READING 1 RATES AND RETURNS

Question 1

Which of the following best describes the required rate of return for an investment?

A. The rate of return an investor actually earns on an investment over a specific period.
B. The minimum rate of return an investor must receive to accept an investment, considering its riskiness.
C. The historical average rate of return for a specific asset class.

Answer 1

B. The minimum rate of return an investor must receive to accept an investment, considering its riskiness.

The required rate of return is the minimum return an investor demands as compensation for the risk they are undertaking. It’s a forward-looking concept used in investment decisions.

Option A describes the realized rate of return or holding period return.
Option C describes a historical measure, which may not reflect future requirements.

Question 2

When analyzing interest rates, the time preference refers to:

A. The preference for liquidity in financial markets
B. The degree to which current consumption is preferred to equal future consumption
C. The tendency of interest rates to increase as bond maturity increases

Answer 2

B. The degree to which current consumption is preferred to equal future consumption

Time preference refers to the degree to which people prefer current consumption over future consumption, which is a fundamental concept in understanding interest rates as required rates of return. Even in a risk-free environment, most individuals prefer to consume now rather than later, requiring compensation for deferring consumption.

Option A is incorrect because liquidity preference relates specifically to the desire to hold cash or highly liquid assets rather than time preference itself.
Option C is incorrect because it describes the term structure of interest rates or yield curve, not time preference.

Question 3

Which of the following statements best describes the relationship between nominal risk-free rate, real risk-free rate, and expected inflation?

A. Nominal risk-free rate = Real risk-free rate × Expected inflation rate
B. Nominal risk-free rate = Real risk-free rate + Expected inflation rate
C. Nominal risk-free rate = Real risk-free rate - Expected inflation rate

Answer 3

B. Nominal risk-free rate = Real risk-free rate + Expected inflation rate

The correct relationship is that the nominal risk-free rate equals the real risk-free rate plus the expected inflation rate. This relationship, often known as the Fisher equation, shows how inflation expectations are incorporated into nominal interest rates.

Question 4

Which of the following risk types is primarily associated with the uncertainty of a borrower’s ability to repay a debt obligation?

A. Liquidity risk
B. Default risk
C. Maturity risk

Answer 4

B. Default risk

Default risk, also known as credit risk, is the risk that a borrower will fail to make promised payments of principal and interest on a timely basis.

Question 5

An investor is considering purchasing a bond that can only be sold quickly at a significant price concession. This bond is most exposed to:

A. Default risk.
B. Liquidity risk.
C. Maturity risk.

Answer 5

B. Liquidity risk.

Liquidity risk is the risk that an investment cannot be bought or sold quickly at a fair price due to a lack of trading volume or market depth.

Question 6

Generally, longer-term bonds are considered to have higher:

A. Default risk.
B. Liquidity risk.
C. Maturity risk.

Answer 6

C. Maturity risk.

Maturity risk is the risk that the prices of longer-term bonds are more volatile than those of shorter-term bonds due to interest rate changes. Investors in longer-term bonds are also exposed to reinvestment risk for a longer period.

Question 7

The required rate of return on a risky asset is the sum of the real risk-free rate, the expected inflation rate, and:

A. Only the default risk premium.
B. The default risk premium, liquidity premium, and maturity risk premium.
C. The historical risk premium for that asset class.

Answer 7

B. The default risk premium, liquidity premium, and maturity risk premium.

The required rate of return on a risky asset compensates investors for the time value of money (real risk-free rate + expected inflation) and the various risk premiums associated with the asset, including default risk, liquidity risk, and maturity risk.

Question 8

Which of the following components is typically added to the nominal risk-free rate to compensate investors for the possibility that the issuer of a bond may fail to make timely payments?

A. Inflation premium
B. Liquidity premium
C. Default risk premium

Answer 8

C. Default risk premium

The default risk premium is the additional return required by investors to compensate them for the risk that the borrower will not honor their debt obligations.

Question 9

A bond that trades infrequently and has a small number of outstanding issues would likely have a relatively high:

A. Maturity risk premium.
B. Default risk premium.
C. Liquidity premium.

Answer 9

C. Liquidity premium.

A bond that is difficult to sell quickly at a fair price due to low trading volume would carry a higher liquidity premium to compensate investors for this lack of marketability.

Question 10

The additional return required by investors for holding a long-term bond instead of a short-term bond is known as the:

A. Default risk premium.
B. Liquidity premium.
C. Maturity risk premium.

Answer 10

C. Maturity risk premium.

The maturity risk premium compensates investors for the increased price volatility associated with longer-term bonds and the greater uncertainty surrounding reinvestment rates.

Question 11

Which of the following is the most fundamental component of the nominal risk-free rate?

A. Inflation premium
B. Real risk-free rate
C. Default risk premium

Answer 11

B. Real risk-free rate

The nominal risk-free rate is composed of the real risk-free rate and the expected inflation rate. The real risk-free rate represents the time value of money in the absence of inflation and risk.

