i

2020 Level I Mock Exam (A) AM

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 Claire Jones, CFA, is an analyst following natural gas companies in the United
States. At an industry energy conference, the CFO of Alpine Energy states they
are interested in making strategic acquisitions. At a separate event, Alpine’s
head of exploration commented he is bullish on natural gas production pros-
pects within Northeastern Pennsylvania. Jones is aware that Alpine currently
has very little exposure to this region. She also knows another company in her
universe, Pure Energy, Inc., is based in Northeastern Pennsylvania and controls
significant assets in the area. Pure Energy is highly leveraged, and Jones believes
they will need to raise additional capital or partner with another firm to move
to the production phase with their assets. Jones attempts to contact Alpine’s
CEO with an unrelated question and is told he is unavailable because he is on
a business trip to Northeastern Pennsylvania. Jones updates her research on
Pure Energy and then recommends the stock to Lisa Wong, CFA, a portfolio
manager who purchases significant positions in client accounts. The following
week, Pure Energy announces that they have entered into an agreement to be
purchased by Alpine for a significant premium. Has either Jones or Wong most
likely violated Standards with regards to the integrity of capital markets?
A No.
B Yes, Jones’ recommendation is based on insider information.
C Yes, both Jones and Wong have acted on insider information.

A is correct because Jones has used the mosaic theory to combine non-­material, non-
public information with material public information.
B is incorrect because if taken in isolation, the information Jones received on the
location of a business trip would be considered non-­material.
C is incorrect because if taken in isolation, the information Jones received on the
location of a business trip would be considered non-­material.

Guidance for Standards I–VII

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visit our website at www.cfainstitute.org.
© 2020 CFA Institute. All rights reserved.
ii 2020 Level I Mock Exam (A) AM

2 Ian O’Sullivan, CFA, is the owner and sole employee of two companies, a
public relations firm and a financial research firm. The public relations firm
entered into a contract with Mallory Enterprises to provide public relations
services, with O’Sullivan receiving 40,000 shares of Mallory stock in payment
for his services. Over the next 10 days, the public relations firm issued several
press releases that discussed Mallory’s excellent growth prospects. O’Sullivan,
through his financial research firm, also published a research report recom-
mending Mallory stock as a “buy.” According to the CFA Institute Standards of
Professional Conduct, O’Sullivan is most likely required to disclose his owner-
ship of Mallory stock in the:
A press releases only.
B research report only.
C both the press release and the research report.

C is correct because members should disclose all matters that reasonably could be
expected to impair the member’s objectivity [Standard I(B), Standard VI(A)].
A is incorrect because both the press release and the research report should disclose
any potential conflict of interest.
B is incorrect because both the press release and the research report should disclose
any potential conflict of interest.

Guidance for Standards I–VII

3 In order to provide investors with a more comprehensive view of a firm’s per-

formance, the current GIPS standards includes new provisions related to:
A various measures of risk.
B all aspects of performance measurement.
C the unique characteristics of each asset class.

A is correct. Historically, the GIPS standards focused primarily on returns. In the spirit
of fair representation and full disclosure, and in order to provide investors with a more
comprehensive view of a firm’s performance, the current GIPS standards includes new
provisions related to risk.
B is incorrect, the GIPS standards do not address all aspects of performance
measurement.
C is incorrect, the GIPS standards do no cover the unique characteristics of each
asset class.

The GIPS Standards

4 When making performance presentations to prospective clients, a GIPS compli-

ant firm should least likely do which of the following?
A Selectively report its top fund performance
B Include the fund performance of former clients
C Report performance history for all market cycles under review
2020 Level I Mock Exam (A) AM iii

A is correct. When a firm complies with GIPS standards it cannot selectively choose its
top fund performances while excluding weaker performing funds. It must include all
fee-­paying discretionary funds managed to a similar investment mandate, objective,
or strategy.
B is incorrect because GIPS standards require the performance of former clients to
be included to avoid survivorship bias.
C is incorrect because GIPS standards require the fund performance to reflect results
across all market cycles for the periods under review. Fund managers are not allowed to
select a time period during which the mandate produced superior results while leaving
out other time period that underperformed (varying time periods).

Introduction to the Global Investment Performance Standards (GIPS)

5 For a retail client's portfolio to be included in a GIPS compliant firm’s compos-

ite, it will most likely be in a composite:
A composed of discretionary funds.
B restricted to retail funds.
C with both fee-­paying and non–fee-­paying funds.

A is correct. A composite must include all actual, fee-­paying, discretionary portfolios

managed in accordance with the same investment mandate, objective, or strategy.
B is incorrect because institutional funds may be included in a composite with retail
funds if it has a similar investment mandate, objective, or strategy.
C is incorrect because non–fee-­paying funds are not required to be in a GIPS com-
pliant composite.

Introduction to the Global Investment Performance Standards (GIPS)

6 In countries where new local laws relating to calculation and presentation of

investment performance conflict with GIPS standards, firms who have claimed
GIPS compliance should most likely:
A stop claiming GIPS compliance.
B follow local laws, continue to claim GIPS compliance, and disclose conflicts.
C continue to claim GIPS compliance, disclosing non-­compliance with new
laws.

B is correct because where local laws and regulations regarding calculation and presen-
tation conflict with GIPS standards, firms must abide by the local laws and regulations.
They are still allowed to claim GIPS compliance but must disclose areas where the local
requirements conflict with those of the GIPS standards.
A is incorrect because while firms must abide by local requirements firms are still
allowed to claim GIPS compliance but must disclose areas where the local requirements
conflict with those of the GIPS standards.
iv 2020 Level I Mock Exam (A) AM

C is incorrect because while firms must abide by local requirements firms are still
allowed to claim GIPS compliance but must disclose areas where the local requirements
conflict with those of the GIPS standards.

Global Investment Performance Standards (GIPS)

7 Prudence Charmaine, a CFA charterholder, was recently accused in writing of

cheating on a professional accounting exam. She denied cheating and suc-
cessfully defended herself against the allegation. As part of her defense and as
evidence of her character, Charmaine stated that she is a CFA charterholder
and upholds the CFA Institute Code of Ethics and Standards of Professional
Conduct. On her next annual Professional Conduct Statement, Charmaine does
not report this allegation to CFA Institute. Did Charmaine most likely violate
the CFA Institute Code of Ethics or Standards of Professional Conduct?
A No
B Yes, she improperly used the CFA Institute Code and Standards to defend
herself.
C Yes, she did not report the allegation on her annual Professional Conduct
Statement.

C is correct because Charmaine should have reported the cheating allegation when mak-
ing her annual Professional Conduct Statement. Even though she successfully defended
herself against the charges and the charges were dropped, she has a responsibility to
report the written complaint involving her integrity. The Code of Ethics requires CFA
charterholders to practice and encourage others to practice in a professional and ethical
manner that will reflect credit on themselves and the profession.
A is incorrect because Charmaine should have reported the cheating charges and the
subsequent successful defense when making her annual Professional Conduct Statement.
Even though she successfully defended herself against the charges, she has a responsi-
bility to report the written complaint involving her integrity. The Code of Ethics requires
CFA charterholders to practice and encourage others to practice in a professional and
ethical manner that will reflect credit on themselves and the profession.
B is incorrect because it is not apparent that Charmaine violated Standard  VII(B)–
Reference to CFA Institute, the CFA Designation, and the CFA Program. Charmaine was
correct in stating she is required to abide by the CFA Code and Standards.

CFA institute Code of Ethics and Standards of Professional Conduct

8 Gardner Knight, CFA, is a product development specialist at an investment

bank. Knight is responsible for creating and marketing collateralized debt
obligations (CDOs) consisting of residential mortgage bonds. In the market-
ing brochure for his most recent CDO, Knight provided a list of the mortgage
bonds that the CDO was created from. The brochure also states “an indepen-
dent third party, the collateral manager, had sole authority over the selection of
all mortgage bonds used as collateral in the CDO.” However, Knight met with
the collateral manager and helped her select the bonds for the CDO. Knight is
least likely to be in violation of which of the following CFA Institute Standards
of Professional Conduct?
A Suitability
B Conflicts of Interest
2020 Level I Mock Exam (A) AM v

C Client Communication

A is correct because there is no indication that the investment is unsuitable for investors
and in violation of Standard III(C)–Suitability.
B is incorrect because the conflict of interest represented when the bank selects the
bonds making up the CDO, instead of the collateral manager, should be disclosed as
required by Standard VI(A)–Disclosure of Conflicts.
C is incorrect because the basic format and general principles of the investment
processes used to analyze investments, select securities, and construct portfolios should
be disclosed as required by Standard V(B)–Communication with Clients and Prospective
Clients, and any changes that might materially affect those processes must be promptly
disclosed.

Guidance for Standards I–VII

9 Jan Loots, CFA, quit his job as a portfolio manager at an investment firm with
whom he had a non-­solicitation agreement he signed several years ago. Loots
received permission to take his investment performance history with him and
also took a copy of the firm’s software-­trading platform. Subsequently, Loots
sent out messages on social media sites announcing he was looking for clients
for his new investment management firm. Access to Loots’ social media sites is
restricted to friends, family, and former clients. Loots least likely violated the
CFA Institute Standards of Professional Conduct concerning his:
A trading software.
B non-­solicitation agreement.
C investment performance history.

C is correct because the portfolio manager received permission to use his investment
performance history from his prior employer. The member violated his non-­solicitation
agreement by indicating his availability to new clients on several social media sites
accessible by clients of his former employer. This is a violation of Standard IV(A)–Loyalty
because he did not act for the benefit of his former employer. In this case, the member
may cause harm to his former employer if his weekend messages result in clients moving
to his new business from his former employer. The member also violated this standard
by taking his employer’s property, trading software.
A is incorrect because the portfolio manager took property of his former employer,
proprietary trading software, and violated Standard IV(A)–Loyalty. Although the man-
ager created the software himself, it was during a period of time when the large money
manager employed him and the software is not his property to take.
B is incorrect because the member violated Standard IV(A)–Loyalty as he did not act
for the benefit of his former employer. In this case, the member may cause harm to his
former employer if his weekend messages result in clients moving to his new business.

Guidance for Standards I–VII

10 Sherry Buckner, CFA, manages equity accounts for government entities whose
portfolios are classified as being conservative and risk averse. Since the objec-
tive of her clients is to maximize returns with the lowest possible risk, Buckner
considers adding to their holdings a new, thinly traded, leveraged derivative
vi 2020 Level I Mock Exam (A) AM

product that she believes has the potential for high returns. To make her invest-
ment decision, Buckner relies upon comprehensive research from an invest-
ment bank with a solid reputation for top quality research. After her review
of that research, Buckner positions her accounts so each has a 10% allocation
to the derivative product. Did Buckner most likely violate any CFA Institute
Standards of Professional Conduct by purchasing the derivative product for her
clients?
A No.
B Yes, related to Suitability.
C Yes, related to Loyalty, Prudence, and Care.

B is correct as Buckner is in violation of Standard III(C) since she did not consider issues
such as the limited liquidity or any potential leverage of this new product when she
invested a substantial percentage of her clients’ portfolios in these instruments.
A is incorrect because Buckner violated the suitability Standard.
C is incorrect because Buckner relied upon comprehensive research from the invest-
ment bank.

Guidance for Standards I–VII

11 Wouter Duyck, CFA, is the sole proprietor of an investment advisory firm

serving several hundred middle class retail clients. Duyck claims to be different
from his competitors because he conducts research himself. He discloses that to
simplify the management of all these accounts he has created a recommended
list of stocks, from which he selects investments for all of his clients based on
their suitability. Duyck’s recommended list of stocks is obtained from his pri-
mary broker, who has completed due diligence on each stock. Duyck’s recom-
mended list least likely violates which of the following CFA Institute Standards
of Professional Conduct?
A Fair Dealing.
B Misrepresentation.
C Diligence and Reasonable Basis.

A is correct because Standard III(B)–Fair Dealing concerns the fair treatment of clients

when making investment recommendations or taking investment action, but there is
no indication that the advisor has discriminated against any clients with regard to his
recommendations as he invests all clients in the same universe of stocks. The advisor has
violated Standard I(C)–Misrepresentation with his research, which is not independently
created and instead relies upon information provided by his broker. This is contrary to
the advisor telling clients he does his own independent investment research. In addition,
the advisor has violated Standard V(A)–Diligence and Reasonable Basis, as he has not
made reasonable and diligent efforts to determine if the third party’s research is sound.
B is incorrect, as the advisor has violated Standard I(C)–Misrepresentation with his
research, which is not independently created and instead relies upon information pro-
vided by his broker.
2020 Level I Mock Exam (A) AM vii

C is incorrect, as the advisor has violated Standard V(A)–Diligence and Reasonable

Basis as he does not have a reasonable basis for making his investment recommendations
and relies solely on his broker’s research to create his list of stock investments. This is
directly contrary to telling clients that he does his own independent investment research.

Guidance for Standards I–VII

12 Which of the following activities if undertaken by CFA Institute members and/

or candidates would most likely violate the Code and Standards?
A An analyst discloses confidential, sensitive information about a client
account as part of an investigation by the CFA Institute Professional
Conduct Program.
B A senior trader does not have safeguards in place to determine whether a
junior trader under their supervision is following the firm’s policies regard-
ing best execution.
C An institutional portfolio manager takes a group of clients to an expensive
restaurant to discuss portfolio returns over the recently completed quarter
without prior written consent from his employer.

B is correct because Standard IV(C)–Responsibilities of Supervisors states that members

and candidates must make reasonable efforts to prevent violation of applicable laws,
rules, regulations, and the Code and Standards by anyone subject to their supervision or
authority. Interviewing with a competitor during lunch or taking clients out to lunch do
not necessarily violate any Standard unless specifically prohibited in company policies.
A is incorrect because Standard III(E)–Preservation of Confidentiality is not intended
to prevent a member or candidate from cooperating with an investigation with the CFA
Institute Professional Conduct Program (PCP). Members and candidates can consider the
PCP an extension of themselves when requested to provide information about a client
in support of a PCP investigation.
C is incorrect because this action does not create a conflict with their employer.
While it may be advisable to get prior approval before this event, this action does not
constitute a clear violation of the Code and Standards as long as it does not conflict with
any of the company’s policies.

