CFA Level 1 - Fixed Income Session 15 - Reading 56

CFA Level 1 - Fixed Income Session 15 - Reading 56 (Notes, Practice Questions, Sample Questions) 1. If the Federal Reserve wishes to lower market interest rates without changing the discount rate, it can: A)buy Treasury securities. {Explanation: Buying Treasury securitiespumps money into the economy, lowering interest rates. Higherreserve requirements will restrict the money supply, causing rates torise. The Federal Reserve has no direct control over the yield onexisting Treasury securities} B)raise the yield on Treasury securities.C)increase bank reserve requirements. 2. Which of the following policy tools is the least likely to be available to the U.S. Federal Reserve Board? A)Buying and selling Treasury securities in the open market.B)Setting the discount rate at which banks can borrow from the FederalReserve. C)Requiring the banking system to tighten or loosen its creditpolicies. {Explanation: The U.S. Federal Reserve can encourage orpersuade banks as a whole to tighten or loosen their credit policies,but it cannot compel them to do so}

3. Which of the following are the two most important tools available to the Federal Reserve? A)Changing the discount rate and open market operations.{Explanation: The two most important tools available to the Fed arechanging the discount rate, the rate at which banks can borrow fromthe Fed’s discount window, and open market operations, the Fed’sactivity of buying and selling Treasury securities} B)Changing the discount rate and changing bank reserve requirements.C)Open market operations and changing bank reserve requirements. 4. The concept of spot and forward rates is most closely associated with which of the following explanations of the term structure of interestrates? A)Segmented market theory. B)Expectations hypothesis. {Explanation: The pure expectationstheory purports that forward rates are solely a function of expectedfuture spot rates. In other words, long-term interest rates equal themean of future expected short-term rates. This implies that aninvestor could earn the same return by investing in a 1-year bond orby sequentially investing in two 6-month bonds. The implications forthe shape of the yield curve under the pure expectations theory are:If the yield-curve is upward sloping, short-term rates are expected torise.

If the curve is downward sloping, short-term rates are expected tofall.A flat yield curve implies that the market expects short-term rates toremain constant} C)Liquidity premium theory. 5. If investors expect future rates will be higher than current rates, the yield curve should be: A)vertical.B)downward sweeping. C)upward sweeping. {Explanation: When interest rates are expectedto go up in the future the yield curve will be upward sweepingbecause time is on the x-axis and rates are on the y-axis, thusforming an upward sweeping curve} 6. A downward sloping yield curve generally implies: A)interest rates are expected to decline in the future. {Explanation:Since a yield curve has time on the x-axis and rates on the y-axis,when the yield curve is downward sloping it means that rates areexpected to decline} B)shorter-term bonds are less risky than longer-term bonds.C)interest rates are expected to increase in the future.

7. Which of the following yield curves represents a situation where long-term rates are less than short-term rates? A)Normal yield curve. {Explanation: A normal yield curve is one inwhich long-term rates are greater than short-term rates. A humpedyield curve represents a situation where rates in the middle of thematurity spectrum are higher or lower than those for both bonds witha short and long-term maturity.} B)Inverted yield curve.C)Humped yield curve. 8. Which of the following is the shape of an inverted yield curve or term structure? A)Downward sloping. {Explanation: An inverted yield curve reflectsthe condition where long-term rates are less than short-term rates,giving it a downward (negative) slope} B)Flat.C)Upward sloping. 9. Which of the following best explains the slope of the yield curve? A)The term spread between the yields of two maturities.{Explanation: Since the yield curve depicts the yield on securitieswith different maturities, the slope of the curve between twomaturities is a function of the maturity spread} B)The nominal spread between two securities with different maturities.

