FRM Test – 09 Answer

1.A company has two machines that produce widgets. An older machine produces 16% defective
widgets, while the new machine produces only 8% defective widgets. In addition, the new machine
employs a superior production process such that it produces three times as many widgets as the older
machine does. Given that a widget was produced by the new machine, what is the probability it is NOT
defective?

A) 0.76.
B) 0.06.
C) 0.92.
C -) 0.92.

The problem is just asking for the conditional probability of a defective widget given that it was produced
by the new machine. Since the widget was produced by the new machine and not selected from the
output randomly (if randomly selected, you would not know which machine produced the widget), we
know there is an 8% chance it is defective. Hence, the probability it is not defective is the complement,
1’8% = 92%.

This question tested from Session 2, Reading 8, LOS c.

2.A very large company has twice as many male employees relative to female employees. If a random
sample of four employees is selected, what is the probability that all four employees selected are female?

A) 0.3333.
B) 0.0123.
C) 0.0625.
B - 0.0123.

Since there are twice as many male employees to female employees, P(male) = 2/3 and P(female) = 1/3.
Therefore, the probability of 4 successes†= (0.333)4 = 0.0123.

This question tested from Session 2, Reading 8, LOS f.

3.Given the following table about employees of a company based on whether they are smokers or
nonsmokers and whether or not they suffer from any allergies, what is the probability of both suffering
from allergies and not suffering from allergies?

Suffer from Don't Suffer from

Total
Allergies Allergies
 Smoker 35 25 60
Nonsmoker 55 185 240
Total 90 210 300
A) 0.00.
B) 0.50.
C) 1.00.
A-

These are mutually exclusive, so the joint probability is zero.

This question tested from Session 2, Reading 8, LOS f.

4.A Treasury bill, with 45 days until maturity, has an effective annual yield of 12.50%. The bill's holding
period yield is closest to:

A) 1.57%.
B) 1.54%.
C) 1.46%.
C -) 1.46%.

The effective annual yield (EAY) is equal to the annualized holding period yield (HPY) based on a 365-
day year. EAY = (1 + HPY)365/t − 1. HPY = (EAY + 1)t/365 − 1 = (1.125)45/365 − 1 = 1.46%.

This question tested from Session 2, Reading 6, LOS f.

5.An investor is considering investing in Tawari Company for one year. He expects to receive $2 in
dividends over the year and feels he can sell the stock for $30 at the end of the year. To realize a return
on the investment over the year of 14%, the price the investor would pay for the stock today is closest to:

A) $29.
B) $28.
C) $32.
B - $28.

HPR = [Dividend + (Ending price − Beginning price)] / Beginning price

0.14 = [2 + (30 − P)] / P

1.14P = 32 so P = $28.07

This question tested from Session 2, Reading 6, LOS c.

6.Each lottery ticket discloses the odds of winning. These odds are based on:
 A) past lottery history.
B) a priori probability.
C) the best estimate of the Department of Gaming.
B - a priori probability.

An a priori probability is based on formal reasoning rather than on historical results or subjective opinion.

This question tested from Session 2, Reading 8, LOS b.

7.According to Chebyshev’s Inequality, for any distribution, what is the minimum percentage of
observations that lie within three standard deviations of the mean?

A) 89%.
B) 94%.
C) 75%.
A-

According to Chebyshev’s Inequality, for any distribution, the minimum percentage of observations that lie
within k standard deviations of the distribution mean is equal to: 1’(1 / k2). If k = 3, then the percentage of
distributions is equal to 1’(1 / 9) = 89%.

This question tested from Session 2, Reading 7, LOS h.

8.A recent ad for a Roth IRA includes the statement that if a person invests $500 at the beginning of each
month for 35 years, they could have $1,000,000 for retirement. Assuming monthly compounding, what
annual interest rate is implied in this statement?

A) 7.411%.
B) 7.625%.
C) 6.988%.
A-

Solve for an annuity due with a future value of $1,000,000, a number of periods equal to (35 × 12) = 420,
payments = -500, and present value = 0. Solve for i. i = 0.61761 × 12 = 7.411% stated annually. Don’t
forget to set your calculator for payments at the beginning of the periods. If you don’t, you’ll get 7.437%.

This question tested from Session 2, Reading 5, LOS f.

9.The following table summarizes the availability of trucks with air bags and bucket seats at a dealership.

Bucket Seats No Bucket Seats Total

 Air Bags 75 50 125Â
 No Air Bags 35 60 95
Â Total 110 110 220

What is the probability of selecting a truck at random that has either air bags or bucket seats?

A) 34%.
B) 107%.
C) 73%.
C -) 73%.

The addition rule for probabilities is used to determine the probability of at least one event among two or
more events occurring. The probability of each event is added and the joint probability (if the events are
not mutually exclusive) is subtracted to arrive at the solution. P(air bags or bucket seats) = P(air bags) +
P(bucket seats) − P(air bags and bucket seats) = (125 / 220) + (110 / 220) − (75 / 220) = 0.57 + 0.50 −
0.34 = 0.73 or 73%.

Alternative: 1 − P(no airbag and no bucket seats) = 1 − (60 / 220) = 72.7%

This question tested from Session 2, Reading 8, LOS f.

