Table of Contents Link
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 Published by
TotalRecall Publications, Inc. 1103 Middlecreek Friendswood, TX 77546 281‐992‐3131
TotalRecall Publications, Inc. This Book Sponsored by The Center For Financial Certification, Inc. Portions Copyright © 1999‐2008 by TotalRecall Publications, Inc.. Portions Copyright © 2005‐2006 by Pegasus, Inc.. All rights reserved. Printed in the United States of America. Except as permitted under the United States Copyright Act of 1976, No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means electronic or mechanical or by photocopying, recording, or otherwise without the prior permission of the publisher. The views expressed in this book are solely those of the author, and do not represent the views of any other party or parties. Printed in United States of America, Canada, and England Paper Back: ISBN: 978‐1‐59095‐945‐9 UPC: 6‐43977‐93703‐2 EBook: ISBN: 978‐1‐59095‐948‐0 UPC: 6‐43977‐93763‐6 The sponsoring editor for this book is Bruce Moran and the production supervisor is Corby R. Tate. This publication is not sponsored by, endorsed by, or affiliated with CFA Institute™, CFA®, and their logo are trademarks or registered trademarks of CFA Institute.org in the United States and certain other countries. All other trademarks are trademarks of their respective owners. Throughout this book, trademarked names are used. Rather than put a trademark symbol after every occurrence of a trademarked name, we used names in an editorial fashion only and to the benefit of the trademark owner. No intention of infringement on trademarks is intended. The CFA Institute™ does not endorse, promote or review the accuracy of the products or services offered by organizations sponsoring or providing CFA® Exam preparation materials or programs, nor does CFA Institute™ verify pass rates or exam results claimed by such organizations. Any warranty regarding the offered products or services is made solely by TotalRecall Publications, Inc., which are not in any way affiliated with CFA Institute™, the Institute of Chartered Financial Analysts (ICFA), or the Financial Analysts Federation (FAF). If you are dissatisfied with the products or services provided, please contact, TotalRecall Publications, Inc. 1103 Middlecreek, Friendswood, TX 77546 (888‐237‐7849). CFA® is a licensed service mark of CFA Institute™. Used by permission. Disclaimer Notice: Judgments as to the suitability of the information herein for purchaser’s purposes are necessarily the purchaser’s responsibility. TotalRecall Publications, Inc. and The Financial Certification Center, Inc. extends no warranties, makes no representations, and assumes no responsibility as to the accuracy or suitability of such information for application to the purchaser’s intended purposes or for consequences of its use.
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. 3. 4. 5. 6. 7. 8. 9. 10. 11.
Study Session 2. Quantitative Methods: Basic Concepts Study Session 3. Quantitative Methods: Application Study Session 4. Economics: Microeconomic Analysis Study Session 5. Economics: Market Structure and Macroeconomic Analysis Study Session 6. Economics: Monetary and Fiscal Economics Study Session 7. Financial Statement Analysis: Introduction Study Session 8. Financial Statement Analysis: Income Statement, Balance Sheet, Cash Study Session 9. Financial Statement Analysis: Inventories, Assets, Taxes, and Debt Study Session 10. Financial Statement Analysis: Techniques, Apps, & International Study Session 11. Corporate Finance
Portfolio Management 12. Study Session 12. Portfolio Management
Asset Valuation 13. 14. 15. 16. 17. 18.
Study Session 13. Analysis of Equity Investments: Securities Markets Study Session 14. Analysis of Equity Investments: Industry and Company Analysis Study Session 15. Analysis of Fixed Income Investments: Basic Concepts Study Session 16. Analysis of Fixed Income Investments: Analysis and Valuation Study Session 17. Derivative Investments 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: Study session 02: Quantitative Methods: Study Session 03: Quantitative Methods: Study Session 4: Introduction Study Session 04: Economics: Study Session 05: Economics: Study Session 06: Economics: Study Session 7: Introduction Study Session 07: Financial Statement Analysis: Study Session 08: Financial Statement Analysis: Study Session 09: Financial Statement Analysis: Study Session 10: Financial Statement Analysis: Study Session 11: Corporate Finance: Study Session 12: Portfolio Management: Study Session 13: Equity Investments: Study Session 14: Equity Investments: Study Session 15: Fixed Income Investments: Study Session 16: Fixed Income Investments: Study Session 17: Derivative Investments: Study Session 18: Alternative Investments: Terminology: Appendix A: Download Instructions
14 34 60 84 112 136 160 184 198 222 248 274 300 330 354 378 402 426 450 474 501 503 526
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
Study Session 4:
Introduction
84
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
Study Session 04:
Economics:
112
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
Study Session 05:
Economics:
136
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
Study Session 06:
Economics:
160
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
Study Session 7:
Introduction
184
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
Study Session 07:
Financial Statement Analysis:
198
An Introduction...............................................................................................................................198 Reading 29: Financial Statement Analysis: An Introduction .....................................................198 Reading 30: Financial Reporting Mechanics ............................................................................198 Reading 31: Financial Reporting Standards .............................................................................198
Study Session 08:
Financial Statement Analysis:
222
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
Study Session 09:
Financial Statement Analysis:
248
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
Study Session 10:
Financial Statement Analysis:
274
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
Study Session 13:
Equity Investments:
354
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
Study Session 14:
Equity Investments:
378
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
Study Session 15:
Fixed Income Investments:
402
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
Study Session 16:
Fixed Income Investments:
426
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: Appendix A: Download Instructions
501 503 526
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 softdollar 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. Reference: CFA® Program Curriculum, Volume 1, pp. 75‐76.
Ethical and Professional Standards 3 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. Reference: CFA® Program Curriculum, Volume 1, pp. 69‐74. 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. B. C. D.
must file a report with the SEC. must sell the shares immediately. must disclose the ownership of the shares by a member of his immediate family. does not need to disclose the fact that his son owns the shares of Bourgogne Vineyard Corporation.
Correct Answer:
D ........................................................................................... LOS: Reading 2‐b
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. Reference: CFA® Program Curriculum, Volume 1, pp. 89‐94.
Ethical and Professional Standards 5 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. Correct Answer:
D ........................................................................................... LOS: Reading 2‐b
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. Reference: CFA® Program Curriculum, Volume 1, pp. 80‐84.
Ethical and Professional Standards 7 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. Reference: CFA® Program Curriculum, Volume 1, pp. 21‐25. 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. B. C. D.
Griffiths is in compliance with the Code and Standards since her clients are satisfied. Griffiths violates the Code and Standards due to the priority she gives to transactions. Griffiths violates the Code and Standards since she lacks independence and objectivity. 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. Reference: CFA® Program Curriculum, Volume 1, pp. 94‐99.
Ethical and Professional Standards 9 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.
10 Study Session 01: 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. Correct Answer:
D ........................................................................................... LOS: Reading 2‐b
Prior to recommending any investments, Anderson should determine Beecham's investment needs, objectives, and tolerance for risk as stated in Standard III(C) Suitability. Reference: CFA® Program Curriculum, Volume 1, pp. 60‐64.
Ethical and Professional Standards 11 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.
12 Study Session 01: 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. B. C. D.
Yes, because the statement misrepresents Janzen’s track record. Yes, because he cannot quote performance for a hypothetical portfolio. Yes, because the statement about return ignores the risk preferences of his clients. No, because the statement is a true and accurate description of Janzen’s track record.
Correct Answer:
D ........................................................................................... LOS: Reading 2‐b
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. Reference: CFA® Program Curriculum, Volume 1, pp. 64‐67.
Ethical and Professional Standards 13 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.
14 Study Session 01: 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. B. C. D.
Only Pierpont complies with the Code and Standards. Only Underhill complies with the Code and Standards. Both Pierpont and Underhill comply with the Code and Standards. Neither Pierpont nor Underhill comply with the Code and Standards.
Correct Answer:
D ........................................................................................... LOS: Reading 2‐b
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. Reference: CFA® Program Curriculum, Volume 1, pp. 99‐101. 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. B. C. D.
to avoid a conflict of interest. to maintain independence and objectivity. to make a fair statement of investment performance. 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. Reference: CFA® Program Curriculum, Volume 1, pp. 64‐67.
Ethical and Professional Standards 15 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.
16 Study Session 01: 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. B. C. D.
Lualua should stop trading with Churner Securities. Lualua may continue trading with Churners Securities. Lualua should disclose this arrangement to Flemish Widows. Lualua should disclose this arrangement to the CFA Institute.
Correct Answer:
C ........................................................................................... LOS: Reading 2‐b
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. Reference: CFA® Program Curriculum, Volume 1, pp. 48‐53.
Ethical and Professional Standards 17 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.
18 Study Session 01: 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. Reference: CFA® Program Curriculum, Volume 1, pp. 60‐64.
Ethical and Professional Standards 19 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.
20 Study Session 01: 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. Reference: CFA® Program Curriculum, Volume 1, pp. 67‐69.
Ethical and Professional Standards 21 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.
22 Study Session 01: 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. Correct Answer:
A ........................................................................................... LOS: Reading 2‐b
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. Reference: CFA® Program Curriculum, Volume 1, pp. 21‐29.
Ethical and Professional Standards 23 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.
24 Study Session 01: 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. Correct Answer:
C ........................................................................................... LOS: Reading 2‐b
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. Reference: CFA® Program Curriculum, Volume 1, pp. 75‐76.
Ethical and Professional Standards 25 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.
26 Study Session 01: 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. Correct Answer:
C ........................................................................................... LOS: Reading 2‐b
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. Reference: CFA® Program Curriculum, Volume 1, pp. 36‐45.
Ethical and Professional Standards 27 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.
28 Study Session 01: 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. Correct Answer:
A ........................................................................................... LOS: Reading 2‐b
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. Reference: CFA® Program Curriculum, Volume 1, pp. 36‐45.
Ethical and Professional Standards 29 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.
30 Study Session 01: 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. Reference: CFA® Program Curriculum, Volume 1, pp. 80‐81.
Ethical and Professional Standards 31 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.
32 Study Session 01: 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. Correct Answer:
A ........................................................................................... LOS: Reading 2‐b
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. Reference: CFA® Program Curriculum, Volume 1, pp. 83‐87.
Ethical and Professional Standards 33 22. Which of the following is not a concept covered by the CFA Institute Code of Ethics? A. B. C. D.
Competence. Integrity and diligence. Independent judgment. 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. Reference: CFA® Program Curriculum, Volume 1, pp. 12‐14.
34 Study Session 02:
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.
36 Study Session 02: 1. The following income streams will be paid from an investment: End year 1 End year 2 End year 3
$15,000 $25,000 $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:
PV =
C ........................................................................................... LOS: Reading 5‐d
$15,000 $25,000 $10,000 + + 1.08 (1.08)2 (1.08)3
= $13,889 + $21,433 + $7,938 = $43,260 Reference: CFA® Program Curriculum, Volume 1, pp. 197‐198. 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. B. C. D.
0.0769. 0.0833. 0.9166. 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. Reference: CFA® Program Curriculum, Volume 1, pp. 320‐321.
Quantitative Methods: Basic Concepts 37 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%.
38 Study Session 02: 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. B. C. D.
12.8%, 13.4%. 12.8%, 27.1%. 13.4%, 22.5%. 14.0%, 22.5%.
Correct Answer:
A ............................................................................................ LOS: Reading 6‐c
2
15
10 + = The money-weighted return is calculated by solving ( 1 + R ) (1 + R )2 So, R = 12.8%. 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% Reference: CFA® Program Curriculum, Volume 1, pp. 222‐223. 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. B. C. D.
10.03%. 14.04%. 15.86%. 16.08%.
Correct Answer:
D ............................................................................................ LOS: Reading 5‐c m
r ⎞ ⎛ EAR = ⎜1 + S ⎟ − 1 ⎝ m⎠
= (1 + 0.0125) − 1 = 16.08% 12
Reference: CFA® Program Curriculum, Volume 1, pp. 182‐183.
Quantitative Methods: Basic Concepts 39 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.
40 Study Session 02: 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 1 2 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.
X 1.1 1.8
Y 3.0 9.0
Correct Answer:
A ............................................................................................LOS: Reading 6‐a N
NPV (X) = ∑
CFt
t =0
(1 + r )
N
CFt
NPV (Y) = ∑
t =0
(1 + r )
1.1 1.8 + = 0.49 1.10 1.10 2
t
= −2 +
t
= −10 +
3.0 9.0 + = 0.49 1.08 1.08 2
Both investments have positive NPVs so they should both be accepted. Reference: CFA® Program Curriculum, Volume 1, pp. 214‐216. 6. Which is the lowest yield on a 90‐day Treasury bill? A. B. C. D.
Bank discount yield. Holding period yield. Money market yield. 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. Reference: CFA® Program Curriculum, Volume 1, pp. 229‐233.
Quantitative Methods: Basic Concepts 41 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.
8. 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%.
42 Study Session 02: 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. B. C. D.
0.00. 0.10. 0.14. 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 Reference: CFA® Program Curriculum, Volume 1, pp. 325‐326. 8. 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. B. C. D.
10.03%. 14.04%. 15.86%. 16.08%.
Correct Answer:
D ............................................................................................ LOS: Reading 5‐c m
r ⎞ ⎛ EAR = ⎜1 + S ⎟ − 1 ⎝ m⎠
= (1 + 0.0125) − 1 = 16.08% 12
Reference: CFA® Program Curriculum, Volume 1, pp. 182‐183.
Quantitative Methods: Basic Concepts 43 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.
44 Study Session 02: 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. B. C. D.
0.06. 0.08. 0.09. 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
Reference: CFA® Program Curriculum, Volume 1, pp. 323‐324. 10. If P(A|B) = P(A) then the events A and B are: A. B. C. D.
exhaustive. independent. mutually exclusive. 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. Reference: CFA® Program Curriculum, Volume 1, p. 327.
Quantitative Methods: Basic Concepts 45 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.
46 Study Session 02: 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. B. C. D.
11.40%. 12.36%. 12.55%. 12.68%.
Correct Answer:
D ............................................................................................ LOS: Reading 5‐c
The effective annual rate (EAR) is given by: m
⎛ r ⎞ EAR = ⎜1 + S ⎟ − 1 ⎝ m⎠ where m rs
= =
number of compounding periods per year quoted annual interest rate
EAR = (1.01)12 - 1 = 12.68% Reference: CFA® Program Curriculum, Volume 1, pp. 179‐180. 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. B. C. D.
$23.12. $23.64. $24.00. $24.50.
Correct Answer:
B............................................................................................ LOS: Reading 7‐d
The harmonic mean is the average price on a per share basis.
XH =
n n ⎛ 1 ∑ ⎜⎜ i =1 ⎝ X i
⎞ ⎟⎟ ⎠
=
4 1 1 1 ⎞ ⎛ 1 + + ⎟ ⎜ + ⎝ 20 25 28 23 ⎠
=
4 = $23.64 0.1692
Reference: CFA® Program Curriculum, Volume 1, p. 272.
Quantitative Methods: Basic Concepts 47 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.
48 Study Session 02: 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. B. C. D.
3.2%. 4.1%. 4.8%. 6.7%.
Correct Answer:
C ........................................................................................... LOS: Reading 7‐d
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 Reference: CFA® Program Curriculum, Volume 1, pp. 269‐270. 14. A deposit of $1,000,000 earns a return of 5% compounded continuously for 8 years. The future value is closest to: A. B. C. D.
$1,400,000. $1,477,000. $1,492,000. $1,500,000.
Correct Answer:
C ........................................................................................... LOS: Reading 8‐d
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 BA II Plus
1 g ex 1 2nd [ex]
2.7183 2.7183
Reference: CFA® Program Curriculum, Volume 1, pp. 171‐182.
Quantitative Methods: Basic Concepts 49 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
5
4
2
7
7
5
6
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
50 Study Session 02: 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 Reference: CFA® Program Curriculum, Volume 1, p. 356. 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 54 2 7 7 5 The mean, median and mode are closest to: Mean Median 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 Correct Answer:
6
Mode
C ........................................................................................... LOS: Reading 7‐d
∑ w i Xi w Mean = X = ∑ i = [1(2) + 3(4) + 4(5) +3(6) +3(7) +1(8)]/15 = 5.4 The median is the middle observation, which is 5. The mode is the most frequently occurring observation, which is 5. Reference: CFA® Program Curriculum, Volume 1, pp. 255‐263.
Quantitative Methods: Basic Concepts 51 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.
52 Study Session 02: 17. Which of the following statements is most accurate regarding a money‐weighted rate of return for a portfolio? A. B. C. D.
It is the internal rate of return. It is always lower than the time-weighted rate of return. It is the arithmetic average of the periodic rates of return. It is the geometric average of the periodic rates of return.
Correct Answer:
A ............................................................................................ LOS: Reading 6‐c
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. Reference: CFA® Program Curriculum, Volume 1, pp. 221‐229. 18. Conditional probability refers to: A. B. C. D.
the probability that an event will happen more than once. the probability that two or more events will occur concurrently. the probability that one of two mutually exclusive events will occur. 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. Reference: CFA® Program Curriculum, Volume 1, p. 322.
Quantitative Methods: Basic Concepts 53 19. The following data is provided on the quarterly performance of a fund.
1st Quarter 2nd Quarter $1,000,000 $1,200,000 Beginning value $100,000 $100,000 Cash inflow at beginning $1,200,000 $1,500,000 Ending value The time‐weighted return for the year is closest to: A.
6.6%.
B.
28.7%.
C.
29.1%.
D.
61.4%.
3rd Quarter 4th Quarter $1,500,000 $1,500,000 ($200,000) $300,000 $1,500,000 $1,600,000
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.
54 Study Session 02: 19. The following data is provided on the quarterly performance of a fund.
1st Quarter 2nd Quarter $1,000,000 $1,200,000 Beginning value $100,000 $100,000 Cash inflow at beginning $1,200,000 $1,500,000 Ending value The time‐weighted return for the year is closest to: A. B. C. D.
3rd Quarter $1,500,000 ($200,000) $1,500,000
4th Quarter $1,500,000 $300,000 $1,600,000
6.6%. 28.7%. 29.1%. 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% Reference: CFA® Program Curriculum, Volume 1, pp. 223‐226.
Quantitative Methods: Basic Concepts 55 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:
CV =
s X
A............................................................................................LOS: Reading 7‐h
X 100
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. Reference: CFA® Program Curriculum, Volume 1, pp. 292‐294.
56 Study Session 02: 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%.
Quantitative Methods: Basic Concepts 57 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.
58 Study Session 02: 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. B. C. D.
33.3%. 42.3%. 55.0%. 60.0%.
Correct Answer:
B........................................................................................... LOS: Reading 8‐m
P(A 1 | B) = Apply Bayes’ formula:
P(A 1 )P(B | A 1 ) 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
P(A 1 | B) =
0.55 × 0.03 (0.55 × 0.03) + (0.45 × 0.05)
= 0.423 Reference: CFA® Program Curriculum, Volume 1, pp. 349‐353.
Quantitative Methods: Basic Concepts 59 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. B. C. D.
$131,808. $134,350. $139,708. $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 formula:
Calculator keystrokes for:
A = $10,000 r = 6% = 0.06
f CLEAR FIN
N = 10 FVN = A
10000 CHS PMT
(1 + r )N 1
-10,000.00
r
6 i 10
= $10,000
BA II Plus
HP‐12C
(1 + 0.06)
0.06
= $10,000 × 13.1808 = $131,808
1
6.00
10 n 10.00 FV
FV = 131,807.95
Reference: CFA® Program Curriculum, Volume 1, pp. 183‐185.
2nd [QUIT] 2nd [CLR TVM] 10000 +/- PMT = -10,000.00 6 I/Y
I/Y = 6.00
10 N
N = 10.00
CPT FV
FV = 131,807.95
60 Study Session 03:
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.
62 Study Session 03: 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. B. C. D.
cluster sampling. simple random sampling. stratified random sampling. 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. Reference: CFA® Program Curriculum, Volume 1, pp. 422‐423. 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. Reference: CFA® Program Curriculum, Volume 1, pp. 389‐397.
Quantitative Methods: Applications 63 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.
64 Study Session 03: 3. A hypothesis is a statement about a: A. B. C. D.
sample statistic. sample parameter. population statistic. 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. Reference: CFA® Program Curriculum, Volume 1, pp. 456‐457. 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. B. C. D.
using the t-statistic is not valid for a small sample. the mean number of days is more than 4 days at the 5% significance level. the mean number of days is still 4 days or less at the 5% significance level. 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.
t 19 =
x −µ 4.5 − 4.0 0.5 = = = 1.49 s 1.5 20 0.335 n
This is within the confidence interval so we do not reject the null hypothesis. Reference: CFA® Program Curriculum, Volume 1, pp. 466‐474.
Quantitative Methods: Applications 65 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.
66 Study Session 03: 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. B. C. D.
0.10. 0.28. 3.54. 10.00.
Correct Answer:
C ..........................................................................................LOS: Reading 10‐e
The standard error of the sample mean is given by
σ
σx =
n
= 25/7.07 = 3.54. Reference: CFA® Program Curriculum, Volume 1, p. 429. 6. Which of the following statements regarding lognormal distributions is most accurate? A. B. C. D.
