2018 Level I Mock Exam (B) PM

The afternoon session of the 2018 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.
Questions Topic Minutes

1–18 Ethical and Professional Standards 27

19–33 Quant 22.5
34–45 Econ 18
46–69 Financial Reporting and Analysis 36
70–78 Corporate Finance 13.5
79–86 Portfolio Management 12
87–98 Equity 18
99–110 Fixed Income 18
111–115 Derivatives 7.5
116–120 Alternative Investments 7.5
Total: 180

By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to
currently registered CFA candidates. Candidates may view and print the exam for personal exam prepara-
tion only. The following activities are strictly prohibited and may result in disciplinary and/or legal action:
accessing or permitting access by anyone other than currently-­registered CFA candidates; copying, posting
to any website, emailing, distributing and/or reprinting the mock exam for any purpose
© 2017 CFA Institute . All rights reserved.
2 2018 Level I Mock Exam (B) PM

2018 LEVEL I MOCK EXAM (B) PM

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

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

Guidance for Standards I–VII

LOS a, b
Standard II(A)–Material Nonpublic Information

2 Ian O’Sullivan, CFA, is the owner and sole employee of two companies, a
public relations firm and a financial research firm. The public relations firm
entered into a contract with Mallory Enterprises to provide public relations
services, with O’Sullivan receiving 40,000 shares of Mallory stock in payment
for his services. Over the next 10 days, the public relations firm issued several
press releases that discussed Mallory’s excellent growth prospects. O’Sullivan,
through his financial research firm, also published a research report recom-
mending Mallory stock as a “buy.” According to the CFA Institute Standards of
Professional Conduct, O’Sullivan is most likely required to disclose his owner-
ship of Mallory stock in the:
A press releases only.
B research report only.
C both the press release and the research report.
2018 Level I Mock Exam (B) PM 3

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

Guidance for Standards I–VII

LOS a
Standard I(B)–Independence and Objectivity, Standard VI(A)–Disclosure of Conflicts

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

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

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

Guidance for Standards I–VII

LOS c
Standard VI(A)–Disclosure of Conflicts

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

formance, the current GIPS standards includes new provisions related to:
A various measures of risk.
B all aspects of performance measurement.
C the unique characteristics of each asset class.
4 2018 Level I Mock Exam (B) PM

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

The GIPS Standards

LOS a

5 Darden Crux, CFA, a portfolio manager at SWIFT Asset Management Ltd.

(SWIFT), calls a friend to join him for dinner. The friend, a financial analyst
at Cyber Kinetics (CK) declines the invitation and explains she is performing
due diligence on Orca Electronics, a company CK is about to acquire. After
the phone call, Crux searches the Internet for any news of the acquisition but
finds nothing. Upon verifying that Orca is on SWIFT’s approved stock list,
Crux purchases Orca’s common stock and call options for selective SWIFT
clients. Two weeks later, CK announces its intention to acquire Orca. The next
day, Crux sells all of the Orca securities, giving the fund a profit of $3 million.
What action should Crux most likely take to avoid violating any CFA Institute
Standards of Professional Conduct?
A Refuse to trade based on the information.
B Purchase the stock and call options for all clients.
C Trade only after analyzing the stock diligently and thoroughly.

A is correct as members/candidates who possess material nonpublic information that

could affect the value of an investment should not act or cause others to act on the
information. Crux traded on the material information that Orca is about to be acquired
by Cyber Kinetics. The information is nonpublic because it is not publicly available, which
was verified when Crux researched Orca on the Internet and found nothing about the
acquisition [Standard II(A)].
B is incorrect because the information is material and nonpublic and should not be
traded.
C is incorrect because the information is material and nonpublic and should not be
traded.

Guidance for Standards I–VII

LOS b
Standard II(A)–Material Nonpublic Information

6 Alexander Newton, CFA, is the chief compliance officer for Mills Investment
Limited. Newton institutes a new policy requiring the pro rata distribution
of new security issues to all established discretionary accounts for which the
new issues are appropriate. The policy also provides for the exclusion of newly
established discretionary accounts from the distribution until they have reached
2018 Level I Mock Exam (B) PM 5

their one-­month anniversary date. This policy is disclosed to all existing and
potential clients. Did Newton most likely violate any CFA Institute Standards of
Professional Conduct?
A Yes.
B No, because this allocation policy is not inequitable under the Standards.
C No, because this policy has been adequately disclosed to all existing and
potential clients.

A is correct because under Standard III(B)–Fair Dealing, members and candidates should
disclose to clients and prospective clients how they select accounts to participate in an
order and how they determine the amount of securities each account will buy or sell.
Trade allocation procedures must be fair and equitable, and disclosure of inequitable
allocation methods does not relieve the member or candidate of this obligation. All
discretionary accounts should be treated in the same manner. Treating newer accounts
differently would be considered inequitable regardless if this policy is disclosed.
B is incorrect because making new accounts wait for an arbitrary anniversary date
before participating is not fair or equitable.
C is incorrect because under Standard III(B) inequitable allocation methods cannot
be disclosed away.

Guidance for Standards I–VII

LOS a
Standard III(B)–Fair Dealing

7 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)

LOS b
GIPS Requirement 0.A.12

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

cheating on a professional accounting exam. She denied cheating and suc-
cessfully defended herself against the allegation. As part of her defense and as
6 2018 Level I Mock Exam (B) PM

evidence of her character, Charmaine stated that she is a CFA charterholder

and upholds the CFA Institute Code of Ethics and Standards of Professional
Conduct. On her next annual Professional Conduct Statement, Charmaine does
not report this allegation to CFA Institute. Did Charmaine most likely violate
the CFA Institute Code of Ethics or Standards of Professional Conduct?
A No
B Yes, she improperly used the CFA Institute Code and Standards to defend
herself.
C Yes, she did not report the allegation on her annual Professional Conduct
Statement.

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

CFA institute Code of Ethics and Standards of Professional Conduct

LOS c

9 Which of the following is not part of the nine major sections of the GIPS
standards?
A Performance Fees
B Disclosure
C Input Data

A is correct. The nine major sections of the GIPS standards do not include performance
fees. The nine major sections are fundamentals of compliance, input data, calculation
methodology, composite construction, disclosure, presentation and reporting, real estate,
private equity, and wrap fee/separately managed account portfolios.
B is incorrect because input data is one of the nine major sections of the GIPS standards.
C is incorrect because disclosure is one of the nine major sections of the GIPS standards.

The GIPS Standards

LOS d
2018 Level I Mock Exam (B) PM 7

10 Which of the following statements related to requirements for the CFA Institute
Standards of Professional Conduct Standard V(B)–Communication with Clients
and Prospective Clients is least likely accurate? The standard requires members
and candidates to:
A divulge the number of investment related personnel responsible for external
communication.
B disclose the basic format and general principles of the investment process.
C distinguish between fact and opinion in the presentation of investment anal-
ysis and recommendations.

A is correct. The CFA Institute Standards of Professional Conduct Standard V(B)–

Communication with Clients and Prospective Clients does not limit the type or number
of staff responsible for external communication.
B is incorrect because disclosure of the basic format and general principles of the
investment process is a requirement.
C is incorrect because distinguishing between fact and opinion in the presentation
of investment analysis and recommendations is a requirement.

Code of Ethics and Standards of Professional Practice

LOS b

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

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

obtained an MBA degree at the time of his hire when in fact he had not. This reflects
adversely on his professional integrity, violating Standard I(D)–Misconduct. Stating that
he passed his CFA exams in three consecutive years is not a violation of Standard VII(B)–
Reference to CFA Institute, the CFA Designation, and the CFA Program if it is factual. There
is no evidence given to indicate he did not pass as claimed.
A is incorrect because Naib knowingly misrepresented himself by stating he had
obtained an MBA degree when in fact he had not. This reflects adversely on his profes-
sional integrity, violating Standard I(D)–Misconduct.
8 2018 Level I Mock Exam (B) PM

C is incorrect because stating he passed his CFA exams consecutively is not a violation
of Standard VII(B)–Reference to CFA Institute, the CFA Designation, and the CFA Program.
There is no evidence given to indicate he did not pass as claimed.

Guidance for Standards I–VII

LOS b

12 Victoria Christchurch, CFA, is a management consultant currently working

with a financial services firm interested in curtailing its high staff turnover, par-
ticularly amongst CFA charterholders. In recent months, the company lost 5 of
its 10 most senior managers, all of whom have cited systemic unethical business
practices as the reason for their leaving. To curtail staff turnover by encouraging
ethical behavior, it would be least appropriate for Christchurch to recommend
the company to do which of the following?
A Implement a whistleblowing policy.
B Encourage staff retention with increased benefits.
C Create, implement, and monitor a corporate code of ethics.

B is correct because the offering of increased benefits to encourage staff retention would
not necessarily stop the unethical behavior causing staff turnover and would effectively
be asking the ethical employees to ignore the unethical behavior, thus being complicit
in the behavior. Under Standard I(A)–Knowledge of the Law, CFA charterholders and
candidates must disassociate themselves from unethical behavior. As the unethical
business practices are seen as systemic, it would likely require them to leave the firm.
Implementing a whistleblowing policy and adopting a corporate code of ethics would
likely help to build a foundation of strong ethical behavior.
A is incorrect as introducing a whistleblowing policy would likely help to build a
foundation of strong ethical behavior
C is incorrect as implementing a corporate code of ethics would likely help to build
a foundation of strong ethical behavior.

Guidance for Standards I–VII

LOS c

13 Millicent Plain has just finished taking Level II of the CFA examination. Upon
leaving the examination site, she meets with four Level III candidates who also
just sat for their exams. Curious about their examination experience, Plain asks
the candidates how difficult the Level III exam was and how they did on it. The
candidates say the essay portion of the examination was much harder than they
had expected and they were not able to complete all questions as a result. The
candidates go on to tell Plain about broad topic areas that were tested and com-
plain about specific formulas they had memorized that did not appear on the
exam. The Level III candidates least likely violated the CFA Institute Standards
of Professional Conduct by discussing:
A specific formulas.
B broad topic areas.
C the examination essays.
2018 Level I Mock Exam (B) PM 9

C is correct because discussing the level of difficulty of the essay portion of the exam-
ination did not violate Standard VII(A)–Conduct as Members and Candidates in the CFA
Program. Standard VII(A) and the Candidate Pledge were violated by candidates revealing
broad topical areas and formulas tested or not tested on the exam.
A is incorrect as Standard VII(A)–Conduct as Members and Candidates in the CFA
Program and the Candidate Pledge was violated by candidates revealing specific formulas
B is incorrect as Standard VII(A)–Conduct as Members and Candidates in the CFA
Program and the Candidate Pledge was violated by candidates revealing portions of
the CBOK covered on the exam and areas not covered

Guidance for Standards I–VII

LOS b
Standard VII(A)–Conduct as Participants in CFA Institute Programs

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

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

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

Guidance for Standards I–VII

LOS c
Standard I(A)–Knowledge of the Law

15 When a client asks her how she makes investment decisions, Petra Vogler, CFA,
tells the client she uses mosaic theory. According to Vogler, the theory involves
analyzing public and nonmaterial nonpublic information including the evalu-
ation of statements made to her by company insiders in one-­on-­one meetings
10 2018 Level I Mock Exam (B) PM

where management discusses new earnings projections not known to the

public. Vogler also gathers general industry information from industry experts
she has contacted. Vogler most likely violates the CFA Institute Standards of
Professional Conduct because of her use of:
A industry expert information.
B one-­on-­one meeting information.
C nonmaterial nonpublic information.

B is correct because a violation of Standard II(A)–Material Nonpublic Information is likely

to occur when using information that is selectively disclosed by corporations to a small
group of investors, analysts, or other market participants. Earnings estimates given in a
one-­on-­one meeting would likely be considered material and nonpublic information.
Information made available to analysts remains nonpublic until it is made available to
investors in general. Under the mosaic theory it is acceptable to use information from
industry contacts as long as the analyst uses appropriate methods to arrive at her con-
clusions. Additionally, it is acceptable to use nonmaterial nonpublic information in her
analysis, and this use is not a violation of Standard II(A)–Material Nonpublic Information.
A is incorrect because under the mosaic theory it is acceptable to use information
from industry contacts as long as the analyst uses appropriate methods to arrive at her
conclusions.
C is incorrect because it is acceptable to use nonmaterial nonpublic information in her
analysis, and this use is not a violation of Standard II(A)–Material Nonpublic Information.

