1

2020 Level I Mock Exam (C) 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 Which of the following is not included in the nine major provisions of the
Global Investment Performance Standards (GIPS)?
A Input Data, Calculation Methodology, and Real Estate
B Fundamentals of Compliance, Composite Construction, and Disclosure
C Calculation Methodology, Composite Construction, and Alternative Assets

C is correct because Alternative Assets is not among the nine major provisions or sec-
tions of the Global Investment Performance Standards, which include: Fundamentals of
Compliance, Input Data, Calculation Methodology, Composite Construction, Disclosure,
Presentation and Reporting, Real Estate, Private Equity, and Wrap Fee/Separately Managed
Account (SMA) Portfolios.
A is incorrect because these are included in the nine major provisions of the GIPS.
B is incorrect because these are included in the nine major provisions of the GIPS.

Global Investment Performance Standards (GIPS)

2 Ron Dunder, CFA, is the CIO for Bling Trust (BT), an investment advisor.
Dunder recently assigned one of his portfolio managers, Doug Chetch, to
manage several accounts that primarily invest in thinly traded micro-­cap stocks.
Dunder soon notices that Chetch places many stock trades for these accounts
on the last day of the month, toward the market’s close. Dunder finds this trad-
ing activity unusual and speaks to Chetch who explains that the trading activity
was completed at the client’s request. Dunder does not investigate further. Six
months later, regulatory authorities sanction BT for manipulating micro-­cap
stock prices at month end in order to boost account values. Did Dunder violate
any CFA Institute Standards of Professional Conduct?
A No.
B Yes, because he failed to reasonably supervise Chetch.
C Yes, because he did not report his findings to regulatory authorities.

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2 2020 Level I Mock Exam (C) AM

B is correct because the CFA Institute Standard on Responsibilities of Supervisors,

Standard IV(C), requires members/candidates to take steps to detect and prevent vio-
lations of laws, rules, and regulations. Dunder failed in his supervisory role when he
accepted Chetch’s explanation of the unusual trading activity. Dunder should have
reviewed the client’s goals and objectives and records to see if they in fact requested
month-­end trading. Regardless of the explanation provided by Chetch, Dunder should
have investigated further.
A is incorrect because there was a violation of the Standards.
C is incorrect because the Standards do not require that the findings be reported to
regulatory authorities.

Guidance for Standards I–VII

3 Vishal Chandarana, an unemployed research analyst, recently registered for

the CFA Level I exam. After two months of intense interviewing, he accepts
a job with a stock brokerage company in a different region of the country.
Chandarana posts on a social media blog how being a CFA candidate really
helped him get a job. He also notes how relieved he was when his new employer
didn’t ask him about being fired from his former employer. Which CFA
Institute Code of Ethics or Standards of Professional Conduct did Chandarana
least likely violate?
A Misconduct
B Loyalty to Employers
C Reference to the CFA Program

C is correct because there is no evidence Chandarana violated Standard VII(B) with regard

to his being a CFA candidate. Specifically, Chandarana does not overstate his competency
or imply he will achieve superior performance as a result of his CFA designation. It does
appear, however, Chandarana did not act with integrity when he hid information that
could potentially harm his new employer’s reputation, thus violating Standard  I(D)–
Professionalism (Misconduct) and Standard IV(A)–Duty to Employers (Loyalty).
A is incorrect because it appears Chandarana did not act with integrity when he
hid information that could potentially harm his new employer’s reputation violating
Standard I(D)–Professionalism (Misconduct).
B is incorrect because it appears Chandarana did not act for the benefit of his employer
when he hid information that could potentially harm his new employer’s reputation
violating Standard IV(A)–Duty to Employers (Loyalty).

Guidance for Standards I–VII

4 Amanda Covington, CFA, works for McJan Investment Management. McJan

employees must receive prior clearance of their personal investments in accor-
dance with McJan’s compliance procedures. To obtain prior clearance, McJan
employees must provide a written request identifying the security, the quantity
of the security to be purchased, and the name of the broker through which the
transaction will be made. Pre-­cleared transactions are approved only for that
trading day. As indicated below, Covington received prior clearance.
2020 Level I Mock Exam (C) AM 3

Security Quantity Broker Prior Clearance

A 100 Easy Trade Yes

B 150 Easy Trade Yes

Two days after she received prior clearance, the price of Stock B had decreased,
so Covington decided to purchase 250 shares of Stock B only. In her decision
to purchase 250 shares of Stock B only, did Covington violate any CFA Institute
Standards of Professional Conduct?
A No.
B Yes, relating to diligence and reasonable basis.
C Yes, relating to her employer’s compliance procedures.

C is correct because prior-­clearance processes guard against potential and actual conflicts
of interest; members are required to abide by their employer’s compliance procedures
[Standard VI(B)].
A is incorrect because Covington did violate the Standards in that she did not follow
her employer’s compliance procedures [Standard VI(B)].
B is incorrect as there is nothing to indicate she violated Standard  V(A)–Diligence
and Reasonable Basis.

Guidance for Standards I–VII

5 Jiro Sato, CFA, deputy treasurer for May College, manages the Student
Scholarship Trust. Sato issued a Request for Proposal (RFP) for domestic equity
managers. Pamela Peters, CFA, a good friend of Sato, introduces him to repre-
sentatives from Capital Investments, who submitted a proposal. Sato selected
Capital as a manager based on the firm’s excellent performance record. Shortly
after the selection, Peters, who had outstanding performance as an equity man-
ager with another firm, accepted a lucrative job with Capital. Which of the CFA
charterholders violated the CFA Institute Standards of Professional Conduct?
A Both violated Standards.
B Peters violated Standards.
C Neither violated Standards.

C is correct because members should use reasonable care and judgment to maintain
independence and objectivity [Standard  I(B)]. There is no indication of inappropriate
behavior in selection of the equity manager or in the acceptance of employment with
that manager; both decisions were based on the excellent performance records of the
manager and the member, respectively.
A is incorrect because there is no indication of inappropriate behavior in selection
of the equity manager or in the acceptance of employment with that manager; both
decisions were based on the excellent performance records of the manager and the
member, respectively.
4 2020 Level I Mock Exam (C) AM

B is incorrect because there is no indication that Peters or Sato violated Standard I(B)

by Peters joining Capital.

Guidance for Standards I–VII

6 Which of the following distinct entities can least likely claim compliance with
the Global Investment Performance Standards (GIPS)?
A A multi-­national financial services holding company
B An investment management division of a regional commercial bank
C A locally incorporated subsidiary undertaking investment management
services

A is correct because the Global Investment Performance Standards require that firms be
defined as an investment firm, subsidiary, or division held out to clients or prospective
clients as a distinct business entity (0.A.12). A multi-­national financial services holding
company is unlikely to be solely operating as an investment firm, and the scope of the
business could also make it more difficult to claim compliance on a firm-­wide basis.
B is incorrect because an investment management division or a regional commercial
bank could fit the definition of a firm as defined in 0.A.12.
C is incorrect because an investment management division of a regional commercial
bank could fit the definition of a firm as defined in 0.A.12.

Global Investment Performance Standards (GIPS)

7 Zhao Xuan, CFA, is a sell side investment analyst. While at a software industry
conference, Zhao hears rumors that Green Run Software may have falsified
its financial results. When she returns to her office, Zhao conducts a thor-
ough analysis of Green Run. Based on her research, including discussions with
some of Green Run’s customers, Zhao is convinced that Green Run’s reported
50% increase in net income during recent quarters is completely fictitious. So
far, however, Zhao is the only analyst suspicious about Green Run’s reported
earnings. According to the CFA Institute Code of Ethics and Standards of
Professional Conduct, the least appropriate action for Zhao is to:
A report her suspicions to Green Run’s management.
B do nothing until other analysts support her analysis.
C recommend that her clients sell their Green Run shares immediately.

B is correct because the analyst has conducted thorough research that indicates the
company falsified its financial results, and she should request the company address this
issue publicly as recommended by Standard II(A)–Material Nonpublic Information. If a
member or candidate determines that information is material, the member or candidate
should make reasonable efforts to achieve public dissemination of the information. This
effort usually entails encouraging the issuer company to make the information public.
If public dissemination is not possible, the member or candidate must communicate
the information only to the designated supervisory and compliance personnel within
the member’s or candidate’s firm and must not take investment action on the basis of
the information.
2020 Level I Mock Exam (C) AM 5

A is incorrect as members and candidates should make reasonable efforts to achieve

public dissemination of information that is material and nonpublic. This effort usually
entails encouraging the issuer company to make the information public. In this case the
original source is not a reliable one, and the analyst would not be expected to request
disclosure based upon the rumor, which is not considered material. However, her thor-
ough research indicates that the company falsified its financial results, and she should
request the company address this issue publicly.
C is incorrect as analysts are in the business of formulating opinions and insights
that are not obvious to the general investing public about the attractiveness of par-
ticular securities. In particular, under the mosaic theory, as outlined in the Guidance to
Standard II(A)–Material Nonpublic Information, an analyst is free to trade based upon
information developed in the course of her own research even if this information would
have been material inside information had it been communicated directly to the analyst
by the company. However, members and candidates should make reasonable efforts to
achieve public dissemination of information that is material and nonpublic. This effort
usually entails encouraging the issuer company to make the information public, which
has not been done in this case, so the analyst would be premature in making a sell
recommendation to clients.

Guidance for Standards I–VII

8 Which of the following statements is least likely correct with regards to the nine
major sections comprising the GIPS standards?
A To claim compliance, firms need only calculate their performance according
to GIPS requirements
B All requirements must be met in order to be fully compliant with the GIPS
C Firms are encouraged to adopt and implement the recommendations

A is correct. To claim compliance, firms must meet all GIPS requirements, not just calculate
their performance according to GIPS requirements.
B is incorrect because the statement that firms are encouraged to adopt and imple-
ment the recommendations is accurate.
C is incorrect because the statement that all requirements must be met in order to
be fully compliant with the GIPS standards is accurate.

The GIPS Standards

9 Jorge Lopez, CFA, is responsible for proxy voting on behalf of his bank’s asset
management clients. Lopez recently performed a cost–benefit analysis, show-
ing that proxy voting analysis might not benefit the bank’s clients. As a result,
Lopez immediately changes the proxy voting policies and procedures without
informing anyone else of the change. Lopez now votes client proxies on the
side of management on all issues with the exception of major mergers where a
significant impact on the stock price is expected. Lopez least likely violated the
CFA Institute Standards of Professional with regards to:
A cost–benefit analysis.
B voting with management.
C proxy voting policy disclosures.
6 2020 Level I Mock Exam (C) AM

A is correct because there is no violation of Standard III(A)–Loyalty, Prudence, and Care

by performing a cost–benefit analysis showing that voting all proxies might not benefit
the client, and concluding voting proxies may not be necessary in all instances. However,
even though voting proxies may not be necessary in all instances, part of a member’s or
candidate’s duty of loyalty under Standard III(A)–Loyalty, Prudence, and Care, includes
voting proxies in an informed and responsible manner, which is not being done by
Lopez by automatically voting with management on the majority of issues. In addition,
members and candidates should disclose to clients their proxy voting policies, including
any changes to that policy as required by Standard III(A)–Loyalty, Prudence, and Care,
which has not been done.
B is incorrect because even though voting proxies may not be necessary in all instances,
part of a member’s or candidate’s duty of loyalty under Standard III(A)–Loyalty, Prudence,
and Care, includes voting proxies in an informed and responsible manner, which is not
being done by Lopez.
C is incorrect because members and candidates should disclose to clients their proxy
voting policies, including any changes to that policy as required by Standard III(A)–Loyalty,
Prudence, and Care.

Guidance for Standards I–VII

10 Edo Ronde, CFA, an analyst for a hedge fund, One World Investments, is
attending a key industry conference for the microelectronics industry. At lunch
in a restaurant adjacent to the conference venue, Ronde sits next to a table of
conference attendees and is able to read their nametags. Ronde realizes the
group includes the president of a publicly traded company in the microelectron-
ics industry, Fulda Manufacturing, a company Ronde follows. Ronde overhears
the president complain about a production delay problem Fulda’s factories are
experiencing. The president mentions that the delay will reduce Fulda earnings
more than 20% during the next year if not solved. Ronde relays this information
to the portfolio manager he reports to at One World explaining that in a recent
research report he recommended Fulda as a buy. The manager asks Ronde to
write up a negative report on Fulda so the fund can sell the stock. According to
the CFA Institute Code of Ethics and Standards of Professional Conduct Ronde
should least likely:
A revise his research report.
B leave his research report as it is.
C request the portfolio manager not act on the information.

A is correct because Ronde should refuse to follow his supervisor’s request. If Ronde
revises his research report based on the information he overheard at the industry con-
ference he would violate Standard II(A)–Material Nonpublic Information. The production
delay information is material and considered nonpublic until it is widely distributed, so
it should not be included in Ronde’s research report or acted on until it becomes public.
Ronde should try to encourage Fulda to make the information public.
B is incorrect because the production delay information is considered material and
nonpublic until it is widely distributed and should not be included in Ronde’s research
report or acted on until it becomes public.
2020 Level I Mock Exam (C) AM 7

C is incorrect because the information Ronde overheard at the industry conference

is material nonpublic information and should not be acted on until it becomes public.

Guidance for Standards I–VII

11 Li Chen, is a CFA candidate and an equity research analyst at an independent

research firm. Chen is contacted by Granite Technologies, Inc., to write an
issuer-­paid research report on the firm to increase awareness of Granite’s stock
amongst the investment community. Which statement best represents how
Chen should respond to this assignment request? Chen should:
A negotiate a flat fee and disclose this relationship in her report.
B decline to write the report as it will compromise her independence.
C accept long-­term warrants on Granite’s stock in lieu of any cash
compensation.

