CFA Institute CFA Institute Certifications CFA-LEVEL-1 Questions & Answers

• Question 801:

  While working abroad, United States citizen Elpida Costa purchases a foreign bond with an annual coupon

  of 10.0 percent for par. She holds the bond for one year and then sells it for 103.6 before she leaves.

  During the year, the dollar depreciated 2.0% relative to the foreign currency.

  Which of the following is closest to Costa's Total Dollar Return?

  A. 11.328%.

  B. 13.600%.

  C. 15.872%.

  D. 5.672%.

  Correct Answer: C

  TheTotal Dollar Returnis calculated as follows:

  Step 1: Calculate the value change in the foreign currency:

  The dollardepreciated0.02, so the foreign currencyappreciatedby 0.02, or 2.0%.

  Step 2: Use the Total Dollar return formula to calculate the return:

  R$= { [ 1+($coupon + VEND- VBEG)/ VBEG] * (1 + g) } - 1,

  WhereR$=Total dollar return,VEND= Bond value at end of period,VBEG =Bond value at end of period,

  andg= % change in thedollarvalue of the foreign currency.

  Here,R$= { [ 1+(10.0 + 103.6 ?100.0)/100.0 ] * (1 + 0.02) } - 1

  = { [1.13600 ] * (1.02) } - 1

  = 0.15782, or15.782%

• Question 802:

  Kira Trace, research analyst at an investment banking firm, took the Level 1 CFA examination in 2001, but did not pass. Last year, she studied alone, and only for one-month before the exam. This year, she is starting earlier and is working with a mentor, Anton Park, CFA. While discussing asset pricing models with Park, Trace makes the following statements. Park can see that Trace still needs to study this area because only one of her statements is correct. Which statement is CORRECT?

  A. According to the Capital Asset Pricing Model (CAPM), the rate of return of a portfolio with a beta of 1.0 and an alpha of 0 is the market expected return.

  B. Assuming assets are not perfectly positively correlated, the systematic risk of a portfolio decreases as more assets are added.

  C. Adding the risk-free asset to a portfolio will reduce return and total risk.

  D. It is difficult for the individual investor to achieve the benefits from diversification because significantly reducing risk requires the purchase of approximately 1,000 securities.

  Correct Answer: A

  Diversification reduces unsystematic or unique risk. With the risk-free asset and a portfolio of risky assets, the equation for the expected standard deviation is linear:wA . A combination of the risk free asset and a portfolio always gives more return for a given level of risk. Risk tends to be reduced, but assuming that assets are not perfectly positively correlated, an investor can achieve the benefits of diversification by adding just one security (Markowitz). Studies have shown that approximately 18-30 stocks are needed for proper diversification. The main point is that the number ofstocks required is small and is significantly less than all securities (and significantly less than 1,000 securities).

• Question 803:

  Consider the following graph of the risk-free asset Rf and the efficient frontier. The letters K, W, X Y, and Z represent risky portfolios. Portfolio M is the market portfolio. The linesRfXandRfYrepresent the combination of the risk-free asset and the risky portfolio.

  Which of the following statements about the above graph is FALSE?

  A. The area to the right of point S represents unsystematic risk, or risk that is not paid for.

  B. Assets W and Z are perfectly positively correlated with each other.

  C. By definition of the capital market line (CML), portfolio K is possible, but not the most efficient because it does not fall on the efficient frontier and is overvalued.

  D. Investors on the capital market line (CML) to the right of M are leveraged and hold more than 100% of portfolio M.

  Correct Answer: C

  By definition, all stocks and portfolios other than M, the market portfolio, fall on or below the CML. Thus, K

  is not a possible portfolio on this graph. Overvaluation/undervaluation is usually expressed in relation to the

  SML (security market line).

  The other statements are true.

