CFA Level II practice questions and exam guide

A regression's residuals appear to have variance proportional to the square of an explanatory variable x. The MOST appropriate remediation is:

1. Multicollinearity effect on standard errors
2. Serial correlation of regression residuals
3. Heteroskedasticity effect on inference
4. Apply weighted least squares with weights 1/x²

Answer: D — Apply weighted least squares with weights 1/x²

A) Multicollinearity effect on standard errors — related concept, not the definition. B) Serial correlation of regression residuals — related concept, not the definition. C) Heteroskedasticity effect on inference — related concept, not the definition. D) Correct — this identifies Apply weighted least squares with weights 1/x².

A quarterly inflation series is modeled as an AR(1) process: x_t = 0.5 + 0.5x_{t-1} + ε_t. The correct basis for concluding the series is covariance stationary is that:

1. The series is stationary because the intercept (0.5) is less than 1
2. The series is nonstationary because the lag coefficient equals the intercept
3. The series is nonstationary because the mean-reverting level (1.0) exceeds the lag coefficient
4. The series is stationary because the absolute value of the lag coefficient (0.5) is less than 1

Answer: D — The series is stationary because the absolute value of the lag coefficient (0.5) is less than 1

A) Misidentifies the stationarity condition — it is the lag coefficient, not the intercept, whose magnitude must be below 1; the intercept can take any value without affecting stationarity. B) The coefficients happening to be numerically equal is irrelevant to stationarity; this is a spurious pattern-match rather than the actual test. C) Comparing the mean-reverting level to the lag coefficient is not the stationarity test — this fabricates a comparison that doesn't determine stationarity. D) Correct — a covariance-stationary AR(1) process requires the absolute value of the lag coefficient to be below 1, which holds here (0.5 < 1); the series reverts to a mean-reverting level of 0.5/(1−0.5) = 1.0.

A Breusch-Pagan test on residuals from a cross-sectional regression returns a chi-square statistic of 17.2 with 4 degrees of freedom (critical value at 5% is 9.49). The analyst should:

1. Multicollinearity effect on standard errors
2. Serial correlation of regression residuals
3. Heteroskedasticity effect on inference
4. Reject the null of homoskedasticity and use

Answer: D — Reject the null of homoskedasticity and use

A) Multicollinearity effect on standard errors — related concept, not the definition. B) Serial correlation of regression residuals — related concept, not the definition. C) Heteroskedasticity effect on inference — related concept, not the definition. D) Correct — this identifies Reject the null of homoskedasticity and use.

A small open economy with a floating exchange rate enacts expansionary fiscal policy. Under Mundell-Fleming with perfect capital mobility, the MOST likely short-run effect on output is:

1. Output gap positive pressure
2. J-curve trade balance dynamic
3. Neutral real policy rate level
4. Output rises only modestly

Answer: D — Output rises only modestly

A) Output gap positive pressure — related concept, not the definition. B) J-curve trade balance dynamic — related concept, not the definition. C) Neutral real policy rate level — related concept, not the definition. D) Correct — this identifies Output rises only modestly.

Country X has 6% expected inflation and Country Y has 2% expected inflation. Under uncovered interest rate parity (UIRP) and the international Fisher effect, the currency of Country X is expected to:

1. Uncovered interest rate parity result
2. Covered interest rate parity result
3. Depreciate by approximately 4% against
4. Marshall-Lerner condition satisfied

Answer: C — Depreciate by approximately 4% against

A) Uncovered interest rate parity result — swapped parity condition. B) Covered interest rate parity result — swapped parity condition. C) Correct — this identifies Depreciate by approximately 4% against Country Y's currency. D) Marshall-Lerner condition satisfied — related concept, not the definition.