Question 12

Which of the following risks is generally considered to be higher for corporate bonds compared to government bonds?

A. Maturity risk
B. Liquidity risk
C. Default risk

Answer 12

C. Default risk

Corporate bonds, issued by companies, typically carry a higher risk of default than government bonds, which are backed by the taxing power of the government.

Question 13

If two bonds have the same maturity and liquidity characteristics, but one has a higher yield, this difference is most likely due to a higher:

A. Inflation expectation.
B. Default risk premium.
C. Real risk-free rate.

Answer 13

B. Default risk premium.

Assuming all other factors are equal, a higher yield on a bond typically reflects a higher compensation for the risk of the issuer defaulting on their obligations.

Question 14

An investor is analyzing two bonds with the same coupon rate and maturity. Bond A is issued by a large, well-established company with a high credit rating, while Bond B is issued by a smaller, newer company with a lower credit rating. Which bond is likely to have a higher required rate of return?

A. Bond A
B. Bond B
C. Both will have the same required rate of return.

Answer 14

B. Bond B

Bond B, issued by a company with a lower credit rating, carries a higher default risk. Investors will demand a higher required rate of return to compensate for this increased risk.

Question 15

Which of the following premiums compensates investors for the uncertainty related to the reinvestment of cash flows from an investment?

A. Default risk premium
B. Liquidity premium
C. Maturity risk premium (partially related for longer-term bonds)

Answer 15

C. Maturity risk premium (partially related for longer-term bonds)

While maturity risk primarily relates to price sensitivity to interest rate changes, for longer-term bonds, it also encompasses the uncertainty of reinvesting coupon payments at future interest rates.

Question 16

Consider a U.S. Treasury bill. Which of the following risk premiums would typically be considered the least significant for this investment?

A. Inflation premium
B. Default risk premium
C. Maturity risk premium

Answer 16

B. Default risk premium

U.S. Treasury bills are generally considered to have negligible default risk due to the backing of the U.S. government. Therefore, the default risk premium would be the least significant.

Question 17

An analyst observes that a particular segment of the bond market experiences infrequent trading and significant price volatility when trades do occur. This segment is likely characterized by a high:

A. Default risk.
B. Liquidity risk.
C. Inflation risk.

Answer 17

B. Liquidity risk.

Infrequent trading and significant price volatility upon trading are hallmarks of low liquidity. Investors in such markets demand a higher liquidity premium to compensate for the difficulty in buying or selling quickly at a fair price.

Question 18

Which of the following best describes the relationship between arithmetic mean return and geometric mean return?

A. The arithmetic mean return is always equal to or greater than the geometric mean return.
B. The geometric mean return is always greater than the arithmetic mean return.
C. The relationship between arithmetic and geometric mean returns depends on the sign of the returns.

Answer 18

A. The arithmetic mean return is always equal to or greater than the geometric mean return.

The arithmetic mean return is always equal to or greater than the geometric mean return, with the difference increasing as the dispersion of observations increases. The two means are equal only when there is no variability in the observations (i.e., all observations are equal).

Option B is incorrect because the geometric mean is never greater than the arithmetic mean.
Option C is incorrect because the relationship holds regardless of the sign of returns.

Question 19

Which type of return measure is most appropriate for evaluating the historical performance of an investment over multiple time periods?

A. Holding period return (HPR)
B. Arithmetic mean return
C. Geometric mean return

Answer 19

C. Geometric mean return

The geometric mean return is most appropriate for evaluating historical performance over multiple periods because it accounts for compounding effects.

The arithmetic mean does not account for compounding and thus overstates the actual growth rate experienced over multiple periods.
The holding period return (HPR) only covers a single period and doesn’t address the multiple-period performance evaluation needed.

Question 20

When calculating returns for a stock that pays dividends, which of the following components must be included in the return calculation to accurately represent the total return?

A. Only the change in price over the holding period
B. Only the dividends received during the holding period
C. Both the change in price and dividends received during the holding period

Answer 20

C. Both the change in price and dividends received during the holding period

Total return must include both price appreciation (or depreciation) and income received (dividends), as both contribute to the investor’s return.

Option A is incorrect because it ignores the income component from dividends.

Option B is incorrect because it ignores the capital appreciation/depreciation component.

Question 21

What is the primary reason that annualized returns are typically used when comparing investments with different holding periods?

A. Annualized returns eliminate the effect of inflation
B. Annualized returns standardize returns to a common time period
C. Annualized returns are mandated by regulatory requirements

Answer 21

B. Annualized returns standardize returns to a common time period

Annualized returns standardize returns to a common time period (one year), making it possible to compare investments with different holding periods.

Option A is incorrect because annualized returns do not adjust for inflation unless specifically calculated as real returns.

