INV3702 Oct/Nov 2012 Exam + Memo
SECTION A: MULTIPLE CHOICE QUESTIONS (30 MARKS)
1. All else equal, which of the following is least likely to increase the interest rate risk of a bond?
1. A call feature.
2. A longer maturity.
3. A lower coupon rate.
4. A decrease in yield to maturity.
Inclusion of a call feature would decrease the duration interest rate risk of a fixed income security. The
other choices would increase duration.
2. One year ago, an investor purchased a 10-year, R1,000 par value, 8% semiannual coupon bond with an
8% yield to maturity. Interest rates have remained unchanged at 8%. If the investor sells the bond
today (immediately after receiving the second coupon payment, and with no transaction costs), he will
realise:
1. a capital loss of R80.
2. a capital gain of R80.
3. no capital gain or loss.
4. a capital gain of R1,080.
One year ago (when he bought the bond) the coupon rate was equal to the YTM, so the bond would
have traded at par. Now (one year later), with interest rates unchanged, the bond will still sell at par.
There would therefore be no capital gain or loss from the sale.
3. Which of the following statements about bond call features is least likely correct? Embedded call
options in callable bonds:
1. expose investors to additional reinvestment rate risk.
2. create risk because they add uncertainty to the bond’s cash flow pattern.
3. can be valued using the difference between the zero-volatility spread and the nominal spread.
4. expose investors to the risk that the price of the bond will decline when there is an increase in
expected yield volatility.
The embedded option can be valued by analysing the difference between the zero-volatility spread and
the option-adjusted spread.
4. A bond priced at par (R1,000) has a modified duration of 8 and convexity of 50. If interest rates fall 50
basis points, the new price is closest to:
1. R 875.00.
2. R 958.75.
3. R1,041.25.
4. R1,059.55.
∆
ௗ ∆ ∆ ଶ 80.005 500.005 ଶ 0.0400 0.00125 4.125%
1000 ! 1.04125 1.041.25
5. Which of the following statements about the risks associated with investing in bonds is least likely
correct?
1. If the issuer/borrower prepays, the holder of the bond has reinvestment risk.
2. Credit risk is the risk that an investor will be unable to sell the security quickly and at a fair price.
3. Volatility risk is the risk that the price of a bond with an embedded option will decline when expected
yield volatility changes.
4. Interest rate risk is the risk that a bondholder faces if the price of a bond held in a portfolio will
decline due to rising market interest rates.
SECTION A: MULTIPLE CHOICE QUESTIONS (30 MARKS)
1. All else equal, which of the following is least likely to increase the interest rate risk of a bond?
1. A call feature.
2. A longer maturity.
3. A lower coupon rate.
4. A decrease in yield to maturity.
Inclusion of a call feature would decrease the duration interest rate risk of a fixed income security. The
other choices would increase duration.
2. One year ago, an investor purchased a 10-year, R1,000 par value, 8% semiannual coupon bond with an
8% yield to maturity. Interest rates have remained unchanged at 8%. If the investor sells the bond
today (immediately after receiving the second coupon payment, and with no transaction costs), he will
realise:
1. a capital loss of R80.
2. a capital gain of R80.
3. no capital gain or loss.
4. a capital gain of R1,080.
One year ago (when he bought the bond) the coupon rate was equal to the YTM, so the bond would
have traded at par. Now (one year later), with interest rates unchanged, the bond will still sell at par.
There would therefore be no capital gain or loss from the sale.
3. Which of the following statements about bond call features is least likely correct? Embedded call
options in callable bonds:
1. expose investors to additional reinvestment rate risk.
2. create risk because they add uncertainty to the bond’s cash flow pattern.
3. can be valued using the difference between the zero-volatility spread and the nominal spread.
4. expose investors to the risk that the price of the bond will decline when there is an increase in
expected yield volatility.
The embedded option can be valued by analysing the difference between the zero-volatility spread and
the option-adjusted spread.
4. A bond priced at par (R1,000) has a modified duration of 8 and convexity of 50. If interest rates fall 50
basis points, the new price is closest to:
1. R 875.00.
2. R 958.75.
3. R1,041.25.
4. R1,059.55.
∆
ௗ ∆ ∆ ଶ 80.005 500.005 ଶ 0.0400 0.00125 4.125%
1000 ! 1.04125 1.041.25
5. Which of the following statements about the risks associated with investing in bonds is least likely
correct?
1. If the issuer/borrower prepays, the holder of the bond has reinvestment risk.
2. Credit risk is the risk that an investor will be unable to sell the security quickly and at a fair price.
3. Volatility risk is the risk that the price of a bond with an embedded option will decline when expected
yield volatility changes.
4. Interest rate risk is the risk that a bondholder faces if the price of a bond held in a portfolio will
decline due to rising market interest rates.
