1. Which of the following is the appropriate redemption price when bonds are called according to the sinking fund provision?
A.Special redemption price.
B.Regular redemption price.
C.General redemption price.
A B C
A
Regular redemption and general redemption price are identical and refer to bonds being called according to the provisions specified in the bond indenture.
2. There are several types of external credit enhancements. All of the following are examples of external credit enhancements EXCEPT:
A.corporate guarantees.
B.letters of credit.
C.setting aside reserve funds.
A B C
C
Setting aside reserve funds is an example of internal, not external credit enhancement.
3. Which of the following is the reason why credit spreads between high quality bonds and low quality bonds widen during poor economic conditions?
A.indenture provisions.
B.interest risk.
C.default risk.
A B C
C
During poor economic conditions, the probability of default increases and thus credit spreads widen.
4. Which of the following will most likely have the least impact on a corporate bond rating? The:
A.issuing company's debt burden.
B.issuing company's liquidity provision.
C.issuing company's volume of sales.
A B C
C
The size of the issuing firm, represented by the amount of sales, will play a role in the financial stability of the firm. However, liquidity and leverage are more directly related to the bond's rating. Smaller firms are not likely to issue bonds and issuers are typically larger firms overall.
5. Which of the following statements regarding the different theories of the term structure of interest rates is FALSE?
A.The preferred habitat theory can be described as investors that prefer to stay within a particular maturity range of the yield curve regardless of yields in other maturity ranges.
B.The market segmentation theory, pure expectations theory, preferred habitat theory, and liquidity preference theory are all consistent with any shape of the yield curve.
C.An upward sloping yield curve can be consistent with the liquidity preference theory even with expectations of declining short term interest rates.
A B C
A
The preferred habitat theory states that investors will move from their preferred maturity on the yield curve to another area on the yield curve to achieve higher yields. With the liquidity preference theory the yield curve can remain upward sloping even if short term rates are predicted to decline as long as the liquidity premium is sufficiently large. With the market segmentation theory the supply of bonds and demand for bonds at various maturities determine their yields and the resulting yield curve.
6. Which of the following are the two most important tools available to the Federal Reserve?
A.Changing the discount rate and changing bank reserve requirements.
B.Open market operations and changing bank reserve requirements.
C.Changing the discount rate and open market operations.
A B C
C
The two most important tools available to the Fed are changing the discount rate, the rate at which banks can borrow from the Fed's discount window, and open market operations, the Fed's activity of buying and selling Treasury securities.
7. The structure of interest rates results from all the following EXCEPT:
A.viewing each bond coupon payment as a separate zero coupon bond.
B.viewing a bond's cash flows as having maturities ranging from the next coupon payment to the final payment at maturity.
C.creating the yield curve by plotting term to maturity against the coupon rate.
A B C
C
The yield curve plots term to maturity and yield to maturity.
8. While working abroad, U. S. citizen Dirk Senik purchases a foreign bond with an annual coupon of 7.5 percent for 95.5. One year later, the exchange rate between the dollar and the foreign currency remains unchanged and he sells the bond for 97.25, resulting in a holding period return of 9.7 percent. If the foreign currency had depreciated in relation to the dollar, Senik's return would be:
A.greater than 9.7 percent.
B.equal to 9.7 percent.
C.less than 9.7 percent.
A B C
C
The return on a foreign bond is a combination of the return on the bond and the movement in the foreign currency. In the base case, the movement in the foreign security was 0 and thus the return was just the holding period return on the bond. If the foreign currency depreciates, the return will be lowered because the investor will lose upon conversion to the dollar.
9. A domestic investor is purchasing foreign bonds. Which of the following statements regarding the exchange rate risk and price movement of the asset is most accurate?
A.The depreciation of both the asset and the foreign currency benefits the domestic investor.
B.The appreciation of both the asset and the foreign currency benefits the domestic investor.
C.The appreciation of the asset and the depreciation of the foreign currency benefit the domestic investor.
