Tài liệu CFA Level I - Study Session 5 pptx

CFA Level I - Study Session 5
1. A. “Demand and Consumer Choice”, including addendum “Consumer
Choice and Indifference Curves”
The candidate should be able to:
a. explain consumer choice in an economic framework;
Principles behind Consumer Choice
i) Limited income versus unlimited desires necessitates choices.
ii) Consumers make rational choices to achieve their goals.
iii) Consumers can substitute between “like” goods.
iv) Consumers make decisions based on less than perfect information.
v) Law of Diminishing Marginal Utility : As consumption of a good increases,
the additional utility derived eventually declines.
Consumer Behavior in making Choices
• Consumer will adjust consumption of a good until the marginal utility of consuming
the good just equals the price of the good.
Consumer Demand Curve:
• Diminishing Marginal Utility implies that as the price of a good rises, the amount
demanded by the consumer should fall.
• Income & a substitution effect associated with change in price.
b. calculate and interpret price and income elasticity of demand;
c. discuss the determinants of price and income elasticity of demand;
Price Elasticity of Demand = %∆Q
d
÷ %∆P where %∆Q
d
= (Q
d
1
– Q
d
0

)/[(Q
d
1
+ Q
d
0
)/2], etc.
• Is always NEGATIVE:
o Increase in price %∆P > will always reduce quantity demanded %∆Q
d
< 0.
• Shows degree of consumer responsive to variations in good’s price.
• Elasticity affected by:
i) Availability of Substitutes,
ii) Share of Total Budget spent on Good, and
iii) Length of Time period.
Income Elasticity of Demand = %∆Q
d
÷ %∆Income
• Shows degree of consumer responsive to variations in income.
i) Normal Goods : positive income elasticity, demand rises with income.
ii) Luxuries : high positive elasticity, demand rises strongly with income.
iii) Inferior Goods : negative income elasticity, demand falls with income.
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d. describe the relationships among total revenue, total expenditures, and price elasticity of
demand;
%∆expenditures ≅ %∆price + %∆quantity
Inelastic Demand: when elasticity of demand is less than one in absolute value, a 10% fall in

price increases quantity demanded by less than 10%. Thus total expenditure by
consumers, and total revenue received by firms, falls.
Elastic Demand: when elasticity of demand is greater than one in absolute value, a 10% fall in
price increases quantity demanded by more than 10%. Thus total expenditure by
consumers, and total revenue received by firms, rises.
e. explain why price elasticity of demand tends to increase in the long run.
Second Law of Demand: buyers’ response will be greater after they have had time to adjust
more fully to a price change. Why?
• Better able to rearrange consumption patterns to take advantage of substitutes
f. discuss the characteristics of consumer indifference curves.
i) More goods are preferable to fewer goods, thus points to upper right preferred to
points in lower left of utility curve diagram.
ii) Goods are substitutable, hence utility curves slope downward to the right.
iii) Diminishing marginal rate of substitution between goods implies utility curves
always convex to origin.
iv) Indifference curves are everywhere dense, i.e. one through every point.
v) Indifference curves cannot cross because if they did then individual would not be
following a rational ordering.
g. discuss the role of the consumption opportunity constraint and the budget constraint in
indifference analysis.
Consumption opportunity constraint: separates consumption bundles that are attainable from
those that are unattainable.
• In money-income economy, usually same as budget constraint.
Budget constraint: separates consumption bundles that consumer can purchase from those
that cannot be purchased, given the consumer’s limited income and the market prices of the
products involved.
• Consumer’s choice determined by the point at which their highest indifference curve
touches the budget (or consumption opportunity) constraint.
• This point yields highest level of utility for given level of income and market prices.
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h. distinguish between the income effect and the substitution effect.
2. Price of Good X falls, Budget line rotates out.
C
3. Consumer moves to Point C. Can break move
into two parts.
U
1
Income & Substitution Effects
Good Y
Good X
A
U
0
1. At original prices, Consumer chooses point A.
B
4. Income effect is move from A to B. Prices
same, but reach higher utility assoc. with C.
5. Substitution effect is move from B to C. Prices
change, but stay on same utility curve.
1. B. “Costs and the Supply of Goods”
The candidate should be able to:
a. describe the principal–agent problem of the firm;
Principal-Agent Problem
• Incentives of principal (purchaser of service) and agent (seller of service) can diverge
if principal cannot observe agent’s performance.
• Agent will pursue own goals, which may only partially overlap with the goals of the
principal who has purchased the agent’s services.
b. distinguish among the types of business firms;