The distribution is bell shaped. The mean of the distribution is zero. Y is a lognormal distribution if LnY is normally distributed. Lognormal distributions are frequently used to reflect the distribution of stock returns.
Correct Answer: A. B. D.
C ............................................................................................ LOS: Reading 9‐j
is not correct, they are positively skewed distributions. is not correct, the lower bound is zero. is not correct, they are frequently used to show the distribution of stock prices.
Reference: CFA® Program Curriculum, Volume 1, pp. 400‐406.
Quantitative Methods: Applications 67 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.
68 Study Session 03: 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. B. C. D.
2.3%. 4.6%. 15.9%. 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%. Reference: CFA® Program Curriculum, Volume 1, pp. 389‐393. 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. B. C. D.
it is approximately a normal distribution. the standard error tends to one as the size of the samples increases. the mean of the distribution will be smaller than the population mean. 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. Reference: CFA® Program Curriculum, Volume 1, pp. 428‐431.
Quantitative Methods: Applications 69 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
70 Study Session 03: 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. B. C. D.
look-ahead bias. data-mining bias. survivorship bias. 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. Reference: CFA® Program Curriculum, Volume 1, pp. 444‐446. 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? A. B. C. D.
Hypothesis test a one-tailed test a one-tailed test a two-tailed test a two-tailed test
Correct Answer:
Test statistic t-test z-test t-test z-test
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.
Quantitative Methods: Applications 71 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.
72 Study Session 03: 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. B. C. D.
reject the null hypothesis at both the 1% and 5% significance level. not reject the null hypothesis at both the 1% and 5% significance level. not reject the null hypothesis at the 1% significance level but reject it at the 5% significance level. not reject the null hypothesis at the 5% significance level but reject it at the 1% significance level.
Correct Answer:
C ..........................................................................................LOS: Reading 11‐e
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. Reference: CFA® Program Curriculum, Volume 1, pp. 466‐474. 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. Reference: CFA® Program Curriculum, Volume 1, pp. 465‐466.
Quantitative Methods: Applications 73 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.
74 Study Session 03: 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. B. C. D.
the null hypothesis is rejected and the results are consistent with a mean of 1.4%. the null hypothesis is not rejected and the results are consistent with a mean of 1.4%. the null hypothesis is rejected and the results are not consistent with a mean of 1.4% 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.
t n −1 =
x −µ 1.25 − 1.4 0.15 = =− = −0.52 s 0.29 1.0 12 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%. Reference: CFA® Program Curriculum, Volume 1, pp. 466‐474. 14. A chi‐square test statistic ( χ ) could be used for hypothesis tests for 2
A. B. C. D.
the mean for a single normally distributed population. the variance for a single normally distributed population. the mean for a single non-normally distributed population. 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. Reference: CFA® Program Curriculum, Volume 1, pp. 482‐484.
Quantitative Methods: Applications 75 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.
76 Study Session 03: 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. B. C. D.
between 12.1 and 37.9. between 15.2 and 34.8. between 20.0 and 30.0. between 15.0 and 40.0.
Correct Answer:
B........................................................................................... LOS: Reading 10‐f
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.
Reference: CFA® Program Curriculum, Volume 1, pp. 433‐435. 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. B. C. D.
structured sampling. systematic sampling. simple random sampling. stratified random sampling.
Correct Answer:
D ......................................................................................... LOS: Reading 10‐b
Stratified random sampling ensures that different subdivisions within a population are represented in the sample. Reference: CFA® Program Curriculum, Volume 1, pp. 422‐425.
Quantitative Methods: Applications 77 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
78 Study Session 03: 17. If a very large sample size is used it is least likely to lead to: A. B. C. D.
a smaller standard error of the sample means. a larger dispersion in the distribution of the sample means. the sampling distribution of the sample mean being approximately a normal distribution. the mean of the sampling distribution of the sample mean being equal to the population mean.
Correct Answer:
B...........................................................................................LOS: Reading 10‐e
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. Reference: CFA® Program Curriculum, Volume 1, pp. 428‐431. 18. Which of the following describe lognormal distributions? A. B. C. D.
Skew positively skewed positively skewed negatively skewed negatively skewed.
Correct Answer:
Often used to describe asset prices returns prices returns
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. Reference: CFA® Program Curriculum, Volume 1, pp. 400‐406.
Quantitative Methods: Applications 79 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.
80 Study Session 03: 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. B. C. D.
the standard deviation of returns. the risk that the value of the portfolio falls below a critical level. the standard deviation of returns relatives to the MSCI World Index. 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. B. C. D.
the average standard deviation of each sample. the standard deviation of the sampling distribution of sample mean. the standard deviation of the sample minus the standard deviation of the population. the standard deviation of the sample divided by the standard deviation of the population.
Correct Answer:
B...........................................................................................LOS: Reading 10‐e
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. Reference: CFA® Program Curriculum, Volume 1, pp. 428‐431.
Quantitative Methods: Applications 81 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: A.
between 4.45 and 7.55.
B.
between 5.48 and 6.52.
C.
between 5.61 and 6.39.
D.
between 5.95 and 6.05.
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.
82 Study Session 03: 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: A. B. C. D.
between 4.45 and 7.55. between 5.48 and 6.52. between 5.61 and 6.39. between 5.95 and 6.05.
Correct Answer:
B........................................................................................... LOS: Reading 10‐j
x ± zα / 2 The confidence interval is given by
σ n
where
x σ
=
sample mean, which is the point estimate of the population mean
=
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. Reference: CFA® Program Curriculum, Volume 1, pp. 433‐439.
Quantitative Methods: Applications 83 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
A. B. C. D.
Expected Return
Standard Deviation
A
25
12
B
15
8
C
10
6
D
8
5
Portfolio A. Portfolio B. Portfolio C. 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. Reference: CFA® Program Curriculum, Volume 1, pp. 397‐400.
84 Study Session 04:
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.
86 Study Session 04:
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).
Introductory Readings 87
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).
88 Study Session 04:
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.
Introductory Readings 89
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.
90 Study Session 04:
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.
Introductory Readings 91 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.
92 Study Session 04:
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.
Introductory Readings 93
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).
94 Study Session 04: 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
real GDPperiod t = nominal GDPperiod t ×
GDP deflatorbase year 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.
Introductory Readings 95
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:
real GDPperiod t = nominal GDPperiod t ×
= $11,381.2 billion ×
GDP deflatorbase year GDP deflatorperiod t
100.0 121.4
= $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.
96 Study Session 04:
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
Introductory Readings 97 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.
98 Study Session 04: 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
SRAS1 SRAS0
YF YSR
AD1
Introductory Readings 99 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 E0
PSR
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).
100 Study Session 04:
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.
Introductory Readings 101 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. Planned aggregate expenditur Unplanne e (AE 45‐degree dinventor AE = GDP ybuil ‐u line d p Unplanne 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 Output GDP 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: Keynesian equilibrium
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.
102 Study Session 04: The expenditure multiplier is related to the MPC and MPS, as shown below:
Equation Int-3
expenditure multiplier =
1 1 = 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 expenditure multiplier =
1 1 1 = = = 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: expenditure multiplier =
1 1 1 = = = 5 1 - MPC 1 - 0.80 0.20
Introductory Readings 103 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.
104 Study Session 04:
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%.
Introductory Readings 105 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.
106 Study Session 04: 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 107
108 Study Session 04:
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.
Introductory Readings 109 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.
Correct Answer: 4.
B
110 Study Session 04: 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.
Correct Answer: 6.
B
The main self-correcting mechanisms will be the fall in real interest rates and resource prices (including labor costs).
Introductory Readings 111 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.
112 Study Session 04:
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.
114 Study Session 04: 1. Economic profit is total revenue less: A. B. C. D.
explicit costs. implicit costs. normal profit. opportunity costs.
Correct Answer:
D ..........................................................................................LOS: Reading 16‐a
Economic profit is after opportunity costs which include both explicit and implicit costs. Normal profit is included in implicit costs. Reference: CFA® Program Curriculum, Volume 2, pp. 94‐95. 2. The momentary supply curve of agricultural crops is generally: A. B. C. D.
vertical. horizontal. an upward sloping curve. linear and passes through the origin.
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. Reference: CFA® Program Curriculum, Volume 2, pp. 26‐27.
Economics: Microeconomic Analysis 115 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.
116 Study Session 04: 3. Which of the following are examples of implicit and explicit opportunity costs? Implicit cost Utility expenses Interest foregone Dividend payments Economic depreciation
A. B. C. D.
Correct Answer:
Explicit cost Rental costs Accounting depreciation Salary costs Bank interest
D ..........................................................................................LOS: Reading 16‐a
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. B. C. D.
increase value for buyers. reduce costs for suppliers. reduce the quantity traded. 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.
Economics: Microeconomic Analysis 117 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.
118 Study Session 04: 5. Which of the following curves is least likely to be U‐shaped? A. B. C. D.
The marginal cost curve. The average total cost curve. The average fixed cost curve. The average variable cost curve.
Correct Answer:
C .......................................................................................... LOS: Reading 17‐c
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. Reference: CFA® Program Curriculum, Volume 2, pp. 129‐134. 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. B. C. D.
Demand for the service will decline. A black market in the service will develop. There will be as shortage of supply of the service. The service providers’ producer surplus will decline.
Correct Answer:
A ..........................................................................................LOS: Reading 15‐a
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. Reference: CFA® Program Curriculum, Volume 2, pp. 60‐66.
Economics: Microeconomic Analysis 119 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.
C.
an upward sloping curve.
D.
linear and passes through the origin.
120 Study Session 04: 7. Technology and labor are usually considered to be which type of resources? Technology Long-run Long-run Short-run Short-run
A. B. C. D.
Correct Answer:
Labor Long-run Short-run Long-run Short-run 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. Reference: CFA® Program Curriculum, Volume 2, pp. 122‐123. 8. If the supply of a product is unit elastic it means that the supply curve is: A. B. C. D.
vertical. horizontal. an upward sloping curve. linear and passes through the origin.
Correct Answer:
D ..........................................................................................LOS: Reading 13‐a
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. Reference: CFA® Program Curriculum, Volume 2, p. 25.
Economics: Microeconomic Analysis 121 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.
122 Study Session 04: 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. B. C. D.
increasing supply. creating overproduction. shifting the supply curve downwards to the right. 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. Reference: CFA® Program Curriculum, Volume 2, pp. 79‐80. 10. Proprietorships in the U.S. are generally characterized by which of the following? A. B. C. D.
The entire wealth of owners is at risk. They are owned by one or more people. Profits are taxed at the proprietorship and owner level. 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. Reference: CFA® Program Curriculum, Volume 2, pp. 101‐102.
Economics: Microeconomic Analysis 123 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.
124 Study Session 04: 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. Reference: CFA® Program Curriculum, Volume 2, pp. 49‐50. 12. It is noted that the income elasticity of a good is slightly negative. It is most likely that the good is: A. B. C. D.
a luxury item. a normal good. an inferior good. 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. Reference: CFA® Program Curriculum, Volume 2, pp. 21‐22.
Economics: Microeconomic Analysis 125 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.
126 Study Session 04: 13. The value of one more unit of a good is least accurately described as: A. B. C. D.
its marginal benefit. the price of the good less the marginal cost of the unit. the maximum price consumers are willing to pay for it. 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. Reference: CFA® Program Curriculum, Volume 2, pp. 38‐40. 14. When a government imposes a quota on a product it is most likely to: A. B. C. D.
benefit consumers of the product. benefit certain producers of the product. increase the marginal cost of production of the good. 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. Reference: CFA® Program Curriculum, Volume 2, pp. 77‐81.
Economics: Microeconomic Analysis 127 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.
128 Study Session 04: 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 A. 10% B. 90% C. 10% D. 90% Correct Answer:
Herfindahl-Hirschman Index 470 470 2,350 2,350
D ..........................................................................................LOS: Reading 16‐g
Four-firm concentration ratio is (30% + 25% + 25% + 10%) = 90% Herfindahl-Hirschman Index is 302 + 252 + 252 + 102 = 2350 Reference: CFA® Program Curriculum, Volume 2, pp. 105‐106. 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. Correct Answer:
C .......................................................................................... LOS: Reading 17‐c
The law of diminishing returns sates that marginal product starts to decline as quantities increase due to technological constraints. Reference: CFA® Program Curriculum, Volume 2, pp. 126‐127.
Economics: Microeconomic Analysis 129 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
130 Study Session 04: 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. B. C. D.
$80,000 $120,000. $130,000 $180,000.
Correct Answer:
A ..........................................................................................LOS: Reading 16‐a
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. Reference: CFA® Program Curriculum, Volume 2, pp. 93‐96. 18. Company ABC provides the following information on labor (workers per day) and total production (units output per day).
Labor 24 25 26
Total Production 5,000 5,200 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 Correct Answer:
B.......................................................................................... LOS: Reading 17‐b
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 Reference: CFA® Program Curriculum, Volume 2, pp. 124‐129.
Economics: Microeconomic Analysis 131 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.
132 Study Session 04: 19. In the market economy, if a good has external benefits it is least likely to lead to: A. B. C. D.
a social loss. a deadweight loss. overproduction of the good. an inefficient quantity being produced.
Correct Answer:
C ..........................................................................................LOS: Reading 14‐e
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. Reference: CFA® Program Curriculum, Volume 2, pp. 46‐48. 20. The efficient quantity produced of a good is least likely to: A. B. C. D.
maximize the sum of the consumer and producer surpluses. be the quantity to which free market forces drive production. be the point where the marginal society benefit equals the marginal society cost. 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. Reference: CFA® Program Curriculum, Volume 2, pp. 43‐46.
Economics: Microeconomic Analysis 133 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.
134 Study Session 04: 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. B. C. D.
0.45. 2.22. 2.33. 2.50.
Correct Answer:
C ......................................................................................... LOS: Reading 13‐b
Price elasticity of demand
=
% ∆Q Dem % ∆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. Reference: CFA® Program Curriculum, Volume 2, pp. 13‐14.
Economics: Microeconomic Analysis 135 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. B. C. D.
0.81. 1.04. 1.22. 1.25.
Correct Answer:
A.......................................................................................... LOS: Reading 13‐a
Cross elasticity of demand
=
%∆Q Dem %∆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 Reference: CFA® Program Curriculum, Volume 2, pp. 19‐21.
136 Study Session 05:
Study Session 05: Economics: 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.
138 Study Session 05: 1. The real wage rate is: A. B. C. D.
the growth in wages adjusted for productivity. the money wage rate multiplied by the price level. the amount of goods that an hour’s work can buy. the money wage rate divided by the inflation rate.
Correct Answer:
C ......................................................................................... LOS: Reading 22‐b
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. Reference: CFA® Program Curriculum, Volume 2, pp. 292‐293. 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. Reference: CFA® Program Curriculum, Volume 2, pp. 297‐300.
Economics: Microeconomic Market Structure and Macroeconomic Analysis 139 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.
140 Study Session 05: 3. One of the reasons single‐price monopolies are said to be inefficient is because: A. B. C. D.
costs are not minimized. excess goods are produced. prices are below marginal revenue. 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. Reference: CFA® Program Curriculum, Volume 2, pp. 181‐186. 4. Which of the following is the least accurate description of a monopoly? A. B. C. D.
A firm which has to decide which price will maximize profits. A producer of a good for which there are no attractive substitutes. A market in which there are only a small number of producers of a good. An industry where there are high barriers to entry for firms looking to enter the business.
Correct Answer:
C ..........................................................................................LOS: Reading 19‐a
A monopoly is a firm or market where there is only one producer of a product. Reference: CFA® Program Curriculum, Volume 2, pp. 176‐181.
Economics: Microeconomic Market Structure and Macroeconomic Analysis 141 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.
142 Study Session 05: 5. When firms are price takers the short‐run market supply curve is: A. B. C. D.
horizontal. slopes upwards to the right. slopes downwards to the right. whether it slopes upwards or downwards to the right, or is horizontal, will depend on the industry.
Correct Answer:
B........................................................................................... LOS: Reading 18‐c
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). Reference: CFA® Program Curriculum, Volume 2, pp. 156‐160. 6. Which of the following would be the least sensible regulatory step to consider in order to increase resource allocation of a monopoly? A. B. C. D.
Abolish licensing requirements that limit entry to the industry. Regulate that the monopoly firm must reduce prices to the marginal cost. Break up the monopoly into smaller companies, if it is not a natural monopoly. Reduce barriers and quotas that are acting as a barrier to foreign firms competing in the industry.
Correct Answer:
B...........................................................................................LOS: Reading 19‐e
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. Reference: CFA® Program Curriculum, Volume 2, pp. 198‐190.
Economics: Microeconomic Market Structure and Macroeconomic Analysis 143 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.
144 Study Session 05: 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 increase increase decrease decrease
A. B. C. D.
Correct Answer:
Expected inflation rate increase decrease increase decrease
C ......................................................................................... LOS: Reading 23‐b
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. Reference: CFA® Program Curriculum, Volume 2, pp. 322‐325. 8. Which of the following statements regarding a monopoly is least accurate? A. B. C. D.
There are high barriers to entry. The demand curve is horizontal. There are no substitutes for a product. There is a single seller of a well-defined product.
Correct Answer:
B...........................................................................................LOS: Reading 19‐a
The demand curve for a monopoly is the market demand curve. It is downward sloping, as price increases demand will fall. Reference: CFA® Program Curriculum, Volume 2, pp. 178‐81.
Economics: Microeconomic Market Structure and Macroeconomic Analysis 145 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
146 Study Session 05: 9. A significant rise in the real wage rate is most likely to indicate that: A. B. C. D.
productivity is rising. the inflation rate is very high. the aggregate hours worked has risen. the employment rate has dropped sharply.
Correct Answer:
A ......................................................................................... LOS: Reading 22‐b
When real wages rise, it usually coincides with an increase in productivity. Reference: CFA® Program Curriculum, Volume 2, pp. 292‐293. 10. Long‐run economic profits can be made by: A. B. C. D.
Price takers Yes Yes No No
Correct Answer:
Firms in monopolistic competition Yes No Yes No D ......................................................................................... LOS: Reading 20‐b
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. Reference: CFA® Program Curriculum, Volume 2, pp. 212‐213.
Economics: Microeconomic Market Structure and Macroeconomic Analysis 147 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.
148 Study Session 05: 11. A profit maximizing firm in monopolistic competition will expand output until marginal revenue equals: A. B. C. D.
market price. marginal cost. average total cost. average variable cost.
Correct Answer:
B.......................................................................................... LOS: Reading 20‐b
Output will be expanded until marginal revenue equals marginal cost. Reference: CFA® Program Curriculum, Volume 2, pp. 210‐212. 12. An increase in the quantity of capital in an economy is likely to: A. B. C. D.
have no effect on the aggregate supply curves. shift only the long-run aggregate supply curve to the right. shift only the short-run aggregate supply curve to the right. shift both the short-run and long-run aggregate supply curves to the right.
Correct Answer:
D ..........................................................................................LOS: Reading 23‐a
The larger the capital base the more productive the labor force and the higher the output shifting both supply curves to the right. Reference: CFA® Program Curriculum, Volume 2, pp. 316‐319.
Economics: Microeconomic Market Structure and Macroeconomic Analysis 149 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.
150 Study Session 05: 13. The lowest possible cost is most likely to be found in a market which is: A. B. C. D.
a monopoly. an oligopoly. in perfect competition. in monoplolistic competition.
Correct Answer:
C ......................................................................................... LOS: Reading 20‐b
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. Reference: CFA® Program Curriculum, Volume 2, pp. 214‐215. 14. Classical economists believe: A. B. C. D.
money wage rates are slow to change in a recession. fiscal policy can be used to stimulate aggregate demand. technological change is a strong influence on aggregate demand. the government should use monetary policy to stimulate demand in a recession.
Correct Answer:
C ......................................................................................... LOS: Reading 23‐d
Classical economists believe technological change is the main driver of aggregate demand and supply, and the economy is effective at self regulation. Reference: CFA® Program Curriculum, Volume 2, p. 335.
Economics: Microeconomic Market Structure and Macroeconomic Analysis 151 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.
152 Study Session 05: 15. If the CPI price index was 75 last year and 82 this year, then the annual inflation rate is closest to: A. B. C. D.
7.0%. 8.2%. 8.5%. 9.3%.
Correct Answer:
D ......................................................................................... LOS: Reading 22‐d
The inflation rate is [(82 - 75)/75] x 100 = 9.33% Reference: CFA® Program Curriculum, Volume 2, pp. 300‐304. 16. A price‐taker market is least likely to be characterized by: A. B. C. D.
identical products. high entry barriers. a large number of participants. each participant has a small market share.
Correct Answer:
B...........................................................................................LOS: Reading 18‐a
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.
Economics: Microeconomic Market Structure and Macroeconomic Analysis 153 17. A profit maximizing price taker will expand output until marginal revenue equals: A.
market price.
B.
marginal cost.
C.
average total cost.
D.
average variable 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.
154 Study Session 05: 17. A profit maximizing price taker will expand output until marginal revenue equals: A. B. C. D.
market price. marginal cost. average total cost. average variable cost.
Correct Answer:
B.......................................................................................... LOS: Reading 18‐b
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. Reference: CFA® Program Curriculum, Volume 2, pp. 151‐152. 18. Which of the following groups of people is least likely to be included in the labor force? A. B. C. D.
