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CFA Level II (CFA Institute): Practice Questions
Original concept-check questions for CFA Level II, reflecting its valuation focus and item-set (vignette) style. Each answer is explained, including why the others are wrong. Filter by domain or difficulty. These are concept checks - not real exam questions.
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CFA Level II questions are delivered as:
Correct answer: C. Level II uses item sets: a case (vignette) followed by several questions. Standalone MCQs are Level I; essays appear at Level III; there is no oral exam. -
Compared with Level I, Level II emphasizes:
Correct answer: D. Level II shifts from knowing to applying, with heavier weighting on valuation (equity, fixed income). It is not pure recall, nor limited to one topic. -
A dividend discount model (DDM) values equity by:
Correct answer: D. The DDM values equity by discounting expected future dividends back to present value at the required return. Using only the current price assumes the answer instead of deriving it, counting shares outstanding just sizes ownership, and multiplying sales by a fixed factor is a price-to-sales style shortcut, not a present-value of cash flows to shareholders. -
All else equal, when market interest rates rise, the price of an existing fixed-rate bond:
Correct answer: B. Bond prices move inversely to yields, so a rate rise pushes an existing fixed-rate bond's price down. 'Doubles' and 'rises' get the direction wrong, and 'is unchanged' ignores the inverse price-yield relationship entirely. -
Duration measures a bond's:
Correct answer: C. Duration approximates the percentage price change for a change in yield (rate sensitivity). Rating, currency and size are different attributes. -
A price-to-earnings (P/E) ratio is an example of:
Correct answer: A. A P/E ratio is a relative valuation multiple, comparing a stock's price to its earnings against peers. An audit procedure is an accounting check, a bond covenant is a lender protection clause in debt terms, and a cash flow statement is a financial statement - none of these is a valuation multiple. -
The weighted average cost of capital (WACC) is:
Correct answer: C. WACC blends the cost of each capital source by its weight. Tax rate, revenue and dividends are different figures. -
Ethics at Level II is:
Correct answer: D. Ethics is weighted at every CFA level, including Level II. It is neither removed nor optional. -
Free cash flow valuation (FCFF/FCFE) values a company based on:
Correct answer: B. Free cash flow models discount cash available to the firm (FCFF) or equity (FCFE). Net income, share count and dividends alone are not the basis. -
The Capital Asset Pricing Model (CAPM) estimates expected return using:
Correct answer: D. CAPM estimates expected return as the risk-free rate plus beta times the market risk premium. The P/E ratio is a valuation multiple, the dividend feeds a dividend discount model, and the coupon rate belongs to bonds - none is a CAPM input. -
Diversification primarily reduces:
Correct answer: A. Diversification reduces firm-specific risk; systematic (market) risk cannot be diversified away. It does not eliminate all risk or change the risk-free rate. -
A good strategy for Level II item sets is to:
Correct answer: A. Item sets require reading the vignette carefully first, then answering each linked question from it. 'Answer before reading the case' and 'skip the vignette' discard the scenario the questions depend on, and 'memorize answer letters' is useless since the questions and order change. -
A CFA Level II 'item set' (vignette) consists of:
Correct answer: B. Level II uses vignette-based item sets. Essays appear at Level III; there is no oral or true/false format. -
The Gordon (constant) growth model values a stock as:
Correct answer: A. The Gordon growth model values a stock as next year's dividend divided by (required return minus growth rate), D1 / (r - g). 'r - g' is only the denominator, 'D1 x r' multiplies instead of divides, and 'price x earnings' is unrelated to a dividend-discount formula. -
An EV/EBITDA multiple, compared with a P/E ratio:
Correct answer: B. EV/EBITDA is largely capital-structure neutral because enterprise value and EBITDA come before financing effects, helping compare firms with different leverage. It does not ignore earnings (EBITDA is an earnings measure), it is not limited to banks, and it is not identical to P/E, which is affected by leverage and taxes. -
A company using LIFO during a period of rising prices will report, versus FIFO:
Correct answer: B. LIFO expenses newer, higher costs first, lowering income and ending inventory in rising-price periods. -
The current ratio is calculated as:
Correct answer: A. The current ratio is current assets divided by current liabilities, a short-term liquidity measure. 'Net income divided by liabilities' is not a standard ratio, 'total assets divided by equity' is a leverage (equity multiplier) ratio, and 'sales divided by assets' is asset turnover. -
Convexity describes:
Correct answer: D. Convexity describes how a bond's duration changes as yields change - the curvature of the price-yield relationship - and it refines duration's estimate for large rate moves. The maturity date, the coupon rate, and the credit rating are fixed bond attributes, not this second-order rate effect. -
Compared with an otherwise identical option-free bond, a callable bond typically has:
Correct answer: C. A callable bond leaves the investor effectively short a call the issuer can exercise, so it trades at a lower price and higher yield to compensate for that call risk. A higher price would reward the investor for risk they actually bear, a zero coupon is unrelated to the call feature, and 'no difference' ignores the embedded option. -
Multiple regression's R-squared indicates:
Correct answer: B. R-squared is the proportion of variation in the dependent variable explained by the model's predictors. The intercept is the fitted value when predictors are zero, the sample size is the number of observations, and the currency used is not a statistical output at all. -
A low p-value (for example below 0.05) on a regression coefficient suggests that:
Correct answer: B. A low p-value indicates the coefficient is statistically significant: the relationship is unlikely to be due to chance. 'The model is useless' and 'there is no relationship' describe a high p-value, and 'the data are corrupted' is not what a p-value measures. -
Purchasing power parity (PPP) suggests exchange rates adjust so that:
Correct answer: A. PPP says exchange rates adjust so identical goods cost about the same across countries once converted. Interest rates equalizing is interest-rate parity, inflation becoming zero is not implied by PPP, and GDP levels equalizing is unrelated to relative prices. -
The value of a forward contract at initiation is typically:
Correct answer: C. A forward is priced so it has zero value at the start. Options, by contrast, require a premium. -
Put-call parity links the prices of:
Correct answer: D. Put-call parity ties together a call, a put (same strike and expiry), the underlying asset, and a risk-free bond. The other groupings - two bonds, a forward and a future, or two stocks - are not the instruments connected by this relationship. -
A hedge fund's '2 and 20' fee structure refers to:
Correct answer: C. '2 and 20' means roughly a 2% annual management fee plus a 20% performance (incentive) fee on gains. '20 funds in one' and 'two managers and 20 analysts' misread the numbers as counts, and 'a two-year lockup with 20% tax' confuses fees with redemption and tax terms. -
The Sharpe ratio measures:
Correct answer: B. Sharpe = (return - risk-free) / standard deviation. The Treynor ratio uses beta; the others are not the Sharpe ratio. -
The security market line (SML) plots expected return against:
Correct answer: A. The SML relates expected return to beta. The capital market line uses total risk; the others are unrelated. -
Active return is:
Correct answer: A. Active return is the portfolio's return minus its benchmark's return - the value added (or lost) versus the benchmark. The total return is the raw portfolio return before subtracting the benchmark, the risk-free rate is the return on a riskless asset, and beta is a sensitivity measure, not a return. -
Other things equal, increasing financial leverage in the capital structure:
Correct answer: D. More leverage magnifies potential returns to equity but also raises financial risk, since fixed debt obligations come first. 'Eliminates interest expense' is backwards (leverage adds interest), 'always reduces risk' reverses the effect, and 'never affects value' ignores the tax shield and distress costs. -
Under the CFA Standards, an analyst who obtains material nonpublic information must:
Correct answer: D. Holding material nonpublic information, the analyst must not trade or cause others to trade on it. 'Trade on it quickly' is illegal insider trading, 'post it publicly to be safe' improperly discloses confidential information, and 'share it with close friends' tips others to trade illegally. -
The residual income model values equity as the current book value plus the present value of:
Correct answer: A. Residual income is earnings in excess of the equity charge (required return times book value), so the model adds the present value of those excess earnings to current book value. Discounting future dividends is the DDM, future sales is a revenue forecast, and future FCFF underlies an enterprise (firm) valuation, not the residual income approach. -
A firm's sustainable growth rate is best estimated as:
Correct answer: C. Sustainable growth equals the retention ratio (earnings kept) multiplied by ROE, the rate a firm can grow from reinvested earnings without new outside equity. Dividend yield times price, revenue minus costs, and beta times the market return are unrelated to internally funded growth. -
In the two-stage free-cash-flow model, the 'terminal value' represents the value of cash flows:
Correct answer: B. The terminal value captures all cash flows from the beginning of the stable-growth phase onward, then is discounted back to today. It is not just year one, not past cash flows, and not limited to debt. -
A justified forward P/E from the Gordon model rises when, all else equal, the:
Correct answer: C. A higher expected growth rate raises the justified P/E because future earnings are worth more. A higher required return lowers it, a payout of zero removes the dividend the formula relies on, and a sharp rise in the risk-free rate raises the required return and lowers the multiple. -
Using an EV/EBITDA multiple, 'enterprise value' is best described as:
Correct answer: D. Enterprise value is the value of the entire business to all capital providers, approximated as market equity plus debt minus cash. Equity value alone ignores debt holders, while net income and revenue are income-statement figures, not a capital-structure value. -
A price/earnings-to-growth (PEG) ratio is used to:
Correct answer: B. The PEG divides the P/E by the expected earnings growth rate to compare valuation across firms with different growth. It does not measure liquidity, value bonds, or calculate the dividend. -
When using comparable-company (relative) valuation, a stock with a P/E well below peers with similar fundamentals may be:
Correct answer: C. Trading at a much lower P/E than otherwise-similar peers suggests possible undervaluation that merits deeper analysis of why the gap exists. A low multiple does not by itself mean overvaluation, makes the stock no less risky, and does not make it identical to peers. -
Free cash flow to equity (FCFE) is generally derived from free cash flow to the firm (FCFF) by:
Correct answer: C. FCFE equals FCFF minus after-tax interest plus net borrowing, reflecting cash available to equity after servicing debt. Adding back all taxes, ignoring debt, or double-counting depreciation would each misstate the cash left for shareholders. -
A dividend discount model is least appropriate for a company that:
Correct answer: B. A DDM struggles when a firm pays no dividends, because there are no payouts to discount, so a free-cash-flow model fits better. Stable payers, mature utilities and firms with long dividend histories are exactly where the DDM works well. -
A bond's spot rate is best described as the:
Correct answer: A. A spot rate is the yield for a single payment at one future date, equivalent to a zero-coupon yield, and a coupon bond is valued by discounting each cash flow at its matching spot rate. The coupon rate, market price and credit rating are different attributes. -
A forward rate implied by the spot curve is the rate for a loan that:
Correct answer: B. An implied forward rate applies to a loan beginning at a future date and is derived from today's spot rates so there is no arbitrage. It does not start today, has not matured, and is implied by market spot rates rather than set solely by the central bank. -
An option-adjusted spread (OAS) removes the effect of embedded options so that bonds with different optionality can be:
Correct answer: D. The OAS strips out the value of embedded options, giving a spread that allows like-for-like comparison across bonds with different optionality. It is not about ignoring bonds, it requires a model, and it does not make any bond risk-free. -
Effective duration is preferred over modified duration for a bond with an embedded option because effective duration:
Correct answer: A. Effective duration uses prices from a model that lets cash flows change with rates, which is essential when an option can alter those cash flows. Modified duration assumes fixed cash flows, so it is the one that ignores option-driven changes; effective duration does not ignore rates or work only for zeros. -
All else equal, a putable bond, compared with an otherwise identical option-free bond, is worth:
Correct answer: B. A put lets the investor sell the bond back, a valuable right, so a putable bond is worth more than an identical option-free bond. The put benefits the investor (not the issuer), so the bond is not worth the same or nothing. -
A credit spread on a corporate bond mainly compensates investors for:
Correct answer: A. The credit spread over a comparable government yield compensates for default risk and possible credit deterioration. Inflation is reflected in the overall yield level, coupon frequency is a payment detail, and currency conversion is a separate FX issue. -
Under a structural credit model (such as a Merton-type model), a company's equity is viewed as a:
Correct answer: B. Structural models treat equity as a call option on the firm's assets with a strike equal to the debt owed, so shareholders gain only above that level. Equity is not a risk-free bond, a fixed annuity, or a government guarantee. -
Key-rate (partial) durations are useful because they show a bond portfolio's sensitivity to:
Correct answer: C. Key-rate durations measure sensitivity to changes at specific points on the yield curve, capturing non-parallel shifts that a single duration misses. They are not limited to parallel shifts and do not measure equity prices or exchange rates. -
Under the equity method, an investor that owns a 30% stake with significant influence reports its share of the investee's profit:
Correct answer: A. The equity method recognises the investor's share of the investee's profit on one income-statement line and raises the carrying value of the investment; dividends received reduce that carrying value. It does not consolidate revenue line by line, does not ignore the profit, and recognises earnings as earned rather than only when dividends are paid. -
When a parent controls a subsidiary, it prepares consolidated statements and reports the portion of the subsidiary it does not own as:
Correct answer: D. Consolidation combines the whole subsidiary and shows the part the parent does not own as non-controlling (minority) interest in equity. Goodwill is the premium paid over fair value, deferred tax arises from timing differences, and treasury stock is a company's own repurchased shares. -
A deferred tax liability typically arises when a company's:
Correct answer: A. Using faster depreciation for tax than for the books lowers taxable income now and creates a liability for taxes expected to be paid later. Slower tax depreciation would tend toward a deferred tax asset, and revenue equalling expenses or cash equalling net income do not by themselves create the timing difference. -
High-quality earnings are generally those that are:
Correct answer: B. High-quality earnings are sustainable and supported by genuine operating cash flow, not accounting artifacts. Earnings driven by one-off gains, aggressive non-cash items, or activities unrelated to the business are lower quality. -
A large and growing gap between reported net income and operating cash flow can be a warning sign of:
Correct answer: A. When net income consistently outpaces operating cash flow, it can signal aggressive revenue recognition or other earnings management worth investigating. It is not a sign of strong cash generation, lower risk, or a higher dividend. -
Capitalising a cost rather than expensing it immediately will, in the year of the spend, tend to make reported net income:
Correct answer: A. Capitalising spreads the cost across future periods through depreciation, so less is expensed now and current net income is higher than if the cost were expensed at once. It does not lower or leave income unchanged in that year, nor automatically turn it negative. -
Under the defined-benefit pension rules, a plan is 'underfunded' when:
Correct answer: C. A defined-benefit plan is underfunded when the present value of the promised benefit obligation exceeds the plan assets set aside, creating a net liability. Assets exceeding the obligation is overfunded, having no employees is not the test, and contributions equalling benefits does not define funded status. -
In a one-period binomial option model, the option is valued using:
Correct answer: B. The binomial model prices an option with risk-neutral probabilities, discounting expected payoffs at the risk-free rate so no arbitrage exists. It does not use the historical average return, the dividend yield alone, or a bond coupon. -
In the Black-Scholes-Merton model, the value of a call option increases when, all else equal, the:
Correct answer: A. Higher volatility raises a call's value because greater dispersion increases the chance of a large favourable move while the downside is capped at the premium. Falling volatility, a collapse of time to expiry, or a sharply lower risk-free rate all tend to reduce a call's value. -
An option's 'delta' measures the change in the option's price for a small change in the:
Correct answer: D. Delta is the sensitivity of the option price to a small move in the underlying asset's price. Sensitivity to the risk-free rate is rho, to the passage of time is theta, and the strike is fixed once the option is written. -
The fixed rate on a newly initiated plain-vanilla interest-rate swap is set so that the swap's value at inception is:
Correct answer: C. The swap fixed rate is chosen so the present values of the fixed and floating legs match, giving the swap zero value to both sides at the start. It is not designed to favour the fixed payer, equal the notional (which is never exchanged), or equal the first coupon. -
Using a covered-interest-parity argument, the forward exchange rate between two currencies is determined by the spot rate and the:
Correct answer: C. Covered interest parity sets the forward rate from the spot rate adjusted by the interest-rate differential, so financing in either currency yields the same hedged return. Inflation alone, stock market levels, and the trade balance do not pin down the no-arbitrage forward. -
Heteroskedasticity in a regression means that the:
Correct answer: D. Heteroskedasticity is non-constant error variance across observations, which can make standard errors unreliable. Constant error variance is the opposite (homoskedasticity), and it is unrelated to whether the model has an intercept or how large the sample is. -
Multicollinearity in a multiple regression occurs when:
Correct answer: D. Multicollinearity arises when independent variables are highly correlated with one another, inflating coefficient standard errors and making individual effects hard to isolate. A binary dependent variable, a single observation, and independent errors describe different issues. -
Serial correlation (autocorrelation) of regression residuals is a particular concern in:
Correct answer: C. Serial correlation means residuals are correlated across periods, a common problem in time-series data that distorts standard errors. It is less of a concern in purely cross-sectional data, data with no time dimension, or a single point. -
Adjusted R-squared is often preferred to R-squared when comparing models because it:
Correct answer: C. Adjusted R-squared penalises extra predictors that do not genuinely improve fit, so it does not simply rise every time a variable is added the way R-squared can. It still relates to the dependent variable and is not the p-value. -
Relative purchasing power parity predicts that a country with persistently higher inflation than its trading partner will see its currency:
Correct answer: B. Relative PPP implies the higher-inflation currency loses value over time so that relative prices realign. It does not appreciate steadily, stay perfectly fixed, or disappear. -
In the neoclassical growth model, long-run growth in output per capita is driven mainly by:
Correct answer: C. The neoclassical model shows that, because capital faces diminishing returns, sustained growth in output per person ultimately comes from technological progress. Saving more raises the level but not the permanent growth rate, and printing money or raising tariffs do not drive long-run real growth. -
A country running a persistent current-account deficit must, by the balance-of-payments identity, generally have an offsetting:
Correct answer: B. Because the balance of payments must net out, a current-account deficit is offset by a capital/financial-account surplus, meaning net foreign capital flows in. It cannot also be a current-account surplus, does not require zero trade, and does not depend on a fixed exchange rate. -
