1

2020 Level I Mock Exam (C) PM

The 2020 Level I Chartered Financial Analyst® Mock Examination has 120 questions.
To best simulate the exam day experience, candidates are advised to allocate an average
of one and a half minutes per question for a total of 180 minutes (3 hours) for this
session of the exam.

1 During an on-­site company visit, Marsha Ward, CFA, accidentally overheard

the Chief Executive Officer (CEO) of Stargazer, Inc., discussing the company’s
tender offer to purchase Dynamica Enterprises, a retailer of Stargazer products.
According to the CFA Institute Standards of Professional Conduct, Ward most
likely cannot use the information because:
A it relates to a tender offer.
B it was overheard and might be considered unreliable.
C she does not have a reasonable and adequate basis for taking investment
action.

A is correct because trading on the information is restricted as it relates to a tender offer;

it is clearly material, nonpublic information [Standard II(A)].
B is incorrect because the information could be considered to come from a reliable
source because if comes from senior management, is nonpublic, and should not be used
since it concerns a tender offer.
C is incorrect because the information is material and is nonpublic so that it should not
be used as the basis for taking investment action. There is simply not enough information
provided to determine if there is a reasonable and adequate basis for investment action.

Guidance for Standards I–VII

2 Adira Badawi, CFA, who owns a research and consulting company, is an

independent board member of a leading cement manufacturer in a small local
market. Because of Badawi’s expertise in the cement industry, a foreign cement
manufacturer looking to enter the local market has hired him to undertake
a feasibility study. Under what circumstances can Badawi most likely under-
take the assignment without violating the CFA Institute Code of Ethics and
Standards of Professional Conduct? If he:
A makes full disclosure to both companies.
B receives written permission from the local company.
C signs confidentiality agreements with both companies.

By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to
currently registered CFA candidates. Candidates may view and print the exam for personal exam prepara-
tion only. The following activities are strictly prohibited and may result in disciplinary and/or legal action:
accessing or permitting access by anyone other than currently-­registered CFA candidates; copying, posting
to any website, emailing, distributing and/or reprinting the mock exam for any purpose
CFA®, Chartered Financial Analyst®, AIMR-­PPS®, and GIPS® are just a few of the trademarks owned by CFA
Institute. To view a list of CFA Institute trademarks and the Guide for Use of CFA Institute Marks, please
visit our website at www.cfainstitute.org.
© 2020 CFA Institute. All rights reserved.
2 2020 Level I Mock Exam (C) PM

A is correct because making full and fair disclosure of all matters that could reasonably
be expected to impair one’s independence and objectivity or interfere with respective
duties to one’s clients is required by Standard VI(A)–Disclosure of Conflicts of the CFA
Institute Code of Ethics and Standards of Professional Conduct.
B is incorrect because written permission from both parties would be needed to
provide full and fair disclosure of all matters that could reasonably be expected to
impair their independence and objectivity or interfere with respective duties to their
clients. The requirement to disclose under Standard VI does not mandate that this be
in writing. In fact, members and candidates have the responsibility of determining how
often, in what manner, and in what particular circumstances the disclosure must be
made [Standard IV(B)–Additional Compensation Arrangements requires written consent].
C is incorrect because the signing of confidentiality agreements does not necessar-
ily provide full and fair disclosure of all matters that could reasonably be expected to
impair Badawi’s independence and objectivity or interfere with respective duties to his
clients as required by Standard VI. Confidentiality agreements could actually restrict the
disclosure of information that would provide fair disclosure.

Guidance for Standards I–VII

3 Noor Mawar, CFA, manages a trust fund with the beneficiary being an
orphaned 18-­year-­old student. The investment policy dictates that trust assets
are expected to provide the student with a stable low-­risk source of income
until she reaches the age of 30 years. Based on information from an Internet
blog, the student asks Mawar to invest in a new business venture that she
expects will provide high returns over the next five years. Mawar ignores the
request, instead securing conservative investments to provide sufficient income.
Did Mawar most likely violate the CFA Institute Code of Ethics and Standards
of Professional Conduct?
A Yes.
B No, because the client’s objectives were met.
C No, because the investment time frame does not match the investment
horizon.

B is correct because the client is the trust/trustees, not the beneficiary. Mawar followed
Standard III(C) –Suitability by managing the trust assets in a way that would likely result
in a stable source of income while keeping the risk profile low, thereby complying with
the investment objectives of the trust.
A is incorrect because Mawar did not violate any Standard as she managed trust
assets considering the suitability for the client, not the beneficiary.
C is incorrect because the client is the trust/trustees, not the beneficiary. Therefore
the time horizon of the investment is not relevant.

Guidance for Standards I–VII

4 In the event of a discrepancy between the official GIPS standards and the local
language translation, the official governing language is:
A English.
B the language of the local country.
2020 Level I Mock Exam (C) PM 3

C the language of a neutral country.

A is correct. Although the GIPS standards may be translated into many languages, if a dis-
crepancy arises, the English version of the GIPS standards is the official governing version.
B is incorrect. The English version of the GIPS standards is the official governing
version, not the language of the local country.
C is incorrect. The English version of the GIPS standards is the official governing
version, not the language of a neutral third country.

The GIPS Standards

5 According to the GIPS standards, firms must do all of the following except:
A Provide investors with a comprehensive view of their performance only in
terms of returns.
B Comply with all requirements of the standards, such as updates, Guidance
Statements, and clarifications.
C Adhere to certain calculation methodologies and make specific disclosures
along with their performance.

A is correct. Firms must provide investors with a comprehensive view of their performance
in terms of risk and returns, not just returns.
B is incorrect. Complying with all requirements of the standards, such as updates,
Guidance Statements, and clarifications is a key feature of the GIPS standards.
C is incorrect. Adhering to certain calculation methodologies and making specific
disclosures along with their performance is a key feature of GIPS standards.

The GIPS Standards

6 Miranda Grafton, CFA, purchased a large block of stock at varying prices

during the trading session. The stock realized a significant gain in value before
the close of the trading day, so Grafton reviewed her purchase prices to deter-
mine what prices should be assigned to each specific account. According to the
Standards of Practice Handbook, Grafton’s least appropriate action is to allocate
the execution prices:
A across the participating client accounts at the same execution price.
B across the participating client accounts pro rata on the basis of account size.
C on a first-­in, first-­out basis with consideration of bundling orders for
efficiency.

B is correct because according to Standard III(B) best practices include allocating pro

rata on the basis of order size, not account size. All clients participating in the block
trade should receive the same execution price and be charged the same commission.
A is incorrect because according to Standard III(B) all clients participating in the block
trade should receive the same execution price and be charged the same commission.
4 2020 Level I Mock Exam (C) PM

C is incorrect because this is one of the recommended procedures to follow for

compliance with Standard III(B).

Guidance for Standards I–VII

7 According to the Global Investment Performance Standards (GIPS), which of

the following is not a part of the verification process? Testing whether the:
A firm has complied with all the composite construction requirements.
B verification is undertaken by the compliance department in the absence of a
third party.
C firm’s processes and procedures are designed to calculate results in compli-
ance with GIPS standards.

B is correct because verification tests (Standard  V) whether the investment firm has
complied with all the composite construction requirements of GIPS on a firm-­wide
basis, and whether the firm’s processes and procedures are designed to calculate and
present performance results in compliance with the GIPS Standards. Verification must
be performed by an independent third party. A firm cannot perform its own verification.
A is incorrect because verification tests whether the investment firm has complied
with all the composite construction requirements of GIPS on a firm-­wide basis,
C is incorrect because verification tests whether the investment firm’s processes and
procedures are designed to calculate and present performance results in compliance
with the GIPS Standards.

Introduction to the Global Investment Performance Standards (GIPS)

8 When can a party, nonmember or firm, most likely claim compliance with the
CFA Institute Code of Ethics and Standards of Professional Conduct? Once they
have:
A ensured that their code and ethics meets the principles of the Code and
Standards.
B notified the CFA Institute of their claim.
C verified their claim of compliance with the CFA Institute.

A is correct. The Code and Standards apply to individual members of CFA Institute and
candidates in the CFA Program. CFA Institute does encourage firms to adopt the Code and
Standards, however, as part of their code of ethics. Those who claim compliance should
fully understand the requirements of each of the principles of the Code and Standard.
B is incorrect. CFA Institute welcomes public acknowledgement when appropriate
and encourages firms to notify the Institute of the adoption plans.
C is incorrect. CFA Institute does not verify claims of compliance with the Code of
Ethics and Standards of Professional Conduct.

Code of Ethics and Standards of Professional Conduct

2020 Level I Mock Exam (C) PM 5

9 Richard Cardinal, CFA, is the founder of Volcano Capital Research, an invest-

ment management firm whose sole activity is short selling. Cardinal seeks out
companies whose stocks have had large price increases. Cardinal also pays sev-
eral lobbying firms to update him immediately on any legislative or regulatory
changes that may impact his target companies. Cardinal sells short those target
companies he estimates are near the peak of their sales and earnings and that
his sources identify as facing legal or regulatory challenges. Immediately after
he sells a stock, Cardinal conducts a public relations campaign to disclose all of
the negative information he has gathered on the company, even if the informa-
tion is not yet public. Which of Cardinal’s following actions is most likely to be
in violation of the CFA Institute Standards of Professional Conduct?
A Selling stock short
B Trading on information from lobbyists
C Disclosing information about target companies

C is correct, as Cardinal’s actions related to the public relations campaign and class action
lawsuits are specifically intended to manipulate share prices lower and to advantage
the manager. Cardinal has made deliberate attempts to create artificial price volatility
designed to have a material impact on the price of an issuer’s stock, in violation of
Standard II(B)–Market Manipulation.
A is incorrect because selling stock short is a management strategy and does not
necessarily violate any aspect of the Code and Standards.
B is incorrect, as it appears a reasonable and diligent effort has been made as required
by Standard V(A)–Diligence and Reasonable Basis to determine the investment action
is sound and suitable for his clients. Information gathering is an integral part of invest-
ment analysis and the methods described do not necessarily violate any aspect of the
CFA Code and Standards.

Guidance for Standards I–VII

10 Gabrielle Gabbe, CFA, has been accused of professional misconduct by one of

her competitors. The allegations concern Gabbe’s personal bankruptcy filing ten
years ago when she was a college student and had a large amount of medical
bills she could not pay. By not disclosing the bankruptcy filing to her clients, did
Gabbe most likely violate any CFA Institute Standards of Professional Conduct?
A No.
B Yes, related to Misconduct.
C Yes, related to Misrepresentation.

A is correct as a personal bankruptcy does not necessarily constitute a violation of

Standard I(D). If the circumstances of the bankruptcy involved fraudulent or deceitful
business conduct, then failing to disclose it may constitute a violation of the Standards.
B is incorrect because there has not been a violation of the Standards.
C is incorrect because there has not been a violation of the Standards.

Guidance for Standards I–VII

6 2020 Level I Mock Exam (C) PM

11 Joyce La Valle, CFA, is a portfolio manager at a global bank. La Valle has been
told she should use a specific vendor for equity investment research that has
been approved by the bank’s headquarters. Because La Valle is located in a
different country than the bank’s headquarters, she is uncomfortable with the
validity of the research provided by this vendor when it applies to her country
and would like to use a local vendor on whom she has already conducted due
diligence. Which research vendor(s) should La Valle most likely use to avoid
violating the CFA Institute Standards of Professional Conduct?
A Use the local research vendor.
B Use the bank-­approved research vendor.
C Use both the local and the bank-­approved research vendors.

A is correct. When a member has reason to suspect that either secondary or third-­party
research or information comes from a source that lacks a sound basis, the member must
not rely on that information as indicated by Standard V(A)–Diligence and Reasonable Basis.
B is incorrect. When a member has reason to suspect that either secondary or third-­
party research or information comes from a source that lacks a sound basis, the member
must refrain from relying on that information.
C is incorrect when a member has reason to suspect that either secondary or third-­
party research or information comes from a source that lacks a sound basis, the member
must refrain from relying on that information.

2014 CFA Level I

12 Abdul Naib, CFA, was recently asked by his employer to submit an updated
document providing the history of his employment and qualifications. The
existing document on file was submitted when he was hired five years ago.
His employer notices that the updated version shows that Naib obtained his
Masters of Business Administration (MBA) two years ago, while the earlier
version indicated he had already obtained his MBA. As the position Naib was
hired for required a minimum qualification of an MBA, Naib is asked to explain
the discrepancy. He justifies his actions by stating, “I knew you wouldn’t hire
me if I didn’t have an MBA degree but I already had my CFA designation.
Knowing you required an MBA, I went back to school on a part-­time basis after
I was hired to obtain it. I graduated at the top of my class, but this shouldn’t
come as any surprise, as you have seen evidence I passed all of my CFA exams
on the first attempt.” Did Naib most likely violate the CFA Institute Standards of
Practice?
A No.
B Yes, with regard to Misconduct.
C Yes, with regard to Reference to the CFA Designation.

B is correct because Naib knowingly misrepresented his qualifications by stating he had

obtained an MBA degree at the time of his hire when in fact he had not. This reflects
adversely on his professional integrity, violating Standard I(D)–Misconduct. Stating that
he passed his CFA exams in three consecutive years is not a violation of Standard VII(B)–
Reference to CFA Institute, the CFA Designation, and the CFA Program if it is factual. There
is no evidence given to indicate he did not pass as claimed.
2020 Level I Mock Exam (C) PM 7

A is incorrect because Naib knowingly misrepresented himself by stating he had

obtained an MBA degree when in fact he had not. This reflects adversely on his profes-
sional integrity, violating Standard I(D)–Misconduct.
C is incorrect because stating he passed his CFA exams consecutively is not a violation
of Standard VII(B)–Reference to CFA Institute, the CFA Designation, and the CFA Program.
There is no evidence given to indicate he did not pass as claimed.