Proprietorship: Business owned by an individual who possesses the ownership rights to the
firm’s profits and is personally liable for the firm’s debts.
Partnership: Business owned by two or more individuals who possesses the ownership rights
to the firm’s profits and is personally liable for the firm’s debts.
Corporation: Business owned by shareholders who have the ownership rights to the firm’s
profits but whose liability is limited to the amount of their initial investment in the firm.
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c. distinguish between (1) explicit costs and implicit costs, (2) economic profit and accounting
profit, and (3) the short run and the long run in production;
Explicit Costs: Payments by a firm to purchase productive resources.
Implicit Costs: Opportunity costs of a firm’s use of resources that it owns. These costs do not
involve direct payments.
Economic Profit: Difference between firms’ total revenue & total cost.
Accounting Profit: Firm revenue minus expenses over given time period. Does not take
implicit costs into account.
Short-Run in Production: Time period short enough so not all factors of production can be
adjusted. Typically plant size fixed.
Long-Run In Production: Time period long enough so all factors of production can be
adjusted.
d. differentiate between economic costs and accounting costs;
Accounting Costs: Payments by a firm to purchase productive resources.
Economic Costs: Opportunity costs of a firm’s use of resources that it owns. These costs do
not always involve direct payments.
e. define various types of costs, including opportunity costs, sunk costs, fixed costs, variable
costs, marginal costs, & average costs;
Total Fixed Costs, TFC:
Sum of costs that do not vary with level of output.
Total Variable Costs, TVC:

Sum of costs that change with the level of output.
Marginal Cost, MC: MC = ∆TC/∆q where TC = TFC + TVC
Change in total cost required to produce an additional unit of output.
Average Costs
Average Fixed Cost: AFC = TFC/quantity produced
Average Variable Cost: AVC = TVC/quantity produced
Average Total Cost: ATC = AFC + AVC = TC/quantity produced
Sunk Costs:
Costs that have already been incurred as the result of past decisions.
f. state the law of diminishing returns & explain its impact on a firm’s costs;
Law of Diminishing Returns to a Factor of Production
As more and more units of a variable input are combined with a fixed amount of
another input, the additional units of the variable input will yield increased output at a
decreasing rate.
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g. describe the shapes of the short-run marginal cost, average variable cost, average fixed
cost, and average total cost curves;
1. Once a firm reaches a level of output at which diminishing returns occur, larger and larger
additions of the variable factor are necessary to increase output by one more unit.
2. The result is that the MC of the additional output increases. So long as MC is below ATC,
producing additional units of output will bring down the ATC curve.
3. At some point, however, MC will rise by enough to exceed ATC. After the point where MC =
ATC, additional units of output will raise ATC causing the ATC curve to be U-shaped. Thus
the MC curve will cut the ATC curve at its minimum point.
Cost Curve Relationships
MC =
∆
TC ÷

∆
q
AVC = TVC ÷ q
ATC = AFC + AVC
Quantity, q
Costs
AFC = TFC ÷ q
MC always cuts ATC and AVC
at their minimum points!
h. define economies and diseconomies of scale, explain how they each is possible, and relate
each to the shape of a firm’s long-run average total cost curve;
Economies of Scale: Reductions in firm’s per unit costs as all factors of production are
increased in an optimal way.
• Possible reasons: 1) Mass production, 2) specialization of factors of production, and 3)
“learning by doing” scale economies.
Diseconomies of Scale: Increases in firm’s per unit costs as all factors of production are
increased in an optimal way.
• Possible reasons: 1) coordination inefficiencies, 2) increasing difficulties in conveying
information, and 3) increased principal-agent problems.
Constant Returns to Scale: No change in firm’s per unit costs as all factors of production
are increased in an optimal way.
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Economies and Diseconomies of Scale
Diseconomies of Scale
Quantity, q
Costs
Economies of Scale
Constant Returns to Scale

i. describe the factors that cause cost curves to shift.
Factors that Cause Cost Curves to Shift
i) Prices of Resources : Increase in price of resources used (inputs to production)
will cause a firm’s cost curves to shift upwards.
ii) Taxes : Increased taxes shift up a firm’s cost curves. Tax on variable input shifts
MC, AVC, & ATC. Fixed tax shifts AFC & ATC.
iii) Technology : Cost-reducing technological improvements will lower a firm’s cost
curves. Which curves depend on whether technology affects fixed or variable costs.
1. C. “Price Takers and the Competitive Process”
The candidate should be able to:
a. distinguish between price takers and price searchers;
Price-Takers:
• Firms that take market price as given when selling their product. Each is small relative
to market, cannot affect price.
Price-Searchers:
• Firms that face a downward-sloping demand curve for their product. Price charged by
firm affects amount it sells.
b. discuss the conditions that characterize a purely competitive (price taker) market;
Purely Competitive Markets
• Markets characterized by large number of small firms producing identical products in
industry with complete freedom or entry/exit.
• Also termed price-taker markets.
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c. explain how and why price takers maximize profits at the quantity for which marginal cost,
price, and revenue are equal;
Marginal Revenue of each unit of output sold = Market Price.
• Price-taking firm sets output so Marginal Cost of last unit of output produced
equals market price = marginal revenue.

