CFA 2018 Question bank 01 The Term Structure and Interest Rate Dynamics

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Test ID: 7441633

The Term Structure and Interest Rate Dynamics

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ᅚ A)

Usethefollowing spotratecurvetoanswerthis question:

Maturity 1 2 3

Spot rates 5% 5.5% 6%

The1-yearforwardrateinoneyear [ƒ(1,1)] andthe1-yearforwardrateintwoyears [ƒ(2,1)] isclosestto: ƒ(1,1) ƒ(2,1)

4% 4.89%

6% 7%

5.25% 5.75%

Explanation

ƒ(1,1) = (1+S )/(1+S ) - 1 = 6% ƒ(2,1) = (1+S )/(1+S ) - 1 = 7%

Volatilityinshort-termratesismostlikelyrelatedtouncertaintyabout:

inflation.

thereal economy. monetary policy.

Explanation

Volatilityinshort-termratesismost likely linkedtomonetary policy, whereas volatilityin long-termratesismost likely linkedto uncertaintyaboutthereal economyandinflation.

Assume thatthe interestrates inthe future are not expectedtodifferfromcurrentspotrates. Insuchacase, the liquidity premiumtheory

ofthe termstructure of interestrates projectsthatthe shape ofthe yieldcurve will be:

upward sloping. 22 1

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variable.

downwardsloping.

Explanation

The liquidity theory holdsthat investorsdemanda premiumtocompensate themto interestrate exposure andthe premium increases with

maturity. Whenthe yieldcurve under pure expectations isflat (i.e., interestrates infuture are expectedto be same ascurrentrates),

additionof liquidity premium (which increases withmaturity) wouldresult inanupwardsloping yieldcurve.

Whichofthefollowing statementsaboutyieldcurvesismost likelyaccurate?

A twist refers to changes to the degree to which the yield curve is humped. Ayieldcurve getssteeper whenspreads widen.

Anegative butterflymeansthattheyieldcurvehas become lesscurved.

Explanation

Atwistreferstoyieldcurvechanges whentheslope becomeseitherflatterorsteeper. Anegativebutterflymeansthatthe

yieldcurvehas becomemorecurved.

Comparedtoayieldcurve basedon government bonds, swap ratecurvesare:

more comparable across countries and have a smaller number of yields at various maturities.

lesscomparableacrosscountriesandhavea greaternumberofyieldsat various maturities.

morecomparableacrosscountriesandhavea greaternumberofyieldsat various maturities.

Explanation

Swap ratecurvesaretypicallydetermined bydollardenominated borrowing basedon LIBOR. Theseratesaredetermined by

market participantsandarenotregulated by governments. Swap ratecurvesarenotaffected bytechnical marketfactorsthat affecttheyieldson government bonds. Swap ratecurvesarealsonotsubjecttosovereigncreditrisk (potential government

defaultondebt)thatisuniqueto governmentdebtineachcountry. Thusswap ratecurvesaremorecomparableacross countries becausetheyreflectsimilar levelsofcreditrisk. Thereisalsoa wider varietyofmaturitiesavailableforswap rate

curves, relativetoayieldcurve basedon USTreasurysecurities, whichhasonlyfouron-the-runmaturitiesoftwoyearsor

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JimMalone, CIO ofSigma bondfundhadasuccessful trackrecordofinvesting ininvestment grade bonds. Recentlythough,

Sigmahas been lagging its peers becauseMalonerefusestoreducethedurationofthe portfolio by purchasing short-term

bondsforthefund. Malone'sactionsaremostconsistent with:

Segmented markets theory.

Preferredhabitattheory. Liquidity preferencetheory.

Explanation

Undersegmentedmarketstheoryinvestorsinonematuritysegmentofthemarket will notmoveintoanyothermaturity

segments.

Suppose thatthere isa parallel upwardshift inthe yieldcurve. Whichofthe following best explainsthis phenomenon? The yield:

decrease is the same for all maturities.

increase isthe same forall maturities.

increase is proportional tothe original level forall maturities.

Explanation

A parallel upwardshift indicatesan equal yield increase acrossall maturities.

Whichofthe following isthe mostimportantconsideration indetermining the numberofobservationstouse to estimate the yield

volatility?

The liquidity of the underlying instrument.

The appropriate time horizon.

The shape ofthe yieldcurve.

Explanation

The appropriate numberofdaysdependsonthe investmenthorizonofthe userofthe volatility measurement, e.g., day traders versus

pensionfundmanagers.

JoeMcBathmakesthefollowing twostatements:

Statement1:Theswap ratecurveindicatescreditspreadover government bondyield.

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Josephismostlikelycorrect withregardto:

Both statements.

Statement 2 butnotstatement1.

Statement1 butnotstatement 2.

Explanation

Swap ratesarenotspreadsandhencetheswap ratecurvedoesnotindicatecreditspread. Theswap ratecurvecan beused

insteadof government bondyieldcurvetoindicate premiumfortime valueofmoney.

