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ExamWise®
Volume 1
CFA 2008 Level I Certification

With Preliminary Reading Assignments The
Candidates Question And Answer Workbook For
Chartered Financial Analyst
Authors
Jane Vessey, CFA
M. Afdal Pamilih, CFA
David Stewart
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This book is dedicated to our fantastic children Adam and Julia who we love very much.
Jane Vessey & M. Afdal Pamilih

This Study Guide is dedicated to the widow(er)s and orphans of the “Silent Spring”. Those who have
sacrificed loved ones to the obscurity of quiet study and endured weekend sacrifice above and
beyond the call of continuing education. On the alter of a profession’s highest accreditation these
unsung heroes have sacrificed time with their spouse, shopping with Mom, and pitch and catch with
Dad. These patient supporters have endured tense attitudes, unfinished chores, extra duties, and
received the respect and appreciation of all who have studied throughout the “Silent Spring”.
In particular, never ending thanks to:
Carol Lee, Mary Elizabeth, Sophia Victoria, David Todd II
David Stewart

ExamWise®
Volume 1
CFA 2008 Level I Certification
With
Preliminary Reading Assignments
The Candidates Question And Answer Workbook
For Chartered Financial Analyst
BY
Authors
Jane Vessey, CFA
M. Afdal Pamilih, CFA
David Stewart
Jane Vessey
Jane Vessey manages a training company in the United Kingdom specializing in financial analysis
and investment. She is a visiting lecturer at Cass Business School teaching classes in asset
management and valuation. She also teaches a CFA® revision course at ISMA (the business school at
Reading University) and is an associate at a leading London financial training company where she
teaches courses covering investment management and related topics. She has developed online
training programs for students taking the CFA examinations and teaches CFA courses for UKSIP (the
UK Society of Investment Professionals).
Jane graduated in Mathematics from Oxford University, United Kingdom, and is a CFA charter
holder. She has some eighteen years experience working in the investment industry, starting out as
an equity analyst before becoming an investment manager. She was based in London and Tokyo and
took responsibility for managing equity portfolios invested in the Japanese and other Asian markets.
In 1990, Jane moved to Indonesia and established and ran an investment management operation on
behalf of Mees Pierson. She took responsibility for all areas of the business, including investment,
operations, marketing and administration. While in Asia, Jane was involved in providing training to
capital market participants and state officials and teaching in courses provided by local universities.

M. Afdal Pamilih
Afdal has 18 yearsʹ experience working in the finance industry. He started his career with J.P.
Morgan, and then with County NatWest Government Securities, in New York specializing in the
development of quantitative products for foreign exchange and fixed income markets. After
returning to Indonesia in 1989 he was responsible for the development of investment services and
subsequently treasury management for leading banks in Jakarta.
Afdal has developed web‐based training programs for the CFA examinations and has wide teaching
experience, including instructing at the School of Management, University of Surrey, United
Kingdom.
He obtained a MSc in Mathematics from the University of Texas at Arlington and holds the
Chartered Financial Analyst (ʺCFAʺ) qualification.

David Stewart:
David Stewart has extensive experience in venture capital and business structural reorganizations. As
president of a private client broker dealer firm, he has business valuation and project valuation
experience on the venture capital side and portfolio management on the asset management side. His
analysis, commentary, books, and study guides have appeared in the financial management,
securities, and exam prep industries.
David has collaborated with experts in the field to produce the 2001 through 2006 editions of this
study guide. His extensive research into the CFA exam program and past exam histories, field work,
and consistent review of CFA Institute information allows him and his co‐authors to deliver high
quality and up to date information.

About the Book:

ExamWise Volume 1 For CFA Level I Concept Check Q&A Workbook With Preliminary Reading
Assignments is designed to give you plenty of practice questions to test your readiness for the CFA
exam. It offers 400+ concept check questions based 18 exam study sessions that cover the Learning
Outcome Statements and their associated CFA Assigned Readings. For additional practice, there is an
accompanying free download test engine that generates multiple mock exams similar in design and
difficulty to the real CFA exam. The questions and explanations have references to the page number
in the related Reading and to the related LOS.
Use this workbook to test your understanding of the basic concepts covered in the CFA Readings and
identify your strengths and weaknesses. Then you can move on to more advanced study materials to
sharpen your weakest knowledge areas.
This book is divided into Study Sessions (1 – 18) that cover the 76 Learning Outcome Statements and
the associated Assigned Readings. Appendix A (Exhibits 1 – 4), is a collection of exhibits and flow
charts for condensed reference and review, including examples of accounting statements, puts and
calls, PE breakdown, and financial ratios.
The 18 2008 CFA Level I Study Sessions breakout is as follows:
Ethical and Professional Standards
1. Study Session 1: Ethical and Professional Standards
Investment Tools
2. Study Session 2. Quantitative Methods: Basic Concepts
3. Study Session 3. Quantitative Methods: Application
4. Study Session 4. Economics: Microeconomic Analysis
5. Study Session 5. Economics: Market Structure and Macroeconomic Analysis
6. Study Session 6. Economics: Monetary and Fiscal Economics
7. Study Session 7. Financial Statement Analysis: Introduction
8. Study Session 8. Financial Statement Analysis: Income Statement, Balance Sheet, Cash
9. Study Session 9. Financial Statement Analysis: Inventories, Assets, Taxes, and Debt
10. Study Session 10. Financial Statement Analysis: Techniques, Apps, & International
11. Study Session 11. Corporate Finance
Portfolio Management
12. Study Session 12. Portfolio Management
Asset Valuation
13. Study Session 13. Analysis of Equity Investments: Securities Markets
14. Study Session 14. Analysis of Equity Investments: Industry and Company Analysis
15. Study Session 15. Analysis of Fixed Income Investments: Basic Concepts
16. Study Session 16. Analysis of Fixed Income Investments: Analysis and Valuation
17. Study Session 17. Derivative Investments
18. Study Session 18. Alternative Investments Equity Investments: Securities Markets

Online Information:
1. What is CFA Institute
http://www.cfainstitute.org/aboutus/index.html
2. CFA Program: http://www.cfainstitute.org/cfaprogram
3. The Code of Ethics (Full Text) http://www.cfainstitute.org/centre/ethics/code/
The Standards of Professional Conduct
Standard I: Fundamental Responsibilities
Standard II: Relationships with and Responsibilities to the Profession
Standard III: Relationships with and Responsibilities to the Employer

Standard IV: Relationships with and Responsibilities to Clients and Prospects
Standard V: Relationships with and Responsibilities to the Public
4. Why The CFA Designation Matters to You: Individual Investor FAQ
http://www.cfainstitute.org/aboutus/investors/articles/cfamatters.html
5. Soft Dollar Standards http://www.cfainstitute.org/centre/ethics/softdollar/
6. CFA Institute-PPSTM AIMR Performance Presentation Standards
http://www.cfapubs.org/doi/ref/10.2469/faj.v57.n2.2433
7. Global Investment Performance Standards http://www.cfainstitute.org/centre/ips/
Click the picture and link to a free CFA Candidates online glossary.

List of Chapters
Study Session 01: Ethical and Professional Standards: 14
Study session 02: Quantitative Methods: 34
Study Session 03: Quantitative Methods: 60
Study Session 4: Introduction 84
Study Session 04: Economics: 112
Study Session 07: Financial Statement Analysis: 198
Study Session 11: Corporate Finance: 300
Study Session 12: Portfolio Management: 330
Study Session 13: Equity Investments: 354
Study Session 15: Fixed Income Investments: 402
Study Session 17: Derivative Investments: 450
Study Session 18: Alternative Investments: 474
Terminology: 501
Appendix A: 503
Download Instructions 526
With the purchase of this book you get FREE Author Collaberation:
Now that you have purchased this product you have access to the Instructors/Authors that authored
this book. Send you questions to us and we will answer them for you.

Table of Contents IX
Table of Contents
About the Book:........................................................................................................................... VI
Online Information:..................................................................................................................... VII
Study Session 01: Ethical and Professional Standards: 14
Reading 1: Code of Ethics and Standards of Professional Conduct ..........................................14
Reading 2: “Guidance” for Standards I–VII.................................................................................14
Reading 3: Introduction to the Global Investment Performance Standards (GIPS) ...................14
Reading 4: Global Investment Performance Standards (GIPS) .................................................14
Study session 02: Quantitative Methods: 34
Basic Concepts ................................................................................................................................34
Reading 5: The Time Value of Money ........................................................................................34
Reading 6: Discounted Cash Flow Applications .........................................................................34
Reading 7: Statistical Concepts and Market Returns .................................................................34
Reading 8: Probability Concepts.................................................................................................34
Study Session 03: Quantitative Methods: 60
Application .......................................................................................................................................60
Reading 9: Common Probability Distributions ............................................................................60
Reading 10: Sampling and Estimation........................................................................................60
Reading 11: Hypothesis Testing .................................................................................................60
Reading 12: Technical Analysis ..................................................................................................60
Introductory Readings......................................................................................................................84
Supply, Demand, and the Market Process CH 5.............................................................................84
Introduction..................................................................................................................................84
Consumer choice and the Law of Demand.................................................................................85
Producer choice and the Law of Supply .....................................................................................85
Price changes and demand and supply......................................................................................86
Shifts in demand .........................................................................................................................87
Shifts in supply ............................................................................................................................88
Impact of changes in demand and supply ..................................................................................88
Supply and Demand: Applications and Extensions CH 4................................................................90
Introduction..................................................................................................................................90
Resources ...................................................................................................................................90
Elasticity and the incidence of tax ...............................................................................................91
Taking the Nation’s Economic Pulse CH 7 ......................................................................................92

X Table of Contents
Introduction ................................................................................................................................. 92
Gross domestic product.............................................................................................................. 92
Working with Our Basic Aggregate Demand/ Aggregate Supply Model CH 10.............................. 96
Introduction ................................................................................................................................. 96
Aggregate demand ..................................................................................................................... 96
Keynesian Foundations of Modern Macroeconomics CH 11........................................................ 100
Introduction ............................................................................................................................... 100
Keynesian economics............................................................................................................... 100
Introductory Readings Concept Check Questions ............................................................... 104
Introductory Readings Concept Check Answers.................................................................. 108
Microeconomic Analysis................................................................................................................ 112
Reading 13: Elasticity ............................................................................................................... 112
Reading 14: Efficiency and Equity............................................................................................ 112
Reading 15: Markets in Action.................................................................................................. 112
Reading 16: Organizing Production.......................................................................................... 112
Reading 17: Output and Costs ................................................................................................. 112
Market Structure and Macroeconomic Analysis............................................................................ 136
Reading 18: Perfect Competition.............................................................................................. 136
Reading 19: Monopoly.............................................................................................................. 136
Reading 20: Monopolistic Competition and Oligopoly.............................................................. 136
Reading 21: Demand and Supply in Factor Markets................................................................ 136
Reading 22: Monitoring Cycles, Jobs, and the Price Level ...................................................... 136
Reading 23: Aggregate Supply and Aggregate Demand ......................................................... 136
Monetary and Fiscal Economics ................................................................................................... 160
Reading 24: Money, Banks, and the Federal Reserve............................................................. 160
Reading 25: Money, Interest, Real GDP, and the Price Level ................................................. 160
Reading 26: Inflation................................................................................................................. 160
Reading 27: Fiscal Policy ......................................................................................................... 160
Reading 28: Monetary Policy.................................................................................................... 160
Introductory Readings ................................................................................................................... 184
Measuring Business Income ......................................................................................................... 184
Introduction ............................................................................................................................... 184

Table of Contents XI
Accounting methods..................................................................................................................184
Financial Reporting and Analysis ..................................................................................................185
Introduction................................................................................................................................185
Balance Sheet ...........................................................................................................................185
Income statement......................................................................................................................186
Inventories .....................................................................................................................................187
Introduction................................................................................................................................187
Inventory....................................................................................................................................187
Inventory cost ............................................................................................................................187
Effect of inventory accounting method......................................................................................188
Current Liabilities and the Time Value of Money...........................................................................190
Introduction................................................................................................................................190
Liabilities....................................................................................................................................190
Contributed Capital ........................................................................................................................191
Introduction................................................................................................................................191
Contributed capital ....................................................................................................................191
Accounting for dividends ...........................................................................................................191
Common stock ..........................................................................................................................191
Preferred stock ..........................................................................................................................191
Stock issuance ..........................................................................................................................192
Treasury stock...........................................................................................................................192
The Corporate Income Statement and the Statement of Stockholders’ Equity .............................192
Introduction................................................................................................................................192
Retained earnings .....................................................................................................................192
Accounting for stock dividends and stock splits........................................................................192
Introduction Concept Check Questions................................................................................193
Introduction Concept Check Answers ..................................................................................195
An Introduction...............................................................................................................................198
Reading 29: Financial Statement Analysis: An Introduction .....................................................198
Reading 30: Financial Reporting Mechanics ............................................................................198
Reading 31: Financial Reporting Standards .............................................................................198
The Income Statement, Balance Sheet, and Cash Flow Statement .............................................222
Reading 32: Understanding the Income Statement ..................................................................222
Reading 33: Understanding the Balance Sheet........................................................................222

XII Table of Contents
Reading 34: Understanding the Cash Flow Statement ............................................................ 222

Inventories, Long-Term Assets, Deferred Taxes, and On- and Off-Balance Sheet Debt ............. 248
Reading 35: Analysis of Inventories ......................................................................................... 248
Reading 36: Analysis of Long-Lived Assets: ............................................................................ 248
Part I—The Capitalization Decision.......................................................................................... 248
Reading 37: Analysis of Long-Lived Assets: ............................................................................ 248
Part II—Analysis of Depreciation and Impairment.................................................................... 248
Reading 38: Analysis of Income Taxes .................................................................................... 248
Reading 39: Analysis of Financing Liabilities ........................................................................... 248
Reading 40: Leases and Off-Balance-Sheet Debt ................................................................... 248
Techniques, Applications, and International Standards Convergence ......................................... 274
Reading 41: Financial Analysis Techniques............................................................................. 274
Reading 42: Financial Statement Analysis: Applications ......................................................... 274
Reading 43: International Standards Convergence ................................................................. 274
Study Session 11: Corporate Finance: 300
Reading 44: Capital Budgeting ................................................................................................. 300
Reading 45: Cost of Capital...................................................................................................... 300
Reading 46: Working Capital Management.............................................................................. 300
Reading 47: Financial Statement Analysis ............................................................................... 300
Reading 48: The Corporate Governance of Listed Companies: .............................................. 300
A Manual for Investors.............................................................................................................. 300
Study Session 12: Portfolio Management: 330
Reading 49: The Asset Allocation Decision.............................................................................. 330
Reading 50: An Introduction to Portfolio Management............................................................. 330
Reading 51: An Introduction to Asset Pricing Models .............................................................. 330
Securities Markets ......................................................................................................................... 354
Reading 52: Organization and Functioning of Securities Markets ........................................... 354
Reading 53: Security-Market Indexes ...................................................................................... 354
Reading 54: Efficient Capital Markets ...................................................................................... 354
Reading 55: Market Efficiency and Anomalies ......................................................................... 354
Industry and Company Analysis.................................................................................................... 378
Reading 56: An Introduction to Security Valuation: Part I ........................................................ 378

Table of Contents XIII
Reading 57: Industry Analysis...................................................................................................378

Reading 58: Equity: Concepts and Techniques........................................................................378
Reading 59: Company Analysis and Stock Valuation...............................................................378
Reading 60: An Introduction to Security Valuation: Part II........................................................378
Reading 61: Introduction to Price Multiples ..............................................................................378
Basic Concepts ..............................................................................................................................402
Reading 62: Features of Debt Securities ..................................................................................402
Reading 63: Risks Associated with Investing in Bonds ............................................................402
Reading 64: Overview of Bond Sectors and Instruments .........................................................402
Reading 65: Understanding Yield Spreads...............................................................................402
Reading 66: Monetary Policy in an Environment of Global Financial Markets .........................402
Analysis and Valuation...................................................................................................................426
Reading 67: Introduction to the Valuation of Debt Securities ...................................................426
Reading 68: Yield Measures, Spot Rates, and Forward Rates ................................................426
Reading 69: Introduction to the Measurement of Interest Rate Risk ........................................426
Study Session 17: Derivative Investments: 450
Reading 70: Derivative Markets and Instruments .....................................................................450
Reading 71: Forward Markets and Contracts ...........................................................................450
Reading 72: Futures Markets and Contracts ............................................................................450
Reading 73: Option Markets and Contracts..............................................................................450
Reading 74: Swap Markets and Contracts ...............................................................................450
Reading 75: Risk Management Applications of Option Strategies ...........................................450
Study Session 18: Alternative Investments: 474
Reading 76: Alternative Investments ........................................................................................474
Terminology: 501
Appendix A: 503
Download Instructions 526

14 Study Session 01:
Study Session 01: Ethical and Professional

Standards:

The readings in this study session present a framework for ethical conduct in the investment
profession by focusing on the CFA Institute Code of Ethics and Standards of Professional Conduct as
well as the Global Investment Performance Standards (GIPS®).
The principles and guidance presented in the CFA Institute Standards of Practice Handbook (SOPH)
form the basis for the CFA Institute self‐regulatory program to maintain the highest professional
standards among investment practitioners. “Guidance” in the SOPH addresses the practical
application of the Code of Ethics and Standards of Professional Conduct. The guidance reviews the
purpose and scope of each standard, presents recommended procedures for compliance, and
provides examples of the standard in practice.
The Global Investment Performance Standards (GIPS) facilitate efficient comparison of investment
performance across investment managers and country borders by prescribing methodology and
standards that are consistent with a clear and honest presentation of returns. Having a global
standard for reporting investment performance minimizes the potential for ambiguous or misleading
presentations.

Reading 1: Code of Ethics and Standards of Professional Conduct
Reading 2: “Guidance” for Standards I–VII
Reading 3: Introduction to the Global Investment Performance Standards (GIPS)
Reading 4: Global Investment Performance Standards (GIPS)

Ethical and Professional Standards 1
1. Jason Vasco, CFA, is the director for a major Talia‐owned investment management firm branch in
Rasen. Talia is known as the world’s centre of investment management with securities laws stricter
than the CFA Institute Code and Standards, and Vasco is governed by Talia’s laws. In Rasen, an
emerging market, the local securities laws and regulations are lenient. They are very vague in the
definition of insider trading and have no provision regulating soft‐dollars. Which of the following is
most accurate?
A. Vasco must comply with Talia’s law.
B. Vasco only has to comply with Rasen’s law and therefore can take the fullest advantage
of soft‐dollar arrangements.
C. Vasco should not worry about Rasen’s law, it is an early stage emerging market and the
law enforcement will be lax, if any at all.
D. As a CFA Institute member, Vasco must only comply with the Code and Standards
regarding insider trading and soft‐dollar arrangements.

2. As an expression of gratitude, Tracy Blanc, CFA, a portfolio manager, is invited to spend a three‐
week vacation valued at $10,000 with her spouse in a luxurious resort owned by a wealthy private
client after she skillfully protected the value of the client’s capital during a severe market downturn.
The private client is a fee‐paying client of Blanc’s firm. According to Standard IV(B) – Disclosure of
Additional Compensation Arrangements:
A. Blanc must refuse the invitation as it may jeopardize her investment judgment.
B. Blanc is recommended to donate the monetary value of the vacation to a charity of her
choice.
C. Blanc may accept such an invitation as long as she reports it in writing to her employer
and gains their approval.
D. Blanc may accept the invitation if she reports it in writing to CFA Institute citing the full
monetary value of the vacation.

2 Study Session 01:
1. Jason Vasco, CFA, is the director for a major Talia‐owned investment management firm branch in
Rasen. Talia is known as the world’s centre of investment management with securities laws stricter
than the CFA Institute Code and Standards, and Vasco is governed by Talia’s laws. In Rasen, an
emerging market, the local securities laws and regulations are lenient. They are very vague in the
definition of insider trading and have no provision regulating soft‐dollars. Which of the following is
most accurate?
A. Vasco must comply with Talia’s law.
B. Vasco only has to comply with Rasen’s law and therefore can take the fullest advantage of soft-
dollar arrangements.
C. Vasco should not worry about Rasen’s law, it is an early stage emerging market and the law
enforcement will be lax, if any at all.
D. As a CFA Institute member, Vasco must only comply with the Code and Standards regarding
insider trading and soft-dollar arrangements.
Correct Answer: A LOS: Reading 2‐b
Standard I (A) stipulates that in foreign jurisdictions members must comply with the stricter of the
applicable laws and the Code of Standards, in this case Talia’s law is the strictest.
Reference: CFA® Program Curriculum, Volume 1, pp. 15‐17.

2. As an expression of gratitude, Tracy Blanc, CFA, a portfolio manager, is invited to spend a three‐
week vacation valued at $10,000 with her spouse in a luxurious resort owned by a wealthy private
client after she skillfully protected the value of the client’s capital during a severe market downturn.
The private client is a fee‐paying client of Blanc’s firm. According to Standard IV(B) – Disclosure of
Additional Compensation Arrangements:
A. Blanc must refuse the invitation as it may jeopardize her investment judgment.
B. Blanc is recommended to donate the monetary value of the vacation to a charity of her choice.
C. Blanc may accept such an invitation as long as she reports it in writing to her employer and gains
their approval.
D. Blanc may accept the invitation if she reports it in writing to CFA Institute citing the full monetary
value of the vacation.
Correct Answer: C ...................................................................................................... Reading 2‐b
Blanc needs to report in writing the additional compensation so her supervisor and the firm can assess
whether it is potentially a conflict of interest. If there is no objection she is free to accept the invitation.

3. Kevin Dudman, CFA, has just been offered an exciting new position with Walton Asset
Management and decides that he will resign from his current position with Trust Asset Management.
Before he resigns he decides to ensure that he uses some of the skills and materials he has developed
at Trust Asset Management. He is least likely to violate the Code and Standards, if he takes:
A. stock market analysis prepared by Dudman when he was working at Trust Asset
Management.
B. internal contact information on Trust Asset Management‘s major clients which is available
from other eternal sources.
C. computer models developed to identify mispriced securities developed by Dudman and a
colleague at Trust Asset Management.
D. experience in pricing unlisted securities which he gained while attending training courses
which were paid for by Trust Asset Management.

4. Joseph Morgon, CFA, is a research analyst covering the Bourgogne Vineyard Corporation.
Morgon’s parents bought $50 worth of Bourgogne Vineyard Corporation shares for his two‐year old
son on his birthday. Under Standard VI(A), Disclosure of Conflicts, Morgon:
A. must file a report with the SEC.

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

4 Study Session 01:
3. Kevin Dudman, CFA, has just been offered an exciting new position with Walton Asset
Management and decides that he will resign from his current position with Trust Asset Management.
Before he resigns he decides to ensure that he uses some of the skills and materials he has developed
at Trust Asset Management. He is least likely to violate the Code and Standards, if he takes:
A. stock market analysis prepared by Dudman when he was working at Trust Asset Management.
B. internal contact information on Trust Asset Management‘s major clients which is available from
other eternal sources.
C. computer models developed to identify mispriced securities developed by Dudman and a colleague
at Trust Asset Management.
D. experience in pricing unlisted securities which he gained while attending training courses which
were paid for by Trust Asset Management.
Correct Answer: D ........................................................................................... LOS: Reading 2‐b
Models and research which he worked on when employed by Trust Asset Management belong to Trust
Asset Management. Client contact details should not be taken from his employer, although he is not
prohibited from collecting client information from outside sources. However skills and experience gained
at Trust Asset Management can be used in his new job, so D is the correct answer.

4. Joseph Morgon, CFA, is a research analyst covering the Bourgogne Vineyard Corporation.
Morgon’s parents bought $50 worth of Bourgogne Vineyard Corporation shares for his two‐year old
son on his birthday. Under Standard VI(A), Disclosure of Conflicts, Morgon:
A. must file a report with the SEC.
B. must sell the shares immediately.
C. must disclose the ownership of the shares by a member of his immediate family.
D. does not need to disclose the fact that his son owns the shares of Bourgogne Vineyard Corporation.
The share ownership is not likely to be material and therefore will not reasonably affect Morgon’s ability to
make unbiased and objective recommendation according to Standard VI(A) Disclosure of Conflicts.

5. Wimpy Greenback, CFA, is the research analyst responsible for following Brown Appliances
Company. This analysis suggests the stock should be rated a “sell” because the market outlook for
the firm’s new products is bleak compared with that of the closest competition. Greenback lives on
the same street as the CFO of Brown Appliances. During a recent neighborhood gathering,
Greenback’s wife overheard the wife of the Chief Financial Officer of Brown Appliances complaining
that her husband had been working late due to a hostile takeover threat from a foreign appliances
group. This fact has not yet been made public by Brown Appliances. Upon returning to his office,
Greenback released a strong “buy” recommendation to the public based on this new information.
Greenback:
A. was in full compliance with the Code and Standards.
B. did not violate the Code and Standards because he used mosaic theory to arrive at his
recommendation.
C. violated the Code and Standards by failing to distinguish between facts and opinions in
his recommendation.
D. violated the Code and Standards because he did not have a reasonable and adequate
basis for his recommendation.

6 Study Session 01:
5. Wimpy Greenback, CFA, is the research analyst responsible for following Brown Appliances
Company. This analysis suggests the stock should be rated a “sell” because the market outlook for
the firm’s new products is bleak compared with that of the closest competition. Greenback lives on
the same street as the CFO of Brown Appliances. During a recent neighborhood gathering,
Greenback’s wife overheard the wife of the Chief Financial Officer of Brown Appliances complaining
that her husband had been working late due to a hostile takeover threat from a foreign appliances
group. This fact has not yet been made public by Brown Appliances. Upon returning to his office,
Greenback released a strong “buy” recommendation to the public based on this new information.
Greenback:
A. was in full compliance with the Code and Standards.
B. did not violate the Code and Standards because he used mosaic theory to arrive at his
recommendation.
C. violated the Code and Standards by failing to distinguish between facts and opinions in his
recommendation.
D. violated the Code and Standards because he did not have a reasonable and adequate basis for his
recommendation.

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

6. The fixed‐income corporate finance department of Golden Brothers, an investment banking firm,
has decided to compete for the advisory and underwriting bond offering of Kia Telcom, a ‘hot’
telecommunications company. The firm’s equity brokerage unit is about to publish a “sell”
recommendation on Kia Telcom due to an unexpected announcement of cost overruns. The head of
fixed‐income investment banking has asked the head of the equity brokerage unit to change the
recommendation from “sell” to “buy” before distributing the research report to clients. According to
the Code and Standards, the best course of action for the equity brokerage unit is to:
A. place Kia Telcom on a restricted list and publish only factual information about the
company.
B. immediately re‐rate the stock to a “buy” since the firm’s overall interest supersedes that
of the client.
C. assign a more senior analyst to decide if the stock deserves a higher rating for the sake of
objectivity since less senior analysts may err in judgment.
D. increase the rating by no more than one increment (in this case, to a “hold”
recommendation) since little harm is done by being a bit more positive, while the firm’s overall
interest is served.

7. Fiona Griffiths, CFA, is an equity sales manager at a London‐based Tiger Securities branch in an
emerging market. Initial public offerings are often oversubscribed making it difficult to ensure a fair
allocation. Griffiths understands the local environment so she is able to influence the allocation
process so that she can personally subscribe to the maximum she can afford and then allocate the rest
to her clients. Her clients never complain because they have almost always profited from investing in
the emerging market over the last couple of years. Which of the following describes Griffiths’
situation?
A. Griffiths is in compliance with the Code and Standards since her clients are satisfied.
B. Griffiths violates the Code and Standards due to the priority she gives to transactions.
C. Griffiths violates the Code and Standards since she lacks independence and objectivity.
D. Griffiths violates the Code and Standards since she does not maintain client,
confidentiality.

8 Study Session 01:
6. The fixed‐income corporate finance department of Golden Brothers, an investment banking firm,
has decided to compete for the advisory and underwriting bond offering of Kia Telcom, a ‘hot’
telecommunications company. The firm’s equity brokerage unit is about to publish a “sell”
recommendation on Kia Telcom due to an unexpected announcement of cost overruns. The head of
fixed‐income investment banking has asked the head of the equity brokerage unit to change the
recommendation from “sell” to “buy” before distributing the research report to clients. According to
the Code and Standards, the best course of action for the equity brokerage unit is to:
A. place Kia Telcom on a restricted list and publish only factual information about the company.
B. immediately re-rate the stock to a “buy” since the firm’s overall interest supersedes that of the
client.
C. assign a more senior analyst to decide if the stock deserves a higher rating for the sake of objectivity
since less senior analysts may err in judgment.
D. increase the rating by no more than one increment (in this case, to a “hold” recommendation) since
little harm is done by being a bit more positive, while the firm’s overall interest is served.
Correct Answer: A ............................................................................................LOS: Reading 2‐a
In this case, any action to accommodate the interest of the investment banking department that may
compromise the independence and objectivity of the brokerage research efforts can violate Standard I(B)
and the Code of Ethics.

7. Fiona Griffiths, CFA, is an equity sales manager at a London‐based Tiger Securities branch in an
emerging market. Initial public offerings are often oversubscribed making it difficult to ensure a fair
allocation. Griffiths understands the local environment so she is able to influence the allocation
process so that she can personally subscribe to the maximum she can afford and then allocate the rest
to her clients. Her clients never complain because they have almost always profited from investing in
the emerging market over the last couple of years. Which of the following describes Griffiths’
situation?
A. Griffiths is in compliance with the Code and Standards since her clients are satisfied.
B. Griffiths violates the Code and Standards due to the priority she gives to transactions.
C. Griffiths violates the Code and Standards since she lacks independence and objectivity.
D. Griffiths violates the Code and Standards since she does not maintain client, confidentiality.
Correct Answer: B............................................................................................ LOS: Reading 2‐b
Griffiths is in violation as Standard VI(B) Priority of Transactions, since she puts her personal investment
ahead of her clients, regardless of whether the clients are pleased with her services.

8. Victoria Anderson, CFA, works for Pluto Capital, a newly established investment counseling
firm. The founding partners of Pluto Capital came from Vulcan Investments which was recently
taken over by a large financial services group. Jonathan Beecham, a prospective client of the firm, is
meeting with Anderson for the first time. Beecham has been a client of Vulcan Investments for years,
but is now considering switching his account to Pluto Capital because he has been disappointed by
Vulcan’s underperformance following the takeover. At the beginning of their meeting, Anderson
sympathized with his situation, then immediately explains to Beecham that she has discovered a
highly undervalued stock that offers large potential gains. Anderson then promises Beecham that she
can buy the stock for his account at the current price if he switches the account within 48 hours.
Anderson’s actions violated the Code and Standards. Which of the following statements best
describes the action Anderson should have taken? Anderson should have:
A. elaborated on the technical features of Pluto’s standard valuation method used to
identify the undervaluation.
B. avoided the meeting with Beecham in the first place because the founding partners of
Pluto came from Vulcan.
C. given Beecham a longer time period to take advantage of the offer price when switching
his account to Pluto.
D. determined Beecham’s investment needs, objectives, and tolerance for risk before making
any investment recommendation.

8. Victoria Anderson, CFA, works for Pluto Capital, a newly established investment counseling
firm. The founding partners of Pluto Capital came from Vulcan Investments which was recently
taken over by a large financial services group. Jonathan Beecham, a prospective client of the firm, is
meeting with Anderson for the first time. Beecham has been a client of Vulcan Investments for years,
but is now considering switching his account to Pluto Capital because he has been disappointed by
Vulcan’s underperformance following the takeover. At the beginning of their meeting, Anderson
sympathized with his situation, then immediately explains to Beecham that she has discovered a
highly undervalued stock that offers large potential gains. Anderson then promises Beecham that she
can buy the stock for his account at the current price if he switches the account within 48 hours.
Anderson’s actions violated the Code and Standards. Which of the following statements best
describes the action Anderson should have taken? Anderson should have:
A. elaborated on the technical features of Pluto’s standard valuation method used to identify the
undervaluation.
B. avoided the meeting with Beecham in the first place because the founding partners of Pluto came
from Vulcan.
C. given Beecham a longer time period to take advantage of the offer price when switching his account
to Pluto.
D. determined Beecham’s investment needs, objectives, and tolerance for risk before making any
investment recommendation.

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

9. Ken Janzen, CFA, is an economist at a large bank and he has never made direct investment
decisions. Jenzen is the latest winner of a well‐publicized portfolio management competition in a
national newspaper. On the recommendation of his friends, he is launching an investment fund. In
the prospectus he tells the prospective clients, “The fund has no long‐term track record as yet, but the
investment manager has shown considerable skills in managing hypothetical portfolios. In a
competition the manager has demonstrated a portfolio total return above 26 percent per year
annualized, and that is more than 12 percent above the benchmark for the same period.” He managed
to raise a significant amount of money from retail investors who are interested in investing in the
fund. Has Janzen violated the Code and Standards?
A. Yes, because the statement misrepresents Janzen’s track record.
B. Yes, because he cannot quote performance for a hypothetical portfolio.
C. Yes, because the statement about return ignores the risk preferences of his clients.
D. No, because the statement is a true and accurate description of Janzen’s track record.

9. Ken Janzen, CFA, is an economist at a large bank and he has never made direct investment
decisions. Jenzen is the latest winner of a well‐publicized portfolio management competition in a
national newspaper. On the recommendation of his friends, he is launching an investment fund. In
the prospectus he tells the prospective clients, “The fund has no long‐term track record as yet, but the
investment manager has shown considerable skills in managing hypothetical portfolios. In a
competition the manager has demonstrated a portfolio total return above 26 percent per year
annualized, and that is more than 12 percent above the benchmark for the same period.” He managed
to raise a significant amount of money from retail investors who are interested in investing in the
fund. Has Janzen violated the Code and Standards?
A. Yes, because the statement misrepresents Janzen’s track record.
B. Yes, because he cannot quote performance for a hypothetical portfolio.
C. Yes, because the statement about return ignores the risk preferences of his clients.
D. No, because the statement is a true and accurate description of Janzen’s track record.

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

10. Martha Pierpont, CFA, works for the securities custody department of North Pole Trust Bank.
She makes a reciprocal referral fee arrangement with Robert Underhill, CFA, an adviser at
BestAdvice.com. She does not disclose the referral arrangement but Underhill does so by inserting
one clause in BestAdvice.com’s investment advisory agreement that includes “… from time to time
referral fees may be arranged with a number of selected securities custodians.” Clients of BestAdvice
regularly use North Pole’s services and pay referral fees. Which of the following is most accurate?
A. Only Pierpont complies with the Code and Standards.
B. Only Underhill complies with the Code and Standards.
C. Both Pierpont and Underhill comply with the Code and Standards.
D. Neither Pierpont nor Underhill comply with the Code and Standards.

11. Charles Chaplane, who is not a member of CFA Institute, is a senior partner of a small brokerage
firm, Blue Moon Securities, which recently participated in a large stock offering. The offering
company has been given an unfavorable recommendation by his research department in the past two
quarters due to lacklustre performance. Chaplane immediately calls his junior analyst John
Blumenberg, CFA, and instructs him to upgrade his recommendation. Blumenberg comes up with a
more favorable recommendation within a short period of time. Blumenberg is least likely to have
violated the Standards because he failed:
A. to avoid a conflict of interest.
B. to maintain independence and objectivity.
C. to make a fair statement of investment performance.
D. to exercise due diligence and thoroughness in making an investment recommendation.

10. Martha Pierpont, CFA, works for the securities custody department of North Pole Trust Bank.
She makes a reciprocal referral fee arrangement with Robert Underhill, CFA, an adviser at
BestAdvice.com. She does not disclose the referral arrangement but Underhill does so by inserting
one clause in BestAdvice.com’s investment advisory agreement that includes “… from time to time
referral fees may be arranged with a number of selected securities custodians.” Clients of BestAdvice
regularly use North Pole’s services and pay referral fees. Which of the following is most accurate?
A. Only Pierpont complies with the Code and Standards.
B. Only Underhill complies with the Code and Standards.
C. Both Pierpont and Underhill comply with the Code and Standards.
D. Neither Pierpont nor Underhill comply with the Code and Standards.

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

11. Charles Chaplane, who is not a member of CFA Institute, is a senior partner of a small brokerage
firm, Blue Moon Securities, which recently participated in a large stock offering. The offering
company has been given an unfavorable recommendation by his research department in the past two
quarters due to lacklustre performance. Chaplane immediately calls his junior analyst John
Blumenberg, CFA, and instructs him to upgrade his recommendation. Blumenberg comes up with a
more favorable recommendation within a short period of time. Blumenberg is least likely to have
violated the Standards because he failed:
A. to avoid a conflict of interest.
B. to maintain independence and objectivity.
C. to make a fair statement of investment performance.
D. to exercise due diligence and thoroughness in making an investment recommendation.
Correct Answer: C ........................................................................................... LOS: Reading 2‐b

The best answer is C, because there is no evidence to suggest that performance presentation is relevant to
the question.

12. Patricia Lualua, CFA, is a portfolio manager of Raven Asset Management. Recently she won a
mandate from the Flemish Widows pension fund trustees to manage the investments of the fund.
One of the Flemish Widows trustees privately mentions that Lualua should direct her trades to
Churner Securities, which is owned by a relative of one of the trustees. Lualua, for fear of losing the
account, directs 50% of the trades to Churner Securities. She is pleased to find that Churner’s quality
of execution is good and the emerging market research quality is excellent. Although Flemish
Widows does not invest in emerging markets, Lualua finds the research useful for the other funds she
manages. Lualua decides not to inform anyone regarding the situation. According to the Code and
Standards:
A. Lualua should stop trading with Churner Securities.
B. Lualua may continue trading with Churners Securities.
C. Lualua should disclose this arrangement to Flemish Widows.
D. Lualua should disclose this arrangement to the CFA Institute.

12. Patricia Lualua, CFA, is a portfolio manager of Raven Asset Management. Recently she won a
mandate from the Flemish Widows pension fund trustees to manage the investments of the fund.
One of the Flemish Widows trustees privately mentions that Lualua should direct her trades to
Churner Securities, which is owned by a relative of one of the trustees. Lualua, for fear of losing the
account, directs 50% of the trades to Churner Securities. She is pleased to find that Churner’s quality
of execution is good and the emerging market research quality is excellent. Although Flemish
Widows does not invest in emerging markets, Lualua finds the research useful for the other funds she
manages. Lualua decides not to inform anyone regarding the situation. According to the Code and
Standards:
A. Lualua should stop trading with Churner Securities.
B. Lualua may continue trading with Churners Securities.
C. Lualua should disclose this arrangement to Flemish Widows.
D. Lualua should disclose this arrangement to the CFA Institute.

Under most securities laws this situation is acceptable but under Standard III(A), Loyalty, Prudence and
Care, Lualua’s trading relationship does not put her client’s interest first.
Lualua should disclose the arrangement to the Board of Trustees of Flemish Widows and let the Board give
the direction.

13. Carlina Paparazzi, a fund manager with Abbotswood Advisors, has just been given the authority
to manage a newly acquired client which has a retirement benefit plan, when she realizes that a US
Government Bond belonging to the account matures the next day. The bond comprises 5% of the total
assets. Abbotswood Advisors is still in the midst of a discussion with the client regarding the
formulation of a new investment policy and portfolio objectives. Looking at what the current market
has to offer, there are a number of attractive opportunities. One opportunity that stands out is a
corporate bond of a major oil company that went out of favor due to an environmental accident that
occurred the week before. She has followed the oil company for a number of years and knows that its
fundamentals are sound. The prospect of an improved credit rating in the next six months is not yet
reflected in the current price. Her supervisor asks Paparazzi to invest the proceeds in the corporate
bond. Paparazzi prefers however to invest them in 3‐month Treasury Bills, albeit with a much lower
yield, until the new investment policy and objectives are formulated. What is the best course of action
for Paparazzi?
A. Invest in the Treasury Bills until the new investment policy and objectives are
established.
B. Split the investment between the corporate bond and the Treasury Bills to diversify the
risk.
C. Revert to the client for a decision and do nothing until the client’s direction is received.
D. Follow her supervisor’s direction as the corporate bond opportunity will benefit the
overall performance of the fund.

13. Carlina Paparazzi, a fund manager with Abbotswood Advisors, has just been given the authority
to manage a newly acquired client which has a retirement benefit plan, when she realizes that a US
Government Bond belonging to the account matures the next day. The bond comprises 5% of the total
assets. Abbotswood Advisors is still in the midst of a discussion with the client regarding the
formulation of a new investment policy and portfolio objectives. Looking at what the current market
has to offer, there are a number of attractive opportunities. One opportunity that stands out is a
corporate bond of a major oil company that went out of favor due to an environmental accident that
occurred the week before. She has followed the oil company for a number of years and knows that its
fundamentals are sound. The prospect of an improved credit rating in the next six months is not yet
reflected in the current price. Her supervisor asks Paparazzi to invest the proceeds in the corporate
bond. Paparazzi prefers however to invest them in 3‐month Treasury Bills, albeit with a much lower
yield, until the new investment policy and objectives are formulated. What is the best course of action
for Paparazzi?
A. Invest in the Treasury Bills until the new investment policy and objectives are established.
B. Split the investment between the corporate bond and the Treasury Bills to diversify the risk.
C. Revert to the client for a decision and do nothing until the client’s direction is received.
D. Follow her supervisor’s direction as the corporate bond opportunity will benefit the overall
performance of the fund.
Correct Answer: A ........................................................................................... LOS: Reading 2‐b

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

14. Muhammad Taqdir, CFA, is an investment manager whose clients are high‐net worth
individuals. Taqdir is a member of a local charity organization that supports children with asthma.
During a meeting at the charity, Taqdir recommends that the organization sends a letter to Xara
Corporation requesting they make a donation to the charity. Taqdir knows of Xara Corporation’s
involvement in this cause from previous discussions with a colleague in the office. The chief
executive and owner of Xara Corporation is a client of the firm. The charity, citing Taqdir’s
recommendation, sent the letter and received a substantial donation. According to the CFA Institute
Code and Standards:
A. Taqdir has done his best since the organisation received a substantial donation.
B. Taqdir should not have disclosed the identity of the chief executive without his prior
approval.
C. Taqdir should have informed the chief executive of Xara that he is going to receive a
letter from the organization.
D. Taqdir should have requested the approval of his colleague before disclosing the name of
the chief executive of Xara.

14. Muhammad Taqdir, CFA, is an investment manager whose clients are high‐net worth
individuals. Taqdir is a member of a local charity organization that supports children with asthma.
During a meeting at the charity, Taqdir recommends that the organization sends a letter to Xara
Corporation requesting they make a donation to the charity. Taqdir knows of Xara Corporation’s
involvement in this cause from previous discussions with a colleague in the office. The chief
executive and owner of Xara Corporation is a client of the firm. The charity, citing Taqdir’s
recommendation, sent the letter and received a substantial donation. According to the CFA Institute
Code and Standards:
A. Taqdir has done his best since the organisation received a substantial donation.
B. Taqdir should not have disclosed the identity of the chief executive without his prior approval.
C. Taqdir should have informed the chief executive of Xara that he is going to receive a letter from the
organization.
D. Taqdir should have requested the approval of his colleague before disclosing the name of the chief
executive of Xara.
Correct Answer: B............................................................................................ LOS: Reading 2‐b

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

15. Marco Maggio, CFA, is scheduled to visit the corporate headquarters of Venus Industries.
Maggio expects to use the information obtained there to complete his research report on Venus stock.
The location of Venus Industries is within a 15‐minute drive of a prestigious golf course. On arrival at
the Venus premises, Marco Maggio learns that Venus is offering Maggio an extension of his stay that
weekend and invites him for a day of golf with all expenses paid. Venus Industries also offers to pay
for all the expenses for the trip, including the cost of meals, hotel room, and air transportation back to
Venus Industries. The total cost for the weekend is about $2,000.
Which of the following actions would be the best course for Maggio to take under the Code and
Standards?
A. Pay for all travel expenses, including costs of meals and incidental items and politely
reject the golf outing offer.
B. Reject the golf outing offer but accept the reimbursement of the travel expenses since
they are legitimate business‐related expenses.
C. Accept both the expenses‐paid trip and the golf outing as more information can often be
extracted from the company in a more leisurely environment.
D. Accept the expenses‐paid trip and disclose the value of the trip in the report, but it is at
Maggio’s discretion to take the golf outing offer without disclosing it as it occurs outside
working hours.

15. Marco Maggio, CFA, is scheduled to visit the corporate headquarters of Venus Industries.
Maggio expects to use the information obtained there to complete his research report on Venus stock.
The location of Venus Industries is within a 15‐minute drive of a prestigious golf course. On arrival at
the Venus premises, Marco Maggio learns that Venus is offering Maggio an extension of his stay that
weekend and invites him for a day of golf with all expenses paid. Venus Industries also offers to pay
for all the expenses for the trip, including the cost of meals, hotel room, and air transportation back to
Venus Industries. The total cost for the weekend is about $2,000.
Which of the following actions would be the best course for Maggio to take under the Code and
Standards?
A. Pay for all travel expenses, including costs of meals and incidental items and politely reject the golf
outing offer.
B. Reject the golf outing offer but accept the reimbursement of the travel expenses since they are
legitimate business-related expenses.
C. Accept both the expenses-paid trip and the golf outing as more information can often be extracted
from the company in a more leisurely environment.
D. Accept the expenses-paid trip and disclose the value of the trip in the report, but it is at Maggio’s
discretion to take the golf outing offer without disclosing it as it occurs outside working hours.

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

16. Simon Freud, CFA, is a private‐client investment manager at Super Echo investment firm based
in Vienna, Austria. One of his clients in Monaco offers him bonus compensation beyond that
provided by his firm if the portfolio performance exceeds the agreed benchmark. To make it more
attractive to Freud, his client will send the bonus compensation to a tax‐free account in a tax haven.
Freud:
A. should report the situation to the compliance officer of the CFA Institute according to
Standard I(B) Independence and Objectivity.
B. should turn down the additional compensation offer because it violates Standard IV(B)
Additional Compensation Arrangements.
C. may accept the additional compensation subject to the approval of his employer as
required by Standard IV(B) Additional Compensation Arrangements.
D. is free to accept the additional compensation in the tax‐free account, as long as the
account is not under the jurisdiction of either Monaco or Austria, it will therefore also be
outside the jurisdiction of the Code and Standards.

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

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

17. Joseph Luny, CFA, is a bank analyst with London Fog Securities. On a recent trip to see a bank
that he covers, he was presented with a rosy outlook for the bank’s earnings in the next two years
which is above the consensus expectations. When probed further about the assumptions, the CFO
inadvertently mentioned that serious discussions are taking place for a tender offer of a smaller well‐
managed bank that Luny also covers. This information has not been made public. Luny feels very
lucky to receive this unexpected tip and rushes back to his office to revise his projections and advise
his major clients to buy the smaller bank’s stock. What should Luny have done instead?
A. Luny should request his supervisor’s approval.

B. Luny is entitled to take advantage of the information as he did not misappropriate it.
C. Luny should refrain from taking any action on the smaller bank’s stock until the bank has
made the tender offer information public.
D. Luny should encourage the bank to disclose the tender offer information to the public but
is free to take advantage of the information in the meantime.

17. Joseph Luny, CFA, is a bank analyst with London Fog Securities. On a recent trip to see a bank
that he covers, he was presented with a rosy outlook for the bank’s earnings in the next two years
which is above the consensus expectations. When probed further about the assumptions, the CFO
inadvertently mentioned that serious discussions are taking place for a tender offer of a smaller well‐
managed bank that Luny also covers. This information has not been made public. Luny feels very
lucky to receive this unexpected tip and rushes back to his office to revise his projections and advise
his major clients to buy the smaller bank’s stock. What should Luny have done instead?
A. Luny should request his supervisor’s approval.
B. Luny is entitled to take advantage of the information as he did not misappropriate it.
C. Luny should refrain from taking any action on the smaller bank’s stock until the bank has made the
tender offer information public.
D. Luny should encourage the bank to disclose the tender offer information to the public but is free to
take advantage of the information in the meantime.

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

18. Marianne Warner, CFA, is a portfolio manager at Creative Investment Management and in
charge of managing several discretionary portfolios. Her husband holds 25 percent of the shares of
Gurita Corporation, a computer services company. In line with the high sector growth, Gurita
Corporation went public earlier in the year. The share price skyrocketed and the value of her
husband’s holding went up from $1 million prior to the public offering to $8 million at the current
market price. Warner believes that the current market price is too high and immediately advises her
husband to sell half of his shares. She also recommends he put the proceeds into one of the
discretionary portfolios she is currently managing. Which one is the best answer?
A. Warner does not violate the Code and Standards.
B. Warner violates the Code and Standards for failing to disclose the conflicts of interest.
C. Warner violates the Code and Standards for possessing material non‐public information.
D. Warner violates the Code and Standards for failing to disclose additional compensation
arrangements.

18. Marianne Warner, CFA, is a portfolio manager at Creative Investment Management and in
charge of managing several discretionary portfolios. Her husband holds 25 percent of the shares of
Gurita Corporation, a computer services company. In line with the high sector growth, Gurita
Corporation went public earlier in the year. The share price skyrocketed and the value of her
husband’s holding went up from $1 million prior to the public offering to $8 million at the current
market price. Warner believes that the current market price is too high and immediately advises her
husband to sell half of his shares. She also recommends he put the proceeds into one of the
discretionary portfolios she is currently managing. Which one is the best answer?
A. Warner does not violate the Code and Standards.
B. Warner violates the Code and Standards for failing to disclose the conflicts of interest.
C. Warner violates the Code and Standards for possessing material non-public information.
D. Warner violates the Code and Standards for failing to disclose additional compensation
arrangements.

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

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

20. Jonathan Seller, CFA, works for an investment bank that is acting as the principal underwriter for
an issue of stock of a large tire manufacturer. Seller found out that the prospectus has concealed an
impending product recall due to a quality control error. Since the number of items affected is
relatively small, the product recall is planned to be a quiet affair. However Seller is aware that
recently a competitor’s product recall received a large amount of adverse publicity. The preliminary
prospectus has been distributed. According to the Code and Standards:
A. Seller should do nothing as it may jeopardize the success of the issue.

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

19. The Professional Conduct staff under the direction of CFA Institute are least likely to make an
enquiry into a member’s conduct when:
A. they perform random checks on members’ professional conduct.
B. they receive a written complaint regarding a member’s professional conduct.
C. the media reports on a member whose professional conduct appears to have been unethical.
D. members self-disclose on their Professional Conduct Statement that they are involved in litigation
regarding their investment advice.
Correct Answer: D .......................................................................................................Reading 1‐a
There is no mention of CFA Institute performing random checks on members’ (or candidates’) behavior.
The circumstances that might prompt an enquiry are self-disclosure by a member, written complaints,
media or other public sources providing information, or whenever a candidate is suspected of comprising
their professional conduct during an examination.
Reference: CFA® Program Curriculum, Volume 1, p. 9.

20. Jonathan Seller, CFA, works for an investment bank that is acting as the principal underwriter for
an issue of stock of a large tire manufacturer. Seller found out that the prospectus has concealed an
impending product recall due to a quality control error. Since the number of items affected is
relatively small, the product recall is planned to be a quiet affair. However Seller is aware that
recently a competitor’s product recall received a large amount of adverse publicity. The preliminary
prospectus has been distributed. According to the Code and Standards:
A. Seller should do nothing as it may jeopardize the success of the issue.
B. Seller should revise the preliminary prospectus to include the omitted information to avoid any
possible misrepresentation.
C. Seller should inform CFA Institute of the violation of the Code and Standards so he can clear
himself of the possible misrepresentation.
D. Seller should inform his supervisor and let him/her deal with the situation since Seller himself
should not jeopardize the success of the issue.
Correct Answer: B....................................................................................................... Reading 2‐b
Standard V requires that members shall make reasonable and diligent efforts to avoid any material
misrepresentation in any research report or investment recommendation. B is the best answer.

21. Tamara Deneuve, CFA, is an investment manager in charge of Asian equity portfolios. Together
with her colleagues, she has developed a new proprietary valuation model for emerging markets in
Asia. Back testing using 12‐month earnings data, the valuation model produces favorable results
particularly when applied to certain industries, but not to others. Deneuve has decided to implement
the new model to those industries but use the usual model for the others. According to the Code and
Standards:
A. Deneuve must inform her clients prior to implementing the model.
B. Deneuve has the sole right to any proprietary model she has developed.
C. Deneuve should not implement the model since it can only be applied to certain
industries.
D. Deneuve may implement the new model without informing her private clients since they
would be unlikely to understand the model.

22. Which of the following is not a concept covered by the CFA Institute Code of Ethics?
A. Competence.
B. Integrity and diligence.
C. Independent judgment.
D. Remuneration levels of investment professionals.

21. Tamara Deneuve, CFA, is an investment manager in charge of Asian equity portfolios. Together
with her colleagues, she has developed a new proprietary valuation model for emerging markets in
Asia. Back testing using 12‐month earnings data, the valuation model produces favorable results
particularly when applied to certain industries, but not to others. Deneuve has decided to implement
the new model to those industries but use the usual model for the others. According to the Code and
Standards:
A. Deneuve must inform her clients prior to implementing the model.
B. Deneuve has the sole right to any proprietary model she has developed.
C. Deneuve should not implement the model since it can only be applied to certain industries.
D. Deneuve may implement the new model without informing her private clients since they would be
unlikely to understand the model.

