Fixed Income Questions

Suppose that the six-month spot rate is equal to 7% and the two-year spot rate is 6%. The one-and a half-year forward rate starting six months from now has to: A)be less than 6%. B)be more than 6%. C)lie between 6% and 7%.

A

Which of the following embedded options in a fixed income security can be exercised by the issuer? A)Call option. B)Conversion option. C)Put option.

A

Which of the following securities is least likely classified as a eurobond? A bond that is denominated in: A)euros and issued in Germany. B)euros and issued in the United States. C)U.S. dollars and issued in Japan.

A

n investor who is calculating the arbitrage-free value of a government security should discount each cash flow using the: A)government spot rate that is specific to its maturity. B)risk-free rate. C)government note yield that is specific to its maturity.

A

An investor wants to take advantage of the 5-year spot rate, currently at a level of 4.0%. Unfortunately, the investor just invested all of his funds in a 2-year bond with a yield of 3.2%. The investor contacts his broker, who tells him that in two years he can purchase a 3-year bond and end up with the same return currently offered on the 5-year bond. What 3-year forward rate beginning two years from now will allow the investor to earn a return equivalent to the 5-year spot rate? A)4.5%. B)3.5%. C)5.6%.

A (1.045 / 1.0322)1/3 - 1 = 4.5%.

A 4 percent Treasury bond has 2.5 years to maturity. Spot rates are as follows: 6 month = 2% 1 year = 2.5% 1.5 year = 3% 2 year = 4% 2.5 year = 6% The note is currently selling for $976. Determine the arbitrage profit, if any, that is possible. A)$19.22. B)$37.63. C)$43.22.

A =20/1.01 + 20/(1+.0125)^2 + 20/(1+.015)^3 +20/(1+.02)^4 +1020/(1+.03)^5 = =$19.22

Which of the following statements with regard to floating rate notes that have caps and floors is most accurate? A)A cap is a disadvantage to the bondholder while a floor is a disadvantage to the issuer. B)A cap is an advantage to the bondholder while a floor is an advantage to the issuer. C)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 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.

TBTF Bank issues credit-linked notes (CLNs) that have 5-year debentures of Ossien Company as their reference asset. If Ossien defaults on its debentures, the CLNs will be redeemed: A)for less than their par value. B)for their par value plus a premium. C)immediately for their par value.

A A credit-linked note (CLN) returns less than the full principal amount at redemption if a credit event on a reference asset has occurred. A CLN returns its full principal at redemption if a credit event on a reference asset has not occurred. In effect the CLN buyer takes on the credit risk of the reference asset.

A renegotiable mortgage has a fixed interest rate that: A)changes to a different fixed rate during its life. B)changes to a variable rate during its life. C)the borrower may change to a variable rate.

A A renegotiable or rollover mortgage has an initial fixed-rate period after which the interest rate changes to another fixed rate. A hybrid mortgage has an initial fixed-rate period after which the interest rate changes to a variable rate. A convertible mortgage may be changed from fixed-rate to variable-rate or from variable-rate to fixed-rate at the borrower's option.

A synthetic collateralized debt obligation (CDO) is backed by a pool of: A)credit default swaps B)leveraged bank loans. C)other CDOs.

A A synthetic CDO is backed by a pool of credit default swaps. Collateralized loan obligations (CLOs) are backed by a pool of leveraged bank loans. CDOs backed by a pool of other CDOs are an example of structured finance CDOs.

Accrued interest on a bond that is sold between coupon dates is: A)paid to the seller. B)split between the buyer and seller. C)paid to the buyer.

A Accrued interest from the most recent coupon payment date to the settlement date is owed to the seller of a bond and is included in the full price.

With respect to auto-loan backed ABS: A)all of them have some sort of credit enhancement. B)some of them have some sort of credit enhancement. C)the underlying loans are collateralized so no credit enhancement is necessary.

A All automobile loan ABS have some sort of credit enhancement to make them attractive to institutional investors.

Neuman Company has bonds outstanding with five years to maturity that trade at a spread of +240 basis points above the five-year government bond yield. Neuman also has five-year bonds outstanding that are identical in all respects except that they are convertible into 30 shares of Neuman common stock. At which of the following spreads are the convertible bonds most likely to trade? A)+210 basis points. B)+270 basis points. C)+330 basis points.

A Because a conversion option is favorable for the bondholder, the convertible bonds should trade at a lower spread than otherwise identical non-convertible bonds.

Bond X is a noncallable corporate bond maturing in ten years. Bond Y is also a corporate bond maturing in ten years, but Bond Y is callable at any time beginning three years from now. Both bonds carry a credit rating of AA. Based on this information: A)Bond Y will have a higher zero-volatility spread than Bond X. B)The option adjusted spread of Bond Y will be greater than its zero-volatility spread. C)The zero-volatility spread of Bond X will be greater than its option-adjusted spread.

A Bond Y will have the higher Z-spread due to the call option embedded in the bond. This option benefits the issuer, and investors will demand a higher yield to compensate for this feature. The option-adjusted spread removes the value of the option from the spread calculation, and would always be less than the Z-spread for a callable bond. Since Bond X is noncallable, the Z-spread and the OAS will be the same.

