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1.Which of the following is the shape of an inverted yield curve or term structure?

A) Flat.
B) Humped.
C) Upward sloping.
D) Downward sloping.
The correct answer was D)
An inverted yield curve reflects the condition where long-term rates are less than short-term rates,
giving it a downward (negative) slope.
2.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.
D) The option adjusted spread between two securities with different maturities.
The correct answer was 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.
3.The concept of spot and forward rates is most closely associated with which of the following
explanations of the term structure of interest rates?
A) Segmented market theory.
B) Preferred habitat hypothesis.
C) Liquidity premium theory.
D) Expectations hypothesis.
The correct answer was D)
The pure expectations theory purports that forward rates are solely a function of expected future
spot rates. In other words, long-term interest rates equal the mean of future expected short-term
rates. This implies that an investor could earn the same return by investing in a 1-year bond or by
sequentially investing in two 6-month bonds. The implications for the shape of the yield curve under
the pure expectations theory are:
If the yield-curve is upward sloping, short-term rates are expected to rise.
If the curve is downward sloping, short-term rates are expected to fall.
A flat yield curve implies that the market expects short-term rates to remain constant.
4.If investors expect future rates will be higher than current rates, the yield curve should be:
A) upward sweeping.
B) downward sweeping.
C) flat.
D) vertical.
The correct answer was A)
When interest rates are expected to go up in the future the yield curve will be upward sweeping
because time is on the x-axis and rates are on the y-axis, thus forming an upward sweeping curve.
5.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.
D) shorter-term bonds are less risky than longer-term bonds.
The correct answer was 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.
6.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.
D) Humped yield curve.
The correct answer was 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. A humped
yield curve represents a situation where rates in the middle of the maturity spectrum are higher or
lower than those for both bonds with a short and long-term maturity.
7.A normally sloped yield curve has a:
A) positive slope.
B) zero slope.
C) negative slope.
D) an infinite slope.
The correct answer was 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.

1.Jonathon Silver, CFA, has a client, Alyce Grossberg, whose only current investment requirement is that she
wants to buy a premium bond. The required market yield is currently 7.25 percent at all maturities. Which of the
following $1,000 face value bonds should Silver select for Grossbergs portfolio? A
A) 15-year, zero-coupon bond priced to yield 9.00%.
B) 10-year, 8.00% semi-annual coupon bond.
C) 5-year, 7.25% annual coupon bond.
D) 10-year, 7.00% semi-annual coupon bond.
The correct answer was B)
A bond sells at a premium when the coupon rate is greater than the required market yield. Here, the 10-year,
8.00% semi-annual coupon bond would sell above par, or at a premium.

The 15-year, zero-coupon bond priced to yield 9.00% would sell at a discount. Zero-coupon bonds sell at a
discount from par, because they pay no coupon. (Coupon rate = 0.00%.) The 10-year, 7.00% semi-annual
coupon bond would also sell at a discount, because the coupon rate is less than the required market yield. The
7.25% annual coupon bond would sell at par, because the coupon rate equals the required market yield. Note:
The information that this is an annual coupon bond is not relevant for this question.

For the examination, remember the following relationships:


Type of Bond 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

2.Kirsten Thompson, CFA candidate, is studying the relationships between a bonds coupon rate and the
required market yield. One study question concerns a new-issue, 15-year, $1,000 face value 6.75 percent semi-
annual coupon bond priced at $1,075. Which of the following choices correctly describes the bond
and accurately represents the relationship of the bonds 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%.
D) Discount bond, required market yield is greater than 6.75%.
The correct answer was 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

3.Gabrielle Daniels and Edin Roth, CFA candidates, are discussing the relationship between a bonds coupon
rate and the required market yield. Looking through the local newspaper, they see a new-issue, 10-year, $1,000
face value 8.00 percent semi-annual coupon bond priced at $950. Daniels makes the following statements.
Which statement does Roth tell her is CORRECT?
A) The current market required rate is less than the coupon rate.
B) The bond is selling at a premium.
C) The bond is low-quality.
D) The bond is selling at a discount.
The correct answer was D)
When the issue price is less than par, the bond is selling at a discount.

