2019 Level I Mock Exam (B) PM 39 Section 5.3 68 When computing the weighted average cost of capital (WACC) and assuming a fixed-r ate non-c allable bond is currently selling above par value, the before-tax cost of debt is closest to the: A coupon rate. B yield to maturity. C current yield. B is correct. With a fixed-r ate non-callable bond, the before-tax cost of debt is the bond’s yield to maturity. A is incorrect because the coupon rate is higher than the yield-to-maturity based on the bond selling above par value. C is incorrect because the current yield is the coupon divided by the bond price which does not equal the yield-t o-maturity. Cost of Capital LOS f Section 3.1 69 A company’s $100 par value preferred stock with a dividend rate of 9.5% per year is currently priced at $103.26 per share. The company’s earnings are expected to grow at an annual rate of 5% for the foreseeable future. The cost of the company’s preferred stock is closest to: A 9.5%. B 9.2%. C 9.7%. B is correct. rp = Dp/Pp (or Dividend/Price) = ($100 × 0.095)/$103.26 = 9.2%. A is incorrect because it uses $100 as the denominator, i.e., ($100 × 0.095)/$100 = 9.5%. C is incorrect because it assumes 5% growth in the dividend, i.e., 9.5 × (1.05)/103.26 = 9.7%. Cost of Capital LOS g Section 3.2 Equity Valuation: Concepts and Basic Tools LOS f Section 4.1 70 A firm is uncertain about both the number of units the market will demand and the price it will receive for them. This type of risk is best described as: A sales risk. B operating risk. C business risk.
40 2019 Level I Mock Exam (B) PM A is correct. Sales risk is associated with uncertainty with respect to total revenue, which, in turn, depends on price and units sold. B is incorrect. Operating risk is the risk attributed to the operating cost structure. A company with a greater proportion of fixed costs in its cost structure has greater operating risk. C is incorrect. Business risk is risk associated with operating earnings and this risk is the combination of sales risk and operating risk. Measures of Leverage LOS a Section 3.1, 3.2 71 If the degree of financial leverage (DFL) is 1.00, the operating breakeven point compared with the breakeven point is most likely: A lower. B the same. C higher. B is correct. When DFL = Operating income/Net income = 1.00, Operating income = Net income, meaning the fixed cost of debt is zero. The breakeven point is: Fixed costs + Fixed cost of debt/Contribution margin. Because the fixed cost of debt is zero, the company’s breakeven point becomes Fixed costs/Contribution margin, which is the same as the operating breakeven point. A is incorrect because the breakeven point is equal to the operating breakeven point when DFL = 1.00. C is incorrect because the breakeven point is equal to the operating breakeven point when DFL = 1.00. Measures of Leverage LOS b, d, e Sections 3.4, 3.6 72 For a 90-d ay US Treasury bill selling at a discount, which of the following meth- ods most likely results in the highest yield? A Discount-b asis yield (DBY) B Money market yield (MMY) C Bond equivalent yield (BEY) C is correct. Note: the face value is greater than the purchase price because the T-Bill sells at a discount. DBY = Face value − Purchase price × 360 Face value Days to maturity MMY = Face value − Purchase price × 360 , MMY > DBY Purchase price Days to maturity
2019 Level I Mock Exam (B) PM 41 BEY = Face value − Purchase price × 365 Purchase price Days to maturity BEY = MMY × 365 360, BEY > MMY > DBY A is incorrect because bond equivalent yield is the highest yield by construction. B is incorrect because bond equivalent yield is the highest yield by construction. Working Capital Management LOS e Section 4.1.1 73 The effective annualized cost (%) of a banker’s acceptance that has an all- inclusive annual rate of 5.25% for a one-m onth loan of $2,000,000 is closest to: A 5.54%. B 5.38%. C 5.27%. C is correct. Calculate the effective annualized cost: Interest × 12 = 2,000,000 × 0.0525 × 1 12 × 12 Net proceeds 2,000,000 × (1 − 0.0525 × 1 12) = 0.0527 = 5.27% A is incorrect. No monthly adjustment is made within the calculation. 0.0554 = 2,000,000 × 0.0525 2,000,000 × (1 − 0.0525) B is incorrect. It is the effective annual rate. 0.0538 = 1 + 0.052512 −1 12 Working Capital Management LOS g Section 8.4, Example 7 74 In the context of strategic asset allocation, adding asset classes with low cor- relation will most likely improve a portfolio’s risk–return trade-o ff as long as the stand-a lone risk of the added asset class: A does not exceed its diversification effect. B equals its diversification effect. C exceeds its diversification effect. A is correct. In general, adding assets classes with low correlation improves the risk–return trade-off as long as the stand-alone risk of the added asset class does not exceed its diversification effect. B is incorrect because adding assets classes with low correlation will only improve the risk–return trade-off if the stand-a lone risk of the added asset class does not exceed its diversification effect.
42 2019 Level I Mock Exam (B) PM C is incorrect because adding assets classes with low correlation will only improve the risk–return trade-o ff if the stand-a lone risk of the added asset class does not exceed its diversification effect. Basics of Portfolio Planning and Construction LOS f Section 3.2 75 Which of the following is most likely a part of the feedback step in the portfolio management process? A Performance measurement B Developing the investment policy statement C Portfolio construction A is correct. Performance measurement, along with portfolio monitoring and rebalancing, is part of the feedback loop. B is incorrect. Developing the investment policy statement is part of the planning step. C is incorrect. Portfolio construction is part of the execution step. Portfolio Management: An Overview LOS d Section 4 76 Selected information about shares of two companies is provided in the follow- ing table: Standard Correlation of Deviation Stock Returns* Portfolio Weights Cable Incorporated 30% 0.65 68% GPT Company 20% 32% * Correlation of returns between Cable Incorporated and GPT Company. The standard deviation of returns of the portfolio formed with these two stocks is closest to: A 32.85%. B 26.80%. C 25.04%. C is correct. standard deviation = Portfolio ( )( ) ( )( )0.682 0.32 + 0.322 0.22 + 2(0.68)(0.32)(0.65)(0.3)(0.2) = 0.2504. A is incorrect. The standard deviation terms are excluded from the third part of the equation and the square root is not taken. This is incorrectly calculated as [(0.682)(0.32) + (0.322)(0.22) + 2(0.68)(0.32)(0.65) = 0.3285.
2019 Level I Mock Exam (B) PM 43 B is incorrect. This is the weighted standard deviations = 0.68 × 0.30 + 0.32 × 0.20 = 0.268. Portfolio Risk and Return: Part I LOS e Section 2.3.3 77 For a portfolio consisting of two assets with a correlation coefficient of +1.0, it is most likely that portfolio risk is: A equal to the weighted average of the risk of the two assets in the portfolio. B less than the weighted average of the risk of the two assets in the portfolio. C greater than the weighted average of the risk of the two assets in the portfolio. A is correct. With a correlation coefficient of +1.0, no diversification benefits are obtained and the portfolio risk is equal to the weighted average of the risk of the two assets in the portfolio. B is incorrect. Portfolio risk is less than the weighted average of the risk of the two assets in the portfolio only when the correlation coefficient is smaller than one. C is incorrect. Portfolio risk can never be greater than the weighted average of the risk of the two assets in the portfolio. Portfolio Risk and Return: Part I LOS f Section 4.1.3 78 Stock X and Stock Y have the same level of total risk. Stock X has twice the systematic risk of Stock Y and half its non-systematic risk. Stock X’s expected return will most likely be: A the same as the expected return of Stock Y. B lower than the expected return of Stock Y. C higher than the expected return of Stock Y. C is correct. Because Stock X has a higher systematic risk level compared with Stock Y, its expected return will be higher than that of Stock Y. A is incorrect because Stock X has a higher systematic risk level compared to Stock Y, implying a higher (not the same) expected return compared to Stock Y. B is incorrect because Stock X has a higher systematic risk level compared to Stock Y, implying a higher (not lower) expected return compared to Stock Y. Portfolio Risk and Return: Part II LOS c Section 3.1 79 Which of the following is least likely an assumption underlying the capital asset pricing model (CAPM)? A Investors analyze securities according to their own future cash flow esti- mates and probability distributions. B There are no restrictions on short selling assets.
44 2019 Level I Mock Exam (B) PM C The amount invested in an asset can be as much or as little as the investor wants. A is correct. The CAPM requires that there are no restrictions on short selling (which is an assumption underlying frictionless markets) and that the amount invested in an asset can be as much or as little as the investor wants (that is, investments are infinitely divisible). The CAPM also assumes that all investors analyze securities in the same way using the same inputs for future cash flows and the same probability distributions; that is, it assumes that investors have homogenous expectations. B is incorrect because no restrictions on short selling assets (which is an assumption underlying frictionless markets) is an assumption of the CAPM. C is incorrect because an investor being able to invest as much or as little in an asset (that is, investments are infinitely divisible) is an assumption of the CAPM. Portfolio Risk and Return: Part II LOS f Section 4.1 80 In a good risk management process, the duties of Chief Risk Officer (CRO) least likely include: A setting the risk tolerance of the organization. B participating in the key strategic decisions of the organization. C building the risk framework for the organization. A is correct. The CRO will be appointed by the CEO and board to build and manage the risk management system, but the CEO and board remain responsible for determining the risk tolerance of the organization as a whole. B is incorrect because the CRO will participate in strategic decision making for the organization. C is incorrect because the CRO will build and manage the risk framework of the organization. Risk Management: An Introduction LOS c Section 3.1 81 Which of the following statements is least accurate? A firm’s free cash flow to equity (FCFE): A is a measure of the firm’s dividend-p aying capacity. B increases with an increase in the firm’s net borrowing. C is significantly affected by the amount of dividends paid by the firm. C is correct. Dividends, a discretionary cash flow from financing activities, have no bearing on a firm’s free cash flow to equity, as can be seen from the formula: FCFE = CFO – FCInv + Net borrowing. A is incorrect. FCFE is a measure of dividend-paying capacity. B is incorrect. FCFE increases with an increase in the firm’s net borrowing.
2019 Level I Mock Exam (B) PM 45 Equity Valuation: Concepts and Basic Tools LOS e Section 4 82 An investor gathers the following data to estimate the intrinsic value of a com- pany’s stock using the justified forward price-to-e arnings ratio (P/E) approach. Next year’s earnings per share $3.00 Return on equity 12.5% Dividend payout ratio 60% Required return on shares 10% The intrinsic value per share is closest to: A $36. B $48. C $72. A is correct. Given that the intrinsic value is P0 = P0/E1 × E1 and the justified forward P/E is P0/E1 = p/(r – g), where p = payout ratio, Dividend growth rate = (1 – Payout ratio) × ROE = (1 – 0.6) × 12.5 = 5% Justified forward P/E = P0/E1 = 0.60/(0.10 – 0.05) = 12×, so Intrinsic value = 12 × $3 = $36 B is incorrect. It switches between retention ratio and payout ratio in computations. Dividend growth rate = 0.6 × 12.5 = 7.5% P/E1 = 0.40/(0.10 – 0.075) = 16× Intrinsic value = Next year’s EPS × P/E1 = $3 × 16 = $48 C is incorrect. It is the mistake of using payout ratio for computing growth rate. Dividend growth rate = Payout ratio × ROE = 0.6 × 12.5 = 7.5% P/E1 = p/(r – g) = 0.60/(0.10 – 0.075) = 24× Intrinsic value = Next year’s EPS × P/E1 = $3 × 24 = $72 Equity Valuation: Concepts and Basic Tools LOS j Section 5.1 83 Given the following information for a company: ●● Market value per share $250 ●● Current dividend per share $5 ●● Dividend growth rate 4% ●● Required rate of return 6% and using the Gordon growth model to estimate the intrinsic value, a share of the company is best described as being: A fairly valued. B overvalued. C undervalued.
