CFA Institute CFA Institute Certifications CFA-LEVEL-1 Questions & Answers

• Question 1511:

  Collete Minogue holds stock in Bracken Entertainment. Although many of her associates still believe that Bracken will be a high-performing stock, Minogue has lost faith and wants to conduct a covered call transaction. Current market conditions are as follows: In assessing whether she should conduct the covered call strategy, Minogue sketches out the following graph. Although her sketch is correct, she cannot remember all the labels.

  

  Which of the following statements about the graph and the covered call strategy is INCORRECT?

  A. If Minogue goes ahead with the covered call, she will limit her gain to $11.

  B. The distance between points C and D is $5.

  C. The call writer will have unlimited upside potential.

  D. Line Y represents the covered call's profit line.

  Correct Answer: C

  The call buyer has unlimited upside potential. If the stock price exceeds $39, the buyer will exercise the option and will realize all gains (once the cost of the premium is recovered). The other statements are true. Minogue is the call writer (a covered call consists of the stock and a short call). Her gain is limited to $11 (the call premium of $5 plus the gain on the stock as long as the market price is less than the strike price, or $39 - $33). The distance between points C and D represents the call premium, or $5. Line Y represents the covered call profit line and Line X represents the stock profit line.

• Question 1512:

  Consider an annual coupon bond with the following characteristics: For a 75 basis point change in interest rates, the bond's duration is:

  A. 8.17 years.

  B. 5.09 years.

  C. 8.79 years.

  D. 5.80 years.

  Correct Answer: B

  Since the bond has an embedded option, we will use the formula for effective duration.(This formula is the same as the formula for modified duration, except that the "upper price bound" is replaced by the call price.) Thus, we only need to calculate the price if the yield increases 75 basis points, or 0.75%. Price if yield increases 0.75%: FV =100, I/Y =7.25= 6.50 + 0.75, N =12, PMT =6.5, Compute PV = 94.12 The formula for effective

  

  jjoachim_SS15_1_C_j_duration

  Where:

  V= Call price/price ceiling

  V+

  = estimated price if yield increases by a given amount,　y

  V0

  = initial observed bond price

  　y

  = change in required yield, in decimal form

  Here,effective duration = (101.75 – 94.12) / (2 * 100 * 0.0075) = 7.63 / 1.5 =5.09 years.

• Question 1513:

  Four years ago, at the advice of J.T. Lindseth, her financial planner, T.J. Ali purchased a $1,000 face, 5.70 percent, semi-annual coupon bond with four years to maturity priced to yield 8.50 percent for $906.70. Now, the bond has matured, and Lindseth calls Ali and informs her that because he had invested the coupons at an annual rate of 10.0 percent, her realized return was approximately:

  A. 8.65%.

  B. 8.50%.

  C. 10.00%.

  D. 8.35%.

  Correct Answer: A

  Time Saving Note:You can answer this question without doing any calculations! Because the coupon reinvestment rate was greater than the original YTM, we would expect the YTM to increase. This narrows down the choices to 8.65% and 10.00%. The rate of 10.00% is an unlikely choice because the coupon payments do not comprise 100% of the return of the bond. Thus, the realized rate will be greater than 8.50%, but less than 10.00%. The only choice that meets this criterion is 8.65%. For those of you who want to work through the calculations: We first need to calculate the FVcoupon annuity, then calculate the Total Future Value of the Bond, and finally calculate the realized return. Step 1: Calculate theFVcoupon annuity

  

  jjoachim_SS15_1_B_e_FVCoupon

  Here, FVcoupon annuity= [ (1 + (0.10 / 2)4*2)-1] / [0.10 / 2] * [(1000 * 0.057) / 2]

  = [ ( 1.05)8?1] / 0.05 * 28.5 = 9.549 * 28.5 = $272.15

  Alternatively, N = 8, I/Y = 5, PMT = 28.5, PV = 0, Compute FV = -272.15

  Step 2: Calculate the Bond's Total Future Value (TFV)

  TFV = Face Value + FVcoupon annuity= $1,000 + $272.15 = $1,272.15.

  Step 3: Calculate the Realized Annual Return

  

  jjoachim_SS15_1_B_e_RealizedR

  Here, Realized ReturnAnnualized Basis= [ (1,272.15 / 906.70)1/8?] * 2 = 0.08648, or 8.65%.

• Question 1514:

  Kwagmyre Investments, Ltd., hold two bonds: a callable bond issued by Mudd Manufacturing Inc. and a putable bond issued by Precarious Builders. Both bonds have option adjusted spreads (OAS) of 135 basis points (bp). Kevin Grisly, a junior analyst at the firm, makes the following statements (each statement is independent). Apparently, Grisly could benefit from a CFA review course, because the only statement that could be CORRECT is:

  A. Given a nominal spread for Precarious Builders of 110 bp, the option cost is -25 bp.

  B. The cost of the call option on the Mudd bond is -15bp.

  C. The Z-spread for Mudd's bond is based on the YTM.

  D. The spread over the spot rates for a Treasury security similar to Mudd's bond is 145 bp.

  Correct Answer: D

  The "spread over the spot rates for a Treasury security similar to Mudd's bond" refers to the Z-spread on the bond.For a callable bond, the OAS < Z-spread, so this could be a true statement because 135bp < 145 bp. The other statements are false. The option cost is calculated using the OAS and theZ-spread,not the nominal spread. The cost of the call option should be positive.(The issuer has to compensate for increased uncertainty from the call option.) The static spread (or Z-spread)is the spread over each of the spot rates in a given Treasury term structure,not the spread over the Treasury's YTM. Following is a more detailed discussion: The option-adjusted spread(OAS) is used when a bond has embedded options. The OAS can be thought of as the difference between the static or Z-spread and the option cost. For the exam, remember the following relationship between the static spread (Z-spread), the OAS, and the embedded option cost: Z Spread - OAS = Option Cost in % terms Remember the following option value relationships:

• Question 1515:

  Scott Malooly recently paid $109.05 for a $1000 face value, semi-annual coupon bond with a quoted price of 105 6/32. Assuming that transaction costs are zero, which of the following statements is TRUE?

