Topic 58: Prices, Discount Factors, and Arbitrage Question 1 ‘Suppose that the discount factor for the frst 180-day coupan periad in Bond ABC is 0.91.What is the price of this bond if it pays $105 six months from today? / A) $95.55, X B) $54.97 X ¢) $115.38 X D) $14.00 Explanation ‘Since $1 to be received in six months is worth $0.91 today, $105 received in six months is worth 0.91 X $106 = $95.55 today. References Question From: Topic Area 4 > Topic 58 > LO 1 Related Material: = Key Concepts by LO Question 2 Which ofthe following statements about zero-coupon bonds is NOT correct? ./ A) A zero coupon bond may sell at a premium to par when interest rates decline, X B) A zero-coupon bond provides a single cash Now at maturity equal tots par value X ©) The lower the price, the greater the retum fora given matuiy X b) Allinterest is eared at maturity Explanation Zero coupon bonds always sell below their par value, or ata discount prior to maturity. The amount of the discount may change as interest rates change, but a zero coupon bond will always be priced less than par. References ‘Question From: Topic Area 4 > Topic 58 > LO 3 Related Mater # Key Concepts by LOQuestion 3 Which of the following statements regarding U.S. Treasury ssues is least accurate? X A) A 5-year Treasury note can be stripped into 11 diferent zero coupon securities. XB) Investment bankere strip the coupone from Treacury notes and bonds to create zero-coupon securities. 1/ &) ine U.S. treasury Issues Zer0 coupon notes, OU: not bonds. X D) Due to the way Treasury STRIPS are taxed, U.S. investors may face negative cash flows before the maturity date. Explanation The Treasury des not issue 7er0-coupan nates or bands. That is why STRIPS were created. A 5-year Treasury ‘note can be stripped into 11 zero coupon securities, consisting of its 10 coupon payments and the principal repayment. The LIS. Intemal Revanuia Service ragards the accrued interast on a 7Ara coupon security as incama ‘on which the security holder must pay taxes even though fe has not received a cash interest payment. References Question Fram: Topic Area 4 > Topic 58> 10 3 Related Material: Key Concepts by LO Question 4 Which of the following is most accurate in relation to P-STRIPS and shorter term C-STRIPS? X A) P-STRIPS: Trade at fair value; C-STRIPS: Trade cheap. X B) P-STRIPS: Trade rch; C-STRIPS: Trade at fair valve. / C) P-STRIPS: Trade a far vale; C-STRIPS Trade rich. X D) P-STRIPS: Trade rich; C-STRIPS: Trade rich. Explanation Principal STRIPS typically trade at fair value. Shorter term coupon STRIPS typically trade rich. Longer term ‘coupon STRIPS tend to vade cheap, References Question From: Topic Area 4 > Topic 58 > LO 3 Related Material: ‘© Key Concepts by LOQuestion 5 When trading Treasury STRIPS, which of the following statement is correct regarding the disadvantages of P-STRIPS and C-STRIPS? X A) Shorter-term C-STRIPS tend to trade cheap. X.B) Longer-term C-STRIPS tend to trade rich. X ) STRIPS are liquid assets ¥ D)P-STRIPS typically rade at fair value. Explanation ‘STRIPS have some disadvantages, which include the following * They can be illiquid * Shorter-term C-STRIPS tend to trada tich * Longer-term C-STRIPS tend to trade cheap. © P-STRIPS typically rade at fair value, References Question From: Topic Area 4 > Topic 58 > LO 3 Related Materia: ‘= Key Conoopts by LOTopic 59: Spot, Forward, and Par Rates Question 6 If 1-year rates are 5 percent, 1-year rates one year from now are expected to be 5.75 percent, and 1-year rates two years from now are expected to be 6.25 percent, then the unbiased expectations theory of interest rates ‘would indicate current 3-year rates should be closest to: X A) 6.37%. / 8) 567% X €) 8.75%. XD) 529% anation ESPERP Fear rates have to equal current 1-year rates compounded by 1-year forward rates. Thus [1+ 1(3)] = (1.05)(1.0575)(1.0625), which generates a current 3-year rate of §.67 percent. References ‘Question From: Tople Area 4 > Topic $9 > LO 4 Related Material: ‘* Key Concepts by LO Question 7 ‘The Treasury spot rate yield curve is closest to which of the following curves? X A) Forward yleld curve rate. / B) Zero-coupon bond yield curve. X €) Reinvestment rate yield curve. X D) Par bond vied curve Explanation ‘The spot rate yield curve shows the appropriate rates for discounting single cash flows occuring at different times In the future. Conceptually, these rates are equivalent to yields on zero-coupon bonds. The par bond yield curve shows the YTMs on coupon bonds by maturity. Forward rates are expected future short-term rates. Reinvestment rates are not part ofthe spot rate yield curve References ‘Question From: Topic Area 4 > Topic 59> LO4Related Material: * Key Concepts by LO Question 8 Risk management: X A) exacerbates the need for a firm to hold a reserve of liquid assets. XB) has no impact on the expected costs of financial cistress, ¥ C) isa substitute for investing eauity capital in liquid assets. XD) has no effect on the need for the firm to hold liquid assets. Explanation ‘A company with liquid assets sufficient to fund all of its positive NPV projects would not be exposed to the underinvestment problem when it encountered cash flow deficits. Alternatively, the company can institute a tisk management program to insure (at some level of statistical significance) that its operating cash flow will not fall below the level needed to fund valuable projects. Thus, risk management can be viewed as a substitute for investing equity capital in liquid assets. Retry Question From: Topic Area 4 > Topic 59 > LO 8 Related Material: ‘= Key Concepts by LO Questions 9-10 Use this table forthe following questions. Marty | srrI@s Price | spot ato | Forward Rate (Years) 05 98.7654 2.50% 2.50% 10 ruse 800% 350% 18 95.2652 3.26% 3.78% 20 93.2775 20% 2% Question 9 ‘The 6-month forward rate in 1.5 years (ending in year 2.0) is closest to:X A) 4.11%. -/ B) 4.26% X ©) 4.57% X 0) 4.04% Explanation First, calculate the spot rate in year 2. 2° [(100198.2775)\1H4)- 1]= 3.51% Next, calculate the forward rate in year 2. (SY 2 tga 120) = 426% References Question From: Topic Area 4 > Topic 59 > LO 4 Related Material: + Key Concepts by LO Question 10 ‘The value of a 1.5-year, 6 percent semiannual coupon, $100 par value bond is closest to: X ayst02.19. X ) $105.6. X ¢) $103.42 / D) $104.00. Explanation __ 103 ERE Question From: Topic Area 4 > Topic 59 > LO bond pric sio4.00 References 4 Related Material: # Key Concepts by LO Question 11Maturity | STRIP Price | Spot Rate | Forward 05 | 987654 | 750% | 2.50% -qn{e2v0a"spothateis closest to 10 | 97.0662 | 3.00% | 3.50% XA) 1,53.87%. 95.2652 3.26% 3.78% XB) 2.0842 93.2775 2.22% 2.270% Xe) 409% o/ D)3.51%. Explanation N= 4; PV = 93.2775; PMT = 0; FV = 100; CPT UY = 1.755%; 2(0.5) = 1.755% X2=9.51%. References ‘Question From: Topic Area 4 > Topic $9 > LO 4 Key Concepts by LO Questions 12-15 Use the following Treasury bond prices to answer the next four questions. Assume the prices are for settlement fon June 4, 2005, today's date. Assume semiannual coupon payments: Coupon | Maturity | Price 7.500% | 12/1/2005 | 102-9 12.375% | 6/1/2006 | 107-15 6.750% | 12/1/2006 | 104-15 5.000% | 6/1/2007 | 102-9 Question 12 ‘The discount factors associated with the bonds maturing in December 2005 and June 2006, are closest to: X A) 0.954610.9606. X B) 0.9696/0,9858. ./ ©) 0.985800.9546. X D) 0.977% Boolean 8/0. 9696.We must calculate the 6-month discount factor first. This is done by dividing today's price by the final payment’s par + coupon (102+3) 75 woos = Ine 1z-montn a'scount ractor g solves the tollowing equation: (12$t8xu soc (w0s!228)a)-rur 438 4-086 Refronces Question From: Topic Area 4 > Topic 59 > LO 4 Related Material: ‘= Key Concepts by LO Question 13 ‘The spot rates associated with the discount factors determined in the previous question are closest to: XA) 1.82%7 56%. XB) 3.26%/5.87% X 0) 2.2576/4.07% YD) 2.88%/4.70% Explanation The easiest way to do this given the discount factors isto use the formula’ a ‘The 6-month spot rate is equal to: 1 (gatg!