Guidance for Standards I–VII

13 Carlos Cruz, CFA, is one of two founders of an equity hedge fund. Cruz man-
ages the fund’s assets while the other co-­founder, Brian Burkeman, CFA, is
responsible for fund sales and marketing. Cruz notices the most recent sales
material used by Burkeman indicates that assets under management are listed
at a higher value than the current market value. Burkeman justifies the discrep-
ancy by stating recent market declines account for the difference. In order to
comply with the CFA Institute Standards of Professional Conduct, Cruz should
least likely take which of the following actions?
A Correct the asset information and provide updates to prospective clients.
B Report the discrepancy to the CFA Institute Professional Conduct Program.
C Provide a disclaimer within marketing material indicating prices are as of a
specific date.

B is correct because a violation of Standard I(A)–Knowledge of the Law is likely to occur

unless the asset base information is corrected. Cruz has yet to violate any CFA Institute
Standards so he need not report a violation. If Cruz does not take action he will be
in violation of the Standards and at that point he would need to report this violation
because Standard I(A) applies as the member should know his conduct may contribute
to a violation of applicable laws, rules, regulations, or the Code and Standards related
to the inaccurate sales materials. Cruz should seek to have the information corrected
and accurate information provided to prospective clients. It may also be prudent to seek
the advice of legal counsel.
A is incorrect as Cruz should seek to have the information corrected and accurate
information provided to prospective clients.
C is incorrect as providing a disclaimer within the marketing material concerning
the date of the market prices would be a prudent step since market prices are likely to
change frequently from when the material was published.

Guidance for Standards I–VII

14 Kelly Amadon, CFA, an investment advisor, has two clients: Ryan Randolf, 65
years old, and Keiko Kitagawa, 45 years old. Both clients earn the same amount
in salary. Randolf, however, has a large amount of assets, while Kitagawa has
few assets outside her investment portfolio. Randolf is single and willing to
invest a portion of his assets very aggressively; Kitagawa wants to achieve a
steady rate of return with low volatility so she can pay for her child’s current
college expenses. Amadon recommends investing 20 percent of both clients’
portfolios in the stock of very low yielding small-­cap companies. Amadon least
likely violated the CFA Institute Code of Ethics and Standards of Professional
Conduct with regards to his investment recommendations for:
A both clients’ portfolio.
8 2020 Level I Mock Exam (C) PM

B only Randolf ’s portfolio.

C only Kitagawa’s portfolio.

B is correct because in Randolf’s case, the investment may be appropriate given this client’s
financial circumstances and aggressive investment position. This investment would not
be suitable for Kitagawa with a need for a steady rate of return and her low risk profile.
A is incorrect because this investment would not be suitable for Kitagawa. Amadon
would violate Standard III(C)–Suitability by investing Kitagawa’s portfolio in low yielding
small-­cap companies that are thought to be high risk due to the limited number of shares
traded, their share volatility, and the risks inherent in a small company with limited reve-
nue sources. These investments are not suitable as they are not likely to meet Kitagawa’s
investment goals of a steady rate of return with low volatility.
C is incorrect because this investment would not be suitable for Kitagawa. Amadon
would violate Standard III(C)–Suitability by investing Kitagawa’s portfolio in low yielding
small-­cap companies. These investments are not suitable as they are not likely to meet
Kitagawa’s investment goals of a steady rate of return with low volatility.

Guidance for Standards I–VII

15 According to the Code and Standards regarding knowledge of laws and regula-
tions, CFA Institute members and candidates must:
A understand the relevant regulations for all the countries where they trade
securities.
B have detailed knowledge of all the laws that could potentially govern the
member’s activities.
C spend a minimum of five hours per calendar year on continuing education
activities related to applicable laws and regulations.

A is correct because Standard  I(A) requires members and candidates to understand

applicable laws and regulations in those countries where they trade or conduct business.
While an understanding of laws and regulations is required, members and candidates
can rely on legal counsel and compliance to be subject matter experts in these areas.
The Standards do not require a minimum of five hours of continuing education.
B is incorrect because Standard I(A) does require members and candidates to become
legal experts. While an understanding of laws and regulations is required, members
and candidates can rely on legal counsel and compliance to be subject matter experts
in these areas.
C is incorrect because members and candidates do not have such a requirement.

Guidance for Standards I–VII

16 Standard III(E)–Preservation of Confidentiality of the CFA Institute Standards

of Professional Conduct most likely requires members and candidates to keep
information about current, former, and prospective clients confidential unless:
A the information concerns illegal activities.
B there is a reasonable and adequate basis for not maintaining confidentiality.
C they understand the limitations and risk associated with the disclosure.
2020 Level I Mock Exam (C) PM 9

A is correct. Standard III(E)–Preservation of Confidentiality requires members and can-

didates to keep information about current, former, and prospective clients confidential
unless the information concerns illegal activities on part of the client or prospective clients.
B is incorrect. The concept of reasonable and adequate basis is part of Standard V–
Investment Analysis, Recommendations, and Actions, subsection Diligence and
Reasonable Basis.
C is incorrect. The concept of understanding the limitations and risk is part of Standard V–
Investment Analysis, Recommendations, and Actions, subsection Communication with
Clients and Prospective Clients.

Code of Ethics and Standards of Professional Conduct

17 Which of the following is most likely an example of an overconfidence bias lead-

ing to poor ethical decision making?
A “I’m sure I did the right thing.”
B “I’m smart; that will keep me out of trouble.”
C “I’m aware of my ethical obligations.”

B is correct. An overconfidence bias is shown by thinking that your intelligence level

will prevent you from acting in an unethical manner. A person who understands ethical
behavior, no matter her intelligence level, can often decipher unethical behavior by
looking at the long-­term consequences of improper actions by an individual.
A is incorrect. Overconfidence bias causes people to not realize they can be subject
to poor ethical decision making in the future, not in hindsight.
C is incorrect. Being aware of your ethical obligations does not necessarily provide a
sense of overconfidence that you will do the right thing. You can be well versed in ethical
obligations but yet purposely set out to act in an unethical behavior.

Ethics and Trust in the Investment Profession

18 Renee Robinson, CFA, an independent contractor, acts as chief compliance

officer for multiple firms, where she is responsible for overseeing adherence
to security laws, firm policies, and the CFA Institute Standards of Professional
Conduct. Robinson works remotely and determines her own hours. Her signed
agreement with each firm outlines her responsibilities and discloses the poten-
tial conflicts of interest due to having multiple clients in the same role and
industry. Is Robinson most likely in violation of any CFA Institute Standard of
Professional Conduct?
A No
B Yes, with regard to having multiple clients
C Yes, with regard to being an independent contractor

A is correct. There is no evidence Robinson is in violation of any CFA Institute Standard

of Professional Conduct. Robinson is most likely not in violation of Standard  VI(A):
Disclosure of Conflicts because she has fully disclosed any potential conflicts of interest
due to having multiple clients in the same industry. The Standard states, “Members
10 2020 Level I Mock Exam (C) PM

and Candidates must make full and fair disclosure of all matters that could reasonably
be expected to impair their independence and objectivity or interfere with respective
duties to their clients, prospective clients, and employer.” She is also most likely not in
violation of Standard IV(A): Loyalty. The Standards do not prohibit a relationship with
an independent contractor. She would most likely not be considered an employee; she
works remotely, has multiple clients, and determines her own hours. Standard  IV(A):
Loyalty states that members and candidates working as an independent contractor are
governed by the oral or written agreement. Care should be taken to clearly define the
scope of the responsibilities and the expectations of each client within the context of
each relationship.
B is incorrect. There is no evidence Robinson is in violation of any CFA Institute
Standard of Professional Conduct. More specifically, Robinson is most likely not in
violation of Standard VI(A): Disclosure of Conflicts because she has fully disclosed any
potential conflicts of interest due to having multiple clients within the same industry.
The Standard states, “Members and candidates must make full and fair disclosure of all
matters that could reasonably be expected to impair their independence and objectivity
or interfere with respective duties to their clients, prospective clients, and employer.”
C is incorrect. There is no evidence Robinson is in violation of any CFA Institute
Standard of Professional Conduct. More specifically, Robinson is most likely not in
violation of Standard IV(A): Loyalty. The Standards do not prohibit a relationship with
an independent contractor. She would most likely not be considered an employee; she
works remotely, has multiple clients, and determines her own hours. Standard  IV(A):
Loyalty states that members and candidates working as an independent contractor are
governed by the oral or written agreement. Care should be taken to clearly define the
scope of the responsibilities and the expectations of each client within the context of
each relationship.

Guidance for Standards I-­VII

19 When an investigator wants to test whether a particular parameter is greater

than a specific value, the null and alternative hypothesis are best defined as:
A H 0: θ ≤ θ0 versus Ha : θ > θ0.
B H 0: θ ≥ θ0 versus Ha : θ < θ0.
C H 0: θ = θ0 versus Ha : θ ≠ θ

A is correct. A positive “hoped for” condition means that the null will be rejected (and
the alternative accepted) only if the evidence indicates that the population parameter
is greater than θ0. Thus, H 0: θ ≤ θ0 versus Ha : θ > θ0 is the correct statement of the null
and alternative hypotheses, respectively.
B is incorrect; it can only discern that a parameter is possibly lesser than a value.
C is incorrect; it can only discern that a parameter is not equal to a value.

Hypothesis Testing

20 An individual wants to be able to spend €80,000 per year for an anticipated

25 years in retirement. To fund this retirement account, he will make annual
deposits of €6,608 at the end of each of his working years. He can earn 6% com-
pounded annually on all investments. The minimum number of deposits that
are needed to reach his retirement goal is closest to:
A 51.
B 40.
2020 Level I Mock Exam (C) PM 11

C 28.

B is correct. The following figure represents the timeline for the problem:

0 1 ... R R+1 ... R + 25

(€6,608) ... (€6,608) (€80,000) ... (€80,000)
Using a financial calculator, the funds needed at retirement (R on the timeline) are
calculated: N = 25; I/Y = 6%; PMT = €80,000; Future value (FV) = €0; Mode = End. The
calculated present value (PV) is €1,022,668.

 1 
1  
 1  r N 
PV  A
 r 
 
 
 1 
1  
 1.0625 
 80, 000
 0.06 
 
 
 1, 022, 688
Then, €1,022,668 is used as the FV (at R on the timeline) for the accumulation phase
annuity as per: I/Y = 6%; PV = €0; PMT = −€6,608; FV = €1,022,668; Mode = End. The
computed N is 40.
Alternatively, 40 could be calculated with the formula:
1  r N  1
FV  A   and solving for N,
 r 
 

1  0.06 N  1
1, 022, 668  6, 608  
 0.06 
 
A is incorrect. 80,000 is multiplied by 25 years (2,000,000) and the result is used as
the FV of the 6,608 annuity at 6% and PV = 0. The result is N = 50.67.
C is incorrect. 80,000 is multiplied by 25 years and then discounted at 6% for 25 years
(465,997). The result is used as the PV of the 6,608 annuity at 6% as follows: I/Y = 6%;
PMT = 6,608; PV =465,997; FV = 0; Calculate N: N = −28.40 and the minus sign is ignored.

The Time Value of Money

21 The discrepancy between a statistically significant result and an economically

meaningful result is least likely the result of:
A transaction costs.
B risk tolerance.
C sampling errors.
12 2020 Level I Mock Exam (C) PM

C is correct. Sampling errors will result in statistical error. A statistically significant result
might not be economically meaningful after an analyst accounts for the risk, transaction
costs, and applicable taxes.
A is incorrect. Same explanation as C.
B is incorrect. Same explanation as C.

Hypothesis Testing

22 An analyst collects data relating to five commonly used measures of financial

leverage and interest coverage for a randomly chosen sample of 300 firms. The
data come from those firms’ fiscal year 2013 annual reports. These data are best
characterized as:
A longitudinal.
B cross sectional.
C time series.

B is correct. Data on some characteristics of companies at a single point in time are

cross-­sectional data.
A is incorrect. The data are not longitudinal data. Longitudinal data are observations
on characteristic(s) of the same observational unit through time.
C is incorrect. The data are not time-­series data. Time-­series data are observations
of a variable over time

Sampling and Estimation

23 An analyst collects the following data related to paired observations for Sample
A and Sample B. Assume that both samples are drawn from normally distrib-
uted populations and that the population variances are not known.
Paired Observation Sample A Value Sample B Value

1 25 18
2 12 9
3 −5 −8
4 6 3
5 −8 1

The t-statistic to test the hypothesis that the mean difference is equal to zero is
closest to:
A 0.52.
B 0.27.
C 0.23.
2020 Level I Mock Exam (C) PM 13

A is correct. First, the mean difference is calculated:

1 n
d   di
n i 1
Then, the sample variance and the standard error of the mean difference are calculated:
n
di  d 
2

i 1
sd2 
n 1

sd = sd n
Then, the t-statistic is calculated:
d  d 0
t 
sd
In this case, the mean difference is 1.4. The sample variance is 36.8. The standard error
of the mean difference is 2.712932. The t-statistic is 0.51605 ~ 0.52.

Differences Minus
Paired Sample Sample B the Mean Difference,
Observation A Value Value Differences Then Squared

1 25 18 7 (7 − 1.4)2 = 31.36
2 12 9 3 (3 − 1.4)2 = 2.56
3 −5 −8 3 (3 − 1.4)2 = 2.56
4 6 3 3 (3 − 1.4)2 = 2.56
5 −8 1 −9 (−9 − 1.4)2 = 108.16
Sum = 7 Sum of squared differ-
ences = 147.2

7/5 = mean difference d of 1.4 

 
Sample Variance sd2 : 147.2/4 = 36.8

Standard Error sd  : (36.8/5)0.5 = 2.712932

t-statistic: (1.4 − 0)/2.712932 = 0.51605 ~ 0.52

B is incorrect. The mistake is to calculate the standard deviations of the separate
samples and then use the average of these two sample standard deviations as the
estimate of sd .