C)The credit spread between two securities with different maturities. 10. A normally sloped yield curve has a: A)zero slope.B)negative slope. C)positive slope. {Explanation: A normally shaped yield curve is onein which long-term rates are greater than short-term rates, thus thecurve exhibits a positive slope} 11. Suppose the term structure of interest rates makes an instantaneous parallel upward shift of 100 basis points. Which of the followingsecurities experiences the largest change in value? A five-year: A)zero-coupon bond. {Explanation: The duration of a zero-couponbond is equal to its time to maturity since the only cash flows made isthe principal payment at maturity of the bond. Therefore, it has thehighest interest rate sensitivity among the four securities. A floatingrate bond is incorrect because the duration, which is the interest ratesensitivity, is equal to the time until the next coupon is paid. So thisbond has a very low interest rate sensitivity.A coupon bond with a coupon rate of 5% is incorrect because theduration of a coupon paying bond is lower than a zero-coupon bondsince cash flows are made before maturity of the bond. Therefore, itsinterest rate sensitivity is lower} B)floating rate bond.C)coupon bond with a coupon rate of 5%.

12. An analyst forecasts that spot interest rates will increase more than the increase implied by the current forward interest rates. Under thesecircumstances: A)the analyst should establish a bullish bond portfolio. B)the analyst should establish a bearish bond portfolio.{Explanation: Bond prices fall with a rise in interest rates. If realizedrates rise more than the associated forward rate implied, then abearish bond position will be the most beneficial} C)all bond positions earn the same return. 13. Which of the following is a correct interpretation of forward rates under the pure expectations hypothesis? Forward rates are equal to theexpected future: A)rate differences between short and long-term bonds. B)spot rates. {Explanation: The pure expectations theory purportsthat forward rates are solely a function of expected future spot rates} C)risk premiums on short-term bills. 14. According to the pure expectations theory an upward-sloping yield curve implies: A)longer-term bonds are riskier than short-term bonds.

B)interest rates are expected to increase in the future. {Explanation:According to the expectations hypothesis, the shape of the yieldcurve results from the interest rate expectations of marketparticipants. More specifically, it holds that any long-term interestrate simply represents the geometric mean of current and future1-year interest rates expected to prevail over the maturity of theissue. The expectations theory can explain any shape of yield curve.Expectations for rising short-term rates in the future cause a rising(upward-sloping) yield curve; expectations for falling short-termrates in the future will cause long-term rates to lie below currentshort-term rates, and the yield curve will decline (or slopedownward).Thus, an upward-sloping yield curve implies that interest rates areexpected to increase in the future} C)interest rates are expected to decline in the future. 15. Which of the following statements regarding the different theories of the term structure of interest rates is least accurate? A)The market segmentation theory, pure expectations theory, preferredhabitat theory, and liquidity preference theory are all consistent withany shape of the yield curve.B)An upward sloping yield curve can be consistent with the liquiditypreference theory even with expectations of declining short terminterest rates. C)The preferred habitat theory suggests that investors prefer to staywithin a particular maturity range of the yield curve regardless ofyields in other maturity ranges. {Explanation: The preferred habitat

theory states that investors prefer to stay within a particularmaturity range but will move from their preferred range to anotherarea on the curve to achieve higher yields. With the liquiditypreference theory the yield curve can remain upward sloping even ifshort term rates are predicted to decline as long as the liquiditypremium is sufficiently large} 16. The term structure theory that rests on the interaction of supply and demand forces in the debt market is the: A)expectation hypothesis. B)market segmentation theory. {Explanation: The marketsegmentation theory holds that the market is segmented intodifferent parts based on the maturity preferences of investors. Thetheory also holds that the supply and demand forces at work withineach segment determine the prevailing level of interest rates for thatpart of the market} C)GIC inverse term structure theory. 17. The liquidity preference theory holds that: A)because they are so marketable, there is a liquidity premium thatnormally has to be paid to invest in short-term debt securities.B)cash should be preferred to Treasury securities because it is moreliquid. C)the yield curve has an upward-sloping bias. {Explanation: Theliquidity preference theory suggests an upward-sloping bias with

