1. An investor is considering purchasing ACQ.

There is a 30% probability that ACQ will be

acquired in the next two months. If ACQ is acquired, there is a 40% probability of earning a 30%
return on the investment and a 60% probability of earning 25%. If ACQ is not acquired, the
expected return is 12%. What is the expected return on this investment?

A) 18.3%.
*B) 16.5%.
@ E(r) = (0.70 * 0.12) + (0.30 * 0.40 * 0.30) + (0.30 * 0.60 * 0.25) = 0.165.
C) 12.3%.

2. The probabilities of earning a specified return from a portfolio are shown below:

Probability Return
0.20 10%
0.20 20%
0.20 22%
0.20 15%
0.20 25%
What are the odds of earning at least 20%?

A) Two to three.

B) Three to five.

*C) Three to two.

@ Odds are the number of successful possibilities to the number of unsuccessful possibilities:

P(E)/[1 – P(E)] or 0.6 / 0.4 or 3/2.

3. A stock priced at $10 has a 60% probability of moving up and a 40% probability of moving
down. If it moves up, it increases by a factor of 1.06. If it moves down, it decreases by a factor
of 1/1.06. What is the expected stock price after two successive periods?
A) $11.24.

*B) $10.27.

@ If the stock moves up twice, it will be worth $10 * 1.06 * 1.06 = $11.24. The probability of
this occurring is 0.60 * 0.60 = 0.36. If the stock moves down twice, it will be worth $10 *
(1/1.06) * (1/1.06) = $8.90. The probability of this occurring is 0.40 * 0.40 = 0.16. If the stock
moves up once and down once, it will be worth $10 * 1.06 * (1/1.06) = $10.00. This can occur
if either the stock goes up then down or down then up. The probability of this occurring is 0.60
* 0.40 + 0.40 * 0.60 = 0.48. Multiplying the potential stock prices by the probability of them
occurring provides the expected stock price: ($11.24 * 0.36) + ($8.90 * 0.16) + ($10.00 * 0.48)
= $10.27.

C) $10.03.

4. Which of the following statements about the defining properties of probability is least
accurate?

A) The sum of the probabilities of events equals one if the events are mutually exclusive and
exhaustive.

B) The probability of an event may be equal to zero or equal to one.

*C) To state a probability, a set of mutually exclusive and exhaustive events must be defined.

@ Stating a probability does not require defining a mutually exclusive and exhaustive set of
events. The two defining properties of probability are that the probability of an event is greater
than or equal to zero and less than or equal to one, and if a set of events is mutually exclusive
and exhaustive, their probabilities sum to one.

5. Which of the following statements about counting methods is least accurate?

A) The labeling formula determines the number of different ways to assign a given number of
different labels to a set of objects.

B) The multiplication rule of counting is used to determine the number of different ways to
choose one object from each of two or more groups.

*C) The combination formula determines the number of different ways a group of objects can
be drawn in a specific order from a larger sized group of objects.

@ The permutation formula is used to find the number of possible ways to draw r objects from
a set of n objects when the order in which the objects are drawn matters. The combination
formula ("n choose r") is used to find the number of possible ways to draw r objects from a set
of n objects when order is not important. The other statements are accurate.

6. The covariance:

A) must be positive.

*B) can be positive or negative.

@ Cov(a,b) = σaσbρa,b. Since ρa,b can be positive or negative, Cov(a,b) can be positive or
negative.

C) must be between -1 and +1.

7. Use the following probability distribution to calculate the standard deviation for the
portfolio.

State of the Economy Probability Return on Portfolio

Boom 0.30 15%
Bust 0.70 3%

A) 6.5%.
*B) 5.5%.

@ [0.30 * (0.15 – 0.066)2 + 0.70 * (0.03 – 0.066)2]1/2 = 5.5%.

C) 6.0%.

8. The safety-first criterion focuses on:

*A) shortfall risk.

@ The safety-first criterion focuses on shortfall risk which is the probability that a portfolio's
value or return will fall below a given threshold level. The safety-first criterion minimizes
the probability of falling below the threshold level or return.

B) margin requirements.

C) SEC regulations.

