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IAR practice questions

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Question 1Economic and Business Information

Under the IAR Code of Ethics, a member who discovers a material error in a research report already distributed to clients should first:

  1. Ask a colleague to reissue the report under the colleague's name
  2. Withdraw the report silently and avoid drawing attention to the error
  3. Wait until the next scheduled review cycle before making any change
  4. Take reasonable steps to correct the error and disclose the correction to affected clients Correct answer.

Explanation

The Code requires members to act with integrity and to correct known material errors promptly. Disclosure to affected clients preserves trust and prevents reliance on inaccurate information. Silence or delay would compound the harm and breach the duty of care owed to clients.

Question 2Economic and Business Information

A central bank unexpectedly raises its policy rate by 50 basis points. In the short run, the most likely effect on a long-duration government bond held by an investor is that its market price:

  1. Is unchanged, because coupon payments are contractually fixed
  2. Rises, because inflation expectations are now anchored
  3. Falls, because the discount rate applied to future cash flows rises Correct answer.
  4. Rises, because the coupon payments become more valuable

Explanation

Bond prices move inversely to yields, and a policy rate increase typically lifts yields across the curve. A higher discount rate reduces the present value of the bond's fixed future cash flows. The effect is larger for longer-duration bonds.

Question 3Economic and Business Information

An analyst is evaluating a company's ability to meet short-term obligations. Which ratio is most directly relevant to that assessment?

  1. Gross margin
  2. Debt-to-equity ratio
  3. Current ratio Correct answer.
  4. Return on equity

Explanation

The current ratio compares current assets to current liabilities and directly measures short-term liquidity. It shows whether near-term resources cover near-term obligations. The other ratios address leverage, profitability, or returns rather than liquidity.

Question 4Economic and Business Information

A country's central bank pursues a contractionary monetary policy while its government simultaneously runs a large fiscal deficit. The most likely combined effect is:

  1. Lower domestic interest rates and rapid currency depreciation
  2. An immediate fall in the public debt-to-GDP ratio
  3. A sharp decline in the demand for government bonds
  4. Upward pressure on interest rates and possible crowding out of private investment Correct answer.

Explanation

Large government borrowing raises demand for loanable funds, pushing rates up, while tighter monetary policy adds further upward pressure. Higher rates can crowd out private investment. The combination tends to raise, not lower, financing costs.

Question 5Economic and Business Information

Which statement best describes the role of a credit rating agency in capital markets?

  1. It guarantees repayment of principal if an issuer defaults
  2. It provides an independent opinion on an issuer's creditworthiness Correct answer.
  3. It sets the coupon rate that issuers must pay on new bonds
  4. It acts as underwriter for the securities it rates

Explanation

Rating agencies issue forward-looking opinions about an issuer's ability and willingness to meet obligations. They do not guarantee payment, set coupons, or underwrite. Investors use ratings as one input among many in assessing credit risk.

Question 6Economic and Business Information

An economy experiences a sustained rise in its consumer price index while nominal wages remain flat. The most direct consequence for households is:

  1. An increase in real purchasing power
  2. A decline in real purchasing power Correct answer.
  3. An automatic rise in real wages
  4. No change in real purchasing power

Explanation

If prices rise while nominal wages are unchanged, each unit of wages buys fewer goods. Real purchasing power therefore falls. This erosion is the core household impact of inflation when incomes do not keep pace.

Question 7Economic and Business Information

A company reports net income of 120 million, total assets of 1,500 million, and total equity of 600 million. Its return on equity is closest to:

  1. 20% Correct answer.
  2. 12%
  3. 25%
  4. 8%

Explanation

Return on equity equals net income divided by total equity. Here 120 divided by 600 equals 0.20, or 20%. Using total assets instead would give return on assets, which is a different measure.

Question 8Economic and Business Information

Which of the following is generally considered a leading economic indicator?

  1. The unemployment rate
  2. New orders for capital goods Correct answer.
  3. The consumer price index for the prior month
  4. Gross domestic product for the last quarter

Explanation

Leading indicators tend to change before the overall economy does, and new orders for capital goods signal future production and investment. Unemployment and GDP are typically coincident or lagging. Prior-month price data describe the past rather than anticipating the future.