A repurchase agreement is described as a "reverse repo" if: A)a bond dealer is the lender. B)collateral is delivered to the lender and returned to the borrower. C)the repurchase price is lower than the sale price.

A Bond dealers frequently use repurchase agreements as sources of funding. When a bond dealer enters a repo as the lender instead of the borrower, the agreement is referred to as a reverse repo.

The type mortgage-backed security that is most likely to offer significant call protection is: A)a commercial mortgage-backed security. B)an agency residential mortgage-backed security. C)a non-agency residential mortgage-backed security.

A Commercial MBS typically have some type of call protection (restriction on prepayments), either in the structure of the MBS or at the loan level. Both agency RMBS and non-agency RMBS typically have no restrictions on prepayments and are subject to prepayment risk.

A covenant that requires the issuer not to let the insurance coverage lapse on assets pledged as collateral is an example of a(n): A)affirmative covenant. B)inhibiting covenant. C)negative covenant.

A Covenants are classified as negative or affirmative. Affirmative covenants specify administrative actions a bond issuer is required to take, such as maintaining insurance coverage on assets pledged as collateral. Negative covenants are restrictions on a bond issuer's actions, such as preventing an issuer from selling any assets that have been pledged as collateral or pledging them again as collateral for additional debt.

An investor purchases a 5-year, A-rated, 7.95% coupon, semiannual-pay corporate bond at a yield to maturity of 8.20%. The bond is callable at 102 in three years. The bond's yield to call is closest to: A)8.9%. B)8.3%. C)8.6%.

A First determine the price paid for the bond:> N = 5 × 2 = 10; I/Y = 8.20 / 2 = 4.10; PMT = 7.95 / 2 = 3.975; FV = 100; CPT PV = -98.99 Then use this value and the call price and date to determine the yield to call: N = 3 × 2 = 6; PMT = 7.95 / 2 = 3.975; PV = -98.99; FV = 102; CPT I/Y = 4.4686 × 2 = 8.937%

For a callable bond, the option-adjusted spread (OAS): A)is less than the zero-volatility spread. B)is greater than the zero-volatility spread. C)can be greater than or equal to the zero-volatility spread.

A For a callable bond, the OAS is less than the zero-volatility spread because of the extra yield required to compensate the bondholder for the call option.

Settlement for a government bond trade most likely occurs on the: A)next trading day after the trade. B)second trading day after the trade C)third trading day after the trade.

A Government bond trades typically settle on the next trading day (T + 1) or have cash settlement (settle on the same day).

If the required margin on a floating rate note is greater than the quoted margin, it is most likely that the: A)credit quality of the FRN has decreased. B)reference rate on the FRN has increased. C)bond will be priced above par at the reset date.

A If the required margin is greater than the quoted margin, the credit quality of the bond must have decreased and the bond will be priced below par at the reset date.

he primary motivation for investing in the support tranche of a planned amortization class CMO, compared to investing in another tranche, is that the support tranche offers: A)a higher interest rate. B)more protection against contraction risk. C)more protection against extension risk.

A In a planned amortization class (PAC) CMO, the support tranches have more extension risk and more contraction risk than the PAC tranches. Because of these higher risks, the support tranches offer a higher interest rate than the PAC tranches.

Treasury Inflation Protected Securities, which provide investors with protection against inflation by adjusting the par value and keeping the coupon rate fixed, are best described as: A)capital-indexed bonds. B)indexed-annuity bonds. C)interest-indexed bonds.

A Indexed bonds that adjust the principal value while keeping the coupon rate fixed are best described as capital-indexed bonds. Interest-indexed bonds adjust the coupon rate. Indexed-annuity bonds are fully amortizing with the payments adjusted.

A quoted Libor interest rate is least likely to refer to a specific: A)bank. B)currency. C)maturity.

A Libor rates are averages calculated from a number of different banks' quotes on the interbank money market. Each Libor rate refers to a specific maturity (in a range from overnight to one year) and currency.

Loss severity is most accurately defined as the: A)amount a bondholder will lose if the issuer defaults. B)percentage of a bond's value a bondholder will receive if the issuer defaults. C)probability that a bond issuer will default.

A Loss severity is the money amount or percentage of a bond's value a bondholder will lose if the issuer defaults. The percentage of a bond's value a bondholder will receive if the issuer defaults is the recovery rate.

The interest rate on excess reserves borrowed by one bank from another bank is most accurately described as a(n): A)central bank funds rate. B)interbank lending rate. C)reserve swap rate.

A Required reserves are deposits with a country's central bank. Banks that deposit more than the required amount with the central bank are said to have excess reserves and may lend these to other banks. This lending is said to take place in the central bank funds market and the interest rates on such loans are known as central bank funds rates.

Consider a 10%, 10-year bond sold to yield 8%. One year passes and interest rates remained unchanged (8%). What will have happened to the bond's price during this period? A)It will have decreased. B)It will have increased. C)It will have remained constant.