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

22. Which of the following is not a concept covered by the CFA Institute Code of Ethics?
A. Competence.
B. Integrity and diligence.
C. Independent judgment.
D. Remuneration levels of investment professionals.
Correct Answer: D ........................................................................................... LOS: Reading 1‐c

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

Study session 02: Quantitative Methods:

Basic Concepts

This introductory study session presents the fundamentals of those quantitative techniques that are
essential in almost any type of financial analysis, and which will be used throughout the remainder of
the CFA curriculum. This session introduces two main building blocks of the quantitative analytical
tool kit: (1) the time value of money and (2) statistics and probability theory.
The time value of money concept is one of the main principles of financial valuation. The calculations
based on this principle (e.g., present value, future value, and internal rate of return) are the basic tools
used to support corporate finance decisions and estimate the fair value of fixed income, equity, or any
other type of security or investment.
Similarly, the basic concepts of statistics and probability theory constitute the essential tools used in
describing the main statistical properties of a population and understanding and applying various
probability concepts in practice.

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

Quantitative Methods: Basic Concepts 35
1. The following income streams will be paid from an investment:
End year 1 $15,000
End year 2 $25,000
End year 3 $10,000

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

2. An analyst states “ …. the odds against the company increasing its dividend are twelve to one”.
This means that the analyst believes that the probability of it increasing the dividend is closest to:
A. 0.0769.
B. 0.0833.
C. 0.9166.
D. 0.9230.

1. The following income streams will be paid from an investment:
End year 1 $15,000
End year 2 $25,000
End year 3 $10,000
At the end of year 3 the investment will have no remaining value. If the discount rate is 8% the present
value of the investment is closest to:
A. $38,580.
B. $39,692.
C. $43,260.
D. $46,721.
Correct Answer: C ........................................................................................... LOS: Reading 5‐d
$15,000 $25,000 $10,000

PV = + +
1.08 (1.08)2 (1.08)3
= $13,889 + $21,433 + $7,938 = $43,260

2. An analyst states “ …. the odds against the company increasing its dividend are twelve to one”.
This means that the analyst believes that the probability of it increasing the dividend is closest to:
A. 0.0769.
B. 0.0833.
C. 0.9166.
D. 0.9230.
Correct Answer: A ............................................................................................ LOS: Reading 8‐c
Odds against of twelve to one, means the probability is 1/(12 + 1) = 0.0769, there is a one in thirteen chance
it will happen.

3. A portfolio increases in value from $10 million to $12 million over the first year. New cash of $2
million is then invested in the fund and the fund increases in value to $15 million at the end of the
second year. The money‐weighted and time‐weighted rates of return are closest to (respectively):
A. 12.8%, 13.4%.
B. 12.8%, 27.1%.
C. 13.4%, 22.5%.
D. 14.0%, 22.5%.

4. If a credit card company charges interest at a rate of 15% compounded monthly, then the
effective annual rate of interest is closest to:
A. 10.03%.
B. 14.04%.
C. 15.86%.
D. 16.08%.

3. A portfolio increases in value from $10 million to $12 million over the first year. New cash of $2
million is then invested in the fund and the fund increases in value to $15 million at the end of the
second year. The money‐weighted and time‐weighted rates of return are closest to (respectively):
A. 12.8%, 13.4%.
B. 12.8%, 27.1%.
C. 13.4%, 22.5%.
D. 14.0%, 22.5%.
2 15
The money-weighted return is calculated by solving 10 + =
So, R = 12.8%.
(1 + R ) (1 + R )2
The time-weighted return is the geometric average of the returns in each period,
(1.20)(1.0714) = (1 + r ) 2 so r = 13.39%

A. 10.03%.
B. 14.04%.
C. 15.86%.
D. 16.08%.
Correct Answer: D ............................................................................................ LOS: Reading 5‐c

m
⎛ r ⎞
EAR = ⎜1 + S ⎟ − 1
⎝ m⎠
= (1 + 0.0125) − 1
12
= 16.08%

5. A manager is offered two investments projects X and Y with net cash flows, in $ million, from
each investment as shown below. The cost of X is $2 million and the cost of Y is $10 million. The cost
of capital for X is 10% and for Y is 8%. Which should be accepted for investment?
End of Year X Y
1 1.1 3.0
2 1.8 9.0

A. Both projects should be accepted.
B. X should be accepted and Y rejected.
C. Y should be accepted and X rejected.
D. Both projects should be rejected.

6. Which is the lowest yield on a 90‐day Treasury bill?
A. Bank discount yield.
B. Holding period yield.
C. Money market yield.
D. Effective annual yield.

5. A manager is offered two investments projects X and Y with net cash flows, in $ million, from
each investment as shown below. The cost of X is $2 million and the cost of Y is $10 million. The cost
of capital for X is 10% and for Y is 8%. Which should be accepted for investment?
End of Year X Y
1 1.1 3.0
2 1.8 9.0
A. Both projects should be accepted.
B. X should be accepted and Y rejected.
C. Y should be accepted and X rejected.
D. Both projects should be rejected.

Correct Answer: A ............................................................................................LOS: Reading 6‐a
N CFt 1.1 1.8
NPV (X) = ∑ = −2 + + = 0.49
t =0 (1 + r ) t
1.10 1.10 2
N CFt 3.0 9.0
NPV (Y) = ∑ = −10 + + = 0.49
t =0 (1 + r ) t
1.08 1.08 2
Both investments have positive NPVs so they should both be accepted.

6. Which is the lowest yield on a 90‐day Treasury bill?
A. Bank discount yield.
B. Holding period yield.
C. Money market yield.
D. Effective annual yield.
Correct Answer: B............................................................................................ LOS: Reading 6‐d

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

7. The probability of a customer in a restaurant ordering potatoes is 40%, the probability of them
ordering rice is 60% and the probability of them ordering both is 10%. What is the probability of a
customer, chosen at random, ordering neither potatoes nor rice?
A. 0.00.
B. 0.10.
C. 0.14.
D. 0.24.

A. 10.03%.
B. 14.04%.
C. 15.86%.
D. 16.08%.

7. The probability of a customer in a restaurant ordering potatoes is 40%, the probability of them
ordering rice is 60% and the probability of them ordering both is 10%. What is the probability of a
customer, chosen at random, ordering neither potatoes nor rice?
A. 0.00.
B. 0.10.
C. 0.14.
D. 0.24.
Correct Answer: B.............................................................................................LOS: Reading 8‐e
Use the general rule of addition to calculate the probability that a customer orders either potatoes or rice:
P(A or B) = P(A) + P(B) – P(A and B)
= 0.4 + 0.6 – 0.1 = 0.9
The probability of a customer ordering neither is 1 – 0.9 = 0.1

A. 10.03%.
B. 14.04%.
C. 15.86%.
D. 16.08%.

m
⎛ r ⎞
EAR = ⎜1 + S ⎟ − 1
⎝ m⎠
= (1 + 0.0125) − 1
12
= 16.08%

9. A shop which sells matches knows that 14 out of 20 boxes of matches will contain 100 matches
exactly; the remainder will contain more than 100 matches. The probability of a customer picking up
a box of matches that contains more than 100 matches, and then picking up a second box containing
more than 100 matches is closest to:
A. 0.06.
B. 0.08.
C. 0.09.
D. 0.12.

10. If P(A|B) = P(A) then the events A and B are:
A. exhaustive.
B. independent.
C. mutually exclusive.
D. equally likely to occur.

9. A shop which sells matches knows that 14 out of 20 boxes of matches will contain 100 matches
exactly; the remainder will contain more than 100 matches. The probability of a customer picking up
a box of matches that contains more than 100 matches, and then picking up a second box containing
more than 100 matches is closest to:
A. 0.06.
B. 0.08.
C. 0.09.
D. 0.12.
Correct Answer: B.............................................................................................LOS: Reading 8‐e
Use the general rule of multiplication, which says that:
P(A and B) = P(A) P(B|A)
= 6/20 × 5/19
= 0.08

10. If P(A|B) = P(A) then the events A and B are:
A. exhaustive.
B. independent.
C. mutually exclusive.
D. equally likely to occur.
Correct Answer: B............................................................................................. LOS: Reading 8‐f

Two events are independent if the occurrence of one event does not affect the probability of the other
event occurring.

11. A mortgage has an annual quoted interest rate of 12 percent. If mortgage payments are made
monthly, then the effective annual interest rate is closest to:
A. 11.40%.
B. 12.36%.
C. 12.55%.
D. 12.68%.

12. An investor puts $50,000 into a mutual fund at the end of each quarter and his purchase prices
are $20, $25, $28, $23. The average price that he pays per share is closest to:
A. $23.12.
B. $23.64.
C. $24.00.
D. $24.50.

11. A mortgage has an annual quoted interest rate of 12 percent. If mortgage payments are made
monthly, then the effective annual interest rate is closest to:
A. 11.40%.
B. 12.36%.
C. 12.55%.
D. 12.68%.

The effective annual rate (EAR) is given by:
m
⎛ r ⎞
EAR = ⎜1 + S ⎟ − 1
⎝ m⎠
where
m = number of compounding periods per year
rs = quoted annual interest rate
EAR = (1.01)12 - 1
= 12.68%

12. An investor puts $50,000 into a mutual fund at the end of each quarter and his purchase prices
are $20, $25, $28, $23. The average price that he pays per share is closest to:
A. $23.12.
B. $23.64.
C. $24.00.
D. $24.50.
Correct Answer: B............................................................................................ LOS: Reading 7‐d

The harmonic mean is the average price on a per share basis.
n 4 4
XH = = = = $23.64
n ⎛ 1 ⎞ ⎛ 1 1 1 1 ⎞ 0.1692
∑ ⎜⎜ ⎟⎟ ⎜ + + + ⎟
i =1 ⎝ X i ⎠ ⎝ 20 25 28 23 ⎠

13. The value of a portfolio starts at $100 million, at the end of the first year it has fallen to $80
million, at the end of the second year it has risen to $105 million, and at the end of the third year it
has risen to $115 million. The geometric mean rate of return is closest to:
A. 3.2%.
B. 4.1%.
C. 4.8%.
D. 6.7%.

14. A deposit of $1,000,000 earns a return of 5% compounded continuously for 8 years. The future
value is closest to:
A. $1,400,000.
B. $1,477,000.
C. $1,492,000.
D. $1,500,000.

13. The value of a portfolio starts at $100 million, at the end of the first year it has fallen to $80
million, at the end of the second year it has risen to $105 million, and at the end of the third year it
has risen to $115 million. The geometric mean rate of return is closest to:
A. 3.2%.
B. 4.1%.
C. 4.8%.
D. 6.7%.
R G = = (1 + R 1 )(1 + R 2 ).....(1 + R n ) − 1
= (0.80 x 1.313 x 1.095) 1/3 – 1
= 0.0476

14. A deposit of $1,000,000 earns a return of 5% compounded continuously for 8 years. The future
value is closest to:
A. $1,400,000.
B. $1,477,000.
C. $1,492,000.
D. $1,500,000.
FV N = PV e rS × N
The future value is given by = $1,000 ,000 e 0.05×8
= $1, 491,825
Note: to find the programmed value of e on your CFA Institute-approved financial calculator, use the
keystrokes:
HP‐12C 1 g ex 2.7183
BA II Plus 1 2nd [ex] 2.7183


15. There is a competition in which there are six contestants and you need to pick winners for 1st,
2nd and 3rd places, how many ways can they be selected?
A. 20.
B. 36.
C. 120.
D. 720.

16. The following information was collected on the average numbers of hours worked per day by the
15 employees of a shop over the last month:
5 5 8 4 4 6 7 6
6 5 4 2 7 7 5
The mean, median and mode are closest to:
Mean Median Mode
A. 5.4 5.0 6.0
B. 5.0 6.0 5.4
C. 5.4 5.0 5.0
D. 5.0 6.0 5.0

15. There is a competition in which there are six contestants and you need to pick winners for 1st,
2nd and 3rd places, how many ways can they be selected?
A. 20.
B. 36.
C. 120.
D. 720.

Correct Answer: C ........................................................................................... LOS: Reading 8‐n
This requires the permutation formula since the order of the r objects matters, so apply:
n!
Number of ways = ( n − r )! = 6!/(6 – 3)! = 120

16. The following information was collected on the average numbers of hours worked per day by the
15 employees of a shop over the last month:
5 58 4 4 6 7 6
6 54 2 7 7 5
The mean, median and mode are closest to:
Mean Median Mode
A. 5.4 5.0 6.0
B. 5.0 6.0 5.4
C. 5.4 5.0 5.0
D. 5.0 6.0 5.0

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

17. Which of the following statements is most accurate regarding a money‐weighted rate of return
for a portfolio?
A. It is the internal rate of return.
B. It is always lower than the time‐weighted rate of return.
C. It is the arithmetic average of the periodic rates of return.
D. It is the geometric average of the periodic rates of return.

18. Conditional probability refers to:
A. the probability that an event will happen more than once.
B. the probability that two or more events will occur concurrently.
C. the probability that one of two mutually exclusive events will occur.
D. the probability of a particular event occurring given that another event has already
occurred.

17. Which of the following statements is most accurate regarding a money‐weighted rate of return
for a portfolio?
A. It is the internal rate of return.
B. It is always lower than the time-weighted rate of return.
C. It is the arithmetic average of the periodic rates of return.
D. It is the geometric average of the periodic rates of return.

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

18. Conditional probability refers to:
A. the probability that an event will happen more than once.
B. the probability that two or more events will occur concurrently.
C. the probability that one of two mutually exclusive events will occur.
D. the probability of a particular event occurring given that another event has already occurred.
Correct Answer: D ........................................................................................... LOS: Reading 8‐d

Conditional probability is the probability of an event occurring given another event has already occurred.
It is ‘conditional’ on the other event.

19. The following data is provided on the quarterly performance of a fund.
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

Beginning value $1,000,000 $1,200,000 $1,500,000 $1,500,000
Cash inflow at beginning $100,000 $100,000 ($200,000) $300,000
Ending value $1,200,000 $1,500,000 $1,500,000 $1,600,000
The time‐weighted return for the year is closest to:
A. 6.6%.
B. 28.7%.
C. 29.1%.
D. 61.4%.

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

19. The following data is provided on the quarterly performance of a fund.
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

Beginning value $1,000,000 $1,200,000 $1,500,000 $1,500,000
Cash inflow at beginning $100,000 $100,000 ($200,000) $300,000
Ending value $1,200,000 $1,500,000 $1,500,000 $1,600,000
The time‐weighted return for the year is closest to:
A. 6.6%.
B. 28.7%.
C. 29.1%.
D. 61.4%.
Correct Answer: C ............................................................................................ LOS: Reading 6‐c

The first step is to calculate the returns for each quarter:
Q1, HPR = ($1,200,000 - $1,100,000)/$1,100,000 = 9.09%
Q2, HPR = ($1,500,000 - $1,300,000)/$1,300,000 = 15.38%
Q3, HPR = ($1,500,000 - $1,300,000)/$1,300,000 = 15.38%
Q4, HPR = ($1,600,000 - $1,800,000)/$1,800,000 = -11.11%
Then calculate the geometric average to get the time-weighted return:
(1.0909) x (1.1538) x (1.1538) x (0.8889) –1 = 0.2909 = 29.1%

20. Stock A has a coefficient of variation of 30% and stock B has a coefficient of variation of 60%.
Which of the following statements is the most accurate?
A. The dispersion of returns relative to the mean is lower for stock A than stock B.
B. The dispersion of returns relative to the mean is higher for stock A than stock B.
C. The standard deviation of stock A is double that of stock B, if the mean returns of both stocks are
the same.
D. The variance of stock A is double that of stock B, if the mean returns of both stocks are the same.
Correct Answer: A............................................................................................LOS: Reading 7‐h
s
CV = X 100
X
Answers C and D are incorrect since, if the mean return is the same the standard deviation of stock A is
half that of B. The coefficient of variation measures the dispersion of returns relative to the mean return.

21. A shop buys pens from two manufacturers, 55% from Mountain Pens and 45% from Valley Pens.
The shop knows that 3% of the pens supplied by Mountain Pens are defective and 5% of the pens
supplied by Valley Pens are defective. The pens in the shops are mixed together. If a pen is chosen at
random and found to be defective what is the probability that it was supplied by Mountain Pens?
A. 33.3%.
B. 42.3%.
C. 55.0%.
D. 60.0%.

22. A person invests $10,000 at the end of each year for the next ten years, if the investment earns 6%
interest annually, the value of the investment at the end of ten years will be closest to:
A. $131,808.
B. $134,350.
C. $139,708.
D. $149,708.

21. A shop buys pens from two manufacturers, 55% from Mountain Pens and 45% from Valley Pens.
The shop knows that 3% of the pens supplied by Mountain Pens are defective and 5% of the pens
supplied by Valley Pens are defective. The pens in the shops are mixed together. If a pen is chosen at
random and found to be defective what is the probability that it was supplied by Mountain Pens?
A. 33.3%.
B. 42.3%.
C. 55.0%.
D. 60.0%.
Correct Answer: B........................................................................................... LOS: Reading 8‐m
P(A 1 )P(B | A 1 )
P(A 1 | B) =
Apply Bayes’ formula:
P(A 1 )P(B | A 1 ) + P(A 2 )P(B | A 2 )
define A1 - Mountain Pens supply the pen
A2 - Valley Pens supply the pen
B - the information that the pen is defective
0.55 × 0.03
P(A 1 | B) =
(0.55 × 0.03) + (0.45 × 0.05)
= 0.423

22. A person invests $10,000 at the end of each year for the next ten years, if the investment earns 6%
interest annually, the value of the investment at the end of ten years will be closest to:
A. $131,808.
B. $134,350.
C. $139,708.
D. $149,708.
Correct Answer: A............................................................................................LOS: Reading 5‐d
This is a question asking for the future value of an annuity, use the annuity formula or a financial
calculator:
This is an annuity type question.
Or use a financial calculator.

Explicit use of annuity
Calculator keystrokes for:
formula:
A = $10,000 HP‐12C BA II Plus

r = 6% = 0.06 f CLEAR FIN 2nd [QUIT] 2nd [CLR TVM]
N = 10 10000 CHS PMT 10000 +/- PMT
(1 + r )N 1 -10,000.00
= -10,000.00
FVN = A
r 6 I/Y I/Y = 6.00
6 i 6.00
10
(1 + 0.06) 1 10 n 10.00
10 N N = 10.00
= $10,000
0.06 CPT FV FV = 131,807.95
FV FV = 131,807.95
= $10,000 × 13.1808
= $131,808

Study Session 03: Quantitative Methods:

Application

This study session introduces the discrete and continuous probability distributions that are most
commonly used to describe the behavior of random variables. Probability theory and calculations are
widely applied in finance, for example, in the field of investment and project valuation and in
financial risk management.
Furthermore, this session teaches how to estimate different parameters (e.g., mean and standard
deviation) of a population if only a sample, rather than the whole population, can be observed.
Hypothesis testing is a closely related topic. This session presents the techniques that can be applied
to accept or reject an assumed hypothesis (null hypothesis) about various parameters of a population.
Finally, you will also learn about the fundamentals of technical analysis. It is important that analysts
properly understand the assumptions and limitations when applying these tools as mis‐specified
models or improperly used tools can result in misleading conclusions.
Reading 9: Common Probability Distributions
Reading 10: Sampling and Estimation
Reading 11: Hypothesis Testing
Reading 12: Technical Analysis

Quantitative Methods: Applications 61
1. An analyst is selecting a sample from the orders received from a firm’s customers. The orders are
time stamped and he decides to include in the sample every 5th order received by the firm. This is an
example of:
A. cluster sampling.
B. simple random sampling.
C. stratified random sampling.
D. systematic random sampling.

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

1. An analyst is selecting a sample from the orders received from a firm’s customers. The orders are
time stamped and he decides to include in the sample every 5th order received by the firm. This is an
example of:
A. cluster sampling.
B. simple random sampling.
C. stratified random sampling.
D. systematic random sampling.
Correct Answer: D ......................................................................................... LOS: Reading 10‐b

Systematic random sampling is when we select every kth member of a population, often used when we
cannot number or label the members of a population.

2. Which of the following statements regarding normal distributions is most accurate?
A. The normal distribution is a good model for the distribution of asset prices.
B. The mean and standard deviation of the standard normal distribution are both 1.
C. A standard normal distribution with low standard deviation will be less peaked than a standard
normal distribution with higher standard deviation.
D. If the returns on individual securities in a portfolio are normally distributed, the returns of a
portfolio containing these securities are normally distributed.
Correct Answer: D ............................................................................................ LOS: Reading 9‐f

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

3. A hypothesis is a statement about a:
A. sample statistic.
B. sample parameter.
C. population statistic.
D. population parameter.

4. A company is analyzing the days that employees take off as sick leave each year and is concerned
that the number of days that employees are taking off has risen above the past average number of 4.0
days. It is assumed that the population is approximately normally distributed. A sample of 20
employees is taken and the mean number of days taken is 4.5 with a standard deviation of 1.5 days. If
the rejection point for a one‐tailed test with 19 degrees of freedom is 1.729 at the 5% significance level
we can conclude that:
A. using the t‐statistic is not valid for a small sample.
B. the mean number of days is more than 4 days at the 5% significance level.
C. the mean number of days is still 4 days or less at the 5% significance level.
D. we should use the z‐test, not the t‐test, if the population is approximately normally
distributed.

3. A hypothesis is a statement about a:
A. sample statistic.
B. sample parameter.
C. population statistic.
D. population parameter.
Correct Answer: D ..........................................................................................LOS: Reading 11‐a
A hypothesis is a statement about a population parameter. We use data from a sample to test whether we
should accept or reject the hypothesis.

4. A company is analyzing the days that employees take off as sick leave each year and is concerned
that the number of days that employees are taking off has risen above the past average number of 4.0
days. It is assumed that the population is approximately normally distributed. A sample of 20
employees is taken and the mean number of days taken is 4.5 with a standard deviation of 1.5 days. If
the rejection point for a one‐tailed test with 19 degrees of freedom is 1.729 at the 5% significance level
we can conclude that:
A. using the t-statistic is not valid for a small sample.
B. the mean number of days is more than 4 days at the 5% significance level.
C. the mean number of days is still 4 days or less at the 5% significance level.
D. we should use the z-test, not the t-test, if the population is approximately normally distributed.
Correct Answer: C ..........................................................................................LOS: Reading 11‐e
Set the null hypothesis as H0: µ ≤ 4.0

We can use the t-test since we are assuming the population is normally distributed.
x −µ 4.5 − 4.0 0.5

t 19 = = = = 1.49
s 1.5 20 0.335
n
This is within the confidence interval so we do not reject the null hypothesis.

5. The standard deviation of a population is 25 and a sample of 50 observations is taken from the
population. The standard error of the sample mean is closest to:
A. 0.10.
B. 0.28.
C. 3.54.
D. 10.00.

6. Which of the following statements regarding lognormal distributions is most accurate?
A. The distribution is bell shaped.
B. The mean of the distribution is zero.
C. Y is a lognormal distribution if LnY is normally distributed.
D. Lognormal distributions are frequently used to reflect the distribution of stock returns.

5. The standard deviation of a population is 25 and a sample of 50 observations is taken from the
population. The standard error of the sample mean is closest to:
A. 0.10.
B. 0.28.
C. 3.54.
D. 10.00.
σ
σx =
The standard error of the sample mean is given by n
= 25/7.07 = 3.54.

6. Which of the following statements regarding lognormal distributions is most accurate?
A. The distribution is bell shaped.
B. The mean of the distribution is zero.
C. Y is a lognormal distribution if LnY is normally distributed.
D. Lognormal distributions are frequently used to reflect the distribution of stock returns.
Correct Answer: C ............................................................................................ LOS: Reading 9‐j

A. is not correct, they are positively skewed distributions.
B. is not correct, the lower bound is zero.
D. is not correct, they are frequently used to show the distribution of stock prices.

7. A stock market rises by an average of 10% a year and the standard deviation of returns is 6%. The
probability of the stock market falling by more than 2% in a year is closest to:
A. 2.3%.
B. 4.6%.
C. 15.9%.
D. 31.7%.

8. The Central Limit Theorem states that if the sampling distribution of the sample mean is
calculated using samples of equal size from a population that is not normal, then:
A. it is approximately a normal distribution.
B. the standard error tends to one as the size of the samples increases.
C. the mean of the distribution will be smaller than the population mean.
D. the dispersion of the distribution is more than the dispersion of the population.

7. A stock market rises by an average of 10% a year and the standard deviation of returns is 6%. The
probability of the stock market falling by more than 2% in a year is closest to:
A. 2.3%.
B. 4.6%.
C. 15.9%.
D. 31.7%.
Correct Answer: A ............................................................................................LOS: Reading 9‐g
A fall of 2% is two standard deviations from the mean. 95.4% of observations fall between the mean plus
or minus two standard deviations so 4.6% lie outside this range. Therefore 2.3% will be below -2% and
2.3% will be above 22%.

8. The Central Limit Theorem states that if the sampling distribution of the sample mean is
calculated using samples of equal size from a population that is not normal, then:
A. it is approximately a normal distribution.
B. the standard error tends to one as the size of the samples increases.
C. the mean of the distribution will be smaller than the population mean.
D. the dispersion of the distribution is more than the dispersion of the population.
Correct Answer: A .......................................................................................... LOS: Reading 10‐f

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

9. Historic analysis suggests that stocks trading on a low price/book value have tended to
outperform the market. If the analysis has not included companies that have gone bankrupt then the
analysis could be biased due to:
A. look‐ahead bias.
B. data‐mining bias.
C. survivorship bias.
D. data‐snooping bias.

10. Hypothesis testing is used to determine the mean return of mutual funds in a single period. A
sample of 25 funds is taken and the null hypothesis is defined as the mean is equal to 12%. Is this an
example of a one or two‐tailed test, and should the z‐test or t‐test be used?
Hypothesis test Test statistic
A. a one‐tailed test t‐test
B. a one‐tailed test z‐test
C. a two‐tailed test t‐test
D. a two‐tailed test z‐test

9. Historic analysis suggests that stocks trading on a low price/book value have tended to
outperform the market. If the analysis has not included companies that have gone bankrupt then the
analysis could be biased due to:
A. look-ahead bias.
B. data-mining bias.
C. survivorship bias.
D. data-snooping bias.
Correct Answer: C ......................................................................................... LOS: Reading 10‐k
It has been argued that if all companies had been included, the companies that went bankrupt would have
been trading on low price/book multiples, and this would have lowered the average performance of the low
price/book value stocks.

10. Hypothesis testing is used to determine the mean return of mutual funds in a single period. A
sample of 25 funds is taken and the null hypothesis is defined as the mean is equal to 12%. Is this an
example of a one or two‐tailed test, and should the z‐test or t‐test be used?
Hypothesis test Test statistic
A. a one-tailed test t-test
B. a one-tailed test z-test
C. a two-tailed test t-test
D. a two-tailed test z-test
Correct Answer: C ..........................................................................LOS: Reading 11‐a and 11‐e
If there is no direction (greater or less than) in the null hypothesis it is two-tailed. Give the sample size of
less than 30 funds the t-test should be used. The z-test should only be used for large samples.
Reference: CFA® Program Curriculum, Volume 1, pp. 458 and 466‐474.

11. An analyst is studying the monthly income of workers at a factory. He is told that the mean
income is $5,000 per month and he decided to look at a sample 100 workers to see if this is correct.
The sample mean is $5,018 with a standard deviation of 80. If he sets the null hypothesis as the
population mean is $5,000 he should:
A. reject the null hypothesis at both the 1% and 5% significance level.
B. not reject the null hypothesis at both the 1% and 5% significance level.
C. not reject the null hypothesis at the 1% significance level but reject it at the 5%
significance level.
D. not reject the null hypothesis at the 5% significance level but reject it at the 1%
significance level.

12. In hypothesis tasting a p‐value of 0.1 indicates that:
A. there is extremely strong evidence that H0 should be rejected.
B. there is extremely strong evidence that H0 should not be rejected.
C. there is a probability of 0.1 of observing a sample value at least as extreme as the value
observed, assuming H0 is correct.
D. there is a probability of 0.1 of observing a sample value at least as extreme as the value
observed, assuming H0 is rejected.

11. An analyst is studying the monthly income of workers at a factory. He is told that the mean
income is $5,000 per month and he decided to look at a sample 100 workers to see if this is correct.
The sample mean is $5,018 with a standard deviation of 80. If he sets the null hypothesis as the
population mean is $5,000 he should:
A. reject the null hypothesis at both the 1% and 5% significance level.
B. not reject the null hypothesis at both the 1% and 5% significance level.
C. not reject the null hypothesis at the 1% significance level but reject it at the 5% significance level.
D. not reject the null hypothesis at the 5% significance level but reject it at the 1% significance level.
Z = (5018-5000)/8 = 2.25. This is less than 2.58 (the critical value for the 1% significance level) so there is no
evidence to reject the null hypothesis at the 1% level.. However it is more than 1.96 (the critical value for
the 5% significance level) so we can reject the hypothesis at the 5% significance level.

12. In hypothesis tasting a p‐value of 0.1 indicates that:
A. there is extremely strong evidence that H0 should be rejected.
B. there is extremely strong evidence that H0 should not be rejected.
C. there is a probability of 0.1 of observing a sample value at least as extreme as the value observed,
assuming H0 is correct.
D. there is a probability of 0.1 of observing a sample value at least as extreme as the value observed,
assuming H0 is rejected.
Correct Answer: C .......................................................................................... LOS: Reading 11‐c

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

13. You are analyzing the monthly returns from a fund over the last year and calculate that the mean
return was 1.25% with a sample standard deviation of 1.0%. You expected the fund to have achieved
a return of 1.4% in line with the risk taken on by the fund and wish to decide at the 10% significance
level whether the results are consistent with a population mean return of 1.4%. Given that t0.05,11=
1.796 you can conclude that:
A. the null hypothesis is rejected and the results are consistent with a mean of 1.4%.
B. the null hypothesis is not rejected and the results are consistent with a mean of 1.4%.
C. the null hypothesis is rejected and the results are not consistent with a mean of 1.4%
D. the null hypothesis is not rejected and the results are not consistent with a mean of 1.4%

14. A chi‐square test statistic ( χ ) could be used for hypothesis tests for

2
A. the mean for a single normally distributed population.
B. the variance for a single normally distributed population.
C. the mean for a single non‐normally distributed population.
D. the variance for a single non‐normally distributed population.

13. You are analyzing the monthly returns from a fund over the last year and calculate that the mean
return was 1.25% with a sample standard deviation of 1.0%. You expected the fund to have achieved
a return of 1.4% in line with the risk taken on by the fund and wish to decide at the 10% significance
level whether the results are consistent with a population mean return of 1.4%. Given that t0.05,11=
1.796 you can conclude that:
A. the null hypothesis is rejected and the results are consistent with a mean of 1.4%.
B. the null hypothesis is not rejected and the results are consistent with a mean of 1.4%.
C. the null hypothesis is rejected and the results are not consistent with a mean of 1.4%
D. the null hypothesis is not rejected and the results are not consistent with a mean of 1.4%
Correct Answer: B...........................................................................................LOS: Reading 11‐e
Set the null hypothesis as H0: µ = 1.4%. We need to apply the t-test because it is a small sample.
x −µ 1.25 − 1.4 0.15
t n −1 = = =− = −0.52
s 1.0 12 0.29
n
This is within the confidence interval so the null hypothesis is not rejected and the results are consistent
with the mean return being 1.4%.

14. A chi‐square test statistic ( χ ) could be used for hypothesis tests for

2
A. the mean for a single normally distributed population.

B. the variance for a single normally distributed population.
C. the mean for a single non-normally distributed population.
D. the variance for a single non-normally distributed population.
Correct Answer: B........................................................................................... LOS: Reading 11‐f

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

15. Large samples are taken from a normal population; the sample mean is 25 and the sample
standard deviation is 5. The 95% confidence interval for the population mean is closest to:
A. between 12.1 and 37.9.
B. between 15.2 and 34.8.
C. between 20.0 and 30.0.
D. between 15.0 and 40.0.

16. When selecting a sample a population is first divided into subpopulations and then random
samples are taken from each subpopulation, the number taken proportional to the size of the
subpopulation. This is an example of:
A. structured sampling.
B. systematic sampling.
C. simple random sampling.
D. stratified random sampling.

15. Large samples are taken from a normal population; the sample mean is 25 and the sample
standard deviation is 5. The 95% confidence interval for the population mean is closest to:

The 95% confidence interval is given by sample mean plus or minus 1.96 standard deviations.
This is
25 ± (1.96 × 5) = 25 ± 9.8 which is between 15.2 and 34.8.

16. When selecting a sample a population is first divided into subpopulations and then random
samples are taken from each subpopulation, the number taken proportional to the size of the
subpopulation. This is an example of:
A. structured sampling.
B. systematic sampling.
C. simple random sampling.
D. stratified random sampling.

Stratified random sampling ensures that different subdivisions within a population are represented in the
sample.

17. If a very large sample size is used it is least likely to lead to:
A. a smaller standard error of the sample means.
B. a larger dispersion in the distribution of the sample means.
C. the sampling distribution of the sample mean being approximately a normal distribution.
D. the mean of the sampling distribution of the sample mean being equal to the population
mean.

18. Which of the following describe lognormal distributions?
Skew Often used to describe asset
A. positively skewed prices
B. positively skewed returns
C. negatively skewed prices
D. negatively skewed. returns

17. If a very large sample size is used it is least likely to lead to:
A. a smaller standard error of the sample means.
B. a larger dispersion in the distribution of the sample means.
C. the sampling distribution of the sample mean being approximately a normal distribution.
D. the mean of the sampling distribution of the sample mean being equal to the population mean.
A large sample size will lead to a smaller standard error of the sample mean since the standard error is
equal to the population standard deviation divided by the square root of the sample size. The central limit
theorem says that the sampling distribution of the sample mean is close to a normal distribution if the
sample size is large (greater than thirty). The mean of the sample means will be the same as the mean of the
population.
However a large sample size will lead to sample means being close to the population mean and therefore
less disperse, so B is the correct answer.

18. Which of the following describe lognormal distributions?
Skew Often used to describe asset
A. positively skewed prices
B. positively skewed returns
C. negatively skewed prices
D. negatively skewed. returns
Correct Answer: A ............................................................................................ LOS: Reading 9‐j

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

19. An investment manager is managing a diversified portfolio of international equities and the
performance benchmark is the MSCI World index. Shortfall risk for the portfolio refers to:
A. the standard deviation of returns.
B. the risk that the value of the portfolio falls below a critical level.
C. the standard deviation of returns relatives to the MSCI World Index.
D. the absolute deviation of returns relatives to the MSCI World Index.

20. The standard error of the sample mean is:
A. the average standard deviation of each sample.
B. the standard deviation of the sampling distribution of sample mean.
C. the standard deviation of the sample minus the standard deviation of the population.
D. the standard deviation of the sample divided by the standard deviation of the
population.

19. An investment manager is managing a diversified portfolio of international equities and the
performance benchmark is the MSCI World index. Shortfall risk for the portfolio refers to:
A. the standard deviation of returns.
B. the risk that the value of the portfolio falls below a critical level.
C. the standard deviation of returns relatives to the MSCI World Index.
D. the absolute deviation of returns relatives to the MSCI World Index.
Correct Answer: B............................................................................................. LOS: Reading 9‐i

Shortfall risk is the risk that the value of a portfolio falls below a certain level, it can be reduced by
minimizing the probability that the return falls below a certain minimum level.
Reference: CFA® Program Curriculum, Volume 1, pp. 397‐ 400.

20. The standard error of the sample mean is:
A. the average standard deviation of each sample.
B. the standard deviation of the sampling distribution of sample mean.
C. the standard deviation of the sample minus the standard deviation of the population.
D. the standard deviation of the sample divided by the standard deviation of the population.
The standard deviation of a sample mean is the standard error. The central limit theorem says that this is
equal to the population standard deviation divided by the square root of the sample size.

21. A sample of 100 observations is taken from a normally distributed population with a standard
deviation of 2. The sample mean is 6. The 99% confidence level is closest to:

22. A client wishes to protect the value of his capital. Which of the following portfolios will be
optimal from a safety‐first analysis?
Asset Expected Return Standard Deviation

A 25 12
B 15 8
C 10 6
D 8 5

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

21. A sample of 100 observations is taken from a normally distributed population with a standard
deviation of 2. The sample mean is 6. The 99% confidence level is closest to:
Correct Answer: B........................................................................................... LOS: Reading 10‐j
σ
x ± zα / 2
The confidence interval is given by
n
where
x = sample mean, which is the point estimate of the population mean
σ = population standard deviation
n = sample size
zα / 2 = reliability factor, the point where α/2 of the probability is in the right tail
The 99% confidence level is 6 ± (2.58 x 2)/10 which is between 5.48 and 6.52.

22. A client wishes to protect the value of his capital. Which of the following portfolios will be
optimal from a safety‐first analysis?
Asset Expected Return Standard Deviation

A 25 12
B 15 8
C 10 6
D 8 5
A. Portfolio A.
B. Portfolio B.
C. Portfolio C.
D. Portfolio D.
Correct Answer: A.............................................................................................LOS: Reading 9‐i
S F Ratio = [E R P − R L ]
( )
σP
where
RP = portfolio return
RL = threshold level
σP = portfolio standard deviation
Calculate the S F Ratio for each portfolio:
S F Ratio(A) = 25/12 = 2.08
S F Ratio(B) = 15/8 = 1.875
S F Ratio(C) = 10/6 = 1.667
S F Ratio(D) = 8/5 = 1.600
A has the highest S F Ratio and is the correct answer.

Study Session 4: Introduction

Introductory Readings
Economics: Private and Public Choice, 10th edition, James D. Gwartney, Richard L. Stroup,
Russell S. Sobel, and David A. Macpherson (South‐Western, 2003)
“Supply, Demand, and the Market Process,” Ch. 3
“Supply and Demand: Applications and Extensions” Ch. 4
“Taking the Nation’s Economic Pulse,” Ch. 7
“Working with Our Basic Aggregate Demand/Aggregate Supply Model,” Ch. 10
“Keynesian Foundations of Modern Macroeconomics,” Ch. 11

Supply, Demand, and the Market Process CH 5

Introduction
This chapter is centered on the laws of supply and demand. The law of supply says that a higher
price means producers produce more of the product, and the law of demand says that consumers
buy less of a good if the price rises, and vice versa. Candidates should know what type of factors
cause shifts in the supply and demand curves and movements along the curves and understand
the concept of market equilibrium.

Introductory Readings 85
Consumer choice and the Law of Demand

Consumers are forced to make choices regarding how they spend their income in order to get the
most value for their money. The Law of Demand states that there is an inverse relationship
between the price of a product and the amount or quantity of it that consumers are willing to
purchase.
Price
Law of Demand
Demand
Quantity

A consumer surplus is the difference between the maximum price that consumers are willing to
pay and the price that they actually pay; this is a net gain to the buyers of the good.
Producer choice and the Law of Supply
All economic participants in an economy are aiming to generate profit, which is the excess of
sales revenue over the production costs. The Law of Supply states that there is a direct
relationship between the price of a product and the amount of it that is offered for sale.

Price
Law of Supply
Supply
Quantity
Price changes and demand and supply

Consumers buy less of a product as the price increases because of the availability of substitutes. The
availability of substitutes is a major factor in deciding the sensitivity to the quantity demanded to a
change in price. If the demand for a product is elastic it means a small price change will lead to a
large change in demand. In the diagram below when the price moves from P1 to P2, the quantity
demanded falls sharply from Q1 to Q2. If demand is inelastic it means that a change in price only has
a small impact on the quantity demanded, so prices move from Q1 to Q2. Unitary elastic means that a
percent change in quantity demanded leads to a percent change in price.
Similarly a supply curve is elastic when the quantity supplied is very responsive to a change in price
(a flat curve) and inelastic when quantity supplied is not very responsive to a change in price (a steep
curve).

Shifts in demand
A shift in the demand curve will be a result of a change in demand due to factors other than price.
Factors that lead to a shift include increases in consumer income, changes in taxes on the product,
changes in price or availability of competing products, and changes in expectations of future prices. It
is important to differentiate between changes in demand (a shift of the demand curve) and changes
in quantity demanded (a movement along the same demand curve).

Shifts in supply
A change in supply indicates a shift in the supply curve. The following are examples of factors that
could lead to a change in supply – changes in resource costs, technology improvements, natural
disasters which limit supply of a product, changes in taxes on the producers of the product.
Equilibrium is defined as a state of balance between forces such as supply and demand. It is
important to differentiate between short run (an insufficient time period for decision makers to fully
adjust to changes in market conditions) and long run (a sufficient time for decision makers to make
adjustments).
High prices will tend to lead to an excess supply illustrated by the points a and b, producers will tend
to lower prices until supply and demand are in balance. On the other hand if prices are too low,
demand will exceed supply, illustrated by points c and d, and producers will increase prices until
equilibrium is reached.
Impact of changes in demand and supply
Increase in demand – the demand curve shifts to the right, which will increase both the equilibrium
price and quantity.
Decrease in demand – the demand curve shifts to the left, which will decrease both the equilibrium
price and quantity.
Increase in supply – the supply curve shifts to the right, which will decrease the equilibrium price
and increase the equilibrium quantity.
Decrease in supply – the supply curve shifts to the left, which will increase the equilibrium price and
decrease the equilibrium quantity.
An unanticipated cut in supply will, in the short run, lead to a sharp increase in price, but in the long
run demand will respond to the price change. Similarly an unanticipated surge in demand for a
product will initially push up prices but longer‐term supply will be increased.

The invisible hand principle says that market prices act as an inducement to individuals to pursue
productive activities that also promote the economic well being of society.

Supply and Demand: Applications and Extensions CH 4

Introduction
This chapter examines some of the applications of supply and demand analysis covered in the
previous Reading. First we look at the impact of wage rates, interest rates and foreign exchange on
supply and demand. Then we look at the impact of government action, including price controls on
markets, and of black markets which are operating outside the legal system. Finally we consider
taxation and how it relates to elasticity of supply and demand.
Resources
The first step in a firm’s production process is the purchase of resources. Resources include raw
materials, labor etc. Resource markets generally have downward‐sloping demand curves and
upward‐sloping supply curves. There is a close link between the markets for the end‐product and the
resources used to make the product. For example, when the price of a resource increases, costs
increase leading to a reduction in supply and higher prices for the end‐product.
The loanable funds market refers to the market that coordinates the borrowing and lending decisions
of firms and households. Participants in the market include commercial banks, and stock and bond
markets. The interest rate is the price of loanable funds.
The demand curve will slope downwards to the right since firms and households will borrow more
at low interest rates. On the other hand, low interest rates will make it less attractive to save so the
supply curve will be upward sloping to the right. Market forces will drive interest rates to a level, E,
where the quantity of funds demanded will equal the quantity of funds supplied.
The interest rate is important because it is the link between the price of something today with its price
in the future.

The foreign exchange market is the market in which different currencies are bought and sold.
Exchange rates between currencies are very important since they determine the price of all goods and
services that are traded in international markets. They will also influence decision makers who are
looking at producing goods in different countries, although other issues such as transport costs, legal
issues will be factors to consider before a decision is made to move production overseas.
A price ceiling is a legal restriction that establishes a maximum price that a good can be sold at. If the
price ceiling is set below the equilibrium price it will increase demand and reduce the quantity
supplied creating a shortage of the good. Non‐price factors (e.g. waiting lists) will determine who is
able to buy the product. Suppliers will be tempted to reduce the quality of the good supplied if they
cannot increase prices.
Price floors establish a minimum price that can be charged for a good. If the price is fixed above the
equilibrium price then a surplus of the good will appear.
The minimum wage is an example of a price floor, and has led to the substitution of machines or
more highly‐skilled workers for low‐paid workers. Also employers will have little incentive to offer
non‐wage benefits to workers on the minimum wage.
A black market is a market that operates outside the legal system, either the sale of illegal goods or
goods at illegal prices or terms. Black markets are characterized by higher profit margins for
suppliers who do not get caught (to compensate the supplier for the higher risk), defective products
and violence (to settle disputes). The point is made that a legal system that allows for settlement of
disputes is essential for the smooth operation of markets.
Tax incidence refers to how the burden of a tax is distributed between buyers and sellers and related
parties (the actual incidence). This will often be quite different to the statutory incidence which is the
legal assignment of the responsibility to pay the tax. It can be shown that the actual incidence is
independent of its statutory incidence, i.e. whether it is imposed on the buyer or the seller.
Looking at the example of when a tax is imposed on the seller of a product, this will shift the supply
curve up by the amount of the tax. The intersection of the demand curve and supply curve will move,
splitting the tax burden between the buyer and seller. The reduction in overall trade (and loss of
benefit of this trade to both parties) results in a deadweight loss; this is the loss over and above the
actual payment of tax to the government.
Elasticity and the incidence of tax
In the case that demand is inelastic and supply elastic the burden of tax will largely fall on the buyer
(e.g. when oil prices rise). Conversely when demand is relatively elastic compared to supply, the
sellers will bear the largest burden.
If either demand or supply is relatively inelastic fewer trades will be eliminated so a rise in tax will
result in a relatively small deadweight loss.

Taking the Nation’s Economic Pulse CH 7

Introduction
The focus of this chapter is on the measurement of GDP as the most commonly quoted measure of
economic performance. Candidates need to know how to calculate GDP using both the expenditure
and the resources cost‐income approaches. They also need to be familiar with the differences between
GDP and GNP, and how to switch between nominal and real GDP given the rate of inflation. At the
end of the chapter we look at alternative measures for the performance of the economy.
Gross domestic product
Gross domestic product (GDP) is defined as the total market value of all final goods and services
produced within a country’s borders during a specific time period. GDP is a broad measure of
current production of goods and services, and GDP calculations exclude second‐hand goods,
intermediate goods, and financial transactions.
There are two main approaches to measuring GDP:
19. 1. Expenditure approach, where GDP is the sum of:
Consumption (C)
Gross private investment (Ig)
Government expenditure (G)
Net Exports (NX)
The expenditure approach is commonly stated as:
GDP = C + Ig + G + NX
Gross private investment includes depreciation expense; gross investment is the sum of net
investment (In) plus depreciation. Net exports (NX) is equal to exports minus imports (X – IM), and
NX can be either positive or negative. If exports are higher than imports, NX will be positive and
added to GDP; if imports are higher than exports, NX will be negative and subtracted from GDP.
20. 2. Cost resource‐income approach, where GDP is the sum of:
Wages, salaries, self-employed income
Rents, profits, and interest
Indirect business taxes
Depreciation
Net income of foreigners
Net income of foreigners can be positive or negative. If foreigners bring in more investment income
into a country than the residents of the same country pay abroad, then net income will be positive.
GDP calculated by the expenditure approach and GDP calculated by the cost‐income approach must
be equal.

Example Int-1 Calculating GDP

The fictitious country of Euphoria has the following expenditure and income categories
and amounts (in millions):
• Imports $95
• Net investment $100
• Wages and salaries $295
• Government expenditure $70
• Depreciation $25
• Indirect business taxes $60
• Issuance of corporate bonds $35
• Self-employed income $95
• Exports $150
• Rents, profits, and interest $140
• Net income of foreigners -$40
• Consumption expenditure $325
The trick to calculating GDP is to identify expenditure versus cost‐income components.
To use the GDP expenditure approach, we must first compute two preliminary items:
Ig = net investment + depreciation = $100 + $25 = $125
NX = exports – imports = $150 – $95 = $55
GDP = C + Ig + G + NX
GDP = $325 + $125 + $70 + $55
GDP = $575
To use the GDP cost‐income approach, sum up all cost‐income components:
GDP = wages and salaries + self‐employed income + rents, profits, and
interest + depreciation + indirect business taxes + net income of foreigners
GDP = $295 + $95 + $140 + $25 + $60 + (‐$40)
GDP = $575
Notice that GDP is equal using either approach. The issuance of bonds is a financial
flow, which is excluded from GDP calculations. (Assume that the asset financed by the
bond flotation has already been counted under gross business investment).

GDP counts the value of goods and services produced inside a nation by residents of that nation and
by foreigners living there, too. Whereas, GNP counts the value of goods and services produced by the
citizens of a country, whether they are living in the country itself or living abroad. GDP and GNP will
be equal only when net income of foreigners is zero.
GDP is measured in the U.S. in dollars. In simple terms, GDP is the sum of price multiplied by
quantity (P × Q) of all final goods and services produced. Quantity represents real production within
an economy; if quantity (or output) changes, then economic activity reported by GDP will change.
However, GDP can change, even if there is no change in output, if prices by themselves change.
Nominal GDP measures economic activity by multiplying current prices with current output;
nominal GDP can increase because of either increasing prices and/or increasing output. Whereas, real
GDP measures economic activity by multiplying historical prices referenced to a particular year by
current output; because prices are held constant, real GDP can only change because of output
changes.
When newspapers or television report GDP forecasts, they almost always mean real GDP.
Inflation is the increase in prices over time, and there are two main ways in which inflation can be
measured. The Consumer Price Index (CPI) measures narrow price changes in a typical “basket” of
goods bought by consumers, captured in the consumption component of GDP calculations. The GDP
deflator measures broad price changes across all categories of economic activity, captured by
consumption, investment, government, and net exports.
Both CPI and the GDP deflator are referenced to a base year, which is assigned a value of 100.0. As
inflation rises, so does the index value of the CPI or the GDP deflator.
The Equation below is used to calculate real GDP when we are given nominal GDP and the GDP
deflator for any given year:
Equation Int-1
GDP deflatorbase year
real GDPperiod t = nominal GDPperiod t ×
GDP deflatorperiod t
Recall that the GDP deflator in the base year is equal to 100.0. Therefore, real GDP will always equal
nominal GDP in the base year.

Example Int-2 Calculating real GDP

Given the following information:
• Nominal GDP in 2005 = $11,381.2 billion
• GDP deflator in 2005 = 121.4
• GDP base year is 1986
Calculate real GDP in 2005:
GDP deflatorbase year
real GDPperiod t = nominal GDPperiod t ×
GDP deflatorperiod t
100.0
= $11,381.2 billion ×
121.4
= $9,375.0 billion
Although GDP attempts to capture a nation’s economic activity, some activities will elude
statisticians and will be excluded from any measure. Such excluded activities include:
• Leisure and human costs;
• Unreported and illegal activities, such as the underground economy;
• Value of unpaid household production, including chores;
• Harmful side effects of production, including pollution of air, water, soil; and
• Quality and variety of product improvements which occur through innovation.
GDP and GNP are the broadest measures of output. However, there are several alternative measures
of economic performance:
• National income (NI) is the earnings of all resource owners, which is the sum of employment
compensation (salaries), rents, corporate profits, interest, and self-employment income.
However, not all of this income is available for personal use.
• Personal income (PI) adjusts NI by subtracting corporate profits and social insurance taxes
and adding transfer payments and dividends. PI can be spent on consumption, saving, or
paying of personal taxes.
• Disposable income (DI) strips away personal taxes from PI. Out of the five output measures,
DI is the narrowest. DI can either be consumed or saved.

Working with Our Basic Aggregate Demand/ Aggregate

Supply Model CH 10
Introduction
We now look at the effects of changes in aggregate demand and supply on other economic indicators,
such as growth, prices and employment. First of all we examine the factors that change supply and
demand and then differentiate between the short‐run and long‐run impact of anticipated versus
unanticipated changes on the economy. We also consider the self‐correcting mechanisms that will
help stabilise the economy.
Aggregate demand
There are, in fact, three separate curves: aggregate demand, short‐run aggregate supply, and long‐run
aggregate supply
The aggregate demand (AD) curve is a downward‐sloping curve, with the price level (P) plotted on
the vertical axis and real GDP (Y) plotted on the horizontal axis. There are six factors that will shift
AD to the right (AD1), also known as an increase in aggregate demand:
• Increase in real wealth
• Decrease in real interest rates
• Increased optimism in the economy
• Higher expected inflation in the future
• Higher incomes abroad, thereby boosting exports
• Domestic currency depreciation, thereby boosting exports and restricting imports
The opposite of these factors will cause the AD curve to shift to the left, also known as a decrease in
aggregate demand (AD2). The diagram below depicts the shape of the original aggregate demand
curve (AD0) and the shifted curves.
Price level Aggregate Demand
AD2 AD0 AD1
Real GDP

The short‐run aggregate supply (SRAS) curve is an upward‐sloping curve, with the price level (P)
plotted on the vertical axis and real GDP (Y) plotted on the horizontal axis. There are five factors that
will shift SRAS to the right (SRAS1), also known as an increase in short‐run aggregate supply:
• Increase in the stock of capital
• Technological improvements
• Reduction in input prices
• Lower expected inflation in the future
• Favourable shocks, such as good weather
The opposite of these factors will cause the SRAS curve to shift to the left, also known as a decrease in
short‐run aggregate supply (SRAS2). The diagram below depicts the shape of the original short‐run
aggregate supply curve (SRAS0) and the shifted curves.
Price level Short-run aggregate supply
SRAS2 SRAS0 SRAS1
Real GDP
The long‐run aggregate supply (LRAS) curve is a vertical curve, with the price level (P) plotted on the
vertical axis and real GDP (Y) plotted on the horizontal axis. There are two factors that will shift
LRAS to the right (SRAS1), also known as an increase in long‐run aggregate supply:
• Increase in the stock of capital
• Technological improvements
Observe that these factors are common to SRAS, which means that whenever the LRAS curve shifts,
the SRAS curve will move with it in the same direction. The opposite of these factors will cause the
LRAS curve to shift to the left, also known as a decrease in long‐run aggregate supply (LRAS2). The
diagram below depicts the shape of the original long‐run aggregate supply curve (LRAS0) and the
shifted curves.

