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CFA Level 1 - EQUITY Questions and Answers 2024
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CFA Level 1 - EQUITY
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CFA Level 1 - EQUITYFunctions of the Financial System - answer- purpose is to: trade assets for immediate or
future use, enable growth in saving for future, raise capital via equity issuance, trade on
information, borrow money for current use, risk management
- in a properly functioning financial system, transaction costs are low, participants are
able to accurately estimate asset value and expected returns, and capital is allocated to
its best use
Determining Rates of Return - answer- money is constantly moving between the
present and the future
- investors who buy bonds/stocks are essentially transferring capital to the future, while
borrowers/equity issuers are moving funds from the future to use them today
- the amount of money invested/consumed depends on the expected rate of return on
the funds, with lower rates stimulating consumption and higher rates prompting
increased capital flows from investors
Capital Allocation Efficiency - answer- companies/governments obtain funds in the
primary capital markets
- funds are allocated efficiently if they are being used for the most productive projects
available
- given that investment capital is limited, investors must choose what to fund and what
not to fund, and they do this through direct or indirect means
Managing Risks - answer- financial risks arise due to fluctuations in market prices
beyond control of the firm (interest rates, exchange rates, raw material prices)
- the financial system aggregates parties who seek to reduce risk, facilitating trading in
instruments that hedge risk
- by aggregating traders, the financial system creates a liquid market for risk
management instruments that minimize transaction costs
Saving - answer- moves money from the present to the future
- can be accomplished by buying a range of assets such as stocks, bonds, investment
funds
,- is independent on investors being bale to realize a fair return for bearing risk, easily
sell the asset in the future, and buy and sell the asset with low-transaction costs
Raising Equity Capital - answer- an alternative to raising capital via debt markets
Facilitates raising equity capital by:
- aggregating buyers and sellers to create a liquid, competitive, and centralized market
for determination of equity instrument value
- facilitating information sharing between firms and investors
Information-Motivated Trading - answer- rely on information to forecast a financial
instrument's future price movements
- they hope their information will enable them to identify attractive trading opportunities
that produce returns in excess of those other market participants without this
information can expect
Borrowing - answer- the debt market, which is part of the financial market, functions to
aggregate lenders and borrwers
- lenders/borrowers interact to determine prices for debt contracts, resulting in a fair cost
of debt for borrowers and a fair return on investment given repayment risk for lenders
- repayment risk can be lowered by offering collateral and communicating the risk and
viability of the project planned with borrowed funds
- repayment risk is lower for borrowers with a strong credit rating who have a history of
repaying loans and have predictable cash flows to repay the loan, such as consistent
salary income for individuals and positive net income for firms
Exchanging Assets for Immediate Delivery (Spot Market Trading) - answer- spot
markets are where assets are traded for immediate delivery
- the financial system aggregates spot buyers and sellers ensuring a competitive market
where assets are priced fairly
- by aggregating buyers and sellers, the financial system eases the process of finding a
counterparty for both buyers and sellers and facilitates economies of scale for sellers,
which minimizes transaction costs
Classification of Assets and Markets - answerSpot Market - financial instruments trade
for immediate delivery
, Forward Markets - trading occurs for future delivery
Primary Market - investors sell securities to investors
Secondary Market - securities are traded between investors
Money Markets - debt instruments that mature in less than a year are traded
Capital Markets - where longer-duration instruments trade
Commodities - answer- can be traded in the spot or futures market
- participants' choice of market(s) will depend on whether they have the ability to take or
make delivery and store the physical products
Contracts - answer- an agreement between two parties to do something at a point in
time
- contract's value is linked to an underlying asset, and settlement can occur physically,
though the delivery of a financial instrument, or for cash
Order-Driven Markets - answer- one type of market structure
- market uses order-matching rules to match buyers and sellers and trade-pricing rules
to control prices for trades
- almost all exchanges use order-driven trading systems
Order-Matching Rules - answer- an order-matching system uses rules to arrange
trading
- the order of precedence hierarchy controls how orders will be sequenced
- price priority supports the highest-priced buy orders and lowest-priced sell orders first
- secondary preference rules establish the arrangement of same-priced orders
Real Assets - answer- real estate, machinery, other items that can provide tax/income
benefits
- investments in real assets (no two which are identical) can occur directly or indirectly
and offers investors another opportunity for their portfolios
Orders - answer- buyers and sellers of financial instruments convey their trading desires
by submitting orders that denote: type of instrument they want to trade, the amount they
want to trade, whether they indent to buy or sell
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