SESSION 2

Question 1: Responsibilities of a board of directors' nominations committee are least likely to include:
A. recruiting qualified members to the board.
B. evaluating the independence of directors.
C. selecting an external auditor for the company.
Explanation
C is correct. Selecting an external auditor (subject to shareholder approval) is a responsibility of the Board's audit committee.

Question 2: Debrin Company uses a tiered pricing strategy. Debrin is most likely to:
A. offer a discount for buying a large number of units.
B. charge higher prices during peak times of day.
C. set a temporarily low price until it builds market share and scales up production.
Explanation
A is correct. Tiered pricing refers to setting prices based on a customer's volume of purchases.

Question 3: In Fama and French's multifactor model, the expected return on a stock is explained by:
A. excess return on the market portfolio, book-to-market ratio, and price momentum.
B. firm size, book-to-market ratio, and excess return on the market portfolio.
C. firm size, book-to-market ratio, and price momentum.
Explanation
B is correct. In the Fama and French model, the three factors that explain individual stock returns are firm size, the firm's
book value-to-market value ratio, and the excess return on the market portfolio. The Carhart model added price momentum
as a fourth factor.

Question 4: Under which business structure are profits potentially subject to double taxation?
A. Corporation.
B. General partnership.
C. Limited partnership.
Explanation
A is correct. Double taxation refers to a situation in which a country taxes corporations' gross earnings and then taxes net
earnings distributed to owners (dividends) as personal income. Partnership profits are subject to only one level of taxation
(they are personal income of the partners).

Question 5: A mutual fund that invests in short-term debt securities and maintains a net asset value of $1.00 per share is best
described as a:
A. balanced fund.
B. bond mutual fund.
C. money market fund.
Explanation
C is correct. Money market funds invest primarily in short-term debt securities and are managed to maintain a constant net
asset value, typically one unit of currency per share. A bond mutual fund typically invests in longer-maturity securities than
a money market fund. A balanced fund invests in both debt and equity securities.

Question 6: Which of the following statements about the optimal portfolio is NOT correct? The optimal portfolio:
A. is the portfolio that gives the investor the maximum level of return.
B. lies at the point of tangency between the efficient frontier and the indifference curve with the highest possible utility.
C. may be different for different investors.
Explanation
A is correct. This statement is incorrect because it does not specify that risk must also be considered.

Question 7: One of the basic principles of capital allocation is that:

A. opportunity costs should be excluded from the analysis of a project.
B. decisions are based on cash flows.
C. projects should be analyzed on a pre-tax basis.
Explanation
B is correct. Key principles of the capital allocation process are:
1. Decisions are based on cash flows, not accounting income.
2. Cash flows are based on opportunity costs.
3. The timing of cash flows is important.
 4. Cash flows are analyzed on an after-tax basis.
5. Financing costs are reflected in the project's required rate of return.

Question 8: The condition that occurs when a company disburses cash too quickly, stretching the company's cash reserves,
is best described as a:
A. pull on liquidity.
B. drag on liquidity.
C. liquidity premium.
Explanation
A is correct. When cash payments are made too quickly, the condition is known as a pull on liquidity. A drag on liquidity
occurs when cash inflows lag.

Question 9: When developing the strategic asset allocation in an IPS, the correlations of returns:
A. among asset classes should be relatively high.
B. within an asset class should be relatively high.
C. within an asset class should be relatively low.
Explanation
B is correct. Asset classes are defined such that correlations of returns within an asset class are relatively high. Low
correlations of returns among asset classes increase the benefits of diversification across asset classes.

Question 10: A $100 par, 8% preferred stock is currently selling for $80. What is the cost of preferred equity?
A. 8.0%.
B. 10.0%.
C. 10.8%.
Explanation
B is correct. kps = $8 / $80 = 10%.

Question 11: Under the assumptions of Modigliani and Miller's Proposition I, the value of a firm:
A. decreases as the use of equity financing rises.
B. increases as the use of debt financing rises.
C. is not affected by its capital structure.
Explanation
C is correct. According to Modigliani and Miller's Proposition I, under certain assumptions, including the absence of taxes
and bankruptcy costs, the value of a firm is unaffected by its capital structure.

Question 12: Sarah Kowalski bought a growth stock for $45 per share that subsequently fell by 35%, and she is reluctant to
sell as she hopes the stock bounces back. Kowalski is most likely exhibiting:
A. availability bias.
B. self-control bias.
C. loss-aversion bias.
Explanation
C is correct. Loss-aversion bias arises from feeling more pain from a loss than pleasure from an equal gain. A consequence
of this bias is that investors may hold onto positions with the hope of getting even rather than selling the position at a loss.
Self-control bias occurs when individuals lack self-discipline and favor short-term satisfaction over long-term goals.
Availability bias occurs when putting undue emphasis on information that is readily available, easy to recall, or based narrowly
on personal experience or knowledge.

Question 13: Examples of financial risks include:

A. credit risk, market risk, and liquidity risk.
B. market risk, liquidity risk, and tax risk.
C. solvency risk, credit risk, and market risk.
Explanation
A is correct. Credit risk, market risk, and liquidity risk are examples of financial risk. Solvency risk and tax risk are classified
as non-financial risks.

Question 14: Which of the following statements about business risk and financial risk is least accurate?
A. Business risk is the riskiness of the company's assets if it uses no debt.
B. The greater a company's business risk, the higher its optimal debt ratio.
C. Factors that affect business risk are demand, sales price, and input price variability.
Explanation
B is correct. The greater a company's business risk, the lower its optimal debt ratio.

