-final-output is used to calculate GDP under the expenditure approach, while sum-of-value-added is used to calculate GDP under the income approach.

Answer 15

A)
Except for a statistical discrepancy, the income and expenditure approaches to calculating GDP should result in the same value for economic output.

Because aggregate income is the same as aggregate output, measuring GDP by summing incomes or expenditures should produce the same value, except for a statistical discrepancy that results from using different data sources. The sum-of-value-added method of calculating GDP records the sum of the increases in value of goods and services at each stage of their production and distribution. The resulting total for GDP is the same as that reached by the value-of-final-output method because the sum of value added to a good at all stages of processing is equal to its selling price. Both methods calculate GDP based on expenditures

Question 16

The J-curve, in the context of trade between two countries, refers to the fact that when the domestic country has a trade deficit:

A)
appreciation of the domestic currency initially leads to a decrease in the trade deficit but will increase the trade deficit in the long term.
B)
an increase in domestic inflation will initially increase the trade deficit but will decrease the trade deficit in the long term.
C)
appreciation of the foreign currency will initially increase the trade deficit but will decrease the trade deficit in the long term.

Answer 16

C)
appreciation of the foreign currency will initially increase the trade deficit but will decrease the trade deficit in the long term

The J-curve effect refers to a plot of the trade deficit over time when the domestic currency depreciates (the foreign currency appreciates). The trade deficit gets worse initially but then improves over time, either because export and import demand are more elastic in the long run or because existing contracts for future delivery are fixed in foreign currency terms in the short run.

Question 17

Which of the following organizations is the most focused on promoting economic growth and reducing poverty by offering both monetary and technical assistance?

A)
World Bank.
B)
World Trade Organization.
C)
International Monetary Fund.

Answer 17

A)
World Bank.

Promoting economic growth and reducing world poverty are among the primary goals of the World Bank. The IMF primarily promotes the growth of international trade, supports exchange rate stability, and provides a forum for cooperation on monetary problems internationally. The WTO has a primary focus on reaching trade agreements and settling trade disputes

Question 18

An investor wants to buy a condominium in Florida. The value of her portfolio is currently $1,000,000, and she needs $100,000 in one year for the down payment. She doesn’t mind decreasing her capital as long she has $950,000 remaining in her portfolio after the down payment is made. She is considering three new portfolios for her holdings. The details on the three portfolios are:

Expected Annual Return Standard Deviation of Returns
Portfolio 1 17% 15%
Portfolio 2 12% 10%
Portfolio 3 8% 6%
According to Roy’s Safety-First criterion, the portfolio she would prefer is:

A)
Portfolio 1.
B)
Portfolio 2.
C)
Portfolio 3.

Answer 18

A)
Portfolio 1.

As long as the investor earns at least a 5% return over the next year, the value of her portfolio after deducting the $100,000 down payment will not fall below $950,000. We first calculate the SFRatio for each of the two possible portfolios. We know that:

17-5/15 = 0.8

The SFRatio is the number of standard deviations that the minimum return is below the mean (expected) return. The optimal portfolio is the one with the greatest SFRatio as it has the lowest probability of a return below the minimum. Based on the SFRatio, the investor would prefer Portfolio 1.

Question 19

A lessor will recognize a lease receivable asset if the lease is classified as:

A)
an operating lease.
B)
a finance lease.
C)
either an operating or a finance lease.

Answer 19

B)
a finance lease.

With a finance lease, the lessor will recognize a lease receivable asset and amortize it over the lease term. With an operating lease, the lessor retains the leased asset on its balance sheet and records depreciation expense over its useful life

Question 20

An investor would like to purchase a 20-year annuity that will pay $45,000 each year beginning when she retires 15 years from now. The amount she would need to invest today to fund this annuity, assuming an annual return of 5%, in order fund this annuity, is closest to:

A)
$269,750.
B)
$274,340.
C)
$283,240.

Answer 20

C)
$283,240.

The amount needed to fund the annuity at t=15 is $588,839. In BGN mode: N = 20; I/Y = 5; PMT = 45,000; FV = 0; CPT PV. The equivalent amount at t=0 is $588,839 / (1.05)15 = $283,242.

Question 21

Adam Farman has been asked to estimate the volatility of a technology stock index. He has identified a statistic which has an expected value equal to the population volatility and has determined that increasing his sample size will decrease the sampling error for this statistic. Based only on these properties, his statistic can best be described as:

A)
unbiased and efficient.
B)
unbiased and consistent.
C)
efficient and consistent.

Answer 21

B)
unbiased and consistent.