• Question 804:

  Duncan Manz believes that he has found an error in a sample CFA Study Program question. Prior to emailing the provider about the error, he discusses his logic with Julia Cook, a fellow finance student at the Hess School of Business. Manz does not believe that the following question provides enough information to completely answer the question. Cook disagrees. Who is correct ?Manz or Cook? And, if Cook is correct, what is the correct answer? Question: An investorportfolio currently consists of 100% of stocks that have a mean return of 18 percent and an expected variance of 0.0625. The investor plans to diversify slightly by replacing 30 percent of her portfolio with U.S. Treasury bills that earn 4.25 percent. Assuming the investor diversifies, what are the expected return and expected standard deviation of the portfolio?

  A. Cook is correct. The portfolio's expected return is 13.875%and the expected standard deviation is 4.375%.

  B. Cook is correct. The portfolio's expected return is 18.000% and the expected standard deviation is 15.250%.

  C. Manz is correct. There is not enough information to completely answer the question.

  D. Cook is correct. The portfolio's expected return is 13.875% and the expected standard deviation is 17.500%.

  Correct Answer: D

  Cook is correct. Since Treasury bills (T-bills) are consideredrisk-free, we know that the standard deviation

  of this asset and the correlation between T-bills and the other stocks is 0. Thus, we can calculate the

  portfolio expected return and standard deviation.

  Step 1: Calculate the expected return:

  Expected ReturnPortfolio= (wT-bills* ERT-bills) + (wStocks* ERStocks)= (0.30) * (0.0425) + (1.00 - 0.30) *

  (0.18) = 0.13875, or 13.875%.

  Step 2: Calculate the expected standard deviation:

  When combining a risk-free asset and a risky asset (or portfolio of risky assets), the equation for the

  standard deviation of 1,2= [(w12)( 12) + (w22)( 22) + 2w1w2 1 2r1,2]1/2reduces to: Portfolio= [(wStocks)

  ( Stocks)] = 0.70 *

  0.06251/2= 0.17500, or 17.500%. (Remember to convert variance to standard deviation.)

• Question 805:

  Which of the following statements about portfolio theory is TRUE?

  A. According to Markowitz, the appropriate measures of risk include variance, semivariance, and covariance.

  B. There are no perfectly positively or perfectly negatively correlated stocks.

  C. A correlation coefficient of zero means that combining the securities eliminates risk.

  D. Risk decreases as the correlation coefficient goes from -1 to +1.

  Correct Answer: B

  Markowitz was the first to identify this. The lack of perfect positive or negative correlation gives rise to the efficient frontier shape. Covariance is a measure of movement, not of risk. A correlation coefficient of zero means that the returns are uncorrelated. A correlation coefficient of negative one means that risk can go to zero. Adding a security with a correlation coefficient of zero may reduce risk, but risk will not be eliminated. Risk increases as the correlation coefficient goes from ? to +1. Risk decreases as the correlation coefficient goes from +1 to -1.

• Question 806:

  Assume that a U.S. investor can invest in two asset classes: Domestic and Foreign Bonds. The data in the following table are risk and return data calculated in U.S. Dollar terms. Given this data, which of the following choices is most likely the correct risk/return combination for a portfolio weighted 50 percent in domestic bonds and 50 percent in foreign bonds?

  A. Risk of 7.50%, Return of 8.25%.

  B. Risk of 8.00%, Return of 10.90%.

  C. Risk of 6.00%, Return of 9.25%.

  D. Risk of 10.00%, Return of 13.50%.

  Correct Answer: C

  According to portfolio theory and the principle of diversification, we would expect that adding more of a security that has a low correlation to an existing portfolio would lower the portfolio risk. Since the correlation between foreign and domestic bonds is low at 0.50, we would expect the risk of the portfolio to decline below 8.00% when we replace domestic bonds with foreign bonds. This narrows the possible correct responses to the two with risk less than 8.00%. In addition, we would expect the return to increase, as the return on foreign bonds is higher than that on domestic bonds, butremain slightly lower than that for the portfolio that is 20% domestic and 80% foreign. We can calculate the estimated portfolio return as the weighted average of returns for the individual asset classes. (0.50 * 12) + (0.50 * 6.5) = 9.25%

• Question 807:

  Maxime Rivela, CFA, is interviewing for a portfolio manager position with a medium-sized investment firm. At the interview, the hiring manager provides the following list of actions taken by the former portfolio manager. The hiring manager asks Rivela to identify which action most likely was the reason that the previous portfolio manager was asked to resign. The former portfolio manager likely:

  A. managed a 40 year old attorney's portfolio with a strategy of a long time horizon and moderate risk.

  B. used the following four-step portfolio management process - write a policy statement, develop the investment strategy, implement the plan, and monitor and update (rebalance) as needed.