A The bond is sold at a premium, as time passes the bond's price will move toward par. Thus it will fall. N = 10; FV = 1,000; PMT = 100; I = 8; CPT → PV = 1,134 N = 9; FV = 1,000; PMT = 100; I = 8; CPT → PV = 1,125

A bond has an effective duration of 7.5. If the bond yield changes by 100 basis points, the price of the bond will change by: A)approximately 7.5%. B)exactly 0.75%. C)approximately 0.75%.

A The change in price due to a change in yield is only approximate because the calculation of effective duration does not reflect all of the curvature of the price-yield curve (convexity). It is a linear approximation of a non-linear relation.

An annualized measure of the prepayments experienced by a pool of mortgages is its: A)conditional prepayment rate. B)PSA prepayment benchmark. C)single monthly mortality rate.

A The conditional prepayment rate (CPR) is an annualized measure of a mortgage pool's prepayments. The single monthly mortality rate is the percentage by which prepayments have reduced the month-end principal balance. The PSA prepayment benchmark is a monthly series of CPRs to which a mortgage pool's CPR may be compared.

Which of the following statements about U.S. Treasury Inflation Protection Securities (TIPS) is most accurate? A)The inflation-adjusted principal value cannot be less than par. B)The coupon rate is fixed for the life of the issue. C)Adjustments to principal values are made annually.

A The coupon rate is set at a fixed rate determined via auction. This is called the real rate. The principal that serves as the basis of the coupon payment and the maturity value is adjusted semiannually. Because of the possibility of deflation, the adjusted principal value may be less than par (however, at maturity the Treasury redeems the bonds at the greater of the inflation-adjusted principal and the initial par value).

In contrast with most asset-backed securities (ABS), a collateralized debt obligation (CDO): A)employs a collateral manager. B)has senior and subordinate tranches. C)is issued through a special purpose vehicle.

A The feature that distinguishes a CDO is that it has a collateral manager who buys and sells securities in the collateral pool to generate cash to meet the CDO's obligations.

A $1,000 par, semiannual-pay bond is trading for 89.14, has a coupon rate of 8.75%, and accrued interest of $43.72. The flat price of the bond is: A)$891.40. B)$935.12. C)$847.69.

A The flat price of the bond is the quoted price, 89.14% of par value, which is $891.40.

The margin above or below LIBOR that is used to determine a floating-rate note's coupon payments is most accurately described as its: A)quoted margin. B)required margin. C)discount margin.

A The quoted margin of a floating-rate note is the number of basis points added to or subtracted from the note's reference rate to determine its coupon payments. The required margin or discount margin is the number of basis points above or below the reference rate that would cause the note's price to return to par value at each reset date. Required margin may be different from quoted margin if a note's credit quality has changed since issuance.

For an option-free bond, as the yield to maturity increases, the bond price: A)decreases at a decreasing rate. B)decreases at an increasing rate. C)increases at a decreasing rate.

A The relationship between price and yield for an option-free bond is inverse and convex toward the origin. As the yield increases, the price decreases, but at a decreasing rate.

An investor pays $100,000 for a security that consists of a zero-coupon bond that will pay $90,000 in three months and $11,000 worth of call options on an equity index that expire in three months. This security is most accurately described as a: A)capital protected instrument. B)guarantee certificate. C)participation instrument.

A The security described here is a capital-protected instrument, but it is not a guarantee certificate because the capital protection (promised payment at maturity) is less than the initial cost of the security. It is not a participation instrument because it does not promise payments that are based on the value of the reference instrument.

A yield curve for coupon bonds is composed of yields on bonds with similar: A)issuers. B)maturities. C)coupon rates.

A Yield curves are typically constructed for bonds of the same or similar issuers, such as a government bond yield curve or AA rated corporate bond yield curve.

Which of the following statements regarding zero-coupon bonds and spot interest rates is most accurate? A)A coupon bond can be viewed as a collection of zero-coupon bonds. B)Spot interest rates will never vary across time. C)Price appreciation creates only some of the zero-coupon bond's return.

A Zero-coupon bonds are quite special. Because zero-coupon bonds have no coupons (all of the bond's return comes from price appreciation), investors have no uncertainty about the rate at which coupons will be invested. Spot rates are defined as interest rates used to discount a single cash flow to be received in the future. Any bond 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.

Matrix pricing is used primarily for pricing bonds that: A)differ from their benchmark bond's credit rating. B)have low liquidity. C)differ from their benchmark bond's maturity.

B

The one-year spot rate is 7.00%. One-year forward rates are 8.15% one year from today, 10.30% two years from today, and 12.00% three years from today. The value of a 4-year, 11% annual pay, $1,000 per bond is closest to: A)$984. B)$1,060. C)$1,052.

B

A 10-year spot rate is least likely the: A)appropriate discount rate on the year 10 cash flow for a 20-year bond. B)yield-to-maturity on a 10-year coupon bond. C)yield-to-maturity on a 10-year zero-coupon bond.

