Practice questions · Finance & Accounting
CFA Level I (CFA Institute): Practice Questions
A large set of original concept-check questions across all ten CFA Level I topics, from ethics and financial statement analysis to fixed income, equity and derivatives. Choose an answer to reveal a full explanation. These are original practice questions, not real exam questions.
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All else equal, receiving $1,000 today is worth more than receiving $1,000 in a year because of:
Correct answer: B. Money available now can be invested to earn a return, so present money has greater value than the same amount later. -
Diversifying a portfolio across many uncorrelated assets primarily reduces:
Correct answer: C. Diversification reduces unsystematic, asset-specific risk. Systematic market risk cannot be diversified away. -
In the CFA Program, the Code of Ethics and Standards of Professional Conduct are:
Correct answer: A. Ethics is heavily weighted at every level and can decide a borderline result, so it should be studied deeply. -
A project with a positive net present value (NPV) is expected to:
Correct answer: A. A positive NPV means the present value of expected cash flows exceeds the cost, so the project adds value. -
All else equal, when market interest rates rise, the price of an existing fixed-rate bond:
Correct answer: A. Bond prices move inversely to interest rates: when rates rise, existing bonds with lower coupons become less valuable. -
The discount rate used to value a project's cash flows should mainly reflect:
Correct answer: C. The discount rate reflects the opportunity cost of capital given the investment's risk; riskier cash flows are discounted more heavily. -
A bond's yield to maturity (YTM) is:
Correct answer: B. YTM is the internal rate of return of holding the bond to maturity, reflecting price, coupons and time remaining. -
In portfolio theory, 'beta' measures:
Correct answer: B. Beta measures systematic (market) risk - how much an asset's return moves relative to the market. -
Which financial statement shows a company's position at a single point in time?
Correct answer: B. The balance sheet is a snapshot of assets, liabilities and equity at a point in time; the others cover a period. -
Under accrual accounting, revenue is recognised when it is:
Correct answer: D. Accrual accounting recognises revenue when earned and expenses when incurred, not when cash changes hands. -
Higher liquidity of an asset generally means:
Correct answer: C. Liquidity is how easily an asset can be sold near its fair value quickly; less-liquid assets often demand a premium. -
Market efficiency, in the CFA curriculum, concerns how far prices:
Correct answer: C. Market efficiency is about how fully and quickly asset prices reflect available information. -
The law of demand states that, all else equal, as the price of a good rises:
Correct answer: B. By the law of demand, a higher price reduces the quantity demanded, tracing a downward-sloping demand curve. 'Supply falls' describes a movement on the supply side, not demand; 'quantity demanded rises' reverses the relationship; and 'demand becomes infinite' is not what the law states. -
Inflation, as measured by a consumer price index, reflects:
Correct answer: C. Inflation tracks the general price level of a representative basket. A single stock, interest rates and one firm's earnings are not the CPI. -
Gross Domestic Product (GDP) measures:
Correct answer: C. GDP is the total output of an economy. Debt, the market index and unemployment are separate measures. -
Monetary policy is conducted by a central bank mainly through:
Correct answer: A. Central banks use interest rates and the money supply. Spending and taxes are fiscal policy; tariffs and dividends are not monetary tools. -
A call option gives the holder the right, but not the obligation, to:
Correct answer: B. A call is the right to buy at the strike price. The right to sell is a put; coupons and voting are unrelated to options. -
A key difference between futures and forward contracts is that futures are:
Correct answer: D. Futures are standardized and traded on an exchange, whereas forwards are customized and traded over-the-counter. 'Never settled' is false (futures are marked to market and settled), 'always cheaper' is not a defining trait, and 'only available for currencies' is wrong since futures cover many underlyings. -
Hedging with derivatives is primarily intended to:
Correct answer: D. Hedging offsets a specific risk. It does not guarantee profit, avoid tax, or remove risk while adding leverage. -
Which is an example of an alternative investment?