46 2019 Level I Mock Exam (B) PM C is correct. The intrinsic value of an equity security based on the Gordon growth model is estimated as follows: V0 = D0 (1 + g) = D1 r−g r−g where: V0 = the estimate of the intrinsic value D0 = the current dividend ($5) and D1 is the next year’s dividend g = the dividend growth rate (4%) r = the required rate of return (6%) The estimate of the intrinsic value is: V0 = D0 (1 + g) = $5(1 + 0.04) = $260 per share (0.06 − 0.04) r−g Given that the market value ($250) is lower than the estimate of the intrinsic value ($260), a share of the company appears to be undervalued. B is incorrect. The estimate of the intrinsic value is V0 = D0 (1 + g) = $5(1 + 0.04) = $260 per share (0.06 − 0.04) r−g Given that the market value is lower than the estimate of the intrinsic value ($250 < $260), a share of the company appears to be undervalued, not overvalued. A share of a company is overvalued when the market value is higher than the intrinsic value. A is incorrect. The estimate of the intrinsic value is V0 = D0 (1 + g) = $5(1 + 0.04) = $260 per share (0.06 − 0.04) r−g Given that the market value is lower than the estimate of the intrinsic value ($250 < $260), a share of the company appears to be undervalued. A share of a company is fairly valued when the intrinsic value is equal to the market value. Using $5 as D1, rather than D0, would lead to the wrong conclusion that a share of the company is fairly valued: $5/(0.06 – 0.04) = $250 per share Equity Valuation: Concepts and Basic Tools LOS g Section 4.2 Market Efficiency LOS b Section 2.2 84 Industry analysis is least useful to those who are engaged in: A a top-d own investment approach. B indexing and passive investing strategies. C portfolio performance attribution. B is correct. Indexing and passive investing strategies would not engage in over- or underweighting of industries, industry rotation, or timing investments in industries. Therefore, industry analysis is not useful to such investors or portfolio managers. A is incorrect. In a top-d own investing approach, industry analysis is useful to identify industries with positive, neutral, or negative outlooks for profitability and growth, which will then help weighting of industries relative to the benchmark.
2019 Level I Mock Exam (B) PM 47 C is incorrect. Portfolio performance attribution, which addresses the sources of a portfolio’s returns, usually in relation to the portfolio’s benchmark, includes industry or sector selection. Introduction to Industry and Company Analysis LOS a Section 2 85 Unlike commercial industry classification systems, industry classification sys- tems developed by governments most likely: A are updated more frequently. B are more transparent. C include private companies. C is correct. Industry classification systems developed by governments do not distinguish between public and private companies, whereas commercial classification systems include only publicly traded organizations. A is incorrect. Commercial industry classification systems are updated more frequently than government classification systems. B is incorrect. Unlike commercial industry classification systems, most government classification systems do not disclose information about specific businesses. Introduction to Industry and Company Analysis LOS b Section 4.3 86 Which of the following statements concerning companies in different industry environments is most accurate? A Companies in mature industries tend to focus on efficiency gains and gain market share through superior products. B An industry’s experience curve declines with a decrease in the utilization of capital equipment and spreading overhead over a fewer number of units. C Companies in fragmented industries would not be highly price competitive because they tend to think individualistically, making coordination difficult. A is correct. Companies in mature industries are likely to pursue replacement demand rather than new buyers and are probably focused on extending successful product lines rather than introducing revolutionary new products. Therefore, they tend to focus on cost rationalization and efficiency gains rather than on taking a lot of market share. Furthermore, companies with superior products or services are likely to gain market share. B is incorrect. An industry’s experience curve declines with an increase in the utilization of capital equipment and spreading overhead over a larger number of units. C is incorrect. Companies in fragmented industries would be highly price competitive because they tend to think individualistically making coordination difficult. Introduction to Industry and Company Analysis LOS e, h Sections 5, 5.1.2, 5.1.5
48 2019 Level I Mock Exam (B) PM 87 The following table shows some data on a company before and after unexpected news is announced to the public: Before the After the Announcement Announcement Market value per share $30 $31 Estimated intrinsic value per share $30 $33 Based on the data in the table, the market for this company’s shares is best described as: A relatively inefficient. B semi-strong efficient. C overvalued. A is correct. In an inefficient market, (1) the market value of a stock adjusts slowly to an unexpected news, and (2) there are probably discrepancies between market value and intrinsic value. Given that after the unexpected news, the estimated intrinsic value increases to $33 (from $30) but the market value increases to only $31 (from $30), it is possible to conclude that the market for this company’s shares is relatively inefficient. B is incorrect. In a semi-s trong-f orm efficient market, prices reflect all publicly known and available information. Given that after the unexpected news is announced to the public the stock price did not fully converge to the intrinsic value ($31 vs. $33), it means that the price did not fully reflect all publicly available information. Therefore, the market for this company’s shares is not semi-strong-form efficient. C is incorrect. The company’s shares are undervalued, not overvalued, because after the announcement the market value per share is lower than the estimated intrinsic value per share ($31 < $33). Market Efficiency LOS a, b Sections 2.1, 2.2, 2.3 88 Which of the following is most likely a cross-sectional anomaly in financial markets? A Closed-e nd fund discount B Overreaction effect C Value effect C is correct. The value effect—that is, stocks with below-a verage price-t o-earnings and market-to-b ook ratios and above-a verage dividend yields have consistently outperformed growth stocks over long periods—is a cross-s ectional anomaly. A is incorrect. A closed-end fund discount is an anomaly where a closed-end fund trades at a discount from its net asset value. It is not a cross-s ectional anomaly. B is incorrect. Overreaction effect is a time-series anomaly, not a cross-sectional anomaly. Market Efficiency LOS f Section 4
2019 Level I Mock Exam (B) PM 49 89 An investor opens a margin account with an initial deposit of $5,000. He then purchases 300 shares of a stock at $30 each on margin, and his account requires a maintenance margin of 30%. Ignoring commissions and interest, the price at which the investor will receive a margin call is closest to: A $19.05. B $23.08. C $23.81 A is correct. Equity = 30% Market value 5,000 + (P × 300) − (30 × 300) = 30% P × 300 P = $19.05 B is incorrect. It uses total purchase price of the stock instead of margin loan. (P × 300) − (30 × 300) = 30% P × 300 P = $23.08 C is incorrect. It subtracts the equity instead of the margin loan in the numerator. (P × 300) − 5,000 = 30% P × 300 P = $23.81 Market Organization and Structure LOS f Section 5.2 90 A trader who owns shares of a stock currently trading at $100 per share places a “GTC, stop $90, limit $85 sell” order (GTC means good till cancelled). Assuming the specified stop condition is satisfied and the order becomes exe- cuted, which of the following statements is most accurate? A The order becomes a market order when the price falls below $85 and remains valid for execution. B The trader faces a maximum realized loss of $15. C The order will be executed at either $90 or $85. B is correct. The order becomes valid when the price falls to, or below, $90. The “limit $85 sell” indicates that the trader is unwilling to sell below $85. Thus, the trader faces a maximum loss of $15 ($100 – $85). A is incorrect. The order becomes invalid for execution when the price falls below $85. C is incorrect. The order can be executed at any prices between $85 and $90. Market Organization and Structure LOS h Section 6.2
50 2019 Level I Mock Exam (B) PM 91 A trader describes her currency contract exposure as “long the euro against the British pound.” Which of the following situations best fits her description? She has a: A contract that allowed her to sell British pounds and acquire euros. B forward contract to buy euros in exchange for British pounds at a predeter- mined exchange rate. C forward contract to buy British pounds, using euros she currently holds. B is correct. The trader has a long forward position in the euro, which means she has committed to purchase euros in exchange for British pounds sometime in the future at an exchange rate determined when the contract was initiated. A is incorrect. This is a spot transaction, so there is no contract. C is incorrect. Forward contracts do not require holding one of the currencies; in most cases, one party will be receiving a foreign currency in the future (a payment in a foreign currency for example), and one party wishes to convert that into the domestic currency at that time without worrying about the exchange rate at the time of payment. Market Organization and Structure LOS e Section 5 Currency Exchange Rates LOS a Section 2.1 92 Participating preference shares are least likely to entitle the shareholders to participate in: A additional distribution of the company’s assets upon liquidation. B corporate decisions through voting rights. C additional dividends if the company’s profits exceed a predetermined level. B is correct. Participating preference shares do not entitle the shareholders to participate in corporate decisions through voting rights. But they do entitle them to (1) an additional dividend if the company’s profits exceed a prespecified level and (2) additional distribu- tion of the company’s assets upon liquidation, above the par. A is incorrect. Participating preference shares entitle the shareholders to participate in additional distribution of the company’s assets upon liquidation, above the par. C is incorrect. Participating preference shares entitle the shareholders to participate in additional dividend if the company’s profits exceed a pre-specific level. Overview of Equity Securities LOS b Section 3.2 93 According to the industry life-c ycle model, companies in a mature industry are most likely to experience: A high barriers to entry. B fierce competition. C low dividend yields.
2019 Level I Mock Exam (B) PM 51 A is correct. In the mature stage of the industry life-c ycle model, brand loyalty and effi- cient cost structures will create barriers to entry. Fierce competition is a characteristic of the shakeout phase: Demand approaches market saturation levels because few new customers are left to enter the market. Because few growth opportunities are available in the mature phase, there is little need for capital investment, and thus greater amounts of earnings are paid out as dividends, increasing dividend yields. B is incorrect. Fierce competition is a characteristic of the shakeout phase, not the mature stage. In the mature stage, the remaining companies in the industry aggressively fight for market share. C is incorrect. Dividends increase in the mature stage, as there are little in the way of growth opportunities, and not much need for capital investment—a greater proportion of earnings are paid out as dividends, increasing dividend yields. Introduction to Industry and Company Analysis LOS h Section 5.1.5 94 Zet Bank has entered into a contract with Louly Corporation in which Zet agrees to buy a 2.5% US Treasury bond maturing in 10 years and promises to sell it back next month at an agreed-o n price. From Zet Bank’s perspective, this contract is best described as a: A repo. B collateralized loan. C reverse repo. C is correct. A reverse repo (repurchase agreement) is collateralized cash lending by purchasing an underlying security now and selling it back in the future. A is incorrect because it is the contract known for Louly Corporate as a collateralized borrowing, i.e., repo. B is incorrect because collateralized short-term borrowing involves selling the security and subsequently repurchasing the collateral posted. Fixed-Income Markets: Issuance, Trading, and Funding LOS i Section 7.3 95 Which of the following bonds are most likely to be bearer bonds? A Foreign bonds B Domestic bonds C Eurobonds C is correct. Most Eurobonds are bearer bonds, meaning that the trustee does not keep records of who owns the bonds; only the clearing system knows who the bond owners are. A is incorrect because most domestic bonds are registered bonds. B is incorrect because most foreign bonds are registered bonds for which ownership is recorded by either name or serial number. Fixed-Income Securities: Defining Elements LOS d
52 2019 Level I Mock Exam (B) PM Section 3.2 96 If an issuer is required to retire a specified portion of the bond’s principal each year, the bond most likely: A is callable. B is a step-u p note. C has a sinking fund provision. C is correct. A sinking fund provision requires retirement of a portion of the bond’s principal every year, rather than retirement of the entire issue at maturity. A is incorrect because a bond that is currently callable may be retired by the issuer, but the issuer is not required to do so. B is incorrect because a step-u p note has a coupon rate that increases over time according to a predetermined schedule. Fixed-Income Securities: Defining Elements LOS e Section 4.1 97 The Delfain Corporation reported a significant improvement in profitability that was followed by a material upgrade in its credit rating. The market responded by immediately requiring a 100 basis point narrower spread to Gilts on Delfain’s 8-y ear bond. If the bond’s modified duration is 6.0 and its convexity is 55.0, the return impact of this change is closest to: A 6.28%. B –5.73%. C 7.10%. A is correct. The return impact of a 60 bps fall in the bond’s yield can be computed as: Return impact ≈ –(MDur × ΔSpread) + ½Cvx × (ΔSpread)2 Return impact ≈ –(6.0 × –0.01) + ½(55.0) × (–0.01)2 = 6.28% B is incorrect because the return impact is incorrectly computed as: Return impact ≈ –(6.0 × 0.01) + ½(55.0) × (0.01)2 = –5.73% C is incorrect because the return impact is incorrectly computed as: Return impact ≈ –(6.0 × –0.01) + 2 × (55.0) × (–0.01)2 = 7.10% Fundamentals of Credit Analysis LOS i Section 6 98 An investor who owns a mortgage pass-through security is exposed to exten- sion risk, which is the risk that when interest rates: A fall, the security will effectively have a shorter maturity than was anticipated at the time of purchase. B rise, the security will effectively have a shorter maturity than was anticipated at the time of purchase.