9. If a stock decreases from $90 to $80, the continuously compounded rate of return for the
period is:

A) -0.1250.

*B) -0.1178.

@ This is given by the natural logarithm of the new price divided by the old price; ln(80 /
90) = -0.1178.

C) -0.1000.

10. Consider a random variable X that follows a continuous uniform distribution: 7 ≤ X ≤

20. Which of the following statements is least accurate?
*A) F(21) = 0.00.
@ F(21) = 1.00. For a cumulative distribution function, the expression F(x) refers to the probability of
an outcome less than or equal to x. In this distribution all the possible outcomes are between 7 and
20. Therefore the probability of an outcome less than or equal to 21 is 100%.

The other choices are true.

F(10) = (10 – 7) / (20 – 7) = 3 / 13 = 0.23

F(12 ≤ X ≤ 16) = F(16) – F(12) = [(16 – 7) / (20 – 7)] – [(12 – 7) / (20 – 7)] = 0.692 – 0.385 = 0.307

B) F(10) = 0.23.

C) F(12 ≤ X ≤ 16) = 0.307.

11. Cumulative z-table:

z 0.00 0.01 0.02 0.03

1.6 0.9452 0.9463 0.9474 0.9484
1.7 0.9554 0.9564 0.9573 0.9582
1.8 0.9641 0.9649 0.9656 0.9664
Monthly sales of hot water heaters are approximately normally distributed with a mean of 21
and a standard deviation of 5. What is the probability of selling 12 hot water heaters or less
next month?

A) 96.41%.
B) 1.80%.
*C) 3.59%.
@ Z = (12 – 21) / 5 = -1.8
From the cumulative z-table, the probability of being more than 1.8 standard deviations below the
mean, probability x < -1.8, is 3.59%.

12. Which of the following represents the mean, standard deviation, and variance of a
standard normal distribution?
A) 1, 2, 4.

B) 1, 1, 1.

*C) 0, 1, 1.

@ By definition, for the standard normal distribution, the mean, standard deviation, and
variance are 0, 1, 1.

13. Assume two stocks are perfectly negatively correlated. Stock A has a standard deviation
of 10.2% and stock B has a standard deviation of 13.9%. What is the standard deviation of
the portfolio if 75% is invested in A and 25% in B?

*A) 4.18%.

@ The standard deviation of the portfolio is found by:

[W12σ12+ W22σ22+ 2W1W2σ1σ2r1,2]0.5, or [(0.75) 2(0.102) 2+ (0.25) 2(0.139) 2+
(2)(0.75)(0.25)(0.102)(0.139)(–1.0)]0.5= 0.0418, or 4.18%.

B) 0.17%.

C) 0.00%.

14. If X follows a continuous uniform distribution over the interval 1 < X < 26, the
probability that X is between 5 and 15 is closest to:

A) 10%.

*B) 40%.

@ Because this distribution is uniform, the probability of an outcome between 5 and 15 is the ratio of
that interval to the entire interval from 1 to 26.

(15 – 5) / (26 – 1) = 10 / 25 = 0.40.

C) 60%.
15. In addition to the usual parameters that describe a normal distribution, to completely
describe 10 random variables, a multivariate normal distribution requires knowing the:

A) overall correlation.

B) 10 correlations.

*C) 45 correlations.

@ The number of correlations in a multivariate normal distribution of n variables is

computed by the formula ((n) * (n-1)) / 2, in this case (10 * 9) / 2 = 45.

16. If two events are mutually exclusive, the probability that they both will occur at the same
time is:

A) 0.50.

*B) 0.00.

@ If two events are mutually exclusive, it is not possible to occur at the same time. Therefore, the
P(A∩B) = 0.

C) Cannot be determined from the information given.

17. The events Y and Z are mutually exclusive and exhaustive: P(Y) = 0.4 and P(Z) = 0.6. If
the probability of X given Y is 0.9, and the probability of X given Z is 0.1, what is the
unconditional probability of X?

*A) 0.42.

@ Because the events are mutually exclusive and exhaustive, the unconditional probability is
obtained by taking the sum of the two joint probabilities: P(X) = P(X | Y) * P(Y) + P(X | Z) *
P(Z) = 0.4 * 0.9 + 0.6 * 0.1 = 0.42.