Guidance for Standards I–VII

LOS b
Standard II(A)–Material Nonpublic Information

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

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

C is correct because Hussein did not likely act with competence and diligence as required
by Standard V(A). One half day of preparation with regard to Islamic investment prod-
ucts would not likely be considered sufficient to give investment advice to pension plan
trustees. Misconduct was not violated by Hussein stating she is an expert in retirement
planning and investments because this is the area she specializes in.
2018 Level I Mock Exam (B) PM 11

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

Guidance for Standards I–VII

LOS b
Standard V(A)–Diligence and Reasonable Basis

17 Dimitri Kuznetsov, CFA, is a portfolio manager and holds shares of Barnikoff

Limited and Matric Ventures in all client portfolios. Both companies have
upcoming annual general meetings scheduled for the same day. The manage-
ment of Barnikoff proposes to change its financial year-­end from September to
December, while Matric Ventures proposes to enter into a high-­risk venture.
The proxy voting policy clause in all client investment management agreements
managed by Kuznetsov states, “When voting proxies provides a cost benefit
to the client, the manager must vote a proxy.” With regard to the proxy votes
for Matric and Barnikoff, Kuznetsov would least likely violate CFA Institute
Standard III(A)–Loyalty, Prudence, and Care if he votes:
A with management.
B only the Matric proxy.
C only the Barnikoff proxy.

B is correct because Standard III(A)–Loyalty, Prudence, and Care states that it is a member
or candidate’s duty to vote proxies on behalf of clients in an informed and responsible
manner. However, if a cost–benefit analysis shows voting all proxies may not benefit the
client, voting all proxies may not be necessary. The member or candidate is responsible
for informing all clients if this is the policy of the fund manager. The member or candidate
must take steps to disclose this proxy voting policy to clients. Voting the Barnikoff proxy
does not appear to offer a benefit because the issue is not of a critical nature, but voting
the proxy for Matric involves a material issue and is a benefit that should be voted on.
A is incorrect because Standard III(A)–Loyalty, Prudence, and Care states that it is
a member or candidate’s duty to vote proxies on behalf of clients in an informed and
responsible manner. A manager must not blindly vote with management without first
considering the impact of the issue at hand and its benefit to the client.
C is incorrect because while Standard III(A)–Loyalty, Prudence, and Care states that it
is a member or candidate’s duty to vote proxies on behalf of clients in an informed and
responsible manner, if a cost–benefit analysis shows voting all proxies may not benefit
the client, voting all proxies may not be necessary.

Guidance for Standards I–VII

LOS b
Standard III(A)–Loyalty, Prudence, and Care

18 Merchant Capital Partners, a regional investment bank, acts as a market maker

for Vital Link Health Services and other small firms listed on an over-­the-­
counter exchange. For those shares for whom Merchant acts as market maker, it
trades for its own book as well as engaging in risk arbitrage trading. Merchant
allows staff members to trade in shares once clients and the company have
12 2018 Level I Mock Exam (B) PM

traded. Merchant recently obtained material nonpublic information regarding

Vital’s planned reverse takeover of a publicly listed competitor. In order to be in
compliance with the CFA Institute Code and Standards, which type of trading
in Vital shares should Merchant least likely suspend?
A Personal
B Risk arbitrage
C Passive proprietary

C is correct because according to Standard II(A)–Material Nonpublic Information,

Recommended Procedures for Compliance, if Merchant stopped market making, a form
of proprietary trading, due to being in possession of material nonpublic information, it
could tip off investors that Vital is likely to be making a major announcement in the near
future. This would be counterproductive to the goals of maintaining the confidentiality
of information and providing market liquidity. The Standard recommends that market
makers remain passive when in possession of material nonpublic information. The
Standard also requires personal trading to be suspended when in possession of material
nonpublic information, and it is prudent to suspend arbitrage trading to prevent profits
from insider trading.
A is incorrect because when in possession of material nonpublic information,
Standard II(A)–Material Nonpublic Information requires personal trading to be suspended.
B is incorrect because when in possession of material nonpublic information, accord-
ing to Standard II(A)–Material Nonpublic Information, it is prudent to suspend arbitrage
trading to prevent profits from insider trading.

Guidance for Standards I–VII

LOS c
Standard II(A)–Material Nonpublic Information

19 Over the past four years, a portfolio experienced returns of –8%, 4%, 17%, and
–12%. The geometric mean return of the portfolio over the four-­year period is
closest to:
A 0.25%.
B –0.37%.
C 0.99%.

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

Statistical Concepts and Market Returns

LOS e
Section 5.4.2

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

than a specific value, the null and alternative hypothesis are best defined as:
2018 Level I Mock Exam (B) PM 13

A H0: θ ≤ θ0 versus Ha: θ > θ0.

B H0: θ ≥ θ0 versus Ha: θ < θ0.
C H0: θ = θ0 versus Ha: θ ≠ θ

A is correct. A positive “hoped for” condition means that the null will be rejected (and
the alternative accepted) only if the evidence indicates that the population parameter
is greater than θ0. Thus, H0: θ ≤ θ0 versus Ha: θ > θ0 is the correct statement of the null
and alternative hypotheses, respectively.
B is incorrect; it can only discern that a parameter is possibly lesser than a value.
C is incorrect; it can only discern that a parameter is not equal to a value.

Hypothesis Testing
LOS a, b
Section 2

21 An analyst has established the following prior probabilities regarding a compa-

ny's next quarter's earnings per share (EPS) exceeding, equaling, or being below
the consensus estimate.
Prior Probabilities

EPS exceed consensus 25%

EPS equal consensus 55%
EPS are less than consensus 20%

Several days before releasing its earnings statement, the company announces a
cut in its dividend. Given this new information, the analyst revises his opinion
regarding the likelihood that the company will have EPS below the consensus
estimate. He estimates the likelihood the company will cut the dividend, given
that EPS exceeds/meets/falls below consensus, as reported below.
Probabilities the Company Cuts Dividends, Conditional
on EPS Exceeding/Equaling/Falling below Consensus

P(Cut div│EPS exceed) 5%

P(Cut div│EPS equal) 10%
P(Cut div│EPS below) 85%

The analyst thus determines that the unconditional probability for a cut in the
dividend, P(Cut div), is equal to 23.75%. Using Bayes’ formula, the updated
(posterior) probability that the company’s EPS are below the consensus is closest
to:
A 85%.
B 72%.
C 20%.

B is correct. Bayes’ Formula:

14 2018 Level I Mock Exam (B) PM

Updated probability of event given the new information

Probability of the new information given event
= × Prior probability of event
Unconditionaal probability of the new information
where
Updated probability of event given the new information: P(EPS below│Cut div);
Probability of the new information given event: P(Cut div│EPS below) = 85%;
Unconditional probably of the new information: P(Cut div) = 23.75%;
Prior probability of event: P(EPS below) = 20%.
Therefore, the probability of EPS falling below the consensus is updated as:

P(EPS below│Cut div) = [P(Cut div│EPS below)/P(Cut div)] × P(EPS

below)
= (0.85/0.2375) × 0.20 = 0.71579 ~ 72%
B is incorrect. It is the given P(Cut div│EPS below).
C is incorrect. It simply multiplies the unconditional probability for a cut in the divi-
dend with the conditional probability of a cut in the dividend given that EPS falls below
consensus: P(Cut div) × P(Cut div│EPS below) = 0.2375 × 0.85 = 20.188.%

Probability Concepts
LOS h, n
Sections 2, 4.1

22 Consider the investment in the following table:

Start of Year 1 One share purchased at $100
End of Year 1 $5.00 dividend/share paid and one additional share purchased
at $125
End of Year 2 $5.00 dividend/share paid and both shares sold for $140 per
share

Assuming dividends are not reinvested, compared with the time-­weighted

return, the money-­weighted return is:
A lower.
B the same.
C higher.

A is correct. The following table represents cash flows of the investment:

Start-­of-­Year
Value after End-­of-­Year End-­of-­Year Value
Year Contribution Contribution Dividend after Dividend

1 1 × $100 1 × $100 = $100 1 × $5 = $5 $125

2 1 × $125 2 × $125 = $250 2 × $5 = $10 (2 × 140) + 10 = $290

The time-­weighted rate of return (TWR) on this investment is found by taking the
geometric mean of the two holding period returns (HPRs):
TWR = [(1 + HPRYear 1) × (1 + HPRYear 2)]1/2 – 1
2018 Level I Mock Exam (B) PM 15

where

HPRYear 1 = ($125 – $100 + $5)/$100 = 30.0%

HPRYear 2 = ($280 – $250 + $10)/$250 = 16.0%
TWR = [(1 + 0.30) × (1 + 0.16)]1/2 – 1 = 22.80%
The money-­weighted rate of return (MWR) is the internal rate of return (IRR) of the
cash flows associated with the investment:
(−125 + 5) (280 + 10)
0 = −100 + + , where r = MWR.
(1 + r1) (1 + r2 )
Using the cash flow (CF) function of a financial calculator:
CF0 = –100, CF1 = (–125 + 5), CF2 = (280 + 10), and solving for IRR: MWR
or IRR = 20.55%.
The difference between the TWR and MWR of this investment = 22.80% – 20.55% =
2.25%, or 225 bps, with MWR being lower than TWR.
B is incorrect. The difference between MWR and TWR is either higher or lower, and
could hardly be equal.
C is incorrect, as per the calculation above.

Discounted Cash Flow Applications

LOS d
Sections 3.1 and 3.2

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

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

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

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

Sampling and Estimation

LOS d
Section 2.3

24 The following information applies to a sample:

● The point estimate of the population mean is 12.5.
● The t-statistic (tα/2) used in calculating the 90% confidence interval is 1.67.
● The sample size is 64.
● The sample standard deviation is 5.
The 90% confidence interval for the population mean is closest to:
A 11.98 to 13.02.
16 2018 Level I Mock Exam (B) PM

B 12.37 to 12.63.
C 11.46 to 13.54.

C is correct. The confidence interval for the population mean is calculated as:

X ± tα 2 (s n)
where X is the mean of the sample (12.5), tα/2 is the appropriate t-statistic (1.67), s is
the sample standard deviation (5), and n is the sample size (64). In this problem, the
( )
confidence interval is 12.5 ± 1.67 × 5 64 = 12.5 ± 1.04375 = 11.45625 to 13.54375,
rounded to 11.46 to 13.54.
A is incorrect. The mistake is to divide 1.67 by 2 rather than use the value as given:
12.5 ± (1.67/2) × 5 ( )
64 = 12.5 ± 0.52188 = 11.97812 to 13.02188, rounded to 11.98 to 13.02.
B is incorrect. The mistake is using 64 instead of the square root of 64 in the calculation:
12.5 ± 1.67 × (5/64) = 12.5 ± 0.13047 = 12.36953 to 12.63047, rounded to 12.37 to 12.63.

Sampling and Estimation

LOS j
Section 4.2

25 Consider a two-­tailed test of the hypothesis that the population mean is zero.
The sample has 50 observations. The population is normally distributed with a
known variance.
t-Test rejection level
Degrees of freedom p = 0.10 p = 0.05 p = 0.025

49 1.299 1.677 2.010

50 1.299 1.676 2.009
z-Test rejection level α = 0.10 α = 0.05 α = 0.025
1.645 1.960 2.330

At a 0.05 significance level, the rejection points are most likely at:
A –2.009 and 2.009.
B –2.010 and 2.010.
C –1.960 and 1.960.

C is correct. The appropriate test statistic is a z-statistic because the sample comes from
a normal distributed population with known variance. A z-test does not use degrees of
freedom. This test is two-­sided at the 0.05 significance level, and the rejection point
conditions are z > 1.960 and z < –1.960.
B is incorrect. As explained in choice C.
A is incorrect. As explained in choice C.

