Free CFA Level I Practice Questions with Answers

Correct answer: B. Private equity investments typically require investor capital to be locked up for many years with limited liquidity

Private equity funds are structured as closed-end vehicles with committed capital drawn down over time and returned only as portfolio companies are exited, typically over a fund life of 7–10+ years. This illiquidity is a core structural feature distinguishing PE from listed equities, which trade continuously on exchanges. Choices A and D are factually wrong (PE is not exchange-traded or regulated like a '40 Act mutual fund), and Choice C is an unsupportable absolute claim — no asset class guarantees outperformance.

• A. This is backwards. Private equity interests are not exchange-listed and generally cannot be sold on demand at a quoted price, which is the opposite of the trait described.
• B. Correct — PE funds typically impose multi-year lockups with capital calls and limited redemption rights, making illiquidity the key distinguishing feature versus public equities.
• C. No investment is guaranteed to outperform; PE returns are dispersed and depend heavily on manager selection and vintage year, so this overstates certainty that doesn't exist.
• D. PE funds are typically far less regulated than open-end mutual funds (e.g., exempt from daily-liquidity and registration requirements under the Investment Company Act of 1940), not identically regulated.

• Source: CFA Institute refresher reading: Alternative Investment Features, Methods, and Structures

Correct answer: D. 65 days

The cash conversion cycle = DOH + DSO − DPO = 60 + 45 − 40 = 65 days. It measures the number of days between paying cash for inputs and collecting cash from customers, netting out the financing benefit of supplier credit (DPO).

• A. 25 days appears to flip a sign when combining the components, such as adding DPO and subtracting DOH, rather than correctly adding DOH and DSO and then subtracting DPO.
• B. 145 days results from adding all three components together (DOH+DSO+DPO) instead of subtracting DPO, the payables deferral, from the operating cycle.
• C. 105 days equals DOH + DSO alone (60+45), which is the operating cycle; it omits netting out the days of payables deferral (DPO) that shortens the true cash conversion cycle.
• D. Cash conversion cycle = DOH + DSO - DPO = 60 + 45 - 40 = 65 days.

Correct answer: A. Equal to the European call's value, since early exercise is never optimal on a non-dividend-paying stock

For a non-dividend-paying underlying, exercising a call early forfeits remaining time value and the insurance against downside for no offsetting benefit — so it is never optimal, and the American call's value collapses to the European call's value. Choice B is the common misconception that flexibility itself always has positive value; here that flexibility is simply never used in equilibrium. Choice C invents a nonexistent risk difference. Choice D is a distraction — the equality holds regardless of volatility level.

• A. Since the stock pays no dividends, early exercise of an American call is never optimal, as it would forfeit remaining time value for no benefit, so the American call's value equals the European call's.
• B. The early-exercise flexibility has no economic value here specifically because there's no dividend to capture early — on a non-dividend payer, this flexibility goes unused, so it doesn't command a value premium.
• C. American and European options here are otherwise identical contracts; there's no additional counterparty risk attached specifically to the American-style feature.
• D. The comparison doesn't require knowing implied volatility; the no-dividend condition alone is sufficient to establish that early exercise is never optimal and the two values are equal.

Correct answer: A. Consumers buy less of the good and shift purchases toward relatively cheaper substitute goods, holding real purchasing power constant

The substitution effect isolates the change in quantity demanded that results purely from a good becoming relatively more expensive compared to substitutes, holding real purchasing power (utility) constant. As the good's relative price rises, rational consumers reallocate spending toward now-comparatively-cheaper substitutes. Choice B describes the income effect, not substitution. Choice C describes a quality-signaling reaction, not the standard substitution effect. Choice D is wrong because for a normal good's price increase, the two effects reinforce each other (both push quantity demanded down).