An unbiased estimator has an expected value equal to the true value of the population parameter. A consistent estimator is more accurate the greater the sample size. An efficient estimator has the sampling distribution that is less than that of any other unbiased estimator

Question 22

A researcher has investigated the returns over the last five years to a long-short strategy based on mean reversion in equity returns volatility. His hypothesis test led to rejection of the hypothesis that abnormal (risk-adjusted) returns to the strategy over the period were less than or equal to zero at the 1% level of significance. He would most appropriately decide that:

A)
his firm should employ the strategy for client accounts because the abnormal returns are positive and statistically significant.
B)
while the abnormal returns are highly significant statistically, they may not be economically meaningful.
C)
as long as the estimated statistical returns are greater than the transactions costs of the strategy, his firm should employ the strategy for client accounts.

Answer 22

B)
while the abnormal returns are highly significant statistically, they may not be economically meaningful.

There are many reasons that a statistically significant result may not be economically significant (meaningful). Besides transactions costs, we must consider the risk of the strategy as well. For example, although the mean abnormal return to the strategy over the 5-year sample period is greater than transactions costs, abnormal returns for various sub-periods may be highly variable. In this case the risk of the strategy return from month to month or quarter to quarter may be too great to make employing the strategy in client accounts economically attractive.

Question 23

Under what conditions is inflation most likely to shift wealth from lenders to borrowers?

A)
Only when inflation is unexpected.
B)
Only when inflation is unexpected and negative.
C)
When inflation is either unexpected or expected.

Answer 23

A)
Only when inflation is unexpected.

Inflation that is unexpected, or higher than expected, shifts wealth from lenders to borrowers. Unexpected deflation has the opposite effect. Because interest rates include a premium for expected inflation, an inflation rate that matches expectations does not shift wealth from lenders to borrowers.

Question 24

The following table summarizes the results of a poll taken of CEOs and analysts about the economic impact of a pending piece of legislation:

Group Number of Respondents who Predict Positive Impact Number of Respondents who Predict Negative Impact
CEOs 40 30
Analysts 70 60
What is the probability that a randomly selected individual from this group will be either an analyst or someone who thinks this legislation will have a positive impact on the economy?

A)
0.75.
B)
0.80.
C)
0.85.

Answer 24

C)
0.85.

Using the addition rule for probabilities, P(analyst or positive) = P(analyst) + P(positive) − P(analyst and positive). P(A or positive) = 130 / 200 + 110 / 200 − (70 / 200) = 0.65 + 0.55 − 0.35 = 0.85. Alternatively, CEOs that predict positive impact = 40, analysts = 130, Prob (CEO positive or analyst) = (40 + 130) / 200 = 85%

Question 25

Which of the following objectives would a national government most likely pursue by placing restrictions on inflows of foreign capital?

A)
Protecting domestic industries.
B)
Supporting domestic asset prices.
C)
Keeping domestic interest rates low.

Answer 25

A)
Protecting domestic industries.

National governments may seek to limit foreign investment in certain domestic industries, for example, those that are seen as essential for national defense. A government seeking to keep domestic interest rates low or support domestic asset prices would be more likely to restrict capital outflows

Question 26

Under U.S. GAAP, which of the following statements about the financial statement effects of issuing bonds is least accurate?

A)
Issuance of debt has no effect on cash flow from operations.
B)
Periodic interest payments decrease cash flow from operations by the amount of interest paid.
C)
Payment of debt at maturity decreases cash flow from operations by the face value of the debt.

Answer 26

C)
Payment of debt at maturity decreases cash flow from operations by the face value of the debt.

Issuing debt results in a cash inflow from financing. Payment of debt at maturity has no effect on cash flow from operations but decreases cash flow from financing by the face value of the debt.

Question 27

A client plans to retire in 15 years and will need to withdraw $50,000 from his retirement account each year for 10 years, beginning on the day he retires. After that, he will need to withdraw $20,000 per year for 25 years. The account returns 4% annually. The amount he needs to have in the account on the day he retires is closest to:

A)
$580,000.
B)
$640,000.
C)
$655,000.

Answer 27

B)
$640,000.

We can treat these cash flows as a 35-year annuity due of $20,000 per year plus a 10-year annuity due of an additional $30,000 per year. With calculator in BGN mode:

$20,000 per year for 35 years: N = 35, PMT = 20,000, I/Y = 4, FV = 0; CPT PV = –388,224

$30,000 per year for 10 years: N = 10, PMT = 30,000, I/Y = 4, FV = 0; CPT PV = –253,060

Question 28

Gordon, Inc., reports using the LIFO cost method. In notes to its financial statements, Gordon discloses inventory of 500 units in 20X1 and 510 units in 20X2 and states a LIFO reserve of $50,000 in 20X1 and $48,000 in 20X2. These inventory disclosures most likely reflect:

A)
decreasing demand.
B)
decreasing prices.
C)
a LIFO liquidation.

Answer 28

B)
decreasing prices.