}-2-2008 Tho 12 mon pt io (osx) References 70% Question From: Topic Area 4 > Topic 59 > LO 4 Related Materi ‘+ Key Concepts by LO Question 14Given the spot rates for the 6-month and 1-year maturing ond, the 6-month forward rate 6 months from ‘ow is closest te X A) 6.04%, X B) 7.28%, X 6) 5.86% o/ D) 6.54%, ‘The key to calculating forward rates is to understand that the longer spot rate has to be equivalent to the product Of the two shorter rates. n this case, an investment in a 1-year rate held over the year has to generate the same cash flow as investing for the first six months and then reinvesting in another 6-month bond. Therefore, the forward rate implied by the annual and the 6-month spot rates is equal to: (0 40 onto) zy a 7) 2 3.27% ‘This value would then be multiplied by 2 to get the 6-month forward rae 6-months from now of 6.54%. References ‘Question From: Topic Area 4 > Topic > LOA Related Material: # Key Concepis by LO Question 15 ‘The yield to maturity (YTM) for the bond maturing June 2007 is closest to: X a) 3.02%. XB) 3.27%, ©) 3.79% X 0) 2.03% eplenetion ‘The YTM is the rate that sets the price of the bond equal tc the present value of the payments. This calculation ‘can be done easily with a financial calculator. For the bond maturing June 2005 (two years from now): PV = -102.30,FV- 100PMT ~26N=491/¥ = 1.897 annual yield = 1.697 x2=3.79% References ‘Question From: Topic Area 4 > Topic 59> LO 4 Related Material:© Key Concepis by LO Question 16 ‘Assume the one-year spot rate is 4 percent, the two-year spot rate is 4.5 percent, and the three-year spot rate is 5 percent. Which of the following statements is TRUE? YA) The two-year rate that will exist one year from today is 6.5 percent. XB) The one-year rate that will exist one year from today is 5.5 percent, X.€) The rate that an investor can earn on a sum invested today for the next three years is 55 percent. XD) The one-year rate that will exist two years from today is 5 percent. Explanation Itmight be best to draw a set of timelines for this problem, ‘The one-year rate that will exist one year from today is: (1,045) (1.04) 1 = 0.08, or 5%. Tpg.gne-year rate that ul exist wo years from today is (TES) P685}"4 $0.06, oF 6 The 20-year rate that wll exist one year rom today i: (105) 1204) = (4.713) = 1.055" 1= 0.055, oF 5.5%. Note that the rate that an investor could earn on a sum invested today for the next three years would be equal to the three-year spot rate of 5%, References Question Fror fopic Area 4 > Topic 59 > LO 4 Related Material: ‘* Key Concepts by LO Question 17 Which of the following statements conceming a forward rate is FALSE? A forward rate is:X A) the interest rate that makes an investor indifferent to investing over a long time period or investing over two or more shorter time penods. X B) the market's best guess as to an interest rate that will exist in the future. X ©) an interest rate tnat can be locked in for some future time period. / D) the rate of interest an investor would eam from now until some point in the future, Explanation ‘The rate of interest an investor could invest at today until some point in the future is the spot rate. The other three statements correctly identity the three possible interpretations ofa forward rate. A forward rate can be interpreted as ‘a break even rate, a locked-in rate for some future period, or an expectation of future spot interest rates. References Question From: lopic Area 4 > Jopic bY > LO 4 Related Material: Key Concepts by LO Question 18 If he five-year spot rae is 6.1 percent and the four-year spot rate is 5:9 percent, what isthe only rate that can be computed? / 8) The one-year fovard rate starting fur years romtoday is 6.9% X B) The foursyear forward rat starting one year from day is 74% X C) The one-year forward rate starting four years from taday is 7.4%. X D) The four-year forward rate starting one year from today is 6.9%. Explanation Using the current five-year spot rate and the current four-year spot rate, we can derive the one-year forward rate starting four years from today. The formula is: (1,081) /(1.059) - 089, or 6.9 percent References Question From: Topic Area 4 > Topic 59 > LO 4 Related Mater Key Concepts by LO Questions 19-21 Use the Treasury bond prices given below for the folowing four problems. Assume the prices are for velllemenl on June 1, 2005, today's dale. Assure semiannual Coupon payrnentsCoupon | Maturity Price 6.00% | 12/1/2005 | 99-15 7.00% | 6/1/2006 | 98-27+ 8.00% | 12/1/2006 | 101-29 9.00% | s//z007 | 102-9 Question 19 The discount factors associated with the bonds maturing in December 2005 and June 2006, respectively, are closest to: X A) 0.9458; 0.9013. / B) 0.9657; 0.9228. X €) 0.9319; 0.8760, X p) 0.9587; 0.9187 Explanation We must calculate the discount factor for the December bond first. This is done by dividing today's price by the final payment's par + coupon: (98+ 15132)/(100 + 6/2) = 0.9657. The 12-month discount factor d solves the following equation: [(7/2\(0.9657)]+ [(100+7/2Ka 2) |= 96+(27.5152y; d 2=0.9228. References Question From: Topic Area 4 > Topic 59 > LO 4 Related Mater © Key Concepts by LO Question 20 ‘Te spot ates associated wih tne alscount factors of he previous problem are aosest‘o X A) 5.48%; 6.70%, / 8) 7.10%; 8.23% X €) 6.26%; 7.05%. X 0) 487%: 6.20% Exclenaton ‘The easiest way to do this given the discount factors isto use the formula ool(gwhere z(t) is the spot rate associated with the discount factors d(). The first spot rate, which pertains to the bond maturing in December 2003, is equal to (1/0.9657 - 1) X 2 = 7.10%. The second spot rate, which pertains to the payment being made in June 2004, is equal to ((1/0.9225) - 1) X2= 8.23%. References Question From: Topic Area 4 > Topic 59 > LO 4 Related Materi # Key Concepts by LO Question 21 Given the spot rates forthe 6-month and 1-year maturing bond, the forward rate inherent in those figures is lass te X A) 4.68% X B) 5.74%, JC) 9.37%. X Dy 6.96%. Explanation The key to calculating forward rates is to understand thatthe longer spot rate has to be equivalent to the product of the two shorter rates. In this case, an investment ina 1-year rate held over the year has to generate the same cash flow as investing for the firs six months and then reinvesting in another 6-month bond. Therefore, the forward rate Implied by the annual and the 6-month spot rate is equal to (ogy (HoH) =4.6831% 4.6831 x 2 = 9.37% annualized return References Question From: Topic Area 4 > Topic 59 > LO 4 Related Material # Key Concepts by LO Question 22 Ifthe one-year spot rate is 7 percent and the one-year forwerd rate is 7.4 percent, what is the two-year spot rate? J Ay720% X B) 7.12%,XC) 7.27%. X D) 7.40%. Explanation "TAB RB=¥ear spot rat: ((1+0.07)(140.074) - 1 = 0.072, or 7.2 percent. References Question From: Topic Area 4 > Topic 59 > LO 4 Related Mat # Key Concepts by LOTopic 60: Returns, Spreads and Yields Question 23, AA 3.year, 8 percent semiannual coupon bond with $100 par value currently yields 8.50 percent. What would be the price ofthe bond? X A) $119.50. X B) $99.24 C) $98.70. X b) $95.49. Explanation Wwe 50/2 = 4.25; FV = 100; = 32-6; (0812 x 100 = 4; PV =-98.70, References Guuvstion From: Tope Ate 4 > Top 00 LO Related Material: ‘© Key Concepts by LO Question 24 ‘Aero coupon bond witha face value of $1,000 has a price of $148, It atures in 20 years, Assuming annual compounding periods, the yield to maturity ofthe bonds: X A) 11.24%. X B) 9.68%. -/ ©) 10.02%, X b) 14.80%. Explanation Pv=-148; 20; F\ ,000; PMT = 0; CPT —+ References Question From: Topic Area 4 > Topic 60> LO 4 Related Material: # Key Concepts by LOQuestion 25 ‘What is the semiannual-pay bond equivalent yield on an anrual-pay bond with a yield to maturity of 12.51 percent? fA) 12.18%, X B) 12.00%. X c) 12.51%. X D) 11.49%. Explanation ‘The semiannual-pay bond equivalent yield of an annual-pay bond pay bond) - 1]= 12.14%, *1(1 + yield to maturity on the annual References Question From: Topic Area 4 > Topic 60 > LO 5 Related Material «Key Concepts by LO Question 26 ‘The price of a semiannual pay, $1,000 face value bond with an 8 percent coupon rate with 10 years to maturity that currently yields 6.25 percent is closest to: X A) $1,179.40, X B) $1,000.00, of ©) $1,128.69. X dy $1,092.38. Explanation N= 20, UY - 3.125, PMT ~ 40, FV - 1,000, CPT > PV - $1,128.69, References ‘Question From: Topic Area 4 > Topic 60> LOS Related Material: # Key Concepts by LO Question 27 ‘A bond with 2 12% coupon, 10 years to maturity and selling at 88 has a yield to maturity of:X A) between 13% and 14%. X B) between 12% and 13%. 