Correct answer: D. Private equity is an alternative asset. Listed stocks and government bonds are traditional; a savings account is cash. -
Investors often add alternative investments to a portfolio mainly to:
Correct answer: C. Alternatives can diversify because they often move differently from stocks and bonds. They do not remove risk, guarantee returns or cut fees. -
The median of a data set is:
Correct answer: D. The median is the middle ordered value. The most frequent value is the mode, the arithmetic average is the mean, and the difference between the largest and smallest values is the range. -
Standard deviation is a measure of:
Correct answer: D. Standard deviation quantifies dispersion (risk) around the mean. Central tendency, correlation and the median are different concepts. -
The correlation coefficient between two variables always lies between:
Correct answer: C. Correlation is bounded by -1 (perfectly negative) and +1 (perfectly positive). '0 and 1 only' omits negative correlation, 'minus infinity and infinity' is the range for covariance, and '0 and 100' treats it as a percentage scale. -
The three primary financial statements are the balance sheet, the income statement and the:
Correct answer: B. The cash flow statement is the third core statement. A tax return, audit letter and press release are not primary statements. -
The income statement primarily reports a company's:
Correct answer: C. The income statement covers performance over a period. Position at a point in time is the balance sheet; the others are not financial statements. -
The statement of cash flows is divided into operating, investing and:
Correct answer: B. The cash flow statement's three sections are operating, investing and financing activities. Marketing, tax and audit are business functions or processes, not sections of this statement. -
Under the CFA Standards, when a conflict arises a member should generally place the interests of:
Correct answer: B. Client interests come before the member's and the employer's. Putting self or employer first violates the duty of loyalty to clients. -
Owning a share of common stock represents:
Correct answer: C. A share is an equity (ownership) interest. A loan with a coupon describes a bond, not a share; a tax credit is unrelated. -
The weighted average cost of capital (WACC) represents:
Correct answer: B. WACC blends the cost of debt and equity, weighted by their proportions. It is not just loan interest, a dividend, or the tax rate. -
Under Standard I(A) Knowledge of the Law, when an applicable local law is stricter than the CFA Institute Code and Standards, a member must:
Correct answer: B. Standard I(A) requires members to comply with the more strict of the applicable law or the Code and Standards. Here local law is stricter, so it governs. The Code does not always override law; members may never pick the easier rule; and an employer policy cannot excuse breaking a stricter law. -
A member receives material nonpublic information by accident at a social event. Under Standard II(A) Material Nonpublic Information, the member should:
Correct answer: A. Standard II(A) prohibits acting or causing others to act on material nonpublic information, regardless of how it was obtained. Trading on it, tipping clients, and feeding it to research all constitute prohibited use of inside information. -
Under Standard III(B) Fair Dealing, when distributing a new investment recommendation, a member must:
Correct answer: D. Fair Dealing requires that all clients be treated fairly when disseminating recommendations, communicating them to clients at substantially the same time. Favouring the largest or institutional clients, or going public before clients, all breach fair dealing. -
A portfolio manager wants to accept a paid board seat at a private company. Under Standard IV(B) Additional Compensation Arrangements, she must:
Correct answer: C. Standard IV(B) requires written consent from all parties involved before accepting compensation or benefits that compete with or could conflict with the employer's interest. Outside roles are not banned outright; silent acceptance and a public-only disclosure rule both fail the consent requirement. -
Under Standard V(A) Diligence and Reasonable Basis, recommending a security requires:
Correct answer: A. Standard V(A) requires a reasonable and adequate basis, supported by appropriate research and investigation, for any recommendation. No standard requires a performance guarantee, sole reliance on issuer marketing, or a fixed number of colleague approvals. -
Under Standard VI(A) Disclosure of Conflicts, a conflict of interest must be disclosed:
Correct answer: C. Standard VI(A) requires full and fair disclosure of conflicts, prominently and in plain language, so clients and employers can judge their effect. Disclosing only to regulators, only on request, or only after the fact all fail this standard. -
A candidate writes that passing CFA Level I means he is 'halfway to being a CFA charterholder.' Under Standard VII(B) Reference to CFA Institute, the CFA Designation, and the CFA Program, this is:
Correct answer: B. Standard VII(B) prohibits misrepresenting the meaning of the program; partial completion does not confer partial designation, and 'halfway to charterholder' overstates Level I. The charter requires passing all three levels plus qualified experience and membership, so the 'mathematically close' and member-status rationales miss the point. -
Under Standard III(A) Loyalty, Prudence, and Care, a manager's primary duty when managing client assets is to:
Correct answer: D. Standard III(A) requires acting with loyalty, prudence, and care for the benefit of clients, putting client interests first. Maximising commissions, defaulting to aggression, or favouring family all subordinate the client's interest. -
Under Standard III(E) Preservation of Confidentiality, client information may be disclosed when:
Correct answer: A. Confidentiality must be preserved except where disclosure is required by law or concerns illegal activities by the client. Sharing with a competitor, using it for marketing, or releasing it merely because a client is inactive all violate the standard. -
