Mock 6

Question 1

Among all analysts who cover Saris Corporation, the consensus earnings estimate for the current period is $2.14. Lee Rutherford, CFA, believes that Saris will release earnings above the consensus number but in his published research report he estimates earnings for Saris to be $2.14 per share. In conversations with some clients Rutherford mentions his reasons for believing that the $2.14 number may be on the low side. With respect to the Code and Standards:

A)
the conversations do not violate the Standards because the research report is the official document, and that is what Rutherford is supporting.
B)
Rutherford is in violation of the Standards by failing to deal with clients fairly in disseminating material changes in investment recommendations.
C)
Saris Corporation is in violation of the Standards by not disclosing material earnings information to the public.

Answer 1

B)
Rutherford is in violation of the Standards by failing to deal with clients fairly in disseminating material changes in investment recommendations.

Rutherford is not treating all clients fairly and is thus violating Standard III(B) Fair Dealing. If he has an opinion regarding a possible surprise earnings announcement, he should include it in his published report.

Question 2

Rob Tegger, CFA, manages the investment account of The Knox Trust. The trustees tell Tegger they are pleased the account has outperformed its benchmark for the first three quarters of the year and that if he can outperform the benchmark over the final quarter, the trust will pay all the expenses for a week’s vacation for Tegger and his wife at a trust property on Maui. To comply with the Code and Standards, Tegger must:

A)
obtain permission from his employer before accepting the offer.
B)
reject the offer because it creates a conflict of interest with his other clients.
C)
inform his employer of the offer, but he is not required to obtain permission before accepting it.

Answer 2

A)
obtain permission from his employer before accepting the offer.

Because the gift depends on Tegger’s future performance, Standard IV(B) Additional Compensation Arrangements requires Tegger to obtain permission from his employer before accepting it. This allows the employer to determine whether other accounts may be disadvantaged

Question 3

Harold Fitcher asks his account manager to direct trades to Foster Brokers. Foster purchases goods and services for Fitcher at his direction. The account manager, to comply with the Standards, should inform Fitcher that he:

A)
cannot direct the trades to Foster because of the Standard regarding soft dollars.
B)
cannot direct trades to Foster because of his duty to seek best execution for his trades.
C)
can direct the trades to Foster if the client tells him the goods and services will benefit the account beneficiaries.

Answer 3

C)
can direct the trades to Foster if the client tells him the goods and services will benefit the account beneficiaries.

Such a directed brokerage arrangement is not a violation of Standard III(A) Loyalty, Prudence, and Care because brokerage commissions are an asset of the client. As long as the client assures the manager that the goods and services will benefit the beneficiaries of the account, such an arrangement does not violate the Standards.

Question 4

Juan Perez, CFA, is an airline industry analyst. Perez does not currently cover New Jet, a relatively new airline. New Jet believes its new service is unique and has offered first class tickets to research analysts in the hopes of receiving increased coverage. Perez believes he can more fully understand the airline’s new concept if he is a passenger, so he accepts a ticket and takes a weekend trip. Perez does not see any differentiation between New Jet and other airlines, and decides the company is too small to warrant analytical coverage. According to the Code and Standards, Perez is:

A)
required to reject the offer of airline tickets.
B)
permitted to accept the airline tickets, but is required to obtain written permission from his employer.
C)
permitted to accept the airline tickets, and is not required to obtain written permission from his employer.

Answer 4

C)
permitted to accept the airline tickets, and is not required to obtain written permission from his employer.

Perez may accept the airline tickets because the offer is not an attempt to influence his independent judgment about the quality of the company or its attractiveness as an investment. Standard I(B) Independence and Objectivity does not require Perez to obtain written permission from his employer

Question 5

Phillip Kevil, CFA, is an investment advisor for Sensible Investments Inc. One of Kevil’s clients, Alan Miller, has requested that Kevil purchase shares of LongShot Technology through a broker that charges higher-than-average fees. Miller maintains a nondiscretionary account and makes each investment decision himself. Even though the account is not discretionary, Miller does allow Kevil to vote all proxies for his account. Kevil generally votes the proxies with management since most of the stocks in Miller’s account are high-tech companies in which the managers are the largest shareholders. Has Kevil violated any Standards?

A)
Kevil has not violated any Standards.
B)
Using Miller’s choice of broker is not a violation, but Kevil’s proxy voting policy is a violation.
C)
Both using Miller’s choice of broker and Kevil’s proxy voting policy are violations.

Answer 5

B)
Using Miller’s choice of broker is not a violation, but Kevil’s proxy voting policy is a violation.