Option C is incorrect because while regulatory reporting may require annualized returns in some contexts, this is not the primary reason for their use in investment comparisons.

Question 22

In which scenario will the harmonic mean be equal to both the arithmetic and geometric means?

A. When all observations are equal
B. When all observations are positive
C. When the standard deviation of observations is exactly half the mean

Answer 22

A. When all observations are equal

When all observations are equal (i.e., there is no variability), all three means (arithmetic, geometric, and harmonic) will be equal.

Option B is incorrect because having positive observations doesn’t ensure equality of the means; there can still be differences if the observations vary.

Option C is incorrect because a specific relationship between standard deviation and mean doesn’t guarantee equality of the three means.

Question 23

For variables that are not of equal importance, which of the following relationships among the different means is correct?

A. Harmonic mean < geometric mean < arithmetic mean
B. Arithmetic mean < geometric mean < harmonic mean
C. The relationship depends on whether the variables are all positive or include negative values

Answer 23

A. Harmonic mean < geometric mean < arithmetic mean

For a set of positive numbers, the relationship is: harmonic mean ≤ geometric mean ≤ arithmetic mean. This relationship holds true regardless of the relative importance of the variables.

Option B is incorrect because it reverses the correct relationship.

Option C is incorrect because while the ability to calculate certain means may be affected by negative values, the relationship among the means for positive values is as stated in option A.

Question 24

The primary application of the harmonic mean in investment analysis is to calculate:

A. The average rate of return over multiple periods
B. The average cost of shares purchased over time
C. The volatility of investment returns

Answer 24

B. The average cost of shares purchased over time

The harmonic mean is primarily used to calculate the average cost of shares purchased over time, particularly when equal dollar amounts are invested periodically (dollar-cost averaging).

Option A is incorrect because geometric mean, not harmonic mean, is typically used for average rates of return over multiple periods.

Option C is incorrect because standard deviation or other dispersion measures, not harmonic mean, are used to measure volatility.

Question 25

What is the primary limitation of using the holding period return (HPR) when comparing investment performance? A. HPR doesn't account for the time value of money B. HPR doesn't standardize for different time periods C. HPR can't be calculated if dividends are involved

Answer 25

B. HPR doesn't standardize for different time periods The primary limitation of HPR is that it doesn't standardize for different time periods, making it difficult to compare investments held for different lengths of time. Option A is incorrect because while HPR doesn't explicitly account for the time value of money, this is not its primary limitation in performance comparison. Option C is incorrect because HPR can certainly incorporate dividends in its calculation.

Question 26

Which measure of return is most appropriate to use when calculating the rate at which an investor's money has grown over multiple periods? A. Arithmetic mean return B. Geometric mean return C. Harmonic mean return

Answer 26

B. Geometric mean return The geometric mean return is most appropriate for measuring the rate at which an investor's money has grown over multiple periods because it accounts for compounding. The arithmetic mean overestimates the actual growth rate when returns vary over time. The harmonic mean is not typically used for measuring growth rates but rather for calculating average costs in dollar-cost averaging scenarios.

Question 27

What is the relationship between the root used in calculating geometric mean return and the time period being analyzed? A. The root equals the number of years, regardless of the holding period frequency B. The root equals the number of holding periods C. The root equals the reciprocal of the holding period length

Answer 27

B. The root equals the number of holding periods The root used in calculating the geometric mean return equals the number of holding periods (the number of observations). When calculating annualized returns from geometric mean returns with non-annual holding periods, further adjustment is needed to convert to annual terms. Options A and C are incorrect because the root in the geometric mean calculation is always based on the number of observations (periods), not specifically the number of years or the reciprocal of period length.

Question 28

When returns include both positive and negative values, which approach can be used to calculate a geometric-like mean? A. Simply exclude the negative returns from the calculation B. Convert the returns to log returns and then take the arithmetic mean C. Use (1 + return) for each period, then subtract 1 from the result

Answer 28

C. Use (1 + return) for each period, then subtract 1 from the result When dealing with a set of returns that includes negative values, the approach is to use (1 + return) for each period in the geometric mean calculation, then subtract 1 from the final result. This approach allows for the inclusion of negative returns in the geometric mean calculation. Option A is incorrect because excluding negative returns would bias the result. Option B is incorrect because while log returns have mathematical properties that relate to geometric means, simply taking their arithmetic mean is not the standard approach for handling negative returns in geometric mean calculations.

Question 29

Which measure of average return is most affected by outliers in the return data? A. Arithmetic mean return B. Geometric mean return C. Trimmed mean return

Answer 29

A. Arithmetic mean return The arithmetic mean return is most affected by outliers because it gives equal weight to all observations, including extreme values. Geometric mean is less affected by outliers than arithmetic mean because it uses multiplication rather than addition. Trimmed mean is specifically designed to reduce the effect of outliers by excluding extreme values before calculating the mean.

