CFA Level 1 - Fixed Income Exam
Questions with Correct Answers
Issuer options - Answer-Call provisions, prepayment options, sinking fund provisions,
and caps.
Callable Bond Provisions - Answer-Issuer has right (not obligation) to retire all or part of
bond prior to maturity. There may be several call dates, and customarily when a bond is
called on the first permissible call date, the call price is above par value. The call price
will normally decline over time according to the schedule.
Doubling Option - Answer-Like a Call Option.
Put Provision - Answer-Grants right to sell (put) the bond to the issuer at a specified
price prior to maturity.
When would it be beneficial for a bondholder to exercise a put option? - Answer-If
interest rates have risen and/or the creditworthiness of the issuer has deteriorated so
that the market price of the bond has fallen below par.
Non-Callable Bond - Answer-Absolute protection against call prior to maturity.
Refunding Provisions - Answer-Nonrefundable bonds prohibit premature retirement of
issue using proceeds of a lower cpn bd. Bds that carry these provisions can be freely
callable, but not refundable.
Non-Refundable Bond - Answer-Prohibit call of an issue using proceeds from a lower
coupon bond issue.
Conversion Option - Answer-Grants bondholder right to convert bond into a fixed
number of common shares. Options adds value to bond.
Exchange Option - Answer-Similar to conversion option, but allows conversion into a
security other than common stock.
Floating Rate Securities - Answer-Bonds that pay a variable rate of interest.
Coupon Formula (Floater) - Answer-Formula used to find new rate on a floating-rate
security
[New Coupon Rate = Reference Rate (+) or (-) Quoted Margin].
Deleveraged Floater - Answer-Scaling factor
New Coupon Rate = (b * Reference Rate) (+) or (-) Quoted Margin.
,Inverse Floater - Answer-Cpn moves in direction opposite to reference rate
New Coupon Rate = Constant Rate (K) - (L * Reference Rate)
Where K is the constant and L is the multiplier
Coupon Rate Cap - Answer-Maximum rate paid by borrower/issuer.
Coupon Rate Floor - Answer-Minimum periodic coupon interest payment received by
lender/security owner.
Coupon Rate Collar - Answer-Simultaneous combination of both cap and floor.
Regular Redemption - Answer-When bonds are redeemed under the call provisions
specified in the bond indenture.
Special Redemption - Answer-When bonds are redeemed to comply with a sinking fund
provision or because of a property sale mandated by government authority.
In Margin Buying - Answer-One borrows funds from a broker or a bank to purchase
securities and the securities themselves are the collateral for the margin loan.
Repo - Answer-Arrangement where an institution sells a security with a commitment to
buy it back at a later date at a specified higher price.
Repo Rate - Answer-The annualized percentage difference between lender's purchase
and sell back price.
Why are Repo issuances preferred among lenders? - Answer-They are not regulated by
the Federal Reserve and providebetter collateral positions for the lenders if the sellers
goes bankrupt. Lenders have only an obligation to sell back the repos rather than stake
a claim against sellers' assets.
Inflation-Indexed Bonds - Answer-Coupon formulas based on inflation; Coupon Formula
Ex.: 3% + annual change in CPI.
Type of Risks - Answer-1) Interest rate risk 2) Yield curve risk 3) Call risk
4) Prepayment risk 5) Reinvestment risk 6) Credit risk
7) Liquidity risk 8) Exchange-rate risk 9) Inflation risk
10)Volatility risk 11)
Event risk 12) Sovereign risk
Interest Rate Risk - Answer-The effect of changes in the prevailing market rate of
interest on bond values. Inverse relationship btwn interest rates and bd prices. i.e.,
When rate goes up, bond prices fall.
, Interest Rate Risk and Bond Features - Answer-LT to Mat bds exhibit higher int rate risk
(all else the same).
Bds w/ smaller cpns exhibit higher int rate risk (all else the same).
Low cpn then high price vol.
High cpn then low price vol.
LT to Mat then high price vol.
ST to Mat then low price vol.
Interest Rate Risk and Bond Features
(Market Interest Rates) - Answer-When mkt int rates are high, price vol will be lower
than when mkt int rates are low.
Increase int rate then decrease vol.
Decrease int rate then increase vol.
Interest Rate Risk and Bond Features
(Deep Discount Bonds 1) - Answer-Deep Disc Bd w/ low cpn relative to mkt then bd has
increased price vol.
Deep Disc Bd w/ high cpn relative to mkt then bd has decreased price vol.
Interest Rate Risk and Bond Features
(Deep Discount Bonds 2) - Answer-Compared w/ Bds selling at par, deep disc bds have
greater price vol.
Investors expecting declining int rates prefer zeros w/ long term to mat.
Decreasing Int Rates then Reinvestment Rate Decreases and will not earn initial YTM
Int Rate Decrease then Bd Price Increases with Increased Cap Gain.
Investors expecting increasing int rates will not prefer zeros w/ long term to mat.
Premium Bond
Constant Discount Rate - Answer-Cpn Rate > Current Yld > YTM
Cpn Rate > required mkt yld, then bd price > par value
Premium/Price decreases to par as bd approaches mat.
Discount Bond
Constant Discount Rate - Answer-Cpn Rate < Current Yld < YTM
Cpn Rate < required mkt yld, then bd price < par value
Discount/Price increases to par as bd approaches mat.
Par Bond
Constant Discount Rate - Answer-Cpn Rate = Current Yld = YTM
Cpn Rate = required mkt yld, then bd price = par value.
Bond Present Value - Answer-If the Discount Rate or Required Yld Increases then PV
Decreases.
If the Discount Rate or Required Yld Decreases then PV Increases.