A is correct because by negotiating a flat fee, her independence and objectivity would
not be questioned as her fee would not be based on the results of her research. In
addition, by fully disclosing the relationship in her report she allows the reader to deter-
mine if her judgment is compromised. As a result, Chen is maintaining compliance with
Standard I(B)–Independence and Objectivity.
B is incorrect because although it needs to be appropriately disclosed, members and
candidates are not prohibited from engaging in issuer-­paid research.
C is incorrect because accepting long-­term warrants tied to Granite’s stock price
would increase the risk that Chen is compromising her ability to write an objective
research report.

Guidance for Standards I–VII

12 PNW Bank publishes Investment Monthly magazine, which highlights a specific

stock in each issue. Publication of the magazine invariably causes the high-
lighted stocks to rise significantly in value. Rachel Coursing, CFA, manager of
PNW’s marketing department, often trades in the securities mentioned in the
Investment Monthly articles prior to publication of the magazine. Coursing has
access to the recommendations prior to the magazine’s publication because
the magazine is created in her department and edited by her. PNW’s Code
of Ethics restricts trading by all of the bank’s analysts and portfolio managers
and requires their trades to be pre-­cleared by the Compliance Department.
Coursing least likely violated which of the following CFA Institute Standards of
Professional Conduct?
A Priority of Transactions
B Diligence and Reasonable Basis
C Material Nonpublic Information

B is correct because Coursing has not violated Standard  V–Investment Analysis,

Recommendations, and Actions, as she is not analyzing investments, making invest-
ment recommendations, or taking investment actions for clients. Coursing has violated
Standard VI(B)–Priority of Transactions as clients of the bank have not been given priority
8 2020 Level I Mock Exam (C) AM

over investment transactions in which a member or candidate is the beneficial owner.

In addition, Coursing violated Standard II(A)–Material Nonpublic Information by trading
on material nonpublic information. The Investment Monthly article written by PNW is
considered nonpublic until the magazine is widely distributed, and publication of the
magazine will materially impact the market price of stocks highlighted. Even though
Coursing is not required by her bank to pre-­clear her trades, she is restricted from trading
by Standard II(A).
A is incorrect because Coursing has violated Standard VI(B)–Priority of Transactions
as clients have not been given priority over investment transactions in which a member
or candidate is the beneficial owner.
C is incorrect because Coursing violated Standard II(A)–Material Nonpublic Information
by trading on material nonpublic information. The Investment Monthly article written by
PNW is considered nonpublic until the magazine is widely distributed, and publication
of the magazine will materially impact the market price of stocks highlighted. Even
though Coursing is not required by her bank to pre-­clear her trades, she is restricted
from trading by Standard II(A).

Guidance for Standards I–VII

13 Anna Saar, CFA, is the head of compliance for Tranne Advisory Services, a
regional financial services group including asset management, investment
banking, and stock brokerage entities. Reviewing a draft client investment
management agreement for the asset management unit, she is concerned that
the relationships between the firm’s various business units are not properly
disclosed. To prevent violating CFA Institute Standard VI(A)–Disclosure of
Conflicts, which of the following should least likely be addressed in the invest-
ment management agreement?
A The group subsidizes staff loans for share purchases.
B Management fees are frequently loss leaders for brokerage.
C Asset managers are likely to support corporate finance deals.

A is correct because the group subsidizing staff loans for the purchase of shares is not a
conflict of interest for clients because it is a funding mechanism and does not interfere
with objectivity when rendering investment advice or taking investment action. However,
asset managers subsidizing their asset management fees and supporting the investment
banking corporate finance deals should be disclosed per Standard  VI(A)–Conflicts of
Interest and Standard VI(B)–Priority of Transactions, respectively.
B is incorrect because asset managers subsidizing their asset management fees on
the basis that they will use the group’s brokerage services is a cross-­departmental con-
flict of interest and should be disclosed in the section on cross-­departmental conflicts.
C is incorrect because the fact that the asset managers will support the investment
banking corporate finance deals is a cross-­departmental conflict of interest and should
be disclosed in the section on cross-­departmental conflicts.

Guidance for Standards I–VII

14 All of the following accurately represent the GIPS standards concerning an

investment firm’s definition and historical performance record except:
A firm must be defined as a distinct business unit.
2020 Level I Mock Exam (C) AM 9

B when changes are made in a firm’s organizational structure the composite

performance of the surviving investment firm is calculated from that point
on.
C firm assets under management include the total market value of discretion-
ary and non-­discretionary assets, including fee-­paying and non–fee-­paying
accounts.

B is correct. When a firm changes its organizational structure, historical composite results
cannot be changed.
A is incorrect because a firm must be defined as a distinct business unit.
C is incorrect because a firm’s assets under management include the total market
value of discretionary and non-­discretionary assets, including fee-­paying and non–fee-­
paying accounts.

The GIPS Standards

15 Standard III(C)–Suitability of the CFA Institute Standards of Professional

Conduct most likely requires members and candidates to judge the suitability of
an investment in the context of the client’s:
A total portfolio.
B total assets.
C net worth.

A is correct. Standard  III(C)–Suitability of the CFA Institute Standards of Professional

Conduct requires that when members and candidates are in an advisory relationship
with a client, they must judge the suitability of investments in the context of the client’s
total portfolio.
B is incorrect. Standard III(C)–Suitability requires that when members and candidates
are in an advisory relationship with a client, they must judge the suitability of investments
in the context of the client’s total portfolio, not their total assets.
C is incorrect. Standard III(C)–Suitability requires that when members and candidates
are in an advisory relationship with a client, they must judge the suitability of investments
in the context of the client’s total portfolio, not their net worth.

Code of Ethics and Standards of Professional Conduct

16 According to the recommended procedures for compliance with CFA Institute

Standard V(C): Record Retention, who is most likely responsible for maintaining
the records that support investment actions?
A The firm
B Research analysts
C The chief compliance officer
10 2020 Level I Mock Exam (C) AM

A is correct. According to the recommended procedures for compliance with CFA Institute
Standard  V(C): Record Retention, the responsibility to maintain records that support
investment action generally lies with the firm, rather than individuals.
B and C are incorrect. According to the recommended procedures for compliance
with Standard V(C): Record Retention, neither research analysts nor the chief compliance
officer is responsible for maintaining records that support investment actions. Members
and candidates must, however, archive research notes and documents that support their
investment-­related communications, all of which belong to the firm. Archiving will assist
firms in complying with this requirement for preservation of internal or external records.

Guidance for Standards I-­VII

17 Which of the following is least likely to be a situational influence challenging

ethical conduct?
A Loyalty to coworkers
B The bystander effect
C An overconfidence bias

C is correct. An overconfidence bias is not a situational influence, nor is it determined by

external factors; instead, it is determined by a person’s judgment about his or her own
capabilities or those of others with whom the person is associated. Loyalty to coworkers
(or colleagues) and the bystander effect are examples of situational influences challeng-
ing ethical conduct.
A and B are incorrect because loyalty to coworkers or colleagues and the bystander
effect are examples of situational influences.

Ethics and Trust in the Investment Profession

18 A general ethical decision-­making framework will most likely:

A define a series of actions for each possible situation.
B facilitate the decision-­making process for all decisions.
C ensure a decision or plan of action does not harm stakeholders.

B is correct. Ethical decision-­making frameworks are designed to facilitate the decision-­

making process for all decisions. They help people look at and evaluate a decision
from multiple perspectives, enabling them to identify important issues they might not
otherwise consider.
A is incorrect because the ethical decision-­making process helps facilitate the decision-­
making process but does not specifically define a series of actions for every possible
situation that may arise.
C is incorrect because a decision-­making framework does not ensure that either a
decision or a course of action will safeguard stakeholders. The framework helps one gain a
broader perspective so as to create a plan of action that is less likely to harm stakeholders.

Ethics and Trust in the Investment Profession

2020 Level I Mock Exam (C) AM 11

19 Using the following sample results drawn as 25 paired observations from their
underlying distributions, test whether the mean returns of the two portfolios
differ from each other at the 1% level of statistical significance. Assume the
underlying distributions of returns for each portfolio are normal and that their
population variances are not known.

Portfolio 1 Portfolio 2 Difference

Mean return 17.00 21.25 4.25

Standard deviation 15.50 15.75 6.25

t-statistic for 24 degrees of freedom and at the 1% level of statistical significance = 2.807
Null hypothesis (H 0): Mean difference of returns = 0

Based on the paired comparisons test of the two portfolios, the most appropri-
ate conclusion is that H 0 should be:
A rejected because the computed test statistic exceeds 2.807.
B accepted because the computed test statistic exceeds 2.807.
C accepted because the computed test statistic is less than 2.807.

A is correct. The test statistic is:

d  d 0
sd n
where

d = the mean difference

μ d 0 = the hypothesized difference in the means
sd = the sample standard deviation of differences
n = the sample size
4.25  0
In this case, the test statistic equals: = 3.40. Because 3.40 > 2.807, the
6.25 25 
null hypothesis that the mean difference is zero is rejected.
B is incorrect because a too large (or too small) test statistic leads to the rejection of
the null hypothesis.
C is incorrect because the correctly computed test statistic exceeds the critical value
of 2.807. A reasonable way to reach response C is to fail to divide the standard error by
the square root of the sample size, erroneously using 4.25/6.25 = 0.68 as the test statistic.

Hypothesis Testing

20 Investors should be most attracted to return distributions that are:

A negatively skewed.
B positively skewed.
C normal.
12 2020 Level I Mock Exam (C) AM

B is correct. Investors should be attracted by a positive skew (distribution skewed to the

right) because the mean return falls above the median. Relative to the mean return, pos-
itive skew amounts to a limited, though frequent, downside compared with a somewhat
unlimited, but less frequent, upside.
A is incorrect. Investors should be attracted to positively skewed return distributions.
In a negatively skewed distribution, the mean falls below the median.
C is incorrect. Investors should be attracted to positively skewed return distributions.
In a normal distribution, median and mean are equal.

Organizing, Visualizing, and Describing Data

21 A discrete uniform distribution consists of the following 12 values:

−2.5 5.3 6.7 8.8 −4.6 9.2
3.3 8.2 1.4 0.8 −5.3 6.9

On a single draw from the distribution, the probability of drawing a value

between −2.0 and 2.0 from the distribution is closest to:
A 16.67%.
B 27.59%.
C 33.33%.

A is correct. First order the values from smallest to largest.

−5.3 −4.6 −2.5 0.8 1.4 3.3

5.3 6.7 6.9 8.2 8.8 9.2
Then note that 2 of the 12 values (i.e., 0.8 and 1.4) are between −2.0 and 2.0. Thus, the
probability of a draw from the distribution being between −2.0 and 2.0 is 2/12 = 0.16667.
B is incorrect; it is calculated as dividing the range between −2 and 2 by the range of
distribution (9.2 − (−5.3) = 14.5 as in 4/14.5 = 0.27586.
C is incorrect; it is calculated as dividing the range between −2 and 2 by the number
of values in the distribution: 4/12 = 0.33333.

Common Probability Distributions

22 The following table shows the forecasted price movements of a stock that is
currently priced at 40 and does not pay a dividend.
Movement Probability of Movement Period Return if Movement

Up 65% +10%
Down 35% −10%

Using the binomial model, the probability that the stock’s price will be $39.60 at
the end of two periods is closest to:
A 45.50%.
B 42.25%.
C 22.75%.
2020 Level I Mock Exam (C) AM 13

A is correct. Across two periods, there are four possibilities:

t=0 t=1 t=2
p = 65% 48.40
p = 65% 44

40 p = 35%
39.60
p = 65%
p = 35% 36

p = 35% 32.40

●● uu: End Value: $48.40

●● ud: End Value: $39.60
●● du: End Value: $39.60
●● dd: End Value: $32.40
where u is an up move and d is a down move.
The probability of an up move followed by a down move is 0.65 × 0.35 = 0.2275.
The probability of a down move followed by an up move is 0.35 × 0.65 = 0.2275. Both
of these sequences result in an end value of $39.60.
Therefore, the probability of an end value of $39.60 is (0.2275 + 0.2275) = 45.50%.
Alternatively, the following formula could be used:
 n n x n! n x
p x  P  X  x    p x 1  p  p x 1  p
x
  n  x !x!
Where

n =2 (number of periods)
x =1 (number of up moves: ud and du)
p =0.65 (probability of an up move)

 2 2 1
p 1    0.651 1  0.65
 1
2!
  0.651  0.352 1
 
2  1 !1!
 2  0.65  0.35  45.50%
C is incorrect because it is does not recognize that there are two branches that end
in $39.60 (probability of 0.65 × 0.35 = 22.75%).
B is incorrect because it is the probability of an up move followed by an up move
(0.65 × 0.65 = 42.25%).

Common Probability Distributions

23 For a positively skewed unimodal distribution, which of the following measures

is most accurately described as the largest?
A Median
B Mean
C Mode

B is correct. For a positively skewed unimodal distribution, the mode is less than the
median, which is less than the mean.
14 2020 Level I Mock Exam (C) AM

A is incorrect. For the positively skewed unimodal distribution, the mode is less than
the median, which is less than the mean.
C is incorrect. For the positively skewed unimodal distribution, the mode is less than
the median, which is less than the mean.

Organizing, Visualizing, and Describing Data

24 A sample of 25 observations has a mean of 8 and a standard deviation of 15.

The standard error of the sample mean is closest to:
A 1.60.
B 3.00.
C 3.06.

B is correct. The standard error of the sample mean, when the sample standard
deviation is known, is:

sX = s n

=
In this case, s X 15
= 25 3.00 .
A is incorrect and is calculated by dividing 8 by the square root of 25.
C is incorrect and is calculated by dividing 15 by the square root of 24.

Sampling and Estimation

25 A two-­tailed test of the null hypothesis that the mean of a distribution is equal
to 4.00 has a p-value of 0.0567. Using a 5% level of significance (i.e., α = 0.05),
the best conclusion is to:
A fail to reject the null hypothesis.
B increase the level of significance to 5.67%.
C reject the null hypothesis.

