Free CFA Level II Practice Questions with Answers

Correct answer: C. 40.1%

Log odds = ln[p/(1-p)] = -0.40, so odds = e^-0.40 = 0.6703 and p = odds/(1+odds) = 0.6703/1.6703 = 0.4013, or 40.1%. Equivalent form: p = 1/(1+e^0.40).

• A. Reports the odds (e^-0.40 = 0.6703) as if they were the probability.
• B. Computes 1 - p, the probability of no default.
• C. Correct: p = 0.6703/1.6703 = 40.1%.
• D. Treats a negative index near zero as 50%; only a log odds of exactly zero implies p = 50%.

Correct answer: B. GBP depreciates 4.0% against JPY

JPY value of the trade = 1.04 x (1 - depreciation) versus repaying 1.005. At 4.0% depreciation 1.04 x 0.96 = 0.9984, below 1.005: a loss. A 3.0% fall gives 1.0088, still a gain. Carry trades lose when the funded currency's move exceeds the differential.

• A. At 3.0% depreciation 1.04 x 0.97 = 1.0088, which still exceeds 1.005; a small gain remains.
• B. Correct: 1.04 x 0.96 = 0.9984 is less than 1.005, so the trade loses.
• C. With no currency move the trade earns the 3.5% differential.
• D. GBP appreciation adds to the interest gain.

Correct answer: D. Pretax income overstated by USD 8 million; operating cash flow overstated by USD 10 million

Expensing would reduce pretax income by 10; capitalizing reduces it by only 2 of amortization, so income is overstated by 8. The 10 of cash spending moves to investing activities, so operating cash flow is overstated by 10.

• A. Ignores the first-year amortization and misses that capitalized cash spending is reclassified out of operating cash flow.
• B. Gets the income effect right but misses that the outflow is reclassified to investing.
• C. Confuses the amortization charge with the overstatement of income.
• D. Correct: income overstated by 10 - 2 = 8; operating cash flow by the full 10.

Correct answer: C. EPS rises because the 5.0% earnings yield exceeds the 4.5% after-tax cost of debt

A debt-funded buyback raises EPS when the earnings yield (1/PE = 5.0%) exceeds the after-tax cost of debt (6% x 0.75 = 4.5%). The comparison must be after tax; the pretax rate overstates the cost.

• A. Compares against the pretax cost, which ignores the interest tax shield.
• B. The financing source changes net income through interest, so it does matter.
• C. Correct: 5.0% earnings yield versus 4.5% after-tax cost of debt.
• D. Fewer shares help only when the lost earnings or added interest is smaller than the share reduction benefit.

Correct answer: D. Residual income, because value starts from book value and does not rely on distant dividends or cash flows

Residual income values equity as book value plus the present value of expected excess earnings, so it works when dividends are zero and FCFE is negative for years. Reliable book value and clean surplus accounting make it well suited here.

• A. Wrong: a zero dividend gives a Gordon value of zero, so the model cannot be used meaningfully.
• B. Wrong: negative cash flow does not lower the discount rate and single-stage growth is unrealistic for six negative years.
• C. Wrong: intrinsic models can be used for non-payers; residual income is designed for that case.
• D. Correct: the model anchors on book value, so most value is recognised near-term even with no payout or free cash flow.

Correct answer: A. Duration 5.10; convexity -80.00

Effective duration = (101.25 - 98.70)/(2 x 100 x 0.0025) = 5.10. Effective convexity = (101.25 + 98.70 - 200)/(100 x 0.0025^2) = -0.05/0.000625 = -80. Negative convexity is typical of a callable bond, whose price gains are capped as rates fall.

• A. Correct: both formulas applied with the 25 bp shift.
• B. Halves both measures, as if the shift were 50 bp.
• C. Gets the sign of convexity wrong; the price pattern shows negative convexity.
• D. Leaves out the factor of two in the duration denominator, doubling the result.

Correct answer: B. 4.96

Risk-neutral probability pi = (1.03 - 0.80)/(1.25 - 0.80) = 0.5111. The payoff is 10 in the up state and 0 in the down state, so c = 0.5111 x 10/1.03 = 4.96.

• A. Uses a 50% probability for the up state: 0.5 x 10 / 1.03.
• B. Correct: 0.5111 x 10 / 1.03 = 4.96.
• C. Computes the expected payoff of 5.11 without discounting it.
• D. Uses (1 - d)/(u - d) as the up probability, omitting the interest rate.

Correct answer: B. 0.68

Net beta = 1.40 x 1.0 - 0.60 x 1.2 = 1.40 - 0.72 = 0.68. Net exposure is 80%, but the shorts have higher beta, so beta is lower than the net exposure.