Retired workers. Part-time workers. People looking for a job. People waiting to start a new job within two weeks.
Correct Answer:
A ..........................................................................................LOS: Reading 22‐a
The labor force includes all the employed and unemployed, it does not include retired workers. Reference: CFA® Program Curriculum, Volume 2, pp. 287‐288.
Economics: Microeconomic Market Structure and Macroeconomic Analysis 155 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
A.
increase
increase
B.
increase
decrease
C.
decrease
increase
D.
decrease
decrease
156 Study Session 05: 19. If a monopoly uses price discrimination it is least likely to have the effect of: A. B. C. D.
minimizing the consumer surplus. finding the single price that will maximize the quantity sold. bringing the market demand curve close to the marginal revenue curve. producing the quantity which is similar to that produced in a perfectly competitive market.
Correct Answer:
B........................................................................................... LOS: Reading 19‐c
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 Reference: CFA® Program Curriculum, Volume 2, pp. 191‐196. 20. Firms acting in collusion in an oligopoly would generally attempt to: A. B. C. D.
Output increase increase decrease decrease
Correct Answer:
Prices increase decrease increase decrease C ..........................................................................................LOS: Reading 20‐a
Collusion is usually with the intention of increasing economic profit for the participants by limiting output and raising pierces. Reference: CFA® Program Curriculum, Volume 2, pp. 220‐222.
Economics: Microeconomic Market Structure and Macroeconomic Analysis 157 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.
158 Study Session 05: 21. Which of the following is a characteristic of monopolistic competition? A. B. C. D.
Firms produce identical products. The market is purely competitive. Firms have downward sloping demand curves. Firms cannot sell products above the market price.
Correct Answer:
C ..........................................................................................LOS: Reading 20‐a
A, B and D are all characteristics of a price-taker or a perfectly competitive market. Reference: CFA® Program Curriculum, Volume 2, pp. 208‐210.
Economics: Microeconomic Market Structure and Macroeconomic Analysis 159 22. The prisoners’ dilemma can be applied to price‐fixing in an oligopoly. It explains why: A. B. C. D.
members of a cartel are tempted to cheat on other members of the cartel. the more players in a cartel, the easier it is to maintain price-fixing agreements. the opportunity to make large profits will tempt new members to join the cartel. 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. Reference: CFA® Program Curriculum, Volume 2, pp. 226‐234.
160 Study Session 06:
Study Session 06: Economics: 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.
162 Study Session 06: 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. Reference: CFA® Program Curriculum, Volume 2, pp. 477‐479. 2. A monetarist is most likely to believe that: A. B. C. D.
long term GDP growth is only affected by technological change. steady money growth will allow the economy to operate at full employment. monetary policy should be constantly adjusted to reflect levels of aggregate demand. the government should adopt expansionary fiscal policies when real GDP is below potential GDP.
Correct Answer:
B.......................................................................................... LOS: Reading 28‐b
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. Reference: CFA® Program Curriculum, Volume 2, pp. 468‐470.
Economics: Monetary and Fiscal Economics 163 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).
164 Study Session 06: 3. The quantity theory of money says that an increase in money supply will lead to an increase in: A. B. C. D.
prices. output. employment. 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. Reference: CFA® Program Curriculum, Volume 2, pp. 386‐389. 4. When the government adopts a counter cyclical fiscal policy in response to a threat of recession the government might: A. B. C. D.
increase business tax rates. reduce its outstanding debt. increase infrastructure spending. reduce the size of the budget deficit (or increase the surplus).
Correct Answer:
C ..........................................................................................LOS: Reading 24‐e
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. Reference: CFA® Program Curriculum, Volume 2, pp. 361‐364.
Economics: Monetary and Fiscal Economics 165 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.
166 Study Session 06: 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. Correct Answer:
B...........................................................................................LOS: Reading 25‐a
The demand for money is simply the amount of money that people wish to hold in cash and highly liquid assets. Reference: CFA® Program Curriculum, Volume 2, pp. 376‐380. 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. Reference: CFA® Program Curriculum, Volume 2, pp. 412‐414.
Economics: Monetary and Fiscal Economics 167 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
A.
increase
increase
B.
increase
decrease
C.
decrease
increase
D.
decrease
decrease
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.
168 Study Session 06: 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 increase increase decrease decrease
A. B. C. D.
Correct Answer:
Rising interest rate increase decrease increase decrease
D ..........................................................................................LOS: Reading 25‐a
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. Reference: CFA® Program Curriculum, Volume 2, pp. 376‐380. 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. Correct Answer:
D ......................................................................................... LOS: Reading 25‐b
In the long run decision-makers would have time to adjust their policies, so the only impact will be a rise in prices. Reference: CFA® Program Curriculum, Volume 2, pp. 386‐387.
Economics: Monetary and Fiscal Economics 169 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.
170 Study Session 06: 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. Correct Answer:
C ..........................................................................................LOS: Reading 24‐a
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. Reference: CFA® Program Curriculum, Volume 2, pp. 348‐352. 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. B. C. D.
$6.25 billion. $160 billion. $400 billion. $3,200 billion.
Correct Answer:
A .......................................................................................... LOS: Reading 25‐c
Use MV = GDP, so M = $50 billion/8 = $6.25 billion. Reference: CFA® Program Curriculum, Volume 2, pp. 387‐389.
Economics: Monetary and Fiscal Economics 171 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.
172 Study Session 06: 11. When aggregate demand drops sharply the Keynesian feedback rule is most likely to lead to the Fed: Interest rates increasing increasing decreasing decreasing
A. B. C. D.
Correct Answer:
Quantity of money increasing decreasing increasing decreasing C .......................................................................................... LOS: Reading 28‐c
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. Reference: CFA® Program Curriculum, Volume 2, pp. 470‐472. 12. Intermediate targets of the Fed’s monetary policy are least likely to include: A. B. C. D.
M1. Treasury-bill rate. the monetary base. the federal funds rate.
Correct Answer:
C ..........................................................................................LOS: Reading 28‐a
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. Reference: CFA® Program Curriculum, Volume 2, pp. 462‐463.
Economics: Monetary and Fiscal Economics 173 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.
174 Study Session 06: 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. B. C. D.
fixed-rule policy. stabilization policy. discretionary policy. feedback-rule policy.
Correct Answer:
C ......................................................................................... LOS: Reading 23‐b
Discretionary policies respond to the state of the economy after taking into account all of the available information so C is the best answer. Reference: CFA® Program Curriculum, Volume 2, pp. 467‐468. 14. Which of the following is an automatic stabilizer? A. B. C. D.
Interest rates. Inflation rates. Exchange rates. Progressive corporate tax.
Correct Answer:
D ..........................................................................................LOS: Reading 27‐e
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. Reference: CFA® Program Curriculum, Volume 2, pp. 452‐455.
Economics: Monetary and Fiscal Economics 175 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.
176 Study Session 06: 15. Which of the following is least likely to be included in M1? A. B. C. D.
Currency. Issued checks. Traveler’s checks. Checking deposits.
Correct Answer:
B.......................................................................................... LOS: Reading 24‐b
M1 is made up of currency, traveler’s checks and checking deposits. Checks are a promise to pay, not a form of money. Reference: CFA® Program Curriculum, Volume 2, pp. 302‐305. 16. The demand for money curve shows that the quantity of money demanded is: A. B. C. D.
positively related to GDP growth. inversely related to GDP growth. positively related to interest rates. inversely related to interest rates.
Correct Answer:
D ..........................................................................................LOS: Reading 25‐a
Demand for money measures the relationship between interest rates and the amount of money that people want to hold. Reference: CFA® Program Curriculum, Volume 2, pp. 376‐380.
Economics: Monetary and Fiscal Economics 177 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
178 Study Session 06: 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. Correct Answer:
D ......................................................................................... LOS: Reading 27‐b
A budge deficit decreases savings supply and therefore increases the real interest rate, this will crowd out private investment. Reference: CFA® Program Curriculum, Volume 2, pp. 444‐445. 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: A. B. C. D.
Loans $1,900,000 $2,000,000 $9,400,000 $9,500,000
Correct Answer:
Deposits $2,000,000 $2,000,000 $9,500,000 $9,500,000 A ......................................................................................... LOS: Reading 24‐d
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. Reference: CFA® Program Curriculum, Volume 2, pp. 356‐359.
Economics: Monetary and Fiscal Economics 179 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.
180 Study Session 06: 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. Correct Answer:
A .......................................................................................... LOS: Reading 27‐c
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. Reference: CFA® Program Curriculum, Volume 2, pp. 445‐447. 20. The slope of the long‐run Phillips curve shows that: A. B. C. D.
unemployment and inflation are inversely related. unemployment and expected inflation are inversely related. at the natural unemployment rate any anticipated inflation rate is possible. an increase in aggregate demand lowers unemployment and increases inflation.
Correct Answer:
C ..........................................................................................LOS: Reading 26‐e
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. Reference: CFA® Program Curriculum, Volume 2, pp. 416‐417.
Economics: Monetary and Fiscal Economics 181 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%
182 Study Session 06: 21. Which of the following is the most accurate description of what generational accounting measures? A. B. C. D.
life expectancy and pension costs of each generation. the tax burden and benefits taken by each generation. the division of the fiscal imbalance between the different generations. present value of a government’s obligation to pay benefits and the present value of its tax revenues.
Correct Answer:
B........................................................................................... LOS: Reading 27‐c
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. Reference: CFA® Program Curriculum, Volume 2, pp. 445‐447.
Economics: Monetary and Fiscal Economics 183 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
Inflation rate =
Price level this year - Price level last year × 100 Price level last year
Inflation rate 2006 =
113 110 × 100 = 2.7% 110
Inflation rate 2007 =
117 113 × 100 = 3.5% 113
The compound annual rate is
(1.027)(1.035) 1 = 3.1%
Reference: CFA® Program Curriculum, Volume 2, pp. 400‐401.
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.
Introductory Readings 185
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.
186 Study Session 7 Introduction
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.
Introductory Readings 187
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.
188 Study Session 7 Introduction
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 = 250 × $5.28 less January 31st inventory = $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 ) COGS
= $1,285.00 = $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
Introductory Readings 189 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
Category 1 Item a Item b Category 2 Item c Item d
Quantity
Cost per Unit
Market Value per Unit
100 $4.00 $4.50 100 $5.00 $3.50 100 $2.00 $1.00 100 $6.00 $5.00 Inventory at the lower of cost or market
Lower of Cost or Market $400.00 $350.00 $100.00 $500.00 $1,350.00
Major Category Method Category 1 Item a Item b Total Category 2 Item c Item d Total
Quantity 100 100
Total Cost $400.00 $500.00 $900.00
Total Market Value
$450.00 $350.00 $800.00 100 $200.00 $100.00 100 $600.00 $500.00 $800.00 $600.00 Inventory at the lower of cost or market
Lower of Cost or Market
$800.00
$600.00 $1,400.00
190 Study Session 7 Introduction
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.
Introductory Readings 191
(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. 2. 3.
Preferred Stock – par value, amount authorized and amount issued and outstanding. Common Stock – par value, amount authorized and amount issued and outstanding. Paid‐in Capital in excess of par value.
Accounting for dividends There are three dates to consider: 1. 2. 3.
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. 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. 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.
192 Study Session 7 Introduction
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.
Introductory Readings 193
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.
194 Study Session 7 Introduction 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.
Introductory Readings 195
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.
196 Study Session 7 Introduction 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.
Economics: Monetary and Fiscal Economics 197
198 Study Session 07:
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.
200 Study Session 07: 1. When a firm records an allowance for uncollectible receivables as a deduction against the receivables account this is: A. B. C. D.
a contra account. an adjunct account. a non-recurring item. an extraordinary item.
Correct Answer:
A ......................................................................................... LOS: Reading 30‐b
An account which reduces the value of an asset, to a new estimate of its net realizable value, is a contra account. Reference: CFA® Program Curriculum, Volume 3, pp. 38‐39. 2. A general journal records all: A. B. C. D.
business transactions by account. business transactions in date order. account balances, usually prepared on a daily basis. 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. Reference: CFA® Program Curriculum, Volume 3, pp. 68‐69.
Financial Statement Analysis: Introduction 201 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.
202 Study Session 07: 3. Income that is independent of a firm’s capital structure is: A. B. C. D.
net income. pre-tax income. operating income. comprehensive income.
Correct Answer:
C ......................................................................................... LOS: Reading 29‐b
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. Reference: CFA® Program Curriculum, Volume 3, p. 13. 4. Which of the following is least likely to be important to an analyst when using financial reports? A. B. C. D.
Detail. Relevance. Materiality. Consistency.
Correct Answer:
A ..........................................................................................LOS: Reading 31‐e
If the financial reports are to be relevant and timely it is not practical for them to include every detail of the financial data. Reference: CFA® Program Curriculum, Volume 3, pp. 109‐110.
Financial Statement Analysis: Introduction 203 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
204 Study Session 07: 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. B. C. D.
decrease by $35,000. decrease by $50,000. increase by $15,000. increase by $50,000.
Correct Answer:
C ......................................................................................... LOS: Reading 30‐d
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? A. B. C. D.
Retailer investing activity operating activity operating activity operating activity
Correct Answer:
Bank investing activity investing activity financing activity operating activity
B...........................................................................................LOS: Reading 30‐a
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. Reference: CFA® Program Curriculum, Volume 3, pp. 36‐37.
Financial Statement Analysis: Introduction 205 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
206 Study Session 07: 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’. Reference: CFA® Program Curriculum, Volume 3, pp. 127‐128. 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? A. B. C. D.
Receives dividend Investing Investing Financing Financing
Correct Answer:
Pays dividend Investing Financing Investing Financing
B...........................................................................................LOS: Reading 30‐a
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. Reference: CFA® Program Curriculum, Volume 3, pp. 36‐37.
Financial Statement Analysis: Introduction 207 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
208 Study Session 07: 9. Under U.S. GAAP minority interest appears in the: A. B. C. D.
balance sheet as an asset. balance sheet as a liability. income statement as a revenue. income statement as an expense.
Correct Answer:
B.......................................................................................... LOS: Reading 30‐b
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. Reference: CFA® Program Curriculum, Volume 3, pp. 38‐40. 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? A. B. C. D.
Receives interest Financing Financing Investing Operating
Correct Answer:
Pays interest Operating Financing Financing Operating
D ..........................................................................................LOS: Reading 30‐a
A bank’s business is taking deposits and making loans so these are both operating activities. Reference: CFA® Program Curriculum, Volume 3, pp. 36‐37.
Financial Statement Analysis: Introduction 209 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.
210 Study Session 07: 11. Owners’ equity is least likely to be referred to as: A. B. C. D.
net book value. a residual claim. total assets less total liabilities. contributed capital less retained earnings.
Correct Answer:
D .......................................................................................... LOS: Reading 30‐c
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. Reference: CFA® Program Curriculum, Volume 3, pp. 40‐43. 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. Correct Answer:
A ......................................................................................... LOS: Reading 31‐b
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. Reference: CFA® Program Curriculum, Volume 3, p. 101.
Financial Statement Analysis: Introduction 211 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.
212 Study Session 07: 13. Information about directors’ compensation is most likely to be included in a firm’s A. B. C. D.
auditor’s report. proxy statement. income statement. Management’s Discussion and Analysis.
Correct Answer:
B...........................................................................................LOS: Reading 29‐e
Proxy statements relate to shareholder meetings. They provide information on board members and management, executive compensation, stock options and major stockholders. Reference: CFA® Program Curriculum, Volume 3, p. 25. 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. Correct Answer:
C ......................................................................................... LOS: Reading 31‐d
Companies can use different combinations of historical cost, current cost, realizable value, present vale and fair value, so C is the best answer. Reference: CFA® Program Curriculum, Volume 3, p. 113.
Financial Statement Analysis: Introduction 213 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
A.
Financing
Operating
B.
Operating
Financing
C.
Investing
Financing
D.
Operating
Operating
214 Study Session 07: 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. Correct Answer:
D ......................................................................................... LOS: Reading 31‐b
The objective is to harmonize U.S. GAAP and IFRS, not to replace one with the other. Reference: CFA® Program Curriculum, Volume 3, pp. 118‐119. 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? A. B. C. D.
Depreciation Financing Operating Investing Operating
Correct Answer:
Income tax Operating Financing Financing Operating D ..........................................................................................LOS: Reading 30‐a
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. Reference: CFA® Program Curriculum, Volume 3, pp. 36‐37.
Financial Statement Analysis: Introduction 215 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.
216 Study Session 07: 17. The Statement of Changes in Owners‘ Equity would be least likely to include information on: A. B. C. D.
net assets. net income. issue of new shares. dividends distributed.
Correct Answer:
A ......................................................................................... LOS: Reading 29‐b
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. Reference: CFA® Program Curriculum, Volume 3, p. 19. 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. Correct Answer:
D ..........................................................................................LOS: Reading 30‐e
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. Reference: CFA® Program Curriculum, Volume 3, pp. 65‐67.
Financial Statement Analysis: Introduction 217 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
218 Study Session 07: 19. Which of the following is least likely to be a constraint in preparing useful financial statements? A. B. C. D.
The time taken to ensure information is accurate. The cost of providing information that is accurate and useful. Many nonquantifiable items are not included in the financial statements. The requirement to include information regardless of whether it is relevant or not.
Correct Answer:
D ......................................................................................... LOS: Reading 31‐d
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. Reference: CFA® Program Curriculum, Volume 3, pp. 110‐111. 20. Historically the approaches of the International Financial Reporting Standards (IFRS) and the Financial Accounting Standards Board (FASB) have been best described as: A. B. C. D.
IFRS Rules-based Rules-based Principles-based Principles-based
Correct Answer:
FASB Rules-based Principles-based Rules-based Principles-based
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. Reference: CFA® Program Curriculum, Volume 3, pp. 122‐123.
Financial Statement Analysis: Introduction 219 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.
220 Study Session 07: 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. Correct Answer:
B........................................................................................... LOS: Reading 30‐c
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. Reference: CFA® Program Curriculum, Volume 3, pp. 40‐46.
Financial Statement Analysis: Introduction 221 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 Reference: CFA® Program Curriculum, Volume 3, pp. 40‐46.
222 Study Session 08:
Study Session 08: Financial Statement Analysis: 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.
224 Study Session 08: 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 No effect Overstated Understated Understated
A. B. C. D.
Correct Answer:
Financing cash flow Understated. No effect. No effect.. Overstated.
B...........................................................................................LOS: Reading 34‐e
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. Reference CFA® Program Curriculum, Volume 3, pp. 279-283. 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. B. C. D.
the firm prefers to hold marketable securities rather than cash. the firm has higher inventory levels compared with the rest of the industry. the firm has a large number of ‘other short-term assets’ in the balance sheet. 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. Reference: CFA® Program Curriculum, Volume 3, pp. 239‐240.
Financial Statement Analysis: Income Statement, Balance Sheet, & Cash Flow 225 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.
226 Study Session 08: 3. Which of the following ratios are correctly described as liquidity and solvency ratios? Liquidity cash current debt to equity financial leverage
A. B. C. D.
Correct Answer:
Solvency current debt to equity financial leverage quick ratio
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. Reference: CFA® Program Curriculum, Volume 3, pp. 239‐240. 4. Under U.S. GAAP which of the following is the least accurate statement concerning extraordinary items? An extraordinary item: A. B. C. D.
is reported net of tax. is not part of operating income. is included in comprehensive income. must be both unusual and infrequent.
Correct Answer:
C ..........................................................................................LOS: Reading 32‐g
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. Reference: CFA® Program Curriculum, Volume 3, p. 168.
Financial Statement Analysis: Income Statement, Balance Sheet, & Cash Flow 227 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.
228 Study Session 08: 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. B. C. D.
increase investing cash flows. increase operating cash flows. decrease operating cash flows. have no impact on operating cash flows.
Correct Answer:
B...........................................................................................LOS: Reading 34‐a
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. Reference: CFA® Program Curriculum, Volume 3, pp. 265‐273. 6. Which inventory accounting method usually gives a valuation of inventory that is closest to its economic value? A. B. C. D.
FIFO. LIFO. Lower of cost or market. Weighted average cost method.
Correct Answer:
A ......................................................................................... LOS: Reading 32‐d
Since FIFO leaves the most recently purchased goods in inventory the valuation will usually be the closest to current values. Reference: CFA® Program Curriculum, Volume 3, pp. 157‐161.
Financial Statement Analysis: Income Statement, Balance Sheet, & Cash Flow 229 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.
230 Study Session 08: 7. Using common‐size statement analysis of the balance sheet of a company will help identify changes in: A. B. C. D.
total assets. profitability. financial leverage. 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%. Reference: CFA® Program Curriculum, Volume 3, pp. 239‐240. 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. B. C. D.
accrual accounting. the matching principle. contingency accounting. the cost recovery method.
Correct Answer:
B........................................................................................... LOS: Reading 32‐c
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. Reference: CFA® Program Curriculum, Volume 3, p. 162.
Financial Statement Analysis: Income Statement, Balance Sheet, & Cash Flow 231 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.
