📘 CFA Level 1 Equity Investments – Part 4 (Q151–200)
Q151. Which of the following is a key assumption of the Dividend Discount Model (DDM)?
A) Dividends grow at a variable rate indefinitely
B) Dividends grow at a constant rate indefinitely
C) Price-to-earnings ratio remains constant
D) Company maintains constant profit margins
✅ Answer: B
📘 Explanation: The DDM assumes that dividends grow at a constant rate (g) indefinitely, making it suitable for stable, mature companies.
Q152. According to the Efficient Market Hypothesis (EMH), which form assumes that stock prices already reflect all public and private information?
A) Weak form
B) Semi-strong form
C) Strong form
D) Rational form
✅ Answer: C
📘 Explanation: The strong form of EMH asserts that stock prices reflect all information (public + insider). However, evidence shows insider information can still yield abnormal returns.
Q153. A stock has an expected return of 12%, a risk-free rate of 4%, and a beta of 1.2. What is the implied market return according to CAPM?
A) 10%
B) 11%
C) 12%
D) 14%
✅ Answer: A
📘 Explanation:
CAPM: E(R)=Rf+β(Rm−Rf)E(R) = R_f + \beta (R_m – R_f)E(R)=Rf+β(Rm−Rf)
12% = 4% + 1.2(Rm – 4%)
8% = 1.2(Rm – 4%) → Rm – 4% = 6.67% → Rm = 10.67% ≈ 10%
Q154. Sector rotation strategies are most commonly associated with:
A) Technical analysis
B) Business cycle investing
C) Random walk theory
D) Bond arbitrage
✅ Answer: B
📘 Explanation: Sector rotation strategies exploit business cycles, shifting investment between cyclical and defensive sectors depending on expected economic conditions.
Q155. Which valuation model is most appropriate for valuing non-dividend-paying companies?
A) Gordon Growth Model
B) Free Cash Flow to Equity (FCFE) Model
C) Dividend Discount Model
D) CAPM
✅ Answer: B
📘 Explanation: For firms that do not pay dividends, analysts use FCFE or DCF models instead of dividend-based approaches.
Q156. Which of the following best explains price-to-book ratio (P/B)?
A) Current stock price ÷ Dividend per share
B) Current stock price ÷ Earnings per share
C) Current stock price ÷ Book value per share
D) Current stock price ÷ Sales per share
✅ Answer: C
📘 Explanation: P/B ratio compares the market price of equity to its book value, often used for value investing.
Q157. Which behavioral bias occurs when investors continue to hold a losing stock, hoping it will rebound?
A) Overconfidence bias
B) Disposition effect
C) Herding bias
D) Recency bias
✅ Answer: B
📘 Explanation: The disposition effect describes investors’ tendency to sell winners too early but hold losers too long.
Q158. An ETF that tracks the S&P 500 is best classified as:
A) Actively managed fund
B) Market-cap weighted index fund
C) Equal-weighted index fund
D) Hedge fund strategy
✅ Answer: B
📘 Explanation: S&P 500 ETFs are passive, market-cap weighted index funds, tracking the performance of the index.
Q159. Which of the following is an advantage of ETFs compared to mutual funds?
A) Higher expense ratios
B) Limited intraday liquidity
C) Tax efficiency and intraday trading
D) Lack of diversification
✅ Answer: C
📘 Explanation: ETFs are more tax-efficient than mutual funds and allow intraday trading like stocks, offering flexibility and lower costs.
Q160. Which stock pricing model incorporates both systematic and unsystematic risk?
A) CAPM
B) Arbitrage Pricing Theory (APT)
C) Dividend Discount Model
D) Efficient Market Hypothesis
✅ Answer: B
📘 Explanation: Unlike CAPM (systematic only), APT considers multiple risk factors, capturing both systematic and industry-specific risks.
Q161. Which valuation approach is most useful for valuing start-up companies?
A) Dividend Discount Model
B) Price-to-Earnings Ratio
C) Free Cash Flow to Firm (FCFF)
D) Residual Income Model
✅ Answer: C
📘 Explanation: Start-ups rarely pay dividends or have stable earnings. FCFF is widely used because it values based on operating cash flows.
Q162. Which of the following is considered a leading economic indicator affecting equity markets?
A) Consumer Price Index (CPI)
B) Industrial Production Index
C) Stock Market Returns
D) Unemployment Rate
✅ Answer: C
📘 Explanation: Stock market returns themselves are considered leading indicators, reflecting investor expectations of future economic conditions.
Q163. Which statement best describes book-to-market ratio?
A) Inverse of P/B ratio
B) Inverse of P/E ratio
C) Measure of profitability
D) Market capitalization ÷ Earnings
✅ Answer: A
📘 Explanation: Book-to-market ratio = Book Value ÷ Market Price, which is the inverse of the P/B ratio.
Q164. Which type of equity index gives equal weight to all constituents, regardless of size?
A) Price-weighted index
B) Market-cap weighted index
C) Equal-weighted index
D) Value-weighted index
✅ Answer: C
📘 Explanation: In equal-weighted indices, every stock has the same weight, giving small-cap and large-cap firms equal influence.
Q165. If a stock’s intrinsic value is higher than its current market price, the stock is:
A) Overvalued
B) Fairly valued
C) Undervalued
D) Efficiently priced
✅ Answer: C
📘 Explanation: If intrinsic value > market price, the stock is undervalued, suggesting a potential buy opportunity.
Q166. Which of the following is a limitation of relative valuation ratios (P/E, P/B, P/S)?
A) Simplicity of calculation
B) Market comparability
C) Difficulty in applying across industries
D) Ability to reflect market sentiment
✅ Answer: C
📘 Explanation: Relative valuation works best within industries but can be misleading across industries with different capital structures and growth prospects.
Q167. Herding behavior in equity markets refers to:
A) Following analyst recommendations blindly
B) Investors mimicking the trades of others
C) Firms replicating financial disclosures
D) Regulators adopting similar rules
✅ Answer: B
📘 Explanation: Herding occurs when investors copy others’ actions, often amplifying bubbles or crashes.
Q168. An investor using top-down analysis will first evaluate:
A) Individual company financials
B) Sector-specific fundamentals
C) Global and macroeconomic conditions
D) Past dividend history
✅ Answer: C
📘 Explanation: In top-down analysis, investors start with macroeconomics, then industry, and finally company-specific fundamentals.
Q169. Which of the following is a limitation of technical analysis in efficient markets?
A) It ignores market psychology
B) It assumes prices reflect only fundamentals
C) It cannot outperform markets consistently
D) It requires quantitative modeling
✅ Answer: C
📘 Explanation: In efficient markets, technical analysis cannot consistently beat the market because past prices already reflect available information.
Q170. Which investment style focuses on undervalued stocks with low P/E or P/B ratios?
A) Growth investing
B) Value investing
C) Momentum investing
D) Contrarian investing
✅ Answer: B
📘 Explanation: Value investing targets undervalued securities based on fundamentals like low P/E, P/B, or high dividend yields.
Q171. Which of the following measures systematic risk in equity securities?
A) Standard deviation
B) Alpha
C) Beta
D) Sharpe ratio
✅ Answer: C
📘 Explanation: Beta measures a stock’s sensitivity to market movements, representing systematic risk.
Q172. Which of the following is a primary market transaction?
A) An IPO of a new tech company
B) Trading shares on the NYSE
C) Buying ETFs through a broker
D) Hedge fund short-selling
✅ Answer: A
📘 Explanation: The primary market is where securities are issued for the first time, e.g., an IPO. Secondary markets handle trading afterward.
Q173. Which of the following is a key advantage of preferred stock?
A) Higher voting rights
B) Priority in dividend payments
C) Unlimited growth potential
D) Greater volatility than common stock
✅ Answer: B
📘 Explanation: Preferred stockholders receive priority dividend payments and liquidation claims before common stockholders.
Q174. Which type of order guarantees execution but not price?
A) Limit order
B) Market order
C) Stop order
D) Stop-limit order
✅ Answer: B
📘 Explanation: Market orders guarantee execution at the best available price, but not the exact price expected.
Q175. Which of the following best explains capital market line (CML)?
A) Relationship between risk-free rate and systematic risk
B) Efficient frontier with the risk-free asset
C) Random walk of stock prices
D) Alpha vs. beta relationship
✅ Answer: B
📘 Explanation: The CML represents the efficient frontier in the presence of a risk-free asset, showing optimal portfolios.
Q176. A portfolio manager believes that stock prices are influenced by multiple risk factors, not just the market portfolio. This is consistent with:
A) CAPM
B) Efficient Market Hypothesis
C) Arbitrage Pricing Theory (APT)
D) Dividend Discount Model
✅ Answer: C
📘 Explanation: APT assumes returns are influenced by multiple factors such as inflation, interest rates, and GDP growth.
Q177. Which of the following is an example of a derivative-based equity strategy?
A) Dividend reinvestment
B) Covered call writing
C) Value investing
D) Index tracking
✅ Answer: B
📘 Explanation: A covered call involves holding a stock and selling a call option, generating additional income while limiting upside.
Q178. Which of the following is a limitation of CAPM in equity valuation?
A) It accounts for systematic risk
B) It assumes investors hold diversified portfolios
C) It ignores transaction costs
D) It incorporates beta
✅ Answer: C
📘 Explanation: CAPM assumes frictionless markets (no taxes or transaction costs), which is unrealistic in practice.
Q179. A company’s stock currently trades at a P/E ratio significantly above the industry average. This most likely indicates:
A) The stock is undervalued
B) The company has higher growth expectations
C) The company is in financial distress
D) Investors are bearish
✅ Answer: B
📘 Explanation: A high P/E ratio usually reflects strong growth expectations by investors.
Q180. Which of the following measures total risk of an equity investment?
A) Beta
B) Standard deviation
C) Sharpe ratio
D) Jensen’s alpha
✅ Answer: B
📘 Explanation: Standard deviation measures total risk (systematic + unsystematic) of a security or portfolio.
Q181. Which of the following is a limitation of using historical P/E ratios for stock valuation?
A) They incorporate inflation effects
B) They may not reflect future growth prospects
C) They are always higher than book value
D) They adjust for business cycles
✅ Answer: B
📘 Explanation: Historical P/E ratios may not capture future earnings potential or changes in company fundamentals.
Q182. Which equity valuation method is most useful for a company that does not pay dividends?
A) Dividend Discount Model
B) Residual Income Model
C) Price-to-Sales Ratio
D) Free Cash Flow Model
✅ Answer: D
📘 Explanation: When firms do not pay dividends, analysts often rely on FCFF or FCFE models.
Q183. Which type of equity security has the lowest risk?
A) Common stock
B) Preferred stock
C) Convertible bonds
D) Treasury shares
✅ Answer: C
📘 Explanation: Convertible bonds combine debt-like security with an option to convert into stock, lowering risk relative to common or preferred equity.
Q184. Which of the following is a strength of the residual income model?
A) It ignores accounting distortions
B) It requires dividend forecasts
C) It can value firms with no dividends
D) It is less sensitive to discount rates
✅ Answer: C
📘 Explanation: Residual income models are particularly useful for firms that do not pay dividends.
Q185. Which of the following equity market anomalies suggests that low P/E stocks outperform high P/E stocks?
A) January effect
B) Value effect
C) Size effect
D) Momentum effect
✅ Answer: B
📘 Explanation: The value effect indicates that stocks with low valuation multiples (like P/E or P/B) tend to outperform.
Q186. Which type of equity order guarantees price but not execution?
A) Market order
B) Limit order
C) Stop order
D) Stop-limit order
✅ Answer: B
📘 Explanation: A limit order guarantees the price but not that the trade will be executed.
Q187. Which type of investors benefit most from dollar-cost averaging?
A) Long-term investors
B) Day traders
C) Market makers
D) Arbitrageurs
✅ Answer: A
📘 Explanation: Dollar-cost averaging is a long-term strategy where investors regularly invest fixed amounts, reducing timing risk.
