I85PREP
⌘ K
CFA Level II study materials
CFA Level II study resources

CFA Level II practice questions

One question at a time. Build your CFA Level II understanding.

First 50 of 200 questions. Each one lists the choices, the correct answer, and an explanation. The checker at the top of this page saves progress in this browser when it is available.

Continue in the practice tool above to load more questions, 50 at a time.

Question 1Ethical and Professional Standards

Which of the following is a component of the CFA Institute Code of Ethics?

  1. Obtain written consent from an employer before executing any personal securities trade
  2. Guarantee that investment recommendations are free from error
  3. Disclose to clients every personal securities holding in accounts that the member manages or recommends
  4. Place the integrity of the investment profession and the interests of clients above one's own personal interests Correct answer.

Explanation

The Code of Ethics requires members to act ethically, to place the integrity of the profession and clients' interests above their own, to use reasonable care and independent judgment, to practice and encourage ethical conduct, to promote the integrity of global capital markets, and to maintain and improve professional competence. The remaining choices describe conduct that is neither required nor possible under the Code.

Question 2Ethical and Professional Standards

A CFA charterholder who works as a fixed-income analyst submits an expense report to his employer that includes a weekend hotel stay that was not related to firm business. Under the CFA Institute Standards of Professional Conduct, this conduct is most likely:

  1. a violation only if the amount claimed exceeds the firm's reimbursement limit
  2. acceptable, provided that he repays the firm within 30 days
  3. a violation of Standard I(D), because the act involves dishonesty Correct answer.
  4. acceptable, because the expense report is unrelated to his investment analysis

Explanation

Standard I(D) Misconduct prohibits professional conduct involving dishonesty, fraud, or deceit, and prohibits acts that reflect adversely on professional reputation, integrity, or competence. Submitting a false expense claim is dishonest regardless of its connection to investment analysis or the size of the amount.

Question 3Ethical and Professional Standards

Near the close of trading, a trader enters large purchase orders for a stock he already owns so that the closing price will rise and his position will show a gain. This behavior is best described as:

  1. permissible, because the orders are genuine trades that are executed
  2. permissible, because the trader disclosed the trades to his employer
  3. transaction-based market manipulation Correct answer.
  4. information-based market manipulation

Explanation

Standard II(B) prohibits practices that distort prices or artificially inflate trading volume. Transaction-based manipulation includes wash trades, prearranged trading, and marking the close, which is what this trader is doing; information-based manipulation involves spreading false or misleading information.

Question 4Ethical and Professional Standards

Under Standard III(D) Performance Presentation, when members communicate investment performance to clients, they must:

  1. state that past performance is a reliable indicator of future results when the strategy is unchanged
  2. exclude the impact of fees so that results can be compared directly with market indexes
  3. make every reasonable effort to ensure that the information is fair, accurate, and complete Correct answer.
  4. include only the performance of accounts that were managed for the entire measurement period, excluding all others

Explanation

Standard III(D) requires members to make reasonable efforts to ensure that performance information is fair, accurate, and complete, and prohibits misstating performance or implying that model or backtested results guarantee actual results. Cherry-picking accounts and omitting fees both produce misleading presentations.

Question 5Ethical and Professional Standards

A portfolio manager is offered a paid advisory role by a company whose shares her firm holds in client accounts. Under Standard IV(B) Additional Compensation Arrangements, the manager may accept the role only if she:

  1. discloses the arrangement to her clients in the next quarterly performance report
  2. obtains written consent from her employer before accepting the compensation Correct answer.
  3. accepts no more than token compensation for the role
  4. limits the role to fewer than ten hours per month

Explanation

Standard IV(B) requires members to obtain written consent from their employer before accepting compensation, gifts, or benefits from third parties that compete with or conflict with the employer's interest. The conflict itself triggers the requirement, not the size of the payment or the hours involved.