A research analyst issues a 'Buy' but personally holds a large short position in the same stock. The most serious problem is a breach of:
Correct answer: B. An undisclosed personal position opposite to a public recommendation is a clear conflict that must be disclosed under VI(A) and undermines independence and objectivity (I(B)). Personal trades are not exempt from disclosure; misrepresentation alone understates the issue; and VII(A) concerns exam conduct, not this scenario. -
Under Standard I(C) Misrepresentation, presenting another analyst's report as one's own work is:
Correct answer: D. Standard I(C) prohibits plagiarism, including presenting others' analysis as one's own. Firm ownership, light edits, or competitor authorship do not make uncredited copying acceptable. -
Under Standard IV(A) Loyalty (to Employer), before leaving to start a competing firm, a member may:
Correct answer: D. Standard IV(A) permits preparing to compete (for example, registering a firm) as long as the member does not misappropriate property or solicit clients while still employed. Taking client lists or trade secrets, soliciting current clients, or diverting business before departure all breach the duty of loyalty. -
Under Standard III(C) Suitability, when a member manages to a stated mandate or index, recommendations must be judged:
Correct answer: A. Suitability requires evaluating investments in the context of the client's portfolio and stated objectives or mandate, not in isolation. A single security's standalone merit, chasing the highest return, or a client's passing mood do not satisfy the suitability analysis. -
Under Standard V(B) Communication with Clients and Prospective Clients, members should:
Correct answer: A. Standard V(B) requires distinguishing fact from opinion and disclosing the basic format, principles, and significant limitations/risks of an analysis. Presenting opinion as fact, hiding risks, or hiding behind jargon all undermine clear communication. -
Under Standard V(C) Record Retention, the supporting records for investment recommendations:
Correct answer: A. Standard V(C) requires developing and maintaining records supporting investment analyses, recommendations, and actions. Records are generally the firm's property and must be retained; deleting them after settlement, on client request, or limiting them to institutional accounts all violate the standard. -
Under Standard I(B) Independence and Objectivity, a lavish, all-expenses-paid trip from a company an analyst covers should be:
Correct answer: C. Standard I(B) requires protecting independence and objectivity; lavish benefits from a covered company can bias judgement and should be declined or strictly limited (modest, customary business courtesies may be acceptable). Accepting for relationship-building, hiding it, or pointing to peers does not preserve independence. -
Under Standard III(D) Performance Presentation, communicating investment performance requires that members:
Correct answer: C. Standard III(D) requires fair, accurate, and complete performance presentation. Cherry-picking top accounts, dropping closed accounts (survivorship bias), or quoting gross returns without disclosure all misrepresent performance. -
A supervisor learns an analyst on her team violated a Standard. Under Standard IV(C) Responsibilities of Supervisors, she should:
Correct answer: B. Standard IV(C) makes supervisors responsible for establishing reasonable procedures to prevent and detect violations and for responding when a breach is found. Ignoring it, merely reassigning the person, or waiting for regulators all fail the supervisory duty. -
Which best describes the relationship between the Code of Ethics and the Standards of Professional Conduct?
Correct answer: D. The Code states broad principles of ethical conduct, while the Standards translate them into specific, enforceable rules of professional conduct. They are not identical, both are mandatory for members and candidates, and both apply to candidates. -
Under the Standards, 'members and candidates' who must comply include:
Correct answer: A. The Code and Standards bind CFA Institute members (including charterholders) and all candidates enrolled in the CFA Program. They are not limited to charterholders, to asset-manager employees, or to a single level. -
A firm reports current assets of $600,000 and current liabilities of $400,000. Its current ratio is:
Correct answer: A. Current ratio = current assets / current liabilities = 600,000 / 400,000 = 1.5. 0.67 inverts the ratio; 2.4 and 1.0 do not match the figures. -
A company has cash of $50,000, receivables of $70,000, inventory of $80,000, and current liabilities of $100,000. Its quick (acid-test) ratio is:
Correct answer: B. Quick ratio = (cash + receivables) / current liabilities = (50,000 + 70,000) / 100,000 = 1.2 (inventory is excluded). Including inventory gives 2.0; 0.8 would be inventory divided by current liabilities, which has nothing to do with the quick ratio; 1.5 does not fit. -
Under the indirect method, the cash flow statement starts from net income and then adds back:
Correct answer: C. The indirect method reconciles net income to operating cash flow by adding back non-cash charges like depreciation and adjusting for working-capital changes. Dividends and share proceeds are financing items, and cash from customers belongs to the direct method. -
A company uses FIFO inventory accounting during a period of rising prices. Compared with LIFO, FIFO will generally report:
Correct answer: A. With rising prices, FIFO leaves newer, higher-cost units in ending inventory and expenses older, cheaper units as COGS, so inventory is higher and COGS is lower (raising net income) than under LIFO. The other choices reverse or contradict these effects. -
Net profit margin is calculated as:
Correct answer: D. Net profit margin = net income / revenue, showing profit per unit of sales. Inverting it is meaningless here; gross profit/assets and net income/equity (ROE) are different ratios. -