• A. This is the definition of the substitution effect: holding real purchasing power fixed, consumers shift away from the now relatively more expensive good toward cheaper substitutes.
• B. This describes the income effect, not the substitution effect — the reduction in real purchasing power from a higher price is a separate channel from the relative-price substitution response.
• C. This describes a signaling or Veblen-good response to price, which is a different phenomenon altogether and not what the substitution effect refers to in standard consumer theory.
• D. The substitution and income effects don't generally cancel for a normal good — both typically push quantity demanded down as price rises, they don't offset each other.

Correct answer: A. Company X will have a lower index weight than Company Y, because only 40% of its shares are available to public investors

Free-float adjustment weights each constituent by only the shares available for public trading, not total shares outstanding. Company X has only 40 million of its 100 million shares freely tradable (40% free float), giving it a free-float market cap of $800 million, versus Company Y's full $2 billion free-float market cap. Despite identical total market capitalization, X receives a much smaller index weight.

• A. Correct — free-float weighting counts only Company X's 40 million publicly tradable shares (excluding the family's 60 million), so despite equal total market cap, X gets a smaller float-adjusted weight than fully tradable Company Y.
• B. Incorrect — identical total market cap doesn't produce identical index weight under free-float adjustment, which weights shares actually available to the public, not total shares outstanding.
• C. Incorrect — closely held shares don't increase index weight through lower trading costs; free-float methodology exists specifically to reflect actual investable supply, which is lower for X.
• D. Incorrect — free-float adjustment is standard practice in modern cap-weighted indices (e.g., S&P, MSCI), not something limited to price-weighted indices.

Correct answer: B. Permissible, because the client's brokerage commissions are being used to obtain research that directly benefits the account generating those commissions.

Client brokerage is considered client property. Standard III(A) permits directing brokerage to a higher-cost broker in exchange for proprietary research, so long as the research obtained is used to benefit the client(s) whose commissions paid for it — this is distinguished from improper use of soft dollars for the manager's own benefit (e.g., paying for firm overhead). Best execution is a holistic standard (price, research value, execution quality, and reliability combined), not simply lowest commission.

• A. Incorrect — best execution weighs total qualitative and quantitative factors, not commission rate alone; using a higher-cost broker for valuable research can still satisfy best execution.
• B. Correct — using client brokerage to obtain research that benefits the same client's account is an accepted practice under Standard III(A), provided the benefit flows to that client.
• C. Incorrect — soft-dollar/client-brokerage arrangements are not banned outright; they are permitted when the client whose commissions are used receives the benefit.
• D. Incorrect — CFA Institute does not pre-approve individual firms' brokerage arrangements; compliance is a firm/individual responsibility, not a registration process.

Correct answer: C. IFRS permits reversal limited to the amount originally written down, while U.S. GAAP prohibits reversal

Under IFRS (IAS 2), a write-down of inventory can be reversed if net realizable value later recovers, but only up to the amount of the original write-down. Under U.S. GAAP, a write-down establishes a new cost basis and cannot be reversed.

• A. IFRS allows reversal, so the frameworks do not both prohibit it.
• B. U.S. GAAP prohibits reversal, so the frameworks do not agree.
• C. Correct. IFRS permits reversal up to the original write-down; U.S. GAAP does not.
• D. The frameworks are reversed in this choice; IFRS permits reversal up to the original write-down, while U.S. GAAP prohibits it.

Correct answer: A. It makes no periodic interest payments and is issued or trades at a discount to face value, with the investor's entire return coming from price appreciation to par at maturity

A zero-coupon bond, by definition, pays no periodic coupons; the investor buys it at a discount and receives the full face value at maturity, so the entire return is embedded in that price appreciation. B and C describe coupon-paying instruments (fixed and floating rate, respectively), not zero-coupon bonds. D correctly notes that zero-coupon bonds have no reinvestment risk (since there are no coupons to reinvest), but incorrectly claims they trade at a premium — they trade at a discount, precisely because all value is deferred to maturity.