10.An investor has two stocks, Stock R and Stock S in her portfolio. Given the following information on
the two stocks, the portfolio's standard deviation is closest to:

 σR = 34%
 σS = 16%
 rR,S = 0.67
 WR = 80%
 WS = 20%

A) 29.4%.
B) 7.8%.
C) 8.7%.
A-

The formula for the standard deviation of a 2-stock portfolio is:

s = [W A2sA2 + W B2sB2 + 2W AW BsAsBrA,B]1/2

s = [(0.82 × 0.342) + (0.22 × 0.162) + (2 × 0.8 × 0.2 × 0.34 × 0.16 × 0.67)]1/2 = [0.073984 + 0.001024 +
0.0116634]1/2 = 0.08667141/2 = 0.2944, or approximately 29.4%.

This question tested from Session 2, Reading 8, LOS l.

11.What is the compound annual growth rate for stock A which has annual returns of 5.60%, 22.67%, and
-5.23%?

A) 6.00%.
 B) 7.08%.
C) 8.72%.
B - 7.08%.

Compound annual growth rate is the geometric mean. (1.056 × 1.2267 × 0.9477)1/3’1 = 7.08%

This question tested from Session 2, Reading 7, LOS e.

12.The mean monthly return on U.S. Treasury bills (T-bills) is 0.42%. The mean monthly return for an
index of small stocks is 4.56%, with a standard deviation of 3.56%. What is the Sharpe measure for the
index of small stocks?

A) 16.56%.
B) 10.60%.
C) 1.16%.
C -) 1.16%.

The Sharpe ratio measures excess return per unit of risk. (4.56’0.42) / 3.56 = 1.16%.

This question tested from Session 2, Reading 7, LOS i.

13.Use the results from the following survey of 500 firms to answer the question.

Number of Employees Frequency

300 up to 400 40
400 up to 500 62
500 up to 600 78
600 up to 700 101
700 up to 800 131
800 up to 900 88

The frequency of the third class is:

A) 78.
B) 180.
C) 156.
A-

The third class is 500 - 600 with a frequency of 78.

This question tested from Session 2, Reading 7, LOS b.

14.Assume that the following returns are a sample of annual returns for firms in the clothing industry.
Given the following sample of returns, what are the sample variance and standard deviation respectively?

Firm 1 Firm 2 Firm 3 Firm 4 Firm 5

15% 2% 5% (7%) 0%
64.5;
A)
8.0.
51.6;
B)
7.2.
32.4;
C)
5.7.
A-

The sample variance is found by taking the sum of all squared deviations from the mean and dividing by
(n − 1). [(15 − 3)2 + (2 − 3)2 + (5 − 3)2 + (-7 − 3)2 + (0 − 3)2] / (5 − 1) = 64.5

The sample standard deviation is found by taking the square root of the sample variance. √64.5 = 8.03

This question tested from Session 2, Reading 7, LOS g.

15.A broker calls with a proposal to buy a Treasury bill (T-bill) with 186 days to maturity. He says the
effective annual yield on the T-bill is 4.217%. What is the holding period yield if you hold the bill until
maturity?

A) 8.44%.
B) 2.02%.
C) 2.13%.
C -) 2.13%.

To calculate the HPY from the EAY, the formula is: (1 + EAY)(t/365) − 1. Therefore, the HPY is:
(1.04217)(186/365) − 1 = 0.0213, or 2.13%.

This question tested from Session 2, Reading 6, LOS f.

16.Which of the following is NOT a problem with the internal rate of return (IRR)?

A) Non-normal cash flow patterns may result in multiple IRRs.

B) A higher IRR does not necessarily indicate a more-profitable project.
C) Sometimes the IRR exceeds the cost of capital.
C -) Sometimes the IRR exceeds the cost of capital.

If the IRR exceeds the cost of capital, that merely indicates that the project is acceptablethis is not a
problem associated with IRR. Non-normal cash flow patterns such as cash outflows during the project's
life can result in multiple IRRs, leaving open the question as to which one is valid. A higher IRR will only
be realized if the project’s cash flows can be reinvested at the IRR, and the true profitability of a project
also depends on project size, not just IRR.
This question tested from Session 2, Reading 6, LOS b.

17.Which of the following statements about the arithmetic mean is least accurate?

A) If the distribution is skewed to the left then the mean will be greater than the median.
The arithmetic mean of a frequency distribution is equal to the sum of the class frequency
B)
times the midpoint of the frequency class all divided by the number of observations.
The arithmetic mean is the only measure of central tendency where the sum of the deviations
C)
of each observation from the mean is always zero.
A-

If the distribution is skewed to the left, then the mean will be less than the median.

This question tested from Session 2, Reading 7, LOS e.

18.The weights and returns for individual positions in a portfolio are shown below:

Position Mkt. Value at 1/1/05($MM) Return for 2005(%)

A 1.3 2.0
B 1.4 4.2
C 2.2 +6.4
D 3.9 +2.1
E 1.7 0.8

What is the return on the portfolio?

A) +1.50%.
B) +1.18%.
C) -1.20%.
B - +1.18%.

The return is equal to sum of the products of each position’s value and return divided by the beginning
portfolio value.

Position Mkt. Value at Return for 2005(%) Position Value × Return ($MM)
1/1/05($MM)
A 1.30 2.0 -0.0260
B 1.40 4.2 -0.0588
C 2.20 +6.4 0.1408
D 3.90 +2.1 0.0819
E 1.70 0.8 -0.0136
Total 10.50 Â 0.1243
0.1243 / 10.5($MM) = +1.1838%

This question tested from Session 2, Reading 7, LOS g.