1 @) over 14% X b)betwoen 10% and 12% Explanation PMT = 120; N= 10; PV =-880; FI 4000; OPT —+1= 14:3 References Question From: Topic Area 4 > Topic 60> LO Related Material © Key Concepts by LO Question 28 1A 20- yar, 8 parent ania coupon hand saling for $1,008 98 fers ald i X A) 10%. X B) 11%. Je) 5% X dy 9%, Explanation N ), PMT = 90, PV = -1,098,96, FV = 1,000, CPT UY eterences Question From: Topic Area 4 > Topic 60 > LO 4 Related Material ‘+ Key Concepts by LO Question 29 ‘An Investor holds a 20-year, semi-annual 8.00 percent coupon Treasury bond Issued at par, Market interest rates are currently at 6.50 percent. The bond is noncallable. A coupon payment is due this week. Which of the following ‘choices best represents the type of risk the investor faces? XA) Prepayment risk / B) Reinvestment risk. X ©) Great nk.X D) Liquidity risk. Explanation Reinvestment risks the risk that if rates fall, cash flows willbe reinvested at lower rates, resulting in a holding return lower than that expected at purchase, Here, the investor wil ikely have to reinvest the coupon at the lower market interest rate, negatively impacting his holding period return Prepayment isk (and call isk) is the risk thatthe issuer will rapay principal prior to maturity. Prepayments are most likely in a dectining interest rate environment because itis cheaper to issue replacement debt. Here, the bond is a ‘Treasury and is noncallable, so the investor can eliminate prepayment risk by holding the bond until maturity. Liquicity risk addresses how quickly and easily an investor can sell a bond. A bond that trades thinly or in small amounts ‘exposes an investor to liquidity risk. Liquidity risk is not a conzern with Treasury bonds. Credit risk is the risk that the issuer will be unable to make coupon or principal payments es scheduled. Any change in the timing ofthe receipt of ‘cash flows affects the bond's holding period return. Credit risk is not a concern with Treasury securities. References Question From: Topic Area 4 > Topic 60 > LO 1 Related Material: © Key Concepis by LO Question 30 When planning to hold a coupon-paying Treasury bond unil maturity, which of the following types of risk would bbe the most important? ¥ A) Reinvestment. X B) Downgrade. X ©) Interest rate. x b) Deraur. txolanavon Since it is a Treasury bond, downgrade and default risk are not relevant. Interest rate risk is not important because the investor plans to hold the bond until mattrity. Reinvestment risk is the most important. The investor will have to worry about the rates at which he/she willbe able to reinvest the coupons over the life of the bond and the principal upon maturity References Question From: Topic Area 4 > Topic 60 > LO 1 Related Material: ‘= Key Concepts by LOQuestion 31 ‘An investment pays $75 annually into perpetuity and yields 5%. Which ofthe following is closest to the price? X a) $750, X B) $1,000 J ¢) $1,500 X b) $375. Explanation PV = Ci = $75/0.05 References Question From: Topic Area 4 > Topic 60 > LOS Related Material: ‘= Key Concepts by LO Question 32 Which of the following statements concerning the yield-tc-maturity on a bond is CORRECT? Yield to maturity (TM) is: XA) below the ourrent yield minus capital gain when the bond sells at a discount, and above the current yield plus capital loss when the bond sells ata premium. ./ B) the discount rate that will set the present valuc of the payments equal to the bond price. X C) always larger than current yield of the bond. X D) based on the assumption that any payments received are reinvested at the current yield, Explanation When a bond is selling at a premium, the current yield will 9 larger than the YTM. Reinvestments occur at the YTM. The YTM will ind the present value of a future value and associated payments. References Qu jon From: Topic Arca 4 > Topic 60 > LO 4 Related Mat Key Concepts by LOQuestion 33 ‘What is the yield to maturity (YTM) of a 20-year, U.S. zero-coupon bond selling for $300? X A) 3.06%, X B) 7.20%, JC) 6.11%. X D) 5.90%, Explanation N= 40; PV = 200; FV = 1,000; CPT 1 = 3.055 « =61t References (Question From: Topic Area 4 > Topic 60> LO4 Rolated Material: ‘= Key Concepts by LO Question 34 Which ofthe following statements relating to reinvestment risk for bonds is TRUE? X A) Long-term bonds should be purchased if the investor anticipates higher reinvestment rates. X 8) unless tne renvestment rate equals he yield to maturty, the noktng period retumn wil Be less than the ye to maturity X €) the investor anticipates ower reinvestment rates, high coupon bonds shouldbe purchased JD) Zero coupon bonds have no reinvestment risk over ther term. Explanation ‘This statement i true only ifthe investor holds the bond until maturity. Reinvestment rsk means that a bond investor risks hhaving to reinvest bond cash lows (both coupon and principal) at arate lower than the promised yield. Reinvestment risk Increases with longer maturities and higher coupons, and decreases for shorter matures and lower coupons. While a bond investor can eliminate price risk by holding @ bond until maturity, ne usually cannot eliminate bond reinvestment risk. One ‘exception is zero-coupon bonds, since these bonds deliver payments in one lump sum at maturity. There are no payments ‘over the life to reinvest ‘The statement, "Long term bonde chould be purchased if the investor anticipates higher reinvestment rates,” should read, "Short-term bonds... an investor expects interest rates to rise, e would want a bond with a shorter maturity so that he recelved his cash flows sooner and could reinvest atthe higher sate Also, ther I less prepayment risk with shorter maturities ‘The statement," an investor anticipates lower reinvestment rates, high coupon bonds should be purchased,” should read, "Jaw coupon bonds should be purchased..." Again, if an investor expects interest rates to fall, he would want a lower-‘coupon bond so that he could reinvest the payments and still maintain his expected YTM. ‘The statement that begins, “Unless the reinvestment rat...” is partially true. However, the holding period return (covered in a later LOS) could be less or greater than the orginal yield to maturty (YTM), Over the investors holding period, interest rates 4are likely to fluctuate both up and down; at some points the invesior will reinvest ata higher rate than the original YTM and ‘sometimes he will invest at a lower rat, References Question From: Topic Area 4 > Topic 60 > LO 1 Related Material: ** Key Concepts by LO Question 35 Which of the following statements about reinvestment risk s least accurate? X A) Reinvestment risk is greater for amortizing secures. XB) A bond!’ yield calculation assumes that coupon cash flows and principal can be reinvested at the computed yield to maturity, ©) Abond investor can eliminate reinvestment risk by holding a coupon bond until maturty. X D) An investor