B A 10-year spot rate is the yield-to-maturity on a 10-year zero-coupon security, and is the appropriate discount rate for the year 10 cash flow for a 20-year (or any maturity greater than or equal to 10 years) bond. Spot rates are used to value bonds and to ensure that bond prices eliminate any possibility for arbitrage resulting from buying a coupon security, stripping it of its coupons and principal payment, and reselling the strips as separate zero-coupon securities. The yield to maturity on a 10-year bond is the (complex) average of the spot rates for all its cash flows.

Donald McKay, CFA, is analyzing a client's fixed income portfolio. As of the end of the last quarter, the portfolio had a market value of $7,545,000 and a portfolio duration of 6.24. McKay is predicting that the yield for all of the securities in the portfolio will decline by 25 basis points next quarter. If McKay's prediction is accurate, the market value of the portfolio: A)at the end of the next quarter will be approximately $7,427,300. B)will increase by approximately $117,700. C)will increase by approximately 6.24%.

B A portfolio's duration can be used to estimate the approximate change in value for a given change in yield. A critical assumption is that the yield for all bonds in the portfolio change by the same amount, known as a parallel shift. For this portfolio the expected change in value can be calculated as: $7,545,000 × 6.24 × 0.0025 = $117,702. The decrease in yields will cause an increase in the value of the portfolio, not a decrease.

A 5-year bond with a 10% coupon has a present yield to maturity of 8%. If interest rates remain constant one year from now, the price of the bond will be: A)higher. B)lower. C)the same.

B A premium bond sells at more than face value, thus as time passes the bond value will converge upon the face value.

As compared to an equivalent nonputable bond, a putable bond's yield should be: A)higher. B)lower. C)the same.

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

The reference rate for a floating-rate note should least likely match the note's: A)currency. B)maturity. C)reset frequency.

B An appropriate reference rate for a floating-rate note should match its currency and the frequency with which its coupon rate is reset, such as 90-day yen Libor for a yen-denominated note that resets quarterly.

Parsons Inc. is issuing an annual-pay bond that will pay no coupon for the first five years and then pay a 10% coupon for the remaining five years to maturity. The 10% coupon interest for the first five years will all be paid (without additional interest) at maturity. If the annual YTM on this bond is 10%, the price of the bond per $1,000 of face value is closest to: A)$778. B)$814. C)$856.

B CF0 = 0, CF1 = 0, F1 = 5, CF2 = 100, F2 = 4, CF3 = 1,600, F3 = 1, NPV, I = 10%, CPT = 813.69.

In a commercial mortgage-backed security (CMBS), which of the following is an example of CMBS-level call protection? A)Prepayment lockout. B)Residual tranche. C)Yield maintenance charges.

B Call protection in the context of a CMBS refers to protection against prepayment risk. Structuring a CMBS with a residual (equity or first-loss) tranche provides investors in the senior tranches with CMBS-level call protection. Prepayment lockout periods and yield maintenance charges are examples of loan-level call protection because they apply to the individual loans.

Which of the following adjustments is most likely to be made to the day count convention when calculating corporate bond yield spreads to government bond yields? A)Adjust the government bond yield to actual months and years. B)Adjust the corporate bond yield to actual months and years. C)Adjust both the corporate and government bond yields to actual months and years.

B Corporate bond yields are typically based on a 30/360 day count. When calculating spreads, corporate yields are often restated to the actual/actual basis typically used to state government bond yields.

Which of the following classes of asset-backed securities typically includes a lockout period? A)Auto loan ABS. B)Credit card ABS. C)Non-agency residential MBS.

B Credit card ABS typically have a lockout period during which principal payments by credit card borrowers are used to purchase additional credit card debt, rather than paid out to the ABS holders.

Which of the following is the reason why credit spreads between high quality bonds and low quality bonds widen during poor economic conditions? A)interest risk. B)default risk. C)indenture provisions.

B During poor economic conditions the probability of default increases and thus credit spreads widen.

A sequential-pay CMO has two tranches. Principal is paid to Tranche S until it is paid off, after which principal is paid to Tranche R. Compared to Tranche R, Tranche S has: A)less contraction risk and more extension risk. B)more contraction risk and less extension risk. C)more contraction risk and more extension risk.

B In a sequential-pay CMO the short tranche, which receives principal payments and prepayments first, has more contraction risk, while the tranche that receives principal payments and prepayments last has more extension risk.

An analyst wants to estimate the yield to maturity on a non-traded 4-year, annual pay bond rated A. Among actively traded bonds with the same rating, 3-year bonds are yielding 3.2% and 6-year bonds are yielding 5.0%. Using matrix pricing the analyst should estimate a YTM for the non-traded bond that is closest to: A)3.6%. B)3.8%. C) 4.1%

B Interpolating: 3.2% + [(4 - 3) / (6 - 3)] × (5.0% - 3.2%) = 3.8%

Key rate duration is best described as a measure of price sensitivity to a: A)change in a bond's cash flows. B)change in yield at a single maturity. C)parallel shift in the benchmark yield curve.

B Key rate duration is the price sensitivity of a bond or portfolio to a change in the interest rate at one specific maturity on the yield curve.

Other things equal, for option-free bonds: A)a bond's value is more sensitive to yield increases than to yield decreases. B)the value of a long-term bond is more sensitive to interest rate changes than the value of a short-term bond. C)the value of a low-coupon bond is less sensitive to interest rate changes than the value of a high-coupon bond

B Long-term, low-coupon bonds are more sensitive than short-term and high-coupon bonds. Prices are more sensitive to rate decreases than to rate increases (duration rises as yields fall).

A structured security is a combination of: A)a corporate bond and a syndicated loan. B)a medium-term note and a derivative. C)commercial paper and a backup line of credit.

B Medium-term notes (MTNs) that are combined with derivatives to create features desired by an investor are known as structured securities.

Which of the following bonds is most likely to exhibit the greatest volatility due to interest rate changes? A bond with a: A)high coupon and a long maturity. B)low coupon and a long maturity. C)low coupon and a short maturity.

B Other things equal, a bond with a low coupon and long maturity will have the greatest price volatility.

A mortgage-backed security has a pass-through rate of 4.3%. The average interest rate on its underlying pool of mortgages is 4.5%. The difference between these rates is most likely due to: A)faster-than-expected prepayments. B)issuance and servicing costs. C)slower-than-expected prepayments.

B Pass-through (i.e., coupon) rates on an MBS are less than the average interest rate on its underlying pool of mortgages because some of the cash flows from the mortgages are used to pay issuance costs and fees to the servicer of the mortgages.

One of the primary benefits of securitization is that it: A)improves the collectability of the loans that are securitized. B)improves the legal claims of the security holders to the loans that are securitized. C)removes problem assets from the issuing firm's balance sheet.

B Securitization reduces the cost of funding the assets. One way that is accomplished is through the transfer of the underlying financial assets to a special purpose entity so that securities holders have clear legal claim to them, something they may not have if they were to invest only in the securities of the securitizer, such as a bank. Securitization does not have improved collectability as a primary benefit. Problem loans are not good candidates for securitization because institutional investors require a minimum credit quality and even well performing loans can require internal or external credit enhancement for the securitized assets.

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

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

An investor buys a 20-year, 10% semi-annual bond for $900. She wants to sell the bond in 6 years when she estimates yields will be 10%. What is the estimate of the future price? A)$946. B)$1,000. C)$1,079.

B Since yields are projected to be 10% and the coupon rate is 10%, we know that the bond will sell at par value

Structural subordination means that a parent company's debt: A)has a higher priority of claims to a subsidiary's cash flows than the subsidiary's debt. B)has a lower priority of claims to a subsidiary's cash flows than the subsidiary's debt. C)ranks pari passu with a subsidiary's debt with respect to the subsidiary's cash flows.

B Structural subordination means that cash flows from a subsidiary are used to pay the subsidiary's debt before they may be paid to the parent company to service its debt. As a result, parent company debt is effectively subordinate to the subsidiary's debt.

A $1,000 par value note is priced at an annualized discount of 1.5% based on a 360-day year and has 150 days to maturity. The note will have a bond equivalent yield that is: A)equal to 1.5%. B)higher than 1.5%. C)lower than 1.5%.

B The BEY is an add-on yield based on a 365-day year. The discount of 1.5% implies a discount of $1,000 × 1.5% × 150/360 = $6.25. The current price is therefore $1,000 - $6.25 = $993.75. This gives a HPR of $6.25 / $993.75 = 0.629%. BEY = 0.629% × 365/150 = 1.53%.

Asset-backed securities (ABS) may have a higher credit rating than the seller's corporate bonds because: A)the seller's ABS are senior to its corporate bonds. B)they are issued by a special purpose entity. C)ABS are investment grade while corporate bonds may be speculative grade.

B The SPE in a securitization is bankruptcy-remote from the seller, which means the seller's creditors do not have a claim against the pool of assets underlying an ABS. As a result, the ABS may have a higher credit rating than the seller's corporate bonds.

PRC International just completed a $234 million floating rate convertible bond offering. As stated in the indenture, the interest rate on the bond is the lesser of 90-day LIBOR or 10%. The indenture also requires PRC to retire $5.6 million per year with the option to retire as much as $10 million. Which of the following embedded options is most likely to benefit the investor? The: A)10% cap on the floating interest rate. B)conversion option on the convertible bonds. C)sinking fund provision for principal repayment.

B The conversion privilege is an option granted to the bondholder. The cap benefits the issuer. A sinking fund is not an embedded option; it is an obligation of the issuer.

An investor most concerned with reinvestment risk would be least likely to: A)prefer a noncallable bond to a callable bond. B)eliminate reinvestment risk by holding a coupon bond until maturity. C)prefer a lower coupon bond to a higher coupon bond.

B The key term here is coupon bond. While an investor in a fixed-coupon bond can usually eliminate interest rate risk by holding a bond until maturity, the same is not true for reinvestment risk. The receipt of periodic coupon payments exposes the investor to reinvestment risk. A noncallable bond reduces reinvestment risk by reducing the risk of repayment. Thus, an investor most concerned with reinvestment risk would prefer a noncallable bond to a callable bond. Since lower coupon bonds have lower reinvestment risk, this same investor would prefer a lower coupon bond to a higher coupon bond.

