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ExamWise
Volume 1
CFA 2008 Level I Certification
With Preliminary Reading Assignments The
Candidates Question And Answer Workbook For
Chartered Financial Analyst

Authors
Jane Vessey, CFA
M. Afdal Pamilih, CFA
David Stewart
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ThisbookisdedicatedtoourfantasticchildrenAdamandJuliawhoweloveverymuch.

Jane Vessey & M. Afdal Pamilih

ThisStudyGuideisdedicatedtothewidow(er)sandorphansoftheSilentSpring.Thosewhohave
sacrificed loved ones to the obscurity of quiet study and endured weekend sacrifice above and
beyond the call of continuing education. On the alter of a professions highest accreditation these
unsungheroeshavesacrificedtimewiththeirspouse,shoppingwithMom,andpitchandcatchwith
Dad. These patient supporters have endured tense attitudes, unfinished chores, extra duties, and
receivedtherespectandappreciationofallwhohavestudiedthroughouttheSilentSpring.
Inparticular,neverendingthanksto:
CarolLee,MaryElizabeth,SophiaVictoria,DavidToddII

David Stewart

ExamWise
Volume 1
CFA 2008 Level I Certification
With
Preliminary Reading Assignments
The Candidates Question And Answer Workbook
For Chartered Financial Analyst
BY
Authors
Jane Vessey, CFA
M. Afdal Pamilih, CFA
David Stewart
Jane Vessey
Jane Vessey manages a training company in the United Kingdom specializing in financial analysis
and investment. She is a visiting lecturer at Cass Business School teaching classes in asset
managementandvaluation.ShealsoteachesaCFA revisioncourseatISMA(thebusinessschoolat
Reading University) and is an associate at a leading London financial training company where she
teaches courses covering investment management and related topics. She has developed online
trainingprogramsforstudentstakingtheCFAexaminationsandteachesCFAcoursesforUKSIP(the
UKSocietyofInvestmentProfessionals).
Jane graduated in Mathematics from Oxford University, United Kingdom, and is a CFA charter
holder.Shehassomeeighteenyearsexperienceworkingintheinvestmentindustry,startingoutas
anequityanalystbeforebecominganinvestmentmanager.ShewasbasedinLondonandTokyoand
tookresponsibilityformanagingequityportfoliosinvestedintheJapaneseandotherAsianmarkets.
In1990,JanemovedtoIndonesiaandestablishedandrananinvestmentmanagementoperationon
behalf of Mees Pierson. She took responsibility for all areas of the business, including investment,
operations,marketingandadministration.WhileinAsia,Janewasinvolvedinprovidingtrainingto
capitalmarketparticipantsandstateofficialsandteachingincoursesprovidedbylocaluniversities.

M. Afdal Pamilih
Afdal has 18 years experience working in the finance industry. He started his career with J.P.
Morgan, and then with County NatWest Government Securities, in New York specializing in the
development of quantitative products for foreign exchange and fixed income markets. After
returning to Indonesia in 1989 he was responsible for the development of investment services and
subsequentlytreasurymanagementforleadingbanksinJakarta.
AfdalhasdevelopedwebbasedtrainingprogramsfortheCFAexaminationsandhaswideteaching
experience, including instructing at the School of Management, University of Surrey, United
Kingdom.
He obtained a MSc in Mathematics from the University of Texas at Arlington and holds the
CharteredFinancialAnalyst(CFA)qualification.

David Stewart:
DavidStewarthasextensiveexperienceinventurecapitalandbusinessstructuralreorganizations.As
president of a private client broker dealer firm, he has business valuation and project valuation
experienceontheventurecapitalsideandportfoliomanagementontheassetmanagementside.His
analysis, commentary, books, and study guides have appeared in the financial management,
securities,andexamprepindustries.
David has collaborated with experts in the field to produce the 2001 through 2006 editions of this
studyguide.HisextensiveresearchintotheCFAexamprogramandpastexamhistories,fieldwork,
and consistent review of CFA Institute information allows him and his coauthors to deliver high
qualityanduptodateinformation.

About the Book:


ExamWise Volume 1 For CFA Level I Concept Check Q&A Workbook With Preliminary Reading
AssignmentsisdesignedtogiveyouplentyofpracticequestionstotestyourreadinessfortheCFA
exam. It offers 400+ concept check questions based 18 exam study sessions that cover the Learning
OutcomeStatementsandtheirassociatedCFAAssignedReadings.Foradditionalpractice,thereisan
accompanyingfreedownloadtestenginethatgeneratesmultiplemockexamssimilarindesignand
difficultytotherealCFAexam.Thequestionsandexplanationshavereferencestothepagenumber
intherelatedReadingandtotherelatedLOS.
UsethisworkbooktotestyourunderstandingofthebasicconceptscoveredintheCFAReadingsand
identifyyourstrengthsandweaknesses.Thenyoucanmoveontomoreadvancedstudymaterialsto
sharpenyourweakestknowledgeareas.
ThisbookisdividedintoStudySessions(118)thatcoverthe76LearningOutcomeStatementsand
the associated Assigned Readings. Appendix A (Exhibits 1 4), is a collection of exhibits and flow
charts for condensed reference and review, including examples of accounting statements, puts and
calls,PEbreakdown,andfinancialratios.

The 18 2008 CFA Level I Study Sessions breakout is as follows:


Ethical and Professional Standards
1.

StudySession1:EthicalandProfessionalStandards

Investment Tools
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.

StudySession2.QuantitativeMethods:BasicConcepts
StudySession3.QuantitativeMethods:Application
StudySession4.Economics:MicroeconomicAnalysis
StudySession5.Economics:MarketStructureandMacroeconomicAnalysis
StudySession6.Economics:MonetaryandFiscalEconomics
StudySession7.FinancialStatementAnalysis:Introduction
StudySession8.FinancialStatementAnalysis:IncomeStatement,BalanceSheet,Cash
StudySession9.FinancialStatementAnalysis:Inventories,Assets,Taxes,andDebt
StudySession10.FinancialStatementAnalysis:Techniques,Apps,&International
StudySession11.CorporateFinance

Portfolio Management
12. StudySession12.PortfolioManagement

Asset Valuation
13.
14.
15.
16.
17.
18.

StudySession13.AnalysisofEquityInvestments:SecuritiesMarkets
StudySession14.AnalysisofEquityInvestments:IndustryandCompanyAnalysis
StudySession15.AnalysisofFixedIncomeInvestments:BasicConcepts
StudySession16.AnalysisofFixedIncomeInvestments:AnalysisandValuation
StudySession17.DerivativeInvestments
StudySession18.AlternativeInvestmentsEquityInvestments:SecuritiesMarkets

Online Information:
1. What is CFA Institute
http://www.cfainstitute.org/aboutus/index.html
2. CFA Program:

http://www.cfainstitute.org/cfaprogram

3. The Code of Ethics (Full Text)

http://www.cfainstitute.org/centre/ethics/code/

The Standards of Professional Conduct


Standard I: Fundamental Responsibilities
Standard II: Relationships with and Responsibilities to the Profession
Standard III: Relationships with and Responsibilities to the Employer
Standard IV: Relationships with and Responsibilities to Clients and Prospects
Standard V: Relationships with and Responsibilities to the Public
4. Why The CFA Designation Matters to You: Individual Investor FAQ
http://www.cfainstitute.org/aboutus/investors/articles/cfamatters.html
5. Soft Dollar Standards

http://www.cfainstitute.org/centre/ethics/softdollar/

6. CFA Institute-PPSTM AIMR Performance Presentation Standards


http://www.cfapubs.org/doi/ref/10.2469/faj.v57.n2.2433
7. Global Investment Performance Standards

http://www.cfainstitute.org/centre/ips/

Click the picture and link to a free CFA Candidates online glossary.

List of Chapters
Study Session 01:
Ethical and Professional Standards:
Study session 02:
Quantitative Methods:
Study Session 03:
Quantitative Methods:
Study Session 4:
Introduction
Study Session 04:
Economics:
Study Session 05:
Economics:
Study Session 06:
Economics:
Study Session 7:
Introduction
Study Session 07:
Financial Statement Analysis:
Study Session 08:
Financial Statement Analysis:
Study Session 09:
Financial Statement Analysis:
Study Session 10:
Financial Statement Analysis:
Study Session 11:
Corporate Finance:
Study Session 12:
Portfolio Management:
Study Session 13:
Equity Investments:
Study Session 14:
Equity Investments:
Study Session 15:
Fixed Income Investments:
Study Session 16:
Fixed Income Investments:
Study Session 17:
Derivative Investments:
Study Session 18:
Alternative Investments:
Terminology:
Appendix A:
Download Instructions

14
34
60
84
112
136
160
184
198
222
248
274
300
330
354
378
402
426
450
474
501
503
526

With the purchase of this book you get FREE Author Collaberation:

NowthatyouhavepurchasedthisproductyouhaveaccesstotheInstructors/Authorsthatauthored
thisbook.Sendyouquestionstousandwewillanswerthemforyou.

TableofContentsIX

Table of Contents
About the Book:........................................................................................................................... VI
Online Information:..................................................................................................................... VII

Study Session 01:

Ethical and Professional Standards:

14

Reading 1: Code of Ethics and Standards of Professional Conduct ..........................................14


Reading 2: Guidance for Standards IVII.................................................................................14
Reading 3: Introduction to the Global Investment Performance Standards (GIPS) ...................14
Reading 4: Global Investment Performance Standards (GIPS) .................................................14

Study session 02:

Quantitative Methods:

34

Basic Concepts ................................................................................................................................34


Reading 5: The Time Value of Money ........................................................................................34
Reading 6: Discounted Cash Flow Applications .........................................................................34
Reading 7: Statistical Concepts and Market Returns .................................................................34
Reading 8: Probability Concepts.................................................................................................34

Study Session 03:

Quantitative Methods:

60

Application .......................................................................................................................................60
Reading 9: Common Probability Distributions ............................................................................60
Reading 10: Sampling and Estimation........................................................................................60
Reading 11: Hypothesis Testing .................................................................................................60
Reading 12: Technical Analysis ..................................................................................................60

Study Session 4:

Introduction

84

Introductory Readings......................................................................................................................84
Supply, Demand, and the Market Process CH 5.............................................................................84
Introduction..................................................................................................................................84
Consumer choice and the Law of Demand.................................................................................85
Producer choice and the Law of Supply .....................................................................................85
Price changes and demand and supply......................................................................................86
Shifts in demand .........................................................................................................................87
Shifts in supply ............................................................................................................................88
Impact of changes in demand and supply ..................................................................................88
Supply and Demand: Applications and Extensions CH 4................................................................90
Introduction..................................................................................................................................90
Resources ...................................................................................................................................90
Elasticity and the incidence of tax ...............................................................................................91
Taking the Nations Economic Pulse CH 7 ......................................................................................92

XTableofContents
Introduction ................................................................................................................................. 92
Gross domestic product.............................................................................................................. 92
Working with Our Basic Aggregate Demand/ Aggregate Supply Model CH 10.............................. 96
Introduction ................................................................................................................................. 96
Aggregate demand ..................................................................................................................... 96
Keynesian Foundations of Modern Macroeconomics CH 11........................................................ 100
Introduction ............................................................................................................................... 100
Keynesian economics............................................................................................................... 100
Introductory Readings Concept Check Questions ............................................................... 104
Introductory Readings Concept Check Answers.................................................................. 108

Study Session 04:

Economics:

112

Microeconomic Analysis................................................................................................................ 112


Reading 13: Elasticity ............................................................................................................... 112
Reading 14: Efficiency and Equity............................................................................................ 112
Reading 15: Markets in Action.................................................................................................. 112
Reading 16: Organizing Production.......................................................................................... 112
Reading 17: Output and Costs ................................................................................................. 112

Study Session 05:

Economics:

136

Market Structure and Macroeconomic Analysis............................................................................ 136


Reading 18: Perfect Competition.............................................................................................. 136
Reading 19: Monopoly.............................................................................................................. 136
Reading 20: Monopolistic Competition and Oligopoly.............................................................. 136
Reading 21: Demand and Supply in Factor Markets................................................................ 136
Reading 22: Monitoring Cycles, Jobs, and the Price Level ...................................................... 136
Reading 23: Aggregate Supply and Aggregate Demand ......................................................... 136

Study Session 06:

Economics:

160

Monetary and Fiscal Economics ................................................................................................... 160


Reading 24: Money, Banks, and the Federal Reserve............................................................. 160
Reading 25: Money, Interest, Real GDP, and the Price Level ................................................. 160
Reading 26: Inflation................................................................................................................. 160
Reading 27: Fiscal Policy ......................................................................................................... 160
Reading 28: Monetary Policy.................................................................................................... 160

Study Session 7:

Introduction

184

Introductory Readings ................................................................................................................... 184


Measuring Business Income ......................................................................................................... 184
Introduction ............................................................................................................................... 184

TableofContentsXI
Accounting methods..................................................................................................................184
Financial Reporting and Analysis ..................................................................................................185
Introduction................................................................................................................................185
Balance Sheet ...........................................................................................................................185
Income statement......................................................................................................................186
Inventories .....................................................................................................................................187
Introduction................................................................................................................................187
Inventory....................................................................................................................................187
Inventory cost ............................................................................................................................187
Effect of inventory accounting method......................................................................................188
Current Liabilities and the Time Value of Money...........................................................................190
Introduction................................................................................................................................190
Liabilities....................................................................................................................................190
Contributed Capital ........................................................................................................................191
Introduction................................................................................................................................191
Contributed capital ....................................................................................................................191
Accounting for dividends ...........................................................................................................191
Common stock ..........................................................................................................................191
Preferred stock ..........................................................................................................................191
Stock issuance ..........................................................................................................................192
Treasury stock...........................................................................................................................192
The Corporate Income Statement and the Statement of Stockholders Equity .............................192
Introduction................................................................................................................................192
Retained earnings .....................................................................................................................192
Accounting for stock dividends and stock splits........................................................................192
Introduction
Concept Check Questions................................................................................193
Introduction
Concept Check Answers ..................................................................................195

Study Session 07:

Financial Statement Analysis:

198

An Introduction...............................................................................................................................198
Reading 29: Financial Statement Analysis: An Introduction .....................................................198
Reading 30: Financial Reporting Mechanics ............................................................................198
Reading 31: Financial Reporting Standards .............................................................................198

Study Session 08:

Financial Statement Analysis:

222

The Income Statement, Balance Sheet, and Cash Flow Statement .............................................222
Reading 32: Understanding the Income Statement ..................................................................222
Reading 33: Understanding the Balance Sheet........................................................................222

XIITableofContents
Reading 34: Understanding the Cash Flow Statement ............................................................ 222

Study Session 09:

Financial Statement Analysis:

248

Inventories, Long-Term Assets, Deferred Taxes, and On- and Off-Balance Sheet Debt ............. 248
Reading 35: Analysis of Inventories ......................................................................................... 248
Reading 36: Analysis of Long-Lived Assets: ............................................................................ 248
Part IThe Capitalization Decision.......................................................................................... 248
Reading 37: Analysis of Long-Lived Assets: ............................................................................ 248
Part IIAnalysis of Depreciation and Impairment.................................................................... 248
Reading 38: Analysis of Income Taxes .................................................................................... 248
Reading 39: Analysis of Financing Liabilities ........................................................................... 248
Reading 40: Leases and Off-Balance-Sheet Debt ................................................................... 248

Study Session 10:

Financial Statement Analysis:

274

Techniques, Applications, and International Standards Convergence ......................................... 274


Reading 41: Financial Analysis Techniques............................................................................. 274
Reading 42: Financial Statement Analysis: Applications ......................................................... 274
Reading 43: International Standards Convergence ................................................................. 274

Study Session 11:

Corporate Finance:

300

Reading 44: Capital Budgeting ................................................................................................. 300


Reading 45: Cost of Capital...................................................................................................... 300
Reading 46: Working Capital Management.............................................................................. 300
Reading 47: Financial Statement Analysis ............................................................................... 300
Reading 48: The Corporate Governance of Listed Companies: .............................................. 300
A Manual for Investors.............................................................................................................. 300

Study Session 12:

Portfolio Management:

330

Reading 49: The Asset Allocation Decision.............................................................................. 330


Reading 50: An Introduction to Portfolio Management............................................................. 330
Reading 51: An Introduction to Asset Pricing Models .............................................................. 330

Study Session 13:

Equity Investments:

354

Securities Markets ......................................................................................................................... 354


Reading 52: Organization and Functioning of Securities Markets ........................................... 354
Reading 53: Security-Market Indexes ...................................................................................... 354
Reading 54: Efficient Capital Markets ...................................................................................... 354
Reading 55: Market Efficiency and Anomalies ......................................................................... 354

Study Session 14:

Equity Investments:

378

Industry and Company Analysis.................................................................................................... 378


Reading 56: An Introduction to Security Valuation: Part I ........................................................ 378

TableofContentsXIII
Reading 57: Industry Analysis...................................................................................................378
Reading 58: Equity: Concepts and Techniques........................................................................378
Reading 59: Company Analysis and Stock Valuation...............................................................378
Reading 60: An Introduction to Security Valuation: Part II........................................................378
Reading 61: Introduction to Price Multiples ..............................................................................378

Study Session 15:

Fixed Income Investments:

402

Basic Concepts ..............................................................................................................................402


Reading 62: Features of Debt Securities ..................................................................................402
Reading 63: Risks Associated with Investing in Bonds ............................................................402
Reading 64: Overview of Bond Sectors and Instruments .........................................................402
Reading 65: Understanding Yield Spreads...............................................................................402
Reading 66: Monetary Policy in an Environment of Global Financial Markets .........................402

Study Session 16:

Fixed Income Investments:

426

Analysis and Valuation...................................................................................................................426


Reading 67: Introduction to the Valuation of Debt Securities ...................................................426
Reading 68: Yield Measures, Spot Rates, and Forward Rates ................................................426
Reading 69: Introduction to the Measurement of Interest Rate Risk ........................................426

Study Session 17:

Derivative Investments:

450

Reading 70: Derivative Markets and Instruments .....................................................................450


Reading 71: Forward Markets and Contracts ...........................................................................450
Reading 72: Futures Markets and Contracts ............................................................................450
Reading 73: Option Markets and Contracts..............................................................................450
Reading 74: Swap Markets and Contracts ...............................................................................450
Reading 75: Risk Management Applications of Option Strategies ...........................................450

Study Session 18:

Alternative Investments:

474

Reading 76: Alternative Investments ........................................................................................474

Terminology:
Appendix A:
Download Instructions

501
503
526

14StudySession01:

Study Session 01: Ethical and Professional


Standards:

The readings in this study session present a framework for ethical conduct in the investment
professionbyfocusingontheCFAInstituteCodeofEthicsandStandardsofProfessionalConductas
wellastheGlobalInvestmentPerformanceStandards(GIPS).
TheprinciplesandguidancepresentedintheCFAInstituteStandardsofPracticeHandbook(SOPH)
form the basis for the CFA Institute selfregulatory program to maintain the highest professional
standards among investment practitioners. Guidance in the SOPH addresses the practical
applicationoftheCodeofEthicsandStandardsofProfessionalConduct.Theguidancereviewsthe
purpose and scope of each standard, presents recommended procedures for compliance, and
providesexamplesofthestandardinpractice.
The Global Investment Performance Standards (GIPS) facilitate efficient comparison of investment
performance across investment managers and country borders by prescribing methodology and
standards that are consistent with a clear and honest presentation of returns. Having a global
standardforreportinginvestmentperformanceminimizesthepotentialforambiguousormisleading
presentations.

Reading1:CodeofEthicsandStandardsofProfessionalConduct
Reading2:GuidanceforStandardsIVII
Reading3:IntroductiontotheGlobalInvestmentPerformanceStandards(GIPS)
Reading4:GlobalInvestmentPerformanceStandards(GIPS)

EthicalandProfessionalStandards1
1. JasonVasco,CFA,isthedirectorforamajorTaliaownedinvestmentmanagementfirmbranchin
Rasen.Taliaisknownastheworldscentreofinvestmentmanagementwithsecuritieslawsstricter
than the CFA Institute Code and Standards, and Vasco is governed by Talias laws. In Rasen, an
emerging market, the local securities laws and regulations are lenient. They are very vague in the
definitionofinsidertradingandhavenoprovisionregulatingsoftdollars.Whichofthefollowingis
mostaccurate?
A.

VascomustcomplywithTaliaslaw.

B.
VascoonlyhastocomplywithRasenslawandthereforecantakethefullestadvantage
ofsoftdollararrangements.
C. VascoshouldnotworryaboutRasenslaw,itisanearlystageemergingmarketandthe
lawenforcementwillbelax,ifanyatall.
D. AsaCFAInstitutemember,VascomustonlycomplywiththeCodeandStandards
regardinginsidertradingandsoftdollararrangements.

2. Asanexpressionofgratitude,TracyBlanc,CFA,aportfoliomanager,isinvitedtospendathree
weekvacationvaluedat$10,000withherspouseinaluxuriousresortownedbyawealthyprivate
clientaftersheskillfullyprotectedthevalueoftheclientscapitalduringaseveremarketdownturn.
TheprivateclientisafeepayingclientofBlancsfirm.AccordingtoStandardIV(B)Disclosureof
AdditionalCompensationArrangements:
A.

Blancmustrefusetheinvitationasitmayjeopardizeherinvestmentjudgment.

B.
Blancisrecommendedtodonatethemonetaryvalueofthevacationtoacharityofher
choice.
C. Blancmayacceptsuchaninvitationaslongasshereportsitinwritingtoheremployer
andgainstheirapproval.
D. BlancmayaccepttheinvitationifshereportsitinwritingtoCFAInstitutecitingthefull
monetaryvalueofthevacation.

2StudySession01:
1. JasonVasco,CFA,isthedirectorforamajorTaliaownedinvestmentmanagementfirmbranchin
Rasen.Taliaisknownastheworldscentreofinvestmentmanagementwithsecuritieslawsstricter
than the CFA Institute Code and Standards, and Vasco is governed by Talias laws. In Rasen, an
emerging market, the local securities laws and regulations are lenient. They are very vague in the
definitionofinsidertradingandhavenoprovisionregulatingsoftdollars.Whichofthefollowingis
mostaccurate?
A.
Vasco must comply with Talias law.
B.
Vasco only has to comply with Rasens law and therefore can take the fullest advantage of softdollar arrangements.
C.
Vasco should not worry about Rasens law, it is an early stage emerging market and the law
enforcement will be lax, if any at all.
D.
As a CFA Institute member, Vasco must only comply with the Code and Standards regarding
insider trading and soft-dollar arrangements.
CorrectAnswer:

LOS:Reading2b

Standard I (A) stipulates that in foreign jurisdictions members must comply with the stricter of the
applicable laws and the Code of Standards, in this case Talias law is the strictest.
Reference:CFAProgramCurriculum,Volume1,pp.1517.

2. Asanexpressionofgratitude,TracyBlanc,CFA,aportfoliomanager,isinvitedtospendathree
weekvacationvaluedat$10,000withherspouseinaluxuriousresortownedbyawealthyprivate
clientaftersheskillfullyprotectedthevalueoftheclientscapitalduringaseveremarketdownturn.
TheprivateclientisafeepayingclientofBlancsfirm.AccordingtoStandardIV(B)Disclosureof
AdditionalCompensationArrangements:
A.
Blanc must refuse the invitation as it may jeopardize her investment judgment.
B.
Blanc is recommended to donate the monetary value of the vacation to a charity of her choice.
C.
Blanc may accept such an invitation as long as she reports it in writing to her employer and gains
their approval.
D.
Blanc may accept the invitation if she reports it in writing to CFA Institute citing the full monetary
value of the vacation.
CorrectAnswer:

C ...................................................................................................... Reading2b

Blanc needs to report in writing the additional compensation so her supervisor and the firm can assess
whether it is potentially a conflict of interest. If there is no objection she is free to accept the invitation.
Reference:CFAProgramCurriculum,Volume1,pp.7576.

EthicalandProfessionalStandards3
3. Kevin Dudman, CFA, has just been offered an exciting new position with Walton Asset
ManagementanddecidesthathewillresignfromhiscurrentpositionwithTrustAssetManagement.
Beforeheresignshedecidestoensurethatheusessomeoftheskillsandmaterialshehasdeveloped
atTrustAssetManagement.HeisleastlikelytoviolatetheCodeandStandards,ifhetakes:
A.
stock market analysis prepared by Dudman when he was working at Trust Asset
Management.
B.
internal contact information on Trust Asset Managements major clients which is available
from other eternal sources.
C.
computer models developed to identify mispriced securities developed by Dudman and a
colleague at Trust Asset Management.
D.
experience in pricing unlisted securities which he gained while attending training courses
which were paid for by Trust Asset Management.

4. Joseph Morgon, CFA, is a research analyst covering the Bourgogne Vineyard Corporation.
Morgonsparentsbought$50worthofBourgogneVineyardCorporationsharesforhistwoyearold
sononhisbirthday.UnderStandardVI(A),DisclosureofConflicts,Morgon:
A.

must file a report with the SEC.

B.

must sell the shares immediately.

C.

must disclose the ownership of the shares by a member of his immediate family.

D.
does not need to disclose the fact that his son owns the shares of Bourgogne Vineyard
Corporation.

4StudySession01:
3. Kevin Dudman, CFA, has just been offered an exciting new position with Walton Asset
ManagementanddecidesthathewillresignfromhiscurrentpositionwithTrustAssetManagement.
Beforeheresignshedecidestoensurethatheusessomeoftheskillsandmaterialshehasdeveloped
atTrustAssetManagement.HeisleastlikelytoviolatetheCodeandStandards,ifhetakes:
A.
stock market analysis prepared by Dudman when he was working at Trust Asset Management.
B.
internal contact information on Trust Asset Managements major clients which is available from
other eternal sources.
C.
computer models developed to identify mispriced securities developed by Dudman and a colleague
at Trust Asset Management.
D.
experience in pricing unlisted securities which he gained while attending training courses which
were paid for by Trust Asset Management.
CorrectAnswer:

D ........................................................................................... LOS:Reading2b

Models and research which he worked on when employed by Trust Asset Management belong to Trust
Asset Management. Client contact details should not be taken from his employer, although he is not
prohibited from collecting client information from outside sources. However skills and experience gained
at Trust Asset Management can be used in his new job, so D is the correct answer.
Reference:CFAProgramCurriculum,Volume1,pp.6974.

4. Joseph Morgon, CFA, is a research analyst covering the Bourgogne Vineyard Corporation.
Morgonsparentsbought$50worthofBourgogneVineyardCorporationsharesforhistwoyearold
sononhisbirthday.UnderStandardVI(A),DisclosureofConflicts,Morgon:
A.
B.
C.
D.

must file a report with the SEC.


must sell the shares immediately.
must disclose the ownership of the shares by a member of his immediate family.
does not need to disclose the fact that his son owns the shares of Bourgogne Vineyard Corporation.

CorrectAnswer:

D ........................................................................................... LOS:Reading2b

The share ownership is not likely to be material and therefore will not reasonably affect Morgons ability to
make unbiased and objective recommendation according to Standard VI(A) Disclosure of Conflicts.
Reference:CFAProgramCurriculum,Volume1,pp.8994.

EthicalandProfessionalStandards5
5. Wimpy Greenback, CFA, is the research analyst responsible for following Brown Appliances
Company. This analysis suggests the stock shouldbe rated a sell because the market outlook for
thefirmsnewproductsisbleakcomparedwiththatoftheclosestcompetition.Greenbackliveson
the same street as the CFO of Brown Appliances. During a recent neighborhood gathering,
GreenbackswifeoverheardthewifeoftheChiefFinancialOfficerofBrownAppliancescomplaining
that her husband had been working late due to a hostile takeover threat from a foreign appliances
group. This fact has not yet been made public by Brown Appliances. Upon returning to his office,
Greenback released a strong buy recommendation to the public based on this new information.
Greenback:
A.

wasinfullcompliancewiththeCodeandStandards.

B.
didnotviolatetheCodeandStandardsbecauseheusedmosaictheorytoarriveathis
recommendation.
C. violatedtheCodeandStandardsbyfailingtodistinguishbetweenfactsandopinionsin
hisrecommendation.
D. violatedtheCodeandStandardsbecausehedidnothaveareasonableandadequate
basisforhisrecommendation.

6StudySession01:
5. Wimpy Greenback, CFA, is the research analyst responsible for following Brown Appliances
Company. This analysis suggests the stock shouldbe rated a sell because the market outlook for
thefirmsnewproductsisbleakcomparedwiththatoftheclosestcompetition.Greenbackliveson
the same street as the CFO of Brown Appliances. During a recent neighborhood gathering,
GreenbackswifeoverheardthewifeoftheChiefFinancialOfficerofBrownAppliancescomplaining
that her husband had been working late due to a hostile takeover threat from a foreign appliances
group. This fact has not yet been made public by Brown Appliances. Upon returning to his office,
Greenback released a strong buy recommendation to the public based on this new information.
Greenback:
A.
was in full compliance with the Code and Standards.
B.
did not violate the Code and Standards because he used mosaic theory to arrive at his
recommendation.
C.
violated the Code and Standards by failing to distinguish between facts and opinions in his
recommendation.
D.
violated the Code and Standards because he did not have a reasonable and adequate basis for his
recommendation.
CorrectAnswer:

D ........................................................................................... LOS:Reading2b

Standard V(A) Diligence and Reasonable Basis, states that members must have a reasonable and adequate
basis for a recommendation. Greenback should have reinvestigated the companys situation and not only
relied on unofficial information. This may well be a misappropriation of material nonpublic information as
stated in Standard V(A) Prohibition against Use of Material Nonpublic Information, if a tender offer to
Brown Appliances follows.
Reference:CFAProgramCurriculum,Volume1,pp.8084.

EthicalandProfessionalStandards7
6. ThefixedincomecorporatefinancedepartmentofGoldenBrothers,aninvestmentbankingfirm,
has decided to compete for the advisory and underwriting bond offering of Kia Telcom, a hot
telecommunications company. The firms equity brokerage unit is about to publish a sell
recommendationonKiaTelcomduetoanunexpectedannouncementofcostoverruns.Theheadof
fixedincome investment banking has asked the head of the equity brokerage unit to change the
recommendationfromselltobuybeforedistributingtheresearchreporttoclients.Accordingto
theCodeandStandards,thebestcourseofactionfortheequitybrokerageunitisto:
A. placeKiaTelcomonarestrictedlistandpublishonlyfactualinformationaboutthe
company.
B.
immediatelyreratethestocktoabuysincethefirmsoverallinterestsupersedesthat
oftheclient.
C. assignamoresenioranalysttodecideifthestockdeservesahigherratingforthesakeof
objectivitysincelesssenioranalystsmayerrinjudgment.
D. increasetheratingbynomorethanoneincrement(inthiscase,toahold
recommendation)sincelittleharmisdonebybeingabitmorepositive,whilethefirmsoverall
interestisserved.

7. FionaGriffiths,CFA,isanequitysalesmanagerataLondonbasedTigerSecuritiesbranchinan
emergingmarket.Initialpublicofferingsareoftenoversubscribedmakingitdifficulttoensureafair
allocation. Griffiths understands the local environment so she is able to influence the allocation
processsothatshecanpersonallysubscribetothemaximumshecanaffordandthenallocatetherest
toherclients.Herclientsnevercomplainbecausetheyhavealmostalwaysprofitedfrominvestingin
the emerging market over the last couple of years. Which of the following describes Griffiths
situation?
A.

Griffiths is in compliance with the Code and Standards since her clients are satisfied.

B.

Griffiths violates the Code and Standards due to the priority she gives to transactions.

C.

Griffiths violates the Code and Standards since she lacks independence and objectivity.

D.
Griffiths violates the Code and Standards since she does not maintain client,
confidentiality.

8StudySession01:
6. ThefixedincomecorporatefinancedepartmentofGoldenBrothers,aninvestmentbankingfirm,
has decided to compete for the advisory and underwriting bond offering of Kia Telcom, a hot
telecommunications company. The firms equity brokerage unit is about to publish a sell
recommendationonKiaTelcomduetoanunexpectedannouncementofcostoverruns.Theheadof
fixedincome investment banking has asked the head of the equity brokerage unit to change the
recommendationfromselltobuybeforedistributingtheresearchreporttoclients.Accordingto
theCodeandStandards,thebestcourseofactionfortheequitybrokerageunitisto:
A.
place Kia Telcom on a restricted list and publish only factual information about the company.
B.
immediately re-rate the stock to a buy since the firms overall interest supersedes that of the
client.
C.
assign a more senior analyst to decide if the stock deserves a higher rating for the sake of objectivity
since less senior analysts may err in judgment.
D.
increase the rating by no more than one increment (in this case, to a hold recommendation) since
little harm is done by being a bit more positive, while the firms overall interest is served.
CorrectAnswer:

A ............................................................................................LOS:Reading2a

In this case, any action to accommodate the interest of the investment banking department that may
compromise the independence and objectivity of the brokerage research efforts can violate Standard I(B)
and the Code of Ethics.
Reference:CFAProgramCurriculum,Volume1,pp.2125.

7. FionaGriffiths,CFA,isanequitysalesmanagerataLondonbasedTigerSecuritiesbranchinan
emergingmarket.Initialpublicofferingsareoftenoversubscribedmakingitdifficulttoensureafair
allocation. Griffiths understands the local environment so she is able to influence the allocation
processsothatshecanpersonallysubscribetothemaximumshecanaffordandthenallocatetherest
toherclients.Herclientsnevercomplainbecausetheyhavealmostalwaysprofitedfrominvestingin
the emerging market over the last couple of years. Which of the following describes Griffiths
situation?
A.
B.
C.
D.

Griffiths is in compliance with the Code and Standards since her clients are satisfied.
Griffiths violates the Code and Standards due to the priority she gives to transactions.
Griffiths violates the Code and Standards since she lacks independence and objectivity.
Griffiths violates the Code and Standards since she does not maintain client, confidentiality.

CorrectAnswer:

B............................................................................................ LOS:Reading2b

Griffiths is in violation as Standard VI(B) Priority of Transactions, since she puts her personal investment
ahead of her clients, regardless of whether the clients are pleased with her services.
Reference:CFAProgramCurriculum,Volume1,pp.9499.

EthicalandProfessionalStandards9
8. Victoria Anderson, CFA, works for Pluto Capital, a newly established investment counseling
firm. The founding partners of Pluto Capital came from Vulcan Investments which was recently
takenoverbyalargefinancialservicesgroup.JonathanBeecham,aprospectiveclientofthefirm,is
meetingwithAndersonforthefirsttime.BeechamhasbeenaclientofVulcanInvestmentsforyears,
butisnowconsideringswitchinghisaccounttoPlutoCapitalbecausehehasbeendisappointedby
Vulcans underperformance following the takeover. At the beginning of their meeting, Anderson
sympathized with his situation, then immediately explains to Beecham that she has discovered a
highlyundervaluedstockthatofferslargepotentialgains.AndersonthenpromisesBeechamthatshe
can buy the stock for his account at the current price if he switches the account within 48 hours.
Andersons actions violated the Code and Standards. Which of the following statements best
describestheactionAndersonshouldhavetaken?Andersonshouldhave:
A. elaboratedonthetechnicalfeaturesofPlutosstandardvaluationmethodusedto
identifytheundervaluation.
B.
avoidedthemeetingwithBeechaminthefirstplacebecausethefoundingpartnersof
PlutocamefromVulcan.
C. givenBeechamalongertimeperiodtotakeadvantageoftheofferpricewhenswitching
hisaccounttoPluto.
D. determinedBeechamsinvestmentneeds,objectives,andtoleranceforriskbeforemaking
anyinvestmentrecommendation.

10StudySession01:
8. Victoria Anderson, CFA, works for Pluto Capital, a newly established investment counseling
firm. The founding partners of Pluto Capital came from Vulcan Investments which was recently
takenoverbyalargefinancialservicesgroup.JonathanBeecham,aprospectiveclientofthefirm,is
meetingwithAndersonforthefirsttime.BeechamhasbeenaclientofVulcanInvestmentsforyears,
butisnowconsideringswitchinghisaccounttoPlutoCapitalbecausehehasbeendisappointedby
Vulcans underperformance following the takeover. At the beginning of their meeting, Anderson
sympathized with his situation, then immediately explains to Beecham that she has discovered a
highlyundervaluedstockthatofferslargepotentialgains.AndersonthenpromisesBeechamthatshe
can buy the stock for his account at the current price if he switches the account within 48 hours.
Andersons actions violated the Code and Standards. Which of the following statements best
describestheactionAndersonshouldhavetaken?Andersonshouldhave:
A.
elaborated on the technical features of Plutos standard valuation method used to identify the
undervaluation.
B.
avoided the meeting with Beecham in the first place because the founding partners of Pluto came
from Vulcan.
C.
given Beecham a longer time period to take advantage of the offer price when switching his account
to Pluto.
D.
determined Beechams investment needs, objectives, and tolerance for risk before making any
investment recommendation.
CorrectAnswer:

D ........................................................................................... LOS:Reading2b

Prior to recommending any investments, Anderson should determine Beecham's investment needs,
objectives, and tolerance for risk as stated in Standard III(C) Suitability.
Reference:CFAProgramCurriculum,Volume1,pp.6064.

EthicalandProfessionalStandards11
9. Ken Janzen, CFA, is an economist at a large bank and he has never made direct investment
decisions. Jenzen is the latest winner of a wellpublicized portfolio management competition in a
nationalnewspaper.Ontherecommendationofhisfriends,heislaunchinganinvestmentfund.In
theprospectushetellstheprospectiveclients,Thefundhasnolongtermtrackrecordasyet,butthe
investment manager has shown considerable skills in managing hypothetical portfolios. In a
competition the manager has demonstrated a portfolio total return above 26 percent per year
annualized,andthatismorethan12percentabovethebenchmarkforthesameperiod.Hemanaged
to raise a significant amount of money from retail investors who are interested in investing in the
fund.HasJanzenviolatedtheCodeandStandards?
A.

Yes,becausethestatementmisrepresentsJanzenstrackrecord.

B.

Yes,becausehecannotquoteperformanceforahypotheticalportfolio.

C.

Yes,becausethestatementaboutreturnignorestheriskpreferencesofhisclients.

D.

No,becausethestatementisatrueandaccuratedescriptionofJanzenstrackrecord.

12StudySession01:
9. Ken Janzen, CFA, is an economist at a large bank and he has never made direct investment
decisions. Jenzen is the latest winner of a wellpublicized portfolio management competition in a
nationalnewspaper.Ontherecommendationofhisfriends,heislaunchinganinvestmentfund.In
theprospectushetellstheprospectiveclients,Thefundhasnolongtermtrackrecordasyet,butthe
investment manager has shown considerable skills in managing hypothetical portfolios. In a
competition the manager has demonstrated a portfolio total return above 26 percent per year
annualized,andthatismorethan12percentabovethebenchmarkforthesameperiod.Hemanaged
to raise a significant amount of money from retail investors who are interested in investing in the
fund.HasJanzenviolatedtheCodeandStandards?
A.
B.
C.
D.

Yes, because the statement misrepresents Janzens track record.


Yes, because he cannot quote performance for a hypothetical portfolio.
Yes, because the statement about return ignores the risk preferences of his clients.
No, because the statement is a true and accurate description of Janzens track record.

CorrectAnswer:

D ........................................................................................... LOS:Reading2b

Although Janzens experience in managing investments is only based on his winning a hypothetical
portfolio management competition, he does not misrepresent his capabilities and experience as described
in Standard III(D) Performance Presentation. Whether it is appropriate for an investor to subscribe to his
investment fund is a different matter. The role of the Code and Standards is to guide self-regulation of CFA
Institute members, not to certify the merit of an investment.
Reference:CFAProgramCurriculum,Volume1,pp.6467.

EthicalandProfessionalStandards13
10. Martha Pierpont, CFA, works for the securities custody department of North Pole Trust Bank.
She makes a reciprocal referral fee arrangement with Robert Underhill, CFA, an adviser at
BestAdvice.com. She does not disclose the referral arrangement but Underhill does so by inserting
oneclauseinBestAdvice.comsinvestmentadvisoryagreementthatincludesfromtimetotime
referralfeesmaybearrangedwithanumberofselectedsecuritiescustodians.ClientsofBestAdvice
regularlyuseNorthPolesservicesandpayreferralfees.Whichofthefollowingismostaccurate?
A.

OnlyPierpontcomplieswiththeCodeandStandards.

B.

OnlyUnderhillcomplieswiththeCodeandStandards.

C.

BothPierpontandUnderhillcomplywiththeCodeandStandards.

D.

NeitherPierpontnorUnderhillcomplywiththeCodeandStandards.

11. CharlesChaplane,whoisnotamemberofCFAInstitute,isaseniorpartnerofasmallbrokerage
firm, Blue Moon Securities, which recently participated in a large stock offering. The offering
companyhasbeengivenanunfavorablerecommendationbyhisresearchdepartmentinthepasttwo
quarters due to lacklustre performance. Chaplane immediately calls his junior analyst John
Blumenberg,CFA,andinstructshimtoupgradehisrecommendation.Blumenbergcomesupwitha
more favorable recommendation within a short period of time. Blumenberg is least likely to have
violatedtheStandardsbecausehefailed:
A.

toavoidaconflictofinterest.

B.

tomaintainindependenceandobjectivity.

C.

tomakeafairstatementofinvestmentperformance.

D.

toexerciseduediligenceandthoroughnessinmakinganinvestmentrecommendation.

14StudySession01:
10. Martha Pierpont, CFA, works for the securities custody department of North Pole Trust Bank.
She makes a reciprocal referral fee arrangement with Robert Underhill, CFA, an adviser at
BestAdvice.com. She does not disclose the referral arrangement but Underhill does so by inserting
oneclauseinBestAdvice.comsinvestmentadvisoryagreementthatincludesfromtimetotime
referralfeesmaybearrangedwithanumberofselectedsecuritiescustodians.ClientsofBestAdvice
regularlyuseNorthPolesservicesandpayreferralfees.Whichofthefollowingismostaccurate?
A.
B.
C.
D.

Only Pierpont complies with the Code and Standards.


Only Underhill complies with the Code and Standards.
Both Pierpont and Underhill comply with the Code and Standards.
Neither Pierpont nor Underhill comply with the Code and Standards.

CorrectAnswer:

D ........................................................................................... LOS:Reading2b

The best choice is D since any referral fee arrangement that a client ultimately pays must be disclosed in
terms of the nature of the consideration or the benefit together with the estimated monetary value, by both
the payer and recipient of the fee. See Standard VI (C) Referral Fees.
Reference:CFAProgramCurriculum,Volume1,pp.99101.

11. CharlesChaplane,whoisnotamemberofCFAInstitute,isaseniorpartnerofasmallbrokerage
firm, Blue Moon Securities, which recently participated in a large stock offering. The offering
companyhasbeengivenanunfavorablerecommendationbyhisresearchdepartmentinthepasttwo
quarters due to lacklustre performance. Chaplane immediately calls his junior analyst John
Blumenberg,CFA,andinstructshimtoupgradehisrecommendation.Blumenbergcomesupwitha
more favorable recommendation within a short period of time. Blumenberg is least likely to have
violatedtheStandardsbecausehefailed:
A.
B.
C.
D.

to avoid a conflict of interest.


to maintain independence and objectivity.
to make a fair statement of investment performance.
to exercise due diligence and thoroughness in making an investment recommendation.

CorrectAnswer:

C ........................................................................................... LOS:Reading2b

The best answer is C, because there is no evidence to suggest that performance presentation is relevant to
the question.
Reference:CFAProgramCurriculum,Volume1,pp.6467.

EthicalandProfessionalStandards15
12. Patricia Lualua, CFA, is a portfolio manager of Raven Asset Management. Recently she won a
mandate from the Flemish Widows pension fund trustees to manage the investments of the fund.
One of the Flemish Widows trustees privately mentions that Lualua should direct her trades to
ChurnerSecurities,whichisownedbyarelativeofoneofthetrustees.Lualua,forfearoflosingthe
account,directs50%ofthetradestoChurnerSecurities.SheispleasedtofindthatChurnersquality
of execution is good and the emerging market research quality is excellent. Although Flemish
Widowsdoesnotinvestinemergingmarkets,Lualuafindstheresearchusefulfortheotherfundsshe
manages. Lualuadecidesnot to inform anyoneregarding thesituation. According to the Code and
Standards:
A.

LualuashouldstoptradingwithChurnerSecurities.

B.

LualuamaycontinuetradingwithChurnersSecurities.

C.

LualuashoulddisclosethisarrangementtoFlemishWidows.

D.

LualuashoulddisclosethisarrangementtotheCFAInstitute.

16StudySession01:
12. Patricia Lualua, CFA, is a portfolio manager of Raven Asset Management. Recently she won a
mandate from the Flemish Widows pension fund trustees to manage the investments of the fund.
One of the Flemish Widows trustees privately mentions that Lualua should direct her trades to
ChurnerSecurities,whichisownedbyarelativeofoneofthetrustees.Lualua,forfearoflosingthe
account,directs50%ofthetradestoChurnerSecurities.SheispleasedtofindthatChurnersquality
of execution is good and the emerging market research quality is excellent. Although Flemish
Widowsdoesnotinvestinemergingmarkets,Lualuafindstheresearchusefulfortheotherfundsshe
manages. Lualuadecidesnot to inform anyoneregarding thesituation. According to the Code and
Standards:
A.
B.
C.
D.

Lualua should stop trading with Churner Securities.


Lualua may continue trading with Churners Securities.
Lualua should disclose this arrangement to Flemish Widows.
Lualua should disclose this arrangement to the CFA Institute.

CorrectAnswer:

C ........................................................................................... LOS:Reading2b

Under most securities laws this situation is acceptable but under Standard III(A), Loyalty, Prudence and
Care, Lualuas trading relationship does not put her clients interest first.
Lualua should disclose the arrangement to the Board of Trustees of Flemish Widows and let the Board give
the direction.
Reference:CFAProgramCurriculum,Volume1,pp.4853.

EthicalandProfessionalStandards17
13. CarlinaPaparazzi,afundmanagerwithAbbotswoodAdvisors,hasjustbeengiventheauthority
tomanageanewlyacquiredclientwhichhasaretirementbenefitplan,whensherealizesthataUS
GovernmentBondbelongingtotheaccountmaturesthenextday.Thebondcomprises5%ofthetotal
assets. Abbotswood Advisors is still in the midst of a discussion with the client regarding the
formulationofanewinvestmentpolicyandportfolioobjectives.Lookingatwhatthecurrentmarket
has to offer, there are a number of attractive opportunities. One opportunity that stands out is a
corporatebondofamajoroilcompanythatwentoutoffavorduetoanenvironmentalaccidentthat
occurredtheweekbefore.Shehasfollowedtheoilcompanyforanumberofyearsandknowsthatits
fundamentalsaresound.Theprospectofanimprovedcreditratinginthenextsixmonthsisnotyet
reflectedinthecurrentprice.HersupervisorasksPaparazzitoinvesttheproceedsinthecorporate
bond.Paparazziprefershowevertoinvestthemin3monthTreasuryBills,albeitwithamuchlower
yield,untilthenewinvestmentpolicyandobjectivesareformulated.Whatisthebestcourseofaction
forPaparazzi?
A. InvestintheTreasuryBillsuntilthenewinvestmentpolicyandobjectivesare
established.
B.
SplittheinvestmentbetweenthecorporatebondandtheTreasuryBillstodiversifythe
risk.
C.

Reverttotheclientforadecisionanddonothinguntiltheclientsdirectionisreceived.

D. Followhersupervisorsdirectionasthecorporatebondopportunitywillbenefitthe
overallperformanceofthefund.

18StudySession01:
13. CarlinaPaparazzi,afundmanagerwithAbbotswoodAdvisors,hasjustbeengiventheauthority
tomanageanewlyacquiredclientwhichhasaretirementbenefitplan,whensherealizesthataUS
GovernmentBondbelongingtotheaccountmaturesthenextday.Thebondcomprises5%ofthetotal
assets. Abbotswood Advisors is still in the midst of a discussion with the client regarding the
formulationofanewinvestmentpolicyandportfolioobjectives.Lookingatwhatthecurrentmarket
has to offer, there are a number of attractive opportunities. One opportunity that stands out is a
corporatebondofamajoroilcompanythatwentoutoffavorduetoanenvironmentalaccidentthat
occurredtheweekbefore.Shehasfollowedtheoilcompanyforanumberofyearsandknowsthatits
fundamentalsaresound.Theprospectofanimprovedcreditratinginthenextsixmonthsisnotyet
reflectedinthecurrentprice.HersupervisorasksPaparazzitoinvesttheproceedsinthecorporate
bond.Paparazziprefershowevertoinvestthemin3monthTreasuryBills,albeitwithamuchlower
yield,untilthenewinvestmentpolicyandobjectivesareformulated.Whatisthebestcourseofaction
forPaparazzi?
A.
Invest in the Treasury Bills until the new investment policy and objectives are established.
B.
Split the investment between the corporate bond and the Treasury Bills to diversify the risk.
C.
Revert to the client for a decision and do nothing until the clients direction is received.
D.
Follow her supervisors direction as the corporate bond opportunity will benefit the overall
performance of the fund.
CorrectAnswer:

A ........................................................................................... LOS:Reading2b

Regardless of whether it is the best investment decision, choices C or D will violate Standard III(C),
Suitability, because the overall investment policy and objectives are not yet established. Choice A is not
correct because the client pays a fee to hire expertise in investment decision making. So the best choice is
B, where the clients interest is protected, as a Treasury Bill is a cash equivalent and is risk-free, as are the
maturing Treasury Bonds.
Reference:CFAProgramCurriculum,Volume1,pp.6064.

EthicalandProfessionalStandards19
14. Muhammad Taqdir, CFA, is an investment manager whose clients are highnet worth
individuals.Taqdirisamemberofalocalcharityorganizationthatsupportschildrenwithasthma.
During a meeting at the charity, Taqdir recommends that the organization sends a letter to Xara
Corporation requesting they make a donation to the charity. Taqdir knows of Xara Corporations
involvement in this cause from previous discussions with a colleague in the office. The chief
executive and owner of Xara Corporation is a client of the firm. The charity, citing Taqdirs
recommendation,senttheletterandreceivedasubstantialdonation.AccordingtotheCFAInstitute
CodeandStandards:
A.

Taqdirhasdonehisbestsincetheorganisationreceivedasubstantialdonation.

B.
Taqdirshouldnothavedisclosedtheidentityofthechiefexecutivewithouthisprior
approval.
C. TaqdirshouldhaveinformedthechiefexecutiveofXarathatheisgoingtoreceivea
letterfromtheorganization.
D. Taqdirshouldhaverequestedtheapprovalofhiscolleaguebeforedisclosingthenameof
thechiefexecutiveofXara.

20StudySession01:
14. Muhammad Taqdir, CFA, is an investment manager whose clients are highnet worth
individuals.Taqdirisamemberofalocalcharityorganizationthatsupportschildrenwithasthma.
During a meeting at the charity, Taqdir recommends that the organization sends a letter to Xara
Corporation requesting they make a donation to the charity. Taqdir knows of Xara Corporations
involvement in this cause from previous discussions with a colleague in the office. The chief
executive and owner of Xara Corporation is a client of the firm. The charity, citing Taqdirs
recommendation,senttheletterandreceivedasubstantialdonation.AccordingtotheCFAInstitute
CodeandStandards:
A.
Taqdir has done his best since the organisation received a substantial donation.
B.
Taqdir should not have disclosed the identity of the chief executive without his prior approval.
C.
Taqdir should have informed the chief executive of Xara that he is going to receive a letter from the
organization.
D.
Taqdir should have requested the approval of his colleague before disclosing the name of the chief
executive of Xara.
CorrectAnswer:

B............................................................................................ LOS:Reading2b

Regardless of the fact that that the organization finally received the substantial donation, Tariq has
violated the preservation of confidentiality under Standard III(E), Preservation of Confidentiality, in
disclosing the name of the chief executive and owner of Xara without prior knowledge of both the chief
executive and his colleague.
Reference:CFAProgramCurriculum,Volume1,pp.6769.

EthicalandProfessionalStandards21
15. Marco Maggio, CFA, is scheduled to visit the corporate headquarters of Venus Industries.
MaggioexpectstousetheinformationobtainedtheretocompletehisresearchreportonVenusstock.
ThelocationofVenusIndustriesiswithina15minutedriveofaprestigiousgolfcourse.Onarrivalat
theVenuspremises,MarcoMaggiolearnsthatVenusisofferingMaggioanextensionofhisstaythat
weekendandinviteshimforadayofgolfwithallexpensespaid.VenusIndustriesalsoofferstopay
foralltheexpensesforthetrip,includingthecostofmeals,hotelroom,andairtransportationbackto
VenusIndustries.Thetotalcostfortheweekendisabout$2,000.
Which of the following actions would be the best course for Maggio to take under the Code and
Standards?
A. Payforalltravelexpenses,includingcostsofmealsandincidentalitemsandpolitely
rejectthegolfoutingoffer.
B.
Rejectthegolfoutingofferbutacceptthereimbursementofthetravelexpensessince
theyarelegitimatebusinessrelatedexpenses.
C. Acceptboththeexpensespaidtripandthegolfoutingasmoreinformationcanoftenbe
extractedfromthecompanyinamoreleisurelyenvironment.
D. Accepttheexpensespaidtripanddisclosethevalueofthetripinthereport,butitisat
Maggiosdiscretiontotakethegolfoutingofferwithoutdisclosingitasitoccursoutside
workinghours.

22StudySession01:
15. Marco Maggio, CFA, is scheduled to visit the corporate headquarters of Venus Industries.
MaggioexpectstousetheinformationobtainedtheretocompletehisresearchreportonVenusstock.
ThelocationofVenusIndustriesiswithina15minutedriveofaprestigiousgolfcourse.Onarrivalat
theVenuspremises,MarcoMaggiolearnsthatVenusisofferingMaggioanextensionofhisstaythat
weekendandinviteshimforadayofgolfwithallexpensespaid.VenusIndustriesalsoofferstopay
foralltheexpensesforthetrip,includingthecostofmeals,hotelroom,andairtransportationbackto
VenusIndustries.Thetotalcostfortheweekendisabout$2,000.
Which of the following actions would be the best course for Maggio to take under the Code and
Standards?
A.
Pay for all travel expenses, including costs of meals and incidental items and politely reject the golf
outing offer.
B.
Reject the golf outing offer but accept the reimbursement of the travel expenses since they are
legitimate business-related expenses.
C.
Accept both the expenses-paid trip and the golf outing as more information can often be extracted
from the company in a more leisurely environment.
D.
Accept the expenses-paid trip and disclose the value of the trip in the report, but it is at Maggios
discretion to take the golf outing offer without disclosing it as it occurs outside working hours.
CorrectAnswer:

A ........................................................................................... LOS:Reading2b

Maggio risks violating Standard I(B) Independence and Objectivity because accepting any significant gift
may impede his independence and objectivity. He should pay, whenever possible, for his own travel
expenses and not accept the golf outing.
Reference:CFAProgramCurriculum,Volume1,pp.2129.

EthicalandProfessionalStandards23
16. SimonFreud,CFA,isaprivateclientinvestmentmanageratSuperEchoinvestmentfirmbased
in Vienna, Austria. One of his clients in Monaco offers him bonus compensation beyond that
provided by his firm if the portfolio performance exceeds the agreed benchmark. To make it more
attractivetoFreud,hisclientwillsendthebonuscompensationtoataxfreeaccountinataxhaven.
Freud:
A. shouldreportthesituationtothecomplianceofficeroftheCFAInstituteaccordingto
StandardI(B)IndependenceandObjectivity.
B.
shouldturndowntheadditionalcompensationofferbecauseitviolatesStandardIV(B)
AdditionalCompensationArrangements.
C. mayaccepttheadditionalcompensationsubjecttotheapprovalofhisemployeras
requiredbyStandardIV(B)AdditionalCompensationArrangements.
D. isfreetoaccepttheadditionalcompensationinthetaxfreeaccount,aslongasthe
accountisnotunderthejurisdictionofeitherMonacoorAustria,itwillthereforealsobe
outsidethejurisdictionoftheCodeandStandards.

24StudySession01:
16. SimonFreud,CFA,isaprivateclientinvestmentmanageratSuperEchoinvestmentfirmbased
in Vienna, Austria. One of his clients in Monaco offers him bonus compensation beyond that
provided by his firm if the portfolio performance exceeds the agreed benchmark. To make it more
attractivetoFreud,hisclientwillsendthebonuscompensationtoataxfreeaccountinataxhaven.
Freud:
A.
should report the situation to the compliance officer of the CFA Institute according to Standard
I(B) Independence and Objectivity.
B.
should turn down the additional compensation offer because it violates Standard IV(B) Additional
Compensation Arrangements.
C.
may accept the additional compensation subject to the approval of his employer as required by
Standard IV(B) Additional Compensation Arrangements.
D.
is free to accept the additional compensation in the tax-free account, as long as the account is not
under the jurisdiction of either Monaco or Austria, it will therefore also be outside the jurisdiction of the
Code and Standards.
CorrectAnswer:

C ........................................................................................... LOS:Reading2b

Standard IV(B) Additional Compensation Arrangements does not prohibit the acceptance of additional
compensation as long as approval from the employer is obtained. The tax-free account is a separate issue
and will have to be viewed in light of tax rules and regulations.
Reference:CFAProgramCurriculum,Volume1,pp.7576.

EthicalandProfessionalStandards25
17. JosephLuny,CFA,isabankanalystwithLondonFogSecurities.Onarecenttriptoseeabank
that he covers, he was presented with a rosy outlook for the banks earnings in the next two years
which is above the consensus expectations. When probed further about the assumptions, the CFO
inadvertentlymentionedthatseriousdiscussionsaretakingplaceforatenderofferofasmallerwell
managed bank that Luny also covers. This information has not been made public. Luny feels very
luckytoreceivethisunexpectedtipandrushesbacktohisofficetorevisehisprojectionsandadvise
hismajorclientstobuythesmallerbanksstock.WhatshouldLunyhavedoneinstead?
A.

Luny should request his supervisors approval.

B.

Luny is entitled to take advantage of the information as he did not misappropriate it.

C.
Luny should refrain from taking any action on the smaller banks stock until the bank has
made the tender offer information public.
D.
Luny should encourage the bank to disclose the tender offer information to the public but
is free to take advantage of the information in the meantime.

26StudySession01:
17. JosephLuny,CFA,isabankanalystwithLondonFogSecurities.Onarecenttriptoseeabank
that he covers, he was presented with a rosy outlook for the banks earnings in the next two years
which is above the consensus expectations. When probed further about the assumptions, the CFO
inadvertentlymentionedthatseriousdiscussionsaretakingplaceforatenderofferofasmallerwell
managed bank that Luny also covers. This information has not been made public. Luny feels very
luckytoreceivethisunexpectedtipandrushesbacktohisofficetorevisehisprojectionsandadvise
hismajorclientstobuythesmallerbanksstock.WhatshouldLunyhavedoneinstead?
A.
Luny should request his supervisors approval.
B.
Luny is entitled to take advantage of the information as he did not misappropriate it.
C.
Luny should refrain from taking any action on the smaller banks stock until the bank has made the
tender offer information public.
D.
Luny should encourage the bank to disclose the tender offer information to the public but is free to
take advantage of the information in the meantime.
CorrectAnswer:

C ........................................................................................... LOS:Reading2b

Under Standard II(A) Material Nonpublic Information Lung should not act or cause others to act on this
information . If it is not appropriate to encourage public dissemination of the information he can only
communicate the information to his supervisor or compliance department.
Reference:CFAProgramCurriculum,Volume1,pp.3645.

EthicalandProfessionalStandards27
18. Marianne Warner, CFA, is a portfolio manager at Creative Investment Management and in
charge of managingseveral discretionary portfolios. Her husband holds25 percent of theshares of
Gurita Corporation, a computer services company. In line with the high sector growth, Gurita
Corporation went public earlier in the year. The share price skyrocketed and the value of her
husbandsholdingwentupfrom$1millionpriortothepublicofferingto$8millionatthecurrent
marketprice.Warnerbelievesthatthecurrentmarketpriceistoohighandimmediatelyadvisesher
husband to sell half of his shares. She also recommends he put the proceeds into one of the
discretionaryportfoliossheiscurrentlymanaging.Whichoneisthebestanswer?
A.

WarnerdoesnotviolatetheCodeandStandards.

B.

WarnerviolatestheCodeandStandardsforfailingtodisclosetheconflictsofinterest.

C.

WarnerviolatestheCodeandStandardsforpossessingmaterialnonpublicinformation.

D. WarnerviolatestheCodeandStandardsforfailingtodiscloseadditionalcompensation
arrangements.

28StudySession01:
18. Marianne Warner, CFA, is a portfolio manager at Creative Investment Management and in
charge of managingseveral discretionary portfolios. Her husband holds25 percent of theshares of
Gurita Corporation, a computer services company. In line with the high sector growth, Gurita
Corporation went public earlier in the year. The share price skyrocketed and the value of her
husbandsholdingwentupfrom$1millionpriortothepublicofferingto$8millionatthecurrent
marketprice.Warnerbelievesthatthecurrentmarketpriceistoohighandimmediatelyadvisesher
husband to sell half of his shares. She also recommends he put the proceeds into one of the
discretionaryportfoliossheiscurrentlymanaging.Whichoneisthebestanswer?
A.
Warner does not violate the Code and Standards.
B.
Warner violates the Code and Standards for failing to disclose the conflicts of interest.
C.
Warner violates the Code and Standards for possessing material non-public information.
D.
Warner violates the Code and Standards for failing to disclose additional compensation
arrangements.
CorrectAnswer:

A ........................................................................................... LOS:Reading2b

Choice B would apply if the advice was given when one or more of the portfolios contain Gurita shares.
There is no mention of material nonpublic information or additional compensation so Warner has not
violated any of the Standards.
Reference:CFAProgramCurriculum,Volume1,pp.3645.

EthicalandProfessionalStandards29
19. The Professional Conduct staff under the direction of CFA Institute are least likely to make an
enquiryintoamembersconductwhen:
A.

theyperformrandomchecksonmembersprofessionalconduct.

B.

theyreceiveawrittencomplaintregardingamembersprofessionalconduct.

C. themediareportsonamemberwhoseprofessionalconductappearstohavebeen
unethical.
D. membersselfdiscloseontheirProfessionalConductStatementthattheyareinvolvedin
litigationregardingtheirinvestmentadvice.

20. JonathanSeller,CFA,worksforaninvestmentbankthatisactingastheprincipalunderwriterfor
anissueofstockofalargetiremanufacturer.Sellerfoundoutthattheprospectushasconcealedan
impending product recall due to a quality control error. Since the number of items affected is
relatively small, the product recall is planned to be a quiet affair. However Seller is aware that
recentlyacompetitorsproductrecallreceivedalargeamountofadversepublicity.Thepreliminary
prospectushasbeendistributed.AccordingtotheCodeandStandards:
A.

Seller should do nothing as it may jeopardize the success of the issue.

B.
Seller should revise the preliminary prospectus to include the omitted information to avoid
any possible misrepresentation.
C.
Seller should inform CFA Institute of the violation of the Code and Standards so he can
clear himself of the possible misrepresentation.
D.
Seller should inform his supervisor and let him/her deal with the situation since Seller
himself should not jeopardize the success of the issue.

30StudySession01:
19. The Professional Conduct staff under the direction of CFA Institute are least likely to make an
enquiryintoamembersconductwhen:
A.
they perform random checks on members professional conduct.
B.
they receive a written complaint regarding a members professional conduct.
C.
the media reports on a member whose professional conduct appears to have been unethical.
D.
members self-disclose on their Professional Conduct Statement that they are involved in litigation
regarding their investment advice.
CorrectAnswer:

D .......................................................................................................Reading1a

There is no mention of CFA Institute performing random checks on members (or candidates) behavior.
The circumstances that might prompt an enquiry are self-disclosure by a member, written complaints,
media or other public sources providing information, or whenever a candidate is suspected of comprising
their professional conduct during an examination.
Reference:CFAProgramCurriculum,Volume1,p.9.

20. JonathanSeller,CFA,worksforaninvestmentbankthatisactingastheprincipalunderwriterfor
anissueofstockofalargetiremanufacturer.Sellerfoundoutthattheprospectushasconcealedan
impending product recall due to a quality control error. Since the number of items affected is
relatively small, the product recall is planned to be a quiet affair. However Seller is aware that
recentlyacompetitorsproductrecallreceivedalargeamountofadversepublicity.Thepreliminary
prospectushasbeendistributed.AccordingtotheCodeandStandards:
A.
Seller should do nothing as it may jeopardize the success of the issue.
B.
Seller should revise the preliminary prospectus to include the omitted information to avoid any
possible misrepresentation.
C.
Seller should inform CFA Institute of the violation of the Code and Standards so he can clear
himself of the possible misrepresentation.
D.
Seller should inform his supervisor and let him/her deal with the situation since Seller himself
should not jeopardize the success of the issue.
CorrectAnswer:

B....................................................................................................... Reading2b

Standard V requires that members shall make reasonable and diligent efforts to avoid any material
misrepresentation in any research report or investment recommendation. B is the best answer.
Reference:CFAProgramCurriculum,Volume1,pp.8081.

EthicalandProfessionalStandards31
21. TamaraDeneuve,CFA,isaninvestmentmanagerinchargeofAsianequityportfolios.Together
withhercolleagues,shehasdevelopedanewproprietaryvaluationmodelforemergingmarketsin
Asia. Back testing using 12month earnings data, the valuation model produces favorable results
particularlywhenappliedtocertainindustries,butnottoothers.Deneuvehasdecidedtoimplement
thenewmodeltothoseindustriesbutusetheusualmodelfortheothers.AccordingtotheCodeand
Standards:
A.

Deneuvemustinformherclientspriortoimplementingthemodel.

B.

Deneuvehasthesolerighttoanyproprietarymodelshehasdeveloped.

C. Deneuveshouldnotimplementthemodelsinceitcanonlybeappliedtocertain
industries.
D. Deneuvemayimplementthenewmodelwithoutinformingherprivateclientssincethey
wouldbeunlikelytounderstandthemodel.

22. WhichofthefollowingisnotaconceptcoveredbytheCFAInstituteCodeofEthics?
A.

Competence.

B.

Integrityanddiligence.

C.

Independentjudgment.

D.

Remunerationlevelsofinvestmentprofessionals.

32StudySession01:
21. TamaraDeneuve,CFA,isaninvestmentmanagerinchargeofAsianequityportfolios.Together
withhercolleagues,shehasdevelopedanewproprietaryvaluationmodelforemergingmarketsin
Asia. Back testing using 12month earnings data, the valuation model produces favorable results
particularlywhenappliedtocertainindustries,butnottoothers.Deneuvehasdecidedtoimplement
thenewmodeltothoseindustriesbutusetheusualmodelfortheothers.AccordingtotheCodeand
Standards:
A.
Deneuve must inform her clients prior to implementing the model.
B.
Deneuve has the sole right to any proprietary model she has developed.
C.
Deneuve should not implement the model since it can only be applied to certain industries.
D.
Deneuve may implement the new model without informing her private clients since they would be
unlikely to understand the model.
CorrectAnswer:

A ........................................................................................... LOS:Reading2b

The application of a new valuation model may constitute a significant change to the investment process.
Her clients must be informed in advance and given sufficient time to evaluate and decide whether such
changes have a significant impact to their situation. This falls under Standard V(B) Communication with
Clients and Prospective Clients.
Reference:CFAProgramCurriculum,Volume1,pp.8387.

EthicalandProfessionalStandards33
22. WhichofthefollowingisnotaconceptcoveredbytheCFAInstituteCodeofEthics?
A.
B.
C.
D.

Competence.
Integrity and diligence.
Independent judgment.
Remuneration levels of investment professionals.

CorrectAnswer:

D ........................................................................................... LOS:Reading1c

Remuneration of investment professionals is not explicitly covered in the Code of Ethics. Disclosure of
compensation is stipulated in Standard IV(B) Additional Compensation Arrangements and in Standard
VI(C) Referral Fees.
Reference:CFAProgramCurriculum,Volume1,pp.1214.

34StudySession02:

Study session 02: Quantitative Methods:


Basic Concepts

Thisintroductorystudysessionpresentsthefundamentalsofthosequantitativetechniquesthatare
essentialinalmostanytypeoffinancialanalysis,andwhichwillbeusedthroughouttheremainderof
theCFAcurriculum.Thissessionintroducestwomainbuildingblocksofthequantitativeanalytical
toolkit:(1)thetimevalueofmoneyand(2)statisticsandprobabilitytheory.
Thetimevalueofmoneyconceptisoneofthemainprinciplesoffinancialvaluation.Thecalculations
basedonthisprinciple(e.g.,presentvalue,futurevalue,andinternalrateofreturn)arethebasictools
usedtosupportcorporatefinancedecisionsandestimatethefairvalueoffixedincome,equity,orany
othertypeofsecurityorinvestment.
Similarly,thebasicconceptsofstatisticsandprobabilitytheoryconstitutetheessentialtoolsusedin
describing the main statistical properties of a population and understanding and applying various
probabilityconceptsinpractice.

Reading5:TheTimeValueofMoney
Reading6:DiscountedCashFlowApplications
Reading7:StatisticalConceptsandMarketReturns
Reading8:ProbabilityConcepts

QuantitativeMethods:BasicConcepts35
1. Thefollowingincomestreamswillbepaidfromaninvestment:
Endyear1

$15,000

Endyear2

$25,000

Endyear3

$10,000

Attheendofyear3theinvestmentwillhavenoremainingvalue.Ifthediscountrateis8%the
presentvalueoftheinvestmentisclosestto:
A.

$38,580.

B.

$39,692.

C.

$43,260.

D.

$46,721.

2. Ananalyststates.theoddsagainstthecompanyincreasingitsdividendaretwelvetoone.
Thismeansthattheanalystbelievesthattheprobabilityofitincreasingthedividendisclosestto:
A.

0.0769.

B.

0.0833.

C.

0.9166.

D.

0.9230.

36StudySession02:
1. Thefollowingincomestreamswillbepaidfromaninvestment:
End year 1
End year 2
End year 3

$15,000
$25,000
$10,000

At the end of year 3 the investment will have no remaining value. If the discount rate is 8% the present
value of the investment is closest to:
A.
$38,580.
B.
$39,692.
C.
$43,260.
D.
$46,721.
CorrectAnswer:

PV =

C ........................................................................................... LOS:Reading5d

$15,000 $25,000 $10,000


+
+
1.08
(1.08)2 (1.08)3

= $13,889 + $21,433 + $7,938 = $43,260


Reference:CFAProgramCurriculum,Volume1,pp.197198.

