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CFA Level I practice questions

50 free exam-style questions across every topic area, each with the answer and the reasoning behind it.

How to use this page

50 questions, 5 for each topic area, written in the style of the CFA® Level I exam. Pick an answer before you open the explanation; the reasoning matters more than the letter. Topics follow the published topic weights.

Ethical & Professional Standards

10–15% of the exam

The Code, the seven Standards, and how examiners phrase violations.

Question 1

A member works in a jurisdiction whose regulation permits front-running client orders. The Code and Standards prohibit it. The member must:

  1. AFollow local law
  2. BFollow the stricter Code and Standards
  3. CDisclose the practice and proceed
  4. DSeek written employer approval
Show the answer

B. Follow the stricter Code and Standards

Members follow the most strict of applicable law, the Code and the Standards. Less strict local law never lowers the bar.

Curriculum area: Standard I(A) — Knowledge of the Law

Question 2

An analyst accepts a paid consulting role outside her firm without informing her employer. She has most likely violated:

  1. AStandard III(A) Loyalty, Prudence and Care
  2. BStandard IV(B) Additional Compensation Arrangements
  3. CStandard V(A) Diligence and Reasonable Basis
  4. DNo standard, because the work is outside the firm
Show the answer

B. Standard IV(B) Additional Compensation Arrangements

Additional compensation arrangements that could conflict with the employer's interest require written consent from all parties involved.

Curriculum area: Standard IV(B) — Additional Compensation Arrangements

Question 3

A member publishes a research summary that omits the fact that his firm holds an 8% beneficial ownership stake in the issuer. This most likely violates:

  1. AStandard VI(A) Disclosure of Conflicts
  2. BStandard II(B) Market Manipulation
  3. CStandard III(D) Performance Presentation
  4. DStandard VII(A) Conduct as Participants
Show the answer

A. Standard VI(A) Disclosure of Conflicts

Beneficial ownership that could reasonably impair independence must be disclosed prominently. Omitting it breaches Standard VI(A).

Curriculum area: Standard VI(A) — Disclosure of Conflicts

Question 4

Which action best satisfies Standard V(B), Communication with Clients and Prospective Clients?

  1. APresenting projections as assured outcomes
  2. BDistinguishing between fact and opinion
  3. COmitting the process used to reach the conclusion
  4. DReporting only the recommendations that performed well
Show the answer

B. Distinguishing between fact and opinion

Members must distinguish fact from opinion and describe the basic process by which conclusions were reached, including its limitations.

Curriculum area: Standard V(B) — Communication with Clients

Question 5

A portfolio manager recommends a security after reading a single sell-side note and performing no further work. The security subsequently performs well. The manager has:

  1. ANot violated the Standards, because the result was favourable
  2. BViolated Standard V(A) regardless of the outcome
  3. CViolated Standard III(A) only if a client lost money
  4. DViolated Standard I(C) Misrepresentation
Show the answer

B. Violated Standard V(A) regardless of the outcome

Standard V(A) requires a reasonable and adequate basis supported by appropriate research. The outcome is irrelevant — the process is what is judged.

Curriculum area: Standard V(A) — Diligence and Reasonable Basis

Quantitative Methods

11–14% of the exam

Returns and benchmarks, time value, distributions, portfolio maths, regression.

Question 6

An investment offers a stated annual rate of 8% compounded quarterly. The effective annual rate is closest to:

r = 8% · m = 4
  1. A8.00%
  2. B8.24%
  3. C8.30%
  4. D8.33%
Show the answer

B. 8.24%

EAR = (1 + 0.08/4)⁴ − 1 = 1.02⁴ − 1 = 8.243%. More frequent compounding always raises the effective rate above the stated rate.

Curriculum area: Quantitative Methods — Types of Financial Returns

Question 7

A researcher rejects the null hypothesis at the 5% significance level when the null is in fact true. This is best described as:

  1. AA Type I error
  2. BA Type II error
  3. CA power failure
  4. DA specification error
Show the answer

A. A Type I error

Rejecting a true null is a Type I error, and its probability equals the significance level chosen. Failing to reject a false null is Type II.