Pricesof zero-coupon, $1 par bondsisshown below:

Maturity (years) Price

1 $0.9615

2 $0.9070

3 $0.8396 4 $0.7629

Thedefaultriskofthese bondsissimilartothedefaultriskofsurveyed banks basedon whichtheswap rateisdetermined. Governmentspotratecurveis given below:

Maturity (years) Rate

1 3.05%

2 4.10%

3 5.25%

4 6.45%

Thethree-yearswap spreadisclosestto:

78 bps. 110 bps.

67 bps.

Explanation

The3-yearswap fixedrateSFR3isdetermined bysolving:

SFR (P + P + P) + P = 1orSFR (0.9615 + 0.9070) + 0.8396 + 8396 = 1 SFR (2.7081) = 0.1604

SFR = 0.1604/2.7081 = 5.92%

Swap spread = SFR - S = 5.92% - 5.25% = 0.67% or67 bps

3 1 2 3 3 3

3

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ᅚ A)

Theuseof whichofthefollowing benchmarksto generateaspread wouldnotreflectcreditrisk? An issuer-specific benchmark.

A global industry-yield benchmark.

A U.S. Treasury benchmark.

Explanation

Anissuer-specific benchmark (another bondofthesamecompany) wouldnotreflectcreditrisk becausethe benchmark would

incorporatethecreditriskofthefirm. Using a U.S. Treasury benchmark wouldreflectcreditrisk becausethe bondto be evaluated wouldhavehighercreditriskthaneither benchmark. Theyieldina global industryisnottypicallyusedasa benchmark.

Whichofthe following isa majorconsideration whenthe daily yield volatility isannualized?

The appropriate day multiple to use for a year.

The appropriate time horizon.

The shape ofthe yieldcurve.

Explanation

Typically, the numberoftrading days per year isused, i.e., 250days.

Suppose thatthere isanonparallel downwardshift inthe yieldcurve. Whichofthe following best explainsthis phenomenon?

The yield decrease is the same for all maturities.

The absolute yielddecrease isdifferentforsome maturities.

The absolute yield increase isdifferentforsome maturities.

Explanation

Anonparallel downward yieldcurve shift indicatesanunequal yielddecrease acrossall maturities, i.e., some maturity yieldsdeclined

more thanothers.

JonSmithsonisa bondtraderat ZezenBank. Thespotratecurveiscurrentlyflat. Smithsonexpectsthatthecurve will becomeupwardsloping inthenextyear. Basedonthisexpectation, theleastappropriateactivestrategyforSmithson would

beto:

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sell all the long-term bondsinthe portfolioandreinvestthe proceedsinshorter

-maturity bonds.

reducethedurationofthe portfolio.

Explanation

The questionisasking for leastappropriatestrategy. Givenanexpectationofsteepening oftheyieldcurve, anactive bond manager wouldreducethedurationofthe portfolio.

Pricesof zero-coupon, $1 par bondsisshown below:

Maturity (years) Price

1 $0.9615

2 $0.9070

3 $0.8396 4 $0.7629

Thedefaultriskofthese bondsissimilartothedefaultriskofsurveyed banks basedon whichtheswap rateisdetermined. Governmentspotratecurveis given below:

Maturity (years) Rate

1 3.05%

2 4.10%

3 5.25%

4 6.45%

Theswap fixedratefora periodof 2 yearsisclosestto:

4.98% 4.00%

4.75%

Explanation

Since weare giventhediscountfactorsdirectly, wecanusethoseinsteadofcomputing theindividual spotrates. The 2-year

swap fixedrateSFR isdetermined bysolving:

SFP (P +P)+P = 1orSFR (09.615+0.9070)+0.9070 = 1 SFR (1.8685) = 0.093

SFR = 0.093/1.8685 = 4.98%

Whichofthefollowing statementsaremostaccurate? 2

2 1 2 2 2

2

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Short-term rates are typically more volatile than long-term rates.

Volatilityofshort-termand long-termratesistypicallyequal. Long-termratesaretypicallymore volatilethanshort-termrates.

Explanation

Volatilityofratesisinverselyrelatedtomaturity: long-termratesare less volatilethanshort-termrates.

Underthe liquidity preferencetheory, expectedfuturespotrates will mostlikely be:

Less than the current forward rate. Morethanthecurrentforwardrate. Equal tothecurrentforwardrate.

Explanation

Existenceofa liquidity premiumunderthe liquidity preferencetheoryimpliesthatthecurrentforwardrateisanupwardly

biasedestimateofthefuturespotrate.

Theswap ratecurveistypically basedon whichinterestrate? Treasury bill and bond rates.

The Fed Fundsrate. LIBOR.

Explanation

Theinterestrate paidonnegotiableCDs by banksin Londonisreferredtoas LIBOR. LIBORisdeterminedeveryday bythe

BritishBankersAssociation. Swap ratecurvesaretypicallydetermined bydollardenominated borrowing basedon LIBOR. The Fed Fundsrateistherate paidoninterbank loans withinthe U.S. Treasury bill and bondratesareusedfordetermining the

yieldcurve, butnotfortheswap ratecurve.

Ifthe liquidity preference hypothesis istrue, whatshape shouldthe termstructure curve have ina period where interestratesare

expectedto be constant?