Kevil has violated his duty under Standard III(A) Loyalty, Prudence, and Care. He must consider all proxy issues carefully and ensure that the proxies are voted in the best interest of his client. He cannot rely on the assumption that because a company’s management happens to be the largest shareholders, they have his client’s best interest in mind. He is allowed to use a more expensive broker for any client if the client specifically requests the use of the broker (client directed brokerage)

Question 6

The Standard on performance presentation least likely requires or recommends that Members and Candidates:

A)
disclose whether performance is gross or net of fees.
B)
support any forecast of future performance with actual data on past performance.
C)
include terminated accounts in performance history.

Answer 6

B)
support any forecast of future performance with actual data on past performance.

Standard III(D) Performance Presentation prohibits members from implying that future investment returns will reflect past performance. (

Question 7

Assuming no tax effects of the capitalization decision, in the period when a firm makes an expenditure, capitalizing the expenditure instead of recognizing it as an expense will result in higher:

A)
debt-to-equity and debt-to-assets ratios.
B)
net income and have no effect on total cash flows.
C)
cash flow from investing and lower cash flow from operations.

Answer 7

B)
net income and have no effect on total cash flows.

Net income is higher with capitalization because it does not decrease by the full amount spent, as it would with expensing. Capitalizing an expenditure changes its cash flow classification from an operating cash outflow to an investing cash outflow. As a result, CFO is higher and CFI is lower than they would be if the expenditure had been immediately expensed. Total cash flow, however, is unaffected (assuming the tax treatment of the expenditure is independent of the financial reporting treatment). Equity is higher in the period of the expenditure with capitalization. Assets are higher because they include the capitalized asset. Debt is unaffected by the decision to capitalize or expense. Thus, the debt-to-equity and debt-to-assets ratios are lower with capitalization.

Question 8

A profitable company can increase its return on equity (other things equal) by:

A)
decreasing its asset turnover.
B)
increasing its financial leverage.
C)
decreasing its ratio of EBT to EBIT.

Answer 8

B)
increasing its financial leverage.

ROE = tax burden × interest burden × EBIT margin × asset turnover × financial leverage. The ratio of EBT to EBIT is the interest burden. Increasing financial leverage will increase a positive ROE. Decreasing the ratio of EBT to EBIT or decreasing asset turnover will decrease a positive ROE.

Question 9

A country’s statistical bureau reports a GDP deflator of 106.5. An analyst should interpret this statistic to mean that since the base period:

A)
the annual inflation rate is 6.5%.
B)
nominal GDP has increased 6.5% relative to real GDP.
C)
real GDP has increased 6.5%.

Answer 9

B)
nominal GDP has increased 6.5% relative to real GDP

If the GDP deflator is 106.5, the price level has increased 6.5% since the base period and nominal GDP is 6.5% greater than real GDP. Because the base period is not necessarily the previous year, we cannot conclude that 6.5% is the annual inflation rate.

Question 10

A simple linear regression model assumes that the model’s residuals:

A)
are positively correlated.
B)
have a constant variance.
C)
are distributed lognormally.

Answer 10

B)
have a constant variance.

Assumptions of a simple linear regression model include that the variance of the residuals is constant for all observations, and that the residuals are uncorrelated and normally distributed.

Question 11

According to which model(s) of international trade will owners of the less-abundant factor of production in each country be made worse off by the lifting of trade restrictions?

A)
The Ricardian model.
B)
The Hecksher-Ohlin model.
C)
Neither the Ricardian model nor the Hecksher-Ohlin model.

Answer 11

B)
The Hecksher-Ohlin model.

Labor and capital are factors in the Hecksher-Ohlin model, which suggests that increased international trade will increase the price of whichever factor is more abundant in a country and decrease the price of the less abundant factor

Question 12

StarCaps, a manufacturer of promotional caps, has a lease expense of $100,000 each period. The labor and materials cost for each cap is $2.00 and StarCaps faces a market price of $4.50. If StarCaps expects to sell 30,000 caps each period, its most appropriate action is to:

A)
shut down now.
B)
continue to operate and renew the lease.
C)
continue to operate until the lease expires, then shut down.

Answer 12

C)
continue to operate until the lease expires, then shut down.

StarCaps’ marginal revenue of $4.50 is greater than its marginal variable cost of $2.00, but total revenue of 30,000 × $4.50 = $135,000 is less than total cost of $100,000 + $30,000(2) = $160,000. The firm should incur losses of $25,000 per period until the lease expires, and then shut down.

Question 13

In the context of a foreign exchange transaction, the “sell side” refers to the:

A)
currency dealer.
B)
party who sells the base currency.
C)
party who sells the price currency.

Answer 13

A)
currency dealer.

In the foreign exchange market, the “sell side” refers to the large multinational banks that act as dealers in currencies.