2. Ananalyststates.theoddsagainstthecompanyincreasingitsdividendaretwelvetoone.
Thismeansthattheanalystbelievesthattheprobabilityofitincreasingthedividendisclosestto:
A.
B.
C.
D.

0.0769.
0.0833.
0.9166.
0.9230.

CorrectAnswer:

A ............................................................................................ LOS:Reading8c

Odds against of twelve to one, means the probability is 1/(12 + 1) = 0.0769, there is a one in thirteen chance
it will happen.
Reference:CFAProgramCurriculum,Volume1,pp.320321.

QuantitativeMethods:BasicConcepts37
3. Aportfolioincreasesinvaluefrom$10millionto$12millionoverthefirstyear.Newcashof$2
millionistheninvestedinthefundandthefundincreasesinvalueto$15millionattheendofthe
secondyear.Themoneyweightedandtimeweightedratesofreturnareclosestto(respectively):
A.

12.8%,13.4%.

B.

12.8%,27.1%.

C.

13.4%,22.5%.

D.

14.0%,22.5%.

4. If a credit card company charges interest at a rate of 15% compounded monthly, then the
effectiveannualrateofinterestisclosestto:
A.

10.03%.

B.

14.04%.

C.

15.86%.

D.

16.08%.

38StudySession02:
3. Aportfolioincreasesinvaluefrom$10millionto$12millionoverthefirstyear.Newcashof$2
millionistheninvestedinthefundandthefundincreasesinvalueto$15millionattheendofthe
secondyear.Themoneyweightedandtimeweightedratesofreturnareclosestto(respectively):
A.
B.
C.
D.

12.8%, 13.4%.
12.8%, 27.1%.
13.4%, 22.5%.
14.0%, 22.5%.

CorrectAnswer:

A ............................................................................................ LOS:Reading6c

15

10 +
=
The money-weighted return is calculated by solving
(
1 + R ) (1 + R )2
So, R = 12.8%.
The time-weighted return is the geometric average of the returns in each period,

(1.20)(1.0714) = (1 + r ) 2 so r = 13.39%
Reference:CFAProgramCurriculum,Volume1,pp.222223.

4. If a credit card company charges interest at a rate of 15% compounded monthly, then the
effectiveannualrateofinterestisclosestto:
A.
B.
C.
D.

10.03%.
14.04%.
15.86%.
16.08%.

CorrectAnswer:

D ............................................................................................ LOS:Reading5c
m

EAR = 1 + S 1
m

= (1 + 0.0125) 1
= 16.08%
12

Reference:CFAProgramCurriculum,Volume1,pp.182183.

QuantitativeMethods:BasicConcepts39
5. A manager is offered two investments projects X and Y with net cash flows, in $ million, from
eachinvestmentasshownbelow.ThecostofXis$2millionandthecostofYis$10million.Thecost
ofcapitalforXis10%andforYis8%.Whichshouldbeacceptedforinvestment?

EndofYear

1.1

3.0

1.8

9.0

A.

Bothprojectsshouldbeaccepted.

B.

XshouldbeacceptedandYrejected.

C.

YshouldbeacceptedandXrejected.

D.

Bothprojectsshouldberejected.

6. Whichisthelowestyieldona90dayTreasurybill?
A.

Bankdiscountyield.

B.

Holdingperiodyield.

C.

Moneymarketyield.

D.

Effectiveannualyield.

40StudySession02:
5. A manager is offered two investments projects X and Y with net cash flows, in $ million, from
eachinvestmentasshownbelow.ThecostofXis$2millionandthecostofYis$10million.Thecost
ofcapitalforXis10%andforYis8%.Whichshouldbeacceptedforinvestment?

EndofYear
1
2
A.

Bothprojectsshouldbeaccepted.

B.

XshouldbeacceptedandYrejected.

C.

YshouldbeacceptedandXrejected.

D.

Bothprojectsshouldberejected.

X
1.1
1.8

Y
3.0
9.0

CorrectAnswer:

A ............................................................................................LOS:Reading6a
N

NPV (X) =

CFt

t =0

(1 + r )

CFt

NPV (Y) =

t =0

(1 + r )

1.1
1.8
+
= 0.49
1.10 1.10 2

= 2 +

= 10 +

3.0
9.0
+
= 0.49
1.08 1.08 2

Both investments have positive NPVs so they should both be accepted.


Reference:CFAProgramCurriculum,Volume1,pp.214216.

6. Whichisthelowestyieldona90dayTreasurybill?
A.
B.
C.
D.

Bank discount yield.


Holding period yield.
Money market yield.
Effective annual yield.

CorrectAnswer:

B............................................................................................ LOS:Reading6d

The holding period yield is not an annualized figure, so for 90-day paper it will be the lowest yield. The
highest will be the effective annual yield, followed by the money market yield, followed by the bank
discount yield. This is a result of the compounding in the effective annual yield calculation, and the money
market yield being based on the purchase price, whereas the bank discount yield is based on the maturity
value.
Reference:CFAProgramCurriculum,Volume1,pp.229233.

QuantitativeMethods:BasicConcepts41
7. The probability of a customer in a restaurant ordering potatoes is 40%, the probability of them
ordering rice is 60% and the probability of them ordering both is 10%. What is the probability of a
customer,chosenatrandom,orderingneitherpotatoesnorrice?
A.

0.00.

B.

0.10.

C.

0.14.

D.

0.24.

8. If a credit card company charges interest at a rate of 15% compounded monthly, then the
effectiveannualrateofinterestisclosestto:
A.

10.03%.

B.

14.04%.

C.

15.86%.

D.

16.08%.

42StudySession02:
7. The probability of a customer in a restaurant ordering potatoes is 40%, the probability of them
ordering rice is 60% and the probability of them ordering both is 10%. What is the probability of a
customer,chosenatrandom,orderingneitherpotatoesnorrice?
A.
B.
C.
D.

0.00.
0.10.
0.14.
0.24.

CorrectAnswer:

B.............................................................................................LOS:Reading8e

Use the general rule of addition to calculate the probability that a customer orders either potatoes or rice:
P(A or B) = P(A) + P(B) P(A and B)
= 0.4 + 0.6 0.1 = 0.9
The probability of a customer ordering neither is 1 0.9 = 0.1
Reference:CFAProgramCurriculum,Volume1,pp.325326.

8. If a credit card company charges interest at a rate of 15% compounded monthly, then the
effectiveannualrateofinterestisclosestto:
A.
B.
C.
D.

10.03%.
14.04%.
15.86%.
16.08%.

CorrectAnswer:

D ............................................................................................ LOS:Reading5c
m

EAR = 1 + S 1
m

= (1 + 0.0125) 1
= 16.08%
12

Reference:CFAProgramCurriculum,Volume1,pp.182183.

QuantitativeMethods:BasicConcepts43
9. Ashopwhichsellsmatchesknowsthat14outof20boxesofmatcheswillcontain100matches
exactly;theremainderwillcontainmorethan100matches.Theprobabilityofacustomerpickingup
aboxofmatchesthatcontainsmorethan100matches,andthenpickingupasecondboxcontaining
morethan100matchesisclosestto:
A.

0.06.

B.

0.08.

C.

0.09.

D.

0.12.

10. IfP(A|B)=P(A)thentheeventsAandBare:
A.

exhaustive.

B.

independent.

C.

mutuallyexclusive.

D.

equallylikelytooccur.

44StudySession02:
9. Ashopwhichsellsmatchesknowsthat14outof20boxesofmatcheswillcontain100matches
exactly;theremainderwillcontainmorethan100matches.Theprobabilityofacustomerpickingup
aboxofmatchesthatcontainsmorethan100matches,andthenpickingupasecondboxcontaining
morethan100matchesisclosestto:
A.
B.
C.
D.

0.06.
0.08.
0.09.
0.12.

CorrectAnswer:

B.............................................................................................LOS:Reading8e

Use the general rule of multiplication, which says that:


P(A and B) = P(A) P(B|A)
= 6/20 5/19
= 0.08

Reference:CFAProgramCurriculum,Volume1,pp.323324.

10. IfP(A|B)=P(A)thentheeventsAandBare:
A.
B.
C.
D.

exhaustive.
independent.
mutually exclusive.
equally likely to occur.

CorrectAnswer:

B............................................................................................. LOS:Reading8f

Two events are independent if the occurrence of one event does not affect the probability of the other
event occurring.
Reference:CFAProgramCurriculum,Volume1,p.327.

QuantitativeMethods:BasicConcepts45
11. A mortgage has an annual quoted interest rate of 12 percent. If mortgage payments are made
monthly,thentheeffectiveannualinterestrateisclosestto:
A.

11.40%.

B.

12.36%.

C.

12.55%.

D.

12.68%.

12. Aninvestorputs$50,000intoamutualfundattheendofeachquarterandhispurchaseprices
are$20,$25,$28,$23.Theaveragepricethathepayspershareisclosestto:
A.

$23.12.

B.

$23.64.

C.

$24.00.

D.

$24.50.

46StudySession02:
11. A mortgage has an annual quoted interest rate of 12 percent. If mortgage payments are made
monthly,thentheeffectiveannualinterestrateisclosestto:
A.
B.
C.
D.

11.40%.
12.36%.
12.55%.
12.68%.

CorrectAnswer:

D ............................................................................................ LOS:Reading5c

The effective annual rate (EAR) is given by:


m

r
EAR = 1 + S 1
m
where
m
rs

=
=

number of compounding periods per year


quoted annual interest rate

EAR = (1.01)12 - 1
= 12.68%
Reference:CFAProgramCurriculum,Volume1,pp.179180.

12. Aninvestorputs$50,000intoamutualfundattheendofeachquarterandhispurchaseprices
are$20,$25,$28,$23.Theaveragepricethathepayspershareisclosestto:
A.
B.
C.
D.

$23.12.
$23.64.
$24.00.
$24.50.

CorrectAnswer:

B............................................................................................ LOS:Reading7d

The harmonic mean is the average price on a per share basis.

XH =

n
n 1

i =1 X i

4
1
1
1
1
+
+
+
20 25 28 23

4
= $23.64
0.1692

Reference:CFAProgramCurriculum,Volume1,p.272.

QuantitativeMethods:BasicConcepts47
13. The value of a portfolio starts at $100 million, at the end of the first year it has fallen to $80
million,attheendofthesecondyearithasrisento$105million,andattheendofthethirdyearit
hasrisento$115million.Thegeometricmeanrateofreturnisclosestto:
A.

3.2%.

B.

4.1%.

C.

4.8%.

D.

6.7%.

14. Adepositof$1,000,000earnsareturnof5%compoundedcontinuouslyfor8years.Thefuture
valueisclosestto:
A.

$1,400,000.

B.

$1,477,000.

C.

$1,492,000.

D.

$1,500,000.

48StudySession02:
13. The value of a portfolio starts at $100 million, at the end of the first year it has fallen to $80
million,attheendofthesecondyearithasrisento$105million,andattheendofthethirdyearit
hasrisento$115million.Thegeometricmeanrateofreturnisclosestto:
A.
B.
C.
D.

3.2%.
4.1%.
4.8%.
6.7%.

CorrectAnswer:

C ........................................................................................... LOS:Reading7d

R G = = (1 + R 1 )(1 + R 2 ).....(1 + R n ) 1
= (0.80 x 1.313 x 1.095) 1/3 1
= 0.0476
Reference:CFAProgramCurriculum,Volume1,pp.269270.

14. Adepositof$1,000,000earnsareturnof5%compoundedcontinuouslyfor8years.Thefuture
valueisclosestto:
A.
B.
C.
D.

$1,400,000.
$1,477,000.
$1,492,000.
$1,500,000.

CorrectAnswer:

C ........................................................................................... LOS:Reading8d

FV N = PV e rS N
The future value is given by

= $1,000 ,000 e 0.058


= $1, 491,825

Note: to find the programmed value of e on your CFA Institute-approved financial calculator, use the
keystrokes:

HP12C
BAIIPlus

1gex
12nd[ex]

2.7183
2.7183

Reference:CFAProgramCurriculum,Volume1,pp.171182.

QuantitativeMethods:BasicConcepts49
15. There isa competition inwhich thereare six contestants andyou need to pick winners for 1st,
2ndand3rdplaces,howmanywayscantheybeselected?
A.

20.

B.

36.

C.

120.

D.

720.

16. Thefollowinginformationwascollectedontheaveragenumbersofhoursworkedperdaybythe
15employeesofashopoverthelastmonth:
5

Themean,medianandmodeareclosestto:

Mean

Median

Mode

A.

5.4

5.0

6.0

B.

5.0

6.0

5.4

C.

5.4

5.0

5.0

D.

5.0

6.0

5.0

50StudySession02:
15. There isa competition inwhich thereare six contestants andyou need to pick winners for 1st,
2ndand3rdplaces,howmanywayscantheybeselected?
A.

20.

B.

36.

C.

120.

D.

720.

CorrectAnswer:

C ........................................................................................... LOS:Reading8n

This requires the permutation formula since the order of the r objects matters, so apply:

n!
Number of ways = ( n r )! = 6!/(6 3)! = 120
Reference:CFAProgramCurriculum,Volume1,p.356.

16. Thefollowinginformationwascollectedontheaveragenumbersofhoursworkedperdaybythe
15employeesofashopoverthelastmonth:
5
58 4
4
6
7
6
54 2
7
7
5
The mean, median and mode are closest to:
Mean
Median
A.
5.4
5.0
6.0
B.
5.0
6.0
5.4
C.
5.4
5.0
5.0
D.
5.0
6.0
5.0
CorrectAnswer:

Mode

C ........................................................................................... LOS:Reading7d

w i Xi
w
Mean = X = i = [1(2) + 3(4) + 4(5) +3(6) +3(7) +1(8)]/15 = 5.4
The median is the middle observation, which is 5.
The mode is the most frequently occurring observation, which is 5.
Reference:CFAProgramCurriculum,Volume1,pp.255263.

QuantitativeMethods:BasicConcepts51
17. Which of the following statements is most accurate regarding a moneyweighted rate of return
foraportfolio?
A.

Itistheinternalrateofreturn.

B.

Itisalwayslowerthanthetimeweightedrateofreturn.

C.

Itisthearithmeticaverageoftheperiodicratesofreturn.

D.

Itisthegeometricaverageoftheperiodicratesofreturn.

18. Conditionalprobabilityrefersto:
A.

theprobabilitythataneventwillhappenmorethanonce.

B.

theprobabilitythattwoormoreeventswilloccurconcurrently.

C.

theprobabilitythatoneoftwomutuallyexclusiveeventswilloccur.

D. theprobabilityofaparticulareventoccurringgiventhatanothereventhasalready
occurred.

52StudySession02:
17. Which of the following statements is most accurate regarding a moneyweighted rate of return
foraportfolio?
A.
B.
C.
D.

It is the internal rate of return.


It is always lower than the time-weighted rate of return.
It is the arithmetic average of the periodic rates of return.
It is the geometric average of the periodic rates of return.

CorrectAnswer:

A ............................................................................................ LOS:Reading6c

B will not be true if there have been cash flows into the portfolio before superior performance. C and D
refer to arithmetic and geometric time-weighted rates of return.
Reference:CFAProgramCurriculum,Volume1,pp.221229.

18. Conditionalprobabilityrefersto:
A.
B.
C.
D.

the probability that an event will happen more than once.


the probability that two or more events will occur concurrently.
the probability that one of two mutually exclusive events will occur.
the probability of a particular event occurring given that another event has already occurred.

CorrectAnswer:

D ........................................................................................... LOS:Reading8d

Conditional probability is the probability of an event occurring given another event has already occurred.
It is conditional on the other event.
Reference:CFAProgramCurriculum,Volume1,p.322.

QuantitativeMethods:BasicConcepts53
19. Thefollowingdataisprovidedonthequarterlyperformanceofafund.

1stQuarter
2ndQuarter
$1,000,000
$1,200,000
Beginning value
$100,000
$100,000
Cash inflow at beginning
$1,200,000
$1,500,000
Ending value
Thetimeweightedreturnfortheyearisclosestto:
A.

6.6%.

B.

28.7%.

C.

29.1%.

D.

61.4%.

3rdQuarter 4thQuarter
$1,500,000
$1,500,000
($200,000)
$300,000
$1,500,000
$1,600,000

20. Stock A has a coefficient of variation of 30% and stock B has a coefficient of variation of 60%.
Whichofthefollowingstatementsisthemostaccurate?
A.

The dispersion of returns relative to the mean is lower for stock A than stock B.

B.

The dispersion of returns relative to the mean is higher for stock A than stock B.

C.
The standard deviation of stock A is double that of stock B, if the mean returns of both
stocks are the same.
D.
The variance of stock A is double that of stock B, if the mean returns of both stocks are the
same.

54StudySession02:
19. Thefollowingdataisprovidedonthequarterlyperformanceofafund.

1stQuarter
2ndQuarter
$1,000,000
$1,200,000
Beginning value
$100,000
$100,000
Cash inflow at beginning
$1,200,000
$1,500,000
Ending value
Thetimeweightedreturnfortheyearisclosestto:
A.
B.
C.
D.

3rdQuarter
$1,500,000
($200,000)
$1,500,000

4thQuarter
$1,500,000
$300,000
$1,600,000

6.6%.
28.7%.
29.1%.
61.4%.

CorrectAnswer:

C ............................................................................................ LOS:Reading6c

The first step is to calculate the returns for each quarter:


Q1, HPR = ($1,200,000 - $1,100,000)/$1,100,000 = 9.09%
Q2, HPR = ($1,500,000 - $1,300,000)/$1,300,000 = 15.38%
Q3, HPR = ($1,500,000 - $1,300,000)/$1,300,000 = 15.38%
Q4, HPR = ($1,600,000 - $1,800,000)/$1,800,000 = -11.11%
Then calculate the geometric average to get the time-weighted return:
(1.0909) x (1.1538) x (1.1538) x (0.8889) 1 = 0.2909 = 29.1%
Reference:CFAProgramCurriculum,Volume1,pp.223226.

QuantitativeMethods:BasicConcepts55
20. Stock A has a coefficient of variation of 30% and stock B has a coefficient of variation of 60%.
Whichofthefollowingstatementsisthemostaccurate?
A.
The dispersion of returns relative to the mean is lower for stock A than stock B.
B.
The dispersion of returns relative to the mean is higher for stock A than stock B.
C.
The standard deviation of stock A is double that of stock B, if the mean returns of both stocks are
the same.
D.
The variance of stock A is double that of stock B, if the mean returns of both stocks are the same.
CorrectAnswer:

CV =

s
X

A............................................................................................LOS:Reading7h

X 100

Answers C and D are incorrect since, if the mean return is the same the standard deviation of stock A is
half that of B. The coefficient of variation measures the dispersion of returns relative to the mean return.
Reference:CFAProgramCurriculum,Volume1,pp.292294.

56StudySession02:
21. Ashopbuyspensfromtwomanufacturers,55%fromMountainPensand45%fromValleyPens.
The shop knows that 3% of the pens supplied by Mountain Pens are defective and 5% of the pens
suppliedbyValleyPensaredefective.Thepensintheshopsaremixedtogether.Ifapenischosenat
randomandfoundtobedefectivewhatistheprobabilitythatitwassuppliedbyMountainPens?
A.

33.3%.

B.

42.3%.

C.

55.0%.

D.

60.0%.

QuantitativeMethods:BasicConcepts57
22. Apersoninvests$10,000attheendofeachyearforthenexttenyears,iftheinvestmentearns6%
interestannually,thevalueoftheinvestmentattheendoftenyearswillbeclosestto:
A.

$131,808.

B.

$134,350.

C.

$139,708.

D.

$149,708.

58StudySession02:
21. Ashopbuyspensfromtwomanufacturers,55%fromMountainPensand45%fromValleyPens.
The shop knows that 3% of the pens supplied by Mountain Pens are defective and 5% of the pens
suppliedbyValleyPensaredefective.Thepensintheshopsaremixedtogether.Ifapenischosenat
randomandfoundtobedefectivewhatistheprobabilitythatitwassuppliedbyMountainPens?
A.
B.
C.
D.

33.3%.
42.3%.
55.0%.
60.0%.

CorrectAnswer:

B........................................................................................... LOS:Reading8m

P(A 1 | B) =
Apply Bayes formula:

P(A 1 )P(B | A 1 )
P(A 1 )P(B | A 1 ) + P(A 2 )P(B | A 2 )

define A1 - Mountain Pens supply the pen


A2 - Valley Pens supply the pen
B - the information that the pen is defective

P(A 1 | B) =

0.55 0.03
(0.55 0.03) + (0.45 0.05)

= 0.423
Reference:CFAProgramCurriculum,Volume1,pp.349353.

QuantitativeMethods:BasicConcepts59
22. Apersoninvests$10,000attheendofeachyearforthenexttenyears,iftheinvestmentearns6%
interestannually,thevalueoftheinvestmentattheendoftenyearswillbeclosestto:
A.
B.
C.
D.

$131,808.
$134,350.
$139,708.
$149,708.

CorrectAnswer:

A............................................................................................LOS:Reading5d

This is a question asking for the future value of an annuity, use the annuity formula or a financial
calculator:
This is an annuity type question.

Oruseafinancialcalculator.

Explicit use of annuity


formula:

Calculator keystrokes for:

A = $10,000
r = 6% = 0.06

f CLEAR FIN

N = 10
FVN = A

10000 CHS PMT

(1 + r )N 1

-10,000.00

6 i
10

= $10,000

BAIIPlus

HP12C

(1 + 0.06)

0.06

= $10,000 13.1808
= $131,808

6.00

10 n 10.00
FV

FV = 131,807.95

Reference:CFAProgramCurriculum,Volume1,pp.183185.

2nd [QUIT] 2nd [CLR TVM]


10000 +/- PMT
= -10,000.00
6 I/Y

I/Y = 6.00

10 N

N = 10.00

CPT FV

FV = 131,807.95

60StudySession03:

Study Session 03: Quantitative Methods:


Application

This study session introduces the discrete and continuous probability distributions that are most
commonlyusedtodescribethebehaviorofrandomvariables.Probabilitytheoryandcalculationsare
widely applied in finance, for example, in the field of investment and project valuation and in
financialriskmanagement.
Furthermore, this session teaches how to estimate different parameters (e.g., mean and standard
deviation) of a population if only a sample, rather than the whole population, can be observed.
Hypothesistestingisacloselyrelatedtopic.Thissessionpresentsthetechniquesthatcanbeapplied
toacceptorrejectanassumedhypothesis(nullhypothesis)aboutvariousparametersofapopulation.
Finally,youwillalsolearnaboutthefundamentalsoftechnicalanalysis.Itisimportantthatanalysts
properly understand the assumptions and limitations when applying these tools as misspecified
modelsorimproperlyusedtoolscanresultinmisleadingconclusions.

Reading9:CommonProbabilityDistributions
Reading10:SamplingandEstimation
Reading11:HypothesisTesting
Reading12:TechnicalAnalysis

QuantitativeMethods:Applications61
1. Ananalystisselectingasamplefromtheordersreceivedfromafirmscustomers.Theordersare
timestampedandhedecidestoincludeinthesampleevery5thorderreceivedbythefirm.Thisisan
exampleof:
A.

clustersampling.

B.

simplerandomsampling.

C.

stratifiedrandomsampling.

D.

systematicrandomsampling.

2. Whichofthefollowingstatementsregardingnormaldistributionsismostaccurate?
A.

Thenormaldistributionisagoodmodelforthedistributionofassetprices.

B.

Themeanandstandarddeviationofthestandardnormaldistributionareboth1.

C. Astandardnormaldistributionwithlowstandarddeviationwillbelesspeakedthana
standardnormaldistributionwithhigherstandarddeviation.
D. Ifthereturnsonindividualsecuritiesinaportfolioarenormallydistributed,thereturns
ofaportfoliocontainingthesesecuritiesarenormallydistributed.

62StudySession03:
1. Ananalystisselectingasamplefromtheordersreceivedfromafirmscustomers.Theordersare
timestampedandhedecidestoincludeinthesampleevery5thorderreceivedbythefirm.Thisisan
exampleof:
A.
B.
C.
D.

cluster sampling.
simple random sampling.
stratified random sampling.
systematic random sampling.

CorrectAnswer:

D ......................................................................................... LOS:Reading10b

Systematic random sampling is when we select every kth member of a population, often used when we
cannot number or label the members of a population.
Reference:CFAProgramCurriculum,Volume1,pp.422423.

2. Whichofthefollowingstatementsregardingnormaldistributionsismostaccurate?
A.
The normal distribution is a good model for the distribution of asset prices.
B.
The mean and standard deviation of the standard normal distribution are both 1.
C.
A standard normal distribution with low standard deviation will be less peaked than a standard
normal distribution with higher standard deviation.
D.
If the returns on individual securities in a portfolio are normally distributed, the returns of a
portfolio containing these securities are normally distributed.
CorrectAnswer:

D ............................................................................................ LOS:Reading9f

The normal distribution is a good model for many asset returns but not prices. By definition a standard
normal distribution has a mean of 0 and standard deviation of 1, so statements B and C are not correct.
Statement D is accurate.
Reference:CFAProgramCurriculum,Volume1,pp.389397.

QuantitativeMethods:Applications63
3. Ahypothesisisastatementabouta:
A.

samplestatistic.

B.

sampleparameter.

C.

populationstatistic.

D.

populationparameter.

4. Acompanyisanalyzingthedaysthatemployeestakeoffassickleaveeachyearandisconcerned
thatthenumberofdaysthatemployeesaretakingoffhasrisenabovethepastaveragenumberof4.0
days. It is assumed that the population is approximately normally distributed. A sample of 20
employeesistakenandthemeannumberofdaystakenis4.5withastandarddeviationof1.5days.If
therejectionpointforaonetailedtestwith19degreesoffreedomis1.729atthe5%significancelevel
wecanconcludethat:
A.

usingthetstatisticisnotvalidforasmallsample.

B.

themeannumberofdaysismorethan4daysatthe5%significancelevel.

C.

themeannumberofdaysisstill4daysorlessatthe5%significancelevel.

D. weshouldusetheztest,notthettest,ifthepopulationisapproximatelynormally
distributed.

64StudySession03:
3. Ahypothesisisastatementabouta:
A.
B.
C.
D.

sample statistic.
sample parameter.
population statistic.
population parameter.

CorrectAnswer:

D ..........................................................................................LOS:Reading11a

A hypothesis is a statement about a population parameter. We use data from a sample to test whether we
should accept or reject the hypothesis.
Reference:CFAProgramCurriculum,Volume1,pp.456457.

4. Acompanyisanalyzingthedaysthatemployeestakeoffassickleaveeachyearandisconcerned
thatthenumberofdaysthatemployeesaretakingoffhasrisenabovethepastaveragenumberof4.0
days. It is assumed that the population is approximately normally distributed. A sample of 20
employeesistakenandthemeannumberofdaystakenis4.5withastandarddeviationof1.5days.If
therejectionpointforaonetailedtestwith19degreesoffreedomis1.729atthe5%significancelevel
wecanconcludethat:
A.
B.
C.
D.

using the t-statistic is not valid for a small sample.


the mean number of days is more than 4 days at the 5% significance level.
the mean number of days is still 4 days or less at the 5% significance level.
we should use the z-test, not the t-test, if the population is approximately normally distributed.

CorrectAnswer:

C ..........................................................................................LOS:Reading11e

Set the null hypothesis as H0: 4.0


We can use the t-test since we are assuming the population is normally distributed.

t 19 =

x
4.5 4.0
0.5
=
=
= 1.49
s
1.5 20 0.335
n

This is within the confidence interval so we do not reject the null hypothesis.
Reference:CFAProgramCurriculum,Volume1,pp.466474.

QuantitativeMethods:Applications65
5. Thestandarddeviationofapopulationis25andasampleof50observationsistakenfromthe
population.Thestandarderrorofthesamplemeanisclosestto:
A.

0.10.

B.

0.28.

C.

3.54.

D.

10.00.

6. Whichofthefollowingstatementsregardinglognormaldistributionsismostaccurate?
A.

Thedistributionisbellshaped.

B.

Themeanofthedistributioniszero.

C.

YisalognormaldistributionifLnYisnormallydistributed.

D.

Lognormaldistributionsarefrequentlyusedtoreflectthedistributionofstockreturns.

66StudySession03:
5. Thestandarddeviationofapopulationis25andasampleof50observationsistakenfromthe
population.Thestandarderrorofthesamplemeanisclosestto:
A.
B.
C.
D.

0.10.
0.28.
3.54.
10.00.

CorrectAnswer:

C ..........................................................................................LOS:Reading10e

The standard error of the sample mean is given by

x =

= 25/7.07 = 3.54.
Reference:CFAProgramCurriculum,Volume1,p.429.

6. Whichofthefollowingstatementsregardinglognormaldistributionsismostaccurate?
A.
B.
C.
D.

The distribution is bell shaped.


The mean of the distribution is zero.
Y is a lognormal distribution if LnY is normally distributed.
Lognormal distributions are frequently used to reflect the distribution of stock returns.

CorrectAnswer:
A.
B.
D.

C ............................................................................................ LOS:Reading9j

is not correct, they are positively skewed distributions.


is not correct, the lower bound is zero.
is not correct, they are frequently used to show the distribution of stock prices.

Reference:CFAProgramCurriculum,Volume1,pp.400406.

QuantitativeMethods:Applications67
7. Astockmarketrisesbyanaverageof10%ayearandthestandarddeviationofreturnsis6%.The
probabilityofthestockmarketfallingbymorethan2%inayearisclosestto:
A.

2.3%.

B.

4.6%.

C.

15.9%.

D.

31.7%.

8. The Central Limit Theorem states that if the sampling distribution of the sample mean is
calculatedusingsamplesofequalsizefromapopulationthatisnotnormal,then:
A.

itisapproximatelyanormaldistribution.

B.

thestandarderrortendstooneasthesizeofthesamplesincreases.

C.

themeanofthedistributionwillbesmallerthanthepopulationmean.

D.

thedispersionofthedistributionismorethanthedispersionofthepopulation.

68StudySession03:
7. Astockmarketrisesbyanaverageof10%ayearandthestandarddeviationofreturnsis6%.The
probabilityofthestockmarketfallingbymorethan2%inayearisclosestto:
A.
B.
C.
D.

2.3%.
4.6%.
15.9%.
31.7%.

CorrectAnswer:

A ............................................................................................LOS:Reading9g

A fall of 2% is two standard deviations from the mean. 95.4% of observations fall between the mean plus
or minus two standard deviations so 4.6% lie outside this range. Therefore 2.3% will be below -2% and
2.3% will be above 22%.
Reference:CFAProgramCurriculum,Volume1,pp.389393.

8. The Central Limit Theorem states that if the sampling distribution of the sample mean is
calculatedusingsamplesofequalsizefromapopulationthatisnotnormal,then:
A.
B.
C.
D.

it is approximately a normal distribution.


the standard error tends to one as the size of the samples increases.
the mean of the distribution will be smaller than the population mean.
the dispersion of the distribution is more than the dispersion of the population.

CorrectAnswer:

A .......................................................................................... LOS:Reading10f

B. is not correct, the standard error tends to zero as the sample size increases.
C. is not correct, the mean of the distribution will be the same as the population mean.
D. is not correct, the dispersion is less than that of the population, or equal if n = 1.
A is correct, the distribution will be approximately normal although the underlying population may not be
normally distributed.
Reference:CFAProgramCurriculum,Volume1,pp.428431.

QuantitativeMethods:Applications69
9. Historic analysis suggests that stocks trading on a low price/book value have tended to
outperformthemarket.Iftheanalysishasnotincludedcompaniesthathavegonebankruptthenthe
analysiscouldbebiaseddueto:
A.

lookaheadbias.

B.

dataminingbias.

C.

survivorshipbias.

D.

datasnoopingbias.

10. Hypothesis testing is used to determine the mean return of mutual funds in a single period. A
sampleof25fundsistakenandthenullhypothesisisdefinedasthemeanisequalto12%.Isthisan
exampleofaoneortwotailedtest,andshouldtheztestorttestbeused?

Hypothesistest

Teststatistic

A.

aonetailedtest

ttest

B.

aonetailedtest

ztest

C.

atwotailedtest

ttest

D.

atwotailedtest

ztest

70StudySession03:
9. Historic analysis suggests that stocks trading on a low price/book value have tended to
outperformthemarket.Iftheanalysishasnotincludedcompaniesthathavegonebankruptthenthe
analysiscouldbebiaseddueto:
A.
B.
C.
D.

look-ahead bias.
data-mining bias.
survivorship bias.
data-snooping bias.

CorrectAnswer:

C ......................................................................................... LOS:Reading10k

It has been argued that if all companies had been included, the companies that went bankrupt would have
been trading on low price/book multiples, and this would have lowered the average performance of the low
price/book value stocks.
Reference:CFAProgramCurriculum,Volume1,pp.444446.

10. Hypothesis testing is used to determine the mean return of mutual funds in a single period. A
sampleof25fundsistakenandthenullhypothesisisdefinedasthemeanisequalto12%.Isthisan
exampleofaoneortwotailedtest,andshouldtheztestorttestbeused?
A.
B.
C.
D.

Hypothesis test
a one-tailed test
a one-tailed test
a two-tailed test
a two-tailed test

CorrectAnswer:

Test statistic
t-test
z-test
t-test
z-test

C ..........................................................................LOS:Reading11aand11e

If there is no direction (greater or less than) in the null hypothesis it is two-tailed. Give the sample size of
less than 30 funds the t-test should be used. The z-test should only be used for large samples.
Reference:CFAProgramCurriculum,Volume1,pp.458and466474.

QuantitativeMethods:Applications71
11. An analyst is studying the monthly income of workers at a factory. He is told that the mean
incomeis$5,000permonthandhedecidedtolookatasample100workerstoseeifthisiscorrect.
The sample mean is $5,018 with a standard deviation of 80. If he sets the null hypothesis as the
populationmeanis$5,000heshould:
A.

rejectthenullhypothesisatboththe1%and5%significancelevel.

B.

notrejectthenullhypothesisatboththe1%and5%significancelevel.

C. notrejectthenullhypothesisatthe1%significancelevelbutrejectitatthe5%
significancelevel.
D. notrejectthenullhypothesisatthe5%significancelevelbutrejectitatthe1%
significancelevel.

12. Inhypothesistastingapvalueof0.1indicatesthat:
A.

thereisextremelystrongevidencethatH0shouldberejected.

B.

thereisextremelystrongevidencethatH0shouldnotberejected.

C. thereisaprobabilityof0.1ofobservingasamplevalueatleastasextremeasthevalue
observed,assumingH0iscorrect.
D. thereisaprobabilityof0.1ofobservingasamplevalueatleastasextremeasthevalue
observed,assumingH0isrejected.

72StudySession03:
11. An analyst is studying the monthly income of workers at a factory. He is told that the mean
incomeis$5,000permonthandhedecidedtolookatasample100workerstoseeifthisiscorrect.
The sample mean is $5,018 with a standard deviation of 80. If he sets the null hypothesis as the
populationmeanis$5,000heshould:
A.
B.
C.
D.

reject the null hypothesis at both the 1% and 5% significance level.


not reject the null hypothesis at both the 1% and 5% significance level.
not reject the null hypothesis at the 1% significance level but reject it at the 5% significance level.
not reject the null hypothesis at the 5% significance level but reject it at the 1% significance level.

CorrectAnswer:

C ..........................................................................................LOS:Reading11e

Z = (5018-5000)/8 = 2.25. This is less than 2.58 (the critical value for the 1% significance level) so there is no
evidence to reject the null hypothesis at the 1% level.. However it is more than 1.96 (the critical value for
the 5% significance level) so we can reject the hypothesis at the 5% significance level.
Reference:CFAProgramCurriculum,Volume1,pp.466474.

12. Inhypothesistastingapvalueof0.1indicatesthat:
A.
there is extremely strong evidence that H0 should be rejected.
B.
there is extremely strong evidence that H0 should not be rejected.
C.
there is a probability of 0.1 of observing a sample value at least as extreme as the value observed,
assuming H0 is correct.
D.
there is a probability of 0.1 of observing a sample value at least as extreme as the value observed,
assuming H0 is rejected.
CorrectAnswer:

C .......................................................................................... LOS:Reading11c

The p-value is the probability of observing a value as extreme or more extreme than the value observed, for
it to be extremely strong evidence it would need to be 0.001 or less.
Reference:CFAProgramCurriculum,Volume1,pp.465466.

QuantitativeMethods:Applications73
13. Youareanalyzingthemonthlyreturnsfromafundoverthelastyearandcalculatethatthemean
returnwas1.25%withasamplestandarddeviationof1.0%.Youexpectedthefundtohaveachieved
areturnof1.4%inlinewiththerisktakenonbythefundandwishtodecideatthe10%significance
levelwhethertheresultsareconsistentwithapopulationmeanreturnof1.4%.Giventhatt0.05,11=
1.796youcanconcludethat:
A.

thenullhypothesisisrejectedandtheresultsareconsistentwithameanof1.4%.

B.

thenullhypothesisisnotrejectedandtheresultsareconsistentwithameanof1.4%.

C.

thenullhypothesisisrejectedandtheresultsarenotconsistentwithameanof1.4%

D.

thenullhypothesisisnotrejectedandtheresultsarenotconsistentwithameanof1.4%

14. Achisquareteststatistic( )couldbeusedforhypothesistestsfor


2

A.

themeanforasinglenormallydistributedpopulation.

B.

thevarianceforasinglenormallydistributedpopulation.

C.

themeanforasinglenonnormallydistributedpopulation.

D.

thevarianceforasinglenonnormallydistributedpopulation.

74StudySession03:
13. Youareanalyzingthemonthlyreturnsfromafundoverthelastyearandcalculatethatthemean
returnwas1.25%withasamplestandarddeviationof1.0%.Youexpectedthefundtohaveachieved
areturnof1.4%inlinewiththerisktakenonbythefundandwishtodecideatthe10%significance
levelwhethertheresultsareconsistentwithapopulationmeanreturnof1.4%.Giventhatt0.05,11=
1.796youcanconcludethat:
A.
B.
C.
D.

the null hypothesis is rejected and the results are consistent with a mean of 1.4%.
the null hypothesis is not rejected and the results are consistent with a mean of 1.4%.
the null hypothesis is rejected and the results are not consistent with a mean of 1.4%
the null hypothesis is not rejected and the results are not consistent with a mean of 1.4%

CorrectAnswer:

B...........................................................................................LOS:Reading11e

Set the null hypothesis as H0: = 1.4%. We need to apply the t-test because it is a small sample.

t n 1 =

x
1.25 1.4
0.15
=
=
= 0.52
s
0.29
1.0 12
n

This is within the confidence interval so the null hypothesis is not rejected and the results are consistent
with the mean return being 1.4%.
Reference:CFAProgramCurriculum,Volume1,pp.466474.

14. Achisquareteststatistic( )couldbeusedforhypothesistestsfor


2

A.
B.
C.
D.

the mean for a single normally distributed population.


the variance for a single normally distributed population.
the mean for a single non-normally distributed population.
the variance for a single non-normally distributed population.

CorrectAnswer:

B........................................................................................... LOS:Reading11f

A chi-square test statistic is used to test for variance when we have a normally distributed population. It
is always 0 or a positive number and has different distributions based on the number of degrees of freedom.
Reference:CFAProgramCurriculum,Volume1,pp.482484.

QuantitativeMethods:Applications75
15. Large samples are taken from a normal population; the sample mean is 25 and the sample
standarddeviationis5.The95%confidenceintervalforthepopulationmeanisclosestto:
A.

between12.1and37.9.

B.

between15.2and34.8.

C.

between20.0and30.0.

D.

between15.0and40.0.

16. When selecting a sample a population is first divided into subpopulations and then random
samples are taken from each subpopulation, the number taken proportional to the size of the
subpopulation.Thisisanexampleof:
A.

structuredsampling.

B.

systematicsampling.

C.

simplerandomsampling.

D.

stratifiedrandomsampling.

76StudySession03:
15. Large samples are taken from a normal population; the sample mean is 25 and the sample
standarddeviationis5.The95%confidenceintervalforthepopulationmeanisclosestto:
A.
B.
C.
D.

between 12.1 and 37.9.


between 15.2 and 34.8.
between 20.0 and 30.0.
between 15.0 and 40.0.

CorrectAnswer:

B........................................................................................... LOS:Reading10f

The 95% confidence interval is given by sample mean plus or minus 1.96 standard deviations.
This is

25 (1.96 5) = 25 9.8 which is between 15.2 and 34.8.

Reference:CFAProgramCurriculum,Volume1,pp.433435.

16. When selecting a sample a population is first divided into subpopulations and then random
samples are taken from each subpopulation, the number taken proportional to the size of the
subpopulation.Thisisanexampleof:
A.
B.
C.
D.

structured sampling.
systematic sampling.
simple random sampling.
stratified random sampling.

CorrectAnswer:

D ......................................................................................... LOS:Reading10b

Stratified random sampling ensures that different subdivisions within a population are represented in the
sample.
Reference:CFAProgramCurriculum,Volume1,pp.422425.

QuantitativeMethods:Applications77
17. Ifaverylargesamplesizeisuseditisleastlikelytoleadto:
A.

asmallerstandarderrorofthesamplemeans.

B.

alargerdispersioninthedistributionofthesamplemeans.

C.

thesamplingdistributionofthesamplemeanbeingapproximatelyanormaldistribution.

D. themeanofthesamplingdistributionofthesamplemeanbeingequaltothepopulation
mean.

18. Whichofthefollowingdescribelognormaldistributions?

Skew

Oftenusedtodescribeasset

A.

positivelyskewed

prices

B.

positivelyskewed

returns

C.

negativelyskewed

prices

D.

negativelyskewed.

returns

78StudySession03:
17. Ifaverylargesamplesizeisuseditisleastlikelytoleadto:
A.
B.
C.
D.

a smaller standard error of the sample means.


a larger dispersion in the distribution of the sample means.
the sampling distribution of the sample mean being approximately a normal distribution.
the mean of the sampling distribution of the sample mean being equal to the population mean.

CorrectAnswer:

B...........................................................................................LOS:Reading10e

A large sample size will lead to a smaller standard error of the sample mean since the standard error is
equal to the population standard deviation divided by the square root of the sample size. The central limit
theorem says that the sampling distribution of the sample mean is close to a normal distribution if the
sample size is large (greater than thirty). The mean of the sample means will be the same as the mean of the
population.
However a large sample size will lead to sample means being close to the population mean and therefore
less disperse, so B is the correct answer.
Reference:CFAProgramCurriculum,Volume1,pp.428431.

18. Whichofthefollowingdescribelognormaldistributions?
A.
B.
C.
D.

Skew
positively skewed
positively skewed
negatively skewed
negatively skewed.

CorrectAnswer:

Often used to describe asset


prices
returns
prices
returns

A ............................................................................................ LOS:Reading9j

A lognormal distribution is bounded by zero on the left and has a long tail on the right so it is positively
skewed. The bound of zero means the distribution is often used to model asset prices.
Reference:CFAProgramCurriculum,Volume1,pp.400406.

QuantitativeMethods:Applications79
19. An investment manager is managing a diversified portfolio of international equities and the
performancebenchmarkistheMSCIWorldindex.Shortfallriskfortheportfoliorefersto:
A.

thestandarddeviationofreturns.

B.

theriskthatthevalueoftheportfoliofallsbelowacriticallevel.

C.

thestandarddeviationofreturnsrelativestotheMSCIWorldIndex.

D.

theabsolutedeviationofreturnsrelativestotheMSCIWorldIndex.

20. Thestandarderrorofthesamplemeanis:
A.

theaveragestandarddeviationofeachsample.

B.

thestandarddeviationofthesamplingdistributionofsamplemean.

C.

thestandarddeviationofthesampleminusthestandarddeviationofthepopulation.

D. thestandarddeviationofthesampledividedbythestandarddeviationofthe
population.

80StudySession03:
19. An investment manager is managing a diversified portfolio of international equities and the
performancebenchmarkistheMSCIWorldindex.Shortfallriskfortheportfoliorefersto:
A.
B.
C.
D.

the standard deviation of returns.


the risk that the value of the portfolio falls below a critical level.
the standard deviation of returns relatives to the MSCI World Index.
the absolute deviation of returns relatives to the MSCI World Index.

CorrectAnswer:

B............................................................................................. LOS:Reading9i

Shortfall risk is the risk that the value of a portfolio falls below a certain level, it can be reduced by
minimizing the probability that the return falls below a certain minimum level.
Reference:CFAProgramCurriculum,Volume1,pp.397400.

20. Thestandarderrorofthesamplemeanis:
A.
B.
C.
D.

the average standard deviation of each sample.


the standard deviation of the sampling distribution of sample mean.
the standard deviation of the sample minus the standard deviation of the population.
the standard deviation of the sample divided by the standard deviation of the population.

CorrectAnswer:

B...........................................................................................LOS:Reading10e

The standard deviation of a sample mean is the standard error. The central limit theorem says that this is
equal to the population standard deviation divided by the square root of the sample size.
Reference:CFAProgramCurriculum,Volume1,pp.428431.

QuantitativeMethods:Applications81
21. A sample of 100 observations is taken from a normally distributed population with a standard
deviationof2.Thesamplemeanis6.The99%confidencelevelisclosestto:
A.

between4.45and7.55.

B.

between5.48and6.52.

C.

between5.61and6.39.

D.

between5.95and6.05.

22. A client wishes to protect the value of his capital. Which of the following portfolios will be
optimalfromasafetyfirstanalysis?

Asset

ExpectedReturn

StandardDeviation

25

12

15

10

A.

PortfolioA.

B.

PortfolioB.

C.

PortfolioC.

D.

PortfolioD.

82StudySession03:
21. A sample of 100 observations is taken from a normally distributed population with a standard
deviationof2.Thesamplemeanis6.The99%confidencelevelisclosestto:
A.
B.
C.
D.

between 4.45 and 7.55.


between 5.48 and 6.52.
between 5.61 and 6.39.
between 5.95 and 6.05.

CorrectAnswer:

B........................................................................................... LOS:Reading10j

x z / 2
The confidence interval is given by

where

sample mean, which is the point estimate of the population mean

population standard deviation

sample size

z / 2

= reliability factor, the point where /2 of the probability is in the right tail
The 99% confidence level is 6 (2.58 x 2)/10 which is between 5.48 and 6.52.
Reference:CFAProgramCurriculum,Volume1,pp.433439.

QuantitativeMethods:Applications83
22. A client wishes to protect the value of his capital. Which of the following portfolios will be
optimalfromasafetyfirstanalysis?

Asset

A.
B.
C.
D.

ExpectedReturn

StandardDeviation

25

12

15

10

Portfolio A.
Portfolio B.
Portfolio C.
Portfolio D.

CorrectAnswer:

A.............................................................................................LOS:Reading9i

( )
S F Ratio = [E R P R L ]

where

RP

= portfolio return

RL

= threshold level

= portfolio standard deviation

Calculate the S F Ratio for each portfolio:


S F Ratio(A) = 25/12 = 2.08
S F Ratio(B) = 15/8 = 1.875
S F Ratio(C) = 10/6 = 1.667
S F Ratio(D) = 8/5 = 1.600
A has the highest S F Ratio and is the correct answer.
Reference:CFAProgramCurriculum,Volume1,pp.397400.

84StudySession04:

Study Session 4: Introduction


Introductory Readings
Economics: Private and Public Choice, 10th edition, James D. Gwartney, Richard L. Stroup,
RussellS.Sobel,andDavidA.Macpherson(SouthWestern,2003)
Supply,Demand,andtheMarketProcess,Ch.3
SupplyandDemand:ApplicationsandExtensionsCh.4
TakingtheNationsEconomicPulse,Ch.7
WorkingwithOurBasicAggregateDemand/AggregateSupplyModel,Ch.10
KeynesianFoundationsofModernMacroeconomics,Ch.11

Supply, Demand, and the Market Process CH 5


Introduction
Thischapteriscenteredonthelawsofsupplyanddemand.Thelawofsupplysaysthatahigher
pricemeansproducersproducemoreoftheproduct,andthelawofdemandsaysthatconsumers
buylessofagoodifthepricerises,andviceversa.Candidatesshouldknowwhattypeoffactors
causeshiftsinthesupplyanddemandcurvesandmovementsalongthecurvesandunderstand
theconceptofmarketequilibrium.

IntroductoryReadings85

Consumer choice and the Law of Demand


Consumersareforcedtomakechoicesregardinghowtheyspendtheirincomeinordertogetthe
most value for their money. The Law of Demand states that there is an inverse relationship
between the price of a product and the amount or quantity of it that consumers are willing to
purchase.
Price

LawofDemand

Demand

Quantity

Aconsumersurplusisthedifferencebetweenthemaximumpricethatconsumersarewillingto
payandthepricethattheyactuallypay;thisisanetgaintothebuyersofthegood.

Producer choice and the Law of Supply


All economic participants in an economy are aiming to generate profit, which is the excess of
sales revenue over the production costs. The Law of Supply states that there is a direct
relationshipbetweenthepriceofaproductandtheamountofitthatisofferedforsale.

86StudySession04:

Price

LawofSupply

Supply

Quantity

Price changes and demand and supply


Consumersbuylessofaproductasthepriceincreasesbecauseoftheavailabilityofsubstitutes.The
availabilityofsubstitutesisamajorfactorindecidingthesensitivitytothequantitydemandedtoa
change in price. If the demand for a product is elastic it means a small price change will lead to a
large change in demand. In the diagram below when the price moves from P1 to P2, the quantity
demandedfallssharplyfromQ1toQ2.Ifdemandisinelasticitmeansthatachangeinpriceonlyhas
asmallimpactonthequantitydemanded,sopricesmovefromQ1toQ2.Unitaryelasticmeansthata
percentchangeinquantitydemandedleadstoapercentchangeinprice.

Similarlyasupplycurveiselasticwhenthequantitysuppliedisveryresponsivetoachangeinprice
(aflatcurve)andinelasticwhenquantitysuppliedisnotveryresponsivetoachangeinprice(asteep
curve).

IntroductoryReadings87

Shifts in demand
Ashiftinthedemandcurvewillbearesultofachangeindemandduetofactorsotherthanprice.
Factors that lead to a shift include increases in consumer income, changes in taxes on the product,
changesinpriceoravailabilityofcompetingproducts,andchangesinexpectationsoffutureprices.It
isimportanttodifferentiatebetweenchangesindemand(ashiftofthedemandcurve)andchanges
inquantitydemanded(amovementalongthesamedemandcurve).

88StudySession04:

Shifts in supply
Achangeinsupplyindicatesashiftinthesupplycurve.Thefollowingareexamplesoffactorsthat
could lead to a change in supply changes in resource costs, technology improvements, natural
disasterswhichlimitsupplyofaproduct,changesintaxesontheproducersoftheproduct.
Equilibrium is defined as a state of balance between forces such as supply and demand. It is
importanttodifferentiatebetweenshortrun(aninsufficienttimeperiodfordecisionmakerstofully
adjusttochangesinmarketconditions)andlongrun(asufficienttimefordecisionmakerstomake
adjustments).

Highpriceswilltendtoleadtoanexcesssupplyillustratedbythepointsaandb,producerswilltend
to lower prices until supply and demand are in balance. On the other hand if prices are too low,
demand will exceed supply, illustrated by points c and d, and producers will increase prices until
equilibriumisreached.

Impact of changes in demand and supply


Increaseindemandthedemandcurveshiftstotheright,whichwillincreaseboththeequilibrium
priceandquantity.
Decreaseindemandthedemandcurveshiftstotheleft,whichwilldecreaseboththeequilibrium
priceandquantity.
Increaseinsupplythesupplycurveshiftstotheright,whichwilldecreasetheequilibriumprice
andincreasetheequilibriumquantity.
Decreaseinsupplythesupplycurveshiftstotheleft,whichwillincreasetheequilibriumpriceand
decreasetheequilibriumquantity.
Anunanticipatedcutinsupplywill,intheshortrun,leadtoasharpincreaseinprice,butinthelong
run demand will respond to the price change. Similarly an unanticipated surge in demand for a
productwillinitiallypushuppricesbutlongertermsupplywillbeincreased.

IntroductoryReadings89

Theinvisiblehandprinciplesaysthatmarketpricesactasaninducementtoindividualstopursue
productiveactivitiesthatalsopromotetheeconomicwellbeingofsociety.

90StudySession04:

Supply and Demand: Applications and Extensions CH 4


Introduction
This chapter examines some of the applications of supply and demand analysis covered in the
previousReading.Firstwelookattheimpactofwagerates,interestratesandforeignexchangeon
supplyanddemand.Thenwelookattheimpactofgovernmentaction,includingpricecontrolson
markets, and of black markets which are operating outside the legal system. Finally we consider
taxationandhowitrelatestoelasticityofsupplyanddemand.

Resources
The first step in a firms production process is the purchase of resources. Resources include raw
materials, labor etc. Resource markets generally have downwardsloping demand curves and
upwardslopingsupplycurves.Thereisacloselinkbetweenthemarketsfortheendproductandthe
resources used to make the product. For example, when the price of a resource increases, costs
increaseleadingtoareductioninsupplyandhigherpricesfortheendproduct.
Theloanablefundsmarketreferstothemarketthatcoordinatestheborrowingandlendingdecisions
offirmsandhouseholds.Participantsinthemarketincludecommercialbanks,andstockandbond
markets.Theinterestrateisthepriceofloanablefunds.
Thedemandcurvewillslopedownwardstotherightsincefirmsandhouseholdswillborrowmore
atlowinterestrates.Ontheotherhand,lowinterestrateswillmakeitlessattractivetosavesothe
supplycurvewillbeupwardslopingtotheright.Marketforceswilldriveinterestratestoalevel,E,
wherethequantityoffundsdemandedwillequalthequantityoffundssupplied.

Theinterestrateisimportantbecauseitisthelinkbetweenthepriceofsomethingtodaywithitsprice
inthefuture.

IntroductoryReadings91
The foreign exchange market is the market in which different currencies are bought and sold.
Exchangeratesbetweencurrenciesareveryimportantsincetheydeterminethepriceofallgoodsand
services that are traded in international markets. They will also influence decision makers who are
lookingatproducinggoodsindifferentcountries,althoughotherissuessuchastransportcosts,legal
issueswillbefactorstoconsiderbeforeadecisionismadetomoveproductionoverseas.
Apriceceilingisalegalrestrictionthatestablishesamaximumpricethatagoodcanbesoldat.Ifthe
price ceiling is set below the equilibrium price it will increase demand and reduce the quantity
suppliedcreatingashortageofthegood.Nonpricefactors(e.g.waitinglists)willdeterminewhois
abletobuytheproduct.Supplierswillbetemptedtoreducethequalityofthegoodsuppliedifthey
cannotincreaseprices.
Pricefloorsestablishaminimumpricethatcanbechargedforagood.Ifthepriceisfixedabovethe
equilibriumpricethenasurplusofthegoodwillappear.
The minimum wage is an example of a price floor, and has led to the substitution of machines or
morehighlyskilledworkersforlowpaidworkers.Alsoemployerswillhavelittleincentivetooffer
nonwagebenefitstoworkersontheminimumwage.
Ablackmarketisamarketthatoperatesoutsidethelegalsystem,eitherthesaleofillegalgoodsor
goods at illegal prices or terms. Black markets are characterized by higher profit margins for
supplierswhodonotgetcaught(tocompensatethesupplierforthehigherrisk),defectiveproducts
andviolence(tosettledisputes).Thepointismadethatalegalsystemthatallowsforsettlementof
disputesisessentialforthesmoothoperationofmarkets.
Taxincidencereferstohowtheburdenofataxisdistributedbetweenbuyersandsellersandrelated
parties(theactualincidence).Thiswilloftenbequitedifferenttothestatutoryincidencewhichisthe
legal assignment of the responsibility to pay the tax. It can be shown that the actual incidence is
independentofitsstatutoryincidence,i.e.whetheritisimposedonthebuyerortheseller.
Lookingattheexampleofwhenataxisimposedonthesellerofaproduct,thiswillshiftthesupply
curveupbytheamountofthetax.Theintersectionofthedemandcurveandsupplycurvewillmove,
splitting the tax burden between the buyer and seller. The reduction in overall trade (and loss of
benefitofthistradetobothparties)resultsinadeadweightloss;thisisthelossoverandabovethe
actualpaymentoftaxtothegovernment.

Elasticity and the incidence of tax


Inthecasethatdemandisinelasticandsupplyelastictheburdenoftaxwilllargelyfallonthebuyer
(e.g. when oil prices rise). Conversely when demand is relatively elastic compared to supply, the
sellerswillbearthelargestburden.
Ifeitherdemandorsupplyisrelativelyinelasticfewertradeswillbeeliminatedsoariseintaxwill
resultinarelativelysmalldeadweightloss.

92StudySession04:

Taking the Nations Economic Pulse CH 7


Introduction
ThefocusofthischapterisonthemeasurementofGDPasthemostcommonlyquotedmeasureof
economicperformance.CandidatesneedtoknowhowtocalculateGDPusingboththeexpenditure
andtheresourcescostincomeapproaches.Theyalsoneedtobefamiliarwiththedifferencesbetween
GDPandGNP,andhowtoswitchbetweennominalandrealGDPgiventherateofinflation.Atthe
endofthechapterwelookatalternativemeasuresfortheperformanceoftheeconomy.

Gross domestic product


Gross domestic product (GDP) is defined as the total market value of all final goods and services
produced within a countrys borders during a specific time period. GDP is a broad measure of
current production of goods and services, and GDP calculations exclude secondhand goods,
intermediategoods,andfinancialtransactions.
TherearetwomainapproachestomeasuringGDP:
19. 1. Expenditureapproach,whereGDPisthesumof:
Consumption (C)
Gross private investment (Ig)
Government expenditure (G)
Net Exports (NX)
Theexpenditureapproachiscommonlystatedas:

GDP=C+Ig+G+NX
Gross private investment includes depreciation expense; gross investment is the sum of net
investment(In)plusdepreciation.Netexports(NX)isequaltoexportsminusimports(XIM),and
NX can be either positive or negative. If exports are higher than imports, NX will be positive and
addedtoGDP;ifimportsarehigherthanexports,NXwillbenegativeandsubtractedfromGDP.
20. 2. Costresourceincomeapproach,whereGDPisthesumof:
Wages, salaries, self-employed income
Rents, profits, and interest
Indirect business taxes
Depreciation
Net income of foreigners
Netincomeofforeignerscanbepositiveornegative.Ifforeignersbringinmoreinvestmentincome
intoacountrythantheresidentsofthesamecountrypayabroad,thennetincomewillbepositive.
GDPcalculatedbytheexpenditureapproachandGDPcalculatedbythecostincomeapproachmust
beequal.

IntroductoryReadings93

Example Int-1 Calculating GDP

ThefictitiouscountryofEuphoriahasthefollowingexpenditureandincomecategories
andamounts(inmillions):
Imports $95
Net investment $100
Wages and salaries
$295
Government expenditure
$70
Depreciation $25
Indirect business taxes $60
Issuance of corporate bonds
$35
Self-employed income $95
Exports $150
Rents, profits, and interest
$140
Net income of foreigners
-$40
Consumption expenditure
$325
ThetricktocalculatingGDPistoidentifyexpenditureversuscostincomecomponents.
TousetheGDPexpenditureapproach,wemustfirstcomputetwopreliminaryitems:

Ig=netinvestment+depreciation=$100+$25=$125

NX=exportsimports=$150$95=$55

GDP=C+Ig+G+NX

GDP=$325+$125+$70+$55

GDP=$575
TousetheGDPcostincomeapproach,sumupallcostincomecomponents:

GDP = wages and salaries + selfemployed income + rents, profits, and


interest+depreciation+indirectbusinesstaxes+netincomeofforeigners

GDP=$295+$95+$140+$25+$60+($40)

GDP=$575
Notice that GDP is equal using either approach. The issuance of bonds is a financial
flow,whichisexcludedfromGDPcalculations.(Assumethattheassetfinancedbythe
bondflotationhasalreadybeencountedundergrossbusinessinvestment).

94StudySession04:
GDPcountsthevalueofgoodsandservicesproducedinsideanationbyresidentsofthatnationand
byforeignerslivingthere,too.Whereas,GNPcountsthevalueofgoodsandservicesproducedbythe
citizensofacountry,whethertheyarelivinginthecountryitselforlivingabroad.GDPandGNPwill
beequalonlywhennetincomeofforeignersiszero.
GDP is measured in the U.S. in dollars. In simple terms, GDP is the sum of price multiplied by
quantity(PQ)ofallfinalgoodsandservicesproduced.Quantityrepresentsrealproductionwithin
an economy; if quantity (or output) changes, then economic activity reported by GDP will change.
However,GDPcanchange,evenifthereisnochangeinoutput,ifpricesbythemselveschange.
Nominal GDP measures economic activity by multiplying current prices with current output;
nominalGDPcanincreasebecauseofeitherincreasingpricesand/orincreasingoutput.Whereas,real
GDP measures economicactivity by multiplying historical pricesreferenced to a particularyear by
current output; because prices are held constant, real GDP can only change because of output
changes.
WhennewspapersortelevisionreportGDPforecasts,theyalmostalwaysmeanrealGDP.
Inflationistheincreaseinpricesovertime,andtherearetwomainwaysinwhichinflationcanbe
measured.TheConsumerPriceIndex(CPI)measuresnarrowpricechangesinatypicalbasketof
goodsboughtbyconsumers,capturedintheconsumptioncomponentofGDPcalculations.TheGDP
deflator measures broad price changes across all categories of economic activity, captured by
consumption,investment,government,andnetexports.
BothCPIandtheGDPdeflatorarereferencedtoabaseyear,whichisassignedavalueof100.0.As
inflationrises,sodoestheindexvalueoftheCPIortheGDPdeflator.
The Equation below is used to calculate real GDP when we are given nominal GDP and the GDP
deflatorforanygivenyear:

Equation Int-1

real GDPperiod t = nominal GDPperiod t

GDP deflatorbase year


GDP deflatorperiod t

RecallthattheGDPdeflatorinthebaseyearisequalto100.0.Therefore,realGDPwillalwaysequal
nominalGDPinthebaseyear.

IntroductoryReadings95

Example Int-2 Calculating real GDP

Giventhefollowinginformation:
Nominal GDP in 2005 = $11,381.2 billion
GDP deflator in 2005
= 121.4
GDP base year is 1986
CalculaterealGDPin2005:

real GDPperiod t = nominal GDPperiod t

= $11,381.2 billion

GDP deflatorbase year


GDP deflatorperiod t

100.0
121.4

= $9,375.0 billion
Although GDP attempts to capture a nations economic activity, some activities will elude
statisticiansandwillbeexcludedfromanymeasure.Suchexcludedactivitiesinclude:
Leisure and human costs;
Unreported and illegal activities, such as the underground economy;
Value of unpaid household production, including chores;
Harmful side effects of production, including pollution of air, water, soil; and
Quality and variety of product improvements which occur through innovation.
GDPandGNParethebroadestmeasuresofoutput.However,thereareseveralalternativemeasures
ofeconomicperformance:
National income (NI) is the earnings of all resource owners, which is the sum of employment
compensation (salaries), rents, corporate profits, interest, and self-employment income.
However, not all of this income is available for personal use.
Personal income (PI) adjusts NI by subtracting corporate profits and social insurance taxes
and adding transfer payments and dividends. PI can be spent on consumption, saving, or
paying of personal taxes.
Disposable income (DI) strips away personal taxes from PI. Out of the five output measures,
DI is the narrowest. DI can either be consumed or saved.

96StudySession04:

Working with Our Basic Aggregate Demand/ Aggregate


Supply Model CH 10
Introduction
Wenowlookattheeffectsofchangesinaggregatedemandandsupplyonothereconomicindicators,
suchasgrowth,pricesandemployment.Firstofallweexaminethefactorsthatchangesupplyand
demand and then differentiate between the shortrun and longrun impact of anticipated versus
unanticipated changes on the economy. We also consider the selfcorrecting mechanisms that will
helpstabilisetheeconomy.

Aggregate demand
Thereare,infact,threeseparatecurves:aggregatedemand,shortrunaggregatesupply,andlongrun
aggregatesupply
Theaggregatedemand(AD)curveisadownwardslopingcurve,withthepricelevel(P)plottedon
theverticalaxisandrealGDP(Y)plottedonthehorizontalaxis.Therearesixfactorsthatwillshift
ADtotheright(AD1),alsoknownasanincreaseinaggregatedemand:
Increase in real wealth
Decrease in real interest rates
Increased optimism in the economy
Higher expected inflation in the future
Higher incomes abroad, thereby boosting exports
Domestic currency depreciation, thereby boosting exports and restricting imports
TheoppositeofthesefactorswillcausetheADcurvetoshifttotheleft,alsoknownasadecreasein
aggregate demand (AD2). The diagram below depicts the shape of the original aggregate demand
curve(AD0)andtheshiftedcurves.
Price level

Aggregate Demand

AD2

AD0

AD1

Real GDP

IntroductoryReadings97
The shortrun aggregate supply (SRAS) curve is an upwardsloping curve, with the price level (P)
plottedontheverticalaxisandrealGDP(Y)plottedonthehorizontalaxis.Therearefivefactorsthat
willshiftSRAStotheright(SRAS1),alsoknownasanincreaseinshortrunaggregatesupply:
Increase in the stock of capital
Technological improvements
Reduction in input prices
Lower expected inflation in the future
Favourable shocks, such as good weather
TheoppositeofthesefactorswillcausetheSRAScurvetoshifttotheleft,alsoknownasadecreasein
shortrunaggregatesupply(SRAS2).Thediagrambelowdepictstheshapeoftheoriginalshortrun
aggregatesupplycurve(SRAS0)andtheshiftedcurves.
Price level

Short-run aggregate supply

SRAS2

SRAS0

SRAS1

Real GDP

Thelongrunaggregatesupply(LRAS)curveisaverticalcurve,withthepricelevel(P)plottedonthe
vertical axis and real GDP (Y) plotted on the horizontal axis. There are two factors that will shift
LRAStotheright(SRAS1),alsoknownasanincreaseinlongrunaggregatesupply:
Increase in the stock of capital
Technological improvements
ObservethatthesefactorsarecommontoSRAS,whichmeansthatwhenevertheLRAScurveshifts,
theSRAScurvewillmovewithitinthesamedirection.Theoppositeofthesefactorswillcausethe
LRAScurvetoshifttotheleft,alsoknownasadecreaseinlongrunaggregatesupply(LRAS2).The
diagram below depicts the shape of the original longrun aggregate supply curve (LRAS0) and the
shiftedcurves.

98StudySession04:
Price level

Long-run aggregate supply


LRAS2

LRAS0

LRAS1

YF2

YF0

YF1

Real GDP

The LRAS curve plays a significant role in regulating the macro economy: the position of LRAS
determinesthelevelofeconomicactivitycorrespondingtofullemployment(YF0).Fullemployment
canonlybeachievedwhenaneconomyisoperatingsomewherealongtheLRAScurve.
An unanticipated change in macroeconomics suggests that people are caught off guard by the
change,butovertime,themarketwillreacttoit.Whenpeopleinitiallyreacttounanticipatedchanges
in either AD or SRAS, then output can change, but only in the short run. (Remember that LRAS
representsthelimitofproductionintheeconomyinthelongrun.)
Consideranunanticipatedincreaseingovernmentexpenditure,acomponentofAD.IftheADcurve
shiftsupwards,thenthenewshortrunequilibriumwilloccurattheintersectionofthenewADcurve
and the original SRAS curve. Thus, output (Y) and price level (P) will be higher in the short run.
However, the economy is now operating beyond its capacity, which exerts pressure on resource
prices. As resource prices increase, SRAS will shift to the left until equilibrium is restored along
LRAS.Thus,output(Y)isrestoredtofullemploymentandthepricelevelishigher.Inthelongrun,
unanticipatedchangesinADresultinchangestothepricelevelonly.
LRAS0

Price level
PLR

ELR

PSR

eSR

P0
E0
AD0

SRAS1
SRAS0

YF YSR

AD1

IntroductoryReadings99
UnanticipatedchangesinSRASwillonlyaffecttheshortrunpositionoftheSRAScurveitself;there
will be no affect on aggregate demand. Consider an economy dependent on agriculture, and an
unexpectedwarmsummerbooststheeconomysmaincrop.Intheshortrun,thefavorableboostin
productionwillshifttheSRAScurvetotheright,leadingtoalowerpricelevelbutahigherlevelof
output. However, the economy is operating beyond its longrun capacity, and there is upward
pressure on resource prices. As resource prices increase, SRAS will shift to the left until longrun
equilibriumisrestoredalongtheLRAScurve.Inthelongrun,unanticipatedchangesinSRASresult
inneitherachangetothepricelevelnorchangeinoutput.
LRAS0
Price level

eSR
P0
E0

PSR

AD0
SRAS0
SRAS1

YF

YSR

Market economies respond when they operate at an output level above or below full employment
(along the LRAS curve). There are two selfcorrecting mechanisms that tend to restore longrun
equilibrium:
Changes in resource prices affect the SRAS curve. We have discussed this in the previous
LOS. For example, when output is higher than full employment, increasing resource prices
tends to decrease SRAS, causing higher price levels and eventually restoring the economy to
full employment.
Changes in real interest rates affect the AD curve. For example, when output is higher than
full employment, real (inflation-adjusted) interest rates will increase as the demand for
money increases. Higher real interest rates depress business investment, which is a
component of AD. Thus, there is a tendency for AD to automatically decrease, which can
help restore the economy to its full employment level of output.
Thethirdselfcorrectingmechanismrelatestoconsumptionexpenditure,whichisalargecomponent
of AD. (Consumption represents approximately 65 percent of GDP in most developed economies.)
Compared with other components of AD, consumption is the most stable component of GDP. The
inherent stability of consumption expenditure helps to mitigate changes to other less stable
componentsofGDP,suchasnetexports(tiedtotheexchangerate)andbusinessinvestment(tiedto
interestratesandficklebusinesssentiment).

100StudySession04:

Keynesian Foundations of Modern Macroeconomics CH


11
Introduction
InthissectionweexplorethemainprinciplesofKeynesiantheorywhichwasdevelopedbyaBritish
economist to explain the prolonged unemployment in the 1930s; it has had a major influence on
subsequent economic thinking. Keynes focused on demand rather than supply and the role of the
governmentsfiscalpolicyintakinganeconomyoutofrecession.Hebelievedthatthegovernment
should run a budget deficit in order to stimulate demand and bring the economy back to full
employment.Thischapterexaminestherationalebehindhisthinkingincludingtheimportanceofthe
expendituremultiplier.