Question 15: Which of the following is the least appropriate method for estimating a firm's before-tax cost of debt capital?
A. Use the market yield on bonds with a rating and maturity similar to the firm’s existing debt.
B. Assume the firm’s cost of debt capital is equal to the yield to maturity on its publicly traded debt.
C. Use the coupon rate on the firm’s most recently issued debt.
Explanation
C is correct. Current market yields, not the coupon rate, should be used to estimate the cost of debt capital.

Question 16: Increasing a company's risk exposure in an effort to increase its growth rate is most likely to be favored by:
A. owners but not lenders.
B. both lenders and owners.
C. neither lenders nor owners.
Explanation
A is correct. Because the upside for lenders is limited to the promised interest payments and repayment of principal, they do
not benefit from an increased growth rate of the company and are unlikely to favor actions that increase a company's risk
exposure and potential for default. Because owners have potentially unlimited upside from a company's growth, they are more
likely to favor actions that increase a company's potential growth rate.

Question 17: Bollinger bands are drawn based on the:

A. difference between two smoothed moving averages.
B. high and low prices in a recent period.
C. standard deviation of recent price changes.
Explanation
C is correct. To use Bollinger bands, an analyst will calculate the standard deviation of prices over some number of trading
days, and typically will draw the bands two standard deviations above and below a moving average for the same number of
days.

Question 18: The technique in which a machine learns to model a set of output data from a given set of inputs is best described
as:
A. deep learning.
B. supervised learning.
C. unsupervised learning.
Explanation
B is correct. Supervised learning is a machine learning technique in which a machine is given labeled input and output data
and then models the output data based on the input data. In unsupervised learning, a machine is given input data in which to
identify patterns and relationships, but no output data to model. Deep learning is a technique to identify patterns of increasing
complexity, and may use supervised or unsupervised learning.

Question 19: Which of the following factors is most likely to cause a firm to need short-term financing?
A. Return of principal from maturing investments.
B. Shorter cash conversion cycle than the industry average.
C. Operating cash inflows that fluctuate seasonally.
Explanation
C is correct. Firms with operating cash inflows that fluctuate seasonally are likely to experience shortterm imbalances
between cash inflows and cash outflows and must forecast these imbalances to manage their net daily cash positions, for
example by arranging short-term borrowing over seasons when operating cash inflows are expected to be relatively low and
operating cash outflows are relatively high.

Question 20: The most appropriate measure of the increase in the purchasing power of a portfolio's value over a given span
of time is a(n):
A. holding period return.
B. after-tax return.
C. real return.
Explanation
C is correct. A real return is adjusted for the effects of inflation and is used to measure the increase in purchasing power over
time.
Question 21: Which of the following is a key determinant of operating leverage?
A. Level and cost of debt.
B. The tradeoff between fixed and variable costs.
C. The competitive nature of the business.
Explanation
B is correct. Operating leverage can be defined as the trade off between variable and fixed costs.

Question 22: Which of the following is least likely to be a reason why a firm's actual capital structure may vary from the
target capital structure?
A. The firm decides to issue additional equity because management believes the firm’s stock is overpriced.
B. The firm decides to issue additional debt due to a temporary discount in underwriting fees for corporate debt.
C. The firm decides to finance a low risk project with 100% debt to improve the project’s profitability.
Explanation
C is correct. A firm should always finance a project based on the firm's weighted average cost of capital, although when
evaluating a project, the firm may apply a risk factor to adjust the risk of the project. A corporate manager generally cannot
deem some projects as being financed by debt and some by equity as all projects are effectively financed proportionately
based on the firm's capital structure. In practice, a firm's actual capital structure will float around its target. For a firm that
does have a target capital structure, the actual structure may vary from the target due to market value fluctuations, or
management's desire to exploit an opportunity in a particular financing source.

Question 23: According to capital market theory, which of the following represents the risky portfolio that should be held by
all investors who desire to hold risky assets?
A. The point of tangency between the capital market line (CML) and the efficient frontier.
B. Any point on the efficient frontier and to the left of the point of tangency between the CML and the efficient frontier.
C. Any point on the efficient frontier and to the right of the point of tangency between the CML and the efficient frontier.
Explanation
A is correct. Capital market theory suggests that all investors should invest in the same portfolio of risky assets, and this
portfolio is located at the point of tangency of the CML and the efficient frontier of risky assets. Any point below the CML is
suboptimal, and points above the CML are not feasible.

Question 24: An example of macro risk that companies may face is:
A. exchange-rate risk.
B. ESG risk.
C. capital investment risk.
Explanation
A is correct. Macro risks include economic factors such as exchange-rate changes. ESG risk and capital investment risk are
examples of firm-specific risks.

Question 25: Garner Corporation is investing $30 million in new capital equipment. The present value of future after-tax
cash flows generated by the equipment is estimated to be $50 million. Currently, Garner has a stock price of $28.00 per share
with 8 million shares outstanding. Assuming that this project represents new information and is independent of other
expectations about the company, what should the effect of the project theoretically be on the firm's stock price?
A. The stock price will increase to $30.50.
B. The stock price will increase to $34.25.
C. The stock price will remain unchanged.
Explanation
A is correct. In theory, a positive NPV project should provide an increase in the value of a firm's shares.
NPV of new capital equipment = $50 million - $30 million = $20 million
Value of company prior to equipment purchase = 8,000,000 × $28.00 = $224,000,000
Value of company after new equipment project = $224 million + $20 million = $244 million
Price per share after new equipment project = $244 million / 8 million = $30.50
Note that in reality, changes in stock prices result from changes in expectations more than changes in NPV.