Curriculum area: Quantitative Methods — Estimation and Hypothesis Testing

Question 8

A sample of 25 monthly returns has a mean of 1.2% and a standard deviation of 3.0%. The standard error of the sample mean is closest to:

x̄ = 1.2% · s = 3.0% · n = 25
  1. A0.12%
  2. B0.60%
  3. C3.00%
  4. D1.20%
Show the answer

B. 0.60%

The standard error is s/√n = 3.0%/5 = 0.60%. It falls with the square root of sample size, not with sample size itself.

Curriculum area: Quantitative Methods — Estimation and Hypothesis Testing

Question 9

In a simple linear regression the coefficient of determination is 0.64. The correlation between the dependent and independent variable is:

R² = 0.64
  1. A0.41
  2. B0.64
  3. C0.80 in absolute value
  4. D1.28
Show the answer

C. 0.80 in absolute value

In simple linear regression R² is the squared correlation, so |r| = √0.64 = 0.80. The sign follows the sign of the slope coefficient.

Curriculum area: Quantitative Methods — Applications of Simple Linear Regression in Finance

Question 10

Which measure of central tendency is most appropriate for describing a compound annual growth rate over multiple periods?

  1. AArithmetic mean
  2. BGeometric mean
  3. CHarmonic mean
  4. DMode
Show the answer

B. Geometric mean

The geometric mean accounts for compounding and gives the constant rate that reproduces the ending value. It is always ≤ the arithmetic mean.

Curriculum area: Quantitative Methods — Statistical Characteristics of Asset Returns

Economics

6–9% of the exam

Market structures, business cycles, policy, trade and exchange rates.

Question 11

A firm faces a downward-sloping demand curve and sells a differentiated product with many close substitutes and low barriers to entry. This market is best characterised as:

  1. APerfect competition
  2. BMonopolistic competition
  3. COligopoly
  4. DMonopoly
Show the answer

B. Monopolistic competition

Product differentiation with many sellers and easy entry defines monopolistic competition. Long-run economic profit is competed away to zero.

Curriculum area: Economics — The Firm and Market Structures, LOS 1.b

Question 12

The inventory–sales ratio rises sharply. This most likely indicates the economy is:

  1. AEntering an expansion
  2. BEntering a contraction
  3. CAt a cyclical trough
  4. DUnaffected — the ratio is not cyclical
Show the answer

B. Entering a contraction

Sales fall before firms cut production, so unsold inventory builds up. A rising inventory–sales ratio is a classic early-contraction signal.

Curriculum area: Economics — Understanding Business Cycles, LOS 2.b

Question 13

The spot USD/EUR rate is 1.1000. The one-year US interest rate is 5% and the euro rate is 3%. The one-year forward USD/EUR rate implied by covered interest rate parity is closest to:

S = 1.1000 · i_USD = 5% · i_EUR = 3%
  1. A1.0787
  2. B1.1000
  3. C1.1214
  4. D1.1550
Show the answer

C. 1.1214

F = S × (1 + i_USD)/(1 + i_EUR) = 1.1000 × 1.05/1.03 = 1.1214. The higher-rate currency trades at a forward discount.

Curriculum area: Economics — Capital Flows and the FX Market, LOS 7.c

Question 14

Which of the following is most accurately described as a lagging economic indicator?

  1. AThe slope of the yield curve
  2. BNew orders for capital goods
  3. CThe average duration of unemployment
  4. DBuilding permits issued
Show the answer

C. The average duration of unemployment

The average duration of unemployment continues rising after a recovery begins, making it a lagging indicator. The other three are leading.

