CFA Quiz-14

					14: Asset Valuation: Debt Investments: Basic Concepts
1.A: Features of Fixed Income Securities
Question ID: 13556 A 15-year, 9 percent semi-annual coupon bond selling for $1,087 offers a yield of:

A. B. C. D. C

11%. 9%. 8%. 10%.

9% X $1,000 = $90 $90 / $1,087 = 0.083 = 8%. Question ID: 13588 If a bond is quoted at 90, it follows that the bond:

A. B. C. D. B

is yielding 10%. can be purchased for $900.00. can be purchased for $90. is trading at a 10% premium.

The value of a bond (assume $1,000 face value) is normally quoted as a percent of par value (the percent sign is usually dropped) and in 32nds of a dollar. Here, the quote 90 represents 90% of $1,000.00 or $900.00. Question ID: 13582 The value of a US Treasury bond quoted at 90:16 is:

A. B. C. D. A

$905.00. $901.60. $90.16. $90.50.

The value of a bond (assume $1,000 face value) is normally quoted as a percent of par value (the percent sign is usually dropped) and in 32nds of a dollar. Here, the quote 90:16 represents 90 and 16/32 percent,

or ( 90 + 16/32) = 90.5%, or $905.00. Question ID: 13560 A bond has a par value of $5,000 and a coupon rate of 8.5 percent payable semi-annually. The bond is currently trading at 112 5/32. What is the dollar amount of the semi-annual coupon payment?

A. B. C. D. B

$238.33. $212.50. $476.66. $425.00.

The dollar amount of the coupon payment is computed as follows: Coupon in $ = $5,000 x 0.085/2 = $212.50 Question ID: 13579 A coupon bond:

A. B. C. D. C

always sells at par. can always be converted into a specific number of shares of common stock in the issuing company. pays interest on a regular basis (typically semi-annually). does not pay intersest on a regular basis, but pays a lump sum at maturity.

This choice accurately describes a coupon bond. With an accrual bond, payments are deferred to maturity and then disbursed along with the par value at maturity. Unlike a normal zero-coupon bond, these issues are sold at (or near) their par values and then the interest accrues at a compound rate on top of that. So, they start at $1,000 and then appreciate from there. A convertible bond contains conversion rights which grant the holder of a bond a right to convert the bond into common shares of the issuer. This choice represents an embedded option (a topic covered in LOS 1.A.i) and is of value to the bondholder. Question ID: 13591 How much would an investor expect to pay for a $10,000 Treasury note quoted at 96:27?

A. B.

$968.44. $9,684.38.

C. D. B

$10,000.00. $9,627.00.

[(96+27/32)/100] x 10,000=$9,684.38 Question ID: 13593 If an investor purchases a 8 1/2s 2001 Feb. $10,000 par Treasury Note at 105:16 and holds it for exactly one year, what is the rate of return if the selling price is 105:16?

A. B. C. D. B

8.00%. 8.06%. 8.22%. 8.50%.

Purchase Price=[(105+16/32)/100]x10,000=$10,550.00 Selling price=[(105+16/32)/100]x10,000= $10,550.00 Interest=8 1/2% of 10,000=$850.00 Return=(P end -P beg + Interest)/P beg=(10,550.00-10,550.00+850.00)/10,550.00=8.06% Question ID: 13596 Given that the coupon rate of a bond is higher than the market interest rate on bonds with similar maturities and payment structures, the bond will be trading:

A. B. C. D. D

at par value. at a discount. with a higher yield. at a premium.

If the bond provides investors with a higher coupon rate than the market interest rate the bond has to be trading at a premium relative to its par value otherwise there is an arbitrage opportunity. Question ID: 21168 Which of the following statements about zero-coupon bonds is FALSE? A zero-coupon bond provides a single cash flow at maturity equal to its par value.

A.

B. C.

The lower the price, the greater the return. All interest is earned at maturity. A zero coupon bond may sell at a premium to par when interest rates decline.

D.

D
Zero coupon bonds always sell below their par value, or at a discount prior to maturity. The amount of the discount may change as interest rates change, but a zero coupon bond will always be priced less than par. Question ID: 13600 Which of the following statements is TRUE concerning zero-coupon bonds?

A.

Investors cannot lock in a high rate of return because of the lack of an annual coupon. The investor must pay taxes on the annual accrued interest even though no interest is actually received unless the bonds are held in tax-sheltered accounts. Zero-coupon bonds generally require the investor to switch to a coupon-bearing bond after a period of 5 years. Large capital losses accrue when interest rates decline.

B.

C. D. B

Question ID: 21169 A 12-year, $1,000 face value zero-coupon bond is priced to yield a return of 7.50 percent compounded semi-annually. What is the bond’s price?

A. B. C. D. A

$413.32. $250.00 $389.75 $419.85.

Using an equation: Pricezerocoupon = Face Value * [ 1 / ( 1 + i/n)

n*2

] Here, Pricezerocoupon = 1000 * [ 1 / (1+

0.075/2)

12*2

] = 1000 * 0.41332 = 413.32.

Using the calculator: N = (12*2) = 24, I/Y = 7.50 / 2 = 3.75, FV = 1000, PMT = 0. PV = -413.32 Question ID: 21170 A 15-year, $1,000 face value zero-coupon bond is priced to yield a return of 8.00 percent compounded semi-annually. What is the price of the bond, and how much interest will the bond pay over its life, respectively?

A. B. C. D. C

$389.75, $610.25. $315.24, $684.76. $308.32, $691.68. $691.68, $308.32.

Using an equation: Pricezerocoupon = Face Value * [ 1 / ( 1 + i/n) Here, Pricezerocoupon = 1000 * [ 1 / (1+ 0.080/2) = 1000 – 308.32 = 691.68.
15*2

n*2

]

] = 1000 * 0.30832 = 308.32. So, interest = Face – Price

Using the calculator: N = (15*2) = 30, I/Y = 8.00 / 2 = 4.00, FV = 1000, PMT = 0. PV = -308.32. Again, Face – Price = 1000 – 308.32 = 691.68. Question ID: 21173 Allcans, an aluminum producer, needs to issue some debt to finance expansion plans, but wants to hedge its bond interest payments against fluctuations in aluminum prices. Jerrod Price, the company’s investment banker, suggests a non-interest rate index floater. This type of bond will provide all the following advantages EXCEPT:

A.

the payment structure helps protect Allcan's credit rating. the bond agreement allows Allcans to set coupon payments based on business results. the bond's coupon rate is linked to the price of aluminum. Allcan will have a lower coupon payment when the price of aluminum is down.

B.

C.

D.

B
The coupon rate is set in the bond agreement (indenture) and cannot be changed unilaterally.

Non-interest rate indexed floaters are indexed to a commodity price such as oil or aluminum. Business results could be impacted by numerous factors other than aluminum prices. All other choices are true. By linking the coupon payments directly to the price of aluminum (meaning that when aluminum prices increase, the coupon rate increases and vice versa), the non-interest index floater allows Allcans to protect its credit rating during adverse circumstances. Contractual interest payments will be lower when aluminum prices are down, and cash flow may be tight. This helps to prevent default. When conditions improve, Allcans will be required to make higher coupon payments. Question ID: 13602 Sometimes floating rate issues have caps and/or floors, which limit the maximum or minimum coupon rate that the issue will pay. Which of the following statements is TRUE with regard to floating rate issues that have caps and floors?

A. B. C. D. C

A cap is an advantage to the bondholder while a floor is an advantage to the issuer. A floor is an advantage to both the issuer and the bondholder while a cap is a disadvantage to both the issuer and the bondholder. A cap is a disadvantage to the bondholder while a floor is a disadvantage to the issuer. A floor is a disadvantage to both the issuer and the bondholder while a cap is an advantage to both the issuer and the bondholder.

A cap limits the upside potential of the coupon rate paid on the floating rate bond and is therefore a disadvantage to the bondholder. A floor limits the downside potential of the coupon rate and is therefore a disadvantage to the bond issuer. Question ID: 13601 Consider a floating rate issue that has a coupon rate that is reset on January 1 of each year. The coupon rate is defined as one-year London Interbank Offered Rate (LIBOR) + 125 basis points and the coupons are paid semi-annually. If the one-year LIBOR is 6.5 percent on January 1, which of the following is the semi-annual coupon payment received by the holder of the issue in that year?

A. B. C. D. D

3.250%. 7.750%. 6.500%. 3.875%.

This value is computed as follows: Semi-annual coupon = (LIBOR + 125 basis points)/2 = 3.875%

Question ID: 21171 Bonds issued by Rally Development contain an inverse-floater provision. The prospectus contains the following information: annual coupon rates calculated using a constant rate of 8.50 percent, a multiplier of 2.0, and a reference rate of 2.50 percent. The face value is $5,000. What is the annual coupon dollar amount?

A. B. C. D. B

$675.00. $175.00. $300.00. $425.00.

Step 1: Calculate coupon rate. The formula to calculate the coupon rate for an inverse floater is: Coupon rate = constant rate – (multiplier * reference rate) Here, Coupon rate = 8.50% - (2 * 2.50%) = 3.50%. Step 2: Calculate coupon payment: Coupon Payment = Face * Coupon rate/n. Here, n = 1 (annual payments), so Coupon Payment = 5000 * 0.035 = $175.00 Question ID: 21174 A floating rate security that is issued with a variable rate but may change to a constant rate under certain circumstances is called a:

A. B. C. D. C

deleveraged floater. collar. drop lock. ratchet bond.

This is the correct definition of a drop lock bond. A security is said to have a collar if it contains both a cap (limit on maximum interest paid) and a floor (limit on minimum interest paid). A deleveraged floater adjusts the reference rate by a scaling factor and then adds a stated margin. A ratchet bond adjusts upward and downward around a reference rate; but once the downward adjustment takes effect, the coupon rate cannot be increased again.

Question ID: 21172 Bonds issued by Roka Investment contain a dual-index floater provision. The prospectus contains the following information: semi-annual coupon rates, reference rate1 = Prime rate (5.50 percent), reference rate2 = 3-month LIBOR (2.30 percent), and a fixed margin (3.75 percent). What is the semi-annual coupon rate?

A. B. C. D. D

$6.95%. $5.78%. $4.50%. $3.475%.

Calculate coupon rate. The formula to calculate the coupon rate for dual-index floater is: Coupon rate = reference rate1 - reference rate2 + fixed margin. Here, Coupon rate = 5.50 – 2.30 + 3.75 = 6.95%. Dividing by 2 gives the semiannual rate: 6.95/2 = 3.475%. Question ID: 21237 In the context of bonds, accrued interest:

A. B. C. D. D

covers the part of the next coupon payment not earned by seller. is discounted along with other cash flows to arrive at the dirty, or full price. applies only to bonds with semi-annual or quarterly coupon payments. equals interest earned from the previous coupon to the sale date.

This is a correct definition of accrued interest on bonds. The other choices are false. Accrued interest can occur on all bonds with periodic coupon payments, not just bonds with payment frequencies greater than one year. Accrued interest is not discounted when calculating the price of the bond. The statement, "covers the part of the next coupon payment not earned by seller," should read, "…not earned by buyer." Question ID: 21239 Peter Stone is considering buying a $100 face value, semi-annual coupon bond with a quoted price of 105 6/32. His colleague points out that the bond is trading ex-coupon. Which

of the following choices best represents what Stone will pay for the bond?

A. B. C. D. D

$105.19 minus the coupon payment. $105.19 plus accrued interest. $105.19 minus accrued interest. $105.19.

Since the bond is trading ex-coupon, the buyer will pay the seller the clean price, or the price without accrued interest. So, Stone will pay the quoted price. The choice $105.19 plus accrued interest represents the dirty price (also known as full price). This bond would be said to trade cum-coupon. Question ID: 13611 Assume a bond's quoted price is 105 7/32 and the accrued interest is $3.54. The bond has a par value of $100. What is the bond's clean price?

A. B. C. D. A

$105.22. $108.76. $103.54. $100.00.

The clean price is the bond price without the accrued interest so it is equal to the quoted price. Question ID: 21238 The dirty, or full, price of a bond:

A. B. C. D. A

equals the present value of all cash flows, plus accrued interest. is usually less than the clean price. applies if an issuer has defaulted. is paid when a security trades ex-coupon.

The dirty price of a bond equals the quoted price plus accrued interest. If an issuer has defaulted,

the bond trades without interest and is said to trade flat. When a security trades ex-coupon, the buyer pays the clean price, which is the quoted price without accrued interest. The dirty price of a bond is greater than the clean price by the amount of the accrued interest. (If the bond trades on a coupon date, the dirty price will equal the clean price.) Question ID: 21240 Austin Traynor is considering buying a $1,000 face value, semi-annual coupon bond with a quoted price of 104 24/32 and accrued interest since the last coupon of $33.50. If Traynor pays the dirty price, how much will the seller receive at the settlement date?

A. B. C. D. D

$1,047.50. $1,033.50. $1,014.00. $1,081.00.

The dirty price is equal to the agreed upon, or quoted price, plus interest accrued from the last coupon date. Here, the quoted price is 1000 * 104.75%, or 1000 * 1.0475 = 1,047.50. Thus, the dirty price = 1047.50 + 33.50 = 1,081.00. Question ID: 21244 Which of the following is NOT an example of a bullet bond? A 10-year municipal bond with two pieces: a 5-year, 7.75% bond and a 10-year, 7.25% bond. A 10-year, $5,000 face value semi-annual coupon bond with a constant rate of 8.50%, a multiplier of 2.0, and a reference rate of 2.50%. A 15-year, $1,000 face value zero-coupon bond priced to yield 8.00%. A 10-year, $1,000 face value, 10.00% semi-annual coupon Treasury bond.

A.

B.

C. D. A

A 10-year municipal bond with two pieces is a simplified example of a serial bond. A serial bond pays off the principal through a series of payments over time. Common in the municipal market, these bonds are actually made up of a series of smaller bonds, each with its own coupon and maturity date. All other choices describe a type of bullet bond – a bond that pays off principal with a lump sum at maturity. The interest payment is not a factor. The choice, "A 10-year, $5,000 face value semi-annual coupon bond with a constant rate of 8.50%, a multiplier of 2.0, and a reference rate of 2.50%," describes an inverse floater.

Question ID: 21242 Which of the following is NOT an example of how an issuer can pay off the principal on a security?

A. B. C. D. C

Mortgage-backed security. Bullet bond. Coupons. Serial bonds.

Coupon payments only reflect the payment of interest and do not reduce principal. Bullet bonds pay the entire principal in one lump sum at maturity. Serial bonds pay off the principal through a series of payments over time. Serial bonds, common in the municipal market, are actually made up of a series of smaller bonds, each with its own coupon and maturity date. A mortgage-backed security is an example of an amortizing security. Amortizing securities make periodic principal and interest payments. Question ID: 21241 Which of the following is an example of a non-amortizing security?

A. B. C. D. D

Mortgage-backed security. Asset-backed security. Collateralized mortgage obligation. Bullet bond.

Bullet bonds are regular coupon-paying bonds with repayment of principal in one lump sum at maturity. All other choices are examples of amortizing securities. Question ID: 21243 Jaqui Bernal is considering purchasing a municipal security but is confused, because the prospectus indicates that it is comprised of 10 parts, each with its own unique maturity (ranging from 2 to 20 years) and coupon rate. She asks her friend, Marcie Korman, CFA, about the bond. Korman informs Bernal that this type of structure is normal for what kind of security?

A. B. C. D. D

Split-maturity municipal. Stepped amortizing bond. Bullet bond. Serial bond.

Serial bonds pay off the principal through a series of payments over time, using a structure similar to that described in the question. Serial bonds are common in the municipal market. A Bullet bond pays the entire principal in one lump sum at maturity Question ID: 13618 Which of the following is TRUE about the call feature of a bond? It:

A. B. C. D. C

describes the credit risk of the bond. describes the maturity date of the bond. stipulates whether and under what circumstances the issuer can redeem the bond prior to maturity. stipulates whether and under what circumstances the bondholders can request an earlier repayment of the principal amount prior to maturity.

Call provisions give the issuer the right (but not the obligation) to retire all or a part of an issue prior to maturity. If the bonds are ―called,‖ the bondholder has no choice but to turn in his bonds. Call features give the issuer the opportunity to get rid of expensive (high coupon) bonds and replace them with lower coupon issues in the event that market interest rates decline during the life of the issue. Call provisions do not pertain to maturity or credit risk. A put provision gives the bondholders certain rights regarding early payment of principal. Question ID: 13615 The refunding provision allows bonds to be retired unless:

A. B. C. D.

the funds come from a lower cost bond issue. All of these choices are correct. the funds come from earnings. the funds come from the sale of new common stock.

A
Refunding from a new debt issue at a higher interest rate is not prohibited, however their purchase cannot be funded by the simultaneous issuance of lower coupon bonds. Question ID: 13619 Which of the following is FALSE about bonds with sinking funds? They have:

A. B. C. D. C

lower default risk. allows the issuer to retire a larger portion of the issue at par at its discretion. lower yields due to shorter average maturities. higher yields due to shorter average maturities.

Question ID: 13622 Bonds that CANNOT be retired by the issuance of new debt are called:

A. B. C. D. A

non refundable bonds. sinking fund bonds. restricted bonds. non callable bonds.

By definition. Question ID: 20021 Which of the following statements about bonds is FALSE?

A. B.

Refunding refers to the source of funds used to redeem a bond. A nonrefundable bond can never be prematurely retired. A nonrefundable bond cannot be retired with the proceeds from a lower coupon bond issue. Redemption refers to how bonds are retired.

C.

D. B

A nonrefundable bond can be retired from using funds from a different source than a new bond issue. For example, operating cash flow or new equity issues. Question ID: 20022 The Rivendell-Hobart Toll Authority currently has a nonrefundable municipal bond issue with a 10-year maturity and a 10.50 percent coupon rate. Interest rates have decreased significantly since issuance, and the Authority wants to retire the debt. Which of the following alternatives is NOT an acceptable method of retirement?

A. B. C. D. B

Issuing new common stock at $40 per share. Issuing a 7-year, nonrefundable bond with a coupon rate of 7.25%. Using funds from operating cash flow. Issuing a 10-year, zero-coupon bond priced to yield 11.00%.

A nonrefundable bond can be redeemed with funds from operations or a new equity issue. A nonrefundable bond cannot be redeemed with a lower coupon issue. Question ID: 20023 Louis Mesina, CFA, has a client who wants to invest in a longer-term security with no prepayment risk. Which of the following terms best describes the type of bond Mesina should recommend?

A. B. C. D. B

Freely callable. Noncallable. Redeemable. Nonrefundable

A bond that is noncallable has absolute protection against premature retirement—it cannot be called for any reason. This is the best choice for this investor. In contrast, a nonrefundable bond can be called for any reason other than refunding. The term refunding specifically means redeeming a bond with a new bond issued at a lower coupon rate. A nonrefundable bond can be redeemed with funds from operations or a new equity issue. The term redeemable refers to redemption, which refers to how the bonds are retired (a sinking fund, for example). All bonds are expected to be redeemed at some point. Freely callable means the issuer can retire the bond at any time (or within set windows.)

Question ID: 20020 Which of the following statements about noncallable bonds and refunding is TRUE?

A. B. C.

A sinking fund is an example of refunding. If a bond is nonrefundable, it must also be noncallable. A noncallable bond provides absolute protection against early retirement. An investor concerned about premature redemption is indifferent between a noncallable bond and a nonrefundable bond.

D.