19.Natalie Brunswick, neurosurgeon at a large U.S. university, was recently granted permission to take
an 18-month sabbatical that will begin one year from today. During the sabbatical, Brunswick will need
$2,500 at the beginning of each month for living expenses that month. Her financial planner estimates
that she will earn an annual rate of 9% over the next year on any money she saves. The annual rate of
return during her sabbatical term will likely increase to 10%. At the end of each month during the year
before the sabbatical, Brunswick should save approximately:

A) $3,356.
B) $3,505.
C) $3,330.
A-

This is a two-step problem. First, we need to calculate the present value of the amount she needs over
her sabbatical. (This amount will be in the form of an annuity due since she requires the payment at the
beginning of the month.) Then, we will use future value formulas to determine how much she needs to
save each month (ordinary annuity).

Step 1:Â Calculate present value of amount required during the sabbatical

Using a financial calculator: Set to BEGIN Mode, then N = 12 × 1.5 = 18; I/Y = 10 / 12 = 0.8333; PMT =
2,500; FV = 0; CPT → PV = 41,974

Step 2:Â Calculate amount to save each month

Make sure the calculator is set to END mode, then N = 12; I/Y = 9 / 12 = 0.75; PV = 0; FV = 41,974;
CPT → PMT = -3,356

This question tested from Session 2, Reading 5, LOS f.

20.Peter Wallace wants to deposit $10,000 in a bank certificate of deposit (CD). Wallace is considering
the following banks:Â

 Bank A offers 5.85% annual interest compounded annually.

 Bank B offers 5.75% annual interest rate compounded monthly.
 Bank C offers 5.70% annual interest compounded daily.

Which bank offers the highest effective interest rate and how much?

A) Bank A, 5.85%.
B) Bank C, 5.87%.
C) Bank B, 5.90%.
C -) Bank B, 5.90%.

Effective interest rates:

Bank A = 5.85 (already annual compounding)

Bank B, nominal = 5.75; C/Y = 12; effective = 5.90

Bank C, nominal = 5.70, C/Y = 365; effective = 5.87

Hence Bank B has the highest effective interest rate.

This question tested from Session 2, Reading 5, LOS c.

21.An investor has the choice of two investments. Investment A offers interest at 7.25% compounded
quarterly. Investment B offers interest at the annual rate of 7.40%. Which investment offers the higher
dollar return on an investment of $50,000 for two years, and by how much?

A) Investment B offers a $36.92 greater return.

B) Investment A offers a $122.18 greater return.
C) Investment A offers a $53.18 greater return.
C -) Investment A offers a $53.18 greater return.

Investment A: I = 7.25 / 4; N = 2 × 4 = 8; PV = $50,000; PMT = 0; CPT → FV = $57,726.98

Investment B: I = 7.40; N = 2; PV = $50,000; PMT = 0; CPT → FV = $57,673.80
Difference = investment A offers a $53.18 greater dollar return.

This question tested from Session 2, Reading 5, LOS f.

22.

Justin Banks just won the lottery and is trying to decide between the annual cash flow payment option or
the lump sum option. He can earn 8% at the bank and the annual cash flow option is $100,000/year,
beginning today for 15 years. What is the annual cash flow option worth to Banks today?

A) $924,423.70.
B) $855,947.87.
C) $1,080,000.00.
A-

First put your calculator in the BGN.

N = 15; I/Y = 8; PMT = 100,000; CPT → PV = 924,423.70.

Alternatively, do not set your calculator to BGN, simply multiply the ordinary annuity (end of the period
payments) answer by 1 + I/Y. You get the annuity due answer and you don’t run the risk of forgetting to
reset your calculator back to the end of the period setting.

OR N = 14; I/Y = 8; PMT = 100,000; CPT → PV = 824,423.70 + 100,000 = 924,423.70.

This question tested from Session 2, Reading 5, LOS e.

23.

A T-bill with a face value of $100,000 and 140 days until maturity is selling for $98,000. What is the bank
discount yield?

A) 5.41%.
B) 5.14%.
C) 4.18%.
B - 5.14%.

Actual discount is 2%, annualized discount is: 0.02(360 / 140) = 5.14%

This question tested from Session 2, Reading 6, LOS e.

24

Which of the following statements about probability is most accurate?

A) An event is a set of one or more possible values of a random variable.

B) An outcome is the calculated probability of an event.
C) A conditional probability is the probability that two or more events will happen concurrently.
A-

Conditional probability is the probability of one event happening given that another event has happened.
An outcome is the numerical result associated with a random variable.

This question tested from Session 2, Reading 8, LOS a.

25.Claude Bellow, CFA, is an analyst with a real-estate focused investment firm. Today, one of the
partners e-mails Bellow the following table and requests that he run some numbers.†The table below
gives five years of annual returns for Marley REIT (real estate investment trust) and a large urban
apartment building. Marley REIT invests in commercial properties. (Note: For this question, calculate the
mean returns using the arithmetic mean.)

Table 1: Annual returns (in %)

Asset Year 1 Year 2 Year 3 Year 4 Year 5
Marley REIT 15.0 8.0 13.0 9.0 13.0
Apartment Bldg 10.0 -1.0 8.0 8.0 9.0

One of the office assistants begins to run some numbers,†but is then called away to an important
meeting. So far, the assistant calculated the variance of the apartment building returns at 15.76%. (He
assumed that the returns given represent the entire population of returns.) Now, Bellow must finish the
work.

Bellow should conclude that the standard deviation of the:

 A) apartment building, if the given returns represent a sample of returns, is 19.70%.
B) REIT, assuming the given returns represent the entire population, is 2.97%.
C) apartment building, if the given returns represent a sample of returns, is 4.44%.
C -) apartment building, if the given returns represent a sample of returns, is 4.44%.