2019 Level I Mock Exam (B) PM 53 C rise, the security will effectively have a longer maturity than was anticipated at the time of purchase. C is correct. Extension risk is the risk faced that when interest rates rise, fewer prepayments will occur because homeowners will be reluctant to give up the benefits of a contractual interest rate that is now lower than the market rate. As a result, the security becomes longer in maturity than anticipated at the time of purchase. A is incorrect because extension risk is the risk faced that when interest rates rise (not fall), fewer prepayments will occur because homeowners are reluctant to give up the benefits of a contractual interest rate that is now lower than the market rate. As a result, the security becomes longer in maturity than anticipated at the time of purchase. B is incorrect because extension risk is the risk faced that when interest rates rise, fewer prepayments will occur because homeowners are reluctant to give up the benefits of a contractual interest rate that is now lower than the market rate. As a result, the security becomes longer (not shorter) in maturity than anticipated at the time of purchase. Introduction to Asset-Backed Securities LOS f Section 5.1.2 99 A synthetic collateralized debt obligation is a CDO backed by a portfolio of: A leveraged bank loans. B residential or commercial mortgage-b acked securities. C credit default swaps. C is correct. Synthetic collateralized debt obligations are CDOs that are backed by a portfolio of credit default swaps. A is incorrect because CDOs backed by a portfolio of leveraged bank loans are col- lateralized loan obligations. B is incorrect because CDOs backed by a portfolio of residential or commercial mortgage-backed securities are structured finance CDOs. Introduction to Asset-B acked Securities LOS i Section 8 100 If the annual market discount rate is 6%, the value of a three-y ear bond that has a 7% coupon rate, has a maturity (par) value of $1,000, and pays interest annu- ally is closest to: A $1,026.73. B $1,049.17. C $973.76. A is correct. $70 + $70 + $1,070 = $66.04 + $62.30 + $898.39 = $1,026.73 1.061 1.062 1.063
54 2019 Level I Mock Exam (B) PM B is incorrect because it doubles the number of payments to 6, as if the bond were making semi-a nnual payments rather than annual. C is incorrect because the coupon rate and discount rate are reversed. Introduction to Fixed-Income Valuation LOS a Section 2.1 101 Which of the following is most likely a limitation of the yield to maturity measure? A It assumes coupon payments can be invested at the yield to maturity. B It does not consider the capital gain or loss the investor will realize by hold- ing the bond to maturity. C It does not reflect the timing of the cash flows. A is correct. Yield to maturity does consider reinvestment income; however, it assumes that the coupon payments can be reinvested at an interest rate equal to the yield to maturity. This is one of the limitations for the yield to maturity measure because the investor is facing reinvestment risk (future interest rates will be less than the yield to maturity at the time the bond is purchased). B is incorrect because the yield to maturity measure considers not only the coupon income but also any capital gain or loss that the investor will realize by holding the bond to maturity. C is incorrect because the yield to maturity measure considers the timing of the cash flows. Introduction to Fixed-Income Valuation LOS b Section 2.2 102 A credit analyst is least likely to use matrix pricing to estimate the required yield and price of a(n): A newly underwritten bond. B actively traded speculative grade bond. C inactively traded investment grade bond. B is correct. Matrix pricing is most suited to pricing inactively traded bonds and newly underwritten bonds. A credit analyst is least likely to use matrix pricing to price an actively traded bond. A is incorrect because matrix pricing is most suited to pricing newly underwritten bonds. C is incorrect because matrix pricing is most suited to pricing inactively traded bonds. Introduction to Fixed-Income Valuation LOS e Section 3.2
2019 Level I Mock Exam (B) PM 55 103 An analyst uses a valuation model to estimate the value of an option-free bond at 92.733 to yield 11%. If the value is 94.474 for a 60 bp decrease in yield and 91.041 for a 60 bp increase in yield, the approximate modified duration of the bond is closest to: A 3.09. B 6.17. C 1.85. A is correct. The approximate modified duration of a bond is (PV−) − (PV+) ApproxModDur = 2 × (∆Yield) × (PV0) where PV_, PV0, and PV+ are the values of the bond when the yield falls, under the current yield, and when the yield rises, respectively, and ΔYield is the size of the yield change. Therefore, 94.474 − 91.041 = 3.09 ApproxModDur = 2 × 0.0060 × 92.733 B is incorrect because it ignores the 2 in the denominator. C is incorrect because it uses ΔYield = 0.01 (1%). Understanding Fixed‑Income Risk and Return LOS e Section 3.2 104 Which of the following most likely exhibits negative convexity? A A callable bond B An option-free bond C A putable bond A is correct. A callable bond exhibits negative convexity at low yield levels and positive convexity at high yield levels. B is incorrect because an option-free bond always exhibits positive convexity. C is incorrect because a putable bond always exhibits positive convexity, higher than an option-free bond. Understanding Fixed-Income Risk and Return LOS h Section 3.6 105 The duration and convexity of an option-free bond priced at $90.25 are 10.34 and 151.60, respectively. If yields increase by 200 bps, the percentage change of the price is closest to: A –17.65%. B –23.71%. C –20.68%.
56 2019 Level I Mock Exam (B) PM A is correct. The percentage change in price is calculated as follows: Duration effect = –10.34 × (0.02) = –20.68% Convexity effect: = 0.5 × 151.60 × (0.02)2 = 3.03% Total percentage change = Duration effect + Convexity effect = –20.68% + 3.03% = –17.65% B is incorrect. It is calculated with negative convexity effect: –20.68% – 3.03% = –23.71%. C is incorrect. It is calculated as the impact for duration effect only: –20.68%. Understanding Fixed-Income Risk and Return LOS i Section 4.1 106 For an option-free, fixed-r ate bond the coupon reinvestment risk would most likely dominate market price risk when the investment horizon is: A greater than the Macaulay duration of the bond. B lower than the Macaulay duration of the bond. C equal to the Macaulay duration of the bond. A is correct. For an option-free, fixed-r ate bond when the investment horizon is greater than the Macaulay duration, the coupon reinvestment risk will tend to dominate market price risk. In such situations, the investor’s risk is to lower interest rates. B is incorrect because for an option-free, fixed-rate bond when the investment horizon is greater than the Macaulay duration, the coupon reinvestment risk will tend to dominate market price risk. C is incorrect because for an option-free, fixed-rate bond when the investment horizon is greater than the Macaulay duration, the coupon reinvestment risk will tend to dominate market price risk. Understanding Fixed-Income Risk and Return LOS k Section 4.2 107 A perfectly hedged position consisting of a derivative and its underlying asset will most likely yield a return that is: A equal to the risk-free rate. B smaller than the risk-free rate. C greater than the risk-free rate. A is correct. If a risk-f ree position earns a return that is different from the risk-free return, arbitrage will lead to the elimination of the mispricing. B is incorrect. If a risk-free position earns a return that is smaller than the risk-free return, arbitrage will lead to the elimination of the mispricing. C is incorrect. If a risk-free position earns a return that is smaller than the risk-free return, arbitrage will lead to the elimination of the mispricing. Basics of Derivative Pricing and Valuation
2019 Level I Mock Exam (B) PM 57 LOS a Section 2.3.2 108 A high convenience yield is most likely associated with holding: A bonds. B equities. C commodities. C is correct. Convenience yield is primarily associated with commodities and generally exists as a result of difficulty in shorting the commodity or unusually tight supplies. A is incorrect. For most financial assets, convenience yield is either nonexistent or extremely limited. B is incorrect. For most financial assets, convenience yield is either nonexistent or extremely limited. Basics of Derivative Pricing and Valuation LOS d Section 2.2.5 109 A swap that involves the exchange of a fixed payment for a floating payment can be interpreted as a series of forward contracts with different expiration dates. These implied forward contracts will most likely have: A different prices due to differences in the price of the underlying at expiration. B identical prices. C different prices due to differences in the cost of carry. C is correct. Due to differences in the cost of carry, implied forward contracts will have different prices. The differences in the cost of carry stem from the timing differences of the payments. A is incorrect. Differences in price are due to differences in the cost of carry. The price of the underlying at expiration is irrelevant for the price. It determines the value of the swap. B is incorrect. The prices will be different due to differences in the cost of carry. Basics of Derivative Pricing and Valuation LOS g Section 3.3 110 Holding other factors constant, the value of a European put option will most likely decrease as the: A risk-free interest rate increases. B volatility of the underlying increases. C value of the underlying decreases.
58 2019 Level I Mock Exam (B) PM A is correct. The value of a European put option will decrease as the risk-free interest rate increases. B is incorrect. The value of a European put option will increase as the volatility of the underlying increases. C is incorrect. The value of a European put option will increase as the value of the underlying decreases. Basics of Derivative Pricing and Valuation LOS k Section 4.1.5 111 In contrast to over-the-c ounter options, futures contracts most likely: A are not exposed to default risk. B represent a right rather than a commitment. C are private, customized transactions. A is correct. Over-the-c ounter options are exposed to default risk, but futures contracts are standardized transactions that take place on futures exchanges and are not exposed to default risk. B is incorrect. Futures contracts are commitments, but options represent a right. C is incorrect. Futures contracts are not private; they are standardized instruments that trade on organized exchanges. Derivative Markets and Instruments LOS a, c Sections 2 and 3 112 Which of these is best classified as a forward commitment? A A convertible bond B A call option C A swap agreement C is correct. A swap agreement is equivalent to a series of forward agreements, which can be described as forward commitments. A is incorrect. A convertible bond does not meet the definition of a forward commitment. B is incorrect. A call option is an example of a contingent claim. Derivative Markets and Instruments LOS b Section 2 113 In efficient financial markets, risk-free arbitrage opportunities: A will not exist. B may persist in the long run. C may exist temporarily.