C
A noncallable bond cannot be called for any reason. An investor concerned about premature redemption would prefer a noncallable bond. A nonrefundable bond can be called for any reason other than refunding. The term refunding specifically means redeeming a bond with funds raised from a new bond issued at a lower coupon rate. A nonrefundable bond can be redeemed with funds from operations or a new equity issue. A bond can be both nonrefundable and callable. A sinking fund is a type of redemption, which refers to the retirement of bonds. Question ID: 20017 Five years ago, Sirocco, Inc., issued bonds with a deferred call provision. The first call date is near, and the firm would like to redeem at least part of the issue as a special redemption, using funds from the sale of land. Which of the following conditions would preclude Sirocco from redeeming at the special redemption price?

A. B. C. D. A

The redemption price is set above par. The bond has a sinking fund. The land sale was seized under eminent domain. The land sale was forced for deregulatory purposes.

The term special redemption price means that the bonds are redeemed at par. The other choices provide correct examples of conditions under which the firm can redeem bonds at par. Question ID: 20018 Callable bonds redeemed at a special redemption price are redeemed:

A. B. C. D. B

at the strike price. at par. below par. above par.

Bonds redeemed at par are redeemed at the special redemption price. When bonds are called at a premium, the issuer redeems them at a price above par, or the regular or general redemption price. Question ID: 20016 When bonds are called at par what is the term used to describe the redemption price?

A. B. C. D. C

General redemption price. Regular redemption price. Special redemption price. Standard redemption price.

Bonds redeemed at par are redeemed at the special redemption price. When bonds are called at a premium, the issuer redeems them at a price above par, or the regular or general redemption price. Question ID: 20019 Callable bonds redeemed at the regular or general redemption price are redeemed:

A. B. C. D. B

below par. above par. at par. at the strike price.

When bonds are called at a premium, the issuer redeems them at a price above par, or the regular or general redemption price. Bonds redeemed at par are redeemed at the special redemption price. Question ID: 20015 When bonds are called at a premium, what is the relationship of price to the par value, and what is the term used to describe the redemption price?

A. B. C. D. D

Above par, special redemption price. Equal to par, regular redemption price. Equal to par, special redemption price. Above par, regular redemption price.

When bonds are called at a premium, the issuer redeems them at a price above par, or the regular or general redemption price. Bonds redeemed at par are redeemed at the special redemption price. Question ID: 20012 Which of the following examples of an embedded option does NOT favor the bondholder?

A. B. C. D. D

Put option. Interest rate floor. Conversion provision. Call option.

A call option gives the issuer of bonds the right to redeem the issue at a date prior to maturity, at a predetermined price. The issuer has the choice of whether or not to call the bond. A call option is the opposite of a put option, which benefits the bondholder by giving him the right to sell the bond to the issuer at what is known as the “put price,” at certain dates prior to maturity. An interest rate floor benefits the holder by providing a lower limit (or minimum) on the interest rate the bondholder will receive. A conversion provision gives the holder the option of converting the bond to common stock, and the holder can decide whether conversion is advantageous. Question ID: 20013 Which of the following statements about call options (on bonds) is TRUE?

A. B.

The call price is determined by the conversion ratio. The call price is usually set below the par value of the bonds. The issuer is likely to call the bond when the market value is above the call price. The call option on debt can trade separately from the bond.

C.

D. C

A market value above the call price likely indicates that interest rates have decreased, and the issuer can replace existing debt with lower cost debt. Thus, the issuer will likely call the bond. Embedded options in bonds (of which a call option is an example) are inseparable from the underlying bond and trade with that bond. The conversion price is determined by the conversion ratio (the number of shares into which each bond is convertible). The call price is usually set above the par value of the bonds. Question ID: 20011 Which of the following examples of an embedded option does NOT favor the bond issuer? Prepayment right granted to the borrower of loans underlying amortizing securities. Call option. Interest rate cap. Put option.

A.

B. C. D. D

A put option benefits the bondholder by giving him the right to sell the bond to the issuer at what is known as the “put price,” at certain dates prior to maturity. A put option is the opposite of a call option, which gives the issuer of bonds the right to redeem the issue at a date prior to maturity, at a predetermined price. An interest rate cap benefits the issuer by providing an upper limit (or maximum) on the interest rate. An example of an amortizing security is a mortgage loan. To understand why the repayment right granted to the borrower of loans underlying amortizing securities benefits the issuer, remember that the issuer here is the homeowner. The bank acts as a passthrough from the homeowner to the owner of a bond collateralized by the loan. The right to prepay if interest rates decrease is a benefit to the homeowner. If the homeowner prepays, the holder of the bond has reinvestment risk. Question ID: 13623 Which of the following statements is TRUE with regard to a call provision?

A.

A call provision will benefit the issuer in times of declining interest rates.

B. C. D. A

An issue with a call provision will trade at a higher price than an identical issue with no call provision. A call provision is a disadvantage to the bondholder in periods of rising interest rates. A call provision is an advantage to the bondholder.

A call provision gives the bond issuer the right to call the bond at a prespecified strike price. A bond issuer will wish to call a bond if he is paying a high coupon and interest rates have, in general, decreased so that he would be able to get cheaper financing in the market than he is able to get with the current bond issue. Question ID: 20014 Under which of the following scenarios will the option on the fixed-income security most likely be exercised? An investor purchased a 30-year bond with a put option priced to yield 5.75%. The market value is currently above par value. Passage Ltd. has $100 million in bonds outstanding with an accelerated sinking fund provision. The market value of the bonds is currently below par. Fahr, Inc., issued 8.00% freely callable bonds. Presently, Fahr could issue similar bonds at 9.00%. A homeowner has an 8.00% fixed rate mortgage. Rates on similar term mortgages are now at 7.00%.

A.

B.

C.

D.

D
The homeowner is likely to exercise his option to refinance the loan with a new loan at a lower interest rate. Fahr, Inc., is not likely to redeem existing debt with a new issue at a higher rate. An accelerated sinking fund provision allows the issuer to retire a larger portion of bonds at par than required in the indenture. Passage, Inc., is most likely to exercise this option when the market value of the bonds is above par. A put option benefits the bondholder by giving him the right to sell the bond to the issuer at what is known as the “put price,” at certain dates prior to maturity. The holder is most likely to exercise the put option if the market value has fallen below par value. Question ID: 13625 Which type of bond gives the bondholder the right to cash before maturity at a specified price after a specific date?

A.

Callable.

B. C. D. C

Coupon. Putable. Treasury.

By definition. Question ID: 20008 The error in the pricing of bonds due to assumption errors and model selection is called:

A. B. C. D. B

behavior risk. modeling risk. bias risk. selection risk.

This is a correct definition of the error in pricing bonds due to errors in assumptions and model selection. Question ID: 20009 Alton Thibedeau, CFA candidate, was just hired by a fixed-income securities firm’s valuation department. Thibedeau’s first assignment is to model the value a large block of callable bonds. He seeks the advice of a colleague, Pierre Guidrey, who makes the following statements. Which of Guidrey’s statements is FALSE?

A.

Embedded options affect only the timing of cash flows. The model should incorporate the expected exercise behavior of both parties. Modeling the future course of interest rates is an essential input into the bond valuation process. Modeling risk includes model selection and assumption errors.

B.

C.

D. A

Embedded options can also affect the magnitude of cash flows. For example, an accelerated sinking fund provision allows the issuer to retire more debt than required under the normal sinking fund agreement.

Question ID: 20010 Which of the following statements about pricing and valuing bonds with embedded options is TRUE?

A.

As long as the assumptions are correct, the valuation will be correct. Modeling (forecasting) the future course of interest rates is an essential input into the bond valuation process. The issuer and holder’s behavior is a function of current interest rates. In most cases, the values of a bond with and without the options are nearly identical.

B.

C.

D.

B
Embedded options affect the value of a bond through both the timing and magnitude of cash flows. In addition, embedded options are not stand-alone; they must be traded with the bond. The issuer and holder’s behavior is a function of the level of future interest rates and the path they follow over time. Options are most likely to be exercised in the future. Even if the assumptions are mostly correct there is always the other component of modeling risk – the error that can occur from incorrect model selection. Question ID: 13626 Which of the following is the maximum price for a callable bond which is callable throughout its life?

A. B. C. D. A

The call strike price. The present value of its par value. Its par value plus accrued interest. Its par value.

Whenever the price of the bond increases above the strike price of the call option it will be optimal for the issuer to call the bond. So in the limit, the bond price can never rise above the call strike price. Question ID: 21151 Which of the following is most likely the buyer in a reverse-repurchase agreement? A(n)

A. B.

government securities dealer. employee in the treasury department of a large corporation.

C. D. A

portfolio manager for a money market fund. financial institution.

For the exam, remember, the buyer in a reverse repurchase agreement is a dealer and the seller is the non-dealer. Thus, the other choices represent potential sellers. Question ID: 21153 A repurchase agreement with a maturity of one day is called a(n):

A. B. C. D. B

immediate repo. overnight repo. short-term repo. term repo.

This is the correct definition for a one-day repurchase (repo) agreement. A term repo has maturity greater than one day. Question ID: 21149 Which of the following potential parties to a repurchase agreement is least likely to participate? A:

A. B. C. D. A

pension fund manager hedging a long-term asset. financial institution. portfolio manager for a money market fund. dealer in Treasury securities.

Repurchase agreements are short term (1-90 days) in nature and would be an unlikely hedge for a long-term asset. The other choices represent possible participants. Money market funds are short-term and better match the repurchase agreement term. Financial institutions often serve as the counterparty in a repurchase

transaction. A dealer in Treasury securities is one of the most common parties to a repurchase transaction. Question ID: 21150 Which of the following is most likely the seller in a repurchase agreement? A(n)

A. B. C. D. B

portfolio manager for a money market fund. government securities dealer. financial institution. employee in the treasury department of a large corporation.

For the exam, remember, the seller in a repurchase agreement (the one borrowing) is a dealer. The buyer is a non-dealer. Thus, the other choices represent potential buyers. Question ID: 21152 The dollar amount of interest charged by the buyer in a repurchase agreement is based on all the following factors EXCEPT the:

A. B. C. D. B

term of the repurchase agreement (number of days). long-term Treasury rate. quality of underlying collateral. amount borrowed.

Since repurchase agreements are short-term (many have maturities of only one day), the interest rate is based on the short end of the yield curve (a rate such as the federal funds rate). The value of the securities does not factor into the repo rate. Question ID: 21154 Which of the following statements about repurchase agreements (repos) is TRUE?

A. B.

In a repurchase agreement, the seller makes funds available to the buyer. Repurchase agreements are risk-free.

C.

The repurchase price of a repo is greater than the original selling price because of movements in the bond's value during the repo period. The same agreement is used for repurchase agreements and reverse purchase agreements.

D.

D
The agreement is the same. The terms repurchase agreement and reverse repurchase agreement are relative to who is borrowing the funds. The statement, “In a repurchase agreement, the seller makes funds available to the buyer,” should read, ―the buyer makes funds available to the seller. The buyer loans the securities. For example, say that you are a government securities dealer who knows that you can sell more Treasuries than you have funds to purchase. If you enter into a repurchase agreement with the Federal Reserve, you agree to sell the Fed the portion that you cannot afford right now, with the agreement that you will purchase the bonds back at a later date (ideally, as you receive orders). You are the seller and the Federal Reserve is the buyer. In effect, the Federal Reserve has loaned you money. The price difference between the repurchase price and the original price is due to interest charged on the funds used. The value of the securities does not factor into the repo rate. Repurchase agreements are low risk, but are not risk free because of counterparty risk. If the market value of the bond declines during the repo period, the counterparty may not be able to payback its loan. If the market value of the bond appreciates during the repo period, the counterparty may not want to deliver the bond. Question ID: 21159 Which of the following statements about repurchase agreements (repos) is TRUE?

A. B. C.

The seller is a dealer, the buyer is a non-dealer. In a repurchase agreement, the seller makes funds available to the buyer. A repurchase agreement with a term of one day is called a short-term repo. The repurchase price of a repo is greater than the original selling price because of movements in the bond’s value during the repo period.

D.

A
The statement, “In a repurchase agreement, the seller makes funds available to the buyer,” should read, “…the buyer makes funds available to the seller. The buyer loans the securities. For example, a government securities dealer knows that she can sell more Treasuries than she has funds to purchase. If she enters into a repurchase agreement with the Federal Reserve, she agrees to sell the Fed the portion that she cannot afford right now, with the agreement that she will purchase the bonds back at a later date

(ideally, as she receives orders). She is the seller and the Federal Reserve is the buyer. In effect, the Federal Reserve has loaned her money. The difference between the two prices (original and repurchase) is referred to as the repo rate and is due to interest charged on the funds used. The value of the securities does not factor into the repo rate. A repurchase agreement with a term of one day is called an overnight repo. Question ID: 21156 What is the typical method used by individual investors to finance bond purchases?

A. B. C. D. C

Financial institution loan. Repurchase agreement. Margin account. Credit card debt.

Private individuals typically use margin accounts to buy stocks and bonds. For individuals, the interest rate on margin accounts is usually less than that on bank loans or credit cards. Institutional investors typically finance bond purchases with repurchase agreements (repos). Institutional investors may use a margin account to buy stock. Question ID: 21155 What is the typical method used by institutional investors to finance bond purchases?

A. B. C. D. C

Margin account. Financial institution loan. Repurchase agreement. Cash.

Institutional investors typically finance bond purchases with repurchase agreements (repos). The interest rate on repos is usually lower than the Federal Funds rate. Institutional investors may use a margin

account to buy stock. Private individuals typically use margin accounts to buy stocks and bonds. For individuals, the interest rate on margin accounts is usually less than that on bank loans or credit cards. Question ID: 21158 Which of the following statements regarding financing bond purchases with margin accounts is FALSE?

A. B. C.

The loan in a margin transaction is collateralized by the purchased security. The required margin percentage changes daily. In the U.S., margin accounts are regulated by the Federal Reserve. Individuals are more likely than institutions to use margin accounts to finance bond purchases.

D.

B
The margin percentage is fixed by contract. The required margin dollars may vary from day to day due to fluctuations in the underlying collateral. Institutional investors are more likely to use repurchase agreements to finance bond purchases. Buying on margin magnifies both gains and losses because of leverage. The investor realizes the same return on the margin portion as on the equity portion of his account. The following example illustrates this: An investor has $5,000, but wants to buy ten $1,000 face value bonds at par (for a total of $10,000. With the cash, he can only purchase five bonds. With a 50% margin account, he can buy all ten bonds ($5,000 cash equity contribution and $5,000 from the margin account.) The following table indicates the change in the portfolio value assuming the investor purchases on margin versus all cash. Note: The example ignores the interest due on the margin account. At Par Portfolio value - if margin Minus debt - if margin Equity value - if margin Portfolio value - if cash Gain (Loss) - if margin Gain (Loss) - if cash 10,000 5,000 5,000 5,000 Price Increases Price Decreases to 110% to 90% 11,000 5,000 6,000 5,500 9,000 5,000 4,000 4,500

0 0

1,000 500

(1,000) (500)

Question ID: 21157 Which of the following statements regarding financing bond purchases is TRUE? In margin transactions, the broker borrows from the bank at the call money rate plus a spread. The rate the investor pays on the loan in a margin transaction is known as the call money rate. The investor loan in a margin transaction is backed by cash held in trust. Purchasing securities on margin allows investors to leverage assets and make larger purchases.

A.

B.

C.

D.

D
Example: An investor has $5,000 cash, but wants to buy ten $1,000 face value bonds at par (for a total of $10,000). With cash only, he can only purchase five of the bonds. With a 50% margin account, he can buy all ten bonds ($5,000 cash equity contribution and $5,000 from the margin account). With the margin account, he will realize the gain or loss on all ten bonds rather than the five he could have purchased with cash only. The statements about the rates paid by the parties to a margin transaction are reversed. The statement, “In margin transactions, the broker borrows from the bank at the call money rate plus a spread,” should read, “…borrows…at the call money rate.” The statement, “The rate the investor pays on the loan in a margin transaction is known as the call money rate.” should read, “…known as the call money rate plus a spread.” Remember that the broker needs to make profit, so the investor will pay a rate higher than the broker pays to the bank. The investor collateralizes the margin loan with the securities purchased. Question ID: 13594 An investor buys a $1,000, 5 year zero for 70:16 and sells it one year later for $735. What is the rate of return?

A. B. C. D.

4.76%. 4.26%. 1.93%. 9.48%.

B it value equal [(70+16/32)/100]*$1000=$705
Note the first quote is a percent, so ( 735 - 705 ) / 705 = 4.26%. Question ID: 13555

A 10 percent bond purchased at the beginning of the year for $1,050 and sold at the end of the year for $1,100 would have a holding period return of:

A. B. C. D. B

10.5%. 14.3%. 10.0%. 15.0%.

Input into your calculator: N = 1, FV = 1,100, PMT = 100, PV = -1050 CPT I / Y = 14.29 Question ID: 13603 Which of the following statements does NOT accurately describe a characteristic of an inverse floater? A floating-rate issue:

A. B. C. D. C

that has an implicit cap on the maximum coupon rate and typically includes a floor on the minimum coupon rate. whose coupon is determined by subtracting a reference rate from some stated maximum rate. that may, under certain circumstances, require the bondholder to make payments to the issuer. whose coupon rate will increase as market rates decrease and decrease as market rates increase.

The bondholder always receives coupon payments made by the issuer and not the opposite since would correspond to a negative interest rate. Question ID: 13561 Given that a bond has a par value of $50,000 and is currently offered at a quoted price of 98 5/32, what is the dollar amount that an investor must pay in order to purchase the bond?

A. B. C. D. D

$4,907,812.50. $98.16. $50,000.00. $49,078.13.

If the quoted price is 98 5/32 this means that the dollar amount is: 0.9815625 x $50,000 = $49,078.13

Setup Text: Janice Brown, is a fixed income portfolio manager for a large investment house. On January 1, 2000, Brown is considering purchasing one of the 10-year AAA corporate bonds shown in Table 1. Prices are quoted as a percentage of par. Brown needs to reduce her cash position in her portfolio by purchasing some fixed income securities. She would like to analyze the behavior of some instruments under various interest rate scenarios that she deems likely. Brown notes that the yield curve is currently flat at 5%. Unless otherwise stated, Brown assumes that yield curve shifts occur in an instantaneous and parallel manner. Table 1 AAA Corporate Bond Characteristics Coupon (SA) Price Callable 6.00% 107.1767 Noncallable Currently 6.20% 107.1767 Callable

Description ABC due Jan. 1, 2009 XYZ due Jan. 1, 2009

Call Price Not applicable 109.00

Janice has noticed that for ABC there are also two other bond issues outstanding: a floating rate (FRN) and an inverse floating rate bond (IF). Their characteristics are shown in Table 2. Table 2 Bond Characteristics for Floating Rate and Inverse Floating Rate Bond Fabozzi Description Coupon (SA) Type Callable Convexity ABC due Jan. 1, LIBOR Floating Rate Noncallable 0.475907198 2009 ABC due Jan. 1, Inverse Floating 12%-LIBOR Noncallable 111.1977205 2009 Rate The price value of a basis point (PVBP) for the ABC Fixed rate bond shown in Table 1 is 748.6068. The ABC FRN has a PVBP of 0.4878. Question ID: 13608 Brown would now like to consider nonparallel shifts in interest rates. Specifically, she is curious about the behavior of the IF in Table 2 when interest rates shift upward in a nonparallel matter immediately following a coupon payment. How is the price of the IF affected? Its price will:

A. B. C. D. A

decrease. remain constant. increase. increase or decrease.

