Fixed Income Introduction To Fixed-Income Valuation: Cfa Level I

CFA LEVEL I
FIXED INCOME
INTRODUCTION TO FIXED-INCOME VALUATION

CFA LEVEL I [INTRODUCTION TO FIXED-INCOME VALUATION]
Question 1.
The market value of an 18-year zero-coupon bond with a maturity value of

$1,000 discounted at a 12% annual interest rate with semi-annual
compounding is closest to:
A. $130.04.
B. $192.86.
C. $122.74.
Page | 1
Solution :
C is correct.
The value of a zero-coupon bond is
where r is the market discount rate per period, and N is the number of evenly
spaced periods to maturity. The value of the zero-coupon bond is
A is incorrect because it uses the annual discount rate and the maturity in years
rather than adjusting the discount rate and maturity for semi-annual periods.
B is incorrect because it uses the semi-annual coupons times the number of
years divided by 1.12.
Page | 2
Question 2.
The value of a 10-year, 6% coupon, $100 par value bond with semiannual
payments, assuming an annual discount rate of 7%, is closest to:
A. $99.07.
B. $92.89.
C. $107.44.
Page | 3
Solution :
B is correct.
A security with 19 semiannual payments of $3 interest and a 20th payment of

$103 (interest plus return of face value) with a semiannual discount rate of
3.5% is computed as:
A is incorrect because it is equal to $106/1.07.
C is incorrect because it reverses the coupon rate and the discount rate.
Page | 4
Question 3.
How much will the value of a three-year $100 par value coupon bond with
annual payments, a coupon rate of 9%, and a discount rate of 7% most likely
change if market interest rates immediately increase by 1%?
A. −2.68
B. −3.47
C. −2.40
Page | 5
Solution :
A is correct.
The value of the bond is
if market interest rates increase, the discount rate will increase, and the value
will be
a change of −2.68.
B is incorrect because it assumes a year passes before the discount rate
increases from 7% to 8% and calculates a new bond value of 101.75.
C is incorrect because it reverses the coupon rate and discount rate in the
calculations.
Page | 6
Question 4.
If the annual market discount rate is 6%, the value of a three-year bond that
has a 7% coupon rate, has a maturity (par) value of $1,000, and pays interest
annually is closest to:
A. $1,026.73.
B. $1,049.17.
C. $973.76.
Page | 7
Solution:
A is correct.
B is incorrect because it doubles the number of payments to 6, as if the bond

were making semi-annual payments rather than annual.
C is incorrect because the coupon rate and discount rate are reversed.
Page | 8
Question 5.
Consider a $100 par value bond with a 7% coupon paid annually and 5 years
to maturity. At a discount rate of 6.5%, the value of the bond today is
$102.08. One day later, the discount rate increases to 7.5%. Assuming the
discount rate remains at 7.5% over the remaining life of the bond, what is
most likely to occur to the price of the bond between today and maturity?
The price:
A. decreases then increases.

B. increases then decreases.
C. decreases then remains unchanged.
Page | 9
Solution :
A is correct.
If the discount rate increases to 7.5% from 6.5%, the price of a bond decreases.
At a discount rate of 7.5%, the bond sells at a discount to face value. As a
discount bond approaches maturity, it will increase in price over time until it
reaches par at maturity.
B is incorrect because the price action is reversed.
C is incorrect because as the bond approaches maturity its price will increase as
it is “pulled to par.”
Page | 10
Question 6.
The maturity effect is least likely to hold for a:
A. low-coupon, long-term bond trading at a discount.

B. zero-coupon bond.
C. low-coupon, long-term bond trading at a premium.
Page | 11
Solution :
A is correct.
In some situations, the maturity effect may not hold for a low-coupon bond
that is trading below par.
B is incorrect because the maturity effect will always hold for a zero-coupon
bond.
C is incorrect because the maturity effect will hold for a low-coupon bond that
is trading above par.
Page | 12
Question 7.
Which of the following is most likely a limitation of the yield to maturity
measure?
A. It assumes coupon payments can be invested at the yield to maturity.
B. It does not consider the capital gain or loss the investor will realize by
holding the bond to maturity.
C. It does not reflect the timing of the cash flows.
Page | 13
Solution :
A is correct.
Yield to maturity does consider reinvestment income; however, it assumes that
the coupon payments can be reinvested at an interest rate equal to the yield to
maturity. This is one of the limitations for the yield to maturity measure
because the investor is facing reinvestment risk (future interest rates will be
less than the yield to maturity at the time the bond is purchased).
B is incorrect because the yield to maturity measure considers not only the
coupon income but also any capital gain or loss that the investor will realize by
holding the bond to maturity.
C is incorrect because the yield to maturity measure considers the timing of the
cash flows.
Page | 14
Question 8.
Consider a five-year option-free bond that is priced at a discount to par value.

Assuming the discount rate does not change, one year from now the value of
the bond will most likely:
A. stay the same.
B. decrease.
C. increase.
Page | 15
Solution :
C is correct.
The bond is priced below its par value but will be worth exactly par value at
maturity. Over time, assuming a stable discount rate, the value of the bond
must rise so that it is equal to par at maturity. That is, the price is “pulled to
par.”
A is incorrect because the bond’s value must rise over time to be equal to its
par value.
B is incorrect because the bond’s value must rise over time to be equal to its
par value.
Page | 16
Question 9.
The option-free bonds of Argus Corporation have a duration of eight years.