• If MR > MC then selling an additional unit adds to profit, should produce more.
• If MR < MC then selling additional unit lowers profit, should produce less.
Maximum profit when MR = P = MC of last unit produced and sold.
d. calculate and interpret the total revenue and the marginal revenue for a price taker;
For a price taker, total revenue is simply equal to the price in the market times the number of units of
output sold.
Marginal revenue, the change in total revenue/change in output, is constant for a price taker and equal
to the market price of the product.
e. explain the decision by price takers with economic losses to either continue to
operate, shut down, or go out of business;
A firm that is making losses, i.e. AC > P, will choose to continue to operate in the short-run
so long as:
1. it can cover all its variable costs, and
2. it expects price to be high enough to cover its average cost in the future.
In the short run, the firm must pay its fixed costs even if it shuts down. So long as price
exceeds average cost, the firm will be able to pay part of its fixed costs. This strategy makes
sense so long as the firm expects that at some point price will rise sufficiently to cover both
its variable and fixed costs.
If either of the conditions above do not hold, i.e. price is too low for the firm to cover its
variable costs OR the firm does not expect price to be sufficient to cover average total cost
in the future, then the firm should go out of business.
f. describe the short-run supply curve for a firm and for a competitive market;
SR Supply for Individual Firm
• = Marginal Cost curve above AVC.
SR Supply for Market
• = horizontal sum of all the marginal cost curves of firms in the industry.
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g. contrast the role of constant cost, increasing-cost, and decreasing-cost industries in

determining the shape of a long-run market supply curve.
Long Run Supply Curve:
• shows minimum price that firms will supply any level of market output, given
sufficient time to adjust all factors of production & allow for any entry/exit from
the industry.
Economies of Scale determine Shape of LR Supply
• Constant Returns to Scale (i.e. Constant cost) industry will have horizontal LR
Supply Curve.
• Increasing Returns to Scale (i.e. Declining cost) industry will have downward-
sloping LR Supply Curve.
• Decreasing Returns to Scale (i.e. Increasing cost) industry will have upward-
sloping LR Supply Curve.
h. explain the impact of time on the elasticity of supply.
Elasticity of supply usually increases in long run as more time is allowed to firms to adjust
production in response to changes in prices. Over time, firms can adjust the levels of all
factors of production in optimal ways to meet changes in price.
1. D. “Price-Searcher Markets with Low Entry Barriers”
The candidate should be able to:
a. describe the conditions that characterize competitive price-searcher markets;
Competitive Price-Searcher Markets
• Each firm faces a downward-sloping demand curve for their output.
• Firms produce differentiated products. Output of other firms close substitutes, so
individual firm’s demand curve is highly elastic.
• Low entry barriers allow entry or exit of firms if existing firms earn non-zero
economic profits. Each firm faces competition from existing firms in industry &
potential new entrants.
b. explain how price searchers choose price and output combinations;
Profit-maximizing Behavior for a Price Searcher
• Sets output level so that Marginal Cost equal to Marginal Revenue.
• For Price Searcher, Marginal Revenue is related to shape of the Demand Curve.

• Intuition for two factors at work to sell additional unit of output.
o Lower price, sell extra unit and receive additional revenue but
o Receive lower price on all existing units also so lose some revenue
o Marginal revenue no longer equals price.
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c. summarize the debate about the efficiency of price-searcher markets with low barriers to
entry, including the concepts of contestable markets, entrepreneurship, allocative efficiency,
and price discrimination;
(PRO) In the long run, competition along with free entry and exit will drive prices down to
level of average costs.
• Contestable markets: market where costs of entry or exit are low, so firms risk
little by entry.
• Efficient production and zero economic profits should prevail.
• Market can be contestable even if capital requirements for entry are high.
(CON) LR equilibrium is not allocatively efficient, however, because firms produce less
than the minimum ATC level of output.
• Advertising in differentiated product markets may be wasteful & self-defeating.
• Benefits of dynamic competition improves customer choices of quality and
convenience versus trade-off of higher prices.
d. explain how price discrimination increases output and reduces allocative inefficiency;
Price discrimination occurs when a producer charges different consumers different prices for
the same product.
• Requires supplier able to identify and separate at least two groups with different
price elasticities, and
• Prevent those buying at low price from reselling to higher priced customers.
• Segmentation of groups with different price elasticities allows suppliers to charge
different prices to each, possibly resulting in higher profits than with single price.
On balance, output in industry higher with price discrimination than without. Moves