Question 6Ethical and Professional Standards

Under Standard V(C) Record Retention, CFA Institute recommends that members retain records supporting their investment analyses, recommendations, and actions for a minimum of:

  1. ten years
  2. three years
  3. seven years Correct answer.
  4. five years

Explanation

Standard V(C) requires members to maintain records supporting their analysis, recommendations, and actions, and CFA Institute recommends a minimum retention period of seven years. Records should be kept in a form that allows the reasoning behind a recommendation or action to be reconstructed, and they generally belong to the firm.

Question 7Ethical and Professional Standards

A member agrees to pay a pension consultant 25% of her management fee for every client the consultant refers to her. To comply with Standard VI(C) Referral Fees, the member must most appropriately:

  1. disclose the arrangement to the client only if the client specifically requests information about the fees involved
  2. disclose the arrangement to her employer and to the client before the client engages her services Correct answer.
  3. avoid the arrangement entirely, because referral fees are not permitted under any circumstances
  4. disclose the arrangement to the consultant's employer only

Explanation

Standard VI(C) requires members to disclose to their employer, clients, and prospective clients any referral fees or arrangements by which they are compensated for recommending products or services. The nature of the consideration should be disclosed before the client enters into the relationship, not on request.

Question 8Ethical and Professional Standards

A member works in a jurisdiction whose securities law permits conduct that the CFA Institute Code and Standards prohibit. The member must:

  1. comply with the Code and Standards, which are the stricter of the two Correct answer.
  2. comply with local law, because local law takes precedence in that jurisdiction
  3. resign from CFA Institute to avoid conflicting obligations
  4. comply with whichever rule was adopted more recently

Explanation

Standard I(A) Knowledge of the Law requires members to understand and comply with all applicable laws, rules, and regulations and with the Code and Standards. When these conflict, members must follow the more strict of the law, rule, or Standard.

Question 9Ethical and Professional Standards

A research analyst covering a mining company is invited by that company to a week-long, all-expenses-paid trip to a resort, which includes golf and spa treatments. To comply with Standard I(B) Independence and Objectivity, the analyst should most appropriately:

  1. accept the trip only if she discloses it in writing to her employer and to all clients
  2. accept the trip, because it allows her to conduct first-hand due diligence on the company she covers
  3. accept the trip only if she pays for her own airfare
  4. decline the trip, because it could reasonably be expected to compromise her objectivity Correct answer.

Explanation

Standard I(B) prohibits offering, soliciting, or accepting gifts, benefits, compensation, or consideration that could reasonably be expected to compromise independence and objectivity. Lavish travel and entertainment from an issuer the analyst covers creates such a threat, and disclosure does not make it acceptable.

Question 10Ethical and Professional Standards

An analyst copies several pages of another firm's research report verbatim into his own report and does not identify the source. This conduct most likely violates:

  1. Standard I(C) Misrepresentation, which prohibits plagiarism Correct answer.
  2. Standard V(C) Record Retention
  3. no Standard, because research reports are distributed to the public
  4. Standard IV(A) Loyalty, because the other firm is a competitor

Explanation

Standard I(C) Misrepresentation prohibits knowingly making false or misleading statements and expressly prohibits plagiarism, which is the use of another's work without attribution. Distributing a report publicly does not license copying it without credit.

Question 11Ethical and Professional Standards

An analyst gathers several pieces of nonmaterial, nonpublic information about a retailer - from a supplier, a landlord, and a former employee - and combines them to conclude that the retailer's sales are falling sharply. Under Standard II(A), acting on this conclusion is most likely:

  1. prohibited, because any nonpublic information cannot be used for investment decisions
  2. permitted, under the mosaic theory, because no single piece of information was material Correct answer.
  3. permitted, only if the analyst shares the conclusion with all clients simultaneously
  4. prohibited, unless the analyst first discloses the sources to the firm's compliance department

Explanation

Under the mosaic theory, members may combine nonmaterial nonpublic information with public information to reach an investment conclusion, because no single input is material or obtained in breach of a duty. The conclusion itself may be nonpublic and still be actionable.