Decreasing prices can cause the LIFO reserve to decrease even when the inventory quantity is stable or increasing. A LIFO liquidation is a decrease in the quantity of inventory. To look for an indication of decreasing demand, an analyst would compare the growth rates of inventories and sales.

Question 29

Excerpts from statistical tables:

Student’s t-Distribution

Level of Significance for Two-Tailed Test
df 0.10 0.05 0.01
27 1.703 2.052 2.771
28 1.701 2.048 2.763
29 1.699 2.045 2.756
Cumulative z-Table

z 0.07 0.08 0.09
1.2 0.8980 0.8997 0.9015
1.3 0.9147 0.9162 0.9177
1.4 0.9292 0.9306 0.9319
An analyst has a sample of 28 observations of the weekly return of an index portfolio that includes 50 stocks. The weekly returns are approximately normally distributed, and the sample mean and sample variance are 1.2% and 0.00175. A 90% confidence interval for a weekly return is closest to:

A)
0.19% to 2.21%.
B)
–0.15% to 2.55%.
C)
–5.92% to 8.32%.

Answer 29

B)
–0.15% to 2.55%.

The sample standard deviation is (0.00175)1/2 = 4.18%. Based on a t-distribution with 27 degrees of freedom, a 90% confidence interval for the mean is 1.2% ± 1.703 × (4.18% / 281/2) = –0.1453% to 2.5453%.

Question 30

The country of Hokah can produce 35 units of cheese or 30 units of leather with one hour of labor. The country of Ymer can produce 20 units of cheese or 25 units of leather with one hour of labor. Which of the following statements is most accurate?

A)
Ymer’s opportunity cost of one unit of leather is 0.80 units of cheese.
B)
Hokah’s opportunity cost of one unit of cheese is 1.167 units of leather.
C)
Hokah has an absolute and a comparative advantage in both cheese and leather.

Answer 30

A)
Ymer’s opportunity cost of one unit of leather is 0.80 units of cheese.

The opportunity cost of one unit of leather for Ymer is 20 / 25 = 0.80 units of cheese, and the opportunity cost of one unit of cheese is 25 / 20 = 1.25 units of leather. The opportunity cost of one unit of cheese for Hokah is 30 / 35 = 0.86 units of leather, and the opportunity cost of one unit of leather is 35 / 30 = 1.167 units of cheese. Hokah has an absolute advantage in both cheese and leather but has a comparative advantage only in cheese

Question 31

Short-run disequilibrium is most likely to be associated with a decreasing price level if it results from a decrease in:

A)
both aggregate demand and short-run aggregate supply.
B)
aggregate demand, if short-run aggregate supply is unchanged.
C)
short-run aggregate supply, if aggregate demand is unchanged.

Answer 31

B)
aggregate demand, if short-run aggregate supply is unchanged.

A decrease in aggregate demand, holding short-run aggregate supply constant, would decrease the price level. A decrease in short-run aggregate supply, holding aggregate demand constant, would increase the price level. If both aggregate demand and short-run aggregate supply decrease, the price level may increase or decrease

Question 32

Degen, Inc., owns a trademark which it originally valued at €15 million on its balance sheet but currently values at €10 million. In the country where Degen is incorporated, trademarks are protected by law for as long as their owner remains a going concern. Degen has most likely:

A)
developed its trademark at a cost of €15 million.
B)
recorded amortization expense of €5 million on its trademark.
C)
recognized €5 million of impairment charges on its trademark.

Answer 32

C)
recognized €5 million of impairment charges on its trademark.

The trademark is an intangible asset with an indefinite life, and its cost is not amortized. The decrease in the trademark’s balance sheet value must be the result of impairment. For the intangible asset to appear on the balance sheet, Degen must have purchased the trademark. If Degen had developed the trademark internally, it would have expensed the cost rather than capitalizing it to the balance sheet.

Question 33

Harding Corp. has a permanently impaired asset. The difference between its carrying value and the present value of its expected cash flows should be written down immediately and:

A)
reported as an operating loss.
B)
charged directly against retained earnings.
C)
reported as a non-operating loss in other comprehensive income.

Answer 33

A)
reported as an operating loss.

Impairment writedowns are reported losses “above the line” and are included in income from continuing operations

Question 34

If market interest rates have changed materially since a firm issued a bond, and the firm uses the effective interest rate method, how is a change in the market value of the firm’s debt most likely to be reported in the firm’s financial statements?

A)
The gain or loss in market value must be calculated and disclosed in the footnotes to the financial statements.
B)
Net income and equity are unaffected, but the change may be discussed in management’s commentary.
C)
Net income is unaffected, but the change in market value is recorded in other comprehensive income.

Answer 34

B)
Net income and equity are unaffected, but the change may be discussed in management’s commentary.

