Equity Investments CFA Level I Exam 2023 Questions with Verified Answers

Q. Which of the following statements is most accurate with respect to rebalancing and reconstitution of security market indexes? Equal-weighted indexes require frequent rebalancing. A price-weighted index requires rebalancing more than a market-capitalization-weighted index. Turnover within an index results from a reconstitution but not from rebalancing - Answer- A is correct. After an equal-weighted index is constructed and the prices of constituent securities change, the index is no longer equally weighted. Therefore, maintaining equal weights requires frequent adjustments (rebalancing) to the index. B is incorrect because price-weighted indexes are not rebalanced because the weight of each constituent security is determined by its price. For market-capitalization-weighted indexes, rebalancing is less of a concern and the weights are only adjusted to reflect mergers, acquisitions, liquidations, and other corporate actions between rebalancing dates. C is incorrect because reconstitution is the process of changing constituent securities in the index; rebalancing refers to adjusting the weights of the constituent securities in the index. Turnover within an index results from both reconstitution and rebalancing. Q. A stop-buy order is most likely placed when a trader: wants to limit the loss on a short position. thinks that the stock is overvalued. wants to limit the loss on a long position. - Answer- A is correct. A trader who has entered into a short sale will incur losses if the stock price begins to increase. A stop-buy order helps limit the loss on a short position because it becomes valid for execution when the stock price rises above the specified stop price. B is incorrect because a stop-buy order is beneficial when the stock is undervalued (not overvalued) but the trader is unwilling to trade without market confirmation. C is incorrect because a stop-sell order is appropriate when the trader holds a long position, not short position. A stop-sell order becomes valid when the stock price falls. Q. An observation that stocks with above average price-to-earnings ratios have consistently underperformed those with below average price-to-earnings ratios least likely contradicts which form of market efficiency? Strong form Semi-strong form Weak form - Answer- C is correct. The observation that stocks with high above average price-to-earnings ratios have consistently underperformed those with below average price-to-earnings ratios is a cross-sectional anomaly. It is a contradiction to the semi-strong form of market efficiency and strong form market efficiency because all the information used to categorize stocks by their price-to-earnings ratios is publicly available. It is not a contradiction to weak form market efficiency. A and B are incorrect because the data on price-to-earnings ratios are publicly available, and the related anomaly therefore is a contradiction to the semi-strong and strong forms of market efficiency. Q. According to behavioral finance, observed overreaction in securities markets most likely occurs because of: disposition effect. loss aversion. gambler's fallacy. - Answer- B is correct. According to loss aversion-related arguments in behavioral theories, investors dislike losses more than they like comparable gains. Thus, such a behavioral bias can explain observed overreaction in markets. A is incorrect because disposition effect is a behavioral bias in which investors tend to avoid realizing losses but rather seek to realize gains. C is incorrect because gambler's fallacy is a behavioral bias in which recent outcomes affect investors' estimates of future probabilities. Q. The economic equilibrium interest rate in a well-functioning financial system is most likely determined by: central bank policy. the time consumption preferences of borrowers. the supply and demand of money. - Answer- C is correct. The economic equilibrium interest rate in a well-functioning financial system is determined by the aggregate supply and demand of money. An expected rate of return exists, in theory, in which the aggregate supply of funds for investing and the aggregate demand for funds through borrowing and equity issuing are equal. A is incorrect because central bank policy is a specific example impacting the supply of money, but it does not address the demand of money. B is incorrect because time consumption preferences of borrowers are a specific example impacting the demand of money, but they do not address the supply of money. Q. A pension fund has decided to invest in alternative investments. Which of the following assets is the fund most likely to include in this strategy? Securitized debt Convertible bonds Equity exchange-traded funds - Answer- A is correct. Securitized debt is an alternative investment, so it could be included in this strategy. B is incorrect because convertible bonds are traditional, not alternative, investments. C is incorrect because equity exchange-traded funds are traditional not alternative investments. Q. Which of the following statements concerning the objectives of market regulation is least accurate? Regulators: set standards to ensure that all agents acting in the market are skilled. promote fair and orderly markets. ensure that systems are in place to prevent fraud. - Answer- A is correct. Regulators help solve agency problems by setting minimum standards of competence, not skill, for agents and by defining and enforcing minimum standards of practice. B is incorrect because one of the objectives of market regulation is to promote fair and orderly markets in which traders can trade at prices that accurately reflect fundamental values. C is incorrect because regulators ensure that systems are in place to protect