Docstoc

cfa_level_1.doc - SSEI

Document Sample
cfa_level_1.doc - SSEI Powered By Docstoc
					ETHICS



1.A.


 Janzen’s statement misrepresents his investment performance. The bulk of his performance came from an investment
that he did not recommend and was, in fact, agains. This investment was concentrated in one client’s portfolio and was
not indicative of all of his clients’ performance. Janzen violated the standards by misrepresenting his performance. The
bulk of his performance came from an investment was concentrated in one client’s portfolio and was not indicative of all of
his clients’ performance. Janzen violated the Standards by misrepresenting his past performance, even if he was not
guaranteeing future results.


2.B.


Brokerage (including the resulting soft dollars) belongs to the clients and should be used to benefit the clients. Laptop
computers are standard products that can be purchased for a variety of purposes. As such, having them does not directly
assist the investment decision process. It would appear that Fisk is simply trying to reward Thomas Securities for referrals
by giving them this soft-dollar arrangement. This is a clear violation of CFA Institute Standards. The use of soft dollars
must directly assists in the investment decision process for the firm’s clients. Since the client brokerage (soft dollars) was
used for a standard product that, by itself does not directly affect the investment decision process, soft dollars should not
be used to purchase it.CFA Institute Standards do permit the use of soft dollars if the product purchased with them
directly assists the investment decision process, whether or not the client directs it.


3.B.


This is the best answer because Crenshaw did not give fair treatment to the institutional clients. He tried to favor the
high-wealth individual clients. Fair treatment means that all clients for whom an investment idea is suitable should be
given the idea simultaneously and shares should be allocated on an equitable basis (such as pro-rata as positions are
bought). In addition, just because his efforts backfired does not make it acceptable.While Crenshaw violated the
Standards by not giving fair treatment to the institutional clients, there is no requirement to only consider investment
suitable to every client.Crenshaw violated the Standards by not giving fair treatment to the institutional clients.


4.C.


The Code and Standards requires following the strictest law when there is a conflict. Elfrink must follow Narnian law, in
this case, because it forbids her from purchasing investments in which her employer makes a market. The Code and
Standards does not prohibit purchasing investments in which a mananger’s firm makes a market, and the fact pattern
specified that U.S. Securities violated the Standards (as well as Narnian law.). Elfrink may not purchase investments in
which her employer makes a market because the Code and Standards requires following the strictest law, which in this
case (Narnia) forbids investment advisors from purchasing such investments.The Code and Standards does not prohibit
investment advisors from purchasing investment in which the employer makes a market. It does, however, require
disclosing any conflicts of interest regarding the investments.


5.B.


Best practices would indicate that an analyst should accept a flat fee prior to producing the research. A flat fee helps
ensure that the analyst does not produce research designed to increase the value of the investment, but represents a true
picture of the subject company.Warrants would have a tendency to increase in value if the analyst delivers a favorable
opinion. Receiving the fee prior to writing the report helps ensure that the payment does not depend on the conclusions or
recommendations.


6.B.


Levell misrepresents his objectivity by not disclosing the compensation arrangement between himself and the firms that
pay a fee for his service. Therefore, the emails represent a violation of the Code and Standards, while the website
correctly discloses his relationship to subject firms and does not violate the Code and Standards.The website correctly
discloses his relationship to subject firms and does not violate the Code and Standards.The emails represent a violation of
the Code and Standards, but the website correctly discloses his relationship to subject firms and does not violate the Code
and Standards.


7.A


. The firm must include all accounts managed to the same strategy or objective in the same composite. Since managers
manage the account to the same mandate as previously, the accounts should continue in the same composite. The firm
has, however, violated GIPS by not including a footnote about the personnel change in the performance presentation. An
analyst looking at this account in the future will no doubt see a difference in the performance between the two accounts
over time, although it may be a very minor difference. So that investors can trace the performance difference back to the
personnel change, the firm must include such information in the footnotes to the performance presentation.


8.A.



To comply with GIPS, firms must list discontinued composites for at least five years after discontinuation.




9.B.



 According to Standard II(B) Market Manipulation, members are prohibited from intentionally misleading market
participants through the artificial manipulation of prices or trading data. ‘Wilson’s actions with regard to BNR stock are not
intended to mislead market participants but are related to a legitimate trading strategy and thus do not violate the
Standards. Even though taking the short position may have played a part in moving the price of BNR stock, it was not
intended to manipulate the price. Wilson did, however, deceive market participants through his message board post
related to I-ITC stock. Thus Wilson violated Standard II(B) in this situation.



10.A



Stating that Baker passed the exams in consecutive years is acceptable, if in- fact he did so, according to Standard VII(B)
Reference to CFA Institute, the CFA Designation, and the CPA Program.

11.C



 According to Standard VI(A) Disclosure of Conflicts, members and candidates must disclose to their clients, prospects,
and employer all situations that could reasonably be expected to compromise their independence and objectivity. Stock
ownership of a company in which clients are invested would need to be disclosed to clients and the employer since a
member may be tempted to purchase more stock for client accounts in order to increase the value of personal holdings.
Participation on the board of directors of a company in which clients are invested would also need to be disclosed to both
clients and the employer. Board positions may inhibit the member’s ability to objectively determine when to sell the stock
of the company and may expose the member to material nonpublic information.
12.B



 According to Standard II(A), an analyst may not use material nonpublic information. The information is material to the
company’s future profitability, and is nonpublic because the lawsuit has not yet been filed and is not yet a matter of public
record. The mosaic theory does not apply here, because the mosaic theory assumes that the nonpublic information
gathered is nonmaterial.




13.C.



  Standard II(B) Market Manipulation, is not intended to prohibit transactions that are done to minimize income taxes, or
trading strategies that are nor intended to distort prices or artificially Inflate trading volume. Thus, neither Gordon nor
Turpin is in violation.



14.A



 According to Standard V(A) Diligence and Reasonable Basis, group consensus is not required in the course of
preparation of analytical reports. Pickle would only need to have her name removed from the report if she believed the
investment committee did not have a reasonable and adequate basis for their changes.



15.A



 Under Standard VI(A) Disclosure of Conflicts, Malone is required to disclose to his employer all matters, including
beneficial ownership of securities or other investments that reasonably could be expected to interfere with his duty to his
employer or ability to make unbiased and objective recommendations. In addition, under Standard VI(A), Malone must
disclose to clients all matters, including beneficial ownership of securities or other investments, that reasonably could be
expected to impair his ability to make unbiased and objective recommendations. Members beneficially own securities or
other investments that they or a member of their immediate family own or that are held in trust for them or their immediate
family

.

16.C



      Although Chavez was arrested, Standard I(D) Misconduct is not intended to cover acts of “civil disobedience.”
Standard IV(A) Loyalty, Chavez has a duty of loyalty to her employer. While she will not be compensated for the
Greensleeves’ Board position, the duties may be time-consuming and should be discussed with her employer in advance.
17.B

Smith has violated Standard I(C) Misrepresentation by copying proprietary computerized information without authorization
of the owner, Bright Star Bank and now Mega Bank. Even if Bright Star has been absorbed by Mega Bank, the assets of
the trust department, including the model, now belong to Mega Bank, even if it chooses not to use them. Smith would
have complied with the Standard if she had obtained permission from Mega Bank to copy the model.




18.C

Standard VII(B). According to the standard, members are not allowed to misrepresent or exaggerate the meaning of the
CFA designation, membership CFA Institute, or candidacy in the CFA program. This applies when the member references
their relationship to the CFA Institute or CFA program verbally, or in writing (both print and electronic). Brown’s statements
regarding the Level 3 candidates at Brinton are acceptable. Stating that the analysts passed all three CFA exams on the
first attempt is a statement of fact and is acceptable. Brown has also made acceptable statements regarding the rigor of
the CFA program and has not over-promised investment results In connection with employing CPA shareholders and
candidates. However, Brown’s statement regarding the Level 2 CPA candidates at Brinton does violate Standard VII(A) by
presuming that these Level 2 candidates will pass the next Level 3 exam and meet the work experience requirement.



19.B



It is likely that Johnson’s outside work competes with her employer, especially since Smith Brothers caters to institutional
clients. Standard IV(A) Loyalty requires that ) own son not engage in conduct that harms her employer. Permission from
employer for the outside work is required.

20.A

Pollard has enough information to determine that the overheard information is indeed material nonpublic information. No
matter how this information was obtained, even through an overheard conversation, Pollard may not act or cause others to
act on it. Even if he had contacted internal counsel before placing the trade, Pollard would have violated Standard II(A)
Material Nonpublic Information.

21.B



Standard III(B) Fair Dealing. Members and candidates must deal fairly and objectively with all clients and should forgo any
sales to themselves or their immediate families to free up additional shares of oversubscribed stock issues for clients. The
fact that most clients will receive fewer shares than they requested is not a violation.



22.A



Standard I(C) Misrepresentation does nor prohibit members and candidates from making truthful statements that some
investments, such as U.S. Treasury securities, are guaranteed in’ one way or another. Suitability does not become a
concern until the potential clients take investment action.



23.A
        Brief presentations are acceptable if they include a statement that detailed information is available upon request.
Standard III(D) Performance Presentation requires members and candidates to make reasonable efforts to ensure fair,
accurate and complete presentation of results. While compliance with GIPS is recommended to meet Standard III(D)
obligations, use of GIPS is not required.



24.A



In accordance with Standard VI(B) Priority of Transactions, employer and client transactions must take priority over any
personal transactions, meaning any transactions in which the member or candidate is the beneficial owner. Disclosure is
not enough to comply with this Standard and the execution price is not relevant.



25.A



Howell is using publicly available financial reports as well as non-material nonpublic information regarding the travel plans
of the company’s executive officers that led him to suspect that the company is planning a merger with a Japanese oil
company. Thus, Howell formed his conclusion using the mosaic theory and did not violate Standard II(A) Material
Nonpublic Information.




26. C



Members and candidates must identify the parties to whom fiduciary duty of loyalty is owed. In this case, Green’s fiduciary
duty is to the beneficiaries of the pension fund, not to Harris. If Green acts in Harris’s best interests, he will violate
Standard III(A) Loyalty, Prudence, and Care.



27.B



       GIPS-compliant results can be presented with non-compliant historical performance added for earlier periods, but
no non-compliant results be presented for any time period after January I, 2000.



28.B



Although simultaneous distribution of information is preferred, distributing recommendations, or changes of
recommendations, first to those clients who have previously expressed interest in these types of securities is acceptable.
Giving preferred treatment to larger accounts would violate Standard III(B) Fair Dealing.



29.A
All of the statements are acceptable according to Standard VII(B), Reference to CFA Institute, the CFA designation, and
the CFA Program. Mu is allowed to make a statement of fact such as the money manager’s right to use the CFA
designation. Mi! may reference the participation of its employees in the CFA program if the employees are currently
registered to take one of the exams. The statement regarding dedication to the investment community and commitment to
the highest ethical standards are proper references regarding the CFA program.



30.C



All discretionary portfolios whether closed or not, must be included in composite results for the period they were managed.
Model results may not be included in composite results.



31.C



Richards has violated Standard V(B) Communication with Clients and Prospective Clients by failing to appropriately
distinguish between fact and opinion. It is her opinion that MegaRx will require a write-down, not a fact. Swanson violated
Standard IV(C) Responsibilities of Supervisors by failing to recognize that the report he was personally reviewing
contained a violation of the Code and Standards, which both he and Richards are bound to uphold.



32.C



       Standard IV(C) Responsibilities of Supervisors requires members and candidates with supervisory responsibility to
make reasonable efforts to detect and prevent violations of rules and regulations (as well as of the Code and Standards)
by those under their supervision. The fact that violations occur is not necessarily evidence that reasonable efforts were not
made. In large organizations, delegating supervisory responsibility may be necessary, but this does not relieve the person
with overall authority of supervisory responsibility.

33.B



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



34.B



Under Standard VI(C) Referral Fees, members and candidates must disclose referral fees to their employer, clients, and
prospects. DTI has noted the details of the referral arrangement with Weston and has thus complied with the Standard. It
is not necessary to provide the exact number of referrals received, just the details of the compensation given or received
as a result of the. referral relationship. Hurley has not provided any disclosure to clients, regarding the referral
arrangement with Weston and has thus violated the Standard. They cannot rely on Weston’s disclosure, but must make
the disclosure themselves.
35. A

        Both statements are correct. Total firm assets must include fee-paying and non-fee- paying accounts. If a sub-
advisor who manages firm assets is selected by the firm, the performance of assets under the sub-advisor’s control must
be included in the performance of the firm’s composite for those assets. (Study Session 1, ,2S.4.a)



36.A



Standard V(C). This Standard requires CFA charter holders and candidates to maintain appropriate records to support
investment recommendations. Shredding all of the supporting documents is clearly a violation of the standard. Mason did
not violate Standard V(B), however, since she fully described the basic characteristics of the investment. The level of
insider buying is not a basic characteristic of an equity security



37.C



In accordance with Standard I(B) Independence and Objectivity, Callahan must only issue recommendations that reflect
his own independent judgment. If Deininger will not permit him to do so, Callahan must refuse to cover the firm under the
conditions specified.]



38. C



       Standard VI(C) Disclosure of Conflicts requires members to disclose to their clients any compensation or benefit
received by, or paid to, others for the recommendation of services. Sergeant’s failure to disclose that he receives legal
services for his referral of clients to Chapman is in violation of the Standards.



39. B



Schultz continued to act in her employer’s best interest while still employed and did not engage in any activities that would
conflict with this duty until her resignation became effective. Standard IV(A) Loyalty does not prohibit her from contacting
clients from her previous firm if she does not get the contact information from the records of her former employer or violate
an applicable non-compete agreement.




40.C

Checking the references given by potential employees is one of the recommended procedures for compliance with
Standard I(D) Misconduct. Other recommended procedures are that the firm adopt a code of ethics and inform employees
of potential violations and their consequences for disciplinary action. Neither testing employees’ knowledge of laws and
regulations nor informing them of actual violations by other employees is specified as a recommended procedure.



41.A
Selling Knoll stock from either the pension fund or Hess’s personal account would be trading on material nonpublic
information, in violation of Standard II(A) Material on public Information.



42.A



While actual knowledge of an upcoming takeover offer is considered material and nonpublic information, the source here,
her podiatrist, is not a reliable source so there is no violation of Standard II(A). The information given indicates that Soros
has researched the stock and knows it well, so there is no apparent violation of StandardV(A).



43.B

According to Standard III(C) Suitability, when a member is in an advisory role, he must determine the investor’s objectives
(risk and return) and constraints, as well as investment experience, and create an Investment Policy Statement (IPS) for
his client. Since each investor’s constraints and objectives are different, Kent has violated the Standard by not working out
an appropriate IPS for Parker. Providing a description of the model is required by Standard V(B) Communication with
Clients and Prospective Clients.



44.C



 According to Standard II(B) Market Manipulation, Reynolds is guilty of information- based manipulation by spreading false
rumors to induce trading by others.



45. B.



According to Standard II(A) Material Nonpublic Information, there are situations in which a research analyst can be
allowed to temporarily move to the investment banking side of the “wall” until all the information is publicly disclosed.
Clearly he cannot use any of this information in research, or share it with colleagues.



46. A

        Both statements are correct. Total firm assets must include fee-paying and non-fee- paying accounts. If a sub-
advisor who manages firm assets is selected by the firm, the performance of assets under the sub-advisor’s control must
be included in the performance of the firm’s composite for those assets. (Study Session 1, ,2S.4.a)



47. A



        Standard V(C). This Standard requires CFA charter holders and candidates to maintain appropriate records to
support investment recommendations. Shredding all of the supporting documents is clearly a violation of the standard.
Mason did not violate Standard V(B), however, since she fully described the basic characteristics of the investment. The
level of insider buying is not a basic characteristic of an equity security



48. C
        In accordance with Standard I(B) Independence and Objectivity, Callahan must only issue recommendations that
reflect his own independent judgment. If Deininger will not permit him to do so, Callahan must refuse to cover the firm
under the conditions specified.]



49.C



Standard VI(C) Disclosure of Conflicts requires members to disclose to their clients any compensation or benefit received
by, or paid to, others for the recommendation of services. Sergeant’s failure to disclose that he receives legal services for
his referral of clients to Chapman is in violation of the Standards.




50. B



       Schultz continued to act in her employer’s best interest while still employed and did not engage in any activities
that would conflict with this duty until her resignation became effective. Standard IV(A) Loyalty does not prohibit her from
contacting clients from her previous firm if she does not get the contact information from the records of her former
employer or violate an applicable non-compete agreement.




51.C



Checking the references given by potential employees is one of the recommended procedures for compliance with
Standard I(D) Misconduct. Other recommended procedures are that the firm adopt a code of ethics and inform employees
of potential violations and their consequences for disciplinary action. Neither testing employees’ knowledge of laws and
regulations nor informing them of actual violations by other employees is specified as a recommended procedure.



52.A



Selling Knoll stock from either the pension fund or Hess’s personal account would be trading on material nonpublic
information, in violation of Standard II(A) Material on public Information.



53.A



While actual knowledge of an upcoming takeover offer is considered material and nonpublic information, the source here,
her podiatrist, is not a reliable source so there is no violation of Standard II(A). The information given indicates that Soros
has researched the stock and knows it well, so there is no apparent violation of StandardV(A).
54.B



        According to Standard III(C) Suitability, when a member is in an advisory role, he must determine the investor’s
objectives (risk and return) and constraints, as well as investment experience, and create an Investment Policy Statement
(IPS) for his client. Since each investor’s constraints and objectives are different, Kent has violated the Standard by not
working out an appropriate IPS for Parker. Providing a description of the model is required by Standard V(B)
Communication with Clients and Prospective Clients.




55.C



 According to Standard II(B) Market Manipulation, Reynolds is guilty of information- based manipulation by spreading false
rumors to induce trading by others.



56. B.



According to Standard II(A) Material Nonpublic Information, there are situations in which a research analyst can be
allowed to temporarily move to the investment banking side of the “wall” until all the information is publicly disclosed.
Clearly he cannot use any of this information in research, or share it with colleagues.




57.B



Under Standard ICC) Misrepresentation, members and candidates may employ ideas from others with proper
acknowledgement. By reviewing the third-party research before distributing it Laird complies with Standard V(A) Diligence
and Reasonable Basis. Standard I(B) Independence and Objectivity concerns outside parties who may wish to influence
an analyst’s independent judgment.




58.A



Under the mosaic theory, financial analysts are free to combine public information with nonmaterial nonpublic information
and act based on their conclusions. Standard II(A) prohibits members and candidates from acting or causing others to act
on material nonpublic information. The obligation to make the reasonable efforts to achieve public dissemination of
nonpublic information applies to situations in which the company discloses information to the analyst that has not yet been
made public.
59.A



Since the information chat the fund intends to sell shares is nonpublic and is also material (an investor considering sale or
purchase of the shares would want to know it prior to making a decision), Rice is prohibited from acting on it by Standard
II(A) Material Nonpublic Information. Rice has also violated Standard VI(B) Priority of Transactions by not executing the
client sell order prior to selling his own shares.



60.B



      A complete withdrawal from marker-making activities could be a signal to outsiders that a significant transaction is
underway. The firm should continue making a market but should only carry out unsolicited transactions for clients,



61.B



Under Standard VI(C) Referral Fees, Pollard is required to inform his clients and his employer of the arrangement with
Timberlake. Disclosure allows the employer and clients to evaluate any possible partiality shown in the direction of trades
and also the full cost of the services. Standard I(B) Independence and Objectivity is intended to apply to situations in
which the member may face pressure to recommend investments or take investment action contrary to his independent
judgment.




62.A



Standard III(E) Preservation of Confidentiality applies to the confidential information of both current and former clients of
the member or candidate. The Professional Conduct Program is considered an extension of the member or candidate with
respect to preservation of confidentiality The Standard does not prohibit the member or candidate from disclosing
confidential information to authorities that concerns illegal activity.




63.A



The GIPS-compliant firm definition must be the corporation, subsidiary, or division that holds itself our to the client as a
specific business entity. If the firm has different geographic locations, this firm definition should include all the locations.




64.C
Todd may nor claim that she is a “Level 3 candidate in the CFA program” because she has not registered for the next
Level 3 CFA examination. There is no partial designation for someone who has passed Level 1, Level 2, or Level 3 of the
CFA examination.




65.A



Standard I(D) Misconduct prohibits members from participating in any professional conduct that reflects adversely on their
professional reputation or integrity. Declari’ personal bankruptcy does not, by itself, reflect adversely on the individual’s
integrity or trustworthiness., If the circumstances of the bankruptcy included any fraudulent or deceitful conduct on the part
of the member, then that would be considered a violation.




66.C



Standard III(D) Performance Presentation does not prohibit showing past performance of funds managed at a previous
firm as part of a performance track record if accompanied by appropriate discourses. In this instance, Arc clearly detailed
that the performance occurred while Mrtin was the manager of Alpha Emerging Markets Fund. A minimum 5-year
performance history is a requirement for GIPS compliance, but use of GIPS is not required by Standard III(D).




67. B



An effective firewall includes a system for review by authorized compliance personnel of communications between
departments on either side of the wall. Prohibiting any buying and selling is not recommended because doing so can
provide a signal to other market participants; the firm should continue to execute unsolicited buy and sell orders from
customers. Distribution of restricted lists should be limited to the compliance personnel responsible for monitoring trading
in the restricted securities.



68.C



According to Standard VII(B) Reference to CPA Institute, the CPA Designation, and the CFA Program, the CPA mark
must not be used as a noun. It is acceptable to state that Wilson completed the examinations n consecutive years if this is
true, but it is not acceptable to claim that this implies superior ability.



69.C
       The enforcement structure for the Code and Standards is centered around the Rules of Procedure, which are
based on two primary principles: fair process and confidentiality of proceedings. “Global application” relates to the Code
and Standards.




70.C



         Russ can make use of her opinions so long as she distinguishes them from fact. The expiated settlement is public
information because the source is a newspaper quote. Russ may use this information but should cite the newspaper
article.




71.B



      Under Standard VI(A) Disclosure of Conflicts, members must make full and fair disclosure of all matters that could
reasonably be expected to interfere with their independence or objectivity when dealing with clients. Disclosure of
Anthony’s new position in Abco will allow his clients the opportunity to judge Anthony’s motives and potential biases for
themselves.




72.C



        Standard VI(C) Referral Fees requires members to disclose to their clients any compensation or benefit received
for the recommendation of services. Full disclosure should be made in writing and should include the nature and value of
the benefit. Disclosure of a compensation arrangement will allow the client to evaluate whether Lewis’ recommendation of
another department within Kite Brothers is influenced by the referral fee.




73.B



       Brenner’s-actions comply with the conditions specified in Standard IV(B) Additional Compensation Arrangements.
He notified his employer in writing (e-mail is acceptable) of the terms and conditions of additional compensation
arrangement and received permission from his employer. Loyalties to other clients may be affected, but it is the
employer’s duty to determine this. Nothing in the Standard specifies that “all parties involved” includes other clients.




74.C
Standard III(E) Preservation of Confidentiality suggests the most appropriate action is to check with compliance or legal
counsel before going forward to the authorities regarding a possible violation. CFA Institute recognizes that in some cases
there may be an obligation to not “preserve confidentiality” and disclose information as required by law. The activities
described are only suspected, and proper care should be taken to not expose her firm to liability if confidential allegations
of impropriety are improperly disclosed.




75. B




Standard I(A) Knowledge of the Law requires candidates and members comply with all applicable rules and regulations,
including the CFA Standards of Practice. Further Standard I(A) requires that members and candidates must not knowingly
participate i violations of applicable laws and Standards. Even though local law permits purchasin shares for personal
accounts before purchasing IPO shares for client accounts, Stand VI(B) Priority of Transactions does not. The analyst
knowingly violated the Code and Standards and, thus, violated Standard I(A). Since the analyst was unaware of the deceit
in the valuation of the IPO stock [a violation of Standard I(D) Misconductl, participation in publishing the research did not
constitute a violation.




QUANTITATIVE METHODS



1.B
 N = 10; I = 15; PMT = 2,500; CPT → FV = $50,759.

2. C
 The total probability rule us used to calculate the unconditional probability of an event from the conditional
probabilities of the event given a mutually exclusive and exhaustive set of outcomes. The rule is expressed as:
P(A) = P(A|B1)P(B1) + P(A|B2)P(B2) + ... + P(A|Bn)P(Bn)

3. C
 The Sharpe ratio measures excess return per unit of risk. Remember that the numerator of the Sharpe ratio is
(portfolio return − risk free rate), hence the importance of excess return. Note that peakedness of a return
distribution is measured by kurtosis.

4.A
 Note that bond problems are just mixed annuity problems. You can solve bond problems directly with your
financial calculator using all five of the main TVM keys at once. For bond-types of problems the bond’s price
(PV) will be negative, while the coupon payment (PMT) and par value (FV) will be positive. N = 10; I/Y = 12; FV
= 1,000; PMT = 100; CPT → PV = –886.99.

5.A
The coefficient of variation is the standard deviation divided by the mean: 5 / 30 = 0.167.

6. B
T = 0: Purchase of first share = -$100.00
T = 1: Dividend from first share = +$1.00
Purchase of 3 more shares = -$267.00
T = 2: Dividend from four shares = +4.00
Proceeds from selling shares = +$392.00
The money-weighted return is the rate that solves the equation:
$100.00 = -$266.00 / (1 + r) + 396.00 / (1 + r)2.
CFO = -100; CF1 = -266; CF2 = 396; CPT → IRR = 6.35%.

7. A
CV = Standard Deviation / Mean = (8 / 20) = 0.4

8. B
If the observation falls at the sixty-fifth percentile, 65% of all the observations fall below that observation.

9B
. Future value of $1,000 for 3 periods at 10% = 1,331
Future value of $1,500 for 2 periods at 10% = 1,815
Future value of $2,000 for 1 period at 10% = 2,200
     Total = $5,346
N = 3; PV = -$1,000; I/Y = 10%; CPT → FV = $1,331
N = 2; PV = -$1,500; I/Y = 10%; CPT → FV = $1,815
N = 1; PV = -$2,000; I/Y = 10%; CPT → FV = $2,200

10. C
A joint probability is the probability that two events occur when neither is certain or a given. Joint probability is
calculated by multiplying the probability of each event together. (0.75) × (0.80) = 0.60 or 60%.

11.A
The answer can be determined by dividing the probability of the event by the probability that it will not occur:
(1/10) / (9/10) = 1 to 9. The probability of the event occurring is one to nine, i.e. in ten occurrences of the event,
it is expected that it will occur once and not occur nine times.

12. A
 The formula for holding period yield is: (P1 − P0 + D1) / (P0), where D1 for a T-bill is zero (it does not have a
coupon). Therefore, the HPY is: ($10,000 − $9,737.50) / ($9,737.50) = 0.0270 = 2.70%.
Alternatively (100 / 97.375) − 1 = 0.02696.

13. C
Mean = (3 + 3 + 5 + 8 + 9 + 13 + 17) / 7 = 8.28; Median = middle of distribution = 8 (middle number); Mode =
most frequent = 3.

14. C
In order to calculate the standard deviation of the company returns, first calculate the expected return, then the
variance, and the standard deviation is the square root of the variance.
The expected value of the company return is the probability weighted average of the possible outcomes:
(0.20)(0.20) + (0.50)(0.15) + (0.30)(0.10) = 0.145.
The variance is the sum of the probability of each outcome multiplied by the squared deviation of each outcome
from the expected return: (0.2)(0.20 - 0.145)2 + (0.5)(0.15 - 0145)2 + (0.3)(0.1-0.145)2 = 0.000605 + 0.0000125
+ 0.0006075 = 0.001225.
The standard deviation is the square root of 0.001225 = 0.035 or 3.5%.