Material changes in the firm’s cost of debt capital should be included in the Management Discussion and Analysis section of the financial statements. If the firm does not use fair value reporting of debt obligations, net income and shareholders’ equity are not affected by changes in the market value of the firm’s debt, and disclosing its gain or loss in market value is not required.

Question 35

If the probability of event J multiplied by the probability of event K is not equal to the joint probability of events J and K, then events J and K are most likely:

A)
dependent events.
B)
independent events.
C)
mutually exclusive events.

Answer 35

A)
dependent events.

Events J and K are dependent. By the multiplication rule, joint probability P(JK) = P(J|K) × P(K), or P(JK) = P(K|J) × P(J). Events are independent if P(J|K) = P(J) and P(K|J) = P(K). This implies that for independent events, P(JK) = P(J) × P(K). If this condition is not met, events J and K are dependent. If events J and K are mutually exclusive, their joint probability is zero. The information given is consistent with this but not sufficient to conclude that this is the case.

Question 36

A random variable follows a discrete uniform distribution with possible outcomes of 2, 4, 6, and 12. The standard deviation of the random variable is closest to:

A)
3.50.
B)
3.75.
C)
4.00.

Answer 36

B)
3.75.

The expected value of the random variable is (2 + 4 + 6 + 12) / 4 = 6.

The variance of the random variable is 0.25(2 – 6)2 + 0.25(4 – 6)2 + 0.25(6 – 6)2 + 0.25(12 – 6)2 = 14.

Standard deviation is 141/2 = 3.74

Question 37

Jordan Loney issues a “sell” recommendation on Sullivan Company because she believes its financial reporting quality is low. Loney writes, “Rapid turnover of key employees in its information systems and accounting units have made Sullivan’s internal monitoring controls ineffective.” Which condition that may lead to low-quality financial reporting has Loney detected at Sullivan?

A)
Opportunity.
B)
Motivation.
C)
Rationalization.

Answer 37

A)
Opportunity.

Ineffective internal controls over accounting may provide opportunities for low-quality financial reporting.

Question 38

Interest paid is reported as an operating cash outflow under:

A)
U.S. GAAP, but may be reported as a financing cash flow under IFRS.
B)
IFRS, but may be reported as an investing cash flow under U.S. GAAP.
C)
U.S. GAAP, but must be reported as either an investing or financing cash flow under IFRS.

Answer 38

A)
U.S. GAAP, but may be reported as a financing cash flow under IFRS.

Interest paid is an operating cash flow under U.S. GAAP but may be reported as either an operating or financing cash flow under IFRS

Question 39

f a firm’s breakeven quantity of sales is equal to its operating breakeven quantity of sales, its degree of:

A)
total leverage is 1.0.
B)
financial leverage is 1.0.
C)
operating leverage is 1.0.

Answer 39

B)
financial leverage is 1.0.

The breakeven quantity of sales is (fixed operating costs + fixed financing costs) / (price – variable cost per unit). The operating breakeven quantity of sales is (fixed operating costs) / (price – variable cost per unit). If a firm has a degree of financial leverage equal to 1 (i.e., no financial leverage), its fixed financing costs are zero. Therefore, its breakeven quantity of sales is equal to its operating breakeven quantity of sales.

Question 40

An investment advisor constructs a portfolio that plots on the capital market line but has less risk and a lower return than the market portfolio. This portfolio is most accurately described as:

A)
a lending portfolio.
B)
a leveraged portfolio.
C)
an inefficient portfolio.

Answer 40

A)
a lending portfolio.

A portfolio that plots on the capital market line with less risk than the market portfolio must include a positive allocation to the risk-free asset. Such a portfolio is called a lending portfolio because investing in the risk-free asset represents lending at the risk-free rate

Question 41

AlcoBanc owns a piece of property that is under consideration for a new bank branch. Which of the following is least likely a relevant incremental cash flow in analyzing this project? The:

A)
interest costs of a loan for the property purchase.
B)
business gained at other branches due to new customers at the proposed site.
C)
$150,000 AlcoBanc could get if they sold the property instead of building a new branch

Answer 41

A)
interest costs of a loan for the property purchase.

Financing costs should not be included in incremental cash flows. They are reflected in the weighted average cost of capital (WACC). New business at other branches is a positive externality and the $150,000 to sell the property is an opportunity cost.

Question 42

A stock has a beta of 0.9 and an estimated return of 10%. The risk-free rate is 7%, and the expected return on the market is 11%. According to the CAPM, this stock:

A)
is overvalued.
B)
is undervalued.
C)
is properly valued.

Answer 42

A)
is overvalued.

E(R) = 7% + 0.9(11% − 7%) = 10.6%. Because the expected return of 10% is less than the required return of 10.6%, the security is overvalued.

