1.Which of the following is NOT a component of credit risk?

A)   Default risk.

B)   Credit spread risk.

C)   Downgrade risk.

D)   Interest rate risk.

2.Brad Taylor is a portfolio manager for a small firm that caters to high net worth individuals. He invests substantial amounts of his clients’ assets in fixed incomes securities, while his partner deals primarily with his clients’ equity investments. Taylor’s particular areas of analytical expertise include corporate bonds, asset-backed securities (ABS), and foreign government bonds. Being in a small firm, Taylor is involved in every aspect of managing the fixed income portion of the portfolio, from the initial identification of a potential investment, to the analysis, and on to the purchase decision. In addition, he also performs an ongoing analysis of assets currently held in the portfolio.

As the size of the portfolio has grown over the past two years, Taylor has become increasingly aware of the fact that he needs to acquire additional support staff in order to adequately perform his fiduciary duties. He has recently hired a new trading assistant, Donald Johnson, whose prior position was at a firm that invested exclusively in equity securities. Johnson has not had much experience in the analysis of fixed income securities and realizes that there are some significant differences between the credit analyses of equities versus that of fixed income securities. He is trying to understand how to evaluate the credit quality of fixed income securities in the specific sectors of corporate bonds, asset-backed securities, and foreign government bonds. Taylor suggests that to begin, Johnson should review one of Taylor’s old fixed income textbooks, to become more familiar with the concepts. Johnson needs to be able to identify which key ratios are used in fixed income analysis, how to calculate them, and the how to interpret them. He is familiar with basic mechanics of a cash flow analysis of an equity investment, but needs to understand why and how cash flow from operations can affect the value of a fixed income security. In addition, Taylor expects Johnson to quickly have a strong working knowledge of each of the following areas: corporate bonds and the measurement of their capitalization and solvency; asset-backed securities and the factors that will determine an issue’s rating; and foreign government bonds and the economic and political risks that can affect their performance.

Johnson is not sure what is meant by a short-term solvency ratio. Which of the following ratios is a measure of short-term solvency?

A)   Current ratio.

B)   Total debt to capitalization ratio.

C)   EBIT interest coverage ratio.

D)   Funds from operations to total debt ratio.

3.Johnson has read about the importance of coverage ratios in order to evaluate the credit risk of a corporate bond. Which of the following statements is most correct?

Coverage ratios are used to:

A)   determine the capital adequacy of long-term assets to meet long-term debt obligations.

B)   test the adequacy of cash flows generated through earnings for purposes of meeting debt and lease obligations.

C)   judge the capital adequacy of liquid assets for meeting short-term obligations as they come due.

D)   determine the extent to which a corporation is trading on its equity, and the resulting financial leverage.

4.Johnson asks Taylor to define a discretionary cash flow. Which of the following is the most correct?

A discretionary cash flow:

A)   results from profits.

B)   may be spent at the company's discretion.

C)   remains available after a company services its debt.

D)   remains available to a company after it funds its operating requirements and capital expenditures.

5．Johnson turns his attention to asset-backed securities (ABS). Which of the following is the least important factor considered by rating agencies in assigning a credit rating to ABS?

A)   Quality of the seller/servicer.

B)   Credit quality of the collateral.

C)   Covenants of the lending agreement.

D)   Cash flow stress and payment structure.

1.Which of the following is NOT a component of credit risk?

A)   Default risk.

B)   Credit spread risk.

C)   Downgrade risk.

D)   Interest rate risk.

The correct answer was  D)

Credit risk is made up of 3 components that include default risk, credit spread risk and downgrade risk.

2.Brad Taylor is a portfolio manager for a small firm that caters to high net worth individuals. He invests substantial amounts of his clients’ assets in fixed incomes securities, while his partner deals primarily with his clients’ equity investments. Taylor’s particular areas of analytical expertise include corporate bonds, asset-backed securities (ABS), and foreign government bonds. Being in a small firm, Taylor is involved in every aspect of managing the fixed income portion of the portfolio, from the initial identification of a potential investment, to the analysis, and on to the purchase decision. In addition, he also performs an ongoing analysis of assets currently held in the portfolio.