Which of the following statements about floating-rate notes is most accurate? A)Inverse floating-rate notes are attractive to investors who expect interest rates to rise, while floating-rate notes are attractive to investors who expect interest rates to fall. B)Floating-rate notes have built-in floors, while inverse floating-rate notes have built-in caps. C)The coupon payment on a floating-rate note at each reset date is typically based on LIBOR as of that date.

B The lowest possible reference rate is zero. If this occurs, the coupon on a floating-rate note cannot go lower than its quoted margin. Hence, the quoted margin is a floor coupon for a floating-rate note. The coupon on an inverse floater is determined by a formula such as "15% - 1.5 × reference rate." If the reference rate goes to zero, the coupon on this inverse floater can go no higher than 15%.

A fixed coupon callable bond issued by Protohype Inc. is trading with a yield to maturity of 6.4%. Compared to this YTM, the bond's option-adjusted yield will be: A)higher. B)lower. C)the same.

B The option-adjusted yield is the yield a bond with an embedded option would have if it were option-free. For a callable bond, the option-adjusted yield is lower than the YTM. This is because the call option may be exercised by the issuer, rather than the bondholder. Bond investors require a higher yield to invest in a callable bond than they would require on an otherwise identical option-free bond.

f the yield curve is downward-sloping, the no-arbitrage value of a bond calculated using spot rates will be: A)less than the market price of the bond. B)equal to the market price of the bond. C)greater than the market price of the bond.

B The value of a bond calculated using appropriate spot rates is its no-arbitrage value. If no arbitrage opportunities are present, this value is equal to the market price of a bond.

Ron Logan, CFA, is a bond manager. He purchased $50 million in 6.0% coupon Southwest Manufacturing bonds at par three years ago. Today, the bonds are priced to yield 6.85%. The bonds mature in nine years. The Southwest bonds are trading at a: A)premium, and the yield to maturity has decreased since purchase. B)discount, and the yield to maturity has increased since purchase. C)discount, and the yield to maturity has decreased since purchase.

B The yield on the bonds has increased, indicating that the value of the bonds has fallen below par. The bonds are therefore trading at a discount. If a bond is selling at a discount, the bond's current price is lower than its par value and the bond's YTM is higher than the coupon rate. Since Logan bought the bonds at par (coupon = YTM = 6%), the YTM has increased.

The zero volatility spread (Z-spread) is the spread that: A)is added to the yield to maturity of a similar maturity government bond to equal the yield to maturity of the risky bond. B)is added to each spot rate on the government yield curve that will cause the present value of the bond's cash flows to equal its market price. C)results when the cost of the call option in percent is subtracted from the option adjusted spread.

B The zero volatility spread (Z-spread) is the interest rate that is added to each zero-coupon bond spot rate that will cause the present value of the risky bond's cash flows to equal its market value. The nominal spread is the spread that is added to the YTM of a similar maturity government bond that will then equal the YTM of the risky bond. The zero volatility spread (Z-spread) is the spread that results when the cost of the call option in percent is added to the option adjusted spread.

An investor buys a 25-year, 10% annual pay bond for $900 and will sell the bond in 5 years when he estimates its yield will be 9%. The price for which the investor expects to sell this bond is closest to: A)$964. B)$1,091. C)$1,122.

B This is a present value problem 5 years in the future. N = 20, PMT = 100, FV = 1000, I/Y = 9 CPT PV = -1,091.29

An agency RMBS pool with a prepayment speed of 50 PSA will have a weighted average life that is: A)equal to its weighted average maturity. B)less than its weighted average maturity. C)greater than its weighted average maturity.

B Weighted average life of a mortgage pool is less than its WAM if there are any prepayments. "50 PSA" means the prepayment speed is assumed to be 50% of the Public Securities Association prepayment benchmark.

Consider $1,000,000 par value, 10-year, 6.5% coupon bonds issued on January 1, 20X5. The market rate for similar bonds is currently 5.7%. A sinking fund provision requires the company to redeem $100,000 of the principal each year. Bonds called under the terms of the sinking fund provision will be redeemed at par. A bondholder would: A)be indifferent between having her bonds called under the sinking fund provision or not called. B)prefer not to have her bonds called under the sinking fund provision. C)prefer to have her bonds called under the sinking fund provision.

B With the market rate currently below the coupon rate, the bonds will be trading at a premium to par value. Thus, a bondholder would prefer not to have her bonds called under the sinking fund provision.

Which of the following statements regarding zero-coupon bonds and spot interest rates is CORRECT? A)If the yield to maturity on a 2-year zero coupon bond is 6%, then the 2-year spot rate is 3%. B)Price appreciation creates all of the zero-coupon bond's return. C)Spot interest rates will never vary across the term structure.