regard to the shape of the yield curve because investors generallyprefer the greater liquidity and reduced risk that accompaniesshort-term securities and, as a result, require a premium (higheryields) to get them to invest in longer-term securities. However, theyield curve can still be downward sloping even with a liquiditypremium, for example if short-term interest rates are expected todecrease sharply in the future} 18. Suppose that the one-year forward rate starting one year from now is 6%. Which of the following statements is most accurate under the pureexpectations hypothesis? The expected: A)future risk premium for short-term bills is 6%.B)one-year forward rate in one year's time is equal to 6%. C)future one-year spot rate in one year's time is equal to 6%.{Explanation: Under the pure expectations hypothesis forward ratesare equal to expected future spot rates} 19. According to the expectations hypothesis, investors’ expectations of decreasing inflation will result in: A)a flat yield curve. B)a downward-sloping yield curve. {Explanation: The expectationshypothesis holds that the shape of the yield curve reflects investorexpectations about the future behavior of inflation and marketinterest rates. Thus, if investors believe inflation will be slowing down

in the future, they will require lower long-term rates today and,therefore, the yield curve will be downward-sloping} C)an upward-sloping yield curve. 20. The six-month spot rate is 4% and the 1 year annualized spot rate is 9% (4.5% on a semiannual basis). Based on the pure expectations theoryof interest rates, the implied six-month rate six months from now isclosest to: A)5%. {Explanation: 1r1 = [(1 + R2)2 / (1 + R1)1] - 1 = [(1.045)2/(1.04)1] - 1[1.092 / 1.04] - 1 = 0.05} B)6%.C)4%. 21. Generally speaking, an upward-sloping yield curve can be expected when: A)the supply of long-term funds falls short of demand. B)the supply of long-term funds falls short of demand and investorsbegin to show a preference for more liquid/less risky short-termsecurities. {Explanation: When demand for loanable funds outstripssupply, interest rates can be expected to rise in that (long-term)segment of the market; also, more preference for short-termsecurities can be expected to drive up long-term rates as theliquidity premium rises. Thus, both circumstances in the answer canbe expected to put upward pressure on the long end of the yieldcurve}

C)inflationary expectations are beginning to subside and investorsbegin to show a preference for more liquid/less risky short-termsecurities. 22. If the slope of the yield curve begins to rise sharply, it is usually an indication that: A)stocks are offering abnormally high rates of return.B)the Fed has been aggressively driving up short-term interest rates. C)the rate of inflation is starting to increase or is expected to do so inthe near future. {Explanation: According to the expectationshypothesis, higher long-term interest rates and, therefore,upward-sloping yield curves will occur if the rate of inflation startsto heat up or is expected to do so in the near future} 23. James McDonald and Veasna Lu were discussing different ways of valuing a Treasury security. During their discussion Lu made thefollowing statements:Statement 1: It is inappropriate to discount the cash flows of a Treasurysecurity by a single discount rate because that is implicitly assumingthat the yield curve is flat. Therefore, each individual cash flow shouldbe discounted by its corresponding spot rate.Statement 2: The spot rates used for different time periods that producea value equal to the market price of a Treasury bond are called forwardrates or future expected spot rates.With regard to the statements made by Lu:

A)only one is correct. {Explanation: Statement 2 is incorrect becausethe spot rates used for different time periods that produce a valueequal to the market price of a Treasury bond are called arbitrage-freeTreasury spot rates. Statement 1 is correct} B)both are correct.C)both are incorrect. 24. The Treasury spot rate yield curve is closest to which of the following curves? A)Zero-coupon bond yield curve. {Explanation: The spot rate yieldcurve shows the appropriate rates for discounting single cash flowsoccuring at different times in the future. Conceptually, these rates areequivalent to yields on zero-coupon bonds. The par bond yield curveshows the YTMs on coupon bonds by maturity. Forward rates areexpected future short-term rates} B)Par bond yield curve.C)Forward yield curve rate. 25. Bond A has a yield of 8.75%. Bond B, the reference bond, has a yield of 7.45%. Assuming both bonds have the same maturity, the relativeyield spread is closest to: A)13%. B)17%. {Explanation: Relative yield spread = absolute yield spread /yield on reference bondRelative yield spread = (8.75% − 7.45%) / 7.45% = 0.17 = 17%}