Suggested Strategy: Since you will have approximately 1.5 minutes for each question and this question
appears very calculation intensive, it is likely that there is a trick.†Here, start with the apartment
building because the labor-intensive part of the calculation has been completed. Remember that the
standard deviation is the square root of the variance and that both the formula for the population variance
and the formula for the sample variance have the same numerator (the sum of the squared result of the
observation less the mean). The denominator of the population variance is the entire data set n, (5 here).
The denominator of the sample variance is n-1, (or 4 here).

Thus, the population variance = (the sum of the square result of the observation less the mean) / number
of observations. Here, 15.76 = x / 5, x = 78.80.

So, the sample variance = 78.80 / 4 = 19.70, and the sample standard deviation = 19.701/2 = 4.44%.

Both remaining statements are incorrect. FYI, the calculations for the REIT are as follows:

 Mean = (15 + 8 + 13 + 9 + 13) / 5 = 11.6

 (The sum of the observation less the mean)2 = [(15-11.6)2 + (8’11.6)2 + (13’11.6)2 + (9’11.6)2 +
(13’11.6)2]Â = 35.2
 The population standard deviation = [(35.2 / 5.0)]1/2 = [7.04]1/2 = 2.65%
 The sample standard deviation = [(35.2 / 4.0)]1/2 = [8.80]1/2 = 2.97%

This question tested from Session 2, Reading 7, LOS g.

26.As the number of compounding periods increases, what is the effect on the EAR? EAR:

A) increases at an increasing rate.

B) increases at a decreasing rate.
C) does not increase.
B - increases at a decreasing rate.

There is an upper limit to the EAR as the frequency of compounding increases. In the limit, with
continuous compounding the EAR = eAPR 1. Hence, the EAR increases at a decreasing rate.

This question tested from Session 2, Reading 5, LOS c.

27.

Robert Mackenzie, CFA, buys 100 shares of GWN Breweries each year for four years at prices of C$10,
C$12, C$15 and C$13 respectively. GWN pays a dividend of C$1.00 at the end of each year. One year
after his last purchase he sells all his GWN shares at C$14. Mackenzie calculates his average cost per
share as [(C$10 + C$12 + C$15 + C$13) / 4] = C$12.50. Mackenzie then uses the internal rate of return
technique to calculate that his money-weighted annual rate of return is 12.9%. Has Mackenzie correctly
determined his average cost per share and money-weighted rate of return?
 Money-weighted
< >> Average cost
return
A) Incorrect Correct
B) Correct Correct
C) Correct Incorrect
B-
Correct Correct

Because Mackenzie purchased the same number of shares each year, the arithmetic mean is appropriate
for calculating the average cost per share. If he had purchased shares for the same amount of money
each year, the harmonic mean would be appropriate. Mackenzie is also correct in using the internal rate
of return technique to calculate the money-weighted rate of return. The calculation is as follows:

Time Purchase/Sale Dividend Net cash flow

0 -1,000 0 -1,000
1 -1,200 +100 -1,100
2 -1,500 +200 -1,300
3 -1,300 +300 -1,000
4 400 × 14 = +5,600 +400 +6,000

CF0 = −1,000; CF1 = −1,100; CF2 = −1,300; CF3 = −1,000; CF4 = 6,000; CPT → IRR = 12.9452.

This question tested from Session 2, Reading 6, LOS d.

28.

The probability of A is 0.4. The probability of AC is 0.6. The probability of (B | A) is 0.5, and the probability
of (B | AC) is 0.2. Using Bayes’ formula, what is the probability of (A | B)?

A) 0.125.
B) 0.625.
C) 0.375.
B - 0.625.

Using the total probability rule, we can compute the P(B):

P(B) = [P(B | A) × P(A)] + [P(B | AC) × P(AC)]
P(B) = [0.5 × 0.4] + [0.2 × 0.6] = 0.32

Using Bayes’ formula, we can solve for P(A | B):

P(A | B) = [ P(B | A) ÷ P(B) ] × P(A) = [0.5 ÷ 0.32] × 0.4 = 0.625

This question tested from Session 2, Reading 8, LOS n.

29.
What is the yield on a discount basis for a Treasury bill priced at $97,965 with a face value of $100,000
that has 172 days to maturity?

A) 2.04%.
B) 4.26%.
C) 3.95%.
B - 4.26%.

($2,035 / $100,000) × (360 / 172) = 0.04259 = 4.26% = bank discount yield.

This question tested from Session 2, Reading 6, LOS e.

30.

There is a 30% chance that the economy will be good and a 70% chance that it will be bad. If the
economy is good, your returns will be 20% and if the economy is bad, your returns will be 10%. What is
your expected return?

A) 13%.
B) 17%.
C) 15%.
A-

Expected value is the probability weighted average of the possible outcomes of the random variable. The
expected return is: ((0.3) × (0.2)) + ((0.7) × (0.1)) = (0.06) + (0.07) = 0.13.

This question tested from Session 2, Reading 8, LOS l.

31.

A nursery sells trees of different types and heights. Suppose that 75 trees chosen at random are sold for
planting at City Hall. These 75 trees average 60 inches in height with a standard deviation of 16 inches.

Using this information, construct a 95% confidence interval for the mean height of all trees in the nursery.

