[ 2009 Mock Exam (PM) ] Fixed Income Investments .Questions 97-108 face, otherwise, decrease, interest, investor

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97. If market interest rates rise, the price of a callable bond, compared to an otherwise identical option-free bond, will most likely decrease by:

A. less than the option-free bond.
B. more than the option-free bond.
C. the same amount as the option-free bond.

98. A U.S. investor who purchases an option-free bond with a 7 percent coupon rate, maturing in 20 years, and issued by a U.S.-based company is most likely exposed to:

A. volatility risk and credit risk.
B. event risk and interest rate risk.
C. volatility risk and yield curve risk.

99. All else equal, an increase in expected yield volatility is most likely to result in an increase in the price of a(n):

A. putable bond.
B. callable bond.
C. option-free bond.

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97. If market interest rates rise, the price of a callable bond, compared to an otherwise identical option-free bond, will most likely decrease by:

A. less than the option-free bond.
B. more than the option-free bond.
C. the same amount as the option-free bond.

Answer: A
“Risks Associated with Investing in Bonds,” Frank J. Fabozzi
2009 Modular Level I, Volume 5, p. 243
Study Session 15-61-d
identify the relationship among the price of a callable bond, the price of an optionfree bond, and the price of the embedded call option.
A callable bond’s value is equal to an option-free bond less the value of the call option. As interest rates rise, the value of the call option decreases by a decreasing amount relative to the straight bond. The option-free bond also declines in value as interest rates rise, but this is offset by the decline in the value of the call option.
Therefore, the price of a callable bond decreases by less than a comparable optionfree bond.

98. A U.S. investor who purchases an option-free bond with a 7 percent coupon rate, maturing in 20 years, and issued by a U.S.-based company is most likely exposed to:

A. volatility risk and credit risk.
B. event risk and interest rate risk.
C. volatility risk and yield curve risk.

Answer: B
“Risks Associated with Investing in Bonds,” Frank J. Fabozzi
2009 Modular Level I, Volume 5, pp. 240-261
Study Session 15-61-a
Explain the risks associated with investing in bonds.
The investor faces event risk in a corporate bond and interest rate risk in a long-dated, fixed coupon bond.

99. All else equal, an increase in expected yield volatility is most likely to result in an increase in the price of a(n):

A. putable bond.
B. callable bond.
C. option-free bond.

Answer: A
“Risks Associated with Investing in Bonds,” Frank J. Fabozzi
2009 Modular Level I, Volume 5, p. 260
Study Session 15-61-n
Explain how yield volatility affects the price of a bond with an embedded option and how changes in volatility affect the value of a callable bond and a putable bond.
An increase in expected yield volatility increases the price of an embedded option.
The price of a putable bond will increase because the price of the putable bond is equal to the price of an option-free bond plus the value of the put option.

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100. An analyst is evaluating the two bonds below:

	Bond A	Bond B
Coupon	6.90%	8.25%
Maturity	Oct 29, 2019	Nov 4, 2019
Callable	No	No
rice	$102.17	$102.39
Yield	6.60%	7.90%

Compared with Bond A, Bond B most likely will have:

A. less interest rate risk and more reinvestment risk.
B. less reinvestment risk and more interest rate risk.
C. more interest rate risk and more reinvestment risk.

101. An analyst determined that if interest rates increase 120 basis points the price of a bond would be $89.70, but if interest rates decrease 120 basis points the price of that bond would be $99.30. If the initial price of the bond is $95.40, the approximate percentage price change for a 100 basis point change in yield is closest to:

A. 2.5%.
B. 4.2%.
C. 8.4%.

102. For an A- rated corporate bond that has deteriorating fundamentals, but is expected to remain investment grade, the greatest risk is most likely:

A. default risk
B. liquidity risk
C. credit spread risk

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100. An analyst is evaluating the two bonds below:

	Bond A	Bond B
Coupon	6.90%	8.25%
Maturity	Oct 29, 2019	Nov 4, 2019
Callable	No	No
rice	$102.17	$102.39
Yield	6.60%	7.90%

Compared with Bond A, Bond B most likely will have:

A. less interest rate risk and more reinvestment risk.
B. less reinvestment risk and more interest rate risk.
C. more interest rate risk and more reinvestment risk.

