Chartered Financial Analyst (CFA) Practice Exam Level 2

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Prepare for the CFA Exam Level 2 with flashcards and multiple-choice questions. Each question includes hints and explanations to boost your confidence and enhance your study process. Get ready for success!

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What outcome occurs if forward rates are used inaccurately when discounting a bond's present value?

The bond is overvalued based on its future cash flows
The bond is undervalued leading to investment opportunities
The bond's market price reflects accurate risk assessments
The investment risks diminish over time

The correct answer is: The bond is undervalued leading to investment opportunities

When forward rates are inaccurately utilized to discount a bond's future cash flows, it's likely that the calculated present value of the bond will not reflect its true worth. If the forward rates imply a higher discount rate than what is appropriate, this can result in estimating the bond's present value to be lower than it should be, leading to an undervaluation of the bond. Investors might perceive this discrepancy as an opportunity to purchase the bond at a price lower than its intrinsic value, anticipating that its true market price will eventually adjust upward as the market corrects this mispricing. This scenario creates a potential investment opportunity, as the undervalue may attract investors who seek to capitalize on such a mispricing by acquiring the bond at a low price. Hence, using forward rates inaccurately opens the door for investment prospects based on perceived value discrepancies in the market.