Sample A Value Squared Differences

25 (25 − 6)2 = 361

12 (12 − 6)2 = 36
−5 (−5 − 6)2 = 121
6 (6 − 6)2 = 0
−8 (−8 − 6)2 = 196
Sum = 30 Sum = 714
Mean = 30/5 = 6 Standard deviation = [714/(5 − 1)]0.5
= 13.36039
14 2020 Level I Mock Exam (C) PM

Sample B Value Squared Differences

18 (18 − 4.6)2 = 179.56

9 (9 − 4.6)2 = 19.36
−8 (−8 − 4.6)2 = 158.76
3 (3 − 4.6)2 = 2.56
1 (1 − 4.6)2 = 12.96
Sum = 23 Sum = 373.2
Mean = 23/5 = 4.6 Standard deviation = [373.2/(5 − 1)]0.5
= 9.65919

The average of the two sample standard deviations is: (13.36039  + 9.65919)/2  =
1.4
11.50979. Then, the result is found as follows: = 0.27.
11.50979 5
C is incorrect. The mistake is to use the sample standard deviation of the differences
rather than the standard error of the mean difference in the t-statistic: 1.4 36.8 = 0.23.

Hypothesis Testing

24 A portfolio manager would like to calculate the compound rate of return on an

investment. Which of the following mean returns will he most likely use?
A Geometric
B Harmonic
C Arithmetic

A is correct. The geometric mean return represents the growth rate or compound rate
of return on an investment.
B is incorrect. The harmonic mean may be viewed as a special type of weighted mean
in which an observation’s weight is inversely proportional to its magnitude. The harmonic
mean is a relatively specialized concept of the mean that is appropriate when averaging
ratios (“amount per unit”) when the ratios are repeatedly applied to a fixed quantity to
yield a variable number of units.
C is incorrect. The arithmetic mean return reflects the average of the single-­periods
performance.

Organizing, Visualizing, and Describing Data

25 A portfolio manager estimates the probabilities of the following events for a

mutual fund:
●● Event A: the fund will earn a return of 5%.
●● Event B: the fund will earn a return below 5%.
The least appropriate description of the events is that they are:
A dependent.
B mutually exclusive.
C exhaustive.
2020 Level I Mock Exam (C) PM 15

C is correct. Events are exhaustive when they cover all possible outcomes. Mutually
exclusive means that only one event can occur at a time. Two events are dependent if
the occurrence of one event does affect the probability of occurrence of the other event.
In this situation, Event A and B are both mutually exclusive (because they cannot occur
at the same time) and dependent (because if one event occurs, the probability of the
other becomes zero). However, the two events are not exhaustive because they do not
cover the event that the fund will earn a return above 5%.
A is incorrect. Events A and B are dependent because if one event occurs, the prob-
ability of the other becomes zero.
B is incorrect. Events A and B are mutually exclusive because they cannot occur at
the same time.

Probability Concepts

26 Which statement is most accurate when considering a multivariate normal dis-

tribution for the returns on 10 stocks from different sectors? There are:
A 45 distinct correlations not equal to one.
B 90 distinct correlations not equal to one.
C 100 distinct correlations.

A is correct. A multivariate normal distribution for the returns of n stocks is defined by

n means, n variances, and n × (n − 1)/2 distinct correlations. There should be 45 = [10 ×
(10 − 1)]/2 distinct correlations in this case.
B is incorrect. There are 90 correlations not equal to one, but there are 45 duplicate
correlations making the number of distinct correlations not equal to one equal to 45
(i.e., 90 − 45 = 45).
C is incorrect. Including correlations equal to one, there are only 55 distinct correla-
tions, of which ten are equal to one.

Common Probability Distributions

27 The confidence interval is most likely to be:

A wider as the sample size increases.
B wider as the point estimate increases.
C narrower as the reliability factor decreases.

C is correct. A confidence interval for a parameter = Point estimate ± Reliability factor

× Standard error. For example, the reliability factors for confidence intervals based on
the standard normal distribution are 1.65 for 90% confidence intervals and 1.96 for 95%
confidence intervals. For a given point estimate and standard error, the confidence
interval will be narrower with a lower reliability factor.
A is incorrect. A larger sample size will reduce standard error making the confidence
interval more narrow.
16 2020 Level I Mock Exam (C) PM

B is incorrect. The point estimate does not affect the width of the confidence interval.

Sampling and Estimation

28 The joint probability of events A and B is 32%, with the probability of event
A being 60% and the probability of event B being 50%. On the basis of this
information, the conditional probability of event A given that event B occurs is
closest to:
A 53.3%.
B 30.0%.
C 64.0%.

C is correct. The conditional probability of A given that B has occurred is equal to the
joint probability of A and B divided by the probability of B. In this case:
P(A | B) = P(AB)/P(B) = 32.0%/50.0% = 64.0%
B is incorrect because it equals P(A) × P(B) = 60.0% × 50.0% = 30.0%
A is incorrect because it is P(B | A) = P(AB)/P(A) = 32.0%/60.0% = 53.3%

Probability Concepts

29 A consumer purchases an automobile using a loan. The amount borrowed is

€30,000, and the terms of the loan call for the loan to be repaid over five years
using equal monthly payments with an annual nominal interest rate of 8% and
monthly compounding. The monthly payment is closest to:
A €626.14.
B €608.29.
C €700.00.

B is correct. Using a financial calculator: N = 60, I/Y = 8/12, PV = 30000, FV = 0, and

compute PMT.
2020 Level I Mock Exam (C) PM 17

Note, 5 years = 60 months. The nominal rate of 8% must be divided by 12 to find

the monthly periodic rate of 0.6666667%. Alternatively, using the present value of an
annuity formula, solve:

 1 
1  mN 
 1  rs m 
PV = A  
rs m
 
 
 

 1 
1  125 
1  0.08 12 
30,000 = A 
 0.08 12 
 
 
30,000 = A × 49.318433
A = 30,000/49.318433
= 608.291829
A is incorrect as it uses N = 5, I/Y = 8, PV = 30000, FV = 0, compute PMT = 7513.69.
7513.69/12 = 626.14.
C is incorrect as it is calculated using: Interest = €30,000 × 0.08 × 5 = €12,000; Payment
= (€30,000 + €12,000)/60 = €700

The Time Value of Money

30 The following table shows the volatility of a series of funds that belong to the
same peer group, ranked in ascending order:

Volatility (%) Volatility (%)

Fund 1 9.81 Fund 8 13.99

Fund 2 10.12 Fund 9 14.47
Fund 3 10.84 Fund 10 14.85
Fund 4 11.33 Fund 11 15.00
Fund 5 12.25 Fund 12 17.36
Fund 6 13.39 Fund 13 17.98
Fund 7 13.42

The approximate value of the first quintile is closest to:

A 10.70%.
B 11.09%.
C 10.84%.

A is correct. The position of the first quintile is found with the following formula:
Ly = (n + 1) × (y/100),
18 2020 Level I Mock Exam (C) PM

where

y = the percentage point at which the distribution is divided. In

this case, y = 20, which corresponds to the 20th percentile (first
quintile)
n = the number of observations (funds) in the peer group. In this case,
n = 13
L 20 = the location of the 20th percentile (first quintile)
L 20 = (13 + 1) × (20/100) = 2.80.
Therefore, the location of the first quintile is between the volatility of Fund 2 and
Fund 3 (because they are ranked in ascending order).
Linear interpolation is used to find the approximate value of the first quintile:
P20 ≈ X2 + (2.80 − 2) × (X3 − X2)
where

X 2 = the volatility of Fund 2

X 3 = the volatility of Fund 3
P 20 = the approximate value of the first quintile

P20 ≈ 10.12% + (2.80 − 2) × (10.84% − 10.12%) = 10.70%

B is incorrect. It is the approximate value of the first quartile. The position of the first
quartile is found as follows: L 25 = (13 + 1) × (25/100) = 3.50. So, the location of the first
quartile is between the volatility of Fund 3 and Fund 4. Linear interpolation is used to
find the approximate value of the first quartile:
P25 ≈ X3 + (3.50 − 3) × (X4 − X3 )
P25 ≈ 10.84% + (3.50 − 3) × (11.33% − 10.84%) = 11.09%
C is incorrect. The position of the first quintile is found with the following formula:
Ly = (n + 1) × (y/100)
L 20 = (13 + 1) × (20/100) = 2.80. 2.80 is then rounded up to 3 and the volatility of Fund
3 is taken. That corresponds to 10.84%.

Organizing, Visualizing, and Describing Data

31 Successful advertising and product differentiation are most likely to have a posi-
tive impact on the economic profits of a producer under:
A monopolistic competition.
B perfect competition.
C monopoly.

A is correct. Advertising and product differentiation are most likely to have a positive
impact on the economic profits of producers under monopolistic competition. The
monopoly aspect of this structure arises from the ability to differentiate its product.
C is incorrect. Under monopoly, advertising and product differentiation are of little
consequence in determining economic profits.
2020 Level I Mock Exam (C) PM 19

B is incorrect. Under perfect competition, all producers (and all consumers) are price
takers, and economic profits do not exist.

The Firm and Market Structures

32 A country with which of the following characteristics is least likely to face long-­
term GDP growth challenges?
A A country with innovations in production processes
B A country with high labor quality
C A country with large natural resources

A is correct. The most important factor affecting economic growth is technology because
it allows an economy to overcome the limits imposed by diminishing marginal returns.
A country with innovations in the production process is least likely to face long-­term
GDP growth challenges compared with a country that relies on input growth, such as
labor or natural resources.
C is incorrect. Natural resources are key inputs to GDP growth; however, technology
is the most important factor that will help the country overcome the limits imposed by
diminishing marginal returns. Even though natural resources are important, they are not
necessary for a country to achieve a high level of income provided it can acquire the
natural resources through trade.
B is incorrect. High labor quality is key input to GDP growth; however, technology
is the most important factor that will help the country overcome the limits imposed by
diminishing marginal returns.

Aggregate Output, Prices, and Economic Growth

33 The most likely initial (short-­run) effect of demand–pull inflation is an increase

in:
A finished good prices.
B employee wages.
C commodity prices.

C is correct. The effect of demand–pull inflation is an increase in the aggregate demand,

which, in turn, leads to an increase (initially) in commodity prices.
A is incorrect. Commodity prices tend to increase initially.
B is incorrect. Commodity prices tend to increase initially.

Understanding Business Cycles

34 In an effort to influence the economy, a central bank conducted open market

activities by selling government bonds. This action implies that the central bank
is most likely attempting to:
A expand the economy through a lower policy interest rate.
B contract the economy through a lower policy interest rate.
C contract the economy by reducing bank reserves.
20 2020 Level I Mock Exam (C) PM

C is correct. Selling government bonds results in a reduction of bank reserves and

reduces their ability to lend, causing a decline in money growth through the multiplier
mechanism and hence leads to a contraction in the economy.
A is incorrect. Central bank selling of bonds is not expansionary.
B is incorrect. Central bank selling of bonds will reduce the money supply through its
impact on bank reserves, which will result in a higher, not lower, interest rate.

Monetary and Fiscal Policy

35 According to the concept of money neutrality, over the long term, the money
supply is least likely to affect:
A inflation expectations.
B inflation.
C the real rate of interest.

C is correct. The concept of money neutrality implies that an increase in the money
supply will leave real variables like output and employment unaffected. The real rate of
interest will be unaffected by money supply changes but inflation and inflation expec-
tations will be affected.
B is incorrect. According to money neutrality, real variables are not affected by changes
in money supply but inflation will be.
A is incorrect. According to money neutrality, real variables are not affected by changes
in money supply but inflation expectations can be.

Monetary and Fiscal Policy

36 Four countries operate within a customs union. One country proposes moving
to a common market structure. What additional level of economic integration
between the countries would most likely arise if this change took place? They
would:
A begin to allow free movement of the factors of production.
B establish common economic institutions and coordination of economic
policies.
C establish common trade barriers against non-­members.

A is correct. A common market structure incorporates all aspects of the customs union
and extends it by allowing free movement of factors of production among members.
B is incorrect. It arises in an economic union.
C is incorrect. A customs union already includes common trade barriers.

International Trade and Capital Flows

2020 Level I Mock Exam (C) PM 21

37 A country implements policies that are expected to increase taxes by €100 mil-

lion, increase government spending by €50 million, and reduce investments and
private sector savings by €25 million each. As a result, the country’s current
account balance is most likely to:
A decrease by €50 million.
B increase by €100 million.
C increase by €50 million.

C is correct.
CA = Sp – I + (T – G – R)
where

CA = current account balance

Sp = private sector savings
I = investments
T = taxes
g = government spending
r = transfers

∆CA = –25 – (–25) + (100 – 50 – 0) = 50

A in incorrect. It uses the wrong sign before the parenthesis for government sector:
∆CA = –25 – (–25) – (100 – 50 – 0) = –50.
B is incorrect. It uses the wrong sign on savings: ∆CA = 25 – (–25) + (100 – 50 – 0) = 100.

International Trade and Capital Flows

38 The following information is available:

New Zealand dollar (NZD) to British pound (GBP) spot exchange rate:
2.0979
Libor interest rates for the British pound: 1.6025%
Libor interest rates for the New Zealand dollar: 3.2875%
All Libor interest rates are quoted on a 360-­day year basis
The 180-­day forward points (scaled up by four decimal places) in NZD/GBP is
closest to:
A 39.
B 348.
C 176.