A) 60 + 1.96(1.85).
B) 60 + 1.96(16).
C) 0.8 + 1.96(16).
A-

Because the sample size is sufficiently large, we can use the z-statistic. A 95% confidence level is
constructed by taking the population mean and adding and subtracting the product of the z-statistic
reliability factor (zα/2) times the standard error of the sample mean: x ± zα/2 × ( s / n1/2) = 60 ± (1.96)
× (16 / 751/2) = 60 ± (1.96) × (16 / 8.6603) = 60 ± (1.96) × (1.85).

This question tested from Session 3, Reading 10, LOS j.

32.

If the threshold return is higher than the risk-free rate, what will be the relationship between Roy’s safety-
first ratio (SF) and Sharpe’s ratio?

A) The SF ratio may be higher or lower depending on the standard deviation.

B) The SF ratio will be higher.
C) The SF ratio will be lower.
C -) The SF ratio will be lower.

Since each ratio has the standard deviation of returns in the denominator, the difference depends upon
the effect on the numerator. Since both the risk-free rate (in the Sharpe ratio) and the threshold rate (in
the SF ratio) are subtracted from the expected return, a larger threshold rate would result in a smaller SF
ratio value.

This question tested from Session 3, Reading 9, LOS n.

33.

Claude Bellow, CFA, is an analyst with a real-estate focused investment firm. Today, one of the partners
e-mails Bellow the following table and requests that he look into the reward-to-variability ratios of two
asset classes. The table below gives five years of annual returns for Marley REIT (real estate investment
trust) and a large urban apartment building. Marley REIT invests in commercial properties. The risk-free
rate is 5.0% and the firm’s threshold rate for this type is investment is 5.7%. (Note: For this question,
calculate the mean returns using the arithmetic mean.)

Table 1: Annual returns (in %)

Asset Year 1 Year 2 Year 3 Year 4 Year 5
Marley REIT 15.0 8.0 13.0 9.0 13.0
Apartment Bldg 10.0 -1.0 8.0 8.0 9.0

One of the office assistants begins to run some numbers,†but is then called away to an important
meeting. So far, the assistant has calculated the standard deviation of the apartment building returns at
3.97% and the standard deviation of the REIT returns at 2.65%. (He assumed that the returns given
represent the entire population of returns.) Now, Bellow must finish the work.

Bellow should conclude that the:

A) safety-first ratio for the REIT is 2.49.

REIT has a higher excess return per unit of risk than the apartment building has per unit of
B)
risk.
partner is asking Bellow to select the investment with the minimal probability that the return
C)
falls below 5.70%.
B - REIT has a higher excess return per unit of risk than the apartment building has per unit of risk.

Another name for the reward-to-variability ratio is the Sharpe ratio, and the Sharpe ratio measures the
excess return per unit of risk. So, the question is asking us to identify which investment has the highest
Sharpe ratio. The formula is:
The Sharpe Ratio measures the excess return per unit of risk.

For the apartment building:

 The standard deviation of apartment building returns is 3.97%.

 The mean expected return of the apartment building = (10 − 1 + 8 + 8 + 9) / 5 = 6.8%
 Thus, the Sharpe RatioApt = (6.80% - 5.00%) / 3.97% = 0.45.

For the REIT:

 The standard deviation of the REIT returns is 2.65%.

 The mean expected return of the REIT = (15 + 8 + 13 + 9 + 13) / 5 = 11.6%
 Thus, the Sharpe RatioREIT = (11.60% − 5.00%) / 2.65% = 2.49.

Thus, the REIT has a higher Sharpe ratio and thus a higher excess return per unit of risk than the
apartment building has per unit of risk. Investors prefer a large Sharpe ratio because it is assumed that
they prefer return to risk.

The other statements are false. Remember that the partner asked about the reward-to-variability ratio.
The safety-first ratio is very similar to the Sharpe ratio, except that the safety-first ratio replaces the risk-
free rate term with the threshold rate. Thus, the safety-first ratio for the REIT = [(11.6% − 5.7%) / 2.65%] =
2.23. If the partner had asked about the safety-first ratio, he would have been asking Bellow to select the
investment with the minimal probability that the return falls below 5.70%. As shown in the calculation of
the REIT Sharpe Ratio, the REIT’s excess return over the risk free rate = 11.6% − 5.0% = 6.60%.

This question tested from Session 3, Reading 9, LOS n.

34.

What kind of test is being used for the following hypothesis and what would a z-statistic of 1.68 tell us
about a hypothesis with the appropriate test and a level of significance of 5%, respectively?

H0: B ≤ 0
HA: B > 0

A) One-tailed test; fail to reject the null.

B) One-tailed test; reject the null.
C) Two-tailed test; fail to reject the null.
B - One-tailed test; reject the null.

The way the alternative hypothesis is written you are only looking at the right side of the distribution. You
are only interested in showing that B is greater than 0. You don't care if it is less than zero. For a one-
tailed test at the 5% level of significance, the critical z value is 1.645. Since the test statistic of 1.68 is
greater than the critical value we would reject the null hypothesis.

This question tested from Session 3, Reading 11, LOS b.

35.

If a stock decreases from $90 to $80, the continuously compounded rate of return for the period is:

A) -0.1250.
B) -0.1000.
C) -0.1178.
C -) -0.1178.

This is given by the natural logarithm of the new price divided by the old price; ln(80 / 90) = -0.1178.

This question tested from Session 3, Reading 9, LOS p.

36.

Consider a random variable X that follows a continuous uniform distribution: 7 ≤ X ≤ 20. Which of the
following statements is least accurate?