• A. Uses net exposure alone (140% - 60%) and ignores the higher beta of the shorts.
• B. Correct: 1.40 x 1.0 - 0.60 x 1.2 = 0.68.
• C. Adds long and short betas (1.40 + 0.72) rather than netting, giving 2.12.
• D. Treats the portfolio as having market beta of 1.0, ignoring short book.

Correct answer: C. 40,000

Standard error falls with the square root of the number of trials. Halving it requires four times as many trials: 4 x 10,000 = 40,000. Doubling the trials reduces the error only by a factor of about 1.41.

• A. Eight times the trials cuts the error to about 0.28%, more than needed.
• B. Ten times the trials is more than needed.
• C. Correct: halving the standard error needs four times the trials.
• D. Doubling the trials gives only about a 29% reduction in error.

Correct answer: C. After clients have had a reasonable opportunity to act on the recommendation

Standard VI(B) gives client and employer transactions priority over personal ones. Dev must wait until clients have had a reasonable opportunity to act on the recommendation. Distribution of the report alone, a small order size, or compliance approval does not satisfy the priority rule.

• A. Wrong: distribution does not mean clients have had time to act.
• B. Wrong: small size does not change the priority of client trades.
• C. Correct: personal trading waits until clients can act.
• D. Wrong: compliance approval does not override the client-priority timing rule.

Correct answer: A. 12.0

F = MSR/MSE = (RSS/k)/(SSE/(n-k-1)) = (180/3)/(100/20) = 60/5 = 12.0. The F-test is one-tailed and compares the statistic with a critical value at k and n-k-1 degrees of freedom.

• A. Correct: mean regression square 60 divided by mean squared error 5.
• B. Divides the residual sum of squares by n-k (21) instead of n-k-1 (20), understating the intercept's use of a degree of freedom.
• C. Divides the residual sum of squares by n (24) instead of n-k-1, ignoring the estimated parameters.
• D. Divides the raw sums of squares (180/100) without dividing each by its degrees of freedom.

Correct answer: A. It worsens, because the elasticities sum to less than 1

Starting from balanced trade, depreciation improves the trade balance only if the sum of the absolute export and import demand elasticities exceeds 1. Here the sum is 0.9, so higher import costs outweigh volume gains and the balance worsens.

• A. Correct: 0.4 + 0.5 = 0.9 is below 1.
• B. Lower export prices do not guarantee a better balance when demand is inelastic.
• C. The J-curve describes a short-run worsening before improvement, but the improvement requires a sum above 1.
• D. Elasticities do not offset; the test compares their sum with 1.

Correct answer: B. In net income for the period

Under current US GAAP, equity securities with readily determinable fair values and no significant influence are measured at fair value with changes recognized in net income. The old available-for-sale route through OCI applies now only to debt securities.

• A. This was the former available-for-sale treatment for equity securities and now applies only to debt.
• B. Correct: fair value changes on such equity holdings go through net income.
• C. Cost measurement is not used for listed equity with a readily determinable fair value.
• D. Fair value changes are current-period results, not prior-period adjustments.

Correct answer: B. 7.2%

Cost of equity = 3.0% + 1.2 x 5.0% = 9.0%. After-tax cost of debt = 6.0% x 0.75 = 4.5%. WACC = 0.40 x 4.5% + 0.60 x 9.0% = 1.8% + 5.4% = 7.2%.

• A. Uses the pretax cost of debt (2.4% + 5.4%).
• B. Correct: 1.8% + 5.4% = 7.2%.
• C. Weights debt and equity equally at 50% each (6.75%, rounded).
• D. Is just the cost of equity, ignoring debt financing.

Correct answer: C. USD 282 million

FCFE = FCFF - Int(1 - t) + net borrowing = 250 - 40 x 0.70 + 60 = 250 - 28 + 60 = USD 282 million. Debt holders receive after-tax interest, and new borrowing adds cash for equity holders.

• A. Subtracts pre-tax interest (40) rather than after-tax interest, giving 270.
• B. Adds after-tax interest instead of subtracting it, giving 338.
• C. Correct: 250 - 28 + 60 = 282.
• D. Subtracts net borrowing instead of adding it, giving 162.

Correct answer: C. USD 30 million

Losses hit the first-loss tranche first. The equity tranche absorbs USD 30 million and is wiped out. The remaining USD 30 million falls on the mezzanine tranche, leaving the senior tranche untouched. Pro rata sharing would apply only to a pari passu structure.

• A. Assigns the entire loss to the mezzanine tranche, ignoring the first-loss layer.
• B. Assumes the mezzanine tranche is wiped out, though losses are not large enough.
• C. Correct: after the equity tranche takes 30 million, the other 30 million falls on the mezzanine.
• D. Allocates losses pro rata to tranche size, which ignores subordination.

Correct answer: D. Delta near zero, positive gamma, positive vega, and negative theta

At the money the call's positive delta offsets the put's negative delta, so net delta is near zero. A long option position has positive gamma and vega and loses value over time, so theta is negative.