As the size of the portfolio has grown over the past two years, Taylor has become increasingly aware of the fact that he needs to acquire additional support staff in order to adequately perform his fiduciary duties. He has recently hired a new trading assistant, Donald Johnson, whose prior position was at a firm that invested exclusively in equity securities. Johnson has not had much experience in the analysis of fixed income securities and realizes that there are some significant differences between the credit analyses of equities versus that of fixed income securities. He is trying to understand how to evaluate the credit quality of fixed income securities in the specific sectors of corporate bonds, asset-backed securities, and foreign government bonds. Taylor suggests that to begin, Johnson should review one of Taylor’s old fixed income textbooks, to become more familiar with the concepts. Johnson needs to be able to identify which key ratios are used in fixed income analysis, how to calculate them, and the how to interpret them. He is familiar with basic mechanics of a cash flow analysis of an equity investment, but needs to understand why and how cash flow from operations can affect the value of a fixed income security. In addition, Taylor expects Johnson to quickly have a strong working knowledge of each of the following areas: corporate bonds and the measurement of their capitalization and solvency; asset-backed securities and the factors that will determine an issue’s rating; and foreign government bonds and the economic and political risks that can affect their performance.

Johnson is not sure what is meant by a short-term solvency ratio. Which of the following ratios is a measure of short-term solvency?

A)   Current ratio.

B)   Total debt to capitalization ratio.

C)   EBIT interest coverage ratio.

D)   Funds from operations to total debt ratio.

The correct answer was  A)

The current ratio is defined as current assets divided by current liabilities. It is a measure of the adequacy of liquid assets for meeting short-term obligations as they come due.

The total debt to capitalization ratio is equal to the sum of current liabilities and long-term debt divided by the sum of long-term debt and shareholders’ equity. It includes longer term assets and liabilities that are not as liquid.

The EBIT interest coverage ratio is earnings before interest and taxes divided by the annual interest expense. It is not a suitable measure of short-term solvency.

The funds from operations/total debt ratio measures the amount of funds from operations relative to total debt.

3.Johnson has read about the importance of coverage ratios in order to evaluate the credit risk of a corporate bond. Which of the following statements is most correct?

Coverage ratios are used to:

A)   determine the capital adequacy of long-term assets to meet long-term debt obligations.

B)   test the adequacy of cash flows generated through earnings for purposes of meeting debt and lease obligations.

C)   judge the capital adequacy of liquid assets for meeting short-term obligations as they come due.

D)   determine the extent to which a corporation is trading on its equity, and the resulting financial leverage.

The correct answer was  B)

Examples of coverage ratios are: EBIT interest coverage ratio, EBITDA interest coverage ratio, funds from operations to total debt ratio, and free operating cash flowto total debt ratio.

4.Johnson asks Taylor to define a discretionary cash flow. Which of the following is the most correct?

A discretionary cash flow:

A)   results from profits.

B)   may be spent at the company's discretion.

C)   remains available after a company services its debt.

D)   remains available to a company after it funds its operating requirements and capital expenditures.

The correct answer was  D)

Discretionary cash flow can be defined as cash flow that is available to a firm after it has funded its basic operating requirements and can be calculated as:

discretionary cash flow = cash flow from operations - nondiscretionary capital expenditures

Nondiscretionary capital expenditures are those required to maintain the productive capacity of the firm's existing fixed assets and the company's competitive position in its industry.

5．Johnson turns his attention to asset-backed securities (ABS). Which of the following is the least important factor considered by rating agencies in assigning a credit rating to ABS?

A)   Quality of the seller/servicer.

B)   Credit quality of the collateral.

C)   Covenants of the lending agreement.

D)   Cash flow stress and payment structure.

The correct answer was  C)

Lending agreement covenants are not a major factor considered by rating agencies.

The role of the servicer is critical in an asset-backed security transaction. Therefore, rating agencies look at the ability of a servicer to perform all the activities that a servicer will be responsible for.

The rating companies will look at the underlying borrower's ability to pay and the borrower's equity in the asset.

The payment structure of an asset-backed security transaction can be either a passthrough or pay through structure. This has important implications for the distribution of the cash flows to the different tranches of the security.