A) F(12 ≤ X ≤ 16) = 0.307.

B) F(21) = 0.00.
C) F(10) = 0.23.
B - F(21) = 0.00.

F(21) = 1.00 The probability density function for a continuous uniform distribution is calculated as follows:
F(X) = (X’a) / (b’a), where a and b are the lower and upper endpoints, respectively. (If the given X is
greater than the upper limit, the probability is 1.0.) Shortcut: If you know the properties of this function,
you do not need to do any calculations to check the other choices.

The other choices are true.

 F(10) = (10’7) / (20’7) = 3 / 13 = 0.23

 F(12 ≤ X ≤ 16) = F(16)’F(12) = [(16’7) / (20’7)] − [(12’7) / (20’7)] = 0.692 − 0.385 = 0.307

This question tested from Session 3, Reading 9, LOS i.

37.

A local high school basketball team had 18 home games this season and averaged 58 points per game. If
we assume that the number of points made in home games is normally distributed, which of the following
is most likely the range of points for a confidence interval of 90%?

A) 24 to 78.
 B) 34 to 82.
C) 26 to 80.
B - 34 to 82.

This question has a bit of a trick. To answer this question, remember that the mean is at the midpoint of
the confidence interval. The correct confidence interval will have a midpoint of 58. (34 + 82) / 2 = 58.

This question tested from Session 3, Reading 10, LOS j.

38

Which of the following statements about hypothesis testing is most accurate?

A Type I error is rejecting the null hypothesis when it is true, and a Type II error is accepting
A)
the alternative hypothesis when it is false.
When the critical Z-statistic is greater than the sample Z-statistic in a two-tailed test, reject the
B)
null hypothesis and accept the alternative hypothesis.
A hypothesized mean of 3, a sample mean of 6, and a standard error of the sampling means
C)
of 2 give a sample Z-statistic of 1.5.
C -) A hypothesized mean of 3, a sample mean of 6, and a standard error of the sampling means of 2
give a sample Z-statistic of 1.5.

Z = (6 - 3)/2 = 1.5. A Type II error is wrongly accepting the null hypothesis. The null hypothesis should be
rejected when the sample Z-statistic is greater than the critical Z-statistic.

This question tested from Session 3, Reading 11, LOS c.

39.

In addition to the usual parameters that describe a normal distribution, to completely describe 10 random
variables, a multivariate normal distribution requires knowing the:

A) overall correlation.
B) 45 correlations.
C) 10 correlations.
B - 45 correlations.

The number of correlations in a multivariate normal distribution of n variables is computed by the formula
((n) × (n-1)) / 2, in this case (10 × 9) / 2 = 45.

This question tested from Session 3, Reading 9, LOS k.

40.

In order to test if the mean IQ of employees in an organization is greater than 100, a sample of 30
employees is taken. The sample value of the computed z-statistic = 3.4. The appropriate decision at a 5%
significance level is to:
 A) reject the null hypotheses and conclude that the population mean is greater than 100.
B) reject the null hypothesis and conclude that the population mean is not equal to 100.
C) reject the null hypothesis and conclude that the population mean is equal to 100.
A-

Ho:µ ≤ 100; Ha: µ > 100. Reject the null since z = 3.4 > 1.65 (critical value).

This question tested from Session 3, Reading 11, LOS g.

41.

A survey is taken to determine whether the average starting salaries of CFA charterholders is equal to or
greater than $62,500 per year. What is the test statistic given a sample of 125 newly acquired CFA
charterholders with a mean starting salary of $65,000 and a standard deviation of $2,600?

A) -10.75.
B) 10.75.
C) 0.96.
B - 10.75.

With a large sample size (125) and an unknown population variance, either the t-statistic or the z-statistic
could be used. Using the z-statistic, it is calculated by subtracting the hypothesized parameter from the
parameter that has been estimated and dividing the difference by the standard error of the sample
statistic. The test statistic = (sample mean’hypothesized mean) / (sample standard deviation / (sample
size1/2)) = (X − µ) / (s / n1/2) = (65,000’62,500) / (2,600 / 1251/2) = (2,500) / (2,600 / 11.18) = 10.75.

This question tested from Session 3, Reading 11, LOS g.

42.A portfolio manager is looking at an investment that has an expected annual return of 10% with a
standard deviation of annual returns of 5%. Assuming the returns are approximately normally distributed,
the probability that the return will exceed 20% in any given year is closest to:

A) 0.0%.
B) 4.56%.
C) 2.28%.
C -) 2.28%.

Given that the standard deviation is 5%, a 20% return is two standard deviations above the expected
return of 10%. Assuming a normal distribution, the probability of getting a result more than two standard
deviations above the expected return is 1 − Prob(Z ≤ 2) = 1 − 0.9772 = 0.0228 or 2.28% (from the Z
table).

This question tested from Session 3, Reading 9, LOS l.

43.Over a period of one year, an investor’s portfolio has declined in value from 127,350 to 108,427. What
is the continuously compounded rate of return?

A) -13.84%.
B) -16.09%.
C) -14.86%.
B - -16.09%.

The continuously compounded rate of return = ln( S1 / S0 ) = ln(108,427 / 127,350) = 16.09%.

This question tested from Session 3, Reading 9, LOS p.

44.Frank Grinder is trying to introduce sampling into the quality control program of an old-line
manufacturer. Currently, each item is individually inspected to make sure it meets size tolerances. For all
items manufactured during August, the standard deviation of size was 0.02 centimeters. If Grinder takes a
sample of 30 items and finds a standard deviation of size of 0.019 centimeters, what is the standard error
of the sample mean?