Hypothesis Testing
LOS g
Section 3
2018 Level I Mock Exam (B) PM 17

26 A risk manager would like to calculate the coefficient of variation of a portfolio.

The following table reports the annual returns of the portfolio and of the risk-­
free rate over the most recent five years:
Year Portfolio Return Risk-­Free Rate

1 4.0% 2.0%
2 –1.0% 1.5%
3 7.0% 1.0%
4 11.0% 1.0%
5 2.0% 0.5%

The coefficient of variation of the portfolio is closest to:

A 1.00.
B 0.74.
C 0.90.

A is correct. First calculate the sample mean return as follows:

n
∑ Xi
i =1
X =
n
where

n = the number of observations in the sample

i = the index for the year
Xi = is the return in year i
(4.0% − 1.0% + 7.0% + 11.0% + 2.0%)
X =
5
23.0%
=
5
= 4.6%
Then calculate the sample standard deviation with the following formula:
n
2
∑( X i − X )
i =1
s=
n −1

Year
( X i − X )2
1 (4.0% – 4.6%)2 = 0.00004
2 (–1.0% – 4.6%)2 = 0.00314
3 (7.0% – 4.6%)2 = 0.00058
4 (11.0% – 4.6%)2 = 0.00410
5 (2.0% – 4.6%)2 = 0.00068

0.00004 + 0.00314 + 0.00058 + 0.00410 + 0.00068

s= = 4.62%
5 −1
18 2018 Level I Mock Exam (B) PM

The coefficient of variation (CV) is calculated with the following formula:

s 4.62%
CV = = = 1.0
X 4.6%
B is incorrect. It is the Sharpe ratio, not the coefficient of variation. First calculate the
mean annual risk-­free return over the five years:
2.0% + 1.5% + 1.0% + 1.0% + 0.5%
RF = = 1.2%
5
Then calculate the Sharpe ratio with the following formula:
R p − RF 4.6% − 1.2%
Sh = = = 0.74
sp 4.62%
C is incorrect. In the formula for the standard deviation, it uses n instead of “n – 1”
in the denominator:

0.00004 + 0.00314 + 0.00058 + 0.00410 + 0.00068

s= = 4.13%
5
Then, calculate the CV:
4.13%
CV = = 0.90
4.6%

Statistical Concepts and Market Returns

LOS e, g, i
Sections 5.1.2, 7.4.2, 7.7

27 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

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
LOS c
Section 2

28 The joint probability of returns for securities A and B are as follows:

2018 Level I Mock Exam (B) PM 19

Joint Probability Function of Security A and Security B

Returns (Entries Are Joint Probabilities)
Return on Return on
Security B = Security B =
30% 20%

Return on Security A = 25% 0.60 0

Return on Security A = 20% 0 0.40

The covariance of the returns between Securities A and B is closest to:

A 12.
B 14.
C 13.

A is correct. First calculate the expected returns on securities A and B with the formula:
n
E (X ) = ∑ P(X i ) X i
i =1
Expected return on security A = 0.6 × 25% + 0.4 × 20% = 15% + 8% = 23%
Expected return on security B = 0.6 × 30% + 0.4 × 20% = 18% + 8% = 26%
Then calculate the covariance of returns between securities A and B with the formula:

Cov(R A,RB) = ∑ ∑ P (RA,i , RB, j )(RA,i − ERA )(RB, j − ERB )

i j
where

R A and RB = the returns on securities A and B, respectively

P = the joint probability
ER A and ERB = the expected returns of securities A and B, respectively
i and j = the line and column of the joint probability function table above

Cov (RA , RB ) = 0.6 (25 − 23)(30 − 26) + 0.4 (20 − 23)(20 − 26)
= 0.6[2 × 4] + 0.4 (−3)(−6)
= 0.6 × 8 + 0.4 × 18
= 4.8 + 7.2
= 12
B is incorrect. In the covariance calculation, it uses the joint probabilities in the wrong
positions:

Cov (RA , RB ) = 0.4 (25 − 23)(30 − 26) + 0.6 (20 − 23)(20 − 26)
= 0.4[2 × 4] + 0.6 (−3)(−6)
= 0.4 × 8 + 0.6 × 18
= 3.2 + 10.8
= 14
20 2018 Level I Mock Exam (B) PM

C is incorrect. In the covariance calculation, it uses a joint probability of 0.5:

Cov (RA , RB ) = 0.5 (25 − 23)(30 − 26) + 0.5 (20 − 23)(20 − 26)
= 0.5[2 × 4] + 0.5 (−3)(−6)
= 0.5 × 8 + 0.5 × 18
= 4+9
= 13

Probability Concepts
LOS m
Section 3

29 An investor deposits £2,000 into an account that pays 6% per annum com-
pounded continuously. The value of the account at the end of four years is
closest to:
A £2,854.
B £2,525.
C £2,542.

C is correct. The future value (FV) of a given lump sum, calculated using continuous
compounding, is: FV = PVerN = 2,000 × e0.06 × 4 = £2,542.49 ~ £2,542.
A is incorrect. It is calculated as: ln(0.06 × 4) × 2,000 = –2,854.23 and ignores the
negative sign of the logarithm.
B is incorrect. It uses annual compounding: 2,000 × (1 + 0.06)4 = 2,524.95.

The Time Value of Money

LOS d, e
Section 3.2

30 The chart below depicts the relative strength lines for a stock index versus both
a bond index and gold. In the month of June, it would be most appropriate for
an analyst using intermarket analysis to move investments from:
2018 Level I Mock Exam (B) PM 21

Relative Strength
2.6

2.4

2.2

2.0

1.8

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

Stock Index vs. Bond Index Stock Index vs. Gold

A gold to stocks.
B stocks to bonds.
C bonds to gold.

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

Technical Analysis
LOS h, b
Sections 3.1.8, 5

31 A normally distributed random variable has a mean of 100 and a standard devi-
ation of 12. The probability of observing a value greater than 82 is the cumula-
tive distribution function (cdf ) of the standard normal variable:
A N(1.5).
B N(–1.5).
C 1 – N(1.5).
22 2018 Level I Mock Exam (B) PM

A is correct. The standardized value of this normal distribution can be obtained using
the formula (X – μ)/σ = (82 – 100)/12 = –1.5. The cdf of N(–1.5) provides the probability
of a value less than or equal to 82.
B is incorrect because 1 – N(1.5) = N(–1.5) is the probability of a value in this distri-
bution of less than 82.
C is incorrect because the probability of observing random draw less than 82 will be
P(Z < –1.5) = N(–1.5) = 1 – N(1.5).

Common Probability Distributions

LOS l
Section 3.2

32 The following statistical table is presented to an analyst

Cumulative Distribution
Probability Function Function
X=x P(x) = P(X = x) F(x) = P(X ≤ x)

1 0.10 0.10
2 0.15 0.25
3 0.50 0.75
4 0.15 0.90
5 0.10 1.00

Which of the following is the best conclusion that can be drawn from the statis-
tical table?
A The probability that the value of X will be equal to 4 is 0.90
B The probability that the value of X will be less than or equal to 5 but greater
than 2 is 0.75.
C The random variable X is continuous.

B is correct. The probability that X is greater than 2 but less than or equal to 5 is: P(2 < X
≤ 5) = [P(X ≤ 5) – P(X ≤ 2)] = 1.00 – 0.25 = 0.75.
A is incorrect because a random variable value of X = 4 has a 15% probability of
occurring. The cumulative probability of 90% shows the probability of X ≤ 4.
C is incorrect because the random variable has a countable number of possible values;
the probability and cumulative distribution functions are therefore for a discrete random
variable is therefore discrete.

Common Probability Distributions

LOS d
Section 2

33 To project the assets and liabilities of a pension plan using a number of different
assumptions, the most appropriate method to employ is:
A Monte Carlo simulation because it can evaluate the effect of changes in
assumptions.
B Monte Carlo simulation because it can provide more insights into cause and
effect relationships than analytical methods.
2018 Level I Mock Exam (B) PM 23

C historical simulation because risk not represented in the time period

observed can be integrated in the simulation.

A is correct. Monte Carlo simulation is better suited to hypothetical “what if” analysis
than historical simulation. To model a pension plan’s status under a number of different
hypothetical assumptions affecting the assets and liabilities, Monte Carlo simulation is
the most appropriate method
B is incorrect because Monte Carlo simulation is not an analytical method that can
provide great insights into cause and effect relationships. It is a complement to analytical
methods.
C is incorrect because historical simulation is not as well suited to hypothetical “what
if” analysis as is Monte Carlo simulation. While historical simulation is easier to model
because it relies on data from the past to predict future probability distributions, it is not
as well suited for meeting the goal of projecting the plan’s assets and liabilities under
different assumptions.

Common Probability Distributions

LOS q
Section 4

34 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.

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

LOS a
Section 2.4

35 According to the Solow neoclassical growth model, sustained long-­term growth

in potential GDP is best explained by:
A capital deepening investments.
B technological change.
C growth in labor supply.
24 2018 Level I Mock Exam (B) PM

B is correct. Growth in potential GDP equals growth in technology plus the weighted
average growth rate of labor and capital. Because of diminishing marginal productivity
(return), the only way to sustain long-­term growth in potential GDP is through techno-
logical change or growth in total factor productivity.
A is incorrect. Growth in potential GDP equals growth in technology plus the weighted
average growth rate of labor and capital. Because of diminishing marginal productivity
(return), the only way to sustain long-­term growth in potential GDP is through techno-
logical change or growth in total factor productivity.
C is incorrect. Growth in potential GDP equals growth in technology plus the weighted
average growth rate of labor and capital. Because of diminishing marginal productivity
(return), the only way to sustain long-­term growth in potential GDP is through techno-
logical change or growth in total factor productivity.

Aggregate Output, Prices, and Economic Growth

LOS n, o
Section 4.1

36 A positive movement in a lagging indicator would least likely be used to:

A confirm that an expansion is currently underway.
B identify a past condition of the economy.
C identify an expected future economic upturn.

C is correct. A positive movement in a lagging indicator would most likely be used to

confirm that an existing expansion is underway or has already occurred. Only a leading
indicator would help identify or predict a future economic event.
A is incorrect. A positive move in a lagging indicator by itself is insufficient to indicate
a positive expansion. However, confirmation would be required from positive changes
in a coincident indicator to indicate expansion.
B is incorrect. A positive move in a lagging indicator is most likely identifying an
upturn in economic activity that occurred in the past.

Understanding Business Cycles

LOS i
Section 5

37 Which of the following is the least likely outcome when a monopolist adopts
first-­degree price discrimination because of customers’ differing demand
elasticities?
A The output increases to the point at which price equals the marginal cost.
B The monopolist shares the total surplus with consumers.
C The price for a marginal unit decreases to less than the price for other units.

B is correct. In a monopoly, perfect price discrimination results in the total surplus being
kept by the producer, the monopolist.
C is incorrect. When a monopolist adopts perfect price discrimination, the price for
the marginal unit will be lower than average price.
2018 Level I Mock Exam (B) PM 25

A is incorrect. Under perfect price discrimination, output increases to the point where
price equals marginal cost.

The Firm and Market Structures

LOS f
Section 6.4

38 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

LOS a
Section 2.2

39 The following data apply to a country in its domestic currency units:

Consumer spending on goods 875,060 Government spending on 305,600
and services goods and services
Business gross fixed 286,400 Government gross fixed 84,120
investment investment
Change in inventories –68,500 Capital consumption 8,540
allowance
Transfer payments 9,300 Statistical discrepancy –2,850
Exports 219,800 Imports 250,980

Using the expenditures approach, the country’s GDP is closest to:

A 1,466,490.
B 1,451,500.
C 1,448,650.

C is correct. Using the expenditures approach:

GDP = Consumer spending on goods and services + Business gross fixed investment
+ Change in inventories + Government spending on goods and services + Government
gross fixed investment + Exports – Imports + Statistical discrepancy

Consumer spending on goods and services 875,060

Business gross fixed investment 286,400
(continued)
26 2018 Level I Mock Exam (B) PM

Change in inventories (68,500)

Government spending on goods and services 305,600
Government gross fixed investment 84,120
Exports 219,800
Imports (250,980)
Statistical discrepancy (2,850)
= Gross domestic product (GDP) 1,448,650

A is incorrect. It includes all items including transfer payments and capital consump-
tion allowance, which are components of the income approach.
= 1,448,650 + 9,300 + 8,540 = 1,466,490
B is incorrect. It ignores statistical discrepancy.
= 1,448,650 + 2,850 = 1,451,500

Aggregate Output, Prices, and Economic Growth

LOS a
Sections 2.2, 2.3

40 Which of the following statements is most accurate based on the FX quotations

in the table?
Spot Rate One-­Year Forward Rate

USD/EUR 1.2952 1.3001

A The forward rate is trading at a discount to the spot rate by 0.0049 points.
B The euro is trading at a forward premium of 49 points.
C The US dollar is trading at a forward premium of 49 points.

