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

• Question 821:

  Isabelle Santana and Marat Loring are studying for the Level 1 CFA examination. Loring is having difficulty determining the objectives and constraints of defined contribution and defined benefit pension plans. To help Loring study, Santana creates the following list of characteristics and asks Loring to select the one that is FALSE. Which statement should Loring select?

  A. For a defined benefit plan, the most important factors that affect long-term fund performance are the individual asset selection process and the degree of market timing allowed.

  B. Both plans are tax-exempt.

  C. Both plans are federally regulated under the Employee Retirement Income Security Act (ERISA).

  D. The employee bears all the investment risk in a defined contribution plan.

  Correct Answer: A

  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. Empirical studies have shown that 85 percent to 95 percent of a portfolio's total return comes from the asset allocation policy decision (determining allowable asset classes and weighting these classes). The other statements are correct.

• Question 822:

  Which of the following equations is INCORRECT?

  A. Real Risk-Free Rate = [(1 + nominal Risk-Free rate) * (1 + inflation rate)] - 1.

  B. Expected Return (SML) =Rnominal Risk-Free+ (RMarket- Rnominal Risk-Free) * Beta.

  C. RequiredReturnnominal= [(1 + Risk-FreeRatereal) * (1 + Expected Inflation) * (1 + Risk Premium)] - 1.

  D. RiskpremiumFundamental view= total risk = business risk + financial risk + liquidity risk + exchange rate risk + country risk.

  Correct Answer: A

  The real Risk-Free Rate = [(1 + nominal Risk-free Rate) divided by (1 + inflation rate)] ?1. The other equations are correct.

• Question 823:

  Clair Boschart is preparing for her CFA study group's discussion of the security market line (SML). She asks her co-worker, a fellow CFA candidate, to review her summary of points. Which of the following statements does the co-worker identify as INCORRECT? If:

  A. risk perception increases, the SML will rotate counterclockwise.

  B. inflation expectations increase, the SML will experience an upward parallel shift.

  C. economic growth decreases, the SML will experience an upward parallel shift.

  D. the capital markets tighten, the SML will experience an upward parallel shift.

  Correct Answer: C

  If economic growth decreases, the SML will experience a downward parallel shift. Investors who supply capital demand a lower rate.

• Question 824:

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

  A. U.S. investors are internationally diversified.

  B. Emerging markets offer the greatest degree of diversification and the highest expected returns because of their industrial composition and currency behavior.

  C. The national beta measures the volatility of a nation's index relative to the referenced stock index, usually the U.S. index or the world index.

  D. The benefits of diversification increase when the weights used for international and domestic countries/ assets conform to relative market capitalization weights.

  Correct Answer: C

  U.S.

  investors are not internationally diversified, because of the following barriers: regulatory accounting and disclosure requirements that keep many foreign firms from registering and selling their shares in the

  U.S.

  capital markets, higher international trading costs, complications of foreign tax laws, and foreign exchange transaction cost and risk. Emerging markets offer the greatest degree of diversification and the highest expected returns because of their low correlations (due to volatile economic and political natures). Industrial composition and currency movements are not considered factors that impact correlations. The benefits of diversification increase when the weights used do not conform to relative market capitalization weights.

• Question 825:

  While working abroad, United States citizen Alex Beggs purchases a foreign bond with an annual coupon of 7.0 percent for 93.0. He holds the bond for one year and then sells it for 95.5 before he leaves. During the year, the dollar appreciated 2.5% relative to the foreign currency.

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

  A. 7.460%.

  B. 12.970%.

  C. 10.215%.

  D. 0.121%.

  Correct Answer: A

  TheTotal Dollar Returnis calculated as follows:

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

  The dollarappreciated0.025, so the foreign currencydepreciatedby 0.025, or 2.5%.

  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+(7.0 + 95.5 ?93.0)/93.0 ] * (1 - 0.025) } - 1

  = { [1.102151 ] * (0.975) } - 1

  = 0.07460, or7.460%

• Question 826:

  Karissa Grossklaus recently joined an investment banking firm as a research analyst. One of the partners asks her to determine whether a certain stock, Park Street Holdings, is overvalued or undervalued, and by how much (expressed as percentage return). Grossklaus runs a regression and finds the following information on the stock: Grossklaus reports that Park Street Holdings stock is:

  A. undervalued by 1.1%.

  B. overvalued by 3.7%.

  C. overvalued by 1.1%.

  D. undervalued by 3.7%.

  Correct Answer: C

  To determine whether a stock is overvalued or undervalued, we need to compare the expected return (or

  holding period return) and the required return (from Capital Asset Pricing Model, or CAPM).

  Step 1: Calculate Expected Return (Holding period return):

  The formula for the (one-year) holding period return is:

  HPR = (D1+ S1?S0) / S0, where D = dividend and S = stock price.

  Here, HPR = (0 + 55 ?45) / 45 = 22.2%

  Step 2: Calculate Required Return:

  The formula for the required return is from the CAPM:

  RR = Rf+ (ERM?Rf) * Beta

  Here, we are given the information we need except for Beta. Remember that Beta can be calculated with:

  Betastock= [covS,M] / [2M]. Here we are given the standard deviation of the market, so the calculation is:

  1.30 / 0.752= 2.31.

  RR = 4.25% + (12.5 ?4.25%) * 2.31 = 23.3%.