We also know that the current market required rate is greater than the coupon rate because the bond is selling
at a discount. We cannot determine credit quality from the information provided.

4.Given that the information on the three bonds below is at issuance, which of the following choices correctly
identifies the bonds as premium, par, and discount.
Bond Market Rate Coupon Rate
1 8.00% 7.00%
2 7.25% 7.50%
3 6.75% 6.75%
Bond 1 Bond 2 Bond 3

A) premium par discount


B) discount premium par
C) par premium discount
D) par discount premium
The correct answer was B)
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
5.If the market rate of interest is greater than the coupon rate, the bond will be valued:
A) at par.
B) less than par.
C) greater than par.
D) cannot be determined.
The correct answer was B)
If the Coupon Rate > market yield, then bond will sell at a premium.
If the Coupon Rate < market yield, then bond will sell at a discount.
If the Coupon Rate = market yield, then bond will sell at par.

6.Given that the coupon rate of a bond is higher than the market interest rate on bonds with similar maturities
and payment structures, the bond will be trading:
A) at par value.
B) at a discount.
C) with a higher yield.
D) at a premium.
The correct answer was D)
If the bond provides investors with a higher coupon rate than the market interest rate the bond has to be trading
at a premium relative to its par value otherwise there is an arbitrage opportunity.

David Korotkin, CFA and a broker at an investment bank, has a client who is very concerned about
maintaining purchasing power over the next year. The investor is conservative, and to date has
been pleased with a consistent return of 8.00%. The banks research department has estimated
next years inflation rate at 2.0%. The client specifically wants to invest in a fixed-coupon bond.
Which of the following statements is most correct? If Korotkin purchases a bond with a 10.00%
coupon, the client:

A) will not lose purchasing power.

B) will realize a real gain.

C) may lose purchasing power.

Investors want to be compensated for the inflation they expect plus for the risk that inflation will
increase during the term of the investment. Here, the banks estimated inflation rate is just that an
estimate. Thus, we cannot say for certain that the investor will not lose purchasing power. Inflation
risk introduces uncertainty to the investment process.
: honeycfa : 2010-4-24 10:54

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 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, Omuras real return is closest to:

A) 9.6%.

B) 6.3%.

C) 5.2%.

Omuras 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%.

: honeycfa : 2010-4-24 10:55

Which of the following statements about inflation risk is FALSE?

A) The short term inflation premium is less than the long term premium.

B) The real return on a fixed coupon bond is variable.

C) Treasury securities are considered immune to inflation and liquidity risk.


The statement Treasury securities are considered immune to inflation and liquidity risk is partially
true Treasury securities are immune to liquidity risk, but fixed-coupon Treasury securities have
high inflation risk and generally low real returns.

The other choices are true. The inflation premium is less in the short term because investors are
better able to predict inflation in the short term inflation risk increases as time increases.
(Investors want to be compensated for this uncertainty.) An investors real return is not fixed- even
though an investor may hold a fixed-rate coupon bond, the real return depends on a variable
inflation. Higher inflation rates result in a reduction of the purchasing power of bond payments.

: honeycfa : 2010-4-24 10:55

Which of the following investors is least susceptible to inflation risk?

A) An individual with a 5 year certificate of deposit at a local financial institution.

The holder of a 15-year bond with a coupon formula equal to the U.S. prime rate plus
B)
3.25%.

C) A financial institution with assets concentrated in fixed-rate mortgages.

A 15-year bond with a coupon formula equal to the U.S. prime rate plus 3.25% is an example of
a floating rate bond. The holder of an adjustable rate asset is impacted less by inflation than the
holder of a fixed-rate asset because the increased cash flow (from the higher coupon payments
when the base rate increases) at least partially offsets the decreased purchasing power caused
by inflation.

The other two choices are examples of investors more susceptible to inflation - those who hold
long-term contracts in which they are to receive a fixed payment.

: honeycfa : 2010-4-24 10:55

Which of the following investors faces the least inflation risk? An investor whose portfolio is
concentrated in:

A) long-term treasury bonds.

B) fixed-rate certificates of deposit.

C) equity securities.