B) 0.40.
C) 0.33.

18. Standard Normal Distribution

P(Z ≤ z) = N(z) for z ≥ 0

z 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.6 0.7257 0.7291 0.7324 0.7357 0.7389 0.7422 0.7454 0.7486 0.7517 0.7549
0.7 0.7580 0.7611 0.7642 0.7673 0.7704 0.7734 0.7764 0.7794 0.7823 0.7852
0.8 0.7881 0.7910 0.7939 0.7967 0.7995 0.8023 0.8051 0.8078 0.8106 0.8133
0.9 0.8159 0.8186 0.8212 0.8238 0.8264 0.8289 0.8315 0.8340 0.8365 0.8389
John Cupp, CFA, has several hundred clients. The values of the portfolios Cupp manages are
approximately normally distributed with a mean of $800,000 and a standard deviation of
$250,000. The probability of a randomly selected portfolio being in excess of $1,000,000 is:
*A) 0.2119.
@ Although the number of clients is discrete, since there are several hundred of them, we can
treat them as continuous. The selected random value is standardized (its z-value is calculated)
by subtracting the mean from the selected value and dividing by the standard deviation. This
results in a z-value of (1,000,000 – 800,000) / 250,000 = 0.8. Looking up 0.8 in the z-value
table yields 0.7881 as the probability that a random variable is to the left of the standardized
value (i.e., less than $1,000,000). Accordingly, the probability of a random variable being to
the right of the standardized value (i.e., greater than $1,000,000) is 1 – 0.7881 = 0.2119.
B) 0.3773.
C) 0.1057.

19. With respect to the units each is measured in, which of the following is the most easily
directly applicable measure of dispersion? The:

A) covariance.
*B) standard deviation.
@ The standard deviation is in the units of the random variable itself and not squared units like
the variance. The covariance would be measured in the product of two units of measure.
C) variance.
20. The number of ships in the harbor is an example of what kind of variable?

A) Continuous.
B) Indiscrete.
*C) Discrete.
@ A discrete variable is one that is represented by finite units.

21. The following table shows the individual weightings and expected returns for the three
stocks in an investor's portfolio:

Stock Weight E(RX)

V 0.40 12%
M 0.35 8%
S 0.25 5%
What is the expected return of this portfolio?

A) 8.33%.
*B) 8.85%.
@ To solve this problem, we need to use the formula for the expected return of a portfolio: E(RP) =
w1E(R1) + w2E(R2) + … + wnE(Rn)

Multiplying the weight of each asset by its expected return, then summing, produces: E(RP) =
0.40(12) + 0.35(8) + 0.25(5) = 8.85%.

C) 9.05%.

22. A discount brokerage firm states that the time between a customer order for a trade and the
execution of the order is uniformly distributed between three minutes and fifteen minutes. If a
customer orders a trade at 11:54 A.M., what is the probability that the order is executed after
noon?

A) 0.500.
B) 0.250.
*C) 0.750.
@ The limits of the uniform distribution are three and 15. Since the problem concerns time, it
is continuous. Noon is six minutes after 11:54 A.M. The probability the order is executed after
noon is (15 – 6) / (15 – 3) = 0.75.

23. The following information is available concerning expected return and standard deviation
of Pluto and Neptune Corporations:

Expected Return Standard Deviation

Pluto Corporation 11% 0.22
Neptune Corporation 9% 0.13
If the correlation between Pluto and Neptune is 0.25, determine the expected return and
standard deviation of a portfolio that consists of 65% Pluto Corporation stock and 35%
Neptune Corporation stock.

A) 10.3% expected return and 2.58% standard deviation.