concerned about reinvestment risk is most concerned with a decrease in interest rates. Explanation ‘The key word here is coupon bond. While an investor in a ixed-coupon bond can usually eliminate price risk by holding a bond until maturity, the same is not true for reinvestment risk. The receipt of periodic coupons exposes the investor to the risk that he will have to invest the coupons at a lower rate, thus negatively impacting his holding period return. An investor can greatly decrease reinvestment risk by holding a zero-coupon, noncallable bond that is nat subject to other prepayments (or embedded options). Zera-coupan bonds deliver all cash flows in one lump sum at maturity ‘The other statements about bond yield calculations and reinvestment risks are correct. References ‘Question From: Topic Area 4 > Topic 60> LO 1 Related Material + Key Concepts by LO Question 36 ‘The risk that an investor will eam less than the quoted yiel¢-to-maturity on a fixed-coupon bond due to a decrease ininterest rates is known as: X A) prepayment risk. X B) event risk. J ©) reinvestment risk. X D) liquidity riek. elenaton Reinvestment risk is the risk that if rates fall, cash flows will 9¢ reinvested at lower rates, resulting in a holding return lower than that expected at purchase. Prepayment risk (and call risk) is the risk that the issuer wll ay principal prior to maturity. Prepayments are most likely to occur in a decining interest rate environment because it is cheaper to issue replacement debt. Liquilty risk addresses how quickly and easily an investor can sell a bond. A bond that trades thinly or in small amounts exposes an investor to liquidity risk. Event risk means that the issuer could face a single event or circumstance that would affect its ability to servicelrepay the debt. For example, a corporation could suffer an industrial accident. References Question From: Topic Area 4 > Topic 60 > LO 1 Related Material: # Key Concepts by LO Question 37 A 16-year, 11 percent semiannual coupon bond with $100 par value currenily yields 6 percent, Compute the price of the bond. X a) $95.91 of B) $126.81 X c) $129.50. X p) $109.54, Explanation Wy =a 4aev (6x2 = 92; PMT = 0.1112 x 100 5.50; PV 26.81 References Question From: Topic Area 4 > Topic 60> LOS Rolated Material # Key Concepts by LOQuestion 38 Consider four bonds that are similar in all features except those shown. The bond with the greatest reinvestment Fisk is: ¥ A) 15% coupon. callable. X B) 15% coupon, non-callable. X (©) 9% coupon, non-calable. x ) 5% coupon, callable. Explanation Reinvestment risk is higher for high-coupon, long maturity bonds. In addition, callable bonds have more reinvestment risk than noncallable bonds, References Question From: Topic Area 4 > Topic 60 > LO 1 Related Materi ‘= Key Concepts by LOTopic 61: One-Factor Risk Metrics and Hedges Question 39 ‘The price value ofa basis point (PVBP) for a 7-year, 10 percent semiannual pay bond with a par value of $1,000 and yield of 6 porcent is closest to X A) $0.92 XB) $0.00. v ¢) $0.64. X D) $0.28. Explanation VBP = intial price - price if yield changed by 1 bps. Inia price: Price wth change: FV= 1000, FV= 1000 PMT = 50 4 W=3% vy =3.005 cPrpv= 1225.92 cpr pv= 1225.28 PVBP = 1.22592 1,725.28 = 064 PVBP is always the absolute value References Quastion From: Topic Ara 4 > Topic 61> 10, 2 Related Mater += Key Concepts by LO Question 40 ‘Can a fixed income securty have a negative convexity? X A) Yes, but only wnen tne price yield curve Is tnear. vB) Yes. XC) No, XD) Need more information to answer questionBaplanation ‘Yes, fixed income securities can have a negative security. The ony type of fixed income security with a negative convexity wil be callable bonds. References Question From: Topic Area 4 > Topic 61 > LO 2 Related Matori ‘* Key Concepts by LO Question 41 How does the convexity of a bond influence the yield on the bond? Al else the same, for @ bond with high convexity investors will require: X A) a higher yiets X B) the same yield as fora low convexity bond. X C) a higher or lower yield depending on the bond's duration. ./ D) a lower yield. Explanation ‘Convexity isto the advantage ofthe bond holder because a high-convexity bond's price will decrease less when rates inerease and wil increase more when rates decrease than a lan-convexity bands pric References Question From: Topic Area 4 > Topic 61 > LO 6 Related Mater += Key Concapte by LO Question 42 ‘The price value of a basis point for a 7% coupon, semiannual pay, 10-year bond with a $1,000 par value, ‘currently trading at par, is closest to ofA) 50.71 X B) $99.55 X ¢) se7.10 X D) $1.42. Eacenation‘The price value of a basis point is the price given a 1 basis point change in the discount rato. N = 20; PMT = 35; FV = 1,000; IV = 7.01/2 = 3.505; CPT — PV = 999.20 $1,000 - $999.29 = $0.71 References Question From: Topic Area 4 > Topic 61 > LO 2 Related Mater ‘© Key Concepts by LO Question 43 Suppose you have a three-securty portfolio containing bonds A, B and C. The effective portfolio duration is 6.9, ‘The market values of bonds A, B and C are $60, $25 and $80, respectively. The durations of bonds A and C are 4.2 and 6.2, respectively. Which ofthe following amounts is closest to the duration of bond B? 1A) 9.0. X B74. Xey74 X py 14. Explanation Plug all he known figures and then solve for the one unknown figure, the duration of bond B, Proof (60/165 x 4.2) + (25/165 x 9.0) + (80/165 * 62)=59 Roteren ‘Question From: Topic Area 4 > Topic 61 > LO7 Related Material: ‘= Key Concepts by LO Question 44 How does tne price-yield relationship fr a putable bond compare to the same relationship for an option-ree bond? The price- Yield relationship is: X A) more convex for a putable bond than for an option-fee bond, X B) concave for ai oplion-iew bond and conver for a pute bun X €) the same for both bond types. / D) moce convex at some yes fo the putable bon thar forthe opton-re bond ‘Explanation‘Since the holder of a putable has an incentive to exercise his put option i yields are high and the bond price is depressed, this pis a Ine limit an the prion af the hand whan inacastvates ara high Tha ine limit intindices a highar eanvexiy of the putable bond compared to an option-ree bond when yields are high References Question From: Topic Area 4 > Topic 61 > LO 8 Related Materi Key Concepts by LO Question 45 .Jayoe Amdld, a CFA candidate, is studying how the market yeld environment affects bond prices. She considers a $1,000 face value, option-ree bond issued at par. Which of he following statements about the bond's doliar price behavior is most likely accurate when yields rise and fall by 2C0 basis points, respectively? Price will X A) incsease by $124, price wil becouse by $148. X_ B) increase by $149, price will decrease by $124. X ©) decrease by $149, price will increase by $124 ./ D) decrease by $124, price will increase by $149, Exolanation ‘As yields incvease, 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 nse (for the same basis point change). Remember that this applies to percentage changes as well References Question From: Topic Area 4 > Topic 61 > LO 8 Related Material: # Key Concepts by LO Question 46 “Amajor problem wth tha use of duration in intrest rata sk management is that it assumes: X A) differential sensitivity of assets and liabilities to changes in interest rates. {J B) only a single change in interest rates over the planing horizon. X Ca nonlinear relationship between prices and rates. X D) an inverse relationship between prices and rates.Explanation Duration assumes only a single and parallel shift in interes: rates over the interest rate management planning horizon, References Question From: Topic Area 4 > Topic 61 > LO 4 Related Mater: ‘= Key Concepts by LO Question 47 When compared to modified duration, effective duration: X A)is equal to modified duration for