• A. Negative gamma and positive theta describe a short straddle, not a long one.
• B. A long option position gains from higher volatility, so vega is positive.
• C. The call and put deltas offset at the money, so net delta is near zero.
• D. Correct: long options give long gamma, long vega and time decay.

Correct answer: D. USD 65 million

FFO = NI + depreciation - gains on sale = 60 + 30 - 10 = 80. AFFO = FFO - straight-line rent adjustment - recurring capex = 80 - 3 - 12 = USD 65 million.

• A. Stops at FFO and makes no adjustments for capex or straight-line rent.
• B. Deducts only the straight-line rent adjustment (80 - 3), leaving out recurring capex.
• C. Deducts only recurring capex (80 - 12), leaving out the straight-line rent adjustment.
• D. Correct: 80 - 3 - 12 = 65.

Correct answer: C. Reverse stress testing

Reverse stress testing starts from a specified loss and works backward to find the scenarios that produce it. Historical scenarios replay past events, sensitivity analysis shocks one factor, and Monte Carlo VaR estimates a loss quantile from random draws.

• A. Produces a loss quantile from simulated returns and does not start from a target loss.
• B. Replays a past event rather than searching for causes of a target loss.
• C. Correct: starts from the loss outcome and finds the causes.
• D. Shocks one factor, so it does not search for combinations of moves.

Correct answer: C. deficient, since she must make reasonable inquiry into how the model's output is produced

Standard V(A) requires a reasonable and adequate basis supported by appropriate research and investigation. Using third-party research or models is permitted, but the member must determine that the process is sound. Reputation alone is not enough, yet purchased models are not prohibited.

• A. Wrong: reputation is not a substitute for understanding the process.
• B. Wrong: naming the source does not supply the missing review.
• C. Correct: she must inquire into how the output is produced.
• D. Wrong: the Standards do not bar use of purchased models; they require diligence.

Correct answer: D. Fail to reject the unit root; the series is nonstationary, so model first differences

The Dickey-Fuller test is lower-tailed: reject the unit-root null only if the statistic is below the critical value. -1.40 is above -2.90, so the null stands, the series is nonstationary, and differencing (or a cointegration check) is needed.

• A. A negative statistic is not itself evidence; it must be more negative than the critical value.
• B. Small absolute value means failure to reject, not rejection; the conclusion is reversed.
• C. A failure to reject the unit root means the series is nonstationary, not stationary; AR estimation on levels would be invalid.
• D. Correct: -1.40 is not below -2.90, so no rejection; difference the series.

Correct answer: B. 1.2238

Relative PPP: S(1) = S(0) x (1 + pi_USD)/(1 + pi_EUR) = 1.2000 x 1.03/1.01 = 1.2238. The currency of the higher-inflation country (USD) is expected to depreciate, so more USD are needed per EUR.

• A. Inverts the ratio (1.01/1.03), implying the high-inflation USD appreciates.
• B. Correct: 1.2000 x 1.03/1.01 = 1.2238.
• C. Applies only US inflation (1.2000 x 1.03), ignoring eurozone inflation.
• D. Applies only eurozone inflation (1.2000 x 1.01), ignoring US inflation.

Correct answer: D. 3.75 times

Capitalized interest does not run through EBIT, so EBIT stays at 300, but total interest cost is 60 + 20 = 80. Adjusted coverage = 300 / 80 = 3.75 times, compared with 5.00 times as reported.

• A. Is the reported ratio, which leaves out the capitalized interest.
• B. Also reduces EBIT by the capitalized interest, but EBIT was never reduced by it.
• C. Subtracts the capitalized interest from the denominator instead of adding it.
• D. Correct: 300 / (60 + 20) = 3.75.

Correct answer: D. A flip-in poison pill

A flip-in poison pill dilutes the hostile bidder by letting other shareholders buy discounted shares in the target after a trigger level is passed. White knights, Pac-Man and crown jewel defenses involve other transactions.

• A. A white knight is a friendly alternative acquirer.
• B. Pac-Man means the target tries to acquire the bidder.
• C. A crown jewel defense sells or encumbers the most valuable assets.
• D. Correct: discounted share purchase rights dilute the bidder's stake.

Correct answer: D. 9.0%

Sustainable growth g = retention rate x ROE. Retention = 1 - 0.40 = 0.60, so g = 0.60 x 15% = 9.0%. Using the payout ratio instead of the retention ratio is the common slip.

• A. Multiplies payout by ROE (0.40 x 15%), which measures dividends relative to equity, not retained growth.
• B. Treats ROE itself as the growth rate, ignoring that 40% of earnings leaves the firm as dividends.
• C. Divides ROE by the retention rate (15%/0.60), an inverted relationship with no basis.
• D. Correct: retention 60% x ROE 15% = 9.0%.