Curriculum area: Economics — Understanding Business Cycles, LOS 2.d

Question 15

A central bank raises its policy rate to combat inflation. Compared with fiscal policy, monetary policy most likely has:

  1. AA longer enactment lag but a shorter impact lag
  2. BA shorter enactment lag but a longer impact lag
  3. CShorter lags on both dimensions
  4. DLonger lags on both dimensions
Show the answer

B. A shorter enactment lag but a longer impact lag

Monetary policy can be enacted quickly by committee decision, but works indirectly through rates, credit and expectations, so its impact lag is long and variable.

Curriculum area: Economics — Monetary Policy, LOS 4.f

Financial Statement Analysis

11–14% of the exam

The three statements, inventories, long-lived assets, quality of earnings.

Question 16

A company reports net income of $480,000, depreciation of $95,000, a $40,000 increase in accounts receivable and a $25,000 increase in accounts payable. Cash flow from operations is closest to:

NI 480,000 · Dep 95,000 · ΔAR +40,000 · ΔAP +25,000
  1. A$510,000
  2. B$560,000
  3. C$600,000
  4. D$640,000
Show the answer

B. $560,000

480,000 + 95,000 − 40,000 + 25,000 = $560,000. An increase in a receivable uses cash; an increase in a payable provides it.

Curriculum area: FSA — Analyzing Statements of Cash Flows I, LOS 4.c

Question 17

During a period of rising prices with stable inventory quantities, a firm using LIFO rather than FIFO will report:

  1. AHigher ending inventory and higher net income
  2. BLower ending inventory and lower net income
  3. CHigher ending inventory and lower net income
  4. DLower ending inventory and higher net income
Show the answer

B. Lower ending inventory and lower net income

LIFO charges the most recent, highest costs to COGS, lowering net income, and leaves older, cheaper costs in ending inventory.

Curriculum area: FSA — Analysis of Inventories, LOS 6.b

Question 18

Under IFRS, which classification of interest paid on the statement of cash flows is permitted?

  1. AOperating only
  2. BFinancing only
  3. CEither operating or financing
  4. DInvesting only
Show the answer

C. Either operating or financing

IFRS allows interest paid to be classified as either operating or financing. US GAAP requires it to be classified as operating.

Curriculum area: FSA — Analyzing Statements of Cash Flows I, LOS 4.a

Question 19

A firm consistently reports net income well above cash flow from operations over several years. This is best interpreted as a signal of:

  1. AStrong earnings quality
  2. BA high accruals component and potentially lower earnings quality
  3. CAggressive but permissible tax planning
  4. DNothing — the two measures are unrelated
Show the answer

B. A high accruals component and potentially lower earnings quality

A persistent gap between net income and operating cash flow indicates a large accruals component, which historically predicts lower earnings persistence.

Curriculum area: FSA — Financial Reporting Quality, LOS 10.d

Question 20

A company capitalises rather than expenses a cost in the current year. In that year, the firm will report:

  1. ALower net income and lower assets
  2. BHigher net income and higher assets
  3. CHigher net income and lower assets
  4. DLower net income and higher assets
Show the answer

B. Higher net income and higher assets

Capitalising moves the cost to the balance sheet, raising assets and deferring the expense, which raises current-year net income. Later years bear the amortisation.

Curriculum area: FSA — Analysis of Long-Term Assets, LOS 7.a

Corporate Finance

6–9% of the exam

Governance, working capital, capital allocation, capital structure.

Question 21

A project requires an initial outlay of $1,000,000 and generates $300,000 per year for five years. At a cost of capital of 10%, the NPV is closest to:

Outlay 1,000,000 · CF 300,000 × 5 yrs · r = 10%
  1. A−$62,000
  2. B+$137,000
  3. C+$500,000
  4. D+$1,137,000
Show the answer

B. +$137,000

The five-year annuity factor at 10% is 3.7908, so PV = 300,000 × 3.7908 = $1,137,236. NPV = 1,137,236 − 1,000,000 ≈ +$137,000.