Code of Ethics and Standards of Professional Conduct

13 Ken Kawasaki, CFA, shares a building with a number of other professionals

who are also involved in the investment management business. Kawasaki makes
arrangements with several of these professionals, including accountants and
lawyers, to refer clients to each other. An informal score is kept on the expec-
tation the referrals will equal out over time, eliminating the need for any cash
payments. Kawasaki never mentions this arrangement to clients or prospective
clients. Does Kawasaki's agreement with the other building occupants most
likely violate any CFA Institute Standards of Professional Conduct?
A No.
B Yes, related to referral fees.
C Yes, related to communication with clients.
viii 2020 Level I Mock Exam (A) AM

B is correct because Standard VI(C) requires disclosure of any compensation, consider-

ation, or benefit received from or paid to others for the recommendation of products
or services. Even without cash changing hands the arrangement provides for a quid pro
quo referral of clients and should be disclosed.
A is incorrect because Kawasaki has violated the Standards.
C is incorrect because this Standard has not been violated as it relates to disclosure
to clients of the general principles of the investment process used and not disclosure
of any compensation, consideration, or benefit received from or paid to others for the
recommendation of products or services as Standard VI(C) requires.

Guidance for Standards I–VII

14 Noor Hussein, CFA, runs a financial advisory business, specializing in retire-

ment planning and investments. One of her clients asks her to advise the firm’s
pension fund trustees on available investments in the market including Islamic
products. On the day prior to the meeting, Hussein spends an hour familiar-
izing herself with Islamic investment products and getting updates on local
market conditions. The next day, she recommends Islamic investment products
to the trustees based on her research and her expertise in retirement planning
and investments. The trustees subsequently incorporate Islamic products into
their investment allocation. Did Hussein’s basis for the recommendation most
likely comply with the CFA Code of Ethics?
A Yes.
B No, with regard to Misconduct.
C No, with regard to Diligence and Reasonable Basis.

C is correct because Hussein did not likely act with competence and diligence as required
by Standard V(A). One half day of preparation with regard to Islamic investment prod-
ucts would not likely be considered sufficient to give investment advice to pension plan
trustees. Misconduct was not violated by Hussein stating she is an expert in retirement
planning and investments because this is the area she specializes in.
A is incorrect because Hussein did not likely act with competence and diligence as
required by Standard V(A). One half day of preparation with regard to Islamic investment
products would not likely be considered sufficient to give investment advice to pension
plan trustees.
B is incorrect because it is not likely she violated Standard I(D)–Misconduct, i.e., con-
duct involving dishonesty, fraud, and/or deceit by stating she is an expert in retirement
planning and investments.

Guidance for Standards I–VII

15 Alan Quanta, CFA, provides credit rating analysis of high-­yield bonds using
external credit ratings as a foundation. At the end of the last quarter, Quanta’s
firm, North Investment Bank, held a large position in the bonds of Veyron
Corporation, a real estate company with all of its land holdings in a country
recently downgraded by several credit rating agencies. The downgrades made
Veyron bonds extremely difficult to sell because the bond price has dropped
every day since the downgrades. Quanta has been asked by his supervisor to
contact the firm’s institutional clients to convince them Veyron bonds are still
2020 Level I Mock Exam (A) AM ix

an attractive purchase, especially at these lower prices. Quanta does not con-
sider the Veyron bonds a buy at this price level. According to the CFA Institute
Code of Ethics and Standards of Professional Conduct, the most appropriate
action for Quanta is to:
A obey his supervisor’s request.
B ignore his supervisor’s request.
C promote the bonds with appropriate disclosures.

B is correct because Quanta must refuse to promote Veyron bonds until they are an
attractive purchase based on fundamental analysis and market pricing. If Quanta followed
the request from his supervisor, he would be in violation of Standard I(B)–Independence
and Objectivity, as he does not rate Veyron bonds as a buy. His opinion of the Veyron
bonds must not be affected by internal pressure or compensation.
A is incorrect because Quanta should refuse to follow his supervisor’s request and
promote the bonds as his opinion of the Veyron bonds must not be affected by internal
pressure or compensation.
C is incorrect because Quanta should refuse to promote the bonds as his opinion of
the Veyron bonds must not be affected by internal pressure or compensation.

Guidance for Standards I–VII

16 “Additional Compensation Agreements” is most likely a sub-­section of which

CFA Institute Standard of Professional Conduct?
A Duties to Employers
B Duties to Clients
C Professionalism

A is correct. Standard IV–Duties to Employers includes a sub-­section entitled “Additional

Compensation Agreements”.
B is incorrect. Standard III–Duties to Clients does not include this sub-­section.
C is incorrect. Standard I–Professionalism does not include this sub-­section.

Code of Ethics and Standards of Professional Conduct

17 Joanne Bryce recently received notification she had successfully completed

the Level III CFA exam. Having met all the necessary requirements, Bryce
would soon be awarded her charter. Bryce’s employer wanted to recognize her
accomplishment and placed an ad in the local newspaper. Which of the follow-
ing statements would least likely comply with the CFA Institute Standards of
Professional Conduct?
A The CFA charter is a key asset in the development of her investment career.
B By becoming a charterholder, she has significantly improved her standing
within the firm.
C Ms. Bryce passed all three levels of the exam consecutively, placing her in an
elite group.
x 2020 Level I Mock Exam (A) AM

C is correct. The ad should not include the statement, “Ms. Bryce passed all three levels
of the exam consecutively, placing her in an elite group.” CFA Standard VII(B): References
to CFA Institute, the CFA Designation, and the CFA Programs states, “When referring to
CFA Institute, CFA Institute membership, the CFA designation, or candidacy in the CFA
Program, Members and Candidates must not misrepresent or exaggerate the meaning or
implications of membership in CFA Institute, holding the CFA designation, or candidacy
in the CFA Program.” CFA charterholders are those individuals who have earned the right
to use the CFA designation granted by CFA Institute. These individuals have satisfied
certain requirements, including completion of the CFA Program and the required years
of acceptable work experience. It would not have been a violation to simply state that
Ms. Bryce had consecutively passed all three levels of the exam; it would simply be a
statement of fact. Adding that it places her in an elite group is an exaggeration of her
accomplishment and could be viewed as misleading.
A and B are incorrect. The statements “The CFA charter is a key asset in the develop-
ment of her investment career” and “By becoming a charterholder, she has significantly
improved her standing within the firm” can be included in the ad. The charter can be
considered a key asset, and that it has significantly improved her standing within the
firm simply indicates that her firm holds the charter in high regard. Neither statement
misrepresents nor exaggerates the meaning or implication of holding the CFA designation.

Guidance for Standards I-­VII

18 Trust is most likely the foundation of the financial industry because:

A financial products and services are often tangible and verifiable.
B investors rely on the specialized knowledge of investment professionals.
C global financial markets and their participants are highly regulated by effec-
tive laws.

B is correct. Trust is the foundation of the financial industry because investors rely on
the specialized knowledge of investment professionals, which allows them to have
more power than their clients with regard to making investment decisions. As a result,
investors must trust their advisers to use their specialized knowledge to benefit their
clients first and foremost.
A is incorrect because many financial products and services are intangible, so investors
heavily rely on investment professionals to act in their best interests and to inform them
honestly about their financial positions.
C is incorrect because most financial markets worldwide and their participants are
highly regulated through effective laws. However, despite this regulation, unethical
behavior can still occur because legal actions can still be unethical. Unethical behavior
has a negative impact on investors. Therefore, trust depends on financial professionals
acting in an ethical manner.

Ethics and Trust in the Investment Profession

19 Over the past four years, a portfolio experienced returns of −8%, 4%, 17%, and
−12%. The geometric mean return of the portfolio over the four-­year period is
closest to:
A 0.25%.
B −0.37%.
2020 Level I Mock Exam (A) AM xi

C 0.99%.

B is correct. Add one to each of the given returns, then multiply them together and take
the fourth root of the resulting product. 0.92 × 1.04 × 1.17 × 0.88 = 0.985121; 0.985121
raised to the 0.25 power is 0.996259. Subtracting one and multiplying by 100 gives the
correct geometric mean return: [(0.92 × 1.04 × 1.17 × 0.88)0.25 − 1] × 100 = −0.37%.
A is incorrect because it is the arithmetic mean of the four numbers.
C is incorrect because it is the solution to: (0.92 × 1.04 × 1.17 × 0.88) = 0.99 (rounded).

Organizing, Visualizing, and Describing Data

20 The following 10 observations are a sample drawn from an approximately nor-

mal population:
Observation 1 2 3 4 5 6 7 8 9 10

Value −3 −11 3 −18 18 20 −6 9 2 −16

The sample standard deviation is closest to:

A 13.18.
B 11.92.
C 12.50.

A is correct. The sample mean is:

n
 Xi
i 1
X 
n

= (−3 − 11 + 3 − 18 + 18 + 20 − 6 + 9 + 2 − 16)/10

= −2.00/10 = −0.20
The sample variance is:
n
 X i  X 
2

i 1
s2 
n  1
The sample standard deviation is the (positive) square root of the sample variance.

Difference vs. Mean

Value [Value − (−0.20)] Difference Squared

−3 −2.8 7.84
−11 −10.8 116.64
3 3.2 10.24
−18 −17.8 316.84
18 18.2 331.24
20 20.2 408.04
−6 −5.8 33.64
(continued)
xii 2020 Level I Mock Exam (A) AM

Difference vs. Mean

Value [Value − (−0.20)] Difference Squared
9 9.2 84.64
2 2.2 4.84
−16 −15.8 249.64
Sum of squared differences 1563.6
Divided by n − 1 173.7333333
Square root 13.18079411

B is incorrect and is calculated by dividing by 11 rather than 9

C is incorrect and is calculated by dividing by 10 rather than 9.

Organizing, Visualizing, and Describing Data

Cumulative Probabilities for a Standard Normal Distribution

P(Z ≤ x) = N(x) for x ≥ 0 or P(Z ≤ z) = N(z) for z ≥ 0
x
or z 0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09

1.10 0.8643 0.8665 0.8686 0.8708 0.8729 0.8749 .08770 0.8790 0.8810 0.8830
1.20 0.8849 0.8869 0.8888 0.8907 0.8925 0.8944 0.8962 0.8980 0.8997 0.9015
1.30 0.9032 0.9049 0.9066 0.9082 0.9099 0.9115 0.9131 0.9147 0.9162 0.9177
…
1.90 0.9713 0.9719 0.9726 0.9732 0.9738 0.9744 0.9750 0.9756 0.9761 0.9767
2.00 0.9772 0.9778 0.9783 0.9788 0.9793 0.9798 0.9803 0.9808 0.9812 0.9817
2.10 0.9821 0.9826 0.9830 0.9834 0.9838 0.9842 0.9846 0.9850 0.9854 0.9857
…
2.50 0.9938 0.9940 0.9941 0.9943 0.9945 0.9946 0.9948 0.9949 0.9951 0.9952
2.60 0.9953 0.9955 0.9956 0.9957 0.9959 0.9960 0.9961 0.9962 0.9963 0.9964
2.70 0.9965 0.9966 0.9967 0.9968 0.9969 0.9970 0.9971 0.9972 0.9973 0.9974

21 A variable is normally distributed with a mean of 5.00 and a variance of 4.00.

Using the excerpt above from the cumulative distribution function for the stan-
dard normal random variable table, the probability of observing a value of −0.40
or less is closest to:
A 2.44%.
B 8.85%.
C 0.35%.

C is correct. First the outcome of interest, −0.40, is standardized for the given normal
distribution:
Z = (X − μ)/σ = (−0.40 − 5.00)/2 = −2.70
2020 Level I Mock Exam (A) AM xiii

Then use the table to find the probability of a Z value being 2.70 standard deviations
below the mean (i.e., when z ≤ 0). The value is 1 − P(Z ≤ +2.70). In this problem, the solu-
tion is: 1 − 0.9965 = 0.0035 = 0.35%.
A is incorrect; it inverts mean and variance: 0.40  4.00 5 = −1.97 (z-value).
The probability is then calculated as: 1 − 0.9756 = 2.44%.
B is incorrect; it divides −5.4 by the variance, 4, and uses 1.35 as the z-value. The
probability is then calculated as: 1 − 0.9115 = 8.85%.

Common Probability Distributions

22 A small-­cap growth fund’s monthly returns for the past 36 months have been
consistently outperforming its benchmark. An analyst is determining whether
the standard deviation of monthly returns is greater than 6%. Which of the
following best describes the hypothesis to be tested?
A H 0: σ2 ≤ 0.36%
B Ha : σ2 > 6%
C H0 : σ2 ≥ 0.36%

A is correct. This is a one-­tailed hypothesis testing with a “greater than” alternative

hypothesis. A squared standard deviation is being used to obtain a test of variance. The
hypotheses are H 0: σ2 ≤ 0.36% versus Ha : σ2 > 0.36%.
B is incorrect as explained in choice A.
C is incorrect as explained in choice A

Hypothesis Testing

23 The following information is available for a portfolio:

Asset Allocation Asset Class Correlation with
Asset Class Weight (%) Return (%) Equities Class (%)

Equities 45 16 100
Mortgages 25 12 30
Cash and equivalents 30 2 10

The return on the portfolio is closest to:

A 10.0%.
B 8.2%.
C 10.8%.

C is correct. The portfolio return is the weighted mean return and is calculated as:
n
Xw   wi X i
i 1
= 0.45 × 16 + 0.25 × 12 + 0.30 × 2
= 10.80.
xiv 2020 Level I Mock Exam (A) AM

B is incorrect. It weights each component by the correlation with equities: 0.45 × 16 ×
1.00 + 0.25 × 12 × 0.30 + 0.30 × 2 × 0.10 = 8.16.
A is incorrect. It is the arithmetic average of the three returns without weights: (16 +
12 + 2)/3 = 10.