Question 26: Which of the following statements is most accurate about integrating ESG considerations into portfolio planning
and construction?
A. Investors who engage in active ownership to pursue their ESG considerations should vote their shares themselves rather
than delegating share voting to an investment manager.
B. Integrating ESG considerations into portfolio planning and construction is likely to decrease portfolio returns.
C. A broad market index is an inappropriate benchmark for a portfolio that uses negative screening to address the investor’s
ESG concerns.
Explanation
C is correct. If a portfolio's investment universe is constrained by negative screening, an appropriate benchmark is an index
that excludes companies or industries that investors with ESG concerns commonly avoid.
Investors engaging in active ownership to pursue their ESG considerations may choose to vote their shares themselves or
instruct an investment manager to vote the shares.
The effect of integrating ESG considerations on portfolio returns is uncertain. While limiting the universe of investment
choices and incurring the costs involved in considering ESG factors may decrease returns, investing in companies with good
corporate governance practices and avoiding those that face ESG-related risks may increase returns.

Question 27: An analyst gathered the following information for ABC Company, which has a target capital structure of 70%
common equity and 30% debt:
Expected market return 9.00%
Risk-free rate 4.00%
Tax rate 40%
Beta 0.90
Bond yield-to-maturity 8.00%
ABC's weighted-average cost of capital is closest to:
A. 8.4%.
B. 6.9%.
C. 7.4%.
Explanation
C is correct. The problem must be solved in two steps. First, calculate the cost of equity:
rCE = Rf + β(RM – Rf) = 0.04 + 0.9(0.09 – 0.04) = 0.085 = 8.5%
Next, calculate the WACC.
WACC = wDrD(1 – t) + wPrP + wCErCE = (0.30)(0.08)(1 – 0.40) + 0 + (0.70)(0.085) = 0.0739 or 7.39%.

Question 28: The following information reflects the projected operating results for Opstalan, a catalog printer.

• Sales = $5.0 million.

• Variable Costs = 40% of sales.
• Fixed Costs = $1.0 million.
• Interest expense = $105,000.
• Tax Rate = 0.0%.
Opstalan's degree of total leverage (DTL) is closest to:
A. 1.41.
B. 2.58.
C. 1.59.
Explanation
C is correct. First, calculate the operating results:
Opstalan Annual Operating Results
Sales $5,000,000
– Variable Costs1 2,000,000
Contribution Margin 3,000,000
– Fixed Costs 1,000,000
EBIT 2,000,000
– Interest Expense 105,000
EBT = Earnings 1,895,000
1Variable costs = 0.40 × 5,000,000
Second, calculate DOL = (Sales – Variable Costs) / (Sales – Variable Costs – Fixed Costs) = 3,000,000 / 2,000,000 = 1.50
Third, calculate DFL = EBIT / (EBIT – I) = 2,000,000 / 1,895,000 = 1.06.
Finally, calculate DTL = DOL × DFL = 1.50 × 1.06 = 1.59.
Question 29: In a perfectly efficient market, portfolio managers should do all of the following EXCEPT:
A. diversify to eliminate systematic risk.
B. monitor their client's needs and circumstances.
C. quantify their risk and return needs within the bounds of the client's liquidity, income, time horizon, legal, and regulatory
constraints.
Explanation
A is correct. Portfolio managers cannot eliminate systematic risk (i.e., market risk) thru the use of diversification. Portfolio
managers should try to eliminate unsystematic portfolio risk.

Question 30: A disadvantage of G-spreads and I-spreads is that they are theoretically correct only if the spot yield curve is:
A. downward sloping.
B. flat.
C. upward sloping.
Explanation
B is correct. G-spreads and I-spreads are only correct when the spot yield curve is flat (yields are about the same across
maturities).

Question 31: A futures investor receives a margin call. If the investor wishes to maintain her futures position, she must make
a deposit that restores her account to the:
A. maintenance margin.
B. daily margin.
C. initial margin.
Explanation
C is correct. In futures trading, a margin call requires the investor to restore the account to the initial margin level or close
the position.

Question 32: Compared to a traditional mutual fund, a hedge fund is more likely to feature:
A. lower leverage.
B. higher liquidity.
C. higher fees.
Explanation
C is correct. A hedge fund typically is more likely to use leverage, is less liquid, and charges higher fees than a traditional
mutual fund.

Question 33: Which of the following statements regarding primary and secondary markets is least accurate?
A. New issues of government securities can be sold on the primary market.
B. Prevailing market prices are determined by primary market transactions and are used in pricing new issues.
C. Secondary market transactions occur between two investors and do not involve the firm that originally issued the
security.
Explanation
B is correct. Prevailing market prices are determined by the transactions that take place on the secondary market. This
information is used to determine the price of new issues sold on primary markets.

Question 34: The measure of return on a security market index that includes any dividends or interest paid by the securities
in the index is known as the:
A. cash flow return.
B. total return.
C. price return.
Explanation
B is correct. The total return on a security market index includes cash flows from the securities (dividends and interest) as
well as price changes. Price return only accounts for changes in the price of the security. Cash flow return (or yield) refers to
the internal rate of return of a portfolio.

Question 35: Other things equal, an increase in storage costs of the underlying asset will:
A. decrease the no-arbitrage forward price.
B. not affect the no-arbitrage forward price.
C. increase the no-arbitrage forward price.
Explanation
C is correct. An increase in holding costs of the underlying asset increases the no-arbitrage forward price, other things equal.
Question 36: A renegotiable mortgage has a fixed interest rate that:
A. changes to a different fixed rate during its life.
B. changes to a variable rate during its life.
C. the borrower may change to a variable rate.
Explanation
A is correct. A renegotiable or rollover mortgage has an initial fixed-rate period after which the interest rate changes to
another fixed rate. A hybrid mortgage has an initial fixed-rate period after which the interest rate changes to a variable rate.
A convertible mortgage may be changed from fixed-rate to variable-rate or from variable-rate to fixed-rate at the borrower's
option.