A B C
B
When the foreign currency appreciates, each foreign currency-denominated cash flow buys more domestic currency units-increasing the domestic currency return from the investment. The appreciation of the foreign asset benefits the investor as well.
10. The concept that forward rates reflect investors' expectations of future rates plus a liquidity premium to compensate them for exposure to interest rate risk is associated with which of the following explanations of the term structure of interest rates?
A.Liquidity premium theory
B.Segmented market theory.
C.Expectations hypothesis.
A B C
A
The pure expectations hypothesis suggests that forward rates are solely a function of expected future spot rates. This theory implies that an investor could earn the same return by investing in a one-year bond or by sequentially investing in two six-month bonds. The liquidity preference theory proposes that forward rates reflect investors' expectations of future rates plus a liquidity premium to compensate them for exposure to interest rate risk. This theory suggests that the liquidity premium is positively related to maturity. The market segmentation theory proposes that lenders and borrowers have preferred maturity ranges. This theory relies on the idea that some investors have restrictions (either legal or practical) on their maturity structure.
11. A downward sloping yield curve generally implies:
A.interest rates are expected to increase in the future.
B.longer-term bonds are riskier than short-term bonds.
C.interest rates are expected to decline in the future.
A B C
C
Since a yield curve has time on the x-axis and rates on the y-axis, when the yield curve is downward sloping it means that rates are expected to decline.
12. Fernando Golpas and Javier Solada were reviewing the financial reports of several Latin American governments. They noticed that the central governments of many Latin American countries such as Argentina, Chile, Peru, and Ecuador had recently been issuing sovereign debt. This sparked a discussion between the two analysts about sovereign debt ratings. During their discussion they made the following statements: Golpas: The rating agencies, such as Moody's, generally assign two ratings to sovereign debt. One is a local currency debt rating and the other is a foreign currency debt rating. The reason for the two ratings is that the default frequency has been greater on local currency denominated debt. Solada: If a central government is willing to raise taxes and control its internal financial system, it should be able to generate sufficient local currency to meet its local currency obligation. That is why the rating on local currency denominated debt is generally higher than the rating on foreign currency denominated debt. Are the statements made by Golpas and Solada regarding sovereign debt ratings correct? Golpas Solada ①A. Correct Correct ②B. Incorrect Correct ③C. Incorrect Incorrect A. ①B. ②C. ③
A B C
B
Golpas' statement is incorrect because the reason for the two ratings (the local currency and the foreign currency debt ratings) is that the default frequency has been greater on foreign currency denominated debt. It is often easier for a central government to print local currency to meet its obligations in the home currency than to exchange the local currency in the foreign exchange markets for a given amount of foreign currency.
13. Which of the following best describes a Treasury note? Pays:
A.implicit interest; is non-callable; has a 2- to 10-year maturity.
B.explicit interest; is callable; has a 1- to 15-year maturity.
C.explicit interest; is non-callable; has a 2- to 10-year maturity.
A B C
C
While some Treasury bonds issued prior to 1984 are callable, notes are not. They pay explicit, semi-annual interest and have original maturities ranging from 2 to 10 years.
14. In the context of bonds, accrued interest:
A.equals interest earned from the previous coupon to the sale date.
B.covers the part of the next coupon payment not earned by seller.
C.is discounted along with other cash flows to arrive at the dirty, or full price.
A B C
A
Accrued interest can occur on all bonds with periodic coupon payments, not just bonds with payment frequencies greater than one year. Accrued interest is not discounted when calculating the price of the bond. The statement, "covers the part of the next coupon payment not earned by seller," should read, "---not earned by buyer. "
15. Which of the following does NOT represent a secondary market offering? When bonds are sold:
A.in a Rule 144A offering.
B.in an over-the-counter dealer market.
C.on an electronic trading network.
A B C
A
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.
