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Crash Course for
Fixed Income
CFA

Level-I Exam

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Fixed Income






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Debt Investment
Basics of Bond
Bonds & Risk
Management
Advanced Features of
Bonds
Bond Pricing
Basic Features of
Bond Structures
Basics of Floating
Rate Bonds
Repayment / Pre-
payment Provisions
Yield Calculation
Indenture: Agreement containing the terms
under which money is borrowed.
Par value: Amount borrower promises to pay
on or before maturity date of the issue
Term to maturity: Length of time until loan
contract or agreement expires.
Coupon rate when multiplied by par value,
gives amt of interest to be paid each period
Zero-coupon bonds: No interest; bonds are
sold at a deep discount to their par values
To derive a bond's value
using spot rates, discount the
individual cash flows by
benchmark rate for each
flow's time horizon. Sum of
PV of the cash flow is bond's
current value. This value is
the arbitrage free value.
Q. Given the following spot rates calculate
the value of 3 year, 6% treasury bond?
1 year 5% 2 year 5.5% 3 year 6%
Ans.



( )
1046 . 100
%) 6 1 (
106
%) 5 . 5 1 (
6
% 5 1
6
3 2
=
+
+
+
+
+
=
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Debt Investment
Basics of Bond
Bonds & Risk
Management
Advanced Features of
Bonds
Bond Pricing
Basic Features of
Bond Structures
Repayment / Pre-
payment Provisions
Yield Calculation
Bullet bonds: Lump sum at maturity, pays entire principal.
Amortizing securities: periodic principal & interest payments.
Serial bonds: Pay- off principal through series of payments over
time.
Sinking fund provisions for bond retirement through pre-defined
principal payments over life of the issue.
Call provisions: Issuer has right (but not obligation) to retire all or
part of issue prior to maturity. Issuer owns option to call the bonds
away from investor.
Non-refundable bonds prohibit premature retirement of an issue
from proceeds of a lower coupon bond. Bonds that carry these
provisions can be freely callable but nonrefundable
Basics of Floating
Rate Bonds
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Basic Features of
Bond Structures
Basics of Floating Rate
Bonds
Repayment / Pre-
payment Provisions
These securities pay
variable rate of interest.
Common procedure for
setting coupon rates on
floating rate bonds starts with
reference rate; then adds/
subtracts a stated spread.
Debt Investment
Basics of Bond
Bonds & Risk
Management
Advanced Features of
Bonds
Bond Pricing Yield Calculation
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Interest Rate Risk
Credit Risk
Reinvestment Risk
Inverse Relationship b/w
Interest Rates & Bond Prices.
Floating Rate Securities have
very low level of price volatility
Longer maturity bonds. Higher interest rate
risk (all else same).
Smaller coupon bonds. Higher interest rate
risk (all else same).
If market interest rates are high, price
volatility will be lower than if market interest
rates are low
If call/put option is embedded, then interest
rate risk will be lower
If coupon rate > required market yield
bond price > par value : premium bond
If coupon rate < required market yield
bond price < par value : discount bond
If coupon rate = required market yield
bond price = par value : par bond
Call
Price
Call
option
value
Option free bond
Price
Yield
Put option
value
Callable
bond
Putable bond
Sovereign Risk
Event Risk
Debt Investment
Basics of Bond
Bonds & Risk
Management
Advanced Features of
Bonds
Bond Pricing Yield Calculation
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Interest Rate Risk
Credit Risk
Reinvestment Risk
If interest rates decline, investors are
forced to reinvest at lower yields.
Bonds with high coupons have greater
risk.
Greatest risk is with callable bonds,
where all or part of principal can be repaid
in low interest rate environment.
Zero Coupon Bonds eliminate
reinvestment risk
Credit spread risk: credit spread is
difference in bond's yield and yield on
risk-free security. All else equal,
riskier the bond, higher the spread
Downgrade risk: Bond may be
reclassified as riskier security by a
major rating agency.
Default risk: Issuer might not make
payments.
Q. How much reinvestment income
needs to be generated to get a CAGR of
7% from 6%, 10 year treasury bond?
Ans. =100*(1.035)
20
= 198.98
Required reinvestment income =
198.98 100 (3*20) = 38.98