232 Study Session 08: 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 $0 $750,000 $750,000 $1,000,000
A. B. C. D.
Correct Answer:
Cost recovery method $0 $0 $750,000 $750,000
B.......................................................................................... LOS: Reading 32‐b
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. Reference: CFA® Program Curriculum, Volume 3, pp. 152‐154. 10. The Comprehensive Income Statement contains: A. B. C. D.
details of income from subsidiaries. information on changes in stockholders’ equity. details on income from joint ventures and associates. 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. Reference: CFA® Program Curriculum, Volume 3, pp. 185‐186.
Financial Statement Analysis: Income Statement, Balance Sheet, & Cash Flow 233 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).
234 Study Session 08: 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. B. C. D.
$0. $200,000. $600,000. $1,800,000.
Correct Answer:
C ......................................................................................... LOS: Reading 32‐b
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 Reference: CFA® Program Curriculum, Volume 3, pp. 148‐152. 12. I.W.S. Inc.’s cash flow from investing was (ref. Question 41): A. B. C. D.
($19 million). ($12 million). ($9 million). ($6 million).
Correct Answer:
C ..........................................................................................LOS: Reading 34‐a
Cash flow from investing activities
Cash flow from investing activities Purchase of land Sale of equipment
(15) 6 (9)
Reference: CFA® Program Curriculum, Volume 3, pp. 271‐273.
Financial Statement Analysis: Income Statement, Balance Sheet, & Cash Flow 235 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.
236 Study Session 08: 13. I.W.S. Inc.’s cash flow from financing was (ref. Question 41): A. B. C. D.
($35 million). ($23 million). ($20 million). ($12 million).
Correct Answer:
C ..........................................................................................LOS: Reading 34‐a
Cash flow from financing activities
Cash flow from financing Retirement of common stock Dividend payment
(12) (8) (20)
Reference: CFA® Program Curriculum, Volume 3, pp. 273‐275. 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. B. C. D.
adjust the reported income in the previous year’s accounts. increase the income received in the current year’s accounts. adjust the retained earnings in the previous year’s balance sheet. recognize the $10,000 as an extraordinary profit in the current year.
Correct Answer:
B...........................................................................................LOS: Reading 32‐g
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. Reference: CFA® Program Curriculum, Volume 3, pp. 169‐170.
Financial Statement Analysis: Income Statement, Balance Sheet, & Cash Flow 237 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.
238 Study Session 08: 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. B. C. D.
extending the payment period for customers. raising cash through the issue of long term bonds. selling land that was not being used for a substantial sum of money. using inventory to meet their customers’ orders and minimizing raw material purchases.
Correct Answer:
D ..........................................................................................LOS: Reading 34‐e
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. Reference: CFA® Program Curriculum, Volume 3, pp. 279‐281. 16. The costs of long‐lived assets are usually allocated: A. B. C. D.
over 5 years. at the time of disposal. over a period that is chosen by the firm. when the impairment of the assets takes place.
Correct Answer:
C ......................................................................................... LOS: Reading 32‐d
Usually the management has discretion over the period, or useful life, that assets are depreciated. Reference: CFA® Program Curriculum, Volume 3, pp. 162‐167.
Financial Statement Analysis: Income Statement, Balance Sheet, & Cash Flow 239 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.
240 Study Session 08: 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 nonoperating items included in net income and then adjust for changes in the balance of operating asset and liability accounts. Correct Answer:
D ......................................................................................... LOS: Reading 34‐d
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. Reference CFA® Program Curriculum, Volume 3, pp. 265-271. 18. Which of the following is least likely to be included in the Statement of Stockholders’ Equity? A. B. C. D.
Capital leases. Retained earnings. Cumulative foreign exchange adjustments. 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. Reference: CFA® Program Curriculum, Volume 3, pp. 226‐230.
Financial Statement Analysis: Income Statement, Balance Sheet, & Cash Flow 241 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).
242 Study Session 08: 19. The cash flow from investments in 2007 for North Company is (ref. question 28): A. B. C. D.
($85,000). ($70,000). $30,000. $130,000.
Correct Answer:
C ..........................................................................................LOS: Reading 34‐a
Investing cash flows Sale of old machine
30
Net from investment
30
Reference: CFA® Program Curriculum, Volume 3, pp. 271‐273. 20. The cash flow from financing in 2007 for North Company is (ref. question 28): A. B. C. D.
($170,000). ($115,000). ($100,000). ($15,000).
Correct Answer:
B...........................................................................................LOS: Reading 34‐a
Financing cash flows: Bank notes Dividends paid
Net from financing
(100) (15) (115)
Reference: CFA® Program Curriculum, Volume 3, pp. 273‐275.
Financial Statement Analysis: Income Statement, Balance Sheet, & Cash Flow 243 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.
244 Study Session 08: 21. W.S. Inc uses U.S. GAAP and supplied the following financial data: $ million Cash payment for salaries Purchase of land Cash payment for interest Retirement of common stock Cash collection from customers Cash payment to suppliers Depreciation expense Dividend payment Sale of equipment
23 15 3 12 115 43 10 8 6
Cash flow from operating activities was: A. $36 million. B. $39 million. C. $46 million. D. $49 million. Correct Answer:
C ..........................................................................................LOS: Reading 34‐a
Cash flow from operating activities
$ million 115 (43) (23) (3) 46
Cash collection from customers Cash payment to suppliers Cash payment for salaries Cash payment for interest
Reference: CFA® Program Curriculum, Volume 3, pp. 265‐271.
Financial Statement Analysis: Income Statement, Balance Sheet, & Cash Flow 245 22. North Company uses U.S. GAAP and provides the following financial statements:
2007 Income statement (in $’000) Sales COGS Depreciation Interest expense Gain on sale of old machinery Income before taxes Income tax expense Net income after taxes
5,400 (4,600) (200) (55) 30 575 (175) 400
Balance sheet (in $’000) Assets: Cash Accounts receivable Inventory Property, plant & Total assets Liabilities: Accounts payable Bank notes Deferred taxes Common stock Retained Earnings Total liabilities Total dividends of $15,000 were paid.
end
beg
895 260 500 300 1,955
100 200 800 500 1,600
370 0 90 1,000 495 1,955
350 100 40 1,000 110 1,600
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.
246 Study Session 08: 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 Interest expense
(200) (55)
Gain on sale of old
30
Income before taxes
575
Income tax expense
(175)
Net income after taxes
400
Balance sheet (in $’000) end 2007
beg 2007
Assets: Cash
895
100
Accounts receivable
260
200
Inventory
500
800
Property, plant &
300
500
1,955
1,600
Total assets
Liabilities:
Accounts payable
Bank notes
370
350
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. B. C. D.
$580,000. $830,000. $880,000. $910,000.
Correct Answer:
C ..........................................................................................LOS: Reading 34‐a
Financial Statement Analysis: Income Statement, Balance Sheet, & Cash Flow 247 Cash flow from operations: Net income Adjust for Depreciation Gain on sale of machinery Deferred taxes Change in accounts receivable Decrease in inventory Change in accounts payable Net from operations
400 200 (30) 50 (60) 300 20 880
Reference: CFA® Program Curriculum, Volume 3, pp. 265‐271.
248 Study Session 09:
Study Session 09: Financial Statement Analysis: Inventories, Long-Term Assets, Deferred Taxes, and Onand 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.
250 Study Session 09: 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 A. LIFO B. FIFO C. LIFO D. FIFO Correct Answer:
Overstated/understated overstated overstated understated understated C .......................................................................................... LOS: Reading 35‐c
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. Reference: CFA® Program Curriculum, Volume 3, pp. 308‐315. 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. Correct Answer:
average age =
A ......................................................................................... LOS: Reading 37‐d
accumul. depreciati on 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. Reference: CFA® Program Curriculum, Volume 3, pp. 402‐404.
Financial Statement Inventories, Assets, Taxes & Debt 251 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.
252 Study Session 09: 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. Correct Answer:
B...........................................................................................LOS: Reading 39‐e
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. Reference: CFA® Program Curriculum, Volume 3, p. 500. 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. Correct Answer:
A ......................................................................................... LOS: Reading 40‐b
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. Reference: CFA® Program Curriculum, Volume 3, pp. 521‐524.
Financial Statement Inventories, Assets, Taxes & Debt 253 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.
254 Study Session 09: 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. Correct Answer:
D ..........................................................................................LOS: Reading 37‐e
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. Reference: CFA® Program Curriculum, Volume 3, pp. 408‐411. 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. B. C. D.
revise the value of the asset and record the gain as ‘other income’. revise the value of the asset and record the gain as an unusual item. revise the value of the asset and record the gain as an extraordinary income. not do anything, an increase in the value of assets cannot be recognized until they are sold.
Correct Answer:
D ......................................................................................... LOS: Reading 37‐d
Under U.S. GAAP an increase in the value of an asset cannot be recognized until sale and also previous impairments cannot be restored. Reference: CFA® Program Curriculum, Volume 3, pp. 402‐406.
Financial Statement Inventories, Assets, Taxes & Debt 255 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.
256 Study Session 09: 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. Correct Answer:
B.......................................................................................... LOS: Reading 36‐b
All the costs of purchase should be capitalized. Reference: CFA® Program Curriculum, Volume 3, p. 360. 8. If a company decided to change the estimated life of an asset that is already owned by the company it must: A. B. C. D.
restate prior years’ accounts. not make any retroactive adjustment. disclose it as a change in accounting principle. calculate the cumulative effect of the change and report net of taxes.
Correct Answer:
B.......................................................................................... LOS: Reading 37‐b
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. Reference: CFA® Program Curriculum, Volume 3, pp. 394‐397.
Financial Statement Inventories, Assets, Taxes & Debt 257 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.
258 Study Session 09: 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. B. C. D.
$15 million. $25 million. $75 million. $85 million.
Correct Answer:
A ......................................................................................... LOS: Reading 35‐b
COGS under FIFO = COGS under LIFO – increase in LIFO reserve. COGS under FIFO = $20 million - $5 million = $15 million Reference: CFA® Program Curriculum, Volume 3, pp. 312‐315. 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. B. C. D.
a restatement of prior years’ accounts. a reduction in the value of deferred tax assets. an increase in the value of deferred tax liabilities. an extraordinary gain which is stated net of tax on the income statement.
Correct Answer:
B...........................................................................................LOS: Reading 38‐g
The lower tax rate reduces the value of the tax benefit when the deferred tax asset is realized. Reference: CFA® Program Curriculum, Volume 3, pp. 427‐432.
Financial Statement Inventories, Assets, Taxes & Debt 259 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.
260 Study Session 09: 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. B. C. D.
$2,500. $5,000. $5,500. $30,000.
Correct Answer:
A ..........................................................................................LOS: Reading 39‐a
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. Reference: CFA® Program Curriculum, Volume 3, pp. 466‐471. 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. B. C. D.
$44,582. $46,296. $50,000. $58,000.
Correct Answer:
B.......................................................................................... LOS: Reading 40‐b
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. Reference: CFA® Program Curriculum, Volume 3, pp. 521‐523.
Financial Statement Inventories, Assets, Taxes & Debt 261 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.
D.
an extraordinary item.
262 Study Session 09: 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. Correct Answer:
A .......................................................................................... LOS: Reading 40‐c
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. Reference: CFA® Program Curriculum, Volume 3, pp. 532‐533. 14. If a deferred tax liability is very unlikely to be paid then it should be treated as: A. B. C. D.
a long-term liability. stockholders’ equity. a short-term liability. an extraordinary item.
Correct Answer:
B.......................................................................................... LOS: Reading 38‐d
If the factors that created the deferred tax liability are unlikely to be reversed, than it is considered part of stockholders’ equity. Reference: CFA® Program Curriculum, Volume 3, pp. 439‐440.
Financial Statement Inventories, Assets, Taxes & Debt 263 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.
264 Study Session 09: 15. In a direct financing lease the sale value reported at the beginning of the lease on the lessor’s financial statements is: A. B. C. D.
the sum of the lease payments. the present value of lease payments. zero, there is no sale value reported. the present value of lease payments plus the present value of the residual value.
Correct Answer:
C ......................................................................................... LOS: Reading 40‐d
With a direct financing lease only financing or interest income is reported. There is no ‘manufacturing’ profit and no sale is recorded. Reference: CFA® Program Curriculum, Volume 3, pp. 550‐551. 16. If a company actively uses operating leases, which of the following statements is least accurate? A. B. C. D.
Total cash flow is understated. Off-balance-sheet financing is significant. Minimum lease payments for the next five years must be disclosed in the company’s accounts. Return on assets should be adjusted downwards to give a clearer view of the company’s efficiency.
Correct Answer:
A ......................................................................................... LOS: Reading 40‐b
Total cash flow is not understated but cash flow from operations is lower than if the lease were capitalized. Reference: CFA® Program Curriculum, Volume 3, pp. 541‐543.
Financial Statement Inventories, Assets, Taxes & Debt 265 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.
266 Study Session 09: 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. Correct Answer:
C ......................................................................................... LOS: Reading 40‐d
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. Reference: CFA® Program Curriculum, Volume 3, pp. 547‐550. 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. Correct Answer:
A .......................................................................................... LOS: Reading 39‐f
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. Reference: CFA® Program Curriculum, Volume 3, pp. 489‐493.
Financial Statement Inventories, Assets, Taxes & Debt 267 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.
268 Study Session 09: 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 lower lower higher higher
A. B. C. D.
Correct Answer:
Return on assets lower higher lower higher D ......................................................................................... LOS: Reading 40‐b
Interest cover will be higher as interest payments will be lower. Return on assets will be higher since assets will be lower. Reference: CFA® Program Curriculum, Volume 3, pp. 521‐524. 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. Correct Answer:
D ..........................................................................................LOS: Reading 37‐a
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. Reference: CFA® Program Curriculum, Volume 3, pp. 425‐452.
Financial Statement Inventories, Assets, Taxes & Debt 269 21. The following financial data is provided by Sportswear Corporation:
$ million (using LIFO) 2006
2007
105
125
300
350
45
55
110
160
1450
1700
Inventory
Current assets LIFO reserve
Current liabilities COGS
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
270 Study Session 09: 21. The following financial data is provided by Sportswear Corporation:
$ million (using LIFO) 2006
2007
105
125
300
350
45
55
110
160
1450
1700
Inventory
Current assets LIFO reserve
Current liabilities COGS
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 Correct Answer:
D ......................................................................................... LOS: Reading 35‐d
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. Reference: CFA® Program Curriculum, Volume 3, pp. 312‐315.
Financial Statement Inventories, Assets, Taxes & Debt 271 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.
272 Study Session 09: 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. B. C. D.
$600. $1,200. $10,800. $11,400.
Correct Answer:
A .......................................................................................... LOS: Reading 38‐f
Tax reporting – straight-line depreciation over two
Revenue Depreciation Taxable income Taxes payable
Year 2 $40,000 $4,000 $36,000 $10,800
Year 1 $40,000 $4,000 $36,000 $10,800
Financial statement reporting – straight-line Revenue Depreciation Pre‐tax income Tax expense of which: Taxes payable Deferred tax
Reference: CFA® Program Curriculum, Volume 3, pp. 425‐470.
Year 1 $40,000 $2,000 $38,000 $11,400 $10,800 $600
Year 2 $40,000 $2,000 $38,000 $11,400 $10,800 $600
Financial Statement Inventories, Assets, Taxes & Debt 273
274 Study Session 10:
Study Session 10: Financial Statement Analysis: 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.
276 Study Session 10: 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. Correct Answer:
A ......................................................................................... LOS: Reading 41‐d
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. Reference: CFA® Program Curriculum, Volume 3, pp. 593‐597. 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. B. C. D.
EBITDA is more sensitive to the gearing of the company. EBITDA is a more volatile number than earning per share. EBITDA does not take into account the cost of using fixed assets. EBITDA gives a better indication of profits available to equity shareholders.
Correct Answer:
C ..........................................................................................LOS: Reading 41‐g
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. Reference: CFA® Program Curriculum, Volume 3, pp. 610‐613.
Financial Statement Techniques, Applications, and International Standards Convergence 277 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.
278 Study Session 10: 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 scenario scenario sensitivity sensitivity
A. B. C. D.
Correct Answer:
Retailer scenario sensitivity scenario sensitivity 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. Reference: CFA® Program Curriculum, Volume 3, pp. 622‐623. 4. Under International Financial Reporting Standards (IFRS) impairment of goodwill: A. B. C. D.
is not permitted, amortization is still used. it charged as a valuation allowance against the acquired assets. leads to a reduction in net income in the period when the impairment is recognized. is charged directly to stockholders’ equity and does not impact on the income statement.
Correct Answer:
C ......................................................................................... LOS: Reading 43‐b
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. Reference: CFA® Program Curriculum, Volume 3, pp. 685‐689.
Financial Statement Techniques, Applications, and International Standards Convergence 279 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.
280 Study Session 10: 5. National Telecoms Corporation’s interest coverage is closest to (ref. financial data in question 34): A. B. C. D.
1.11. 2.11. 2.67. 6.00.
Correct Answer:
C ......................................................................................... LOS: Reading 41‐d
Interest coverage = EBIT interest expense
= 120 = 2.67 45
Reference: CFA® Program Curriculum, Volume 3, pp. 593‐597. 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. Correct Answer:
D ......................................................................................... LOS: Reading 41‐d
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. Reference: CFA® Program Curriculum, Volume 3, pp. 597‐601.
Financial Statement Techniques, Applications, and International Standards Convergence 281 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.
282 Study Session 10: 7. A company has a low fixed asset base relative to its sector average. It is generally the case that: A. B. C. D.
its sales variability is higher than that of other companies in the sector. the company’s financial risk is lower than that of other companies in the sector. operating profits will be relatively volatile compared to other companies in the sector. investors will tolerate a higher debt-to-equity relative to other companies in the sector.
Correct Answer:
D ......................................................................................... LOS: Reading 41‐d
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. Reference: CFA® Program Curriculum, Volume 3, pp. 593‐594. 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. Correct Answer:
B.......................................................................................... LOS: Reading 41‐d
The total capital will have been reduced by the repayment of debt, thereby increasing the return on total capital. Reference: CFA® Program Curriculum, Volume 3, pp. 597‐601.
Financial Statement Techniques, Applications, and International Standards Convergence 283 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%
1.5
1.7
Total asset turnover The numbers could be explained by:
Financial leverage
Net profit margin
A.
increased
increased
B.
increased
decreased
C.
decreased
increased
D.
decreased
decreased
284 Study Session 10: 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. B. C. D.
a lower tax rate. higher financial leverage. lower interest costs as a percentage of sales. lower interest costs as a percentage of operating profit.
Correct Answer:
B.......................................................................................... LOS: Reading 41‐d
Return on equity = net profit margin x total asset turnover x financial leverage Reference: CFA® Program Curriculum, Volume 3, pp. 597‐601. 10. A company provides the following information:
2006
2007
Return on equity
8.9%
9.4%
Return on total assets
4.5%
4.2%
1.5
1.7
Total asset turnover The numbers could be explained by: A. B. C. D.
Financial leverage increased increased decreased decreased
Correct Answer:
Net profit margin increased decreased increased decreased
B........................................................................................... LOS: Reading 41‐f
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. Reference: CFA® Program Curriculum, Volume 3, pp. 84‐89.
Financial Statement Techniques, Applications, and International Standards Convergence 285 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.
286 Study Session 10: 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. Correct Answer:
A ......................................................................................... LOS: Reading 41‐b
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. Reference: CFA® Program Curriculum, Volume 3, pp. 572‐573. 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. Correct Answer:
B........................................................................................... LOS: Reading 42‐c
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
Financial Statement Techniques, Applications, and International Standards Convergence 287 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.
288 Study Session 10: 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 completed contract completed contract percentage of completion percentage of completion
A. B. C. D.
IFRS percentage of completion revenue if contract costs can be recovered completed contract revenue if contract costs can be recovered
Correct Answer:
B.......................................................................................... LOS: Reading 43‐b
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. Reference: CFA® Program Curriculum, Volume 3, p. 684. 14. A firm has a higher return on equity to its competitors; this is least likely to be explained by: A. B. C. D.
a lower tax burden. higher asset turnover. a lower interest burden. lower financial leverage.
Correct Answer:
D .......................................................................................... LOS: Reading 41‐f
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. Reference: CFA® Program Curriculum, Volume 3, pp. 604‐609.
Financial Statement Techniques, Applications, and International Standards Convergence 289 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
A.
increase
increase
B.
increase
decrease
C.
decrease
increase
D.
decrease
decrease
290 Study Session 10: 15. Under International Financial Reporting Standards (IFRS) unrealized gains on which type of marketable securities are recorded in the income statement? A. B. C. D.
held-for-trading securities only. available-for-sale securities only. held-for-trading securities and available-for sale securities only. held-for-trading securities, available-for sale securities and held-to-maturity securities.
Correct Answer:
A ..........................................................................................LOS: Reading 43‐a
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. Reference: CFA® Program Curriculum, Volume 3, pp. 681‐683. 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: A. B. C. D.
Inventory turnover increase increase decrease decrease
Correct Answer:
Receivables turnover increase decrease increase decrease
A ......................................................................................... LOS: Reading 41‐d
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. Reference: CFA® Program Curriculum, Volume 3, pp. 586‐589.
