SESSION 2

Question 1: Government regulators typically require periodic disclosure of a company's financial performance for:
A. private companies only.
B. public companies only.
C. both private and public companies.
Explanation
B is correct. Regulators typically require periodic reporting of financial results for public companies. Private companies are
typically not subject to these requirements.

Question 2: If two projects are mutually exclusive, a company:

A. can accept either project, but not both projects.
B. must accept both projects or reject both projects.
C. can accept one of the projects, both projects, or neither project.
Explanation
A is correct. Mutually exclusive means that out of the set of possible projects, only one project can be selected. Given two
mutually exclusive projects, the company can accept one of the projects or reject both projects, but cannot accept both projects.

Question 3: In a defined benefit pension plan:

A. the employee is promised a periodic payment upon retirement.
B. the employee is responsible for making investment decisions.
C. the employer’s pension expense is equal to its contributions to the plan.
Explanation
A is correct. In a defined benefit pension plan, a periodic payment, typically based on the employee's salary, is promised to
the employee upon retirement and the employer contributes to an investment trust that generates the principal growth and
income to meet the pension obligation. The employees do not direct the investments in their accounts as they do in a defined
contribution plan. Pension expense for a defined benefit plan has several components, including service cost, prior service
cost, and interest cost, and depends on actuarial assumptions and the expected rate of return on plan assets.

Question 4: An example of a primary source of liquidity is:

A. using trade credit from vendors.
B. renegotiating debt agreements.
C. filling for bankruptcy.
Explanation
A is correct. Primary sources of liquidity include cash resulting from selling goods and services, collecting receivables,
generating cash from other sources and sources of short-term funding such as trade credit from vendors and lines of credit
from banks. Filing for bankruptcy and renegotiating debt agreements are best described as secondary sources of liquidity
because they are sources to which a firm resorts when in financial distress.

Question 5: According to the CAPM, a rational investor would be least likely to choose as his optimal portfolio:
A. a 130% allocation to the market portfolio.
B. the global minimum variance portfolio.
C. a 100% allocation to the risk-free asset.
Explanation
B is correct. According to the CAPM, rational, risk-averse investors will optimally choose to hold a portfolio along the capital
market line. This can range from a 100% allocation to the riskfree asset to a leveraged position in the market portfolio
constructed by borrowing at the risk-free rate to invest more than 100% of the portfolio equity value in the market portfolio.
The global minimum variance portfolio lies below the CML and is not an efficient portfolio under the assumptions of the
CAPM.

Question 6: Which of the following is NOT an assumption of capital market theory?

A. Investors can lend at the risk-free rate, but borrow at a higher rate.
B. All assets are infinitely divisible.
C. The capital markets are in equilibrium.
Explanation
A is correct. Capital market theory assumes that investors can borrow or lend at the risk-free rate. The other statements are
basic assumptions of capital market theory.
Question 7: Risks that may arise from ineffective corporate governance least likely include:
A. reduced default risk.
B. less effective decision making.
C. weaker financial performance.
Explanation
A is correct. Ineffective corporate governance is likely to increase default risk.

Question 8: A publicly traded company has a beta of 1.2, a debt/equity ratio of 1.5, ROE of 8.1%, and a marginal tax rate of
40%. The unlevered beta for this company is closest to:
A. 0.632.
B. 1.071.
C. 0.832.
Explanation
A is correct. The unlevered beta for this company is calculated as:
1
𝛽𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 = 1.2 [ ] = 0.6316 ≈ 0.632
(1
1 + − 0.40) × 1.5

Question 9: The conclusion of Modigliani and Miller's capital structure model with taxes is that:
A. capital structure decisions do not affect the value of a firm.
B. there is a trade-off between tax savings on debt increased risk of bankruptcy.
C. firms should be financed with all debt.
Explanation
C is correct. Because MM with taxes does not consider costs of financial distress, it concludes that tax savings of debt
financing are maximized at 100% debt.

Question 10: A firm that invests the majority of a portfolio to track a benchmark index, and uses active investment strategies
for the remaining portion, is said to be using:
A. a core-satellite approach.
B. risk budgeting.
C. strategic asset allocation.
Explanation
A is correct. With a core-satellite approach, a firm invests the majority of a portfolio passively and uses active strategies for
the remaining portion. Strategic asset allocation refers to specifying the percentages of a portfolio's value to allocate to specific
asset classes. Risk budgeting refers to allocating a portfolio's overall permitted risk among strategic asset allocation, tactical
asset allocation, and security selection.

Question 11: Which of the following statements about an organization's risk tolerance is most accurate?
A. An organization with low risk tolerance should take steps to reduce each of the risks it identifies.
B. Risk tolerance is the degree to which an organization is able to bear the various risks that may arise from outside the
organization.
C. The financial strength of an organization is one of the factors it should consider when determining its risk tolerance.
Explanation
C is correct. Financial strength is an important factor in an organization's risk tolerance because it reflects the organization's
ability to withstand losses. Even if its risk tolerance is low, an organization may choose to bear some risks that are consistent
with achieving the organization's objectives. Risk tolerance includes risks that arise from within the organization as well as
risks from outside.

Question 12: Jayco, Inc. has a division that makes red ink for the accounting industry. The unit has fixed costs of $10,000
per month, and is expected to sell 40,000 bottles of ink per month. If the variable cost per bottle is $2.00 what price must the
division charge in order to breakeven?
A. $2.25.
B. $2.50.
C. $2.75.
Explanation
A is correct. 40,000 = $10,000/(P - $2)
40,000P – $80,000 = $10,000
P = $90,000/40,000 = $2.25.
Question 13: The trend line for a stock in an uptrend is constructed by drawing a straight line through the:
A. highs.
B. lows.
C. periodic averages.
Explanation
B is correct. Trendlines connect the increasing low points on a price chart in an uptrend and the decreasing high points in a
downtrend.

