6. Fixed Income

Question: 5%, 15-year, annual pay option-free Xeleon Corp bond trades at a market price of $95.72 per $100 par. The government spot rate curve is flat at 5%. Suppose that the Xeleon bond was callable in 10 years at par and an analyst computed the Z-spread on the bond ignoring the embedded option. Relative to the Z-spread on an option- free bond, the calculated Z-spread will most likely be:

• A) the same Correct
• B) higher
• C) lower

Page 1 | Status: ✅ Correct

Question: Which one of the following is least likely a reason to use the swap rate curve?

• A) The swap market is not regulated by any government
• B) Swap rates reflect credit risk of commercial banks and not government Correct
• C) Swap rates are less volatile than government bond yields

Page 1 | Status: ✅ Correct

Question: Credit risk in the banking system is most accurately captured by the:

• A) I-spread Correct
• B) 10-year swap spread
• C) TED spread

Page 1 | Status: ✅ Correct

Question: Suppose that the short-term and long-term rates decrease by 75bps while the intermediate- term rates decrease by 30bps. The movement in yield curve is best described as involving changes in the:

• A) level only
• B) level and curvature Correct
• C) curvature only

Page 2 | Status: ✅ Correct

Question: Jorgen Welsher, CFA obtains the following quotes for zero coupon government bonds all with a par value of $100. Type of Price Delivery (years) Maturity (years) Price Spot 0 3 $91.51 Forward 2 3 $94.55 Spot 0 2 $92.45 Welsher can earn arbitrage profits by:

• A) buying the 2-year bond in the spot market, going long the forward contract and selling the 3-year bond in the spot market Correct
• B) buying the 2-year bond in the spot market, going short the forward contract and selling the 3-year bond in the spot market
• C)

Page 2 | Status: ✅ Correct

Question: Rising inflation when the economy is expanding could most likely lead to a:

• A) bearish flattening Correct
• B) bearish steepening
• C) bullish steepening

Page 3 | Status: ✅ Correct

Question: Which theory explains the shape of the yield curve by considering the relative demands for various maturities?

• A) The pure expectations theory
• B) The segmentation theory Correct
• C) The liquidity premium theory. Carol Stephens, CFA, oversees five portfolio managers who all manage fixed income portfolios for one institutional client. Stephens feels that interest rates will change over the next year but is uncertain about the extent and direction of this change. She is confident, however, that the yield curve will change in a nonparallel manner and that modified duration will not accurately measure the overall total portfolio's yield-curve risk exposure. To help her evaluate the risk of her client's total portfolio, she has assembled the table of rate durations shown below. Issue Value ($millions) 3 mo 2 yr 5 yr 10 yr 15 yr 20 yr 25 yr 30 yr Portfolio 1 100 0.03 0.14 0.49 1.35 1.71 1.59 1.47 4.62 Portfolio 2 200 0.02 0.13 1.47 0.00 0.00 0.00 0.00 0.00 Portfolio 3 150 0.03 0.14 0.51 1.40 1.78 1.64 2.34 2.83

Page 3 | Status: ✅ Correct

Question: For this question only, imagine that the original yield curve undergoes a parallel shift such that the rates at all key maturities increase by 50 basis points. The new value of the total portfolio will be closest to:

• A) $980,537,500 Correct
• B) $1,019,462,500
• C) $961,075,000

Page 4 | Status: ✅ Correct

Question: For this question only, imagine that the original yield curve undergoes a shift such that 3- month rates remain constant and all other rates increase by 135 basis points. The new value of portfolio 4 will be closest to:

• A) $243,375,000 Correct
• B) $229,750,000
• C) $250,000,000

Page 4 | Status: ✅ Correct

Question: The 10-year key rate duration for the total portfolio is closest to:

• A) 1.350 Correct
• B) 0.345
• C) 1.375

Page 4 | Status: ✅ Correct

Question: The effective duration for Portfolio 2 is closest to:

• A) 1.47 Correct
• B) 0.023 Your Answer
• C) 1.62

Page 5 | Status: ❌ Incorrect

Question: 5%, 15-year, annual pay option-free Xeleon Corp bond trades at a market price of $95.72 per $100 par. The government spot rate curve is flat at 5%. The Z-spread on Xeleon Corp bond is closest to:

• A) 300 bps Correct
• B) 325 bps Your Answer
• C) 250 bps

Page 5 | Status: ❌ Incorrect

Question: To jump start a sluggish economy could most likely lead to a:

• A) bullish steepening Correct
• B) bearish flattening Your Answer
• C) bearish steepening

Page 5 | Status: ❌ Incorrect

Question: Independence Bank is a small retail bank that specializes in demand deposits and invests in CMO tranches. For the purpose of valuation of Independence Bank's assets and liabilities, the most appropriate reference yield curve would be:

• A) MRR-OIS curve
• B) government spot curve Correct
• C) swap rate curve

Page 6 | Status: ⏸️ Unattempted

Question: Under the liquidity preference theory, expected future spot rates will most likely be:

• A) More than the current forward rate Correct
• B) Less than the current forward rate
• C) Equal to the current forward rate

Page 6 | Status: ⏸️ Unattempted

Question: The swap spread will increase with:

• A) a deterioration in one party’s credit Your Answer
• B) the variability of interest rates Correct
• C) an increase in the credit spread embedded in the reference. James Wallace, CFA, is a fixed income fund manager at a large investment firm. Each year, the firm recruits a group of new college graduates in the spring to enter in the firm's management training program. The program is a rigorous six-month course that exposes every candidate to each of the different departments within the firm. After successfully completing the six-month training period, candidates then receive offers for employment in one of the departments within the investment firm. Recently, Wallace was selected by his boss to teach the fixed income portion of the firm's training program. He will be able to hold several two-hour sessions with the new hires over a two-week time period, during which he is expected to instruct the trainee's on all aspects of fixed income analysis. These sessions serve as preparation for the trainees to be able to complete a month long rotation on the fixed income trading desk. His first few sessions will cover the core concepts of fixed income investing. Wallace believes that in order to fully grasp the more complicated concepts of fixed income analysis, the new hires must first begin by having a complete knowledge of the term structure and the volatility of interest rates. The new hires each have different educational backgrounds and varying amounts of work experience, so Wallace decides to begin with the most very basic concepts. He wants to start by teaching the various theories of the term structure of interest rates, and the implications of each theory for the shape of the Treasure yield curve. To evaluate the trainees' understanding of the subjects at hand, he creates a series of questions

Page 7 | Status: ❌ Incorrect

Question: Following Wallace's first lecture he asks the trainees which of the following explains an upward sloping yield curve according to the (unbiased) pure expectations theory of the term structure of interest rates?

• A) There is greater demand for short-term securities than for long-term securities Correct
• B) There is a risk premium associated with more distant maturities
• C) The market expects short-term rates to rise through the relevant future

Page 8 | Status: ✅ Correct

Question: Wallace now poses a similar question regarding the liquidity preference theory. Which of the following could explain an upward sloping yield curve according to the liquidity preference theory of the term structure of interest rates?

• A) There is a risk premium associated with more distant maturities
• B) The market expects short-term rates to rise through the relevant future Correct
• C) There is greater demand for short-term securities than for long-term securities

Page 8 | Status: ✅ Correct

Question: Wallace presents the relationships between spot and forward rates according to the pure expectations theory. Which of the following is closest to the one-year implied forward rate one year from now?

• A) 6.25% Correct
• B) 6.58%
• C) 5.75%

Page 9 | Status: ✅ Correct

Question: Wallace completes his first lecture by tying the relationship between Treasury prices and the shape of the term structure. He is particularly interested in the implications of a steepening yield curve. Which of the following is most accurate for a steepening yield curve?

• A) The price of short-term Treasury securities increases relative to the price of long- term Treasury securities Correct
• B) The price of long-term Treasury securities increases relative to the price of short- term Treasury securities
• C) The price of short-term Treasury securities increases

Page 9 | Status: ✅ Correct

Question: Don McGuire, fixed income specialist at MCB bank makes the following statement: "In the very short-term, the expected rate of return from investing in any bond, including risky bonds, is the risk-free rate of return". McGuire's statement is most consistent with:

• A) unbiased expectations theory
• B) local expectations theory Correct
• C) liquidity preference theory

Page 9 | Status: ✅ Correct

Question: A swap spread is the difference between:

• A) the fixed rate on an interest rate swap and the rate on a Treasury bond of maturity equal to that of the swap
• B) the fixed-rate and floating-rate payment rates at the inception of the swap Correct
• C) MRR and the fixed rate on the swap

Page 10 | Status: ✅ Correct

Question: The liquidity theory of the term structure of interest rates is a variation of the pure expectations theory that explains why:

• A) the yield curve usually slopes downward Correct
• B) duration is an imprecise measure
• C) the yield curve usually slopes upward

Page 10 | Status: ✅ Correct

Question: If an active bond portfolio manager believes future spot rates will be lower than indicated by today's forward rates, then she will most likely:

• A) be indifferent because her holding period return will be unaffected Correct
• B) sell bonds because the market appears to be discounting future cash flows at “too high” of a discount rate
• C) purchase bonds because the market is discounting future cash flows at “too high” of a discount rate

Page 10 | Status: ✅ Correct

Question: Suppose the government spot rate curve is flat at 3%. An active manager is planning on purchasing a five-year government bond at par. The realized return on this bond will most likely be:

• A) more than 3% if the bond is held to maturity while the yield curve remains flat but decreases below 3% Correct
• B) 3% if the bond is held to maturity provided that the yield curve remains flat at 3%
• C) 3% if the bond is held to maturity regardless of the shape of the yield curve Your Answer

Page 11 | Status: ❌ Incorrect

Question: If the spot curve is upward sloping, the forward curve is most likely to be:

• A) steeper than the spot curve and above the spot curve Correct
• B) parallel to the spot curve and below the spot curve
• C) parallel to the spot curve and above the spot curve Your Answer

Page 11 | Status: ❌ Incorrect

Question: According to the pure expectations theory, which of the following statements is most accurate? Forward rates:

• A) are biased estimates of market expectations Correct
• B) always overestimate future spot rates
• C)

Page 11 | Status: ✅ Correct

Question: The following are some of the current par rates: Year Par rate 1 1.00% 2 2.00% 3 3.00% 4 4.00% 5 5.00% Using bootstrapping, the 2-year spot rate is closest to:

• A) 1.50% Correct
• B) 2.01%
• C) 2.25%

Page 12 | Status: ✅ Correct

Question: Which of the following most accurately explains the "locked-in-rate" interpretation of forward rates? The forward rate allows an investor to lock in:

• A) a coupon rate for some future period Correct
• B) a coupon rate for the current period
• C) an interest rate for some future period

Page 12 | Status: ✅ Correct

Question: Assuming the pure expectations theory is correct, an upward sloping yield curve implies:

• A) longer-term bonds are riskier than short-term bonds Your Answer
• B) interest rates are expected to decline in the future Correct
• C) interest rates are expected to increase in the future

Page 13 | Status: ❌ Incorrect

Question: Based on Forecast 1, what is the most appropriate expected change in the shape of the yield curve?

• A) A bullish steepening
• B) A bearish steepening Correct
• C) A bearish flattening

Page 15 | Status: ✅ Correct

Question: What would be the most appropriate duration-neutral strategy based on information presented in Forecast 2?

• A) Rotate into a barbell strategy
• B) Rotate into a long-maturity bullet portfolio Correct
• C) Rotate into a short-maturity bullet portfolio

Page 15 | Status: ✅ Correct

Question: Based on her first comment about bond spreads, Eden is most likely tracking which spread?

• A) TED spread Correct
• B) MRR-OIS spread
• C)

Page 15 | Status: ✅ Correct

Question: Eden's second comment about bond spreads is most likely:

• A) correct Correct
• B) incorrect, because a narrowing spread indicates a reduction in risk in the banking system
• C) incorrect, because the spread does not give a specific indication about risk in the banking system Your Answer

Page 16 | Status: ❌ Incorrect

Question: During the recent credit crises in the country of Maltovia, several money market funds reported large losses. Subsequently, the Maltovian regulatory body imposed strict restrictions on maturity of securities that money market funds could invest in. The reaction of Maltovian regulatory body was most likely based on a belief in:

• A) market segmentation theory
• B) preferred habitat theory Correct
• C) local expectations theory Your Answer

Page 16 | Status: ❌ Incorrect

Question: Compared to a yield curve based on government bonds, swap rate curves are:

• A) more comparable across countries and have a greater number of yields at various maturities Correct
• B) more comparable across countries and have a smaller number of yields at various maturities
• C) less comparable across countries and have a greater number of yields at various maturities

Page 17 | Status: ✅ Correct

Question: The active bond portfolio management strategy of rolling down the yield curve is most consistent with:

• A) liquidity preference theory Correct
• B) segmented markets theory
• C) pure expectations theory

Page 17 | Status: ✅ Correct

Question: The following are some of the current par rates: Year Par rate 1 5.00% 2 6.00% 3 7.00% Using bootstrapping, the 3-year spot rate is closest to:

• A) 6.93% Correct
• B) 6.67%
• C) 7.09%

Page 18 | Status: ✅ Correct

Question: The price of a five-year zero coupon bond is $0.7835 for $1 par and the price of a two-year zero-coupon bond is $0.9426 for $1 par. The three-year forward rate two years from now is closest to:

• A) 4.87% Correct
• B) 6.36%
• C) 5.54%

Page 18 | Status: ✅ Correct

Question: The benchmark bond being assessed by Holly is most likely:

• A) undervalued by $3.69
• B) overvalued by $2.90
• C) overvalued by $3.75

Page 20 | Status: ⏸️ Unattempted

Question: The comment made by Ross is most likely:

• A) inaccurate with respect to the statement about spot rates, forward rates, and yields
• B) inaccurate with respect to the statement about rolling down the yield curve Correct
• C) inaccurate in both respects

Page 20 | Status: ⏸️ Unattempted

Question: Smith's comments about interest rates in Happyland most likely supports which theory of the term structure of interest rates?

• A) Liquidity preference theory
• B) Segmented markets theory Correct
• C) Local expectations theory

Page 21 | Status: ⏸️ Unattempted

Question: The most appropriate measure for Alex Allan to assess bond price sensitivity is:

• A) key rate duration
• B) effective duration Correct
• C) Macaulay duration

Page 21 | Status: ⏸️ Unattempted

Question: With respect to local expectations theory, which of the following statements is most consistent with market evidence?

• A) Short-term holding period return of long-maturity bonds exceeds the short-term holding period returns of short-maturity bonds
• B) Short-term holding period return of short-maturity bonds exceeds the short-term holding period returns of long-maturity bonds
• C) Short-term holding period return of long-maturity bonds and the short-term holding period return of short-maturity bonds is the same

Page 21 | Status: ⏸️ Unattempted

Question: Assume that the interest rates in the future are not expected to differ from current spot rates. In such a case, the liquidity premium theory of the term structure of interest rates projects that the shape of the yield curve will be:

• A) variable
• B) upward sloping Correct
• C) downward sloping

Page 22 | Status: ⏸️ Unattempted

Question: Which of the following statements are most accurate?

• A) Short-term rates are typically more volatile than long-term rates Correct
• B) Volatility of short-term and long-term rates is typically equal
• C) Long-term rates are typically more volatile than short-term rates

Page 22 | Status: ⏸️ Unattempted

Question: Which of the following most accurately explains the "break-even-rate" interpretation of forward rates? The forward rate is the rate that will make an investor indifferent between investing:

• A) investing at the spot or forward interest rate Correct
• B) now or at a forward time
• C) for the full investment horizon, or for part of it, and then rolling over the proceeds for the balance of the investment horizon at the forward rate

Page 22 | Status: ⏸️ Unattempted

Question: Use the following spot rate curve to answer this question: Maturity 1 2 3 Spot rates 5% 5.5% 6% The price of a 1-year $1 par, zero-coupon bond to be issued in two years is closest to:

• A) $0.9434
• B) $0.9345
• C) $0.8396

Page 23 | Status: ⏸️ Unattempted

Question: Given annual spot interest rates for 1 year, 2 years, 3 years, 4 years, and 5 years, the maximum number of forward rates that can be derived is closest to:

• A) 5
• B) 8
• C) 10

Page 23 | Status: ⏸️ Unattempted

Question: Volatility in short-term rates is most likely related to uncertainty about:

• A) monetary policy Correct
• B) the real economy
• C) inflation. Martha Garret, CFA, manages fixed-income portfolios for Jones Brothers, Inc. (JBI). JBI has been in the portfolio management business for over 23 years and provides investors with

Page 23 | Status: ⏸️ Unattempted

Question: Evaluate Walsh's comments regarding the method used to estimate the expected increase in interest rate volatility and the term structure of interest rates.