15. C
The expected return of a portfolio composed of n-assets is the weighted average of the expected returns of the
assets in the portfolio: ((w1) × (E(R1)) + ((w2) × (E(R2)) = (0.5 × 0.1) + (0.5 × 0.2) = 0.15.

16. A
 January – March return = 51,000 / 50,000 − 1 = 2.00%
April – June return = 60,000 / (51,000 + 10,000) − 1 = –1.64%
July – December return = 33,000 / (60,000 − 30,000) − 1 = 10.00%
Time-weighted return = [(1 + 0.02)(1 − 0.0164)(1 + 0.10)] − 1 = 0.1036 or 10.36%

17. C
(75 − 60 + 1.50) / 60 = 27.5%.

18. C
A covariance only measures the linear relationship. The covariance can be zero while a non-linear relationship
exists. Both remaining statements are true.

19. B
A set of probabilities must sum to one.

20. B
This is a conditional expectation. The analyst indicates how an expected value will change given another event.

21. A
HPR = [D + End Price − Beg Price] / Beg Price
HPR = [2 + 37.50 − 32] / 32 = 0.2344.

22. A
The relative frequency is the percentage of total observations falling within each interval. It is found by taking
the frequency of the interval and dividing that number by the sum of all frequencies.

23. B
(1 + 0.045 / 12)12 − 1 = 1.0459 − 1 = 0.0459.

24. B
According to Chebyshev’s Inequality, for any distribution, the minimum percentage of observations that lie within
k standard deviations of the distribution mean is equal to: 1 – (1 / k2). If k = 3, then the percentage of
distributions is equal to 1 – (1 / 9) = 89%.

25. A
The sample standard deviation is the square root of the variance: (36,000,000)1/2 = $6,000. The standard error
of the sample mean is estimated by dividing the standard deviation of the sample by the square root of the
sample size: σmean = s / (n)1/2 = 6,000 / (81)1/2 = $667.

26. A
For a distribution that is non-normally distributed, a nonparametric test may be most appropriate. A
nonparametric test tends to make minimal assumptions about the population, while parametric tests rely on
assumptions regarding the distribution of the population. Both kinds of tests are often used in conjunction with
one another.

27. C
Survivorship bias is not likely to significantly influence the results of this study because the authors looked at the
stocks in the S&P 500 at the beginning of the year and measured performance over the following three months.
Look-ahead bias could be a problem because earnings-price ratios are calculated and the trading strategy
implemented at a time before earnings are actually reported. Finally, the study is conducted over a relatively
short time period during the long bull market of the 1990s. This suggests the results may be time-specific and
the result of time-period bias.

28. A
Lognormal distribution returns are used for asset pricing models because this will not result in asset returns of
less than 100% because the lowest the asset price can decrease to is zero which is the lowest value on the
lognormal distribution. The normal distribution allows for asset prices less than zero which could result in a
return of less than -100% which is impossible.

29. C
A Type I error is the probability of rejecting the null hypothesis when the null hypothesis is true.

30. C
The probability of a value being rolled is 1/6 regardless of the previous value rolled.

31. B
The reliability factor corresponding with a 5% significance level (95% confidence level) for the Student’s t-
distribution with (20 − 1) degrees of freedom is 2.093. The confidence interval is equal to: 2.5 ± 2.093(0.4 / √20)
= 2.313 to 2.687. (We must use the Student’s t-distribution and reliability factors because of the small sample
size.)
32. B
Sampling error is the difference between any sample statistic (the mean, variance, or standard deviation of the
sample) and its corresponding population parameter (the mean, variance or standard deviation of the
population). For example, the sampling error for the mean is equal to the sample mean minus the population
mean.

33. B
Depending upon the author there can be as many as seven steps in hypothesis testing which are:
Stating the hypotheses.
Identifying the test statistic and its probability distribution.
Specifying the significance level.
Stating the decision rule.
Collecting the data and performing the calculations.
Making the statistical decision.
Making the economic or investment decision.

34. C
Ho: µ = 16; Ha: µ ≠ 16. Do not reject the null since |t| = 1.09 < 1.96 (critical value).

35. C
If the population sampled has a known variance, the z-test is the correct test to use. In general, a t-test is used
to test the mean of a population when the population is unknown. Note that in special cases when the sample is
extremely large, the z-test may be used in place of the t-test, but the t-test is considered to be the test of choice
when the population variance is unknown. A t-test is also used to test the difference between two population
means while an F-test is used to compare differences between the variances of two populations.

36. B
At a 5% significance level, the critical t-statistic using the Student’s t distribution table for a one-tailed test and
29 degrees of freedom (sample size of 30 less 1) is 1.699 (with a large sample size the critical z-statistic of
1.645 may be used). Because the critical t-statistic is greater than the calculated t-statistic, meaning that the
calculated t-statistic is not in the rejection range, we fail to reject the null hypothesis and we conclude that the
population mean is not significantly greater than 100.

37. B
Ho:µ ≤ 100; Ha: µ > 100. Reject the null since z = 3.4 > 1.65 (critical value).

38. C
 A Type I error is the rejection of the null when the null is actually true. The significance level of the test (alpha)
(which is one minus the confidence level) is the probability of making a Type I error. A Type II error is the failure
to reject the null when it is actually false.

39. A
Simple random sampling is a method of selecting a sample in such a way that each item or person in the
population being studied has the same (non-zero) likelihood of being included in the sample.

40. C
To calculate this answer, we will use the properties of the standard normal distribution. First, we will calculate
the Z-value for the upper and lower points and then we will determine the approximate probability covering that
range. Note: This question is an example of why it is important to memorize the general properties of the
normal distribution.
Z = (observation – population mean) / standard deviation
Z26.75 = (26.75 – 35) / 5 = -1.65. (1.65 standard deviations to the left of the mean)
Z40 = (40 – 35) / 5 = 1.0 (1 standard deviation to the right of the mean)
Using the general approximations of the normal distribution:
68% of the observations fall within ± one standard deviation of the mean. So, 34% of the area falls between 0
and +1 standard deviation from the mean.
90% of the observations fall within ± 1.65 standard deviations of the mean. So, 45% of the area falls between 0
and +1.65 standard deviations from the mean.
Here, we have 34% to the right of the mean and 45% to the left of the mean, for a total of 79%.
41. B
The study suffers from look-ahead bias because traders at the beginning of the year would not be able to know
the book value changes. Financial statements usually take 60 to 90 days to be completed and released.

42. C
 Given the population standard deviation and the standard error of the sample mean, you can solve for the
sample size. Because the standard error of the sample mean equals the standard deviation of the population
divided by the square root of the sample size, 4 = 20 / n1/2, so n1/2 = 5, so n = 25.

43. C
The central limit theorem tells us that for a population with a mean m and a finite variance σ2, the sampling
distribution of the sample means of all possible samples of size n will approach a normal distribution with a
mean equal to m and a variance equal to σ2 / n as n gets large.

44. C
The hypotheses are always stated in terms of a population parameter. Type I and Type II are the two types of
errors you can make – reject a null hypothesis that is true or fail to reject a null hypothesis that is false. The
alternative may be one-sided (in which case a > or < sign is used) or two-sided (in which case a ≠ is used).

45. A
 The probability that a parameter lies within a range of estimated values is given by 1 − α. The standard error of
the sample means when the standard deviation of the population is known equals σ / √n, where σ = population
standard deviation.

46. C
In an “innocent until proven guilty” justice system, the null hypothesis is that the accused is innocent. The
hypothesis can only be rejected by evidence proving guilt beyond a reasonable doubt, favoring the avoidance of
type I errors.

47. A
 With a large sample size (115) the z-statistic is used. The z-statistic is calculated by subtracting the
hypothesized parameter from the parameter that has been estimated and dividing the difference by the
standard error of the sample statistic. Here, the test statistic = (sample mean – hypothesized mean) /
(population standard deviation / (sample size)1/2 = (X − µ) / (σ / n1/2) = (65,000 – 57,000) / (4,500 / 1151/2) =
(8,000) / (4,500 / 10.72) = 19.06.

48. A
 The way the question is worded, this is a two tailed test.The alternative hypothesis is not Ha: M > 7 because in
a two-tailed test the alternative is =, while < and > indicate one-tailed tests. A test statistic is calculated by
subtracting the hypothesized parameter from the parameter that has been estimated and dividing the difference
by the standard error of the sample statistic. Here, the test statistic = (sample mean – hypothesized mean) /
(standard error of the sample statistic) = (5 - 7) / (1) = -2. The calculated Z is -2, while the critical value is -1.96.
The calculated test statistic of -2 falls to the left of the critical Z-statistic of -1.96, and is in the rejection region.
Thus, the null hypothesis is rejected and the conclusion is that the sample mean of 5 is significantly different
than 7. What the negative sign shows is that the mean is less than 7; a positive sign would indicate that the
mean is more than 7. The way the null hypothesis is written, it makes no difference whether the mean is more or
less than 7, just that it is not 7.


49. B

A random variable must be a number. Sometimes there is an obvious method for assigning a number, such as
when the random variable is a number itself, like a P/E ratio. A stock symbol of a randomly selected stock could
have a number assigned to it like the number of letters in the symbol. The symbol itself cannot be a random
variable.

50. A

First, the annual yield must be converted to a semiannual yield. The result is then doubled to obtain the bond-
equivalent yield.
Semiannual yield = 1.10.5 − 1 = 0.0488088.
The bond-equivalent yield = 2 × 0.0488088 = 0.097618.




51.B

A parameter measures a characteristic of the underlying population.

52. A

  N = 6, PMT = -$20,000, I/Y = 10%, FV = 0, Compute PV → $87,105.21.

53. A

. The money-weighted return is the internal rate of return on a portfolio that equates the present value of inflows
and outflows over a period of time.

54.A

HPY = (1,020 + 30 + 30 – 910) / 910 = 0.1868 or 18.7%.

55.B

The standard deviation is more useful than the variance because the standard deviation is in the same units as
the mean. The median does not help in creating intervals around the mean.

56. A

 When projects are independent, you can use either the NPV method or IRR method to make the accept or
reject decision. Only Project C has an IRR in excess of 11%. Acceptance of Project A reduces the firm’s value
by $4,600.

57.A

 There is an upper limit to the EAR as the frequency of compounding increases. In the limit, with continuous
compounding the EAR = eAPR –1. Hence, the EAR increases at a decreasing rate.

58. A

With PV = 20,000, N = 4, I/Y = 8, computed Pmt = 6,038.42. Interest (Yr1) = 20,000(0.08) = 1600. Interest (Yr2)
= (20,000 − (6038.42 − 1600))(0.08) = 1244.93

59. C

 The effective annual yield (EAY) is based on a 365-day year and accounts for compound interest. EAY = (1 +
holding period yield)365/t − 1. The holding period yield formula is (price received at maturity − initial price +
interest payments) / (initial price) = (10,000 − 9,900 + 0) / (9,900) = 1.01%. EAY = (1.0101)365/40 − 1 = 9.60%.

60. B

For a positively skewed distribution, the mode is less than the median, which is less than the mean (the mean is
greatest). Remember that investors are attracted to positive skewness because the mean return is greater than
the median return.

61. B

Calculations are as follows:

   1. Sample mean = (125 + 175 + 150 + 155 + 135) / 5 = 148
     2. Sample Variance = [(125 – 148)2 + (175 – 148)2 + (150 – 148)2 + (155 – 148)2 + (135 – 148)2] / (5 – 1) =
        1,480 / 4 = 370
     3. Sample Standard Deviation = 3701/2 = 19.24%.

62. A

ln(18,682/10,000) = 0.6250/5 = 12.50%

or

(18,682/10,000)1/5 = 1.133143
ln(1.133143) = 12.4995%

63.B

. The standard deviation of the portfolio is found by:

[W12 σ12 + W22 σ22 + 2W1W2σ1σ2r1,2]0.5, or [(0.30)2(0.046)2 + (0.70)2(0.078)2 +
(2)(0.30)(0.70)(0.046)(0.078)(0.45)]0.5 = 0.0620, or 6.20%.

64.B

 Since Hilbilee’s correlation coefficient with the existing portfolio is less than 1, there are benefits to
diversification, and adding it to the existing portfolio would reduce the variance below the current level of 0.024.
(See calculations below). The other choices are correct.

ERPortfolio = (wDrysdahl × ERDrysdahl) + (wClampett × ERClampett) = (0.40 × 10.5%) + (0.60 × 16.55%) = 14.13%.

The equation for the standard deviation = σ1,2 = [(w12)(σ12) + (w22)(σ22) + 2w1w2σ1σ2ρ1,2]1/2,

Here stock 1 = Drysdahl and stock 2 = Clampett, and r1,2 = cov1,2 / (σ1 × σ2) = 0.001 / (0.085 × 0.25) = 0.047

σPortfolio = [(0.402 × 0.0852) + (0.602 × 0.252) + (2 × 0.40 × 0.60 × 0.085 × 0.25 × 0.047)]1/2 = 0.0241/2, or 0.155 =
15.5%. (The variance is 0.024).

65.B

The present value of the current lease is $508,766.38, while the present value of the lease being offered is
$459,177.59; a savings of 49,589. Alternatively, the present value of the extra $40,000 at the beginning of each
of the next 4 years is $129,589 which is $49,589 more than the extra $80,000 added to the payment today.

66.B

P(A) = 0.30. P(B | A) = 0.10. P(AB) = (0.30)(0.10) = 0.03 or 3%.

67. C

The standard error for the mean = s / (n)0.5 = 25% / (60)0.5 = 3.227%. The critical value from the t-table should
be based on 60 − 1 = 59 df. Since the standard tables do not provide the critical value for 59 df the closest
available value is for 60 df. This leaves us with an approximate confidence interval. Based on 99% confidence
and df = 60, the critical t-value is 2.660. Therefore the 99% confidence interval is approximately: 7% ±
2.660(3.227) or 7% ± 8.584% or -1.584% to 15.584%.

If you use a z-statistic, the confidence interval is 7% ± 2.58(3.227) = -1.326% to 15.326%, which is closest to
the correct choice.

68.A

The way the alternative hypothesis is written you are only looking at the right side of the distribution. You are
only interested in showing that B is greater than 0. You don't care if it is less than zero. For a one-tailed test at
the 5% level of significance, the critical z value is 1.645. Since the test statistic of 1.68 is greater than the critical
value we would reject the null hypothesis.

69.A

There is no sample statistic for non-normal distributions with unknown variance for small samples, but the t-
statistic is used when the sample size is large.

70.C

This is a one-sided alternative because of the “greater than” belief. We expect to reject the null.

71.A

 Because we can compute the population standard deviation, we use the z-statistic. A 95% confidence level is
constructed by taking the population mean and adding and subtracting the product of the z-statistic reliability
(zα/2) factor times the known standard deviation of the population divided by the square root of the sample size
(note that the population variance is given and its positive square root is the standard deviation of the
population): x ± zα/2 × ( σ / n1/2) = 96 ± 1.96 × (91/2 / 4001/2) = 96 ± 1.96 × (0.15) = 96 ± 0.294 = 95.706 to 96.294.

72.A

Because we know the population standard deviation, we use the z-statistic. The z-statistic reliability factor for a
99% confidence interval is 2.575. The confidence interval is 1.5% ± 2.575[(8.0%)/√121] or 1.5% ± 1.9%.

73.A

 A 95% confidence interval for the population mean (α = 5%), for example, is a range of estimates within which
the actual value of the population mean will lie with a probability of 95%. Point estimates, on the other hand, are
single (sample) values used to estimate population parameters. There is no such thing as a α percent point
estimate or a (1 − α) percent cross-sectional point estimate.

74. C

We will use the process of Hypothesis testing to determine whether Shoffield should reject Ho:

        Step 1: State the Hypothesis

                Ho: μ ≤ 3,000

                Ha: μ > 3,000

        Step 2: Select Appropriate Test Statistic

               Here, we have a normally distributed population with an unknown variance (we are given only the
               sample standard deviation) and a small sample size (less than 30.) Thus, we will use the t-
               statistic.

        Step 3: Specify the Level of Significance

               Here, the confidence level is 90%, or 0.90, which translates to a 0.10 significance level.

        Step 4: State the Decision Rule

               This is a one-tailed test. The critical value for this question will be the t-statistic that corresponds to
               an α of 0.10, and 14 (n-1) degrees of freedom. Using the t-table , we determine that the
               appropriate critical value = 1.345. Thus, we will reject the null hypothesis if the calculated test
               statistic is greater than 1.345.

        Step 5: Calculate sample (test) statistic
              The test statistic = t = (3,150 – 3,000) / (450 / √ 15) = 1.291

        Step 6: Make a decision

              Fail to reject the null hypothesis because the calculated statistic is less than the critical value.
              Shoffield cannot state with 90% certainty that the home game attendance exceeds 3,000.

The other statements are false. As shown above, the appropriate test is a t-test, not a Z-test. There is a test
statistic for an normally distributed population, an unknown variance and a small sample size – the t-statistic.
There is no test for a non-normal population with unknown variance and small sample size.

75.B

If we try to draw any conclusions from an analysis of a mutual fund database with survivorship bias, we
overestimate the average mutual fund return, because we don’t include the poorer-performing funds that
dropped out. A larger sample size from a database with survivorship bias will still result in a biased estimate.

76.B

The significance level is the risk of making a Type 1 error and rejecting the null hypothesis when it is true.

77. A

 If a smooth curve is to represent a probability density function, the total area under the curve must be one
(probability of all outcomes equals 1) and the curve must not fall below the horizontal axis (no outcome can
have a negative chance of occurring).

78. C

Z = ($60,000 – $47,500) / $12,500 = 1.0

From the table of areas under the normal curve, 84.13% of observations lie to the left of +1 standard deviation
of the mean. So, 100% – 84.13% = 15.87% with incomes of $60,000 or more.

79.A

 If the population sampled has a known variance, the z-test is the correct test to use. In general, a t-test is used
to test the mean of a population when the population is unknown. Note that in special cases when the sample is
extremely large, the z-test may be used in place of the t-test, but the t-test is considered to be the test of choice
when the population variance is unknown. A t-test is also used to test the difference between two population
means while an F-test is used to compare differences between the variances of two populations.

80. B

We can construct a confidence interval by adding and subtracting some amount from the point estimate. In
general, confidence intervals have the following form:

Point estimate +/- Reliability factor x Standard error

Point estimate = the value of a sample statistic of the population parameter

Reliability factor = a number that depends on the sampling distribution of the point estimate and the probability
the point estimate falls in the confidence interval (1 – α)

Standard error = the standard error of the point estimate

81. A

A 95% confidence level is 1.96 standard deviations from the mean, so 0.177 ± 1.96(0.339) = (–48.7%, 84.1%).
82.C

 The standard deviation is the positive square root of the variance. The variance is the expected value of the
squared deviations around the expected value, weighted by the probability of each observation. The expected
value is: (0.5) × (0.12) + (0.3) × (0.1) + (0.2) × (0.15) = 0.12. The variance is: (0.5) × (0.12 − 0.12)2 + (0.3) × (0.1
− 0.12)2 + (0.2) × (0.15 − 0.12)2 = 0.0003. The standard deviation is the square root of 0.0003 = 0.017 or 1.7%.

83. B

Using END mode, the PV of this annuity due is $10,000 plus the present value of a 9-year ordinary annuity:
N=9; I/Y=12.5; PMT=-10,000; FV=0; CPT PV=$52,285; $52,285 + $10,000 = $62,285.

Or set your calculator to BGN mode then N=10; I/Y=12.5; PMT=-10,000; FV=0; CPT PV= $62,285.

84. C

For event “E,” the probability stated as odds is: P(E) / [1 – P(E)]. Here, the probability that a poultry research
assistant received a salary increase in excess of 2.5% = 2,000 / 10,000 = 0.20, or 1/5 and the odds are (1/5) / [1
– (1/5)] = 1/4, or 1 to 4.

85. C

The variance is the sum of the squared deviations from the expected value weighted by the probability of each
outcome.
The expected value is E(X) = 0.3 × 2 + 0.4 × 3 + 0.3 × 4 = 3.
The variance is 0.3 × (2 − 3)2 + 0.4 × (3 − 3)2 + 0.3 × (4 − 3)2 = 0.6.

86. C

 This is a joint probability. From the information: P(Bear Market given inverted yield curve) = 0.75 and P(inverted
yield curve) = 0.20. The joint probability is the product of these two probabilities: (0.75)(0.20) = 0.15.

87. C

 The answer can be determined by dividing the probability of the event by the probability that it will not occur:
(1/5) / (4/5) = 1 to 4. The probability against the event occurring is four to one, i.e. in five occurrences of the
event, it is expected that it will occur once and not occur four times.

88. C

N = 8; I/Y = 12%; PMT = -$100; FV = 0; CPT → PV = $496.76.

89. B

 A distribution with a mean that is less than its median is a negatively skewed distribution. A negatively skewed
distribution is characterized by many small gains and a few extreme losses. Note that kurtosis is a measure of
the peakedness of a return distribution.

90. C

To calculate the time-weighted return:

Step 1: Separate the time periods into holding periods and calculate the return over that period:

Holding period 1: P0 = $50.00

D1 = $5.00

P1 = $75.00 (from information on second stock purchase)
HPR1 = (75 − 50 + 5) / 50 = 0.60, or 60%

Holding period 2: P1 = $75.00

D2 = $7.50

P2 = $100.00

HPR2 = (100 − 75 + 7.50) / 75 = 0.433, or 43.3%.

Step 2: Use the geometric mean to calculate the return over both periods

Return = [(1 + HPR1) × (1 + HPR2)]1/2 − 1 = [(1.60) × (1.433)]1/2 − 1 = 0.5142, or 51.4%.



91. B

When completed, the frequency distribution table should look as follows:

Frequency Distribution of Monthly Small Cap Stock Returns
     Interval    Absolute Frequency Relative Frequency
-4.0% to -2.0%             1                 11.1%
 -2.0% to 0.0%             1                 11.1%
  0.0% to 2.0%             5                 55.6%
  2.0% to 4.0%             2                 22.2%
      Total                9                100.0%

The relative frequency of the interval -2.0% to 0.0% does not equal the relative frequency of the interval 2.0% to
4.0%.

92.C

 The value of the account at maturity will be: $5,000 × (1 + 0.05 / 4)(3.5 × 4) = $5.949.77;
or with a financial calculator: N = 3 years × 4 quarters/year + 2 = 14 periods; I = 5% / 4 quarters/year = 1.25; PV
= $5,000; PMT = 0; CPT → FV = $5,949.77.



93. A

 The effective annual yield (EAY) is equal to the annualized holding period yield (HPY) based on a 365-day
year. EAY = (1 + HPY)365/t − 1 = (1.0317) 365/90 − 1 = 13.49%.

94. B

 The high temperature population variance is less than the sample variance. Calculating the high temperature
population variance would take quite a bit of time – so look for a shortcut! For the population of high
temperatures, we are given the mode and the CV. Here, there are two tricks: remember that the CV = standard
deviation / mean and that for a normal distribution, the mean = median = mode. We can manipulate the CV
equation as standard deviation = mean × CV, or 13 × 0.165 = 2.145. Squaring this result gives a variance of
2.1452 = 4.60. Thus, the high temperature population variance is less than the sample variance.Both remaining
statements are true. The strategy here is to work from the “easiest” to the most difficult calculations. (Note: all
units are oC unless stated otherwise.)

       The question tells us that the low temperatures are positively skewed with a mean of 6.9. For a positively
        skewed distribution, we know that the mean > median > mode. Thus, the mode is less than the mean, or
        6.9.
       The population with the lowest CV has the least dispersion. Thus, the population of high temperatures
        (CV of 0.165) is less dispersed than in the population of low temperatures (CV of 0.328).
        Again, calculating the low temperature population standard deviation would take quite a bit of time – so
         look for a shortcut! For the population of high temperatures, we are given the mean and the CV. Here,
         there is only one trick (we are given the mean): manipulate the CV equation as standard deviation =
         mean × CV, or 6.9 × 0.328 = 2.26. Unfortunately, there is no real shortcut for the low temperature sample
         standard deviation, which is calculated as follows:
             Sample mean is given at 7.2.
             Variance = [(3 – 7.2)2 + (6 – 7.2)2 + (10 – 7.2)2 + (9 – 7.2)2 + (8 – 7.2)2] / (5 – 1) = 7.7
             Standard Deviation = 7.71/2 = 2.78.

Thus, the population standard deviation of 2.26 is less than the sample standard deviation of 2.78.

95. C According to Bayes' formula: P(B / default) = P(default and B) / P(default).

P(default and B )= P(default / B) × P(B) = 0.250 × 0.300 = 0.075

P(default and CCC) = P(default / CCC) × P(CCC) = 0.400 × 0.700 = 0.280

P(default) = P(default and B) + P(default and CCC) = 0.355

P(B / default) = P(default and B) / P(default) = 0.075 / 0.355 = 0.211



96. C

 The standard error of the sample is the standard deviation divided by the square root of n, the sample size.
6/201/2 = 1.34%.The confidence interval = point estimate +/- (reliability factor × standard error) confidence
interval = 3 +/- (1.96 × 1.34) = 0.37 to 5.629

97. C

This is the formula for the continuously compounded rate of return.

98. C

 The %K and %D lines refer to stochastic oscillators. The %K line is calculated based on the highest and lowest
prices reached in a selected number of days, and the %D line is a moving average of the %K line. Used as
trading signals, crossovers of the %K line above the %D line are buy signals and crossovers below the %D line
are sell signals.With a moving average convergence/divergence oscillator, a sell signal is indicated when the
MACD line crosses below the signal line, which is a moving average of the MACD line. If a rate of change
oscillator is used to generate signals, these would typically be indicated when the oscillator crosses above or
below the level around which it fluctuates (either 0 or 100).

99. C

While data errors would certainly come to bear on the analysis, in their presence we would not be able to assert
either statistical or economic significance. In other words, data errors are not a valid explanation. The others are
all mitigating factors that can cause statistically significant results to be less than economically significant.

100. B

The discrete uniform distribution is characterized by an equal probability for each outcome. A single die roll is
an often-used example of a uniform distribution. In combining two random variables, such as coin flip or die roll
outcomes, the sum will not be uniformly distributed.




ECONOMICS
1. C.

Reason : The law of demand says that price and quantity demanded of the product are inversely
related,
             ceteris paribus. This does not hold good in the cases of (a), (b) . Hence, the answer is (e).
2.
MR2.5 (refer the class discussion notes)
3. C
Reason : For the consumer to be in equilibrium

             MU1MU2
                  =
               P1P2
             If MU1is twice the MU

             2MU2MU2
                   =, and P1= 2P2
               P1P2
             Therefore, the answer is (d).
4. C
Reason : A monopolist faces a downward sloping demand curve. Given the demand curve, he can decide
             the price and sell the quantity taken by the market or decide the output and charge a
             price at
             which the output can be sold. This way a monopolist can control either price or output but
             not
             both the variables.
5. C
Reason : If the demand for wheat is highly inelastic, bumper crop will lead to a sharp decline in price
                 thereby reducing farm incomes.
             In the long run both supply and demand curves tend to be more elastic since the
                 responsiveness of producers and consumers to a price change will be more in the long
                 run
                 than in the short run.
             (Demand for necessities is not as responsive to price change as the case with luxuries.
             If the demand is elastic, % change in Q > % change in P. For a given increase in price,
                 decrease in Q will be more than proportionate to the increase in price thereby leading
                 to
                 decrease in total revenue.
             Price effect is the sum of income and substitution effects. For a Giffen good, the income
                 effect is negative and more than the substitution effect thereby leading to a direct
                 relation
                 between price and quantity. If the negative income effect is less than the substitution
                 effect,
                 the good is inferior but not a Giffen good.
6. C
Reason : Long run average cost curve (LAC)
             I, II and IV are true and hence the answer is (c).
7.C
Reason : The supply curve for a highly perishable good is almost vertical. All other options are true.
8. A
Reason : Q = 100 –2P
When P = 40, Q = 20
                  ∂QP40
ep=.= –2 x= –4
                   ∂PQ20
9. C
Reason : Budget line is

                   YP1Q1
Q2=−
                   P2P2
The slope is determined by P1and P2.
The position is determined by Y. Therefore the answer is (d).




