schweser printable answers - fixed inc 2

Schweser Printable Answers - Fixed Inc 2

Test ID#: 10

Question 1 - #96834

Which of the following assets is the least liquid?

Your answer: A was incorrect. The correct answer was C)

Limited Partnership.

All other choices are considered highly liquid assets. On-the-run Treasuries are recently issued and are often more liquid than older issues.

This question tested from Session 15, Reading 61, LOS k.

Question 2 - #97919

If an investor purchases a 9 ¾s 2001 Feb. $10,000 par Treasury Note at 101:11 and holds it for exactly one year, what is the rate of return if the selling price is 101:17?

Your answer: A was correct!

Purchase price = [(101 + 11 / 32) / 100] × 10,000 = $10,134.375

Selling price = [(101 + 17 / 32) / 100] × 10,000 = $10,153.125

Interest = 9¾% of 10,000 = $975.00

Return = (Pend − Pbeg + Interest) / Pbeg = (10,153.125 − 10,134.375 + 975.00) / 10134.375 = 9.81%

This question tested from Session 15, Reading 62, LOS b, (Part 1).

Question 3 - #96505

Bond A has a yield of 8.75%. Bond B, the reference bond, has a yield of 7.45%. Assuming both bonds have the same maturity, the relative yield spread is closest to:

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A) Foreign exchange futures contract. B) On-the-run Treasury security. C) Limited Partnership.

A) 9.81%.B) 9.75%.C) 8.75%.

A) 13%. B) 15%.

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Your answer: A was incorrect. The correct answer was C) 17%.

Relative yield spread = absolute yield spread / yield on reference bond Relative yield spread = (8.75% − 7.45%) / 7.45% = 0.17 = 17%

This question tested from Session 15, Reading 63, LOS e.

Question 4 - #96673

All of the following risks are types of event risk EXCEPT:


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.

This question tested from Session 15, Reading 61, LOS o.

Question 5 - #97596

Which of the following does NOT represent a secondary market offering? When bonds are sold:

Your answer: A was incorrect. The correct answer was C) in a Rule 144A offering.

When bonds are sold in a Rule 144A offering, they are sold privately to a small number of investors or institutions. This offering does not require registration with the SEC and this is valuable to the issuer. The investor will require a slightly higher yield because the bonds cannot be resold to the public unless they are registered with the SEC. The other sales transactions in the responses represent secondary market offerings.


Question 6 - #97136

One year ago, Makato Omura purchased a 6.50% fixed coupon bond for 98.50. Recently, she sold the bond for 99.25 and calculated her return at 7.4%. Her friend, Takanino Takemiya, CFA, reminds Omura that this is the

C) 17%.

A) disaster/accident risk. B) political risk. C) interest rate risk.

A) on an exchange.B) in an over-the-counter dealer market.C) in a Rule 144A offering.



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:


5.2%.

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%.

This question tested from Session 15, Reading 61, LOS m.

Question 7 - #96578

The structure of interest rates results from all the following EXCEPT:


The yield curve plots term to maturity and yield to maturity. The other choices are true.

This question tested from Session 15, Reading 61, LOS g.

Question 8 - #96722

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?

Your answer: A was incorrect. The correct answer was B)

A) 9.6%. B) 6.3%. C) 5.2%.

A) creating the yield curve by plotting term to maturity against the coupon rate. B) assuming that individual discount rates do not change by the same amount. C) viewing each bond coupon payment as a separate zero coupon bond.

A) Liquidity Risk. B) Event Risk. C) Call Risk.



Event 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.

This question tested from Session 15, Reading 61, LOS o.

Question 9 - #97557

Portfolio duration is best described as the:

Your answer: A was incorrect. The correct answer was B) sensitivity of a portfolio’s value to equal changes in yield for all the bonds in the portfolio.

Portfolio duration is a measure of a portfolio’s interest rate risk. It measures the sensitivity of the portfolio’s value to an equal change in yield for all the bonds in the portfolio. It can be calculated as the weighted average of the individual bond durations using the proportions of the total portfolio value represented by each of the bonds. Portfolio duration does not capture the effect of changes in the yield curve (term structure).


Question 10 - #98124

Consider a corporate bond with a yield of 6.8% and a municipal bond (with equivalent risk) with a 4.9% yield. Which of the following statements is most accurate?


An investor with a marginal tax rate of 28% has a tax-equivalent yield on the municipal bond of 6.8% and is, therefore, indifferent between the two bonds (of equivalent risk). As the marginal tax rate increases, the investor will prefer the municipal bond to the corporate bond. Note that with a marginal tax rate of 35%, the tax-equivalent yield for the municipal bond would be 4.9 / (1 − 0.35), or 7.54%.

This question tested from Session 15, Reading 63, LOS i.


Austin Traynor is considering buying a $1,000 face value, semi-annual coupon bond with a quoted price of 104.75

A) sensitivity of a portfolio’s value to changes in the term structure of interest rates.B) sensitivity of a portfolio’s value to equal changes in yield for all the bonds in the portfolio.C) arithmetic mean of the durations of each bond in a portfolio.

A) An investor with a marginal tax rate of 28% is indifferent between the two bonds.B) An investor with a marginal tax rate of 40% prefers the corporate bond.C) The tax-equivalent yield for an investor with a 35% marginal tax rate is 7.32%.



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?

Your answer: A was incorrect. The correct answer was B) $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 1,000 × 104.75%, or 1,000 × 1.0475 = 1,047.50. Thus, the dirty price = 1,047.50 + 33.50 = 1,081.00.

This question tested from Session 15, Reading 60, LOS c.


What is the typical face value of a corporate bond?


The most common face value of a corporate bond is $1,000.

This question tested from Session 15, Reading 62, LOS h.


Which of the following entities play a critical role in the ability to create an asset backed security with a higher credit rating than the corporation?


SPVs, or special purpose corporations, buy the assets from the corporation. The SPV separates the assets used as collateral from the corporation that is seeking financing. This shields the assets from other creditors.

This question tested from Session 15, Reading 62, LOS i, (Part 1).


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

A) $1,014.00.B) $1,081.00.C) $1,047.50.

A) $1,000.B) $100,000.C) $100.

A) Special purpose vehicles (SPVs).B) Rating agencies.C) Investment banks.



Your answer: A was incorrect. The correct answer was C) Purchase corporate bonds and sell treasury bonds.

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.

This question tested from Session 15, Reading 63, LOS f.


Often central governments will announce auctions to issue new bonds when they believe prevailing market conditions appear most suitable. At the time of the auction, the amount to be auctioned and the maturity of the security to be offered are announced. This method of distributing new government securities is called:

Your answer: A was incorrect. The correct answer was C) an ad hoc auction method.

An ad hoc auction system is a method in which a central government distributes new government securities via auction when it determines that market conditions are advantageous.

This question tested from Session 15, Reading 62, LOS a.


Assume a bond's quoted price is 105.22 and the accrued interest is $3.54. The bond has a par value of $100. What is the bond's clean price?


The clean price is the bond price without the accrued interest so it is equal to the quoted price.



Which of the following statements about duration is TRUE?

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

A) a regular auction cycle / single-price method.B) the tap method.C) an ad hoc auction method.

A) $105.22.B) $103.54.C) $108.76.

A) The result of the formula for effective duration is for a 0.01% change in interest rates.

The formula for effective duration is: (price when yields fall - price when yields rise) / (initial price *




A bond's percentage change in price and dollar change in price are both tied to the underlying price volatility.

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.