Financial Statement Techniques, Applications, and International Standards Convergence 291 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)
Cash and cash equivalents
Current liabilities
($ ‘000)
40 Short term debt
25
Receivables
650 Accounts payable
420
Inventories
350 Taxes payable
120
Other current assets
Total
70 Other current liabilities
1,110 Total
The quick ratio is closest to:
A.
0.07.
B.
1.13.
C.
1.55.
D.
1.82.
45
610
292 Study Session 10: 17. Which of the following actions would be least likely to improve a firm’s working capital turnover? A. B. C. D.
Reducing inventory levels. Tightening credit terms given to customers. Reducing the fixed assets used in the business. Maintaining working capital at current levels whilst achieving steady revenue growth.
Correct Answer:
C ......................................................................................... LOS: Reading 41‐d
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. Reference: CFA® Program Curriculum, Volume 3, pp. 583‐589. 18. South Inc.’s breakdown of current assets and liabilities is as follows:
Current assets Cash and cash equivalents Receivables Inventories Other current assets
Total A. B. C. D.
($ ‘000)
Current liabilities
($ ‘000)
40 650 350 70
Short term debt Accounts payable Taxes payable Other current liabilities
25 420 120 45
1,110 Total
610
The quick ratio is closest to: 0.07. 1.13. 1.55. 1.82.
Correct Answer:
B.......................................................................................... LOS: Reading 41‐d
Quick ratio = cash + market securities + receivables current liabilities = 690 = 1.13 610 Reference: CFA® Program Curriculum, Volume 3, pp. 590‐593.
Financial Statement Techniques, Applications, and International Standards Convergence 293 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.
294 Study Session 10: 19. Which of the following ratios is least likely to be used to measure profitability? A. B. C. D.
Return on assets. Total asset turnover. Operating profit margin. Return on common equity.
Correct Answer:
B.......................................................................................... LOS: Reading 41‐d
Total asset turnover is a measure of activity rather than profitability. Reference: CFA® Program Curriculum, Volume 3, pp. 597‐598. 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. Correct Answer:
A ......................................................................................... LOS: Reading 41‐d
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-intime manufacturing system means that computers are manufactured in response to customer demand which will reduce inventory levels, so A is correct. Reference: CFA® Program Curriculum, Volume 3, pp. 583‐589.
Financial Statement Techniques, Applications, and International Standards Convergence 295 21. ABC Corporation provides you with the following information:
Income statement $ million
Balance sheet Average over period $ million
Sales
150 Cash
90 Accounts payable
30
COGS
(75) Accounts receivable
10 Short‐term bank notes
25
70 Long‐term debt
60
Gross profit SGA expenses
75 Inventory (20) Property, P & E
150
55 Depreciation
Op. profit
(70) Common stock
Interest expense (15) Investment
30 Retained earnings
(10)
Tax
Net income
30 Total assets
280 Total liabilities & equity
Inventory turnover is closest to: 0.47.
B.
0.93.
C.
1.07.
D.
2.14.
115
A.
50
280
296 Study Session 10: 21. ABC Corporation provides you with the following information:
Income statement $ million
Balance sheet Average over period $ million
Sales
150 Cash
90 Accounts payable
30
COGS
(75) Accounts receivable
10 Short‐term bank notes
25
70 Long‐term debt
60
75 Inventory
Gross profit
(20) Property, P & E
SGA expenses
150
55 Depreciation
Op. profit
(70) Common stock
Interest expense (15) Investment
30 Retained earnings
(10)
Tax
Net income
30 Total assets
280 Total liabilities & equity
C ......................................................................................... LOS: Reading 41‐d
Inventory turnover =
115
Inventory turnover is closest to: A. 0.47. B. 0.93. C. 1.07. D. 2.14. Correct Answer:
50
COGS 75 = = 1.07 averageinventory 70
Reference: CFA® Program Curriculum, Volume 3, pp. 583‐586.
280
Financial Statement Techniques, Applications, and International Standards Convergence 297 22. National Telecoms Corporation provides the following information:
Income statement
Balance sheet
$ million
Average over period $ million
Sales
1,050 Cash
COGS
(780) Accounts
90 Accounts payable
270 Inventory*
Gross profit
170 Notes payable
125
200 Long‐term debt
300
SGA exp.
(150) Property, P&E
Op. profit
120 Depreciation
Interest exp.
(45)
Retained earnings
Tax
(25)
Net income
50
Total assets
650 (430) Common stock
680
Total liabilities & 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.
50
150 55 680
298 Study Session 10: 22. National Telecoms Corporation provides the following information:
Income statement
Balance sheet
$ million
Average over period $ million
Sales
1,050 Cash
COGS
(780) Accounts
90 Accounts payable
270 Inventory*
Gross profit
170 Notes payable
125
200 Long‐term debt
300
SGA exp.
(150) Property, P&E
Op. profit
120 Depreciation
Interest exp.
(45)
Retained earnings
Tax
(25)
Net income
50
Total assets
650 (430) Common stock
680
*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. Correct Answer:
50
Total liabilities & equity
150 55 680
B.......................................................................................... LOS: Reading 41‐d
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 Reference: CFA® Program Curriculum, Volume 3, pp. 583‐589.
Financial Statement Techniques, Applications, and International Standards Convergence 299
300 Study Session 11:
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.
302 Study Session 11: 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. B. C. D.
36.5%. 44.6%. 106.0%. 109.0%.
Correct Answer:
D ......................................................................................... LOS: Reading 46‐d
The cost of trade credit is calculated as the implicit rate of return which is represented by the trade discount offer.
0.02 1+ 1 - 0.02
Cost =
365 / 20
- 1 = 109%
Reference: CFA® Program Curriculum, Volume 4, pp. 120‐121. 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. B. C. D.
on the net day. on the day or purchase. on the last day of the discount period just after the discount period has ended.
Correct Answer:
C ......................................................................................... LOS: Reading 46‐d
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. Reference: CFA® Program Curriculum, Volume 4, pp. 120‐121.
Corporate Finance 303 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.
304 Study Session 11: 3. Which of the following is least likely to be a pull on liquidity for a company? A. B. C. D.
paying vendors early. low liquidity positions. uncollected receivables. limited short-term lines of credit.
Correct Answer:
C ..........................................................................................LOS: Reading 46‐a
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. Reference: CFA® Program Curriculum, Volume 4, pp. 88‐89. 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 1 2 3 A. B. C. D.
Project A 1.1 0.8 0.4
Project B 2.0 4.0 7.0
Both projects should be rejected. Both projects should be accepted. A should be accepted and B rejected. B should be accepted and A rejected.
Correct Answer:
A ......................................................................................... LOS: Reading 44‐d
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. Reference: CFA® Program Curriculum, Volume 4, pp. 12‐14.
Corporate Finance 305 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%.
306 Study Session 11: 5. To enable a board to act in the best long‐term interests of shareowners, it is least appropriate it possesses: A. B. C. D.
resources. independence. political affiliation. experience and expertise.
Correct Answer:
C ......................................................................................... LOS: Reading 48‐d
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. Reference: CFA® Program Curriculum, Volume 4, pp. 164‐168. 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. B. C. D.
5.33%. 7.46%. 7.55%. 7.67%.
Correct Answer:
D ......................................................................................... LOS: Reading 45‐h
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
ke =
D1 $1.685 +g= + 5.33% = 7.67% P $72
Reference: CFA® Program Curriculum, Volume 4, pp. 54‐55.
Corporate Finance 307 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.
308 Study Session 11: 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. B. C. D.
7.50% 7.85% 8.05%. 8.15%
Correct Answer:
D ..........................................................................................LOS: Reading 46‐g
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) Reference: CFA® Program Curriculum, Volume 4, pp. 126‐127. 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. Correct Answer:
D .......................................................................................... LOS: Reading 48‐c
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. Reference: CFA® Program Curriculum, Volume 4, pp. 165‐166.
Corporate Finance 309 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.
310 Study Session 11: 9
Which of the following ratios would be useful in evaluating a company’s internal liquidity? A. B. C. D.
Quick ratio. Equity turnover. Interest coverage. Debt to equity ratio.
Correct Answer:
A ..........................................................................................LOS: Reading 46‐a
Quick ratio = cash + marketable securities + receivables current liabilities The ratio measures the current assets that can be quickly liquidated to meet current liabilities. Reference: CFA® Program Curriculum, Volume 4, pp. 89‐91. 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. Correct Answer:
A ..........................................................................................LOS: Reading 44‐e
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. Reference: CFA® Program Curriculum, Volume 4, pp. 25‐28.
Corporate Finance 311 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.
312 Study Session 11: 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. B. C. D.
10.0%. 12.8%. 51.2%. there is insufficient information given to calculate the return on equity.
Correct Answer: return on equity
B...........................................................................................LOS: Reading 47‐a = net profit margin x sales turnover x financial leverage = net profit margin x equity turnover = 0.04 x 3.2 = 12.8%
Reference: CFA® Program Curriculum, Volume 4, pp. 136‐145. 12. In order to secure short‐term funding a company factors its accounts receivable. This means that: A. B. C. D.
receivables are being used as collateral for a loan. it pays over any receivables collected to the factor in return for short-term funding. sells the receivables to the factor who takes responsibility for collecting the receivables. it takes out protection from the factor against its customers defaulting on payment of money owed.
Correct Answer:
C ..........................................................................................LOS: Reading 46‐g
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. Reference: CFA® Program Curriculum, Volume 4, pp. 125‐126.
Corporate Finance 313 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.
314 Study Session 11: 13. In proforma analysis which of the following items is usually considered to be a fixed rather than a sales‐driven burden? A. B. C. D.
tax rate. depreciation. selling expenses. employees’ salaries.
Correct Answer:
A ......................................................................................... LOS: Reading 47‐b
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. Reference: CFA® Program Curriculum, Volume 4, pp. 149‐153. 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. Correct Answer:
D ..........................................................................................LOS: Reading 48‐g
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. Reference: CFA® Program Curriculum, Volume 43, pp. 183‐186.
Corporate Finance 315 15. Islington Corporation provides you with the following information:
Income Statement
Balance Sheet
$ million
Average over period $ million
Sales on credit
298
Cash
50
Accounts Payable
80
COGS
(200)
Accounts Receivable
60
Accrued Expenses
65
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.
316 Study Session 11: 15. Islington Corporation provides you with the following information:
Income Statement
Balance Sheet
$ million
Average over period $ million
Sales on credit
298
Cash
50
Accounts Payable
80
COGS
(200)
Accounts Receivable
60
Accrued Expenses
65
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. 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 Reference: CFA® Program Curriculum, Volume 4, pp. 89‐91.
Corporate Finance 317 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
318 Study Session 11: 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 Correct Answer:
D ..........................................................................................LOS: Reading 46‐a
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 Reference: CFA® Program Curriculum, Volume 4, pp. 87‐95.
Corporate Finance 319 17. Islington Corporation provides you with the following information:
Income Statement
Balance Sheet
$ million
Average over period $ million
Sales on credit
298
Cash
50
Accounts Payable
80
COGS
(200)
Accounts Receivable
60
Accrued Expenses
65
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 quick ratio is closest to: A.
0.34.
B.
0.63.
C.
0.76.
D.
1.45.
320 Study Session 11: 17. Islington Corporation provides you with the following information:
Income Statement
Balance Sheet
$ million
Average over period $ million
Sales on credit
298
Cash
50
Accounts Payable
80
COGS
(200)
Accounts Receivable
60
Accrued Expenses
65
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 quick ratio is closest to: A. 0.34. B. 0.63. C. 0.76. D. 1.45. Correct Answer:
C ..........................................................................................LOS: Reading 46‐a
Quick ratio = (cash + marketable securities + receivables)/current liabilities = (50 + 60)/145 = 0.76 Reference: CFA® Program Curriculum, Volume 4, pp. 89‐90.
Corporate Finance 321 18. National Telecoms Corporation provides the following information:
Income Statement 2007
Balance Sheet end 2007
$ million
Average over period
$ million
Credit Sales
1050
Cash
90 Accounts Payable
COGS
(780)
Accounts Receivable
170 Notes payable
125
Gross Profit
270
Inventory
200 Long term debt
300
SGA exp.
(150)
Property, P & E
650
Op. Profit
120
Depreciation
(430) Common Stock
Interest exp.
(45)
Retained Earnings
Tax
(25)
Net Income
50
Total Assets
680 Total Liabilities & 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.
50
150 55 680
322 Study Session 11: 18. National Telecoms Corporation provides the following information:
Income Statement 2007
Balance Sheet end 2007
$ million
Average over period
$ million
Credit Sales
1050
Cash
90 Accounts Payable
COGS
(780)
Accounts Receivable
170 Notes payable
125
Gross Profit
270
Inventory
200 Long term debt
300
SGA exp.
(150)
Property, P & E
650
Op. Profit
120
Depreciation
(430) Common Stock
Interest exp.
(45)
Retained Earnings
Tax
(25)
Net Income
50
Total Assets
680 Total Liabilities &
50
150 55 680
Equity Dividends Paid 12 Inventory level unchanged from 2006 levels. National Telecoms Corporation’s net operating cycle in 2007 is closest to: A. B. C. D.
58 days. 130 days. 153 days. 176 days.
Correct Answer:
B.......................................................................................... LOS: Reading 46‐b
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 Reference: CFA® Program Curriculum, Volume 4, pp. 89‐95.
Corporate Finance 323 19. National Telecoms Corporation provides the following information:
Income Statement $ million 1050 (780) 270 (150) 120 (45) (25) 50
Credit Sales COGS Gross Profit SGA exp. Op. Profit Interest exp. Tax Net Income
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.
324 Study Session 11: 19. National Telecoms Corporation provides the following information:
Income Statement $ million 1050 (780) 270 (150) 120 (45) (25) 50
Credit Sales COGS Gross Profit SGA exp. Op. Profit Interest exp. Tax Net Income
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. Correct Answer:
C ......................................................................................... LOS: Reading 47‐b
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. Reference: CFA® Program Curriculum, Volume 4, pp. 164‐167.
Corporate Finance 325 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
326 Study Session 11: 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 Correct Answer:
C ......................................................................................... LOS: Reading 44‐d
First of all calculate the present values of the cash flows:
Year
Net Cash Flow ($ million)
Discounted Net Cash Flow ($ million)
0 1 2 3 4 5 Total
‐150 25 50 55 40 60
‐150.0 22.7 41.3 41.3 27.3 37.3 19.9
Reference: CFA® Program Curriculum, Volume 4, p. 19.
Corporate Finance 327 21. The cost of a project is $150 million and it will be depreciated using the straight line method over 5 years with a zero salvage value. The following net income is anticipated.
Year 1 2 3 4 5
Net Income ($ million) 4 20 22 20 – 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.
328 Study Session 11: 21 The cost of a project is $150 million and it will be depreciated using the straight line method over 5 years with a zero salvage value. The following net income is anticipated.
Year 1 2 3 4 5
Net Income ($ million) 4 20 22 20 – 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% Correct Answer:
D ......................................................................................... LOS: Reading 44‐d
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% Reference: CFA® Program Curriculum, Volume 4, p. 18.
Corporate Finance 329 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. Reference: CFA® Program Curriculum, Volume 4, pp. 173‐175.
330 Study Session 12:
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.
332 Study Session 12: 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. Correct Answer:
B...........................................................................................LOS: Reading 49‐e
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. Reference: CFA® Program Curriculum, Volume 4, pp. 223‐224. 2. The beta of an asset: A. B. C. D.
lies between -1 and 1. is a measure of unsystematic risk. is 1 if the asset is the market portfolio. is the covariance of the asset with the market.
Correct Answer:
C ......................................................................................... LOS: Reading 51‐d
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. Reference: CFA® Program Curriculum, Volume 4, pp. 264‐269.
Portfolio Management 333 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.
334 Study Session 12: 3. Which of the following is least likely to be a step in the investment process? A. B. C. D.
Asset allocation. Monitoring the portfolio. Forecasting market returns. Submitting regulatory reports to the appropriate authority.
Correct Answer:
D ..........................................................................................LOS: Reading 49‐a
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. Reference: CFA® Program Curriculum, Volume 4, pp. 202‐203. 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. Correct Answer:
B...........................................................................................LOS: Reading 51‐e
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. Reference: CFA® Program Curriculum, Volume 4, pp. 263‐266.
Portfolio Management 335 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.
336 Study Session 12: 5.
If a stock lies above the security market line (SML) this would indicate that the stock:
A. B. C. D.
is overvalued. is undervalued. has a higher expected return than the market. has a lower expected return than the market.
Correct Answer:
B...........................................................................................LOS: Reading 51‐e
The stock is undervalued because the expected rate of return is higher than the required rate of return to compensate for its beta risk. Reference: CFA® Program Curriculum, Volume 4, pp. 263‐267. 6. The characteristic line is used to estimate: A. B. C. D.
the risk-free rate. the beta of a stock. the risk aversion of an investor. the standard deviation of a portfolio.
Correct Answer:
B.......................................................................................... LOS: Reading 51‐d
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. Reference: CFA® Program Curriculum, Volume 4, pp. 267‐269.
Portfolio Management 337 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.
338 Study Session 12: 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. B. C. D.
0.0013. 0.0019. 0.0027. 0.0039.
Correct Answer:
A ..........................................................................................LOS: Reading 51‐a
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 = 0.0013 2
Reference: CFA® Program Curriculum, Volume 4, pp. 256‐258. 8. In capital market theory the Market Portfolio can be least accurately described as: A. B. C. D.
the portfolio where systematic risk has been completely diversified away. it is the point where the Capital Market Line touches the efficient frontier. the portfolio which contains all risky assets in proportion to their market value. the point where the tangent from the risk-free rate touches the efficient frontier.
Correct Answer:
A ......................................................................................... LOS: Reading 51‐b
A is not correct – it is the unsystematic risk that can be diversified away. Reference: CFA® Program Curriculum, Volume 4, p. 259.
Portfolio Management 339 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.
340 Study Session 12: 9. If an investor has steep utility curves it is likely to indicates that: A. B. C. D.
the investor is aggressive. the investor is conservative. the investor has a long time horizon. the investor has a short time horizon.
Correct Answer:
B...........................................................................................LOS: Reading 50‐g
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. Reference: CFA® Program Curriculum, Volume 4, pp. 248‐249. 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. Reference: CFA® Program Curriculum, Volume 4, pp. 256‐259.
Portfolio Management 341 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.
342 Study Session 12: 11. Which of the following is a least accurate description of an assumption of Capital Market Theory? A. B. C. D.
Capital markets are in equilibrium. All investors have the same time horizon. Investors can borrow or lend at the risk-free rate. Investors are not able to correctly anticipate inflation.
Correct Answer:
D ..........................................................................................LOS: Reading 51‐a
Capital Market Theory makes the assumption that there is no inflation or change in interest rates, or any inflation is fully anticipated. Reference: CFA® Program Curriculum, Volume 4, pp. 254‐255. 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. B. C. D.
14.0. 50.4. 71.4. 140.0.
Correct Answer:
rxy =
B.......................................................................................... LOS: Reading 50‐d
cov ariance xy σxσy
cov ariance = 0.6 × 7 × 12 = 50.4 where: rxy
=
σx = σy =
correlation between the returns of x and y standard deviation of returns of x standard deviation of returns of y
Reference: CFA® Program Curriculum, Volume 4, pp. 236‐237.
Portfolio Management 343 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%.
344 Study Session 12: 13. The efficient frontier represents portfolios that: A. B. C. D.
offer the highest return for a given level of total risk. offer the highest return for a given level of systematic risk. are equally attractive to an investor with a specified level of total risk tolerance. are equally attractive to an investor with a specified level of systematic risk tolerance.
Correct Answer:
A .......................................................................................... LOS: Reading 50‐f
The efficient frontier represents the portfolios which offer the highest return for any given level of risk so A is correct. Reference: CFA® Program Curriculum, Volume 4, pp. 247‐249. 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%. Correct Answer:
B........................................................................................... LOS: Reading 50‐c
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 σ = 0.01897 or 1.9% 2
2
Reference: CFA® Program Curriculum, Volume 4, pp. 230‐231.
Portfolio Management 345 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.
346 Study Session 12: 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. B. C. D.
6.0%. 8.5%. 11.0%. 14.5%.
Correct Answer:
B.......................................................................................... LOS: Reading 51‐d
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 = RM = i =
the risk-free rate market return beta of stock
Reference: CFA® Program Curriculum, Volume 4, pp. 263‐267. 16. The beta of a stock can be computed from the: A. B. C. D.
relative volatility of the stock returns to the market returns. correlation of the stock with the market and the market return. correlation of the stock with the market and the variance of the stock returns. covariance of the stock with the market and the variance of the market returns.
Correct Answer:
D ......................................................................................... LOS: Reading 51‐d
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.
Portfolio Management 347 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.
348 Study Session 12: 17. In a rapidly rising market, a stock with a beta of 0.5 is expected, relative to the market performance, to: Performance outperform outperform underperform underperform
A. B. C. D.
Correct Answer:
Direction Same Opposite Same Opposite C ......................................................................................... LOS: Reading 51‐d
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. Reference: CFA® Program Curriculum, Volume 4, pp. 263‐266. 18. The characteristic line: A. B. C. D.
is a regression line used to estimate a stock’s systematic risk. is a regression line used to estimate a stock’s standard deviation. indicates the required rate of return of a stock given its systematic risk. indicates the required rate of return of a stock given its standard deviation.
