Reading 63: Understanding Yield Spreads- LOS e～ Q1-5

relative, measures, contrast, reference

LOS e: Compute, compare, and contrast the various yield spread measures.

Q1. Bond A has a yield of 8.75%. Bond B, the reference bond, has a yield of 7.45%. The risk-free rate of return is 3.50%. Assuming both bonds have the same maturity, the relative yield spread is closest to:

A) 1.17%.

B) 0.17%.

C) 1.30%.

Q2. A Treasury security carries a yield of 4.2% and a non-Treasury security carries a yield of 6.4%. Using the Treasury rate as the reference rate, which of the following statements is least accurate?

A) If the Treasury rate rises and the absolute spread stays the same, the yield ratio declines.

B) The yield ratio is 1.022.

C) The absolute yield spread is 2.2%.

Q3. James Walters, CFA, is an active fixed income portfolio manager. He manages a portfolio of fixed income securities worth$7,500,000 for an institutional client. Walters expects a widening yield spread between intermediate and long term securities. He would like to capitalize on his expectations and considers several transactions in a number of different securities. On 01/31/2005, Walters expects the yield of the 2-Year Treasury Note to decrease by 10 basis points and the yield of the 30-Year Treasury Bond to increase by 11 basis points. The characteristics of these two fixed income securities are shown in Table 1. Prices are quoted as a percentage of par value.

Table 1
Security Characteristics
	2-Year T-Note	30-Year T-Bond
Maturity	01/31/07	11/15/34
Bid-Ask Spread (basis points)	5.0	5.0
Coupon	5.375%	6.125%
Bid Price	99.7236	104.6086
Ask Price	99.7736	104.6586
Yield to Maturity	5.51%	5.80%
Price Value of a Basis Point	186.6484	1461.1733

He also has the three year term structure of interest rates. This is shown in Table 2.

Table 2
Term Structure of Interest Rates
Year	Spot Rate
0.50	5.5227%
1.00	5.5537%
1.50	5.5444%
2.00	5.5205%
2.50	5.5114%
3.00	5.5156%

Walters thinks of several different trading strategies that would allow him to take advantage of his expectations. He would like to evaluate each strategy to determine which offers the best risk-return tradeoff.

Compute the yield spread between the T-Note and T-Bond given the information in Table 1.

A) 0.29%.

B) 0.00%.

C) 0.75%.

Q4. Assume the following corporate yield curve.

One-year rate: 5%
Two-year rate: 6%
Three-year rate: 7%

If a 3-year annual-pay corporate bond has a coupon of 6%, its yield to maturity is closest to:

A) 6.92%.

B) 6.08%.

C) 7.00%.

Q5. A Treasury bond due in one-year has a yield of 8.5%. A Treasury bond due in 5 years has a yield of 9.3%. A bond issued by General Motors due in 5 years has a yield of 9.9%. A bond issued by Exxon due in one year has a yield of 9.4%. The default risk premiums on the bonds issued by Exxon and General Motors are:

Exxon General Motors

A) 0.9% 0.6%

B) 0.1% 0.6%

C) 0.1% 1.4%