A municipal bond carries a coupon of 6.75% and is traded at par. To a taxpayer in the 28% tax bracket, this bond provides an equivalent taxable yield of:

Your answer: A was incorrect. The correct answer was C) 9.38%.

ETY = Yield/(1 − Marginal Tax Rate)

0.0675/(1 − 0.28) = 9.38%



Duration measures the:

Your answer: A was incorrect. The correct answer was B) timing of cash flows weighted by the proportionate value of each flow's present value.

The sensitivity of a bond’s price to changes in yield is known as a bond’s effective duration. Macaulay’s duration is calculated by the timing of cash flows weighted by the proportionate value of each flow’s present value.



B) change in yield expressed as a decimal).

C) A bond's percentage change in price and dollar change in price are both tied to the underlying price volatility.

A) 6.75%.B) 8.53%.C) 9.38%.

A) length of time until a bond matures.B) timing of cash flows weighted by the proportionate value of each flow's present value.C) cash flows weighted by the timing of the cash flows.



A bond issued by the government of Italy is likely to be denominated in which one of the following currencies?


Bonds issued by governments are likely to be denominated in the currency of the country where the bond is issued. In this case, the Euro is the Italian currency and bonds issued by the Italian government would normally be issued in Euros.



Interest rate risk for a bond refers to the fact that when interest rates:


Interest rate risk is the risk that the bond’s value will decrease because interest rates increase. Reinvestment risk is the risk that a bond’s cash flows will be reinvested at lower-than-expected rates. Prepayment risk refers to the fact that prepayments of a mortgage-backed security’s principal may differ from the expected rate.



What is the duration of a floating rate bond that has six years remaining to maturity and has semi-annual coupon payments. Assume a flat-term structure of 6%. Which of the following is closest to the correct duration?

Your answer: A was incorrect. The correct answer was B) 0.500.

The duration of a floating rate bond is equal to the time until the next coupon payment takes place. As the coupon rate changes semi-annually with the level of the interest rate, a floating rate bond has the same duration as a pure discount bond with time to maturity equal to the time to the next coupon payment of the floating rate bond.



When market rates were 6% an analyst observed a $1,000 par value callable bond selling for $950. At the same

A) Euros.B) U.S. dollars.C) Swiss francs.

A) increase, the bond’s value decreases.B) decrease, the realized yield on the bond will be less than the yield to maturity.C) increase, prepayments of principal will decrease.

A) 6.000.B) 0.500.C) 4.850.



time the analyst also observed an identical non-callable bond selling for $980. What would the analyst estimate the value of the call option on the callable bond to be worth?

Your answer: A was incorrect. The correct answer was B) $30.

The noncallable bond has the traditional PY shape. The callable bond bends backwards. The difference between the two curves is the value of the option. 980 − 950 = $30.

This question tested from Session 15, Reading 61, LOS d.


Consider three corporate bonds that are identical in all respects except as noted:

� Bond F has $100 million face value outstanding. On average, 200 bonds trade per day. � Bond G has $300 million face value outstanding. On average, 200 bonds trade per day. � Bond H has $100 million face value outstanding. On average, 500 bonds trade per day.

Will the yield spreads to Treasuries of Bond G and Bond H be higher or lower than the yield spread to Treasuries of Bond F?


Liquidity is attractive to investors, so they will pay a higher price (demand a lower yield) for a more liquid bond than for an identical bond that is less liquid. Bond G is more liquid than Bond F because of its greater size. Bond H is more liquid than Bond F because it trades in greater volume. Therefore both Bond G and Bond H will tend to have lower yield spreads to Treasuries than Bond F.



Which of the following statements is FALSE? All else equal, a floating-rate bond with:


coupon reset dates every 3 months will have more price fluctuation than a bond with reset dates every 6 months.

A) $20.B) $30.C) $80.

A) Lower for both.B) Higher for both.C) Higher for one only.

A) a fixed-margin rate in the coupon formula will experience greater price fluctuation than a bond with an adjustable margin rate.

B) coupon reset dates every 3 months will have more price fluctuation than a bond with reset dates every 6 months.

C) an interest rate cap will have more price fluctuation than a bond with no interest rate cap.



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.



If a U.S. investor is forecasting that the yield spread between U.S. Treasury bonds and U.S. corporate bonds is going to widen, then which of the following is most likely to be TRUE?

Your answer: A was incorrect. The correct answer was B) The economy is going to contract.

If economic conditions are expected to get worse, then the probability that corporations may default increases and causes credit spreads to widen.



Which of the following is the least significant risk faced by a holder of a mortgage-backed security?

Your answer: A was incorrect. The correct answer was C) Scheduled principal payment risk.

Interest rate risk and reinvestment risk are both significant for mortgage-backed securities. There is no risk embedded in a scheduled principal payment.

This question tested from Session 15, Reading 62, LOS e, (Part 1).


Simone Girau holds a callable bond and Chi Rigazio holds a putable bond. Which of the following statements about the two investors is most accurate?

A) The economy is going to expand.B) The economy is going to contract.C) The U.S. dollar will weaken.

A) Reinvestment risk.B) Interest rate risk.C) Scheduled principal payment risk.

A) As the yield volatility increases, the value of both Girau's bond and the underlying option increases.B) Girau's bond has less potential for price appreciation.

C) Both investors calculate the value of the bond held by adding the value of the option to the value of a similar straight bond.



Your answer: A was incorrect. The correct answer was B) Girau's bond has less potential for price appreciation.

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.

The other statements are false. 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. Embedded options (puts and calls) increase in value when volatility increases.



A payment made that is in excess of the required monthly mortgage payment is called:

Your answer: A was incorrect. The correct answer was C) prepayment.

This is the definition of prepayment. Curtailment is when the prepayment is not for the entire amount. Prepayment risk is the risk that relates to the amount and timing of cash flows from a mortgage.


Question 30 - #119460

Anthony Schmidt, CFA, makes the following statements while discussing issuance of new debt:

Are Schmidt’s Statements accurate?

Your answer: A was incorrect. The correct answer was B) Only one of these statements is accurate.

Statement 1 is incorrect. A firm commitment (not a best-efforts offering) is an arrangement where the investment banker purchases the entire issue and resells it.

Statement 2 is accurate. Under a private placement, a firm can avoid registration with the SEC, but the buyer will

A) prepayment risk.B) curtailment.C) prepayment.

Statement 1: A best-efforts offering, which is a form of a negotiated offering, occurs when an investment banker purchases an entire issue to resell.

Statement 2: Registration with the SEC can be avoided with a private placement, but a higher yield will be required to compensate for the limited liquidity.

A) Both of these statements are accurate.B) Only one of these statements is accurate. C) Neither of these statements is accurate.



require a higher yield to compensate for the illiquidity of the issue.



Which of the following 10-year fixed-coupon bonds has the most price volatility? All else equal, the bond with a coupon rate of:


5.00%.

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.



Which of the following statements regarding financing bond purchases with margin accounts is FALSE?


The margin percentage is fixed by contract. The required margin dollars may vary from day to day due to fluctuations in the underlying collateral.



If a U.S. Treasury bond is quoted at 92-16, the price of the bond is:

A) 6.00%. B) 5.00%. C) 8.00%.

A) The required margin percentage changes daily. B) In the U.S., margin accounts are regulated by the Federal Reserve. C) Individuals are more likely than institutions to use margin accounts to finance bond purchases.

A) $925.00.B) $92.50.C) $92.16.




92 − 16 = 92 16/32 = 92.5% of par value

0.925 × $1,000 = $925



Which of the following statements about a callable bond is TRUE?


A bondholder usually loses if a bond is called by being forced to reinvest the proceeds at a lower interest rate.

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.



Which of the following institutions are federally-related institutions?

Your answer: A was incorrect. The correct answer was B) Government National Mortgage Association.

Federally-related (or government-owned) agencies are arms of the federal government. Both of the other institutions listed are government-sponsored enterprises.



A) Callable bonds follow the standard inverse relationship between interest rates and price.

B) A bondholder usually loses if a bond is called by being forced to reinvest the proceeds at a lower interest rate.

C) The call option on a bond trades separately from the bond itself.

A) Student Loan Marketing Association.B) Government National Mortgage Association.C) Federal National Mortgage Association.



A debt security that is collateralized by emerging market debt would be a(n):


A CDO (collaterized debt obligation) is a debt obligation that is backed by an underlying diversified pool of business loans, mortgages, emerging market debt, corporate bonds, asset-backed securities, or non-performing loans. A MTN is a medium-term note issued by a corporation. A CMO (collaterized mortgage obligation) is a debt obligation that is backed by mortgages.

This question tested from Session 15, Reading 62, LOS j.


Which of the following statements is TRUE for both callable and putable bonds?


When yield volatility increases, the value of the option increases.

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.

This question tested from Session 15, Reading 61, LOS n.


Which of the following statements about U.S. debt securities is most accurate?


One type of issuer of federal agency securities is government sponsored enterprises (GSE). GSE securities are not backed by the full faith and credit of the Treasury. Municipal bond guarantees may apply to both principal and interest guarantees.

This question tested from Session 15, Reading 62, LOS g, (Part 2).

A) CDO.B) CMO.C) MTN.

A) The value of the bond is equal to the value of a similar straight bond plus the value of the option. B) When yield volatility increases, the value of the option increases. C) When yield volatility increases, the value of the bond increases.

A) General obligation bonds are backed by the full faith and credit of the issuer. B) Government agency issues are backed by the full faith and credit of the Treasury. C) Municipal bond guarantees apply to principal but not interest payments in the event of default.




Suppose that a corporate bond and a government bond have equivalent characteristics. They both have a coupon rate of 6% paid annually and have two years remaining to maturity. Assuming a flat government term structure of 7% which of the following is a possible price of the corporate bond?


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 + 106 / 1.072 = 98.19

This question tested from Session 15, Reading 61, LOS j.


When bonds are sold in a bought deal, the transaction takes place on the:


When bonds are sold in a bought deal, the transaction takes place on the primary markets. In a bought deal, the investment banker buys the issue of bonds from the issuer and then resells them (i.e. they have underwritten the offer and the arrangement is termed a firm commitment). Bonds are sold in secondary markets after being sold the first time (after they have been issued in the primary market). The term over-the-counter does not apply.



The term structure theory that rests on the interaction of supply and demand forces in the debt market is the:

Your answer: A was incorrect. The correct answer was C) market segmentation theory.

The market segmentation theory holds that the market is segmented into different parts based on the maturity preferences of investors. The theory also holds that the supply and demand forces at work within each segment determine the prevailing level of interest rates for that part of the market.

This question tested from Session 15, Reading 63, LOS c, (Part 1).

A) 97.76.B) 98.19.C) 101.35.

A) primary market.B) over-the-counter market.C) secondary market.

A) expectation hypothesis.B) GIC inverse term structure theory.C) market segmentation theory.




If the Federal Reserve wishes to lower market interest rates without changing the discount rate, it can:

Your answer: A was incorrect. The correct answer was C) buy Treasury securities.

Buying Treasury securities pumps money into the economy, lowering interest rates. Higher reserve requirements will restrict the money supply, causing rates to rise. The Federal Reserve has no direct control over the yield on existing Treasury securities.



Which of the following statements concerning bond duration is least accurate? Duration:

Your answer: A was incorrect. The correct answer was B) increases as market yields rise.

Duration decreases as market yields rise.



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, 7.5% 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?

Your answer: A was incorrect. The correct answer was C) 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.

A) raise the yield on Treasury securities. B) increase bank reserve requirements. C) buy Treasury securities.

A) decreases as the coupon increases.B) increases as market yields rise.C) is the weighted-average maturity of the cash flows of the bond.

A) 4.2.B) 3.5.C) 2.5.





Which of the following statements concerning the exchange rate risk of investing in foreign bonds is most accurate? If the foreign currency:


If the foreign currency depreciates, bond investors lose, all else equal. This occurs because the bond’s coupon payments and principal will convert to fewer U.S. dollars.

This question tested from Session 15, Reading 61, LOS l.


Which of the following embedded options benefits the bond investor?


A put provision allows the investor to put the bond back to the issuer.



Which of the following refers to the U.S. Treasury bonds that are sold in the form of zero-coupon securities?

Your answer: A was incorrect. The correct answer was B) Strip-Ts.

The U.S. Treasury does not issue zero coupon notes and bonds, therefore investment bankers began stripping the coupons from Treasuries to create synthetic zeros to meet investor demand. The Separate Trading of Registered Interest and Principal Securities (STRIP) was introduced in 1985 to meet this need.



A) depreciates, bond investors lose, all else equal.B) appreciates, the bond's coupon increases.C) depreciates, the bond's coupon payments will turn into more U.S. dollars.

A) Put provision.B) Call provision.C) Prepayment option.

A) Treasury calls.B) Strip-Ts.C) Pass-throughs.



As compared to an equivalent nonputable bond, a putable bond’s yield should be:

Your answer: A was incorrect. The correct answer was B) lower.

A putable bond favors the buyer (investor). Hence, a premium will be paid for the option, which means the yield will be lower.



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?


zero-coupon bonds, straight coupon bonds, callable bonds, mortgage-backed securities.

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



Which of the following statements about how the features of a bond impact interest rate risk is TRUE?

A) the same.B) lower.C) higher.

A) zero-coupon bonds, mortgage-backed securities, straight coupon bonds, callable bonds. B) callable bonds, straight coupon bonds, zero-coupon bonds, mortgage-backed securities. C) zero-coupon bonds, straight coupon bonds, callable bonds, mortgage-backed securities.

A) Zero-coupon bonds have the highest price volatility.

B) 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 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. 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.



In the context of bonds, accrued interest:


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 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."



A mortgage-backed security has the following characteristics:

� It was created by pooling a collection of more than a thousand mortgages � Not all investors face the same prepayment risk � Investors receive three distinct kinds of cash flows � Freddie Mac issued the security

This security is a(n):


While most mortgage-backed securities pay three types of cash flows, only mortgage passthroughs and collateralized mortgage obligations (CMOs) are formed by pooling mortgages. Only CMOs divide investors into

C) Market yields are the most important determinant of bond price volatility.

A) is discounted along with other cash flows to arrive at the dirty, or full price. B) equals interest earned from the previous coupon to the sale date. C) covers the part of the next coupon payment not earned by seller.

A) collateralized mortgage obligation. B) agency debenture. C) mortgage passthrough security.



tranches with different cash flows and risk profiles. Debentures are securities not backed by collateral.



Which of the following is most accurate about a bond with a deferred call provision?

Your answer: A was incorrect. The correct answer was C) It could not be called right after the date of issue.

A deferred call provision means the issue is initially (say, for the first 5 to 7 years) non-callable, after which time it becomes freely callable. In other words, there is a deferment period during which time the bond cannot be called, but after that, it becomes freely callable.



There are several types of external credit enhancements. All of the following are examples of external credit enhancements EXCEPT:


setting aside reserve funds.

Setting aside reserve funds is an example of internal, not external credit enhancement.