B is correct. Forward premium = Forward rate – Spot rate = 1.3001 – 1.2952 = 0.0049.
To convert to points, scale four decimal places—that is, multiply by 10,000 = 10,000 ×
0.0049 = 49 points. Because the forward rate exceeds the spot rate for the base currency
(euro), the euro is trading at a forward premium of 49 points.
C is incorrect. When the forward rate (1.3001) is higher than the spot rate (1.2952),
the base currency (EUR) is said to be trading at a forward premium, not a discount, to
the price currency (USD).
A is incorrect. When the forward rate (1.3001) is higher than the spot rate (1.2952),
the forward points are positive, and the forward rate is said to be trading at a premium
to the spot rate. The wrong number is derived from 1.3001 – 1.2952 = 0.0049. The USD/
EUR is quoted to four decimal places, so it needs to be scaled up by four decimal places
or multiplied by 10,000 to 49 points.

Currency Exchange Rates

LOS g
Section 3.3

41 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.
2018 Level I Mock Exam (B) PM 27

B buy securities.
C sell securities.

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

LOS h
Sections 2.3.2.1, 2.3.2.2

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

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

Monetary and Fiscal Policy

LOS d, e
Sections 2.1.6, 2.1.7

43 Which of the following events would most likely have a positive impact on the
GDP of Switzerland and the gross national product (GNP) of France?
A An industrial components manufacturer in France produces industrial com-
ponents in France using Swiss workers.
B A Swiss company purchases machine tools from a manufacturing firm
located in France.
C An accounting firm located in France provides accounting services to a
manufacturer located in Switzerland.
28 2018 Level I Mock Exam (B) PM

C is correct. GDP measures the market value of all final goods and services produced by
factors of production (such as labor and capital) located within a country, therefore Swiss
GDP includes the accounting services provided within Switzerland. GNP measures the
market value of all final goods and services produced by factors of production supplied
by residents of a country, regardless of whether such production takes place within
the country or outside of the country. Therefore, GNP includes the accounting services
produced by a French citizen abroad.
A is incorrect. The production in France (outside of Switzerland) will not have a positive
impact on Swiss GDP. Although it will be included in France’s GDP (production in France
by nationals and foreigners), it will not be included in France’s GNP. GNP only includes
value of goods and services produced by a country’s residents.
B is incorrect. The purchase of French machine tools is an import which reduces
Swiss GDP.

International Trade and Capital Flows

LOS a, h
Sections 2.1, 4.4

44 A member of the labor force quit her job last week and will begin a new job
next week. During this interim period, for the purposes of calculating unem-
ployment statistics, this person is most likely classified as:
A hidden unemployed.
B frictionally unemployed.
C voluntarily unemployed.

B is correct. Frictional unemployment is short term and transitory in nature; it includes

people who are “between jobs,” as in this case, and those who are not working because
they are taking time to search for a job that better matches their skills, interests, and
other preferences.
A is incorrect. The hidden unemployed encompass discouraged workers and under-
employed people. Discouraged workers are those who have stopped looking for a job,
and the underemployed are those who have a job but have qualifications to work at
significantly higher paying jobs.
C is incorrect. Although this person likely left their old job voluntarily, frictionally
unemployed is a better answer here because they do have a job waiting for them.
The voluntarily unemployed are persons outside the labor force who might refuse an
available vacancy if the pay rate is below their reservation wage or those who might
have retired early.

Understanding Business Cycles

LOS d
Section 4.1

45 The primary goal of both monetary and fiscal policy focuses on balancing eco-
nomic growth and:
A income distribution.
B inflation.
C employment.
2018 Level I Mock Exam (B) PM 29

B is correct. The goal of both monetary and fiscal policy is the creation of an economic
environment characterized by positive, stable growth and low, stable inflation.
A is incorrect because the distribution of income (and wealth) lies within the purview
of fiscal policy involving the government’s decisions concerning spending and taxes. By
contrast, monetary policy refers to central bank activities directed toward influencing
the quantity of money and credit in an economy. Income distribution is not a policy
domain of monetary policy.
C is incorrect because the overarching goal of monetary and fiscal policy is to create
economic conditions characterized by positive, stable economic growth and low, stable
inflation. Achieving this goal promotes stability (rather than cyclicality) in employment,
consumption, and saving/investment outcomes.

Monetary and Fiscal Policy

LOS a
Section 1

46 An accounting document that records transactions in the order in which they

occur is best described as a:
A trial balance.
B general ledger.
C general journal.

C is correct. The general journal records transactions in the order in which they occur
(chronological order) and is thus sorted by date.
A is incorrect. The trial balance lists all account balances at a particular point in time.
B is incorrect. The general ledger is a document that shows all business transactions
by account.

Financial Reporting Mechanics

LOS g
Section 6.1

47 Which of the following statements best describes the role of the International
Organization of Securities Commissions (IOSCO)? The IOSCO
A is the oversight body to which the International Accounting Standards
Board (IASB) reports.
B is responsible for regulating financial markets of member nations.
C assists in attaining the goal of cross-­border cooperation in combating viola-
tions of securities laws.

C is correct. The IOSCO is not a regulator of financial markets. Its role is to assist in attaining
the goal of uniform regulation and enforcement of international financial standards and
in attaining the goal of cross-­border cooperation in combating violations of securities
and derivative laws.
A is incorrect. The IOSCO assists in attaining the goal of uniform regulation of inter-
national financial standards including IFRS, but the IASB does not report to it.
30 2018 Level I Mock Exam (B) PM

B is incorrect. The IOSCO is not a regulatory authority.

Financial Reporting Standards

LOS b
Section 3.2.1

48 The following information is available on a company for the current year.

Net income $1,000,000
Average number of common shares outstanding 100,000

Details of convertible securities outstanding:

Convertible preferred shares outstanding 2,000
 Dividend/share $10
 Each preferred share is convertible into five shares of
common stock

Convertible bonds, $100 face value per bond $80,000

 8% coupon
 Each bond is convertible into 25 shares of common stock

Corporate tax rate 40%

The company’s diluted EPS is closest to:

A $7.72.
B $7.57.
C $7.69.

A is correct. Because both the preferred shares and the bonds are dilutive, they should
both be converted to calculate the diluted EPS. Diluted EPS is the lowest possible value.

Diluted
Diluted EPS: Diluted
EPS: Bond Preferred EPS: Both
Basic EPS Converted Converted Converted

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

Preferred dividends –$20,000 –$20,000 0 0
After-­tax cost of $3,840 $3,840
interest
8% × $80,000 × (1
– 0.40)
Numerator $980,000 $983,840 $1,000,000 $1,003,840
Average common 100,000 100,000 100,000 100,000
shares outstanding
Preferred converted 10,000 10,000
Bond converted 20,000 20,000
Denominator 100,000 120,000 110,000 130,000
2018 Level I Mock Exam (B) PM 31

Diluted
Diluted EPS: Diluted
EPS: Bond Preferred EPS: Both
Basic EPS Converted Converted Converted

EPS $9.80 $8.20 $9.09 $7.72

B is incorrect. Preferred dividends were included after preferred conversion (see table).
C is incorrect. After-­tax interest on bonds was not added back after bond conversion:
after-­tax interest is (1 – 0.40) × 8% × $80,000 = 3,840 (see table).

Understanding Income Statements

LOS h, i
Sections 6.2, 6.3

49 For which of the following inventory valuation methods is the gross profit mar-
gin least likely to be the same under both a perpetual inventory system and a
periodic inventory system?
A LIFO
B Specific identification
C FIFO

A is correct. The periodic and perpetual systems result in the same inventory and cost
of goods sold values (and thus gross profit margin) using both FIFO and specific identi-
fication valuation methods, but not always under LIFO.
B is incorrect. The periodic and perpetual systems result in the same inventory and
cost of goods sold values (and thus gross profit margin) using both FIFO and specific
identification valuation methods, but not always under LIFO.
C is incorrect. The periodic and perpetual systems result in the same inventory and
cost of goods sold values (and thus gross profit margin) using both FIFO and specific
identification valuation methods, but not always under LIFO.

Inventories
LOS c
Section 3.6

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

ing financial statement elements most accurately represents inflows of economic
resources to a company?
A Revenues
B Assets
C Owners’ equity

A is correct. The financial statement elements under IFRS are assets, liabilities, owners’
equity, revenue, and expenses. Revenues are inflows of economic resources. Assets are
economic resources but not inflows. Equity is the residual claim on those economic
resources.
32 2018 Level I Mock Exam (B) PM

B is incorrect. Assets are economic resources, but not inflows.

C is incorrect. Equity is a residual claim on economic resources.

Financial Reporting Mechanics

LOS b
Section 3

51 Under IFRS, which of the following balance sheet presentation formats is most
acceptable? Classifying assets and liabilities:
A into operating, investing, and financing categories.
B in liquidity order.
C as monetary vs. non-­monetary.

B is correct. A liquidity-­based presentation can be used when it provides information

that is reliable and more relevant. Entities that typically choose this format include banks.
A is incorrect. Cash flow statements are divided into these categories.
C is incorrect. The monetary/non-­monetary categorization would be required in prepa-
ration for translating the balance sheet of a foreign subsidiary because different exchange
rates apply. However, this approach is not an acceptable balance sheet reporting format.

Understanding Balance Sheets

LOS c
Section 2.2, 2.3

52 Previously, a manufacturer of high-­quality industrial electrical generators only

sold its units to customers, but it has just introduced a leasing program. The
generators have expected useful lives of about 25 years, and the company antic-
ipates that the leases will have a term of 20 years or more. The company reports
under International Financial Reporting Standards. Which of the following
statements about the first year of the new leasing program is most accurate?
A Regardless of how the company classifies the lease, its total cash flow and
operating cash flow will be the same.
B If the lease is classified as an operating lease, the company’s profits should
be higher for a given leased asset than they would be under a finance lease.
C If the lease is classified as a finance lease, it will decrease the company’s
liquidity position compared with when the company was only selling its
generators.

C is correct. Whether the company sells or leases the asset, inventory will be reduced.
For sales, the company would report an accounts receivable classified as a current asset
(assuming sales terms are not in question). If the leases qualify as finance leases, then the
company will report a lease receivable, which is primarily long term. Therefore, compared
with selling units outright, the company’s current assets are lower under leasing and its
liquidity position will decrease.
A is incorrect. Total cash flow over the lease term under the two different methods of
lease accounting will be the same, but the total operating cash flows will not be: operating
cash flows will be lower under the finance lease, but investing cash flows will be higher.
2018 Level I Mock Exam (B) PM 33

B is incorrect. Total profits over a lease term under the two different methods of
lease accounting will be the same, but net income will be higher in the early years of the
finance lease compared to the net of lease revenues less depreciation reported under
an operating lease.

Long-­Lived Assets
LOS p
Section 9.2.2
Non- ­Current (Long-­Term) Liabilities
LOS g
Section 3.2.2

53 The most appropriate treatment for intangible assets with indefinite useful lives
is to:
A expense.
B capitalize with no amortization.
C capitalize and amortize.

B is correct. Intangible assets assumed to have indefinite useful lives (i.e., no foreseeable
limit to the period over which the asset is expected to generate net cash inflows for the
company) are capitalized and not amortized.
A is incorrect. Acceptable amortization methods for intangible assets are the same
as those for deprecation, but given that the intangible has an indefinite life, expensing
it is not an option.
C is incorrect. Acceptable amortization methods for intangible assets are the same as
those for deprecation, but given that the intangible has an indefinite life, the straight-­
line method is not an option.