Organizing, Visualizing, and Describing Data

24 If the distribution of the population from which samples of size n are drawn is
positively skewed and given that the sample size, n, is large, the sampling distri-
bution of the sample means is most likely to have a:
A mean smaller than the mean of the entire population.
B variance equal to that of the entire population.
C distribution that is approximately normal.

C is correct. Given a population that has a finite variance and a large sample size, the
central limit theorem establishes that the sampling distribution of sample means will be
approximately normal, will have a mean equal to the population mean, and will have a
variance equal to the population variance divided by the sample size.
A is incorrect. Given a population that has a finite variance and a large sample size,
the central limit theorem establishes that the sampling distribution of samples means
will have a mean equal to the population mean.
B is incorrect. Given a population that has a finite variance and a large sample size,
the central limit theorem establishes that the sampling distribution of sample means will
have a variance equal to the population variance divided by the sample size.

Sampling and Estimation

25 A fund manager would like to estimate the probability of a daily loss higher
than 5% on the fund he manages. He decides to use a method that uses the rel-
ative frequency of occurrence based on historical data. The resulting probability
is best described as a(n):
A subjective probability.
B a priori probability.
C empirical probability.

C is correct. An empirical probability is a probability estimated from data as a relative

frequency of occurrence.
A is incorrect. A subjective probability is a probability drawing on personal or sub-
jective judgment.
B is incorrect. An a priori probability is a probability obtained based on logical analysis.

Probability Concepts
2020 Level I Mock Exam (A) AM xv

Population 1 2

Sample size n1=5 n2=5

Sample variance
s12 = 4 s22 = 28

26 The samples are drawn independently and both populations are assumed to be
normally distributed
Using the above data, an analyst is trying to test the null hypothesis that the
population variances are equal (H 0: 12  22 ) against the alternative hypothe-
sis that the variances are not equal (Ha : 12  22 ) at the 5% level of signifi-
cance. The table of the F-distribution is provided below.

Table  of the F-Distribution

Panel A: Critical values for right-­hand tail area equal to 0.05
df1 (read across)
1 2 3 4 5

df2 1 161 200 216 225 230

(read down) 2 18.5 19.0 19.2 19.2 19.3
3 10.1 9.55 9.28 9.12 9.01
4 7.71 6.94 9.59 6.39 6.26
5 6.61 5.79 5.41 5.19 5.05

Panel B: Critical values for right-­hand tail area equal to 0.025

df1 (read across)
1 2 3 4 5

df2 1 648 799 864 900 922

(read down) 2 38.51 39.00 39.17 39.25 39.30
3 17.44 16.04 15.44 15.10 14.88
4 12.22 10.65 9.98 9.60 9.36
5 10.01 8.43 7.76 7.39 7.15

Which of the following statements is most appropriate? The critical value is:
A 6.39 and reject the null.
B 9.60 and do not reject the null.
C 7.15 and do not reject the null.

B is correct. The test statistic makes use of the F-distribution and is the ratio of the vari-
ances, with the larger variance in the numerator. The test statistic is F = s2 s1 = 28/4 =
2 2

7. The degrees of freedom are 4 by 4. As it is a two-­tailed test, the correct critical value
at α = 5% is 9.60 (Panel B). As the test statistic is less than the critical value (i.e., 7 < 9.60),
the null hypothesis cannot be rejected.
A is incorrect. It uses 4 by 4 degrees of freedom and does not divide the given alpha
by two as is appropriate for a two-­tailed test.
xvi 2020 Level I Mock Exam (A) AM

C is incorrect. It uses the 5 by 5 critical value (i.e., 5 degrees of freedom) rather than
correctly using the 4 by 4 value (i.e., 4 degrees of freedom).

Hypothesis Testing

27 A z-test regarding a mean is most appropriate when the variance is unknown

and the:
A sample is not normally distributed.
B central limit theorem is applicable.
C sample is small and normally distributed.

B is correct. If the population variance is unknown and the sample is large, we can use
a z-test relying on the central limit theorem.
A is incorrect because a t-test is appropriate in the case of an unknown variance with
moderate departures from normality.
C is incorrect because in the case of a hypothesis test of the population mean with
an unknown variance, a test statistic is used when either 1) the sample is large, or 2) the
sample is small but normally distributed, or approximately normally distributed. A t-test
is typically used with small samples and an unknown population variance.

Hypothesis Testing

28 Which of the following tests should be used to evaluate the difference between
the means of two normally distributed populations?
A An approximate t-test if the population variances are unknown and assumed
unequal and the samples are assumed to be independent.
B An approximate t-test that involves the calculation of a pooled estimator of
the population variances which are assumed unequal.
C A paired comparison test if the two samples are independent and the popu-
lation variances are unknown.

A is correct. An approximate t-test is used to test the differences between means of two
populations when the unknown population variances cannot be assumed to be equal.
B is incorrect because a pooled estimator is used when the two population variances
are assumed to be equal.
C is incorrect because a paired comparison test is used to test mean differences when
the samples are assumed to be dependent.

Hypothesis Testing

29 A random number between zero and one is generated according to a continu-

ous uniform distribution. What is the probability that the first number gener-
ated will have a value of exactly 0.30?
A 70%
B 0%
2020 Level I Mock Exam (A) AM xvii

C 30%

B is correct. The probability of generating a random number equal to any fixed point
under a continuous uniform distribution is zero.
C is incorrect because this is the cumulative distribution function of the continuous
uniform distribution. The probability P(0 ≤ x ≤ 0.3) in a continuous uniform distribution
with a = 0 and b = 1 is equal to:
x  a 0.3  0
F 0.3    0.3
ba 1 0
A is incorrect because this is the probability of a random number x in this continuous
uniform distribution taking a value greater than or equal to 0.3; P(x ≥ 0.3) = 1 − F(0.3) = 0.7.

Common Probability Distributions

30 A company has reported annual revenue for the past five years as follows (£
millions):
2008 2009 2010 2011 2012

250,738 279,347 316,480 355,589 392,008

The company’s compound annual growth rate in revenue is closest to:

A 11.8%.
B 14.1%.
C 9.4%.

A is correct. Compound growth rate can be calculated as

 Ending value 1 number of periods   392, 008 1 4 
   1      1  11.8%
 Beginning value    350, 738  
 
B is incorrect because it determines the average growth rate: [(392,008/250,738)
– 1]/4 =14.1%.
C is incorrect because it uses 5 periods instead of 4: [(392,008/250,738)1/5 – 1] = 9.35%.

The Time Value of Money

31 The following information applies to a start-­up company solely owned by an

entrepreneur.
  Value

Total units produced 3,550

Average revenue $1,110
Average variable cost $750
Total fixed cost $300,000
Total investment $1,550,000
(continued)
xviii 2020 Level I Mock Exam (A) AM

  Value
Required rate of return 12.5%
Opportunity cost of owner’s labor $125,000

The company’s economic profit is closest to:

A $659,250.
B $784,250.
C $318,750.

A is correct.
Economic profit = Accounting profit – Total implicit opportunity costs
where

Accounting profit = Total revenue – Total variable costs – Total

fixed costs
Total opportunity costs = opportunity cost of capital + opportunity cost
of labor

Total revenue 3,550 × $1,110 $3,940,500 # units × average

revenue
Less Total variable 3,550 × $750 $2,662,500 # units × average var
costs cost
Less Total fixed costs $300,000 given
Accounting profit $978,000

Opportunity cost of $1,550,000 × $193,750 Investment × Required

capital 0.125 return
Opportunity cost of $125,000 Given
owner’s labor
Total opportunity $318,750
costs
Economic profit $659,250

C is incorrect because it calculates the normal profit or the total implicit opportunity
cost.
B is incorrect because it does not take into account the opportunity cost of labor. Total
implicit opportunity cost = $1,550,000 × 0.125 = $193,750. Economic profit = $978,000
– $193,750 = $784,250.

The Firm and Market Structures

32 If the prices of substitute resources decrease, the demand for a given resource
will most likely:
A remain unchanged.
B decrease.
C increase.
2020 Level I Mock Exam (A) AM xix

B is correct. A decrease in the price of a substitute resource would encourage producers

to use the substitute resource thus reducing demand for the resource in question.
C is incorrect. A decrease in the price of a substitute good would induce consumers
to use the substitute good, reducing demand for the good in question.
A is incorrect. A decrease in the price of a substitute good would induce consumers
to use the substitute good, reducing demand for the good in question.

Topics in Demand and Supply Analysis

33 The following information applies to a hypothetical economy:

Total population 1,100
Working age population 975
Labor force 750
Underemployed 120
Unemployed 95
Discouraged workers 80
Frictionally unemployed 25
Voluntarily unemployed 40

The unemployment rate is closest to:

A 12.7%.
B 16.0%.
C 9.7%.

A is correct. Unemployment rate = (Unemployed/Labor force) × 100 = (95/750) × 100 =

12.7%.
B is incorrect. It includes the frictionally unemployed (which is already part of the
unemployed): (95 + 25)/750 × 100 = 16.0%
C is incorrect. It compares the unemployed to the working age population: 95/975 ×
100 = 9.7%.

Understanding Business Cycles

34 Based on the elasticities approach, a country can implement an exchange rate

policy to improve its trade balance most effectively if it imports and exports
products:
A that are consumer necessities.
B with no good substitute.
C traded in competitive markets.

C is correct. In the elasticities approach, changes in exchange rate policy will be a more-­
effective mechanism for trade balance adjustment if a country imports and exports
products that trade in competitive markets, with good substitutes, and luxury products
rather than necessities.
xx 2020 Level I Mock Exam (A) AM

A is incorrect. In the elasticities approach, changes in exchange rate policy will be a

more-­effective mechanism for trade balance adjustment if a country imports and exports
products that trade in competitive markets, with good substitutes, and luxury products
rather than necessities.
B is incorrect. In the elasticities approach, changes in exchange rate policy will be a
more-­effective mechanism for trade balance adjustment if a country imports and exports
products that trade in competitive markets, with good substitutes, and luxury products
rather than necessities.

Currency Exchange Rates

35 Assuming its trading partner does not retaliate, which of the following condi-
tions must hold in order for a large country to increase its national welfare by
imposing a tariff?
A The deadweight loss must be smaller than the benefit of its improving terms
of trade.
B It must auction the import licenses for a fee to offset the decline in the con-
sumer surplus.
C It must have a comparative advantage in the production of the imported
good.

A is correct. The large country is able to cause the foreign exporter to reduce price in
order to retain market share. In the large country, domestic producers gain from higher
volume and the government gains from collecting the tariff. The sum of these two gains
must exceed the deadweight loss to domestic consumers to achieve a national welfare
gain. The change in terms of trade causes income redistribution from the foreign exporter
to the domestic producer.
B is incorrect. An import license relates to a quota, not a tariff.
C is incorrect. If the large country had a comparative advantage, it would be exporting
more than importing. This is not relevant to whether there is a net domestic gain from
the tariff. The tariff hurts domestic consumers. Unless the gain from the tariff exceeds
the loss to consumers, national welfare will decrease.

International Trade and Capital Flows

36 A central bank announcement of a program to raise rates to moderate inflation

will most likely lead to:
A a weaker domestic currency.
B revised interest rate expectations.
C higher asset prices.

B is correct. Companies and individuals often make investment and purchasing decisions
based on interest rate expectations extrapolated from recent events. As the economic
actors perceive that a central bank will be implementing rate increases, they will antic-
ipate rising rates and adjust their behavior accordingly. These revised higher interest
rate expectations will typically lead to a stronger domestic currency and declines in
consumption, asset prices, and borrowing. These outcomes are consistent with a policy
action to moderate inflation.
2020 Level I Mock Exam (A) AM xxi

A is incorrect because raising central bank rates to moderate inflation typically leads
to a stronger (rather than a weaker) domestic currency. The strengthening domestic
currency makes domestic exports more expensive to foreign buyers thereby dampen-
ing demand, an outcome that is consistent with the objective of moderating inflation.
C is incorrect because raising central bank rates to moderate inflation typically leads
to declining asset prices as the discount rate rises. Declining asset prices lead market
participants to a view that higher interest rates result in slower economic growth,
reduced profits, and reduced borrowing to finance asset purchases. Reduced consumer
demand from the wealth effect of declining asset prices also tempers consumption and
inflationary pressures.

Monetary and Fiscal Policy

37 The structural deficit is equal to the budget deficit:

A adjusted for inflation.
B that would exist at full employment.
C excluding the impact of automatic stabilizers.

B is correct. The structural deficit is the deficit that would exist if the economy was at full
employment (or full potential output). Economists often consider the structural deficit
as an indicator of the fiscal policy stance.
A is incorrect because the structural deficit makes no adjustment for inflation.
C is incorrect because the structural deficit includes (rather than excludes) the impact
of automatic stabilizers on the budget assuming full employment.

Monetary and Fiscal Policy

38 Both monetary and fiscal policies can most likely be used by a government to:
A redistribute income and wealth.
B affect the level of interest rates.
C influence the level of economic activity.

C is correct. Both monetary and fiscal policies are used to regulate economic activity
over time.
A is incorrect. Only fiscal policy can be used to redistribute income and wealth.
B is incorrect. Only monetary policy can be used to affect the level of interest rates.

Monetary and Fiscal Policy

39 Which statement about the Ricardian model of trade is most accurate? The
model:
A allows for a redistribution of income through trade.
B incorporates the benefit of technology in labor productivity.
C predicts that a country with abundant labor resources relative to capital will
likely export labor-­intensive goods and import capital-­intensive goods.
xxii 2020 Level I Mock Exam (A) AM

B is correct. In the Ricardian model of trade, labor is the only input and the benefit of
technology is reflected in labor productivity.
A is incorrect. Income redistribution cannot happen in a Ricardian model because
capital is not an input in the Ricardian model. Income redistribution can happen in the
Heckscher–Ohlin model of trade because the model incorporates capital and labor.
C is incorrect. The Ricardian model does not have capital as an input and consequently
cannot predict trade on the basis of labor-­intensive goods and capital-­intensive goods.
Trade predictions based on capital and labor can be determined using the Heckscher–
Ohlin model.