A) 0.00365.
B) 0.00200.
C) 0.00600.
A-

If we know the standard deviation of the population (in this case we do), then the standard error of the
sample mean = the standard deviation of the population / the square root of the sample size = 0.02 / √30
= 0.00365 centimeters.

This question tested from Session 3, Reading 10, LOS f.

45.For a certain class of junk bonds, the probability of default in a given year is 0.2. Whether one bond
defaults is independent of whether another bond defaults. For a portfolio of five of these junk bonds, what
is the probability that zero or one bond of the five defaults in the year ahead?

A) 0.0819.
B) 0.7373.
C) 0.4096.
B - 0.7373.

The outcome follows a binomial distribution where n = 5 and p = 0.2. In this case p(0) = 0.85 = 0.3277 and
p(1) = 5 × 0.84 × 0.2 = 0.4096, so P(X=0 or X=1) = 0.3277 + 0.4096.

This question tested from Session 3, Reading 9, LOS f.

46.
According to the Central Limit Theorem, the distribution of the sample means is approximately normal if:

A) the underlying population is normal.

B) the sample size n > 30.
C) the standard deviation of the population is known.
B - the sample size n > 30.

The Central Limit Theorem states that if the sample size is sufficiently large (i.e. greater than 30) the
sampling distribution of the sample means will be approximately normal.

This question tested from Session 3, Reading 10, LOS e.

47.A traffic engineer is trying to measure the effects of carpool-only lanes on the expressway. Based on a
sample of 100 cars at rush hour, he finds that the mean number of occupants per car is 2.5, and the
sample standard deviation is 0.4. What is the standard error of the sample mean?

A) 0.04.
B) 1.00.
C) 5.68.
A-

The standard error of the sample mean when the standard deviation of the population is not known is
estimated by the standard deviation of the sample divided by the square root of the sample size. In this
case, 0.4 / √100 = 0.04.

This question tested from Session 3, Reading 10, LOS f.

48.Which of the following statements about sampling and estimation is most accurate?

A confidence interval estimate consists of a range of values that bracket the parameter with a
A)
specified level of probability, 1 − β.
B) Time-series data are observations over individual units at a point in time.
A point estimate is a single estimate of an unknown population parameter calculated as a
C)
sample mean.
C -) A point estimate is a single estimate of an unknown population parameter calculated as a sample
mean.

Time-series data are observations taken at specific and equally-spaced points.

A confidence interval estimate consists of a range of values that bracket the parameter with a specified
level of probability, 1 − α.

This question tested from Session 3, Reading 10, LOS h.

49.
Frank Grinder is trying to introduce sampling into the quality control program of an old-line manufacturer.
Grinder samples 38 items and finds that the standard deviation in size is 0.019 centimeters. What is the
standard error of the sample mean?

A) 0.00204.
B) 0.00615.
C) 0.00308.
C -) 0.00308.

If we do not know the standard deviation of the population (in this case we do not), then we estimate the
standard error of the sample mean = the standard deviation of the sample / the square root of the sample
size = 0.019 / √38 = 0.00308 centimeters.

This question tested from Session 3, Reading 10, LOS f.

50.

Brandee Shoffield is the public relations manager for Night Train Express, a local sports team. Shoffield is
trying to sell advertising spots and wants to know if she can say with 90% confidence that average home
game attendance is greater than 3,000. Attendance is approximately normally distributed. A sample of the
attendance at 15 home games results in a mean of 3,150 and a standard deviation of 450. Which of the
following statements is most accurate?

A) The calculated test statistic is 1.291.

With an unknown population variance and a small sample size, no statistic is available to test
B)
Shoffield's hypothesis.
C) Shoffield should use a two-tailed Z-test.
A-

Here, we have a normally distributed population with an unknown variance (we are given only the sample
standard deviation) and a small sample size (less than 30.) Thus, we will use the t-statistic.

The test statistic = t = (3,150’3,000) / (450 / √ 15) = 1.291

This question tested from Session 3, Reading 11, LOS g.

51.Standardizing a normally distributed random variable requires the:

A) mean, variance and skewness.

B) natural logarithm of X.
C) mean and the standard deviation.
C -) mean and the standard deviation.

All that is necessary is to know the mean and the variance. Subtracting the mean from the random
variable and dividing the difference by the standard deviation standardizes the variable.

This question tested from Session 3, Reading 9, LOS m.

52.A Type II error:

A) fails to reject a true null hypothesis.

B) rejects a true null hypothesis.
C) fails to reject a false null hypothesis.
C -) fails to reject a false null hypothesis.

A Type II error is defined as accepting the null hypothesis when it is actually false. The chance of making
a Type II error is called beta risk.

This question tested from Session 3, Reading 11, LOS c.

53.Abby Ness is an analyst for a firm that specializes in evaluating firms involved in mineral extraction.
Ness believes that the earnings of copper extracting firms are more volatile than those of bauxite
extraction firms. In order to test this, Ness examines the volatility of returns for 31 copper firms and 25
bauxite firms. The standard deviation of earnings for copper firms was $2.69, while the standard deviation
of earnings for bauxite firms was $2.92. Ness’s Null Hypothesis is σ12 ≤ σ22. Based on the samples, can
we reject the null hypothesis at a 95% confidence level using an F-statistic and why? Null is:

A) not rejected. The critical value exceeds the F-value by 0.71.