Keynesian economics
ThedistinctionbetweenclassicalandKeynesianeconomicsstemsfromtheassumptionsmadeonthe
length of recessions. The classical school assumed that the economy operated mostly at or near its
longrunlevelofoutput;recessionstendedtobeshortlivedastheeconomyautomaticallyrevertedto
longrunoutputandemploymentthroughtheSRASmechanismdiscussedinthepreviousReading.
Keynesians are followers of John Maynard Keynes, a British economist of the early 20th century.
Writing during the Great Depression, Keynes (hence Keynesians) believed that the economy could
getstuckinprolongedrecession,withreducedoutputandwidespreadunemployment.Keynesians
donotbelievethatadjustmentstoSRASwillrestoreequilibrium.Rather,theybelievethatrecessions
stemfromadeficiencyofAD,andthegovernmentcanonlyrestorelongrunoutputandemployment
levelsbyboostingAD.AccordingtotheKeynesians,SRASadjustmentsaretooslow,ifindeedthey
operateatall.
TheKeynesianmodelexplainstheoutputlevelatwhichaneconomycanoperate,intheabsenceof
eitheranexplicitSRASorLRAScurve.
The model distinguishes between autonomous verses induced expenditure. (Recall the major
components of expenditure: C, I, G, and NX.) Autonomous expenditure has no relationship with
levels of income; whereas induced expenditure is a function of income. For example, consumption
expenditure increases as disposable income increases (induced). However, even when disposable
incomeisequaltozero,theeconomywillmaintainalevelofconsumptionbydrawingdownassets
(autonomous).
In a simplified economy consisting of consumers, total expenditure is equal to consumption
expenditure.TotalexpenditureisanupwardslopingfunctionofGDP(output),andevenwhenGDP
iszero,therewillbeautonomousexpenditure.TheaggregateexpenditurecurveisshownastheAE
curveinthegraphbelow.

IntroductoryReadings101
Businesses plan for a certain level of expenditure, and they build inventories to meet consumption
expenditure.Inthegraphbelow,businesseswishtooperatealonga45degreeline,whereplanned
aggregate expenditure is equal to actual output. If people consume more than is planned, then
businessesinventorieswillbedepletedfasterthanexpected.Businessesincreaseproductiontomeet
the unanticipated expenditure, which boosts output. Alternatively, if people consume less than is
planned, then businesses inventories will be unexpectedly increased. In response, businesses
decreasetheirproduction,resultinginloweroutput.

Plannedaggregate

expenditur
Unplanne

e (AE
45degree
dinventor

AE=GDP
ybuil u
line

d
p
Unplanne

dinventor

ryeductio

ActualAE
n

Keynesian macro
Keynesian equilibrium (Planned
equilibrium occurs
AE Y)
along the 45degree
line, when real GDP
Planned AE < Planned AE >
is equal to planned
Output
Output
GDP
GDP
aggregate
increased
decreased
RealGDP
expenditure.
The
marginal
propensitytoconsume(MPC)isadditionalconsumptionrelatedtoanadditionalunitofdisposable
income,isshownintheEquationInt2below:
Keynesianequilibrium

Equation Int-2

marginalpropensitytoconsume=consumptionexpenditure

disposableincome

whereisuppercaseGreekletterdeltameaningchange.
TheMPCisanumbergreaterthanzerobutlessthanone(0<MPC<1).Recallthatdisposableincome
canbeeitherconsumedorsaved;therefore,wecandefinethemarginalpropensitytosave(MPS)as1
MPC.NotethatMPC+MPS=1.

102StudySession04:
TheexpendituremultiplierisrelatedtotheMPCandMPS,asshownbelow:

Equation Int-3

expendituremultiplier =

1
1
=

1 - MPC MPS

Example Int-3 Marginal propensity to consume and expenditure


multiplier
When disposable income is $150, consumption expenditure is $120; and when
disposableincomeis$200,consumptionexpenditureis$157.50.Calculatethemarginal
propensitytoconsumeandtheexpendituremultiplier.
UseEquationsInt2andInt3,respectively:
marginalpropensitytoconsume

consump. exp.
$157.50 $120 $37.5
=
=
= 0.75
disposable income
$200 $150
$50

NotethattheMPS=1MPC=10.75=0.25
expendituremultiplier =

1
1
1
=
=
= 4
1 - MPC 1 - 0.75 0.25

The expenditure multiplier explains the total increase in output caused by an initial change in
autonomousexpenditure.TheexpendituremultiplierispositivelyrelatedtotheMPCandnegatively
relatedtoMPS.Intuitively,ifsomeoftheincreaseinautonomousexpenditureissavedratherthan
spent,theeffectoftheautonomousstimulusontheeconomywillbereduced.
Assume that the MPC = 0.75, which yields an expenditure multiplier of 4. If the government
increased autonomous expenditure by $10, then the total effect of the governments increased
expenditurewouldbea$104=$40increaseintotaloutput(Y).
If,however,peoplehadatendencytoconsumemoreoftheautonomousincrease(MPC=0.80),then
thenewexpendituremultiplierwouldbe:
expendituremultiplier =

1
1
1
=
=
= 5
1 - MPC 1 - 0.80 0.20

IntroductoryReadings103
If the government increased autonomous expenditure by $10, then the total effect of the
governmentsincreasedexpenditurewouldbea$105=$50increaseintotaloutput(Y).
IntermsoftheKeynesianmodel,anincreaseinautonomousexpenditurewouldshifttheactualAE
curveupwards,resultinginamultipliedincreaseinoutput(Y)untilplannedaggregateexpenditure
equalsoutput.
Keynesiansbelievethatprivateinvestmentisthemostvolatilecomponentofaggregateexpenditure.
An unexplained decline in business confidence results in an autonomous decrease in private
investment,whichreverberatesthroughouttheentireeconomybythemultipliereffect.
Thedecreaseinaggregatedemandcausesadeclineinoutputandemploymentlevels.Theeconomys
builtin stabilizers might not be enough to offset the decline in AD, so Keynesian believe that the
governmentoughttoincreaseexpendituretorestorefullemployment.
Alternatively, an increase in business confidence would result in an autonomous increase in
investment expenditure, which would reverberate throughout the economy via the expenditure
multiplier.Ifoutputexpandsbeyondfullemployment,inflationpressureswouldemerge.

104StudySession04:

Introductory Readings Concept Check Questions


1. Itisnoticedthatasmallchangeinpricehasabigimpactondemandforaproduct.Thismeans
thedemandis:
A.

elastic, with a flat demand curve.

B.

elastic, with a steep demand curve.

C.

inelastic, with a flat demand curve.

D.

inelastic, with a steep demand curve.

2. Anaturaldisasterwilloftencause:
A.

a shift in the supply curve to the left.

B.

a shift in the supply curve to the right.

C.

a move to the left along the supply curve.

D.

a move to the right along the supply curve.

3. IftheGDPdeflatorinacountryhasrisenfrom100in1985,to130in2005andnominalGDPhas
risenfrom$85billionto$125billionthenthechangeinrealGDPovertheperiodisclosestto:
A.

a fall of 3.9%.

B.

an increase of 13.1%.

C.

an increase of 17.1%.

D.

an increase of 62.5%.

IntroductoryReadings105
4. Which of the following statements is CORRECT regarding gross national product (GNP) and
grossdomesticproduct(GDP)?
A.

GNP and GDP are both the same, but different terms are used in different countries.

B.
GNP is GDP less the income of foreigners in the country plus the income earned by the
countrys citizens overseas.
C.

GNP is GDP less depreciation costs.

D.

GNP is calculated using the expenditure approach and GDP using the income approach.

5. Whichofthefollowingwouldcauseashiftinaggregatedemand?
I. Anincreaseinrealinterestrates.
II. Newtechnologyincreasingproductivity.
III. Achangeininflationaryexpectations.
IV. Asignificantchangeintheexchangerate.
A.

II only.

B.

I and III only.

C.

I, III and IV only.

D.

All of the above.

6. Wheneconomicoutputislessthantheeconomyspotential,whichofthefollowingwillactasa
selfcorrectingmechanism?
A.

Fiscal stimulus.

B.

Real interest rates will decline.

C.

Real resource prices will rise.

D.

Rising inflation.

106StudySession04:
7. TheKeynesianmodelimpliesthat:
A.
market forces are sufficient to ensure that the economy operates at the full employment
level in the long term.
B.
adjusting money supply is the primary tool that should be used to stimulate aggregate
demand.
C.
adjusting interest rates is the primary tool that should be used to stimulate aggregate
demand.
D.
macroeconomic policy should focus on maintaining aggregate expenditures at the level
that leads to full employment .

8. Ifthemarginalpropensitytoconsume(MPC)is0.7andinvestmentspendingisincreasedby$3
billionthentheadditionalincomegeneratedisclosestto:
A.

$3.33 billion.

B.

$4.28 billion.

C.

$7.00 billion.

D.

$10.00 billion

IntroductoryReadings107

108StudySession04:

Introductory Readings Concept Check Answers


1. Itisnoticedthatasmallchangeinpricehasabigimpactondemandforaproduct.Thismeans
thedemandis:
A.

elastic, with a flat demand curve.

B.

elastic, with a steep demand curve.

C.

inelastic, with a flat demand curve.

D.

inelastic, with a steep demand curve.

CorrectAnswer:1.

Demand is elastic since it is highly responsive to a change in price, this will lead to a flat demand curve.

2. Anaturaldisasterwilloftencause:
A.

a shift in the supply curve to the left.

B.

a shift in the supply curve to the right.

C.

a move to the left along the supply curve.

D.

a move to the right along the supply curve.

CorrectAnswer:2.

The supply curve shifts to the left as supply is decreased. This will in turn increase the equilibrium price.

IntroductoryReadings109
3. IftheGDPdeflatorinacountryhasrisenfrom100in1985,to130in2005andnominalGDPhas
risenfrom$85billionto$125billionthenthechangeinrealGDPovertheperiodisclosestto:
A.

a fall of 3.9%.

B.

an increase of 13.1%.

C.

an increase of 17.1%.

D.

an increase of 62.5%.

CorrectAnswer:3.

Real GDP (2004) = $125 billion x (100/130) = $96.15 billion


This is an increase of 13.1%

4. Which of the following statements is CORRECT regarding gross national product (GNP) and
grossdomesticproduct(GDP)?
A.

GNP and GDP are both the same, but different terms are used in different countries.

B.
GNP is GDP less the income of foreigners in the country plus the income earned by the
countrys citizens overseas.
C.

GNP is GDP less depreciation costs.

D.

GNP is calculated using the expenditure approach and GDP using the income approach.

CorrectAnswer:4.

110StudySession04:
5. Whichofthefollowingwouldcauseashiftinaggregatedemand?
I. Anincreaseinrealinterestrates.
II. Newtechnologyincreasingproductivity.
III. Achangeininflationaryexpectations.
IV. Asignificantchangeintheexchangerate.
A.

II only.

B.

I and III only.

C.

I, III and IV only.

D.

All of the above.

CorrectAnswer:5.

Item II would lead to a shift in the supply curve.

6. Wheneconomicoutputislessthantheeconomyspotential,whichofthefollowingwillactasa
selfcorrectingmechanism?
A.

Fiscal stimulus.

B.

Real interest rates will decline.

C.

Real resource prices will rise.

D.

Rising inflation.

CorrectAnswer:6.

The main self-correcting mechanisms will be the fall in real interest rates and resource prices (including labor
costs).

IntroductoryReadings111
7. TheKeynesianmodelimpliesthat:
A.
market forces are sufficient to ensure that the economy operates at the full employment
level in the long term.
B.
adjusting money supply is the primary tool that should be used to stimulate aggregate
demand.
C.
adjusting interest rates is the primary tool that should be used to stimulate aggregate
demand.
D.
macroeconomic policy should focus on maintaining aggregate expenditures at the level
that leads to full employment .

CorrectAnswer:7.

8. Ifthemarginalpropensitytoconsume(MPC)is0.7andinvestmentspendingisincreasedby$3
billionthentheadditionalincomegeneratedisclosestto:
A.

$3.33 billion.

B.

$4.28 billion.

C.

$7.00 billion.

D.

$10.00 billion

CorrectAnswer:8.

The expenditure multiplier is 1/(1 0.7) or 3.33. Therefore the additional income is $3 billion x 3.33 or $10
billion.

112StudySession04:

Study Session 04: Economics:


Microeconomic Analysis

Thisstudysessionfocusesonmicroeconomicconceptsandhowfirmsareaffectedbytheseconcepts.
Oneofthemainconceptsrelatedtotheequilibriumbetweendemandandsupplyiselasticity,which
measures the dependencybetween demand and supply and the impact of changes in either on the
equilibriumpricelevel.Asecondkeyconceptisefficiency,whichisameasureofthefirmsoptimal
output given its cost and revenue functions. Understanding these concepts enables analysts to
differentiateamongvariouscompaniesonanindividuallevel,andtodeterminetheirattractiveness
foraninvestor.

Reading13:Elasticity
Reading14:EfficiencyandEquity
Reading15:MarketsinAction
Reading16:OrganizingProduction
Reading17:OutputandCosts

Economics:MicroeconomicAnalysis113
1. Economicprofitistotalrevenueless:
A.

explicitcosts.

B.

implicitcosts.

C.

normalprofit.

D.

opportunitycosts.

2. Themomentarysupplycurveofagriculturalcropsisgenerally:

A.

vertical.

B.

horizontal.

C.

anupwardslopingcurve.

D.

linearandpassesthroughtheorigin.

114StudySession04:
1. Economicprofitistotalrevenueless:
A.
B.
C.
D.

explicit costs.
implicit costs.
normal profit.
opportunity costs.

CorrectAnswer:

D ..........................................................................................LOS:Reading16a

Economic profit is after opportunity costs which include both explicit and implicit costs. Normal profit is
included in implicit costs.
Reference:CFAProgramCurriculum,Volume2,pp.9495.

2. Themomentarysupplycurveofagriculturalcropsisgenerally:
A.
B.
C.
D.

vertical.
horizontal.
an upward sloping curve.
linear and passes through the origin.

CorrectAnswer:

A ..........................................................................................LOS:Reading13a

The quantity of agricultural goods available will depend on decisions on planting of the crop made some
time previously. Generally producers cannot rapidly change their output so supply is inelastic and the
supply curve is vertical.
Reference:CFAProgramCurriculum,Volume2,pp.2627.

Economics:MicroeconomicAnalysis115
3. Whichofthefollowingareexamplesofimplicitandexplicitopportunitycosts?

Implicitcost

Explicitcost

A.

Utilityexpenses

Rentalcosts

B.

Interestforegone

Accountingdepreciation

C.

Dividendpayments

Salarycosts

D.

Economicdepreciation

Bankinterest

4. Makingamarketinagoodillegalismostlikelyto:
A.

increasevalueforbuyers.

B.

reducecostsforsuppliers.

C.

reducethequantitytraded.

D.

createasurplusofthegood.

116StudySession04:
3. Whichofthefollowingareexamplesofimplicitandexplicitopportunitycosts?
Implicit cost
Utility expenses
Interest foregone
Dividend payments
Economic depreciation

A.
B.
C.
D.

CorrectAnswer:

Explicit cost
Rental costs
Accounting depreciation
Salary costs
Bank interest

D ..........................................................................................LOS:Reading16a

Implicit costs are when there is no payment made but another action has been foregone, these are often
related to use of capital and use of owners resources. Interest forgone and economic depreciation are both
forms of implicit costs. Explicit costs are paid for in money, such as bank interest, salaries, utilities, rental
expense.
Reference:CFAProgramCurriculum,Volume2,pp.9295

4. Makingamarketinagoodillegalismostlikelyto:
A.
B.
C.
D.

increase value for buyers.


reduce costs for suppliers.
reduce the quantity traded.
create a surplus of the good.

CorrectAnswer:

C ......................................................................................... LOS:Reading15d

Making a market illegal is likely to push up costs for suppliers (if there is a penalty on suppliers) and/or
reduce value for buyers (if there is a penalty on buyers). This will lead to a move in the equilibrium point
to the left, reducing quantities traded.
Reference:CFAProgramCurriculum,Volume2,p.8184.

Economics:MicroeconomicAnalysis117
5. WhichofthefollowingcurvesisleastlikelytobeUshaped?
A.

Themarginalcostcurve.

B.

Theaveragetotalcostcurve.

C.

Theaveragefixedcostcurve.

D.

Theaveragevariablecostcurve.

6. Ifagovernmentputsapriceceilingonaservicewhichisbelowtheequilibriumprice,whichof
thefollowingisleastlikelytohappen?
A.

Demandfortheservicewilldecline.

B.

Ablackmarketintheservicewilldevelop.

C.

Therewillbeasshortageofsupplyoftheservice.

D.

Theserviceprovidersproducersurpluswilldecline.

118StudySession04:
5. WhichofthefollowingcurvesisleastlikelytobeUshaped?
A.
B.
C.
D.

The marginal cost curve.


The average total cost curve.
The average fixed cost curve.
The average variable cost curve.

CorrectAnswer:

C .......................................................................................... LOS:Reading17c

The average total, marginal and variable costs decrease at low outputs and increase at high outputs, they
are U-shaped. The average fixed cost decreases steadily as output increases.
Reference:CFAProgramCurriculum,Volume2,pp.129134.

6. Ifagovernmentputsapriceceilingonaservicewhichisbelowtheequilibriumprice,whichof
thefollowingisleastlikelytohappen?
A.
B.
C.
D.

Demand for the service will decline.


A black market in the service will develop.
There will be as shortage of supply of the service.
The service providers producer surplus will decline.

CorrectAnswer:

A ..........................................................................................LOS:Reading15a

The price ceiling will lead to a drop in supply, reducing the producer surplus. Demand will be unchanged,
or increase, so Demand for the service will decline. is the correct choice. A black market may well
develop to fulfill demand.
Reference:CFAProgramCurriculum,Volume2,pp.6066.

Economics:MicroeconomicAnalysis119
7. Technologyandlaborareusuallyconsideredtobewhichtypeofresources?

Technology

Labor

A.

Longrun

Longrun

B.

Longrun

Shortrun

C.

Shortrun

Longrun

D.

Shortrun

Shortrun

8. Ifthesupplyofaproductisunitelasticitmeansthatthesupplycurveis:
A.

vertical.

B.

horizontal.

C.

anupwardslopingcurve.

D.

linearandpassesthroughtheorigin.

120StudySession04:
7. Technologyandlaborareusuallyconsideredtobewhichtypeofresources?
Technology
Long-run
Long-run
Short-run
Short-run

A.
B.
C.
D.

CorrectAnswer:

Labor
Long-run
Short-run
Long-run
Short-run
B...........................................................................................LOS:Reading17a

Technology cannot usually be varied in the short run so is considered a long-run resource. Labor is usually
a variable input so is a short-run resource.
Reference:CFAProgramCurriculum,Volume2,pp.122123.

8. Ifthesupplyofaproductisunitelasticitmeansthatthesupplycurveis:
A.
B.
C.
D.

vertical.
horizontal.
an upward sloping curve.
linear and passes through the origin.

CorrectAnswer:

D ..........................................................................................LOS:Reading13a

Unit elastic means that the percentage change in price equals the percentage change in quantity supplied,
so the supply curve is a straight line and passes through the origin.
Reference:CFAProgramCurriculum,Volume2,p.25.

Economics:MicroeconomicAnalysis121
9 Whenagovernmentintroducesasubsidyonanagriculturalproduct,inthedomesticmarketthis
isleastlikelytohavetheeffectof:
A.

increasingsupply.

B.

creatingoverproduction.

C.

shiftingthesupplycurvedownwardstotheright.

D.

marginalcostontheoriginalsupplycurvefallingbelowmarginalbenefit.

10. ProprietorshipsintheU.S.aregenerallycharacterizedbywhichofthefollowing?
A.

Theentirewealthofownersisatrisk.

B.

Theyareownedbyoneormorepeople.

C.

Profitsaretaxedattheproprietorshipandownerlevel.

D.

Thecostofcapitalandlaborarelowerthanforcorporations.

122StudySession04:
9. Whenagovernmentintroducesasubsidyonanagriculturalproduct,inthedomesticmarketthis
isleastlikelytohavetheeffectof:
A.
B.
C.
D.

increasing supply.
creating overproduction.
shifting the supply curve downwards to the right.
marginal cost on the original supply curve falling below marginal benefit.

CorrectAnswer:

D ......................................................................................... LOS:Reading15d

A subsidy is a payment by the government to producers. The supply curve is the marginal cost curve and
the demand curve the marginal benefit curve. A subsidy increases supply so original marginal cost rises
above marginal benefit, creating overproduction and a deadweight loss.
Reference:CFAProgramCurriculum,Volume2,pp.7980.

10. ProprietorshipsintheU.S.aregenerallycharacterizedbywhichofthefollowing?
A.
B.
C.
D.

The entire wealth of owners is at risk.


They are owned by one or more people.
Profits are taxed at the proprietorship and owner level.
The cost of capital and labor are lower than for corporations.

CorrectAnswer:

A ..........................................................................................LOS:Reading14e

A proprietor has unlimited liability, if a proprietorship cannot pay its debts then the parties owed money
can claim the assets of the proprietor, so A is correct. Proprietorships can only be owned by a single
person, so B is not correct. Profits are only taxed once as the owners income so C is not correct. The cost
of capital is usually higher than that of a corporation so D is not correct.
Reference:CFAProgramCurriculum,Volume2,pp.101102.

Economics:MicroeconomicAnalysis123
11. Followersofutilitarianismaremostlikelytobelievethat:
A.

peopleshouldbetreatedfairlyandtheirpropertyrightsrespected.

B.

administrativecostsreducetheimpactoftransferringwealthbetweendifferentparties.

C. thestateshouldnotownpropertytoensureallparticipantshaveequalaccesstogoods
andservices.
D. allparticipantsshouldhavethesameincometomaximizethebenefitsgainedfromthe
economicpie.

12. Itisnotedthattheincomeelasticityofagoodisslightlynegative.Itismostlikelythatthegood
is:
A.

aluxuryitem.

B.

anormalgood.

C.

aninferiorgood.

D.

asubstitutegood.

124StudySession04:
11. Followersofutilitarianismaremostlikelytobelievethat:
A.
people should be treated fairly and their property rights respected.
B.
administrative costs reduce the impact of transferring wealth between different parties.
C.
the state should not own property to ensure all participants have equal access to goods and
services.
D.
all participants should have the same income to maximize the benefits gained from the economic
pie.
CorrectAnswer:

D .......................................................................................... LOS:Reading14f

Utilitarianism says that all participants should have the same income as this maximizes the combined
marginal benefit of consuming goods so D is correct. A and C are part of the symmetry principle, and B is
an argument against utilitarianism.
Reference:CFAProgramCurriculum,Volume2,pp.4950.

12. Itisnotedthattheincomeelasticityofagoodisslightlynegative.Itismostlikelythatthegood
is:
A.
B.
C.
D.

a luxury item.
a normal good.
an inferior good.
a substitute good.

CorrectAnswer:

C ..........................................................................................LOS:Reading13a

Income elasticity measures the change in demand when income changes. For most goods this is positive,
as when incomes rise, spending on goods usually rises. However, for inferior goods demand moves in the
opposite direction to income, these are goods typically bought by people on low incomes.
Reference:CFAProgramCurriculum,Volume2,pp.2122.

Economics:MicroeconomicAnalysis125
13. Thevalueofonemoreunitofagoodisleastaccuratelydescribedas:
A.

itsmarginalbenefit.

B.

thepriceofthegoodlessthemarginalcostoftheunit.

C.

themaximumpriceconsumersarewillingtopayforit.

D.

thepricepaidfortheunitplustheconsumersurplusfromit.

14. Whenagovernmentimposesaquotaonaproductitismostlikelyto:
A.

benefitconsumersoftheproduct.

B.

benefitcertainproducersoftheproduct.

C.

increasethemarginalcostofproductionofthegood.

D.

leadtothemarginalcostbeinghigherthanmarginalbenefit.

126StudySession04:
13. Thevalueofonemoreunitofagoodisleastaccuratelydescribedas:
A.
B.
C.
D.

its marginal benefit.


the price of the good less the marginal cost of the unit.
the maximum price consumers are willing to pay for it.
the price paid for the unit plus the consumer surplus from it.

CorrectAnswer:

B.......................................................................................... LOS:Reading14b

The value is the same as the marginal benefit, which is the most consumers are willing to pay to buy
another unit of the good. The consumer surplus for each good is the value or marginal benefit less the
price. The price of the good less the marginal cost of the unit is the producer, not consumer, surplus.
Reference:CFAProgramCurriculum,Volume2,pp.3840.

14. Whenagovernmentimposesaquotaonaproductitismostlikelyto:
A.
B.
C.
D.

benefit consumers of the product.


benefit certain producers of the product.
increase the marginal cost of production of the good.
lead to the marginal cost being higher than marginal benefit.

CorrectAnswer:

B........................................................................................... LOS:Reading15c

A quota is likely to create a supply shortage, which pushes up the price creating extra profits for producers
who are allocated the quota, so B is the best answer. The marginal cost will decline as supply drops and
consumers will face shortages and higher prices so A, C and D are not correct.
Reference:CFAProgramCurriculum,Volume2,pp.7781.

Economics:MicroeconomicAnalysis127
15. Anindustryhasfiveparticipantswithmarketsharesof30%,25%,25%10%and10%.Thefour
firmconcentrationratioandHerfindahlHirschmanIndexare:

Fourfirmconcentrationratio

HerfindahlHirschmanIndex

A.

10%

470

B.

90%

470

C.

10%

2,350

D.

90%

2,350

16. Thelawofdiminishingreturnsimpliesthat
A.

totalprofitsdiminishasoutputincreases.

B.
marginalproductisinitiallyupwardslopingthendownwardslopingasquantities
increase.
C.

asmoreunitsofavariableresourceareaddedmarginalproducteventuallydecreases.

D. marginalproductiseventuallyhigherthenaverageproductwhensufficientunitsofa
variableresourceareadded.

128StudySession04:
15. Anindustryhasfiveparticipantswithmarketsharesof30%,25%,25%10%and10%.Thefour
firmconcentrationratioandHerfindahlHirschmanIndexare:
Four firm concentration ratio
A.
10%
B.
90%
C.
10%
D.
90%
CorrectAnswer:

Herfindahl-Hirschman Index
470
470
2,350
2,350

D ..........................................................................................LOS:Reading16g

Four-firm concentration ratio is (30% + 25% + 25% + 10%) = 90%


Herfindahl-Hirschman Index is 302 + 252 + 252 + 102 = 2350
Reference:CFAProgramCurriculum,Volume2,pp.105106.

16. Thelawofdiminishingreturnsimpliesthat
A.
total profits diminish as output increases.
B.
marginal product is initially upward sloping then downward sloping as quantities increase.
C.
as more units of a variable resource are added marginal product eventually decreases.
D.
marginal product is eventually higher then average product when sufficient units of a variable
resource are added.
CorrectAnswer:

C .......................................................................................... LOS:Reading17c

The law of diminishing returns sates that marginal product starts to decline as quantities increase due to
technological constraints.
Reference:CFAProgramCurriculum,Volume2,pp.126127.

Economics:MicroeconomicAnalysis129
17. Amanufacturingcompanyhassalesof$1millionperannumandexplicitcostsof$700,000.The
ownerofthecompany,whoalsoownsthefactory,ischarginganannualrentofonly$25,000forthe
factorywhereastherenthecouldreceiveintheopenmarketis$75,000.Healsodoesnotchargefor
histime(wageswouldbe$60,000perannum).Interestforgoneis$20,000andeconomicdepreciation
is$40,000perannum.Theownercouldearnanormalannualprofitof$50,000inasimilarbusiness.
Theeconomicprofitofthemanufacturingcompanyisclosestto:
A.

$80,000

B.

$120,000.

C.

$130,000

D.

$180,000.

18. Company ABC provides the following information on labor (workers per day) and total
production(unitsoutputperday).

Labor

TotalProduction

24

5,000

25

5,200

26

5,350

Whenlaborincreasefrom25to26perdaythemarginalandaverageproductareclosestto:

marginalproduct

averageproduct

A.

150units

150.0units

B.

150units

205.8units

C.

200units

208.0units

D.

350units

207.0units

130StudySession04:
17. Amanufacturingcompanyhassalesof$1millionperannumandexplicitcostsof$700,000.The
ownerofthecompany,whoalsoownsthefactory,ischarginganannualrentofonly$25,000forthe
factorywhereastherenthecouldreceiveintheopenmarketis$75,000.Healsodoesnotchargefor
histime(wageswouldbe$60,000perannum).Interestforgoneis$20,000andeconomicdepreciation
is$40,000perannum.Theownercouldearnanormalannualprofitof$50,000inasimilarbusiness.
Theeconomicprofitofthemanufacturingcompanyisclosestto:
A.
B.
C.
D.

$80,000
$120,000.
$130,000
$180,000.

CorrectAnswer:

A ..........................................................................................LOS:Reading16a

The economic profit is therefore


$1,000,000 - $700,000 - $50,000 (additional implicit cost of rental)
- $60,000 (wages foregone)
- $20,000 - $40,000 - $ 50,000 (normal profit lost).
This equals $80,000.
Reference:CFAProgramCurriculum,Volume2,pp.9396.

18. Company ABC provides the following information on labor (workers per day) and total
production(unitsoutputperday).

Labor
24
25
26

TotalProduction
5,000
5,200
5,350

When labor increase from 25 to 26 per day the marginal and average product are closest to:
marginal product
average product
A.
150 units
150.0 units
B.
150 units
205.8 units
C.
200 units
208.0 units
D.
350 units
207.0 units
CorrectAnswer:

B.......................................................................................... LOS:Reading17b

The marginal product is the increase in total product for one additional unit of labor, this is 5,350 5,200
which equals 150 units. Average product is total product divided by the quantity of labor employed, which
is 5,350 divided by 26 equals 205.8
Reference:CFAProgramCurriculum,Volume2,pp.124129.

Economics:MicroeconomicAnalysis131
19. Inthemarketeconomy,ifagoodhasexternalbenefitsitisleastlikelytoleadto:
A.

asocialloss.

B.

adeadweightloss.

C.

overproductionofthegood.

D.

aninefficientquantitybeingproduced.

20. Theefficientquantityproducedofagoodisleastlikelyto:
A.

maximizethesumoftheconsumerandproducersurpluses.

B.

bethequantitytowhichfreemarketforcesdriveproduction.

C.

bethepointwherethemarginalsocietybenefitequalsthemarginalsocietycost.

D.

disregardexternalbenefitsandexternalcoststotheconsumerandproducerrespectively.

132StudySession04:
19. Inthemarketeconomy,ifagoodhasexternalbenefitsitisleastlikelytoleadto:
A.
B.
C.
D.

a social loss.
a deadweight loss.
overproduction of the good.
an inefficient quantity being produced.

CorrectAnswer:

C ..........................................................................................LOS:Reading14e

External benefits refer to benefits that accrue to people other than a consumer of a good so the demand
curve for the good does not reflect all the benefits that accrue. This will lead to underproduction of the
good, this inefficient production level leads to a deadweight loss. This is a loss to society as a whole, which
is a social loss.
Reference:CFAProgramCurriculum,Volume2,pp.4648.

20. Theefficientquantityproducedofagoodisleastlikelyto:
A.
B.
C.
D.

maximize the sum of the consumer and producer surpluses.


be the quantity to which free market forces drive production.
be the point where the marginal society benefit equals the marginal society cost.
disregard external benefits and external costs to the consumer and producer respectively.

CorrectAnswer:

D ..........................................................................................LOS:Reading14e

External costs and benefits will distort the quantity produced and consumed so the efficient quantity is
unlikely to be produced if they are disregarded.
Reference:CFAProgramCurriculum,Volume2,pp.4346.

Economics:MicroeconomicAnalysis133
21. Ifthepriceoftelevisionsproducedbymanufacturerisincreasedby10%from$500to$550then
demand is forecast to fall by 20%, from 100,000 units to 80,000 units. The elasticity of demand is
closestto:
A.

0.45.

B.

2.22.

C.

2.33.

D.

2.50.

Note:percentagesarecalculatedontheaveragepriceandaveragequantity.Wealsoignore
minussigns;wearemeasuringthemagnitudeofelasticity.

22. ThepriceofABCFinancialNewsisincreasedfrom$2.00to$2.50,thisleadstoanincreaseinthe
sales of a competing financial magazine , XYZ Finance, which now sells 120,000 copies a week, up
from100,000copiesaweek.Thecrosselasticityofdemandisclosestto:
A.

0.81.

B.

1.04.

C.

1.22.

D.

1.25.

134StudySession04:
21. Ifthepriceoftelevisionsproducedbymanufacturerisincreasedby10%from$500to$550then
demand is forecast to fall by 20%, from 100,000 units to 80,000 units. The elasticity of demand is
closestto:
A.
B.
C.
D.

0.45.
2.22.
2.33.
2.50.

CorrectAnswer:

C ......................................................................................... LOS:Reading13b

Price elasticity of demand

% Q Dem
% P

where
QDem = quantity demanded
P
= price

%QDem

percentage change in quantity demanded, this is

Q / Q ave

%Q Dem
20/90
=
= 2.33
% P
50 / 525
Note:
percentages are calculated on the average price and average quantity. We also ignore minus signs; we are
measuring the magnitude of elasticity.
Reference:CFAProgramCurriculum,Volume2,pp.1314.

Economics:MicroeconomicAnalysis135
22. ThepriceofABCFinancialNewsisincreasedfrom$2.00to$2.50,thisleadstoanincreaseinthe
sales of a competing financial magazine , XYZ Finance, which now sells 120,000 copies a week, up
from100,000copiesaweek.Thecrosselasticityofdemandisclosestto:
A.
B.
C.
D.

0.81.
1.04.
1.22.
1.25.

CorrectAnswer:

A.......................................................................................... LOS:Reading13a

Cross elasticity of demand

%Q Dem
%PC

where
QDem = quantity demanded
PC
= price of substitute or complement

%Q Dem

percentage change in quantity demanded.

The cross elasticity of demand is:

%Q Dem
20 / 110
0.1818
=
=
= 0.81
%PC
$0.50 $2.25 0.2222
Reference:CFAProgramCurriculum,Volume2,pp.1921.

136StudySession05:

Study Session 05: Economics:


Market Structure and Macroeconomic Analysis

This study session first compares and contrasts the different market structures in which firms
operate. The market environment influences the price a firm can demand for its goods or services.
Amongthemostimportantofthesemarketformsaremonopolyandperfectcompetition,although
monopolisticcompetitionandoligopolyarealsocovered.
The study session then introduces the macroeconomic concepts that have an impact on all firms in
the same environment, be it a country, a group of related countries, or a particular industry. The
readingsexplainthebusinesscycle,andhowtoforecastchangesinthebusinesscycleandtheimpact
on,amongotherthings,pricelevelsandprofitability.Thestudysessionconcludesbydescribinghow
aneconomysaggregatesupplyandaggregatedemandaredetermined.

Reading18:PerfectCompetition
Reading19:Monopoly
Reading20:MonopolisticCompetitionandOligopoly
Reading21:DemandandSupplyinFactorMarkets
Reading22:MonitoringCycles,Jobs,andthePriceLevel
Reading23:AggregateSupplyandAggregateDemand

Economics:MicroeconomicMarketStructureandMacroeconomicAnalysis137
1. Therealwagerateis:
A.

thegrowthinwagesadjustedforproductivity.

B.

themoneywageratemultipliedbythepricelevel.

C.

theamountofgoodsthatanhoursworkcanbuy.

D.

themoneywageratedividedbytheinflationrate.

2. Fullemploymentis:
A.

whenunemploymentiszero.

B.

thelevelofunemploymentafterallowingforcyclicalconditionsinthelabormarkets.

C. thelevelofunemploymentafterallowingforcyclicalandfrictionalconditionsinthe
labormarkets.
D. thelevelofunemploymentafterallowingforfrictionalandstructuralconditionsinthe
labormarkets.

138StudySession05:
1. Therealwagerateis:
A.
B.
C.
D.

the growth in wages adjusted for productivity.


the money wage rate multiplied by the price level.
the amount of goods that an hours work can buy.
the money wage rate divided by the inflation rate.

CorrectAnswer:

C ......................................................................................... LOS:Reading22b

The real wage is simply the money wage rate divided by the price level, or the quantity of goods that an
hours work can buy.
Reference:CFAProgramCurriculum,Volume2,pp.292293.

2. Fullemploymentis:
A.
when unemployment is zero.
B.
the level of unemployment after allowing for cyclical conditions in the labor markets.
C.
the level of unemployment after allowing for cyclical and frictional conditions in the labor markets.
D.
the level of unemployment after allowing for frictional and structural conditions in the labor
markets.
CorrectAnswer:

D .......................................................................................... LOS:Reading22c

Full employment is the level of employment after allowing for the normal/natural rate of unemployment
caused by frictional and structural factors.
Reference:CFAProgramCurriculum,Volume2,pp.297300.

Economics:MicroeconomicMarketStructureandMacroeconomicAnalysis139
3. Oneofthereasonssinglepricemonopoliesaresaidtobeinefficientisbecause:
A.

costsarenotminimized.

B.

excessgoodsareproduced.

C.

pricesarebelowmarginalrevenue.

D.

pricesarekeptbelowproductioncosts.

4. Whichofthefollowingistheleastaccuratedescriptionofamonopoly?
A.

Afirmwhichhastodecidewhichpricewillmaximizeprofits.

B.

Aproducerofagoodforwhichtherearenoattractivesubstitutes.

C.

Amarketinwhichthereareonlyasmallnumberofproducersofagood.

D.

Anindustrywheretherearehighbarrierstoentryforfirmslookingtoenterthebusiness.

140StudySession05:
3. Oneofthereasonssinglepricemonopoliesaresaidtobeinefficientisbecause:
A.
B.
C.
D.

costs are not minimized.


excess goods are produced.
prices are below marginal revenue.
prices are kept below production costs.

CorrectAnswer:

A ......................................................................................... LOS:Reading19b

In a single-price monopoly a shortage of goods is produced, costs are not minimized. For a monopoly price
exceeds marginal revenue, so price also exceeds marginal cost.
Reference:CFAProgramCurriculum,Volume2,pp.181186.

4. Whichofthefollowingistheleastaccuratedescriptionofamonopoly?
A.
B.
C.
D.

A firm which has to decide which price will maximize profits.


A producer of a good for which there are no attractive substitutes.
A market in which there are only a small number of producers of a good.
An industry where there are high barriers to entry for firms looking to enter the business.

CorrectAnswer:

C ..........................................................................................LOS:Reading19a

A monopoly is a firm or market where there is only one producer of a product.


Reference:CFAProgramCurriculum,Volume2,pp.176181.

Economics:MicroeconomicMarketStructureandMacroeconomicAnalysis141
5. Whenfirmsarepricetakerstheshortrunmarketsupplycurveis:
A.

horizontal.

B.

slopesupwardstotheright.

C.

slopesdownwardstotheright.

D. whetheritslopesupwardsordownwardstotheright,orishorizontal,willdependon
theindustry.

6. Whichofthefollowingwouldbetheleastsensibleregulatorysteptoconsiderinordertoincrease
resourceallocationofamonopoly?
A.

Abolishlicensingrequirementsthatlimitentrytotheindustry.

B.

Regulatethatthemonopolyfirmmustreducepricestothemarginalcost.

C.

Breakupthemonopolyintosmallercompanies,ifitisnotanaturalmonopoly.

D. Reducebarriersandquotasthatareactingasabarriertoforeignfirmscompetinginthe
industry.

142StudySession05:
5. Whenfirmsarepricetakerstheshortrunmarketsupplycurveis:
A.
B.
C.
D.

horizontal.
slopes upwards to the right.
slopes downwards to the right.
whether it slopes upwards or downwards to the right, or is horizontal, will depend on the industry.

CorrectAnswer:

B........................................................................................... LOS:Reading18c

Firms will increase supply if the price rises so the supply curve slopes upwards to the right. (Note the
long-run supply curve will not necessarily slope upwards to the right).
Reference:CFAProgramCurriculum,Volume2,pp.156160.

6. Whichofthefollowingwouldbetheleastsensibleregulatorysteptoconsiderinordertoincrease
resourceallocationofamonopoly?
A.
B.
C.
D.

Abolish licensing requirements that limit entry to the industry.


Regulate that the monopoly firm must reduce prices to the marginal cost.
Break up the monopoly into smaller companies, if it is not a natural monopoly.
Reduce barriers and quotas that are acting as a barrier to foreign firms competing in the industry.

CorrectAnswer:

B...........................................................................................LOS:Reading19e

Regulating that a monopoly must price their product at the marginal cost would lead to the monopoly
making losses, it would be better to use the average total cost.
Reference:CFAProgramCurriculum,Volume2,pp.198190.

Economics:MicroeconomicMarketStructureandMacroeconomicAnalysis143
7. Whatistheimpactofanincreaseinforeignexchangerate(strengtheningoflocalcurrency)and
anincreaseintheexpectedinflationrateonaggregatedemand?

Foreignexchangerate

Expectedinflationrate

A.

increase

increase

B.

increase

decrease

C.

decrease

increase

D.

decrease

decrease

8. Whichofthefollowingstatementsregardingamonopolyisleastaccurate?
A.

Therearehighbarrierstoentry.

B.

Thedemandcurveishorizontal.

C.

Therearenosubstitutesforaproduct.

D.

Thereisasinglesellerofawelldefinedproduct.

144StudySession05:
7. Whatistheimpactofanincreaseinforeignexchangerate(strengtheningoflocalcurrency)and
anincreaseintheexpectedinflationrateonaggregatedemand?
Foreign exchange rate
increase
increase
decrease
decrease

A.
B.
C.
D.

CorrectAnswer:

Expected inflation rate


increase
decrease
increase
decrease

C ......................................................................................... LOS:Reading23b

An increase in the foreign exchange rate will decrease aggregate demand since net exports will decline. An
increase in the expected inflation rate increases aggregate demand as people choose to buy goods today
before prices rise.
Reference:CFAProgramCurriculum,Volume2,pp.322325.

8. Whichofthefollowingstatementsregardingamonopolyisleastaccurate?
A.
B.
C.
D.

There are high barriers to entry.


The demand curve is horizontal.
There are no substitutes for a product.
There is a single seller of a well-defined product.

CorrectAnswer:

B...........................................................................................LOS:Reading19a

The demand curve for a monopoly is the market demand curve. It is downward sloping, as price increases
demand will fall.
Reference:CFAProgramCurriculum,Volume2,pp.17881.

Economics:MicroeconomicMarketStructureandMacroeconomicAnalysis145
9. Asignificantriseintherealwagerateismostlikelytoindicatethat:
A.

productivityisrising.

B.

theinflationrateisveryhigh.

C.

theaggregatehoursworkedhasrisen.

D.

theemploymentratehasdroppedsharply.

10. Longruneconomicprofitscanbemadeby:

Pricetakers

Firmsinmonopolisticcompetition

A.

Yes

Yes

B.

Yes

No

C.

No

Yes

D.

No

No

146StudySession05:
9. Asignificantriseintherealwagerateismostlikelytoindicatethat:
A.
B.
C.
D.

productivity is rising.
the inflation rate is very high.
the aggregate hours worked has risen.
the employment rate has dropped sharply.

CorrectAnswer:

A ......................................................................................... LOS:Reading22b

When real wages rise, it usually coincides with an increase in productivity.


Reference:CFAProgramCurriculum,Volume2,pp.292293.

10. Longruneconomicprofitscanbemadeby:
A.
B.
C.
D.

Price takers
Yes
Yes
No
No

CorrectAnswer:

Firms in monopolistic competition


Yes
No
Yes
No
D ......................................................................................... LOS:Reading20b

Price takers and firms in monopolistic completion are operating in markets where there are no barriers to
entry and exit. Therefore in the long run they will make zero economic profits.
Reference:CFAProgramCurriculum,Volume2,pp.212213.

Economics:MicroeconomicMarketStructureandMacroeconomicAnalysis147
11. Aprofitmaximizingfirminmonopolisticcompetitionwillexpandoutputuntilmarginalrevenue
equals:
A.

marketprice.

B.

marginalcost.

C.

averagetotalcost.

D.

averagevariablecost.

12. Anincreaseinthequantityofcapitalinaneconomyislikelyto:
A.

havenoeffectontheaggregatesupplycurves.

B.

shiftonlythelongrunaggregatesupplycurvetotheright.

C.

shiftonlytheshortrunaggregatesupplycurvetotheright.

D.

shiftboththeshortrunandlongrunaggregatesupplycurvestotheright.

148StudySession05:
11. Aprofitmaximizingfirminmonopolisticcompetitionwillexpandoutputuntilmarginalrevenue
equals:
A.
B.
C.
D.

market price.
marginal cost.
average total cost.
average variable cost.

CorrectAnswer:

B.......................................................................................... LOS:Reading20b

Output will be expanded until marginal revenue equals marginal cost.


Reference:CFAProgramCurriculum,Volume2,pp.210212.

12. Anincreaseinthequantityofcapitalinaneconomyislikelyto:
A.
B.
C.
D.

have no effect on the aggregate supply curves.


shift only the long-run aggregate supply curve to the right.
shift only the short-run aggregate supply curve to the right.
shift both the short-run and long-run aggregate supply curves to the right.

CorrectAnswer:

D ..........................................................................................LOS:Reading23a

The larger the capital base the more productive the labor force and the higher the output shifting both
supply curves to the right.
Reference:CFAProgramCurriculum,Volume2,pp.316319.

Economics:MicroeconomicMarketStructureandMacroeconomicAnalysis149
13. Thelowestpossiblecostismostlikelytobefoundinamarketwhichis:
A.

amonopoly.

B.

anoligopoly.

C.

inperfectcompetition.

D.

inmonoplolisticcompetition.

14. Classicaleconomistsbelieve:
A.

moneywageratesareslowtochangeinarecession.

B.

fiscalpolicycanbeusedtostimulateaggregatedemand.

C.

technologicalchangeisastronginfluenceonaggregatedemand.

D.

thegovernmentshouldusemonetarypolicytostimulatedemandinarecession.

150StudySession05:
13. Thelowestpossiblecostismostlikelytobefoundinamarketwhichis:
A.
B.
C.
D.

a monopoly.
an oligopoly.
in perfect competition.
in monoplolistic competition.

CorrectAnswer:

C ......................................................................................... LOS:Reading20b

In monopolistic competition firms produce below the efficient amount which increases costs. Also
monopolies and oligopolies set prices above an efficient point which reduces quantity and increases
average costs.
Reference:CFAProgramCurriculum,Volume2,pp.214215.

14. Classicaleconomistsbelieve:
A.
B.
C.
D.

money wage rates are slow to change in a recession.


fiscal policy can be used to stimulate aggregate demand.
technological change is a strong influence on aggregate demand.
the government should use monetary policy to stimulate demand in a recession.

CorrectAnswer:

C ......................................................................................... LOS:Reading23d

Classical economists believe technological change is the main driver of aggregate demand and supply, and
the economy is effective at self regulation.
Reference:CFAProgramCurriculum,Volume2,p.335.

Economics:MicroeconomicMarketStructureandMacroeconomicAnalysis151
15. IftheCPIpriceindexwas75lastyearand82thisyear,thentheannualinflationrateisclosestto:
A.

7.0%.

B.

8.2%.

C.

8.5%.

D.

9.3%.

16. Apricetakermarketisleastlikelytobecharacterizedby:
A.

identicalproducts.

B.

highentrybarriers.

C.

alargenumberofparticipants.

D.

eachparticipanthasasmallmarketshare.

152StudySession05:
15. IftheCPIpriceindexwas75lastyearand82thisyear,thentheannualinflationrateisclosestto:
A.
B.
C.
D.

7.0%.
8.2%.
8.5%.
9.3%.

CorrectAnswer:

D ......................................................................................... LOS:Reading22d

The inflation rate is [(82 - 75)/75] x 100 = 9.33%


Reference:CFAProgramCurriculum,Volume2,pp.300304.

16. Apricetakermarketisleastlikelytobecharacterizedby:
A.
B.
C.
D.

identical products.
high entry barriers.
a large number of participants.
each participant has a small market share.

CorrectAnswer:

B...........................................................................................LOS:Reading18a

A price-taker market is one with perfect competition. There are no restrictions or barriers to entry.
Reference:CFAProgramCurriculum,Volume2,p.150151.

Economics:MicroeconomicMarketStructureandMacroeconomicAnalysis153
17. Aprofitmaximizingpricetakerwillexpandoutputuntilmarginalrevenueequals:
A.

marketprice.

B.

marginalcost.

C.

averagetotalcost.

D.

averagevariablecost.

18. Whichofthefollowinggroupsofpeopleisleastlikelytobeincludedinthelaborforce?
A.

Retiredworkers.

B.

Parttimeworkers.

C.

Peoplelookingforajob.

D.

Peoplewaitingtostartanewjobwithintwoweeks.

154StudySession05:
17. Aprofitmaximizingpricetakerwillexpandoutputuntilmarginalrevenueequals:
A.
B.
C.
D.

market price.
marginal cost.
average total cost.
average variable cost.

CorrectAnswer:

B.......................................................................................... LOS:Reading18b

Output will be expanded until Price = Marginal revenue = Marginal cost. Marginal revenue always equals
market price in a price taker, which is a purely competitive, market.
Reference:CFAProgramCurriculum,Volume2,pp.151152.

18. Whichofthefollowinggroupsofpeopleisleastlikelytobeincludedinthelaborforce?
A.
B.
C.
D.

Retired workers.
Part-time workers.
People looking for a job.
People waiting to start a new job within two weeks.

CorrectAnswer:

A ..........................................................................................LOS:Reading22a

The labor force includes all the employed and unemployed, it does not include retired workers.
Reference:CFAProgramCurriculum,Volume2,pp.287288.

Economics:MicroeconomicMarketStructureandMacroeconomicAnalysis155
19. Ifamonopolyusespricediscriminationitisleastlikelytohavetheeffectof:
A.

minimizingtheconsumersurplus.

B.

findingthesinglepricethatwillmaximizethequantitysold.

C.

bringingthemarketdemandcurveclosetothemarginalrevenuecurve.

D. producingthequantitywhichissimilartothatproducedinaperfectlycompetitive
market.

20. Firmsactingincollusioninanoligopolywouldgenerallyattemptto:

Output

Prices

A.

increase

increase

B.

increase

decrease

C.

decrease

increase

D.

decrease

decrease

156StudySession05:
19. Ifamonopolyusespricediscriminationitisleastlikelytohavetheeffectof:
A.
B.
C.
D.

minimizing the consumer surplus.


finding the single price that will maximize the quantity sold.
bringing the market demand curve close to the marginal revenue curve.
producing the quantity which is similar to that produced in a perfectly competitive market.

CorrectAnswer:

B........................................................................................... LOS:Reading19c

Price discrimination has the effect of transferring the consumer surplus to the monopoly, bringing the
market demand curve close to the marginal revenue curve and producing a higher quantity. By definition
price discrimination is not a single-price monopoly so answer B is not accurate
Reference:CFAProgramCurriculum,Volume2,pp.191196.

20. Firmsactingincollusioninanoligopolywouldgenerallyattemptto:
A.
B.
C.
D.

Output
increase
increase
decrease
decrease

CorrectAnswer:

Prices
increase
decrease
increase
decrease
C ..........................................................................................LOS:Reading20a

Collusion is usually with the intention of increasing economic profit for the participants by limiting
output and raising pierces.
Reference:CFAProgramCurriculum,Volume2,pp.220222.

Economics:MicroeconomicMarketStructureandMacroeconomicAnalysis157
21. Whichofthefollowingisacharacteristicofmonopolisticcompetition?
A.

Firmsproduceidenticalproducts.

B.

Themarketispurelycompetitive.

C.

Firmshavedownwardslopingdemandcurves.

D.

Firmscannotsellproductsabovethemarketprice.

22. Theprisonersdilemmacanbeappliedtopricefixinginanoligopoly.Itexplainswhy:
A.

membersofacartelaretemptedtocheatonothermembersofthecartel.

B.

themoreplayersinacartel,theeasieritistomaintainpricefixingagreements.

C.

theopportunitytomakelargeprofitswilltemptnewmemberstojointhecartel.

D.

cartelscanbemaintainedaslongasthereareonlyasmallnumberofmembers.

158StudySession05:
21. Whichofthefollowingisacharacteristicofmonopolisticcompetition?
A.
B.
C.
D.

Firms produce identical products.


The market is purely competitive.
Firms have downward sloping demand curves.
Firms cannot sell products above the market price.

CorrectAnswer:

C ..........................................................................................LOS:Reading20a

A, B and D are all characteristics of a price-taker or a perfectly competitive market.


Reference:CFAProgramCurriculum,Volume2,pp.208210.

Economics:MicroeconomicMarketStructureandMacroeconomicAnalysis159
22. Theprisonersdilemmacanbeappliedtopricefixinginanoligopoly.Itexplainswhy:
A.
B.
C.
D.

members of a cartel are tempted to cheat on other members of the cartel.


the more players in a cartel, the easier it is to maintain price-fixing agreements.
the opportunity to make large profits will tempt new members to join the cartel.
cartels can be maintained as long as there are only a small number of members.

CorrectAnswer:

A..........................................................................................LOS:Reading20d

Game theory shows that Nash equilibrium is reached when participants cheat, although this is not the
best outcome for participants.
Reference:CFAProgramCurriculum,Volume2,pp.226234.

160StudySession06:

Study Session 06: Economics:


Monetary and Fiscal Economics

Thisstudysessionfocusesonthemonetarysectorofaneconomy.Itexaminesthefunctionsofmoney
andhowitiscreated,highlightingthespecialroleofthecentralbankwithinaneconomy.Supplyand
demandforresources,suchaslaborandcapital,andgoodsarestronglyinterrelated,andthisstudy
session describes circumstances when this may lead to inflation and the transmission mechanisms
betweenthemonetarysectorandtherealpartoftheeconomy.Finally,thegoalsandimplicationsof
fiscal and monetary policy are explored by examining some of the main models of macroeconomic
theory(Keynesian,classical,andmonetarist).

Reading24:Money,Banks,andtheFederalReserve
Reading25:Money,Interest,RealGDP,andthePriceLevel
Reading26:Inflation
Reading27:FiscalPolicy
Reading28:MonetaryPolicy

Economics:MonetaryandFiscalEconomics161
1. ItisimportanttheFedspoliciestocontrolinflationhavecredibilitywhenfacedwiththeprospect
ofrisinginflationsinceitismorelikelythat:
A.

inflationwillfallwithoutanincreaseinunemployment.

B.

inflationwillfallandrealGDPwillfallbelowpotentialGDP.

C.

aggregatedemandwillbelessthanexpectedwhentheFedraisesinterestrates.

D. thesupplycurveshiftsmoresharplytotheleft,comparedtotheshiftwithan
unanticipatedpolicychange.

2. Amonetaristismostlikelytobelievethat:
A.

longtermGDPgrowthisonlyaffectedbytechnologicalchange.

B.

steadymoneygrowthwillallowtheeconomytooperateatfullemployment.

C.

monetarypolicyshouldbeconstantlyadjustedtoreflectlevelsofaggregatedemand.

D. thegovernmentshouldadoptexpansionaryfiscalpolicieswhenrealGDPisbelow
potentialGDP.

162StudySession06:
1. ItisimportanttheFedspoliciestocontrolinflationhavecredibilitywhenfacedwiththeprospect
ofrisinginflationsinceitismorelikelythat:
A.
inflation will fall without an increase in unemployment.
B.
inflation will fall and real GDP will fall below potential GDP.
C.
aggregate demand will be less than expected when the Fed raises interest rates.
D.
the supply curve shifts more sharply to the left, compared to the shift with an unanticipated policy
change.
CorrectAnswer:

A ......................................................................................... LOS:Reading28d

If the Feds policies are anticipated then wage rates will grow more slowly reflecting the expectations of
lower aggregate demand so inflation can be reduced without a move towards recession or increased
unemployment. If the policy is not anticipated demand is still expected to increase at a higher rate and
money wage rates continue to rise at a higher rate, so the supply curve moves to the left slowing GDP.
Reference:CFAProgramCurriculum,Volume2,pp.477479.

2. Amonetaristismostlikelytobelievethat:
A.
B.
C.
D.

long term GDP growth is only affected by technological change.


steady money growth will allow the economy to operate at full employment.
monetary policy should be constantly adjusted to reflect levels of aggregate demand.
the government should adopt expansionary fiscal policies when real GDP is below potential GDP.

CorrectAnswer:

B.......................................................................................... LOS:Reading28b

Monetarists believe that the economy is self regulating and it will normally operate at full employment if
the pace of money growth is kept steady.
Reference:CFAProgramCurriculum,Volume2,pp.468470.

Economics:MonetaryandFiscalEconomics163
3. Thequantitytheoryofmoneysaysthatanincreaseinmoneysupplywillleadtoanincreasein:
A.

prices.

B.

output.

C.

employment.

D.

thevelocityofmoney.

4. Whenthegovernmentadoptsacountercyclicalfiscalpolicyinresponsetoathreatofrecession
thegovernmentmight:
A.

increasebusinesstaxrates.

B.

reduceitsoutstandingdebt.

C.

increaseinfrastructurespending.

D.

reducethesizeofthebudgetdeficit(orincreasethesurplus).

164StudySession06:
3. Thequantitytheoryofmoneysaysthatanincreaseinmoneysupplywillleadtoanincreasein:
A.
B.
C.
D.

prices.
output.
employment.
the velocity of money.

CorrectAnswer:

A .......................................................................................... LOS:Reading25c

The quantity theory of money says a change in money supply will lead to the same change in price levels,
since velocity and output are unaffected by the quantity of money. This is derived from MV = PY.
Reference:CFAProgramCurriculum,Volume2,pp.386389.

4. Whenthegovernmentadoptsacountercyclicalfiscalpolicyinresponsetoathreatofrecession
thegovernmentmight:
A.
B.
C.
D.

increase business tax rates.


reduce its outstanding debt.
increase infrastructure spending.
reduce the size of the budget deficit (or increase the surplus).

CorrectAnswer:

C ..........................................................................................LOS:Reading24e

A countercyclical policy attempts to move the economy in the opposite direction to the business cycle and
therefore ahead of a recession the policy would be aimed at stimulating demand.
Reference:CFAProgramCurriculum,Volume2,pp.361364.

Economics:MonetaryandFiscalEconomics165
5. Thedemandformoneyis:
A.

theamountofmoneydrawnoutofcashandsavingsaccountsoveroneyear.

B.

theamountofmoneythatpeoplewishtoholdincashandhighlyliquidassets.

C. ameasureofconsumerswillingnesstoincreaseproductivityforadditional
remuneration.
D. theinterestratelevelthatwillattractindividualstoplaceagreaterproportionoftheir
wealthondepositwithbanks.

6. Whichofthefollowingisleastlikelytobeanimpactofhigherinflationifthehigherinflationwas
anticipated?
A.

Anincreaseineffectivetaxrates.

B.

RealGDPwillfallbelowpotentialGDP.

C.

Areductionofinvestmentbybusinesses.

D. Decisionmakersspendmoretimeforecastingtheimpactofinflationandlesstimein
productiveactivities.

166StudySession06:
5. Thedemandformoneyis:
A.
the amount of money drawn out of cash and savings accounts over one year.
B.
the amount of money that people wish to hold in cash and highly liquid assets.
C.
a measure of consumers willingness to increase productivity for additional remuneration.
D.
the interest rate level that will attract individuals to place a greater proportion of their wealth on
deposit with banks.
CorrectAnswer:

B...........................................................................................LOS:Reading25a

The demand for money is simply the amount of money that people wish to hold in cash and highly liquid
assets.
Reference:CFAProgramCurriculum,Volume2,pp.376380.

6. Whichofthefollowingisleastlikelytobeanimpactofhigherinflationifthehigherinflationwas
anticipated?
A.
An increase in effective tax rates.
B.
Real GDP will fall below potential GDP.
C.
A reduction of investment by businesses.
D.
Decision-makers spend more time forecasting the impact of inflation and less time in productive
activities.
CorrectAnswer:

B.......................................................................................... LOS:Reading26d

Unanticipated inflation will reduce real GDP below potential GDP, but anticipated inflation should not do
so as resource costs will rise in anticipation of higher prices, so the aggregate demand and aggregate supply
curves will both shift together.
Reference:CFAProgramCurriculum,Volume2,pp.412414.

Economics:MonetaryandFiscalEconomics167
7. Theimpactondemandformoney(M1)offinancialinnovationandrisinginterestratesintheU.S.
aremostlikelytobe:

inancialinnovation

Risinginterestrate

A.

increase

increase

B.

increase

decrease

C.

decrease

increase

D.

decrease

decrease

8. Amovebygovernmenttoadoptamoreexpansionarymonetarypolicyinresponsetothethreat
ofaneconomicslowdownwill,inthelongrun:
A.

havenoeffectontheeconomy.

B.

beineffectivesinceitwillbetooearlytoadjustpolicy.

C.

tendtostabilizetheeconomyasoutputrespondstothechangeinpolicy.

D. beineffectiveinincreasingoutputsincedecisionmakerswilladjusttheirexpectationsto
reflectthepolicy.

168StudySession06:
7. Theimpactondemandformoney(M1)offinancialinnovationandrisinginterestratesintheU.S.
aremostlikelytobe:
inancial innovation
increase
increase
decrease
decrease

A.
B.
C.
D.

CorrectAnswer:

Rising interest rate


increase
decrease
increase
decrease

D ..........................................................................................LOS:Reading25a

Financial innovation tends to reduce the demand for money, new products such as credit card and ATMs
have reduced the demand for M1. As interest rates rise the opportunity cost of holding money in currency
or checking accounts, which give zero interest, increases and money is placed in interest bearing securities
such as savings accounts. This decreases the demand of money.
Reference:CFAProgramCurriculum,Volume2,pp.376380.

8. Amovebygovernmenttoadoptamoreexpansionarymonetarypolicyinresponsetothethreat
ofaneconomicslowdownwill,inthelongrun:
A.
have no effect on the economy.
B.
be ineffective since it will be too early to adjust policy.
C.
tend to stabilize the economy as output responds to the change in policy.
D.
be ineffective in increasing output since decision-makers will adjust their expectations to reflect
the policy.
CorrectAnswer:

D ......................................................................................... LOS:Reading25b

In the long run decision-makers would have time to adjust their policies, so the only impact will be a rise
in prices.
Reference:CFAProgramCurriculum,Volume2,pp.386387.

Economics:MonetaryandFiscalEconomics169
9. Inthecasethathouseholdsincreasetheirholdingsofcurrencyandreducethebalancesintheir
checkingaccountsbyanequalamount,andtheFederalReservedoesnottakeanyoffsettingaction,
theimpactonthemoneysupplywillbe:
A.

toreducebanksrequiredreserves,whichwillincreasemoneysupply.

B.

toincreasemoneysupplysincethecurrencyisavailableforimmediateuse.

C. toreducetheamountthatcanbeloanedbybanks,whichwilltendtoreducethemoney
supply.
D. therewillbenoimpactonmoneysupply,sincetheincreasedholdingsincurrencywill
offsetthereductionincheckingaccounts.

10. AccordingtothequantitytheoryofmoneyiftheGDPofacountryis$50billionandthevelocity
ofcirculationis8,thenthequantityofmoneyis:
A.

$6.25billion.

B.

$160billion.

C.

$400billion.

D.

$3,200billion.

170StudySession06:
9. Inthecasethathouseholdsincreasetheirholdingsofcurrencyandreducethebalancesintheir
checkingaccountsbyanequalamount,andtheFederalReservedoesnottakeanyoffsettingaction,
theimpactonthemoneysupplywillbe:
A.
to reduce banks required reserves, which will increase money supply.
B.
to increase money supply since the currency is available for immediate use.
C.
to reduce the amount that can be loaned by banks, which will tend to reduce the money supply.
D.
there will be no impact on money supply, since the increased holdings in currency will offset the
reduction in checking accounts.
CorrectAnswer:

C ..........................................................................................LOS:Reading24a

Checking accounts and currency are included in money supply. If the balances in checking accounts are
reduced then it will not directly affect the money supply but it will reduce the amount of reserves that the
banks need to keep and also reduce the amount that they can loan, which will reduce the money supply.
Reference:CFAProgramCurriculum,Volume2,pp.348352.

10. AccordingtothequantitytheoryofmoneyiftheGDPofacountryis$50billionandthevelocity
ofcirculationis8,thenthequantityofmoneyis:
A.
B.
C.
D.

$6.25 billion.
$160 billion.
$400 billion.
$3,200 billion.

CorrectAnswer:

A .......................................................................................... LOS:Reading25c

Use MV = GDP, so M = $50 billion/8 = $6.25 billion.


Reference:CFAProgramCurriculum,Volume2,pp.387389.

Economics:MonetaryandFiscalEconomics171
11. WhenaggregatedemanddropssharplytheKeynesianfeedbackruleismostlikelytoleadtothe
Fed:

Interestrates

Quantityofmoney

A.

increasing

increasing

B.

increasing

decreasing

C.

decreasing

increasing

D.

decreasing

decreasing

12. IntermediatetargetsoftheFedsmonetarypolicyareleastlikelytoinclude:
A.

M1.

B.

Treasurybillrate.

C.

themonetarybase.

D.

thefederalfundsrate.

172StudySession06:
11. WhenaggregatedemanddropssharplytheKeynesianfeedbackruleismostlikelytoleadtothe
Fed:
Interest rates
increasing
increasing
decreasing
decreasing

A.
B.
C.
D.

CorrectAnswer:

Quantity of money
increasing
decreasing
increasing
decreasing
C .......................................................................................... LOS:Reading28c

The Fed would decrease the interest rate and increase the quantity of money in order to shift the aggregate
demand curve back to the right.
Reference:CFAProgramCurriculum,Volume2,pp.470472.

12. IntermediatetargetsoftheFedsmonetarypolicyareleastlikelytoinclude:
A.
B.
C.
D.

M1.
Treasury-bill rate.
the monetary base.
the federal funds rate.

CorrectAnswer:

C ..........................................................................................LOS:Reading28a

Intermediate targets give the Fed information on whether the monetary policy is having the desired effect.
Typically these targets will be monetary aggregates (M1, M2 and/or the monetary base) and the federal
funds rate.
Reference:CFAProgramCurriculum,Volume2,pp.462463.

Economics:MonetaryandFiscalEconomics173
13. AfteranalysisoftheeconomicenvironmenttheFeddecidesnottochangeitsmonetarypolicyin
responsetoademanddrivenslowdownintheeconomy.Thisismostlikelytobeanexampleofa:
A.

fixedrulepolicy.

B.

stabilizationpolicy.

C.

discretionarypolicy.

D.

feedbackrulepolicy.

14. Whichofthefollowingisanautomaticstabilizer?
A.

Interestrates.

B.

Inflationrates.

C.

Exchangerates.

D.

Progressivecorporatetax.

174StudySession06:
13. AfteranalysisoftheeconomicenvironmenttheFeddecidesnottochangeitsmonetarypolicyin
responsetoademanddrivenslowdownintheeconomy.Thisismostlikelytobeanexampleofa:
A.
B.
C.
D.

fixed-rule policy.
stabilization policy.
discretionary policy.
feedback-rule policy.

CorrectAnswer:

C ......................................................................................... LOS:Reading23b

Discretionary policies respond to the state of the economy after taking into account all of the available
information so C is the best answer.
Reference:CFAProgramCurriculum,Volume2,pp.467468.

14. Whichofthefollowingisanautomaticstabilizer?
A.
B.
C.
D.

Interest rates.
Inflation rates.
Exchange rates.
Progressive corporate tax.

CorrectAnswer:

D ..........................................................................................LOS:Reading27e

Automatic stabilizers will tend to expand a budget deficit during a recession and contract a budget deficit
in a boom. They include unemployment benefits, progressive corporate and personal taxes.
Reference:CFAProgramCurriculum,Volume2,pp.452455.

Economics:MonetaryandFiscalEconomics175
15. WhichofthefollowingisleastlikelytobeincludedinM1?
A.

Currency.

B.

Issuedchecks.

C.

Travelerschecks.

D.

Checkingdeposits.

16. Thedemandformoneycurveshowsthatthequantityofmoneydemandedis:
A.

positivelyrelatedtoGDPgrowth.

B.

inverselyrelatedtoGDPgrowth.

C.

positivelyrelatedtointerestrates.

D.

inverselyrelatedtointerestrates.

176StudySession06:
15. WhichofthefollowingisleastlikelytobeincludedinM1?
A.
B.
C.
D.

Currency.
Issued checks.
Travelers checks.
Checking deposits.

CorrectAnswer:

B.......................................................................................... LOS:Reading24b

M1 is made up of currency, travelers checks and checking deposits. Checks are a promise to pay, not a
form of money.
Reference:CFAProgramCurriculum,Volume2,pp.302305.

16. Thedemandformoneycurveshowsthatthequantityofmoneydemandedis:
A.
B.
C.
D.

positively related to GDP growth.


inversely related to GDP growth.
positively related to interest rates.
inversely related to interest rates.

CorrectAnswer:

D ..........................................................................................LOS:Reading25a

Demand for money measures the relationship between interest rates and the amount of money that people
want to hold.
Reference:CFAProgramCurriculum,Volume2,pp.376380.

Economics:MonetaryandFiscalEconomics177
17. Thecrowdingoutmodelsays:
A.

increasingbudgetdeficitstostimulategrowthhasnoeffectoneconomicactivity.

B.

increasingbudgetdeficitstostimulategrowthwillbeleadtoadeclineinnetexports.

C. increasingbudgetdeficitstostimulategrowthwillbefinancedbyhighertotalsavings
rates.
D. theeffectofincreasingbudgetdeficitstostimulategrowthwillbedampenedbythe
negativeimpactofhigherrealinterestratesonprivatespending.

18. Ifbanksretain5%ofnewdepositsinreservesandlendout95%,whenacustomerputs$100,000
ondepositwithabank,itwillleadtoapotentialincreaseinloansanddepositsof:

Loans

Deposits

A.

$1,900,000

$2,000,000

B.

$2,000,000

$2,000,000

C.

$9,400,000

$9,500,000

D.