Long-­Lived Assets
LOS f
Section 3.2

54 The following data are available on a company:

Metric

Working capital $60 million

Non-­current assets $235 million
Equity $170 million
Current ratio 1.75

The company’s financial leverage is closest to:

A 1.7.
B 2.2.
C 1.2.
34 2018 Level I Mock Exam (B) PM

B is correct. First determine current assets, where CA = Current assets, CL = Current

liabilities, WC = Working capital, and CR = Current ratio.

CR = CA/CL = 1.75
CL = CA/1.75
WC = CA – CL
60 = CA – CA/1.75
60 = 0.75/1.75 × CA
CA = 140
Then solve for total assets and determine financial leverage:

Metric

Current assets $140 million

Non-­current assets + $235 million
Total assets $375 million
Equity $170 million
Financial leverage = Total assets/Equity 2.2

A is incorrect. Instead of calculating total assets, the sum of non-­current assets and
working capital was used:

Metric (all $ amounts in millions)

Working capital 60
Non-­current assets + 235
Incorrect total assets 295
Equity 170
Financial leverage = Total assets/Equity 1.7

C is incorrect. Instead of calculating financial leverage, total liabilities to equity was

calculated:

Metric (all $ amounts in millions)

Total assets per calculation above 375

Less: Equity –170
Total liabilities 205
Incorrect Financial leverage calculation (Total
1.2
liabilities/Equity)

Understanding Balance Sheets

LOS h
Section 7.2

55 Selected information from a company’s comparative income statement and

balance sheet is presented below:
2018 Level I Mock Exam (B) PM 35

Selected Income Statement Data for the Year Ended 31

August ($ thousands)
2013 2012

Sales revenue 100,000 95,000

Cost of goods sold 47,000 47,500
Depreciation expense 4,000 3,500
Net Income 11,122 4,556

Selected Balance Sheet Data as of 31 August ($ thousands)

2013 2012

Current Assets
Cash and investments 21,122 25,000
Accounts receivable 25,000 13,500
Inventories 13,000 8,500
Total current assets 59,122 47,000

Current liabilities
Accounts payable 15,000 15,000
Other current liabilities 7,000 9,000
Total current liabilities 22,000 24,000

The cash collected from customers in 2013 is closest to:

A $111,500.
B $96,100.
C $88,500.

C is correct.

Cash collected from customers = Revenues – Increase in accounts

receivable
= $100 – (25 – 13.5)
= $88.5 thousand
A is incorrect. It adds the increase in accounts receivable to sales: $100 + (25 – 13.5)
= 111.5.
B is incorrect. It deducts the decrease in cash from revenues: 100 – (25 – 21.1) = 96.1.

Understanding Cash Flow Statements

LOS e, f
Section 3.2.1.1
36 2018 Level I Mock Exam (B) PM

56 The following information is available about a company for its current fiscal
year:
Accounting profit (earnings before taxes) $250,000
Taxable income $215,000
Tax rate 30%
Income taxes paid in year $61,200
Deferred tax liability, start of year $82,400
Deferred tax liability, end of year $90,650

The income tax expense reported on the current year’s statement of earnings is
closest to:
A $72,750.
B $69,450.
C $64,500.

A is correct. Income tax expense equals income tax payable (the tax rate multiplied
by the taxable income) plus the increase in the deferred tax liabilities.
(0.30 × $215,000) + ($90,650 – $82,400) = $64,500 + $8,250 = $72,750
B is incorrect. It is the tax paid plus the increase in deferred taxes: 61,200 + 8,250 =
69,450.
C is incorrect it is just the tax rate × the taxable income: 30 × 215,000 = 64,500.

Income Taxes
LOS a, d
Section 2

57 On 1 January 2014, the market rate of interest on a company’s bonds is 5%, and
it issues a bond with the following characteristics:
Face value €50 million
Coupon rate, paid annually 4%
Time to maturity 10 years (31 December 2023)
Issue price (per €100) €92.28

If the company uses International Financial Reporting Standards (IFRS), its

interest expense (in millions) in 2014 is closest to:
A €2.307.
B €2.386.
C €1.846.

A is correct. IFRS requires the effective interest method for the amortization of bond
discounts/premiums. The bond is issued for 0.9228 × €50 million = €46.140.
Interest expense = Liability value × Market rate at issuance = 0.05 ×
€46.140 = €2.307
C is incorrect. It uses the coupon rate of 4% × 46.140 = 1.8456.
2018 Level I Mock Exam (B) PM 37

B is incorrect. It uses the straight-­line method of bond amortization, which is allowed

under US GAAP but not IFRS.
50 × 4% – [(100 – 92.28) × 50]/10 years = 2 + 386,000 = 2.386

Non- ­Current (Long-­Term) Liabilities

LOS b
Section 2.2

58 A company that prepares its financial statements according to US GAAP leased

a piece of equipment on 1 January 2013. Information relevant to the transaction
is as follows:
●● Five annual lease payments of $25,000, with the first payment due 1
January 2013
●● Interest rate on similar company debt is currently 8%
●● The fair value of the equipment is $115,000
●● Useful life of the equipment is seven years
●● The company depreciates other equipment in the same asset class on a
straight-­line basis
The total expense related to the lease on the company’s 2013 income statement
will be closest to:
A $25,000.
B $28,185.
C $22,024.

B is correct. The lease would qualify as a finance (capital) lease under US GAAP because
the present value (PV) of the lease payments is more than 90% of the fair value.
Using a financial calculator for an annuity due at the beginning of the period:
PV of lease payments: PMT = $25,000, i = 8%, N = 5, Mode = Begin,
Compute PV.
PV = $107,803, 90% of the fair value: 0.90 × $115,000 = $103,500
Therefore, the lease is greater than 90% and would be capitalized at $107,803.

Present value of the lease (asset value capital- $107,803

ized and initial liability)
Payment 1 January 2013 –25,000
Liability value 1 January 2013 $82,803

Interest expense in 2013 0.08 × $82,803 $6,624.25

Amortization expense for the year using the $107,803/5 $21,560.63
lease term as the useful life (no indication that
the lease will be renewed beyond the initial
term)
Total expense in 2013 $28,184.88

A is incorrect. It assumes it is an operating lease and simply deducts the lease pay-
ment. If you do not calculate the PV as an annuity due then it does not trip the criteria
and you would incorrectly classify it as operating. N = 5, i = 8, PMT = 25,000, PV = 99,817
vs. 90% of 115,000 = 103,500.
38 2018 Level I Mock Exam (B) PM

C is incorrect. It correctly classifies it as a finance lease but amortizes it over 7 years:

107,803/7 = 15,400; 15,400 + 6,624 = 22,024.

Non- ­Current (Long-­Term) Liabilities

LOS g, h
Section 3.2.1

59 An equity analyst is forecasting next year’s net profit margin of a heavy equip-
ment manufacturing firm by using the average net profit margin over the past
three years. In making his profit projection, he identifies the following three
items:
1 The company reported losses from discontinued operations in each of the
past three years.
2 The most recent year’s tax rate was only half of the prior two years’ rate as a
result of a fiscal stimulus.
3 The company reported gains on the sale of investments in each of the past
three years.
Which of the following statements about the preparation of the forecast is most
accurate? The analyst would:
A use the most recent tax rate because it is the best predictor of future tax
rates.
B exclude the gains on the sale from investments because the company is a
manufacturing firm.
C include the losses from discontinued operations because they appear to be
an ongoing feature for this company.

B is correct. The company is a heavy equipment manufacturer. Because gains on invest-

ments are not a core part of the company’s business, they should not be viewed as an
ongoing source of earnings. Discontinued operations are considered to be non-­recurring
items (even though they have occurred in the past three years); they are normally treated
as random and unsustainable and should not be included in a short-­term forecast. The
change in the current tax rate is best viewed as temporary in the absence of additional
information and should not be the basis of the calculation of the average tax rate.
A is incorrect. The long(er) run tax rate should be used; the change in the current tax
rate is best viewed as temporary in the absence of additional information and should
not be the basis of the calculation of the average tax rate.
C is incorrect. The discontinued items should be considered random and unsustain-
able for a short-­term forecast.

Understanding Income Statements

LOS f
Sections 5.1, 5.5
Financial Statement Analysis: Applications
LOS b
Section 3

60 A company has consistently and significantly increased its cash balance over the
past three years. The least likely explanation for the increase in cash is a:
A forthcoming issue of new equity.
B potential acquisition.
2018 Level I Mock Exam (B) PM 39

C planned increase in the dividend.

A is correct. A new equity issue will provide additional cash, so it does not explain an
increase in cash holdings prior to the issue.
B is incorrect. A company might increase its cash to build a “war chest” in order to
make an acquisition.
C is incorrect. A company might increase its cash to pay a larger dividend.

Financial Statement Analysis: Applications

LOS a
Section 2

61 The financial statement that would be most useful to an analyst in understand-

ing the changes that have occurred in a company’s retained earnings over a year
is the statement of:
A comprehensive income.
B financial position.
C changes in equity.

C is correct. The statement of changes in equity reports the changes in the components
of shareholders’ equity over the year, which would include the retained earnings account.
A is incorrect. The net income determined in the calculation of comprehensive income
is a component of the change in retained earnings, but there are other changes that
may also have occurred (the payment of dividends, for example) that are not included
on the statement of comprehensive income.
B is incorrect. Although the year-­end balances of retained earnings may be reported
on the statement of financial position (depending on if the company breaks out the
components of shareholders’ equity), it would not detail the changes over the year.

Financial Statement Analysis: An Introduction

LOS b
Section 3.1.3

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

A is correct. Interest paid must be categorized as an operating cash flow activity under
US GAAP, although it can be categorized as either an operating or financing cash flow
activity under IFRS.
B is incorrect. Interest paid cannot be categorized as a financing cash flow under US
GAAP but can be under IFRS.
40 2018 Level I Mock Exam (B) PM

C is incorrect. Interest paid cannot be categorized as a financing cash flow under US

GAAP but can be under IFRS.

Understanding Cash Flow Statements

LOS a, c
Section 3.2.1.5

63 A firm reported the following financial statement items:

€ millions

Net income 2,100

Non-­cash charges 400
Interest expense 300
Capital expenditures 210
Working capital expenditures 0
Net borrowing 1,600
Tax rate 40%

The free cash flow to the firm (FCFF) is closest to:

A €2,110.
B €2,470.
C €2,590.

B is correct.
FCFF = NI + NCC + Int(1 – t) – FCInv – WCInv

Amount (€
Cash Flow Item millions)

NI Net income 2,100

NCC Plus non-­cash charges 400
Int(1 – t) Plus interest expense (1 – tax rate) 300 (1 – 0.40) 180
FCInv Less capital expenditures (210)
WCInv Less working capital expenditures 0
FCFF Free cash flow to the firm €2,470

A is incorrect. It incorrectly subtracted interest expense.

Cash Flow Item Amount (€)

Net income + €2,100

Non-­cash charges + 400
Capital expenditure – 210
 Interest Expense: Int × (1 – 180
– t)
FCFF €2,110

C is incorrect. It ignores the tax effect on interest expense.

2018 Level I Mock Exam (B) PM 41

Cash Flow Item Amount (€)

Net income 2,100

Plus Non-­cash charges 400
Plus Interest expense 300
Less Capital expenditure (210)
Less working capital expenditures 0
FCFF €2,590

Understanding Cash Flow Statements

LOS i
Section 4.3

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

€ millions

Revenues for the year 12,500

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

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

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

C is correct.
Total comprehensive income = Net income + Other comprehensive income
Net Income = Revenues – Expenses.
Other comprehensive income includes gains or losses on available-­for-­sale (AFS)
securities and translation adjustments on foreign subsidiaries.
(Revenues – Expenses) + Gain on AFS securities – Loss on FX translation
(12,500 – 10,000) + 1,475 – 325 = 3,650.
A is incorrect because it is just the other comprehensive income (1,475 – 325) and not
the total comprehensive income.
B is incorrect because it also deducts dividends, which are deducted when calculating
the change in shareholders’ equity but not total comprehensive income.