Question 14

Based on the following 10 observations drawn from a distribution:

34, 14, 51, 36, 25, 48, 60, 19, 39, 7

The 70th percentile is closest to:

A)
39.
B)
45.
C)
48.

Answer 14

B)
45.

The observations in ascending order are: 7, 14, 19, 25, 34, 36, 39, 48, 51, 60. The position of the 70th percentile is (10 + 1) × (70 / 100) = 7.7. The 70th percentile is therefore the value of the 7th observation (in ascending order) plus 7/10 of the difference between the 7th observation and the 8th observation: 39 + 0.7(48 − 39) = 45.3.

Question 15

Lewis Equipment Company manufactured a construction crane with an estimated useful life of 20 years and market value of $1 million. Valley Builders leases the crane from Lewis for five years with payments of $100,000 per year. The lease includes an option to buy the crane at the end of the lease. Both parties expect that Valley will exercise the purchase option at the end of the lease term. This lease will be reported on the companies’ financial statements as:

A)
a finance lease by Valley and Lewis.
B)
an operating lease by Valley and Lewis.
C)
an operating lease by Valley and a finance lease by Lewis.

Answer 15

A)
a finance lease by Valley and Lewis.

If a lease includes an option to buy the leased asset and the lessee is expected to exercise it, the lease must be classified as a finance lease. The accounting standards for classifying a lease as a financing or operating lease are the same for lessees and lessors

Question 16

The currency of Xyzia (XYZ) has an exchange rate with the euro (EUR) of 2.50 XYZ/EUR on July 31 and 2.60 XYZ/EUR on August 31. The euro exchange rate with the U.S. dollar (USD) is 1.10 USD/EUR on July 31 and 1.20 USD/EUR on August 31. The XYZ has:

A)
appreciated relative to the U.S. dollar.
B)
depreciated relative to the U.S. dollar.
C)
remained unchanged relative to the U.S. dollar.

Answer 16

A)
appreciated relative to the U.S. dollar.

The USD / XYZ exchange rate is 1.10 × 1 / 2.50 = 0.4400 on July 31 and 1.20 × 1 / 2.60 = 0.4615 on August 31. The XYZ has appreciated by 0.4615 / 0.4400 − 1 = 4.9% relative to the USD

Question 17

Joe’s Supermarket has been experiencing rising product prices, while quantities sold have remained stable. The company uses the LIFO method to account for its inventory. If the company had used the FIFO method, what impact would it have had on the company’s working capital?

A)
No impact on working capital.
B)
Lower working capital.
C)
Higher working capital.

Answer 17

C)
Higher working capital.

With increasing prices, the FIFO method results in a higher inventory value compared to the LIFO method. The higher inventory level (higher current assets) would increase working capital.

Question 18

JiffyCo’s tax rate is 40%. JiffyCo purchases a $200 asset with no salvage value which is depreciated on a straight-line basis for four years for tax purposes and five years for financial reporting. At the end of the second year:

A)
JiffyCo’s effective tax rate has decreased.
B)
the asset’s carrying value is greater than its tax base.
C)
the deferred tax liability has a balance of $20.

Answer 18

B)
the asset’s carrying value is greater than its tax base.

Tax depreciation is 200 / 4 = $50; book depreciation is 200 / 5 = $40. Thus, after two years, the carrying value is $120 [200 − (40 × 2 years)], and the tax base is $100 [200 − (50 × 2 years)]. The effective tax rate is not affected by temporary differences. The deferred tax liability at the end of the second year is $8 [(120 carrying value − 100 tax base) × 40%]

Question 19

An analyst wants to illustrate the dispersion of a country’s quarterly GDP growth rates over the last 60 years. The analyst should most appropriately employ a:

A)
variance polygon.
B)
histogram.
C)
time series plot.

Answer 19

B)
histogram.

A histogram is a bar chart representing the relative frequencies of observations in the sample (i.e., the frequency distribution).

Question 20

In the chain of events by which monetary policy affects the economy, which is most likely to have limitations that make a policy action less effective in achieving its desired outcome?

A)
Changes in interbank lending rates are reflected in other short-term interest rates.
B)
Long-term interest rates change in response to changes in short-term interest rates.
C)
Central bank purchases or sales of securities change the amount of excess reserves in the banking system.

Answer 20

B)
Long-term interest rates change in response to changes in short-term interest rates.

While the central bank can control short-term interest rates, their relationship to long-term interest rates is not direct or proportionate. Long-term nominal interest rates include a premium for expected inflation. If a central bank’s policy actions to reduce short-term rates cause market participants to expect higher future inflation, long-term rates will not decrease as much as short-term rates, and may actually increase.