C is correct. Covered interest arbitrage will ensure identical terminal values by investing
the same initial amounts at the respective country’s domestic interest rates:
GBP investment: ₤1 × (1 + 0.016025 × 180/360) = ₤1.008013
NZD investment: NZ$2.0979 × (1 + 0.032875 × 180/360) = NZ$2.13238
22 2020 Level I Mock Exam (C) PM

The forward rate is determined by equating these two terminal amounts:

NZD/GBP forward rate = NZ$2.13238/₤1.008013 = 2.115429

Forward points = (Forward – Spot) × 10,000

 = (2.1155– 2.0979) × 10,000
 = 175.3 =176 (rounded)
A is incorrect. It inverts the currencies.
GBP investment: ₤2.0979 × (1 + 0.016025 × 180/360) = ₤2.1147
NZD investment: NZ$1 × (1 + 0.032875 × 180/360) = NZ$1.0164
The forward rate is determined by equating these two terminal amounts:
NZD/GBP forward rate = NZ$1.0164/₤2.1147 = 0.4806
Inverted Spot: 1/2.0979 = 0.47667

Forward points = (Forward – Spot) × 10,000

 = (0.4806– 0.4767) × 10,000
 = 39
B is incorrect. It ignores the half-­year time frame of the contract:
GBP investment: ₤1 × (1 + 0.016025) = ₤1.016025
NZD investment: NZ$2.0979 × (1 + 0.032875) = NZ$2.16687
NZD/GBP forward rate = NZ$2.16687/₤1.016025 = 2.1327

Forward points = (Forward – Spot) × 10,000

 = (2.1327 – 2.0979) × 10,000
 = 347.9

Currency Exchange Rates

39 The government embarks on a policy intended to reduce the budget deficit.

This is most likely:
A an expansionary fiscal policy.
B a contractionary fiscal policy.
C an example of quantitative easing.

B is correct. A policy intended to reduce a budget deficit would involve raising taxes
and/or reducing spending. Either action is fiscal and would likely cause the economy to
slow, which is contractionary.
A is incorrect. Reducing the budget deficit would slow the economy, not expand it.
C is incorrect. Quantitative easing is an action of monetary policy and does not address
the budget deficit, which is a fiscal issue.

Monetary and Fiscal Policy

40 Which market participants are most likely to limit the use of leverage in the
management of their accounts?
2020 Level I Mock Exam (C) PM 23

A Exchange-­traded funds
B Commodity trading advisers
C Bank proprietary trading desks

A is correct. Exchange-­traded funds are part of a class of institutional investors referred

to as real money accounts. They are usually restricted in their use of leverage or financial
derivatives in their accounts.
B is incorrect. Commodity trading advisers are part of the professional trading com-
munity that uses leverage or financial derivatives in the management of their accounts.
C is incorrect. Proprietary trading desks at banks are part of the professional trad-
ing community that uses leverage or financial derivatives in the management of their
accounts.

Currency Exchange Rates

41 A small startup company produces packages of ingredients and recipes for

meals delivered to clients’ homes and targets local young urban workers. After
enjoying quick early success and operating profits, it decided to expand into
other regions in the country and other demographic segments.
Senior management believed the key to the company’s success was to source
local foods and cater to local tastes; therefore, for each new city the company
entered, it set up an assembly facility and hired a manager, a sales team, and
a production manager who operated with autonomy. Two years after starting
its expansion plans, the company found that sales had grown as expected and
operating margins were positive but lower than before expansion. Which of
the following economic scenarios most likely describes the company’s results to
date? The company:
A has yet to reach its breakeven volume.
B is suffering from diseconomies of scale.
C has reached its minimum efficient scale.

B is correct. The company is most likely suffering from diseconomies of scale. It is having
to duplicate all costs in each location, and by targeting different demographics, it has
added additional costs for inputs and marketing. Therefore, the company’s fixed costs
have increased faster than output, and the economic result is diseconomies of scale.
A is incorrect. Breakeven is the point where total revenues equal total costs and hence
operating profit is zero. The company’s operating margins are positive; therefore, it is
operating above breakeven.
C is incorrect. The minimum efficient scale is the minimum point on the long-­run
average cost curve. Since profits are lower than before the expansion, the company is
not yet operating at the least-­cost point.

Topics in Demand and Supply Analysis

42 The costs associated with the production and sale of a good are indicated in the
following table:
24 2020 Level I Mock Exam (C) PM

Cost of Input Price of Output (£/

Activity (£/unit) unit) in Current Period

Input materials produced in prior period 3.50 5.42

Production 5.42 8.02
Distributing good to stores (wholesale) 8.02 11.23
Selling good to consumers (retail) 11.23 16.50

The contribution (in £/unit) that this good makes to current GDP is closest to:
A 13.00.
B 16.50.
C 24.67.

A is correct. GDP is defined as the market value of all final goods and services produced
within the economy in a given period of time. In this case, it is the retail value of the
good less the value of raw materials produced in the prior period (16.50 – 3.50 = 13.00).

Price of
Output (£) Value Added
Cost of in Current (£) in Current
Activity Input (£) Period Period

Input materials produced in 3.50 5.42 1.92

prior period
Production 5.42 8.02 2.60
Distributing good to stores 8.02 11.23 3.21
(wholesale)
Selling good to consumers 11.23 16.50 5.27
(retail)
Total 28.17 41.17 13.00

As indicated in the preceding table, GDP can also be determined either (1) by the
difference between the sum of the selling prices at each stage of the process in the cur-
rent period less the total costs of the inputs at each stage of the process arising in the
current period (41.17 – 28.17 = 13.00) or (2) by summing the value added at each stage
of the process in the current period (1.92 + 2.60 + 3.21 + 5.27 = 13.00).
B is incorrect: £16.50 is the selling price of the final good. Since the input materials
were produced in the prior period, their cost needs to be deducted from the selling price
(16.50 – 3.50 = 13.00) to determine the current contribution to GDP.
C is incorrect: £24.67 is the sum of all the input costs incurred in the current period
(28.17 – 3.50 = 24.67).

Aggregate Output, Prices, and Economic Growth

43 The following data apply to two comparable companies that are in direct
competition.
2020 Level I Mock Exam (C) PM 25

  Company A Company B

Times interest earned ratio 2.50 2.50

Return on equity (ROE) 10.13% 16.88%
Return on assets (ROA) 6.75% 11.25%
Asset turnover 1.50 2.50

Which of the following statements is most accurate?

A Company A has a lower net profit margin.
B Both companies have the same amount of interest expense.
C Company A has a higher degree of financial leverage than Company B.

B is correct

Company A Company B Comparison

Net profit ROA 6.75/1.50 = 11.25/2.50 = Same

margin 4.50% 4.50%
Asset turnover
Financial ROE 10.13/6.75 = 16.88/11.25 = Same
leverage 1.50 1.50
ROA

In this instance, times interest earned can be found as the correct answer by process
of eliminating the other choices as potential correct answers. Keep in mind, however,
that even when companies have equal times interest earned ratios, it does not mean
that the amount of interest expense is the same for both because the companies may
not be of equal size.
A is incorrect. In this instance, times interest earned can be found as the correct
answer by process of eliminating the other choices as potential correct answers. Keep
in mind, however, that even when companies have equal times interest earned ratios,
it does not mean that the amount of interest expense is the same for both because the
companies may not be of equal size.
C is incorrect. In this instance, times interest earned can be found as the correct
answer by process of eliminating the other choices as potential correct answers. Keep
in mind, however, that even when companies have equal times interest earned ratios,
it does not mean that the amount of interest expense is the same for both because the
companies may not be of equal size.

Financial Analysis Techniques

44 A company incurs the following costs related to its inventory during the year:
Cost ¥ millions

Purchase price 100,000

Trade discounts 5,000
Import duties 20,000
Shipping of raw materials to manufacturing facility 10,000
Manufacturing conversion costs 50,000
Abnormal costs as a result of waste material 8,000
Storage cost of finished goods prior to shipping to customers 2,000
26 2020 Level I Mock Exam (C) PM

The amount charged to inventory cost (in millions) is closest to:

A ¥177,000.
B ¥185,000.
C ¥175,000.

C is correct. The costs to include in inventories are all costs of purchase, costs of con-
version, and other costs incurred in bringing the inventories to their present location
and condition. It does not include abnormal waste costs or storage of finished product.

Cost ¥ millions

Purchase price 100,000

Minus trade discounts –5,000
Import duties 20,000
Shipping of raw materials to manufacturing facility 10,000
Manufacturing conversion costs 50,000
Total inventory costs 175,000

A is incorrect. It mistakenly includes the ¥2,000 storage cost: ¥175,000  + ¥2,000  =

¥177,000.
B is incorrect. It mistakenly adds, not subtracts, the trade discounts of ¥5,000 from
the purchase price: ¥175,000 + ¥10,000 = ¥185,000.

Inventories

45 The objective of general purpose financial reporting is best described as:

A providing information about financial performance to a wide range of users.
B facilitating resource allocation decisions by current and potential investors
and creditors.
C reporting an entity’s economic resources and claims, and changes therein, to
shareholders.

B is correct. According to the Conceptual Framework for Financial Reporting 2010 within
the International Financial Reporting Standards, as well as Concept Statement 8 under
US GAAP, “the objective of general purpose financial reporting is to provide financial
information about the reporting entity that is useful to existing and potential investors,
lenders, and other creditors in making decisions about providing resources to the entity.”
A is incorrect. The scope of this statement is limited to financial performance, rather
than the broader financial reporting scope. Further, the target audience of financial
reporting reflects the 1989 version of the framework.
C is incorrect. Both the scope and the target audience are too narrow in this statement.
The scope reflects the 1989 version of the framework.

Financial Reporting Standards

46 For a company issuing securities in the United States to meet its obligations
under the Sarbanes–Oxley Act, which of the following is management required
to attest to?
2020 Level I Mock Exam (C) PM 27

A The suitability of management and director compensation agreements

B The adequacy of internal control over financial reporting
C The accuracy of estimates and assumptions used in preparing the financial
statements

B is correct. To be in compliance with Sarbanes–Oxley, it is mandatory that management’s

Report to Shareholders discuss internal financial controls and their effectiveness, as well
as the company’s auditor’s opinion of these internal controls.
A is incorrect. Information on management and director compensation agreements
will be found in the proxy statement and/or notes to the financial statements.
C is incorrect. Estimates and assumptions used in preparing financial statements are
found in the notes to the financial statements.

Financial Statement Analysis: An Introduction

47 A company purchased a €2,000 million long-­term asset in 2012 when the cor-

porate tax rate was 30%.
Asset’s Year-­End Value for 2013 (€ millions) 2012 (€ millions)

Accounting purposes 1,800 1,900

Tax purposes 1,280 1,600

On 15 January 2013, the government lowered the corporate tax rate to 25% for
2013 and beyond. The deferred tax liability (€ millions) as of 31 December 2013,
is closest to:
A 130.
B 231.
C 156.

A is correct. The deferred tax liability equals the difference between the value for
accounting purposes and the value for tax purposes times the current tax rate in effect.
(€1,800 – €1,280) × 0.25 = €520 × 0.25 = €130 million
B is incorrect. It assumes the differences are cumulative and each at the rate in effect
for that period: (520 × 0.30) + (300 × 0.25) = 156 + 75 = 231.
C is incorrect. It uses the tax rate in effect when the asset was purchased and does
not account for the change in the rate: (1,800 – 1,280) × 0.30 = 520 × 0.30 = 156.

Income Taxes

48 Which of the following statements about the direct method for presenting cash
from operating activities is most appropriate? The direct method:
A shows the reasons for differences between net income and operating cash
flows.
B provides information on the specific sources of operating cash receipts and
payments.
28 2020 Level I Mock Exam (C) PM

C shows the impact of accruals.

B is correct. The direct method provides information on the specific sources of operating
cash receipts and payments. This approach is in contrast to the indirect method, which
reconciles net income to cash flow and shows only the net result of these receipts and
payments.
A is incorrect. This is the primary argument for presenting cash from operating activ-
ities using the indirect method.
C is incorrect. This is an argument for presenting cash from operating activities using
the indirect method.

Understanding Cash Flow Statements

49 Selected information about a company is as follows:

  Current Year Projection for Next Year
($ thousands) ($ thousands)

Sales 2,200 2,500

Variable operating costs (% of sales) 28% 30%
Fixed operating costs 1,400 1,400
Tax rate 25% 25%
Dividends paid 55 60
Interest bearing debt at 5% 500 500

The forecasted net income (in $ thousands) for next year is closest to:
A 169.
B 244.
C 202.

B is correct. Forecasted net income (in $ thousands) is calculated as follows:

Sales 2,500 Given

Variable costs –750 30% of sales

Fixed costs –1,400 Given
Interest expense –25 0.05 × Average debt of $500
Earnings before taxes (EBT) 325
Taxes –81.25 25% of EBT
Net income 243.75 Rounded to $244

A is incorrect. It calculates interest expense as a percent of sales not as a percent of debt:

Interest as
Correct Dividends Percent of Sales

Sales 2,500 2,500 2,500

Variable costs 750 750 750
Fixed costs 1,400 1,400 1,400
2020 Level I Mock Exam (C) PM 29

Interest as
Correct Dividends Percent of Sales
Dividends 55
interest expense 25 25 125
EBT 325 270 225
Taxes 81.25 67.5 56.25
Net income 243.75 202.5 168.75

C is incorrect. It deducts dividends as a before tax expense.

Interest as
Correct Dividends Percent of Sales

Sales 2,500 2,500 2,500

Variable costs 750 750 750
fixed costs 1,400 1,400 1,400
Dividends 55
interest expense 25 25 125
EBT 325 270 225
Taxes 81.25 67.5 56.25
Net income 243.75 202.5 168.75

Financial Statement Analysis: Applications

50 The following information is from a company’s accounting records:

€ millions

Revenues for the year 12,500

Total expenses for the year 10,000
Gains from available-­for-­sale securities 1,475
Loss on foreign currency translation adjustments on a foreign 325
subsidiary
Dividends paid 500

The company’s total comprehensive income (in € millions) is closest to:

A 1,150.
B 3,150.
C 3,650.

C is correct.
Total comprehensive income = Net income + Other comprehensive income
Net Income = Revenues – Expenses.
Other comprehensive income includes gains or losses on available-­for-­sale (AFS)
securities and translation adjustments on foreign subsidiaries.
(Revenues – Expenses) + Gain on AFS securities – Loss on FX translation
(12,500 – 10,000) + 1,475 – 325 = 3,650.
30 2020 Level I Mock Exam (C) PM

A is incorrect because it is just the other comprehensive income (1,475 – 325) and not
the total comprehensive income.
B is incorrect because it also deducts dividends, which are deducted when calculating
the change in shareholders’ equity but not total comprehensive income.