A is correct. Because the p-value (0.0567) exceeds the stated level of significance (0.05),
the null hypothesis cannot be rejected.
B is incorrect. A 5% confidence level does not allow the significance level to be
increased beyond 5%.
C is incorrect. As the p-value (0.0567) exceeds the stated level of significance (0.05),
the null hypothesis cannot be rejected.

Hypothesis Testing

26 An economist states that the probability of having the gross domestic product
(GDP) of a country higher than 3% is 0.20. What are the odds against a GDP
higher than 3%?
A 5 to 1
B 6 to 1
C 4 to 1
2020 Level I Mock Exam (C) AM 15

C is correct. Given the probability of an event, P(E), the odds against that event are:
[1 − P(E]/P(E). By using the input of the problem, Odds against E = (1 − 0.2)/0.2 = 4. This
means that given the probability stated by the economist, the odds against a GDP above
3% are 4 to 1.
A is incorrect. It uses a wrong calculation: (1/0.20) = 5. Thus, 5 to 1.
B is incorrect. It uses a wrong formula: (1 + 0.2)/0.2 = 6. Thus, 6 to 1.

Probability Concepts

27 A group of fund analysts have to select the first, second, and third best fund
manager of the year for 2012 based on their subjective judgment. If 10 fund
managers are candidates for the three awards, the number of ways in which
each analyst can make his ranking is closest to:
A 30.
B 720.
C 120.

B is correct. This problem is a counting one in which order does matter. For this reason,
n!
use the permutation formula nPr = ,
n  r!
where

n = the total number of fund managers; in the problem, n = 10.

r = the number of fund managers that will receive the awards (first, sec-
ond, and third); in the problem, r = 3.

10! 10! 3, 628,800

10P3 =   = 720
10  3! 7! 5, 040
There are 720 ways that each analyst can rank 3 fund managers out of 10, when order
does matter.
A is incorrect. It uses the following calculation: 3 × 10 = 30.
C is incorrect. It uses the combination formula as follows:
 n n! 10! 10! 3, 628,800
nCr =     = 120
 r  n  r!r! 10  3!3! 7!3! 30, 240

Probability Concepts

28 If the stated annual interest rate is 20% and the frequency of compounding is
monthly, the effective annual rate (EAR) is closest to:
A 20%.
B 21%.
C 22%.
16 2020 Level I Mock Exam (C) AM

C is correct. EAR = (1  + periodic interest rate) m − 1  = (1  + 0.20/12)12 − 1  = 0.21939%,

rounded to 22%.
A is incorrect. It is simply the given stated annual rate.
B is incorrect. It uses semiannual compounding as follows: (1 + 0.20/2)2 − 1 = 21%.

The Time Value of Money

29 Which sampling-­related bias is most likely to result in finding apparent signifi-

cance when none exists?
A Sample selection bias
B Look-­ahead bias
C Data mining bias

C is correct. Data mining bias comes from overuse or misuse of the data and can result
in finding models or patterns where none exist.
A is incorrect. Sample selection bias often results when data availability leads to
certain data being excluded from the analysis.
B is incorrect. Look-­ahead bias exists if the model uses data not available to the analyst
at the time the analyst act on the model.

Sampling and Estimation

30 During the past 36 months, the standard deviation of a portfolio’s monthly

returns has been 4.9%. To test a claim that this portfolio’s investment strategy
results in a standard deviation of monthly returns that is less than 5.0%, the
value of the test statistic is closest to:
A 34.30.
B 33.61.
C 34.57.

B is correct. The most appropriate test is chi-­square, with 36 − 1  = 35 degrees of

freedom. The calculated test statistic is:

n  1 s 2 36  10.0492
2    33.61
02 0.052
where

χ2 = is the chi-­square test statistic

n = is the sample size
s 2 = is the sample variance
σ02 = the hypothesized value of the variance σ2
2020 Level I Mock Exam (C) AM 17

A is incorrect. If there is no squared to both s and σ.

36  10.049
 34.30
0.05
C is incorrect. If using n as degrees of freedom instead of n − 1, that is

360.0492
 34.57
0.052

Hypothesis Testing

31 A small country has a comparative advantage in the production of pencils. The

government establishes an export subsidy for pencils to promote economic
growth. Which of the following will be the most likely result of this policy?
A Although domestic producers will receive a net benefit, the policy will give
rise to inefficiencies that cause a deadweight loss to the national welfare.
B As new domestic producers enter the pencils market, supply will increase
and domestic prices will decline.
C The increase in the domestic producer surplus will exceed the sum of the
subsidy and the decrease in the domestic consumer surplus.

A is correct. Export subsidies interfere with the functioning of the free market and result
in a deadweight loss to society. The deadweight loss arises on the producer side because
the higher subsidized price causes inefficient producers to remain in the market. On the
consumer side, the higher price causes those that would have purchased at the lower
price to be shut out of the market.
B is incorrect. Producers shift output from the domestic to the export market to capture
the subsidy. Furthermore, as a small country, the domestic market is a price taker and thus
consumers pay the international price plus the subsidy causing the domestic price to rise.
C is incorrect. As prices rise and producers increase production beyond the efficient
level, efficiencies diminish. National welfare must decline, as the increase in producer
surplus is less than the combined cost to consumer and government.

International Trade and Capital Flows

32 If the quantity demanded of pears falls by 4% when the price of apples decreases
by 3%, then apples and pears are best described as:
A complements.
B substitutes.
C inferior goods.
18 2020 Level I Mock Exam (C) AM

B is correct. The cross-­price elasticity of demand is defined as the percentage change

in quantity demanded divided by the percentage change in the price of a substitute or
complement. If the cross-­price elasticity of demand is positive, the goods are substitutes.
In this case, the 4 percent decline in quantity of pears is divided by the 3 percent decline
in the price of apples, which is a positive number:
–4/–3 = +1.33
A is incorrect because the cross-­price elasticity of demand between pears and apples
is positive. Complements have a negative cross-­price elasticity of demand.
C is incorrect because inferior goods relates to income elasticity of demand, not
cross-­price elasticity.

Topics in Demand and Supply Analysis

33 Three firms operate under perfect competition, producing 900 units of the
same product but using different production technologies. Each company’s cost
structure is indicated in the table:
Company X Y Z

Total Variable Costs $2,700 $3,600 $4,500

Total Fixed Costs 2,700 1,800 900
Total Costs $5,400 $5,400 $5,400

Which of the following statements is most accurate? If the unit selling price is:
A $6.00, all firms should exit the market in the long run.
B $4.50, all firms should continue to operate in the short run, but exit the
market in the long run if these conditions are expected to persist.
C $3.00, Firm X should continue to operate in the short run, but Firms Y and
Z should shut down production.

C is correct.

Short-­Run
Revenue–Cost Relationship Decision Long-­Term Decision

TR ≥ TC Stay in market Stay in market

TR > TVC but TR < TFC + TVC Stay in market Exit market
TR < TVC Shut down Exit market
production

TR = Total Revenue; TC = Total Costs; TVC = Total Variable Costs; TFC = Total Fixed Costs

Hence, if the selling price is $3.00, total revenue for all firms will be $3.00/unit × 900
units = $2,700. Only Firm X’s variable costs are covered and it should continue operating,
while Firms Y and Z should immediately shut down production.
A is incorrect. If total revenue equals or exceeds total costs, the firms should remain in
the market both in the long and short run: each firm is just earning an economic profit,
which includes its opportunity cost.
2020 Level I Mock Exam (C) AM 19

B is incorrect. At $4.50, total revenue is $4.50  × 900  = $4,050. Only Firms X and Y
cover their variable costs; Firm Z should shut down. It is true, however, that if conditions
persist, all should shut down in the long run as they won’t be covering their total costs.

Topics in Demand and Supply Analysis

34 If the scale of a single producer is small relative to the demand for an undiffer-
entiated good, the market structure of the producer is best described as being:
A an oligopoly.
B monopolistic competition.
C perfect competition.

C is correct. Perfect competition involves the sale of a homogeneous product by many

sellers; monopolistic competition may also involve many sellers, but its product is
differentiated.
A is incorrect. Oligopolies involve only a few sellers.
B is incorrect. Firms in monopolistic competition sell differentiated products although
there may be many of these firms.

The Firm and Market Structures

35 An increase in current prices will most likely:

A decrease real GDP.
B increase real GDP.
C increase the GDP deflator.

C is correct. Nominal GDP is defined as the value of goods and services measured at
current prices. Real GDP is not affected by price increases, but nominal GDP and the
GDP deflator increase with price increases:
Real GDPcurrent year = Nominal GDPcurrent year × 100/GDP deflator
Real GDPcurrent year = Pbase year × Qcurrent year
B is incorrect. Real GDP is not affected by the increase in current prices.
A is incorrect. Real GDP is not affected by the increase in current prices.

Aggregate Output, Prices, and Economic Growth

36 Assume that a central bank has decided to lower interest rates in the economy.
To carry out this policy, the central bank will most likely:
A increase required reserve requirements.
B buy securities.
C sell securities.
20 2020 Level I Mock Exam (C) AM

B is correct. In implementing monetary policy, central banks have three primary tools
available to them: open market operations, setting the official policy rate, and reserve
requirements. When the central bank purchases securities (open market operations), it
increases the reserves held by private sector banks. These increased reserves lead to a
reduction in interest rates on money market securities and, ultimately, to a reduction in
other interest rates in the economy
A is incorrect. An increased reserve requirement reduces the money supply (as banks
can lend out less) and leads to higher interest rates
C is incorrect. If the central bank sells securities, reserves fall and interest rates are
likely to increase.

Monetary and Fiscal Policy

37 If a strengthening economy leads discouraged workers to return to an active

employment search, the number of unemployed people would, at least initially,
most likely:
A increase.
B decrease.
C remain unchanged.

A is correct. The unemployed are defined as those who are actively seeking employment
but are currently without a job. Discouraged workers are without a job but have given
up searching for work and so are not classified as being unemployed. A strengthening
economy will lead discouraged workers to once again actively search for work; they will
be reclassified as unemployed, and at least initially, the number of unemployed people
will increase and the unemployment rate will rise.
B is incorrect. In the longer term, if the economy is strengthening the number of
unemployed people may decrease; however, when people from outside the labor force
first re-­join the labor force to look for employment they will, at least, initially increase
the number of unemployed people.
C is incorrect. Although the number of people without jobs has not immediately
changed, while classified as discouraged workers the people were excluded from the
labor force. Once re-­joining the labor force to actively seek employment they will, at
least initially, increase the number of unemployed people.

Understanding Business Cycles

38 A central bank increases its purchases of bonds from commercial banks

intending to decrease interest rates, boost confidence, increase asset prices, and
ultimately raise the general level of employment, production, and prices in the
economy. This is most likely an example of:
A money neutrality.
B expansionary fiscal policy.
C the monetary transmission mechanism.
2020 Level I Mock Exam (C) AM 21

C is correct. The implementation of monetary policy may work through the economy
via four interrelated channels: lending rates, asset prices, agents’ expectations, and
exchange rates.
A is incorrect. If money neutrality holds, only prices would rise whereas employment
and output would not change.
B is incorrect. Expansionary fiscal policy is implemented by reducing taxes and/or
raising government spending.

Monetary and Fiscal Policy

39 The most likely reason for a country to encourage foreign direct investment
while heavily restricting foreign investment in liquid domestic assets is to:
A prevent capital flight.
B generate an increase in the domestic interest rate.
C stabilize the production capacity of the domestic country.

A is correct. Capital flight occurs when foreign investment in liquid domestic assets
suddenly decreases. Restricting foreign investment in liquid domestic assets and encour-
aging foreign direct investment (i.e., investment in illiquid domestic assets) prevents
capital flight.
B is incorrect. Restricting foreign investment in liquid domestic assets will keep the
domestic interest rate from rising.
C is incorrect. Foreign direct investment increases the production capacity of the
domestic country.

International Trade and Capital Flows

40 A European foreign exchange dealer gives the following exchange rate informa-
tion to a European client: USD/EUR spot rate = 1.1640; three-­month forward
points = 12.8. The best interpretation of the exchange rate information is that:
A the US dollar is trading at a premium to its forward rate.
B the three-­month US real interest rate is expected to rise.
C three-­month eurozone interest rates are lower than those in the United
States.

C is correct. A positive forward premium indicates that the interest rates in the base
currency region (eurozone) are lower than the interest rates in the price currency region
(United States).
A is incorrect. The euro, which is the base currency, is trading at a premium to its
forward rate. The positive forward points indicate that the euro forward rate is above
the spot rate. The US dollar, which is the price currency, is trading at a discount to its
forward rate.
B is incorrect. The forward rate does not predict the direction of real interest rates.

Currency Exchange Rates

22 2020 Level I Mock Exam (C) AM

41 In order to improve the yield of his corn crop, a farmer has subdivided his acre-
age this year and has experimented with different amounts of water per acre.
The results of his study are shown in the following table:
Gallons of water used Yield in bushels
per acre per acre

2,400 100
2,600 110
2,800 120
3,000 130
3,150 135
3,300 115

The point (in gallons of water per acre) where the effect of diminishing returns
is first observed is closest to:
A 3,000.
B 3,150.
C 3,300.

B is correct. The yield per gallon, shown in the following table, peaks at 3,000 gallons
and starts to decline above that—that is, at 3,150.

Gallons of water used Yield in bushels Yield per

per acre per acre gallon

2,400 100 0.0417

2,600 110 0.0423
2,800 120 0.0428
3,000 130 0.0433
3,150 135 0.0428
3,300 115 0.0348

A is incorrect. It is the volume of maximum efficiency based on yield per acre.

C is incorrect. It is where there is the largest decrease in yield in bushels per acre but
is not the first point of diminishing returns per gallon of water.