Open market operations by the central bank directly change the amount of bank excess reserves. Because various forms of short-term financing are close substitutes, the relationship among different short-term rates is closer than the relationship between short-term rates and long-term rates

Question 21

An increase in which of the following accounts will increase shareholders’ equity?

A)
Treasury stock.
B)
Revaluation surplus.
C)
Valuation allowance.

Answer 21

B)
Revaluation surplus.

Revaluation surplus is an account in shareholders’ equity that reflects cumulative increases in the fair value of long-lived assets above their historical cost, when a firm uses the revaluation model under IFRS. Treasury stock is a contra account in shareholders’ equity that increases when a firm repurchases its own shares. Under U.S. GAAP, a valuation allowance is a contra account in assets that reflects a decrease in the realizable value of a deferred tax asset. An increase in a valuation allowance increases income tax expense and decreases shareholders’ equity

Question 22

A company that wants to increase its reported net income for the current period would be least likely to:

A)
decrease a valuation allowance.
B)
slow down their payments to suppliers.
C)
increase the expected useful life of a machine.

Answer 22

B)
slow down their payments to suppliers.

Slowing payments to suppliers will not affect net income (other than to decrease it if finance charges or failure to take advantage of discounts increases expenses) but increases operating cash flow. A decrease in the valuation allowance for a deferred tax asset will increase the net deferred tax asset which will decrease income tax expense. Increasing the useful life of a machine would decrease depreciation expense.

Question 23

Under which of the following exchange rate regimes do the actions of a country’s monetary authority keep the domestic currency closest to its stated target exchange rate with another currency?

A)
Fixed peg.
B)
Dollarization.
C)
Currency board.

Answer 23

C)
Currency board.

Under a currency board arrangement, the monetary authority agrees to exchange its domestic currency for a foreign currency at a fixed rate. A fixed peg arrangement allows variation within a band of ±1% around the target exchange rate. With dollarization, a member country does not have a domestic currency of its own.

Question 24

For a firm that reports its long-term debt at market value, a decrease in the rating on its long-term debt will:

A)
decrease its equity.
B)
decrease its debt-to-assets ratio.
C)
have no effect on its reported solvency ratios.

Answer 24

B)
decrease its debt-to-assets ratio.

A decrease in the firm’s bond rating will increase the required yield on its debt and decrease its market value. A decrease in the market (and book) value of its debt will decrease the firm’s reported debt-to-assets ratio (a solvency ratio). A decrease in balance sheet liabilities will increase equity as long as assets are unchanged.

Question 25

Espresso Inc. sells its commercial machines for $3,500. It has fixed operating costs of $1,200,000, variable operating costs of $1,900 per unit, and pays $500,000 in interest each year. Espresso’s sales are currently at the operating breakeven level. Other things equal, to achieve the breakeven level, sales must increase by:

A)
36%.
B)
42%.
C)
47%.

Answer 25

B)
42%.

Operating breakeven is 1,200,000 / (3,500 − 1,900) = 750 units. Breakeven is (1,200,000 + 500,000) / (3,500 − 1,900) = 1,063 units. Percentage increase = 1,063/750 − 1 = 41.73%.

Alternatively, 500,000/1,200,000 = 41.67%.

Question 26

Which of the following reasons why a firm’s profitability might decrease is most accurately classified as a firm-specific risk factor?

A)
New competitors with the firm emerge.
B)
The firm’s reputation for social responsibility decreases.
C)
Exchange rates with the firm’s largest foreign market change unfavorably.

Answer 26

B)
The firm’s reputation for social responsibility decreases.

ESG risk is a firm-specific risk factor. Exchange rate fluctuations are a macro risk factor. Competitive intensity is an industry risk factor

Question 27

The creation and redemption of shares by authorized participants, which keeps the price of fund shares close to their net asset value, is a feature unique to which of the following types of pooled investments?

A)
Hedge funds.
B)
Closed-end funds.
C)
Exchange-traded funds.

Answer 27

C)
Exchange-traded funds.

A unique feature of ETFs is that they will create shares when institutional investors deposit securities that are included in the ETF basket and will redeem ETF shares for institutional investors. This is done to ensure an efficient and orderly market in the shares and to prevent the fund shares from trading at (much of) a premium or discount, thereby avoiding one of the pitfalls of closed-end funds.

Question 28

A company has estimated the installed cost of a new machine to be $1.5 million. The machine is expected to increase after-tax cash flows by $600,000 in each of the next three years and by $300,000 for two years after that. After five years the machine will be removed and disposed of at a cost of $200,000. If the firm uses a discount rate of 9% for evaluating capital projects, its estimate of the NPV of the proposed investment will be closest to:

A)
$283,000.
B)
$296,000.
C)
$307,000.