International Trade and Capital Flows

40 An exchange rate between two currencies has decreased to 1.3500. If the base
currency has depreciated by 7% against the price currency, the initial exchange
rate between the two currencies was closest to:
A 1.2617.
B 1.4445.
C 1.4516.

C is correct. To calculate the initial exchange rate, the current exchange rate is divided by
1 minus the percentage depreciation in the exchange rate of the base currency: 1.3500 ÷
(1 – 0.07) = 1.3500 ÷ 0.93 = 1.4516.
A is incorrect. The calculation incorrectly divides the current exchange rate by 1 plus
the percentage depreciation in the exchange rate: 1.3500 ÷ 1.07 = 1.2617.
B is incorrect. The calculation incorrectly multiplies the current exchange rate by 1
plus the percentage depreciation in the exchange rate: 1.3500 × 1.07 = 1.4445.

Currency Exchange Rates

41 Which of the following statements about a downward-­sloping long-­run average

cost (LRAC) curve is most accurate? A downward-­sloping LRAC curve is repre-
sentative of a firm experiencing:
A economies of scale.
B diseconomies of scale.
C decreasing levels of investment.

A is correct. When the LRAC curve is downward sloping, it means the firm is producing
units at lower average costs per unit as production levels rise. This situation represents
economies of scale in production.
B is incorrect. An upward-­sloping LRAC curve would be representative of disecon-
omies of scale.
2020 Level I Mock Exam (A) AM xxiii

C is incorrect. Decreasing levels of investment alone would not result in a downward-­

sloping LRAC curve; it would also depend on the volume of production. If the level of
production drops proportionately more than the level of investment, the LRAC curve
could be upward sloping.

Topics in Demand and Supply Analysis

42 Selected information is taken from the GDP data of a hypothetical country:

Amount
Account Name ($ trillions)

GDP 18.0
Wages, salaries, and other labor income 9.0
Taxes 3.5
Capital consumption allowance 2.3
Undistributed corporate profits 1.0
Transfer payments 1.9

Personal income (in $ trillions) for this country is closest to:

A 10.9.
B 15.4.
C 17.7.

C is correct. Personal income = National income – Taxes – Undistributed corporate profits

+ Transfer payments, where
National income = GDP + Capital consumption allowance = 18 + 2.3 = 20.3
Personal income = 20.3 – 3.5 – 1.0 + 1.9 = 17.7
A is incorrect. It is only cash flows to households through wages, salaries, and other
labor income plus transfer payments = 9.0 + 1.9 = 10.9.
B is incorrect. It ignores capital consumption allowance in determining national
income. National income is incorrectly calculated as
National income = GDP + Capital consumption allowance = 18 + 0 = 18,
with

Personal income = National income – Taxes – Undistributed corporate

profits + Transfer payments
  = 18.0 – 3.5 – 1.0 + 1.9 = 15.4.

Aggregate Output, Prices, and Economic Growth,”

43 Under International Financial Reporting Standards (IFRS), which of the fol-

lowing is most likely one of the general features underlying the preparation of
financial statements?
A Understandability
B Timeliness
C Consistency
xxiv 2020 Level I Mock Exam (A) AM

C is correct. Consistency is one of the general features underlying the preparation of

financial statements based on IFRS.
A is incorrect. Understandability is one of the qualitative characteristics of financial
statements under IFRS framework for the preparation and presentation of financial
statements. It is not a general feature.
B is incorrect. Timeliness is one of the qualitative characteristics of financial statements
under IFRS framework for the preparation and presentation of financial statements. It
is not a general feature.

Financial Reporting Standards

44 A company acquires a license for $6,500 with the right to use the license for
four years. Management expects to derive benefits from the license for three
years and uses the straight-­line amortization method. Accumulated amortiza-
tion at the end of Year 2 is closest to:
A $4,333.
B $3,250.
C $2,167.

A is correct. Accumulated amortization for the intangible asset at the end of Year 2 is
closest to $4,333. At the end of the second year, amortization taken = 2 years × (6,500/3)
= $4,333.
B is incorrect. It mistakenly uses the legal life of four years instead of three years. This
gives an amortization expense of $6,500/4 = $1,625 per year. Using a four-­year useful life,
accumulated amortization at the end of Year 2 is calculated as 2 years × $1,625 = $3,250.
C is incorrect. It calculates amortization expense in Year 2, $6,500/3 = $2,167 but for-
gets to add the amortization expense from Year 1 to arrive at accumulated amortization.

Long-­Lived Assets

45 Under IFRS, the costs incurred in the issuance of bonds are most likely:
A expensed when incurred.
B included in the measurement of the bond liability.
C deferred as an asset and amortized on a straight-­line basis.

B is correct. Under IFRS, debt issuance costs are included in the measurement of the
bond liability.
A is incorrect. Under both US GAAP and IFRS, they are not expensed.
C is incorrect. This is US GAAP.

Non- ­Current (Long-­Term) Liabilities

46 In the current year, a company increased its deferred tax asset by $500,000.
During the year, the company most likely:
2020 Level I Mock Exam (A) AM xxv

A became entitled to a $500,000 tax refund.

B had permanent differences between accounting profit and taxable income.
C reported a lower accounting profit than taxable income.

C is correct. Deferred tax assets represent taxes that have been paid (because of the
higher taxable income) but have not yet been recognized on the income statement
(because of the lower accounting profit).
A is incorrect. Deferred tax assets are simply the results of differences between
accounting profit and taxable income. It is not an amount of a tax refund that would be
an income tax receivable.
B is incorrect. Only temporary differences create deferred tax assets or liabilities

Income Taxes

47 A company acquires some new depreciable assets. It uses straight-­line depre-

cation for all of its assets. Which of the following combinations of estimated
residual values and useful lives is most likely to produce the highest net profit
margin? Estimated residual values should be:
A high with long average lives.
B low with long average lives.
C high with short average lives.

A is correct. A high residual value estimate reduces the depreciable base and thus
depreciation expense. Long average lives reduce the annual depreciation expense for
any given depreciable base. The combination of the two would result in the lowest
depreciation expense, which would lead to the highest net income and profit margins.
B is incorrect. Low residual values increase depreciation, though long lives reduce it.
C is incorrect. Short lives increase depreciation expense, though high residual values
reduce it.

Long-­Lived Assets

48 Which of the following suggestions is best aligned with CFA Institute advocacy
for financial reporting that reflects economic reality?
A Cash flow statements prepared using the direct format for cash flow from
operations (CFO)
B Conservatism in revenue recognition policies
C Detailed cost information for long-­lived assets

A is correct. The CFA Institute position paper “A Comprehensive Business Reporting

Model: Financial Reporting for Investors” (2007) advocated for financial reporting that
reflects economic reality. It specifically identified a preference for using the direct format
for CFO in cash flow statements.
B is incorrect. The position paper advocated for neutrality in financial reporting.
xxvi 2020 Level I Mock Exam (A) AM

C is incorrect. The position paper advocated for information regarding the current
fair value of assets and liabilities, not cost information.

Financial Reporting Standards

49 The year-­end balances in a company’s last-­in, first-­out (LIFO) reserve are

$56.8 million as reported in the company’s financial statements for both 2013
and 2014. For 2014, the measure that will most likely be the same regardless of
whether the company uses the LIFO or the first-­in, first-­out (FIFO) inventory
method is the:
A gross profit margin.
B amount of working capital.
C inventory turnover.

A is correct. The LIFO reserve did not change from 2013 to 2014. With no change in the
LIFO reserve, cost of goods sold will be the same under both methods. Sales are always
the same for both methods, so gross profit margin will be the same for 2014. The FIFO
inventory will be higher because the LIFO inventory and LIFO reserve are added to
compute FIFO inventory. Because the inventory balances would differ under FIFO, both
inventory turnover and the amount of working capital would also differ under FIFO.
B is incorrect. The FIFO inventory would be higher because the LIFO inventory and
LIFO reserve are added to compute FIFO inventory. Because the inventory balances would
be different under FIFO, net working capital would be different under FIFO.
C is incorrect. The FIFO inventory would be higher because the LIFO inventory and
LIFO reserve are added to compute FIFO inventory. Because the inventory balances
would be different under FIFO, the inventory turnover would be different under FIFO.

Inventories

50 Under IFRS, dividends received are least likely classified as which type of cash
flow on the cash flow statement?
A Financing
B Operating
C Investing

A is correct. Dividends received can be classified as either an operating or investing

activity under IFRS but not as a financing activity.
B is incorrect because dividends received can be classified as an operating activity
under IFRS.
C is incorrect because dividends received can be classified as an investing activity
under IFRS.

Understanding Cash Flow Statements

51 The following information is available on a company:

2020 Level I Mock Exam (A) AM xxvii

Metric  

Fixed charge coverage ratio required by debt covenant 3.50

Forecasted interest expense ($ thousands) 850
Forecasted interest payments ($ thousands) 800
Forecasted lease payments ($ thousands) 300
Tax rate 30%

The minimum net income (in thousands) that the company must generate to
meet its debt covenant requirement is closest to:
A $2,700.
B $1,890.
C $2,100.

B is correct. The fixed charge coverage ratio is:

Net income + Income tax expense + Interest expense + Lease payments
Interest payments + Lease payments

Calculation $ thousands

Denominator ($ thousands): Interest 800 + 300 1,100

payments + Lease payments
Minimum numerator: Net income Denominator × 3,850
+ Income tax expense + Interest 3.50
expense + Lease payments
Minus interest expense –850
Minus lease payments –300
Income before tax 2,700
Minus income tax expense 2,700 × 30% –810
Minimum net income 1,890

A is incorrect. This answer incorrectly omits tax expense from the numerator. The
answer provided is actually net income before tax as calculated above, not net income.
C is incorrect. This answer incorrectly assumes that the numerator in the ratio is EBIT.

($ thousands)

Minimum numerator (from above): Denominator × 3.50 3,850

Incorrectly assumed to be EBIT
Less: interest expense –850
Incorrect income before tax 3,000
Less: income tax expense $3,000 × 30% –900
Incorrect minimum net income 2,100

Financial Analysis Techniques

52 Which of the following is the best example of conservative accounting?

xxviii 2020 Level I Mock Exam (A) AM

A Reducing the allowance for bad debt expense below the experienced loss
rate.
B Deferring R&D expenses to a subsequent year.
C Choosing to depreciate new equipment over the shortest estimate of its
useful life.

C is correct. Depreciating equipment over the shortest estimated period of its useful life
is a conservative accounting choice that reduces earnings in the early years and increases
them in the future, creating a positive trajectory.
A is incorrect. Reducing the bad debt allowance below the experienced loss rate is
an aggressive choice that causes earnings to appear higher in the current year.
B is incorrect. Deferring R&D is an aggressive choice that causes earnings to appear
higher in the current year.

Financial Reporting Quality

53 The following financial information is available at the end of the year.

Share Information
Issued and
Security Authorized Outstanding Other Features

Common stock 500,000 250,000 Currently pays a dividend of $1 per share.

Preferred stock, Series 50,000 12,000 Nonconvertible, cumulative; pays a dividend of $4
A per share.
Preferred stock, Series B 50,000 30,000 Convertible; pays a dividend of $7.50 per share. Each
share is convertible into 2.5 common shares.
Additional information:
Reported income for the year $1,000,000

The diluted EPS (earnings per share) is closest to:

A $3.08.
B $2.93.
C $2.91.

C is correct. The convertible preferred shares are anti-­dilutive, as shown in the following
table. Therefore, the diluted EPS is the same as the basic EPS, $2.91.

Diluted EPS
(using if-­converted
Basic EPS method)

Net income $1,000,000 $1,000,000

Preferred stock, Series A (48,000) (48,000) 12,000 shares × $4/share
Preferred stock, Series B (225,000) 0 30,000 shares × $7.50/share
Earnings available to common $727,000 $952,000
shareholders
2020 Level I Mock Exam (A) AM xxix

Weighted Average Number of Common Shares (WACS)

Shares outstanding 250,000 250,000

If converted — 75,000 2.5 common/preferred × 30,000
preferred
WACS 250,000 325,000
EPS = Earnings available to $2.91 $2.93*
common shareholders/WACS

* Exceeds Basic EPS; Series B is anti-­dilutive and is thus not included.

A is incorrect. It ignores the Series A dividends and incorrectly includes the anti-­dilutive
effect of converting the Series B shares.
From the table:
Earnings to Common = 1,000,000 (ignores Series A, converts)
Common shares outstanding = 325,000, as per table with conversion of
convertible
EPS = $1,000,000/325,000 shares = $3.08/share
B is incorrect. It includes the conversion of the convertible securities, which are
anti-­dilutive.

Understanding Income Statements

54 A company’s balance sheet at the end of the year shows the following:
Current Assets
 Cash and cash equivalents $2,950
 Marketable securities 730
 Notes and accounts receivable, trade 5,740
 Less allowance for doubtful accounts and sales returns (650)
 Inventories 1,320
 Other current assets 1,850
Total current assets $11,940

Current Liabilities
 Accounts payable and other accrued liabilities $5,100
 Current portion of borrowings 1,820
 Other current liabilities 2,560
Total current liabilities $9,480

The company’s quick ratio is closest to:

A 0.99.
B 0.93.
C 1.26.

B is correct.
xxx 2020 Level I Mock Exam (A) AM

Ratio Formula Calculation

Quick Ratio (Cash + Marketable securities + Receivables)/Current (2,950 + 730 + 5,740 – 650)/9,480 = 0.93
liabilities

A is incorrect. It is the quick ratio calculated without removing the adjustment for
doubtful accounts from accounts receivable.

Ratio Formula Calculation

Quick Ratio (Cash + Marketable securities + Receivables)/Current (2,950 + 730 +5,740 – 650)/9,480 = 0.93
liabilities
Quick Ratio (Cash + Marketable securities + Receivables)/Current (2,950 + 730 + 5,740)/9,480 = 0.99
with error liabilities
Current Ratio Current assets/Current liabilities 11,940/9,480 = 1.3

C is incorrect. It is the current ratio.