Since LIBOR is subtracted from a fixed rate, an increase in LIBOR will result in a lower coupon for

this security. Therefore, its price will decrease if the term structure shifts up (whether it is a parallel or a nonparallel shift). Question ID: 13608 Brown would now like to compute the best estimate of the price of the IF when there is an upward shift in the term structure of 100 basis points. Which of the following is the closest to the actual price of the IF under this interest rate scenario?

A. B. C. D. A

100.49. 94.87. 99.87. 101.34.

The new bond price is computed as follows: Inverse Floating Price = 2 x Fixed Rate Price – Floating Rate Price The fixed rate bond has a coupon of 6% and the term structure is flat at 6% after the term structure shift. Therefore, the fixed rate bond is trading at par. The floating rate bond price is obtained as follows: Floating Rate Price = (100 + Coupon)/(1+r/2) So we have Floating Rate Price = (100 + 2.5)/(1 + 0.06/2) = 99.5146 Therefore, Inverse Floating Price = 2 x 100.0000 - 99.5146 = 100.4854 Question ID: 13616 A 15-year, 10 percent annual coupon bond is sold for $1,150. It can be called at the end of 5 years for $1,100. What is the bond's yield to call (YTC)?

A. B. C. D. A

8.0%. 9.2%. 8.4%. 9.6%.

Input into your calculator: N = 5, FV = 1100, PMT = 100, PV = -1,150 CPT I / Y = 7.95%. Question ID: 13586 If a U.S. Treasury bond is quoted at 92:16, the price of the bond is:

A. B. C. D. A
92+(16/32)=92.5

$925.00. $92.50. $92,160. $92.16.

0.925 x $1000=$925 Question ID: 13621 Most often the initial call price of a bond is its:

A. B. C. D. D

par value plus one year's interest. par value. principal less a discount fee. principal plus a premium.

Customarily, when a bond is called on the first permissible call date, the call price represents a premium above the par value. If the bonds are not called entirely or not called at all, the call price declines over time according to a schedule. For example, a call schedule may specify that a 20-year bond issue can be called after 5 years at a price of 110. Thereafter, the call price declines by a dollar a year until it reaches 100 in the fifteenth year, after which the bonds can be called at par. Question ID: 13557 A 20-year, 10 percent annual coupon bond sells for $1,196 to yield 8 percent. If the bond is held to maturity what is the interest on the interest component of the total return?

A. B. C. D. B

$4,576. $2,576. $2,000. $3,576.

Input in your calculator: N = 20, PV = 0, I = 8, PMT = 100

CPT FV = 4576 subtract CF of 20 X 100 = $2576.

1.B: Risks Associated with Investing in Bonds
Question ID: 13636 Which of the following situations lead to short-term profit opportunities in the bond market?

A. B. C. D. B
I=12% PMT=0 N=20 FV=1,000 PV=? PV=103.6668

The increasing use of deferred call privileges. Interest rates become more volatile. Inflation is expected to rise. Yields of all maturities start to rise.

Question ID: 13634 Which of the following statements relating to reinvestment risk for bonds is TRUE?

A. B. C. D. C

Long-term bonds should be purchased if the investor anticipates higher reinvestment rates. Unless the reinvestment rate equals the yield to maturity, the holding period return will be less than the yield to maturity. Zero coupon bonds have no reinvestment risk over their term. If the investor anticipates lower reinvestment rates, high coupon bonds should be purchased.

This statement is true only if the investor holds the bond until maturity. Reinvestment risk means that a bond investor risks having to reinvest bond cash flows (both coupon and principal) at a rate lower than the promised yield. Reinvestment risk increases with longer maturities and higher coupons, and decreases for shorter maturities and lower coupons. While a bond investor can eliminate price risk by holding a bond until maturity, he usually cannot eliminate bond reinvestment risk. One exception is zero-coupon bonds, since these bonds deliver payments in one lump sum at maturity. There are no payments over the life to reinvest. The statement. "Long-term bonds should be purchased if the investor anticipates higher reinvestment

rates," should read, "Short-term bonds...".If an investor expects interest rates to rise, he would want a bond with a shorter maturity so that he received his cash flows sooner and could reinvest at the higher rate. Also, there is less prepayment risk with shorter maturities. The statement. "If an investor anticipates lower reinvestment rates, high coupon bonds should be purchased," should read, "...low coupon bonds should be purchased...." Again, if an investor expects interest rates to fall, he would want a lower-coupon bond so that he could reinvest the payments and still maintain his expected YTM. The statement that begins, "Unless the reinvestment rate...," is partially true. However, the holding period return (covered in a later LOS) could be less or greater than the original yield to maturity (YTM). Over the investor's holding period, interest rates are likely to fluctuate both up and down; at some points the investor will reinvest at a higher rate than the original YTM and sometimes he will reinvest at a lower rate. Question ID: 13629 Assume a flat term structure of interest rates at 5 percent. A three-year bond pays an annual coupon of 6 percent. By how much does the bond price change if the term structure shifts up in parallel manner by 1 percent?

A. B. C. D. C

$2.72. -$0.05. -$2.72. $0.00.

The bond price has to decrease if the interest rate increases since a higher discount rate has to be used to compute the present value of the bond cash flows. The bond price change is computed as follows: Bond Price = 6/1.05 + 6/1.05 +106/1.05 – 100 = -$2.72 Question ID: 13631 For bondholders, the required return can be decomposed into the following three components: an expected inflation premium, the expected reinvestment rate, and the current risk-free rate. the risk-free rate, the real rate of return, and a risk premium. the real rate of return, a risk premium, and an expected inflation premium. the risk-free rate of return, the coupon interest rate, and the current inflation rate.
2 3

A.

B. C.

D.

C

Question ID: 22282 An investor recently purchased a 15-year, 7.25 percent, $1,000 face value semi-annual coupon bond for $935. Soon after the purchase, interest rates increased. Which of the following statements about the bond is TRUE now? The

A. B. C. D. D

bond will sell at a premium. coupon payments will increase. price will not change until the next coupon date. price will fall below $935.

When interest rates change, the price of a fixed-coupon bond changes in the opposite direction. This is because the bond’s value is determined by discounting the cash flows. A higher discount rate results in lower discounted cash flows, and vice versa. Thus, the price will fall. Another way to look at this: When interest rates increase, newer bonds will carry higher coupon rates and will be more attractive to investors than existing, lower coupon bonds (all else equal). Thus, demand for the existing bond will decrease and investors will bid down the bond’s price. The coupon payments are fixed in the indenture. The bond will not sell at a premium over par because the interest rate increased, not decreased. To increase the price of the bond over par, the interest rates would need to decrease. The bond’s price is set in the market and can change many times in one day. The timing of the coupon dates affect accrued interest. Question ID: 22280 One year ago, Lorenzo Suarez purchased a 10-year, $1,000 face value 8.00 percent semi-annual coupon bond at par (market rates were at 8.00 percent). The bond’s most recent market price quote was at $1,100. All else equal, which of the following statements about the current market interest rate is TRUE? The current market interest rate is:

A. B. C. D. A

less than 8.00%. greater than 8.00%. equal to 10.00%. equal to 8.00%.

The relationship between the price of a fixed-coupon bond and interest rates is inverse. Here, we are given that the bond price increased, so interest rates decreased and must be less than 8.00%. Another way to look at this: When interest rates decrease, newer bonds will carry lower coupon rates and will be

less attractive to investors than existing, higher coupon bonds (all else equal). Thus, demand for the existing bond will increase and investors will bid up the bond’s price. At a market rate of 8.00%, the bond would likely trade at par. At market rates greater than 8.00%, the price would decrease (reverse the logic above). The choice 10.00% represents the percentage appreciation in the bond’s price. Question ID: 22277 When interest rates fall, the prices of fixed-coupon bonds:

A. B. C. D. B

fluctuate depending upon the coupon rate. increase. decrease. remain constant.

When interest rates change, the price of a fixed-coupon bond changes in the opposite direction. This is because the bond’s value is determined by discounting the cash flows. A higher discount rate results in lower discounted cash flows, and vice versa. The coupon rate is used to determine whether bonds are issued at a premium or discount. Question ID: 13637 As interest rates rise, bond prices:

A. B. C. D. C

rise. remain constant. fall. fluctuate up and down.

When interest rates change, the price of a fixed-coupon bond changes in the opposite direction. This is because the bond’s value is determined by discounting the cash flows. A higher discount rate results in lower discounted cash flows, and vice versa. Question ID: 22283 An investor recently purchased a 15-year, 7.75 percent, $1,000 face value semi-annual coupon bond at par. Interest rates recently decreased. Which of the following statements about the bond is TRUE? The

A. B. C. D. D

bond's price will decrease until it matches the return required by the market. bond's cash flows are reduced. bond is less attractive to new investors. bond's price will increase until it matches the return required by the market.

When interest rates decrease, newer bonds will carry lower coupon rates and will be less attractive to investors than existing, higher coupon bonds (all else equal). Thus, demand for the bond will increase and investors will bid up the bond’s price. The bond's cash flows are not reduced – the present value is what fluctuates. In this case, the present value has increased because the market interest rate (discount rate) has decreased. Question ID: 22279 The relationship between a fixed-coupon bond’s price and interest rates is:

A. B. C. D. D

dependent upon issue price. linear. direct. inverse.

When interest rates change, the price of a fixed-coupon bond changes in the opposite direction. This is because the bond’s value is determined by discounting the cash flows. A higher discount rate results in lower discounted cash flows, and vice versa. As we will learn in a later LOS, the relationship is not linear. Question ID: 22278 The probability of a fixed-coupon bond decreasing in price when interest rates rise is known as:

A. B. C.

reinvestment risk risk. liquidity risk. interest rate risk.

D. C

prepayment risk.

The probability of a fixed-coupon bond decreasing in price when interest rates rise is the correct definition of interest rate risk. Reinvestment risk is the risk that if rates fall, cash flows will be reinvested at lower rates, resulting in a holding return lower than that expected at purchase. Prepayment risk (and call risk) is the risk that the issuer will repay principal prior to maturity. Prepayments are most likely in a declining interest rate environment, because it is cheaper to issue replacement debt. Liquidity risk addresses how quickly and easily an investor can sell a bond. A bond that trades thinly and in small amounts exposes an investor to liquidity risk. Question ID: 22281 One year ago, Ulla Werth purchased a 10-year, $1,000 face value 8.00 percent semi-annual coupon bond at par (market rates were at 8.00 percent). The bond’s most recent market price quote was at $900. All else equal, which of the following statements about the current market interest rate is TRUE? The current market interest rate is:

A. B. C. D. C

equal to 8.00%. equal to 10.00%. greater than 8.00%. less than 8.00%.

The relationship between the price of a fixed-coupon bond and interest rates is inverse. Here, we are given that the bond price decreased, so interest rates increased and must be greater than 8.00%. Another way to look at this: When interest rates increase, newer bonds will carry higher coupon rates and will be more attractive to investors than existing, lower coupon bonds (all else equal). Thus, demand for the existing bond will decrease and investors will bid down the bond’s price. At a market rate of 8.00%, the bond would likely trade at par. At market rates less than 8.00%, the price would increase (reverse the logic above). The choice 10.00% represents the percentage depreciation in the bond’s price. Question ID: 13638 If the market rate of interest is greater than the coupon rate, the bond will be valued:

A. B. C.

at par. less than par. cannot be determined.

D. B

greater than par.

Question ID: 22285 Gabrielle Daniels and Edin Roth, CFA candidates, are discussing the relationship between a bond’s coupon rate and the required market yield. Looking through the local newspaper, they see a new-issue, 10-year, $1,000 face value 8.00 percent semi-annual coupon bond priced at $950. Daniels makes the following statements. Which statement does Roth tell her is CORRECT?

A. B. C. D. A

The bond is selling at a discount. The bond is low-quality. The current market required rate is less than the coupon rate. The bond is selling at a premium.

When the issue price is less than par, the bond is selling at a discount. We also know that the current market required rate is greater than the coupon rate because the bond is selling at a discount. We cannot determine credit quality from the information provided. Question ID: 22284 Given that the information on the three bonds below is at issuance, which of the following choices correctly identifies the bonds as premium, par, and discount. Bond Market Rate Coupon Rate 1 8.00% 7.00% 2 7.25% 7.50% 3 6.75% 6.75%

A. B. C. D. C

1 - premium, 2 - par, 3 - discount. 1 - par, 2 - discount, 3 - premium. 1 - discount, 2 - premium, 3 - par. 1 - par, 2 - premium, 3 - discount.

For the examination, remember the following relationships: Type of Bond Premium Par Discount Question ID: 22287 Jonathon Silver, CFA, has a client, Alyce Grossberg, whose only current investment requirement is that she wants to buy a premium bond. The required market yield is currently 7.25 percent. Which of the following $1,000 face value bonds should Silver select for Grossberg’s portfolio? A Market Yield to Coupon Market Yield < Coupon Market Yield = Coupon Market Yield > Coupon Price to Par Price > Par Price = Par Price < Par

A. B. C. D. B

5-year, 7.25% annual coupon bond. 10-year, 8.00% semi-annual coupon bond. 15-year, zero-coupon bond priced to yield 9.00%. 10-year, 7.00% semi-annual coupon bond.

A bond sells at a premium when the coupon rate is greater than the required market yield. Here, the 10-year, 8.00% semi-annual coupon bond would sell above par, or at a premium. The 15-year, zero-coupon bond priced to yield 9.00% would sell at a discount. Zero-coupon bonds sell at a discount from par, because they pay no coupon. (Coupon rate = 0.00%.) The 10-year, 7.00% semi-annual coupon bond would also sell at a discount, because the coupon rate is less than the required market yield. The 7.25% annual coupon bond would sell at par, because the coupon rate equals the required market yield. Note: The information that this is an annual coupon bond is not relevant for this question. For the examination, remember the following relationships: Type of Bond Premium Market Yield to Coupon Market Yield < Coupon Price to Par Price > Par

Par Discount Question ID: 22286

Market Yield = Coupon Market Yield > Coupon

Price = Par Price < Par

Kirsten Thompson, CFA candidate, is studying the relationships between a bond’s coupon rate and the required market yield. One study question concerns a new-issue, 15-year, $1,000 face value 6.75 percent semi-annual coupon bond priced at $1,075. Which of the following choices correctly describes the bond and accurately represents the relationship of the bond’s market yield to the coupon?

A. B. C. D. B

Discount bond, required market yield is greater than 6.75%. Premium bond, required market yield is less than 6.75%. Premium bond, required market yield is greater than 6.75%. Discount bond, required market yield is less than 6.75%.

When the issue price is greater than par, the bond is selling at a premium. We also know that the current market required rate is less than the coupon rate of 6.75%, because the bond is selling at a premium. For the examination, remember the following relationships: Type of Bond Premium Par Discount Question ID: 22292 The factors that determine how changes in interest rates affect bond values include all of the following EXCEPT: Market Yield to Coupon Market Yield < Coupon Market Yield = Coupon Market Yield > Coupon Price to Par Price > Par Price = Par Price < Par

A. B. C. D. D

coupon rate. term to maturity. embedded options. issue price.

The issue price determines whether a bond is said to trade at a premium or at a discount. The change in

price of a fixed-coupon bond is inversely related to the direction of the change in interest rates whether the bond was sold at a discount or at a premium. The other choices are correct factors. Question ID: 13640 If the volatility of interest rates increases, which of the following bond will experience the largest price decrease?

A. B. C. D. B

Zero-coupon option-freebond. Callable bond. Option-free coupon bond. Putable bond.

For a callable bond the issuer has the option to call the bond if the interest rate decreases during its callability period. The issuer will call the bond if interest rates have decreased in order to obtain cheaper financing elsewhere. If the interest rate volatility increases the chance the it is optimal for the issuer to call the bond increases, making the call option more valuable. Therefore, the bond price is depressed by an increase in interest rate volatility. Question ID: 22288 Which of the following fixed-coupon bonds has the least price volatility? All else equal, the bond with a maturity of:

A. B. C. D. A

5 years. 10 years. 15 years. 20 years.

If bonds are identical except for maturity, the one with the shortest maturity will exhibit the least price volatility. This is because a bond’s price is determined by discounting the value of the cash flows. A shorter-term bond pays its cash flows earlier than a longer-term bond, and near-term cash flows are not discounted as heavily. Another way to think about this: The relationship between maturity and price volatility (all else equal) is direct – a greater maturity results in greater price volatility. Question ID: 22291 Which of the following statements about how the features of a bond impact interest rate risk is FALSE?

A.

An inverse relationship between interest rates and bond prices means that

the greater the change in interest rates, the less the change in fixed-coupon bond prices. All else equal, a longer-term bond is more sensitive to interest rates than a shorter-term bond. Bond price movements depend upon the direction and magnitude of changes in interest rates. A lower-coupon bond is more sensitive to interest rate movements than a higher-coupon bond (all else equal).

B.

C.

D.

A
The inverse relationship between interest rates and bond prices means that when interest rates increase, fixed-coupon bond prices decrease. In other words, the inverse relationship means that interest rates and bond prices move in opposite directions, it does not infer anything about the magnitude of the change. The relationship between maturity and price volatility (all else equal) is direct – a greater maturity results in greater price volatility. The relationship between the coupon rate and price volatility (all else equal) is inverse – a greater coupon results in less price volatility. Remember, if you have a problem with this on the examination, keep in mind that a zero-coupon bond has the highest interest rate risk because it delivers all its cash flows at maturity. Since a zero-coupon bond has a 0.00% coupon, a low coupon equates to high price volatility. Question ID: 22289 Which of the following 10-year fixed-coupon bonds has the most price volatility? All else equal, the bond with a coupon of:

A. B. C. D. B

7.00%. 5.00%. 8.00%. 6.00%.

If bonds are identical except for the coupon rate, the one with the lowest coupon will exhibit the most price volatility. This is because a bond’s price is determined by discounting the cash flows. A lower-coupon bond pays more of its cash flows later (more of the cash flow is comprised of principal at maturity) than a higher-coupon bond does. Longer-term cash flows are discounted more heavily in the present value calculation. Another way to think about this: The relationship between the coupon rate and price volatility (all else equal) is inverse – a greater coupon results in less price volatility. Examination tip: If you get confused on the examination, remember that a zero-coupon bond has the highest interest rate risk because it delivers all its cash flows at maturity. Since a zero-coupon bond has a 0.00% coupon, a low coupon equates to high price volatility.

Question ID: 22293 Which of the following statements about how the features of a bond impact interest rate risk is TRUE? Cash flows that occur further in the future add more to the price of a bond than near-term cash flows. For a given change in yield, a higher coupon bond will experience a larger change in price than a lower-coupon bond. Zero-coupon bonds have the highest price volatility. Market yields are the most important determinant of bond price volatility.

A.

B.

C. D. C

Zero-coupon bonds have the highest interest rate risk because they deliver all their cash flows at maturity. Another way to think about this: A zero-coupon bond has the lowest coupon (0.00%), so it has the highest price volatility, since the coupon rate is inversely related to price volatility. In addition to market yields, the timing and magnitude of cash flows affect price volatility. Cash flows that occur further in the future add less to the price of a bond than near-term cash flows (think time value of money). For a given change in yield, a higher coupon bond will experience a smaller change in price than a lower-coupon bond. The relationship between maturity and price volatility (all else equal) is direct – a greater maturity results in greater price volatility. Question ID: 22290 Maria Cavilero, a bond investor, is most concerned with price volatility. All else equal, which of the following fixed-coupon bonds would she most likely buy? A fixed coupon-bond with:

A. B. C. D. A

10 years to maturity and an 8.5% coupon. 15 years to maturity and a 6.5% coupon. 15 years to maturity and an 8.5% coupon. 10 years to maturity and a 6.5% coupon.