In capital budgeting, when NPV and IRR rankings conflict for mutually exclusive projects, an analyst should generally rely on:
Correct answer: D. NPV is preferred for mutually exclusive projects because it directly measures the value added and is not distorted by reinvestment-rate and scale assumptions that can mislead IRR. The payback period and accounting rate of return ignore the time value of money and the full cash-flow profile. -
A 'real option' in a capital project, such as the option to expand or abandon, adds value because it gives management:
Correct answer: C. Real options add value by giving management the flexibility to expand, delay or abandon as new information arrives, which a static NPV ignores. They are rights rather than obligations, do not automatically lower the discount rate, and do not guarantee profit. -
Holding business risk constant, increasing financial leverage raises a firm's:
Correct answer: D. More leverage loads additional financial risk onto equity holders, so the cost of equity rises. It does not fall to zero, leverage changes financial rather than business risk, and it does not directly raise revenue. -
A multifactor model such as the Fama-French approach explains returns using:
Correct answer: D. Multifactor models extend the single-factor CAPM by adding systematic factors such as size and value alongside the market. Using the market alone is the CAPM, company-specific news is idiosyncratic, and the risk-free rate alone explains nothing about risk premia. -
Arbitrage pricing theory (APT) differs from the CAPM mainly because APT:
Correct answer: A. APT prices assets using multiple systematic risk factors rather than the CAPM's single market factor. It does not use only one factor, does not ignore risk, and is not limited to bonds. -
The information ratio measures a manager's active return relative to:
Correct answer: C. The information ratio divides active return (over the benchmark) by tracking error, the volatility of that active return, gauging consistency of value added. It is not divided by total return, the risk-free rate, or assets under management. -
The Treynor ratio differs from the Sharpe ratio because Treynor divides excess return by:
Correct answer: B. The Treynor ratio uses beta (systematic risk) in the denominator, while the Sharpe ratio uses total standard deviation. The dividend and the coupon are income items, not risk measures. -
In Markowitz mean-variance analysis, the benefit of combining two assets grows as their correlation:
Correct answer: A. Lower correlation means returns offset more, so diversification benefit grows as correlation falls toward -1. Correlation near +1 offers little benefit, the effect is not limited to exactly zero, and correlation is central, not irrelevant. -
A real estate property's capitalisation ('cap') rate is calculated as:
Correct answer: D. The cap rate is net operating income divided by property value, an income yield used to value and compare properties. Inverting it, doubling gross rent, or quoting the mortgage rate do not give the cap rate. -
In private-equity performance reporting, the 'distributed to paid-in' (DPI) multiple measures:
Correct answer: B. DPI compares cash distributions actually returned to investors with the capital they paid in, a measure of realised performance. Unrealised value is captured by RVPI, and DPI is neither the management fee nor the hurdle rate. -
Under the Standard on diligence and reasonable basis, before making a recommendation an analyst must:
Correct answer: D. The Standards require a reasonable and adequate basis, supported by appropriate research and analysis, before recommending an action. Relying on a rumour, copying a competitor, or guaranteeing the outcome all violate that diligence requirement. -
Under the Standards, when an analyst uses another author's work, they must:
Correct answer: A. The misconduct and misrepresentation Standards require acknowledging sources to avoid plagiarism. Presenting others' work as one's own is plagiarism, deleting the data is unnecessary, and charging a fee does not address attribution. -
If a member believes an employer's instruction would violate the law or the Standards, the member should:
Correct answer: D. The Standards require members not to take part in a violation and to seek to resolve the matter through appropriate channels (such as compliance or supervisors). Quietly complying participates in the breach, immediate resignation is not the required first step, and blaming a colleague avoids responsibility. -
Because Level II item sets share one vignette across several questions, a misread of the case can:
Correct answer: C. Since multiple questions draw on the same vignette, misreading the case can spread errors across several linked questions, which is why careful reading matters. It rarely affects only one question, does not improve the score, and cannot be safely ignored. -
A sound time-management approach for a vignette-based exam is to:
Correct answer: A. Budgeting time per item set, moving on, and flagging hard questions to revisit keeps the whole exam on pace. Spending unlimited time on one set, answering only easy sets, or skipping the reading all cost marks elsewhere.
Practice questions FAQ
- Are these real CFA Level II exam questions?
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- 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.
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