Questions with Correct Answers
Issuer options - Answer-Call provisions, prepayment options, sinking fund provisions,
and caps.
Callable Bond Provisions - Answer-Issuer has right (not obligation) to retire all or part of
bond prior to maturity. There may be several call dates, and customarily when a bond is
called on the first permissible call date, the call price is above par value. The call price
will normally decline over time according to the schedule.
Doubling Option - Answer-Like a Call Option.
Put Provision - Answer-Grants right to sell (put) the bond to the issuer at a specified
price prior to maturity.
When would it be beneficial for a bondholder to exercise a put option? - Answer-If
interest rates have risen and/or the creditworthiness of the issuer has deteriorated so
that the market price of the bond has fallen below par.
Non-Callable Bond - Answer-Absolute protection against call prior to maturity.
Refunding Provisions - Answer-Nonrefundable bonds prohibit premature retirement of
issue using proceeds of a lower cpn bd. Bds that carry these provisions can be freely
callable, but not refundable.
Non-Refundable Bond - Answer-Prohibit call of an issue using proceeds from a lower
coupon bond issue.
Conversion Option - Answer-Grants bondholder right to convert bond into a fixed
number of common shares. Options adds value to bond.
Exchange Option - Answer-Similar to conversion option, but allows conversion into a
security other than common stock.
Floating Rate Securities - Answer-Bonds that pay a variable rate of interest.
Coupon Formula (Floater) - Answer-Formula used to find new rate on a floating-rate
security
[New Coupon Rate = Reference Rate (+) or (-) Quoted Margin].
Deleveraged Floater - Answer-Scaling factor
New Coupon Rate = (b * Reference Rate) (+) or (-) Quoted Margin.
,Inverse Floater - Answer-Cpn moves in direction opposite to reference rate
New Coupon Rate = Constant Rate (K) - (L * Reference Rate)
Where K is the constant and L is the multiplier
Coupon Rate Cap - Answer-Maximum rate paid by borrower/issuer.
Coupon Rate Floor - Answer-Minimum periodic coupon interest payment received by
lender/security owner.
Coupon Rate Collar - Answer-Simultaneous combination of both cap and floor.
Regular Redemption - Answer-When bonds are redeemed under the call provisions
specified in the bond indenture.
Special Redemption - Answer-When bonds are redeemed to comply with a sinking fund
provision or because of a property sale mandated by government authority.
In Margin Buying - Answer-One borrows funds from a broker or a bank to purchase
securities and the securities themselves are the collateral for the margin loan.
Repo - Answer-Arrangement where an institution sells a security with a commitment to
buy it back at a later date at a specified higher price.
Repo Rate - Answer-The annualized percentage difference between lender's purchase
and sell back price.
Why are Repo issuances preferred among lenders? - Answer-They are not regulated by
the Federal Reserve and providebetter collateral positions for the lenders if the sellers
goes bankrupt. Lenders have only an obligation to sell back the repos rather than stake
a claim against sellers' assets.
Inflation-Indexed Bonds - Answer-Coupon formulas based on inflation; Coupon Formula
Ex.: 3% + annual change in CPI.
Type of Risks - Answer-1) Interest rate risk 2) Yield curve risk 3) Call risk
4) Prepayment risk 5) Reinvestment risk 6) Credit risk
7) Liquidity risk 8) Exchange-rate risk 9) Inflation risk
10)Volatility risk 11)
Event risk 12) Sovereign risk
Interest Rate Risk - Answer-The effect of changes in the prevailing market rate of
interest on bond values. Inverse relationship btwn interest rates and bd prices. i.e.,
When rate goes up, bond prices fall.
, Interest Rate Risk and Bond Features - Answer-LT to Mat bds exhibit higher int rate risk
(all else the same).
Bds w/ smaller cpns exhibit higher int rate risk (all else the same).
Low cpn then high price vol.
High cpn then low price vol.
LT to Mat then high price vol.
ST to Mat then low price vol.
Interest Rate Risk and Bond Features
(Market Interest Rates) - Answer-When mkt int rates are high, price vol will be lower
than when mkt int rates are low.
Increase int rate then decrease vol.
Decrease int rate then increase vol.
Interest Rate Risk and Bond Features
(Deep Discount Bonds 1) - Answer-Deep Disc Bd w/ low cpn relative to mkt then bd has
increased price vol.
Deep Disc Bd w/ high cpn relative to mkt then bd has decreased price vol.
Interest Rate Risk and Bond Features
(Deep Discount Bonds 2) - Answer-Compared w/ Bds selling at par, deep disc bds have
greater price vol.
Investors expecting declining int rates prefer zeros w/ long term to mat.
Decreasing Int Rates then Reinvestment Rate Decreases and will not earn initial YTM
Int Rate Decrease then Bd Price Increases with Increased Cap Gain.
Investors expecting increasing int rates will not prefer zeros w/ long term to mat.
Premium Bond
Constant Discount Rate - Answer-Cpn Rate > Current Yld > YTM
Cpn Rate > required mkt yld, then bd price > par value
Premium/Price decreases to par as bd approaches mat.
Discount Bond
Constant Discount Rate - Answer-Cpn Rate < Current Yld < YTM
Cpn Rate < required mkt yld, then bd price < par value
Discount/Price increases to par as bd approaches mat.
Par Bond
Constant Discount Rate - Answer-Cpn Rate = Current Yld = YTM
Cpn Rate = required mkt yld, then bd price = par value.
Bond Present Value - Answer-If the Discount Rate or Required Yld Increases then PV
Decreases.
If the Discount Rate or Required Yld Decreases then PV Increases.