Question 37: Which of the following statements with regard to floating rate notes that have caps and floors is most accurate?
A. A cap is an advantage to the bondholder while a floor is an advantage to the issuer.
B. A cap is a disadvantage to the bondholder while a floor is a disadvantage to the issuer.
C. A floor is a disadvantage to both the issuer and the bondholder while a cap is an advantage to both the issuer and the
bondholder.
Explanation
B is correct. A cap limits the upside potential of the coupon rate paid on the floating rate bond and is therefore a disadvantage
to the bondholder. A floor limits the downside potential of the coupon rate and is therefore a disadvantage to the bond issuer.

Question 38: Return and risk data on alternative investments may be affected by backfill bias if:
A. a firm’s historical returns are included when it is added to an index.
B. data only include currently existing firms.
C. the incorrect distribution is used to model volatility.
Explanation
A is correct. Backfill bias refers to bias introduced by including the previous performance data for firms added to a benchmark
index.

Question 39: A structured security is a combination of:

A. a corporate bond and a syndicated loan.
B. a medium-term note and a derivative.
C. commercial paper and a backup line of credit.
Explanation
B is correct. Medium-term notes (MTNs) that are combined with derivatives to create features desired by an investor are
known as structured securities.

Question 40: A firm's cost of equity capital is least accurately described as the:
A. expected total return on the firm’s equity shares in equilibrium.
B. minimum rate of return investors require to invest in the firm’s equity securities.
C. ratio of the firm’s net income to its average book value.
Explanation
C is correct. The ratio of the firm's net income to its average book value is the firm's return on equity, which can be greater
than, equal to, or less than the firm's cost of equity. Cost of equity for a firm can be defined as the expected equilibrium total
return in the market on its equity shares, or as minimum rate of return that investors require as compensation for the risk of
the firm's equity securities.

Question 41: Commercial index providers typically classify companies by:

A. statistical grouping.
B. principal business activity.
C. sensitivity to business cycles.
Explanation
B is correct. Commercial providers such as Standard and Poor's and MSCI Barra classify companies according to their
principal business activity and the products and services they provide.

Question 42: The risk of receiving less than market value when selling a bond is referred to as:
A. recovery rate risk.
B. market liquidity risk.
C. loss severity risk.
Explanation
B is correct. Market liquidity risk is the risk of receiving less than market value when selling a bond and is reflected in the
size of the bid-ask spreads. Market liquidity risk is greater for the bonds of less creditworthy issuers and for the bonds of
smaller issuers with relatively little publicly traded debt. Loss severity and recovery rate refer to defaults.

Question 43: With respect to venture capital, the term "mezzanine-stage financing" is used to describe the financing:
A. to initiate commercial manufacturing.
B. that supports product development and market research.
C. to prepare for an initial public offering.
Explanation
C is correct. Mezzanine-stage venture capital financing provides capital during the period prior to an initial public offering.

Question 44: An investor will exercise a European put option on a stock at its expiration date if the stock price is:
A. greater than the exercise price.
B. equal to the exercise price.
C. less than the exercise price.
Explanation
C is correct. A put option gives its owner the right to sell the underlying good at a specified exercise price for a specified
time period. When the stock's price is less than the exercise price a put option has value and is said to be in-the-money.

Question 45: A hedge fund strategy that takes positions in shares of firms undergoing restructuring or acquisition is said to
be pursuing:
A. a macro strategy.
B. an event driven strategy.
C. an equity hedge strategy.
Explanation
B is correct. Event-driven strategies include merger arbitrage, distressed/restructuring, and special situations strategies that
involve long or short positions in common equity, preferred equity, or debt of a specific corporation. Macro strategies are
based on global economic trends and events, and may involve long or short positions in equities, fixed income, currencies, or
commodities. Equity hedge strategies seek to profit from long and short positions in publicly traded equities and derivatives
with equities as their underlying assets, but are not based on events such as restructuring or acquisition.

Question 46: What is the value of a stock that paid a $0.25 dividend last year, if dividends are expected to grow at a rate of
6% forever? Assume that the risk-free rate is 5%, the expected return on the market is 10%, and the stock's beta is 0.5.
A. $17.67.
B. $16.67.
C. $3.53.
Explanation
A is correct. The discount rate is ke = 0.05 + 0.5(0.10 – 0.05) = 0.075. Use the infinite period dividend discount model to
value the stock. The stock value = D1 / (ke – g) = (0.25 × 1.06) / (0.075 – 0.06) = $17.67.

Question 47: Which of the following statements concerning the price volatility of bonds is most accurate?
A. As the yield on callable bonds approaches the coupon rate, the bond's price will approach a "floor" value.
B. Bonds with higher coupons have lower interest rate risk.
C. Bonds with longer maturities have lower interest rate risk.
Explanation
B is correct. Other things equal, bonds with higher coupons have lower interest rate risk. Note that the other statements are
false. Bonds with longer maturities have higher interest rate risk. Callable bonds have a ceiling value as yields decline.