Topics in Demand and Supply Analysis

42 Assuming that there are no changes in the fiscal or trade balances, if investment
expenditures become highly sensitive to interest rates, the aggregate demand
curve is most likely to be:
A flatter.
B steeper.
C unaffected.
2020 Level I Mock Exam (C) AM 23

A is correct. Since there are no changes in the fiscal or trade balances, the balance between
aggregate expenditure and aggregate income requires that changes in investment
spending equal changes in private savings. Assume that interest rates fall: Investment
will increase (by a larger amount, given the increased sensitivity to rates); savings will
have to fall (this arises because there is less incentive to save, given the lower interest
rate; consumption will increase; and national income will increase. The IS curve will be
flatter the more sensitive investments are to interest rates. This means that income will
have to move more to induce a large enough change in savings to match the change in
investment spending, which implies a flatter aggregate demand curve.
B and C are incorrect. If investment expenditure is more sensitive to interest rates, the
IS curve will be flatter, meaning that income will have to move more to induce a large
enough change in savings to match the change in investment spending, which implies
a flatter aggregate demand curve.

Aggregate Output, Prices, and Economic Growth

43 Which of the following is least likely to be a general feature underlying the

preparation of financial statements within the International Financial Reporting
Standards (IFRS) Conceptual Framework?
A Matching
B Accrual basis
C Materiality

A is correct. The IFRS Conceptual Framework specifies a number of general features

underlying the preparation of financial statements, including materiality and accrual
basis. Matching is not one of those general features; it is a general principle of expense
recognition.
B is incorrect. Accrual basis is one of the general features underlying the preparation
of financial statements under the IFRS Framework
C is incorrect. Materiality is one of the general features underlying the preparation
of financial statements under the IFRS Framework

Financial Reporting Standards

44 In a period of rising prices, when compared with a company that uses weighted
average cost for inventory, a company using FIFO will most likely report higher
values for its:
A inventory turnover.
B return on sales.
C debt-­to-­equity ratio.

B is correct. In periods of rising prices, FIFO results in a higher inventory value and a lower
cost of goods sold and thus a higher net income. The higher net income increases return
on sales. The higher reported net income also increases retained earnings and thus results
in a lower debt-­to-­equity ratio, not a higher one. The combination of higher inventory
and lower cost of goods sold (CGS) decreases inventory turnover (CGS/Inventory).
24 2020 Level I Mock Exam (C) AM

A is incorrect. The combination of higher inventory and lower cost of goods sold
decreases inventory turnover (CGS/Inventory).
C is incorrect. The higher reported net income increases retained earnings and there-
fore results in a lower debt-­to-­equity ratio, not a higher one.

Inventories

45 A company decided to exchange a truck that it had purchased three years ear-
lier for a piece of land owned by another company. The following table provides
details related to both items:
  Truck* Land**

Original cost $57,000 $18,000

Estimated life 8 years
Estimated salvage value at purchase $15,000
Depreciation method Declining balance, 20% per year
Current fair value of item $27,000 $21,000

* The last sale of a similar truck by the company occurred more than six months ago.
** The land is one of four identical parcels of land recently sold by the company.

The income statement for the company that disposes of the truck is most likely
to report a loss of:
A $2,184.
B $8,184.
C $9,000.

B is correct. The land acquired, and hence the proceeds for the disposition of the truck, is
measured at the fair value given up, unless the acquired asset’s fair value is more clearly
evident. In this situation, the land’s value is more clearly evident because of the recent sale
of identical parcels. Therefore, the income statement will report any difference between
the fair value of the land and the carrying amount of the item given up.
Determine the carrying value of the delivery vehicle:

Start-­of-­Year
Year Value Depreciation End-­of-­Year Value

1 $57,000 $11,400 $45,600

2 $45,600 $9,120 $36,480
3 $36,480 $7,296 $29,184
Start value Start value × Start value
Depreciation rate – Depreciation

An alternative derivation: $57,000 × (1 – 0.20)3 = $29,184

Determine the gain or loss on the exchange:

Gain = Fair value of land acquired – Carrying value of truck given up

 = $21,000 – $29,184
 = –$8,184
2020 Level I Mock Exam (C) AM 25

A is incorrect. It assumes the FV of the truck is the relevant disposal price: 27,000 –
29,184 = 2,184.
C is incorrect. It is the difference between the original cost of land and the fair value
of truck: 18,000 – 27,000 = –9,000.

Long-­Lived Assets

46 An analyst gathers the following information about a company:

($ millions) 2014 2013

Sales 283.5 234.9

Year-­end inventory (LIFO inventory method) 81.4 53.7
LIFO reserve 36.4 21.8
Cost of goods sold (LIFO) 203.9 167.3

Had the company used the first-­in, first-­out (FIFO) inventory method instead
of last-­in, first-­out (LIFO), the company’s 2014 gross profit margin would be
closest to:
A 22.9%.
B 15.2%.
C 33.2%.

C is correct. The FIFO cost of goods sold (COGS) is determined from the LIFO COGS less
the change in LIFO reserve:

Change in LIFO Reserve = 2014 LIFO reserve – 2013 LIFO reserve =

36.4 – 21.8 = 14.6
FIFO COGS = LIFO COGS – Change in LIFO reserve =
203.9 – 14.6 = 189.3
FIFO gross profit = Sales – FIFO COGS = 283.5 – 189.3 = 94.2
FIFO gross profit margin = Gross profit/Sales = 94.2/283.5 = 33.2%
A is incorrect. It adds the change in LIFO reserve to LIFO COGS to arrive at FIFO COGS.

Change in LIFO Reserve = 2014 LIFO reserve – 2013 LIFO reserve =

36.4 – 21.8 = 14.6
FIFO COGS = LIFO COGS + Change in LIFO reserve =
203.9 + 14.6 = 218.5 [error by adding]
FIFO gross profit = Sales – FIFO COGS = 283.5 – 218.5 = 65.0
FIFO gross profit margin = Gross profit/Sales = 65.0/283.5 = 22.9%
B is incorrect. It adds the LIFO reserve to LIFO COGS to arrive at FIFO COGS (confusion
with obtaining FIFO end inventory).

FIFO COGS = LIFO COGS + LIFO reserve = 203.9 + 36.4 =

240.3 [error by adding]
FIFO gross profit = Sales – FIFO COGS = 283.5 – 240.3 = 43.2
FIFO gross profit margin = Gross profit/Sales= 43.2/283.5 = 15.2%

Inventories
26 2020 Level I Mock Exam (C) AM

47 Under International Financial Reporting Standards (IFRS), which of the follow-

ing is most commonly classified as a non-­current liability?
A Deferred tax liability
B Warranties
C Notes payable

A is correct. Under IFRS, deferred tax liabilities are always classified as non-­current.
B is incorrect. A warranty liability can be classified as either current or noncurrent,
depending on the timing estimated by the company.
C is incorrect. Notes payable are classified as current liabilities if due within one year.
Beyond that, they are classified as non-­current liabilities.

Understanding Balance Sheets

48 A company acquired a customer list for $300,000 and a trademark for

$5,000,000. Management expects the customer list to be useful for three years,
and it expects to use the trademark for the foreseeable future. The trademark
must be renewed every 10 years with the Patent and Trademark office for a
nominal amount; otherwise it expires. If the company uses straight-­line depre-
ciation for all its intangible assets, the annual amortization expense for these
two assets will be closest to:
A $100,000.
B $600,000.
C $0.

A is correct. The trademark can be renewed at a minimal cost, so it is considered to have

an indefinite life and amortization expense is not required.
Annual amortization expense on the customer list = $300,000/3 years =
$100,000.
B is incorrect.
600,000 = 300,000/3 + 5,000,000/10
However, amortization is not required for the patent.
C is incorrect. It assumes neither is amortized.

Long-­Lived Assets

49 The following data are available for a company’s first year of operations:
Metric £ thousands

Earnings before tax reported on the income statement 2,640

Depreciation expense included in earnings before tax 4,500
Accounting expenses that are not deductible for tax purposes 2,130
2020 Level I Mock Exam (C) AM 27

Metric £ thousands
Depreciation expense deductible for tax purposes in first year of 6,340
operations
Corporate tax rate 25%

The company’s end-­of-­year balance sheet will most likely include (in thousands)
a deferred tax
A asset of £73.
B liability of £460.
C liability of £733.

B is correct. Deferred tax balances result from temporary differences between a compa-
ny’s income as reported for tax purposes and income reported for financial statement
purposes. The temporary difference in this case arises from the difference between the
depreciation for accounting purposes and the depreciation for tax purposes. Because of
this difference, the company would report more income tax expense than would actually
be paid in taxes. The difference is a deferred tax liability.

Temporary difference balance = Depreciation expense for accounting

purposes – Depreciation for tax purposes
 = £6,340 – £4,500
 = £1,840
Deferred tax balance = Temporary difference balance ×
Corporate tax rate
 = £1,840 × 25%
 = £460
A is incorrect. This balance would be obtained by mistakenly assuming that the
accounting expenses that are not deductible for tax purposes are also a temporary
difference, resulting in the calculation of a deferred tax asset.

Deferred tax balance = Temporary difference balance × Corporate tax

rate
 = (£1,840 – £2,130) × 25%
 = £73
C is incorrect. This is the tax payable balance, not the deferred tax balance.

Taxable income = Accounting income ± Permanent differences ±

Temporary differences
 = £2,640 + £2,130 – £1,840
 = £2,930
Tax payable = Taxable income × Corporate tax rate
 = £2,930 × 25%
 = £733

Understanding Balance Sheets

50 The following financial statement data are available for a company:

28 2020 Level I Mock Exam (C) AM

Metric $ thousands

Operating income 3,390

Net income 2,210
Operating assets 3,850
Change in cash and cash equivalents 1,010
Change in cash from operating activities 1,750
Free cash flow to the firm 2,240

The company’s cash-­to-­income ratio is closest to:

A 0.79.
B 0.66.
C 0.52.

C is correct.

Cash to income = Cash flow from operating activities (CFO)/Operating

income
 = (1,750/3,390)
 = 0.52
B is incorrect. The calculation incorrectly uses free cash flow in the numerator.

Incorrect cash to income = Free cash flow to the firm/Operating income

 = 2,240/3,390
 = 0.66
A is incorrect. The calculation incorrectly uses net income in the denominator.

Incorrect cash to income = Cash flow from operations/Net income

 = 1,750/2,210
 = 0.79

Understanding Cash Flow Statements

51 Selected information for a company is provided.

  $ millions

Sales 4,800
Cost of goods sold 2,880
Purchases 2,940
Average receivables 625
Average inventory 710
Average payables 145

The company’s cash conversion cycle (in days) is closest to:

A 84.
B 138.
C 120.
2020 Level I Mock Exam (C) AM 29

C is correct.
Cash conversion cycle = Days sales outstanding + Days of inventory on hand
– Days of payables

Accounts Receivable: Inventory:

Days Sales Outstanding Days on Hand Accounts Payables:
(DSO) (DOH) Days in Payables

Turnover (Sales/Average receivables) (Cost of goods sold/Inventory) (Purchases/Payables)

4,800/625 = 7.68 times 2,880/710 = 4.06 times 2,940/145 = 20.3 times
In days 365/7.68 = 48 days 365/4.06 = 90 days 354/20.3 = 18 days

Cash conversion cycle = DSO + DOH – Days in payables

 = 48 + 90 – 18
 = 120 days
A is incorrect. It calculates DOH based on sales, not CGS: 4,800/710  = 6.76 times;
365/6.76 = 54; 48 + 54 – 18 = 84.
B is incorrect. It does not subtract the days in payables: 48 + 90 = 138 days.

Financial Analysis Techniques

52 Which of the following conditions would most likely create opportunities for a
company to issue low-­quality financial reports?
A A company with an audit committee comprised only of independent board
members
B Government cutbacks in the enforcement branch of the financial regulator
C Accounting standards that provide few choices

B is correct. Cutbacks in the enforcement branch of the financial regulator could lead to
less effective enforcement and oversight of financial issuers, thus creating an opportunity
for low-­quality financial reporting.
A is incorrect. An independent audit committee reduces the opportunity to produce
low-­quality financial reports.
C is incorrect. Accounting standards that do not allow a range of choices reduce the
opportunity for low-­quality financial reporting.

Financial Reporting Quality

53 An analyst wants to compare a company with its industry and gathers the fol-
lowing selected financial information for the company:
Current assets including inventory €260,000
Current liabilities €80,000
LIFO reserve €53,000
30 2020 Level I Mock Exam (C) AM

If the industry norm is to use the FIFO method of inventory valuation, the cur-
rent ratio of the company that the analyst would use for comparison purposes is
closest to:
A 3.91.
B 3.25.
C 2.59.

A is correct. The company must be currently using LIFO, based on the disclosure of the
LIFO reserve. For comparison purposes the analyst should adjust for the difference in
accounting methods and increase current assets by the LIFO reserve.
The adjusted current ratio is [(260,000 + 53,000)/80,000] = 3.91.
B is incorrect. It fails to add the LIFO reserve: (260,000/80,000) = 3.25.
C is incorrect. It subtracts the LIFO reserve: [(260,000 – 53,000)/80,000] = 2.59.

Financial Statement Analysis: Applications

54 A company that prepares its financial statements in accordance with IFRS

incurred and capitalized €2 million of development costs during the year. These
costs were fully deductible immediately for tax purposes, but the company is
depreciating them over two years for financial reporting purposes. The com-
pany has a long history of profitability, which is expected to continue. Which
is the most appropriate way for an analyst to incorporate the differential tax
treatment in his analysis? He should include it in:
A equity when calculating the company’s return-­on-­equity ratio.
B liabilities when calculating the company’s debt-­to-­equity ratio.
C liabilities when calculating the company’s current ratio.