Question 9Economic and Business Information

An investor holds a portfolio of equities in a single emerging market. Adding a diversified basket of developed-market equities is most likely to:

  1. Reduce portfolio risk if the two markets are imperfectly correlated Correct answer.
  2. Guarantee a higher expected return than the original portfolio
  3. Eliminate all market risk from the portfolio
  4. Increase total portfolio risk because more assets are held

Explanation

Diversification lowers risk when assets are not perfectly correlated, because their returns do not move in lockstep. Cross-market diversification can reduce volatility from country-specific shocks. It cannot eliminate systematic market risk or guarantee higher returns.

Question 10Economic and Business Information

A sudden sharp depreciation of a country's currency is most likely to:

  1. Immediately reduce the country's import bill in domestic currency terms
  2. Have no effect on the relative prices of traded goods
  3. Make its exports cheaper abroad and its imports more expensive at home Correct answer.
  4. Make its exports more expensive abroad and its imports cheaper at home

Explanation

A weaker currency lowers the foreign-currency price of exports and raises the domestic-currency cost of imports. This can improve export competitiveness while adding to imported inflation. The import bill in domestic currency usually rises rather than falls, at least initially.

Question 11Economic and Business Information

Which measure of inflation excludes volatile food and energy prices to reveal underlying price trends?

  1. Producer price inflation
  2. Headline inflation
  3. Asset price inflation
  4. Core inflation Correct answer.

Explanation

Core inflation strips out food and energy, whose prices swing sharply, to show the persistent trend in prices. Central banks often monitor it alongside headline inflation. Headline inflation includes all items in the basket.

Question 12Economic and Business Information

A firm's inventory turnover ratio has fallen sharply from one year to the next while sales are flat. The most plausible interpretation is that the firm:

  1. Has improved its working capital efficiency
  2. Is collecting receivables more quickly
  3. Is holding more inventory relative to its sales Correct answer.
  4. Has reduced its warehousing costs

Explanation

Inventory turnover equals cost of goods sold divided by average inventory. With sales flat, a falling ratio implies inventory has grown relative to sales. This may signal weak demand, obsolescence risk, or overstocking.

Question 13Economic and Business Information

In the context of business cycle analysis, a recession is typically defined as:

  1. Any quarter in which GDP growth is below its long-run average
  2. A single quarter of negative GDP growth
  3. A significant decline in economic activity spread across the economy lasting more than a few months Correct answer.
  4. A sustained rise in the unemployment rate above 4%

Explanation

Recessions are characterized by a broad, significant decline in activity lasting more than a few months, affecting output, employment, and income. A single quarter of contraction is not sufficient on its own. The definition is broader than a threshold on any one indicator.

Question 14Economic and Business Information

A company issues a bond with a call provision. From the perspective of the investor, this feature:

  1. Fixes the bond's price until maturity
  2. Eliminates the issuer's default risk
  3. Benefits the investor by guaranteeing a higher coupon
  4. Benefits the issuer by allowing early repayment if rates fall Correct answer.

Explanation

A call provision gives the issuer the right to redeem the bond early, typically when refinancing is cheaper because rates have fallen. This is valuable to the issuer but disadvantages investors, who face reinvestment risk. Callable bonds usually offer higher yields to compensate.

Question 15Economic and Business Information

Which of the following best describes the function of a stock exchange in an economy?

  1. It provides a regulated secondary market where existing securities can be traded Correct answer.
  2. It sets the dividends that listed companies must pay
  3. It lends capital directly to companies and bears their default risk
  4. It insures investors against losses on their holdings

Explanation

Exchanges provide a regulated marketplace that gives investors liquidity by allowing them to trade existing securities. They facilitate price discovery and transparency. They do not lend capital directly, set dividends, or insure investor losses.

Question 16Economic and Business Information

An economy has a comparative advantage in producing a good when it:

  1. Has the highest wage levels in that industry
  2. Can produce more of the good than any other country in absolute terms
  3. Has the lowest opportunity cost of producing that good Correct answer.
  4. Produces the good using the most advanced technology

Explanation

Comparative advantage is based on opportunity cost, not absolute output. A country gains from specializing where its opportunity cost is lowest relative to trading partners. This underpins the mutual gains from trade.