• A) Walsh is correct with respect to both interest rate volatility and term structure Correct
• B) Walsh is incorrect with respect to both interest rate volatility and term structure
• C) Walsh is correct only with respect to interest rate volatility

Page 25 | Status: ⏸️ Unattempted

Question: Which of the following best evaluates Terry's justification for using the swap curve as the benchmark for the Atlantic Fund? Terry's justification is:

• A) incorrect because there are different levels of credit risk in the swap curves of different countries
• B) incorrect because there are actually more maturity points to construct the swap curve
• C) correct

Page 25 | Status: ⏸️ Unattempted

Question: The least important factor explaining the changes in the shape of the yield curve is:

• A) Level Correct
• B) Steepness
• C) Curvature

Page 26 | Status: ⏸️ Unattempted

Question: When the yield curve is downward sloping, the TED spread is most likely to be:

• A) zero
• B) positive Correct
• C) negative

Page 26 | Status: ⏸️ Unattempted

Question: Joe McBath makes the following two statements: Statement 1: The swap rate curve indicates credit spread over government bond yield. Statement 2: The swap rate curve indicates the premium for time value of money at different maturities. Joseph is most likely correct with regard to:

• A) Both statements
• B) Statement 1 but not statement 2
• C) Statement 2 but not statement 1

Page 26 | Status: ⏸️ Unattempted

Question: Jon Smithson is a bond trader at Zezen Bank. The spot rate curve is currently flat. Smithson expects that the curve will become upward sloping in the next year. Based on this expectation, the least appropriate active strategy for Smithson would be to:

• A) increase the duration of the portfolio Correct
• B) sell all the long-term bonds in the portfolio and reinvest the proceeds in shorter- maturity bonds
• C) reduce the duration of the portfolio

Page 27 | Status: ⏸️ Unattempted

Question: An active bond portfolio manager would most appropriately buy bonds when expected spot rates are:

• A) less than current forward rates Correct
• B) greater than current forward rates
• C) equal to current forward rates

Page 27 | Status: ⏸️ Unattempted

Question: For an interest rate swap, the swap spread is the difference between the:

• A) average fixed rate and the average floating rate over the life of the contract
• B) fixed rate and the floating rate in a given period
• C)

Page 27 | Status: ⏸️ Unattempted

Question: Which of the following best describes key rate duration? Key rate duration is determined by:

• A) shifting the whole yield curve in a parallel manner
• B) changing the yield of a specific maturity
• C) changing the curvature of the entire yield curve

Page 28 | Status: ⏸️ Unattempted

Question: According to the pure expectations theory, how are forward rates interpreted? Forward rates are:

• A) expected future spot rates Correct
• B) equal to futures rates
• C) expected future spot rates if the risk premium is equal to zero

Page 28 | Status: ⏸️ Unattempted

Question: It is now January 1, 20x7. The one-year spot rate now is exactly equal to the one-year forward rate for a loan in one year as of January 1, 20x6. The current forward price of $1 par, zero-coupon bond for delivery on January 1, 20x8 will most likely be:

• A) lower than it was on January 1, 20x6
• B) the same as it was on January 1, 20x6
• C) higher than it was on January 1, 20x6

Page 28 | Status: ⏸️ Unattempted

Question: Which one of the following actions is most consistent with the strategy of riding an upward sloping the yield curve? Buying bonds with a maturity:

• A) shorter than the investor’s horizon Correct
• B) equal to the investor’s horizon
• C) longer than the investor’s horizon

Page 29 | Status: ⏸️ Unattempted

Question: What are the implications for the shape of the yield curve according to the liquidity theory? The yield curve:

• A) may have any shape
• B) is always flat
• C) must be upward sloping

Page 29 | Status: ⏸️ Unattempted

Question: According to the liquidity theory, how are forward rates interpreted? Forward rates are:

• A) expected future spot rates
• B) expected future spot rate plus a rate exposure premium Correct
• C) equal to futures rates

Page 30 | Status: ⏸️ Unattempted

Question: A 2-year $1,000 par, 5% (semi-annual pay) Mexa-corp bond has a Z-spread of 45bps. Using the following spot curve, compute the invoice price of the bond. Maturity 0.50 1.00 1.50 2.00 Spot rates 4.50% 5% 5.25% 5.5%

• A) $993.45
• B) $982.65
• C) $956.32

Page 30 | Status: ⏸️ Unattempted

Question: Which of the following is NOT a reason why market participants prefer the swap rate curve over a government bond yield curve? The swap market:

• A) reflects sovereign credit risk
• B) is free of government regulation Correct
• C) it is not affected by technical factors

Page 30 | Status: ⏸️ Unattempted

Question: Volatility in long-term rates is most likely related to uncertainty about:

• A) the real economy and inflation Correct
• B) fiscal policy
• C) central bank actions

Page 31 | Status: ⏸️ Unattempted

Question: Jill Sebelius, editor-in-chief of a monthly interest-rate newsletter uses the following model to forecast short-term interest rates: For the current newsletter, Sebelius has issued the following expectations: a=0.40, b = 3%, r = 2%. According to the model used by Sebelius, volatility in the short-term in interest rate is most likely:

• A) independent of the current level of the short-term interest rate Correct
• B) negatively related to the current level of the short-term interest rate
• C) positively related to the current level of the short-term interest rate. Dan Laske, CFA, recently joined Axes Bank as a bond trader. Laske is reviewing bank's interest rate models and meets with Sheila Jensen, a senior portfolio manager at the bank. Jensen makes the following statements: Statement 1: I don't want any random noise in the short-term rate forecasts. Statement 2: I like interest models to incorporate mean reversion of rates. Statement 3: I prefer that the interest rate volatility varies with the level of interest rates. Laske finally decides on using the Gauss+ model and asks Jensen about her opinion. Jensen makes the following observations about the Gauss+ model: Observation 1: Gauss+ models are primarily used for forecasting long-term rates, while equilibrium models are used for short-term rates. Observation 2: Gauss+ models assume that the long-term rates are mean reverting, while the central bank actions determine the short-term rates. dr = a(b −r) dt + σ√rdz

Page 1 | Status: ✅ Correct

Question: Based on Jensen's Statement 1, which model is most appropriate?

• A) The Kalotay-Williams-Fabozzi (KWF) model
• B) A Gauss+ multifactor model Correct
• C) The Ho-Lee model Your Answer

Page 2 | Status: ❌ Incorrect

Question: Based on Jensen's Statement 2, which model is least appropriate?

• A) The Vasicek model Correct
• B) The Cox-Ingersoll-Ross (CIR) model
• C) The Ho-Lee model Your Answer

Page 2 | Status: ❌ Incorrect

Question: Based on Jensen's Statement 3, which model is most appropriate?

• A) The Cox-Ingersoll-Ross (CIR) model Correct
• B) The Kalotay-Williams-Fabozzi (KWF) model
• C) The Vasicek model Your Answer

Page 2 | Status: ❌ Incorrect

Question: Regarding Jensen's observations:

• A) both observations are incorrect Correct
• B) only Observation 2 is correct
• C) only Observation 1 is correct Your Answer

Page 2 | Status: ❌ Incorrect

Question: The government bond spot rate curve is given below: Maturity (years) Spot rate 0.5 1.25% 1.0 1.30% 1.5 1.80% 2.0 2.00% 2.5 2.20% 3.0 2.25% 3.5 2.28% 4.0 2.30% Compute the issue price of a 3-year, 3% semiannual coupon government bond with a par value of $100.

• A) $102.15 Correct
• B) $104.09 Your Answer
• C) $102.20

Page 3 | Status: ❌ Incorrect

Question: Relative to the binomial model, Monte Carlo method is most likely:

• A) less flexible in forcing interest rates to mean revert Correct Your Answer
• B) more flexible as it does not need a volatility estimate
• C) more suitable when valuing securities whose cash flows are interest rate path dependent

Page 3 | Status: ❌ Incorrect

Question: A binomial model or any other model that uses the backward induction method cannot be used to value a mortgage-backed security (MBS) because:

• A) the cash flows for an MBS only depend on the current rate, not the path that rates have followed Correct
• B) the cash flows for the MBS are dependent upon the path that interest rates follow
• C) the prepayments occur linearly over the life of an interest rate trend (either up or down)

Page 4 | Status: ✅ Correct

Question: For a 3-year, semiannual coupon payment bond, the number of interest rate paths that would be generated using the pathwise valuation is closest to:

• A) 4 Correct
• B) 64
• C) 32

Page 4 | Status: ✅ Correct

Question: Sam Roit, CFA, has collected the following information on the par rate curve, spot rates, and forward rates to generate a binomial interest rate tree consistent with this data. Maturity Par Rate Spot Rate 1 5% 5.000% 2 6% 6.030% 3 7% 7.097% The binomial tree generated is shown below (one year forward rates) assuming a volatility level of 10%: 0 1 2 5% 7.7099% C A 9.2625% B Riot also generated another tree using the same spot rates but this time assuming a volatility level of 20% as shown below: 0 1 2 5% 8.9480% 13.8180% 5.9980% 9.2625% 6.2088% The one-year forward rate represented by 'A' is closest to:

• A) 6.3123% Correct
• B) 5.4223%
• C) 6.7732%

Page 5 | Status: ✅ Correct

Question: A 3-year, 3% annual pay, $100 par bond is valued using pathwise valuation. The interest rate paths are provided below: Path Year 1 Year 2 Year 3 1 2% 2.8050% 4.0787% 2 2% 2.8050% 3.0216% 3 2% 2.0780% 3.0216% 4 2% 2.0780% 2.2384% The value of the bond in path 4 is closest to:

• A) $102.58 Correct
• B) $101.88
• C) $100.02

Page 6 | Status: ✅ Correct

Question: A 3-year, 3% annual pay, $100 par bond is valued using pathwise valuation. The interest rate paths are provided below: Path Year 1 Year 2 Year 3 1 2% 2.8050% 4.0787% 2 2% 2.8050% 3.0216% 3 2% 2.0780% 3.0216% 4 2% 2.0780% 2.2384% The value of the bond in path 2 is closest to:

• A) $100.88 Correct
• B) $101.15
• C) $102.72

Page 7 | Status: ✅ Correct

Question: With respect to interest rate models, backward induction refers to determining:

• A) convexity from duration
• B) the current value of a bond based on possible final values of the bond Correct
• C) one portion of the yield curve from another portion

Page 7 | Status: ✅ Correct

Question: Which of the following is a correct statement concerning the backward induction technique used within the binomial interest rate tree framework? From the maturity date of a bond:

• A) the corresponding interest rates are weighted by the bond's duration to discount the value of the bond
• B) the corresponding interest rates and interest rate probabilities are used to discount the value of the bond Correct
• C) a deterministic interest rate path is used to discount the value of the bond.

Page 7 | Status: ✅ Correct

Question: Sam Roit, CFA, has collected the following information on the par rate curve, spot rates, and forward rates to generate a binomial interest rate tree consistent with this data. Maturity Par Rate Spot Rate 1 5% 5.000% 2 6% 6.030% 3 7% 7.097% The binomial tree generated is shown below (one year forward rates) assuming a volatility level of 10%: 0 1 2 5% 7.7099% C A 9.2625% B Roit also generated another tree using the same spot rates but this time assuming a volatility level of 20% as shown below: 0 1 2 5% 8.9480% 13.8180% 5.9980% 9.2625% 6.2088% The one-year forward rate represented by 'B' is closest to:

• A) 8.7732% Correct
• B) 7.5835%
• C) 7.4223%

Page 8 | Status: ✅ Correct

Question: Jill Sebelius, editor-in-chief of a monthly interest-rate newsletter uses the following model to forecast short-term interest rates: For the current newsletter, Sebelius has issued the following expectations: a=0.40, b = 3%, r = 2%. Based on Sebelius's estimates, over a sufficiently long period of time, the expected value of the short-term interest rate is closest to:

• A) 3% Correct
• B) 2.4% Your Answer
• C) 2%

Page 9 | Status: ❌ Incorrect

Question: The process of stripping is most likely to be used to earn arbitrage profits in a situation where:

• A) a portfolio of treasury strips is trading for a lower price than an intact treasury bond Correct
• B) one treasury bond trades at a lower price than another treasury bond with identical characteristics Your Answer
• C) Security valuations are not consistent with the value additivity principle

Page 9 | Status: ❌ Incorrect

Question: Tim Brospack is generating a binomial interest rate tree assuming a volatility of 15%. Current 1-year spot rate is 5%. The 1-year forward rate in the second year is either a low estimate of 5.250% or a high estimate of 7.087%. The middle 1-year forward rate in year three is estimated at 6.25%. The upper node 1-year forward rate in year three is closest to:

• A) 7.747% Correct
• B) 6.445%
• C) 8.437%

Page 10 | Status: ✅ Correct

Question: Which of the following choices is least likely a property of a binomial interest rate tree?

• A) Non-negative interest rates
• B) Adjacent forward rates in a nodal period are one standard deviation apart Correct
• C) Higher volatility at higher rates

Page 10 | Status: ✅ Correct

Question: Currently the term structure of interest rate is downward sloping. Which of the following models most accurately describe the current term structure?

• A) Vasicek model Correct
• B) Cox-Ingersoll-Ross model
• C) Ho-Lee model

Page 11 | Status: ✅ Correct

Question: Which of the following choices is least likely a property of a binomial interest rate tree?

• A) Mean reversion of interest rates
• B) Non-negative interest rates Correct
• C) Higher volatility at higher rates

Page 11 | Status: ✅ Correct

Question: Jill Sebelius, editor-in-chief of a monthly interest-rate newsletter uses the following model to forecast short-term interest rates: For the current newsletter, Sebelius has issued the following expectations: a=0.40, b = 3%, r = 2%. Sebelius's model is most accurately described as the:

• A) Vasicek model Correct
• B) Ho-Lee model
• C) Cox-Ingersoll-Ross model. dr = a(b −r) dt + σ√rdz

Page 11 | Status: ✅ Correct

Question: Sam Roit, CFA, has collected the following information on the par rate curve, spot rates, and forward rates to generate a binomial interest rate tree consistent with this data. Maturity Par Rate Spot Rate 1 5% 5.000% 2 6% 6.030% 3 7% 7.097% The binomial tree generated is shown below (one year forward rates) assuming a volatility level of 10%: 0 1 2 5% 7.7099% C A 9.2625% B Riot also generated another tree using the same spot rates but this time assuming a volatility level of 20% as shown below: 0 1 2 5% 8.9480% 13.8180% 5.9980% 9.2625% 6.2088% The one-year forward rate represented by 'C' is closest to:

• A) 8.7732% Correct
• B) 7.4223%
• C) 11.3132%

Page 12 | Status: ✅ Correct

Question: A bond with a 10% annual coupon will mature in two years at par value. The current one- year spot rate is 8.5%. For the second year, the yield volatility model forecasts that the one- year rate will be either 8% or 9%. Using a binomial interest rate tree, what is the current price?