Ratio Formula Calculation

Quick Ratio (Cash + Marketable securities + Receivables)/Current (2,950 + 730 +5,740 – 650)/9,480 = 0.93
liabilities
Quick Ratio (Cash + Marketable securities + Receivables)/Current (2,950 + 730 + 5,740)/9,480 = 0.99
with error liabilities
Current Ratio Current assets/Current liabilities 11,940/9,480 = 1.3

Understanding Balance Sheets

55 Under US GAAP, interest paid is most likely included in which of the following
cash flow activities?
A Operating only
B Financing only
C Either operating or financing

A is correct. Interest paid must be categorized as an operating cash flow activity under
US GAAP, although it can be categorized as either an operating or financing cash flow
activity under IFRS.
B is incorrect. Interest paid cannot be categorized as a financing cash flow under US
GAAP but can be under IFRS.
C is incorrect. Interest paid cannot be categorized as a financing cash flow under US
GAAP but can be under IFRS.

Understanding Cash Flow Statements

56 Common-­size financial statements are most likely a component of which step in

the financial analysis framework?
A Collect data
B Analyze/interpret data
C Process data
2020 Level I Mock Exam (A) AM xxxi

C is correct. Preparing common-­size financial statements is part of the process data step.
A is incorrect. The financial statements are obtained in the collect data step, but not
converted into common-­size statements until the process step.
B is incorrect. Preparing common-­size financial statements is part of the process data
stage, after which the analyst will analyze/interpret the processed data.

Financial Statement Analysis: An Introduction

57 When using ratios to screen for potential equity investments, analysts can most
effectively control for exposure to which of the following risks?
A Regulatory
B Financial
C Technological

B is correct. Ratio analysis provides a quick and direct way of comparing metrics address-
ing financial risk across a pool of companies.
A is incorrect. Regulatory risk is not readily assessed by ratio analysis. This risk is more
likely to be assessed based on knowledge of regulatory trends, and the likely impact of
regulatory change on individual companies.
C is incorrect. Technological risk is not readily assessed by ratio analysis. This risk is
more likely to be assessed based on knowledge of technology trends in the market and
the technological expertise of individual companies.

Financial Statement Analysis: Applications

58 Which of the following will be higher using the LIFO method compared with
the FIFO method during periods of rising inventory unit costs?
A Gross profit
B Cost of sales
C Ending inventory

B is correct. Under either a perpetual or periodic inventory system, using the LIFO
method will result in higher cost of sales than the FIFO method when inventory costs
are increasing. This is because the cost allocated to cost of sales under the LIFO method
more closely reflects current replacement values of inventory, which is higher than older
inventory which was purchased at a lower cost.
A is incorrect because under either a perpetual or periodic inventory system, using the
LIFO method will result in a higher cost of sales during periods of rising inventory costs
because the cost of sales more closely reflects current replacement values. As such, the
higher cost of sales will result in a lower gross profit, operating income, and net income
as compared with the FIFO method.
xxxii 2020 Level I Mock Exam (A) AM

C is incorrect because in an environment of rising inventory costs, ending inventory

amounts under the LIFO method are typically not reflective of current replacement value
because the ending inventory is assumed to be the oldest inventory, which is lower than
current replacement costs. As such, ending inventory amounts under the LIFO method
will be lower than the FIFO method.

Inventories

59 The following information is available for a company:

  2016 (in € millions)

EBIT (earnings before interest and taxes) 1,015.0

Interest expense 73.4
Tax expense 201.4
Total assets 5,305.0
Average total assets 5,421.0
Total debt 1,048.0

  2015

Interest coverage 15.3×

Debt to total assets 18.2%
Operating return on assets (ROA) 17.3%

Compared with 2015, which of the following ratios most likely indicates an
improvement in the creditworthiness of the company? The change in the
company’s:
A operating ROA.
B debt-­to-­total assets.
C interest coverage.

A is correct. When calculated for 2016, interest coverage decreased and debt to total
assets and return on assets both increased. In general, a decrease in interest coverage
and an increase in debt to total assets would reduce creditworthiness, but an increase
in return on assets would improve creditworthiness. Calculations are as follows:

Calculation 2016 Comment

Debt to total assets Total debt/ 19.8% Higher than 2015 (18.2%), which would
Total assets = reduce creditworthiness
€1,048/€5,305 =
Interest coverage EBIT/Interest 13.8× Lower than 2015 (15.3×), which would
payments = reduce creditworthiness
€1,015/€73.4 =
Operating ROA EBIT/Average 18.7% Higher than 2015 (17.3%), which would
total assets = improve creditworthiness
€1,015/€5,421 =

B is incorrect because an increase in debt-­to-­total assets would likely reduce

creditworthiness.
2020 Level I Mock Exam (A) AM xxxiii

C is incorrect because a decrease in the interest coverage ratio would likely reduce
creditworthiness.

Financial Analysis Techniques

60 An income statement in a single-­step format presents a subtotal for:

A amortization of intangibles.
B operating income.
C gross margin.

B is correct. Single-­step income statements present a subtotal for operating income.

A is incorrect because income statements in single-­step format do not present a
subtotal for amortization of intangibles.
C is incorrect because income statements in single-­step format do not present a
subtotal for gross margin. When an income statement shows a gross profit subtotal, it
is said to use a multi-­step format rather than a single-­step format.

Understanding Income Statements

61 Which action is most likely considered a secondary source of liquidity?

A Increasing the efficiency of cash flow management
B Renegotiating current debt contracts to lower interest payments
C Increasing the availability of bank lines of credit

B is correct. Renegotiating debt contracts is a secondary source of liquidity because it

may affect the company’s operating and/or financial positions.
A is incorrect. Increasing cash flow management efficiency is a primary source of
liquidity.
C is incorrect. Increasing bank lines of credit is a primary source of liquidity.

Working Capital Management

62 Which of the following is most likely considered an example of matrix pricing

when determining the cost of debt?
A Debt-­rating approach only.
B Yield-­to-­maturity approach only.
C Both the yield-­to-­maturity and the debt-­rating approaches.

A is correct. The debt-­rating approach is an example of matrix pricing.

B is incorrect because the yield-­to-­maturity approach is not an example of matrix
pricing.
xxxiv 2020 Level I Mock Exam (A) AM

C is incorrect because the yield-­to-­maturity approach is not an example of matrix

pricing.

Cost of Capital

Income Statement Millions ($)

Revenues 9.8
Variable operating costs 7.2
Fixed operating costs 1.5
Operating income 1.1
Interest 0.6
Taxable income 0.5
Tax 0.2
Net income 0.3

63 The degree of operating leverage (DOL) is closest to:

A 2.4.
B 1.1.
C 1.7.

A is correct.
Revenues − Variable operating costs
DOL =
Revenues − Variable operating costs − Fixed operating costs

9.8 − 7.2
 =
9.8 − 7.2 − 1.5
 = 2.36
B is incorrect because it is Revenues/(Variable operating costs + Fixed operating costs).
C is incorrect because it is (Revenues – Variable operating costs)/Fixed operating costs.

Measures of Leverage

64 The acceptance of which of the following capital budgeting projects is most

likely to expose a company to the highest level of uncertainty?
A Replacement of worn out equipment
B Expansion projects
C Newly launched product or services

C is correct. Investments related to new products or services expose the company to

even more uncertainties than expansion projects. These decisions are more complex
and will involve more people in the decision-­making process.
A is incorrect. Replacement of worn out equipment is simply an improvement to the
existing project with recurring revenues.
2020 Level I Mock Exam (A) AM xxxv

B is incorrect. Investments related to new products or services expose the company

to even more uncertainties than expansion projects. These decisions are more complex
and will involve more people in the decision-­making process

Capital Budgeting

65 The annual cost of trade credit assuming a 365-­day year for terms 3/10 net 40 is
closest to:
A 43.3%.
B 44.9%.
C 32.0%.

B is correct.
Cost of trade credit
365 Number of days beyond disccount period
 Discount 
= 1   1
 1  Discount

365 30
 3% 
Cost of trade credit = 1    1= 44.9%
  3%
1 
C is incorrect because the “number of days beyond discount” is set to 40.
A is incorrect because (1 + 3%) is the rate being compounded.

Working Capital Management

66 Which method of calculating the firm’s cost of equity is most likely to incorpo-
rate the long-­run return relationship between the firm’s stock and the market
portfolio?
A Capital asset pricing model
B Dividend discount model
C Bond yield plus risk premium approach

A is correct. The capital asset pricing model uses the firm’s equity beta, which is computed
from a market model regression of the company’s stock returns against market returns.
B is incorrect. Dividend discount model estimates the equity risk premium by adding
the dividend yield and the growth rate in dividends.
C is incorrect. Cost of equity under this method is the additional of cost of debt and
risk premium (the additional yield on a company’s stock relative to its bonds).

Cost of Capital

67 Financial risk is least likely affected by:

A debentures.
B dividends.
xxxvi 2020 Level I Mock Exam (A) AM

C long-­term leases.

B is correct. By taking on fixed obligations, such as debt (including debentures) and long-­
term leases, a company increases its financial risk. Dividends will not increase financial risk.
A is incorrect because the use of debentures (one type of bond) is directly associated
with financial risk.
C is incorrect because the use of long-­term leases is directly related to financial risk.

Measures of Leverage

68 A firm with a marginal tax rate of 40% has a weighted average cost of capital
of 7.11%. The before-­tax cost of debt is 6%, and the cost of equity is 9%. The
weight of equity in the firm’s capital structure is closest to:
A 79%.
B 65%.
C 37%.

B is correct.

WACC = wdrd (1 – t) + were , where wd + we = 1

7.11 = (1 – we ) × 6 × (1 – 0.4) + we × 9
we = 65%
A is incorrect. It is calculated by dividing 7.11 by 9.
C is incorrect. It fails to adjust debt for taxes.

Cost of Capital

69 A company recently issued a 10-­year, 6% semiannual coupon bond for $864.

The bond has a maturity value of $1,000. If the marginal tax rate is 35%, the
after-­tax cost of debt (%) is closest to:
A 3.9%.
B 5.2%.
C 2.6%.

B is correct. The pre-­tax cost of debt is the yield to maturity (YTM) of the bond. The
bond’s YTM can be calculated by solving the following equation for i:
 20 30 
864      1000
t 1 1  it  1  i20
 
Using a financial calculator, enter N = 20 (semiannual periods), w = –864, PMT = 30,
and FV = 1,000. Compute I/YR. The six-­month yield (or calculated I/YR) is 4%. The YTM
is obtained by doubling the six-­month yield to get 8%. Multiplying the pre-­tax cost of
debt by (1 – Tax rate) gives the result of 8 × (1 – 0.35) = 5.2%.
2020 Level I Mock Exam (A) AM xxxvii

A is incorrect. If the after-­tax amount of the coupon rate is used, the result will be
0.06(1 – 0.35) = 3.9%.
C is incorrect. If the after-­tax cost for six-­month yield is used, the result will be 0.04(1
– 0.35) = 2.6%.

Cost of Capital

70 Based on good corporate governance practices, it is most appropriate for a com-

pany’s compensation committee to:
A develop director remuneration policies.
B recommend remuneration for the external auditors.
C include some external directors.

A is correct. Under good corporate governance practices the compensation committee

develops remuneration policies for directors as well as key executives. The audit com-
mittee, not the compensation committee, would be involved in the remuneration of
the external auditors.
C is incorrect. The committee should be composed of independent (non-­executive)
members only.
B is incorrect. The audit committee is responsible for proposing the external auditor’s
remuneration.

Corporate Governance and ESG: An Introduction

71 A project has the following annual cash flows:

Year 0 Year 1 Year 2 Year 3

–$606,061 $2,151,515 –$2,542,424 $1,000,000

Which discount rate most likely provides a positive net present value (NPV)?
A. 15%
B 21%
C 18%

B is correct.

Year Cash Flow K = 15% K = 18% K = 21% Calculation

0 –$606,061 –$606,061.00 –$606,061.00 –$606,061.00 –606,061

1 2,151,515 1,870,882.60 1,823,317.80 1,778,111.60 +2,151,515/
(1 + K)
2 –2,542,424 –1,922,437.80 –1,825,929.30 –1,736,509.80 –2,542,424/
(1 + K)2
3 1,000,000 657,516.20 608,630.90 564,473.90 +1,000,000/
(1 + K)3
(continued)
xxxviii 2020 Level I Mock Exam (A) AM

Year Cash Flow K = 15% K = 18% K = 21% Calculation

NPV –$100.00 –$41.60 +$14.70 K = Discount

rate

The NPV at 21% is $14.7, whereas the other two NPVs are negative.
A is incorrect because it has a negative NPV.
C is incorrect because it has a negative NPV.

Capital Budgeting

72 Which of the following is least likely to be of concern to values-­based ESG

investors?
A Avoidance of companies that conflict with moral values
B Reduction in risks associated with increased litigation costs
C Increase in risk-­adjusted returns through ESG factor ranking

A is correct. The objective of a values-­based ESG approach is to mitigate risks and iden-
tify opportunities by analyzing ESG considerations in addition to traditional finance
metrics. Avoidance of companies that conflict with moral or ethical values reflects a
values-­based approach.
B and C are incorrect. The objective of a values-­based ESG approach is to mitigate
risks and identify opportunities by analyzing ESG considerations in addition to traditional
finance metrics.

Corporate Governance and ESG: An Introduction

73 The behavioral bias in which investors tend to avoid realizing losses but rather
seek to realize gains is best described as:
A mental accounting.
B the gambler’s fallacy.
C the disposition effect.

C is correct. Behavioral biases in which investors tend to avoid realizing losses but rather
seek to realize gains is the disposition effect.
A is incorrect. The disposition effect is a behavioral bias in which investors tend to
avoid realizing losses but rather seek to realize gains.
B is incorrect. The gambler’s fallacy is a behavioral bias in which recent outcomes
affect investors’ estimates of future probabilities.