Curriculum area: Corporate Finance — Capital Investments and Capital Allocation, LOS 5.c

Question 22

When NPV and IRR give conflicting rankings for two mutually exclusive projects, an analyst should most appropriately:

  1. AChoose the project with the higher IRR
  2. BChoose the project with the higher NPV
  3. CChoose the project with the shorter payback
  4. DReject both projects
Show the answer

B. Choose the project with the higher NPV

NPV measures the value added in currency terms and assumes reinvestment at the cost of capital, which is the economically defensible assumption.

Curriculum area: Corporate Finance — Capital Investments and Capital Allocation, LOS 5.d

Question 23

A firm has a target capital structure of 40% debt and 60% equity, a pre-tax cost of debt of 6%, a cost of equity of 11% and a tax rate of 25%. Its WACC is closest to:

w_d 40% · r_d 6% · w_e 60% · r_e 11% · t 25%
  1. A7.80%
  2. B8.40%
  3. C9.00%
  4. D9.20%
Show the answer

B. 8.40%

WACC = 0.40 × 6% × (1 − 0.25) + 0.60 × 11% = 1.80% + 6.60% = 8.40%. Only the debt component is tax-affected; forgetting the tax shield gives 9.00%, the planted distractor.

Curriculum area: Corporate Finance — Capital Structure, LOS 6.b

Question 24

A firm reports days of inventory on hand of 60, days sales outstanding of 45 and days of payables of 30. Its cash conversion cycle is:

DOH 60 · DSO 45 · DPO 30
  1. A45 days
  2. B75 days
  3. C105 days
  4. D135 days
Show the answer

B. 75 days

CCC = DOH + DSO − DPO = 60 + 45 − 30 = 75 days. This is the length of time cash is tied up in the operating cycle.

Curriculum area: Corporate Finance — Working Capital and Liquidity, LOS 4.c

Question 25

The conflict of interest between controlling and minority shareholders is best described as:

  1. AA principal–agent problem
  2. BA principal–principal problem
  3. CA stakeholder externality
  4. DA regulatory arbitrage
Show the answer

B. A principal–principal problem

Both parties are owners, so it is a principal–principal conflict. The principal–agent problem sits between shareholders and managers.

Curriculum area: Corporate Finance — Corporate Governance, LOS 3.a

Equities

11–14% of the exam

Market organisation, indexes, industry analysis, dividend models.

Question 26

A stock just paid an annual dividend of $2.00. Dividends are expected to grow at 4% indefinitely and the required return is 9%. The value of the stock is closest to:

D₀ = $2.00 · g = 4% · r = 9%
  1. A$40.00
  2. B$41.60
  3. C$50.00
  4. D$52.00
Show the answer

B. $41.60

D₁ = 2.00 × 1.04 = $2.08. V₀ = 2.08 / (0.09 − 0.04) = $41.60. Using D₀ directly gives $40.00, the planted distractor.

Curriculum area: Equities — Discounted Cash Flow and Growth Models, LOS 6.b

Question 27

A two-for-one stock split of a constituent affects a price-weighted index by:

  1. AReducing the index level permanently
  2. BRequiring an adjustment to the divisor
  3. CIncreasing the constituent's weight
  4. DHaving no effect on any index type
Show the answer

B. Requiring an adjustment to the divisor

The divisor is adjusted so the index level is unchanged by the split. In a market-cap weighted index no adjustment is required at all.

Curriculum area: Equities — Sources of Equity Returns, LOS 4.c

Question 28

A firm has a retention ratio of 40% and a return on equity of 15%. Its sustainable growth rate is:

b = 40% · ROE = 15%
  1. A4.0%
  2. B6.0%
  3. C9.0%
  4. D15.0%
Show the answer

B. 6.0%

g = b × ROE = 0.40 × 0.15 = 6.0%. This is the rate at which the firm can grow without issuing new equity.

Curriculum area: Equities — Discounted Cash Flow and Growth Models, LOS 6.d

Question 29

The justified leading P/E for a firm with a payout ratio of 60%, a required return of 10% and a growth rate of 5% is closest to:

(1 − b) = 0.60 · r = 10% · g = 5%
  1. A6.0×
  2. B10.0×
  3. C12.0×
  4. D20.0×
Show the answer

C. 12.0×

P/E = (1 − b)/(r − g) = 0.60/(0.10 − 0.05) = 12.0×. The same inputs that drive a dividend model drive the justified multiple.