Understanding Income Statements

51 Using the following information, a Mexican corporation is computing the

depreciation expense for a piece of manufacturing equipment that it purchased
at the start of the current year. The company takes a full year’s depreciation in
the year of acquisition.
Cost of equipment MXN2,000,000
Estimated residual value MXN200,000
Expected useful life 10 years
Total productive capacity 5,000,000 units
Production during year 800,000 units

The first year’s depreciation expense (in MXN) will most likely be higher by:
A 112,000, using the double-­declining method compared with the units-­of-­
production method.
B 140,000, using the units-­of-­production method compared with the straight-­
line method.
C 180,000, using the double-­declining balance method compared with the
straight-­line method.

A is correct. The difference between the double-­declining balance method and the
units-­of-­production method (in MXN) is 400,000 – 288,000 = 112,000.

  Straight Line Units of Production Declining Balance

Rate 1/10 5,000,000 units 1/10 × 2 = 20%

Annual (2,000,000 (2,000,000 – 200,000) × 0.20 × 2,000,000
expense – 200,000)/10 (800,000/5,000,000)
= 180,000 = 288,000 = 400,000

B is incorrect. It correctly calculated the straight-­line method expense: (2,000,000

– 200,000)/10  = 180,000. However, it forgot to deduct the residual value in calculat-
ing depreciation expense using the units-­of-­production method and got 320,000:
(2,000,000/5,000,000) × 800,000 = 320,000. The difference became 140,000 instead of
the correct 108,000.
C is incorrect. It correctly calculated the straight-­line method expense: (2,000,000 –
200,000)/10 = 180,000. However, it mistakenly deducted the residual value in calculating
depreciation expense using the double-­declining balance method and got 360,000:
(2,000,000 – 200,000) × 20%. The difference became 180,000 instead of the correct
220,000.

Long-­Lived Assets
2020 Level I Mock Exam (C) PM 31

52 A company has announced that it is going to distribute a group of long-­lived

assets to its owners in a spin-­off. The most appropriate way to account for the
assets until the distribution occurs is to classify them as:
A held for sale with no depreciation taken.
B held for use until disposal with no deprecation taken.
C held for use until disposal with depreciation continuing to be taken.

C is correct. Long-­lived assets that will be disposed of other than by sale, such as in a
spin-­off, an exchange for other assets, or abandonment, are classified as held for use
until disposal and continue to be depreciated until that time.
A is incorrect. Assets to be disposed of by means other than by sale are not classified
as held for sale.
B is incorrect. The assets would be held for use until disposal, but would continue
to be depreciated.

Long-­Lived Assets

53 Which of the following statements regarding inventory valuation is most

accurate?
A IFRS defines market value as net realizable value less a normal profit
margin.
B Both IFRS and US GAAP allow the reversal of write-­downs back to the orig-
inal cost.
C Both IFRS and US GAAP allow agricultural inventories to be valued at net
realizable value.

C is correct. Both IFRS and US GAAP allow agricultural inventories to be valued at net
realizable value.
A is incorrect. IFRS defines net realizable value as selling price less costs to get it ready
to sell and to make the sale.
B is incorrect. US GAAP does not allow reversal of a write-­down generally.

Inventories

54 A company sells a non-­refundable, two-­year service contract for €420. Based

on historical patterns, the company expects to incur 25% of service costs in the
first year of the contract and the remainder in the second year. The amount of
revenue the company recognizes in the first year is closest to:
A €105.
B €420.
C €210.
32 2020 Level I Mock Exam (C) PM

A is correct. Service revenues are recognized by reference to the stage of completion

of the service contract. Historical patterns provide evidence that 25% of the services
performed under the contract are incurred during the contract’s first year. As such, only
25% of the contract revenue would be recognized in the first year:

      
  Calculation

Total contract value €420

Stage of completion at end of first year 25%
Revenue recognized in first year €105 25% × €420

B is incorrect. This calculation incorrectly implies that all of the services provided
under the warranty have been rendered by the end of the first year.
C is incorrect. This calculation incorrectly implies that half of the services provided
under the warranty have been rendered by the end of the first year. In fact, historical
experience indicates that only 25% of the services provided will have been rendered by
the end of that year.

Understanding Income Statements

55 Under the indirect method of presenting operating cash flows, which action to
alter the cash flow from operations will be most difficult to detect?
A Defer payment of a current liability
B Transact with an unconsolidated special purpose entity
C Change inventory costing from FIFO to weighted average

B is correct. Unconsolidated special purpose entities are outside of the view of investors.
Transacting with such an entity may initially produce the appearance of a positive or
negative cash flow for the controlling company. Ultimately, this transaction will most
likely be reversed along with the appearance of the initial cash flow.
A is incorrect because an examination of cash provided by operating activities will
reveal that the increase in cash due to the deferred payment is offset by a comparable
increase in accounts payable.
C is incorrect because changes in inventory accounting may affect gross profit and
therefore net income, but with an opposite effect on the ending inventory value. Together
these effects would likely have an offsetting impact on the appearance of cash generated
by operating activities. One possible exception might be the effect on derived expenses
such as the provision for income tax.

Financial Reporting Quality

56 Which of the following is most likely to signal manipulation of financial report-

ing for a large, diversified company?
A A history of large expense items classified as unusual
B Operating margins out of line with other diversified companies
C Changes in accounting policies to reflect new accounting standards
2020 Level I Mock Exam (C) PM 33

A is correct. A history of unusual expense items may indicate a pattern of management

manipulating the way investors perceive operating income performance. Repeated use
of the “unusual” or “non-­recurring” category decreases the value of this classification
and suggests that management may be trying to manipulate users’ perceptions of
sustainable profitability levels.
B is incorrect. Diversified companies include a mix of businesses and, depending on
that mix, may or may not be expected to have similar operating margins.
C is incorrect. Accounting policies must be changed to comply with new accounting
standards. Changes for this purpose are not suspect.

Financial Reporting Quality

57 Unless it is impractical to do so, changes in accounting policies are to be

reported:
A prospectively.
B retrospectively.
C at the bottom of the income statement in the year of change.

B is correct. Changes in accounting policies are reported through retrospective applica-

tion unless it is impractical to do so.
A is incorrect because companies may be permitted to adopt new standards prospec-
tively, but changes in accounting policies are reported through retrospective application
unless it is impractical to do so.
C is incorrect because in years prior to 2005, but not now, under both IFRS and US
GAAP, the cumulative effect of changes in accounting policies was typically shown at
the bottom of the income statement in the year of change instead of using retrospective
application.

Understanding Income Statements

58 In an issuer’s financial statements, reported interest expense for a bond is com-

puted using the:
A bond’s coupon rate.
B market rate of interest.
C effective interest rate.

C is correct. Reported interest expense for a company’s bonds is computed using the
effective interest rate, which is the market interest rate at issuance.
A is incorrect because the effective interest rate (not the bond’s coupon rate) is used
to compute a bond’s reported interest expense.
B is incorrect because the effective interest rate (not the market rate of interest) is
used to compute a bond’s reported interest expense.

Non- ­Current (Long-­Term) Liabilities

34 2020 Level I Mock Exam (C) PM

59 Which of the following common debt covenants best describes an affirmative

covenant?
A Restricting future borrowings
B Prohibiting financial ratios from falling below specified levels
C Limiting dividend payments

B is correct. Common covenants include specifying minimum acceptable levels of finan-

cial ratios. Affirmative covenants restrict the borrower's activities by requiring certain
actions, like maintaining certain ratios.
A is incorrect because restricting future borrowings is a negative covenant in that
it restricts the borrower from taking certain actions, like issuing new debt securities.
C is incorrect because limiting dividend payments is a negative covenant in that it
restricts the borrower from taking certain actions, like increasing dividends.

Non- ­Current (Long-­Term) Liabilities

USE THE FOLLOWING COMMON-­SIZE BALANCE

SHEET INFORMATION TO ANSWER QUESTION 60

Company X Company Y Company Z

Assets
Cash and cash equivalents 15.6% 12.0% 2.0%
Marketable securities 3.4% 5.1% 12.0%
Trade and other receivables 10.9% 12.7% 4.8%
Other non-­financial assets 14.3% 11.7% 7.4%
Total current assets 44.2% 41.5% 26.2%

Goodwill 1.6% 2.2% 28.8%

Intangible assets 17.6% 7.0% 24.0%
Property, plant, and equipment 17.7% 25.3% 8.2%
Other financial assets 12.4% 24.0% 9.6%
Other non-­financial assets 0.3% 0.0% 2.1%
Deferred tax assets 6.2% 0.0% 1.1%
Total non-­current assets 55.8% 58.5% 73.8%

Total assets 100.0% 100.0% 100.0%

Liabilities and shareholders’ equity

Trade and other payables 3.4% 3.5% 2.1%
Bank loans and other financial liabilities 8.4% 3.2% 6.0%
Other non-­financial liabilities 5.0% 11.7% 9.0%
Deferred income 11.8% 9.8% 0.0%
Total current liabilities 28.6% 28.2% 17.1%
2020 Level I Mock Exam (C) PM 35

Company X Company Y Company Z

Financial liabilities 18.4% 18.3% 17.4%
Other non-­financial liabilities 12.8% 5.7% 7.9%
Deferred tax liabilities 2.5% 4.2% 18.6%
Total non-­current liabilities 33.7% 27.5% 43.9%
Total liabilities 62.3% 55.7% 61.0%

Total shareholders’ equity 37.7% 44.3% 39.0%

Total liabilities and shareholders’ equity 100.0% 100.0% 100.0%

60 Based solely on the debt-­to-­equity ratio, which company exhibits the most
financial risk?
A Company X
B Company Y
C Company Z

A is correct. As calculated below, Company X has the highest, and thus the weakest,
debt-­to-­equity ratio.
Total debt
= Debt-to-equity ratio
Total equity

26.8%/37.7% = 71.1%

Company X Company Y Company Z

Bank loans and other financial 8.4% 3.2% 6.0%

liabilities
Financial liabilities 18.4% 18.3% 17.4%
Total debt 26.8% 21.5% 23.4%
Total equity 37.7% 44.3% 39.0%
Debt-­to-­equity ratio 71.1% 48.5% 60.0%

B is incorrect because Company Y has the lowest debt-­to-­equity ratio at 21.5%/44.3%

= 48.5%.
C is incorrect because Company Z’s debt-­to-­equity ratio is 23.4%/39.0% = 60.0%,
lower than Company X’s.

Understanding Balance Sheets

61 Which of the following sources of short-­term financing is most likely used by

smaller companies?
A Commercial paper
B Collateralized loans
C Uncommitted lines
36 2020 Level I Mock Exam (C) PM

B is correct. Smaller companies use collateralized loans, factoring, or loans from non-­
bank companies as their sources of short-­term financing. Larger companies can take
advantage of commercial paper, banker’s acceptances, uncommitted lines, and revolving
credit agreements.
A is incorrect. Smaller companies use collateralized loans, factoring, or loans from
non-­bank companies as their sources of short-­term financing. Larger companies can
take advantage of commercial paper, banker’s acceptances, uncommitted lines, and
revolving credit agreements.
C is incorrect. Smaller companies use collateralized loans, factoring, or loans from
non-­bank companies as their sources of short-­term financing. Larger companies can
take advantage of commercial paper, banker’s acceptances, uncommitted lines, and
revolving credit agreements.

Working Capital Management

62 A company’s data are provided in the following table:

Cost of debt 10%
Cost of equity 16%
Debt-­to-­equity ratio (D/E) 50%
Tax rate 30%

The weighted average cost of capital (WACC) is closest to:

A 14.0%.
B 11.5%.
C 13.0%.

C is correct. Convert the D/E to determine the weights of debt and equity as follows:
DE 50%
wd    33.3%
1  D E 1  50%

we = 1 – wd = 66.7%

WACC = wdrd (1 – t) + wprp + were

= 33.3% × 10% × (1 – 30%) + 66.7% × 16% = 13.0%
A is incorrect because the debt is not tax adjusted when determining the WACC.
WACC = 33.3% × 10% + 66.7% × 16% = 14.0%
B is incorrect because the D/E is used as the weight for debt and equity.
WACC = 50% × 10% × (1 – 30%) + 50% × 16% = 11.5%

Cost of Capital

63 Proponents of dual-­class voting structures believe that the benefits to public

shareholders most likely include:
A reducing conflicts of interest between management and those with eco-
nomic interests.
2020 Level I Mock Exam (C) PM 37

B trading values that are typically at a slight premium to single-­class peers.

C promoting company stability by insulating management from short-­term
investor pressures.

C is correct. Proponents of dual-­class structures argue that management is better able to

make long-­term strategic investments that may have negative short-­term implications
when control is wielded by a small group of shareholders with superior voting rights.
A is incorrect. Because of their reduced ability to influence management, shareholders
with economic but not voting interest are more likely to view management’s interests
in conflict with their own.
B is incorrect. Entities with multiple voting structures tend to trade at a discount to
their peers, not a premium.

Corporate Governance and ESG: An Introduction

64 Other factors held constant, the reduction of a company’s average accounts

payable because of suppliers offering less trade credit will most likely:
A not affect the operating cycle.
B reduce the operating cycle.
C increase the operating cycle.

A is correct. Payables are not part of the operating cycle calculation, which includes
receivables and inventory.
B is incorrect. As per above, payables are not part of the operating cycle calculation.
C is incorrect. As per above, payables are not part of the operating cycle calculation.

Financial Analysis Techniques

65 A firm’s estimated costs of debt, preferred stock, and common stock are 12%,
17%, and 20%, respectively. Assuming equal funding from each source and a
marginal tax rate of 40%, the weighted average cost of capital (WAAC) is closest
to:
A 13.9%.
B 14.7%.
C 16.3%.