$9,500,000

$9,500,000

178StudySession06:
17. Thecrowdingoutmodelsays:
A.
increasing budget deficits to stimulate growth has no effect on economic activity.
B.
increasing budget deficits to stimulate growth will be lead to a decline in net exports.
C.
increasing budget deficits to stimulate growth will be financed by higher total savings rates.
D.
the effect of increasing budget deficits to stimulate growth will be dampened by the negative
impact of higher real interest rates on private spending.
CorrectAnswer:

D ......................................................................................... LOS:Reading27b

A budge deficit decreases savings supply and therefore increases the real interest rate, this will crowd out
private investment.
Reference:CFAProgramCurriculum,Volume2,pp.444445.

18. Ifbanksretain5%ofnewdepositsinreservesandlendout95%,whenacustomerputs$100,000
ondepositwithabank,itwillleadtoapotentialincreaseinloansanddepositsof:
A.
B.
C.
D.

Loans
$1,900,000
$2,000,000
$9,400,000
$9,500,000

CorrectAnswer:

Deposits
$2,000,000
$2,000,000
$9,500,000
$9,500,000
A ......................................................................................... LOS:Reading24d

The bank keeps $5,000 as reserves and can lend out $95,000. This money is in turn placed on deposit at
another bank (after being used as payment in a transaction) and the next bank keeps $4,750 as reserves
and lends out $90,250. If we continue the exercise we can see that the total increase in deposits is
$100,000 + $95,000 + $90,250 + . = $100,000(1/0.05) = $2,000,000
The potential deposit expansion multiplier is 1/0.05 = 20.
The increase in loans will be $2,000,000, less the original $100,000.
Reference:CFAProgramCurriculum,Volume2,pp.356359.

Economics:MonetaryandFiscalEconomics179
19. Agenerationalimbalancecreatedbyfiscalpolicyrefersto:
A.

differentgenerationsarelikelytopaydifferentproportionsofanyfiscalimbalance.

B.
thedifferencebetweenthepresentvalueofexpectedtaxrevenuesandsocialsecurity
obligations.
C. thedifferencebetweenthecurrentyearsforecasttaxrevenuesandsocialsecurity
obligations.
D. theimbalancebetweentheamountoftaxcollectedfromtheyoungergenerationandthe
amountcollectedfromtheoldergenerationinanyonecalendaryear.

20. TheslopeofthelongrunPhillipscurveshowsthat:
A.

unemploymentandinflationareinverselyrelated.

B.

unemploymentandexpectedinflationareinverselyrelated.

C.

atthenaturalunemploymentrateanyanticipatedinflationrateispossible.

D.

anincreaseinaggregatedemandlowersunemploymentandincreasesinflation.

180StudySession06:
19. Agenerationalimbalancecreatedbyfiscalpolicyrefersto:
A.
different generations are likely to pay different proportions of any fiscal imbalance.
B.
the difference between the present value of expected tax revenues and social security obligations.
C.
the difference between the current years forecast tax revenues and social security obligations.
D.
the imbalance between the amount of tax collected from the younger generation and the amount
collected from the older generation in any one calendar year.
CorrectAnswer:

A .......................................................................................... LOS:Reading27c

The generational imbalance refers to how the load of the fiscal imbalance will be spread among different
generations. In the U.S. it looks likely that part of the imbalance will have to be paid for by future
generations.
Reference:CFAProgramCurriculum,Volume2,pp.445447.

20. TheslopeofthelongrunPhillipscurveshowsthat:
A.
B.
C.
D.

unemployment and inflation are inversely related.


unemployment and expected inflation are inversely related.
at the natural unemployment rate any anticipated inflation rate is possible.
an increase in aggregate demand lowers unemployment and increases inflation.

CorrectAnswer:

C ..........................................................................................LOS:Reading26e

The LRPC is the relationship between inflation and unemployment when the inflation rate equals the
expected rate. It is vertical since GDP equals potential GDP when inflation is anticipated and
unemployment is at its natural rate.
Reference:CFAProgramCurriculum,Volume2,pp.416417.

Economics:MonetaryandFiscalEconomics181
21. Which of the following is the most accurate description of what generational accounting
measures?

A.

lifeexpectancyandpensioncostsofeachgeneration.

B.

thetaxburdenandbenefitstakenbyeachgeneration.

C.

thedivisionofthefiscalimbalancebetweenthedifferentgenerations.

D. presentvalueofagovernmentsobligationtopaybenefitsandthepresentvalueofitstax
revenues.

22. Theyearendpricedataforacountrywas:

Yearend

Pricelevel

2005

110

2006

113

2007

117

Theannualinflationratein2006andthecompoundannualrateforthe20052007periodwere
closestto:

2006inflationrate

20052007annualrate

A.

2.7%

3.1%

B.

2.7%

6.2%

C.

3.0%

7.0%

D.

3.5%

3.1%

182StudySession06:
21. Which of the following is the most accurate description of what generational accounting
measures?
A.
B.
C.
D.

life expectancy and pension costs of each generation.


the tax burden and benefits taken by each generation.
the division of the fiscal imbalance between the different generations.
present value of a governments obligation to pay benefits and the present value of its tax revenues.

CorrectAnswer:

B........................................................................................... LOS:Reading27c

Generational accounting is the method used to measure tax (income and social security) paid by each
generation versus the social security benefit they receive in retirement. D refers to fiscal balances across all
generations and C refers to the generational imbalance.
Reference:CFAProgramCurriculum,Volume2,pp.445447.

Economics:MonetaryandFiscalEconomics183
22. Theyearendpricedataforacountrywas:

Yearend

Pricelevel

2005

110

2006

113

2007

117

The annual inflation rate in 2006 and the compound annual rate for the 2005-2007 period were closest to:
2006 inflation rate
2005-2007 annual rate
A.
2.7%
3.1%
B.
2.7%
6.2%
C.
3.0%
7.0%
D.
3.5%
3.1%
CorrectAnswer:

A.......................................................................................... LOS:Reading26a

Inflation rate =

Price level this year - Price level last year


100
Price level last year

Inflation rate 2006 =

113 110
100 = 2.7%
110

Inflation rate 2007 =

117
113
100 = 3.5%
113

Thecompoundannualrateis

(1.027)(1.035) 1 = 3.1%

Reference:CFAProgramCurriculum,Volume2,pp.400401.

184StudySession7Introduction

Study Session 7: Introduction


Introductory Readings
Financial Accounting, 8th edition, Belverd E. Needles, Jr., and Marian Powers, (Houghton
Mifflin,2004)
MeasuringBusinessIncome,Ch.3
FinancialReportingandAnalysis,Ch.5,pp.246258
Inventories,Ch.8
CurrentLiabilitiesandtheTimeValueofMoney,Ch.9,pp.412426
ContributedCapital,Ch.12,pp.543553
TheCorporateIncomeStatementandtheStatementofStockholdersEquity,Ch.13,pp.584591

Measuring Business Income


Introduction
This section looks at the concept of net income which is used to measure a companys
profitability. Candidates need to be familiar with the accrual basis of accounting and the
matchingprincipleandwhytheyareused,ratherthanaccountingsimplyonacashbasis.

Accounting methods
Financialstatementsarepreparedattheendofregularaccountingperiodstomakecomparisons
betweendifferentaccountingperiodseasier.Afiscalyearreferstothetwelvemonthperiodused
byacompany(whichinmanycasesisnotthesameasthecalendaryear).
Although revenues and expenses can be accounted for on a cash basis for tax purposes, this is
generally regarded as unsatisfactory since revenues are often earned in a different period from
which the payments are received,and expenses paid in a different period from which they are
incurred. The matching rule states that revenues must be assigned to the periods when the
services are performed or the goods are sold, and expenses must be assigned to the period in
whichtheyproducetherevenue.
Accrual accounting refers to methods that accountants use to apply the matching rule, i.e.that
revenuesarerecognizedwhentheyareearnedandexpenseswhentheyareincurredratherthan
when they are actually paid. Accounts are likely to need adjustment. For example transactions
mayoccurinoneaccountingperiodbutthebenefitsmayspreadovermorethanoneaccounting
period.

IntroductoryReadings185

Financial Reporting and Analysis


Introduction
InthissectionCandidateslearnthedefinitionofeachcategoryorcomponentonthebalancesheet
andincomestatement.Wewillrefertobalancesheetandincomestatementitemsthroughoutthe
rest of the Financial Statement Analysis notes so it is essential you are comfortable with the
structure,presentationandcontentsoffinancialstatements.

Balance Sheet
Themajorcategoriesofabalancesheetareasfollows:

ASSETS

LIABILITIES

CurrentAssets

CurrentLiabilities

Investments

LongtermLiabilities

Property,PlantandEquipment

IntangibleAssets

STOCKHOLDERSEQUITY

ContributedCapital

RetainedEarnings

CurrentAssetscashandotherassetswhichcanreasonablybeexpectedtoberealizedincashor
usedwithinoneyear,orwithinthenormaloperatingcycleofthebusiness,whicheverislonger.
Investments assets that are not used in the normal operation of the business and are not
expectedtobeconvertedintocashwithinoneyear.
Property, Plant and Equipment longterm assets used in the continuing operation of the
business.Theseassetsaredepreciatedtoallocatethecostoftheassetsovertheperiodwhenthey
areused.
IntangibleAssetslongtermassetswithnophysicalsubstancee.g.patents,goodwill.
Current Liabilities obligations due to be paid or performed within one year, or within the
normaloperatingcycleofthebusiness,whicheverislonger.
LongTermLiabilitiesdebtsthatareduetobepaidoutinmorethanoneyearorbeyondthe
normaloperatingcycle.
ContributedCapitaltheparvalueofissuedstockplustheamountspaidininexcessofthepar
value.
RetainedEarningsearningsthathavebeenretainedbythecompany,ratherthandistributedto
stockholders.

186StudySession7Introduction

Income statement
Thecomponentsofamultistepincomestatementareasfollows:

NetSales

CostofGoodsSold

GrossProfit

OperatingExpenses

IncomefromOperations

+/

OtherRevenueandExpenses

IncomebeforeIncomeTaxes

IncomeTaxes

=
NetIncome
NetSalesgrossproceedsfromsales,lesssalesreturnedanddiscountsoffered.
CostofGoodsSoldamountpaidforthegoodsthatweresold.
Operating Expenses costs other than the cost of goods sold, often broken down into selling
expensesandgeneralandadministrativeexpenses.
Other Revenueand Expenses revenuesand expenses thatarenot a result of operatingactivities,
theseincludeinterestincomeandinterestexpenses.

IntroductoryReadings187

Inventories
Introduction
Inventory isanother shortterm assetappearing onthe balancesheet and thecost ofinventory will
also affect the income statement. There are four methods of accounting for inventory and the
candidateneedstounderstandtheimpactonthebalancesheetandincomestatementofthemethod
used.ThisReadingiscoveredinmoredetailinStudySession9,Reading39.

Inventory
Inventoryisacurrentassetandconsistsofgoodsheldforsaleinthenormalcourseofbusiness.The
costofinventorywillincludethecostsofrawmaterialsused,costoflaborandoverheadcosts.The
cost of goods sold (COGS) is measured as the cost of goods available for sale less the value of
inventory at the end of the accounting period. The valuation method used to value inventory is
criticalsinceitwilldecidetheCOGSandgrossprofitofthecompanyandthevalueofinventoryon
thebalancesheet.

Inventory cost
Inventorycostisthepriceorconsiderationpaidtoacquireanasset.Therearethreecomponentsto
inventorycost:
Invoice price less purchase discounts.
Freight or transportation including insurance costs when in transit.
Applicable taxes and tariffs.
It could be argued that other costs, such as storage costs, should also be included in the cost of
inventory.Allocationofthesecostsisdifficultsotheyareusuallyexpensed.
When assigning costs to items that are sold, different methods can be used. These methods make
differentassumptionsontheorderinwhichitemsaresold.Thefourmostcommonlyusedmethods
areshownbelow.

Specific Identification Method


Thismethodcanbeusedwhenitispossibletomatchunitsleftininventorywithaspecificpurchase.
Thismightbeusedbyanartdealerwheretherearehighpriceditemsforsalethatareallunique.

Average-Cost Method
Under this method inventory is priced at the average cost of items available for sale during the
period.

First-In, First-Out Method (FIFO)


Thisisbasedontheassumptionthatthecostofgoodssoldisassociatedwiththeearliestpurchasesin
inventory.Thismeansthatthecostofgoodsheldininventoryisassociatedwiththosethathavebeen
purchasedmostrecently.

Last-In, First-Out Method (LIFO)


The assumption under LIFO is that the cost of goods sold is associated with the most recently
purchased, the cost of goods held in inventory are associated with those that have been purchased
theearliest.

188StudySession7Introduction

Example Int-1

Calculating cost of inventory

On December 31st a company holds 200 units in inventory with an assigned total value of
$1,000, or $5.00 per unit. On January 10th it purchases 30 additional units at a cost of $5.50
per unit and on January 20th it purchases 70 additional units at a cost of $6.00 per unit. 50
units are sold over the month so 250 units are left in inventory at the end of January.

SpecificIdentificationMethod
This requires additional information. If we are told that the specific cost of the 50 units
sold was $4.50 each, then
CostofGoodsSold(COGS)
= 50 $4.50 = $225.00
January31stinventory =CostsofgoodsavailableforsaleCOGS

=$1,000+(30x$5.50)+(70x$6.00)$225=$1,360.00
AverageCostMethod
Averageunitcostofgoodsavailableforsale

=Costofgoodsavailableforsale/unitsavailable

=$1,585/(200+30+70)=$5.28
Costofgoodsavailable=$1,585.00
= 250 $5.28
lessJanuary31stinventory

= $1,320.00
COGS

=$265.00
FirstIn,FirstOutMethod(FIFO)
In this case the 50 units sold are those that were purchased first at a cost of $5.00 per unit
Costofgoodsavailable=$1,585.00
lessJanuary31stinventory = (150 $5.00 ) + (30 $5.50 ) + (70 $6.00 )

= $1,335.00

COGS

=$250.00
LastIn,FirstOutMethod(LIFO)
Inthiscasethe50unitssoldarethosethatwerepurchasedlastatacostof$6.00per
unit.
Costsofgoodsavailable
=$1,585.00
lessJanuary31stinventory
= (200 $5.00 ) + (30 $5.50 ) + (20 $6.00 )

COGS

=$1,285.00
=$300.00

Effect of inventory accounting method


Intheaboveexample,wherepricesarerising,wecanseethatLIFOgivesthehighestCOGSandFIFO
the lowest COGS, so LIFO will give the lowest gross margin. For income statement items LIFO is
generally considered the best method since it more closely follows the matching rule, the current
valueofcostsisused.However,lookingatthebalancesheet,theinventoryvaluerecordedishigher

IntroductoryReadings189
underFIFOthanLIFO.InthiscaseFIFOcouldbeconsideredabettermethodsinceinventoryvalues
areclosertocurrentvalues.
Whenthereplacementcostofinventoryfallsbelowthehistoriccost,perhapsduetoadeclineinprice
levels or obsolescence, then the inventory should be written down to the lowerofcostormarket.
Therearetwomethodsfordoingthis:

Item-by-Item Method
Costandmarketvaluesarecomputedforeachitemininventory.
MajorCategoryMethod
Totalcostandtotalmarketvaluesarecomputedforeachcategoryofgoods.

Example Int-2

Calculating inventory values


ItembyItemMethod

Category1
Itema
Itemb
Category2
Itemc
Itemd

Quantity

Costper
Unit

Market
Valueper
Unit

100
$4.00
$4.50
100
$5.00
$3.50

100
$2.00
$1.00
100
$6.00
$5.00
Inventoryatthelowerofcostormarket

Lowerof
Costor
Market
$400.00
$350.00
$100.00
$500.00
$1,350.00

MajorCategoryMethod
Category1
Itema
Itemb
Total
Category2
Itemc
Itemd
Total

Quantity
100
100

TotalCost
$400.00
$500.00
$900.00

Total
Market
Value

$450.00
$350.00
$800.00

100
$200.00
$100.00
100
$600.00
$500.00
$800.00
$600.00
Inventoryatthelowerofcostormarket

Lowerof
Costor
Market

$800.00

$600.00
$1,400.00

190StudySession7Introduction

Current Liabilities and the Time Value of Money


Introduction
We now move on to look at the liability side of the balance sheet. Candidates need to be able to
differentiate between current liabilities and longterm liabilities and know how to treat liabilities
whentheamountorlikelihoodofpaymentisuncertain.

Liabilities
Aliabilityisalegalobligationtomakeafuturepaymentofassets,orperformaserviceinthefuture,
asaresultofapasttransaction.Currentliabilitiesareliabilitiesthatareexpectedtobepaidwithina
year,orwithinanormaloperatingcycle,whicheverislonger.Longtermliabilitiesaredueafterone
year or operating cycle. Generally, current liabilities are paid from the current assets or from the
proceeds of current operations whereas longterm liabilities represent the financing of longterm
assets.
Liabilitiesareusuallyvaluedattheamountofmoneyneedtopaythedebtorthevalueofgoodsor
services to be delivered. Whilst in some cases the amount is definitely known in other cases an
estimate is made, perhaps based on past experience. An example is when a sale is made but there
remainsaliabilitytoservicetheitemsold.
Currentliabilitiescanbebrokendowninto:

(i) Definitely Determinable Liabilities

Accounts payable
Bank loans and commercial paper
Notes payable
Accrued liabilities
Dividends payable
Sales and excise tax payable
Current portion of long-term debt
Payroll liabilities
Unearned revenues

(ii) Estimated Liabilities


The existence of a liability is clear but often the amount will not be known until later. These items
include:
Income taxes a companys managers will usually only know the profits after the year-end
so an estimated figure must be used.
Property tax payable these are usually paid to the local governments in the U.S., and the
assessment dates are unlikely to match a firms year-end. Therefore an estimated figure
should be used.
Product warranty liability whilst a warranty or guarantee is outstanding on a product there
is a liability and a firm should estimate how much the warranty is likely to cost.
Vacation pay liability not all employees will collect vacation pay so this should also be
recorded as an estimated liability.

IntroductoryReadings191

(iii)Contingent liabilities
Acontingentliabilityisnotanexistingliabilitybutapotentialliabilityinthesensethatitdependson
theoutcomeofafutureeventthatarisesbecauseofapasttransaction.
It should be entered in the accounts if it is both (i) probable and (ii) can be reasonably estimated.
Potential liabilities that do not meet these conditions should be referred to in the notes to the
accounts.

Contributed Capital
Introduction
Candidatesare expected to know the breakdown ofcontributed capitaland the differencebetween
preferred stock and ordinary stock. We also look at payments to stockholders in the form of cash
dividends or repurchase of stock and the impact on the balance sheet. Dividends are revisited in
StudySession13.

Contributed capital
Thisismadeupofthreecomponents:
1.
2.
3.

PreferredStockparvalue,amountauthorizedandamountissuedandoutstanding.
CommonStockparvalue,amountauthorizedandamountissuedandoutstanding.
PaidinCapitalinexcessofparvalue.

Accounting for dividends


Therearethreedatestoconsider:
1.
2.
3.

Date of declaration when the directors declare that a dividend is going to be paid, the
issuerwillrecordacashdividendpayableitemasaliability.
Date of record when ownership of the stock entitles the owner to receive the dividend.
Afterthis,andpriortopayment,thestockisexdividend.Noaccountingentriesareneeded.
Dateofpaymentthedatethedividendispaid,andtheliabilityissettled.

Common stock
Thisistheresidualequitywhichmeansthattheholdershavethelastclaimonassetsinthecasethat
the company goes into liquidation. It is usually theonly stock that carries voting rights. Dividends
maybepaidtostockholderswhichmeansthatpartofthestockholdersequity,usuallyearnings,is
beingpaidouttostockholders.

Preferred stock
Thishaspreferenceovercommonstock,usuallyintermsofbothdividendsandclaimonassetsinthe
case of liquidation. Dividends are often quoted as a percentage of par value and in this sense the
characteristicsofpreferredstockaresimilartothoseofafixedincomeinstrument.Differenttypesof
preferredstockare:
Cumulativepreferredstockifadividendismissedthenitaccumulatesandmustbepaidbeforea
dividendcanbepaidtocommonstockholders.
Convertiblepreferredstockcanbeexchangedintocommonstock.
Callablepreferredstocktheissuercanredeemthestockataprespecifiedprice.

192StudySession7Introduction

Stock issuance
ParvaluestocktheparvalueiscreditedtotheCommonStock(orPreferredStock)accountandany
surplus,ordeficit,tothePaidinCapitalinExcessofParValueaccount,ordebitedtotheDiscount
onCapitalStockaccountrespectively.
NoparstocktheproceedsoftheissuearecreditedtotheCommonStockaccount.

Treasury stock
Thisisstockthathasbeenboughtbackbytheissuer,usuallyinthestockmarket,andnotbeenresold
orretired.
Itistreatedasstockthathasbeenissuedbutisnolongeroutstanding,andthereforedoesnothave
votingrights,rightstodividendsetc.

The Corporate Income Statement and the Statement of


Stockholders Equity
Introduction
Here we consider stock dividends and stock splits which are corporate actions that do not affect a
companysincomeorassetvalue.

Retained earnings
Retained earnings are the part of stockholders equity that represents the stockholders claim on
assetsgeneratedbythefirmsearnings.Itistheprofits(orlosses)sinceinceptionlessanydividends
paidtostockholdersortransferstocontributedcapital.

Accounting for stock dividends and stock splits


Stock dividends
This is a distribution of shares to existing common stockholders in proportion to the size of their
holding. This does not involve a cash payment and leads only to a transfer of funds from retained
earnings to the contributed capital account. The amount transferred is determined by the market
valueofthesharesissued.

Stock splits
This is when a corporation increases the number of issued shares and reduces the par value
accordingly. Again this does not involve a cash payment. The motivation is usually to reduce the
marketpriceandincreaseliquidityoftheshares.

IntroductoryReadings193

Introduction Concept Check Questions


1. Inafirmsfinancialstatementsexpensesshouldberecorded:

A.

when they occur.

B.

when they are paid.

C.

once they can be reasonably estimated.

D.

in the same period that related revenues are recorded.

2. Wheninventorycostsareincreasingduetoinflation,thedecisiontouseLIFOratherthanFIFO
willleadto:

A.

lower net income and lower inventory balances.

B.

lower net income and higher inventory balances.

C.

higher net income and lower inventory balances.

D.

higher net income and higher inventory balances.

194StudySession7Introduction
3. Astockdividend:

A.

Has no impact on the financial statements.

B.

Reduces the par value of stock outstanding.

C.

Transfers an amount from retained earnings to contributed capital.

D.

On the declaration date reduces stockholders equity by the size of the dividend payable.

4. If Treasury stock is included in a firms balance sheet as part of stockholders equity it means
that:
A.

the firm has issued preferred shares.

B.

the firm has repurchased its own stock.

C.

the firm has invested in Treasury notes or Treasury bonds.

D.

the firm has issued stock where the dividends are linked to Treasury bill yields.

IntroductoryReadings195

Introduction Concept Check Answers

1. Inafirmsfinancialstatementsexpensesshouldberecorded:

A.

when they occur.

B.

when they are paid.

C.

once they can be reasonably estimated.

D.

in the same period that related revenues are recorded.

CorrectAnswer1:

The matching rule says that related revenues and expenses should be recorded in the same
accounting period.

2. Wheninventorycostsareincreasingduetoinflation,thedecisiontouseLIFOratherthanFIFO
willleadto:

A.

lower net income and lower inventory balances.

B.

lower net income and higher inventory balances.

C.

higher net income and lower inventory balances.

D.

higher net income and higher inventory balances.

CorrectAnswer2:

COGS will be higher under LIFO reducing net income. Ending inventory will be lower since it
will include old inventory bought at lower prices.

196StudySession7Introduction
3. Astockdividend:

A.

has no impact on the financial statements.

B.

reduces the par value of stock outstanding.

C.

transfers an amount from retained earnings to contributed capital.

D.

on the declaration date reduces stockholders equity by the size of the dividend payable.

CorrectAnswer3:

B refers to a stock split. D is not true since no cash is paid out.

4. If Treasury stock is included in a firms balance sheet as part of stockholders equity it means
that:
A.

the firm has issued preferred shares.

B.

the firm has repurchased its own stock.

C.

the firm has invested in Treasury notes or Treasury bonds.

D.

the firm has issued stock where the dividends are linked to Treasury bill yields.

3.
CorrectAnswer4:

Treasury stock refers to repurchased stock. This is likely to have happened because the managers
believed the stock was undervalued in the market or as a defense against a takeover.

Economics:MonetaryandFiscalEconomics197

198StudySession07:

Study Session 07: Financial Statement Analysis:


An Introduction
The readings in this study session discuss the general principles of the financial reporting system,
underscoringthecriticalroleoftheanalysisoffinancialreportsininvestmentdecisionmaking.
The first reading introduces the range of information that an analyst may use in analyzing the
financial performance of a company, including the principal financial statements (the income
statement,balancesheet,cashflowstatement,andstatementofchangesinownersequity),notesto
those statements, and management discussion and analysis of results. A general framework for
addressingmostfinancialstatementanalysistasksisalsopresented.
A companys financial statements are the endproducts of a process for recording the business
transactions of the company. The second reading illustrates this process, introducing such basic
conceptsastheaccountingequationandaccountingaccruals.
Thepresentationoffinancialinformationtothepublicbyacompanymustconformtothegoverning
setoffinancialreportingstandardsapplyinginthejurisdictioninwhichtheinformationisreleased.
The final reading in this study explores the role of financial reporting standardsetting bodies
worldwideandtheInternationalFinancialReportingStandardsframeworkpromulgatedbyonekey
body, the International Accounting Standards Board. The movement towards worldwide
convergenceoffinancialreportingstandardsisalsointroduced.

Note:
Newrulingsand/orpronouncementsissuedafterthepublicationofthereadingsinStudySessions7
through 10 in financial statement analysis may cause some of the information in these readings to
become dated. Candidates are expected to be familiar with the overall analytical framework
containedinthestudysessionreadings,aswellastheimplicationsofalternativeaccountingmethods
forfinancialanalysisandvaluation,asprovidedintheassignedreadings.ForthepurposeofLevelI
questions on financial statement analysis, when a ratio is defined and calculated differently in
varioustexts,candidatesshouldusethedefinitionsgivenintheCFAInstitutecopyrightedreadings
byRobinson,etal.Variationsinratiodefinitionsarepartofthenatureofpracticalfinancialanalysis.

Reading29:FinancialStatementAnalysis:AnIntroduction
Reading30:FinancialReportingMechanics
Reading31:FinancialReportingStandards

FinancialStatementAnalysis:Introduction199
1. When a firm records an allowance for uncollectible receivables as a deduction against the
receivablesaccountthisis:
A.

acontraaccount.

B.

anadjunctaccount.

C.

anonrecurringitem.

D.

anextraordinaryitem.

2. Ageneraljournalrecordsall:
A.

businesstransactionsbyaccount.

B.

businesstransactionsindateorder.

C.

accountbalances,usuallypreparedonadailybasis.

D.

accountbalances,usuallypreparedattheendofeachaccountingperiod.

200StudySession07:
1. When a firm records an allowance for uncollectible receivables as a deduction against the
receivablesaccountthisis:
A.
B.
C.
D.

a contra account.
an adjunct account.
a non-recurring item.
an extraordinary item.

CorrectAnswer:

A ......................................................................................... LOS:Reading30b

An account which reduces the value of an asset, to a new estimate of its net realizable value, is a contra
account.
Reference:CFAProgramCurriculum,Volume3,pp.3839.

2. Ageneraljournalrecordsall:
A.
B.
C.
D.

business transactions by account.


business transactions in date order.
account balances, usually prepared on a daily basis.
account balances, usually prepared at the end of each accounting period.

CorrectAnswer:

B...........................................................................................LOS:Reading30g

The general journal is the fist step in the flow of information through a financial reporting system. It is
where all transactions are recorded showing which accounts they affect, they are recorded in date order.
Reference:CFAProgramCurriculum,Volume3,pp.6869.

FinancialStatementAnalysis:Introduction201
3. Incomethatisindependentofafirmscapitalstructureis:
A.

netincome.

B.

pretaxincome.

C.

operatingincome.

D.

comprehensiveincome.

4. Whichofthefollowingisleastlikelytobeimportanttoananalystwhenusingfinancialreports?

A.

Detail.

B.

Relevance.

C.

Materiality.

D.

Consistency.

202StudySession07:
3. Incomethatisindependentofafirmscapitalstructureis:
A.
B.
C.
D.

net income.
pre-tax income.
operating income.
comprehensive income.

CorrectAnswer:

C ......................................................................................... LOS:Reading29b

Operating income is revenues less costs of goods sold, SGA, and research and development. Therefore it is
prior to interest costs which reflect the cost of debt financing.
Reference:CFAProgramCurriculum,Volume3,p.13.

4. Whichofthefollowingisleastlikelytobeimportanttoananalystwhenusingfinancialreports?
A.
B.
C.
D.

Detail.
Relevance.
Materiality.
Consistency.

CorrectAnswer:

A ..........................................................................................LOS:Reading31e

If the financial reports are to be relevant and timely it is not practical for them to include every detail of the
financial data.
Reference:CFAProgramCurriculum,Volume3,pp.109110.

FinancialStatementAnalysis:Introduction203
5. Acompanysells$50,000ofgoodsbutundercredittermsgiventocustomers,paymentwillnotbe
received for 30 days. The cost of the goods is recorded as $35,000. As a result of this transaction
assetswill:
A.

decreaseby$35,000.

B.

decreaseby$50,000.

C.

increaseby$15,000.

D.

increaseby$50,000.

6. Two firms buy new photocopiers. The first firm is a retailer of office equipment and the
photocopierwillberesold,andthesecondfirmisabankplanningtousethephotocopierinitshead
office.Howwillthepurchasesbeclassified?

Retailer

Bank

A.

investingactivity

investingactivity

B.

operatingactivity

investingactivity

C.

operatingactivity

financingactivity

D.

operatingactivity

operatingactivity

204StudySession07:
5. Acompanysells$50,000ofgoodsbutundercredittermsgiventocustomers,paymentwillnotbe
received for 30 days. The cost of the goods is recorded as $35,000. As a result of this transaction
assetswill:
A.
B.
C.
D.

decrease by $35,000.
decrease by $50,000.
increase by $15,000.
increase by $50,000.

CorrectAnswer:

C ......................................................................................... LOS:Reading30d

The accounting entries will be to increase accounts receivable (an asset) by $50,000 and decrease
inventory by $35,000, a net increase in assets of $15,000. Additionally revenue of $50,000 and COGS of
$35,000 are recorded.
Reference CFA Program Curriculum, Volume 3, pp. 50-58.

6. Two firms buy new photocopiers. The first firm is a retailer of office equipment and the
photocopierwillberesold,andthesecondfirmisabankplanningtousethephotocopierinitshead
office.Howwillthepurchasesbeclassified?
A.
B.
C.
D.

Retailer
investing activity
operating activity
operating activity
operating activity

CorrectAnswer:

Bank
investing activity
investing activity
financing activity
operating activity

B...........................................................................................LOS:Reading30a

The purchase will be part of the day-to-day activity of the retailer so it will be classed as an operating
activity. For the bank the photocopier will be a long-term asset to support its operations so it will be an
investing activity.
Reference:CFAProgramCurriculum,Volume3,pp.3637.

FinancialStatementAnalysis:Introduction205
7. When new accounting standards areissued which will be implemented in the future, which of
thefollowingbestdescribestherequirementsofacompanyunderInternationalFinancialReporting
Standards(IFRS)?
A. Thecompanymustdisclosewhetherthenewstandardswillorwillnotapplytoits
financialstatements.
B.
Atpresentacompanyisnotobligedtocommentonnewstandardsuntiltheyareactually
implemented.
C. Thecompanymustprovidedetailedinformationonthelikelyimpactofthestandardson
thefinancialstatements.
D. Thecompanymustprovideadiscussiononwhethertherewillbeanyimpactfromthe
newstandardsonthefinancialstatements.

8. Amanufacturingcompanyreceivesdividendsonalongterminvestmentithasmadeinanother
companys shares and paysa dividend to its ownstockholders. Theseare likely to be classifiedas
whichtypesofactivity?

Receivesdividend Paysdividend

A.

Investing

Investing

B.

Investing

Financing

C.

Financing

Investing

D.

Financing

Financing

206StudySession07:
7. When new accounting standards areissued which will be implemented in the future, which of
thefollowingbestdescribestherequirementsofacompanyunderInternationalFinancialReporting
Standards(IFRS)?
A.
The company must disclose whether the new standards will or will not apply to its financial
statements.
B.
At present a company is not obliged to comment on new standards until they are actually
implemented.
C.
The company must provide detailed information on the likely impact of the standards on the
financial statements.
D.
The company must provide a discussion on whether there will be any impact from the new
standards on the financial statements.
CorrectAnswer:

D ......................................................................................... LOS:Reading31h

Companies are expected to provide a discussion on the impending regulations, the conclusions can be
anything from does not apply to management is still evaluating the impact to the impact of adoption is
discussed.
Reference:CFAProgramCurriculum,Volume3,pp.127128.

8. Amanufacturingcompanyreceivesdividendsonalongterminvestmentithasmadeinanother
companys shares and paysa dividend to its ownstockholders. Theseare likely to be classifiedas
whichtypesofactivity?
A.
B.
C.
D.

Receives dividend
Investing
Investing
Financing
Financing

CorrectAnswer:

Pays dividend
Investing
Financing
Investing
Financing

B...........................................................................................LOS:Reading30a

Receiving dividends from a long-term investment, if this is not the companys main business, will be an
investing activity. Paying dividends to its own stockholders is a financing activity.
Reference:CFAProgramCurriculum,Volume3,pp.3637.

FinancialStatementAnalysis:Introduction207
9. UnderU.S.GAAPminorityinterestappearsinthe:
A.

balancesheetasanasset.

B.

balancesheetasaliability.

C.

incomestatementasarevenue.

D.

incomestatementasanexpense.

10. Abanklendsmoneyandreceivesinterestfromtheborrowers;italsotakesdepositsonwhichit
paysinterest.Theseactivitiesarelikelytobeclassifiedaswhichtypesofactivity?

Receivesinterest

Paysinterest

A.

Financing

Operating

B.

Financing

Financing

C.

Investing

Financing

D.

Operating

Operating

208StudySession07:
9. UnderU.S.GAAPminorityinterestappearsinthe:
A.
B.
C.
D.

balance sheet as an asset.


balance sheet as a liability.
income statement as a revenue.
income statement as an expense.

CorrectAnswer:

B.......................................................................................... LOS:Reading30b

Minority interest refers to equity held by other investors in a subsidiary that is consolidated in the
accounts; it is reported as a liability under U.S. GAAP and is a balance sheet item.
Reference:CFAProgramCurriculum,Volume3,pp.3840.

10. Abanklendsmoneyandreceivesinterestfromtheborrowers;italsotakesdepositsonwhichit
paysinterest.Theseactivitiesarelikelytobeclassifiedaswhichtypesofactivity?
A.
B.
C.
D.

Receives interest
Financing
Financing
Investing
Operating

CorrectAnswer:

Pays interest
Operating
Financing
Financing
Operating

D ..........................................................................................LOS:Reading30a

A banks business is taking deposits and making loans so these are both operating activities.
Reference:CFAProgramCurriculum,Volume3,pp.3637.

FinancialStatementAnalysis:Introduction209
11. Ownersequityisleastlikelytobereferredtoas:
A.

netbookvalue.

B.

aresidualclaim.

C.

totalassetslesstotalliabilities.

D.

contributedcapitallessretainedearnings.

12. TheInternationalAccountingStandardsBoard(IASB)is:
A. astandardsettingbodywhichwassetuptoharmonizeaccountingstandards
internationally.
B.
responsiblefordevelopinginternationalfinancialreportingandaccountingstandards
outsidetheU.S.
C. aregulatorybodywithresponsibilityforensuringthatcompaniesadheretoInternational
FinancialReportingStandards.
D. responsibleforensuringthatinvestorsreceivefinancialinformationfromcompaniesthat
bestassiststheminmakinginvestmentdecisions.

210StudySession07:
11. Ownersequityisleastlikelytobereferredtoas:
A.
B.
C.
D.

net book value.


a residual claim.
total assets less total liabilities.
contributed capital less retained earnings.

CorrectAnswer:

D .......................................................................................... LOS:Reading30c

Owners equity is total assets less total liabilities, which is net book value. This is equivalent to
contributed capital plus retained earnings. Owners equity is also referred to as a residual claim since it is
what remains after all the liabilities are settled.
Reference:CFAProgramCurriculum,Volume3,pp.4043.

12. TheInternationalAccountingStandardsBoard(IASB)is:
A.
a standard-setting body which was set up to harmonize accounting standards internationally.
B.
responsible for developing international financial reporting and accounting standards outside the
U.S.
C.
a regulatory body with responsibility for ensuring that companies adhere to International Financial
Reporting Standards.
D.
responsible for ensuring that investors receive financial information from companies that best
assists them in making investment decisions.
CorrectAnswer:

A ......................................................................................... LOS:Reading31b

The IASB is a standard-setting organization responsible for developing international financial reporting
and accounting standards in major countries including the U.S. One of its objectives is to achieve
convergence in accounting standards, so A is the best answer.
Reference:CFAProgramCurriculum,Volume3,p.101.

FinancialStatementAnalysis:Introduction211
13. Informationaboutdirectorscompensationismostlikelytobeincludedinafirms
A.

auditorsreport.

B.

proxystatement.

C.

incomestatement.

D.

ManagementsDiscussionandAnalysis.

14. Whichofthefollowingstatementsismostaccurateindescribingthemeasurementofassetsand
liabilities?
A.

Wheneverpossiblefairvaluesofassetsshouldbeused.

B.

Assetsshouldgenerallybestatedathistoricalcostandliabilitiesatpresentvalue.

C. Acompanyispermittedtouseanumberofdifferentmethodstocalculateassetand
liabilityvalues.
D. Acompanymustselectwhethertousehistoricalorcurrentcostmethodsandapplythe
samemethodtoallassetsandliabilities.

212StudySession07:
13. Informationaboutdirectorscompensationismostlikelytobeincludedinafirms
A.
B.
C.
D.

auditors report.
proxy statement.
income statement.
Managements Discussion and Analysis.

CorrectAnswer:

B...........................................................................................LOS:Reading29e

Proxy statements relate to shareholder meetings. They provide information on board members and
management, executive compensation, stock options and major stockholders.
Reference:CFAProgramCurriculum,Volume3,p.25.

14. Whichofthefollowingstatementsismostaccurateindescribingthemeasurementofassetsand
liabilities?
A.
Whenever possible fair values of assets should be used.
B.
Assets should generally be stated at historical cost and liabilities at present value.
C.
A company is permitted to use a number of different methods to calculate asset and liability values.
D.
A company must select whether to use historical or current cost methods and apply the same
method to all assets and liabilities.
CorrectAnswer:

C ......................................................................................... LOS:Reading31d

Companies can use different combinations of historical cost, current cost, realizable value, present vale and
fair value, so C is the best answer.
Reference:CFAProgramCurriculum,Volume3,p.113.

FinancialStatementAnalysis:Introduction213
15. WhichofthefollowingstatementsisleastaccurateregardingU.S.GAAP?
A.

RelevanceandreliabilityareconsideredprimaryqualitiesintheU.S.GAAPframework.

B.

U.S.GAAPincludesstandardsestablishedbyanumberofdifferentorganizations.

C. U.S.GAAPhasahierarchicalstructurewithstandardsissuedbytheFASBholdingthe
highestposition.
D. ThetargetistoreplaceU.S.GAAPbyInternationalFinancialReportingStandardsby
2012.

16. A manufacturing company records a depreciation expense associated with the purchase of
machinery and the company pays income tax. These are likely to be classified as which types of
activity?

Depreciation

Incometax

A.

Financing

Operating

B.

Operating

Financing

C.

Investing

Financing

D.

Operating

Operating

214StudySession07:
15. WhichofthefollowingstatementsisleastaccurateregardingU.S.GAAP?
A.
Relevance and reliability are considered primary qualities in the U.S. GAAP framework.
B.
U.S. GAAP includes standards established by a number of different organizations.
C.
U.S. GAAP has a hierarchical structure with standards issued by the FASB holding the highest
position.
D.
The target is to replace U.S. GAAP by International Financial Reporting Standards by 2012.
CorrectAnswer:

D ......................................................................................... LOS:Reading31b

The objective is to harmonize U.S. GAAP and IFRS, not to replace one with the other.
Reference:CFAProgramCurriculum,Volume3,pp.118119.

16. A manufacturing company records a depreciation expense associated with the purchase of
machinery and the company pays income tax. These are likely to be classified as which types of
activity?
A.
B.
C.
D.

Depreciation
Financing
Operating
Investing
Operating

CorrectAnswer:

Income tax
Operating
Financing
Financing
Operating
D ..........................................................................................LOS:Reading30a

Depreciation is a cost of using machinery which is likely to be used to manufacture goods for sale, therefore
it is an operating item. Paying income tax is an operating item, since it results from the operations of the
company.
Reference:CFAProgramCurriculum,Volume3,pp.3637.

FinancialStatementAnalysis:Introduction215
17. TheStatementofChangesinOwnersEquitywouldbeleastlikelytoincludeinformationon:
A.

netassets.

B.

netincome.

C.

issueofnewshares.

D.

dividendsdistributed.

18. Accrualsappearinfinancialstatementswhen:
A.

acompanyusesacashbasedaccountingmethod.

B.

thereisuncertaintywhetherrevenueisgoingtoberealizedoranexpensepaid.

C. thereisanadjustmenttovaluesofassetsandliabilitiesonthebalancesheettoreflectfair
values.
D. thereisadifferencebetweenthetimingofcashmovementsandtherecognitionofa
revenueorexpense.

216StudySession07:
17. TheStatementofChangesinOwnersEquitywouldbeleastlikelytoincludeinformationon:
A.
B.
C.
D.

net assets.
net income.
issue of new shares.
dividends distributed.

CorrectAnswer:

A ......................................................................................... LOS:Reading29b

The Statement of Changes in Owners Equity contains information on the composition and changes in
owners equity over the reporting period. This would include information on new shares issued and
retained income. It would not explicitly include information on net assets; this would be in the balance
sheet.
Reference:CFAProgramCurriculum,Volume3,p.19.

18. Accrualsappearinfinancialstatementswhen:
A.
a company uses a cashbased accounting method.
B.
there is uncertainty whether revenue is going to be realized or an expense paid.
C.
there is an adjustment to values of assets and liabilities on the balance sheet to reflect fair values.
D.
there is a difference between the timing of cash movements and the recognition of a revenue or
expense.
CorrectAnswer:

D ..........................................................................................LOS:Reading30e

Accrual accounting requires that revenue is recognized when it is earned and expenses when they are
incurred. This may be before or after the cash is received or paid which gives rise to accrual entries.
Reference:CFAProgramCurriculum,Volume3,pp.6567.

FinancialStatementAnalysis:Introduction217
19. Whichofthefollowingisleastlikelytobeaconstraintinpreparingusefulfinancialstatements?
A.

Thetimetakentoensureinformationisaccurate.

B.

Thecostofprovidinginformationthatisaccurateanduseful.

C.

Manynonquantifiableitemsarenotincludedinthefinancialstatements.

D.

Therequirementtoincludeinformationregardlessofwhetheritisrelevantornot.

20. Historically the approaches of the International Financial Reporting Standards (IFRS) and the
FinancialAccountingStandardsBoard(FASB)havebeenbestdescribedas:

IFRS

FASB

A.

Rulesbased

Rulesbased

B.

Rulesbased

Principlesbased

C.

Principlesbased

Rulesbased

D.

Principlesbased

Principlesbased

218StudySession07:
19. Whichofthefollowingisleastlikelytobeaconstraintinpreparingusefulfinancialstatements?
A.
B.
C.
D.

The time taken to ensure information is accurate.


The cost of providing information that is accurate and useful.
Many nonquantifiable items are not included in the financial statements.
The requirement to include information regardless of whether it is relevant or not.

CorrectAnswer:

D ......................................................................................... LOS:Reading31d

Information that is not relevant, in terms of being out of date or would not influence decision makers, is
not useful and does not automatically need to be included in financial statements. D is the best answer.
Reference:CFAProgramCurriculum,Volume3,pp.110111.

20. Historically the approaches of the International Financial Reporting Standards (IFRS) and the
FinancialAccountingStandardsBoard(FASB)havebeenbestdescribedas:
A.
B.
C.
D.

IFRS
Rules-based
Rules-based
Principles-based
Principles-based

CorrectAnswer:

FASB
Rules-based
Principles-based
Rules-based
Principles-based

C ..........................................................................................LOS:Reading31g

IFRS adopt a principlesbased approach which gives more flexibility on the preparation of financial
reports. The FASB has been rules-based which means there are specific rules for each element or
transaction. This difference in approach has created a barrier to establishing a single coherent framework
for financial reporting.
Reference:CFAProgramCurriculum,Volume3,pp.122123.

FinancialStatementAnalysis:Introduction219
21. Thefollowinginformationisprovidedonacompany:
Retainedearningsatbeginningofyear

$220million

Estimatedincomeforyear

$35million

Estimatedrevenueforyear

$345million

Repurchaseofstockoveryear

$60million

Estimateddividendspaidoveryear

$20million

Theestimatedretainedearningsatendofyearare:
A.

$155million.

B.

$215million.

C.

$255million.

D.

$525million.

22. Thefollowinginformationisprovidedonacompany
Retainedearningsatendofpreviousyear

$28million

Netincomeoveryear

$6million

Contributedcapitalatyearend

$35million

Dividendspaidoveryear

$2million

Expensesoveryear

$3million

Ownersequityatyearendwillbe:
A.

$32million.

B.

$63million.

C.

$64million.

D.

$67million.

220StudySession07:
21. Thefollowinginformationisprovidedonacompany:
Retained earnings at beginning of year
$220 million
Estimated income for year
$35 million
Estimated revenue for year
$345 million
Repurchase of stock over year
$60 million
Estimated dividends paid over year
$20 million
The estimated retained earnings at end of year are:
A.
$155 million.
B.
$215 million.
C.
$255 million.
D.
$525 million.
CorrectAnswer:

B........................................................................................... LOS:Reading30c

Estimated retained earnings at end of year


= retained earnings at beginning of year + net income dividends paid
= $220 million + $35 million - $20 million = 215 million
The repurchase of stock affects paid-up equity rather than retained earnings.
Reference:CFAProgramCurriculum,Volume3,pp.4046.

FinancialStatementAnalysis:Introduction221
22. Thefollowinginformationisprovidedonacompany

Retainedearningsatendofpreviousyear $28million
Netincomeoveryear

$6million

Contributedcapitalatyearend

$35million

Dividendspaidoveryear

$2million

Expensesoveryear

$3million

Owners equity at year end will be:


A.
$32 million.
B.
$63 million.
C.
$64 million.
D.
$67 million.
CorrectAnswer:

D ......................................................................................... LOS:Reading30c

Owners equity = contributed capital + retained earnings


= $35 million + $28 million + ($6 million $2 million) = $67 million
Reference:CFAProgramCurriculum,Volume3,pp.4046.

222StudySession08:

Study Session 08: Financial Statement Analysis:


The Income Statement, Balance Sheet, and Cash Flow
Statement

Eachreadinginthisstudysessionfocusesononeofthethreemajorfinancialstatements:thebalance
sheet,theincomestatement,andthestatementofcashflows.Foreachfinancialstatement,thechapter
details its purpose, construction, pertinent ratios, and commonsize analysis. Understanding these
concepts allows a financial analyst to evaluate trends in performance over several measurement
periodsandtocomparetheperformanceofdifferentcompaniesoverthesameperiod(s).Additional
analysttoolssuchastheearningspersharecalculationarealsodescribed.

Reading32:UnderstandingtheIncomeStatement
Reading33:UnderstandingtheBalanceSheet
Reading34:UnderstandingtheCashFlowStatement

FinancialStatementAnalysis:IncomeStatement,BalanceSheet,&CashFlow223
1. Amanufacturingcompanyacquiresasmallercompetitor.Theacquirercombinestheinventoryof
the two companies which will be sold to generate future sales. This is most likely to have the
followingeffectontheacquiringcompanyscashflows:

Operatingcashflow

Financingcashflow

A.

Noeffect

Understated.

B.

Overstated

Noeffect.

C.

Understated

Noeffect..

D.

Understated

Overstated.

2. If a firms quick ratio is above the industry average but the cash ratio is below the industry
averagethismightbeexplainedby:
A.

thefirmpreferstoholdmarketablesecuritiesratherthancash.

B.

thefirmhashigherinventorylevelscomparedwiththerestoftheindustry.

C.

thefirmhasalargenumberofothershorttermassetsinthebalancesheet.

D. thefirmhasextendedtotheircustomersmorefavorablecredittermsthantheir
competitors.

224StudySession08:
1. Amanufacturingcompanyacquiresasmallercompetitor.Theacquirercombinestheinventoryof
the two companies which will be sold to generate future sales. This is most likely to have the
followingeffectontheacquiringcompanyscashflows:
Operating cash flow
No effect
Overstated
Understated
Understated

A.
B.
C.
D.

CorrectAnswer:

Financing cash flow


Understated.
No effect.
No effect..
Overstated.

B...........................................................................................LOS:Reading34e

The acquirer will not be recognizing the cost of the inventory as an operating cash outflow; it will be
recorded as an investment activity. Therefore cash flow from operations will be overstated. There is no
direct impact on cash flow from financing activities.
Reference CFA Program Curriculum, Volume 3, pp. 279-283.

2. If a firms quick ratio is above the industry average but the cash ratio is below the industry
averagethismightbeexplainedby:
A.
B.
C.
D.

the firm prefers to hold marketable securities rather than cash.


the firm has higher inventory levels compared with the rest of the industry.
the firm has a large number of other short-term assets in the balance sheet.
the firm has extended to their customers more favorable credit terms than their competitors.

CorrectAnswer:

D .......................................................................................... LOS:Reading33i

The quick ratio includes cash, marketable securities and receivables in the numerator whereas the cash
ratio only includes cash and marketable securities. The relatively high quick ratio therefore indicates high
levels of receivables, or customers owing money.
Reference:CFAProgramCurriculum,Volume3,pp.239240.

FinancialStatementAnalysis:IncomeStatement,BalanceSheet,&CashFlow225
3. Whichofthefollowingratiosarecorrectlydescribedasliquidityandsolvencyratios?

Liquidity

Solvency

A.

cash

current

B.

current

debttoequity

C.

debttoequity

financialleverage

D.

financialleverage

quickratio

4. Under U.S. GAAP which of the following is the least accurate statement concerning
extraordinaryitems?Anextraordinaryitem:
A.

isreportednetoftax.

B.

isnotpartofoperatingincome.

C.

isincludedincomprehensiveincome.

D.

mustbebothunusualandinfrequent.

226StudySession08:
3. Whichofthefollowingratiosarecorrectlydescribedasliquidityandsolvencyratios?
Liquidity
cash
current
debt to equity
financial leverage

A.
B.
C.
D.

CorrectAnswer:

Solvency
current
debt to equity
financial leverage
quick ratio

B........................................................................................... LOS:Reading33i

Liquidity ratios measure a companys ability to meet its short-term obligations; solvency ratios measure
the ability to meet long-term and other obligations.
Reference:CFAProgramCurriculum,Volume3,pp.239240.

4. Under U.S. GAAP which of the following is the least accurate statement concerning
extraordinaryitems?Anextraordinaryitem:
A.
B.
C.
D.

is reported net of tax.


is not part of operating income.
is included in comprehensive income.
must be both unusual and infrequent.

CorrectAnswer:

C ..........................................................................................LOS:Reading32g

An extraordinary item will be reported separately on the income statement, below discontinued
operations, and net of tax. Therefore it will impact on net income and is not reported separately in
comprehensive income.
Reference:CFAProgramCurriculum,Volume3,p.168.

FinancialStatementAnalysis:IncomeStatement,BalanceSheet,&CashFlow227
5. Ifacompanydecidestochangefromapolicyofleasingplantandequipmentthroughoperating
leasestopurchasingitsownplantandequipmentthiswill:
A.

increaseinvestingcashflows.

B.

increaseoperatingcashflows.

C.

decreaseoperatingcashflows.

D.

havenoimpactonoperatingcashflows.

6. Whichinventoryaccountingmethodusuallygivesavaluationofinventorythatisclosesttoits
economicvalue?
A.

FIFO.

B.

LIFO.

C.

Lowerofcostormarket.

D.

Weightedaveragecostmethod.

228StudySession08:
5. Ifacompanydecidestochangefromapolicyofleasingplantandequipmentthroughoperating
leasestopurchasingitsownplantandequipmentthiswill:
A.
B.
C.
D.

increase investing cash flows.


increase operating cash flows.
decrease operating cash flows.
have no impact on operating cash flows.

CorrectAnswer:

B...........................................................................................LOS:Reading34a

Lease rentals are classified as an operating cash flow and the purchase of equipment is classified as an
investing cash flow. The decision to switch from leasing to purchasing plant and equipment will increase
operating cash flows but decrease investing cash flows.
Reference:CFAProgramCurriculum,Volume3,pp.265273.

6. Whichinventoryaccountingmethodusuallygivesavaluationofinventorythatisclosesttoits
economicvalue?
A.
B.
C.
D.

FIFO.
LIFO.
Lower of cost or market.
Weighted average cost method.

CorrectAnswer:

A ......................................................................................... LOS:Reading32d

Since FIFO leaves the most recently purchased goods in inventory the valuation will usually be the closest
to current values.
Reference:CFAProgramCurriculum,Volume3,pp.157161.

FinancialStatementAnalysis:IncomeStatement,BalanceSheet,&CashFlow229
7. Using commonsize statement analysis of the balance sheet of a company will help identify
changesin:
A.

totalassets.

B.

profitability.

C.

financialleverage.

D.

efficiencyofuseofassets

8. Whenacompanyrecognizesawarrantyexpenseinthesameaccountingperiodasthesaleofa
goodthisisanapplicationof:
A.

accrualaccounting.

B.

thematchingprinciple.

C.

contingencyaccounting.

D.

thecostrecoverymethod.

230StudySession08:
7. Using commonsize statement analysis of the balance sheet of a company will help identify
changesin:
A.
B.
C.
D.

total assets.
profitability.
financial leverage.
efficiency of use of assets

CorrectAnswer:

C .......................................................................................... LOS:Reading33i

Common-size statement analysis of the balance sheet will help identify changes in ratios which use
balance sheet items; this includes financial leverage which is assets/equity. Total assets will also be read off
the balance sheet, but in common-size statements assets will always be 100%.
Reference:CFAProgramCurriculum,Volume3,pp.239240.

8. Whenacompanyrecognizesawarrantyexpenseinthesameaccountingperiodasthesaleofa
goodthisisanapplicationof:
A.
B.
C.
D.

accrual accounting.
the matching principle.
contingency accounting.
the cost recovery method.

CorrectAnswer:

B........................................................................................... LOS:Reading32c

Under matching principles expenses should be recognized in the same period as the associated revenues,
so the company should recognize estimated warranty expenses in the same period as the sale.
Reference:CFAProgramCurriculum,Volume3,p.162.

FinancialStatementAnalysis:IncomeStatement,BalanceSheet,&CashFlow231
9. Thesaleofapropertywhichcost$3,000,000isagreed.Thepurchasermakesadownpaymentof
$1,500,000andagreestopayfurtherinstallmentsof$600,000peryearattheendofeachofthenext
fiveyears.Theprofitthatwillberecognizedasaresultofthedownpayment,usingtheinstallment
methodandcostrecoverymethodisclosestto:

Installmentmethod

Costrecoverymethod

A.

$0

$0

B.

$750,000

$0

C.

$750,000

$750,000

D.

$1,000,000

$750,000

10. TheComprehensiveIncomeStatementcontains:
A.

detailsofincomefromsubsidiaries.

B.

informationonchangesinstockholdersequity.

C.

detailsonincomefromjointventuresandassociates.

D.

adetailedbreakdownofcostofgoodssoldandotherexpenses.

232StudySession08:
9. Thesaleofapropertywhichcost$3,000,000isagreed.Thepurchasermakesadownpaymentof
$1,500,000andagreestopayfurtherinstallmentsof$600,000peryearattheendofeachofthenext
fiveyears.Theprofitthatwillberecognizedasaresultofthedownpayment,usingtheinstallment
methodandcostrecoverymethodisclosestto:
Installment method
$0
$750,000
$750,000
$1,000,000

A.
B.
C.
D.

CorrectAnswer:

Cost recovery method


$0
$0
$750,000
$750,000

B.......................................................................................... LOS:Reading32b

Installment method: the profit to sales ratio is ($4,500,000 - $3,000,000)/$3,000,000 equals 50%. The
profit recognized from the down payment is 50% x $1,500,000, equals $750,000.
Cost recovery method: no profit is recognized until the costs have been recovered.
Reference:CFAProgramCurriculum,Volume3,pp.152154.

10. TheComprehensiveIncomeStatementcontains:
A.
B.
C.
D.

details of income from subsidiaries.


information on changes in stockholders equity.
details on income from joint ventures and associates.
a detailed breakdown of cost of goods sold and other expenses.

CorrectAnswer:

B........................................................................................... LOS:Reading32l

Comprehensive income is the change in stockholders equity as a result of net income and other revenue
and expense items that have been excluded from the income statement. These items include foreign
currency translation adjustments, pension liability adjustments, unrealized gains and losses on derivatives
contracts and investments.
Reference:CFAProgramCurriculum,Volume3,pp.185186.

FinancialStatementAnalysis:IncomeStatement,BalanceSheet,&CashFlow233
11. JonesConstructiontakesonanewprojectwhichitanticipateswilltaketwoyearstocomplete.It
agreesatotalcontractpriceof$4,000,000anditsexpectedoperatingcostsare$3,000,000.Inthefirst
yearitincurscostsof$1,800,000andreceivespaymentsof$2,000,000.Ifitisusingthepercentageof
completionmethodtorecognizerevenuethentheoperatingincomerecordedinthefirstyearwillbe:
A.

$0.

B.

$200,000.

C.

$600,000.

D.

$1,800,000.

12. I.W.S.Inc.scashflowfrominvestingwas(ref.Question41):
A.

($19million).

B.

($12million).

C.

($9million).

D.

($6million).

234StudySession08:
11. JonesConstructiontakesonanewprojectwhichitanticipateswilltaketwoyearstocomplete.It
agreesatotalcontractpriceof$4,000,000anditsexpectedoperatingcostsare$3,000,000.Inthefirst
yearitincurscostsof$1,800,000andreceivespaymentsof$2,000,000.Ifitisusingthepercentageof
completionmethodtorecognizerevenuethentheoperatingincomerecordedinthefirstyearwillbe:
A.
B.
C.
D.

$0.
$200,000.
$600,000.
$1,800,000.

CorrectAnswer:

C ......................................................................................... LOS:Reading32b

The revenue in the first year is: $1,800,000 x $4,000,000 = $2,400,000


$3,000,000
Costs = $1,800,000
Operating income = $2,400,000 - $1,800,000 = $600,000
Reference:CFAProgramCurriculum,Volume3,pp.148152.

12. I.W.S.Inc.scashflowfrominvestingwas(ref.Question41):
A.
B.
C.
D.

($19 million).
($12 million).
($9 million).
($6 million).

CorrectAnswer:

C ..........................................................................................LOS:Reading34a

Cash flow from investing activities

Cashflowfrominvestingactivities
Purchaseofland
Saleofequipment

(15)
6
(9)

Reference:CFAProgramCurriculum,Volume3,pp.271273.

FinancialStatementAnalysis:IncomeStatement,BalanceSheet,&CashFlow235
13. I.W.S.Inc.scashflowfromfinancingwas(ref.Question41):
A.

($35million).

B.

($23million).

C.

($20million).

D.

($12million).

14. AU.S.consultancycompanydiscoversthatatransactionthattookplacelastyearwasincorrectly
recordedandinfactaclientpaidanadditional$10,000offeesoverthatrecordedasabonusbasedon
thebenefitshereceivedfromtheconsultancyprovidedinthatperiod.Thecompanyshould:
A.

adjustthereportedincomeinthepreviousyearsaccounts.

B.

increasetheincomereceivedinthecurrentyearsaccounts.

C.

adjusttheretainedearningsinthepreviousyearsbalancesheet.

D.

recognizethe$10,000asanextraordinaryprofitinthecurrentyear.

236StudySession08:
13. I.W.S.Inc.scashflowfromfinancingwas(ref.Question41):
A.
B.
C.
D.

($35 million).
($23 million).
($20 million).
($12 million).

CorrectAnswer:

C ..........................................................................................LOS:Reading34a

Cash flow from financing activities

Cashflowfromfinancing
Retirementofcommonstock
Dividendpayment

(12)
(8)
(20)

Reference:CFAProgramCurriculum,Volume3,pp.273275.

14. AU.S.consultancycompanydiscoversthatatransactionthattookplacelastyearwasincorrectly
recordedandinfactaclientpaidanadditional$10,000offeesoverthatrecordedasabonusbasedon
thebenefitshereceivedfromtheconsultancyprovidedinthatperiod.Thecompanyshould:
A.
B.
C.
D.

adjust the reported income in the previous years accounts.


increase the income received in the current years accounts.
adjust the retained earnings in the previous years balance sheet.
recognize the $10,000 as an extraordinary profit in the current year.

CorrectAnswer:

B...........................................................................................LOS:Reading32g

Adjustments to prior years accounts through adjustment to the retained earnings is only to be used for
accounting errors. The adjustment should be reported in the current years income statement. Although it
is a non recurring item it is not an extraordinary item.
Reference:CFAProgramCurriculum,Volume3,pp.169170.

FinancialStatementAnalysis:IncomeStatement,BalanceSheet,&CashFlow237
15. Bishop Steel Manufacturing reported little change in net income whereas the operating cash
flowsrosesharply.Thismightbeexplainedbythecompany:
A.

extendingthepaymentperiodforcustomers.

B.

raisingcashthroughtheissueoflongtermbonds.

C.

sellinglandthatwasnotbeingusedforasubstantialsumofmoney.

D.

usinginventorytomeettheircustomersordersandminimizingrawmaterialpurchases.

16. Thecostsoflonglivedassetsareusuallyallocated:
A.

over5years.

B.

atthetimeofdisposal.

C.

overaperiodthatischosenbythefirm.

D.

whentheimpairmentoftheassetstakesplace.

238StudySession08:
15. Bishop Steel Manufacturing reported little change in net income whereas the operating cash
flowsrosesharply.Thismightbeexplainedbythecompany:
A.
B.
C.
D.

extending the payment period for customers.


raising cash through the issue of long term bonds.
selling land that was not being used for a substantial sum of money.
using inventory to meet their customers orders and minimizing raw material purchases.

CorrectAnswer:

D ..........................................................................................LOS:Reading34e

A is not correct since this would increase receivables and reduce operating cash flow.
B is not correct since the issue of bonds would be classified as a financing cash flow.
C is not correct since the sale of land would be classified as an investment cash flow.
D is correct since this would raise cash from the sale of inventory.
Reference:CFAProgramCurriculum,Volume3,pp.279281.

16. Thecostsoflonglivedassetsareusuallyallocated:
A.
B.
C.
D.

over 5 years.
at the time of disposal.
over a period that is chosen by the firm.
when the impairment of the assets takes place.

CorrectAnswer:

C ......................................................................................... LOS:Reading32d

Usually the management has discretion over the period, or useful life, that assets are depreciated.
Reference:CFAProgramCurriculum,Volume3,pp.162167.

FinancialStatementAnalysis:IncomeStatement,BalanceSheet,&CashFlow239
17. The indirect method of reporting cash flows calculates operating cash flow by which of the
followingmethods?
A. Startwithcashcollectionsfortheperiodanddeductcashoutflowsincurredincollecting
thiscash.
B.
Startwithnetincomefortheperiodandadjustforallnoncashexpenses/revenuesand
adjustfornonoperatingitemsincludedinnetincome.
C. Startwithcashcollectionsfortheperiodanddeductcashoutflowsincurredincollecting
thiscash,andthenadjustforchangesinthebalanceofoperatingassetandliabilityaccounts.
D. Startwithnetincomefortheperiod,adjustforallnoncashexpenses/revenues,adjustfor
nonoperatingitemsincludedinnetincomeandthenadjustforchangesinthebalanceof
operatingassetandliabilityaccounts.

18. WhichofthefollowingisleastlikelytobeincludedintheStatementofStockholdersEquity?
A.

Capitalleases.

B.

Retainedearnings.

C.

Cumulativeforeignexchangeadjustments.

D.

Additionalpaidincapitalabovetheparvalueofcommonstock.

240StudySession08:
17. The indirect method of reporting cash flows calculates operating cash flow by which of the
followingmethods?
A.
Start with cash collections for the period and deduct cash outflows incurred in collecting this cash.
B.
Start with net income for the period and adjust for all non cash expenses/revenues and adjust for
non-operating items included in net income.
C.
Start with cash collections for the period and deduct cash outflows incurred in collecting this cash,
and then adjust for changes in the balance of operating asset and liability accounts.
D.
Start with net income for the period, adjust for all non cash expenses/revenues, adjust for nonoperating items included in net income and then adjust for changes in the balance of operating asset and
liability accounts.
CorrectAnswer:

D ......................................................................................... LOS:Reading34d

The indirect method starts at the net income figure and makes adjustments whereas the direct method
works through the cash items staring with cash collections.
Reference CFA Program Curriculum, Volume 3, pp. 265-271.

18. WhichofthefollowingisleastlikelytobeincludedintheStatementofStockholdersEquity?
A.
B.
C.
D.

Capital leases.
Retained earnings.
Cumulative foreign exchange adjustments.
Additional paid in capital above the par value of common stock.

CorrectAnswer:

A ......................................................................................... LOS:Reading33h

Capital leases are reported in the assets and liabilities section of the balance sheet. All the other items
appear as part of shareholders equity.
Reference:CFAProgramCurriculum,Volume3,pp.226230.

FinancialStatementAnalysis:IncomeStatement,BalanceSheet,&CashFlow241
19. Thecashflowfrominvestmentsin2007forNorthCompanyis(ref.question28):
A.

($85,000).

B.

($70,000).

C.

$30,000.

D.

$130,000.

20. Thecashflowfromfinancingin2007forNorthCompanyis(ref.question28):
A.

($170,000).

B.

($115,000).

C.

($100,000).

D.

($15,000).

242StudySession08:
19. Thecashflowfrominvestmentsin2007forNorthCompanyis(ref.question28):
A.
B.
C.
D.

($85,000).
($70,000).
$30,000.
$130,000.

CorrectAnswer:

C ..........................................................................................LOS:Reading34a

Investingcashflows
Saleofoldmachine

30

Netfrominvestment

30

Reference:CFAProgramCurriculum,Volume3,pp.271273.

20. Thecashflowfromfinancingin2007forNorthCompanyis(ref.question28):
A.
B.
C.
D.

($170,000).
($115,000).
($100,000).
($15,000).

CorrectAnswer:

B...........................................................................................LOS:Reading34a

Financingcashflows:
Banknotes
Dividendspaid

Netfromfinancing

(100)
(15)
(115)

Reference:CFAProgramCurriculum,Volume3,pp.273275.

FinancialStatementAnalysis:IncomeStatement,BalanceSheet,&CashFlow243
21. W.S.IncusesU.S.GAAPandsuppliedthefollowingfinancialdata:

$million
Cashpaymentforsalaries

23

Purchaseofland

15

Cashpaymentforinterest

Retirementofcommonstock

12

Cashcollectionfromcustomers

115

Cashpaymenttosuppliers

43

Depreciationexpense

10

Dividendpayment

Saleofequipment

Cashflowfromoperatingactivitieswas:
A.

$36million.

B.

$39million.

C.

$46million.

D.

$49million.

244StudySession08:
21. W.S.IncusesU.S.GAAPandsuppliedthefollowingfinancialdata:
$ million
Cash payment for salaries
Purchase of land
Cash payment for interest
Retirement of common stock
Cash collection from customers
Cash payment to suppliers
Depreciation expense
Dividend payment
Sale of equipment

23
15
3
12
115
43
10
8
6

Cash flow from operating activities was:


A.
$36 million.
B.
$39 million.
C.
$46 million.
D.
$49 million.
CorrectAnswer:

C ..........................................................................................LOS:Reading34a

Cashflowfromoperatingactivities

$million
115
(43)
(23)
(3)
46

Cashcollectionfromcustomers
Cashpaymenttosuppliers
Cashpaymentforsalaries
Cashpaymentforinterest

Reference:CFAProgramCurriculum,Volume3,pp.265271.

FinancialStatementAnalysis:IncomeStatement,BalanceSheet,&CashFlow245
22. NorthCompanyusesU.S.GAAPandprovidesthefollowingfinancialstatements:

2007Incomestatement(in$000)
Sales
COGS
Depreciation
Interestexpense
Gainonsaleofoldmachinery
Incomebeforetaxes
Incometaxexpense
Netincomeaftertaxes

5,400
(4,600)
(200)
(55)
30
575
(175)
400

Balancesheet(in$000)

Assets:
Cash
Accountsreceivable
Inventory
Property,
plant
&
Totalassets

Liabilities:
Accountspayable
Banknotes
Deferredtaxes
Commonstock
RetainedEarnings
Totalliabilities
Totaldividendsof$15,000werepaid.

end

beg

895
260
500
300
1,955

100
200
800
500
1,600

370
0
90
1,000
495
1,955

350
100
40
1,000
110
1,600

Oldmachinerywassold;themachineryhadalreadybeenfullydepreciated.
Thecashflowfromoperationsin2007is:
A.

$580,000.

B.

$830,000.

C.

$880,000.

D.

$910,000.

246StudySession08:
22. NorthCompanyusesU.S.GAAPandprovidesthefollowingfinancialstatements:

2007Incomestatement(in$000)

Sales

5,400

COGS

(4,600)

Depreciation
Interestexpense

(200)
(55)

Gainonsaleofold

30

Incomebeforetaxes

575

Incometaxexpense

(175)

Netincomeaftertaxes

400

Balancesheet(in$000)
end2007

beg2007

Assets:
Cash

895

100

Accountsreceivable

260

200

Inventory

500

800

Property,plant&

300

500

1,955

1,600

Totalassets

Liabilities:

Accountspayable

Banknotes

370

350

100

Deferredtaxes

90

40

Commonstock

1,000

1,000

RetainedEarnings

495

110

Totalliabilities

1,955

1,600

Totaldividendsof$15,000werepaid.
Oldmachinerywassold;themachineryhadalreadybeenfullydepreciated.
Thecashflowfromoperationsin2007is:
A.
B.
C.
D.

$580,000.
$830,000.
$880,000.
$910,000.