Question 14: Which of the following sources of liquidity is the most reliable?
A. Revolving line of credit.
B. Committed line of credit.
C. Uncommitted line of credit.
Explanation
A is correct. A revolving line of credit is typically for a longer term than an uncommitted or committed line of credit and
thus is considered a more reliable source of liquidity. With an uncommitted line of credit, the issuing bank may refuse to lend
if conditions of the firm change. An overdraft line of credit is similar to a committed line of credit agreement between banks
and firms outside of the U.S. Both committed and revolving lines of credit can be verified and can be listed in the footnotes
to a firm's financial statements as sources of liquidity.

Question 15: A firm is least likely to reduce its capital needs by adopting which of the following business models?
A. Asset-light.
B. Bundling.
C. Pay-in-advance.
Explanation
B is correct. Bundling is a pricing strategy for multiple products. Firms that rent or lease major assets (an asset-light model)
or receive cash before providing goods or services (a pay-in-advance model) tend to have less need for capital than firms that
own fixed assets or do not collect cash in advance.

Question 16: Investors in an initial coin offering (ICO) typically receive:

A. registered securities.
B. cryptocurrency.
C. voting rights in the ICO issuer.
Explanation
B is correct. An ICO is a sale of cryptocurrency to investors in exchange for cash or another cryptocurrency.

Question 17: Which of the following is least likely to be useful to an analyst who is estimating the pretax cost of a firm's
fixed-rate debt?
A. The coupon rate on the firm’s existing debt.
B. The yield to maturity of the firm’s existing debt.
C. Seniority and any special covenants of the firm’s anticipated debt.
Explanation
A is correct. Ideally, an analyst would use the YTM of a firm's existing debt as the pretax cost of new debt. When a firm's
debt is not publicly traded, however, a market YTM may not be available. In this case, an analyst may use the yield curve for
debt with the same rating and maturity to estimate the market YTM. If the anticipated debt has unique characteristics that
affect YTM, these characteristics should be accounted for when estimating the pretax cost of debt. The cost of debt is the
market interest rate (YTM) on new (marginal) debt, not the coupon rate on the firm's existing debt. If you are provided with
both coupon and YTM on the exam, you should use the YTM.

Question 18: Nebrid Company describes itself as a B2B firm. This means that Nebrid:
A. is a marketplace for buyers and sellers.
B. provides both inbound and outbound logistics.
C. sells its products or services to other businesses.
Explanation
C is correct. B2B businesses are those that sell their products to other businesses.

Question 19: Greg Brown receives new information regarding one of his stocks. This information appears to be reliable and
conflicts with Brown's earlier forecast of what the stock should be trading for at this time. However, Brown does not revise
his estimate of the stock's value. Brown is most likely exhibiting:
A. confirmation bias.
B. conservatism bias.
C. hindsight bias.
Explanation
B is correct. Conservatism bias refers to failing to change a view as new information becomes available, and may result in
investors keeping assets too long because they are slow to update a view or forecast. Confirmation bias refers to when investors
seek out information that supports their beliefs, while avoiding conflicting views. Hindsight bias refers to selective memory
of past events resulting in individuals believing these events were more predictable than they seemed before they happened.

Question 20: Which of the following statements most accurately characterizes how debt ratings may affect a firm's capital
structure policy?
A. A firm may be deterred from increasing the use of debt to avoid having its credit rating reduced below some minimum
acceptable level.
B. Firms that have their credit ratings reduced below investment grade are not able to issue additional debt.
C. Because credit ratings are based upon cash flow coverage of interest expense, they are not influenced by the firm’s
capital structure.
Explanation
A is correct. Credit ratings can be factored into management's capital structure policy if a firm has a minimum rating objective,
and this is likely to be adversely affected by issuing additional debt.

Question 21: Which of the following best describes a firm with low operating leverage? A large change in:
A. the number of units a firm produces and sells result in a similar change in the firm’s earnings before interest and taxes.
B. earnings before interest and taxes result in a small change in net income.
C. sales result in a small change in net income.
Explanation
A is correct. Operating leverage is the result of a greater proportion of fixed costs compared to variable costs in a firm's
capital structure and is characterized by the sensitivity in operating income (earnings before interest and taxes) to change in
sales. A firm that has equal changes in sales and operating income would have low operating leverage (the least it can be is
one). Note that the relationship between operating income and net income is impacted by the degree of financial leverage,
and the relationship between sales and net income is impacted by the degree of total leverage.

Question 22: Which of the following statements regarding the covariance of rates of return is least accurate?
A. Covariance is positive if two variables tend to both be above their mean values in the same time periods.
B. If the covariance is negative, the rates of return on two investments will always move in diáerent directions relative to
their means.
C. Covariance is not a very useful measure of the strength of the relationship between rates of return.
Explanation
B is correct. Negative covariance means rates of return for one security will tend to be above its mean return in periods when
the other is below its mean return, and vice versa. Positive covariance means that returns on both securities will tend to be
above (or below) their mean returns in the same time periods. For the returns to always move in opposite directions, they
would have to be perfectly negatively correlated. Negative covariance by itself does not imply anything about the strength of
the negative correlation, it must be standardized by dividing by the product of the securities' standard deviations of return.