Price level Long-run aggregate supply
LRAS2 LRAS0 LRAS1
YF2 YF0 YF1 Real GDP
The LRAS curve plays a significant role in regulating the macro economy: the position of LRAS
determines the level of economic activity corresponding to full employment (YF0). Full employment
can only be achieved when an economy is operating somewhere along the LRAS curve.
An unanticipated change in macroeconomics suggests that people are caught off guard by the
change, but over time, the market will react to it. When people initially react to unanticipated changes
in either AD or SRAS, then output can change, but only in the short run. (Remember that LRAS
represents the limit of production in the economy in the long run.)
Consider an unanticipated increase in government expenditure, a component of AD. If the AD curve
shifts upwards, then the new short‐run equilibrium will occur at the intersection of the new AD curve
and the original SRAS curve. Thus, output (Y) and price level (P) will be higher in the short run.
However, the economy is now operating beyond its capacity, which exerts pressure on resource
prices. As resource prices increase, SRAS will shift to the left until equilibrium is restored along
LRAS. Thus, output (Y) is restored to full employment and the price level is higher. In the long run,
unanticipated changes in AD result in changes to the price level only.
LRAS0
Price level
PLR ELR
PSR eSR
P0
E0
AD0 AD1
SRAS1
SRAS0
YF YSR

Unanticipated changes in SRAS will only affect the short‐run position of the SRAS curve itself; there
will be no affect on aggregate demand. Consider an economy dependent on agriculture, and an
unexpected warm summer boosts the economy’s main crop. In the short run, the favorable boost in
production will shift the SRAS curve to the right, leading to a lower price level but a higher level of
output. However, the economy is operating beyond its long‐run capacity, and there is upward
pressure on resource prices. As resource prices increase, SRAS will shift to the left until long‐run
equilibrium is restored along the LRAS curve. In the long run, unanticipated changes in SRAS result
in neither a change to the price level nor change in output.
LRAS0
Price level
eSR
P0
PSR E0
AD0
SRAS0
SRAS1
YF YSR
Market economies respond when they operate at an output level above or below full employment
(along the LRAS curve). There are two self‐correcting mechanisms that tend to restore long‐run
equilibrium:
• Changes in resource prices affect the SRAS curve. We have discussed this in the previous
LOS. For example, when output is higher than full employment, increasing resource prices
tends to decrease SRAS, causing higher price levels and eventually restoring the economy to
full employment.
• Changes in real interest rates affect the AD curve. For example, when output is higher than
full employment, real (inflation-adjusted) interest rates will increase as the demand for
money increases. Higher real interest rates depress business investment, which is a
component of AD. Thus, there is a tendency for AD to automatically decrease, which can
help restore the economy to its full employment level of output.
The third self‐correcting mechanism relates to consumption expenditure, which is a large component
of AD. (Consumption represents approximately 65 percent of GDP in most developed economies.)
Compared with other components of AD, consumption is the most stable component of GDP. The
inherent stability of consumption expenditure helps to mitigate changes to other less stable
components of GDP, such as net exports (tied to the exchange rate) and business investment (tied to
interest rates and fickle business sentiment).

Keynesian Foundations of Modern Macroeconomics CH

11
Introduction
In this section we explore the main principles of Keynesian theory which was developed by a British
economist to explain the prolonged unemployment in the 1930s; it has had a major influence on
subsequent economic thinking. Keynes focused on demand rather than supply and the role of the
government’s fiscal policy in taking an economy out of recession. He believed that the government
should run a budget deficit in order to stimulate demand and bring the economy back to full
employment. This chapter examines the rationale behind his thinking including the importance of the
expenditure multiplier.
Keynesian economics
The distinction between classical and Keynesian economics stems from the assumptions made on the
length of recessions. The classical school assumed that the economy operated mostly at or near its
long‐run level of output; recessions tended to be short lived as the economy automatically reverted to
long‐run output and employment through the SRAS mechanism discussed in the previous Reading.
Keynesians are followers of John Maynard Keynes, a British economist of the early 20th century.
Writing during the Great Depression, Keynes (hence Keynesians) believed that the economy could
get stuck in prolonged recession, with reduced output and widespread unemployment. Keynesians
do not believe that adjustments to SRAS will restore equilibrium. Rather, they believe that recessions
stem from a deficiency of AD, and the government can only restore long‐run output and employment
levels by boosting AD. According to the Keynesians, SRAS adjustments are too slow, if indeed they
operate at all.
The Keynesian model explains the output level at which an economy can operate, in the absence of
either an explicit SRAS or LRAS curve.
The model distinguishes between autonomous verses induced expenditure. (Recall the major
components of expenditure: C, I, G, and NX.) Autonomous expenditure has no relationship with
levels of income; whereas induced expenditure is a function of income. For example, consumption
expenditure increases as disposable income increases (induced). However, even when disposable
income is equal to zero, the economy will maintain a level of consumption by drawing down assets
(autonomous).
In a simplified economy consisting of consumers, total expenditure is equal to consumption
expenditure. Total expenditure is an upward sloping function of GDP (output), and even when GDP
is zero, there will be autonomous expenditure. The aggregate expenditure curve is shown as the AE
curve in the graph below.

Businesses plan for a certain level of expenditure, and they build inventories to meet consumption
expenditure. In the graph below, businesses wish to operate along a 45‐degree line, where planned
aggregate expenditure is equal to actual output. If people consume more than is planned, then
businesses inventories will be depleted faster than expected. Businesses increase production to meet
the unanticipated expenditure, which boosts output. Alternatively, if people consume less than is
planned, then businesses inventories will be unexpectedly increased. In response, businesses
decrease their production, resulting in lower output.

Keynesian equilibrium

Planned aggregate
expenditur Unplanne
e (AE dinventor 45‐degree
ybuil ‐u AE = GDP
line
Unplanne d p
dinventor
ryeductio
Actual AE
n

Keynesian macro‐
Keynesian equilibrium (Planned
equilibrium occurs
AE Y)
along the 45‐degree
line, when real GDP
Planned AE < Planned AE > is equal to planned
Output
GDP Output
GDP aggregate
increased decreased Real GDP expenditure.
The marginal
propensity to consume (MPC) is additional consumption related to an additional unit of disposable
income, is shown in the Equation Int‐2 below:
Equation Int-2
marginal propensity to consume = Δ consumption expenditure
Δ disposable income
where Δ is uppercase Greek letter delta meaning change.
The MPC is a number greater than zero but less than one (0 < MPC <1). Recall that disposable income
can be either consumed or saved; therefore, we can define the marginal propensity to save (MPS) as 1
– MPC. Note that MPC + MPS = 1.

The expenditure multiplier is related to the MPC and MPS, as shown below:
Equation Int-3
1 1
expenditure multiplier = =
1 - MPC MPS

Example Int-3 Marginal propensity to consume and expenditure

multiplier
When disposable income is $150, consumption expenditure is $120; and when
disposable income is $200, consumption expenditure is $157.50. Calculate the marginal
propensity to consume and the expenditure multiplier.
Use Equations Int‐2 and Int‐3, respectively:
marginal propensity to consume
∆ consump. exp. $157.50 − $120 $37.5
= = = = 0.75
∆ disposable income $200 − $150 $50
Note that the MPS = 1 – MPC = 1 – 0.75 = 0.25
1 1 1
expenditure multiplier = = = = 4
1 - MPC 1 - 0.75 0.25
The expenditure multiplier explains the total increase in output caused by an initial change in
autonomous expenditure. The expenditure multiplier is positively related to the MPC and negatively
related to MPS. Intuitively, if some of the increase in autonomous expenditure is saved rather than
spent, the effect of the autonomous stimulus on the economy will be reduced.
Assume that the MPC = 0.75, which yields an expenditure multiplier of 4. If the government
increased autonomous expenditure by $10, then the total effect of the government’s increased
expenditure would be a $10 × 4 = $40 increase in total output (Y).
If, however, people had a tendency to consume more of the autonomous increase (MPC = 0.80), then
the new expenditure multiplier would be:
1 1 1
expenditure multiplier = = = = 5
1 - MPC 1 - 0.80 0.20

If the government increased autonomous expenditure by $10, then the total effect of the
government’s increased expenditure would be a $10 × 5 = $50 increase in total output (Y).
In terms of the Keynesian model, an increase in autonomous expenditure would shift the actual AE
curve upwards, resulting in a multiplied increase in output (Y) until planned aggregate expenditure
equals output.
Keynesians believe that private investment is the most volatile component of aggregate expenditure.
An unexplained decline in business confidence results in an autonomous decrease in private
investment, which reverberates throughout the entire economy by the multiplier effect.
The decrease in aggregate demand causes a decline in output and employment levels. The economy’s
built‐in stabilizers might not be enough to offset the decline in AD, so Keynesian believe that the
government ought to increase expenditure to restore full employment.
Alternatively, an increase in business confidence would result in an autonomous increase in
investment expenditure, which would reverberate throughout the economy via the expenditure
multiplier. If output expands beyond full employment, inflation pressures would emerge.

Introductory Readings Concept Check Questions

1. It is noticed that a small change in price has a big impact on demand for a product. This means
the demand is:
A. elastic, with a flat demand curve.

B. elastic, with a steep demand curve.
C. inelastic, with a flat demand curve.
D. inelastic, with a steep demand curve.

2. A natural disaster will often cause:
A. a shift in the supply curve to the left.

B. a shift in the supply curve to the right.
C. a move to the left along the supply curve.
D. a move to the right along the supply curve.

3. If the GDP deflator in a country has risen from 100 in 1985, to 130 in 2005 and nominal GDP has
risen from $85 billion to $125 billion then the change in real GDP over the period is closest to:
A. a fall of 3.9%.
B. an increase of 13.1%.
C. an increase of 17.1%.
D. an increase of 62.5%.

4. Which of the following statements is CORRECT regarding gross national product (GNP) and
gross domestic product (GDP)?
A. GNP and GDP are both the same, but different terms are used in different countries.
B. GNP is GDP less the income of foreigners in the country plus the income earned by the
country’s citizens overseas.
C. GNP is GDP less depreciation costs.
D. GNP is calculated using the expenditure approach and GDP using the income approach.

5. Which of the following would cause a shift in aggregate demand?
I. An increase in real interest rates.
II. New technology increasing productivity.
III. A change in inflationary expectations.
IV. A significant change in the exchange rate.
A. II only.
B. I and III only.
C. I, III and IV only.
D. All of the above.

6. When economic output is less than the economy’s potential, which of the following will act as a
self‐correcting mechanism?
A. Fiscal stimulus.
B. Real interest rates will decline.
C. Real resource prices will rise.
D. Rising inflation.

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

8. If the marginal propensity to consume (MPC) is 0.7 and investment spending is increased by $3
billion then the additional income generated is closest to:
A. $3.33 billion.
B. $4.28 billion.
C. $7.00 billion.
D. $10.00 billion


Introductory Readings Concept Check Answers

1. It is noticed that a small change in price has a big impact on demand for a product. This means
the demand is:
A. elastic, with a flat demand curve.

B. elastic, with a steep demand curve.
C. inelastic, with a flat demand curve.
D. inelastic, with a steep demand curve.

Correct Answer: 1. A
Demand is elastic since it is highly responsive to a change in price, this will lead to a flat demand curve.

2. A natural disaster will often cause:
A. a shift in the supply curve to the left.

B. a shift in the supply curve to the right.
C. a move to the left along the supply curve.
D. a move to the right along the supply curve.
Correct Answer: 2. A
The supply curve shifts to the left as supply is decreased. This will in turn increase the equilibrium price.

3. If the GDP deflator in a country has risen from 100 in 1985, to 130 in 2005 and nominal GDP has
risen from $85 billion to $125 billion then the change in real GDP over the period is closest to:
A. a fall of 3.9%.
B. an increase of 13.1%.
C. an increase of 17.1%.
D. an increase of 62.5%.

Correct Answer: 3. B
Real GDP (2004) = $125 billion x (100/130) = $96.15 billion
This is an increase of 13.1%

4. Which of the following statements is CORRECT regarding gross national product (GNP) and
gross domestic product (GDP)?
A. GNP and GDP are both the same, but different terms are used in different countries.
B. GNP is GDP less the income of foreigners in the country plus the income earned by the
country’s citizens overseas.
C. GNP is GDP less depreciation costs.
D. GNP is calculated using the expenditure approach and GDP using the income approach.

5. Which of the following would cause a shift in aggregate demand?
I. An increase in real interest rates.
II. New technology increasing productivity.
III. A change in inflationary expectations.
IV. A significant change in the exchange rate.
A. II only.
B. I and III only.
C. I, III and IV only.
D. All of the above.

Correct Answer: 5. C
Item II would lead to a shift in the supply curve.

6. When economic output is less than the economy’s potential, which of the following will act as a
self‐correcting mechanism?
A. Fiscal stimulus.
B. Real interest rates will decline.
C. Real resource prices will rise.
D. Rising inflation.
The main self-correcting mechanisms will be the fall in real interest rates and resource prices (including labor
costs).

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

Correct Answer: 7. D

8. If the marginal propensity to consume (MPC) is 0.7 and investment spending is increased by $3
billion then the additional income generated is closest to:
A. $3.33 billion.
B. $4.28 billion.
C. $7.00 billion.
D. $10.00 billion
Correct Answer: 8. D
The expenditure multiplier is 1/(1 – 0.7) or 3.33. Therefore the additional income is $3 billion x 3.33 or $10
billion.

Study Session 04: Economics:

Microeconomic Analysis

This study session focuses on microeconomic concepts and how firms are affected by these concepts.
One of the main concepts related to the equilibrium between demand and supply is elasticity, which
measures the dependency between demand and supply and the impact of changes in either on the
equilibrium price level. A second key concept is efficiency, which is a measure of the firm’s “optimal”
output given its cost and revenue functions. Understanding these concepts enables analysts to
differentiate among various companies on an individual level, and to determine their attractiveness
for an investor.

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

Economics: Microeconomic Analysis 113
1. Economic profit is total revenue less:
A. explicit costs.
B. implicit costs.
C. normal profit.
D. opportunity costs.

2. The momentary supply curve of agricultural crops is generally:

A. vertical.
B. horizontal.
C. an upward sloping curve.
D. linear and passes through the origin.

1. Economic profit is total revenue less:
A. explicit costs.
B. implicit costs.
C. normal profit.
D. opportunity costs.
Economic profit is after opportunity costs which include both explicit and implicit costs. Normal profit is
included in implicit costs.

2. The momentary supply curve of agricultural crops is generally:
A. vertical.
B. horizontal.
Correct Answer: A ..........................................................................................LOS: Reading 13‐a
The quantity of agricultural goods available will depend on decisions on planting of the crop made some
time previously. Generally producers cannot rapidly change their output so supply is inelastic and the
supply curve is vertical.

3. Which of the following are examples of implicit and explicit opportunity costs?
Implicit cost Explicit cost
A. Utility expenses Rental costs
B. Interest foregone Accounting depreciation
C. Dividend payments Salary costs
D. Economic depreciation Bank interest

4. Making a market in a good illegal is most likely to:
A. increase value for buyers.
B. reduce costs for suppliers.
C. reduce the quantity traded.
D. create a surplus of the good.

3. Which of the following are examples of implicit and explicit opportunity costs?
Implicit cost Explicit cost
A. Utility expenses Rental costs
B. Interest foregone Accounting depreciation
C. Dividend payments Salary costs
D. Economic depreciation Bank interest
Implicit costs are when there is no payment made but another action has been foregone, these are often
related to use of capital and use of owner’s resources. Interest forgone and economic depreciation are both
forms of implicit costs. Explicit costs are paid for in money, such as bank interest, salaries, utilities, rental
expense.
Reference: CFA® Program Curriculum, Volume 2, pp. 92‐95

4. Making a market in a good illegal is most likely to:
A. increase value for buyers.
B. reduce costs for suppliers.
C. reduce the quantity traded.
D. create a surplus of the good.
Correct Answer: C ......................................................................................... LOS: Reading 15‐d

Making a market illegal is likely to push up costs for suppliers (if there is a penalty on suppliers) and/or
reduce value for buyers (if there is a penalty on buyers). This will lead to a move in the equilibrium point
to the left, reducing quantities traded.
Reference: CFA® Program Curriculum, Volume 2, p. 81‐84.

5. Which of the following curves is least likely to be U‐shaped?
A. The marginal cost curve.
B. The average total cost curve.
C. The average fixed cost curve.
D. The average variable cost curve.

6. If a government puts a price ceiling on a service which is below the equilibrium price, which of
the following is least likely to happen?
A. Demand for the service will decline.
B. A black market in the service will develop.
C. There will be as shortage of supply of the service.
D. The service providers’ producer surplus will decline.

5. Which of the following curves is least likely to be U‐shaped?
A. The marginal cost curve.
B. The average total cost curve.
C. The average fixed cost curve.
D. The average variable cost curve.

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

6. If a government puts a price ceiling on a service which is below the equilibrium price, which of
the following is least likely to happen?
A. Demand for the service will decline.
B. A black market in the service will develop.
C. There will be as shortage of supply of the service.
D. The service providers’ producer surplus will decline.
The price ceiling will lead to a drop in supply, reducing the producer surplus. Demand will be unchanged,
or increase, so “Demand for the service will decline.” is the correct choice. A black market may well
develop to fulfill demand.

7. Technology and labor are usually considered to be which type of resources?
Technology Labor
A. Long‐run Long‐run
B. Long‐run Short‐run
C. Short‐run Long‐run
D. Short‐run Short‐run

8. If the supply of a product is unit elastic it means that the supply curve is:
A. vertical.
B. horizontal.

7. Technology and labor are usually considered to be which type of resources?
Technology Labor
A. Long-run Long-run
B. Long-run Short-run
C. Short-run Long-run
D. Short-run Short-run
Correct Answer: B...........................................................................................LOS: Reading 17‐a
Technology cannot usually be varied in the short run so is considered a long-run resource. Labor is usually
a variable input so is a short-run resource.

8. If the supply of a product is unit elastic it means that the supply curve is:
A. vertical.
B. horizontal.
Unit elastic means that the percentage change in price equals the percentage change in quantity supplied,
so the supply curve is a straight line and passes through the origin.

9 When a government introduces a subsidy on an agricultural product, in the domestic market this
is least likely to have the effect of:
A. increasing supply.
B. creating overproduction.
C. shifting the supply curve downwards to the right.
D. marginal cost on the original supply curve falling below marginal benefit.

10. Proprietorships in the U.S. are generally characterized by which of the following?
A. The entire wealth of owners is at risk.
B. They are owned by one or more people.
C. Profits are taxed at the proprietorship and owner level.
D. The cost of capital and labor are lower than for corporations.

9. When a government introduces a subsidy on an agricultural product, in the domestic market this
is least likely to have the effect of:
A. increasing supply.
B. creating overproduction.
C. shifting the supply curve downwards to the right.
D. marginal cost on the original supply curve falling below marginal benefit.
Correct Answer: D ......................................................................................... LOS: Reading 15‐d

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

10. Proprietorships in the U.S. are generally characterized by which of the following?
A. The entire wealth of owners is at risk.
B. They are owned by one or more people.
C. Profits are taxed at the proprietorship and owner level.
D. The cost of capital and labor are lower than for corporations.
Correct Answer: A ..........................................................................................LOS: Reading 14‐e
A proprietor has unlimited liability, if a proprietorship cannot pay its debts then the parties owed money
can claim the assets of the proprietor, so A is correct. Proprietorships can only be owned by a single
person, so B is not correct. Profits are only taxed once as the owner’s income so C is not correct. The cost
of capital is usually higher than that of a corporation so D is not correct.

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

12. It is noted that the income elasticity of a good is slightly negative. It is most likely that the good
is:
A. a luxury item.
B. a normal good.
C. an inferior good.
D. a substitute good.

11. Followers of utilitarianism are most likely to believe that:
A. people should be treated fairly and their property rights respected.
B. administrative costs reduce the impact of transferring wealth between different parties.
C. the state should not own property to ensure all participants have equal access to goods and
services.
D. all participants should have the same income to maximize the benefits gained from the economic
pie.
Correct Answer: D .......................................................................................... LOS: Reading 14‐f

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

12. It is noted that the income elasticity of a good is slightly negative. It is most likely that the good
is:
A. a luxury item.
B. a normal good.
C. an inferior good.
D. a substitute good.
Correct Answer: C ..........................................................................................LOS: Reading 13‐a
Income elasticity measures the change in demand when income changes. For most goods this is positive,
as when incomes rise, spending on goods usually rises. However, for inferior goods demand moves in the
opposite direction to income, these are goods typically bought by people on low incomes.

13. The value of one more unit of a good is least accurately described as:
A. its marginal benefit.
B. the price of the good less the marginal cost of the unit.
C. the maximum price consumers are willing to pay for it.
D. the price paid for the unit plus the consumer surplus from it.

14. When a government imposes a quota on a product it is most likely to:
A. benefit consumers of the product.
B. benefit certain producers of the product.
C. increase the marginal cost of production of the good.
D. lead to the marginal cost being higher than marginal benefit.

13. The value of one more unit of a good is least accurately described as:
A. its marginal benefit.
B. the price of the good less the marginal cost of the unit.
C. the maximum price consumers are willing to pay for it.
D. the price paid for the unit plus the consumer surplus from it.
Correct Answer: B.......................................................................................... LOS: Reading 14‐b

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

14. When a government imposes a quota on a product it is most likely to:
A. benefit consumers of the product.
B. benefit certain producers of the product.
C. increase the marginal cost of production of the good.
D. lead to the marginal cost being higher than marginal benefit.
Correct Answer: B........................................................................................... LOS: Reading 15‐c

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

15. An industry has five participants with market shares of 30%, 25%, 25% 10% and 10%. The four
firm concentration ratio and Herfindahl‐Hirschman Index are:

Four firm concentration ratio Herfindahl‐Hirschman Index
A. 10% 470
B. 90% 470
C. 10% 2,350
D. 90% 2,350

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

15. An industry has five participants with market shares of 30%, 25%, 25% 10% and 10%. The four
firm concentration ratio and Herfindahl‐Hirschman Index are:
Four firm concentration ratio Herfindahl-Hirschman Index

A. 10% 470
B. 90% 470
C. 10% 2,350
D. 90% 2,350
Correct Answer: D ..........................................................................................LOS: Reading 16‐g
Four-firm concentration ratio is (30% + 25% + 25% + 10%) = 90%

Herfindahl-Hirschman Index is 302 + 252 + 252 + 102 = 2350

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

The law of diminishing returns sates that marginal product starts to decline as quantities increase due to
technological constraints.

17. A manufacturing company has sales of $1 million per annum and explicit costs of $700,000. The
owner of the company, who also owns the factory, is charging an annual rent of only $25,000 for the
factory whereas the rent he could receive in the open market is $75,000. He also does not charge for
his time (wages would be $60,000 per annum). Interest forgone is $20,000 and economic depreciation
is $40,000 per annum. The owner could earn a normal annual profit of $50,000 in a similar business.
The economic profit of the manufacturing company is closest to:
A. $80,000
B. $120,000.
C. $130,000
D. $180,000.

18. Company ABC provides the following information on labor (workers per day) and total
production (units output per day).
Labor Total Production
24 5,000
25 5,200
26 5,350
When labor increase from 25 to 26 per day the marginal and average product are closest to:
marginal product average product
A. 150 units 150.0 units
B. 150 units 205.8 units
C. 200 units 208.0 units
D. 350 units 207.0 units

17. A manufacturing company has sales of $1 million per annum and explicit costs of $700,000. The
owner of the company, who also owns the factory, is charging an annual rent of only $25,000 for the
factory whereas the rent he could receive in the open market is $75,000. He also does not charge for
his time (wages would be $60,000 per annum). Interest forgone is $20,000 and economic depreciation
is $40,000 per annum. The owner could earn a normal annual profit of $50,000 in a similar business.
The economic profit of the manufacturing company is closest to:
A. $80,000
B. $120,000.
C. $130,000
D. $180,000.
The economic profit is therefore
$1,000,000 - $700,000 - $50,000 (additional implicit cost of rental)
- $60,000 (wages foregone)
- $20,000 - $40,000 - $ 50,000 (normal profit lost).
This equals $80,000.

18. Company ABC provides the following information on labor (workers per day) and total
production (units output per day).
Labor Total Production
24 5,000
25 5,200
26 5,350
When labor increase from 25 to 26 per day the marginal and average product are closest to:
marginal product average product
A. 150 units 150.0 units
B. 150 units 205.8 units
C. 200 units 208.0 units
D. 350 units 207.0 units
The marginal product is the increase in total product for one additional unit of labor, this is 5,350 – 5,200
which equals 150 units. Average product is total product divided by the quantity of labor employed, which
is 5,350 divided by 26 equals 205.8

19. In the market economy, if a good has external benefits it is least likely to lead to:
A. a social loss.
B. a deadweight loss.
C. overproduction of the good.
D. an inefficient quantity being produced.

20. The efficient quantity produced of a good is least likely to:
A. maximize the sum of the consumer and producer surpluses.
B. be the quantity to which free market forces drive production.
C. be the point where the marginal society benefit equals the marginal society cost.
D. disregard external benefits and external costs to the consumer and producer respectively.

19. In the market economy, if a good has external benefits it is least likely to lead to:
A. a social loss.
B. a deadweight loss.
C. overproduction of the good.
D. an inefficient quantity being produced.
External benefits refer to benefits that accrue to people other than a consumer of a good so the demand
curve for the good does not reflect all the benefits that accrue. This will lead to underproduction of the
good, this inefficient production level leads to a deadweight loss. This is a loss to society as a whole, which
is a social loss.

20. The efficient quantity produced of a good is least likely to:
A. maximize the sum of the consumer and producer surpluses.
B. be the quantity to which free market forces drive production.
C. be the point where the marginal society benefit equals the marginal society cost.
D. disregard external benefits and external costs to the consumer and producer respectively.
Correct Answer: D ..........................................................................................LOS: Reading 14‐e
External costs and benefits will distort the quantity produced and consumed so the efficient quantity is
unlikely to be produced if they are disregarded.

21. If the price of televisions produced by manufacturer is increased by 10% from $500 to $550 then
demand is forecast to fall by 20%, from 100,000 units to 80,000 units. The elasticity of demand is
closest to:
A. 0.45.
B. 2.22.
C. 2.33.
D. 2.50.

Note: percentages are calculated on the average price and average quantity. We also ignore
minus signs; we are measuring the magnitude of elasticity.

22. The price of ABC Financial News is increased from $2.00 to $2.50, this leads to an increase in the
sales of a competing financial magazine , XYZ Finance, which now sells 120,000 copies a week, up
from 100,000 copies a week. The cross elasticity of demand is closest to:
A. 0.81.
B. 1.04.
C. 1.22.
D. 1.25.

21. If the price of televisions produced by manufacturer is increased by 10% from $500 to $550 then
demand is forecast to fall by 20%, from 100,000 units to 80,000 units. The elasticity of demand is
closest to:
A. 0.45.
B. 2.22.
C. 2.33.
D. 2.50.
Correct Answer: C ......................................................................................... LOS: Reading 13‐b
% ∆Q Dem
Price elasticity of demand =
% ∆P
where
QDem = quantity demanded
P = price
%∆QDem = percentage change in quantity demanded, this is ∆Q / Q ave
%∆Q Dem 20/90

= = 2.33
% ∆P 50 / 525
Note:
percentages are calculated on the average price and average quantity. We also ignore minus signs; we are
measuring the magnitude of elasticity.

22. The price of ABC Financial News is increased from $2.00 to $2.50, this leads to an increase in the
sales of a competing financial magazine , XYZ Finance, which now sells 120,000 copies a week, up
from 100,000 copies a week. The cross elasticity of demand is closest to:
A. 0.81.
B. 1.04.
C. 1.22.
D. 1.25.
Correct Answer: A.......................................................................................... LOS: Reading 13‐a
%∆Q Dem
Cross elasticity of demand =
%∆PC
where
QDem = quantity demanded
PC = price of substitute or complement
%∆Q Dem = percentage change in quantity demanded.
The cross elasticity of demand is:

%∆Q Dem 20 / 110 0.1818
= = = 0.81
%∆PC $0.50 $2.25 0.2222


Market Structure and Macroeconomic Analysis

This study session first compares and contrasts the different market structures in which firms
operate. The market environment influences the price a firm can demand for its goods or services.
Among the most important of these market forms are monopoly and perfect competition, although
monopolistic competition and oligopoly are also covered.
The study session then introduces the macroeconomic concepts that have an impact on all firms in
the same environment, be it a country, a group of related countries, or a particular industry. The
readings explain the business cycle, and how to forecast changes in the business cycle and the impact
on, among other things, price levels and profitability. The study session concludes by describing how
an economy’s aggregate supply and aggregate demand are determined.
Reading 18: Perfect Competition
Reading 19: Monopoly
Reading 20: Monopolistic Competition and Oligopoly
Reading 21: Demand and Supply in Factor Markets
Reading 22: Monitoring Cycles, Jobs, and the Price Level
Reading 23: Aggregate Supply and Aggregate Demand

Economics: Microeconomic Market Structure and Macroeconomic Analysis 137
1. The real wage rate is:
A. the growth in wages adjusted for productivity.
B. the money wage rate multiplied by the price level.
C. the amount of goods that an hour’s work can buy.
D. the money wage rate divided by the inflation rate.

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

1. The real wage rate is:
A. the growth in wages adjusted for productivity.
B. the money wage rate multiplied by the price level.
C. the amount of goods that an hour’s work can buy.
D. the money wage rate divided by the inflation rate.

The real wage is simply the money wage rate divided by the price level, or the quantity of goods that an
hour’s work can buy.

2. Full employment is:
A. when unemployment is zero.
B. the level of unemployment after allowing for cyclical conditions in the labor markets.
C. the level of unemployment after allowing for cyclical and frictional conditions in the labor markets.
D. the level of unemployment after allowing for frictional and structural conditions in the labor
markets.
Correct Answer: D .......................................................................................... LOS: Reading 22‐c

Full employment is the level of employment after allowing for the normal/natural rate of unemployment
caused by frictional and structural factors.

3. One of the reasons single‐price monopolies are said to be inefficient is because:
A. costs are not minimized.
B. excess goods are produced.
C. prices are below marginal revenue.
D. prices are kept below production costs.

4. Which of the following is the least accurate description of a monopoly?
A. A firm which has to decide which price will maximize profits.
B. A producer of a good for which there are no attractive substitutes.
C. A market in which there are only a small number of producers of a good.
D. An industry where there are high barriers to entry for firms looking to enter the business.

3. One of the reasons single‐price monopolies are said to be inefficient is because:
A. costs are not minimized.
B. excess goods are produced.
C. prices are below marginal revenue.
D. prices are kept below production costs.
Correct Answer: A ......................................................................................... LOS: Reading 19‐b

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

4. Which of the following is the least accurate description of a monopoly?
A. A firm which has to decide which price will maximize profits.
B. A producer of a good for which there are no attractive substitutes.
C. A market in which there are only a small number of producers of a good.
D. An industry where there are high barriers to entry for firms looking to enter the business.
A monopoly is a firm or market where there is only one producer of a product.

5. When firms are price takers the short‐run market supply curve is:
A. horizontal.
B. slopes upwards to the right.
C. slopes downwards to the right.
D. whether it slopes upwards or downwards to the right, or is horizontal, will depend on
the industry.

6. Which of the following would be the least sensible regulatory step to consider in order to increase
resource allocation of a monopoly?
A. Abolish licensing requirements that limit entry to the industry.
B. Regulate that the monopoly firm must reduce prices to the marginal cost.
C. Break up the monopoly into smaller companies, if it is not a natural monopoly.
D. Reduce barriers and quotas that are acting as a barrier to foreign firms competing in the
industry.

5. When firms are price takers the short‐run market supply curve is:
A. horizontal.
B. slopes upwards to the right.
C. slopes downwards to the right.
D. whether it slopes upwards or downwards to the right, or is horizontal, will depend on the industry.

Firms will increase supply if the price rises so the supply curve slopes upwards to the right. (Note – the
long-run supply curve will not necessarily slope upwards to the right).

6. Which of the following would be the least sensible regulatory step to consider in order to increase
resource allocation of a monopoly?
A. Abolish licensing requirements that limit entry to the industry.
B. Regulate that the monopoly firm must reduce prices to the marginal cost.
C. Break up the monopoly into smaller companies, if it is not a natural monopoly.
D. Reduce barriers and quotas that are acting as a barrier to foreign firms competing in the industry.
Regulating that a monopoly must price their product at the marginal cost would lead to the monopoly
making losses, it would be better to use the average total cost.

7. What is the impact of an increase in foreign exchange rate (strengthening of local currency) and
an increase in the expected inflation rate on aggregate demand?
Foreign exchange rate Expected inflation rate
A. increase increase
B. increase decrease
C. decrease increase
D. decrease decrease

8. Which of the following statements regarding a monopoly is least accurate?
A. There are high barriers to entry.
B. The demand curve is horizontal.
C. There are no substitutes for a product.
D. There is a single seller of a well‐defined product.

7. What is the impact of an increase in foreign exchange rate (strengthening of local currency) and
an increase in the expected inflation rate on aggregate demand?
Foreign exchange rate Expected inflation rate

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

8. Which of the following statements regarding a monopoly is least accurate?
A. There are high barriers to entry.
B. The demand curve is horizontal.
C. There are no substitutes for a product.
D. There is a single seller of a well-defined product.
The demand curve for a monopoly is the market demand curve. It is downward sloping, as price increases
demand will fall.

9. A significant rise in the real wage rate is most likely to indicate that:
A. productivity is rising.
B. the inflation rate is very high.
C. the aggregate hours worked has risen.
D. the employment rate has dropped sharply.

10. Long‐run economic profits can be made by:
Price takers Firms in monopolistic competition
A. Yes Yes
B. Yes No
C. No Yes
D. No No

9. A significant rise in the real wage rate is most likely to indicate that:
A. productivity is rising.
B. the inflation rate is very high.
C. the aggregate hours worked has risen.
D. the employment rate has dropped sharply.

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

10. Long‐run economic profits can be made by:
Price takers Firms in monopolistic competition
A. Yes Yes
B. Yes No
C. No Yes
D. No No

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

11. A profit maximizing firm in monopolistic competition will expand output until marginal revenue
equals:
A. market price.
B. marginal cost.
C. average total cost.
D. average variable cost.

12. An increase in the quantity of capital in an economy is likely to:
A. have no effect on the aggregate supply curves.
B. shift only the long‐run aggregate supply curve to the right.
C. shift only the short‐run aggregate supply curve to the right.
D. shift both the short‐run and long‐run aggregate supply curves to the right.

11. A profit maximizing firm in monopolistic competition will expand output until marginal revenue
equals:
A. market price.
B. marginal cost.

Output will be expanded until marginal revenue equals marginal cost.

12. An increase in the quantity of capital in an economy is likely to:
A. have no effect on the aggregate supply curves.
B. shift only the long-run aggregate supply curve to the right.
C. shift only the short-run aggregate supply curve to the right.
D. shift both the short-run and long-run aggregate supply curves to the right.
The larger the capital base the more productive the labor force and the higher the output shifting both
supply curves to the right.

13. The lowest possible cost is most likely to be found in a market which is:
A. a monopoly.
B. an oligopoly.
C. in perfect competition.
D. in monoplolistic competition.

14. Classical economists believe:
A. money wage rates are slow to change in a recession.
B. fiscal policy can be used to stimulate aggregate demand.
C. technological change is a strong influence on aggregate demand.
D. the government should use monetary policy to stimulate demand in a recession.

13. The lowest possible cost is most likely to be found in a market which is:
A. a monopoly.
B. an oligopoly.
C. in perfect competition.
D. in monoplolistic competition.

In monopolistic competition firms produce below the efficient amount which increases costs. Also
monopolies and oligopolies set prices above an efficient point which reduces quantity and increases
average costs.

14. Classical economists believe:
A. money wage rates are slow to change in a recession.
B. fiscal policy can be used to stimulate aggregate demand.
C. technological change is a strong influence on aggregate demand.
D. the government should use monetary policy to stimulate demand in a recession.

Classical economists believe technological change is the main driver of aggregate demand and supply, and
the economy is effective at self regulation.

15. If the CPI price index was 75 last year and 82 this year, then the annual inflation rate is closest to:
A. 7.0%.
B. 8.2%.
C. 8.5%.
D. 9.3%.

16. A price‐taker market is least likely to be characterized by:
A. identical products.
B. high entry barriers.
C. a large number of participants.
D. each participant has a small market share.

15. If the CPI price index was 75 last year and 82 this year, then the annual inflation rate is closest to:
A. 7.0%.
B. 8.2%.
C. 8.5%.
D. 9.3%.

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

16. A price‐taker market is least likely to be characterized by:
A. identical products.
B. high entry barriers.
C. a large number of participants.
D. each participant has a small market share.
A price-taker market is one with perfect competition. There are no restrictions or barriers to entry.
Reference: CFA® Program Curriculum, Volume 2, p. 150‐151.

17. A profit maximizing price taker will expand output until marginal revenue equals:
A. market price.
B. marginal cost.

18. Which of the following groups of people is least likely to be included in the labor force?
A. Retired workers.
B. Part‐time workers.
C. People looking for a job.
D. People waiting to start a new job within two weeks.

17. A profit maximizing price taker will expand output until marginal revenue equals:
A. market price.
B. marginal cost.

Output will be expanded until Price = Marginal revenue = Marginal cost. Marginal revenue always equals
market price in a price taker, which is a purely competitive, market.

18. Which of the following groups of people is least likely to be included in the labor force?
A. Retired workers.
B. Part-time workers.
C. People looking for a job.
D. People waiting to start a new job within two weeks.
The labor force includes all the employed and unemployed, it does not include retired workers.

19. If a monopoly uses price discrimination it is least likely to have the effect of:
A. minimizing the consumer surplus.
B. finding the single price that will maximize the quantity sold.
C. bringing the market demand curve close to the marginal revenue curve.
D. producing the quantity which is similar to that produced in a perfectly competitive
market.

20. Firms acting in collusion in an oligopoly would generally attempt to:
Output Prices

19. If a monopoly uses price discrimination it is least likely to have the effect of:
A. minimizing the consumer surplus.
B. finding the single price that will maximize the quantity sold.
C. bringing the market demand curve close to the marginal revenue curve.
D. producing the quantity which is similar to that produced in a perfectly competitive market.

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

20. Firms acting in collusion in an oligopoly would generally attempt to:
Output Prices
Collusion is usually with the intention of increasing economic profit for the participants by limiting
output and raising pierces.

21. Which of the following is a characteristic of monopolistic competition?
A. Firms produce identical products.
B. The market is purely competitive.
C. Firms have downward sloping demand curves.
D. Firms cannot sell products above the market price.

22. The prisoners’ dilemma can be applied to price‐fixing in an oligopoly. It explains why:
A. members of a cartel are tempted to cheat on other members of the cartel.
B. the more players in a cartel, the easier it is to maintain price‐fixing agreements.
C. the opportunity to make large profits will tempt new members to join the cartel.
D. cartels can be maintained as long as there are only a small number of members.

21. Which of the following is a characteristic of monopolistic competition?
A. Firms produce identical products.
B. The market is purely competitive.
C. Firms have downward sloping demand curves.
D. Firms cannot sell products above the market price.
A, B and D are all characteristics of a price-taker or a perfectly competitive market.

22. The prisoners’ dilemma can be applied to price‐fixing in an oligopoly. It explains why:
A. members of a cartel are tempted to cheat on other members of the cartel.
B. the more players in a cartel, the easier it is to maintain price-fixing agreements.
C. the opportunity to make large profits will tempt new members to join the cartel.
D. cartels can be maintained as long as there are only a small number of members.
Correct Answer: A..........................................................................................LOS: Reading 20‐d
Game theory shows that Nash equilibrium is reached when participants cheat, although this is not the
best outcome for participants.


Monetary and Fiscal Economics

This study session focuses on the monetary sector of an economy. It examines the functions of money
and how it is created, highlighting the special role of the central bank within an economy. Supply and
demand for resources, such as labor and capital, and goods are strongly interrelated, and this study
session describes circumstances when this may lead to inflation and the transmission mechanisms
between the monetary sector and the real part of the economy. Finally, the goals and implications of
fiscal and monetary policy are explored by examining some of the main models of macroeconomic
theory (Keynesian, classical, and monetarist).
Reading 24: Money, Banks, and the Federal Reserve
Reading 25: Money, Interest, Real GDP, and the Price Level
Reading 26: Inflation
Reading 27: Fiscal Policy
Reading 28: Monetary Policy

Economics: Monetary and Fiscal Economics 161
1. It is important the Fed’s policies to control inflation have credibility when faced with the prospect
of rising inflation since it is more likely that:
A. inflation will fall without an increase in unemployment.
B. inflation will fall and real GDP will fall below potential GDP.
C. aggregate demand will be less than expected when the Fed raises interest rates.
D. the supply curve shifts more sharply to the left, compared to the shift with an
unanticipated policy change.

2. A monetarist is most likely to believe that:
A. long term GDP growth is only affected by technological change.
B. steady money growth will allow the economy to operate at full employment.
C. monetary policy should be constantly adjusted to reflect levels of aggregate demand.
D. the government should adopt expansionary fiscal policies when real GDP is below
potential GDP.

1. It is important the Fed’s policies to control inflation have credibility when faced with the prospect
of rising inflation since it is more likely that:
A. inflation will fall without an increase in unemployment.
B. inflation will fall and real GDP will fall below potential GDP.
C. aggregate demand will be less than expected when the Fed raises interest rates.
D. the supply curve shifts more sharply to the left, compared to the shift with an unanticipated policy
change.
Correct Answer: A ......................................................................................... LOS: Reading 28‐d

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

2. A monetarist is most likely to believe that:
A. long term GDP growth is only affected by technological change.
B. steady money growth will allow the economy to operate at full employment.
C. monetary policy should be constantly adjusted to reflect levels of aggregate demand.
D. the government should adopt expansionary fiscal policies when real GDP is below potential GDP.

Monetarists believe that the economy is self regulating and it will normally operate at full employment if
the pace of money growth is kept steady.

3. The quantity theory of money says that an increase in money supply will lead to an increase in:
A. prices.
B. output.
C. employment.
D. the velocity of money.

4. When the government adopts a counter cyclical fiscal policy in response to a threat of recession
the government might:
A. increase business tax rates.
B. reduce its outstanding debt.
C. increase infrastructure spending.
D. reduce the size of the budget deficit (or increase the surplus).

3. The quantity theory of money says that an increase in money supply will lead to an increase in:
A. prices.
B. output.
C. employment.
D. the velocity of money.
Correct Answer: A .......................................................................................... LOS: Reading 25‐c

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

4. When the government adopts a counter cyclical fiscal policy in response to a threat of recession
the government might:
A. increase business tax rates.
B. reduce its outstanding debt.
C. increase infrastructure spending.
D. reduce the size of the budget deficit (or increase the surplus).
A countercyclical policy attempts to move the economy in the opposite direction to the business cycle and
therefore ahead of a recession the policy would be aimed at stimulating demand.

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

6. Which of the following is least likely to be an impact of higher inflation if the higher inflation was
anticipated?
A. An increase in effective tax rates.
B. Real GDP will fall below potential GDP.
C. A reduction of investment by businesses.
D. Decision‐makers spend more time forecasting the impact of inflation and less time in
productive activities.

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

6. Which of the following is least likely to be an impact of higher inflation if the higher inflation was
anticipated?
A. An increase in effective tax rates.
B. Real GDP will fall below potential GDP.
C. A reduction of investment by businesses.
D. Decision-makers spend more time forecasting the impact of inflation and less time in productive
activities.
Correct Answer: B.......................................................................................... LOS: Reading 26‐d

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

7. The impact on demand for money (M1) of financial innovation and rising interest rates in the U.S.
are most likely to be:
inancial innovation Rising interest rate

8. A move by government to adopt a more expansionary monetary policy in response to the threat
of an economic slowdown will, in the long run:
A. have no effect on the economy.
B. be ineffective since it will be too early to adjust policy.
C. tend to stabilize the economy as output responds to the change in policy.
D. be ineffective in increasing output since decision‐makers will adjust their expectations to
reflect the policy.

7. The impact on demand for money (M1) of financial innovation and rising interest rates in the U.S.
are most likely to be:
inancial innovation Rising interest rate
Financial innovation tends to reduce the demand for money, new products such as credit card and ATMs
have reduced the demand for M1. As interest rates rise the opportunity cost of holding money in currency
or checking accounts, which give zero interest, increases and money is placed in interest bearing securities
such as savings accounts. This decreases the demand of money.

8. A move by government to adopt a more expansionary monetary policy in response to the threat
of an economic slowdown will, in the long run:
A. have no effect on the economy.
B. be ineffective since it will be too early to adjust policy.
C. tend to stabilize the economy as output responds to the change in policy.
D. be ineffective in increasing output since decision-makers will adjust their expectations to reflect
the policy.

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

9. In the case that households increase their holdings of currency and reduce the balances in their
checking accounts by an equal amount, and the Federal Reserve does not take any offsetting action,
the impact on the money supply will be:
A. to reduce banks’ required reserves, which will increase money supply.
B. to increase money supply since the currency is available for immediate use.
C. to reduce the amount that can be loaned by banks, which will tend to reduce the money
supply.
D. there will be no impact on money supply, since the increased holdings in currency will
offset the reduction in checking accounts.

10. According to the quantity theory of money if the GDP of a country is $50 billion and the velocity
of circulation is 8, then the quantity of money is:
A. $6.25 billion.
B. $160 billion.
C. $400 billion.
D. $3,200 billion.

9. In the case that households increase their holdings of currency and reduce the balances in their
checking accounts by an equal amount, and the Federal Reserve does not take any offsetting action,
the impact on the money supply will be:
A. to reduce banks’ required reserves, which will increase money supply.
B. to increase money supply since the currency is available for immediate use.
C. to reduce the amount that can be loaned by banks, which will tend to reduce the money supply.
D. there will be no impact on money supply, since the increased holdings in currency will offset the
reduction in checking accounts.
Checking accounts and currency are included in money supply. If the balances in checking accounts are
reduced then it will not directly affect the money supply but it will reduce the amount of reserves that the
banks need to keep and also reduce the amount that they can loan, which will reduce the money supply.

10. According to the quantity theory of money if the GDP of a country is $50 billion and the velocity
of circulation is 8, then the quantity of money is:
A. $6.25 billion.
B. $160 billion.
C. $400 billion.
D. $3,200 billion.

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

11. When aggregate demand drops sharply the Keynesian feedback rule is most likely to lead to the
Fed:
Interest rates Quantity of money
A. increasing increasing
B. increasing decreasing
C. decreasing increasing
D. decreasing decreasing

12. Intermediate targets of the Fed’s monetary policy are least likely to include:
A. M1.
B. Treasury‐bill rate.
C. the monetary base.
D. the federal funds rate.

11. When aggregate demand drops sharply the Keynesian feedback rule is most likely to lead to the
Fed:
Interest rates Quantity of money
A. increasing increasing
B. increasing decreasing
C. decreasing increasing
D. decreasing decreasing

The Fed would decrease the interest rate and increase the quantity of money in order to shift the aggregate
demand curve back to the right.

12. Intermediate targets of the Fed’s monetary policy are least likely to include:
A. M1.
B. Treasury-bill rate.
C. the monetary base.
D. the federal funds rate.
Intermediate targets give the Fed information on whether the monetary policy is having the desired effect.
Typically these targets will be monetary aggregates (M1, M2 and/or the monetary base) and the federal
funds rate.

13. After analysis of the economic environment the Fed decides not to change its monetary policy in
response to a demand‐driven slowdown in the economy. This is most likely to be an example of a:
A. fixed‐rule policy.
B. stabilization policy.
C. discretionary policy.
D. feedback‐rule policy.

14. Which of the following is an automatic stabilizer?
A. Interest rates.
B. Inflation rates.
C. Exchange rates.
D. Progressive corporate tax.

13. After analysis of the economic environment the Fed decides not to change its monetary policy in
response to a demand‐driven slowdown in the economy. This is most likely to be an example of a:
A. fixed-rule policy.
B. stabilization policy.
C. discretionary policy.
D. feedback-rule policy.

Discretionary policies respond to the state of the economy after taking into account all of the available
information so C is the best answer.

14. Which of the following is an automatic stabilizer?
A. Interest rates.
B. Inflation rates.
C. Exchange rates.
D. Progressive corporate tax.
Automatic stabilizers will tend to expand a budget deficit during a recession and contract a budget deficit
in a boom. They include unemployment benefits, progressive corporate and personal taxes.

15. Which of the following is least likely to be included in M1?
A. Currency.
B. Issued checks.
C. Traveler’s checks.
D. Checking deposits.

16. The demand for money curve shows that the quantity of money demanded is:
A. positively related to GDP growth.
B. inversely related to GDP growth.
C. positively related to interest rates.
D. inversely related to interest rates.

15. Which of the following is least likely to be included in M1?
A. Currency.
B. Issued checks.
C. Traveler’s checks.
D. Checking deposits.

M1 is made up of currency, traveler’s checks and checking deposits. Checks are a promise to pay, not a
form of money.

16. The demand for money curve shows that the quantity of money demanded is:
A. positively related to GDP growth.
B. inversely related to GDP growth.
C. positively related to interest rates.
D. inversely related to interest rates.
Demand for money measures the relationship between interest rates and the amount of money that people
want to hold.

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

18. If banks retain 5% of new deposits in reserves and lend out 95%, when a customer puts $100,000
on deposit with a bank, it will lead to a potential increase in loans and deposits of:
Loans Deposits
A. $1,900,000 $2,000,000
B. $2,000,000 $2,000,000
C. $9,400,000 $9,500,000
D. $9,500,000 $9,500,000

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

A budge deficit decreases savings supply and therefore increases the real interest rate, this will crowd out
private investment.

18. If banks retain 5% of new deposits in reserves and lend out 95%, when a customer puts $100,000
on deposit with a bank, it will lead to a potential increase in loans and deposits of:
Loans Deposits
A. $1,900,000 $2,000,000
B. $2,000,000 $2,000,000
C. $9,400,000 $9,500,000
D. $9,500,000 $9,500,000

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

19. A generational imbalance created by fiscal policy refers to:
A. different generations are likely to pay different proportions of any fiscal imbalance.
B. the difference between the present value of expected tax revenues and social security
obligations.
C. the difference between the current year’s forecast tax revenues and social security
obligations.
D. the imbalance between the amount of tax collected from the younger generation and the
amount collected from the older generation in any one calendar year.

20. The slope of the long‐run Phillips curve shows that:
A. unemployment and inflation are inversely related.
B. unemployment and expected inflation are inversely related.
C. at the natural unemployment rate any anticipated inflation rate is possible.
D. an increase in aggregate demand lowers unemployment and increases inflation.

19. A generational imbalance created by fiscal policy refers to:
A. different generations are likely to pay different proportions of any fiscal imbalance.
B. the difference between the present value of expected tax revenues and social security obligations.
C. the difference between the current year’s forecast tax revenues and social security obligations.
D. the imbalance between the amount of tax collected from the younger generation and the amount
collected from the older generation in any one calendar year.

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

20. The slope of the long‐run Phillips curve shows that:
A. unemployment and inflation are inversely related.
B. unemployment and expected inflation are inversely related.
C. at the natural unemployment rate any anticipated inflation rate is possible.
D. an increase in aggregate demand lowers unemployment and increases inflation.
The LRPC is the relationship between inflation and unemployment when the inflation rate equals the
expected rate. It is vertical since GDP equals potential GDP when inflation is anticipated and
unemployment is at its natural rate.

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

A. life expectancy and pension costs of each generation.
B. the tax burden and benefits taken by each generation.
C. the division of the fiscal imbalance between the different generations.
D. present value of a government’s obligation to pay benefits and the present value of its tax
revenues.

22. The year‐end price data for a country was:
Year‐end Price level
2005 110
2006 113
2007 117

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

21. Which of the following is the most accurate description of what generational accounting
measures?
A. life expectancy and pension costs of each generation.
B. the tax burden and benefits taken by each generation.
C. the division of the fiscal imbalance between the different generations.
D. present value of a government’s obligation to pay benefits and the present value of its tax revenues.