Question 12Ethical and Professional Standards

An investment manager directs client trades to a broker that charges above-market commissions, in exchange for research reports that will benefit all of the manager's clients. Under Standard III(A) Loyalty, Prudence and Care, this practice is most likely:

  1. acceptable, only if the research is used exclusively for the accounts that generated the commissions
  2. unacceptable, unless the manager obtains written consent from each client
  3. unacceptable, because client brokerage must always be directed to the broker with the lowest commission
  4. acceptable, if the research benefits clients and the commissions are reasonable relative to its value Correct answer.

Explanation

Client brokerage may be used to obtain research that benefits clients, provided the commissions are reasonable in relation to the value of the research received. Client assets must not be used to purchase goods or services that benefit the manager's firm, such as equipment or rent.

Question 13Ethical and Professional Standards

At 10:00 a.m. a manager completes a report recommending the purchase of a stock. Before the report is sent to clients, she purchases the stock for her largest client's account. Under Standard III(B) Fair Dealing, her action is most likely:

  1. a violation of Standard VI(B) Priority of Transactions only
  2. a violation, because recommendations must be disseminated to clients fairly and equitably Correct answer.
  3. acceptable, because no client was disadvantaged relative to any other client of the firm at that time
  4. acceptable, because the largest client pays the highest fees to the firm

Explanation

Standard III(B) requires members to deal fairly and objectively with all clients when providing investment analysis, recommendations, and actions. Acting on a recommendation for one client before it is disseminated disadvantages the others and is a breach, regardless of the client's fee level.

Question 14Ethical and Professional Standards

A client instructs her portfolio manager to buy a large position in a highly speculative stock that is inconsistent with the objectives and constraints recorded in her investment policy statement. The manager should most appropriately:

  1. execute the trade as instructed and document the client's request in the file
  2. decline the trade and terminate the client relationship
  3. update the investment policy statement, after discussing the change with the client Correct answer.
  4. execute the trade, because client instructions always override the investment policy statement

Explanation

Standard III(C) requires members in an advisory relationship to follow the client's documented objectives and constraints and to update the policy statement as circumstances change. If the client wants a different strategy, the policy statement should be revised in writing before the trade is made.

Question 15Ethical and Professional Standards

A member's client reveals that he is using the member's firm to transfer funds obtained from an illegal scheme. Under Standard III(E) Preservation of Confidentiality, the member should:

  1. report the conversation to all of the firm's other clients
  2. maintain complete confidentiality, because the duty of confidentiality continues indefinitely after the relationship ends
  3. disclose the information to the appropriate authorities, because it concerns illegal activity Correct answer.
  4. resign from the firm before taking any further action

Explanation

Standard III(E) requires members to keep information about current, former, and prospective clients confidential, but the duty is not absolute. Disclosure is permitted or required when the information concerns illegal activities by the client or when disclosure is required by law or by CFA Institute.

Question 16Ethical and Professional Standards

A member intends to leave her employer to start her own firm. Which action is most consistent with Standard IV(A) Loyalty?

  1. Contacting her employer's clients to announce her new firm before resigning
  2. Soliciting her employer's colleagues to join the new firm before she has informed her employer
  3. Copying the employer's client list to her personal email account before resigning
  4. Preparing a business plan for her new firm without using confidential employer information Correct answer.

Explanation

Standard IV(A) permits members to make preparations to leave an employer, including forming a business plan and arranging financing or premises, provided they do not use confidential employer information and continue to act in the employer's interest until they resign. Soliciting clients or colleagues before leaving breaches the duty of loyalty.

Question 17Ethical and Professional Standards

A supervisor learns that one of his subordinates has been executing trades for personal accounts ahead of client orders. He tells the subordinate to stop but takes no other action and does not escalate the matter. The supervisor has most likely:

  1. complied, because he learned of the violation promptly and directed the subordinate to stop immediately
  2. violated Standard IV(C), which requires reasonable efforts to detect and prevent violations Correct answer.
  3. violated Standard III(B) Fair Dealing only
  4. complied, because responsibility for the trades rests entirely with the subordinate

Explanation

Standard IV(C) requires members with supervisory responsibility to make reasonable efforts to ensure that procedures exist to detect and prevent violations, and to escalate and remedy known breaches. Simply telling a subordinate to stop, without further action, falls short of that duty.

