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Question 106

In contrast to the full valuation approach to measuring interest rate risk, the duration/convexity approach:

A) simplifies the process of estimating the value impact of changes in yield.

B) provides a more accurate assessment of interest rate risk.

C) accounts for the curvature of the price-yield relation.

D) is used to evaluate the price effects of more complex interest rate scenarios.

The correct answer was A) simplifies the process of estimating the value impact of changes in yield.

The duration/convexity approach provides an approximation of the interest rate sensitivity of a bond/bond portfolio. This approach estimates the risk for a parallel shift in the yield curve and allows the analyst to express interest rate risk with the summary measures of duration and convexity. The full valuation approach is more precise and can be used to evaluate the risk from more complex interest rate change scenarios than a parallel shift in the yield curve. Both approaches account for the curvature of the price-yield relation.

This question tested from Session 16, Reading 69, LOS a

Question 107

To finance the purchase of a bond, dealers typically:

A) use margin transactions, borrowing money from intermediaries to purchase securities.

B) sell a security with a commitment to buy it back at a later date.

C) use margin and repurchase agreements equally.

D) borrow from banks.

The correct answer was B) sell a security with a commitment to buy it back at a later date.

Individuals use margin, institutional dealers typically use repurchase agreements to finance the purchase of securities.

This question tested from Session 15, Reading 62, LOS f

Question 108

By purchasing a mortgage passthrough security, it is least likely that an investor:

A) can select a tranche that offers the desired prepayment risk characteristics.

B) receives monthly cash flows.

C) has a claim to a proportionate share of the interest and principal payments from a mortgage pool.

D) will receive principal payments earlier than scheduled if mortgage interest rates decrease.

The correct answer was A) can select a tranche that offers the desired prepayment risk characteristics.

Collateralized mortgage obligations, not mortgage passthrough securities, have tranches with different prepayment risk. Mortgage passthrough securities represent a proportionate claim to the cash flows from a pool of mortgages. These securities feature monthly cash flows that consist of interest, scheduled principal payments, and principal prepayments. Prepayments tend to increase when mortgage interest rates decrease.

This question tested from Session 15, Reading 64, LOS e, (Part 1)

Question 109

Which of the following statements about liquidity risk is least accurate?

A) Liquidity risk and the bid-ask spread are not relevant to an investor who is planning to hold a security to maturity.

B) The bid-ask spread is an indication of the liquidity of a security.

C) If trading activity in a security decreases, the bid-ask spread typically widens.

D) A lack of liquidity may make it difficult to determine the value of a security.

The correct answer was A) Liquidity risk and the bid-ask spread are not relevant to an investor who is planning to hold a security to maturity.

Even if the investor plans to hold the security until maturity rather than trade it, poor liquidity can have adverse consequences stemming from the need to periodically mark securities to market. When a security has little liquidity, the variation in dealers’ bid prices (or a lack of bids) makes valuation more difficult. Bid-ask spreads tend to be narrower for more liquid securities and wider for less liquid securities.

This question tested from Session 15, Reading 63, LOS k

Question 110

A $1,000 par value, 10%, semiannual, 20-year debenture bond is currently selling for $1,100. What is this bond's current yield and will the current yield be higher or lower than the yield to maturity?

Current Yield Current Yield vs. YTM

A) 8.9% higher

B) 9.1% higher

C) 9.1% lower

D) 8.9% lower

The correct answer was B) 9.1% higher

Current yield = annual coupon payment/price of the bond

CY = 100/1,100 = 0.0909

The current yield will be between the coupon rate and the yield to maturity. The bond is selling at a premium, so the YTM must be less than the coupon rate, and therefore the current yield is greater than the YTM.

The YTM is calculated as: FV = 1,000; PV = -1,100; N = 40; PMT = 50; CPT → I = 4.46 × 2 = 8.92

This question tested from Session 16, Reading 68, LOS b, (Part 1)