This question is asking: given a change in yield, which of the bonds will exhibit the least price change? Of the four choices, Cavilero is most likely to buy the bond with the shortest maturity and highest coupon because it will have the least price volatility. Price volatility is directly related to maturity and inversely related to the coupon rate. All else equal, the bond with the shorter term to maturity is least sensitive to changes in interest rates.

Cash flows that are further into the future are discounted more than near-term cash flows, so the nearer to maturity the cash flows are received, the higher the present value. Here, this means that one of the 10-year bonds will have the least volatility. Similar reasoning applies to the coupon rate. A higher coupon bond delivers more of its total cash flow earlier than a lower coupon bond. All else equal, a bond with a higher coupon will exhibit less price volatility than a lower-coupon bond. Here, this means that of the 10-year bonds, the one with the 8.50% coupon rate will exhibit less price volatility than the bond with the 6.50% coupon. Question ID: 22299 A callable bond has the following characteristics: an annual coupon rate of 7.75 percent, a maturity in 10 years, first call date in 1 week, and a current market price of 95.5 (prices are quoted as a percent of par). Current market rates are 7.73 percent. Which of the following best describes how the bond’s price will behave if market rates fall by 75 basis points? The bond’s price will:

A. B. C. D. A

remain the same. increase. equal par. fall.

As market yields approach the coupon rate, the value of the callable bond approaches the call value (which serves as a ceiling on the bond’s price), so the value of 95.5 is likely close to the call price. If interest rates fall, the bond’s price will not follow the normal fixed-coupon bond inverse relationship (interest rates down, price up) because the call price serves as a cap. The existence of the call option restricts the inverse relationship. The price of a similar, noncallable bond would increase in response to a decrease in interest rates. Question ID: 13647 Assume that a straight 5 percent coupon bond with annual coupon payments has two years to maturity. A callable bond that is the same in every respect as the straight bond is priced at 91.76. With the term structure flat at 6 percent what is the value of the embedded call option?

A. B. C. D. D

-8.24. 4.58. 10.10. 6.41.

The option value is just the difference between the option-free bond price and the corresponding callable bond price. So its value is computed as follows: Option Value = 5/1.06 + 105/1.06 – 91.76 = 6.41 Question ID: 22294 Which of the following statements about the value of a callable bond is FALSE? As the yield on a callable bond approaches the coupon rate, the value approaches the call price. As interest rates decrease, the value of the call option increases. When yields rise, the value of a callable bond may exhibit less of a price change than a noncallable bond. The value of a callable bond equals the value of the bond without the option plus the option value.
2

A.

B.

C.

D.

D
The value of the call option is subtracted from the value of the bond without the option because the option is of value to the issuer, not the holder. As interest rates decrease, the issuer values the call option more because the company has the potential to call the bond and replace existing debt with lower-coupon (and thus lower cost) debt. Also, it is more likely that the bond will be called. The other choices are true. Question ID: 22297 Jori England, CFA candidate, is studying the value of callable bonds. She has the following information: a callable bond with a call option value calculated at 1.75 (prices are quoted as a percent of par) and a straight bond similar in all other aspects priced at 98.0. Which of the following choices is closest to what England calculates as the value for the callable bond?

A. B. C. D. A

96.25. 96.0. 98.75. 99.75.

To calculate the callable bond value, use the following formula: Value of callable bond = Value of straight bond – Call option value

Value of callable bond = 98.0 – 1.75 = 96.25.

Remember: The call option is of value to the issuer, not the holder. Question ID: 22298 A callable bond has the following characteristics: - An annual coupon rate of 7.25 percent - A maturity in 5 years - First call date in one week - Current market price of 94.5 (prices are quoted as a percent of par). If current market rates are 7.23 percent, which of the following best describes the bond call price? The call price is:

A. B. C. D. C

more than 94.5. less than 94.5. approximately equal to 94.5. equal to par.

As market yields approach the coupon rate, the value of the callable bond approaches the call value (which serves as a ceiling on the bond’s value). Question ID: 22296 As part of his job at an investment banking firm, Damian O’Connor, CFA, needs to calculate the value of bonds that contain a call option. Today, he must value a 10-year, 7.50 percent annual coupon bond callable in five years priced at 96.5 (prices are stated as a percentage of par). A straight bond that is similar in all other aspects as the callable bond is priced at 99.0. Which of the following is closest to the value of the call option?

A. B. C.

4.2. 3.5. 1.0.

D. D

2.5.

To calculate the option value, rearrange the formula for a callable bond to look like: Value of embedded call option = Value of straight bond – Callable bond value Value of call option = 99.0 – 96.5 = 2.5.

Remember: The call option is of value to the issuer, not the holder. Question ID: 22295 Which of the following statements about a callable bond is TRUE?

A. B.

A bondholder usually loses if a bond is called. The call option on a bond trades separately from the bond itself. Callable bonds follow the standard inverse relationship between interest rates and price. As interest rates fall, the value of a callable bond will exceed that of a similar straight bond.

C.

D.

A
A bondholder will most likely lose if a bond is called because a bond is most likely to be called in a declining interest rate environment. The issuer will likely call the bond and replace it with lower cost (lower coupon debt). The holder faces prepayment and reinvestment risk, because he must reinvest the bond cash flows into lower-yielding current investments. In bond trading, the call option is bundled with the bond and is not traded separately. The price of a callable bond does not follow the standard inverse relationship. As yields fall, the call option becomes more valuable to the issuer. With a decrease in interest rates, the value of a callable bond can only increase to approximately the call value. Straight bonds will continue to exhibit the inverse relationship between yields and prices as there is no ceiling call price. When yields rise, the value of callable bond may not fall as much as that of a similar straight bond because of the embedded call option feature. Question ID: 22305 Which of the following statements is FALSE? All else equal, a floating-rate bond with: an interest rate cap will have more price fluctuation than a bond with no interest rate cap. a fixed-margin rate in the coupon formula will experience greater price

A.

B.

fluctuation than a bond with an adjustable margin rate. an interest rate cap will benefit the issuer in a period of rapidly rising interest rates. coupon reset dates every 3 months will have more price fluctuation than a bond with reset dates every 6 months.

C.

D.

D
The more frequent the reset dates, the less the time lag that causes volatility. The greater the gap between reset dates, the greater the amount of price fluctuation. Over the life of a bond, the required market margin is not constant. A fixed-margin coupon exposes the bond to more price fluctuations than an adjustable margin (as is the case with an extendible reset bond). Cap risk refers to when market interest rates rise to the point that the coupon on a floating-rate security hits the cap and the bond begins to behave like a fixed coupon bond, which has more price fluctuations. An interest rate cap acts as a ceiling on the coupon rate that must be paid and, therefore, benefits the issuer. Question ID: 22307 The risk to a holder of a floating-rate bond that market rates will increase to the point where the bond behaves like a fixed-rate bond (increased price fluctuation) is known as:

A. B. C. D. B

call risk. cap risk. inflation risk. yield curve risk.

This is the correct definition of cap risk. Cap risk occurs with floating-rate bonds that have a cap placed on how high the coupon rate can go. Inflation risk refers to the risk that the rate of inflation will be higher than the investor anticipated, resulting in reduced purchasing power. An investor can reduce exposure to inflation risk by holding floating-rate bonds. Call risk refers to the risk that a bond will be called prior to maturity, exposing the investor to reinvestment risk. Both floating and fixed-rate bonds can be callable. Question ID: 22306 Which of the following choices regarding the coupon rate on extendible reset bonds is FALSE? The coupon rate:

A.

is calculated using an adjustable margin.

B. C. D. C

takes into account the issuer's credit rating. changes continuously. is set using information polled from market participants.

Although extendible reset bonds adjust periodically, they do not adjust continually. All other statements are true. Question ID: 22304 Which of the following is NOT given as a reason that the prices of floating-rate bonds fluctuate from par?

A. B. C. D. D

Cap risk. Coupon reset time lags. Coupon formulas with fixed-rate margins. Extendible reset risk.

As discussed in Study Session 14, LOS 1.A.c, extendible reset floating-rate bonds do a better job of solving the problem of keeping a bond’s value close to par. These bonds reset the coupon rate based on input from market participants such as investment bankers and have an adjustable margin. All other choices are valid reasons that floating-rate bond prices fluctuate from par. Question ID: 22308 Which of the following statements about floating-rate bonds is FALSE? Prices of floating-rate bonds are less susceptible to interest rate fluctuations. With a perfect, continuously resetting coupon rate, a floating-rate bond's value would always equal par. A cap rate can increase the price volatility of a floating-rate bond. Holding a floating-rate bond eliminates price fluctuations.

A.

B.

C. D.

D
Holding floating-rate bonds minimizes, but does not eliminate price fluctuations. The other statements are true. Question ID: 13651 Assuming a flat term structure of interest rates of 5 percent, what is the duration of a zero-coupon bond with 5 years remaining to maturity?

A. B. C. D. A

5.00. 6.34. 3.76. 4.35.

The duration of a zero coupon bond is always equal to its time to maturity. Question ID: 22311 A $1,000.00 face value, 15-year semi-annual coupon bond pays a 7.25 percent coupon. The current market price is $1,046.71 at market rates of 6.75 percent. If the market yield declines by 75 basis points, the price increases to $1,122.50. If the market yield rises by 75 basis points, the price decreases to $977.71. Which of the following choices is closest to the approximate percentage change in price for a 100 basis point change in the market interest rate?

A. B. C. D. D

8.75%. 0.922%. 6.92%. 9.22%.

Approximate % change in price = (price if yield down – price if yield up) / (2 * initial price * yield change expressed as a decimal) Here, (1122.50 - 977.71) / (2 * 1046.71 * 0.0075) = 144.79 / 15.70 = 9.22. Question ID: 22312 A 30-year semi-annual coupon bond issued today with market rates at 6.75 percent pays a 6.75 percent coupon. If the market yield declines by 30 basis points, the price increases to

$1,039.59. If the market yield rises by 30 basis points, the price decreases to $962.77. Which of the following choices is closest to the approximate percentage change in price for a 100 basis point change in the market interest rate?

A. B. C. D. D

3.84%. 6.50%. 1.28%. 12.80%.

Approximate % change in price = (price if yield down – price if yield up) / (2 * initial price * yield change expressed as a decimal). Here, the initial price is par, or $1,000 because we are told the bond was issued today at par. So, the calculation is: (1039.59 – 962.77) / (2 * 1000 * 0.003) = 76.82 / 6.00 = 12.80. Question ID: 22313 A 10-year semi-annual coupon bond issued today with market rates at 8.50 percent pays a 10.00 percent coupon. The current market price is $1,099.71. If the market yield declines by 45 basis points, the price increases to $1,132.21. If the market yield rises by 45 basis points, the price decreases to $1,068.44. Which of the following choices is closest to the approximate percentage change in price for a 45 basis point change in the market interest rate?

A. B. C. D. D

3.26%. 1.30%. 0.29%. 2.90%.

Approximate % change in price = (price if yield down – price if yield up) / (2 * initial price * yield change expressed as a decimal) Here, we also need to multiply the result by 0.45 because the formula calculates the approximate change in price for a 100 basis point change. So, the calculation is: 0.45 * (1132.21 – 1068.44) / (2 * 1099.71 * 0.0045) = 0.45 * (63.77 / 9.90) = 0.45 *

6.44 = 2.90. Question ID: 22309 Which of the following statements about duration is FALSE? The numerator of the effective duration formula assumes that market rates increase and decrease by the same number of basis points. Price volatility has a direct relationship with interest rate risk. For a specific bond, the effective duration formula results in a value of 8.80%. For a 50 basis point change in yield, the approximate change in price of the bond would be 4.40%. Effective duration is the exact change in price due to a 100 basis point change in rates.

A.

B.

C.

D.

D
Effective duration is an approximation because the duration calculation ignores the curvature in the price/yield graph. Question ID: 22310 Which of the following statements about duration is TRUE? The formula for effective duration is: (price when yields fall - price when yields rise) / (initial price * change in yield expressed as a decimal). A bond's percentage change in price and dollar change in price are both tied to the underlying price volatility. For a given change in interest rates, the greater the duration, the lower the price volatility. The result of the formula for effective duration is for a 0.01% change in interest rates.

A.

B.

C.

D.

B
The statement that a bond's percentage change in price and dollar change in price are both tied to the underlying price volatility is true. The effective duration formula result is for a 1.00% change in interest rates (100 basis points equals 1.00%, or 0.01 in decimal form). The denominator is multiplied by 2. The greater the duration, the greater the price volatility. Remember that price volatility is directly related to maturity and inversely related to the coupon rate.

Question ID: 13662 A portfolio manager anticipates a major increase in market interest rates. Which trading strategy should generate above-average returns?

A. B. C. D. D

Purchasing long-maturity bonds with low coupon rates. Purchasing junk bonds with high coupon rates. Purchasing bonds with high durations. Purchasing short-maturity bonds with high coupon rates.

Question ID: 13660 Which of the following statements is FALSE?

A. B. C. D. A

There is a direct relationship between yield to maturity and duration. The effective duration of a zero coupon bond is equal to its maturity. There is a direct relationship between duration and maturity. There is an inverse relationship between coupon and duration.

Question ID: 23517 In 1997, an investor purchases a zero-coupon bond issued in 1991 and maturing in 2001. What is the bond's effective duration?

A. B. C. D. A

4 years. 6 years. Cannot be determined. 10 years.

Duration is approximately equal to the point in years where you will receive half of the present value of the bond's cash flows. Since a zero coupon bond only has one cash flow at maturity, the half way point would have to be at maturity. Here, there are 4 years until maturity, so the effective duration is approximately equal to 4 years. We use the term approximately because this ignores the curvature of the price/yield curve.

Question ID: 20743 Which one of the following is an incorrect statement about duration?

A. B. C. D. A

The higher the YTM, the greater the duration. The difference in duration is small between bonds maturing in more than 20 years. The higher the coupon, the shorter the duration. The duration is the same as term to maturity only in the case of zero-coupon bonds.

Question ID: 13667 Which set of conditions will result in a bond with the greatest volatility?

A. B. C. D. D

A high coupon and a short maturity. A low coupon and a short maturity. A high coupon and a long maturity. A low coupon and a long maturity.

If bonds are identical except for maturity and coupon, the one with the longest maturity and lowest coupon will have the greatest volatility. The relationship of maturity to volatility is direct - the longer the time to maturity, the greater the volatility. A longer-term bond pays its cash flows later than a shorter-term bond, increasing the volatility. This is because a bond’s price is determined by discounting the value of the cash flows. A longer-term bond pays its cash flows later than a shorter-term bond, and longer-term cash flows are discounted more heavily. The relationship of coupon to volatility is indirect - the lower the coupon rate, the greater the volatility. This is because a bond’s price is determined by discounting the value of the cash flows. A lower coupon bond pays less cash flows over the bond's life and more at maturity than a higher coupon bond. As noted above, longer-term cash flows are discounted more heavily. Question ID: 20739 All else held equal, the duration of bonds selling at higher yields compared to bonds selling at lower yields will be:

A. B.

lower. greater.

C. D. A

cannot be determined with the information given. equal.

Duration is inversely related to yield to maturity (YTM). The higher the YTM, the lower the duration. This is because the change in the bond's price (or present value) is inversely related to changes in interest rates. When market yields rise, the value (or cash flow) of a bond decreases without decreasing the time to maturity. Duration is also a function of volatility (risk). Higher volatility (risk) = higher duration. A higher coupon bond has a lower duration relative to a similar bond with a lower coupon because the bond holder is getting more of their cash value sooner (because of the higher coupon). This lowers the overall risk of the bond resulting in a lower duration.

Question ID: 13664 Which one of the following bonds has the shortest duration?

A. B. C. D. B

8% coupon, 13-year maturity. 8% coupon, 10-year maturity. Zero-coupon, 13-year maturity. Zero-coupon, 10-year maturity.

If bonds are identical except for maturity, and coupon, the one with the shortest maturity and highest coupon will have the shortest duration. The rationale for this is similar to that for price volatility. Duration is approximately equal to the point in years where the investor receives half of the present value of the bond's cash flows. Therefore, the earlier the cash flows are received, the shorter the duration. The relationship of maturity to duration is direct - the shorter the time to maturity, the shorter the duration. A shorter-term bond pays its cash flows earlier than a longer-term bond, decreasing the duration. Here, one of the 10-year bonds will have the shortest duration. The relationship of coupon to duration is indirect - the higher the coupon rate, the shorter the duration. A higher coupon bond pays higher annual cash flows than a lower coupon bond and thus has more influence on duration. Here, the 10-year bond with the highest coupon (8.00%) will have the shortest duration. Note: In addition to having the highest price volatility, zero-coupon bonds have the longest duration (at approximately equal to maturity). This is because zero coupon bonds pay all cash flows in one lump sum at maturity. Question ID: 13668 Duration measures the:

A.

length of time until a bond matures.

B. C. D. C

cash flows weighted by the timing of the cash flows. timing of cash flows weighted by the proportionate value of each flow's present value. length of time until a bond is callable.

Question ID: 13680 Consider a $1,000 face, 10-year semiannual bond with a 6.00% coupon currently selling at $928.94. If the yield declines by 75 basis points (bp), the price increases to $981.62. If the yield increases by 75 bp, the price declines to $879.76. What choice is closest to the approximate percentage change in price for a 100 basis point change in rates?

A. B. C. D. C

5.48% 8.75% 7.31% 0.731%

Using the formula for effective duration: Approximate % change in price = (price when yield falls - price when yield rises) 2* (initial price) * (yield change expressed as a decimal) = (981.62 - 879.76) / (2 * 928.94 * 0.0075) = 101.86 / 13.93 = 7.31% Question ID: 13673 Assume that the duration of a bond is 5.47 and its current price is 98.63. Which of the following is a good estimate of the bond price change if interest rates increase by 2 percent?

A. B. C. D.

-$10.79. $10.94. $10.79. -$10.94.

A
The approximate bond price change is computed as follows: Estimated Bond Price Change = - 5.47/100 x 98.63 x 2 = -10.79 Question ID: 13675 Which of the following bonds will have the smallest percent price change if the required yield goes up by 150 basis points?

A. B. C. D. B

20-year, 0% coupon. 10-year, 15% coupon. 10-year, 10% coupon. 20-year, 15% coupon.

The smallest percentage price change equates to the shortest duration. If bonds are identical except for maturity and coupon, the one with the shortest maturity and highest coupon will have the shortest duration. The rationale for this is similar to that for price volatility. Duration is approximately equal to the point in years where the investor receives half of the present value of the bond's cash flows. Therefore, the earlier the cash flows are received, the shorter the duration. The relationship of maturity to duration is direct - the shorter the time to maturity, the shorter the duration. A shorter-term bond pays its cash flows earlier than a longer-term bond, decreasing the duration. Here, one of the 10-year bonds will have the shortest duration. The relationship of coupon to duration is inverse - the higher the coupon rate, the shorter the duration. A higher coupon bond pays higher annual cash flows than a lower coupon bond and thus has more influence on duration. Here, the 10-year bond with the highest coupon (15.00%) will have the shortest duration. Note: In addition to having the highest price volatility, zero-coupon bonds have the longest duration (at approximately equal to maturity). This is because zero coupon bonds pay all cash flows in one lump sum at maturity.

