CFA Investment Tools and Concepts 3 — Questions and Answers
Question 1: Which statistical measure describes the degree to which two variables move together, standardized to range between -1 and +1?
- Covariance
- Correlation coefficient (Correct answer)
- Standard deviation
- Beta
Correct answer: Correlation coefficient
The correlation coefficient standardizes covariance by dividing by the product of the two variables' standard deviations.
Question 2: Under the Gordon Growth Model, if a stock's required return equals its dividend growth rate, the model implies the stock price is:
- Zero
- Negative
- Undefined (infinite) (Correct answer)
- Equal to the annual dividend
Correct answer: Undefined (infinite)
When required return equals growth rate, the denominator (r - g) equals zero, making the price undefined/infinite.
Question 3: A bond's yield to maturity (YTM) assumes that all coupon payments are:
- Spent immediately
- Reinvested at the coupon rate
- Reinvested at the YTM rate (Correct answer)
- Not reinvested
Correct answer: Reinvested at the YTM rate
YTM implicitly assumes all intermediate coupon payments are reinvested at a rate equal to the YTM itself.
Question 4: Which of the following best describes a 'call option'?
- Obligation to sell an asset at a specified price
- Right to buy an asset at a specified price (Correct answer)
- Right to sell an asset at a specified price
- Obligation to buy an asset at a specified price
Correct answer: Right to buy an asset at a specified price
A call option gives the buyer the right, but not the obligation, to purchase the underlying asset at the strike price.
Question 5: In portfolio construction, the minimum-variance frontier represents portfolios that:
- Maximize return for any given level of risk
- Minimize variance for any given level of expected return (Correct answer)
- Offer the highest Sharpe ratio
- Eliminate all unsystematic risk
Correct answer: Minimize variance for any given level of expected return
The minimum-variance frontier plots the lowest possible variance achievable for each target return level.
Question 6: Negative convexity in a mortgage-backed security (MBS) primarily occurs due to:
- Rising credit spreads
- Prepayment risk when interest rates fall (Correct answer)
- Extension risk when rates rise
- Default by the issuer
Correct answer: Prepayment risk when interest rates fall
MBS exhibit negative convexity because homeowners prepay mortgages when rates fall, limiting price appreciation.
Question 7: The time value of a European call option approaches zero as:
- Volatility increases
- Time to expiration decreases toward zero (Correct answer)
- The underlying price rises
- Interest rates fall
Correct answer: Time to expiration decreases toward zero
Time value decays (theta decay) and reaches zero at expiration, leaving only intrinsic value.
CFA Investment Tools and Concepts 3
Which statistical measure describes the degree to which two variables move together, standardized to range between -1 and +1?