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

22. The year‐end price data for a country was:
Year‐end Price level
2005 110
2006 113
2007 117

The annual inflation rate in 2006 and the compound annual rate for the 2005-2007 period were closest to:
2006 inflation rate 2005-2007 annual rate
A. 2.7% 3.1%
B. 2.7% 6.2%
C. 3.0% 7.0%
D. 3.5% 3.1%
Correct Answer: A.......................................................................................... LOS: Reading 26‐a

Price level this year - Price level last year
Inflation rate = × 100
Price level last year
113 110
Inflation rate 2006 = × 100 = 2.7%
110
117 113
Inflation rate 2007 = × 100 = 3.5%
113
The compound annual rate is
(1.027)(1.035) 1 = 3.1%


184 Study Session 7 Introduction
Study Session 7: Introduction

Introductory Readings
Financial Accounting, 8th edition, Belverd E. Needles, Jr., and Marian Powers, (Houghton
Mifflin, 2004)
“Measuring Business Income,” Ch. 3
“Financial Reporting and Analysis,” Ch. 5, pp. 246–258
“Inventories,” Ch. 8
“Current Liabilities and the Time Value of Money,” Ch. 9, pp. 412–426
“Contributed Capital,” Ch. 12, pp. 543‐553
“The Corporate Income Statement and the Statement of Stockholders’ Equity,” Ch.13, pp. 584‐591
Measuring Business Income

Introduction
This section looks at the concept of net income which is used to measure a company’s
profitability. Candidates need to be familiar with the accrual basis of accounting and the
matching principle and why they are used, rather than accounting simply on a cash basis.
Accounting methods
Financial statements are prepared at the end of regular accounting periods to make comparisons
between different accounting periods easier. A fiscal year refers to the twelve‐month period used
by a company (which in many cases is not the same as the calendar year).
Although revenues and expenses can be accounted for on a cash basis for tax purposes, this is
generally regarded as unsatisfactory since revenues are often earned in a different period from
which the payments are received, and expenses paid in a different period from which they are
incurred. The matching rule states that revenues must be assigned to the periods when the
services are performed or the goods are sold, and expenses must be assigned to the period in
which they produce the revenue.
Accrual accounting refers to methods that accountants use to apply the matching rule, i.e. that
revenues are recognized when they are earned and expenses when they are incurred rather than
when they are actually paid. Accounts are likely to need adjustment. For example transactions
may occur in one accounting period but the benefits may spread over more than one accounting
period.

Financial Reporting and Analysis

Introduction
In this section Candidates learn the definition of each category or component on the balance sheet
and income statement. We will refer to balance sheet and income statement items throughout the
rest of the Financial Statement Analysis notes so it is essential you are comfortable with the
structure, presentation and contents of financial statements.
Balance Sheet
The major categories of a balance sheet are as follows:
ASSETS LIABILITIES
Current Assets Current Liabilities
Investments Long‐term Liabilities
Property, Plant and Equipment
Intangible Assets STOCKHOLDERS’ EQUITY
Contributed Capital
Retained Earnings
Current Assets – cash and other assets which can reasonably be expected to be realized in cash or
used within one year, or within the normal operating cycle of the business, whichever is longer.
Investments – assets that are not used in the normal operation of the business and are not
expected to be converted into cash within one year.
Property, Plant and Equipment – long‐term assets used in the continuing operation of the
business. These assets are depreciated to allocate the cost of the assets over the period when they
are used.
Intangible Assets – long‐term assets with no physical substance – e.g. patents, goodwill.
Current Liabilities – obligations due to be paid or performed within one year, or within the
normal operating cycle of the business, whichever is longer.
Long‐Term Liabilities – debts that are due to be paid out in more than one year or beyond the
normal operating cycle.
Contributed Capital – the par value of issued stock plus the amounts paid‐in in excess of the par
value.
Retained Earnings – earnings that have been retained by the company, rather than distributed to
stockholders.

Income statement
The components of a multi‐step income statement are as follows:
Net Sales
– Cost of Goods Sold
= Gross Profit
– Operating Expenses
= Income from Operations
+/‐ Other Revenue and Expenses
= Income before Income Taxes
– Income Taxes
= Net Income
Net Sales – gross proceeds from sales, less sales returned and discounts offered.
Cost of Goods Sold – amount paid for the goods that were sold.
Operating Expenses – costs other than the cost of goods sold, often broken down into selling
expenses and general and administrative expenses.
Other Revenue and Expenses – revenues and expenses that are not a result of operating activities,
these include interest income and interest expenses.

Inventories
Introduction
Inventory is another short‐term asset appearing on the balance sheet and the cost of inventory will
also affect the income statement. There are four methods of accounting for inventory and the
candidate needs to understand the impact on the balance sheet and income statement of the method
used. This Reading is covered in more detail in Study Session 9, Reading 39.
Inventory
Inventory is a current asset and consists of goods held for sale in the normal course of business. The
cost of inventory will include the costs of raw materials used, cost of labor and overhead costs. The
cost of goods sold (COGS) is measured as the cost of goods available for sale less the value of
inventory at the end of the accounting period. The valuation method used to value inventory is
critical since it will decide the COGS and gross profit of the company and the value of inventory on
the balance sheet.
Inventory cost
Inventory cost is the price or consideration paid to acquire an asset. There are three components to
inventory cost:
• Invoice price less purchase discounts.
• Freight or transportation including insurance costs when in transit.
• Applicable taxes and tariffs.
It could be argued that other costs, such as storage costs, should also be included in the cost of
inventory. Allocation of these costs is difficult so they are usually expensed.
When assigning costs to items that are sold, different methods can be used. These methods make
different assumptions on the order in which items are sold. The four most commonly used methods
are shown below.
Specific Identification Method
This method can be used when it is possible to match units left in inventory with a specific purchase.
This might be used by an art dealer where there are high priced items for sale that are all unique.
Average-Cost Method
Under this method inventory is priced at the average cost of items available for sale during the
period.
First-In, First-Out Method (FIFO)
This is based on the assumption that the cost of goods sold is associated with the earliest purchases in
inventory. This means that the cost of goods held in inventory is associated with those that have been
purchased most recently.
Last-In, First-Out Method (LIFO)
The assumption under LIFO is that the cost of goods sold is associated with the most recently
purchased, the cost of goods held in inventory are associated with those that have been purchased
the earliest.

Example Int-1 Calculating cost of inventory

On December 31st a company holds 200 units in inventory with an assigned total value of
$1,000, or $5.00 per unit. On January 10th it purchases 30 additional units at a cost of $5.50
per unit and on January 20th it purchases 70 additional units at a cost of $6.00 per unit. 50
units are sold over the month so 250 units are left in inventory at the end of January.
Specific Identification Method
This requires additional information. If we are told that the specific cost of the 50 units
sold was $4.50 each, then
Cost of Goods Sold (COGS) = 50 × $4.50 = $225.00
January 31st inventory = Costs of goods available for sale – COGS
= $1,000 + (30 x $5.50) + (70 x $6.00) ‐‐ $225 = $1,360.00
Average‐Cost Method
Average unit cost of goods available for sale
= Cost of goods available for sale/units available
= $1,585/(200 + 30 + 70) = $5.28
Cost of goods available = $1,585.00
less January 31st inventory = 250 × $5.28
= $1,320.00
COGS = $265.00
First‐In, First‐Out Method (FIFO)
In this case the 50 units sold are those that were purchased first at a cost of $5.00 per unit
Cost of goods available = $1,585.00
less January 31st inventory = (150 × $5.00 ) + (30 × $5.50 ) + (70 × $6.00 )
= $1,335.00
COGS = $250.00
Last‐In, First‐Out Method (LIFO)
In this case the 50 units sold are those that were purchased last at a cost of $6.00 per
unit.
Costs of goods available = $1,585.00
less January 31st inventory = (200 × $5.00 ) + (30 × $5.50 ) + (20 × $6.00 )
= $1,285.00
COGS = $300.00
Effect of inventory accounting method
In the above example, where prices are rising, we can see that LIFO gives the highest COGS and FIFO
the lowest COGS, so LIFO will give the lowest gross margin. For income statement items LIFO is
generally considered the best method since it more closely follows the matching rule, the current
value of costs is used. However, looking at the balance sheet, the inventory value recorded is higher

under FIFO than LIFO. In this case FIFO could be considered a better method since inventory values
are closer to current values.
When the replacement cost of inventory falls below the historic cost, perhaps due to a decline in price
levels or obsolescence, then the inventory should be written down to the lower‐of‐cost‐or‐market.
There are two methods for doing this:
Item-by-Item Method
Cost and market values are computed for each item in inventory.
Major Category Method
Total cost and total market values are computed for each category of goods.
Example Int-2 Calculating inventory values

Item‐by‐Item Method
Market Lower of
Cost per
Quantity Value per Cost or
Unit
Unit Market
Category 1
Item a 100 $4.00 $4.50 $400.00
Item b 100 $5.00 $3.50 $350.00
Category 2
Item c 100 $2.00 $1.00 $100.00
Item d 100 $6.00 $5.00 $500.00
Inventory at the lower of cost or market $1,350.00
Major Category Method
Total Lower of
Category 1 Quantity Total Cost Market Cost or
Value Market
Item a 100 $400.00 $450.00
Item b 100 $500.00 $350.00
Total $900.00 $800.00 $800.00
Category 2
Item c 100 $200.00 $100.00
Item d 100 $600.00 $500.00
Total $800.00 $600.00 $600.00
Inventory at the lower of cost or market $1,400.00

Current Liabilities and the Time Value of Money

Introduction
We now move on to look at the liability side of the balance sheet. Candidates need to be able to
differentiate between current liabilities and long‐term liabilities and know how to treat liabilities
when the amount or likelihood of payment is uncertain.
Liabilities
A liability is a legal obligation to make a future payment of assets, or perform a service in the future,
as a result of a past transaction. Current liabilities are liabilities that are expected to be paid within a
year, or within a normal operating cycle, whichever is longer. Long‐term liabilities are due after one
year or operating cycle. Generally, current liabilities are paid from the current assets or from the
proceeds of current operations whereas long‐term liabilities represent the financing of long‐term
assets.
Liabilities are usually valued at the amount of money need to pay the debt or the value of goods or
services to be delivered. Whilst in some cases the amount is definitely known in other cases an
estimate is made, perhaps based on past experience. An example is when a sale is made but there
remains a liability to service the item sold.
Current liabilities can be broken down into:
(i) Definitely Determinable Liabilities
• Accounts payable
• Bank loans and commercial paper
• Notes payable
• Accrued liabilities
• Dividends payable
• Sales and excise tax payable
• Current portion of long-term debt
• Payroll liabilities
• Unearned revenues
(ii) Estimated Liabilities
The existence of a liability is clear but often the amount will not be known until later. These items
include:
• Income taxes – a company’s managers will usually only know the profits after the year-end
so an estimated figure must be used.
• Property tax payable – these are usually paid to the local governments in the U.S., and the
assessment dates are unlikely to match a firm’s year-end. Therefore an estimated figure
should be used.
• Product warranty liability – whilst a warranty or guarantee is outstanding on a product there
is a liability and a firm should estimate how much the warranty is likely to cost.
• Vacation pay liability – not all employees will collect vacation pay so this should also be
recorded as an estimated liability.

(iii)Contingent liabilities
A contingent liability is not an existing liability but a potential liability in the sense that it depends on
the outcome of a future event that arises because of a past transaction.
It should be entered in the accounts if it is both (i) probable and (ii) can be reasonably estimated.
Potential liabilities that do not meet these conditions should be referred to in the notes to the
accounts.
Contributed Capital
Introduction
Candidates are expected to know the breakdown of contributed capital and the difference between
preferred stock and ordinary stock. We also look at payments to stockholders in the form of cash
dividends or repurchase of stock and the impact on the balance sheet. Dividends are revisited in
Study Session 13.
Contributed capital
This is made up of three components:
1. Preferred Stock – par value, amount authorized and amount issued and outstanding.
2. Common Stock – par value, amount authorized and amount issued and outstanding.
3. Paid‐in Capital in excess of par value.
Accounting for dividends
There are three dates to consider:
1. Date of declaration – when the directors declare that a dividend is going to be paid, the
issuer will record a cash dividend payable item as a liability.
2. Date of record – when ownership of the stock entitles the owner to receive the dividend.
After this, and prior to payment, the stock is ex‐dividend. No accounting entries are needed.
3. Date of payment – the date the dividend is paid, and the liability is settled.
Common stock
This is the residual equity which means that the holders have the last claim on assets in the case that
the company goes into liquidation. It is usually the only stock that carries voting rights. Dividends
may be paid to stockholders which means that part of the stockholders’ equity, usually earnings, is
being paid out to stockholders.
Preferred stock
This has preference over common stock, usually in terms of both dividends and claim on assets in the
case of liquidation. Dividends are often quoted as a percentage of par value and in this sense the
characteristics of preferred stock are similar to those of a fixed‐income instrument. Different types of
preferred stock are:
Cumulative preferred stock – if a dividend is missed then it accumulates and must be paid before a
dividend can be paid to common stock holders.
Convertible preferred stock – can be exchanged into common stock.
Callable preferred stock – the issuer can redeem the stock at a pre‐specified price.

Stock issuance
Par value stock – the par value is credited to the Common Stock (or Preferred Stock) account and any
surplus, or deficit, to the ‘Paid‐in Capital in Excess of Par Value’ account, or debited to the ‘Discount
on Capital Stock’ account respectively.
No‐par stock – the proceeds of the issue are credited to the Common Stock account.
Treasury stock
This is stock that has been bought back by the issuer, usually in the stock market, and not been resold
or retired.
It is treated as stock that has been issued but is no longer outstanding, and therefore does not have
voting rights, rights to dividends etc.
The Corporate Income Statement and the Statement of

Stockholders’ Equity
Introduction
Here we consider stock dividends and stock splits which are corporate actions that do not affect a
company’s income or asset value.
Retained earnings
Retained earnings are the part of stockholders’ equity that represents the stockholders’ claim on
assets generated by the firm’s earnings. It is the profits (or losses) since inception less any dividends
paid to stockholders or transfers to contributed capital.
Accounting for stock dividends and stock splits
Stock dividends
This is a distribution of shares to existing common stockholders in proportion to the size of their
holding. This does not involve a cash payment and leads only to a transfer of funds from retained
earnings to the contributed capital account. The amount transferred is determined by the market
value of the shares issued.
Stock splits
This is when a corporation increases the number of issued shares and reduces the par value
accordingly. Again this does not involve a cash payment. The motivation is usually to reduce the
market price and increase liquidity of the shares.

Introduction Concept Check Questions
1. In a firm’s financial statements expenses should be recorded:
A. when they occur.

B. when they are paid.
C. once they can be reasonably estimated.
D. in the same period that related revenues are recorded.

2. When inventory costs are increasing due to inflation, the decision to use LIFO rather than FIFO
will lead to:
A. lower net income and lower inventory balances.

B. lower net income and higher inventory balances.
C. higher net income and lower inventory balances.
D. higher net income and higher inventory balances.

3. A stock dividend:
A. Has no impact on the financial statements.

B. Reduces the par value of stock outstanding.
C. Transfers an amount from retained earnings to contributed capital.
D. On the declaration date reduces stockholders’ equity by the size of the dividend payable.

4. If Treasury stock is included in a firm’s balance sheet as part of stockholders’ equity it means
that:
A. the firm has issued preferred shares.

B. the firm has repurchased its own stock.
C. the firm has invested in Treasury notes or Treasury bonds.
D. the firm has issued stock where the dividends are linked to Treasury bill yields.

Introduction Concept Check Answers

1. In a firm’s financial statements expenses should be recorded:
A. when they occur.

B. when they are paid.
C. once they can be reasonably estimated.
D. in the same period that related revenues are recorded.
Correct Answer 1: D
The matching rule says that related revenues and expenses should be recorded in the same
accounting period.

2. When inventory costs are increasing due to inflation, the decision to use LIFO rather than FIFO
will lead to:
A. lower net income and lower inventory balances.

B. lower net income and higher inventory balances.
C. higher net income and lower inventory balances.
D. higher net income and higher inventory balances.
Correct Answer 2: A
COGS will be higher under LIFO reducing net income. Ending inventory will be lower since it
will include ‘old’ inventory bought at lower prices.

3. A stock dividend:
A. has no impact on the financial statements.

B. reduces the par value of stock outstanding.
C. transfers an amount from retained earnings to contributed capital.
D. on the declaration date reduces stockholders’ equity by the size of the dividend payable.
Correct Answer 3: C
B refers to a stock split. D is not true since no cash is paid out.

4. If Treasury stock is included in a firm’s balance sheet as part of stockholders’ equity it means
that:
A. the firm has issued preferred shares.

B. the firm has repurchased its own stock.
C. the firm has invested in Treasury notes or Treasury bonds.
D. the firm has issued stock where the dividends are linked to Treasury bill yields.
3.
Correct Answer 4: B
Treasury stock refers to repurchased stock. This is likely to have happened because the managers
believed the stock was undervalued in the market or as a defense against a takeover.


Study Session 07: Financial Statement Analysis:

An Introduction
The readings in this study session discuss the general principles of the financial reporting system,
underscoring the critical role of the analysis of financial reports in investment decision making.
The first reading introduces the range of information that an analyst may use in analyzing the
financial performance of a company, including the principal financial statements (the income
statement, balance sheet, cash flow statement, and statement of changes in owners’ equity), notes to
those statements, and management discussion and analysis of results. A general framework for
addressing most financial statement analysis tasks is also presented.
A company’s financial statements are the end‐products of a process for recording the business
transactions of the company. The second reading illustrates this process, introducing such basic
concepts as the accounting equation and accounting accruals.
The presentation of financial information to the public by a company must conform to the governing
set of financial reporting standards applying in the jurisdiction in which the information is released.
The final reading in this study explores the role of financial reporting standard‐setting bodies
worldwide and the International Financial Reporting Standards framework promulgated by one key
body, the International Accounting Standards Board. The movement towards worldwide
convergence of financial reporting standards is also introduced.
Note:
New rulings and/or pronouncements issued after the publication of the readings in Study Sessions 7
through 10 in financial statement analysis may cause some of the information in these readings to
become dated. Candidates are expected to be familiar with the overall analytical framework
contained in the study session readings, as well as the implications of alternative accounting methods
for financial analysis and valuation, as provided in the assigned readings. For the purpose of Level I
questions on financial statement analysis, when a ratio is defined and calculated differently in
various texts, candidates should use the definitions given in the CFA Institute copyrighted readings
by Robinson, et al. Variations in ratio definitions are part of the nature of practical financial analysis.

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

Financial Statement Analysis: Introduction 199
1. When a firm records an allowance for uncollectible receivables as a deduction against the
receivables account this is:
A. a contra account.
B. an adjunct account.
C. a non‐recurring item.
D. an extraordinary item.

2. A general journal records all:
A. business transactions by account.
B. business transactions in date order.
C. account balances, usually prepared on a daily basis.
D. account balances, usually prepared at the end of each accounting period.

1. When a firm records an allowance for uncollectible receivables as a deduction against the
receivables account this is:
A. a contra account.
B. an adjunct account.
C. a non-recurring item.

An account which reduces the value of an asset, to a new estimate of its net realizable value, is a contra
account.

2. A general journal records all:
A. business transactions by account.
B. business transactions in date order.
C. account balances, usually prepared on a daily basis.
D. account balances, usually prepared at the end of each accounting period.
Correct Answer: B...........................................................................................LOS: Reading 30‐g
The general journal is the fist step in the flow of information through a financial reporting system. It is
where all transactions are recorded showing which accounts they affect, they are recorded in date order.

3. Income that is independent of a firm’s capital structure is:
A. net income.
B. pre‐tax income.
C. operating income.
D. comprehensive income.

4. Which of the following is least likely to be important to an analyst when using financial reports?

A. Detail.
B. Relevance.
C. Materiality.
D. Consistency.

3. Income that is independent of a firm’s capital structure is:
A. net income.
B. pre-tax income.
C. operating income.
D. comprehensive income.

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

4. Which of the following is least likely to be important to an analyst when using financial reports?
A. Detail.
B. Relevance.
C. Materiality.
D. Consistency.
If the financial reports are to be relevant and timely it is not practical for them to include every detail of the
financial data.

5. A company sells $50,000 of goods but under credit terms given to customers, payment will not be
received for 30 days. The cost of the goods is recorded as $35,000. As a result of this transaction
assets will:
A. decrease by $35,000.
B. decrease by $50,000.
C. increase by $15,000.
D. increase by $50,000.

6. Two firms buy new photocopiers. The first firm is a retailer of office equipment and the
photocopier will be resold, and the second firm is a bank planning to use the photocopier in its head
office. How will the purchases be classified?
Retailer Bank
A. investing activity investing activity
B. operating activity investing activity
C. operating activity financing activity
D. operating activity operating activity

5. A company sells $50,000 of goods but under credit terms given to customers, payment will not be
received for 30 days. The cost of the goods is recorded as $35,000. As a result of this transaction
assets will:
A. decrease by $35,000.
B. decrease by $50,000.
C. increase by $15,000.
D. increase by $50,000.

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

6. Two firms buy new photocopiers. The first firm is a retailer of office equipment and the
photocopier will be resold, and the second firm is a bank planning to use the photocopier in its head
office. How will the purchases be classified?
Retailer Bank
A. investing activity investing activity
B. operating activity investing activity
C. operating activity financing activity
D. operating activity operating activity
The purchase will be part of the day-to-day activity of the retailer so it will be classed as an operating
activity. For the bank the photocopier will be a long-term asset to support its operations so it will be an
investing activity.

7. When new accounting standards are issued which will be implemented in the future, which of
the following best describes the requirements of a company under International Financial Reporting
Standards (IFRS)?
A. The company must disclose whether the new standards will or will not apply to its
financial statements.
B. At present a company is not obliged to comment on new standards until they are actually
implemented.
C. The company must provide detailed information on the likely impact of the standards on
the financial statements.
D. The company must provide a discussion on whether there will be any impact from the
new standards on the financial statements.

8. A manufacturing company receives dividends on a long‐term investment it has made in another
company’s shares and pays a dividend to its own stockholders. These are likely to be classified as
which types of activity?
Receives dividend Pays dividend
A. Investing Investing
B. Investing Financing
C. Financing Investing
D. Financing Financing

7. When new accounting standards are issued which will be implemented in the future, which of
the following best describes the requirements of a company under International Financial Reporting
Standards (IFRS)?
A. The company must disclose whether the new standards will or will not apply to its financial
statements.
B. At present a company is not obliged to comment on new standards until they are actually
implemented.
C. The company must provide detailed information on the likely impact of the standards on the
financial statements.
D. The company must provide a discussion on whether there will be any impact from the new
standards on the financial statements.
Correct Answer: D ......................................................................................... LOS: Reading 31‐h

Companies are expected to provide a discussion on the impending regulations, the conclusions can be
anything from ‘does not apply’ to ‘management is still evaluating the impact’ to ‘the impact of adoption is
discussed’.

8. A manufacturing company receives dividends on a long‐term investment it has made in another
company’s shares and pays a dividend to its own stockholders. These are likely to be classified as
which types of activity?
Receives dividend Pays dividend
A. Investing Investing
B. Investing Financing
C. Financing Investing
D. Financing Financing
Receiving dividends from a long-term investment, if this is not the company’s main business, will be an
investing activity. Paying dividends to its own stockholders is a financing activity.

9. Under U.S. GAAP minority interest appears in the:
A. balance sheet as an asset.
B. balance sheet as a liability.
C. income statement as a revenue.
D. income statement as an expense.

10. A bank lends money and receives interest from the borrowers; it also takes deposits on which it
pays interest. These activities are likely to be classified as which types of activity?
Receives interest Pays interest
A. Financing Operating
B. Financing Financing
C. Investing Financing
D. Operating Operating

9. Under U.S. GAAP minority interest appears in the:
A. balance sheet as an asset.
B. balance sheet as a liability.
C. income statement as a revenue.
D. income statement as an expense.

Minority interest refers to equity held by other investors in a subsidiary that is consolidated in the
accounts; it is reported as a liability under U.S. GAAP and is a balance sheet item.

10. A bank lends money and receives interest from the borrowers; it also takes deposits on which it
pays interest. These activities are likely to be classified as which types of activity?
Receives interest Pays interest
B. Financing Financing
A bank’s business is taking deposits and making loans so these are both operating activities.

11. Owners’ equity is least likely to be referred to as:
A. net book value.
B. a residual claim.
C. total assets less total liabilities.
D. contributed capital less retained earnings.

12. The International Accounting Standards Board (IASB) is:
A. a standard‐setting body which was set up to harmonize accounting standards
internationally.
B. responsible for developing international financial reporting and accounting standards
outside the U.S.
C. a regulatory body with responsibility for ensuring that companies adhere to International
Financial Reporting Standards.
D. responsible for ensuring that investors receive financial information from companies that
best assists them in making investment decisions.

11. Owners’ equity is least likely to be referred to as:
A. net book value.
B. a residual claim.
C. total assets less total liabilities.
D. contributed capital less retained earnings.

Owners’ equity is total assets less total liabilities, which is net book value. This is equivalent to
contributed capital plus retained earnings. Owners’ equity is also referred to as a residual claim since it is
what remains after all the liabilities are settled.

12. The International Accounting Standards Board (IASB) is:
A. a standard-setting body which was set up to harmonize accounting standards internationally.
B. responsible for developing international financial reporting and accounting standards outside the
U.S.
C. a regulatory body with responsibility for ensuring that companies adhere to International Financial
Reporting Standards.
D. responsible for ensuring that investors receive financial information from companies that best
assists them in making investment decisions.

The IASB is a standard-setting organization responsible for developing international financial reporting
and accounting standards in major countries including the U.S. One of its objectives is to achieve
convergence in accounting standards, so A is the best answer.

13. Information about directors’ compensation is most likely to be included in a firm’s
A. auditor’s report.
B. proxy statement.
C. income statement.
D. Management’s Discussion and Analysis.

14. Which of the following statements is most accurate in describing the measurement of assets and
liabilities?
A. Whenever possible fair values of assets should be used.
B. Assets should generally be stated at historical cost and liabilities at present value.
C. A company is permitted to use a number of different methods to calculate asset and
liability values.
D. A company must select whether to use historical or current cost methods and apply the
same method to all assets and liabilities.

13. Information about directors’ compensation is most likely to be included in a firm’s
A. auditor’s report.
B. proxy statement.
C. income statement.
D. Management’s Discussion and Analysis.
Proxy statements relate to shareholder meetings. They provide information on board members and
management, executive compensation, stock options and major stockholders.

14. Which of the following statements is most accurate in describing the measurement of assets and
liabilities?
A. Whenever possible fair values of assets should be used.
B. Assets should generally be stated at historical cost and liabilities at present value.
C. A company is permitted to use a number of different methods to calculate asset and liability values.
D. A company must select whether to use historical or current cost methods and apply the same
method to all assets and liabilities.

Companies can use different combinations of historical cost, current cost, realizable value, present vale and
fair value, so C is the best answer.

15. Which of the following statements is least accurate regarding U.S. GAAP?
A. Relevance and reliability are considered primary qualities in the U.S. GAAP framework.
B. U.S. GAAP includes standards established by a number of different organizations.
C. U.S. GAAP has a hierarchical structure with standards issued by the FASB holding the
highest position.
D. The target is to replace U.S. GAAP by International Financial Reporting Standards by
2012.

16. A manufacturing company records a depreciation expense associated with the purchase of
machinery and the company pays income tax. These are likely to be classified as which types of
activity?
Depreciation Income tax
B. Operating Financing

15. Which of the following statements is least accurate regarding U.S. GAAP?
A. Relevance and reliability are considered primary qualities in the U.S. GAAP framework.
B. U.S. GAAP includes standards established by a number of different organizations.
C. U.S. GAAP has a hierarchical structure with standards issued by the FASB holding the highest
position.
D. The target is to replace U.S. GAAP by International Financial Reporting Standards by 2012.

The objective is to harmonize U.S. GAAP and IFRS, not to replace one with the other.

16. A manufacturing company records a depreciation expense associated with the purchase of
machinery and the company pays income tax. These are likely to be classified as which types of
activity?
Depreciation Income tax
B. Operating Financing
Depreciation is a cost of using machinery which is likely to be used to manufacture goods for sale, therefore
it is an operating item. Paying income tax is an operating item, since it results from the operations of the
company.

17. The Statement of Changes in Owners‘ Equity would be least likely to include information on:
A. net assets.
B. net income.
C. issue of new shares.
D. dividends distributed.

18. Accruals appear in financial statements when:
A. a company uses a cash–based accounting method.
B. there is uncertainty whether revenue is going to be realized or an expense paid.
C. there is an adjustment to values of assets and liabilities on the balance sheet to reflect fair
values.
D. there is a difference between the timing of cash movements and the recognition of a
revenue or expense.

17. The Statement of Changes in Owners‘ Equity would be least likely to include information on:
A. net assets.
B. net income.
C. issue of new shares.
D. dividends distributed.

The Statement of Changes in Owners‘ Equity contains information on the composition and changes in
owners’ equity over the reporting period. This would include information on new shares issued and
retained income. It would not explicitly include information on net assets; this would be in the balance
sheet.

18. Accruals appear in financial statements when:
A. a company uses a cash–based accounting method.
B. there is uncertainty whether revenue is going to be realized or an expense paid.
C. there is an adjustment to values of assets and liabilities on the balance sheet to reflect fair values.
D. there is a difference between the timing of cash movements and the recognition of a revenue or
expense.
Accrual accounting requires that revenue is recognized when it is earned and expenses when they are
incurred. This may be before or after the cash is received or paid which gives rise to accrual entries.

19. Which of the following is least likely to be a constraint in preparing useful financial statements?
A. The time taken to ensure information is accurate.
B. The cost of providing information that is accurate and useful.
C. Many nonquantifiable items are not included in the financial statements.
D. The requirement to include information regardless of whether it is relevant or not.

20. Historically the approaches of the International Financial Reporting Standards (IFRS) and the
Financial Accounting Standards Board (FASB) have been best described as:
IFRS FASB
A. Rules‐based Rules‐based
B. Rules‐based Principles‐based
C. Principles‐based Rules‐based
D. Principles‐based Principles‐based

19. Which of the following is least likely to be a constraint in preparing useful financial statements?
A. The time taken to ensure information is accurate.
B. The cost of providing information that is accurate and useful.
C. Many nonquantifiable items are not included in the financial statements.
D. The requirement to include information regardless of whether it is relevant or not.

Information that is not relevant, in terms of being out of date or would not influence decision makers, is
not useful and does not automatically need to be included in financial statements. D is the best answer.

20. Historically the approaches of the International Financial Reporting Standards (IFRS) and the
Financial Accounting Standards Board (FASB) have been best described as:
IFRS FASB
A. Rules-based Rules-based
B. Rules-based Principles-based
C. Principles-based Rules-based
D. Principles-based Principles-based
Correct Answer: C ..........................................................................................LOS: Reading 31‐g
IFRS adopt a principles–based approach which gives more flexibility on the preparation of financial
reports. The FASB has been rules-based which means there are specific rules for each element or
transaction. This difference in approach has created a barrier to establishing a single coherent framework
for financial reporting.

21. The following information is provided on a company:
Retained earnings at beginning of year $220 million
Estimated income for year $35 million
Estimated revenue for year $345 million
Repurchase of stock over year $60 million
Estimated dividends paid over year $20 million

The estimated retained earnings at end of year are:
A. $155 million.
B. $215 million.
C. $255 million.
D. $525 million.

22. The following information is provided on a company
Retained earnings at end of previous year $28 million
Net income over year $6 million
Contributed capital at year‐end $35 million
Dividends paid over year $2 million
Expenses over year $3 million

Owners’ equity at year end will be:
A. $32 million.
B. $63 million.
C. $64 million.
D. $67 million.

21. The following information is provided on a company:
Retained earnings at beginning of year $220 million
Estimated income for year $35 million
Estimated revenue for year $345 million
Repurchase of stock over year $60 million
Estimated dividends paid over year $20 million
The estimated retained earnings at end of year are:
A. $155 million.
B. $215 million.
C. $255 million.
D. $525 million.

Estimated retained earnings at end of year
= retained earnings at beginning of year + net income – dividends paid
= $220 million + $35 million - $20 million = £215 million
The repurchase of stock affects paid-up equity rather than retained earnings.

22. The following information is provided on a company
Retained earnings at end of previous year $28 million
Net income over year $6 million
Contributed capital at year‐end $35 million
Dividends paid over year $2 million
Expenses over year $3 million
Owners’ equity at year end will be:

A. $32 million.
B. $63 million.
C. $64 million.
D. $67 million.
Correct Answer: D ......................................................................................... LOS: Reading 30‐c

Owners’ equity = contributed capital + retained earnings
= $35 million + $28 million + ($6 million – $2 million) = $67 million


The Income Statement, Balance Sheet, and Cash Flow
Statement

Each reading in this study session focuses on one of the three major financial statements: the balance
sheet, the income statement, and the statement of cash flows. For each financial statement, the chapter
details its purpose, construction, pertinent ratios, and common‐size analysis. Understanding these
concepts allows a financial analyst to evaluate trends in performance over several measurement
periods and to compare the performance of different companies over the same period(s). Additional
analyst tools such as the earnings per share calculation are also described.
Reading 32: Understanding the Income Statement
Reading 33: Understanding the Balance Sheet
Reading 34: Understanding the Cash Flow Statement

Financial Statement Analysis: Income Statement, Balance Sheet, & Cash Flow 223
1. A manufacturing company acquires a smaller competitor. The acquirer combines the inventory of
the two companies which will be sold to generate future sales. This is most likely to have the
following effect on the acquiring company’s cash flows:
Operating cash flow Financing cash flow
A. No effect Understated.
B. Overstated No effect.
C. Understated No effect..
D. Understated Overstated.

2. If a firm’s quick ratio is above the industry average but the cash ratio is below the industry
average this might be explained by:
A. the firm prefers to hold marketable securities rather than cash.
B. the firm has higher inventory levels compared with the rest of the industry.
C. the firm has a large number of ‘other short‐term assets’ in the balance sheet.
D. the firm has extended to their customers more favorable credit terms than their
competitors.

1. A manufacturing company acquires a smaller competitor. The acquirer combines the inventory of
the two companies which will be sold to generate future sales. This is most likely to have the
following effect on the acquiring company’s cash flows:
Operating cash flow Financing cash flow
A. No effect Understated.
B. Overstated No effect.
C. Understated No effect..
D. Understated Overstated.
The acquirer will not be recognizing the cost of the inventory as an operating cash outflow; it will be
recorded as an investment activity. Therefore cash flow from operations will be overstated. There is no
direct impact on cash flow from financing activities.

2. If a firm’s quick ratio is above the industry average but the cash ratio is below the industry
average this might be explained by:
A. the firm prefers to hold marketable securities rather than cash.
B. the firm has higher inventory levels compared with the rest of the industry.
C. the firm has a large number of ‘other short-term assets’ in the balance sheet.
D. the firm has extended to their customers more favorable credit terms than their competitors.
Correct Answer: D .......................................................................................... LOS: Reading 33‐i

The quick ratio includes cash, marketable securities and receivables in the numerator whereas the cash
ratio only includes cash and marketable securities. The relatively high quick ratio therefore indicates high
levels of receivables, or customers owing money.

3. Which of the following ratios are correctly described as liquidity and solvency ratios?
Liquidity Solvency
A. cash current
B. current debt to equity
C. debt to equity financial leverage
D. financial leverage quick ratio

4. Under U.S. GAAP which of the following is the least accurate statement concerning
extraordinary items? An extraordinary item:
A. is reported net of tax.
B. is not part of operating income.
C. is included in comprehensive income.
D. must be both unusual and infrequent.

3. Which of the following ratios are correctly described as liquidity and solvency ratios?
Liquidity Solvency
A. cash current
B. current debt to equity
C. debt to equity financial leverage
D. financial leverage quick ratio
Correct Answer: B........................................................................................... LOS: Reading 33‐i

Liquidity ratios measure a company’s ability to meet its short-term obligations; solvency ratios measure
the ability to meet long-term and other obligations.

4. Under U.S. GAAP which of the following is the least accurate statement concerning
extraordinary items? An extraordinary item:
A. is reported net of tax.
B. is not part of operating income.
C. is included in comprehensive income.
D. must be both unusual and infrequent.
An extraordinary item will be reported separately on the income statement, below discontinued
operations, and net of tax. Therefore it will impact on net income and is not reported separately in
comprehensive income.

5. If a company decides to change from a policy of leasing plant and equipment through operating
leases to purchasing its own plant and equipment this will:
A. increase investing cash flows.
B. increase operating cash flows.
C. decrease operating cash flows.
D. have no impact on operating cash flows.

6. Which inventory accounting method usually gives a valuation of inventory that is closest to its
economic value?
A. FIFO.
B. LIFO.
C. Lower of cost or market.
D. Weighted average cost method.

5. If a company decides to change from a policy of leasing plant and equipment through operating
leases to purchasing its own plant and equipment this will:
A. increase investing cash flows.
B. increase operating cash flows.
C. decrease operating cash flows.
D. have no impact on operating cash flows.
Lease rentals are classified as an operating cash flow and the purchase of equipment is classified as an
investing cash flow. The decision to switch from leasing to purchasing plant and equipment will increase
operating cash flows but decrease investing cash flows.

6. Which inventory accounting method usually gives a valuation of inventory that is closest to its
economic value?
A. FIFO.
B. LIFO.
C. Lower of cost or market.
D. Weighted average cost method.

Since FIFO leaves the most recently purchased goods in inventory the valuation will usually be the closest
to current values.

7. Using common‐size statement analysis of the balance sheet of a company will help identify
changes in:
A. total assets.
B. profitability.
C. financial leverage.
D. efficiency of use of assets

8. When a company recognizes a warranty expense in the same accounting period as the sale of a
good this is an application of:
A. accrual accounting.
B. the matching principle.
C. contingency accounting.
D. the cost recovery method.

7. Using common‐size statement analysis of the balance sheet of a company will help identify
changes in:
A. total assets.
B. profitability.
C. financial leverage.
D. efficiency of use of assets
Correct Answer: C .......................................................................................... LOS: Reading 33‐i

Common-size statement analysis of the balance sheet will help identify changes in ratios which use
balance sheet items; this includes financial leverage which is assets/equity. Total assets will also be read off
the balance sheet, but in common-size statements assets will always be 100%.

8. When a company recognizes a warranty expense in the same accounting period as the sale of a
good this is an application of:
A. accrual accounting.
B. the matching principle.
C. contingency accounting.
D. the cost recovery method.

Under matching principles expenses should be recognized in the same period as the associated revenues,
so the company should recognize estimated warranty expenses in the same period as the sale.

9. The sale of a property which cost $3,000,000 is agreed. The purchaser makes a down payment of
$1,500,000 and agrees to pay further installments of $600,000 per year at the end of each of the next
five years. The profit that will be recognized as a result of the down payment, using the installment
method and cost recovery method is closest to:
Installment method Cost recovery method
A. $0 $0
B. $750,000 $0
C. $750,000 $750,000
D. $1,000,000 $750,000

10. The Comprehensive Income Statement contains:
A. details of income from subsidiaries.
B. information on changes in stockholders’ equity.
C. details on income from joint ventures and associates.
D. a detailed breakdown of cost of goods sold and other expenses.

9. The sale of a property which cost $3,000,000 is agreed. The purchaser makes a down payment of
$1,500,000 and agrees to pay further installments of $600,000 per year at the end of each of the next
five years. The profit that will be recognized as a result of the down payment, using the installment
method and cost recovery method is closest to:
Installment method Cost recovery method
A. $0 $0
B. $750,000 $0
C. $750,000 $750,000
D. $1,000,000 $750,000

Installment method: the profit to sales ratio is ($4,500,000 - $3,000,000)/$3,000,000 equals 50%. The
profit recognized from the down payment is 50% x $1,500,000, equals $750,000.
Cost recovery method: no profit is recognized until the costs have been recovered.

10. The Comprehensive Income Statement contains:
A. details of income from subsidiaries.
B. information on changes in stockholders’ equity.
C. details on income from joint ventures and associates.
D. a detailed breakdown of cost of goods sold and other expenses.
Correct Answer: B........................................................................................... LOS: Reading 32‐l

Comprehensive income is the change in stockholders’ equity as a result of net income and other revenue
and expense items that have been excluded from the income statement. These items include foreign
currency translation adjustments, pension liability adjustments, unrealized gains and losses on derivatives
contracts and investments.

11. Jones Construction takes on a new project which it anticipates will take two years to complete. It
agrees a total contract price of $4,000,000 and its expected operating costs are $3,000,000. In the first
year it incurs costs of $1,800,000 and receives payments of $2,000,000. If it is using the percentage‐of‐
completion method to recognize revenue then the operating income recorded in the first year will be:
A. $0.
B. $200,000.
C. $600,000.
D. $1,800,000.

12. I.W.S. Inc.’s cash flow from investing was (ref. Question 41):
A. ($19 million).
B. ($12 million).
C. ($9 million).
D. ($6 million).

11. Jones Construction takes on a new project which it anticipates will take two years to complete. It
agrees a total contract price of $4,000,000 and its expected operating costs are $3,000,000. In the first
year it incurs costs of $1,800,000 and receives payments of $2,000,000. If it is using the percentage‐of‐
completion method to recognize revenue then the operating income recorded in the first year will be:
A. $0.
B. $200,000.
C. $600,000.
D. $1,800,000.

The revenue in the first year is: $1,800,000 x $4,000,000 = $2,400,000
$3,000,000
Costs = $1,800,000
Operating income = $2,400,000 - $1,800,000 = $600,000

12. I.W.S. Inc.’s cash flow from investing was (ref. Question 41):
A. ($19 million).
B. ($12 million).
C. ($9 million).
D. ($6 million).
Cash flow from investing activities
Cash flow from investing activities
Purchase of land (15)
Sale of equipment 6
(9)

13. I.W.S. Inc.’s cash flow from financing was (ref. Question 41):
A. ($35 million).
B. ($23 million).
C. ($20 million).
D. ($12 million).

14. A U.S. consultancy company discovers that a transaction that took place last year was incorrectly
recorded and in fact a client paid an additional $10,000 of fees over that recorded as a bonus based on
the benefits he received from the consultancy provided in that period. The company should:
A. adjust the reported income in the previous year’s accounts.
B. increase the income received in the current year’s accounts.
C. adjust the retained earnings in the previous year’s balance sheet.
D. recognize the $10,000 as an extraordinary profit in the current year.

13. I.W.S. Inc.’s cash flow from financing was (ref. Question 41):
A. ($35 million).
B. ($23 million).
C. ($20 million).
D. ($12 million).
Cash flow from financing activities
Cash flow from financing
Retirement of common stock (12)
Dividend payment (8)
(20)

14. A U.S. consultancy company discovers that a transaction that took place last year was incorrectly
recorded and in fact a client paid an additional $10,000 of fees over that recorded as a bonus based on
the benefits he received from the consultancy provided in that period. The company should:
A. adjust the reported income in the previous year’s accounts.
B. increase the income received in the current year’s accounts.
C. adjust the retained earnings in the previous year’s balance sheet.
D. recognize the $10,000 as an extraordinary profit in the current year.
Adjustments to prior years’ accounts through adjustment to the retained earnings is only to be used for
accounting errors. The adjustment should be reported in the current year’s income statement. Although it
is a non recurring item it is not an extraordinary item.

15. Bishop Steel Manufacturing reported little change in net income whereas the operating cash
flows rose sharply. This might be explained by the company:
A. extending the payment period for customers.
B. raising cash through the issue of long term bonds.
C. selling land that was not being used for a substantial sum of money.
D. using inventory to meet their customers’ orders and minimizing raw material purchases.

16. The costs of long‐lived assets are usually allocated:
A. over 5 years.
B. at the time of disposal.
C. over a period that is chosen by the firm.
D. when the impairment of the assets takes place.

15. Bishop Steel Manufacturing reported little change in net income whereas the operating cash
flows rose sharply. This might be explained by the company:
A. extending the payment period for customers.
B. raising cash through the issue of long term bonds.
C. selling land that was not being used for a substantial sum of money.
D. using inventory to meet their customers’ orders and minimizing raw material purchases.
A is not correct since this would increase receivables and reduce operating cash flow.
B is not correct since the issue of bonds would be classified as a financing cash flow.
C is not correct since the sale of land would be classified as an investment cash flow.
D is correct since this would raise cash from the sale of inventory.

16. The costs of long‐lived assets are usually allocated:
A. over 5 years.
B. at the time of disposal.
C. over a period that is chosen by the firm.
D. when the impairment of the assets takes place.

Usually the management has discretion over the period, or useful life, that assets are depreciated.

17. The indirect method of reporting cash flows calculates operating cash flow by which of the
following methods?
A. Start with cash collections for the period and deduct cash outflows incurred in collecting
this cash.
B. Start with net income for the period and adjust for all non cash expenses/revenues and
adjust for non‐operating items included in net income.
C. Start with cash collections for the period and deduct cash outflows incurred in collecting
this cash, and then adjust for changes in the balance of operating asset and liability accounts.
D. Start with net income for the period, adjust for all non cash expenses/revenues, adjust for
non‐operating items included in net income and then adjust for changes in the balance of
operating asset and liability accounts.

18. Which of the following is least likely to be included in the Statement of Stockholders’ Equity?
A. Capital leases.
B. Retained earnings.
C. Cumulative foreign exchange adjustments.
D. Additional paid in capital above the par value of common stock.

17. The indirect method of reporting cash flows calculates operating cash flow by which of the
following methods?
A. Start with cash collections for the period and deduct cash outflows incurred in collecting this cash.
B. Start with net income for the period and adjust for all non cash expenses/revenues and adjust for
non-operating items included in net income.
C. Start with cash collections for the period and deduct cash outflows incurred in collecting this cash,
and then adjust for changes in the balance of operating asset and liability accounts.
D. Start with net income for the period, adjust for all non cash expenses/revenues, adjust for non-
operating items included in net income and then adjust for changes in the balance of operating asset and
liability accounts.

The indirect method starts at the net income figure and makes adjustments whereas the direct method
works through the cash items staring with cash collections.

18. Which of the following is least likely to be included in the Statement of Stockholders’ Equity?
A. Capital leases.
B. Retained earnings.
C. Cumulative foreign exchange adjustments.
D. Additional paid in capital above the par value of common stock.
Correct Answer: A ......................................................................................... LOS: Reading 33‐h

Capital leases are reported in the assets and liabilities section of the balance sheet. All the other items
appear as part of shareholders’ equity.

19. The cash flow from investments in 2007 for North Company is (ref. question 28):
A. ($85,000).
B. ($70,000).
C. $30,000.
D. $130,000.

20. The cash flow from financing in 2007 for North Company is (ref. question 28):
A. ($170,000).
B. ($115,000).
C. ($100,000).
D. ($15,000).

19. The cash flow from investments in 2007 for North Company is (ref. question 28):
A. ($85,000).
B. ($70,000).
C. $30,000.
D. $130,000.
Investing cash flows
Sale of old machine 30
Net from investment 30


20. The cash flow from financing in 2007 for North Company is (ref. question 28):
A. ($170,000).
B. ($115,000).
C. ($100,000).
D. ($15,000).
Financing cash flows:
Bank notes (100)
Dividends paid (15)
Net from financing (115)


21. W.S. Inc uses U.S. GAAP and supplied the following financial data:

$ million
Cash payment for salaries 23
Purchase of land 15
Cash payment for interest 3
Retirement of common stock 12
Cash collection from customers 115
Cash payment to suppliers 43
Depreciation expense 10
Dividend payment 8
Sale of equipment 6

Cash flow from operating activities was:
A. $36 million.
B. $39 million.
C. $46 million.
D. $49 million.

21. W.S. Inc uses U.S. GAAP and supplied the following financial data:
$ million
Cash payment for salaries 23
Purchase of land 15
Cash payment for interest 3
Retirement of common stock 12
Cash payment to suppliers 43
Depreciation expense 10
Dividend payment 8
Sale of equipment 6
Cash flow from operating activities was:

A. $36 million.
B. $39 million.
C. $46 million.
D. $49 million.
$ million
Cash flow from operating activities
Cash payment to suppliers (43)
Cash payment for salaries (23)
Cash payment for interest (3)
46

22. North Company uses U.S. GAAP and provides the following financial statements:
2007 Income statement (in $’000)
Sales 5,400
COGS (4,600)
Depreciation (200)
Interest expense (55)
Gain on sale of old machinery 30
Income before taxes 575
Income tax expense (175)
Net income after taxes 400

Balance sheet (in $’000)
end beg
Assets:
Cash 895 100
Accounts receivable 260 200
Inventory 500 800
Property, plant & 300 500
Total assets 1,955 1,600

Liabilities:
Accounts payable 370 350
Bank notes 0 100
Deferred taxes 90 40
Common stock 1,000 1,000
Retained Earnings 495 110
Total liabilities 1,955 1,600
Total dividends of $15,000 were paid.
Old machinery was sold; the machinery had already been fully depreciated.
The cash flow from operations in 2007 is:
A. $580,000.
B. $830,000.
C. $880,000.
D. $910,000.

22. North Company uses U.S. GAAP and provides the following financial statements:
2007 Income statement (in $’000) Balance sheet (in $’000)
Sales 5,400 end 2007 beg 2007
COGS (4,600) Assets:
Depreciation (200) Cash 895 100
Interest expense (55) Accounts receivable 260 200
Gain on sale of old 30 Inventory 500 800
Income before taxes 575 Property, plant & 300 500
Income tax expense (175) Total assets 1,955 1,600
Net income after taxes 400
Liabilities:
Accounts payable 370 350
Bank notes 0 100
Deferred taxes 90 40
Common stock 1,000 1,000
Retained Earnings 495 110
Total liabilities 1,955 1,600
Total dividends of $15,000 were paid.
Old machinery was sold; the machinery had already been fully depreciated.
The cash flow from operations in 2007 is:
A. $580,000.
B. $830,000.
C. $880,000.
D. $910,000.

Cash flow from operations:

Net income 400
Adjust for
Depreciation 200
Gain on sale of machinery (30)
Deferred taxes 50
Change in accounts receivable (60)
Decrease in inventory 300
Change in accounts payable 20
Net from operations 880


Inventories, Long-Term Assets, Deferred Taxes, and On-
and Off-Balance Sheet Debt
The readings in this study session examine specific categories of assets and liabilities that are
particularly susceptible to the impact of alternative accounting policies and estimates. Analysts must
understand the effects of alternative policies on financial statements and ratios, and be able to execute
appropriate adjustments to enhance comparability between companies. In addition, analysts must be
alert to differences between a companyʹs reported financial statements and economic reality.
The description and measurement of inventories require careful attention because the investment in
inventories is frequently the largest current asset for merchandizing and manufacturing companies.
For these companies, the measurement of inventory cost (i.e., cost of goods sold) is a critical factor in
determining gross profit and other measures of company profitability. Long‐term operating assets are
often the largest category of assets on a companyʹs balance sheet. The analyst needs to scrutinize
managementʹs choices with respect to recognizing expenses associated with the operating assets
because of the potentially large impact such choices can have on reported earnings.
A companyʹs accounting policies (such as depreciation choices) can cause differences in taxes
reported in financial statements and taxes reported on tax returns. The reading “Analysis of Income
Taxes” discusses several issues that arise relating to deferred taxes.
Both on‐ and off‐balance‐sheet debt affect a companyʹs liquidity and solvency, and have
consequences for its long‐term growth and viability. The notes of the financial statements must be
carefully reviewed to ensure that all potential liabilities (e.g., leasing arrangements and other
contractual commitments) are appropriately evaluated for their conformity to economic reality.
Adjustments to the financial statements may be required to achieve comparability when evaluating
several companies, and may also be required to improve credit and investment decision‐making.
Reading 35: Analysis of Inventories
Reading 36: Analysis of Long‐Lived Assets:
Part I—The Capitalization Decision
Reading 37: Analysis of Long‐Lived Assets:
Part II—Analysis of Depreciation and Impairment
Reading 38: Analysis of Income Taxes
Reading 39: Analysis of Financing Liabilities
Reading 40: Leases and Off‐Balance‐Sheet Debt

Financial Statement Inventories, Assets, Taxes & Debt 249
1. When a company reports a large LIFO reserve, has it (1) been using LIFO or FIFO to calculate
inventory balances and has it (2) overstated or understated the value of inventory compared with the
current market value?
Inventory balances Overstated/understated
A. LIFO overstated
B. FIFO overstated
C. LIFO understated
D. FIFO understated

2. The average age of Manufacturers Corporation’s machinery is lower than other companies in the
same industry. Which of the following is the least likely to explain this?
A. The company has just made major write downs of impaired assets.
B. The company uses a shorter depreciation life for machinery than its competitors.
C. The company has just finished a major capital expenditure program to replace
machinery.
D. The company has just acquired another manufacturing company and is making use of its
machinery, at the time of acquisition the depreciation on this machinery was set at zero.

1. When a company reports a large LIFO reserve, has it (1) been using LIFO or FIFO to calculate
inventory balances and has it (2) overstated or understated the value of inventory compared with the
current market value?
Inventory balances Overstated/understated
A. LIFO overstated
B. FIFO overstated
C. LIFO understated
D. FIFO understated

The LIFO reserve is reported by companies using LIFO. Accounting using LIFO usually leads to an
understatement of the inventory balance compared with current values, so information on the LIFO
reserve is provided.