B Zero-coupon bonds are quite special. Because zero-coupon bonds have no coupons (all of the bond's return comes from price appreciation), investors have no uncertainty about the rate at which coupons will be invested. Spot rates are defined as interest rates used to discount a single cash flow to be received in the future. If the yield to maturity on a 2-year zero is 6%, we can say that the 2-year spot rate is 6

An investor holds $100,000 (par value) worth of TIPS currently trading at par. The coupon rate of 4% is paid semiannually, and the annual inflation rate is 2.5%. What coupon payment will the investor receive at the end of the first six months? A)$2,000. B)$2,025. C)$2,050.

B coupon payment=($100,000×1.0125)(0.04/2)=$2,025

Interest rates have fallen over the seven years since a $1,000 par, 10-year bond was issued with a coupon of 7%. What is the present value of this bond if the required rate of return is currently four and one-half percent? (For simplicity, assume annual payments.) A)$1,044.33. B)$1,052.17. C)$1,068.72

C

The Treasury spot rate yield curve is closest to which of the following curves? A)Forward yield curve rate. B)Par bond yield curve. C)Zero-coupon bond yield curve.

C

Which of the following is a general problem associated with external credit enhancements? External credit enhancements: A)are only available on a short-term basis. B)are very long-term agreements and are therefore relatively expensive. C)are subject to the credit risk of the third-party guarantor.

C

Which of the following sources of short-term funding is available to banks but typically unavailable to other corporations? A)Commercial paper. B)Syndicated loans. C)Central bank funds.

C

An analyst collects the following information regarding spot rates: 1-year rate = 4%. 2-year rate = 5%. 3-year rate = 6%. 4-year rate = 7%. The 2-year forward rate two years from today is closest to: A)8.03%. B)7.02%. C)9.04%.

C (1.07)^4/(1.05)^2)^.5−1=0.0904

If yield to maturity and risk factors remain constant over the remainder of a coupon bond's life, and the bond is trading at a discount today, it will have a: A)negative current yield and a capital gain. B)positive current yield and a capital gain. C)positive current yield, only.

C A coupon bond will have a positive current yield. It will not have a capital gain because its price will increase toward par along its constant-yield price trajectory as long as its YTM remains constant.

Which of the following coupon payment structures represents a leveraged inverse floater? A)10% - 0.75 times 180-day Libor. B)6% - 30-day Libor. C)8% - 1.5 times 90-day Libor.

C A leveraged inverse floater has a coupon that increases or decreases by more than the change in its reference rate. A deleveraged inverse floater has a coupon that increases or decreases by less than the change in its reference rate.

A waterfall structure is least likely describe: A)auto loan ABS. B)credit card ABS. C)agency RMBS.

C A waterfall structure, where principal losses are allocated first to the lowest priority securities issued, would most likely describe auto loan ABS or credit card ABS, which often have a senior-subordinated structure. Agency RMBS are pass-through securities and do not have a senior-subordinated structure.

Compared to a term repurchase agreement, an overnight repurchase agreement is most likely to have a: A)higher repo rate and repo margin. B)lower repo rate and higher repo margin. C)lower repo rate and repo margin

C Both the repo rate and the repo margin tend to be higher for longer repo terms. Therefore an overnight repo should have a lower repo rate and a lower repo margin than a term (i.e., longer than overnight) repo.

Securitization least likely benefits the financial system by: A)increasing liquidity for mortgages and other loans. B)increasing the amount banks are able to lend. C)removing liabilities from bank balance sheets.

C By enabling banks to raise cash by selling their existing loans and mortgages (which are balance sheet assets for banks), securitization increases the amount banks are able to lend.

Total cash flows to investors in an ABS issue are: A)equal to the total interest and principal payments from the underlying asset pool if only one class of ABS has been issued from the trust. B)equal to the total interest and principal payments from the underlying asset pool. C)less than the total interest and principal payments from the underlying asset pool.

C Cash flows from the underlying asset pool are used to pay fees to the servicer as well as payments to the ABS investors. Thus payments to investors are less than the total cash flows from the pool of assets.

Yield spreads tend to widen when equity market performance is: A)stable. B)strong. C)weak.

C Conditions that cause equity markets to weaken, such as poor economic growth, also tend to widen yield spreads in the bond market. Likewise, strong equity market performance tends to coincide with narrowing yield spreads. Yield spreads tend to narrow when equity markets are stable because investors "reaching for yield" increase their demand for bonds.

Settlement for corporate bond trades is most likely to happen on what basis? A)Cash settlement. B)Trade date + 1 day. C)Trade date + 3 days.

C Corporate bonds typically settle on the second or third trading day after the trade (T + 2 or T + 3), although in some markets their settlement can be as much as T + 7. Some money market securities are settled on the trade date (cash settlement) and government bonds typically settle on the trading day following the trade date (T + 1).

Venenata Foods has a 10-year bond outstanding with an annual coupon of 6.5%. If the bond is currently priced at $1,089.25, which of the following is closest to the semiannual-bond basis yield? A)5.33%. B)5.42%. C)5.26%.

C First, find the annual yield to maturity of the bond as: FV = $1,000; PMT = $65; N = 10; PV = -1,089.25; CPT → I/Y = 5.33%. Then, find the semiannual-bond basis yield as: 2 × [(1 + 0.0533)^0.5 - 1] = 0.0526 = 5.26%.