CorrectAnswer:

C ..........................................................................................LOS:Reading34a

FinancialStatementAnalysis:IncomeStatement,BalanceSheet,&CashFlow247
Cash flow from operations:
Net income
Adjust for
Depreciation
Gain on sale of machinery
Deferred taxes
Change in accounts receivable
Decrease in inventory
Change in accounts payable
Net from operations

400
200
(30)
50
(60)
300
20
880

Reference:CFAProgramCurriculum,Volume3,pp.265271.

248StudySession09:

Study Session 09: Financial Statement Analysis:


Inventories, Long-Term Assets, Deferred Taxes, and Onand Off-Balance Sheet Debt
The readings in this study session examine specific categories of assets and liabilities that are
particularlysusceptibletotheimpactofalternativeaccountingpoliciesandestimates.Analystsmust
understandtheeffectsofalternativepoliciesonfinancialstatementsandratios,andbeabletoexecute
appropriateadjustmentstoenhancecomparabilitybetweencompanies.Inaddition,analystsmustbe
alerttodifferencesbetweenacompanysreportedfinancialstatementsandeconomicreality.
Thedescriptionandmeasurementofinventoriesrequirecarefulattentionbecausetheinvestmentin
inventoriesisfrequentlythelargestcurrentassetformerchandizingandmanufacturingcompanies.
Forthesecompanies,themeasurementofinventorycost(i.e.,costofgoodssold)isacriticalfactorin
determininggrossprofitandothermeasuresofcompanyprofitability.Longtermoperatingassetsare
often the largest category of assets on a companys balance sheet. The analyst needs to scrutinize
managements choices with respect to recognizing expenses associated with the operating assets
becauseofthepotentiallylargeimpactsuchchoicescanhaveonreportedearnings.
A companys accounting policies (such as depreciation choices) can cause differences in taxes
reportedinfinancialstatementsandtaxesreportedontaxreturns.ThereadingAnalysisofIncome
Taxesdiscussesseveralissuesthatariserelatingtodeferredtaxes.
Both on and offbalancesheet debt affect a companys liquidity and solvency, and have
consequences for its longterm growth and viability. The notes of the financial statements must be
carefully reviewed to ensure that all potential liabilities (e.g., leasing arrangements and other
contractual commitments) are appropriately evaluated for their conformity to economic reality.
Adjustmentstothefinancialstatementsmayberequiredtoachievecomparabilitywhenevaluating
severalcompanies,andmayalsoberequiredtoimprovecreditandinvestmentdecisionmaking.

Reading35:AnalysisofInventories
Reading36:AnalysisofLongLivedAssets:

PartITheCapitalizationDecision

Reading37:AnalysisofLongLivedAssets:

PartIIAnalysisofDepreciationandImpairment

Reading38:AnalysisofIncomeTaxes
Reading39:AnalysisofFinancingLiabilities
Reading40:LeasesandOffBalanceSheetDebt

FinancialStatementInventories,Assets,Taxes&Debt249
1. When a company reports a large LIFO reserve, has it (1) been using LIFO or FIFO to calculate
inventorybalancesandhasit(2)overstatedorunderstatedthevalueofinventorycomparedwiththe
currentmarketvalue?

Inventorybalances

Overstated/understated

A.

LIFO

overstated

B.

FIFO

overstated

C.

LIFO

understated

D.

FIFO

understated

2. TheaverageageofManufacturersCorporationsmachineryislowerthanothercompaniesinthe
sameindustry.Whichofthefollowingistheleastlikelytoexplainthis?
A.

Thecompanyhasjustmademajorwritedownsofimpairedassets.

B.

Thecompanyusesashorterdepreciationlifeformachinerythanitscompetitors.

C. Thecompanyhasjustfinishedamajorcapitalexpenditureprogramtoreplace
machinery.
D. Thecompanyhasjustacquiredanothermanufacturingcompanyandismakinguseofits
machinery,atthetimeofacquisitionthedepreciationonthismachinerywassetatzero.

250StudySession09:
1. When a company reports a large LIFO reserve, has it (1) been using LIFO or FIFO to calculate
inventorybalancesandhasit(2)overstatedorunderstatedthevalueofinventorycomparedwiththe
currentmarketvalue?
Inventory balances
A.
LIFO
B.
FIFO
C.
LIFO
D.
FIFO
CorrectAnswer:

Overstated/understated
overstated
overstated
understated
understated
C .......................................................................................... LOS:Reading35c

The LIFO reserve is reported by companies using LIFO. Accounting using LIFO usually leads to an
understatement of the inventory balance compared with current values, so information on the LIFO
reserve is provided.
Reference:CFAProgramCurriculum,Volume3,pp.308315.

2. TheaverageageofManufacturersCorporationsmachineryislowerthanothercompaniesinthe
sameindustry.Whichofthefollowingistheleastlikelytoexplainthis?
A.
The company has just made major write downs of impaired assets.
B.
The company uses a shorter depreciation life for machinery than its competitors.
C.
The company has just finished a major capital expenditure program to replace machinery.
D.
The company has just acquired another manufacturing company and is making use of its machinery,
at the time of acquisition the depreciation on this machinery was set at zero.
CorrectAnswer:

average age =

A ......................................................................................... LOS:Reading37d

accumul. depreciati on
depreciat. expense

Impairment of assets would lead to lower current depreciation charges; this will lead to a higher average
asset life. B, C and D will lead to lower average age.
Reference:CFAProgramCurriculum,Volume3,pp.402404.

FinancialStatementInventories,Assets,Taxes&Debt251
3. Acompanyhasjustissuedabondwithcovenants.Whichofthefollowingclausesisleastlikely
tobeincludedinthebondcovenants?
A.

Acaponleverageratiosatspecifieddatesoverthelifeofthebond.

B.

Arequirementthatreturnoncapitalshouldexceedaspecifiedpercentage.

C. Arestrictionondividendpaymentstoshareholdersiftheywouldreducestockholders
equitybelowaspecifiedlevel.
D. Arequirementthatnofuturedebtcanbeissuedthatrankshigherthantheoriginalbonds
givingtheholdersapriorclaimonassets.

4. Whichofthefollowingstatementsismostaccurateregardingcashflowimpactforalesseeofa
capitallease?
A.

Totalcashoutfloweachyearisthesameastheleasepayment.

B.

Alloftherentalpaymentsaretreatedascashflowfromoperations.

C. Therentalpaymentsarepartlyallocatedascashflowfromoperationsandpartlyascash
flowfrominvesting.
D. Thepresentvalueoftheleasepaymentsisclassifiedasaninvestingcashoutflowatthe
beginningofthelease.

252StudySession09:
3. Acompanyhasjustissuedabondwithcovenants.Whichofthefollowingclausesisleastlikely
tobeincludedinthebondcovenants?
A.
A cap on leverage ratios at specified dates over the life of the bond.
B.
A requirement that return on capital should exceed a specified percentage.
C.
A restriction on dividend payments to shareholders if they would reduce stockholders equity
below a specified level.
D.
A requirement that no future debt can be issued that ranks higher than the original bonds giving
the holders a prior claim on assets.
CorrectAnswer:

B...........................................................................................LOS:Reading39e

Covenants tend to focus on clauses that restrict leverage, issuance of new debt or spending (on dividends
or investment) that would limit the funds available to repay bond holders. Therefore a return on capital
requirement is least likely to be specified.
Reference:CFAProgramCurriculum,Volume3,p.500.

4. Whichofthefollowingstatementsismostaccurateregardingcashflowimpactforalesseeofa
capitallease?
A.
Total cash outflow each year is the same as the lease payment.
B.
All of the rental payments are treated as cash flow from operations.
C.
The rental payments are partly allocated as cash flow from operations and partly as cash flow from
investing.
D.
The present value of the lease payments is classified as an investing cash outflow at the beginning of
the lease.
CorrectAnswer:

A ......................................................................................... LOS:Reading40b

There is no cash outflow at the beginning of the lease, other than lease payments, since the asset is not
purchased.
The rental payments are partly allocated to cash flow from operations and partly to cash flow from
financing.
Reference:CFAProgramCurriculum,Volume3,pp.521524.

FinancialStatementInventories,Assets,Taxes&Debt253
5. Aminingcompanyisrequiredbyregulationtorestorelandtoitsoriginalstatewhenmininghas
finished.UnderSFAS143thecompanyisrequiredto:
A. calculatetheundiscountedcostofrestoringthelandtoitsoriginalstateanddepreciate
thiscostoverthelifeofthemine.
B.
calculatethepresentvalueofrestoringthelandtoitsoriginalstateanddeductthisfrom
thecarryingvalueoftheassets.
C. calculatethepresentvalueofrestoringthelandtoitsoriginalstateandrecognizethisas
anexpenseinthefirstyearofoperationofthemine.
D. calculatethepresentvalueofrestoringthelandtoitsoriginalstateattheendofeach
yearandrecognizethedifferencefromthepreviousyearisanaccretionexpense.

6. AU.S.companyreviewsthevalueofitsfixedassetsandfindsthatanassetthathadbeenwritten
downduetoimpairmentinthepreviousaccountingperiodnowhasacarryingvaluelessthanthe
futurecashflowsexpectedtobereceivedfromtheuseoftheasset.Thecompanyshould,underU.S.
GAAP:
A.

revisethevalueoftheassetandrecordthegainasotherincome.

B.

revisethevalueoftheassetandrecordthegainasanunusualitem.

C.

revisethevalueoftheassetandrecordthegainasanextraordinaryincome.

D. notdoanything,anincreaseinthevalueofassetscannotberecognizeduntiltheyare
sold.

254StudySession09:
5. Aminingcompanyisrequiredbyregulationtorestorelandtoitsoriginalstatewhenmininghas
finished.UnderSFAS143thecompanyisrequiredto:
A.
calculate the undiscounted cost of restoring the land to its original state and depreciate this cost
over the life of the mine.
B.
calculate the present value of restoring the land to its original state and deduct this from the
carrying value of the assets.
C.
calculate the present value of restoring the land to its original state and recognize this as an expense
in the first year of operation of the mine.
D.
calculate the present value of restoring the land to its original state at the end of each year and
recognize the difference from the previous year is an accretion expense.
CorrectAnswer:

D ..........................................................................................LOS:Reading37e

A is not correct; the cost should be discounted.


B is not correct; present value should be added to the asset value.
C is not correct; the cost should be added to the asset value and be depreciated over the useful life of the
mine.
Reference:CFAProgramCurriculum,Volume3,pp.408411.

6. AU.S.companyreviewsthevalueofitsfixedassetsandfindsthatanassetthathadbeenwritten
downduetoimpairmentinthepreviousaccountingperiodnowhasacarryingvaluelessthanthe
futurecashflowsexpectedtobereceivedfromtheuseoftheasset.Thecompanyshould,underU.S.
GAAP:
A.
B.
C.
D.

revise the value of the asset and record the gain as other income.
revise the value of the asset and record the gain as an unusual item.
revise the value of the asset and record the gain as an extraordinary income.
not do anything, an increase in the value of assets cannot be recognized until they are sold.

CorrectAnswer:

D ......................................................................................... LOS:Reading37d

Under U.S. GAAP an increase in the value of an asset cannot be recognized until sale and also previous
impairments cannot be restored.
Reference:CFAProgramCurriculum,Volume3,pp.402406.

FinancialStatementInventories,Assets,Taxes&Debt255
7. Afranchiseewhobuystherightstouseaname,aproductandmanagementexpertiseofanother
companyshould:
A.

expensethecostsofpurchasingtheserights.

B.

capitalizethecostofpurchasingtheserights.

C. capitalizethecostofpurchasingtherightstouseanameandexpensethecostoftheright
touseaproductandmanagementexpertise.
D. capitalizethecostofpurchasingtherightstouseanameandaproductandexpensethe
costoftherighttousemanagementexpertise.

8. If a company decided to change the estimated life of an asset that is already owned by the
companyitmust:
A.

restateprioryearsaccounts.

B.

notmakeanyretroactiveadjustment.

C.

discloseitasachangeinaccountingprinciple.

D.

calculatethecumulativeeffectofthechangeandreportnetoftaxes.

256StudySession09:
7. Afranchiseewhobuystherightstouseaname,aproductandmanagementexpertiseofanother
companyshould:
A.
expense the costs of purchasing these rights.
B.
capitalize the cost of purchasing these rights.
C.
capitalize the cost of purchasing the rights to use a name and expense the cost of the right to use a
product and management expertise.
D.
capitalize the cost of purchasing the rights to use a name and a product and expense the cost of the
right to use management expertise.
CorrectAnswer:

B.......................................................................................... LOS:Reading36b

All the costs of purchase should be capitalized.


Reference:CFAProgramCurriculum,Volume3,p.360.

8. If a company decided to change the estimated life of an asset that is already owned by the
companyitmust:
A.
B.
C.
D.

restate prior years accounts.


not make any retroactive adjustment.
disclose it as a change in accounting principle.
calculate the cumulative effect of the change and report net of taxes.

CorrectAnswer:

B.......................................................................................... LOS:Reading37b

A, C and D are not correct since changing an estimate of life of an asset is not a change in accounting
principle.
Since this is only a change in accounting estimate there is no need to make retroactive adjustments, only
current and future depreciation expense will be affected.
Reference:CFAProgramCurriculum,Volume3,pp.394397.

FinancialStatementInventories,Assets,Taxes&Debt257
9. IftheCostofGoodsSoldunderLIFOis$20million,theincreaseinLIFOreserveoverthesame
periodis$5million,andtheclosinginventoryunderLIFOis$80million,thentheCostofGoodsSold
underFIFOis:
A.

$15million.

B.

$25million.

C.

$75million.

D.

$85million.

10. Taxratesarereducedatthebeginningofacompanysfinancialyear.Inthecompanysfinancial
statementsthetaxratereductionwillleadto:
A.

arestatementofprioryearsaccounts.

B.

areductioninthevalueofdeferredtaxassets.

C.

anincreaseinthevalueofdeferredtaxliabilities.

D.

anextraordinarygainwhichisstatednetoftaxontheincomestatement.

258StudySession09:
9. IftheCostofGoodsSoldunderLIFOis$20million,theincreaseinLIFOreserveoverthesame
periodis$5million,andtheclosinginventoryunderLIFOis$80million,thentheCostofGoodsSold
underFIFOis:
A.
B.
C.
D.

$15 million.
$25 million.
$75 million.
$85 million.

CorrectAnswer:

A ......................................................................................... LOS:Reading35b

COGS under FIFO = COGS under LIFO increase in LIFO reserve.


COGS under FIFO = $20 million - $5 million = $15 million
Reference:CFAProgramCurriculum,Volume3,pp.312315.

10. Taxratesarereducedatthebeginningofacompanysfinancialyear.Inthecompanysfinancial
statementsthetaxratereductionwillleadto:
A.
B.
C.
D.

a restatement of prior years accounts.


a reduction in the value of deferred tax assets.
an increase in the value of deferred tax liabilities.
an extraordinary gain which is stated net of tax on the income statement.

CorrectAnswer:

B...........................................................................................LOS:Reading38g

The lower tax rate reduces the value of the tax benefit when the deferred tax asset is realized.
Reference:CFAProgramCurriculum,Volume3,pp.427432.

FinancialStatementInventories,Assets,Taxes&Debt259
11. Marketratesare5%perannumanda6%semiannualcouponbondisissuedat$1,100withaface
value of $1,000. If an investor buys 1,000 bonds at issue and receives a coupon payment after six
monthshowmuchofthiscouponpaymentwillberecordedasprincipalrepaymentbytheissuer?
A.

$2,500.

B.

$5,000.

C.

$5,500.

D.

$30,000.

12. A company enters into an agreement to lease equipment (treated as a capital lease) over two
yearsandwillpayleasepaymentsof$50,000attheendofeachyear.Ifthediscountrateusedis8%
theclosingliabilityattheendofthefirstyearisclosestto:
A.

$44,582.

B.

$46,296.

C.

$50,000.

D.

$58,000.

260StudySession09:
11. Marketratesare5%perannumanda6%semiannualcouponbondisissuedat$1,100withaface
value of $1,000. If an investor buys 1,000 bonds at issue and receives a coupon payment after six
monthshowmuchofthiscouponpaymentwillberecordedasprincipalrepaymentbytheissuer?
A.
B.
C.
D.

$2,500.
$5,000.
$5,500.
$30,000.

CorrectAnswer:

A ..........................................................................................LOS:Reading39a

The coupon paid will be 3% multiplied by $1,000,000, which is $30,000. The interest the investor earns is
2.5% multiplied by $1,100,000, which is $27,500, so the remainder is principal repayment of $2,500.
Reference:CFAProgramCurriculum,Volume3,pp.466471.

12. A company enters into an agreement to lease equipment (treated as a capital lease) over two
yearsandwillpayleasepaymentsof$50,000attheendofeachyear.Ifthediscountrateusedis8%
theclosingliabilityattheendofthefirstyearisclosestto:
A.
B.
C.
D.

$44,582.
$46,296.
$50,000.
$58,000.

CorrectAnswer:

B.......................................................................................... LOS:Reading40b

At the beginning of the lease period the liability will be the present value of the lease payments, which is
$89,163. The first lease payment is divided between interest (8% x $89,163 = $7,133) and principal
repayment. Therefore the liability is reduced by $42,867 to $46,296.
Reference:CFAProgramCurriculum,Volume3,pp.521523.

FinancialStatementInventories,Assets,Taxes&Debt261
13. Whichofthefollowingisanexampleofatakeorpaycontract?
A. Afirmagreestobuyacertainamountofoilfromanoilproduceratthemarketpriceeach
yearforthenextfiveyears.
B.
Afirmhastheoptiontobuyacertainamountofoilfromanoilproduceratthemarket
priceeachyearforthenextfiveyears.
C. Anoilproducerhastheoptiontosellacertainamountofoiltoanotherfirmatafixed
priceeachyearforthenextfiveyears.
D. Anoilproducerhastheoptiontosellacertainamountofoiltoanotherfirmatthe
marketpriceeachyearforthenextfiveyears.

14. Ifadeferredtaxliabilityisveryunlikelytobepaidthenitshouldbetreatedas:
A.

alongtermliability.

B.

stockholdersequity.

C.

ashorttermliability.

D.

anextraordinaryitem.

262StudySession09:
13. Whichofthefollowingisanexampleofatakeorpaycontract?
A.
A firm agrees to buy a certain amount of oil from an oil producer at the market price each year for
the next five years.
B.
A firm has the option to buy a certain amount of oil from an oil producer at the market price each
year for the next five years.
C.
An oil producer has the option to sell a certain amount of oil to another firm at a fixed price each
year for the next five years.
D.
An oil producer has the option to sell a certain amount of oil to another firm at the market price
each year for the next five years.
CorrectAnswer:

A .......................................................................................... LOS:Reading40c

A take-or-pay contract is a firm commitment, not an option, at either a fixed or market price, and can
provide security of supply of a raw material for the buyer and security of income for the seller. These
contracts are an example of off-balance-sheet financing since future commitments are not treated as debt.
Reference:CFAProgramCurriculum,Volume3,pp.532533.

14. Ifadeferredtaxliabilityisveryunlikelytobepaidthenitshouldbetreatedas:
A.
B.
C.
D.

a long-term liability.
stockholders equity.
a short-term liability.
an extraordinary item.

CorrectAnswer:

B.......................................................................................... LOS:Reading38d

If the factors that created the deferred tax liability are unlikely to be reversed, than it is considered part of
stockholders equity.
Reference:CFAProgramCurriculum,Volume3,pp.439440.

FinancialStatementInventories,Assets,Taxes&Debt263
15. In a direct financing lease the sale value reported at the beginning of the lease on the lessors
financialstatementsis:
A.

thesumoftheleasepayments.

B.

thepresentvalueofleasepayments.

C.

zero,thereisnosalevaluereported.

D.

thepresentvalueofleasepaymentsplusthepresentvalueoftheresidualvalue.

16. Ifacompanyactivelyusesoperatingleases,whichofthefollowingstatementsisleastaccurate?
A.

Totalcashflowisunderstated.

B.

Offbalancesheetfinancingissignificant.

C. Minimumleasepaymentsforthenextfiveyearsmustbedisclosedinthecompanys
accounts.
D. Returnonassetsshouldbeadjusteddownwardstogiveaclearerviewofthecompanys
efficiency.

264StudySession09:
15. In a direct financing lease the sale value reported at the beginning of the lease on the lessors
financialstatementsis:
A.
B.
C.
D.

the sum of the lease payments.


the present value of lease payments.
zero, there is no sale value reported.
the present value of lease payments plus the present value of the residual value.

CorrectAnswer:

C ......................................................................................... LOS:Reading40d

With a direct financing lease only financing or interest income is reported. There is no manufacturing
profit and no sale is recorded.
Reference:CFAProgramCurriculum,Volume3,pp.550551.

16. Ifacompanyactivelyusesoperatingleases,whichofthefollowingstatementsisleastaccurate?
A.
B.
C.
D.

Total cash flow is understated.


Off-balance-sheet financing is significant.
Minimum lease payments for the next five years must be disclosed in the companys accounts.
Return on assets should be adjusted downwards to give a clearer view of the companys efficiency.

CorrectAnswer:

A ......................................................................................... LOS:Reading40b

Total cash flow is not understated but cash flow from operations is lower than if the lease were
capitalized.
Reference:CFAProgramCurriculum,Volume3,pp.541543.

FinancialStatementInventories,Assets,Taxes&Debt265
17. Acompanymanufacturesamachineandagreestoleasethemachineunderasalestypecapital
leaseagreement.Thecompanywillrecordthegrossinvestmentinthemachineas:
A.

thesumoftheminimumleasepayments.

B.

thesumofthepresentvaluesoftheminimumleasepayments.

C.

thesumoftheminimumleasepaymentsplustheresidualvalueofthemachine.

D. thesumofthepresentvaluesoftheminimumleasepaymentsplusthepresentvalueof
theresidualvalueofthemachine.

18. Whenmarketinterestratesdecline,acompanythathasfixedratedebtoutstandingwill:
A.

loseineconomicterms.

B.

gainineconomicterms.

C. thedebtonthebalancesheetisautomaticallyadjustedtocurrentmarketvaluesothe
economiclosswillbereflectedasanaccountingloss.
D. thedebtonthebalancesheetisautomaticallyadjustedtocurrentmarketvaluesothe
economicgainwillbereflectedasanaccountinggain.

266StudySession09:
17. Acompanymanufacturesamachineandagreestoleasethemachineunderasalestypecapital
leaseagreement.Thecompanywillrecordthegrossinvestmentinthemachineas:
A.
the sum of the minimum lease payments.
B.
the sum of the present values of the minimum lease payments.
C.
the sum of the minimum lease payments plus the residual value of the machine.
D.
the sum of the present values of the minimum lease payments plus the present value of the residual
value of the machine.
CorrectAnswer:

C ......................................................................................... LOS:Reading40d

Net investment looks at the present value of the payments, the difference between the gross investment
and net investment is the interest component of the revenue represented by unearned income.
Reference:CFAProgramCurriculum,Volume3,pp.547550.

18. Whenmarketinterestratesdecline,acompanythathasfixedratedebtoutstandingwill:
A.
lose in economic terms.
B.
gain in economic terms.
C.
the debt on the balance sheet is automatically adjusted to current market value so the economic loss
will be reflected as an accounting loss.
D.
the debt on the balance sheet is automatically adjusted to current market value so the economic
gain will be reflected as an accounting gain.
CorrectAnswer:

A .......................................................................................... LOS:Reading39f

The debt on the balance sheet reflects the market rate at issuance and therefore if market interest rates
decline the market value of the debt will increase which leads to an economic loss.
Reference:CFAProgramCurriculum,Volume3,pp.489493.

FinancialStatementInventories,Assets,Taxes&Debt267
19. Thefinancialratiosforacompany,whichusesoperatingleasescomparedtoacompanythatuses
capitalleases,willbeasfollows:

Interestcover

Returnonassets

A.

lower

lower

B.

lower

higher

C.

higher

lower

D.

higher

higher

20. Ananalystnoticesthatacompanysnetdeferredtaxliabilityhasdeclined;thisismostlikelyto
beexplainedby:
A.

thecompanyhasmadeaprofit.

B.

anewtaxlawhasincreasedtaxrates.

C.

itisagrowingcompanywithrisingcapitalexpenditure.

thecompanyhaswrittendownassetvaluesduetoimpairment.

268StudySession09:
19. Thefinancialratiosforacompany,whichusesoperatingleasescomparedtoacompanythatuses
capitalleases,willbeasfollows:
Interest cover
lower
lower
higher
higher

A.
B.
C.
D.

CorrectAnswer:

Return on assets
lower
higher
lower
higher
D ......................................................................................... LOS:Reading40b

Interest cover will be higher as interest payments will be lower.


Return on assets will be higher since assets will be lower.
Reference:CFAProgramCurriculum,Volume3,pp.521524.

20. Ananalystnoticesthatacompanysnetdeferredtaxliabilityhasdeclined;thisismostlikelyto
beexplainedby:
A.
the company has made a profit.
B.
a new tax law has increased tax rates.
C.
it is a growing company with rising capital expenditure.
the company has written down asset values due to impairment.
CorrectAnswer:

D ..........................................................................................LOS:Reading37a

A would not reduce deferred tax liabilities.


B is not correct since this would increase deferred tax liabilities
C is not correct since this would to lead to increasing deferred tax liabilities if accelerated tax depreciation
methods are used for tax reporting.
Reference:CFAProgramCurriculum,Volume3,pp.425452.

FinancialStatementInventories,Assets,Taxes&Debt269
21. ThefollowingfinancialdataisprovidedbySportswearCorporation:

$million(usingLIFO) 2006

2007

105

125

300

350

45

55

110

160

1450

1700

Inventory

Currentassets
LIFOreserve

Currentliabilities
COGS

ThecurrentratiosusingFIFOareclosestto:

2006

2007

A.

1.36

1.13

B.

2.32

1.84

C.

2.73

2.19

D.

3.14

2.53

270StudySession09:
21. ThefollowingfinancialdataisprovidedbySportswearCorporation:

$million(usingLIFO) 2006

2007

105

125

300

350

45

55

110

160

1450

1700

Inventory

Currentassets
LIFOreserve

Currentliabilities
COGS

The current ratios using FIFO are closest to:


2006
2007
A.
1.36
1.13
B.
2.32
1.84
C.
2.73
2.19
D.
3.14
2.53
CorrectAnswer:

D ......................................................................................... LOS:Reading35d

Adjust current assets by adding the LIFO reserve to get current assets under FIFO of 345 in 2006 and 405
in 2007.
Current ratio is current assets /current liabilities = 345/110 and 405/160 respectively which equal 3.14 and
2.53 respectively.
Reference:CFAProgramCurriculum,Volume3,pp.312315.

FinancialStatementInventories,Assets,Taxes&Debt271
22. Thefollowinginformationisgivenregardingacompanysactivities:
Taxrateis30%.
Theonlyexpenseisdepreciation.
Anewmachineispurchasedatacostof$10,000.
Annualrevenuesof$40,000aregeneratedfromthenewmachine.
Thecompany,initsfinancialreports,depreciatesthemachinebyusingthestraightline
methodoverfouryearsandthesalvagevalueisestimatedtobe$2,000.
Fortaxpurposesthemachineisdepreciatedusingthestraightlinemethodovertwoyearswiththe
samesalvagevalue.
Thedeferredtaxexpenseinyear2willbe:
A.

$600.

B.

$1,200.

C.

$10,800.

D.

$11,400.

272StudySession09:
22. Thefollowinginformationisgivenregardingacompanysactivities:
Tax rate is 30%.
The only expense is depreciation.
A new machine is purchased at a cost of $10,000.
Annual revenues of $40,000 are generated from the new machine.
The company, in its financial reports, depreciates the machine by using the straight-line method over four
years and the salvage value is estimated to be $2,000.
Fortaxpurposesthemachineisdepreciatedusingthestraightlinemethodovertwoyearswiththe
samesalvagevalue.
Thedeferredtaxexpenseinyear2willbe:
A.
B.
C.
D.

$600.
$1,200.
$10,800.
$11,400.

CorrectAnswer:

A .......................................................................................... LOS:Reading38f

Tax reporting straight-line depreciation over two

Revenue
Depreciation
Taxableincome
Taxespayable

Year2
$40,000
$4,000
$36,000
$10,800

Year1
$40,000
$4,000
$36,000
$10,800

Financial statement reporting straight-line


Revenue
Depreciation
Pretaxincome
Taxexpense
ofwhich:
Taxespayable
Deferredtax

Reference:CFAProgramCurriculum,Volume3,pp.425470.

Year1
$40,000
$2,000
$38,000
$11,400

$10,800
$600

Year2
$40,000
$2,000
$38,000
$11,400
$10,800
$600

FinancialStatementInventories,Assets,Taxes&Debt273

274StudySession10:

Study Session 10: Financial Statement Analysis:


Techniques, Applications, and International Standards
Convergence

Thereadingsinthisstudysessiondiscussfinancialanalysistechniques,financialstatementanalysis
applications,andtheinternationalconvergenceofaccountingstandards.
Thefirstreadingpresentsthemostfrequentlyusedtoolsandtechniquesusedtoevaluatecompanies,
including common size analysis, crosssectional analysis, trend analysis, and ratio analysis. The
second reading then shows the application of financial analysis techniques to major analyst tasks
including the evaluation of past and future financial performance, credit risk, and the screening of
potential equity investments. The reading also discussesanalyst adjustments to reported financials.
Suchadjustmentsareoftenneededtoputcompaniesreportedresultsonacomparablebasis.
This study session concludes with a reading on convergence of international and U.S. accounting
standards.Althoughtherehasbeenmuchprogressinharmonizingaccountingstandardsglobally,as
this reading discusses, there are still significant variations between generally accepted accounting
principlesfromonecountrytoanother.

Reading41:FinancialAnalysisTechniques
Reading42:FinancialStatementAnalysis:Applications
Reading43:InternationalStandardsConvergence

FinancialStatementTechniques,Applications,andInternationalStandardsConvergence275
1. Ifthedebttocapitalratiohasdecreasedforafirmthisismostlikelytobeexplainedby:
A.

thefirmhasjustcompletedanewissueofequitytofinanceitsexpansion.

B.
thebookvalueofdebthasnotchangedbutthemarketvalueoflongtermdebthas
decreased.
C. thebookvalueofdebthasnotchangedbutthemarketvalueoflongtermdebthas
increased.
D. thefirmhasswitchedfromusinglongtermdebttousingmoreshorttermborrowingto
financeitsactivities.

2. Some analysts prefer to use EBITDA rather than earnings per share to value a companys
performance,whichofthefollowingwouldsupportthispreference?
A.

EBITDAismoresensitivetothegearingofthecompany.

B.

EBITDAisamorevolatilenumberthanearningpershare.

C.

EBITDAdoesnottakeintoaccountthecostofusingfixedassets.

D.

EBITDAgivesabetterindicationofprofitsavailabletoequityshareholders.

276StudySession10:
1. Ifthedebttocapitalratiohasdecreasedforafirmthisismostlikelytobeexplainedby:
A.
the firm has just completed a new issue of equity to finance its expansion.
B.
the book value of debt has not changed but the market value of long-term debt has decreased.
C.
the book value of debt has not changed but the market value of long-term debt has increased.
D.
the firm has switched from using long-term debt to using more short-term borrowing to finance its
activities.
CorrectAnswer:

A ......................................................................................... LOS:Reading41d

Debt-to-capital ratio is total debt divided by total debt plus shareholders equity. B and C are not correct
since the book value of debt is used in the calculation. Usually total interest bearing debt is used in the
calculation of capital so D is not correct.
A would lead to an increase in total equity so would explain a fall in the debt-to-capital ratio.
Reference:CFAProgramCurriculum,Volume3,pp.593597.

2. Some analysts prefer to use EBITDA rather than earnings per share to value a companys
performance,whichofthefollowingwouldsupportthispreference?
A.
B.
C.
D.

EBITDA is more sensitive to the gearing of the company.


EBITDA is a more volatile number than earning per share.
EBITDA does not take into account the cost of using fixed assets.
EBITDA gives a better indication of profits available to equity shareholders.

CorrectAnswer:

C ..........................................................................................LOS:Reading41g

Usually earnings per share are more volatile than EBITDA, since they are after interest which is effectively
a fixed charge. EBITDA is profit available to all providers of capital, since it is before interest, and is not
directly sensitive to the level of gearing.
Since EBITDA is before depreciation and capital expenditure it does not take into account the cost of using
fixed assets, so might be used of compare companies with very different levels of fixed asset investment.
Reference:CFAProgramCurriculum,Volume3,pp.610613.

FinancialStatementTechniques,Applications,andInternationalStandardsConvergence277
3. Ananalystisevaluatingtheimpactofchangesinoilpricesonanairlinesprofitability;another
analystisprojectingthecashflowsforaretailerbasedondifferenteconomicforecasts.Theanalysts
aremostlikelytousewhichtypeofanalysis?

Airline

Retailer

A.

scenario

scenario

B.

scenario

sensitivity

C.

sensitivity

scenario

D.

sensitivity

sensitivity

4. UnderInternationalFinancialReportingStandards(IFRS)impairmentofgoodwill:
A.

isnotpermitted,amortizationisstillused.

B.

itchargedasavaluationallowanceagainsttheacquiredassets.

C.

leadstoareductioninnetincomeintheperiodwhentheimpairmentisrecognized.

D.

ischargeddirectlytostockholdersequityanddoesnotimpactontheincomestatement.

278StudySession10:
3. Ananalystisevaluatingtheimpactofchangesinoilpricesonanairlinesprofitability;another
analystisprojectingthecashflowsforaretailerbasedondifferenteconomicforecasts.Theanalysts
aremostlikelytousewhichtypeofanalysis?
Airline
scenario
scenario
sensitivity
sensitivity

A.
B.
C.
D.

CorrectAnswer:

Retailer
scenario
sensitivity
scenario
sensitivity
C ......................................................................................... LOS:Reading41h

Sensitivity analysis will give a range of possible outcomes if a variable changes, so would be applicable to
measuring the sensitivity of the airlines profits to an oil price move. In scenario analysis forecasts are made
based on specific assumptions or outcomes, so this would accommodate using different economic forecasts
to predict cash flows for the retailer.
Reference:CFAProgramCurriculum,Volume3,pp.622623.

4. UnderInternationalFinancialReportingStandards(IFRS)impairmentofgoodwill:
A.
B.
C.
D.

is not permitted, amortization is still used.


it charged as a valuation allowance against the acquired assets.
leads to a reduction in net income in the period when the impairment is recognized.
is charged directly to stockholders equity and does not impact on the income statement.

CorrectAnswer:

C ......................................................................................... LOS:Reading43b

Impairment reduces income in the year it is recorded, reduces the value of net asset and reduces
stockholders equity. Under IFRS goodwill must be checked annually for impairment, amortization is not
permitted.
Reference:CFAProgramCurriculum,Volume3,pp.685689.

FinancialStatementTechniques,Applications,andInternationalStandardsConvergence279
5. NationalTelecomsCorporationsinterestcoverageisclosestto(ref.financialdatainquestion34):
A.

1.11.

B.

2.11.

C.

2.67.

D.

6.00.

6. The gross profit margin of a company has declined relative to its competitors. This could be
explainedby:
A.

thecompanyhasrecognizedlossesonplantandequipmentthathasbecomeobsolete.

B.
thecompanyscreditqualityhasdeclinedpushinguptheinterestrateonshortterm
debt.
C. thecompanyhasincreaseditsmarketingeffortsandhiredadditionalmarketing
executives.
D. thecompanyhasswitchedtousingLIFOaccountingratherthanFIFOaccountinginan
inflationaryenvironment.

280StudySession10:
5. NationalTelecomsCorporationsinterestcoverageisclosestto(ref.financialdatainquestion34):
A.
B.
C.
D.

1.11.
2.11.
2.67.
6.00.

CorrectAnswer:

C ......................................................................................... LOS:Reading41d

Interest coverage =
EBIT
interest expense

= 120 = 2.67
45

Reference:CFAProgramCurriculum,Volume3,pp.593597.

6. The gross profit margin of a company has declined relative to its competitors. This could be
explainedby:
A.
the company has recognized losses on plant and equipment that has become obsolete.
B.
the companys credit quality has declined pushing up the interest rate on short-term debt.
C.
the company has increased its marketing efforts and hired additional marketing executives.
D.
the company has switched to using LIFO accounting rather than FIFO accounting in an
inflationary environment.
CorrectAnswer:

D ......................................................................................... LOS:Reading41d

Gross profit margin is (revenue COGS)/revenue.


Interest expense, losses on sale of plant and equipment and marketing expense are not part of COGS. LIFO
accounting would increase the cost of inventory sold thereby reducing the gross margin.
Reference:CFAProgramCurriculum,Volume3,pp.597601.

FinancialStatementTechniques,Applications,andInternationalStandardsConvergence281
7. Acompanyhasalowfixedassetbaserelativetoitssectoraverage.Itisgenerallythecasethat:
A.

itssalesvariabilityishigherthanthatofothercompaniesinthesector.

B.

thecompanysfinancialriskislowerthanthatofothercompaniesinthesector.

C.

operatingprofitswillberelativelyvolatilecomparedtoothercompaniesinthesector.

D.

investorswilltolerateahigherdebttoequityrelativetoothercompaniesinthesector.

8. Thereturnontotalcapitalofacompanyhasincreased.Thiscouldbeexplainedby:
A.

thecompanysoperatingprofithasbeendeterioratingascompetitivepressureincreases.

B.

thecompanyhassoldunprofitablebusinessunitsandusedtheproceedstoreducedebt.

C. thecompanyhasbecomelessriskyandthereforeahigherreturnontotalinvestedcapital
isrequired.
D. thecompanyhasincreasedborrowingtoexpanditsoperatingcapacitybutthishasnot
yetbeenreflectedinariseinearnings.

282StudySession10:
7. Acompanyhasalowfixedassetbaserelativetoitssectoraverage.Itisgenerallythecasethat:
A.
B.
C.
D.

its sales variability is higher than that of other companies in the sector.
the companys financial risk is lower than that of other companies in the sector.
operating profits will be relatively volatile compared to other companies in the sector.
investors will tolerate a higher debt-to-equity relative to other companies in the sector.

CorrectAnswer:

D ......................................................................................... LOS:Reading41d

A low fixed asset base generally leads to lower operating leverage, i.e. operating profits are less sensitive to
changes in sales revenue. Investors will usually accept greater financial risk if operating risk is lower. One
of the measures of financial risk is the debt-to-equity ratio.
Reference:CFAProgramCurriculum,Volume3,pp.593594.

8. Thereturnontotalcapitalofacompanyhasincreased.Thiscouldbeexplainedby:
A.
the companys operating profit has been deteriorating as competitive pressure increases.
B.
the company has sold unprofitable business units and used the proceeds to reduce debt.
C.
the company has become less risky and therefore a higher return on total invested capital is
required.
D.
the company has increased borrowing to expand its operating capacity but this has not yet been
reflected in a rise in earnings.
CorrectAnswer:

B.......................................................................................... LOS:Reading41d

The total capital will have been reduced by the repayment of debt, thereby increasing the return on total
capital.
Reference:CFAProgramCurriculum,Volume3,pp.597601.

FinancialStatementTechniques,Applications,andInternationalStandardsConvergence283
9. Amajorcompetitorofacompanyhasthesamenetprofitmarginandtotalassetturnoverasthe
company.Thecompetitorsreturnonequityishigher;thisisexplainedbythecompetitorhaving:
A.

alowertaxrate.

B.

higherfinancialleverage.

C.

lowerinterestcostsasapercentageofsales.

D.

lowerinterestcostsasapercentageofoperatingprofit.

10. Acompanyprovidesthefollowinginformation:

2006

2007

Returnonequity

8.9%

9.4%

Returnontotalassets

4.5%

4.2%

1.5

1.7

Totalassetturnover

Thenumberscouldbeexplainedby:

Financialleverage

Netprofitmargin

A.

increased

increased

B.

increased

decreased

C.

decreased

increased

D.

decreased

decreased

284StudySession10:
9. Amajorcompetitorofacompanyhasthesamenetprofitmarginandtotalassetturnoverasthe
company.Thecompetitorsreturnonequityishigher;thisisexplainedbythecompetitorhaving:
A.
B.
C.
D.

a lower tax rate.


higher financial leverage.
lower interest costs as a percentage of sales.
lower interest costs as a percentage of operating profit.

CorrectAnswer:

B.......................................................................................... LOS:Reading41d

Return on equity = net profit margin x total asset turnover x financial leverage
Reference:CFAProgramCurriculum,Volume3,pp.597601.

10. Acompanyprovidesthefollowinginformation:

2006

2007

Returnonequity

8.9%

9.4%

Returnontotalassets

4.5%

4.2%

1.5

1.7

Totalassetturnover
Thenumberscouldbeexplainedby:
A.
B.
C.
D.

Financial leverage
increased
increased
decreased
decreased

CorrectAnswer:

Net profit margin


increased
decreased
increased
decreased

B........................................................................................... LOS:Reading41f

Return on equity = return on assets x financial leverage. Return on equity has increased when return on
assets fell, so financial leverage must have increased.
Return on assets = net profit margin x total asset turnover. If return on assets fell and total asset turnover
increased in must be because net profit margins fell.
Reference:CFAProgramCurriculum,Volume3,pp.8489.

FinancialStatementTechniques,Applications,andInternationalStandardsConvergence285
11. Which of the following is least likely to be a limitation of using ratio analysis to evaluate the
financialperformanceofacompany?
A.

Ratiosaremoreapplicableforequityanalysisandarelessusefulforcreditanalysis.

B.
Ratiosbasedonfinancialstatementsusingdifferentaccountingmethodsmaynotbe
comparable.
C. Therearepotentialinconsistenciesbetweenthesignalsdifferentratiosaregivingabouta
companysfinancialhealth.
D. Acompanysoperationsmaybediverseanditisnotalwayseasytofindcompaniesthat
canprovideusefulindustrycomparisons.

12. When Moodys calculates that a firms retained cash flow to debt is 0.25, this is most likely to
meanthat:
A.

thefirmcouldpayoffitsdebtfromretainedcashflowinaboutthreemonths.

B.
unlessthefirmhasaheavycapitalexpenditureprogramitcouldpayoffitsdebtfrom
retainedcashflowinaboutfouryears.
C. thecashflowsrequiredtopayinterestonthedebtareapproximatelyaquarterofthe
firmstotalcashflows,aftercapitalexpenditure.
D. thefirmcouldincreasedebtfinancingbyafactoroffourtimesandstillhavesufficient
cashflowtocoverinterestpaymentsonthedebt.

286StudySession10:
11. Which of the following is least likely to be a limitation of using ratio analysis to evaluate the
financialperformanceofacompany?
A.
Ratios are more applicable for equity analysis and are less useful for credit analysis.
B.
Ratios based on financial statements using different accounting methods may not be comparable.
C.
There are potential inconsistencies between the signals different ratios are giving about a
companys financial health.
D.
A companys operations may be diverse and it is not always easy to find companies that can provide
useful industry comparisons.
CorrectAnswer:

A ......................................................................................... LOS:Reading41b

Ratios are widely used by both equity analysts and credit analysts so A is not correct. B, C and D are all
potential limitations of using ratios for financial analysis.
Reference:CFAProgramCurriculum,Volume3,pp.572573.

12. When Moodys calculates that a firms retained cash flow to debt is 0.25, this is most likely to
meanthat:
A.
the firm could pay off its debt from retained cash flow in about three months.
B.
unless the firm has a heavy capital expenditure program it could pay off its debt from retained cash
flow in about four years.
C.
the cash flows required to pay interest on the debt are approximately a quarter of the firms total
cash flows, after capital expenditure.
D.
the firm could increase debt financing by a factor of four times and still have sufficient cash flow to
cover interest payments on the debt.
CorrectAnswer:

B........................................................................................... LOS:Reading42c

Retained cash flow is defined as operating cash flow before working capital changes, less dividends. If
cash flows and debt remains stable and there were no capital expenditures then the company could pay off
its debt from retained cash flow in 1/0.25, or 4 years.
Reference:CFAProgramCurriculum,Volume3,pp.649652

FinancialStatementTechniques,Applications,andInternationalStandardsConvergence287
13. Whenafirmcannotconfidentlyforecasttheoutcome,intermsortotalrevenuesandcosts,ofa
constructionprojecttheappropriateaccountingtreatmentsforrecognizingrevenueunderU.S.GAAP
andInternationalFinancialReportingStandards(IFRS)are:

U.S.GAAP

IFRS

A.

completedcontract

percentageofcompletion

B.

completedcontract

revenueifcontractcostscanberecovered

C.

percentageofcompletion

completedcontract

D.

percentageofcompletion

revenueifcontractcostscanberecovered

14. Afirmhasahigherreturnonequitytoitscompetitors;thisisleastlikelytobeexplainedby:
A.

alowertaxburden.

B.

higherassetturnover.

C.

alowerinterestburden.

D.

lowerfinancialleverage.

288StudySession10:
13. Whenafirmcannotconfidentlyforecasttheoutcome,intermsortotalrevenuesandcosts,ofa
constructionprojecttheappropriateaccountingtreatmentsforrecognizingrevenueunderU.S.GAAP
andInternationalFinancialReportingStandards(IFRS)are:
U.S. GAAP
completed contract
completed contract
percentage of completion
percentage of completion

A.
B.
C.
D.

IFRS
percentage of completion
revenue if contract costs can be recovered
completed contract
revenue if contract costs can be recovered

CorrectAnswer:

B.......................................................................................... LOS:Reading43b

Under IFRS, revenue can be recognised to the extent that contract costs can be recovered. Under U.S.
GAAP, the completed contract method must be used.
Reference:CFAProgramCurriculum,Volume3,p.684.

14. Afirmhasahigherreturnonequitytoitscompetitors;thisisleastlikelytobeexplainedby:
A.
B.
C.
D.

a lower tax burden.


higher asset turnover.
a lower interest burden.
lower financial leverage.

CorrectAnswer:

D .......................................................................................... LOS:Reading41f

Return on equity, using DuPont analysis, can be decomposed into


total asset turnover x leverage x tax burden x interest burden x EBIT margin.
Therefore lower financial leverage would tend to reduce return on equity.
Reference:CFAProgramCurriculum,Volume3,pp.604609.

FinancialStatementTechniques,Applications,andInternationalStandardsConvergence289
15. Under International Financial Reporting Standards (IFRS) unrealized gains on which type of
marketablesecuritiesarerecordedintheincomestatement?
A.

heldfortradingsecuritiesonly.

B.

availableforsalesecuritiesonly.

C.

heldfortradingsecuritiesandavailableforsalesecuritiesonly.

D.

heldfortradingsecurities,availableforsalesecuritiesandheldtomaturitysecurities.

16. Acompanyhasemployedanewfinancialcontrollerwhohasinstalledanewsystemtoimprove
the efficiency of inventory management, and who has written off a large amount of uncollectible
receivables.Thisislikelyto:

Inventoryturnover

Receivablesturnover

A.

increase

increase

B.

increase

decrease

C.

decrease

increase

D.

decrease

decrease

290StudySession10:
15. Under International Financial Reporting Standards (IFRS) unrealized gains on which type of
marketablesecuritiesarerecordedintheincomestatement?
A.
B.
C.
D.

held-for-trading securities only.


available-for-sale securities only.
held-for-trading securities and available-for sale securities only.
held-for-trading securities, available-for sale securities and held-to-maturity securities.

CorrectAnswer:

A ..........................................................................................LOS:Reading43a

Unrealized gains are not recognized for held-to-maturity securities. Available-for sale securities are
recorded at market value but any unrealized gains flow straight through to shareholders equity. Only
unrealized gains on held-for-trading securities are recorded in the income statement.
Reference:CFAProgramCurriculum,Volume3,pp.681683.

16. Acompanyhasemployedanewfinancialcontrollerwhohasinstalledanewsystemtoimprove
the efficiency of inventory management, and who has written off a large amount of uncollectible
receivables.Thisislikelyto:
A.
B.
C.
D.

Inventory turnover
increase
increase
decrease
decrease

CorrectAnswer:

Receivables turnover
increase
decrease
increase
decrease

A ......................................................................................... LOS:Reading41d

More efficient management of inventory would be expected to increase the inventory turnover, by
reducing the number of days goods were held as inventory. Writing off receivables would reduce the
denominator in the receivables turnover, thereby increasing receivables turnover.
Reference:CFAProgramCurriculum,Volume3,pp.586589.

FinancialStatementTechniques,Applications,andInternationalStandardsConvergence291
17. Which of the following actions would be least likely to improve a firms working capital
turnover?
A.

Reducinginventorylevels.

B.

Tighteningcredittermsgiventocustomers.

C.

Reducingthefixedassetsusedinthebusiness.

D.

Maintainingworkingcapitalatcurrentlevelswhilstachievingsteadyrevenuegrowth.

18. SouthInc.sbreakdownofcurrentassetsandliabilitiesisasfollows:

Currentassets

($000)

Cashandcashequivalents

Currentliabilities

($000)

40 Shorttermdebt

25

Receivables

650 Accountspayable

420

Inventories

350 Taxespayable

120

Othercurrentassets

Total

70 Othercurrentliabilities

1,110 Total

Thequickratioisclosestto:

A.

0.07.

B.

1.13.

C.

1.55.

D.

1.82.

45

610

292StudySession10:
17. Which of the following actions would be least likely to improve a firms working capital
turnover?
A.
B.
C.
D.

Reducing inventory levels.


Tightening credit terms given to customers.
Reducing the fixed assets used in the business.
Maintaining working capital at current levels whilst achieving steady revenue growth.

CorrectAnswer:

C ......................................................................................... LOS:Reading41d

Working capital turnover is revenue/average working capital, where working capital is current assets less
current liabilities. Reducing working capital by, for example reducing inventory levels would improve the
ratio. Increasing revenue collection from customers would reduce receivables and as long as the cash
collected was not held in cash equivalents this would improve the ratio. Fixed assets are not part of
working capital so reducing fixed assets would not directly affect working capital turnover.
Reference:CFAProgramCurriculum,Volume3,pp.583589.

18. SouthInc.sbreakdownofcurrentassetsandliabilitiesisasfollows:

Currentassets
Cashandcashequivalents
Receivables
Inventories
Othercurrentassets

Total
A.
B.
C.
D.

($000)

Currentliabilities

($000)

40
650
350
70

Shorttermdebt
Accountspayable
Taxespayable
Othercurrentliabilities

25
420
120
45

1,110 Total

610

The quick ratio is closest to:


0.07.
1.13.
1.55.
1.82.

CorrectAnswer:

B.......................................................................................... LOS:Reading41d

Quick ratio = cash + market securities + receivables


current liabilities
= 690
= 1.13
610
Reference:CFAProgramCurriculum,Volume3,pp.590593.

FinancialStatementTechniques,Applications,andInternationalStandardsConvergence293
19. Whichofthefollowingratiosisleastlikelytobeusedtomeasureprofitability?
A.

Returnonassets.

B.

Totalassetturnover.

C.

Operatingprofitmargin.

D.

Returnoncommonequity.

20. Acomputermanufacturingcompanyhasveryshortdaysofinventoryonhandcomparedwith
itscompetitors,thiscouldbeexplainedby:
A.

thecompanyrunsajustintimemanufacturingsystem.

B.

asignificantproportionofthecompanysinventoryisobsolete.

C.

thecompanymaintainshighinventorylevelsinordertomeetcustomerorderspromptly.

D. theresourcesofthecompanytiedupininventoryarerelativelyhighcomparedwithits
competitors.

294StudySession10:
19. Whichofthefollowingratiosisleastlikelytobeusedtomeasureprofitability?
A.
B.
C.
D.

Return on assets.
Total asset turnover.
Operating profit margin.
Return on common equity.

CorrectAnswer:

B.......................................................................................... LOS:Reading41d

Total asset turnover is a measure of activity rather than profitability.


Reference:CFAProgramCurriculum,Volume3,pp.597598.

20. Acomputermanufacturingcompanyhasveryshortdaysofinventoryonhandcomparedwith
itscompetitors,thiscouldbeexplainedby:
A.
the company runs a just-in-time manufacturing system.
B.
a significant proportion of the companys inventory is obsolete.
C.
the company maintains high inventory levels in order to meet customer orders promptly.
D.
the resources of the company tied up in inventory are relatively high compared with its
competitors.
CorrectAnswer:

A ......................................................................................... LOS:Reading41d

Short DOH indicates high inventory turnover (cost of goods sold/inventory) so it is unlikely the inventory
is obsolete and the resources of the company tied up in inventory is smaller than its competitors. A just-intime manufacturing system means that computers are manufactured in response to customer demand
which will reduce inventory levels, so A is correct.
Reference:CFAProgramCurriculum,Volume3,pp.583589.

FinancialStatementTechniques,Applications,andInternationalStandardsConvergence295
21. ABCCorporationprovidesyouwiththefollowinginformation:

Incomestatement
$million

Balancesheet
Averageoverperiod$million

Sales

150 Cash

90 Accountspayable

30

COGS

(75) Accountsreceivable

10 Shorttermbanknotes

25

70 Longtermdebt

60

Grossprofit
SGAexpenses

75 Inventory
(20) Property,P&E

150

55 Depreciation

Op.profit

(70) Commonstock

Interestexpense (15) Investment

30 Retainedearnings

(10)

Tax

Netincome

30 Totalassets

280 Totalliabilities&
equity

Inventoryturnoverisclosestto:
0.47.

B.

0.93.

C.

1.07.

D.

2.14.

115

A.

50

280

296StudySession10:
21. ABCCorporationprovidesyouwiththefollowinginformation:

Incomestatement
$million

Balancesheet
Averageoverperiod$million

Sales

150 Cash

90 Accountspayable

30

COGS

(75) Accountsreceivable

10 Shorttermbanknotes

25

70 Longtermdebt

60

75 Inventory

Grossprofit

(20) Property,P&E

SGAexpenses

150

55 Depreciation

Op.profit

(70) Commonstock

Interestexpense (15) Investment

30 Retainedearnings

(10)

Tax

Netincome

30 Totalassets

280 Totalliabilities&
equity

C ......................................................................................... LOS:Reading41d

Inventory turnover =

115

Inventory turnover is closest to:


A.
0.47.
B.
0.93.
C.
1.07.
D.
2.14.
CorrectAnswer:

50

COGS
75
= = 1.07
averageinventory 70

Reference:CFAProgramCurriculum,Volume3,pp.583586.

280

FinancialStatementTechniques,Applications,andInternationalStandardsConvergence297
22. NationalTelecomsCorporationprovidesthefollowinginformation:

Incomestatement

Balancesheet

$million

Averageoverperiod$million

Sales

1,050 Cash

COGS

(780) Accounts

90 Accountspayable

270 Inventory*

Grossprofit

170 Notespayable

125

200 Longtermdebt

300

SGAexp.

(150) Property,P&E

Op.profit

120 Depreciation

Interestexp.

(45)

Retainedearnings

Tax

(25)

Netincome

50

Totalassets

650
(430) Commonstock

680

Totalliabilities&
equity

*Inventoryisunchangedovertheperiod

NationalTelecomsCorporationscashconversioncycleisclosestto:
A.

58days.

B.

130days.

C.

153days.

D.

176days.

50

150
55
680

298StudySession10:
22. NationalTelecomsCorporationprovidesthefollowinginformation:

Incomestatement

Balancesheet

$million

Averageoverperiod$million

Sales

1,050 Cash

COGS

(780) Accounts

90 Accountspayable

270 Inventory*

Grossprofit

170 Notespayable

125

200 Longtermdebt

300

SGAexp.

(150) Property,P&E

Op.profit

120 Depreciation

Interestexp.

(45)

Retainedearnings

Tax

(25)

Netincome

50

Totalassets

650
(430) Commonstock

680

*Inventory is unchanged over the period


National Telecoms Corporations cash conversion cycle is closest to:
A.
58 days.
B.
130 days.
C.
153 days.
D.
176 days.
CorrectAnswer:

50

Totalliabilities&
equity

150
55
680

B.......................................................................................... LOS:Reading41d

Days of sales outstanding = 365/annual receivables turnover = 365/(1050/170) = 59 days


Days of inventory on hand = 365/inventory turnover = 365/(780/200) = 94 days
Days of payables = 365/payables turnover = 365/(780/50) = 23 days
Cash conversion cycle =
Receivables collection period + inventory processing period payables payment period= 130 days
Reference:CFAProgramCurriculum,Volume3,pp.583589.

FinancialStatementTechniques,Applications,andInternationalStandardsConvergence299

300StudySession11:

Study Session 11: Corporate Finance:

Thisstudysessioncoverstheprinciplesthatcorporationsusetomaketheirinvestingandfinancing
decisions. Capital budgeting is the process of making decisions about which longterm projects the
corporationshouldacceptforinvestment,andwhichitshouldreject.Boththeexpectedreturnofa
projectandthefinancingcostshouldbetakenintoaccount.Thecostofcapital,ortherateofreturn
requiredforaproject,mustbedevelopedusingeconomicallysoundmethods.
Corporate managers are concerned with liquidity and solvency, and use financial statements to
evaluateperformanceaswellastodevelopandcommunicatefutureplans.Thefinalreadinginthis
studysessionisoncorporategovernancepractices,whichcanexposethefirmtoaheightenedriskof
ethicallapses.Althoughthesepracticesmaynotbeinherentlyunethical,theycreatethepotentialfor
conflicts of interest to develop between shareholders and managers, and the extent of that conflict
affectsthefirmsvaluation.

Reading44:CapitalBudgeting
Reading45:CostofCapital
Reading46:WorkingCapitalManagement
Reading47:FinancialStatementAnalysis
Reading48:TheCorporateGovernanceofListedCompanies:

AManualforInvestors

CorporateFinance301
1. A company has trade credit which is 2/10, net 30. The company pays on the 20th day. The
effectiveborrowingcostofnotpayingonthe10thdayisclosestto:
A.

36.5%.

B.

44.6%.

C.

106.0%.

D.

109.0%.

2. Acompanyhastradecreditwithitssuppliersandreceivesadiscountifitpayswithinaspecified
number of days. It works out the cost of trade credit is 50% if it pays on the net day. If the
companysshorttermcostoffundsis18%thenthecompanyshouldpay:
A.

onthenetday.

B.

onthedayorpurchase.

C.

onthelastdayofthediscountperiod

D.

justafterthediscountperiodhasended.

302StudySession11:
1. A company has trade credit which is 2/10, net 30. The company pays on the 20th day. The
effectiveborrowingcostofnotpayingonthe10thdayisclosestto:
A.
B.
C.
D.

36.5%.
44.6%.
106.0%.
109.0%.

CorrectAnswer:

D ......................................................................................... LOS:Reading46d

The cost of trade credit is calculated as the implicit rate of return which is represented by the trade
discount offer.

0.02
1+
1 - 0.02

Cost =

365 / 20

- 1 = 109%

Reference:CFAProgramCurriculum,Volume4,pp.120121.

2. Acompanyhastradecreditwithitssuppliersandreceivesadiscountifitpayswithinaspecified
number of days. It works out the cost of trade credit is 50% if it pays on the net day. If the
companysshorttermcostoffundsis18%thenthecompanyshouldpay:
A.
B.
C.
D.

on the net day.


on the day or purchase.
on the last day of the discount period
just after the discount period has ended.

CorrectAnswer:

C ......................................................................................... LOS:Reading46d

The discount offers a higher return for the company compared to its borrowing rate so it should take
advantage of the discount offered and pay on the last day of the discount period. Losing the discount is
more costly than delaying payment to the net day.
Reference:CFAProgramCurriculum,Volume4,pp.120121.

CorporateFinance303
3. Whichofthefollowingisleastlikelytobeapullonliquidityforacompany?
A.

payingvendorsearly.

B.

lowliquiditypositions.

C.

uncollectedreceivables.

D.

limitedshorttermlinesofcredit.

4. A company is offered two projects with the net cash flows, in $ million, from each project as
shownbelow.ThecostofprojectAis$2millionandthecostofprojectBis$10million.Thecostof
capital for project A is 10% and for project B is 12%. Which of the projects should be accepted for
inclusioninthecapitalbudget?

Endofyear

ProjectA

ProjectB

1.1

2.0

0.8

4.0

0.4

7.0

A.

Bothprojectsshouldberejected.

B.

Bothprojectsshouldbeaccepted.

C.

AshouldbeacceptedandBrejected.

D.

BshouldbeacceptedandArejected.

304StudySession11:
3. Whichofthefollowingisleastlikelytobeapullonliquidityforacompany?
A.
B.
C.
D.

paying vendors early.


low liquidity positions.
uncollected receivables.
limited short-term lines of credit.

CorrectAnswer:

C ..........................................................................................LOS:Reading46a

A pull on liquidity refers to payments that are made too early or when credit availability is limited forcing
the company to pay out funds before they receive money from sales or other sources. Uncollected
receivables or not a pull, but a drag, on liquidity.
Reference:CFAProgramCurriculum,Volume4,pp.8889.

4. A company is offered two projects with the net cash flows, in $ million, from each project as
shownbelow.ThecostofprojectAis$2millionandthecostofprojectBis$10million.Thecostof
capital for project A is 10% and for project B is 12%. Which of the projects should be accepted for
inclusioninthecapitalbudget?

Endofyear
1
2
3
A.
B.
C.
D.

ProjectA
1.1
0.8
0.4

ProjectB
2.0
4.0
7.0

Both projects should be rejected.


Both projects should be accepted.
A should be accepted and B rejected.
B should be accepted and A rejected.

CorrectAnswer:

A ......................................................................................... LOS:Reading44d

The present value of the cash flows for project A, discounted at 10%, is $1.96 million (1.00 + 0.66 + 0.30)
which is less than the cost, therefore the project should be rejected.
The present value of the cash flows for project B, discounted at 12%, is $9.96 million (1.79 + 3.19 + 4.98)
which is less than the cost; therefore the project should be rejected.
Reference:CFAProgramCurriculum,Volume4,pp.1214.

CorporateFinance305
5. Toenableaboardtoactinthebestlongterminterestsofshareowners,itisleastappropriateit
possesses:
A.

resources.

B.

independence.

C.

politicalaffiliation.

D.

experienceandexpertise.

6. North Company has a common stock price of $72. The latest reported earnings per share were
$4.80anddividendspersharewere$1.60.Thereturnonequityis8%.Thecostofequityisclosestto:
A.

5.33%.

B.

7.46%.

C.

7.55%.

D.

7.67%.

306StudySession11:
5. Toenableaboardtoactinthebestlongterminterestsofshareowners,itisleastappropriateit
possesses:
A.
B.
C.
D.

resources.
independence.
political affiliation.
experience and expertise.

CorrectAnswer:

C ......................................................................................... LOS:Reading48d

The major factors that enable a board to act in the best long-term interests of shareowners are
independence, experience and expertise, and the resources to support the independent work. Political
affiliation may work in the short term but may well be detrimental in the long term.
Reference:CFAProgramCurriculum,Volume4,pp.164168.

6. North Company has a common stock price of $72. The latest reported earnings per share were
$4.80anddividendspersharewere$1.60.Thereturnonequityis8%.Thecostofequityisclosestto:
A.
B.
C.
D.

5.33%.
7.46%.
7.55%.
7.67%.

CorrectAnswer:

D ......................................................................................... LOS:Reading45h

The growth rate is the earnings retention rate multiplied by the ROE, this is 5.33%.
Next years dividends will be $1.60 x 1.0533 = $1.685

ke =

D1
$1.685
+g=
+ 5.33% = 7.67%
P
$72

Reference:CFAProgramCurriculum,Volume4,pp.5455.

CorporateFinance307
7. Afirmislookingatborrowingfortwomonthsandcouldissue$500,000nominalofcommercial
paperat7.5%.Dealerscommissionwouldbe0.25%andbackuplinecostswouldbe0.3%basedon
the$500,000issued.Thecostofborrowingisclosestto:
A.

7.50%

B.

7.85%

C.

8.05%.

D.

8.15%

8 Thecasethattheboardchairalsoholdsthetitleofchiefexecutive,fromthecorporategovernance
pointofview,is:
A.

unacceptablebecauseitisuniversallyprohibitedinalljurisdictions.

B.
acceptable,becausecombiningthetwopositionswillsavecostsandhenceenhance
shareholdervalue.
C. acceptable,becausetheeffectivenessofthechiefexecutivewouldbeenhancedbyhisor
herpositionasthechairpersonoftheboard.
D. unacceptablebecausecombiningthetwopositionsmayreducetheabilityand
willingnessofindependentboardmemberstoexercisetheirindependentjudgment.

308StudySession11:
7. Afirmislookingatborrowingfortwomonthsandcouldissue$500,000nominalofcommercial
paperat7.5%.Dealerscommissionwouldbe0.25%andbackuplinecostswouldbe0.3%basedon
the$500,000issued.Thecostofborrowingisclosestto:
A.
B.
C.
D.

7.50%
7.85%
8.05%.
8.15%

CorrectAnswer:

D ..........................................................................................LOS:Reading46g

cost = (interest + dealers commission + back-up costs)/net proceeds x 12


= [(0.075 + 0.0025 + 0.003) x $500,000 x 2/12] x 6 = 0.0805/0.9875 = 8.15%
$500,000 (0.075 x $500,000 x 2/12)
Reference:CFAProgramCurriculum,Volume4,pp.126127.

8 Thecasethattheboardchairalsoholdsthetitleofchiefexecutive,fromthecorporategovernance
pointofview,is:
A.
unacceptable because it is universally prohibited in all jurisdictions.
B.
acceptable, because combining the two positions will save costs and hence enhance shareholder
value.
C.
acceptable, because the effectiveness of the chief executive would be enhanced by his or her
position as the chairperson of the board.
D.
unacceptable because combining the two positions may reduce the ability and willingness of
independent board members to exercise their independent judgment.
CorrectAnswer:

D .......................................................................................... LOS:Reading48c

Choice A is incorrect because there are some jurisdictions that allow the combining of the two positions.
Choice B is incorrect, because the saving in cost is not the main issue from the corporate governance point
of view.
Choice C is incorrect because it is not the effectiveness of the chief executive that is being questioned.
The main issue is whether the boards independence would be compromised.
Reference:CFAProgramCurriculum,Volume4,pp.165166.

CorporateFinance309
9

Whichofthefollowingratioswouldbeusefulinevaluatingacompanysinternalliquidity?
A.

Quickratio.

B.

Equityturnover.

C.

Interestcoverage.

D.

Debttoequityratio.

10 Which of the following statements is most accurate concerning the different methods for
evaluatingprojects?
A.

TheIRRmethodcangivemultipleanswersiftherearenonconventionalcashflows.

B.

Iftheprofitabilityindexispositiveitindicatesthataprojectshouldbeaccepted.

C.

TheIRRmethodispreferredsinceitassumesreinvestmentattheprojectscostofcapital.

D. Theaverageaccountingrateofreturnisattractivebecauseitdoesnotneedapresent
valuecalculation.

310StudySession11:
9

Whichofthefollowingratioswouldbeusefulinevaluatingacompanysinternalliquidity?
A.
B.
C.
D.

Quick ratio.
Equity turnover.
Interest coverage.
Debt to equity ratio.

CorrectAnswer:

A ..........................................................................................LOS:Reading46a

Quick ratio = cash + marketable securities + receivables


current liabilities
The ratio measures the current assets that can be quickly liquidated to meet current liabilities.
Reference:CFAProgramCurriculum,Volume4,pp.8991.

10 Which of the following statements is most accurate concerning the different methods for
evaluatingprojects?
A.
The IRR method can give multiple answers if there are nonconventional cash flows.
B.
If the profitability index is positive it indicates that a project should be accepted.
C.
The IRR method is preferred since it assumes reinvestment at the projects cost of capital.
D.
The average accounting rate of return is attractive because it does not need a present value
calculation.
CorrectAnswer:

A ..........................................................................................LOS:Reading44e

When a project has nonconventional cash flows (such as more than one cash inflow over the projects life)
the IRR method can give more than one solution, or multiple IRRs. A profitability index of over 1 means a
project should be accepted, the IRR method discounts back at the IRR, andthe lack of adjustment for time
value of money is a disadvantage of the AAR method.
Reference:CFAProgramCurriculum,Volume4,pp.2528.

CorporateFinance311
11. Thefollowingfinancialinformationisgivenforacompany:
Netprofitmargin

=4%

Operatingprofitmargin =16%
Equityturnover

=3.2

Totalassetturnover

=2.5

Thereturnonequityisclosestto:

A.

10.0%.

B.

12.8%.

C.

51.2%.

D.

thereisinsufficientinformationgiventocalculatethereturnonequity.

12. Inordertosecureshorttermfundingacompanyfactorsitsaccountsreceivable.Thismeansthat:
A.

receivablesarebeingusedascollateralforaloan.

B.

itpaysoveranyreceivablescollectedtothefactorinreturnforshorttermfunding.

C.

sellsthereceivablestothefactorwhotakesresponsibilityforcollectingthereceivables.

D. ittakesoutprotectionfromthefactoragainstitscustomersdefaultingonpaymentof
moneyowed.

312StudySession11:
11. Thefollowingfinancialinformationisgivenforacompany:
Net profit margin
= 4%
Operating profit margin
= 16%
Equity turnover
= 3.2
Total asset turnover
= 2.5
The return on equity is closest to:
A.
B.
C.
D.

10.0%.
12.8%.
51.2%.
there is insufficient information given to calculate the return on equity.

CorrectAnswer:
return on equity

B...........................................................................................LOS:Reading47a
= net profit margin x sales turnover x financial leverage
= net profit margin x equity turnover
= 0.04 x 3.2
= 12.8%

Reference:CFAProgramCurriculum,Volume4,pp.136145.

12. Inordertosecureshorttermfundingacompanyfactorsitsaccountsreceivable.Thismeansthat:
A.
B.
C.
D.

receivables are being used as collateral for a loan.


it pays over any receivables collected to the factor in return for short-term funding.
sells the receivables to the factor who takes responsibility for collecting the receivables.
it takes out protection from the factor against its customers defaulting on payment of money owed.

CorrectAnswer:

C ..........................................................................................LOS:Reading46g

When a company factors its accounts receivables it sells its receivables to the factor and transfers credit
granting and collection to the factor. This is different to when receivables are used as collateral for a loan
which is an assignment of the accounts receivable.
Reference:CFAProgramCurriculum,Volume4,pp.125126.

CorporateFinance313
13. Inproformaanalysiswhichofthefollowingitemsisusuallyconsideredtobeafixedratherthan
asalesdrivenburden?
A.

taxrate.

B.

depreciation.

C.

sellingexpenses.

D.

employeessalaries.