Question 48: In order to value an option with a one-period binomial model, three things an analyst would need to know are:
A. the probability of an up-move, the option exercise price, and the current asset price.
B. the risk-free rate, the volatility of the price of the underlying, and the current asset price.
C. the risk-adjusted discount rate, the volatility of the price of the underlying asset, and option exercise price.
Explanation
B is correct. The risk-free rate, the volatility of the price of the underlying, and the current asset price are three of the required
variables needed to value an option with a one-period binomial model. The risk-adjusted rate of return and (actual) probability
of an up-move are not required.

Question 49: Which of the following shows the dividend payment chronology in its proper sequence?
A. Declaration date, ex-dividend date, holder-of-record date, payment date.
B. Declaration date, holder-of-record date, ex-dividend date, payment date.
C. Ex-dividend date, holder-of-record date, declaration date, payment date.
Explanation
A is correct. The dividend payment chronology begins with the declaration of a dividend by the board of directors. The ex-
dividend date occurs one or two business days before the holder-ofrecord date.

Question 50: Consider a $1,000-face value, 12-year, 8%, semiannual coupon bond with a YTM of 10.45%. The change in
value for a decrease in yield of 38 basis points is:
A. $21.18.
B. $22.76.
C. $23.06.
Explanation
C is correct. With YTM = 10.45% (I/Y = 5.225), PMT = 40, N = 24, FV = 1,000, PV = $834.61. With YTM = 10.07% (I/Y
= 5.035), PV = $857.67, an increase of $23.06.

Question 51: A derivative is defined as a security that has a value:

A. established outside an organized exchange.
B. stated in a contract between two counterparties.
C. based on another security, commodity, or index.
Explanation
C is correct. A derivative is a security the value of which is derived from the value of some other underlying asset. Some
derivatives trade on organized exchanges. The price at which a transaction will (or may) take place in the future is stated in a
derivatives contract.

Question 52: Social infrastructure assets most likely include:

A. broadcasting towers.
B. waste treatment plants.
C. health care facilities.
Explanation
C is correct. Health care facilities are categorized as social infrastructure. Waste treatment plants are utility infrastructure.
Broadcasting towers are communications infrastructure.

Question 53: Private equity investment securities are issued:

A. only by private firms.
B. by both public and private firms.
C. by public firms but not by private firms.
Explanation
B is correct. Private equity securities are not registered for public trading but may be issued by firms that have issued publicly
traded common stock (public firms) as well as firms that do not have any publicly traded securities (private firms). A private
investment in public equity (PIPE) is an example of private equity securities issued by a public company.

Question 54: Which of the following is least likely an example of an external credit enhancement?
A. Letter of credit.
B. Bank guarantee.
C. An excess spread account.
Explanation
C is correct. Internal credit enhancements are built into the structure of a bond issue. An excess spread account is an example
of an internal credit enhancement. An excess spread account involves setting aside amounts to protect against losses.
External credit enhancements are essentially backing from third parties, such as letters of credit or bank guarantees.

Question 55: Which of the following is NOT a reason bond market indexes are more difficult to create than stock market
indexes?
A. There is a lack of continuous trade data available for bonds.
B. The universe of bonds is much broader than that of stocks.
C. Bond deviations tend to be relatively constant.
Explanation
C is correct. Bond prices are quite volatile as measured by the bond's duration.
Question 56: Which of the following statements regarding zero-coupon bonds and spot interest rates is CORRECT?
A. If the yield to maturity on a 2-year zero coupon bond is 6%, then the 2-year spot rate is 3%.
B. Price appreciation creates all of the zero-coupon bond's return.
C. Spot interest rates will never vary across the term structure.
Explanation
B is correct. Zero-coupon bonds are quite special. Because zero-coupon bonds have no coupons (all of the bond's return
comes from price appreciation), investors have no uncertainty about the rate at which coupons will be invested. Spot rates are
defined as interest rates used to discount a single cash flow to be received in the future. If the yield to maturity on a 2-year
zero is 6%, we can say that the 2-year spot rate is 6%.

Question 57: A bond portfolio manager who wants to decrease the duration of her portfolio would most appropriately:
A. enter an interest rate swap as the floating rate payer.
B. enter an interest rate swap as the fixed rate payer.
C. take a long position in government bond futures.
Explanation
B is correct. The pay fixed side of an interest rate swap is equivalent to issuing a floating rate bond and purchasing a fixed
rate bond, which will reduce the portfolio duration, effectively substituting a floating rate bond for a fixed rate portfolio bond.
A long position in government bond futures will have gains when yields go down and losses when yields go up, increasing
the portfolio duration.

Question 58: Austin Bruno, CFA, places a fill or kill, limit buy order at 92 for a stock. Bruno's order specifies:
A. execution and clearing instructions.
B. validity and execution instructions.
C. clearing and validity instructions.
Explanation
B is correct. Fill or kill is a validity instruction as it indicates when the order can be filled (i.e. immediately or cancel the
order). A limit buy order is an execution instruction as it indicates how the order should be filled (e.g. buy at $92 or less).
Clearing instructions indicate how to settle the trade (i.e., how and when to transfer the cash and the security).

Question 59: A private equity provision that requires managers to return any periodic incentive fees resulting in investors
receiving less than 80% of profits is a:
A. high water mark.
B. drawdown.
C. clawback.
Explanation
C is correct. A clawback provision requires the manager to return any periodic incentive fees to investors that would result
in investors receiving less than 80% of the profits generated by portfolio investments as a whole.