Question 30

For reporting the performance of an investment portfolio to clients, which of the following return measures is most commonly used? A. Holding period return B. Arithmetic mean return C. Time-weighted return (a form of geometric mean)

Answer 30

C. Time-weighted return (a form of geometric mean) Time-weighted return, which is a form of geometric mean, is most commonly used for reporting portfolio performance to clients because it eliminates the effects of cash flows into and out of the portfolio. Holding period return doesn't account for the timing of cash flows and is not standardized for time. Arithmetic mean return overestimates the actual growth rate experienced by investors over time.

Question 31

The primary reason why the geometric mean return is always less than or equal to the arithmetic mean return is: A. The geometric mean gives more weight to lower returns B. The arithmetic mean is biased upward by the compounding effect C. The difference increases as the dispersion of observations increases

Answer 31

C. The difference increases as the dispersion of observations increases The primary reason for the inequality is that the difference between arithmetic and geometric means increases as the dispersion (variability) of observations increases. Option A is incorrect because the geometric mean doesn't specifically give more weight to lower returns; rather, it accounts for the multiplicative effect of returns. Option B is incorrect because the arithmetic mean doesn't account for compounding at all (which is why it differs from the geometric mean), so it's not "biased" by compounding effects.

Question 32

When evaluating the average cost basis for tax purposes of an investment where equal dollar amounts were invested at different prices, which mean should be used? A. Arithmetic mean of the prices B. Geometric mean of the prices C. Harmonic mean of the prices

Answer 32

C. Harmonic mean of the prices The harmonic mean of the prices should be used when calculating the average cost basis for tax purposes when equal dollar amounts were invested at different prices. This reflects the mathematical relationship between periodic equal investments and the resulting average cost per share. The arithmetic mean would incorrectly overstate the average cost per share. The geometric mean would not correctly represent the average cost in this situation.

Question 33

The default risk premium is best described as compensation for: A. The possibility that a borrower will fail to make timely payments B. The loss of purchasing power due to inflation C. The inability to sell an investment quickly at fair market value

Answer 33

A. The possibility that a borrower will fail to make timely payments The default risk premium compensates investors for taking on the risk that the borrower might not make promised payments in a timely manner. It's the additional yield required to account for potential default. Option B incorrectly describes the inflation premium, not the default risk premium. Option C incorrectly describes the liquidity premium, not the default risk premium.

Question 34

Which of the following premiums explains why long-term bonds typically offer higher yields than short-term bonds of the same credit quality? A. Default risk premium B. Liquidity premium C. Maturity risk premium

Answer 34

C. Maturity risk premium The maturity risk premium compensates investors for the greater price volatility of longer-term bonds. Longer-maturity bonds have more price risk than shorter-term bonds and therefore require additional yield compensation. Option A is incorrect because default risk is related to credit quality, which is held constant in the question. Option B is incorrect because liquidity risk doesn't necessarily increase with maturity in a systematic way like maturity risk does.

Question 35

Interest rates as required rates of return can be best interpreted as: A. The return that compensates for time preference only B. The minimum return needed to attract investors to a particular investment C. The difference between nominal and real returns

Answer 35

B. The minimum return needed to attract investors to a particular investment Interest rates as required rates of return represent the minimum return that investors and savers require to get them to willingly lend their funds for a particular investment, given its risk characteristics. Option A is incorrect because required rates of return compensate for more than just time preference—they also account for various risk premiums. Option C is incorrect as it describes the inflation component, not the entire concept of required return.

Question 36

The inflation premium in interest rates is best described as compensation for: A. Expected decreases in purchasing power over the investment period B. Unexpected fluctuations in the general price level C. The risk that the investment cannot be sold quickly at fair value

Answer 36

A. Expected decreases in purchasing power over the investment period The inflation premium compensates investors for the expected decrease in purchasing power due to inflation over the investment period. It's incorporated into nominal interest rates. Option B incorrectly refers to inflation risk or uncertainty, which would be an additional premium beyond expected inflation. Option C incorrectly describes liquidity risk, not inflation.

Question 37

When economists refer to the "real risk-free rate" of interest, they are referring to: A. The observed yield on short-term Treasury bills B. The theoretical rate that contains no expectation of inflation and zero probability of default C. The actual return earned after accounting for realized inflation

Answer 37

B. The theoretical rate that contains no expectation of inflation and zero probability of default The real risk-free rate is a theoretical rate that contains no expectation of inflation and zero probability of default. It represents pure time preference and is not directly observable. Option A is incorrect because observed Treasury bill yields contain inflation expectations and are nominal rates. Option C is incorrect because it describes the ex-post real return, not the ex-ante real risk-free rate.