14. Whichoneofthefollowingisleastlikelytobeconsideredgoodcorporategovernanceofalisted
company?
A.

Theboardmembersactionsanddecisionsrepresentthebestinterestsofshareowners.

B.
Appropriatecontrolsandproceduresareinplacecoveringmanagementsactivitiesin
runningthedaytodayoperationsofthecompany.
C. Theboardanditscommitteesarestructuredtoactindependentlyfrommanagementand
otherpartiesthatmightinfluencethemanagement.
D. Allshareownershavethesamerighttoparticipateinthegovernanceofthecompany,
withfoundingshareownersnormallygiventherighttovetocertainresolutions.

314StudySession11:
13. Inproformaanalysiswhichofthefollowingitemsisusuallyconsideredtobeafixedratherthan
asalesdrivenburden?
A.
B.
C.
D.

tax rate.
depreciation.
selling expenses.
employees salaries.

CorrectAnswer:

A ......................................................................................... LOS:Reading47b

Income items with the exception of interest costs and tax are usually assumed to grow in line with sales.
Unless there is a change in government tax rates the tax rate is assumed to be constant.
Reference:CFAProgramCurriculum,Volume4,pp.149153.

14. Whichoneofthefollowingisleastlikelytobeconsideredgoodcorporategovernanceofalisted
company?
A.
The board members actions and decisions represent the best interests of shareowners.
B.
Appropriate controls and procedures are in place covering managements activities in running the
day-to-day operations of the company.
C.
The board and its committees are structured to act independently from management and other
parties that might influence the management.
D.
All shareowners have the same right to participate in the governance of the company, with
founding shareowners normally given the right to veto certain resolutions.
CorrectAnswer:

D ..........................................................................................LOS:Reading48g

In a listed company, all shareowners should have equal rights to participate in the governance of the
company. Differentiating between economic and voting rights should be avoided.
Reference:CFAProgramCurriculum,Volume43,pp.183186.

CorporateFinance315
15. IslingtonCorporationprovidesyouwiththefollowinginformation:

IncomeStatement

BalanceSheet

$million

Averageoverperiod$million

Salesoncredit

298

Cash

50

AccountsPayable

80

COGS

(200)

Accounts
Receivable

60

AccruedExpenses

65

GrossProfit

98

Inventory

100

LongtermDebt

150

SGAExpenses

(60)

Property,P&E

375

Op.Profit

38

Depreciation

(85)

CommonStock

140

Interestexpense (6)

RetainedEarnings

65

Tax

(13)

NetIncome

19

TotalAssets

500

TotalLiabilities& 500
Equity

TheaveragereceivablescollectionperiodforIslingtonCorporationisclosestto:
A.

1.4days.

B.

5.0days.

C.

73.5days.

D.

109.5days.

316StudySession11:
15. IslingtonCorporationprovidesyouwiththefollowinginformation:

IncomeStatement

BalanceSheet

$million

Averageoverperiod$million

Salesoncredit

298

Cash

50

AccountsPayable

80

COGS

(200)

Accounts
Receivable

60

AccruedExpenses

65

GrossProfit

98

Inventory

100

LongtermDebt 150

SGAExpenses

(60)

Property,P&E

375

Op.Profit

38

Depreciation

(85)

CommonStock

140

Interestexpense (6)

RetainedEarnings

65

Tax

(13)

NetIncome

19

TotalAssets

500

TotalLiabilities& 500
Equity

The average receivables collection period for Islington Corporation is closest to:
A.
1.4 days.
B.
5.0 days.
C.
73.5 days.
D.
109.5 days.
CorrectAnswer:

C .........................................................................................LOS:Reading46a

Receivables turnover = credit sales/average receivables


= 298/60
= 4.966
Average receivables collection period = 365/receivables turnover
= 73.5 days
Reference:CFAProgramCurriculum,Volume4,pp.8991.

CorporateFinance317
16. Acompanyprovidesthefollowinginformation

Creditsales

$125million

Costofgoodssold

$80million

Accountsreceivable

$15million

BeginningInventory

$16million

EndingInventory

$22million

Accountspayable

$13million

Theoperatingcycleandnetoperatingcycleareclosestto:

Operatingcycle

Netoperatingcycle

A.

108.2

48.9

B.

108.2

53.1

C.

144.2

84.9

D.

144.2

89.0

318StudySession11:
16. Acompanyprovidesthefollowinginformation
Creditsales

$125million

Costofgoodssold

$80million

Accountsreceivable

$15million

BeginningInventory

$16million

EndingInventory

$22million

Accountspayable

$13million

The operating cycle and net operating cycle are closest to:
Operating cycle
Net operating cycle
A.
108.2
48.9
B.
108.2
53.1
C.
144.2
84.9
D.
144.2
89.0
CorrectAnswer:

D ..........................................................................................LOS:Reading46a

Operating cycle
= number of days of receivables + number of days of inventory
= (15/125) x 365 + (22/80) x 365 = 43.8 + 100.38 = 144.18 days
Net operating cycle or cash conversion cycle
= number of days of receivables + number of days of inventory number of days of payables
To calculate number of days of payables, we need to calculate purchases
= $80 million + ( $22 - $16) million = $86 million
= 144.18 days - (13/86) x 365 = 144.18 55.18 = 89.00 days
Reference:CFAProgramCurriculum,Volume4,pp.8795.

CorporateFinance319
17. IslingtonCorporationprovidesyouwiththefollowinginformation:

IncomeStatement

BalanceSheet

$million

Averageoverperiod$million

Salesoncredit

298

Cash

50

AccountsPayable

80

COGS

(200)

Accounts
Receivable

60

AccruedExpenses

65

GrossProfit

98

Inventory

100

LongtermDebt

150

SGAExpenses

(60)

Property,P&E

375

Op.Profit

38

Depreciation

(85)

CommonStock

140

Interestexpense

(6)

RetainedEarnings

65

Tax

(13)

NetIncome

19

TotalAssets

500

TotalLiabilities& 500
Equity

Thequickratioisclosestto:
A.

0.34.

B.

0.63.

C.

0.76.

D.

1.45.

320StudySession11:
17. IslingtonCorporationprovidesyouwiththefollowinginformation:

IncomeStatement

BalanceSheet

$million

Averageoverperiod$million

Salesoncredit

298

Cash

50

AccountsPayable

80

COGS

(200)

Accounts
Receivable

60

AccruedExpenses

65

GrossProfit

98

Inventory

100

LongtermDebt

150

SGAExpenses

(60)

Property,P&E

375

Op.Profit

38

Depreciation

(85)

CommonStock

140

Interestexpense

(6)

RetainedEarnings

65

Tax

(13)

NetIncome

19

TotalAssets

500

TotalLiabilities& 500
Equity

The quick ratio is closest to:


A.
0.34.
B.
0.63.
C.
0.76.
D.
1.45.
CorrectAnswer:

C ..........................................................................................LOS:Reading46a

Quick ratio = (cash + marketable securities + receivables)/current liabilities


= (50 + 60)/145
= 0.76
Reference:CFAProgramCurriculum,Volume4,pp.8990.

CorporateFinance321
18. NationalTelecomsCorporationprovidesthefollowinginformation:

Income Statement 2007

Balance Sheet end 2007

$ million

Average over period

$ million

CreditSales

1050

Cash

90 AccountsPayable

COGS

(780)

AccountsReceivable

170 Notespayable

125

GrossProfit

270

Inventory

200 Longtermdebt

300

SGAexp.

(150)

Property,P&E

650

Op.Profit

120

Depreciation

(430) CommonStock

Interestexp.

(45)

RetainedEarnings

Tax

(25)

NetIncome

50

TotalAssets

680 TotalLiabilities&
Equity

DividendsPaid12
Inventorylevelunchangedfrom2006levels.
NationalTelecomsCorporationsnetoperatingcyclein2007isclosestto:
A.

58days.

B.

130days.

C.

153days.

D.

176days.

50

150
55
680

322StudySession11:
18. NationalTelecomsCorporationprovidesthefollowinginformation:

Income Statement 2007

Balance Sheet end 2007

$ million

Average over period

$ million

CreditSales

1050

Cash

90 AccountsPayable

COGS

(780)

AccountsReceivable

170 Notespayable

125

GrossProfit

270

Inventory

200 Longtermdebt

300

SGAexp.

(150)

Property,P&E

650

Op.Profit

120

Depreciation

(430) CommonStock

Interestexp.

(45)

RetainedEarnings

Tax

(25)

NetIncome

50

TotalAssets

680 TotalLiabilities&

50

150
55
680

Equity
DividendsPaid12
Inventorylevelunchangedfrom2006levels.
NationalTelecomsCorporationsnetoperatingcyclein2007isclosestto:
A.
B.
C.
D.

58 days.
130 days.
153 days.
176 days.

CorrectAnswer:

B.......................................................................................... LOS:Reading46b

number of days of receivables = 365/annual receivables turnover =365/(1050/170) = 59 days


number of days of inventory = 365/inventory turnover = 365/(780/200) = 94 days
= number of days of receivables + number of days of inventory = 153 days
Reference:CFAProgramCurriculum,Volume4,pp.8995.

CorporateFinance323
19. NationalTelecomsCorporationprovidesthefollowinginformation:

IncomeStatement
$ million
1050
(780)
270
(150)
120
(45)
(25)
50

Credit Sales
COGS
Gross Profit
SGA exp.
Op. Profit
Interest exp.
Tax
Net Income

It is assumed that sales and related costs are growing at 5%per annum and there is no change in
capitalstructure,thenNationalTelecomCorporationsproformanetincomein2008isclosestto:
A.

$51.25million.

B.

$52.50million.

C.

$54.00million.

D.

$56.00million.

324StudySession11:
19. NationalTelecomsCorporationprovidesthefollowinginformation:

IncomeStatement
$ million
1050
(780)
270
(150)
120
(45)
(25)
50

Credit Sales
COGS
Gross Profit
SGA exp.
Op. Profit
Interest exp.
Tax
Net Income

It is assumed that sales and related costs are growing at 5%per annum and there is no change in capital
structure, then National Telecom Corporations proforma net income in 2008 is closest to:
A.
$ 51.25 million.
B.
$ 52.50 million.
C.
$ 54.00 million.
D.
$ 56.00 million.
CorrectAnswer:

C ......................................................................................... LOS:Reading47b

Operating profit will grow at 5% to $126 million, interest expense is assumed constant at $45 million and
the tax ate is 33.33% so tax will be $81 million x 33.33% = $27 million, so profoma net income will be $54
million.
Reference:CFAProgramCurriculum,Volume4,pp.164167.

CorporateFinance325
20. The cost of a project is $150 million and the following cash flows are anticipated, the cost of
capitalis10%.

Year

NetCashFlow
($million)

150

25

50

55

40

60

Total

Theimplieddecisiontoacceptorrejecttheproject,andtheProfitabilityIndex(PI)isclosestto:

Accept/reject

PI

A.

Reject

0.13

B.

Reject

0.53

C.

Accept

1.13

D.

Accept

1.70

326StudySession11:
20. The cost of a project is $150 million and the following cash flows are anticipated, the cost of
capitalis10%.

Year

NetCashFlow($million)

150

25

50

55

40

60

Total

The implied decision to accept or reject the project, and the Profitability Index (PI) is closest to:
Accept/reject
PI
A.
Reject
0.13
B.
Reject
0.53
C.
Accept
1.13
D.
Accept
1.70
CorrectAnswer:

C ......................................................................................... LOS:Reading44d

First of all calculate the present values of the cash flows:

Year

NetCashFlow
($million)

DiscountedNetCashFlow
($million)

0
1
2
3
4
5
Total

150
25
50
55
40
60

150.0
22.7
41.3
41.3
27.3
37.3
19.9

Reference:CFAProgramCurriculum,Volume4,p.19.

CorporateFinance327
21. Thecostofaprojectis$150millionanditwillbedepreciatedusingthestraightlinemethodover
5yearswithazerosalvagevalue.Thefollowingnetincomeisanticipated.

Year
1
2
3
4
5

NetIncome
($million)
4
20
22
20
5

Theaverageaccountingrateofreturn(AAR)oftheprojectisclosestto
A.

4.1%

B.

8.1%

C.

12.2%

D.

16.3%

22. A company prohibits itself from offering shares at discounted prices to management, board
membersandotherinsiderspriortoapublicofferingofitssecurities.Thispracticeis:
A. preferredbythetaxofficebecauseitavoidsimputationofincometaxesforthe
executives.
B.
preferredbyinvestorsbecauseitdemonstratesthatthecompanyalignsitselfwiththe
investorsinterests.
C. notpreferredbythecapitalmarketsregulatorybodybecauseitmightencouragean
opportunityforinsiderstrading.
D. notpreferredfromacorporategovernancepointofviewbecauseitmightencouragethe
executivestogivecompensationtothemselvesfromshorttermsharetransactions.

328StudySession11:
21 Thecostofaprojectis$150millionanditwillbedepreciatedusingthestraightlinemethodover
5yearswithazerosalvagevalue.Thefollowingnetincomeisanticipated.

Year
1
2
3
4
5

NetIncome
($million)
4
20
22
20
5

The average accounting rate of return (AAR) of the project is closest to


A.
4.1%
B.
8.1%
C.
12.2%
D.
16.3%
CorrectAnswer:

D ......................................................................................... LOS:Reading44d

Average book value is ($150 million + $0million)/2 = $75 million


Average net income is $(4 + 20 + 22 + 20 5)million/5 = $12.2 million
AAR = Average net income
= $12.2 million
Average book value
$75 million
= 16.3%
Reference:CFAProgramCurriculum,Volume4,p.18.

CorporateFinance329
22. A company prohibits itself from offering shares at discounted prices to management, board
membersandotherinsiderspriortoapublicofferingofitssecurities.Thispracticeis:
A.
preferred by the tax office because it avoids imputation of income taxes for the executives.
B.
preferred by investors because it demonstrates that the company aligns itself with the investors
interests.
C.
not preferred by the capital markets regulatory body because it might encourage an opportunity for
insiders trading.
D.
not preferred from a corporate governance point of view because it might encourage the executives
to give compensation to themselves from short-term share transactions.
CorrectAnswer:

B .......................................................................................... LOS:Reading48g

This is a preferred practice from a corporate governance point of view, which indicates it is beneficial for
the long-term interests of the investors.
Reference:CFAProgramCurriculum,Volume4,pp.173175.

330StudySession12:

Study Session 12: Portfolio Management:

As the first discussion within the CFA curriculum on portfolio management, this study session
providesthecriticalframeworkandcontextforsubsequentLevelIstudysessionscoveringequities,
fixedincome,derivatives,andalternativeinvestments.Furthermore,thisstudysessionprovidesthe
underlyingtheoriesandtoolsforportfoliomanagementatLevelsIIandIII.
Thefirstreadingdiscussestheassetallocationdecisionandtheportfoliomanagementprocessthey
are an integrated set of steps undertaken in a consistent manner to create and maintain an
appropriateportfolio(combinationofassets)tomeetclientsstatedgoals.Thelasttworeadingsfocus
onthedesignofaportfolioandintroducesthecapitalassetpricingmodel(CAPM),acenterpieceof
modernfinancialeconomicsthatrelatestheriskofanassettoitsexpectedreturn.

Reading49:TheAssetAllocationDecision
Reading50:AnIntroductiontoPortfolioManagement
Reading51:AnIntroductiontoAssetPricingModels

PortfolioManagement331
1. The asset allocation of investors between equities and fixed income in the major international
capitalmarketsis:
A.

verysimilar,sinceinvestorsareusingthesameoptimizationmodels.

B.
quitedifferent,sinceinvestorsaremakingdecisionsindifferenteconomicandsocial
environments.
C. verysimilar,sinceassetallocationisthemostimportantstepinportfolioconstructionin
allmajormarkets.
D. verysimilar,sincelongtermequityandfixedincomereturnshavebeenconsistentacross
differentmarkets.

2. Thebetaofanasset:
A.

liesbetween1and1.

B.

isameasureofunsystematicrisk.

C.

is1iftheassetisthemarketportfolio.

D.

isthecovarianceoftheassetwiththemarket.

332StudySession12:
1. The asset allocation of investors between equities and fixed income in the major international
capitalmarketsis:
A.
very similar, since investors are using the same optimization models.
B.
quite different, since investors are making decisions in different economic and social environments.
C.
very similar, since asset allocation is the most important step in portfolio construction in all major
markets.
D.
very similar, since long term equity and fixed income returns have been consistent across different
markets.
CorrectAnswer:

B...........................................................................................LOS:Reading49e

The different social and economic environments, in addition to political and tax issues, have led to
different weightings in equities and fixed income in portfolios in different countries.
Reference:CFAProgramCurriculum,Volume4,pp.223224.

2. Thebetaofanasset:
A.
B.
C.
D.

lies between -1 and 1.


is a measure of unsystematic risk.
is 1 if the asset is the market portfolio.
is the covariance of the asset with the market.

CorrectAnswer:

C ......................................................................................... LOS:Reading51d

A. is not correct since beta does not lie in any fixed range.
B. is not correct, it is a measure of systematic risk.
D. is not correct because beta is the covariance divided by the variance of the market.
By definition the beta of the market itself is one.
Reference:CFAProgramCurriculum,Volume4,pp.264269.

PortfolioManagement333
3. Whichofthefollowingisleastlikelytobeastepintheinvestmentprocess?
A.

Assetallocation.

B.

Monitoringtheportfolio.

C.

Forecastingmarketreturns.

D.

Submittingregulatoryreportstotheappropriateauthority.

4. The stock analyst in your firm recommends that you buy shares in Mayfair Corp. The current
sharepriceis$26andsheforecaststhatayearfromnowthesharepricewillhaverisento$30.There
is no dividend payment expected. You note that the beta of the stock is 0.8, the expected market
return over the next year is 15% and the riskfree rate is 5%. On the basis of the analysts forecast,
MayfairCorp.sstockis:
A.

overvalued.

B.

undervalued.

C.

correctlyvalued.

D. thequestionneedstoprovidedataonthemarketriskpremiumtobeabletodecide
whetherthestockisfairlyvalued.

334StudySession12:
3. Whichofthefollowingisleastlikelytobeastepintheinvestmentprocess?
A.
B.
C.
D.

Asset allocation.
Monitoring the portfolio.
Forecasting market returns.
Submitting regulatory reports to the appropriate authority.

CorrectAnswer:

D ..........................................................................................LOS:Reading49a

The portfolio management process consists of 4 steps: construct the policy statement, forecast future
economic and market trends, construct the portfolio and continually monitor and evaluate performance.
Submitting regulatory reports is not part of the investment decision-making process so D is the best
answer.
Reference:CFAProgramCurriculum,Volume4,pp.202203.

4. The stock analyst in your firm recommends that you buy shares in Mayfair Corp. The current
sharepriceis$26andsheforecaststhatayearfromnowthesharepricewillhaverisento$30.There
is no dividend payment expected. You note that the beta of the stock is 0.8, the expected market
return over the next year is 15% and the riskfree rate is 5%. On the basis of the analysts forecast,
MayfairCorp.sstockis:
A.
overvalued.
B.
undervalued.
C.
correctly valued.
D.
the question needs to provide data on the market risk premium to be able to decide whether the
stock is fairly valued.
CorrectAnswer:

B...........................................................................................LOS:Reading51e

Using CAPM the estimated return is:

R x = R f + [E(R m ) R f ] = 5% + 0.8(15% 5% ) = 13%

The analyst is forecasting a return of 15.4% so the stock looks undervalued.


Reference:CFAProgramCurriculum,Volume4,pp.263266.

PortfolioManagement335
5. Ifastockliesabovethesecuritymarketline(SML)thiswouldindicatethatthestock:
A.

isovervalued.

B.

isundervalued.

C.

hasahigherexpectedreturnthanthemarket.

D.

hasalowerexpectedreturnthanthemarket.

6. Thecharacteristiclineisusedtoestimate:
A.

theriskfreerate.

B.

thebetaofastock.

C.

theriskaversionofaninvestor.

D.

thestandarddeviationofaportfolio.

336StudySession12:
5.

Ifastockliesabovethesecuritymarketline(SML)thiswouldindicatethatthestock:

A.
B.
C.
D.

is overvalued.
is undervalued.
has a higher expected return than the market.
has a lower expected return than the market.

CorrectAnswer:

B...........................................................................................LOS:Reading51e

The stock is undervalued because the expected rate of return is higher than the required rate of return to
compensate for its beta risk.
Reference:CFAProgramCurriculum,Volume4,pp.263267.

6. Thecharacteristiclineisusedtoestimate:
A.
B.
C.
D.

the risk-free rate.


the beta of a stock.
the risk aversion of an investor.
the standard deviation of a portfolio.

CorrectAnswer:

B.......................................................................................... LOS:Reading51d

The characteristic line is the regression line of best fit through a scatter diagram of points representing a
stocks return against the market return; the slope gives the stock beta.
Reference:CFAProgramCurriculum,Volume4,pp.267269.

PortfolioManagement337
7. Aportfoliois70%investedinanindexfundand30%inariskfreeasset.Theindexfundhasa
varianceofreturnsof0.0027,thevarianceforthetotalportfolioisclosestto:
A.

0.0013.

B.

0.0019.

C.

0.0027.

D.

0.0039.

8. IncapitalmarkettheorytheMarketPortfoliocanbeleastaccuratelydescribedas:
A.

theportfoliowheresystematicriskhasbeencompletelydiversifiedaway.

B.

itisthepointwheretheCapitalMarketLinetouchestheefficientfrontier.

C.

theportfoliowhichcontainsallriskyassetsinproportiontotheirmarketvalue.

D.

thepointwherethetangentfromtheriskfreeratetouchestheefficientfrontier.

338StudySession12:
7. Aportfoliois70%investedinanindexfundand30%inariskfreeasset.Theindexfundhasa
varianceofreturnsof0.0027,thevarianceforthetotalportfolioisclosestto:
A.
B.
C.
D.

0.0013.
0.0019.
0.0027.
0.0039.

CorrectAnswer:

A ..........................................................................................LOS:Reading51a

The variance and standard deviation of the risk-free asset are zero. Therefore the variance of the portfolio
is:

2port = w 12 12 + w 22 22 + 2r12 w 1 w 2 1 2
= (0.7 ) 0.0027
= 0.0013
2

Reference:CFAProgramCurriculum,Volume4,pp.256258.

8. IncapitalmarkettheorytheMarketPortfoliocanbeleastaccuratelydescribedas:
A.
B.
C.
D.

the portfolio where systematic risk has been completely diversified away.
it is the point where the Capital Market Line touches the efficient frontier.
the portfolio which contains all risky assets in proportion to their market value.
the point where the tangent from the risk-free rate touches the efficient frontier.

CorrectAnswer:

A ......................................................................................... LOS:Reading51b

A is not correct it is the unsystematic risk that can be diversified away.


Reference:CFAProgramCurriculum,Volume4,p.259.

PortfolioManagement339
9. Ifaninvestorhassteeputilitycurvesitislikelytoindicatesthat:
A.

theinvestorisaggressive.

B.

theinvestorisconservative.

C.

theinvestorhasalongtimehorizon.

D.

theinvestorhasashorttimehorizon.

10. AU.S.basedinvestmentmanagerisconcernedthatthevolatilityofaninternationalequityfund
heismanagingistoohigh.Whichofthefollowingwouldbeanappropriatecourseofaction?
A.

Increasetheweightinginhighbetastocks.

B.

SelltheinternationalholdingsandonlyholdU.S.stocks.

C. Considerinvestinginmarketswhichhavealowcorrelationwiththeexistingassetsin
theportfolio.
D. Sellsmallcapitalizationstocksandconcentratetheportfolioinasmallnumberofbig
marketcapitalizationstocks.

340StudySession12:
9. Ifaninvestorhassteeputilitycurvesitislikelytoindicatesthat:
A.
B.
C.
D.

the investor is aggressive.


the investor is conservative.
the investor has a long time horizon.
the investor has a short time horizon.

CorrectAnswer:

B...........................................................................................LOS:Reading50g

A steep utility curve shows that the investor needs to be compensated for taking a small amount of
additional risk by receiving a significantly higher return, indicating he is conservative with a low appetite
for risk.
Reference:CFAProgramCurriculum,Volume4,pp.248249.

10. AU.S.basedinvestmentmanagerisconcernedthatthevolatilityofaninternationalequityfund
heismanagingistoohigh.Whichofthefollowingwouldbeanappropriatecourseofaction?
A.
Increase the weighting in high beta stocks.
B.
Sell the international holdings and only hold U.S. stocks.
C.
Consider investing in markets which have a low correlation with the existing assets in the
portfolio.
D.
Sell small capitalization stocks and concentrate the portfolio in a small number of big market
capitalization stocks.
CorrectAnswer:

C .......................................................................................... LOS:Reading50f

In order to reduce volatility, which is the standard deviation of returns, the manager could include assets
which have a low correlation with the existing assets in the portfolio.
Reference:CFAProgramCurriculum,Volume4,pp.256259.

PortfolioManagement341
11. WhichofthefollowingisaleastaccuratedescriptionofanassumptionofCapitalMarketTheory?
A.

Capitalmarketsareinequilibrium.

B.

Allinvestorshavethesametimehorizon.

C.

Investorscanborroworlendattheriskfreerate.

D.

Investorsarenotabletocorrectlyanticipateinflation.

12. Thecorrelationcoefficientbetweenthereturnsoftwoassetsis0.6andthestandarddeviationsof
returnsofthetwoassetsare7%and12%.Thecovarianceofreturnsisclosestto:
A.

14.0.

B.

50.4.

C.

71.4.

D.

140.0.

342StudySession12:
11. WhichofthefollowingisaleastaccuratedescriptionofanassumptionofCapitalMarketTheory?
A.
B.
C.
D.

Capital markets are in equilibrium.


All investors have the same time horizon.
Investors can borrow or lend at the risk-free rate.
Investors are not able to correctly anticipate inflation.

CorrectAnswer:

D ..........................................................................................LOS:Reading51a

Capital Market Theory makes the assumption that there is no inflation or change in interest rates, or any
inflation is fully anticipated.
Reference:CFAProgramCurriculum,Volume4,pp.254255.

12. Thecorrelationcoefficientbetweenthereturnsoftwoassetsis0.6andthestandarddeviationsof
returnsofthetwoassetsare7%and12%.Thecovarianceofreturnsisclosestto:
A.
B.
C.
D.

14.0.
50.4.
71.4.
140.0.

CorrectAnswer:

rxy =

B.......................................................................................... LOS:Reading50d

cov ariance xy
xy

cov ariance = 0.6 7 12 = 50.4


where:
rxy

x =
y
=

correlation between the returns of x and y


standard deviation of returns of x
standard deviation of returns of y

Reference:CFAProgramCurriculum,Volume4,pp.236237.

PortfolioManagement343
13. Theefficientfrontierrepresentsportfoliosthat:
A.

offerthehighestreturnforagivenleveloftotalrisk.

B.

offerthehighestreturnforagivenlevelofsystematicrisk.

C.

areequallyattractivetoaninvestorwithaspecifiedleveloftotalrisktolerance.

D.

areequallyattractivetoaninvestorwithaspecifiedlevelofsystematicrisktolerance.

14. Thefollowingdataisprovidedontheexpectedreturnofanassetunderdifferentscenarios:

Probability Return
0.20

12%

0.60

15%

0.20

18%

Thestandarddeviationofthereturnsisclosestto:
A.

1.2%.

B.

1.9%.

C.

2.3%.

D.

3.6%.

344StudySession12:
13. Theefficientfrontierrepresentsportfoliosthat:
A.
B.
C.
D.

offer the highest return for a given level of total risk.


offer the highest return for a given level of systematic risk.
are equally attractive to an investor with a specified level of total risk tolerance.
are equally attractive to an investor with a specified level of systematic risk tolerance.

CorrectAnswer:

A .......................................................................................... LOS:Reading50f

The efficient frontier represents the portfolios which offer the highest return for any given level of risk so A
is correct.
Reference:CFAProgramCurriculum,Volume4,pp.247249.

14. Thefollowingdataisprovidedontheexpectedreturnofanassetunderdifferentscenarios:

Probability Return
0.20

12%

0.60

15%

0.20

18%

The standard deviation of the returns is closest to:


A.
1.2%.
B.
1.9%.
C.
2.3%.
D.
3.6%.
CorrectAnswer:

B........................................................................................... LOS:Reading50c

The expected return is (0.20 x 12%) + (0.60 x 15%) + (0.20 x 18%) = 15%.
The standard deviation is given by , where

2 = 0.2(0.12 0.15) + 0.2(0.18 0.15) = 0.00036


= 0.01897 or 1.9%
2

Reference:CFAProgramCurriculum,Volume4,pp.230231.

PortfolioManagement345
15. Theexpectedreturnfromamarketis12%andtheriskfreerateis5%andastockhasabetaof
0.5.Therequiredrateofreturnfromthestockis:
A.

6.0%.

B.

8.5%.

C.

11.0%.

D.

14.5%.

16. Thebetaofastockcanbecomputedfromthe:
A.

relativevolatilityofthestockreturnstothemarketreturns.

B.

correlationofthestockwiththemarketandthemarketreturn.

C.

correlationofthestockwiththemarketandthevarianceofthestockreturns.

D.

covarianceofthestockwiththemarketandthevarianceofthemarketreturns.

346StudySession12:
15. Theexpectedreturnfromamarketis12%andtheriskfreerateis5%andastockhasabetaof
0.5.Therequiredrateofreturnfromthestockis:
A.
B.
C.
D.

6.0%.
8.5%.
11.0%.
14.5%.

CorrectAnswer:

B.......................................................................................... LOS:Reading51d

Using CAPM we can calculate the required return from the stock:

R x = R f + [E(R m ) R f ] = 5% + 0.5(12% 5% ) = 8.5% .


where:
Rf
=
RM =
i
=

the risk-free rate


market return
beta of stock

Reference:CFAProgramCurriculum,Volume4,pp.263267.

16. Thebetaofastockcanbecomputedfromthe:
A.
B.
C.
D.

relative volatility of the stock returns to the market returns.


correlation of the stock with the market and the market return.
correlation of the stock with the market and the variance of the stock returns.
covariance of the stock with the market and the variance of the market returns.

CorrectAnswer:

D ......................................................................................... LOS:Reading51d

The beta of an asset is the covariance of the assets returns with market returns divided by the variance of
the market returns.
Reference:CFAProgramCurriculum,Volume4,pp.267221.

PortfolioManagement347
17. In a rapidly rising market, a stock with a beta of 0.5 is expected, relative to the market
performance,to:

Performance

Direction

A.

outperform

Same

B.

outperform

Opposite

C.

underperform

Same

D.

underperform

Opposite

18. Thecharacteristicline:
A.

isaregressionlineusedtoestimateastockssystematicrisk.

B.

isaregressionlineusedtoestimateastocksstandarddeviation.

C.

indicatestherequiredrateofreturnofastockgivenitssystematicrisk.

D.

indicatestherequiredrateofreturnofastockgivenitsstandarddeviation.

348StudySession12:
17. In a rapidly rising market, a stock with a beta of 0.5 is expected, relative to the market
performance,to:
Performance
outperform
outperform
underperform
underperform

A.
B.
C.
D.

CorrectAnswer:

Direction
Same
Opposite
Same
Opposite
C ......................................................................................... LOS:Reading51d

A low beta means the stock will move by less than the market if the market moves upwards by more than
the risk-free rate. The positive beta means it will move in the same direction as the market.
Reference:CFAProgramCurriculum,Volume4,pp.263266.

18. Thecharacteristicline:
A.
B.
C.
D.

is a regression line used to estimate a stocks systematic risk.


is a regression line used to estimate a stocks standard deviation.
indicates the required rate of return of a stock given its systematic risk.
indicates the required rate of return of a stock given its standard deviation.

CorrectAnswer:

A ......................................................................................... LOS:Reading51d

Systematic risk is often calculated by using regression analysis to examine the return of an asset against
the return of the market. The slope of the line is the beta which measures systematic risk.
Reference:CFAProgramCurriculum,Volume4,pp.267271.

PortfolioManagement349
19. Aninvestorpolicystatementisimportantbecauseit:
A.

clarifiestheinvestorsobjectives.

B.

providestheinvestorwiththeportfoliomanagersmarketoutlook.

C.

providesdetailsonthestocksthatwillbepurchasedfortheportfolio.

D.

meansthattheinvestortakesresponsibilityforinvestmentperformance.

20. Theoptimalportfolioforaninvestorisrepresentedbythepointwherethe:
A.

investorutilitycurvesintersecteachother.

B.

securitymarketlineistangenttotheefficientfrontier.

C.

investorutilitycurveistangenttotheefficientfrontier.

D.

investorutilitycurveistangenttothesecuritymarketline.

350StudySession12:
19. Aninvestorpolicystatementisimportantbecauseit:
A.
B.
C.
D.

clarifies the investors objectives.


provides the investor with the portfolio managers market outlook.
provides details on the stocks that will be purchased for the portfolio.
means that the investor takes responsibility for investment performance.

CorrectAnswer:

A ......................................................................................... LOS:Reading49b

A policy statement helps the investor specify realistic goals and in setting the goals become more aware of
the risks of investing. It is a valuable way of communicating with the portfolio manager. It also helps set
the benchmark against which performance can be measured.
Reference:CFAProgramCurriculum,Volume4,pp.203206.

20. Theoptimalportfolioforaninvestorisrepresentedbythepointwherethe:
A.
B.
C.
D.

investor utility curves intersect each other.


security market line is tangent to the efficient frontier.
investor utility curve is tangent to the efficient frontier.
investor utility curve is tangent to the security market line.

CorrectAnswer:

C ..........................................................................................LOS:Reading50g

The utility curves represent the trade-off between risk and return. The optimal portfolio will be where the
highest utility curve touches the efficient frontier.
Reference:CFAProgramCurriculum,Volume4,pp.238249.

PortfolioManagement351
21. Aportfolioisinvestedequallybetweentwoassets,theassetshavestandarddeviationsof4%and
8%, and the correlation between the two assets is 0.3. The standard deviation of the combined
portfolioisclosestto:

A.

4.98%.

B.

6.00%.

C.

6.64%.

D.

24.80%.

22. Twoassetshavezerocorrelation.Ifaportfolioisinvestedwith30%inthefirstassetthathasa
variance of 12, and 70% in the second asset that has a variance of 8, the variance of the combined
portfolioisclosestto:

A.

2.2.

B.

5.0.

C.

6.7.

D.

9.2.

352StudySession12:
21. Aportfolioisinvestedequallybetweentwoassets,theassetshavestandarddeviationsof4%and
8%, and the correlation between the two assets is 0.3. The standard deviation of the combined
portfolioisclosestto:
A.
B.
C.
D.

4.98%.
6.00%.
6.64%.
24.80%.

CorrectAnswer:

A .......................................................................................... LOS:Reading50c

2port = w 12 12 + w 22 22 + 2r12 w 1 w 2 1 2
= (0.5) (0.04 ) + (0.5) (0.08) + 2(0.3)(0.5)(0.04 )(0.5)(0.08)
2

= 0.0004 + 0.0016 + 0.00048


= 0.00248
= 0.0498
where:

standard deviation of returns of asset i

rij

=
standard deviation of returns of asset j
wi =
weighting of asset i in the portfolio
= correlation between the returns of assets i and j
Reference:CFAProgramCurriculum,Volume4,pp.238241.

PortfolioManagement353
22. Twoassetshavezerocorrelation.Ifaportfolioisinvestedwith30%inthefirstassetthathasa
variance of 12, and 70% in the second asset that has a variance of 8, the variance of the combined
portfolioisclosestto:
A.
B.
C.
D.

2.2.
5.0.
6.7.
9.2.

CorrectAnswer:

B .......................................................................................... LOS:Reading50c

Variance is given by:

2port = w 12 12 + w 22 22 + 2r12 w 1 w 2 1 2
= (0.3) 12 + (0.7 ) 8
2

= 1.08 + 3.92
=5

where:

standard deviation of returns of asset i

wi
rij

=
=

weighting of asset i in the portfolio


correlation between the returns of assets i and j

Reference:CFAProgramCurriculum,Volume4,pp.238241.

354StudySession13:

Study Session 13: Equity Investments:


Securities Markets

This study session addresses how securities are bought and sold and what constitutes a well
functioningsecuritiesmarket.Thereadingonmarketindexesgivesanunderstandingofhowindexes
areconstructedandcalculatedandthebiasesinherentineachoftheweightingschemesused.
Some of the most interesting and important work in the investment field during the past several
decadesrevolvesaroundtheefficientmarkethypothesis(EMH)anditsimplicationsforactiveversus
passiveequityportfoliomanagement.Thereadingsonthissubjectprovideanunderstandingofthe
EMH and the seemingly persistent anomalies to the theory, an understanding that is necessary to
judgethevalueoffundamentalortechnicalsecurityanalysis.

Reading52:OrganizationandFunctioningofSecuritiesMarkets
Reading53:SecurityMarketIndexes
Reading54:EfficientCapitalMarkets
Reading55:MarketEfficiencyandAnomalies

EquityInvestments:SecuritiesMarkets355
1. Acorporationlookingtoraisefundsmaydecidetodoaprivateplacementbecause:
A.

itwillreduceissuingcosts.

B.

itwillavoidusinganinvestmentbank.

C.

itwillprovidegreaterliquidityinthesecondarymarket.

D.

theissuecanbesoldatahigherpricethanifitwassoldinapublicoffering.

2. WhenastockintheDowJonesIndustrialAveragehasastocksplitthiswillleadto:
A.

thedivisorincreasing.

B.

thedivisordecreasing.

C.

therebeingnochangeinthedivisor.

D. thedivisorincreasingifthestockisahighpricedstockandfallingifitisalowpriced
stock.

356StudySession13:
1. Acorporationlookingtoraisefundsmaydecidetodoaprivateplacementbecause:
A.
B.
C.
D.

it will reduce issuing costs.


it will avoid using an investment bank.
it will provide greater liquidity in the secondary market.
the issue can be sold at a higher price than if it was sold in a public offering.

CorrectAnswer:

A ......................................................................................... LOS:Reading52b

A private placement will have lower issue costs, mainly since the requirement for lengthy registration
documentation is reduced. However the pricing will be lower than for a public offer since the purchasers
will need to be compensated for the lack of liquidity in the secondary market.
Reference:CFAProgramCurriculum,Volume5,p.9.

2. WhenastockintheDowJonesIndustrialAveragehasastocksplitthiswillleadto:
A.
B.
C.
D.

the divisor increasing.


the divisor decreasing.
there being no change in the divisor.
the divisor increasing if the stock is a high-priced stock and falling if it is a low-priced stock.

CorrectAnswer:

B...........................................................................................LOS:Reading53a

When there is a stock split the stock price will fall, there is no immediate impact on the index so the
divisor must also decrease.
Reference:CFAProgramCurriculum,Volume5,pp.4242.

EquityInvestments:SecuritiesMarkets357
3. Ashortsellerofastockwillgenerally:
A.

sellthestockwhenthepriceisfalling.

B.

benefitfromariseinpriceofthestock.

C.

depositcollateralwhenheborrowsstock.

D.

benefitfromthepricefallwhenastockgoesexdividend.

4. TherearetwostocksABCandXYZincludedinanunweightedindexandthefollowingdatais
provided:

Stock

Numberofshares

Priceatend

Priceatend

ABC

10,000

$25.00

$30.00

XYZ

50,000

$35.00

$36.75

Iftheindexiscomputedusinggeometricaverages,theincreaseintheindexover2007isclosest
to:
A.

8.33%.

B.

11.25%.

C.

12.25%.

D.

12.50%.

358StudySession13:
3. Ashortsellerofastockwillgenerally:
A.
B.
C.
D.

sell the stock when the price is falling.


benefit from a rise in price of the stock.
deposit collateral when he borrows stock.
benefit from the price fall when a stock goes ex-dividend.

CorrectAnswer:

C .......................................................................................... LOS:Reading52f

A is not correct since he must sell on an uptick trade, B is not correct since he will benefit when the price
falls and he can buy back the stock at a cheaper price. D is not correct since he must pay the dividends to
the lender of the stock. Usually the lender of stock will require collateral as protection against the
borrower failing to return the stock.
Reference:CFAProgramCurriculum,Volume5,pp.2526.

4. TherearetwostocksABCandXYZincludedinanunweightedindexandthefollowingdatais
provided:

Stock

Numberofshares

Priceatend

Priceatend

ABC

10,000

$25.00

$30.00

XYZ

50,000

$35.00

$36.75

If the index is computed using geometric averages, the increase in the index over 2007 is closest to:
A.
8.33%.
B.
11.25%.
C.
12.25%.
D.
12.50%.
CorrectAnswer:

C ..........................................................................................LOS:Reading53a

An unweighted index is computed on the basis that an equal dollar amount is invested in each of stocks
ABC and XYZ. ABC rose by 20% and XYZ by 5% so the index performance is given by (1.20 x 1.05)1/2 1 =
0.1225 = 12.25%.
Reference:CFAProgramCurriculum,Volume5,pp.4446.

EquityInvestments:SecuritiesMarkets359
5. AninvestorcallsabrokeronthefirstdayofthemonthtofindoutthepriceofABCInc.sshares
andisquoted$103bid103ask.Thesharesareveryliquid.Thesharepricethenmovesto$98
98beforerisingto$115115attheendofthemonth.Iftheinvestorhad(i)placedamarketorder
tobuythesharesonthefirstdayandthensoldthemonthelastday(ii)alimitordertobuyat$100
andsellattheendofthemonth,hisprofitbeforetransactioncostswouldbeclosestto:
A.

(i)11.11%(ii)15.00%.

B.

(i)11.11%(ii)15.75%.

C.

(i)12.39%(ii)15.00%.

D.

(i)12.39%(ii)15.75%.

6. Aninformationallyefficientmarketisonewhere:
A.

informationisavailableonatimelybasistoallinvestors.

B.

investorsallocatetheirfundstothecompaniesthatcanmakethebestuseofthem.

C. securitypricesadjustslowlytothearrivalofnewinformationgivinginvestorstimeto
takeadvantageofpositivenews.
D. securitypricesadjustrapidlytothearrivalofnewinformationandthereforesecurity
pricesreflectallinformationaboutthesecurity.

360StudySession13:
5. AninvestorcallsabrokeronthefirstdayofthemonthtofindoutthepriceofABCInc.sshares
andisquoted$103bid103ask.Thesharesareveryliquid.Thesharepricethenmovesto$98
98beforerisingto$115115attheendofthemonth.Iftheinvestorhad(i)placedamarketorder
tobuythesharesonthefirstdayandthensoldthemonthelastday(ii)alimitordertobuyat$100
andsellattheendofthemonth,hisprofitbeforetransactioncostswouldbeclosestto:
A.
B.
C.
D.

(i) 11.11% (ii) 15.00%.


(i) 11.11% (ii) 15.75%.
(i) 12.39% (ii) 15.00%.
(i) 12.39% (ii) 15.75%.

CorrectAnswer:

A ..........................................................................................LOS:Reading52e

(i) If it is a market order he will pay the ask price to buy the shares, i.e. $103 and he will sell at the bid
price of $115 making a profit of 11.11%. (ii) A limit order to buy at $100 will be executed and he will sell at
$115 giving a profit of 15%.
Reference:CFAProgramCurriculum,Volume5,pp.2526.

6. Aninformationallyefficientmarketisonewhere:
A.
information is available on a timely basis to all investors.
B.
investors allocate their funds to the companies that can make the best use of them.
C.
security prices adjust slowly to the arrival of new information giving investors time to take
advantage of positive news.
D.
security prices adjust rapidly to the arrival of new information and therefore security prices reflect
all information about the security.
CorrectAnswer:

D ..........................................................................................LOS:Reading54a

An informationally efficient market is one where security prices adjust very rapidly to the arrival of new
information.
Reference:CFAProgramCurriculum,Volume5,pp.6263.

EquityInvestments:SecuritiesMarkets361
7. Buyingonmarginmeansthat:
A. ifthemarginrequirementis60%,theinvestormayborrow60%ofthecostofbuying
shares,allowinghimtoleveragehistransaction.
B.
thereturnsfrombuyingonmarginwillonlybehigherthanpayinginfullforshares
whenthesharepricemovessignificantlyupordown.
C. ifaninvestorhasboughtsharesonmarginandthesharepriceriseshewillhavemadea
moreattractivereturnonhisinvestmentthanifhehadfullypaidfortheshares.
D. ifaninvestorhasboughtsharesonmarginhewillberequiredtokeepamaintenance
marginwiththebroker;ifthesharepricefallshewillimmediatelyreceiveamargincall.

8. Acallmarketrefersto:
A.

amarketwheretradesaredonebyopenoutcry.

B.

amarketwhichspecializesinprovidingderivativestrading.

C.

amarketwhereitisattemptedtomatchallthebidsandasksataspecifiedtime.

D.

amarketwhereallthetradingisdonebycomputerratherthanonatradingfloor.

362StudySession13:
7. Buyingonmarginmeansthat:
A.
if the margin requirement is 60%, the investor may borrow 60% of the cost of buying shares,
allowing him to leverage his transaction.
B.
the returns from buying on margin will only be higher than paying in full for shares when the share
price moves significantly up or down.
C.
if an investor has bought shares on margin and the share price rises he will have made a more
attractive return on his investment than if he had fully paid for the shares.
D.
if an investor has bought shares on margin he will be required to keep a maintenance margin with
the broker; if the share price falls he will immediately receive a margin call.
CorrectAnswer:

C ..........................................................................................LOS:Reading52g

A is not true since if the margin requirement is 60% the investor can only borrow 40%.
B is not true since if the share moves down the losses will be higher if the investor has bought on margin.
D is not true since if the maintenance margin is lower than the initial margin the investor will only receive
a margin call after the shares have fallen to a level where the proportion of equity to the total value of stock
is below the maintenance margin.
C is true due to the leverage effect.
Reference:CFAProgramCurriculum,Volume5,pp.2629.

8. Acallmarketrefersto:
A.
B.
C.
D.

a market where trades are done by open outcry.


a market which specializes in providing derivatives trading.
a market where it is attempted to match all the bids and asks at a specified time.
a market where all the trading is done by computer rather than on a trading floor.

CorrectAnswer:

C .......................................................................................... LOS:Reading52c

In a call market all the bids and asks for a stock are collected and a stock price that will best match buyers
and sellers is decided.
Reference:CFAProgramCurriculum,Volume5,p.15.

EquityInvestments:SecuritiesMarkets363
9. WhichofthefollowingisleastlikelytobeamemberofaU.S.securitiesexchange?
A.

Aspecialist.

B.

Afloorbroker.

C.

Anunderwriter.

D.

Aregisteredtrader.

10. ThequotationsforthepriceofBrownandCo.aregivenby3dealersasshownbelow:

Dealer1
Dealer2
Dealer3

Bid
17
17
17

Ask
18
18
18

IfDealer3hasexcessinventoryofBrownandCo.stock,changinghisquotetowhichofthe
followingwouldbethemosteffectiveinreducinghisinventory?
A.

1718.

B.

1718.

C.

1718.

D.

1717.

364StudySession13:
9. WhichofthefollowingisleastlikelytobeamemberofaU.S.securitiesexchange?
A.
B.
C.
D.

A specialist.
A floor broker.
An underwriter.
A registered trader.

CorrectAnswer:

C ..........................................................................................LOS:Reading52e

The four major categories of membership are:


1.
Specialist.
2.
Commission broker.
3.
Floor broker.
4.
Registered trader.
Reference:CFAProgramCurriculum,Volume5,pp.2425.

10. ThequotationsforthepriceofBrownandCo.aregivenby3dealersasshownbelow:

Dealer1
Dealer2
Dealer3

Bid
17
17
17

Ask
18
18
18

If Dealer 3 has excess inventory of Brown and Co. stock, changing his quote to which of the following
would be the most effective in reducing his inventory?
A.
17 - 18.
B.
17 - 18 .
C.
17 - 18 .
D.
17 - 17 .
CorrectAnswer:

D ..........................................................................................LOS:Reading52e

Moving the ask price lower than the other dealers will mean the dealer is able to sell stock, and moving the
bid price lower will mean he is unlikely to have to buy stock, until the other dealers move their prices.
Reference:CFAProgramCurriculum,Volume5,pp.2023.

EquityInvestments:SecuritiesMarkets365
11. When investors prefer to read research that agrees with their own views, rather than read a
contraryopinion,thisisreferredtoinbehavioralfinanceas:
A.

escalationbias.

B.

prospecttheory.

C.

overconfidence.

D.

confirmationbias.

12. Acallmarketisoneinwhich:
A.

shortsellingisnotpermitted.

B.

dealersaremakingmarketsinstocks.

C.

stockpricesaredeterminedbyauction.

D.

individualstocksaretradedatspecifiedtimes.

366StudySession13:
11. When investors prefer to read research that agrees with their own views, rather than read a
contraryopinion,thisisreferredtoinbehavioralfinanceas:
A.
B.
C.
D.

escalation bias.
prospect theory.
overconfidence.
confirmation bias.

CorrectAnswer:

D ......................................................................................... LOS:Reading54d

Research shows that investors seek out information that confirms their own views, this is called
confirmation bias.
Reference:CFAProgramCurriculum,Volume5,pp.8384.

12. Acallmarketisoneinwhich:
A.
B.
C.
D.

short selling is not permitted.


dealers are making markets in stocks.
stock prices are determined by auction.
individual stocks are traded at specified times.

CorrectAnswer:

D .......................................................................................... LOS:Reading52c

B and C are types of continuous market. Short selling may or may not be permitted in a call market.
In a call market the exchange usually sets the price and all trades are executed at a specified time at this
price.
Reference:CFAProgramCurriculum,Volume5,pp.1415.

EquityInvestments:SecuritiesMarkets367
13. Apricinganomalyisbestdescribedas:
A.

apricemovethatreflectsafactorthatisspecifictotheindividualstock.

B.

apredictabledeviationbetweenexpectedandactualreturnsforastock.

C.

outorunderperformanceofastockagainstthemarketaverageperformance.

D.

ashorttermrandommovementinastockpricesgivinganopportunitytomakeaprofit.

14. Ifamarketisperfectlyefficientandaportfoliomanagerdoesnothavesuperioranalyststhenthe
portfoliomanagershould:
A.

onlyholdcash.

B.

selectaportfolioofsecuritiesatrandom.

C.

increasethesystematicriskoftheportfolio.

D. diversifyawayunsystematicriskandadjustthesystematicriskofeachportfoliotomeet
clientsobjectives.

368StudySession13:
13. Apricinganomalyisbestdescribedas:
A.
B.
C.
D.

a price move that reflects a factor that is specific to the individual stock.
a predictable deviation between expected and actual returns for a stock.
out or underperformance of a stock against the market average performance.
a short-term random movement in a stock prices giving an opportunity to make a profit.

CorrectAnswer:

B.......................................................................................... LOS:Reading55b

A key element of an anomaly is that it is a predictable, rather than a random, move.


Reference:CFAProgramCurriculum,Volume5,p.100.

14. Ifamarketisperfectlyefficientandaportfoliomanagerdoesnothavesuperioranalyststhenthe
portfoliomanagershould:
A.
only hold cash.
B.
select a portfolio of securities at random.
C.
increase the systematic risk of the portfolio.
D.
diversify away unsystematic risk and adjust the systematic risk of each portfolio to meet clients
objectives.
CorrectAnswer:

D .......................................................................................... LOS:Reading54c

Portfolio managers who do not have superior analysts should do the following:
(i) Quantify their clients risk tolerance.
(ii) Construct a portfolio which has the appropriate risk profile and maintain this risk level on an
ongoing basis.
(iii) Diversify to eliminate any unsystematic risk by investing globally.
(iv) Minimize costs including taxes, transaction costs and avoid holding illiquid stocks.
Reference:CFAProgramCurriculum,Volume5,pp.8789.

EquityInvestments:SecuritiesMarkets369
15. Which of the following is least likely to be a reason why we should be skeptical of claims by
analyststohavediscoveredananomaly?
A.

Datamining.

B.

Survivorshipbias.

C.

Nonsynchronoustrading.

D.

Limitedcapitalofarbitrageurs.

16. Ifaninvestorbuys1,000sharesat$50andtheinitialmarginis60%andthemaintenancemargin
is30%,he/shewillreceivethefirstmargincallwhenthestockpricefallsbelow:
A.

$14.00.

B.

$21.00.

C.

$28.57.

D.

$49.99.

370StudySession13:
15. Which of the following is least likely to be a reason why we should be skeptical of claims by
analyststohavediscoveredananomaly?
A.
B.
C.
D.

Data mining.
Survivorship bias.
Nonsynchronous trading.
Limited capital of arbitrageurs.

CorrectAnswer:

D ......................................................................................... LOS:Reading55d

Limited capital can constrain the ability of arbitrageurs to take advantage of anomalies, but it is not a
reason to be skeptical that they exist.
Reference:CFAProgramCurriculum,Volume5,pp.100104.

16. Ifaninvestorbuys1,000sharesat$50andtheinitialmarginis60%andthemaintenancemargin
is30%,he/shewillreceivethefirstmargincallwhenthestockpricefallsbelow:
A.
B.
C.
D.

$14.00.
$21.00.
$28.57.
$49.99.

CorrectAnswer:

C ..........................................................................................LOS:Reading52g

The amount borrowed would be $20,000. We need to calculate when the value of the equity equals 30% of
the total value of the stock. This is given by:
1,000P - $20,000 = 0.30(1,000P)
P = $28.57
Reference:CFAProgramCurriculum,Volume5,pp.2629.

EquityInvestments:SecuritiesMarkets371
17. Twoindexescontainexactlythesamestocks;oneisavalueweightedindexwhichincreasedby
12%whereastheotherisanunweightedindexwhichincreasedby5%overthesameperiod.Thisis
explainedby:
A.

therewerealargenumberofstocksplitsovertheperiod.

B.

therewereasmallnumberofstocksplitsovertheperiod.

C.

smallcapitalizationstocksoutperformedlargecapitalizationstocks.

D.

largecapitalizationstocksoutperformedsmallcapitalizationstocks.

18. Theinitialmarginrequirementforastockpurchaseis:
A.

themarketvalueofthestocklesstheamountborrowed.

B.

themarketvalueofthestocklesstheamountpaidincash.

C.

thepercentageofthetransactionvaluethatcanbeborrowed.

D.

thepercentageofthetransactionvaluethatmustbepaidforincash.

372StudySession13:
17. Twoindexescontainexactlythesamestocks;oneisavalueweightedindexwhichincreasedby
12%whereastheotherisanunweightedindexwhichincreasedby5%overthesameperiod.Thisis
explainedby:
A.
B.
C.
D.

there were a large number of stock splits over the period.


there were a small number of stock splits over the period.
small capitalization stocks outperformed large capitalization stocks.
large capitalization stocks outperformed small capitalization stocks.

CorrectAnswer:

D ..........................................................................................LOS:Reading53a

Stock splits will not affect either index since in the market-value-weighted index when there is a stock
split the number of shares outstanding will increase but the share price will fall by a corresponding
amount. An unweighted index will be computed on an equal amount of money invested in each stock
regardless of price or market value.
In a value-weighted index companies with a larger market capitalization will have a higher weighting so D
is the correct answer.
Reference:CFAProgramCurriculum,Volume5,pp.4446.

18. Theinitialmarginrequirementforastockpurchaseis:
A.
B.
C.
D.

the market value of the stock less the amount borrowed.


the market value of the stock less the amount paid in cash.
the percentage of the transaction value that can be borrowed.
the percentage of the transaction value that must be paid for in cash.

CorrectAnswer:

D ..........................................................................................LOS:Reading52g

The initial margin is simply the percentage or proportion of the transaction value that must be paid for in
cash, rather than borrowed.
Reference:CFAProgramCurriculum,Volume5,pp.2629.

EquityInvestments:SecuritiesMarkets373
19. TheEfficientMarketHypothesisandthetestsdonetoprovetheHypothesisimplydoingwhich
ofthefollowingistheleastusefulforportfoliomanagers?
A.

Usingtechnicalanalysis.

B.

Minimizingtotaltransactioncosts.

C.

Focusingonanalyzingneglectedcompanies.

D. Usinganalystswhohavetheabilitytoestimateeconomicvariablesthathaveanimpact
onsecurityprices.

20. WhichofthefollowingsupportsthesemistrongformoftheEfficientMarketHypothesis?
A.

TheJanuaryeffect.

B.

Theneglectedfirmeffect.

C.

Theperformanceofstockswithalowprice/bookvalueratio.

D.

Theperformanceofstocksthathaveannouncedachangeinaccountingmethods.

374StudySession13:
19. TheEfficientMarketHypothesisandthetestsdonetoprovetheHypothesisimplydoingwhich
ofthefollowingistheleastusefulforportfoliomanagers?
A.
Using technical analysis.
B.
Minimizing total transaction costs.
C.
Focusing on analyzing neglected companies.
D.
Using analysts who have the ability to estimate economic variables that have an impact on security
prices.
CorrectAnswer:

A .......................................................................................... LOS:Reading54c

The weak-form of the Efficient Market Hypothesis implies that technical analysis based on past trading
data does not have any value.
Reference:CFAProgramCurriculum,Volume5,p.85.

20. WhichofthefollowingsupportsthesemistrongformoftheEfficientMarketHypothesis?
A.
B.
C.
D.

The January effect.


The neglected firm effect.
The performance of stocks with a low price/book value ratio.
The performance of stocks that have announced a change in accounting methods.

CorrectAnswer:

D ......................................................................................... LOS:Reading54b

The January effect, the neglected firm effect and the outperformance of low price/book value stocks are all
anomalies of the semistrong-form of the EMH. The performance of stocks that have announced a change in
accounting methods supports the semistrong-form of the EMH. Studies find that analysts look at the true
value of companies rather than the effects of a change in the way financial performance is reported.
Reference:CFAProgramCurriculum,Volume5,pp.6779.

EquityInvestments:SecuritiesMarkets375
21. BasedonhistoricdatathecorrelationbetweentheS&P500andtheRussellSmallCapindexand
theIFCEmergingMarketindexareasshowninthetablebelow.

Index

CorrelationwithS&P500

RussellSmallCapindex

0.783

IFCEmergingMarketindex

0.392

Onthebasisofthedatagiven,inordertodiversifyaportfoliothatisinvestedinS&P500stocks,from
whichindexisitlikelytobemosteffectivetoincludestocks,andwhichisthemostimportantfactor
inexplainingthecorrelationfigures?

Includestocksfrom

Correlationexplainedby

A.

RussellSmallCapindex

Indexconstruction

B.

RussellSmallCapindex

Indexconstituents

C.

IFCEmergingMarketindex

Indexconstruction

D.

IFCEmergingMarketindex

Indexconstituents

22. Avalueweightedindexismadeupoftwostocks,XandY,andthefollowingdataisprovided:

December31st2006

December31st2007

Stock

Price

Sharesoutstanding

Price

Sharesoutstanding

$25

10,000

$15

20,000*

$50

6,000

$65

6,000

*aftera2for1stocksplit
Thebaseindexissetat100onDecember31st2006.TheindexonDecember31st2007isclosestto:
A.

98.18.

B.

106.67.

C.

125.45.

D.

126.67.

376StudySession13:
21. BasedonhistoricdatathecorrelationbetweentheS&P500andtheRussellSmallCapindexand
theIFCEmergingMarketindexareasshowninthetablebelow.

Index

CorrelationwithS&P500

RussellSmallCapindex

0.783

IFCEmergingMarketindex

0.392

On the basis of the data given, in order to diversify a portfolio that is invested in S&P 500 stocks, from
which index is it likely to be most effective to include stocks, and which is the most important factor in
explaining the correlation figures?

A.
B.
C.
D.

Include stocks from


Russell Small-Cap index
Russell Small-Cap index
IFC Emerging Market index
IFC Emerging Market index

CorrectAnswer:

Correlation explained by
Index construction
Index constituents
Index construction
Index constituents

D .......................................................................................... LOS:Reading53c

A low correlation indicates that there are stronger diversification benefits, so including stocks from the
IFC Emerging Market index would be most effective, based on historic data. Most of the major indexes
(except for the Nikkei) are value weighted, the most important factor in explaining low correlation is the
different constituent stocks in the indexes.
Reference:CFAProgramCurriculum,Volume5,pp.5658.

EquityInvestments:SecuritiesMarkets377
22. Avalueweightedindexismadeupoftwostocks,XandY,andthefollowingdataisprovided:

December31st2006

December31st2007

Stock

Price

Shares
outstanding

Price

Shares
outstanding

$25

10,000

$15

20,000*

$50

6,000

$65

6,000

* after a 2 for 1 stock split


The base index is set at 100 on December 31st 2006. The index on December 31st 2007 is closest to:
A.
B.
C.
D.

98.18.
106.67.
125.45.
126.67.

CorrectAnswer:

C .......................................................................................... LOS:Reading53a

Total market value on Dec. 31st 2006 is ($25 x 10,000) + ($50 x 6,000) = $550,000
Total market value on Dec. 31st 2007 is ($15 x 20,000) + ($65 x 6,000) = $690,000
The index = ($690,000/$550,000) x100 = 125.45
Reference:CFAProgramCurriculum,Volume5,pp.4445.

378StudySession14:

Study Session 14: Equity Investments:


Industry and Company Analysis

Thisstudysessionfocusesonindustryandcompanyanalysisanddescribesthetoolsusedinforming
anopinionaboutinvestinginaparticularstockorgroupofstocks.
This study session begins with the essential tools of equity valuation: the discounted cash flow
technique and the relative valuation approach. These techniques provide the means to estimate
reasonable price for a stock. The readings on industry analysis are an important element in the
valuationprocess,providingthetopdowncontextcrucialtoestimatingacompanyspotential.Also
addressedisestimatingacompanysearningspersharebyforecastingsalesandprofitmargins.
Thelastreadinginthisstudysessionfocusesonpricemultiples,oneofthemostfamiliarandwidely
used tools in estimating the value of a company, and introduces the application of four commonly
usedpricemultiplestovaluation.

Reading56:AnIntroductiontoSecurityValuation:PartI
Reading57:IndustryAnalysis
Reading58:Equity:ConceptsandTechniques
Reading59:CompanyAnalysisandStockValuation
Reading60:AnIntroductiontoSecurityValuation:PartII
Reading61:IntroductiontoPriceMultiples

EquityInvestments:IndustryandCompanyAnalysis379
1. If an investors required rate of return is 12% and a companys stock price is $45.00, the next
dividendisestimatedtobe$3.60andthegrowthrateofdividendsisaconstant4.5%,thenthestock
is:
A.

overvalued.

B.

undervalued.

C.

fairlyvalued.

D.

informationisneededonthedividendpayoutratiotoanswerthequestion.

2. Whichofthefollowingwouldbeapositivefactorforproducersprofitability?
A.

Lowentrybarriers.

B.

Strongbuyerpower.

C.

Weaksupplierpower.

D.

Availabilityofsubstitutes.

380StudySession14:
1. If an investors required rate of return is 12% and a companys stock price is $45.00, the next
dividendisestimatedtobe$3.60andthegrowthrateofdividendsisaconstant4.5%,thenthestock
is:
A.
B.
C.
D.

overvalued.
undervalued.
fairly valued.
information is needed on the dividend payout ratio to answer the question.

CorrectAnswer:

B.......................................................................................... LOS:Reading60b

The stock price using the DDM should be 3.6/(0.12 0.045) = $48, if the price is $45 the stock is
undervalued.
Reference:CFAProgramCurriculum,Volume5,pp.177182.

2. Whichofthefollowingwouldbeapositivefactorforproducersprofitability?
A.
B.
C.
D.

Low entry barriers.


Strong buyer power.
Weak supplier power.
Availability of substitutes.

CorrectAnswer:

C ..........................................................................................LOS:Reading58e

Weak supplier power means that the suppliers to the industry are in a weak negotiating position and are
unable to squeeze the producers profits; this is a positive factor for the producers profitability.
Low entry barriers will increase competition, reducing profit margins. Strong buyer power means the
buyers can demand low prices reducing profitability. Availability of substitutes restrains producers who
wish to raise prices.
Reference:CFAProgramCurriculum,Volume5,pp.141144.

EquityInvestments:IndustryandCompanyAnalysis381
3. Whichofthefollowingfactorsisleastlikelytodirectlydeterminethelevelofcompetitioninan
industry?
A.

Entrybarriers.

B.

Unitlaborcosts.

C.

Bargainingpowerofbuyers.

D.

Availabilityofsubstituteproducts.

4. Ananalystforecastsacompanywillpaydividendsof$2inthefirstyear,$3inthesecondyear
and$3.50inthethirdyear.Afterthethirdyeardividendsareforecasttogrowat4%perannum.Ifan
investorsrequiredrateofreturnis12%thevalueofthestockisclosestto:
A.

$36.56.

B.

$37.81.

C.

$39.05

D.

$51.69.

382StudySession14:
3. Whichofthefollowingfactorsisleastlikelytodirectlydeterminethelevelofcompetitioninan
industry?
A.
B.
C.
D.

Entry barriers.
Unit labor costs.
Bargaining power of buyers.
Availability of substitute products.

CorrectAnswer:

B...........................................................................................LOS:Reading58e

Unit labor costs impact the profitability of an industry, and although they indirectly affect how attractive a
business is for participants they are not a direct factor determining competition.
Reference:CFAProgramCurriculum,Volume5,pp.141144.

4. Ananalystforecastsacompanywillpaydividendsof$2inthefirstyear,$3inthesecondyear
and$3.50inthethirdyear.Afterthethirdyeardividendsareforecasttogrowat4%perannum.Ifan
investorsrequiredrateofreturnis12%thevalueofthestockisclosestto:
A.
B.
C.
D.

$36.56.
$37.81.
$39.05
$51.69.

CorrectAnswer:

C ......................................................................................... LOS:Reading60b

First, calculate the value of the stock at the end of year three,

Value =

D4
$3.50(1.04)
=
= $45.50
(k g ) (0.12 0.04)

The value of the stock today is the sum of the present values of the first three years dividends plus the
present value of the end-year-three value.

Value =

P + D3
D1
D2
$2
$3
$45.50 + $3.50
+
+
=
+
+
= $39.05
2
3
2
(1 + k ) (1 + k ) (1 + k ) (1.12) (1.12)
(1.12)3

Reference:CFAProgramCurriculum,Volume5,pp.176182.

EquityInvestments:IndustryandCompanyAnalysis383
5. Acompanyisoperatingatthepeakofthebusinesscycle.WhichofthefollowingEPScalculations
islikelytogivethehighestP/Eratio?
A.

LeadingP/E.

B.

TrailingP/E.

C.

CurrentP/E.

D.

P/Eusingnormalizedearnings.

6. Estimatingacompanyearningsmultiplierusingmacroanalysisinvolves:
A.

examiningtherelationshipbetweenthecompanyearningsmultiplierandtheeconomy.

B.
examiningtherelationshipbetweenthecompanyearningsmultiplierandthemarket
earningsmultiplier.
C. examiningtherelationshipbetweenthehistoricearningsmultiplierforthecompanyand
companyperformance.
D. examiningthespecificvariablesthatinfluencetheearningsmultiplier,includingthe
dividendpayoutratioandrequiredratesofreturn.

384StudySession14:
5. Acompanyisoperatingatthepeakofthebusinesscycle.WhichofthefollowingEPScalculations
islikelytogivethehighestP/Eratio?
A.
B.
C.
D.

Leading P/E.
Trailing P/E.
Current P/E.
P/E using normalized earnings.

CorrectAnswer:

D ..........................................................................................LOS:Reading61a

Normalized earnings will calculate the earnings at the midpoint of the cycle so is likely to be lower than
current/trailing earnings or prospective earnings; hence the P/E will be higher on this basis.
Reference CFA Program Curriculum, Volume 5, pp. 205-210.

6. Estimatingacompanyearningsmultiplierusingmacroanalysisinvolves:
A.
examining the relationship between the company earnings multiplier and the economy.
B.
examining the relationship between the company earnings multiplier and the market earnings
multiplier.
C.
examining the relationship between the historic earnings multiplier for the company and company
performance.
D.
examining the specific variables that influence the earnings multiplier, including the dividend
payout ratio and required rates of return.
CorrectAnswer:

B.......................................................................................... LOS:Reading59b

Macroanalysis is estimating a P/E or earnings multiplier by looking at the relationship between the
company and its market and industry. Answer D refers to microanalysis.
Reference:CFAProgramCurriculum,Volume5,pp.160166.

EquityInvestments:IndustryandCompanyAnalysis385
7. Acompanywhoseearningsareverysensitivetothebusinesscycleisa:
A.

growthstock.

B.

cyclicalstock.

C.

growthcompany.

D.

cyclicalcompany.

8. Valuechainanalysisinreturnexpectationsanalysisisimportantbecauseitstudies:
A.

coopetitionrisks.

B.

competitionbetweenrivalfirmsinanindustry.

C.

thegovernmentsabilitytoraisevalueaddedtaxes.

D. howgoodsaretransformedfromrawmaterialsthroughtothefinishedgoodandprofits
aresharedbetweenfirmsalongthechain.

386StudySession14:
7. Acompanywhoseearningsareverysensitivetothebusinesscycleisa:
A.
B.
C.
D.

growth stock.
cyclical stock.
growth company.
cyclical company.

CorrectAnswer:

D ..........................................................................................LOS:Reading59a

A cyclical company is one whose sales and earnings are very sensitive to the business cycle such as auto or
steel companies. A cyclical stock is defined differently; it is one which has a high beta so it has changes in
rates of return which are larger than the changes in rates of return of the market.
Reference:CFAProgramCurriculum,Volume5,pp.150151.

8. Valuechainanalysisinreturnexpectationsanalysisisimportantbecauseitstudies:
A.
co-opetition risks.
B.
competition between rival firms in an industry.
C.
the governments ability to raise value added taxes.
D.
how goods are transformed from raw materials through to the finished good and profits are shared
between firms along the chain.
CorrectAnswer:

D ......................................................................................... LOS:Reading58b

Value chain analysis in return expectations analysis looks at how returns are split between the
participants in a value chain. Co-opetition risks refer to risks, not returns, in the value chain and
competition between rival firms is not referring to firms in the same value chain.
Reference:CFAProgramCurriculum,Volume5,pp.136140.

EquityInvestments:IndustryandCompanyAnalysis387
9. Ananalystisvaluingacompanywherehesuspectsthatthemanagementhasbeenmanipulating
the accounts by capitalizing expenses that should have been treated as operating expenses. Which
wouldbeanappropriateapproachtotakewhenvaluingthecompany?
A.

Usenormalizedearningsratherthancurrentearningsinthepricetoearningscalculation.