Answer 28

B)
$296,000.

I/Y = 9; CF0 = –1.5, C01 = 0.6, F01 = 3, C02 = 0.3, F02 = 1, C03 = 0.1, F03 = 1; NPV = 0.296297 million

Question 29

An investor’s wealth is approximately 50% in bonds and broad-based equities and 50% in shares of a company she founded. Which of the following measures of risk-adjusted returns is least appropriate for this investor’s portfolio?

A)
M-squared.
B)
Sharpe ratio.
C)
Jensen’s alpha.

Answer 29

C)
Jensen’s alpha.

Jensen’s alpha is based on systematic risk and is not appropriate for a portfolio with a 50% concentration in a single entity (i.e., not well diversified). Both the Sharpe ratio and the M-squared measure are based on total portfolio risk and are appropriate for a portfolio that is not well diversified.

Question 30

A company is considering whether to allocate capital to a new product line. They estimate the project will require an initial cash outflow of $3 million. If the new product succeeds, they foresee a profitable opportunity to expand the project in three years, which would require a $3 million cash outflow. In evaluating the opportunity to introduce the new product line, how should the company most appropriately consider the opportunity to expand the project in the future?

A)
Include it and assign it a positive value.
B)
Not consider it in the capital allocation decision.
C)
Include a probability-weighted negative value for the possible future cash outflow

Answer 30

A)
Include it and assign it a positive value.

The company should give a positive value to the expansion option when estimating the NPV of the project. Just as with financial options, real options cannot have negative values because the company can choose not to exercise them

Question 31

Which of the following types of capital budgeting projects would typically require the most detailed analysis?

A)
Purchase of a new machine to increase production.
B)
Replacing a machine with a new one to maintain production.
C)
Purchase of a new machine to reduce materials waste and production costs.

Answer 31

A)
Purchase of a new machine to increase production.

Purchase of new machinery to increase production requires the explicit estimation of future demand as well as the materials and production costs, and will therefore require the most detailed analysis.

Question 32

An analyst predicts that the return on Royal Company stock will be 15%. The analyst is provided with the following data for Royal and the broad market:

Royal Company beta 1.5
Risk-free rate 5%
Expected market return 11%
Based on these data, the analyst should conclude that Royal Company stock is:

A)
overvalued.
B)
undervalued.
C)
correctly valued.

Answer 32

B)
undervalued.

For Royal Company, the required return equals 0.05 + 1.5(0.11 − 0.05) = 14%. The analyst predicts the stock will return 15%, implying that she thinks Royal Company stock is undervalued.

Question 33

The least appropriate target capital structure weights for calculating a firm’s WACC would be those based on:

A)
industry average weights.
B)
the firm’s current capital structure weights based on balance sheet values.
C)
the firm’s current capital structure weights based on market values adjusted for the trend in weights over time.

Answer 33

B)
the firm’s current capital structure weights based on balance sheet values.

The weights should be based on the market values of outstanding securities, not their balance sheet values.

Question 34

Standard Foods has a degree of operating leverage of 1.3 and a degree of financial leverage of 2.2 based on its most recent financial results, which show sales of $42 million, net income of $2.7 million, and beginning shareholder equity of $30 million. The increase in Standard’s return on beginning equity resulting from an increase in sales of 5% is closest to:

A)
1.3%.
B)
5.0%.
C)
14.3%

Answer 34

A)
1.3%.

Current ROE = 2.7 / 30 = 9%. Degree of total leverage is 1.3 × 2.2 = 2.86. The expected increase in net income for a 5% increase in sales is 2.86 × 5% = 14.3%, so return on beginning equity increases to (1.143 × 2.7) / 30 = 10.3%, an increase from the current ROE of 10.3% − 9% = 1.3%.

Question 35

The lowest-cost source of short-term funding for a large creditworthy company is:

A)
factoring of receivables.
B)
issuing commercial paper.
C)
an uncommitted line of credit.

Answer 35

B)
issuing commercial paper.

Large creditworthy borrowers can issue commercial paper, which is the lowest cost source of short-term funds.

Question 36

Summit Industries targets a debt-to-equity ratio of 0.33. Its after-tax cost of equity is 13% and its after-tax cost of debt is 5%. The most appropriate estimate for Summit’s WACC is:

A)
10.2%.
B)
10.7%.
C)
11.0%.

Answer 36

C)
11.0%.

For a D/E of 0.33, debt will be 0.33 / (1.00 + 0.33) = 0.248 weight for debt and a 1.0 – 0.248 = 0.752 weight in equity. The weighted average cost of capital is 0.248(5%) + 0.752(13%) = 11.0%

Question 37

Gordon Castparts has fixed operating costs of $1.2 million and fixed financing costs of $400,000. If the price per unit is $39 and variable costs are $22 per unit, Gordon’s operating breakeven quantity of sales is closest to:

A)
54,500.
B)
70,600.
C)
94,100.