Question 17Economic and Business Information

A firm reports operating cash flow of 80 million and capital expenditures of 50 million for the year. Its free cash flow to the firm is closest to:

  1. 30 million Correct answer.
  2. 50 million
  3. 80 million
  4. 130 million

Explanation

A simple measure of free cash flow subtracts capital expenditures from operating cash flow. Here 80 minus 50 equals 30 million. This residual cash is available for debt repayment, dividends, or reinvestment.

Question 18Economic and Business Information

Which of the following is a primary function of a country's central bank?

  1. Conducting monetary policy to manage inflation and support financial stability Correct answer.
  2. Approving the annual budgets of listed companies
  3. Setting individual income tax rates
  4. Underwriting corporate bond issues

Explanation

Central banks conduct monetary policy, act as lender of last resort, and oversee financial stability. They do not approve corporate budgets, set tax rates, or underwrite securities. Those functions belong to other institutions.

Question 19Economic and Business Information

An analyst notes that a company's price-to-earnings ratio is well above its industry average while its earnings growth is in line with peers. The most reasonable interpretation is that the market:

  1. Expects the company's dividend to be cut
  2. Has priced in a higher valuation multiple than peers justify Correct answer.
  3. Expects the company's earnings to grow much faster than peers in future
  4. Believes the company's earnings are overstated

Explanation

A P/E above the peer average implies investors are paying more per unit of current earnings. If growth is merely in line with peers, the premium multiple suggests the market has priced in optimistic expectations or the valuation is stretched. This warrants further scrutiny of growth prospects and risk.

Question 20Economic and Business Information

A government introduces a price ceiling below the market-clearing price for a staple good. Economic theory predicts that this will most likely lead to:

  1. A shortage of the good as quantity demanded exceeds quantity supplied Correct answer.
  2. A surplus of the good as supply exceeds demand
  3. No change in the quantity traded
  4. An increase in the market-clearing price

Explanation

A binding price ceiling set below equilibrium prevents the price from rising to clear the market. At that lower price, quantity demanded exceeds quantity supplied, creating a shortage. Non-price rationing or black markets often emerge.

Question 21Economic and Business Information

Which of the following best explains why a central bank might raise reserve requirements for commercial banks?

  1. To lower the interest rate that banks charge borrowers
  2. To reduce the money supply by limiting banks' capacity to create credit Correct answer.
  3. To increase the amount of lending banks can undertake
  4. To guarantee the solvency of individual banks

Explanation

Higher reserve requirements force banks to hold more funds at the central bank, reducing the reserves available for lending. This contracts credit creation and the money supply. It is a contractionary policy tool.

Question 22Economic and Business Information

A country runs a persistent current account deficit. Which combination of factors is most consistent with this outcome?

  1. Low domestic savings relative to investment and strong import demand Correct answer.
  2. High domestic savings and weak import demand
  3. A large trade surplus combined with capital outflows
  4. Rapid export growth with falling domestic consumption

Explanation

A current account deficit reflects that a country is investing more than it saves and importing more than it exports. Low savings relative to investment requires capital inflows to finance the gap. Strong import demand widens the trade deficit further.

Question 23Economic and Business Information

An investor is comparing two bonds with identical credit quality and maturity but different coupons. If market yields rise sharply, the bond that will experience the larger percentage price decline is the one with:

  1. The shorter time to maturity
  2. The lower coupon Correct answer.
  3. The lower credit rating
  4. The higher coupon

Explanation

For bonds of equal maturity, lower-coupon bonds have greater duration because more of their value comes from distant cash flows. Greater duration means greater price sensitivity to yield changes. The lower-coupon bond therefore falls more when yields rise.

Question 24Economic and Business Information

Which statement accurately describes the relationship between a firm's weighted average cost of capital and its capital budgeting decisions?