Downward sweeping.

Upwardsweeping.

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ᅞ A) ᅚ B) ᅞ C) Explanation

The liquidity theory holdsthat investorsdemanda premiumtocompensate themfor interestrate exposure andthe premium increases

withmaturity. Addthis premiumtoaflatcurve andthe result isanupwardsloping yieldcurve.

Whichofthefollowing is NOTareason whymarket participants prefertheswap ratecurveovera government bondyield curve? Theswap market:

it is not affected by technical factors.

isfreeof governmentregulation. reflectssovereigncreditrisk.

Explanation

Swap ratecurvesaretypicallydetermined bydollardenominated borrowing basedon LIBOR. Theseratesaredetermined by

market participantsandarenotregulated by governments. Swap ratecurvesarenotaffected bytechnical marketfactorsthat affecttheyieldson government bonds. Theswap ratecurveisalsonotsubjecttosovereigncreditrisk (potential government

defaultondebt)thatisuniquetoeachcountry.

Ifthe 2-yearspotrateis4% and1-yearspotrateis7%, theoneyearforwardrateoneyearfromnow isclosestto:

1%

2%

3%

Explanation

(1+S ) = (1+s )[1+ƒ(1,1)]

ƒ(1,1) = (1.04)/(1.07)- 1 = 0.0108 = 1.08%

Whichofthefollowing isclosesttotheannualizedyield volatility (250trading days peryear)ifthedailyyield volatilityisequal to0.45%?

112.50%. 7.12%. 9.73%.

Explanation

Annualizedyield volatility = σ × 22 1

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where:

σ = thedailyyield volatility

So, annualizedyield volatility = (0.45%) = 7.12%.

Whichofthefollowing ismostlikelytooccurifthereisatwistintheyieldcurve? The curvature of the yield curve increases.

Theyieldcurveflattensorsteepens.

Theyieldcurve becomeshumpedatintermediatematurities.

Explanation

Twistsrefertoyieldcurvechanges whentheslope becomeseitherflatterormoresteep. Aflattening (steepening)oftheyield curvemeansthatthespread betweenshort- and long-termrateshasnarrowed (widened).

Currentlythetermstructureofinterestrateisdownwardsloping. Whichofthefollowing modelsmostaccuratelydescribethe

currenttermstructure?

Vasicek model.

Cox-Ingersoll-Rossmodel. Ho-Leemodel.

Explanation

Ho-Leemodel isanarbitrage-freetermstructurethatiscalibratedtothecurrentactual termstructure (regardlessof whetherit

isupwardordownwardsloping). VasicekandCox-Ingersoll-Rossmodel areexamplesofequilibriumtermstructuremodels

andmay generatetermstructuresinconsistent withcurrentmarketobservations.

Carol Stephens, CFA, overseesfive portfoliomanagers whoall managefixedincome portfoliosforoneinstitutional client.

Stephensfeelsthatinterestrates will changeoverthenextyear butisuncertainabouttheextentanddirectionofthischange.

Sheisconfident, however, thattheyieldcurve will changeinanonparallel mannerandthatmodifiedduration will not accuratelymeasuretheoverall total portfolio'syield-curveriskexposure. Tohelp herevaluatetheriskofherclient'stotal portfolio, shehasassembledthetableofratedurationsshown below.

Issue Value

($millions) 3mo 2 yr 5 yr 10yr 15 yr 20yr 25 yr 30yr

Portfolio1 100 0.03 0.14 0.49 1.35 1.71 1.59 1.47 4.62

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Portfolio3 150 0.03 0.14 0.51 1.40 1.78 1.64 2.34 2.83

Portfolio4 250 0.06 0.00 0.00 0.00 0.00 0.00 0.00 0.00

Portfolio 5 300 0.00 0.88 0.00 0.00 1.83 0.00 0.00 0.00

The valueofthetotal portfoliois $1,000,000,000.

Forthis questiononly, imaginethatthefollowing threekeyrateschange whiletheothersremainconstant: The3-monthrateincreases by 20 basis points.

The 5-yearrateincreases by 90 basis points.

The30-yearratedecreases by150 basis points.

Thenew total valueofthe portfolioaftertheseratechanges will beclosestto:

$1,009,469,000.

$961,075,000. $1,004,735,000.

Explanation

KeyRateDurations

weight 3mo 2 yr 5 yr 10yr 15 yr 20yr 25 yr 30yr Effective

Duration

Portfolio1 0.10 0.03 0.14 0.49 1.35 1.71 1.59 1.47 4.62 11.40

Portfolio 2 0.20 0.02 0.13 1.47 0.00 0.00 0.00 0.00 0.00 1.62

Portfolio3 0.15 0.03 0.14 0.51 1.40 1.78 1.64 2.34 2.83 10.67

Portfolio4 0.25 0.06 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.06

Portfolio 5 0.30 0.00 0.88 0.00 0.00 1.83 0.00 0.00 0.00 2.71

Total Portfolio 1.00 0.0265 0.3250 0.4195 0.3450 0.9870 0.4050 0.4980 0.8865 3.8925

Changein Portfolio Value

Changefrom3-monthkeyrateincrease: (20 bp)(0.0265) = 0.0053% decrease

Changefrom 5-yearkeyrateincrease: (90 bp)(0.4195) = 0.3776% decrease

Changefrom30-yearkeyratedecrease: (150 bp)(0.8865) = 1.3298% increase

Netchange 0.9469% increase

Thismeansthatthetotal portfolio valueaftertheyieldcurveshiftis: 1,000,000,000(1 + 0.009469) = $1,009,469,000 (LOS46.f)

Forthis questiononly, imaginethattheoriginal yieldcurveundergoesa parallel shiftsuchthattheratesatall keymaturities

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$961,075,000. $1,019,462,500.