C)15%.Assume the following corporate yield curve.One-year rate: 5%Two-year rate: 6%Three-year rate: 7% 26. If a 3-year annual-pay corporate bond has a coupon of 6%, its yield to maturity is closest to: A)6.08%.B)7.00%. C)6.92%. {Explanation: First determine the current price of thecorporate bond:= 6 / 1.05 + 6 / (1.06)2 + 106 / (1.07)3 = 5.71 + 5.34 + 86.53 = 97.58Then compute the yield of the bond:N = 3; PMT = 6; FV = 100; PV = -97.58; CPT → I/Y = 6.92%} 27. 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 referencerate, which of the following statements is least accurate? A)If the Treasury rate rises and the absolute spread stays the same, theyield ratio declines.B)The absolute yield spread is 2.2%. C)The yield ratio is 1.022. {Explanation: The yield ratio is (6.4%) /(4.2%) = 1.524, or one plus the relative yield spread}

28. Which of the following is the most appropriate strategy for a fixed income portfolio manager under the anticipation of an economicexpansion? A)Sell corporate bonds and purchase Treasury bonds. B)Purchase corporate bonds and sell Treasury bonds. {Explanation:During periods of economic expansion corporate yield spreadsgenerally narrow, reflecting decreased credit risk. If yield spreadsnarrow, the prices of corporate bonds increase relative to the pricesof Treasuries. Selling lower-rated bonds and buying higher-ratedbonds is an appropriate strategy if an economic contraction isanticipated} C)Sell lower-rated corporate bonds and buy higher-rated corporatebonds. 29. If investors expect greater uncertainty in the bond markets, you should see yield spreads between AAA and B rates bonds: A)slope downward.B)narrow. C)widen. {Explanation: With greater uncertainty, investors require ahigher return for taking on more risk. Therefore credit spreads willwiden} 30. If a U.S. investor is forecasting that the yield spread between U.S. Treasury bonds and U.S. corporate bonds is going to widen, then whichof the following is most likely to be CORRECT?

A)The economy is going to expand. B)The economy is going to contract. {Explanation: If economicconditions are expected to get worse, then the probability thatcorporations may default increases and causes credit spreads towiden} C)The U.S. dollar will weaken. 31. Which of the following is the reason why credit spreads between high quality bonds and low quality bonds widen during poor economicconditions? A)default risk.{Explanation: During poor economic conditions theprobability of default increases and thus credit spreads widen} B)indenture provisions.C)interest risk. 32. As compared to an equivalent noncallable bond, a callable bond’s yield should be: A)the same. B)higher.{Explanation: A callable bond favors the issuer. Hence, thevalue of the bond is discounted by the value of the option, whichmeans the yield will be higher} C)lower.

33. As compared to an equivalent nonputable bond, a putable bond’s yield should be: A)the same.B)higher. C)lower.{Explanation: A putable bond favors the buyer (investor).Hence, a premium will be paid for the option, which means the yieldwill be lower} 34. Relative to a bond sold as part of a large issue, an otherwise equivalent bond that is sold as part of a smaller issue will be sold for a: A)lower price and have a higher yield to maturity. {Explanation:Bonds that are sold as part of a smaller issue have higher liquidityrisk than bonds that are sold in a large issue. Investors will demand ahigher yield to maturity to cover the liquidity risk; therefore, thesebonds will be sold for less than bonds from larger issues} B)lower price and have a lower yield to maturity.C)higher price and have a lower yield to maturity. 35. Consider three corporate bonds that are identical in all respects except as noted:Bond F has $100 million face value outstanding. On average, 200 bondstrade per day.Bond G has $300 million face value outstanding. On average, 200 bondstrade per day.