Answer: A
“Risks Associated with Investing in Bonds,” Frank J. Fabozzi
2009 Modular Level I, Volume 5, pp. 242, 252-253
Study Session 15-61-c, i
Explain how features of a bond (e.g., maturity, coupon, and embedded options) and the level of a bond’s yield affect the bond’s interest rate risk;
Identify the factors that affect the reinvestment risk of a security and explain why prepayable amortizing securities expose investors to greater reinvestment risk than nonamortizing securities.
Since both securities have essentially the same maturity, all else the same, the bond with the lower coupon rate will have a higher sensitivity to changes in interest rates. The higher the yield on the bond, the more the reinvestment risk, because the investor must be able to reinvest at the same yield.

101. An analyst determined that if interest rates increase 120 basis points the price of a bond would be $89.70, but if interest rates decrease 120 basis points the price of that bond would be $99.30. If the initial price of the bond is $95.40, the approximate percentage price change for a 100 basis point change in yield is closest to:

A. 2.5%.
B. 4.2%.
C. 8.4%.

Answer: B
“Risks Associated with Investing in Bonds,” Frank J. Fabozzi
2009 Modular Level I, Volume 5, pp. 245-247
Study Session 15-61-f
Compute and interpret the duration and dollar duration of a bond.
The formula for calculating the duration of a bond (estimated percentage price change for a 100 basis point change in yield) is:


102. For an A- rated corporate bond that has deteriorating fundamentals, but is expected to remain investment grade, the greatest risk is most likely:

A. default risk
B. liquidity risk
C. credit spread risk

Answer: C
“Risks Associated with Investing in Bonds,” Frank J. Fabozzi
2009 Modular Level I, Volume 5, pp. 253-254
Study Session 15-61-j
describe the various forms of credit risk and describe the meaning and role of credit ratings.
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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103. The difference between nominal spread and zero-volatility spread will most likely be greatest for a mortgage-backed security:

A. in an inverted yield curve environment.
B. in a steep upward-sloping yield curve environment.
C. with short maturity in a flat yield curve environment.

104. A fixed income portfolio manager is evaluating investments in the mortgage market but is concerned about prepayment risk. The security that will most likely minimize prepayment risk is:

A. a mortgage passthrough security.
B. a portfolio of interest-only mortgage loans.
C. tranche B of a collateralized mortgage obligation.

105. An analyst is evaluating various debt securities issued by a company. The type of security that is most likely to yield the lowest recovery in a bankruptcy is a:

A. mortgage bond
B. debenture bond.
C. collateral trust bond.

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103. The difference between nominal spread and zero-volatility spread will most likely be greatest for a mortgage-backed security:

A. in an inverted yield curve environment.
B. in a steep upward-sloping yield curve environment.
C. with short maturity in a flat yield curve environment.

Answer: B
“Yield Measures, Spot Rates, and Forward Rates,” Frank J. Fabozzi
2009 Modular Level I, Volume 5, pp. 418
Study Session 16-65-f
Differentiate between the nominal spread, the zero-volatility spread, and the optionadjusted spread.
The difference between the Z-spread and the nominal spread is greater for issues in which the principal is repaid over time rather than only at maturity. In addition, the difference between the Z-spread and the nominal spread is greater in a steep yield curve environment.

104. A fixed income portfolio manager is evaluating investments in the mortgage market but is concerned about prepayment risk. The security that will most likely minimize prepayment risk is:

A. a mortgage passthrough security.
B. a portfolio of interest-only mortgage loans.
C. tranche B of a collateralized mortgage obligation.

Answer: C
“Overview of Bond Sectors and Instruments,” Frank J. Fabozzi
2009 Modular Level I, Volume 5, pp. 281-288
Study Session 15-62-f
State the motivation for creating a collateralized mortgage obligation.
A collateralized mortgage obligation or CMO, is structured to distribute prepayment risk among different classes or tranches of bonds. Tranche A would be repaid first, followed by tranche B, then C, etc.

105. An analyst is evaluating various debt securities issued by a company. The type of security that is most likely to yield the lowest recovery in a bankruptcy is a:

A. mortgage bond
B. debenture bond.
C. collateral trust bond.

Answer: B
“Overview of Bond Sectors and Instruments,” Frank J. Fabozzi
2009 Modular Level I, Volume 5, pp. 294-296
Study Session 15-62-h
Describe the characteristics and motivation for the various types of debt issued by corporations (including corporate bonds, medium-term notes, structured notes, commercial paper, negotiable CDs, and bankers acceptances).
A debenture bond is unsecured and would be expected to recover less should the company file for bankruptcy, while mortgage and collateral trust bonds are secured by real property.