Explanation

KeyRateDurations

weight 3mo 2 yr 5 yr 10yr 15 yr 20yr 25 yr 30yr

Effective

Duration

Portfolio1 0.10 0.03 0.14 0.49 1.35 1.71 1.59 1.47 4.62 11.40

Portfolio 2 0.20 0.02 0.13 1.47 0.00 0.00 0.00 0.00 0.00 1.62

Portfolio3 0.15 0.03 0.14 0.51 1.40 1.78 1.64 2.34 2.83 10.67

Portfolio4 0.25 0.06 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.06

Portfolio 5 0.30 0.00 0.88 0.00 0.00 1.83 0.00 0.00 0.00 2.71

Total Portfolio 1.00 0.0265 0.3250 0.4195 0.3450 0.9870 0.4050 0.4980 0.8865 3.8925

Sincetheyieldcurveunderwenta parallel shift, theimpacton portfolio valuecan becomputeddirectlyusing the portfolio's

effectiveduration. Therearetwomethodsthatcan beusedtocalculateeffectivedurationinthissituation. Bothmethodsuse themarket weightoftheindividual bondsinthe portfolio. Asshowninthesecondcolumnofthetableabove, thetotal portfolio

weightofeachsubportfolioequals:Bond value/Portfolio value, wherethe portfolio valueis $1,000,000,000.

Method1) Effectivedurationofthe portfolioisthesumofthe weightedaveragesofthekeyratedurationsforeachissue. The

3-monthkeyratedurationforthetotal portfoliocan becalculatedasfollows:

(0.10)(0.03) + (0.20)(0.02) + (0.15)(0.03) + (0.25)(0.06) + (0.30)(0) = 0.0265

Thismethodcan beusedto generatetherestofthekeyratedurationshowninthe bottomrow ofthetableaboveand summedtoyieldaneffectiveduration = 3.8925.

Method 2) Effectivedurationofthe portfolioisthe weightedaverageoftheeffectivedurationsforeachissue. Theeffective

durationofeachissueisthesumoftheindividual ratedurationsforthatissue. These valuesareshownintheright-hand columnofthetableabove. Using thisapproach, theeffectivedurationofthe portfoliocan becomputedas:

(0.10)(11.4) + (0.20)(1.62) + (0.15)(10.67) + (0.25)(0.06) + (0.30)(2.71) = 3.8925

Using aneffectivedurationof3.8925, the valueofthe portfoliofollowing a parallel 50 basis pointshiftintheyieldcurvecan be

computedasfollows: Percentagechange = (50 basis points)(3.8925) = 1.9463% decrease. $1,000,000,000 × (1-0.0194625) = $980,537.500. (LOS46.f)

Forthis questiononly, imaginethattheoriginal yieldcurveundergoesashiftsuchthat3-monthratesremainconstantandall

otherratesincrease by135 basis points. Thenew valueof portfolio4 will beclosestto: $243,375,000.

$229,750,000. $250,000,000.

Explanation

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Duration

Portfolio1 0.10 0.03 0.14 0.49 1.35 1.71 1.59 1.47 4.62 11.40

Portfolio 2 0.20 0.02 0.13 1.47 0.00 0.00 0.00 0.00 0.00 1.62

Portfolio3 0.15 0.03 0.14 0.51 1.40 1.78 1.64 2.34 2.83 10.67

Portfolio4 0.25 0.06 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.06

Portfolio 5 0.30 0.00 0.88 0.00 0.00 1.83 0.00 0.00 0.00 2.71

Total Portfolio 1.00 0.0265 0.3250 0.4195 0.3450 0.9870 0.4050 0.4980 0.8865 3.8925

Sincethe3-monthratedidnotchange, andall otherkeyratedurationsfor Portfolio4are zero, a135 basis pointchange will

havenoeffectonthe valueof Portfolio4. Hence, Portfolio4remains valuedat $250,000,000. (LOS46.f)

The10-yearkeyratedurationforthetotal portfolioisclosestto:

0.345. 1.350.

1.375.