2019 Level I Mock Exam (B) PM 59 C is correct. In efficient financial markets, risk-free arbitrage opportunities may exist temporarily, but their continuous exploitation will eliminate these arbitrage opportu- nities in the long run. A is incorrect. Financial markets being efficient does not mean that risk-free arbitrage opportunities cannot exist. B is incorrect. In efficient financial markets, any risk-free arbitrage opportunities will exist only temporarily because their continuous exploitation will result in these arbitrage opportunities being eliminated in the long run. Derivative Markets and Instruments LOS e Section 7.2 114 Compared with traditional investments, over longer periods, alternative invest- ments are least likely to have: A better diversifying power. B higher expected returns. C more efficiently priced assets. C is correct. Alternative investment strategies are more likely to include securities that trade in less liquid markets than securities that trade in relatively more liquid markets in which traditional, long-only investments trade. A is incorrect because alternative investments generally have low return correlations with traditional asset markets, providing better diversification benefits. B is incorrect because alternative investments are expected to produce higher returns (particularly on a risk-adjusted basis) than traditional markets, in part because they focus on less efficient markets. Introduction to Alternative Investments LOS a Section 2 115 Categories of alternative investments would least likely be described by which of the following? A Fine wine and other tangibles B Schools and other long-lived real assets C Cash and other liquid investments C is correct. Cash and other short-term liquid investments would not generally be con- sidered alternative investments. Alternative investments fall outside of the definition of long-only publicly traded investments in stocks, bonds, and cash (often referred to as traditional investments). In other words, these investments are alternatives to long-o nly positions in stocks, bonds, and cash. A is incorrect because the category “collectibles” would include tangible assets such as fine wine, art, antique furniture, and automobiles. B is incorrect because the category “infrastructure” would include capital intensive, long-lived, real assets, such as roads, dams, and schools. Introduction to Alternative Investments
60 2019 Level I Mock Exam (B) PM LOS b Section 2.1 116 Based on the historical record, adding alternative investments to a traditional investment portfolio consisting of publicly traded debt and equity will most likely decrease the portfolio’s: A liquidity. B downside risk. C risk-adjusted return. A is correct. Many categories of alternative assets have low liquidity because of the fund structures used (e.g., limited partnerships for hedge funds and private equity) or high transactions costs for underlying assets (e.g., real estate). Alternative assets have gen- erally had high downside risks. However, low correlations with traditional asset classes suggest strong diversifying potential, and high returns result in relatively strong Sharpe ratios (high risk-adjusted returns). B is incorrect because many alternative investments have exhibited high downside risks. C is incorrect because many alternative investments have exhibited strong risk-adjusted returns and low correlations with traditional asset classes. Introduction to Alternative Investments LOS c Section 2 117 Which attribute would a private equity firm most likely desire when deciding if a company is particularly attractive as a leveraged buyout target? A Sustainable cash flow B Efficient management C Market value exceeds intrinsic value A is correct. Private equity firms look for companies that have strong cash flows and a significant amount of physical assets. These physical assets can be used as security and borrowed against. B is incorrect because private equity firms look for companies that are inefficiently managed. The goal is to turn them around and thus perform better. C is incorrect because private equity firms look for companies that have an intrinsic value that exceeds their market value. Introduction to Alternative Investments LOS d Section 4.2.1.2 118 The three main sources of return for commodities futures contracts most likely are: A convenience yield, dividend yield, and spot price return. B collateral yield, roll yield, and spot price return. C collateral yield, convenience yield, and roll yield.
2019 Level I Mock Exam (B) PM 61 B is correct. The three main sources of return for a commodities futures contract are collateral yield, roll yield, and spot price return. A is incorrect because collateral yield and roll yield are missing. Dividend yield is not a source of return for commodities futures investments. C is incorrect because spot price return is missing. A high convenience yield results in a situation where the futures price will be below the spot price. In this case, the price of the futures contract rolls up to the spot price as the expiry date of the contract approaches. Introduction to Alternative Investments LOS e Section 6.4.1 119 In commodity futures market pricing, when the convenience yield is higher than the cost of carry, the roll yield is positive for: A long futures. B short futures. C both long and short futures. A is correct. The futures market is in backwardation when the convenience yield is higher than the cost of carry. The futures price then generally rolls up (moves up along the for- ward curve) to the spot price curve as the expiry date of the futures contract approaches, which results in a positive roll yield for the long positions. B is incorrect because when the futures market is in backwardation, the roll yield for the short futures is negative. C is incorrect because when the futures market is in backwardation, the roll yield for the short futures is negative, not positive. Introduction to Alternative Investments LOS f Section 6.4.1 120 A measure that is most likely well suited to analyzing the performance of alter- native investments that may exhibit negative skewness in returns is the: A Sortino ratio. B Sharpe ratio. C safety-first measure. A is correct. The Sharpe ratio and the safety-first measure use standard deviation as the measure of risk, which ignores the negative skewness in returns. The Sortino ratio uses the downside deviation as the measure of risk, which will reflect negative skewness if present. B is incorrect because the Sharpe ratio does not reflect negative skewness if present. C is incorrect because the safety-first measure does not reflect negative skewness if present. Introduction to Alternative Investments LOS g Section 9.2
1 2019 Level I Mock Exam (C) AM The morning session of the 2019 Level I Chartered Financial Analyst® Mock Examination has 120 questions. To best simulate the exam day experience, candidates are advised to allocate an average of one and a half minutes per question for a total of 180 minutes (3 hours) for this session of the exam. Questions Topic Minutes 1–19 Ethical and Professional Standards 28.5 20–31 Quantitative Methods 18 32–43 Economics 18 44–61 Financial Reporting and Analysis 27 62–73 Corporate Finance 18 74–80 Portfolio Management 10.5 81–93 Equity 19.5 94–106 Fixed Income 19.5 107–113 Derivatives 10.5 114–120 Alternative Investments 10.5 Total: 180 By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently registered CFA candidates. Candidates may view and print the exam for personal exam prepara- tion only. The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-r egistered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose © 2019 CFA Institute. All rights reserved.
2 2019 Level I Mock Exam (C) AM 2019 LEVEL I MOCK EXAM (C) AM 1 Which of the following statements is most likely consistent with the CFA Institute Code of Ethics? CFA Institute members and CFA candidates must: A promote the integrity of and uphold the rules governing capital markets. B practice the highest level of personal and professional integrity and always act in the best interest of their employers. C maintain their professional competence and require investment profession- als under their supervision to adopt the CFA Code of Ethics. A is correct because the Code of Ethics requires CFA members and candidates to pro- mote the integrity of and uphold rules governing capital markets. While the Code of Ethics requires members and candidates to act with integrity, and the interests of the client are paramount, not all requests of clients are appropriate to follow, particularly if considered unethical or illegal. The Code of Ethics does not require members and candidates to encourage others to pursue the CFA designation, but to improve their professional competence. B is incorrect because there are times when acting in the best interests of an employer may conflict with the Code and Standards or in the best interests of clients C is incorrect because there is no such requirement for supervisors. Code of Ethics and Standards of Professional Conduct LOS b 2 Tibor Figeczky, CFA, is an equity trader at Global Investment Bank (GB). Figeczky traded the bank’s investment portfolio profitably for the past three years and earned significant bonuses for his efforts. Subsequently, internal auditors of GB formally accused Figeczky of exceeding his trading authority and engaging in unauthorized trades. According to the CFA Institute Code of Ethics and Standards of Professional Conduct, Figeczky should most likely: A disclose the complaint to CFA Institute. B refuse further bonuses until the issue is resolved. C request a temporary suspension of his CFA Institute membership. A is correct as members and candidates must self-disclose on the annual Professional Conduct Statement all matters that question their professional conduct, such as involve- ment in civil litigation or a criminal investigation or being the subject of a written complaint. B is incorrect as the Code and Standards do not prohibit a member from accepting a bonus while an investigation into his professional behavior is conducted. In this case, the member’s actions have been questioned but he has not yet had an opportunity to defend his behavior and may in fact have acted within his authority and earned the compensation fairly. C is incorrect as the Code does not require a member to request a suspension of their membership while a complaint is being investigated. Code of Ethics and Standards of Professional Conduct LOS c
2019 Level I Mock Exam (C) AM 3 3 Amanda Covington, CFA, works for McJan Investment Management. McJan employees must receive prior clearance of their personal investments in accor- dance with McJan’s compliance procedures. To obtain prior clearance, McJan employees must provide a written request identifying the security, the quantity of the security to be purchased, and the name of the broker through which the transaction will be made. Pre-c leared transactions are approved only for that trading day. As indicated below, Covington received prior clearance. Security Quantity Broker Prior Clearance A 100 Easy Trade Yes B 150 Easy Trade Yes Two days after she received prior clearance, the price of Stock B had decreased, so Covington decided to purchase 250 shares of Stock B only. In her decision to purchase 250 shares of Stock B only, did Covington violate any CFA Institute Standards of Professional Conduct? A No. B Yes, relating to diligence and reasonable basis. C Yes, relating to her employer’s compliance procedures. C is correct because prior clearance processes guard against potential and actual conflicts of interest; members are required to abide by their employer’s compliance procedures [Standard VI(B)]. A is incorrect because Covington did violate the Standards in that she did not follow her employer’s compliance procedures [Standard VI(B)]. B is incorrect as there is nothing to indicate she violated Standard V(A)–Diligence and Reasonable Basis. Guidance for Standards I–VII LOS a Standard V(A)–Diligence and Reasonable Basis, Standard VI(B)–Priority of Transactions 4 Kazuya Kato, CFA, is a widely followed economist at a global investment bank. When Kato opines on economic trends, markets react by moving stock valua- tions considerably. When Kato receives information of a temporary oversupply of rare earth metals, he issues a forecast that price trends for rare earth met- als will be down significantly on a long-term basis. Kato also secretly sells his report to a widely followed Internet site. Prior to issuing this forecast, Kato emailed all portfolio managers at his bank with a copy of his report indicating that his opinion would be reversed shortly so there will be trading opportu- nities. Kato most likely violated which of the following CFA Institute Code of Ethics and Standards of Professional Conduct? A Market Manipulation. B Priority of Transactions. C Additional Compensation Arrangements.
4 2019 Level I Mock Exam (C) AM B is correct because Kato exaggerated the potential for negative price movement with rare earth metals and violated Standard II(B)–Market Manipulation by aiming to profit on the volatility created by his actions. Standard II(B) requires that members and candi- dates uphold market integrity by prohibiting market manipulation. Market manipulation includes the dissemination of false or misleading information and transactions that deceive or would be likely to mislead market participants by distorting the price-setting mech- anism of financial instruments. Standard IV(B)–Additional Compensation Arrangements was violated when he sold his report to the internet site. Standard VI(B)–Priority of Transactions has not been violated as it relates to investment transactions for clients and employers having priority over Member or Candidate transactions. A is incorrect because Kato exaggerated the potential for negative price movement with rare earth metals and violated Standard II(B)–Market Manipulation by aiming to profit on the volatility created by his actions. Standard II(B) requires that members and candidates uphold market integrity by prohibiting market manipulation. Market manipu- lation includes the dissemination of false or misleading information and transactions that deceive or would be likely to mislead market participants by distorting the price-s etting mechanism of financial instruments. C is incorrect because Standard IV(B)–Additional Compensation Arrangements was violated when he sold his report to the internet site. Guidance for Standards I–VII LOS a Standard II(B)–Market Manipulation, Standard IV(B)–Additional Compensation Arrangements, Standard VI(B)–Priority of Transactions 5 Mailaka Securities (MS) advertises the use of a “bottom up” investment style in its marketing material. Recently, MS senior management decided to switch to a “top down” approach, citing the fact that it is less labor intensive. All other aspects of the research process are to remain the same. The head of research at MS, Mara Cherogony, CFA, is instructed to supervise the implementation of the new procedures, notify clients of the changes, and revise the text of mar- keting materials when new material is produced. Which of the following CFA Standards pertaining to Investment Analysis, Recommendations, and Actions is Cherogony least likely in danger of violating? A Supervisory Responsibility B Communication with Clients C Diligence and Reasonable Basis C is correct because research can still be considered diligent and having a reasonable basis if done using a “top down” research methodology as opposed to a “bottom up” methodology. By not communicating to prospective clients the change in the invest- ment process through the delay in the creation of new marketing material, however, Cherogony violates Standard V(B)–Communication with Clients, which requires mem- bers and candidates to disclose to clients and prospective clients the basic format and general principles of the investment processes they use to analyze investments, select securities, and construct portfolios and must promptly disclose any changes that might materially affect those processes. As a supervisor, Cherogony is responsible for ensuring compliance with the Code and Standards. A is incorrect because by delaying the change in the marketing material until the inventory is depleted, there is a possibility that the new investment process policy will not be clearly communicated to prospective clients. As a supervisor, Cherogony is responsible to ensure the compliance with the Code and Standards.