In the basic accounting equation, assets equal:
Correct answer: B. The accounting equation is Assets = Liabilities + Owners' Equity, the foundation of the balance sheet. Subtracting equity or liabilities breaks the identity, and revenue minus expenses is net income, not total assets. -
Return on equity (ROE) of 15% means the company generated:
Correct answer: C. ROE = net income / shareholders' equity, so 15% means $0.15 of net income per $1 of equity. It is not a revenue-to-asset measure, a per-share dividend, or a share-price return. -
A 3-step DuPont analysis decomposes ROE into net profit margin, total asset turnover and:
Correct answer: C. The 3-step DuPont identity is ROE = net profit margin x asset turnover x equity multiplier (financial leverage). The current ratio, payout ratio, and quick ratio are not part of this decomposition. -
Goodwill recognised in an acquisition is reported on the balance sheet as:
Correct answer: C. Goodwill is a non-current intangible asset that is not amortised but tested for impairment. It is neither a current asset nor a liability, and it never appears as revenue. -
The interest coverage ratio is best defined as:
Correct answer: A. Interest coverage = EBIT / interest expense, measuring how easily operating profit covers interest. Using net income understates capacity (interest is already deducted), and the revenue/debt and cash/interest forms are different metrics. -
Under IFRS, inventory is generally measured at:
Correct answer: B. IFRS requires inventory at the lower of cost and net realisable value, recognising write-downs when value falls. Pure historical cost ignores impairment; fair-value-through-P&L and replacement cost are not the IFRS inventory rule. -
Total asset turnover of 0.5 indicates the company generates:
Correct answer: A. Total asset turnover = revenue / total assets, so 0.5 means $0.50 of revenue per $1 of assets. The 2.00 figure inverts it, and the income- and equity-based readings confuse turnover with other ratios. -
Treating a routine repair as a capital expenditure (capitalising it) rather than expensing it will, in the current year:
Correct answer: B. Capitalising a cost moves it to the balance sheet as an asset and spreads it over time via depreciation, so current-year expense is lower and net income higher than if expensed. It therefore does not lower income, leaves an effect on income, and increases (not reduces) assets. -
The matching principle requires that expenses be recognised:
Correct answer: C. The matching principle pairs expenses with the revenues they produce in the same period, a core accrual concept. Cash timing, the fiscal-year start, and managerial approval do not govern expense recognition. -
A common-size income statement expresses each line item as a percentage of:
Correct answer: C. On a common-size income statement, each line is shown as a percentage of revenue, aiding comparison across firms and periods. Total assets and equity are bases for common-size balance sheets; net income is not the base. -
If a company's accounts receivable turnover is 8, the average collection period (days sales outstanding) is approximately:
Correct answer: D. Days sales outstanding = 365 / receivables turnover = 365 / 8 ~ 46 days. 8 days mistakes the turnover for days; 365 ignores the division; 120 implies a turnover near 3, not 8. -
A stock is expected to pay a $2.00 dividend next year, dividends grow at 3% forever, and the required return is 8%. Using the Gordon (constant) growth model, the stock's value is:
Correct answer: D. Gordon growth value = D1 / (r - g) = 2.00 / (0.08 - 0.03) = 2.00 / 0.05 = $40.00. $25 uses an 8% denominator; $66.67 uses 3%; $20 uses 10%. -
A company earns $5.00 per share and trades at $75. Its price-to-earnings (P/E) ratio is:
Correct answer: C. P/E = price / earnings per share = 75 / 5 = 15. 0.067 inverts it (the earnings yield), 375 multiplies instead of divides, and 20 does not match the figures. -
In the dividend discount model, a higher required rate of return, all else equal, leads to a:
Correct answer: A. A higher required return increases the denominator (r - g), reducing the present value of future dividends and the estimated stock value. It does not raise value, leave it unchanged, or change the growth rate, which is a separate input. -
A price-weighted stock index (like a simple average of prices) is most affected by:
Correct answer: C. In a price-weighted index, each stock's influence is proportional to its share price, so the highest-priced stock dominates. Market cap drives a value-weighted index; share count and dividends do not determine price-weighting. -
Preferred stock typically differs from common stock in that preferred shareholders usually:
Correct answer: D. Preferred stock generally pays a fixed dividend and has priority over common stock for dividends and in liquidation, but usually carries limited or no voting rights. It does not guarantee higher returns, and 'junior only by name' misstates its true subordination to debt. -
The earnings yield is the:
Correct answer: D. Earnings yield = EPS / price = 1 / (P/E), useful for comparing equity earnings power with bond yields. Dividend/price is the dividend yield, and earnings growth and bond coupons are unrelated. -
A market order to buy a stock instructs the broker to:
Correct answer: A. A market order executes promptly at the best available price, prioritising speed over price. Buying at or below a set price is a limit order, a stop order triggers at a specified price, and waiting for the close describes a market-on-close order. -
In a secondary market transaction, the proceeds of the sale go to:
Correct answer: C. Secondary-market trades occur between investors, so the selling investor receives the proceeds; the company raised capital earlier in the primary market. The regulator and underwriter are not the counterparties receiving sale proceeds. -
Buying stock on margin (with borrowed money) primarily:
Correct answer: D. Margin uses leverage, which amplifies percentage gains and losses on the investor's equity. It does not remove downside risk, guarantee returns, or cancel the obligation to repay the borrowed funds plus interest. -
Under the semi-strong form of market efficiency, prices fully reflect:
Correct answer: B. The semi-strong form holds that prices reflect all publicly available information, so fundamental analysis of public data cannot reliably earn excess returns. Past prices alone describe the weak form, while reflecting private/inside information describes the strong form. -
The book value of equity is best described as:
Correct answer: D. Book value of equity equals total assets minus total liabilities, the accounting net worth. Market price times shares is market capitalisation, the discounted dividends give intrinsic value, and the IPO price is historical, not book value. -
A company with a dividend payout ratio of 40% retains:
Correct answer: A. Retention ratio = 1 - payout ratio = 1 - 0.40 = 60% of earnings reinvested. 40% is the amount paid out, not retained; 100% and 0% ignore the payout entirely. -
All else equal, a stock with a higher expected dividend growth rate should have a:
Correct answer: D. Faster expected dividend growth raises the present value of future dividends, increasing intrinsic value (and typically the justified P/E). It does not lower value or change the required return, and the conditional P/E statement is incorrect. -
Depositary receipts (such as ADRs) allow investors to:
Correct answer: A. Depositary receipts represent foreign shares but trade on a domestic exchange in local currency, easing access to foreign equities. They do not eliminate currency risk, guarantee dividends, or convert equity into debt. -
Free float (free-float market capitalisation) refers to:
Correct answer: A. Free float counts shares available to the investing public, excluding closely held, government, or restricted holdings, and is used in many index weightings. It is not total issued shares, insider-only holdings, or company cash. -
A bond's modified duration is 6. If yields rise by 1% (100 basis points), the bond's price will fall by approximately:
Correct answer: C. Approximate price change ~ -duration x change in yield = -6 x 1% = -6%. 0.6% understates by a factor of ten, while 16% and 60% are far too large. -
A bond trading above its par (face) value is said to be trading at a:
Correct answer: A. A price above par is a premium, which occurs when the coupon rate exceeds the market yield. Below par is a discount, exactly at par is 'at par', and default refers to missed payments, not price level. -
If a bond's coupon rate is below its yield to maturity, the bond will trade at:
Correct answer: C. When the coupon rate is below the market yield (YTM), investors pay less than par, so the bond trades at a discount. A coupon above the yield gives a premium, an equal coupon and yield give par, and twice face value is not implied. -
Convexity describes the fact that the relationship between a bond's price and its yield is:
Correct answer: C. Convexity captures the curvature of the price-yield relationship; because of it, duration underestimates price increases when yields fall and overestimates price decreases when yields rise. The relationship is neither linear, flat, nor random. -
Credit (default) risk in a bond is the risk that the issuer:
Correct answer: B. Credit/default risk is the risk the issuer cannot make scheduled interest or principal payments. Early redemption is call risk, a floating coupon is a feature not a default, and listing location is irrelevant to default risk. -
An inverted yield curve is one where:
Correct answer: C. An inverted curve has short-term yields above long-term yields, often watched as a recession signal. The normal upward slope has long above short, a flat curve has equal yields, and negativity at all maturities is a separate phenomenon. -
A callable bond, compared with an otherwise identical non-callable bond, will offer investors:
Correct answer: C. The call option benefits the issuer, so investors demand a higher yield to compensate for the risk the bond is called when rates fall. It therefore does not carry a lower yield, lack a coupon, or guarantee appreciation. -
Zero-coupon bonds pay no periodic interest and instead:
Correct answer: C. Zero-coupon bonds are sold below par and mature at par; the difference is the investor's return. They make no periodic or floating payments, pay nothing up front, and do repay principal at maturity. -
The par value (face value) of a bond is the amount:
Correct answer: D. Par (face) value is the principal repaid at maturity and the base for coupon calculations. Purchase price can differ from par, the coupon is a percentage of par, and accrued interest is a separate amount owed between coupon dates. -
All else equal, a longer-maturity bond generally has:
Correct answer: A. Longer maturity means cash flows are discounted over more periods, giving higher duration and greater price sensitivity to rate changes. So it does not have lower or zero rate risk, and maturity does not dictate the coupon. -
Reinvestment risk is the risk that:
Correct answer: B. Reinvestment risk arises when interest rates fall and coupons (or principal) must be reinvested at lower yields, reducing total return. Default is credit risk, inability to sell is liquidity risk, and zero inflation is not a risk to coupon reinvestment. -
A floating-rate note (FRN) resets its coupon periodically based on a reference rate. Compared with a fixed-rate bond, an FRN typically has:
Correct answer: A. Because the coupon resets toward prevailing rates, an FRN's price stays closer to par and has lower interest-rate risk than a fixed-rate bond. It still carries credit risk, and its price can move with the issuer's creditworthiness. -
The current yield of a bond is calculated as:
Correct answer: C. Current yield = annual coupon / current price, a simple income measure. It is not YTM minus coupon; coupon/par is the coupon rate; and capital gain/price ignores the coupon income. -