Question 43

hich of the following is most likely a violation of a pension fund’s fiduciary duty?

A)
Using ESG factors when estimating companies’ expected returns.
B)
Choosing one stock over another similar stock because of ESG considerations.
C)
Allocating 10% of assets to the five companies in its investing universe with the highest ESG scores.

Answer 43

C)
Allocating 10% of assets to the five companies in its investing universe with the highest ESG scores.

Selecting securities based on ESG factors without considering their risk and return characteristics is very likely a violation of the fiduciary responsibility of the managers of a pension trust. Incorporating ESG factors into a risk and return analysis or choosing between two securities of equivalent risk and return based on ESG factors are not violations

Question 44

In which step of the portfolio management process does an investment manager rebalance the portfolio to its target asset allocation percentages?

A)
Analysis step.
B)
Feedback step.
C)
Execution step

Answer 44

B)
Feedback step.

The three major steps in the portfolio management process are planning, execution, and feedback. Rebalancing the portfolio to its desired asset allocation is part of the feedback step

Question 45

Which of the following is most likely to improve a company’s cash position, other things equal?

A)
Decreasing days’ payables.
B)
Decreasing inventory turnover.
C)
Decreasing credit terms from 2/60 to 2/45.

Answer 45

C)
Decreasing credit terms from 2/60 to 2/45.

Changing credit terms from 2/60 to 2/45 can be expected to result in the earlier receipt of payments on credit purchases, improving a company’s cash position. Decreasing days’ payables and decreasing inventory turnover will both result in reduced operating cash flow.

Question 46

In the context of the capital asset pricing model, an active manager would be most likely to purchase a security that plots:

A)
on the security market line.
B)
below the security market line.
C)
above the security market line.

Answer 46

C)
above the security market line.

Active management seeks to identify mispriced assets, which are likely to earn abnormal returns. A security that plots above the security market line (SML) is undervalued (i.e., expected to earn a return that is higher than it would if it were priced at its equilibrium price, given its systematic risk).

Question 47

Using historical index returns for an equities market over a 20-year period, an analyst has calculated the average annual return as 5.60% and the holding period return as 170%. The compound annual index return over the period is closest to:

A)
2.69%.
B)
5.09%.
C)
5.24%.

Answer 47

B)
5.09%.

(1 + 1.7)’1/20 - 1 = 5.09

Question 48

Under what conditions will the percentage change in a company’s earnings per share be larger than the percentage change in its earnings before interest and taxes (EBIT)? The company’s degree of:

A)
operating leverage is positive.
B)
total leverage is greater than one.
C)
financial leverage is greater than one.

Answer 48

C)
financial leverage is greater than one.

Earnings per share will increase by a greater percentage than EBIT if a company has financial leverage (i.e., a degree of financial leverage greater than one).

Question 49

If a stock’s beta is equal to 1.2, its standard deviation of returns is 28%, and the standard deviation of the returns on the market portfolio is 14%, the covariance of the stock’s returns with the returns on the market portfolio is closest to:

A)
0.168.
B)
0.024.
C)
0.600.

Answer 49

B)
0.024.

From the fact that betai = Covi,mkt / Varmkt, we have Covi,mkt = betai × varmkt.

Covi,mkt = 1.2 × 0.142 = 0.02352.

Question 50

Based on parity relations for options prices, the value of a put minus the value of a call (on the same asset with same exercise prices) must equal:

A)
the price of a forward contract on the asset minus the present value of the option exercise price.
B)
the present value of the price of a forward contract on the asset minus the option exercise price.
C)
the present value of the difference between the option exercise price and the price of a forward contract on the asset.

Answer 50

C)
the present value of the difference between the option exercise price and the price of a forward contract on the asset.

Question 51

An investor with an investment horizon of 5 years has purchased a 15-year 6% coupon bond at par. The bond has a modified duration of 9.8. The duration gap for this investor is closest to:

A)
–4.2.
B)
4.8.
C)
5.4.

Answer 51

C)
5.4.

The duration gap is calculated as the bond’s Macaulay duration minus the investor’s investment horizon. Modified duration is Macaulay duration / (1 + YTM), so we can calculate the Macaulay duration as 9.8 × 1.06 = 10.388. The duration gap is 10.388 – 5 = 5.388.

Question 52

An analytical duration would be preferred to an empirical duration in instances where:

A)
the goal is to test the sensitivity of assumptions.
B)
the change in the credit spread is positively correlated with the change in the benchmark yield curve.
C)
the change in the credit spread is negatively correlated with the change in the benchmark yield curve.

Answer 52

A)
the goal is to test the sensitivity of assumptions.

