jawz

The risk that an investor will earn less than the quoted yield-to-maturity on a fixed-coupon bond due to a decrease in interest rates is known as:

A) reinvestment risk.

B) prepayment risk.

C) event risk.

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Reinvestment risk is the risk that if rates fall, cash flows will be reinvested at lower rates, resulting in a holding return lower than that expected at purchase.
Prepayment risk (and call risk) is the risk that the issuer will repay principal prior to maturity. Prepayments are most likely to occur in a declining interest rate environment because it is cheaper to issue replacement debt. Event risk means that the issuer could face a single event or circumstance that would affect its ability to service/repay the debt. For example, a corporation could suffer an industrial accident.

jawz

When determining credit risk spread, the benchmark security is most likely a(n):

A) AA rated bond.

B) high-yield corporate bond.

C) Treasury bond.

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The credit risk spread is measured in relation to a default-free security. Of the choices above, the security with the least chance of default is the Treasury bond. The AA rated bond is high quality, but not the highest quality (which would have an AAA rating). The high-yield corporate bond is an unlikely candidate for the benchmark security because high yield usually denotes high risk.

jawz

Benjamin Zoeller and Tara McGonigal are preparing for the Level I CFA examination. Zoeller is studying credit spread risk. McGonigal is farther along in her studies, but has forgotten how to determine the default free rate if given the yield on a bond rated BBB+ of 9.50% and a risk premium of 3.00%. What does Zoeller tell her to use for the default free rate?

A) 9.50%.

B) 6.50%.

C) 12.50%.

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The formula for credit spread risk (or the yield on a risky asset) is:
YieldRisky = YieldRF + Risk Premium, where RF = default − free rate.
Rearranging this formula results in: YieldRF = YieldRisky – Risk Premium, or YieldRF = 9.50% – 3.00% = 6.50%.

jawz

Suppose that a corporate bond and a government bond have equivalent characteristics. They both have a coupon rate of 6% paid annually and have two years remaining to maturity. Assuming a flat government term structure of 7% which of the following is a possible price of the corporate bond?

A) 98.19.

B) 101.35.

C) 97.76.

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Since the corporate bond involves credit risk and the government bond doesn't. The corporate bond price has to be less than the government bond price which is computed as follows:
Government Bond Price = 6 / 1.07 + 106 / 1.072 = 98.19

jawz

Which of the following will most likely have the least impact on a corporate bond rating? The:

A) issue's indenture provisions.

B) issuing company's volume of sales.

C) issuing company's debt burden.

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The size of the issuing firm, represented by the amount of sales, will play a role in the financial stability of the firm. However, the other choices, leverage and indenture provisions, are more directly related to the bond’s rating. Smaller firms are not likely to issue bonds and issuers are typically larger firms overall.

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.

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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.

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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.

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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.

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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.

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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).