CIMA Applied Finance & Economics 3 — Questions and Answers
Question 1: Which concept explains why a monopolist produces at a lower output and charges a higher price than a perfectly competitive firm in equilibrium?
- Monopolist equates MR = MC where MR < P (Correct answer)
- Monopolist faces a horizontal demand curve
- Monopolist operates in the long run only
- Monopolist always earns zero economic profit
Correct answer: Monopolist equates MR = MC where MR < P
A monopolist faces a downward-sloping demand curve, so MR < P at every output level, leading to higher prices and lower output than competitive markets.
Question 2: An investor uses a zero-cost collar strategy on a stock position. This strategy involves:
- Buying a put and selling a call at equal premiums (Correct answer)
- Buying both a put and a call on the same stock
- Selling a put and buying a call at equal premiums
- Writing covered calls only
Correct answer: Buying a put and selling a call at equal premiums
A zero-cost collar involves buying a protective put and selling a covered call such that the premiums offset, creating downside protection at no net cost.
Question 3: In the context of fixed income, 'negative convexity' is most commonly associated with:
- Zero-coupon bonds
- Mortgage-backed securities (Correct answer)
- Convertible bonds
- Treasury inflation-protected securities
Correct answer: Mortgage-backed securities
MBS exhibit negative convexity because prepayments accelerate when rates fall, limiting price appreciation—similar to callable bonds.
Question 4: The Fisher Effect states that the nominal interest rate equals approximately:
- Real interest rate minus expected inflation
- Real interest rate plus expected inflation (Correct answer)
- Risk-free rate plus credit spread
- Real interest rate divided by inflation
Correct answer: Real interest rate plus expected inflation
The Fisher Effect: nominal rate ≈ real rate + expected inflation, meaning nominal rates adjust to compensate for anticipated inflation.
Question 5: GDP measured by the expenditure approach equals the sum of:
- C + I + G + (X – M) (Correct answer)
- C + S + T + Transfers
- Wages + Rent + Interest + Profit
- NNP + Depreciation – Net Foreign Factor Income
Correct answer: C + I + G + (X – M)
The expenditure approach sums Consumption, Investment, Government spending, and Net Exports (Exports minus Imports).
Question 6: Which measure of risk captures only the downside deviations below a target return?
- Standard deviation
- Beta
- Semi-variance (semi-deviation) (Correct answer)
- Tracking error
Correct answer: Semi-variance (semi-deviation)
Semi-variance (or semi-deviation) measures volatility only for returns falling below a target or mean, focusing exclusively on downside risk.
Question 7: A company's WACC is 10%. A new project has an IRR of 8%. Which statement best describes the investment decision?
- Accept the project since IRR is positive
- Reject the project since IRR < WACC (Correct answer)
- Accept only if the payback period is under 3 years
- Reject only if NPV is exactly zero
Correct answer: Reject the project since IRR < WACC
When IRR < WACC, the project destroys value because financing costs exceed the return generated; the NPV will be negative.
CIMA Applied Finance & Economics 3
Which concept explains why a monopolist produces at a lower output and charges a higher price than a perfectly competitive firm in equilibrium?