Analytic methods lend themselves to estimating the effect of changing a particular assumption or estimate. When, historically, changes in the benchmark yield curve have been correlated with changes in the credit spread, empirical duration may be a more accurate measure of interest rate sensitivity

Question 53

The following information applies to JNC Advisers, a hedge fund:

$250 million in AUM as of prior year-end
2% management fee (based on year-end AUM)
20% incentive fee calculated net of management fees, using a 4% soft hurdle rate and a high-water mark ($275 million as of prior year-end)
In the current year, the fund’s gross return is 20%. An investor’s net-of-fees return for the year is closest to:

A)
13.0%.
B)
15.6%.
C)
16.1%.

Answer 53

C)
16.1%.

End-of-year AUM = $250 million × 1.20 = $300 million Management fees = $300 million × 2% = $6 million AUM net of management fees = $300 million – $6 million = $294 million Return net of management fees = $294 / $250 – 1 = 17.6%

Because returns for the year net of management fees exceeded the soft hurdle rate, the fund can collect incentive fees, but only on gains above the high-water mark.

Incentive fees = 20% × ($294 – $275) = $3.8 million Total fees to JNC Advisers = $6 + $3.8 = $9.8 million After-fee return = [(300 – 9.8) / 250] – 1 = 16.08%

Question 54

A non-cumulative preferred stock will be most risky if it is:

A)
putable.
B)
callable.
C)
option-free.

Answer 54

B)
callable.

A callable preferred is most risky because it can be redeemed for a fixed price if its value increases beyond that call price. Option-free and putable preferred stocks do not have this risk.

Question 55

If the risk-free rate of interest is 3%, the spot price of an asset is 35, and its net cost of carry is –2, the no-arbitrage price of a one-year forward contract on units of the asset is closest to:

A)
33.99.
B)
38.05.
C)
38.11.

Answer 55

C)
38.11.

A negative net cost of carry means that the costs of holding the asset are greater than the benefits, so we must add 2 to the spot price to get a no-arbitrage price for a one-year forward contract of 1.03(35 + 2) = 38.11.

Question 56

Recent economic data suggest an increasing likelihood that the economy will soon enter a recessionary phase. What is the most likely effect on the yields of lower-quality corporate bonds and on credit spreads of lower-quality versus higher-quality corporate bonds?

A)
Both will increase.
B)
Both will decrease.
C)
One will increase and one will decrease.

Answer 56

A)
Both will increase.

During economic contractions, the probability of default increases for lower-quality issues and their yields increase. When investors anticipate an economic downturn, they tend to sell low-quality issues and buy high-quality issues, causing credit spreads to widen

Question 57

Which of the following statements about put options at expiration is least accurate? The:

A)
put buyer’s maximum loss is the put option’s premium.
B)
maximum loss to the put writer is the exercise price less the premium.
C)
put holder will exercise the option whenever the underlying price is greater than the exercise price

Answer 57

C)
put holder will exercise the option whenever the underlying price is greater than the exercise price.

The put holder will exercise the option at expiration whenever the underlying price is less than the exercise price. (

Question 58

Which of the following scenarios is inconsistent with efficient financial markets?

A)
An analyst’s buy recommendations have returned 2% more than the broad market index, on average.
B)
Johnson, Inc. reports an increase of 8% in its earnings from a year earlier, and its stock price declines 5% on the news.
C)
Earl Baker, an investor, earns consistently superior risk-adjusted returns by buying stocks when most investment advisors are pessimistic and selling stocks when most investment advisors are optimistic.

Answer 58

C)
Earl Baker, an investor, earns consistently superior risk-adjusted returns by buying stocks when most investment advisors are pessimistic and selling stocks when most investment advisors are optimistic.

If markets are efficient, investors should not earn consistently superior returns from technical trading rules such as a contrary opinion strategy. A stock price will decrease on a report of an increase in earnings if that increase is less than investors expected based on all the information previously available. An analyst’s recommendations could be for stocks with more than market risk, or the analyst’s industry may outperform for some period of time. Both could account for outperformance even though markets are efficient

Question 59

Changes in a fixed-coupon bond’s cash flows that result from changes in yield would be reflected in the bond’s:

A)
effective duration.
B)
modified duration.
C)
Macaulay duration.

Answer 59

A)
effective duration.

Effective duration and effective convexity capture the effects from changes in a bond’s cash flows when the yield changes (e.g., an increase in the likelihood of a bond being called when its yield has decreased). For this reason, they are the appropriate measures of interest rate sensitivity for bonds with embedded options.

Question 60

A hedge fund that invests in nontraded securities uses a pricing model to calculate portfolio values. The most likely result of this method for portfolio valuation is upward bias to:

A)
Sharpe ratios.
B)
returns over time.
C)
return correlations with other investments.

Answer 60

A)
Sharpe ratios.