Bond H has $100 million face value outstanding. On average, 500 bondstrade per day. Will the yield spreads to Treasuries of Bond G and Bond H be higher orlower than the yield spread to Treasuries of Bond F? A)Higher for both.B)Higher for one only. C)Lower for both. {Explanation: Liquidity is attractive to investors, sothey will pay a higher price (demand a lower yield) for a more liquidbond than for an identical bond that is less liquid. Bond G is moreliquid than Bond F because of its greater size. Bond H is more liquidthan Bond F because it trades in greater volume. Therefore both BondG and Bond H will tend to have lower yield spreads to Treasuries thanBond F} 36. A municipal bond carries a coupon of 6.75% and is traded at par. To a taxpayer in the 28% tax bracket, this bond provides an equivalenttaxable yield of: A)6.75%.B)8.53%. C)9.38%. {Explanation: ETY = Yield/(1 − Marginal Tax Rate)0.0675/(1 − 0.28) = 9.38%}

37. A 6% annual coupon paying bond has two years remaining to maturity and is priced at par. Assuming a 40% tax rate, the after-taxyield for this bond is closest to: A)4.8%. B)3.6%. {Explanation: Since the bond is trading at par, its yield tomaturity is equal to its coupon rate of 6.0%. The after-tax yield is (1 −0.4)(6.0%) = 3.6%} C)2.4%. 38. A municipal bond carries a coupon of 6% and is traded at par. To a taxpayer in the 34% tax bracket, this bond provides an equivalenttaxable yield of: A)9.09%. {Explanation: ETY = yield/(1 − marginal tax rate)0.06/(1 − 0.34) = 9.09%} B)8.53%.C)6.00%. 39. A municipal bond selling at 12% above par offers a yield of 3.2%. A taxable Treasury note selling at an 8% discount offers a yield of 4.6%. Aninvestor in the 32.5% tax bracket wishes to purchase an equal dollaramount of both bonds. The after-tax yield of the two-bond portfolio isclosest to: A)4.67%.B)2.63%.

C)3.15%. {Explanation: The after-tax yield of the Treasury note is thestated yield times one minus the tax rate, or 4.6% times 67.5%, or 3.1%.To calculate the portfolio yield, take the average after-tax yields ofboth bonds, which is 3.15%} 40. What would the marginal tax rate have to be for an investor to be indifferent between a 6% yield on tax exempt municipal bonds and a10% corporate bond? A)60%.B)20%. C)40%. {Explanation: 10 = 6 / (1 − MTR )0.10 = 0.06 / (1 – MTR); 0.10 – 0.1MTR = 0.06;MTR = -0.04 / -0.10 = 0.40 or 40%} 41. The interest rate paid on negotiable CDs by banks in London is referred to as: A)LIBOR. {Explanation: The interest rate paid on negotiable CDs bybanks in London is referred to as LIBOR. LIBOR is determined everyday by the British Bankers Association. The Fed Funds rate is the ratepaid on interbank loans within the U.S. The London rate is afabricated term in this context} B)the Fed Funds rate.C)the London rate.

42. The most important LIBOR rate for funded investors is the: A)1 year or less rate. {Explanation: A funded investor is one whoborrows to invest. These investors typically borrow short-term andthe interest rate on their loan is typically short-term LIBOR plus amargin (e.g. LIBOR plus 30 basis points)} B)20 year rate.C)10 year rate. 43. A funded investor has a short-term investment returning a 7% return. The borrowing costs are 20 basis points above the reference rate. If theT-bill rate is 3% and the LIBOR rate is 3.5%, what is the investor’s currentprofit on this investment? A)3.8%.B)1.5%. C)3.3%. {Explanation: A funded investor is one who borrows to invest.These investors typically borrow short-term and the interest rate ontheir loan is typically short-term LIBOR plus a margin, here LIBORplus 20 basis points. Thus in this example, the investor’s cost of fundsis 3.7%. His profit is then 7% − 3.7% = 3.3%}