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

• Question 811:

  An overvalued stock is one whose:

  A. estimated return is more than the required return.

  B. return is expected to be less than the expected market return.

  C. estimated return is less than the required return.

  D. return is expected to be greater than the expected market return.

  Correct Answer: C

• Question 812:

  Which of the following statements about international portfolio investing is FALSE?

  A. The majority of risk for individual foreign country markets is unsystematic.

  B. When markets are volatile, global diversification is of increased value.

  C. Barriers to international diversification include lack of liquidity, currency controls, and exchange rate risk.

  D. While the introduction of foreign stocks ("second layer") into a domestically-only diversified portfolio shifts the efficient frontier up and left, adding a "third layer" of foreign bonds shifts the efficient frontier even more up and left.

  Correct Answer: B

  When markets are volatile, global diversification is of limited value. Studies show that correlations between

  markets increase as market volatility increases, which limits the benefits of diversification. In particular,

  studies show that correlations increase when markets are falling.

  The other statements are true. Although foreign exchange risk is not considered a factor that impacts

  correlations, it is a significant barrier to international investing.

• Question 813:

  While in the managerial training program for a large multinational corporation, Daniel Waite is assigned a one-year rotation in the Mediterranean. Upon arriving at the assignment, he purchases a local (foreign currency) bond with an annual coupon of 8.5 percent for 96.5. He holds the bond for one year and then sells it for 98.0. Waite is pleased with his return, which he calculates at 10.4%. On the plane ride home, Waite is seated next to his fellow coworker, Penny King, who begins to talk about the depressed local economy and the negative returns she had experienced on her local bond investments over the same period as Waite. She states that her total dollar return on an 8.0 percent annual coupon bond purchased at the same time as Waite's for 95.0 and sold for 98.0 (at the same time as Waite's) was a disappointing negative 10.737%. Assume that King's calculation is correct and that Waite made some calculation error. Which of the following is closest to Waite's actual total dollar return?

  A. -32.435%.

  B. -10.363%.

  C. -18.756%.

  D. -11.712%.

  Correct Answer: D

  Waite forgot to take into account the impact of the percentage change in the dollar value of the foreign

  currency.

  Using the information provided by King, we can calculate the percentage change in the value of the foreign

  currency and then calculate Waite's total dollar return. Using the formula for total dollar return of:

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

  -0.10737= { [ 1+(8.0 + 98.0 ?95.0)/95.0 ] * (1 + FChange) } - 1

  -0.10737 = { [1.115789] * (1 + FChange) } - 1

  -0.2000 = FChange, or 20.0% depreciation.

  Now, we can calculate Waite's total dollar return.

  R$ Waite= { [ 1+(8.5 + 98.0 - 96.5)/96.5 ] * (1 - 0.20) } - 1

  R$ Waite= -11.712%

• Question 814:

  Which of the following statements about Arbitrage Pricing Theory (APT) and the Capital Asset Pricing Model (CAPM) is FALSE?

  A. APT can equal CAPM.

  B. In both the APT and the CAPM, the risk-free rate is added to a premium for risk factor (X) and the responsiveness of the asset's returns to factor (X).

  C. If zero-investment arbitrage does not hold, the APT does not hold.

  D. APT is a multi-factored model with restrictive assumptions.

  Correct Answer: D

  Arbitrage Pricing Theory is a multifactored model with few limiting assumptions. More than one risk factor is able to influence security prices. The other statements are true. Arbitrage Pricing Theory can equal the Capital Asset Pricing Model (CAPM) if there is only one risk factor ?market risk. Zero-investment arbitrage is an assumption of the APT. More specifically, zero-investment arbitrage means that if an investor buys an overpriced security, the investor has access to the short-sale money needed to buy an underpriced security.

• Question 815:

  Which of the following statements about portfolio management is TRUE?

  A. As an investor diversifies away the unsystematic portion of risk, the correlation between his portfolio return and that of the market approaches negative one.

  B. The security market line (SML) measures systematic and unsystematic risk versus expected return; the CML measures total risk.

  C. Combining the capital market line (CML) (risk-free rate and efficient frontier) with an investor's indifference curve map separates out the decision to invest from the decision of what to invest in.

  D. The expected return on a 0 beta security is the expected market return.

  Correct Answer: C

  Combining the CML (risk-free rate and efficient frontier) with an investor's indifference curve map separates out the decision to invest from what to invest in and is called the separation theorem. The investment selection process is thus simplified from stock picking to efficient portfolio construction through diversification. The other statements are false. As an investor diversifies away the unsystematic portion of risk, the correlation between his portfolio return and that of the market approaches positive one. (Remember that the market portfolio has no unsystematic risk). The SML measures systematic risk, or beta risk. The expected return on a 0 beta security is the risk free rate (the market premium term has a value of 0).

• Question 816:

  Turi Teigen, CFA candidate, prepares the following question for her weekly Level 1 study program.

  Using the graph (along with the list of assumptions), determine which of the following statements is CORRECT.