Question 38

The component of interest rates that compensates investors for the possibility of selling an investment at a loss due to interest rate changes is the: A. Default risk premium B. Liquidity premium C. Maturity risk premium

Answer 38

C. Maturity risk premium The maturity risk premium compensates investors for the interest rate risk associated with longer-term securities. Longer-term bond prices are more volatile when interest rates change, creating greater price risk. Option A is incorrect because default risk premium compensates for potential borrower non-payment, not interest rate risk. Option B is incorrect because liquidity premium compensates for the difficulty of selling at fair value, not specifically losses due to interest rate changes.

Question 39

When comparing U.S. Treasury bills to corporate bonds, the higher yield typically offered by corporate bonds is primarily due to: A. The maturity risk premium B. The default risk premium C. The inflation premium

Answer 39

B. The default risk premium Corporate bonds typically offer higher yields primarily due to the default risk premium, which compensates investors for the greater possibility that a corporation might default compared to the U.S. government. Option A is incorrect because maturity risk would be relevant only when comparing securities of different maturities, not different issuers. Option C is incorrect because the inflation premium would be similar for both types of securities denominated in the same currency with similar maturities.

Question 40

According to economic theory, the nominal risk-free rate will increase if: A. Expected inflation decreases B. Time preference for current consumption increases C. The maturity risk premium decreases

Answer 40

B. Time preference for current consumption increases If time preference for current consumption increases (people value present consumption more highly relative to future consumption), the real risk-free rate will increase to compensate lenders, which in turn increases the nominal risk-free rate. Option A is incorrect because decreasing inflation expectations would lead to a decrease, not an increase, in nominal rates. Option C is incorrect because a decrease in maturity risk premium would lead to lower, not higher, interest rates for longer-term securities.

Question 41

Which of the following statements about the internal rate of return (IRR) as it relates to investment portfolios is MOST accurate? A. IRR is used primarily to evaluate the relative performance of portfolio managers. B. IRR is the discount rate at which a series of cash flows has a net present value (NPV) of zero. C. IRR is independent of the timing and magnitude of cash flows into and out of a portfolio.

Answer 41

B. IRR is the discount rate at which a series of cash flows has a net present value (NPV) of zero. The IRR is the discount rate that equates the present value of all cash inflows and outflows to zero. This makes B the correct answer as it accurately defines IRR in the context of investment portfolios. Option A is incorrect because IRR (or money-weighted return) is not the primary measure used to evaluate relative performance of portfolio managers since it's affected by cash flow timing that may be outside their control. Option C is incorrect because IRR specifically depends on both the timing and magnitude of cash flows, making it sensitive to when money moves in and out of the portfolio.

Question 42

When evaluating portfolio performance, the money-weighted rate of return is BEST described as: A. A measure that gives equal weighting to each time period regardless of the amount invested. B. The IRR of a portfolio that accounts for all cash inflows and outflows. C. A measure that eliminates the effect of cash flows when evaluating manager performance.

Answer 42

B. The IRR of a portfolio that accounts for all cash inflows and outflows. The money-weighted rate of return is defined as the IRR on a portfolio that takes into account all cash inflows and outflows, making option B correct. Option A incorrectly describes the time-weighted rate of return, which gives equal weight to each time period regardless of the amount invested. Option C is incorrect because rather than eliminating the effect of cash flows, the money-weighted return specifically incorporates and is affected by cash flow timing and magnitude.

Question 43

Which statement BEST describes the relationship between time-weighted and money-weighted rates of return during periods of fluctuating performance? A. They will always be identical if the portfolio maintains consistent performance. B. The time-weighted return will be higher than the money-weighted return if large deposits are made before periods of strong performance. C. The money-weighted return will be higher than the time-weighted return if large deposits are made just before periods of strong performance.

Answer 43

C. The money-weighted return will be higher than the time-weighted return if large deposits are made just before periods of strong performance. Option C is correct because if large deposits are made before periods of strong performance, more money experiences the higher returns, giving those periods greater weight in the money-weighted calculation. Option A is incorrect because even with consistent performance, the two measures can differ if cash flows occur. Option B incorrectly reverses the relationship. When deposits occur before strong performance, the money-weighted return (not the time-weighted return) would be higher.

Question 44

Which of the following statements regarding performance measurement distortions is MOST accurate? A. The time-weighted return creates distortions by overweighting periods with larger invested capital. B. The money-weighted return creates distortions by overweighting periods of high returns. C. The time-weighted return removes distortions caused by the timing of external cash flows.

Answer 44

C. The time-weighted return removes distortions caused by the timing of external cash flows. Option C is correct because the time-weighted return methodology specifically eliminates the impact of external cash flow timing, providing a more accurate measure of investment selection skill. Option A is incorrect because it describes the money-weighted return, not the time-weighted return. Option B is incorrect because the money-weighted return overweights periods with larger invested capital, not necessarily periods of high returns.

Question 45

If a portfolio has experienced no external cash flows during the measurement period, which of the following statements is MOST accurate? A. The money-weighted return must be calculated using specialized software. B. The money-weighted and time-weighted returns will be identical. C. The time-weighted return cannot be calculated without daily valuation data.