callable bonds b.t not putable bonds. ./ B) factors in how embedded options will change expected cash flows. X ) places less weight on recent changes in the bond's ratings, X b) places more weight on revant changes in the bond's ratings Enviar ‘The point of effective duration is to consider expected changes in cash flow from features such as ‘embedded options. References Question From: Topic Area 4 > Topic 61 > LO 4 Related Mater ‘© Key Concepts by LO Question 48 \Which of tne following bonds bears the greatest price impact if ts yield dectines by one percent? A bond with: ./ 8) 30-year maturity and selina at 70 X B) 30-year maturity and selling at 100. X €) 10-year maturity and seting at 70. X b) 10-year maturity and seling at 100, Explanation There are three features that determine the magnitude of duration: (1) The lower the coupon, the greater the bond price volatity(2) The longer the term to maturity, the greater the price volatility (3) The lower the intial yield, the greater the price volatility. ‘The bond with the 30-year maturity will have a greater price impact than the 10-year maturity. The bond selling at the ‘greatest discount will have a large price impact, a discount means that the coupon payments are low or the initial yield is low. So, the bond with the 30-year maturity and selling at 70 will have the greatest price volatilty, References Question From: Topic Area 4 > Topic 61 > LO Related Material: ‘© Key Concepts by LO Question 49 Which ofthe following statements about duration is FALSE? X A) Price volatity has a direct relationship with interest rate risk 18) Effective duration is the exact change in price dia to a 100 basis point change in rates X_¢) Fora specie bond, the effective duration formula results in a value of 8.80%, For a 60 basis point changa in yal, the approximate change in price ofthe bond would ba 4.40%, X D) The numerator of the effective duration formula assumes that market rates increase ‘and decrease by the same number of basis polrts. Explanation Effective duration is an approximation because the duration calculation ignores the curvature in the pricelyield graph. References ‘Question From: Topic Area 4 > Topic 61 > LO 4 Related Material + Key Concepts by LO Question 50 ‘Abond pontlio consists of a AAA bond, a AA bond, and an A bond. The prices ofthe bonds are $1,050, $1,000, ‘and $950 respectively. The durations are 8, 6, and 4 respectvely. What isthe duration of the pontolio? X a) 1890 X B) 6.67, se) 6.00, X D) 6.00.Explanation ‘The duration of a bond portfolio isthe weighted average of the durations of the bonds in the portfolio, The weights (1050'3000)+6 (1000/3000)+4" are the value of each bond divided by the value of the portfoo: portfolio duration (950/300) = 2.8+2+1.27 = 6.07. References Question From: Topic Area 4 > Topic 61 > LO 7 Related Mater ‘= Key Concepts by LO Question 51 ‘A.10-year, 11 percent annual coupon bond with $100 par value currently yiolds 0 percent. What is the duration of. the bond given a 50 basis point change in yield? X A) 4.80 years. YB) 6.19 years. X €)7.27 years, XD) 0.95 years, Explanation Wy = 9.00; FV 0; PMT = 0.11 x 100= 11; PVE V = 112.84 10; PMT = 0.11 x 100 = 11; PV=V= 116.40 FV = 100; N= 10; PMT = 0.11 x 100 = 11, PV=V = 109.42 = ettective curation = (V = V J (4¥ (Ay) 116.40 - 109.42)/2x1 12.84x0.005) =6.19 References Question From: Topic Area 4 > Topic 61 > LO 4 Related Material: ++ Key Concepts by LO Questions 52-54 June Klein, CFA, manages a $200 milion (market value) U.S. government bond portfolio fora large institution. Klein anticipates a small, parallel shift inthe yield curve of 10 basis pois and wants to fully hedge the portfolio against any such change. Klein would ike 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 ‘Valve of Ponttoio: | $100,000,000 Duration of Proto: | 8.88438 Mar-00 Futures 94.15625 Settlement Date: 0217/00 Final Delivery Date: | 03/31/00 Fist Dalvery Date: | 03/01/00 Klein is not as comfortable with the T-bond futures contract as she would lke to be. Consequently, she decides to familiarize herself with the characteristics ofthe futures contract and its asseciated delivery process. She collects ll ofthe 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 @ basis point (PVBP) are per $1 milion par value. Table 2: Treasury Bonds Deliverable for T-Bond Futures Contract Maturity or | Price | Accrued PVBP $ per Conversion | Cost of Coe st call date| (at) | interest |"? | mon par |" | factor | detvery ro,000% | rtsits | 133202 | 2.5828 | 634% | 12112204 1.759 | 23.0331 ‘ein's broker supplies the characteristics ofthe Treasury bond that is curently the cheapest-o-deliver bond. These are shown in Table 3. Table 3: Cheapest-to-Deliver Treasury Bond Matury or meee) pace | Accrved VBP $ po Conversion] Cost of ou st cal ray uration cope nay | interest | Y™*T | mutton par | "2" | tector | aotvery rozs0% | weir | rosao7s | oaar | ercom | rvsooo| 7.00420 | 14000 | +0502 Question 52 ‘Kein wants to compute the interest rate sensitvty of the highlighted bond in Table 2. She assumes that the yield increases by ‘one basis point. How much, per $1 milion par positon, will the velue ofthis bond change (tothe nearest dollar)? XA) $12. XB) $121,123, X €) $121,128. ¥ py-st.2it Explanation “This is tho price valu ofa bass point (PVBP) per one milion dolar paras shown in Table 2. References Question From: Topic Area 4 > Topic 61 > LO2Related Material: * Key Concepts by LO Question 53 Using tne information in Table 2, Kien would tke 10 compute the duration ofthe highighted bond. Which Is the closest to Klein's answer? ¥ A) 8.88. X B) 10.64 X €) 9.06, XD) 12.11 Explanation VBP = (0.0001) x D (price + acerued interest) x 10,000 Note: The 10,000is to convert the price to $1,000,000 par to mach the PVBP units. Rearcanging, 2 = PRP + (prion + inves!) = Aa 211984 + (199.75 + 5824) = : Topic Area 4 > Topic 61 > LO 2 Related Materia: + Koy Concopte by LO Question 54 Ksn wou kato quantity the annreximatevalin lass of hee parflin fram an inernas in yn nacarting to ar ‘expectations. Using the information in Table 1 which ofthe folowing isthe closest to Klein's answer? X A) $1,211,228. ¥ 8) $086,438. X ¢) $8,884. x b) $8,864 ‘Change in portfolio value = -0.001 x duration x portfolio value. Cxange in portfolio value ~$888,438. 0.001 x 8.88438 * $100,000,000 References ‘Question Fror fopio Area 4 > Topic 61> LO 2 Related Materia: ‘+ Key Concepts by LOQuestion 55 Which ofthe folowing statements regarding duration is FALSE? X A) Duration of a portfolio of bonds is equal o the market velue weighted average ofthe duration of individual bonds in the portfolio, YB) Duration is untiess. 1X G) Luration is a measure oF percentage change in price tora gwen change in rea. X D) Other things equal, duration of a coupon bond is higher when the bond's YTM is lower. Explanation Duration is a measure of percentage change in price fora given change in yield. Holding all else constant, the duration of 2 ‘coupon bond is higher when the bond's YTM is lower. Portfolio duration can be computed as simply markel-value weighted durations of individual bonds in the portfolio. References ‘Question From: Topic Area 4 > Topic 61 > LO4 Related Material: ‘+ Key Concepts by LO Question 56 For a 20-year, $1,000 par value, 6 percent coupan T-bond yieldrg § percent, the dollar value of a basis point (OVO1) and associated percentage price change (PPC) are closest to X A) $0.57 and 0.06%. X B) $2.49 and 0.20%. X €) $0.14 and 0.01%. ¥ 0)$1.37 and 0.12%. PRIT~60V2: FV-1000; CPT .PV~1,126.61-Voh-20¥2; Wy=4.9912; PMT=6012; FV=1000; CPT-»PV=1,126.88=V- DVOt=1,126.86-4,125.51-81.37. PPC=DVOIN =1.371,125.51-00012 References ‘Question From ‘opic Area 4 > Topic 61 > LO 2 Related Materia: + Key Concepts by LOQuestion 57 Negative convexity fo a callable bond is mast likely to be important when the: XA) bond is