B.
Usepricetocashflowasthemainrelativemeasureusingfreecashflowsinthe
calculation.
C. Notattempttovaluethecompanyifthereareconcernsaboutthequalityofthereported
accounts.
D. Focusonpricetobookvaluesincebookvaluewillnothavebeenaffectedbyany
manipulationoftheaccounts.

10. Which of the following is most likely to lead to a companys earnings multiplier being higher
thanthemarketmultiplier?
A.

Thecompanyhasahighbeta.

B.

Theriskofthecompanysearningsishigherthanthemarket.

C.

Lowreturnonequityforthecompanyrelativetothemarket.

D.

Highearningsgrowthratesforthecompanyrelativetothemarket.

388StudySession14:
9. Ananalystisvaluingacompanywherehesuspectsthatthemanagementhasbeenmanipulating
the accounts by capitalizing expenses that should have been treated as operating expenses. Which
wouldbeanappropriateapproachtotakewhenvaluingthecompany?
A.
Use normalized earnings rather than current earnings in the price to earnings calculation.
B.
Use price to cash flow as the main relative measure using free cash flows in the calculation.
C.
Not attempt to value the company if there are concerns about the quality of the reported accounts.
D.
Focus on price to book value since book value will not have been affected by any manipulation of
the accounts.
CorrectAnswer:

B...........................................................................................LOS:Reading61a

Normalized earnings will look at earnings over a business cycle so will not resolve the issue of earnings
manipulation. Book value will also reflect a decision to capitalize rather than expense earnings. Cash flow
will reflect the actual cash going in and out of the company so will be less subject to manipulation.
Answer D is possible but analysts may not have the choice to ignore companies where they suspect that
the accounts have been manipulated. They will need to attempt to value them by adjusting the accounts
and/or using cash flow methods.
Reference:CFAProgramCurriculum,Volume5,pp.204210.

10. Which of the following is most likely to lead to a companys earnings multiplier being higher
thanthemarketmultiplier?
A.
B.
C.
D.

The company has a high beta.


The risk of the companys earnings is higher than the market.
Low return on equity for the company relative to the market.
High earnings growth rates for the company relative to the market.

CorrectAnswer:

D ......................................................................................... LOS:Reading59b

High growth generally leads to a high multiplier, so D is the correct answer.


A high beta would lead to a high required rate of return and therefore a lower multiplier so A is not correct.
Higher risk means a higher required rate of return, and therefore a lower multiplier so B is not correct.
Low return on equity implies low growth rates which would lead to a lower multiplier so C is not correct.
Reference:CFAProgramCurriculum,Volume5,pp.160166.

EquityInvestments:IndustryandCompanyAnalysis389
11. ABC Commodities is sensitive to the economic cycle and an analyst decides that the six years
ending 2007 reflect a business cycle for the company. He collects the following data: earnings per
share(EPS),bookvaluepershare(BVPS)andreturnonequity(ROE):.

2002

2003 2004

2005

2006

2007

Adjusted*EPS,$

1.30

2.65

5.50

4.30

3.25

1.00

ROE*%

0.04

0.13

0.22

0.18

0.12

0.03

BVPS,$

32.00

*Adjustedfornonrecurringitems
ThecurrentsharepriceofABCCommoditiesis$30.00
TheP/EofABCcommoditiesbasedontheaveragehistoricalEPSisclosestto:
A.

7.81.

B.

9.37.

C.

10.00.

D.

33.33.

12. Whichofthefollowingisleastlikelytobeanadjustmentmadetobookvalueinordertomakeit
betterreflectthevalueofshareholdersinvestment?

A.

Usetangiblebookvalueratherthantotalbookvalue.

B.

Adjustbookvalueforoffbalancesheetassetsandliabilities.

C.

Usehistoricaverageofpastbookvaluesoverabusinesscycle.

D.

Adjustbookvaluefordifferencesinfairvalueandhistoriccostofassets.

390StudySession14:
11. ABC Commodities is sensitive to the economic cycle and an analyst decides that the six years
ending 2007 reflect a business cycle for the company. He collects the following data: earnings per
share(EPS),bookvaluepershare(BVPS)andreturnonequity(ROE):.

2002 2003 2004 2005 2006

1.30
2.65 5.50
4.30
3.25
Adjusted*EPS,$
0.04
0.13 0.22
0.18
0.12
ROE*%

BVPS,$
* Adjusted for non-recurring items
The current share price of ABC Commodities is $30.00
The P/E of ABC commodities based on the average historical EPS is closest to:
A.
7.81.
B.
9.37.
C.
10.00.
D.
33.33.
CorrectAnswer:

2007
1.00
0.03
32.00

C ......................................................................................... LOS:Reading61b

The average EPS = (1.30 + 2.65 + 5.50 + 4.30 + 3.25 + 1.00)/6 = 3.00
P/E = 30.00/3.00 = 10.00
Reference:CFAProgramCurriculum,Volume5,pp.206210.

12. Whichofthefollowingisleastlikelytobeanadjustmentmadetobookvalueinordertomakeit
betterreflectthevalueofshareholdersinvestment?
A.
B.
C.
D.

Use tangible book value rather than total book value.


Adjust book value for off-balance-sheet assets and liabilities.
Use historic average of past book values over a business cycle.
Adjust book value for differences in fair value and historic cost of assets.

CorrectAnswer:

C ..........................................................................................LOS:Reading61a

Since book value is a cumulative number, reflecting retained earnings, it is a more stable number than one
year earnings, so it is less likely that an average historic figure would be used.
Reference:CFAProgramCurriculum,Volume5,pp.210218.

EquityInvestments:IndustryandCompanyAnalysis391
13. Ifacompanyhasanearningsretentionratioof60%,earningsaregrowingat5%perannumand
investorsrequiredrateofreturnis12%,theP/Eofthestockisclosestto:
A.

3.33.

B.

4.44.

C.

5.71.

D.

8.57.

14. Whichofthefollowingfactorswillencouragenewentrantstoanindustry?

A.

Highexitcosts.

B.

Asteepcostcurve.

C.

Excessindustrycapacity.

D.

Highindustryprofitability.

392StudySession14:
13. Ifacompanyhasanearningsretentionratioof60%,earningsaregrowingat5%perannumand
investorsrequiredrateofreturnis12%,theP/Eofthestockisclosestto:
A.
B.
C.
D.

3.33.
4.44.
5.71.
8.57.

CorrectAnswer:

C .......................................................................................... LOS:Reading60c

Reference:CFAProgramCurriculum,Volume5,pp.186188.

14. Whichofthefollowingfactorswillencouragenewentrantstoanindustry?
A.
B.
C.
D.

High exit costs.


A steep cost curve.
Excess industry capacity.
High industry profitability.

CorrectAnswer:

D ..........................................................................................LOS:Reading58e

High profitability will attract new entrants whereas a steep cost curve means it is difficult to enter the
industry with small volumes. High exit costs, such as irreversibility of required capital investment,
discourages new entrants, and excess capacity means existing manufacturers may be willing to cut prices
to deter new entrants.
Reference:CFAProgramCurriculum,Volume5,pp.143144.

EquityInvestments:IndustryandCompanyAnalysis393
15. Whichofthefollowingisleastlikelytobeareasonforusingaprice/sales(P/S)ratiotovaluea
company?
A.

Salesaregenerallymorestablethanearningspershare.

B.

Salesnumbersarelesssubjecttoaccountingmanipulation.

B.

P/Sisviewedasanappropriatevaluationmethodforcyclicalcompanies.

D.

P/Svaluationmethodscanbeusedcomparingcompanieswithdifferentcoststructures.

16. Whichstageoftheindustrycycleischaracterizedbyfastsalesgrowthandhighprofitmargins?
A.

Maturegrowth.

B.

Marketmaturity.

C.

Pioneeringdevelopment.

D.

Rapidacceleratinggrowth.

394StudySession14:
15. Whichofthefollowingisleastlikelytobeareasonforusingaprice/sales(P/S)ratiotovaluea
company?
A.
B.
B.
D.

Sales are generally more stable than earnings per share.


Sales numbers are less subject to accounting manipulation.
P/S is viewed as an appropriate valuation method for cyclical companies.
P/S valuation methods can be used comparing companies with different cost structures.

CorrectAnswer:

D ..........................................................................................LOS:Reading61a

P/S is not a good method for comparing companies with different cost structures because it doesnt take
into account a companys profitability. It is generally only useful for comparing companies operating in the
same industry.
Reference:CFAProgramCurriculum,Volume5,pp.218221.

16. Whichstageoftheindustrycycleischaracterizedbyfastsalesgrowthandhighprofitmargins?
A.
B.
C.
D.

Mature growth.
Market maturity.
Pioneering development.
Rapid accelerating growth.

CorrectAnswer:

D .......................................................................................... LOS:Reading58c

Rapid accelerating growth is the second stage when the industry is seeing rapid growth in sales and the
potential for high profit margins because new entrants and therefore competition may be limited.
Reference:CFAProgramCurriculum,Volume5,pp.137138.

EquityInvestments:IndustryandCompanyAnalysis395
17. Iftheexpectedinflationrateinacountryis3%andtherealriskfreerateis6%thentherequired
nominalriskfreerateisclosestto:
A.

2.9%.

B.

9.0%.

C.

9.2%.

D.

18.0%.

18. Aninvestorwhofollowsanindustryrotationstrategybelievestheeconomyhaspastitstrough
andthereisconfirmationofrecovery.Whichstrategywouldhe/shebelikelytofollow?
A.

Sellproperty.

B.

Purchasestocks.

C.

Purchasebonds.

D.

Sellcommodities.

396StudySession14:
17. Iftheexpectedinflationrateinacountryis3%andtherealriskfreerateis6%thentherequired
nominalriskfreerateisclosestto:
A.
B.
C.
D.

2.9%.
9.0%.
9.2%.
18.0%.

CorrectAnswer:

C ......................................................................................... LOS:Reading60d

NRFR = [1 +RRFR] [1 + E(I)] 1


where:
NRFR = nominal risk-free rate
RRFR = real risk-free rate
E(I) = expected rate of inflation
NRFR = (1.06)(1.03 1) = 9.18%
Reference:CFAProgramCurriculum,Volume5,pp.191193.

18. Aninvestorwhofollowsanindustryrotationstrategybelievestheeconomyhaspastitstrough
andthereisconfirmationofrecovery.Whichstrategywouldhe/shebelikelytofollow?
A.
B.
C.
D.

Sell property.
Purchase stocks.
Purchase bonds.
Sell commodities.

CorrectAnswer:

B...........................................................................................LOS:Reading58a

If the economy is in the recovery stage the best performance would be expected to come from cyclical
stocks and commodities, and then property, so B is the best answer.
Reference:CFAProgramCurriculum,Volume5,pp.130132.

EquityInvestments:IndustryandCompanyAnalysis397
19. Which of the following would be least likely to be a result of structural change in the U.S.
economy?
A.

Risingconsumerconfidenceleadingtoasurgeinautosales.

B.

Ariseintheminimumwageincreasingcostsforfastfoodoutlets.

C.

Increasingdemandforresidentialnursingcareasthepopulationages.

D. Themoveinpopulationawayfromcitiesleadingtostrongerdemandforcatalogueand
onlineshopping.

20. Which of the following is one of the reasons why price to book value is a useful valuation
measure?
A.

Itcanbeusedtovaluelossmakingcompanies.

B.

Itisusefulforcomparingthevalueofstocksacrossindustries.

C.

Bookvalueisnotusuallydistortedbytheaccountingmethodsused.

D.

Bookvaluehasprovedtobeagoodindicatorofthemarketvalueofacompanysassets.

398StudySession14:
19. Which of the following would be least likely to be a result of structural change in the U.S.
economy?
A.
Rising consumer confidence leading to a surge in auto sales.
B.
A rise in the minimum wage increasing costs for fast-food outlets.
C.
Increasing demand for residential nursing care as the population ages.
D.
The move in population away from cities leading to stronger demand for catalogue and online
shopping.
CorrectAnswer:

A ............................................................................................. LOS:Reading57

Rising consumer confidence leading to a surge in auto sales would usually be the result of a cyclical move
in the economy. The other choices reflect longer-term structural changes in the economy, so A is the best
answer.
Reference:CFAProgramCurriculum,Volume5,pp.125127.

20. Which of the following is one of the reasons why price to book value is a useful valuation
measure?
A.
B.
C.
D.

It can be used to value loss-making companies.


It is useful for comparing the value of stocks across industries.
Book value is not usually distorted by the accounting methods used.
Book value has proved to be a good indicator of the market value of a companys assets.

CorrectAnswer:

A ..........................................................................................LOS:Reading61a

Loss making companies cannot be valued using current P/E and will often also have negative cash flow so
P/B, which is based on book value representing cumulative earnings and paid up capital, is a method that
can usually be applied.
Reference:CFAProgramCurriculum,Volume5,pp.210218.

EquityInvestments:IndustryandCompanyAnalysis399
21. When a fund manager uses topdown analysis to manage equity portfolios he is least likely to
consider:
A.

impactofeconomicenvironmentondifferentindustries.

B.

impactofindustryenvironmentonindividualcompanies.

C.

theimpactofmonetaryandfiscalpoliciesonthemarketenvironment.

D.

technicalfactorsthatwillaffectsupplyanddemandforsharesinthemarket.

22. Ananalystcalculatesthepricetosalesratioforacompanyandfindsitissignificantlylessthan
themarketaverage,thiscouldbeexplainedby:
A.

salespersharearehigherthanfortheaveragecompany.

B.

thecompanyhasalowprofitmarginrelativetotheaverageforthemarket.

C.

thecompanyhasexhibitedrapidsalesgrowthrelativetothemarketaverage.

D.

salesgrowthhasbeenconsistentandtheriskofsalesgrowthfalteringissmall.

400StudySession14:
21. When a fund manager uses topdown analysis to manage equity portfolios he is least likely to
consider:
A.
B.
C.
D.

impact of economic environment on different industries.


impact of industry environment on individual companies.
the impact of monetary and fiscal policies on the market environment.
technical factors that will affect supply and demand for shares in the market.

CorrectAnswer:

D ............................................................................................. LOS:Reading56

Top-down approaches usually focusing on fundamental rather than technical analysis. The first step is to
analyze alternative economies and securities markets. The objective is to decide the country allocation and
the allocation between bonds, equities and cash in each market. Analysts of economies will study a
governments fiscal and monetary policies, inflation, interest rates, corporate and consumer expenditure,
and exchange rates. The next step is to use economic and market analysis to decide which industries will
benefit and which will suffer in the expected environment. Individual companies are analyzed within the
industries selected. This will include analyzing each companys past performance and forecasting its future
prospects and then determining its value.
Reference:CFAProgramCurriculum,Volume5,pp.117121.

EquityInvestments:IndustryandCompanyAnalysis401
22. Ananalystcalculatesthepricetosalesratioforacompanyandfindsitissignificantlylessthan
themarketaverage,thiscouldbeexplainedby:
A.
B.
C.
D.

sales per share are higher than for the average company.
the company has a low profit margin relative to the average for the market.
the company has exhibited rapid sales growth relative to the market average.
sales growth has been consistent and the risk of sales growth faltering is small.

CorrectAnswer:

B ..........................................................................................LOS:Reading61b

P/S is the same as P/E multiplied by the profit margin, so a low profit margin could explain a low P/S ratio.
Answers C and D would push up the P/S ratio. High sales per share are not going to necessarily lead to a
low P/S ratio.
Reference:CFAProgramCurriculum,Volume5,pp.218221.

402StudySession15:

Study Session 15: Fixed Income Investments:


Basic Concepts

This study session presents the foundation for fixed income investments, one of the largest and
fastest growing segments of global financial markets. It begins with an introduction to the basic
features and characteristics of fixed income securities and the associated risks. The session then
builds by describing the primary issuers, sectors, and types of bonds. Finally, the study session
concludeswithanintroductiontoyieldsandspreadsandtheeffectofmonetarypolicyonfinancial
markets. These readings combined are the primary building blocks for mastering the analysis,
valuation,andmanagementoffixedincomesecurities.

Reading62:FeaturesofDebtSecurities
Reading63:RisksAssociatedwithInvestinginBonds
Reading64:OverviewofBondSectorsandInstruments
Reading65:UnderstandingYieldSpreads
Reading66:MonetaryPolicyinanEnvironmentofGlobalFinancialMarkets

FixedIncomeInvestments:BasicConcepts403
1. Which of the following is least likely to be an example of embedded options that might be
grantedtobondholders?
A.

Acaponafloater.

B.

Aflooronafloater.

C.

Conversionprivileges.

D.

Therighttoputtheissue.

2. Whichofthefollowingisanexampleofanegativecovenant?
A.

Theissuermustsubmitperiodicstatementstothebondtrustee.

B.

Mortgageholdersarenotpermittedtoprepaymortgagesaheadofthescheduleddate.

C. Afloatingratesecurityhasaminimumcouponratethatmustbepaidifthereference
ratedeclinesbelowacertainlevel.
D. Theissuercannotsecureanyofitsassetstoanewdebtissuewithoutgivingequal
treatmenttotheexistingdebtholders.

404StudySession15:
1. Which of the following is least likely to be an example of embedded options that might be
grantedtobondholders?
A.
B.
C.
D.

A cap on a floater.
A floor on a floater.
Conversion privileges.
The right to put the issue.

CorrectAnswer:

A ......................................................................................... LOS:Reading62b

A cap on a floater is a benefit to the issuer if interest rates rise, not to the bondholders.
Reference:CFAProgramCurriculum,Volume5,pp.242246.

2. Whichofthefollowingisanexampleofanegativecovenant?
A.
The issuer must submit periodic statements to the bond trustee.
B.
Mortgage holders are not permitted to prepay mortgages ahead of the scheduled date.
C.
A floating rate security has a minimum coupon rate that must be paid if the reference rate declines
below a certain level.
D.
The issuer cannot secure any of its assets to a new debt issue without giving equal treatment to the
existing debt holders.
CorrectAnswer:

D ..........................................................................................LOS:Reading62a

A negative covenant is a restriction on the issuer to protect investors in the bond. An example is when
unsecured debt holders are protected from the assets of the issuer being given as collateral in a subsequent
debt issue.
Reference:CFAProgramCurriculum,Volume5,p.239.

FixedIncomeInvestments:BasicConcepts405
3. Whentheissuerofabondagreestoretireacertainproportionofabondissueeachyear,thisis
anexampleof:
A.

acallablebond.

B.

arefundablebond.

C.

aprepaymentoption.

D.

asinkingfundprovision.

4. Aninvestorpaystaxatamarginalrateof40%andholdsataxexemptissuethathasayieldof
6%.Thetaxableequivalentyieldis:
A.

2.4%.

B.

3.6%.

C.

10.0%.

D.

15.0%.

406StudySession15:
3. Whentheissuerofabondagreestoretireacertainproportionofabondissueeachyear,thisis
anexampleof:
A.
B.
C.
D.

a callable bond.
a refundable bond.
a prepayment option.
a sinking fund provision.

CorrectAnswer:

D ..........................................................................................LOS:Reading62e

A sinking fund provision allows the issuer of a bond to retire a certain proportion of a bond issue each year.
Reference:CFAProgramCurriculum,Volume5,pp.251.

4. Aninvestorpaystaxatamarginalrateof40%andholdsataxexemptissuethathasayieldof
6%.Thetaxableequivalentyieldis:
A.
B.
C.
D.

2.4%.
3.6%.
10.0%.
15.0%.

CorrectAnswer:

C .......................................................................................... LOS:Reading65i

taxable-equivalent yield = tax-exempt yield/(1 marginal tax rate)


= 0.06/0.6 = 0.1 or 10%
Reference:CFAProgramCurriculum,Volume5,pp.359361.

FixedIncomeInvestments:BasicConcepts407
5. Afloatingratenotehasthefollowingcouponformula:
SixmonthTreasurybillrate+60basispointswithacapof7%andafloorof6.5%
The6monthTreasurybillratesareasfollows:

6month Treasury
billrate

Firstresetdate

6.5%

Secondresetdate

5.8%

Thirdresetdate

6.3%

Fourthresetdate

6.1%

Whatwouldbethecouponratesatthefirstandthesecondresetdates,respectively?
A.

6.5%

5.8%

B.

6.5%

6.5%

C.

7.0%

6.5%

D.

7.6%

7.1%

6. Liquidityriskinbondmarketscanbemeasuredby:
A.

recoveryrates.

B.

pricevolatility.

C.

thebidaskspread.

D.

theslopeoftheyieldcurve.

408StudySession15:
5. Afloatingratenotehasthefollowingcouponformula:
SixmonthTreasurybillrate+60basispointswithacapof7%andafloorof6.5%
The6monthTreasurybillratesareasfollows:

6month Treasury
billrate

Firstresetdate

6.5%

Secondresetdate

5.8%

Thirdresetdate

6.3%

Fourthresetdate
6.1%
Whatwouldbethecouponratesatthefirstandthesecondresetdates,respectively?
A.
B.
C.
D.

6.5%
6.5%
7.0%
7.6%

CorrectAnswer:

5.8%
6.5%
6.5%
7.1%
C ......................................................................................... LOS:Reading62b

The coupon rate at the first reset date is 6.5% + 0.6% = 7.1% which is higher than the cap rate. Therefore it
takes on the cap rate, which is 7.0%.
The coupon rate at the second reset date is 5.8% + 0.6% = 6.4% which is lower than the floor rate.
Therefore it takes on the floor rate, which is 6.5%.
Reference:CFAProgramCurriculum,Volume5,pp.242246.

6. Liquidityriskinbondmarketscanbemeasuredby:
A.
B.
C.
D.

recovery rates.
price volatility.
the bid-ask spread.
the slope of the yield curve.

CorrectAnswer:

C ......................................................................................... LOS:Reading63k

The bid-ask spread quoted by dealers reflects the liquidity of an issue.


Reference:CFAProgramCurriculum,Volume5,pp.281283.

FixedIncomeInvestments:BasicConcepts409
7. Whichoneofthefollowingistheleastlikelytobeanexampleofasecuritizedbond?
A.

Mortgagebond.

B.

Mortgagebackedsecurity.

C.

CollateralizedMortgageObligation.

D.

CreditCardReceivablesAssetBackedsecurity.

8. The difference in yield between bonds issued by industrial companies and bonds issued by
informationtechnologycompaniesisanexampleofa:
A.

creditspread.

B.

qualityspread.

C.

intermarketsectorspread.

D.

intramarketsectorspread.

410StudySession15:
7. Whichoneofthefollowingistheleastlikelytobeanexampleofasecuritizedbond?
A.
B.
C.
D.

Mortgage bond.
Mortgage-backed security.
Collateralized Mortgage Obligation.
Credit Card Receivables Asset-Backed security.

CorrectAnswer:

A ..........................................................................................LOS:Reading64e

Mortgage bonds are loans secured by mortgages to the companys assets. They are not structured with
securitization techniques, such as the use of bankruptcy-remote special purpose vehicles.
Reference:CFAProgramCurriculum,Volume5,p.305.

8. The difference in yield between bonds issued by industrial companies and bonds issued by
informationtechnologycompaniesisanexampleofa:
A.
B.
C.
D.

credit spread.
quality spread.
intermarket sector spread.
intramarket sector spread.

CorrectAnswer:

C ..........................................................................................LOS:Reading65e

The credit or quality spread is the difference in yield between Treasury securities and non-Treasury
securities. The intramarket sector spread is the difference in yield between two bonds with the same
maturity, in the same sector in a market. Industrial companies are in a distinct sector to information
technology companies.
Reference:CFAProgramCurriculum,Volume5,pp.355356.

FixedIncomeInvestments:BasicConcepts411
9. Iftheyieldspreadofabondhaswideneditmeansthat:
A.

itisalowgradebond.

B.

itisahighgradebond.

C.

thebondpricehasrisenrelativetothatofanequivalentTreasurybondissue.

D.

thebondpricehasdeclinedrelativetothatofanequivalentTreasurybondissue.

10. Mediumtermnotes(MTNs)differfromcorporatebondssince:
A.

MTNshaveamaximummaturityof5years.

B.

MTNshaveamaximummaturityof10years.

C.

MTNsarenotratedbyanyofthemajorcreditratingorganizations.

D.

MTNsareofferedtoinvestorsonacontinuousbasisbytheissueroritsagent.

412StudySession15:
9. Iftheyieldspreadofabondhaswideneditmeansthat:
A.
B.
C.
D.

it is a low-grade bond.
it is a high-grade bond.
the bond price has risen relative to that of an equivalent Treasury bond issue.
the bond price has declined relative to that of an equivalent Treasury bond issue.

CorrectAnswer:

D .......................................................................................... LOS:Reading63j

The credit or yield spread is the difference between the yield on the bond and the yield on a Treasury bond.
If the spread has widened it means that the yield demanded by an investor in the bond has increased, so
the price has fallen, relative to a Treasury bond.
Reference:CFAProgramCurriculum,Volume5,pp.277278.

10. Mediumtermnotes(MTNs)differfromcorporatebondssince:
A.
B.
C.
D.

MTNs have a maximum maturity of 5 years.


MTNs have a maximum maturity of 10 years.
MTNs are not rated by any of the major credit rating organizations.
MTNs are offered to investors on a continuous basis by the issuer or its agent.

CorrectAnswer:

D ......................................................................................... LOS:Reading64h

The unique feature of MTNs is that they are offered to investors on a continuous basis by the issuer or its
agent.
Reference:CFAProgramCurriculum,Volume5,pp.322325.

FixedIncomeInvestments:BasicConcepts413
11. Fromtheequitymarkets,centralbanksfinditmostusefultoderiveinformationon:
A.

futureeconomicactivity.

B.

internationaltradeactivity.

C.

marketexpectationsofinterestrates.

D.

ownershipofequitiesbyindividuals.

12. Which of the following embedded options is increasingly valuable to an investor in a rising
interestrateenvironment?
A.

Putoption.

B.

Calloption.

C.

Interestratecap.

D.

Acceleratedsinkingfundprovision.

414StudySession15:
11. Fromtheequitymarkets,centralbanksfinditmostusefultoderiveinformationon:
A.
B.
C.
D.

future economic activity.


international trade activity.
market expectations of interest rates.
ownership of equities by individuals.

CorrectAnswer:

A ......................................................................................... LOS:Reading66b

Equity markets provide information on anticipated economic activity.


Reference:CFAProgramCurriculum,Volume5,pp.379383.

12. Which of the following embedded options is increasingly valuable to an investor in a rising
interestrateenvironment?
A.
B.
C.
D.

Put option.
Call option.
Interest rate cap.
Accelerated sinking fund provision.

CorrectAnswer:

A ..........................................................................................LOS:Reading62e

From the investor perspective, a put option is beneficial when interest rates rise. The investor benefits
from being able to sell back the bond at a specified price that is higher than the prevailing market price.
Reference:CFAProgramCurriculum,Volume5,pp.252254.

FixedIncomeInvestments:BasicConcepts415
13. Thelegalentitythatisusedinassetsecuritizationforbankruptcyremotenessis:
A.

aratingagency.

B.

anindenturetrustee.

C.

aninvestmentbank.

D.

aspecialpurposevehicle.

14. Abondisinitiallypricedat97.99.Iftheyielddeclinesby50basispoints,thepriceincreasesto
99.99.Iftheyieldrisesby50basispoints,thepricedecreasesto94.89.Thedurationofthebondis:
A.

0.50.

B.

1.00.

C.

5.25.

D.

10.50.

416StudySession15:
13. Thelegalentitythatisusedinassetsecuritizationforbankruptcyremotenessis:
A.
B.
C.
D.

a rating agency.
an indenture trustee.
an investment bank.
a special purpose vehicle.

CorrectAnswer:

D .......................................................................................... LOS:Reading64i

A special purpose vehicle is the legal entity that the assets are sold to, so the assets used as collateral are
separate from the firm that is requiring funding.
Reference:CFAProgramCurriculum,Volume5,pp.328329.

14. Abondisinitiallypricedat97.99.Iftheyielddeclinesby50basispoints,thepriceincreasesto
99.99.Iftheyieldrisesby50basispoints,thepricedecreasesto94.89.Thedurationofthebondis:
A.
B.
C.
D.

0.50.
1.00.
5.25.
10.50.

CorrectAnswer:

C .......................................................................................... LOS:Reading63f

The duration = (99.99 94.89)/(2 x 97.99 x 0.005) = 5.25


Reference:CFAProgramCurriculum,Volume5,pp.269271.

FixedIncomeInvestments:BasicConcepts417
15. Abondisinitiallypricedat97.99.Iftheyielddeclinesby50basispoints,thepriceincreasesto
99.99.Iftheyieldrisesby50basispoints,thepricedecreasesto94.89.Iftheparvalueofthebondis
$100,000thenthedollardurationis:
A.

$500.

B.

$1,000.

C.

$5,250.

D.

$10,500.

16. Asinkingfundprovisionreferstowhen:
A.

anissuerisrequiredtoretireaprespecifiedportionofabondeachyear.

B.
anissuerhasmadeanarrangementtobuybackabondatparinthecaseofdeterioration
inthequalityofcollateralforabond.
C. aninvestorhastherighttosellthebondsbacktotheissuerpriortomaturityifthe
marketpricehasfallenbelowaprespecifiedlevel.
D. mortgageesareprepaidaheadofscheduleandthecashreceivedissetasideintoafund
whichwillbeusedtopaybackinvestorsatalaterdate.

418StudySession15:
15. Abondisinitiallypricedat97.99.Iftheyielddeclinesby50basispoints,thepriceincreasesto
99.99.Iftheyieldrisesby50basispoints,thepricedecreasesto94.89.Iftheparvalueofthebondis
$100,000thenthedollardurationis:
A.
B.
C.
D.

$500.
$1,000.
$5,250.
$10,500.

CorrectAnswer:

C .......................................................................................... LOS:Reading63f

The duration = (99.99 94.89)/(2 x 97.99 x 0.005) = 5.25


The dollar duration will be 5.25% x $100,000 = $5,250
Reference:CFAProgramCurriculum,Volume5,pp.269271.

16. Asinkingfundprovisionreferstowhen:
A.
an issuer is required to retire a pre-specified portion of a bond each year.
B.
an issuer has made an arrangement to buy back a bond at par in the case of deterioration in the
quality of collateral for a bond.
C.
an investor has the right to sell the bonds back to the issuer prior to maturity if the market price
has fallen below a prespecified level.
D.
mortgagees are prepaid ahead of schedule and the cash received is set aside into a fund which will
be used to pay back investors at a later date.
CorrectAnswer:

A ......................................................................................... LOS:Reading62d

A sinking fund requirement is usually put in place to reduce credit risk because the issuer has to retire a
portion of the bond issue prior to maturity, either by buying bonds in the market or providing cash for the
trustee to call bonds using a lottery system.
Reference:CFAProgramCurriculum,Volume5,pp.251255.

FixedIncomeInvestments:BasicConcepts419
17. Whichafirmissuesbondsthatarenonrefundablethismeansthat:
A.

thebondscannotbecalledpriortothematuritydate.

B.
thebondscanbecalledbuttheinvestorcannotbeofferedareplacementbondwitha
similaryield.
C. aninvestorcannotexerciseanembeddedputoptionwhilsttheyareinaprespecified
nonrefundingperiod.
D. thebondscannotberedeemedusingproceedsofanotherdebtissuethathasprovideda
lowercostsourceoffunds.

18. AcredibleandtransparentmonetarypolicyoftheECBisreflectedin:
A.

stableexchangerates.

B.

astrongeuroagainstthedollar.

C.

insignificantovernightinterestratemovesfollowingapolicyannouncement.

D.

anincreasedlevelofimpliedvolatilityofthebondmarketsoverthelastfewyears.

420StudySession15:
17. Whichafirmissuesbondsthatarenonrefundablethismeansthat:
A.
the bonds cannot be called prior to the maturity date.
B.
the bonds can be called but the investor cannot be offered a replacement bond with a similar yield.
C.
an investor cannot exercise an embedded put option whilst they are in a prespecified nonrefunding
period.
D.
the bonds cannot be redeemed using proceeds of another debt issue that has provided a lower cost
source of funds.
CorrectAnswer:

D ..........................................................................................LOS:Reading62e

When a callable bond is issued it may have restrictions on when it can be called, nonrefundable is such a
restriction and means that the firm cannot issue a new bond on a lower yield to pay back the original bond
holders.
Reference:CFAProgramCurriculum,Volume5,pp.247251.

18. AcredibleandtransparentmonetarypolicyoftheECBisreflectedin:
A.
B.
C.
D.

stable exchange rates.


a strong euro against the dollar.
insignificant overnight interest rate moves following a policy announcement.
an increased level of implied volatility of the bond markets over the last few years.

CorrectAnswer:

C .......................................................................................... LOS:Reading66c

A credible and transparent policy means that market participants can forecast very accurately any policy
announcements so there is little change in rates following an announcement.
Reference:CFAProgramCurriculum,Volume5,pp.379381.

FixedIncomeInvestments:BasicConcepts421
19. Thecleanpriceofabondis:
A.

theagreedbondpricewithoutaccruedinterest.

B.

theaccruedinterestcomponentofthebondprice.

C.

theagreedbondpriceplustheaccruedinterestduetothesellerofthebond.

D.

theagreedbondpriceforthebondlesstheaccruedinterestduetothebuyerofthebond..

20. Which of the following is least likely to be an example of embedded options that might be
grantedtotheissuerofabond?
A.

Aflooronafloater.

B.

Therighttocalltheissue.

C.

Anacceleratedsinkingfundprovision.

D.

Therighttoprepayanamountabovethescheduledprincipalrepayment.

422StudySession15:
19. Thecleanpriceofabondis:
A.
B.
C.
D.

the agreed bond price without accrued interest.


the accrued interest component of the bond price.
the agreed bond price plus the accrued interest due to the seller of the bond.
the agreed bond price for the bond less the accrued interest due to the buyer of the bond.

CorrectAnswer:

A ......................................................................................... LOS:Reading62b

The clean price of a bond is the quoted price of a bond where the accrued interest is excluded.
Reference:CFAProgramCurriculum,Volume5,p.246.

20. Which of the following is least likely to be an example of embedded options that might be
grantedtotheissuerofabond?
A.
B.
C.
D.

A floor on a floater.
The right to call the issue.
An accelerated sinking fund provision.
The right to prepay an amount above the scheduled principal repayment.

CorrectAnswer:

A ......................................................................................... LOS:Reading62b

A floor on a floater is a benefit to the holder of the bond if interest rates fall, not to the issuer.
Reference:CFAProgramCurriculum,Volume5,pp.242246.

FixedIncomeInvestments:BasicConcepts423
21. Thefollowinginformationisgiven:

Issue

Yield
6.15%
7.85%
8.00%

10yearontherunTreasury6%coupon
10yearABGCorporationSeriesJ5%coupon
10yearIBNLimited8.0%coupon

TheabsoluteyieldspreadbetweenIBNLimitedandABGCorporationbondsis:
A.

0.015%.

B.

3.000%.

C.

3basispoints.

D.

15basispoints.

22. Thefollowinginformationisgiven:

Issue

Yield
6.15%
7.85%
8.00%

10yearontherunTreasury6%coupon
10yearABGCorporationSeriesJ5%coupon
10yearIBNLimited8.0%coupon

Theyieldratiobetweenthe10yearABGCorpandthe10yearTreasuryisclosestto:
A.

0.78.

B.

0.83.

C.

1.20.

D.

1.28.

424StudySession15:
21. Thefollowinginformationisgiven:

Issue

Yield
6.15%
7.85%
8.00%

10yearontherunTreasury6%coupon
10yearABGCorporationSeriesJ5%coupon
10yearIBNLimited8.0%coupon

The absolute yield spread between IBN Limited and ABG Corporation bonds is:
A.
0.015%.
B.
3.000%.
C.
3 basis points.
D.
15 basis points.
CorrectAnswer:

D ..........................................................................................LOS:Reading65e

The absolute yield spread = 8.0% - 7.85% = 0.15% or 15 basis points.


Do not use the coupon rates.
Reference:CFAProgramCurriculum,Volume5,pp.352354.

FixedIncomeInvestments:BasicConcepts425
22. Thefollowinginformationisgiven:

Issue

Yield
6.15%
7.85%
8.00%

10yearontherunTreasury6%coupon
10yearABGCorporationSeriesJ5%coupon
10yearIBNLimited8.0%coupon

The yield ratio between the 10-year ABG Corp and the 10-year Treasury is closest to:
A.
0.78.
B.
0.83.
C.
1.20.
D.
1.28.
CorrectAnswer:

D ......................................................................................... LOS:Reading65e

The yield ratio 7.85%/6.15% = 1.28.


Again do not use the coupon rates.
Reference:CFAProgramCurriculum,Volume5,pp.352354.

426StudySession16:

Study Session 16: Fixed Income Investments:


Analysis and Valuation

Thisstudysessionillustratestheprimarytoolsforvaluationandanalysisoffixedincomesecurities
andmarkets.Itbeginswithastudyofbasicvaluationtheoryandtechniquesforbondsandconcludes
withamoreindepthexplanationoftheprimarytoolsforfixedincomeinvestmentvaluation,
specifically,interestrateandyieldvaluationandinterestrateriskmeasurementandanalysis.

Reading67:IntroductiontotheValuationofDebtSecurities
Reading68:YieldMeasures,SpotRates,andForwardRates
Reading69:IntroductiontotheMeasurementofInterestRateRisk

FixedIncomeInvestments:AnalysisandValuation427
1. Ifthedurationofabondportfoliois5andtheaverageyieldofbondsintheportfoliorisesby100
basispointsthen:
A.

themarketvalueoftheportfoliowillfall,butbylessthan5%.

B.

themarketvalueoftheportfoliowillfallbyapproximately5%.

C.

themarketvalueoftheportfoliowillrisebyapproximately5%.

D. wedonothavesufficientinformationtocalculatetheimpactonthemarketvalueofthe
portfolio.

2. TheMacaulaydurationofabondis:
A.

eithernegativeorpositive.

B.

thesameasthematurityofthebond.

C.

alwayspositiveandlessthan,orequalto,thetermtomaturityofabond.

D.

alwayspositiveandmorethan,orequalto,thetermtomaturityofabond..

428StudySession16:
1. Ifthedurationofabondportfoliois5andtheaverageyieldofbondsintheportfoliorisesby100
basispointsthen:
A.
B.
C.
D.

the market value of the portfolio will fall, but by less than 5%.
the market value of the portfolio will fall by approximately 5%.
the market value of the portfolio will rise by approximately 5%.
we do not have sufficient information to calculate the impact on the market value of the portfolio.

CorrectAnswer:

D .......................................................................................... LOS:Reading69f

The yield of each bond in the portfolio must rise by 100 basis points, namely there should be a parallel shift
in the yield curve, for the portfolio duration to be an indicator of the price move of the total portfolio. We
need to know information on whether there was a parallel shift in the yield curve or the curve changed
shape (e.g. steepened or flattened), so D is the correct answer.
Reference:CFAProgramCurriculum,Volume5,pp.499501.

2. TheMacaulaydurationofabondis:
A.
B.
C.
D.

either negative or positive.


the same as the maturity of the bond.
always positive and less than, or equal to, the term to maturity of a bond.
always positive and more than, or equal to, the term to maturity of a bond.

CorrectAnswer:

C ..........................................................................................LOS:Reading69e

The unit of Macaulay duration is years. It is a measure of average time to the present value of cash flow
receipts. Mathematically it means that Macaulay duration will always be positive and less than, or equal
to, the term to maturity of a bond. It is only the same as the maturity when it is a zero coupon bond. Other
measures of duration such as effective duration, can take any number either positive or negative because it
better measures the interest rate sensitivity of bonds and takes into account changes in cash flows due to
interest rate changes.
Reference:CFAProgramCurriculum,Volume5,p.497.

FixedIncomeInvestments:AnalysisandValuation429
3. TheMacaulaydurationofasemiannualbondwitha12%couponis6.0andtheyieldtomaturity
is8%.Themodifieddurationisclosestto:
A.

5.66.

B.

5.77.

C.

6.24.

D.

6.36.

4. Ifthesemiannualyieldtomaturityofabondis5%,thebondequivalentyieldisclosestto:
A.

5.1%.

B.

10.0%.

C.

10.3%.

D.

10.6%.

430StudySession16:
3. TheMacaulaydurationofasemiannualbondwitha12%couponis6.0andtheyieldtomaturity
is8%.Themodifieddurationisclosestto:
A.
B.
C.
D.

5.66.
5.77.
6.24.
6.36.

CorrectAnswer:

B...........................................................................................LOS:Reading69e

Semiannual bonds mean k = 2


Modified duration
= Macaulay duration/[(1 + yield/k)]
= 6.0/(1.04)
= 5.77
Reference:CFAProgramCurriculum,Volume5,p.497.

4. Ifthesemiannualyieldtomaturityofabondis5%,thebondequivalentyieldisclosestto:
A.
B.
C.
D.

5.1%.
10.0%.
10.3%.
10.6%.

CorrectAnswer:

B.......................................................................................... LOS:Reading68d

The bond-equivalent yield is simply double the semiannual yield.


Reference:CFAProgramCurriculum,Volume5,pp.424425.

FixedIncomeInvestments:AnalysisandValuation431
5. Thetotaldollarreturnfromabondis:
A.

thecurrentyieldmultipliedbythepriceofthebond.

B.

theyieldtomaturitymultipliedbythepriceofthebond.

C.

thecouponincomeplusthereinvestmentincomeplusthecapitalgain/lossonthebond.

D. thecouponincomeplusthevalueofthequotedmarginplusthecapitalgain/lossonthe
bond.

6. An8%bondmakessemiannualcouponpayments,therearetwofurthercouponstobepaidand
thebondmaturesat$100in273days(thereare182daysinacouponperiod).Iftheyieldtomaturity
is6%thenthefullpriceofthebondisclosestto:
A.

$96.12.

B.

$98.27.

C.

$101.91.

D.

$103.42.

432StudySession16:
5. Thetotaldollarreturnfromabondis:
A.
B.
C.
D.

the current yield multiplied by the price of the bond.


the yield to maturity multiplied by the price of the bond.
the coupon income plus the reinvestment income plus the capital gain/loss on the bond.
the coupon income plus the value of the quoted margin plus the capital gain/loss on the bond.

CorrectAnswer:

C ..........................................................................................LOS:Reading68a

The total dollar return is the coupon income plus the reinvestment income plus the capital gain/loss on the
bond. Multiplying by yield to maturity may be inaccurate since it assumes that coupons can be reinvested
at the rate equivalent to the yield to maturity.
Reference:CFAProgramCurriculum,Volume5,pp.42423.

6. An8%bondmakessemiannualcouponpayments,therearetwofurthercouponstobepaidand
thebondmaturesat$100in273days(thereare182daysinacouponperiod).Iftheyieldtomaturity
is6%thenthefullpriceofthebondisclosestto:
A.
B.
C.
D.

$96.12.
$98.27.
$101.91.
$103.42.

CorrectAnswer:

D .......................................................................................... LOS:Reading67c

273 days is equivalent to 1 coupon periods so:


PV
= $4/(1.03)1/2 + $104/(1.03)3/2
= $3.94 + $99.49
= $103.42
Reference:CFAProgramCurriculum,Volume5,pp.392395.

FixedIncomeInvestments:AnalysisandValuation433
7. Theappropriatedurationmeasuretouseforahighcouponcallablebondis:
A.

effectiveduration.

B.

modifiedduration.

C.

Macaulayduration.

D.

optionadjustedduration.

8. Iftheyieldtomaturityonanannualpaybondis12%itsbondequivalentyieldisclosestto:
A.

11.66%.

B.

12.00%.

C.

12.36%.

D.

12.72%.

434StudySession16:
7. Theappropriatedurationmeasuretouseforahighcouponcallablebondis:
A.
B.
C.
D.

effective duration.
modified duration.
Macaulay duration.
option-adjusted duration.

CorrectAnswer:

A ..........................................................................................LOS:Reading69e

In a callable bond, the cash flows might change as interest rates change. The most appropriate duration
measure is effective duration.
Reference:CFAProgramCurriculum,Volume5,p.496.

8. Iftheyieldtomaturityonanannualpaybondis12%itsbondequivalentyieldisclosestto:
A.
B.
C.
D.

11.66%.
12.00%.
12.36%.
12.72%.

CorrectAnswer:

A ......................................................................................... LOS:Reading68d

bond-equivalent yield = 2[(1+ yield on annual-pay bond)1/2 1] = 11.66%


Reference:CFAProgramCurriculum,Volume5,p.431.

FixedIncomeInvestments:AnalysisandValuation435
9. Anoncallablebondhas:
A.

positiveconvexitythroughouttheyieldrange.

B.

negativeconvexitythroughouttheyieldrange.

C.

positiveconvexityatlowyieldsandnegativeconvexityathighyields.

D.

negativeconvexityatlowyieldsandpositiveconvexityathighyields.

10. When a dealer purchases a package of Treasury strips to create a synthetic Treasury bond, the
procedureiscalled:
A.

hedging.

B.

stripping.

C.

reconstitution.

D.

bootstrapping.

436StudySession16:
9. Anoncallablebondhas:
A.
B.
C.
D.

positive convexity throughout the yield range.


negative convexity throughout the yield range.
positive convexity at low yields and negative convexity at high yields.
negative convexity at low yields and positive convexity at high yields.

CorrectAnswer:

A ......................................................................................... LOS:Reading69b

The presence of embedded options, such as a call option in a bond, would make the convexity negative in
certain yield ranges. Non-callable bonds have positive convexity throughout the yield range.
Reference:CFAProgramCurriculum,Volume5,pp.484488.

10. When a dealer purchases a package of Treasury strips to create a synthetic Treasury bond, the
procedureiscalled:
A.
B.
C.
D.

hedging.
stripping.
reconstitution.
bootstrapping.

CorrectAnswer:

C .......................................................................................... LOS:Reading67f

Reconstitution occurs when a Treasury bonds price is greater than its arbitrage-free value, and a dealer
can purchase a package of Treasury strips to create a synthetic Treasury bond.
Reference:CFAProgramCurriculum,Volume5,p.410.

FixedIncomeInvestments:AnalysisandValuation437
11. Whichofthefollowingistheleastaccuratestatementregardingreinvestmentrisk?
A. Forzerocouponbonds,thereinvestmentincomeisimportanttoproducetheyield
promisedatpurchasedate.
B.
Thelongerthetimetomaturitythemorethebondisdependentonthereinvestment
incometoproducetheyieldpromisedatthepurchasedate.
C. Thehigherthecouponratethemorethebondisdependentonthereinvestmentincome
toproducetheyieldpromisedatthepurchasedate.
D. Forbondsboughtatapremium,ratherthanatadiscount,thereinvestmentincomeis
moreimportanttoproducetheyieldpromisedatthepurchasedate.

12. Giventhefollowinginformationonabond:
Duration =

7.5670.

Convexity

41.0935.

Yieldsfallby:

250basispoints.

Thetotalestimatedpricechangeinpercentagetermsisclosestto:
A.

2.57%.

B.

7.57%.

C.

18.92%.

D.

21.49%.

438StudySession16:
11. Whichofthefollowingistheleastaccuratestatementregardingreinvestmentrisk?
A.
For zero-coupon bonds, the reinvestment income is important to produce the yield promised at
purchase date.
B.
The longer the time to maturity the more the bond is dependent on the reinvestment income to
produce the yield promised at the purchase date.
C.
The higher the coupon rate the more the bond is dependent on the reinvestment income to produce
the yield promised at the purchase date.
D.
For bonds bought at a premium, rather than at a discount, the reinvestment income is more
important to produce the yield promised at the purchase date.
CorrectAnswer:

A .......................................................................................... LOS:Reading68c

Zero-coupon bonds have no reinvestment risk since they have no interim income from coupons to be
reinvested.
Reference:CFAProgramCurriculum,Volume5,pp.425430.

12. Giventhefollowinginformationonabond:
Duration
=
Convexity =
Yields fall by:

7.5670.
41.0935.
250 basis points.

The total estimated price change in percentage terms is closest to:


A.
2.57%.
B.
7.57%.
C.
18.92%.
D.
21.49%.
CorrectAnswer:

D ......................................................................................... LOS:Reading69d

Estimated change using duration


7.5670% x 0.025 x 100
Convexity adjustment:
41.0935 x (0.025)2 x 100
Total estimated percentage price change
Reference:CFAProgramCurriculum,Volume5,pp.488492.

= 18.9175
= 2.5684
= 21.4858

FixedIncomeInvestments:AnalysisandValuation439
13. An optionfree bond has a remaining life of three years and carries an 8% annual coupon rate
payableannuallyandhasayieldtomaturityof9%.Iftheoneandtwoyearspotratesare6.0%and
6.5%,respectively,thenthethreeyearspotrateisclosestto:
A.

7.0%.

B.

8.1%.

C.

9.2%.

D.

14.5%.

14. Whichofthefollowingisleastlikelytobeacharacteristicofbondswithpositiveconvexity?
A.

Thepercentagepricechangeforagivenyieldchangeisnotthesameforallbonds.

B.
Foralargechangeinyields,thepercentagepricedecreaseisgreaterthanthepercentage
priceincrease.
C. Forasmallchangeinyields,thepercentagechangesareroughlythesame,whetherthe
yieldincreasesordecreases.
D. Foralargechangeinyields,thepercentagepricechangeisnotthesameforanincrease
inyieldsasitisforadecreaseinyields.

440StudySession16:
13. .
An optionfree bond has a remaining life of three years and carries an 8% annual coupon
ratepayableannuallyandhasayieldtomaturityof9%.Iftheoneandtwoyearspotratesare6.0%
and6.5%,respectively,thenthethreeyearspotrateisclosestto:
A.
B.
C.
D.

7.0%.
8.1%.
9.2%.
14.5%.

CorrectAnswer:

C ......................................................................................... LOS:Reading68h

The following relationship must hold, where the three-year spot rate is z:
8/(1.09)+8/(1.09)2+108/(1.09)3=8/(1.06)+8/(1.065)2+108/(1+z)3
97.47=14.60+108/(1+z)3
(1+z)3=108/82.87
1+z=(1.3032)1/3
z=9.23%

Reference:CFAProgramCurriculum,Volume5,pp.458461.

14. Whichofthefollowingisleastlikelytobeacharacteristicofbondswithpositiveconvexity?
A.
The percentage price change for a given yield change is not the same for all bonds.
B.
For a large change in yields, the percentage price decrease is greater than the percentage price
increase.
C.
For a small change in yields, the percentage changes are roughly the same, whether the yield
increases or decreases.
D.
For a large change in yields, the percentage price change is not the same for an increase in yields as
it is for a decrease in yields.
CorrectAnswer:

B........................................................................................... LOS:Reading69c

For a large change in yields, the percentage price increase is greater than the percentage price decrease,
when a bond has positive convexity.
Reference:CFAProgramCurriculum,Volume5,pp.501503.

FixedIncomeInvestments:AnalysisandValuation441
15. An analyst uses a model to calculate effective duration and finds a collateralized mortgage
obligation(CMO)whichhasdurationwhichislongerthanthelifeoftheunderlyingmortgageloans.
Whichofthefollowingstatementsismostaccurate?
A. Effectivedurationisaninappropriatemeasureofdurationtousesincethereareno
embeddedoptionsinaCMO.
B.
ThemodellookstohaveproducedanincorrectestimateofdurationsinceCMOswould
beexpectedtohavenegativeduration.
C. Itisinappropriatetouseamodeltoestimateeffectiveduration;inputsshouldbetaken
fromamarketsource,suchasdealersprices.
D. LongerdurationoftheCMOthanthemortgageloansispossibleandsimplyindicatesthe
sensitivityoftheCMOtointerestratemoves.

16. Wheninterestrateschange,itisobservedthatthepriceofacallablebondwithacouponof5%
movesasfollows:

Ratesdown50basispoints

Ratesup50basispoints

Price+5%

Price3%

Thebondislikelytohave

Convexity

Yield

A.

Positive

Lessthan5%

B.

Positive

Morethan5%

C.

Negative

Lessthan5%

D.

Negative

Morethan5%

442StudySession16:
15. An analyst uses a model to calculate effective duration and finds a collateralized mortgage
obligation(CMO)whichhasdurationwhichislongerthanthelifeoftheunderlyingmortgageloans.
Whichofthefollowingstatementsismostaccurate?
A.
Effective duration is an inappropriate measure of duration to use since there are no embedded
options in a CMO.
B.
The model looks to have produced an incorrect estimate of duration since CMOs would be
expected to have negative duration.
C.
It is inappropriate to use a model to estimate effective duration; inputs should be taken from a
market source, such as dealers prices.
D.
Longer duration of the CMO than the mortgage loans is possible and simply indicates the
sensitivity of the CMO to interest rate moves.
CorrectAnswer:

D ..........................................................................................LOS:Reading69e

Effective duration is the correct method to use since cash flows from the CMO are influenced by interest
rates. It is reasonable to use a model to calculate effective duration and effective duration can be positive
(and longer then the maturity of the underlying loans) or negative depending on the structure and terms of
the CMO.
Reference:CFAProgramCurriculum,Volume5,pp.496499.

16. Wheninterestrateschange,itisobservedthatthepriceofacallablebondwithacouponof5%
movesasfollows:

Ratesdown50basispoints

Ratesup50basispoints

Price+5%

Price3%

The bond is likely to have


Convexity
A.
Positive
B.
Positive
C.
Negative
D.
Negative
CorrectAnswer:

Yield
Less than 5%
More than 5%
Less than 5%
More than 5%

B........................................................................................... LOS:Reading69c

The bond has positive convexity since the gain is more than the loss for an equal move in interest rates.
The bonds coupon is probably less than market yields meaning it is unlikely to be called in the near future.
As yields fall the bond is more likely to be called and starts to exhibit negative convexity.
Reference:CFAProgramCurriculum,Volume5,pp.484487.

FixedIncomeInvestments:AnalysisandValuation443
17. Azerocouponbondwithtwoyearsremainingtomaturityiscurrentlytradingat$82.65.Ifthe
parvalueis$100,theyieldtomaturityisclosestto:
A.

8.7%.

B.

9.0%.

C.

9.8%.

D.

11.0%.

18. Abondwithoutanyembeddedoptionshasaremaininglifeofthreeyears,carriesan8%coupon
ratepayableannually,andhasayieldtomaturityof7%.Iftheoneandthreeyearspotratesare8.0%
and7.0%,respectively,thenthetwoyearspotrateisclosestto:
A.

6.0%.

B.

6.5%.

C.

7.5%.

D.

13.5%.

444StudySession16:
17. Azerocouponbondwithtwoyearsremainingtomaturityiscurrentlytradingat$82.65.Ifthe
parvalueis$100,theyieldtomaturityisclosestto:
A.
B.
C.
D.

8.7%.
9.0%.
9.8%.
11.0%.

CorrectAnswer:

C ..........................................................................................LOS:Reading67e

Let x be the semiannual yield we are looking for, then:

82.65 =

100

(1 + x )4

(1 + x )4 = 100 82.65 = 1.21


x = 0.0488
or 9.8% annual yield
Reference:CFAProgramCurriculum,Volume5,pp.398399.

18. Abondwithoutanyembeddedoptionshasaremaininglifeofthreeyears,carriesan8%coupon
ratepayableannually,andhasayieldtomaturityof7%.Iftheoneandthreeyearspotratesare8.0%
and7.0%,respectively,thenthetwoyearspotrateisclosestto:
A.
B.
C.
D.

6.0%.
6.5%.
7.5%.
13.5%.

CorrectAnswer:

B.......................................................................................... LOS:Reading68h

The following relationship must hold, where z is the two-year spot rate:
8/(1.07) + 8/(1.07)2 + 108/(1.07)3 = 8/(1.08) + 8/(1+ z)2 + 108/(1.07)3
14.46 = 7.41 + 8/(1+z)2
(1 + z)2 = 8/7.06
1 + z = (1.1337)1/2
z = 6.45%
Reference:CFAProgramCurriculum,Volume5,pp.458461.

FixedIncomeInvestments:AnalysisandValuation445
19. Thepricevalueofabasispointis:
A.

theabsolutechangeinpriceofabondifthereisaonebasispointchangeinyield.

B.

thepercentagechangeinpriceofabondifthereisaonebasispointchangeinyield.

C. theabsolutechangeindollardurationofabondifthereisaonehundredbasispoint
changeinyield.
D. thepercentagechangeindollardurationofabondifthereisaonehundredbasispoint
changeinyield.

20. TheZspreadis:
A.

theoptionadjustedspreadifabondhasembeddedoptions.

B.

theadjustmenttotheoptionadjustedspreadasvolatilitychanges.

C.

thespreadbetweenspotandforwardratesoverthelifeofabond.

D.

thespreadearnedonabondovertheTreasuryspotratecurveifitisheldtomaturity.

446StudySession16:
19. Thepricevalueofabasispointis:
A.
B.
C.
yield.
D.
yield.

the absolute change in price of a bond if there is a one basis point change in yield.
the percentage change in price of a bond if there is a one basis point change in yield.
the absolute change in dollar duration of a bond if there is a one hundred basis point change in
the percentage change in dollar duration of a bond if there is a one hundred basis point change in

CorrectAnswer:

A .......................................................................................... LOS:Reading69i

The price value of a basis point is the absolute change in price of a bond if there is a one basis point change
in yield. It is a special case of dollar duration.
Reference:CFAProgramCurriculum,Volume5,pp.504505.

20. TheZspreadis:
A.
B.
C.
D.

the option-adjusted spread if a bond has embedded options.


the adjustment to the option-adjusted spread as volatility changes.
the spread between spot and forward rates over the life of a bond.
the spread earned on a bond over the Treasury spot rate curve if it is held to maturity.

CorrectAnswer:

D .......................................................................................... LOS:Reading68f

The Z-spread, also called zero volatility or static spread, is the spread that must be added to the Treasury
spot rate to give a discount rate which will make the discounted cash flows from a bond equal to its price.
Reference:CFAProgramCurriculum,Volume5,pp.445450.

FixedIncomeInvestments:AnalysisandValuation447
21. Thefollowingdataiscollected:

Yearsto

Spotrate

0.5

5.75%

1.0

6.25%

1.5

7.00%

2.0

7.25%

Basedontheabovedata,thesixmonthimpliedforwardrateoneandahalfyearsfromnowisclosest
to:
A.

4.00%.

B.

6.25%.

C.

6.75%.

D.

8.00%.

22. Given:

Period

Years

Annualyieldto
maturity(BEY)

Price

Spotrate(BEY)

0.5

4.00

4.0000

1.0

4.30

4.3000

1.5

4.65

100

4.6606

The6monthforwardrate,oneyearfromnowisclosestto:
A.

4.3000%.

B.

4.4803%.

C.

5.3535%.

D.

5.3837%.

448StudySession16:
21. Thefollowingdataiscollected:

Yearsto

Spotrate

0.5

5.75%

1.0

6.25%

1.5

7.00%

2.0

7.25%

Basedontheabovedata,thesixmonthimpliedforwardrateoneandahalfyearsfromnowisclosest
to:
A.
B.
C.
D.

4.00%.
6.25%.
6.75%.
8.00%.

CorrectAnswer:

D ......................................................................................... LOS:Reading68h

1f3=[(1+0.03625)4/(1+0.035)3]1
=4.0%
Theforwardrateis4.0%x2=8.0%

Reference:CFAProgramCurriculum,Volume5,pp.453458.

FixedIncomeInvestments:AnalysisandValuation449
22. Given:

Period

Years

Annualyieldto
maturity(BEY)

Price

Spotrate(BEY)

0.5

4.00

4.0000

1.0

4.30

4.3000

1.5

4.65

100

4.6606

The 6-month forward rate, one year from now is closest to:
A.
4.3000%.
B.
4.4803%.
C.
5.3535%.
D.
5.3837%.
CorrectAnswer:

D .........................................................................................LOS:Reading68h

1f2 = (1 + z3)3/(1 + z2)2 -1 = (1.023303)3/(1.02150)2 -1 = 1.0269 1 = 2.6919%


The 6-month forward rate, one year from now, is 2 x 2.6919% = 5.3837%
Reference:CFAProgramCurriculum,Volume5,pp.453458.

450StudySession17:

Study Session 17: Derivative Investments:

Derivativesfinancialinstrumentsthatofferareturnbasedonthereturnofsomeunderlyingasset
havebecomeincreasinglyimportantandfundamentalineffectivelymanagingfinancialriskand
creatingsyntheticexposurestoassetclasses.Asinothersecuritymarkets,arbitrageandmarket
efficiencyplayacriticalroleinestablishingpricesandmaintainingparity.
Thisstudysessionbuildstheconceptualframeworkforunderstandingderivativeinvestments
(forwards,futures,options,andswaps),derivativemarkets,andtheuseofoptionsinrisk
management.

Reading70:DerivativeMarketsandInstruments
Reading71:ForwardMarketsandContracts
Reading72:FuturesMarketsandContracts
Reading73:OptionMarketsandContracts
Reading74:SwapMarketsandContracts
Reading75:RiskManagementApplicationsofOptionStrategies

DerivativeInvestments451
1. A trader writes a European call option on a stock. The stocks current price is $24, the option
price is $4 and the exercise price is $23. At the expiration of the option the stock price is $30. The
profit/lossoftheoptionwriterisa:
A.

lossof$4.

B.

lossof$3.

C.

profitof$3.

D.

profitof$4.

2. Thenotionalprincipalinaplainvanillainterestrateswapis:
A.

neverpaid.

B.

paidatthetimethattheswapagreementismade.

C.

paidinequalpartswheneachswappaymentismade.

D. paidatthetimethattheswapagreementissignedandreturnedwhenthefinalswap
paymentismade.

452StudySession17:
1. A trader writes a European call option on a stock. The stocks current price is $24, the option
price is $4 and the exercise price is $23. At the expiration of the option the stock price is $30. The
profit/lossoftheoptionwriterisa:
A.
B.
C.
D.

loss of $4.
loss of $3.
profit of $3.
profit of $4.

CorrectAnswer:

B.......................................................................................... LOS:Reading75b

The writer has received the premium of $4 but the loss when the option is exercised is $30 minus $23
giving an overall loss of $3.
Reference:CFAProgramCurriculum,Volume6,pp.151158.

2. Thenotionalprincipalinaplainvanillainterestrateswapis:
A.
B.
C.
D.
made.

never paid.
paid at the time that the swap agreement is made.
paid in equal parts when each swap payment is made.
paid at the time that the swap agreement is signed and returned when the final swap payment is

CorrectAnswer:

A ......................................................................................... LOS:Reading74b

The notional principal is the amount on which the interest payments are calculated and does not change
hands in an interest rate swap.
Reference:CFAProgramCurriculum,Volume6,pp.134138.

DerivativeInvestments453
3. Thevalueofaputoptionatexpiryis:
A.

maximumof(i)zeroand(ii)exercisepriceminusstockprice.

B.

maximumof(i)zeroand(ii)stockpriceminusexerciseprice.

C.

maximumof(i)zeroand(ii)stockpriceminusexerciseprice,minustheoptionpremium.

D.

maximumof(i)zeroand(ii)exercisepriceminusstockprice,minustheoptionpremium.

4. A company has borrowed to finance its operations using floatingrate debt but it is now
concerned that shortterm interest rates are going to rise sharply. The company should consider
enteringinto:
A.

acurrencyswapagreementwheretheytakethepayfixedside

ofthetransaction.
B.

acurrencyrateswapagreementwheretheytakethereceivefixedsideofthetransaction.

C. aplainvanillainterestrateswapagreementwheretheytakethepayfixedsideofthe
transaction.
D. aplainvanillainterestrateswapagreementwheretheytakethereceivefixedsideofthe
transaction.

454StudySession17:
3. Thevalueofaputoptionatexpiryis:
A.
B.
C.
D.

maximum of (i) zero and (ii) exercise price minus stock price.
maximum of (i) zero and (ii) stock price minus exercise price.
maximum of (i) zero and (ii) stock price minus exercise price, minus the option premium.
maximum of (i) zero and (ii) exercise price minus stock price, minus the option premium.

CorrectAnswer:

A ..........................................................................................LOS:Reading73e

The holder of a put option will exercise the option if the exercise price is above the stock price. In that case
he could theoretically buy the stock in the market and sell it at a higher price. If the stock price is higher
than the exercise price he will let the option lapse worthless. The option premium should only be taken
into account if the profit/loss on the option is being calculated.
Reference:CFAProgramCurriculum,Volume6,pp.9699.

4. A company has borrowed to finance its operations using floatingrate debt but it is now
concerned that shortterm interest rates are going to rise sharply. The company should consider
enteringinto:
A.
a currency swap agreement where they take the pay-fixed side
of the transaction.
B.
a currency rate swap agreement where they take the receive-fixed side of the transaction.
C.
a plain vanilla interest rate swap agreement where they take the pay-fixed side of the transaction.
D.
a plain vanilla interest rate swap agreement where they take the receive-fixed side of the
transaction.
CorrectAnswer:

C ......................................................................................... LOS:Reading74b

In a plain vanilla interest rate swap if the company pays a fixed rate of interest and receives a floating rate
of interest, the floating rate interest payment will, if the agreement is correctly structured, offset the
interest rate risk of its debt payments.
Reference:CFAProgramCurriculum,Volume6,pp.134138.

DerivativeInvestments455
5. Whenatraderwritesacoveredcallthiswilloftenbewiththeobjectiveof:
A.

increasingincome.

B.

insuringhisportfoliovalue.

C.

reducingthevolatilityofhisreturn.

D.

increasinghisgainifthestockpricerisesabovetheexercisepriceplusthepremium.

6. An investor believes that the S&P Index is going to decline sharply over the next two years.
Whichofthefollowingstrategieswouldbeconsistentwiththisview?
A.

BuycalloptionsontheS&PIndex.

B.

WriteputoptionsontheS&PIndex.

C.

TakealongpositioninfuturesontheS&PIndex.

D. Enterintoatwoyearequityswaptoreceiveafixedpaymentandpayanequitypayment
basedontheperformanceoftheS&Pindex.

456StudySession17:
5. Whenatraderwritesacoveredcallthiswilloftenbewiththeobjectiveof:
A.
B.
C.
D.

increasing income.
insuring his portfolio value.
reducing the volatility of his return.
increasing his gain if the stock price rises above the exercise price plus the premium.

CorrectAnswer:

A ......................................................................................... LOS:Reading75b

Writing a covered call means that the trader will increase his income by the option premium. If the stock
price rises above the exercise price his shares will be called and he will lose the capital gain he would have
made if he had not written the option.
Reference:CFAProgramCurriculum,Volume6,pp.151158.

6. An investor believes that the S&P Index is going to decline sharply over the next two years.
Whichofthefollowingstrategieswouldbeconsistentwiththisview?
A.
Buy call options on the S&P Index.
B.
Write put options on the S&P Index.
C.
Take a long position in futures on the S&P Index.
D.
Enter into a two-year equity swap to receive a fixed payment and pay an equity payment based on
the performance of the S&P index.
CorrectAnswer:

D ......................................................................................... LOS:Reading74b

If the S&P Index falls the investor will receive both the fixed payment and an equity payment so this
would be a viable strategy.
Reference:CFAProgramCurriculum,Volume6,pp.138141.

DerivativeInvestments457
7. An investor deposits an initial margin of $20,000 for a futures trade and the next day makes a
$2,000 loss on the trade. The next day he makes a further loss of $2,000. If the maintenance
requirementis$15,000thenhemustdepositavariationmarginof:
A.

$1,000.

B.

$4,000.

C.

$5,000.

D.

thereisnorequirementtopayavariationmargin.

8. Atradersellsbothacallandaputoptiononastockwiththesameexercisepriceandthesame
expiration,hewillmakeaprofitonthetransaction:
A.

ifthestockpricerisessharplyorfallssharply.

B.

onlyifthestockpricefallssharplybelowtheexerciseprice.

C.

onlyifthestockpricerisessharplyabovetheexerciseprice.

D.

ifthestockpriceremainswithinanarrowrangeoftheexerciseprice.

458StudySession17:
7. An investor deposits an initial margin of $20,000 for a futures trade and the next day makes a
$2,000 loss on the trade. The next day he makes a further loss of $2,000. If the maintenance
requirementis$15,000thenhemustdepositavariationmarginof:
A.
B.
C.
D.

$1,000.
$4,000.
$5,000.
there is no requirement to pay a variation margin.

CorrectAnswer:

D ......................................................................................... LOS:Reading72b

The variation margin only needs to be paid if the investors equity has fallen below the maintenance
requirement. This is not the case since the equity is still $16,000 ($20,000 - $2,000 - $2,000).
Reference:CFAProgramCurriculum,Volume6,pp.5560.

8. Atradersellsbothacallandaputoptiononastockwiththesameexercisepriceandthesame
expiration,hewillmakeaprofitonthetransaction:
A.
B.
C.
D.

if the stock price rises sharply or falls sharply.


only if the stock price falls sharply below the exercise price.
only if the stock price rises sharply above the exercise price.
if the stock price remains within a narrow range of the exercise price.

CorrectAnswer:

D ..........................................................................................LOS:Reading75a

This is a straddle (not explicitly covered in the readings) but the candidate can work out that if the stock
price moves up sharply the call option would be exercised, or if it moves down sharply the put option
would be exercised. If the move is significant the loss made on either option would be greater than the
premium income received. His strategy is profitable if the stock price does not move by more than the
combined value of the premiums received away from the exercise price.
Reference:CFAProgramCurriculum,Volume6,pp.151158.

DerivativeInvestments459
9. Ifputoptionsareusedtoinsureaportfoliowhichofthefollowingstatementsis
mostaccurate?
A.

Theinsuredportfoliowillonlyreportsubstantiallossesinasmallnumberofcases.

B.
Inthemajorityofcasestheinsuredportfoliowilloutperformanequivalentuninsured
portfolio.
C. Theprobabilityoftheinsuredportfolioachievinghighpositivegainsislessthanforthe
uninsuredportfolio.
D. Thereisahigherprobabilitythattheinsuredportfoliowillachieveanygivenpositive
returnthantheuninsuredportfolio.

10. Anoptiononafuturesisbestdescribedas:
A.

anoptionwheretheunderlyingassetisafuturescontract.

B.

afuturescontractwheretheholderagreestobuyaprespecifiedoptionatafuturedate.

C. afuturescontractwheretheholderhasanoptionatthedeliverydatetoextendthe
contract.
D. afuturescontractwheretheholderhastheoptiontobuyaprespecifiedassetatan
agreedpriceatafuturedate.