Correct Answer:
A ......................................................................................... LOS: Reading 51‐d
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. Reference: CFA® Program Curriculum, Volume 4, pp. 267‐271.
Portfolio Management 349 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.
350 Study Session 12: 19. An investor policy statement is important because it: A. B. C. D.
clarifies the investors’ objectives. provides the investor with the portfolio manager’s market outlook. provides details on the stocks that will be purchased for the portfolio. means that the investor takes responsibility for investment performance.
Correct Answer:
A ......................................................................................... LOS: Reading 49‐b
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. Reference: CFA® Program Curriculum, Volume 4, pp. 203‐206. 20. The optimal portfolio for an investor is represented by the point where the: A. B. C. D.
investor utility curves intersect each other. security market line is tangent to the efficient frontier. investor utility curve is tangent to the efficient frontier. investor utility curve is tangent to the security market line.
Correct Answer:
C ..........................................................................................LOS: Reading 50‐g
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. Reference: CFA® Program Curriculum, Volume 4, pp. 238‐249.
Portfolio Management 351 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 portfolio is closest to: A.
2.2.
B.
5.0.
C.
6.7.
D.
9.2.
352 Study Session 12: 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. B. C. D.
4.98%. 6.00%. 6.64%. 24.80%.
Correct Answer:
A .......................................................................................... LOS: Reading 50‐c
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
rij
= standard deviation of returns of asset j wi = weighting of asset i in the portfolio = correlation between the returns of assets i and j Reference: CFA® Program Curriculum, Volume 4, pp. 238‐241.
Portfolio Management 353 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 portfolio is closest to: A. B. C. D.
2.2. 5.0. 6.7. 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 rij
= =
weighting of asset i in the portfolio correlation between the returns of assets i and j
Reference: CFA® Program Curriculum, Volume 4, pp. 238‐241.
354 Study Session 13:
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.
356 Study Session 13: 1. A corporation looking to raise funds may decide to do a private placement because: A. B. C. D.
it will reduce issuing costs. it will avoid using an investment bank. it will provide greater liquidity in the secondary market. the issue can be sold at a higher price than if it was sold in a public offering.
Correct Answer:
A ......................................................................................... LOS: Reading 52‐b
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. Reference: CFA® Program Curriculum, Volume 5, p. 9. 2. When a stock in the Dow Jones Industrial Average has a stock split this will lead to: A. B. C. D.
the divisor increasing. the divisor decreasing. there being no change in the divisor. the divisor increasing if the stock is a high-priced stock and falling if it is a low-priced stock.
Correct Answer:
B...........................................................................................LOS: Reading 53‐a
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. Reference: CFA® Program Curriculum, Volume 5, pp. 42‐42.
Equity Investments: Securities Markets 357 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%.
358 Study Session 13: 3. A short seller of a stock will generally: A. B. C. D.
sell the stock when the price is falling. benefit from a rise in price of the stock. deposit collateral when he borrows stock. benefit from the price fall when a stock goes ex-dividend.
Correct Answer:
C .......................................................................................... LOS: Reading 52‐f
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. Reference: CFA® Program Curriculum, Volume 5, pp. 25‐26. 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%. Correct Answer:
C ..........................................................................................LOS: Reading 53‐a
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%. Reference: CFA® Program Curriculum, Volume 5, pp. 44‐46.
Equity Investments: Securities Markets 359 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.
360 Study Session 13: 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. B. C. D.
(i) 11.11% (ii) 15.00%. (i) 11.11% (ii) 15.75%. (i) 12.39% (ii) 15.00%. (i) 12.39% (ii) 15.75%.
Correct Answer:
A ..........................................................................................LOS: Reading 52‐e
(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%. Reference: CFA® Program Curriculum, Volume 5, pp. 25‐26. 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. Correct Answer:
D ..........................................................................................LOS: Reading 54‐a
An informationally efficient market is one where security prices adjust very rapidly to the arrival of new information. Reference: CFA® Program Curriculum, Volume 5, pp. 62‐63.
Equity Investments: Securities Markets 361 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.
362 Study Session 13: 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. Correct Answer:
C ..........................................................................................LOS: Reading 52‐g
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. Reference: CFA® Program Curriculum, Volume 5, pp. 26‐29. 8. A call market refers to: A. B. C. D.
a market where trades are done by open outcry. a market which specializes in providing derivatives trading. a market where it is attempted to match all the bids and asks at a specified time. a market where all the trading is done by computer rather than on a trading floor.
Correct Answer:
C .......................................................................................... LOS: Reading 52‐c
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. Reference: CFA® Program Curriculum, Volume 5, p. 15.
Equity Investments: Securities Markets 363 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:
Dealer 1 Dealer 2 Dealer 3
Bid 17 ¾ 17 ½ 17 ⅝
Ask 18 ¼ 18 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.
364 Study Session 13: 9. Which of the following is least likely to be a member of a U.S. securities exchange? A. B. C. D.
A specialist. A floor broker. An underwriter. A registered trader.
Correct Answer:
C ..........................................................................................LOS: Reading 52‐e
The four major categories of membership are: 1. Specialist. 2. Commission broker. 3. Floor broker. 4. Registered trader. Reference: CFA® Program Curriculum, Volume 5, pp. 24‐25. 10. The quotations for the price of Brown and Co. are given by 3 dealers as shown below:
Dealer 1 Dealer 2 Dealer 3
Bid 17 ¾ 17 ½ 17 ⅝
Ask 18 ¼ 18 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. Correct Answer:
D ..........................................................................................LOS: Reading 52‐e
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. Reference: CFA® Program Curriculum, Volume 5, pp. 20‐23.
Equity Investments: Securities Markets 365 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.
366 Study Session 13: 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. B. C. D.
escalation bias. prospect theory. overconfidence. confirmation bias.
Correct Answer:
D ......................................................................................... LOS: Reading 54‐d
Research shows that investors seek out information that confirms their own views, this is called confirmation bias. Reference: CFA® Program Curriculum, Volume 5, pp. 83‐84. 12. A call market is one in which: A. B. C. D.
short selling is not permitted. dealers are making markets in stocks. stock prices are determined by auction. individual stocks are traded at specified times.
Correct Answer:
D .......................................................................................... LOS: Reading 52‐c
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. Reference: CFA® Program Curriculum, Volume 5, pp. 14‐15.
Equity Investments: Securities Markets 367 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.
368 Study Session 13: 13. A pricing anomaly is best described as: A. B. C. D.
a price move that reflects a factor that is specific to the individual stock. a predictable deviation between expected and actual returns for a stock. out or underperformance of a stock against the market average performance. a short-term random movement in a stock prices giving an opportunity to make a profit.
Correct Answer:
B.......................................................................................... LOS: Reading 55‐b
A key element of an anomaly is that it is a predictable, rather than a random, move. Reference: CFA® Program Curriculum, Volume 5, p. 100. 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. Correct Answer:
D .......................................................................................... LOS: Reading 54‐c
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. Reference: CFA® Program Curriculum, Volume 5, pp. 87‐89.
Equity Investments: Securities Markets 369 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.
370 Study Session 13: 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. B. C. D.
Data mining. Survivorship bias. Nonsynchronous trading. Limited capital of arbitrageurs.
Correct Answer:
D ......................................................................................... LOS: Reading 55‐d
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. Reference: CFA® Program Curriculum, Volume 5, pp. 100‐104. 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. B. C. D.
$14.00. $21.00. $28.57. $49.99.
Correct Answer:
C ..........................................................................................LOS: Reading 52‐g
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 Reference: CFA® Program Curriculum, Volume 5, pp. 26‐29.
Equity Investments: Securities Markets 371 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.
372 Study Session 13: 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. B. C. D.
there were a large number of stock splits over the period. there were a small number of stock splits over the period. small capitalization stocks outperformed large capitalization stocks. large capitalization stocks outperformed small capitalization stocks.
Correct Answer:
D ..........................................................................................LOS: Reading 53‐a
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. Reference: CFA® Program Curriculum, Volume 5, pp. 44‐46. 18. The initial margin requirement for a stock purchase is: A. B. C. D.
the market value of the stock less the amount borrowed. the market value of the stock less the amount paid in cash. the percentage of the transaction value that can be borrowed. the percentage of the transaction value that must be paid for in cash.
Correct Answer:
D ..........................................................................................LOS: Reading 52‐g
The initial margin is simply the percentage or proportion of the transaction value that must be paid for in cash, rather than borrowed. Reference: CFA® Program Curriculum, Volume 5, pp. 26‐29.
Equity Investments: Securities Markets 373 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.
374 Study Session 13: 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. Correct Answer:
A .......................................................................................... LOS: Reading 54‐c
The weak-form of the Efficient Market Hypothesis implies that technical analysis based on past trading data does not have any value. Reference: CFA® Program Curriculum, Volume 5, p. 85. 20. Which of the following supports the semistrong‐form of the Efficient Market Hypothesis? A. B. C. D.
The January effect. The neglected firm effect. The performance of stocks with a low price/book value ratio. The performance of stocks that have announced a change in accounting methods.
Correct Answer:
D ......................................................................................... LOS: Reading 54‐b
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. Reference: CFA® Program Curriculum, Volume 5, pp. 67‐79.
Equity Investments: Securities Markets 375 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.
376 Study Session 13: 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?
A. B. C. D.
Include stocks from Russell Small-Cap index Russell Small-Cap index IFC Emerging Market index IFC Emerging Market index
Correct Answer:
Correlation explained by Index construction Index constituents Index construction Index constituents
D .......................................................................................... LOS: Reading 53‐c
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. Reference: CFA® Program Curriculum, Volume 5, pp. 56‐58.
Equity Investments: Securities Markets 377 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. B. C. D.
98.18. 106.67. 125.45. 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 Reference: CFA® Program Curriculum, Volume 5, pp. 44‐45.
378 Study Session 14:
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.
380 Study Session 14: 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. B. C. D.
overvalued. undervalued. fairly valued. information is needed on the dividend payout ratio to answer the question.
Correct Answer:
B.......................................................................................... LOS: Reading 60‐b
The stock price using the DDM should be 3.6/(0.12 – 0.045) = $48, if the price is $45 the stock is undervalued. Reference: CFA® Program Curriculum, Volume 5, pp. 177‐182. 2. Which of the following would be a positive factor for producers’ profitability? A. B. C. D.
Low entry barriers. Strong buyer power. Weak supplier power. Availability of substitutes.
Correct Answer:
C ..........................................................................................LOS: Reading 58‐e
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. Reference: CFA® Program Curriculum, Volume 5, pp. 141‐144.
Equity Investments: Industry and Company Analysis 381 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.
382 Study Session 14: 3. Which of the following factors is least likely to directly determine the level of competition in an industry? A. B. C. D.
Entry barriers. Unit labor costs. Bargaining power of buyers. Availability of substitute products.
Correct Answer:
B...........................................................................................LOS: Reading 58‐e
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. Reference: CFA® Program Curriculum, Volume 5, pp. 141‐144. 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. B. C. D.
$36.56. $37.81. $39.05 $51.69.
Correct Answer:
C ......................................................................................... LOS: Reading 60‐b
First, calculate the value of the stock at the end of year three,
Value =
D4 $3.50(1.04) = = $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.
Value =
P + D3 D1 D2 $2 $3 $45.50 + $3.50 + + = + + = $39.05 2 3 2 (1 + k ) (1 + k ) (1 + k ) (1.12) (1.12) (1.12)3
Reference: CFA® Program Curriculum, Volume 5, pp. 176‐182.
Equity Investments: Industry and Company Analysis 383 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.
384 Study Session 14: 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. B. C. D.
Leading P/E. Trailing P/E. Current P/E. P/E using normalized earnings.
Correct Answer:
D ..........................................................................................LOS: Reading 61‐a
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. Reference CFA® Program Curriculum, Volume 5, pp. 205-210. 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. Correct Answer:
B.......................................................................................... LOS: Reading 59‐b
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. Reference: CFA® Program Curriculum, Volume 5, pp. 160‐166.
Equity Investments: Industry and Company Analysis 385 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.
386 Study Session 14: 7. A company whose earnings are very sensitive to the business cycle is a: A. B. C. D.
growth stock. cyclical stock. growth company. cyclical company.
Correct Answer:
D ..........................................................................................LOS: Reading 59‐a
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. Reference: CFA® Program Curriculum, Volume 5, pp. 150‐151. 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. Correct Answer:
D ......................................................................................... LOS: Reading 58‐b
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. Reference: CFA® Program Curriculum, Volume 5, pp. 136‐140.
Equity Investments: Industry and Company Analysis 387 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.
388 Study Session 14: 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. Correct Answer:
B...........................................................................................LOS: Reading 61‐a
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. Reference: CFA® Program Curriculum, Volume 5, pp. 204‐210. 10. Which of the following is most likely to lead to a company’s earnings multiplier being higher than the market multiplier? A. B. C. D.
The company has a high beta. The risk of the company’s earnings is higher than the market. Low return on equity for the company relative to the market. High earnings growth rates for the company relative to the market.
Correct Answer:
D ......................................................................................... LOS: Reading 59‐b
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. Reference: CFA® Program Curriculum, Volume 5, pp. 160‐166.
Equity Investments: Industry and Company Analysis 389 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.
390 Study Session 14: 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 1.30 2.65 5.50 4.30 3.25 Adjusted* EPS, $ 0.04 0.13 0.22 0.18 0.12 ROE* % BVPS, $ * 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. Correct Answer:
2007 1.00 0.03 32.00
C ......................................................................................... LOS: Reading 61‐b
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 Reference: CFA® Program Curriculum, Volume 5, pp. 206‐210. 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. B. C. D.
Use tangible book value rather than total book value. Adjust book value for off-balance-sheet assets and liabilities. Use historic average of past book values over a business cycle. Adjust book value for differences in fair value and historic cost of assets.
Correct Answer:
C ..........................................................................................LOS: Reading 61‐a
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. Reference: CFA® Program Curriculum, Volume 5, pp. 210‐218.
Equity Investments: Industry and Company Analysis 391 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.
392 Study Session 14: 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. B. C. D.
3.33. 4.44. 5.71. 8.57.
Correct Answer:
C .......................................................................................... LOS: Reading 60‐c
Reference: CFA® Program Curriculum, Volume 5, pp. 186‐188. 14. Which of the following factors will encourage new entrants to an industry? A. B. C. D.
High exit costs. A steep cost curve. Excess industry capacity. High industry profitability.
Correct Answer:
D ..........................................................................................LOS: Reading 58‐e
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. Reference: CFA® Program Curriculum, Volume 5, pp. 143‐144.
Equity Investments: Industry and Company Analysis 393 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.
394 Study Session 14: 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. B. B. D.
Sales are generally more stable than earnings per share. Sales numbers are less subject to accounting manipulation. P/S is viewed as an appropriate valuation method for cyclical companies. P/S valuation methods can be used comparing companies with different cost structures.
Correct Answer:
D ..........................................................................................LOS: Reading 61‐a
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. Reference: CFA® Program Curriculum, Volume 5, pp. 218‐221. 16. Which stage of the industry cycle is characterized by fast sales growth and high profit margins? A. B. C. D.
Mature growth. Market maturity. Pioneering development. Rapid accelerating growth.
Correct Answer:
D .......................................................................................... LOS: Reading 58‐c
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. Reference: CFA® Program Curriculum, Volume 5, pp. 137‐138.
Equity Investments: Industry and Company Analysis 395 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.
396 Study Session 14: 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. B. C. D.
2.9%. 9.0%. 9.2%. 18.0%.
Correct Answer:
C ......................................................................................... LOS: Reading 60‐d
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% Reference: CFA® Program Curriculum, Volume 5, pp. 191‐193. 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. B. C. D.
Sell property. Purchase stocks. Purchase bonds. Sell commodities.
Correct Answer:
B...........................................................................................LOS: Reading 58‐a
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. Reference: CFA® Program Curriculum, Volume 5, pp. 130‐132.
Equity Investments: Industry and Company Analysis 397 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.
398 Study Session 14: 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. Reference: CFA® Program Curriculum, Volume 5, pp. 125‐127. 20. Which of the following is one of the reasons why price to book value is a useful valuation measure? A. B. C. D.
It can be used to value loss-making companies. It is useful for comparing the value of stocks across industries. Book value is not usually distorted by the accounting methods used. Book value has proved to be a good indicator of the market value of a company’s assets.
Correct Answer:
A ..........................................................................................LOS: Reading 61‐a
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. Reference: CFA® Program Curriculum, Volume 5, pp. 210‐218.
Equity Investments: Industry and Company Analysis 399 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.
400 Study Session 14: 21. When a fund manager uses top‐down analysis to manage equity portfolios he is least likely to consider: A. B. C. D.
impact of economic environment on different industries. impact of industry environment on individual companies. the impact of monetary and fiscal policies on the market environment. 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. Reference: CFA® Program Curriculum, Volume 5, pp. 117‐121.
Equity Investments: Industry and Company Analysis 401 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. B. C. D.
sales per share are higher than for the average company. the company has a low profit margin relative to the average for the market. the company has exhibited rapid sales growth relative to the market average. 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. Reference: CFA® Program Curriculum, Volume 5, pp. 218‐221.
402 Study Session 15:
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.
404 Study Session 15: 1. Which of the following is least likely to be an example of embedded options that might be granted to bondholders? A. B. C. D.
A cap on a floater. A floor on a floater. Conversion privileges. The right to put the issue.
Correct Answer:
A ......................................................................................... LOS: Reading 62‐b
A cap on a floater is a benefit to the issuer if interest rates rise, not to the bondholders. Reference: CFA® Program Curriculum, Volume 5, pp. 242‐246. 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. Correct Answer:
D ..........................................................................................LOS: Reading 62‐a
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. Reference: CFA® Program Curriculum, Volume 5, p. 239.
Fixed Income Investments: Basic Concepts 405 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%.
406 Study Session 15: 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. B. C. D.
a callable bond. a refundable bond. a prepayment option. a sinking fund provision.
Correct Answer:
D ..........................................................................................LOS: Reading 62‐e
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. B. C. D.
2.4%. 3.6%. 10.0%. 15.0%.
Correct Answer:
C .......................................................................................... LOS: Reading 65‐i
taxable-equivalent yield = tax-exempt yield/(1 – marginal tax rate) = 0.06/0.6 = 0.1 or 10% Reference: CFA® Program Curriculum, Volume 5, pp. 359‐361.
Fixed Income Investments: Basic Concepts 407 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.
408 Study Session 15: 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. B. C. D.
6.5% 6.5% 7.0% 7.6%
Correct Answer:
5.8% 6.5% 6.5% 7.1% C ......................................................................................... LOS: Reading 62‐b
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%. Reference: CFA® Program Curriculum, Volume 5, pp. 242‐246. 6. Liquidity risk in bond markets can be measured by: A. B. C. D.
recovery rates. price volatility. the bid-ask spread. 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. Reference: CFA® Program Curriculum, Volume 5, pp. 281‐283.
Fixed Income Investments: Basic Concepts 409 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.
410 Study Session 15: 7. Which one of the following is the least likely to be an example of a securitized bond? A. B. C. D.
Mortgage bond. Mortgage-backed security. Collateralized Mortgage Obligation. Credit Card Receivables Asset-Backed security.
Correct Answer:
A ..........................................................................................LOS: Reading 64‐e
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. Reference: CFA® Program Curriculum, Volume 5, p. 305. 8. The difference in yield between bonds issued by industrial companies and bonds issued by information technology companies is an example of a: A. B. C. D.
credit spread. quality spread. intermarket sector spread. intramarket sector spread.
Correct Answer:
C ..........................................................................................LOS: Reading 65‐e
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. Reference: CFA® Program Curriculum, Volume 5, pp. 355‐356.
Fixed Income Investments: Basic Concepts 411 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.
412 Study Session 15: 9. If the yield spread of a bond has widened it means that: A. B. C. D.
it is a low-grade bond. it is a high-grade bond. the bond price has risen relative to that of an equivalent Treasury bond issue. 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. Reference: CFA® Program Curriculum, Volume 5, pp. 277‐278. 10. Medium‐term notes (MTNs) differ from corporate bonds since: A. B. C. D.
MTNs have a maximum maturity of 5 years. MTNs have a maximum maturity of 10 years. MTNs are not rated by any of the major credit rating organizations. MTNs are offered to investors on a continuous basis by the issuer or its agent.
Correct Answer:
D ......................................................................................... LOS: Reading 64‐h
The unique feature of MTNs is that they are offered to investors on a continuous basis by the issuer or its agent. Reference: CFA® Program Curriculum, Volume 5, pp. 322‐325.
Fixed Income Investments: Basic Concepts 413 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.
414 Study Session 15: 11. From the equity markets, central banks find it most useful to derive information on: A. B. C. D.
future economic activity. international trade activity. market expectations of interest rates. ownership of equities by individuals.
Correct Answer:
A ......................................................................................... LOS: Reading 66‐b
Equity markets provide information on anticipated economic activity. Reference: CFA® Program Curriculum, Volume 5, pp. 379‐383. 12. Which of the following embedded options is increasingly valuable to an investor in a rising interest rate environment? A. B. C. D.
