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102
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practice questions: 398
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Level I topics

Fixed IncomeFree

Three option-free bonds are priced at the same yield to maturity. Which one is most likely to have the highest convexity?

AA 10-year bond with a 7% coupon.
BA 25-year bond with a 2% coupon.Correct
CA 10-year bond with a 2% coupon.

Why B is right. Convexity is increased by the same features that increase duration: a longer maturity and a lower coupon rate (and a lower yield, which is equal here). The 25-year, 2% coupon bond combines the longest maturity with the lowest coupon, so it has the most convexity.

Why not A. This bond has both the shorter maturity and the higher coupon, so it has the least convexity of the three.

Why not C. The low coupon raises convexity relative to the 7% bond, but with a 10-year maturity it is less convex than the 25-year bond with the same coupon.

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Question 1Free

Hannah Kowalczyk makes the following trades in Silverleaf Foods shares, with no taxes or transaction costs:

Today: buys one share at $30.00.
One year from today: buys a second share at $36.00.
Two years from today: sells both shares at $41.00 each.

Silverleaf pays a dividend of $1.50 per share at the end of year 1 and $2.00 per share at the end of year 2. Dividends are not reinvested. Kowalczyk's required return is 10%. Her money-weighted rate of return is closest to:

Show answer and explanation

Correct answer: B

The money-weighted return is the internal rate of return of the cash flows the investor actually pays and receives. At the end of year 1 the $1.50 dividend on the first share is netted against the $36.00 purchase. At the end of year 2 she receives the sale proceeds and the dividends on two shares. The 10% required return is not an input.

t	Cash flow
0	−30.00
1	+1.50 − 36.00 = −34.50
2	2 × 41.00 + 2 × 2.00 = +86.00

- 30.00 - \frac{34.50}{1 + r} + \frac{86.00}{( 1 + r ) ^{2}} = 0 \Rightarrow r = 0.2131 \approx 21.3%

TI BA II Plus: [CF] [2ND] [CLR WORK]; CF0 = −30; C01 = −34.5, F01 = 1; C02 = 86, F02 = 1; [IRR] [CPT] = 21.31.

Why the other options are wrong

A. 15.9% is the IRR after ignoring both dividends (CF1 = −36, CF2 = +82). Dividends that are paid out are cash received by the investor.
C. 22.2% is the time-weighted return: $H P R_{1} = (36 - 30 + 1.5) /30 = 25.0%$ and $H P R_{2} = (41 - 36 + 2) /36 = 19.4%$ , so $1.250 \times 1.194 - 1 = 22.2%$ . This measure ignores the fact that more money was invested in year 2.

Key takeaway For an MWR share problem, net the dividend received against any purchase on the same date, and include dividends on all shares held at the end.

Question 2Free

Tamarind Beverages reports under US GAAP. It owns a beverage brand that it acquired several years ago, and management has concluded that the brand has an indefinite useful life. The annual impairment review of the brand produces the following estimates.

Tamarind Beverages: impairment review of an indefinite-lived brand

Item	$ millions
Carrying amount	64
Undiscounted expected future cash flows	90
Present value of expected future cash flows (value in use)	58
Fair value	52
Costs to sell	3

The impairment loss that Tamarind recognizes on the brand is closest to:

Show answer and explanation

Correct answer: A

An intangible asset with an indefinite useful life is not amortized. It is tested for impairment at least annually, and an impairment loss is recognized when its carrying amount exceeds its fair value. Under US GAAP there is no recoverability screen based on undiscounted cash flows for such an asset, so the $64 million carrying amount is compared directly with the $52 million fair value. The loss of $12 million is measured against fair value itself, with no deduction for costs to sell.

Impairment loss = carrying amount - fair value = 64 - 52 = $12 million

The brand is written down to $52 million and the $12 million loss is reported in the income statement.

For comparison, the two tests that do not apply here:

Test	Calculation	Result
US GAAP recoverability test for PP&E held for use	undiscounted cash flows 90 > carrying amount 64	no impairment
IFRS recoverable amount	$max (52 - 3, 58) = 58$ ; loss $= 64 - 58$	loss of 6

Why the other options are wrong

B. $6 million uses the IFRS recoverable amount, the higher of fair value less costs to sell ($49 million) and value in use ($58 million). Tamarind reports under US GAAP, which measures the loss against fair value.
C. $0 applies the US GAAP recoverability test used for PP&E and finite-lived assets held for use: undiscounted cash flows of $90 million exceed the carrying amount, so that test would stop there. An indefinite-lived intangible asset is compared directly with its fair value, so the undiscounted cash flows do not matter.

Key takeaway Under US GAAP, PP&E held for use passes an undiscounted cash flow test before any loss is measured. An indefinite-lived intangible asset skips that screen: whenever its carrying amount exceeds fair value, the excess is an impairment loss, even if undiscounted cash flows are well above the carrying amount.

Question 3Free

Gloria Ansel, a retired bus driver who lives on the income from a small annuity, asks Viktor Lindqvist, CFA, to buy 8,000 shares of Quarrystone Genetics, a newly formed biotechnology start-up. The purchase would materially change the risk of her portfolio, and Lindqvist believes it is unsuitable given her investment policy statement. Consistent with the Standards, Lindqvist should most appropriately:

Show answer and explanation

Correct answer: C

When a client makes an unsolicited request for an unsuitable trade, the member should discuss it with the client before acting. Because this trade would have a material effect on the portfolio, the right step is to discuss whether it reflects a change in her objectives and risk tolerance, i.e., whether she wants to update her investment policy statement.

Why the other options are wrong

A. Refusing outright is premature. The first step is a discussion with the client; only if she will not update her IPS might the member follow firm policy, such as a separate client-directed account, or reconsider the relationship.
B. Obtaining the client's acknowledgement under firm procedures is appropriate when an unsuitable unsolicited trade has only a minor effect on the portfolio. Here the effect is material.

Key takeaway For an unsolicited, unsuitable trade, a minor effect on the portfolio leads to the firm's acknowledgement procedure; a material effect leads to a discussion of updating the IPS.

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