Market Efficiency

74 Returns from a depository receipt are least likely affected by which of the fol-
lowing factors?
A Exchange rate movements
2020 Level I Mock Exam (A) AM xxxix

B Number of depository receipts

C Analysts’ recommendations

B is correct. The price of each depository receipt (and, in turn, returns) will be affected by
factors that affect the price of the underlying shares—such as company fundamentals,
market conditions, analysts’ recommendations, and exchange rate movements. The
number of depository receipts issued affects their price but does not affect the returns.
A is incorrect. The price of each depository receipt (and, in turn, returns) will be affected
by such factors as company fundamentals, market conditions, analysts’ recommendations,
and exchange rate movements.
C is incorrect. The price of each depository receipt (and, in turn, returns) will be affected
by such factors as company fundamentals, market conditions, analysts’ recommendations,
and exchange rate movements.

Overview of Equity Securities

75 Which of the following statements is least accurate with respect to fixed-­

income indexes?
A Many of the underlying securities in the index tend to be illiquid.
B The indexes are susceptible to turnover of the underlying securities.
C Compared with equity indexes, it is easier and less expensive to replicate
fixed-­income indexes.

C is correct. Compared with equity indexes, the large number of fixed-­income securi-
ties—combined with the lack of liquidity of some securities—has made it more costly and
difficult for investors to replicate fixed-­income indexes and duplicate their performance.
A is incorrect. Many of the underlying securities in the index tend to be illiquid because
fixed-­income markets are predominantly dealer markets.
B is incorrect. The indexes are susceptible to turnover of the underlying securities
because over time, fixed-­income securities mature and issuers offer new securities to
meet their financial needs.

Security Market Indexes

76 Which of the following is most likely one of the main functions of the financial
system?
A Determining an equilibrium interest rate
B Ensuring that markets are informationally efficient
C Ensuring that all investment projects receive sufficient funding

A is correct. One of the main functions of the financial system is to determine the equi-
librium interest rate, which is the only interest rate that would exist if all securities were
equally risky, had equal terms, and were equally liquid.
B is incorrect. Informational market efficiency is not a key function of the financial
system, rather that of regulatory framework
xl 2020 Level I Mock Exam (A) AM

C is incorrect. The financial system provides sufficient funding only to the most pro-
ductive projects. An important function of the financial system is to direct resources
away from wealth-­diminishing projects.

Market Organization and Structure

77 An equity analyst follows two industries with the following characteristics:

Industry 1:
A few companies with proprietary technologies, products with unique fea-
tures, high switching costs, and minimal regulatory influences.
Industry 2:
A few companies producing relatively similar products, sales varying with
disposable income and employment levels, high capital costs and investment
in physical plants, rapid shifts in market shares of competing firms, and
minimal regulatory influences.
Based on the above information, the analyst will most appropriately conclude
that, compared with the firms in Industry 2, those in Industry 1 would poten-
tially have:
A over-­capacity problems.
B high bargaining power of customers.
C larger economic profits.

C is correct. The economic profit (the spread between the return on invested capital and
the cost of capital) tends to be larger in industries with differentiated products, greater
pricing power, and high switching costs to customers. Industry 1 has these features. In
contrast, firms in Industry 2 have little pricing power (undifferentiated products and
rapid shifts in market shares, indicating intense rivalry), which is indicative of potentially
smaller economic profits.
A is incorrect. The characteristics of Industry 1 do not indicate a potential for over-­
capacity problems. If anything, Industry 2 is prone to such a problem because of high
capital costs and investment in physical capital, cyclical demand for products, and rapid
shifts in market shares.
B is incorrect. Industry 1 is less prone to the bargaining power of customers because
of differentiated products and high switching costs for customers.

Introduction to Industry and Company Analysis

78 For a US investor, which of the following statements concerning investing in

depository receipts (DRs) is least accurate?
A Investing in DRs could provide arbitrage opportunities and entail currency
risk.
B Investors in unsponsored DRs would have the same voting rights as the
direct owners of common shares.
C Sponsored DRs are subject to greater reporting requirements than unspon-
sored DRs.
2020 Level I Mock Exam (A) AM xli

B is correct. Investors of unsponsored DRs would not have the same voting rights as the
direct owners of common shares because the depository bank retains the voting rights.
A is incorrect because it is an accurate statement. The DRs trading on multiple
exchanges could experience short-­term valuation discrepancies, potentially giving rise
to a quick arbitrage profit opportunity for astute traders to exploit. The price of each DR
will be affected by factors that affect the price of the underlying shares and exchange
rate movements.
C is incorrect because it is an accurate statement. Sponsored DRs are subject to
greater reporting requirements than unsponsored DRs. In the United States, sponsored
DRs must be registered with the SEC.

Overview of Equity Securities

79 An industry experiencing intense competitive rivalry among incumbent compa-

nies is best characterized by:
A differentiated products and low exit barriers.
B a small number of competitors and low fixed costs.
C customers basing purchase decisions largely on price.

C is correct. The factor that most influences customer purchase decisions is likely to
also be the focus of competitive rivalry in the industry. In general, industries in which
price is a large factor in customer purchase decisions tend to be more competitive than
industries in which customers value other attributes more highly.
A is incorrect. Industries experiencing more intense rivalry among incumbent com-
panies are characterized by undifferentiated products and high exit barriers.
B is incorrect. Industries experiencing more intense rivalry among incumbent com-
panies are fragmented among many small competitors and they tend to have high
fixed costs.

Introduction to Industry and Company Analysis

80 Which of the following is most likely associated with secondary capital markets?
A Continuous trading
B Lead underwriters
C Book building

A is correct. A secondary market is where investors continue to trade the securities among
themselves. Continuous trading is typically associated with secondary capital markets.
B is incorrect. Lead underwriter is associated with primary markets.
C is incorrect. Book building is associated with primary markets.

Market Organization and Structure

81 An investor gathers the following information about a company:

xlii 2020 Level I Mock Exam (A) AM

Current dividend per share $3

Historical annual dividend growth rate 4%
Expected annual dividend growth rate for the next three years 8%
Expected stock value per share at the end of Year 3 $33

If the investors’ required rate of return is 15%, the current estimate of the
intrinsic value per share is closest to:
A $28.36.
B $29.65.
C $29.08.

B is correct.

3  1.083   33
3  1.08 3  1.08
2
 
V 0 =  
1  0.15 1  0.15 2
1  0.153
= 2.82 + 2.65 + 2.48 + 21.70
= $29.65
A is incorrect. It uses the historical growth rate and the constant growth model for
estimating the intrinsic value.
3  1.04
V 0 =
0.15  0.04
= $28.36
B is incorrect. It uses the historical growth rate rather than an analyst’s growth forecast.

3  1.043   33
3  1.04 3  1.04
2
 
V 0 =  
1  0.15 1  0.15 2
1  0.153
= 2.71 + 2.45 + 2.22 + 21.70
= $29.08

Equity Valuation: Concepts and Basic Tools

82 An equity index consists of three securities with market information as follows:

Price at
Shares Beginning of Price at End of Dividend per
Security Outstanding Period Period Share

A 5,000,000 $10.00 $9.50 $1.00

B 2,000,000 $20.00 $21.50 $0.80
C 1,500,000 $30.00 $33.00 $0.60

The price-­weighted total return index is closest to:

A 10.7%.
B 6.7%.
C 9.5%.
2020 Level I Mock Exam (A) AM xliii

A is correct.

Calculation of Index and Return Based on Price-­Weighted Method

Shares Dividends per
Security Outstanding BOP Price EOP Price Share

A 5,000,000 $10.00 $9.50 $1.00

B 2,000,000 $20.00 $21.50 $0.80
C 1,500,000 $30.00 $33.00 $0.60
Total $60.00 $64.00 $2.40
Index value 20.00 21.33 0.80

Type of Index BOP Value EOP Value Return

Price return $20.00 $21.33 6.65%

Total return $20.00 $22.13 10.65%

BOP = Beginning of period; EOP = Ending of period

B is incorrect. It is the price-­weighted index based on price changes only; it ignores

dividends.
C is incorrect. It is the return based on equal-­weighted method.

Calculation of Index and Return Based on Equal-­Weighted Method

Weight Weight
(33.3%) (33.3%)
Price Total × Price × Total
BOP EOP Dividends Return Return Return Return
Security Price Price per share (%) (%) (%) (%)

A 10.00 9.50 1.00 –5.00% 5.00% –1.67% 1.67%

B 20.00 21.50 0.80 7.50% 11.50% 2.50% 3.83%
C 30.00 33.00 0.60 10.00% 12.00% 3.33% 4.00%
Total 4.17% 9.50%

BOP = Beginning of period; EOP = Ending of period

Security Market Indexes

83 A company has issued non-­callable, non-­convertible preferred stock with the

following features:
●● Par value per share: $10
●● Annual dividend per share: $2
●● Maturity: 15 years
xliv 2020 Level I Mock Exam (A) AM

An investor’s required rate of return is 8%, and the current market price per
share of the preferred stock is $25. By comparing the estimated intrinsic value
with the market price of the preferred stock, the most likely conclusion is that
the preferred stock is:
A fairly valued at $25.00.
B overvalued by $4.73.
C undervalued by $15.00.

B is correct. Using a financial calculator to find the present value (PV) of the future cash
flows, intrinsic value is thus: FV = $10; n = 15; PMT = $2; r = 8%. Compute PV = $20.27.
The preferred stock is overvalued by $4.73 (Market price of $25 – Estimated value
of $20.27).
A is incorrect. It ignores the maturity information and treats it as a perpetual pre-
ferred stock.
V0 = D0/r = $2/0.08 = $25
C is incorrect. It ignores the time value of money and simply sums up the total of
dividends and the par value.

V 0 = (Annual dividend per share × Maturity) + Par Value = (2 × 15) + 10

= 40
Thus, the preferred stock appears to be undervalued by $15.00 (Market price of $25
– Estimated value of $40).

Equity Valuation: Concepts and Basic Tools

84 An analyst collects the following data on a company:

Return on Equity (%) Payout Ratio (%) Justified Forward P/E

12.0 30 7.5

Using a required return of 12.4%, if the company increases its dividend payout
ratio to 40%, the justified forward P/E ratio will be closest to:
A 11.5.
B 7.7.
C 5.3.

B is correct.
Dividend growth rate = (1 – Payout ratio) × ROE
Justified forward P/E: P0/E1 = p/(r – g), where p = Payout ratio.
Using the new payout ratios, the justified forward P/E ratios, are calculated:
New dividend growth rate = (1 – 0.4) × 12% = 7.2%;
New justified forward P/E = 0.4/(0.124 – 0.072) = 7.7×.
2020 Level I Mock Exam (A) AM xlv

C is incorrect. It uses wrong dividend growth rate by taking a product of payout

ratio and ROE.
New dividend growth rate = (0.4) × 12% = 4.8%;
New Justified forward P/E = 0.4/(0.124 – 0.048) = 5.3×
A is incorrect. It uses payout ratio instead of retention rate to calculate new justified
P/E ratio.
New dividend growth rate = (1 – 0.4) × 12% = 7.2%;
New justified forward P/E = (1 – 0.4)/(0.124 – 0.072) = 11.5×

Equity Valuation: Concepts and Basic Tools

85 The value effect market-­pricing anomaly most likely occurs when stocks that
have below-­average price-­to-­earnings and market-­to-­book ratios, as well as
above-­average dividend yields, consistently outperform:
A large-­cap stocks.
B growth stocks.
C stocks that have had negative earnings surprises.

B is correct. The value effect occurs when value stocks, which are generally referred to
as stocks that have below-­average price-­to-­earnings and market-­to-­book ratios, as well
as above-­average dividend yields, outperform growth stocks consistently and for long
periods.
A is incorrect. It is the size effect, not the value effect, that compares returns with
respect to large-­cap stocks.
C is incorrect. Value effect does not compare stocks on the basis of earnings surprises.
It is the “earnings surprise” anomaly that compares companies on the basis of the unex-
pected part of the earnings announcement.

Market Efficiency

86 Ted Nguyen is an investor domiciled in a country with an original issue dis-

count tax provision. He purchases a zero-­coupon bond at a deep discount to
par value with the intention of holding the bond until maturity. At maturity, he
will most likely face:
A a capital gain.
B neither a capital loss nor gain.
C a capital loss.

B is correct. An original issue discount tax provision allows the investor to increase the cost
basis of the bond, so when the bond matures, the investor faces no capital gain or loss.
A is incorrect because the investor will face neither a capital gain nor a loss as the orig-
inal issue discount tax provision allows the investor to increase the cost basis of the bond.
xlvi 2020 Level I Mock Exam (A) AM

C is incorrect because the investor will face neither a capital gain nor a loss as the orig-
inal issue discount tax provision allows the investor to increase the cost basis of the bond.

Fixed-­Income Securities: Defining Elements

87 Which of the following is least likely a short-­term funding method available to

banks?
A Central bank funds
B Negotiable certificate of deposits
C Syndicated loans

C is correct. A syndicated loan is a loan from a group of lenders, called the “syndicate,”
to a single borrower. Syndicated loans are primarily originated by banks, and the loans
are extended to companies but also to governments and government-­related entities.
A is incorrect because central bank funds are one of the short-­term wholesale funds
available to banks for short-­term funding needs.
B is incorrect because a negotiable CD allows any depositor (initial or subsequent) to
sell the CD in the open market prior to the maturity date. CDs are an important source
of funds for financial institutions.

Fixed-­Income Markets: Issuance, Trading, and Funding

88 In a securitization structure, credit tranching allows investors to choose

between:
A subordinated bonds and senior bonds.
B extension risk and contraction risk.
C partially amortizing loans and fully amortizing loans.

A is correct. Credit tranching allows investors to choose between subordinate and

senior bond classes as a means of credit enhancement. The purpose of this structure is
to redistribute the credit risk associated with the collateral.
B is incorrect because extension and contraction risks refer to the types of prepayment
risks in a securitization structure.
C is incorrect because partially and fully amortizing loans refer to two ways in which
the loan principal can be repaid.