Investment-grade bonds are those rated:
Correct answer: B. Investment grade spans BBB-/Baa3 and above; ratings below that (BB+/Ba1 and lower) are high-yield ('junk'). Restricting it to AAA only is too narrow, and below CCC is deep junk. -
Sovereign bonds issued by a stable government in its own currency are generally considered:
Correct answer: C. Such sovereign bonds carry relatively low credit risk and frequently serve as benchmark or proxy risk-free rates. They are not the riskiest bonds, not equity, and only specific issues (like inflation-linked bonds) provide inflation protection. -
According to the Capital Asset Pricing Model (CAPM), with a risk-free rate of 3%, a market return of 9%, and a beta of 1.5, the expected return is:
Correct answer: C. CAPM: E(R) = Rf + beta x (Rm - Rf) = 3% + 1.5 x (9% - 3%) = 3% + 9% = 12%. 9% ignores beta, 13.5% applies beta to the full market return, and 6% drops the risk-free rate. -
The Sharpe ratio measures:
Correct answer: D. The Sharpe ratio = (portfolio return - risk-free rate) / standard deviation, rewarding return per unit of total risk. Return per unit of beta is the Treynor ratio, raw total return ignores risk, and correlation is a different statistic. -
The security market line (SML) plots expected return against:
Correct answer: C. The SML graphs expected return versus beta (systematic risk), with its slope equal to the market risk premium. Standard deviation is used on the capital market line; liquidity and dividend yield are not the SML's axis. -
An investor with a long time horizon and high tolerance for volatility generally has a higher:
Correct answer: B. A long horizon and high tolerance for volatility increase the ability and willingness to bear risk, i.e., risk capacity and tolerance. They do not by themselves raise income needs, set a tax rate, or increase liquidity requirements. -
In modern portfolio theory, the efficient frontier represents portfolios that:
Correct answer: B. The efficient frontier is the set of portfolios giving the maximum expected return for each level of risk (or minimum risk for each return). It does not maximise risk, eliminate risk, or consist of single-asset holdings. -
Combining two assets with a correlation of less than +1 produces a portfolio whose risk is:
Correct answer: A. When correlation is below +1, imperfect co-movement reduces portfolio standard deviation below the weighted average of the components, the core diversification benefit. The risk is not simply the average, not necessarily zero, and not always higher than the components. -
An investment policy statement (IPS) primarily documents a client's:
Correct answer: B. The IPS sets out the client's return and risk objectives plus constraints (liquidity, horizon, tax, legal/regulatory, unique circumstances) to guide management. It is not a record of trade tickets, commission schedules, or tax returns. -
Strategic asset allocation refers to:
Correct answer: A. Strategic asset allocation sets the long-term target weights across asset classes consistent with the investor's objectives and constraints. Short-term timing is tactical allocation, daily stock-picking is security selection, and borrowing is leverage. -
Rebalancing a portfolio back to its target weights after a strong equity rally typically involves:
Correct answer: A. Rebalancing restores target weights by trimming the outperformers (now overweight) and adding to underperformers, a disciplined 'sell high, buy low' process. Buying more winners increases drift, doing nothing abandons the target, and going all-cash is not rebalancing. -
Systematic risk is best described as risk that:
Correct answer: B. Systematic (market) risk affects all assets and cannot be removed by diversification, so it commands a risk premium. Diversifiable, company-specific risk is unsystematic, and systematic risk is not limited to bonds. -
A risk-averse investor, choosing between two portfolios with the same expected return, will prefer the one with:
Correct answer: C. Risk aversion means that, for equal expected return, the investor prefers less risk, i.e., lower standard deviation. Higher standard deviation, higher beta, and more leverage all add risk without added expected return. -
The capital market line (CML) describes combinations of the risk-free asset and:
Correct answer: D. The CML links the risk-free asset with the optimal risky (market) portfolio, showing the best risk-return trade-offs available. It is not built from a single stock, a particular bond, or a zero-coupon bond. -
You invest $1,000 at 6% compounded annually. Its value after 2 years is approximately:
Correct answer: A. FV = 1,000 x (1.06)^2 = 1,000 x 1.1236 = $1,123.60. $1,060 is one year only, $1,120 uses simple interest (6% x 2), and $1,200 overstates the growth. -
The effective annual rate (EAR) for a 12% nominal rate compounded semi-annually is:
Correct answer: D. EAR = (1 + 0.12/2)^2 - 1 = (1.06)^2 - 1 = 0.1236 = 12.36%. 12% ignores compounding, 6% is the periodic rate, and 24% wrongly doubles the nominal rate. -
An ordinary annuity differs from an annuity due in that ordinary-annuity payments occur:
Correct answer: B. Ordinary-annuity cash flows arrive at the end of each period, whereas an annuity due pays at the beginning. A single payment is not an annuity, and continuous payment is a different concept. -
Holding the nominal rate fixed, increasing the compounding frequency causes the effective annual rate to:
Correct answer: D. More frequent compounding lets interest earn interest sooner, so the effective annual rate rises (approaching the continuously compounded limit). It does not fall, stay identical, or turn negative. -
A distribution with a long right tail (a few very large values) is described as:
Correct answer: A. A long right tail pulls the mean above the median, indicating positive (right) skew. A long left tail is negative skew, a balanced shape is symmetric, and a flat equal-probability shape is uniform. -
For a normal distribution, approximately 95% of observations fall within how many standard deviations of the mean?