Understanding Income Statements

LOS l, m
Section 8

65 Under US GAAP, which of the following is least likely a disclosure concerning

inventory?
42 2018 Level I Mock Exam (B) PM

A The amount of inventories recognized as an expense during the period

B The carrying amounts of inventories carried at fair value less costs to sell
C The amount of the reversal of any write-­down of inventories

C is correct. US GAAP does not permit the reversal of prior year write-­downs; therefore,
there are no disclosures related to reversals.
A is incorrect. Under both US GAAP and IFRS, disclosure is required about the amount
of inventories expensed during the period (cost of goods sold).
B is incorrect. Both US GAAP and IFRS require disclosures of any inventories carried
at fair value less costs to sell (NRV).

Inventories
LOS i
Section 7.1

66 Which of the following accounting actions would increase stockholders’ equity

in the current period?
A Using LIFO rather than FIFO accounting for inventory in an inflationary
environment.
B Capitalizing, rather than expensing, a payment.
C Increasing the allowance for uncollectible accounts receivable.

B is correct. The capitalization of payments is an example of how choices affect both the
balance sheet and income statement. Capitalizing a payment changes the benefit from
only the current period—making it an expense—to a benefit in future periods as an
asset. The creation of an asset results in a comparable increase in stockholder’s equity.
A is incorrect because adopting last-­in,-first-­out accounting for inventory in an
inflationary environment assumes newer and costlier purchases of inventory are sold
to customers with the result that the remaining inventory reflects the older costs. This
will contribute to lower net income from sales and a decrease in stockholders’ equity
C is incorrect because increasing the allowance for uncollectible accounts receivable
will increase the uncollectible accounts expense reported for the period. This will con-
tribute to lower net income and a decrease in stockholders’ equity.

Financial Reporting Quality

LOS h
Section 4.2.1

67 Conservative, rather than aggressive, accounting is most likely associated with:

A increased sustainability of earnings.
B higher current reported performance.
C recognition of losses once certain.
2018 Level I Mock Exam (B) PM 43

A is correct. Conservative accounting choices decrease a company’s reported performance

and results in the current period and may increase its reported performance and financial
position in later periods. Therefore, it typically avoids a sustainability issue.
B is incorrect because higher current reported performance is a result associated with
aggressive accounting choices, not conservative ones.
C is incorrect because in general, conservatism means that losses are recognized
when probable; waiting to recognize losses until they are certain would be an aggressive
approach rather than a conservative one.

Financial Reporting Quality

LOS c
Section 2.5.1

68 Using the data below, an analyst is in the process of comparing two companies
(A and B) that are in the same industry.

Company A (in $ millions, except per share data)

Net income $7,098
Weighted average common shares outstanding 4,366
Common share dividends $1,700
Stock price per share at year-­end $41.00

Company B
Basic EPS $4.35
Earnings multiple 21.17×
Dividend payout ratio 25.9%

Compared with Company B, Company A most likely has a higher:

A price-­to-­earnings ratio.
B dividend payout ratio.
C earnings per share.

A is correct. Company A has a higher price-­to-­earnings ratio (P/E). Its P/E of 25.15× is
calculated as follows:
44 2018 Level I Mock Exam (B) PM

Company
Calculation A Comment

EPS Net income/Weighted average $1.63 Lower than B ($4.35)

number of common shares
outstanding = 7,098/4,366 =
P/E Market price/EPS = 25.15× Higher than B
41.00/1.63 = (21.17×)
Dividend Common share dividends/Net 24.0% Lower than B
payout income = 1,700/7,098 = (25.9%)

B is incorrect because Company A has a lower dividend payout than Company B:

24.0% vs. 25.9%.
C is incorrect because Company A has a lower EPS than Company B: 1.63 vs. 4.35.

Financial Analysis Techniques

LOS e
Section 5.1
Understanding Income Statements
LOS h
Section 6.2

69 The following information is available for a company:

2016 (in €
millions)

EBIT (earnings before interest and taxes) 1,015.0

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

2015

Interest coverage 15.3×

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

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

A is correct. When calculated for 2016, interest coverage decreased and debt to total
assets and return on assets both increased. In general, a decrease in interest coverage
and an increase in debt to total assets would reduce creditworthiness, but an increase
in return on assets would improve creditworthiness. Calculations are as follows:
2018 Level I Mock Exam (B) PM 45

Calculation 2016 Comment

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

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

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

Financial Analysis Techniques

LOS e
Section 6

70 A 20-­year $1,000 fixed-­rate non-­callable bond with 8% annual coupons cur-

rently sells for $1,105.94. Assuming a 30% marginal tax rate and an additional
risk premium for equity relative to debt of 5%, the cost of equity using the
bond-­yield-­plus-­risk-­premium approach is closest to:
A 9.9%
B 12.0%
C 13.0%

B is correct. First, determine the yield to maturity, which is the discount rate that
sets the bond price to $1,105.94 and is equal to 7%. This calculation can be done with
a financial calculator:
FV = –$1,000, PV = $1,105.94, N = 20, PMT = –$80, solve for i, which will
equal 7%.
The bond-­yield-­plus-­risk-­premium approach is calculated by adding a risk premium
to the cost of debt (i.e., the yield to maturity for the debt), making the cost of equity
12.00% (= 7% +5%).
A is incorrect because it uses the after-­tax cost of debt: 9.90% = 7% × (1 – 30%) + 5%.
C is incorrect because it uses the coupon rate instead of the yield-­to-­maturity: 13.00%
= 8% + 5%.

Cost of Capital
LOS f, h
Sections 3.1.1, 3.3.3

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

Cost of debt 10%
Cost of equity 16%
Debt-­to-­equity ratio (D/E) 50%
Tax rate 30%
46 2018 Level I Mock Exam (B) PM

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

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

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

we = 1 – wd = 66.7%

WACC = wdrd(1 – t) + wprp + were

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

Cost of Capital
LOS a, b
Sections 2, 2.1, 2.2

72 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%.
2018 Level I Mock Exam (B) PM 47

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%.
B is incorrect because it does not adjust net income in the solution.
(Net Income/Assets)/50% = 20%

Measures of Leverage
LOS c
Section 3.4

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

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
LOS j, h
Section 4.2 and 3.3

74 A company extends its trade credit terms by four days to all its credit custom-
ers. These credit customers are most likely to experience a four-­day:
A decrease in their net operating cycle.
B increase in their operating cycle.
C decrease in their operating cycle.

A is correct. The company’s customers are receiving a four-­day increase in their number
of days of payables, which will reduce the company’s cash conversion cycle (net oper-
ating cycle) by four days.
48 2018 Level I Mock Exam (B) PM

B is incorrect because a four-­day increase in the number of days of payables will not
affect the operating cycle (DHO + DSO) but will reduce the net operating cycle by four days
C is incorrect because a four-­day increase in the number of days of payables will not
affect the operating cycle (DHO + DSO) but will reduce the net operating cycle by four
days.

Financial Analysis Techniques

Section 4.2- ­4.3
LOS b
Working Capital Management
LOS c
Section 2.2

75 Which of the following statements describes the most appropriate treatment of

cash flows in capital budgeting?
A Interest costs are included in the project’s cash flows to reflect financing
costs.
B A project is evaluated using its incremental cash flows on an after-­tax basis.
C Sunk costs and externalities should not be included in the cash flow
estimates.

B is correct. All of the incremental cash flows arising from a project should be analyzed
on an after-­tax basis.
C is incorrect. Only sunk costs should be ignored in a project’s cash flow estimation,
but not any externalities. Sunk costs cannot be recovered once they have been incurred.
Externalities (both positive and negative ones) are the effects of an investment decision
on other things beside the investment itself; they should therefore be included in the
cash flow estimation.
A is incorrect. Financing costs like interest costs are excluded from calculations of
operating cash flows. The financing costs are reflected in the required rate of return for
an investment project. If financing costs are included, we would be double-­counting
these costs.

Capital Budgeting
LOS b
Section 3

76 Based on a need to borrow $2 million for one month, which of the following
alternatives has the least expensive effective annual cost?
A A credit line at 6.0% annually with a $4,000 annual commitment fee
B A banker’s acceptance with an all-­inclusive annual rate of 6.1%
C Commercial paper at 5.9% annually with a dealer’s annual commission of
$3,000 and a backup line annual cost of $4,000

B is correct.
2018 Level I Mock Exam (B) PM 49

Method Formula Calculation

Banker’s Interest Interest: 0.061/12 × $2,000,000 = 10,167

Acceptance × 12 Net proceeds: 2,000,000 – 10,167 = 1,989,833
(BA)
Net proceeds BA cost (10,167 × 12)/1,989,833 = 0.0613
Line of Interest + Commitment fee Interest: 0.06/12 × $2,000,000 = 10,000
credit × 12 Commitment fee: $4,000/12 = 333
(LOC)
Usable loan amount Usable loan: $2,000,000
LOC cost (10,333 × 12)/2,000,000 = 0.0620
Commercial Interest + Dealer's commissions + Interest:costs
Backup 0.059/12 × $2,000,000 = 9,833
Paper (CP) × 12 $3,000/12 = 250
Dealer commission:
Net proceeds Backup costs: $4,000/12 = 333
Total costs: 9,833 + 250 + 333 = 10,416
Net proceeds: 2,000,000 – 9,833 = 1,990,167
CP cost: (10,416 × 12)/1,990,167 = 0.0628

Banker’s acceptance has the lowest annual effective cost of 0.0613.

A is incorrect because the line of credit effective annual cost is 6.20%.
C is incorrect because the commercial paper effective annual cost is 6.28%.

Working Capital Management

LOS g
Section 8.4

77 Which of the following best allows a board of directors to act in the interest of
the company and shareholders?
A Independent board members are selected from outside the industry.
B Internal directors provide monitoring of the firm’s management.
C The board has the authority to select and terminate senior management.

C is correct. The board has a duty to make decisions in the best interest of the company
and shareholders. It reviews management’s performance in executing the strategy set
by the board. In order to ensure strong execution of the strategy, the board must have
the authority to select and terminate senior management.
A is incorrect. At least some independent members should have industry expertise.
B is incorrect. External directors should provide monitoring within the firm.

Corporate Governance and ESG: An Introduction

LOS f
Section 5.2

78 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.
50 2018 Level I Mock Exam (B) PM

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
LOS d
Section 4.4

79 The execution step of the portfolio management process includes:

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

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

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

Portfolio Management: An Overview

LOS d
Section 4

80 An investor with $10,000 decides to borrow an additional $5,000 at the risk-­free

rate and invest all the available funds in the market portfolio. This investor’s
portfolio beta is closest to:
A 0.5.
B 1.0.
C 1.5.
2018 Level I Mock Exam (B) PM 51

C is correct. The weight in the market portfolio is 15,000/10,000 = 1.5 and the weight
in the risk-­free asset is –5,000/10,000 = –0.5. Because the beta of the risk-­free asset is
0 and the market portfolio’s beta is 1, the portfolio’s beta is β p = 0(–0.5) + 1(1.5) = 1.5.
A is incorrect because it is computed using weights of 0.5 for the risk-­free asset and
the market portfolio, that is: 0(0.5) + 1(0.5) = 0.5.
B is incorrect because it is the market portfolio’s beta.

Portfolio Risk and Return: Part II

LOS b, e
Sections 2.2 and 4.2

81 The variance of returns of a security and the market portfolio are 0.25 and 0.09,
respectively. If the covariance of security returns and market returns is 0.06, the
security’s beta is closest to:
A 0.24.
B 0.67.
C 0.40.

B is correct. The security's beta is:

Cov (Ri , Rm ) 0.06
βi = = = 0.67
σ2m 0.09
A is incorrect because it is computed as (0.06/0.25) = 0.24.
C is incorrect because it is computed as the correlation between the returns on the
security and the market portfolio as [0.06/(0.5 × 0.3)] = 0.4.

Portfolio Risk and Return: Part II

LOS e
Section 3.2

82 Risk management is most likely the process by which an organization:

A minimizes its exposure to potential losses.
B adjusts its risk to a predetermined level.
C maximizes its risk-­adjusted return.

B is correct. An organization with a strong competitive position can recover from losses
more easily than one with a weaker competitive position. Therefore, an organization’s risk
tolerance should reflect its competitive position. An organization’s size does not define
the risk sources it faces or the relative losses it can absorb, so it should not be reflected
in its risk tolerance. Neither the risk sources affecting an organization nor the size of the
losses an organization can absorb are a function of its perception of market stability.
A is incorrect because a minimum risk position may not be optimal for the organization.
52 2018 Level I Mock Exam (B) PM

C is incorrect because a high risk-­adjusted return may require a level of risk taking
that is beyond the organization’s capacity to absorb.