• A. Correct — a zero-coupon bond pays no periodic coupons, is sold at a discount, and the investor's entire return comes from price appreciation to face value at maturity.
• B. Incorrect — this reverses the actual structure; zero-coupon bonds pay no coupons at all, and full principal (face value) is returned at maturity.
• C. Incorrect — a floating coupon rate describes a floater, not a zero-coupon bond, which pays no coupon whatsoever.
• D. Incorrect — zero-coupon bonds trade at a discount, not a premium; the absence of reinvestment risk (true, since there are no coupons to reinvest) doesn't imply premium pricing.

Correct answer: B. The security's beta (its systematic risk contribution to the diversified portfolio)

Because the investor is already well-diversified, the security's unsystematic risk will largely be diversified away when added to the portfolio; what matters for pricing and risk contribution is its systematic risk, measured by beta. Total standard deviation (Choice A) reflects risk that is irrelevant to a diversified holder since much of it is unsystematic and washes out. Choices C and D are not standard measures of a security's contribution to portfolio risk.

• A. Incorrect — total standard deviation includes diversifiable (unsystematic) risk, which is largely eliminated for an investor who already holds a broad market portfolio, making it a less relevant measure here.
• B. Correct — for a diversified investor, only the security's systematic risk contribution (beta) affects the portfolio's overall risk, since unsystematic risk is diversified away.
• C. Incorrect — dividend yield volatility isn't a standard or relevant measure of a security's risk contribution to a diversified portfolio.
• D. Incorrect — book-to-market ratio is a valuation/style characteristic, not a measure of a security's risk contribution to portfolio risk.

• Source: CFA Institute refresher reading: Portfolio Risk and Return: Part II

Correct answer: D. A Type I error

A Type I error is the rejection of a true null hypothesis. Here, the null hypothesis (equal means) is actually true, but the researcher rejected it — by definition, this is a Type I error. The probability of a Type I error is the chosen significance level (5% here), but choosing that level does not prevent the error from occurring on any individual test.

• A. Incorrect — a Type II error is failing to reject a false null hypothesis; here the null was rejected, not retained.
• B. Incorrect — this scenario is unrelated to the central limit theorem, which concerns the sampling distribution of the mean, not hypothesis-test outcomes.
• C. Incorrect — choosing a significance level in advance does not make any specific decision 'correct'; it only sets the long-run probability of a Type I error.
• D. Correct — rejecting a null hypothesis that is actually true is precisely the definition of a Type I error.

• Source: CFA Institute refresher reading: Hypothesis Testing

Correct answer: B. The incentive fee applies only to the return in excess of the hurdle rate (15% − 5% = 10%); incentive fee ≈ 20% × 10% = 2.0%, plus a 2% management fee, for an approximate net return of 11%.

Under a hard hurdle structure, the incentive fee is charged only on the portion of return in excess of the hurdle rate — the return up to the hurdle is never subject to the performance fee, even after the hurdle is cleared. Here, incentive fee ≈ 20% × (15% − 5%) = 2.0% of assets; combined with the 2% management fee, total fees ≈ 4%, leaving an approximate net return of 15% − 4% = 11%.

• A. Incorrect — ignores the hurdle rate entirely, charging the incentive fee on the full gross return rather than only the excess over 5%.
• B. Correct — correctly applies the incentive fee only to the return above the 5% hurdle and combines it with the management fee for the net return.
• C. Incorrect — describes a SOFT hurdle mechanic (fee on full return once hurdle is cleared), which is the opposite of how a hard hurdle works.
• D. Incorrect — a hard hurdle excludes the fee on returns below the hurdle; it does not cap the total incentive fee at the hurdle percentage.

Correct answer: D. NPV, because it directly measures the increase in shareholder wealth in currency terms and assumes reinvestment of interim cash flows at the more realistic cost of capital rather than at the project's own IRR

When NPV and IRR rank mutually exclusive projects differently — typically due to differences in scale, timing, or the pattern of cash flows — NPV is the preferred decision criterion because it measures the absolute dollar increase in shareholder wealth and implicitly assumes cash flows are reinvested at the cost of capital, a more defensible assumption than IRR's implicit assumption that they are reinvested at the project's own (potentially unrealistic) IRR.