Question 23: When interest rates have fallen to low levels that are expected to persist, firms are most likely to have a
preference for:
A. issuing debt.
B. issuing equity.
C. repurchasing equity.
Explanation
A is correct. When interest rates have fallen to low levels that are expected to persist, firms often increase their target
proportion of debt to reflect its lower cost. Firms may issue equity when they perceive the market price of their stock to be
temporarily high or repurchase their stock when they judge the price to be low.

Question 24: The financial manager at Genesis Company is looking into the purchase of an apartment complex for $550,000.
Net after-tax cash flows are expected to be $65,000 for each of the next five years, then drop to $50,000 for four years.
Genesis' required rate of return is 9% on projects of this nature. After nine years, Genesis Company expects to sell the property
for after-tax proceeds of $300,000. What is the respective internal rate of return on this project?
A. 7.01%.
B. 13.99%.
C. 6.66%.
Explanation
A is correct. CF0 = –$550,000; CF1 = $65,000; F1 = 5; CF2 = $50,000; F2 = 3; CF3 = $350,000; F3 = 1. CPT IRR = 7.0152.
Note that the cash flows in year 9 have to be netted to calculate the IRR correctly.

Question 25: A stock that plots below the Security Market Line most likely:
A. is overvalued.
B. has a beta less than one.
C. is below the efficient frontier.
Explanation
A is correct. Since the equation of the SML is the capital asset pricing model, you can determine if a stock is over- or
underpriced graphically or mathematically. Your answers will always be the same.
Graphically: If you plot a stock's expected return on the SML and it falls below the line, it indicates that the stock is currently
overpriced, causing its expected return to be too low. If the plot is above the line, it indicates that the stock is underpriced. If
the plot falls on the SML, it indicates the stock is properly priced.
Mathematically: In the context of the SML, a security is underpriced if the required return is less than the holding period (or
expected) return, is overpriced if the required return is greater the holding period (or expected) return, and is correctly priced
if the required return equals the holding period (or expected) return.

Question 26: With sales of $45 million, the operating earnings of Poston Industries are $3.8 million. Fixed operating costs
are $4.2 million, net profit margin is 4.5%, and unit variable costs are $35.50. At the current level of sales, Poston's degree of
operating leverage is closest to:
A. 1.2.
B. 1.6.
C. 2.1.
Explanation
C is correct. Operating earnings = EBIT = Sales - TVC - Fixed operating costs
Sales − TVC EBIT + Fixed operating costs 3.8 + 4.2
DOL = = = = 2.1
Sales − TVC − Fixed operating costs EBIT 3.8

Question 27: The major components of a typical investment policy statement (IPS) least likely include:
A. the investment manager’s compensation.
B. investment objectives.
C. duties and responsibilities of the investment manager.
Explanation
A is correct. Investment manager's compensation is not among the major components of a typical IPS. The major components
include a description of the client; a statement of purpose; a statement of duties and responsibilities; procedures to update the
IPS; investment objectives; investment constraints; investment guidelines; and benchmark for evaluation of performance.

Question 28: Given the following information about a company's capital structure:

Type of Capital Percent of Capital Structure Before-Tax Component Cost

Debt 40% 7.5%

Preferred Stock 5% 11.0%

Common Stock 55% 15.0%

If the company's tax rate is 40%, its weighted average cost of capital is closest to:

A. 10.6%.
B. 13.3%.
C. 7.1%.
Explanation
A is correct. WACC = (Wd)[Kd (1 - t)] + (Wp)(Kp) + (Wce)(Kce)
WACC = 0.4(7.5%)(1 - 0.4) + 0.05(11%) + 0.55(15%) = 10.6%.

Question 29: A market that directs capital to its most productive use is best described as:
A. operationally efficient.
B. informationally efficient.
C. allocationally efficient.
Explanation
C is correct. Markets are said to be allocationally efficient when capital is directed to its most productive uses. Operationally
efficient markets are those that have low trading costs. Informationally efficient markets are those in which security prices
reflect all information associated with fundamental value in a timely fashion.

Question 30: In a 2-and-20 hedge fund fee structure, the "2" refers to a hedge fund's:
A. incentive fee.
B. management fee.
C. hurdle rate.
Explanation
B is correct. "2-and-20" denotes a 2% management fee and a 20% incentive fee.

Question 31: Which of the following statements regarding a forward commitment is least accurate? A forward commitment:
A. can involve a stock index.
B. is not legally binding.
C. is a contractual promise.
Explanation
B is correct. A forward commitment is a legally binding promise to perform some action in the future and can involve a stock
index or portfolio.

Question 32: Which of the following contains the overall rights of the bondholders?
A. Covenant.
B. Indenture.
C. Rights offering.
Explanation
B is correct. An indenture specifies the rights of bondholders and the obligations of the issuer. Covenants are specific
provisions within the indenture. A rights offering is typically associated with an equity security.

Question 33: Compared to S&P 500 index weighting, an equities index that is weighted based on a fundamental factor, such
as earnings, will most likely:
A. have a value tilt.
B. have a momentum tilt.
C. overweight firms with high EPS.
Explanation
A is correct. Compared to the S&P 500 index, which is market cap weighted, an index that is weighted based on fundamentals
will have a value tilt. Firms that have a higher earnings weight than market cap weight will be those with higher earnings
yields. Weights are based on firm earnings, not earnings per share.

Question 34: A collateralized debt obligation (CDO) in which the collateral is a pool of residential mortgage-backed securities
is most accurately described as a:
A. collateralized loan obligation (CLO).
B. structured finance CDO.
C. synthetic CDO.
Explanation
B is correct. In a structured finance CDO the collateral is a pool of mortgage-backed securities, assetbacked securities, or
other CDOs. In a synthetic CDO the collateral is a pool of credit default swaps. In a CLO the collateral is a pool of leveraged
bank loans.