industry output closer to competitive output level associated with allocative efficiency.
1. E. “Price-Searcher Markets with High Entry Barriers”
The candidate should be able to:
a. discuss entry barriers that protect some firms against competition from potential market
entrants;
• Economies of Scale : Large fixed costs mean decreasing per unit costs.
• Government Licensing : Legal barriers to entry established by gov’t.
• Patents : Property rights given to newly invented products or processes.
• Control over an Essential Resource : Single firm has control over an essential resource
or technology.
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b. differentiate between a monopoly and an oligopoly;
Monopoly is a market characterized by:
• Single seller of a well-defined product with no good substitutes.
• High barriers to entry of any other firms into market for the product.
Oligopoly is a market characterized by:
• Small number of rival firms in industry.
• Interdependence among sellers as each is large relative to market.
• Substantial economies of scale in production of the good.
• High barriers to entry firms into market.
c. describe how a profit-maximizing monopolist sets prices and determines output;
Profit-maximizing Behavior for a Monopolist
• Sets output level so that Marginal Cost equal to Marginal Revenue.
• Marginal Revenue is related to shape of the Demand Curve. Intuition for two
factors at work to sell additional unit of output.
Profit-Maximizing Monopolist
Cost, C and
Price, p

Quantity, q
MR Curve
Demand
MC = Supply
q
Monop
p
Monop
q
Comp
p
Comp
d. discuss price and output under oligopoly, with and without collusion;
Collusion:
Under collusion, i.e. acting as a cartel, oligopolists can coordinate supply decisions to
maximize the joint profits of all the firms. The cartel essentially acts like a monopolist in
market, setting higher price and lower output in order to generate positive economic profits.
Without Collusion:
Once the collusion by the cartel has established the monopoly price in the market, each
member of the cartel has an incentive to cheat by increasing their own supply at the high
price to increase its share of profits in the market. Thus without collusion, the oligopolists
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end up competing with one another on prices, driving the market outcome to that associated
with perfect competition, where price is lower, output is higher, and all firms earn zero
economic profits.
e. discuss why oligopolists have a strong incentive to collude and to cheat on collusive
agreements;
By colluding, i.e. acting as a cartel, oligopolists can coordinate supply decisions to

maximize the joint profits of all the firms. Cartel seeks to create a monopoly in market that
results in higher prices and positive economic profits.
Once the collusion by the cartel has established the monopoly price in the market, however,
each member of the cartel has an incentive to cheat by increasing their own supply at the
high price to increase its share of profits in the market.
f. discuss the obstacles to collusion among oligopolistic firms;
Incentive for any firm to cheat on cartel agreement to increase its profits. Obstacles to
success of collusion:
• Increase in number of firms making up oligolpoly.
• If price cuts by individual firms difficult to detect & prevent.
• Low barriers to entry. Successful collusion induces new entrants.
• Unstable demand conditions lower likelihood collusion successful.
• Vigorous antitrust actions increase cost of collusion.
g. describe government policy alternatives that are intended to reduce the problems stemming
from high barriers to entry.
i) Restructure existing firm or firms to stimulate competition.
• May not be possible if economies of scale form barrier. Natural monopoly
occurs if declining per unit costs of large range of output.
ii) Reduce Artificial Barriers to Trade
• If few firms dominate domestic market, may get increased competition by
encouraging foreign firms to supply market.
iii) Regulate the Dominant Producer(s)
• Government may regulate price charged by monopolist or oligopolists in the
market to achieve more efficient outcomes.
o Average Cost Pricing: set output so ATC = Demand Curve
o Marginal Cost Pricing: set output so MC = Demand Curve
iv) Supply Market with Government Production
• Particularly appropriate for public goods. Concerns about efficiency.
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F. “The Supply of and Demand for Productive Resources”
*** All New for 2003
The candidate should be able to
a. explain the relationship between the price of a resource and the quantity demanded of that
resource;
The demand for a resource is a “derived” demand, in that the demand for the resource arises
indirectly from the demand for goods that that resource helps to produce.
As the price of a resource rises, producers using that resource respond in two ways:
i) they substitute towards other resources that are less expensive; and
ii) they pass on the higher price of the resource as higher prices and reduced quantities
of the goods being produced using the resource.
Both of these responses produce an inverse relationship between the price of the resources
and the quantity of the resource demanded, i.e. its demand curve is downward-sloping.
b. identify and describe the influence of three factors that cause shifts in the demand curve
for a resource;
The three factors that cause shifts in the demand curve for a resource are:
i) A change in the demand for a product will cause a similar change in the demand for
the resource used in the production of that product:
ii) Changes in the productivity of the resource will alter the demand for that resource.
An increase in the productivity of a resource will increase its demand because this
makes the resource cheaper per unit of output it produces.
iii) Changes in the price of a related resource will alter the demand for the original
resource. A rise in the price of a related resource that is complementary in production
to the original resource will cause the demand for the original resource to fall. A rise in
the price of a related resource that is a substitute in production to the original resource
will cause the demand for the original resource to rise.
c. define the marginal revenue product of a resource and explain how it influences the
demand for that resource;
Marginal Revenue Product (MRP) of a resource is equal to its marginal product times the