• A. Incorrect — ease of interpretation as a percentage doesn't resolve the ranking conflict; IRR's reinvestment assumption can make it misleading for choosing between mutually exclusive projects.
• B. Incorrect — payback period ignores the time value of money and cash flows beyond the payback point, and is not the preferred resolution to an NPV/IRR conflict.
• C. Incorrect — NPV and IRR are not always equivalent for mutually exclusive projects with scale/timing differences; that is precisely why conflicts arise.
• D. Correct — NPV directly reflects wealth added and uses the more realistic cost-of-capital reinvestment assumption, which is why it is preferred when rankings conflict.

Correct answer: A. The notional principal is never exchanged; only net interest payments are settled periodically between the two parties

In a plain vanilla interest rate swap, the notional principal is purely a reference amount used to calculate interest payments; only the net difference between the fixed and floating interest amounts changes hands each period. Choice B describes a feature more associated with certain currency swaps, not standard interest rate swaps. Choice C is internally contradictory — one party pays fixed, the other pays floating. Choice D reverses the benefit direction: the fixed-rate payer benefits when rates rise (since they continue paying a below-market fixed rate while receiving a higher floating rate).

• A. In a plain vanilla interest rate swap, only the net interest difference is exchanged periodically; the notional principal itself is never exchanged since it's used solely as a reference amount for payment calculations.
• B. Notional principal is not exchanged at initiation or maturity in an interest rate swap, unlike a currency swap; it exists purely as a calculation basis here.
• C. In a fixed-for-floating swap, one party pays fixed and receives floating while the counterparty does the reverse — both parties do not pay the same floating rate to each other.
• D. The fixed-rate payer benefits when rates rise, since they continue paying a below-market fixed rate while receiving a now-higher floating rate, not when rates fall.

Correct answer: C. Depreciation because the relative expected return on domestic-currency assets declines, reducing capital inflows and pressuring the currency.

A lower relative yield reduces demand for domestic-currency assets and pressures the currency downward in the short run, all else equal.

• A. A lower rate makes domestic bonds less attractive, not more, so capital flows out rather than in.
• B. Interest rate differentials and expected returns on assets affect exchange rates in the short run, not just trade balances.
• C. Reduced relative expected return on domestic assets lowers demand for the currency, so it depreciates.
• D. An output effect does not dominate the immediate rate-differential effect, which points to depreciation.

Correct answer: D. If a company omits a dividend, cumulative preferred stockholders are entitled to receive the missed dividends before common shareholders receive any future dividend, while noncumulative preferred stockholders permanently forfeit the missed dividend.

The cumulative feature means any omitted preferred dividends accumulate as arrears and must be paid in full before any dividend can be paid to common shareholders in a later period. Noncumulative preferred shareholders have no such claim — a skipped dividend is simply lost.

• A. Wrong — describes convertible preferred stock, an independent feature unrelated to the cumulative provision.
• B. Wrong — describes a stated dividend growth feature, unrelated to how missed dividends are treated.
• C. Wrong — describes voting versus nonvoting preferred stock; preferred stock (cumulative or not) is typically nonvoting regardless.
• D. Correct.

• Source: CFA Institute refresher reading: Overview of Equity Securities

Correct answer: C. Potentially a violation, because Standard I(D) covers conduct involving dishonesty, fraud, or deceit, or that reflects adversely on the member's professional reputation, integrity, or competence, regardless of whether it occurs in a professional or personal setting.

Standard I(D) is deliberately broad: it is not limited to conduct that occurs on the job. It reaches any act involving dishonesty, fraud, or deceit, or any conduct that reflects adversely on a member's or candidate's professional reputation, integrity, or competence. Whether a specific incident rises to that level requires a facts-and-circumstances analysis (e.g., pattern of behavior, severity, whether it involves an element of scienter), but the categorical claim that personal conduct is automatically exempt is false.