16. While serving as visiting conductor at the University of Edinburgh, U. S. Citizen William Golson purchases a 9.0 percent annual coupon bond denominated in the local currency for 93.0. One year later, before his return to the U. S. , he sells the bond for 99.5. Using a holding period return formula he remembers from his undergraduate studies, he calculates his return at 16.7 percent. On the flight home, he is seated next to Kristin Meyer, CFA. She is puzzled because she has heard that similar investments yielded negative returns over the same time period. After consulting her financial newspaper, she recalculates Golson's return at a disappointing negative 5.2 percent. Assuming Meyer is correct, which of the following statements is the most likely reason for the difference in the calculated returns? Golson:
A.forgot to include the impact of foreign currency appreciation in relation to the dollar.
B.forgot to include the impact of foreign currency depreciation in relation to the dollar.
C.omitted the impact of inflation.
A B C
B
Golson most likely forgot to take into account the impact of the percentage change in the dollar value of the foreign currency. Here, since the correct return (calculated by Meyer) is lower than that calculated by Golson (who omitted the impact of foreign exchange), the foreign currency depreciated in relation to the dollar. The appreciation in the bond value was not enough to offset the currency depreciation, and the total return in dollar terms was negative.
17. All else equal, which of the following is least likely to increase the interest rate risk of a bond?
A.A longer maturity.
B.Inclusion of a call feature.
C.A lower coupon.
A B C
B
Inclusion of a call feature will decrease the duration of a fixed income security.
18. Is an option-free bond's price sensitivity positively correlated with the: Bond's coupon rate Level of market interest rates ①A. No Yes ②B. No No ③C. Yes No A. ①B. ②C. ③
A B C
B
An option-free bond's price sensitivity (interest rate risk) is greater when both the coupon rate and level of market interest are low; price sensitivity is negatively correlated with both factors.
19. The yield on an industrial bonds is 8.59 percent while the yield on a benchmark bond with the same maturity is 6. 83 percent. The relative yield spread is closest to;
A.1.8%
B.20.5%
C.25.8%
A B C
C
(8.59%-6.83%)/6.83%=25.8%.
20. An analyst forecasts that spot interest rates will increase more than the increase implied by the current forward interest rates. Under these circumstances:
A.the analyst should establish a bearish bond portfolio.
B.all bond positions earn the same return.
C.the analyst should establish a bullish bond portfolio.
A B C
A
Bond prices fall with a rise in interest rates. If realized rates rise more than the associated forward rate implied, then a bearish bond position will be the most beneficial.
21. Which of the following statements regarding separate trading of registered interest and principal of securities (STRIPS) is TRUE? A 20-year Treasury bond can be used as the basis for:
A.40 coupon strips and 1 principal strip.
B.40 principal strips and 1 coupon strip.
C.41 coupon strips.
A B C
A
A 20-year Treasury bond can be used as the basis for 40 coupon strips and 1 principal strip.
22. Which of the following best explains the slope of the yield curve?
A.The term spread between the yields of two maturities.
B.The credit spread between two securities with different maturities.
C.The nominal spread between two securities with different maturities.
A B C
A
Since the yield curve depicts the yield on securities with different maturities, the slope of the curve between two maturities is a function of the maturity spread.
23. 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?
A.Rating agencies.
B.Investment banks.
C.Special purpose vehicles (SPVs).
A B C
C
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.
24. All else being equal, the ceiling on a floating-rate security is most likely to benefit the:
A.issuer if interest rates fall.
B.issuer if interest rates rise.
C.bondholder if interest rates rise.
A B C
B
When the interest rate increases, the periodic payment will be limited to the ceiling rate for the issue, which does great protection for the issuer.
25. Which one of the following alternatives represents the correct series of payments made by a typical 6 percent U. S. Treasury note with a par value of $100000 issued today with five years to maturity ? Number and size of each intermediate payment Payment made at maturity ①A. 9 semiannual payments of $3000 $100000 ②B. 4 annual payments of $6000 $106000 ③C. 9 semiannual payments of $3000 $103000 A. ①B. ②C. ③
A B C
C
Payments for U. S. Treasury bonds and notes are semiannual and are fixed for the life of each bond or note. The coupon rate is quoted on an annual basis but each payment is made on the basis of one half the annual rate multiplied by the maturity or par value.