10. B
Reason : Economic profit = Accounting profit – Implicit costs.




11. B
             MUAMUB
Reason :=
                 PAPB
             600900
                =
             PA120
                           600
             ∴PA== Rs.80
                           7.5
12. A
Reason : In the long run a firm can continue to earn profit if entry is blocked. Otherwise, profits will
             attract new entry and profit will be eliminated. In monopoly entry is blocked by definition.
13. C
Reason : In monopolistic competition products are differentiated but close substitutes because of large
             number of sellers.
14. B
                            ∆TC500
Reason : AVC=== 10
                              ∆Q50
             TVC where Q = 100 is 10×100 = 1000
             F C = TC – TVC
             =1500 – 1000
             =500
15. C
                       ∆QP
Reason : ep=.
                       ∆PQ
             ∆Q = –500Q = 2000
             ∆P = 1.50P = 8.50
                        −5008.50
             ∴ep=×= |1.42|
                        1.502000


16. B
Reason : As long as MPL> APL, APLincreases and if MPL< APL, APLdecreases.
17. C
Reason : AC will be rising only if MC > AC. Option (c) is not true because MC can be rising but still less
             than AC, in which case AC will be decreasing.
18. B
Reason : MRP = (Price×MP). This is also equivalent to the additional revenue generated by employing
             one more unit of input.
19. C
Reason For the downward sloping demand curve ‘D’, at no point is the MR > Price, but MR = Price at P
             where the elasticity is infinity.
20. B
Reason : The market will be in equilibrium when quantity demanded of a product is equal to the
quantity
             supplied of the product. When the quantity demanded (Qd) is not equal to the quantity
             supplied
            (Qs), the market is not in equilibrium and market forces will restore equilibrium by
            changing the
            price of the product. If Qd > Qs, there is scarcity of the good and price will increase
            thereby
            eliminating the scarcity. If Qs > Qd, there is a surplus which will be eliminated by a fall in
            the
            price. Further, profits of the firms will increase (decrease) when price of the product
            increases
            (decreases), cetirus paribus.
            Options (a) and (c) are not correct as the market forces will raise the price when Qd > Qs.
            Option (d) is not correct because increase in price would increase profits of the firm.
            Option (e)
            is not correct because increase in price would decrease the quantity demanded of the
            product.
21. C
Reason : Implicit costs are opportunity costs which may not involve a cash outgo. Explicit costs are
out-
            of-pocket costs which are visible.
            Options (a), (b), (c) and (d) are explicit costs as they are visible and involve cash outgo.
            Option (e) is an example of implicit cost as the opportunity cost of the asset is the rent
            foregone.
22. B
Reason : Average total cost (AC) = Average variable cost (AVC) + Average fixed cost (AFC).
            As output increases AFC continues to decline since fixed cost is a constant amount. As
            AFC
            declines, AC and AVC tend to converge.
            Options (a) and (b) are not the answer. Though both the statements are correct they are
            not the
            reasons for convergence of AC and AVC.
            Option (c) is not correct as AFC decreases as the output increases.
23. B
Reason : A perfectly competitive industry will be in equilibrium when all the firms in the industry are
in
            equilibrium and economic profits are zero. A firm will be in equilibrium when MR =
            MC.
            Economic profits are zero when AR = AC. In a perfectly competitive industry AR = P.
            therefore,
            the long run equilibrium of the industry is described by MC = MR = P = AC.
            Options (a) and (c) are not answers because MR≠P.
            Option (d) is not the answer because MC≠MR≠AC≠P.
            Option (d) is not the answer because MR≠AC.
24. A
Reason : A firm should shut down if price (P) is less than the average variable cost (AVC). If P<AVC,
            undertaking production will add to losses as the price is insufficient to recover the variable
            costs.
If P>AVC, additional production will increase profits or minimize losses.
Options (a), (b) and (e) does not imply any decision rules.
Option (d) is not the answer as the firm can reduce losses by undertaking production as
long as
P>AVC.
25. C
Reason : Elasticity of demand measures how responsive the demand is to a given change in the price.
In
            the given situation decrease in supply causes an increase in the price. Hence elasticity of
            demand
            cannot be computed and the answer is (e).
26. B
Reason : On a straight-line demand curve elasticity of demand at any point is equal to lower
segment of
            the demand curve / upper segment.
            Option (a) is incorrect as elasticity of demand at midpoint is equal to one.
            Option (b) is correct as elasticity of demand falls as we move down the demand curve.
27. B
Reason : Price elasticity of demand for a good is determined by the following factors:
            Number of substitutes: more the number of substitutes, more elastic the demand is.
            Proportion of income spent on the good: if significant portion of the consumers’ income is
            spent
            on a good, demand will be more elastic.
            Time period: demand will be more elastic in the long run.
            Nature of the good: demand for essentials will be less elastic.
            Current price level: demand tends to be more elastic at higher price level. Hence the
            answer is
            (b).
28. B
Reason : Supply and demand forces determine the equilibrium price and quantity in a market
economy. If
            supply increases (decreases), equilibrium price decreases (increases) and the
            equilibrium
            quantity increases (decreases). On the other hand, if demand increases (decreases),
            equilibrium
            price increases (decreases) and the equilibrium quantity also increases (decreases).
            is not the answer because increase in demand results in an increase in both the price as
            well
            as quantity.
            is not the answer because increase in supply results in a decrease in price and increase
            in
            quantity.
            is not the answer because decrease in demand results in an decrease in both the price as
            well
            as quantity.
           is not the answer because increase in both supply of and demand for the product increase
           the
           equilibrium quantity, but the effect on the price is uncertain.
29. B
Reason : The difference between a firm operating under perfect competition and imperfect
competition is
           that demand curve faced by a firm under perfect competition is horizontal and demand
           curve
           faced by a firm under imperfect competition is downward sloping. When the demand
           curve faced
           by a firm is horizontal, the price is given and the firm has to decide only the profit-
           maximizing
           output. Where as pricing of a product is an important decision for a firm under
           imperfect
           competition.
           (a) is not the answer as all the firms, both under perfect competition as well as under
           imperfect
           competition, have to decide the quantity of a product to be produced.
           (c) and (d) are not the answer as all the firms, both under perfect competition as well as
           under
           imperfect competition, have to decide about the efficient production and optimum
           input
           combination
30. C
Reason : Under perfect competition, long-run equilibrium is established when MC=MR=P=AC.
This
            ensures efficiency in production as the AC will be minimum (MC=AC). Under
            monopolistic
            competition, long-run equilibrium is established when MC=MR and P=AC.




                       Equilibrium of a firm under Monopolistic Competition
            As the demand curve is downward sloping MR≠P and equilibrium occurs on the
            downward
            sloping portion of the AC curve, and not at the minimum point on the AC. This is called
            the
            ‘excess capacity’ problem in the monopolistic competition.
            (a) is not the answer as the production is not efficient under monopolistic competition.
            (b) is not the answer as the firm under monopolistic competition produces on falling side
            of the
            AC curve


31. B
Reason : To maximize profits a firm should equate MC to MR and the slope of MC should be greater
than
            the slope of MR.
            (a) is not the answer because maximizing the difference between marginal revenue and
            marginal
            cost does not maximize profits.
            (b) is the answer as profit maximizing requires MC=MR
            (c) is not the answer because MC=AVC indicates minimum AVC situation where profits
            are not
            maximized.
32. B
Reason : When a firm increases price but competitors do not respond, the firm looses a significant
market
            share to competitors, hence the demand curve faced by the firm is highly elastic for any
            increase
            in the price. On the other hand, if price is decreased by the firm competitors also follow
            suit and
           the firm do not gain market share, hence the demand curve far any decrease in the
           price is
           inelastic. This makes the demand curve faced by the firm kinked at the current price.
           (a) is not the answer as a horizontal demand curve means a perfectly elastic demand,
           which is
           not true in this case.
           (c) is not the answer as a vertical demand curve means a perfectly inelastic demand, which
           is not
           true in this case.
33. B
                  n
Reason : TCn =∑MCi.
                 i=1
Therefore, TC = 50+25+20+30=125.

11
34. B
Reason : (a) True. Price elasticity of demand is always negative for a normal good as the price
and
             quantity demanded are inversely related.
             (b) False. To earn a normal rate of return the firm is required to break-even. This is
             because of
             inclusion of normal profits in the total cost.
             (c) True. An industry in which economies of scale are so large that it makes sense to
             have just
             one firm in the industry is defined as a natural monopoly.


             .
35. B
                  1
Reason : MR = P1−
                  ep
                              
                            1
             = 401−
                       (1)
                         3
             = 40 (1 – 3)
             = – 80
             ∴MR is – Rs.80.
36. B
Reason : If MU can be measured in rupees, the consumer can maximize his total utility by consuming
the
             good until MU = P.
∴Equilibrium Quality is
200 – 10 QA= 20
10 QA=180
QA=18
∴The individual would demand 18 units. Hence the answer is (b).
37. B
Reason : In the short run a firm cannot avoid fixed costs. Whether the firm undertakes production or not
             the fixed costs are incurred by the firm. Therefore, the deciding factor for the firm is whether
             it
             is able to recover its variable costs or not. As long as the revenue (price) is greater than
             the
             variable (average variable) cost it is in the interest of the firm to undertake production.
38. C
Reason : Long run average cost curve (LAC)




             (I) and (III) are true and hence the answer is (c).
39. C

             MUAMUB
Reason :=
               PAPB
             120180
                =
             PA24
                         120
             ∴PA== Rs.16.
                          7.5




40. C
Reason : Given the income (budget) of the consumer and the prices of the goods the budget constraint
             (line) indicates the combinations of the two goods the consumer can buy. Utility
             maximizing
             consumer would like to reach the farthest possible indifference curve from the origin.
             Therefore,
             every point that lies to the right of the budget constraint is desirable for the consumer as he
             can
             move onto a higher indifference curve, but not attainable.
41. C
Reason : For a Giffen good the income effect is negative and stronger then the positive substitution effect.
             Hence the price effect is negative.
42. B
                                       %∆Q
Reason : When the demand is elastic, ep=> 1.
                                       %∆P
∴%∆Q > %∆P
%∆TR = %∆Q + %∆P (approximately)

∴For a decrease in price TR will increase as %∆Q > %∆P if ep> 1.
43. A
Reason : Price effect = Income effect + Substitution effect
1000 = 900 + Substitution effect
∴Substitution effect = 100
44. C
Reason : Shutdown point is the output where price of the product is equal to the average variable cost
             (AVC). If price falls below the shutdown point the firm can minimize losses by closing down
             operations. If the price is greater than the AVC the firm can minimize losses or maximize
             profits
             by undertaking production.
45. B
Reason : Two indifference curves (ICs) can never intersect as an IC represents a certain level of utility.
             Further, an IC is convex to origin and MRS decreases as we go on substituting good X for
             good
             Y. In case of perfectly substitutable goods MRS is constant and hence IC is a straight line.
46. C
Reason : Two goods are substitutes when both the goods can satisfy the same want and can be
substituted
             for one another. In the given options only tea and coffee are substitutes. All other
             combinations
             are complementary goods.
47. A
Reason : A firm can maximize profits or minimize losses only when the MC is equal to MR. If MR > MC
             marginal profit is positive and the firm can improve profitability by increasing productivity.
             On
             the other hand if MR < MC the firm can improve profitability by decreasing output.
48. C
Reason : Large economies of scale leading to existence of a single firm in an industry is defined as a
             natural monopoly.
49. C
Reason : Consumers expenditure increases when he buys same amount of goods even after the increased
              price. This is possible when the demand of the consumer is inelastic (i.e. less than one).
50. C
Reason : a.Long run average cost (LAC = LTC/Q) is U-shaped because of economies of scale
              initially and diseconomies of scale at later stages of production.
         b.Long run marginal cost (LMC =∂LTC/∂Q) is U-shaped as cost of producing additional units
              reduces at the beginning because of economies of scale, but raises later due to diseconomies
              of
              scale.
        c & d. Short run average cost (SAC = STC/Q) and AVC (= TVC/Q) falls and raises due to operation
            of ‘law of diminishing marginal productivity’.
        e.Average fixed cost (AFC = TFC/Q) falls at a decreasing rate with the increase of output
            because of constant total fixed cost.
51. B
Reason : If the firm can produce higher output by a proportional increase in inputs, its average cost
            remains the same. This indicates that the company is experiencing constant returns to
            scale
            (CRS).
            a.Average cost increases with the increase of output if the firm operates under decreasing
                returns to scale.
            b.Average cost remains the same if the firm operates under constant returns to scale.
            c.When the firm operates under constant returns to scale, the marginal cost remains the
                same.
52. B
Reason : In a perfect competition, the market price of the good is determined by the market forces –
            supply and demand. Hence, a perfectly competitive firm will have no control on the
            market
            price. Thus, a perfectly competitive firm is only a price taker and not a price maker.
            A.In a perfect competition, the product is homogenous and is not differentiable with respect
                 to products of other firms. Promotional spending is not a feature of perfect competition,
                 in
                 fact it is source of imperfection in the market.
            B.A perfectly competitive firm can control its costs of production to maximize its profits by
                 minimizing its costs. Hence, the firm should spend more time on decisions making
                 relating to cost of production.
            C.In a perfect competition, the products of different sellers will be homogenous and the
                 consumers cannot differentiate the product of one seller with other. As the firm
                 produces
                 only homogenous goods, it need not spend much time on the design of the product.




53. B
Reason : Governments across the world enact anti-monopoly laws to achieve efficiency through
            competition. If competition is encouraged then competitive firms sell goods at a lower price
            by
            controlling their costs. This results in development of efficiency in the market.
54. C
Reason : To maximize his total utility, a consumer should spend his income such that the last rupee
            spent on all goods gives same amount of additional utility i.e. MUx/Px = MUy/Py. The
            marginal utilities of last good X and good Y are same, hence it can be written as MUx/Px =
            MUx/Py. As the price of good X is more than good Y, MUx/Px < MUx/Py, which means that
            the consumer has not achieved maximum possible satisfaction. In order to reach
            maximum
            satisfaction, he should, thus, consume more of good Y and less of good X because marginal
            utility per rupee from good Y is more than good X.
55. C
Reason : As long as the firm experiences diseconomies of scale, the average cost of the firm increases.
            Conversely, the firm’s average cost decreases during the range of production where the
            firm
            experiences economies of scale. As the firm is experiencing diseconomies of scale initially and
            later economies of scale, the average cost increases initially, but decreases eventually.
            Hence,
            the firm’s long-run average cost curve will rise initially, but falls later and forms an inverted
            U-
            shaped curve.
56. C
Reason : % Change in total revenue = % Change in quantity + % Change in price. With law of demand
            in operation, the percentage change in total revenue will be positive (negative) if the
            percentage
            change in quantity sold is more (less) than the percentage change in price.
            (a)If the demand for a product is unit elastic, any given percentage change in the price will
                 resulting an equal but opposite percentage in quantity demanded. The net effect would
                 be
                 no change in total revenue because the downward force would exactly offset the
                 upward
                 force on revenue.
            (b)Suppose the demand for a product is inelastic, the percentage increase in quantity
                 demanded caused by price cut would be smaller than the percentage fall in price
                 that
                 caused it. Under such circumstances, the upward influence on the price cut on
                 revenue
                 would be stronger than the effect of the increase in quantity demanded on revenue.
            (c)Suppose the demand for a product is elastic, the percentage increase in quantity demanded
                 caused by price cut would be larger than the percentage fall in price that caused it.
                 Under
                 such circumstances, the depressing effect of the price cut on revenue would be lower
                 than
                 the effect of the increase in quantity demanded on revenue and hence the revenue
                 will
                 increase.
61. B
Reason : a.Meal costs more in cities because the firm incur higher cost of living. This does not
                 constitute price discrimination.
            b.When a super market offers special sale prices for goods during 9 a.m. to 12 a.m. it means
                 that they have sub-divided the market into two based on the timing and is charged
                 with
                 different prices. Hence, this constitutes price discrimination.
            c.The insurance company is charging higher premium on expensive stores because of
                 higher risk. This does not constitute to price discrimination.
            d.Buy one and get one free is available to everyone and hence is not an example of price
                 discrimination.


20
62. A
Reason : If the price of a complement falls, the demand for X will increase, increasing quantity and
             increasing price in the short run. Economic profits will induce new firms to enter the market
             and the supply curve will shift to the right. Since it is a constant cost industry, the long-run
             supply curve will be horizontal and the price comes to its initial price level.
63. A
Reason : In a monopoly, the firm’s demand curve is the demand curve of the industry. When the market
             transforms to perfect competition, the demand curve of the firm will turn horizontal. But,
             the
             market demand curve remains downward sloping. Hence, the statement (a) is the correct.
64. C
Reason : A price war in an oligopoly refers to successive and continued price cuts by the member firms
             to increase sales and revenues. A price war aims at increasing market share, but not
             profits.
             Hence (a) is not correct.
65. C
Reason : The degree of substitutability of products can be measured by the cross-price elasticity of
             demand for goods produced by the firms. If the substitutability is perfect (that is if the
             two
             firms are selling a homogenous product), the cross-price elasticity will be infinity. On the
             other
             hand, if the products are differentiated, the cross-price elasticity of demand will be positive
             and
             finite. If the products have no substitutes then the cross-price elasticity of those goods will
             be
             zero.
            (a)In perfect competition, since the products are homogenous, the cross-price elasticity will
                 be infinity.
            (b)In a monopoly there will be no substitutes and hence the cross-price elasticity of goods is
                 zero.
21
            (c)In monopolistic competition and differentiated oligopoly the products are differentiated
                 but not homogenous, hence the cross-price elasticity will be between 0 to infinite.
66. C
Reason : The difference between marginal revenue gained by a firm and the marginal cost incurred for
             producing the good indicates the additional profit the firm has gained by selling one
             additional
             unit; which is known as marginal profit.
             a.Net revenue = Total revenue – Total cost = Profits. Hence is not the correct answer.
             b.Average revenue = Total revenue/Quantity sold.
             c.Marginal profit = Marginal revenue – marginal cost
Reason : Product differentiation exists only when consumers can differentiate the product sold by one
             producer from another. There are two conditions that must be fulfilled for price
             discrimination
             (i) the market must be divided into sub-markets with different price elasticities and (ii)
             there
             must be effective separation of the sub-markets so that no reselling can take place from a
             low-
             price market to a high-price market. But these two conditions are not necessary for
             product
             differentiation. Hence (a), (b) and (c) are not correct.
67. B
Reason : Tea, milk, rice and water are necessary because of their importance in daily life. Ice cream is
             considered to be luxury. For luxuries the income elasticity of demand will be high.
68. B
Reason : When the price of good X doubles, the consumer can buy less of the good X with the given
             income, but can buy same quantity of another good. Hence, the budget line will fan inside at
             Y-
             intercept to the left.
69. C
Reason : Price effect = Income effect + substitution effect. For any good, the substitution effect is
             positive. That is, when a good becomes relatively cheaper, it is substituted for other goods.
             a.In the case of Giffen good, negative income effect is greater than the positive substitution
                 effect; hence price and quantity demanded of the good are positively related.
             b.Income effect will be negative in case of inferior good as fewer quantities are demanded
                 when real income increases.
             c.For normal goods, both income effect and substitution effect work in the same direction.
70. C
Reason : The profit of a firm refers to the difference between total revenue and total cost. Hence, to
             maximize the profits, the firm should maximize the difference between total revenue and
             total
             cost. The difference between average revenue (AR) and average cost (AC) represents
             the
             average profit of the firm. Hence maximization of difference between average revenue
             and
             average cost also indicates profit maximization. A firm maximizes its profit when it produces
             and sells an output at which marginal revenue (MR) is equal to marginal cost (MC).
71. B
Reason : In long run, all costs are variable, which means there will be no fixed costs.
             a.In the long run, the fixed cost will be zero. Hence, the fixed cost of a firm in the long run
                  will be lesser than the fixed cost of the firm in the short run.

22
            b.With the increase of output The average fixed cost falls at a
            decreasing rate. Hence the
                 statement (d) is not correct.
            c.When the firm is not producing anything, its variable cost will be
            zero. Hence, the total
                 cost of the firm will be just equal to its fixed costs.
72. B
Reason : Ignorance and costs of obtaining information often make the products
of one firm an imperfect
            substitute for another.
            (a) The given situation does not represent a perfect competition
            because there is no free flow
                 of information.
            (b) The chief characteristic of monopolistic competition is
            product differentiation. Product
                 differentiation can arise depending on the location and
                 accessibility. Here, the sentence
                 “she finally brought the dress as she felt that if would take
                 more time in locating other
                 showrooms” signifies product differentiation in the form of
                 location.
            (c) In monopoly, there should be only one seller. But in the given
            situation, there is more than
                 one show- room in the city.
73. A
Reason : The shape of the indifference curves reveals the degree of
substitutability between two goods.
            In case of perfect substitutes, as there is perfect degree of
            substitutability between goods, the
            indifference curve will be linear. For complementary goods –
            goods that cannot be substituted
                            for each other at all – the indifference curve will be L-shaped.
                            Indifference curves are convex
                            to origin because the marginal rate of substitution decreases as we
                            move right.
               74. C
               Reason : Price ceiling inevitably result in shortages when they are set below
               market equilibrium price.
                            Because the rent ceiling is more than the market equilibrium rent,
                            it will not have any impact
                            on the equilibrium rent, quantity of house demanded and supplied.
              75. B
                                                            ∂QP
              Reason : Point price elasticity of Demand (ep) =.
                                                            ∂PQ
                            ∂QQ
              =ep.
                            ∂PP
                                         40
              =–2 x= –4
                                         20
                                    ∂Q
              Since=   (1/Slope of the demand curve)
                                    ∂P
                                                   ∂P1
              Slope of the demand curve is== –0.25 =0.25
                                                   ∂Q−4
              76. A
              Reason : Price effect = Income effect + Substitution effect
              1000 = 900 + Substitution effect
77. C

When the Fed lowers the Fed Funds Rate the exchange rate falls (as ‘hot’ money flows
out) and aggregate demand increases (as consumption, investment and net exports rise).
              ∴Substitution effect = 100
78. C

The ripple effect is felt in the labor market as initially in an expansion, the quantity of labor
increases due to an increase in labor demand (due to business optimism), and the quantity of
labor further rises as labor supply increases (due to intertemporal substitution).

79. A

The Phillips curve illustrates the relationship between inflation and unemployment.

80. B

If the inter-temporal substitution were strong, it would support the assertions of RBC theory

81. A
If Country B devotes all of its resources to producing corn, it will make 8 units while, under the
same circumstances, Country A will make 4 units. Therefore, Country B is twice as productive
with respect to corn as Country A. Country B can also produce more cloth (16 units) in relation
to Country A (14 units) supposing all resources are used for cloth. However, rather than being
twice as productive as was the case for corn, it is only slightly more productive. Therefore,
Country B has a comparative advantage in corn, and thus should specialize in its production,
while Country A should specialize in the production of cloth.

82. A
The lowering of trade barriers is hoped to lead to economic growth opportunities and increased
competition worldwide.

83. A
The Japanese government’s action is an example of a tariff. A tariff is a tax imposed on imports
and benefits the Japanese government because it collects the tariff. Domestic producers benefit
because the reduction in the supply of imported goods means a higher domestic price.The other
choices are incorrect. A tariff is considered less harmful than a quota (an import quantity
limitation) because under a quota, the domestic government does not receive any funds as it
would under a tariff (the foreign producers receive the revenue transfer). In the long run, trade
restrictions do not protect the net number of jobs in the country. The number of jobs protected by
import restrictions will be offset by jobs lost in the import/export industry. Import/export firms
will be unable to sell the overpriced domestic products abroad or import and sell the lower priced
restricted foreign-made product.

84. A
First, convert to one currency (we will convert to EUR), then assume that consumers will
purchase from the cheapest suppliers. The cheapest country appears in bold.
Good              France (in EUR) United Kingdom (in EUR)
Jeans             42              26 × 1.5 = 39
Wine              18              14 × 1.5 = 21
Cheese            5               3 × 1.5 = 4.5
LCD Screens 85                 50 × 1.5 = 75
Thus, French consumers will minimize cost by purchasing French wine and British jeans, cheese,
and LCD screens


85. A
Tariffs raise domestic prices, benefiting domestic suppliers.

86. A
Firms dump their goods at a price lower than cost in order to drive out the competition. Once this
is complete, they will be able to raise prices to much higher levels in order to gain abnormal
profits. Of course, once prices are increased, new competitors may arise.


87. A
The number of jobs protected by import restrictions will be offset by jobs lost in the
import/export industries. In the long run, trade restrictions cannot protect the net number of jobs
in a country.


88. A
Using the following IRP equation: ForwardFC:DC = SpotFC:DC × [(1 + rdomestic) / (1 + rforeign )]
Solving for the spot rate: SpotFC:DC = ForwardFC:DC × [(1 + rforeign) / (1 + rdomestic)]
                       = [(1 + 0.09) / (1 + 0.07)](5)
                       = (1.09 / 1.07)(5)
                       = 5.09


89. A
Set up a bid-ask matrix using:
USD:CHF bid-ask 1.3096 − 1.4528
USD:DKK bid-ask 2.4365 − 2.5843
(USD:CHF 1.3096) / (USD:DKK 2.5843) = DKK:CHF 0.50675
(USD:CHF 1.4528) / (USD:DKK 2.4365) = DKK:CHF 0.59627


90. A
Total SEK cost = 390 × 6 = 2,340 SEK. Invert the quote = 1 / 6.9 = SEK:USD 0.1449 .
Total dollar cost = SEK:USD 0.1449 × 2,340 SEK = USD 339.13

91. A
Foreign exchange quotations can be expressed on a direct basis — the home currency price of
another currency—or an indirect basis—the foreign currency price of the home currency.

92. A
The approximate forward premium/discount is given by the interest rate differential. This
differential is: 6.25% − 5.15% = 1.10%. Since Tunisia has higher interest rates, its currency will
be at a discount in the forward market. This discount equals: 0.011 × 0.8105 = 0.0089. Since the
exchange rate is quoted in CHF:TND, as a depreciating currency, it will take more TND to buy
one CHF. The forward rate is thus: 0.8105 + 0.0089 = CHF:TND 0.8194. In other words, the
CHF is stronger in the forward market.

93. A
We know that arbitrage is possible because 2.2 × (1.08/1.06) = 2.2415 > 2.0. This means that the
GBP is overvalued in the forward market (it takes too few of them to buy one USD), and should
be sold forward. This means that we need to buy GBP today so that we have them to sell
forward.
Step 1: Borrow $1,000 at 6% (repay $1,060 in one year), convert the $1,000 at the spot rate to
2,200 GBP
Step 2: Lend out the GBP 2,200 at 8% (will receive GBP 2,376 in one year)
Step 3: Sell the GBP forward at the quoted forward rate, 2,376/2.0 = $1,188
Step 4: Repay loan, $1,188 − $1,060 = $128 profit

94. A
The percentage spread is the same irrespective of how the quote is made. The percentage spread
is calculated as: (1.435 − 1.425) / 1.435 × 100 = 0.697


95. A
% spread = [(ask price – bid price) / ask price] × 100

96. A
Percent spread = [(Ask price – Bid price)/Ask price] × 100
Percent spread = [(1.5570 – 1.5558)/1.5570] × 100 = 0.07707%


97. A
This problem demonstrates the "Bid-Ask Matrix Method" to calculate the bid and ask quotes:
Step 1: Put the bid-ask quotes into a matrix. Use direct quotes in the common currency.
Currency Bid            Ask
MXN          0.11001 0.11036
PEN          0.28818 0.28918
Step 2: "Divide Out" the diagonals and take the reciprocal. Remember that the quotes are direct
quotes for a USD investor.
(Remember to put MXN in the numerator - because MXN is in the numerator of the quote we are
asked to calculate.)
MXNBid / PENAsk = 0.11001 / 0.28918 = MXN:PEN 0.38042,
1 / MXN:PEN 0.38042 = PEN:MXN 2.62867
MXNAsk / PENBid = 0.11036 / 0.28818 = PEN:MXN 0.38296,
1 / MXN:PEN 0.38296 = PEN:MXN 2.61127
Step 3: Quote : The PEN:MXN Bid-Ask is:
(Note: The lower number from Step 2 is the bid, the higher number is the ask.)
PEN:MXN 2.61127 to 2.62867


98. A
The bid price is 1.0000 / 2.0100 = GBP:EUR 0.4975.
The ask price is 1.0015 / 2.0000 = GBP:EUR 0.5008.
The bid-ask spread is 0.5008 − 0.4975 = 0.0033.