B) rejected. The F-value exceeds the critical value by 0.849.
C) rejected. The F-value exceeds the critical value by 0.71.
A-

F = s12 / s22 = $2.922 / $2.692 = 1.18

From an F table, the critical value with numerator df = 24 and denominator df = 30 is 1.89.

This question tested from Session 3, Reading 11, LOS j.

54.Which of the following is the correct sequence of events for testing a hypothesis?

State the hypothesis, select the level of significance, compute the test statistic, formulate the
A)
decision rule, and make a decision.
State the hypothesis, select the level of significance, formulate the decision rule, compute the
B)
test statistic, and make a decision.
State the hypothesis, formulate the decision rule, select the level of significance, compute the
C)
test statistic, and make a decision.
B - State the hypothesis, select the level of significance, formulate the decision rule, compute the test
statistic, and make a decision.

Depending upon the author there can be as many as seven steps in hypothesis testing which are:

1. Stating the hypotheses.

 2. Identifying the test statistic and its probability distribution.
3. Specifying the significance level.
4. Stating the decision rule.
5. Collecting the data and performing the calculations.
6. Making the statistical decision.
7. Making the economic or investment decision.

This question tested from Session 3, Reading 11, LOS b.

55.An investment has a mean return of 15% and a standard deviation of returns equal to 10%. If returns
are normally distributed, which of the following statements is least accurate? The probability of obtaining
a return:

A) greater than 25% is 0.32.

B) between 5% and 25% is 0.68.
C) greater than 35% is 0.025.
A-

Sixty-eight percent of all observations fall within +/- one standard deviation of the mean of a normal
distribution. Given a mean of 15 and a standard deviation of 10, the probability of having an actual
observation fall within one standard deviation, between 5 and 25, is 68%. The probability of an
observation greater than 25 is half of the remaining 32%, or 16%. This is the same probability as an
observation less than 5. Because 95% of all observations will fall within 20 of the mean, the probability of
an actual observation being greater than 35 is half of the remaining 5%, or 2.5%.

This question tested from Session 3, Reading 9, LOS l.

56.

Which of the following portfolios provides the optimal safety first†return if the minimum acceptable
return is 9%?

Portfolio Expected Return (%) Standard Deviation (%)

1 13 5
2 11 3
3 9 2
A) 2.
B) 1.
C) 3.
B - 1.

Roy’s safety-first criterion requires the maximization of the SF Ratio:

SF Ratio = (expected return’threshold return) / standard deviation

Portfolio Expected Return (%) Standard Deviation (%) SF Ratio

1 13 5 0.80
2 11 3 0.67
 3 9 2 0.00

Portfolio #1 has the highest safety-first ratio at 0.80.

This question tested from Session 3, Reading 9, LOS n.

57.A random variable follows a continuous uniform distribution over 27 to 89. What is the probability of an
outcome between 34 and 38?

A) 0.0546.
B) 0.0719.
C) 0.0645.
C -) 0.0645.

P(34 ≤ X ≤ 38) = (38 − 34) / (89 − 27) = 0.0645

This question tested from Session 3, Reading 9, LOS i.

58.Monthly sales of hot water heaters are approximately normally distributed with a mean of 21 and a
standard deviation of 5. What is the probabilility of selling 12 hot water heaters or less next month?

A) 3.59%.
B) 1.80%.
C) 96.41%.
A-

Z = (12’21) / 5 = -1.8

From the cumulative z-table, the probability of being more than 1.8 standard deviations below the mean,
probability x < -1.8, is 3.59%.

This question tested from Session 3, Reading 9, LOS m.

59.A traffic engineer is trying to measure the effects of carpool-only lanes on the expressway. Based on a
sample of 20 cars at rush hour, he finds that the mean number of occupants per car is 2.5, with a
standard deviation of 0.4. If the population is normally distributed, what is the confidence interval at the
5% significance level for the number of occupants per car?

A) 2.387 to 2.613.
B) 2.313 to 2.687.
C) 2.410 to 2.589.
B - 2.313 to 2.687.
The reliability factor corresponding with a 5% significance level (95% confidence level) for the Student’s t-
distribution with (20 − 1) degrees of freedom is 2.093. The confidence interval is equal to: 2.5 ±
2.093(0.4 / √20) = 2.313 to 2.687. (We must use the Student’s t-distribution and reliability factors because
of the small sample size.)

This question tested from Session 3, Reading 10, LOS j.

60.

The table below is for five samples drawn from five separate populations. The far left columns give
information on the population distribution, population variance, and sample size. The right-hand columns
give three choices for the appropriate tests: z = z-statistic, and t = t-statistic. None†means that a test
statistic is not available.

Sampling From Test Statistic Choices

Distribution Variance n One Two Three
Non-normal 0.75 100 z z z
Normal 5.60 75 z z z
Non-normal n/a 15 t t none
Normal n/a 18 t t t
Non-normal 14.3 15 z t none

Which set of test statistic choices (One, Two, or Three) matches the correct test statistic to the sample for
all five samples?

A) Three.
B) One.
C) Two.
A-

For the exam: COMMIT THE FOLLOWING TABLE TO MEMORY!

When you are sampling from a: and the sample size is small, and the sample size is large,
use a: use a:
Normal distribution with a known variance z-statistic z-statistic
Normal distribution with an unknown
t-statistic t-statistic
variance
Nonnormal distribution with a known
not available z-statistic
variance
Nonnormal distribution with an unknown
not available t-statistic
variance

This question tested from Session 3, Reading 11, LOS g.