• A) 101.837 Correct
• B) 103.572
• C) 102.659

Page 13 | Status: ✅ Correct

Question: Tim Brospack is generating a binomial interest rate tree assuming a volatility of 15%. Current 1-year spot rate is 5%. The 1-year forward rate in the second year is either a low estimate of 5.250% or a high estimate of 7.087%.The middle 1-year forward rate in year three is estimated at 6.25%. The lower node 1-year forward rate in year three is closest to:

• A) 6.747% Correct
• B) 4.63%
• C) 5.342%

Page 13 | Status: ✅ Correct

Question: Using the following interest rate tree of semiannual interest rates what is the value of an option free bond that has one year remaining to maturity and has 5% coupon rate with semi-annual coupon payments. Today 6 Months 7.30% 6.20% 5.90%

• A) 97.53 Correct
• B) 98.98
• C) 98.67

Page 15 | Status: ✅ Correct

Question: Suppose that we calculate the value of an option-free, fixed-rate coupon bond, discounting the cash flows using two methods: I. the zero-coupon yield curve. II. an arbitrage-free binomial lattice. Compared to the first methodology, the second method is expected to produce:

• A) the same value Correct
• B) a lower value if the bond carries a coupon higher than the corresponding benchmark bond
• C) a higher value in the presence of volatility

Page 15 | Status: ✅ Correct

Question: A 3-year, 3% annual pay, $100 par bond is valued using pathwise valuation. The interest rate paths are provided below: Path Year 1 Year 2 Year 3 1 2% 2.8050% 4.0787% 2 2% 2.8050% 3.0216% 3 2% 2.0780% 3.0216% 4 2% 2.0780% 2.2384% The value of the bond in path 3 is closest to:

• A) $99.88 Correct
• B) $100.02
• C) $101.85

Page 16 | Status: ✅ Correct

Question: Which of the following is equal to the value of a noncallable / nonputable convertible bond? The value of the corresponding:

• A) callable bond plus the value of the call option on the stock Correct
• B) straight bond Your Answer
• C) straight bond plus the value of the call option on the stock

Page 1 | Status: ❌ Incorrect

Question: Which of the following statements is most accurate concerning a convertible bond? A convertible bond's value depends:

• A) only on changes in the market price of the stock Correct
• B) on both interest rate changes and changes in the market price of the stock Your Answer
• C) only on interest rate changes

Page 1 | Status: ❌ Incorrect

Question: The effective convexity of a bond is most likely to be negative if the bond is:

• A) callable Correct
• B) putable Your Answer
• C) option-free. Bill Woods, CFA, is a portfolio manager for Matrix Securities Fund, a closed-end bond fund that invests in U.S. Treasuries, mortgage-backed securities (MBS), asset-backed securities (ABS), and MBS derivatives. The fund has assets of approximately $400 million, has a current stock price of $14.50 and a net asset value (NAV) of $16.00. Woods is a member of a four person investment team that is responsible for all aspects of managing the portfolio, including interest rate forecasting, performing basic financial analysis and valuation of the portfolio, and selecting appropriate investments for Matrix. His expertise is in the analysis and valuation of MBS and ABS. The fund pays a $0.12 monthly dividend that is paid from current income. The basic operating strategy of Matrix is to leverage its capital by investing in fixed income securities, and then financing those assets through repurchase agreements. Matrix then earns the spread between the net coupon of the underlying assets and the cost to finance the asset. Therefore, when evaluating a security for investment, it is critical that Matrix can be reasonably assured that it will earn a positive spread. During the course of his analysis, Woods utilizes several methodologies to evaluate current portfolio holdings and potential investments. Valuation methods he uses include nominal spreads, Z-spreads, and option-adjusted spreads (OAS). There is ongoing debate among the investment team as to the merits and shortcomings of each of the methods. Woods believes that the OAS method is by far a superior tool in all circumstances, while his fellow portfolio manager, Yuri Ackerman, feels that each of the methods can at times serve a useful purpose. Wood and Ackerman's current discussion involves two similar FNMA adjustable-rate mortgage (ARM) securities Wood is considering purchasing. Both ARM "A" and ARM "B" are indexed off of 6-month LIBOR, are new production, and have similar net coupons. Select Financial Information: ARM Net Coupon WAM Nominal Spread OAS (bps) Z-spread (bps) A 6.27% 360 81 98 135 B 6.41% 358 95 116 129 Woods recommends that Matrix purchase ARM "A" with the 6.27% net coupon. He has based his conclusion on the calculated OAS of the securities, which he believes indicates that ARM "A" is the cheaper of the two securities. Ackerman disagrees with Woods, arguing that OAS

Page 1 | Status: ❌ Incorrect

Question: Woods is most likely resistant to the zero-volatility spread because the spread:

• A) only considers one path of interest rates, the current Treasury spot rate curve Correct
• B) fails to consider price risk, which is uncertainty regarding terminal cash flows
• C) does not indicate how much of the spread reflects the significant prepayment risk associated with MBS Your Answer

Page 2 | Status: ❌ Incorrect

Question: In general, the investment team at Matrix attempts to buy "cheap" securities because they are undervalued on a relative basis. What is a characteristic of a "cheap" security for a given Z-spread and effective duration?

• A) High OAS relative to the required OAS and high option costs Correct
• B) High OAS relative to the required OAS and low option costs
• C) Low OAS relative to the required OAS and low option costs Your Answer

Page 2 | Status: ❌ Incorrect

Question: Which of the two bonds Woods is considering purchasing has the greater interest rate exposure?

• A) ARM B, because it has a smaller duration Correct
• B) The interest rate exposure cannot determine without a specific measure of convexity
• C) ARM A, because it has a larger duration Your Answer

Page 2 | Status: ❌ Incorrect

Question: Matrix also currently has investments in several ABS. Which of the following spread measures is most appropriate in the analysis of ABS backed by credit card receivables?

• A) Monte Carlo simulation model, because representative paths can be utilized Correct
• B) Z-spread, because credit card ABS have no prepayment option
• C) OAS, because the cash flows are interest rate path dependent. Alnoor Hudda, CFA, is valuing two floaters issued by Mateo Bank. Both floaters have a par value of $100, three year life and pay based on annual MRR. Hudda has generated the following binomial tree for MRR. 1-year forward rates starting in year: 0 1 2 Your Answer

Page 2 | Status: ❌ Incorrect

Question: Value of a capped floater with a cap of 4% is closest to:

• A) $96.71 Correct
• B) $97.38 Your Answer
• C) $98.70

Page 3 | Status: ❌ Incorrect

Question: Value of the cap in a capped floater with a cap of 4% is closest to:

• A) $4.41 Correct
• B) $1.29 Your Answer
• C) $1.23

Page 3 | Status: ❌ Incorrect

Question: Suppose that the stock price of a common stock increases by 10%. Which of the following is most accurate for the price of the recently issued convertible bond? The value of the convertible bond will:

• A) increase by 10% Correct
• B) increase by less than 10%
• C) remain unchanged

Page 3 | Status: ⏸️ Unattempted

Question: Using the following tree of semiannual interest rates what is the value of a 5% callable bond that has one year remaining to maturity, a call price of 99 and pays coupons semiannually? 7.76% 6.20% 5.45%

• A) 97.17 Correct
• B) 98.29 Your Answer
• C) 99.01. Kate Inka is a new hire for Maya Incorporated, a fixed income fund manager. On her first week on the job, she is asked to prepare a presentation on valuation and analysis of bonds with embedded options. Inka starts her presentation with the following three statements: Statement "In times of increased expectations of interest rate volatility the value of callable bonds will fall."

Page 3 | Status: ❌ Incorrect

Question: Which value for the backwardly induced price of the corporate callable bond using the binomial tree in Exhibit 1 is most accurate?

• A) $105.69 Correct
• B) $104.89 Your Answer
• C) $105.20

Page 5 | Status: ❌ Incorrect

Question: How many of Inka's comments about her binomial tree exercise are correct?

• A) One Correct
• B) Two Your Answer
• C) Three

Page 5 | Status: ❌ Incorrect

Question: How many of Inka's comments about duration are accurate?

• A) One Correct
• B) Three Your Answer
• C) Two

Page 5 | Status: ❌ Incorrect

Question: Which of the following is the appropriate "nodal decision" within the backward induction methodology of the interest tree framework for a putable bond?

• A) Min(put value, discounted value) Correct
• B) Max(par value, discounted value)
• C) Max(put price, discounted value) Your Answer

Page 5 | Status: ❌ Incorrect

Question: Joseph Dentice, CFA is evaluating three bonds. All three bonds have a coupon rate of 3%, maturity of five years and are generally identical in every respect except that bond A is an option-free bond, bond B is callable in two years and bond C is putable in two years. If interest rates decrease, the duration of which bond is most likely to decrease?

• A) Bond C Correct
• B)
• C)

Page 5 | Status: ⏸️ Unattempted

Question: Which of the following correctly describes one of the basic features of a convertible bond? A convertible bond is a security that can be converted into:

• A) common stock at the option of the investor Correct
• B) common stock at the option of the issuer
• C) another bond at the option of the issuer Your Answer

Page 6 | Status: ❌ Incorrect

Question: Which of the following is the appropriate "nodal decision" within the backward induction methodology of the interest tree framework for a callable bond?

• A) Max(call price, discounted value) Correct
• B) Min(par value, discounted value)
• C) Min(call price, discounted value) Your Answer

Page 6 | Status: ❌ Incorrect

Question: Which of the following statements about how interest rate volatility affects the value bond is most accurate? When interest rate volatility increases, the value of a:

• A) callable bond decreases Correct
• B) putable bond decreases
• C) straight bond decreases Your Answer

Page 6 | Status: ❌ Incorrect

Question: If a bond's key rate durations for maturity points shorter than the bond's maturity are negative, it is most likely that the bond being analyzed is a:

• A) zero coupon bond Correct
• B) putable bond
• C) callable bond. Eric Rome works in the back office at Finance Solutions, a limited liability firm that specializes in designing basic and sophisticated financial securities. Most of their clients are commercial and investment banks, and the detection, and control of interest rate risk is Financial Solution's competitive advantage. One of their clients is looking to design a fairly straightforward security: a callable bond. The bond pays interest annually over a two-year life, has a 7% coupon payment, and has a par value of $100. The bond is callable in one year at par ($100). Rome uses a binomial tree approach to value the callable bond. He's already determined, using a similar approach, that the value of the option-free counterpart is $102.196. This price came from discounting cash flows at on-the-run rates for the issuer. Those discount rates are given below: Your Answer

Page 6 | Status: ❌ Incorrect

Question: Using the binomial tree model, what is the value of the callable bond?

• A) $101.735 Correct
• B) $95.521 Your Answer
• C) $102.196

Page 7 | Status: ❌ Incorrect

Question: What is the value of the call option embedded in this bond?

• A) $6.675 Correct
• B) $0.461 Your Answer
• C) $12.924

Page 7 | Status: ❌ Incorrect

Question: If the bond is putable in one year at par, the value of the put is closest to:

• A) $0.461 Correct
• B) $0.291 Your Answer
• C) $12.487

Page 7 | Status: ❌ Incorrect

Question: The market conversion premium ratio for Stellar's convertible bond is closest to:

• A) 20.6% Correct
• B) 28% Your Answer
• C) 2.40%

Page 7 | Status: ❌ Incorrect

Question: Which of the following scenarios will lead to a convertible bond underperforming the underlying stock? The:

• A) stock price is stable Correct
• B) stock price falls
• C) stock price rises

Page 7 | Status: ✅ Correct

Question: Bill Moxley, CFA is evaluating three bonds for inclusion in fixed income portfolio for one of his pension fund clients. All three bonds have a coupon rate of 3%, maturity of five years and are generally identical in every respect except that bond A is an option-free bond, bond B is callable in two years and bond C is putable in two years. The yield curve is currently flat. If the yield curve is expected to have a parallel downward shift, the bond with the highest price appreciation is least likely to be:

• A) Bond A Correct
• B) Bond B
• C) Bond C

Page 8 | Status: ✅ Correct

Question: For a convertible bond with a call provision, with respect to the bond's convertibility feature and the call feature, the Black-Scholes option model can apply to:

• A) only one feature Correct
• B) both features
• C) neither features

Page 8 | Status: ✅ Correct

Question: How does the value of a callable bond compare to a noncallable bond? The callable bond value is:

• A) lower or higher Correct
• B) lower
• C) higher

Page 8 | Status: ✅ Correct

Question: Joseph Dentice, CFA is evaluating three bonds. All three bonds have a coupon rate of 3%, maturity of five years and are generally identical in every respect except that bond A is an option-free bond, bond B is callable at any time at par and bond C is putable at any time at par. Yield curve is currently flat at 3%. The bond with the lowest one-sided down-duration is most likely to be:

• A) Correct
• B) Bond
• C) Bond C

Page 8 | Status: ✅ Correct

Question: Generally speaking, an analyst would like the option adjusted spread (OAS) to be large, controlling for:

• A) Credit and liquidity risk Correct
• B) Credit, liquidity and option risk
• C) Option risk

Page 9 | Status: ✅ Correct

Question: How is the value of the embedded call option of a callable bond determined? The value of the embedded call option is:

• A) determined using the standard Black-Scholes model Correct
• B) equal to the amount by which the callable bond value exceeds the option-free bond value
• C) the difference between the value of the option-free bond and the callable bond

Page 9 | Status: ✅ Correct

Question: A callable bond and an option-free bond have the same coupon, maturity and rating. The callable bond currently trades at par value. Which of the following lists correctly orders the values of the indicated items from lowest to highest?

• A) $0, embedded call, callable bond, option-free bond Correct
• B) Embedded call, callable bond, $0, option-free bond
• C) Embedded call, $0, callable bond, option-free bond

Page 9 | Status: ✅ Correct

Question: The value of a callable bond is equal to the:

• A) callable bond plus the value of the embedded call option Correct
• B) option-free bond value minus the value of the call option
• C) callable bond value minus the value of the put option minus the value of the call option

Page 9 | Status: ✅ Correct

Question: The value of a convertible bond is most likely to be calculated as the value of an equivalent straight bond:

• A) plus the value of a call option on the bond Correct
• B) plus the value of a call option on the stock
• C) minus the value of a put option on the bond

Page 10 | Status: ✅ Correct

Question: Which bonds would have its maturity-matched rate as its most critical rate?

• A) High coupon callable bonds Correct
• B) Low coupon putable bonds
• C) Low coupon callable bonds

Page 10 | Status: ✅ Correct

Question: For an option-free bond trading at par, it is least likely that:

• A) The spot rate for the maturity of the bond is least important rate affecting the value of the bond Correct
• B) The rate durations for all the rates other than the maturity-matched rate are zero
• C) Its maturity key rate duration is the same as its effective duration

Page 10 | Status: ✅ Correct

Question: Suppose the market price of a convertible security is $1,050 and the conversion ratio is 26.64. What is the market conversion price?

• A) $1,050.00 Correct
• B) $26.64
• C) $39.41

Page 10 | Status: ✅ Correct

Question: For a convertible bond without any other options, the call feature implied by the convertibility feature will do all of the following EXCEPT:

• A) increase the value of the bond over that of a comparable option-free bond Correct
• B) cause negative convexity
• C) place a lower limit on the possible values of the bond. George Nagy is a fixed income manager with Luna Securities. Nagy is analyzing several securities issued by Redna, Inc. First, he is looking at a three-year, annual-pay floating rate note with an embedded cap of 6.5% paying coupons in arrears

Page 10 | Status: ✅ Correct

Question: What is the value of the capped floater using Nagy's line manager's binomial tree of interest rate expectations?

• A) $98.80
• B) $99.26
• C) $101.44

Page 11 | Status: ⏸️ Unattempted

Question: Which of the following statements is/are correct? Statement I: The straight bond should trade for less than $102. Statement II: If interest rate volatility were to increase then the price differential between the two Redna bonds would widen.

• A) Both statements are correct
• B) Statement I is correct but Statement II is incorrect
• C) Statement I is incorrect but Statement II is correct

Page 11 | Status: ⏸️ Unattempted

Question: Suppose Redna were to issue a bond that was identical in all respects to the existing callable bond except that instead it was putable. How would a binomial tree valuation be adapted?

• A) The put option becomes an effective floor price at each applicable node, instead of the call’s effective ceiling price
• B) The put option becomes an effective floor price at each applicable node, as well as the call’s effective ceiling price
• C) The put option becomes an effective ceiling price at each applicable node

Page 11 | Status: ⏸️ Unattempted

Question: Using the report of the economist, which of the following order of effective durations (highest to lowest) of otherwise identical bonds is most accurate:

• A) callable, putable, straight
• B) straight, callable, putable
• C) straight, putable, callable

Page 12 | Status: ⏸️ Unattempted

Question: A callable bond and an option-free bond have the same coupon, maturity and rating. The callable bond currently trades at par value. Which of the following lists correctly orders the values of the indicated items from lowest to highest?