fist issued. X.B) S&P or Moody/s rating on the bond falls. X C) market interest rate rises above the bond's coupon rate ¥ D) price ofthe bond approaches the call price. Explanation Negative convexity illustrates how the relationship between the pice ofa bond and market yields changes as the bond price ‘ises and approaches the cal price. The convex curve that we genarally eee for non-callabla honds bends hackward ta become concave (Le., exhibit negative convexity) as the bond approaches the call price. References ‘Question From: Topic Area 4 > Topic 61 > LO ‘+ Key Concepts by LO Question 58 ‘The goal of computing effective duration is to get X A) preliminary estimate of Macaulay duration, X B) preliminary estimate of modified duration. X C) measure of duration tha is effectively constant forthe life ofthe bond. ¥ D) more accurate measure ofthe bond's price sensitivity when embedded options exist Explanation ‘The point of effective duration is to consider expected changes in cashflow from features such as embedded options. When embedded options exist, the effective duration will give a better measure ofthe bond's price sensitivity to interest rate changes. ‘Question From: Topic Area 4 > Topic 61 > LO 4 Related Materia: ‘+ Key Concepts by LO Question 59 Which ofthe following siatements eyarding Lorvexly, barbell puttovs, in bullet purty is feast acuta?|. The convexity of shorter-term coupon bonds is generally greater than the convexity of longer-term coupon bonds. |. A barbell strategy wil tnd to have greater convenity than a bullet strategy. |i.Bullet and barbell strategies may have the same duration. X A) Ill only XB) Hand I X €) Nand Il ¥ D) only. Explanation “The convexity of shorter torm coupon bonds ie generally logs thar the convexity oflongor term bende, That is beeause convexity increases withthe square of matury. ‘A arbell strategy is where a manager uses bonds with short and long maturities—forgoing any intermediate-term bonds. A bullet strategy is when managers buy bonds concentrated in the intermediate maturity range. Therefore, the barbell wll tend to have the greater convexity due tothe exponential (squared) influence ofthe longer-term bonds. ‘Since auration is near related to maturty, tis possible fo @bulet and a barbell stategy o have the same duration References ‘Question From: Topic Area 4> Topic 61> LOS Related Materia: ‘* Key Concepts By LU Question 60 ‘Suppose you have a two-securty portfolio containing bonds A ard B. The book value of bond As $20 and the market value is '$35, The book value of bond B is $40 and the markel value is $50. The duration of bond A is 4.7 and the duration of bond B is 15.9. Which ofthe folowing amounts is closest to the duration ofthe portflio? X A) 5.6, vB) 5.4 XC) 5.5, X D) 5.3. Explanation ‘Market values (not book values) should be used to calculate effective portfolio duration. (95185 « 4.7) + (60185 * 5.9) At References ‘Question From: Topic Area 4 > Topic 61 > LO 7 Related Materia'* Key Concepts by LO Question 61 Duration of a bond can be defined as the: M.A) weighted: average maturity af a band portfolio. ¥_B) sensitivity of the value of the bond to a change n interest rates. XC) ‘sensitivity of the value of the bond to a change in maturity. X B) sensitwity Of the value of the bond to a change in the value of market portfolio, Explanation Duration is the fist derivative of price with respect to yield and hence measures the sensitivity of the value ofthe bond to a ‘change in interest rates. Weighted average maturity does not taka info account cash flows or yield. Sensitivity ofthe value of ‘an asset to change in maturity isnot defined; and sensitivity ofthe value of an asset to change in the value of the market portolio is defined as beta. References ‘Question From: Topic Area 4 > Topic 61 > LO 4 Related Materia: ++ Key Concepts by LO Question 62 ‘A 12.year, § percent semiannual coupon bond with $100 par valve currently yelds 8.00 percent. What isthe duration ofthe ‘bond given a 100 basis point increase and decrease in yield? X A) 12.98. ¥ B) 6.36 X ¢) 16.78. X D) 7.80, Explanation VY = 82-4; FV = 100; N= 24; PMT = 0.05/2 x 100 = 2,50; PV = Y= 77.13 VY ~ 7/2-3.50; FV = 100; N= 24; PMT = 0.05/2 x 100 ~ 2.50; PV = V ~ 83.94 VY = 9/2=4,50; FV = 100; N = 24; PMT = 0.05/2 x 100 = 2.50; PV = effective durati w-yavay = (83.94-71)/(2x77.13x0.01) 38 yearsReferences ‘Question From: Iopic Area 4 > lopic b1 > LO 4 Related Materia: ‘+ Key Concepts by LO Question 63 Immunization is the process of offsetting the effec of interest-rate changes on the value of assets and lables. Coverage of labilties with significant convexity may be more effectively matcted with a X A) mortgage portfolio, especially in a highly volatile rate environment. ¥ B) barbell portfolio with positive convexity. X ¢) bullet portfolio with little convexity. X D) callable bond portfolio, especially in a declining-rate environment. Explanation Barbell portfolios usually contain substantial convexity, which car be used to offset changes in lablties not met with duration matches, References ‘Question From: Topic Area 4 > Topic 61 > LO © Related Materia *# Key Concepts by LO Question 64 ‘A bond with an 8% semi-annual coupon and 10-year maturity is currently priced at $904.52 to yield 9.5%. If the yeld dectines 0.9%, the bond's price wll increase to $894.90, and ifthe yield increases to 10%, the bond's price wll decrease to $075.90. Estimate the percentage price change for a 100 basis point change in rates. X A) 2.19%. XB) 435% X ¢) 8.41%. v 0) 6.58% Explanation The formula forthe percentage price chande is: (price when veld fall - rice when yields rise) 2 x (intial price) x 0,008 ($934.96 - 875.38) / 2(8004.52)(0.008) = $59.58 / $9.05 = 6.58%. Note that this formula is also referred to as the bond's cffective duration,References ‘Question From: Iopic Area 4 > lopic b1 > LO 4 Related Materia: ‘+ Key Concepis by LO Question 65 Which othe flowing statements best describes the concept of negative convexity in bond prices? As interest rates XA) fall, the bonds price incraases at an increasing rate. X B) rise, the bond's price approaches a minimum value ¥ © fal the bones price increases ata decreasing rte, X ) Fico, tho bonete price docraacos at a decroacing rat Explanation Nogative convexity occurs with bonds that have prepaymentcallfeatures. As interest rates fall, the borrowerissuer is more likely to repaylcall the bond, which causes the bond's price to approach a maximum. As such, the bond's price increases at a decreasing rate as interest rates decrease, References ‘Question From: Topic Area 4 > Topic 61 > LO 8 Related Material *# Key Concepts by LO Question 66 "Negative convexily is most ely to be observed in X A) municipal bonds. ¥ 8) callable bonds. x ) zero coupon bonds. X D) treasury bonds. Explanation {All noncallable bonds exhibit the trait of being positively convex and callable bonds have a negative convexiy. Callable bonds have a negative convexity because once the yield falls below a certain point, as yields fall, prices will rise at a decreasing rate, thus giving the curve a negative convex shape, FferenoosQuestion From: Topic Area 4 > Topic 61 > LO 8 Related Materia: + Key Concepts by LO Question 67 ‘When calculating duration, which ofthe folowing bonds would ar investor least ikely use effective duration on rather than modified duration? ¥ A) Option-ree bond X B) Convertible bond X)Caltable bond. X ) Putable bona Explanation “The duration computation remains the same, The only ference between modified and effective duration i that effective uration fe ued fr bonde wth embedded optone. Modified duration aceumce that al the cach lowe onthe band wil not change, while effective duration considers expected cash flow changes that may occur with embedded options References ‘Question From: Topic Avea 4 > Topie 61 > LO 4 Related