burning0spear

Which of the following investors is least susceptible to inflation risk?

A) The holder of a 15-year bond with a coupon formula equal to the U.S. prime rate plus 3.25%.

B) An individual with a 5 year certificate of deposit at a local financial institution.

C) A financial institution with assets concentrated in fixed-rate mortgages.

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A 15-year bond with a coupon formula equal to the U.S. prime rate plus 3.25% is an example of a floating rate bond. The holder of an adjustable rate asset is impacted less by inflation than the holder of a fixed-rate asset because the increased cash flow (from the higher coupon payments when the base rate increases) at least partially offsets the decreased purchasing power caused by inflation.
The other two choices are examples of investors more susceptible to inflation - those who hold long-term contracts in which they are to receive a fixed payment.

burning0spear

Which of the following statements about inflation risk is NOT correct?

A) Treasury securities are considered immune to inflation and liquidity risk.

B) The short term inflation premium is less than the long term premium.

C) The real return on a fixed coupon bond is variable.

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The statement Treasury securities are considered immune to inflation and liquidity risk is partially true – Treasury securities are immune to liquidity risk, but fixed-coupon Treasury securities have high inflation risk and generally low real returns.
The other choices are correct. The inflation premium is less in the short term because investors are better able to predict inflation in the short term – inflation risk increases as time increases. (Investors want to be compensated for this uncertainty.) An investor’s real return is not fixed- even though an investor may hold a fixed-rate coupon bond, the real return depends on a variable – inflation. Higher inflation rates result in a reduction of the purchasing power of bond payments.

burning0spear

One year ago, Makato Omura purchased a 6.50% fixed coupon bond for 98.50. Recently, she sold the bond for 99.25 and calculated her return at 7.4%. Her friend, Takanino Takemiya, CFA, reminds Omura that this is the nominal return and that to calculate the real return, she needs to factor in the inflation rate over the holding period. If the price index for the current year is 118.5 and the price index one year ago was 115.9, Omura’s real return is closest to:

A) 9.6%.

B) 6.3%.

C) 5.2%.

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Omura’s real return is approximated by subtracting the inflation rate from the calculated (nominal) return. The inflation rate is calculated using the formula:Inflation = (Price Indexthis year – Price Indexlast year) / Price Indexlast year
Here, inflation = (118.5 – 115.9) / 115.9 = 0.0224, or approximately 2.2%.
Thus, the real return = 7.4% - 2.2% = 5.2%.

burning0spear

David Korotkin, CFA and a broker at an investment bank, has a client who is very concerned about maintaining purchasing power over the next year. The investor is conservative, and to date has been pleased with a consistent return of 8.00%. The bank’s research department has estimated next year’s inflation rate at 2.0%. The client specifically wants to invest in a fixed-coupon bond. Which of the following statements is most correct? If Korotkin purchases a bond with a 10.00% coupon, the client:

A) will not lose purchasing power.

B) may lose purchasing power.

C) will realize a real gain.

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Investors want to be compensated for the inflation they expect plus for the risk that inflation will increase during the term of the investment. Here, the bank’s estimated inflation rate is just that – an estimate. Thus, we cannot say for certain that the investor will not lose purchasing power. Inflation risk introduces uncertainty to the investment process.

burning0spear

Simone Girard, CFA candidate, is studying yield volatility and the value of callable bonds. She has the following information: a callable bond with a call option value calculated at 1.25 (prices are quoted as a percent of par) and a straight bond similar in all other aspects priced at 98.5. Girard also wants to determine how the bond’s value will change if yield volatility increases. Which of the following choices is closest to what Girard calculates as the value for the callable bond and correctly describes the bond’s price behavior as yield volatility increases?

A) 97.25, price decreases.

B) 97.25, price increases.

C) 99.75, price decreases.

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To calculate the callable bond value, use the following formula:
Value of callable bond = Value of straight bond – Call option value
Value of callable bond = 98.5 – 1.25 = 97.25.
Remember: The call option is subtracted from the bond value because the call option is of value to the issuer, not the holder.
As yield volatility increases, the value of the embedded option increases. The formula above shows that for a callable bond, an increase in the option value results in a decreased bond value.

burning0spear

Which of the following statements about embedded options and yield volatility is NOT correct?

A) As yield volatility increases, the value of the call option increases along with the value of the callable bond.

B) Putable bondholders benefit from increases in yield volatility.

C) A call option benefits the issuer and a put option benefits the holder.

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As yield volatility increases, the value of the call option increases, and the value of the callable bond decreases and thus the bondholder loses. (As shown by the equation: Value of callable bond = Value of straight bond – Call option value.) The other choices are true. A holder of a put option benefits from increased yield volatility because the value of the put option increases, increasing the putable bond value. (Value of putable bond = Value of straight bond + Put option value.)

burning0spear

Which of the following statements concerning the effects of interest rate volatility on bonds with embedded options is least accurate?

A) A putable bond's value is its straight bond value plus the value of the embedded put option.

B) As yield volatility increases, the value of callable bonds decreases.

C) A callable bond's value is its straight bond value plus the value of the embedded call option.

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A callable bond’s value is its straight bond value minus the value of the embedded call option. Since the bondholder is effectively short a call option, the value of the option is subtracted from the bond price. This is why the value of callable bonds decreases when yield volatility rises.

burning0spear

Which of the following statements is CORRECT for both callable and putable bonds?

A) When yield volatility increases, the value of the option increases.

B) The value of the bond is equal to the value of a similar straight bond plus the value of the option.

C) When yield volatility increases, the value of the bond increases.

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To calculate the value of a putable bond, it is correct to add the option value to the value of a similar straight bond. However, to calculate the callable bond value, subtract the option value from that of a similar straight bond. As a result, when yield volatility increases (thus increasing the option value), the value of a callable bond decreases and the value of a putable bond increases.

burning0spear

Tina Donaldson, CFA candidate, is studying yield volatility and the value of putable bonds. She has the following information: a putable bond with a put option value calculated at 0.75 (prices are quoted as a percent of par) and a straight bond similar in all other aspects priced at 99.0. Donaldson also wants to determine how the bond’s value will change if yield volatility decreases. Which of the following choices is closest to what Donaldson calculates as the value for the putable bond and correctly describes the bond’s price behavior as yield volatility decreases?

A) 99.75, price increases.

B) 99.75, price decreases.

C) 98.25, price decreases.

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To calculate the putable bond value, use the following formula:
Value of putable bond = Value of straight bond + Put option value
Value of putable bond = 99.0 + 0.75 = 99.75.
Remember: The put option is added to the bond value because the put option is of value to the bondholder, not the issuer.
As yield volatility decreases, the value of the embedded option decreases. The formula above shows that for a putable bond, a decrease in the option value results in a decreased bond value.

burning0spear

Which of the following is NOT an example of event risk?

A) A corporation calls a large bond issue.

B) Ratings agencies downgrade a company's rating after the company takes on a significant amount of debt to fund a leveraged buy-out (LBO).

C) An interim South American government imposes restrictions on the outflow of capital.

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A corporation calling a large bond issue is an example of call risk.
The other choices are examples of types of event risk, which includes disaster/accident, corporate, regulatory, and political risks. Event risk refers to the possibility that there may be a single event or circumstance that could have a major effect on the ability of an issuer to repay a bond obligation. The South American government’s actions are an example of political event risk. The LBO-related rating downgrade is an example of corporate event risk.