2. The average age of Manufacturers Corporation’s machinery is lower than other companies in the
same industry. Which of the following is the least likely to explain this?
A. The company has just made major write downs of impaired assets.
B. The company uses a shorter depreciation life for machinery than its competitors.
C. The company has just finished a major capital expenditure program to replace machinery.
D. The company has just acquired another manufacturing company and is making use of its machinery,
at the time of acquisition the depreciation on this machinery was set at zero.
accumul. depreciati on
average age =
depreciat. expense
Impairment of assets would lead to lower current depreciation charges; this will lead to a higher average
asset life. B, C and D will lead to lower average age.

3. A company has just issued a bond with covenants. Which of the following clauses is least likely
to be included in the bond covenants?
A. A cap on leverage ratios at specified dates over the life of the bond.
B. A requirement that return on capital should exceed a specified percentage.
C. A restriction on dividend payments to shareholders if they would reduce stockholders’
equity below a specified level.
D. A requirement that no future debt can be issued that ranks higher than the original bonds
giving the holders a prior claim on assets.

4. Which of the following statements is most accurate regarding cash flow impact for a lessee of a
capital lease?
A. Total cash outflow each year is the same as the lease payment.
B. All of the rental payments are treated as cash flow from operations.
C. The rental payments are partly allocated as cash flow from operations and partly as cash
flow from investing.
D. The present value of the lease payments is classified as an investing cash outflow at the
beginning of the lease.

3. A company has just issued a bond with covenants. Which of the following clauses is least likely
to be included in the bond covenants?
A. A cap on leverage ratios at specified dates over the life of the bond.
B. A requirement that return on capital should exceed a specified percentage.
C. A restriction on dividend payments to shareholders if they would reduce stockholders’ equity
below a specified level.
D. A requirement that no future debt can be issued that ranks higher than the original bonds giving
the holders a prior claim on assets.
Covenants tend to focus on clauses that restrict leverage, issuance of new debt or spending (on dividends
or investment) that would limit the funds available to repay bond holders. Therefore a return on capital
requirement is least likely to be specified.

4. Which of the following statements is most accurate regarding cash flow impact for a lessee of a
capital lease?
A. Total cash outflow each year is the same as the lease payment.
B. All of the rental payments are treated as cash flow from operations.
C. The rental payments are partly allocated as cash flow from operations and partly as cash flow from
investing.
D. The present value of the lease payments is classified as an investing cash outflow at the beginning of
the lease.

There is no cash outflow at the beginning of the lease, other than lease payments, since the asset is not
purchased.
The rental payments are partly allocated to cash flow from operations and partly to cash flow from
financing.

5. A mining company is required by regulation to restore land to its original state when mining has
finished. Under SFAS 143 the company is required to:
A. calculate the undiscounted cost of restoring the land to its original state and depreciate
this cost over the life of the mine.
B. calculate the present value of restoring the land to its original state and deduct this from
the carrying value of the assets.
C. calculate the present value of restoring the land to its original state and recognize this as
an expense in the first year of operation of the mine.
D. calculate the present value of restoring the land to its original state at the end of each
year and recognize the difference from the previous year is an accretion expense.

6. A U.S. company reviews the value of its fixed assets and finds that an asset that had been written
down due to impairment in the previous accounting period now has a carrying value less than the
future cash flows expected to be received from the use of the asset. The company should, under U.S.
GAAP:
A. revise the value of the asset and record the gain as ‘other income’.
B. revise the value of the asset and record the gain as an unusual item.
C. revise the value of the asset and record the gain as an extraordinary income.
D. not do anything, an increase in the value of assets cannot be recognized until they are
sold.

5. A mining company is required by regulation to restore land to its original state when mining has
finished. Under SFAS 143 the company is required to:
A. calculate the undiscounted cost of restoring the land to its original state and depreciate this cost
over the life of the mine.
B. calculate the present value of restoring the land to its original state and deduct this from the
carrying value of the assets.
C. calculate the present value of restoring the land to its original state and recognize this as an expense
in the first year of operation of the mine.
D. calculate the present value of restoring the land to its original state at the end of each year and
recognize the difference from the previous year is an accretion expense.
A is not correct; the cost should be discounted.
B is not correct; present value should be added to the asset value.
C is not correct; the cost should be added to the asset value and be depreciated over the useful life of the
mine.

6. A U.S. company reviews the value of its fixed assets and finds that an asset that had been written
down due to impairment in the previous accounting period now has a carrying value less than the
future cash flows expected to be received from the use of the asset. The company should, under U.S.
GAAP:
A. revise the value of the asset and record the gain as ‘other income’.
B. revise the value of the asset and record the gain as an unusual item.
C. revise the value of the asset and record the gain as an extraordinary income.
D. not do anything, an increase in the value of assets cannot be recognized until they are sold.

Under U.S. GAAP an increase in the value of an asset cannot be recognized until sale and also previous
impairments cannot be restored.

7. A franchisee who buys the rights to use a name, a product and management expertise of another
company should:
A. expense the costs of purchasing these rights.
B. capitalize the cost of purchasing these rights.
C. capitalize the cost of purchasing the rights to use a name and expense the cost of the right
to use a product and management expertise.
D. capitalize the cost of purchasing the rights to use a name and a product and expense the
cost of the right to use management expertise.

8. If a company decided to change the estimated life of an asset that is already owned by the
company it must:
A. restate prior years’ accounts.
B. not make any retroactive adjustment.
C. disclose it as a change in accounting principle.
D. calculate the cumulative effect of the change and report net of taxes.

7. A franchisee who buys the rights to use a name, a product and management expertise of another
company should:
A. expense the costs of purchasing these rights.
B. capitalize the cost of purchasing these rights.
C. capitalize the cost of purchasing the rights to use a name and expense the cost of the right to use a
product and management expertise.
D. capitalize the cost of purchasing the rights to use a name and a product and expense the cost of the
right to use management expertise.

All the costs of purchase should be capitalized.

8. If a company decided to change the estimated life of an asset that is already owned by the
company it must:
A. restate prior years’ accounts.
B. not make any retroactive adjustment.
C. disclose it as a change in accounting principle.
D. calculate the cumulative effect of the change and report net of taxes.

A, C and D are not correct since changing an estimate of life of an asset is not a change in accounting
principle.
Since this is only a change in accounting estimate there is no need to make retroactive adjustments, only
current and future depreciation expense will be affected.

9. If the Cost of Goods Sold under LIFO is $20 million, the increase in LIFO reserve over the same
period is $5 million, and the closing inventory under LIFO is $80 million, then the Cost of Goods Sold
under FIFO is:
A. $15 million.
B. $25 million.
C. $75 million.
D. $85 million.

10. Tax rates are reduced at the beginning of a company’s financial year. In the company’s financial
statements the tax rate reduction will lead to:
A. a restatement of prior years’ accounts.
B. a reduction in the value of deferred tax assets.
C. an increase in the value of deferred tax liabilities.
D. an extraordinary gain which is stated net of tax on the income statement.

9. If the Cost of Goods Sold under LIFO is $20 million, the increase in LIFO reserve over the same
period is $5 million, and the closing inventory under LIFO is $80 million, then the Cost of Goods Sold
under FIFO is:
A. $15 million.
B. $25 million.
C. $75 million.
D. $85 million.

COGS under FIFO = COGS under LIFO – increase in LIFO reserve.
COGS under FIFO = $20 million - $5 million = $15 million

10. Tax rates are reduced at the beginning of a company’s financial year. In the company’s financial
statements the tax rate reduction will lead to:
A. a restatement of prior years’ accounts.
B. a reduction in the value of deferred tax assets.
C. an increase in the value of deferred tax liabilities.
D. an extraordinary gain which is stated net of tax on the income statement.
The lower tax rate reduces the value of the tax benefit when the deferred tax asset is realized.

11. Market rates are 5% per annum and a 6% semi annual coupon bond is issued at $1,100 with a face
value of $1,000. If an investor buys 1,000 bonds at issue and receives a coupon payment after six
months how much of this coupon payment will be recorded as principal repayment by the issuer?
A. $2,500.
B. $5,000.
C. $5,500.
D. $30,000.

12. A company enters into an agreement to lease equipment (treated as a capital lease) over two
years and will pay lease payments of $50,000 at the end of each year. If the discount rate used is 8%
the closing liability at the end of the first year is closest to:
A. $44,582.
B. $46,296.
C. $50,000.
D. $58,000.

11. Market rates are 5% per annum and a 6% semi annual coupon bond is issued at $1,100 with a face
value of $1,000. If an investor buys 1,000 bonds at issue and receives a coupon payment after six
months how much of this coupon payment will be recorded as principal repayment by the issuer?
A. $2,500.
B. $5,000.
C. $5,500.
D. $30,000.
The coupon paid will be 3% multiplied by $1,000,000, which is $30,000. The interest the investor earns is
2.5% multiplied by $1,100,000, which is $27,500, so the remainder is principal repayment of $2,500.

12. A company enters into an agreement to lease equipment (treated as a capital lease) over two
years and will pay lease payments of $50,000 at the end of each year. If the discount rate used is 8%
the closing liability at the end of the first year is closest to:
A. $44,582.
B. $46,296.
C. $50,000.
D. $58,000.

At the beginning of the lease period the liability will be the present value of the lease payments, which is
$89,163. The first lease payment is divided between interest (8% x $89,163 = $7,133) and principal
repayment. Therefore the liability is reduced by $42,867 to $46,296.

13. Which of the following is an example of a take‐or‐pay contract?
A. A firm agrees to buy a certain amount of oil from an oil producer at the market price each
year for the next five years.
B. A firm has the option to buy a certain amount of oil from an oil producer at the market
price each year for the next five years.
C. An oil producer has the option to sell a certain amount of oil to another firm at a fixed
price each year for the next five years.
D. An oil producer has the option to sell a certain amount of oil to another firm at the
market price each year for the next five years.

14. If a deferred tax liability is very unlikely to be paid then it should be treated as:
A. a long‐term liability.
B. stockholders’ equity.
C. a short‐term liability.

13. Which of the following is an example of a take‐or‐pay contract?
A. A firm agrees to buy a certain amount of oil from an oil producer at the market price each year for
the next five years.
B. A firm has the option to buy a certain amount of oil from an oil producer at the market price each
C. An oil producer has the option to sell a certain amount of oil to another firm at a fixed price each
D. An oil producer has the option to sell a certain amount of oil to another firm at the market price
each year for the next five years.

A take-or-pay contract is a firm commitment, not an option, at either a fixed or market price, and can
provide security of supply of a raw material for the buyer and security of income for the seller. These
contracts are an example of off-balance-sheet financing since future commitments are not treated as debt.

14. If a deferred tax liability is very unlikely to be paid then it should be treated as:
A. a long-term liability.
B. stockholders’ equity.
C. a short-term liability.

If the factors that created the deferred tax liability are unlikely to be reversed, than it is considered part of
stockholders’ equity.

15. In a direct financing lease the sale value reported at the beginning of the lease on the lessor’s
financial statements is:
A. the sum of the lease payments.
B. the present value of lease payments.
C. zero, there is no sale value reported.
D. the present value of lease payments plus the present value of the residual value.

16. If a company actively uses operating leases, which of the following statements is least accurate?
A. Total cash flow is understated.
B. Off‐balance‐sheet financing is significant.
C. Minimum lease payments for the next five years must be disclosed in the company’s
accounts.
D. Return on assets should be adjusted downwards to give a clearer view of the company’s
efficiency.

15. In a direct financing lease the sale value reported at the beginning of the lease on the lessor’s
financial statements is:
A. the sum of the lease payments.
B. the present value of lease payments.
C. zero, there is no sale value reported.
D. the present value of lease payments plus the present value of the residual value.

With a direct financing lease only financing or interest income is reported. There is no ‘manufacturing’
profit and no sale is recorded.

16. If a company actively uses operating leases, which of the following statements is least accurate?
A. Total cash flow is understated.
B. Off-balance-sheet financing is significant.
C. Minimum lease payments for the next five years must be disclosed in the company’s accounts.
D. Return on assets should be adjusted downwards to give a clearer view of the company’s efficiency.

Total cash flow is not understated but cash flow from operations is lower than if the lease were
capitalized.

17. A company manufactures a machine and agrees to lease the machine under a sales‐type capital
lease agreement. The company will record the gross investment in the machine as:
A. the sum of the minimum lease payments.
B. the sum of the present values of the minimum lease payments.
C. the sum of the minimum lease payments plus the residual value of the machine.
D. the sum of the present values of the minimum lease payments plus the present value of
the residual value of the machine.

18. When market interest rates decline, a company that has fixed‐rate debt outstanding will:
A. lose in economic terms.
B. gain in economic terms.
C. the debt on the balance sheet is automatically adjusted to current market value so the
economic loss will be reflected as an accounting loss.
D. the debt on the balance sheet is automatically adjusted to current market value so the
economic gain will be reflected as an accounting gain.

17. A company manufactures a machine and agrees to lease the machine under a sales‐type capital
lease agreement. The company will record the gross investment in the machine as:
A. the sum of the minimum lease payments.
B. the sum of the present values of the minimum lease payments.
C. the sum of the minimum lease payments plus the residual value of the machine.
D. the sum of the present values of the minimum lease payments plus the present value of the residual
value of the machine.

Net investment looks at the present value of the payments, the difference between the gross investment
and net investment is the interest component of the revenue represented by unearned income.

18. When market interest rates decline, a company that has fixed‐rate debt outstanding will:
A. lose in economic terms.
B. gain in economic terms.
C. the debt on the balance sheet is automatically adjusted to current market value so the economic loss
will be reflected as an accounting loss.
D. the debt on the balance sheet is automatically adjusted to current market value so the economic
gain will be reflected as an accounting gain.

The debt on the balance sheet reflects the market rate at issuance and therefore if market interest rates
decline the market value of the debt will increase which leads to an economic loss.

19. The financial ratios for a company, which uses operating leases compared to a company that uses
capital leases, will be as follows:
Interest cover Return on assets
A. lower lower
B. lower higher
C. higher lower
D. higher higher

20. An analyst notices that a company’s net deferred tax liability has declined; this is most likely to
be explained by:
A. the company has made a profit.
B. a new tax law has increased tax rates.
C. it is a growing company with rising capital expenditure.
the company has written down asset values due to impairment.

19. The financial ratios for a company, which uses operating leases compared to a company that uses
capital leases, will be as follows:
Interest cover Return on assets
A. lower lower
B. lower higher
C. higher lower
D. higher higher

Interest cover will be higher as interest payments will be lower.
Return on assets will be higher since assets will be lower.

20. An analyst notices that a company’s net deferred tax liability has declined; this is most likely to
be explained by:
A. the company has made a profit.
B. a new tax law has increased tax rates.
C. it is a growing company with rising capital expenditure.
the company has written down asset values due to impairment.
A would not reduce deferred tax liabilities.
B is not correct since this would increase deferred tax liabilities
C is not correct since this would to lead to increasing deferred tax liabilities if accelerated tax depreciation
methods are used for tax reporting.

21. The following financial data is provided by Sportswear Corporation:
$ million (using LIFO) 2006 2007

Inventory 105 125
Current assets 300 350
LIFO reserve 45 55
Current liabilities 110 160
COGS 1450 1700

The current ratios using FIFO are closest to:
2006 2007
A. 1.36 1.13
B. 2.32 1.84
C. 2.73 2.19
D. 3.14 2.53

21. The following financial data is provided by Sportswear Corporation:
$ million (using LIFO) 2006 2007

Inventory 105 125
Current assets 300 350
LIFO reserve 45 55
Current liabilities 110 160
COGS 1450 1700
The current ratios using FIFO are closest to:

2006 2007
A. 1.36 1.13
B. 2.32 1.84
C. 2.73 2.19
D. 3.14 2.53

Adjust current assets by adding the LIFO reserve to get current assets under FIFO of 345 in 2006 and 405
in 2007.
Current ratio is current assets /current liabilities = 345/110 and 405/160 respectively which equal 3.14 and
2.53 respectively.

22. The following information is given regarding a company’s activities:
Tax rate is 30%.
The only expense is depreciation.
A new machine is purchased at a cost of $10,000.
Annual revenues of $40,000 are generated from the new machine.
The company, in its financial reports, depreciates the machine by using the straight‐line
method over four years and the salvage value is estimated to be $2,000.
For tax purposes the machine is depreciated using the straight‐line method over two years with the
same salvage value.
The deferred tax expense in year 2 will be:
A. $600.
B. $1,200.
C. $10,800.
D. $11,400.

22. The following information is given regarding a company’s activities:
Tax rate is 30%.
The only expense is depreciation.
A new machine is purchased at a cost of $10,000.
Annual revenues of $40,000 are generated from the new machine.
The company, in its financial reports, depreciates the machine by using the straight-line method over four
years and the salvage value is estimated to be $2,000.
For tax purposes the machine is depreciated using the straight‐line method over two years with the
same salvage value.
The deferred tax expense in year 2 will be:
A. $600.
B. $1,200.
C. $10,800.
D. $11,400.

Tax reporting – straight-line depreciation over two Financial statement reporting – straight-line
Year 2 Year 1 Year 1 Year 2
Revenue $40,000 $40,000 Revenue $40,000 $40,000
Depreciation $4,000 $4,000 Depreciation $2,000 $2,000
Taxable income $36,000 $36,000 Pre‐tax income $38,000 $38,000
Taxes payable $10,800 $10,800 Tax expense $11,400 $11,400
of which:
Taxes payable $10,800 $10,800
Deferred tax $600 $600




Techniques, Applications, and International Standards
Convergence

The readings in this study session discuss financial analysis techniques, financial statement analysis
applications, and the international convergence of accounting standards.
The first reading presents the most frequently used tools and techniques used to evaluate companies,
including common size analysis, cross‐sectional analysis, trend analysis, and ratio analysis. The
second reading then shows the application of financial analysis techniques to major analyst tasks
including the evaluation of past and future financial performance, credit risk, and the screening of
potential equity investments. The reading also discusses analyst adjustments to reported financials.
Such adjustments are often needed to put companies’ reported results on a comparable basis.
This study session concludes with a reading on convergence of international and U.S. accounting
standards. Although there has been much progress in harmonizing accounting standards globally, as
this reading discusses, there are still significant variations between generally accepted accounting
principles from one country to another.

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

Financial Statement Techniques, Applications, and International Standards Convergence 275
1. If the debt‐to‐capital ratio has decreased for a firm this is most likely to be explained by:
A. the firm has just completed a new issue of equity to finance its expansion.
B. the book value of debt has not changed but the market value of long‐term debt has
decreased.
C. the book value of debt has not changed but the market value of long‐term debt has
increased.
D. the firm has switched from using long‐term debt to using more short‐term borrowing to
finance its activities.

2. Some analysts prefer to use EBITDA rather than earnings per share to value a company’s
performance, which of the following would support this preference?
A. EBITDA is more sensitive to the gearing of the company.
B. EBITDA is a more volatile number than earning per share.
C. EBITDA does not take into account the cost of using fixed assets.
D. EBITDA gives a better indication of profits available to equity shareholders.

1. If the debt‐to‐capital ratio has decreased for a firm this is most likely to be explained by:
A. the firm has just completed a new issue of equity to finance its expansion.
B. the book value of debt has not changed but the market value of long-term debt has decreased.
C. the book value of debt has not changed but the market value of long-term debt has increased.
D. the firm has switched from using long-term debt to using more short-term borrowing to finance its
activities.

Debt-to-capital ratio is total debt divided by total debt plus shareholders’ equity. B and C are not correct
since the book value of debt is used in the calculation. Usually total interest bearing debt is used in the
calculation of capital so D is not correct.
A would lead to an increase in total equity so would explain a fall in the debt-to-capital ratio.

2. Some analysts prefer to use EBITDA rather than earnings per share to value a company’s
performance, which of the following would support this preference?
A. EBITDA is more sensitive to the gearing of the company.
B. EBITDA is a more volatile number than earning per share.
C. EBITDA does not take into account the cost of using fixed assets.
D. EBITDA gives a better indication of profits available to equity shareholders.
Usually earnings per share are more volatile than EBITDA, since they are after interest which is effectively
a fixed charge. EBITDA is profit available to all providers of capital, since it is before interest, and is not
directly sensitive to the level of gearing.
Since EBITDA is before depreciation and capital expenditure it does not take into account the cost of using
fixed assets, so might be used of compare companies with very different levels of fixed asset investment.

3. An analyst is evaluating the impact of changes in oil prices on an airline’s profitability; another
analyst is projecting the cash flows for a retailer based on different economic forecasts. The analysts
are most likely to use which type of analysis?
Airline Retailer
A. scenario scenario
B. scenario sensitivity
C. sensitivity scenario
D. sensitivity sensitivity

4. Under International Financial Reporting Standards (IFRS) impairment of goodwill:
A. is not permitted, amortization is still used.
B. it charged as a valuation allowance against the acquired assets.
C. leads to a reduction in net income in the period when the impairment is recognized.
D. is charged directly to stockholders’ equity and does not impact on the income statement.

3. An analyst is evaluating the impact of changes in oil prices on an airline’s profitability; another
analyst is projecting the cash flows for a retailer based on different economic forecasts. The analysts
are most likely to use which type of analysis?
Airline Retailer
A. scenario scenario
B. scenario sensitivity
C. sensitivity scenario
D. sensitivity sensitivity
Correct Answer: C ......................................................................................... LOS: Reading 41‐h

Sensitivity analysis will give a range of possible outcomes if a variable changes, so would be applicable to
measuring the sensitivity of the airlines profits to an oil price move. In scenario analysis forecasts are made
based on specific assumptions or outcomes, so this would accommodate using different economic forecasts
to predict cash flows for the retailer.

4. Under International Financial Reporting Standards (IFRS) impairment of goodwill:
A. is not permitted, amortization is still used.
B. it charged as a valuation allowance against the acquired assets.
C. leads to a reduction in net income in the period when the impairment is recognized.
D. is charged directly to stockholders’ equity and does not impact on the income statement.

Impairment reduces income in the year it is recorded, reduces the value of net asset and reduces
stockholder’s equity. Under IFRS goodwill must be checked annually for impairment, amortization is not
permitted.

5. National Telecoms Corporation’s interest coverage is closest to (ref. financial data in question 34):
A. 1.11.
B. 2.11.
C. 2.67.
D. 6.00.

6. The gross profit margin of a company has declined relative to its competitors. This could be
explained by:
A. the company has recognized losses on plant and equipment that has become obsolete.
B. the company’s credit quality has declined pushing up the interest rate on short‐term
debt.
C. the company has increased its marketing efforts and hired additional marketing
executives.
D. the company has switched to using LIFO accounting rather than FIFO accounting in an
inflationary environment.

5. National Telecoms Corporation’s interest coverage is closest to (ref. financial data in question 34):
A. 1.11.
B. 2.11.
C. 2.67.
D. 6.00.

Interest coverage = EBIT = 120 = 2.67
interest expense 45

6. The gross profit margin of a company has declined relative to its competitors. This could be
explained by:
A. the company has recognized losses on plant and equipment that has become obsolete.
B. the company’s credit quality has declined pushing up the interest rate on short-term debt.
C. the company has increased its marketing efforts and hired additional marketing executives.
D. the company has switched to using LIFO accounting rather than FIFO accounting in an
inflationary environment.

Gross profit margin is (revenue – COGS)/revenue.
Interest expense, losses on sale of plant and equipment and marketing expense are not part of COGS. LIFO
accounting would increase the cost of inventory sold thereby reducing the gross margin.

7. A company has a low fixed asset base relative to its sector average. It is generally the case that:
A. its sales variability is higher than that of other companies in the sector.
B. the company’s financial risk is lower than that of other companies in the sector.
C. operating profits will be relatively volatile compared to other companies in the sector.
D. investors will tolerate a higher debt‐to‐equity relative to other companies in the sector.

8. The return on total capital of a company has increased. This could be explained by:
A. the company’s operating profit has been deteriorating as competitive pressure increases.
B. the company has sold unprofitable business units and used the proceeds to reduce debt.
C. the company has become less risky and therefore a higher return on total invested capital
is required.
D. the company has increased borrowing to expand its operating capacity but this has not
yet been reflected in a rise in earnings.

7. A company has a low fixed asset base relative to its sector average. It is generally the case that:
A. its sales variability is higher than that of other companies in the sector.
B. the company’s financial risk is lower than that of other companies in the sector.
C. operating profits will be relatively volatile compared to other companies in the sector.
D. investors will tolerate a higher debt-to-equity relative to other companies in the sector.

A low fixed asset base generally leads to lower operating leverage, i.e. operating profits are less sensitive to
changes in sales revenue. Investors will usually accept greater financial risk if operating risk is lower. One
of the measures of financial risk is the debt-to-equity ratio.

8. The return on total capital of a company has increased. This could be explained by:
A. the company’s operating profit has been deteriorating as competitive pressure increases.
B. the company has sold unprofitable business units and used the proceeds to reduce debt.
C. the company has become less risky and therefore a higher return on total invested capital is
required.
D. the company has increased borrowing to expand its operating capacity but this has not yet been
reflected in a rise in earnings.

The total capital will have been reduced by the repayment of debt, thereby increasing the return on total
capital.

9. A major competitor of a company has the same net profit margin and total asset turnover as the
company. The competitor’s return on equity is higher; this is explained by the competitor having:
A. a lower tax rate.
B. higher financial leverage.
C. lower interest costs as a percentage of sales.
D. lower interest costs as a percentage of operating profit.

10. A company provides the following information:

2006 2007
Return on equity 8.9% 9.4%
Return on total assets 4.5% 4.2%
Total asset turnover 1.5 1.7

The numbers could be explained by:
Financial leverage Net profit margin
A. increased increased
B. increased decreased
C. decreased increased
D. decreased decreased

9. A major competitor of a company has the same net profit margin and total asset turnover as the
company. The competitor’s return on equity is higher; this is explained by the competitor having:
A. a lower tax rate.
B. higher financial leverage.
C. lower interest costs as a percentage of sales.
D. lower interest costs as a percentage of operating profit.

Return on equity = net profit margin x total asset turnover x financial leverage

10. A company provides the following information:
2006 2007
Return on equity 8.9% 9.4%
Return on total assets 4.5% 4.2%
Total asset turnover 1.5 1.7
The numbers could be explained by:
Financial leverage Net profit margin
A. increased increased
B. increased decreased
C. decreased increased
D. decreased decreased

Return on equity = return on assets x financial leverage. Return on equity has increased when return on
assets fell, so financial leverage must have increased.
Return on assets = net profit margin x total asset turnover. If return on assets fell and total asset turnover
increased in must be because net profit margins fell.

11. Which of the following is least likely to be a limitation of using ratio analysis to evaluate the
financial performance of a company?
A. Ratios are more applicable for equity analysis and are less useful for credit analysis.
B. Ratios based on financial statements using different accounting methods may not be
comparable.
C. There are potential inconsistencies between the signals different ratios are giving about a
company’s financial health.
D. A company’s operations may be diverse and it is not always easy to find companies that
can provide useful industry comparisons.

12. When Moody’s calculates that a firm’s retained cash flow to debt is 0.25, this is most likely to
mean that:
A. the firm could pay off its debt from retained cash flow in about three months.
B. unless the firm has a heavy capital expenditure program it could pay off its debt from
retained cash flow in about four years.
C. the cash flows required to pay interest on the debt are approximately a quarter of the
firm’s total cash flows, after capital expenditure.
D. the firm could increase debt financing by a factor of four times and still have sufficient
cash flow to cover interest payments on the debt.

11. Which of the following is least likely to be a limitation of using ratio analysis to evaluate the
financial performance of a company?
A. Ratios are more applicable for equity analysis and are less useful for credit analysis.
B. Ratios based on financial statements using different accounting methods may not be comparable.
C. There are potential inconsistencies between the signals different ratios are giving about a
company’s financial health.
D. A company’s operations may be diverse and it is not always easy to find companies that can provide
useful industry comparisons.

Ratios are widely used by both equity analysts and credit analysts so A is not correct. B, C and D are all
potential limitations of using ratios for financial analysis.

12. When Moody’s calculates that a firm’s retained cash flow to debt is 0.25, this is most likely to
mean that:
A. the firm could pay off its debt from retained cash flow in about three months.
B. unless the firm has a heavy capital expenditure program it could pay off its debt from retained cash
flow in about four years.
C. the cash flows required to pay interest on the debt are approximately a quarter of the firm’s total
cash flows, after capital expenditure.
D. the firm could increase debt financing by a factor of four times and still have sufficient cash flow to
cover interest payments on the debt.

Retained cash flow is defined as operating cash flow before working capital changes, less dividends. If
cash flows and debt remains stable and there were no capital expenditures then the company could pay off
its debt from retained cash flow in 1/0.25, or 4 years.
Reference: CFA® Program Curriculum, Volume 3, pp. 649‐652

13. When a firm cannot confidently forecast the outcome, in terms or total revenues and costs, of a
construction project the appropriate accounting treatments for recognizing revenue under U.S. GAAP
and International Financial Reporting Standards (IFRS) are:
U.S. GAAP IFRS
A. completed contract percentage of completion
B. completed contract revenue if contract costs can be recovered
C. percentage of completion completed contract
D. percentage of completion revenue if contract costs can be recovered

14. A firm has a higher return on equity to its competitors; this is least likely to be explained by:
A. a lower tax burden.
B. higher asset turnover.
C. a lower interest burden.
D. lower financial leverage.

13. When a firm cannot confidently forecast the outcome, in terms or total revenues and costs, of a
construction project the appropriate accounting treatments for recognizing revenue under U.S. GAAP
and International Financial Reporting Standards (IFRS) are:
U.S. GAAP IFRS

A. completed contract percentage of completion
B. completed contract revenue if contract costs can be recovered
C. percentage of completion completed contract
D. percentage of completion revenue if contract costs can be recovered

Under IFRS, revenue can be recognised to the extent that contract costs can be recovered. Under U.S.
GAAP, the completed contract method must be used.

14. A firm has a higher return on equity to its competitors; this is least likely to be explained by:
A. a lower tax burden.
B. higher asset turnover.
C. a lower interest burden.
D. lower financial leverage.

Return on equity, using DuPont analysis, can be decomposed into
total asset turnover x leverage x tax burden x interest burden x EBIT margin.
Therefore lower financial leverage would tend to reduce return on equity.

15. Under International Financial Reporting Standards (IFRS) unrealized gains on which type of
marketable securities are recorded in the income statement?
A. held‐for‐trading securities only.
B. available‐for‐sale securities only.
C. held‐for‐trading securities and available‐for sale securities only.
D. held‐for‐trading securities, available‐for sale securities and held‐to‐maturity securities.

16. A company has employed a new financial controller who has installed a new system to improve
the efficiency of inventory management, and who has written off a large amount of uncollectible
receivables. This is likely to:
Inventory turnover Receivables turnover

15. Under International Financial Reporting Standards (IFRS) unrealized gains on which type of
marketable securities are recorded in the income statement?
A. held-for-trading securities only.
B. available-for-sale securities only.
C. held-for-trading securities and available-for sale securities only.
D. held-for-trading securities, available-for sale securities and held-to-maturity securities.
Unrealized gains are not recognized for held-to-maturity securities. Available-for sale securities are
recorded at market value but any unrealized gains flow straight through to shareholders’ equity. Only
unrealized gains on held-for-trading securities are recorded in the income statement.

16. A company has employed a new financial controller who has installed a new system to improve
the efficiency of inventory management, and who has written off a large amount of uncollectible
receivables. This is likely to:
Inventory turnover Receivables turnover

More efficient management of inventory would be expected to increase the inventory turnover, by
reducing the number of days goods were held as inventory. Writing off receivables would reduce the
denominator in the receivables turnover, thereby increasing receivables turnover.

17. Which of the following actions would be least likely to improve a firm’s working capital
turnover?
A. Reducing inventory levels.
B. Tightening credit terms given to customers.
C. Reducing the fixed assets used in the business.
D. Maintaining working capital at current levels whilst achieving steady revenue growth.

18. South Inc.’s breakdown of current assets and liabilities is as follows:
Current assets ($ ‘000) Current liabilities ($ ‘000)

Cash and cash equivalents 40 Short term debt 25
Receivables 650 Accounts payable 420
Inventories 350 Taxes payable 120
Other current assets 70 Other current liabilities 45
Total 1,110 Total 610

The quick ratio is closest to:
A. 0.07.
B. 1.13.
C. 1.55.
D. 1.82.

17. Which of the following actions would be least likely to improve a firm’s working capital
turnover?
A. Reducing inventory levels.
B. Tightening credit terms given to customers.
C. Reducing the fixed assets used in the business.
D. Maintaining working capital at current levels whilst achieving steady revenue growth.

Working capital turnover is revenue/average working capital, where working capital is current assets less
current liabilities. Reducing working capital by, for example reducing inventory levels would improve the
ratio. Increasing revenue collection from customers would reduce receivables and as long as the cash
collected was not held in cash equivalents this would improve the ratio. Fixed assets are not part of
working capital so reducing fixed assets would not directly affect working capital turnover.

18. South Inc.’s breakdown of current assets and liabilities is as follows:
Current assets ($ ‘000) Current liabilities ($ ‘000)

Cash and cash equivalents 40 Short term debt 25
Receivables 650 Accounts payable 420
Inventories 350 Taxes payable 120
Other current assets 70 Other current liabilities 45
Total 1,110 Total 610
A. 0.07.
B. 1.13.
C. 1.55.
D. 1.82.

Quick ratio = cash + market securities + receivables
current liabilities
= 690 = 1.13
610

19. Which of the following ratios is least likely to be used to measure profitability?
A. Return on assets.
B. Total asset turnover.
C. Operating profit margin.
D. Return on common equity.

20. A computer manufacturing company has very short days of inventory on hand compared with
its competitors, this could be explained by:
A. the company runs a just‐in‐time manufacturing system.
B. a significant proportion of the company’s inventory is obsolete.
C. the company maintains high inventory levels in order to meet customer orders promptly.
D. the resources of the company tied up in inventory are relatively high compared with its
competitors.

19. Which of the following ratios is least likely to be used to measure profitability?
A. Return on assets.
B. Total asset turnover.
C. Operating profit margin.
D. Return on common equity.

Total asset turnover is a measure of activity rather than profitability.

20. A computer manufacturing company has very short days of inventory on hand compared with
its competitors, this could be explained by:
A. the company runs a just-in-time manufacturing system.
B. a significant proportion of the company’s inventory is obsolete.
C. the company maintains high inventory levels in order to meet customer orders promptly.
D. the resources of the company tied up in inventory are relatively high compared with its
competitors.

Short DOH indicates high inventory turnover (cost of goods sold/inventory) so it is unlikely the inventory
is obsolete and the resources of the company tied up in inventory is smaller than its competitors. A just-in-
time manufacturing system means that computers are manufactured in response to customer demand
which will reduce inventory levels, so A is correct.

21. ABC Corporation provides you with the following information:
Income statement Balance sheet
$ million Average over period $ million
Sales 150 Cash 90 Accounts payable 30
COGS (75) Accounts receivable 10 Short‐term bank notes 25
Gross profit 75 Inventory 70 Long‐term debt 60
SGA expenses (20) Property, P & E 150
Op. profit 55 Depreciation (70) Common stock 50
Interest expense (15) Investment 30 Retained earnings 115
Tax (10)
Net income 30 Total assets 280 Total liabilities & 280

equity

Inventory turnover is closest to:
A. 0.47.
B. 0.93.
C. 1.07.
D. 2.14.

21. ABC Corporation provides you with the following information:
Sales 150 Cash 90 Accounts payable 30
COGS (75) Accounts receivable 10 Short‐term bank notes 25
Gross profit 75 Inventory 70 Long‐term debt 60
SGA expenses (20) Property, P & E 150
Interest expense (15) Investment 30 Retained earnings 115
Tax (10)

equity
Inventory turnover is closest to:
A. 0.47.
B. 0.93.
C. 1.07.
D. 2.14.
COGS 75
Inventory turnover = = = 1.07
averageinventory 70

22. National Telecoms Corporation provides the following information:
Sales 1,050 Cash 90 Accounts payable 50
COGS (780) Accounts 170 Notes payable 125
Gross profit 270 Inventory* 200 Long‐term debt 300
SGA exp. (150) Property, P&E 650
Interest exp. (45) Retained earnings 55
Tax (25)
equity
*Inventory is unchanged over the period

National Telecoms Corporation’s cash conversion cycle is closest to:
A. 58 days.
B. 130 days.
C. 153 days.
D. 176 days.

Sales 1,050 Cash 90 Accounts payable 50
COGS (780) Accounts 170 Notes payable 125
Gross profit 270 Inventory* 200 Long‐term debt 300
SGA exp. (150) Property, P&E 650
Interest exp. (45) Retained earnings 55
Tax (25)
equity
*Inventory is unchanged over the period
National Telecoms Corporation’s cash conversion cycle is closest to:
A. 58 days.
B. 130 days.
C. 153 days.
D. 176 days.

Days of sales outstanding = 365/annual receivables turnover = 365/(1050/170) = 59 days
Days of inventory on hand = 365/inventory turnover = 365/(780/200) = 94 days
Days of payables = 365/payables turnover = 365/(780/50) = 23 days
Cash conversion cycle =
Receivables collection period + inventory processing period – payables payment period= 130 days


Study Session 11: Corporate Finance:

This study session covers the principles that corporations use to make their investing and financing
decisions. Capital budgeting is the process of making decisions about which long‐term projects the
corporation should accept for investment, and which it should reject. Both the expected return of a
project and the financing cost should be taken into account. The cost of capital, or the rate of return
required for a project, must be developed using economically sound methods.
Corporate managers are concerned with liquidity and solvency, and use financial statements to
evaluate performance as well as to develop and communicate future plans. The final reading in this
study session is on corporate governance practices, which can expose the firm to a heightened risk of
ethical lapses. Although these practices may not be inherently unethical, they create the potential for
conflicts of interest to develop between shareholders and managers, and the extent of that conflict
affects the firm’s valuation.

Reading 44: Capital Budgeting
Reading 45: Cost of Capital
Reading 46: Working Capital Management
Reading 47: Financial Statement Analysis
Reading 48: The Corporate Governance of Listed Companies:
A Manual for Investors

Corporate Finance 301
1. A company has trade credit which is 2/10, net 30. The company pays on the 20th day. The
effective borrowing cost of not paying on the 10th day is closest to:
A. 36.5%.
B. 44.6%.
C. 106.0%.
D. 109.0%.

2. A company has trade credit with its suppliers and receives a discount if it pays within a specified
number of days. It works out the cost of trade credit is 50% if it pays on the net day. If the
company’s short term cost of funds is 18% then the company should pay:
A. on the net day.
B. on the day or purchase.
C. on the last day of the discount period
D. just after the discount period has ended.

1. A company has trade credit which is 2/10, net 30. The company pays on the 20th day. The
effective borrowing cost of not paying on the 10th day is closest to:
A. 36.5%.
B. 44.6%.
C. 106.0%.
D. 109.0%.

The cost of trade credit is calculated as the implicit rate of return which is represented by the trade
discount offer.
365 / 20
Cost = 0.02
1+ - 1 = 109%
1 - 0.02

2. A company has trade credit with its suppliers and receives a discount if it pays within a specified
number of days. It works out the cost of trade credit is 50% if it pays on the net day. If the
company’s short term cost of funds is 18% then the company should pay:
A. on the net day.
B. on the day or purchase.
C. on the last day of the discount period
D. just after the discount period has ended.

The discount offers a higher return for the company compared to its borrowing rate so it should take
advantage of the discount offered and pay on the last day of the discount period. Losing the discount is
more costly than delaying payment to the net day.

3. Which of the following is least likely to be a pull on liquidity for a company?
A. paying vendors early.
B. low liquidity positions.
C. uncollected receivables.
D. limited short‐term lines of credit.

4. A company is offered two projects with the net cash flows, in $ million, from each project as
shown below. The cost of project A is $2 million and the cost of project B is $10 million. The cost of
capital for project A is 10% and for project B is 12%. Which of the projects should be accepted for
inclusion in the capital budget?
End of year Project A Project B

1 1.1 2.0
2 0.8 4.0
3 0.4 7.0
A. Both projects should be rejected.
B. Both projects should be accepted.
C. A should be accepted and B rejected.
D. B should be accepted and A rejected.

3. Which of the following is least likely to be a pull on liquidity for a company?
A. paying vendors early.
B. low liquidity positions.
C. uncollected receivables.
D. limited short-term lines of credit.
A pull on liquidity refers to payments that are made too early or when credit availability is limited forcing
the company to pay out funds before they receive money from sales or other sources. Uncollected
receivables or not a pull, but a drag, on liquidity.

4. A company is offered two projects with the net cash flows, in $ million, from each project as
shown below. The cost of project A is $2 million and the cost of project B is $10 million. The cost of
capital for project A is 10% and for project B is 12%. Which of the projects should be accepted for
inclusion in the capital budget?
End of year Project A Project B

1 1.1 2.0
2 0.8 4.0
3 0.4 7.0
A. Both projects should be rejected.
B. Both projects should be accepted.
C. A should be accepted and B rejected.
D. B should be accepted and A rejected.

The present value of the cash flows for project A, discounted at 10%, is $1.96 million (1.00 + 0.66 + 0.30)
which is less than the cost, therefore the project should be rejected.
The present value of the cash flows for project B, discounted at 12%, is $9.96 million (1.79 + 3.19 + 4.98)
which is less than the cost; therefore the project should be rejected.

5. To enable a board to act in the best long‐term interests of shareowners, it is least appropriate it
possesses:
A. resources.
B. independence.
C. political affiliation.
D. experience and expertise.

6. North Company has a common stock price of $72. The latest reported earnings per share were
$4.80 and dividends per share were $1.60. The return on equity is 8%. The cost of equity is closest to:
A. 5.33%.
B. 7.46%.
C. 7.55%.
D. 7.67%.

5. To enable a board to act in the best long‐term interests of shareowners, it is least appropriate it
possesses:
A. resources.
B. independence.
C. political affiliation.
D. experience and expertise.

The major factors that enable a board to act in the best long-term interests of shareowners are
independence, experience and expertise, and the resources to support the independent work. Political
affiliation may work in the short term but may well be detrimental in the long term.

6. North Company has a common stock price of $72. The latest reported earnings per share were
$4.80 and dividends per share were $1.60. The return on equity is 8%. The cost of equity is closest to:
A. 5.33%.
B. 7.46%.
C. 7.55%.
D. 7.67%.

The growth rate is the earnings retention rate multiplied by the ROE, this is 5.33%.
Next year’s dividends will be $1.60 x 1.0533 = $1.685
D1 $1.685
ke = +g= + 5.33% = 7.67%
P $72

7. A firm is looking at borrowing for two months and could issue $500,000 nominal of commercial
paper at 7.5%. Dealer’s commission would be 0.25% and backup line costs would be 0.3% based on
the $500,000 issued. The cost of borrowing is closest to:
A. 7.50%
B. 7.85%
C. 8.05%.
D. 8.15%

8 The case that the board chair also holds the title of chief executive, from the corporate governance
point of view, is:
A. unacceptable because it is universally prohibited in all jurisdictions.
B. acceptable, because combining the two positions will save costs and hence enhance
shareholder value.
C. acceptable, because the effectiveness of the chief executive would be enhanced by his or
her position as the chairperson of the board.
D. unacceptable because combining the two positions may reduce the ability and
willingness of independent board members to exercise their independent judgment.

7. A firm is looking at borrowing for two months and could issue $500,000 nominal of commercial
paper at 7.5%. Dealer’s commission would be 0.25% and backup line costs would be 0.3% based on
the $500,000 issued. The cost of borrowing is closest to:
A. 7.50%
B. 7.85%
C. 8.05%.
D. 8.15%
cost = (interest + dealer’s commission + back-up costs)/net proceeds x 12
= [(0.075 + 0.0025 + 0.003) x $500,000 x 2/12] x 6 = 0.0805/0.9875 = 8.15%
$500,000 – (0.075 x $500,000 x 2/12)

8 The case that the board chair also holds the title of chief executive, from the corporate governance
point of view, is:
A. unacceptable because it is universally prohibited in all jurisdictions.
B. acceptable, because combining the two positions will save costs and hence enhance shareholder
value.
C. acceptable, because the effectiveness of the chief executive would be enhanced by his or her
position as the chairperson of the board.
D. unacceptable because combining the two positions may reduce the ability and willingness of
independent board members to exercise their independent judgment.

Choice A is incorrect because there are some jurisdictions that allow the combining of the two positions.
Choice B is incorrect, because the saving in cost is not the main issue from the corporate governance point
of view.
Choice C is incorrect because it is not the effectiveness of the chief executive that is being questioned.
The main issue is whether the board’s independence would be compromised.

9 Which of the following ratios would be useful in evaluating a company’s internal liquidity?
A. Quick ratio.
B. Equity turnover.
C. Interest coverage.
D. Debt to equity ratio.

10 Which of the following statements is most accurate concerning the different methods for
evaluating projects?
A. The IRR method can give multiple answers if there are nonconventional cash flows.
B. If the profitability index is positive it indicates that a project should be accepted.
C. The IRR method is preferred since it assumes reinvestment at the project’s cost of capital.
D. The average accounting rate of return is attractive because it does not need a present
value calculation.

9 Which of the following ratios would be useful in evaluating a company’s internal liquidity?
A. Quick ratio.
B. Equity turnover.
C. Interest coverage.
D. Debt to equity ratio.
Quick ratio = cash + marketable securities + receivables
current liabilities
The ratio measures the current assets that can be quickly liquidated to meet current liabilities.

10 Which of the following statements is most accurate concerning the different methods for
evaluating projects?
A. The IRR method can give multiple answers if there are nonconventional cash flows.
B. If the profitability index is positive it indicates that a project should be accepted.
C. The IRR method is preferred since it assumes reinvestment at the project’s cost of capital.
D. The average accounting rate of return is attractive because it does not need a present value
calculation.
When a project has nonconventional cash flows (such as more than one cash inflow over the project’s life)
the IRR method can give more than one solution, or multiple IRRs. A profitability index of over 1 means a
project should be accepted, the IRR method discounts back at the IRR, andthe lack of adjustment for time
value of money is a disadvantage of the AAR method.

11. The following financial information is given for a company:
Net profit margin = 4%
Operating profit margin = 16%
Equity turnover = 3.2
Total asset turnover = 2.5
The return on equity is closest to:

A. 10.0%.
B. 12.8%.
C. 51.2%.
D. there is insufficient information given to calculate the return on equity.

12. In order to secure short‐term funding a company factors its accounts receivable. This means that:
A. receivables are being used as collateral for a loan.
B. it pays over any receivables collected to the factor in return for short‐term funding.
C. sells the receivables to the factor who takes responsibility for collecting the receivables.
D. it takes out protection from the factor against its customers defaulting on payment of
money owed.

11. The following financial information is given for a company:
Net profit margin = 4%
Operating profit margin = 16%
Equity turnover = 3.2
Total asset turnover = 2.5
The return on equity is closest to:
A. 10.0%.
B. 12.8%.
C. 51.2%.
D. there is insufficient information given to calculate the return on equity.
return on equity = net profit margin x sales turnover x financial leverage
= net profit margin x equity turnover
= 0.04 x 3.2
= 12.8%

12. In order to secure short‐term funding a company factors its accounts receivable. This means that:
A. receivables are being used as collateral for a loan.
B. it pays over any receivables collected to the factor in return for short-term funding.
C. sells the receivables to the factor who takes responsibility for collecting the receivables.
D. it takes out protection from the factor against its customers defaulting on payment of money owed.
When a company factors its accounts receivables it sells its receivables to the factor and transfers credit
granting and collection to the factor. This is different to when receivables are used as collateral for a loan
which is an assignment of the accounts receivable.

13. In proforma analysis which of the following items is usually considered to be a fixed rather than
a sales‐driven burden?
A. tax rate.
B. depreciation.
C. selling expenses.
D. employees’ salaries.

14. Which one of the following is least likely to be considered good corporate governance of a listed
company?
A. The board members’ actions and decisions represent the best interests of shareowners.
B. Appropriate controls and procedures are in place covering management’s activities in
running the day‐to‐day operations of the company.
C. The board and its committees are structured to act independently from management and
other parties that might influence the management.
D. All shareowners have the same right to participate in the governance of the company,
with founding shareowners normally given the right to veto certain resolutions.

13. In proforma analysis which of the following items is usually considered to be a fixed rather than
a sales‐driven burden?
A. tax rate.
B. depreciation.
C. selling expenses.
D. employees’ salaries.

Income items with the exception of interest costs and tax are usually assumed to grow in line with sales.
Unless there is a change in government tax rates the tax rate is assumed to be constant.

14. Which one of the following is least likely to be considered good corporate governance of a listed
company?
A. The board members’ actions and decisions represent the best interests of shareowners.
B. Appropriate controls and procedures are in place covering management’s activities in running the
day-to-day operations of the company.
C. The board and its committees are structured to act independently from management and other
parties that might influence the management.
D. All shareowners have the same right to participate in the governance of the company, with
founding shareowners normally given the right to veto certain resolutions.
In a listed company, all shareowners should have equal rights to participate in the governance of the
company. Differentiating between economic and voting rights should be avoided.

15. Islington Corporation provides you with the following information:
Income Statement Balance Sheet
Sales on credit 298 Cash 50 Accounts Payable 80
COGS (200) Accounts 60 Accrued Expenses 65

Receivable
Gross Profit 98 Inventory 100 Long‐term Debt 150
SGA Expenses (60) Property, P & E 375
Op. Profit 38 Depreciation (85) Common Stock 140
Interest expense (6) Retained Earnings 65
Tax (13)
Net Income 19 Total Assets 500 Total Liabilities & 500

Equity

The average receivables collection period for Islington Corporation is closest to:
A. 1.4 days.
B. 5.0 days.
C. 73.5 days.
D. 109.5 days.


Receivable
Tax (13)

Equity
The average receivables collection period for Islington Corporation is closest to:
A. 1.4 days.
B. 5.0 days.
C. 73.5 days.
D. 109.5 days.
Correct Answer: C .........................................................................................LOS: Reading 46‐a
Receivables turnover = credit sales/average receivables
= 298/60
= 4.966
Average receivables collection period = 365/receivables turnover
= 73.5 days

16. A company provides the following information
Credit sales $125 million
Cost of goods sold $80 million
Accounts receivable $15 million
Beginning Inventory $16 million
Ending Inventory $22 million
Accounts payable $13 million

The operating cycle and net operating cycle are closest to:
Operating cycle Net operating cycle
A. 108.2 48.9
B. 108.2 53.1
C. 144.2 84.9
D. 144.2 89.0

16. A company provides the following information
Credit sales $125 million
Cost of goods sold $80 million
Accounts receivable $15 million
Beginning Inventory $16 million
Ending Inventory $22 million
Accounts payable $13 million
The operating cycle and net operating cycle are closest to:
Operating cycle Net operating cycle
A. 108.2 48.9
B. 108.2 53.1
C. 144.2 84.9
D. 144.2 89.0
Operating cycle
= number of days of receivables + number of days of inventory
= (15/125) x 365 + (22/80) x 365 = 43.8 + 100.38 = 144.18 days
Net operating cycle or cash conversion cycle
= number of days of receivables + number of days of inventory – number of days of payables
To calculate number of days of payables, we need to calculate purchases
= $80 million + ( $22 - $16) million = $86 million
= 144.18 days - (13/86) x 365 = 144.18 – 55.18 = 89.00 days


Receivable
Tax (13)

Equity
A. 0.34.
B. 0.63.
C. 0.76.
D. 1.45.


Receivable
Tax (13)

Equity
A. 0.34.
B. 0.63.
C. 0.76.
D. 1.45.
Quick ratio = (cash + marketable securities + receivables)/current liabilities
= (50 + 60)/145
= 0.76

Income Statement 2007 Balance Sheet end 2007
Credit Sales 1050 Cash 90 Accounts Payable 50
COGS (780) Accounts Receivable 170 Notes payable 125
Gross Profit 270 Inventory 200 Long term debt 300
SGA exp. (150) Property, P & E 650
Interest exp. (45) Retained Earnings 55
Tax (25)
Equity
Dividends Paid 12
Inventory level unchanged from 2006 levels.
National Telecoms Corporation’s net operating cycle in 2007 is closest to:
A. 58 days.
B. 130 days.
C. 153 days.
D. 176 days.

Income Statement 2007 Balance Sheet end 2007
Credit Sales 1050 Cash 90 Accounts Payable 50
COGS (780) Accounts Receivable 170 Notes payable 125
Gross Profit 270 Inventory 200 Long term debt 300
SGA exp. (150) Property, P & E 650
Interest exp. (45) Retained Earnings 55
Tax (25)
Equity
Dividends Paid 12
Inventory level unchanged from 2006 levels.
National Telecoms Corporation’s net operating cycle in 2007 is closest to:
A. 58 days.
B. 130 days.
C. 153 days.
D. 176 days.

number of days of receivables = 365/annual receivables turnover =365/(1050/170) = 59 days
number of days of inventory = 365/inventory turnover = 365/(780/200) = 94 days
= number of days of receivables + number of days of inventory = 153 days

Income Statement
$ million
Credit Sales 1050
COGS (780)
Gross Profit 270
SGA exp. (150)
Op. Profit 120
Interest exp. (45)
Tax (25)
Net Income 50
It is assumed that sales and related costs are growing at 5%per annum and there is no change in
capital structure, then National Telecom Corporation’s proforma net income in 2008 is closest to:
A. $ 51.25 million.
B. $ 52.50 million.
C. $ 54.00 million.
D. $ 56.00 million.