  C. set the objectives for a well-funded, local private college's endowment fund as total return focused primarily in long-term, taxable investments.

  D. focused on timing and security selection when constructing a client investment strategy.

  Correct Answer: D

  Even though these two investment decisions (timing and individual security selection) add value to the portfolio, the real foundation of returns comes from the original asset allocation policy decisions (determining allowable asset classes and weighting these classes). Empirical studies have shown that 85 percent to 95 percent of a portfolio's total return comes from the asset allocation policy decision. The other choices describe appropriate actions. The 40 year old attorney is most likely in the consolidation phase of the investing life cycle, and a long time horizon and moderate risk strategy are appropriate. The steps in the four-step portfolio management process are correct and are listed in the correct order. The objective and investments for the endowment fund appear appropriate given the information in the question. Since endowments are tax-exempt, it would not necessarily benefit from tax-exempt securities.

• Question 808:

  In the context of the security market line (SML), the expected (or required) return will decrease in the following situations EXCEPT:

  A. The U.S. Federal Reserve takes action that tightens the capital markets.

  B. Leading market indicators decrease, causing consumers to expect lower inflation levels.

  C. A firm announces that it has won a major product-liability lawsuit.

  D. The growth in the U.S. economy is expected to slow from 2.7% last year to 1.5% this year.

  Correct Answer: A

  If the capital markets tighten, the SML will shift upward in a parallel manner, resulting in a higher required return. If the capital markets loosen, the SML will shift downward in a parallel fashion, resulting in a decrease in expected return. All other choices result in a downward shift in the SML. After the lawsuit is "won," investors would likely view a firm as less risky and would move down along the SML to require a lower return. If economic growth decreases or if inflation decreases, the SML will shift downward in a parallel fashion. Investment growth opportunities are determined by the economy's long-term growth rate and factor into the real risk-free rate, which is a component of required return. When the growth rate decreases, investors who supply capital require a lower rate of return.

• Question 809:

  Nicki Tobin, CFA candidate, has just started studying portfolio management. She notes the following similarities between the graphical representations of the fundamental and systematic views of risk. Which one of her observations is INCORRECT? For both views of risk:

  A. the y-axis represents expected return.

  B. investors require a higher expected return for riskier investments.

  C. investors demand a risk premium above the nominal risk-free rate.

  D. the graphs plot the market's risk premium against expected return.

  Correct Answer: D

  The systematic view of risk is that the security's required risk premium is a function of its systematic, or non diversifiable risk, while the fundamental view of risk is that the security's risk premium is a function of its total risk. However, the market's risk premium is not on either axis for either view. The fundamental view plots total risk versus expected return, and the systematic view plots beta (systematic risk) versus expected return. Although both views use the concept of a risk premium over the risk-free rate, the calculation differs. The risk premiumFundamental view= total risk = business risk + financial risk + liquidity risk + exchange rate risk + country risk. The risk premiumsystematic view= Expected ReturnMarket? Nominal ReturnRisk-Free. The equation for the stock's risk premium is: [Expected ReturnMarket?Nominal ReturnRisk-Free] * Beta.

• Question 810:

  An investor has two stocks, Stock R and Stock S in her portfolio. What is the standard deviation of the portfolio given the following information about the two stocks?

  A. 0.0056.

  B. 0.0867.

  C. 0.2944.

  D. 0.0208.

  Correct Answer: C

  Standard deviation of a two-stock portfolio = [W1212+ W2222+ 2W1W212r1,2]1/2=[(.8)2(.34)2+ (.2)2(.16)2

  + 2(.8)(.2)(.34)(.16)(.67)]1/2= 0.29439