Risk Management: An Introduction

LOS a
Section 3.2

83 A good risk governance process would most likely:

A provide guidance on the size of the largest acceptable loss for the
organization.
B provide different risk targets for each unit within the organization.
C be a bottom-­up process that reflects the current risk exposures of all parts
of the organization.

A is correct. A quality risk governance process takes a top-­down approach and is charged
with risk oversight for the entire organization. It should operate on an enterprise-­wise
basis rather than viewing each unit in isolation. It will determine the organization’s risk
tolerance and provide a sense of the maximum loss the organization can absorb.
B is incorrect because a good risk governance process looks at the enterprise as a
whole rather than viewing individual units in isolation.
C is incorrect because a risk governance process is a top-­down process.

Risk Management: An Introduction

LOS c
Section 3

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

A is correct. Investment time horizon is an objective factor that measures the investor’s
ability to take risk.
B is incorrect because luck is a subjective factor that measures willingness to take risk.
C is incorrect because safety of principal is a subjective factor that measures willing-
ness to take risk.

Basics of Portfolio Planning and Construction

LOS d
Section 2.2.1

85 Which of the following portfolios of risky assets is most likely the global
minimum-­variance portfolio?
2018 Level I Mock Exam (B) PM 53

Expected Standard
Portfolio Return Deviation

A 5% 20%
B 8% 33%
C 3% 20%

A Portfolio C
B Portfolio A
C Portfolio B

B is correct. The global minimum-­variance portfolio is the left-­most point on the minimum-­
variance frontier among all portfolios of risky assets. Portfolios A and C have the same
standard deviation, but Portfolio A dominates Portfolio C because of a higher return.
A is incorrect because it has a lower expected return while having the same variance
as portfolio A. It is unlikely to be located on the minimum-­variance frontier.
C is incorrect because it has a higher variance than portfolio A.

Portfolio Risk and Return: Part I

LOS f
Section 5.2

86 An analyst observes that stock markets usually demonstrate return distributions

concentrated to the right with a higher frequency of negative deviation from the
mean. This feature is most likely known as:
A positive skewness.
B negative skewness.
C kurtosis.

B is correct. The negatively skewed investment characteristic is usually related to the

stock returns whose distribution is concentrated to the right.
A is incorrect positive skew has more large positive deviation from the mean.
C is incorrect because kurtosis is related to the fat-­tail feature.

Portfolio Risk and Return: Part I

LOS b
Section 2.5

87 Returns from a depository receipt are least likely affected by which of the fol-
lowing factors?
A Exchange rate movements
B Number of depository receipts
C Analysts’ recommendations
54 2018 Level I Mock Exam (B) PM

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

Overview of Equity Securities

LOS d, e
Section 5.2

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

A is correct. One of the main functions of the financial system is to determine the equi-
librium interest rate, which is the only interest rate that would exist if all securities were
equally risky, had equal terms, and were equally liquid.
B is incorrect. Informational market efficiency is not a key function of the financial
system, rather that of regulatory framework
C is incorrect. The financial system provides sufficient funding only to the most pro-
ductive projects. An important function of the financial system is to direct resources
away from wealth-­diminishing projects.

Market Organization and Structure

LOS a
Section 2.2

89 A portfolio manager analyzes a market and discovers that it is not possible to

achieve consistent and superior risk-­adjusted returns, net of all expenses. This
market is most likely characterized by:
A persistent anomalies.
B informational efficiency.
C restrictions on short selling.

B is correct. In an informationally efficient market, consistent and superior risk-­adjusted

returns (net of all expenses) are not achievable.
A is incorrect. In an informationally efficient market, consistent and superior risk-­
adjusted returns (net of all expenses) are not achievable. In such a situation, persistent
anomalies are unlikely.
2018 Level I Mock Exam (B) PM 55

C is incorrect. Some market experts argue that restrictions on short selling limit
arbitrage trading, which impedes market efficiency.

Market Efficiency
LOS a
Section 2.1

90 The financial systems that are operationally efficient are most likely character-
ized by:
A security prices that reflect fundamental values.
B liquid markets with low commissions and order price impacts.
C the use of resources where they are most valuable.

B is correct. Operationally efficient markets are liquid markets in which the costs of
arranging trades, commissions, bid–ask spreads, and order price impacts are low.
A is incorrect. Informationally efficient markets, not the operationally efficient markets,
are characterized by prices that reflect fundamental values so that prices vary primarily
in response to changes in fundamental values and not to demands for liquidity made
by uninformed traders.
C is incorrect. Allocationally efficient markets, not the operationally efficient markets,
are characterized by using resources where they are most valuable.

Market Organization and Structure

LOS k
Section 9

91 According to the industry life-­c ycle model, an industry in the shakeout stage is
best characterized as experiencing:
A little or no growth and industry consolidation.
B slowing growth and intense competition.
C relatively high barriers to entry and periodic price wars.

B is correct. The shakeout stage is usually characterized by slowing growth, intense compe-
tition, and declining profitability. During the shakeout stage, demand approaches market
saturation levels because few new customers are left to enter the market. Competition
is intense as growth becomes increasingly dependent on market share gains.
A is incorrect. Little or no growth and industry consolidation are characteristics of
an industry in mature phase.
C is incorrect. Relatively high barriers to entry and periodic price wars are character-
istic of mature phase.

Introduction to Industry and Company Analysis

LOS h
Section 5.1.5

92 In the semi-­strong-­form of market efficiency, fundamental analysis most likely

requires the analyst to:
56 2018 Level I Mock Exam (B) PM

A extrapolate historical data to estimate future values and make investment

decisions.
B use trading rules for detecting the price movements that lead to new equi-
librium prices.
C do a superior job of estimating the relevant variables and predicting earn-
ings surprises.

C is correct. Fundamental analysis facilitates a semi-­strong-­form efficient market by

disseminating value-­relevant information. Fundamental analysis can be profitable in
terms of generating abnormal returns if the analyst creates a comparative advantage
with respect to this information. Such an advantage can be achieved by doing a superior
job of estimating the relevant variables and predicting earnings surprises.
A is incorrect. Simply extrapolating historical data may not produce superior returns
in an efficient market.
B is incorrect. The use of technical rules for detecting the price movements and gradual
price adjustments comprises technical analysis, not fundamental analysis.

Market Efficiency
LOS d
Section 3.4.1

93 A price-­weighted index series is composed of the following three stocks:

Price before Split Price after Split

Stock End of Day 1 End of Day 2

X $10 $12
Y $20 $19
Z $60 $22

If stock Z completes a three-­for-­one split at the end of Day 1, the value of the
index after the split (at the end of Day 2) is closest to:
A 31.7.
B 32.3.
C 29.9.

A is correct. The value of the price-­weighted index is determined by dividing the sum of
the security values by the divisor, which is typically set at inception to equal the initial
number of securities in the index. In the case of a stock split, the index provider must
adjust the value of the divisor by dividing the sum of the constituent prices after the split
2018 Level I Mock Exam (B) PM 57

by the value of the index before the split. This adjustment results in a new divisor that
keeps the index value at the same level as before the split. The new divisor will then be
used to calculate the index value after the split.
10 + 20 + 60
Index before the split =
3
= 30
10 + 20 + 20
New divisor, X: 30 =
X
X = 1.67
12 + 19 + 22
Index after the split =
1.67
= 31.7
B is incorrect. It calculates the changes in prices and uses it to derive the new index.
C is incorrect. It uses price after split to calculate the new divisor.

Security Market Indexes

LOS b, e
Section 3.2.1

94 A firm reports negative earnings for the year just ended. The price multiple of
the firm’s stock that is least likely to be meaningful is:
A trailing price to earnings.
B price to cash flow.
C leading price to earnings.

A is correct. Negative earnings in the last year result in a negative ratio of trailing price to
earnings and are not meaningful. Practitioners may use the ratio of (1) current price to cash
flow or (2) leading price to earnings by replacing last year’s loss with forecasted earnings.
B is incorrect. Alternative to negative trailing price-­to-­earnings ratio, practitioners
may use price-­to-­cash-­flow ratio because it is possible cash flow would be positive in
spite of a small loss.
C is incorrect. Alternative to negative trailing price-­to-­earnings ratio, practitioners
may use leading price-­to-­earnings ratio by replacing last year’s loss with forecasted
earnings which may be positive.

Equity Valuation: Concepts and Basic Tools

LOS j
Section 5

95 Which of the following types of companies is most sensitive to economic

conditions?
A Cyclical
B Growth
C Defensive
58 2018 Level I Mock Exam (B) PM

A is correct. The performance of companies with cyclical demand for their products is
highly variable and depends on economic conditions.
B is incorrect. Growth firms have steady increases in demand and are less dependent
on economic conditions.
C is incorrect. Defensive demand is stable and does not fluctuate with the economic
cycle, except in severe recessions.

Introduction to Industry and Company Analysis

LOS c
Section 5.1.7

96 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

LOS e
Section 4

97 An index provider launches a new index that will include value stocks in a spe-
cific country. This index will most likely be a:
A large-­capitalization index.
B style index.
C fundamentally weighted index.

B is correct. Style indexes represent a group of securities classified according to market

capitalization, value, and growth or a combination of these characteristics. Therefore,
the new index will most likely be a style index with a value classification.
A is incorrect. Large-­capitalization indexes represent and track the largest securities
in terms of market capitalization. They do not represent the category of value stocks.
2018 Level I Mock Exam (B) PM 59

C is incorrect. Fundamentally weighted indexes use measures such as book value,

cash flow, revenues, earnings, dividends, and number of employees to weight the con-
stituent securities. Securities of different styles and sectors could be included in the
same fundamentally weighted index. Therefore, fundamentally weighted indexes do
not represent the category of value stocks.

Security Market Indexes

LOS h
Section 5.4

98 Given the following information for a company:

●● Market value per share $250
●● Current dividend per share $5
●● Dividend growth rate 4%
●● Required rate of return 6%
and using the Gordon growth model to estimate the intrinsic value, a share of
the company is best described as being:
A fairly valued.
B overvalued.
C undervalued.

C is correct. The intrinsic value of an equity security based on the Gordon growth
model is estimated as follows:
D0 (1 + g ) D1
V0 = =
r−g r−g
where:

V0 = the estimate of the intrinsic value

D0 = the current dividend ($5) and D1 is the next year’s dividend
g = the dividend growth rate (4%)
r = the required rate of return (6%)
The estimate of the intrinsic value is:
D0 (1 + g ) $5(1 + 0.04)
V0 = = = $260 per share
r−g (0.06 − 0.04)
Given that the market value ($250) is lower than the estimate of the intrinsic value
($260), a share of the company appears to be undervalued.
B is incorrect. The estimate of the intrinsic value is
D0 (1 + g ) $5(1 + 0.04)
V0 = = = $260 per share
r−g (0.06 − 0.04)
Given that the market value is lower than the estimate of the intrinsic value ($250 <
$260), a share of the company appears to be undervalued, not overvalued. A share of a
company is overvalued when the market value is higher than the intrinsic value.
A is incorrect. The estimate of the intrinsic value is
D0 (1 + g ) $5(1 + 0.04)
V0 = = = $260 per share
r−g (0.06 − 0.04)
60 2018 Level I Mock Exam (B) PM

Given that the market value is lower than the estimate of the intrinsic value ($250 <
$260), a share of the company appears to be undervalued. A share of a company is fairly
valued when the intrinsic value is equal to the market value. Using $5 as D1, rather than
D0, would lead to the wrong conclusion that a share of the company is fairly valued:
$5/(0.06 – 0.04) = $250 per share

Equity Valuation: Concepts and Basic Tools

LOS g
Section 4.2
Market Efficiency
LOS b
Section 2.2

99 What type of risk most likely affects an investor’s ability to buy and sell bonds in
the desired amounts and at the desired time?
A Market liquidity
B Spread
C Default

A is correct. The size of the spread between the bid price and the ask price is the primary
measure of market liquidity of the issue. Market liquidity risk is the risk that the investor
will have to sell a bond below its indicated value. The wider the bid–ask spread, the
greater the market liquidity risk.
B is incorrect because spread risk is the risk that spreads widen.
C is incorrect because default risk is the risk the borrower defaults.