  1. A higher WACC makes more projects acceptable
  2. The WACC should be ignored when evaluating risky projects
  3. Projects with expected returns above the WACC generally add value to the firm Correct answer.
  4. The WACC equals the risk-free rate for all firms

Explanation

The WACC represents the minimum return required by the firm's capital providers. Accepting projects expected to earn more than the WACC should increase shareholder value. Riskier projects should use a discount rate adjusted upward from the WACC.

Question 25Economic and Business Information

A research analyst is asked to publish a report on a company in which the analyst holds a significant personal shareholding. According to professional ethical standards, the analyst should:

  1. Publish the report without mentioning the holding
  2. Disclose the personal holding and manage the conflict of interest appropriately Correct answer.
  3. Delegate the report to a colleague without any disclosure
  4. Sell the shares after publication to avoid scrutiny

Explanation

Personal holdings create a conflict of interest that must be disclosed so readers can judge the objectivity of the research. Firms also typically impose restrictions on trading around publication. Concealment or post-publication trading would breach ethical standards.

Question 26Economic and Business Information

An analyst is assessing how a sustained increase in the general price level affects a company's reported financial statements. Under historical cost accounting, which item is most likely to be understated in real terms during a period of high inflation?

  1. The cost of goods sold for inventory purchased recently
  2. The interest expense on floating-rate debt
  3. The nominal coupon payments on newly issued bonds
  4. The carrying value of property, plant, and equipment Correct answer.

Explanation

Historical cost accounting records assets at their original acquisition cost, so during high inflation the carrying amount of long-held property, plant, and equipment falls below its current replacement or market value in real terms. Floating-rate interest and recently purchased inventory reflect current prices, so they are not systematically understated.

Question 27Economic and Business Information

A country's central bank wants to reduce the money supply to counter rising inflationary pressure. Which action is most directly consistent with this objective?

  1. Lowering the discount rate charged to commercial banks
  2. Purchasing government securities in the open market
  3. Reducing the interest rate paid on excess reserves
  4. Raising the reserve requirement ratio for commercial banks Correct answer.

Explanation

Raising the reserve requirement forces banks to hold a larger share of deposits as reserves, which reduces the funds available for lending and contracts the money multiplier. Open-market purchases, a lower discount rate, and a lower rate on excess reserves all tend to expand liquidity rather than contract it.

Question 28Economic and Business Information

An economy is operating at full employment when a large fiscal stimulus increases aggregate demand. According to the short-run Phillips curve framework, which outcome is most likely?

  1. Higher inflation with lower unemployment Correct answer.
  2. Unchanged inflation with unchanged unemployment
  3. Lower inflation with higher unemployment
  4. Higher inflation with higher unemployment

Explanation

The short-run Phillips curve posits an inverse relationship between inflation and unemployment: stronger aggregate demand pushes output above potential, lowering unemployment while bidding up prices and wages. A simultaneous rise in both inflation and unemployment would correspond to stagflation, which is not the standard short-run prediction of demand stimulus.

Question 29Economic and Business Information

A government imposes a tariff on imported steel. Which group is most likely to be harmed in the short run by this policy?

  1. Domestic steel producers
  2. The government collecting tariff revenue
  3. Domestic manufacturers that use steel as an input Correct answer.
  4. Domestic steel workers

Explanation

A tariff raises the domestic price of the imported good, which benefits import-competing producers and their workers but raises costs for downstream industries that use the protected good as an input. The government gains tariff revenue, so it is not among the harmed parties.

Question 30Economic and Business Information

A company reports a current ratio of 2.0 and a quick ratio of 0.8. Which conclusion is most consistent with these figures?

  1. The company is likely to face a liquidity crisis
  2. Accounts receivable turnover has deteriorated sharply
  3. Inventory represents a large share of current assets Correct answer.
  4. The company has excessive cash relative to its liabilities

Explanation

The gap between the current ratio (2.0) and the quick ratio (0.8) is explained by inventory and other less-liquid current assets, which must be large relative to current liabilities. A high current ratio alone does not signal a liquidity crisis, and the ratios do not directly measure receivables turnover.

Question 31Investment Vehicle Characteristics

An investor buys a bond at a premium to par and holds it to maturity. Under standard fixed-income mathematics, what happens to the yield to maturity relative to the coupon rate?