Sovereign Risk
Event Risk
Debt Investment
Basics of Bond
Bonds & Risk
Management
Advanced Features of
Bonds
Bond Pricing Yield Calculation
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Interest Rate Risk
Credit Risk
Reinvestment Risk
Risks in investing in a
foreign bond:
Adverse Price Change
Credit Spread Risk
Downgrade Risk
Default
Unwillingness of
foreign government
to pay
Inability to pay due
to unfavorable
economic
conditions

The ability of an issuer to make
interest and principal payment
changes drastically and unexpectedly
because of one of the following
factors:
A natural disaster
An industrial accident
A takeover
Corporate restructuring
A regulatory change

Sovereign Risk
Event Risk
Debt Investment
Basics of Bond
Bonds & Risk
Management
Advanced Features of
Bonds
Bond Pricing Yield Calculation
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Accrued Interest &
Clean Prices
Full price/Dirty Price includes accrued
interest. Bond price without accrued
interest is clean price.
Full price = Clean price + Accrued interest
Basic Bond Pricing
Treat each cash flow as a single zero-
coupon bond & find PV of each bond
using appropriate spot rates for each
cash flow. Prices must be the same to
prevent arbitrage.
Discount at constant rate applied to all
cash flows (YTM) to find all future cash
flows' PV
Q. What is the market price of a ten year, $1,000
bond with a 5% coupon paid annually, if the
bonds yield-to-maturity is 6%?
Ans. = 50/1.06
1
+ 50/1.06
2
+.+1050/1.06
10
= 926.40
Q. If you want to purchase a $1,000 bond
with a 5% coupon, paid semiannually.
Today is July 15th. The last coupon was
paid June 30
th
. If the quoted price is $902,
how much is the cash or full price
Ans. Cash Price = Quoted Price + Accrued
Interest = 902 + (1,000)(0.05)(15/365)
= 902 + 2.05 = $904.05
( ) ( ) ( )
..
YTM 1
CF
YTM 1
CF
YTM 1
CF
price Market
3
3
2
2
1
1
+
+
+
+
+
+
=
( ) ( ) ( )
...
S 1
CF
S 1
CF
S 1
CF
price Market
3
3
2
2 1
+
+
+
+
+
+
=
Using Calculator:
Y=6%, T=10, PMT=50, FV=1000
CMP PV -> -926.40
Debt Investment
Basics of Bond
Bonds & Risk
Management
Advanced Features of
Bonds
Bond Pricing Yield Calculation
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Current yield = annual
coupon payment / bond
price
Converting a bond
equivalent yield (BEY) to an
equivalent annual yield
(EAY) or vice versa:
BEY of an annual pay bond


Annual equivalent Yield=
(1+(BEY/2))
2
-1
Q. If a bond has a 5.5% annual
pay coupon and the current
market price of the bond is
$1,050, the current yield is
Ans. = 55/1050 = 5.24%
YTM is a IRR based on bond price
& its future cash flow

..
YTM) (1
CF
YTM) (1
CF
Price Bond
2
2
1
1
+
+
+
+
=
Forward rate is a lending rate for
a future loan
(1+S
2
)
2
= (1+S
1
)*(1+
1
f
1
)
Q. Calculate the 1yr fwd rate two
years from now, if S
1
=4% S
2
=5%
& S
3
=6%
Ans. (1+S
3
)
3
= (1+S
2
)
2
*(1+
1
f
2
)
1
f
2
= 8.03%
( ) | | 1 YTM 1 * 2
1/2
Pay Annual
+ =
Nominal Spread


Z-Spread
Solve for ZS where price =



OAS
Option Adjusted Spread = Z-Spread
Option Cost











Yield Volatility







When the yield level is
high, a change in interest
rates does not produce a
large change in price.
However, when yields
are low, changes in interest
rates produces a large
change in price.