99. A
The gain or loss on a forward contract is unrelated to the spot rate. Gains or losses are measured
relative to the forward contract rate, not the spot rate. Forward contracts call for delivery of a
specified amount of a currency quoted against the dollar on a specific future date.


100. A
A foreign currency is at a forward premium if the forward rate expressed in dollars is above the
spot rate. Forward premium = forward rate – spot rate = 5 − 4 = 1.


101. A
Step 1:Determine whether an arbitrage opportunity exists.
We can arrange the formula for covered interest rate parity (CIP) to look like: (1 + rdomestic) − [((1
+ rforeign) × ForwardDC/FC) / SpotDC/FC] = 0
If this condition holds with the financial data above, there are no arbitrage opportunities: (1 +
0.06500) − [((1 + 0.05200) × 31.5000) / 30.73000] = 1.06500 − 1.07836 = -0.01336
Since the no arbitrage condition does not hold, we move on to:
Step 2:Borrow Domestic or Foreign?
Rule 1: If the sign on the result of Step 1 is negative, borrow domestic. If the sign is positive,
borrow foreign. Here, the sign is negative, so borrow domestic.
Rule 2: See table below. (Rule 2 is an alternative to Rule 1).
(rd − rf) < (Forward − Spot) / Spot Borrow Domestic
(rd − rf) > (Forward − Spot) / Spot Borrow Foreign
Here, (0.06500 – 0.05200) compared to (31.5000 – 30.73000) / 30.73000 0.013000 < 0.02506,
borrow domestic.
Step 3: Conduct Arbitrage and Calculate Profits.
Step Description                      Rate Calculation                                 Result
a Borrow Domestic                             MUR 1,000,000                            MUR 1,000,000
b Exchange MUR for $                  Spot = MUR 1,000,000 / 30.73000 MUR/$ $32,541
c Lend $ at Foreign (U.S.) Rate               = $32,541 × (1.05200)                    $34,233
d Contract to sell proceeds fwd     1 Fwd = $34,233 × 31.50000 MUR/$                   MUR 1,078,340
e Calculate loan payoff2                      = MUR 1,000,000 × (1.06500)              MUR 1,065,000
f     Calculate profit (d-e)                                                           MUR 13,340
Note:   1 This is the amount you will have available to repay the loan. 2 This is the amount you

need to repay
102. A.
Remember that the forward premium or discount is always on the currency in the denominator of
the quote.
USD/EUR premium/discount = [(1.2067 − 1.2139) / 1.2139](12 / 6) = -1.19%. Since the Euro is
selling at a forward discount, the Euro is weak relative to the dollar and the dollar is strong
relative to the Euro.
USD/GBP premium/discount = [(1.7894 − 1.7730) / 1.7730](12 / 6) = 1.85%. Since the Pound is
selling at a forward premium, the Pound is strong relative to the dollar and the dollar is weak
relative to the Pound.
JPY/USD premium/discount = [(114.867 − 115.674) / 115.674](12 / 6) = -1.40%. Since the
dollar is selling at a forward discount, the dollar is weak relative to the yen and the yen is strong
relative to the dollar.
Note that you did not necessarily need to calculate the amount of the discount or premium for
this question.


103. A
Forward (DC/FC) = Spot (DC/FC)[(1 + rdomestic) / (1 + rforeign)]
(80 CY/EGP)[(1 + 0.055) / (1 + 0.06)]
(80)(0.99528)
= 79.6226


104. A
Use the following formula to determine if an arbitrage opportunity exists and which currency to
borrow.
if 1 + rD> [(1 + rF)(Forward rate)] / Spot rate then borrow foreign.
1.0723 > [(1.0694)(1.70)] / 1.73
1.0723 > 1.81798 / 1.73
1.0723 > 1.0509, therefore borrow foreign (pounds).
Alternatively, the dollar is appreciating. [(1.73 − 1.70) / 1.70] = 1.76% and the $U.S. interest rate
is higher. Clearly, investing in $U.S. (and borrowing pounds) is the way to go.


105. A
Interest rate parity is given by:



ForwardFC:DC = 0.5500 × (1.075/1.06) = NZD:USD 0.55778
FSA




1 .A.

The financial statement analysis framework consists of six steps. Step 2: “Gather data”
includes acquiring the company’s financial statements and other relevant data on its
industry and the economy. Step 3. “Process the data” includes activities such as making
any appropriate adjustments to the financial statements and preparing exhibits such as
graphs and common-size balance sheets.



2 .C.

A current liability is expected to be settled within one year or operating cycle, whichever
is greater. It is not necessary to settle a current liability with cash. There are a number
of ways to settle a current liability. For example, unearned revenue is a liability that is
settled by providing goods or services.



3 .B.

The acquisition goodwill is equal to $1.8 million [$4 million purchase price – $2.2 million
fair value of net assets acquired ($3.5 million assets at fair value – $1.3 million liabilities
at fair value)]. Under IFRS or U.S. GAAP, goodwill is not amortized but is subject to an
annual impairment test.



4 .A.

Acquired copyrights and patents are intangible assets that can be separately identified.
Identifiable intangible assets are amortized over their useful lives.



5 .A.

Liquidation values of equipment used in the production of goods or services is not a
required disclosure for firms that are expected to continue to operate. The other items
must be reported in the financial statements.
6 .B.

Held-to-maturity securities are reported on the balance sheet at amortized cost while
available-for-sale securities are reported at fair value. Amortized cost includes the
amortization of a premium or discount that was created when the security was
purchased.



7 .C.

The par value of common stock is the stated or nominal value assigned to the stock.
Par value has no relationship to market value. The amount the corporation receives
from the issuance of common stock is equal to the par value plus the additional paid-in-
capital (proceeds in excess of par).



8 .B.

Revenue may be recorded as production occurs (% of completion), at completion of
production, and at the time of sale.



9 .B.

Under the accrual concept, revenue is recognized when the earnings process is
completed (earned) and ultimate realization (cash receipt) is assured.



10 .C.

The percentage of completion method recognizes revenues in proportion to the
proportion of expenses incurred.



11 .A.

The key word is "unreliable." The completed contract method is used when cost
estimates are unreliable. The percentage-of-completion method recognizes profit
corresponding to the percentage of cost incurred to total estimated costs associated
with long-term construction contracts. Percent-of-completion is used where contracts
and cost estimates are reliable.
The cost recovery method is similar to the installment sales method but is more
conservative. Sales are recognized when cash is received, but no gross profit is
recognized until all of the cost of goods sold is collected.



12 .C.

Under the accrual concept, income is recognized when the earning activities are
substantially completed, risk of ownership has transferred from buyer to seller, and
payment is realizable and collectible. Under the matching principle, expenses incurred
that directly relate to the sold item are expensed in the same period as the revenue is
recognized.



13 .B.

Recognition of income depends on cash collected under both methods.



14 .B.

The completed contract method is used when a reliable estimate of the total costs
cannot be determined until the contract is finished. Because of the significant
uncertainty surrounding the ground water costs, the completed contract method should
be used in this transaction, and no revenue should be recognized in 2004 or any later
year until the contract is completed or the cost uncertainty is resolved.



15 .C.

Interest received from customers and interest received from investments are a part of
normal operations of a financial institution. Thus, the First National Bank will report the
interest income from both sources as components of operating income.



16 .B.

Since Red Oak is a nonfinancial firm, the accrued interest is considered a nonoperating
activity, related to how the firm is financed. Dividends paid to preferred shareholders do
not affect net income.
17 .A.

Since Pinto is a nonfinancial firm, dividends received would be considered a
nonoperating component. An increase in cost of goods sold would be considered a part
of normal operations.



18 .A.

The key word here is "or." Unusual or infrequent items are unusual orinfrequent, but
NOT both. These items are reported (as a separate line item) as a component of net
income from continuing operations.

Examples of unusual or infrequent items include:

        Gains or losses from the disposal of a business segment (employee separation
          costs, plant shutdown costs, etc.)
        Gains or losses from the sale of assets or investments in subsidiaries
        Provisions for environmental remediation
        Impairments, write-offs, write-downs, and restructuring costs
        Integration expenses associated iwth businesses that have been recently
          acquired.



19 .B.

EPS = earnings available to common shareholders divided by the weighted average
number of common shares outstanding. With no preferred shareholders, all of net
income is available to the common shareholders. The weighted average number of
shares outstanding equals the original 2 million shares plus 4/12 of the additional
600,000 shares. The 4/12 weight is used because the new shares were only
outstanding 4 months of the year. Thus, EPS = $8.8 million / [2 million +
(4/12)(600,000)] = 8.8/2.2 = $4.00.



20 .A.

Stock splits and stock dividends are applied to all shares that existed at the beginning of
the period and shares that were issued or repurchased during the period, but prior to
the split or dividend. For SSP, the 5 million beginning-of-year shares outstanding are
adjusted to 7.5 million shares (5.0 × 3/2) as a result of the 3:2 split.
21 .B.

[400,000 shares × 12 months + 40,000 × 12 months + 90,000 × 6 months - (12,000 × 1
months)] divided by 12 = 484,000 shares.



22 .B.

Connecticut’s January 1 balance of common shares outstanding is adjusted
retroactively for the 1 for 3 reverse stock split, meaning there are (360,000 / 3) =
120,000 “new” shares treated as if they had been outstanding since January 1. The
weighted average of the shares issued in July, (60,000 × 6 / 12) = 30,000 is added to
that figure, for a total of 150,000.



23 .A.

The reacquisition of treasury stock affects the denominator of both the EPS and Diluted
EPS equations, but does not cause identical numbers to become different. The other
factors will introduce potential earning dilution and therefore could cause diluted EPS to
be less than basic EPS.



24 .C.

Dilutive securities are securities that decrease EPS if they are exercised or converted to
common stock. Stock options, warrants, convertible debt, and convertible preferred
stock are examples of potentially dilutive securities. Note that if diluted EPS when
considering the convertible preferred stock is greater than basic EPS, the convertible
preferred stock would be antidilutive and should not be treated as common stock in
computing diluted EPS.



25 .C.

Not all preferred stock is dilutive. Only convertible preferred stock is potentially dilutive.



26 .A.
The interest expense for three months net of tax is added to the numerator (12% ×
$100,000 × 3/12 × 60 %) = $1,800. The number of shares added to the denominator are
4,500. (18,000 × 3 / 12).



27 .A.

To compute Hampshire’s basic EPS ((net income – preferred dividends) / weighted
average common shares outstanding), the weighted average common shares must be
computed. 100,000 shares were outstanding from January 1, and 30,000 shares were
issued on September 1, so the weighted average is 100,000 + (30,000 × 4 / 12) =
110,000. Basic EPS is ($2,800,000 – (10,000 × $1,000 × 0.06)) / 110,000 = $20.00.

If the warrants were exercised, cash inflow would be 10,000 × $150 × 10 = $15,000,000
for 10 × 10,000 = 100,000 shares. Using the treasury stock method, the number of
Hampshire shares that can be purchased with the cash inflow (cash inflow / average
share price) is $15,000,000 / $250 = 60,000. The number of shares that would be
created is 100,000 – 60,000 = 40,000. Diluted EPS is $2,200,000 / (110,000 + 40,000)
= $14.67.



28 .C.

(816)(5) = $4,080. $4,080 / $8 = 510 shares. 816 − 510 = 306 new shares or [(8 − 5) /
8]816 = 306.



29 .A.

Net income is equal to $41,000 ($100,000 revenue – $40,000 COGS – $20,000
operating expenses + $1,000 realized gain on sale of equipment). Comprehensive
income includes all transactions that affect stockholders’ equity except transactions with
shareholders. Comprehensive income includes net income, unrealized gains and losses
from available-for-sales securities, unrealized gains and losses from cash flow hedging
derivatives, and gains and losses from foreign currency translation. Thus,
comprehensive income is equal to $43,000 ($41,000 net income + $5,000 unrealized
gain from foreign currency translation – $3,000 unrealized loss from cash flow hedging
derivatives). Dividends paid is a transaction with shareholders and is not included in
comprehensive income.



30 .A.
When recognizing a gain on the sale of fixed assets, the amount is a deduction to
operating cash flows. This is because the gain would be double counted in the investing
section and in net income. Therefore, the gain must be removed from net income. The
direct method of cash flow calculation converts the income statement items to their cash
equivalents, not the indirect method. Also, depreciation is added to net income in order
to calculate CFO using the indirect method.



31 .B.

Issuing bonds in exchange for equipment does not affect cash flow. Interest paid is an
operating cash flow. Exchanging bonds for stock does not affect cash, but should still be
disclosed in a footnote to the Statement of Cash Flows. Dividends paid are considered
financing activities. In this case, only the preferred stock dividends paid would be
considered CFF.



32 .C.

There are three components that Stone will need to calculate Soft Corporation's
projected net cash flow from financing activities, issuance of long-term debt, issuance of
common stock, and payment of cash dividends. The calculation will be the same under
both the direct and indirect methods and is as follows:

(40.0 – 20.0) + (10.0) – (4.0) = 26.0

The issuance of common stock is from the exercise of the employee stock options. The
correct choice is 26.0.



33 .B.

Soft Corporation's net cash flow from operations are $1.0 million, they spent $(25.0)
million on PP&E, and received $26.0 million from financing activities. This makes the
net change in cash $2,000,000. Note that projected cash for 2005 is 2.0 million greater
than at year-end 2004.



34 .B.

Purchase of equipment -$50
Fixed asset sold            $60
    CFI                     $10


35 .A.

The main components of cash flow from operations are changes in working capital
items (accounts receivable, inventory, accounts payable), and items that flow through
the income statement. Capitalization activities, sale of assets and purchases of
securities would all be part of cash flows from investing. Repayment of bonds and
issuance of common stock would also be part of cash flows from financing. The stock
split would be a non-cash activity.



36 .A.

Purchases of equipment are considered to be cash flows from investing. Interest paid or
received and dividends received are considered to be cash flows from operations under
U.S. GAAP.



37 .A.

Selling stock of the company would be a financing cash flow.



38 .B.

Cash flow from financing increases when stock is issued, while cash flow from investing
decreases when spending for purchases of fixed assets.



39 .A.

Operating liabilities result from the operations of the firm and consist of operating and
trade liabilities such as accounts payable, customer advances, and accrued liabilities.
Financing liabilities are a result of prior financing inflows. Financing liabilities (current)
include short-term notes payable and the current maturities of long-term debt.
40 .C.

Dividends paid to stockholders are considered cash outlays from financing according to
U.S. GAAP.



41 .B.

Retiring bonds by issuing common stock to the bondholders is a non-cash transaction
and is disclosed separately in a note or supplementary schedule to the cash flow
statement, rather than as a financing cash flow. The cash borrowed for the equipment
purchase is a financing inflow and the cash cost of the equipment is reported as an
investing cash flow in the cash flow statement. Had a bond been issued to the seller of
the equipment, it would be treated as a non-cash transaction and reported only in the
notes to the cash flow statement.



42 .A.

The purchase of plant and equipment with financing provided by the seller is a non-cash
transaction. Non-cash transactions are disclosed separately in a note or supplementary
schedule to the cash flow statement.



43 .A.

Only the acquisition of common stock of the affiliate for $2.7 million and the purchase of
the patent for $3.3 million are included in cash flow from investing activities. Since the
acquisition of the stock purchase was financed with a bank loan, $2.7 million will be
reported as a financing inflow. Both remaining transactions are non-cash transactions
and are disclosed in the notes to or in a supplementarty schedule to the cash flow
statement.



44 .A.

Cash paid for insurance = insurance expense + change in prepaid insurance, so
insurance expense for 2007 is equal to $925,000 [($750,000 cash paid for insurance −
(-$175,000)]. Interest expense for 2007 is equal to $950,000 ($900,000 cash interest
paid + $50,000 increase in interest payable).
45 .B.

It is the direct method, not the indirect method, that presents operating cash receipts
and payments and is thus more consistent with the objectives of the cash flow
statement. The direct method provides more information than the indirect method and is
preferred by analysts who are estimating future cash flows.



46 .A.

If a firm sells more than it collects, accounts receivable will increase. If a firm pays
suppliers more than it purchases, accounts payable will decrease.



47 .A.

Extraordinary items are reported below income from continuing operations but above
net income. You must adjust for changes in the working capital accounts: accounts
receivable, inventory, and accounts payable.



48 .C.

          Indirect Method
EAT                          +1,000
Depreciation                  +500
Change in Inv.       + 100 a source
Change in Accts.
                         (300) a use
Rec.
CFO                            1,300
           Direct Method
Net Sales                    +3,500
Change in Accts.
                         (300) a use
Rec.
COGS                       (1,500)
Cash Taxes                   (500)
Change in Inv.       +100 a source
CFO                          1,300
49 .A.

Cost of goods sold was (beginning inventory plus purchases less ending inventory)
($500,000 + $1,800,000 − $800,000 =) $1,500,000. Cash flow from operations under
the direct method is calculated by:

     Cash collections: $3,100,000 (net sales plus decrease in accounts receivable) of
       ($3,000,000 + ($300,000 − $200,000))
     Less direct cash inputs: $1,800,000 (cost of goods sold plus increase in
       inventory) of ($1,500,000 + $300,000)
     Less other cash outflows of $400,000

CFO = ($3,100,000 – 1,800,000 – 400,000) = $900,000



50 .A.

Dividends declared in 2004 are net income less the increase in retained earnings
($800,000 - $300,000 = $500,000). Dividends declared less the increase in dividends
payable is dividends paid ($500,000 – ($300,000 - $200,000) = $400,000). This is a
cash outflow so it is a negative number. Dividends are always cash flow from financing.
Note that accounts payable changes are included in cash flow from operations (CFO).



51 .A.

Proceeds in a primary market go to the issuing firm. Proceeds from a sale in the
secondary market go to the current owner who is selling the securities.



52 .C.

Other cash outflows is the third step in calculating CFO using the direct method. It
consists of Cash taxes paid + Cash interest paid.

Cash interest paid = interest expense less increase in interest payable: ($900,000 –
(1,200,000 - $800,000) =) $500,000.

Cash taxes paid =     tax expense of $1,000,000
                    + decrease in income taxes payable (1,000,000-800,000) = 200,000
                    - increase in deferred income taxes (2,600,000-2,900,000) = 300,000
                      $900,000
Other cash outflows = $500,000 + 900,000 = $1,400,000



53 .A.

A decrease in accounts payable represents an outflow. Hence, a negative adjustment
will be required. Conversely, an increase represents an inflow and a positive
adjustment.



54 .A.

Cash flow from operations (CFO) using the indirect method is computed by taking net
income plus non-cash expenses (i.e. depreciation) less gains from the equipment sale.
Note that cash flow from operations must be adjusted downward for the amount of the
gain on the sale of the equipment. Cash flow from operations is ($850,000 + $200,000 –
($100,000 − $50,000)) = $1,000,000. Note that interest and income taxes paid are
expenses shown on the income statement and will already be factored into net income.
The other information relates to financial and investing cash flows.



55 .A.

Silverstone Company’s cash flow from operations would be calculated as +Net Income
$8,000 + Inventory $250 - Prepaid exp. $500 + Depreciation $175 + A/P $200 = $8,125.

Bonds payable is a financing activity and would not be included in the cash flow from
operations. The indirect method takes the change in the non-cash accounts and
decreases or increases net income to get to the change in cash flow.



56 .B.

Using the indirect method, CFO is net income increased by 2005 depreciation
($1,000,000) and decreased by the gain recognized on the sale of the plane
[$10,000,000 sale price − ($15,000,000 original cost − $10,000,000 accumulated
depreciation including 2005) = $5,000,000]. $12,000,000 + $1,000,000 − $5,000,000 =
$8,000,000.



57 .B.
Net income is ($6,000 – 3,200 – 800)(1 – 0.4) = $1,200. Adjustments to reconcile net
income to cash flow from operating activities will require that depreciation ($800) be
added back, and increase in accounts receivable ($1,000) be subtracted: $1,200 + 800
– 1,000 = $1,000.



58 .A.

Decreasing accounts payable turnover saves cash by delaying payments to suppliers.
The result is an operating source of cash, not a financing source. Decreasing accounts
payable turnover is not a sustainable source of cash flow because suppliers will refuse
to extend credit, at some point, if payment is slower and slower.



59 .B.

A cash flow statement can be presented in common-size format by expressing each line
item as a percentage of total revenue or by expressing each inflow of cash as a
percentage of total cash inflows and each outflow as a percentage of total cash
outflows. Expressing each line item of the cash flow statement as a percentage of
revenue is useful in forecasting future cash flows since revenue usually drives the
forecast.



60 .B.

The reinvestment ratio measures a firm’s ability to acquire long-term assets with cash
flows from operations. In contrast, the investing and financing ratio, which is more
comprehensive, measures the firm’s ability to purchase assets, satisfy debts, and pay
dividends.

The cash-to-income ratio measures the ability to generate cash from a firm’s operations
and is a performance ratio for cash flow analysis purposes. The debt payment ratio
measures the firm’s ability to satisfy long-term debt with cash flow from operations but it
is more of a coverage ratio than a performance ratio.



61 .C.

Leverage increased as measured by the debt-to-equity ratio from 2.25 in 2005 to 3.68 in
2007. Gross profit margin declined from 20.0% in 2005 to 18.5% in 2007. Return on
equity has improved since 2005. One measure of ROE is ROA × financial leverage.
Financial leverage (assets / equity) can be derived by adding 1 to the debt-to-equity
ratio. In 2005, ROE was 23.4% [7.2% ROA × (1 + 2.25 debt-to-equity)]. In 2007, ROE
was 27.6% [5.9% ROA × (1 + 3.68 debt-to-equity)].




62 .C.

Current ratio = (0.4 + 2.0 + 0.8 + 1.2) / 4.0 = 1.1.

Quick ratio = (0.4 + 2.0 + 0.8) / 4.0 = 0.8.

Cash ratio = (0.4 + 2.0) / 4.0 = 0.6.



63 .C.

Vertical common-size statements enable the analyst to make better comparisons of two
firms of different sizes that operate in the same industry. Horizontal common-size
financial statements express each line as a percentage of the base year figure; thus,
horizontal common-size statements can be used to identify structural changes in a
firm’s operating results and financial condition over time.



64 .A.

The restructuring charge and asset write-down are non-recurring transactions; thus, net
income will be higher in 20X8, all else equal. In 20X8, fixed asset turnover will be the
same as 20X7, all else equal. The asset impairment charge is a one-time charge, so
fixed assets will not be reduced further in 20X8.



65 .B.

Operating profit margin = (EBIT / net sales) = ($150,000 / $500,000) = 30%

66 .A.First, calculate beginning inventory given COGS, purchases, and ending
inventory. Beginning inventory was $35 million [$130 million COGS + $45 million ending
inventory – $140 million purchases]. Next, calculate average inventory of $40 million
[($35 million beginning inventory + $45 million ending inventory) / 2]. Finally, calculate
inventory turnover of 3.25 [$130 million COGS / $40 million average inventory].
67 .C.

ROE = (EAT / S)(S / A)(A / EQ)
ROE = (0.1)(1.2)(1.5) = 0.18 68 .A.

Although manipulation of cash flow can occur, the P/E ratio is easier to manipulate
because earnings are based on the numerous estimates and judgments of accrual
accounting. EPS does not facilitate comparisons among firms. Two firms may have the
same amount of earnings but the number of shares outstanding may differ significantly.



69 .A.

Sensitivity analysis develops a range of possible outcomes as specific inputs are
changed one at a time. Sensitivity analysis is also known as “what-if” analysis. Scenario
analysis is based on a specific set of outcomes for multiple variables. Computer
generated analysis, based on developing probability distributions of key variables, is
known as simulation analysis.



70 .B.

20X8 sales are expected to be $110 million [$100 million × 1.1] and COGS is expected
to be $44 million [$110 million sales × 40%]. With 73 days of inventory on hand,
average inventory is $8.8 million [($44 million COGS / 365) × 73 days].



71 .A.

Using LIFO cost of goods sold (COGS) gives a more accurate measure of future
earnings because the LIFO COGS is more representative of the current cost of product
sold as compared to using FIFO therefore net income will be more accurately
represented.

72 .A.

Under the assumptions of this question and using LIFO, the most expensive units go to
COGS, resulting in lower net income.
73 .A.

Inventory turnover makes no sense at all for firms using LIFO due to the mismatching of
costs (the numerator is current while the denominator is historical). FIFO based
inventory is relatively unaffected by price changes and is a good approximation of actual
turnover. In this way, current costs are matched in the numerator and denominator.



74 .A.

In a LIFO liquidation, a firm allows inventory to decrease so that it is using lower-cost
materials (purchased in the past). This will lower the COGS and increase income and
profit. This is one of the ways that a firm’s management can manipulate earnings.



75 .C.

The allocation of fixed production overhead is based on units produced relative to
normal production capacity. Since Markus is operating at 75% of normal capacity, 75%
of the fixed overhead (75% × $4 million = $3 million) is capitalized (and eventually
recognized as cost of goods sold when the related inventory is sold) and 25% of the
fixed overhead (25% × $4 million = $1 million) is expensed in the period when the cost
is incurred.



76 .B.

Market is equal to the replacement cost subject to replacement cost being within a
specific range. The upper bound is net realizable value (NRV), which is equal to selling
price ($80) less selling costs ($2) for an NRV of $78. The lower bound is NRV ($78) less
normal profit (5% of selling price = $4) for a net amount of $74. Since replacement cost
($73) is less than NRV minus normal profit ($74), then market equals NRV minus
normal profit ($74). As well, we have to use the lower of cost ($90) or market ($74)
principle so the recorders should be recorded at the lower amount of $74.



77 .B.

Under FIFO:

 COGS = 500 @ $5 = $2,500
Inventory = 200 @ $7 + 400 @ $6 = $3,800

78 .A.

LIFO is more accurate for income statement purposes because LIFO's COGS more
closely reflects current costs and therefore provides a better measure of current income.



79 .A.

During inflation, FIFO will generate higher earnings because cost of goods will be lower
than if LIFO was used. However, LIFO will generate higher cash flows since cash
outflows for taxes will be lower for LIFO.



80 .A.

LIFO is the most informative inventory accounting method for income statement
purposes in periods of rising prices and stable or growing inventories. It allocates the
most recent purchase prices to COGS, and thus provides a better measure of current
income and future profitability.



81 .C.

Neither metric is directly relevant in evaluating the stability of a firm’s inventory levels.
Determining stability would presumably require other information such as purchase and
sales levels, for example. The inventory turnover ratio and the number of days in
inventory can be used to evaluate the relative age of a firm’s inventory as well as the
effectiveness of a firm’s inventory management.



82 .A.

Low inventory turnover (high number of days in inventory) may be a sign of slow-moving
or obsolete inventory, especially when coupled with low or declining revenue growth
compared to the industry. Low inventory value compared to cost of goods sold,
however, implies a high inventory turnover ratio. This suggests much less risk of
obsolescence.
83 .A.