Answer 37

B)
70,600.

Operating breakeven quantity of sales = 1.2 million/(39 – 22) = 70,588 units

Question 38

For three otherwise identical bonds, which feature would result in the largest increase in value during a period of rising interest rate volatility?

A)
Put feature.
B)
Call feature.
C)
Floating rate coupon.

Answer 38

A)
Put feature.

The price of a putable bond equals the price of an otherwise identical, yet non-putable, bond plus the price of the bond put option. The price of the bond put option increases when interest rate volatility increases. Therefore, the price of the putable bond will rise. The price of a callable bond equals the price of an otherwise identical, yet non-callable, bond minus the price of the bond call option. The price of the bond call option increases when interest rate volatility increases. Therefore, the price of the callable bond will fall. The price of a floating rate bond will not change significantly, especially if the coupon reset dates are not far apart.

Question 39

Natalia Coffey enters a forward contract to sell 10,000 shares of Drebin PLC for £120 per share. By entering this contract, Coffey most likely:

A)
establishes a hedge.
B)
takes on short exposure to the underlying.
C)
agrees to deliver 10,000 shares on the settlement date.

Answer 39

B)
takes on short exposure to the underlying.

As the seller of the forward contract, Coffey has short exposure to the underlying because the value of the contract to Coffey will increase if the underlying price decreases and will decrease if the underlying price increases. Coffey may be hedging an existing risk or speculating on the underlying asset price. A forward contract may be deliverable or cash-settled.

Question 40

Jones Company declares a 10% stock dividend. Smith Company carries out a 1-for-2 reverse stock split. Other things equal and ignoring transactions costs, what effects will these transactions have on shareholders’ equity?

A)
Both Jones and Smith will decrease their shareholders’ equity.
B)
Neither Jones nor Smith will change their shareholders’ equity.
C)
Jones will decrease its shareholders’ equity and Smith will increase its shareholders’ equity.

Answer 40

B)
Neither Jones nor Smith will change their shareholders’ equity.

Stock dividends, stock splits, and reverse stock splits do not change a firm’s shareholders’ equity.

Question 41

For a profitable and rapidly growing firm, holders of preference shares are least likely to benefit from the firm’s growth if the preference shares are:

A)
convertible.
B)
cumulative.
C)
participating.

Answer 41

B)
cumulative.

Preference shares are cumulative if any dividends in arrears must be paid before the firm pays any common dividends. A profitable and rapidly growing firm is unlikely to be in arrears on its preferred dividends. Participating preference shares may receive additional dividends if the firm’s profits exceed a stated level. Convertible preference shares can benefit from the firm’s growth because they may be converted to common shares

Question 42

A bond issuer that wishes to structure a deleveraged inverse floater would be most likely to specify a coupon rate of:

A)
4% minus 30-day LIBOR.
B)
2% plus half of 90-day LIBOR.
C)
8% minus half of 60-day LIBOR.

Answer 42

C)
8% minus half of 60-day LIBOR.

The coupon structure of a deleveraged inverse floater subtracts a multiple less than one of a reference rate from a fixed rate.

Question 43

Samuelson Company has two bond issues outstanding. One is a zero coupon bond. The other has a 10% semiannual coupon. Both bonds have AA credit ratings, 10 years to maturity, and yields to maturity of 7.5%. The zero coupon bond has:

A)
less reinvestment risk and less interest rate risk than the coupon paying bond.
B)
more reinvestment risk and less interest rate risk than the coupon paying bond.
C)
less reinvestment risk and more interest rate risk than the coupon paying bond.

Answer 43

C)
less reinvestment risk and more interest rate risk than the coupon paying bond.

All else equal, a zero coupon bond has less reinvestment risk and more interest rate risk (duration) than a coupon paying bond

Question 44

Recently issued government bonds that trade frequently are least likely referred to as:

A)
benchmark bonds.
B)
on-the-run bonds.
C)
current yield bonds.

Answer 44

C)
current yield bonds.

The most recently issued government bonds actively traded and are referred to as on-the-run bonds or as benchmark bonds

Question 45

An annual-pay bond with a modified duration of 7.61 is priced with a yield-to-maturity of 7.5%. If an investor has an expected holding period for the bond of 8 years, an investment in this bond will have reinvestment risk that:

A)
is less than its price risk.
B)
just offsets its price risk.
C)
is greater than its price risk.

Answer 45

A)
is less than its price risk.