Treasury Bond
YTM YTM Spread Nominal =
( ) ( ) (
(

+ +
+
(
(

+ +
=
2 1
2 1
Coupon
ZS rate Spot 1yr 1
Coupon
ZS rate Spot yr
Debt Investment
Basics of Bond
Bonds & Risk
Management
Advanced Features of
Bonds
Bond Pricing Yield Calculation
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Expectations Hypothesis:
Yield curve shape reflects
investor expectations about
future behavior of short-term
interest rates. Fwd rates
computed using today's spot
rates are best guess of future
interest rates.
Term Structure Theories
Liquidity Preference
Theory: Investors
prefer greater liquidity
and will demand
premium for
illiquidity(higher yields
to invest in longer-term
issues).
Market Segmentation
Theory: Market for debt
securities is segmented on
basis of investors maturity
preference. Each segment's
interest rate level is
determined by
supply/demand
Duration & Convexity
Other Duration Measures
Debt Investment
Basics of Bond
Bonds & Risk
Management
Advanced Features of
Bonds
Bond Pricing Yield Calculation
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Term Structure Theories
Duration & Convexity
Convexity is a measure of degree of
curvature or convexity in the price/yield
relationship. Convexity accounts for amt of
error in estimated price (based on duration)
Duration is the slope of a bond's price-yield
function. It is steeper at low interest rates,
flatter at high interest rates. So, duration
(interest rate sensitivity) is high at low rates
and low at higher rates, this holds for non
callable bonds.
A callable bond is likely to be called as
yields fall, so no one will pay a price
higher than the call price. The price won't
rise significantly as yield falls & you'll see
negative convexity at work as yields fall,
prices rise at a decreasing rate. For a
positively convex bond, as yields fall,
prices rise at an increasing rate
Effective duration (D) =(V
-
-V
+
)/(2V
0
(y))
Convexity measures curvature of the price yield
function


Note: y is in decimal form
Q. Calculate the new price of a bond
currently trading at 105.5 having a duration
of 7.5, if its yield rises to 6.5% from 6.2%?
Ans. % change in price =-0.3%*7.5=-2.25%
= (1 - 2.25%)*105.5 = 103.1263
Modified duration assumes that bond is a non
callable bond, due to which cash flows of the
bond will not change in calculation of duration


( ) YTM 1
Duration Macaulay
Duration Modified
+
=
100 * ] ) ( * * [ %
2
y Convexity y Duration P A + A = A
Other Duration Measures
Debt Investment
Basics of Bond
Bonds & Risk
Management
Advanced Features of
Bonds
Bond Pricing Yield Calculation
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DV01/PVBP
It is the absolute value of the change
in the price of a bond for a 1 basis
point change in yield


Term Structure Theories
Dollar Duration
The approximate dollar price
change for a 100bps change
in yield
Duration & Convexity
Other Duration Measures
Value Bond * 0.01% * Duration PVBP =
Debt Investment
Basics of Bond
Bonds & Risk
Management
Advanced Features of
Bonds
Bond Pricing Yield Calculation
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Question 1
A floating rate issue has the following provision in which the coupon rate is calculated
as 6- month LIBOR 80 basis points. The issue has a floor at 5.5%. If the 6-month
LIBOR on the reset date is 5.8%, the coupon rate is closest to
A. 4.5%
B. 5.5%
C.5.0%
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Answer 1
B.
Coupon rate = ref rate + quoted margin = 5.8% - 80 basis points = 5.0%. Since the
floater has a floor at 5.5%. The coupon is set to 5.5% on the reset date.
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Question 2
A buyer of a bond pays the seller $105 2/5 for a at par bond. The bond is cum-coupon.
The full price and the clean price is closest to
Full Price Clean Price
A 5 2/5 $100
B 3 3/8 $105
C 2 1/2 $100

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Answer 2
A.
The full price = bond price + accrued interest. Since the bond is at par the bond price is
$100 (clean price) and the accrued interest is 5 2/5.
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Question 3
For a 100 basis points downward shift in the yield curve which of the following bonds
will have the lowest percentage price change
A. An option-free bond
B. A callable bond
C.A putable bond

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Answer 3
B.
The value of a callable bond does not rise as much as a comparable option-free bond.
Price of a putable bond = price of an option-free bond + price of the embedded put. So
when the yield curve is shifted downwards the price of a putable bond will change
more than a comparable option-free bond.
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Question 4
Carl and Karen are CFA Level I candidates. Carl says that a zero coupon bond has
higher interest rate risk than a coupon bond of the same maturity. While Karen says
that a callable bond has higher volatility risk than an option-free bond. Which of the two
statements are most likely correct
Carl Karen
A. No Yes
B Yes No
C. Yes Yes