customers from fraud. Q. Which of the following statements concerning a security market index is most accurate? Estimated market prices of constituent securities are not used to calculate the index value. The divisor will be adjusted to prevent changes not related to prices of constituent securities. At inception, the total return version of an index will be greater than the price version of an index. - Answer- B is correct. An index provider will adjust the value of the divisor as necessary to avoid changes in the index value that are unrelated to changes in the prices of constituent securities. A is incorrect because the value of an index is calculated using either the actual or estimated market prices of the individual securities. C is incorrect because at inception, the value of a total return index will be equal to the price index. Q. For portfolio managers of passive funds, market indexes are least useful as: proxies to measure systematic risk. benchmarks for portfolio performance attribution. tools to develop exchange-traded funds for non-accessible markets. - Answer- B is correct. Market indexes are used as benchmarks for actively managed portfolios, which is not relevant to passively managed funds. A is incorrect because market indexes are used as proxies to measure systematic risk. The use is relevant to passively managed funds. C is incorrect because market indexes are used as model portfolios to develop new ETFs. The use is relevant to these portfolio managers as some emerging markets are not easily accessible for direct investments. Q. Which of the following financial intermediaries is most likely to provide liquidity service to its clients? Brokers Dealers Exchanges - Answer- B is correct. The service that dealers provide is liquidity. Liquidity is the ability to buy or sell with low transaction costs when investors want to trade. By allowing their clients to trade when they want to trade, dealers provide liquidity to them. A is incorrect because brokers are agents who fill orders for their clients. They do not trade with their clients. C is incorrect because exchanges provide places where traders and dealers can meet to arrange their trades. Q. Which of the following statements concerning financial regulatory bodies is least accurate? Financial regulatory bodies: act to level the playing field for market participants. define minimum standards of competence for agents. require that regulated firms maintain optimum levels of capital. - Answer- C is correct. Financial regulators impose minimum levels of capital that apply across the board to all regulated firms—not the optimum level, which is firm specific. Q. A trader buys a stock at $30 and wants to limit downside risk. Which of the following orders will most likely guarantee that he can sell the stock at $25? (GTC means good till cancelled) Put option buy market order with a strike price of $25 GTC, stop $25, limit $25 sell order GTC, stop $25, market sell order - Answer- A is correct. Option contracts can be viewed as limit orders for which execution is guaranteed at the strike price. Therefore, a put buy order at a strike price of $25 will guarantee selling the stock at $25. C is incorrect because a "GTC, stop $25, market sell" order becomes a market order when the price drops to or below $25 and is executed at the best price available in the market. Thus, the selling price of $25 is not guaranteed. B is incorrect because a "GTC, stop $25, limit $25 sell" order limits the lower boundary to $25 but it does not guarantee execution at $25; in a fast-moving market prices may have dropped below the limit and the order will then not be executed. Q. The type of efficiency that exists in an economy that distributes capital in the most productive way is best described as: allocational. informational. operational. - Answer- A is correct. Economies are said to be allocationally efficient when their financial systems allocate capital (funds) to those uses that are most productive. B is incorrect because an informationally efficient financial system is one in which the prices of assets and contracts reflect all available information related to their fundamental values. C is incorrect because an operationally efficient financial system is one in which the costs of arranging trades are low. Q. Which of the following statements is least accurate with respect to fixed-income indexes? Many of the underlying securities in the index tend to be illiquid. The indexes are susceptible to turnover of the underlying securities. Compared with equity indexes, it is easier and less expensive to replicate fixed-income indexes. - Answer- C is correct. Compared with equity indexes, the large number of fixed-income securities—combined with the lack of liquidity of some securities—has made it more costly and difficult for investors to replicate fixed-income indexes and duplicate their performance. A is incorrect because many of the underlying securities in the index tend to be illiquid because fixed-income markets are predominantly dealer markets. B is incorrect because the indexes are susceptible to turnover of the underlying securities because over time, fixed-income securities mature and issuers offer new securities to meet their financial needs. Q. Which of the following is least likely to be directly reflected in the returns on a commodity index? Changes in the futures prices of commodities in the index Changes in the spot prices of underlying commodities Roll yield - Answer- B is correct. Commodity index returns reflect the changes in future prices and the roll yield. Changes in the underlying commodity spot prices are not reflected in a commodity index. Q. Compared with its market-value-weighted counterpart, a fundamental-weighted index is least likely to have a: momentum