Correct answer: A. Under the empirical rule, about 95% of values lie within ~2 standard deviations of the mean (about 68% within 1 and about 99.7% within 3). 0.5 is far too narrow. -
In hypothesis testing, a Type I error occurs when an analyst:
Correct answer: A. A Type I error is rejecting a null hypothesis that is actually true (a 'false positive'); its probability is the significance level. Failing to reject a false null is a Type II error, and the other choices are not errors. -
If two events are mutually exclusive, the probability that both occur at the same time is:
Correct answer: D. Mutually exclusive events cannot happen together, so the joint probability is 0; their probabilities add for the chance that either occurs. It is not 1.0, 0.5, or their sum (which is P(A or B)). -
The geometric mean return is generally preferred over the arithmetic mean for measuring:
Correct answer: B. The geometric mean captures compounding across multiple periods, giving the true average growth rate of an investment. It is unnecessary for a single period, and it is unrelated to the mode or the range. -
A 95% confidence interval for a mean means that, over many samples, about 95% of such intervals are expected to:
Correct answer: B. A 95% confidence interval is constructed so that, in repeated sampling, roughly 95% of the intervals capture the true population parameter. It is not about containing the sample mean (which is always its centre), being identical, or having zero width. -
If the price elasticity of demand for a good is 0.4, demand is:
Correct answer: B. An elasticity below 1 (in absolute value) means quantity demanded responds less than proportionally to price, i.e., inelastic demand. Above 1 is elastic, exactly 1 is unit elastic, and perfectly elastic is an infinite response. -
In a market, a binding price ceiling set below the equilibrium price tends to cause:
Correct answer: B. A price ceiling below equilibrium holds price down, raising quantity demanded above quantity supplied and creating a shortage. A surplus results from a price floor above equilibrium; a binding ceiling does change quantities and cannot raise price above the cap. -
Expansionary fiscal policy refers to:
Correct answer: D. Fiscal policy uses the government budget; expansion means more spending or lower taxes to boost aggregate demand. Interest rates, the money supply, and open-market bond sales are tools of monetary policy. -
In a perfectly competitive market, an individual firm is best described as a:
Correct answer: B. Under perfect competition, many firms sell identical products, so each is a price taker facing the market price. A price maker, monopolist, and sole supplier all describe firms with market power, the opposite of perfect competition. -
A natural monopoly typically arises when:
Correct answer: D. A natural monopoly exists when high fixed costs and economies of scale let a single firm serve the whole market more cheaply than several firms could (for example, utilities). Many small firms describe competition, and the other options do not define a natural monopoly. -
If a country's currency appreciates, all else equal, its exports become:
Correct answer: D. A stronger (appreciated) currency raises the foreign-currency price of the country's exports, making them more expensive abroad and typically less competitive. So exports do not get cheaper, and they are clearly affected by the exchange rate. -
The unemployment that exists because workers are between jobs or searching for a first job is called:
Correct answer: B. Frictional unemployment reflects the normal time spent searching for or transitioning between jobs. Cyclical unemployment follows the business cycle, structural reflects skills/location mismatches, and seasonal follows predictable calendar patterns. -
Real GDP differs from nominal GDP in that real GDP is:
Correct answer: D. Real GDP is adjusted for inflation using constant prices, isolating changes in output from price changes. Nominal GDP uses current prices, real GDP is not always larger, and neither equals the unemployment rate. -
When a central bank raises its policy interest rate, the typical intended effect is to:
Correct answer: C. Higher policy rates make borrowing costlier, dampening spending and investment to restrain inflation. They are contractionary (not stimulative), work on rates rather than directly setting the money supply, and tend to support (not lower) the currency. -
Opportunity cost is best defined as:
Correct answer: B. Opportunity cost is the value of the single next-best alternative given up by a decision, a core economic concept. It is broader than the cash cost, is not the sum of all alternatives, and is not limited to taxes. -
A project costs $100 today and returns $110 in one year. At a 10% required return, its net present value (NPV) is:
Correct answer: A. NPV = -100 + 110/1.10 = -100 + 100 = $0, so the project exactly meets the required return. $10 ignores discounting, $110 omits the initial cost, and -$10 over-discounts. -
The internal rate of return (IRR) of a project is the discount rate at which the project's:
Correct answer: B. IRR is the discount rate that sets NPV to zero; a project is attractive when IRR exceeds the required return. It is unrelated to minimising payback, maximising accounting profit, or equating revenue with COGS. -
If a firm's cost of equity is 12% and its after-tax cost of debt is 6%, with 50% equity and 50% debt, its WACC is:
Correct answer: D. WACC = 0.5 x 12% + 0.5 x 6% = 6% + 3% = 9%. 6% and 12% are the individual component costs, and 18% wrongly adds them. -
All else equal, the tax deductibility of interest payments makes debt financing:
Correct answer: C. Because interest is tax-deductible, the after-tax cost of debt is lower than its stated rate, producing an interest tax shield that lowers WACC at moderate leverage. So debt is not more expensive after tax, not irrelevant, and not automatically equal to equity. -
Financial leverage refers to a company's use of:
Correct answer: B. Financial leverage is the use of fixed-cost capital (mainly debt) to finance the firm, which magnifies returns to equity but adds risk. Retained earnings and common equity are equity financing, and dividends are distributions, not leverage. -
