jawz

With respect to bond investing, reinvestment risk is a very important component of what other type of risk?

A) Call risk.

B) Liquidity risk.

C) Default risk.

---

Call risk is composed of three components: the unpredictability of the cash flows, the compression of the bond’s price, and the high probability that when the bond is called the investor will be faced with less attractive investment opportunities. This latter risk is reinvestment risk. Reinvestment risk is not a directly related to any of the other choices.

jawz

When planning to hold a coupon-paying Treasury bond until maturity, which of the following types of risk would be the most important?

A) Default.

B) Reinvestment.

C) Interest rate.

---

Since it is a Treasury bond, default risk is not relevant. Interest rate risk is not important because the investor plans to hold the bond until maturity. Reinvestment risk is the most important. The investor will have to worry about the rates at which he/she will be able to reinvest the coupons over the life of the bond and the principal upon maturity.

jawz

Credit risk is measured in several ways. The yield differential above the return on a benchmark security measures the:

A) default risk.

B) recovery rate.

C) credit spread risk.

---

The yield differential above the return on a benchmark security measures the credit spread risk. Credit spread risk is also known as the risk premium or spread.

jawz

Which of the following statements is CORRECT?

A) When a rating agency downgrades a security, the bond's price usually falls.

B) Default risk is important because if a bond issuer defaults, the bondholder likely loses his entire investment.

C) Technical default usually refers to the issuer's failure to make interest or principal payments as scheduled in the indenture.

---

The market will likely demand a higher yield from the downgraded bond (the risk premium has increased) and thus the price will likely fall.
Technical default usually refers to an issuer’s violation of bond covenants, such as debt ratios, rather than the failure to pay interest or principal. In the event of default, the holder (lender) may recover some or all of the investment through legal action or negotiation. The percentage recovered is known as the recovery rate.

jawz

Which of the following investors is least likely to have liquidity risk concerns? A:

A) corporate bond investor who intends to hold securities until maturity.

B) financial institution heavily involved in the repurchase market.

C) trader who invests exclusively in Treasury bonds.

---

Treasury securities are the most liquid of the investments mentioned.
The repurchase market is short term in nature and the collateral is marked-to-market daily. Thus, the need to quickly convert securities to cash (and at approximately market value) is very important. Emerging markets are usually less liquid than established markets, one reason being the small trading volumes. Even if an investor intends to hold the security to maturity, liquidity risk impacts portfolios when marking to market and through changes in investor tastes and preferences over time. For example, liquidity is important to institutional investors that must determine market values for net asset values (NAVs).

jawz

Which of the following statements regarding liquidity risk is NOT correct?

A) Liquidity risk is not important to an investor who intends to hold a security until maturity.

B) Emerging markets typically have more liquidity risk than established markets.

C) The bid-ask spread is one measurement of liquidity risk.

---

Even if an investor intends to hold securities to maturity, liquidity risk impacts portfolios when marking to market and through changes in investor tastes and preferences over time. For example, liquidity is important to institutional investors that must determine market values for net asset values (NAVs) and to dealers in the repurchase market for collateral valuation.
A narrow bid-ask spread indicates a liquid asset, while a wide bid-ask spread indicates an illiquid asset. For example, the spreads on recently issued Treasury securities are often only a few basis points. Emerging markets are usually less liquid than established markets, one reason being the small trading volumes.

jawz

Which of the following statements does NOT describe a characteristic of an illiquid asset or market?

A) Large block trades that do not materially affect prices.

B) Small trading volumes.

C) Wide bid-ask spreads.

---

In a liquid market with large trading volumes, large block trades should not affect prices. The other choices are characteristics of illiquid markets or assets.

jawz

Which of the following assets is the least liquid?

A) Foreign exchange futures contract.

B) On-the-run Treasury security.

C) Limited Partnership.

---

All other choices are considered highly liquid assets. On-the-run Treasuries are recently issued and are often more liquid than older issues.

jawz

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

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

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

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

---

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.

jawz

Assume there are two investors, one in the U.S. and one in Switzerland. In the context of bond investments, appreciation in the Swiss franc benefits the:

A) U.S. investor holding Swiss bonds.

B) U.S. investor holding U.S. bonds.

C) Swiss investor holding U.S. bonds.

---

The appreciation of the foreign currency (Swiss franc) benefits domestic investors (U.S. citizens) who own foreign (Swiss) bonds. When the Swiss franc appreciates, each Swiss franc buys more of the U.S. dollar than before. Here, the U.S. investor gains by owning foreign bonds because the investor realizes not only the return from the bond but also a gain from the foreign currency appreciation. The return realized by the Swiss investor holding U.S. bonds is decreased by the depreciation of the U.S. dollar against the Swiss franc.