effect. contrarian effect. value tilt. - Answer- A is correct. The momentum effect is a characteristic of a market-capitalization-weighted index, not a fundamental index. B is incorrect because the fundamental indexes generally have a contrarian effect in that the portfolio weights will shift away from securities that have increased in relative value whenever the portfolio is rebalanced. C is incorrect because fundamental weighting leads to a value tilt because the ratios of book value, earnings, dividends, etc., to market value of the firms in a fundamental index tend to be larger than those of the firms in its market-capitalization-weighted counterpart. An equity fund manager is considering a market index as the benchmark for his portfolio, and he has the following preferences: the index should have a contrarian effect; shares held by controlling shareholders should be included; dividends should be included in the weighting of constituent securities; and the weights of constituent securities should not be arbitrarily determined by the index provider. Which of the following weightings of indexes best meets the fund manager's preferences? Equal Float-adjusted market capitalization Fundamental - Answer- C is correct. Fundamental weighting satisfies the fund manager's preferences. Fundamental indexes use a single measure, such as total dividends, to weight the constituent securities. Fundamentally weighted indexes generally will have a contrarian effect in that the portfolio weights will shift away from securities that have increased in relative value and toward securities that have fallen in relative value whenever the portfolio is rebalanced. All shares are included in a fundamental weighted index. A is incorrect because the weights in an equal-weighted index are arbitrarily assigned by the index provider. The fund manager does not like this feature. B is incorrect because in float-adjusted market-capitalization weighting, the shares held by controlling shareholders are excluded. The fund manager does not like this feature. Q. Which of the following is most likely one of the main functions of the financial system? Determining an equilibrium interest rate Ensuring that markets are informationally efficient Ensuring that all investment projects receive sufficient funding - Answer- A is correct. One of the main functions of the financial system is to determine the equilibrium interest rate, which is the only interest rate that would exist if all securities were equally risky, had equal terms, and were equally liquid. B is incorrect because informational market efficiency is not a key function of the financial system, rather that of regulatory framework. C is incorrect because the financial system provides sufficient funding only to the most productive projects. An important function of the financial system is to direct resources away from wealth-diminishing projects. Q. A university endowment fund is mandated to hold some of its value in alternative investments. Which of the following would most likely be included in the fund's alternative investments portfolio? Real estate securities Exchange-traded funds Convertible preferred shares - Answer- A is correct. Real estate securities qualify as alternative investments. B is incorrect because exchange-traded funds are publicly traded and do not qualify as alternative investments. C is incorrect because convertible preferred shares may be publicly traded and do not qualify as alternative investments. Q. When parties exchange fixed cash payments for payments that depend on the returns to a stock or a stock index, they are purchasing a(n): equity swap. index fund. stock option. - Answer- A is correct. Equity swaps consist of parties exchanging fixed cash payments for payments that depend on the returns to a stock or a stock index. B is incorrect because the payments depend on the returns to a stock or a stock index, but an index fund has not been directly purchased. C is incorrect because an option contract allows the holder (the purchaser) of the option to buy or sell an underlying instrument at a specified price at or before a specified date in the future. Q. Forward contracts are most likely to be attractive hedging vehicles to investors who: do not want to make an upfront outlay of cash. want to reserve the right to close out their position early. are not in a position to investigate the creditworthiness of their counterparties. - Answer- A is correct. Most forward contracts do not require an upfront cash outlay. Other hedging vehicles, such as futures (which require margin accounts) and options (which must be purchased for a fee), do require upfront payments. B is incorrect because forward contracts are custom agreements, it is difficult to find another party who is both willing to take over the contract obligations and acceptable to the existing counterparty. Futures would be more suitable in this circumstance because they can be closed out early. C is incorrect because forward contracts are custom agreements that depend on each counterparty's knowledge of the creditworthiness of the other. Q. A closed-end fund is trading at a premium to its net asset value. This scenario most likely reflects: a belief that the portfolio securities are undervalued. concerns about the quality of management. excess demand for redemption of the shares. - Answer- A is correct. Closed-end funds may trade at a premium (discount) to net asset value when investors believe that the portfolio securities are undervalued (overvalued). B is incorrect because concerns about the quality of management could suggest discounts from net asset value. C is incorrect because excess redemption demand suggests selling pressure, which could indicate a discount to net asset value. Q. Dark pools are best described as: