optiix

Which of the following statements about embedded call options is most accurate?

A) The call price acts as a floor on the value of a callable bond.

B) When yields rise, the value of a callable bond may not fall as much as a similar, straight bond.

C) The value of a callable bond is equal to the value of the straight bond component plus the value of the embedded call option.

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The value of a callable bond is equal to the value of the straight bond component minus the value of the embedded call option. Remember, the call option benefits the issuer, not the investor. The call price acts as a ceiling on the value of a callable bond. The value of a callable bond will always be equal to or less than an otherwise identical non-callable bond.

optiix

Which of the following is least likely to be given as a reason that the prices of floating-rate bonds fluctuate from par?

A) Coupon formulas with fixed-rate margins.

B) Cap risk.

C) Call risk.

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Call risk pertains to callable bonds and is the risk of the bond issuer "calling the bond" when interest rates decrease. The issuer replaces the current bond with lower interest rate debt but the current bond holder usually loses due to having to replace their bond with a lower paying coupon bond. This has nothing to do with floating rate bonds. The rest of the choices are reasons why floating rate bonds fluctuate from par.
With a cap, when the market yield is above its capped coupon rate, a floating-rate security will trade at a discount.  With fixed rate margins, if the creditworthiness of the firm improves, the floater is less risky and will trade at a premium to par.

optiix

Which of the following statements is NOT correct? All else equal, a floating-rate bond with:

A) coupon reset dates every 3 months will have more price fluctuation than a bond with reset dates every 6 months.

B) a fixed-margin rate in the coupon formula will experience greater price fluctuation than a bond with an adjustable margin rate.

C) an interest rate cap will have more price fluctuation than a bond with no interest rate cap.

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The more frequent the reset dates, the less the time lag that causes volatility. The greater the gap between reset dates, the greater the amount of price fluctuation.
Over the life of a bond, the required market margin is not constant. A fixed-margin coupon exposes the bond to more price fluctuations than an adjustable margin (as is the case with an extendible reset bond). Cap risk refers to when market interest rates rise to the point that the coupon on a floating-rate security hits the cap and the bond begins to behave like a fixed coupon bond, which has more price fluctuations.

optiix

The risk to a holder of a floating-rate bond that market rates will increase to the point where the bond behaves like a fixed-rate bond (increased price fluctuation) is known as:

A) inflation risk.

B) yield curve risk.

C) cap risk.

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This is the correct definition of cap risk. Cap risk occurs with floating-rate bonds that have a cap placed on how high the coupon rate can go.
Inflation risk refers to the risk that the rate of inflation will be higher than the investor anticipated, resulting in reduced purchasing power. An investor can reduce exposure to inflation risk by holding floating-rate bonds.

optiix

Which of the following statements about floating-rate bonds is NOT correct?

A) Holding a floating-rate bond eliminates price fluctuations.

B) With a perfect, continuously resetting coupon rate, a floating-rate bond's value would always equal par.

C) A cap rate can increase the price volatility of a floating-rate bond.

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Holding floating-rate bonds minimizes, but does not eliminate price fluctuations. The other statements are true.

optiix

Which of the following statements regarding floating-rate securities is most accurate?

A) The longer the time until the next reset for a floating-rate security, the less interest rate risk it has.

B) A floating-rate security’s price will always equal par at its coupon reset date.

C) Prices of floating-rate securities are less sensitive to changes in market yields than the prices of fixed-rate securities.

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Floating-rate securities have a coupon rate that resets periodically. The objective of this floating mechanism is to bring the coupon rate in line with the current market yield so that the bond sells at or near its par value, reducing interest rate risk compared to that of a fixed-rate security.
In general, the longer the time until the next reset, the greater the interest rate risk of the floating-rate security. The interest rate risk of a floating-rate security decreases as the reset date approaches because the coupon reset will return the price to par, as long as the margin above the reference rate accurately reflects the bond’s risk. If this fixed margin does not reflect changes in the issuer’s creditworthiness, the bond’s price may differ from par at its reset date.

optiix

An option-free bond has a market price and par value equal to $1,000. For small changes in the yield of this bond, its price will change one dollar for every basis point change in the yield. What is the duration of the bond?

A) 1.

B) 5.

C) 10.

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Duration = [1001 − 999] / [2 × 1000 × 0.0001] = 10.

optiix

Which of the following bonds has the shortest duration? A bond with a:

A) 10-year maturity, 10% coupon rate.

B) 20-year maturity, 6% coupon rate.

C) 10-year maturity, 6% coupon rate.

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All else constant, a bond with a longer maturity will be more sensitive to changes in interest rates. All else constant, a bond with a lower coupon will have greater interest rate risk.

optiix

Assuming a flat term structure of interest rates of 5%, the duration of a zero-coupon bond with 5 years remaining to maturity is closest to:

A) 4.35.

B) 5.00.

C) 3.76.

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The duration of a zero coupon bond is approximately equal to its time to maturity.

optiix

Which of the following statements about duration is CORRECT?

A) A bond's percentage change in price and dollar change in price are both tied to the underlying price volatility.

B) The result of the formula for effective duration is for a 0.01% change in interest rates.

C) The formula for effective duration is: (price when yields fall − price when yields rise) / (initial price × change in yield expressed as a decimal).

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The statement that a bond's percentage change in price and dollar change in price are both tied to the underlying price volatility is correct.
The effective duration formula result is for a 1.00% change in interest rates (100 basis points equals 1.00%, or 0.01 in decimal form). The denominator is multiplied by 2.