26. Which of the following statements about debt securities is least accurate?
A.Commercial paper is a short-term (less than nine months) vehicle for corporate borrowing.
B.A MTN is a shelf-registered debt instrument that is continually offered to investors by an agent of the issuer and varies in maturity from nine months to over 30 years.
C.A medium-term note (MTN) differs from a corporate bond in that a MTN is sold to investors on a "firm commitment" basis wherein the investment banker guarantees a price to the issuer.
A B C
C
A medium-term note is sold on a "best efforts" basis where the underwriter does not guarantee a price for the bonds to the issuer but tries to get the best price possible. Price risk is completely borne by the issuing firm.
27. Which of the following statements is TRUE?
A.When a rating agency downgrades a security, the bond's price usually falls.
B.Technical default usually refers to the issuer's failure to make interest or principal payments as scheduled in the indenture.
C.Default risk is important because if a bond issuer defaults, the bondholder likely loses his entire investment.
A B C
A
The market will likely demand a higher yield from the downgraded bond (the risk premium has increased) and thus the price wilt likely fall. Technical default usually refers to an issuer's violation of bond covenants, such as debt ratios, rather than the failure to pay interest or principal. In the event of default, the holder (lender) may recover some or all of the investment through legal action or negotiation.
28. Which of the following reasons is the best reason NOT to enhance the credit quality of an asset backed security (ABS) pool?
A.Liquidity.
B.Regulatory.
C.Cost.
A B C
C
Credit enhancements increase the costs associated with borrowing using ABS.
29. If investors expect greater uncertainty in the bond markets, yon should see yield spreads between AAA and B rates bonds:
A.widen.
B.narrow.
C.slope downward.
A B C
A
With greater uncertainty, investors require a higher return for taking on more risk. Therefore credit spreads will widen.
30. If the issuer of a bond is in default, the bond will be trading:
A.registered.
B.on accrual.
C.flat.
A B C
C
If an issuer of a bond is in default (i. e. it has not been making periodic contractual coupon payments), the bond is traded without accrued interest and is said to trade flat. A registered bond is a bond whose owner's name is recorded as a book entry on the books of the issuer or its transfer agent.
31. Which of the following circumstances is an example of event risk?
A.A currency devalues due to foreign exchange market forces.
B.A local government regulatory agency introduces more stringent clean-water requirements that will significantly reduce the cash flow of an area paper mill.
C.The U. S. Federal Reserve unexpectedly increases interest rates by 100 basis points.
A B C
B
A local government regulatory agency introducing more stringent clean-water requirements that will significantly reduce the cash flow of an area paper mill is an example of regulatory risk, which is a type of event risk. The impact of regulatory risk can be long-term, in that the company may be unable to pass on the increased cost to customers.
32. Which of the following statements regarding a bond being called is TRUE? Call prices are known as regular redemption prices when bonds are called at:
A.under the call provisions specified in the bond indenture.
B.at a discount.
C.at a premium.
A B C
A
When bonds are redeemed under the call provisions specified in the bond indenture, these are known as regular redemptions and the call prices are referred to as regular redemption prices which can be either at a premium or at par.
33. Which of the following yield curves represents a situation where long-term rates are less than short-term rates?
A.Normal yield curve.
B.Inverted yield curve.
C.Flat yield curve.
A B C
B
A normal yield curve is one in which long-term rates are greater than short-term rates. A flat yield curve represents a situation where the yield on all maturities is essentially the same.
34. When bonds are sold in a bought deal, the transaction takes place on the:
A.primary market.
B.secondary market.
C.tertiary market.
A B C
A
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).