Explanation

KeyRateDurations

Duration

Portfolio1 0.10 0.03 0.14 0.49 1.35 1.71 1.59 1.47 4.62 11.40

Portfolio 2 0.20 0.02 0.13 1.47 0.00 0.00 0.00 0.00 0.00 1.62

Portfolio3 0.15 0.03 0.14 0.51 1.40 1.78 1.64 2.34 2.83 10.67

Portfolio4 0.25 0.06 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.06

Portfolio 5 0.30 0.00 0.88 0.00 0.00 1.83 0.00 0.00 0.00 2.71

Total Portfolio 1.00 0.0265 0.3250 0.4195 0.3450 0.9870 0.4050 0.4980 0.8865 3.8925

Thetotal portfoliokeyratedurationforaspecificmaturityisthe weighted valueofthekeyratedurationsoftheindividual

issuesforthatmaturity. Inthiscase, the10-yearkeyratedurationforthe portfoliois:

(0.10)(1.35) + (0.20)(0.00) + (0.15)(1.40) + (0.25)(0.00) + (0.30)(0.00) = 0.345 (LOS46.f)

Theeffectivedurationfor Portfolio 2 isclosestto:

1.47. 1.62.

0.023.

Explanation

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Duration

Portfolio1 0.10 0.03 0.14 0.49 1.35 1.71 1.59 1.47 4.62 11.40

Portfolio 2 0.20 0.02 0.13 1.47 0.00 0.00 0.00 0.00 0.00 1.62

Portfolio3 0.15 0.03 0.14 0.51 1.40 1.78 1.64 2.34 2.83 10.67

Portfolio4 0.25 0.06 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.06

Portfolio 5 0.30 0.00 0.88 0.00 0.00 1.83 0.00 0.00 0.00 2.71

Total Portfolio 1.00 0.0265 0.3250 0.4195 0.3450 0.9870 0.4050 0.4980 0.8865 3.8925

Theeffectivedurationforanyindividual issueisthesumoftheindividual keyratedurationsforthatissue. For Portfolio 2, the effectivedurationis:

0.02 + 0.13 + 1.47 = 1.62 (LOS46.f)

Which portfolioismostaccuratelydescribedasa laddered portfolio?

Portfolio 3.

Portfolio4. Portfolio 5.

Explanation

KeyRateDurations

Duration

Portfolio3 0.15 0.03 0.14 0.51 1.40 1.78 1.64 2.34 2.83 10.67

Portfolio4 0.25 0.06 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.06

Portfolio 5 0.30 0.00 0.88 0.00 0.00 1.83 0.00 0.00 0.00 2.71

A ladder portfolio'sdurationsarerelativelyequal acrossall maturities, and Portfolio3exhibitsthiskindofequal durationacross maturities.

Portfolio4is bestdescribedasa bullet portfolioasitsdurationisconcentratedinonematurity.

Portfolio 5 is bestdescribedasa barbell portfolio, asitsdurationisconcentratedintheshortand long regionsofthe

maturities. (LOS46.f)

The liquiditytheoryofthetermstructureofinterestratesisa variationofthe pureexpectationstheorythatexplains why:

the yield curve usually slopes upward.

theyieldcurveusuallyslopesdownward.

durationisanimprecisemeasure.

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The pureexpectationshypothesissaysthattheshapeoftheyieldcurveonlyreflectsexpectationsoffutureshort-termrates. Yet, theyieldcurve generallyslopesupward. The liquiditytheorysaysthattheyieldcurveincorporatesexpectationsofshort -termrates; however, thetendencyfortheyieldcurvetoslopeupwardreflectsthedemandforahigherreturntocompensate

investorsfortheextrainterestrateriskassociated with bonds with longermaturities.

7.5%, 15-year, annual payoption-free XeleonCorp bondtradesatamarket priceof $95.72 per $100 par. The government

spotratecurveisflatat 5%.

The Z-spreadon XeleonCorp bondisclosestto:

250 bps

300 bps 325 bps

Explanation

Sincethespotratecurveisflat, wecansimplycomputetheyieldonthe bondandsubtractthespotratefromittoobtainthe

Z-spread.

PV = - 95.72; N = 15; PMT = 7.50; FV = 100; I/Y=?=8%. Z-spread = 8% - 5% = 3% or300bps

Ayieldcurveisflat, andthenitundergoesanon-parallel shift. Aftertheshift, whichofthefollowing must beleastaccurate?

Thenew yieldcurveis:

a straight line.

flat.

curvilinear.

Explanation

Ifayieldcurve beginsflatandthenexperiencesanon-parallel shift, thismeansthatsomerateschangedmorethanothers.

Afterthenon-parallel shifttheformerlyflatyieldcurvecanno longer beflat.

Whatadjustmentmust be made tothe key rate durationstomeasure the riskofasteepening ofanalready upwardsloping yieldcurve?

Decrease the key rates at the short end of the yield curve.

Increase all key rates by the same amount.

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ᅞ A) ᅚ B) ᅞ C) Explanation

Decreasing the key ratesatthe short endofthe yieldcurve makesanupwardsloping yieldcurve steeper. Performing the corresponding

change in portfolio value will determine the riskofasteepening yieldcurve.

Anactive bond portfoliomanager wouldmostappropriately buy bonds whenexpectedspotratesare:

greater than current forward rates.

equal tocurrentforwardrates. lessthancurrentforwardrates.

Explanation

Whenexpectedspotratesare lessthantheforwardrates priced bythemarket, bondsareundervalued (theyarediscounted

attoohigharate)andhenceshould be purchased.