Answer 45

B. The money-weighted and time-weighted returns will be identical. Option B is correct because when there are no external cash flows, both methodologies measure the same thing and will produce identical results. Option A is incorrect because with no cash flows, the money-weighted return doesn't require specialized calculation tools. Option C is incorrect because time-weighted returns can be calculated with any periodic valuation data, not just daily data, especially when there are no intervening cash flows.

Question 46

Which performance measurement approach is MOST aligned with the investment decision-making authority of the typical mutual fund manager? A. Money-weighted rate of return B. Time-weighted rate of return C. Net present value method

Answer 46

B. Time-weighted rate of return Option B is correct because mutual fund managers typically cannot control when investors purchase or redeem fund shares, making time-weighted returns more appropriate for evaluating their investment selection skill. Option A is incorrect because the money-weighted return would unfairly reward or penalize the manager for cash flow timing decisions made by fund investors. Option C is incorrect because net present value is not a performance measurement approach for ongoing investment portfolios but rather an evaluation method for discrete investment opportunities.

Question 47

From the perspective of an individual investor evaluating their personal investment results, which return measure MOST accurately reflects their actual experience? A. Time-weighted rate of return B. Money-weighted rate of return C. Arithmetic average return

Answer 47

B. Money-weighted rate of return Option B is correct because the money-weighted return incorporates the timing and magnitude of the investor's personal cash flows, reflecting their actual investment experience and wealth creation. Option A is incorrect because while time-weighted return is useful for evaluating manager skill, it doesn't represent the investor's actual experience as it ignores the effect of their specific cash flow timing decisions. Option C is incorrect because arithmetic average return doesn't account for compounding effects or cash flow timing.

Question 48

Which of the following situations would MOST likely result in a money-weighted return that is lower than the time-weighted return for the same portfolio? A. Large withdrawals are made after periods of strong performance. B. Large contributions are made just before periods of poor performance. C. No external cash flows occur during a period of steadily increasing returns.

Answer 48

B. Large contributions are made just before periods of poor performance. Option B is correct because if large contributions are made just before poor performance, more capital experiences the lower returns, dragging down the money-weighted return compared to the time-weighted return. Option A is incorrect because withdrawals after strong performance would typically result in a higher money-weighted return than time-weighted return. Option C is incorrect because with no external cash flows, the money-weighted and time-weighted returns would be identical regardless of return patterns.

Question 49

In the context of the CFA Institute standards for performance reporting, which of the following statements is MOST accurate? A. Only money-weighted returns are required for compliant performance presentations. B. Time-weighted returns are required for performance comparisons between portfolios or against benchmarks. C. Both money-weighted and time-weighted returns must be presented side by side.

Answer 49

B. Time-weighted returns are required for performance comparisons between portfolios or against benchmarks. Option B is correct because the CFA Institute's Global Investment Performance Standards (GIPS) requires time-weighted returns for performance presentations to enable fair comparisons between portfolios and benchmarks. Option A is incorrect because GIPS emphasizes time-weighted returns, not money-weighted returns, as the primary performance metric. Option C is incorrect because while both metrics can provide valuable information, GIPS does not require presenting both side by side for compliant presentations.

Question 50

The time-weighted rate of return is the MOST appropriate performance measure when: A. The portfolio manager has complete control over the timing of cash flows into and out of the account. B. There are no cash flows during the measurement period. C. The portfolio manager does not control the timing of client deposits and withdrawals.

Answer 50

C. The portfolio manager does not control the timing of client deposits and withdrawals. Option C is correct because time-weighted return is the preferred method of performance measurement in the investment management industry specifically because portfolio managers typically do not control when clients make deposits or withdrawals. Option A is incorrect because when managers have complete control over cash flow timing, the money-weighted return would be more appropriate. Option B is incorrect because while time-weighted return would work in this scenario, the absence of cash flows would make both time-weighted and money-weighted returns equivalent. The distinguishing value of time-weighted returns is specifically in scenarios with cash flows outside the manager's control.

Question 51

What is the primary purpose of expressing returns as annualized measures? A. To maximize the reported return value B. To allow for fair comparison between investments with different holding periods C. To eliminate the effects of compounding from return calculations

Answer 51

B. To allow for fair comparison between investments with different holding periods The correct answer is B because annualizing returns creates a standardized time frame (one year) that enables investors to compare returns from investments held for different periods. Option A is incorrect because the purpose is standardization, not maximization of the reported value. Option C is incorrect because annualization actually incorporates compounding effects rather than eliminating them.