Using model prices tends to smooth returns over time, which biases both the standard deviation of returns and return correlations with other investment classes downward. Because the Sharpe ratio is calculated as excess returns per unit of standard deviation of returns, a downward bias in estimated standard deviations will bias Sharpe ratios upward. Returns over time are not necessarily biased upward or downward by using model values

Question 61

Benefits of derivative markets most likely include:

A)
decreasing the probability of counterparty defaults.
B)
increasing investors’ ability to hedge against systemic risks.
C)
discovery of market information that is not otherwise available.

Answer 61

C)
discovery of market information that is not otherwise available.

One of the benefits of derivative markets is the ability to discover information that is not available from cash market transactions, such as implied volatility from options markets. Risks of derivative markets include counterparty credit risk and greater systemic risk

Question 62

Four non-convertible bonds have the indicated yield spreads to Treasury securities:

Maturity Government Spread Zero- Volatility Spread Option- Adjusted Spread
Bond W 2 years 156 bp 155 bp 130 bp
Bond X 3 years 173 bp 174 bp 199 bp
Bond Y 5 years 188 bp 189 bp 164 bp
Bond Z 10 years 202 bp 201 bp 226 bp
Based on these spreads, it is most likely that:

A)
Bond X is callable, and Bond Y is putable.
B)
Bond W is callable, and Bond Z is putable.
C)
Bond Z is callable, and the spot yield curve is inverted.

Answer 62

B)
Bond W is callable, and Bond Z is putable.

Bonds W and Y are most likely callable, and Bonds X and Z are most likely putable. If the option-adjusted spread is less than the zero-volatility spread, the embedded option has a negative value to the bondholder (e.g., a call option), and if the option-adjusted spread is greater than the zero-volatility spread, the embedded option has a positive value to the bondholder (e.g., a put option). Zero-volatility spreads adjust for the fact that nominal spreads (between the yields to maturity of two bonds) are theoretically correct only when the spot yield curve is flat. All of these bonds’ zero-volatility spreads are nearly identical to their government spreads, which suggests the spot yield curve is approximately flat.

Question 63

Based on the following interest rates:

1-year spot rate 3.0%
1-year forward rate one year from now 5.0%
2-year forward rate one year from now 6.5%
The 3-year spot rate is closest to:

A)
5.0%.
B)
5.3%.
C)
9.3%.

Answer 63

B)
5.3%.

The 3-year spot rate is the discount rate for a 3-year zero-coupon security. To eliminate any opportunity for arbitrage, the 3-year spot rate should equal the compounded equivalent of borrowing at expected forward rates:

3-year spot rate = [(1 + 0.03)(1 + 0.065)2]1/3 – 1 = 0.0532 = 5.32%.

Note that the answer can be approximated simply by averaging the 1-year rate and the 2-year forward rate one year from now: (3 + 6.5 + 6.5) / 3 = 5.33%.

Question 64

To ensure the continuity of a value-weighted index when one of the stocks in the index is split:

A)
no adjustment is necessary.
B)
only the denominator must be adjusted for the split.
C)
both the numerator and the denominator must be adjusted for the split.

Answer 64

A)
no adjustment is necessary.

Value-weighted indexes do not need to be adjusted for stock splits because the market capitalization of the company remains the same

Question 65

Which of the following is a risk faced by issuers of commercial paper?

A)
Default risk.
B)
Rollover risk.
C)
Reinvestment risk.

Answer 65

B)
Rollover risk.

Rollover risk is the risk that an issuer who relies on the commercial paper market as a funding source may not be able to issue new commercial paper when an outstanding issue matures. Default risk and reinvestment risk are faced by bondholders.

Question 66

An analyst using a risk-neutral one-period binomial model calculates a probability- weighted average of an option’s values following an up-move and a down-move. According to this model, this average is most likely:

A)
equal to the option’s value today.
B)
less than the option’s value today.
C)
greater than the option’s value today.

Answer 66

C)
greater than the option’s value today.

The probability-weighted average calculated by the analyst is the option’s value after one period. To estimate the option’s value today, this result must be discounted by one period.

Question 67

A contract that requires one party to pay $100,000 each quarter to another company that will make a variable quarterly payment based on the market value of an equities portfolio is referred to as:

A)
a swap.
B)
an index option.
C)
portfolio insurance.

Answer 67

A)
a swap.

In an equity swap, one party pays a fixed amount periodically in return for a payment that is calculated using a specific amount and the return on a stock or portfolio of stocks.

Question 68

Visser, Inc. is an unprofitable fishing enterprise. Visser rents most of its boats and equipment but owns valuable transferable fishing quotas. If a competitor is interested in acquiring Visser, the most appropriate equity valuation model to use is:

A)
an asset-based valuation model.
B)
an earnings multiplier model.
C)
a Gordon growth model.