An investor observes that a country's nominal short-term interest rate is 8% while realized inflation over the same period was 5%. A colleague claims the investor earned an 8% real return. The BEST critique of this claim is that:

1. The claim is correct, because nominal rates already reflect the market's compensation for realized inflation risk
2. The claim understates the real return, because the Fisher relation requires adding, not subtracting, the inflation rate to nominal rates
3. The claim overstates the real return; the approximate real rate is closer to 3% (nominal minus inflation), reflecting the Fisher relation
4. The claim is irrelevant, because real returns can only be computed using expected, not realized, inflation

Answer: C — The claim overstates the real return; the approximate real rate is closer to 3% (nominal minus inflation), reflecting the Fisher relation

A) Misconception — conflates the nominal rate with the real return; nominal rates embed expected inflation, but the realized real return still requires subtracting realized inflation. B) Direction reversal — the Fisher relation implies subtracting (approximately) inflation from the nominal rate to get the real rate, not adding it. C) Correct. D) Plausible-but-incomplete — while ex-ante decisions often use expected inflation, computing an ex-post real return with realized inflation is a standard and meaningful exercise, so dismissing it as irrelevant overstates the critique.

Under IFRS (IAS 19R), periodic pension cost in the income statement consists of:

1. Service cost plus the full expected return on plan assets, both flowing through net income
2. Only the current service cost, with all interest and remeasurement effects deferred to OCI
3. Interest cost on the gross pension obligation only, with no offset for the return on plan assets
4. Service cost plus interest expense on the NET pension liability (or income on a net pension asset), with remeasurements recognized in OCI

Answer: D — Service cost plus interest expense on the NET pension liability (or income on a net pension asset), with remeasurements recognized in OCI

A) IFRS uses net interest, not the full expected return on plan assets, in net income. B) Interest on the net liability is also included in net income under IFRS, not deferred entirely to OCI. C) IAS 19R nets the return on plan assets against interest cost rather than reporting gross interest cost alone. D) Correct — IAS 19R income statement pension cost is service cost plus net interest on the net defined benefit liability (or asset), with remeasurements in OCI.

Ferrous Metal Corp has significant deferred tax assets from net operating loss carryforwards. Given a recent history of cumulative losses and no clear evidence of future taxable income, the company's auditors would MOST likely require:

1. Reclassifying the deferred tax assets as deferred tax liabilities
2. Immediately writing off the net operating losses as an extraordinary item
3. No adjustment, since deferred tax assets are always recorded at full value regardless of realizability
4. Recording a valuation allowance to reduce the deferred tax assets to the amount more likely than not to be realized

Answer: D — Recording a valuation allowance to reduce the deferred tax assets to the amount more likely than not to be realized

A) Nonsensical — DTAs and DTLs arise from opposite-direction temporary differences; a realizability concern does not convert one into the other. B) Misstates the mechanism — extraordinary-item classification is no longer used under current GAAP, and the appropriate response to realizability doubt is a valuation allowance against the DTA, not a write-off of the NOLs themselves. C) A common misconception — DTAs must be assessed for realizability, and are recorded net of a valuation allowance when realization is not more likely than not. D) Correct — under a pattern of cumulative losses and no persuasive evidence of future taxable income, a valuation allowance is required to state the deferred tax asset at the amount expected to be realized.

An analyst notices a firm reports accrual ratios well above industry medians and Days Sales Outstanding (DSO) rising from 45 to 78 days. The MOST appropriate concern is:

1. A conservative accounting policy that understates the firm's reported earnings
2. Aggressive revenue recognition or channel stuffing inflating receivables and reported earnings quality
3. Improved collections efficiency, since customers are paying their invoices faster than before
4. Lower ending inventory value shown on the balance sheet

Answer: B — Aggressive revenue recognition or channel stuffing inflating receivables and reported earnings quality

A) Direction reversal — high accrual ratios and rising DSO point toward aggressive, not conservative, reported earnings. B) Correct — high accruals paired with rising DSO suggest revenue is being recognized before cash is collected, consistent with aggressive recognition or channel stuffing. C) Direction reversal — rising DSO indicates customers are paying more slowly, not faster. D) A lower ending inventory value doesn't explain rising receivables/DSO; it points to a different earnings-quality concern.

Pecking-order theory predicts that, when external funding is needed, firms prefer:

1. Pecking order internal-first ranking
2. Internal funds, then debt, then equity,
3. Modigliani-Miller with corporate tax
4. Modigliani-Miller no-tax irrelevance

Answer: B — Internal funds, then debt, then equity,

A) Pecking order internal-first ranking — related concept, not the definition. B) Correct — this identifies Internal funds, then debt, then equity,. C) Modigliani-Miller with corporate tax — related concept, not the definition. D) Modigliani-Miller no-tax irrelevance — related concept, not the definition.