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106. A U.S. investor has purchased a tax-exempt 5-year municipal bond at a yield of 3.86 percent which is 100 basis points less than the yield on a 5-year option-free U.S. Treasury. If the investor’s marginal tax rate is 32 percent, then the yield ratio are closest to:

A. 0.79
B. 1.26
C. 5.68

107. An analyst has gathered the following information provided in the table below:

eriod	Years	U.S. Treasury Spot Rate (%)	Credit Spread (%)
1 2 3 4 5	1 2 3 4 5	3.00 3.50 4.00 4.50 5.00	0.20 0.30 0.40 0.50 0.60

Based on the information provided in the table, the current market price of a $1,000 par value, option-free, 0 percent coupon corporate bond maturing in 5 years is closest to:

A. $758.70.
B. $781.20.
C. $804.44.

108. An analyst gathered the following information about a portfolio comprised of
three bonds:

Bond	rice ($)	ar Amount Owned	Duration
A	102.000	$7 million	1.89
B	94.356	$5 million	7.70
C	88.688	$3 million	11.55

Assuming there is no accrued interest, then the portfolio duration is closest to:

A. 5.55 years.
B. 5.76 years.
C. 6.82 years.

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106. A U.S. investor has purchased a tax-exempt 5-year municipal bond at a yield of 3.86 percent which is 100 basis points less than the yield on a 5-year option-free U.S. Treasury. If the investor’s marginal tax rate is 32 percent, then the yield ratio are closest to:

A. 0.79
B. 1.26
C. 5.68

Answer: A
“Understanding Yield Spread,” Frank J. Fabozzi
2009 Modular Level I, Volume 5, pp. 335-336
Study Session 16-63-e, i
Compute, compare, and contrast the various yield spread measures.
Compute the after-tax yield of a taxable security and the tax-equivalent yield of a tax-exempt security.
Yield ratio = (yield on tax-exempt bond) / (yield of US Treasury) = 3.86 / (3.86 + 100bp) = 3.86 / 4.86 = 0.79

107. An analyst has gathered the following information provided in the table below:

eriod	Years	U.S. Treasury Spot Rate (%)	Credit Spread (%)
1 2 3 4 5	1 2 3 4 5	3.00 3.50 4.00 4.50 5.00	0.20 0.30 0.40 0.50 0.60

Based on the information provided in the table, the current market price of a $1,000 par value, option-free, 0 percent coupon corporate bond maturing in 5 years is closest to:

A. $758.70.
B. $781.20.
C. $804.44.

Answer: A
“Introduction to the Valuation of Debt Securities,” Frank J. Fabozzi
2009 Modular Level I, Volume 5, pp. 366-371
Study Session 16-64-e
Compute the value of a zero-coupon bond.
The appropriate discount rate is 5.6% = 5% + 0.6%. The semiannual discount rate is 2.8%. The price of the bond using semiannual discounting is:


108. An analyst gathered the following information about a portfolio comprised of
three bonds:

Bond	rice ($)	ar Amount Owned	Duration
A	102.000	$7 million	1.89
B	94.356	$5 million	7.70
C	88.688	$3 million	11.55

Assuming there is no accrued interest, then the portfolio duration is closest to:

A. 5.55 years.
B. 5.76 years.
C. 6.82 years.

Answer: A
“Introduction to the Measurement of the Interest Rate Risk,” Frank J. Fabozzi
2009 Modular Level I, Volume 5, pp. 468
Study Session 16-66-f
Compute the duration of a portfolio, given the duration of the bonds comprising the portfolio, and explain the limitations of portfolio duration.
Portfolio value = (1.02 × 7 mil) + (0.94356 × 5 mil) + (0.88688 × 3 mil) =14,518,440
Weight, Bond A = 7,140,000 / 14,518,440 = 0.492
Weight, Bond B = 4,717,800 / 14,518,440 = 0.325
Weight, Bond C = 2,660,640 / 14,518,440 = 0.183
Portfolio duration = (0.492 × 1.89) + (0.325 × 7.70) + (0.183 × 11.55) = 5.55

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