35. Which of the following statements concerning taxable bonds is TRUE?
A.Corporates have the lowest yields, followed by Treasuries, then by corporates, which provide the highest returns.
B.Treasuries have the lowest yields, followed by corporates, then by agencies, which provide the highest returns.
C.Treasuries have the lowest yields, followed by agencies, then by corporates, which provide the highest returns.
A B C
C
The difference in yields is largely due to the default risk premium. Treasuries are considered to be default-risk free, while corporate bonds have the highest default risk.
36. If the Federal Reserve wishes to lower market interest rates without changing the discount rate, it can:
A.increase bank reserve requirements.
B.raise the yield on Treasury securities.
C.buy Treasury securities.
A B C
C
Buying Treasury securities pumps money into the economy, lowering interest rates. Higher reserve requirements and tighter lending requirements will restrict the money supply, causing rates to rise. The Federal Reserve has no direct control over the yield on existing Treasury securities.
37. Kirsten Thompson, CFA candidate, is studying the relationships between a bond's coupon rate and the required market yield. One study question concerns a new-issue, 15-year, $1000 face value 6.75 percent semi-annual coupon bond priced at $1075. Which of the following choices correctly describes the bond and accurately represents the relationship of the bond's market yield to the coupon?
A.Premium bond, required market yield is less than 6.75%.
B.Premium bond, required market yield is greater than 6.75%.
C.Discount bond, required market yield is less than 6.75%.
A B C
A
When the issue price is greater than par, the bond is selling at a premium. We also know that the current market required rate is less than the coupon rate of 6.75%, because the bond is selling at a premium. For the examination, remember the following relationships:
Type of Bond
Market Yield to Coupon
Price to Par
Premium
Market Yield<Coupon
Price>Par
Par
Market Yield=Coupon
Price=Par
Discount
Market Yield>Coupon
Price<Par
38. Which of the following statements about fixed income securities is FALSE?
A.The corporate bond sector is more important in the US than in Japan and Germany.
B.Coupon interest and capital gains from municipal bonds are tax exempt at the federal level.
C.Treasuries and agencies are quoted in 32nds of a price point.
A B C
B
Coupon or interest income is exempt from federal income taxes. Capital gains taxes associated with municipal bonds are not exempt from federal taxes.
39. Which of the following statements about a callable bond is TRUE?
A.The call option on a bond trades separately from the bond itself.
B.A bondholder usually loses if a bond is called by being forced to reinvest the proceeds at a lower interest rate.
C.Callable bonds follow the standard inverse relationship between interest rates and price.
A B C
B
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.
40. A normally sloped yield curve has a:
A.positive slope.
B.zero slope.
C.negative slope.
A B C
A
A normally shaped yield curve is one in which long-term rates are greater than short-term rates, thus the curve exhibits a positive slope.
41. An analyst is considering two bonds: Bond A yields 7.5% , and Bond B yields 7.0%. Using Bond B as the reference bond, the absolute yield spread and the yield ratio for Bond A are closest to: Spread Ratio ①A. -0.5% 1.07 ②B. -015% 0.93 ③C. 0.5% 1.07 A. ①B. ②C. ③
A B C
C
absolute yield spread = yield on Bond A- yield on Bond B =7.5%-7.0%=0.5% yield ratio = Bond A yield/Bond B yield =7.5%/7.0% =1.071.
42. The current coupon period for a 10-year IBM bond with face value $100000 and a 7% coupon rate is 183 days in length. The next coupon will be paid 85 days from today's settlement date. What is the accrued interest on this bond?
A.$3748.
B.$1626.
C.$1874.
A B C
C
The next coupon payment will be $100000×7%/2 = $3500. The bond has accrued interest for 183-85=98 days. The amount of accrued is 98/183×3500=$1874.
43. Peter Stone is considering buying a $100 face value, semi-annual coupon bond with a quoted price of 105.19. His colleague points out that the bond is trading ex-coupon. Which of the following choices best represents what Stone will pay for the bond?