2019 Level I Mock Exam (C) AM 5 B is incorrect because Cherogony violates Standard V, which requires members and candidates to disclose to clients and prospective clients the basic format and general principles of the investment processes they use to analyze investments, select securities, and construct portfolios and must promptly disclose any changes that might materi- ally affect those processes. By delaying the change in the marketing material until the inventory is depleted, there is a possibility that the new investment process policy will not be clearly communicated to prospective clients. Guidance for Standards I–VII LOS a Standard IV(C)–Responsibility of Supervisors, Standard V(A)–Diligence and Reasonable Basis, Standard V(B)–Communication with Clients and Prospective Clients 6 While at a bar in the financial district after work, Ellen Miffitt, CFA, overhears several employees of a competitor discuss how they will manipulate down the price of a thinly traded micro cap stock’s price over the next few days. Miffitt’s clients have large positions of this stock so when she arrives at work the next day she immediately sells all of these holdings. Because she had determined the micro cap stock was suitable for all of her accounts at its previously higher price, Miffitt buys back her client's original exposure at the end of the week at the new, lower price. Which CFA Institute Standards of Professional Conduct did Miffitt least likely violate? A Market Manipulation B Preservation of Confidentiality C Material Nonpublic Information B is correct as Miffitt has not violated the confidentiality standard that involves informa- tion about former, current, and prospective clients. A is incorrect because even though she did not initiate the market manipulation, Miffitt added to the stock’s price movement when she sold into a declining market particularly with thinly traded stocks which can be easily influenced by changes in the volume of activity. By repurchasing the shares for her clients she is seeking to take advantage of the manipulation and is in violation of Standard II(B). C is incorrect as she has attempted to benefit her clients by trading on information that could affect the value of the micro cap stock and as such would be classified as material nonpublic information. Information that is known regarding orders for large trades before they are executed is considered material nonpublic information. Guidance for Standards I–VII LOS b Standard II(A)–Material Nonpublic Information, Standard II(B)–Market Manipulation, Standard III(E)–Preservation of Confidentiality 7 Sergio Morales, CFA, believes he has found evidence that his supervisor is engaged in fraudulent activity involving a client’s account. When Morales confronts his supervisor, he is told the client is fully aware of the issue. Later that day, Morales contacts the client and upon disclosing the fraudulent activity, is told by the client to mind his own business. Following the requirements of local law, Morales provides all of his evidence, along with copies of the client’s most recent account statements, to a government whistle blower program. Has Morales most likely violated the CFA Institute Standards of Professional Conduct?
6 2019 Level I Mock Exam (C) AM A No. B Yes, concerning Duties to Employers. C Yes, concerning Preservation of Confidentiality. A is correct because Morales believes his supervisor and potentially the client are engaged in fraudulent activity and by following the requirements of local law, through their whis- tleblower program, he has not violated Standard III(E)–Preservation of Confidentiality or Standard (V)–Duties to Employers. B is incorrect because Morales has not violated Standard (V)–Duties to Employers. C is incorrect because Morales believes that his supervisor and potentially the cli- ent are engaged in fraudulent activity and by following the requirements of local law, through their whistleblower program, he has not violated Standard III(E)–Preservation of Confidentiality. Guidance for Standards I–VII LOS b Standard III(E)–Preservation of Confidentiality, Standard IV–Duties to Employers 8 Leng Bo, CFA, is a bond portfolio manager for individual investors. Last year, a client whose portfolio is limited to investment-g rade bonds approved Bo’s purchase of a below investment grade bond. Because yields in the high grade fixed-income markets declined, Bo subsequently decides to enhance this client’s portfolio by investing in several additional bonds with ratings one or two notches below investment grade. The investment strategy implemented by Bo most likely violated which of the following CFA Institute Standards of Professional Conduct? A Suitability B Communications with Clients C Independence and Objectivity A is correct because the client only approved the purchase of one below investment grade bond while the portfolio manager has purchased several additional bonds below investment grade without client approval in violation of Standard III(C). B is incorrect because no violation of this Standard has occurred. C is incorrect because no violation of this Standard has occurred. Guidance for Standards I–VII LOS b Standard I(B)–Independence and Objectivity, III(C)–Suitability, Standard V(B)– Communication with Clients and Prospective Clients 9 Stian Klun, CFA, is preparing a brochure to advertise his firm. The brochure includes the following disclosures: “I am a CFA so I am a member of the CFA Institute, which consti- tutes the most elite group of professionals within the investment management business. In order to become a CFA charterholder, I had to complete a comprehensive program of study in the investment management field.”
2019 Level I Mock Exam (C) AM 7 Klun is least likely to have violated the CFA Institute Standards of Professional Conduct related to referencing the: A CFA Institute. B CFA Program. C CFA Designation. B is correct as the CFA Program has been properly referenced while the CFA Institute and CFA Designation have been improperly referenced in violation of Standard VII(B)– Reference to the CFA Institute, the CFA Designation, and the CFA Program. CFA Institute cannot be referred to as the most elite group of professionals within the investment management business as this is an opinion that cannot be objectively determined. The CFA acronym should be used an adjective rather than a noun, i.e. CFA Charterholder. A is incorrect as individuals must not exaggerate the meaning or implications of membership in CFA Institute. C is incorrect because Klum has indicated that he is a CFA and improperly referenced the designation. Guidance for Standards I–VII LOS b Standard VII(B)–Reference to CFA Institute, the CFA Designation, and the CFA Program 10 Alexandra Zagoreos, CFA, is the head of a government pension plan. Whenever Zagoreos hires a money management firm to work with the pension plan, she finalizes the deal over dinner at a nice restaurant. At these meals, Zagoreos also arranges for the money manager to provide her payments equal to 10% of the management fee the manager receives from the pension plan with no formal documentation of this agreement. Zagoreos keeps half of the payments for her own use and distributes the remainder as cash incentives to a handful of her most trusted staff. Zagoreos least likely violated which of the following CFA Institute Code of Ethics and Standards of Professional Conduct? A Referral fees. B Loyalty, Prudence and Care. C Additional Compensation Arrangements. A is correct as the money should not be accepted without receiving written consent from all parties involved; therefore, Zagoreos is in violation of Standard IV(B)–Additional Compensation Arrangements. The manager has acted for her own benefit by receiving compensation that competes with or might reasonably be expected to create a conflict of interest with her employer’s interest without receiving written consent from all par- ties involved. This action is a violation of Standard III(A)–Loyalty, Prudence, and Care, which requires that members act for the benefit of their clients, and places their client’s interests before their employer’s or their own interests. However, there is no indication that the member has received compensation, consideration, or benefit received from, or paid to, others for the recommendation of products or services and therefore has not violated Standard VI(C) related to referral fees. B is incorrect because the manager has acted for their own benefit by receiving com- pensation that competes with or might reasonably be expected to create a conflict of interest with her employer’s interest without receiving written consent from all parties
8 2019 Level I Mock Exam (C) AM involved. This action is a violation of Standard III(A)–Loyalty, Prudence, and Care, which requires that members act for the benefit of their clients, and places their client’s interests before their employer’s or their own interests. C is incorrect as the manager has accepted compensation that competes with or might reasonably be expected to create a conflict of interest with her employer’s interest without receiving written consent from all parties involved, in violation of Standard IV(B)– Additional Compensation Arrangements. Guidance for Standards I–VII LOS b Standard III(A)–Loyalty, Prudence, and Care, Standard IV(B)–Additional Compensation Arrangements, Standard VI(C)–Referral Fees 11 Florence Zuelekha, CFA, is an equity portfolio manager at Grid Equity Management (GEM), a firm specializing in commodities. Zuelekha, who previ- ously focused on alternative energy, recently attends her first commodity con- ference, sponsored in large part by GEM. Independent industry experts argued that commodities would increase in value and recommended that investors hold at least 10% of their portfolio assets in commodities based on consistent increases in their values over the previous two years. Without doing any addi- tional research, Zuelekha recommends to all her clients an immediate allocation of 5% of their portfolio into commodities. Over the next few weeks, Zuelekha moves her own portfolio to a 10% commodity allocation. Which of the CFA Standards did Zuelekha most likely violate? A Priority of Transactions. B Independence and Objectivity. C Diligence and a Reasonable Basis. C is correct, as Standard (V)–Diligence and a Reasonable Basis requires members and candidates to have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment analysis, recommendation, or action. Relying solely upon attendance at a one-day conference listening to industry experts to make an investment recommendation, especially when the industry experts have based their recommendations upon price data only, would not meet the requirements of the Code and Standards with regard to Diligence and a Reasonable Basis. A is incorrect because there has not been a violation of this standard. B is incorrect, as even though the portfolio manager has allocated a portion of her portfolio to an asset class she recommended for clients there has not been a violation of this Standard since the manager has not front run any of her clients. Guidance for Standards I–VII LOS b Standard V(A)–Diligence and a Reasonable Basis 12 Charles Mbuwanga, a Level 3 CFA Candidate, is the Business Development Manager for Sokoza Investment Group, an investment management firm with high-n et-worth retail clients throughout Africa. Sokoza introduced listed Kenyan Real Estate Investment Trusts (REITs) to its line of investment products based on new regulations introduced in Kenya so as to diversify its product offering to clients. The product introduction comes after months of researching Kenyan property correlations with other property markets and asset classes in Africa. Sokoza assigns Mbuwanga as part of the sales team in introducing this product to its clients across Africa. Mbuwanga subsequently determines that