Net working capital is calculated as:
Correct answer: A. Net working capital = current assets - current liabilities, gauging short-term liquidity. Total assets minus total liabilities is equity, revenue minus expenses is profit, and equity minus debt is not a standard measure. -
When a company's IRR on a project exceeds its cost of capital, the project should generally be:
Correct answer: C. An IRR above the cost of capital implies a positive NPV, so the project creates value and should be accepted. Rejecting, deferring indefinitely, or selling it forgoes value-adding investment. -
Agency costs in corporate finance arise mainly from:
Correct answer: D. Agency costs stem from the principal-agent conflict where managers may act in their own interest rather than shareholders', requiring monitoring and incentives. Regulation, taxes, and audited statements are not the source of agency conflict (audits actually help mitigate it). -
A typical hedge fund '2 and 20' fee structure means:
Correct answer: D. '2 and 20' means a 2% annual management fee on assets plus a 20% share of profits as a performance fee. Calling 2% the performance fee and 20% the management fee reverses the two; a flat 22% misreads the structure; and fees are not waived until the fund doubles. -
A 'high-water mark' in a hedge fund ensures that performance fees are charged only when the fund's value:
Correct answer: B. A high-water mark requires the fund to surpass its prior highest value before new incentive fees apply, so managers are not paid twice for recovering losses. It is not tied to falling value, matching an index, or doubling. -
Private equity investments are generally characterised by:
Correct answer: D. Private equity is typically illiquid with multi-year lock-ups and no daily market price. It does not offer high liquidity, guaranteed dividends, or public-exchange trading (that describes listed equities). -
Real estate as an alternative investment is often valued for its potential to provide:
Correct answer: C. Direct real estate can generate rental income and tends to offer partial inflation protection as rents and values rise with prices. It does not guarantee zero correlation, daily liquidity, or a government-backed fixed return. -
Commodities are frequently added to portfolios mainly because they can offer:
Correct answer: B. Commodities often move differently from stocks and bonds and can hedge inflation, aiding diversification. They pay no coupon, carry no corporate voting rights, and do not guarantee capital preservation (prices are volatile). -
Compared with traditional investments, alternative investments typically have:
Correct answer: A. Alternatives generally charge higher fees, are less liquid, and offer less transparency and infrequent valuation than traditional assets. They do not usually feature higher liquidity, daily public pricing, or lower minimums. -
Venture capital is a form of private equity that invests primarily in:
Correct answer: B. Venture capital funds early-stage start-ups with high growth potential and high failure risk. Mature blue-chips, government bonds, and listed index funds are not the venture-capital focus. -
Survivorship bias in reported hedge fund index returns tends to make historical performance look:
Correct answer: A. Survivorship bias overstates returns because funds that closed (often poor performers) are excluded, leaving only survivors in the index. It does not understate performance, leave it accurate, or stay unrelated to closures. -
A put option gives the holder the right, but not the obligation, to:
Correct answer: D. A put is the right to sell the underlying at the strike price, gaining value as the asset falls. The right to buy is a call; receiving a dividend and lending the asset are not what a put conveys. -
The maximum loss for the buyer of a call option is limited to:
Correct answer: D. A long call buyer can lose at most the premium paid, since they simply let a worthless option expire. The loss is not unlimited (that risk is for the option writer or short stock), nor the strike price or full underlying value. -
In a plain-vanilla interest-rate swap, the two parties typically exchange:
Correct answer: C. A plain-vanilla interest-rate swap exchanges fixed for floating interest payments on a notional principal, which is usually not itself exchanged. It does not swap shares or commodities, and the notional principal generally is not exchanged. -
At expiration, the value of a forward contract to the long position is approximately:
Correct answer: D. At expiration the long's payoff is spot minus the contracted forward price; a higher spot benefits the long. It is not the strike alone, not always zero, and forwards have no up-front premium (unlike options). -
Compared with exchange-traded futures, over-the-counter (OTC) forward contracts generally have:
Correct answer: C. OTC forwards are privately negotiated and customisable but carry higher counterparty credit risk because there is no clearinghouse. Lower credit risk, daily mark-to-market, and standardisation are features of exchange-traded futures. -
The main economic purpose of a clearinghouse in futures markets is to:
Correct answer: B. A clearinghouse becomes the buyer to every seller and the seller to every buyer, using margin and marking-to-market to reduce default risk. It does not set market prices, guarantee profits, or remove margin requirements (it enforces them).
Practice questions FAQ
- Are these real CFA Level I exam questions?
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- How should I use these practice questions?
- Answer each one, read the explanation (including why the wrong options are wrong), and use the per-domain score below to focus your revision on weak areas. Revisit before exam day.
- How many questions should I do before the exam?
- Enough to score consistently across every domain, alongside full-length practice from official or reputable providers. Understanding why each answer is right matters more than raw volume.
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