Chartered Financial Analyst (CFA) Exam 2

Explanation: High-yield bonds (D), also known as junk bonds, have the highest credit risk due to their lower credit ratings. Investment-grade bonds (A) have lower credit risk, municipal bonds (B) are issued by local governments and generally have low credit risk, and Treasury bonds (C) are issued by the federal government and are considered very low risk.

Explanation: The primary function of a financial derivative (B) is to hedge risk or speculate on price movements of the underlying asset. Derivatives can be used to manage exposure to various risks, including interest rate, currency, and commodity price risks. Options A, C, and D are unrelated to the primary function of derivatives.

Explanation: A stock exchange (D) is an example of a secondary market where existing securities are traded among investors. An IPO (A), private placement (B), and new bond issuance (C) are primary market activities where new securities are issued.

Explanation: A forward contract (A) is an agreement to buy or sell an asset at a specified price on a future date. Unlike options (B), forward contracts obligate both parties to the transaction. They are not standardized (C) and are typically traded over-the-counter. A short-term debt instrument (D) does not describe a forward contract.

Explanation: The cost of equity (B) is the required return for its shareholders, representing the compensation investors demand for the risk of owning the company's stock. The interest rate on debt (A) is the cost of debt. The average return on investments (C) and the cost of issuing new shares (D) do not specifically describe the cost of equity.

Explanation: A primary market transaction (C) involves a company issuing new shares to raise capital. Buying (A) and selling (B) shares on the stock exchange and trading bonds in the secondary market (D) are secondary market transactions.

Explanation: The primary goal of a central bank's monetary policy (B) is to control inflation and stabilize the economy. This involves managing the money supply and interest rates to achieve stable prices and sustainable economic growth. Options A and C are not central bank objectives, and D is often a secondary goal linked to overall economic stability.

Explanation: The payback period (A) is the time it takes for an investment to generate enough cash flows to recover its initial cost. The total return on an investment (B) is not specific to the payback period. Option C describes net present value, and D describes the internal rate of return (IRR).

Explanation: A growth stock (C) is characterized by high growth potential and above-average earnings growth. These stocks typically have higher price-to-earnings and price-to-book ratios compared to value stocks. A stock with a high dividend yield (A) is typically a value stock, and a stock with stable and predictable earnings (D) may be considered a defensive stock.

Explanation: The gross profit margin (A) measures a company's ability to generate profit from its operations by comparing gross profit to revenue. It indicates how efficiently a company produces goods and services. The current ratio (B) measures liquidity, the debt-to-equity ratio (C) measures financial leverage, and the price-to-earnings ratio (D) measures valuation.

Explanation: The main advantage of using an Exchange-Traded Fund (ETF) (C) is that they can be traded throughout the day like stocks, providing liquidity and flexibility. ETFs are generally less expensive than actively managed mutual funds (A), and they typically have lower management fees (D). Option B is incorrect because ETFs are usually passively managed.

Explanation: The main purpose of hedging (C) in finance is to protect against potential losses by reducing risk exposure. It involves taking offsetting positions in related securities to mitigate the impact of adverse price movements. Options A and B are contrary to hedging, and D describes speculation.

Explanation: Liquidity (A) refers to the ability to sell an asset quickly at its market value without significantly affecting its price. It is a measure of how easily an asset can be converted into cash. Options B, C, and D are not related to liquidity.

Explanation: Beta (C) measures the volatility of an investment relative to the market. It indicates how much an investment's returns move in relation to the overall market. Total risk (A) is measured by standard deviation, return relative to a benchmark (B) is alpha, and correlation (D) measures the relationship between two investments.

Explanation: An initial public offering (IPO) (A) is a company's first sale of stock to the public, marking the company's transition from a private to a public entity. The issuance of additional shares by an existing public company (C) is a secondary offering. Options B and D do not accurately describe an IPO.

Explanation: The primary purpose of the capital market (C) is to facilitate the transfer of long-term funds between investors and borrowers. It deals with securities that have maturities longer than one year, such as stocks and bonds. Short-term financing (A) is the function of the money market, and options B and D are unrelated to the primary purpose of the capital market.

Explanation: A recession (C) is characterized by declining economic activity, typically marked by a decrease in GDP, rising unemployment, and reduced consumer spending. Rising employment (A) and increasing consumer spending (D) are associated with economic expansion, while increasing inflation (B) can occur in both expansions and recessions but is not a defining characteristic of a recession.

Explanation: A callable bond (C) is a bond that can be redeemed by the issuer before its maturity date. This allows the issuer to refinance the debt if interest rates decline. Options A and B describe convertible and floating-rate bonds, respectively, and option D describes a zero-coupon bond.

Explanation: Unsystematic risk (C), also known as specific or idiosyncratic risk, is unique to individual investments and can be eliminated through diversification. Market risk (A), interest rate risk (B), and currency risk (D) are systematic risks that affect the entire market and cannot be eliminated by diversification.

Explanation: The internal rate of return (IRR) (A) is the interest rate that sets the net present value (NPV) of an investment to zero. It represents the break-even discount rate where the present value of cash inflows equals the initial investment. Options B and D describe other types of returns, and C refers to the discount rate used in NPV calculations.