Supposethattheshort-termand long-termratesdecrease by75bps whiletheintermediate-termratesdecrease by30bps.

Themovementinyieldcurveisbestdescribedasinvolving changesinthe:

level and curvature. curvatureonly. level only.

Explanation

Thedecreaseinshort-termand long-termratesisanindicationofchangein level ofinterestrates. Becauseintermediate-term

rateschangedifferentlythantheshort-termand long-termrates, thereisalsoachangeinthecurvatureoftheyieldcurve.

DonMcGuire, fixedincomespecialistatMCB bankmakesthefollowing statement: "Inthe veryshort-term, theexpectedrate

ofreturnfrominvesting inany bond, including risky bonds, istherisk-freerateofreturn".

McGuire'sstatementismostconsistent with:

unbiased expectations theory.

local expectationstheory. liquidity preferencetheory.

Explanation

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ᅞ A)

ᅚ B)

ᅞ C)

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ᅚ A)

notextendtherisk-neutralityassumptiontoeverymaturitystrategy liketheunbiasedexpectationstheory.

Z-spreadismostaccuratelydescribedastheconstantspreadthatis:

added to the zero volatility binomial tree such that an option-free bond is correctly valued.

addedtothespotratecurveto generatediscountratesforeachofthe bond'scash

flowssuchthatthe present valueofthecashflowsisexactlyequal tothemarket price

ofthe bond.

equal tothedifference betweena bond'syieldandtheyieldona government bond.

Explanation

Z-spreadistheconstantspreadaddedtothespotratecurveto generatediscountrates whichthen valuethe bondatits currentmarket price. Thedifference betweenyieldsofariskyand government bond will besameasthe Z-spreadonly when theyieldcurveisflat. A Zero-volatility binomial treedoesnotexist!

Jill Sebelius, editor-in-chiefofamonthlyinterest-ratenewsletterusesthefollowing model toforecastshort-terminterestrates:

Forthecurrentnewsletter, Sebeliushasissuedthefollowing expectations:

a=0.40, b = 3%, r = 2%.

BasedonSebelius"sestimates, overasufficiently long periodoftime, theexpected valueoftheshort-terminterestrateis

closestto:

2%

2.4%

3%

Explanation

The long-termexpected valueofshort-termratesisthemeanreverting level (b)estimated bySebeliusto be3%.

Whichoneofthefollowing isleastlikelyareasontousetheswap ratecurve?

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ᅞ B) ᅞ C)

Question #41 of 101

QuestionID:463734

Question #4

2 of 101

QuestionID:472554

Question #43 of 101

QuestionID:472550

Swap ratesreflectcreditriskofcommercial banksandnot government.

Theswap marketisnotregulated byany government.

Explanation

Lower volatilityofswap ratesrelativeto government bondyieldsasa generalizationisanincorrectstatement.

According tothe pure expectationstheory, how are forwardrates interpreted? Forwardratesare:

expected future spot rates if the risk premium is equal to zero.

expectedfuture spotrates.

equal tofuturesrates.

Explanation

The pure expectationstheory, alsoreferredtoasthe unbiased expectationstheory, purportsthatforwardratesare solely afunctionof

expectedfuture spotrates. This impliesthat long-term interestratesrepresentthe geometricmeanoffuture expectedshort-termrates,

nothing more.

Ifthespotcurveisupwardsloping, theforwardcurveismostlikelyto be:

steeper than the spot curve and above the spot curve.

parallel tothespotcurveand below thespotcurve. parallel tothespotcurveandabovethespotcurve.

Explanation

Whenthespotcurveisupwardsloping, theforwardcurve will be lieabovethespotcurveand will also beupwardsloping with

asteeperslope.

Givenannual spotinterestratesfor1year, 2 years, 3years, 4years, and 5 years, themaximumnumberofforwardratesthat

can bederivedisclosestto:

8 5

10

(18)

Question #44 of 101

QuestionID:472562

Question #4

5 of 101

QuestionID:463717

Questions #46

-5

1 of 101

Selectall forwardrates ƒ(j,k)suchthat j+k ≤ 5. Thereare10forwardrates possible: ƒ(1,1), ƒ(1,2), ƒ(1,3), ƒ(1,4), ƒ(2,1), ƒ(2,2), ƒ(2,3), ƒ(3,1), ƒ(3,2), ƒ(4,1)

Theactive bond portfoliomanagementstrategyofrolling downtheyieldcurveismostconsistent with:

segmented markets theory.

liquidity preferencetheory. pureexpectationstheory.

Explanation

Underthe liquidity preferencetheory, investors wouldearnanextrareturnforinvesting in longer-maturity bondsratherthanin

shorter-maturity bonds. Suchextra positiverisk-premium linkedtomaturityofthe bondsisabsentinthe pureexpectationsand

themarketsegmentationtheory.

Whichofthefollowing benchmarks would generatethe greatestspread whenusedtoexaminea bondyield? Bond sector benchmark.

A U.S. Treasurysecurity.

Theissuerofaspecificcompany.

