*** Level I
Question 1: In a purely floating exchange rate economy, a shift toward a restrictive fiscal policy will move the
capital account toward a ________. The current account will move toward a ________.
a) none of these answers
b) deficit, surplus
c) deficit, deficit also
d) surplus, surplus also
e) surplus, deficit
Question 2: Which of the following is/are true?
I. Every project has a unique NPV.
II. Every project has a unique IRR.
III. Every project has a unique payback period.
a) II & III
b) I & II
c) III only
d) II only
e) I only
f) I, II & III
g) I & III
Question 3: "Inside trading is a fruitless venture on average since it is already reflected in the security prices." This
statement is characteristic of which form of efficient markets hypothesis?
a) Unbiased form
b) Semi-strong form
c) Strong form
d) Weak form
Answer 1: b
Rationale:
When the government institutes a restrictive fiscal policy, the aggregate demand decreases and the inflation rate
decreases. Savings increase and the supply of loanable funds rises. Further, since the government is not as active as
a borrower, the demand for loanable funds decreases. This leads to a reduction in the real rates of interest.
Consequently, foreign investment decreases, leading to a decreased demand for the domestic currency. The domestic
currency therefore depreciates.
The capital account moves toward a deficit because of a decreased demand for domestic currency. Consequently, the
current account moves toward a surplus since in a purely floating exchange rate system, changes in the current and
capital account must sum up to zero.
While analyzing questions about current and capital account, always remember that capital account effects will win
out over current account effects due to the high fluidity in the financial markets. Therefore, always look at the
effects on the capital account first.
Answer 2: g
Rationale:
The payback period is defined as the minimum number of years required to recoup the initial investment. For every
project, this is a unique number. Similarly, the NPV is a unique number. However, depending on the nature of the
project's cash flows, a project can have multiple discount rates at which its NPV is zero, i.e. it can have multiple
IRRs.
Answer 3: c
Rationale:
The strong form of efficiency holds that security prices reflect not only publicly available information, but also any
inside information. Hence, while an insider may make profits at times based on inside information, he will not be
able to do this on a consistent basis and in a manner that allows him to outperform the market on a risk-adjusted
basis.
As can be expected, the strong form does not hold up very well in practice and its value is more in terms of clearly
demarcating and defining the issues in market efficiency at hand.
*** Level II
Question: Compare and contrast the monthly prepayment option embedded in an MBS with a callable or putable
bond and with a non-callable bond. Answer: An investor's risk can be illustrated using the concept of convexity.
When interest rates decline sharply, convexity becomes negative. In a mortgage pool, an increasing portion of the
mortgages in the pool prepays. When interest rates decline below the coupon rate, most people prepay and the price-
yield relationship experiences negative convexity in this area.
For higher interest rates, negative convexity also may occur, or there will at least be less positive convexity than is
the case with bonds. The reason for this is that people who might want to upgrade their house or to relocate are
discouraged to do so because of the much higher payments on the new home. In this case, prepayments are below
what would normally occur, which is known as extension risk. Duration of the instrument increases and if the term
structure is upward-sloping, the value decline is more than occurs with a fixed-rate, stated-maturity bond.
The possibility of negative convexity in a high interest environment
makes mortgage securities very different from a noncallable, fixed-income security for which positive convexity
prevails. With all other things constant, for significant interest-rate changes, a mortgage security will perform more
poorly than a fixed-rate stated maturity bond.
*** Level III
Question: When a firm presents portfolios included in a wrap-fee composite that do not meet the wrap-fee
definition, what must the firm disclose for each year presented?
Answer:
What must be presented is:
1. the dollar amount of assets represented and
2. the fee deducted.
When wrap-fee composite returns are presented before fees (acceptable only in presentations to non-wrap-fee
prospective clients), the performance presentation must disclose:
1. fees,
2. investments style, and
3. the information that "pure" gross-of-fees return does not include transaction costs.