2019 Level I Mock Exam (C) AM 9 most of Sokoza’s clients’ portfolios would benefit from having a small Kenyan property exposure to help diversify their investment portfolios. By promoting the Kenyan REITS for Sokoza’s client portfolios as planned, Mbuwanga would least likely violate which of the following Standards? A Suitability B Knowledge of the Law C Independence and Objectivity C is correct because there is no indication Mbuwanga’s recommendation is based on any compensation package based on sales targets as being part of the sales team. If he had a sales target as part of his responsibility to promote the new product, it could be conceived his independence and objectively was in question. Mbuwanga does however seem to be in violation of Standard III(C)–Suitability in that while research with regard to correlation was undertaken, an analysis based on each individual client’s return and risk objectives was not done. He may also be in violation of Standard I(A)–Knowledge of Law in that he would need to determine if the Kenyan REIT product is allowable in each of the countries where his clients reside. A is incorrect because while research with regard to correlation was undertaken, an analysis based on each individual clients’ return and risk objectives was not done. B is incorrect as the new REIT products are being recommended to all clients based on new regulations introduced in Kenya. Mbuwanga may be in violation of Standard I(A)– Knowledge of the Law depending on the rules and regulations in each of the African countries where his clients reside if those regulations do not allow investments outside of the country and/or in this investment type. Guidance for Standards I–VII LOS c 13 When Abdullah Younis, CFA, was hired as a portfolio manager at an asset management firm two years ago and was told he could allocate his work hours as he saw fit. At that time, Younis served on the board of three nonpublic golf equipment companies and managed a pooled investment fund for several members of his immediate family. Younis was not compensated for his board service or for managing the pooled fund. Younis’ investment returns attract interest from friends and co-workers who persuade him to include their assets in his investment pool. Younis recently retired from all board responsibilities and now spends more than 80% of his time managing the investment pool for which he charges non-family members a management fee. Younis has never told his employer about any of these activities. To comply with the CFA Institute Standards of Professional Conduct with regards to his business activities over the past two years, Younis would least likely be required to disclose which of the following to his employer? A Board activities B Family investment pool management C Non-family member management fees A is correct because golf equipment is a business independent of the financial services industry such that any board obligations would not likely be considered a conflict of interest requiring disclosure according to Standard IV(B)–Additional Compensation
10 2019 Level I Mock Exam (C) AM Arrangements. Standard IV(B) requires members and candidates to obtain permission from their employer before accepting compensation or other benefits from third parties for the services that might create a conflict with their employer’s interests. Managing investments for family and non-family members could likely create a conflict of interest for Younis’ employer and should be disclosed to his employer. B is incorrect, as Younis should have made full and fair disclosure of all matters that could reasonably be expected to impair his independence and objectivity or interfere with his respective duties to his clients, prospective clients, and employer as required by Standard VI(A)–Disclosure of Conflicts. Since the majority of his time is now spent on fund management, in potential competition with his employer, he would need to disclose this. Disclosure of the outside work should also have been made at the time of employment so that his employer was fully aware of these activities and could make their own judgment on whether or not these activities impaired the broker’s ability to complete his responsibilities at the financial services organization. C is incorrect, as Younis should have made full and fair disclosure of all matters that could reasonably be expected to impair his independence and objectivity or interfere with his respective duties to his clients, prospective clients, and employer as required by Standard VI(A)–Disclosure of Conflicts. Since the majority of his time is now spent on fund management, in potential competition with his employer, he would need to disclose this. Disclosure of the outside work should also have been made at the time of employment so that his employer was fully aware of these activities and could make their own judgment on whether or not these activities impaired the broker’s ability to complete his responsibilities at the financial services organization. Guidance for Standards I–VII LOS c 14 Hezi Cohen, a CFA candidate, is a heavy user of social networking sites on the Internet. His favorite site only allows a limited number of characters for each entry so he has learned to abbreviate everything, including CFA trademarks. Cohen also enjoys professional networking sites and contributes regularly to blogs that discuss the broad topical areas covered within the CFA Program. In addition, he posts to these blogs pieces he has written in his area of expertise: retirement planning. By claiming to be an expert on retirement planning, he believes his stature within the investment community increases and he can gain more clients. Which internet activity can Cohen most likely continue to be in compliance with the CFA Standards of Professional Conduct? A Use of abbreviations. B Claiming retirement planning expertise. C Blogging about broad topical areas within the CFA Program. B is correct because the Standards do not prevent a person from claiming to be an expert in their area of specialty as long it is not a misrepresentation and/or an exaggeration of their skill and expertise. A is incorrect because according to Standard VII, CFA Institute trademarks are not allowed to be abbreviated. C is incorrect because Standard VII–Responsibilities as a CFA Institute Member or CFA Candidate restricts the disclosing of all aspects of the CFA exam, including broad topical areas. These are considered confidential and thus should not be discussed over the Internet. Guidance for Standards I–VII LOS c Standard VII–Responsibilities as a CFA Institute Member or CFA Candidate
2019 Level I Mock Exam (C) AM 11 15 Jacques Lagarde, CFA, is a sell-side analyst at Springhill Financial, a small investment bank. Springhill is the lead manager for the equity offering of Chorale Music. Lagarde is not part of the IPO team for this offering. While finalizing a research report on Chorale, Lagarde discovers inconsistencies that makes him believe the company may have concealed losses in its leasing divi- sion last quarter that would significantly reduce its earnings. Lagarde suspects that Springhill’s investment banking team are aware of these unreported losses. The prospectus for Chorale’s equity offering has already been approved by regulators and distributed to potential investors. According to the CFA Institute Code of Ethics and Standards of Professional Conduct, Lagarde should most likely: A report the issue to his supervisor. B issue a report showing the leasing division losses. C issue the report using data as reported in the prospectus. A is correct because Lagarde has potentially uncovered material omissions that would impact Chorale’s IPO, and the most appropriate first step would be to report this issue to his supervisor. This issue should be investigated more fully. If the losses are confirmed, Lagarde should insist that these losses be made public. B is incorrect because given the sensitive (and potentially criminal) nature involving a company concealing losses from an earnings report, it would be inappropriate for Lagarde to issue a report showing the losses when his opinion may not be correct. C is incorrect because it would be inappropriate for Lagarde to issue a report using the data from the prospectus when he has reason to believe this information is factually inaccurate. Guidance for Standards I–VII LOS c Standard I(A)–Knowledge of the Law, Standard II(A)–Material Nonpublic Information 16 For firms to claim compliance with the GIPS standards they most likely must: A take responsibility for their claim of compliance and maintaining that compliance. B hire an independent third party to test a sample of their composites. C increase the consistency and quality of the firm’s compliant presentations. A is correct. Firms claiming compliance with the GIPS standards are responsible for their claim of compliance and for maintaining that compliance. That is, firms self-regulate their claim of compliance. B is incorrect because verification is performed to test the process with respect to an entire firm, not on specific composites or a sample of composites. C is incorrect, verification not the firm, may increase the knowledge of the firm’s performance measurement team and improve the consistency and quality of the firm’s compliant presentations. Introduction to the Global Investment Performance Standards (GIPS) LOS c
12 2019 Level I Mock Exam (C) AM 17 When claiming GIPS compliance, a firm will least likely have to apply all of the required provisions in the first five major sections of the GIPS standards when investing in: A separately managed accounts. B equity mutual funds or unit trusts. C commodity related portfolios. A is correct. Certain provisions of Sections 0–5 do not apply to real estate investments, private equity investments and/or separately managed accounts. Private equity, real estate, and separately managed accounts have their own sections within the GIPS stan- dards specific to each respective asset class (Sections 6–8). B is incorrect because mutual funds or unit trusts would be subject to the provisions in Sections 0–5. C is incorrect because commodity funds would be subject to the provisions in Sections 0–5. The GIPS Standards LOS d 18 Which of the following best outlines the minimally acceptable behaviors expected of a member belonging to a societal group? A Standards of conduct B Code of ethics C A firm’s employee handbook A is correct. Standards of conduct outline the minimally acceptable behaviors expected of a member of a societal group. The code of ethics serves as a general guide for how community members should act. B is incorrect. A code of ethics does not outline the minimally acceptable behaviors expected of its societal members, it serves as a general guide for how community of members should act. C is incorrect. A firm’s employee handbook does not outline the minimally acceptable behaviors expected of its societal members, it outlines the expected behavior of the firm’s employees. Ethics and Trust in the Investment Profession LOS a Section 2 19 Most societies would least likely consider ethical principles to include: A justice. B duplicity. C diligence.
2019 Level I Mock Exam (C) AM 13 B is correct. Most societies acknowledge the ethical principles of honesty, fairness or justice, diligence, and respect for the rights of others. Duplicity or deception would be in violation of most ethical principles. A is incorrect. Justice is often considered an ethical principle in most societies. C is incorrect. Diligence is often considered an ethical principle in most societies. Ethics and Trust in the Investment Profession LOS a Section 2 20 The following is an excerpt from the cumulative distribution function for the standard normal random variable table: Cumulative Probabilities for a Standard Normal Distribution P(Z ≤ x) = N(x) for x ≥ 0 or P(Z ≤ z) = N(z) for z ≥ 0 x 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 or z 0 0.10 0.5398 0.5438 0.5478 0.5517 0.5557 0.5596 0.5636 0.5675 0.5714 0.5753 0.20 0.5793 0.5832 0.5871 0.5910 0.5948 0.5987 0.6026 0.6064 0.6103 0.6141 0.30 0.6179 0.6217 0.6255 0.6293 0.6331 0.6368 0.6406 0.6443 0.6480 0.6517 0.40 0.6554 0.6591 0.6628 0.6664 0.6700 0.6736 0.6772 0.6808 0.6844 0.6879 … 1.10 0.8643 0.8665 0.8686 0.8708 0.8729 0.8749 0.8770 0.8790 0.8810 0.883 1.20 0.8849 0.8869 0.8888 0.8907 0.8925 0.8944 0.8962 0.8980 0.8997 0.9015 1.30 0.9032 0.9049 0.9066 0.9082 0.9099 0.9115 0.9131 0.9147 0.9162 0.9177 1.40 0.9192 0.9207 0.9222 0.9236 0.9251 0.9265 0.9279 0.9292 0.9306 0.9319 … 1.80 0.9641 0.9649 0.9656 0.9664 0.9671 0.9678 0.9686 0.9693 0.9699 0.9706 1.90 0.9713 0.9719 0.9726 0.9732 0.9738 0.9744 0.9750 0.9756 0.9761 0.9767 2.00 0.9772 0.9778 0.9783 0.9788 0.9793 0.9798 0.9803 0.9808 0.9812 0.9817 2.10 0.9821 0.9826 0.9830 0.9834 0.9838 0.9842 0.9846 0.9850 0.9854 0.9857 A variable is normally distributed with a mean of 2.00 and a variance of 16.00. Using the excerpt, the probability of observing a value of 7.40 or less is closest to: A 63.3%. B 91.2%. C 96.8%. B is correct. First the outcome of interest, 7.40, is standardized for the given normal distribution: Z = (X − µ σ) = (7.40 − 2.00) 16 = 1.35 Then, the given table of values is used to find the probability of a Z-value being less than or equal to 1.35 standard deviations above the mean. The value is P(Z ≤ 1.35) = 0.9115 = 91.2%.