With sales of $5.5 million and a gross margin of 0.32, the COGS (on a LIFO basis) is
$3.74 million. In order to convert COGS to a FIFO basis, we need to subtract the
change in LIFO reserve during the year: $3,740,000 − ($75,000 − $175,000) =
$3,840,000.



84 .C.

LIFO results in higher cost of goods sold during periods of rising prices because the last
items bought, which are the most expensive, are the first items sold resulting in a higher
cost of goods sold.



85 .A.

Ending Inventory under FIFO includes more recently purchased higher cost goods than
under LIFO. The LIFO inventory consists of older, cheaper goods. Both before and after
tax earnings under FIFO will be higher because less expensive goods are used for the
cost of goods sold (COGS). Working capital, which is equal to current assets – current
liabilities will also be higher under FIFO due the higher inventory balance causing a
higher level of current assets.



86 .A.

When prices are declining and LIFO is used the COGS is smaller than if FIFO is used
leading to a larger net income.



87 .A.

Return on total equity (net income / total equity) was ($800,000 / ($2,200,000 +
$1,800,000) =) 20%. Under FIFO, net income increases by the increase in the LIFO
reserve multiplied by (1 – tax rate). FIFO net income for 2001 was ($800,000 +
($600,000 – $400,000) (1 – 0.40) = ) $920,000. Total equity increases by the amount of
accumulated FIFO profits that are added to retained earnings which is calculated by
multiplying the amount of the ending LIFO reserve by (1 – tax rate) for an increase of
(($600,000) * (1 – 0.40) =) $360,000. Total equity is ($2,200,000 + $1,800,000 +
$360,000 =) $4,360,000. FIFO return on total equity is ($920,000 / $4,360,000 =)
21.1%.
88 .A.

In periods of rising prices LIFO results in lower current assets because the ending
inventory is based on inventory items that were purchased first at a lower price.



89 .C.

EBT = Sales − (COGS + SGA)

COGS = Beginning inventory + Purchases − Ending inventory

Ending inventory in units = 559 + 785 − 848 = 496 units
Average cost = (559 × $1 + $785 × $5) / (559 + 785)
= ($559 + $3,925) / 1,344 = $3.3363
Ending inventory = 496 × $3.3363 = $1,654.81

COGS = $559 + $3,925 − $1,654.81 = $2,829.19

EBT = 12,720 − (2,829.19 + 3,191) = $6,699.81.



90 .A.

To convert LIFO inventory balances to a FIFO basis, simply add the LIFO reserve to the
LIFO inventory:

INVF = INVL + LIFO Reserve



91 .A.

The formula to convert an ending inventory value from the LIFO to the FIFO method is
to FIFO inventory = LIFO inventory + LIFO reserve.



92 .A.

Since older layers of inventory that are liquidated were purchased at lower prices, the
cost of goods sold will be lower and earnings will be higher.
93 .A.

Although a forward may have value to someone other than the original counterparties,
the non-standardized terms limit the level of interest, hence its marketability and
liquidity. The standardized terms of a future give it far more flexibility to traders, giving
rise to a strong secondary market and greater liquidity.

94 .C.

A decline in LIFO reserve is due to either falling prices or LIFO liquidations. In the case
of LIFO liquidation, the income statement does not reflect the current costs and should
be adjusted. In the case of falling prices, the LIFO income statement amounts are
current and do not need adjustment.



95 .B.

A decline in the LIFO reserve occurs when the increasing prices that created the
reserve begin declining or when the inventory is liquidated (i.e. less units in inventory at
the end of the year than at the beginning). LIFO reserves are not amortized.



96 .A.

Company A will most likely have a competitive advantage from using newer equipment
on average. Company B’s assets are mostly depreciated. Therefore, depreciation
expense will be lower and if all other aspects are similar, the earnings and taxes for
Company B will be higher.



97 .A.

Acquired patents are most likely purchased with the intent to use over a specific period
of time and therefore would be an example of an intangible asset with a finite life.
Goodwill, by definition, is an intangible asset with an indefinite life. Trademarks that can
be renewed at minimal cost are also considered to be intangible assets with infinite
lives.

98 .B.
Intangible assets with finite lives are amortized over their expected useful lives, which is
an estimate. Actual lives of intangible assets are often not known in advance. Intangible
assets with infinite lives are not amortized, but are tested for impairment at least
annually.



99 .A.

Assets, liabilities and depreciation will be higher. Net profit margin will be lower because
net income is lower and times interest earned will be lower because the interest
expense is higher.

100 .A.

Any future expenditure that is required for environmental remediation must be recorded
as a liability according to the present value of its expected cost at time of acquisition.
The present value of the asset retirement obligation (ARO) is recognized as a liability,
and the same value is added to the carrying value of the asset.

101 .C.

With an abandonment of an asset, the carrying value of the machinery is removed from
the balance sheet and a loss of that amount is recognized in the income statement. The
carrying value is $360,000, which equals the original cost ($500,000) less the
accumulated depreciation ($140,000).

102 .A.

In future years, less depreciation expense is recognized on the written-down asset
resulting in higher net income and return on assets since ROA = NI/Total Assets.
Deferred tax liabilities related to the asset decrease because the impairment cannot be
deducted from taxable income until the asset is sold or disposed of. The debt/equity
ratio increases because equity decreases while debt is unchanged.

103 .A.

An asset is impaired if its future cash flows (undiscounted) are less than its carrying
value.




104 .A.
Income tax expense will be less than taxes payable because the firm can only
recognize warranty expense as they occur. Thus, if the warranty expenses are
overestimated on the financial statements income tax expense will be less that taxes
payable.



105 .C.

Permanent difference will not result in deferred taxes since they are not expected to
reverse in the future.

106 .B.

Straight-line depreciation is $12,675 / 5 = $2,535.
Financial statement income is $7,192 − $2,535 = $4,657.
Accelerated depreciation is $12,675(0.35) = $4,436 in years 1 and 2 and $12,675(0.3) =
$3,803 in year 3.
Taxable income is $7,192 − $4,436 = $2,756 in years 1 and 2 and $7,192 − $3,803 =
$3,389 in year 3.

At the old tax rate of 41%:
Deferred Tax liability for year 1 = $779.41 [($4,657 − $2,756)(0.41)]
Deferred Tax liability for year 2 = $779.41 [($4,657 − $2,756)(0.41)]
Deferred Tax liability for year 3 = $519.88 [($4,657 − $3,389)(0.41)]
Deferred tax liability at the end of year 3, before the change in tax rate, is $2,079 =
($779.41 + $779.41 + $519.88)

At the new tax rate of 31%:
Deferred Tax liability for year 1 = $589.31 [($4,657 − $2,756)(0.31)]
Deferred Tax liability for year 2 = $589.31 [($4,657 − $2,756)(0.31)]
Deferred Tax liability for year 3 = $393.08 [($4,657 − $3,389)(0.31)]
Deferred tax liability at the end of year 3, after the change in tax rate, will be $1,572 =
($589.31 + $589.31 + $393.08)

The deferred tax liability will decrease by $507 = ($2,079 − $1,572) due to the new
lower tax rate. An adjustment of $507 in tax expense will result in increase in net
income by the same amount $507.

Another way of answering this question is as follows:

The deferred tax liability is the cost of the oven multiplied by the difference in the
amount of depreciation at the end of year 3 between accelerated depreciation (100%)
and straight line (60%) depreciation methods multiplied by the tax rate ((12,675 × 0.4) ×
0.31 = $1,572).
The change in net income due to the change in tax rates is the cost of the oven
multiplied by the difference in the amount of depreciation at the end of year 3 multiplied
by the difference in tax rates (12,675 × 0.4 × (0.41 − 0.31) = 507).



107 .A.

A permanent difference between tax and financial reporting is a difference that is
expected to not reverse itself. Under normal circumstances, the effects of the different
depreciation methods will reverse.

108 .A.

Deferred tax assets and liabilities must be separated between current and noncurrent
accounts.



109 .A.

Total taxes eventually due on 2004 activities were (($2,000,000 × 0.40) + ($4,000,000 ×
0.20) =) $1,600,000. Permanent differences are adjusted in the effective tax rate, which
is ($1,600,000 / $7,000,000 =) 22.86%. Of the $1,600,000 taxes due, (($2,000,000 ×
0.50 × 0.40) + ($4,000,000 × 0.25 × 0.20) =) $600,000 were paid in 2004 and
$1,000,000 ($1,600,000 − $600,000) is added to deferred tax liability.



110 .C.

In some cases, an analyst will not consider the deferred tax liabilities either liability or
equity. This is done if non-reversal is uncertain or when financial statement depreciation
is deemed inadequate and, therefore, is difficult to justify increasing stockholder’s
equity.



111 .B.

The procedures for compliance with Standard III(C) include determining all of the
aspects of a client’s investment objectives and constraints mentioned above, but do not
include gathering information about the client’s social habits and interests.
112 .A.

The ROA will not be affected by the classification of the deferred taxes. The total assets
will remain the same regardless of whether the deferred taxes are classified as a liability
or equity.



113 .A.

For financial analysis, an analyst must decide on the appropriate treatment of deferred
taxes on a case-by-case basis. These can be classified as liabilities or stockholder’s
equity, depending on various factors. Sometimes, deferred taxes are just ignored
altogether.



114 .A.

Depends on the "performance" of the timing difference.

115 .B.The present value of the future payments will not impact the classification of
deferred tax liabilities. Growth of the firm and the firm’s operations can each have an
impact on classification of deferred tax liabilities. These can result in non-payment of
deferred taxes even if they are reversed.



116 .A.

When deferred tax liabilities are included in equity, it will reduce the debt-to-equity ratio
(by increasing the denominator), in some cases considerably.



117 .C.

Tax payable for year one will be $2,259 = [{$14,384 − ($25,352 × 0.35)} × 0.41].



118 .A.

The deferred tax liability for year 1 will be $780.
Pretax Income = $9,314 ( $14,384 − $5,070).
Taxable Income = $5,511 ($14,384 − $8,873).
Deferred Tax liability = $1,559 [($9,314 − $5,511)(0.41)].



119 .A.

The deferred tax liability at the end of year 3 will be $4,158 ($1,559 + $1,559 + $1,040).
Pretax Income = $9,314 = ( $14,384 − $5,070).
Taxable Income = $6,778 = [$14,384 − ($25,352 × 0.30)].
Deferred Tax liability for year 3 = $1,040 = [($9,314 − $6,778)(0.41)].

Deferred Tax liability for year 1 = $1,559 = [($9,314 − $5,511)(0.41)].
Deferred Tax liability for year 2 = $1,559 = [($9,314 − $5,511)(0.41)].



120 .C.

                    Year 1 Year 2 Year 3 Year 4
Income tax
                    $400    $400     $360    $320
expense
Taxes paid          $320    $360     $360    $400
Deferred tax
                    $80     $120     $120    $40
liability


121 .A.

Since taxable income ($119,000) exceeds pretax income ($94,000), Camphor will have
a deferred tax asset of $8,500 = [($119,000 − $94,000)(0.34)].



122 .A.

Net income in year 1 for financial reporting purposes will be $2,748 = [($7,192 −
$2,535)(1 − 0.41)]

The annual depreciation expense on financial statements will be $2,535 = ($12,676 / 5
years)

123 .B.
Accounting profit from the installment sale was ($5,000,000 − $2,500,000 =)
$2,500,000. Income tax expense is calculated based on 40% of accounting profit, so tax
expense from the transaction is ($2,500,000 × 0.40 =) $1,000,000. Income taxes
payable, as of December 31, 2006, were (($1,000,000 − ($2,500,000 × $1,000,000 /
$5,000,000)) × 0.40 =) $200,000. The excess of income tax expense over income taxes
payable is a credit to deferred tax liability of ($1,000,000 − $200,000 =) $800,000.



124 .A.

A valuation allowance is a contra account (offset) against deferred tax assets that
reflects the likelihood that the deferred tax assets will never be realized. The
establishment of a valuation allowance reduces reported income, offsets (reduces)
assets, and reduces equity.



125 .A.

The permanent differences are never reversed, while there is no time limit on temporary
differences to reverse. Permanent differences never result in tax deferrals; temporary
differences always result in deferred tax assets or liabilities.



126 .C.

The correct statements are 2 and 4. Statement 1 is incorrect because the analysis of
the effective tax rate typically requires that the analyst, at a minimum, use the
information in the management analysis and discussion (MD&A). Furthermore, it is
recommended that the analyst seek additional information from the management if
needed. Statement 3 is incorrect because, by definition, sporadic items are not repeated
and are difficult to predict. Therefore they will complicate trend analysis and forecasting.



127 .B.

Permanent tax differences such as tax credits, non-deductible expenses, and tax
differences between capital gains and operating income give rise to differences in the
effective and statutory tax rates.



128 .A.
Comparability decreases when the comparison period is relatively short (e.g. quarters
vs. years), with the presence of volatility in the effective tax rate over the comparison
period, and operations in different tax jurisdictions.



129 .C.

Reported effective tax rate = Income tax expense / pretax income

= $3,000 / $10,000

= 30%



130 .B.

Under U.S. GAAP, deferred tax assets and liabilities are classified as current or non-
current according to the classification of the underlying asset or liability. Under IFRS,
deferred tax assets and deferred tax liabilities are all classified as noncurrent, with
footnote disclosure about the expected timing of reversals.



131 .C.

Lenders and other creditors use debt covenants in their lending agreements to restrict
the activities of the debtor that could adversely impact the creditors’ position. If any
bond covenant is violated, the firm is in technical default on its debt. The creditors can
demand payment of the debt, however, the terms are generally renegotiated. As such,
the company does not automatically enter into bankruptcy and have its assets liquidated
by the creditors.




132 .C.

Cash interest is only part of the interest expense. The amortization of the bond discount
at maturity is charged to financing cash flow when in fact it should be charged against
cash flow from operations, so CFO will be overstated.
133 .A.

The coupon payment is a cash outflow from operations. ($10,000,000 × 0.09) =
$900,000.



134 .A.

FV = 1000; PMT = 80/2; N = 5 × 2; I/Y = 10/2; solve for PV = 923.



135 .A.

For all off-balance-sheet liabilities, including operating leases, take-or-pay or throughput
contracts, and account receivables with recourse, the details of each liability should be
provided in the footnotes to the financial statements.



136 .A.

When analyzing disclosures related to financing liabilities, analysts would review the
balance sheet and find the present value of the promised future liability payments.
These payments would then be discounted at the rate in effect at issuance (i.e., the
yield to maturity), not the coupon rate of the bonds.



137 .B.

Firms that issued the debt at a lower cost than the current rates will benefit from an
increase in interest rates. The higher interest rates will decrease the market value of
their outstanding debt.



138 .C.

For the purpose of analysis, the value of debt should be adjusted for a change in
interest rates. This will change the debt-to-equity ratio. Because changes in interest
rates will change the market value of the debt, but not the coupon, interest expense will
be unchanged. (However, if a firm has variable-rate debt, interest expense will change
when interest rates change, but the market value of the variable-rate debt will not
change significantly.)



139 .B.

As the conversion price is above the current share price by a reasonable margin (5/44 =
11%), it is unlikely that the bonds will be converted. Thus, there will be no effect on the
debt to total capital ratio.

The exchangeable bond transaction has no gain or loss so there is no effect on equity.
But the liabilities will be reduced by $20 million and so this will decrease the debt to total
capital ratio.



140 .B.

Interest expense for bonds with warrants attached is higher because the value of the
warrants is treated as equity and the bond portion as if it were issued at a discount. The
cash interest plus the amortization of the discount will be greater than the (cash) interest
expense for the convertible bonds. Since the discounted liability will be smaller and
assets are the same (at issuance), equity is greater for the bonds with warrants
attached. Another way to think about this is that the estimated value of the warrants is
added to equity, whereas the value of the conversion option on convertible bonds is not.



141 .A.

Debt after conversion = $205 million − $80 million = $125 million

Equity = $400 million + $80 million = $480 million

Debt to Total Capital = Debt / (Debt + Equity) = $125 million / ($125 million + $480
million) = 0.207



142 .A.

Bonds with warrants attached will result in a lower debt-to-total-capital ratio than the
other two choices because part of the funds raised will be allocated to equity and the
balance sheet liability will be smaller by that amount. The remaining choices each result
in the same initial balance sheet liability.
143 .A.

The $0.7 million of redeemable preferred shares are treated as debt and will increase
liabilities.

The exchange of the bonds results in a decrease in liabilities of $1.2 million and a gain
of $0.3 million. The latter results in an increase in equity by $0.3 million (the net effect of
the two transactions also decreases assets by $0.9 million).

Liabilities = $8 million + $0.7 million - $1.2 million = $7.5 million

Equity = $10 million + $0.3 million = $10.3 million

Debt to total capital ratio = Liabilities / (Liabilities + Equity) = $7.5 million / ($7.5 million +
$10.3 million) = 0.421.


144 .A.

If the lessee has bond covenants (e.g., debt-to-equity ratio) relating to its financial
policies that it must follow, it is best to have an operating lease due to the fact that the
operating lease will keep the asset off of the balance sheet resulting in less liabilities.



145 .B.

Cash payments due under an operating lease must be disclosed in the notes to the
financial statements for each of the following five years and in aggregate. Operating
leases are simpler to account for and the often adverse ratio implications of offsetting
increases in assets and liabilities are avoided.



146 .A.

Lease capitalization adds both current and noncurrent liabilities to debt, resulting in a
corresponding increase in the debt-to-equity and other leverage ratios. Thus, Company
X’s (Debt + Lease)/Equity is greater than Company Y’s Debt/Equity.



147 .B.

The principal portion of a finance lease payment is a financing cash outflow for the
lessee. The interest portion is an operating cash outflow.
148 .A.

In a direct-financing lease, the implicit rate is such that the present value of the MLPs
equals the cost of the leased asset. Thus, at lease inception the total assets do not
change and no gain is recognized.



149 .A.

In a sales-type lease, the implicit interest rate is such that the present value of MLP is
the selling price of the asset. At the time of the lease inception, the lessor will recognize
a gain equaling the present value of the MLPs, less the cost of the leased asset.



150 .C.

At the inception of a finance lease, the leased asset and liability is recognized on the
balance sheet. Take-or-pay contracts and assets and liabilities of minority owned
subsidiaries are examples of off-balance-sheet financing.




COPORATE FINANCE



1 .B.

Lutz’s first statement is correct. The timing of cash flows is important for making correct
capital budgeting decisions. Capital budgeting decisions account for the time value of
money. Lutz’s second statement is incorrect. Capital budgeting decisions should be
based on incremental after-tax cash flows, not net (accounting) income.


2 .A.
Independent projects are projects for which the cash flows are independent from one
another and can be evaluated based on each project’s individual profitability. Since
Woischke is accepting both projects, the projects must be independent. If the projects
were mutually exclusive, only one of the two projects could be accepted. The
opportunity to invest in Bubble is a result of project sequencing, which means that
investing in a project today creates the opportunity to decide to invest in a related
project in the future.


3 .C.

Both statements are incorrect. An independent board should have the ability to seek
specialized advice by hiring outside consultants without management approval. The
size of the board should be appropriate for the facts and circumstances of the firm;
having more members does not imply that the board will be more independent if the
additional members are aligned closely with management or are less well qualified.


4 .B.

Marian’s first statement is correct. A breakpoint calculated as (amount of capital where
component cost changes / weight of component in the WACC). The component cost of
equity for Arlington will increase when the amount of new equity raised is $200 million,
which will occur at ($200 million / 0.70) = $285.71 million, or $286 million of new capital.
Marian’s second statement is also correct. If Arlington wants to finance $600 million of
total assets, the firm will need to raise $600 − $300 = $300 million of additional capital.
Using the target capital structure of 70% equity and 30% debt, Arlington will need to
raise $300 × 0.70 = $210 million in new equity and $300 × 0.30 = $90 million in new
debt. Looking at the capital schedules, these levels of new financing correspond with
rates of 9.0% and 4.2% for costs of equity and debt respectively, and the WACC is
equal to (9.0% × 0.70) + (4.2% × 0.30) = 7.56%.




5 .B.

Regarding the regular payback period, after 1 year, the amount to recover is $2,000
($5,000 - $3,000). After the second year, the amount is fully recovered.
The discounted payback period is found by first calculating the present values of each
future cash flow. These present values of future cash flows are then used to determine
the payback time period.
3,000 / (1 + .10)1 = 2,727
2,000 / (1 + .10)2 = 1,653
2,000 / (1 + .10)3 = 1,503.
Then:
5,000 - (2,727 + 1,653) = 620
620 / 1,503 = .4.
So, 2 + 0.4 = 2.4.



6 .C.

(0.3)(0.1)(1 - 0.4) + (0.2)(0.11) + (0.5)(0.18) = 0.13


7 .A.

Each statement that Haggerty has made to the board of directors regarding the
weighted average cost of capital is correct. New projects should have a return that is
higher than the cost to finance those projects.


8 .C.

The weights in the calculation of WACC should be based on the firm’s target capital
structure, that is, the proportions (based on market values) of debt, preferred stock, and
equity that the firm expects to achieve over time. Book values should not be used. As
such, the weight of debt is 41% ($10.5 ÷ $25.7), the weight of preferred stock is 6%
($1.5 ÷ $25.7) and the weight of common stock is 53% ($13.7 ÷ $25.7).


9 .A.

WACC = (1 − t) (rd) (D ÷ A) + (rp) (P/A) + (rce) (E ÷ A)
WACC = (1 − 0.4) (0.053) (58 ÷ 611) + (0.072) (28 ÷ 611) + (0.08) (525 ÷ 611)
WACC = 0.003 + 0.0033 + 0.0687
WACC = 7.50%


10 .A.

In order to calculate the weighted average cost of capital (WACC), market value weights
should be used.
For the bonds = 200,000 × $965 = $193,000,000
For the stocks = 6,000,000 × $28 = $168,000,000
                                     $361,000,000
The weight of debt would be: 193,000,000 / 361,000,000 = 0.5346 = 53.46%
The weight of common stock would be: 168,000,000 / 361,000,000 = 0.4654 = 46.54%
11 .C.


Greater days of receivables will increase both the cash conversion cycle and operating
cycle, other things equal.



12 .A.


Despite the theoretical superiority of the NPV and IRR methods for determining and
ranking project profitability, surveys of corporate managers show that a variety of
methods are used. Firms that were most likely to use the payback period method were
European firms and management teams with less education.


13 .B.

Despite the theoretical superiority of the NPV and IRR methods for determining and
ranking project profitability, surveys of corporate managers show that a variety of
methods are used. Firms that use the NPV and IRR methods tend to be larger, publicly-
traded, companies.



14 .A.

Both statements are incorrect. The wealth effect causes real consumption spending to
decrease at higher price levels because consumers have less wealth in real terms, and
consequently spend less. When interest rates increase, consumers spend less in the
current period as they delay purchases until future periods. They substitute purchases
later for purchases now (intertemporal substitution).



15 .A.

Based on the data provided, the analyst can conclude that Iridescent Carpeting has
weaker profitability than its competitors based on the net profit margin and return on
equity. The analyst can also conclude that the company has less financial leverage
(risk) than the industry average based on the total debt / total capital and the times
interest earned ratios. The analyst can conclude that the company has better short-term
liquidity than the industry average (i.e., its competitors) based on the current ratio.



16 .A.

Financial ratios are meaningless by themselves. To have meaning an analyst must use
them with other information. An analyst should evaluate financial ratios based on
industry norms and economic conditions. Statement 1 is correct. However, statement 2
is not because financial ratios tend to improve when the economy is strong and weaken
when the economy is in a recession. So, financial ratios should be reviewed in light of
the current stage of the business cycle.



17 .A.


The multiple IRR problem occurs if a project has non-normal cash flows, that is, the sign
of the net cash flows changes from negative to positive to negative, or vice versa. For
the exam, a shortcut to look for is the project cash flows changing signs more than
once. Only Project Blackjack has this cash flow pattern. The 0 net cash flow in T2 for
Project Keno and likely negative net present value (NPV) for Project Roulette would not
necessarily result in multiple IRRs.



18 .A.

Payback Period
$200,000 / $90,000 = 2.22 years
NPV Method
First, calculate the weights for debt and equity
wd + w e = 1
we = 1 − w d
wd / we = 0.40
wd = 0.40 × (1 − wd)
wd = 0.40 − 0.40wd
1.40wd = 0.40
wd = 0.286, we = 0.714
Second, calculate WACC
WACC = (wd × kd) × (1 − t) + (we × ke) = (0.286 × 0.07 × 0.66) + (0.714 × 0.14) = 0.0132
+ 0.100 = 0.1132
Third, calculate the PV of the project cash flows
90 / (1 + 0.1132)1 + 90 / (1 + 0.1132)2 + 90 / (1 + 0.1132)3 = $218,716
And finally, calculate the project NPV by subtracting out the initial cash flow
NPV = $218,716 − $200,000 = $18,716



19 B
Regulatory projects are forced upon companies by the government, and do not directly
generate any revenue

20 .C

While calculating the net present value of a project, net after-tax cash flows are
considered. Opportunity costs should be considered, and analysts must try to account
for any externalities as well.

21 .B

A firm uses capital rationing when it has limited funds and must select the most lucrative
projects from a variety of options.

22 .C

[CF][2nd][CE|C]
50000 [+/-] [ENTER]
[↓] 20000 [ENTER]
[↓][↓] 30000 [ENTER]
[↓] [↓] 35000 [ENTER]


23 .A


Value of the cash flow stream in Year 5 = 5,500,000 / 0.11 = $50,000,000

[CF] [2ND] [FV] [2ND] [CE|C]
42,000,000 [+|-] [ENTER] [↓]
2,120,000 [ENTER] [↓] [↓]
2,838,000 [ENTER] [↓] [↓]
3,480,000 [ENTER] [↓] [↓]
4,570,000[ENTER] [↓] [↓]
50,000,000 [ENTER]
[NPV] 11 [ENTER] [↓] [CPT]
NPV = -2,559,192.663


24 .A
Years          0             1         2            3       4
Cumulative cash
-120,000    -85,000          -40,000       10,000       60,000
flows ($)

The payback period for this investment equals 2 full years plus a fraction of the third
year.
This fraction equals: 40,000 / 50,000 = 0.8

Therefore, payback period = 2 + 0.8 = 2.8 years


25 .

Present value of future cash flows:

[CF] [2ND] [FV] [2ND] [CE|C]
0 [ENTER] [↓]
10 [ENTER] [↓] [↓]
10 [ENTER] [↓] [↓]
15 [ENTER] [↓] [↓]
15 [ENTER]
[NPV] 12 [ENTER] [↓] [CPT]
NPV = 37.11 million

Initial cost = $40 million

Profitability Index = PV of future cash flows / Initial investment

Profitability index = 37.11 / 40 = 0.93




26 .A

A potential supplier of capital will not provide capital to a company if the return offered
by the company is equal to the return that could be earned elsewhere at a lower risk.
27 .C


Percentage of equity in the capital structure = 52.8 / 96 = 55%

Percentage of debt in the capital structure = 11.52 / 96 = 12%

Percentage of preferred stock in the capital structure = 31.68 / 96 = 33%

WACC = (0.55 * 0.09) + [0.12 * 0.09 * (1 – 0.3)] + (0.33 * 0.11) = 9.336%



28 .B

Cost of preferred stock = 5.6 / 52 = 10.769%
17. An analyst gathered the following information regarding MT Technologies:



Current market share price = $42
Current dividend = $1.02 per share
Earnings retention rate = 70%
Return on equity = 22%
After-tax cost of debt = 9%
Marginal tax rate = 35%
Target debt-to-equity ratio = 0.3




29 .B

N = 40; PV = -$984.5; FV = $1,000; PMT = $35; CPT I/Y; I/Y = 3.5734%

Before-tax cost of debt = 3.5734 * 2 = 7.1468%

After-tax cost of debt = 0.071468 * (1 – 0.4) = 4.29%

30 .A


Proportion of new debt raised = 550 * (1.2 / 2.2) = $300

Proportion of new equity raised = 550 (1 / 2.2) = $250
WACC = (0.055 * 1.2/2.2) + (0.075 * 1/2.2) = 6.4091%


31 .B

Degree of operating leverage = Q * (P – V)
Kunal Agrawal       Order No : 4588    Order Date :2011-10-14      7/5, Burdwan
Road,      kunalagrawal1988@gmail.com                  Q * (P – V) – F

DOL =       11,200,000          = 1.6716
   11,200,000 – 4,500,000

32 .C

Degree of operating leverage = Q * (P – V)
                   Q * (P – V) – F

DOL =       250,000 * 30      = 1.1905
   (250,000 * 30) – 1,200,000

This implies that a 1% change in units sold will result in a 1.1905% change in the
company’s
operating income. Therefore, a 20% increase in the number of units sold will increase
operating income by 23.81% (1.1905 * 20).