Curriculum area: Equities — Relative Value Equity Valuation Approaches, LOS 7.b

Question 30

Which characteristic most strongly indicates that an industry has high pricing power?

  1. ALow industry concentration
  2. BMinimal barriers to entry
  3. CHigh switching costs for customers
  4. DRapid technological change
Show the answer

C. High switching costs for customers

High switching costs lock customers in and reduce buyer power, which supports pricing power. The other three erode it.

Curriculum area: Equities — Industry and Competitive Analysis, LOS 9.c

Fixed Income

11–14% of the exam

Pricing, yield measures, duration, convexity, credit spreads.

Question 31

A bond with a modified duration of 7.2 is held when yields rise by 40 basis points. Using duration alone, the estimated percentage price change is closest to:

ModDur = 7.2 · Δy = +0.40%
  1. A−2.88%
  2. B−0.29%
  3. C+2.88%
  4. D−7.20%
Show the answer

A. −2.88%

−ModDur × Δy = −7.2 × 0.0040 = −2.88%. The sign is negative because yields rose; convexity would make the true loss slightly smaller.

Curriculum area: Fixed Income — Yield-Based Bond Duration Measures, LOS 11.c

Question 32

A bond pays a 6% annual coupon while the market yield on comparable bonds is 4.5%. The bond most likely trades at:

  1. AA discount to par
  2. BPar value
  3. CA premium to par
  4. DA price that cannot be determined
Show the answer

C. A premium to par

When the coupon rate exceeds the required yield, the cash flows are richer than the market demands, so the price is bid above par.

Curriculum area: Fixed Income — Bond Valuation: Prices and Yields, LOS 6.b

Question 33

Compared with a duration-only estimate, adding a positive convexity adjustment for a large yield increase will:

  1. ALower the estimated price
  2. BRaise the estimated price
  3. CLeave the estimate unchanged
  4. DReverse the sign of the estimate
Show the answer

B. Raise the estimated price

Positive convexity means the true price–yield curve lies above the tangent line, so the convexity term is additive for moves in either direction.

Curriculum area: Fixed Income — Yield-Based Bond Convexity, LOS 12.b

Question 34

Spread duration measures the sensitivity of a corporate bond’s price to a change in:

  1. AThe benchmark government yield
  2. BThe credit spread only
  3. CBoth the benchmark and the spread
  4. DThe realised default frequency
Show the answer

B. The credit spread only

Spread duration isolates the credit spread component, holding the benchmark curve fixed. Effective duration captures the benchmark move.

Curriculum area: Fixed Income — Credit Risk, LOS 14.b

Question 35

Which statement about Macaulay and modified duration is correct?

  1. AModified duration always exceeds Macaulay duration
  2. BThey are always equal
  3. CMacaulay duration divided by (1 + periodic yield) gives modified duration
  4. DMacaulay duration is measured in percent
Show the answer

C. Macaulay duration divided by (1 + periodic yield) gives modified duration

ModDur = MacDur / (1 + periodic yield), so modified duration is always slightly smaller. Macaulay duration is expressed in years.

Curriculum area: Fixed Income — Yield-Based Bond Duration Measures, LOS 11.a

Derivatives

6–9% of the exam

Forwards, futures, swaps, options and arbitrage-free pricing.

Question 36

A non-dividend-paying stock trades at $50. The one-year risk-free rate is 4%. The no-arbitrage one-year forward price is closest to:

S₀ = $50 · r = 4% · T = 1
  1. A$48.08
  2. B$50.00
  3. C$52.00
  4. D$54.00
Show the answer

C. $52.00

F₀ = S₀(1 + r)ᵀ = 50 × 1.04 = $52.00. The expected future price of the stock is irrelevant to the forward price.