Question 35: If the yield to maturity on a bond decreases after purchase but before the first coupon date and the bond is
held to maturity, reinvestment risk is:
A. less than price risk and the realized yield will be lower than the YTM at purchase.
B. less than price risk and the realized yield will be higher than the YTM at purchase.
C. greater than price risk and the realized yield will be lower than the YTM at purchase.
Explanation
C is correct. If the bond is held to maturity, the investor will receive all coupons and principal and reinvest them at a lower
return than the YTM at purchase, resulting in a lower realized yield.

Question 36: A corporation that employs hedge accounting and uses an interest rate swap to offset changes in the value of
fixed rate bond liability is said to be employing a:
A. cash flow hedge.
B. net investment hedge.
C. fair value hedge.
Explanation
C is correct. Using an interest rate swap to hedge changes in the value of a balance sheet liability is considered a fair value
hedge. If the interest rate swap is used to convert the fixed-rate payments on a bond liability to floating-rate payments, it
would be considered a cash flow hedge.

Question 37: The strong-form efficient market hypothesis (EMH) asserts that stock prices fully reflect which of the following
types of information?
A. Market.
B. Public and private.
C. Public, private, and future.
Explanation
B is correct. The strong-form EMH assumes that stock prices fully reflect all information from public and private sources.

Question 38: Indexes for alternative investments are least likely to exhibit:
A. backfill bias.
B. time-period bias.
C. survivorship bias.
Explanation
B is correct. Index returns for alternative investments are often subject to both backfill and survivorship bias. Time-period
bias is a concern in hypothesis testing.

Question 39: The factors that must be considered when estimating the credit risk of a bond include:
A. only the bond rating and the recovery rate.
B. only the bond rating.
C. the bond rating, the recovery rate, and the yield volatility.
Explanation
A is correct. Credit risk is calculated with the probability of default (estimated from the bond rating) and the estimated
recovery value should the bond default. Yield volatility is combined with duration to estimate the price risk of a bond.

Question 40: The primary reason for a firm to issue equity securities is to:
A. acquire the assets necessary to carry out its operations.
B. improve its solvency ratios.
C. increase publicity for the firm’s products.
Explanation
A is correct. While issuing equity securities can improve a company's solvency ratios and increase the firm's visibility with
the public, the primary reason to issue equity is to raise the capital needed to acquire operating assets.

Question 41: An investor could best replicate the position of the floating rate payer in a swap by:
A. borrowing at a fixed rate and entering a series of zero-value FRAs.
B. borrowing at a floating rate and entering a series of zero-value FRAs.
C. borrowing at a floating rate and buying a fixed-rate bond.
Explanation
C is correct. The investor in the swap will pay the reference rate and receive fixed-rate payments (on a notional principal
amount). The net payments can be replicated by borrowing at a floating rate and investing the proceeds in a fixed-rate bond.
The payments could also be replicated by taking a floating-rate loan (or issuing a floating-rate bond) and entering a series of
FRAs, but these would not necessarily (or likely) be zero-value FRAs; zero-value FRAs would typically not all have the same
fixed rate as swap payments do.

Question 42: An additional risk of direct investment in real estate, which is not typically a significant risk in a portfolio of
traditional investments, is:
A. liquidity risk.
B. market risk.
C. counterparty risk.
Explanation
A is correct. Direct investment in real estate involves liquidity risk because large sums may be invested for long periods
before a sale of the property can take place. Market risk exists for both traditional portfolio and real estate investments.
Counterparty risk applies mainly to derivative contracts that require a payment from a counterparty, such as swaps and
forwards.

Question 43: Which of the following industries is most likely to be classified as non-cyclical?
A. Autos.
B. Utilities.
C. Housing.
Explanation
B is correct. Non-cyclical industries are those for which demand is not highly sensitive to business cycles, such as utilities,
health care, and food and beverages. Housing and autos are examples of cyclical industries.

Question 44: A company with a return on equity (ROE) of 27%, required return on equity (ke) of 20%, and a dividend payout
ratio of 40% has an implied sustainable growth rate closest to:
A. 10.80%.
B. 12.00%.
C. 16.20%.
Explanation
C is correct. g = (RR)(ROE) = (.60)(.27) = 0.162 or 16.2%.

Question 45: Which type of issuer is most likely to issue bonds by auction?
A. Corporate.
B. Municipal.
C. Sovereign.
Explanation
C is correct. Many national governments use auctions to issue sovereign bonds. Corporate bonds are typically issued in an
underwriting or private placement process while municipal bonds are typically issued in a negotiated or underwritten process.

Question 46: If the discount margin is lower than the quoted margin on a floating rate note, it is most likely that:
A. the note is priced at a discount.
B. the note’s credit quality has improved.
C. the reference rate has decreased.
Explanation
B is correct. The quoted margin of a floating-rate note is the number of basis points added to or subtracted from the note's
reference rate to determine its coupon payments.
The required margin or discount margin is the number of basis points above or below the reference rate that would cause the
note's price to return to par value at each reset date.
The discount margin may be different from quoted margin if a note's credit quality has changed since issuance. If there is an
improvement in credit quality, the discount margin will be less than quoted margin and the note will trade at a premium.
Changes in the reference rate will not impact the relative difference between the discount and quoted margin.

Question 47: An example of a relative value hedge fund strategy is:

A. merger arbitrage.
B. market neutral.
C. convertible arbitrage.
Explanation
C is correct. Relative value strategies include convertible arbitrage fixed income, asset-backed fixed income, general fixed
income, volatility, and multi-strategy. Market neutral is an equity hedge strategy. Merger arbitrage is an event driven strategy.