Question ID: 13678 A bond has an effective duration of 5 years. If rates go down 50 basis points the bond's price goes:

A. B. C. D.

up .25%. down 2.5%. up 2.50%. down .25%.

C
To answer this question, we first need to calculate the appropriate effective duration and then determine the direction of the price change. The formula for effective duration calculates the approximate change in price for a 100 basis point change in rates. Here, we are asked to provide the approximate percentage change in the bond's price for a 50bp change, which is 1/2, or 0.50 of 100bp. Thus, the duration calculation is:0.50 * 5.00% = 2.50%. Since rates fell, the bond price increased, or went up (because of the inverse relationship between bond price and interest rates). Thus, the correct answer is up 2.50%. Question ID: 13681 Consider a $1,000 face, 13-year semiannual bond with a 7.00% coupon currently selling at par, or $1,000.00. If the yield declines by 50 basis points (bp), the price increases to $1,043.43. If the yield increases by 50 bp, the price declines to $958.93. What choice is closest to the approximate percentage change in price for a 100 basis point change in rates?

A. B. C. D. A

8.45% 4.23% 7.50% 0.845%

Using the formula for effective duration: Approximate % change in price = (price when yield falls - price when yield rises) 2* (initial price) * (yield change expressed as a decimal) = (1,043.43 - 958.93) / (2 * 1,000.00 * 0.005) = 84.50 / 10.00 = 8.45% Question ID: 24891 Vijay Ranjin, CFA, is a portfolio manager with Golson Investment Group. He manages a fixed-coupon bond portfolio with a face value of $120.75 million and a current market value of $116.46 million. Golson’s economics department has forecasted that interest rates are going to decrease by 50 basis points. Based on this forecast, Ranjin estimates that the portfolio’s value will increase by 2.12 million if interest rates fall and will decrease by 2.07 million if interest rates rise. Which of the following choices is closest to the portfolio’s dollar duration?

A.

$2.10 million.

B. C. D.

$2.12 million. $4.19 million. $3.60 million.

C The estimate of the dollar duration is computed as follows:

Step 1: Calculate Effective Duration Effective Duration = (price when interest rates fall - price when interest rates rise) / (2 * initial price * basis point change)

Here, effective duration = (118.58 – 114.39) / (2 * 116.46 * .005) = 3.60. Step 2: Calculate Dollar Duration Approximate dollar change in price (dollar duration) = (effective duration * current bond/portfolio value) / 100. Here, Dollar duration = (3.60 * 116.46) / 100 = 4.19. Question ID: 13687 Assume that the price of a bond is currently 102.50. If interest rates increase by 0.5 percent the value of the bond decreases to 100 and if interest rates decrease by 0.5 percent the price of the bond increases to 105.5. Using this information, which of the following is a good estimate of the new bond price if the yield decreases by 1 percent from its current level?

A. B. C. D. B

107.87. 108.00. 108.14. 109.43.

The estimate of the new bond price is computed as follows: Step 1: Calculate Effective Duration Effective Duration = (price when interest rates fall - price when interest rates rise) / (2 * initial price * basis point change) Here, = (105.5 - 100) / (2*102.5*.005) = 5.37 Remember: The result of the effective duration formula is for a 100 basis point, or 1% change in rates. Since this question asks for the result for a 1% change, we do not have to adjust the result. Step 2: Calculate Dollar Duration Approximate dollar change in price (dollar duration) = (effective duration * current bond/portfolio value) /

100. Here, = (5.37 * 102.50) / 100 = 5.504 Step 3: Calculate New Price Interest rates fell, so the price of the bond increased and the dollar change in price is positive (because of the inverse relationship between bond prices and interest rates). Thus, the new price is calculated as follows: New Price = Current price + approximate dollar change in price. Here, New price = 102.5 + 5.50 = 108.0. Question ID: 13688 A $900 bond has an effective duration of 7.5 years. If rates rise 20 basis points the bond's price goes:

A. B. C. D. C

down $135.00. up $135.00. down $13.50. up $13.50.

To answer this question, first calculate the appropriate dollar duration and then determine the direction of the price change. Approximate dollar change in price, or dollar duration = (effective duration * current bond value) / 100. Remember that the effective duration number represents the duration for a 100 basis point change. Here, the question asks for the dollar change in price if rates rise only 20 basis points. Thus, the calculation is: Approximate dollar change in price = 0.20 * [ ( 7.5 * 900.0) / 100] = 13.50 Here, interest rates increased, so the dollar change in price is negative (or down) (this is because of the inverse relationship between bond prices and interest rates). Thus, the bond price went down $13.50. Question ID: 24886 Mary-Claire Austen and Phil Wilkie, Level 1 CFA candidates, are quizzing each other on dollar duration. Wilke presents a bond with a current price of $1,025 and an effective duration of 9.91. He asks Austen to calculate the approximate new price of the bond if interest rates fall by 1.00 percent. Which of the following is closest to the correct answer?

A. B. C. D.

$1,225. $1,050. $1,127. $923.

C To calculate the new bond price, we need to adjust the current price by the dollar duration (or approximate dollar change in price).

Dollar duration = (effective duration * current bond value) / 100.

Remember that the effective duration formula calculates the duration for a 100 basis point change. Here, no adjustment is necessary because the question concerns a 1.00% change. Thus, the calculation is:

Dollar duration = (9.91 * 1,025) / 100] = 101.58, or 102.0.

Note: Because interest rates decreased, we know that the bond price increased because of the inverse relationship between bond prices and interest rates. So,

New Dollar Price = Current price + Dollar duration = 1,025 + 102 = 1,127. Question ID: 24911 A $1,000 face value, zero-coupon bond with 7 years until maturity has a current market price of $660. Assume interest rates increase by 50 basis points. Which of the following choices is closest to the bond’s new price?

A. B. C. D. A

$637. $614. Insufficient information given. $683.

For a zero coupon bond, the effective duration is approximately equal to the maturity. Thus, we will assume the effective duration is approximately 7 years. Remember: The result of the effective duration formula is for a 100 basis point, or 1% change in rates. Since this question asks for the result for a 50 basis point change, we have to adjust the result by: 0.50 * 7.00 = 3.50. Step 1: Compute Dollar Duration Dollar duration = [ (0.50 * 7.00) * 660) ] / 100 = 23. Step 2: Compute New Price Here, interest rates increased, so the price decreased and the formula for the new price is: New price = current price – dollar duration = 660 – 23 = 637.

Question ID: 21258 An upward sloping yield curve implies:

A. B. C. D. B

shorter-term bonds are less risky than longer-term bonds. interest rates are expected to increase in the future. interest rates are expected to decline in the future. longer-term bonds are riskier than short-term bonds.

The yield curve slopes upward because short-term rates are lower than long-term rates. Since market rates are determined by supply and demand, it follows that investors (demand side) expect rates to be higher in the future than in the near-term. Question ID: 24977 Nicolas Panagopoulis and Paul Berarducci are studying for Level 1 of the CFA examination. One of the study questions asks them to calculate the effective duration for a 7-year, zero-coupon bond with the following characteristics:  Current price of $660  A price of $639 when interest rates rise 50 basis points  A price of $684 when interest rates fall 50 basis points Panagopoulis quickly answers that the effective duration is 7. Berarducci uses the effective duration formula to calculate 6.8. What is the most likely reason for the difference between their answers?

A.

Berarducci made a mistake when calculating the effective duration. Effective duration is only an approximation - rounding errors are built into the formula. Price compression. A nonzero slope in the price-yield curve.

B.

C. D. D

Berarducci’s calculations are correct. Up to this point, we have been approximating the effective duration of a zero-coupon bond with its maturity. Although the first part of the statement beginning, “Effective duration…” is correct, the second part is not. Rounding errors are not built into the effective duration formula. Price compression relates to call risk and is covered in the next LOS (1.B.n). Note: The curve in the yield curve affects the effective duration calculation for all bonds. The shape of the yield curve is why we say that the effective duration calculation is an approximation. Question ID: 24971

Which of the following statements about the yield curve is TRUE? If long-term rates are low, the present value of cash flows far into the future will be low,and the bond's value will be low. Greater price sensitivity implies a lower bond duration. In a typical upward sloping yield curve, short and intermediate term rates are lower than long term rates. Parallel shifts in the yield curve are not of concern to bond investors.

A.

B.

C.

D. C

The statement, "If long-term rates are low, the present value of cash flows far into the future will be low,and the bond’s value will be low," should read, "If long-term rates are low, the present value of cash flows far into the future will be high,and the bond’s value will be high." The value of a bond is comprised of discounted cash flows, and a lower discount rate translates to higher cash flows. Any shift in the yield curve creates uncertainty and is of concern to bond investors. Greater price sensitivity implies a higher bond duration. Question ID: 24967 The structure of interest rates results from all the following EXCEPT: viewing a bond’s cash flows as having maturities ranging from the next coupon payment to the final payment at maturity. viewing each bond coupon payment as a separate zero coupon bond. assuming that individual discount rates do not change by the same amount. creating the yield curve by plotting term to maturity against the coupon rate.

A.

B. C. D. D

The yield curve plots term to maturity and yield to maturity. The other choices are true. Question ID: 24964 Which of the following statements about the yield curve is TRUE? A nonparallel shift occurs when rates change by the same number of basis points for all maturities.

A.

B.

A nonparallel shift is more common than a parallel shift. A parallel shift occurs when different maturities undergo different changes in yield. The yield curve usually has a nonzero slope because rates change by approximately the same number of basis points across maturities.

C.

D.

B
The definitions for parallel and nonparallel shifts are reversed. The first part of the statement that begins, "The yield curve usually has a nonzero slope,…" is correct. However, the second part is incorrect – the slope occurs because rates change by different basis points across maturities. Question ID: 24923 Tanig Panosian and Hovig Chorbadjian, Level 1 CFA candidates, are studying the various methods used to measure yield curve risk. Panosian makes the following statements. Which one does Chorbadjian tell him is FALSE? There is no single measure of duration for a portfolio that can be used to estimate the overall price impact of differing yield changes. If the yield curve is flat, the effective duration formula will be less of an approximation. Calculating the durations for only the key maturities is known as key rate duration. Calculating rate duration is less involved than calculating key rate duration.

A.

B.

C.

D. D

Calculating rate duration is more involved than calculating key rate duration because rate duration calculates duration for all rates in the term structure, with only one of the rates changing at a time. The other choices are correct. Question ID: 24929 Which of the following statements regarding yield curve risk is FALSE? Yield curve risk: means that bond and duration calculations are approximate rather than exact. makes it impossible to determine the impact of yield changes on portfolio/bond values.

A.

B.

C.

means that different bonds are affected to a different extent by interest rate changes. means that no single measure of duration can be used to estimate the overall price impact of different yield changes.

D.

D
Even though yield curve risk complicates the analysis of the impact of yield changes on portfolio/bond values, analysis is possible. One method used is key rate duration. Question ID: 24921 Which of the following choices best completes the following sentence? Key rate duration is a technique for estimating the price sensitivity of a bond portfolio by calculating the portfolio duration for:

A. B. C. D. C

all rates in the term structure, changing only one of the rates at a time. the largest denomination bonds. the key maturities in the portfolio. the most frequent coupon rate.

The choice, “all rates in the term structure, changing only one of the rates at a time,” is the definition of rate duration. Analysts usually calculate duration for only the key maturities in the portfolio in order to save the work of calculating the duration for each bond – hence the term key rate duration. Question ID: 24924 Tanig Panosian and Hovig Chorbadjian, Level 1 CFA candidates, are studying the various methods used to measure yield curve risk. Panosian makes the following statements. Which one does Chorbadjian tell him is FALSE?

A.

Calculating rate duration is less involved than calculating key rate duration. Calculating the durations for only the key maturities is known as key rate duration. If the yield curve is flat, the effective duration formula will be less of an approximation. There is no single measure of duration for a portfolio that can be used to

B.

C.

D.

estimate the overall price impact of differing yield changes.

A
Calculating rate duration is more involved than calculating key rate duration because rate duration calculates duration for all rates in the term structure, with only one of the rates changing at a time. The other choices are correct. Question ID: 24928 Which of the following statements regarding yield curve risk is FALSE? Yield curve risk: makes it impossible to determine the impact of yield changes on portfolio/bond values. means that no single measure of duration can be used to estimate the overall price impact of different yield changes. means that different bonds are affected to a different extent by interest rate changes. means that bond and duration calculations are approximate rather than exact.

A.

B.

C.

D.

A
Even though yield curve risk complicates the analysis of the impact of yield changes on portfolio/bond values, analysis is possible. One method used is key rate duration. Question ID: 24948 Which of the following statements is FALSE? Compared to a callable bond, a noncallable bond:

A. B. C. D. B

is more attractive to an investor concerned with reinvestment risk. provides a higher yield. has more predictable cash flows. has greater price appreciation potential.

When compared to a callable bond, the yield on a noncallable bond is less. With a noncallable bond, the issuer does not have to compensate the investor for call risk/cash flow uncertainty with any premium. The other choices are true. Call risk is the combination of cash flow uncertainty and reinvestment risk. When a bond is called, the investor faces a disruption in cash flow and a reduced rate of return. The call price

serves as a cap on the value of the bond and thus reduces price appreciation potential. Question ID: 24934 Price compression:

A. B. C. D. B

occurs when a bond's cap and floor are set close together. reduces the potential for price appreciation. benefits the investor. occurs when demand for a bond is high near the first call date.

When a bond has a call provision, the potential for price appreciation is reduced, because the call caps the price of the bond near the call price, even if interest rates fall considerably. It is unlikely that investors would pay a price that exceeds the call price. Price compression benefits the issuer, because it allows the issuer to call the bond if interest rates decrease allowing the issuer to replace the existing debt with lower cost debt. Question ID: 24936 Which of the following statements about callable bonds is TRUE? As interest rates decrease, the value to the investor of the call option increases. When yields rise, the value of a callable bond is less sensitive and will exhibit less of a price change than a noncallable bond. A bondholder usually gains if a bond is called. As interest rates fall, the value of a callable bond will exceed that of a similar straight bond.

A.

B.

C.

D.

B
When yields rise, the value of callable bond may not fall as much as that of a similar straight bond because of the embedded call option feature. With a decrease in interest rates, the value of a callable bond can increase to only approximately the call value (the call price serves as a cap or “ceiling.”). Straight bonds will continue to exhibit the inverse relationship between yields and prices, as there is no “ceiling” call price. A bondholder will most likely lose if a bond is called, because a bond is most likely to be called in a declining interest rate environment. The issuer will likely call the bond and replace it with lower cost (lower coupon debt). The holder faces prepayment and reinvestment risk, because he must reinvest the bond cash flows into lower-yielding current investments. The statement that begins, “As interest rates decrease…,” should continue, “.. the value to the issuer of the call option increases.” As

interest rates decrease, the issuer values the call option more because the company has the potential to call the bond and replace existing debt with lower-coupon (and thus lower cost) debt. Question ID: 24949 Which of the following statements is FALSE? Compared to a callable bond, a noncallable bond:

A. B. C. D. A

provides a higher yield. is more attractive to an investor concerned with reinvestment risk. has greater price appreciation potential. has more predictable cash flows.

When compared to a callable bond, the yield on a noncallable bond is less. With a noncallable bond, the issuer does not have to compensate the investor for call risk/cash flow uncertainty with any premium. The other choices are true. Call risk is the combination of cash flow uncertainty and reinvestment risk. When a bond is called, the investor faces a disruption in cash flow and a reduced rate of return. The call price serves as a cap on the value of the bond and thus reduces price appreciation potential. Question ID: 24946 Jonah Wiley, CFA, has a client who holds a $1,000,000 face, 8.00 percent semi-annual coupon bond with 10 years to maturity and one month remaining to the call date. Interest rates recently declined significantly and the current market price of the bond is close to the call price. Wiley advises his client that the bond is likely to be called. The client wants to invest the proceeds to obtain the highest return possible with similar risk. Which of the following bonds is the most feasible investment option? (Assume all the bonds have 10 years remaining until maturity and are of similar investment quality.) A(n):

A. B. C. D. A

annual coupon bond priced to yield 6.50%. semi-annual bond priced to yield 8.00%. semi-annual coupon bond priced to yield 10.00% zero-coupon bond priced to yield 9.00%.

Since interest rates have decreased since the bond was issued and the bond is likely to be called, it is unlikely that there are any investment options available that yield equal to or more than the callable bond’s coupon.

Question ID: 24938 A call provision introduces all of the following except:

A. B. C. D.

Prepayment risk. Reinvestment risk. Event risk. Interest rate risk.

C Event risk means that the issuer could face a single event or circumstance that would affect its ability to
service/repay the debt. For example, a corporation could suffer an industrial accident. Event risk can affect all bonds, not just those with a call provision.

Reinvestment risk is the risk that if rates fall, cash flows will be reinvested at lower rates, resulting in a holding return lower than that expected at purchase. Call risk increases reinvestment risk because a bond is most likely called during a period of declining interest rates. If a bond is called, it is unlikely that the investor can reinvest the funds in a similar instrument with an equal yield.

Prepayment risk (and call risk) is the risk that the issuer will repay principal prior to maturity. Prepayments are most likely to occur in a declining interest rate environment because it is cheaper to issue replacement debt. The term prepayment risk is usually used when the asset is a mortgage-backed or asset-backed security, and the term call risk is more commonly used when the asset is a bond. Question ID: 24935 Which of the following statements about callable bonds is TRUE? As interest rates fall, the value of a callable bond will exceed that of a similar straight bond. When yields rise, the value of a callable bond is less sensitive and will exhibit less of a price change than a noncallable bond. A bondholder usually gains if a bond is called. As interest rates decrease, the value to the investor of the call option increases.

A.

B.

C.

D.

B

When yields rise, the value of callable bond may not fall as much as that of a similar straight bond because of the embedded call option feature. With a decrease in interest rates, the value of a callable bond can increase to only approximately the call value (the call price serves as a cap or “ceiling.”). Straight bonds will continue to exhibit the inverse relationship between yields and prices, as there is no “ceiling” call price. A bondholder will most likely lose if a bond is called, because a bond is most likely to be called in a declining interest rate environment. The issuer will likely call the bond and replace it with lower cost (lower coupon debt). The holder faces prepayment and reinvestment risk, because he must reinvest the bond cash flows into lower-yielding current investments. The statement that begins, “As interest rates decrease…,” should continue, “.. the value to the issuer of the call option increases.” As interest rates decrease, the issuer values the call option more because the company has the potential to call the bond and replace existing debt with lower-coupon (and thus lower cost) debt. Question ID: 22318 Kyle Barnes, CFA, is meeting his friend, Lita Rombach, about possible bond investments. Rombach is concerned about reinvestment risk. Which of the following statements about Rombach is TRUE? Rombach:

A. B. C. D. C

need only be concerned about reinvestment risk on coupon payments. is most concerned in an increasing interest rate environment. will prefer a noncallable bond to a callable bond. will prefer a higher coupon bond to a lower coupon bond.

A noncallable bond reduces reinvestment risk by reducing the risk of repayment. With her primary concern being reinvestment risk, Romach will prefer a lower coupon bond to a higher coupon bond. An investor concerned about reinvestment risk is most concerned about a decreasing interest rate environment. When interest rates decrease, the investor is forced to reinvest coupons and other cash flows at a lower rate. With a lower coupon, this risk is less. Reinvestment risk applies to all bond cash flows, not just the coupon payments. Question ID: 22316 Which of the following statements about reinvestment risk is FALSE? A bond's yield calculation assumes that coupon cash flows and principal can be reinvested at the computed yield to maturity. An investor concerned about reinvestment risk is most concerned with a decrease in interest rates. Reinvestment risk is a form of interest rate risk.