Question 18Ethical and Professional Standards

A portfolio manager bases a buy recommendation entirely on the output of a quantitative model supplied by a third party, without reviewing the model's assumptions or data quality. She has most likely:

  1. complied, because a quantitative model is an objective and therefore reliable source of information
  2. violated Standard V(A), which requires a reasonable basis and an assessment of third-party research Correct answer.
  3. violated Standard I(C) only, for misrepresenting the model's output
  4. complied, because the model was produced by an unrelated third party

Explanation

Standard V(A) Diligence and Reasonable Basis requires members to exercise diligence and have a reasonable basis for their recommendations, including reviewing the assumptions, rigor, and independence of third-party research and models. Reliance on a model without such review fails that requirement.

Question 19Ethical and Professional Standards

A research analyst covering a technology company is elected to that company's board of directors. Under Standard VI(A) Disclosure of Conflicts, the analyst must most appropriately:

  1. disclose the board seat to her employer and to clients Correct answer.
  2. disclose the board seat only if the company becomes a client of her firm
  3. disclose the board seat only to her employer's compliance department
  4. resign from the board and continue covering the company as before

Explanation

Standard VI(A) requires members to make full and fair disclosure of all matters that could reasonably be expected to impair independence and objectivity, including board memberships, to their employer, clients, and prospective clients. Disclosure must be prominent and in plain language.

Question 20Ethical and Professional Standards

A portfolio manager learns from his brother-in-law, an executive at an issuer, that the issuer will announce a major acquisition next week. The manager does not trade the stock, but he telephones a friend, who buys the stock. Under Standard II(A) Material Nonpublic Information, the manager has most likely:

  1. violated the Standard only if the friend's purchase is later shown to be profitable
  2. complied, because the information came from a family member rather than from the issuer directly
  3. violated the Standard by communicating material nonpublic information to his friend Correct answer.
  4. complied, because he did not trade for his own account or for clients

Explanation

Standard II(A) prohibits members from acting or causing others to act on material nonpublic information. Passing the information to another person so that the other person trades is itself a violation, whether or not the member trades.

Question 21Ethical and Professional Standards

A portfolio manager shifts a client's portfolio from a value discipline to a growth discipline; the change is permitted by the client's broad mandate. Under Standard V(B) Communication with Clients and Prospective Clients, the manager should most appropriately:

  1. inform the client of the change and describe the risks involved Correct answer.
  2. notify the client only after the next quarterly performance report has been issued
  3. obtain the client's prior approval for each individual security that is purchased
  4. make the change without notifying the client, because the broad mandate permits it

Explanation

Standard V(B) requires members to keep clients informed of the general principles and basic format of the investment process, and to inform them promptly of any changes to that process, along with the risks involved. A broad mandate does not eliminate the duty to communicate.

Question 22Ethical and Professional Standards

A portfolio manager has just recommended a stock to clients and expects client orders to be executed over the next two days. She wishes to buy the same stock for her own account. Under Standard VI(B) Priority of Transactions, she should most appropriately:

  1. buy at the same time as clients so that all accounts receive the same execution price
  2. buy for her own account after disclosing the purchase to all affected clients
  3. wait until clients and her employer have had an adequate opportunity to act Correct answer.
  4. buy first, because her employer's procedures do not address personal trading

Explanation

Standard VI(B) provides that transactions for clients and employers must take priority over transactions in which a member is the beneficial owner. Personal trading should occur only after clients and the employer have had an adequate opportunity to act, and disclosure does not cure a priority breach.