On November 15, 2006, Grinell Construction Company decided to issue bonds to help finance the acquisition of new construction equipment. They issued bonds totaling $10,000,000 with a 6% coupon rate due June 15, 2026. Grinell has agreed to pay the entire amount borrowed in one lump sum payment at the maturity date. Grinell is not required to make any principal payments prior to maturity. What type of bond structure has Grinell issued?

Your answer: A was incorrect. The correct answer was C) Bullet maturity.

A) It could be called at any time during the initial call period, but not later.B) Principal repayment can be deferred until it reaches maturity.C) It could not be called right after the date of issue.

A) letters of credit. B) corporate guarantees. C) setting aside reserve funds.

A) Serial bonds.B) Income bonds.C) Bullet maturity.



These bonds have a bullet maturity structure because the issuer has agreed to pay the entire amount borrowed in one lump-sum payment at maturity.



The issuance of asset backed securities (ABSs) versus straight debt would be desirable if:

Your answer: A was incorrect. The correct answer was B) a better credit quality is desired on the asset backed versus the corporation.

If there are time constraints, straight debt would be easier to issue. Also, if the corporation could be upgraded, it would benefit in straight debt but not its ABSs.



An option-free bond has a market price and par value equal to $1,000. For small changes in the yield of this bond, its price will change one dollar for every basis point change in the yield. What is the duration of the bond?


10.

A dollar change in price for this bond is a 0.01% change in its quoted price.

Duration = [100.1 − (99.9)] / [2 × (100) × (0.0001)] = 10.



If a prepayment of principal is for an amount that is less than the full outstanding balance of the loan, it is know as a(n):


A) there are time constraints on the deal.B) a better credit quality is desired on the asset backed versus the corporation.C) the corporation's credit rating may go up in the future.

A) 1. B) 5. C) 10.

A) participation. B) intermediate payment. C) curtailment.



curtailment.

If a prepayment of principal is for an amount that is less than the full outstanding balance of the loan, it is know as a curtailment.



Which of the following statements about fixed income securities is least accurate?


Coupon or interest income is exempt from federal income taxes. Capital gains taxes associated with municipal bonds are not exempt from federal taxes.



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% on January 1, which of the following is the semi-annual coupon payment received by the holder of the issue in that year?


This value is computed as follows:

Semi-annual coupon = (LIBOR + 125 basis points) / 2 = 3.875%



Suppose that IBM has a $1,000 par value bond outstanding with a 12% semiannual coupon that is currently trading at 102.25 with seven years to maturity. Which of the following is closest to the yield to maturity (YTM) on the bond?

A) Coupon interest and capital gains from municipal bonds are tax exempt at the federal level.B) The main innovation of CMO is that they offer stable maturities to investors.C) The corporate bond sector is more important in the US than in Japan and Germany.

A) 3.875%.B) 3.250%.C) 7.750%.

A) 11.21%.B) 11.52%.C) 11.91%.



Your answer: A was incorrect. The correct answer was B) 11.52%.

To find the YTM, enter PV = –$1,022.50; PMT = $60; N = 14; FV = $1,000; CPT → I/Y = 5.76%. Now multiply by 2 for the semiannual coupon payments: (5.76)(2) = 11.52%.



A 6% semi-annual pay bond, priced at $860 has 10 years to maturity. Find the yield to maturity and determine if the price of this bond will be lower or higher than a zero coupon bond.

YTM Compared to zero coupon bond


N = 2 × 10 = 20; PV = -$860.00; PMT = $30; FV = $1,000. Compute I/Y = 4.033 × 2 = 8.07%.

The price of this bond will most likely be higher than a zero coupon bond because this bond pays coupons to the holder.



Which of the following statements is most accurate concerning the differences between modified convexity and effective convexity?


Effective convexity is most appropriate for bonds with embedded options because it takes into account changes in cash flows due to changes in yield, while modified convexity does not. For an option-free bond, modified convexity and effective convexity should be very nearly equal.



If a 15-year, $1,000 U.S. zero-coupon bond is priced to yield 10%, what is its market price?

A) 8.07% lower priceB) 4.03% higher priceC) 8.07% higher price

8.07% higher price

A) Effective convexity is most appropriate for bonds with embedded options.

B) Modified convexity takes into account changes in cash flows due to embedded options, while effective convexity does not.

C) For an option-free bond, modified convexity is slightly greater than effective convexity.



Your answer: A was incorrect. The correct answer was B) $231.38.

N = 30; I/Y = 5; PMT = 0; FV = 1,000; CPT → PV = 231.38.



A discount bond (nothing changes except the passage of time):

Your answer: A was incorrect. The correct answer was B) rises in value as time passes.

A discount bond sells at less than face value, therefore as time passes the bond value will converge upon the face value.



A 20-year, 10% semi-annual coupon bond selling for $925 has a promised yield to maturity (YTM) of:


N = 40, PMT = 50, PV = -925, FV = 1,000, CPT I/Y.



A bond’s duration is 4.5 and its convexity is 43.6. If interest rates rise 100 basis points, the bond’s percentage price change is closest to:


A) $23.50.B) $231.38.C) $239.39.

A) falls in value as time passes.B) rises in value as time passes.C) price is not related to time passing.

A) 10.93%.B) 11.23%.C) 9.23%.

A) -4.50%. B) -4.94%. C) -4.06%.



-4.06%.

Recall that the percentage change in prices = Duration effect + Convexity effect = [-duration × (change in yields)] + [convexity × (change in yields)2] = (-4.5)(0.01) + (43.6)(0.01)2 = -4.06%. Remember that you must use the decimal representation of the change in interest rates when computing the duration and convexity adjustments.



In capital markets, stock dividends and bond coupons generally provide what is referred to as:

Your answer: A was incorrect. The correct answer was B) current yield.

Current yield is based on actual cash received during the investment horizon and is typically composed of dividends and interest.



Which of the following statements about portfolio duration is FALSE? It is:

Your answer: A was incorrect. The correct answer was B) a simple average of the duration estimates of the securities in the portfolio.

Portfolio duration uses a weighted average figure, not a simple average.

This question tested from Session 16, Reading 66, LOS f, (Part 1).


Which of the following bonds may have negative convexity?


Both of these choices are correct.

A) internal yield. B) current yield.C) capital gain yield.

A) a measure of interest rate risk.B) a simple average of the duration estimates of the securities in the portfolio.C) the weighted average of the duration estimates of the securities in the portfolio.

A) Mortgage backed securities. B) Callable bonds. C) Both of these choices are correct.



Negative convexity is the idea that as interest rates decrease they get to a certain point where the value of certain bonds (bonds with negative convexity) will start to increase in value at a decreasing rate.

Interest rate risk is the risk of having to reinvest at rates that are lower than what an investor is currently receiving.

Mortgage backed securities (MBS) may have negative convexity because when interest rates fall mortgage owners will refinance for lower rates, thus prepaying the outstanding principle and increasing the interest rate risk that investors of MBS may incur.

Callable bonds are similar to MBS because of the possibility that the principle is being returned to the investor sooner than expected if the bond is called causing a higher level of interest rate risk.



When a bond's coupon rate is greater than its current yield, and its current yield is greater than its yield to maturity, the bond is a:

Your answer: A was incorrect. The correct answer was C) premium bond.

For a premium bond, coupon rate > current yield > yield to maturity. For a par bond, coupon rate = current yield = yield to maturity. For a discount bond, coupon rate < current yield < yield to maturity.



Find the yield to maturity of a 6% coupon bond, priced at $1,115.00. The bond has 10 years to maturity and pays semi-annual coupon payments.


N = 10 × 2 = 20; PV = -1,115.00; PMT = 60/2 = 30; FV = 1,000.

Compute I = 2.28 (semiannual) × 2 = 4.56%



A) discount bond.B) par value bond.C) premium bond.

A) 8.07%.B) 4.56%.C) 5.87%.



A $1,000 bond with an annual coupon rate of 10% has 10 years to maturity and is currently priced at $800. What is the bond's approximate yield-to-maturity?


13.8%.

FV = 1,000, PMT = 100, N = 10, PV = -800

Compute I = 13.8



Using the following spot rates, what is the price of a three-year bond with annual coupon payments of 5%?

� One-year rate: 4.78% � Two-year rate: 5.56% � Three-year rate: 5.98%

Your answer: A was incorrect. The correct answer was C) $97.47.

The bond price is computed as follows:

Bond price = (5 / 1.0478) + (5 / 1.05562) + (105 / 1.05983) = $97.47



When computing the yield to maturity, the implicit reinvestment assumption is that the interest payments are reinvested at the:


yield to maturity at the time of the investment.

The reinvestment assumption states that reinvestment must occur at the YTM in order for an investor to earn the

A) 12.6%. B) 13.8%. C) 11.7%.

A) $98.87.B) $93.27.C) $97.47.

A) prevailing yield to maturity at the time interest payments are received. B) yield to maturity at the time of the investment. C) coupon rate.



YTM. The assumption also states that payments are received in a prompt and timely fashion resulting in immediate reinvestment of those funds.



When compared to modified duration, effective duration:


factors in how embedded options will change expected cash flows.

The point of effective duration is to consider expected changes in cash flow from features such as embedded options.



Given the following Treasury data, what is the 1-year spot rate?


The bond with 6 months left to maturity has a semiannual discount rate of 0.01/2 = 0.005 therefore the 1-year spot rate can be found by solving the following equation:

0.75/1.005 + 100.75/(1 + S1.0/2)2 = 100

Solving for S1.0/2: 100.75/(1 + S1.0/2)2 = 100 - 0.75/1.005

100.75/(1 + S1.0/2)2 = 99.2537

100.75 / 99.25370.5 = (1 + S1.0/2)2

(100.75 / 99.254).5 – 1 = S1.0/2

A) is equal to modified duration for callable bonds but not putable bonds. B) factors in how embedded options will change expected cash flows. C) places less weight on recent changes in the bond's ratings.

Maturity YTM Coupon Price

6 months 1.0% 1.0% 100

1 year 1.5% 1.5% 100

18 months 2.5% 2.5% 100

A) 1.50%.B) 1.13%.C) 1.51%.



0.007509 = S1.0/2

2 × 0.007509= S1.0

S1.0 = 0.01502 or 1.5%



Calculate the effective duration for a 7-year 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


6.8.

The formula for calculating the effective duration of a bond is:

where:

� V- = bond value if the yield decreases by ∆y

� V+ = bond value if the yield increases by ∆y � V0 = initial bond price � ∆y = yield change used to get V- and V+, expressed in decimal form

The duration of this bond is calculated as:

This question tested from Session 16, Reading 66, LOS d, (Part 1).


Jayce Arnold, a CFA candidate, is studying how the market yield environment affects bond prices. She considers a $1,000 face value, option-free bond issued at par. Which of the following statements about the bond’s dollar price behavior is most likely accurate when yields rise and fall by 200 basis points, respectively? Price will:

A) 3.1. B) 6.5. C) 6.8.

A) decrease by $124, price will increase by $149.




As yields increase, bond prices fall, the price curve gets flatter, and changes in yield have a smaller effect on bond prices. As yields decrease, bond prices rise, the price curve gets steeper, and changes in yield have a larger effect on bond prices. Thus, the price increase when interest rates decline must be greater than the price decrease when interest rates rise (for the same basis point change). Remember that this applies to percentage changes as well.



Current spot rates are as follows:

1-Year: 6.5% 2-Year: 7.0% 3-Year: 9.2%

Which of the following is TRUE?


Spot interest rates can be used to price coupon bonds by taking each individual cash flow and discounting it at the appropriate spot rate for that year’s payment. Note that the yield to maturity is the bond’s internal rate of return that equates all cash flows to the bond’s price. Current spot rates have nothing to do with the bond’s yield to maturity.



Which of the following statements on spreads is FALSE?

Your answer: A was incorrect. The correct answer was C) The Z-spread may be used for bonds that contain call options.

The Z-spread is used for risky bonds that do NOT contain call options in an attempt to improve on the

B) increase by $149, price will decrease by $124. C) decrease by $149, price will increase by $124.

A)For a 3-year annual pay coupon bond, the first coupon can be discounted at 6.5%, the second coupon can be discounted at 7.0%, and the third coupon plus maturity value can be discounted at 9.2% to find the bond's arbitrage-free value.

B) For a 3-year annual pay coupon bond, all cash flows can be discounted at 9.2% to find the bond's arbitrage-free value.

C) The yield to maturity for 3-year annual pay coupon bond can be found by taking the geometric average of the 3 spot rates.

A) The Z-spread will equal the nominal spread if the term structure of interest rates is flat. B) The option-adjusted spread (OAS) is the difference between the Z-spread and the option cost. C) The Z-spread may be used for bonds that contain call options.



shortcomings of the nominal spread. The other statements are correct.



A bond is issued with the following data:

� $10 million face value. � 9% coupon rate. � 8% market rate. � 3-year bond with semiannual payments.

What is the present value of the bond?

Your answer: A was incorrect. The correct answer was C) $10,262,107.

FV = 10,000,000; PMT = 450,000; I/Y = 4; N = 6; CPT → PV = -10,262,107



A non-callable bond with 18 years remaining maturity has an annual coupon of 7% and a $1,000 par value. The current yield to maturity on the bond is 8%. Which of the following is closest to the effective duration of the bond?


First, compute the current price of the bond as:

FV = $1,000; PMT = $70; N = 18; I/Y = 8%; CPT → PV = –$906.28

Next, change the yield by plus-or-minus the same amount. The amount of the change can be any value you like. Here we will use ±50 basis points.

Compute the price of the bond if rates rise by 50 basis points to 8.5% as:

FV = $1,000; PMT = $70; N = 18; I/Y = 8.5%; CPT → PV = –$864.17

Then compute the price of the bond if rates fall by 50 basis points to 7.5% as:

FV = $1,000; PMT = $70; N = 18; I/Y = 7.5%; CPT → PV = –$951.47

A) $10,138,754.B) $10,000,000.C) $10,262,107.

A) 9.63.B) 8.24.C) 11.89.



The formula for effective duration is:

(V- – V+) / (2V0∆y)

Therefore, effective duration is:

($951.47 – $864.17) / (2 × $906.28 × 0.005) = 9.63.



What is the value of a zero-coupon bond if the term structure of interest rates is flat at 6% and the bond has two years remaining to maturity?



Zero-Coupon Bond Price = 100/1.034 = 88.85.

The value 83.75 is incorrect because the principal is discounted over a three-year period but the bond has only two years remaining to maturity. The value 100.00 is incorrect because the principal received at maturity has to be discounted over a period of two years.



A 6-year annual interest coupon bond was purchased one year ago. The coupon rate is 10% and par value is $1,000. At the time the bond was bought, the yield to maturity (YTM) was 8%. If the bond is sold after receiving the first interest payment and the bond's yield to maturity had changed to 7%, the annual total rate of return on holding the bond for that year would have been:


Price 1 year ago N = 6, PMT = 100, FV = 1,000, I = 8, Compute PV = 1,092

Price now N = 5, PMT = 100, FV = 1,000, I = 7, Compute PV = 1,123

% Return = (1,123.00 + 100 − 1,092.46)/1,092.46 x 100 = 11.95%


A) 88.85.B) 83.75.C) 100.00.

A) 7.00%.B) 11.95%.C) 8.00%.




A non-callable bond with 4 years remaining maturity has an annual coupon of 12% and a $1,000 par value. The current price of the bond is $1,063.40. Given a change in yield of 50 basis points, which of the following is closest to the effective duration of the bond?


First, find the current yield to maturity of the bond as:

FV = $1,000; PMT = $120; N = 4; PV = –$1,063.40; CPT → I/Y = 10%

Then compute the price of the bond if rates rise by 50 basis points to 10.5% as:

FV = $1,000; PMT = $120; N = 4; I/Y = 10.5%; CPT → PV = –$1,047.04

Then compute the price of the bond if rates fall by 50 basis points to 9.5% as:

FV = $1,000; PMT = $120; N = 4; I/Y = 9.5%; CPT → PV = –$1,080.11

The formula for effective duration is:

(V-–V+) / (2V0∆y)

Therefore, effective duration is:

($1,080.11 – $1,047.04) / (2 × $1,063.40 × 0.005) = 3.11



Assume an option-free 5% coupon bond with annual coupon payments has two years remaining to maturity. A putable bond that is the same in every respect as the option-free bond is priced at 101.76. With the term structure flat at 6% what is the value of the embedded put option?


The value of the embedded put option of the putable bond is the difference between the price of the putable bond and the price of the option-free bond.

The value of the option-free bond is computed as follows: PMT = 5; N = 2; FV = 100; I = 6; CPT → PV = -98.17(ignore sign).

A) 2.94.B) 3.11.C) 3.27.

A) 3.59.B) 1.76.C) -3.59.



The option value = 101.79 − 98.17 = 3.59.



Given the implied forward rates of: R1 = 0.04; 1r1 = 0.04300; 1r2 = 0.05098; 1r3 = 0.051005, what is the theoretical 4-period spot rate?


[(1.04)(1.043)(1.05098)(1.051005)].25−1

This question tested from Session 16, Reading 65, LOS h, (Part 1).


A bond with an 8% semi-annual coupon and 10-year maturity is currently priced at $904.52 to yield 9.5%. If the yield declines to 9%, the bond’s price will increase to $934.96, and if the yield increases to 10%, the bond’s price will decrease to $875.38. Estimate the percentage price change for a 100 basis point change in rates.


The formula for the percentage price change is: (price when yields fall – price when yields rise) / 2 × (initial price) × 0.005 = ($934.96 – 875.38) / 2($904.52)(0.005) = $59.58 / $9.05 = 6.58%. Note that this formula is also referred to as the bond’s effective duration.



Janice Brown, is a fixed income portfolio manager for a large investment house. On January 1, 2005, 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 C

A) 6.67%.B) 2.33%.C) 4.62%.

A) 6.58%.B) 4.35%.C) 2.13%.

Description Coupon (SA) Price Callable Call Price



Brown 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

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.

Part 1) Brown wonders how the interest rate sensitivity of the coupon-paying ABC bond in Table 1 differs from the interest rate sensitivity of an otherwise equivalent zero-coupon bond. Which of the following is correct? The interest rate sensitivity of the coupon-paying ABC bond is:

Your answer: A was incorrect. The correct answer was C) lower.

Since there is only one payoff at maturity for the zero-coupon bond and no interim cash flows, its price will be maximally affected by changing interest rates. The interest rate sensitivity of a bond is measured by its duration. A zero-coupon bond's duration is equal to its time to maturity.






ABC due Jan. 1, 2014 6.00% 107.1767 Noncallable Not applicable

XYZ due Jan. 1, 2014 6.20% 107.1767 Currently Callable 109.00

Description Coupon (SA) Type Callable Fabozzi Convexity

ABC due Jan. 1, 2014 LIBOR Floating Rate Noncallable 0.475907198

ABC due Jan. 1, 2014 12% -LIBOR Inverse Floating Rate Noncallable 111.1977205

A) higher.B) higher or lower.C) lower.








Part 2) Brown is now considering the effects of convexity in isolation. Of all the bonds in Tables 1 and 2, Brown wonders which would be the most likely to have the best convexity properties with respect to investing. Which of the following bonds has the most desirable convexity properties?

Your answer: A was incorrect. The correct answer was C) IF.

The IF will have the highest convexity of all the bonds. The higher the convexity the better for the investor.











A) FRN.B) Fixed coupon ABC bond.C) IF.









Part 3) Brown now begins analyzing the FRN in Table 2. Specifically, she would like to price the FRN immediately following a coupon payment. Which of the following is the closest to Brown's answer?


At a coupon reset date, the floating rate bond is always equal to its par value since the coupon yield is the same as the discount rate used to price the bond. So the two rates cancel each other.



The yield to call is a less conservative yield measure than the yield to maturity whenever the price of a callable bond is quoted at a value:


The more conservative yield measure is the one that results in a lower yield. The YTM on a discount bond will always be less than its yield to call.



June Klein, CFA, manages a $200 million (market value) U.S. government bond portfolio for a large institution. Klein anticipates a small, parallel shift in the yield curve of 10 basis points and wants to fully hedge the portfolio against any such change. Klein would like to use the T-bond futures contract to implement the hedge. She tabulates some essential information about her portfolio and the corresponding futures contract. The results are shown in Table 1.

Table 1: Portfolio and Treasury Bond Futures Contract Characteristics

Klein is not as comfortable with the T-bond futures contract as she would like to be. Consequently, she decides to familiarize herself with the characteristics of the futures contract and its associated delivery process. She collects all of the deliverable bonds for the futures contract. This information is shown in Table 2. Klein will test her

A) 107.18.B) 100.00.C) 97.56.

A) equal to par value less one year's interest.B) equal to or greater than par value plus one year's interst.C) more than par.

Value of Portfolio: $100,000,000

Duration of Portfolio: 8.88438

Mar-00 Futures: 94.15625

Settlement Date: 02/17/00

Final Delivery Date: 03/31/00

First Delivery Date: 03/01/00



understanding using the highlighted bond in Table 2. The price value of a basis point (PVBP) are per $1 million par value.

Table 2: Treasury Bonds Deliverable for T-Bond Futures Contract

Klein's broker supplies the characteristics of the Treasury bond that is currently the cheapest-to-deliver bond. These are shown in Table 3.

Table 3: Cheapest-to-Deliver Treasury Bond

Part 1) Klein wants to compute the interest rate sensitivity of the highlighted bond in Table 2. She assumes that the yield increases by one basis point. How much, per $1 million par position, will the value of this bond change (to the nearest dollar)?

Your answer: A was incorrect. The correct answer was B) -$1,211.

This is the price value of a basis point (PVBP) per one million dollar par as shown in Table 2.




Klein is not as comfortable with the T-bond futures contract as she would like to be. Consequently, she decides to familiarize herself with the characteristics of the futures contract and its associated delivery process. She collects

CouponMaturity or first

call date

Price (flat)

Accrued interest YTM/YTC

PVBP $ per million

parDuration Conversion

factorCost of delivery

10.000% 11/15/15 133 24/32 2.5824 6.534% 1211.2284 1.1759 23.0331


call date

Price (flat)


PVBP $ per

million parDuration Conversion


13.250% 11/15/17 135.4375 3.4217 9.166% 1110.0814 7.99429 1.4899 -4.8502

A) -$12.B) -$1,211.C) -$121,123.









all of the deliverable bonds for the futures contract. This information is shown in Table 2. Klein will test her understanding using the highlighted bond in Table 2. The price value of a basis point (PVBP) are per $1 million par value.




Part 2) Using the information in Table 2, Klein would like to compute the duration of the highlighted bond. Which is the closest to Klein's answer?

Your answer: A was incorrect. The correct answer was C) 8.88.

PVBP = (0.0001) × D × (price + accrued interest) × 10,000 Note: The 10,000 is to convert the price to $1,000,000 par to match the PVBP units. Rearranging, D = PVBP ÷ (price + interest) = 1,211.2284 ÷ (133.75 + 2.5824) = 8.88





call date

Price (flat)


PVBP $ per million



10.000% 11/15/15 133 24/32 2.5824 6.534% 1211.2284 1.1759 23.0331


call date

Price (flat)


PVBP $ per



13.250% 11/15/17 135.4375 3.4217 9.166% 1110.0814 7.99429 1.4899 -4.8502

A) 12.11.B) 9.06.C) 8.88.









Klein is not as comfortable with the T-bond futures contract as she would like to be. Consequently, she decides to familiarize herself with the characteristics of the futures contract and its associated delivery process. She collects all of the deliverable bonds for the futures contract. This information is shown in Table 2. Klein will test her understanding using the highlighted bond in Table 2. The price value of a basis point (PVBP) are per $1 million par value.




Part 3) Klein would like to quantify the approximate value loss of her portfolio from an increase in yields according to her expectations. Using the information in Table 1 which of the following is the closest to Klein's answer?

Your answer: A was incorrect. The correct answer was B) -$888,438.

Change in portfolio value = -0.001 × duration × portfolio value. Change in portfolio value = -0.001 × 8.88438 × $100,000,000 = −$888,438.



Suppose that the six-month spot rate is equal to 7% and the two-year spot rate is 6%. Which of the following is the best answer concerning the level of the one-and a half-year forward rate starting six months from now? The forward rate has to:


The following relationship has to hold:


call date

Price (flat)


PVBP $ per million



10.000% 11/15/15 133 24/32 2.5824 6.534% 1211.2284 1.1759 23.0331


call date

Price (flat)


PVBP $ per



13.250% 11/15/17 135.4375 3.4217 9.166% 1110.0814 7.99429 1.4899 -4.8502

A) -$8,884.B) -$888,438.C) -$1,211,228.

A) be less than 6%.B) lie between 6% and 7%.C) be more than 6%.



(1 + spot rate0,0.5/2)1 * (1 + forward rate0.5,2/2)3 = (1 + spot rate0,2/2)4. For this relationship to hold the forward rate has to be less than 6%.

This question tested from Session 16, Reading 65, LOS h, (Part 1).


A bond with a semi-annually coupon rate of 3% sells for $850. It has a modified duration of 10 and is priced at a yield to maturity (YTM) of 8.5%. If the YTM increases to 9.5%, the predicted change in price, using the duration concept decreases by:


Approximate percentage price change of a bond = (-)(duration)(∆y)

∆y = 9.5% − 8.5% = 1%

(-10)(1%) = -10%

($850)(-0.1) = -$85



An analyst has obtained the following Treasury data for bonds currently trading at their par values:

Using the method of bootstrapping, which of the following is closest to the theoretical Treasury spot rate curve?

6-month spot rate 1-year spot rate 18-month spot rate


The bond with six months left to maturity has a semiannual discount rate of 0.03/2 = 0.015 or 3.0% on an annual bond equivalent yield (BEY) basis. Since the bond will only make a single payment of 101.50 in six months, the YTM is the spot rate for cash flows to be received six months from now.

A) $85.00.B) $77.56.C) $79.92.

Maturity Coupon Price

6 months 3.0% 100

1 year 4.0% 100

18 months 5.0% 100

A) 3.0% 4.0101% 5.1333%B) 3.0% 4.0101% 5.0339%C) 1.5% 4.2501% 5.0339%

3.0% 4.0101% 5.0339%



The one-year bond will make two payments, one in six months of 2 and one in one year of 102. We can solve for the one-year spot rate in the equation:

where S1.0 is the annualized 1-year spot rate.

Solving we get: S1.0 = 4.01005%.

Using the 6-month and 1-year spot rates, we can use the same approach to find the 18-month spot rate from the equation:

where S1.0 is the annualized 18-month spot rate.

Solving we get: S1.5 = 5.0338823%.



You are considering the purchase of a three-year annual coupon bond with a par value of $1,000 and a coupon rate of 5.5%. You have determined that the spot rate for year 1 is 5.2%, the spot rate for year two is 5.5%, and the spot rate for year three is 5.7%. What would you be willing to pay for the bond now?


You need the find the present value of each cash flow using the spot rate that coincides with each cash flow. The present value of cash flow 1 is: FV = $55; PMT = 0; I/Y = 5.2%; N = 1; CPT → PV = -$52.28. The present value of cash flow 2 is: FV = $55; PMT = 0; I/Y = 5.5%; N = 2; CPT → PV = –$49.42. The present value of cash flow 3 is: FV = $1,055; PMT = 0; I/Y = 5.7%; N = 3; CPT → PV = –$893.36. The most you pay for the bond is the sum of: $52.28 + $49.42 + $893.36 = $995.06.



Can spot interest rates be used to value a callable bond?

A) $937.66.B) $995.06.C) $1,000.00.

A) No. B) It depends on the slope of the term structure. C) Yes.




Yes.

Any complex debt instruments (like callable bonds, putable bonds, and mortgage-backed securities) can be viewed as the sum of the present value of its individual cash flows where each of those cash flows are discounted at the appropriate zero-coupon bond spot rate. It should be noted that while the appropriate spot interest rate can be used to discount each cash flow, determining the actual pattern of cash flows is uncertain due to the possibility of the bond being called away.



A bond has a convexity of 25.72. What is the approximate percentage price change of the bond due to convexity if rates rise by 150 basis points?


The convexity effect, or the percentage price change due to convexity, formula is: convexity × (∆y)2. The percentage price change due to convexity is then: (25.72)(0.015)2 = 0.0058.



Which of the following statements concerning the arbitrage-free valuation of non-Treasury securities is TRUE? The credit spread is:


a function of default risk and the term to maturity.

For valuing non-Treasury securities, a credit spread is added to each treasury spot yields. The credit spread is a function of default risk and the term to maturity.


Question 100 - #95864

One major difference between standard convexity and effective convexity is:

A) 0.71%.B) 0.58%.C) 0.26%.

A) only a function of the bond's term to maturity. B) a function of default risk and the term to maturity. C) only a function of the bond's default risk.




effective convexity reflects any change in estimated cash flows due to embedded bond options.

The calculation of effective convexity requires an adjustment in the estimated bond values to reflect any change in estimated cash flows due to the presence of embedded options. Note that this is the same process used to calculate effective duration.


Question 101 - #96066

In which of the following conditions is the bond selling at a premium? The coupon rate:

Your answer: A was incorrect. The correct answer was C) is greater than current yield, which is greater than yield-to-maturity.

When a bond is selling at a premium the nominal yield, coupon payment divided by face value, will be greater than current yield and current yield will be greater than YTM.


Question 102 - #95821

Consider the following two statements about putable bonds:

Statement #1: As yields fall, the price of putable bonds will rise less quickly than similar option-free bonds (beyond a critical point) due to the decrease in value of the embedded put option.