  1. The yield to maturity is higher than the coupon rate.
  2. The yield to maturity is unrelated to the purchase price.
  3. The yield to maturity equals the coupon rate.
  4. The yield to maturity is lower than the coupon rate. Correct answer.

Explanation

When a bond trades above par, the investor pays more than the principal returned at maturity, so the amortized premium reduces the total return below the coupon payments. Therefore YTM falls below the coupon rate. The reverse holds for a discount bond.

Question 32Investment Vehicle Characteristics

A money market instrument quoted on a discount basis with a 360-day year has a bank discount yield of 4.00% and 90 days to maturity. Which statement best describes the relationship between its bank discount yield and its bond equivalent yield?

  1. The bond equivalent yield is higher because the discount is measured against the purchase price rather than face value. Correct answer.
  2. The bond equivalent yield is lower because the price is higher.
  3. The bond equivalent yield is higher only if the instrument pays a coupon.
  4. The two yields are identical because both use the same day count.

Explanation

Bank discount yield divides the discount by face value and uses a 360-day year, which understates the return relative to the price actually paid. Converting to a bond equivalent yield restates the discount over the purchase price and a 365-day year, producing a higher figure.

Question 33Investment Vehicle Characteristics

Which characteristic distinguishes a closed-end fund from an open-end mutual fund?

  1. Closed-end funds must redeem shares daily at net asset value.
  2. Closed-end funds issue a fixed number of shares that trade on an exchange, often at prices different from NAV. Correct answer.
  3. Open-end funds trade at market-determined premiums or discounts to NAV.
  4. Open-end funds are prohibited from holding illiquid securities.

Explanation

A closed-end fund raises a fixed pool of capital in an initial offering, and its shares then trade on an exchange at market prices that may diverge from NAV. Open-end funds instead continuously issue and redeem shares at NAV.

Question 34Investment Vehicle Characteristics

An ETF and a traditional open-end mutual fund both hold the same basket of large-cap equities. Which structural feature most directly explains the ETF's typically lower taxable capital gain distributions to shareholders?

  1. ETFs are exempt from securities regulation.
  2. ETFs are required to hold securities for less than one year.
  3. ETFs use in-kind creation and redemption with authorized participants, allowing low-cost basis shares to be transferred out. Correct answer.
  4. ETFs never distribute dividends from underlying holdings.

Explanation

Authorized participants exchange baskets of securities for ETF shares, and the fund can deliver low-basis holdings in redemptions without selling them in the market. This in-kind mechanism avoids realizing gains that would otherwise be distributed. ETFs still distribute dividends and are fully regulated.

Question 35Investment Vehicle Characteristics

A limited partnership structure is used for many private equity funds. Which feature best describes the liability of the limited partners?

  1. Both limited and general partners have liability capped at their investment.
  2. Limited partners have liability limited to their committed capital, while the general partner bears unlimited liability. Correct answer.
  3. Limited partners are personally liable for all fund obligations.
  4. Limited partners manage daily operations and therefore assume fiduciary liability.

Explanation

In a limited partnership, limited partners contribute capital but are passive, and their liability is generally capped at their commitment. The general partner runs the fund and bears unlimited liability, which is why the GP is often organized as an LLC.

Question 36Investment Vehicle Characteristics

A hedge fund charges a 2% management fee on assets and a 20% incentive fee on profits, calculated on ending NAV before fees, with a 5% hard hurdle rate. The fund begins the year at $100 per share and ends at $120 before fees. What is the approximate incentive fee per share?

  1. $5.00
  2. $4.00
  3. $2.00
  4. $3.00 Correct answer.

Explanation

The hurdle requires the fund to earn 5% before any incentive fee applies, so the hurdle amount is $5 per share. The excess profit is $20 − $5 = $15, and 20% of $15 equals $3.00 per share. A hard hurdle applies the fee only to profits above the threshold.

Question 37Investment Vehicle Characteristics

Which statement correctly describes the tax treatment of municipal bond interest for a resident of the issuing state?

