CFA Level II - Fixed Income Midterm
Exam Questions And Correct Detailed
Answers.
Spot rates - Answer are the annualized market interest rates for a single payment to be received in the
future. Generally, we use spot rates for government securities (risk-free) to generate the spot rate curve.
Spot rates can be interpreted as the yields on zero-coupon bonds, and for this reason we sometimes
refer to spot rates as zero-coupon rates
forward rate - Answer is an interest rate (agreed to today) for a loan to be made at some future date.
term structure of interest rates - Answer = the graph of interest rates at different maturities
The expected return will be equal to the bond's yield only when all three of the following are true: -
Answer •The bond is held to maturity.
•All payments (coupon and principal) are made on time and in full.
•All coupons are reinvested at the original YTM.
The second requirement implies that the bond is option-free and there is no default risk.
The last requirement, reinvesting coupons at the YTM, is the least realistic assumption. If the yield curve
is not flat, the coupon payments will not be reinvested at the YTM and the expected return will differ
from the yield.
Realized return on a bond refers to the actual return that the investor experiences over the investment's
holding period. Realized return is based on actual reinvestment rates
par rate - Answer the yield to maturity of a bond trading at par. Par rates for bonds with different
maturities make up the par rate curve or simply the par curve. By definition, the par rate will be equal to
the coupon rate on the bond. Generally, par curve refers to the par rates for government or benchmark
bonds.
, For an upward-sloping spot curve, the forward rate rises as j increases. (For a downward-sloping yield
curve, the forward rate declines as j increases.) For an upward-sloping spot curve, the forward curve will
be above the spot curve as shown in Figure 1 . Conversely, when the spot curve is downward sloping, the
forward curve will be below it. - Answer
the spot rate for a long-maturity security will equal the geometric mean of the one period spot rate and
a series of one-year forward rates. - Answer
If the future spot rates actually evolve as forecasted by the forward curve, the forward price will remain
unchanged. Therefore, a change in the forward price indicates that the future spot rate(s) did not
conform to the forward curve. When spot rates turn out to be lower (higher) than implied by the
forward curve, the forward price will increase (decrease). A trader expecting lower future spot rates
(than implied by the current forward rates) would purchase the forward contract to profit from its
appreciation. - Answer For a bond investor, the return on a bond over a one-year horizon is always
equal to the one-year risk-free rate if the spot rates evolve as predicted by today's forward curve. If the
spot curve one year from today is not the same as that predicted by today's forward curve, the return
over the one-year period will differ, with the return depending on the bond's maturity.
Riding the Yield Curve - Answer Under this strategy, an investor will purchase bonds with maturities
longer than his investment horizon. In an upward-sloping yield curve, shorter maturity bonds have lower
yields than longer maturity bonds. As the bond approaches maturity (i.e., rolls down the yield curve), it
is valued using successively lower yields and, therefore, at successively higher prices.
If the yield curve remains unchanged over the investment horizon, riding the yield curve strategy will
produce higher returns than a simple maturity matching strategy, increasing the total return of a bond
portfolio. The greater the difference between the forward rate and the spot rate, and the longer the
maturity of the bond, the higher the total return.
The fixed rate in an interest rate swap is called the swap fixed rate or swap rate. - Answer
swap rate curve - Answer Market participants prefer the swap rate curve as a benchmark interest rate
curve rather than a government bond yield curve for the following reasons:
•Swap rates reflect the credit risk of commercial banks rather than the credit risk of governments.
•The swap market is not regulated by any government, which makes swap rates in different countries
more comparable. (Government bond yield curves additionally reflect sovereign risk unique to each
country.)
Exam Questions And Correct Detailed
Answers.
Spot rates - Answer are the annualized market interest rates for a single payment to be received in the
future. Generally, we use spot rates for government securities (risk-free) to generate the spot rate curve.
Spot rates can be interpreted as the yields on zero-coupon bonds, and for this reason we sometimes
refer to spot rates as zero-coupon rates
forward rate - Answer is an interest rate (agreed to today) for a loan to be made at some future date.
term structure of interest rates - Answer = the graph of interest rates at different maturities
The expected return will be equal to the bond's yield only when all three of the following are true: -
Answer •The bond is held to maturity.
•All payments (coupon and principal) are made on time and in full.
•All coupons are reinvested at the original YTM.
The second requirement implies that the bond is option-free and there is no default risk.
The last requirement, reinvesting coupons at the YTM, is the least realistic assumption. If the yield curve
is not flat, the coupon payments will not be reinvested at the YTM and the expected return will differ
from the yield.
Realized return on a bond refers to the actual return that the investor experiences over the investment's
holding period. Realized return is based on actual reinvestment rates
par rate - Answer the yield to maturity of a bond trading at par. Par rates for bonds with different
maturities make up the par rate curve or simply the par curve. By definition, the par rate will be equal to
the coupon rate on the bond. Generally, par curve refers to the par rates for government or benchmark
bonds.
, For an upward-sloping spot curve, the forward rate rises as j increases. (For a downward-sloping yield
curve, the forward rate declines as j increases.) For an upward-sloping spot curve, the forward curve will
be above the spot curve as shown in Figure 1 . Conversely, when the spot curve is downward sloping, the
forward curve will be below it. - Answer
the spot rate for a long-maturity security will equal the geometric mean of the one period spot rate and
a series of one-year forward rates. - Answer
If the future spot rates actually evolve as forecasted by the forward curve, the forward price will remain
unchanged. Therefore, a change in the forward price indicates that the future spot rate(s) did not
conform to the forward curve. When spot rates turn out to be lower (higher) than implied by the
forward curve, the forward price will increase (decrease). A trader expecting lower future spot rates
(than implied by the current forward rates) would purchase the forward contract to profit from its
appreciation. - Answer For a bond investor, the return on a bond over a one-year horizon is always
equal to the one-year risk-free rate if the spot rates evolve as predicted by today's forward curve. If the
spot curve one year from today is not the same as that predicted by today's forward curve, the return
over the one-year period will differ, with the return depending on the bond's maturity.
Riding the Yield Curve - Answer Under this strategy, an investor will purchase bonds with maturities
longer than his investment horizon. In an upward-sloping yield curve, shorter maturity bonds have lower
yields than longer maturity bonds. As the bond approaches maturity (i.e., rolls down the yield curve), it
is valued using successively lower yields and, therefore, at successively higher prices.
If the yield curve remains unchanged over the investment horizon, riding the yield curve strategy will
produce higher returns than a simple maturity matching strategy, increasing the total return of a bond
portfolio. The greater the difference between the forward rate and the spot rate, and the longer the
maturity of the bond, the higher the total return.
The fixed rate in an interest rate swap is called the swap fixed rate or swap rate. - Answer
swap rate curve - Answer Market participants prefer the swap rate curve as a benchmark interest rate
curve rather than a government bond yield curve for the following reasons:
•Swap rates reflect the credit risk of commercial banks rather than the credit risk of governments.
•The swap market is not regulated by any government, which makes swap rates in different countries
more comparable. (Government bond yield curves additionally reflect sovereign risk unique to each
country.)
