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11. Compared with an otherwise identical amortizing security, a zero-coupon bond will most likely have: A. less reinvestment risk and the same interest rate risk. B. less reinvestment risk and more interest rate risk. C. the same reinvestment risk and the same interest rate risk.

Ans: B; Less reinvestment risk: An amortizing security is exposed to reinvestment risk since it receives periodic payments of both interest and principal that must be reinvested ; while a zero-coupon bond has no reinvestment risk since no cash flows are received that must be reinvested before maturity. More interest rate risk: Because zero-coupon bonds do not have periodic cash flows, they have higher interest rate risk for a given maturity and a given change in market yields.

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12. Two amortizing bonds have the same maturity date and same yield to maturity. The reinvestment risk for an investor holding the bonds to maturity is greatest for the bond that is: A. a coupon bond selling at a discount to par as a result of market yields increasing after the bond was issued. B. a zero-coupon bond. C. a coupon bond selling at a premium to par.

Ans: C; Reinvestment risk refers to the risk that interest rates will decline causing the future income expected from reinvesting coupon payments to decline. The higher the coupon being paid, the greater the reinvestment risk. Because the two amortizing bonds have the same maturity date and the same yield to maturity, the bond selling at a premium must have a higher coupon rate and a higher amount requiring reinvestment and thus higher reinvestment risk.

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13. An investor fears that economic conditions will worsen and the market prices of her portfolio of investment-grade corporate bonds will decrease more than her portfolio of government bonds. The investor’s fear is best described as a fear of: A. downgrade risk. B. default risk. C. credit spread risk.

Ans: C; A is not correct. Downgrade risk is the risk that a credit rating agency will lower a bond’s rating. B is not correct. Default risk is the risk that the issuer not making timely interest and principal payments as promised. C is the correct answer. Credit spread risk is the risk that the yield required in the market for a given rating can increase even while the yield on the Treasury security of similar maturity remains unchanged. Since the market prices of the investor’s portfolio of corporate bonds will decrease more than her portfolio of government bonds, the spreads on those bonds widens relative to default-free bonds. Thus the investor is concerned about credit spread risk.

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14. For an A- rated corporate bond that has deteriorating fundamentals, but is expected to remain investment grade, the greatest risk is most likely: A. liquidity risk. B. default risk. C. credit spread risk.

Ans: C; Credit spread risk is correct since the bond is expected to see a widening of spreads as a result of deteriorating fundamentals and a potential downgrade but still remaining investment grade.

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15. What risk does the bid-ask spread most closely measure: A. Liquidity risk. B. Credit spread risk. C. Inflation risk.

Ans: A; A is correct. Liquidity risk is the risk that the investor will have to sell a bond below its indicated value. The size of the spread between the bid price and the ask price is the primary measure of liquidity of the issue. If trading activity in a particular security declines, the bid-ask spread will widen, and the issue is considered less liquid.

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16. All else equal, an increase in expected yield volatility is most likely to cause the price of a: A. callable price to increase. B. callable price to decrease. C. putable price to decrease.

Ans: B; An increase in expected yield volatility increases the values of both put options and call options. However, Value of a callable bond = Value of an option-free bond – Value of the call Note here the call option is retained by the issuer. Value of a putable bond = Value of an option-free bond + Value of the put Note here the put option is owned by the bond holder. Therefore, an increase in expected yield volatility will cause the price of a callable price to decrease and a putable price to increase. Therefore B is the correct answer.

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17. A portfolio of option-free bonds is least likely to be exposed to: A. yield curve risk. B. volatility risk. C. reinvestment risk

Ans: B; Volatility risk is present for fixed-income securities that have embedded options. Changes in interest rate volatility affect the value of the embedded options and thus affect the values of securities with embedded options. By definition, option-free bonds are not affected by volatility risk.