Income Statement
$ million
Credit Sales 1050
COGS (780)
Gross Profit 270
SGA exp. (150)
Op. Profit 120
Interest exp. (45)
Tax (25)
Net Income 50
It is assumed that sales and related costs are growing at 5%per annum and there is no change in capital
structure, then National Telecom Corporation’s proforma net income in 2008 is closest to:
A. $ 51.25 million.
B. $ 52.50 million.
C. $ 54.00 million.
D. $ 56.00 million.

Operating profit will grow at 5% to $126 million, interest expense is assumed constant at $45 million and
the tax ate is 33.33% so tax will be $81 million x 33.33% = $27 million, so profoma net income will be $54
million.

20. The cost of a project is $150 million and the following cash flows are anticipated, the cost of
capital is 10%.
Year Net Cash Flow
($ million)
0 ‐150
1 25
2 50
3 55
4 40
5 60
Total

The implied decision to accept or reject the project, and the Profitability Index (PI) is closest to:
Accept/reject PI
A. Reject 0.13
B. Reject 0.53
C. Accept 1.13
D. Accept 1.70

20. The cost of a project is $150 million and the following cash flows are anticipated, the cost of
capital is 10%.
Year Net Cash Flow ($ million)
0 ‐150
1 25
2 50
3 55
4 40
5 60
Total
The implied decision to accept or reject the project, and the Profitability Index (PI) is closest to:
Accept/reject PI
A. Reject 0.13
B. Reject 0.53
C. Accept 1.13
D. Accept 1.70

First of all calculate the present values of the cash flows:

Year Net Cash Flow Discounted Net Cash Flow

($ million) ($ million)
0 ‐150 ‐150.0
1 25 22.7
2 50 41.3
3 55 41.3
4 40 27.3
5 60 37.3
Total 19.9

21. The cost of a project is $150 million and it will be depreciated using the straight line method over
5 years with a zero salvage value. The following net income is anticipated.
Year Net Income
($ million)
1 4
2 20
3 22
4 20
5 – 5

The average accounting rate of return (AAR) of the project is closest to
A. 4.1%
B. 8.1%
C. 12.2%
D. 16.3%

22. A company prohibits itself from offering shares at discounted prices to management, board
members and other insiders prior to a public offering of its securities. This practice is:
A. preferred by the tax office because it avoids imputation of income taxes for the
executives.
B. preferred by investors because it demonstrates that the company aligns itself with the
investors’ interests.
C. not preferred by the capital markets regulatory body because it might encourage an
opportunity for insiders’ trading.
D. not preferred from a corporate governance point of view because it might encourage the
executives to give compensation to themselves from short‐term share transactions.

21 The cost of a project is $150 million and it will be depreciated using the straight line method over
5 years with a zero salvage value. The following net income is anticipated.
Year Net Income
($ million)
1 4
2 20
3 22
4 20
5 – 5
The average accounting rate of return (AAR) of the project is closest to

A. 4.1%
B. 8.1%
C. 12.2%
D. 16.3%

Average book value is ($150 million + $0million)/2 = $75 million
Average net income is $(4 + 20 + 22 + 20 – 5)million/5 = $12.2 million
AAR = Average net income = $12.2 million
Average book value $75 million
= 16.3%

22. A company prohibits itself from offering shares at discounted prices to management, board
members and other insiders prior to a public offering of its securities. This practice is:
A. preferred by the tax office because it avoids imputation of income taxes for the executives.
B. preferred by investors because it demonstrates that the company aligns itself with the investors’
interests.
C. not preferred by the capital markets regulatory body because it might encourage an opportunity for
insiders’ trading.
D. not preferred from a corporate governance point of view because it might encourage the executives
to give compensation to themselves from short-term share transactions.
Correct Answer: B .......................................................................................... LOS: Reading 48‐g

This is a preferred practice from a corporate governance point of view, which indicates it is beneficial for
the long-term interests of the investors.

Study Session 12: Portfolio Management:

As the first discussion within the CFA curriculum on portfolio management, this study session
provides the critical framework and context for subsequent Level I study sessions covering equities,
fixed income, derivatives, and alternative investments. Furthermore, this study session provides the
underlying theories and tools for portfolio management at Levels II and III.
The first reading discusses the asset allocation decision and the portfolio management process—they
are an integrated set of steps undertaken in a consistent manner to create and maintain an
appropriate portfolio (combination of assets) to meet clients’ stated goals. The last two readings focus
on the design of a portfolio and introduces the capital asset pricing model (CAPM), a centerpiece of
modern financial economics that relates the risk of an asset to its expected return.
Reading 49: The Asset Allocation Decision
Reading 50: An Introduction to Portfolio Management
Reading 51: An Introduction to Asset Pricing Models

Portfolio Management 331
1. The asset allocation of investors between equities and fixed income in the major international
capital markets is:
A. very similar, since investors are using the same optimization models.
B. quite different, since investors are making decisions in different economic and social
environments.
C. very similar, since asset allocation is the most important step in portfolio construction in
all major markets.
D. very similar, since long term equity and fixed income returns have been consistent across
different markets.

2. The beta of an asset:
A. lies between ‐1 and 1.
B. is a measure of unsystematic risk.
C. is 1 if the asset is the market portfolio.
D. is the covariance of the asset with the market.

1. The asset allocation of investors between equities and fixed income in the major international
capital markets is:
A. very similar, since investors are using the same optimization models.
B. quite different, since investors are making decisions in different economic and social environments.
C. very similar, since asset allocation is the most important step in portfolio construction in all major
markets.
D. very similar, since long term equity and fixed income returns have been consistent across different
markets.
The different social and economic environments, in addition to political and tax issues, have led to
different weightings in equities and fixed income in portfolios in different countries.

2. The beta of an asset:
A. lies between -1 and 1.
B. is a measure of unsystematic risk.
C. is 1 if the asset is the market portfolio.
D. is the covariance of the asset with the market.

A. is not correct since beta does not lie in any fixed range.
B. is not correct, it is a measure of systematic risk.
D. is not correct because beta is the covariance divided by the variance of the market.
By definition the beta of the market itself is one.

3. Which of the following is least likely to be a step in the investment process?
A. Asset allocation.
B. Monitoring the portfolio.
C. Forecasting market returns.
D. Submitting regulatory reports to the appropriate authority.

4. The stock analyst in your firm recommends that you buy shares in Mayfair Corp. The current
share price is $26 and she forecasts that a year from now the share price will have risen to $30. There
is no dividend payment expected. You note that the beta of the stock is 0.8, the expected market
return over the next year is 15% and the risk‐free rate is 5%. On the basis of the analyst’s forecast,
Mayfair Corp.’s stock is:
A. overvalued.
B. undervalued.
C. correctly valued.
D. the question needs to provide data on the market risk premium to be able to decide
whether the stock is fairly valued.

3. Which of the following is least likely to be a step in the investment process?
A. Asset allocation.
B. Monitoring the portfolio.
C. Forecasting market returns.
D. Submitting regulatory reports to the appropriate authority.
The portfolio management process consists of 4 steps: construct the policy statement, forecast future
economic and market trends, construct the portfolio and continually monitor and evaluate performance.
Submitting regulatory reports is not part of the investment decision-making process so D is the best
answer.

4. The stock analyst in your firm recommends that you buy shares in Mayfair Corp. The current
share price is $26 and she forecasts that a year from now the share price will have risen to $30. There
is no dividend payment expected. You note that the beta of the stock is 0.8, the expected market
return over the next year is 15% and the risk‐free rate is 5%. On the basis of the analyst’s forecast,
Mayfair Corp.’s stock is:
A. overvalued.
B. undervalued.
C. correctly valued.
D. the question needs to provide data on the market risk premium to be able to decide whether the
stock is fairly valued.
Using CAPM the estimated return is:
R x = R f + β[E(R m ) − R f ] = 5% + 0.8(15% − 5% ) = 13%
The analyst is forecasting a return of 15.4% so the stock looks undervalued.

5. If a stock lies above the security market line (SML) this would indicate that the stock:
A. is overvalued.
B. is undervalued.
C. has a higher expected return than the market.
D. has a lower expected return than the market.

6. The characteristic line is used to estimate:
A. the risk‐free rate.
B. the beta of a stock.
C. the risk aversion of an investor.
D. the standard deviation of a portfolio.

5. If a stock lies above the security market line (SML) this would indicate that the stock:
A. is overvalued.
B. is undervalued.
C. has a higher expected return than the market.
D. has a lower expected return than the market.
The stock is undervalued because the expected rate of return is higher than the required rate of return to
compensate for its beta risk.

6. The characteristic line is used to estimate:
A. the risk-free rate.
B. the beta of a stock.
C. the risk aversion of an investor.
D. the standard deviation of a portfolio.

The characteristic line is the regression line of best fit through a scatter diagram of points representing a
stock’s return against the market return; the slope gives the stock beta.

7. A portfolio is 70% invested in an index fund and 30% in a risk‐free asset. The index fund has a
variance of returns of 0.0027, the variance for the total portfolio is closest to:
A. 0.0013.
B. 0.0019.
C. 0.0027.
D. 0.0039.

8. In capital market theory the Market Portfolio can be least accurately described as:
A. the portfolio where systematic risk has been completely diversified away.
B. it is the point where the Capital Market Line touches the efficient frontier.
C. the portfolio which contains all risky assets in proportion to their market value.
D. the point where the tangent from the risk‐free rate touches the efficient frontier.

7. A portfolio is 70% invested in an index fund and 30% in a risk‐free asset. The index fund has a
variance of returns of 0.0027, the variance for the total portfolio is closest to:
A. 0.0013.
B. 0.0019.
C. 0.0027.
D. 0.0039.
The variance and standard deviation of the risk-free asset are zero. Therefore the variance of the portfolio
is:
σ 2port = w 12 σ12 + w 22 σ 22 + 2r12 w 1 w 2 σ1σ 2
= (0.7 ) 0.0027
2
= 0.0013

8. In capital market theory the Market Portfolio can be least accurately described as:
A. the portfolio where systematic risk has been completely diversified away.
B. it is the point where the Capital Market Line touches the efficient frontier.
C. the portfolio which contains all risky assets in proportion to their market value.
D. the point where the tangent from the risk-free rate touches the efficient frontier.

A is not correct – it is the unsystematic risk that can be diversified away.

9. If an investor has steep utility curves it is likely to indicates that:
A. the investor is aggressive.
B. the investor is conservative.
C. the investor has a long time horizon.
D. the investor has a short time horizon.

10. A U.S. based investment manager is concerned that the volatility of an international equity fund
he is managing is too high. Which of the following would be an appropriate course of action?
A. Increase the weighting in high beta stocks.
B. Sell the international holdings and only hold U.S. stocks.
C. Consider investing in markets which have a low correlation with the existing assets in
the portfolio.
D. Sell small capitalization stocks and concentrate the portfolio in a small number of big
market capitalization stocks.

9. If an investor has steep utility curves it is likely to indicates that:
A. the investor is aggressive.
B. the investor is conservative.
C. the investor has a long time horizon.
D. the investor has a short time horizon.
A steep utility curve shows that the investor needs to be compensated for taking a small amount of
additional risk by receiving a significantly higher return, indicating he is conservative with a low appetite
for risk.

10. A U.S. based investment manager is concerned that the volatility of an international equity fund
he is managing is too high. Which of the following would be an appropriate course of action?
A. Increase the weighting in high beta stocks.
B. Sell the international holdings and only hold U.S. stocks.
C. Consider investing in markets which have a low correlation with the existing assets in the
portfolio.
D. Sell small capitalization stocks and concentrate the portfolio in a small number of big market
capitalization stocks.
Correct Answer: C .......................................................................................... LOS: Reading 50‐f

In order to reduce volatility, which is the standard deviation of returns, the manager could include assets
which have a low correlation with the existing assets in the portfolio.

11. Which of the following is a least accurate description of an assumption of Capital Market Theory?
A. Capital markets are in equilibrium.
B. All investors have the same time horizon.
C. Investors can borrow or lend at the risk‐free rate.
D. Investors are not able to correctly anticipate inflation.

12. The correlation coefficient between the returns of two assets is 0.6 and the standard deviations of
returns of the two assets are 7% and 12%. The covariance of returns is closest to:
A. 14.0.
B. 50.4.
C. 71.4.
D. 140.0.

11. Which of the following is a least accurate description of an assumption of Capital Market Theory?
A. Capital markets are in equilibrium.
B. All investors have the same time horizon.
C. Investors can borrow or lend at the risk-free rate.
D. Investors are not able to correctly anticipate inflation.
Capital Market Theory makes the assumption that there is no inflation or change in interest rates, or any
inflation is fully anticipated.

12. The correlation coefficient between the returns of two assets is 0.6 and the standard deviations of
returns of the two assets are 7% and 12%. The covariance of returns is closest to:
A. 14.0.
B. 50.4.
C. 71.4.
D. 140.0.
cov ariance xy
rxy =
σxσy
cov ariance = 0.6 × 7 × 12 = 50.4
where:
rxy = correlation between the returns of x and y
σx = standard deviation of returns of x
σy
= standard deviation of returns of y

13. The efficient frontier represents portfolios that:
A. offer the highest return for a given level of total risk.
B. offer the highest return for a given level of systematic risk.
C. are equally attractive to an investor with a specified level of total risk tolerance.
D. are equally attractive to an investor with a specified level of systematic risk tolerance.
14. The following data is provided on the expected return of an asset under different scenarios:
Probability Return
0.20 12%
0.60 15%
0.20 18%
The standard deviation of the returns is closest to:
A. 1.2%.
B. 1.9%.
C. 2.3%.
D. 3.6%.

13. The efficient frontier represents portfolios that:
A. offer the highest return for a given level of total risk.
B. offer the highest return for a given level of systematic risk.
C. are equally attractive to an investor with a specified level of total risk tolerance.
D. are equally attractive to an investor with a specified level of systematic risk tolerance.

The efficient frontier represents the portfolios which offer the highest return for any given level of risk so A
is correct.

14. The following data is provided on the expected return of an asset under different scenarios:
Probability Return
0.20 12%
0.60 15%
0.20 18%
The standard deviation of the returns is closest to:
A. 1.2%.
B. 1.9%.
C. 2.3%.
D. 3.6%.

The expected return is (0.20 x 12%) + (0.60 x 15%) + (0.20 x 18%) = 15%.
The standard deviation is given by , where
σ 2 = 0.2(0.12 − 0.15) + 0.2(0.18 − 0.15) = 0.00036

2 2
σ = 0.01897 or 1.9%

15. The expected return from a market is 12% and the risk‐free rate is 5% and a stock has a beta of
0.5. The required rate of return from the stock is:
A. 6.0%.
B. 8.5%.
C. 11.0%.
D. 14.5%.

16. The beta of a stock can be computed from the:
A. relative volatility of the stock returns to the market returns.
B. correlation of the stock with the market and the market return.
C. correlation of the stock with the market and the variance of the stock returns.
D. covariance of the stock with the market and the variance of the market returns.

15. The expected return from a market is 12% and the risk‐free rate is 5% and a stock has a beta of
0.5. The required rate of return from the stock is:
A. 6.0%.
B. 8.5%.
C. 11.0%.
D. 14.5%.

Using CAPM we can calculate the required return from the stock:
R x = R f + β[E(R m ) − R f ] = 5% + 0.5(12% − 5% ) = 8.5% .

where:
Rf = the risk-free rate
RM = market return
i = beta of stock

16. The beta of a stock can be computed from the:
A. relative volatility of the stock returns to the market returns.
B. correlation of the stock with the market and the market return.
C. correlation of the stock with the market and the variance of the stock returns.
D. covariance of the stock with the market and the variance of the market returns.

The beta of an asset is the covariance of the assets returns with market returns divided by the variance of
the market returns.
Reference: CFA® Program Curriculum, Volume 4, pp. 267 ‐221.

17. In a rapidly rising market, a stock with a beta of 0.5 is expected, relative to the market
performance, to:
Performance Direction
A. outperform Same
B. outperform Opposite
C. underperform Same
D. underperform Opposite

18. The characteristic line:
A. is a regression line used to estimate a stock’s systematic risk.
B. is a regression line used to estimate a stock’s standard deviation.
C. indicates the required rate of return of a stock given its systematic risk.
D. indicates the required rate of return of a stock given its standard deviation.

17. In a rapidly rising market, a stock with a beta of 0.5 is expected, relative to the market
performance, to:
Performance Direction
A. outperform Same
B. outperform Opposite
C. underperform Same
D. underperform Opposite

A low beta means the stock will move by less than the market if the market moves upwards by more than
the risk-free rate. The positive beta means it will move in the same direction as the market.

18. The characteristic line:
A. is a regression line used to estimate a stock’s systematic risk.
B. is a regression line used to estimate a stock’s standard deviation.
C. indicates the required rate of return of a stock given its systematic risk.
D. indicates the required rate of return of a stock given its standard deviation.

Systematic risk is often calculated by using regression analysis to examine the return of an asset against
the return of the market. The slope of the line is the beta which measures systematic risk.

19. An investor policy statement is important because it:
A. clarifies the investors’ objectives.
B. provides the investor with the portfolio manager’s market outlook.
C. provides details on the stocks that will be purchased for the portfolio.
D. means that the investor takes responsibility for investment performance.

20. The optimal portfolio for an investor is represented by the point where the:
A. investor utility curves intersect each other.
B. security market line is tangent to the efficient frontier.
C. investor utility curve is tangent to the efficient frontier.
D. investor utility curve is tangent to the security market line.

19. An investor policy statement is important because it:
A. clarifies the investors’ objectives.
B. provides the investor with the portfolio manager’s market outlook.
C. provides details on the stocks that will be purchased for the portfolio.
D. means that the investor takes responsibility for investment performance.

A policy statement helps the investor specify realistic goals and in setting the goals become more aware of
the risks of investing. It is a valuable way of communicating with the portfolio manager. It also helps set
the benchmark against which performance can be measured.

20. The optimal portfolio for an investor is represented by the point where the:
A. investor utility curves intersect each other.
B. security market line is tangent to the efficient frontier.
C. investor utility curve is tangent to the efficient frontier.
D. investor utility curve is tangent to the security market line.
The utility curves represent the trade-off between risk and return. The optimal portfolio will be where the
highest utility curve touches the efficient frontier.

21. A portfolio is invested equally between two assets, the assets have standard deviations of 4% and
8%, and the correlation between the two assets is 0.3. The standard deviation of the combined
portfolio is closest to:

A. 4.98%.
B. 6.00%.
C. 6.64%.
D. 24.80%.

22. Two assets have zero correlation. If a portfolio is invested with 30% in the first asset that has a
variance of 12, and 70% in the second asset that has a variance of 8, the variance of the combined

A. 2.2.
B. 5.0.
C. 6.7.
D. 9.2.

21. A portfolio is invested equally between two assets, the assets have standard deviations of 4% and
8%, and the correlation between the two assets is 0.3. The standard deviation of the combined
A. 4.98%.
B. 6.00%.
C. 6.64%.
D. 24.80%.
σ 2port = w 12 σ12 + w 22 σ 22 + 2r12 w 1 w 2 σ1σ 2

= (0.5) (0.04 ) + (0.5) (0.08) + 2(0.3)(0.5)(0.04 )(0.5)(0.08)
2 2 2 2
= 0.0004 + 0.0016 + 0.00048

= 0.00248
σ = 0.0498
where:
σi = standard deviation of returns of asset i
σj
= standard deviation of returns of asset j
wi = weighting of asset i in the portfolio
rij = correlation between the returns of assets i and j

22. Two assets have zero correlation. If a portfolio is invested with 30% in the first asset that has a
variance of 12, and 70% in the second asset that has a variance of 8, the variance of the combined
A. 2.2.
B. 5.0.
C. 6.7.
D. 9.2.
Correct Answer: B .......................................................................................... LOS: Reading 50‐c

Variance is given by:
σ 2port = w 12 σ12 + w 22 σ 22 + 2r12 w 1 w 2 σ1σ 2

= (0.3) 12 + (0.7 ) 8
2 2
= 1.08 + 3.92
=5
where:
σi = standard deviation of returns of asset i
wi = weighting of asset i in the portfolio
rij = correlation between the returns of assets i and j

Study Session 13: Equity Investments:

Securities Markets

This study session addresses how securities are bought and sold and what constitutes a well‐
functioning securities market. The reading on market indexes gives an understanding of how indexes
are constructed and calculated and the biases inherent in each of the weighting schemes used.
Some of the most interesting and important work in the investment field during the past several
decades revolves around the efficient market hypothesis (EMH) and its implications for active versus
passive equity portfolio management. The readings on this subject provide an understanding of the
EMH and the seemingly persistent anomalies to the theory, an understanding that is necessary to
judge the value of fundamental or technical security analysis.
Reading 52: Organization and Functioning of Securities Markets
Reading 53: Security‐Market Indexes
Reading 54: Efficient Capital Markets
Reading 55: Market Efficiency and Anomalies

Equity Investments: Securities Markets 355
1. A corporation looking to raise funds may decide to do a private placement because:
A. it will reduce issuing costs.
B. it will avoid using an investment bank.
C. it will provide greater liquidity in the secondary market.
D. the issue can be sold at a higher price than if it was sold in a public offering.

2. When a stock in the Dow Jones Industrial Average has a stock split this will lead to:
A. the divisor increasing.
B. the divisor decreasing.
C. there being no change in the divisor.
D. the divisor increasing if the stock is a high‐priced stock and falling if it is a low‐priced
stock.

1. A corporation looking to raise funds may decide to do a private placement because:
A. it will reduce issuing costs.
B. it will avoid using an investment bank.
C. it will provide greater liquidity in the secondary market.
D. the issue can be sold at a higher price than if it was sold in a public offering.

A private placement will have lower issue costs, mainly since the requirement for lengthy registration
documentation is reduced. However the pricing will be lower than for a public offer since the purchasers
will need to be compensated for the lack of liquidity in the secondary market.

2. When a stock in the Dow Jones Industrial Average has a stock split this will lead to:
A. the divisor increasing.
B. the divisor decreasing.
C. there being no change in the divisor.
D. the divisor increasing if the stock is a high-priced stock and falling if it is a low-priced stock.
When there is a stock split the stock price will fall, there is no immediate impact on the index so the
divisor must also decrease.

3. A short seller of a stock will generally:
A. sell the stock when the price is falling.
B. benefit from a rise in price of the stock.
C. deposit collateral when he borrows stock.
D. benefit from the price fall when a stock goes ex‐dividend.

4. There are two stocks ABC and XYZ included in an unweighted index and the following data is
provided:

Stock Number of shares Price at end Price at end
ABC 10,000 $25.00 $30.00
XYZ 50,000 $35.00 $36.75

If the index is computed using geometric averages, the increase in the index over 2007 is closest
to:
A. 8.33%.
B. 11.25%.
C. 12.25%.
D. 12.50%.

3. A short seller of a stock will generally:
A. sell the stock when the price is falling.
B. benefit from a rise in price of the stock.
C. deposit collateral when he borrows stock.
D. benefit from the price fall when a stock goes ex-dividend.

A is not correct since he must sell on an uptick trade, B is not correct since he will benefit when the price
falls and he can buy back the stock at a cheaper price. D is not correct since he must pay the dividends to
the lender of the stock. Usually the lender of stock will require collateral as protection against the
borrower failing to return the stock.

4. There are two stocks ABC and XYZ included in an unweighted index and the following data is
provided:
Stock Number of shares Price at end Price at end

ABC 10,000 $25.00 $30.00
XYZ 50,000 $35.00 $36.75
If the index is computed using geometric averages, the increase in the index over 2007 is closest to:
A. 8.33%.
B. 11.25%.
C. 12.25%.
D. 12.50%.
An unweighted index is computed on the basis that an equal dollar amount is invested in each of stocks
ABC and XYZ. ABC rose by 20% and XYZ by 5% so the index performance is given by (1.20 x 1.05)1/2 – 1 =
0.1225 = 12.25%.

5. An investor calls a broker on the first day of the month to find out the price of ABC Inc.’s shares
and is quoted $103 bid – 103½ ask. The shares are very liquid. The share price then moves to $98 –
98½ before rising to $115 –115¾ at the end of the month. If the investor had (i) placed a market order
to buy the shares on the first day and then sold them on the last day (ii) a limit order to buy at $100
and sell at the end of the month, his profit before transaction costs would be closest to:
A. (i) 11.11% (ii) 15.00%.
B. (i) 11.11% (ii) 15.75%.
C. (i) 12.39% (ii) 15.00%.
D. (i) 12.39% (ii) 15.75%.

6. An informationally efficient market is one where:
A. information is available on a timely basis to all investors.
B. investors allocate their funds to the companies that can make the best use of them.
C. security prices adjust slowly to the arrival of new information giving investors time to
take advantage of positive news.
D. security prices adjust rapidly to the arrival of new information and therefore security
prices reflect all information about the security.

5. An investor calls a broker on the first day of the month to find out the price of ABC Inc.’s shares
and is quoted $103 bid – 103½ ask. The shares are very liquid. The share price then moves to $98 –
98½ before rising to $115 –115¾ at the end of the month. If the investor had (i) placed a market order
to buy the shares on the first day and then sold them on the last day (ii) a limit order to buy at $100
and sell at the end of the month, his profit before transaction costs would be closest to:
A. (i) 11.11% (ii) 15.00%.
B. (i) 11.11% (ii) 15.75%.
C. (i) 12.39% (ii) 15.00%.
D. (i) 12.39% (ii) 15.75%.
(i) If it is a market order he will pay the ask price to buy the shares, i.e. $103 ½ and he will sell at the bid
price of $115 making a profit of 11.11%. (ii) A limit order to buy at $100 will be executed and he will sell at
$115 giving a profit of 15%.

6. An informationally efficient market is one where:
A. information is available on a timely basis to all investors.
B. investors allocate their funds to the companies that can make the best use of them.
C. security prices adjust slowly to the arrival of new information giving investors time to take
advantage of positive news.
D. security prices adjust rapidly to the arrival of new information and therefore security prices reflect
all information about the security.
An informationally efficient market is one where security prices adjust very rapidly to the arrival of new
information.

7. Buying on margin means that:
A. if the margin requirement is 60%, the investor may borrow 60% of the cost of buying
shares, allowing him to leverage his transaction.
B. the returns from buying on margin will only be higher than paying in full for shares
when the share price moves significantly up or down.
C. if an investor has bought shares on margin and the share price rises he will have made a
more attractive return on his investment than if he had fully paid for the shares.
D. if an investor has bought shares on margin he will be required to keep a maintenance
margin with the broker; if the share price falls he will immediately receive a margin call.

8. A call market refers to:
A. a market where trades are done by open outcry.
B. a market which specializes in providing derivatives trading.
C. a market where it is attempted to match all the bids and asks at a specified time.
D. a market where all the trading is done by computer rather than on a trading floor.

7. Buying on margin means that:
A. if the margin requirement is 60%, the investor may borrow 60% of the cost of buying shares,
allowing him to leverage his transaction.
B. the returns from buying on margin will only be higher than paying in full for shares when the share
price moves significantly up or down.
C. if an investor has bought shares on margin and the share price rises he will have made a more
attractive return on his investment than if he had fully paid for the shares.
D. if an investor has bought shares on margin he will be required to keep a maintenance margin with
the broker; if the share price falls he will immediately receive a margin call.
A is not true since if the margin requirement is 60% the investor can only borrow 40%.
B is not true since if the share moves down the losses will be higher if the investor has bought on margin.
D is not true since if the maintenance margin is lower than the initial margin the investor will only receive
a margin call after the shares have fallen to a level where the proportion of equity to the total value of stock
is below the maintenance margin.
C is true due to the leverage effect.

8. A call market refers to:
A. a market where trades are done by open outcry.
B. a market which specializes in providing derivatives trading.
C. a market where it is attempted to match all the bids and asks at a specified time.
D. a market where all the trading is done by computer rather than on a trading floor.

In a call market all the bids and asks for a stock are collected and a stock price that will best match buyers
and sellers is decided.

9. Which of the following is least likely to be a member of a U.S. securities exchange?
A. A specialist.
B. A floor broker.
C. An underwriter.
D. A registered trader.

10. The quotations for the price of Brown and Co. are given by 3 dealers as shown below:

Bid Ask
Dealer 1 17 ¾ 18 ¼
Dealer 2 17 ½ 18
Dealer 3 17 ⅝ 18

If Dealer 3 has excess inventory of Brown and Co. stock, changing his quote to which of the
following would be the most effective in reducing his inventory?
A. 17 ⅝ ‐ 18.
B. 17 ⅝ ‐ 18 ¼.
C. 17 ¼ ‐ 18 ¼.
D. 17 ¼ ‐ 17 ¾.

9. Which of the following is least likely to be a member of a U.S. securities exchange?
A. A specialist.
B. A floor broker.
C. An underwriter.
D. A registered trader.
The four major categories of membership are:
1. Specialist.
2. Commission broker.
3. Floor broker.
4. Registered trader.

10. The quotations for the price of Brown and Co. are given by 3 dealers as shown below:
Bid Ask
Dealer 1 17 ¾ 18 ¼
Dealer 2 17 ½ 18
Dealer 3 17 ⅝ 18
If Dealer 3 has excess inventory of Brown and Co. stock, changing his quote to which of the following
would be the most effective in reducing his inventory?
A. 17 - 18.
B. 17 - 18 ¼.
C. 17 ¼ - 18 ¼.
D. 17 ¼ - 17 ¾.
Moving the ask price lower than the other dealers will mean the dealer is able to sell stock, and moving the
bid price lower will mean he is unlikely to have to buy stock, until the other dealers move their prices.

11. When investors prefer to read research that agrees with their own views, rather than read a
contrary opinion, this is referred to in behavioral finance as:
A. escalation bias.
B. prospect theory.
C. overconfidence.
D. confirmation bias.

12. A call market is one in which:
A. short selling is not permitted.
B. dealers are making markets in stocks.
C. stock prices are determined by auction.
D. individual stocks are traded at specified times.

11. When investors prefer to read research that agrees with their own views, rather than read a
contrary opinion, this is referred to in behavioral finance as:
A. escalation bias.
B. prospect theory.
C. overconfidence.
D. confirmation bias.

Research shows that investors seek out information that confirms their own views, this is called
confirmation bias.

12. A call market is one in which:
A. short selling is not permitted.
B. dealers are making markets in stocks.
C. stock prices are determined by auction.
D. individual stocks are traded at specified times.

B and C are types of continuous market. Short selling may or may not be permitted in a call market.
In a call market the exchange usually sets the price and all trades are executed at a specified time at this
price.

13. A pricing anomaly is best described as:
A. a price move that reflects a factor that is specific to the individual stock.
B. a predictable deviation between expected and actual returns for a stock.
C. out or underperformance of a stock against the market average performance.
D. a short‐term random movement in a stock prices giving an opportunity to make a profit.

14. If a market is perfectly efficient and a portfolio manager does not have superior analysts then the
portfolio manager should:
A. only hold cash.
B. select a portfolio of securities at random.
C. increase the systematic risk of the portfolio.
D. diversify away unsystematic risk and adjust the systematic risk of each portfolio to meet
clients’ objectives.

13. A pricing anomaly is best described as:
A. a price move that reflects a factor that is specific to the individual stock.
B. a predictable deviation between expected and actual returns for a stock.
C. out or underperformance of a stock against the market average performance.
D. a short-term random movement in a stock prices giving an opportunity to make a profit.

A key element of an anomaly is that it is a predictable, rather than a random, move.

14. If a market is perfectly efficient and a portfolio manager does not have superior analysts then the
portfolio manager should:
A. only hold cash.
B. select a portfolio of securities at random.
C. increase the systematic risk of the portfolio.
D. diversify away unsystematic risk and adjust the systematic risk of each portfolio to meet clients’
objectives.

Portfolio managers who do not have superior analysts should do the following:
(i) Quantify their clients’ risk tolerance.
(ii) Construct a portfolio which has the appropriate risk profile and maintain this risk level on an
ongoing basis.
(iii) Diversify to eliminate any unsystematic risk by investing globally.
(iv) Minimize costs including taxes, transaction costs and avoid holding illiquid stocks.

15. Which of the following is least likely to be a reason why we should be skeptical of claims by
analysts to have discovered an anomaly?
A. Data mining.
B. Survivorship bias.
C. Nonsynchronous trading.
D. Limited capital of arbitrageurs.

16. If an investor buys 1,000 shares at $50 and the initial margin is 60% and the maintenance margin
is 30%, he/she will receive the first margin call when the stock price falls below:
A. $14.00.
B. $21.00.
C. $28.57.
D. $49.99.

15. Which of the following is least likely to be a reason why we should be skeptical of claims by
analysts to have discovered an anomaly?
A. Data mining.
B. Survivorship bias.
C. Nonsynchronous trading.
D. Limited capital of arbitrageurs.

Limited capital can constrain the ability of arbitrageurs to take advantage of anomalies, but it is not a
reason to be skeptical that they exist.

16. If an investor buys 1,000 shares at $50 and the initial margin is 60% and the maintenance margin
is 30%, he/she will receive the first margin call when the stock price falls below:
A. $14.00.
B. $21.00.
C. $28.57.
D. $49.99.
The amount borrowed would be $20,000. We need to calculate when the value of the equity equals 30% of
the total value of the stock. This is given by:
1,000P - $20,000 = 0.30(1,000P)
P = $28.57

17. Two indexes contain exactly the same stocks; one is a value‐weighted index which increased by
12% whereas the other is an unweighted index which increased by 5% over the same period. This is
explained by:
A. there were a large number of stock splits over the period.
B. there were a small number of stock splits over the period.
C. small capitalization stocks outperformed large capitalization stocks.
D. large capitalization stocks outperformed small capitalization stocks.

18. The initial margin requirement for a stock purchase is:
A. the market value of the stock less the amount borrowed.
B. the market value of the stock less the amount paid in cash.
C. the percentage of the transaction value that can be borrowed.
D. the percentage of the transaction value that must be paid for in cash.

17. Two indexes contain exactly the same stocks; one is a value‐weighted index which increased by
12% whereas the other is an unweighted index which increased by 5% over the same period. This is
explained by:
A. there were a large number of stock splits over the period.
B. there were a small number of stock splits over the period.
C. small capitalization stocks outperformed large capitalization stocks.
D. large capitalization stocks outperformed small capitalization stocks.
Stock splits will not affect either index since in the market-value-weighted index when there is a stock
split the number of shares outstanding will increase but the share price will fall by a corresponding
amount. An unweighted index will be computed on an equal amount of money invested in each stock
regardless of price or market value.
In a value-weighted index companies with a larger market capitalization will have a higher weighting so D
is the correct answer.

18. The initial margin requirement for a stock purchase is:
A. the market value of the stock less the amount borrowed.
B. the market value of the stock less the amount paid in cash.
C. the percentage of the transaction value that can be borrowed.
D. the percentage of the transaction value that must be paid for in cash.
The initial margin is simply the percentage or proportion of the transaction value that must be paid for in
cash, rather than borrowed.

19. The Efficient Market Hypothesis and the tests done to prove the Hypothesis imply doing which
of the following is the least useful for portfolio managers?
A. Using technical analysis.
B. Minimizing total transaction costs.
C. Focusing on analyzing neglected companies.
D. Using analysts who have the ability to estimate economic variables that have an impact
on security prices.

20. Which of the following supports the semistrong‐form of the Efficient Market Hypothesis?
A. The January effect.
B. The neglected firm effect.
C. The performance of stocks with a low price/book value ratio.
D. The performance of stocks that have announced a change in accounting methods.

19. The Efficient Market Hypothesis and the tests done to prove the Hypothesis imply doing which
of the following is the least useful for portfolio managers?
A. Using technical analysis.
B. Minimizing total transaction costs.
C. Focusing on analyzing neglected companies.
D. Using analysts who have the ability to estimate economic variables that have an impact on security
prices.

The weak-form of the Efficient Market Hypothesis implies that technical analysis based on past trading
data does not have any value.

20. Which of the following supports the semistrong‐form of the Efficient Market Hypothesis?
A. The January effect.
B. The neglected firm effect.
C. The performance of stocks with a low price/book value ratio.
D. The performance of stocks that have announced a change in accounting methods.

The January effect, the neglected firm effect and the outperformance of low price/book value stocks are all
anomalies of the semistrong-form of the EMH. The performance of stocks that have announced a change in
accounting methods supports the semistrong-form of the EMH. Studies find that analysts look at the true
value of companies rather than the effects of a change in the way financial performance is reported.

21. Based on historic data the correlation between the S&P 500 and the Russell Small‐Cap index and
the IFC Emerging Market index are as shown in the table below.
Index Correlation with S&P 500
Russell Small‐Cap index 0.783
IFC Emerging Market index 0.392
On the basis of the data given, in order to diversify a portfolio that is invested in S&P 500 stocks, from
which index is it likely to be most effective to include stocks, and which is the most important factor
in explaining the correlation figures?
Include stocks from Correlation explained by
A. Russell Small‐Cap index Index construction
B. Russell Small‐Cap index Index constituents
C. IFC Emerging Market index Index construction
D. IFC Emerging Market index Index constituents

22. A value‐weighted index is made up of two stocks, X and Y, and the following data is provided:
December 31st 2006 December 31st 2007
Stock Price Shares outstanding Price Shares outstanding
X $25 10,000 $15 20,000*
Y $50 6,000 $65 6,000
* after a 2 for 1 stock split
The base index is set at 100 on December 31st 2006. The index on December 31st 2007 is closest to:
A. 98.18.
B. 106.67.
C. 125.45.
D. 126.67.

21. Based on historic data the correlation between the S&P 500 and the Russell Small‐Cap index and
the IFC Emerging Market index are as shown in the table below.
Index Correlation with S&P 500
Russell Small‐Cap index 0.783
IFC Emerging Market index 0.392
On the basis of the data given, in order to diversify a portfolio that is invested in S&P 500 stocks, from
which index is it likely to be most effective to include stocks, and which is the most important factor in
explaining the correlation figures?
Include stocks from Correlation explained by

A. Russell Small-Cap index Index construction
B. Russell Small-Cap index Index constituents
C. IFC Emerging Market index Index construction
D. IFC Emerging Market index Index constituents

A low correlation indicates that there are stronger diversification benefits, so including stocks from the
IFC Emerging Market index would be most effective, based on historic data. Most of the major indexes
(except for the Nikkei) are value weighted, the most important factor in explaining low correlation is the
different constituent stocks in the indexes.

22. A value‐weighted index is made up of two stocks, X and Y, and the following data is provided:
December 31st 2006 December 31st 2007
Stock Price Shares Price Shares
outstanding outstanding
X $25 10,000 $15 20,000*
Y $50 6,000 $65 6,000
* after a 2 for 1 stock split
The base index is set at 100 on December 31st 2006. The index on December 31st 2007 is closest to:
A. 98.18.
B. 106.67.
C. 125.45.
D. 126.67.
Correct Answer: C .......................................................................................... LOS: Reading 53‐a

Total market value on Dec. 31st 2006 is ($25 x 10,000) + ($50 x 6,000) = $550,000
Total market value on Dec. 31st 2007 is ($15 x 20,000) + ($65 x 6,000) = $690,000
The index = ($690,000/$550,000) x100 = 125.45

Study Session 14: Equity Investments:

Industry and Company Analysis

This study session focuses on industry and company analysis and describes the tools used in forming
an opinion about investing in a particular stock or group of stocks.
This study session begins with the essential tools of equity valuation: the discounted cash flow
technique and the relative valuation approach. These techniques provide the means to estimate
reasonable price for a stock. The readings on industry analysis are an important element in the
valuation process, providing the top–down context crucial to estimating a company’s potential. Also
addressed is estimating a company’s earnings per share by forecasting sales and profit margins.
The last reading in this study session focuses on price multiples, one of the most familiar and widely
used tools in estimating the value of a company, and introduces the application of four commonly
used price multiples to valuation.
Reading 56: An Introduction to Security Valuation: Part I
Reading 57: Industry Analysis
Reading 58: Equity: Concepts and Techniques
Reading 59: Company Analysis and Stock Valuation
Reading 60: An Introduction to Security Valuation: Part II
Reading 61: Introduction to Price Multiples

Equity Investments: Industry and Company Analysis 379
1. If an investor’s required rate of return is 12% and a company’s stock price is $45.00, the next
dividend is estimated to be $3.60 and the growth rate of dividends is a constant 4.5%, then the stock
is:
A. overvalued.
B. undervalued.
C. fairly valued.
D. information is needed on the dividend payout ratio to answer the question.

2. Which of the following would be a positive factor for producers’ profitability?
A. Low entry barriers.
B. Strong buyer power.
C. Weak supplier power.
D. Availability of substitutes.

1. If an investor’s required rate of return is 12% and a company’s stock price is $45.00, the next
dividend is estimated to be $3.60 and the growth rate of dividends is a constant 4.5%, then the stock
is:
A. overvalued.
B. undervalued.
C. fairly valued.
D. information is needed on the dividend payout ratio to answer the question.

The stock price using the DDM should be 3.6/(0.12 – 0.045) = $48, if the price is $45 the stock is
undervalued.

2. Which of the following would be a positive factor for producers’ profitability?
A. Low entry barriers.
B. Strong buyer power.
C. Weak supplier power.
D. Availability of substitutes.
Weak supplier power means that the suppliers to the industry are in a weak negotiating position and are
unable to squeeze the producers’ profits; this is a positive factor for the producers’ profitability.
Low entry barriers will increase competition, reducing profit margins. Strong buyer power means the
buyers can demand low prices reducing profitability. Availability of substitutes restrains producers who
wish to raise prices.

3. Which of the following factors is least likely to directly determine the level of competition in an
industry?
A. Entry barriers.
B. Unit labor costs.
C. Bargaining power of buyers.
D. Availability of substitute products.

4. An analyst forecasts a company will pay dividends of $2 in the first year, $3 in the second year
and $3.50 in the third year. After the third year dividends are forecast to grow at 4% per annum. If an
investor’s required rate of return is 12% the value of the stock is closest to:
A. $36.56.
B. $37.81.
C. $39.05
D. $51.69.

3. Which of the following factors is least likely to directly determine the level of competition in an
industry?
A. Entry barriers.
B. Unit labor costs.
C. Bargaining power of buyers.
D. Availability of substitute products.
Unit labor costs impact the profitability of an industry, and although they indirectly affect how attractive a
business is for participants they are not a direct factor determining competition.

4. An analyst forecasts a company will pay dividends of $2 in the first year, $3 in the second year
and $3.50 in the third year. After the third year dividends are forecast to grow at 4% per annum. If an
investor’s required rate of return is 12% the value of the stock is closest to:
A. $36.56.
B. $37.81.
C. $39.05
D. $51.69.

First, calculate the value of the stock at the end of year three,
D4 $3.50(1.04)
Value = = = $45.50
(k − g ) (0.12 − 0.04)
The value of the stock today is the sum of the present values of the first three years’ dividends plus the
present value of the end-year-three value.
D1 D2 P + D3 $2 $3 $45.50 + $3.50
Value = + + = + + = $39.05
(1 + k ) (1 + k ) (1 + k ) (1.12) (1.12)
2 3 2
(1.12)3

5. A company is operating at the peak of the business cycle. Which of the following EPS calculations
is likely to give the highest P/E ratio?
A. Leading P/E.
B. Trailing P/E.
C. Current P/E.
D. P/E using normalized earnings.

6. Estimating a company earnings multiplier using macroanalysis involves:
A. examining the relationship between the company earnings multiplier and the economy.
B. examining the relationship between the company earnings multiplier and the market
earnings multiplier.
C. examining the relationship between the historic earnings multiplier for the company and
company performance.
D. examining the specific variables that influence the earnings multiplier, including the
dividend payout ratio and required rates of return.

5. A company is operating at the peak of the business cycle. Which of the following EPS calculations
is likely to give the highest P/E ratio?
A. Leading P/E.
B. Trailing P/E.
C. Current P/E.
D. P/E using normalized earnings.
Normalized earnings will calculate the earnings at the midpoint of the cycle so is likely to be lower than
current/trailing earnings or prospective earnings; hence the P/E will be higher on this basis.

6. Estimating a company earnings multiplier using macroanalysis involves:
A. examining the relationship between the company earnings multiplier and the economy.
B. examining the relationship between the company earnings multiplier and the market earnings
multiplier.
C. examining the relationship between the historic earnings multiplier for the company and company
performance.
D. examining the specific variables that influence the earnings multiplier, including the dividend
payout ratio and required rates of return.

Macroanalysis is estimating a P/E or earnings multiplier by looking at the relationship between the
company and its market and industry. Answer D refers to microanalysis.

7. A company whose earnings are very sensitive to the business cycle is a:
A. growth stock.
B. cyclical stock.
C. growth company.
D. cyclical company.

8. Value chain analysis in return expectations analysis is important because it studies:
A. co‐opetition risks.
B. competition between rival firms in an industry.
C. the government’s ability to raise value added taxes.
D. how goods are transformed from raw materials through to the finished good and profits
are shared between firms along the chain.

7. A company whose earnings are very sensitive to the business cycle is a:
A. growth stock.
B. cyclical stock.
C. growth company.
D. cyclical company.
A cyclical company is one whose sales and earnings are very sensitive to the business cycle such as auto or
steel companies. A cyclical stock is defined differently; it is one which has a high beta so it has changes in
rates of return which are larger than the changes in rates of return of the market.

8. Value chain analysis in return expectations analysis is important because it studies:
A. co-opetition risks.
B. competition between rival firms in an industry.
C. the government’s ability to raise value added taxes.
D. how goods are transformed from raw materials through to the finished good and profits are shared
between firms along the chain.

Value chain analysis in return expectations analysis looks at how returns are split between the
participants in a value chain. Co-opetition risks refer to risks, not returns, in the value chain and
competition between rival firms is not referring to firms in the same value chain.

9. An analyst is valuing a company where he suspects that the management has been manipulating
the accounts by capitalizing expenses that should have been treated as operating expenses. Which
would be an appropriate approach to take when valuing the company?
A. Use normalized earnings rather than current earnings in the price to earnings calculation.
B. Use price to cash flow as the main relative measure using free cash flows in the
calculation.
C. Not attempt to value the company if there are concerns about the quality of the reported
accounts.
D. Focus on price to book value since book value will not have been affected by any
manipulation of the accounts.

10. Which of the following is most likely to lead to a company’s earnings multiplier being higher
than the market multiplier?
A. The company has a high beta.
B. The risk of the company’s earnings is higher than the market.
C. Low return on equity for the company relative to the market.
D. High earnings growth rates for the company relative to the market.

9. An analyst is valuing a company where he suspects that the management has been manipulating
the accounts by capitalizing expenses that should have been treated as operating expenses. Which
would be an appropriate approach to take when valuing the company?
A. Use normalized earnings rather than current earnings in the price to earnings calculation.
B. Use price to cash flow as the main relative measure using free cash flows in the calculation.
C. Not attempt to value the company if there are concerns about the quality of the reported accounts.
D. Focus on price to book value since book value will not have been affected by any manipulation of
the accounts.
Normalized earnings will look at earnings over a business cycle so will not resolve the issue of earnings
manipulation. Book value will also reflect a decision to capitalize rather than expense earnings. Cash flow
will reflect the actual cash going in and out of the company so will be less subject to manipulation.
Answer D is possible but analysts may not have the choice to ignore companies where they suspect that
the accounts have been manipulated. They will need to attempt to value them by adjusting the accounts
and/or using cash flow methods.

10. Which of the following is most likely to lead to a company’s earnings multiplier being higher
than the market multiplier?
A. The company has a high beta.
B. The risk of the company’s earnings is higher than the market.
C. Low return on equity for the company relative to the market.
D. High earnings growth rates for the company relative to the market.

High growth generally leads to a high multiplier, so D is the correct answer.
A high beta would lead to a high required rate of return and therefore a lower multiplier so A is not correct.
Higher risk means a higher required rate of return, and therefore a lower multiplier so B is not correct.
Low return on equity implies low growth rates which would lead to a lower multiplier so C is not correct.

11. ABC Commodities is sensitive to the economic cycle and an analyst decides that the six years
ending 2007 reflect a business cycle for the company. He collects the following data: earnings per
share (EPS), book value per share ( BVPS) and return on equity (ROE):.
2002 2003 2004 2005 2006 2007

Adjusted* EPS, $ 1.30 2.65 5.50 4.30 3.25 1.00
ROE* % 0.04 0.13 0.22 0.18 0.12 0.03
BVPS, $ 32.00
* Adjusted for non‐recurring items
The current share price of ABC Commodities is $30.00
The P/E of ABC commodities based on the average historical EPS is closest to:
A. 7.81.
B. 9.37.
C. 10.00.
D. 33.33.

12. Which of the following is least likely to be an adjustment made to book value in order to make it
better reflect the value of shareholders’ investment?

A. Use tangible book value rather than total book value.
B. Adjust book value for off‐balance‐sheet assets and liabilities.
C. Use historic average of past book values over a business cycle.
D. Adjust book value for differences in fair value and historic cost of assets.

11. ABC Commodities is sensitive to the economic cycle and an analyst decides that the six years
ending 2007 reflect a business cycle for the company. He collects the following data: earnings per
share (EPS), book value per share ( BVPS) and return on equity (ROE):.
2002 2003 2004 2005 2006 2007

Adjusted* EPS, $ 1.30 2.65 5.50 4.30 3.25 1.00
ROE* % 0.04 0.13 0.22 0.18 0.12 0.03
BVPS, $ 32.00
* Adjusted for non-recurring items
The current share price of ABC Commodities is $30.00
The P/E of ABC commodities based on the average historical EPS is closest to:
A. 7.81.
B. 9.37.
C. 10.00.
D. 33.33.

The average EPS = (1.30 + 2.65 + 5.50 + 4.30 + 3.25 + 1.00)/6 = 3.00
P/E = 30.00/3.00 = 10.00

12. Which of the following is least likely to be an adjustment made to book value in order to make it
better reflect the value of shareholders’ investment?
A. Use tangible book value rather than total book value.
B. Adjust book value for off-balance-sheet assets and liabilities.
C. Use historic average of past book values over a business cycle.
D. Adjust book value for differences in fair value and historic cost of assets.
Since book value is a cumulative number, reflecting retained earnings, it is a more stable number than one
year earnings, so it is less likely that an average historic figure would be used.

13. If a company has an earnings retention ratio of 60%, earnings are growing at 5% per annum and
investors’ required rate of return is 12%, the P/E of the stock is closest to:
A. 3.33.
B. 4.44.
C. 5.71.
D. 8.57.

14. Which of the following factors will encourage new entrants to an industry?

A. High exit costs.
B. A steep cost curve.
C. Excess industry capacity.
D. High industry profitability.

13. If a company has an earnings retention ratio of 60%, earnings are growing at 5% per annum and
investors’ required rate of return is 12%, the P/E of the stock is closest to:
A. 3.33.
B. 4.44.
C. 5.71.
D. 8.57.

14. Which of the following factors will encourage new entrants to an industry?
A. High exit costs.

B. A steep cost curve.
C. Excess industry capacity.
D. High industry profitability.
High profitability will attract new entrants whereas a steep cost curve means it is difficult to enter the
industry with small volumes. High exit costs, such as irreversibility of required capital investment,
discourages new entrants, and excess capacity means existing manufacturers may be willing to cut prices
to deter new entrants.

15. Which of the following is least likely to be a reason for using a price/sales (P/S) ratio to value a
company?
A. Sales are generally more stable than earnings per share.
B. Sales numbers are less subject to accounting manipulation.
B. P/S is viewed as an appropriate valuation method for cyclical companies.
D. P/S valuation methods can be used comparing companies with different cost structures.

16. Which stage of the industry cycle is characterized by fast sales growth and high profit margins?
A. Mature growth.
B. Market maturity.
C. Pioneering development.
D. Rapid accelerating growth.

15. Which of the following is least likely to be a reason for using a price/sales (P/S) ratio to value a
company?
A. Sales are generally more stable than earnings per share.
B. Sales numbers are less subject to accounting manipulation.
B. P/S is viewed as an appropriate valuation method for cyclical companies.
D. P/S valuation methods can be used comparing companies with different cost structures.
P/S is not a good method for comparing companies with different cost structures because it doesn’t take
into account a company’s profitability. It is generally only useful for comparing companies operating in the
same industry.

16. Which stage of the industry cycle is characterized by fast sales growth and high profit margins?
A. Mature growth.
B. Market maturity.
C. Pioneering development.
D. Rapid accelerating growth.

Rapid accelerating growth is the second stage when the industry is seeing rapid growth in sales and the
potential for high profit margins because new entrants and therefore competition may be limited.

17. If the expected inflation rate in a country is 3% and the real risk‐free rate is 6% then the required
nominal risk‐free rate is closest to:
A. 2.9%.
B. 9.0%.
C. 9.2%.
D. 18.0%.

18. An investor who follows an industry rotation strategy believes the economy has past its trough
and there is confirmation of recovery. Which strategy would he/she be likely to follow?
A. Sell property.
B. Purchase stocks.
C. Purchase bonds.
D. Sell commodities.