Put option. Call option. Interest rate cap. Accelerated sinking fund provision.
Correct Answer:
A ..........................................................................................LOS: Reading 62‐e
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. Reference: CFA® Program Curriculum, Volume 5, pp. 252‐254.
Fixed Income Investments: Basic Concepts 415 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.
416 Study Session 15: 13. The legal entity that is used in asset securitization for bankruptcy remoteness is: A. B. C. D.
a rating agency. an indenture trustee. an investment bank. 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. Reference: CFA® Program Curriculum, Volume 5, pp. 328‐329. 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. B. C. D.
0.50. 1.00. 5.25. 10.50.
Correct Answer:
C .......................................................................................... LOS: Reading 63‐f
The duration = (99.99 – 94.89)/(2 x 97.99 x 0.005) = 5.25 Reference: CFA® Program Curriculum, Volume 5, pp. 269‐271.
Fixed Income Investments: Basic Concepts 417 15. 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. 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.
418 Study Session 15: 15. 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. If the par value of the bond is $100,000 then the dollar duration is: A. B. C. D.
$500. $1,000. $5,250. $10,500.
Correct Answer:
C .......................................................................................... LOS: Reading 63‐f
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 Reference: CFA® Program Curriculum, Volume 5, pp. 269‐271. 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. Correct Answer:
A ......................................................................................... LOS: Reading 62‐d
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. Reference: CFA® Program Curriculum, Volume 5, pp. 251‐255.
Fixed Income Investments: Basic Concepts 419 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.
420 Study Session 15: 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. Correct Answer:
D ..........................................................................................LOS: Reading 62‐e
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. Reference: CFA® Program Curriculum, Volume 5, pp. 247‐251. 18. A credible and transparent monetary policy of the ECB is reflected in: A. B. C. D.
stable exchange rates. a strong euro against the dollar. insignificant overnight interest rate moves following a policy announcement. an increased level of implied volatility of the bond markets over the last few years.
Correct Answer:
C .......................................................................................... LOS: Reading 66‐c
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. Reference: CFA® Program Curriculum, Volume 5, pp. 379‐381.
Fixed Income Investments: Basic Concepts 421 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..
20. Which of the following is least likely to be an example of embedded options that might be 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.
422 Study Session 15: 19. The clean price of a bond is: A. B. C. D.
the agreed bond price without accrued interest. the accrued interest component of the bond price. the agreed bond price plus the accrued interest due to the seller of the bond. the agreed bond price for the bond less the accrued interest due to the buyer of the bond.
Correct Answer:
A ......................................................................................... LOS: Reading 62‐b
The clean price of a bond is the quoted price of a bond where the accrued interest is excluded. Reference: CFA® Program Curriculum, Volume 5, p. 246. 20. Which of the following is least likely to be an example of embedded options that might be granted to the issuer of a bond? A. B. C. D.
A floor on a floater. The right to call the issue. An accelerated sinking fund provision. The right to prepay an amount above the scheduled principal repayment.
Correct Answer:
A ......................................................................................... LOS: Reading 62‐b
A floor on a floater is a benefit to the holder of the bond if interest rates fall, not to the issuer. Reference: CFA® Program Curriculum, Volume 5, pp. 242‐246.
Fixed Income Investments: Basic Concepts 423 21. The following information is given:
Issue
Yield 6.15% 7.85% 8.00%
10‐year on‐the‐run Treasury 6% coupon 10‐year ABG Corporation Series J 5% coupon 10‐year IBN Limited 8.0% coupon
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.
22. The following information is given:
Issue
Yield 6.15% 7.85% 8.00%
10‐year on‐the‐run Treasury 6% coupon 10‐year ABG Corporation Series J 5% coupon 10‐year IBN Limited 8.0% coupon
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.
424 Study Session 15: 21. The following information is given:
Issue
Yield 6.15% 7.85% 8.00%
10‐year on‐the‐run Treasury 6% coupon 10‐year ABG Corporation Series J 5% coupon 10‐year IBN Limited 8.0% coupon
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. Correct Answer:
D ..........................................................................................LOS: Reading 65‐e
The absolute yield spread = 8.0% - 7.85% = 0.15% or 15 basis points. Do not use the coupon rates. Reference: CFA® Program Curriculum, Volume 5, pp. 352‐354.
Fixed Income Investments: Basic Concepts 425 22. The following information is given:
Issue
Yield 6.15% 7.85% 8.00%
10‐year on‐the‐run Treasury 6% coupon 10‐year ABG Corporation Series J 5% coupon 10‐year IBN Limited 8.0% coupon
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. Reference: CFA® Program Curriculum, Volume 5, pp. 352‐354.
426 Study Session 16:
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..
428 Study Session 16: 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. B. C. D.
the market value of the portfolio will fall, but by less than 5%. the market value of the portfolio will fall by approximately 5%. the market value of the portfolio will rise by approximately 5%. we do not have sufficient information to calculate the impact on the market value of the portfolio.
Correct Answer:
D .......................................................................................... LOS: Reading 69‐f
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. Reference: CFA® Program Curriculum, Volume 5, pp. 499‐501. 2. The Macaulay duration of a bond is: A. B. C. D.
either negative or positive. the same as the maturity of the bond. always positive and less than, or equal to, the term to maturity of a bond. always positive and more than, or equal to, the term to maturity of a bond.
Correct Answer:
C ..........................................................................................LOS: Reading 69‐e
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. Reference: CFA® Program Curriculum, Volume 5, p. 497.
Fixed Income Investments: Analysis and Valuation 429 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%.
430 Study Session 16: 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. B. C. D.
5.66. 5.77. 6.24. 6.36.
Correct Answer:
B...........................................................................................LOS: Reading 69‐e
Semiannual bonds mean k = 2 Modified duration = Macaulay duration/[(1 + yield/k)] = 6.0/(1.04) = 5.77 Reference: CFA® Program Curriculum, Volume 5, p. 497. 4. If the semiannual yield to maturity of a bond is 5%, the bond‐equivalent yield is closest to: A. B. C. D.
5.1%. 10.0%. 10.3%. 10.6%.
Correct Answer:
B.......................................................................................... LOS: Reading 68‐d
The bond-equivalent yield is simply double the semiannual yield. Reference: CFA® Program Curriculum, Volume 5, pp. 424‐425.
Fixed Income Investments: Analysis and Valuation 431 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.
432 Study Session 16: 5. The total dollar return from a bond is: A. B. C. D.
the current yield multiplied by the price of the bond. the yield to maturity multiplied by the price of the bond. the coupon income plus the reinvestment income plus the capital gain/loss on the bond. the coupon income plus the value of the quoted margin plus the capital gain/loss on the bond.
Correct Answer:
C ..........................................................................................LOS: Reading 68‐a
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. Reference: CFA® Program Curriculum, Volume 5, pp. 42‐423. 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. B. C. D.
$96.12. $98.27. $101.91. $103.42.
Correct Answer:
D .......................................................................................... LOS: Reading 67‐c
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 Reference: CFA® Program Curriculum, Volume 5, pp. 392‐395.
Fixed Income Investments: Analysis and Valuation 433 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%.
434 Study Session 16: 7. The appropriate duration measure to use for a high coupon callable bond is: A. B. C. D.
effective duration. modified duration. Macaulay duration. option-adjusted duration.
Correct Answer:
A ..........................................................................................LOS: Reading 69‐e
In a callable bond, the cash flows might change as interest rates change. The most appropriate duration measure is effective duration. Reference: CFA® Program Curriculum, Volume 5, p. 496. 8. If the yield to maturity on an annual‐pay bond is 12% its bond‐equivalent yield is closest to: A. B. C. D.
11.66%. 12.00%. 12.36%. 12.72%.
Correct Answer:
A ......................................................................................... LOS: Reading 68‐d
bond-equivalent yield = 2[(1+ yield on annual-pay bond)1/2 –1] = 11.66% Reference: CFA® Program Curriculum, Volume 5, p. 431.
Fixed Income Investments: Analysis and Valuation 435 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.
436 Study Session 16: 9. A non‐callable bond has: A. B. C. D.
positive convexity throughout the yield range. negative convexity throughout the yield range. positive convexity at low yields and negative convexity at high yields. negative convexity at low yields and positive convexity at high yields.
Correct Answer:
A ......................................................................................... LOS: Reading 69‐b
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. Reference: CFA® Program Curriculum, Volume 5, pp. 484‐488. 10. When a dealer purchases a package of Treasury strips to create a synthetic Treasury bond, the procedure is called: A. B. C. D.
hedging. stripping. reconstitution. bootstrapping.
Correct Answer:
C .......................................................................................... LOS: Reading 67‐f
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. Reference: CFA® Program Curriculum, Volume 5, p. 410.
Fixed Income Investments: Analysis and Valuation 437 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%.
438 Study Session 16: 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. Correct Answer:
A .......................................................................................... LOS: Reading 68‐c
Zero-coupon bonds have no reinvestment risk since they have no interim income from coupons to be reinvested. Reference: CFA® Program Curriculum, Volume 5, pp. 425‐430. 12. Given the following information on a bond: Duration = Convexity = Yields fall by:
7.5670. 41.0935. 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%. Correct Answer:
D ......................................................................................... LOS: Reading 69‐d
Estimated change using duration 7.5670% x 0.025 x 100 Convexity adjustment: 41.0935 x (0.025)2 x 100 Total estimated percentage price change Reference: CFA® Program Curriculum, Volume 5, pp. 488‐492.
= 18.9175 = 2.5684 = 21.4858
Fixed Income Investments: Analysis and Valuation 439 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.
440 Study Session 16: 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. B. C. D.
7.0%. 8.1%. 9.2%. 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% Reference: CFA® Program Curriculum, Volume 5, pp. 458‐461. 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. Correct Answer:
B........................................................................................... LOS: Reading 69‐c
For a large change in yields, the percentage price increase is greater than the percentage price decrease, when a bond has positive convexity. Reference: CFA® Program Curriculum, Volume 5, pp. 501‐503.
Fixed Income Investments: Analysis and Valuation 441 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%
442 Study Session 16: 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. Correct Answer:
D ..........................................................................................LOS: Reading 69‐e
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. Reference: CFA® Program Curriculum, Volume 5, pp. 496‐499. 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 A. Positive B. Positive C. Negative D. Negative Correct Answer:
Yield Less than 5% More than 5% Less than 5% More than 5%
B........................................................................................... LOS: Reading 69‐c
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. Reference: CFA® Program Curriculum, Volume 5, pp. 484‐487.
Fixed Income Investments: Analysis and Valuation 443 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%.
444 Study Session 16: 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. B. C. D.
8.7%. 9.0%. 9.8%. 11.0%.
Correct Answer:
C ..........................................................................................LOS: Reading 67‐e
Let x be the semiannual yield we are looking for, then:
82.65 =
100
(1 + x )4
(1 + x )4 = 100 82.65 = 1.21 x = 0.0488 or 9.8% annual yield Reference: CFA® Program Curriculum, Volume 5, pp. 398‐399. 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. B. C. D.
6.0%. 6.5%. 7.5%. 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% Reference: CFA® Program Curriculum, Volume 5, pp. 458‐461.
Fixed Income Investments: Analysis and Valuation 445 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.
446 Study Session 16: 19. The price value of a basis point is: A. B. C. yield. D. yield.
the absolute change in price of a bond if there is a one basis point change in yield. the percentage change in price of a bond if there is a one basis point change in yield. the absolute change in dollar duration of a bond if there is a one hundred basis point change in the percentage change in dollar duration of a bond if there is a one hundred basis point change in
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. Reference: CFA® Program Curriculum, Volume 5, pp. 504‐505. 20. The Z‐spread is: A. B. C. D.
the option-adjusted spread if a bond has embedded options. the adjustment to the option-adjusted spread as volatility changes. the spread between spot and forward rates over the life of a bond. the spread earned on a bond over the Treasury spot rate curve if it is held to maturity.
Correct Answer:
D .......................................................................................... LOS: Reading 68‐f
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. Reference: CFA® Program Curriculum, Volume 5, pp. 445‐450.
Fixed Income Investments: Analysis and Valuation 447 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 maturity (BEY)
Price
Spot rate (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%.
448 Study Session 16: 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. B. C. D.
4.00%. 6.25%. 6.75%. 8.00%.
Correct Answer:
D ......................................................................................... LOS: Reading 68‐h
1f3 = [(1+ 0.03625)4/(1 + 0.035)3] – 1 = 4.0% The forward rate is 4.0% x 2 = 8.0% Reference: CFA® Program Curriculum, Volume 5, pp. 453‐458.
Fixed Income Investments: Analysis and Valuation 449 22. Given:
Period
Years
Annual yield to maturity (BEY)
Price
Spot rate (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% Reference: CFA® Program Curriculum, Volume 5, pp. 453‐458.
450 Study Session 17:
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.
452 Study Session 17: 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. B. C. D.
loss of $4. loss of $3. profit of $3. profit of $4.
Correct Answer:
B.......................................................................................... LOS: Reading 75‐b
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. Reference: CFA® Program Curriculum, Volume 6, pp. 151‐158. 2. The notional principal in a plain vanilla interest rate swap is: A. B. C. D. made.
never paid. paid at the time that the swap agreement is made. paid in equal parts when each swap payment is made. paid at the time that the swap agreement is signed and returned when the final swap payment is
Correct Answer:
A ......................................................................................... LOS: Reading 74‐b
The notional principal is the amount on which the interest payments are calculated and does not change hands in an interest rate swap. Reference: CFA® Program Curriculum, Volume 6, pp. 134‐138.
Derivative Investments 453 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.
454 Study Session 17: 3. The value of a put option at expiry is: A. B. C. D.
maximum of (i) zero and (ii) exercise price minus stock price. maximum of (i) zero and (ii) stock price minus exercise price. maximum of (i) zero and (ii) stock price minus exercise price, minus the option premium. maximum of (i) zero and (ii) exercise price minus stock price, minus the option premium.
Correct Answer:
A ..........................................................................................LOS: Reading 73‐e
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. Reference: CFA® Program Curriculum, Volume 6, pp. 96‐99. 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. Correct Answer:
C ......................................................................................... LOS: Reading 74‐b
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. Reference: CFA® Program Curriculum, Volume 6, pp. 134‐138.
Derivative Investments 455 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.
456 Study Session 17: 5. When a trader writes a covered call this will often be with the objective of: A. B. C. D.
increasing income. insuring his portfolio value. reducing the volatility of his return. increasing his gain if the stock price rises above the exercise price plus the premium.
Correct Answer:
A ......................................................................................... LOS: Reading 75‐b
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. Reference: CFA® Program Curriculum, Volume 6, pp. 151‐158. 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. Correct Answer:
D ......................................................................................... LOS: Reading 74‐b
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. Reference: CFA® Program Curriculum, Volume 6, pp. 138‐141.
Derivative Investments 457 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.
458 Study Session 17: 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. B. C. D.
$1,000. $4,000. $5,000. there is no requirement to pay a variation margin.
Correct Answer:
D ......................................................................................... LOS: Reading 72‐b
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). Reference: CFA® Program Curriculum, Volume 6, pp. 55‐60. 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. B. C. D.
if the stock price rises sharply or falls sharply. only if the stock price falls sharply below the exercise price. only if the stock price rises sharply above the exercise price. if the stock price remains within a narrow range of the exercise price.
Correct Answer:
D ..........................................................................................LOS: Reading 75‐a
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. Reference: CFA® Program Curriculum, Volume 6, pp. 151‐158.
Derivative Investments 459 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.
460 Study Session 17: 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. Correct Answer:
C ......................................................................................... LOS: Reading 75‐b
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. Reference: CFA® Program Curriculum, Volume 6, pp. 162‐165. 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. Correct Answer:
A ......................................................................................... LOS: Reading 73‐b
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. Reference: CFA® Program Curriculum, Volume 6, p. 94.
Derivative Investments 461 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.
462 Study Session 17: 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. B. C. D.
long position in a 6 x 3 FRA. short position in a 6 x 3 FRA. long position in a 6 x 9 FRA. short position in a 6 x 9 FRA.
Correct Answer:
D .......................................................................................... LOS: Reading 71‐f
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. Reference: CFA® Program Curriculum, Volume 6, pp. 40‐43. 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. B. C. D.
loss if the stock price rises above the breakeven point of $70. loss if the stock price rises above the breakeven point of $72. profit if the stock price rises above the breakeven point of $70. profit if the stock price rises above the breakeven point of $72.
Correct Answer:
D ..........................................................................................LOS: Reading 73‐e
Breakeven is when 0 = maximum [ 0, (S – X)] – premium, when S = $72 Reference: CFA® Program Curriculum, Volume 6, pp. 96‐100.
Derivative Investments 463 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.
464 Study Session 17: 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. B. C. D.
$2.93 per bushel. $3.92 per bushel. $4.08 per bushel. $5.45 per bushel.
Correct Answer:
C .......................................................................................... LOS: Reading 72‐c
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. Reference: CFA® Program Curriculum, Volume 6, pp. 55‐60. 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. B. C. D.
$5,000,000. $8,767,123. $9,575,343. $11,232,877.
Correct Answer:
B.......................................................................................... LOS: Reading 74‐b
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 Reference: CFA® Program Curriculum, Volume 6, pp. 138‐141.
Derivative Investments 465 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.
466 Study Session 17: 15. Which of the following statements concerning futures and forward contracts is most accurate? A. B. C. D.
Only forward contracts are guaranteed by a clearinghouse. Forward contracts tend to be more heavily regulated than futures contracts. A futures contract is a type of forward contract that has standardized contract terms. A forward contract is a type of futures contract that is traded on a recognized exchange.
Correct Answer:
C ..........................................................................................LOS: Reading 70‐a
A futures contract is a type of forward contract that has standardized contract terms and is traded on a regulated exchange. Reference: CFA® Program Curriculum, Volume 6, pp. 9‐12. 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. Correct Answer:
C ......................................................................................... LOS: Reading 71‐b
Taking a short position will mean that they no longer have any net exposure to price movements in the underlying asset. Reference: CFA® Program Curriculum, Volume 6, pp. 33‐34.
Derivative Investments 467 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.
468 Study Session 17: 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. Correct Answer:
B...........................................................................................LOS: Reading 71‐g
The payoff is given by:
⎡ (0.05 − 0.04)(180 360) ⎤ ⎛ 0.005 ⎞ $1,000,000 ⎢ = $1,000,000⎜ ⎟ = $4,878 ⎥ ⎝ 1.025 ⎠ ⎣ 1 + 0.05(180 360 ) ⎦ Since the end user had a short position he must pay $4,878 to the dealer Reference: CFA® Program Curriculum, Volume 6, pp. 40‐43. 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. B. C. D.
Party X pays Yen 110 million, and Party Y pays U.S. dollars 6 million. Party Y pays Yen 110 million, and Party X pays U.S. dollars 6 million. Party X pays Yen 11,110 million, and Party Y pays U.S. dollars 106 million. Party Y pays Yen 11,110 million, and Party X pays U.S. dollars 106 million.
Correct Answer:
A ......................................................................................... LOS: Reading 74‐b
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. Reference: CFA® Program Curriculum, Volume 6, pp. 130‐134.
Derivative Investments 469 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.
470 Study Session 17: 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. B. C. D.
$2. $6. $8. $14.
Correct Answer:
B...........................................................................................LOS: Reading 75‐a
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. Reference: CFA® Program Curriculum, Volume 6, pp. 154‐158. 20. A portfolio insurance strategy for a diversified stock portfolio can be implemented by: A. B. C. D.
buying a put option on the stock index representing the underlying stock portfolio. writing a put option on the stock index representing the underlying stock portfolio. buying a call option on the stock index representing the underlying stock portfolio. writing a covered call option on the stock index representing the underlying stock portfolio.
Correct Answer:
A ......................................................................................... LOS: Reading 75‐b
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. Reference: CFA® Program Curriculum, Volume 6, pp. 162‐165.
Derivative Investments 471 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.
472 Study Session 17: 21. The least likely benefit for an investor if a market includes financial derivatives is: A. B. C. D.
price discovery. trading efficiency. regulatory protection. instruments available for risk management.
Correct Answer:
C .......................................................................................... LOS: Reading 70‐c
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. Reference: CFA® Program Curriculum, Volume 6, pp. 20‐22.
Derivative Investments 473 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. B. C. D.
pays $1 million. pays $1.5 million. receives $1 million. receives $1.5 million.
Correct Answer:
C ..........................................................................................LOS: Reading 74‐b
The payment received is $100 million x (9% - 8%) = $1 million. Reference: CFA® Program Curriculum, Volume 6, pp. 134‐138.
474 Study Session 18:
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.
476 Study Session 18: 1. Capital provided to a company that is close to going public is: A. B. C. D.
first-stage financing. third-stage financing. mezzanine financing. second-stage financing.
Correct Answer:
C ..........................................................................................LOS: Reading 76‐g
Mezzanine or bridge financing is given to companies who are planning to go public in the near term. Reference: CFA® Program Curriculum, Volume 6, pp. 201‐202. 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. Correct Answer:
C ..........................................................................................LOS: Reading 76‐g
Entrepreneurs often have weak management skills so the venture capitalist can help in providing direction and strategic guidance to the company. Reference: CFA® Program Curriculum, Volume 6, pp. 202‐204.