A proxy advisor reviewing Atlas Energy's board finds: (1) the CEO also serves as board chair, (2) directors serve staggered three-year terms, (3) the compensation committee is majority non-independent directors, and (4) the audit committee is composed entirely of independent directors who meet at least four times per year. Which feature is LEAST likely to raise a governance concern on its own?

1. The combined CEO/chair role, since it can concentrate power and weaken independent board oversight
2. The staggered board terms, since they can entrench incumbent directors and serve as a takeover defense
3. An audit committee composed entirely of independent directors meeting at least four times per year
4. A majority non-independent compensation committee, since it weakens independent oversight of executive pay

Answer: C — An audit committee composed entirely of independent directors meeting at least four times per year

A) A genuine governance concern — combining CEO and chair roles is widely viewed as concentrating power and reducing board independence. B) A genuine concern — staggered boards can function as an entrenchment device and takeover defense, a common red flag for proxy advisors. C) Correct — a fully independent, actively meeting audit committee is a governance best practice, not a red flag; it is the one feature here that supports, rather than undermines, oversight. D) A genuine concern — non-independent control of the compensation committee weakens arm's-length oversight of executive pay.

An analyst BEST demonstrates understanding of the cost of capital when evaluating a new project by:

1. Using a discount rate that reflects the project's own business and financial risk, rather than the firm's overall WACC, when the project's risk differs materially from the firm's existing operations
2. Applying the firm's overall WACC to every new project regardless of its risk characteristics, since WACC reflects the firm's long-run cost of capital
3. Using the risk-free rate as the discount rate for any project financed entirely with retained earnings, since no new capital is raised
4. Applying only the cost of debt when a project is financed entirely with newly issued debt

Answer: A — Using a discount rate that reflects the project's own business and financial risk, rather than the firm's overall WACC, when the project's risk differs materially from the firm's existing operations

A) Correct — the discount rate should reflect the risk of the specific project's cash flows; using the firm-wide WACC for a materially different-risk project misstates its true cost of capital. B) A common practitioner shortcut, but it is a misconception — applying a single firm-wide WACC to all projects systematically over-values high-risk projects and under-values low-risk ones. C) A misconception — retained earnings still carry an opportunity cost equal to what shareholders could otherwise earn; it is not a free, risk-free source of capital. D) A misconception — capital structure should be evaluated at the target/marginal level for the firm as a whole; financing a single project entirely with debt doesn't mean equity holders no longer bear residual risk on that investment.

A stock has ROE of 16%, a sustainable growth rate of 6%, and a required return on equity of 12%. Using the Gordon growth model, the justified trailing P/B multiple is CLOSEST to:

1. 2.67
2. 1.67
3. 0.60
4. 0.83

Answer: B — 1.67

A) Uses ROE/(r − g) = 0.16/0.06 without netting the growth rate out of the numerator, omitting the required (ROE − g) term. B) Correct — justified P/B = (ROE − g)/(r − g) = (0.16 − 0.06)/(0.12 − 0.06) = 0.10/0.06 ≈ 1.67. C) Inverts the ratio, computing (r − g)/(ROE − g) instead of (ROE − g)/(r − g). D) Uses (ROE − g)/r = 0.10/0.12 instead of (ROE − g)/(r − g), forgetting to subtract g from the denominator.

A pro-rata, as-if-freely-traded (marketable minority) value of a 10% stake in a private company is $2,400,000. Applying a discount for lack of marketability (DLOM) of 30% to reflect the illiquidity of the private shares, the estimated nonmarketable minority value of the stake is CLOSEST to:

1. $1,680,000
2. $2,400,000
3. $3,120,000
4. $1,428,000

Answer: A — $1,680,000

A) Correct — nonmarketable minority value = $2,400,000 × (1 − 0.30) = $1,680,000. B) Fails to apply the DLOM at all, using the marketable minority value unadjusted despite the private shares' illiquidity. C) Adds the 30% factor instead of subtracting it, incorrectly increasing rather than discounting the value. D) Applies an additional minority discount on top of the DLOM ($2,400,000 × 0.70 × 0.85), double-counting a minority-interest adjustment that is already embedded in the $2,400,000 base value.