selling price of the product that it helps to produce. The marginal product of a resource is
equal to the additional units of the good produced by using one additional unit of the
resource as an input in production.
A profit-maximizing firm will increase their use of the resource as long as the marginal cost
(MC) of the additional unit of the resource is less than the resource’s marginal revenue
product.
Profit is maximized when the level of the resource is such that its marginal cost is equal to its
marginal revenue product. i.e. MRP = MC
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d. explain the necessary conditions to achieve the cost-minimizing employment levels for two
or more variable resources;
A profit-maximizing firm with two or more variable resources will set the level of utilization
of each resource so that the MRP of that resource is just equal to its Marginal Cost.
MRP
j
= MC
j
= Price of Resource j per unit for each resource j = 1, 2, 3, …
For each resource, its MRP is the price of the final good (P) times the Marginal Product of
that resource for the output of the final good (MP
j
).
MRP = P x MP
j
= MC
j
= Price of Resource j per unit or
Price of Resource j

j
MP
P=
This is true for each resource used in producing the final good so the cost-minimizing
condition can be summarized as:
3
1 2
Price of Resource 1 Price of Resource 2 Price of Resource 3
MP
MP MP
P= = = =K
e. discuss the factors that influence the supply and demand of resources in the short run and
long run;
In the short-run:
Supply: Many resources tend to be fixed in amount or relatively immobile across markets.
This leads to a short-run supply curve that is inelastic, i.e. steeply sloping upwards, as
owners of resources demand higher prices in the face of increased short-run demand.
Demand: Adjusting the production process to changes in resource prices is difficult in the
short-run, thus the short-run demand for resources is also likely to be inelastic, i.e.
steeply sloping downwards.
In the long-run:
Supply: Investment, exploration and depreciation allows for greater changes in the amount
of resources available. Thus the long-run supply curve tends to be more elastic, i.e. less
steeply sloped upwards, than the short-run supply curve for the resource.
Demand: Adjusting the production process to changes in resource prices is easier in the
long-run, thus the long-run demand for resources is also likely to be more elastic, i.e.
less steeply sloped downwards than short run demand.
f. explain how prices for resources are determined in a market economy;
In a market economy the equilibrium price of a resource is the level that equilibrates demand
and supply. If there is an excess supply of the resource at a given market price, then the

unemployed resources will place downward pressure on the market price, bringing demand
and supply back into equilibrium.
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g. explain the process through which changing resource prices influence resource utilization
and the performance of the economic system.
Changes in the price of a resource influence the behavior of both its users and its suppliers.
When the price of a resource rises, users will search for ways to economize on the use of the
resource and they may also switch to resources that are substitutes in the production process.
Higher prices will lead suppliers of the resource to look for ways to increase the supply of the
resource through additional investment and exploration. It is likely new supply will take some
period of time to reach the market.
2. “The Financial Environment: Markets, Institutions, and Interest
Rates” *** All New for 2004
The candidate should be able to
a. identify and explain the factors that influence the supply and demand for capital;
Supply of Capital from savers in the economy is influenced by the following factors:
- Time Preferences for consumption : high rate of time preference indicate that current
consumption is highly valued relative to future consumption. This leads to a lower supply of
capital from savers.
- Risk: Higher levels of risk in lending mean less capital will be supplied for any given rate of
return.
- Inflation: Higher expected inflation leads savers to require higher rates of return to offset the
effects of inflation on the purchasing power of money.
Demand for Capital is influenced by the following factors:
- Production Opportunities : The more productive the projects financed by the borrowed savings,
the higher the rate of return borrowers will be willing to pay to secure the financing.
b. describe the role of interest rates in allocating capital;
Firms with the more profitable projects to finance will bid away capital from firms with less profitable

projects. Thus interest rates in capital markets ensure that scarce capital made available by savers
finances the most profitable projects in the economy.
c. explain how the supply of and demand for funds determine interest rates;
Interest rates are the rental price of capital determined by demand and supply in the capital markets.
The interest rate for each type of security is determined by the intersection of demand and supply in
each market. At this point the supply of capital from savers in each market is just equal to the demand
for capital from firms in each market.
d. discuss the factors that cause the supply and demand curves for funds to shift;
Supply and demand curves in a capital market shift if with changes in any of the fundamental factors
in LOS 2.1.a. Thus an increase in time preference will reduce the supply of saving (and capital) to the
market. Similarly, and increase in the profitability of projects in the economy as a whole will increase
the demand for capital, shifting the demand curve outwards.
Capital markets are also interdependent, thus a change in demand or supply in one market is likely to
spill over into affecting demand or supply in related capital markets. A rise in demand in the market
for one type of security raises the interest rate in that market. The higher return will lead some savers
to redirect their savings into this market, increasing the supply of capital in the original market while
simultaneously decreasing the supply of capital to the other types of securities.
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e. distinguish between the real and the nominal risk-free rate of interest;
Real risk-free rate of interest, k*
- The interest rate earned on a riskless security if no inflation were expected. Alternatively, the
rate of interest on a riskless security measured in terms of purchasing power. Generally taken
to be the interest rate on a short-term US Treasury security in an inflation-free world.
Nominal risk-free rate of interest, k
RF
= k* + IP
- The interest rate earned on a riskless security whose return is indexed to expected inflation
such as a short-term indexed US Treasury security. IP is termed the inflation premium which