Question 48: Which of the following statements about securities exchanges is NOT correct?
A. In call markets, there is only one negotiated price set to clear the market for a given stock.
B. In continuous markets, prices are set only by the auction process.
C. Securities exchanges may be structured as call markets or continuous markets.
Explanation
B is correct. In continuous markets, the price is set by either the auction process or by dealer bid-ask quotes.

Question 49: In a commercial mortgage-backed security (CMBS), which of the following is an example of CMBS-level call
protection?
A. Prepayment lockout.
B. Residual tranche.
C. Yield maintenance charges.
Explanation
B is correct. Call protection in the context of a CMBS refers to protection against prepayment risk. Structuring a CMBS with
a residual (equity or first-loss) tranche provides investors in the senior tranches with CMBS-level call protection. Prepayment
lockout periods and yield maintenance charges are examples of loan-level call protection because they apply to the individual
loans.

Question 50: An investor calculates that the premium of a European put option is less than its value based on put-call parity.
In exploiting this arbitrage opportunity, the investor is most likely to:
A. sell the underlying short.
B. sell the call option.
C. invest the present value of the exercise price at the risk-free rate.
Explanation
B is correct. Put-call parity indicates that P = C + PV(X) – S. With P < [C + PV(X) – S], the arbitrage transaction is to buy
the put and sell the call, borrow the PV of the exercise price (X), and buy the stock.

Question 51: When compared to traditional investments, alternative investments are characterized by:
A. more regulation and transparency.
B. less liquidity of assets held.
C. less concentrated portfolios.
Explanation
B is correct. Alternative investments typically exhibit several characteristics including less liquidity of assets held, relatively
more concentrated portfolios, and less regulation and transparency

Question 52: Analysis of a firm's intellectual capital, equity market capitalization, depreciation, and intangible assets is
associated with which aspect of credit analysis?
A. Capacity.
B. Collateral.
C. Covenants.
Explanation
B is correct. These items are part of analyzing a borrower's collateral. Analyzing depreciation expense and equity market
capitalization can provide insight into the quality of a firm's fixed assets. Intellectual capital and intangible assets can
potentially be used as collateral if they can be separated from the firm and sold. Capacity refers to a borrower's ability to repay
its obligations. Analysis of capacity focuses on industry structure and company fundamentals. Covenants are terms and
conditions of a bond issue.

Question 53: Which of the following statements about moneyness is most accurate? When the stock price is:
A. below the strike price, a call option is in-the-money.
B. above the strike price, a put option is in-the-money.
C. above the strike price, a put option is out-of-the-money.
Explanation
C is correct. hen the stock price is above the strike price, a put option is out-of-the-money.
When the stock price is below the strike price, a call option is out-of-the-money.

Question 54: Hume Inc. announces fourth quarter earnings per share of $1.20, which is 15% higher than last year. Hume's
earnings are equal to the consensus analyst forecast for the quarter. Assuming markets are efficient, the announcement will
most likely cause the price of Hume's stock to:
A. decrease.
B. increase.
C. remain the same.
Explanation
C is correct. An efficient capital market would price Hume's stock based on the expectation for earnings per share. Since
actual earnings equal expected earnings, the stock price should not change as a result of the announcement.

Question 55: The difference between a firm's balance sheet assets and liabilities is equal to the firm's:
A. book value of equity.
B. market value of equity.
C. intrinsic value of equity.
Explanation
A is correct. Book value of equity is equal to balance sheet assets minus liabilities. Market value of equity is equal to shares
outstanding times the share price. Intrinsic value of equity is typically estimated using one or more valuation models.

Question 56: A portfolio manager who adds commodities to a portfolio of traditional investments is most likely seeking to:
A. increase expected returns only.
B. decrease portfolio variance only.
C. both increase expected returns and decrease portfolio variance.
Explanation
B is correct. Unlike most alternative investments, expected returns on commodities are typically less than expected returns
on traditional investments. However, because their returns typically have a low correlation with returns on traditional
investments, adding commodities to a portfolio of traditional investments can decrease portfolio variance.

Question 57: In futures markets, the primary role of the clearinghouse is to:
A. reduce transaction costs by making contract prices public.
B. act as guarantor to both sides of a futures trade.
C. prevent arbitrage and enforce federal regulations.
Explanation
B is correct. Acting as the counterparty for all buyers and sellers is the primary role of the clearinghouse. By providing
liquidity, the clearinghouse may also help lower transaction costs indirectly.

Question 58: Using the following spot rates for pricing the bond, what is the present value of a three-year security that pays
a fixed annual coupon of 6%?
• Year 1: 5.0%
• Year 2: 5.5%
• Year 3: 6.0%
A. 100.10.
B. 102.46.
C. 95.07.
Explanation
A is correct. This value is computed as follows:
Present Value = 6/1.05 + 6/1.0552 + 106/1.063 = 100.10
The value 95.07 results if the coupon payment at maturity of the bond is neglected.

Question 59: Declining prices that result from the development of substitute products are most likely to characterize an
industry in the:
A. decline stage.
B. mature stage.
C. shakeout stage.
Explanation
A is correct. The decline stage of the industry life cycle is often characterized by declining prices as substitute products or
global competition emerge, or as a result of decreasing demand due to societal changes.

Question 60: The principal value of a sovereign bond is $1,000 at issuance and $1,055 two years after issuance. This bond
most likely:
A. has been upgraded.
B. is indexed for inflation.
C. trades at a premium.
Explanation
B is correct. Inflation-indexed bonds often have a capital-indexed structure in which the principal value is adjusted
periodically by the inflation rate. Credit rating upgrades or downgrades do not affect the principal value of bonds. A bond is
trading at a premium when its market price is greater than its principal value.

