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CFA·ModuleCFA-L1

CFA Level I

Prepare for CFA Level I with CFA practice questions covering 111 topics. Build your knowledge, track your progress, and study effectively with PopCFA.

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13 units

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A few questions from this module, with the answer and a full explanation. The complete bank is available when you start practising.

  1. An immunised pension fund holds a significant allocation to agency mortgage-backed securities (MBS). Interest rates fall sharply by 200 basis points. An LDI manager reviews the portfolio and is concerned about contraction risk. How does contraction risk arise in this scenario?

    • Contraction risk means the portfolio's market value contracts (falls) when rates decrease, because MBS have negative convexity at all yield levels
    • Falling rates increase the duration of MBS by reducing the discount rate, causing the portfolio to over-hedge the liability and accumulate excess assets above what is needed
    • Contraction risk arises because falling rates cause issuers of callable bonds to exercise their call options, converting long-duration bonds into short-duration reinvestment obligations
    • Falling rates accelerate mortgage prepayments, shortening the expected maturity of MBS and reducing the portfolio's effective duration below the liability horizon, potentially causing under-accumulation of value
      Correct answer
    Explanation

    Contraction risk is the mirror image of extension risk and occurs when interest rates fall:

    • When rates fall, homeowners refinance their mortgages at lower rates, causing elevated prepayment speeds on MBS.
    • Faster prepayments mean MBS investors receive their principal back sooner than expected, shortening the bond's expected life.
    • This contracts the effective duration of the MBS below the originally estimated value.
    • In an immunised portfolio, if asset duration contracts below the liability horizon, the immunisation condition (Macaulay duration of assets = liability horizon) is violated.
    • The reinvestment risk then dominates: the returned principal must be reinvested at the new, lower rates, which may be insufficient to accumulate the required liability amount at the horizon.

    Note: For callable bonds, falling rates trigger calls (issuers redeem bonds and refinance at lower rates), which is a form of contraction risk — the bond that was expected to have a long duration is called away early.

  2. Under IFRS, dividends received from investees can be classified in which section(s) of the cash flow statement?

    • Only cash flow from financing activities (CFF), as dividends received relate to financing relationships.
    • Either CFO or CFF, not CFI, under IFRS.
    • Either cash flow from operations (CFO) or cash flow from investing activities (CFI), at the company's discretion under IFRS.
      Correct answer
    • Only cash flow from operations (CFO), consistent with US GAAP treatment.
    Explanation

    Under IFRS (IAS 7), companies have flexibility in classifying dividends received: they may be classified as CFO (because dividends are revenue in some business models) or CFI (because they represent a return on an investment). Under US GAAP, dividends received are always classified as CFO. This IFRS flexibility means analysts must identify the classification used before computing FCFF from CFO, and may need to adjust if dividends received are in CFI (to add them back to CFO for FCFF purposes).

  3. A portfolio manager holds 10,000 shares of a stock at USD 45 per share. She writes a covered call with X = USD 50 and receives a premium of USD 2.50 per share. An unexpected earnings announcement causes the stock to jump to USD 62 before expiry. What is the manager's total profit and loss per share, and what is the opportunity cost of the covered call strategy?

    • Total profit = USD 7.50 per share; opportunity cost = USD 12 per share (the full stock gain from USD 45 to USD 57)
    • Total profit = USD 17 per share; no opportunity cost because the covered call outperforms in all scenarios
    • Total profit = USD 2.50 per share (premium only); opportunity cost = USD 14.50 per share
    • Total profit = USD 7.50 per share; opportunity cost = USD 9.50 per share (the gain foregone above the strike minus the premium)
      Correct answer
    Explanation

    Covered call profit at S_T = 62:

    • Stock gain: 62 – 45 = USD 17
    • Short call loss (assignment): –(62 – 50) = –USD 12
    • Premium received: +USD 2.50
    • Net profit = 17 – 12 + 2.50 = USD 7.50 per share

    Opportunity cost (vs. holding the stock outright):

    • Stock outright gain: USD 17
    • Covered call gain: USD 7.50
    • Opportunity cost = USD 17 – USD 7.50 = USD 9.50 per share

    The opportunity cost is the gain surrendered above the call strike due to assignment, reduced by the premium received: (62 – 50) – 2.50 = 12 – 2.50 = USD 9.50. This is the hidden cost of writing covered calls in sharply rising markets.