Materia: *# Key Concepts by LO Question 68 Evaluated at the same yield, the investment thats expected to have the greatest convexity is @ X A) 6% coupon bond of 10-year duration. X 8) 10-year zero-coupon bond ©) portfolio with a duration of 10 that contains a 6-year zero-coupon bond and a 15-year zer0- ‘coupon bond. XD) callable 6% coupon bond of 10-year duration Explanation [A barbell porttolo wil nave greater convexity than a bullet portolo, 50 convexty of the barbell portolo is greater than the cconvexty ofthe 10-year zero-coupon bond. In general, the highe the coupon, the lower the convexity, so convexiy ofthe 10 year zero-coupon bond is greater than the convexity ofthe 6% ccupon bond of 10-year duration and the callable 6% coupon ‘bond of 10-year duration.References ‘Question From: Iopic Area 4 > lopic b1 > LO 9 Related Materia: ‘+ Key Concepts by LO Question 69 Which ofthe following statements about portfolio duration is FALSE? Is XA) measured using market prices ofthe bonds. XB) the weighted average of the duration estimates of the secures in the portfolio. ©) a simple average of the duration estimates ofthe secures in the portfolio. XD) a moacure of intorst rato rok. Explanation Portfolio duration uses a weighted average figure, not a simple average. References ‘Question From: Topic Area 4 > Topic 61 > LOT Related Material: '* Key Concepts by LO Question 70 ‘Consider two bonds, A and B. Bath bonds are presently selling ai par. Each pays interest of $120 annually. Bond A will mature in 5 years while bond B will mature in G years. Ifthe yields to maturity on the two bonds change from 12 percent to 10 percent, both bonds wil ¥ A)inerease in value, but bond B wl increase more than Sond A. X 8) increase in value, but bond A wil increase more than bone B. XC) decrease in value, but bond A wil decrease more than bond BX D) ecrease in value, but bond & wil decrease more than bond A. Explanation here are three features that determine the magnitude of he bondpice voaiiy (1) The lower the coupon the greater he bond pric vl. (2) The longer the trm to maturity, the greater the price volt. (9) The lower the inital yield, the greater the price volatility.‘Since both ofthese bonds are the same with the exception of the term to matury, the bond with the longer term to maturity will have a greater price voatity, Sines bond value hae an inverea relationship with interaet rates, whan interest rates decrease bond value increases, References Question From: Topic Avea 4 > Topic 61 > LO 8 Related Material: '* Key Concepts by LO Question 71 Interest rate risk is most commonly associated with YA) fined income instants XB) futures market. XC) commodity market. X D) equity market Explanation Interest rate risk is most commonly associated with fied income instruments or bonds. Futures, equity, and commodity markets ere affected by interest rate rk only indirectly. References Question From: Topic Area 4 > Topic 61 > LO 1 Related Material: *# Key Concepts By LO Question 72 Convexityis more important when rates are: X A) low. ¥ B) unstable, X €) depends on whether the note is seling at a premium ora discount. X Dy high. Explanation Since interest rates and the price of bonds are inversely related, unstable interest rates wil lead to larger price Muctuations in bonds. The larger the change in the price ofa bond the more error will be introduced in determining the new price ofthe bond it only duration is used because duration assumes the price yield reationship is linear when in fact tis a curved convex line. Ifduration alone is used to price the bond, the curvature of the line magnifies the error introduced by yield changes, and makes the convexity adjustment even more important References ‘Question From: Topic Area 4 > Topic 61 > LOS Related Materia: + Kay Concopte ByLO Question 73, Non-callable bond prices go up faster than they go down. This is referred to as: XA) embedded benefits. X 8) negative convent. ¥ ©) postive convexity. XD inverse features. Explanation Yen bora rs yo up faster ta they go dom iis called postive vey. References ‘Question From: Topic Area 4 > Topie 61 > LOB Related Material: “+ Key Concepts by LO Question 74 ‘A 12-year, 8 percent annual coupon bond with $100 par value currently slls at par. The bond is callable at 102. Whatis the cffecive duration ofthe bond assuming interest rates change by 100 basis points? x A) 5.08. X B) 10.50. ¥ 6) 4.58 x 0) 7.56. Exolanation ‘Since the bond is selling at par, its yield = coupon rate = 8%, 2; PMT = 0.08 x 100 = 8; PV=V. Since the call price is 102 which is lower than 107.94, we use 107.94. 102VY =9.00; FV = 100; N= 12; PMT=0.08 x 100 = 8; PV= Y= 92.84 D = Duration = (V - V y2V (Ay) - + @cePARATIAT = 4.58 References ‘Question From: Tonic Area 4> Tonic 61 > LO 4 Related Materia: ‘+ Key Concepts by LO Question 75 With respect to an option-ree bond, when interest-rate changes are large, the duration measure will overestimate the: XA) increase in a bond's price from a given ineroase in intoreat rates. X B) associated change in the bond's rating, 6) all in a bond's price from a given increase in interest rats. X D) final bond price from a given increase in interest rates, Explanation ‘When interest rates increase by 50-100 basis points or more, the duration measure overestimates the decrease in the bond's ce. References Question From: Topic Area 4 > Topic 61 > LO 6 Related Materia: ‘+ Key Concepts by LO Question 76 Which ofthe folowing bonds may have negative convexly: X A) High yield bonds. ¥_ B)Allof these choices are correct. X €) Morigaye backed sevuiles. X D) Callable bonds. ‘ExplanationNegative convenitys the idea that as interest rates decrease they get toa certain point where the value of certain bonds (bonds with negative convexity) will start to increase in value at adecreasing rate Interest rate risk isthe risk of having to reinvest at rates that are lower than what an investor is currently receiving Mortgage backed secures (MBS) may have negative convexity because when interest rates fall morgage owners wil refinance fr lnwer rates, thus prepaying the tstanding princinal and increasing the interest rate risk that invastars of MBS may incur. Callable bonds are similar to MBS because of the possibly thatthe principal is being returned tothe investor sooner than expected if the bond is called causing a higher level of interest rae risk. High yield bonds may exhibit negative convesity because they are lower quay bonds wit large coupon payments thus, causing larger potential for intoret rate rick when intorect rates ‘all cause the invector hae to reinvest thor cach flowe at 2 lower interest rate which is similar to both MBS and callable bonds. High yield issuers would be more prone to refinancing theit debt ao interest rates fall since they pay on initly high rate of interest and would greally benef by refinancing. References ‘Question From: Topic zea 4> Topic 61 > LO 8 Related Material: 1s Key Concepts by LO Question 77 CConvexity is important because YA) the slope ofthe price yield curve isnot linear. XB) it measures the votatlity of non-callable bonds. X C) it can be used to indicate the optimal hedge ratio. X D) the slope of the callable bond price/yield curve is backward bending at high intrest rates. Explanation 'Moainea duration Is a good approximation of price changes for an option-ttee bond only fr relatively small changes in interest rates. As rate changes grow larger, the curvature ofthe bond price/yeld relationship becomes more prevalent, meaning that a linear estimate of price changes will contain errors. The modtied duration estimate isa linear estimate, as assumes that the ‘change is the same for each basis point change in required yield. The errr inthe estimate is due to the curvature ofthe actual price path. This is the degree of convent. If we can generate a measure ofthis convexily, we