  A. Malooly purchased the bond between coupon dates.

  B. The price Malooly paid covers the amount of the next coupon payment not earned by the seller.

  C. The bond was trading ex-coupon.

  D. The price Malooly paid includes the discounted amount of accrued interest due to seller.

  Correct Answer: A

  When a bond trades between two consecutive coupon dates, the seller is entitled to receive interest earned from the previous coupon date until the date of the sale. The price paid includes accrued interest and is referred to as the "dirty price." The other statements are false. The price Malooly paid covers the amount of the next coupon payment not earned by the buyer. When a security trades ex-coupon, the buyer pays the clean price, which is the quoted price without accrued interest. Accrued interest is not discounted when calculating the dirty price of a bond.

• Question 1516:

  A 12-year, $1,000 face value zero-coupon bond is priced to yield a return of 7.00 percent on a semi-annual basis. What is the price of the bond, and how much interest will the bond pay over its life, respectively? (Select the choice that is closest to the correct answer.)

  A. $562, $438.

  B. $444, $556.

  C. $840, $160.

  D. $438, $562.

  Correct Answer: D

  Using the equation:Pricezerocoupon= Face Value * [ 1 / ( 1 + i/n)n*2]

  Here,Pricezerocoupon= 1000 * [ 1 / (1+ 0.070/2)12*2] = 1000 * 0.43796 = 437.95, or approximately438.So,

  interest = Face Value ?Price = 1000 ?438 =562.

  Using thecalculator:N = (12*2) =24, I/Y = 7.00 / 2 =3.50, FV = 1000, PMT = 0. PV = -437.95, or

  approximately $438

• Question 1517:

  Assume an investor makes the following investments:

  During year one, the stock paid a $5.00 per share dividend. In year two, the stock paid a $7.50 per share

  dividend.

  The time-weighted return is:

  A. 51.4%.

  B. 51.7%.

  C. 23.2%.

  D. 14.7%.

  Correct Answer: A

  To calculate the time-weighted return:

  Step 1: Separate the time periods into holding periods and calculate the return over that period:

  Holding period 1:P0= $50.00

  D1= $5.00

  P1= $75.00 (from information on second stock purchase)

  HPR1 = (75 ?50 + 5) / 50 = 0.60, or 60%

  Holding period 2:P1= $75.00

  D2= $7.50

  P2= $100.00

  HPR2 = (100 ?75 + 7.50) / 75 = 0.433, or 43.3%.

  Step 2: Use the geometric mean to calculate the return over both periods

  Return = [(1 + HPR1) * (1 + HPR2)]1/2?1 = [(1.60) * (1.433)]1/2?1 = .5142, or51.4%.

• Question 1518:

  A bond has a yield of 10 percent and an effective duration of 7.5 years. If the market yield changes by 10 basis points, what is the change in the bond's price?

  A. 0.375%.

  B. 1.500%.

  C. 2.000%.

  D. 0.750%.

  Correct Answer: D

  The formula for effective duration calculates the approximate change in price for a 100 basis point change. Here, we are asked to provide the approximate percentage change in the bond's price for a 10bp change. Ten basis points is 1/10th, or 0.10 of 100bp. Thus, the calculation is 0.10 * 7.50 = 0.750%.

• Question 1519:

  Jay Crewson, equity analyst at a large investment bank, formerly worked with a group of contrary-opinion

  technician traders who traded exclusively using contrary indicators. He was recently transferred to support

  a group of smart-money technicians. Since he is still adjusting to the "new" rules, he asks Richard Ruscoe,

  another analyst in the group, to review his work. Ruscoe reviews Crewson's latest recommendation list and

  points out that one of the statements is incorrect.

  Which of the following is the INCORRECT statement? Buy:

  A. debit balances in brokerage accounts increased.

  B. the ratio of short sales by specialists to total NYSE short sales fell below 0.30.

  C. investor credit balances in brokerage accounts increased.

  D. the yield-differential between high quality and lower-quality bonds decreased to 90 basis points.

  Correct Answer: C

  Increased investor credit balances in brokerage accounts (indicating a bearish trend) are a bullish sign to contrary-opinion technicians. The other statements are true and are indicators used by smart-money technicians. When the yield- differential between high quality and lower-quality bonds narrows (or decreases), it indicates that the confidence index has increased and smart-money technicians are bullish.

• Question 1520:

  Mikal Cosce uses technical analysis to determine his trading behavior. Cosce would be least likely to agree with which of the following statements?

  A. He supports the weak form of the efficient market hypothesis.

  B. Stock prices move in trends, and these trends persist.

  C. Technical analysis tells him when to buy.

  D. He does not have to rely on accounting information.

  Correct Answer: A

  The weak form of the efficient market hypothesis (EMH) refutes technical trading. The tests for the weak form of the EMH indicate that after incorporating trading costs, simple trading rules cannot generate positive, consistent, abnormal returns. The other statements are true.