Question 60: A bond is priced at 95.80. Using a pricing model, an analyst estimates that a 25 bp parallel upward shift in the
yield curve would decrease the bond's price to 94.75, while a 25 bp parallel downward shift in the yield curve would increase
its price to 96.75. The bond's effective convexity is closest to:
A. 4
B. 3,340.
C. –167.
Explanation
C is correct. Approximate effective convexity is calculated as [ V– + V+ – 2V0 ] / [ (V0)(change in curve)2 ].
[ 96.75 + 94.75 – 2(95.80) ] / [ (95.80)(0.0025)2 ] = –167.01.

Question 61: What is the price-weighted index of the following three stocks?

As of December 31, 2001

Company Stock Price Shares Outstanding
A $50 10,000
B $35 20,000
C $110 30,000
A. 80.
B. 65.
C. 75.
Explanation
B is correct. The price-weighted index equals [(50 + 35 + 110) / 3] = 65.

Question 62: Yield spreads tend to widen when equity market performance is:
A. stable.
B. weak.
C. strong.
Explanation
B is correct. Conditions that cause equity markets to weaken, such as poor economic growth, also tend to widen yield spreads
in the bond market. Likewise, strong equity market performance tends to coincide with narrowing yield spreads. Yield spreads
tend to narrow when equity markets are stable because investors "reaching for yield" increase their demand for bonds.

Question 63: Bea Moran wants to establish a long derivatives position in a commodity she will need to acquire in six months.
Moran observes that the six-month forward price is 45.20 and the sixmonth futures price is 45.10. This difference most likely
suggests that for this commodity:
A. long investors should prefer futures contracts to forward contracts.
B. futures prices are negatively correlated with interest rates.
C. there is an arbitrage opportunity among forward, futures, and spot prices.
Explanation
B is correct. Differences may exist between forward and futures prices for otherwise identical contracts if futures prices are
correlated with interest rates. If futures prices are negatively correlated with interest rates, daily settlement of long futures
contracts will require cash when interest rates are increasing and produce cash when interest rates are decreasing. As a result
the futures price will be lower than the forward price. The difference in price does not provide an arbitrage opportunity or
suggest that investors should prefer forward or futures contracts.

Question 64: A market's efficiency is most likely to decrease by:

A. a ban on short selling.
B. high volumes of trading activity.
C. substantial analyst coverage of exchange-listed companies.
Explanation
A is correct. Short selling helps to prevent market prices from becoming overvalued, while limiting short selling has the
opposite effect. More analyst coverage and more liquidity (high trading volume) contribute to market efficiency.

Question 65: A hedge fund has a 2-and-20 fee structure with a soft hurdle rate of 5% and a high water mark. Incentive fees
are calculated net of management fees. The fund's gross return is 15% in Year 1, -10% in Year 2, and 30% in Year 3. Incentive
fees for Year 3 will be:
A. less than 20% of the increase in value in Year 3 after management fees.
B. equal to 20% of the increase in value in Year 3 after management fees.
C. greater than 20% of the increase in value in Year 3 after management fees.
Explanation
A is correct. Because the fund lost value in Year 2 and has a high water mark, incentive fees for Year 3 will be 20% of only
the portion of the Year 3 gain that exceeds the previous highest value.

Question 66: Strategic default by a mortgage borrower is most likely if the loan is:
A. non-amortizing.
B. non-conforming.
C. non-recourse.
Explanation
C is correct. If a mortgage is a non-recourse loan, the lender has no claim against the borrower's assets other than the collateral
for the loan. If the value of the collateral has decreased significantly below the remaining principal on a non-recourse loan,
the borrower has an incentive to engage in "strategic default" and surrender the collateral to the lender.

Question 67: An investor purchases 100 shares at $75 per share with an initial margin of 50%. Assume there is no interest
on the call loan and no transactions fees. If the stock price rises to $112.50, the rate of return to the investor is:
A. 100%.
B. 200%.
C. 50%.
Explanation
A is correct. $75/share × 100 shares = $7,500.
50% margin means investor only pays half of the $7,500 in cash, or $3,750, and borrows the remaining $3,750.
Rate of return = (market value – initial investment – margin loan repayment) / initial equity = ($11,250 – $3,750 – $3,750) /
$3,750 = 100%.

Question 68: The price of a fixed-for-floating interest rate swap contract:

A. may vary over the life of the contract.
B. is established at contract initiation.
C. is directly related to changes in the floating rate.
Explanation
B is correct. The price of a swap contract is set such that the contract has a value of zero at initiation. The value of a fixed-
for-floating interest rate swap contract may vary over its life as the floating rate changes.

Question 69: Which of the following best describes a benefit from investing in commodities? Commodities:
A. benefit from markets oscillating between contango and backwardation.
B. can serve as a hedge against inflation.
C. have a strong positive correlation with stock and bond prices.
Explanation
B is correct. Commodities can serve as a hedge against inflation because commodity prices tend to move with inflation rates.
A traditional investment portfolio may gain a diversification benefit from an allocation to commodities because they do not
have a strong positive correlation with stock and bond prices. While it is possible for commodity futures markets to change
between backwardation and contango, this does not necessarily benefit a commodities investor.

Question 70: Bonds issued by the International Monetary Fund (IMF) are most accurately described as:
A. non-sovereign government bonds.
B. supranational bonds.
C. quasi-government bonds.
Explanation
B is correct. Supranational bonds are issued by multilateral organizations such as the IMF.
Quasi-government bonds are issued by agencies established or sponsored by national government.
Non-sovereign government bonds are issued by state, provincial, and local government or municipal entities.