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Answer 4
B.
Callable options have lower volatility risk than option-free bond because of the
embedded call option in the bond. Zero-coupon bonds have a higher interest rate risk
and their prices can change significantly if the yields change.
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Question 5
GNB has a portfolio of mortgage loans. These amortizing loans have three distinct
cash flows. Which of the following is least likely to be considered as a cash flow for the
mortgages
A. Interest payments
B. Servicer costs
C.Scheduled principal payments

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Answer 5
B.
Servicer costs are not one of the cash flows from a mortgage


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Question 6
Sally makes the following statement regarding corporate debts, CPs is a long term
note that can have maturity of up to 15 years or more. In an IAN (Index Amortizing
Note) the maturity increases when interest rate increases. Sally is most likely correct
regarding
Commercial Papers IAN
A Correct Incorrect
B Incorrect Correct
C Incorrect Incorrect

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Answer 6
B.
CPs is a short term note. Maturity of IANs increases when the rates rise. An IAN is
similar to a CMO and the maturity lengthens as interest rates go up.
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Question 7
Smith is comparing the yields that he gets from investing in two securities. The first one
is a taxable issue A with a yield of 8.75%, the other is a tax-exempt issue B with a yield
of 6.25%. Smith is in the 40% marginal tax bracket. In which of the securities is Smith
most likely to invest
A. Security A; since the yield is higher
B. Security B; since the tax-equivalent yield is higher
C. Both the securities provide the same yield

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Answer 7
B.
Tax-equivalent yield for security B is 6.25 %/( 1-0.4) = 10.42% which is significantly
higher than the yield for security A.


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Question 8
Carl says that treasury strips offered by his bank are guaranteed by the full faith and
credit of the US Government. He also says that strips provide better yield as compared
to an on-the-run Treasury security of the same maturity. Carl is most likely
A. Correct regarding both the statements
B. Incorrect regarding one of the statements and Correct regarding the other
C. Incorrect regarding both the statements

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Answer 8
A.
Treasury strips are created by stripping securities issued by the US Government,
hence they are effectively guaranteed by the full faith and credit of the US government.
Since they are zero coupon securities they provide a better relationship between yield
and maturity as compared to a comparable on-the-run Treasury security of the same
maturity. Strips do not face any reinvestment risk as they do not pay any coupons.


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Question 9
A callable bond will have a higher yield spread than a comparable putable bond. The
statement is most likely
A. Correct; the call option is favorable to the issuer hence the bond should have a
higher yield
B. Correct; the put option is favorable to the issuer hence the bond can have a lower
yield
C. Incorrect; the call option embedded in the bond is favorable to the investor hence
the yield should be lower

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Answer 9
A.
A call option is favorable to the issuer hence the yield spread relative to a Treasury
security should be larger than that of a comparable putable bond.


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Question 10
For an 8% 10-year semi-annual coupon bond the discount rate is 6.5% p.a. The fair
value is closest to
A. 110.9
B. 112.9
C.102.9

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Answer 10
A.
For the 10-year 8% semi-annual coupon bond. The cash flows include 20 coupon
payments and one principal payment. Using the cash flow function in your calculator
the NPV= 110.9



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Question 11
For a 7% 3-year semi-annual option-free bond. The Treasury spot rates are

6 month 5.2%
12 month 5.5%
18 month 5.8%
24 month 6.0%
30 month 6.2%
36 month 6.5%

The bond is at par. Calculate the no-arbitrage price for the bond. If the market price is
$104.5 the BEY is closest to

No-arbitragePrice BEY
A 102.34 5.45%
B 101.48 5.36%
C 104.5 5.25%
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Answer 11
B.
No-arbitrage price is calculated by discounting all the cash flows by the spot rates
Cash Flow PV Factor PV of Cash Flow
3.5 0.9747 3.41
3.5 0.9472 3.32
3.5 0.9178 3.21
3.5 0.8885 3.11
3.5 0.8584 3.00
103.5 0.8254 85.43
Total PV of Cash Flows 101.48

The bond equivalent yield can be calculated by using the CF function
Input 6 cash flows for coupon payment and one principal payment cash flow. CF0 =
104.5 CPT IRR. IRR = 2.68%
BEY = 2* IRR = 5.36%


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Question 12
A fixed income analyst makes the following two statements
Statement 1: YTM assumes that coupon payments are reinvested at the rate equal
to the cash flow yield.
Statement 2: The bond is assumed to be held till maturity.
Statement 1 Statement 2
A Correct Correct
B Correct Incorrect
C Incorrect Correct

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Answer 12
A.
Both the statements are true.