Answer 68

A)
an asset-based valuation model.

Asset-based models are often used to value natural resources companies and companies that are being liquidated. Because Visser is unprofitable, an earnings multiplier model or a dividend discount model such as the Gordon growth model may not produce a meaningful value for the firm

Question 69

Market conditions have increased the storage costs and decreased the convenience yield of a commodity. Other things equal, what effects will these changes have on the value of a forward contract on that commodity? The forward contract value:

A)
will increase.
B)
will decrease.
C)
may increase or decrease.

Answer 69

A)
will increase.

The value of a forward contract at any time before its expiration is the spot price of the underlying asset, plus the present value of storage costs, minus the present value of monetary and nonmonetary benefits of holding the underlying, minus the present value of the forward price. An increase in storage costs and a decrease in convenience yield (a non-monetary benefit of holding the asset) will increase the value of a forward contract, other things equal.

Question 70

In a transaction referred to as a management buyout (MBO):

A)
management sells its shares to an investor group attempting to gain control of a company.
B)
management buys a controlling interest in a public company to gain control of the board of directors.
C)
an investor group that includes management buys all the shares of a company and they no longer trade on an exchange.

Answer 70

C)
an investor group that includes management buys all the shares of a company and they no longer trade on an exchange.

Management buyout refers to a situation where an investor group that includes the firm’s key management purchases all the outstanding shares (not just a controlling interest) of a public company in order to take it private. Once this is done, the shares are no longer registered for public trading and, as a result, are no longer traded on exchanges or in other public markets.

Question 71

Archer Products is in an industry that has experienced low levels of price competition but recently excess capacity has led to aggressive price cutting. An analyst would be least likely to describe Archer’s industry as:

A)
concentrated and with high barriers to exit.
B)
in the shakeout stage with low concentration.
C)
in the maturity stage with high barriers to entry

Answer 71

C)
in the maturity stage with high barriers to entry.

The maturity phase of an industry life cycle is not typically characterized by excess capacity or price competition. The conditions described may be consistent with a concentrated industry (typically characterized by low levels of price competition, since firms in the industry seek to avoid it) that is moving into the decline phase of an industry life cycle (excess capacity leads to aggressive price cutting, especially when barriers to exit are high). These conditions could also be consistent with an industry that is moving into the shakeout phase (characterized by developing excess capacity and intense price competition) following the growth phase (during which price competition is low).

Question 72

An investor who chooses to invest in a fund-of-funds rather than in an individual hedge fund is least likely concerned with:

A)
diversification among hedge fund strategies.
B)
minimizing management and incentive fees.
C)
the manager’s expertise in selecting hedge funds.

Answer 72

B)
minimizing management and incentive fees.

Investing in a fund-of-funds can offer diversification among hedge fund strategies and provide manager expertise in selecting individual hedge funds. However, managers for these funds may charge both a management fee (e.g., 1%) and an incentive fee (e.g., 10%) that are in addition to the fees charged by the funds in which the fund-of-funds invests

Question 73

In what way is approximate convexity different from effective convexity?

A)
Effective convexity takes embedded options into account, while approximate convexity does not.
B)
Effective convexity results in a more accurate estimate of an option-free bond’s change in price than approximate convexity.
C)
Approximate convexity can be used with an unequal increase and decrease in yield, while effective convexity can only be used with an equal increase or decrease in yield.

Answer 73

A)
Effective convexity takes embedded options into account, while approximate convexity does not.

The distinction between effective convexity and approximate convexity is that effective convexity accounts for the effects of embedded options on the bond’s cash flows at different yields. For bonds that do not have embedded options, there is no difference between effective convexity and approximate convexity. Both measures are used to improve the estimate of the change in a bond’s price for a given change in yield

Question 74

A multi-market index is most likely to overweight countries that have recently experienced high equity market returns if it weights the securities in each country index by:

A)
dividend yield, and weights the country index returns by market capitalization.
B)
dividend yield, and weights the country index returns by gross domestic product.
C)
market capitalization, and weights the country index returns by gross domestic product.

Answer 74

A)
dividend yield, and weights the country index returns by market capitalization.

Weighting countries in a multi-market index by market capitalization, rather than a fundamental factor such as GDP, is likely to overweight countries with previously high stock returns.

Question 75

Given the put-call parity relationship, a synthetic underlying asset can be created by forming a portfolio of a:

A)
long call, long put, and short risk-free bond.
B)
long call, short put, and long risk-free bond.
C)
short call, long put, and long risk-free bond.

Answer 75

B)
long call, short put, and long risk-free bond.

An asset underlying put and call options can be replicated with a long European call option, a short European put option, and a long position in a risk-free bond that pays the exercise price on the expiration date