B is correct. The different treatment for tax purposes and financial reporting purposes is
a temporary difference and would create a deferred tax liability. Deferred tax liabilities
should be classified as debt if they are expected to reverse with subsequent tax payments.
The long history of profitability implies the company will likely be paying taxes in the
following years, and hence an analyst could reasonably expect the temporary difference
to reverse. Under IFRS, all deferred tax liabilities are non-­current.
A is incorrect. It would be included in equity only if there were no expectation of
subsequent tax payment, which is not likely given the history of profitability.
C is incorrect. Under IFRS, all deferred tax liabilities are non-­current, so it would not
be included in the current ratio even though it is expected to reverse next year.

Income Taxes

55 An analysis used to forecast earnings that shows a range of possible out-

comes as specific assumptions change best describes which of the following
techniques?
A Scenario analysis
B Simulation
2020 Level I Mock Exam (C) AM 31

C Sensitivity analysis

C is correct. Sensitivity analysis, also known as “what if” analysis, shows the range of
possible outcomes as specific assumptions are changed.
A is incorrect. Scenario analysis shows changes in key financial quantities that result
from given economic events.
B is incorrect. Simulation is a computer-­generated sensitivity or scenario analysis
based on probability models for the factors that drive outcomes.

Financial Analysis Techniques

56 Under general principles of expense recognition, a company should:

A apply uniform treatment for administrative and depreciation costs.
B recognize expenses in the period that it consumes the associated economic
benefits.
C allocate lost economic benefits prospectively over the expected period in
which the benefits would have been earned.

B is correct. In general, a company recognizes expenses in the period that it consumes

(i.e., uses up) the economic benefits associated with the expenditure or loses some
previously recognized economic benefit.
A is incorrect because administrative and depreciation costs are not treated uniformly;
administrative costs are expensed immediately, and depreciation is allocated over time.
C is incorrect because a company recognizes expenses in the period that it loses some
previously recognized economic benefit or consumes the economic benefits associated
with the expenditure, not when benefits would have been earned.

Understanding Income Statements

57 Selected year-­end financial data for Mega Industries follows:

Net income $100 million
Tax rate 25 percent
Weighted average number of common shares outstanding 25 million
Convertible preferred shares* 10 million
Preferred dividend per share $1.00

* Each share is convertible into 0.5 shares of common stock.

The net difference between Mega’s reported basic EPS and its diluted EPS is
closest to:
A $0.74.
B $0.27.
C $0.37.
32 2020 Level I Mock Exam (C) AM

B is correct. As the calculations below show, the basic and diluted EPS are $3.60 and
$3.33, respectively, and the resulting net difference is $0.27.

Net income  Preferred dividends

Basic EPS 
Weighted average number of shares outstanding
$100 million  10 million preferred shares  $1.00 preferred dividend per share

25 million
$100  $10

25
 $3.60

Net income
Diluted EPS 
Weighted average number New common shares that would

of shares outstanding have been issued at conversion
$100 million

25 million  10 million  0.5
 $3.33
Net difference = $3.60 – $3.33 = $0.27
C is incorrect because in the basic EPS calculation, the preferred dividends subtracted
are not tax adjusted:

Net income  Preferred dividends  1  Tax rate

Basic EPS 
Weighted average number of shares outstanding
$100 million  10 million preferred shares  $1.00 preferred dividend per share  1  0.25

25 million
$100  $7.5

25
 $3.70

Net income
Diluted EPS 
Weighted average number New common shares that would

of shares outstanding have been issued at conversion
$100 million

25 million  10 million  0.5
 $3.33
Net difference = $3.70 – $3.33 = $0.37
A is incorrect because the conversion of the preferred shares into common stock for
determining diluted EPS is miscalculated:
2020 Level I Mock Exam (C) AM 33

Net income  Preferred dividends

Basic EPS 
Weighted average number of shares outstanding
$100 million  10 million preferred shares  $1.00 preferred dividend per share

25 million
$100  $10

25
 $3.60

Net income
Diluted EPS 
Weighted average number New common shares that would

of shares outstanding have been issued at conversion
$100 million

25 million  10 million
 $2.86
Net difference = $3.60 – $2.86 = $0.74
The correct number of new shares for the preferred stock conversion in the denom-
inator of the diluted EPS calculation is 5 million (each preferred share is convertible into
0.5 common shares), not 10 million shares.

Understanding Income Statements

58 Which of the following statements relating to the financial reporting of defined

contribution pension plans is correct?
A The only balance sheet impact from contributions to defined-­contribution
plans is on an asset account.
B Defined-­contribution plans require companies to make several assumptions
in order to estimate their pension obligations.
C Under a defined-­contribution plan, company contributions to the plan are
treated as an operating cash flow.

C is correct. Under a defined-­contribution plan, company contribution to the plan are

treated as an operating cash flow.
A is incorrect because, if some portion of the agreed-­upon contribution has not been
paid by fiscal year end, a liability is recognized on the balance sheet.
B is incorrect because defined benefit plans (not defined-­contribution plans) require
companies to make several assumptions in order to estimate their pension obligations.

Non- ­Current (Long-­Term) Liabilities

59 Which of the following statements best describes the usual balance sheet pre-
sentation of long-­term debt?
A Long-­term debt due after one year is presented as multiple line items.
B Non-­current, long-­term debt is presented as a single line item.
C All long-­term debt is excluded from classification as a current liability.
34 2020 Level I Mock Exam (C) AM

B is correct. The non-­current (long-­term) liabilities section of the balance sheet usually
includes a single line item of the total amount of a company's long-­term debt due after
one year.
A is incorrect because the non-­current (long-­term) liabilities section of the balance
sheet usually includes a single line item of the total amount of a company’s long-­term
debt due after one year.
C is incorrect because the portion of long-­term debt due in the next twelve months
is shown as a current liability.

Non- ­Current (Long-­Term) Liabilities

60 Which of the following best describes the link between the cash flow statement
and the balance sheet?
A The statement’s investing activities section reconciles the changes in current
assets on the balance sheet.
B The cash flow statement reconciles the beginning and ending balances of
cash reported on the balance sheet.
C The cash flow statement reconciles changes in all accounts on the balance
sheet.

B is correct. The statement of cash flows ultimately shows the change in cash during an
accounting period. The company’s balance sheet shows the beginning and ending cash
balances for the previous and current years, and the bottom of the cash flow statement
reconciles beginning cash with ending cash. Non-­cash changes in accounts may appear
on the balance sheet; therefore, not all changes in the balance sheet are reconciled on
the cash flow statement.
A is incorrect. The changes in current assets are in the operating section of the CFS
not the investing section.
C is incorrect. There could be non-­cash changes in accounts on the balance sheet
therefore not all changes in the balance sheet are reconciled on the CFS.

Understanding Cash Flow Statements

61 A project has a cost of €16,253 with a net present value (NPV) of €423.11. The
corresponding profitability index (PI) is most likely:
A 1.42.
B 0.03.
C 1.03.

C is correct. The PI is:

¬423.11
1  1.026
¬16, 253
A is incorrect because it is 1 + NPV/100.
2020 Level I Mock Exam (C) AM 35

B is incorrect because it is the ratio of the NPV over the cost.

Capital Budgeting

62 A company’s $100 par value preferred stock with a dividend rate of 9.5% per
year is currently priced at $103.26 per share. The company’s earnings are
expected to grow at an annual rate of 5% for the foreseeable future. The cost of
the company’s preferred stock is closest to:
A 9.5%.
B 9.2%.
C 9.7%.

B is correct. r p = D p /P p (or Dividend/Price) = ($100 × 0.095)/$103.26 = 9.2%.

A is incorrect because it uses $100 as the denominator, i.e., ($100 × 0.095)/$100 = 9.5%.
C is incorrect because it assumes 5% growth in the dividend, i.e., 9.5 × (1.05)/103.26 =
9.7%.

Cost of Capital

63
Income Statement Millions ($)

Revenues 10.2
Variable operating costs 4.6
Fixed operating costs 2.0
Operating income 3.6
Interest 1.2
Taxable income 2.4
Tax 1.0
Net income 1.4

The degree of financial leverage (DFL) is closest to:

A 2.6.
B 1.5.
C 1.7.

B is correct. DFL = Operating income/Operating income – Interest expense, or operating

income divided by pretax earnings:

 = $3.6/($3.6 – $1.2)
 = 1.50
C is incorrect because it is Pre-­tax income/Net income = $2.4 million/$1.4 million.
36 2020 Level I Mock Exam (C) AM

A is incorrect because it is Operating income/Net income = $3.6 million/$1.4 million.

Measures of Leverage

64 The unit contribution margin for a product is $12. Assuming fixed costs of
$12,000, interest costs of $3,000, and a tax rate of 40%, the operating breakeven
point (in units) is closest to:
A 1,250.
B 750.
C 1,000.

C is correct. The operating breakeven point, Q OBE, is:

Fixed operating costs $12, 000
= = 1, 000
Contribution margin $12
B is incorrect because the numerator is ($12,000 + $3,000) × (1 – 40%).
A is incorrect because the numerator is ($12,000 + $3,000) making it the breakeven
quantity, Q BE, and not the operating breakeven quantity, Q OBE.

Measures of Leverage

65 A company is considering a switch from an all-­equity capital structure to a

structure with equal amounts of equity and debt without increasing assets.
This change will reduce the net income by 30%. If the current return on equity
(ROE) is 10%, the ROE under the proposed capital structure will be closest to:
A 6%.
B 20%.
C 14%.

C is correct.

All Equity Half Equity and Debt

Net income Net income × (1 – 30%)

Equity = 100% × Assets Equity = 50% × Assets
ROE: ROE:
= Net income/equity = [Net income × (1 – 30%)]/Equity
= Net income/(100% × Assets) = [Net income × (1 - 30%)]/(50% × Assets)
= Net income/Assets = (Net income/Assets) × [(1 – 30%)/50%]
= 10% = 10% × 1.4 = 14%

Alternatively, looking at the effects of the changes in sequence:

When equity decreases by half, ROE would become 10%/0.50 = 20%.
When net income decreases by 30%, the adjusted ROE would become = 20% × (1 –
0.30) = 14%.
A is incorrect because it uses (Net Income × 30%) instead of (Net Income × [1 – 30%])
in the solution. (Net Income/Assets) × (30%/50%) = 10% × 0.6 = 6%.
2020 Level I Mock Exam (C) AM 37

B is incorrect because it does not adjust net income in the solution.

(Net Income/Assets)/50% = 20%

Measures of Leverage

66 Which is most likely considered a secondary source of liquidity?

A Centralized cash management system
B Trade credit
C Liquidating long-­term assets

C is correct. Liquidating long-­term assets is a secondary source of liquidity.

A is incorrect. Centralized cash management system is considered as a primary source
of liquidity.
B is incorrect. Trade credit (part of short-­term funds) is considered as a primary source
of liquidity.

Working Capital Management

67 For a 90-­day US Treasury bill selling at a discount, which of the following meth-
ods most likely results in the highest yield?
A Discount-­basis yield (DBY)
B Money market yield (MMY)
C Bond equivalent yield (BEY)

C is correct. Note: the face value is greater than the purchase price because the T-­Bill
sells at a discount.
Face value  Purchase price 360
DBY  
Face value Days to maturity

Face value  Purchase price 360

MMY   , MMY  DBY
Purchase price Days to maturity

Face value  Purchase price 365

BEY  
Purchase price Days to maturity
BEY  MMY  365 360, BEY  MMY  DBY
A is incorrect because bond equivalent yield is the highest yield by construction.
B is incorrect because bond equivalent yield is the highest yield by construction.

Working Capital Management

68 The following information is available for a firm in a developing country:

38 2020 Level I Mock Exam (C) AM

Risk-­free rate 2.0%

Firm’s equity beta 1.5
Equity risk premium in a developed country 3.0%
Developing country risk premium 4.0%
Sovereign yield spread 2.5%

The firm’s cost of equity using the CAPM approach is closest to:
A 10.5%.
B 12.5%.
C 10.3%.

B is correct. Cost of equity = Risk-­free rate + Equity beta × (Equity risk premium + Country
risk premium) = 0.02 + 1.5 × (0.03 + 0.04) = 12.5%.
C is incorrect. Uses sovereign yield spread instead of equity premium.
0.02 + 1.5 × (0.03 + 0.025) = 10.25%.
A is incorrect. The developing country risk premium is added:
0.02 + 1.5(0.03) + 0.04 = 10.5
Or
(0.03 + 0.04) × 1.5, ignoring the risk free rate

Cost of Capital

69 A company needs to nominate an independent director for its board of direc-

tors. The following candidates are being considered:
●● A retired senior management official of the company
●● A representative of a pension fund that owns 10% of the company’s shares
●● A former government employee who was involved in regulating the industry
Based on good corporate governance practices, which candidate is the most
appropriate nominee?
A The pension fund representative
B The retired senior management official
C The former government employee

C is correct. Independent directors must not have material relationships with the com-
pany with regard to employment, ownership, or remuneration. The former government
employee best meets these criteria.
B is incorrect. The retired senior management officer has been employed by the com-
pany and likely still receives remuneration from the company in the form of a pension. He
may also be reluctant to be critical of his own prior decisions or those of his co-­managers.
A is incorrect. The pension fund has a material ownership relationship with the com-
pany, so its representative cannot be considered independent.

Corporate Governance and ESG: An Introduction

2020 Level I Mock Exam (C) AM 39

70 A project has the following cash flows ($) where the cash inflows are earned
evenly throughout the year:
Year 0 Year 1 Year 2 Year 3 Year 4

–1,525 215 345 475 1,215

Assuming a discount rate of 11% annually, the discounted payback period (in
years) is closest to:
A 3.4.
B 3.9.
C 4.0.