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Question 13
An option-free bond has duration of 5.25 and convexity of 94.6. The change in the
value for a 100 bps upward shift in the yield curve is closest to
A. - 5.2405%
B. - 5.273%
C.- 5.354%

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Answer 13
A.
Duration effect = -5.25*0.01*100 = -5.25
Convexity effect = 94.6 * (0.01)2 = 0.0095
Total effect = -5.2405%




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Question 14
A bond is likely to get matured in next three years has a par value of $500 and a
coupon rate of 7.75% payable semiannually. Which of the following is closest amount
of semiannual coupon payment?
a. Rs 38.75
b. Rs 19.375
c. Rs 19.75

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Answer 14
B.
The correct answer is Rs 19.375
=500*7.75%/2 =19.375


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Question 15
Institutional users use a number of methods for borrowing money for the purchase of
bonds, the least likely method of borrowing is
A. Margin buying
B. Repurchase agreement
C. Loan against property


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Answer 15
C.
Institutional users generally borrow margin money through collateralized securities or
through a repurchase agreement. Loan against property is generally not permitted for
trading activities.
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Question 16
A $100 par value bond has duration of 12.7 If the price rises to 104.57 when the yield
declines by 50 basis points, the price when the yield rises by 50 basis points is closest
to
A. 95.7
B. 91.8
C.92.5

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Answer 16
B.
Duration = Price if yield declines price if yield rises /( 2 * (initial price) * (change in
yield in decimals))
Price if yield rises = 104.57 12.7*(2*100*0.005)= 91.8

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Question 17
Carl an analyst with a fixed income hedge fund states that investments in high yield
securities from emerging economies carries a number of risk factors. Which of the
following is least likely to be listed as a risk when investing in high yield securities from
emerging markets
A. Sovereign risk
B. Exchange rate risk
C.Downgrade risk

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Answer 17
C.
A high yield bond has generally a low-credit and is of speculative nature. Investments
in foreign currency bonds carry exchange rate risks. The bonds also have sovereign
risk due to the risk of actions of the foreign government in case of default.
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Question 18
Carl a fixed income analyst is discussing investment strategies with Karen. He says
that a $ 100mn 8% 10-year semi-annual T-note issued by the US government can be
stripped into 20 Treasury strips. The 20th treasury strip is the final coupon and principal
strip and has a maturity value of $104mn. Karen disagrees with both the points. She is
most likely correct regarding

Number of Treasury Strip Maturity value
A Incorrect Incorrect
B Correct Correct
C Incorrect Correct


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Answer 18
B.
The Treasury note can be stripped into 20 coupon strips and one principal strip. The
21st strip is the principal strip of $100mn. When Karen disagrees with Carl she is
correct regarding both the point
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Question 19
Bart wants to invest in a municipal bond. Which of the following is he least likely to
invest in
A. Tax backed bonds
B. Revenue bonds
C. Bankruptcy bonds

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Answer 19
C.
The types of municipal bonds are a) tax backed bonds b) revenue bonds c) special
bond structures


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Question 20
Ted makes the following statements:
Statement 1: In a bought deal the underwriting firm offers the issuer to buy a specified
amount of securities with a certain coupon rate and maturity.
Statement 2: In a bought deal the underwriting firm usually has presold most of the
securities and has hedged its interest rate risk.
Which of the above statements is most likely to be correct?
Statement 1 Statement 2
A Correct Incorrect
B Correct Correct
C Incorrect Incorrect


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Answer 20
B.
Both the statements are true for bought deals
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Question 21
The pure expectation theory suggests that an upwardly sloping curve means that the
rates are expected to rise. However the liquidity preference theory an upwardly sloping
curve least likely suggests
A. The future interest rates are likely to rise
B. The rates will be unchanged or may even fall; but yield premium will change
C. The rates will be unchanged or may even fall; but yield premium will remain the
same