Explanation

The U.S. Treasurysecurity would generatethehighestspread becausetheyieldonTreasurysecurities will bethe lowestas

theyhavethe lowestcreditand liquidityrisk. Theyieldsona bondsector benchmarkandforaspecificcompany will behigher.

Bill Woods, CFA, isa portfoliomanagerforMatrix Securities Fund, aclosed-end bondfundthatinvestsin U.S. Treasuries,

mortgage-backedsecurities (MBS), asset-backedsecurities (ABS), andMBSderivatives. Thefundhasassetsof

approximately $400million, hasacurrentstock priceof $14.50andanetasset value (NAV)of $16.00. Woodsisamemberof afour personinvestmentteamthatisresponsibleforall aspectsofmanaging the portfolio, including interestrateforecasting, performing basicfinancial analysisand valuationofthe portfolio, andselecting appropriateinvestmentsforMatrix. His

expertiseisintheanalysisand valuationofMBSandABS.

Thefund paysa $0.12 monthlydividendthatis paidfromcurrentincome. The basicoperating strategyofMatrix isto leverage

itscapital byinvesting infixedincomesecurities, andthenfinancing thoseassetsthroughrepurchaseagreements. Matrix then earnsthespread betweenthenetcouponoftheunderlying assetsandthecosttofinancetheasset. Therefore, when

evaluating asecurityforinvestment, itiscritical thatMatrix can bereasonablyassuredthatit will earna positivespread.

During thecourseofhisanalysis, Woodsutilizesseveral methodologiestoevaluatecurrent portfolioholdingsand potential

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Question #46 of 101

QuestionID:472574

ᅞ A) ᅞ B)

ᅚ C)

Question #47 of 101

QuestionID:472575

ongoing debateamong theinvestmentteamastothemeritsandshortcomingsofeachofthemethods. Woods believesthat the OASmethodis byfarasuperiortool inall circumstances, whilehisfellow portfoliomanager, YuriAckerman, feelsthat eachofthemethodscanattimesserveauseful purpose. WoodandAckerman'scurrentdiscussioninvolvestwosimilar FNMA

adjustable-ratemortgage (ARM)securities Woodisconsidering purchasing. BothARM "A" andARM "B" areindexedoffof6

-month LIBOR, arenew production, andhavesimilarnetcoupons.

Se

l

ect

F

inancia

l

Information:

A

RM

Net

C

o

u

po

n W

A

M

N

o

m

inal

S

p

rea

d

O

A

S

(b

ps)

Z-

sp

rea

d

(b

ps)

A

6 .2

7 %

360

81

9

8

13

5 B

6 .

41 %

3

5

8

95

116

1

29

WoodsrecommendsthatMatrix purchaseARM "A" withthe6.27% netcoupon. Hehas basedhisconclusiononthecalculated

OASofthesecurities, whichhe believesindicatesthatARM "A" isthecheaperofthetwosecurities. Ackermandisagrees with

Woods, arguing that OASisonlyonecomponentofanyanalysis, andthata buyorsell recommendationshouldnot bemade baseduponthe OASspreadalone. Ackermanclaimsthatothermeasures, suchasoneofthemanydurationmeasuresand convexity, needto beincorporatedintotheanalysis. He pointsoutthat bothARMshaveequal convexities, butARM "A" hasa

durationof7.2 yearsandARM "B" hasdurationof6.8years. Thesecharacteristics will affecttheexpectedreturninany interestratescenario. Woodsadmitsthathehadnotconsideredthedifferencesinthe bond'sdurations, andheacknowledges

thatothersfactorsshould beconsidered beforearecommendationcan bemade.

Woodsismostlikelyresistanttothe zero-volatilityspread becausethespread:

fails to consider price risk,which is uncertainty regarding terminal cash flows. doesnotindicatehow muchofthespreadreflectsthesignificant prepaymentrisk

associated withMBS.

onlyconsidersone pathofinterestrates, thecurrentTreasuryspotratecurve.

Explanation

Zero-volatilityspreadisacommonlyusedmeasureofrelative valueforMBSandABS. However, itonlyconsidersone pathof

interestrates, while OASconsiderseveryspotratealong everyinterestrate path. (StudySession15, LOS 50.a)

OAScan beusedtoderiveoptioncostratherthanusing anoption pricing model. The OAScan beinterpretedastheMBS spreadaftertheaffectoftheembeddedoptiononcashflowsisconsidered. Whichofthefollowing summariesismost

accurate?

option cost =zero-volatility spread − option-adjusted spread. optioncost = option-adjustedspread− zero-volatilityspread.

optioncost = nominal spread−option-adjustedspread.

Explanation

OASistheMBSspreadafterthe "optionality" ofthecashflowsistakenintoaccount. OAScan beusedtoexpressthedollar

(20)

(21)

ᅞ C)

Question #

52 of 101

QuestionID:463748

Question #

5 3 of 101

QuestionID:472581

Question #

5 4 of 101

QuestionID:472596

OAS, becausethecashflowsareinterestrate pathdependent.