B is correct. WACC = wdrd (1 – t) + wprp + were = [0.12 × (1 – 0.40) + 0.17 + 0.20]/3 = 14.73%.
A is incorrect because tax effect is miscalculated: [0.12 × 0.40 + 0.17 + 0.20]/3 = 13.93%.
C is incorrect because tax effect is ignored: [0.12 + 0.17 + 0.20]/3 = 16.33%.

Cost of Capital

66 The following information is available for a company’s bank account:

38 2020 Level I Mock Exam (C) PM

Total deposits (millions) $16.0

Average daily float (millions) $2.5
Number of days 15

The float factor for the company is closest to:

A 2.3.
B 6.4.
C 0.4.

A is correct.

Float factor = Average daily float/Average daily deposit

 = $2.5 million/($16 million/15) = 2.3
B is incorrect because it uses (Total deposit/Average daily float).
C is incorrect because it uses (Average daily deposit/Average daily float).

Working Capital Management

67 The following information is available for a firm:

Sales price per unit €85
Variable cost per unit €65
Fixed operating costs €50 million
Fixed financial costs €30 million

The firm’s breakeven quantity of sales (in million units) is closest to:
A 4.0.
B 2.5.
C 1.0.

A is correct. Breakeven quantity of sales,

F C
Q BE =
P V
 = (€50 million + €30 million)/(€85 – €65) = 4.0 million units
B is incorrect. If operating breakeven units is calculated, the answer will be Q OBE =
F/(P – V) = (€50 million)/(€85 – €65) = 2.5 million.
C is incorrect. If there is a wrong signage in the numerator, the answer will be =
(€50 million – €30 million)/(€85 – €65) = 1.0 million units.

Measures of Leverage

68 Given two mutually exclusive projects with normal cash flows, the point at
which their net present value profiles intersect the horizontal axis is most likely
the projects’:
2020 Level I Mock Exam (C) PM 39

A weighted average cost of capital.

B crossover rate.
C internal rate of return.

C is correct. For a project with normal cash flows, the NPV profile intersects the horizontal
axis at the point where the discount rate equals the IRR. The crossover rate is the discount
rate at which the NPVs of the projects are equal. Although it is possible that the crossover
rate is equal to each project’s IRR, it is not a likely event. It is also possible that the IRR is
equal to the WACC, but that scenario is not the most likely one.
B is incorrect. The crossover rate is the discount rate at which the NPVs of the projects
are equal. While it is possible that the crossover rate is equal to each project’s IRR, it is
not a likely event.
A is incorrect. The project’s net present value (NPV) occurs when the NPV profile
intersects the vertical axis or when the discount rate = 0.

Capital Budgeting

69 A firm’s before-­tax costs of debt, preferred stock, and equity are 12%, 17%, and
20%, respectively. Assuming equal funding from each source and a marginal tax
rate of 40%, the weighted average cost of capital (%) is closest to:
A 14.7%.
B 9.8%.
C 13.9%.

A is correct.

WACC = wdrd (1 – t) + wprp + were

 = (1/3)(0.12)(1 – 0.4) + (1/3)(0.17) + (1/3)(0.20)
 = 14.73%
B is incorrect. If all costs are considered after tax:
[(1/3)(0.12) + (1/3)(0.17) + (1/3)(0.20)] × (1 – 0.4) = 9.8%
C is incorrect. If tax effect on cost of debt is miscalculated:
(1/3)(0.12)(0.4) + (1/3)(0.17) + (1/3)(0.20) = 13.93%

Cost of Capital

70 When a new project reduces the cash flows of an existing project of the same
firm, it is best described as a(n):
A sunk cost.
B opportunity cost.
C externality.
40 2020 Level I Mock Exam (C) PM

C is correct. A new project reducing the cash flows of an existing project is an externality
called cannibalization.
A is incorrect because it is an example of cannibalization and not a sunk cost.
B is incorrect because it is an example of cannibalization and not an opportunity cost.

Capital Budgeting

71 An investment strategy that focuses on climate change is most likely following

which approach to environmental, social, and governance (ESG) investing?
A Thematic
B Best in class
C Impact

A is correct. A strategy that considers a single factor, such as climate change, is a thematic
investment strategy.
B is incorrect. Best-­in-­class ESG investing focuses on identifying the best ESG scoring
companies in each industry.
C is incorrect. Impact investing attempts to achieve targeted social or environmental
objectives.

Corporate Governance and ESG: An Introduction

72 Which of the following stakeholder groups would be most likely use covenants
to protect their interests and exert some control over a company?
A Creditors
B Shareholders
C Managers and employees

A is correct. Covenants are used in fixed-­income securities to restrict the activities of the
borrower and would be a means used by creditors of a company to protect their interests.
B is incorrect. Covenants are used by creditors, not shareholders
C is incorrect. Covenants are used by creditors, not managers and employees.

Corporate Governance and ESG: An Introduction

73 Which of the following statements concerning financial regulatory bodies is

least accurate? Financial regulatory bodies:
A act to level the playing field for market participants.
B define minimum standards of competence for agents.
C require that regulated firms maintain optimum levels of capital.
2020 Level I Mock Exam (C) PM 41

C is correct. Financial regulators impose minimum levels of capital that apply across the
board to all regulated firms—not the optimum level, which is firm specific.
A is incorrect. Financial regulators act to level the playing field for market participants
as in the case of regulation concerning insider trading.
B is incorrect. Financial regulators help define minimum standards of competence
for agents (e.g., the GIPS standards from CFA Institute).

Market Organization and Structure

74 An investor buys a stock on margin. Assume that the interest on the loan and
the dividend are both paid at the end of the holding period. The data related to
the transaction are as follows:
Number of shares 500
Purchase price per share $28
Leverage ratio 3.33
Commission $0.05/share
Position holding period Six months
Sale price per share $30
Call money rate 5% per year
Dividend $0.40/share

The investor’s total return on this investment over the margin holding period is
closest to:
A 15.6%.
B 16.7%.
C 21.4%.

C is correct.

Initial investment [($28 × 500) × (1/3.33)] + ($0.05 × $4,229

500)
– Purchase commission $0.05 × 500 –25
+ Trading gain ($30 – $28) × 500 1,000
– Margin interest paid $9,800 × 0.05 × 6 months –245
+ Dividends received $0.40 × 500 200
– Sales commission $0.05 × 500 –25
paid
= Remaining equity $5,134
Return on investment ($5,134 – $4,229)/$4,229 21.4%

A is incorrect. It computes margin interest for the entire year, not six months.

Initial investment [($28 × 500) × (1/3.33)] + ($0.05 × $4,229

500)
– Purchase commission $0.05 × 500 –25
+ Trading gain ($30 – $28) × 500 1,000
– Margin interest paid $9,800 × 0.05   
–490
(continued)
42 2020 Level I Mock Exam (C) PM

+ Dividends received $0.40 × 500 200

– Sales commission $0.05 × 500 –25
paid
= Remaining equity $4,889
Return on investment ($4,889 – $4,229)/$4,229 15.6%

B is incorrect. It ignores the dividend received during the margin period.

Initial investment [($28 × 500) × (1/3.33)] + ($0.05 × $4,229

500)
– Purchase commission $0.05 × 500 –25
+ Trading gain ($30 – $28) × 500 1,000
– Margin interest paid $9,800 × 0.05 × 6 months –245
+ Dividends received 0
– Sales commission paid $0.05 × 500 –25
= Remaining equity $4,934
Return on investment ($4,934 – $4,229)/$4,229 16.7%

Market Organization and Structure

75 If the number of financial analysts who follow or analyze a company increases

substantially, then the market for this company’s shares will most likely become:
A more attractive for active investors.
B overvalued.
C more efficient.

C is correct. The number of financial analysts who follow or analyze a security or asset
should be positively related to market efficiency. Therefore, if more analysts cover a
company, the market for this company’s shares will most likely become more efficient.
A is incorrect. In a more efficient market, less profitable trading opportunities exist
and as a consequence, it becomes less attractive for active investors.
B is incorrect. In a more efficient market, prices should converge toward fair value.

Market Efficiency

76 The voting rights of an unsponsored depository receipt (DR) belong to the:

A depository bank.
B direct owners of the foreign common shares.
C foreign company whose shares are held by the depository.

A is correct. In the case of unsponsored DRs, the depository bank, not the investors in
the DR, retains the voting rights.
B is incorrect because investors in sponsored DRs have the same rights as the direct
owners of the common shares.
2020 Level I Mock Exam (C) PM 43

C is incorrect because the foreign firm does not maintain voting rights with DRs.

Overview of Equity Securities

77 Companies pursuing cost leadership will most likely:

A invest in productivity-­improving capital equipment.
B establish strong market research teams to match customer needs with prod-
uct development.
C engage in defensive pricing when the competitive environment is one of
high rivalry.

A is correct. Companies pursuing cost leadership must be able to invest in productivity-­

improving capital equipment in order to be low-­cost producers and maintain efficient
operating systems.
B is incorrect. Establishing strong market research teams to match customer needs with
product development is appropriate for companies pursuing a differentiation strategy.
C is incorrect. Defensive pricing is appropriate when the competitive environment
is one of low rivalry, not high.

Introduction to Industry and Company Analysis

78 Industry analysis is least useful to those who are engaged in:

A a top-­down investment approach.
B indexing and passive investing strategies.
C portfolio performance attribution.

B is correct. Indexing and passive investing strategies would not engage in over- or
underweighting of industries, industry rotation, or timing investments in industries.
Therefore, industry analysis is not useful to such investors or portfolio managers.
A is incorrect. In a top-­down investing approach, industry analysis is useful to identify
industries with positive, neutral, or negative outlooks for profitability and growth, which
will then help weighting of industries relative to the benchmark.
C is incorrect. Portfolio performance attribution, which addresses the sources of a
portfolio’s returns, usually in relation to the portfolio’s benchmark, includes industry or
sector selection.

Introduction to Industry and Company Analysis

79 For portfolio managers of active funds, market indexes are least useful as:
A model portfolios.
B proxies to measure risk-­adjusted performance.
C benchmarks.
44 2020 Level I Mock Exam (C) PM

A is correct. Market indexes are used as model portfolios for index funds and exchange-­
traded funds, but they are not useful as model portfolios for active funds.
B is incorrect. Market indexes are used as proxies to measure risk-­adjusted perfor-
mance of active funds.
C is incorrect. Market indexes are used as benchmarks to evaluate the relative per-
formance of active funds.

Security Market Indexes

80 Which of the following statements about the forms of market efficiency is least
accurate? If the form of market efficiency is:
A weak, then investment strategies based on fundamental analysis could
achieve abnormal returns.
B semi-­strong, then security prices fully reflect all past market data.
C strong, then prices reflect only private information.

C is correct. If markets are strong-­form efficient, prices reflect not only private information
but also past market data and public information. If markets are weak-­form efficient,
investment strategies based on fundamental analysis of public information and past
market data could achieve abnormal returns. The semi-­strong-­form of market efficiency
also encompasses the weak form. Therefore, security prices reflect not only publicly
known and available information but also all past market data.
A is incorrect. This statement is correct because if markets are weak-­form efficient only,
investment strategies based on fundamental analysis could achieve abnormal returns.
B is incorrect. This statement is correct because the semi-­strong-­form of market
efficiency also encompasses the weak-­form; therefore, security prices reflect not only
publicly known and available information but also all past market data.

Market Efficiency

81 An investor gathered the following data:

Par value of preferred stock offered with a 6% dividend rate $100
Company’s sustainable growth rate 5%
Yield on comparable preferred stock issues 11.5%
Investor’s marginal tax rate 30%

The value of the company’s preferred stock is closest to:

A $96.92.
B $54.78.
C $52.17.

C is correct.
$100 × 0.06
V0 = D0/r = = $52.17
0.115
2020 Level I Mock Exam (C) PM 45

A is incorrect. It uses constant growth (where growth is ≠ 0) model;

V = $100(0.06)(1.05)/(0.115 – 0.05) = $96.92
B is incorrect. It uses D 1 instead of D 0
V = $100(0.06)(1.05)/0.115 = $54.78

Equity Valuation: Concepts and Basic Tools

82 An investor evaluating a company’s common stock has gathered the following

data.
Current dividend per share $2.40
Dividend growth rate expected during Years 1 to 2 20%
Dividend growth rate expected from Year 3 onward 4%
Company’s weighted average cost of capital 13%
Required rate of return on equity 15%

The intrinsic value per share of this common stock is closest to:
A $29.82.
B $24.86.
C $26.59.

A is correct. Using the two-­stage dividend discount model:

D1 Dn Pn
V0 =  
1 n
1  r 1  r 1  rn
V 0 = intrinsic value of a stock
Dt = expected dividend in year t
r = required rate of return on the stock
Dt = Current dividend per share = $2.40
2.401.20 2.401.20 2.401.20 1.04
2 2
1
V 0 =   
1.15 1.15 2 0 . 15  0 . 04 1.152
= $2.50 + $2.61 + $24.71 = $29.82
B is incorrect. It uses incorrect computations for D 1, D 2, and D 3 by making mistakes
in accounting for time periods.

2.40 2.401.20 2.401.201.04 1

V =   
1.15 1.15 2 0.15  0.04 1.152
= $2.09 + $2.18 + $20.59 = $24.86
46 2020 Level I Mock Exam (C) PM

C is incorrect. D 1, D 2, and D 3 are correctly computed, but the terminal value at the
end of Year 2 is incorrectly discounted with n = 3 instead of n = 2.

2.401.20 2.401.20 2.401.20 1.04

2 2
1
V =   
1.15 1.15 2 0.15  0.04 1.153
= $2.50 + $2.61 + $21.48 = $26.59

Equity Valuation: Concepts and Basic Tools

83 In comparison to the makeup of fixed-­income indexes, the constituent securi-

ties of equity indexes are best described as:
A harder to price.
B drawn from a larger universe.
C more liquid.