Question 61: A net benefit from holding the underlying asset of a forward contract will:
A. increase the value of the forward contract during its life.
B. decrease the no-arbitrage forward price at initiation.
C. decrease the value of the forward contract at expiration.
Explanation
B is correct. Compared to an underlying asset with no net holding cost or benefit, a net benefit from holding the underlying
asset will decrease the no-arbitrage forward price at initiation and the value of a forward contract during its life. Holding costs
and benefits have no effect on the value of a forward contract at expiration.

Question 62: A hedge fund that employs a fundamental growth strategy using equity securities is most likely to seek out
shares of companies that are:
A. undervalued only.
B. growing revenues and earnings rapidly.
C. either undervalued or overvalued.
Explanation
B is correct. Fundamental growth refers to investing in companies that are experiencing high growth and for which the fund
managers anticipate significant capital appreciation.

Question 63: The purchaser of a stock will receive the next dividend if the order is filled before the:
A. ex-dividend date.
B. holder-of-record date.
C. payment date.
Explanation
A is correct. The ex-dividend date is the cutoff date for receiving the dividend and occurs one or two business days before
the holder-of-record date. An investor who buys a share on or after the ex-dividend date will not receive the dividend.

Question 64: Behavioral finance theory suggests that investors tend to:
A. mimic the actions of better-informed investors.
B. underestimate their ability to analyze security information.
C. be more risk averse with respect to gains than with respect to losses.
Explanation
A is correct. Mimicking the actions of better-informed investors is an example of herding behavior. Behavioral finance
suggests investors are more risk averse with respect to losses than gains and tend to overestimate their ability to analyze
security information.

Question 65: Funds that invest in specific commodity sectors such as oil and gas or precious metals are best described as:
A. sector funds.
B. specialized funds.
C. managed futures funds.
Explanation
B is correct. Specialized funds focus on specific commodities such as oil and gas, grains, precious metals, or industrial metals.
Sector funds restrict investments to a particular sector of the market, such as energy or health care. Some managed futures
funds may concentrate on specific sectors (e.g., agricultural commodities), while others may be more diversified.

Question 66: Securitized bonds are most likely to be issued by:

A. banking institutions.
B. special purpose entities.
C. supranational entities.
Explanation
B is correct. The issuer of a securitized bond is typically a special purpose entity (SPE), also known as a special purpose
vehicle (SPV) or special purpose company (SPC). An SPE is formed specifically to purchase and administer assets that will
provide the cash flows to pay interest and principal on bonds the entity issues. These bonds are called securitized bonds.

Question 67: An investor purchases a 5-year, A-rated, 7.95% coupon, semiannual-pay corporate bond at a yield to maturity
of 8.20%. The bond is callable at 102 in three years. The bond's yield to call is closest to:
A. 8.9%.
B. 8.6%.
C. 8.3%.
Explanation
A is correct. First determine the price paid for the bond:>
N = 5 × 2 = 10; I/Y = 8.20 / 2 = 4.10; PMT = 7.95 / 2 = 3.975; FV = 100; CPT PV = – 98.99
Then use this value and the call price and date to determine the yield to call:
N = 3 × 2 = 6; PMT = 7.95 / 2 = 3.975; PV = –98.99; FV = 102; CPT I/Y = 4.4686 × 2 = 8.937%.

Question 68: If the price of a forward contract is greater than the price of an identical futures contract, the most likely
explanation is that:
A. the futures contract requires daily settlement and the forward contract does not.
B. the futures contract is more difficult to exit than the forward contract.
C. the forward contract is more liquid than the futures contract.
Explanation
A is correct. The reason there may be a difference in price between a forward contract and an identical futures contract is that
a futures position has daily settlement and so makes or requires cash flows during its life.

Question 69: When using margin to invest in equities, which of the following defines initial margin and what level will the
margin be brought back to in the event of a margin call?
A. Initial Margin: amount of borrowed funds in the transactions and Margin Call Action: a deposit must be made to bring
the margin back to the maintenance margin.
B. Initial Margin: minimum amount of equity required of the investor and Margin Call Action: a deposit must be made to
bring the margin back to the initial margin.
C. Initial Margin: minimum amount of equity required of the investor and Margin Call Action: a deposit must be made to
bring the margin back to the maintenance margin
Explanation
C is correct. The initial margin requirement refers to the minimum amount of equity required of the investor.
With equities, if the margin falls below the maintenance margin, funds must be deposited to bring it back up to the maintenance
margin level.

Question 70: Annual Macaulay duration is least accurately interpreted as the:

A. weighted average number of years until a bond’s cash flows are scheduled to be paid.
B. approximate percentage change in a bond’s value for a 1% change in its yield to maturity.
C. investment horizon at which a bond’s market price risk and reinvestment risk exactly offset.
Explanation
B is correct. Modified duration is the approximate percentage change in a bond's value for a 1% change in its YTM. Macaulay
duration is the weighted average number of periods until a bond's cash flows are scheduled to be paid and represents the
investment horizon at which a bond's market price risk and reinvestment risk exactly offset.

Question 71: An index provider maintains a price index and a total return index for the same 40 stocks. Assuming both
indexes begin the year with the same value, the total return index at the end of the year will least likely be:
A. equal to the price index if the constituent stocks do not pay dividends.
B. greater than the price index.
C. less than the price index if the price index increases and greater than the price index if the price index decreases.
Explanation
C is correct. A price index only includes the prices of the constituent securities in the calculation of the index value. A total
return index includes the prices and the dividends paid in the calculation of the index value. If all of the constituents are non-
dividend paying stocks, then the total return index will be the same as the price index at the end of the year. Otherwise the
total return index will be greater than the price index.