is equal to the average expected inflation over the life of the security.
f. explain the effect of inflation on the real rate of return earned by financial securities and by
physical assets;
The return offered by most financial securities is set in nominal terms, i.e. money terms, rather than
purchasing power. For any given nominal return, higher inflation reduces the real return on a financial
security. The returns on physical assets, in contrast, tend to be less affected by inflation because the
prices of the goods or services produced by the physical assets rise with inflation, reducing or
eliminating changes in the real returns.
g. define the inflation premium and describe how the inflation premium is determined;
Inflation premium:
- Determined as the average rate of inflation expected over the life of the security under
consideration. The inflation premium may thus vary across assets with different maturities.
- Calculated using inflation rates expected over the future, not the rate experienced in the past.
h. describe the default risk, liquidity, and maturity risk premiums;
Default Risk premium:
- Default risk is the risk that the borrower will default on their loan, i.e. not repay interest or
principal on the loan.
- Calculated as the difference between the interest rates on a US Treasury security and a
corporate bond of equal maturity and marketability.
Liquidity premium:
- Liquidity risk is the risk that the security cannot be converted quickly to cash at a “fair market
value”. Associated with the marketability of the security and the efficiency of the market.
- Calculated as difference between the interest rates on two securities of equal maturity and risk.
Maturity Risk premium:
- Maturity risk premium is related to the increased exposure of long-term securities to both
interest rate and reinvestment risk.
- Calculated as the difference between interest rate on two securities of equal risk and
marketability. Often calculated using US Treasury securities to control default risk.
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Review 2005 Level I – SS 5 – Macroeconomics Page 15 of 23
i. explain interest rate risk and reinvestment rate risk.
Interest Rate Risk:
- The prices of long maturity bonds are more sensitive to changes in interest rates than those of
shorter maturity bonds. A rise in interest rates causes a greater decline in the value of longer
maturity bonds.
Reinvestment Rate Risk:
- Shorter maturity bonds are sensitive to changes in interest rates when the lender’s time
horizon is longer than the maturity of the bond. Shorter maturity bonds must then be
reinvested, and thus a fall in interest rates will result in a decline in interest income when the
bonds are reinvested at the lower rates.
2004 Mock Exam Level I SS #5 Answers on last page
 2004 Prof. John M. Veitch, CFA. All rights reserved. Reproduction in any form, in whole or in part, is
prohibited without permission.
1. Which one of the following statements regarding the demand for a resource is incorrect?
A. Demand for a resource is a derived demand.
B. A rise in the price of a resource leads producers to substitute to less expensive
resources.
C. A rise in the price of a resource leads to an increase in the demand for goods produced
using the resource.
D. A rise in the price of a resource leads to a decrease in the demand for the resource.
2. Which one of the following factors leads to an inward shift in the demand curve for a
resource?
A. Increased demand for products produced using the resource.
B. Increased productivity of the resource.
C. Rise in the price of a substitute resource.
D. Rise in the price of a complementary resource.
3. Which one of the following factors does not affect the supply of capital from savers in the
economy?
A. Inflation.

B. Production opportunities.
C. Time preference for consumption.
D. Risk.
4. The increased federal budget deficit leads to an increase in bond issuance by the U.S.
government. Which one of the following is unlikely to happen as a result?
A. Demand for capital in the bond market increases.
B. Supply of capital to the bond market increases.
C. Supply of capital to the equity market decreases.
D. Demand for capital in the equity market decreases.
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Review 2005 Level I – SS 5 – Macroeconomics Page 16 of 23
5. The additional return demanded by a lender for the risk that he or she may not receive
repayment of interest or principal on a loan is:
A. Maturity risk.
B. Default risk.
C. Inflation risk.
D. Liquidity risk.
6. An oligolopoly is less likely to operate collusively when
A. There are low barriers to entry.
B. Demand conditions in the industry are very stable.
C. There are high barriers to entry.
D. There are a larger number of oligopolists in the industry.
7. Which one of the following is a feature of a price-taker market but not a price searcher with
low entry barriers market?
A. Profits are maximized by setting MR = MC.
B. Positive economic profits to firms if P > ATC.
C. Profits are maximized by setting P = MC.
D. Entry occurs when economic profits are positive.
8. Which one of the following statements is false?