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Answer 21
C.
Liquidity preference theory says that an upward sloping yield curve may indicate that
the rates are likely to rise or remain unchanged or even fall with a change in the yield
premiums
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Question 22
A 10-year Treasury security has a yield of 5.2%. A 10-year corporate bond issued by
Motorola has a yield of 5.65%. The absolute spread, relative spread and the yield ratio
is closest to
A. 45 bps; 9%; 1.09
B. 40 bps; 9%; 1.10
C. 45 bps; 8%; 1.09

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Answer 22
A.
Absolute spread = 5.65 5.2 = 0.45
Relative spread = 0.45/5.2 = 9%
Yield ratio = 5.65/5.2 = 1.09


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Question 23
Carl is discussing valuation models with Karen. Carl states that all valuation models
are calibrated using on-the-run Treasury securities. Karen states that volatility of
interest rates can vary from period to period; all models make some critical
assumptions regarding the volatility of short term interest rates. The two statements are
most likely
Carls Statement Karens Statement
A Incorrect Incorrect
B Correct Correct
C Correct Incorrect


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Answer 23
B.
Both the statements are true. Treasury securities are used for calibrating a model. The
model should give a value equal to its market price. Also all the models make some
assumptions regarding volatility.
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Question 24
Karen invests in an 8% 5-year semi-annual callable bond on 5th January 2010. The
Z-spread for the callable bond is 150bps. The option cost is 56 bps. The OAS is closest
to
A. 100 bps
B. 94 bps
C. 206 bps

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Answer 24
B.
OAS = Z-spread option cost = 150 -56 = 94 bps


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Question 25
Sally states that there are a number of yield measures that are used traditionally in the
bond market. The least likely yield measure that is used
A. Yield to call
B. Yield to worst
C. Yield to settlement

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Answer 25
C.
Yield to settlement is not a traditional measure of yield. The yield measures that are
generally used are a) yield to maturity b) yield to call c) yield to put d) yield to worst
e)current yield f) cash flow yield.


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Question 26
Carl manages the following portfolio








The value for the portfolio duration is closest to
A. 5.833
B. 4.351
C. 4.555

Coupon Maturity Par Value Market Value Duration
8% 5 years $ 5 mn $ 4 mn 4.87
11% 7 years $ 10mn $11.4mn 5.72
9.75% 10 years $ 15mn $14.5mn 8.50
10.25% 5 years $ 20mn $ 21.2 4.25
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Answer 26
A.











Issue Market Value MV % of Port Folio Value Duration MV% * Duration
A $ 4mn 7.83% 4.87 0.3813
B $ 11.4mn 22.31% 5.72 1.2761
C $14.5mn 28.38% 8.50 2.4123
D $ 21.2mn 41.49% 4.25 1.7633
Total $ 51.1mmn 100% 5.8330
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Question 27
Duration is not a good measure for large changes in yield. Duration also assumes that
the yield curve will shift in a parallel fashion. The statements are most likely
A. Both statements are correct.
B. Only one statement is correct.
C. Both the statements are incorrect.



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Answer 27
A .
Both the statements are correct as the duration measure is not useful for measuring
changes in price when there are large changes in yield. The duration also assumes
that yields change is parallel across the entire yield curve.
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Question 28
A straight 7% bond with two years to maturity is priced at $97.65. A putable bond which
is similar to straight bond in all aspects except for the put feature is priced at $98.45
and a callable bond that is same as the straight bond except for the call feature is
priced at $96.95. Which of the following will be the closest value of the call option and
put option?
Call option value Put option value
A. $0.75 $0.75
B. $0.8 $0.7
C. $0.7 $0.8



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Answer 28
C.
Call option value: $0.7, Put option value: $0.8
Call option value= 97.65 96.95 =0.7
Put option value= 98.45 97.65=0.8


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Question 29
Which of the following is true:
A. When the yield level is high, a change in interest rates produces a large change in
price.
B. When yields are low, changes in interest rates produces a large change in price.
C. Change in Yields at any level will produce the same change in price
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Answer 29
B.
When the yield level is high, a change in interest rates does not produce a large change
in price.
However, when yields are low, changes in interest rates produces a large change in
price.

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