17. If the expected inflation rate in a country is 3% and the real risk‐free rate is 6% then the required
nominal risk‐free rate is closest to:
A. 2.9%.
B. 9.0%.
C. 9.2%.
D. 18.0%.

NRFR = [1 +RRFR] [1 + E(I)] – 1
where:
NRFR = nominal risk-free rate
RRFR = real risk-free rate
E(I) = expected rate of inflation
NRFR = (1.06)(1.03 – 1) = 9.18%

18. An investor who follows an industry rotation strategy believes the economy has past its trough
and there is confirmation of recovery. Which strategy would he/she be likely to follow?
A. Sell property.
B. Purchase stocks.
C. Purchase bonds.
D. Sell commodities.
If the economy is in the recovery stage the best performance would be expected to come from cyclical
stocks and commodities, and then property, so B is the best answer.

19. Which of the following would be least likely to be a result of structural change in the U.S.
economy?
A. Rising consumer confidence leading to a surge in auto sales.
B. A rise in the minimum wage increasing costs for fast‐food outlets.
C. Increasing demand for residential nursing care as the population ages.
D. The move in population away from cities leading to stronger demand for catalogue and
online shopping.

20. Which of the following is one of the reasons why price to book value is a useful valuation
measure?
A. It can be used to value loss‐making companies.
B. It is useful for comparing the value of stocks across industries.
C. Book value is not usually distorted by the accounting methods used.
D. Book value has proved to be a good indicator of the market value of a company’s assets.

19. Which of the following would be least likely to be a result of structural change in the U.S.
economy?
A. Rising consumer confidence leading to a surge in auto sales.
B. A rise in the minimum wage increasing costs for fast-food outlets.
C. Increasing demand for residential nursing care as the population ages.
D. The move in population away from cities leading to stronger demand for catalogue and online
shopping.
Correct Answer: A ............................................................................................. LOS: Reading 57

Rising consumer confidence leading to a surge in auto sales would usually be the result of a cyclical move
in the economy. The other choices reflect longer-term structural changes in the economy, so A is the best
answer.

20. Which of the following is one of the reasons why price to book value is a useful valuation
measure?
A. It can be used to value loss-making companies.
B. It is useful for comparing the value of stocks across industries.
C. Book value is not usually distorted by the accounting methods used.
D. Book value has proved to be a good indicator of the market value of a company’s assets.
Loss making companies cannot be valued using current P/E and will often also have negative cash flow so
P/B, which is based on book value representing cumulative earnings and paid up capital, is a method that
can usually be applied.

21. When a fund manager uses top‐down analysis to manage equity portfolios he is least likely to
consider:
A. impact of economic environment on different industries.
B. impact of industry environment on individual companies.
C. the impact of monetary and fiscal policies on the market environment.
D. technical factors that will affect supply and demand for shares in the market.

22. An analyst calculates the price to sales ratio for a company and finds it is significantly less than
the market average, this could be explained by:
A. sales per share are higher than for the average company.
B. the company has a low profit margin relative to the average for the market.
C. the company has exhibited rapid sales growth relative to the market average.
D. sales growth has been consistent and the risk of sales growth faltering is small.

21. When a fund manager uses top‐down analysis to manage equity portfolios he is least likely to
consider:
A. impact of economic environment on different industries.
B. impact of industry environment on individual companies.
C. the impact of monetary and fiscal policies on the market environment.
D. technical factors that will affect supply and demand for shares in the market.
Correct Answer: D ............................................................................................. LOS: Reading 56

Top-down approaches usually focusing on fundamental rather than technical analysis. The first step is to
analyze alternative economies and securities markets. The objective is to decide the country allocation and
the allocation between bonds, equities and cash in each market. Analysts of economies will study a
government’s fiscal and monetary policies, inflation, interest rates, corporate and consumer expenditure,
and exchange rates. The next step is to use economic and market analysis to decide which industries will
benefit and which will suffer in the expected environment. Individual companies are analyzed within the
industries selected. This will include analyzing each company’s past performance and forecasting its future
prospects and then determining its value.

22. An analyst calculates the price to sales ratio for a company and finds it is significantly less than
the market average, this could be explained by:
A. sales per share are higher than for the average company.
B. the company has a low profit margin relative to the average for the market.
C. the company has exhibited rapid sales growth relative to the market average.
D. sales growth has been consistent and the risk of sales growth faltering is small.
Correct Answer: B ..........................................................................................LOS: Reading 61‐b
P/S is the same as P/E multiplied by the profit margin, so a low profit margin could explain a low P/S ratio.
Answers C and D would push up the P/S ratio. High sales per share are not going to necessarily lead to a
low P/S ratio.

Study Session 15: Fixed Income Investments:

Basic Concepts

This study session presents the foundation for fixed income investments, one of the largest and
fastest growing segments of global financial markets. It begins with an introduction to the basic
features and characteristics of fixed income securities and the associated risks. The session then
builds by describing the primary issuers, sectors, and types of bonds. Finally, the study session
concludes with an introduction to yields and spreads and the effect of monetary policy on financial
markets. These readings combined are the primary building blocks for mastering the analysis,
valuation, and management of fixed income securities.
Reading 62: Features of Debt Securities
Reading 63: Risks Associated with Investing in Bonds
Reading 64: Overview of Bond Sectors and Instruments
Reading 65: Understanding Yield Spreads
Reading 66: Monetary Policy in an Environment of Global Financial Markets

Fixed Income Investments: Basic Concepts 403
1. Which of the following is least likely to be an example of embedded options that might be
granted to bondholders?
A. A cap on a floater.
B. A floor on a floater.
C. Conversion privileges.
D. The right to put the issue.

2. Which of the following is an example of a negative covenant?
A. The issuer must submit periodic statements to the bond trustee.
B. Mortgage holders are not permitted to prepay mortgages ahead of the scheduled date.
C. A floating rate security has a minimum coupon rate that must be paid if the reference
rate declines below a certain level.
D. The issuer cannot secure any of its assets to a new debt issue without giving equal
treatment to the existing debt holders.

granted to bondholders?
A. A cap on a floater.
B. A floor on a floater.
C. Conversion privileges.
D. The right to put the issue.

A cap on a floater is a benefit to the issuer if interest rates rise, not to the bondholders.

2. Which of the following is an example of a negative covenant?
A. The issuer must submit periodic statements to the bond trustee.
B. Mortgage holders are not permitted to prepay mortgages ahead of the scheduled date.
C. A floating rate security has a minimum coupon rate that must be paid if the reference rate declines
below a certain level.
D. The issuer cannot secure any of its assets to a new debt issue without giving equal treatment to the
existing debt holders.
A negative covenant is a restriction on the issuer to protect investors in the bond. An example is when
unsecured debt holders are protected from the assets of the issuer being given as collateral in a subsequent
debt issue.

3. When the issuer of a bond agrees to retire a certain proportion of a bond issue each year, this is
an example of:
A. a callable bond.
B. a refundable bond.
C. a prepayment option.
D. a sinking fund provision.

4. An investor pays tax at a marginal rate of 40% and holds a tax‐exempt issue that has a yield of
6%. The taxable‐equivalent yield is:
A. 2.4%.
B. 3.6%.
C. 10.0%.
D. 15.0%.

3. When the issuer of a bond agrees to retire a certain proportion of a bond issue each year, this is
an example of:
A. a callable bond.
B. a refundable bond.
C. a prepayment option.
D. a sinking fund provision.
A sinking fund provision allows the issuer of a bond to retire a certain proportion of a bond issue each year.
Reference: CFA® Program Curriculum, Volume 5, pp. 251.

4. An investor pays tax at a marginal rate of 40% and holds a tax‐exempt issue that has a yield of
6%. The taxable‐equivalent yield is:
A. 2.4%.
B. 3.6%.
C. 10.0%.
D. 15.0%.

taxable-equivalent yield = tax-exempt yield/(1 – marginal tax rate)
= 0.06/0.6 = 0.1 or 10%

5. A floating‐rate note has the following coupon formula:
Six‐month Treasury bill rate + 60 basis points with a cap of 7% and a floor of 6.5%
The 6‐month Treasury bill rates are as follows:
6‐month Treasury
bill rate
First reset date 6.5%
Second reset date 5.8%
Third reset date 6.3%
Fourth reset date 6.1%

What would be the coupon rates at the first and the second reset dates, respectively?
A. 6.5% 5.8%
B. 6.5% 6.5%
C. 7.0% 6.5%
D. 7.6% 7.1%

6. Liquidity risk in bond markets can be measured by:
A. recovery rates.
B. price volatility.
C. the bid‐ask spread.
D. the slope of the yield curve.

5. A floating‐rate note has the following coupon formula:
Six‐month Treasury bill rate + 60 basis points with a cap of 7% and a floor of 6.5%
The 6‐month Treasury bill rates are as follows:
6‐month Treasury
bill rate
First reset date 6.5%
Second reset date 5.8%
Third reset date 6.3%
Fourth reset date 6.1%
What would be the coupon rates at the first and the second reset dates, respectively?
A. 6.5% 5.8%
B. 6.5% 6.5%
C. 7.0% 6.5%
D. 7.6% 7.1%

The coupon rate at the first reset date is 6.5% + 0.6% = 7.1% which is higher than the cap rate. Therefore it
takes on the cap rate, which is 7.0%.
The coupon rate at the second reset date is 5.8% + 0.6% = 6.4% which is lower than the floor rate.
Therefore it takes on the floor rate, which is 6.5%.

6. Liquidity risk in bond markets can be measured by:
A. recovery rates.
B. price volatility.
C. the bid-ask spread.
D. the slope of the yield curve.
Correct Answer: C ......................................................................................... LOS: Reading 63‐k

The bid-ask spread quoted by dealers reflects the liquidity of an issue.

7. Which one of the following is the least likely to be an example of a securitized bond?
A. Mortgage bond.
B. Mortgage‐backed security.
C. Collateralized Mortgage Obligation.
D. Credit Card Receivables Asset‐Backed security.

8. The difference in yield between bonds issued by industrial companies and bonds issued by
information technology companies is an example of a:
A. credit spread.
B. quality spread.
C. intermarket sector spread.
D. intramarket sector spread.

7. Which one of the following is the least likely to be an example of a securitized bond?
A. Mortgage bond.
B. Mortgage-backed security.
C. Collateralized Mortgage Obligation.
D. Credit Card Receivables Asset-Backed security.
Mortgage bonds are loans secured by mortgages to the company’s assets. They are not structured with
securitization techniques, such as the use of bankruptcy-remote special purpose vehicles.

8. The difference in yield between bonds issued by industrial companies and bonds issued by
information technology companies is an example of a:
A. credit spread.
B. quality spread.
C. intermarket sector spread.
D. intramarket sector spread.
The credit or quality spread is the difference in yield between Treasury securities and non-Treasury
securities. The intramarket sector spread is the difference in yield between two bonds with the same
maturity, in the same sector in a market. Industrial companies are in a distinct sector to information
technology companies.

9. If the yield spread of a bond has widened it means that:
A. it is a low‐grade bond.
B. it is a high‐grade bond.
C. the bond price has risen relative to that of an equivalent Treasury bond issue.
D. the bond price has declined relative to that of an equivalent Treasury bond issue.

10. Medium‐term notes (MTNs) differ from corporate bonds since:
A. MTNs have a maximum maturity of 5 years.
B. MTNs have a maximum maturity of 10 years.
C. MTNs are not rated by any of the major credit rating organizations.
D. MTNs are offered to investors on a continuous basis by the issuer or its agent.

9. If the yield spread of a bond has widened it means that:
A. it is a low-grade bond.
B. it is a high-grade bond.
C. the bond price has risen relative to that of an equivalent Treasury bond issue.
D. the bond price has declined relative to that of an equivalent Treasury bond issue.
Correct Answer: D .......................................................................................... LOS: Reading 63‐j

The credit or yield spread is the difference between the yield on the bond and the yield on a Treasury bond.
If the spread has widened it means that the yield demanded by an investor in the bond has increased, so
the price has fallen, relative to a Treasury bond.

10. Medium‐term notes (MTNs) differ from corporate bonds since:
A. MTNs have a maximum maturity of 5 years.
B. MTNs have a maximum maturity of 10 years.
C. MTNs are not rated by any of the major credit rating organizations.
D. MTNs are offered to investors on a continuous basis by the issuer or its agent.

The unique feature of MTNs is that they are offered to investors on a continuous basis by the issuer or its
agent.

11. From the equity markets, central banks find it most useful to derive information on:
A. future economic activity.
B. international trade activity.
C. market expectations of interest rates.
D. ownership of equities by individuals.

12. Which of the following embedded options is increasingly valuable to an investor in a rising
interest rate environment?
A. Put option.
B. Call option.
C. Interest rate cap.
D. Accelerated sinking fund provision.

11. From the equity markets, central banks find it most useful to derive information on:
A. future economic activity.
B. international trade activity.
C. market expectations of interest rates.
D. ownership of equities by individuals.

Equity markets provide information on anticipated economic activity.

12. Which of the following embedded options is increasingly valuable to an investor in a rising
interest rate environment?
A. Put option.
B. Call option.
C. Interest rate cap.
D. Accelerated sinking fund provision.
From the investor perspective, a put option is beneficial when interest rates rise. The investor benefits
from being able to sell back the bond at a specified price that is higher than the prevailing market price.

13. The legal entity that is used in asset securitization for bankruptcy remoteness is:
A. a rating agency.
B. an indenture trustee.
C. an investment bank.
D. a special purpose vehicle.

14. A bond is initially priced at 97.99. If the yield declines by 50 basis points, the price increases to
99.99. If the yield rises by 50 basis points, the price decreases to 94.89. The duration of the bond is:
A. 0.50.
B. 1.00.
C. 5.25.
D. 10.50.

13. The legal entity that is used in asset securitization for bankruptcy remoteness is:
A. a rating agency.
B. an indenture trustee.
C. an investment bank.
D. a special purpose vehicle.
Correct Answer: D .......................................................................................... LOS: Reading 64‐i

A special purpose vehicle is the legal entity that the assets are sold to, so the assets used as collateral are
separate from the firm that is requiring funding.

99.99. If the yield rises by 50 basis points, the price decreases to 94.89. The duration of the bond is:
A. 0.50.
B. 1.00.
C. 5.25.
D. 10.50.

The duration = (99.99 – 94.89)/(2 x 97.99 x 0.005) = 5.25

99.99. If the yield rises by 50 basis points, the price decreases to 94.89. If the par value of the bond is
$100,000 then the dollar duration is:
A. $500.
B. $1,000.
C. $5,250.
D. $10,500.

16. A sinking fund provision refers to when:
A. an issuer is required to retire a pre‐specified portion of a bond each year.
B. an issuer has made an arrangement to buy back a bond at par in the case of deterioration
in the quality of collateral for a bond.
C. an investor has the right to sell the bonds back to the issuer prior to maturity if the
market price has fallen below a prespecified level.
D. mortgagees are prepaid ahead of schedule and the cash received is set aside into a fund
which will be used to pay back investors at a later date.

99.99. If the yield rises by 50 basis points, the price decreases to 94.89. If the par value of the bond is
$100,000 then the dollar duration is:
A. $500.
B. $1,000.
C. $5,250.
D. $10,500.

The duration = (99.99 – 94.89)/(2 x 97.99 x 0.005) = 5.25
The dollar duration will be 5.25% x $100,000 = $5,250

16. A sinking fund provision refers to when:
A. an issuer is required to retire a pre-specified portion of a bond each year.
B. an issuer has made an arrangement to buy back a bond at par in the case of deterioration in the
quality of collateral for a bond.
C. an investor has the right to sell the bonds back to the issuer prior to maturity if the market price
has fallen below a prespecified level.
D. mortgagees are prepaid ahead of schedule and the cash received is set aside into a fund which will
be used to pay back investors at a later date.

A sinking fund requirement is usually put in place to reduce credit risk because the issuer has to retire a
portion of the bond issue prior to maturity, either by buying bonds in the market or providing cash for the
trustee to call bonds using a lottery system.

17. Which a firm issues bonds that are nonrefundable this means that:
A. the bonds cannot be called prior to the maturity date.
B. the bonds can be called but the investor cannot be offered a replacement bond with a
similar yield.
C. an investor cannot exercise an embedded put option whilst they are in a prespecified
nonrefunding period.
D. the bonds cannot be redeemed using proceeds of another debt issue that has provided a
lower cost source of funds.

18. A credible and transparent monetary policy of the ECB is reflected in:
A. stable exchange rates.
B. a strong euro against the dollar.
C. insignificant overnight interest rate moves following a policy announcement.
D. an increased level of implied volatility of the bond markets over the last few years.

17. Which a firm issues bonds that are nonrefundable this means that:
A. the bonds cannot be called prior to the maturity date.
B. the bonds can be called but the investor cannot be offered a replacement bond with a similar yield.
C. an investor cannot exercise an embedded put option whilst they are in a prespecified nonrefunding
period.
D. the bonds cannot be redeemed using proceeds of another debt issue that has provided a lower cost
source of funds.
When a callable bond is issued it may have restrictions on when it can be called, nonrefundable is such a
restriction and means that the firm cannot issue a new bond on a lower yield to pay back the original bond
holders.

18. A credible and transparent monetary policy of the ECB is reflected in:
A. stable exchange rates.
B. a strong euro against the dollar.
C. insignificant overnight interest rate moves following a policy announcement.
D. an increased level of implied volatility of the bond markets over the last few years.

A credible and transparent policy means that market participants can forecast very accurately any policy
announcements so there is little change in rates following an announcement.

19. The clean price of a bond is:
A. the agreed bond price without accrued interest.
B. the accrued interest component of the bond price.
C. the agreed bond price plus the accrued interest due to the seller of the bond.
D. the agreed bond price for the bond less the accrued interest due to the buyer of the bond..

granted to the issuer of a bond?
A. A floor on a floater.
B. The right to call the issue.
C. An accelerated sinking fund provision.
D. The right to prepay an amount above the scheduled principal repayment.

19. The clean price of a bond is:
A. the agreed bond price without accrued interest.
B. the accrued interest component of the bond price.
C. the agreed bond price plus the accrued interest due to the seller of the bond.
D. the agreed bond price for the bond less the accrued interest due to the buyer of the bond.

The clean price of a bond is the quoted price of a bond where the accrued interest is excluded.

granted to the issuer of a bond?
A. A floor on a floater.
B. The right to call the issue.
C. An accelerated sinking fund provision.
D. The right to prepay an amount above the scheduled principal repayment.

A floor on a floater is a benefit to the holder of the bond if interest rates fall, not to the issuer.

21. The following information is given:

Issue Yield
10‐year on‐the‐run Treasury 6% coupon 6.15%
10‐year ABG Corporation Series J 5% coupon 7.85%
10‐year IBN Limited 8.0% coupon 8.00%

The absolute yield spread between IBN Limited and ABG Corporation bonds is:
A. 0.015%.
B. 3.000%.
C. 3 basis points.
D. 15 basis points.


Issue Yield

The yield ratio between the 10‐year ABG Corp and the 10‐year Treasury is closest to:
A. 0.78.
B. 0.83.
C. 1.20.
D. 1.28.

Issue Yield
The absolute yield spread between IBN Limited and ABG Corporation bonds is:
A. 0.015%.
B. 3.000%.
C. 3 basis points.
D. 15 basis points.
The absolute yield spread = 8.0% - 7.85% = 0.15% or 15 basis points.
Do not use the coupon rates.

Issue Yield
The yield ratio between the 10-year ABG Corp and the 10-year Treasury is closest to:
A. 0.78.
B. 0.83.
C. 1.20.
D. 1.28.
Correct Answer: D ......................................................................................... LOS: Reading 65‐e

The yield ratio 7.85%/6.15% = 1.28.
Again do not use the coupon rates.

Study Session 16: Fixed Income Investments:

Analysis and Valuation

This study session illustrates the primary tools for valuation and analysis of fixed income securities
and markets. It begins with a study of basic valuation theory and techniques for bonds and concludes
with a more in‐depth explanation of the primary tools for fixed income investment valuation,
specifically, interest rate and yield valuation and interest rate risk measurement and analysis.
Reading 67: Introduction to the Valuation of Debt Securities
Reading 68: Yield Measures, Spot Rates, and Forward Rates
Reading 69: Introduction to the Measurement of Interest Rate Risk

Fixed Income Investments: Analysis and Valuation 427
1. If the duration of a bond portfolio is 5 and the average yield of bonds in the portfolio rises by 100
basis points then:
A. the market value of the portfolio will fall, but by less than 5%.
B. the market value of the portfolio will fall by approximately 5%.
C. the market value of the portfolio will rise by approximately 5%.
D. we do not have sufficient information to calculate the impact on the market value of the
portfolio.

2. The Macaulay duration of a bond is:
A. either negative or positive.
B. the same as the maturity of the bond.
C. always positive and less than, or equal to, the term to maturity of a bond.
D. always positive and more than, or equal to, the term to maturity of a bond..

1. If the duration of a bond portfolio is 5 and the average yield of bonds in the portfolio rises by 100
basis points then:
A. the market value of the portfolio will fall, but by less than 5%.
B. the market value of the portfolio will fall by approximately 5%.
C. the market value of the portfolio will rise by approximately 5%.
D. we do not have sufficient information to calculate the impact on the market value of the portfolio.

The yield of each bond in the portfolio must rise by 100 basis points, namely there should be a parallel shift
in the yield curve, for the portfolio duration to be an indicator of the price move of the total portfolio. We
need to know information on whether there was a parallel shift in the yield curve or the curve changed
shape (e.g. steepened or flattened), so D is the correct answer.

2. The Macaulay duration of a bond is:
A. either negative or positive.
B. the same as the maturity of the bond.
C. always positive and less than, or equal to, the term to maturity of a bond.
D. always positive and more than, or equal to, the term to maturity of a bond.
The unit of Macaulay duration is years. It is a measure of average time to the present value of cash flow
receipts. Mathematically it means that Macaulay duration will always be positive and less than, or equal
to, the term to maturity of a bond. It is only the same as the maturity when it is a zero coupon bond. Other
measures of duration such as effective duration, can take any number either positive or negative because it
better measures the interest rate sensitivity of bonds and takes into account changes in cash flows due to
interest rate changes.

3. The Macaulay duration of a semiannual bond with a 12% coupon is 6.0 and the yield to maturity
is 8%. The modified duration is closest to:
A. 5.66.
B. 5.77.
C. 6.24.
D. 6.36.

4. If the semiannual yield to maturity of a bond is 5%, the bond‐equivalent yield is closest to:
A. 5.1%.
B. 10.0%.
C. 10.3%.
D. 10.6%.

3. The Macaulay duration of a semiannual bond with a 12% coupon is 6.0 and the yield to maturity
is 8%. The modified duration is closest to:
A. 5.66.
B. 5.77.
C. 6.24.
D. 6.36.
Semiannual bonds mean k = 2
Modified duration = Macaulay duration/[(1 + yield/k)]
= 6.0/(1.04)
= 5.77

4. If the semiannual yield to maturity of a bond is 5%, the bond‐equivalent yield is closest to:
A. 5.1%.
B. 10.0%.
C. 10.3%.
D. 10.6%.

The bond-equivalent yield is simply double the semiannual yield.

5. The total dollar return from a bond is:
A. the current yield multiplied by the price of the bond.
B. the yield to maturity multiplied by the price of the bond.
C. the coupon income plus the reinvestment income plus the capital gain/loss on the bond.
D. the coupon income plus the value of the quoted margin plus the capital gain/loss on the
bond.

6. An 8% bond makes semiannual coupon payments, there are two further coupons to be paid and
the bond matures at $100 in 273 days (there are 182 days in a coupon period). If the yield to maturity
is 6% then the full price of the bond is closest to:
A. $96.12.
B. $98.27.
C. $101.91.
D. $103.42.

5. The total dollar return from a bond is:
A. the current yield multiplied by the price of the bond.
B. the yield to maturity multiplied by the price of the bond.
C. the coupon income plus the reinvestment income plus the capital gain/loss on the bond.
D. the coupon income plus the value of the quoted margin plus the capital gain/loss on the bond.
The total dollar return is the coupon income plus the reinvestment income plus the capital gain/loss on the
bond. Multiplying by yield to maturity may be inaccurate since it assumes that coupons can be reinvested
at the rate equivalent to the yield to maturity.

6. An 8% bond makes semiannual coupon payments, there are two further coupons to be paid and
the bond matures at $100 in 273 days (there are 182 days in a coupon period). If the yield to maturity
is 6% then the full price of the bond is closest to:
A. $96.12.
B. $98.27.
C. $101.91.
D. $103.42.

273 days is equivalent to 1 ½ coupon periods so:
PV = $4/(1.03)1/2 + $104/(1.03)3/2
= $3.94 + $99.49
= $103.42

7. The appropriate duration measure to use for a high coupon callable bond is:
A. effective duration.
B. modified duration.
C. Macaulay duration.
D. option‐adjusted duration.

8. If the yield to maturity on an annual‐pay bond is 12% its bond‐equivalent yield is closest to:
A. 11.66%.
B. 12.00%.
C. 12.36%.
D. 12.72%.

7. The appropriate duration measure to use for a high coupon callable bond is:
A. effective duration.
B. modified duration.
C. Macaulay duration.
D. option-adjusted duration.
In a callable bond, the cash flows might change as interest rates change. The most appropriate duration
measure is effective duration.

8. If the yield to maturity on an annual‐pay bond is 12% its bond‐equivalent yield is closest to:
A. 11.66%.
B. 12.00%.
C. 12.36%.
D. 12.72%.

bond-equivalent yield = 2[(1+ yield on annual-pay bond)1/2 –1] = 11.66%

9. A non‐callable bond has:
A. positive convexity throughout the yield range.
B. negative convexity throughout the yield range.
C. positive convexity at low yields and negative convexity at high yields.
D. negative convexity at low yields and positive convexity at high yields.

10. When a dealer purchases a package of Treasury strips to create a synthetic Treasury bond, the
procedure is called:
A. hedging.
B. stripping.
C. reconstitution.
D. bootstrapping.

9. A non‐callable bond has:
A. positive convexity throughout the yield range.
B. negative convexity throughout the yield range.
C. positive convexity at low yields and negative convexity at high yields.
D. negative convexity at low yields and positive convexity at high yields.

The presence of embedded options, such as a call option in a bond, would make the convexity negative in
certain yield ranges. Non-callable bonds have positive convexity throughout the yield range.

10. When a dealer purchases a package of Treasury strips to create a synthetic Treasury bond, the
procedure is called:
A. hedging.
B. stripping.
C. reconstitution.
D. bootstrapping.

Reconstitution occurs when a Treasury bond’s price is greater than its arbitrage-free value, and a dealer
can purchase a package of Treasury strips to create a synthetic Treasury bond.

11. Which of the following is the least accurate statement regarding reinvestment risk?
A. For zero‐coupon bonds, the reinvestment income is important to produce the yield
promised at purchase date.
B. The longer the time to maturity the more the bond is dependent on the reinvestment
income to produce the yield promised at the purchase date.
C. The higher the coupon rate the more the bond is dependent on the reinvestment income
to produce the yield promised at the purchase date.
D. For bonds bought at a premium, rather than at a discount, the reinvestment income is
more important to produce the yield promised at the purchase date.

12. Given the following information on a bond:
Duration = 7.5670.
Convexity = 41.0935.
Yields fall by: 250 basis points.

The total estimated price change in percentage terms is closest to:
A. 2.57%.
B. 7.57%.
C. 18.92%.
D. 21.49%.

11. Which of the following is the least accurate statement regarding reinvestment risk?
A. For zero-coupon bonds, the reinvestment income is important to produce the yield promised at
purchase date.
B. The longer the time to maturity the more the bond is dependent on the reinvestment income to
produce the yield promised at the purchase date.
C. The higher the coupon rate the more the bond is dependent on the reinvestment income to produce
the yield promised at the purchase date.
D. For bonds bought at a premium, rather than at a discount, the reinvestment income is more
important to produce the yield promised at the purchase date.

Zero-coupon bonds have no reinvestment risk since they have no interim income from coupons to be
reinvested.

12. Given the following information on a bond:
Duration = 7.5670.
Convexity = 41.0935.
Yields fall by: 250 basis points.
The total estimated price change in percentage terms is closest to:

A. 2.57%.
B. 7.57%.
C. 18.92%.
D. 21.49%.

Estimated change using duration 7.5670% x 0.025 x 100 = 18.9175
Convexity adjustment: 41.0935 x (0.025)2 x 100 = 2.5684
Total estimated percentage price change = 21.4858

13. An option‐free bond has a remaining life of three years and carries an 8% annual coupon rate
payable annually and has a yield to maturity of 9%. If the one‐ and two‐year spot rates are 6.0% and
6.5%, respectively, then the three‐year spot rate is closest to:
A. 7.0%.
B. 8.1%.
C. 9.2%.
D. 14.5%.

14. Which of the following is least likely to be a characteristic of bonds with positive convexity?
A. The percentage price change for a given yield change is not the same for all bonds.
B. For a large change in yields, the percentage price decrease is greater than the percentage
price increase.
C. For a small change in yields, the percentage changes are roughly the same, whether the
yield increases or decreases.
D. For a large change in yields, the percentage price change is not the same for an increase
in yields as it is for a decrease in yields.

13. . An option‐free bond has a remaining life of three years and carries an 8% annual coupon
rate payable annually and has a yield to maturity of 9%. If the one‐ and two‐year spot rates are 6.0%
and 6.5%, respectively, then the three‐year spot rate is closest to:
A. 7.0%.
B. 8.1%.
C. 9.2%.
D. 14.5%.
Correct Answer: C ......................................................................................... LOS: Reading 68‐h

The following relationship must hold, where the three-year spot rate is z:
8/(1.09)+8/(1.09)2+108/(1.09)3=8/(1.06)+8/(1.065)2+108/(1+z)3
97.47 = 14.60+108/(1+z)3
(1+z)3 = 108/82.87
1+z = (1.3032)1/3
z = 9.23%


14. Which of the following is least likely to be a characteristic of bonds with positive convexity?
A. The percentage price change for a given yield change is not the same for all bonds.
B. For a large change in yields, the percentage price decrease is greater than the percentage price
increase.
C. For a small change in yields, the percentage changes are roughly the same, whether the yield
increases or decreases.
D. For a large change in yields, the percentage price change is not the same for an increase in yields as
it is for a decrease in yields.

For a large change in yields, the percentage price increase is greater than the percentage price decrease,
when a bond has positive convexity.

15. An analyst uses a model to calculate effective duration and finds a collateralized mortgage
obligation (CMO) which has duration which is longer than the life of the underlying mortgage loans.
Which of the following statements is most accurate?
A. Effective duration is an inappropriate measure of duration to use since there are no
embedded options in a CMO.
B. The model looks to have produced an incorrect estimate of duration since CMOs would
be expected to have negative duration.
C. It is inappropriate to use a model to estimate effective duration; inputs should be taken
from a market source, such as dealers’ prices.
D. Longer duration of the CMO than the mortgage loans is possible and simply indicates the
sensitivity of the CMO to interest rate moves.

16. When interest rates change, it is observed that the price of a callable bond with a coupon of 5%
moves as follows:
Rates down 50 basis points Rates up 50 basis points
Price + 5% Price ‐ 3%

The bond is likely to have
Convexity Yield
A. Positive Less than 5%
B. Positive More than 5%
C. Negative Less than 5%
D. Negative More than 5%

15. An analyst uses a model to calculate effective duration and finds a collateralized mortgage
obligation (CMO) which has duration which is longer than the life of the underlying mortgage loans.
Which of the following statements is most accurate?
A. Effective duration is an inappropriate measure of duration to use since there are no embedded
options in a CMO.
B. The model looks to have produced an incorrect estimate of duration since CMOs would be
expected to have negative duration.
C. It is inappropriate to use a model to estimate effective duration; inputs should be taken from a
market source, such as dealers’ prices.
D. Longer duration of the CMO than the mortgage loans is possible and simply indicates the
sensitivity of the CMO to interest rate moves.
Effective duration is the correct method to use since cash flows from the CMO are influenced by interest
rates. It is reasonable to use a model to calculate effective duration and effective duration can be positive
(and longer then the maturity of the underlying loans) or negative depending on the structure and terms of
the CMO.

16. When interest rates change, it is observed that the price of a callable bond with a coupon of 5%
moves as follows:
Rates down 50 basis points Rates up 50 basis points
Price + 5% Price ‐ 3%
The bond is likely to have
Convexity Yield
A. Positive Less than 5%
B. Positive More than 5%
C. Negative Less than 5%
D. Negative More than 5%

The bond has positive convexity since the gain is more than the loss for an equal move in interest rates.
The bond’s coupon is probably less than market yields meaning it is unlikely to be called in the near future.
As yields fall the bond is more likely to be called and starts to exhibit negative convexity.

17. A zero‐coupon bond with two years remaining to maturity is currently trading at $82.65. If the
par value is $100, the yield to maturity is closest to:
A. 8.7%.
B. 9.0%.
C. 9.8%.
D. 11.0%.

18. A bond without any embedded options has a remaining life of three years, carries an 8% coupon
rate payable annually, and has a yield to maturity of 7%. If the one‐ and three‐year spot rates are 8.0%
and 7.0%, respectively, then the two‐year spot rate is closest to:
A. 6.0%.
B. 6.5%.
C. 7.5%.
D. 13.5%.

17. A zero‐coupon bond with two years remaining to maturity is currently trading at $82.65. If the
par value is $100, the yield to maturity is closest to:
A. 8.7%.
B. 9.0%.
C. 9.8%.
D. 11.0%.
Let x be the semiannual yield we are looking for, then:
100
82.65 =
(1 + x )4
(1 + x )4 = 100 82.65 = 1.21
x = 0.0488
or 9.8% annual yield

18. A bond without any embedded options has a remaining life of three years, carries an 8% coupon
rate payable annually, and has a yield to maturity of 7%. If the one‐ and three‐year spot rates are 8.0%
and 7.0%, respectively, then the two‐year spot rate is closest to:
A. 6.0%.
B. 6.5%.
C. 7.5%.
D. 13.5%.
Correct Answer: B.......................................................................................... LOS: Reading 68‐h

The following relationship must hold, where z is the two-year spot rate:
8/(1.07) + 8/(1.07)2 + 108/(1.07)3 = 8/(1.08) + 8/(1+ z)2 + 108/(1.07)3
14.46 = 7.41 + 8/(1+z)2
(1 + z)2 = 8/7.06
1 + z = (1.1337)1/2
z = 6.45%

19. The price value of a basis point is:
A. the absolute change in price of a bond if there is a one basis point change in yield.
B. the percentage change in price of a bond if there is a one basis point change in yield.
C. the absolute change in dollar duration of a bond if there is a one hundred basis point
change in yield.
D. the percentage change in dollar duration of a bond if there is a one hundred basis point
change in yield.

20. The Z‐spread is:
A. the option‐adjusted spread if a bond has embedded options.
B. the adjustment to the option‐adjusted spread as volatility changes.
C. the spread between spot and forward rates over the life of a bond.
D. the spread earned on a bond over the Treasury spot rate curve if it is held to maturity.

19. The price value of a basis point is:
A. the absolute change in price of a bond if there is a one basis point change in yield.
B. the percentage change in price of a bond if there is a one basis point change in yield.
C. the absolute change in dollar duration of a bond if there is a one hundred basis point change in
yield.
D. the percentage change in dollar duration of a bond if there is a one hundred basis point change in
yield.
Correct Answer: A .......................................................................................... LOS: Reading 69‐i

The price value of a basis point is the absolute change in price of a bond if there is a one basis point change
in yield. It is a special case of dollar duration.

20. The Z‐spread is:
A. the option-adjusted spread if a bond has embedded options.
B. the adjustment to the option-adjusted spread as volatility changes.
C. the spread between spot and forward rates over the life of a bond.
D. the spread earned on a bond over the Treasury spot rate curve if it is held to maturity.

The Z-spread, also called zero volatility or static spread, is the spread that must be added to the Treasury
spot rate to give a discount rate which will make the discounted cash flows from a bond equal to its price.

21. The following data is collected:
Years to Spot rate
0.5 5.75%
1.0 6.25%
1.5 7.00%
2.0 7.25%

Based on the above data, the six‐month implied forward rate one and a half years from now is closest
to:
A. 4.00%.
B. 6.25%.
C. 6.75%.
D. 8.00%.

22. Given:

Period Years Annual yield to Price Spot rate (BEY)
maturity (BEY)
1 0.5 4.00 4.0000
2 1.0 4.30 4.3000
3 1.5 4.65 100 4.6606

The 6‐month forward rate, one year from now is closest to:
A. 4.3000%.
B. 4.4803%.
C. 5.3535%.
D. 5.3837%.

21. The following data is collected:
Years to Spot rate
0.5 5.75%
1.0 6.25%
1.5 7.00%
2.0 7.25%

Based on the above data, the six‐month implied forward rate one and a half years from now is closest
to:
A. 4.00%.
B. 6.25%.
C. 6.75%.
D. 8.00%.

1f3 = [(1+ 0.03625)4/(1 + 0.035)3] – 1
= 4.0%
The forward rate is 4.0% x 2 = 8.0%


22. Given:
Period Years Annual yield to Price Spot rate (BEY)

maturity (BEY)
1 0.5 4.00 4.0000
2 1.0 4.30 4.3000
3 1.5 4.65 100 4.6606
The 6-month forward rate, one year from now is closest to:
A. 4.3000%.
B. 4.4803%.
C. 5.3535%.
D. 5.3837%.
Correct Answer: D .........................................................................................LOS: Reading 68‐h
1f2 = (1 + z3)3/(1 + z2)2 -1 = (1.023303)3/(1.02150)2 -1 = 1.0269 – 1 = 2.6919%
The 6-month forward rate, one year from now, is 2 x 2.6919% = 5.3837%

Study Session 17: Derivative Investments:

Derivatives—financial instruments that offer a return based on the return of some underlying asset—
have become increasingly important and fundamental in effectively managing financial risk and
creating synthetic exposures to asset classes. As in other security markets, arbitrage and market
efficiency play a critical role in establishing prices and maintaining parity.
This study session builds the conceptual framework for understanding derivative investments
(forwards, futures, options, and swaps), derivative markets, and the use of options in risk
management.
Reading 70: Derivative Markets and Instruments
Reading 71: Forward Markets and Contracts
Reading 72: Futures Markets and Contracts
Reading 73: Option Markets and Contracts
Reading 74: Swap Markets and Contracts
Reading 75: Risk Management Applications of Option Strategies

Derivative Investments 451
1. A trader writes a European call option on a stock. The stock’s current price is $24, the option
price is $4 and the exercise price is $23. At the expiration of the option the stock price is $30. The
profit/loss of the option writer is a:
A. loss of $4.
B. loss of $3.
C. profit of $3.
D. profit of $4.

2. The notional principal in a plain vanilla interest rate swap is:
A. never paid.
B. paid at the time that the swap agreement is made.
C. paid in equal parts when each swap payment is made.
D. paid at the time that the swap agreement is signed and returned when the final swap
payment is made.

1. A trader writes a European call option on a stock. The stock’s current price is $24, the option
price is $4 and the exercise price is $23. At the expiration of the option the stock price is $30. The
profit/loss of the option writer is a:
A. loss of $4.
B. loss of $3.
C. profit of $3.
D. profit of $4.

The writer has received the premium of $4 but the loss when the option is exercised is $30 minus $23
giving an overall loss of $3.

2. The notional principal in a plain vanilla interest rate swap is:
A. never paid.
B. paid at the time that the swap agreement is made.
C. paid in equal parts when each swap payment is made.
D. paid at the time that the swap agreement is signed and returned when the final swap payment is
made.

The notional principal is the amount on which the interest payments are calculated and does not change
hands in an interest rate swap.

3. The value of a put option at expiry is:
A. maximum of (i) zero and (ii) exercise price minus stock price.
B. maximum of (i) zero and (ii) stock price minus exercise price.
C. maximum of (i) zero and (ii) stock price minus exercise price, minus the option premium.
D. maximum of (i) zero and (ii) exercise price minus stock price, minus the option premium.

4. A company has borrowed to finance its operations using floating‐rate debt but it is now
concerned that short‐term interest rates are going to rise sharply. The company should consider
entering into:
A. a currency swap agreement where they take the pay‐fixed side
of the transaction.
B. a currency rate swap agreement where they take the receive‐fixed side of the transaction.
C. a plain vanilla interest rate swap agreement where they take the pay‐fixed side of the
transaction.
D. a plain vanilla interest rate swap agreement where they take the receive‐fixed side of the
transaction.

3. The value of a put option at expiry is:
A. maximum of (i) zero and (ii) exercise price minus stock price.
B. maximum of (i) zero and (ii) stock price minus exercise price.
C. maximum of (i) zero and (ii) stock price minus exercise price, minus the option premium.
D. maximum of (i) zero and (ii) exercise price minus stock price, minus the option premium.
The holder of a put option will exercise the option if the exercise price is above the stock price. In that case
he could theoretically buy the stock in the market and sell it at a higher price. If the stock price is higher
than the exercise price he will let the option lapse worthless. The option premium should only be taken
into account if the profit/loss on the option is being calculated.

4. A company has borrowed to finance its operations using floating‐rate debt but it is now
concerned that short‐term interest rates are going to rise sharply. The company should consider
entering into:
A. a currency swap agreement where they take the pay-fixed side
of the transaction.
B. a currency rate swap agreement where they take the receive-fixed side of the transaction.
C. a plain vanilla interest rate swap agreement where they take the pay-fixed side of the transaction.
D. a plain vanilla interest rate swap agreement where they take the receive-fixed side of the
transaction.

In a plain vanilla interest rate swap if the company pays a fixed rate of interest and receives a floating rate
of interest, the floating rate interest payment will, if the agreement is correctly structured, offset the
interest rate risk of its debt payments.

5. When a trader writes a covered call this will often be with the objective of:
A. increasing income.
B. insuring his portfolio value.
C. reducing the volatility of his return.
D. increasing his gain if the stock price rises above the exercise price plus the premium.

6. An investor believes that the S&P Index is going to decline sharply over the next two years.
Which of the following strategies would be consistent with this view?
A. Buy call options on the S&P Index.
B. Write put options on the S&P Index.
C. Take a long position in futures on the S&P Index.
D. Enter into a two‐year equity swap to receive a fixed payment and pay an equity payment
based on the performance of the S&P index.

5. When a trader writes a covered call this will often be with the objective of:
A. increasing income.
B. insuring his portfolio value.
C. reducing the volatility of his return.
D. increasing his gain if the stock price rises above the exercise price plus the premium.

Writing a covered call means that the trader will increase his income by the option premium. If the stock
price rises above the exercise price his shares will be called and he will lose the capital gain he would have
made if he had not written the option.

6. An investor believes that the S&P Index is going to decline sharply over the next two years.
Which of the following strategies would be consistent with this view?
A. Buy call options on the S&P Index.
B. Write put options on the S&P Index.
C. Take a long position in futures on the S&P Index.
D. Enter into a two-year equity swap to receive a fixed payment and pay an equity payment based on
the performance of the S&P index.

If the S&P Index falls the investor will receive both the fixed payment and an equity payment so this
would be a viable strategy.

7. An investor deposits an initial margin of $20,000 for a futures trade and the next day makes a
$2,000 loss on the trade. The next day he makes a further loss of $2,000. If the maintenance
requirement is $15,000 then he must deposit a variation margin of:
A. $1,000.
B. $4,000.
C. $5,000.
D. there is no requirement to pay a variation margin.

8. A trader sells both a call and a put option on a stock with the same exercise price and the same
expiration, he will make a profit on the transaction:
A. if the stock price rises sharply or falls sharply.
B. only if the stock price falls sharply below the exercise price.
C. only if the stock price rises sharply above the exercise price.
D. if the stock price remains within a narrow range of the exercise price.

7. An investor deposits an initial margin of $20,000 for a futures trade and the next day makes a
$2,000 loss on the trade. The next day he makes a further loss of $2,000. If the maintenance
requirement is $15,000 then he must deposit a variation margin of:
A. $1,000.
B. $4,000.
C. $5,000.
D. there is no requirement to pay a variation margin.

The variation margin only needs to be paid if the investor’s equity has fallen below the maintenance
requirement. This is not the case since the equity is still $16,000 ($20,000 - $2,000 - $2,000).

8. A trader sells both a call and a put option on a stock with the same exercise price and the same
expiration, he will make a profit on the transaction:
A. if the stock price rises sharply or falls sharply.
B. only if the stock price falls sharply below the exercise price.
C. only if the stock price rises sharply above the exercise price.
D. if the stock price remains within a narrow range of the exercise price.
This is a straddle (not explicitly covered in the readings) but the candidate can work out that if the stock
price moves up sharply the call option would be exercised, or if it moves down sharply the put option
would be exercised. If the move is significant the loss made on either option would be greater than the
premium income received. His strategy is profitable if the stock price does not move by more than the
combined value of the premiums received away from the exercise price.

9. If put options are used to insure a portfolio which of the following statements is
most accurate?
A. The insured portfolio will only report substantial losses in a small number of cases.
B. In the majority of cases the insured portfolio will outperform an equivalent uninsured
portfolio.
C. The probability of the insured portfolio achieving high positive gains is less than for the
uninsured portfolio.
D. There is a higher probability that the insured portfolio will achieve any given positive
return than the uninsured portfolio.

10. An option on a futures is best described as:
A. an option where the underlying asset is a futures contract.
B. a futures contract where the holder agrees to buy a pre‐specified option at a future date.
C. a futures contract where the holder has an option at the delivery date to extend the
contract.
D. a futures contract where the holder has the option to buy a pre‐specified asset at an
agreed price at a future date.

9. If put options are used to insure a portfolio which of the following statements is
most accurate?
A. The insured portfolio will only report substantial losses in a small number of cases.
B. In the majority of cases the insured portfolio will outperform an equivalent uninsured portfolio.
C. The probability of the insured portfolio achieving high positive gains is less than for the uninsured
portfolio.
D. There is a higher probability that the insured portfolio will achieve any given positive return than
the uninsured portfolio.

Correctly insuring a portfolio using put options should eliminate the possibility of a large loss since the
portfolio value will not fall below the exercise price less the premium. But if the return from the assets is
positive the uninsured portfolio will outperform the insured portfolio because of the cost of the premium.

10. An option on a futures is best described as:
A. an option where the underlying asset is a futures contract.
B. a futures contract where the holder agrees to buy a pre-specified option at a future date.
C. a futures contract where the holder has an option at the delivery date to extend the contract.
D. a futures contract where the holder has the option to buy a pre-specified asset at an agreed price at
a future date.

An option on a futures is simply an option where the underlying asset is a futures contract. The option
holder has the right to enter into a futures contract (call option for a long position, put for a short position)
at a fixed price.

11. A corporate treasurer knows that his firm will receive a large cash inflow in 180 days’ time. He is
concerned that interest rates are going to fall and he wishes to put the money on 90‐day LIBOR on
receipt. He should consider taking a:
A. long position in a 6 x 3 FRA.
B. short position in a 6 x 3 FRA.
C. long position in a 6 x 9 FRA.
D. short position in a 6 x 9 FRA.

12. An investor buys a call option at a premium of $10 on a stock which has a market price of $60. If
the exercise price is $62 the investor will make a:
A. loss if the stock price rises above the breakeven point of $70.
B. loss if the stock price rises above the breakeven point of $72.
C. profit if the stock price rises above the breakeven point of $70.
D. profit if the stock price rises above the breakeven point of $72.

11. A corporate treasurer knows that his firm will receive a large cash inflow in 180 days’ time. He is
concerned that interest rates are going to fall and he wishes to put the money on 90‐day LIBOR on
receipt. He should consider taking a:
A. long position in a 6 x 3 FRA.
B. short position in a 6 x 3 FRA.
C. long position in a 6 x 9 FRA.
D. short position in a 6 x 9 FRA.

A short position will generate a profit if interest rates fall which will offset the loss from placing the cash
inflow on deposit at a lower rate. A 6 x 9 FRA is required, that is a 180-day forward contract based on
deposits that mature in 270 days. He is effectively locking in the rate he will receive in 180 days’ time.

12. An investor buys a call option at a premium of $10 on a stock which has a market price of $60. If
the exercise price is $62 the investor will make a:
A. loss if the stock price rises above the breakeven point of $70.
B. loss if the stock price rises above the breakeven point of $72.
C. profit if the stock price rises above the breakeven point of $70.
D. profit if the stock price rises above the breakeven point of $72.
Breakeven is when 0 = maximum [ 0, (S – X)] – premium, when S = $72

13. A trader sells one wheat futures contract, which is for 5,000 bushels of wheat, at $4 per bushel.
The trader posts an initial margin of $1,500. If the required maintenance margin is $1,100 the trader
would first receive a maintenance margin call at a wheat price closest to:
A. $2.93 per bushel.
B. $3.92 per bushel.
C. $4.08 per bushel.
D. $5.45 per bushel.

14. ABC Asset Management is running a fund whose returns are linked to the performance of the
S&P Index. It has a U.S.$100 million cash inflow and it decides to use a swap agreement to gain
exposure to the market. It enters into a one‐year agreement with XYZ investment bank where XYZ
agree to pay the return on the S&P Total Return Index and ABC will pay a fixed rate of 5% on a
notional principal of U.S.$100 million. The payments are to be made quarterly with the first payment
on the last day in March and the payments will be based on the actual day count/365 basis.
If the S&P Index rises by 10% in the quarter ending 31 March the first payment made by XYZ
will be closest to:

A. $5,000,000.
B. $8,767,123.
C. $9,575,343.
D. $11,232,877.

13. A trader sells one wheat futures contract, which is for 5,000 bushels of wheat, at $4 per bushel.
The trader posts an initial margin of $1,500. If the required maintenance margin is $1,100 the trader
would first receive a maintenance margin call at a wheat price closest to:
A. $2.93 per bushel.
B. $3.92 per bushel.
C. $4.08 per bushel.
D. $5.45 per bushel.

When he has made a loss of $400 he would receive a margin call, this is equivalent to a price rise of 8 cents,
since he sold the contract.

14. ABC Asset Management is running a fund whose returns are linked to the performance of the
S&P Index. It has a U.S.$100 million cash inflow and it decides to use a swap agreement to gain
exposure to the market. It enters into a one‐year agreement with XYZ investment bank where XYZ
agree to pay the return on the S&P Total Return Index and ABC will pay a fixed rate of 5% on a
notional principal of U.S.$100 million. The payments are to be made quarterly with the first payment
on the last day in March and the payments will be based on the actual day count/365 basis.
If the S&P Index rises by 10% in the quarter ending 31 March the first payment made by XYZ will be
closest to:
A. $5,000,000.
B. $8,767,123.
C. $9,575,343.
D. $11,232,877.

ABC will make a payment of
$100m x 5% x 90/365
= $1,232,877
XYZ pays $10,000,000
The net payment made by XYZ is $8,767,123

15. Which of the following statements concerning futures and forward contracts is most accurate?
A. Only forward contracts are guaranteed by a clearinghouse.
B. Forward contracts tend to be more heavily regulated than futures contracts.
C. A futures contract is a type of forward contract that has standardized contract terms.
D. A forward contract is a type of futures contract that is traded on a recognized exchange.

16. If an investor has taken a long position in a forward contract but then wishes to terminate the
contract prior to expiry he can:
A. do nothing; it is impossible to terminate contracts.
B. go to the exchange and request an immediate cash settlement of the contract.
C. take a short position in a new contract with same expiry and underlying asset as the
original contract.
D. go back to the counterparty and take a long position in another contract with the same
expiry and underlying asset as the original contract.

15. Which of the following statements concerning futures and forward contracts is most accurate?
A. Only forward contracts are guaranteed by a clearinghouse.
B. Forward contracts tend to be more heavily regulated than futures contracts.
C. A futures contract is a type of forward contract that has standardized contract terms.
D. A forward contract is a type of futures contract that is traded on a recognized exchange.
A futures contract is a type of forward contract that has standardized contract terms and is traded on a
regulated exchange.

16. If an investor has taken a long position in a forward contract but then wishes to terminate the
contract prior to expiry he can:
A. do nothing; it is impossible to terminate contracts.
B. go to the exchange and request an immediate cash settlement of the contract.
C. take a short position in a new contract with same expiry and underlying asset as the original
contract.
D. go back to the counterparty and take a long position in another contract with the same expiry and
underlying asset as the original contract.

Taking a short position will mean that they no longer have any net exposure to price movements in the
underlying asset.

17. A dealer quotes on a 90‐day FRA, where the underlying is 180‐day dollar LIBOR, at a rate of 4%.
The end user takes a short position, with a notional principal of $1 million.
At expiration the rate on 180‐day LIBOR is 5%. The payoff for the end user is closest to:
A. a loss of $5,000.
B. a loss of $4,878.
C. a profit of $4,878.
D. a profit of $5,000.

18. Two parties X and Y enter into a ten‐year fixed‐for‐fixed currency swap. Party X holds U.S.
dollars and wishes to exchange these for Yen, Party Y holds Yen and wishes to exchange these for
U.S. dollars. The principal is $100 million. The U.S. dollar equals Yen 110 when the agreement is
signed and the fixed rates on U.S. dollars is set at 6% and Yen at 1%. At the end of the first year:
A. Party X pays Yen 110 million, and Party Y pays U.S. dollars 6 million.
B. Party Y pays Yen 110 million, and Party X pays U.S. dollars 6 million.
C. Party X pays Yen 11,110 million, and Party Y pays U.S. dollars 106 million.
D. Party Y pays Yen 11,110 million, and Party X pays U.S. dollars 106 million.