Explanation

Creditcardreceivable-backedABShaveno prepaymentoption, therefore prepaymentsarenot pathdependentandthe

Z-spreadisthemostappropriatemodel. (StudySession15, LOS 50.h, i)

Ananalysthasa listofkeyratedurationsfora portfolioof bonds. Ifonlyoneinterestrateontheyieldcurvechanges, the effectonthe valueofthe bond portfolio will bethechangeofthatratemultiplied bythe:

median of the key rate durations.

keyratedurationassociated withthematurityoftheratethatchanged. weightedaverageofthekeyratedurations.

Explanation

Thisishow ananalystuseskeyratedurations: Fora givenchangeintheyieldcurve, eachratechangeismultiplied bythe associatedkeyrateduration. Thesumofthose products givesthechangeinthe valueofthe portfolio. Ifonlythefive-year

interestratechanges, forexample, thentheeffectonthe portfolio will bethe productofthatchangetimesthefive-yearkey

rateduration.

Ascomparedtothe10-yearswap spread, thecreditriskinthe banking systemismoreaccuratelycaptured bythe:

Libor-OIS spread.

Z-spread.

TEDspread.

Explanation

Theriskof banking systemismoreaccuratelycaptured bytheTEDspread. 10-yearswap spreadcapturesdiffering

demand/supplyconditions.

Volatilityin long-termratesismostlikelyrelatedtouncertaintyabout:

fiscalpolicy.

thereal economyandinflation.

central bankactions.

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Question #

55 of 101

QuestionID:472563

Question #

5 6 of 101

QuestionID:472561

ᅞ A) ᅞ B)

ᅚ C)

Question #

5 7 of 101

QuestionID:472552

ᅞ A)

ᅚ B) ᅞ C)

Volatilityin long-termratesismost likely linkedtouncertaintyaboutthereal economyandinflation, whereas volatilityinshort -termratesismost likely linkedtomonetary policy.

Whichoneofthefollowing actionsismostconsistent withthestrategyofriding anupwardsloping theyieldcurve? Buying bonds withamaturity:

longer than than the investor's horizon. shorterthantheinvestor'shorizon.

equal totheinvestor'shorizon.

Explanation

Iftheyieldcurveisupwardsloping andisexpectedtoremainthesame, higherreturnscan beobtained byriding theyield curve, i.e., buying bonds witha longermaturitythantheinvestor'shorizon.

Ifanactive bond portfoliomanager believesfuturespotrates will be lowerthanindicated bytoday'sforwardrates, thenshe will mostlikely:

be indifferent because her holdingperiod return willbe unaffected.

sell bonds becausethemarketappearsto bediscounting futurecashflowsat "too high" ofadiscountrate.

purchase bonds becausethemarketisdiscounting futurecashflowsat "toohigh" ofa

discountrate.

Explanation

Ifaninvestor believesfuturespotrates will be lowerthanindicated bytoday'sforwardrates, thensheshould purchase bonds

(ata presumablyattractive price) becausethemarketappearsto bediscounting futurecashflowsat "toohigh" ofadiscount rate.

Supposethe governmentspotratecurveisflatat3%. Anactivemanageris planning on purchasing afive-year government bondat par. Therealizedreturnonthis bond will mostlikely be:

more than 3% if the bond is held to maturity while the yield curve remains flat but decreases below 3%.

3% ifthe bondisheldtomaturity providedthattheyieldcurveremainsflatat3%.

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Question #

5 8 of 101

QuestionID:472593

Question #

59 of 101

QuestionID:463736

Question #60 of 101

QuestionID:472591

ᅞ A) Explanation

Thereisno priceriskforadefault-free bondheldtomaturity. However, thereisreinvestmentriskforthecoupon payments

receivedduring the lifeofthe bond (inthisinstance, the bondisa par bondandhencehasthesamecouponrateasitsyield).

Iftheyieldcurveshiftsdown, thereinvestmentrate would be lowerandtherealizedholding periodreturn would be lowerthan

3%.

A bond portfoliohasthefollowing keyratedurations: D = 0.50; D = 2.70andD = 7.23.

Supposethatthechangeinyieldcurveresultsinchangesinthefollowing spotrates: S = +50bps; S = +100bps; S = +25 bps; S = -75bps; S = -100bps.

Thechangeinthe valueofthe portfolio will beclosestto:

-2.80%

+6.30% +4.75%

Explanation

%△P = -(0.50)(0.5)-(2.70)(0.25)-(7.23)(-1) = 6.31%

According tothe pureexpectationstheory, whichofthefollowing statementsismostaccurate? Forwardrates:

are biased estimates of market expectations.

alwaysoverestimatefuturespotrates.

exclusivelyrepresentexpectedfuturespotrates.

Explanation

The pureexpectationstheory, alsoreferredtoastheunbiasedexpectationstheory, purportsthatforwardratesaresolelya functionofexpectedfuturespotrates. Underthe pureexpectationstheory, ayieldcurvethatisupward (downward)sloping,

meansthatshort-termratesareexpectedtorise (fall). Aflatyieldcurveimpliesthatthemarketexpectsshort-termratesto

remainconstant.

Theleastimportantfactorexplaining thechangesintheshapeoftheyieldcurveis:

Level

2 5 15