33 .

Degree of operating leverage = Q * (P – V)
                   Q * (P – V) – F

Mercury Inc’s DOL =       300,000 (20 – 7)           = 1.3448
             [300,000 (20 – 7)] – 1,000,000

Jupiter Inc’s DOL =      300,000 (25 – 10)       = 1.3235
              [300,000 (25 – 10)] – 1,100,000

Degree of financial leverage = Q * (P – V) – F
                    Q * (P – V) – F – C

Mercury Inc’s DFL =      300,000 (20 – 7) – 1,000,000       = 1.208
              [300,000 (20 – 7)] – 1,000,000 – 500,000

Jupiter Inc’s DFL =     300,000 (25 – 10) – 1,100,000       = 1.172
             [300,000 (25 – 10) – 1,100,000 – 500,000
34 .B

Degree of financial leverage = Q * (P – V) – F
                    Q * (P – V) – F – C

DFL =       (500,000 * 22) – 1,500,000        = 1.044
(500,000 * 22) – 1,500,000 – 400,000

Degree of total leverage =      Q * (P – V)
                 Q * (P – V) – F – C

DTL =        (500,000 * 22)       = 1.209
   (500,000 * 22) – 1,500,000 – 400,000


35 .A

Degree of operating leverage = Q * (P – V)
                        Q * (P – V) – F

     1.30645 =    450,000 (15 – 6)
           [450,000 (15 – 6)] – F

     F = 4,050,000 – 4,050,000 = $949,996.1728
               1.30645

36 .C

Degree of financial leverage = Q * (P – V) – F
                    Q * (P – V) – F – C

     1.08772 = [450,000 (15 – 6)] – 949,996.1728
           [450,000 (15 – 6)] – 949,996.1728 – C
C = 3,100,003.827 – 3,100,003.827 = $250,002.1474
                   1.08772

37 .B

Degree of total leverage = DOL * DFL

DTL = 1.30645 * 1.08772 = 1.4211


38 .C
A company’s net income will be less sensitive to changes in the number of units sold if
fixed financing costs fall to $200,000.

A company’s operating income will be less sensitive to changes in the number of units
sold at higher sales volumes.

A company’s net income will be less sensitive to changes in operating income if fixed
financing costs fall to $200,000.


39 .B

The DOL measures the sensitivity of operating income to changes in the number of
units sold.


40 .A

The DTL and DOL are different at different levels of units sold. The DFL is different at
different levels of operating earnings.
Use the following information regarding Alpha Inc to answer Questions 1 to 6:

Alpha Inc has 5 million shares outstanding. The stock is currently trading for $40, with
an EPS of $1.60 and a P/E multiple of 25. The company’s directors announce a 10%
stock dividend.



41 .A

Shares outstanding after the stock dividend = 5,000,000 * 1.1 = 5,500,000

Therefore, EPS after the stock dividend = (1.6 * 5,000,000) / 5,500,000 = $1.4545




42 .B

Stock price after the stock dividend = (40 * 5,000,000) / 5,500,000 = $36.3636


43 .C

The market value of a company does not change in response to a stock dividend.
44 .C

Number of share held after the stock dividend = 1,200 * 1.1 = 1,320

Therefore, cost per share after the stock dividend = (36 * 1,200) / 1,320 = $32.7273


45 .C

The company’s P/E multiple does not change in response to a stock dividend.

46. A

The point of intersection of the NPV profile with the x-axis gives the IRR of the project.
The point of intersection of the NPV profile with the y-axis equals total net cash flows
from the project. The crossover point is the point where the projects’ NPV’s are equal.

47. A

Years          0           1           2            3       4
Cumulative cash
-120,000    -85,000        -40,000         10,000       60,000
flows ($)

The payback period for this investment equals 2 full years plus a fraction of the third
year.

This fraction equals: 40,000 / 50,000 = 0.8

Therefore, payback period = 2 + 0.8 = 2.8 years

48. B


Years            1             2             3         4        5
Revenue          50,000            60,000        80,000     80,000    80,000
Depreciation      40,000            40,000        40,000     40,000    40,000
Net income        10,000            20,000        40,000     40,000    40,000


Average net income = (10,000 + 20,000 + 40,000 + 40,000 + 40,000) / 5 = $30,000

Average book value = (200,000 + 0) / 2 = $100,000
Average accounting rate of return = Average net income / Average book value

Average accounting rate of return = 30,000 / 100,000 = 30%

49 : A

NPV of the new project = 120 – 90 = $30 million

Company value before the purchase = 3 million * 50 = $150 million

Company value after the purchase = 150 + 30 = $180 million

50. C

A company’s DOL is different at different levels of sales.

The higher the proportion of fixed costs in a company’s cost structure, the higher its
earnings volatility.




PORTFOLIO MANAGEMENT




1.B
E(R5p) (20% —10%) + (50% x 10%) + (30% x 20%) —2% + 5% + 6% 9% E(R) = (40% x 5%) + (60% x 9%) =
7.4%

2.C
The assumptions underlying capital market theory are: all investors use the Markowitz mean-variance
framework, unlimited risk-free lending and borrowing, homogeneous expectations one period time
horizon, divisible assets, frictionless markets, no inflation, constant interest rates (not normally
distributed interest rates), and equilibrium.
3.C
Risk averse investors prefer lower to higher risk for a given level of expected return and will only accept
a riskier investment if they are compensated with higher expected return. A risk averse investor does
not avoid all risk.

4.C
Diversification reduces the portfolio standard deviation below the weighted average of the standard
deviations if they are less than perfectly positively correlated. However, the minimum standard
deviation occurs when the correlation is equal to negative one, not zero.

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

6. B
 When determining an investor's risk tolerance, an advisor should analyze the investor’s personal
situation, but should also gauge the investor’s attitude toward the risk and uncertainty about
investment outcomes. Risk tolerance is affected by the investor’s psychological profile (i.e., willingness
to take risk) as well as by the investor’s net worth, income, cash reserves, age, family status, and
insurance coverage (i.e., ability to take risk). Age is an important influence on risk tolerance; younger
investors generally are more able to withstand short-term losses because they have a longer time
horizon in which to recover. Investors with high net worth are also more able to withstand short- term
losses than investors with lower net worth, and thus tend to be more tolerant of risk.

7.A
Risk averse investors prefer the lowest-risk investment for any given level of expected return, or the
highest expected returns for any given level of risk. A risk-averse investor might prefer a risky
investment if she feels the expected return will be higher.

8.B
Without a risk-free asset, an investor’s optimal portfolio will be at the point where the investor’s highest
attainable indifference curve is tangent to the efficient frontier. Investors with different levels of risk
aversion will therefore have different optimal portfolios. Pal optimal portfolio with have a lower
expected return than Colson because Johnson is more risk averse than Colson, and his highest attainable
indifference curve will be tangent to the efficient frontier at a lower expected return.

9.C
Issues involving taxes fall in the tax concerns category and issues regarding regulation fall in the legal
and regulatory factors category. Specific guidance from the investor on permitted businesses for
investment is included in unique needs and preferences.

10.A
The return of the risk-free asset is certain, so its standard deviation will be zero and its covariance and
correlation with other assets will be zero. Therefore, adding the risk-free asset to a risky portfolio will
decrease the portfolio standard deviation.

11.B
Investing on margin in the market portfolio will increase both risk and expected returns. This strategy
would be mean-variance efficient. Other strategies such as shifting a portion of total funds to higher risk
assets would achieve the higher return goal but would leave the portfolio below the CML and thus
would not be an optimal strategy

12.B
The capital asset pricing model is the equation for the security market line (SML): risk-free rate plus beta
times market risk premium, where the market risk premium equals the difference between the
expected market return and the risk-free rate, The starting point (intercept) for the SML is the risk-free
rate (5%), and the slope For the SML is the market risk premium (8%). For Stock X, the required return
equals 0.05 + 1.5(0.08) 17%, and for Stocky equals 0.05 + 2(0.08) 21%. Linn predicts 20% for each stock.
Therefore, Linn’s predicted return for Stock X lies above the SML and for Stock Y lies below the SML. She
should conclude that Stock X is undervalued and Stock Y is overvalued.

13.C
One of the underlying assumptions of the Markowitz model is that investors view investment
opportunities as distributions of expected returns. Another assumption of the Markowita model is that
investors measure risk as the variance of expected returns (not the probability of a loss of wealth).
Additionally, the model assumes that investors make investment decisions in a risk and return
framework.

14.A
The SML uses either the covariance between assets and the market or beta as the measure of risk. Beta
is the covariance of a stock with the market divided by the variance of the market. Securities that plot
above the SML are undervalued and securities that plot’ below the SML are overvalued.

15.C
The formula for the standard deviation for an individual asset is the square root of E p[R — E(R)J2,
where Pt IS the probability for outcome t, R1 is the return associated with outcome t and E(R) is the
expected return for the stock. E(R) is calculated as follows;
       E(R) = Ep1R = 0.25(20%) + 0.50(10%) + 0.25(0%) = 10%
       The variance is calculated as:
       variance = Ep[R — E(R)]2 = 0.25(20% — 10%)2 + 0.50(10% — 10%)2 +
       0.25(0% — l0%)2 = 0.5
       The standard deviation is the square root of the variance:
       standard deviation. (0.5%)12= 7.07%

16.B
Investment objectives should be expressed in terms of risk and return. IF objectives are only expressed
in terms of return, the investor may be exposed to strategies with excessive risk or too little risk.

17.B
The efficient frontier represents the set of portfolios that has the highest expected return for a given
level of risk. An indifference curve (in modern portfolio theory) represents the risk and return
combinations that yield the same level of utility for an investor An investor’s utility curve (in modern
portfolio theory) measures an investor’s utility as a function of risk and return.

18.B
If the expected return on the zero-beta portfolio exceeds the risk-free rate, the slope of the zero-beta
CAPM is less than the slope of the traditional CAPM.


19.A
Both stocks have the same total risk, but Shaw has more systematic risk (higher beta) than Melon. In
equilibrium, both stocks will plot on the Security Market Line, and the expected return will be greater
for the higher-beta stock,

20.B
Steeper indifference curves indicate greater risk aversion. Individuals with steeper indifference curves
will choose optimal portfolios with lower levels of risk than an individual with a less steep indifference
curve. The optimal portfolio for an investor occurs at the point of tangency between the investor’s
highest attainable indifference curve and the Markowitz efficient frontier. Since individuals have
differing levels of risk aversion, they will have different points of tangency and different optimal
portfolios.

21.B
The standard deviation for a combination of a risky asset, A, and a risk-free asset, F, equals WAOA
because the standard deviation of a risk-free asset, by definition, is zero. So, Hull’s standard deviation
equals 0.40(0.20) = 8%.

22.B
Craig’s expected return is she probability-weighted return on bonds. E(Rbonds) (30% x 15%) + (50% x
8%) + (20% x -10%) 4.5% + 4% - 2% = 6.5%.
Jow invests 30% in stocks, 20% in Treasury bills, and 0% in bonds. The expected return on Jow’s
investment equals:
         E(Rp) = (30% x 12%) + (20% x 4%) + (50% x 6.5%) = 7.65%.

        The equally-weighted benchmark invests one-third in each of the three asset classes. The
expected return for the equally-weighted benchmark is simply the arithmetic average of the three asset
class expected returns:

                    12%+4%+6.5%
        E(Rbenh)=             3             =7.5%

        Jow’s expected return exceeds the equally-weighted benchmark, whereas Craig’s expected
return falls below the equally-weighted benchmark.

23.A
Total return is the objective associated with growing the value of a portfolio through capital
appreciation and current income in order to meet future needs. Capital preservation is the objective of
earning a return at least equal to inflation with the goal of maintaining the purchasing power of the
portfolio. Capital appreciation is the objective increasing the value of a portfolio in real terms.

24.B
Asset allocation refers to the process of allocating funds across various asset classes such as stock,
bonds, and cash. It does not refer to the selection of specific securities within each asset class. Target
asset allocation refers to the normal weights assigned to each asset class. Studies have shown that
approximately 90% of the variation in a single portfolio’s return is attributable to the portfolio’s target
asset allocation.

25.A
Empirical research has shown that target asset allocation explains approximately 40% of the cross-
sectional variation in fund returns, and asset allocation policy explains 90% the variation in returns over
rime for an individual portfolio.

26.A
All portfolios on the CML include the same tangency portfolio of risky assets, except the intercept (all
invested in risk-free asset). The tangency portfolio contains none of the risk-free asset and “borrowing
portfolios” can be constructed with a negative allocation to the risk-free asset. Portfolios of the CML are
efficient (well-diversified) and have no unsystematic risk.

27.B
Using the CAPM, the required return for any stock equals:

        k=RFR+B[E(Rm)—RFR]
        Cayman: k 0.05 + 1(0.12—0.05) 12.0°/c. Northerland’s forecast return (12.0%) equals Cayman’s
required return (12.0%). According to Northerland’s forecast, the Cayman stock is properly valued.
        Bonaire: k = 0.05 + 1.5(0.12 — 0.05) = 15.5%. Northerland’s forecast return (16,3%) 1 exceeds
Bonaire’s required return (15.5%). According to Northerland’s forecast, the Bonaire stock is
undervalued.
        Lucia: k 0.05 + 2(0.12 —0.05) = 19.0%. Northerland’s forecast return (18.2%) is 1e than Lucia’s
required return (19.0%), According to Northerland’s forecast, the ucia stock is overvalued.

28.B
The equation for the capital asset pricing model is:
       E(R1) = RF+ B1[E(Rm) — RF]

         Beta measures the sensitivity of the stock’s returns to changes in the returns on the market
portfolio and is a standardized measure of the stock’s systematic or non-diversifiable risk. As indicated
by the CAPM equation, the expected return for any stock is related to its beta. In contrast, unsystematic
risk does not affect the CAPM expected return. Therefore, according to the CAPM, expected returns are
identical for assets with identical betas. Stock X has identical systematic risk but greater unsystematic
risk than Stock Y, resulting in greater total risk (standard deviation).


29.A
The Markowitz framework assumes that all investors view risk as the variability of returns. The
variability of returns is measured as the variance (or equivalently standard deviation) of returns. The
capital asset pricing model (CAPM) employs beta as the measure of an investment’s systematic risk.

30.C
Covariance indicates the direction of the linear relationship (i.e., positive or negative) between two
variables, but its magnitude does not directly indicate the strength of that relationship. 110.91 was the
correlation, rather than the covariance, it would indicate the monthly returns on these two stocks have
a strong linear relationship.

31.A
Both statements are accurate. Markowitz’s assumptions about investor behavior state that investors
base investment decisions solely on expected return and risk, and that all investments can be
represented in a probability distribution of expected returns.

32.A
The theoretical market portfolio used to firm the capital market line (CML) is a market weighted global
portfolio of all risky assets in existence. Since this portfolio contains all assets, it is well diversified.

33.B
A stock with an expected return less than its required return is overvalued and will plot below the
security market line (SML). A stock with an expected return equal to its required return is fairly valued
and will plot on the SML. A stock with an expected return greater than its required return is undervalued
and will ‘plot above the SML.

34.C
Capital appreciation is the most appropriate strategy Capital preservation, the most conservative
strategy, is inappropriate given the client’s ability and willingness to assume risk. Current income is an
inappropriate objective given that the investor does not need additional current income and is
concerned about taxes.

35.C
The covariance equals the product of the correlation and the two standard deviations.

        The standard deviation for Lumber Providers is 0.16 = 0.40 and for Smithson Homebuilders is =
0.25. Therefore, covariance = —0.60 x (0.40) x (0.50) =0.12.

36.A
As stocks are randomly added to a portfolio, unsystematic risk decreases. A well- diversified 20-stock
portfolio has little unsystematic risk.


37. A
As the correlation between two assets decreases, the benefits of diversification increase. Combining
assets that are not perfectly correlated reduces the risk of the portfolio, as measured by standard
deviation.


38. C
Under the core-satellite approach, investors invest most of their funds in passive investments and trade
a small proportion of assets actively.

39. C
Tactical asset allocation refers to an allocation where the manager deliberately deviates from the
strategic asset allocation for the short term if she believes that another asset class will perform relatively
better.

40. A
A change in the investor’s objectives or constraints would result in a shift in her indifference curves. A
change in capital market expectations would cause a movement in the efficient frontier.A change in
either of, or both the efficient frontier and the investor’s indifference curve would require the strategic
asset allocation to be adjusted.

41. C
A portfolio’s allocation across various asset classes is the primary determinant of portfolio returns.

42. C
With a high income and a long time horizon, Susan’s ability to take risk is high. However, she is only
willing to invest in government bonds and gold, investments that are considered to be relatively safe.
Therefore, her willingness to take risk is low.

43. B
The investment policy statement does not guarantee investment success. It only provides discipline for
the investment process and reduces the possibility of making hasty, inappropriate decisions.

44. B
This is an absolute risk objective as the investor specifically states the level of risk he Is willing to take.

45. A
Required return on Asset A = 0.06 + [2.1 * (0.14 – 0.06)] = 22.8%
The required return on Asset A (22.8%) is more than the expected return (20%). Therefore, Jessica
should not invest in it.
 Required return on Asset B = 0.06 + [1.6 * (0.14 – 0.06)] = 18.8%
The required return on Asset B (18.8%) is less than the expected return (20%). Therefore, Jessica should
invest in it.

46. B
A security whose required rate of return is greater than the expected rate of return is considered
overvalued and plots below the security market line.
 A security whose expected rate of return is greater than the required rate of return is
considered undervalued and plots above the security market line.

47.C
Required return of Stock A = 5% + 0.7 (12% - 5%) = 9.9%
 Expected return of Stock A = (23 – 20 + 1) / 20 = 20%
Since the expected return of Stock A is greater than its required return, it is underpriced and therefore,
the analyst should buy it.
Required return of Stock B = 5% + 1.1 (12% - 5%) = 12.7%
Expected return of Stock B = (37 – 35 + 1) / 35 = 8.57%
Since the expected return of Stock B is less than its required return, it is overpriced and, therefore the
analyst should sell it.
48. C
The capital market line plots returns against total risk as measured by the standard deviation of returns.



49. A
The CAPM is a single period model.

50. B
Jensen’s alpha equals the difference between the portfolio’s actual return and the required return (as
predicted by the CAPM) based on the asset’s systematic risk. An investor should not pay the portfolio
manager a fee greater than the portfolio’s Jensen’s alpha as such a fee would take the portfolio’s net
return lower than the risk of a passively managed portfolio.




EQUITY



1 .C.

The market value weighted index = [(($1)(5,000) + ($20)(2,500) +
($60)(1,000))/$150,000](100)

= ($115,000/$150,000)(100)

= (0.767)(100)

= 76.67 or 77



2 .A.

All combinations appear likely to yield diversification benefits. However, while B and C
clearly have the lowest correlation between the pairs, we cannot determine which
combination will have the lowest overall standard deviation of returns without knowing
the standard deviations of the individual markets.
3 .B.

CAPM = 10 + (5)(1.2) = 16%.
Discounted Cash Flow: D1 = 2(1.08) = 2.16, now (2.16 / 27) + 0.08 = 16%



4 .C.


k = [(D1 / P) + g] = [(2/50) + 0.05] = 0.09, or 9.00%.



5 .A.


The current stock price is equal to (D1 + P1) / (1 + ke). D1 equals $6.10(1.04) = $6.34.
The equity discount rate is 3% + 12% = 15%. Therefore the current stock price is ($6.34
+ $60)/(1.15) = $57.70




6 .B.

D0 (1 + g) / P0 + g = k
1.00 (1.05) / 20 + 0.05 = 10.25%.



7 .A.

A call market is a market where a security is only traded at specific times.



8 .A.

The OTC market is the largest U.S. market in terms of number of issues traded.
However, it is about sixty percent of the size of the NYSE in terms of value. Stocks
listed on an exchange may also be traded in the OTC market. While a stock must meet
certain minimum listing requirements to trade on the Nasdaq system, the NASD does
not "approve" securities. The fourth market refers to trading of exchange-listed shares
that takes place on alternative trading systems such as electronic crossing networks.



9 .A.

The third market is the portion of the Over the Counter (OTC) market in which non-
member investment firms can make markets in and trade registered securities without
going through the exchanges. The fourth market describes the direct trading of
exchange-listed stocks between investors, for example by using electronic
communications networks or electronic crossing systems. Block trades are large trades
often made by institutions.



10 .A.


Stop loss sell orders are limit sell orders that are placed below market price. When the
share price drops to the designated price, a sell order is executed protecting the
investor from further declines.




11 .A.


A limit order to buy is placed below the current market price.
A limit order to sell is placed above the current market price.
A stop (loss) order to buy is placed above the current market price.
A stop (loss) order to sell is placed below the current market price.
A stop order becomes a market order if the price is hit.



12 .C.

An increase in a firm’s stock price will, everything else being equal (i.e., the CF does not
change), cause the P/CF ratio to increase.



13 .A.
6% profit margin = $650,000/x; x (sales) = $10,833,333.
Sales per share = $10.83 M/1,000,000 = $10.83 per share.
P/Sales = $30.00/$10.83 = 2.77.



14 .C.


One set of tests for the semi-strong form of the EMH examines security performance
adjusted for market risk.



15 .A.


The weak form of the efficient market hypothesis argues that, over time, security returns
are independent of each other. Runs tests contend that stock price changes (upticks
and downticks) are independent over time.




16 .B.


There should be zero correlation between observations, or all observations should be
independent of each other, if the weak-form EMH is true.



17 .A.


Early tests for the semi-strong form of the efficient market hypothesis (EMH) examine
security performance relative to the market return. Weak-form EMH tests include auto
correlation, run, and trading rule tests.



18 .A.
The superior historical performance of exchange specialists and corporate insiders
rejects the strong form of the EMH.
The other statements are correct. Statistical and trading rule tests support the weak-
form EMH contention that security prices reflect all historical market information and that
mechanical trading rules do not result in superior returns. Cross-sectional tests such as
the price-earnings ratio, neglected firms tests, and book value to market value tests
reject the semi-strong form of the EMH. These tests show that certain stocks have high
realized returns (for example, low P/E stocks and high book value to market value
stocks). Tests show that professional money managers perform no better than a
random buy and hold strategy. This supports the semi-strong form EMH contention that
stock prices reflect all public information. (Aside from corporate insiders and specialists,
no group has monopolistic access to information that would result in superior returns.)



19 .A.



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.




20 .C.


Ending LIFO reserve = (LIFO COGS − FIFO COGS) + Beginning LIFO reserve
= ($3,988 − $2,004) + $2,484
= $4,468
21 .C.
$2(1.06)/0.14 - 0.06 = $26.50.
This calculation is an example of the Gordon Growth Model also known as the constant
growth model.



22 .A.


If the dividend remains constant, g = 0.
P = D1 / (k-g) = 1.15 / (0.095 - 0) = $12.10
23 .A.


P4 = D5/(k-g) = 1/(.12-.05) = 14.29
P0 = [FV = 14.29; n = 4; i = 12] = $9.08.



24 .A.


Starting with the dividend discount model P0 = D1/(ke - g), and dividing both sides by E1
yields: P0/E1 = (D1/E1)/(ke - g)
Thus, the P/E ratio is determined by:
The expected dividend payout ratio (D1/E1).
The required rate of return on the stock (ke).
The expected growth rate of dividends (g).



25 .A.

Financial reporting refers to the way companies show their financial performance to
investors, creditors, and other interested parties by preparing and presenting financial
statements. The objective of financial statements, not analysis, is to provide information
about the financial position, performance and changes in financial position of an entity
that is useful to a wide range of users in making economic decisions. The role of
financial statement analysis, not reporting, is to use the information in a company’s
financial statements, along with other relevant information, to assess a company’s past
performance in order to draw conclusions about the company’s ability to generate cash
and profits in the future.



26 .B.


A short position profits from declines in stock price and experiences losses as the price
rises. A stop loss buy is a limit order that is placed above the market price. When the
stock price reaches the stop price, the limit order is executed curtailing further loses.




27 .A.
Proceeds from the short sale must remain in the brokerage account along with the
required margin deposit.



28 .B.


Hampton originally purchased 100 shares at $75 for a total value of $7500. Half of the
value ($3750) was borrowed and Hampton paid cash for the other half. The current total
market value of the stock is $6200. If Hampton sells her holdings she will have $2450
left after she pays off the loan. Hampton’s return on her original investment is:

$2450/3750 – 1 = 0.65 – 1 = -0.35 = -35%.



29 .A.


Margin is the amount of equity in the account at a given time. Initial margin is the
amount of equity required initially to execute an order.



30 .A.

The initial margin requirement refers to the minimum amount of equity required of the
investor.
With equities, if the margin falls below the maintenance margin, funds must be
deposited to bring it back up to the maintenance margin level.


31 .A.


Many academics believe that the size effect is an anomaly due to the capital asset
pricing model's (CAPM) inability to provide a complete measure of risk.



32 .A.
The size effect indicates that small firms consistently experienced significantly larger
risk-adjusted returns than larger firms.



33 .A.


In general, study results support the strong form of the efficient market hypothesis.
Exceptions include corporate insiders and exchange specialists since they appear to
have monopolistic access to important information that may allow them to achieve
positive abnormal returns.



34 .A.


Proceeds in a primary market go to the issuing firm. Proceeds from a sale in the
secondary market go to the current owner who is selling the securities.




35 .C.



Assuming market efficiency, any approach, including a top down approach, will not
produce superior results as long as it relies exclusively on historical data.



36 .A.

An analyst cannot obtain superior results by relying on historical data. The analyst must
be able to do a superior job of interpreting and estimating variables that are relevant to
the value of the security.




37 .A.
The implication of the strong-form tests is that money managers as a group have not
outperformed the buy-and-hold policy. In fact after accounting for fees, mutual funds,
bank trust departments, pension plans, and endowment funds are not able to match the
performance of a simple buy-and-hold policy.



38 .A.


The implication of the weak-form EMH is that there should be no relationship between
past price changes and future price changes. Results of runs tests and filter tests
suggest that excess returns are not possible. Tests related to insider or private
information are related to the strong-form EMH.



39 .B.


An index fund is designed to duplicate the composition of a specific index series or
market segment. There is a strong argument suggesting that portfolio managers cannot
beat the market after fees, therefore an index fund should be used to try to match the
market.



40 .A.


When payout ratio increases, the P/E multiple increases only if we assume that the
growth rate will not change as a result.



41 .C.


Payout increases from 50% to 55%, cost of equity increases from 10% to 11%, and
dividend growth rate stays at 5%, the P/E will change from 10 to 9.16:
P/E = (D/E) / (k – g).
P/E0 = 0.50 / (0.10 – 0.05) = 10.
P/E1 = 0.55 / (0.11 – 0.05) = 9.16.
42 .C.


The country risk premium includes business, financial, liquidity, exchange rate, and
country risk.



43 .A.


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, increasing the required rate of return, and decreasing the long term growth
rate will all serve to decrease the P/E ratio.



44 .A.