Question 23Ethical and Professional Standards

A firm that has adopted the Asset Manager Code executes a large block order for several client accounts and later allocates the shares that rose the most that day to its largest client. The firm has most likely violated the Code's requirement to:

  1. maintain records of client holdings and transactions for at least seven years
  2. obtain written consent from clients before aggregating their orders
  3. allocate trades fairly among clients under a written policy Correct answer.
  4. execute all client orders at the volume-weighted average price for the day

Explanation

The Asset Manager Code requires firms to allocate transactions fairly and equitably among client accounts in accordance with a stated, written allocation policy, and not to favour any account. Retroactive allocation of the best-performing shares to a favoured client breaches that duty.

Question 24Ethical and Professional Standards

A firm that claims compliance with the Global Investment Performance Standards (GIPS) must most appropriately:

  1. present composite returns computed on an equal-weighted basis
  2. present only the returns of the firm's largest composite, since smaller composites are immaterial
  3. remove terminated portfolios from the historical returns of the composites in which they were managed
  4. include all actual, fee-paying, discretionary portfolios in at least one composite Correct answer.

Explanation

GIPS requires a firm to include all actual, fee-paying, discretionary portfolios in at least one composite, with composites defined according to investment mandate, objective, or strategy. The historical performance of terminated portfolios must remain in the composite, and composite returns must be asset-weighted.

Question 25Quantitative Methods

In a multiple linear regression, the estimated slope coefficient on an independent variable is best interpreted as:

  1. the partial correlation between the dependent variable and that independent variable
  2. the share of total variation in the dependent variable explained by that variable alone
  3. the change in the dependent variable per one-unit change in that independent variable, other regressors held constant Correct answer.
  4. the change in the dependent variable per one-unit change in that independent variable, with the other regressors free to vary as well

Explanation

Each slope in a multiple regression measures a partial effect: the change in the dependent variable for a one-unit change in its regressor while all other regressors are held fixed. This ceteris paribus condition is what distinguishes multiple regression from simple regression.

Question 26Quantitative Methods

In a multiple regression with n observations, an intercept, and k independent variables, the F-statistic tests the null hypothesis that:

  1. the regression residuals are normally distributed
  2. the intercept of the model equals zero
  3. each individual slope coefficient is separately equal to zero
  4. all slope coefficients are jointly equal to zero Correct answer.

Explanation

The F-statistic in a multiple regression is a joint test that every slope coefficient is zero at once, i.e., that the regressors collectively have no explanatory power for the dependent variable.

Question 27Quantitative Methods

Heteroskedasticity in a regression model most likely:

  1. arises only when the dependent variable in the regression is a dummy variable
  2. is reliably detected by a large Durbin-Watson statistic
  3. makes the usual standard errors unreliable, while the coefficient estimates stay consistent Correct answer.
  4. causes the OLS slope coefficient estimates to be biased and inconsistent in large samples

Explanation

Heteroskedasticity violates the constant-variance assumption, so the conventional OLS standard errors are wrong and the associated t- and F-tests cannot be trusted. The coefficient estimates themselves remain unbiased and consistent.

Question 28Quantitative Methods

A regression on quarterly data includes an intercept and a dummy variable for each of the four quarters. This specification:

  1. violates the no-perfect-multicollinearity assumption and cannot be estimated Correct answer.
  2. is the standard textbook way of capturing quarterly seasonality in a regression model
  3. requires replacing the dummy variables with a probit model
  4. produces unbiased but inefficient coefficient estimates

Explanation

Using a full set of category dummies together with an intercept makes the dummies sum exactly to the intercept column, so the regressor matrix is singular. The standard remedy is to omit one category as the benchmark and interpret the remaining dummies relative to it.

Question 29Quantitative Methods

An AR(1) model, x_t = b0 + b1*x_(t-1) + e_t, is covariance stationary only if:

  1. the intercept b0 equals zero
  2. the error terms are positively serially correlated
  3. the absolute value of b1 is less than one Correct answer.
  4. b1 is exactly equal to one

Explanation

Covariance stationarity of an AR(1) requires the root of the characteristic equation to lie outside the unit circle, which is equivalent to |b1| < 1. When |b1| is one or greater, the variance of the series grows without bound or is undefined.