  Step 3: Determine over/under valuation:

  The required return is greater than the expected return, so the security is overvalued. The amount = 23.3%

  -22.2% = 1.1%.

• Question 827:

  Consider the following graph of the Security Market Line (SML). The letters X, Y, and Z represent risky asset portfolios. The SML crosses the y-axis at the point 0.07. The expected market return equals 13.0 percent. Note: The graph is NOT drawn to scale.

  Using the graph above and the information provided, determine which of the following statements is TRUE.

  A. Portfolio Y is undervalued.

  B. The correct label for the x-axis is total risk.

  C. Portfolio X's required return is greater than the market expected return.

  D. The expected return (or holding period return) for Portfolio Z equals 14.8%.

  Correct Answer: D

  At first, it appears that we are not given the information needed to calculate the holding period, or expected return (beginning price, ending price, or annual dividend). However, we are given the information required to calculate the required return (CAPM) and since Portfolio Z is on the SML, we know that the required return (RR) equals the expected return (ER). So, ER = RR = Rf+ (ERM?Rf) * Beta = 7.0% + (13.0% 7.0%) * 1.3 = 14.8%. The SML plots beta (orsystematic risk) versus expected return, the CML plots total risk (systematic plus unsystematic risk) versus expected return. Portfolio Y is overvalued ?any portfolio located below the SML has an RR>; ER and is thus overpriced. Since Portfolio X plots above the SML, it is undervalued and the statement should read, "Portfolio X's required return islessthan the market expected return."

• Question 828:

  Which of the following statements about portfolio theory is FALSE?

  A. For a two-stock portfolio, the lowest risk occurs when the correlation coefficient is close to negative one.

  B. Assuming that the correlation coefficient is less than one, the risk of the portfolio will always be less than the simple weighted average of individual stock risks.

  C. Risk aversion results in an upward sloping security market line (SML).

  D. When the return on an asset added to a portfolio has a correlation coefficient of less than one with the other portfolio asset returns but has the same risk, adding the asset will not decrease the overall portfolio standard deviation.

  Correct Answer: D

  This statement misstates the principle of diversification and should read, "When the return on an asset added to a portfolio has a correlation coefficient of less than one with the other portfolio asset returns but has the same risk, adding the asset will decrease the overall portfolio standard deviation." Anytime the correlation coefficient is less than one, there are benefits from diversification. The other choices are true.

• Question 829:

  Gregg Goebel and Mason Erikson are studying for the Level 1 CFA examination. They have just started the section on Portfolio Management and Erikson is having difficulty with the equations for the covariance (cov1,2) and the correlation coefficient (r1,2) for two-stock portfolios. Goebel is confident with the material and creates the following quiz for Erikson. Using the information in the table below, he asks Erickson to fill in the question marks.

  Which of the following choices correctly gives the covariance for Portfolio J and the correlation coefficients for Portfolios K and L, respectively?

  A. 1.680, 0.002, 0.000.

  B. 0.011, 0.833, 0.056.

  C. 0.110, 0.224, 0.076.

  D. 0.083, 0.011, 0.417.

  Correct Answer: B

  The calculations are as follows:

  Portfolio J covariance= cov1,2= (r1,2) * ( 1) * ( 2) = 0.75 * 0.08 * 0.18 = 0.0108, or 0.011.

  Portfolio K correlation coefficient= (r1,2) = cov1,2/ [ ( 1) * ( 2) ] = 0.02 / (0.20 * 0.12) = 0.833

  Portfolio L correlation coefficient= (r1,2) = cov1,2/ [ ( 1) * ( 2)1/2] = 0.003 / (0.18 * 0.091/2) = 0.003 / (0.18 *

  0.30) = 0.056Remember:The standard deviation is the square root of the variance. Read carefully on the

  exam!

• Question 830:

  An internationally diverse group of students attending the London School of Economics has formed a Level 1 CFA Study Group. Three of the students (from Germany, Japan, and the U.S) are assigned the Portfolio Management Study Session reading on selecting global investments. As part of determining how changes in currency rates can affect returns on foreign investments, the group analyzes the return in the U.S. bond market from the late 1980s to the mid 1990s and ranks the U.S. bond market returns in the following three ways: 1- measured in each individual's home currency, 2- adjusted for exchange rate changes and expressed in U.S. dollar terms, and 3 ?on a risk adjusted basis. They summarized their results in the following table:

  *

  Rank is out of the set: Germany, Japan, and U.S.

  Following is a set of possible conclusions drawn from their results. Which of the statements is

  INCORRECT?

  A.

  Investors in different countries may earn different local currency returns even if they invest in the same investments.

  B.

  Even though the non-U.S. markets experienced higher returns over this period, the increased risk of the non-U.S. securities offset the higher return and lowered the return/risk ratio.

  C.

  The U.S. dollar strengthened during the time period observed.

  D.

  Foreign exchange rate effects can have negative impacts on investment returns.

  Correct Answer: C

  Since the U.S. Bond rank decreased when expressed in U.S. dollar terms, the U.S. dollar weakened over the time period observed. As the dollar weakens, a U.S. investor would earn higher returns on foreign investments because each unit of foreign currency buys more dollars. A foreign investor would also be able to earn higher returns in the U.S., as it would take less of a foreign currency to buy dollars.