  1. Interest is generally exempt from federal income tax and from that state's income tax. Correct answer.
  2. Interest is taxable at both the federal and state levels.
  3. Interest is taxable at the federal level but exempt at the state level.
  4. Interest is exempt from federal tax only for capital appreciation bonds.

Explanation

Municipal bonds issued within an investor's home state typically provide interest exempt from both federal income tax and the home state's income tax. Out-of-state municipal interest is usually federally exempt but state taxable. Capital appreciation bonds are not a special exemption category.

Question 38Investment Vehicle Characteristics

An investor in the 32% federal tax bracket is comparing a taxable corporate bond yielding 5.60% with a municipal bond of comparable risk. What is the minimum municipal yield that would make the investor indifferent on an after-tax basis?

  1. 5.60%
  2. 4.20%
  3. 3.81% Correct answer.
  4. 1.79%

Explanation

The tax-equivalent yield formula rearranges to municipal yield = taxable yield × (1 − tax rate). Here, 5.60% × (1 − 0.32) = 5.60% × 0.68 = 3.808%, or about 3.81%. At that municipal yield the after-tax outcomes are equal.

Question 39Investment Vehicle Characteristics

Which risk is most specifically associated with callable corporate bonds from the holder's perspective?

  1. The issuer defaults on coupon payments during a recession.
  2. The issuer redeems the bond when interest rates fall, forcing reinvestment at lower yields. Correct answer.
  3. Inflation erodes the real value of fixed coupons.
  4. The bond's price falls when market interest rates rise.

Explanation

A call provision gives the issuer the right to retire the bond early, which it will typically exercise when rates decline and refinancing is cheaper. The holder then faces reinvestment risk at lower prevailing yields. Default, inflation, and interest rate risks affect bonds generally, not callables specifically.

Question 40Investment Vehicle Characteristics

A convertible bond has a conversion ratio of 25 shares and the underlying stock trades at $44. The bond is priced at $1,050. What is the conversion premium per bond?

  1. $50 Correct answer.
  2. $0
  3. $150
  4. $100

Explanation

Conversion value equals the conversion ratio times the stock price: 25 × $44 = $1,100. The conversion premium is the bond price minus conversion value: $1,050 − $1,100 = −$50, meaning the bond trades $50 below parity. Expressed as a premium, the bond is at a discount of $50.

Question 41Investment Vehicle Characteristics

Which feature most accurately describes a participating preferred stock?

  1. It converts automatically to common stock after a fixed period.
  2. It receives a stated dividend and may share in additional distributions with common shareholders. Correct answer.
  3. It has priority over all debt obligations in liquidation.
  4. It carries a mandatory sinking fund redemption schedule.

Explanation

Participating preferred pays its stated dividend and can also participate with common shareholders in excess earnings or liquidation proceeds beyond its preference amount. This participation feature distinguishes it from straight preferred, which receives only its fixed dividend.

Question 42Investment Vehicle Characteristics

An investor holds a cumulative preferred stock that skipped its dividend for two years. What is the most likely consequence when the company resumes distributions?

  1. The preferred dividend rate is permanently reduced.
  2. The preferred shares convert to common stock to compensate for the shortfall.
  3. The accumulated dividends in arrears must be paid before any common dividend. Correct answer.
  4. The skipped dividends are permanently forfeited.

Explanation

Cumulative preferred carries a right to dividends in arrears, which must be satisfied before the company can pay anything to common shareholders. This protection distinguishes cumulative from non-cumulative preferred. Forfeiture would apply only to non-cumulative shares.

Question 43Investment Vehicle Characteristics

Which statement best describes the role of a real estate investment trust's payout requirement?

  1. REITs must retain at least 90% of income to avoid double taxation.
  2. REITs are taxed as partnerships regardless of distributions.
  3. REITs must distribute at least 90% of taxable income to shareholders to maintain pass-through tax status. Correct answer.
  4. REITs must distribute 50% of gross revenue to qualify.

Explanation

To qualify for pass-through treatment, a REIT must distribute at least 90% of its taxable income to shareholders as dividends. Retaining income beyond that limit triggers entity-level tax. The threshold applies to taxable income, not gross revenue.