14 2019 Level I Mock Exam (C) AM A is incorrect; it divides 5.4 (that is the result of 7.4 – 2) by the variance, 16, and uses 0.34 as the z-value: P(Z≤0.34) = 0.6331 = 63.3%. C is incorrect; it divides the value, 7.4, by the standard deviation, 4, and uses 1.85 as the Z-value: P(Z ≤ 1.85) = 0.9678 = 96.8%. Common Probability Distributions LOS c, d, k, l Section 3.2 21 Which of the following most accurately describes how to standardize a random variable X? A Subtract the mean of X from X, and then divide that result by the standard deviation of the standard normal distribution. B Divide X by the difference between the standard deviation of X and the stan- dard deviation of the standard normal distribution. C Subtract the mean of X from X, and then divide that result by the standard deviation of X. C is correct. There are two steps in standardizing a random variable X: Subtract the mean of X from X, and then divide that result by the standard deviation of X. This is represented by the following formula: Z = (X – μ)/σ. A is incorrect. There are two steps in standardizing a random variable X: Subtract the mean of X from X, and then divide that result by the standard deviation of X. This is represented by the following formula: Z = (X – μ)/σ. B is incorrect. There are two steps in standardizing a random variable X: Subtract the mean of X from X, and then divide that result by the standard deviation of X. This is represented by the following formula: Z = (X – μ)/σ. Common Probability Distributions LOS l Section 3.2 22 The time-weighted rate of return: A results in a lower return when compared with the money-w eighted rate of return. B is affected by the amount and timing of cash flows to and from a portfolio. C calculates multi-p eriod cash flows mirroring a portfolio’s compound growth rate. C is correct. Time-w eighted rate of return reflects the compound rate of growth of one unit of currency invested over a stated measurement period, and it removes the effects of timing and amount of withdrawals and additions to the portfolio. A is incorrect. Time-w eighted rate of return can be the same, higher, or lower than money-weighted rate of return. B is incorrect because this is in fact the explanation for money-weighted return. Discounted Cash Flow Applications LOS d Section 3.2
2019 Level I Mock Exam (C) AM 15 23 Given a discount rate of 10%, the net present value (NPV) of the following investment is closest to: Time 012345 6 Cash flow –1,500 300 600 1,000 200 500 300 A 605. B 578. C 636. C is correct. The given cash flows are inserted into a financial calculator along with the 10% discount rate: CF0 = –1,500, CF1 = 300, CF2 = 600, CF3 = 1,000, CF4 = 200, CF5 = 500, CF6 = 300, I = 10. Computing NPV the result is 636.32 ~ 636. Alternatively, the net present value of the project is found by discounting each cash flow by the time at which it arises, at the appropriate discount rate, as follows: −1500 + 300 + 600 + 1000 + 200 + 500 + 300 NPV = (1.10)0 (1.10)1 (1.10)2 (1.10)3 (1.10)4 (1.10)5 (1.10)6 = 636.32 ~ 636 B is incorrect; 578 occurs when the cash flows are discounted by one period too many (i.e., Year 0 is discounted as if it were Year 1, Year 1 is discounted as if it were Year 2, etc.): CF1 = –1,500, CF2 = 300, CF3 = 600, CF4 = 1,000, CF5 = 200, CF6 = 500, CF7 = 300, I = 10. Computing NPV the result is 578. A is incorrect; the mistake is to use the average cash flow across the six years (483.33). Using a financial calculator: PMT = –483.33, N = 6, I/Y = 10, FV = 0. Computing PV (PV = 2,105.03) and subtracting 1,500: 2,105.03 – 1500 = 605.03 ~ 605. Discounted Cash Flow Applications LOS a Section 2.1 Capital Budgeting LOS d Section 4.1 24 A parametric test is most likely preferred to a non-parametric test when: A the data are given in ratio or ordinal scale. B defined sets of assumptions are given. C the population is heavily skewed. B is correct. A parametric test is more appropriate than a non-p arametric one when an analyst is concerned with parameters whose validity depends on a definite set of assumptions—for example, assumptions about the distribution of the population pro- ducing the sample. A is incorrect. A nonparametric test is suitable for this case. C is incorrect. A nonparametric test is also suitable for this. Hypothesis Testing LOS k Section 5
16 2019 Level I Mock Exam (C) AM 25 The conditional expected value of a random variable is best described as the: A expected value of a random variable given an event or scenario. B probability-w eighted average of the possible outcomes of the random variable. C weighted average of the probabilities of an event given all possible scenarios. A is correct. The conditional expected value of a random variable is the expected value of a random variable given an event or scenario. B is incorrect because an expected value (not a conditional expected value) is defined as the probability-weighted average of the possible outcomes of the random variable. C is incorrect because an expected value is not a probability. This answer defines the total probability rule, which is the weighted average of the probabilities of an event given all possible scenarios. Probability Concepts LOS i Section 8.2 26 The variance of returns of Asset A is 625. The variance of returns of Asset B is 1,225. The covariance of returns between Asset A and Asset B is 600. The cor- relation of returns between Asset A and Asset B is closest to: A 0.29. B 0.69. C 0.47. B is correct. Correlation of returns between asset i and j, ρ(Ri,Rj), is defined as: ρ(Ri,Rj) = Cov(Ri,Rj)/σ(Ri)σ(Rj)where Ri and Rj = the returns of assets i and j Cov(Ri,Rj) = the covariance of returns between assets i and j σ(Ri) and σ(Rj) = the standard deviations of returns of assets i and j ( )In this problem, the correlation is 600 625 × 1,225 = 0.6857 ~ 0.69. ( )A is incorrect. The mistake is an incorrect order of operations as in 600 625 × 1,255 = 840, then the square root of 840 is taken: 840 = 28.98. The result is divided by 100: 28.98/100 = 0.2898 ~ 0.29. C is incorrect. It is calculated as follows: 6002/(625 × 1,225) = 0.47. Probability Concepts LOS k Section 3 27 Survivorship bias is most likely an example of which bias? A Sample selection B Data mining C Look-ahead
2019 Level I Mock Exam (C) AM 17 A is correct. Sample selection bias often results when a lack of data availability leads to certain data being excluded from the analysis. Survivorship bias is an example of sample selection bias. B is incorrect. Data mining bias relates to the overuse of the same or related data, i.e., searching for pattern. And survivorship bias is not an example of data mining bias. C is incorrect. Look-a head bias exists if the model uses data not available to the analyst at the time the analyst act on the model. Survivorship bias is not an example of look-ahead bias. Sampling and Estimation LOS k Section 5.2 28 A sample of 438 observations is randomly selected from a population. The mean of the sample is 382, and the standard deviation is 14. Based on Chebyshev’s inequality, the endpoints of the interval that must contain at least 88.89% of the observations are closest to: A 340 and 424. B 396 and 480. C 354 and 410. A is correct. According to Chebyshev’s inequality, the proportion of the observations within k standard deviations of the arithmetic mean is at least 1 – 1/k2 for all k >1. For k = 3, that proportion is 1 – 1/32, which is 88.89%. The lower endpoint is, therefore, the mean (382) minus 3 times 14 (the standard deviation), and the upper endpoint is 382 plus 3 times 14 (i.e., 340 and 424, respectively). C is incorrect; it is based on 2 standard deviations, not 3: 382 – 2 × 14 = 354 and 382 + 2 × 14 = 410. B is incorrect; it centers the interval around the number of observations (438) rather than the mean (382). Statistical Concepts and Market Returns LOS h Section 7.6 29 Compared with the occurrence of fundamental developments related to a com- pany, when do technical analysts believe that related security price movements are most likely to arise? A After B Before C Simultaneously B is correct. Technicians believe that security price movements occur before fundamental developments of a company unfold and before they are reported to the public. A is incorrect. Technicians believe that security price movements occur before, not after, fundamental developments unfold—certainly before they are reported. C is incorrect. Technicians believe that security price movements occur before, not at the same time as, fundamental developments unfold—certainly before they are reported.
18 2019 Level I Mock Exam (C) AM Technical Analysis LOS a Section 2.1 30 If the stated annual interest rate is 9% and the frequency of compounding is daily, the effective annual rate (EAR) is closest to: A 9.00%. B 9.86%. C 9.42%. C is correct. EAR = (1 + periodic interest rate)m – 1 = [1 + (0.09/365)]365 – 1 = 0.094162, rounded to 9.42%. A is incorrect because it treats the stated rate and the EAR as equivalents. B is incorrect; it is calculated using (9/365) × 4 = 0.09863. The Time Value of Money LOS c Sections 3.2, 3.3, 31 Using a discount rate of 5%, compounded monthly, the present value (PV) of $5,000 to be received three years from today is closest to: A $4,319. B $4,305. C $4,250. B is correct. PV = FVN(1 + rs/m)–mN. In this case, PV = $5,000(1 + 0.05/12)(–12×3) = $4,304.88. Using a financial calculator: FV = $5,000, N = 36, I/Y = 5/12, PMT = 0, and solve for PV. A is incorrect. It is calculated without monthly compounding (N = 3, I/Y = 5). Alternatively: 5,000(1 + 0.05)(–3) = 4,319 (rounded) C is incorrect. It is calculated as PV = 5,000[1 – (0.05 × 3)] = 4,250. The Time Value of Money LOS d, e Section 5.2 32 Assume the following: 0.7500 1.4300 Current spot rate for the USD/EUR 400 points Forward rate for the EUR/AUD EUR/AUD forward premium to the spot rate USD: US dollar; EUR: Euro; AUD: Australian dollar The USD/AUD spot rate is closest to: A 1.0296. B 1.0425. C 1.1154.
2019 Level I Mock Exam (C) AM 19 B is correct. Step 1: Find the spot rate for the EUR/AUD Spot = Forward Rate – Forward Points = 1.4300 – (400/10,000) = 1.3900 Step 2: Calculate current cross rate (USD/AUD) = (EUR/AUD) × (USD/AUD) = 0.7500 × 1.3900 = 1.0425 A is incorrect. It incorrectly subtracts forward premium from 1. (1 – 400/10000) × 1.43 = 1.3728 1.3728 × 0.75 = 1.0296 C is incorrect. It incorrectly adds forward premium to 1. (1 + 400/10000) × 1.43 = 1.4872 1.4872 × 0.75 = 1.1154 Currency Exchange Rates LOS d, e Sections 3.2 and 3.3 33 If the domestic currency is trading at a forward premium, then relative to the interest rate of the domestic country, the interest rate in the foreign country is most likely: A lower. B higher. C the same. B is correct. The currency with the higher (lower) interest rate will always trade at a discount (premium) in the forward market. The lower interest rate in the domestic country will be offset by the appreciation of the domestic country’s currency over the investment horizon. A is incorrect because the forward rate is trading at a premium and not at a discount. C is incorrect because the forward rate does not equal the spot rate. Currency Exchange Rates LOS h Section 3.3 34 In the classification of currency regimes, a currency board system (CBS) most likely differs from a fixed-r ate parity system in that: A a CBS can peg to a basket of currencies but a fixed-r ate system cannot. B the monetary authority within a CBS does not act as a traditional lender of last resort. C a CBS has a discretionary target level of foreign exchange reserves.