Alternative Investments 477 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.
478 Study Session 18: 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. B. C. D.
a futures fund. a long/short fund. an event-driven fund. a market-neutral fund.
Correct Answer:
C .......................................................................................... LOS: Reading 76‐i
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. Reference: CFA® Program Curriculum, Volume 6, pp. 211‐213. 4. One of the reasons that the shares in closely held companies usually trade at a discount to publicly traded securities is: A. B. C. D.
the shares are less liquid. they have high market betas. investors often hold a majority stake. 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. Reference: CFA® Program Curriculum, Volume 6, pp. 223‐224.
Alternative Investments 479 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.
480 Study Session 18: 5. An investor in an Exchange Traded Fund (ETF) is exposed to tracking error risk; this is the risk that: A. B. C. D.
the bid-ask spread for shares in the ETF widens. the ETF fails to make dividend payments to investors. the currency the fund is denominated in does not track the U.S. dollar. the fund does not closely replicate the performance of the index that it is following.
Correct Answer:
D .......................................................................................... LOS: Reading 76‐c
Tracking error is a measure of the deviations between ETF returns and the index returns. Reference: CFA® Program Curriculum, Volume 6, pp. 186‐187. 6. Which of the following is the least accurate description of a characteristic of commodity investment, based on historic data? A. B. C. D.
It offers inflation protection. It has low volatility of returns. It produces attractive returns in periods of economic growth. 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. Reference: CFA® Program Curriculum, Volume 6, pp. 225‐227.
Alternative Investments 481 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.
482 Study Session 18: 7. Investors in hedge funds are least likely to be motivated by which of the following? A. B. C. D.
Consistent returns across the different categories of hedge funds. The low volatility of returns from hedge funds compared to equity returns. Higher average returns provided by hedge funds compared to other investments. 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. Reference: CFA® Program Curriculum, Volume 6, pp. 217‐219. 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. Correct Answer:
C ..........................................................................................LOS: Reading 76‐g
Trade sales refer to a venture capital investment being sold to or merged with another company. Reference: CFA® Program Curriculum, Volume 6, p. 204.
Alternative Investments 483 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.
484 Study Session 18: 9. Which of the following is least likely to be used as a method of valuing real estate? A. B. C. D.
Cost approach. Income approach. Balance sheet approach. Discounted cash flow approach.
Correct Answer:
C ..........................................................................................LOS: Reading 76‐e
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. Reference: CFA® Program Curriculum, Volume 6, pp. 190‐198. 10. The prices of hedge funds are often smoothed because: A. B. C. D.
they use arbitrage strategies. the managers are risk averse. they are actively dealing in derivative exchanges. 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. Reference: CFA® Program Curriculum, Volume 6, pp. 220‐221.
Alternative Investments 485 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.
486 Study Session 18: 11. Investors in a load open‐end fund: A. B. C. D.
purchase shares at the net asset value. purchase shares at a discount to the net asset value. pay an annual management charge which is called a load. purchase shares at the net asset value plus an initial charge.
Correct Answer:
D ..........................................................................................LOS: Reading 76‐a
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. Reference: CFA® Program Curriculum, Volume 6, pp. 177‐180. 12. The objective of a stock market index fund is to: A. B. D. C.
track the return from the stock market index. outperform the return from the stock market index. generate a return which is independent of the stock market return. generate a return which is higher then the CPI index by investing in equities.
Correct Answer:
A ......................................................................................... LOS: Reading 76‐b
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. Reference: CFA® Program Curriculum, Volume 6, p. 180.
Alternative Investments 487 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
488 Study Session 18: 13. Which stage of venture capital financing is when capital is provided for product development and research? A. B. C. D.
Seed financing. Start-up financing. First-stage financing. 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. Reference: CFA® Program Curriculum, Volume 6, pp. 201‐202. 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: A. B. C. D.
Market capitalization rate lower lower higher higher
Correct Answer:
Valuation lower higher lower higher
B........................................................................................... LOS: Reading 76‐f
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. Reference: CFA® Program Curriculum, Volume 6, pp. 193‐194.
Alternative Investments 489 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.
490 Study Session 18: 15. The after‐tax cash flow from a real estate investment adjusts the net operating income for all of the following except: A. B. C. D.
cost of debt. proceeds from sale of property. depreciation expense less tax savings. taxation on capital gains when the property is sold.
Correct Answer:
C .......................................................................................... LOS: Reading 76‐f
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. Reference: CFA® Program Curriculum, Volume 6, pp. 193‐198. 16. Investing in a hedge fund is least likely to be attractive because: A. B. C. D.
the returns are higher than those available on equity funds. the volatility of returns is lower than that of a fund investing in equities. the fund will provide greater transparency than a traditional mutual fund. 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. Reference: CFA® Program Curriculum, Volume 6, pp. 207‐210.
Alternative Investments 491 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.
492 Study Session 18: 17. In the U.S. global funds refer to funds that: A. B. C. D.
only invest outside the U.S. are only marketed outside the U.S. invest in both the U.S. and internationally. are marketed in both the U.S. and internationally.
Correct Answer:
C ......................................................................................... LOS: Reading 76‐b
‘Global funds’ refer to funds that are investing in both the U.S. and international markets. Reference: CFA® Program Curriculum, Volume 6, p. 177. 18. The role of venture capital investors is least likely to include: A. B. C. D.
assisting companies to go public. providing financing to small privately held companies. assisting the companies that they invest in with strategic planning. making a market in the shares of their investments that have gone public.
Correct Answer:
D ..........................................................................................LOS: Reading 76‐g
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. Reference: CFA® Program Curriculum, Volume 6, pp. 200‐202.
Alternative Investments 493 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
4%
None
Redemption fees
None
5% in the first year but declining by 1% point each year thereafter
Annual expenses
Front‐end fees
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%
494 Study Session 18: 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
4%
None
Redemption fees
None
5% in the first year but declining by 1% point each year thereafter
Annual expenses
Front‐end fees
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% Correct Answer:
B...........................................................................................LOS: Reading 76‐a
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%.
Reference: CFA® Program Curriculum, Volume 6, pp. 178‐180.
Alternative Investments 495 20. 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
4%
None
Redemption fees
None
5% in the first year but declining by 1% point each year thereafter
Annual expenses
Front‐end fees
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 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%
496 Study Session 18: 20. 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
4%
None
Redemption fees
None
5% in the first year but declining by 1% point each year thereafter
Annual expenses
Front‐end fees
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 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% Correct Answer:
A ..........................................................................................LOS: Reading 76‐a
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%.
Reference: CFA® Program Curriculum, Volume 6, pp. 178‐180.
Alternative Investments 497 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 Probability of failure
1
2
3
4
5
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.
498 Study Session 18: 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. Correct Answer: NOI
D .......................................................................................... LOS: Reading 76‐f
= 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. Reference: CFA® Program Curriculum, Volume 6, pp. 193‐194.
Alternative Investments 499 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 Probability of failure
1
2
3
4
5
0.40
0.35
0.25
0.20
0.20
The expected net present value (NPV) of the project is closest to A. B. C. D.
$159,400. $346,400. $870,000. $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
Reference: CFA® Program Curriculum, Volume 6, pp. 205‐207.
500 Study Session 18:
2008 JUNE EXAM 15 February 2008 Second deadline for new CFA Program enrollments and exam registrations to be received by CFA Institute March 2008
Online sample exams available
17 March 2008 Final deadline for new CFA Program enrollments and exam registrations to be received by CFA Institute 17 March 2008 Final deadline for disability accommodation requests and requests for religious alternative dates to be received by CFA Institute 17 March 2008
All test center change requests must be received by CFA Institute
Late April 2008
Exam admission tickets available online
7 June 2008
Exam date and 8 June 2008
June‐July 2008
Exams graded
Late July 2008
Exam results available online for Level I candidates
Exam date in Eastern Asia and Oceania
Late August 2008 Exam results available online for Level II and III candidates
2008 DECEMBER EXAM 17 March 2008 First deadline for new CFA Program enrollments and exam registrations to be received by CFA Institute 15 August 2008 Second deadline for new CFA Program enrollments and exam registrations to be received by CFA Institute 15 September 2008 Final deadline for new CFA Program enrollments and exam registrations to be received by CFA Institute 15 September 2008 Final deadline for disability accommodation requests and requests for religious alternative dates to be received by CFA Institute 15 September 2008 All test center change requests must be received by CFA Institute October 2008
Online sample exams available
Late October 2008 Exam admission tickets available online 6 December 2008 Exam date and 7 December 2008 Exam date in Eastern Asia and Oceania December 2008
Exams graded
January 2009
Exam results available online
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.
502 Exhibit
FREE Author Collaberation: With the purchase of this book you also receive the following communications free!
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.
This is a free Feature for CFA Candidates of all levels. http://www.financialexams.com/ContentPages/DrHarvey/tabid/71/D efault.aspx
Thank you for reading our book
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 moment in the life of an asset Convert assets into profit to return to Inv or Stkhldrs Equity
Income Statement
Balance Sheet Assets
Sales
Profit
Assets come into Balance Sheet in SE to get to Assets
Stk Eqty Investors Decisions Income Statement
Statement of Cash Flows
Sales - COGS
CFO
CFI
CFF
Gross Margin Expenses EBIT - Interest EBT - Tax EAT
Inventory stored converted to product CEOs look at things from viewpoint of Cash Flow ... to pay bills, liquidity
Balance Sheet
Operating
Investment Financing
FA LTD SE
A growing company never has cash enough collection to grow the inventory.
Sale
Cash Collection
CL AP
and
Operation Cycle Acquire Inventory
CA AR Inv
CEO is always for looking something which will grow cash.
Newspaper cycles daily, Boeing could take 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 Value
Long Put Value V>0
V>0
Positive
Value of the long put will be the amount less than the strike that the stock is trading. Long put will never have a value less than zero.
positive
0 negative
S X
Value of the long call will be the amount over strike the stock is trading. Long call will never have a value less than zero.
0 X negative
X S
Short Call Value
Short Put Value
V<0
Positive
0 negative
S X
Value of the short call will be the amount over the strike the stock is trading. Short call will never have a value greater than zero.
V<0
Positive
0 negative
X S
Value of the short put will be the amount less than the strike the stock is trading. Short put will never have a value greater than 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
0 cost of C
Loss
X
X+C Å stock price Æ
Profit of the long call is the amount over the strike + cost of the call (X+C). Loss on the call is the amount the stock is under the call + strike, not to exceed the cost of the call.
0 cost of P Loss
X
Å stock price Æ
Short Call
Short Put
Loss > X+C, Profit < X+C Profit Rec’d fm C
0 Loss
X
X+C
Å stock price Æ
X+P
Profit the long put is the amount under the strike and cost of the put. Loss on the put is the amount the stock is over the strike, not to exceed the cost of the put.
Profit of the short call is the amount under the strike + cost of the call (X+C), not to exceed the proceeds received from the call. Loss on the call is the amount the stock is over the call + strike.
Loss > X, Profit > X Profit
Profit the short put is the amount more than the strike of the put, not to exceed the proceeds received from the put. Loss on the put is X+P the amount the stock is less than Å stock price Æ the strike.
Rec’d fm C
0 Loss
X
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 shareholders
- Taxes
Gov’t happy
EAT
Stockholders happy
earns
for
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 [ (S) (EBDIT) - D - I ] (1-t) pending ratio Depr Inter tax sales per shr Exp adj
We know last year’s P & P/E Can calc next year’s earnings then Proportion via P/E to get Pproj EOY Pproj EOY = (EProj EOY) (P/E) Earnings, DDM & ROE Calc P = Div / Earn E k–g
Dividend pay-out k-g
(Retention) (ROE) k = Real Rate + Interest Prem + Risk Prem Tax * Interest * Oper’g * Asset Nominal rate should really multiply Reten Burden Profit Turnover 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 * EBT EBIT P0 = D 1 k-g WACC = (weke) + (wdkd)
EBIT * Sls Sls
Assets
ReturnEstimated = Cash Div + PriceEnd - PriceNow PriceNow
restate:
EBIT * Sls * Sls Assets
Assets Equity
Oper Total -Interest Financial * Tax Profit * Asset Expense * Leverage Retention Margin Turnover Rate Multiplier Rate
P0 = D 1 k-g T)
P0 = D 1 k-g
* Financial Leverage
k= D +g P
-
Assets
Bad
Int
* Assets
Equity
side
*
(1 -
Note: tax ret (1-t)
Good
side
f
= k = Rf + β(Rm - Rf) also k = (1+RR)(1+IP)(1+RP) 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 Current Liabilities Quick ratio Acid Test
Cash + mkt sec + AR CL
Working Capital = CA - CL
not include. inventory a.k.a. Quick Ratio
CA - Inv CL
Cash ratio
Cash + mkt sec CL
Receivables Turnover Days Receivable Working Cap / Sales
even more conservative
Avg collection: Net Annual Sales Avg Receivables 365 Avg Receivables
365 Annual Turnover
Avg # of days to get paid
higher % indicates more liquidity CA - CL Net Sales
@ payable period: 365 Payables Turnover COGS @ 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: Inventory Turnover
sales per something @ Inventory period COGS @ Inventory
365 Inventory
Turnover Total Asset Turnover Fixed Asset Turnover
high or low relative to industry? Net Sales @ Tot Net Assets low: tie up too much assets utilization of fixed assets Net Sales @ Net Fixed Assets hi: old depr equipment
Appendix A: 511 Equity Turnover
excludes CL & LT Debt Net Sales Average Equity Avg collection period: Net Annual Sales Avg Receivables
Receivables Turnover
365 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 Net Sales
(GP = Sls - COGS) relative cost price position in industry?
Operating Profit Margin
Operating Profit Net Sales
(EBIT) variability is business risk indicator
Net Profit Margin
Net Income Net Sales
NI = EAT
EBT Margin
before tax profit margin
EBT 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 Return on Owners Equity Return on Equity (ROE):
Net Income @ Total Equity
ROE
Net Income – Preferred Dividend @ Common Equity DuPont System duPont formulation ROE = NI / Equity or EAT/Equity
512 Exhibit 3 Step ROE =
NI
=
Net Equity
* Asset * Financial a.k.a.Equity Multiplier Profit Turnover Leverage Margin NI Sls
4 Step ROE
=
NI
= Tax Equity
*
Oper
* Total Profit Margin EBIT Sls
*
Assets Equity
Note:(Sls)(Assets) (Sls)(Assets)
* Interest * Oper’g * Asset * Financial Reten Burden Profit Turnover Leverage NI * EBT
5 Step Equation =
Sls Assets
*
EBT * EBIT EBIT Sls
*
Sls Assets
*
Assets Equity
Interest Financial * Tax Asset Expense * Leverage Turnover Rate Multiplier Sls Assets
-
Int Assets
*
Assets Equity
Retention Rate *
(1 - T)
Financial Risk: Uncertainty of returns to equity holders due to a firm’s use of fixed obligation debt securities Debt / Equity
LTD / LT Cap
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 = Long Term Debt
LT Cap = Long Term Capital
Total Debt / Total Capital NI + Tax + Int Exp EBIT Interest Expense Int Exp (Note: Look for this on the exam
Interest Coverage
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) Mean Operating Earnings Sales Volatility sd of sales mean sales
need 5
10 yrs to compute coef of variation
Coefficient of Variation of Sales CV = σ/mean prime determinant of earnings variability
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.
516 Practice Exam Features
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.
Practice Exam Features 517
FinancialExams Quizzer Features 1.
Each database contains 200 to 1200+ questions 3. Easy to upgrade
2.
5.
Essay style questions
6.
7. 9. 11.
Performance based questions Questions randomized Print a category of questions
8. 10. 12.
13. 15. 17.
Single module studies Simulation exam studies Instant exam feedback
14. 16. 18.
Statistical analysis Individual exam analysis Font selection Graphics User Notes creation Some Links to Electronic Book content 31. Free version updates via email
20. 22. 24. 26. 28. 30.
19. 21. 23. 25. 27. 29.
4.
32.
Easy to install Multiple choice Style questions Fill-in-the-blank Style questions Flash Card Style questions Hot Spot Style questions Drag/Drop/Mix/Match questions Answers randomized Print one question Cheat key or Flash Card option Instant question feedback Adaptive exam studies Skills assessment Historical analysis Resizable screen Most have Explanations References
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: [email protected] [email protected] [email protected]
Telephone: Toll Free: International: Fax:
(888) 992-3131 (281) 992-3131 (281) 482-5390
518 Practice Exam Features
Changing subjects FinancialExams Quizzer provides several practice exams to test your knowledge. To change exams: 1. 2. 3.
Click the Change Exam button in the Main window. Select the exam for the test you want to run from the Select Exam window. 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. 2. 3.
Click on the box to the right of the Number of Questions field in the Main window. Type a number of questions, between 1 and 250, in the Number of Questions field. 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. 2.
From the Subcategories frame, select the desired general category from the Categories drop down list. 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. 2. 3. 4.
Select Options from the View pull-down menu. Select the Printing Options radial button. The Printing Options window appears. Select the options for your printer. 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.
Practice Exam Features 519
Using FinancialExams Quizzer options FinancialExams Quizzer provides a number of additional options to customize your test. The following options are available: 1 2 3 4
Stop On Wrong Answers Enable Cheat Key Resizable Screen 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. 2. 3. 4. 5.
Clear the Historical Analysis Take four (4) adaptive exams in a row. Study the contents after each adaptive exam. View the historical analysis to identify your strength and weakness at the end of the four (4) adaptive exams. Go back to reviewing using the Study Sessions by Sub Category Repeat process until you are ready to pass the real exam.
Take the Adaptive Exam 1. 2. 3.
4.
Click the Adaptive Exam radial button from the Main window. Click the Start button. The Adaptive Exam window appears. 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). Click the Next button to continue.
520 Practice Exam Features 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. 2.
Click the Correct Answer button. 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. 2.
Select the Study Session radial button. 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.
Practice Exam Features 521
Checking your score during a test The X% button displays the current percentage of questions that have been answered correctly. 1. 2.
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. 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. 2.
3.
Click the Historical Analysis button from the Main window. The Historical Analysis window appears. 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. 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).
522 Practice Exam Features 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. 2.
Click the Correct Answer button. 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. 2. 3. 4. 5.
You should not view the answer until you have thought about the answer. You have an unlimited time limit to think about each question. Use this option a few days before the real exam to go through a lot of questions in a short period of time. The FlashCard option can be used as a review of all questions in the database. Use the FlashCard option to provide Positive Feed Back with Correct Answers.
Practice Exam Features 523
Starting a FlashCard Session After you choose a subcategory to test yourself on, start FlashCards. 1. 2.
3. 4. 5.
Select the FlashCards Session radial button. 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. This is the time to THINK of the answer. Pause a moment than hit the F4 function on your keyboard. (CheatKey) Review the displayed answer. Did you get it correct? 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
Special: Free Financial Forum Access: Visit http://www.financialcertification.com FREE Demo at www.financialcertification.com/cfademo
ebooster 527
ebooster limited is the authorized distributor for TotalRecall Publications materials in Europe, the Middle East and Africa. We stock the full range of TRP products and charge at competitive prices, especially for volume orders. Come to us direct or order from your favorite distributors and retailers including Amazon.co.uk, Waterstones, Borders, Books Etc., Gardners and Bertram Books.
e/booster limited FAO: Chris MacNeil 502, trottenham Court Rd London, England W1T 1JY
Office +44 (0) 207 993 2253 Fax +44 (0) 207 993 2253
email: [email protected]
Web Site www.ebooster.co.uk
Download Instructions The Financial Certification Center (TFCC) version 4.0 Chartered Financial Analyst (CFA) Level 1 Exam System Requirements: Windows 95 & 98, Windows NT, Windows 2000/XP, and Windows Server 2003 with a minimum of 40 MB hard disk space and 64 MB RAM The Center For Financial Certification, Inc. will help you accomplish your CFA Certifications. This state of art software program is designed to cut your study time in half, and get you to a passing knowledge level in the easiest and shortest amount of time possible. The program will adapt to you personally, and then lay out a prioritized study plan that will visually show you your progress on a day to day basis. When the software has recognized that you are at a passing level in each objective category, you're ready to sit for the exam. It's really that easy! Installation Instructions: To obtain the FE practice exam simply visit the engine download link. TotalRecall CFA Level I Practice Exam and Engine Download * Click on the link or copy it to your browser http://snipurl.com/2008CFAL1eWBZ to download the software. When the computer prompts you to open or save, choose ʺsave this file to disk.ʺ Select the location for the download file CFA2008eWorkBook.ZIP License Key
1. FE-JV 2008_ConceptCheckQuestions 400 = 313112131882 2. Financial Terminology Evaluation = 322478807587 Visit: http://www.financialexams.com/member_signup.php http://www.financialcertification.com/forum/registration_rules.asp or contact [email protected] for Download and Installation Instructions: Please use InsidersChoice Workbook as the Subject. Starting FinancialExams To start the program the next time (if it doesn’t start automatically), select FinancialExams from the Program’s menu. Assistance with running and using FE is available under the Help menu.
FREE Content Downloads and Financial Forums Call 281-992-3398 888-992-3398 www.financialexams.com www.cfaexams.com Good Luck with your certification! Your Book Registration Number is IC-94501-3000