can use tis to improve our estimate of bond price changes. References ‘Question From: Topic Area 4 > Topic 61 > LO 8 Related Materia: ‘+ Key Concepts by LOQuestion 78 How does the price-yeld relationship for a callable bond compare to the same relationship for an option-free bond? The price- fled relationship is X A) concave for the callable bond and convex for an option free bond. ¥ B) concave for low yields for the callable bond and always convex for the option- hee bund. X 6) concave for ani optlunetiee bunu aru Curve for & Gallaule bum. D) the same for both bond types. Explanation ‘Since the issuer ofa callable bond has an incentive to call the bond when interest rates are very low in order to get cheaper financing. tis puts an upper limit on the bond price for low interest rates and thus introduces the concave relationship between yields and prices. References ‘Question From: Topic Area 4 > Topic 61 > LO 8 Related Materia: ‘= Key Concepts by LO Question 79 ‘The price value of a basis point (PVBP) for a 18 year, 8 percent annual pay bond with a par value of $1,000 and yield of 9 percent is closest to vA) $0.82. X 8) $0.03. X ¢) $0.80. XD) $0.44, Explanation Pver inal price - price if yletd changed by 1 bps. Initial price: Price with change: FV= 1000 FV= 1000 PMT = 80 PMT = 80PVBP = 912.44375 -911.627 VBP is always the absolute value. 82 References ‘Question From: Topic Area 4> Topic 61 > LO 2 Related Materia: Question 80 Which ofthe following statements describe a property of bond convexity? Convey: |. Increases as yields increase. |. increases wit the square of maturity. measures the rate of change in duration. IV, increases ifthe coupon on a bond is increased. X A) Il and IV only. YB) and Il only. XC) land Ill only. X Dy I and IV only Explanation Convexity is inversely related to yield and is indirectly related tothe coupon rate on a bond, Convexily isthe second derivative ‘of price with respect to yield, which means that convexity measures the rate of change in duration. Convexiy increases with the square of maturity, References ‘Question From: Topic Area 4 > Topic 61 > LO 6 Related Materia: ‘+ Key Concepts by LO Question 81 “The most commonly used measure of interest-rate risk is:X A) coupon, +8) duration X ¢) yield. x D) maturity Explanation LDuration measures the senstivty of an instrument's market value to changes in interest rates. Note that matunty, yet, and coupon, ae all features of bonds that ti fo determining duratior. References ‘Question From: Topic area 4 > Topic 61 > LO-4 Related Material: ‘+ Key Concepts by LO Question 82 \Which ofthe following is most accurate about a bond with positive convexity? X A) Price increases and decreases at a faster rate than the change in yield ¥ B) Price increases when yields drop are greater than price decreases when yields rise by the same ‘amount. X €} Price changes are the same for both increases and desreases in yields. X ) Positive changes in yield lead to positive changes in rice Explanation ‘A convex pricelyeld graph has a larger increase in price as yield decreases than the decrease in price when yields increase. ‘This comes from the definition of convex graph. References ‘Question From: Topic Area 4 > Topic 61 > LO 8 Related Mater: '* Key Concepts by LO Question 83 ‘The convexty of a U.S Treasury bond is usualy: X A) additional information is required. X B) zero.¥ C) positive, X D) negative. Explenation ‘One characteristic of all noncallable bonds is that they have postive convexity and U.S. Treasury bonds are noncallable bonds. ‘Question From: Topic Area 4 > Topic 61 > LO 8 Related Materia: ‘+ Key Concepts by LO Question 84 Fora given chango in yeldo, the diference between the actu Jerange in a bond's price ond that prodicted using the duration measure willbe greater for: X A) a bond with less convexity ¥ B)abond with greater ‘convexity. X €) inverse convexity. X b) a shorterm bond, Explanation Duration is a linear measure of the relationship between a bond's price and yield. The true relationship isnot linear as measured by the convexity. When convexity is higher, duration will be less accurate in predicting @ bond's price for a given ‘change in inlerest rates. Short-term bonds generally have low cowenxty. References Question Fro fopio Area 4 > Tople 61> LO 6 Related Materia 1s Key Cancapis by LO Question 85 ‘The price value of a basis point (PVBP) of a bond is $0.75 Ifthe yield on the bond goes up by 1 bps, the price of the bond wil: XA) incroaee by $0.76. X B) is less volatile than a bond with a PBVP of $0.50. YC) dectine by $0.75,XD) increase or decrease by $0.75. Explanation Invorse relationships exst between price and yields on bonds. The larger the PVBP, the more volatile the bons price. Relarencee ‘Question From: Topic Area 4> Topic 61 >LO2 Related Matorial: *# Key Concepts by LO Question 86 Ia 12.year, 8 percent annual coupon bond with $100 par value i curently selling at par what isthe convexity ofthe bond? vA) 78.0. X B) 96.0. X ¢) 100.5. X D) 57.0. Explanation Since the bond is selling at par, i's yield = coupon rate = V=Par= 100. B%. 0 For convexity, change in yield used in calculations is arbitrary - so we use 100 bps in our calculations below. 00; FV = 100; N= 12; PMT = 0.08 x 100 = 8; PV = V = 107.94 .005 FV = 100; N= 12; PMT = 0.08 x 100 = 8; PV= V.= 92.84 (107.94¥92.84-200)(100x0.01 References ‘Question From: Topic Area 4> Topic 61 > LO 6 Related Materi ‘+ Key Concepts by LO Question 87 Why is convexity a good thing for a bond holder? Because when compared to alow convexity bonds a high convexity bond:X A) is more sensitive to interest rate changes, increasing the potential payoft. ¥ B) has better price changes regardless of the direction of the yield change. X G) is usually underpriced. X D) has Improved estimation of price changes. Explanation lative to @ bonds witn low convexty, the pre ot a Bona with nigh convexty wil increase more when rates dectine ana decrease less when rates rise, References ‘Question From: Topic Area 4 > Topic 61 > LO 6 Related Material: ‘+ Key Concepts by LO Question 88 Positive convexity in bond prices implies all but which ofthe folowing statements? XA) As yields increase, changes in yield have a smaller effect on bond prices. X B) As yields decrease, changes in yield have a larger effect on bond prices. X.€) The price volatility of non-callable bonds is inversely rated tothe level of market yields YD) Bond prices approach a ceiling as interest rates fall Explonation “The negative convexity of bond prices means that bond prices as a function of interest rates approach a floor s interest rates vise eferonces ‘Question From: Topic Area 4> Topic 61 > LO 8 Related Materia: *# Key Concepts by LO Question 89 For @ given bond and yield, the dolar value of a one basis punt change in yk! is typically, X A) greater fora yield increase. X B) equal fora yield increase and decrease, YG) greater for a yield decrease.X D) unrelated to the bonds convexity. Explanation When you calculate the dolar value of a basis point for a 1bp uptck and 1 bp downtick, itis greater fora yield decrease. This, 's a function of bond convexity. References ‘Question From: lopic Area 4> lopic 61 > LO 2 Related Mater += Key Concepts by LO Questions 90 ‘A 10-year maturity Treasury bond has a par value of $10,000 and a 5 percent coupon. The yield on the bond is 4.5 percent Assume that the yild can fall to 4.45 peant or rise to 4.55 parent. Question IN: 4904A@ ‘The effective duration for the bond is closest to X A) 7.24 ¥ 8) 1.88 X ¢) 8.07, XD) 7.61 Explanation N= 20, IY ~ 4.4572; PNET ~ 50012; FV ~ 10,000; CPT PY ~ 10,440.05 - V N=20,0Y= 552; PMT = 00/2; FV = 10,000; CPT PV = 10,388.33 = V+ N YY = 4.5012; PMN 0,398.09 = vo Vo=Vs | $10,440.05 ~ $10,358.33 uration = cay) ~ 20810 39909)(00005) 786 References Question From: Topic Area 4 > Topic 61 > LO 4 Related Material