The bond’s Macaulay duration is 7.61 × 1.075 = 8.18. For a holding period of 8 years, which is less than the bond’s Macaulay duration, this bond’s reinvestment risk is less than its price risk

Question 46

A financial intermediary that offers to buy an asset at a bid price and to sell the same asset at an ask price is best described as:

A)
a dealer.
B)
a broker.
C)
an arbitrageur.

Answer 46

A)
a dealer.

Dealers maintain an inventory of securities and profit from a bid-ask spread. Brokers locate counterparties for buyers and sellers. Arbitrageurs seek to earn a riskless profit by buying an asset in one market and simultaneously selling the same asset for a higher price in another market.

Question 47

A $50,000 10-year 7% bond with semi-annual coupon payments is issued on January 1, 20X0. The full price for a trade of this bond, with a 7% yield to maturity to settle on April 30, 20X6, using the 30/360 day-count convention, is closest to:

A)
$51,150.
B)
$51,164.
C)
$51,177.

Answer 47

A)
$51,150.

The full price (including accrued interest) of the bond at settlement is $50,000(1.035) 119/180 = 51,150.19

Question 48

An annual-pay 5% coupon corporate bond with two years to maturity is trading with a zero-volatility spread of 150 basis points. The 1-year government bond spot rate is 3.5%, and the 2-year government bond spot rate is 4.0%. The price of the corporate bond (as a percent of par) is closest to:

A)
99.10.
B)
99.55.
C)
101.90.

Answer 48

A)
99.10.

To value the bond using spot rates, add the zero-volatility spread of 1.5% (150 bp) to each government spot rate and discount the bond’s cash flows using these rates. The price of the bond is 5 / 1.050 + 105 / 1.0552 = 99.10.

Question 49

An investor who sells a stock short is most likely required to:

A)
lend the stock.
B)
make dividend payments.
C)
pay margin loan interest.

Answer 49

B)
make dividend payments.

A short seller owes the lender any dividends declared on the shorted stock

Question 50

A floating-rate note that uses 6-month LIBOR as a reference rate has a quoted margin of +25 basis points and a required margin of +15 basis points. At its next coupon reset date, the note’s price is most likely to be:

A)
equal to par value.
B)
less than par value.
C)
greater than par value.

Answer 50

C)
greater than par value.

If the quoted margin is greater than the required margin, the note’s credit quality has improved and its price should revert to a level greater than par value at the next coupon reset date

Question 51

Jack George, CFA, is evaluating Dunger, Inc., a waste management firm. The company has been experiencing a strong 15% growth rate, which is forecast to continue over the next three years before growth slows to a sustainable rate of 8%. The company recently paid a dividend of $0.50 per share. George has calculated a 10% weighted average cost of capital for Dunger. The firm has no debt. The company’s last reported trade was $35 per share. Based on the multi-stage dividend discount model, George should:

A)
not buy the stock.
B)
buy the stock because its intrinsic value is $38 per share.
C)
buy the stock because its intrinsic value is $41 per share.

Answer 51

A)
not buy the stock.

Question 52

When put-call-forward parity for European options holds, the present value of the price of a forward contract on an asset:

A)
plus the value of a put option is equal to the value of a long call option on the same underlying asset plus a long zero coupon risk-free bond with face value equal to the exercise price of the options.
B)
plus the value of a call option is equal to the value of a long call option on the same underlying asset plus a long zero coupon risk-free bond with face value equal to the exercise price of the options.
C)
less the value of a put option is equal to the value of a long call option on the same underlying asset plus a long zero coupon risk-free bond with face value equal to the exercise price of the options.

Answer 52

A)
plus the value of a put option is equal to the value of a long call option on the same underlying asset plus a long zero coupon risk-free bond with face value equal to the exercise price of the options.

Put-call-forward parity for European options holds if the present value of the forward price plus the value of a put option is equal to the value of a fiduciary call position (a long call and long zero coupon risk-free bond with a face value equal to the exercise price of the options)

Question 53

A bond for which the holder has a legal claim on specific financial assets as well as the overall assets of the issuing corporation is most appropriately termed:

A)
a secured bond.
B)
a covered bond
C)
an asset-backed security.

Answer 53

B)
a covered bond.

“Covered bond” refers to a bond for which specific balance sheet assets are legally segregated as collateral for the bond and for which the bondholder also has a claim against the firm’s overall assets in the event the segregated assets prove insufficient. “Asset-backed security” is backed by financial assets sold by a company to a special purpose entity (the issuer of the bond) for which the bondholder does not have a claim against the company that has sold the underlying financial assets to the SPE. “Secured bond” refers to any bond that has a priority claim to specific firm assets

Question 54

A hedge fund investor is analyzing several funds’ returns relative to risk, and believes the appropriate risk measure is a fund’s largest decrease in value. This investor should compare the funds based on their:

A)
Calmar ratios.
B)
Sortino ratios.
C)
Treynor ratios.