Introduction to Asset-­Backed Securities

89 DMT Corp. issued a five-­year floating-­rate note (FRN) that pays a quarterly
coupon of three-­month Libor plus 125 bps. The FRN is priced at 96 per 100 of
par value. Assuming a 30/360-­day count convention, evenly spaced periods, and
constant three-­month Libor of 5%, the discount margin for the FRN is closest
to:
A 180 bps.
B 400 bps.
C 221 bps.
2020 Level I Mock Exam (A) AM xlvii

C is correct. The interest payment each period per 100 of par value is
Index  QM   FV 0.05  0.0125  100
  1.5625
m 4
The discount margin can be estimated by solving for DM in the equation
1.5625 1.5625 1.5625
96   
1 2 20
 0.05  DM   0.05  DM   0.05  DM 
1   1   1  
 4   4   4 
The solution for the discount rate, r = (0.05  + DM)/4 is 1.8025%. Therefore, DM =
2.21% or 221 bps.
A is incorrect because it uses the quarterly discount rate 1.8025% as the solution,
i.e., 180 bps.
B is incorrect because it uses the price discount of 100% – 96% = 4%, i.e., 400 bps.

Introduction to Fixed-­Income Valuation

90 The bonds of Apex Corporations have a par value of $10,000 each and an
annual required rate of return of 10%. The bonds make quarterly coupon pay-
ments at an annual rate of 6% and have two years remaining until maturity. The
current market price of each bond is closest to:
A $10,749.
B $9,283.
C $9,306.

B is correct. Using the quarterly coupon payment of $150 [= (0.06 × 10000)/4] over eight
quarters and a quarterly required rate of return of 2.5%, we calculate the bond’s price as:

P 0 = 150/(1.025)1 + 150/(1.025)2 + ... + 150/(1.025)8 + 10,000/(1.025)8

  = $9,282.99
A is incorrect because the bond’s price is computed using a quarterly coupon payment
of $250 [= (0.10 × 10000)/4] and a quarterly required rate of return of 1.5%:

P 0 = 250/(1.015)1 + 250/(1.015)2 + ... + 250/(1.015)8 + 10000/(1.015)8

  = $10,748.59
C is incorrect because the bond’s price is computed using the annual coupon payment
of $600 [= (0.06 × 10,000)] over 2 years and the annual required rate of return of 10%:

P 0 = 600/(1.10)1 + (600 + 10,000)/(1.10)2

  = $9,305.79

Introduction to Fixed-­Income Valuation

91 A bond’s duration is 7.31, and its convexity is –24.85. Using the duration model
with convexity adjustment, the bond’s percentage change in price if interest
rates decrease 2% is closest to:
A 15.12%.
xlviii 2020 Level I Mock Exam (A) AM

B 15.60%.
C 14.12%.

C is correct. The duration model estimates the percentage change in price as –AnnModDur
× ΔYield, or –7.31 × (–0.02)= +14.62%, and the convexity adjustment is ½ × AnnConvexity
× (∆Yield)2, or ½ × (–24.85) × (0.02)2 = –0.50%, and 14.62% – 0.50% = 14.12%.
A is incorrect because it uses –C × ∆i as the convexity adjustment or –24.85 × –0.02 =
0.50% and 14.62% + 0.50% = 15.12%.
B is incorrect because it uses –C × (∆i)2 × 100 or –24.85 × (0.02)2 × 100 = +0.98% as
the convexity adjustment and 14.62% + 0.98% = 15.60%.

Understanding Fixed-­Income Risk and Return

92 Consider the following information on three bonds: Bond A, Bond B, and Bond
C.
Bond A Bond B Bond C

Time to maturity (years) 10 6 4

Par value $10,000,000 $10,000,000 $10,000,000
Market value $9,323,381 $11,189,092 $10,000,000
Annualized modified 7.3105 4.6880 3.4370
duration

A fixed-­income portfolio contains Bond A and Bond B. If another $10 million

is added to the portfolio and is used to purchase Bond C, then the annualized
modified duration of the portfolio will be closest to:
A 5.0793.
B 5.1452.
C 6.5668.

A is correct. The new modified duration of the portfolio is calculated as follows:

The initial market value of the portfolio = $9,323,381 + $11,189,092 = $20,512,473.
The portfolio market value with the purchase of Bond C is:
New portfolio market value = $20,512,473 + $10,000,000 = $30,512,473.
 9, 323, 381   11,189, 092   10, 000, 000 
ModDur  7.3105   4.6880   3.4370  30,512, 473
 30,512, 473  30, 512, 473
 5.0793
where the first term in each set of brackets is the annualized modified duration and
the second term is the weighting factor based on market value.
B is incorrect because the calculation of 5.1452 uses par value rather than market value
in determining the portfolio value of $30,000,000 and in setting the weighting factors:

 10, 000, 000   10, 000, 000   10, 000, 000 

ModDur  7.3105    4.6880    3.4370 
 30, 000, 000  30, 000, 000  30, 000, 000
 5.1452
2020 Level I Mock Exam (A) AM xlix

C is incorrect because the calculation of 6.5668 uses the time to maturity rather than
the annualized modified duration for each bond:

 9, 323, 381   11,189, 092   10, 000, 000 

ModDur  10    6    4 
 30, 512, 473  30, 512, 473  30, 512, 473
 6.5668

Understanding Fixed-­Income Risk and Return

93 The estimated percentage change in bond price for a given change in the term
structure of yield volatility depends on modified duration and:
A convexity only.
B the change in yield to maturity only.
C both convexity and the change in yield to maturity.

C is correct. The estimated percentage change in the bond price depends on modified
duration and convexity as well as on the yield-­to-­maturity change.
A is incorrect because the estimated percentage change in the bond price depends
on the change in yield to maturity as well as modified duration and convexity.
B is incorrect because the estimated percentage change in the bond price depends
on convexity as well as modified duration and the change in yield to maturity.

Understanding Fixed-Income Risk and Return

94 The yield spread on a corporate bond would most likely narrow as:
A issuer size increases.
B downgrade risk increases.
C trading frequency decreases.

A is correct. Market liquidity risk is affected by the size of the issuer and the credit qual-
ity of the issuer. In general, the less debt an issuer has outstanding, the less frequently
it trades, the higher the market liquidity risk. Thus, an increase in issue size (publicly
traded debt the issuer has outstanding) is consistent with less market liquidity risk and
narrower spreads.
B is incorrect. Downgrade risk refers to the risk that a bond issuer’s creditworthiness
deteriorates, leading investors to believe the risk of default is higher and thus causing
the yield spreads on the issuer’s bonds to widen.
C is incorrect. As trading frequency decreases, market liquidity risk increases. An
increase in market liquidity is consistent with yield spreads widening.

Fundamentals of Credit Analysis

95 Below are several key statistics for three countries:

l 2020 Level I Mock Exam (A) AM

(In billions except where noted) Country A Country B Country C

Nominal GDP $1,796.19 $1,511.25 $53.24

Population (millions) 206.10 50.80 7.13
Government expenditures $749.00 $338.00 $20.31
Government revenues $726.60 $351.60 $19.53
Current account balance –$23.53 $98.68 $2.20
Imports $139.40 $371.10 $27.00
Exports $184.50 $511.80 $24.96
Government debt $1,329.90 $544.74 $15.44

Based on the statistics provided, which country is most likely to be the highest-­
rated credit?
A Country A
B Country B
C Country C

B is correct. Overall, Country B will most likely have the highest credit rating. Country
B has the highest GDP per capita, the highest current account as a share of GDP, the
highest budget and trade surpluses, and a relatively low government debt-­to-­GDP ratio
(second only to Country C).

Country A Country B Country C

Government debt/GDP 74.04% 36.05% 29.00%

GDP per capita $8,715.14 $29,749.02 $7,467.04
Current account as share of GDP –1.31% 6.53% 4.13%
(%)
Budget balance (surplus/deficit) –$22.40 $13.60 –$0.78
Balance of trade (surplus/deficit) $45.10 $140.70 –$2.04

A is incorrect. Country A has the highest government debt/GDP of the three countries
and a relatively low GDP per capita. Additionally, its current account as a share of GDP is
negative, which means it must attract funding from outside the country. On the bright
side, the country has a trade surplus, but that is offset by the budget deficit and other
factors already mentioned.
C is incorrect. Country C does have the lowest government debt/GDP, but only by
a small margin. In every other category, Country B appears stronger than Country C.

Fundamentals of Credit Analysis

96 A key distinction between commercial mortgage-­backed securities (CMBSs)

and residential mortgage-­backed securities (RMBSs) is that CMBSs most likely:
A have balloon maturities.
B have amortizing principal.
C do not have call protection.
2020 Level I Mock Exam (A) AM li

A is correct. Many commercial loans backing CMBSs are balloon loans that require a
substantial principal repayment at maturity of the loan. If the borrower fails to make the
balloon payment, the borrower is in default. CMBSs generally do not have amortizing
principal as RMBSs do, and they do offer call protection.
B is incorrect. CMBSs generally do not have amortizing principal as RMBSs do.
C is incorrect. CMBSs generally do offer call protection.

Introduction to Asset-­Backed Securities

97 An inverse floater will most likely have:

A a maximum coupon rate.
B a face value that changes as the reference rate changes.
C a coupon rate that changes by more than the change in the reference rate.

A is correct. The general formula for the coupon rate of an inverse floater is C – (L × R),
where C is the maximum coupon rate if the reference rate (R) is equal to zero and L is
the coupon leverage, which is greater than zero.
B is incorrect. The face value of an inverse floater does not change as the reference
rate changes; rather, the coupon rate changes.
C is incorrect. Inverse floaters can have leverage less than 1 (deleveraged inverse float-
ers), so the coupon rate changes by less than the change in the reference rate; leverage
greater than 1 (leveraged inverse floaters), so the coupon rate changes by more than
the change in the reference rate; or leverage equal to 1, so the coupon rate changes by
the same amount as the change in the reference rate.

Fixed-­Income Markets: Issuance, Trading, and Funding

98 An analyst gathers the following information on a bond:

Approximate modified duration 10.3829
Approximate modified convexity 141.217

What is the estimated percentage price change for the bond if yield to maturity
decreases by 50 bps?
A –5.01%
B 5.37%
C 5.54%
lii 2020 Level I Mock Exam (A) AM

B is correct. The convexity-­adjusted estimate of the percentage change in bond price

is calculated as follows:
1 2
%PV Full  AnnModDur  Yield    AnnConvexity  Yield 
2 
1 2
 10.3829  0.005    141.217  0.005 
 2 
 0.051915  0.001765
 0.05368
C is incorrect. It is the result of neglecting to multiply the convexity adjustment by ½.

 10.3829  0.005  141.217  0.005 

2
 
 0.051915  0.00353
 0.0554
A is incorrect. It is the result of omitting the negative sign for the change in yield.

1 2
 10.3829  0.005    141.217  0.005 
2 
 0.051915  0.001765
 0.0501

Understanding Fixed-­Income Risk and Return

99 A swap in which the investor receives a variable payment in line with market
conditions and makes a fixed payment can best be replicated by purchasing a:
A set of long futures contracts which are matched with short forward
contracts.
B series of forward contracts, each with an initial value of zero.
C floating rate bond financed using a fixed-­rate bond.

C is correct. The payment structure is replicated by being long the floating rate bond
and being short the fixed-­rate bond.
A is incorrect. This strategy does not replicate a swap in which the investor receives
a variable payment in line with market conditions and makes a fixed payment.
B is incorrect. Due to differences in timing, the forward contracts need to be off-­
market contracts.

Basics of Derivative Pricing and Valuation

100 Which of the following is least likely to be an example of a derivative?

A An exchange-­traded fund
B A contract to sell Alphabet Inc.’s shares at a fixed price
C A contract to buy Australian dollars at a predetermined exchange rate
2020 Level I Mock Exam (A) AM liii

A is correct. Although an exchange-­traded fund derives its value from the underlying
assets it holds, it does not transform the performance of those assets and so is not a
derivative.
B is incorrect. A contract to sell Alphabet Inc.’s shares transforms the performance of
the underlying shares of Alphabet Inc and is an example of an option derivative.
C is incorrect. A contract to buy Australian dollars transforms the performance of the
underlying currency and is an example of a currency derivative.

Derivative Markets and Instruments

101 Which of the following derivatives is least likely to be classified as a contingent

claim?
A A futures contract
B A call option contract
C A credit default swap

A is correct. A futures contract is classified as a forward commitment in which the buyer

undertakes to purchase the underlying asset from the seller at a later date and at a price
agreed on by the two parties when the contract is initiated.
B is incorrect. A call option contract is a contingent claim in which the buyer of the
option has a right to purchase the underlying asset at a fixed price on or before a pre-­
specified expiration date.
C is incorrect. A credit default swap is a contingent claim in which the credit protec-
tion seller provides protection to the credit protection buyer against the credit risk of
a third party.

Derivative Markets and Instruments

102 In a credit default swap, the party that receives a series of cash payments in
return for promising to pay compensation for credit losses resulting from a
third party’s default is most likely the:
A clearinghouse.
B seller of the swap.
C buyer of the swap.

B is correct. A credit default swap is a derivatives contract between a credit protection

buyer and a credit protection seller in which the seller receives a series of cash payments
from the buyer in return for a promise of compensation for credit losses resulting from
a third party’s default.
A is incorrect. A credit default swap is a derivatives contract between a credit protection
buyer and a credit protection seller in which the seller (not the clearinghouse) receives
a series of cash payments from the buyer in return for a promise of compensation for
credit losses resulting from a third party’s default.
liv 2020 Level I Mock Exam (A) AM

C is incorrect. A credit default swap is a derivatives contract between a credit pro-

tection buyer and a credit protection seller in which the seller (not the buyer) receives
a series of cash payments from the buyer in return for a promise of compensation for
credit losses resulting from a third party’s default.

Derivative Markets and Instruments

103 All, else held equal, the value of a European call option is best characterized as
having a:
A negative relationship with the price of the underlying.
B negative relationship with the volatility of the underlying.
C positive relationship with the time to expiration.