• A) Embedded call, $0, callable bond, option-free bond
• B) Embedded call, callable bond, $0, option-free bond
• C) $0, embedded call, callable bond, option-free bond

Page 12 | Status: ⏸️ Unattempted

Question: Which of the following most accurately explains how the effective convexity is computed using the binomial model. In order to compute the effective convexity the:

• A) binomial tree has to be shifted upward and downward by the same amount for all nodes
• B) yield curve has to be shifted upward and downward in a parallel manner and the binomial tree recalculated each time
• C) volatility has to be shifted upward and downward and the binomial tree recalculated each time

Page 12 | Status: ⏸️ Unattempted

Question: Joseph Dentice, CFA is evaluating three bonds. All three bonds have a coupon rate of 3%, maturity of five years and are generally identical in every respect except that bond A is an option-free bond, bond B is callable in two years and bond C is putable in two years. The bond with the lowest duration is least likely to be:

• A)
• B)
• C) Bond C

Page 12 | Status: ⏸️ Unattempted

Question: Sharon Rogner, CFA is evaluating three bonds for inclusion in fixed income portfolio for one of her pension fund clients. All three bonds have a coupon rate of 3%, maturity of five years and are generally identical in every respect except that bond A is an option-free bond, bond B is callable in two years and bond C is putable in two years. Rogner computes the OAS of bond A to be 50bps using a binomial tree with an assumed interest rate volatility of 15%. If Rogner revises her estimate of interest rate volatility to 10%, the computed OAS of Bond C would most likely be:

• A) equal to 50bps
• B) higher than 50bps
• C) lower than 50bps. MediSoft Inc. develops and distributes high-tech medical software used in hospitals and clinics across the United States and Canada. The firm's software provides an integrated solution to monitoring, analyzing, and managing output from a variety of diagnostic medical equipment including MRIs, CT scans, and EKG machines. MediSoft has grown rapidly since its inception ten years ago, averaging 25% growth in sales over the past decade. The company went public three years ago. Twelve months after its IPO, MediSoft made two semiannual coupon bond offerings, the first of which was a convertible bond. At the time of issuance, the convertible bond had a coupon rate of 7.25%, a par value of $1,000, a conversion price of $55.56, and ten years until maturity. Two years after issuance, the bond became callable at 102% of par value. Soon after the issuance of the convertible bond, the company issued another series of bonds, which were putable but contained no conversion or call features. The putable bonds were issued with a coupon of 8.0%, a par value of $1,000, and 15 years until maturity. One year after their issuance, the put feature of the putable bonds became active, allowing the bonds to be put at a price of 95% of par value, and increasing linearly over five years to 100% of par value. MediSoft's convertible bonds are now trading in the market for a price of $947 with an estimated straight value of $917. The company's putable bonds are trading at a price of $1,052. Volatility in the price of MediSoft's common stock has been relatively high over the past few months. Currently, the stock is priced at $50 on the New York Stock Exchange and is expected to continue its annual dividend in the amount of $1.80 per share. High-tech industry analysts for Brown & Associates, a money management firm specializing in fixed-income investments, have been closely following MediSoft ever since it went public three years ago. In general, portfolio managers at Brown & Associates do not participate in initial offerings of debt investments, preferring instead to see how the issue trades before considering taking a position in the issue. Because MediSoft's bonds have had ample time to trade in the marketplace, analysts and portfolio managers have taken an interest in the company's bonds. At a meeting to discuss the merits of MediSoft's bonds, the following comments were made by various portfolio managers and analysts at Brown & Associates: "Choosing to invest in MediSoft's convertible bond would benefit our portfolios in many ways, but the primary benefit is the limited downside risk associated with the bond. Because the straight value will provide a floor for the value of the convertible bond, downside risk is limited to the difference between the market price of the bond and the straight value." "Decreasing volatility in the price of MediSoft's common stock as well as increasing volatility in the level of interest rates are expected in the near future. The combined effects of these changes in volatility will be a decrease in the price of MediSoft's putable bonds and an increase in the price of the convertible bonds. Therefore, only the convertible bonds would be a suitable purchase."

Page 13 | Status: ⏸️ Unattempted

Question: Assuming the common stock of MediSoft underwent a one-for-two reverse split, how would the features of the company's bonds be adjusted? The:

• A) conversion value of the convertible bond would be reduced by half
• B) market conversion price of the convertible bond would be reduced by half
• C) conversion ratio of the convertible bond would be reduced by 50%

Page 14 | Status: ⏸️ Unattempted

Question: Under what circumstances will the analyst's comments regarding the limited downside risk of MediSoft's convertible bonds be accurate?

• A) The convertible bond is trading in the market as a common stock equivalent
• B) Short-term and long-term interest rates are expected to remain the same
• C) The Federal Reserve Bank decides to pursue a restrictive monetary policy

Page 14 | Status: ⏸️ Unattempted

Question: Subsequent to purchasing one of the putable bonds for his portfolio, one of the managers at Brown & Associates realized that the bond contained a soft put. Which of the following securities cannot be used to redeem the bond in the event the bond becomes putable?

• A) Thirty-year Treasury notes with a coupon of 4.5%
• B) MediSoft’s 9.0% subordinated notes with a maturity of 10 years
• C) Shares of MediSoft’s common stock

Page 14 | Status: ⏸️ Unattempted

Question: Bill Moxley, CFA is evaluating three bonds for inclusion in fixed income portfolio for one of his pension fund clients. All three bonds have a coupon rate of 3%, maturity of five years and are generally identical in every respect except that bond A is an option-free bond, bond B is callable in two years and bond C is putable in two years. The yield curve is currently flat. If the yield curve becomes upward sloping, the bond least likely to have the highest price impact would be:

• A) Bond B
• B) Bond A
• C) Bond C Company Isla has a four-year, 6.5% bond that is callable under the following schedule: 102 in one year's time 101 in two years' time 100 in three years' time The binomial interest rate assuming a 10% rate volatility is shown in Exhibit 1. At each of the nodes: F = the value of the bond obtained by applying the backward induction process (i.e., the expected PV of future cash flows from the bond)

Page 14 | Status: ⏸️ Unattempted

Question: Which of the following represent the correct values that should be within the tree in the places marked by A and B?

• A) A = 99.041 B = 100.000
• B) A = 99.041 B = 100.315
• C) A = 100.000 B = 100.000

Page 17 | Status: ⏸️ Unattempted

Question: Which of the following represent the correct value that should be within the tree in the place marked by D?

• A) 102.000
• B) 101.723
• C) 101.000

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Question: Which of the following is most accurate regarding the use of a binomial tree to calculate the option adjusted spread (OAS) of bonds with embedded options?

• A) The binomial tree can be used to calculate the OAS of a callable corporate bond but not a mortgage backed security (MBS), as the MBS does not contain an option
• B) The spot rate curve cannot be used to calculate the OAS of a callable corporate bond but can be used for a mortgage backed security (MBS)
• C) The binomial tree can be used to calculate the OAS of a callable corporate bond but not a mortgage backed security (MBS), as the MBS value is path dependent

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Question: Which of the following represent the correct value that should be within the tree in the place marked by G?

• A) 96.352
• B) 102.000
• C) 102.576

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Question: Joseph Dentice, CFA is evaluating three bonds. All three bonds have a coupon rate of 3%, maturity of five years and are generally identical in every respect except that bond A is an option-free bond, bond B is callable in two years and bond C is putable in two years. If interest rates increase, the duration of which bond is most likely to decrease?

• A)
• B) Bond
• C) Bond B

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Question: Suppose that the value of an option-free bond is equal to 100.16, the value of the corresponding callable bond is equal to 99.42, and the value of the corresponding putable bond is 101.72. What is the value of the call option?

• A) 0.74
• B) 0.64
• C) 0.21

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Question: Bill Moxley, CFA is evaluating three bonds for inclusion in fixed income portfolio for one of his pension fund clients. All three bonds have a coupon rate of 3%, maturity of five years and are generally identical in every respect except that bond A is an option-free bond, bond B is callable in two years and bond C is putable in two years. The yield curve is currently flat. If the yield curve becomes downward sloping, the bond with the highest price impact is least likely to be:

• A) Bond C
• B) Bond B
• C) Bond A Dawn Adams, CFA, along with her recently hired staff, have responsibilities that require them to be familiar with backward induction methodology as it is used with a binomial valuation model. Adams, however, is concerned that some of her staff, particularly those not enrolled in the CFA program, are a little weak in this area. To assess their understanding of the binomial model and its uses, Adams presented her staff with the first two years of the binomial interest rate tree for an 8% annually compounded bond (shown below). The forward rates and the corresponding values shown in this tree are based on an assumed interest rate volatility of 20%. A member of Adams' staff has been asked to respond to the following:

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Question: Compute V1L, the value of the bond at node 1L.

• A) $95.99
• B) $103.58
• C) $101.05

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Question: Assume that the bond is putable in one year at par ($100) and that the put will be exercised if the computed value is less than par. What is the value of the putable bond?

• A) $103.04
• B) $95.38
• C) $105.17

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Question: Assume that the bond is putable in one year at par ($100) and that the put will be exercised if the computed value is less than par. What is the value of the put option?

• A) $0.42
• B) $1.86
• C) $3.70

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Question: Using the following interest rate tree, what is the value of a callable bond that has two years remaining to maturity, a call price of 99, and a 2.50% coupon rate? Assume that the call option can be exercised at t=1 year from now. 3.80% 3.18% 2.61%

• A) 99.21
• B) 98.25
• C) 98.65

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Question: The primary benefit of owning a convertible bond over owning the common stock of a corporation is the:

• A) bond has more upside potential
• B) bond has lower downside risk
• C) conversion premium

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Question: For a putable bond, callable bond, or putable/callable bond, the nodal-decision process within the backward induction methodology of the interest rate tree framework requires that at each node the possible values will:

• A) not be higher than the call price or lower than the put price
• B) include the face value of the bond
• C) be, in number, two plus the number of embedded options

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Question: As the volatility of interest rates increases, the value of a callable bond will:

• A) rise
• B) decline
• C) rise if the interest rate is below the coupon rate, and fall if the interest rate is above the coupon rate

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Question: Sharon Rogner, CFA is evaluating three bonds for inclusion in fixed income portfolio for one of her pension fund clients. All three bonds have a coupon rate of 3%, maturity of five years and are generally identical in every respect except that bond A is an option-free bond, bond B is callable in two years and bond C is putable in two years. Rogner computes the OAS of bond A to be 50bps using a binomial tree with an assumed interest rate volatility of 15%. If Rogner revises her estimate of interest rate volatility to 20%, the computed OAS of Bond B would most likely be:

• A) lower than 50bps
• B) equal to 50bps
• C) higher than 50bps

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Question: An analyst has constructed an interest rate tree for an on-the-run Treasury security. The analyst now wishes to use the tree to calculate the convexity of a callable corporate bond with maturity and coupon equal to that of the Treasury security. The usual way to do this is to calculate the option-adjusted spread (OAS):

• A) compute the convexity of the Treasury security, and add the OAS
• B) compute the convexity of the Treasury security, and divide by (1+OAS)
• C) shift the Treasury yield curve, compute the new forward rates, add the OAS to those forward rates, enter the adjusted values into the interest rate tree, and then use the usual convexity formula

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Question: If the spot-rate curve experiences a parallel downward shift of 50 basis points:

• A) Portfolio 1 will experience the best price performance
• B) all three portfolios will experience the same price performance
• C) Portfolio 3 will experience the best price performance

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Question: If the 5- and 10-year key rates increase by 20 basis points, but the 2- and 20-year key rates remain unchanged:

• A) Portfolio 2 will experience the best price performance
• B) all three portfolios will experience the same price performance
• C) Portfolio 1 will experience the best price performance

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Question: Is Berg correct about the specified change in yield needed to obtain an accurate estimate of the effective duration and effective convexity of a callable bond using a binomial model?

• A) No, because the specified change in yield can be larger than, smaller than, or equal to the OAS
• B) No, because the specified change in yield must be larger than the option-adjusted spread (OAS)
• C) No, because the specified change in yield must be smaller than the OAS

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Question: Joseph Dentice, CFA is evaluating three bonds. All three bonds have a coupon rate of 3%, maturity of five years and are generally identical in every respect except that bond A is an option-free bond, bond B is callable at any time at par and bond C is putable at any time at par. Yield curve is currently flat at 3%. The bond least likely to have the highest one-sided down-duration is:

• A) Bond
• B)
• C) Bond A

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Question: Which of the following is equal to the value of the putable bond? The putable bond value is equal to the:

• A) option-free bond value plus the value of the put option
• B) callable bond plus the value of the put option
• C) option-free bond value minus the value of the put option

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Question: As the volatility of interest rates increases, the value of a putable bond will:

• A) rise
• B) rise if the interest rate is below the coupon rate, and fall if the interest rate is above the coupon rate
• C) decline

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Question: What is the market conversion price of a convertible security?

• A) The value of the security if it is converted immediately
• B) The price that an investor pays for the common stock in the market
• C) The price that an investor pays for the common stock if the convertible bond is purchased and then converted into the stock

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Question: A putable bond with a 6.4% annual coupon will mature in two years at par value. The current one-year spot rate is 7.6%. For the second year, the yield volatility model forecasts that the one-year rate will be either 6.8% or 7.6%. The bond is putable in one year at 99. Using a binomial interest rate tree, what is the current price?

• A) 98.190
• B) 98.885
• C) 98.246

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Question: How do the risk-return characteristics of a newly issued convertible bond compare with the risk-return characteristics of ownership of the underlying common stock? The convertible bond has:

• A) higher risk and higher return potential
• B) lower risk and lower return potential
• C) lower risk and higher return potential

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Question: Using the following binomial interest rate tree, calculate the value of a two-year, 2.5% putable bond. The American style embedded put option can be exercised anytime and has a strike price of 99. The value is closest to: 3.75% 3.175% 2.665%

• A) 97.92
• B) 99.00
• C) 98.75

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Question: On a given day, a bond with a call provision rose in value by 1%. What can be said about the level and volatility of interest rates?

• A) The only possible explanation is that level of interest rates fell
• B) A possibility is that the level of interest rates remained constant, but the volatility of interest rates rose
• C) A possibility is that the level of interest rates remained constant, but the volatility of interest rates fell

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Question: For a convertible bond, which of the following is least accurate?

• A) The issuer can decide when to convert the bonds to stock
• B)
• C)

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Question: Sharon Rogner, CFA is evaluating three bonds for inclusion in fixed income portfolio for one of her pension fund clients. All three bonds have a coupon rate of 3%, maturity of five years and are generally identical in every respect except that bond A is an option-free bond, bond B is callable in two years and bond C is putable in two years. Rogner computes the OAS of bond A to be 50bps using a binomial tree with an assumed interest rate volatility of 15%. If Rogner revises her estimate of interest rate volatility to 10%, the computed OAS of Bond B would most likely be:

• A) lower than 50bps
• B) equal to 50bps
• C) higher than 50bps

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Question: A callable bond with an 8.2% annual coupon will mature in two years at par value. The current one-year spot rate is 7.9%. For the second year, the yield-volatility model forecasts that the one-year rate will be either 6.8% or 7.6%. The call price is 101. Using a binomial interest rate tree, what is the current price?

• A) 100.279
• B) 100.558
• C) 101.000

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Question: For a callable bond, the value of an embedded option is the price of the option-free bond:

• A) minus the price of a callable bond of the same maturity, coupon and rating
• B) plus the price of a callable bond of the same maturity, coupon and rating
• C) plus the risk-free rate. Patrick Wall is a new associate at a large international financial institution. Wall has recently completed graduate school with a Master's degree in finance, and is also currently a CFA Level I candidate. His previous work experience includes three years as a credit analyst at a small retail bank. Wall's new position is as the assistant to the firm's fixed income portfolio manager. His boss, Charles Johnson, is responsible for getting Wall familiar with the basics of fixed income investing. Johnson asks Wall to evaluate the bonds shown in Table 1. The bonds are otherwise identical except for the call feature present in one of the bonds. The callable bond is callable at par and exercisable on the coupon dates only. Table 1: Bond Descriptions Non-Callable Callable Bond Price $100.83 $98.79 Time to Maturity (years) 5 5 Time to First Call Date -- 0

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Question: Johnson asks Wall to compute the value of the call option. Using the given information what is the value of the embedded call option?