Z-spread (Zero-volatility spread) is:

1. The constant spread added to the spot
2. Pure expectations of forward rates
3. Modified duration linear estimate
4. Macaulay duration weighted years

Answer: A — The constant spread added to the spot

A) Correct — this identifies The constant spread added to the spot rate curve such. B) Pure expectations of forward rates — related concept, not the definition. C) Modified duration linear estimate — look-alike duration measure. D) Macaulay duration weighted years — look-alike duration measure.

A fixed income strategist observes a persistently upward-sloping yield curve even during periods when short-term rates are expected to remain flat. Which term structure theory BEST explains this pattern without requiring an expectation of rising future rates?

1. Pure expectations theory, because forward rates are unbiased predictors of future spot rates
2. Market segmentation theory, because supply and demand within maturity segments are entirely independent of one another
3. Liquidity preference theory, because investors require a term premium for bearing the added interest-rate and liquidity risk of longer maturities
4. Preferred habitat theory, because investors never deviate from their preferred maturity segment regardless of yield differences

Answer: C — Liquidity preference theory, because investors require a term premium for bearing the added interest-rate and liquidity risk of longer maturities

A) Under pure expectations alone, an upward slope implies the market expects future short rates to rise — but the scenario states rates are expected to stay flat, so this theory does not fit without contradicting the given expectation. B) Overstates segmentation theory — it explains curve shape via supply/demand imbalances across maturity segments but does not specifically require or best explain a persistent upward bias absent rate expectations, since segments can still trade independently without producing a systematic upward slope. C) Correct — liquidity preference theory adds a maturity/term premium that increases with maturity to compensate investors for greater interest-rate and liquidity risk, producing an upward-sloping curve even when expected future short rates are flat. D) Mischaracterizes preferred habitat theory — investors can and do leave their preferred habitat if offered adequate compensation; the theory does not claim investors never deviate.

An investor holds a protective put (long stock plus long put) on a stock trading at $60. The put is struck at $58, expires in 6 months, and is priced at $2.50. Using put-call parity with a 4% continuously compounded risk-free rate (ignore dividends), the price of the corresponding 6-month, $58-strike call is closest to:

1. $5.65, using C = P + S − Ke^(−rT)
2. $4.50, using C = P + S − K without discounting the strike
3. $2.50, assuming the call must trade at the same premium as the put
4. $60.00, treating the call as equivalent in value to owning the stock outright

Answer: A — $5.65, using C = P + S − Ke^(−rT)

A) Correct — C = P + S − Ke^(−rT) = 2.50 + 60 − 58e^(−0.04×0.5) ≈ 2.50 + 60 − 56.85 ≈ $5.65. B) Omitting the discounting of the strike price ignores the time value of money embedded in parity. C) Put-call parity does not imply equal premiums; it relates the two prices through the stock and discounted strike. D) A call option is a leveraged, limited-loss claim on the stock, not equivalent in value to owning the shares outright.

A stock index trades at 4,000. The continuously compounded risk-free rate is 6%, the continuously compounded dividend yield is 2%, and a one-year forward contract is being priced. The no-arbitrage forward price is closest to:

1. $4,163.24, using F0 = S0 × e^((r−δ)T) with continuous compounding over the full one-year horizon
2. $4,247.35, using F0 = S0 × e^(rT) and omitting the dividend yield adjustment entirely
3. $3,843.16, using F0 = S0 × e^((δ−r)T), reversing the sign of the net cost-of-carry term
4. $4,160.00, using simple (linear) compounding F0 = S0 × (1 + (r−δ)T) instead of continuous compounding

Answer: A — $4,163.24, using F0 = S0 × e^((r−δ)T) with continuous compounding over the full one-year horizon

A) Correct — F0 = 4,000 × e^((0.06 − 0.02) × 1) = 4,000 × e^0.04 ≈ 4,000 × 1.0408 ≈ $4,163.24. B) Ignores the dividend yield, which lowers the forward price by reducing the net cost of carry; this overstates the forward price. C) Reverses the sign of the net carry term (uses δ − r instead of r − δ), producing a forward price below spot when the risk-free rate exceeds the dividend yield — the wrong direction. D) Uses linear rather than continuous compounding for the carry adjustment, a close but technically incorrect approximation given the stated continuously compounded rates.