A.

B.

C.

D.

A bond investor can eliminate reinvestment risk by holding a coupon bond until maturity.

D
The key word here is coupon bond. While an investor in a fixed-coupon bond can usually eliminate price risk by holding a bond until maturity, the same is not true for reinvestment risk. The receipt of periodic coupons exposes the investor to the risk that he will have to invest the coupons at a lower rate, thus negatively impacting his holding period return. An investor can greatly decrease reinvestment risk by holding a zero-coupon, noncallable bond that is not subject to other prepayments (or embedded options). Zero-coupon bonds deliver all cash flows in one lump sum at maturity. The other statements about bond yield calculations and reinvestment risks are correct. Question ID: 22314 The risk that an investor will earn less than the quoted yield-to-maturity on a fixed-coupon bond due to a decrease in interest rates is known as:

A. B. C. D. C

prepayment risk. event risk. reinvestment risk. liquidity risk.

Reinvestment risk is the risk that if rates fall, cash flows will be reinvested at lower rates, resulting in a holding return lower than that expected at purchase. Prepayment risk (and call risk) is the risk that the issuer will repay principal prior to maturity. Prepayments are most likely to occur in a declining interest rate environment because it is cheaper to issue replacement debt. Liquidity risk addresses how quickly and easily an investor can sell a bond. A bond that trades thinly or in small amounts exposes an investor to liquidity risk. Event risk means that the issuer could face a single event or circumstance that would affect its ability to service/repay the debt. For example, a corporation could suffer an industrial accident. Question ID: 22315 An investor holds a 20-year, semi-annual 8.00 percent coupon Treasury bond issued at par. Market interest rates are currently at 6.50 percent. The bond is noncallable. A coupon payment is due this week. Which of the following choices best represents the type of risk the investor faces?

A. B.

Credit risk. Prepayment risk.

C. D. D

Liquidity risk. Reinvestment risk.

Reinvestment risk is the risk that if rates fall, cash flows will be reinvested at lower rates, resulting in a holding return lower than that expected at purchase. Here, the investor will likely have to reinvest the coupon at the lower market interest rate, negatively impacting his holding period return. Prepayment risk (and call risk) is the risk that the issuer will repay principal prior to maturity. Prepayments are most likely in a declining interest rate environment because it is cheaper to issue replacement debt. Here, the bond is a Treasury and is noncallable, so the investor can eliminate prepayment risk by holding the bond until maturity. Liquidity risk addresses how quickly and easily an investor can sell a bond. A bond that trades thinly or in small amounts exposes an investor to liquidity risk. Liquidity risk is not a concern with Treasury bonds. Credit risk is the risk that the issuer will be unable to make coupon or principal payments as scheduled. Any change in the timing of the receipt of cash flows affects the bond’s holding period return. Credit risk is not a concern with Treasury securities. Question ID: 22317 Silhouette Enterprises must make a balloon loan payment of $1,000,000 in 3 years. The firm’s treasurer wants to purchase a bond that will provide funds for repayment and minimize reinvestment risk. Assume the company has the following four investment options (all with face values of $1,000,000). Market rates are at 8.00 percent. All bonds are noncallable and are otherwise similar except as noted. Which option best meets the treasurer’s requirements?

A. B. C. D. D

A 2-year, zero-coupon bond priced to yield 9.00%. A 3-year, 8.00% semi-annual coupon bond priced at par. A 4-year, zero coupon bond priced to yield 8.50%. A 3-year, zero coupon bond priced to yield 8.00%.

Since all the choices are non-callable, the treasurer will prefer a zero-coupon to a coupon bond. While a bond investor can eliminate price risk by holding a bond until maturity, he usually cannot eliminate reinvestment risk. One exception is zero-coupon bonds, since these bonds deliver payments in one lump sum at maturity. Although the 3-year coupon bond fulfills the treasurer’s requirement concerning funds for repayment, it does not minimize reinvestment risk. Among the zero-coupon bonds, the one that best matches the loan’s maturity will minimize reinvestment risk. The treasurer will thus prefer the 3-year, zero-coupon bond. If he purchased the 4-year zero-coupon bond, he would have to sell the bond prior to maturity to payoff the loan and would face price risk. The 2-year zero-coupon bond is attractive because of the higher yield. However, the bond matures one year before the loan is due and would expose the firm to reinvestment risk.

Question ID: 26642 Which of the following choices correctly places callable bonds, straight coupon bonds, mortgage-backed securities, and zero-coupon bonds in order from the type of security with the least reinvestment risk to the one with the most reinvestment risk? mortgage-backed securities, zero-coupon bonds, callable bonds, straight coupon bonds. callable bonds, straight coupon bonds, zero-coupon bonds, mortgage-backed securities. zero-coupon bonds, mortgage-backed securities, straight coupon bonds, callable bonds. zero-coupon bonds, straight coupon bonds, callable bonds, mortgage-backed securities.

A.

B.

C.

D.

D
Of the three choices, zero-coupon bonds have the least reinvestment risk. An investor can nearly eliminate reinvestment risk by holding a noncallable zero-coupon bond until maturity because zero-coupon bonds deliver all cash flows in one lump sum at maturity. Straight coupon bonds (no prepayment or other embedded options) have the next most reinvestment risk because of the periodic coupon payments. If interest rates decline, the bondholder will have to reinvest the coupons at a rate lower than that required to earn the original expected yield-to-maturity. Callable bonds have more reinvestment risk because the right to prepay principal compounds reinvestment risk. A call option is one form of prepayment right that benefits the issuer, or borrower. Mortgage backed and other asset backed securities have the most prepayment risk because in addition to cash flows from periodic interest payments (bond coupons, for example), these securities have periodic repayment of principal. The lower the interest rate, the higher chance that the loans underlying these assets will repay in full Question ID: 13692 Which of the following statements is FALSE regarding bond ratings?

A. B. C. D. B

Bonds rated BB and below are referred to as high yield or "junk" bonds. Once a rating is assigned to an issue it cannot be changed for the first two years after which it is reviewed on a regular basis. The bonds assigned one of the top four rating classes are considered investment grade bonds. The ratings assigned are meant to indicate the probability of default for the bond issuer.

Question ID: 26644 Which of the following statements about balancing reinvestment risk and price risk is TRUE? When interest rates:

A. B. C. D. C

rise, price risk decreases and reinvestment risk increases. rise, price risk increases and reinvestment risk increases. decline, price risk decreases and reinvestment risk increases. decline, price risk decreases and reinvestment risk decreases.

All else equal, reinvestment risk and price risk move in opposite directions. For example, when interest rates rise, bond prices decrease, but the loss is at least partially offset by decreased reinvestment risk (it is less likely that a bond will be called and bondholders can invest coupon payments at higher yields). When interest rates fall, price risk decreases because the bond value is rising and reinvestment risk increases because it is more likely that the issuer/borrower will call the security and the bondholder must reinvest coupon payments at lower yields. Question ID: 26643 Which of the following statements is TRUE?

A. B.

The prepayment option on a mortgage loan benefits the issuer. A bond with high reinvestment risk also has high price, or interest rate risk. Mortgage backed and asset backed securities have lower reinvestment risk than straight coupon bonds. Zero-coupon bonds have high interest rate risk and high reinvestment risk.

C.

D. A

In the case of a mortgage or auto loan, the issuer is the borrower and is the party that benefits from the prepayment option. In a declining interest rate environment, the issuer can retire higher cost debt and replace it with lower cost debt (i.e. refinancing a mortgage). When an issuer (borrower) calls, or prepays, the lending institution (the security holder) faces reinvestment risk because it must reinvest the proceeds at lower rates. Zero-coupon bonds have high interest rate risk and low reinvestment risk. An investor can nearly eliminate reinvestment risk by holding a noncallable zero-coupon bond until maturity because zero-coupon bonds deliver all cash flows in one lump sum at maturity. Mortgage backed and other asset backed securities have high reinvestment (or prepayment) risk because in addition to cash flows from periodic interest payments (like bond coupons), these securities have repayment of principal. The lower

the interest rate, the higher chance that the loans underlying these assets will repay in full due to refinancings. A bond, such as a zero coupon bond, can have high interest rate risk (because its single cash flow subjects it to the full amount of discounting when interest rates change) and low reinvestment risk (the single cash flow minimizes prepayment risk). Question ID: 25185 Benjamin Zoeller and Tara McGonigal are preparing for the Level 1 CFA examination. Zoeller is studying credit spread risk. McGonigal is farther along in her studies, but has forgotten how to determine the default free rate if given the yield on a bond rated BBB+ of 9.50 percent and a risk premium of 3.00 percent. What does Zoeller tell her to use for the default free rate?

A. B. C. D. A

6.50%. 9.50%. 4.50%. 12.50%.

The formula for credit spread risk (or the yield on a risky asset) is: YieldRisky = YieldRF + Risk Premium, where RF = default -free rate. Rearranging this formula results in: YieldRF = YieldRisky – Risk Premium, or YieldRF = 9.50% – 3.00% = 6.50%. Question ID: 25557 Which of the following statements is FALSE? Default risk is narrowly defined as the failure of an issuer to meet principal and/or interest payments. Credit spread risk is also referred to as the risk premium. The percentage not recovered when a bond issuer defaults is referred to as the loss percentage. The higher the risk premium, the riskier the security.

A.

B.

C.

D. A

The market typically views default risk as the risk that the issuer/borrower will fail to make interest and/or principal payments as scheduled. However, this is not the only type of default. Default risk also encompasses technical default, which usually refers to an issuer’s violation of bond covenants, such as debt ratios, rather than to the payment of interest or principal. The other choices are true.

Question ID: 13695 The risk free rate of return is 5 percent. The expected inflation rate is 3 percent. The inflation rate last year was 6 percent. The risk premium for agencies is 1 percent and for AA corporates is 4 percent. What is the nominal rate of return for AA corporate bonds?

A. B. C. D. B

8%. 12%. 9%. 15%.

5 + 3 + 4 = 12 Question ID: 25438 Which of the following statements is TRUE?

A.

Bond ratings are determined by the market. Technical default usually refers to the issuer's failure to make interest or principal payments as scheduled in the indenture. When a rating agency downgrades a security, the bond's price usually falls. Default risk is important because if a bond issuer defaults, the bondholder likely loses his entire investment.

B.

C.

D.

C
The market will likely demand a higher yield from the downgraded bond (the risk premium has increased) and thus the price will likely fall. Technical default usually refers to an issuer’s violation of bond covenants, such as debt ratios, rather than the failure to pay interest or principal. In the event of default, the holder (lender) may recover some or all of the investment through legal action or negotiation. The percentage recovered is known as the recovery rate. Rating agencies such as Moody’s and Standard and Poor’s assign bond ratings. The market reflects these ratings through a higher or lower market yield. Question ID: 25437 When determining credit risk spread, the benchmark security is most likely a(n):

A. B.

high-yield corporate bond. AA rated bond.

C. D. D

low-yield corporate bond. Treasury bond.

The credit risk spread is measured in relation to a default-free security. Of the choices above, the security with the least chance of default is the Treasury bond. The AA rated bond is high quality, but not the highest quality (which would have an AAA rating). The high-yield corporate bond is an unlikely candidate for the benchmark security because high yield usually denotes high risk. The low-yield corporate bond is a possibility, but it is not likely that this bond is as default-free as the Treasury security. Question ID: 13702 Which of the following is NOT a major rating agency for bonds?

A. B. C. D. A

Value Line. Standard and Poor's. Fitch Investors Service. Moody's.

Question ID: 13700 Bonds that have received one of the top four ratings (Aaa through Baa, or AAA through BBB) are designated as:

A. B. C. D. B

benchmark bonds. investment grade bonds. high return bonds. liquid bonds.

Question ID: 13697 Which of the following is TRUE about the bond ratings by Moody's and Standard & Poor's? They are:

A. B.

determined by sophisticated, automated statistical models. always the same for each bond.

C. D. C

based on the likelihood of default. changed frequently to reflect the slight changes in financial situations.

Question ID: 13708 One characteristic of junk bonds is that they have:

A. B. C. D. D

excessive risk so investors may shy away from investment in these securities. yields that are closely tied to the rate of inflation. price behaviors that are very closely linked to the behavior of market interest rates. some characteristics of equity securities, and are referred to as hybrid securities.

Question ID: 13705 Which of the following is TRUE concerning junk bonds?

A. B. C. D. C

The companies that issue them have inadequate amounts of debt in their corporate structures. They are usually issued by foreign companies. They have a high risk of default and the debt is unsecured. They are secured by low quality equipment collateral rather than by cash.

Question ID: 13703 A bond that has moderate protection of principal and interest would be rated:

A. B. C. D.

BB to B. D or below. a or above. CCC to C.

A
Question ID: 13709 The highest concentration of high yield bonds is:

A. B. C. D. C

B and BBB. BBB. B and BB. AA, BBB, and BB.

Question ID: 25912 Which of the following assets is the least liquid?

A. B. C. D. B

A stock traded on the New York Stock Exchange (NYSE). Limited Partnership. Foreign exchange futures contract. On-the-run Treasury security.

All other choices are considered highly liquid assets. On-the-run Treasuries are recently issued and are often more liquid than older issues. Question ID: 25913 Which of the following statements does not describe a characteristic of an illiquid asset or market?

A. B. C. D.

Small trading volumes. Wide bid-ask spreads. Wide variation in prices from transaction to transaction. Large block trades that do not materially affect prices.

D
In a liquid market with large trading volumes, large block trades should not affect prices. All other choices are characteristics of illiquid markets or assets. Question ID: 26261 Which of the following investors is least likely to have liquidity risk concerns? A(n):

A. B. C. D. C

corporate bond investor who intends to hold securities until maturity. portfolio manager for an emerging-market fund. trader who invests exclusively in Treasury bonds. financial institution heavily involved in the repurchase market.

Treasury securities are the most liquid of the investments mentioned. The repurchase market is short term in nature and the collateral is marked-to-market daily. Thus, the need to quickly convert securities to cash (and at approximately market value) is very important. Emerging markets are usually less liquid than established markets, one reason being the small trading volumes. Even if an investor intends to hold the security to maturity, liquidity risk impacts portfolios when marking to market and through changes in investor tastes and preferences over time. For example, liquidity is important to institutional investors that must determine market values for net asset values (NAVs). Question ID: 25914 Which of the following statements regarding liquidity risk is FALSE?

A.

The bid-ask spread is one measurement of liquidity risk. Emerging markets typically have more liquidity risk than established markets. In an illiquid market, the market price may not reflect actual value. Liquidity risk is not important to an investor who intends to hold a security until maturity.

B.

C.

D.

D
Even if an investor intends to hold securities to maturity, liquidity risk impacts portfolios when marking to market and through changes in investor tastes and preferences over time. For example, liquidity is important to institutional investors that must determine market values for net asset values (NAVs) and to

dealers in the repurchase market for collateral valuation. A narrow bid-ask spread indicates a liquid asset, while a wide bid-ask spread indicates an illiquid asset. For example, the spreads on recently issued Treasury securities are often only a few basis points. Emerging markets are usually less liquid than established markets, one reason being the small trading volumes. When a market is illiquid, even if there is a market price listed, there may not be a buyer at the time that the investor wants to sell. Question ID: 26646 Which of the following statements is FALSE? The bid price represents the price at which dealers are willing to sell a security. Treasury bills have narrow bid-ask spreads. The ask price represents the price at which dealers are willing to sell a security. The ask price represents the price at which dealers are willing to sell a security.

A.

B.

C.

D.

A
The bid price represents the price at which dealers are willing to buy a security. The other choices are true. Setup Text: Ellie Hass, CFA, a fixed-income trader, asks her research analyst to provide bid-ask quotes for a certain high quality corporate bond issue. The analyst summarizes the information in the following table: Dealer Northern Bid Price Ask Price Question ID: 26649 Assuming that Hass will be conducting both buy and sell trades with only one dealer, which dealer will she use to minimize transaction costs? 95-6/32 95-20/32 Southern 95-8/32 95-25/32 Eastern 94-25/32 95-16/32 Western 94-30/32 95-15/32

A. B.

Eastern. Northern.

C. D. B

Southern. Western.

To minimize transaction costs, Hass will trade with the dealer with the best, or lowest, bid-ask spread. The bid/ask spreads are as follows: Northern – 14/32, Southern & Western – 17/32, and Eastern – 23/32. Thus, Hass will trade with Northern, which has the lowest bid-ask spread. Question ID: 26649 Assume Hass wants to conduct trades at the best market bid-ask spread. Which dealer will she buy from and which dealer will she sell to?

A. B. C. D. A

Buy from Western, sell to Southern. Buy from Northern, sell to Northern. Buy from Eastern, sell to Southern. Buy from Southern, sell to Western.

For the best market bid-ask spread, Hass will buy from the dealer with the lowest ask price (Western) and sell to the dealer with the highest bid price (Southern). Question ID: 13711 Suppose that for a particular bond the following bid-ask spreads are quoted by dealers: Bid Price Ask Price Dealer A 97 3/32 97 7/32 Dealer B 97 2/32 97 5/32 Dealer C 97 4/32 97 7/32 Which of the following is the market bid-ask spread?

A. B. C. D. D

2/32. 4/32. 3/32. 1/32.

The market bid-ask spread is the difference between the highest quoted bid price and the lowest quoted ask price which is 1/32 in this case. Question ID: 26647 Which of the following statements is TRUE?

A. B.

The bid price is typically higher than the ask price. Bid-ask spreads for liquid assets are large. To determine the best dealer bid-ask spread for an asset, compute the bid-ask spread for each dealer and then pick the spread that is the lowest. To compute the best market bid-ask spread, take the difference between the highest ask price and the lowest bid price across all dealers.

C.

D.

C
To compute the market bid/ask spread, take the difference between the highest bid price and the lowest ask price across all dealers. The bid price is lower than the ask price. Bid-ask spreads are large for illiquid assets. Question ID: 25744 While working abroad, U.S. citizen Dirk Senik purchases a foreign bond with an annual coupon of 7.5 percent for 95.5. One year later, the exchange rate between the dollar and the foreign currency remains unchanged and he sells the bond for 97.25, resulting in a holding period return of 9.7 percent. If the foreign currency had depreciated in relation to the dollar, Senik’s return would be:

A. B. C.

less than 9.7 percent. equal to 9.7 percent. greater than 9.7 percent.

D. A

negative.

The return on a foreign bond is a combination of the return on the bond and the movement in the foreign currency. In the base case, the movement in the foreign security was 0 and thus the return was just the holding period return on the bond. If the foreign currency depreciates, the return will be lowered because the investor will lose upon conversion to the dollar. We are not given enough information to determine whether the foreign currency depreciation was large enough to make the total return on the bond negative. Calculating the total dollar return on a bond is discussed in more detail later in Study Session 18. Question ID: 25910 Which of the following statements is FALSE? An investor who purchases a foreign bond gains the most when both the asset and the foreign currency appreciate in value. Exchange-rate risk may benefit a bond investor. If the home currency appreciates against the foreign currency of the bond payments, each foreign currency unit will be worth less in terms of the home currency. The depreciation of foreign currency benefits domestic investors who buy foreign securities.

A.

B.

C.

D.

D
This statement should read, "The appreciation of foreign currency benefits domestic investors who buy foreign securities." The other choices are true. Exchange rate risk creates uncertainty for the investor, but is not always bad for the investor. If a domestic investor purchased a foreign currency denominated bond, appreciation in the foreign currency would benefit the investor. Question ID: 25558 Assume there are two investors: a U.S. citizen and a Swiss citizen. The United States is considered the domestic country and Switzerland is the foreign country. In the context of bond investments, appreciation in the Swiss Franc (CHF) benefits the:

A. B. C.

U.S. investor buying U.S. bonds. Swiss investor buying Swiss bonds. U.S. investor buying Swiss bonds.

D. C

Swiss investor buying U.S. bonds.

The appreciation of the foreign currency (Swiss Franc-CHF) benefits domestic investors (U.S. citizens) who buy foreign (Swiss) bonds. When the CHF appreciates, each unit of CHF is worth more in that it buys more of the U.S. dollar than before. Here, the U.S. investor gains by buying foreign bonds because the investor realizes not only the return from the bond but also a gain from the foreign currency appreciation Question ID: 25906 While serving as visiting conductor at the University of Edinburgh, U.S. Citizen William Golson purchases a 9.0 percent annual coupon bond denominated in the local currency for 93.0. One year later, before his return to the U.S., he sells the bond for 99.5. Using a holding period return formula he remembers from his undergraduate studies, he calculates his return at 16.7 percent. On the flight home, he is seated next to Kristin Meyer, CFA. She is puzzled because she has heard that similar investments yielded negative returns over the same time period. After consulting her financial newspaper, she recalculates Golson’s return at a disappointing negative 5.2 percent. Assuming Meyer is correct, which of the following statements is the most likely reason for the difference in the calculated returns? Golson:

A.

made a computational error. forgot to include the impact of foreign currency appreciation in relation to the dollar. omitted the impact of inflation. forgot to include the impact of foreign currency depreciation in relation to the dollar.

B.

C.

D.

D
Golson most likely forgot to take into account the impact of the percentage change in the dollar value of the foreign currency. Here, since the correct return (calculated by Meyer) is lower than that calculated by Golson (who omitted the impact of foreign exchange), the foreign currency depreciated in relation to the dollar. The appreciation in the bond value was not enough to offset the currency depreciation, and the total return in dollar terms was negative. Calculating the total dollar return on a bond is discussed in more detail later in Study Session 18. Question ID: 27269 Which of the following statements about inflation risk is FALSE?

A. B.

Treasury securities are considered immune to inflation and liquidity risk. Inflation risk is of most concern to the long-term investor.

C. D. A

The short term inflation premium is less than the long term premium. The real return on a fixed coupon bond is variable.

The statement Treasury securities are considered immune to inflation and liquidity risk is partially true – Treasury securities are immune to liquidity risk, but fixed-coupon Treasury securities have high inflation risk and generally low real returns. The other choices are true. The inflation premium is less in the short term because investors are better able to predict inflation in the short term – inflation risk increases as time increases. (Investors want to be compensated for this uncertainty.) An investor’s real return is not fixed- even though an investor may hold a fixed-rate coupon bond, the real return depends on a variable – inflation. Higher inflation rates result in a reduction of the purchasing power of bond payments. Inflation risk is of more concern to the long-term investor because it is more difficult to predict inflation long-term and there is more chance for purchasing power erosion. Question ID: 27266 Which of the following investors faces the least inflation risk? An investor whose portfolio is concentrated in:

A. B. C. D. D

long-term treasury bonds. fixed-rate certificates of deposit. medium-term fixed-rate coupon bonds. equity securities.

Inflation risk refers to the possibility that prices of general goods and services will increase in the economy. Empirical evidence shows that equity securities, or stocks, have the least inflation risk of the investments listed here. Since fixed coupon bonds pay a constant coupon, increasing prices erode the buying power associated with bond payments. Fixed-coupon Treasury securities and fixed-rate certificates of deposit have high inflation risk. Question ID: 27270 Which of the following investors is least susceptible to inflation risk? The holder of a 15-year bond with a coupon formula equal to the U.S. prime rate plus 3.25%. The holder of a 30-year, 6.50% semi-annual coupon Treasury bond.

A.

B.

C.

A financial institution with assets concentrated in fixed-rate mortgages. An individual with a 5 year certificate of deposit at a local financial institution.

D.

A
The a 15-year bond with a coupon formula equal to the U.S. prime rate plus 3.25% is an example of a floating rate bond. The holder of an adjustable rate asset is impacted less by inflation than the holder of a fixed-rate asset because the increased cash flow (from the higher coupon payments when the base rate increases) at least partially offsets the decreased purchasing power caused by inflation. The other three choices are examples of investors more susceptible to inflation - those who hold long-term contracts in which they are to receive a fixed payment. Question ID: 27268 One year ago, Makato Omura purchased a 6.50 percent fixed coupon bond for 98.50. Recently, she sold the bond for 99.25 and calculated her return at 7.4 percent. Her friend, Takanino Takemiya, CFA, reminds Omura that this is the nominal return and that to calculate the real return, she needs to factor in the inflation rate over the holding period. If the price index for the current year is 118.5 and the price index one year ago was 115.9, Omura’s real return is closest to:

A. B. C. D. B

9.6%. 5.2%. 7.4%. 5.0%.

Omura’s real return is approximated by subtracting the inflation rate from the calculated (nominal) return. As indicated in the preliminary reading for Study Session 4, LOS 1.B.e, the inflation rate is calculated using the formula: Inflation = (Price Indexthis year – Price Indexlast year) / Price Indexlast year Here, inflation = (118.5 – 115.9)/115.9 = 0.0224, or approximately 2.2%. Thus, the real return = 7.4% - 2.2% = 5.2%. Question ID: 27267 David Korotkin, CFA and a broker at an investment bank, has a client who is very concerned about maintaining purchasing power over the next year. The investor is conservative, and to date has been pleased with a consistent return of 8.00 percent. The bank’s research department has estimated next year’s inflation rate at 2.0 percent. The client specifically wants to invest in a fixed-coupon bond. Which of the following statements is most correct? If Korotkin purchases a bond with a 10.00 percent coupon, the client:

A. B. C. D. A

may lose purchasing power. will not lose purchasing power. will eliminate inflation risk. will realize a real gain.

Investors want to be compensated for the inflation they expect plus for the risk that inflation will increase during the term of the investment. Here, the bank’s estimated inflation rate is just that – an estimate. Thus, we cannot say for certain that the investor will not lose purchasing power. Inflation risk introduces uncertainty to the investment process. Question ID: 27260 Which of the following statements is TRUE for both callable and putable bonds?

A.

When yield volatility increases, the value of the bond increases. The value of the bond is equal to the value of a similar straight bond plus the value of the option. When yield volatility increases, the value of the option increases. The options both benefit the bond issuer.

B.

C. D. C

To calculate the value of a putable bond, it is correct to add the option value to the value of a similar straight bond. However, to calculate the callable bond value, subtract the option value from that of a similar straight bond. As a result, when yield volatility increases (thus increasing the option value), the value of a callable bond decreases and the value of a putable bond increases. A call option does benefit the issuer, but a put option benefits the holder. Question ID: 27257 Which of the following statements about embedded options and yield volatility is FALSE?

A.

A call option benefits the issuer and a put option benefits the holder. As yield volatility increases, the value of the call option increases along with the value of the callable bond. The greater the volatility of the underlying price, the greater the value of the

B.

C.

embedded option.

D. B

Putable bondholders benefit from increases in yield volatility.

As yield volatility decreases, the value of the call option increases, and the value of the callable bond decreases and thus the bondholder loses. (As shown by the equation: Value of callable bond = Value of straight bond – Call option value.) The other choices are true. A holder of a put option benefits from increased yield volatility because the value of the put option increases, increasing the putable bond value. (Value of putable bond = Value of straight bond – Put option value.) Question ID: 27256 Which of the following statements about embedded options and yield volatility is TRUE? As yield volatility increases, the value of the put option increases along with the value of the putable bond. Volatility risk is associated only with embedded options. Investors holding callable bonds benefit from increases in yield volatility. Bond price impacts yield volatility, which impacts embedded options.

A.

B. C. D. A

The statement as yield volatility increases, the value of the put option increases along with the value of a putable bond is true, as given by the equation: Value of putable bond = Value of straight bond + Put option value When yield volatility increases, the value of the put option increases, increasing the putable bond value. Yield changes impact bond prices, which impact options (not the order stated in the choice above). As yield volatility increases, the value of the call option increases, and the value of the callable bond decreases and thus the bondholder loses. (As shown by the equation: Value of callable bond = Value of straight bond – Call option value). Volatility risk is the variability in the price of an instrument and impacts most all securities, not just those with embedded options. Question ID: 27259 Tina Donaldson, CFA candidate, is studying yield volatility and the value of putable bonds. She has the following information: a putable bond with a put option value calculated at 0.75 (prices are quoted as a percent of par) and a straight bond similar in all other aspects priced at 99.0. Donaldson also wants to determine how the bond’s value will change if yield volatility decreases. Which of the following choices is closest to what Donaldson calculates as the value for the putable bond and correctly describes the bond’s price behavior as yield volatility decreases?

A.

98.25, price increases.

B. C. D. C

99.75, price increases. 99.75, price decreases. 98.25, price decreases.

To calculate the putable bond value, use the following formula: Value of putable bond = Value of straight bond + Put option value Value of putable bond = 99.0 + 0.75 = 99.75. Remember: The put option is added to the bond value because the call option is of value to the bondholder, not the issuer. As yield volatility decreases, the value of the embedded option decreases. The formula above shows that for a putable bond, a decrease in the option value results in a decreased bond value. Question ID: 27258 Simone Girard, CFA candidate, is studying yield volatility and the value of callable bonds. She has the following information: a callable bond with a call option value calculated at 1.25 (prices are quoted as a percent of par) and a straight bond similar in all other aspects priced at 98.5. Girard also wants to determine how the bond’s value will change if yield volatility increases. Which of the following choices is closest to what Girard calculates as the value for the callable bond and correctly describes the bond’s price behavior as yield volatility increases?

A. B. C. D. A

97.25, price decreases. 99.75, price decreases. 97.25, price increases. 99.75, price increases.

To calculate the callable bond value, use the following formula: Value of callable bond = Value of straight bond – Call option value Value of callable bond = 98.5 – 1.25 = 97.25. Remember: The call option is subtracted from the bond value because the call option is of value to the issuer, not the holder. As yield volatility increases, the value of the embedded option increases. The formula above shows that for a callable bond, an increase in the option value results in a decreased bond value. Question ID: 27262 All of the following risks are types of event risk EXCEPT:

A. B. C. D. D

Disaster/accident risk. Political risk. Regulatory risk. Interest rate risk.

Interest rate risk is the risk that interest rates will increase, decreasing the price of certain investments, including fixed-coupon bonds. The other choices are examples of event risk, which refers to the possibility that there may be a single event or circumstance that could have a major effect on the ability of an issuer to repay a bond obligation. Question ID: 27264 SBG Entertainment, an outdoor concert tour management company located in the northwestern United States, holds approximately 80 concerts per year. SBG recently hired Stuart Frye, CFA. Frye enters into the following cap contract: SBG will receive $100,000 for each rain event (defined as cancellation due to inclement weather) over 13 rain events (maximum payments of $1,000,000). The premium, or cost of this agreement, is $300,000. Given this information, which of the following statements is FALSE?

A. B. C. D. C

The cap contract reduces SBG's exposure to event risk. The cap contract forces SBG to absorb some rain risk. If there are 15 rain events next year, SBG will recoup its premium. SBG's maximum loss is the premium.

In this simple example, SBG would recoup its premium if there are 16 rain events next year: [ (16 – 13) * 100,000)] = 300,000. If there are 15 rain events, SBG will receive $200,000, or [[ (15 – 13) * 100,000)], which is less than the premium. Although the cap contract does reduce SBG’s event risk, it still leaves SBG exposed to the risk of the first 13 rain events. Question ID: 27263 Which of the following circumstances is an example of event risk? The U.S. Federal Reserve unexpectedly increases interest rates by 100 basis points.

A.

B.

A currency devalues due to foreign exchange market forces. A local government regulatory agency introduces more stringent clean-water requirements that will significantly reduce the cash flow of an area paper mill. A bond's bid/ask spread widens.

C.

D. C

A local government regulatory agency introducing more stringent clean-water requirements that will significantly reduce the cash flow of an area paper mill is an example of regulatory risk, which is a type of event risk. The impact of regulatory risk can be long-term, in that the company may be unable to pass on the increased cost to customers. The other choices are examples of other types of risk that bondholders face. A widening bid-ask spread indicates increased liquidity risk. The Federal Reserve’s action is an example of interest rate risk. The currency’s devaluation is an example of currency risk. Question ID: 27265 Kira Sigard, CFA and an attorney with an investment banking firm, structures a client’s bond issue to include a “poison put.” This is a provision that requires the issuer to redeem the bond at par in the case of a corporate takeover, a merger, or anti-takeover measure that would dissipate significant corporate assets. An investor who purchases this bond is protected from what type of risk?

A. B. C. D. A

Event Risk. Call Risk. Liquidity Risk. Reinvestment Risk.

Event risk refers to the possibility that there may be a single event or circumstance that could have a major effect on the ability of an issuer to repay a bond obligation. The poison put specifically protects an investor from corporate event risk. Call Risk, or prepayment risk, is the risk that the issuer will repay principal prior to maturity. Prepayments are most likely to occur in a declining interest rate environment because it is cheaper to issue replacement debt. Liquidity risk addresses how quickly and easily an investor can sell a bond. Reinvestment risk is the risk that if rates fall, cash flows will be reinvested at lower rates, resulting in a holding return lower than that expected at purchase. Here, the investor will likely have to reinvest the coupon at the lower market interest rate, negatively impacting his holding period return. Question ID: 27261 Which of the following is NOT an example of event risk?

A.

The U.S. Food and Drug Administration (FDA) determines that a biotech company's flagship product is harmful to consumers and cannot be marketed. An interim South American government imposes restrictions on the outflow of capital. A corporation calls a large bond issue. Ratings agencies downgrade a company's rating after the company takes on a significant amount of debt to fund a leveraged buy-out (LBO).

B.

C.

D.

C
A corporation calling a large bond issue is an example of call risk. All other choices are examples of types of event risk, which includes disaster/accident, corporate, regulatory, and political risks. Event risk refers to the possibility that there may be a single event or circumstance that could have a major effect on the ability of an issuer to repay a bond obligation. The South American government’s actions are an example of political event risk. The FDA’s actions represent regulatory event risk. The LBO-related rating downgrade is an example of corporate event risk. Question ID: 13707 Which statement about the high-yield bond market is TRUE?

A. B. C. D. B

Almost half of the issues of high-yield bonds are rated CCC. The major ownership groups have been mutual funds, insurance companies, and pension funds. The major growth in new issue high-yield bonds began in 1979. Prior to 1980, most of the bonds in this category were "rising stars."

Question ID: 13679 An annual pay coupon bond has a Macaulay duration of 10. If rates change from 8 percent to 8.1 percent, what is the change in the price of the bond?

A. B. C.

up .926%. down .952%. up .952%.

D. D

down .926%.

Question ID: 13677 A 9-year bond has a yield of 10 percent and an effective duration of 6.54 years. If the market yield changes by 50 basis points, what is the change in the bond's price?

A. B. C. D. A

3.27%. 6.54%. 3.66%. 7.21%.

The formula for effective duration calculates the approximate change in price for a 100 basis point change in rates. Here, we are asked to provide the approximate percentage change in the bond's price for a 50bp change, which is 0.50 of 100bp. Thus, the calculation for the change in the bond's price is 0.50 * 6.54% = 3.27%. Question ID: 13635 Which of the following is NOT regarded as a source of systematic risk for bonds?

A. B. C. D. A

Default risk. Market risk. Purchasing power risk. Interest rate risk.

Question ID: 13663 Why do bond portfolio managers use the concept of duration?

A. B. C. D.

Duration is the only measure of bond risk. It enables direct comparisons between bond issues with different levels of risk. It assesses the time element of bonds in terms of both coupon and term to maturity. It allows structuring a portfolio to take advantage of changes in credit

quality.

C
Question ID: 13648 Assume a straight 5 percent coupon bond with annual coupon payments has two years remaining to maturity. A putable bond that is the same in every respect as the straight bond is priced at 101.76. With the term structure flat at 6 percent what is the value of the embedded put option?

A. B. C. D. B

1.76. 3.59. -3.59. -1.76.

The value of the embedded put option of the putable bond is just the difference between the price of the putable bond and the price of the straight bond. So it is computed as follows: Option Value = 101.76 - (5/1.06 + 105/1.06 ) = 3.59 Question ID: 13682 Consider a $1,000 face, 8-year semiannual bond with a 10.00% coupon currently selling at $1,181.41. If the yield declines by 10 basis points (bp), the price increases to $1,188.16. If the yield increases by 10 bp, the price declines to $1,174.71. What choice is closest to the approximate percentage change in price for a 100 basis point change in rates?
2

A. B. C. D. D

6.27% 5.50% 0.57% 5.70%

Using the formula for effective duration: Approximate % change in price = (price when yield falls - price when yield rises) 2* (initial price) * (yield change expressed as a decimal) = (1,188.16 - 1,174.71) / (2 * 1,181.41 * 0.001)

= 13.45 / 2.36 = 5.70%. Question ID: 13693 Suppose that a corporate bond and a government bond have equivalent characteristics. They both have a coupon rate of 6 percent paid annually and have two years remaining to maturity. Assuming a flat government term structure of 7 percent which of the following is a possible price of the corporate bond?

A. B. C. D. B

101.35. 97.76. 98.19. 98.78.

Since the corporate bond involves credit risk and the government bond doesn't. The corporate bond price has to be less than the government bond price which is computed as follows: Government Bond Price = 6/1.07 + 6/1.07 = 98.19 Question ID: 13690 Which of the following cause fluctuation of interest rates?
2

A. B. C. D. A

Real risk-free rate of interest. Expected GDP. All of these choices are correct. Historical rate of inflation.

Question ID: 13641 Which of the following five year bonds has the highest interest rate sensitivity?

A. B. C. D.

option-free 5% coupon bond. zero-coupon bond. callable 5% coupon bond. floating rate bond.

B
The duration of a zero-coupon bond is equal to its time to maturity. Its price maximally affected by changes interest rates because its only cash-flow is at maturity which is discounted for the whole period until now. Question ID: 13718 A treasury inflation protected security (TIPS) of $100,000 par value the coupon rate paid semi-annually is 2.5 percent and the annual inflation is 3 percent. What is the principal of the bond after six months assuming that it is now trading at par?

A. B. C. D.
B

$100,000. $101,500. $102,500. $103,000.

The annual inflation rate is 3% which corresponds to 1.5% semi-annually. Therefore, the principal of the TIPS has increased by 1.5%. So we have: New Principal = $100,000 x 1.015 = $101,500 Question ID: 13722 Assume that $14.5 billion of five-year T-Notes are auctioned. The amount of non-competitive bids is $2.5 billion, and the amount of competitive bids is $31.5 billion. Suppose that of the competitive bids $11.5 billion are higher than the stop yield and the rest are at the stop yield. For the bidders at the stop yield, what is the proportion of their bids that they receive?

A. B. C. D.
D

72.50%. 38.10%. 46.03%. 60.00%.

This value is computed as follows: Proportion Received = ($14.5b - $2.5b) / ($31.5b - $11.5b) = 60.00% This value is computed as follows: Proportion Received = ($14.5b - $2.5b) / ($31.5b - $11.5b) = 60.00% C Question ID: 13727 Consider a 20-year $1 million mortgage with an 8 percent mortgage rate paid monthly. What

is the monthly mortgage payment?

A. B. C. D.
C

$9,766. $100,373. $8,369. $8,565.

This amount is computed as follows:

0.08 0.08 240 x (1 + ) 12 12 0.08 240 (1 + ) -1 12 Question ID: 13729 Assume a 20-year $1 million mortgage with an 8 percent monthly mortgage rate. What is the interest amount that has to be paid in the first month?

A. B. C. D.
C

$6,434.03. $80,000.00. $6,666.67. $6,353.73.

This amount is computed as follows: Interest Amount = $1 million x 0.08 / 12 = $6,666.67 Question ID: 13730 A collateralised mortgage obligation (CMO) has a total underlying loan amount of $100 million, and there are 4 tranches (A to D) of $25 million each. Furthermore, 1/3 of the borrowers default on their loans. What is the value of a $1 million par amount in tranche C?

A. B. C. D.

$1,000,000. $0. $666,800. $333,400.

C After tranches A and B are satisfied, there are $16.67 million left. These are distributed to shareholders of tranche C. So each shareholder in tranche C receives a proportion of 16.67/25 of his original amount which for a $1 million dollar amount is $666,800. Question ID: 13735 One of the major problems associated with mortgage-backed securities is that:

A. B. C. D.
D

they are refundable. the principal portion of each payment is considered taxable income. they are serial issues. they are self-liquidating.

Question ID: 13733 Which of the following statements is TRUE concerning Government National Mortgage Association (GNMA) pass-through securities?

A. B. C. D.
A

They pay income to holders on a monthly basis that consist of interest and principal. They are fully guaranteed by the United States government. Their interest income is not subject to state and federal tax. They usually have long (25-30 year) maturities.

Question ID: 13743 A municipal bond carries a coupon of 6 3/4 percent and is traded at par. To a taxpayer in the 28 percent tax bracket, this bond provides an equivalent taxable yield of:

A. B. C. D.

7.88%. 9.38%. 6.75%. 8.53%.

B ETY=Yield/(1-Marginal Tax Rate)

0.0675/(1-0.28)=9.38% Question ID: 13740 A municipal bond carries a coupon of 6 percent and is traded at par. To a taxpayer in the 34 percent tax bracket, this bond provides an equivalent taxable yield of:

A. B. C. D.

6.00%. 8.53%. 10.44%. 9.09%.

D ETY=yield/(1-marginal tax rate) 0.06/(1-0.34)=9.09% Question ID: 13739 Which of the following statements are TRUE?

A. B. C. D.
D

Municipal bond interest and capital gains are exempt from federal taxation. All of these choices are correct. Municipal revenue bonds generally pay lower returns than municipal general obligation bonds because of their lower default risk. Municipal bond guarantees guarantee the principal and interest of municipal bonds in the event the issuer defaults.

Question ID: 13737 What is the equivalent taxable yield of a 6 percent municipal bond purchased for $700? The investor's marginal tax rate is 30 percent.

A. B. C. D.
D

9.2% 4.2% 8.6% cannot be determined.

Question ID: 13744

Support for the revenue bonds comes from:

A. B. C. D.
C

property taxes based on the project. the issuer's unlimited taxing power. the net revenues of the underlying project. the gross revenues of the underlying project.

Question ID: 13748 Which of the following ranks lowest in sequence in terms of its claim on earnings and or assets?

A. B. C. D.
C

A junior bond. An equipment trust certificate. A subordinated debenture. A convertible debenture.

Question ID: 13745 When a company issues a bond backed by its financial assets which are held by a third party, the bond is known as:

A. B. C. D.
C

an income bond. a mortgage bond. a collateral trust bond. a pass-through bond.

Question ID: 13753 What is the typical face value of a corporate bond?

A.

$100.

B. C. D.
D

$10,000. $100,000. $1,000.

Question ID: 13752 Which of the following is a difference between publicly and privately placed corporate debt instruments of the same issuer with the same characteristics? Privately placed corporate debt instruments:

A. B. C. D.

sell at a lower price. are callable. have a higher credit risk. sell at a higher price.

A Privately placed debt instruments sell at a lower price since they cannot be traded for a two-year period and are therefore less liquid than their publicly issued equivalent. Hence investors have to be compensated for the cost of illiquidity. So these instruments have to sell at a lower price. Since both types of instruments are of the same issuer and have the same bond characteristics, the credit risk is the same. Question ID: 13758 Bonds issued in a country in non-domestic currency units to non-citizens are called?

A. B. C. D.
A

foreign bonds. Euro Bonds. Non-domestic bonds. Yankee Bonds.

Question ID: 13760 Each of the following could be a reason why a global bond is traded at slightly different prices at two different locations EXCEPT:

A. B.

market segmentation. tax differences.

C. D.

arbitrage. liquidity differences.

C If arbitrage is possible it forces the two prices to be exactly the same not different. Due to market frictions pure arbitrage, however, is not always possible. Question ID: 13732 What is the disadvantage of collateralized mortgage obligations (CMO's) to investors?

A. B. C. D.
D

Low yield relative to securities of similar risk. Interest income is not tax exempt. High default risk. A less predictable payment stream.

Question ID: 13746 Purchasers of collateral trust bonds are most concerned about:

A. B. C. D.
B

the future cash flow of the issuer. financial assets of the issuer. all available assets of the issuer. the current earnings of the issuer.

Question ID: 13749 A debenture is:

A. B. C. D.
D

a short-term debt. a bond secured by specific assets. a mortgaged bond. an unsecured bond.

Question ID: 13755 Which of the following statements concerning corporate bonds is TRUE? The denomination is usually:

A. B. C. D.
C

$100,000, and the maturities usually range from 10 to 20 years. $1,000, and the maturities usually range from 10 to 20 years. $1,000, and the maturities usually range from 5 to 10 years. $100,000, and the maturities usually range from 5 to 10 years.

Question ID: 13734 Which of the following statements about Collateralized Mortgage Obligations (CMO) is TRUE?

A. B. C. D.
D

Later classes have no protection from early payments of principal. Early classes have a rate of return higher than the later classes. A CMO always has five trenches plus the Z class. Effectively later classes have a longer maturity than the early classes.

Question ID: 13741 Which of the following statements concerning municipal bonds is FALSE?

A. B. C. D.
B

Yields on municipal bonds are usually lower than yields on Treasury bonds. Municipal bonds are of lower risk that Treasury bonds because of their lower yield. Municipals are most appealing to individuals with high incomes. The vast majority of municipal bonds sell at lower yields because their bond interest is exempt from federal income tax.

Question ID: 13736 Which of the following statements is FALSE?

A. B. C. D.
D

The main innovation of CMO is that they offer stable maturities to investors. The corporate bond sector is more important in the US than in Japan and Germany. Treasuries and agencies are quoted in 32
nds

of a price point.

Coupon interest and capital gains municipal bonds are tax exempt at the federal level.

Question ID: 13754 Which of the following statements concerning taxable bonds is TRUE?

A. B. C. D.
B

Corporates have the lowest yields, followed by Treasuries, then by corporates, which provide the highest returns. Treasuries have the lowest yields, followed by agencies, then by corporates, which provide the highest returns. Agencies have the lowest yields, followed by Treasuries,then by corporates, which provide the highest returns. Treasuries have the lowest yields, followed by corporates, then by agencies, which provide the highest returns.

Question ID: 13719 Suppose for a treasury inflation protective security (TIPS) of $100,000 par value and currently trading at par, the coupon rate paid semi-annually is 4 percent and the annual inflation rate is 2.5 percent. What is the coupon payment after six months has passed?

A. B. C. D.
C

$2,050. $2,000. $2,025. $4,000.

This coupon payment is computed as follows: Coupon Payment = ($100,000 x 1.0125) x 0.04/2 = $2,025

1.D: Understanding Yield Spreads

Question ID: 13762 Which of the following applies to an on-the-run Treasury issue? An on-the-run issue is:

A. B. C. D.

a bond that is alive rather than having matured already. the most widely held Treasury security type. a short-term Treasury security. the most recently issued Treasury security.

D The on-the-run Treasury issue is the most recently issued Treasury security of a certain type as opposed to an off-the-run issue that has been issued earlier. Question ID: 13767 Which of the following statements concerning the yield curve is CORRECT?

A.

The slope of the yield curve appears very stable in the past thirty years. The yield curve is constructed by plotting yields for a group of bonds that are similar in all respect except maturity. A yield curve reflects the actual rate of return an investor will receive. A downward slopin yield curve indicates that the current inflation rate is very low.

B.

C.

D.

B Question ID: 13770 According to the expectations hypothesis, an normal yield curve implies that interest rates are expected to:

A. B. C. D.

increase in the future. decline in the future. remain stable in the future. decline first, then increase.

A Question ID: 13764 The yield curve is the relationship between: the bond's

A. B. C. D.
D

yield to maturity and its coupon rate. market return and its term to maturity. yield to maturity and its duration. yield to maturity and it term to maturity.

Question ID: 13777 Which of the following factors will directly affect the term structure of interest rates?

A. B. C. D.
D

Term to call and yield to call. Term to call and yield to maturity. Current yield and coupon rate. Term to maturity and yield to maturity.

Question ID: 13771 With respect to the term structure of interest rate, the market segmentation theory holds that: the yield curve reflects the maturity preferences of financial institutions and investors. investors are indifferent between investing in short-term bonds and buying long-maturity bonds as long as they provide the same yields. an excess demand in the market for long-term funds could lead to a

A.

B.

C.

downward sloping yield curve. expectations about future inflation are the major determinants of the shape of the yield curve.

D.

A Question ID: 13773 What does an inverted yield curve imply for the one-year forward rate starting in a year from now? The forward rate will be:

A. B. C. D.
A

less than the two-year spot rate. higher than the two-year spot rate. positive. negative.

If the yield curve is inverted this means that it has a negative slope. Therefore, the two-year spot rate has to be less than the one-year spot rate. In order for that to be true, the one-year forward rate starting in one year from now has to be even less than the two-year spot rate. The relationship between the rates is as follows. (1 + spot rate0,1)(1 + forward rate1,2) = (1 + spot rate0,2) where the subscripts indicate the periods that are covered by the respective rates. Question ID: 13778 The term structure of interest rates is: the relationship between the:

A. B. C. D.
D

yield on a bond and its default rate. all of these answers are correct. rates of interest on all securities. interest rate on a security and its time to maturity.

Question ID: 13781 Assume the following corporate yield curve. One-year rate: 5.50 percent

Two-year rate: 6.00 percent Three-year rate: 7.00 percent If an annually compounded corporate bond has a coupon of 5 percent and the on the run three year US Treasury is yielding 5 percent, then what is the absolute yield spread?

A. B. C. D.

.27%. .56%. 0%. 5.4%.

A The corporate bond has a yield of 5.27% with a price of 94.9. Question ID: 13784 James Walters, CFA, is an active fixed income portfolio manager. He manages a portfolio of fixed income securities worth$7,500,000 for an institutional client. Walters expects a widening yield spread between intermediate and long term securities. He would like to capitalize on his expectations and considers several transactions in a number of different securities. On 01/31/98, Walters expects the yield of the 2-Year Treasury Note to decrease by 10 basis points and the yield of the 30-Year Treasury Bond to increase by 11 basis points. The characteristics of these two fixed income securities are shown in Table 1. Prices are quoted as a percentage of par value. Table 1 Security Characteristics 2-Year T-Note 30-Year T-Bond Maturity 01/31/00 11/15/27 Bid-Ask Spread (basis points) 5.0 5.0 Coupon 5.375% 6.125% Bid Price 99.7236 104.6086 Ask Price 99.7736 104.6586

Yield to Maturity 5.51% 5.80% Price Value of a Basis Point 186.6484 1461.1733 He also has the three year term structure of interest rates. This is shown in Table 2. Table 2 Term Structure of Interest Rates Year Spot Rate 0.50 5.5227% 1.00 5.5537% 1.50 5.5444% 2.00 5.5205% 2.50 5.5114% 3.00 5.5156% Walters thinks of several different trading strategies that would allow him to take advantage of his expectations. He would like to evaluate each strategy to determine which offers the best risk-return tradeoff. Compute the yield spread between the T-Note and T-Bond given the information in Table 1.

A. B. C. D.

0.34%. 0.29%. 0.00%. 0.75%.

B The yield spread is computed as follows: Yield Spread = Yield to MaturityT-Bond – Yield to MaturityT-Note

So we have Yield Spread = 5.80% - 5.51% = 29 bp (basis points) Question ID: 13787 Assume that the following hypothetical Treasury securities (settlement date: 30-October-00) are trading actively. Coupon Maturity Price Bond A 8% 15-September-01 100.35 Bond B 9.75% 15-August-20 100 Assume that an investor believes that all yield curves are going to flatten. Under this scenario and using these bonds, which of the following trades are CORRECT??

A. B. C. D.

Intramarket trade that buys bond A and short sells bond B. Intramarket trade that short sells bond A and buys bond B. Intermarket trade that buys bond A and short sells bond B. Intermarket trade that short sells bond A and buys bond B.

B If you expect the yield curve to flatten then short term interest rates have to increase relative to long term interest rates (but not necessarily in absolute terms). Therefore, this strategy is consistent with your beliefs. Question ID: 13792 If investors expect greater uncertainty in the bond markets, you should see yield spreads between AAA and B rates bonds:

A. B. C. D.

narrow. widen. slope downward. stay the same.

B Question ID: 13791 If a US investor is forecasting that the yield spread between US Treasury bonds and US corporate bonds is going to widen, then which of the following is most likely to be TRUE?

A. B. C. D.
C

The economy is going to expand. No change in the economy. The economy is going to contract. The US dollar will weaken.

Question ID: 13790 Which of the following is the reason why credit spreads between high quality bonds and low quality bonds widen durning poor economic conditions?

A. B. C. D.
C

interest risk. delinquency risk. default risk. indenture provisions.

Question ID: 13794 Which of the following is a possible explanation why Treasury bonds tend to have higher yields than short-term treasury securities (bills)? Treasury bonds:

A. B. C. D.

tend to be off-the-run issues. have a higher duration than bills. tend to have lower liquidity than bills. tend to be held by investors requiring a higher return.

C T-bills tend to be more liquid than T-bonds. Therefore, investors only require a lower return. This, however, is only one of a number of reasons for the above finding. Question ID: 13795 Which of the following statement concerning the liquidity of a bond is TRUE? Higher liquidity:

A. B. C. D.

increases a bond's interest rate sensitivity. positively affects the price of a bond. decreases a bond's interest rate sensitivity. negatively affects the price of a bond.

B Since more liquid bonds have lower transaction costs associated with them and tend to trade more frequently, investors prefer liquidity and are therefore willing to pay premium prices for more liquid bonds. Question ID: 13796 Assume that the following hypothetical Treasury securities are trading actively. Coupon Maturity Price Non Treasury Bond A 6% 15-August-20 100.35 US Treasury Bond B 9.75% 15-August-20 100 Which of the following is most likely to be TRUE?

A. B. C. D.
B

Bond B is a Flower bond. Bond A is a tax exempt issue. Bond A is a corporate issue with an embedded call option. Bond B is an off the run US Treasury.

Question ID: 13798 Assume that an annual 6 percent coupon paying bond has two years remaining to maturity. Use the following spot rate to price each security. One-year rate: 5.5 percent Two-year rate: 6.5 percent Which of the following is the approximate tax equivalent yield for this security assuming a 40 percent tax rate?

A. B. C. D.

3.63%. 3.90%. 3.60%. 2.42%.

A 6 * 6.053% = 3.63% Question ID: 13780 A Treasury bond due in one-year has a yield of 8.5 percent. A Treasury bond due in 5 years has a yield of 9.3 percent. A bond issued by General Motors due in 5 years has a yield of 9.9 percent. A bond issued by Exxon due in one year has a yield of 9.4 percent. The default risk premiums on the bonds issued by Exxon and General Motors, respectively, are:

A. B. C. D.
C 9.4 - 8.5 = .9 9.9 - 9.3 = .6

0.1% and 1.4%. 0.1% and 0.6%. 0.9% and 0.6%. 0.0% and 1.4%.

Question ID: 13772 Which of the following statements is TRUE? The basic conclusion of the expectations hypothesis theory is that the long-term rate is equal to the anticipated long-term rate.

A.

B.

The segmentations hypothesis theory contends that borrowers and lenders are constrained to particular segments of the yield curve. The liquidity preference hypothesis theory indicates that, all other things being equal, longer maturities will have lower yields. The expectations hypothesis theory predicts a flat yield curve if anticipated future short-term rates exceed the current short-term rate.

C.

D.

B Question ID: 13763 An upward sloping yield curve:

A.

is an indication that interest rates are expected to increase. reflects the compounding of the liquidity premium without interest rate expectations. does not incorporate a liquidity premium. all of these answers are correct.

B.

C. D.
A

Question ID: 13765 What is the conclusion of the expectations hypothesis? The yield curve:

A. B. C. D.
B

can be any shave above. should always be upward sloping. should always be downward sloping. should always be flat.

Question ID: 13782

Assume the following corporate yield curve. One-year rate: 5.00 percent Two-year rate: 6.00 percent Three-year rate: 7.00 percent If an annually compounded corporate bond has a coupon of 6 percent and the on the run three year US Treasury is yielding 6 percent, then what is it's relative yield spread?

A. B. C. D.
D

2.40%. .15%. 0%. 2.50%.

Question ID: 13788 Assume that the following hypothetical Treasury securities (settlement date: 30-October-00) are trading actively. Coupon Maturity Price Bond A 8% 15-September-01 100.35 Bond B 9.75% 15-August-20 100 Assume that an investor believes that all yield curves are going to steepen. Under this scenario and using these bonds, which of the following trades are CORRECT??

A. B. C. D.
B

Intermarket trade that buys bond A and short sells bond B. Intramarket trade that buys bond A and short sells bond B. Intramarket trade that short sells bond A and buys bond B. Intermarket trade that short sells bond A and buys bond B.

If you expect the yield curve to steepen then short term interest rates have to decrease relative to long term interest rates (but not necessarily in absolute terms). Therefore, this strategy is consistent with your beliefs. Question ID: 13779 The yield curve:

A. B. C. D.
A

is a graphical depiction of term structure of interest rates. is usually depicted for corporate bonds of different ratings. has maturity plotted on the Y axis and interest rates plotted along the X axis. is usually depicted for U.S. Treasuries in order to hold risk constant across maturities and yields.

Question ID: 13768 An inverted yield curve implies that: Intermediate term interest rates are higher than either short-term or long-term interest rates. Long-term interest rates are higher than short-term interest rates. Long-term interest rates are lower than short-term interest rates. Long-term interest rates are the same as short-term interest rates.

A.

B. C. D.
C

Question ID: 13793 Which of the following is the most appropriate strategy for a fixed income portfolio manager under the anticipation of an economic expansion?

A. B. C. D.
A

Purchase corporate bonds and sell treasury bonds. Sell corporate bonds and purchase treasury bonds. Enter a pay-floating, receive-fixed rate swap. Enter a pay-fixed, receive-floating rate swap.

During periods of economic expansion corporate yield spreads generally narrow, reflecting corporate bonds decreased credit risk. If yield spreads narrow, the price of corporate bonds increases relative to the price of treasuries. Question ID: 13774 The yield curve depicts the relationship between yield and:

A. B. C. D.
A

term to maturity. safety. coupon rate. risk.


				
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