20 2019 Level I Mock Exam (C) AM B is correct. In a CBS, the monetary authority has an obligation to maintain 100% for- eign currency reserves against the monetary base. It therefore cannot lend to troubled financial institutions. As long as the country under a fixed parity regime maintains its exchange peg, the central bank can serve as a lender of last resort. A is incorrect. It is the fixed-r ate system that can use a basket of currencies for the peg. C is incorrect. In a fixed parity system the monetary authority has a discretionary target level of reserves, but in a CBS it does not because there is a commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate. Currency Exchange Rates LOS i Sections 4.3.2, 4.3.3 35 During the last month, a food company located in the United States had the following transactions: Transaction Amount (US$ millions) Bought raw material from Indonesia 50.0 Sold food products to France 65.0 Received royalty fees from its branch in the United Kingdom 0.5 Donated to a charitable institution in Africa 0.1 Borrowed from a bank in Singapore 2.0 Paid legal fees to its German legal consultant company 1.2 Received interest coupon from its investment in Eurobonds issued 0.8 in Luxembourg These transactions will most likely increase the US current account by: A $15.0 million. B $14.5 million. C $17.0 million. A is correct. Note that the borrowing from a bank in Singapore is not a current account transaction. Transaction Current Account (US$ millions) Bought raw material from Indonesia Sold food products to France –50.0 Received royalty fees from its branch in the United Kingdom 65 Donated to charitable institution in Africa 0.5 Borrowed from a bank in Singapore –0.1 Paid legal fees to its German legal consultant company Received interest coupon from its investment in Eurobonds Omit issued in Luxembourg –1.2 0.8 Total 15
2019 Level I Mock Exam (C) AM 21 B is incorrect because the royalty fee is not included. C is incorrect because the bank loan is included. International Trade and Capital Flows LOS h Sections 4.2–4.3 36 The transmission of a central bank’s policy rate action through the economy ultimately affects: A total demand. B inflation. C long-term interest rates. B is correct. The monetary transmission mechanism is the process whereby a central bank’s interest rate gets transmitted through the economy and ultimately affects the rate of increase of prices (inflation). A is incorrect because, although policy rate actions do transmit through the economy by affecting total demand, this influence on total demand is an intermediate effect that drives subsequent domestic inflationary pressure. In effect, policy rate actions ultimately impact inflation through the avenue of total demand. C is incorrect because although policy rate actions do transmit through the economy through the channel of market rates (both short-term and long-term interest rates), this is just one of four channels and multiple interconnected channel relationships that impacts total demand. In effect, policy rate actions ultimately impact inflation through the channel of market interest rates (including long-term interest rates). Monetary and Fiscal Policy LOS i Section 2.3.3 37 If there is a policy rate of 3%, a real trend rate of growth in the underlying econ- omy of 1%, and long-r un expected inflation of 3%, then the central bank policy stance operating within a credible inflation-targeting regime is best described as: A neutral. B contractionary. C expansionary. C is correct. A real trend rate of growth of 1%, coupled with 3% long-run expected inflation, suggests a 4% neutral rate of interest that neither spurs on nor slows down the underlying economy. The 3% policy rate is less than the 4% neutral rate of interest. When the policy rate is below the neutral rate, monetary policy is described as expansionary. A is incorrect because, with a neutral policy stance, the central bank’s policy rate would be equal to the neutral rate. In this case, the policy rate of 3% is less than the neutral rate of 4% (1% trend growth plus 3% long-run inflation expectation), which is expansionary (not neutral). B is incorrect because, with a contractionary policy stance, the central bank’s policy rate would be greater than the neutral rate. In this case, the policy rate of 3% is less than the neutral rate of 4% (1% trend growth plus 3% long-run inflation expectation), which is expansionary (not contractionary).
22 2019 Level I Mock Exam (C) AM Monetary and Fiscal Policy LOS m Section 2.4 38 The two dominant supermarket chains in the area are attempting to increase their market share by moving to 24-h our service instead of closing at 9 p.m. every night. The strategic outcomes and payoff matrix that arise from their actions are depicted in the diagram (with the shaded sections representing pay- offs for Chain 2). Chain 2 Chain 1 Close at 9 p.m. Open 24 hours Open 24 hours Close at 9 p.m. 290 592 180 55 75 140 540 108 According to the Nash equilibrium, the best strategy is for: A both chains to open for 24 hours. B only Chain 2 to open for 24 hours. C both chains to close at 9 p.m. A is correct. Each company will consider the other’s reaction in selecting its strategy. Using the following summary, it is best for both chains to provide 24-hour service. Chain Consideration Best Decision 1 Open for 24 hours If it opens for 24 hours, it will see a higher 2 payoff regardless of what Chain 2 does. Open for 24 hours Chain 2 Chain 2 Closes at 9 p.m. Opens for 24 hours Chain 1 earns 540 Chain 1 earns 108 instead of 180 instead of 55 If it opens for 24 hours, it will see a higher payoff regardless of what Chain 1 does. Chain 1 Chain 1 Closes at 9 p.m. Opens for 24 hours Chain 2 earns 592 Chain 2 earns 140 instead of 290 instead of 75 B is incorrect because it produces the highest combined profit from all combina- tions but is not relevant for any 1 chain in this market environment.
2019 Level I Mock Exam (C) AM 23 C is incorrect. As indicated in the table, both chains have an incentive to open for 24 hours because they will do better regardless of what their competitor does. The Firm and Market Structures LOS a, d, e Section 5.1 39 First-d egree price discrimination is best described as pricing that allows pro- ducers to increase their economic profit while consumer surplus: A is eliminated. B increases. C decreases. A is correct. In first-d egree price discrimination, the entire consumer surplus is captured by the producer; the consumer surplus falls to zero. B is incorrect. In first degree price discrimination, the entire consumer surplus is captured by the producer; the consumer surplus falls to zero. C is incorrect. In first degree price discrimination, the entire consumer surplus is captured by the producer; the consumer surplus falls to zero. The Firm and Market Structures LOS d, e Section 6.4 40 Over a given period, the price of a commodity falls by 5.0%, and the quantity demanded rises by 7.5%. The price elasticity of demand for the commodity is best described as: A perfectly elastic. B elastic. C inelastic. B is correct. If demand is elastic, a 1 percent reduction in price increases the quantity sold by more than 1 percent. Therefore, when demand is elastic, the magnitude (ignor- ing algebraic sign) of the coefficient is greater than one. In this case, price elasticity is: E d = %∆Qxd = 7.5% = −1.5 px %∆Px −5.0% where E d = the price elasticity px %∅Qxd = the change in quantity (in %) %∅Px = the change in price (in %) C is incorrect because if demand is inelastic, a 1 percent price reduction increases the quantity sold by less than 1 percent. A is incorrect because if demand is perfectly elastic, a 1 percent price reduction increases the quantity demanded by an infinitely large percentage. Topics in Demand and Supply Analysis LOS a Section 2.2
24 2019 Level I Mock Exam (C) AM 41 Assume economic activity is accelerating, inflation is increasing modestly, and unemployment is low. The economy is most likely in which phase of the busi- ness cycle? A Peak B Early expansion C Late expansion C is correct. The late expansion phase is characterized by acceleration of growth rate, decreasing of unemployment rate, and increasing of inflation rate. Early Expansion Late Expansion Peak Economic Gross domestic Activity measures Activity measures Activity product (GDP), show an accelerating show decelerating Employment industrial produc- rate of growth. rate of growth tion, and other mea- Inflation sures of economic Business begins full Business slows its rate activity turn from time rehiring as of hiring; however, decline to expansion. overtime hours rise. the unemployment The unemployment rate continues to fall. Layoffs slow (and rate falls to low net employment levels. Inflation further turns positive), but accelerates. new hiring does not Inflation picks up yet occur and the modestly. unemployment rate remains high. At first, business turns to overtime and tem- porary employees to meet rising product demands. Inflation remains moderate and may continue to fall. A is incorrect because the peak phase is characterized by deceleration of growth rate. B is incorrect because the early expansion phase is not characterized by low unemployment. Understanding Business Cycles LOS a Section 2.1 42 Holding the working-a ge population constant, if the labor force participation rate declines while the number of people employed remains unchanged, the unemployment rate will most likely: A remain unchanged. B increase. C decrease.
2019 Level I Mock Exam (C) AM 25 C is correct. For a given working-a ge population, a decline in the labor force participa- tion rate (often caused by an increase in discouraged workers) reduces the labor force. If the number of people employed remains the same while the labor force becomes smaller, the number of workers defined to be unemployed must be smaller and thus the unemployment rate lower. The following example illustrates the direction of change: Working-age population Initial Case After Change Labor force = Employed + Unemployed Labor force participation rate 100 100 Unemployment rate 60 + 20 = 80 60 + 15 = 75 80% 75% 20/80 = 25% 15/75 = 20% Labor force participation rate = Labor force/Working age population Unemployment rate = Unemployed/Labor force A is incorrect, as per table above. B is incorrect, as per table above. Understanding Business Cycles LOS d Section 4.1 43 The unemployment rate is best described as the ratio of unemployed to: A labor force. B labor force minus frictionally unemployed. C total population of people who are of working age. A is correct. The unemployment rate is the ratio of unemployed to labor force. B is incorrect because unemployment rate includes all the labor force. C is incorrect because unemployment rate is based on the labor force and the working age. The labor force is defined as the number of people who either have a job or are actively looking for a job. Understanding Business Cycles LOS d Section 4.1 44 A company’s most recent balance sheet shows the following values (NZ$ thousands): Accounts payable 3,800 Long-term debt 5,590 Other long-term liabilities 800 Common stock 1,200 Retained earnings 1,810 The company’s debt-to-c apital ratio is closest to:
26 2019 Level I Mock Exam (C) AM A 0.77. B 1.86. C 0.65. C is correct. The debt-to-c apital ratio is Total debt = 5,590 = 0.650 Total debt + Total shareholders' equity 5,590 + 1,200 + 1,810 where total debt includes only interest-bearing debt. A is incorrect. It includes current liabilities and other long-term liabilities as a part of total debt: [(3,800 + 5,590 + 800)/(3,800 + 5,590 + 800 + 1,200 + 1,810)] = 0.7719. B is incorrect. It calculates long-term debt to equity: [5,590/(1,200 + 1,810)] = 1.86. Financial Analysis Techniques LOS c, e Sections 4.4.1 45 An analysis used to forecast earnings that shows the changes in key financial quantities that result from alternative sets of economic events best describes which of the following techniques? A Sensitivity analysis B Simulation C Scenario analysis C is correct. Scenario analysis shows the changes in key financial quantities that result from given economic events, such as the loss of customers or a catastrophic event. A is incorrect. Sensitivity analysis, also known as “what if” analysis, shows the range of possible outcomes as specific assumptions are changed. B is incorrect. Simulation is a computer-generated sensitivity or scenario analysis based on probability models for the factors that drive outcomes. Financial Analysis Techniques LOS g Section 8 46 A company operating in a highly fragmented and competitive industry reported an increase in return on equity (ROE) over the prior year. Which of the fol- lowing reasons for the increase in ROE is least likely to be sustainable? The company: A increased the prices of its product significantly. B decided to make greater use of long-term borrowing capacity. C implemented a new IT system, allowing it to reduce working capital levels as a percentage of assets. A is correct.
2019 Level I Mock Exam (C) AM 27 ROE = Net income × Revenues × Average total assets Revenues Average total assets Average shareholders' equity An increase in price is not sustainable in a fragmented and competitive industry. Fragmented industries tend to be highly price competitive because of the need to increase market share and undercut prices in an attempt to steal share. B is incorrect. Increasing the use of long-term borrowing capacity will increase leverage and increase ROE and is sustainable as long as the company maintains that level of leverage. C is incorrect. By lowering the amount of working capital in the business, the com- pany lowered its average total assets and average shareholders’ equity and increased its turnover ratio. Holding all else equal, a lower average total asset will increase the ROE through the higher turnover ratio. This strategy is sustainable because it relies on an improvement in productivity generated by new technology (new IT system). Financial Analysis Techniques LOS d Section 4.6.2 Introduction to Industry and Company Analysis LOS g Section 5.1.2 47 The following data are available on a company: Financial data (HK$ millions) Current Year Prior Year Revenue 18,980 18,250 Cost of sales 14,600 14,040 Ending inventory 2,150 1,850 Ending accounts receivable 2,900 3,300 Ending accounts payable 2,700 2,900 Ratios 60 70 Number of days of payables 40 Days of sales outstanding (DSO) Days of inventory on hand (DOH) The least likely explanation for the improvement in the cash conversion cycle is that the firm improved on its: A ability to collect from customers. B payments to suppliers. C inventory management. C is correct. The cash conversion cycle = DSO + DOH – Days in payables. Days of inventory on hand (DOH) Current Year Cost of sales 14,600 Divided by average inventory (1,850 + 2,150)/2 2,000 = Inventory turnover 7.30 (continued)
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