Answer 54

A)
Calmar ratios.

The Calmar ratio uses maximum drawdown, the decline in a fund’s value from peak to trough, as its risk measure. The Sortino ratio uses downside deviation and the Treynor ratio uses beta.

Question 55

Rob Ealey purchases an option-free bond with a 6.5% coupon that is currently selling at 94.73 to yield 7.25%. If yields increase by 50 basis points, the new price of the bonds would be 91.41, and if yields decrease by 50 basis points, the new price of the bond would be 98.20. If yields decrease by 75 basis points, the price of the bond would be closest to:

A)
89.64.
B)
99.82.
C)
104.92.

Answer 55

B)
99.82.

First, calculate the bond’s appropriate modified duration as follows: (98.2 − 91.41) / (2 × 94.73 × 0.005) = 6.79 / 0.9473 = 7.17. The estimated change in price would be:

−7.17 × (−0.0075) × 94.73 = 5.09, for a new price of 94.73 + 5.09 = 99.82

Question 56

For a corporate bond, it is most likely that a decrease in its bond rating will:

A)
be preceded by a decrease in price.
B)
increase expected loss severity.
C)
be followed by a decrease in the bond’s credit spread.

Answer 56

A)
be preceded by a decrease in price.

Market prices and credit spreads change faster than bond ratings, so we can expect a decrease in price to precede a decrease in bond rating.

Question 57

When a commodity has very little or no convenience yield, the futures market is said to be in:

A)
contango.
B)
backwardation.
C)
no-arbitrage equilibrium.

Answer 57

A)
contango.

When there is little or no convenience yield, futures markets are most likely in contango, a situation where futures prices are higher than spot prices. Backwardation refers a market where futures prices are less than spot prices and is associated with a high convenience yield. The no-arbitrage condition is what theoretically drives the relationship between spot commodity prices and futures prices.

Question 58

Which of the following statements regarding the differences between interest rate swaps and forward rate agreements is most accurate?

A)
Forward rate agreements are commitments, whereas interest rate swaps are contingent claims.
B)
Forward rate agreements have a single settlement date, whereas interest rate swaps have several settlement dates.
C)
Ignoring transactions costs, forward rate agreements require no upfront payment, whereas interest rate swaps require the payment of an upfront premium.

Answer 58

B)
Forward rate agreements have a single settlement date, whereas interest rate swaps have several settlement dates.

Interest rate swaps settle periodically during their tenor, whereas an FRA settles only once, at maturity. Both are forward commitments and neither requires an upfront payment.

Question 59

A security that promises a minimum payment at maturity plus 20% of any gains on an index of small cap stocks is most accurately described as:

A)
a guarantee certificate.
B)
a capital protected instrument.
C)
a principal protected security.

Answer 59

B)
a capital protected instrument.

This describes a capital protected instrument, which is termed a guarantee certificate only if the minimum payment at maturity is equal to the original cost of the security.

Question 60

In securitization, the party that purchases the loans is least likely:

A)
the issuer.
B)
the servicer.
C)
a special purpose entity.

Answer 60

B)
the servicer

The issuer purchases the loans or other financial securities and issues the asset-backed securities. The issuer is created as a special purpose entity. Often, the originator of the loans also services the loans.

Question 61

A clawback provision is most likely to be included in the partnership agreement of an alternative investment fund that has:

A)
a catch-up clause.
B)
a high-water mark.
C)
a deal-by-deal waterfall.

Answer 61

C)
a deal-by-deal waterfall.

With a deal-by-deal waterfall structure, if successful deals that generate gains are exited early in a fund’s life and unsuccessful deals that generate losses are exited later, it is possible that incentive fees exceed the agreed-upon percentage of gains over the fund’s life. With a clawback provision, the general partner is required to return any excess incentive fees to the limited partners.

Question 62

An index is composed of the following three stocks:

December 31, 20X1 December 31, 20X2
Stock Price Shares Price Shares
Perez $140 1,000,000 $154 1,000,000
Quinton $70 1,500,000 $70 2,000,000
Ranovich $90 2,000,000 $81 2,000,000
An equal-weighted index of the three stocks has a value on December 31, 20X1 = 100. The index value on December 31, 20X2 is closest to:

A)
100.
B)
102.
C)
107.

Answer 62

A)
100.

Percentage price changes were +10% for Perez, 0% for Quinton, and −10% for Ranovich. The change in an equal-weighted index is (10% + 0% −10%) / 3 = 0% and the index value remains equal to 100.