A.$105.19 plus accrued interest.
B.$105.19 minus accrued interest.
C.$105.19.
A B C
C
Since the bond is trading ex-coupon, the buyer will pay the seller the clean price, or the price without accrued interest. So, Stone will pay the quoted price. The choice $105.19 plus accrued interest represents the dirty price (also known as full price). This bond would be said to trade cure-coupon.
44. A Treasury bond due in one-year has a yield of 8.5 percent. A Treasury bond due in 5 years has a yield of 9.3 percent. A bond issued by General Motors due in 5 years has a yield of 9.9 percent. A bond issued by Exxon due in one year has a yield of 9.4 percent. The default risk premiums on the bonds issued by Exxon and General Motors are: Exxon General Motors ①A. 0.1% 0.6% ②B. 0.1% 1.4% ③C. 0.9% 0.6% A. ①B. ②C. ③
A B C
C
9.4-8.5=0.9; 9.9-9.3=0.6.
45. The return in excess of the return on a benchmark, default-free security demanded by investors to compensate them for the risk of buying a risky security is called:
A.default risk premium.
B.downgrade risk premium.
C.reinvestment risk premium.
A B C
A
Default risk is the possibility that the issuer will fail to meet its obligations under the indenture, for which investors demand a premium above the return on a default-risk-free security. Downgrade risk is the risk that a bond is reclassified as a riskier security by a credit rating agency. Reinvestment risk is the risk that the investor will have to reinvest the proceeds available for reinvestment at a lower interest rate than anticipated.
46. Which of the following statements regarding liquidity risk is FALSE?
A.The bid-ask spread is one measurement of liquidity risk.
B.Emerging markets typically have more liquidity risk than established markets.
C.Liquidity risk is not important to an investor who intends to hold a security until maturity.
A B C
C
Even if an investor intends to hold securities to maturity, liquidity risk impacts portfolios when marking to market and through changes in investor tastes and preferences over time. For example, liquidity is important to institutional investors that must determine market values for net asset values (NAVs) and to dealers in the repurchase market for collateral valuation.
47. Bond A has a yield of 8.75 percent. Bond B, the reference bond, has a yield of 7.45 percent. The risk-free rate of return is 3.50 percent. Assuming both bonds have the same maturity, the relative yield spread is closest to:
A.1.30.
B.0.17.
C.1.17.
A B C
B
Relative yield spread = absolute yield spread/yield on reference bond Relative yield spread = (8.75%-7.45%)/7.45% =0.17.
48. The term structure theory that rests on the interaction of supply and demand forces in the debt market is the:
A.GIC inverse term structure theory.
B.market segmentation theory.
C.bootstrap theory of sliding rates.
A B C
B
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.
49. Consider the following two statements about put-able bonds: Statement 1: As yields rise, the price of put-able bonds will fall more quickly than similar option-free bonds (beyond a critical point) due to the decline in value of the embedded put option. Statement 2: As yields fall, the price of put-able bonds will rise more quickly than similar option-free bonds (beyond a critical point) due to the increase in value of the embedded put option. Should an analyst agree or disagree with these statements? Statement 1 Statement 2 ①A. Agree Agree ②B. Disagree Disagree ③C. Agree Disagree A. ①B. ②C. ③
A B C
B
As yields rise, the value of the embedded put option in a put-able bond increases and (beyond a critical point) reduces the decline in the value of the bond compared to a similar option-free bond. As yields fall, the value of the embedded put option decreases, and (beyond a critical point) the put-able bond behaves much the same as a similar option-free bond since the embedded put option has little or no value.
50. On November 15, 2008, Grinell Construction Company decided to issue bonds to help finance the acquisition of new construction equipment. They issued bonds totaling $10000000 with a 6% coupon rate due June 15, 2028. 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?
A.Serial bonds.
B.Bullet maturity.
C.Redeemable bonds.
A B C
B
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.