An investor holds a fully collateralized long position in a commodity futures contract. Over the period, the spot price return is +3%, the futures curve is in contango generating a roll yield of −4%, and the collateral (T-bill) yield is +2%. The total return on the fully collateralized position is closest to:

1. +9%, summing the absolute values of all three components regardless of sign
2. −1%, reversing the sign of the collateral yield, treating it as a cost rather than a yield
3. +5%, omitting the roll yield component and summing only the spot return and collateral yield
4. +1%, summing the spot return, roll yield, and collateral yield with their respective signs

Answer: D — +1%, summing the spot return, roll yield, and collateral yield with their respective signs

A) Sums the magnitudes without regard to the negative sign on roll yield, overstating total return. B) Flips the sign on the collateral yield, which is a genuine positive component of a fully collateralized futures position (the return on the posted collateral), not a cost. C) Omits the roll yield entirely — a common oversight that ignores the real, and here negative, drag that contango imposes on a long futures position. D) Correct — total return ≈ spot return + roll yield + collateral yield = 3% + (−4%) + 2% = +1%.

A real estate fund manager reports quarterly returns using appraisal-based, rather than transaction-based, valuations. Compared to an otherwise identical portfolio marked to frequent transaction prices, the appraisal-based fund's reported return series will MOST likely exhibit:

1. Higher volatility and no serial correlation, since appraisals are updated independently each quarter
2. Lower volatility and positive serial correlation, because infrequent appraisals smooth and lag true value changes
3. The same volatility and correlation profile, since both track the same underlying property fundamentals
4. A higher Sharpe ratio that reflects genuine outperformance by the manager

Answer: B — Lower volatility and positive serial correlation, because infrequent appraisals smooth and lag true value changes

A) Appraisal-based valuations are typically smoothed and lagged, not independent and more volatile. B) Correct — infrequent, lagged appraisals dampen apparent volatility and introduce positive autocorrelation relative to true (transaction-based) value changes. C) The valuation methodology itself materially changes the statistical properties of the reported return series, even with identical underlying assets. D) A higher Sharpe ratio here is a smoothing artifact from understated volatility, not evidence of manager skill.

A retiree with a $2.5 million portfolio plans an initial-year withdrawal of $120,000, with subsequent withdrawals increased 3% annually for inflation. Relative to the traditional ~4% initial safe withdrawal rate guideline, this retiree's plan is BEST characterized as:

1. Conservative relative to the traditional 4% guideline, since the plan's initial withdrawal rate is below typical safe-withdrawal-rate estimates
2. Irrelevant to sustainability analysis, because the safe withdrawal rate framework applies only to fixed-dollar withdrawals, not inflation-adjusted ones
3. Guaranteed to succeed over a 30-year horizon, because the withdrawal rate is close to standard guidance and portfolio balances tend to mean-revert
4. Modestly aggressive relative to the traditional ~4% guideline, since the initial withdrawal rate of 4.8% exceeds it, raising the risk of portfolio depletion under adverse sequence-of-returns scenarios

Answer: D — Modestly aggressive relative to the traditional ~4% guideline, since the initial withdrawal rate of 4.8% exceeds it, raising the risk of portfolio depletion under adverse sequence-of-returns scenarios

A) Reverses the comparison — $120,000/$2,500,000 = 4.8%, which is ABOVE the ~4% guideline, not below it. B) Mischaracterizes the framework — the classic safe-withdrawal-rate research (e.g., the Bengen 4% rule) is specifically built around inflation-adjusted annual withdrawals, not fixed-dollar ones. C) No withdrawal-rate plan can be 'guaranteed' to succeed; sequence-of-returns risk means even withdrawal rates near standard guidance carry a meaningful probability of shortfall, especially when starting above the guideline. D) Correct — an initial withdrawal rate of 4.8% (120,000/2,500,000) exceeds the traditional ~4% guideline, which increases the risk of portfolio depletion, particularly if early returns are poor.