B is correct. The discounted cash flows (CF) and their cumulative sum are:

Cumulative Cumulative Cash

Year Discounted CF Discounted CF Inflows

0 –1,525.00 –1,525.00
1 193.69 = 215/(1.11)1 –1,331.31 193.69
2 280.01 = 345/(1.11)2 –1,051.30 473.70
3 347.32 = 475/(1.11)3 –703.98 821.02
4 800.36 = 1,215/(1.11)4 96.38 1,621.38

After three years, $821.02 of the $1,525 investment is recovered leaving, $703.98 left
to recover in the fourth year. Proportionately, only 0.88 (= $703.98/$800.36) of the cash
flow in the fourth year is necessary to recover all of the investment, which makes the
discounted payback equal to 3.9 years (rounded up from 3.88).
A is incorrect. This is the calculation with the payback period, which is not discounted.
C is incorrect. Based on the above calculation, the discounted payback to 3.88 years,
the nearest round off value should be 3.9.

Capital Budgeting

71 In countries where employee representatives commonly sit on supervisory

boards, the employee representatives are most likely:
A appointed by the CEO.
B elected by employees.
C members of the management board.

B is correct. Employee representatives on supervisory boards are typically elected by

the employees.
A is incorrect. Employee representatives are typically elected by the employees.
C is incorrect. Employee representatives are usually part of the supervisory board,
not the management board.

Corporate Governance and ESG: An Introduction

40 2020 Level I Mock Exam (C) AM

72 Green finance is most likely an example of which ESG-­related investment

approach?
A Impact investing
B Negative screening
C Values-­based investing

A is correct. Green finance is an example of impact investing, which seeks to achieve

targeted social or environmental objectives by direct investment in projects or compa-
nies. Values-­based investing is used to express the moral or ethical beliefs of the investor.
Negative screening refers to the practice of excluding certain sectors or companies that
deviate from acceptable standards.
B is incorrect. Negative screening refers to the practice of excluding certain sectors
or companies that deviate from acceptable standards.
C is incorrect. Values-­based investing is used to express the moral or ethical beliefs
of the investor.

Corporate Governance and ESG: An Introduction

73 According to behavioral finance, observed overreaction in securities markets

most likely occurs because of:
A disposition effect.
B loss aversion.
C gambler’s fallacy.

B is correct. According to loss aversion–related arguments in behavioral theories, inves-

tors dislike losses more than they like comparable gains. Thus, such a behavioral bias
can explain observed overreaction in markets.
A is incorrect. Disposition effect is a behavioral bias in which investors tend to avoid
realizing losses but rather seek to realize gains.
C is incorrect. Gambler’s fallacy is a behavioral bias in which recent outcomes affect
investors’ estimates of future probabilities.

Market Efficiency

74 Forward contracts are most likely to be attractive hedging vehicles to investors

who:
A do not want to make an upfront outlay of cash.
B want to reserve the right to close out their position early.
C are not in a position to investigate the creditworthiness of their
counterparties.

A is correct. Most forward contracts do not require an upfront cash outlay. Other hedging
vehicles, such as futures (which require margin accounts) and options (which must be
purchased for a fee), do require upfront payments.
2020 Level I Mock Exam (C) AM 41

B is incorrect. Because forward contracts are custom agreements, it is difficult to find

another party who is both willing to take over the contract obligations and acceptable to
the existing counterparty. Futures would be more suitable in this circumstance because
they can be closed out early.
C is incorrect. Forward contracts are custom agreements that depend on each coun-
terparty’s knowledge of the creditworthiness of the other.

Market Organization and Structure

75 Compared with public equity markets, which of the following statements is

most accurate about private equity markets? Operating in the private market:
A offers stronger incentives to improve corporate governance.
B allows more opportunities to raise capital.
C allows management to better adopt a long-­term focus.

C is correct. The management of a public firm is under pressures to meet shorter-­term

demands, such as meeting quarterly sales and earnings projections from analysts. Private
owners are thus better able to focus on longer-­term value creation opportunities.
A is incorrect. By operating under public scrutiny, companies are incentivized to be
more open in terms of corporate governance and executive compensation to ensure
that they are acting for the benefit of shareholders.
B is incorrect because public equity markets are much larger than private ones.

Overview of Equity Securities

76 The type of voting in board elections that is most beneficial to shareholders

with a small number of shares is best described as:
A statutory voting.
B cumulative voting.
C voting by proxy.

B is correct. Cumulative voting allows shareholders to direct their total voting rights to
specific candidates, as opposed to having to allocate their voting rights evenly among all
candidates. Thus, applying all of the votes to one candidate provides the opportunity for a
higher level of representation on the board than would be allowed under statutory voting.
A is incorrect. In statutory voting, votes cannot be cast on a cumulative basis thereby
making it disadvantageous to investors with small number of shares to elect their pre-
ferred candidate(s) to the board.
C is incorrect. Voting by proxy allows a designated party—such as another shareholder,
a shareholder representative, or management—to vote on the shareholders’ behalf. By
itself it does not provide a benefit to small investors in board elections.

Overview of Equity Securities

77 Which of the following decisions most likely occurs as part of the index man-
agement phase of constructing and managing an index?
42 2020 Level I Mock Exam (C) AM

A How to identify which securities should be selected from the target market
B When to rebalance
C Which weighting method to use

B is correct. One of the decisions that must be made during the management phase
of constructing and managing an index is when to rebalance the index. Rebalancing is
necessary to maintain the weight of each security consistent with the index’s weighting
method.
A is incorrect. Identifying which securities to use from the target market is part of
deciding how to construct an index and not part of deciding how to manage it.
C is incorrect. Choosing the method of weighting to be used in the index is part of
the construction of an index process.

Security Market Indexes

78 Which of the following most accurately describes the basis for construction of
nearly all bond market indexes?
A Dealer prices
B Model prices
C Market prices

A is correct. Firms (dealers) are assigned to specific securities and are responsible for
creating liquid markets for those securities by purchasing and selling them from their
inventory. In addition, many securities do not trade frequently and, as a result, are rela-
tively illiquid. As a result, index providers must contact dealers to obtain current prices on
constituent securities to update the index, or they must estimate the prices of constituent
securities using the prices of traded fixed-­income securities with similar characteristics.
B is incorrect. Fixed-­income markets are predominantly dealer markets, and many
securities do not trade frequently.
C is incorrect. Many fixed-­income securities do not trade frequently. Though index
providers may estimate the prices of constituent securities using prices of traded fixed-­
income securities with similar characteristics, fixed-­income markets are predominantly
dealer markets.

Security Market Indexes

79 An industry characterized by rapidly increasing demand, improving profitabil-

ity, and falling prices is most likely in which of the following stages of life cycle?
A Growth
B Maturity
C Embryonic

A is correct. A growth industry tends to be characterized by rapidly increasing demand,

improving profitability, falling prices, and relativity low competition among companies
in the industry.
2020 Level I Mock Exam (C) AM 43

B is incorrect. During the maturity stage, industry growth tends to be limited to

replacement demand and population expansion because the market at this stage is
completely saturated.
C is incorrect. During the embryonic stage, demand growth is slow because customers
tend to be unfamiliar with the industry’s product and volumes are not yet sufficient to
achieve meaningful economic of scale.

Introduction to Industry and Company Analysis

80 Which of the following is least likely a primary reason a company would raise
capital through the issuance of equity securities? To:
A finance the purchase of long-­lived assets
B maximize the wealth of shareholders
C directly satisfy stock compensation plans

C is correct. In general, a company will utilize share buybacks to satisfy stock compen-
sation plans.
A is incorrect. In most cases, the capital that is raised is used to finance the purchase
of long-­lived assets, capital expansion projects, research and development, the entry
into new product or geographic regions, and the acquisition of other companies.
B is incorrect. The primary goal of raising capital is to finance the company’s revenue
generating activities in order to increase its net income and maximize the wealth of its
shareholders.

Overview of Equity Securities

81 Which of the following is the most appropriate reason for using a free cash flow
to equity (FCFE) model to value equity of a company?
A FCFE models provide more accurate valuations than the dividend discount
model.
B A firm’s borrowing activities could influence dividend decisions, but they
would not affect FCFE.
C FCFE is a measure of the firm’s dividend paying capacity.

C is correct. FCFE is a measure of the firm’s dividend-­paying capacity.

A is incorrect. The statement that FCFE models provide more accurate valuations
than the dividend discount models is not necessarily true. The appropriateness and the
effectiveness of a model depend on the firm characteristics and the analyst’s ability in
making predictions.
B is incorrect. A firm’s borrowing activities do impact FCFE, as in the expression:
FCFE = CFO – FCInv + Net borrowing.

Equity Valuation: Concepts and Basic Tools

44 2020 Level I Mock Exam (C) AM

82 An investor uses the following data and Gordon’s constant growth dividend
discount model to evaluate a company’s common stock. To estimate growth,
she uses the average of the
1 average value of the compounded annual dividend growth rate over the
period of 2006–2011, and
2 dividend payout ratio for the year 2011.
Year Earnings per Share Dividend per Share Return on Equity

2011 $3.20 $1.92 12%

2010 $3.60 $1.85 17%
2009 $2.44 $1.74 13%
2008 $2.08 $1.62 15%
2007 $2.76 $1.35 11%
2006 $2.25 $1.25 9%

If her required return is 15%, the stock’s intrinsic value is closest to:
A $30.14.
B $25.31.
C $23.71.

B is correct. V 0 = D 1/(r – g); First estimate the two growth rates.

1 Compound annual dividend growth rate over the period 2006–2011 =
1.25 × (1 + g)5 = 1.92
g = 8.96% ≈ 9%

2 Sustainable growth rate for the year 2011 using the dividend payout ratio:
b = earnings retention rate = (1 –
Dividend payout ratio)
= [1 – (1.92/3.20)] = 0.40
g = b × ROE; g = 0.40 × 12% = 4.8%

Average of the two approaches = (9 + 4.8)/2 = 6.90%

V 0 = D 1/(r – g)
= (1.92 × 1.069)/(0.15 – 0.069)
= 2.05/0.081 = $25.31
A is incorrect. It uses the payout ratio instead of the retention ratio in computing
sustainable growth rate: g = 0.60 × 12% = 7.2%;
Average of the two approaches = (9 + 7.2)/2 = 8.1%;
V0 = D1/(r – g) = $1.92(1.081)/(0.15 – 0.081) = $2.08/0.069 = $30.14
C is incorrect. It uses D 0 instead of D 1.
$1.92/(0.15 – 0.069) = $1.92/0.081 = $23.71

Equity Valuation: Concepts and Basic Tools

83 An investor gathers the following data.

2020 Level I Mock Exam (C) AM 45

Year Earnings per Share ($) Dividends per Share ($) ROE

2014 3.20 1.92 12%

2013 3.60 1.80 17%
2012 2.44 1.71 13%
2011 2.50 1.60 15%

To estimate the stock’s justified forward P/E, the investor prefers to use the
compounded annual earnings growth and the average of the payout ratios over
the relevant period (i.e., 2011–2014).
If the investor uses 11.5% as her required rate of return, the stock’s justified
forward P/E is closest to:
A 21.
B 10.
C 12.

A is correct.
P0/E1 = p/(r – g)
Earnings growth rate (g) over the period of 2011–2014 = 2.50(1 + g)3 = 3.20;
g = 8.6%.
Payout ratio (p) computation: for example, 2014: 1.92/3.20 = 0.60.
Average payout ratio = (0.60 + 0.50 + 0.70 + 0.64)/4 = 0.61.
P0/E1 = p/(r – g); = 0.61/(0.115 – 0.086) = 0.61/0.029 = 21.0.
B is incorrect. Uses dividend growth rate, not earnings growth rate.
Dividend growth rate over the period 2008–2011 = 1.92(1 + g)3 = 1.60; g =
6.3%
P/E1 = p/(r – g); = 0.61/(0.124 – 0.063) = 0.61/0.061 = 10.0
C is incorrect. It uses n = 4, not 3, for computing earnings growth rate.
Earnings growth rate = 2.50(1 + g)4 = 3.20; g = 6.4%
P/E1 = p/(r – g); = 0.61/(0.115 – 0.064) = 0.61/0.051 = 12.0

Equity Valuation: Concepts and Basic Tools

84 Which of the following is most likely classified as a defensive industry?

A A mature industry with government-­controlled pricing
B A non-­c yclical, high-­growth industry
C A cyclical industry with a few competitors

A is correct. A defensive industry is non-­c yclical with stable earnings. A mature industry
with government-­controlled pricing will have stable earnings and be non-­c yclical.
B is incorrect. A defensive industry will have stable earnings, not growing earnings.
46 2020 Level I Mock Exam (C) AM

C is incorrect, A defensive industry is non-­c yclic.

Introduction to Industry and Company Analysis

85 Relative to the industry, which company’s ratios show the most contradictory
results?
A Company A
B Company B
C Company C

C is correct. The P/S and P/BV multiples for Company C are above the industry averages,
but the P/E and P/CF multiples are below the industry averages. In contrast, all of the
price multiples for Company A are above the industry averages, providing for a more
uniform level of consistency in Company A’s valuation multiples. Similarly, all of the price
multiples for Company B are below the industry averages, showing a more uniform level
of consistency in Company B’s valuation multiples. Therefore, Company C’s valuation
multiples show the most contradictory results.
A is incorrect because all of the price multiples for Company A are above the industry
averages, providing for a more uniform level of consistency in Company A’s valuation
multiples than Company A.
B is incorrect because all of the price multiples for Company B are below the industry
averages, providing for a more uniform level of consistency in Company B’s valuation
multiples than Company A.

Equity Valuation: Concepts and Basic Tools

86 A BBB rated corporation wishes to issue debt to finance its operations at the
lowest cost possible. If it decides to sell a pool of receivables into a special pur-
pose vehicle (SPV), its primary motivation is most likely to:
A receive a guaranty from the SPV to improve the corporation’s credit rating.
B allow the corporation to retain a first lien on the assets of the SPV.
C segregate the assets into a bankruptcy-­remote entity for bondholders.

C is correct. A key motivation for a corporation to establish a SPV is to separate it as a

legal entity. In the case of bankruptcy for the corporation, the SPV is unaffected because
it is not a subsidiary of the corporation. Given this arrangement, the SPV can achieve a
rating as high as AAA and borrow at lower rates than the corporation.
A is incorrect because the SPV does not receive a guaranty.
B is incorrect because the corporation does have a lien on those assets.

Fixed-­Income Securities: Defining Elements

87 An investor purchases the bonds of JLD Corp., which pay an annual coupon of
10% and mature in 10 years, at an annual yield to maturity of 12%. The bonds
will most likely be selling at:
A par.
2020 Level I Mock Exam (C) AM 47

B a premium.
C a discount.

C is correct. The coupon rate on the bonds is lower than the yield to maturity, implying that
the bonds should be selling at a price lower than their par value—that is, at a discount.
A is incorrect because the bonds will sell at par if the coupon rate on the bonds is
equal to the yield to maturity.
B is incorrect because the bonds will sell at a premium if the coupon rate on the bonds
is higher than the yield to maturity.

Introduction to Fixed-­Income Valuation

88 In the securitization process, which of the following is most likely a third party
to the transaction? The:
A seller of the collateral.
B special purpose entity.
C financial guarantor.

C is correct. In the securitization process, the seller of the collateral, the special purpose
entity, and the servicer of the loan are the main parties. All other parties, including
independent accountants, lawyers/attorneys, trustees, underwriters, rating agencies,
and financial guarantors are third parties to the transaction.
A is incorrect because in the securitization process the seller of the collateral is one
of the main parties to the transaction.
B is incorrect because in the securitization process the special purpose entity is one
of the main parties to the transaction.

Introduction to Asset-­Backed Securities

89 Which of the following is the best example of an embedded option granted to

bondholders?
A An increasing sinking fund provision
B A prepayment option
C A put if the issuer’s rating changes

C is correct. A put allows the bondholder to sell the security back to the issuer if the
bondholder chooses to do so.
A is incorrect because this is an embedded option granted to the issuer who can call
more than is necessary to meet the sinking fund requirement.
B is incorrect because this is an embedded option granted to the issuer who can call
a portion of the issue.

Fixed-­Income Securities: Defining Elements

48 2020 Level I Mock Exam (C) AM

90 A 90-­day commercial paper issue is quoted at a discount rate of 4.75% for a

360-­day year. The bond equivalent yield for this instrument is closest to:
A 4.87%.
B 4.81%.
C 4.75%.

A is correct. The price of the commercial paper per 100 of par value is
 Days 
PV  FV  1   DR
 Year 
where PV and FV are the price and face value of the money market instrument, Days
is the number of days between settlement and maturity, Year is number of days in the
year, and DR is the discount rate stated as an annual percentage.
 90 
PV  100  1   0.0475  98.8125
 360 
The bond equivalent yield is
Year  FV  PV 
AOR   
Days  PV 
365 100  98.8125 
  
90  98.8125 
 4.874%
B is incorrect because the price of the commercial paper is incorrectly computed as
 90 
PV  100  1   0.0475  98.8288
 365 
The bond equivalent yield is computed as
Year  FV  PV 
AOR   
Days  PV 
365 100  98.8288 
  
90  98.8288 
 4.806%
C is incorrect because it is just the discount rate itself.

Introduction to Fixed-­Income Valuation

91 AMK Corp. purchased US government bonds through the Bloomberg fixed-­

income electronic trading platform. This transaction is most likely known as:
A exchange traded.
B private placement.
C over-­the-­counter.

C is correct. In the over-­the-­counter market, buy and sell orders initiated from various
locations are matched through a communication network, such as the Bloomberg fixed-­
income electronic trading platform.
2020 Level I Mock Exam (C) AM 49

A is incorrect because exchanged-­traded deals are transacted through the exchange

according to the rules imposed by the exchange.
B is incorrect because private placement is a form of primary markets instead of
secondary markets for bonds.

Fixed-­Income Markets: Issuance, Trading, and Funding

92 A measure of a bond’s price sensitivity to a change in the benchmark yield

curve at a specified maturity segment best describes:
A OAS duration.
B key rate duration.
C modified duration.

B is correct. Key rate duration (or partial duration) is a measure of a bond’s sensitivity to
a change in the benchmark yield curve at a specific maturity segment. Key rate duration
helps identify a bond’s “shaping risk” sensitivity to non-­parallel (steepening or flattening)
movements in the yield curve.
A is incorrect because OAS (option-­adjusted spread) duration is an effective duration
measure derived from an option-­pricing model that is also used to calculate a bond’s
option-­adjusted spread. OAS duration recognizes that when the par curve is shifted
parallel in the model, the government spot curve is also shifted, but not in the same
parallel manner as the par curve. While OAS duration does capture this curve shift nuance
between the par and spot curves, it does not measure a bond’s sensitivity to changes in
the shape of the benchmark yield curve at a specific maturity segment.
C is incorrect because modified duration is a yield duration measure of a bond’s price
sensitivity to changes in its own yield to maturity rather than to changes in a benchmark
yield curve.

Understanding Fixed-­Income Risk and Return

93 Calculating portfolio duration as the weighted average of time to receipt of the

aggregate cash flows:
A accommodates portfolios that include callable bonds.
B facilitates the evaluation of the effect of benchmark yield changes on portfo-
lio value.
C results in a theoretically correct but less commonly used measure of portfo-
lio interest rate risk.

C is correct. Portfolio duration calculated as the weighted average of time to receipt of

the aggregate cash flows is the theoretically correct approach but is not commonly used
by portfolio managers in practice due to computation and application issues. Portfolio
duration calculated as the weighted average of individual bond durations is more
commonly used but results in an approximation of the theoretically correct approach.
A is incorrect because calculating portfolio duration as the weighted average of
time to receipt of aggregate cash flows depends on portfolio cash flow certainty to be
effective. Portfolios that contain callable or putable bonds or floating-­rate notes lack
requisite cash flow certainty for this measure of portfolio duration to be meaningful.
50 2020 Level I Mock Exam (C) AM

B is incorrect because portfolio duration calculated as the weighted average of time

to receipt of aggregate cash flows measures the percentage change in portfolio value
given a change in cash flow yield (the portfolio’s internal rate of return). Changes in the
cash flow yield are not necessarily the same as changes in the yield to maturity. Fixed-­
income managers more commonly interpret interest rate risk relative to changes in
benchmark yields rather than the portfolio’s cash flow yield.

Understanding Fixed-­Income Risk and Return

94 When a bond investor’s coupon reinvestment risk dominates market price risk,
the investor’s investment horizon must be:
A less than the Macaulay duration of the bond.
B equal to the Macaulay duration of the bond.
C greater than the Macaulay duration of the bond.

C is correct. When the investment horizon is greater than the Macaulay duration of the
bond, coupon reinvestment risk dominates market price risk and the investor is at risk
of lower interest rates.
A is incorrect because when the investment horizon is less than the Macaulay duration
of the bond, market price risk dominates coupon reinvestment risk and the investor is
at risk of higher interest rates.
B is incorrect because when the investment horizon is equal to the Macaulay duration
of the bond, coupon reinvestment risk offsets market price risk.

Understanding Fixed-Income Risk and Return

95 Which of the following is the least likely reason a company would issue subor-
dinated debt? Subordinated debt is less:
A expensive than equity.
B restrictive than secured debt.
C expensive than senior debt.

C is correct. Issuing subordinated debt is costlier than issuing secured debt because of
the increased credit risk inherent in its lower priority of claims.
A is incorrect. Issuing subordinated debt is less expensive than issuing equity because
debtholders require a lower return than equityholders require. Debtholders have a
higher priority of claim in the event of default, which is why they accept a lower return
on investment.
B is incorrect. Subordinated debt is typically less restrictive than senior debt.

Fundamentals of Credit Analysis

96 The following table shows selected data from a company’s cash flow statement:
2020 Level I Mock Exam (C) AM 51

2018

Net income $516

Depreciation $88
Amortization $66
Change in working capital –$44
Additions to property and equipment –$62
Proceeds from sale of property and equipment $8

The company’s free cash flow before dividends is closest to:

A 572.
B 660.
C 696.

B is correct. Free cash flow before dividends is calculated as net income (excluding
non-­recurring charges) plus depreciation and amortization minus the increase (plus
the decrease) in working capital minus capital expenditures. It is, depending on the
treatment of dividends and interest in the cash flow statement, approximated by the
cash flow from operating activities minus capital expenditures.
FCF = 516 + 88 + 66 + 44 – 62 + 8 = 660.
A is incorrect. It incorrectly subtracts the change in working capital. Free cash flow
before dividends is calculated as net income (excluding non-­recurring charges) plus
depreciation and amortization minus the increase (plus the decrease) in working capital
minus capital expenditures.
FCF = 516 + 88 + 66 – 44 – 62 + 8 = 572.
C is incorrect. It incorrectly adds capital expenditures. Free cash flow before dividends
is calculated as net income (excluding non-­recurring charges) plus depreciation and
amortization minus the increase (plus the decrease) in working capital minus capital
expenditures.
FCF = 516 + 88 + 66 – 44 + 62 + 8 = 696.

Fundamentals of Credit Analysis

97 An asset-­backed securitization with a waterfall structure is most likely using

which type of credit enhancement?
A Subordination
B Time tranching
C Special-­purpose entity (SPE)

A is correct. Asset-­backed securitizations can be structured with subordinated bond

classes. They function as credit protection for the more senior bond classes; that is, losses
are realized by the subordinated bond classes before any losses are realized by the senior
bond classes. This type of protection is also commonly referred to as a waterfall structure
because of the cascading flow of payments between bond classes in the event of default.
52 2020 Level I Mock Exam (C) AM

The creation of bond classes that possess different expected maturities is referred to as
time tranching. An SPE is a bankruptcy remote legal entity that holds the collateral and is
considered not an enhancement but, rather, a prerequisite for establishing securitizations.
B is incorrect. The creation of bond classes that possess different expected maturities
is referred to as time tranching.
C is incorrect. An SPE is a bankruptcy remote legal entity that holds the collateral and is
considered not an enhancement but, rather, a prerequisite for establishing securitizations.

Introduction to Asset-­Backed Securities

98 An investor purchases a 30-­year, 5% annual pay bond at 86.24 and plans to sell
it in 11 years. Immediately after purchase, interest rates increase by 1%, and
they remain at that level until maturity. Assuming coupons are reinvested at the
new yield, the investor’s realized horizon yield is closest to:
A 5.67%.
B 6.0%.
C 6.13%.

A is correct. Total return is determined by adding the return from reinvested coupons
to the sales price of the bond when you sell in 11 years.
First, determine the current yield to maturity by using either the annuity or bond
function on your financial calculator.
Using the annuity function:

N = 30.
PMT = 5.
PV = –86.24.
FV = 100.
CPT I/Y = 6.0%.
Since interest rates increased by 1% immediately after purchase, the reinvested cou-
pons are compounded at 7% for 11 years.
Using the annuity function, solve for FV:

N = 11.
I/Y = 7%.
PV = 0.
PMT = –5.
CPT FV = 78.92.
After the bond is sold in 11 years, there are 19 years remaining until maturity. The sale
price is determined by using the annuity or bond function on your calculator.

N = 19.
I/Y = 7%.
PMT = –5.
FV = –100.
CPT PV = 79.33.
2020 Level I Mock Exam (C) AM 53

Total return is 158.25(78.92 + 79.33), resulting in a realized 11-­year rate of return of

5.67%.
158.25
86.24 
1  r11
r = 0.0567.
B is incorrect. It is the result of using the original yield to maturity (6%) and failing to
adjust for the interest rate increase.
C is incorrect. It is the result of incorrectly calculating the bond sale price using 9,
rather than 19, years remaining until maturity.

Understanding Fixed-­Income Risk and Return

99 All else equal, interest rate risk is lowest for which of the following non-­callable
bonds?
A Discount
B Premium
C Zero-­coupon

B is correct. All else equal, high-­coupon bonds have less interest rate risk (lower duration)
than low-­coupon bonds. Therefore, a bond trading at a premium will have lower interest
rate risk than a comparable zero-­coupon or discount bond.
C is incorrect. All else equal, lower-­coupon bonds have higher durations and more
interest rate risk, so a zero-­coupon bond would have the highest interest rate risk.
A is incorrect. All else equal, lower-­coupon bonds have higher durations and more
interest rate risk, so a discount bond would have higher interest rate risk than a com-
parable premium bond.

Understanding Fixed-­Income Risk and Return

100 According to put–call–forward parity, if the put in a protective put with for-
ward contract expires out of the money, the payoff is most likely equal to:
A the market value of the underlying asset.
B zero.
C the face value of a risk-­free bond.

A is correct. A protective put with forward contract is defined as a long position in (1) a
bond that has the face value equal to the forward contract, (2) a forward contract, and
(3) a long position in a put. If the put expires out of the money, the value of the overall
position is equal to the market value of the asset.

+ F0(t) (payoff of bond)

+ ST – F0(t) (payoff of forward)
+0 (payoff of option)
= ST (payoff of strategy)
54 2020 Level I Mock Exam (C) AM

B is incorrect. Zero is the payoff of the put alone. This ignores the other positions in
the strategy.
C is incorrect. The face value of the risk-­free bond is the payoff of the protective put
with forward contract if the put expires in the money

Basics of Derivative Pricing and Valuation

101 Which of the following is least likely one of the main benefits of derivative mar-
kets? Derivative markets:
A exhibit lower volatility compared with the spot market.
B enable companies to more easily practice risk management.
C reveal prices and volatility of the underlying assets.

A is correct. Derivative markets are not necessarily more or less volatile than spot markets.
Derivative markets reveal prices and volatilities of the underlying assets and facilitate
risk management.
B is incorrect. One of the main purposes of derivative markets is risk management
C is incorrect. One of the main purposes of derivative markets is price discovery.

Derivative Markets and Instruments

102 Replication is most likely used to:

A reduce portfolio risk.
B increase leverage.
C exploit pricing differentials.

C is correct. Replication is the process of creating an asset or portfolio from another asset,
portfolio, and/or derivative. It is used to exploit pricing differentials.
A is incorrect. Replication is not a technique used to reduce portfolio risk. Other
techniques such as hedging or diversification are used to lower portfolio risk.
B is incorrect. Replication is not a technique used to increase leverage.

Basics of Derivative Pricing and Valuation

103 The value of a long position in a forward contract at expiration is best defined
as:
A forward price agreed in the contract minus spot price of the underlying.
B spot price of the underlying minus forward price agreed in the contract.
C value of the forward at initiation minus spot price of the underlying.

B is correct. The value of a long position in a forward contract at expiration is defined as

spot price of the underlying minus forward price agreed in the contract.
A is incorrect. This is the value of a short position.
2020 Level I Mock Exam (C) AM 55

C is incorrect. The value of a long position in a forward contract does not depend on
the value of the forward at initiation.

Basics of Derivative Pricing and Valuation

104 Exercise of a European put option is most likely justified if:

A the option is out of the money.
B the exercise price exceeds the value of the underlying.
C the exercise value is negative.

B is correct. If the exercise price exceeds the value of the underlying at expiration, the
option has positive exercise value and may be exercised.
A is incorrect. An out-­of-­the-­money option should not be exercised and will expire
worthless.
C is incorrect. An option that generates a negative cash flow when exercised should
not be exercised.

Basics of Derivative Pricing and Valuation

105 A swap that involves the exchange of a fixed payment for a floating payment is
most likely equivalent to a series of:
A off-­market forward contracts.
B forward contracts that all have an initial positive value.
C forward contracts that all have an initial value equal to the fixed payment.

A is correct. Because the cost of carrying an asset over different time periods will vary,
the values of the implicit forward contracts embedded in the swap will not be equal:
some may be positive, and some may be negative. Off-­market forward contracts satisfy
this condition because they can be set at any value.
B is incorrect. Because the initial market value of the swap is zero by definition, it
cannot be replicated by a series of forward contracts with an initial positive value.
C is incorrect. Because the cost of carrying an asset over different time periods will vary,
the prices of the implicit forward contracts embedded in the swap cannot all be equal.

Basics of Derivative Pricing and Valuation

106 The price of a pay-­fixed receive-­floating interest rate swap is most likely:
A the fixed rate that results in a market value of zero for the swap at initiation.
B the present value of the floating-­rate payments minus the present value of
the fixed-­rate payments.
C the sum of the fixed-­rate payments minus the sum of the floating-­rate
payments.
56 2020 Level I Mock Exam (C) AM

A is correct. The price of the swap is the fixed rate on the swap at the start of the trans-
action such that the present value of fixed payments is equal to the present value of the
floating payments and the market value of the swap is zero.
B and C are incorrect. These calculations provide the market value of the swap to
one of the parties.

Basics of Derivative Pricing and Valuation

107 An alternative investments fund that uses leverage and takes long and short
positions in securities is most likely a:
A leveraged buyout fund.
B hedge fund.
C venture capital fund.

B is correct. Hedge funds invest in securities and may take long and short positions.
They may also use leverage.
A is incorrect. Leveraged buyout funds make equity investments in established
companies
C is incorrect. Venture capital funds provide capital to start-­up firms with high growth
potential.

Introduction to Alternative Investments

108 Which of the following infrastructure investments would most likely be easiest
to value? A:
A master limited partnership holding greenfield investments.
B master limited partnership holding brownfield investments.
C private equity fund holding brownfield investments.

B is correct. A master limited partnership (MLP) is publicly traded, whereas a private

equity fund is not. Therefore the MLP will have market pricing information to help with
valuation. A brownfield investment is an existing asset that likely has operational and
financial history to aid in valuation; a greenfield investment is in new construction.
A is incorrect because greenfield investments have no operational or financial history
to aid in valuation, whereas brownfield investments do.
C is incorrect because master limited partnerships are publicly traded, with market
pricing data available for valuation purposes, whereas private equity funds are not.

Introduction to Alternative Investments

109 Investors look at many key due diligence factors when investing in hedge funds.
Which of the following factors is most likely the biggest challenge to fully
assess?
A Investment strategy and process
2020 Level I Mock Exam (C) AM 57

B Size and longevity

C Track record

A is correct. The investment strategy and process of a hedge fund is likely to be challeng-
ing to fully assess because hedge funds often limit disclosure in order to maintain their
competitive advantage and to not give away information that is considered proprietary.
B is incorrect because the size and longevity of a hedge fund are common items for
review and not as difficult to obtain as proprietary information.
C is incorrect because a hedge fund’s track record should be readily available to
investors.

Introduction to Alternative Investments

110 When the futures price of a commodity exceeds the spot price, the commodity
market is most likely in:
A contango.
B backwardation.
C carry.

A is correct. When a commodity market is in contango, futures prices are higher than
spot prices. When spot prices are higher than the futures price, the market is said to be
in backwardation.
B is incorrect because backwardation is the opposite of contango; the futures price
is below the spot price.
C is incorrect because carry refers to storage plus interest costs. It does not say any-
thing about futures prices relative to spot prices.

Introduction to Alternative Investments

111 A real estate investor looking for equity exposure in the public market is most
likely to invest in:
A real estate limited partnerships.
B shares of real estate investment trusts.
C collateralized mortgage obligations.

B is correct. Shares in real estate investment trusts are publicly traded and represent an
equity investment in real estate.
A is incorrect. Real estate limited partnerships are an example of a private real estate
investment.
C is incorrect. A collateralized mortgage obligation is an example of debt-­based
exposure to real estate.

Introduction to Alternative Investments

58 2020 Level I Mock Exam (C) AM

112 Investors in alternative assets who seek liquidity are most likely to invest in:
A hedge funds.
B real estate investment trusts.
C private equity.

B is correct. Real estate investment trusts are publicly traded and thus provide liquidity.
A is incorrect. Hedge funds may have long lockup periods.
C is incorrect. Private equity funds may have long lockup periods.

Introduction to Alternative Investments

113 A hedge fund with $225 million of initial capital charges a management fee of
1% and an incentive fee of 10%. The management fee is based on assets under
management at year-­end, and the incentive fee is calculated independently from
the management fee. Assuming the fund earns a 15% return at year-­end, total
fees earned by the hedge fund during the year are closest to:
A $5.96 million.
B $5.70 million.
C $5.63 million.

A is correct. Total fees earned by the hedge fund are closest to $5.96 million:

Year-­end value = $225 million × 1.15 = $258.75 million

Management fee = Year-­end value × Management fee %
 = $258.75 million × 1% = $2.5875 million
Incentive fee = (Year-­end value – Beginning value) × Incentive fee %
 = ($258.75 million – $225 million) × 10% =
$3.375 million
Total fees = Management fee + Incentive fee
 = $2.5875 million + $3.375 million = $5.9625 million =
$5.96 million
C is incorrect because $5.63  million results from calculating the management fee
based on assets under management at the beginning of the period, rather than the
end of the period:

Year-­end value = $225 million × 1.15 = $258.75 million

Management fee = Beginning value × Management fee %
 = $225 million × 1% = $2.25 million
Incentive fee = (Year-­end value – Beginning value) × Incentive fee %
 = ($258.75 million – $225 million) × 10% =
$3.375 million
Total fees = Management fee + Incentive fee
 = $2.25 million + $3.375 million = $5.625 million =
$5.63 million
2020 Level I Mock Exam (C) AM 59

B is incorrect because $5.70 million represents the total fees earned if the incentive
fee was calculated net of the management fee as opposed to independently from the
management fee:

Year-­end value = $225 million × 1.15 = $258.75 million

Management fee = Year-­end value × Management fee %
 = $258.75 million × 1% = $2.5875 million
Incentive fee = (Year-­end value – Beginning value – Management fee)
× Incentive fee %
 = ($258.75 million – $225 million – $2.5875 million) ×
10% = $3.1163 million
Total fees = Management fee + Incentive fee
 = $2.5875 million + $3.1163 million = $5.7038 million =
$5.70 million

Introduction to Alternative Investments

114 A technical analyst has detected a price chart pattern with three segments. The
left segment shows a decline followed by a reversal to the starting price level.
The middle segment shows a more pronounced decline than in the first seg-
ment and again a reversal to near the starting price level. The third segment is
roughly a mirror image of the first segment. This chart pattern is most accu-
rately described as:
A a triple bottom.
B an inverse head and shoulders.
C a head and shoulders.

B is correct. An inverse head and shoulders pattern consists of a left segment (left
shoulder) that shows a decline followed by a reversal to the starting price level; a middle
segment (head) that shows a more pronounced decline than in the first segment and
again a reversal to near the starting price level; and a third segment (right shoulder) that
is roughly a mirror image of the first segment.
A is incorrect. Triple bottoms consist of three troughs at roughly the same price level.
C is incorrect. A head and shoulders pattern consists of a left segment (left shoulder)
that shows a rally followed by a reversal to the starting price level; a middle segment
(head) that shows a more pronounced rally than in the first segment and again a reversal
to near the starting price level; and a third segment (right shoulder) that is roughly a
mirror image of the first segment.

Technical Analysis

115 A portfolio manager decides to temporarily invest more of a portfolio in equi-

ties than the investment policy statement prescribes because he expects equities
will generate a higher return than other asset classes. This decision is most likely
an example of:
A rebalancing.
B tactical asset allocation.
C strategic asset allocation.
60 2020 Level I Mock Exam (C) AM

B is correct. Tactical asset allocation is the decision to deliberately deviate from the policy
exposures to systematic risk factors with the intent to add value based on forecasts of
the near-­term returns of those asset classes.
A is incorrect. Rebalancing is the process of returning to the strategic asset allocation.
C is incorrect. Strategic asset allocation is the set of exposures to IPS-­permissible asset
classes that is expected to achieve the client’s long-­term objectives given the client’s
investment constraints.

Basics of Portfolio Planning and Construction

116 Based on the capital asset pricing model (CAPM), the expected return on FGL
Corp’s shares is 12%. Using a model independent of the CAPM, an analyst has
estimated the returns on the stock at 10%. Based on this information, the ana-
lyst is most likely to consider the stock to be:
A overvalued.
B correctly valued.
C undervalued.

A is correct. Because the estimated return on the stock is lower than the expected return
using the CAPM, the stock does not compensate the investor for the level of risk and so
it is most likely overvalued.
B is incorrect. Because the estimated return on the stock is lower than the expected
return using the CAPM, the stock does not compensate the investor for the level of risk
and so it is most likely overvalued (not correctly valued).
C is incorrect. Because the estimated return on the stock is lower than the expected
return using the CAPM, the stock does not compensate the investor for the level of risk
and so it is most likely overvalued (not undervalued).

Portfolio Risk and Return: Part II

117 Information about a portfolio that consists of two assets is provided below:
Asset Portfolio Weight Standard Deviation

A 25% 12%
B 75% 16%

If the correlation coefficient between the two assets is 0.75, the standard devia-
tion of the portfolio is closest to:
A 15.00%.
B 12.37%.
C 14.39%.

C is correct.
[(0.252 × 0.122) + (0.752 × 0.162) + (2 × 0.25 × 0.75 × 0.12 × 0.16 × 0.75)]0.5 =
0.1439 = 14.39%
2020 Level I Mock Exam (C) AM 61

A is incorrect. It omits the correlation coefficient in calculating the standard deviation:

[(0.252 × 0.122) + (0.752 × 0.162) + (2 × 0.25 × 0.75 × 0.12 × 0.16)]0.5 = 0.15 = 15%, which is
the weighted average standard deviation.
B is incorrect. It omits the third term in the formula in calculating the standard devi-
ation: [(0.252 ××0.122) + (0.752 × 0.162)]0.5 = 0.1237 = 12.37%.

Portfolio Risk and Return: Part I

118 ABC Fund invests in Singapore’s government debt with maturities up to three
months. It is most likely classified as a:
A fixed-­income arbitrage fund.
B money market fund.
C bond mutual fund.

B is correct. Money market funds invest in short-­term corporate or government debt.

The difference between a bond mutual fund and a money market fund is the maturity
of the underlying assets. In a money market fund, the maturity is as short as overnight
and rarely longer than 90 days.
A is incorrect because a fixed-­income arbitrage fund attempts to profit from arbitrage
opportunities in interest rate securities.
C is incorrect because bond mutual funds hold bonds with maturities as short as one
year and as long as 30 years.

Portfolio Management, An Overview

119 A top-­down process that offers guidance and directs activities that seek to max-
imize the value of an enterprise is most likely an element of:
A risk governance.
B risk infrastructure.
C risk monitoring and mitigation.

A is correct. Risk governance is the top-­down process and guidance that directs risk
management activities to align with and support the overall enterprise.
B is incorrect. Risk infrastructure refers to the people and systems required to track risk
exposures and to perform quantitative risk analysis to allow assessment of a risk profile.
C is incorrect. Active risk monitoring and mitigation requires pulling together risk
governance, identification, measurement, infrastructure, policies, and procedures and
continually reevaluating in the face of changing risk exposures and risk drivers.

Risk Management: An Introduction

120 Which of the following errors would most likely be a result of overfitting a
machine learning model?
A Inability to recognize relationships within the training data
B A predictive model that treats true parameters as if they are noise
C The discovery of unsubstantiated patterns that lead to prediction errors
62 2020 Level I Mock Exam (C) AM

C is correct. Overfitting a model can lead to the discovery of unsubstantiated patterns

that lead to prediction errors and incorrect output forecasts.
A is incorrect. The inability to recognize relationships within the training data most
likely results from underfitting the model.
B is incorrect. The development of a predictive model that treats true parameters as
if they are noise is most likely a result of underfitting the model.

Fintech in Investment Management