460StudySession17:
9. Ifputoptionsareusedtoinsureaportfoliowhichofthefollowingstatementsis
most accurate?
A.
The insured portfolio will only report substantial losses in a small number of cases.
B.
In the majority of cases the insured portfolio will outperform an equivalent uninsured portfolio.
C.
The probability of the insured portfolio achieving high positive gains is less than for the uninsured
portfolio.
D.
There is a higher probability that the insured portfolio will achieve any given positive return than
the uninsured portfolio.
CorrectAnswer:

C ......................................................................................... LOS:Reading75b

Correctly insuring a portfolio using put options should eliminate the possibility of a large loss since the
portfolio value will not fall below the exercise price less the premium. But if the return from the assets is
positive the uninsured portfolio will outperform the insured portfolio because of the cost of the premium.
Reference:CFAProgramCurriculum,Volume6,pp.162165.

10. Anoptiononafuturesisbestdescribedas:
A.
an option where the underlying asset is a futures contract.
B.
a futures contract where the holder agrees to buy a pre-specified option at a future date.
C.
a futures contract where the holder has an option at the delivery date to extend the contract.
D.
a futures contract where the holder has the option to buy a pre-specified asset at an agreed price at
a future date.
CorrectAnswer:

A ......................................................................................... LOS:Reading73b

An option on a futures is simply an option where the underlying asset is a futures contract. The option
holder has the right to enter into a futures contract (call option for a long position, put for a short position)
at a fixed price.
Reference:CFAProgramCurriculum,Volume6,p.94.

DerivativeInvestments461
11. Acorporatetreasurerknowsthathisfirmwillreceivealargecashinflowin180daystime.Heis
concernedthatinterestratesaregoingtofallandhewishestoputthemoneyon90dayLIBORon
receipt.Heshouldconsidertakinga:
A.

longpositionina6x3FRA.

B.

shortpositionina6x3FRA.

C.

longpositionina6x9FRA.

D.

shortpositionina6x9FRA.

12. Aninvestorbuysacalloptionatapremiumof$10onastockwhichhasamarketpriceof$60.If
theexercisepriceis$62theinvestorwillmakea:
A.

lossifthestockpricerisesabovethebreakevenpointof$70.

B.

lossifthestockpricerisesabovethebreakevenpointof$72.

C.

profitifthestockpricerisesabovethebreakevenpointof$70.

D.

profitifthestockpricerisesabovethebreakevenpointof$72.

462StudySession17:
11. Acorporatetreasurerknowsthathisfirmwillreceivealargecashinflowin180daystime.Heis
concernedthatinterestratesaregoingtofallandhewishestoputthemoneyon90dayLIBORon
receipt.Heshouldconsidertakinga:
A.
B.
C.
D.

long position in a 6 x 3 FRA.


short position in a 6 x 3 FRA.
long position in a 6 x 9 FRA.
short position in a 6 x 9 FRA.

CorrectAnswer:

D .......................................................................................... LOS:Reading71f

A short position will generate a profit if interest rates fall which will offset the loss from placing the cash
inflow on deposit at a lower rate. A 6 x 9 FRA is required, that is a 180-day forward contract based on
deposits that mature in 270 days. He is effectively locking in the rate he will receive in 180 days time.
Reference:CFAProgramCurriculum,Volume6,pp.4043.

12. Aninvestorbuysacalloptionatapremiumof$10onastockwhichhasamarketpriceof$60.If
theexercisepriceis$62theinvestorwillmakea:
A.
B.
C.
D.

loss if the stock price rises above the breakeven point of $70.
loss if the stock price rises above the breakeven point of $72.
profit if the stock price rises above the breakeven point of $70.
profit if the stock price rises above the breakeven point of $72.

CorrectAnswer:

D ..........................................................................................LOS:Reading73e

Breakeven is when 0 = maximum [ 0, (S X)] premium, when S = $72


Reference:CFAProgramCurriculum,Volume6,pp.96100.

DerivativeInvestments463
13. Atradersellsonewheatfuturescontract,whichisfor5,000bushelsofwheat,at$4perbushel.
Thetraderpostsaninitialmarginof$1,500.Iftherequiredmaintenancemarginis$1,100thetrader
wouldfirstreceiveamaintenancemargincallatawheatpriceclosestto:
A.

$2.93perbushel.

B.

$3.92perbushel.

C.

$4.08perbushel.

D.

$5.45perbushel.

14. ABC Asset Management is running a fund whose returns are linked to the performance of the
S&P Index. It has a U.S.$100 million cash inflow and it decides to use a swap agreement to gain
exposuretothemarket.ItentersintoaoneyearagreementwithXYZinvestmentbankwhereXYZ
agree to pay the return on the S&P Total Return Index and ABC will pay a fixed rate of 5% on a
notionalprincipalofU.S.$100million.Thepaymentsaretobemadequarterlywiththefirstpayment
onthelastdayinMarchandthepaymentswillbebasedontheactualdaycount/365basis.
IftheS&PIndexrisesby10%inthequarterending31MarchthefirstpaymentmadebyXYZ
willbeclosestto:

A.

$5,000,000.

B.

$8,767,123.

C.

$9,575,343.

D.

$11,232,877.

464StudySession17:
13. Atradersellsonewheatfuturescontract,whichisfor5,000bushelsofwheat,at$4perbushel.
Thetraderpostsaninitialmarginof$1,500.Iftherequiredmaintenancemarginis$1,100thetrader
wouldfirstreceiveamaintenancemargincallatawheatpriceclosestto:
A.
B.
C.
D.

$2.93 per bushel.


$3.92 per bushel.
$4.08 per bushel.
$5.45 per bushel.

CorrectAnswer:

C .......................................................................................... LOS:Reading72c

When he has made a loss of $400 he would receive a margin call, this is equivalent to a price rise of 8 cents,
since he sold the contract.
Reference:CFAProgramCurriculum,Volume6,pp.5560.

14. ABC Asset Management is running a fund whose returns are linked to the performance of the
S&P Index. It has a U.S.$100 million cash inflow and it decides to use a swap agreement to gain
exposuretothemarket.ItentersintoaoneyearagreementwithXYZinvestmentbankwhereXYZ
agree to pay the return on the S&P Total Return Index and ABC will pay a fixed rate of 5% on a
notionalprincipalofU.S.$100million.Thepaymentsaretobemadequarterlywiththefirstpayment
onthelastdayinMarchandthepaymentswillbebasedontheactualdaycount/365basis.
IftheS&PIndexrisesby10%inthequarterending31MarchthefirstpaymentmadebyXYZwillbe
closestto:
A.
B.
C.
D.

$5,000,000.
$8,767,123.
$9,575,343.
$11,232,877.

CorrectAnswer:

B.......................................................................................... LOS:Reading74b

ABC will make a payment of


$100m x 5% x 90/365
= $1,232,877
XYZ pays $10,000,000
The net payment made by XYZ is $8,767,123
Reference:CFAProgramCurriculum,Volume6,pp.138141.

DerivativeInvestments465
15. Whichofthefollowingstatementsconcerningfuturesandforwardcontractsismostaccurate?
A.

Onlyforwardcontractsareguaranteedbyaclearinghouse.

B.

Forwardcontractstendtobemoreheavilyregulatedthanfuturescontracts.

C.

Afuturescontractisatypeofforwardcontractthathasstandardizedcontractterms.

D.

Aforwardcontractisatypeoffuturescontractthatistradedonarecognizedexchange.

16. If an investor has taken a long position in a forward contract but then wishes to terminate the
contractpriortoexpiryhecan:
A.

donothing;itisimpossibletoterminatecontracts.

B.

gototheexchangeandrequestanimmediatecashsettlementofthecontract.

C. takeashortpositioninanewcontractwithsameexpiryandunderlyingassetasthe
originalcontract.
D. gobacktothecounterpartyandtakealongpositioninanothercontractwiththesame
expiryandunderlyingassetastheoriginalcontract.

466StudySession17:
15. Whichofthefollowingstatementsconcerningfuturesandforwardcontractsismostaccurate?
A.
B.
C.
D.

Only forward contracts are guaranteed by a clearinghouse.


Forward contracts tend to be more heavily regulated than futures contracts.
A futures contract is a type of forward contract that has standardized contract terms.
A forward contract is a type of futures contract that is traded on a recognized exchange.

CorrectAnswer:

C ..........................................................................................LOS:Reading70a

A futures contract is a type of forward contract that has standardized contract terms and is traded on a
regulated exchange.
Reference:CFAProgramCurriculum,Volume6,pp.912.

16. If an investor has taken a long position in a forward contract but then wishes to terminate the
contractpriortoexpiryhecan:
A.
do nothing; it is impossible to terminate contracts.
B.
go to the exchange and request an immediate cash settlement of the contract.
C.
take a short position in a new contract with same expiry and underlying asset as the original
contract.
D.
go back to the counterparty and take a long position in another contract with the same expiry and
underlying asset as the original contract.
CorrectAnswer:

C ......................................................................................... LOS:Reading71b

Taking a short position will mean that they no longer have any net exposure to price movements in the
underlying asset.
Reference:CFAProgramCurriculum,Volume6,pp.3334.

DerivativeInvestments467
17. Adealerquotesona90dayFRA,wheretheunderlyingis180daydollarLIBOR,atarateof4%.
Theendusertakesashortposition,withanotionalprincipalof$1million.
Atexpirationtherateon180dayLIBORis5%.Thepayofffortheenduserisclosestto:
A.

alossof$5,000.

B.

alossof$4,878.

C.

aprofitof$4,878.

D.

aprofitof$5,000.

18. Two parties X and Y enter into a tenyear fixedforfixed currency swap. Party X holds U.S.
dollars and wishes to exchange these for Yen, Party Y holds Yen and wishes to exchange these for
U.S. dollars. The principal is $100 million. The U.S. dollar equals Yen110 when the agreement is
signedandthefixedratesonU.S.dollarsissetat6%andYenat1%.Attheendofthefirstyear:
A.

PartyXpaysYen110million,andPartyYpaysU.S.dollars6million.

B.

PartyYpaysYen110million,andPartyXpaysU.S.dollars6million.

C.

PartyXpaysYen11,110million,andPartyYpaysU.S.dollars106million.

D.

PartyYpaysYen11,110million,andPartyXpaysU.S.dollars106million.

468StudySession17:
17. Adealerquotesona90dayFRA,wheretheunderlyingis180daydollarLIBOR,atarateof4%.
Theendusertakesashortposition,withanotionalprincipalof$1million.
At expiration the rate on 180-day LIBOR is 5%. The payoff for the end user is closest to:
A.
a loss of $5,000.
B.
a loss of $4,878.
C.
a profit of $4,878.
D.
a profit of $5,000.
CorrectAnswer:

B...........................................................................................LOS:Reading71g

The payoff is given by:

(0.05 0.04)(180 360)


0.005
$1,000,000
= $1,000,000
= $4,878

1.025
1 + 0.05(180 360 )
Since the end user had a short position he must pay $4,878 to the dealer
Reference:CFAProgramCurriculum,Volume6,pp.4043.

18. Two parties X and Y enter into a tenyear fixedforfixed currency swap. Party X holds U.S.
dollars and wishes to exchange these for Yen, Party Y holds Yen and wishes to exchange these for
U.S. dollars. The principal is $100 million. The U.S. dollar equals Yen110 when the agreement is
signedandthefixedratesonU.S.dollarsissetat6%andYenat1%.Attheendofthefirstyear:
A.
B.
C.
D.

Party X pays Yen 110 million, and Party Y pays U.S. dollars 6 million.
Party Y pays Yen 110 million, and Party X pays U.S. dollars 6 million.
Party X pays Yen 11,110 million, and Party Y pays U.S. dollars 106 million.
Party Y pays Yen 11,110 million, and Party X pays U.S. dollars 106 million.

CorrectAnswer:

A ......................................................................................... LOS:Reading74b

Party X pays interest on the Yen borrowed which is:


Yen 11,000 million x 1% = Yen 110 million.
Party Y pays interest on the U.S. dollars borrowed which is:
U.S. dollars 100 million x 6% = U.S. dollars 6 million.
The principals would be exchanged at the beginning of the agreement.
Reference:CFAProgramCurriculum,Volume6,pp.130134.

DerivativeInvestments469
19. Aninvestorwritesaputoptionatapremiumof$6onastockwithanexercisepriceof$62.Ifthe
stockpriceis$70atexpirationtheinvestorwillmakeaprofitof:
A.

$2.

B.

$6.

C.

$8.

D.

$14.

20. Aportfolioinsurancestrategyforadiversifiedstockportfoliocanbeimplementedby:
A.

buyingaputoptiononthestockindexrepresentingtheunderlyingstockportfolio.

B.

writingaputoptiononthestockindexrepresentingtheunderlyingstockportfolio.

C.

buyingacalloptiononthestockindexrepresentingtheunderlyingstockportfolio.

D. writingacoveredcalloptiononthestockindexrepresentingtheunderlyingstock
portfolio.

470StudySession17:
19. Aninvestorwritesaputoptionatapremiumof$6onastockwithanexercisepriceof$62.Ifthe
stockpriceis$70atexpirationtheinvestorwillmakeaprofitof:
A.
B.
C.
D.

$2.
$6.
$8.
$14.

CorrectAnswer:

B...........................................................................................LOS:Reading75a

The put option will lapse worthless since the exercise price is lower than the market price, so the investor
makes a profit of the premium that he collected.
Reference:CFAProgramCurriculum,Volume6,pp.154158.

20. Aportfolioinsurancestrategyforadiversifiedstockportfoliocanbeimplementedby:
A.
B.
C.
D.

buying a put option on the stock index representing the underlying stock portfolio.
writing a put option on the stock index representing the underlying stock portfolio.
buying a call option on the stock index representing the underlying stock portfolio.
writing a covered call option on the stock index representing the underlying stock portfolio.

CorrectAnswer:

A ......................................................................................... LOS:Reading75b

In the situation that the stock market index falls, the losses on the underlying portfolio will be offset by
the profits on the put option.
Reference:CFAProgramCurriculum,Volume6,pp.162165.

DerivativeInvestments471
21. Theleastlikelybenefitforaninvestorifamarketincludesfinancialderivativesis:
A.

pricediscovery.

B.

tradingefficiency.

C.

regulatoryprotection.

D.

instrumentsavailableforriskmanagement.

22. A firm enters into a plain vanilla interest rate swap agreement to pay a fixed rate of 8%, the
counterparty agrees to pay one year LIBOR. Annual payments will be made in arrears. The swap
coversa fiveyear periodand is based on a notionalprincipal of$100 million.The one year LIBOR
rateatthetimeofagreementis8.25%.Attheendofoneyearitis9%,andattheendofthesecond
yearitis9.5%.Thenetpaymentthatthepayfixedfirmreceives/paysattheendofthesecondyearis:
A.

pays$1million.

B.

pays$1.5million.

C.

receives$1million.

D.

receives$1.5million.

472StudySession17:
21. Theleastlikelybenefitforaninvestorifamarketincludesfinancialderivativesis:
A.
B.
C.
D.

price discovery.
trading efficiency.
regulatory protection.
instruments available for risk management.

CorrectAnswer:

C .......................................................................................... LOS:Reading70c

Price discovery, ability to hedge risk and market efficiency including low transaction costs are all benefits
of derivatives. Although exchange-traded derivatives provide some regulatory protection, OTC derivatives
often offer little regulatory protection.
Reference:CFAProgramCurriculum,Volume6,pp.2022.

DerivativeInvestments473
22. A firm enters into a plain vanilla interest rate swap agreement to pay a fixed rate of 8%, the
counterparty agrees to pay one year LIBOR. Annual payments will be made in arrears. The swap
coversa fiveyear periodand is based on a notionalprincipal of$100 million.The one year LIBOR
rateatthetimeofagreementis8.25%.Attheendofoneyearitis9%,andattheendofthesecond
yearitis9.5%.Thenetpaymentthatthepayfixedfirmreceives/paysattheendofthesecondyearis:
A.
B.
C.
D.

pays $1 million.
pays $1.5 million.
receives $1 million.
receives $1.5 million.

CorrectAnswer:

C ..........................................................................................LOS:Reading74b

The payment received is $100 million x (9% - 8%) = $1 million.


Reference:CFAProgramCurriculum,Volume6,pp.134138.

474StudySession18:

Study Session 18: Alternative Investments:

Due to diversification benefits and higher expectations of investment returns, investors are
increasingly turning to alternative investments. This study session describes the common types of
alternativeinvestments,methodsfortheirvaluation,uniquerisksandopportunitiesassociatedwith
them,andtherelationbetweenalternativeinvestmentsandtraditionalinvestments.
Althoughfindingasingledefinitionofanalternativeinvestmentisdifficult,certainfeatures(e.g.,
limited liquidity, infrequent valuations, and unique legal structures) are typically associated with
alternativeinvestments.Thisstudysessiondiscussesthesefeaturesandhowtoevaluatetheirimpact
on expected returns and investment decisions in more detail. The reading providesan overview of
themajorcategoriesofalternativeinvestments,includingrealestate,privateequity,venturecapital,
hedgefunds,closelyheldcompanies,distressedsecurities,andcommodities.
Each one of these categories has several unique characteristics, and the readings discuss valuation
methods for illiquid assets (such as direct real estate or closely held companies), performance
measuresforprivateequityandventurecapitalinvestments,differencesbetweenvarioushedgefund
strategies,andimplementationvehiclesforinvestmentsinalternativeassets.

Reading76:AlternativeInvestments

AlternativeInvestments475
1. Capitalprovidedtoacompanythatisclosetogoingpublicis:
A.

firststagefinancing.

B.

thirdstagefinancing.

C.

mezzaninefinancing.

D.

secondstagefinancing.

2. Whichofthefollowingstatementsistheleastaccuratedescriptionofacharacteristicofventure
capitalinvesting?
A.

Illiquidityisafeatureofventurecapitalinvestment.

B.

Investorsoftenneedtomakealongtermcommitment.

C. Entrepreneurshavestrongmanagementskillswhichincreasetheprobabilityof
companiesbeingsuccessful.
D. Investorsexpecttoachievehigherinvestmentreturnsthantheyreceivefrominvestingin
publiclylistedsecurities.

476StudySession18:
1. Capitalprovidedtoacompanythatisclosetogoingpublicis:
A.
B.
C.
D.

first-stage financing.
third-stage financing.
mezzanine financing.
second-stage financing.

CorrectAnswer:

C ..........................................................................................LOS:Reading76g

Mezzanine or bridge financing is given to companies who are planning to go public in the near term.
Reference:CFAProgramCurriculum,Volume6,pp.201202.

2. Whichofthefollowingstatementsistheleastaccuratedescriptionofacharacteristicofventure
capitalinvesting?
A.
Illiquidity is a feature of venture capital investment.
B.
Investors often need to make a long-term commitment.
C.
Entrepreneurs have strong management skills which increase the probability of companies being
successful.
D.
Investors expect to achieve higher investment returns than they receive from investing in publicly
listed securities.
CorrectAnswer:

C ..........................................................................................LOS:Reading76g

Entrepreneurs often have weak management skills so the venture capitalist can help in providing direction
and strategic guidance to the company.
Reference:CFAProgramCurriculum,Volume6,pp.202204.

AlternativeInvestments477
3. A hedge fund manager specializes in taking long positions in companies that are being bid for
andtakingshortpositionsintheacquiringcompany.Heislikelytobemanagingahedgefundthat
is:
A.

afuturesfund.

B.

along/shortfund.

C.

aneventdrivenfund.

D.

amarketneutralfund.

4. One of the reasons that the shares in closely held companies usually trade at a discount to
publiclytradedsecuritiesis:
A.

thesharesarelessliquid.

B.

theyhavehighmarketbetas.

C.

investorsoftenholdamajoritystake.

D.

investorsoftenhaveagreaterinfluenceonthecompanysmanagement.

478StudySession18:
3. A hedge fund manager specializes in taking long positions in companies that are being bid for
andtakingshortpositionsintheacquiringcompany.Heislikelytobemanagingahedgefundthat
is:
A.
B.
C.
D.

a futures fund.
a long/short fund.
an event-driven fund.
a market-neutral fund.

CorrectAnswer:

C .......................................................................................... LOS:Reading76i

C is the best answer since the long and short positions are being taken as a result of specific events, in this
case an acquisition.
Reference:CFAProgramCurriculum,Volume6,pp.211213.

4. One of the reasons that the shares in closely held companies usually trade at a discount to
publiclytradedsecuritiesis:
A.
B.
C.
D.

the shares are less liquid.


they have high market betas.
investors often hold a majority stake.
investors often have a greater influence on the companys management.

CorrectAnswer:

A ......................................................................................... LOS:Reading76n

Closely held companies shares are often not publicly traded and lack marketability, so investors are
compensated with a liquidity discount.
Reference:CFAProgramCurriculum,Volume6,pp.223224.

AlternativeInvestments479
5. AninvestorinanExchangeTradedFund(ETF)isexposedtotrackingerrorrisk;thisistherisk
that:
A.

thebidaskspreadforsharesintheETFwidens.

B.

theETFfailstomakedividendpaymentstoinvestors.

C.

thecurrencythefundisdenominatedindoesnottracktheU.S.dollar.

D.

thefunddoesnotcloselyreplicatetheperformanceoftheindexthatitisfollowing.

6. Which of the following is the least accurate description of a characteristic of commodity


investment,basedonhistoricdata?
A.

Itoffersinflationprotection.

B.

Ithaslowvolatilityofreturns.

C.

Itproducesattractivereturnsinperiodsofeconomicgrowth.

D.

Thereturnshavelowcorrelationswithbondandequityreturns.

480StudySession18:
5. AninvestorinanExchangeTradedFund(ETF)isexposedtotrackingerrorrisk;thisistherisk
that:
A.
B.
C.
D.

the bid-ask spread for shares in the ETF widens.


the ETF fails to make dividend payments to investors.
the currency the fund is denominated in does not track the U.S. dollar.
the fund does not closely replicate the performance of the index that it is following.

CorrectAnswer:

D .......................................................................................... LOS:Reading76c

Tracking error is a measure of the deviations between ETF returns and the index returns.
Reference:CFAProgramCurriculum,Volume6,pp.186187.

6. Which of the following is the least accurate description of a characteristic of commodity


investment,basedonhistoricdata?
A.
B.
C.
D.

It offers inflation protection.


It has low volatility of returns.
It produces attractive returns in periods of economic growth.
The returns have low correlations with bond and equity returns.

CorrectAnswer:

B.......................................................................................... LOS:Reading76q

Historically commodities have exhibited higher volatility than equities.


Reference:CFAProgramCurriculum,Volume6,pp.225227.

AlternativeInvestments481
7. Investorsinhedgefundsareleastlikelytobemotivatedbywhichofthefollowing?
A.

Consistentreturnsacrossthedifferentcategoriesofhedgefunds.

B.

Thelowvolatilityofreturnsfromhedgefundscomparedtoequityreturns.

C.

Higheraveragereturnsprovidedbyhedgefundscomparedtootherinvestments.

D.

Thepotentialtousehedgefundstodiversifyportfoliosthatholdotherassetclasses.

8. Which of the following statements regarding trade sales of venture capital investments is the
mostaccurate?
A.

Atradesaleisthefirststepinthepublicofferingprocess.

B.

Tradesalesareanunattractiveexitstrategyformostventurecapitalists.

C. Tradesalesareoneofthemostcommonmethodsofventurecapitalinvestorsdivesting
theirholdings.
D. Tradesalesmeansthataventurecapitalinvestmentissoldtoanothercompany
operatinginthesameindustry.

482StudySession18:
7. Investorsinhedgefundsareleastlikelytobemotivatedbywhichofthefollowing?
A.
B.
C.
D.

Consistent returns across the different categories of hedge funds.


The low volatility of returns from hedge funds compared to equity returns.
Higher average returns provided by hedge funds compared to other investments.
The potential to use hedge funds to diversify portfolios that hold other asset classes.

CorrectAnswer:

A .......................................................................................... LOS:Reading76i

Different types of hedge funds (e.g. fixed-income arbitrage versus global macro) have quite different
performance records.
Reference:CFAProgramCurriculum,Volume6,pp.217219.

8. Which of the following statements regarding trade sales of venture capital investments is the
mostaccurate?
A.
A trade sale is the first step in the public offering process.
B.
Trade sales are an unattractive exit strategy for most venture capitalists.
C.
Trade sales are one of the most common methods of venture capital investors divesting their
holdings.
D.
Trade sales means that a venture capital investment is sold to another company operating in the
same industry.
CorrectAnswer:

C ..........................................................................................LOS:Reading76g

Trade sales refer to a venture capital investment being sold to or merged with another company.
Reference:CFAProgramCurriculum,Volume6,p.204.

AlternativeInvestments483
9. Whichofthefollowingisleastlikelytobeusedasamethodofvaluingrealestate?
A.

Costapproach.

B.

Incomeapproach.

C.

Balancesheetapproach.

D.

Discountedcashflowapproach.

10. Thepricesofhedgefundsareoftensmoothedbecause:
A.

theyusearbitragestrategies.

B.

themanagersareriskaverse.

C.

theyareactivelydealinginderivativeexchanges.

D.

theyinvestinoverthecounterinstrumentswhosepricesarebasedonestimates.

484StudySession18:
9. Whichofthefollowingisleastlikelytobeusedasamethodofvaluingrealestate?
A.
B.
C.
D.

Cost approach.
Income approach.
Balance sheet approach.
Discounted cash flow approach.

CorrectAnswer:

C ..........................................................................................LOS:Reading76e

The methods that are covered in the text are the cost approach, sales comparison approach, income
approach and the discounted after-tax cash flow approach.
Reference:CFAProgramCurriculum,Volume6,pp.190198.

10. Thepricesofhedgefundsareoftensmoothedbecause:
A.
B.
C.
D.

they use arbitrage strategies.


the managers are risk averse.
they are actively dealing in derivative exchanges.
they invest in over-the-counter instruments whose prices are based on estimates.

CorrectAnswer:

D .......................................................................................... LOS:Reading76l

Over the counter instruments do not have market prices and the estimated values are often less volatile
than exchange-traded instruments.
Reference:CFAProgramCurriculum,Volume6,pp.220221.

AlternativeInvestments485
11. Investorsinaloadopenendfund:
A.

purchasesharesatthenetassetvalue.

B.

purchasesharesatadiscounttothenetassetvalue.

C.

payanannualmanagementchargewhichiscalledaload.

D.

purchasesharesatthenetassetvalueplusaninitialcharge.

12. Theobjectiveofastockmarketindexfundisto:
A.

trackthereturnfromthestockmarketindex.

B.

outperformthereturnfromthestockmarketindex.

D.

generateareturnwhichisindependentofthestockmarketreturn.

C.

generateareturnwhichishigherthentheCPIindexbyinvestinginequities.

486StudySession18:
11. Investorsinaloadopenendfund:
A.
B.
C.
D.

purchase shares at the net asset value.


purchase shares at a discount to the net asset value.
pay an annual management charge which is called a load.
purchase shares at the net asset value plus an initial charge.

CorrectAnswer:

D ..........................................................................................LOS:Reading76a

An open-end investment company continues to buy and sell shares after the initial offering. A managed or
load fund is when the offering price is the NAV plus an initial charge called a front-end load.
Reference:CFAProgramCurriculum,Volume6,pp.177180.

12. Theobjectiveofastockmarketindexfundisto:
A.
B.
D.
C.

track the return from the stock market index.


outperform the return from the stock market index.
generate a return which is independent of the stock market return.
generate a return which is higher then the CPI index by investing in equities.

CorrectAnswer:

A ......................................................................................... LOS:Reading76b

The objective of an index fund is to perform in line with a specified index, perhaps by owning all the shares
in the index with the same weighting as their representation in the index.
Reference:CFAProgramCurriculum,Volume6,p.180.

AlternativeInvestments487
13. Which stage of venture capital financing is when capital is provided for product development
andresearch?
A.

Seedfinancing.

B.

Startupfinancing.

C.

Firststagefinancing.

D.

Secondstagefinancing.

14. A property which is considered a lower risk investment than another property investment,
assumingtheybothgeneratethesamenetoperatingincome,willbelikelytohavea:

Marketcapitalizationrate Valuation

A.

lower

lower

B.

lower

higher

C.

higher

lower

D.

higher

higher

488StudySession18:
13. Which stage of venture capital financing is when capital is provided for product development
andresearch?
A.
B.
C.
D.

Seed financing.
Start-up financing.
First-stage financing.
Second-stage financing.

CorrectAnswer:

A ..........................................................................................LOS:Reading76g

Seed financing is the first stage of venture capital investing, for product development and market research.
The product is still at the idea stage.
Reference:CFAProgramCurriculum,Volume6,pp.201202.

14. A property which is considered a lower risk investment than another property investment,
assumingtheybothgeneratethesamenetoperatingincome,willbelikelytohavea:
A.
B.
C.
D.

Market capitalization rate


lower
lower
higher
higher

CorrectAnswer:

Valuation
lower
higher
lower
higher

B........................................................................................... LOS:Reading76f

The market capitalization rate reflects the investors required rate of return from the property, a low risk
project will tend to have a low capitalization rate and therefore, for equal net operating income, a higher
value.
Reference:CFAProgramCurriculum,Volume6,pp.193194.

AlternativeInvestments489
15. Theaftertaxcashflowfromarealestateinvestmentadjuststhenetoperatingincomeforallof
thefollowingexcept:
A.

costofdebt.

B.

proceedsfromsaleofproperty.

C.

depreciationexpenselesstaxsavings.

D.

taxationoncapitalgainswhenthepropertyissold.

16. Investinginahedgefundisleastlikelytobeattractivebecause:
A.

thereturnsarehigherthanthoseavailableonequityfunds.

B.

thevolatilityofreturnsislowerthanthatofafundinvestinginequities.

C.

thefundwillprovidegreatertransparencythanatraditionalmutualfund.

D.

thereturnfromthefundislikelytohavealowcorrelationwithlistedstocksandbonds.

490StudySession18:
15. Theaftertaxcashflowfromarealestateinvestmentadjuststhenetoperatingincomeforallof
thefollowingexcept:
A.
B.
C.
D.

cost of debt.
proceeds from sale of property.
depreciation expense less tax savings.
taxation on capital gains when the property is sold.

CorrectAnswer:

C .......................................................................................... LOS:Reading76f

The net operating income (NOI) is before depreciation, and depreciation is a non-cash item, so no
adjustment is made for the depreciation, although the tax saving is included in the calculation.
Reference:CFAProgramCurriculum,Volume6,pp.193198.

16. Investinginahedgefundisleastlikelytobeattractivebecause:
A.
B.
C.
D.

the returns are higher than those available on equity funds.


the volatility of returns is lower than that of a fund investing in equities.
the fund will provide greater transparency than a traditional mutual fund.
the return from the fund is likely to have a low correlation with listed stocks and bonds.

CorrectAnswer:

C .......................................................................................... LOS:Reading76j

The most common legal structure is limited partnership (in the U.S.) or an offshore corporation. The legal
structure gives the fund managers not only the freedom to implement a variety of strategies but there are
less stringent disclosure requirements than for traditional funds. Lack of transparency of hedge funds can
be a major drawback for investors.
Reference:CFAProgramCurriculum,Volume6,pp.207210.

AlternativeInvestments491
17. IntheU.S.globalfundsrefertofundsthat:
A.

onlyinvestoutsidetheU.S.

B.

areonlymarketedoutsidetheU.S.

C.

investinboththeU.S.andinternationally.

D.

aremarketedinboththeU.S.andinternationally.

18. Theroleofventurecapitalinvestorsisleastlikelytoinclude:
A.

assistingcompaniestogopublic.

B.

providingfinancingtosmallprivatelyheldcompanies.

C.

assistingthecompaniesthattheyinvestinwithstrategicplanning.

D.

makingamarketinthesharesoftheirinvestmentsthathavegonepublic.

492StudySession18:
17. IntheU.S.globalfundsrefertofundsthat:
A.
B.
C.
D.

only invest outside the U.S.


are only marketed outside the U.S.
invest in both the U.S. and internationally.
are marketed in both the U.S. and internationally.

CorrectAnswer:

C ......................................................................................... LOS:Reading76b

Global funds refer to funds that are investing in both the U.S. and international markets.
Reference:CFAProgramCurriculum,Volume6,p.177.

18. Theroleofventurecapitalinvestorsisleastlikelytoinclude:
A.
B.
C.
D.

assisting companies to go public.


providing financing to small privately held companies.
assisting the companies that they invest in with strategic planning.
making a market in the shares of their investments that have gone public.

CorrectAnswer:

D ..........................................................................................LOS:Reading76g

The role of venture capitalists is not just to provide finance but to also work with the management team to
develop and expand the business. This would usually include assisting with a company going public as
venture capitalists have experience dealing with underwriters and other financial institutions. They would
not normally be specialists or market makers.
Reference:CFAProgramCurriculum,Volume6,pp.200202.

AlternativeInvestments493
19. Amutualfundhasissuedtwoclassesofshares.Eachclassholdsthesameunderlyingportfolioof
securitiesbuttheexpensestructuresdiffer,thefeesareshowninthetablebelow:

ClassA

ClassB

4%

None

Redemptionfees

None

5%inthefirstyearbutdeclining
by1%pointeachyearthereafter

Annualexpenses

Frontendfees

Distributionfees

0.30%

0.30%

Managementfees

0.75%

1.00%

Otherexpenses

0.20%

0.20%

1.25%

1.50%

Whatwouldbethereturnforeachoftheclassesofsharesifaninvestorinvests$1foraperiod
offiveyears,assumingthefundgrowsby8%annually?

FundA

FundB

A.

32.46%

34.88%

B.

32.46%

36.24%

C.

33.08%

34.88%

D.

33.08%

37.01%

494StudySession18:
19. Amutualfundhasissuedtwoclassesofshares.Eachclassholdsthesameunderlyingportfolioof
securitiesbuttheexpensestructuresdiffer,thefeesareshowninthetablebelow:

ClassA

ClassB

4%

None

Redemptionfees

None

5%inthefirstyearbutdeclining
by1%pointeachyearthereafter

Annualexpenses

Frontendfees

Distributionfees

0.30%

0.30%

Managementfees

0.75%

1.00%

Otherexpenses

0.20%

0.20%

1.25%

1.50%

What would be the return for each of the classes of shares if an investor invests $1 for a period of five years,
assuming the fund grows by 8% annually?
Fund A
Fund B
A.
32.46%
34.88%
B.
32.46%
36.24%
C.
33.08%
34.88%
D.
33.08%
37.01%
CorrectAnswer:

B...........................................................................................LOS:Reading76a

FundA:
Duetothefrontendfeeof4%,only$0.96fromthe$1willbeavailabletoinvest.
Attheendoffiveyears,$1investedinthefundwillbeworth

$0.96x(1.08)5x(10.0125)5=$1.3246,orareturnof32.46%.

FundB:
Attheendof5years,$1investedinthefundswillbeworth

$1x(1.08)5x(10.015)5=$1.3624,orareturnof36.24%.

Reference:CFAProgramCurriculum,Volume6,pp.178180.

AlternativeInvestments495
20. Amutualfundhasissuedtwoclassesofshares.Eachclassholdsthesameunderlyingportfolioof
securitiesbuttheexpensestructuresdiffer,thefeesareshowninthetablebelow:

ClassA

ClassB

4%

None

Redemptionfees

None

5%inthefirstyearbutdeclining
by1%pointeachyearthereafter

Annualexpenses

Frontendfees

Distributionfees

0.30%

0.30%

Managementfees

0.75%

1.00%

Otherexpenses

0.20%

0.20%

1.25%

1.50%

Whatwouldbethereturnforeachoftheclassesofsharesifaninvestorinvests$1andredeems
hissharesaftertwoyears,assumingthefundgrowsby8%annually?

FundA

FundB

A.

9.19%

8.64%

B.

9.19%

8.89%

C.

9.40%

8.64%

D.

9.40%

9.77%

496StudySession18:
20. Amutualfundhasissuedtwoclassesofshares.Eachclassholdsthesameunderlyingportfolioof
securitiesbuttheexpensestructuresdiffer,thefeesareshowninthetablebelow:

ClassA

ClassB

4%

None

Redemptionfees

None

5%inthefirstyearbutdeclining
by1%pointeachyearthereafter

Annualexpenses

Frontendfees

Distributionfees

0.30%

0.30%

Managementfees

0.75%

1.00%

Otherexpenses

0.20%

0.20%

1.25%

1.50%

What would be the return for each of the classes of shares if an investor invests $1 and redeems his shares
after two years, assuming the fund grows by 8% annually?
Fund A
Fund B
A.
9.19%
8.64%
B.
9.19%
8.89%
C.
9.40%
8.64%
D.
9.40%
9.77%
CorrectAnswer:

A ..........................................................................................LOS:Reading76a

FundA:
Thereisnoredemptionfee,sotheinvestmentinthefundaftertwoyearswillbeworth

$0.96x(1.08)2x(10.0125)2=$1.0919,orareturnof9.19%.

FundB:
Aftertwoyearstheredemptionfeewillbe4%,i.e.adeclineof1%pointfrom5%.
Theinvestmentinthefundaftertwoyearswillbeworth

$1x(1.08)2x(10.015)2x(10.04)=$1.0864orareturnof8.64%.

Reference:CFAProgramCurriculum,Volume6,pp.178180.

AlternativeInvestments497
21. An investor is considering purchasing an office building as an investment, and the following
informationhasbeencollected.Thefiguresareonanannualbasis.
Grosspotentialrentalincome

$1,000,000

Estimatedvacancyandcollectionlosses

5%

Insuranceandtaxes

$80,000

Utilities

$30,000

Repairsandmaintenance

$60,000

Depreciation

$70,000

Interestonproposedfinancing

$90,000

Thenetoperatingincome(NOI)perannumisclosestto
A.

$620,000.

B.

$690,000.

C.

$710,000.

D.

$780,000.

22. An investor is looking at investing $1 million in a project, where the expected payout is $10
millionattheendoffiveyears.Theinvestorscostofequityfortheprojectis10%.Howeverthereisa
significant risk of failure and the probability of failure in any year is given in the table below. The
probabilityisbasedontheconditionthattheprojecthassurvivedthepreviousyear.

Year
Probabilityoffailure

0.40

0.35

0.25

0.20

0.20

Theexpectednetpresentvalue(NPV)oftheprojectisclosestto
A.

$159,400.

B.

$346,400.

C.

$870,000.

D.

$972,400.

498StudySession18:
21. An investor is considering purchasing an office building as an investment, and the following
informationhasbeencollected.Thefiguresareonanannualbasis.

Grosspotentialrentalincome

$1,000,000

Estimatedvacancyandcollectionlosses

5%

Insuranceandtaxes

$80,000

Utilities

$30,000

Repairsandmaintenance

$60,000

Depreciation

$70,000

Interestonproposedfinancing

$90,000

The net operating income (NOI) per annum is closest to


A.
$620,000.
B.
$690,000.
C.
$710,000.
D.
$780,000.
CorrectAnswer:
NOI

D .......................................................................................... LOS:Reading76f

= gross potential rental income minus expenses

=$1,000,000(0.05x$1,000,000)$80,000$30,000$60,000

=$780,000
Note the expenses for this calculation do not include depreciation (it is assumed that repairs will maintain
the building in good condition indefinitely) and interest expense.
Reference:CFAProgramCurriculum,Volume6,pp.193194.

AlternativeInvestments499
22. An investor is looking at investing $1 million in a project, where the expected payout is $10
millionattheendoffiveyears.Theinvestorscostofequityfortheprojectis10%.Howeverthereisa
significant risk of failure and the probability of failure in any year is given in the table below. The
probabilityisbasedontheconditionthattheprojecthassurvivedthepreviousyear.

Year
Probabilityoffailure

0.40

0.35

0.25

0.20

0.20

Theexpectednetpresentvalue(NPV)oftheprojectisclosestto
A.
B.
C.
D.

$159,400.
$346,400.
$870,000.
$972,400.

CorrectAnswer:

A..........................................................................................LOS:Reading76h

The probability that the project survives throughout the five years is given by the product of the individual
probabilities it survives each year, which is:
(10.40)(10.35)(10.25)(10.20)(10.20)=18.7%

Iftheprojectsurvivesthepresentvalueis:$10million/(1.10)5$1million=$5.2million

Iftheprojectfailsthepresentvalueis:$1million.

TheexpectedNPV:

0.187($5.2million)+0.813($1million)=$159,400

Reference:CFAProgramCurriculum,Volume6,pp.205207.

500StudySession18:

2008 JUNE EXAM


15February2008 SeconddeadlinefornewCFAProgramenrollmentsandexamregistrationstobe
receivedbyCFAInstitute
March2008

Onlinesampleexamsavailable

17March2008
Final deadline for new CFA Program enrollments and exam registrations to be
receivedbyCFAInstitute
17March2008
Final deadline for disability accommodation requests and requests for religious
alternativedatestobereceivedbyCFAInstitute
17March2008

AlltestcenterchangerequestsmustbereceivedbyCFAInstitute

LateApril2008

Examadmissionticketsavailableonline

7June2008

Examdateand8June2008

JuneJuly2008

Examsgraded

LateJuly2008

ExamresultsavailableonlineforLevelIcandidates

ExamdateinEasternAsiaandOceania

LateAugust2008 ExamresultsavailableonlineforLevelIIandIIIcandidates

2008 DECEMBER EXAM


17March2008
First deadline for new CFA Program enrollments and exam registrations to be
receivedbyCFAInstitute
15August2008
SeconddeadlinefornewCFAProgramenrollmentsandexamregistrationstobe
receivedbyCFAInstitute
15September2008Final deadline for new CFA Program enrollments and exam registrations to be
receivedbyCFAInstitute
15September2008Final deadline for disability accommodation requests and requests for religious
alternativedatestobereceivedbyCFAInstitute
15September2008AlltestcenterchangerequestsmustbereceivedbyCFAInstitute
October2008

Onlinesampleexamsavailable

LateOctober2008 Examadmissionticketsavailableonline
6December2008 Examdateand7December2008ExamdateinEasternAsiaandOceania
December2008

Examsgraded

January2009

Examresultsavailableonline

Terminology501

Terminology:
Appraisalforrealestate,theprocessofestimatingthecurrentmarketvalueofaproperty.
Comparativesalesapproachthevalueofarealestateis,atthemost,thecostofthelandand
constructingthebuildingatcurrentprices.
Incomeapproachthevalueofrealestateisthepresentvalueofitfutureincome.
Marketcapitalizationratedivideapropertysnetoperatingincomebytheappropriatemarket
capitalizationratetoarriveatanestimateforitscurrentmarketvalue.Itreflectstherateofreturn
requiredbyinvestorsinsuchaproperty.
Positiveleveragethereturnfromarealestateinvestmentishigherthanthecostofdebt,aninvestor
willachieveahigherrateofreturnifhe/sheusesleveragetopurchasetheproperty.
RealEstateInvestmentTrust(REIT)aclosedendinvestmentcompanythatinvestsinrealestate
andmortgagesonrealestate.
RealEstateLimitedPartnership(RELP)arealestatesyndicatethatinvestsindifferenttypesofreal
estate.
Seedfinancingventurecapitalprovidedforproductdevelopmentandmarketresearch,the
productisstillattheideastage.
Startupfinancingventurecapitalprovidedforearlystageproductdevelopmentandinitial
marketing.
Firststagefinancingventurecapitalprovidedforinitialcommercialmanufactureandsales.
Mezzanine(orbridge)financingventurecapitalprovidedforacompanythatexpectstogopublic
inthenearfuture.
Turnaroundscapitalprovidedtorestructureacompanythathasproblems.
Leveragedbuyouts(LBOs)capitaltofundamanagementgroup(amanagementbuyout)orother
investorswhowishtopurchaseabusinessorcompany.
Investmentcompanyacompanythatsellitsownsharesandusestheproceedstobuystocks,bonds
orotherfinancialinstruments.
Closedendinvestmentcompanyaninvestmentcompanythatissuesafixednumberofshares,the
sharesarethentradedinthesecondarymarket.
Openendinvestmentcompanyacompanythatoffersnewsharestoinvestorsandredeemsshares
continuously.
Mutualfundanopenendinvestmentcompany.
Noloadfundsharesaresoldatnetassetvalue,withnosaleschargeadded.
Loadfundafundthatmakesaninitialsalescharge,sotheofferingpriceisthenetassetvalueplus
aload.

502Exhibit

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Appendix A: 503

Appendix A:
Exhibits

Exhibit 1: Accounting Statements

Exhibit 2: Puts and Calls

Exhibit 3: PE Breakdown

Exhibit 4: Ratios

504 Exhibit

Exhibit 1: Accounting Statements


Income
Stmt:
Particular
moment in the
life of an asset
Convert assets into
profit to return to
Inv or Stkhldrs
Equity

Income Statement

Balance Sheet
Assets

Sales

Profit

Assets
come
into
Balance
Sheet in SE to
get to Assets

Stk
Eqty
Investors
Decisions
Income Statement

Statement of Cash Flows

Sales
- COGS

CFO

CFI

CFF

Gross Margin
Expenses
EBIT
- Interest
EBT
- Tax
EAT

Inventory
stored
converted to product
CEOs look at things
from viewpoint of
Cash Flow ... to pay
bills, liquidity

Balance Sheet

Operating

Investment
Financing

FA
LTD
SE

A
growing
company never has
cash
enough
collection to grow
the inventory.

Sale

Cash Collection

CL
AP

and

Operation
Cycle
Acquire
Inventory

CA
AR
Inv

CEO is always
for
looking
something which
will grow cash.

Newspaper cycles
daily,
Boeing could take
years

Appendix A: 505

Notes:

506 Exhibit

Exhibit 2: Puts and Calls


Interpret the diagrams that depict the expiration-day values of the long call, short call, long put and short put strategies;
(X = strike price, S = Stock price, C = cost of Call, P = cost of Put)

Long Call
Value

Long Put
Value
V>0

V>0

Positive

Value of the long


put will be the
amount
less
than the strike
that the stock is
trading.
Long
put will never
have a value less
than zero.

positive

0
negative

S X

Value of the long


call will be the
amount
over
strike the stock
is trading. Long
call will never
have a value less
than zero.

0
X
negative

X S

Short Call
Value

Short Put
Value

V<0

Positive

0
negative

S X

Value of the short


call will be the
amount over the
strike the stock is
trading.
Short
call will never
have a value
greater
than
zero.

V<0

Positive

0
negative

X S

Value of the
short put will be
the amount less
than the strike
the
stock
is
trading.
Short
put will never
have a value
greater
than
zero.

Interpret the profit/loss diagrams for the long call, short call, long put, and short put strategies;
Long Call
Long Put
Loss < C, Profit > X+C

Loss < X+P, Profit < X

Profit

Profit

0
cost of C

Loss

X+C
stock price

Profit of the long


call is the amount
over the strike +
cost of the call
(X+C). Loss on the
call is the amount
the stock is under
the call + strike,
not to exceed the
cost of the call.

0
cost of P
Loss

stock price

Short Call

Short Put

Loss > X+C, Profit < X+C


Profit
Recd fm C

0
Loss

X+C

stock price

X+P

Profit the long


put
is
the
amount under
the strike and
cost of the put.
Loss on the put
is the amount
the stock is over
the strike, not to
exceed the cost
of the put.

Profit of the short


call is the amount
under the strike +
cost of the call
(X+C), not to exceed
the proceeds received
from the call. Loss
on the call is the
amount the stock is
over the call + strike.

Loss > X, Profit > X


Profit

Profit the short


put is the amount
more than the
strike of the put,
not to exceed the
proceeds received
from the put.
Loss on the put is
X+P
the amount the
stock is less than
stock price
the strike.

Recd fm C

0
Loss

Appendix A: 507

Notes:

508 Exhibit

Exhibit 3: PE Breakdown
Note: 3 Stage ROE

Profit Margin * Total Asset Turnover * Financial Leverage


NI
*
Sales
*
Total Assets
Sales
Total Assets
Equity

Editors Review:
Income Statement
Sales
- COGS
Gross
Margin
- Expenses

(mgmt hides its perks if EAT is


OK)

EBIT
- Interest

Bank happy

EBT

What
mgmt
shareholders

- Taxes

Govt happy

EAT

Stockholders happy

earns

for

Appendix A: 509
EAT = EBT - EBT(t)
EAT = EBT(1-t)
Expected EPS = Expected Sales/share

* Expected Net profit Margin


Income Stmt: Next years projected
[ (S)
(EBDIT) - D - I ] (1-t)
pending
ratio
Depr Inter tax
sales
per shr Exp adj

We know last years P & P/E


Can calc next years earnings
then Proportion via P/E to get Pproj EOY
Pproj EOY = (EProj EOY) (P/E)
Earnings, DDM & ROE Calc
P = Div / Earn
E
kg

Dividend pay-out
k-g

(Retention) (ROE)
k = Real Rate + Interest Prem + Risk Prem
Tax * Interest * Operg * Asset
Nominal rate should really multiply Reten Burden
Profit
Turnover
Rate
Margin
k = Rf + (Rm - Rf) is # units of risk in the stock
Stockholders want and pay for k, k determines the P NI * EBT *
EBT
EBIT
P0 = D 1
k-g
WACC = (weke) + (wdkd)

EBIT * Sls
Sls

Assets

ReturnEstimated = Cash Div + PriceEnd - PriceNow


PriceNow

restate:

EBIT * Sls *
Sls
Assets

Assets
Equity

Oper
Total
-Interest
Financial * Tax
Profit * Asset
Expense * Leverage
Retention
Margin Turnover Rate
Multiplier
Rate

P0 = D 1
k-g
T)

P0 = D 1
k-g

* Financial
Leverage

k= D +g
P

Assets

Bad

Int

* Assets

Equity

side

(1 -

Note: tax ret (1-t)

Good

side

= k = Rf + (Rm - Rf) also k = (1+RR)(1+IP)(1+RP)


real infl risk
should be in equilibrium

510 Exhibit

Exhibit 4: Ratios
calculate the financial ratios in each major category of analysis and discuss the uses of those ratios;
Common Size Statements: B/S in percent of Total Assets, I/S in percent of Sales
Quickly compare two different size firms, same firm trends over time, structure of firms financial
statements
Internal Liquidity (Solvency): ability of firm to meet future short term obligations, compare near term
obligations with current assets or cash flows
Current Ratio: Current Assets
Current Liabilities
Quick ratio
Acid Test

Cash + mkt sec + AR


CL

Working Capital = CA - CL

not include. inventory


a.k.a. Quick Ratio

CA - Inv
CL

Cash ratio

Cash + mkt sec


CL

Receivables Turnover
Days Receivable
Working Cap / Sales

even more conservative

Avg collection:
Net Annual Sales
Avg Receivables
365
Avg Receivables

365
Annual Turnover

Avg # of days to get paid

higher % indicates more liquidity


CA - CL
Net Sales

@ payable period:
365
Payables Turnover COGS
@ AP (do they pay their bills) Annual Turnover
Operating Performance:

How well management is operating the business

Operating Efficiency Ratios:

How management uses its assets and capital

Activity ratios:
Inventory Turnover

sales per something


@ Inventory period
COGS
@ Inventory

365
Inventory

Turnover
Total Asset Turnover
Fixed Asset Turnover

high or low relative to industry?


Net Sales
@ Tot Net Assets
low:
tie up too much assets
utilization of fixed assets
Net Sales
@ Net Fixed Assets
hi: old depr equipment

Appendix A: 511
Equity Turnover

excludes CL & LT Debt


Net Sales
Average Equity
Avg collection period:
Net Annual Sales
Avg Receivables

Receivables Turnover

365
Annual Turnover

Operating Profitability: rate of profit on sales, % return on capital


(How good is mgmt turning profits into sales)
Note: Run down Income Statement and ratio to Sales (GP, EBIT, EBT, EAT)
EBIT:
Mgmt earns
Tax:

Government earns

Interest:

Bankers earn

EBT:

Stockholders earn

Gross Profit Margin

Gross Profit
Net Sales

(GP = Sls - COGS)


relative cost price position in industry?

Operating Profit Margin

Operating Profit
Net Sales

(EBIT)
variability is business risk indicator

Net Profit Margin

Net Income
Net Sales

NI = EAT

EBT Margin

before tax profit margin

EBT
Net Sales

Common Size Income Statement


lists all expense and income items as a % of sales
(Inc Stmt: / Sls) (Bal: / Sls or Tot Assets)
Return on Total Capital

Net Income + Interest Expense Debt, Pref. Stock, C Stock


Average Total Capital
return on all capital

employed
Return on Total Equity
Return on Owners Equity
Return on Equity (ROE):

Net Income
@ Total Equity

ROE

Net Income Preferred Dividend


@ Common Equity
DuPont System duPont formulation
ROE = NI / Equity or EAT/Equity

512 Exhibit
3 Step ROE =

NI

Net
Equity

*
Asset
* Financial
a.k.a.Equity Multiplier
Profit
Turnover
Leverage
Margin
NI
Sls

4 Step ROE

NI

=
Tax
Equity

Oper

*
Total
Profit
Margin
EBIT
Sls

Assets
Equity

Note:(Sls)(Assets)
(Sls)(Assets)

* Interest * Operg * Asset * Financial


Reten
Burden
Profit
Turnover
Leverage
NI *
EBT

5 Step Equation =

Sls
Assets

EBT * EBIT
EBIT
Sls

Sls
Assets

Assets
Equity

Interest
Financial *
Tax
Asset
Expense *
Leverage
Turnover
Rate
Multiplier
Sls
Assets

Int
Assets

Assets
Equity

Retention
Rate
*

(1 - T)

Financial Risk: Uncertainty of returns to equity holders due to a firms use of fixed obligation debt
securities
Debt / Equity

LTD / LT Cap

remember firm value is Db + Eq


Db=1, Eq=2, firm value = 3, D/E =
(not D/E=1/3, easy mistake in a hurry)
LTD = Long Term Debt

LT Cap = Long Term Capital

Total Debt / Total Capital


NI + Tax + Int Exp
EBIT
Interest Expense
Int Exp
(Note: Look for this on the exam

Interest Coverage

Cash Flow / LTD


Cash Flow / Total Debt

Appendix A: 513
Growth Analysis
Retention rate
earnings retained / total earnings
(remember: growth = retention rate * ROE)
ROE

see above, profitability

Total Asset Turnover

see above, operational performance

Total Assets / Equity

note component of ROE

Net Profit Margin

see above, profitability

Sustainable growth rate

g = retention * ROE

retention rate = 1 (Oper Inc after taxes)


Risk Analysis: uncertainty of income flows for the total firm and for sources of capital
Business Risk: Uncertainty of income caused by a firms industry
Variability of sales due to products, customers, production methods
Business Risk Coefficient of variation of operating income CV = /mean
Standard Deviation of Operating Earnings (OE)
Mean Operating Earnings
Sales Volatility
sd of sales
mean sales

need 5<Thru> 10 yrs


to compute coef of variation

Coefficient of Variation of Sales CV = /mean


prime determinant of earnings variability

Operating Leverage %OE / %Sls or | [%OE] / [%Sls] | / N employment of fixed production


costs direction of change not important, but relative size of the change is relevant
OL = % change in operating earnings / % change in

sales , calc from #s not %

514 Practice Exam Features

FinancialExam Features
Using FinancialExams Quizzer
In Brief .......................................................................................................................................515
Study Session..................................................................................................................514
Practice Exams..........................................................................................................................516
FinancialExams Quizzer Features ............................................................................................517
Online Help ......................................................................................................................517
Email:...............................................................................................................................517
Telephone:.......................................................................................................................517
Changing subjects ...........................................................................................................518
Changing the number of questions..................................................................................518
Changing the subcategories............................................................................................518
Setting up your printer .....................................................................................................518
Printing questions ............................................................................................................518
Using FinancialExams Quizzer options ...........................................................................519
The Adaptive Exam ...................................................................................................................519
How to take advantage of Adaptive testing: ....................................................................519
Take the Adaptive Exam .................................................................................................519
Reviewing an Adaptive Exam..........................................................................................520
Starting a Study Session ...........................................................................................................520
Checking your score during a test ...................................................................................521
Checking your performance ............................................................................................521
Checking your overall progress .......................................................................................521
Simulated Exam ........................................................................................................................521
Take the Simulated Exam ...............................................................................................521
Reviewing a Simulated Exam..........................................................................................522
FlashCard Option ......................................................................................................................522
Starting a FlashCard Session....................................................................................................523
How to use a FlashCards ..........................................................................................................523
Taking Notes .............................................................................................................................523
Take notes from a study session.....................................................................................523
Export your notes.............................................................................................................523

Practice Exam Features 515

Using FinancialExams Quizzer


In Brief
The FinancialExams Quizzer exam software is designed to identify your personal areas of
weakness relative to passing specific exam objectives. Once this software determines just what
those weaknesses are, it will force you to continually face them until you can demonstrate
mastery over them. Then it will find something else to haunt you with.
To use this software successfully, follow these simple steps.
1) Spend some time getting familiar with the program. When youre ready to settle down to
work, clear the history (the button is on the main screen). Do not clear the history again
until all of the following steps have been completed.
2) Take four (4) Adaptive Exams. During this process, you have no choices. The software is
in control. It is using its internal logic to determine your strengths and weaknesses on a
topic-by-topic basis. (Note: You dont have to take all four at one sitting.)
3) After the four Adaptive Exams, look at your Historical Analysis (the button is on the
main screen). This will give you a graphical presentation of how you have done
cumulatively in each category. Let this be your guide as to which subcategories to begin
studying. Start with your weakest and work your way up.
4) Begin taking Study Sessions on selected topics. Select the Category and Subcategories
that you will be focusing on. You have two primary goals in Study Session mode.
a) See and answer every question on that topic at least once. Keep in mind that any
question answered incorrectly will be in the very next Study Session you take on that
topic. Once you are able to answer it correctly, it will get shuffled to the bottom of the
deck. When you have cycled through available questions, correctly answered questions
will begin to reappear.
b) Achieve a minimum score of at least 85% on each and every subcategory topic before
moving on to the Simulated Exam. If you want to bounce around a little between
subcategories a little, thats okay. The program will remember where you left off.
However, its important that you dont cheat yourself on this step.
5) Take the Simulated Exam. Dont be too disappointed if you dont pass the first time. The
software has been gaining knowledge about your weaknesses and has just done
everything in its power to make you fail this exam. Arent you glad that wasnt the real
thing?
6) Clear your history and repeat the above steps two more times. Thats right two more
times. But now, achieve a minimum of 90% and 95% respectfully on each pass through
before taking the Simulated Exam.
You will find that the number of Study Sessions and the amount of time necessary to achieve
these scores will get smaller. The better you know the material, the quicker the whole process
becomes.
The rest of this document goes into more detail on using specific features of the FinancialExams
Quizzer software. Spend some time getting to know this program. It has helped thousands of
people achieve their certification goals. It can do the same for you.

516 Practice Exam Features

Study Session
FinancialExams Quizzer tests your knowledge as you learn about new subjects through
interactive quiz sessions. Study Session questions are selected from a single database for each
session, dependent on the subcategory selected and the number of times each question has been
previously answered correctly. In this way, questions you have answered correctly are not
repeated until you have answered all the new questions. Questions that you have missed
previously will reappear in later sessions and keep coming back to haunt you until you get the
question correct. In addition, you can track your progress by displaying the number of questions
you have answered with the Historical Analysis option. You can reset the progress tracking by
clicking on the Clear History button. Each time a question is presented the answers are
randomized so you will not memorize a pattern or letter that goes with the question. You will
start to memorize the correct answer that goes with the question concept.

Practice Exams
FinancialExams Quizzer also provides Adaptive and Simulated certification exams. Questions are
chosen at random from the database. The Simulated Exam is a timed test that presents a similar
number of questions as the real exam. A break from testing occurs at the mid-point of the exam.
The Adaptive Exam presents a fixed number questions with a maximum time allotment. The
Adaptive Exam is most helpful in identifying areas of weakness in the candidates knowledge of
the exam objectives.
After you finish an exam, FinancialExams Quizzer displays your score and the passing score
required for the FinancialExams Quizzer test. You may display the exam results of this specific
exam from this menu. You may review each question, display the correct answer, identify a
resource, link to an available electronic book and view an explanation for the answer.

Practice Exam Features 517

FinancialExams Quizzer Features


1.

Each database contains 200 to


1200+ questions
3.
Easy to upgrade

2.

5.

Essay style questions

6.

7.
9.
11.

Performance based questions


Questions randomized
Print a category of questions

8.
10.
12.

13.
15.
17.

Single module studies


Simulation exam studies
Instant exam feedback

14.
16.
18.

Statistical analysis
Individual exam analysis
Font selection
Graphics
User Notes creation
Some Links to Electronic Book
content
31.
Free version updates via email

20.
22.
24.
26.
28.
30.

19.
21.
23.
25.
27.
29.

4.

32.

Easy to install
Multiple choice Style
questions
Fill-in-the-blank Style
questions
Flash Card Style questions
Hot Spot Style questions
Drag/Drop/Mix/Match
questions
Answers randomized
Print one question
Cheat key or Flash Card
option
Instant question feedback
Adaptive exam studies
Skills assessment
Historical analysis
Resizable screen
Most have Explanations
References

Online Help
This manual installs on your PC along with the FinancialExams Quizzer. To access it, select
Contents from the Help pull-down menu. Additional help can be obtained via:

Email:
Support@BFQPress.com
AskTheExpert@BFQPress.com
CustomerService@BFQPress.com

Telephone:
Toll Free:
International:
Fax:

(888) 992-3131
(281) 992-3131
(281) 482-5390

518 Practice Exam Features

Changing subjects
FinancialExams Quizzer provides several practice exams to test your knowledge. To change
exams:
1.
2.
3.

Click the Change Exam button in the Main window.


Select the exam for the test you want to run from the Select Exam window.
Click OK to change to the selected exam, or the Cancel to keep the current exam.

Changing the number of questions


You can choose the number of questions presented in each quiz session. To change the number of
questions:
1.
2.
3.

Click on the box to the right of the Number of Questions field in the Main window.
Type a number of questions, between 1 and 250, in the Number of Questions field.
If the number of questions selected exceeds the number available in the chosen
subcategory, all that are available will be displayed.

Changing the subcategories


Each FinancialExams Quizzer subject has a number of categories and subcategories. You can take
a test on any one or any combination of the subcategories.
1.
2.

From the Subcategories frame, select the desired general category from the Categories
drop down list.
Select the desired subcategory from the list box. To select multiple subcategories, hold
down the CTRL key while clicking items in the list box.

Setting up your printer


FinancialExams Quizzer allows you to customize your print jobs.
1.
2.
3.
4.

Select Options from the View pull-down menu.


Select the Printing Options radial button. The Printing Options window appears.
Select the options for your printer.
Click OK to exit and save changes.

Printing questions
FinancialExams Quizzer allows you to print questions from your tests, with or without the
correct answer(s) marked. To print the question(s), select the desired print option from the File
pull-down menu in the Question window.

Practice Exam Features 519

Using FinancialExams Quizzer options


FinancialExams Quizzer provides a number of additional options to customize your test. The
following options are available:
1
2
3
4

Stop On Wrong Answers


Enable Cheat Key
Resizable Screen
Font Setting

To select an advanced option, select Options from the View pull-down menu. The Exam
Preferences window appears.

Adaptive Exam
Adaptive testing is a time saving option used to identify the candidates strengths and
weaknesses. Before using Adaptive testing, clear historical Analysis. Before you learn about your
subject using the Quizzer Study Sessions, you should take the Adaptive exams. This exam style
does not simulate all of the exam environments that are found on certification exams. You cannot
choose specific subcategories for the Adaptive exam and once a question has been answered you
cannot go back to a previous question. You have a time limit in which to complete the adaptive
exam. This time varies from subject to subject, although it is usually 15 to 25 questions in 30
minutes. When the time limit has been reached, your exam automatically ends.

How to take advantage of Adaptive testing:


1.
2.
3.
4.
5.

Clear the Historical Analysis


Take four (4) adaptive exams in a row. Study the contents after each adaptive exam.
View the historical analysis to identify your strength and weakness at the end of the four
(4) adaptive exams.
Go back to reviewing using the Study Sessions by Sub Category
Repeat process until you are ready to pass the real exam.

Take the Adaptive Exam


1.
2.
3.

4.

Click the Adaptive Exam radial button from the Main window.
Click the Start button. The Adaptive Exam window appears.
Click the circle to the left of the correct answer. There may be more than one correct
answer. Text in the bottom left corner of the window instructs you to Choose the Best
Answer (if there is only one answer) or Mark All Correct Answers (if there is more than
one correct answer).
Click the Next button to continue.

520 Practice Exam Features


After the allotted time has elapsed, the exam exits to review mode. To quit the test at any time,
click the Finish button. After you have completed the Adaptive exam, FinancialExams Quizzer
displays your score and the passing score required for the test. Display your exam results by
selecting Details You may review each question, display the correct answer, and view an
explanation for the answer (if available).

Reviewing an Adaptive Exam


After you have taken an Adaptive exam, you can review the questions, your answers, and the
correct answers. You may only review your questions immediately after completing an Adaptive
exam. To review your questions:
1.
2.

Click the Correct Answer button.


To see your answer, click the Your Answer button.

Starting a Study Session


After you choose a subcategory to test yourself on, start the Study Session.
To start a study session:
1.
2.

Select the Study Session radial button.


Click the Start button. The Question window appears. Optionally, you can select Study
Session from the Start pull-down menu. Click the checkbox to the left of the correct
answer. There may be more than one correct answer. Text in the bottom left corner of
the window instructs you to Choose the Best Answer (if there is only one answer) or
Mark All Correct Answers (if there is more than one correct answer).
3. Click the Next button to continue. FinancialExams Quizzer provides immediate feedback
on your answer at the bottom of the window.
If you answered the question correctly, a new question appears. If you did not answer the
question correctly, you may try to guess again or move to the next question. If you have selected
the Prompt on Wrong Answers option, you have the following choices:
1. To try again, click the Try Again button.
2. To move to the next question after an incorrect guess, click the Next Question button.
3. View the correct answer
4. View the Explanation option
To quit the test at any time, click the Finish button.

Practice Exam Features 521

Checking your score during a test


The X% button displays the current percentage of questions that have been answered correctly.
1.
2.

Click the X% button. A window appears displaying the number of questions that have
been asked and the number of questions that have been answered correctly.
Click OK to return to the test.

Checking your performance


Click the QID button. A window appears, displaying the number of times you have been asked
this question and the number of times you have answered this question correctly.

Checking your overall progress


1.
2.

3.

Click the Historical Analysis button from the Main window. The Historical Analysis
window appears.
FinancialExams Quizzer displays your progress in each test using a graphical progress
bar. Hold the cursor over the progress bar and a dialog box will open. The number of
times you have answered questions in that category correctly as a percentage of the
total number of questions is displayed.
To get detailed information on your performance on any subject, click and hold the
progress bar for that subject. FinancialExams Quizzer displays the performance details
in the bottom left hand corner of the screen.

Simulated Exam
After you have learned about your subject using the Study Sessions, you can take a simulated
exam. This exam simulates the exam environment that might be found on a certification exam.
You cannot choose subcategories for a Simulated Exam. You have a fixed limit equal to that of the
real exam to complete the Simulated Exam. When this time limit has been reached, your exam
automatically ends.

Take the Simulated Exam


1. Click the Simulated Exam radial button from the Main window.
2. Click the Start button. The Simulated Exam window appears.
3. Click the circle to the left of the correct answer.
There may be more than one correct answer. Text in the bottom left corner of the window
instructs you to Choose the Best Answer (if there is only one answer) or Mark All Correct
Answers (if there is more than one correct answer).

522 Practice Exam Features


4.

If you are unsure of the answer and wish to mark the question so you can return to it
later, check the Mark box in the upper left hand corner. To review which questions you
have marked, which you have answered, and which you have not answered, click the
Review button.
5. Click the Next button to continue.
After the allotted time for testing, the exam exits to review mode. To quit the test at any time,
click the Finish button. After you have completed the Simulated Exam, FinancialExams Quizzer
displays your score and the passing score required for the test. Display your exam results by
selecting Details. You may review each question, display the correct answer, and view an
explanation for the answer (if available).

Reviewing a Simulated Exam


After you have taken a simulated exam, you can review the questions, your answers, and the
correct answers. You may only review your questions immediately after a Simulated Exam.
To review your questions:
1.
2.

Click the Correct Answer button.


To see your answer, click the Your Answer button.

FlashCard Option
After you have learned about your subject using the Study Sessions, Adaptive, and Simulated
exam go to the Thinking Option. The FlashCard environment is very different and will help you
more that you might believe on a certification exam. The Flash Card Option is very effect when
used with Terminology or Glossary Fill-in-the-Blank style questions.
Read the displayed question, Think of the answer, Hit the F4 Function key to display the correct
answer, Read the Answer, Go to the next question.
1.
2.
3.
4.
5.

You should not view the answer until you have thought about the answer.
You have an unlimited time limit to think about each question.
Use this option a few days before the real exam to go through a lot of questions in a short
period of time.
The FlashCard option can be used as a review of all questions in the database.
Use the FlashCard option to provide Positive Feed Back with Correct Answers.

Practice Exam Features 523

Starting a FlashCard Session


After you choose a subcategory to test yourself on, start FlashCards.
1.
2.

3.
4.
5.

Select the FlashCards Session radial button.


Click the Start button. The Question window appears. Optionally, you can select
FlashCards Session from the Start pull-down menu. You will find no answers to check
or any visible area to type your answer into.
This is the time to THINK of the answer. Pause a moment than hit the F4 function on
your keyboard. (CheatKey)
Review the displayed answer. Did you get it correct?
When you are ready to proceed Click the Next button to continue.

How to use a FlashCards


1. Read the displayed question
2. Think of the answer
3. Hit the F4 Function key to display the correct answer
4. Read the Answer
5. Go to the next question.
To quit the test at any time, click the Finish button.
Note: Some questions may ask for more than one answer: Bypass questions that state "Which of
the Following" and "Select all that apply" etc.

Taking Notes
While you are taking your exam, you may wish to write down notes about a particular question
that you can use in later Study Sessions. FinancialExams Quizzer allows you to enter notes about
each question. The notes will be permanently stored in the database for the subject you are
studying. You can also use this feature to record any comments you have about a particular
question and send it in for review. If you would like to print or view your notes, you can export
your notes to a standard text editor.

Take notes from a study session


Create your own information or reference.
1. Click the Notes button from the Question window.
2. Type your note.
3. Click OK to keep the note, or Cancel to delete the note.
Note: You cannot take notes during a Simulated or Adaptive session until you have finished the
exam and have entered the Review mode.

Export your notes


Click the Notes button from the Main window and export to Note Pad or any text editor you
wish to use.

526 CFA Exam Forum

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