Free CFA® Level I Practice Questions

Why: Ethics refers to a society's or group's shared beliefs about good, acceptable, and right conduct, articulated as moral principles that guide behavior and choices. Statutes and regulations describe legal standards, which are created by governments and can lag ethical expectations; disciplinary sanctions are merely one enforcement mechanism a body may use, not ethics itself.

Why: Ethical conduct weighs one's own interests against the effects of one's actions on others; behavior that improves outcomes for others, or at least does not harm them unfairly, is the hallmark of acting ethically. Equating ethical conduct with legal conduct is incorrect because legal and ethical standards can diverge, and following workplace custom is no guarantee of ethical behavior — common practices can themselves be unfair or harmful to others.

Why: An interest rate can be viewed as the sum of a real risk-free rate plus premiums that compensate investors for bearing distinct types of risk. The liquidity premium compensates for the risk of loss relative to fair value if an investment needs to be converted to cash quickly, which is exactly the concern described. The maturity premium compensates for the greater price sensitivity of longer-term instruments to interest rate changes, not for difficulty selling near fair value. The default risk premium compensates for the possibility that the borrower fails to make promised payments, which is a different risk from being unable to sell quickly.

Why: Interest rates can be interpreted as required rates of return, discount rates, or opportunity costs. When a saver weighs current consumption against saving, the interest rate measures the value of the consumption that is given up, so 4% is the opportunity cost of spending the money today. The discount-rate interpretation applies when a known future cash flow is being converted into today's equivalent value, which is not the framing of a spend-versus-save decision. Describing the whole rate as a default-related premium confuses one possible component of an interest rate with the interpretation of the entire rate in a consumption choice.

Why: The breakeven point is the output level at which total revenue equals total cost. With constant per-unit price and variable cost, the formula is: Breakeven quantity = Total fixed costs ÷ (Price per unit − Variable cost per unit). Substituting the stem's numbers: Breakeven quantity = 36,000 ÷ (30 − 18) = 36,000 ÷ 12 = 3,000 units. Check: at 3,000 units, total revenue = 3,000 × $30 = $90,000 and total cost = $36,000 + 3,000 × $18 = $90,000, so revenue exactly covers all costs. Dividing fixed costs by the $30 selling price (36,000 ÷ 30 = 1,200) ignores variable costs entirely, while dividing fixed costs by the $18 variable cost per unit (36,000 ÷ 18 = 2,000) divides by a cost figure instead of the per-unit contribution margin of $12.

Why: The shutdown decision compares price with average variable cost (AVC) in the short run and with average total cost (ATC) in the long run. AVC = Total variable costs ÷ Quantity and ATC = (Total variable costs + Total fixed costs) ÷ Quantity. Substituting: AVC = 88,000 ÷ 4,000 = $22 and ATC = (88,000 + 40,000) ÷ 4,000 = 128,000 ÷ 4,000 = $32. The $25 price lies between AVC and ATC. Because price exceeds AVC, each unit contributes (25 − 22) × 4,000 = $12,000 per month toward fixed costs: the operating loss of 128,000 − 100,000 = $28,000 is smaller than the $40,000 loss (full fixed costs) from shutting down, so the firm should keep producing in the short run. Because price is below ATC, economic losses persist, so the firm should exit in the long run if the price does not recover. Halting production immediately applies the average total cost benchmark to the short-run decision, when the correct short-run shutdown threshold is average variable cost. Continuing indefinitely treats coverage of variable costs as sufficient for long-run viability, but staying in the market in the long run requires price to cover average total cost.

Why: The financial statement analysis framework begins with articulating the purpose and context of the analysis: identifying the questions the analysis must answer, the audience, and the form and timing of the end product. Only after the objective is defined can the analyst determine what data are relevant. Collecting input data is the second step of the framework and depends on the defined purpose, since the purpose determines which information is needed. Processing data into adjusted statements, common-size statements, and ratios is the third step and presupposes that data have already been gathered.

Why: In the framework's data-processing step, the analyst transforms raw inputs into an analytically comparable form — making adjustments for differing accounting choices, preparing common-size statements, and computing ratios all belong to this step. Collecting input data refers to gathering the financial reports, industry information, and other raw material before any transformation occurs. Developing and communicating conclusions is a later step in which the analyst prepares the report and recommendation that answer the questions established at the outset; it uses the processed data rather than creating it.