• A. Incorrect — this is the classic absolute-language trap; Standard I(D) is not confined to professional-context conduct, and conduct that reflects adversely on integrity or reputation can be covered even without dishonesty toward a client.
• B. Incorrect — the Standard's applicability does not depend on whether an employer's manual separately names the conduct; firm policy does not define the scope of the Standard.
• C. Correct — the Standard applies based on the nature of the conduct (dishonesty/fraud/deceit or adverse reflection on integrity/competence), not the setting in which it occurred.
• D. Incorrect — same flaw as the first no-violation choice; the Standard explicitly is not restricted to on-the-job conduct.

Correct answer: D. 0.75

Quick ratio = (Cash + Marketable securities + Receivables) / Current liabilities = ($50 + $30 + $70) / $200 = $150 / $200 = 0.75. Inventory and prepaid expenses are excluded because they are less readily convertible to cash (inventory requires a sale; prepaid expenses are not converted to cash at all).

• A. Wrong — mistakenly retains prepaid expenses in the numerator; only cash, securities, and receivables belong in quick assets.
• B. Wrong — this is the (more conservative) cash ratio, which improperly excludes receivables from the numerator.
• C. Wrong — this is the current ratio, which improperly includes inventory and prepaid expenses.
• D. Correct.

Correct answer: A. $964.33

Price = $60/(1.08) + $60/(1.08)^2 + $1,000/(1.08)^2 = $55.56 + $51.44 + $857.34 = $964.33. Since the 8% YTM exceeds the 6% coupon rate, the bond must trade at a discount to par, consistent with this result. Choice B mirrors the discount amount as a premium ($1,000 + $35.67) — a sign error. Choice C ignores the fact that YTM does not equal the coupon rate, incorrectly assuming the bond prices at par. D is a plausible-looking but incorrect arithmetic result.

• A. Correct — discounting $60 in year 1 and $1,060 in year 2 at 8% gives $55.56 + $908.78 = $964.33.
• B. Incorrect — $1,035.67 would apply if the yield were below the coupon rate (a premium bond), but here YTM (8%) exceeds the coupon (6%), so the bond trades at a discount.
• C. Incorrect — $1,000.00 (par) only holds when the coupon rate equals yield to maturity, which isn't the case here (6% vs. 8%).
• D. Incorrect — $945.87 understates the price; recheck the year-2 discount factor (1.08^2 = 1.1664) applied to the $1,060 final cash flow.

• Source: CFA Institute refresher reading: Fixed-Income Bond Valuation: Prices and Yields

Correct answer: D. About 10%

Variance = 0.25(0.04) + 0.25(0.04) + 2(0.5)(0.5)(-0.5)(0.04) = 0.01, so volatility is 10%.

• A. This is the result with zero correlation, not -0.5.
• B. This understates volatility by omitting the variance terms from the individual assets.
• C. This is the result with perfect positive correlation.
• D. Portfolio variance of 0.01 gives a standard deviation of 10%.

Correct answer: A. Fail to reject zero alpha at 1%; a 3% p-value is not the probability the null is true

The decision rule uses the precommitted 1% level, and a p-value of 0.03 exceeds it, so the null is not rejected. A p-value is not the probability that the null or alternative is true.

• A. The p-value of 0.03 is above the 1% threshold, so zero alpha is not rejected, and a p-value is not a probability about the null.
• B. The significance level must be fixed before the test; switching to a looser 5% level after seeing the result invalidates the test.
• C. A p-value does not give the probability that alpha is positive; it measures data extremeness assuming the null is true.
• D. Failing to reject does not prove the null; the test simply lacks sufficient evidence against it.