Question 30Quantitative Methods

When an additional independent variable is added to a regression, the adjusted R-squared:

  1. increases only if the new variable's t-statistic exceeds one in absolute value Correct answer.
  2. always increases, just as the unadjusted R-squared does whenever a regressor is added
  3. can never be negative regardless of the quality of the model's fit
  4. always decreases, because one degree of freedom is lost with each new regressor

Explanation

Adding a regressor lowers the residual sum of squares but costs a degree of freedom. Adjusted R-squared rises only when the improvement in fit outweighs that cost, which occurs approximately when the added variable's t-statistic exceeds one in absolute value.

Question 31Quantitative Methods

In a regression of the natural log of wages on years of experience, the estimated slope is 0.04. The most appropriate interpretation is that:

  1. a one-year increase in experience is associated with a wage about 4% higher Correct answer.
  2. a 1% increase in experience raises wages by 0.04%
  3. experience explains 4% of the variation in wages
  4. wages rise by 0.04 currency units for each additional year of experience

Explanation

In a log-linear specification the slope multiplied by 100 approximates the percentage change in the dependent variable for a one-unit change in the regressor. A slope of 0.04 therefore implies roughly a 4% higher wage per additional year of experience.

Question 32Quantitative Methods

Which consequence is most characteristic of severe multicollinearity among the regressors of a model?

  1. biased and inconsistent coefficient estimates that grow worse as the sample size increases
  2. inflated standard errors and unstable coefficient estimates Correct answer.
  3. residuals that are strongly heteroskedastic
  4. an intercept that cannot be given any interpretation

Explanation

Severe multicollinearity inflates the standard errors of the affected coefficients and makes the estimates sensitive to small changes in the data, so individual t-statistics are unreliable. The OLS estimates themselves remain unbiased and consistent.

Question 33Quantitative Methods

If the residuals of a regression estimated on time-series data display positive serial correlation, the OLS standard errors are most likely:

  1. overstated, so the t-statistics are understated
  2. understated, so the t-statistics are overstated Correct answer.
  3. unaffected, because OLS coefficient estimates remain unbiased
  4. understated, so the t-statistics are also understated

Explanation

Positive serial correlation means residuals of the same sign tend to appear in runs, so the conventional OLS formula understates the true sampling variability. Inflated t-statistics follow, raising the chance of incorrectly rejecting a true null hypothesis.

Question 34Quantitative Methods

A time series that contains a unit root:

  1. is covariance stationary around a deterministic linear trend
  2. is nonstationary and is typically transformed by taking first differences Correct answer.
  3. has residuals that are white noise by construction
  4. can only be modeled as a moving-average process

Explanation

A unit root series is nonstationary: its variance grows with time and it does not revert to a finite long-run mean. Differencing once usually produces a stationary series whose regressions are not prone to spurious results.

Question 35Quantitative Methods

Two time series are each integrated of order one, but a particular linear combination of them is stationary. This evidence indicates that:

  1. both series are covariance stationary in levels
  2. the regression is spurious and should be discarded entirely
  3. the series must be modeled as an AR(2) process
  4. the series are cointegrated, so the regression is not necessarily spurious Correct answer.

Explanation

When individually nonstationary series share a stationary linear combination, they are cointegrated: they move together toward a long-run equilibrium. A regression between them captures that equilibrium relationship rather than a spurious correlation.

Question 36Quantitative Methods

When comparing the out-of-sample forecasting performance of two competing models, the preferred model is the one with the:

  1. the lowest Durbin-Watson statistic relative to the benchmark value of two
  2. the highest in-sample R-squared
  3. the highest adjusted R-squared
  4. the lowest root mean squared forecast error Correct answer.

Explanation

Out-of-sample accuracy is evaluated from the size of realized forecast errors, and the root mean squared forecast error is a standard summary of those errors. In-sample fit statistics say nothing about how well a model predicts observations it has not seen.