Curriculum area: Derivatives — Arbitrage, Replication and the Cost of Carry, LOS 4.b

Question 37

According to put–call parity, a synthetic long call can be constructed from:

c + X/(1+r)ᵀ = p + S₀
  1. ALong put, long stock, short bond
  2. BShort put, long stock, long bond
  3. CLong put, short stock, long bond
  4. DShort put, short stock, short bond
Show the answer

A. Long put, long stock, short bond

Rearranging gives c = p + S₀ − X/(1+r)ᵀ: long put, long the underlying, and short a bond with face value equal to the strike.

Curriculum area: Derivatives — Option Replication Using Put–Call Parity, LOS 9.a

Question 38

In a one-period binomial model with u = 1.25, d = 0.80 and a risk-free rate of 5%, the risk-neutral probability of an up move is closest to:

u = 1.25 · d = 0.80 · r = 5%
  1. A0.44
  2. B0.50
  3. C0.56
  4. D0.62
Show the answer

C. 0.56

π = (1 + r − d)/(u − d) = (1.05 − 0.80)/(1.25 − 0.80) = 0.25/0.45 = 0.556. The actual probability of an up move is not used.

Curriculum area: Derivatives — Valuing a Derivative Using a One-Period Binomial Model, LOS 10.b

Question 39

At initiation, the value of a plain vanilla interest rate swap to the fixed-rate payer is:

  1. APositive
  2. BNegative
  3. CZero
  4. DEqual to the notional principal
Show the answer

C. Zero

The fixed rate is set precisely so the present values of the two legs are equal, making the swap worth zero to both parties at inception.

Curriculum area: Derivatives — Pricing and Valuation of Interest Rate Swaps, LOS 7.a

Question 40

Which of the following best describes the credit risk of an exchange-traded futures contract relative to an otherwise identical forward?

  1. AHigher, because of daily settlement
  2. BLower, because of daily settlement and the clearinghouse
  3. CIdentical, because the payoffs are identical
  4. DUndefined, because futures carry no credit risk at all
Show the answer

B. Lower, because of daily settlement and the clearinghouse

Daily mark-to-market settlement and the clearinghouse acting as counterparty substantially reduce credit risk relative to a bilateral forward.

Curriculum area: Derivatives — Derivative Instrument and Market Features, LOS 1.c

Alternative Investments

6–9% of the exam

Private capital, real estate, natural resources, hedge funds, digital assets.

Question 41

A hedge fund charges a 2% management fee on beginning assets and a 20% incentive fee on returns net of the management fee. Beginning assets are $100m and the gross return is 15%. The total fee is closest to:

AUM $100m · gross return 15% · 2% mgmt · 20% incentive, net of mgmt
  1. A$4.60m
  2. B$4.80m
  3. C$5.00m
  4. D$5.60m
Show the answer

A. $4.60m

Management fee = $2m. Gross gain = $15m; net of management fee = $13m. Incentive = 20% × 13 = $2.6m. Total = $4.6m.

Curriculum area: Alternative Investments — Performance and Returns, LOS 2.c

Question 42

A property generates net operating income of $450,000 and comparable properties transact at a capitalisation rate of 6%. The estimated value is:

NOI $450,000 · cap rate 6%
  1. A$2,700,000
  2. B$7,500,000
  3. C$4,500,000
  4. D$27,000
Show the answer

B. $7,500,000

Value = NOI / cap rate = 450,000 / 0.06 = $7,500,000. Direct capitalisation assumes NOI is constant in perpetuity.

Curriculum area: Alternative Investments — Real Estate and Infrastructure, LOS 4.c

Question 43

The J-curve effect in private equity refers to:

  1. ARising fees over a fund's life
  2. BEarly negative returns followed by later positive returns
  3. CThe shape of the capital call schedule
  4. DPersistent underperformance versus public markets
Show the answer

B. Early negative returns followed by later positive returns

Fees and early write-downs are recognised before exits generate gains, so reported returns are negative early and recover later.