• A) $0.00
• B) $1.21
• C) $2.04

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Question: Wall is a little confused over the relationship between the embedded option and the callable bond. How does the value of the embedded call option change when interest rate volatility increases? The value:

• A) may increase or decrease
• B) increases
• C) decreases

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Question: Wall wonders how the value of the callable bond changes when interest rate volatility increases. How will an increase in volatility affect the value of the callable bond? The value:

• A) may increase or decrease
• B) decreases
• C) increases

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Question: Wall now turns his attention to the value of the embedded call option. How does the value of the embedded call option react to an increase in interest rates? The value of the embedded call is most likely to:

• A) increase
• B) remain the same
• C) decrease. Mike Diffle has been asked to evaluate the bonds of Hardin, Inc. The specific issue Diffle is considering has an 8% annual coupon and matures in two years. The bonds are currently callable at 101, and beginning in six months, they are callable at par. Bratton Corporation, Hardin's competitor, also has bonds outstanding which are identical to Hardin's except that they are not callable. Diffle believes the AA rating of both bonds is an accurate reflection of their credit risk. Diffle is wondering if the Bratton bonds might be a better investment than the Hardin bonds. Assume that the following 1-year interest rate tree is used to value bonds with a maturity of up to three years (this tree assumes interest rate volatility of 10%)

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Question: Puldo still believes that Diffle must include the OAS for the Hardin bonds in his report. Puldo points out that a proper benchmark is critical to any OAS analysis. Which of the following statements regarding benchmark interest rates and OAS is most accurate? Since liquidity risk is a critical issue, the OAS calculation for the Hardin bonds should:

• A) use on-the-run U.S. Treasury rates as a benchmark in order to isolate the credit risk of the Hardin bonds
• B) use on-the-run interest rates for other callable Hardin bonds as a benchmark in order to isolate the liquidity risk of the 2-year bond issue
• C) be based on a benchmark that has no credit risk

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Question: Puldo notes that the duration estimate for the two bonds is not directly comparable. Assuming that the underlying option is at- or near-the-money, the duration of one of the bonds will be lower than the other one. Which of the following most accurately critiques the OAS discussion between Diffle and Puldo? Puldo is:

• A) correct that the OAS will provide insight into the liquidity risk of the Hardin bonds, and Diffle is correct that different volatility assumptions would change the OAS
• B) incorrect that the OAS will provide insight into the liquidity risk of the Hardin Bonds, but Diffle is correct that different volatility assumptions would change the OAS
• C) correct that the OAS will provide insight into the liquidity risk of the Hardin Bonds, but Diffle is incorrect since OAS implicitly adjusts for the volatility of interest rates

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Question: Puldo notes that the duration estimate for the two bonds is not directly comparable. Assuming that the underlying option is at- or near-the-money, the duration of one of the bonds will be lower than the other one. Indicate whether the statements made by Diffle in his memo regarding the value of the embedded option and the effect of the volatility assumption are correct.

• A) Both statements are correct
• B) Only the statement regarding the effect of the volatility assumption is correct
• C) Only the statement regarding the value of the embedded option is correct

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Question: Which of the following is equal to the value of a noncallable / nonputable convertible bond? The value of the corresponding:

• A) callable bond plus the value of the call option on the stock
• B) straight bond
• C) straight bond plus the value of the call option on the stock. Explanation The value of a noncallable/nonputable convertible bond can be expressed as: Option-free convertible bond value = straight value + value of the call option on the stock. (Module 27.8, LOS 27.n)

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Question: Which of the following statements is most accurate concerning a convertible bond? A convertible bond's value depends:

• A) only on changes in the market price of the stock
• B) on both interest rate changes and changes in the market price of the stock
• C) only on interest rate changes. Explanation The value of convertible bond includes the value of a straight bond plus an option giving the bondholder the right to buy the common stock of the issuer. Hence, interest rates affect the bond value and the underlying stock price affects the option value. (Module 27.8, LOS 27.n)

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Question: The effective convexity of a bond is most likely to be negative if the bond is:

• A) callable
• B) putable
• C) option-free. Explanation The effective convexity of a callable bond be negative (meaning that the upside for the callable bond is smaller than the downside) when the call option is near the money. Option-free bonds exhibit positive convexity, meaning that the price rises more when interest rates fall than the bond price declines when interest rates rise by the same amount. The convexity of putable bonds is always positive. (Module 27.6, LOS 27.l) Bill Woods, CFA, is a portfolio manager for Matrix Securities Fund, a closed-end bond fund that invests in U.S. Treasuries, mortgage-backed securities (MBS), asset-backed securities (ABS), and MBS derivatives. The fund has assets of approximately $400 million, has a current stock price of $14.50 and a net asset value (NAV) of $16.00. Woods is a member of a four person investment team that is responsible for all aspects of managing the portfolio, including interest rate forecasting, performing basic financial analysis and valuation of the portfolio, and selecting appropriate investments for Matrix. His expertise is in the analysis and valuation of MBS and ABS. The fund pays a $0.12 monthly dividend that is paid from current income. The basic operating strategy of Matrix is to leverage its capital by investing in fixed income securities, and then financing those assets through repurchase agreements. Matrix then earns the spread

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Question: Woods is most likely resistant to the zero-volatility spread because the spread:

• A) only considers one path of interest rates, the current Treasury spot rate curve
• B) fails to consider price risk, which is uncertainty regarding terminal cash flows
• C) does not indicate how much of the spread reflects the significant prepayment risk associated with MBS. Explanation Zero-volatility spread is a commonly used measure of relative value for MBS and ABS. However, it only considers one path of interest rates, while OAS considers every spot rate along every interest rate path. (Module 27.4, LOS 27.g)

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Question: In general, the investment team at Matrix attempts to buy "cheap" securities because they are undervalued on a relative basis. What is a characteristic of a "cheap" security for a given Z-spread and effective duration?

• A) High OAS relative to the required OAS and high option costs
• B) High OAS relative to the required OAS and low option costs
• C) Low OAS relative to the required OAS and low option costs. Explanation A higher OAS indicates a larger risk-adjusted spread, which leads to a lower relative price. The implied cost of the embedded option in a security with a call feature is the option cost, so a buyer would prefer a lower cost. (Module 27.4, LOS 27.g)

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Question: Which of the two bonds Woods is considering purchasing has the greater interest rate exposure?

• A) ARM B, because it has a smaller duration
• B) The interest rate exposure cannot determine without a specific measure of convexity
• C) ARM A, because it has a larger duration. Explanation Effective duration is a measure of interest rate risk. All things equal, the larger the duration of a security the greater the interest rate risk. (Module 27.4, LOS 27.g)

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Question: Matrix also currently has investments in several ABS. Which of the following spread measures is most appropriate in the analysis of ABS backed by credit card receivables?

• A) Monte Carlo simulation model, because representative paths can be utilized
• B) Z-spread, because credit card ABS have no prepayment option
• C) OAS, because the cash flows are interest rate path dependent. Explanation Credit card receivable-backed ABS have no prepayment option, therefore prepayments are not path dependent and the Z-spread is the most appropriate model. (Module 27.4, LOS 27.g) Alnoor Hudda, CFA, is valuing two floaters issued by Mateo Bank. Both floaters have a par value of $100, three year life and pay based on annual MRR. Hudda has generated the following binomial tree for MRR. 1-year forward rates starting in year: 0 1 2 2% 5.7798% 6.0512% 3.8743% 4.0562% 2.7190%

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Question: Value of a capped floater with a cap of 4% is closest to:

• A) $96.71
• B) $97.38
• C) $98.70 Explanation

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Question: Value of the cap in a capped floater with a cap of 4% is closest to:

• A) $4.41
• B) $1.29
• C) $1.23 Explanation value of the cap = $100 – $98.71 = $1.29 The cap will be in the money for nodes 2,UU; 2,UL; and 1,U. V2,UU = 104/1.060512 = 98.07 V2,UL = 104/1.040562 = 99.95 V2,UL = 102.7190/1.027190 = 100 (Module 27.7, LOS 27.m)

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Question: Suppose that the stock price of a common stock increases by 10%. Which of the following is most accurate for the price of the recently issued convertible bond? The value of the convertible bond will:

• A) increase by 10%
• B) increase by less than 10%
• C) remain unchanged. Explanation When the underlying stock price rises, the convertible bond will underperform because of the conversion premium. However, buying convertible bonds in lieu of stocks limits downside risk. The price floor set by the straight bond value causes this downside protection. (Module 27.8, LOS 27.q) V1,U = = 97.38 V 1,L = = 99.98 V0 = = 98.71 ( + 4) 98.07 + 99.95 2 1.057798 ( + 3.8743) 100 + 99.95 2 1.038743 ( + 2) 97.38 + 99.98 2 1.02 V1,U = = 97.38 V 1,L = = 99.98 V0 = = 98.71 ( + 4) 98.07 + 99.95 2 1.057798 ( + 3.8743) 100 + 99.95 2 1.038743 ( + 2) 97.38 + 99.98 2 1.02

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Question: Using the following tree of semiannual interest rates what is the value of a 5% callable bond that has one year remaining to maturity, a call price of 99 and pays coupons semiannually? 7.76% 6.20% 5.45%

• A) 97.17
• B) 98.29
• C) 99.01. Explanation The callable bond price tree is as follows: 100.00 A → 98.67 98.29 100.00 99.00 100.00 As an example, the price at node A is obtained as follows: PriceA = min[(prob × (Pup + (coupon / 2)) + prob × (Pdown + (coupon/2)) / (1 + (rate / 2)), call price] = min[(0.5 × (100 + 2.5) + 0.5 × (100 + 2.5)) / (1 + (0.0776 / 2)), 99} = 98.67. The bond values at the other nodes are obtained in the same way. (Module 27.2, LOS 27.f) Kate Inka is a new hire for Maya Incorporated, a fixed income fund manager. On her first week on the job, she is asked to prepare a presentation on valuation and analysis of bonds with embedded options. Inka starts her presentation with the following three statements: Statement 1: "In times of increased expectations of interest rate volatility the value of callable bonds will fall." Statement 2: "When trying to analyze the return for credit and liquidity risk on a corporate callable bond relative to a government bond, the Z-spread must be calculated. The Z-spread can be viewed as the constant spread added to treasury spot rates such that the present value of the callable bonds coupons and principal equate to its market price." Statement 3: "When analyzing the interest rate risk of a callable bond it is worth keeping in mind that its effective convexity will be less than or equal to the equivalent option free bond." Inka is analyzing a three-year, 6% annual coupon, $100 par callable bond. The bond has a European call feature allowing it to be called at 101% of par in two years' time. Inka uses a binomial tree assuming interest rate volatility of 20% as shown in Exhibit 1. Exhibit 1: Binomial Lattice T0 T1 T2 6.34% 5.45% 3% ????? 3.65%

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Question: How many of Inka's opening statements are correct?

• A) Two
• B) Three
• C) One. Explanation Statement 1 is true. The value of a callable bond = value of an identical straight bond – value of embedded call. The value of embedded options, (both call and put) will increase in times of higher expected interest rate volatility. Therefore, the value of a callable bond will fall when rate volatility rises. Statement 2 is false. The Z-spread on a callable bond will be affected by credit risk and liquidity risk, relative to benchmark bonds used to calculate the spot rates. Z-spreads are also affected by embedded options. Embedded call (put) option increases (decreases) the Z-spread. The option adjusted spread (AOS) removes the uncertainty of the embedded option feature by modelling the impact on the bonds cash flows. Instead of the Z-spread, a constant OAS should be added to each spot and expected future 1-period rates in a binomial tree such that the backwardly induced price converges with market price. The OAS reflects credit and liquidity risk relative to the benchmark securities only. Statement 3 is true. Callable bonds exhibit negative convexity when yields fall to low levels. This is due to the price compression the bond experiences relative to a straight bond as the option moves towards the money. (Module 27.6, LOS 27.l)

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Question: Which value for the backwardly induced price of the corporate callable bond using the binomial tree in Exhibit 1 is most accurate?

• A) $105.69
• B) $104.89
• C) $105.20. Explanation First compute the missing rate using the relationship: upper rate = lower rate e2 × volatility = 2.85%e2×0.2 = 4.25% Then use backward induction: Value at T2 Upper: 106 / 1.0634 = 99.68. Value at T2 Middle: 106 / 1.0425 = 101.67. Replace with the call price of $101. Value at T2 Lower: 106 / 1.0285 = 103.06. Replace with the call price of $101. Value at T1 Upper: ((99.68 + 101) / 2 + 6) / 1.0545 = 100.84. Bond is not callable at T1. Value at T1 Lower: ((101 + 101) / 2 + 6) / 1.0365 = 103.23. Bond is not callable at T1. Value at T0 ((100.84 + 103.23) / 2 + 6) / 1.03 = $104.89. (Module 27.2, LOS 27.f)

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Question: How many of Inka's comments about her binomial tree exercise are correct?

• A) One
• B) Two
• C) Three. Explanation Comment 1 is true. A correctly calibrated (to treasury securities) binomial tree will reflect the credit and liquidity risk of treasury securities. Corporate bonds typically will have greater credit and liquidity risk than government securities and as a result, the rates in the tree are too low. Backward induction using the tree would value the corporate bond too high relative to its market price. Comment 2 is true. The option adjusted spread (OAS) is the constant spread when added to the treasury spot and expected future 1-period rates in the tree, will value the callable corporate bonds equal to its market price. Comment 3 is true. If the analyst increases the volatility assumption used to build the tree the spread between lower and upper forward rates will widen. Backwardly inducing the corporate callable bond will now result in a lower value. It is important to note that this is the analyst changing their assumption used to build the tree which will not impact the bond's actual market price. As the backwardly induced value is now lower but the market price remains unchanged, a smaller OAS needs to be added to force the backwardly induced value to be equal to the market price. (Module 27.4, LOS 27.h)

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Question: How many of Inka's comments about duration are accurate?

• A) One
• B) Three
• C) Two. Explanation Comment 1 is true. Effective duration calculates sensitivity to a 100 basis point change in yield to maturity by taking the arithmetic mean impact of parallel upwards and downwards shift in a bonds yield on price. Even for option free bonds, this linear estimation approach causes estimation error due to the convex nature of bonds. An embedded option causes greater estimation error. A callable bond will react very differently to upwards and downwards shifts in yield due to the option moving towards or away from the money. A solution to this is to analyze sensitivity to upwards and downwards shifts in yield separately by using one-sided durations. Comment 2 is false. Effective duration of a callable bond will be less than (or equal to) an otherwise identical straight bond. Comment 3 is false. Key rate duration measures the sensitivity of a bond's price to a change in a single par rate, holding all other par rates constant. For an option free bond, the highest key rate duration is the maturity-matched key rate. For callable bonds with low coupons, the greatest key rate duration will be the maturity-matched key rate (due to the low probability of the bond being called). As the coupon rate is increased, the probability of the bond being called increases and as a result the key rate duration relating to the call date will increase while the maturity-matched key rate duration will decrease. (Module 27.6, LOS 27.k)

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Question: Which of the following is the appropriate "nodal decision" within the backward induction methodology of the interest tree framework for a putable bond?

• A) Min(put value, discounted value)
• B) Max(par value, discounted value)
• C) Max(put price, discounted value). Explanation When valuing a putable bond using the backward induction methodology, the relevant cash flow to use at each nodal period is the coupon to be received during that nodal period plus the computed value or exercise price, whichever is greater. (Module 27.2, LOS 27.f)

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Question: Joseph Dentice, CFA is evaluating three bonds. All three bonds have a coupon rate of 3%, maturity of five years and are generally identical in every respect except that bond A is an option-free bond, bond B is callable in two years and bond C is putable in two years. If interest rates decrease, the duration of which bond is most likely to decrease?

• A)
• B) Explanation Decrease in rates would increase the likelihood of the call option being exercised and reduce the expected life (and duration) of the callable bond the most. (Module 27.5, LOS 27.j)
• C) Bond

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Question: Which of the following correctly describes one of the basic features of a convertible bond? A convertible bond is a security that can be converted into:

• A) common stock at the option of the investor
• B) common stock at the option of the issuer
• C) another bond at the option of the issuer. Explanation The owner of a convertible bond can exchange the bond for the common shares of the issuer. (Module 27.8, LOS 27.n)

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Question: Which of the following is the appropriate "nodal decision" within the backward induction methodology of the interest tree framework for a callable bond?

• A) Max(call price, discounted value)
• B) Min(par value, discounted value)
• C) Min(call price, discounted value). Explanation When valuing a callable bond using the backward induction methodology, the relevant cash flow to use at each nodal period is the coupon to be received during that nodal period plus the computed value or the call price, whichever is less. (Module 27.2, LOS 27.f)

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Question: Which of the following statements about how interest rate volatility affects the value bond is most accurate? When interest rate volatility increases, the value of a:

• A) callable bond decreases
• B) putable bond decreases
• C) straight bond decreases. Explanation Option values are positively related to the volatility of the underlying. Thus, when interest rate volatility increases, the values of both call and put options increase. When interest rate volatility increases, the value of a callable bond (where the investor is short the call option) decreases and the value of a putable bond (where the investor is long the put option) increases. The value of a straight bond is unaffected by changes in the volatility of interest rate, though value is affected by changes in the level of interest rate. (Module 27.3, LOS 27.d)

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Question: If a bond's key rate durations for maturity points shorter than the bond's maturity are negative, it is most likely that the bond being analyzed is a:

• A) zero coupon bond
• B) putable bond
• C) callable bond

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Question: Using the binomial tree model, what is the value of the callable bond?