C is correct. The constituents of equity indexes are more liquid than those of fixed-­
income indexes. The number of fixed-­income securities is many times larger than the
number of equity securities. Fixed-­income markets are predominantly dealer markets,
which means that dealers are assigned to specific securities and are responsible for
creating liquid markets for those securities by purchasing and selling them from their
inventory. In addition, many fixed-­income securities do not trade frequently and are
therefore relatively illiquid. As a result, index providers must contact dealers to obtain
current prices on constituent securities to update the index, or they must estimate the
prices of constituent securities using the prices of traded fixed-­income securities with
similar characteristics.
A is incorrect. Fixed income markets are predominantly dealer markets. This means that
dealers are assigned to specific securities and are responsible for creating liquid markets
for those securities by purchasing and selling them from their inventory. In addition, many
fixed-­income securities do not trade frequently and, as a result, are relatively illiquid. As
a result, index providers must contact dealers to obtain current prices on constituent
securities to update the index or they must estimate the prices of constituent securities
using the prices of traded fixed-­income securities with similar characteristics.
B is incorrect. The number of fixed-­income securities is many times larger than the
number of equity securities.

Security Market Indexes

84 A company just paid an annual dividend of €1.25 per share. If the required
annual rate of return is 14% and dividends are expected to grow indefinitely at a
constant rate of 8%, the company’s intrinsic value per share is:
A €16.88.
B €20.83.
C €22.50.
2020 Level I Mock Exam (C) PM 47

C is correct. The value of the shares can be estimated using the Gordon growth model
as follows:
¬1.251.08 ¬1.35
V0  
0.14  0.08 0.06
V0 = €22.50
A is incorrect because €16.88 is derived using the growth rate in the denominator
of the formula instead of the difference between the required rate of return and the
growth rate:
V0 = €1.35/0.08 = €16.88
B is incorrect because €20.83 results from incorrectly using D 0 (instead of D 1) as the
next period dividend:
V0 = €1.25/0.06 = €20.83

Equity Valuation: Concepts and Basic Tools

85 An asset-­based valuation model is most applicable for a company with

significant:
A intangible assets.
B property, plant, and equipment.
C proportions of current assets and current liabilities and few intangible
assets.

C is correct. Asset-­based valuations work well for companies that do not have a high
proportion of intangible or “off the books” assets and that do have a high proportion
of current assets and current liabilities.
A is incorrect because when a company has significant intangibles, the analyst should
prefer a forward-­looking cash flow valuation to an asset-­based valuation model.
B is incorrect because companies with assets that do not have easily determinable
market (fair) values—such as those with significant property, plant, and equipment—are
very difficult to analyze using asset-­based valuation methods.

Equity Valuation: Concepts and Basic Tools

86 To obtain the spot yield curve, a bond analyst would most likely use the most:
A recently issued and actively traded corporate bonds.
B recently issued and actively traded government bonds.
C seasoned and actively traded government bonds.

B is correct. To obtain the spot yield curve, a bond analyst would prefer to use the most
recently issued and actively traded government bonds. Such bonds will have similar
liquidity as well as fewer tax effects because they will be priced closer to par value.
48 2020 Level I Mock Exam (C) PM

A is incorrect because the spot yield curve is derived from the most recently issued
and actively traded government, not corporate, bonds.
C is incorrect because seasoned government bonds tend to be less liquid than newly
issued ones because they are typically owned by buy-­and-­hold investors.

Introduction to Fixed-­Income Valuation

87 One limitation as to why using the average duration of the bonds in a portfolio
does not properly reflect that portfolio’s yield curve risk is that the approach
assumes:
A a parallel shift in the yield curve.
B all the bonds have the same discount rate.
C a non-­parallel shift in the yield curve.

A is correct. A limitation to using the average duration approach in calculating portfolio

duration is that it assumes all interest rates across the yield curve change by the same
amount and, therefore, each bond’s price changes by the same percentage.
B is incorrect because the duration of each bond is calculated using the appropriate
discount rate for the bond, not the same discount rate for all bonds.
C is incorrect because the duration of each bond is calculated using the bond’s
coupon rate payment.

Understanding Fixed‑Income Risk and Return

88 Which of the following terms in a bond issue most likely helps to reduce credit
risk?
A Term maturity structure
B Floating-­rate note
C Sinking fund arrangement

C is correct. A sinking fund arrangement is a way to reduce credit risk by making the
issuer set aside funds over time to retire the bond issue.
A is incorrect because a term maturity structure is paid off in a lump sum at maturity
and therefore carries more credit risk than a serial maturity structure such as sinking
fund arrangement.
B is incorrect because a floating-­rate note is a way to reduce interest rate risk instead
of credit risk.

Fixed-­Income Markets: Issuance, Trading, and Funding

89 The bonds of Whakatane and Co. are priced for settlement on 15 July 2014 and
have the following features.
Par value $100.00

Annual coupon rate 8%

Coupon payment frequency Semiannual
2020 Level I Mock Exam (C) PM 49

Par value $100.00

Coupon payment dates 15 May and 15 November
Maturity date 15 November 2017
Day count convention Actual/Actual
Annual yield to maturity 5.5%

On the basis of this information, the difference between the full and flat prices is
closest to:
A 1.333.
B 2.667.
C 0.917.

A is correct. The difference between the full and flat prices is the accrued interest, which
is computed as follows. Based on the Actual/Actual day convention, the number of days
between the coupon periods is 183 days. Also, using the Actual/Actual day count conven-
tion, the number of days between 15 May 2014 and 15 July 2014 is 16 days remaining in
May + 30 days in June + 15 days in July = 61 days. Accrued interest (per $100 par value)
= (61/183)(8.00/2) = 1.333.
B is incorrect because the accrued interest is computed using the annual coupon
payment as: Accrued interest (per 100 par value) = (61/183)(8.00) = 2.667.
C is incorrect because the accrued interest is computed using the yield-­to-­maturity
to compute the coupon payment as: Accrued interest (per 100 par value) = (61/183)
(5.50/2) = 0.917.

Introduction to Fixed-­Income Valuation

90 Which of the following instruments is most likely to offer investors some pro-
tection against increases in the market interest rate?
A Inverse floating-­rate notes
B Fixed-­rate bonds
C Floating-­rate notes

C is correct. A floating-­rate note will be less affected when market interest rates increase
because the coupon rate varies directly with market interest rates and is reset at regular
intervals.
A is incorrect because in an inverse floating-­rate note the coupon rate has an inverse
relationship to the reference rate. When market interest rates increase, the coupon rate
on an inverse floating-­rate note will fall.
B is incorrect because fixed-­rate bonds will decline in value when the market interest
rate increases.

Fixed-­Income Securities: Defining Elements

91 Which of the following is least likely a feature of an auto loan ABS?

A Non-­amortizing collateral
B Overcollateralization
50 2020 Level I Mock Exam (C) PM

C Senior/subordinated tranche structure

A is correct. An auto loan ABS involves the use of amortizing collateral, that is, the cash
flows for an auto loan ABS include interest payments, scheduled principal repayments,
and any prepayments, if allowed.
B is incorrect because overcollateralization is one of the typical features of an auto
loan ABS.
C is incorrect because an auto loan ABS typically has some form of credit enhance-
ment, such as a senior/subordinated tranche structure.

Introduction to Asset-­Backed Securities

92 From the perspective of a CDO manager, an arbitrage collateralized debt

obligation most likely differs from a traditional asset-­backed security because it
involves the:
A pooling of debt obligations.
B active management of the collateral.
C creation of a special purpose entity.

B is correct. Unlike a traditional asset-­backed security, an arbitrage collateralized debt

obligation involves active management because the CDO manager buys and sells debt
obligations with the objective of paying off different classes of bondholders as well as
generating a high return for the subordinated/equity tranche and the manager.
A is incorrect because both arbitrage collateralized debt obligations and traditional
asset-­backed securities involve the pooling of debt obligations.
C is incorrect because both arbitrage collateralized debt obligations and traditional
asset-­backed securities involve the creation of a special purpose entity.

Introduction to Asset-­Backed Securities

93 Consider the following information for a fixed-­rate bond:

Yield to maturity 6.57%
Annual coupon rate (paid semiannually) 9.00%
Market value $11,189,092
Annualized modified duration 4.687985

If the bond’s yield to maturity increases to 7.25%, the bond’s estimated market
value will be closest to:
A $9,746,599.
B $10,271,142.
C $10,832,402.

C is correct. Modified duration provides an estimate of the percentage price change

for a bond given a change in its yield to maturity: (%ΔPVFull ≈ –AnnModDur × ΔYield).
2020 Level I Mock Exam (C) PM 51

Given the bond’s modified duration of 4.687985 and the change in yield of 0.68%
(= 7.25% – 6.57%),
%ΔPVFull ≈ –4.687985 × 0.0068 ≈ –0.0319 or –3.19%.
Given an increase in the yield from 6.57% to 7.25%, the market value of the bond would
decline by approximately 3.19%, resulting in an estimated market value of $10,832,160:
$11,189,092 × (1 – 0.0319) = $10,832,403 (rounded).
A is incorrect because $9,746,818 results from incorrectly using a yield to maturity of
4.5% (the semiannual coupon rate rather than the 6.57% yield to maturity):
ΔYield = 7.25% – 4.50% = 2.75% or 0.0275

%ΔPVFull ≈ –AnnModDur × ΔYield

  ≈ –4.687985 × 0.0275 ≈ –0.1289 or –12.89%

$11,189,092 × (1 – 0.1289) = $9,746,599.

B is incorrect because the result incorrectly applies the annual coupon rate in deriving
the ΔYield term:
ΔYield = 9.00% – 7.25% = 1.75% or 0.0175

%ΔPVFull ≈ –AnnModDur × ΔYield

  ≈ –4.687985 × 0.0175 ≈ –0.0820 or –8.20%

$11,189,092 × (1 – 0.0820) = $10,271,142.

Understanding Fixed-­Income Risk and Return

94 Which of the following statements relating to parallel and non-­parallel shifts in

the yield curve is correct?
A A parallel shift requires the yield curve to be a straight line.
B Calculations of effective duration can accommodate non-­parallel shifts in
the yield curve.
C Factors affecting supply and demand of short-­term versus longer-­term secu-
rities can change the shape of the yield curve.

C is correct. The shape of the yield curve changes based on factors affecting the supply
and demand of shorter-­term versus longer-­term securities.
A is incorrect because a parallel shift does not require the yield curve to be a straight
line. The key assumption is that all yields to maturity under consideration rise or fall by
the same amount across the curve. This scenario can also be described as a “shape-­
preserving” shift in the yield curve. Yield curves are typically upward sloping and rarely
(if ever) in the shape of a straight line.
B is incorrect because effective duration calculations cannot accommodate non-­parallel
shifts in the yield curve. Effective duration is a curve duration statistic in that it measures
interest rate risk in terms of a parallel shift in the benchmark yield curve.

Understanding Fixed-Income Risk and Return

52 2020 Level I Mock Exam (C) PM

95 Which of the following balance sheet items is least likely a sign of high-­quality
assets? High amounts of:
A patents.
B goodwill.
C capital expenditure relative to depreciation.

B is correct. Goodwill is not considered a high-­quality asset. In fact, sustained weak

financial performance most likely implies that a company’s goodwill will be written
down, reinforcing its poor quality.
A is incorrect. Patents are considered high-­quality intangible assets because they can
be sold if necessary to cover liabilities.
C is incorrect. High capital expenditure relative to depreciation implies that man-
agement is sufficiently investing in its business, which will lead to high-­quality assets.

Fundamentals of Credit Analysis

96 Relative to a non-­recourse mortgage loan, in a recourse mortgage loan the:

A lender can change the interest rate charged.
B borrower does not have a strategic default option.
C borrower is not liable for any shortfall between the property sale proceeds
and the loan amount.

B is correct. There are recourse and non-­recourse mortgage loans. In a non-­recourse

loan, the lender does not have a claim against the borrower and thus can look only to
the property to recover the outstanding mortgage balance. In a recourse loan, the lender
can seek to recover any shortfall from the sale of the property to cover the mortgage
loan. The borrower, therefore, has a strategic default option only in non-­recourse loans;
for example, if the mortgage is greater than the property value, he may select to default
without further personal obligation.
A is incorrect. Recourse and non-­recourse do not refer to any pricing terms.
C is incorrect. In a recourse loan, the borrower does not have an incentive to default
on an underwater mortgage since the lender can seek to recover any shortfall beyond
the sale of the property from the borrower.

Introduction to Asset-­Backed Securities

97 Which of the following is least likely a characteristic of commercial paper?

A Short-­term maturity
B Supported by credit enhancement
C Not rated by an independent agency

C is correct. Investors typically rely on ratings from independent rating agencies as well
as their own credit analyses. The three major independent rating agencies provide ratings
for commercial paper issues.
2020 Level I Mock Exam (C) PM 53

A is incorrect. Commercial paper is a short-­term security with original maturity less

than 270 days in the United States and under one year elsewhere.
B is incorrect. Typically, commercial paper issuers must obtain a backup line of credit
from a bank in case there are problems rolling over the paper (refinancing it with a new
issue) at maturity.

Fixed-­Income Markets: Issuance, Trading, and Funding

98 An analyst gathers the following information for a bond:

Position (par value) $100,000,000
Flat price 97.1251
Accrued interest 0.4392
Macaulay duration 8.586
Annual modified duration 8.450

The money duration of the bond position is closest to:

A 837,687,080.
B 824,418,335.
C 833,916,109.

B is correct. Money duration is calculated as the annual modified duration times the full
price of the bond including accrued interest:
MoneyDur = AnnModDur × PVFull.
The full price of the bond is 97.5643 (97.1251 + 0.4392) per 100 of par, or $97,564,300.
Therefore, the money duration of this bond position is $824,418,335 (97,564,300 × 8.45).
A is incorrect. It is the result if the full price of the bond is incorrectly multiplied by
Macaulay duration:
$837,687,080 ≈ (97,564,300 × 8.586).
C is incorrect. It is the result of neglecting to incorporate accrued interest when pricing
the bond position and erroneously multiplying by Macaulay duration.

Understanding Fixed-­Income Risk and Return

99 Convenience yield is best described as a nonmonetary benefit of holding a(n):

A option contract.
B asset.
C forward contract.