Question 52

Which statement regarding annualized returns is most accurate? A. Annualized returns must always be calculated using the exact number of days in a year (365 or 366) B. Annualized returns convert holding period returns of any length to a standardized annual basis C. Annualized returns are only applicable for investments held for more than one year

Answer 52

B. Annualized returns convert holding period returns of any length to a standardized annual basis The correct answer is B because annualized returns standardize returns regardless of the actual length of the time period, converting any holding period return to an annual basis for comparison purposes, as stated in the reading. Option A is incorrect because the annualization formula uses a standard 365 days convention rather than requiring the exact number of days. Option C is incorrect because annualized returns can be calculated for periods shorter than one year, as demonstrated in the first example where a 90-day return is annualized.

Question 53

How does increasing the frequency of compounding affect the present value of a future cash flow, all else being equal? A. It increases the present value B. It decreases the present value C. It has no effect on the present value

Answer 53

B. It decreases the present value The correct answer is B because, as explicitly stated in the material, "an increase in the frequency of compounding increases the effective interest rate, it also decreases the present value of a given cash flow." Option A is incorrect because higher compounding frequency results in a lower present value, not higher. Option C is incorrect because compounding frequency does have an effect on present value calculations.

Question 54

What is the relationship between compounding frequency and future value, all else being equal? A. Higher compounding frequency leads to lower future value B. Higher compounding frequency leads to higher future value C. Compounding frequency has no effect on future value

Answer 54

B. Higher compounding frequency leads to higher future value he correct answer is B because the material states that "more frequent compounding has an impact on future value" and specifically "an increase in the frequency of compounding increases the effective interest rate, it also increases the future value." Option A is incorrect because future value increases, not decreases, with higher compounding frequency. Option C is incorrect as compounding frequency does affect future value calculations.

Question 55

What is the mathematical limit of shortening the compounding period in financial calculations? A. Simple interest B. Continuous compounding C. Daily compounding

Answer 55

B. Continuous compounding The correct answer is B because the material explicitly states "The mathematical limit of shortening the compounding period is known as continuous compounding." Option A is incorrect because simple interest represents the absence of compounding, not its mathematical limit. Option C is incorrect because daily compounding is just one discrete compounding frequency, not the mathematical limit of shortening the period.

Question 56

Which of the following best describes a key property of continuously compounded rates of return? A. They are multiplicative across time periods B. They are additive across time periods C. They are always higher than discretely compounded returns

Answer 56

B. They are additive across time periods The correct answer is B because the material states "A useful property of continuously compounded rates of return is that they are additive for multiple periods." Option A is incorrect because continuously compounded returns are additive, not multiplicative, across periods. Option C is incorrect because the relationship between continuously compounded returns and discretely compounded returns depends on the specific circumstances and is not always higher.

Question 57

How does the continuously compounded return (Rcc) relate to the holding period return (HPR)? A. Rcc = (1 + HPR) - 1 B. Rcc = ln(1 + HPR) C. Rcc = HPR × 365/days

Answer 57

B. Rcc = ln(1 + HPR) The correct answer is B because the material shows that Rcc = ln(1 + HPR) or equivalently, Rcc = ln(ending value/beginning value). Option A is incorrect as it describes a simple return, not a continuously compounded return. Option C is incorrect as it describes the formula for annualizing returns, not calculating continuously compounded returns.

Question 58

In the context of return measures, what is the primary difference between discrete compounding and continuous compounding? A. Discrete compounding applies to bonds while continuous compounding applies to stocks B. Discrete compounding occurs at finite intervals while continuous compounding occurs at every instant C. Discrete compounding is more accurate for regulatory reporting purposes

Answer 58

B. Discrete compounding occurs at finite intervals while continuous compounding occurs at every instant The correct answer is B because discrete compounding occurs at specific intervals (annual, semi-annual, quarterly, etc.) while continuous compounding represents the mathematical limit where compounding occurs at every instant (infinite frequency). Option A is incorrect because both compounding methods can apply to any financial instrument. Option C is incorrect because accuracy for regulatory reporting depends on the specific regulations, not on the mathematical properties of the compounding method.

Question 59

What is the primary difference between gross return and net return? A. Gross return includes dividends while net return excludes dividends B. Gross return is before deducting management fees while net return is after deducting these fees C. Gross return is adjusted for inflation while net return is not

Answer 59

B. Gross return is before deducting management fees while net return is after deducting these fees The correct answer is B because as stated in the material, "Gross return refers to the total return on a security portfolio before deducting fees for the management and administration of the investment account. Net return refers to the return after these fees have been deducted." Option A is incorrect because both gross and net returns include dividends; the difference is solely about management fees. Option C is incorrect because neither gross nor net return is adjusted for inflation; that would be real return.

Question 60

How is real return most accurately defined? A. Return after taxes but before inflation adjustment B. Return after management fees have been deducted C. Nominal return adjusted for inflation

Answer 60

C. Nominal return adjusted for inflation he correct answer is C because the material explicitly states "Real return is nominal return adjusted for inflation." Option A is incorrect because real return relates to inflation adjustment, not tax effects (which would be after-tax return). Option B is incorrect because that describes net return, not real return.