B) 10.0% expected return and 16.05% standard deviation.
*C) 10.3% expected return and 16.05% standard deviation.
@ ERPort = (WPluto)(ERPluto) + (WNeptune)(ERNeptune)
= (0.65)(0.11) + (0.35)(0.09) = 10.3%
σp= [(w1)2(σ1)2 + (w2)2(σ2)2 + 2w1w2σ1σ2 r1,2]1/2
= [(0.65)2(22)2 + (0.35)2(13)2 + 2(0.65)(0.35)(22)(13)(0.25)]1/2
= [(0.4225)(484) + (0.1225)(169) + 2(0.65)(0.35)(22)(13)(0.25)]1/2
= (257.725)1/2 = 16.0538%

24. Pat Binder, CFA, is examining the effect of an inverted yield curve on the stock market.
She determines that in the past century, 75% of the times the yield curve has inverted, a bear
market in stocks began within the next 12 months. Binder believes the probability of an
inverted yield curve in the next year is 20%. Binder's estimate of the probability that there
will be an inverted yield curve in the next year followed by a bear market is closest to:

A) 38%.

*B) 15%.
@ This is a joint probability. From the information: P(Bear Market given inverted yield
curve) = 0.75 and P(inverted yield curve) = 0.20. The joint probability is the product of these
two probabilities: (0.75)(0.20) = 0.15.

C) 50%.

25. Joe Mayer, CFA, projects that XYZ Company's return on equity varies with the state of the
economy in the following way:

State of Economy Probability of Occurrence Company Returns

Good .20 20%
Normal .50 15%
Poor .30 10%
The standard deviation of XYZ's expected return on equity is closest to:

*A) 3.5%.
@ In order to calculate the standard deviation of the company returns, first calculate the
expected return, then the variance, and the standard deviation is the square root of the variance.
The expected value of the company return is the probability weighted average of the possible
outcomes: (0.20)(0.20) + (0.50)(0.15) + (0.30)(0.10) = 0.145.
The variance is the sum of the probability of each outcome multiplied by the squared deviation
of each outcome from the expected return: (0.2)(0.20 - 0.145)2 + (0.5)(0.15 - 0.145)2 +
(0.3)(0.1-0.145)2 = 0.000605 + 0.0000125 + 0.0006075 = 0.001225.
The standard deviation is the square root of 0.001225 = 0.035 or 3.5%.
B) 12.3%.
C) 1.5%.

26. Bonds rated B have a 25% chance of default in five years. Bonds rated CCC have a 40%
chance of default in five years. A portfolio consists of 30% B and 70% CCC-rated bonds. If a
randomly selected bond defaults in a five-year period, what is the probability that it was a B-
rated bond?

A) 0.625.
*B) 0.211.
@ According to Bayes' formula: P(B | default) = P(default and B) / P(default).
P(default and B) = P(default | B) * P(B) = 0.250 * 0.300 = 0.075
P(default and CCC) = P(default | CCC) * P(CCC) = 0.400 * 0.700 = 0.280
P(default) = P(default and B) + P(default and CCC) = 0.355
P(B | default) = P(default and B) / P(default) = 0.075 / 0.355 = 0.211
C) 0.250.

27. Which of the following could least likely be a probability function?

A) X:(1,2,3,4) p(x) = (x2) / 30.

B) X:(1,2,3,4) p(x) = x / 10.
*C) X:(1,2,3,4) p(x) = 0.2.

@ In a probability function, the sum of the probabilities for all of the outcomes must equal
one. Only one of the probability functions in these answers fails to sum to one.

28. Monte Carlo simulation is necessary to:

*A) approximate solutions to complex problems.

@ This is the purpose of this type of simulation. The point is to construct distributions using
complex combinations of hypothesized parameters.

B) compute continuously compounded returns.

C) reduce sampling error.

29. A company says that whether it increases its dividends depends on whether its earnings
increase. From this we know:

*A) P(earnings increase | dividend increase) is not equal to P(earnings increase).

@ If two events A and B are dependent, then the conditional probabilities of P(A | B) and
P(B | A) will not equal their respective unconditional probabilities (of P(A) and P(B),
respectively). Both remaining choices may or may not occur, e.g., P(A | B) = P(B) is possible
but not necessary.

B) P(dividend increase | earnings increase) is not equal to P(earnings increase).

C) P(both dividend increase and earnings increase) = P(dividend increase).

30. Given Cov(X,Y) = 1,000,000. What does this indicate about the relationship between X
and Y?

A) It is strong and positive.

B) It is weak and positive.

*C) Only that it is positive.

@ A positive covariance indicates a positive linear relationship but nothing else. The
magnitude of the covariance by itself is not informative with respect to the strength of the
relationship.

31. Which of the following is an a priori probability?

A) The probability the Fed will lower interest rates prior to the end of the year.

B) For a stock, based on prior patterns of up and down days, the probability of the stock
having a down day tomorrow.

*C) On a random draw, the probability of choosing a stock of a particular industry from the
S&P 500.

@ A priori probability is based on formal reasoning and inspection. Given the number of
stocks in the airline industry in the S&P500 for example, the a priori probability of selecting
an airline stock would be that number divided by 500.
32. In a continuous probability density function, the probability that any single value of a
random variable occurs is equal to what?

A) One.

*B) Zero.

@ Since there are infinite potential outcomes in a continuous pdf, the probability of any
single value of a random variable occurring is 1/infinity = 0.

C) 1/N.

33. Which of the following would least likely be categorized as a multivariate distribution?

*A) The days a stock traded and the days it did not trade.

@ The number of days a stock traded and did not trade describes only one random variable.
Both of the other cases involve two or more random variables.

B) The return of a stock and the return of the DJIA.

C) The returns of the stocks in the DJIA.

34. Approximately 95% of all observations for a normally distributed random variable fall in
the interval:

A) u +/- 3σ.

B) u +/- σ.

*C) u +/- 2σ.

@ Approximately 95% of the outcomes for a normally distributed random variable are within
two standard deviations of the mean, so the correct answer is u +/- 2σ.
35. The probability that a normally distributed random variable will be more than two
standard deviations above its mean is:

*A) 0.0228.

@ 1 – F(2) = 1 – 0.9772 = 0.0228.

B) 0.4772.

C) 0.9772.

36. If X has a normal distribution with μ = 100 and σ = 5, then there is approximately a 90%
probability that:

A) P(90.2 < X < 109.8).

B) P(93.4 < X < 106.7).

*C) P(91.8 < X < 108.3).

@ 100 +/- 1.65 (5) = 91.75 to 108.25 or P (P(91.75 < X < 108.25).

37. The unconditional probability of an event, given conditional probabilities, is determined

by using the:

A) multiplication rule of probability.

B) addition rule of probability.

*C) total probability rule.

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

38. A cumulative distribution function for a random variable X is given as follows:

x F(x)
5 0.14
10 0.25
15 0.86
20 1.00
The probability of an outcome less than or equal to 10 is:

*A) 25%.
@ A cumulative distribution function (cdf) gives the probability of an outcome for a random
variable less than or equal to a specific value. For the random variable X, the cdf for the
outcome 10 is 0.25, which means there is a 25% probability that X will take a value less than
or equal to 10.
B) 14%.
C) 39%.

39. There is a 90% chance that the economy will be good next year and a 10% chance that it
will be bad. If the economy is good, there is a 60% chance that XYZ Incorporated will have
EPS of $4.00 and a 40% chance that their earnings will be $3.00. If the economy is bad, there
is an 80% chance that XYZ Incorporated will have EPS of $2.00 and a 20% chance that their
earnings will be $1.00. What is the firm's expected EPS?

A) $2.50.
B) $5.40.
*C) $3.42.
@ The expected EPS is calculated by multiplying the probability of the economic environment
by the probability of the particular EPS and the EPS in each case. The expected EPS in all four
outcomes are then summed to arrive at the expected EPS:
(0.90 * 0.60 * $4.00) + (0.90 * 0.40 * $3.00) + (0.10 * 0.80 * $2.00) + (0.10 * 0.20 * $1.00) =
$2.16 + $1.08 + $0.16 + $0.02 = $3.42.

40. Data shows that 75 out of 100 tourists who visit New York City visit the Empire State
Building. It rains or snows in New York City one day in five. What is the joint probability that
a randomly chosen tourist visits the Empire State Building on a day when it neither rains nor
snows?

A) 95%.
*B) 60%.
@ A joint probability is the probability that two events occur when neither is certain or a
given. Joint probability is calculated by multiplying the probability of each event together.
(0.75) * (0.80) = 0.60 or 60%.
C) 15%.