Statement #2: As yields rise, the price of putable bonds will fall more quickly than similar option-free bonds (beyond a critical point) due to the increase in value of the embedded put option.

You should:

Your answer: A was incorrect. The correct answer was C) disagree with both statements.

Both statements are false. As yields fall, the value of the embedded put option in a putable bond decreases and (beyond a critical point) the putable bond behaves much the same as an option-free bond. As yields rise, the value of the embedded put option increases and (beyond a critical point) the putable bond decreases in value less

A) effective convexity is Macaulay's duration divided by [1 + yield/2]. B) effective convexity reflects any change in estimated cash flows due to embedded bond options. C) standard convexity reflects any change in estimated cash flows due to embedded options.

A) current rate and yield-to-maturity are all the same.B) is less than current yield, which is less than yield-to-maturity.C) is greater than current yield, which is greater than yield-to-maturity.

A) agree with both statements.B) agree with only one statement.C) disagree with both statements.



quickly than a similar option-free bond.

This question tested from Session 16, Reading 66, LOS b.

Question 103 - #96136

Randy Harris is contemplating whether to add a bond to his portfolio. It is a semiannual, 6.5% bond with 7 years to maturity. He is concerned about the change in value due to interest rate fluctuations and would like to know the bond’s value given various scenarios. At a yield to maturity of 7.5% or 5.0%, the bond’s fair value is closest to:


Given a YTM of 7.5%, calculate the value of the bond as follows: N = 14; I/Y = 7.5/2 = 3.75%; PMT = 32.50; FV = 1,000; CPT → PV = 946.30

Given a YTM of 5.0%, calculate the value of the bond as follows: N = 14; I/Y = 5/2 = 2.5%; PMT = 32.50; FV = 1,000; CPT → PV = 1,087.68


Question 104 - #96086

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


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 105 - #96048

What is the bond-equivalent yield given if the monthly yield is equal to 0.7%?

7.5% 5.0%

A) 974.03 1,052.36B) 1,032.67 959.43C) 946.30 1,087.68

946.30 1,087.68

A) $413.32. B) $250.00 C) $419.85.

A) 8.65%.




The bond equivalent yield (BEY) is computed as follows:

BEY = 2 × [(1 + monthly yield)6 − 1] = 2 × [(1 + 0.007)6 − 1] = 8.55%


Question 106 - #96101

What is the present value of a 7% semiannual-pay bond with a $1,000 face value and 20 years to maturity if similar bonds are now yielding 8.25%?


N = 20 × 2 = 40; I/Y = 8.25/2 = 4.125; PMT = 70/2 = 35; and FV = 1,000.

Compute PV = 878.56.


Question 107 - #95887

A zero coupon bond with a face value of $1,000 has a price of $148. It matures in 20 years. Assuming annual compounding periods, the yield to maturity of the bond is:


PV = -148; N = 20; FV = 1,000; PMT = 0; CPT → I = 10.02.


Question 108 - #95938

An 11% coupon bond with annual payments and 10 years to maturity is callable in 3 years at a call price of $1,100. If the bond is selling today for 975, the yield to call is:

B) 8.40%.C) 8.55%.

A) $879.52.B) $878.56.C) $1,000.00.

A) 10.02%.B) 9.68%.C) 14.80%.

A) 14.97%.




PMT = 110, N = 3, FV = 1,100, PV = 975

Compute I = 14.97


Question 109 - #96112

A 15-year zero coupon bond that has a par value of $1,000 and a required return of 8% would be priced at what value assuming annual compounding periods:

Your answer: A was incorrect. The correct answer was B) $315.

N = 15 FV = 1,000 I = 8 PMT = 0 PV = ? PV = 315.24


Question 110 - #95933

An investor has the following options available to them:

� They can buy a 10% semi annual coupon, 10-year bond for $1,000. � The coupons can be reinvested at 12%. � They estimate the bond will be sold in 3 years $1,050.

Based on this information, what would be the average annual rate of return over the 3 years?


1. Find the FV of the coupons and interest on interest:

N = 3(2) = 6; I = 12/2 = 6; PMT = 50; CPT → FV = 348.77

B) 9.25%. C) 10.26%.

A) $464.B) $315.C) $308.

A) 11.5%.B) 13.5%.C) 9.5%.



2. Determine the value of the bond at the end of 3 years:

1,050.00 (given) + 348.77 (computed in step 1) = 1,398.77

3. Equate FV (1,398.77) with PV (1,000) over 3 years (N = 6); CPT → I = 5.75(2) = 11.5%


Question 111 - #95694

A non-callable bond has an effective duration of 7.26. Which of the following is the closest to the approximate price change of the bond with a 25 basis point increase in rates using duration?

Your answer: A was incorrect. The correct answer was B) -1.820%.

The formula for the percentage price change is: –(duration)(∆y). Therefore, the estimated percentage price change using duration is: –(7.26)(0.25%) = –1.82%.


Question 112 - #95867

A 12% coupon bond with semiannual payments is callable in 5 years. The call price is $1,120. If the bond is selling today for $1,110, what is the yield-to-call?


PMT = 60; N = 10; FV = 1,120; PV = 1,110; CPT → I = 5.47546

(5.47546)(2) = 10.95


Question 113 - #96030

Assume that a callable bond's call period starts two years from now with a call price of $102.50. Also assume that the bond pays an annual coupon of 6% and the term structure is flat at 5.5%. Which of the following is the price of the bond assuming that it is called on the first call date?

A) -0.018%.B) -1.820%.C) 1.820%.

A) 11.25%.B) 10.25%.C) 10.95%.

A) $100.00.B) $103.17.C) $102.50.





Bond price = 6/1.055 + (102.50 + 6)/1.0552 = $103.17


Question 114 - #96120

Today an investor purchases a $1,000 face value, 10%, 20-year, semi-annual bond at a discount for $900. He wants to sell the bond in 6 years when he estimates the yields will be 9%. What is the estimate of the future price?

Your answer: A was incorrect. The correct answer was C) $1,079.

In 6 years, there will be 14 years (20 − 6), or 14 × 2 = 28 semi-annual periods remaining of the bond's life So, N = (20 − 6)(2) = 28; PMT = (1,000 × 0.10) / 2 = 50; I/Y = 9/2 = 4.5; FV = 1,000; CPT → PV = 1,079.

Note: Calculate the PV (we are interested in the PV 6 years from now), not the FV.


Question 115 - #96115

A bond with a 12% coupon, 10 years to maturity and selling at 88 has a yield to maturity of:


PMT = 120; N = 10; PV = -880; FV = 1,000; CPT → I = 14.3


Question 116 - #95741

Which of the following statements about duration is most accurate?

Your answer: A was incorrect. The correct answer was C) Effective duration accounts for changes in a bond’s

A) $1,152.B) $946.C) $1,079.

A) over 14%.B) between 13% and 14%.C) between 10% and 12%.

A) Modified duration is the most appropriate measure of interest rate sensitivity for bonds with embedded options.

B) Effective duration is calculated from past price changes in response to changes in yield.C) Effective duration accounts for changes in a bond’s cash flows resulting from interest rate changes.



cash flows resulting from interest rate changes.

Neither Macaulay nor modified duration is an appropriate measure of interest rate risk for bonds with embedded options. Macaulay duration does not take the current YTM into account as modified duration does. Effective duration, however, explicitly takes into account changes in a bond’s cash flows due to interest rate changes and is calculated from expected price changes in response to a given increase or decrease in yield.


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