If a callable bond has an option-adjusted spread (OAS) of 75 basis points, this most likelysuggests: A)the implied cost of the call option is the bond's nominal spread minus 75 basis points. B)the 75 basis points represent the investor's compensation for credit risk, liquidity risk, and volatility risk. C)the bond has a zero-volatility spread greater than 75 basis points.

C For a bond with an embedded call option, the OAS is less than its zero-volatility spread by the option cost. Therefore, the zero-volatility spread is greater than the OAS for callable bonds. If the embedded call option has any value to the issuer, a callable bond with an OAS of 75 basis points will have a Z-spread that is greater than 75 basis points. Because the OAS represents the bond's spread to the spot yield curve excluding the effect of the embedded option, it does not include any compensation for the volatility risk related to the option. The implied cost of an embedded option is the difference between the bond's zero-volatility spread (not the nominal spread) and its OAS.

Which type of issuer is most likely to issue bonds by auction? A)Corporate. B)Municipal. C)Sovereign.

C Many national governments use auctions to issue sovereign bonds. Corporate bonds are typically issued in an underwriting or private placement process while municipal bonds are typically issued in a negotiated or underwritten process

Which of the following will be the greatest for a putable bond at relatively high yields? A)Modified duration of the bond ignoring the option. B)Effective duration of the bond. C)Macaulay duration of the bond ignoring the option.

C Modified duration is less than Macaulay duration. The effective duration of a putable bond is less than its modified duration ignoring the put option.

Which of the following five year bonds has the highest interest rate sensitivity? A)Floating rate bond. B)Option-free 5% coupon bond. C)Zero-coupon bond.

C The Macaulay duration of a zero-coupon bond is equal to its time to maturity. Its price is greatly affected by changes in interest rates because its only cash-flow is at maturity and is discounted from the time at maturity until the present.

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

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

A bond's indenture least likely specifies the: A)source of funds for repayment. B)covenants that apply to the issuer. C)identity of the lender.

C The identity of the lender (i.e., the bondholder) is not specified in a bond's indenture because a bond may be traded during its life. An indenture or trust deed is a legal contract that specifies a bond issuer's obligations and restrictions. The indenture may include covenants that require the issuer to take or refrain from taking certain actions and may specify the source of funds for repayment, such as a project to be funded or the taxing power of a government.

The bonds of Grinder Corp. trade at a G-spread of 150 basis points above comparable maturity U.S. Treasury securities. The option adjusted spread (OAS) on the Grinder bonds is 75 basis points. Using this information, and assuming that the Treasury yield curve is flat: A)the zero-volatility spread is 225 basis points. B)the zero-volatility spread is 75 basis points. C)the option cost is 75 basis points.

C The option cost is the difference between the zero volatility spread and the OAS, or 150 − 75 = 75 bp. With a flat yield curve, the G-spread and zero volatility spread will be the same.

When computing the yield to maturity, the implicit reinvestment assumption is that the interest payments are reinvested at the: A)coupon rate. B)prevailing yield to maturity at the time interest payments are received. C)yield to maturity at the time of the investment.

C The reinvestment assumption states that reinvestment must occur at the YTM in order for an investor to earn the YTM. The assumption also states that payments are received in a prompt and timely fashion resulting in immediate reinvestment of those funds.

A bond is quoted at 96.25 bid and 96.75 ask. Based only on this information, this bond is most likely: A)a corporate bond. B)non-investment grade. C)relatively illiquid

C The spread between the bid and ask prices is one-half percent of par, which most likely reflects an illiquid market for this bond. Bonds with liquid secondary markets typically have bid-ask spreads of approximately 10 to 12 basis points.

Which of the following statements concerning the support tranche in a planned amortization class (PAC) CMO backed by agency RMBS is least accurate? A)The purpose of a support tranche is to provide prepayment protection for one or more PAC tranches. B)If prepayments are too low to maintain the scheduled PAC payments, the shortfall is provided by the support tranche. C)The support tranches are exposed to high levels of credit risk.

C The support tranches are exposed to high levels of prepayment risk, not credit risk.

When using duration and convexity to estimate the effect on a bond's value of changes in its credit spread, an analyst should most appropriately use: A)a convexity measure that has been adjusted for the bond's credit risk. B)Macaulay duration rather than modified duration. C)the same method used when estimating the effect of changes in yield.

C We can use duration and convexity to estimate the price effect of changes in spread in the same way we use them to estimate the price effect of changes in yield: Percent change in bond value = -duration(change in yield or spread) + (1/2)(convexity)(squared change in yield or spread) No adjustment for credit risk is needed and an analyst should use modified or effective duration.

A bond has a modified duration of 7 and convexity of 100. If interest rates decrease by 1%, the price of the bond will most likely: A)decrease by 7.5%. B)increase by 6.5%. C)increase by 7.5%.

C Percentage Price Change = -(7) (-0.01) + (½)(100) (-0.01)^2=7.5%.