Question 37Quantitative Methods

Quarterly sales data exhibit strong seasonality. In an autoregressive model, this pattern is most appropriately handled by:

  1. first-differencing the series twice
  2. dropping the four most recent observations from the sample
  3. fitting a log-linear trend model
  4. adding a seasonal lag at the fourth lag Correct answer.

Explanation

Seasonality appears as correlation between observations a full seasonal cycle apart, so for quarterly data the seasonal lag is the fourth lag. Including that lag, often alongside seasonal dummy variables, captures the recurring pattern.

Question 38Quantitative Methods

In a logistic regression predicting bond default, the estimated coefficient on leverage is 0.60, so exp(0.60) is approximately 1.82. This is best interpreted as:

  1. a one-unit increase in leverage raises the probability of default by 0.60 percentage points
  2. leverage explains about 60% of the variation in default status
  3. a one-unit increase in leverage multiplies the probability of default by 1.82
  4. a one-unit increase in leverage multiplies the odds of default by about 1.82 Correct answer.

Explanation

In a logistic model the coefficients are expressed in log-odds units, so exponentiating a coefficient yields an odds ratio. A one-unit increase in leverage therefore multiplies the odds of default by about 1.82, holding the other regressors constant.

Question 39Quantitative Methods

An ARCH(1) model is used for:

  1. modeling time-varying volatility of the error term Correct answer.
  2. testing whether two series are cointegrated
  3. correcting first-order serial correlation in the residuals
  4. removing a unit root from the dependent variable

Explanation

An ARCH model treats the error variance as time-varying, regressing squared residuals on their own lagged values to capture volatility clustering. It is a model of conditional heteroskedasticity rather than of the mean of the series.

Question 40Quantitative Methods

Compared with ordinary least squares, ridge regression has the property that:

  1. it sets some coefficients exactly to zero, performing variable selection
  2. it shrinks coefficients toward zero, trading bias for lower variance Correct answer.
  3. it cannot be applied when the regressors are highly correlated
  4. it always produces unbiased coefficient estimates

Explanation

Ridge regression adds a penalty proportional to the sum of squared coefficients, which shrinks the estimates toward zero. The shrinkage introduces a small bias but reduces estimation variance, which is valuable when regressors are correlated or the sample is small.

Question 41Economics

An analyst observes a spot rate of USD 1.2500 per EUR and a one-year forward rate of USD 1.2625 per EUR. The euro is trading in the forward market at an annualized forward:

  1. discount of 0.80%
  2. discount of 1.00%
  3. premium of 1.00% Correct answer.
  4. premium of 5.00%

Explanation

The forward premium or discount equals (F − S)/S, here (1.2625 − 1.2500)/1.2500 = 1.00%. Because the forward price of the euro in dollars exceeds the spot price, the euro is at a forward premium. With a one-year horizon the periodic and annualized figures coincide.

Question 42Economics

Absolute purchasing power parity predicts that the spot exchange rate between two currencies is determined by:

  1. the spread between the two countries' nominal interest rates
  2. the ratio of the two countries' real output levels
  3. the gap between the two countries' growth rates of real GDP
  4. the ratio of the two countries' price levels Correct answer.

Explanation

Absolute PPP states that a basket of goods should cost the same in both countries once converted at the spot rate, so the exchange rate equals the ratio of the two price levels. Interest rate spreads, output levels, and growth rates play no direct role in the absolute version of the theory.

Question 43Economics

Which feature distinguishes a customs union from a free trade area?

  1. Members harmonize product standards only
  2. Members apply a common external tariff Correct answer.
  3. Members adopt a single currency
  4. Members permit free movement of labor

Explanation

A free trade area removes internal tariffs but lets each member set its own tariffs on non-members, whereas a customs union adds a common external tariff wall. A single currency defines a monetary union and labor mobility characterizes a common market. Harmonizing standards alone is far short of either arrangement.