B is correct. Convenience yield represents the nonmonetary advantage of holding the

asset.
A is incorrect. Convenience yield is a benefit for the holder of the asset and not the
holder of an option contract.
54 2020 Level I Mock Exam (C) PM

C is incorrect. Convenience yield is a benefit for the holder of the asset and not the
holder of a forward contract.

Basics of Derivative Pricing and Valuation

100 Using put–call parity, a long call can best be replicated by going:
A long the put, short the asset, and long the bond.
B short the put, long the asset, and short the bond.
C long the put, long the asset, and short the bond.

C is correct. According to put–call parity, a long call is equal to long put, long asset,
short bond.
A is incorrect. The short asset position must be a long position, and the long bond
position must be a short position. According to put–call parity, a long call is equal to
long put, long asset, short bond.
B is incorrect. The short put position must be a long position. According to put–call
parity, a long call is equal to long put, long asset, short bond.

Basics of Derivative Pricing and Valuation

101 In a currency swap, the underlying principal amount is exchanged:

A only at the start of the swap.
B only at the end of the swap.
C both at the start and at the end of the swap.

C is correct. In a currency swap, the underlying principal is denominated in different

currencies and is typically exchanged at the start and end of the swap.
A is incorrect. In a currency swap, the underlying principal is denominated in different
currencies and would typically be exchanged not only at the start of the swap but also
at the end of the swap.
B is incorrect. In a currency swap, the underlying principal is denominated in different
currencies and would typically be exchanged not just at the end of the swap but at the
start of the swap as well.

Derivative Markets and Instruments

102 If a forward contract requires no cash outlay at initiation, it is most likely true
that at initiation:
A value exceeds price.
B price exceeds value.
C price is equal to value.
2020 Level I Mock Exam (C) PM 55

B is correct. At initiation, value is equal to zero. Price is a positive number that states the
amount that must be paid when the purchase takes place.
A is incorrect. Value is zero; price is a positive number.
C is incorrect. Value is zero; price is a positive number.

Basics of Derivative Pricing and Valuation

103 If the exercise price of a European put option at expiration is below the price of
the underlying, the value of the option is most likely:
A equal to zero.
B less than zero.
C greater than zero.

A is correct. If the exercise price of a European put option is below the underlying price
at expiration, the option is worthless and has a value of zero.
B is incorrect. The value of an option can never be negative.
C is incorrect. For a positive value, exercise price must be below the price of underlying.

Basics of Derivative Pricing and Valuation

104 At expiration, an option that is in the money will most likely have:
A time value, but no exercise value.
B exercise value, but no time value.
C both time value and exercise value.

B is correct. At expiration, options have no time value; if they are in the money, they
have exercise value.
A is incorrect. At expiration, options have no time value.
C is incorrect. At expiration, options have no time value.

Basics of Derivative Pricing and Valuation

105 According to put–call–forward parity, for European options, a long put on an

asset is equal to:
A long call + long risk-­free bond + short forward.
B short call + long risk-­free bond + short forward.
C short call + short risk-­free bond + long forward.
56 2020 Level I Mock Exam (C) PM

A is correct. The put–call–forward parity relationship states that

F0 T  x
 p0  c0 
t
1  r 1  rt
That is,
Long forward + Long put = Long call + Long risk-­free bond.
Rearranging terms gives
Long put = Long call + Long risk-­free bond + Short forward.
B and C are incorrect. Long put = Long call + Long risk-­free bond + Short forward.

Basics of Derivative Pricing and Valuation

106 Alternative investments that rely on estimates rather than observable market
prices for valuation purposes are most likely to report:
A returns that are understated.
B volatility of returns that is understated.
C correlations of returns with the returns of traditional assets that are
overstated.

B is correct. The use of estimates tends to smooth the return series. As a consequence,
the volatility of returns will be understated.
A is incorrect. There is a tendency for returns to be overestimated or at least smoothed.
C is incorrect. Correlations of returns with the returns of traditional assets tend to be
understated as a consequence of smoothing the return series.

Introduction to Alternative Investments

107 Which of the following investments most likely provides an investor with indi-
rect equity exposure to real estate?
A Real estate limited partnerships
B Real estate investment trusts
C Commercial mortgage-­backed securities

B is correct. Real estate investment trusts (REITs) provide investors with indirect equity
real estate exposure. Real estate investment partnerships are a form of direct real estate
equity investment. Commercial mortgage-­backed securities (CMBS) provide investors
with indirect debt investment opportunities in real estate.
A is incorrect. Real estate investment partnerships are a form of direct real estate
equity investment.
C is incorrect. Commercial mortgage backed securities (CMBS) provide investors with
indirect debt investment opportunities in real estate.

Introduction to Alternative Investments

2020 Level I Mock Exam (C) PM 57

108 With regard to venture capital, which of the following statements is most likely
true regarding venture capital?
A Investments typically are in later stage and more established companies.
B Investors tend to have short time horizons.
C Investors require a higher return than investors in publicly traded equity.

C is correct. The historical standard deviations of annual return for venture capital are
higher than that of common stocks. Investors should therefore require a higher return
in exchange for accepting this higher risk, along with the illiquidity of venture capital
investing.
A is incorrect because the venture capital strategy typically invests in start-­up or early
stage companies, not later stage companies.
B is incorrect because venture capital investments require long time horizons.

Introduction to Alternative Investments

109 High Plains Capital is a hedge fund with a portfolio valued at $475,000,000 at
the beginning of the year. One year later, the value of assets under management
is $541,500,000. The hedge fund charges a 1.5% management fee based on the
end-­of-­year portfolio value as well as a 10% incentive fee. If the incentive fee
and management fee are calculated independently, the effective return for a
hedge fund investor is closest to:
A 12.29%.
B 10.89%.
C 11.06%.

B is correct.

Management fee = $541,500,000 × 0.015 = $8,122,500

Incentive fee = ($541,500,000 – $475,000,000) × 0.10 = $6,650,000
Total fees = $14,772,500
Return = ($541,500,000 – $475,000,000 –
$14,772,500)/$475,000,000 = 0.1089 or 10.89%
A is incorrect because only the management fee is included in the return calculation.

Return = ($541,500,000 – $475,000,000 – $8,122,500)/$475,000,000 =

0.1229 or 12.29%
C is incorrect. The incentive fee is incorrect. It is incorrectly calculated as follows:

Incentive fee = ($541,500,000 – $475,000,000 – $8,122,500) × 0.10 =

$5,837,750
Total fees = $13,960,250 = $8,122,500 + $5,837,750
Return = ($541,500,000 – $475,000,000 –
$13,960,250)/$475,000,000 = 0.1106 or 11.06%

Introduction to Alternative Investments

58 2020 Level I Mock Exam (C) PM

110 A manager is compensated with a management fee based on committed capital

plus an incentive fee based on fund performance. This scenario best describes
the fee structure of a:
A private equity fund.
B hedge fund.
C mutual fund.

A is correct. A private equity manager is compensated through a management fee based

on committed capital plus an incentive fee.
B is incorrect. The management fee of a hedge fund is based on assets under
management.
C is incorrect. The fee structure for mutual funds usually includes only a management
fee, not an incentive fee.

Introduction to Alternative Investments

111 The real estate valuation method that uses a discounted cash flow model is best
characterized as:
A a comparable sales approach.
B a cost approach.
C an income approach.

C is correct. The income approach to real estate valuation values a property by using a
discounted cash flow model.
A is incorrect. The comparable sales approach involves determining a value based
on recent sales of similar properties.
B is incorrect. The cost approach evaluates the replacement cost of the property.

Introduction to Alternative Investments

112 Management fees for a private equity fund are most likely based on the:
A fair value of assets under management.
B drawdown of committed capital plus any undistributed capital gains.
C total committed capital minus capital returned from investments that are
exited.

C is correct. Private equity management fees are based on the full amount of committed
capital, whether drawn down or not, minus capital that has been returned to investors
from investments that have been exited.
A is incorrect because it is hedge funds, not private equity funds, which base their
management fees on the fair value of assets under management.
2020 Level I Mock Exam (C) PM 59

B is incorrect because private equity funds charge management fees on all commit-
ted capital, not just drawdowns, and do not charge management fees on capital gains.

Introduction to Alternative Investments

113 With regard to commodities, it is most likely true that:

A exposure is most commonly achieved via commodity derivatives.
B their returns are based on an income stream such as interest or dividends.
C they are physical products so most investors prefer to trade the actual
commodity.

A is correct. Commodity exposure is most commonly accessed via commodity derivatives.

B is incorrect because commodities returns are based on changes in price rather
than income streams.
C is incorrect because holding commodities (i.e., the physical products) incurs costs
for transportation and storage. Thus, most commodity investors do not trade actual
physical commodities, but rather trade commodity derivatives.

Introduction to Alternative Investments

Relative Strength
2.6

2.4

2.2

2.0

1.8

1.6
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Stock Index vs. Bond Index Stock Index vs. Gold

The chart above depicts the relative strength lines for a stock index versus both
a bond index and gold. In the month of June, it would be most appropriate for
an analyst using intermarket analysis to move investments from:
A gold to stocks.
B stocks to bonds.
C bonds to gold.
60 2020 Level I Mock Exam (C) PM

B is correct. In intermarket analysis, technicians often look for inflection points in one
market as a warning sign to start looking for a change in trend in a related market.
To identify these intermarket relationships, a commonly used tool is relative strength
analysis, which charts the price of one security divided by the price of another. In June,
only the dashed line shows an inflection point (a top and reversal of trend) and that is an
indication that the stock index started to weaken relative to the bond index. Therefore,
it is a signal that the time had come to move investments from stocks to bonds.
A is incorrect. Starting from June, the continuous line is basically flat, indicating
that neither stocks nor gold have a relative strength compared to each other (neutral
performance).
C is incorrect. Given that from June, bonds indicate relative strength vs. stocks and
that there is no relative strength between stocks and gold, it can be inferred that bonds
have also a relative strength vs. gold. Therefore, it is not appropriate moving from bonds
to gold.

Technical Analysis

115 The execution step of the portfolio management process includes:

A preparing the investment policy statement.
B finalizing the asset allocation.
C monitoring the portfolio performance.

B is correct. Asset allocation occurs in the execution step.

A is incorrect. Preparation of the investment policy statement occurs in the planning
step.
C is incorrect. Portfolio monitoring occurs in the feedback step.

Portfolio Management: An Overview

116 A portfolio with equal parts invested in a risk-­free asset and a risky portfolio
will most likely lie on:
A the efficient frontier.
B a capital allocation line.
C the security market line.

B is correct. A capital allocation line shows possible combinations of a risky portfolio

and the risk-­free asset.
A is incorrect. A portfolio that is 100% invested in an efficient risky portfolio will lie
on the efficient frontier. When combined with a risk-­free asset, the resulting portfolio
will lie on a capital allocation line.
C is incorrect. Only a portfolio with 50% in a risk-­free asset and 50% in the market
portfolio will lie on the capital market line.

Portfolio Risk and Return: Part II

2020 Level I Mock Exam (C) PM 61

117 In a strategic asset allocation, assets within a specific asset class are least likely
to have:
A low paired correlations.
B low correlations with other asset classes.
C similar risk and return expectations.

A is correct. In a strategic asset allocation, assets within a specific asset class have high
paired correlations and low correlations with other asset classes.
B is incorrect. Assets within a specific asset class will have low correlations with assets
in other asset classes.
C is incorrect. Assets within a specific asset class share similar risk and return
expectations.

Basics of Portfolio Management and Construction

118 Based on the following historical data, which is closest to the standard deviation
for the two-­asset portfolio shown in the table?
Asset A Asset B Asset A and B

Standard deviation 4.7% 7.7%

Portfolio weight 0.4 0.6
Correlation 0.3

A 6.5%
B 5.0%
C 5.5%

C is correct. The standard deviation of a two-­asset portfolio is calculated as follows:

σ p = w12  12  w22  22  2 w1w2 1,2 12

 = 0.42  4.7%2  0.62  7.7%2  2  0.4  0.6  0.3  4.7%  7.7%

 = 5.5%
A is incorrect. This is the simple weighted average of the standard deviations of the
assets: w 1 × σ1 + w 2 × σ2 = 0.4 × 4.7% + 0.6 × 7.7% = 6.5%.
B is incorrect. This is the portfolio standard deviation when the asset correlation is
ignored or set equal to zero.

w12  12  w22  22  0.42  4.7%2  0.62  7.7%2  5.0%

Portfolio Risk and Return: Part I

62 2020 Level I Mock Exam (C) PM

119 The German firm IHK AG has entered into a three-­month forward currency
contract to purchase USD35 million versus euros from US firm GED Corp. to
hedge a future payment obligation. The US dollar appreciates 5% in the coming
three months. IHK should most likely focus on:
A market risk.
B liquidity risk.
C counterparty risk.

C is correct. IHK’s potential risk is settlement risk, which is a type of counterparty risk.
Settlement risk deals with the settling of payments that occur just before a default. If
IHK wires the euros to GED and GED then declares bankruptcy, IHK will not be able to
get the money back.
A is incorrect. IHK would not face market risk since the forward contract would have
become more valuable during the three months.
B is incorrect. Liquidity risk is the risk of a significant downward valuation adjustment
when selling a financial asset and is not applicable for a contract for which the price was
fixed when the contract was initiated.

Risk Management: An Introduction

120 One concern about the use of distributed ledger technology is most likely that
it:
A may be shared with entities within a network.
B uses a consensus mechanism to confirm new entries.
C generally requires massive amounts of energy to verify transaction activity.

C is correct. The underlying processes for distributed ledger technology generally require
massive amounts of energy to verify transaction activity.
A is incorrect. The fact that distributed ledger technology can be shared across a
network is one of its desirable features.
B is incorrect. The consensus mechanism enables the creation of records that are, for
the most part, considered immutable, or unchangeable, yet they are transparent and
accessible to network participants on a nearly real-­time basis.

Fintech in Investment Management