Fundamentals of Credit Analysis

LOS a
Section 2

100 Which of the following most likely exhibits negative convexity?

A A callable bond
B An option-­free bond
C A putable bond

A is correct. A callable bond exhibits negative convexity at low yield levels and positive
convexity at high yield levels.
B is incorrect because an option-­free bond always exhibits positive convexity.
C is incorrect because a putable bond always exhibits positive convexity, higher than
an option-­free bond.

Understanding Fixed-­Income Risk and Return

LOS h
Section 3.6

101 If a bank wants the ability to retire debt prior to maturity in order to take
advantage of lower borrowing rates, it most likely issues a:
2018 Level I Mock Exam (B) PM 61

A convertible bond.
B callable bond.
C putable bond.

B is correct. Callable bonds give issuers the ability to retire debt prior to maturity. The
most compelling reason for them to do so is to take advantage of lower borrowing rates.
A is incorrect because convertible bonds give bondholders the ability to convert the
bond to a predetermined number of shares of the company.
C is incorrect because putable bonds give bondholders the ability to sell the bond
at predetermined price to issuers.

Fixed-­Income Markets: Issuance, Trading, and Funding

LOS g
Section 6.3.5

102 An investor purchases a 5% coupon bond maturing in 15 years for par value.
Immediately after purchase, the yield required by the market increases. The
investor would then most likely have to sell the bond at:
A a premium.
B a discount.
C par.

B is correct. The bond would sell below par or at a discount if the yield required by the
market rises above the coupon rate. Because the bond initially was purchased at par, the
coupon rate equals the yield required by the market. Subsequently, if yields rise above
the coupon, the bond’s market price would fall below par.
A is incorrect because the yield is now greater than the coupon.
C is incorrect because the yield is now greater than the coupon.

Introduction to Fixed-­Income Valuation

LOS b
Section 2.3

103 The process of securitization is least likely to allow banks to:

A originate loans.
B reduce the layers between borrowers and ultimate investors.
C repackage loans into simpler structures.

C is correct. Securitization allows banks to originate (or create) loans, and the process
results in a reduction in the layers between borrowers and ultimate investors. The loans
are repackaged into more complex, not simpler, structures.
A is incorrect because securitization allows banks to originate (or create) loans.
62 2018 Level I Mock Exam (B) PM

B is incorrect because securitization results in a reduction in the layers between

borrowers and ultimate investors.

Introduction to Asset-­Backed Securities

LOS a
Section 2

104 Which of the following is least likely a component of yield spread?

A Taxation
B Expected inflation rate
C Credit risk

B is correct. Building blocks of the yield curve are spread (risk premium) and a benchmark
(risk-­free rate of return). Expected inflation rate and expected real rate are components
of the risk-­free rate of return (i.e., the benchmark).
A is incorrect because taxation is part of the yield spread providing the investor with
compensation for the tax impact of holding a specific bond.
C is incorrect because credit risk is part of the yield spread providing the investor
with compensation for the credit risks of holding a specific bond.

Introduction to Fixed-­Income Valuation

LOS i
Section 5.1

105 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%
2018 Level I Mock Exam (B) PM 63

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

LOS f
Section 3.5

106 The factor least likely to influence the yield spread on an option-­free, fixed-­rate
bond is a change in the:
A credit risk of the issuer.
B expected inflation rate.
C liquidity of the bond.

B is correct. For an option-­free, fixed-­rate bond, changes in the yield spread can arise
from changes in the credit risk of the issuer and/or changes in the liquidity of the issue.
Changes in the expected inflation rate influence the benchmark rate.
C is incorrect because changes in the yield spread an option-­free, fixed-­rate bond
arise from changes in the liquidity of the issue.
A is incorrect because changes in the yield spread an option-­free, fixed-­rate bond
arise from changes in the credit risk of the issuer.

Understanding Fixed-­Income Risk and Return

LOS l
Section 5

107 Samsung Electronics Co has issued a five-­year bond with a par value of $1,000
and a coupon rate of 6.5%. This bond is most likely to be classified as a:
A capital market security.
B surety bond.
C consol.

A is correct. Fixed-­income securities with original maturities that are longer than one year
are called capital market securities. The bond mentioned in the question has a five-­year
maturity and therefore is a capital market security.
B is incorrect because a surety bond is a bond that reimburses investors for any losses
incurred if the issuer defaults.
64 2018 Level I Mock Exam (B) PM

C is incorrect because a consol has no stated maturity date.

Fixed-­Income Securities: Defining Elements

LOS a
Section 2.1.2

108 In a mortgage pass-­through security, the pass-­through rate:

A is adjusted as market rates rise or fall.
B adjusts the rate on the underlying pool of mortgages by a servicing fee.
C is equal to the mortgage rate on the underlying pool of mortgages.

B is correct. In a mortgage pass-­through security, the pass-­through rate is less than the
mortgage rate on the underlying pool of mortgages by an amount equal to the servicing
(and other administrative) fees.
A is incorrect because in a mortgage pass-­through security, the pass-­through rate is
less than the mortgage rate on the underlying pool of mortgages by an amount equal
to the servicing (and other administrative) fees.
C is incorrect because in a mortgage pass-­through security, the pass-­through rate is
less than the mortgage rate on the underlying pool of mortgages by an amount equal
to the servicing (and other administrative) fees.

Introduction to Asset-­Backed Securities

LOS e
Section 5.1.1

109 Which of the following is most likely an example of a Eurobond?

A A Canadian borrower issuing British pound–denominated bonds in the UK
market.
B A Japanese borrower issuing US dollar–denominated bonds in the US
market.
C An Australian borrower issuing Canadian dollar–denominated bonds in the
UK market.

C is correct. A Eurobond is an international bond issued outside the jurisdiction of any

one country and not denominated in the currency of the country where it is issued.
A is incorrect because this is an example of a foreign bond, which is a bond issued by
an entity incorporated in a country other than where the bond is issued and in whose
currency the bond is denominated.
B is incorrect because this is an example of a foreign bond, which is a bond issued by
an entity incorporated in a country other than where the bond is issued and in whose
currency the bond is denominated.

Fixed-­Income Securities: Defining Elements

LOS d
Section 3.2
2018 Level I Mock Exam (B) PM 65

110 A bond is currently selling for 102.31. A valuation model estimates the price
will fall to 101.12 if interest rates increase by 20 bps and rise to 103.74 if interest
rates decrease by 20 bps. Using these estimates, the effective duration of the
bond is closest to:
A 6.48.
B 6.40.
C 6.31.

B is correct. The effective duration of a bond is

(PV− ) − (PV+ )
EffDur =
2 × (∆Curve) × (PV0 )
where PV–, PV0, and PV+ are the values of the bond when the yield falls, under the
current yield, and when the yield rises, respectively, and ΔCurve is the change in the
benchmark yield curve.
103.74 − 101.12
EffDur = = 6.40
2 × 102.31 × 0.002
A is incorrect because it has 101.12 in the denominator instead of 102.31:
103.74 − 101.12
= 6.48
2 × 101.12 × 0.002
C is incorrect because it has 103.74 in the denominator instead of 102.31:
103.74 − 101.12
= 6.31
2 × 103.74 × 0.002

Understanding Fixed‑Income Risk and Return

LOS b
Section 3.2

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

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

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

undertakes to purchase the underlying asset from the seller at a later date and at a price
agreed on by the two parties when the contract is initiated.
B is incorrect. A call option contract is a contingent claim in which the buyer of the
option has a right to purchase the underlying asset at a fixed price on or before a pre-­
specified expiration date.
66 2018 Level I Mock Exam (B) PM

C is incorrect. A credit default swap is a contingent claim in which the credit protec-
tion seller provides protection to the credit protection buyer against the credit risk of
a third party.

Derivative Markets and Instruments

LOS b
Section 4.1.2

112 Forward rate agreements are most likely used to hedge an exposure in the:
A foreign exchange market.
B money market.
C equity market.

B is correct. Forward rate agreements are used to hedge interest rate exposure present
in the money market.
A is incorrect. Forward rate agreements are used to hedge interest rate exposure and
not foreign exchange exposure.
C is incorrect. Forward rate agreements are used to hedge interest rate exposure
and not equity exposure.

Basics of Derivative Pricing and Valuation

LOS e
Section 3.1.4

113 An investor notices that the price of an American call option is above the price
of a European call option with otherwise identical features. What is the most
likely reason for this difference?
A The options are close to expiration.
B The options are deep in the money.
C The underlying will go ex-­dividend.

C is correct. American call prices can differ from European call prices only if there are
cash flows on the underlying.
A is incorrect. Early expiration of the option is not a reason for pricing differences
between American and European call options. American call prices can differ from
European call prices only if there are cash flows on the underlying.
B is incorrect. The fact that the option is deep in the money is not a reason for pricing
differences between American and European call options. American call prices can differ
from European call prices only if there are cash flows on the underlying.

Basics of Derivative Pricing and Valuation

LOS o
Section 4.3

114 If the exercise price of a European put option at expiration is below the price of
the underlying, the value of the option is most likely:
A equal to zero.
2018 Level I Mock Exam (B) PM 67

B less than zero.

C greater than zero.

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

Basics of Derivative Pricing and Valuation

LOS i
Section 4.1.1

115 In efficient financial markets, risk-­free arbitrage opportunities:

A will not exist.
B may persist in the long run.
C may exist temporarily.

C is correct. In efficient financial markets, risk-­free arbitrage opportunities may exist

temporarily, but their continuous exploitation will eliminate these arbitrage opportu-
nities in the long run.
A is incorrect. Financial markets being efficient does not mean that risk-­free arbitrage
opportunities cannot exist.
B is incorrect. In efficient financial markets, any risk-­free arbitrage opportunities will
exist only temporarily because their continuous exploitation will result in these arbitrage
opportunities being eliminated in the long run.

Derivative Markets and Instruments

LOS e
Section 7.2

116 Do management fees most likely get paid to the manager of a hedge fund,
regardless of the fund’s performance?
A No, only when the fund’s net asset value exceeds the previous high-­water
mark
B No, only when the fund’s gross return is positive
C Yes

C is correct. Regardless of performance, the management fee is always paid to the fund
manager.
B is incorrect because the gross return can be at any level and the manager is still
paid the management fee.
68 2018 Level I Mock Exam (B) PM

A is incorrect because the management fee is paid regardless of the value of the
assets in the fund.

Introduction to Alternative Investments

LOS f
Section 3.3.1

117 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

LOS d
Section 8.1.1

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

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

Introduction to Alternative Investments

LOS e
Section 5.4

119 Which of the following is least likely to reduce the likelihood of being defrauded
by a dishonest money manager?
A Third-­party custody of assets under management
B Strong and consistent reported investment performance
C Independent verification of investment results
2018 Level I Mock Exam (B) PM 69

B is correct. To prevent fraud, involvement of third parties in the reporting and asset
management process is helpful. A strong and consistent reported investment perfor-
mance that lacks outside verification may actually be a warning sign.
A is incorrect. Third-­party custody of assets under management helps to reduce the
possibility of fraud.
C is incorrect. Independent verification of investment results helps to reduce the
possibility of fraud.

Introduction to Alternative Investments

LOS g
Section 8.3

120 In valuing underlying hedge fund positions, the most conservative approach is
most likely one that uses:
A the average of the bid and ask prices.
B bid prices for longs and ask prices for shorts.
C the most recent market prices.

B is correct A conservative and theoretically accurate approach is to use bid prices for
longs and ask prices for shorts because these are the prices at which the positions could
be closed.
A is incorrect because although using the average quote [(bid + ask)/2] is a common
approach, a more conservative and theoretically accurate approach is to use bid prices
for longs and ask prices for shorts as these are the prices at which the positions could
be closed.
C is incorrect because when market prices or quotes are used for valuation, funds
may differ in which price or quote they use (for example, bid price, ask price, average
quote, and median quote).

Introduction to Alternative Investments

LOS d
Section 3.4