A. MC cuts AVC at its minimum point.
B. MC cuts ATC at its minimum point.
C. MC cuts AFC at its minimum point.
D. AFC is always below ATC.
9. A firm sells 200 units of its product when the price is $10 per unit but sells only 160 units
when it raises the price to $14 per unit. The own price elasticity of the good is thus:
A. Inelastic and equal to 1/2.
B. Elastic and equal to 2/3.
C. Inelastic and equal to -2/3.
D. Elastic and equal to -1/2.
10. When Ozzie Nelson was earning $8000 per month he would buy 10 martinis during the
month. Ozzie has received a $1000 increase in his salary and now buys 15 martinis per
month. Independent of addiction issues, Ozzie’s income elasticity for martinis is closest to:
A. -4.0
B. 3.4
C. 3.0
D. -3.0
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Review 2005 Level I – SS 5 – Macroeconomics Page 17 of 23
2003 Mock Exam Level I SS #5 Answers on last page
 2003 Prof. John M. Veitch, CFA. All rights reserved. Reproduction in any form, in whole or in part, is
prohibited without permission.
X

Y
A
B
C
D
E
1. In the above diagram, which movement represents the substitution effect of the fall in the
price of Good Y?:
A. A to B.
B. A to C
C. B to C.
D. C to B.
2. Initially you are consuming 12 units of a good whose price is $1.50. The price of the good
falls to $1.00 and you now consume 24 units of the good. Assuming all else constant,
your price elasticity of demand for this good is closest to:
A. -0.600
B. -1.667
C. 1.667

D. -1.333.
3. Which of the following statements is correct?
A. Raising price when demand is inelastic results in lower total revenue.
B. Raising price when demand is elastic results in higher total revenue.
C. Lowering price when demand is inelastic results in higher total revenue.
D. Lowering price when demand is elastic results in higher total revenue.
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Review 2005 Level I – SS 5 – Macroeconomics Page 18 of 23
4. Initially your income is $500 per week and you consume 12 units of a good. Your income
rises to $1,500 per week and you now consume 24 units of the good. Assuming all else
constant, your income elasticity of demand for this good is closest to:
A. 0.600
B. 1.667
C. 0.667
D. -1.333.
5. Which of the following statements is correct?
A. Economic profit is always lower than accounting profit because economic profit uses
opportunity costs while accounting profit does not.
B. Economic profit is always higher than accounting profit because accounting profit
uses opportunity costs while economic profit does not.
C. Economic profit and accounting profit have no necessary relationship.
D. Economic profit is always lower than accounting profit because accounting profit
uses opportunity costs while economic profit does not.
6. Which of the following statements about average cost curves is not true?
A. The law of diminishing marginal returns means the marginal cost curve must
eventually be upward-sloping.
B. The marginal cost curve always cuts the average fixed cost curve at its minimum
point.
C. The marginal cost curve always cuts the average variable cost curve at its minimum

point.
D. The marginal cost curve always cuts the average total cost curve at its minimum
point.
7. I. Price is expected to rise above average total cost in the long run.
II. Price is currently above the average fixed cost of production.
III. Price is currently above the average variable cost of production.
IV. Price is currently below the average variable cost of production.
In the short run, price-takers earning economic losses will continue to operate so long as:
A. I. and II. hold.
B. I. and III. hold.
C. I. and IV. hold.
D. II. and IV. hold.
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Review 2005 Level I – SS 5 – Macroeconomics Page 19 of 23
8. Which of the following characterize a monopolist but not a competitive price searcher
market?
I. Well-defined product with no good substitutes
II. Downward-sloping demand curve for their good
III. High barriers to entry
IV. Zero economic profits in the long run
A. I., II., III., & IV.
B. I. & III.
C. II. & IV.
D. II., III., & IV.
9. Which of the following factors will not cause a shift in the demand curve for a resource?
A. Change in the price of the resource.
B. Change in productivity of the resource.
C. Change in demand for the output produced by the resource.
D. Change in the productivity of the resource.

10. As plant manager you must determine the highest profit (lowest cost) way of expanding
your labor force. One unit of your output sells for $14.00
Type of Labor Output per hour Hourly wage
Unskilled 0.9 units $13.20
Semi-skilled 1.8 units 25.50
Skilled 7.5 units $99.50
Using the table above, expanding which category or categories of labor will increase the
firm’s profit?
A. Increase the amount of unskilled labor.
B. Increase the amount of semi-skilled labor.
C. Increase the amount of skilled labor.
D. Expanding any category of labor will raise profit.
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Review 2005 Level I – SS 5 – Macroeconomics Page 20 of 23
2002 Mock Exam Level I SS #5 Answers on last page
 2002 Prof. John M. Veitch, CFA. All rights reserved. Reproduction in any form, in whole or in part, is
prohibited without permission.
1. Which one of the following is not part of consumer choice in an economic framework?
A. Limited income vs. unlimited desires.
B. Law of diminishing returns.
C. Consumers make rational choices.
D. Consumers can substitute between similar goods.
2. When John had a monthly income of $2,000 he went to 4 movies per month. When his
income increased to $3,000 per month, he went to 8 movies per month. Assuming the price
of movies did not change what is John’s income elasticity of demand for movies?
A. 1.00
B. 100.
C. 0.600
D. 1.667.