Q188. Which of the following is an advantage of ETFs over mutual funds?
A) Lower transaction costs
B) Intraday trading ability
C) Higher management fees
D) Active management
✅ Answer: B
📘 Explanation: ETFs trade like stocks, allowing intraday buy/sell flexibility unlike mutual funds.
Q189. Which of the following best explains the momentum effect in equity markets?
A) Past losers continue to underperform
B) Stocks revert to their mean valuations
C) Investors overweight dividends
D) Market prices fully reflect fundamentals
✅ Answer: A
📘 Explanation: Momentum effect: past winners continue to perform well, while past losers continue to underperform in the short term.
Q190. Which of the following is a limitation of book value per share as a valuation tool?
A) It is forward-looking
B) It is based on historical accounting numbers
C) It captures market expectations
D) It includes intangibles
✅ Answer: B
📘 Explanation: Book value relies on historical accounting, which may not reflect the current market value of assets.
Q191. A portfolio with a Sharpe ratio higher than its benchmark indicates:
A) Lower risk-adjusted performance
B) Higher risk-adjusted performance
C) Market underperformance
D) Higher systematic risk
✅ Answer: B
📘 Explanation: A higher Sharpe ratio means better risk-adjusted returns compared to the benchmark.
Q192. Which of the following is a disadvantage of equal-weighted indices?
A) They ignore small-cap firms
B) They overweight small-cap firms
C) They underrepresent large-cap firms
D) They only measure value stocks
✅ Answer: B
📘 Explanation: Equal-weighting gives all firms the same weight, which unintentionally overweights smaller-cap firms.
Q193. Which of the following is the best measure of market efficiency?
A) Price-to-book ratio
B) Stock price volatility
C) Speed of information incorporation into prices
D) Dividend yield
✅ Answer: C
📘 Explanation: A market is efficient when prices quickly and fully incorporate new information.
Q194. Which of the following is a risk of passive index investing?
A) Higher fees than active funds
B) Market underperformance
C) Overconcentration in large-cap stocks
D) Limited liquidity
✅ Answer: C
📘 Explanation: Market-cap weighted indices can become overconcentrated in large-cap firms.
Q195. Which of the following investor biases causes them to hold losing stocks too long?
A) Overconfidence
B) Disposition effect
C) Anchoring bias
D) Herding
✅ Answer: B
📘 Explanation: The disposition effect is when investors sell winners too early but hold on to losers hoping they will rebound.
Q196. Which statement best describes the random walk theory of equity prices?
A) Prices follow predictable cycles
B) Prices follow no predictable pattern
C) Prices reflect only dividends
D) Prices are determined by insiders
✅ Answer: B
📘 Explanation: Random walk theory suggests that stock prices move randomly and cannot be consistently predicted.
Q197. Which of the following best describes a contrarian investment strategy?
A) Buying stocks during bull markets
B) Selling when others are buying, and buying when others are selling
C) Following analyst recommendations
D) Mimicking institutional trades
✅ Answer: B
📘 Explanation: Contrarian investors go against prevailing market sentiment, buying undervalued assets when others are selling.
Q198. Which valuation model directly incorporates the required rate of return and expected growth rate?
A) Residual Income Model
B) CAPM
C) Gordon Growth Model (DDM)
D) Arbitrage Pricing Theory
✅ Answer: C
📘 Explanation: The Gordon Growth Model (Dividend Discount Model) = D1 / (r – g), using return and growth rates directly.
Q199. Which of the following is a key difference between technical and fundamental analysis?
A) Technical focuses on company earnings
B) Fundamental focuses on past price data
C) Technical uses charts and patterns; fundamental uses financial statements
D) Both rely on market psychology
✅ Answer: C
📘 Explanation: Technical analysis studies past price/volume patterns, while fundamental analysis uses company/industry financials.
Q200. Which of the following describes a primary advantage of equity financing for companies?
A) No dilution of ownership
B) Lower cost than debt financing
C) No mandatory repayment obligation
D) Tax-deductible dividends
✅ Answer: C
📘 Explanation: Equity financing does not require mandatory repayments, unlike debt financing.