Question 71: A covenant that requires the issuer not to let the insurance coverage lapse on assets pledged as collateral is an
example of a(n):
A. affirmative covenant.
B. inhibiting covenant.
C. negative covenant.
Explanation
A is correct. Covenants are classified as negative or affirmative. Affirmative covenants specify administrative actions a bond
issuer is required to take, such as maintaining insurance coverage on assets pledged as collateral. Negative covenants are
restrictions on a bond issuer's actions, such as preventing an issuer from selling any assets that have been pledged as collateral
or pledging them again as collateral for additional debt.

Question 72: An aggressive price reduction to gain market share is most likely to be associated with a:
A. service differentiation strategy.
B. product differentiation strategy.
C. cost leadership strategy.
Explanation
C is correct. Michael Porter identified two competitive strategies: cost leadership and product or service differentiation. A
firm that uses a cost leadership or low-cost strategy seeks to have low production costs that will enable it to offer lower prices
than its competitors to protect or gain market share. A product or service differentiation strategy seeks to gain a price premium
for its products by making them distinctive to the consumer.

Question 73: An annualized measure of the prepayments experienced by a pool of mortgages is its:
A. conditional prepayment rate.
B. PSA prepayment benchmark.
C. single monthly mortality rate.
Explanation
A is correct. The conditional prepayment rate (CPR) is an annualized measure of a mortgage pool's prepayments. The single
monthly mortality rate is the percentage by which prepayments have reduced the month-end principal balance. The PSA
prepayment benchmark is a monthly series of CPRs to which a mortgage pool's CPR may be compared.

Question 74: A decrease in the riskless rate of interest, other things equal, will:
A. decrease call option values and decrease put option values.
B. increase call option values and decrease put option values.
C. decrease call option values and increase put option values.
Explanation
C is correct. A decrease in the risk-free rate of interest will decrease call option values and increase put option values.

Question 75: To exit an investment in a portfolio company through a trade sale, a private equity firm sells:
A. the portfolio company to one of the portfolio company’s competitors.
B. the portfolio company to another private equity firm.
C. shares of a portfolio company to the public.
Explanation
A is correct. A trade sale involves selling a portfolio company to a competitor or another strategic buyer. An IPO involves
selling all or some shares of a portfolio company to the public. A secondary sale involves selling a portfolio company to
another private equity firm or a group of investors.

Question 76: Of the following types of firm, which is most suitable for P/B ratio analysis?
A. A service industry firm without significant fixed assets.
B. A firm with accounting standards consistent to other firms.
C. A firm with accounting standards different from other firms.
Explanation
B is correct. Assuming consistent accounting standards across firms, P/B ratios can reveal signs of misvaluation across firms.

Question 77: Which of the following least likely represents a primary market offering? When bonds are sold:
A. from a dealer’s inventory.
B. in a private placement.
C. on a best-efforts basis.
Explanation
A is correct. When bonds are sold from a dealer's inventory, the bonds have already been sold once and the transaction takes
place on the secondary market. The other transactions in the responses take place in the primary market. When bonds are sold
on a best-efforts basis, the investment banker does not take ownership of the securities and agrees to sell all she can. In a
private placement, the bonds are sold privately to a small number of investors.

Question 78: An investor finds that for a 1% increase in yield to maturity, a bond's price will decrease by 4.21% compared
to a 4.45% increase in value for a 1% decline in YTM. If the bond is currently trading at par value, the bond's approximate
modified duration is closest to:
A. 4.33.
B. 8.66.
C. 43.30.
Explanation
A is correct. Modified duration is a measure of a bond's sensitivity to changes in interest rates.
Approximate modified duration = (V- – V+) / [2V0(change in required yield)] where:
V- = estimated price if yield decreases by a given amount
V+ = estimated price if yield increases by a given amount
V0 = initial observed bond price
Thus, duration = (104.45 – 95.79)/(2 × 100 × 0.01) = 4.33. Remember that the change in interest rates must be in decimal
form.

Question 79: Preference shares will have the most risk for the investor if the shares are:
A. callable and cumulative.
B. callable and non-cumulative.
C. non-callable and non-cumulative.
Explanation
B is correct. Preference shares (preferred stock) has more risk for the investor if they are noncumulative than if they are
cumulative, because with cumulative preference shares the firm must pay the holder any omitted dividends before it can pay
any dividends to common shareholders. Callable shares have more risk for the investor than non-callable shares because the
call option limits their potential for price appreciation.

Question 80: For an underlying asset that has no holding costs or benefits, the value of a forward contract to the long during
the life of the contract is the:
A. spot price minus the present value of the forward price.
B. difference between the spot price and the forward price.
C. present value of the difference between the spot price and the forward price.
Explanation
A is correct. During the life of a forward contract on an underlying asset with no holding costs or benefits, the value to the
long equals the spot price minus the present value of the forward price:
Vt(T) = St – F0(T) (1 + Rf)-(T-t).

Question 81: A portfolio manager who adds hedge funds to a portfolio of traditional securities is most likely seeking to:
A. decrease portfolio variance only.
B. increase expected returns only.
C. both increase expected returns and decrease portfolio variance.
Explanation
C is correct. For a portfolio of traditional securities, adding alternative investments such as hedge funds can potentially
increase the portfolio's expected returns, because these investments often have higher expected returns than traditional
investments, and decrease portfolio variance, because returns on these investments are less than perfectly correlated with
returns on traditional investments.

Question 82: The opportunity to take advantage of the downward pressure on stock prices that result from end-of-the-year
tax selling is known as the:
A. end-of-the-year anomaly.
B. January anomaly.
C. end-of-the-year effect.
Explanation
B is correct. The January Anomaly is most likely the result of tax induced trading at year end. An investor can profit by
buying stocks in December and selling them during the first week in January.