An institutional investor's IPS specifies an absolute return objective AND a downside risk constraint. The most appropriate optimization framework is:

1. Anchoring bias in updating
2. Framing effect on decision
3. Mean-CVaR in this context
4. Availability heuristic bias

Answer: C — Mean-CVaR in this context

A) Anchoring bias in updating — wrong behavioral bias. B) Framing effect on decision — wrong behavioral bias. C) Correct — this identifies Mean-CVaR in this context. D) Availability heuristic bias — related concept, not the definition.

A charterholder based in Country X (strict securities regulation) manages assets for a client incorporated in Country Y, where disclosure requirements are more lenient than Country X's rules. Under Standard I(A) Knowledge of the Law, the charterholder should follow:

1. The stricter of the applicable laws, regulations, or the Code and Standards
2. The law of the client's jurisdiction, since client protection is the paramount concern
3. The law of the charterholder's home jurisdiction regardless of where the client is domiciled
4. Only the CFA Institute Code and Standards, since they supersede any local law

Answer: A — The stricter of the applicable laws, regulations, or the Code and Standards

A) Correct — Standard I(A) requires compliance with whichever of the applicable law, regulation, or the Code and Standards is most strict, determined case by case rather than by a fixed jurisdictional default. B) Client-jurisdiction law can matter, but automatically deferring to it ignores cases where the charterholder's home law or the Code is stricter — a half-right rule missing the controlling comparison. C) Defaulting to home jurisdiction regardless of comparison ignores instances where the client's law or the Code is stricter, reversing the actual test. D) The Code and Standards are one input into the strictness comparison, not an automatic override of local law in every case.

A manager's GIPS-compliant composite reports a 3-year annualized return of 8.2%. A prospective client asks why the report doesn't include the firm's flagship hedge fund. The firm-wide GIPS claim requires that:

1. Standard III(E) Preservation of Confidentiality
2. Standard I(B) Independence and Objectivity
3. Standard IV(C) Supervisor Responsibilities
4. All fee-paying discretionary portfolios firm-wide be

Answer: D — All fee-paying discretionary portfolios firm-wide be

A) Standard III(E) Preservation of Confidentiality — wrong Standard cited. B) Standard I(B) Independence and Objectivity — wrong Standard cited. C) Standard IV(C) Supervisor Responsibilities — wrong Standard cited. D) Correct — this identifies All fee-paying discretionary portfolios firm-wide be.

What is a defined benefit (DB) pension plan?

Employer guarantees specified retirement benefit (often based on salary + years). Employer bears investment risk; PBO is the obligation.

How does an interest-rate binomial tree value bonds?

Build tree of rates (calibrated to spot curve + volatility). At each node, compute PV of next cash flows; for callable bonds, take min(option-free value, call price).

What is the key difference between a payer swaption and a receiver swaption?

A payer swaption gives its holder the right, but not the obligation, to enter a swap as the FIXED-rate payer (paying fixed, receiving floating) — it is exercised, and thus valuable, when market rates rise above the swaption's strike rate. A receiver swaption gives the right to enter a swap as the fixed-rate RECEIVER (receiving fixed, paying floating) — it is exercised when market rates fall below the strike rate. Payer swaptions behave like puts on bond prices (calls on rates); receiver swaptions behave like calls on bond prices (puts on rates).

In a vignette: firm switches from LIFO to FIFO during inflation. Effects on financials?

Inventory and equity rise; COGS lower; gross margin and EPS up; tax up (cash impact). Comparability requires LIFO reserve adjustment for prior years.

What is the Sharpe ratio?

(Rp − Rf) / σp. Total-risk-adjusted excess return. Higher = better. Use to compare investments with similar risk profiles.

In a vignette: analyst recommends client front-running their own firm's research call. Action?

Violation of Standards III(B) Fair Dealing and VI(B) Priority of Transactions. Refuse, report, document. Personal/family transactions must follow client transactions.