• A) $101.735
• B) $95.521
• C) $102.196. Explanation The value of this bond at node 0 is V0 = ½ × [($99.391 + $7) ÷ 1.048755 + ($100.000 + $7) ÷ 1.048755] = $101.735, so the price of the callable bond is $101.735. (Module 27.2, LOS 27.f)

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Question: What is the value of the call option embedded in this bond?

• A) $6.675
• B) $0.461
• C) $12.924. Explanation Given in the problem is the value of the bond's option-free counterpart: $102.196. From Part A we've determined the price of the callable bond to be $101.735. From the relationship: Vcall = Voption-free – Vcallable We can determine that the value of the call option is $102.196 – $101.735 = $0.461. (Module 27.2, LOS 27.f)

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Question: The market conversion premium ratio for Stellar's convertible bond is closest to:

• A) 20.6%
• B) 28%
• C) 2.40% Explanation An investor who purchases the convertible bond rather than the underlying stock will pay a premium over the current market price of the stock. This market conversion premium per share is equal to the difference between the market conversion price and the current market price of the stock. Market conversion price = market price of CB ÷ conversion ratio = 1024 / 25 = 40.96 Market conversion premium = conversion price − market price = 40.96 − 32 = 8.96 (Module 27.2, LOS 27.f)

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Question: Which of the following scenarios will lead to a convertible bond underperforming the underlying stock? The:

• A) stock price is stable
• B) stock price falls
• C) stock price rises. Explanation A convertible bond underperforms the underlying common stock when that stock increases in value. This is because of the conversion premium which means that the bond will increase less than the increase in stock price. If the stock price falls, the convertible bond should outperform the stock because of the floor created by the straight-value. If the stock is stable, the bond is likely to outperform the stock because of the higher current yield of the bond. If the bond is upgraded, the bond should increase in value. There is no reason that upgrading the bond should lead to the bond underperforming the stock. (Module 27.8, LOS 27.q)

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Question: For a convertible bond with a call provision, with respect to the bond's convertibility feature and the call feature, the Black-Scholes option model can apply to:

• A) only one feature
• B) both features
• C) neither features. Explanation The Black-Scholes model applies to the convertibility feature just as it does to the common stock. The Black-Scholes model is not appropriate for the call feature because the volatility of the bond cannot be assumed constant. (Module 27.8, LOS 27.n)

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Question: How does the value of a callable bond compare to a noncallable bond? The callable bond value is:

• A) lower or higher
• B) lower
• C) higher. Explanation Since the issuer has the option to call the bonds before maturity, he is able to call the bonds when their coupon rate is high relative to the market interest rate and obtain cheaper financing through a new bond issue. This, however, is not in the interest of the bond holders who would like to continue receiving the high coupon rates. Therefore, they will only pay a lower price for callable bonds. (Module 27.1, LOS 27.b)

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Question: A convertible bond has a conversion ratio of 12 and a straight value of $1,010. The market value of the bond is $1,055, and the market value of the stock is $75. What is the market conversion price and premium over straight value of the bond? Market conversion price Premium over straight value

• A) $75.00 0.1029
• B) $87.92 0.0446
• C) $84.17 0.1222 Explanation The market conversion price is: (market price of the bond) / (conversion ratio) = $1,055 / 12 = $87.92. The premium over straight price is: (market price of bond) / (straight value) − 1 = ($1,055 / $1,010) − 1 = 0.0446. (Module 27.8, LOS 27.o)

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Question: Generally speaking, an analyst would like the option adjusted spread (OAS) to be large, controlling for:

• A) Credit and liquidity risk
• B) Credit, liquidity and option risk
• C) Option risk. Explanation OAS is "Option-adjusted" and hence includes no compensation for option risk: OAS is compensation for taking credit and liquidity risk. (Nominal spread, by comparison, includes compensation for liquidity risk, credit risk, and option risk.) Analysts prefer higher OAS, after controlling for credit and liquidity risk. (Module 27.4, LOS 27.g)

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Question: A callable bond and an option-free bond have the same coupon, maturity and rating. The callable bond currently trades at par value. Which of the following lists correctly orders the values of the indicated items from lowest to highest?

• A) $0, embedded call, callable bond, option-free bond
• B) Embedded call, callable bond, $0, option-free bond
• C) Embedded call, $0, callable bond, option-free bond. Explanation The embedded call will always have a positive value prior to expiration, and this is especially true if the callable bond trades at par value. Since investors must be compensated for the call feature, the value of the option-free bond must exceed that of a callable bond with the same coupon and maturity and rating. (Module 27.1, LOS 27.b)

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Question: The value of a callable bond is equal to the:

• A) callable bond plus the value of the embedded call option
• B) option-free bond value minus the value of the call option
• C) callable bond value minus the value of the put option minus the value of the call option. Explanation The value of a bond with an embedded call option is simply the value of a noncallable (Vnoncallable) bond minus the value of the option (Vcall). That is: Vcallable = Vnoncallable – Vcall. (Module 27.1, LOS 27.b)

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Question: The value of a convertible bond is most likely to be calculated as the value of an equivalent straight bond:

• A) plus the value of a call option on the bond
• B) plus the value of a call option on the stock
• C) minus the value of a put option on the bond. Explanation

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Question: Which bonds would have its maturity-matched rate as its most critical rate?

• A) High coupon callable bonds
• B) Low coupon putable bonds
• C) Low coupon callable bonds. Explanation Callable bonds with low coupon rate are unlikely to be called; hence, their maturity- matched rate is their most critical rate (i.e., the highest key rate duration corresponds to the bond's maturity). Similarly, putable bonds with high coupon rates are unlikely to be put and are most sensitive to their maturity-matched rates. (Module 27.6, LOS 27.k)

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Question: For an option-free bond trading at par, it is least likely that:

• A) The spot rate for the maturity of the bond is least important rate affecting the value of the bond
• B) The rate durations for all the rates other than the maturity-matched rate are zero
• C) Its maturity key rate duration is the same as its effective duration. Explanation If an option-free bond is trading at par, the bond's maturity-matched rate (or the spot rate applicable to its maturity) is the only rate that affects the bond's value. Its maturity key rate duration is the same as its effective duration, and all other key rate durations are zero. (Module 27.6, LOS 27.k)

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Question: Suppose the market price of a convertible security is $1,050 and the conversion ratio is 26.64. What is the market conversion price?

• A) $1,050.00
• B) $26.64
• C) $39.41. Explanation The market conversion price is computed as follows: Market conversion price = market price of convertible security/conversion ratio = $1,050/26.64 = $39.41 (Module 27.8, LOS 27.o)

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Question: What is the value of the capped floater using Nagy's line manager's binomial tree of interest rate expectations?

• A) $98.80
• B) $99.26
• C) $101.44. Explanation

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Question: Which of the following statements is/are correct? Statement I: The straight bond should trade for less than $102. Statement II: If interest rate volatility were to increase then the price differential between the two Redna bonds would widen.

• A) Both statements are correct
• B) Statement I is correct but Statement II is incorrect
• C) Statement I is incorrect but Statement II is correct. Explanation The straight bond will be priced higher, as the investor will not have the risk of the bond being called. If interest rate volatility rises then the call option will become more valuable, and the price differential will widen. (Module 27.1, LOS 27.b)

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Question: Suppose Redna were to issue a bond that was identical in all respects to the existing callable bond except that instead it was putable. How would a binomial tree valuation be adapted?

• A) The put option becomes an effective floor price at each applicable node, instead of the call’s effective ceiling price
• B) The put option becomes an effective floor price at each applicable node, as well as the call’s effective ceiling price
• C) The put option becomes an effective ceiling price at each applicable node. Explanation A put option is an effective floor at each node. Call feature would no longer be relevant. (Module 27.2, LOS 27.f)

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Question: Using the report of the economist, which of the following order of effective durations (highest to lowest) of otherwise identical bonds is most accurate:

• A) callable, putable, straight
• B) straight, callable, putable
• C) straight, putable, callable. Explanation Since the rates are trending lower, the call option is likely to be exercised while the put will not. Therefore the effective duration of callable < effective duration of putable. Otherwise identical straight bonds will always have a higher (or same) effective durations than either callables or putables. (Module 27.5, LOS 27.j)

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Question: A callable bond and an option-free bond have the same coupon, maturity and rating. The callable bond currently trades at par value. Which of the following lists correctly orders the values of the indicated items from lowest to highest?

• A) Embedded call, $0, callable bond, option-free bond
• B) Embedded call, callable bond, $0, option-free bond
• C) $0, embedded call, callable bond, option-free bond. Explanation The embedded call will always have a positive value prior to expiration, and this is especially true if the callable bond trades at par value. Since investors must be compensated for the call feature, the value of the option-free bond must exceed that of a callable bond with the same coupon and maturity and rating. (Module 27.2, LOS 27.c)

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Question: Which of the following most accurately explains how the effective convexity is computed using the binomial model. In order to compute the effective convexity the:

• A) binomial tree has to be shifted upward and downward by the same amount for all nodes
• B) yield curve has to be shifted upward and downward in a parallel manner and the binomial tree recalculated each time
• C) volatility has to be shifted upward and downward and the binomial tree recalculated each time. Explanation Apply parallel shifts to the yield curve and use these curves to compute new forward rates in the interest rate tree. The resulting bond values are then used to compute the effective convexity. (Module 27.5, LOS 27.i)

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Question: Using the following tree of semiannual interest rates what is the value of a putable semiannual bond that has one year remaining to maturity, a put price of 98 and a 4% coupon rate? The bond is putable today. 7.59% 6.35% 5.33%

• A) 98.00
• B) 98.75
• C) 97.92. Explanation The putable bond price tree is as follows: 100.00 A ==> 98.27 98.00 100.00 99.35 100.00 As an example, the price at node A is obtained as follows: PriceA = max{(prob × (Pup + coupon/2) + prob × (Pdown + coupon/2))/(1 + rate/2), putl price} = max{(0.5 × (100 + 2) + 0.5 × (100 + 2))/(1 + 0.0759/2),98} = 98.27. The bond values at the other nodes are obtained in the same way. The price at node 0 = [0.5 × (98.27+2) + 0.5 × (99.35+2)]/ (1 + 0.0635/2) = $97.71 but since this is less than the put price of $98 the bond price will be $98. (Module 27.2, LOS 27.f)

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Question: Assuming the common stock of MediSoft underwent a one-for-two reverse split, how would the features of the company's bonds be adjusted? The:

• A) conversion value of the convertible bond would be reduced by half
• B) market conversion price of the convertible bond would be reduced by half
• C) conversion ratio of the convertible bond would be reduced by 50%. Explanation

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Question: Under what circumstances will the analyst's comments regarding the limited downside risk of MediSoft's convertible bonds be accurate?

• A) The convertible bond is trading in the market as a common stock equivalent
• B) Short-term and long-term interest rates are expected to remain the same
• C) The Federal Reserve Bank decides to pursue a restrictive monetary policy. Explanation If interest rates are not expected to change then the straight value of the bond will not change (ignoring the change in value resulting from the passage of time). If the straight value does not change, then downside risk is indeed limited to the difference between the price paid for the bond and the straight value. If, however, interest rates rise as the price of the common stock falls, the conversion value will fall and the straight value will fall, exposing the holder of the convertible bond to more downside risk. (Module 27.8, LOS 27.o)

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Question: Subsequent to purchasing one of the putable bonds for his portfolio, one of the managers at Brown & Associates realized that the bond contained a soft put. Which of the following securities cannot be used to redeem the bond in the event the bond becomes putable?

• A) Thirty-year Treasury notes with a coupon of 4.5%
• B) MediSoft’s 9.0% subordinated notes with a maturity of 10 years
• C) Shares of MediSoft’s common stock. Explanation A bond with an embedded soft put is redeemable through the issuance of cash, subordinated notes, common stock, or any combination of these three securities. In contrast, a bond with a hard put is only redeemable using cash. (Module 27.1, LOS 27.a)

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Question: Bill Moxley, CFA is evaluating three bonds for inclusion in fixed income portfolio for one of his pension fund clients. All three bonds have a coupon rate of 3%, maturity of five years and are generally identical in every respect except that bond A is an option-free bond, bond B is callable in two years and bond C is putable in two years. The yield curve is currently flat. If the yield curve becomes upward sloping, the bond least likely to have the highest price impact would be:

• A) Bond B
• B) Bond A
• C) Bond C Explanation

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Question: Which of the following represent the correct values that should be within the tree in the places marked by A and B?

• A) A = 99.041 B = 100.000
• B) A = 99.041 B = 100.315
• C) A = 100.000 B = 100.000 Explanation A is 99.041 since the call price is higher at 100 and the issuer will choose the cheapest route. The missing value F = 106.5 ÷ 1.06166 = 100.315 and hence B is 100 since it is cheaper for the issuer to call. (Module 27.6, LOS 27.l)

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Question: Which of the following represent the correct value that should be within the tree in the place marked by D?

• A) 102.000
• B) 101.723
• C) 101.000. Explanation Lower of F (101.723) and the call price in two years' time of 101. (Module 27.2, LOS 27.f)

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Question: Which of the following is most accurate regarding the use of a binomial tree to calculate the option adjusted spread (OAS) of bonds with embedded options?

• A) The binomial tree can be used to calculate the OAS of a callable corporate bond but not a mortgage backed security (MBS), as the MBS does not contain an option
• B) The spot rate curve cannot be used to calculate the OAS of a callable corporate bond but can be used for a mortgage backed security (MBS)
• C) The binomial tree can be used to calculate the OAS of a callable corporate bond but not a mortgage backed security (MBS), as the MBS value is path dependent. Explanation OAS on callable or putable bonds can be calculated using binomial interest rate trees. MBS has a prepayment risk, and hence has an embedded call option. Binomial interest rate tree cannot be used to value MBS as the prepayment risk (call risk) in MBS is path dependent. Spot rate curve comprises a single rate for each time period and hence cannot be used to value securities with embedded options. If spot rate curve is used, implicitly you would be assuming zero volatility in rates, and therefore end up valuing the time value component of the option value as zero. (Module 27.4, LOS 27.h)

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Question: Which of the following represent the correct value that should be within the tree in the place marked by G?

• A) 96.352
• B) 102.000
• C) 102.576. Explanation Make sure to use the lower of the call price or calculated value for lower node in year 2 (i.e., $101). G = {(101 + 100.27) / 2 + 6.50} / (1.044448) = 102.57 (Module 27.6, LOS 27.k)

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Question: Joseph Dentice, CFA is evaluating three bonds. All three bonds have a coupon rate of 3%, maturity of five years and are generally identical in every respect except that bond A is an option-free bond, bond B is callable in two years and bond C is putable in two years. If interest rates increase, the duration of which bond is most likely to decrease?

• A)
• B) Explanation Increase in rates would increase the likelihood of the put option being exercised and reduce the expected life (and duration) of the putable bond the most. (Module 27.5, LOS 27.j)
• C) Bond

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Question: Suppose that the value of an option-free bond is equal to 100.16, the value of the corresponding callable bond is equal to 99.42, and the value of the corresponding putable bond is 101.72. What is the value of the call option?

• A) 0.74
• B) 0.64
• C) 0.21. Explanation The call option value is just the difference between the value of the option-free bond and the value of the callable bond. Therefore, we have: Call option value = 100.16 – 99.42 = 0.74. (Module 27.1, LOS 27.b)

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Question: Compute V1L, the value of the bond at node 1L.

• A) $95.99
• B) $103.58
• C) / (1 + r1L)] V1L = (½)[(99.455 + 8) / (1 + 0.05331)] + [(102.755 + 8) / (1 + 0.05331)] = $103.583 (Module 27.2, LOS 27.f)

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Question: Compute V0, the value of the bond at node 0.

• A) $104.76
• B) $99.07
• C) $101.35. Explanation

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Question: Assume that the bond is putable in one year at par ($100) and that the put will be exercised if the computed value is less than par. What is the value of the putable bond?