Question 83: A $1,000 par value, 10% annual coupon bond with 15 years to maturity is priced at $951. The bond's yield to
maturity is:
A. greater than its current yield.
B. equal to its current yield.
C. less than its current yield.
Explanation
A is correct. The bond's YTM is:
N = 15; PMT = 100; PV = –951; FV = 1,000; CPT I/Y = 10.67%
Current Yield = annual coupon payment / bond price
CY = 100 / $951 = 0.1051 or 10.51%

Question 84: Adjusting for convexity improves an estimated price change for a bond compared to using duration alone
because:
A. it measures the volatility of non-callable bonds.
B. the slope of the callable bond price/yield curve is backward bending at high interest rates.
C. the slope of the price/yield curve is not constant.
Explanation
C is correct. Modified duration is a good approximation of price changes for an option-free bond only for relatively small
changes in interest rates. As rate changes grow larger, the curvature of the bond price/yield relationship becomes more
prevalent, meaning that a linear estimate of price changes will contain errors. The modified duration estimate is a linear
estimate, as it assumes that the change is the same for each basis point change in required yield. The error in the estimate is
due to the curvature of the actual price path. This is the degree of convexity. If we can generate a measure of this convexity,
we can use this to improve our estimate of bond price changes.

Question 85: Consider a European call option and put option that have the same exercise price, and a forward contract to buy
the same underlying asset as the two options. An investor buys a risk-free bond that will pay, on the expiration date of the
options and the forward contract, the difference between the exercise price and the forward price. According to the put-call-
forward parity relationship, this bond can be replicated by:
A. writing the call option and buying the put option.
B. buying the call option and writing the put option.
C. writing the call option and writing the put option.
Explanation
A is correct. The put-call-forward parity relationship may be expressed as:
p0 – c0 = [X – F0(T)](1 + Rf)-T
That is, at initiation of a forward contract on the underlying asset, buying a put option and writing a call option with exercise
price X will have the same cost as a risk-free bond which, at expiration of the forward and options, will pay the difference
between X and the forward price.

Question 86: All else equal, the price-to-earnings (P/E) ratio of a stable firm will increase if the:
A. dividend payout is decreased.
B. long-term growth rate is decreased.
C. ROE is increased.
Explanation
C is correct. The increase in growth rate will increase the P/E ratio of a stable firm and growth rate can be calculated by the
formula g = ROE × retention ratio. All else being equal an increase in ROE will therefore increase the P/E ratio. Note that
decreasing the dividend payout ratio and decreasing the long term growth rate will both serve to decrease the P/E ratio.

Question 87: Over the past few years, the companies in an industry have experienced positive but decreasing profitability
and growth rates. The companies have begun to compete intensely with each other and customers switch frequently among
brands. This industry's life-cycle stage is most accurately described as:
A. maturity.
B. shakeout.
C. growth.
Explanation
B is correct. The shakeout industry life-cycle stage is characterized by slowing (but still positive) growth, intense competition,
and declining profitability, as demand begins to approach market saturation. In contrast, the decline industry stage is
characterized by negative growth. The lack of brand loyalty among customers suggests the industry has not yet reached the
mature stage.

Question 88: Historical data on returns of real estate are most likely to exhibit:
A. smoothing.
B. downward-biased measures of risk-adjusted returns.
C. overstated correlations with other asset classes.
Explanation
A is correct. Appraisal methods used to value real estate tend to produce smoothed return patterns that understate standard
deviations of returns. This causes measures of risk-adjusted returns, such as the Sharpe ratio, to be biased upward. Methods
used to construct real estate indexes tend to understate the correlation of real estate returns with other asset classes (and thus
overstate its diversification benefits).

Question 89: Assume a company has earnings per share of $5 and pays out 40% in dividends. The earnings growth rate for
the next 3 years will be 20%. At the end of the third year the company will start paying out 100% of earnings in dividends
and earnings will increase at an annual rate of 5% thereafter. If a 12% rate of return is required, the value of the company is
closest to:
A. $102.80.
B. $55.70.
C. $92.90.
Explanation
A is correct. First, calculate the dividends in years 0 through 3: (We need D3 to calculate the value in Year 2)
D0 = (0.4)(5) = 2
D1 = (2)(1.2) = 2.40
 D2 = (2.4)(1.2) = 2.88
D3 = E3 = 5(1.2)2 = 8.64
Because D3 will grow at a constant rate, we can use it to estimate a terminal value for the stock at t = 2:
P2 = D3 / (k – g) = 8.64 / (0.12 – 0.05) = $123.43
Present value of the cash flows = value of stock = 2.4 / (1.12) 1 + 2.88 / (1.12)2 + 123.43 / (1.12)2 = 102.83.

Question 90: Becque Ltd. is a European Union company with the following selected financial information:

€ billions Year 1 Year 2 Year 3

Operating income 262 361 503

Depreciation & amortization 201 212 256

Capital expenditures 78 97 140

Cash flow from operations 303 466 361

Total debt 2,590 2,717 2,650

Dividends 70 70 72
Becque's three-year average debt-to-EBITDA ratio is closest to:

A. 3.6x.
B. 4.6x.
C. 7.6x.
Explanation
B is correct. EBITDA = Operating income + depreciation + amortization
Year 1: 262 + 201 = €463 billion
Year 2: 361 + 212 = €573 billion
Year 3: 503 + 256 = €759 billion
Debt/EBITDA ratio:
Year 1: 2,590 / 463 = 5.6x
Year 2: 2,717 / 573 = 4.7x
Year 3: 2,650 / 759 = 3.5x
Three-year average = 4.6x.