Curriculum area: Alternative Investments — Investments in Private Capital, LOS 3.b

Question 44

An illiquid strategy reports a Sharpe ratio far above comparable liquid strategies. The most likely explanation is:

  1. AGenuinely superior risk-adjusted skill
  2. BReturn smoothing from appraisal-based valuation
  3. CA higher risk-free rate assumption
  4. DSurvivorship bias in the risk-free rate
Show the answer

B. Return smoothing from appraisal-based valuation

Stale and appraisal-based marks smooth reported returns, understating volatility and inflating the Sharpe ratio. It is a measurement artefact.

Curriculum area: Alternative Investments — Performance and Returns, LOS 2.d

Question 45

Compared with a direct investment in a hedge fund, a fund-of-funds most likely offers:

  1. ALower total fees and higher manager concentration
  2. BHigher total fees and greater diversification
  3. CIdentical fees and identical diversification
  4. DLower fees and greater diversification
Show the answer

B. Higher total fees and greater diversification

A fund-of-funds adds a second layer of fees but provides diversification across managers and access to closed funds.

Curriculum area: Alternative Investments — Hedge Funds, LOS 6.b

Portfolio Construction

8–12% of the exam

Risk and return, the CAPM, IPS construction, behavioural biases.

Question 46

Two assets have a correlation of exactly +1.0. Combining them in a portfolio will produce:

ρ₁,₂ = +1.0
  1. AA reduction in portfolio standard deviation
  2. BNo diversification benefit
  3. CA risk-free portfolio at some weight
  4. DA portfolio with zero expected return
Show the answer

B. No diversification benefit

With perfect positive correlation the portfolio standard deviation is the weighted average of the individual standard deviations — no benefit at all.

Curriculum area: Portfolio Management — Portfolio Risk and Return: Part I, LOS 1.d

Question 47

A stock has a beta of 1.4. The risk-free rate is 3% and the expected market return is 9%. Its required return under the CAPM is:

β = 1.4 · R_f = 3% · E(R_m) = 9%
  1. A9.0%
  2. B11.4%
  3. C12.6%
  4. D15.6%
Show the answer

B. 11.4%

E(R) = 3% + 1.4 × (9% − 3%) = 3% + 8.4% = 11.4%. Note the market risk premium is 6%, not 9%.

Curriculum area: Portfolio Management — Portfolio Risk and Return: Part II, LOS 2.e

Question 48

A security plots above the security market line. It is best described as:

  1. AOvervalued, with a negative alpha
  2. BUndervalued, with a positive alpha
  3. CCorrectly valued
  4. DUndervalued, but only if beta exceeds 1
Show the answer

B. Undervalued, with a positive alpha

Plotting above the SML means the expected return exceeds what the CAPM requires for its beta — a positive alpha, so it is undervalued.

Curriculum area: Portfolio Management — Portfolio Risk and Return: Part II, LOS 2.f

Question 49

A client has substantial wealth and a long horizon but becomes visibly anxious during drawdowns. The adviser should most appropriately:

  1. AFollow the higher ability to take risk
  2. BFollow the lower willingness to take risk and educate the client
  3. CAverage the two assessments
  4. DDecline the engagement
Show the answer

B. Follow the lower willingness to take risk and educate the client

When willingness and ability conflict, the lower governs. The adviser should adopt the more conservative position while educating the client.

Curriculum area: Portfolio Management — Basics of Portfolio Planning and Construction, LOS 4.b

Question 50

An investor holds a losing position because selling would confirm the loss. This bias is best classified and remedied as:

  1. AA cognitive error, to be corrected with information
  2. BAn emotional bias, to be moderated
  3. CA cognitive error, to be moderated
  4. DAn emotional bias, to be corrected with information
Show the answer

B. An emotional bias, to be moderated

Loss aversion is an emotional bias arising from feeling rather than faulty reasoning, so it is generally moderated and accommodated rather than corrected.

Curriculum area: Portfolio Management — The Behavioral Biases of Individuals, LOS 5.b

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