• A) $103.04
• B) $95.38
• C) $105.17. Explanation The relevant value to be discounted using a binomial model and backward induction methodology for a putable bond is the value that will be received if the put option is exercised or the computed value, whichever is greater. In this case, the relevant value at node 1U is the exercise price ($100.000) since it is greater than the computed value of $99.127. At node 1L, the computed value of $103.583 must be used. Therefore, the value of the putable bond is: V0 = (½)[(100.00 + 8) / (1 + 0.043912)] + [(103.583 + 8) / (1 + 0.043912)] = $105.17314 (Module 27.2, LOS 27.f)

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Question: Assume that the bond is putable in one year at par ($100) and that the put will be exercised if the computed value is less than par. What is the value of the put option?

• A) $0.42
• B) $1.86
• C) $3.70. Explanation Vputable = Vnonputable + Vput Rearranging, the value of the put can be stated as: Vput = Vputable − Vnonputable Vputable was computed to be $105.173 in the previous question, and Vnonputable was determined to be $104.755 in the question prior to that. So the value of the embedded put option for the bond under analysis is: $105.173 − 104.755 = $0.418 (Module 27.2, LOS 27.f)

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Question: Using the following interest rate tree, what is the value of a callable bond that has two years remaining to maturity, a call price of 99, and a 2.50% coupon rate? Assume that the call option can be exercised at t=1 year from now. 3.80% 3.18% 2.61%

• A) 99.21
• B) 98.25
• C) 98.65. Explanation The callable bond price tree is as follows: 100.00 98.75 98.26 100.00 99.00 100.00 The formula for the price at each node is: Price = min{(prob × (Pup + coupon) + prob × (Pdown + coupon)) / (1 + rate), call price}. Up Node at t = 0.5: min{(0.5 × (100 + 2.5) + 0.5 × (100 + 2.5)) / (1 + 0.038), 99} = 98.75. Down Node at t = 0.5: min{(0.5 × (100 + 2.5) + 0.5 × (100 + 2.5)) / (1 + 0.026), 99} = 99.00. Node at t = 0.0: min{(0.5 × (98.75 + 2.5) + 0.5 × (99 + 2.5)) / (1 + 0.0318), 99} = 98.25. (Module 27.2, LOS 27.f)

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Question: The primary benefit of owning a convertible bond over owning the common stock of a corporation is the:

• A) bond has more upside potential
• B) bond has lower downside risk
• C) conversion premium. Explanation The straight value of the bond forms a floor for the convertible bond's price. This lowers the downside risk. The conversion premium is a disadvantage of owning the convertible bond, and it is the reason the bond has lower upside potential when compared to the stock. (Module 27.8, LOS 27.q)

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Question: As the volatility of interest rates increases, the value of a callable bond will:

• A) rise
• B) decline
• C) rise if the interest rate is below the coupon rate, and fall if the interest rate is above the coupon rate. Explanation As volatility increases, so will the option value, which means the value of a callable bond will decline. Remember that with a callable bond, the investor is short the call option. (Module 27.3, LOS 27.d)

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Question: Sharon Rogner, CFA is evaluating three bonds for inclusion in fixed income portfolio for one of her pension fund clients. All three bonds have a coupon rate of 3%, maturity of five years and are generally identical in every respect except that bond A is an option-free bond, bond B is callable in two years and bond C is putable in two years. Rogner computes the OAS of bond A to be 50bps using a binomial tree with an assumed interest rate volatility of 15%. If Rogner revises her estimate of interest rate volatility to 20%, the computed OAS of Bond B would most likely be:

• A) lower than 50bps
• B) equal to 50bps
• C) higher than 50bps. Explanation The OAS of the three bonds should be same as they are given to be identical bonds except for the embedded options (OAS is after removing the option feature and hence would not be affected by embedded options). Hence the OAS of bond B would be 50 bps absent any changes in assumed level of volatility. When the assumed level of volatility in the tree is increased, the value of the embedded call option would increase and the computed value of the callable bond would decrease. The constant spread now needed to force the computed value to be equal to the market price is therefore lower than before. Hence an increase in volatility estimate reduces the computed OAS for a callable bond. (Module 27.4, LOS 27.h)

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Question: An analyst has constructed an interest rate tree for an on-the-run Treasury security. The analyst now wishes to use the tree to calculate the convexity of a callable corporate bond with maturity and coupon equal to that of the Treasury security. The usual way to do this is to calculate the option-adjusted spread (OAS):

• A) compute the convexity of the Treasury security, and add the OAS
• B) compute the convexity of the Treasury security, and divide by (1+OAS)
• C) shift the Treasury yield curve, compute the new forward rates, add the OAS to those forward rates, enter the adjusted values into the interest rate tree, and then use the usual convexity formula. Explanation The analyst uses the usual convexity formula, where the upper and lower values of the bonds are determined using the tree. (Module 27.5, LOS 27.i)

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Question: Are the two observations Berg writes down after the fixed income conference advantages to using the swap rate curve as a benchmark instead of a government bond curve?

• A) Only Statement 1 is an advantage
• B) Both statements are advantages
• C) Only Statement 2 is an advantage. Explanation Swap rates are fixed rates on plain-vanilla interest rate swaps. The swap rate curve (also known as the LIBOR curve) is the series of swap rates quoted by swap dealers over maturities extending from 2 to 30 years. Both of Berg's observations are advantages to using the swap rate curve instead of a government bond curve as a benchmark rate curve. (Module 25.3, LOS 25.e)

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Question: If the spot-rate curve experiences a parallel downward shift of 50 basis points:

• A) Portfolio 1 will experience the best price performance
• B) all three portfolios will experience the same price performance
• C) Portfolio 3 will experience the best price performance. Explanation The sum of a portfolio's key rate durations is the effective duration of the portfolio. Each of the portfolios has an effective duration of five, so a parallel shift in the yield curve will have the same effect on each portfolio, and each will experience the same price performance. (Module 25.6, LOS 25.j)

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Question: If the 5- and 10-year key rates increase by 20 basis points, but the 2- and 20-year key rates remain unchanged:

• A) Portfolio 2 will experience the best price performance
• B) all three portfolios will experience the same price performance
• C) Portfolio 1 will experience the best price performance. Explanation

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Question: Is Berg correct about the specified change in yield needed to obtain an accurate estimate of the effective duration and effective convexity of a callable bond using a binomial model?

• A) No, because the specified change in yield can be larger than, smaller than, or equal to the OAS
• B) No, because the specified change in yield must be larger than the option- adjusted spread (OAS)
• C) No, because the specified change in yield must be smaller than the OAS. Explanation The steps in the process of calculating the effective duration of a callable bond using a binomial tree are as follows: Step 1: Given assumptions about benchmark interest rates, interest rate volatility, and the call and/or put rule, calculate the OAS for the issue using the binomial model. Step 2: Impose a small parallel shift in the on-the-run yield curve by an amount equal to +Δy. Step 3: Build a new binomial interest rate tree using the new yield curve. Step 4: Add the OAS to each of the 1-year forward rates in the interest rate tree to get a "modified" tree. (We assume that the OAS does not change when interest rates change.) Step 5: Compute BV+Δy using this modified interest rate tree. Step 6: Repeat steps 2 through 5 using a parallel rate shift of −Δy to estimate a value of BV-Δy. There is no restriction on the relationship between the assumed change in the yield (Δy) and the OAS. (Module 27.5, LOS 27.i)

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Question: An analyst has constructed an interest rate tree for an on-the-run Treasury security. The analyst now wishes to use the tree to calculate the duration of the Treasury security. The usual way to do this is to estimate the changes in the bond's price associated with a:

• A) parallel shift up and down of the forward rates implied by the binomial model
• B) shift up and down in the current one-year spot rate all else held constant
• C) parallel shift up and down of the yield curve. Explanation The usual method is to apply parallel shifts to the yield curve, use those curves to compute new sets of forward rates, and then enter each set of rates into the interest rate tree. The resulting volatility of the present value of the bond is the measure of effective duration. (Module 27.5, LOS 27.i)

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Question: Which of the following is equal to the value of the putable bond? The putable bond value is equal to the:

• A) option-free bond value plus the value of the put option
• B) callable bond plus the value of the put option
• C) option-free bond value minus the value of the put option. Explanation The value of a putable bond can be expressed as Vputable = Vnonputable + Vput. (Module 27.1, LOS 27.b)

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Question: As the volatility of interest rates increases, the value of a putable bond will:

• A) rise
• B) rise if the interest rate is below the coupon rate, and fall if the interest rate is above the coupon rate
• C) decline

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Question: What is the market conversion price of a convertible security?

• A) The value of the security if it is converted immediately
• B) The price that an investor pays for the common stock in the market
• C) The price that an investor pays for the common stock if the convertible bond is purchased and then converted into the stock. Explanation The market conversion price, or conversion parity price, is the price that the convertible bondholder would effectively pay for the stock if she bought the bond and immediately converted it. market conversion price = market price of convertible bond ÷ conversion ratio. (Module 27.8, LOS 27.o)

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Question: A putable bond with a 6.4% annual coupon will mature in two years at par value. The current one-year spot rate is 7.6%. For the second year, the yield volatility model forecasts that the one-year rate will be either 6.8% or 7.6%. The bond is putable in one year at 99. Using a binomial interest rate tree, what is the current price?

• A) 98.190
• B) 98.885
• C) 98.246. Explanation The tree will have three nodal periods: 0, 1, and 2. The goal is to find the value at node 0. We know the value at all nodes in nodal period 2: V2=100. In nodal period 1, there will be two possible prices: Vi,U = [(100 + 6.4) / 1.076 + (100+6.4) / 1.076] / 2 = 98.885 Vi,L = [(100 + 6.4) / 1.068 + (100 + 6.4) / 1.068] / 2 = 99.625. Since 98.885 is less than the put price, Vi,U = 99 V0 = [(99 + 6.4) / 1.076) + (99.625 + 6.4) / 1.076)] / 2 = 98.246. (Module 27.2, LOS 27.f)

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Question: A CFA charter holder observes a 12-year 7 ¾ percent semiannual coupon bond trading at 102.9525. If interest rates rise immediately by 50 basis points the bond will sell for 99.0409. If interest rates fall immediately by 50 basis points the bond will sell for 107.0719. What are the bond's effective duration (E

• A) ED = 7.801, EC = 80.73
• B) ED = 8.031, EC = 2445.120
• C) ED = 40.368, EC = 7.801

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Question: How do the risk-return characteristics of a newly issued convertible bond compare with the risk-return characteristics of ownership of the underlying common stock? The convertible bond has:

• A) higher risk and higher return potential
• B) lower risk and lower return potential
• C) lower risk and higher return potential. Explanation Buying convertible bonds in lieu of direct stock investing limits downside risk due to the price floor set by the straight bond value. The cost of the risk protection is the reduced upside potential due to the conversion premium. (Module 27.8, LOS 27.q)

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Question: Using the following binomial interest rate tree, calculate the value of a two-year, 2.5% putable bond. The American style embedded put option can be exercised anytime and has a strike price of 99. The value is closest to: 3.75% 3.175% 2.665%

• A) 97.92
• B) 99.00
• C) 98.75. Explanation The putable bond price tree is as follows: A ==> 99.00 99.00 99.84 As an example, the price at node A is obtained as follows: PriceA = max[par value + coupon / (1 + rate), put price] = max[ (100 + 2.5) / (1 + 0.0375) ,99] = 99.00. The bond values at the other nodes are obtained in the same way. The calculated price at node 0 = [0.5(99.00 + 2.5) + 0.5(99.84 + 2.5)] / (1 + 0.03175) = $98.78 but since the put price is $99 the price of the bond will not go below $99. (Module 27.2, LOS 27.f)

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Question: On a given day, a bond with a call provision rose in value by 1%. What can be said about the level and volatility of interest rates?

• A) The only possible explanation is that level of interest rates fell
• B) A possibility is that the level of interest rates remained constant, but the volatility of interest rates rose
• C) A possibility is that the level of interest rates remained constant, but the volatility of interest rates fell. Explanation As volatility declines, so will the option value, which means the value of a callable bond will rise. (Module 27.3, LOS 27.d)

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Question: For a convertible bond, which of the following is least accurate?

• A) The issuer can decide when to convert the bonds to stock
• B) The conversion ratio times the price per share of common stock is a lower limit on the bond's price
• C) A convertible bond may be putable. Explanation All of these are true except the possibility of the issuer to force conversion. The bondholder has the option to convert. (Module 27.8, LOS 27.n)

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Question: Sharon Rogner, CFA is evaluating three bonds for inclusion in fixed income portfolio for one of her pension fund clients. All three bonds have a coupon rate of 3%, maturity of five years and are generally identical in every respect except that bond A is an option-free bond, bond B is callable in two years and bond C is putable in two years. Rogner computes the OAS of bond A to be 50bps using a binomial tree with an assumed interest rate volatility of 15%. If Rogner revises her estimate of interest rate volatility to 10%, the computed OAS of Bond B would most likely be:

• A) lower than 50bps
• B) equal to 50bps
• C) higher than 50bps. Explanation The OAS of the three bonds should be same as they are given to be identical bonds except for the embedded options (OAS is after removing the option feature and hence would not be affected by embedded options). Hence the OAS of bond B would be 50 bps absent any changes in assumed level of volatility. When the assumed level of volatility in the tree is decreased, the value of the call option would decrease and the computed value of the callable bond would increase. The constant spread now needed to force the computed value to be equal to the market price is therefore higher than before. Hence a decrease in the volatility estimate increases the computed OAS for a callable bond. (Module 27.4, LOS 27.h)

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Question: A callable bond with an 8.2% annual coupon will mature in two years at par value. The current one-year spot rate is 7.9%. For the second year, the yield-volatility model forecasts that the one-year rate will be either 6.8% or 7.6%. The call price is 101. Using a binomial interest rate tree, what is the current price?

• A) 100.279
• B) 100.558
• C) 101.000. Explanation The tree will have three nodal periods: 0, 1, and 2. The goal is to find the value at node 0. We know the value for all the nodes in nodal period 2: V2=100. In nodal period 1, there will be two possible prices: V1,U =[(100+8.2)/1.076+(100+8.2)/1.076]/2 = 100.558 V1,L =[(100+8.2)/1.068+(100+8.2)/1.068]/2= 101.311 Since V1,L is greater than the call price, the call price is entered into the formula below: V0=[(100.558+8.2)/1.079)+(101+8.2)/1.079)]/2 = 101.000. (Module 27.2, LOS 27.f)

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Question: For a callable bond, the value of an embedded option is the price of the option-free bond:

• A) minus the price of a callable bond of the same maturity, coupon and rating
• B) plus the price of a callable bond of the same maturity, coupon and rating
• C) plus the risk-free rate. Explanation The value of the option embedded in a bond is the difference between that bond and an option-free bond of the same maturity, coupon and rating. The callable bond will have a price that is less than the price of a non-callable bond. Thus, the value of the embedded option is the option-free bond's price minus the callable bond's price. (Module 27.1, LOS 27.b) Patrick Wall is a new associate at a large international financial institution. Wall has recently completed graduate school with a Master's degree in finance, and is also currently a CFA Level I candidate. His previous work experience includes three years as a credit analyst at a small retail bank. Wall's new position is as the assistant to the firm's fixed income portfolio manager. His boss, Charles Johnson, is responsible for getting Wall familiar with the basics of fixed income investing. Johnson asks Wall to evaluate the bonds shown in Table 1. The bonds are otherwise identical except for the call feature present in one of the bonds. The callable bond is callable at par and exercisable on the coupon dates only. Table 1: Bond Descriptions Non-Callable Callable Bond Price $100.83 $98.79 Time to Maturity (years) 5 5 Time to First Call Date -- 0 Annual Coupon $6.25 $6.25 Interest Payment Semi-annual Semi-annual Yield to Maturity 6.0547% 6.5366% Price Value per Basis Point 428.0360 --

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Question: Johnson asks Wall to compute the value of the call option. Using the given information what is the value of the embedded call option?

• A) $0.00
• B) $1.21
• C) $2.04. Explanation The call option value is simply the difference between the value of the callable and the non-callable bond. Call Option Value = $100.83 − $98.79 = $2.04 (Module 27.2, LOS 27.f)

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Question: Wall is a little confused over the relationship between the embedded option and the callable bond. How does the value of the embedded call option change when interest rate volatility increases? The value:

• A) may increase or decrease
• B) increases
• C) decreases. Explanation All option values increase when the volatility of the underlying asset increases. (Module 27.2, LOS 27.f)

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Question: Wall wonders how the value of the callable bond changes when interest rate volatility increases. How will an increase in volatility affect the value of the callable bond? The value:

• A) may increase or decrease
• B) decreases
• C) increases. Explanation The value of the callable bond decreases if the interest rate volatility increases because the value of the embedded call option increases. Since the value of the callable bond is the difference between the value of the non-callable bond and the value of the embedded call option, its value has to decrease. (Module 27.2, LOS 27.f)

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Question: Wall now turns his attention to the value of the embedded call option. How does the value of the embedded call option react to an increase in interest rates? The value of the embedded call is most likely to:

• A) increase
• B) remain the same
• C) decrease. Explanation

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Question: Which of the following statements is most accurate regarding Diffle's calculation of duration and convexity?