The expected growth rate of dividends is the retention rate (RR) times the return on the
equity portion of new investments (ROE), g = (RR)(ROE). The retention rate is 1 minus
the payout rate. RR = (1 - 0.80) = 0.20. g = (0.20)(0.15)= 3.00%.
The value of the stock will be the dividend paid next year divided by the required rate of
return minus the growth rate. Next year's dividend is $0.80 × 1.03 = $0.824. So the
value is 0.824 / (.10 - 0.03) = 0.824 / 0.07 = $11.77


45 .C.


Better supplier terms lead to increased profitability. Better profit margins lead to an
increase in ROE. This leads to an increase in the dividend growth rate. The difference
between the cost of equity and the dividend growth rate will decline, causing the stock
price to increase.



46 .A.


Since g = retention rate * ROE, or (1 - payout ratio) * ROE, the only choice that would
result in a higher g is a higher ROE. A low ROE, or a high dividend payout rate (which is
the same as a low retention rate) would result in a low growth rate.
47 .A.


A limit buy is placed below the current market price, but a stop buy order is placed
above the current market price (stop buy orders are often placed to protect a short sale
from a rising market).
The other choices are true. A well-functioning securities market includes the following
characteristics:
timely and accurate information on price and volume of past transactions.
timely and accurate information on the supply and demand for current transactions.
liquidity (as indicated by low bid-ask spreads).
marketability.
price continuity.
depth (many buyers and sellers willing to transact above and below the current price).
internal efficiency (low transaction costs).
informational/external efficiency (rapidly adjusting prices).




48 .B.


If technological changes result in changes in the set of skills required of workers, this is
likely to lead to changes in educational curriculum (and possibly delivery). Such
changes often result in the production and demand for new or different products.



49 .C.


Value of preferred = D / kp = $11.50 / 0.14 = $82.14



50 .A.
Total original value held by Jensen is 400 x $60 = $24,000.

Amount of equity is 50% ($24,000) = $12,000.

Current total value is 400 x $40 = $16,000.

So Jensen’s equity is $16,000 - $12,000 = $4,000 which is 4,000/16,000 = 25% of the
total market value.



FIXED INCOME



1 .A.

Accrued interest is found by simply dividing the coupon rate by two and then multiplying
the result by $1,000. The full price or dirty price of the bond is the price of the bond plus
accrued interest, if any.


2 .A.

Payments for U.S. Treasury bonds and notes are semiannual and are fixed for the life of
each bond or note. The coupon rate is quoted on an annual basis but each payment is
made on the basis of one half the annual rate multiplied by the maturity or par value.


3 .C.

The change in value is computed as follows:
Change in ValueT-Note = Price Value of a Basis Point / 10 × (-Yield Change)
So we have
Price ChangeT-Bond = 186.6484 / 10 × (-10 bp) = $186.65


4 .B.

Present Value:
Since the current interest rate is above the coupon rate the bond will be issued at a
discount. FV = $5,000,000; N = 20; PMT = (0.04)(5 million) = $200,000; I/Y = 4.5; CPT
→ PV = -$4,674,802
Value in 7 Years:
Since the current interest rate is above the coupon rate the bond will be issued at a
discount. FV = $5,000,000; N = 6; PMT = (0.04)(5 million) = $200,000; I/Y = 4.5; CPT →
PV = -$4,871,053
5 .A.

To calculate the CY and YTC, we first need to calculate the present value of the bond:
FV = 1,000; N = 5 × 2 = 10; PMT = (1000 × 0.0875) / 2 = 43.75; I/Y = (9.25 / 2) = 4.625;
CPT → PV = -980.34 (negative sign because we entered the FV and payment as
positive numbers). Then, CY = (Face value × Coupon) / PV of bond = (1,000 × 0.0875) /
980.34 = 8.93%.
And the YTC calculation is: FV = 1,025 (price at first call); N = (2 × 2) = 4; PMT = 43.75
(same as above); PV = –980.34 (negative sign because we entered the FV and
payment as positive numbers); CPT → I/Y = 5.5117 (semi-annual rate, need to multiply
by 2) = 11.02%.

6 .A.

A floor sets a minimum coupon rate for a floating-rate bond and protects the security
owner from decreases in rates. A prepayment option is included in many amortizing
securities and allows the holder of the option to make additional payments against
outstanding principal.


7 .B.

This is the price value of a basis point (PVBP) per one million dollar par as shown in
Table 2.



8 .C.


PVBP = (0.0001) × D × (price + accrued interest) × 10,000
Note: The 10,000 is to convert the price to $1,000,000 par to match the PVBP units.
Rearranging, D = PVBP ÷ (price + interest) = 1,211.2284 ÷ (133.75 + 2.5824) = 8.88



9 .A.


N = 20 × 2 = 40; I/Y = 6.375/2 = 3.1875; PMT = 70/2 = 35; FV = 1,000; CPT → PV =
$1,070.09.
The taxable-equivalent yield on the municipal bond is: 4.16% / (1 − 0.35) = 6.4%
The investor would prefer the municipal bond because the taxable-equivalent yield is
greater than the yield on the corporate bond: 6.4% > 6.375%
10 .C.

Spot Rates:
Year 1 = 7%.
Year 2 = [(1.07)(1.0815)]1/2 – 1 = 7.57%.
Year 3 = [(1.07)(1.0815)(1.103)]1/3 – 1 = 8.48%.
Year 4 = [(1.07)(1.0815)(1.103)(1.120)]1/4 – 1 = 9.35%.
Bond Value:
N = 1; FV = 110; I/Y = 7; CPT → PV = 102.80
N = 2; FV = 110; I/Y = 7.57; CPT → PV = 95.06
N = 3; FV = 110; I/Y = 8.48; CPT → PV = 86.17
N = 4; FV = 1,110; I/Y = 9.35; CPT → PV = 776.33
102.80 + 95.06 + 86.17 + 776.33 = 1,060.36



11 .A.

The bond with six months left to maturity has a semiannual discount rate of 0.025/2 =
0.0125 or 2.5% on an annual bond equivalent yield (BEY) basis. Since the bond will
only make a single payment of 101.25 in six months, the YTM is the spot rate for cash
flows to be received six months from now.
The one-year bond will make two payments, one in six months of 1.75 and one in one
year of 101.75. We can solve for the one-year spot rate in the equation:


where S1.0 is the annualized 1-year spot rate.
Using the 6-month and 1-year spot rates, we can use the same approach to find the 18-
month spot rate from the equation:


where S1.5 is the annualized 18-month spot rate.
Solving we get: S1.5 = 4.53047%.



12 .B.

Series U, the most recently issued note, was the on-the-run 3-year Treasury note as of
November 30, 2006. Market prices of on-the-run issues provide better information about
current market yields than off-the-run issues because of their higher liquidity and
because their values are often closer to par.
13 .A.

For the examination, remember the following relationships:
Type of Bond Market Yield to Coupon Price to Par
Premium       Market Yield < Coupon Price> Par
Par           Market Yield = Coupon Price = Par
Discount      Market Yield> Coupon Price < Par




14 .A.

If the coupon rate > market yield, then bond will sell at a premium.
If the coupon rate < market yield, then bond will sell at a discount.
If the coupon rate = market yield, then bond will sell at par.
In addition, if the bond is selling at a premium, the current yield will be between the
coupon rate and market rate.


15 .B.


The yield spread is computed as follows:
Yield Spread = Yield to MaturityT-Bond – Yield to MaturityT-Note
So we have
Yield Spread = 5.80% − 5.51% = 29 bp (basis points)


16 .A.

Using an equation: Pricezerocoupon = Face Value × [ 1 / ( 1 + i/n)n × 2 ]

Here, Pricezerocoupon = 1000 × [ 1 / (1+ 0.080/2)15 × 2] = 1000 × 0.30832 = 308.32. So,
interest = Face – Price = 1000 – 308.32 = 691.68.

Using the calculator: N = (15 × 2) = 30, I/Y = 8.00 / 2 = 4.00, FV = 1000, PMT = 0. PV =
-308.32. Again, Face – Price = 1000 – 308.32 = 691.68.

17 .A.

Currently, an arbitrage opportunity exists with the three bonds. An investor could
purchase Bonds #2 and #3 and sell Bond #1 for an arbitrage-free profit of $23.81
(10,000 + -476.19 + -9,500). This action will result in positive income today in return for
no future obligation – an arbitrage opportunity. Hence, buying pressure on Bond #3
should increase its value to the point where the arbitrage opportunity would cease to
exist.


18 .B.

For valuing non-Treasury securities, a credit spread is added to each treasury spot
yields. The credit spread is a function of default risk and the term to maturity.


19 .A.

Pension plans are not taxable entities so they do not have to worry about implicit
interest taxation. Both of the other statements are true.


20 .C.

There are two ways to approach this problem. The easier way is to just take the
difference in cash from the two years: $35 − $50 = -$15.
The harder way is to create a statement of cash flows:
CFO = Net Income (44) + (Depreciation) (10) – (increase in Accounts Receivable) (20)
+ (decrease in Inventory) (5) – (decrease in Accounts Payable) (25) – (decrease in
Wages Payable) (5) = $9.
CFI = $25 (fixed assets decreased by $25 representing a source of cash)
CFF = Dividends paid ((0.20) × (44)) = -9 – (decrease in bonds) (10) − (decrease in
common stock) (30) = -$49.
The net change in cash = 9 + 25 – 49 = -$15, or a decrease of $15.


21 .A.

The Government National Mortgage Association is the only item listed that is backed by
the full faith and credit of the U.S. government.



22 .B.


Statement 1 is incorrect. A borrower who prepays a mortgage is in effect exercising a
call option, similar to a corporate bond issuer who calls a bond and prepays the
principal. Therefore the pool of mortgages and the securities created from it behave as
if they had an embedded call feature.
Statement 2 is also incorrect. Sequential tranches issued as a collateralized mortgage
obligation do not have proportionate claims on the cash flows from the pool. Instead
they have sequential claims. The shortest-term tranche receives principal and interest
payments until it is paid off. The cash flows then go to the second tranche until it is paid
off, and so on. This structure allows securities with different timing and risk profiles to be
issued from the same pool of certificates.




23 .A.

Interest rate risk and reinvestment risk are both significant for mortgage-backed
securities. There is no risk embedded in a scheduled principal payment.



24 .B.

If a prepayment of principal is for an amount that is less than the full outstanding
balance of the loan, it is know as a curtailment.



25 .C.

Tranche III has the least amount of prepayment risk since it receives the prepayments
last.



26 .B.

Tranche III has the least amount of prepayment risk; therefore, there is a greater
chance that the investor will be able to hold on to the investment for a longer time
horizon.



27 .A.

Creating a CMO usually redistributes the risk between the tranches on an unequal
basis, not on a random basis.
28 .A.


Some interest on municipal bonds, such as municipal bond issues to build
stadiums/arenas, is taxable at the federal level. Note though that most municipal bonds
are tax-exempt – taxable munis tend to be the exception rather than the rule.




29 .A.

The price sensitivity is lower when the level of interest rates is higher. Bond issue 2 has
the highest market yield and therefore is least susceptible to larger price swings as
interest rates change. Put another way, Bond issue 2 has the lowest duration and is
therefore the least sensitive to changes in interest rates.



30 .A.


A lower yield to maturity would result in a longer duration and higher interest rate risk.



31 .A.

The value of the call option is subtracted from the value of the bond without the option
because the option is of value to the issuer, not the holder.

As interest rates decrease, the issuer values the call option more because the company
has the potential to call the bond and replace existing debt with lower-coupon (and thus
lower cost) debt. Also, it is more likely that the bond will be called. The other choices are
true.


32 .A.

Because the bondholder has given something of value to the issue of a callable bond,
the value of the embedded call option should be subtracted from the value of the
straight bond.
33 .C.


A bondholder will most likely lose if a bond is called because a bond is most likely to be
called in a declining interest rate environment. The issuer will likely call the bond and
replace it with lower cost (lower coupon debt). The holder faces prepayment and
reinvestment risk, because he must reinvest the bond cash flows into lower-yielding
current investments.

In bond trading, the call option is bundled with the bond and is not traded separately.
The price of a callable bond does not follow the standard inverse relationship. As yields
fall, the call option becomes more valuable to the issuer. With a decrease in interest
rates, the value of a callable bond can only increase to approximately the call value.
Straight bonds will continue to exhibit the inverse relationship between yields and prices
as there is no ceiling call price. When yields rise, the value of callable bond may not fall
as much as that of a similar straight bond because of the embedded call option feature.



34 .B.

The more frequent the reset dates, the less the time lag that causes volatility. The
greater the gap between reset dates, the greater the amount of price fluctuation.

Over the life of a bond, the required market margin is not constant. A fixed-margin
coupon exposes the bond to more price fluctuations than an adjustable margin (as is
the case with an extendible reset bond). Cap risk refers to when market interest rates
rise to the point that the coupon on a floating-rate security hits the cap and the bond
begins to behave like a fixed coupon bond, which has more price fluctuations.


35 .B.

A dollar change in price for this bond is a 0.01% change in its quoted price.
Duration = [100.1 − (99.9)] / [2 × (100) × (0.0001)] = 10.


36 .A.

The statement that a bond's percentage change in price and dollar change in price are
both tied to the underlying price volatility is true.

The effective duration formula result is for a 1.00% change in interest rates (100 basis
points equals 1.00%, or 0.01 in decimal form). The denominator is multiplied by 2.
37 .C.


Duration is inversely related to yield to maturity (YTM).The higher the YTM, the lower
the duration. This is because the change in the bond's price (or present value) is
inversely related to changes in interest rates. When market yields rise, the value (or
cash flow) of a bond decreases without decreasing the time to maturity.
Duration is also a function of volatility (risk). Higher volatility (risk) = higher duration. A
higher coupon bond has a lower duration relative to a similar bond with a lower coupon
because the bond holder is getting more of their cash value sooner (because of the
higher coupon). This lowers the overall risk of the bond resulting in a lower duration.



38 .A.


Because of convexity, it will be approximately a 7.5% change in price, not an actual
7.5% change in price. The readings are very explicit about this distinction.



39 .B.


For a zero-coupon bond duration is approximately equal to the number of years to
maturity. Here, there are 4 years until maturity, so the effective duration is
approximately equal to 4 years. We use the term approximately because this ignores
the curvature of the price/yield curve.


40 .A.

The definitions for parallel and nonparallel shifts are reversed. The first part of the
statement that begins, "The yield curve usually has a nonzero slope,…" is correct.
However, the second part is incorrect – the slope occurs because rates change by
different basis points across maturities.


41 .A.

The statement, "If long-term rates are low, the present value of cash flows far into the
future will be low,and the bond’s value will be low," should read, "If long-term rates are
low, the present value of cash flows far into the future will be high,and the bond’s value
will be high." The value of a bond is comprised of discounted cash flows, and a lower
discount rate translates to higher cash flows. Any shift in the yield curve creates
uncertainty and is of concern to bond investors.


42 .C.

Prepayments instill uncertainty into the assumed cash flows used to compute cash flow
yield.


43 .A.

Since zero-coupon bonds have a higher duration than coupon-paying bonds of the
same maturity, they are more sensitive to interest rate changes.


44 .A.

For the calculated YTM to hold true all reinvestments must occur at that YTM, otherwise
a new YTM will occur and we will not be able to calculate it.


45 .A

FV = 1,000
PMT = 37.5
N = 12
I/Y = 3%
CPT PV = 1,074.66
1,074.66 – 1,011 = 64


46 .B.

The bond with 6 months left to maturity has a semiannual discount rate of 0.01/2 =
0.005 therefore the 1-year spot rate can be found by solving the following equation:
0.75/1.005 + 100.75/(1 + S1.0/2)2 = 100
Solving for S1.0/2: 100.75/(1 + S1.0/2)2 = 100 - 0.75/1.005
100.75/(1 + S1.0/2)2 = 99.2537
100.75 / 99.25370.5 = (1 + S1.0/2)2
(100.75 / 99.254).5 – 1 = S1.0/2
0.007509 = S1.0/2
2 × 0.007509= S1.0
S1.0 = 0.01502 or 1.5%
47 .A.

Statement 1 is incorrect. If we know one actual spot rate, we can calculate the
theoretical spot rate for the next longer period. With these two spot rates we can
calculate the next theoretical spot rate, and so on up the coupon curve. Statement 2 is a
correct description of the methodology for computing a theoretical Treasury spot rate.


48 .A.


The bond with six months left to maturity has a semiannual discount rate of 0.03/2 =
0.015 or 3.0% on an annual bond equivalent yield (BEY) basis. Since the bond will only
make a single payment of 101.50 in six months, the YTM is the spot rate for cash flows
to be received six months from now.
The one-year bond will make two payments, one in six months of 2 and one in one year
of 102. We can solve for the one-year spot rate in the equation:


where S1.0 is the annualized 1-year spot rate.
Solving we get: S1.0 = 4.01005%.
Using the 6-month and 1-year spot rates, we can use the same approach to find the 18-
month spot rate from the equation:


where S1.0 is the annualized 18-month spot rate.
Solving we get: S1.5 = 5.0338823%.


49 .B.

The value of the bond is simply the present value of discounted future cash flows, using
the appropriate spot rate as the discount rate for each cash flow. The coupon payment
of the bond is $80 (0.08 × 1,000) and the face value is $1,000. Hence, bond price of
1,100= 80/(1.05)+ 80/(1.06)2 + 1,080/(1 + 3-year spot rate)3. Using the yx key on our
calculator, we can solve for the 3-year spot rate of 4.27%.



50 .B.


Any complex debt instruments (like callable bonds, putable bonds, and mortgage-
backed securities) can be viewed as the sum of the present value of its individual cash
flows where each of those cash flows are discounted at the appropriate zero-coupon
bond spot rate. It should be noted that while the appropriate spot interest rate can be
used to discount each cash flow, determining the actual pattern of cash flows is
uncertain due to the possibility of the bond being called away.




51 .A.

A funded investor is one who borrows to invest. These investors typically borrow short-
term and the interest rate on their loan is typically short-term LIBOR plus a margin (e.g.
LIBOR plus 30 basis points).



52 .A.


Duration to maturity is longer than duration to first call because one measure of duration
is the time until maturity or until the bond is called. Since the time until the first call is
shorter than if the bond was not called the duration to first call is shorter than duration to
maturity.



53 .C.


The duration computation remains the same. The only difference between modified and
effective duration is that effective duration is used for bonds with embedded options.
Modified duration assumes that all the cash flows on the bond will not change, while
effective duration considers expected cash flow changes that may occur with embedded
options.



54 .B.


Market values (not book values) should be used to calculate effective portfolio duration.
(35/85 × 4.7) + (50/85 × 5.9) = 5.41


55 .A.
The most significant limitation of portfolio duration is the assumption that the yield for all
maturities changes by the same amount (a parallel shift in the yield curve).


56 .A.

Bond duration is calculated using market values; changes in book values are irrelevant.



57 .A.


Duration is a linear approximation of a nonlinear function. The use of market values has
no direct effect on the inherent limitation of the portfolio duration measure. Duration
assumes a parallel shift in the yield curve, and this is an additional limitation.


58 .A.


Relative to a bonds with low convexity, the price of a bond with high convexity will
increase more when rates decline and decrease less when rates rise.



59 .C.


Convexity is to the advantage of the bond holder because a high-convexity bond's price
will decrease less when rates increase and will increase more when rates decrease
than a low-convexity bond's price.



60 .A.

Duration is a linear measure of the relationship between a bond’s price and yield. The
true relationship is not linear as measured by the convexity. When convexity is higher,
duration will be less accurate in predicting a bond’s price for a given change in interest
rates. Short-term bonds generally have low convexity.



61 .A.
The estimated price change is:
-(duration)(∆y) + (convexity) × (∆y)2 = -10.62 × 0.02 + 91.46 × (0.022) = -0.2124 +
0.0366 = -0.1758 or –17.58%.




62 .B.


PVBP = initial price – price if yield changed by 1 bps.
  Initial price:               Price with change:
  FV = 1000                    FV = 1000
  PMT = 80                     PMT = 80
  N = 18                       N = 18
  I/Y = 9%                     I/Y = 9.01
  CPT PV = 912.44375 CPT PV = 911.6271
PVBP = 912.44375 – 911.6271 = 0.82
PVBP is always the absolute value.



63 .C.


PVBP = initial price – price if yield changed by 1 bps.
  Initial price:           Price with change:
  FV = 1000                FV = 1000
  PMT = 50                 PMT = 50
  N = 14                   N = 14
  I/Y = 3%                 I/Y = 3.005
  CPT PV = 1225.92 CPT PV = 1225.28
PVBP = 1,225.92 – 1,225.28 = 0.64
PVBP is always the absolute value.



64 .A.


Inverse relationships exist between price and yields on bonds. The larger the PVBP, the
more volatile the bond’s price.
65 .A.

The coupon bond has a cash flow at maturity of 104, which discounted at 9% results in
a bond price of 99.52. Therefore, the bond is underpriced. An arbitrage trade can be set
up by short-selling 1.04 units of the zero-coupon bond at 99.52 and then using the
proceeds to buy 1.02 units of the coupon bond.



66 .A.


By purchasing bond #1 and selling bonds #2 and #3, the investor could obtain an
arbitrage profit of $44.62 (-10,000 + 384.62 + 9,660). This action will result in positive
income today in return for no future obligation – an arbitrage opportunity. Notice that in
year 1, the coupon payments from bond #1 will cover the bond #2 par value obligation.
In year 2, the coupon payment and principal payment from bond #1 will cover the bond
#3 obligation.



67 .A.

By purchasing bonds #2 and 3 and selling bond #1, the investor could obtain a arbitrage
profit of $65.38 (10,000-374.62-9,560). This action will result in positive income today in
return for no future obligation – an arbitrage opportunity. Notice that in year 1, the
principal payment from bond #2 will cover the bond #1 coupon obligation. In year 2, the
coupon payment and principal obligation for bond #1 will be covered by the principal
payment from bond #3



68 .A.


Treasury bonds are considered default free and have the least amount of risk. After-tax
yields are highest for individuals in the highest tax bracket who benefit the most from
the municipal bond’s tax-exempt status. Before tax yields on municipal bonds are lower
due to their tax shield.


69 .C.
Series X is a revenue bond. Because they pay interest and principal only if revenues
from the project they finance are sufficient, revenue bonds are typically riskier and
therefore have higher market yields than general obligation bonds. Series Y is an
insured bond. Municipal bond insurance typically results in a higher rating, and therefore
a lower market yield, than an equivalent bond from the same municipal issuer. So of
these three bonds, Series X should have the highest market yield and Series Y the
lowest.



70 .B.

Relative yield spread = absolute yield spread / yield on reference bond
Relative yield spread = (8.75% − 7.45%) / 7.45% = 0.17%



71 .A.

The credit rating of an ABS pool is a function of its credit enhancements, which are
quite common. The more credit enhancements, the higher the ratings.



72 .B.

Credit enhancements increase the costs associated with borrowing using ABS.




73 .A.

Both of the reasons are valid.



74 .A.

A CDO (collaterized debt obligation) issued to profit on the spread between the return
on the underlying assets and the return paid to investors is referred to as an arbitrage
CDO. A balance sheet CDO is created by a bank or insurance company wishing to
reduce their loan exposure on the balance sheet. Spread CDO is a fabricated term.
75 .A.

When bonds are sold in a Rule 144A offering, they are sold privately to a small number
of investors or institutions. This offering does not require registration with the SEC and
this is valuable to the issuer. The investor will require a slightly higher yield because the
bonds cannot be resold to the public unless they are registered with the SEC. The other
sales transactions in the responses represent secondary market offerings.



DERIVATIVES



1.A

Exploiting market inefficiencies is no longer considered a motivation for entering into
swap agreements. Historically, there were two basic motivations for swaps, to exploit
market inefficiencies and to attempt to obtain cheaper financing. Both were based on
the belief that financial markets were inefficient. Today, the swap markets have matured
and there are few arbitrage opportunities. The swap markets are considered
operationally efficient and flexible. Thus, the main reasons to enter into swap
agreements today include: to reduce transaction costs, to avoid costly regulations, and
to maintain privacy.

2. A

If the price of the underlying instrument sold forward increases, the seller of the futures
contract will have to pay more than planned to deliver the product and will lose on the
forward part of the transaction. For example, say that a dairy farmer contracts to sell
milk for delivery three months from now at $11.80 per hundred weight. Assume that by
the end of three months that the spot price of milk is $13.00 per hundred weight.
Because of convergence, the futures price must move closer to the spot price as
delivery nears. If the farmer takes the opposite position in the futures contract (buys) to
close out the contract, he will lose $1.20 per hundredweight in the futures transaction.

3. B

Marking to market is the practice of adding to or subtracting from the margin balance to
adjust for the daily change in the contract value.

4. B

In a deliverable contract, the long is obligated to buy the portfolio at the forward price.
The forward contract price will generally (except for a very high dividend paying
portfolio) be higher than the current market price; a rise in price from the current level is
no guarantee of profits on the contract.

5. B

If two options are identical (maturity, underlying stock, strike price, etc.) in all ways,
except one is a European option and the other is an American option, the value of the
American option will equal or exceed the value of the European option. Why? The
American option has more flexibility than the European option, so it should be worth
more. If you choose not to exercise the American option, it will be equal to the European
option and have the same value.

The other statements are false. Exercise is at the option of the holder, not the writer.

6. C

The following table provides the potential payoffs from puts and calls.
                          Buyer/Holder                   Seller/Writer
                  Potential Gain Potential Loss Potential Gain Potential Loss
        Call        Unlimited       Premium       Premium         Unlimited
                    Strike P -                                    Strike P -
        Put                         Premium       Premium
                    Premium                                        Premium


7. C

Prior to expiration, a futures position (long or short) is closed out by an
offsetting/reversing trade. The other methods are used to settle positions at contract
expiration.

8. C

Since the option is out-of-the-money at expiration (MAX (0, S-X)), the option is
worthless. Also, the stock decreased in value from $45 per share to $32 per share,
creating a $13 loss. The $13 loss is partially offset by the $1.45 premium Knight
received. Therefore, the total loss from the covered call position is $11.55 (-$13+$1.45).

9. B

A swap consists of a series of forward commitments on multiple ‘settlement’ dates. A
strap is an options strategy and a stack is a type of hedge.

10. C
A put option gives its owner the right to sell the underlying good at a specified price
(strike price) for a specified time period. When the stock's price is less than the strike
price a put option has value and is said to be in-the-money.

11. B

The delivery price for Treasury bonds under the contract is multiplied by the conversion
factor for the bond the short chooses to deliver. The other statements are true.

12. C

The intrinsic value of a call is given as: max [0, S − X], where S = stock price and X =
strike price. Here, max [0, 43 − 42] = max [0, 1] = 1.

The other answers are incorrect. Grey wrote the option and thus cannot exercise. The
intrinsic value of the put is correct at $0, or max [0, X − S], but as previously noted, the
put is out-of-the money at a stock price of $43. The put is at-the-money when the stock
price is equal to the strike price, or $38.

13. A

Although options are a zero-sum game, it is the counterparty exposures that nets to
zero. For example, the put buyer’s maximum loss = put writer’s maximum gain = the
premium. The other statements are true. Note that the reason why Grey’s loss is
unlimited is that he does not currently own the stock. In other words, he has a naked
position. If the stock were to rise, Grey would be forced to buy the stock in the open
market to settle the exercise of the option. Because the potential for the stock to rise is
unlimited, the potential loss for the naked call writer is also unlimited.

14. C



The most any option buyer can lose is the amount paid for the option.

15. A

Although forward contracts are between private parties, no margin is required. The
other statements are true. Futures and forwards are both contracts to sell an asset in
the future.

16. A

Add-on interest = LIBOR × (60/360) × $250 million
Interest = 7.5% × (1/6) × $250 million = $3.125 million
17. B

The correct adjustment is to subtract the present value of the expected dividend
payments from the current stock price.