Why: Organizational forms differ in owner liability, taxation, and control. In a corporation, shareholders enjoy limited liability: the most they can lose is the capital they contributed, whereas a sole proprietor is personally responsible for the business's obligations without limit. Pass-through taxation at the owner level is a feature of sole proprietorships and partnerships, not the typical corporate form, where profits are generally taxed at the entity level before any distribution. Direct day-to-day control by owners characterizes a sole proprietorship; in a corporation, owners usually delegate operating control to professional managers.

Why: Comparing organizational forms, a limited partnership has two classes of partners with different liability and control. The general partner operates the business and remains personally liable for the partnership's obligations without limit. A liability cap equal to invested capital combined with a passive, non-management role describes the limited partners, not the general partner. Equal shared control with proportional liability for every partner describes neither class: limited partners must stay out of management to preserve their liability protection, and the general partner's exposure is not capped at its ownership share.

Why: Among the main functions of the financial system are helping people achieve their purposes in using the system (such as saving, borrowing, raising capital, and managing risk), discovering the rate of return that balances aggregate savings with aggregate borrowing, and allocating capital to its most productive uses. The system does not promise savers any particular real return; realized returns depend on the investments chosen and can fall short of inflation. Nor does it equalize outcomes across traders; informed traders are expected to earn returns from their information, which is precisely what motivates the price discovery the system relies on.

Why: One of the purposes the financial system serves is information-motivated trading: trading by investors who expect to profit from superior information or analysis. The firm is acting on research that identifies a gap between price and estimated value, and its buying pressure pushes the price toward that value, which contributes to efficient capital allocation. Saving describes moving wealth through time to fund future expenditures, typically without an expectation of profiting from mispricing, which does not match a research-driven purchase of an undervalued stock. Hedging describes reducing a pre-existing risk exposure, but the firm is deliberately taking on a new exposure to capture an expected profit, not offsetting one it already has.

Why: The par value, also called the face or principal amount, is the sum the issuer contracts to return to bondholders at maturity, and it forms the basis on which coupon interest is calculated. The coupon is the periodic interest payment rather than the repaid principal, and the market price is what the bond trades for, which fluctuates with yields and usually differs from par.

Why: A floating-rate note carries a coupon tied to a reference rate plus a quoted margin and is reset at scheduled dates, so its interest payment moves with market rates. A step-up bond raises its coupon according to a preset schedule independent of any reference rate, and a fixed-rate bond pays the same coupon for its whole life without resetting to a market benchmark.

Why: A derivative is a contract that derives its value from the value or performance of an underlying — an asset, interest rate, exchange rate, or index — so its payoff is contingent on how that underlying behaves. Being priced solely by its own supply and demand describes a standalone asset, not a derivative, and a direct ownership claim on a firm's cash flows describes equity rather than a derivative, whose value instead changes as the underlying moves.

Why: Derivative contracts are defined by common features: an identified underlying, a contract size or notional amount, and a stated settlement or expiration date that fixes when the payoff is determined. Paying the full price of the underlying upfront is characteristic of a cash purchase rather than a derivative, which typically requires little or no initial outlay, and most derivatives settle on value differences rather than transferring ownership of the underlying at initiation.

Why: A defining feature of alternative investments is that, relative to traditional publicly traded securities, they tend to be less liquid, subject to lighter regulation, and less transparent in their pricing and holdings. The combinations that pair illiquidity with heavier regulation and more transparency invert the actual pattern: alternatives are generally illiquid AND lightly regulated AND opaque, not a mix of those traits with their opposites.

Why: Private real estate and infrastructure are standard alternative investment categories alongside private capital, hedge funds, natural resources, and digital assets. Publicly traded investment-grade bonds and listed large-cap equities are traditional asset classes; the structure used to hold them (a separately managed account) does not convert a traditional security into an alternative investment.

Why: Fixed-income securities promise a defined stream of interest (coupon) payments and the return of principal at maturity, and as a class they have historically exhibited lower average returns and lower return volatility than common equity. Common equity represents a residual ownership claim with no contractual payment promise and historically higher volatility, while direct real estate is a tangible-asset class whose returns derive from rents and price appreciation rather than a contractual interest-and-principal stream.

Why: Asset classes are groupings of securities with broadly similar characteristics and return/risk drivers; defining them lets an investor allocate across distinct sources of return and risk rather than analyzing each security in isolation. It is not true that asset classes share identical expected returns — they differ precisely in return and risk — and combining asset classes does not guarantee outperformance of every single security; diversification reduces risk but offers no certainty of beating any individual holding.