17. A dealer quotes on a 90‐day FRA, where the underlying is 180‐day dollar LIBOR, at a rate of 4%.
The end user takes a short position, with a notional principal of $1 million.
At expiration the rate on 180-day LIBOR is 5%. The payoff for the end user is closest to:
A. a loss of $5,000.
B. a loss of $4,878.
C. a profit of $4,878.
D. a profit of $5,000.
The payoff is given by:
⎡ (0.05 − 0.04)(180 360) ⎤ ⎛ 0.005 ⎞
$1,000,000 ⎢ ⎥ = $1,000,000⎜ ⎟ = $4,878
⎣ 1 + 0.05(180 360 ) ⎦ ⎝ 1.025 ⎠
Since the end user had a short position he must pay $4,878 to the dealer

18. Two parties X and Y enter into a ten‐year fixed‐for‐fixed currency swap. Party X holds U.S.
dollars and wishes to exchange these for Yen, Party Y holds Yen and wishes to exchange these for
U.S. dollars. The principal is $100 million. The U.S. dollar equals Yen 110 when the agreement is
signed and the fixed rates on U.S. dollars is set at 6% and Yen at 1%. At the end of the first year:
A. Party X pays Yen 110 million, and Party Y pays U.S. dollars 6 million.
B. Party Y pays Yen 110 million, and Party X pays U.S. dollars 6 million.
C. Party X pays Yen 11,110 million, and Party Y pays U.S. dollars 106 million.
D. Party Y pays Yen 11,110 million, and Party X pays U.S. dollars 106 million.

Party X pays interest on the Yen borrowed which is:
Yen 11,000 million x 1% = Yen 110 million.
Party Y pays interest on the U.S. dollars borrowed which is:
U.S. dollars 100 million x 6% = U.S. dollars 6 million.
The principals would be exchanged at the beginning of the agreement.

19. An investor writes a put option at a premium of $6 on a stock with an exercise price of $62. If the
stock price is $70 at expiration the investor will make a profit of:
A. $2.
B. $6.
C. $8.
D. $14.

20. A portfolio insurance strategy for a diversified stock portfolio can be implemented by:
A. buying a put option on the stock index representing the underlying stock portfolio.
B. writing a put option on the stock index representing the underlying stock portfolio.
C. buying a call option on the stock index representing the underlying stock portfolio.
D. writing a covered call option on the stock index representing the underlying stock
portfolio.

19. An investor writes a put option at a premium of $6 on a stock with an exercise price of $62. If the
stock price is $70 at expiration the investor will make a profit of:
A. $2.
B. $6.
C. $8.
D. $14.
The put option will lapse worthless since the exercise price is lower than the market price, so the investor
makes a profit of the premium that he collected.

20. A portfolio insurance strategy for a diversified stock portfolio can be implemented by:
A. buying a put option on the stock index representing the underlying stock portfolio.
B. writing a put option on the stock index representing the underlying stock portfolio.
C. buying a call option on the stock index representing the underlying stock portfolio.
D. writing a covered call option on the stock index representing the underlying stock portfolio.

In the situation that the stock market index falls, the losses on the underlying portfolio will be offset by
the profits on the put option.

21. The least likely benefit for an investor if a market includes financial derivatives is:
A. price discovery.
B. trading efficiency.
C. regulatory protection.
D. instruments available for risk management.

22. A firm enters into a plain vanilla interest rate swap agreement to pay a fixed rate of 8%, the
counterparty agrees to pay one year LIBOR. Annual payments will be made in arrears. The swap
covers a five year period and is based on a notional principal of $100 million. The one year LIBOR
rate at the time of agreement is 8.25%. At the end of one year it is 9%, and at the end of the second
year it is 9.5%. The net payment that the pay‐fixed firm receives/pays at the end of the second year is:
A. pays $1 million.
B. pays $1.5 million.
C. receives $1 million.
D. receives $1.5 million.

21. The least likely benefit for an investor if a market includes financial derivatives is:
A. price discovery.
B. trading efficiency.
C. regulatory protection.
D. instruments available for risk management.

Price discovery, ability to hedge risk and market efficiency including low transaction costs are all benefits
of derivatives. Although exchange-traded derivatives provide some regulatory protection, OTC derivatives
often offer little regulatory protection.

22. A firm enters into a plain vanilla interest rate swap agreement to pay a fixed rate of 8%, the
counterparty agrees to pay one year LIBOR. Annual payments will be made in arrears. The swap
covers a five year period and is based on a notional principal of $100 million. The one year LIBOR
rate at the time of agreement is 8.25%. At the end of one year it is 9%, and at the end of the second
year it is 9.5%. The net payment that the pay‐fixed firm receives/pays at the end of the second year is:
A. pays $1 million.
B. pays $1.5 million.
C. receives $1 million.
D. receives $1.5 million.
Correct Answer: C ..........................................................................................LOS: Reading 74‐b
The payment received is $100 million x (9% - 8%) = $1 million.

Study Session 18: Alternative Investments:

Due to diversification benefits and higher expectations of investment returns, investors are
increasingly turning to alternative investments. This study session describes the common types of
alternative investments, methods for their valuation, unique risks and opportunities associated with
them, and the relation between alternative investments and traditional investments.
Although finding a single definition of an “alternative” investment is difficult, certain features (e.g.,
limited liquidity, infrequent valuations, and unique legal structures) are typically associated with
alternative investments. This study session discusses these features and how to evaluate their impact
on expected returns and investment decisions in more detail. The reading provides an overview of
the major categories of alternative investments, including real estate, private equity, venture capital,
hedge funds, closely held companies, distressed securities, and commodities.
Each one of these categories has several unique characteristics, and the readings discuss valuation
methods for illiquid assets (such as direct real estate or closely held companies), performance
measures for private equity and venture capital investments, differences between various hedge fund
strategies, and implementation vehicles for investments in alternative assets.

Reading 76: Alternative Investments

Alternative Investments 475
1. Capital provided to a company that is close to going public is:
A. first‐stage financing.
B. third‐stage financing.
C. mezzanine financing.
D. second‐stage financing.

2. Which of the following statements is the least accurate description of a characteristic of venture
capital investing?
A. Illiquidity is a feature of venture capital investment.
B. Investors often need to make a long‐term commitment.
C. Entrepreneurs have strong management skills which increase the probability of
companies being successful.
D. Investors expect to achieve higher investment returns than they receive from investing in
publicly listed securities.

1. Capital provided to a company that is close to going public is:
A. first-stage financing.
B. third-stage financing.
C. mezzanine financing.
D. second-stage financing.
Mezzanine or bridge financing is given to companies who are planning to go public in the near term.

2. Which of the following statements is the least accurate description of a characteristic of venture
capital investing?
A. Illiquidity is a feature of venture capital investment.
B. Investors often need to make a long-term commitment.
C. Entrepreneurs have strong management skills which increase the probability of companies being
successful.
D. Investors expect to achieve higher investment returns than they receive from investing in publicly
listed securities.
Entrepreneurs often have weak management skills so the venture capitalist can help in providing direction
and strategic guidance to the company.

3. A hedge fund manager specializes in taking long positions in companies that are being bid for
and taking short positions in the acquiring company. He is likely to be managing a hedge fund that
is:
A. a futures fund.
B. a long/short fund.
C. an event‐driven fund.
D. a market‐neutral fund.

4. One of the reasons that the shares in closely held companies usually trade at a discount to
publicly traded securities is:
A. the shares are less liquid.
B. they have high market betas.
C. investors often hold a majority stake.
D. investors often have a greater influence on the company’s management.

3. A hedge fund manager specializes in taking long positions in companies that are being bid for
and taking short positions in the acquiring company. He is likely to be managing a hedge fund that
is:
A. a futures fund.
B. a long/short fund.
C. an event-driven fund.
D. a market-neutral fund.

C is the best answer since the long and short positions are being taken as a result of specific events, in this
case an acquisition.

4. One of the reasons that the shares in closely held companies usually trade at a discount to
publicly traded securities is:
A. the shares are less liquid.
B. they have high market betas.
C. investors often hold a majority stake.
D. investors often have a greater influence on the company’s management.
Correct Answer: A ......................................................................................... LOS: Reading 76‐n

Closely held companies’ shares are often not publicly traded and lack marketability, so investors are
compensated with a liquidity discount.

5. An investor in an Exchange Traded Fund (ETF) is exposed to tracking error risk; this is the risk
that:
A. the bid‐ask spread for shares in the ETF widens.
B. the ETF fails to make dividend payments to investors.
C. the currency the fund is denominated in does not track the U.S. dollar.
D. the fund does not closely replicate the performance of the index that it is following.

6. Which of the following is the least accurate description of a characteristic of commodity
investment, based on historic data?
A. It offers inflation protection.
B. It has low volatility of returns.
C. It produces attractive returns in periods of economic growth.
D. The returns have low correlations with bond and equity returns.

5. An investor in an Exchange Traded Fund (ETF) is exposed to tracking error risk; this is the risk
that:
A. the bid-ask spread for shares in the ETF widens.
B. the ETF fails to make dividend payments to investors.
C. the currency the fund is denominated in does not track the U.S. dollar.
D. the fund does not closely replicate the performance of the index that it is following.

Tracking error is a measure of the deviations between ETF returns and the index returns.

6. Which of the following is the least accurate description of a characteristic of commodity
investment, based on historic data?
A. It offers inflation protection.
B. It has low volatility of returns.
C. It produces attractive returns in periods of economic growth.
D. The returns have low correlations with bond and equity returns.
Correct Answer: B.......................................................................................... LOS: Reading 76‐q

Historically commodities have exhibited higher volatility than equities.

7. Investors in hedge funds are least likely to be motivated by which of the following?
A. Consistent returns across the different categories of hedge funds.
B. The low volatility of returns from hedge funds compared to equity returns.
C. Higher average returns provided by hedge funds compared to other investments.
D. The potential to use hedge funds to diversify portfolios that hold other asset classes.

8. Which of the following statements regarding trade sales of venture capital investments is the
most accurate?
A. A trade sale is the first step in the public offering process.
B. Trade sales are an unattractive exit strategy for most venture capitalists.
C. Trade sales are one of the most common methods of venture capital investors divesting
their holdings.
D. Trade sales means that a venture capital investment is sold to another company
operating in the same industry.

7. Investors in hedge funds are least likely to be motivated by which of the following?
A. Consistent returns across the different categories of hedge funds.
B. The low volatility of returns from hedge funds compared to equity returns.
C. Higher average returns provided by hedge funds compared to other investments.
D. The potential to use hedge funds to diversify portfolios that hold other asset classes.
Correct Answer: A .......................................................................................... LOS: Reading 76‐i

Different types of hedge funds (e.g. fixed-income arbitrage versus global macro) have quite different
performance records.

8. Which of the following statements regarding trade sales of venture capital investments is the
most accurate?
A. A trade sale is the first step in the public offering process.
B. Trade sales are an unattractive exit strategy for most venture capitalists.
C. Trade sales are one of the most common methods of venture capital investors divesting their
holdings.
D. Trade sales means that a venture capital investment is sold to another company operating in the
same industry.
Trade sales refer to a venture capital investment being sold to or merged with another company.

9. Which of the following is least likely to be used as a method of valuing real estate?
A. Cost approach.
B. Income approach.
C. Balance sheet approach.
D. Discounted cash flow approach.

10. The prices of hedge funds are often smoothed because:
A. they use arbitrage strategies.
B. the managers are risk averse.
C. they are actively dealing in derivative exchanges.
D. they invest in over‐the‐counter instruments whose prices are based on estimates.

9. Which of the following is least likely to be used as a method of valuing real estate?
A. Cost approach.
B. Income approach.
C. Balance sheet approach.
D. Discounted cash flow approach.
The methods that are covered in the text are the cost approach, sales comparison approach, income
approach and the discounted after-tax cash flow approach.

10. The prices of hedge funds are often smoothed because:
A. they use arbitrage strategies.
B. the managers are risk averse.
C. they are actively dealing in derivative exchanges.
D. they invest in over-the-counter instruments whose prices are based on estimates.
Correct Answer: D .......................................................................................... LOS: Reading 76‐l

Over the counter instruments do not have market prices and the estimated values are often less volatile
than exchange-traded instruments.

11. Investors in a load open‐end fund:
A. purchase shares at the net asset value.
B. purchase shares at a discount to the net asset value.
C. pay an annual management charge which is called a load.
D. purchase shares at the net asset value plus an initial charge.

12. The objective of a stock market index fund is to:
A. track the return from the stock market index.
B. outperform the return from the stock market index.
D. generate a return which is independent of the stock market return.
C. generate a return which is higher then the CPI index by investing in equities.

11. Investors in a load open‐end fund:
A. purchase shares at the net asset value.
B. purchase shares at a discount to the net asset value.
C. pay an annual management charge which is called a load.
D. purchase shares at the net asset value plus an initial charge.
An open-end investment company continues to buy and sell shares after the initial offering. A managed or
load fund is when the offering price is the NAV plus an initial charge called a front-end load.

12. The objective of a stock market index fund is to:
A. track the return from the stock market index.
B. outperform the return from the stock market index.
D. generate a return which is independent of the stock market return.
C. generate a return which is higher then the CPI index by investing in equities.

The objective of an index fund is to perform in line with a specified index, perhaps by owning all the shares
in the index with the same weighting as their representation in the index.

13. Which stage of venture capital financing is when capital is provided for product development
and research?
A. Seed financing.
B. Start‐up financing.
C. First‐stage financing.
D. Second‐stage financing.

14. A property which is considered a lower risk investment than another property investment,
assuming they both generate the same net operating income, will be likely to have a:
Market capitalization rate Valuation
A. lower lower
B. lower higher
C. higher lower
D. higher higher

13. Which stage of venture capital financing is when capital is provided for product development
and research?
A. Seed financing.
B. Start-up financing.
C. First-stage financing.
D. Second-stage financing.
Correct Answer: A ..........................................................................................LOS: Reading 76‐g
Seed financing is the first stage of venture capital investing, for product development and market research.
The product is still at the ‘idea’ stage.

14. A property which is considered a lower risk investment than another property investment,
assuming they both generate the same net operating income, will be likely to have a:
Market capitalization rate Valuation
A. lower lower
B. lower higher
C. higher lower
D. higher higher

The market capitalization rate reflects the investors’ required rate of return from the property, a low risk
project will tend to have a low capitalization rate and therefore, for equal net operating income, a higher
value.

15. The after‐tax cash flow from a real estate investment adjusts the net operating income for all of
the following except:
A. cost of debt.
B. proceeds from sale of property.
C. depreciation expense less tax savings.
D. taxation on capital gains when the property is sold.

16. Investing in a hedge fund is least likely to be attractive because:
A. the returns are higher than those available on equity funds.
B. the volatility of returns is lower than that of a fund investing in equities.
C. the fund will provide greater transparency than a traditional mutual fund.
D. the return from the fund is likely to have a low correlation with listed stocks and bonds.

15. The after‐tax cash flow from a real estate investment adjusts the net operating income for all of
the following except:
A. cost of debt.
B. proceeds from sale of property.
C. depreciation expense less tax savings.
D. taxation on capital gains when the property is sold.

The net operating income (NOI) is before depreciation, and depreciation is a non-cash item, so no
adjustment is made for the depreciation, although the tax saving is included in the calculation.

16. Investing in a hedge fund is least likely to be attractive because:
A. the returns are higher than those available on equity funds.
B. the volatility of returns is lower than that of a fund investing in equities.
C. the fund will provide greater transparency than a traditional mutual fund.
D. the return from the fund is likely to have a low correlation with listed stocks and bonds.
Correct Answer: C .......................................................................................... LOS: Reading 76‐j

The most common legal structure is limited partnership (in the U.S.) or an offshore corporation. The legal
structure gives the fund managers not only the freedom to implement a variety of strategies but there are
less stringent disclosure requirements than for traditional funds. Lack of transparency of hedge funds can
be a major drawback for investors.

17. In the U.S. global funds refer to funds that:
A. only invest outside the U.S.
B. are only marketed outside the U.S.
C. invest in both the U.S. and internationally.
D. are marketed in both the U.S. and internationally.

18. The role of venture capital investors is least likely to include:
A. assisting companies to go public.
B. providing financing to small privately held companies.
C. assisting the companies that they invest in with strategic planning.
D. making a market in the shares of their investments that have gone public.

17. In the U.S. global funds refer to funds that:
A. only invest outside the U.S.
B. are only marketed outside the U.S.
C. invest in both the U.S. and internationally.
D. are marketed in both the U.S. and internationally.

‘Global funds’ refer to funds that are investing in both the U.S. and international markets.

18. The role of venture capital investors is least likely to include:
A. assisting companies to go public.
B. providing financing to small privately held companies.
C. assisting the companies that they invest in with strategic planning.
D. making a market in the shares of their investments that have gone public.
The role of venture capitalists is not just to provide finance but to also work with the management team to
develop and expand the business. This would usually include assisting with a company going public as
venture capitalists have experience dealing with underwriters and other financial institutions. They would
not normally be specialists or market makers.

19. A mutual fund has issued two classes of shares. Each class holds the same underlying portfolio of
securities but the expense structures differ, the fees are shown in the table below:
Class A Class B
Front‐end fees 4% None
Redemption fees None 5% in the first year but declining
by 1% point each year thereafter
Annual expenses
Distribution fees 0.30% 0.30%
Management fees 0.75% 1.00%
Other expenses 0.20% 0.20%
1.25% 1.50%

What would be the return for each of the classes of shares if an investor invests $1 for a period
of five years, assuming the fund grows by 8% annually?
Fund A Fund B
A. 32.46% 34.88%
B. 32.46% 36.24%
C. 33.08% 34.88%
D. 33.08% 37.01%

Class A Class B
Annual expenses
1.25% 1.50%
What would be the return for each of the classes of shares if an investor invests $1 for a period of five years,
assuming the fund grows by 8% annually?
Fund A Fund B
A. 32.46% 34.88%
B. 32.46% 36.24%
C. 33.08% 34.88%
D. 33.08% 37.01%
Fund A:
Due to the front‐end fee of 4%, only $0.96 from the $1 will be available to invest.
At the end of five years, $1 invested in the fund will be worth
$0.96 x (1.08)5 x (1 – 0.0125)5 = $1.3246, or a return of 32.46%.

Fund B:
At the end of 5 years, $1 invested in the funds will be worth
$1 x (1.08)5 x (1 – 0.015)5 = $1.3624, or a return of 36.24%.



Class A Class B
Annual expenses
1.25% 1.50%

What would be the return for each of the classes of shares if an investor invests $1 and redeems
his shares after two years, assuming the fund grows by 8% annually?
Fund A Fund B
A. 9.19% 8.64%
B. 9.19% 8.89%
C. 9.40% 8.64%
D. 9.40% 9.77%

Class A Class B
Annual expenses
1.25% 1.50%
What would be the return for each of the classes of shares if an investor invests $1 and redeems his shares
after two years, assuming the fund grows by 8% annually?
Fund A Fund B
A. 9.19% 8.64%
B. 9.19% 8.89%
C. 9.40% 8.64%
D. 9.40% 9.77%
Fund A:
There is no redemption fee, so the investment in the fund after two years will be worth
$0.96 x (1.08)2 x (1 – 0.0125)2 = $1.0919, or a return of 9.19%.

Fund B:
After two years the redemption fee will be 4%, i.e. a decline of 1% point from 5%.
The investment in the fund after two years will be worth
$1 x (1.08)2 x (1 – 0.015)2 x (1 ‐ 0.04) = $1.0864 or a return of 8.64%.


21. An investor is considering purchasing an office building as an investment, and the following
information has been collected. The figures are on an annual basis.
Gross potential rental income $1,000,000
Estimated vacancy and collection losses 5%
Insurance and taxes $80,000
Utilities $30,000
Repairs and maintenance $60,000
Depreciation $70,000
Interest on proposed financing $90,000

The net operating income (NOI) per annum is closest to
A. $620,000.
B. $690,000.
C. $710,000.
D. $780,000.

22. An investor is looking at investing $1 million in a project, where the expected payout is $10
million at the end of five years. The investor’s cost of equity for the project is 10%. However there is a
significant risk of failure and the probability of failure in any year is given in the table below. The
probability is based on the condition that the project has survived the previous year.
Year 1 2 3 4 5
Probability of failure 0.40 0.35 0.25 0.20 0.20
The expected net present value (NPV) of the project is closest to
A. $159,400.
B. $346,400.
C. $870,000.
D. $972,400.

21. An investor is considering purchasing an office building as an investment, and the following
information has been collected. The figures are on an annual basis.
Gross potential rental income $1,000,000
Estimated vacancy and collection losses 5%
Insurance and taxes $80,000
Utilities $30,000
Repairs and maintenance $60,000
Depreciation $70,000
Interest on proposed financing $90,000
The net operating income (NOI) per annum is closest to

A. $620,000.
B. $690,000.
C. $710,000.
D. $780,000.

NOI = gross potential rental income minus expenses
= $1,000,000 – (0.05 x $1,000,000) ‐ $80,000 ‐ $30,000 ‐ $60,000
= $780,000
Note the expenses for this calculation do not include depreciation (it is assumed that repairs will maintain
the building in good condition indefinitely) and interest expense.

22. An investor is looking at investing $1 million in a project, where the expected payout is $10
million at the end of five years. The investor’s cost of equity for the project is 10%. However there is a
significant risk of failure and the probability of failure in any year is given in the table below. The
probability is based on the condition that the project has survived the previous year.
Year 1 2 3 4 5
Probability of failure 0.40 0.35 0.25 0.20 0.20
The expected net present value (NPV) of the project is closest to
A. $159,400.
B. $346,400.
C. $870,000.
D. $972,400.
Correct Answer: A..........................................................................................LOS: Reading 76‐h
The probability that the project survives throughout the five years is given by the product of the individual
probabilities it survives each year, which is:
(1 – 0.40) (1 – 0.35) (1 – 0.25) (1 – 0.20) (1 – 0.20) = 18.7%

If the project survives the present value is: $10 million/(1.10)5 ‐ $1 million = $5.2 million

If the project fails the present value is: – $1 million.

The expected NPV:
0.187($5.2 million) + 0.813(– $1 million) = $159,400


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Terminology 501
Terminology:
Appraisal – for real estate, the process of estimating the current market value of a property.
Comparative sales approach – the value of a real estate is , at the most, the cost of the land and
constructing the building at current prices.
Income approach – the value of real estate is the present value of it future income.
Market capitalization rate – divide a property’s net operating income by the appropriate market
capitalization rate to arrive at an estimate for its current market value. It reflects the rate of return
required by investors in such a property.
Positive leverage – the return from a real estate investment is higher than the cost of debt, an investor
will achieve a higher rate of return if he/she uses leverage to purchase the property.
Real Estate Investment Trust (REIT) – a closed‐end investment company that invests in real estate
and mortgages on real estate.
Real Estate Limited Partnership (RELP) – a real estate syndicate that invests in different types of real
estate.
Seed financing – venture capital provided for product development and market research, the
product is still at the ‘idea’ stage.
Start‐up financing – venture capital provided for early stage product development and initial
marketing.
First‐stage financing – venture capital provided for initial commercial manufacture and sales.
Mezzanine (or bridge) financing – venture capital provided for a company that expects to go public
in the near future.
Turnarounds – capital provided to restructure a company that has problems.
Leveraged buyouts (LBOs) – capital to fund a management group (a management buyout) or other
investors who wish to purchase a business or company.
Investment company – a company that sell its own shares and uses the proceeds to buy stocks, bonds
or other financial instruments.
Closed‐end investment company – an investment company that issues a fixed number of shares, the
shares are then traded in the secondary market.
Open‐end investment company – a company that offers new shares to investors and redeems shares
continuously.
Mutual fund – an open‐end investment company.
No‐load fund – shares are sold at net asset value, with no sales charge added.
Load fund – a fund that makes an initial sales charge, so the offering price is the net asset value plus
a load.

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Appendix A: 503
Appendix A:
Exhibits
Exhibit 1: Accounting Statements
Exhibit 2: Puts and Calls
Exhibit 3: PE Breakdown
Exhibit 4: Ratios
504 Exhibit
Exhibit 1: Accounting Statements

Income Stmt:
Particular Sales Assets
moment in the
life of an asset
Convert assets into Assets come
Profit Stk into Balance
profit to return to Eqty
Inv or Stkhldrs Sheet in SE to
Equity get to Assets
Investors
Decisions
Statement of Cash Flows Income Statement Balance Sheet
Sales
- COGS
CFO Operating CA CL
AR AP
Gross Margin
Inv
- Expenses
CFI EBIT Investment
FA
- Interest
EBT
Financing LTD
- Tax
SE
CFF EAT
Inventory stored and

converted to product
A growing
company never has
CEOs look at things enough cash
from viewpoint of collection to grow
Cash Flow ... to pay Operation the inventory.
bills, liquidity Cycle
Acquire CEO is always

Inventory Sale looking for
something which
will grow cash.
Newspaper cycles
daily,
Boeing could take
Cash Collection years
Appendix A: 505
Notes:
506 Exhibit
Exhibit 2: Puts and Calls

Interpret the diagrams that depict the expiration-day values of the long call, short call, long put and short put strategies;
(X = strike price, S = Stock price, C = cost of Call, P = cost of Put)
Long Call Long Put
Value V>0 Value V>0 Value of the long
Positive positive put will be the
amount less
Value of the long than the strike
call will be the that the stock is
0 amount over 0 trading. Long
strike the stock put will never
is trading. Long X have a value less
negative call will never negative than zero.
have a value less
S X X S
than zero.
Short Call Short Put

Value of the
Value V<0 Value V<0
short put will be
Positive Positive
Value of the short the amount less
call will be the than the strike
amount over the the stock is
0 strike the stock is 0 trading. Short
trading. Short put will never
call will never have a value
negative have a value negative greater than
greater than zero.
S X X S
zero.
Interpret the profit/loss diagrams for the long call, short call, long put, and short put strategies;
Long Call Long Put
Loss < C, Profit > X+C Loss < X+P, Profit < X
Profit Profit
Profit of the long Profit the long
call is the amount put is the
over the strike + amount under
0 cost of the call 0 the strike and
(X+C). Loss on the cost of the put.
cost of C call is the amount cost of P Loss on the put
Loss the stock is under Loss is the amount
the call + strike, the stock is over
X X+C X X+P
not to exceed the the strike, not to
Å stock price Æ cost of the call. Å stock price Æ exceed the cost
of the put.
Short Call Short Put

Loss > X+C, Profit < X+C Loss > X, Profit > X
Profit Profit Profit the short
Profit of the short
Rec’d fm C Rec’d fm C put is the amount
call is the amount
under the strike + more than the
0 cost of the call 0 strike of the put,
(X+C), not to exceed not to exceed the
the proceeds received proceeds received
from the call. Loss from the put.
Loss Loss Loss on the put is
on the call is the
X X+C amount the stock is
X X+P the amount the
over the call + strike. stock is less than
Å stock price Æ Å stock price Æ
the strike.
Appendix A: 507
Notes:
508 Exhibit
Exhibit 3: PE Breakdown
Note: 3 Stage ROE Profit Margin * Total Asset Turnover * Financial Leverage
NI * Sales * Total Assets
Sales Total Assets Equity
Editor’s Review:
Income Statement
Sales
- COGS
Gross
Margin
- Expenses (mgmt hides it’s perks if EAT is
OK)
EBIT
- Interest Bank happy
EBT What mgmt earns for
shareholders
- Taxes Gov’t happy
EAT Stockholders happy
Appendix A: 509
EAT = EBT - EBT(t)

EAT = EBT(1-t)
Expected EPS = Expected Sales/share * Expected Net profit Margin
Income Stmt: Next year’s projected
We know last year’s P & P/E [ (S) (EBDIT) - D - I ] (1-t)
Can calc next year’s earnings pending ratio Depr Inter tax
then Proportion via P/E to get Pproj EOY sales per shr Exp adj
Pproj EOY = (EProj EOY) (P/E)
Earnings, DDM & ROE Calc
P = Div / Earn Dividend pay-out

E k–g k-g
(Retention) (ROE)
k = Real Rate + Interest Prem + Risk Prem Tax * Interest * Oper’g * Asset * Financial
Nominal rate should really multiply Reten Burden Profit Turnover Leverage
Rate Margin
k = Rf + β(Rm - Rf) β is # units of risk in the stock

Stockholders want and pay for k, k determines the P NI * EBT * EBIT * Sls * Assets
EBT EBIT Sls Assets Equity
P0 = D 1
k-g Oper Total -Interest Financial * Tax
WACC = (weke) + (wdkd) Profit * Asset Expense * Leverage Retention
Margin Turnover Rate Multiplier Rate
P0 = D 1
k-g EBIT * Sls - Int * Assets * (1 -
T)
Sls Assets Assets Equity Note: tax ret (1-t)
ReturnEstimated = Cash Div + PriceEnd - PriceNow

PriceNow Good side
Bad side
f
P0 = D 1 restate: k= D +g = k = Rf + β(Rm - Rf) also k = (1+RR)(1+IP)(1+RP)

k-g P real infl risk
should be in equilibrium
510 Exhibit
Exhibit 4: Ratios
calculate the financial ratios in each major category of analysis and discuss the uses of those ratios;
Common Size Statements: B/S in percent of Total Assets, I/S in percent of Sales
Quickly compare two different size firms, same firm trends over time, structure of firm’s financial
statements
Internal Liquidity (Solvency): ability of firm to meet future short term obligations, compare near term
obligations with current assets or cash flows
Current Ratio: Current Assets Working Capital = CA - CL

Current Liabilities
Quick ratio Cash + mkt sec + AR not include. inventory

CL
Acid Test CA - Inv a.k.a. Quick Ratio

CL
Cash ratio Cash + mkt sec even more conservative

CL
Receivables Turnover Net Annual Sales Avg collection: 365

Avg Receivables Annual Turnover
Days Receivable 365 Avg # of days to get paid

Avg Receivables
Working Cap / Sales CA - CL higher % indicates more liquidity

Net Sales
Payables Turnover COGS @ payable period: 365

@ AP (do they pay their bills) Annual Turnover
Operating Performance: How well management is operating the business
Operating Efficiency Ratios: How management uses its assets and capital
Activity ratios: sales per something

Inventory Turnover COGS @ Inventory period 365
@ Inventory Inventory
Turnover
Total Asset Turnover Net Sales high or low relative to industry?

@ Tot Net Assets low: tie up too much assets
Fixed Asset Turnover Net Sales utilization of fixed assets

@ Net Fixed Assets hi: old depr equipment
Appendix A: 511
Equity Turnover Net Sales excludes CL & LT Debt

Average Equity
Receivables Turnover Net Annual Sales Avg collection period: 365

Avg Receivables Annual Turnover
Operating Profitability: rate of profit on sales, % return on capital

(How good is mgmt turning profits into sales)
Note: Run down Income Statement and ratio to Sales (GP, EBIT, EBT, EAT)
EBIT: Mgmt earns
Tax: Government earns
Interest: Banker’s earn
EBT: Stockholder’s earn
Gross Profit Margin Gross Profit (GP = Sls - COGS)

Net Sales relative cost price position in industry?
Operating Profit Margin Operating Profit (EBIT)

Net Sales variability is business risk indicator
Net Profit Margin Net Income NI = EAT

Net Sales
EBT Margin EBT before tax profit margin

Net Sales
Common Size Income Statement

lists all expense and income items as a % of sales
(Inc Stmt: / Sls) (Bal: / Sls or Tot Assets)
Return on Total Capital Net Income + Interest Expense Debt, Pref. Stock, C Stock
Average Total Capital return on all capital
employed
Return on Total Equity Net Income ROE

@ Total Equity
Return on Owners Equity Net Income – Preferred Dividend

@ Common Equity
Return on Equity (ROE): DuPont System duPont formulation

ROE = NI / Equity or EAT/Equity
512 Exhibit
3 Step ROE = NI = Net * Asset * Financial a.k.a.Equity Multiplier

Equity Profit Turnover Leverage
Margin
NI * Sls * Assets Note:(Sls)(Assets)

Sls Assets Equity (Sls)(Assets)
4 Step ROE = NI = Tax * Interest * Oper’g * Asset * Financial

Equity Reten Burden Profit Turnover Leverage
NI * EBT * EBIT * Sls * Assets

EBT EBIT Sls Assets Equity
5 Step Equation = Oper * Total - Interest Financial * Tax

Profit Asset Expense * Leverage Retention
Margin Turnover Rate Multiplier Rate
EBIT * Sls - Int * Assets * (1 - T)

Sls Assets Assets Equity
Financial Risk: Uncertainty of returns to equity holders due to a firm’s use of fixed obligation debt
securities
Debt / Equity remember firm value is Db + Eq

Db=1, Eq=2, firm value = 3, D/E = ½
(not D/E=1/3, easy mistake in a hurry)
LTD / LT Cap LTD = Long Term Debt LT Cap = Long Term Capital
Total Debt / Total Capital
Interest Coverage EBIT NI + Tax + Int Exp

Interest Expense Int Exp
(Note: Look for this on the exam
Cash Flow / LTD
Cash Flow / Total Debt

Appendix A: 513
Growth Analysis
Retention rate earnings retained / total earnings
(remember: growth = retention rate * ROE)
ROE see above, profitability
Total Asset Turnover see above, operational performance
Total Assets / Equity note component of ROE
Net Profit Margin see above, profitability
Sustainable growth rate g = retention * ROE
retention rate = 1 – (Oper Inc after taxes)
Risk Analysis: uncertainty of income flows for the total firm and for sources of capital
Business Risk: Uncertainty of income caused by a firm’s industry

Variability of sales due to products, customers, production methods
Business Risk Coefficient of variation of operating income CV = σ/mean
Standard Deviation of Operating Earnings (OE) need 5<Thru> 10 yrs

Mean Operating Earnings to compute coef of variation
Sales Volatility Coefficient of Variation of Sales CV = σ/mean
sd of sales prime determinant of earnings variability

mean sales
Operating Leverage %∆OE / %∆Sls or Σ | [%∆OE] / [%∆Sls] | / N employment of fixed production

costs direction of change not important, but relative size of the change is relevant
OL = % change in operating earnings / % change in sales , calc from #’s not %

514 Practice Exam Features
FinancialExam Features
Using FinancialExams Quizzer
In Brief .......................................................................................................................................515
Study Session..................................................................................................................514
Practice Exams..........................................................................................................................516
FinancialExams Quizzer Features ............................................................................................517
Online Help ......................................................................................................................517
Email:...............................................................................................................................517
Telephone:.......................................................................................................................517
Changing subjects ...........................................................................................................518
Changing the number of questions..................................................................................518
Changing the subcategories............................................................................................518
Setting up your printer .....................................................................................................518
Printing questions ............................................................................................................518
Using FinancialExams Quizzer options ...........................................................................519
The Adaptive Exam ...................................................................................................................519
How to take advantage of Adaptive testing: ....................................................................519
Take the Adaptive Exam .................................................................................................519
Reviewing an Adaptive Exam..........................................................................................520
Starting a Study Session ...........................................................................................................520
Checking your score during a test ...................................................................................521
Checking your performance ............................................................................................521
Checking your overall progress .......................................................................................521
Simulated Exam ........................................................................................................................521
Take the Simulated Exam ...............................................................................................521
Reviewing a Simulated Exam..........................................................................................522
FlashCard Option ......................................................................................................................522
Starting a FlashCard Session....................................................................................................523
How to use a FlashCards ..........................................................................................................523
Taking Notes .............................................................................................................................523
Take notes from a study session.....................................................................................523
Export your notes.............................................................................................................523
Practice Exam Features 515
Using FinancialExams Quizzer

In Brief
The FinancialExams Quizzer exam software is designed to identify your personal areas of
weakness relative to passing specific exam objectives. Once this software determines just what
those weaknesses are, it will force you to continually face them until you can demonstrate
mastery over them. Then it will find something else to haunt you with.
To use this software successfully, follow these simple steps.
1) Spend some time getting familiar with the program. When you’re ready to settle down to
work, clear the history (the button is on the main screen). Do not clear the history again
until all of the following steps have been completed.
2) Take four (4) Adaptive Exams. During this process, you have no choices. The software is
in control. It is using its internal logic to determine your strengths and weaknesses on a
topic-by-topic basis. (Note: You don’t have to take all four at one sitting.)
3) After the four Adaptive Exams, look at your Historical Analysis (the button is on the
main screen). This will give you a graphical presentation of how you have done
cumulatively in each category. Let this be your guide as to which subcategories to begin
studying. Start with your weakest and work your way up.
4) Begin taking Study Sessions on selected topics. Select the Category and Subcategories
that you will be focusing on. You have two primary goals in Study Session mode.
a) See and answer every question on that topic at least once. Keep in mind that any
question answered incorrectly will be in the very next Study Session you take on that
topic. Once you are able to answer it correctly, it will get shuffled to the bottom of the
deck. When you have cycled through available questions, correctly answered questions
will begin to reappear.
b) Achieve a minimum score of at least 85% on each and every subcategory topic before
moving on to the Simulated Exam. If you want to bounce around a little between
subcategories a little, that’s okay. The program will remember where you left off.
However, it’s important that you don’t cheat yourself on this step.
5) Take the Simulated Exam. Don’t be too disappointed if you don’t pass the first time. The
software has been gaining knowledge about your weaknesses and has just done
everything in its power to make you fail this exam. Aren’t you glad that wasn’t the real
thing?
6) Clear your history and repeat the above steps two more times. That’s right… two more
times. But now, achieve a minimum of 90% and 95% respectfully on each pass through
before taking the Simulated Exam.
You will find that the number of Study Sessions and the amount of time necessary to achieve
these scores will get smaller. The better you know the material, the quicker the whole process
becomes.
The rest of this document goes into more detail on using specific features of the FinancialExams
Quizzer software. Spend some time getting to know this program. It has helped thousands of
people achieve their certification goals. It can do the same for you.
Study Session
FinancialExams Quizzer tests your knowledge as you learn about new subjects through
interactive quiz sessions. Study Session questions are selected from a single database for each
session, dependent on the subcategory selected and the number of times each question has been
previously answered correctly. In this way, questions you have answered correctly are not
repeated until you have answered all the new questions. Questions that you have missed
previously will reappear in later sessions and keep coming back to haunt you until you get the
question correct. In addition, you can track your progress by displaying the number of questions
you have answered with the Historical Analysis option. You can reset the progress tracking by
clicking on the Clear History button. Each time a question is presented the answers are
randomized so you will not memorize a pattern or letter that goes with the question. You will
start to memorize the correct answer that goes with the question concept.
Practice Exams
FinancialExams Quizzer also provides Adaptive and Simulated certification exams. Questions are
chosen at random from the database. The Simulated Exam is a timed test that presents a similar
number of questions as the real exam. A break from testing occurs at the mid-point of the exam.
The Adaptive Exam presents a fixed number questions with a maximum time allotment. The
Adaptive Exam is most helpful in identifying areas of weakness in the candidate’s knowledge of
the exam objectives.
After you finish an exam, FinancialExams Quizzer displays your score and the passing score
required for the FinancialExams Quizzer test. You may display the exam results of this specific
exam from this menu. You may review each question, display the correct answer, identify a
resource, link to an available electronic book and view an explanation for the answer.
FinancialExams Quizzer Features
1. Each database contains 200 to 2. Easy to install

1200+ questions
3. Easy to upgrade 4. Multiple choice Style
questions
5. Essay style questions 6. Fill-in-the-blank Style
questions
7. Performance based questions 8. Flash Card Style questions
9. Questions randomized 10. Hot Spot Style questions
11. Print a category of questions 12. Drag/Drop/Mix/Match
questions
13. Single module studies 14. Answers randomized
15. Simulation exam studies 16. Print one question
17. Instant exam feedback 18. Cheat key or Flash Card
option
19. Statistical analysis 20. Instant question feedback
21. Individual exam analysis 22. Adaptive exam studies
23. Font selection 24. Skills assessment
25. Graphics 26. Historical analysis
27. User Notes creation 28. Resizable screen
29. Some Links to Electronic Book 30. Most have Explanations
content
31. Free version updates via e- 32. References
mail
Online Help
This manual installs on your PC along with the FinancialExams Quizzer. To access it, select
Contents from the Help pull-down menu. Additional help can be obtained via:
Email:
Support@BFQPress.com
AskTheExpert@BFQPress.com
CustomerService@BFQPress.com
Telephone:
Toll Free: (888) 992-3131
International: (281) 992-3131
Fax: (281) 482-5390
Changing subjects
FinancialExams Quizzer provides several practice exams to test your knowledge. To change
exams:
1. Click the Change Exam button in the Main window.

2. Select the exam for the test you want to run from the Select Exam window.
3. Click OK to change to the selected exam, or the Cancel to keep the current exam.
Changing the number of questions
You can choose the number of questions presented in each quiz session. To change the number of
questions:
1. Click on the box to the right of the Number of Questions field in the Main window.
2. Type a number of questions, between 1 and 250, in the Number of Questions field.
3. If the number of questions selected exceeds the number available in the chosen
subcategory, all that are available will be displayed.
Changing the subcategories
Each FinancialExams Quizzer subject has a number of categories and subcategories. You can take
a test on any one or any combination of the subcategories.
1. From the Subcategories frame, select the desired general category from the Categories
drop down list.
2. Select the desired subcategory from the list box. To select multiple subcategories, hold
down the CTRL key while clicking items in the list box.
Setting up your printer

FinancialExams Quizzer allows you to customize your print jobs.
1. Select Options from the View pull-down menu.

2. Select the Printing Options radial button. The Printing Options window appears.
3. Select the options for your printer.
4. Click OK to exit and save changes.
Printing questions
FinancialExams Quizzer allows you to print questions from your tests, with or without the
correct answer(s) marked. To print the question(s), select the desired print option from the File
pull-down menu in the Question window.
Using FinancialExams Quizzer options

FinancialExams Quizzer provides a number of additional options to customize your test. The
following options are available:
1 Stop On Wrong Answers

2 Enable Cheat Key
3 Resizable Screen
4 Font Setting
To select an advanced option, select Options from the View pull-down menu. The Exam
Preferences window appears.
Adaptive Exam
Adaptive testing is a time saving option used to identify the candidate’s strengths and
weaknesses. Before using Adaptive testing, clear historical Analysis. Before you learn about your
subject using the Quizzer Study Sessions, you should take the Adaptive exams. This exam style
does not simulate all of the exam environments that are found on certification exams. You cannot
choose specific subcategories for the Adaptive exam and once a question has been answered you
cannot go back to a previous question. You have a time limit in which to complete the adaptive
exam. This time varies from subject to subject, although it is usually 15 to 25 questions in 30
minutes. When the time limit has been reached, your exam automatically ends.
How to take advantage of Adaptive testing:

1. Clear the Historical Analysis
2. Take four (4) adaptive exams in a row. Study the contents after each adaptive exam.
3. View the historical analysis to identify your strength and weakness at the end of the four
(4) adaptive exams.
4. Go back to reviewing using the Study Sessions by Sub Category
5. Repeat process until you are ready to pass the real exam.
Take the Adaptive Exam

1. Click the Adaptive Exam radial button from the Main window.
2. Click the Start button. The Adaptive Exam window appears.
3. Click the circle to the left of the correct answer. There may be more than one correct
answer. Text in the bottom left corner of the window instructs you to Choose the Best
Answer (if there is only one answer) or Mark All Correct Answers (if there is more than
one correct answer).
4. Click the Next button to continue.
After the allotted time has elapsed, the exam exits to review mode. To quit the test at any time,
click the Finish button. After you have completed the Adaptive exam, FinancialExams Quizzer
displays your score and the passing score required for the test. Display your exam results by
selecting Details You may review each question, display the correct answer, and view an
explanation for the answer (if available).
Reviewing an Adaptive Exam

After you have taken an Adaptive exam, you can review the questions, your answers, and the
correct answers. You may only review your questions immediately after completing an Adaptive
exam. To review your questions:
1. Click the Correct Answer button.

2. To see your answer, click the Your Answer button.
Starting a Study Session

After you choose a subcategory to test yourself on, start the Study Session.
To start a study session:
1. Select the Study Session radial button.

2. Click the Start button. The Question window appears. Optionally, you can select Study
Session from the Start pull-down menu. Click the checkbox to the left of the correct
answer. There may be more than one correct answer. Text in the bottom left corner of
the window instructs you to Choose the Best Answer (if there is only one answer) or
Mark All Correct Answers (if there is more than one correct answer).
3. Click the Next button to continue. FinancialExams Quizzer provides immediate feedback
on your answer at the bottom of the window.
If you answered the question correctly, a new question appears. If you did not answer the
question correctly, you may try to guess again or move to the next question. If you have selected
the Prompt on Wrong Answers option, you have the following choices:
1. To try again, click the Try Again button.

2. To move to the next question after an incorrect guess, click the Next Question button.
3. View the correct answer
4. View the Explanation option
To quit the test at any time, click the Finish button.
Checking your score during a test

The X% button displays the current percentage of questions that have been answered correctly.
1. Click the X% button. A window appears displaying the number of questions that have
been asked and the number of questions that have been answered correctly.
2. Click OK to return to the test.
Checking your performance
Click the QID button. A window appears, displaying the number of times you have been asked
this question and the number of times you have answered this question correctly.
Checking your overall progress

1. Click the Historical Analysis button from the Main window. The Historical Analysis
window appears.
2. FinancialExams Quizzer displays your progress in each test using a graphical progress
bar. Hold the cursor over the progress bar and a dialog box will open. The number of
times you have answered questions in that category correctly as a percentage of the
total number of questions is displayed.
3. To get detailed information on your performance on any subject, click and hold the
progress bar for that subject. FinancialExams Quizzer displays the performance details
in the bottom left hand corner of the screen.
Simulated Exam
After you have learned about your subject using the Study Sessions, you can take a simulated
exam. This exam simulates the exam environment that might be found on a certification exam.
You cannot choose subcategories for a Simulated Exam. You have a fixed limit equal to that of the
real exam to complete the Simulated Exam. When this time limit has been reached, your exam
automatically ends.
Take the Simulated Exam

1. Click the Simulated Exam radial button from the Main window.
2. Click the Start button. The Simulated Exam window appears.
3. Click the circle to the left of the correct answer.
There may be more than one correct answer. Text in the bottom left corner of the window
instructs you to Choose the Best Answer (if there is only one answer) or Mark All Correct
Answers (if there is more than one correct answer).
4. If you are unsure of the answer and wish to mark the question so you can return to it
later, check the Mark box in the upper left hand corner. To review which questions you
have marked, which you have answered, and which you have not answered, click the
Review button.
5. Click the Next button to continue.
After the allotted time for testing, the exam exits to review mode. To quit the test at any time,
click the Finish button. After you have completed the Simulated Exam, FinancialExams Quizzer
displays your score and the passing score required for the test. Display your exam results by
selecting Details. You may review each question, display the correct answer, and view an
explanation for the answer (if available).
Reviewing a Simulated Exam

After you have taken a simulated exam, you can review the questions, your answers, and the
correct answers. You may only review your questions immediately after a Simulated Exam.
To review your questions:
1. Click the Correct Answer button.

2. To see your answer, click the Your Answer button.
FlashCard Option
After you have learned about your subject using the Study Sessions, Adaptive, and Simulated
exam go to the Thinking Option. The FlashCard environment is very different and will help you
more that you might believe on a certification exam. The Flash Card Option is very effect when
used with Terminology or Glossary “Fill-in-the-Blank” style questions.
Read the displayed question, Think of the answer, Hit the F4 Function key to display the correct
answer, Read the Answer, Go to the next question.
1. You should not view the answer until you have thought about the answer.
2. You have an unlimited time limit to think about each question.
3. Use this option a few days before the real exam to go through a lot of questions in a short
period of time.
4. The FlashCard option can be used as a review of all questions in the database.
5. Use the FlashCard option to provide Positive Feed Back with Correct Answers.
Starting a FlashCard Session

After you choose a subcategory to test yourself on, start FlashCards.
1. Select the FlashCards Session radial button.
2. Click the Start button. The Question window appears. Optionally, you can select
FlashCards Session from the Start pull-down menu. You will find no answers to check
or any visible area to type your answer into.
3. This is the time to THINK of the answer. Pause a moment than hit the F4 function on
your keyboard. (CheatKey)
4. Review the displayed answer. Did you get it correct?
5. When you are ready to proceed Click the Next button to continue.
How to use a FlashCards
1. Read the displayed question
2. Think of the answer
3. Hit the F4 Function key to display the correct answer
4. Read the Answer
5. Go to the next question.
To quit the test at any time, click the Finish button.
Note: Some questions may ask for more than one answer: Bypass questions that state "Which of
the Following" and "Select all that apply" etc.
Taking Notes
While you are taking your exam, you may wish to write down notes about a particular question
that you can use in later Study Sessions. FinancialExams Quizzer allows you to enter notes about
each question. The notes will be permanently stored in the database for the subject you are
studying. You can also use this feature to record any comments you have about a particular
question and send it in for review. If you would like to print or view your notes, you can export
your notes to a standard text editor.
Take notes from a study session
Create your own information or reference.
1. Click the Notes button from the Question window.
2. Type your note.
3. Click OK to keep the note, or Cancel to delete the note.
Note: You cannot take notes during a Simulated or Adaptive session until you have finished the
exam and have entered the Review mode.
Export your notes
Click the Notes button from the Main window and export to Note Pad or any text editor you
wish to use.
526 CFA Exam Forum
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Table of Contents Link

CFA 2008 Level I Certification

TotalRecall Publications, Inc.

Jane Vessey & M. Afdal Pamilih

About the Book:

Standard III: Relationships with and Responsibilities to the Employer

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

Reading 57: Industry Analysis...................................................................................................378

Study Session 01: Ethical and Professional

A. must file a report with the SEC.

Correct Answer: D ........................................................................................... LOS: Reading 2‐b

Correct Answer: D ........................................................................................... LOS: Reading 2‐b

Correct Answer: D ........................................................................................... LOS: Reading 2‐b

Correct Answer: D ........................................................................................... LOS: Reading 2‐b

Correct Answer: C ........................................................................................... LOS: Reading 2‐b

Correct Answer: C ........................................................................................... LOS: Reading 2‐b

Correct Answer: A ........................................................................................... LOS: Reading 2‐b

Correct Answer: B............................................................................................ LOS: Reading 2‐b

Correct Answer: A ........................................................................................... LOS: Reading 2‐b

Correct Answer: C ........................................................................................... LOS: Reading 2‐b

A. Luny should request his supervisor’s approval.

Correct Answer: C ........................................................................................... LOS: Reading 2‐b

Correct Answer: A ........................................................................................... LOS: Reading 2‐b

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

Correct Answer: B....................................................................................................... Reading 2‐b

Correct Answer: A ........................................................................................... LOS: Reading 2‐b

Correct Answer: D ........................................................................................... LOS: Reading 1‐c

Study session 02: Quantitative Methods:

Correct Answer: C ........................................................................................... LOS: Reading 5‐d

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

Correct Answer: A ............................................................................................ LOS: Reading 8‐c

Correct Answer: A ............................................................................................ LOS: Reading 6‐c

Correct Answer: D ............................................................................................ LOS: Reading 5‐c

Correct Answer: B............................................................................................ LOS: Reading 6‐d

Correct Answer: D ............................................................................................ LOS: Reading 5‐c

Correct Answer: B............................................................................................. LOS: Reading 8‐f

Correct Answer: D ............................................................................................ LOS: Reading 5‐c

Correct Answer: B............................................................................................ LOS: Reading 7‐d

Correct Answer: C ........................................................................................... LOS: Reading 7‐d

Correct Answer: C ........................................................................................... LOS: Reading 8‐d

Correct Answer: C ........................................................................................... LOS: Reading 7‐d

Correct Answer: A ............................................................................................ LOS: Reading 6‐c

Correct Answer: D ........................................................................................... LOS: Reading 8‐d

1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

Correct Answer: C ............................................................................................ LOS: Reading 6‐c

Correct Answer: B........................................................................................... LOS: Reading 8‐m

A = $10,000 HP‐12C BA II Plus

Study Session 03: Quantitative Methods:

Correct Answer: D ......................................................................................... LOS: Reading 10‐b

Correct Answer: D ............................................................................................ LOS: Reading 9‐f

Set the null hypothesis as H0: µ ≤ 4.0

x −µ 4.5 − 4.0 0.5

Correct Answer: C ............................................................................................ LOS: Reading 9‐j

Correct Answer: A .......................................................................................... LOS: Reading 10‐f

Correct Answer: C ......................................................................................... LOS: Reading 10‐k

Correct Answer: C .......................................................................................... LOS: Reading 11‐c

14. A chi‐square test statistic ( χ ) could be used for hypothesis tests for

14. A chi‐square test statistic ( χ ) could be used for hypothesis tests for

A. the mean for a single normally distributed population.

Correct Answer: B........................................................................................... LOS: Reading 11‐f

Correct Answer: B........................................................................................... LOS: Reading 10‐f

Correct Answer: D ......................................................................................... LOS: Reading 10‐b