C is correct. The value of a European call option is directly related to the time to expira-
tion. That is, all else held equal, the value of a European call option is higher the longer
the time to expiration.
A is incorrect. The value of a European call option is directly related to the price of
the underlying.
B is incorrect. The value of a European call option is directly related to the volatility
of the underlying.

Basics of Derivative Pricing and Valuation

104 If dividends paid by the underlying increase, the value of a European call option
will most likely:
A not change.
B increase.
C decrease.

C is correct. A European call option is worth less the more dividends are paid by the
underlying.
A is incorrect. A European call option is worth less the more dividends are paid by
the underlying.
B is incorrect. A European call option is worth less the more dividends are paid by
the underlying.

Basics of Derivative Pricing and Valuation

105 For an investor with a long position, the price of a futures contract will most
likely be higher than the price on a forward contract on the same asset with the
same expiration date if there is a:
A zero correlation between the futures price and interest rates.
B positive correlation between the futures price and interest rates.
C negative correlation between the futures price and interest rates.
2020 Level I Mock Exam (A) AM lv

B is correct. If there is a positive correlation between futures prices and interest rates, an
investor with a long position will favor futures over forwards because rising prices lead
to futures profits that are reinvested at higher interest rates. With forwards, all the gains
are received at expiration and thus there is no gain from reinvestment.
A is incorrect. In this case, futures and forward prices will be the same.
C is incorrect. With negative correlation between futures prices and interest rates,
falling prices lead to losses during periods of rising interest rates. Forward prices will be
higher than futures prices.

Basics of Derivative Pricing and Valuation

106 The real estate index most likely to suffer from sample selection bias is a(n):
A repeat sales index.
B REIT index.
C appraisal index.

A is correct. Only properties that sell in each period and are included in the index and
vary over time which may not be representative of the whole market.
B is incorrect. The REIT index is based on a set of publicly traded REITs and thus does
not suffer from sample selection bias.
C is incorrect. The appraisal index is based on a set of properties that is appraised
regularly. Thus it does not suffer from sample selection bias.

Introduction to Alternative Investments

107 In the context of venture capital financing, seed-­stage financing most likely
supports:
A initial commercial production and sales.
B product development and/or marketing efforts.
C transformation of an idea into a business plan.

B is correct. Support of product development and/or marketing efforts takes place during
seed-­stage financing.
A is incorrect. Support of initial commercial production and sales takes place during
early stage financing.
C is incorrect. Support in the transformation of an idea into a business plan takes
place during angel investing.

Introduction to Alternative Investments

108 Relative to traditional investments, alternative investments are best character-

ized as having:
A higher correlations with other asset classes.
B unique legal and tax considerations.
lvi 2020 Level I Mock Exam (A) AM

C greater liquidity.

B is correct. Alternative investments are more likely characterized as having unique legal
and tax considerations because of the broad range and complexity of the investments.
A is incorrect because alternative investments typically have lower correlations with
traditional investments, such as stocks, bonds, and cash.
C is incorrect because alternative investments typically have underlying investments
that are illiquid.

Introduction to Alternative Investments

109 For a hedge fund investor, a benefit of investing in a fund of funds is least likely
the:
A higher level of due diligence expertise.
B multilayered fee structure.
C ability to negotiate better redemption terms.

B is correct. Funds of funds have a multilayered fee structure that will reduce the returns
to the investor.
A is incorrect because one advantage of fund of funds is that they usually have a high
level of due diligence expertise.
C is incorrect because another advantage of fund of funds is their ability to negotiate
better redemption terms such as shorter lockup and notice periods.

Introduction to Alternative Investments

110 If the level of broad inflation indexes is largely determined by commodity

prices, the average real yield on direct commodity investments is most likely:
A less than zero.
B equal to zero.
C greater than zero.

B is correct. As the price increases of commodities are mirrored in higher price indexes,
the nominal return is equal to inflation and thus the real return is zero.
A is incorrect. A negative real return implies inflation greater than nominal return.
This is not the case if commodity price increases determine inflation.
C is incorrect. A positive real return implies inflation less than nominal return. This is
not the case if commodity price increases determine inflation.

Introduction to Alternative Investments

111 An investor seeking an indirect debt investment in real estate will:

A purchase a mortgage-­backed security.
2020 Level I Mock Exam (A) AM lvii

B purchase a commercial property.

C originate a residential mortgage.

A is correct. Mortgage-­backed securities are pools of loans that are securitized and
offered to the financial markets providing indirect debt investment opportunities in
residential property.
C is incorrect because originators (generally financial institutions) of residential mort-
gages are making a direct debt investment in the home.
B is incorrect because commercial property is considered an appropriate direct invest-
ment—equity (i.e., ownership) and debt (i.e. lender)—for institutional or high-­net-­worth
investors with long time horizons and limited liquidity needs.

Introduction to Alternative Investments

112 A hedge fund with $98 million of initial capital charges a management fee of
2% and an incentive fee of 20%. The management fee is based on assets under
management at year end and the incentive fee is calculated independently from
the management fee. The fee structure has a high-­water mark provision. The
fund value is $112 million at the end of Year 1, $100 million at the end of Year,
and $116 million at the end of Year 3. The net-­of-­fees return earned by the fund
in Year 3 is closest to:
A 14.15%.
B 12.33%.
C 11.87%.

A is correct. The net-­of-­fees return to the fund in Year 3 is closest to 14.15%, calculated
as follows:
Year 1:

Portfolio gain = Year-­end value – Beginning value = $112 mil-

lion − $98 million = $14 million
Management fee = Year-­end value × Management fee % =
$112 million × 2% = $2.24 million
Incentive fee = Portfolio gain × Incentive fee % = $14 million ×
20% = $2.8 million
Total fees = Management fee + Incentive fee = $2.24 mil-
lion + $2.8 million = $5.04 million
Ending Capital Position = Year-­end value – Total fees
  = $112 million − $5.04 million = $106.96 million
High water mark = Ending capital position = $106.96 million
Year 2:
lviii 2020 Level I Mock Exam (A) AM

No incentive fee is earned as the fund declines in value; the high water mark estab-
lished in Year 1 is not exceeded.

Management fee = Year-­end value × Management fee % =

$100 million × 2% = $2 million
Ending Capital Position = Year-­end value – Management fee
  = $100 million − $2 million = $98 million
High water mark = Highest ending capital position =
$106.96 million
Year 3:
Net-­of-­fee returns are affected by the Year 1 high water mark and the Year 2 net capital
position (i.e. Year 3 beginning capital position).

Management fee = Year-­end value × Management fee % = $116 million

× 2% = $2.32 million
Incentive fee = (Year-­end value – High water mark) × Incentive fee
%
  = ($116 million – $106.96 million) × 20% =
$1.81 million.
Total fees = Management fee + Incentive fee = $2.32 million +
$1.81 million = $4.13 million
Net-­of-­fees return = (Year-­end value – Total fees – Beginning capital
position)/Beginning capital position
  = ($116 million – $4.13 million – $98 mil-
lion)/$98 million = 14.15%.
C is incorrect because 11.87% results from calculating the return based on a Year 2
ending capital position (i.e., Year 3 beginning capital position) of $100 million. Instead, the
return should be calculated based on the Year 2 ending capital position of $98 million,
which is net of fees ($100 million – $2 million).

Management fee = Year-­end value × Management fee % = $116 million

× 2% = $2.32 million
Incentive fee = (Year-­end value – High water mark) × Incentive fee
%
= ($116 million – $106.96 million) × 20% =
$1.81 million.
Total fees = Management fee + Incentive fee = $2.32 million +
$1.81 million = $4.13 million
Net-­of-­fees return = (Year-­end value – Total fees – Beginning capital
position)/Beginning capital position
= ($116 million – $4.13 million – $100 mil-
lion)/$100 million = 11.87%.
2020 Level I Mock Exam (A) AM lix

B is incorrect because 12.33% results from calculating the incentive fee using the net
capital position at the end of Year 2 instead of the high-­water mark value established
at the end of Year 1.

Management fee = Year-­end value × Management fee % = $116 million

× 2% = $2.32 million
Incentive fee = (Year-­end value – Year 2 Ending capital position) ×
Incentive fee %
= ($116 million – $98 million) × 20% = $3.60 million.
Total fees = Management fee + Incentive fee = $2.32 million +
$3.60 million = $5.92 million
Net-­of-­fees return = (Year-­end value – Total fees – Beginning capital
position)/Beginning capital position
= ($116 million – $5.92 million – $98 million)/$98 mil-
lion = 12.33%.

Introduction to Alternative Investments

113 When a security that was in an upward trend falls 1% below its trendline, a
technical analyst will most likely determine that:
A a downward trend is beginning.
B the upward trend is ending.
C the trendline needs an adjustment.

C is correct. When a security’s price drops through the trendline by a significant amount
(at least 5% to 10%), this decline signals that the uptrend has ended and further decline
may follow. Minor breakthroughs simply call for the trendline to be moderately adjusted
over time. A security falling 1% below its trendline is considered a minor breakthrough.
A is incorrect. The amount the price falls below the trendline would need to be at
least 5% before it would be considered a signal that the uptrend is ending and may
signal a further decline in price.
B is incorrect. The amount the price falls below the trendline would need to be at
least 5% before it would be considered a signal that the uptrend is ending.

Technical Analysis

114 Following its decision to divest its non-­core assets, analysts expect HCL Corp’s
standard deviation of returns to rise to 30% and its correlation with the market
portfolio to remain unchanged at 0.8. The risk-­free rate and the market risk pre-
mium are expected to remain unchanged at 6% and 8%, respectively. The mar-
ket portfolio’s standard deviation of returns, however, is expected to decrease to
15%. The firm’s expected return after the restructure is closest to:
A 9.2%.
B 17.6%.
C 18.8%.
lx 2020 Level I Mock Exam (A) AM

C is correct. We first compute the firm’s beta using

i ,m i
i 
m
The beta is
0.80.30
i   1.6
0.15
The expected return is computed using
E(Ri ) = Rf + [E(Rm ) – Rf ]β i
So, E(Ri ) = 0.06 + (0.08)1.6 = 18.8%.
A is incorrect because the beta is incorrectly calculated as [(0.8 × 0.15)/0.30] = 0.4,
resulting in an expected return of 0.06 + (0.08)0.4 = 9.2%.
B is incorrect because the expected return is incorrectly calculated as 0.08 + (0.06)1.6 =
17.6%.

Portfolio Risk and Return: Part II

115 Security analysis is most likely a part of which step in the portfolio management
process?
A The feedback step
B The execution step
C The planning step

B is correct. The execution step of the portfolio management process has three parts:
asset allocation, security analysis, and portfolio construction.
A is incorrect because under the planning step, there are two parts: understating the
client’s needs and preparation of an investment policy statement.
C is incorrect because under the feedback step, there are two parts: portfolio moni-
toring and rebalancing and performance measurement and reporting.

Portfolio Management, An Overview

116 Which of the following is most likely associated with an investor’s ability to take
risk rather than the investor’s willingness to take risk?
A The investor has a long investment time horizon.
B The investor believes earning excess returns on stocks is a matter of luck.
C Safety of principal is very important to the investor.

A is correct. Investment time horizon is an objective factor that measures the investor’s
ability to take risk.
B is incorrect because luck is a subjective factor that measures willingness to take risk.
2020 Level I Mock Exam (A) AM lxi

C is incorrect because safety of principal is a subjective factor that measures willing-

ness to take risk.

Basics of Portfolio Planning and Construction

117 An investment has a 50% probability of returning 12% and a 50% probability of
returning 6%. An investor prefers this uncertain investment over a guaranteed
return of 10%. This preference most likely indicates that the investor is risk:
A seeking.
B averse.
C neutral.

A is correct. The expected value of the uncertain investment is 9%, which is less than
the guaranteed return of 10%. Only a risk-­seeking person would be willing to accept
this investment.
B is incorrect. A risk-­averse person would prefer the guaranteed outcome of 10%.
C is incorrect. A risk-­neutral person would prefer the guaranteed outcome of 10%.

Portfolio Risk and Return: Part I

118 John Smith is given two investment options. Option A is a payment with a 50%
chance of getting $100 and a 50% chance of getting $0. Option B is a guaranteed
payment of $50. If Smith chooses Option A over Option B, his risk preference is
best described as risk:
A seeking.
B averse.
C neutral.

A is correct. Both options have the same expected return of $50. Option A, however, has
a higher risk (standard deviation) than Option B. Therefore, John Smith’s risk preference
is that of risk seeking.
B is incorrect because a risk-­averse person would prefer a lower risk profile given the
same expected return.
C is incorrect because a risk-­neutral person would be indifferent about the risk profile
of the outcome.

Portfolio Risk and Return: Part I

119 Risk management is a process that can most likely be best described as:
A minimizing risks while attempting to maximize returns.
B forecasting the level of risk that can meet a defined required return.
C defining a level of risk to be taken with the goal of maximizing the portfo-
lio’s value.
lxii 2020 Level I Mock Exam (A) AM

C is correct. Risk management is the process by which an organization or individual

defines the level of risk to be taken, measures the level of risk being taken, and adjusts
the latter toward the former, with the goal of maximizing the company’s or portfolio’s
value or the individual’s overall satisfaction or utility.
A is incorrect. Risk management is actively understanding how to best balance the
achievement of goals with an acceptable chance of failure.
B is incorrect. Risk management is not about predicting risks.

Risk Management: An Introduction

120 “Fintech” is best described as:

A technology-­driven innovation in the financial service industry.
B the collection of large quantities of financial data from a variety of sources
in multiple formats.
C the use of technical models to describe patterns in financial markets and
make trading decisions.

A is correct. In its broadest sense, the term “fintech” generally refers to technology-­driven
innovation occurring in the financial service industry.
B is incorrect. The collection of large quantities of data from a variety of sources in
multiple formats is the description of big data.
C is incorrect. The use of technical models to describe patterns in financial markets
and make trading decisions is the description of technical analysis.

Fintech in Investment Management