Question 72: Other things equal, a short put position would become more valuable as a result of an increase in:
A. the time to expiration.
B. the price of the underlying asset.
C. the volatility of the price of the underlying asset.
Explanation
B is correct. An increase in the price of the underlying asset would decrease the value of a put option, which would make a
long position in the put less valuable and a short position more valuable. An increase in either the volatility of the underlying
asset price or time to expiration would increase the put value and decrease the value of a short position.

Question 73: Structural subordination means that a parent company's debt:

A. has a higher priority of claims to a subsidiary’s cash flows than the subsidiary’s debt.
B. has a lower priority of claims to a subsidiary’s cash flows than the subsidiary’s debt.
C. ranks pari passu with a subsidiary’s debt with respect to the subsidiary’s cash flows.
Explanation
B is correct. Structural subordination means that cash flows from a subsidiary are used to pay the subsidiary's debt before
they may be paid to the parent company to service its debt. As a result, parent company debt is effectively subordinate to the
subsidiary's debt.

Question 74: A step-up coupon bond is structured such that its coupon rate increases:
A. if the issuer’s credit rating decreases.
B. if a reference interest rate increases.
C. on a predetermined schedule.
Explanation
C is correct. Step-up coupon bonds feature a coupon rate that increases on a predetermined schedule. Credit linked coupon
bonds have a coupon rate that changes inversely with the issuer's credit rating. Floating-rate notes have coupon rates that are
based on a reference interest rate.

Question 75: For a given set of underlying real estate properties, the type of real estate index that is most likely to have the
lowest standard deviation is a(n):
A. repeat sales index.
B. appraisal index.
C. REIT trading price index.
Explanation
B is correct. Appraisal index returns are based on estimates of property values. Because estimating values tends to introduce
smoothing into returns data, appraisal index returns are likely to have lower standard deviations than index returns based on
repeat sales or trading prices of REIT shares.

Question 76: Economic profits are most likely to be earned by firms in an industry that is characterized by:
A. high power of suppliers and low threat of entry.
B. low threat of substitutes and high rivalry among existing competitors.
C. high barriers to entry and low power of buyers.
Explanation
C is correct. High barriers to entry (low threat of entry) and low power of buyers both increase the potential for economic
profits within an industry. The five forces that shape industry competition are rivalry among existing competitors, threat of
entry, threat of substitutes, power of buyers, and power of suppliers. The stronger any of these forces are within an industry,
the less potential that industry has to generate (or continue to earn) economic profits.

Question 77: An analyst studying Albion Industries determines that the average EV/EBITDA ratio for Albion's industry is
10. The analyst obtains the following information from Albion's financial statements:
EBITDA = £11,000,000
Market value of debt = £30,000,000
Cash = £1,000,000
Based on the industry's average enterprise value multiple, what is the equity value of Albion Industries?
A. £110,000,000.
B. £80,000,000.
C. £81,000,000.
Explanation
C is correct. Enterprise value = Average EV/EBITDA × company EBITDA = 10 × £11,000,000 = £110,000,000
Enterprise value = Equity value + debt – cash
Equity value = Enterprise value – debt + cash = £110,000,000 – £30,000,000 + £1,000,000 = £81,000,000.
Question 78: On November 15, 20X1, Grinell Construction Company decided to issue bonds to help finance the acquisition
of new construction equipment. They issued bonds totaling $10,000,000 with a 6% coupon rate due June 15, 20X9. Grinell
has agreed to pay the entire amount borrowed in one lump sum payment at the maturity date. Grinell is not required to make
any principal payments prior to maturity. What type of bond structure has Grinell issued?
A. Amortizing maturity structure.
B. Serial maturity structure.
C. Term maturity structure.
Explanation
C is correct. These bonds have a term maturity structure because the issuer has agreed to pay the entire amount borrowed in
one lump-sum payment at maturity.

Question 79: Securitization least likely benefits the financial system by:
A. increasing liquidity for mortgages and other loans.
B. increasing the amount banks are able to lend.
C. removing liabilities from bank balance sheets.
Explanation
C is correct. By enabling banks to raise cash by selling their existing loans and mortgages (which are balance sheet assets for
banks), securitization increases the amount banks are able to lend.

Question 80: The notice period for a hedge fund is best described as the period following:
A. an investment in the fund, during which the investor is not permitted to redeem shares.
B. the opening of the fund to investors, before the fund is closed to new investors.
C. a request for redemption of shares, within which the fund must fulfill the request.
Explanation
C is correct. The notice period is the time within which a hedge fund must fulfill a request for redemption of shares. The
period during which investors may not redeem shares is called a lockup period.

Question 81: The table below lists information on price per share and shares outstanding for three stocks.

As of Beginning of Year As of End of Year

Stock Price per Share ($) # Shares Outstanding Price per Share ($) # shares Outstanding

Mertz 10 10,000 15 10,000

Norton 50 5,000 50 5,000

Rubble 100 500 85 500

At the beginning of the year, the value of a market-cap weighted index of these three stocks was 100. The index value at year-
end is closest to:

A. 44.3
B. 93.8
C. 110.6
Explanation
C is correct. Market-cap weighted index = (ending market capitalization / beginning market capitalization) × beginning index
value.
Beginning market capitalization = (10)(10,000) + (50)(5,000) + (100)(500) = 400,000
Ending market capitalization = (15)(10,000) + (50)(5,000) + (85)(500) = 442,500
Index value = (442,500 / 400,000) × 100 = 110.625.