  A. The expected return on Portfolio Y could be 15.00%.

  B. The expected return on Portfolio Z is greater than the required return.

  C. The required return on Portfolio X is 10.25%.

  D. Portfolio X is overvalued.

  Correct Answer: C

  Note: RR = required return, ER = expected return.Remember that the SML graph plots systematic, or beta, risk versus expected return. Thus, the numbers on the x-axis represent beta. Using the Capital Asset Pricing Model (CAPM) equation, RR = Rf+ (ERM?Rf) * Beta = 5.0% + (7.5%) * 0.7 = 10.25%. Portfolio Y lies below the SML and is thus overvalued and the expected return must be less than the required return. Using the CAPM, RR = Rf+ (ERM?Rf) * Beta = 5.0% + (7.5%) * 1.0 = 12.50%. (On the exam, you can quickly determine the RR for a portfolio/asset with a beta of 1.0 by adding the risk-free rate and the market premium.) Since the ER must be less than the RR, the ER must be less than 12.50% and cannot be 15.00%. Since Portfolio Z is on the SML, it is fairly valued and RR = ER. Since Portfolio X lies above the SML, it isundervalued.

• Question 817:

  Fabrice Miro and Victoria Leete are studying for the Level 1 CFA examination. Miro wants to test Leete's understanding of the graph of the capital market line (CML) and the efficient frontier. He develops the following statements and asks her to identify the one that is FALSE. Assuming that Leete answers correctly, which statement does she select?

  A. The market portfolio lies on the CML and has only unsystematic risk.

  B. The CML is not always straight.

  C. Investors move up and down the CML by varying the weightings of the risk-free asset and portfolio M by either lending or borrowing the risk-free asset.

  D. One weakness of the CML graph is that it measures standard deviation against returns.

  Correct Answer: A

  The first part of this statement is true - the market portfolio does lie on the CML. However, the market portfolio is completely diversified and thus has no unsystematic risk. The risk that remains is market portfolio risk, or nondiversifiable, or systematic risk. The other choices are true. The CML will "kink" if the borrowing rate and lending rate are not equal. The CML does measure standard deviation (or total risk) against returns, and this is considered a weakness since systematic, or undiversifiable, risk is what investors are compensated for undertaking. The securitymarket line (SML) better represents this because it measures systematic, or beta, risk against expected returns.

• Question 818:

  Kendra Jackson, CFA, is given the following information on two stocks, Rockaway and Bridgeport. Assuming that Jackson must construct a portfolio using only these two stocks, which of the following combinations will result in the minimum variance portfolio?

  A. 100% in Rockaway.

  B. 50% in Bridgeport, 50% in Rockaway.

  C. 80% in Bridgeport, 20% in Rockaway.

  D. 100% in Bridgeport.

  Correct Answer: D

  First, calculate the correlation coefficient to check whether diversification will provide any benefit.

  rBridgeport, Rockaway= covBridgeport, Rockaway/ [ ( Bridgeport) * ( Rockaway) ] = 0.0325 / (0.13 * 0.25)

  = 1.00

  Since the stocks are perfectly positively correlated, there are no diversification benefits and we select the

  stock with the lowest risk (as measured by variance or standard deviation), which is Bridgeport.

• Question 819:

  The graph below combines the efficient frontier with the indifference curves for two different investors, X and Y (represented by U(X) and U(Y)). The letters A, B, C, and D represent four distinct portfolios.

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

  A. The backward bend in the efficient frontier is due to less than perfect correlation between portfolio assets.

  B. Investor X would be better off moving to indifference curve U(X)1 and Portfolio C because of the higher return on that portfolio.

  C. Investor X is less risk-averse than Investor Y.

  D. Portfolio B is an optimal portfolio, Portfolio A is suboptimal.

  Correct Answer: A

  This statement is true. Markowitz was the first person to recognize that there are no perfectly positively correlated assets or perfectly negatively correlated assets. Thus, the efficient frontier has the shape noted above. The other choices are incorrect. The optimal portfolio for each investor is on the highest indifference curve that is tangent to the efficient frontier. Thus, portfolios A and B are both optimal portfolios, but for different investors. In addition, any portfolio on the efficient frontier is superior to one that is not. Thus, Investor X would not be better off with Portfolio C (this portfolio is on a lower indifference curve and has more risk.) Investor X has a steep indifference curve, indicating that he is risk-averse. Flatter curves, such as those for investor Y, indicate a less risk-averse investor.

• Question 820:

  Which of the following statements about institutional investors is TRUE?

  A. Banks have high liquidity needs and short time horizons.

  B. Pension funds and endowment funds have low liquidity needs and long time horizons, carry tax exempt status, and both are regulated at the state and federal level.

  C. In general, Life Insurance companies have lower liquidity needs and shorter time horizons than Property/Casualty Insurance Companies.

  D. The liquidity and time horizon parameters for defined contribution pension plans are determined by employee age and turnover rate.

  Correct Answer: A

  Banks have high liquidity needs and short time horizons due to the need to maintain a positive spread and the need to pay out deposits and fund loans. Pension funds are regulated at the Federal level under ERISA and endowments are regulated at the state level. Life Insurance companies have longer time horizons than Property/Casualty Insurance Companies. (Lower liquidity needs usually translate to longer time horizons.) The liquidity and time horizon parameters for defined benefit pension plans are determined by employee age and turnover rate. These are plans where the employer promises the employee a specific income stream upon retirement.