Question 44Investment Vehicle Characteristics

An investor compares a non-traded REIT with a listed REIT. Which characteristic is most accurate regarding valuation?

  1. Both are valued continuously by exchange trading.
  2. The non-traded REIT's shares are marked to market daily by the fund sponsor.
  3. The listed REIT's NAV is fixed at the initial offering price.
  4. The non-traded REIT's share value is periodically estimated by an appraisal process rather than set by market trading. Correct answer.

Explanation

Non-traded REITs are not exchange-listed, so their per-share value is determined periodically through appraisals or a valuation process, which may lag market conditions. Listed REITs trade continuously, and their market price can diverge from NAV.

Question 45Investment Vehicle Characteristics

A commodity futures-based exchange-traded product is held in contango. Which statement best describes the roll yield effect on the product's return?

  1. Rolling futures forward generates a negative yield because later contracts are more expensive. Correct answer.
  2. Rolling futures forward generates a positive yield because later contracts are cheaper.
  3. Contango guarantees a return equal to the spot price change.
  4. Contango has no effect on returns when the product holds futures.

Explanation

In contango, deferred futures contracts trade above near-term contracts, so as the product rolls its position it sells cheaper expiring contracts and buys more expensive later ones. This creates a negative roll yield that drags on returns relative to spot price changes.

Question 46Investment Vehicle Characteristics

Which statement correctly describes the difference between a forward contract and a futures contract?

  1. Forwards are standardized and exchange-traded, while futures are customized and traded over the counter.
  2. Both are standardized and cleared through a central counterparty.
  3. Forwards are customized and traded over the counter, while futures are standardized and exchange-traded with daily settlement. Correct answer.
  4. Futures carry no counterparty credit risk because they are customized.

Explanation

A forward is a private, customized agreement between two parties with settlement at maturity, exposing each to counterparty credit risk. A futures contract is standardized, exchange-traded, and marked to market daily through a clearinghouse, which mitigates counterparty risk.

Question 47Investment Vehicle Characteristics

An investor buys a put option on a stock with a strike of $50 and pays a premium of $3. At expiration the stock trades at $40. What is the investor's profit per share?

  1. −$3
  2. $3
  3. $7 Correct answer.
  4. $10

Explanation

The put's intrinsic value at expiration is the strike minus the stock price: $50 − $40 = $10. Subtracting the $3 premium paid gives a profit of $7 per share. The premium reduces but does not eliminate the gain.

Question 48Investment Vehicle Characteristics

A portfolio manager wishes to hedge a long equity position against a broad market decline using index options. Which strategy most directly accomplishes the hedge?

  1. Selling index call options
  2. Buying index call options
  3. Buying index put options Correct answer.
  4. Selling index put options

Explanation

A long put gains value when the index falls, offsetting losses in the equity portfolio. Buying a put is the standard protective hedge. Selling puts or calls would add exposure rather than protect against a decline.

Question 49Investment Vehicle Characteristics

Which statement best describes the investment characteristics of a non-agency residential mortgage-backed security compared with an agency MBS?

  1. Non-agency MBS are backed exclusively by conforming loans.
  2. Non-agency MBS lack a government guarantee and therefore carry credit risk tied to the underlying borrowers. Correct answer.
  3. Agency MBS expose investors to full borrower default risk without any guarantee.
  4. Non-agency MBS carry no credit risk because they are government guaranteed.

Explanation

Agency MBS are guaranteed by a government-sponsored entity, so investors face mainly prepayment risk. Non-agency MBS have no such guarantee, so investors bear credit risk from the underlying non-conforming loans.

Question 50Investment Vehicle Characteristics

An investor is evaluating the tranches of a collateralized debt obligation. Which tranche typically bears the first losses on the underlying collateral?

  1. The mezzanine tranche
  2. The equity tranche Correct answer.
  3. The senior tranche
  4. The super-senior tranche

Explanation

The equity tranche sits at the bottom of the waterfall and absorbs the first losses from the collateral pool. Senior and super-senior tranches have priority claims on cash flows and are protected until junior tranches are exhausted. Mezzanine tranches absorb losses after equity but before senior.