18. B




19. B

A short position in an FRA will have a positive payoff when the reference rate is less
than the contract rate, and a negative payoff when the reference rate is greater than the
contract rate, at expiration. A short interest rate call will have a negative payoff when the
reference rate is greater than the strike rate, and a long put will have a positive payoff
when the reference rate is less than the strike rate.

20. A



The futures market uses a standardized contract, which increases the liquidity of the
contract. Also, futures exchanges assume the credit risk. However, as the time horizon
increases, the liquidity of futures contracts decreases substantially. Therefore, swaps
are considered a better method of hedging over long time horizons.

21. A

In order to be considered arbitrage there must be no risk in the trade.

It doesn’t matter if commissions are paid as long as the amount of the price discrepancy
is enough to offset the amount paid in commissions.

In order to be considered arbitrage there must be no initial investment of one’s own
capital. One must finance any cash outlay through borrowing.

22. B

The profit/loss diagram for the covered call looks like the profit/loss diagram for a short
put position. Both option positions have limited profit potential, with the potential loss
equal to the strike price less the premium.
23. C

The other statements are false.

Physical deliveries and cash settlements combined represent less than one percent of
all settlements.

An exchange for physicals differs from a delivery in that:

       The traders actually exchange the goods.
       The contract is not closed on the floor of the exchange.
       The two traders privately negotiate the terms of the transaction.

24. C

Margin can be posted in cash, bank letters of credit, or T-bills.

25. A

Arbitrage is defined as the existence of riskless profit without investment and involves
selling an asset and simultaneously buying the same asset for a lower price. Since the
trades cancel each other, no investment is required. Because it is done simultaneously,
a profit is guaranteed, making the transaction risk free. Arbitrage actually helps make
markets more efficient because price discrepancies are immediately eradicated by the
actions of arbitrageurs.

26. C

Dealers do not make most of their profits from speculating on price moves or interest
rate moves. They profit from the bid-ask spread. They take offsetting positions with
different end users to hedge their price risk.

27. B

The net payment formula for the fixed-rate payer is:

Fixed Rate Paymentt = (Swap Fixed Rate − LIBORt-1) × (# days in term / 360) × Notional
Principal

If the result is positive, the fixed-rate payer owes a net payment and if the result is
negative, then the fixed-rate payer receives a net inflow. Note:We are assuming a 360
day year.

Fixed Rate Payment = (0.085 − 0.072) × (180 / 360) × 5,000,000 = $32,500.
Since the result is positive, XYZ owes this amount to the dealer, who will remit to SSP.

28. C

An increase in the risk-free rate of interest will increase call option values and decrease
put option values.

29. B

A long call and short put on interest rates is equivalent to a long position in a forward
rate agreement. Both gain when forward rates increase and decline in value when
interest rates decrease.

30. C

Derivatives are often likened to gambling due to the high leverage involved in the
payoffs. One of the benefits of derivatives is that they reduce transactions costs.
Another benefit of derivatives is that they allow risk to be managed and shifted among
market participants.

31. C

The correct adjustment is to subtract the present value of the expected dividend
payments from the current asset price.

32. C

For European puts, it is possible that the longer term option can be less valuable than a
shorter-term option.

33. C

The parties agreeing to swap cash flows are called the counterparties.

34. C

This value diagram represents a short call position. The seller (writer) of the option
receives a premium. However, as the stock price rises further above the exercise price,
the seller of the option loses more. Note that the greatest profit the call seller (writer)
can receive is the amount of the premium, while the potential loss is unlimited.

35. B

The covered call: stock plus a short call, or a short put. The term covered means that
the stock covers the inherent obligation assumed in writing the call. Why would you
write a covered call? You feel the stock’s price will not go up any time soon, and you
want to increase your income by collecting some call option premiums. To add some
insurance that the stock won’t get called away, the call writer can write out-of-the money
calls. You should know that this strategy for enhancing one’s income is not without risk.
The call writer is trading the stock’s upside potential for the call premium. The
desirability of writing a covered call to enhance income depends upon the chance that
the stock price will exceed the exercise price at which the trader writes the call. This is
similar reasoning to selling (or going short) a put. A put is in-the-money when the
exercise price is above the stock price. Since the seller of a put prefers that the buyer
just pay the premium and never exercise, the seller wants the price of the stock to
remain above the exercise price.

36. A

The owner of a European option may exercise it only at expiration whereas an
American option can be exercised at any time before or at expiration. Investors pay a
premium for this flexibility. Therefore, an American option cannot be worth less than a
European option. If the investor chooses not to exercise the American option, it will be
equal to the European option and will have the same value.

37. A

If the periodic return on the equity is negative, the fixed-rate payer must pay the fixed
rate plus the percentage of (negative) equity return, times the notional principal.

38. A

OTC derivative contracts (securities) are customized and have poor liquidity. The
contract is with a specific counterparty and there is default risk since there is no
clearinghouse to guarantee performance.

39. A

The exchange decides which contracts will be traded and their specifications. The
clearinghouse acts as the counterparty to every contract and guarantees performance.

40. C

A swap contract in which at least one party makes payments based on the return on an
equity, portfolio, or market index, is called an equity swap.

41. C

The U.S. bank pays 6.5% fixed on Euro 15,170,000, which makes for an annual
payment of Euro 986,050. The variable rate to be used at time period 2 is set at time
period 1 (the arrears method). Therefore, the German bank pays 6.5% + 2% = 8.5%
times US$15,000,000 for a payment of US$1,275,000.

42. C

Eurodollar deposits are USD denominated deposits in large banks held outside the
United States. By convention, the rates are quoted as an add-on yield. Following this
convention, euro-denominated deposits held outside of the euro-block countries would
be “Euroeuro” deposits.

43. A

There is no interest rate risk for the bank because the bank has fixed rates for two years
on both the asset and the liability. However, the bank faces a problem in that if the
Australian dollar decreases in value, the loan (and the interest payments from the loan)
will not translate back into as many U.S. dollars. Indeed, if the Australian dollar
decreases significantly, the loan (and the interest payments from the loan) may not
translate back into enough U.S. dollars to repay the CDs.

44. C

The breakeven point is the strike price plus the premium, or $100 + $8 = $108. Any
price greater than this would result in a profit, and the only choice that exceeds this
amount is $110.

45. B

320 + 100,000(0.08201 − 0.08196) = $325

46. A

A stock and a put combined with borrowing the present value of the exercise price will
replicate the payoffs on a call at option expiration.

47. C

The variable rate to be used at the end of 360 days is set at the 180-day period (the
arrears method). Therefore, the appropriate variable rate is 10%, the fixed rate is 11%,
the time period is 180 days, and the interest payments are netted. The fixed-rate payer,
counterparty A, pays according to:

(Swap Fixed Rate – LIBORt-1)(# of days/360)(Notional Principal).

In this case, we have (0.11 - 0.10)(180/360)($120 million) = $0.6 million
48. B

Swaps typically do not require a payment from either party at initiation. The exception is
currency swaps.

49. C

A European option can be exercised by its owner only at contract expiration.

50. C

86,450 − 10 × 250 × (1000.2 − 998.4) = $81,950



ALTERNATE INVESTMENT



1.    An analyst is interested in determining the value of a real estate investment and
has estimated the following data for the property:
      ____________________________________________________________
      Net operating income         $50,480      Cost of debt         8.2%
      Depreciation         $3,550                  Cost of equity              12.5%
      Interest expense           $2,720            WACC                        9.6%
             Tax                   35%          Cap rate      11.0%
      Using the income approach, the value of the property is        closest to:
      A. $403,900.
      B. $458,900.
      C. $466,500.


2. A venture capital project has a 60% probability of failure during its seed stage, a 25%
probability of failure during its formative stage, and a 10% probability of failure during its
later Stages. The project requires an initial investment of$l,000,000 and the cost of
capital is 10%. Based on the project’s conditional failure probabilities, the expected
value of the payoff in five years is $2,700,000. The net present value of the venture
capital project is closest to:
       A. -$550,000
       B. +$450,000
       C. +$675,000

3.     Which of the following statements about closely held companies is most
accurate?
       A. The legal definition of “fundamental value” of a closely held company is based
on the cost approach to valuation.
      B. Ownership rights of investors in a closely held company depend on the
company’s legal form of organization.
      C. The comparables approach to valuation of a closely held company requires
the analyst to identify a publicly traded company with similar characteristics.


4.    A commodity market is in contango if the spot price is:
      A. higher than the futures price.
      B. equal to the futures price.
      C. lower than the futures price.

5.   A hedge fund that engages primarily in distressed debt          investing and
merger arbitrage is most likely a(n):

      A. long/short fund.
         B. event-driven fund.
         C. global macro fund.

6.      When compared to a traditional mutual fund, an exchange-traded fun will most
likely offer:

      A. better risk management.
         B. less portfolio transparency.

      C. higher exposure to capital gains distribution txes.

7.    A long-only commodity index investment using futures is        most likely

      A. to perform poorly in inflationary periods.

      B. considered a passive investment strategy.

      C. exposed to risk from economic cycles.


8.     Archie Boone, CFA, is the managing director at Hoffman        Advisors, a
alternative investment management company. Boone is reviewing the work of a real
estate analyst and finds   that in calculating net operating income (NOl) for a property,
       the analyst has understated vacancy by $3,000, overstated depreciation
expense by $4,000, overstated insurance          expense by $4,000, and understated
interest expense by $2,000. If Boone corrects the analyst’s estimates of NOl for all
       these items, the updated estimate will:

       A. increase by $1,000 as the restatement of vacancy will be partially offset by
the restatement of insurance expense.
        B. increase by $1,000 as the restatement of depreciation      expense will be
partially offset by the restatement of                vacancy.

      C. decrease by $1,000 as the restatement of insurance      expense will be
more than offset by the restatement of vacancy and interest expense.

9.     The gold futures market is said to be in contango if prices for gold futures are
currently:

       A. equal to the spot price.
       B. less than the spot price.
       C. greater than the spot price.

10. The leverage employed by a typical hedge fund least likely:

      A. is legally unlimited since the typical fund is domiciled offshore.
      B. can be increased by using derivatives rather than the underlying securities.
      C. may include margin borrowing from brokers and borrowing from external
sources.

11.   An investor would be most likely to use ETFs instead of similar index funds
because ETFs provide:
      A. lower market risk.
      B. intraday valuation and trading.
      C. less tracking error.

12.   A comparison of distressed securities investing and venture capital investing
would most likely indicate that:

       A. both are illiquid and require significant investor   involvement.
       B. venture capital investing requires more extensive analytical      work.
       C. distressed securities investing generally requires a longer time horizon.


13.   The annual income and expense figures for a proposed property under
consideration for purchase, along with some recent sales data, are given below.

__________________________________________________________________
                       Proposed Office            Apartment       Office
                               Building             Complex           Building
                   (under               (recently       (recently
     construction)             sold)    sold)
___________________________________________________________________

Potential gross rental income     $324,000`
Vacancy and collection loss        7.5%

Taxes and Insurance         $27,000
.
Depreciation                $37,800

Other expenses                     $32,000

Net operating income                                           $300,000      $272,000

Price at which property sold                                    $2,400,000 $1,700,000

       The appraised value for the proposed property using the income approach is
closest to:

      A. $1,250,000.
      B. $1,500,000.
      C. $1,625,000.

14. Henry Okah, CFA, holds a majority position in Naomp Composites, a privately held
composites manufacturing company; Okah wants to estimate the value of his stake hi
Nacomp usking the comparables approach. If Okah uses publicly traded shares of
another composites company as a benchmark value he should most appropriately add
a premium for:

      A. liquidity only.
      B. a controlling interest only1
      C. both liquidity and a controlling Interest.



15.   Changes in commodity prices due to the economic cycle are most likely:

      A. less than cyclical changes in the prices of finished goods.

      B. greater than cyclical change8 in the prices of finished goods.

      C. proportional to cyclical changes in the prices of finished goods.

16.   If the futures market for a commodity is in backwardation, roll yield will be:

      A. zero.
      B. positive.
      C. negative.
17.   Welch’s Venture Fund is evaluating a $5 million investment in Perry Industries.
The fund manager has calculated a cost       of equity of 17% and estimates that if
Perry survives for four    years, the payoff from selling the stake in Perry will be $30
       million. The fund manager has estimated the following failure         probabilities
for Perry Industries:

       Year                        1              2    3        4
       Probability of Failure      30%            20% 15%       10%

       The net present value of the potential investment in Perry      Industries is closest
to:

       A. $1,850,000.
       B. $4,700,000.
       C. $11,950,000.

18.     The effect of survivorship bias on hedge fund risk and returns        from
historical results is to overstate:
        A. both risk and expected returns.
        B. expected returns and understate risk.
        C. risk and understate expected returns.

19.    The stage of venture capital investing that is the earliest stage        of a business
and involves funding research and development            is referred to as the:

       A. seed stage.
       B. first stage.
       C. start-up stage.

20.    An advantage of investing in a fund-of-funds hedge fund is that:

       A. the diversification among hedge funds decreases risk and increases returns.
       B. a fund of funds may give an investor access to an investment in a hedge fund
that would otherwise be closed.
       C. professional managers will select hedge funds that have superior returns to
what an individual investor could achieve.



21. Which of the following similarities between distressed security investing and venture
capital investing is least likely correct? Both:
A. asset classes are illiquid.
B. assets have reasonably short expected investment horizons.
C. assets may require significant involvement by investors in order to be successful.

22. An open-end fund has the following holdings at the end of the business day:
• 500,000 shares of A valued at $20 each.
• 100,000 shares of B valued at $10 each.
• 200,000 shares of C valued at $15 each.
• $1,000,000 in cash.
• The fund currently has one million shares outstanding.
The fund’s net asset value per share is:
A. $13.
B. $14.
C. $15.

23. An investor buys two gold futures contracts at $350 per ounce. Each gold futures
contract is based on 5,000 ounces of gold. At the same time he collateralizes his
position by buying the required amount of T-bills yielding 3%. Two months later the
price of gold is $347.40 a, mature. The net gain or loss on the value of the investor’s
collateralized futures position is closest to:
A. $8,500 loss.
B. $26,000 loss.
C. $34,500 gain.

24. A highly risk-averse investor with a long time horizon who w
inflation is most likely to invest in:
A. long-term corporate bonds.
B. market-neutral hedge funds.
C. commingled real estate funds.

25.     Supplying capital to companies that are just moving into operation, but do not as
yet have a product or service available to sell, is a description that best relates to which
of the following stages of venture capital investing?
A. Seed stage.
B. Second stage.
C. Early stage.

26. An apartment complex would earn $2 million annually if fully occupied. The complex
has a 10% vacancy rate and annual operating expenses of $200,000 a year. The
interest costs of financing the purchasel building would be $150,000 a year. The
investor’s marginal tax rate is 40%. The investor wants to earn 10% on this investment.
Using the income approach, the value the investor would place on the office building
would be closest to:
A. $8,700,000.
B. $14,500,000.
C. $16,000,000.

27. The creation and redemption of “in-kind” shares by authorized participants is a
feature that’s unique to which of the following types of securities?
A. Hedge funds.
B. Closed-end funds.
C. Exchange-traded funds.
28. Which of the following is least aCcurate regarding the cost approach to valuing real
estate?
A. The approach may be problematic because obtaining a land appraisal may not be
straightforward.
B. The approach is reliable since there is generally a negligible difference between
construction cost and market value of an existing property.
C. It is similar to using the replacement cost of total assets in equity valuation.

29. The yield on a long-only commodity futures position that is dependeni on whether
the contract ir i contango o hackwardation is the.
A. collateral yield.
B. roll yield.
C. contract yield.

30. The term “mezzanine financing” is used to describe the financing that:
A. provides capital preceding an initial public offering.
B. represents capital provided to initiate commercial manufacturing.
C. provides capital that supports product development and market research.

31. Which of the following statements about valuation techniques for real estate is least
likely correct?
A. The cost approach to valuation is based on what it would cost to rebuild the property
at today’s prices.
B. The sales comparison approach to valuation is based on the sales price of properties
similar to the subject property.
C. The income approach to valuation calculates the property’s value as the present
value of its future annual after-tax cash flows, ignoring financing costs.

32. Biggs, Inc., is considering a real estate investment that provides gross revenues (if
fully occupied) of $250,000, a vacancy rate of 4%, and operating expenses of $15,000.
The property costs $1,000,000, and the depreciation expense on the property is 2.6% of
the cost in the first year and 1.3% of the cost over the next several years. The marginal
tax rate is 35%. The after-tax cash flow in year 1 if the property is purchased for cash is:
A. $69,650.
B. $129,350.
C. $155,350.


33. Which of the following statements with respect to hedge fund investing is least
accurate?
A. Hedge funds only publicly disclose performance intormation on a voluntary basis.
B. Hedge funds are not typically registered with the SEC in the United States.
C. Survivorship bias in hedge fund data causes risk to be overstated because funds that
take on more risk tend to have higher returns.

34. Which of the following is least likely a valuation method for closely held companies?
A. Cost approach.
B. Comparables approach.
C. Discount/premium approach.

35. Michelle Arthur, CFA, is explaining the characteristics of venture capital
investments. She states, (1) Direct venture capital investing requires a long time horizon
because the payoff typically depends on an eventual initial public offering or private sale
of the firm. (2) A successful venture capital manager should focus on selecting
promising ventures but should not expect to influence their operations. Are Arthur’s
statements accurate?
A. Both of these statements are accurate.
B. Neither of these statements is accurate.
C. Only one of these statements is accurate.

36. A building has the following characteristics:
• The building generates $100,000 per year in gross rental income.
• Property taxes are $20,000 per year.
• Other expenses are 20% of gross rental income.
• The market capitalization rate is 15%.
Usin’g the income approach, the value of the building is:
A. $400,000.
B. $500,000.
C. $600,000.

37. Which choice below correctly specifies both an advantage and a disadvantage of
exchange-traded funds (ETFs) relative to other equity investments?
Advantages of ETFs                   Disadvantages of ETFs
A.Diversification                    Large bid-ask spread
B. Trade like traditional           Increased capital gainstax
C.Mayhavebetterriskmanagement Composition of fund is notmade public

38. Which of the following is least likely a type of hedge fund strategy?
A. Event-driven.
B. Market-neutral.
C. Exchange-traded.

39. Compared with purchasing commodities, long positions in commodity
derivatives offer the benefit of:
A. no storage costs.
B. less volatility.
C. better correlation with spot prices.

40. A manager establishes a long commodity futures position and depos Treasury bills
to meet the initial margin requirement. If this futures market is in backwardation, the
position is most likely to have a negative:
A. roll yield.
B. price return.
C. collateral yield.


41.Which of the following statements regarding REIT and RELP is correct?
A) An investor may redeem a REIT at net asset value.
B)The NAV of a RELP is easily determined by adding up the values of the underlying
properties.
C) REITs can make equity investments in real properties (such as office buildings,
shopping malls, and apartment buildings), or they can invest in mortgages on real
estate.
42.Hedge funds differ from other kinds of investment funds in that:
Hedge funds are more likely to engage in riskier transactions (short selling, use of
financial leverage, use of derivatives) than the typical mutual fund.
Mutual funds attempt to outperform their benchmarks by managing the betas of their
portfolios, while Mutual funds attempt to outperform their benchmarks by managing the
alphas of their portfolios.
Hedge fund managers usually receive only a base fee equal to a percentage of the
assets under management, while other kinds of investment funds typically participate
directly in the profits generated by the fund.

43.An analyst determines that it will take an estimated four years for a $4 million venture
capital investment to reach IPO viability. The IPO value is expected to be about $5
million. The probability of failure for this investment each year is:
                       Yr. 1     Yr. 2     Yr. 3    Yr. 4
         P(Failure)    0.4       0.3       0.3      0.2
Based on the above information and a discount rate of 25%, this project’s net present
value (NPV) is closest to:
A)$(608,000)
B)$332,000
C)$14,432,000


44.
Zoning restrictions and the demographic composition of an area would most likely affect
t that area’s real estate:
        Zoning        Demographic
        Restrictions composition
a.      Supply        Supply
b.      Supply        Demand
c.      Demand        Supply

45.
An investor purchased $1,000 of shares in an open-end mutual fund and sold them four
years later. The fund’s gross annual return each year was 7%, expense ratio was 1.25%
annually, and there was a 2% back end load if sold during the first five years of the
investment. The investor’s proceeds at redemption were closest to:
$1,221
$1,226
$1,250

46.
A real estate analyst compiled information on three comparable properties that sold
recently:
                        Property A    Property B      Property C
      NOI               685,000       375,000         450,000
      Selling Price     10,000,000    4,285,000       10,000,000
The analyst finds another comparable property for sale with net operating income of
$575,000. The estimated value for this property is closest to:
$8.09 million
$8.60 million
$9.25. million



47. In an open-end fund:

A. Shares are issued and are traded in secondary markets
B. Investors can redeem their shares at any point in time, at market value
C. Investors cannot redeem shares for a certain number of years that are specified at
the initiation of the contract

48.An analyst gathered the following information regarding ZCB fund:7/5, Burdwan
Road,      kunalagrawal1988@gmail.com

Assets = $1,000,000
Liabilities = $300,000
Total shares outstanding = 500,000 shares

The net asset value of the fund is closest to:

A. $2
B. $1.4
C. $0.6



49.. A type of fund strategy that concentrates on investing in a specific industry is most
likely classified as:

A. Style
B. Sector
C. Factor




50. An index strategy most likely:

A. Involves investing in securities from all over the world
B. Invests in short-term, fixed income securities or instruments that offer a fixed rate of
return and timely payments.
C. Aims to track the performance of a specified index
51. Which if the following statement is most accurate?rdwan Road,
kunalagrawal1988@gmail.com
A. The return on an ETF is exactly the same as that of the index
B. The return on the ETF is similar, but not identical to the return on the index because
the ETF does not hold the same proportion of shares as the index it tracks
C. The return on the ETF is similar, but not identical to the return on the index
because the ETF charges a management fee

52.. Which of the following is least likely an advantage of ‘in-kind’ redemption?

A. ETF prices remain very close to their NAV’s
B. No capital gain is realized by the fund as redemption is in the form of shares, not
cash proceeds from sale of shares
C. ETFs with ‘in-kind’ redemption clauses tend to trade at significant discounts and
premiums to their NAV.



53. Which of the following statements regarding ETFs is most accurate?

A. Even though ETF’s are listed on stock exchanges and trade similarly to stocks, they
cannot be bought on margin or sold short
B. Open-end mutual funds trade at their NAV, which is released in the morning before
trading starts
C. Diversification can easily be obtained with one transaction



54. ETFs most likely tend to charge:

A. Back-end, but not front-end loads
B. Front-end, but not back-end loads
C. Neither back-end nor front-end loads

55. Which of the following is least likely regarding ETFs?

A. Long-term investors do not really benefit from intraday trading opportunities offered
by ETFs
B. Investors may prefer actively managed open-end funds over passively managed
ETFs
C. Some ETFs have low liquidity and thus, narrower bid-ask spreads.
56. Which of the following statements regarding risks associated with ETFs is least
likely correct?

A. Investors do not have to face market risk because ETF share prices do not fluctuate
with market conditions
B. Tracking error risk arises when the ETF’s composition differs from the index it is set
to track
C. Derivatives risk is specific to those ETFs that invest in derivatives and includes risk
from increased leverage and counterparty credit risk

 Road,      kunalagrawal1988@gmail.com
57. Which of the following forms of real estate investments is most likely referred to as
fee simple?

A. Leveraged equity
B. Free and clear equity
C. Mortgages


58. Commingled funds are most likely an example of:

A. Leveraged equity
B. Free and clear equity
C. Aggregation vehicles


59. Using regression analysis, a real estate company has come up with the following
information to value different residential properties with similar characteristics:

Characteristics               Units              Slope coefficient
Number of rooms             Number                   50,000
Distance to city center       Kilometers                -11,000
Age                     Years                  -15,000
Quality of premises         0-5, with 5 being excellent     18,000
Total area                Square feet               15


Using the Hedonic pricing model the value of a brand new property that has 6 rooms, is
7 kilometers away from the city center, has a quality rating of 4.5 and has a total area
of 9,500 square feet is closest to:

A. $446,500
B. $431,500
C. $379,000

60. Mezzanine financing most likely:
A. Allows a company to expand and help itself go public
B. Refers to capital provided to fund major expansions
C. Refers to funding for initiation of commercial operations

61. Which of the following statements regarding venture capital investments is least
likely correct?

A. Venture capital investments need financial expertise and operational knowledge
B. There may be little or no information available about the business’s competitors
C. Venture capital investments are significantly liquid as the company’s shares are
traded publicly.

62. Which of the following is least likely a challenge to venture capital valuation?

A. Too much information
B. Uncertain payoff at the time of exit
C. Inexperienced management


63. Distressed securities funds are most likely classified as:

A. Long/short funds
B. Market-neutral funds
C. Event-driven funds


64. Which of the following statements regarding market-neutral funds is most accurate?

A. The sensitivity of their long positions is more than the sensitivity of their short
positions.
B. They seek to hedge against general market movements
C. They place bets on security prices, interest rates, currencies and other economic
variables

65. Which of the following is most likely a limitation of investing in a fund of funds?

A. An FOF is not equipped to undertake the necessary due-diligence required by many
institutional investors to invest in a hedge fund
B. The total fee charged to an FOF investor is usually much lower
C. FOFs may select hedge funds based on their past performance, which might not be
repeated in the future.

66. One of the advantages of a fund of funds is that:
A. It may enable investors to access hedge funds which have been closed to new
investors
B. Information regarding hedge fund performance is readily available
C. It gives access to a wide variety of hedge funds that increases the total risk of the
investment to the investor

67. Short squeeze risk most likely:

A. Occurs when a highly leveraged hedge fund is unable to borrow any further
B. Refers to risk that the counterparty will be unable to deliver the specified
security/cash on the settlement date
C. Occurs when a short seller is forced to buy in her position at a higher price


68. Historical information provided by hedge fund indices indicates that the Sharpe ratio
for hedge funds, as compared to that of other asset classes, has most likely been:

A. Higher
B. Lower
C. The same


69. Historical information provided by hedge fund indices most likely indicates that:

A. Hedge funds have exhibited higher volatility than traditional equity investments.
B. Hedge funds have a high correlation with equity investments in bull markets and a
relatively low correlation in bear markets
C. Hedge funds look for capital appreciation during bearish spells.

70. Consider the following statement:

When a fund’s performance is included in a database, its past performance is also
recorded. Thus, only fund managers with superior track records are willing to disclose
their performance and enter an index.

This is least likely an example of:

A.7,Self-selection biaskunalagrawal1988@gmail.com
B. Backfilling bias
C. Gaming



71. The income approach to valuing closely-held companies most likely:

A. Focuses on how much it would cost today to replace all assets of the company
B. Uses a benchmark to estimate the value of a closely-held company
C. Determines the NPV of the forecasted cash flow stream


72. A marketability discount is most likely:

A. Applied for investors who hold a minority interest and have no influence on company
decisions
B. Applied to compensate investors for holding shares that are relatively illiquid
C. Applied to compensate investors for holding securities with no market where they
can be traded


73. Which of the following is most likely a way for investors to gain exposure to
commodities?

A. Futures contracts on agricultural products, energy sources and base and precious
metals
B. Stocks in companies that produce the commodity whose earnings are negatively
correlated with commodity prices
C. Bonds whose returns are indexed to a specified company’s price

74. Which of the following is most likely regarding characteristics of real estate as an
investable asset class?

A. Real estate investments usually carry much lower transaction costs and
management fees
B. Real estate investments can be directly compared to other properties
C. There is no established market for real estate, thus market prices are difficult to
ascertain


75. The cost approach for valuation of real estate most likely:

A. Uses replacement cost to determine real estate value
B. Estimates the value of a property based on the market value of a similar property
C. Links the value of property to cash flows from the investment

				
DOCUMENT INFO
Shared By:
Categories:
Tags:
Stats:
views:0
posted:9/27/2013
language:English
pages:150