Question 44Economics

In the Solow growth model without technological progress, an increase in the saving rate:

  1. permanently raises the growth rate of output per worker
  2. raises steady-state output but necessarily lowers long-run consumption per worker
  3. has no effect on the steady-state level of capital per worker
  4. raises the steady-state level of capital per worker but not the long-run growth rate Correct answer.

Explanation

A higher saving rate shifts the economy to a new steady state with more capital and output per worker, but growth of output per worker returns to zero once that steady state is reached. Only technological progress generates sustained growth in output per worker in the model.

Question 45Economics

According to the Fisher effect, a one-percentage-point increase in expected inflation will, in the long run, be matched by:

  1. no change in the nominal interest rate if the real rate is constant
  2. a one-percentage-point rise in the real interest rate
  3. a one-percentage-point fall in the real interest rate
  4. a one-percentage-point rise in the nominal interest rate Correct answer.

Explanation

The Fisher relation decomposes the nominal rate into the real rate plus expected inflation. If the real rate is determined by real factors and does not change, expected inflation passes one-for-one into the nominal rate.

Question 46Economics

The one-year risk-free rate is 4.00% in the United States and 2.00% in the United Kingdom. The spot rate is USD 1.3000 per GBP. If covered interest rate parity holds, the one-year forward rate is closest to:

  1. 1.2800
  2. 1.3255 Correct answer.
  3. 1.3000
  4. 1.2750

Explanation

Covered interest parity sets the forward rate as the spot rate multiplied by (1 + i_quote)/(1 + i_base), giving 1.3000 × 1.04/1.02 = 1.3255. The higher-interest currency trades at a forward discount, so the pound is worth more dollars forward than spot.

Question 47Economics

Dealer quotes are EUR/USD = 1.1000 (USD per EUR) and USD/JPY = 110.00 (JPY per USD). A second dealer quotes EUR/JPY = 120.00 (JPY per EUR). The no-arbitrage EUR/JPY cross rate implied by the first two quotes is closest to:

  1. 123.00
  2. 120.00
  3. 108.91
  4. 121.00 Correct answer.

Explanation

Cross rates are computed by chaining the quotes: EUR/JPY = (USD per EUR) × (JPY per USD) = 1.1000 × 110.00 = 121.00. Because the observed quote of 120.00 differs from the implied 121.00, a triangular arbitrage opportunity exists.

Question 48Economics

An investor borrows in a low-yielding currency to fund an unhedged long position in a high-yielding currency. The position will most likely lose money if:

  1. the low-yielding currency depreciates against the high-yielding currency
  2. the high-yielding currency's interest rate falls modestly
  3. both interest rates are unchanged and the spot rate is stable
  4. the high-yielding currency depreciates by more than the interest rate differential Correct answer.

Explanation

The carry trade earns the interest rate differential but bears unhedged currency risk, so it is profitable only if the high-yielding currency does not depreciate by more than the differential. A depreciation larger than the differential turns the trade into a loss.

Question 49Economics

According to uncovered interest rate parity, a currency with a higher one-year interest rate than its counterpart should be expected to:

  1. appreciate by more than the interest rate differential
  2. depreciate by approximately the interest rate differential Correct answer.
  3. appreciate by approximately the interest rate differential
  4. remain unchanged in expected value

Explanation

Uncovered interest rate parity states that the expected exchange rate change offsets the interest differential, so the high-yielding currency is expected to depreciate by roughly that differential. Otherwise investors could earn a riskless expected profit from borrowing in the low-yield currency.

Question 50Economics

A country with a floating exchange rate runs a persistent current account deficit. In the balance of payments accounts, this deficit must be:

  1. matched by a net inflow in the capital and financial account Correct answer.
  2. eliminated automatically by a rising domestic saving rate
  3. offset by an equal deficit in the capital and financial account
  4. financed exclusively by drawing down official reserves

Explanation

The balance of payments sums to zero, so a current account deficit is financed by a surplus (net inflow) on the capital and financial account, including reserve sales. Reserve depletion is only one component of that financing and cannot offset the deficit on its own indefinitely.