Question 61

What does a leveraged return measure? A. The return on an investment that uses borrowed funds in addition to investor's capital B. The return adjusted for different tax rates on various income components C. The return after inflation has been factored in

Answer 61

A. The return on an investment that uses borrowed funds in addition to investor's capital The correct answer is A because the material defines a leveraged return as "a return to an investor that is a multiple of the return on the underlying asset" and explains it's "calculated as the gain or loss on the investment as a percentage of an investor's cash investment." Option B is incorrect because tax adjustment relates to after-tax returns, not leveraged returns. Option C is incorrect because inflation adjustment pertains to real returns, not leveraged returns.

Question 62

Which statement best describes the relationship between nominal return and real return when inflation is positive? A. Real return equals nominal return B. Real return exceeds nominal return C. Real return is less than nominal return

Answer 62

C. Real return is less than nominal return he correct answer is C because when inflation is positive, real return is reduced by the inflation rate. The material demonstrates this with an example where a 7% nominal return with 2% inflation results in a real return of approximately 4.9%. Option A is incorrect because real and nominal returns are only equal when inflation is zero. Option B is incorrect because positive inflation makes real returns lower than nominal returns, not higher.

Question 63

What is the primary purpose of calculating real return? A. To determine tax liability on investment returns B. To measure the increase in an investor's purchasing power C. To compare performance against market benchmarks

Answer 63

B. To measure the increase in an investor's purchasing power The correct answer is B because the material explicitly states "Real return measures the increase in an investor's purchasing power—how much more goods she can purchase at the end of the year due to the increase in the value of her investments." Option A is incorrect because tax liability is related to pretax and after-tax returns, not real returns. Option C is incorrect because while real returns can be used in performance comparisons, the primary purpose is specifically to measure purchasing power changes.

Question 64

How does positive leverage affect investment returns when the return on the investment exceeds the borrowing cost? A. It reduces overall returns due to interest expenses B. It amplifies returns on the investor's capital C. It has no effect on the percentage return

Answer 64

B. It amplifies returns on the investor's capital The correct answer is B because leverage amplifies returns when the investment return exceeds borrowing costs. This is illustrated in the formula showing how leveraged return becomes a multiple of the underlying asset's return. Option A is incorrect because when investment returns exceed borrowing costs, leverage increases overall returns despite interest expenses. Option C is incorrect because leverage definitely affects percentage returns, either positively or negatively.

Question 65

According to the professor's note, how is the relationship between real return and nominal return most accurately expressed when considering risk premiums? A. Real return equals nominal return minus inflation B. Real return equals the sum of real risk-free rate and risk premium, divided by inflation premium C. Real return equals nominal return divided by inflation rate

Answer 65

B. Real return equals the sum of real risk-free rate and risk premium, divided by inflation premium he correct answer is B because the professor's note states "The Level I curriculum states this relationship as (1 + real return) = (1 + real risk-free rate)(1 + risk premium)/(1 + inflation premium)." Option A is incorrect because this is a simplified approximation, not the precise relationship that accounts for risk premiums. Option C is incorrect because real return is not calculated by dividing nominal return by the inflation rate.

Question 66

What components are included in the after-tax nominal return? A. Return after deducting management fees but before tax effects B. Return after all tax liabilities have been accounted for C. Return adjusted for both taxes and inflation

Answer 66

B. Return after all tax liabilities have been accounted for The correct answer is B because the material states "After-tax nominal return refers to the return after the tax liability is deducted." Option A is incorrect because it describes net return, not after-tax return. Option C is incorrect because after-tax nominal return has not been adjusted for inflation.

Question 67

In the formula for leveraged return, what does subtracting the term (rB × VB) represent? A. Accounting for the decrease in asset value B. Removing the effects of inflation C. Deducting the interest cost on borrowed funds

Answer 67

C. Deducting the interest cost on borrowed funds The correct answer is C because in the formula, rB is the interest rate on borrowed funds and VB is the amount borrowed, so their product represents the interest cost that must be deducted from returns. Option A is incorrect because asset value changes are already accounted for in the overall return calculation. Option B is incorrect because the leveraged return formula does not address inflation adjustments.

Question 68

An investment manager’s gross return is: A. an after-tax nominal, risk-adjusted return. B. the return earned by the manager prior to deduction of trading expenses. C. an often-used measure of an investment manager’s skill because it does not include expenses related to management or administration.

Answer 68

C is correct. Gross returns are calculated on a pre-tax basis; trading expenses are accounted for in the computation of gross returns as they contribute directly to the returns earned by the manager. A is incorrect because investment managers’ gross returns are pre-tax and not adjusted for risk. B is incorrect because managers’ gross returns do reflect the deduction of trading expenses since they contribute directly to the return earned by the manager.