Correct answer: A. Long the target and short the acquirer; the main risk is that the deal fails and the target's price falls back

In a stock-for-stock deal the target typically trades at a discount to the offer value. The arbitrageur buys the target and shorts the acquirer at the exchange ratio to capture the spread while hedging acquirer price moves. The main risk is deal failure, when the target's price drops back toward its pre-deal level.

• A. Correct. Long target and short acquirer captures the spread, and deal failure is the principal loss scenario.
• B. The positions are reversed; shorting the target would lose money as the spread converges.
• C. Being long the acquirer adds market and acquirer risk instead of hedging it.
• D. The positions are right, but an earlier closing realizes the spread sooner and is not the primary risk.

Correct answer: C. 9.05%

WACC = 0.70(11%) + 0.30(6%)(1 - 0.25) = 7.70% + 1.35% = 9.05%.

• A. This does not follow from the weights, costs and tax rate given.
• B. This uses the pretax debt cost and ignores the interest tax shield (7.70% + 1.80%).
• C. 7.70% + 1.35% = 9.05%.
• D. This is the cost of equity alone and ignores debt financing.

Correct answer: D. Out-of-the-money

A put option is in-the-money when the stock price is below the strike (S < X), and out-of-the-money when the stock price is above the strike (S > X). Here S = $82 > X = $75, so exercising the put (selling at $75 when the market price is $82) would be unfavorable — the put is out-of-the-money. It is not at-the-money (which requires S ≈ X), and moneyness is determined by S vs. X alone, not the premium paid.

• A. Incorrect — moneyness is determined purely by comparing the strike to the current stock price and doesn't require knowing the option's premium.
• B. Incorrect — in-the-money for a put requires the stock price to be below the strike; here the stock ($82) is above the strike ($75), so it's out-of-the-money.
• C. Incorrect — at-the-money requires the stock price to equal, or be very close to, the strike price; $82 vs. $75 is too large a gap.
• D. Correct — a put with a $75 strike is out-of-the-money when the stock trades above the strike ($82 > $75), since exercising to sell at $75 would be worse than the current market price.

• Source: CFA Institute refresher reading: Pricing and Valuation of Options

Correct answer: C. Consumers are given a longer time horizon to adjust their purchasing behavior

Demand becomes more elastic (more responsive to price) when consumers have more time to find substitutes, change habits, or adjust consumption patterns, so a longer adjustment horizon increases elasticity. Few substitutes (A), necessity status (B), and a small budget share (D) are all classic determinants of relatively inelastic, not elastic, demand.

• A. Incorrect — few substitutes make demand less elastic (more inelastic), since consumers have limited ability to switch away from the good when its price rises.
• B. Incorrect — necessities tend to have inelastic demand, since consumers keep purchasing them regardless of price changes.
• C. Correct — a longer adjustment horizon lets consumers find substitutes, change habits, or otherwise adjust consumption more fully, making demand more elastic over time.
• D. Incorrect — goods representing a very small share of the budget, such as table salt, tend to have inelastic demand, since price changes barely affect the consumer's overall spending power.

Correct answer: A. A stop (stop-loss) order: once the stock trades at or through $36, it converts into a market order and executes at the next available price, which could be above or below $36

A stop order to sell is dormant until the market price reaches the stop price, at which point it converts into a market order — filled at the best available price, not a guaranteed one. A limit order works differently: it guarantees a price (or better) but has no trigger mechanism tied to a decline. Choice C is wrong because stop orders never guarantee a specific fill price, and D misdescribes limit-order logic for a sell instruction.

• A. This is a stop (stop-loss) order — once the stock trades at or through $36, it converts to a market order and executes at the next available price, which may be above or below $36.
• B. A limit sell order guarantees execution only at a specified price or better, and it wouldn't be the order type used to trigger a sale as the price falls through $36.
• C. A stop order does not guarantee execution at the exact stop price — once triggered it becomes a market order, so the fill price can differ from $36, especially in a fast-moving market.
• D. The order is designed to sell as the price falls to $36, not to execute only at prices above $36, which mischaracterizes both the order type and its trigger direction.