3. Which of the following is not a source of economies of scale?
i. Specialization of factors of production.
ii. Learning by Doing.
iii. Mass production.
iv. Increased principal-agent interactions.
4. Firms maximize profits by operating according to which rule?
v. Price = MC.
vi. MR = price.
vii. MR = MC.
viii. MR = AVC.
5. Which of the following does not characterize a price-searcher market with low barriers to
entry?
A. Positive economic profits should prevail.
B. Advertising may be wasteful and self-defeating.
C. Improved customer choice of quality.
D. Price should equal average cost.
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Review 2005 Level I – SS 5 – Macroeconomics Page 21 of 23
6. The essential characteristics of a monopoly are:
V. Well-defined product with no good substitutes
VI. Control over an essential resource
VII. High barriers to entry
A. I & II.
B. II & III.
C. I & III.
D. I only.
7. Which of the following is not an obstacle to collusion in an oligopolistic market?
A. High barriers to entry.
B. Larger number of firms in the industry.

C. Unstable demand conditions.
D. Effective antitrust actions.
8. In the short run a price-taking firm will produce output as long as:
A. Price > MR.
B. Price > AFC.
C. Price > AVC.
D. Price > ATC.
9. Which statement is correct for a firm with constant returns to scale?
A. The firm’s LR supply curve is downward-sloping.
B. The firm’s LR supply curve is U-shaped.
C. The firm’s LR supply curve is horizontal.
D. The firm’s LR supply curve is upward-sloping.
10. Price discrimination is not characterized by one of the following:
A. Decreases output.
B. Requires groups of consumers with different price elasticities.
C. Prevention of resale between customer groups.
D. Charge differing prices to different consumers.
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Review 2005 Level I – SS 5 – Macroeconomics Page 22 of 23
2004 Study Session #5 Answers
1 C LOS Level I Study Session 5-1.A.h
2 D. LOS Level I Study Session 5-1.A.b
3 B. LOS Level I Study Session 5-1.A.b
4 D. LOS Level I Study Session 5-1.A.b
5 B. LOS Level I Study Session 5-1.B.c
6 D. LOS Level I Study Session 5-1.B.f
7 C. LOS Level I Study Session 5-1.C.e
8 C. LOS Level I Study Session 5-1.D.a
and 5-1.E.b

9 C. LOS Level I Study Session 5-1.F.b
10 B. LOS Level I Study Session 5-1.F.d
2003 Study Session #5 Answers
1 C LOS Level I Study Session 5-1.A.h
2 B. LOS Level I Study Session 5-1.A.b
3 D. LOS Level I Study Session 5-1.A.b
4 C. LOS Level I Study Session 5-1.A.b
5 A. LOS Level I Study Session 5-1.B.c
6 B. LOS Level I Study Session 5-1.B.f
7 B. LOS Level I Study Session 5-1.C.e
8 B. LOS Level I Study Session 5-1.D.a
and 5-1.E.b
9 A. LOS Level I Study Session 5-1.F.b
10 C. LOS Level I Study Session 5-1.F.d
2002 Study Session #5 Answers
1. B. LOS Level I Study Session 5-1.A.a
2. D. LOS Level I Study Session 5-1.A.b
3. D. LOS Level I Study Session 5-1.B.e
4. C. LOS Level I Study Session 5-1.C.c
5. A. LOS Level I Study Session 5-1.D.c
6. C. LOS Level I Study Session 5-1.E.b
7. A. LOS Level I Study Session 5-1.E.e
8. C. LOS Level I Study Session 5-1.C.d
9. C. LOS Level I Study Session 5-1.C.e
10. A. LOS Level I Study Session 5-1.D.d
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Study Guide. Copyright (2000), Association for Investment Management and Research,
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Study Guide. Copyright (2001), Association for Investment Management and Research,

Charlottesville, VA. All rights reserved.
Reprinted with permission from the 2003 Level I CFA
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Study Guide. Copyright (2002), Association for Investment Management and Research,
Charlottesville, VA. All rights reserved.
Reprinted with permission from the 2004 Level I CFA
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Study Guide. Copyright (2003), Association for Investment Management and Research,
Charlottesville, VA. All rights reserved.
Reprinted with permission from the 2005 Level I CFA
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Study Guide. Copyright (2004), CFA Institute, Charlottesville, VA. All rights reserved.
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