Question 82: An investor buys a bond that has a Macaulay duration of 3.0 and a yield to maturity of 4.5%. The investor plans
to sell the bond after three years. If the yield curve has a parallel downward shift of 100 basis points immediately after the
investor buys the bond, her annualized horizon return is most likely to be:
A. approximately 4.5%.
B. greater than 4.5%.
C. less than 4.5%.
Explanation
A is correct. With Macaulay duration equal to the investment horizon, market price risk and reinvestment risk approximately
offset and the annualized horizon return should be close to the yield to maturity at purchase.

Question 83: The most likely use of a forward rate agreement is to:
A. lock in an interest rate for future borrowing or lending.
B. exchange a ëoating-rate obligation for a fixed-rate obligation.
C. obtain the right, but not the obligation, to borrow at a certain interest rate.
Explanation
A is correct. The purpose of a forward rate agreement (FRA) is to manage interest rate risk by locking in an interest rate for
future borrowing or lending. An FRA is a forward commitment rather than a contingent claim. An interest rate swap is used
to exchange a floating-rate obligation for a fixed-rate obligation.

Question 84: The zero volatility spread (Z-spread) is the spread that:
A. is added to each spot rate on the government yield curve that will cause the present value of the bond's cash flows to
equal its market price.
B. results when the cost of the call option in percent is subtracted from the option adjusted spread.
C. is added to the yield to maturity of a similar maturity government bond to equal the yield to maturity of the risky bond.
Explanation
A is correct. The zero volatility spread (Z-spread) is the interest rate that is added to each zero-coupon bond spot rate that
will cause the present value of the risky bond's cash flows to equal its market value. The nominal spread is the spread that is
added to the YTM of a similar maturity government bond that will then equal the YTM of the risky bond. The zero volatility
spread (Z-spread) is the spread that results when the cost of the call option in percent is added to the option adjusted spread.

Question 85: A UK 12-year corporate bond with a 4.25% coupon is priced at £107.30. This bond's duration and convexity
are 9.5 and 107.2. If the bond's yield decreases by 125 basis points, the estimated price of the bond is closest to:
A. £121.84.
B. £120.95.
C. £112.72.
Explanation
B is correct.
Return impact ≈ -(Duration × ΔYield) + (1/2) × (Convexity × (ΔYield))2
≈ -(9.5 × -0.0125) + (1/2) × (107.2) × (-0.0125)2
≈ 0.1188 + 0.0084
≈ 0.1272 or 12.72%

Estimated price of bond = (1 + 0.1272) × 107.30

= 120.95

Question 86: Participating preference shares most likely:

A. give the shareholder the right to sell the shares back to the firm at a specific price.
B. receive extra dividends if firm profits exceed a predetermined threshold.
C. can be exchanged for common stock at a ratio determined at issuance.
Explanation
B is correct. Participating preference shares receive extra dividends if firm profits exceed a predetermined threshold.
Convertible preference shares can be exchanged for common stock at a conversion ratio determined at issuance. Putable
common shares give the shareholder the right to sell the shares back to the firm at a specific price.

Question 87: One method of valuing a call option with a one-period binomial model involves:
A. finding a combination of the call option and the underlying that will have the same value regardless of the price of the
underlying at expiration.
B. discounting the average call value at expiration by the risk-free rate.
C. using the probabilities of an up-move and a down-move to get the expected value of the payment at expiration.
Explanation
A is correct. A portfolio combining the call option with the underlying asset can be constructed that will have the same value
at option expiration whether there is an up-move or a down move in the asset price. The present value of this portfolio is the
discounted present value of the certain future payment, which can then be used to value the option. The expected value of the
option at expiration is not a certain payment, so cannot be simply discounted at the risk-free rate. The average call value is
not a certain future payment.

Question 88: Jem Capital is a hedge fund with $150 million of initial investment capital. The fund charges a 2% management
fee based on assets under management at the end of the year and a 20% incentive fee. Incentive fees and management fees
are calculated independently. In the first year, Jem Capital has a 25% return. What is an investor's after-fee return for the
year?
A. 3.0%.
B. 17.5%.
C. 22.5%.
Explanation
B is correct. Gross value end of year: $150 million × 1.25 = $187.5 million
Management fee: $187.5 million × 2% = $3.75 million
Incentive fee: ($187.5 million – $150 million) × 20% = $7.5 million
Total fees to Jem Capital: $11.25 million
The after-fee return: [(187.5 – 11.25) / 150] – 1 = 17.5%.

Question 89: Changes in population size and average age that affect industry growth and profitability are best described as:
A. macroeconomic influences.
B. demographic influences.
C. social influences.
Explanation
B is correct. Among the external influences that affect industries, "demographic factors" refers to those that are related to the
size and composition of the population.

Question 90: Day and Associates is experiencing a period of abnormal growth. The last dividend paid by Day was $0.75.
Next year, they anticipate growth in dividends and earnings of 25% followed by negative 5% growth in the second year. The
company will level off to a normal growth rate of 8% in year three and is expected to maintain an 8% growth rate for the
foreseeable future. Investors require a 12% rate of return on Day. The value of Day stock today is closest to:
A. $24.05.
B. $18.65.
C. $20.70.
Explanation
C is correct. First find the abnormal dividends:
D1 = $0.75 × 1.25 = $0.9375
D2 = $0.9375 × 0.95 = $0.89
D2 is the first dividend that will grow at a constant rate. We can use this dividend in the constant growth DDM to get a
value for the stock in period 1:
$0.89 / (0.12 – 0.08) = $22.25
Value of the stock today = ($22.25 + $0.9375) / 1.12 = $20.70.