Explanation: The main purpose of a stock buyback (C) is to return capital to shareholders. By repurchasing its own shares, a company reduces the number of shares outstanding, potentially increasing the value of remaining shares and signaling confidence in its financial health. Options A and D are incorrect, and B is not the main purpose.

Explanation: A convertible bond (A) is a bond that can be converted into a predetermined number of shares of the issuing company's stock. A bond with variable interest payments (B) is a floating-rate bond. A bond that can be redeemed before maturity (C) is a callable bond. A bond with no coupon payments (D) is a zero-coupon bond.

Explanation: The primary purpose of the Efficient Market Hypothesis (EMH) (B) is to describe how stock prices reflect all available information. According to EMH, it is impossible to consistently achieve higher returns than the overall market through stock picking or market timing because stock prices already incorporate all relevant information. Options A, C, and D do not accurately describe the EMH.

Explanation: Market capitalization (B) refers to the total value of a company's equity, calculated by multiplying the current stock price by the number of outstanding shares. It represents the market's valuation of the company's equity. Options A, C, and D describe other financial metrics.

Explanation: A bond's yield to maturity (YTM) (B) is the total return anticipated if the bond is held until it matures, taking into account all interest payments and the difference between the purchase price and face value. The current yield (A) is the annual interest payment divided by the bond's current price, and the interest rate (C) is the coupon rate. Option D is part of the YTM calculation but not a complete definition.

Explanation: Leverage (A) refers to the use of debt to finance an investment. It involves borrowing funds to increase the potential return on an investment. Option B refers to equity, C to total assets, and D to profitability, none of which specifically define leverage.

Explanation: Systematic risk (B) refers to the risk of a market-wide economic event affecting all securities, such as changes in interest rates or economic downturns. It cannot be eliminated through diversification. Option A describes unsystematic risk, C refers to credit risk, and D is related to interest rate risk.

A floating-rate bond (B) has interest payments that vary with market interest rates. The interest rate on these bonds is typically tied to a benchmark rate, such as LIBOR or the prime rate. A bond with a fixed interest rate (A) does not change, a convertible bond (C) can be converted into stock, and a callable bond (D) can be redeemed before maturity.

Explanation: Demand deposits (C) are a component of the money supply, as they are funds held in bank accounts that can be withdrawn on demand. Savings bonds (A) and Treasury bonds (D) are government securities and not part of the money supply. Certificates of deposit (B) are time deposits and typically not included in the narrow definition of the money supply.

Explanation: Stocks (C) are not a type of derivative. Derivatives are financial contracts whose value is derived from an underlying asset or index. Options (A), futures (B), and swaps (D) are all types of derivatives.

Explanation: Stock market returns (D) are considered a leading economic indicator because they often reflect investors' expectations about future economic performance. The unemployment rate (A) is a lagging indicator, GDP (B) is a coincident indicator, and CPI (C) measures inflation but is not specifically leading.

Explanation: The primary purpose of a company's capital structure (C) is to determine the mix of debt and equity financing. It involves managing the company's funding sources to balance risk and return. Options A, B, and D are related to other aspects of corporate management.

Explanation: A bear market (B) is characterized by falling stock prices and economic contraction. It typically reflects a downturn in economic conditions. Options A, C, and D describe characteristics of a bull market or stable economic conditions.

Explanation: Diversification (B) involves spreading investments across various asset classes to reduce risk. It aims to minimize the impact of poor performance in any single investment. Options A and D describe concentration strategies, while C focuses on high-risk investments, which is not the goal of diversification.

Explanation: Fundamental analysis (C) focuses on a company's financial statements to assess its value by analyzing its financial health, performance, and growth prospects. Technical analysis (A) examines price movements and trading volume, sentiment analysis (B) assesses market psychology, and quantitative analysis (D) uses mathematical models and statistics.

Explanation: A value stock (D) is characterized by a low price-to-earnings ratio, indicating that it is undervalued compared to its earnings. Value stocks typically have low price-to-book ratios and may not have high growth potential (C). High price-to-earnings (A) and price-to-book ratios (B) are characteristic of growth stocks.

Explanation: The gross profit margin (C) measures a company's profitability relative to its revenue by comparing gross profit to total revenue. Return on Equity (ROE) (A) and Return on Assets (ROA) (B) measure profitability relative to equity and assets, respectively, while the Price-to-Earnings (P/E) Ratio (D) measures valuation relative to earnings.

Explanation: The primary purpose of a company's dividend policy (C) is to provide a return to shareholders through dividend payments. While dividend policy can influence cash flow management (B), capital structure (A), and growth strategy (D), its main focus is on returning value to shareholders.

Explanation: A central bank (D) is not a financial intermediary. It is a government institution responsible for monetary policy and regulating the financial system. Commercial banks (A), investment banks (B), and mutual funds (C) are financial intermediaries that facilitate the transfer of funds between savers and borrowers.

Explanation: The primary function of an investment bank (C) is to assist companies in raising capital and provide advisory services for mergers, acquisitions, and other financial transactions. Accepting deposits and making loans (A) is the function of a commercial bank, providing insurance services (B) is the role of an insurance company, and managing individual retirement accounts (D) is typically done by asset management firms.