• A) The duration estimate will be inaccurate since it does not account for any change in cash flows due to the call option embedded in the Hardin bond
• B) The estimates for both duration and convexity will be inaccurate because the OAS was not estimated again after the rate shock
• C) The duration estimate for the Bratton bonds will reflect the projected percentage change in price for a 100-basis-point change in interest rates. Explanation The duration formula given will calculate the percentage change in price for a 100 basis point change in yield, regardless of the actual change in rates used to derive BV– and BV+. The standard backward induction process would ensure that the derived values of BV– and BV+ reflect any potential change in cash flows due to embedded options. (Module 27.6, LOS 27.l)

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Question: Puldo notes that the duration estimate for the two bonds is not directly comparable. Assuming that the underlying option is at- or near-the-money, the duration of one of the bonds will be lower than the other one. Which of the following most accurately critiques the OAS discussion between Diffle and Puldo? Puldo is:

• A) correct that the OAS will provide insight into the liquidity risk of the Hardin bonds, and Diffle is correct that different volatility assumptions would change the OAS
• B) incorrect that the OAS will provide insight into the liquidity risk of the Hardin Bonds, but Diffle is correct that different volatility assumptions would change the OAS
• C) correct that the OAS will provide insight into the liquidity risk of the Hardin Bonds, but Diffle is incorrect since OAS implicitly adjusts for the volatility of interest rates. Explanation The OAS accounts for compensation for credit and liquidity risk after the optionality has been removed (i.e., after cash flows have been adjusted). Since in this case the credit risk of the bonds is similar, the OAS could prove helpful in evaluating the relative liquidity risk. OAS will be affected by different assumptions regarding the volatility of interest rates. (Module 27.4, LOS 27.h)

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Question: Puldo notes that the duration estimate for the two bonds is not directly comparable. Assuming that the underlying option is at- or near-the-money, the duration of one of the bonds will be lower than the other one. Indicate whether the statements made by Diffle in his memo regarding the value of the embedded option and the effect of the volatility assumption are correct.

• A) Both statements are correct
• B) Only the statement regarding the effect of the volatility assumption is correct
• C) Only the statement regarding the value of the embedded option is correct. Explanation Statement 1 is correct. The value of the option would be the difference between the value calculated with no call feature (the Bratton bonds) and the value calculated assuming the bond is callable (the Hardin bonds). Recall that the vignette stated the Bratton and Hardin bonds were identical except for the call feature in the Hardin bonds. The option value would therefore be: 100.915 – 100.472 = 0.443. Statement 2 is also correct. Increased volatility would increase the value of the option, thus lowering the value of the callable bond. (Module 27.5, LOS 27.j)

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Question: Credit scores and credit ratings are both:

• A) cardinal rankings
• B) qualitative ratings Correct Your Answer
• C) ordinal rankings

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Question: Credit scores are most likely to be used for:

• A) sovereign bonds
• B) small businesses Correct Your Answer
• C) ABS

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Question: Which of the following factors is least likely a determinant of term structure of credit spreads?

• A) Existence of off-balance sheet liabilities
• B) Equity market volatility Correct Your Answer
• C) Financial conditions in the market

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Question: Higher rated bonds have lower:

• A) returns
• B) credit spreads Correct
• C) price

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Question: Under the structural model, owning equity in a company is equivalent to:

• A) long position in a call option on the assets of the company Correct
• B) short position in a put option on the assets of the company
• C) long position in a call option on the firm’s debt

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Question: Which key input into a reduced form model can be estimated using a regression model?

• A) Default intensity Correct
• B) Loss intensity
• C) Recovery rate

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Question: If investors are expecting an impending recession, credit spreads would most likely:

• A) widen Correct
• B) remain unchanged
• C) narrow

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Question: An investor in an ABS would face which risks on account of the ABS servicer?

• A) Operational and concentration risk
• B) Operational and counterparty risk Correct
• C) Credit and concentration risk

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Question: A corporate bond has one year to maturity with a probability of default of 2.05% and a recovery rate of $32.00 per $100 par value. If an investor holds $100,000 of par value, what is the expected loss?

• A) $1,394 Correct
• B) $2,050
• C) $656

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Question: To analyze the credit risk of a company with significant off-balance sheet liabilities, which credit model is most appropriate?

• A) Econometric model
• B) Reduced form model Correct
• C) Structural model. Philip Bagundang, CFA, is an experienced analyst working for the corporate credit department of a global investment bank. Bagundang is evaluating the proposed two-year, zero coupon, £100 par Shumensko bond. Using a 2% probability of default assumption, Bagundang calculates the CVA on the bond to be £1.820. Two-year, risk-free zero-coupon bonds currently yield 0.8%. Bagundang is evaluating a three-year, zero-coupon bond issued by Alligator, Inc. Using a hazard rate of 2% and estimated recovery rate of 70%, and a flat 2.5% benchmark yield curve, a partial table of analysis is completed as shown in Exhibit 1. Exhibit 1: Alligator, Inc. Bond Year Exposure Loss given default Probability of survival Probability of default Expected loss 1 95.18 28.55 98.00% 2.00% 0.5711

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Question: Based on Exhibit 1, and the stated risk-free rate on two-year zero-coupon bonds, the credit spread on the Shumensko bond is closest to:

• A) 0.12% Correct
• B) 0.18% Your Answer
• C) 0.95%

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Question: In relation to structural models, the instrument that Monera cannot recall is most likely a:

• A) long put with a strike price equal to the value of assets Correct
• B) short put with a strike price equal to the value of debt
• C) short put with a strike price equal to the value of assets

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Question: The summary provided in Exhibit 2 is best described as:

• A) accurate
• B) inaccurate in regards to default risk Correct
• C) inaccurate in regards to parameter estimation

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Question: Credit valuation adjustment is most likely:

• A) the sum of present values of expected losses Correct
• B) higher when the recovery rate is higher
• C) higher when the probability of survival is higher

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Question: Under the structural model, owning risky debt is equivalent to a long position in a similar risk-free bond and a:

• A) long position in a put option on the assets of the company
• B) short position in a put option on the assets of the company Correct
• C) long position in a call option on the assets of the company. Freeman LLC, is a large investment firm based on the East Coast of the United States. The company manages a range of investment funds with several different objectives but focuses mainly on fixed income investments. Josh Scowen is a credit analyst who has just taken up a position with the firm and is currently familiarizing himself with the various models and techniques used by Freeman. Scowen's first task is to assess the present value of the expected loss (CVA) on a bond issued by Dreamy, Inc., an online retailer of designer fashion products. The company expanded rapidly two years ago, but business conditions have deteriorated recently. Scowen's supervisor is concerned that the company may run into serious trouble soon. Exhibit 1: Dreamy Bond Par $1,000 Annual coupon 8% Time to maturity 2 years Note: the risk-free rate of return is 1.22% (assume a flat yield curve)

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Question: Which of the assumptions stated by Scowen regarding the reduced form model is most accurate?

• A) Assumption 3 Correct
• B) Assumption 1 Your Answer
• C) Assumption 2

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Question: Using information in Exhibit 2, the value of the Sleepy Bond is closest to:

• A) $9,433.50 Correct
• B) $9,566.27 Your Answer
• C) $9,500.00

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Question: Scowen's comment regarding option pricing theory and structural models is best described as:

• A) accurate Correct
• B) inaccurate, as structural models value risky debt by deducting the value of a call option on the company’s assets from the value of risk free debt
• C) inaccurate, as structural models value risky debt by adding the value of a put option on the company’s assets to the value of risk-free debt Your Answer

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Question: When assessing a company's credit risk using structural models, which of the following statements is most accurate?

• A) Owning debt is economically equivalent to owning a European call option on the company’s assets
• B) Structural models do not account for the impact of interest rate risk of the value of a company’s assets Correct
• C) Owning equity is economically equivalent to owning a risk free bond and simultaneously selling a put option on the assets of the company

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Question: Fico scores are inversely related to the:

• A) variety of credit types used Correct
• B) length of credit history
• C) number of ‘hard’ inquiries

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Question: Using the structural model, the value of the put option on the assets of the company is equal to:

• A) value of the risky bond minus value of the risk-free bond Correct
• B) credit valuation adjustment of the bond
• C) the value of the call option on assets of the company

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Question: Which of the following statements regarding evaluating credit risk of Asset Backed Securities (ABS) is least accurate?

• A) Unlike for corporate debt, structural and reduced form models are not appropriate Your Answer
• B) The analysis should entail consideration of the composition of the collateral pool and the cash flow waterfall Correct
• C) Credit rating agencies do not use the same credit ratings for ABS as for corporate debt

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Question: Mihor Kotak is evaluating the impact of a ratings upgrade on 1Team bonds. The bonds have a modified duration of 5.88 and the current credit spread on the bonds is 60 bps. After the upgrade, Kotak expects that the spreads will narrow by 15bps. Based on Kotak's expectations, what will be the estimated change in the price of the bond if the upgrade occurs?

• A) 8.82% Correct
• B) 0.38% Your Answer
• C) 0.88%

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Question: As compared to otherwise identical corporate debt, securitized debt is least likely to have:

• A) higher leverage for the issuer Correct
• B) the same risk premium
• C) lower cost for the issuer

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Question: An ABS security backed by a highly granular collateral pool composed of hundreds of clearly defined loans, analysis of collateral pool can be done using:

• A) summary statistics for analyzing credit risk Correct
• B) examination of individual loans
• C) distribution waterfall analysis

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Question: Upward sloping credit curve is most likely an indication of:

• A) expectations of a recession
• B) upward sloping benchmark curve Correct
• C) expectations of an economic expansion

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Question: Zack Ma is evaluating a five-year, 4% Zem bond. Ma has calculated the CVA on the bond to be $2.12 per $100 par. Current benchmark rates are flat at 3%. The credit spread on the bond is closest to:

• A) 0.21% Correct
• B) 0.97%
• C) 0.46%

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Question: As compared to other secured debt, investors in a covered bond have:

• A) an embedded put option
• B) an embedded conversion option
• C) recourse rights Correct

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Question: Gill Westmore is the fixed income portfolio manager for Allied Insurance. Westmore has bought protection using a 2-year CDS on CDX-IG (125 constituent) index. The notional is $200 million. Company X, an index constituent defaults and trades at 25% of par. The payoff on the CDS on account of default of X and the notional principal of the CDS after default are closest to: Payoff Notional

• A) $1.5 million $198 million
• B) $1.6 million $200 million Correct
• C) $1.2 million $198.4 million

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Question: Which of the following statements about credit default swaps (CDS) is least accurate? A credit default swap's reference obligation is:

• A) typically a senior unsecured bond
• B) the only obligation of the reference entity covered by a single-name CDS Correct
• C) delivered by the protection buyer to the protection seller, upon default, in the case of physical settlement

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Question: Which of the following strategies would be most appropriate use of CDS given an expectation of credit curve steepening?

• A) A curve flattening trade
• B) A curve steepening trade Correct
• C)

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Question: -year, 5% Zillon Corp. bonds currently trade at $980 reflecting credit spread of 3%. A 5-year CDS for Zillon bonds has a coupon rate of 5%. The duration of the CDS = 4. The upfront payment made/received by the protection buyer on a $4 million notional CDS is closest to:

• A) $400,000 received by the protection buyer Correct Your Answer
• B) $320,000 received by the protection buyer
• C) $300,000 paid by the protection buyer

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Question: A credit default swap (CDS) will change in value:

• A) only when a failure to pay, a bankruptcy, or a restructuring occurs Your Answer
• B) whenever the credit quality of the reference entity changes Correct
• C) only when default occurs

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Question: Considering the two parties to a credit default swaps (CDS), the protection buyer is most likely to be:

• A) said to be long the reference entity’s credit risk Correct Your Answer
• B) bullish on the financial condition of the reference entity
• C) exposed to the credit risk of the protection seller

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Question: It is most accurate to state that the upfront payment associated with a credit default swap (CDS) is:

• A) greater when the reference obligation is high-yield debt rather than investment- grade debt
• B) always zero due to the way CDS are priced at origination
• C) sometimes made by the credit protection seller to the credit protection buyer. Peter Nathan an asset manager for a hedge fund and looking to include credit default swaps (CDS) in the portfolio. Nathan wants to know more about credit default swaps (CDS). He read a report that explained the characteristics of these products and the pricing theory. The report contained the following: Comment 1: In a CDS, the protection buyer is long the credit risk of the reference entity. Comment 2: In an index CDS, the lower the credit correlation, the cheaper the premium. Nathan owns some intermediate-term bonds issued by ABC Company and has become concerned about the risk of a near-term default, although he is not very concerned about a default in the long term. ABC Company's two-year duration CDS currently trades at 400 bps, and the five-year duration CDS is at 700 bps. Nathan evaluates the bonds of VAX and believes that some trading opportunities exist. The VAX bonds are currently trading at 260 bps above MRR in an asset swap, while the CDS premium is 200 bps Correct

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Question: Which of the following best describe Comments 1 and 2?

• A) Both comments are correct Correct
• B) Both comments are incorrect
• C) Only one of the two comments is correct

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Question: Assume that Nathan sells $400 million of protection on the equally weighted CDX IG index which consists of 125 entities. Concerned about the creditworthiness of an entity A, he purchases $2 million of single-name CDS protection on entity

• A) $1.2 million Correct
• B) $3.2 million
• C) $2.0 million

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Question: Describe a potential curve trade that Nathan could use to hedge the default risk of ABC Company.

• A) Nathan should position himself short in the short term CDS and short in the long term CDS Correct
• B) Nathan should position himself long in the short term CDS and short in the long term CDS
• C) Nathan should position himself short in the short term CDS and long in the long term CDS

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Question: The most appropriate trade for the VAX bond is:

• A) short the VAX bonds and buy the CDS Correct
• B) long the VAX bonds and buy the CDS
• C) long the VAX bonds and sell the CDS

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Question: Credit default swap (CDS) fixed payments are most likely to:

• A) be made until the maturity of the CDS whether a credit event occurs or not
• B) be set at 1% for investment-grade debt and 5% for high-yield debt Correct
• C) be made by the protection seller to the protection buyer

Page 5 | Status: ✅ Correct

Question: In anticipation of an announcement of leveraged buyout of a publicly traded company, which of the following actions would be most appropriate?

• A) Sell protection of the company’s bond and buy put options on the company’s stock
• B) Buy both the stock and the bonds of the company Correct
• C) Buy the stock of the company and buy CDS protection on company’s debt. Idrissa Sylla and Joel Lynch both work for Kazenga Asset Management. The fund made losses on fixed income securities during the 2008 credit crunch and is keen to minimize the risk of losses due to credit events going forward. Sylla and Lynch have been tasked with writing a report on the hedging of credit risk for the firm's investment committee. Extracts of their report are included below. Introduction:

Page 5 | Status: ✅ Correct

Question: Which of the three statements in the introductory paragraph is correct?

• A) The statement describing the separation of credit and interest rate risk Correct
• B) The statement describing the bonds covered by a single name CDS
• C) The statement describing the payoff on a credit event Your Answer

Page 7 | Status: ❌ Incorrect

Question: Using the information under the heading "Illustration CTD," which of the three bonds would be the cheapest to deliver?

• A) Bond Q Correct
• B) Bond P Your Answer
• C)

Page 7 | Status: ❌ Incorrect

Question: Using information in Exhibit 2, the gain on the position is closest to:

• A) £1,080,000 Correct
• B) £1,440,000 Your Answer
• C) £4,320,000

Page 8 | Status: ❌ Incorrect

Question: Which of the comments relating to the credit curve is least accurate?

• A) The definition of the credit curve Correct
• B) The description and example of the naked CDS position
• C) The description and example of the curve trade Your Answer

Page 8 | Status: ❌ Incorrect

Question: Regarding CDS credit events, a CDS is least likely to pay off upon occurrence of a:

• A) failure to pay Correct
• B) restructuring Your Answer
• C) bankruptcy

Page 8 | Status: ❌ Incorrect