When interest rates rise by 100 bps, the bond’s price declines by 7.9%. When
interest rates fall by 100 bps, however, the price rises by 8.2%. The
asymmetrical price change is most likely caused by the:
A. coupon effect.
B. maturity effect.
C. convexity effect.
Page | 17
Solution :
C is correct.
A fall in interest rates will result in a higher percentage rise in the bond’s price
compared with the percentage fall in the bond’s price when interest rates rise
by the same amount.
A is incorrect because the coupon effect relates to the sensitivity of bond price
changes to changes in the coupon rate.
B is incorrect because the maturity effect relates to the sensitivity of bond price
changes to the time to maturity.
Page | 18
Question 10.
Given two otherwise identical bonds, when interest rates rise, the price of
Bond A declines more than the price of Bond B. Compared with Bond B, Bond
A most likely:
A. has a shorter maturity.

B. is callable.
C. has a lower coupon.
Page | 19
Solution :
C is correct.
The lower the coupon rate, the more sensitive the bond’s price is to changes in
interest rates.
A is incorrect because the maturity would have to be longer for Bond A relative
to Bond B.
B is incorrect because when interest rates rise, the price of a callable bond will
not fall as much as an otherwise option-free bond.
Page | 20
Question 11.
Treasury spot rates on a semiannual bond equivalent yield basis are provided
below.
Maturity Semiannual Bond Equivalent Yield
0.5 years 0.40%
1.0 years 0.80%
1.5 years 1.00%
2.0 years 1.10%
2.5 years 1.20%
Using these spot rates, the value of a 2.5-year Treasury security that makes
semiannual payments based on a 2% coupon rate is closest to:
A. 101.98.
B. 106.88.
C. 99.06.
Page | 21
Solution :
A is correct.
= 0.9980 + 0.9920 + 0.9851 + 0.9783 + 98.0238 = 101.98
B is incorrect because it discounts all cash flows at the 2.5-spot rate and uses the annual coupon rate instead of
the semi-annual:
= 1.9881 + 1.9762 + 1.9644 + 1.9527 + 98.9943 = 106.88
C is incorrect because it fails to divide the spot rates by 2 as required because they are presented on a bond-
equivalent yield basis:
= 0.9960 + 0.9842 + 0.9706 + 0.9572 + 95.1522 = 99.06
Page | 22
Question 12.
A two-year spot rate of 5% is most likely the:
A. yield to maturity on a zero-coupon bond maturing at the end of Year 2.

B. coupon rate in Year 2 on a coupon-paying bond maturing at the end of
Year 4.
C. yield to maturity on a coupon-paying bond maturing at the end of Year
2.
Page | 23
Solution :
A is correct.
A spot rate is defined as the yield to maturity on a zero-coupon bond maturing

at the date of that cash flow.
B is incorrect because the spot rate is the yield to maturity on a zero-coupon

bond maturing at that point in time and not the coupon rate on a coupon-
paying bond.
C is incorrect because the spot rate is the yield to maturity on a zero-coupon

bond maturing at that point in time and not the yield to maturity on a coupon-
paying bond.
Page | 24
Question 13.
An investor sells a bond at the quoted price of $98.00. In addition, she

receives accrued interest of $4.40. The flat price of the bond is equal to the:
A. par value plus accrued interest.

B. agreed-on bond price excluding accrued interest.
C. accrued interest plus the agreed-on bond price.
Page | 25
Solution :
B is correct.
The agreed-on bond price excluding accrued interest is referred to as the flat
price.
A is incorrect because flat price is the agreed-upon bond price excluding

accrued interest.
C is incorrect because flat price excludes accrued interest.
Page | 26
Question 14.
Consider a $100 par value bond with an 8% coupon paid annually, maturing in
20 years. If the bond currently sells for $96.47, the yield to maturity is closest
to:
A. 8.37%.
B. 8.29%.
C. 7.41%.
Page | 27
Solution :
A is correct.
A security with a present value of 96.47, 19 interest payments of 8, and a 20th

payment of principal plus interest (108) has a yield to maturity of 8.37%.
B is incorrect because it is the security’s current yield: ($8/$96.47).
C is incorrect because it is: $8/$108 = 0.0741.
Page | 28
Question 15.
A bond has a 10-year maturity, a $1,000 face value, and a 7% coupon rate. If
the market requires a yield of 8% on similar bonds, it will most likely trade at
a:
A. discount.
B. premium.
C. discount or premium, depending on its duration.
Page | 29
Solution :
A is correct.
When the required yield is higher than the coupon rate, the bond will trade at a
discount to par.
B is incorrect because a bond trades at a premium when the required yield is

less than the coupon rate.
C is incorrect because a bond trades at a discount when the required yield is

higher than the coupon rate.
Page | 30
Question 16.
A credit analyst is least likely to use matrix pricing to estimate the required
yield and price of a(n):
A. newly underwritten bond.

B. actively traded speculative grade bond.
C. inactively traded investment grade bond.
Page | 31
Solution :
B is correct.
Matrix pricing is most suited to pricing inactively traded bonds and newly
underwritten bonds. A credit analyst is least likely to use matrix pricing to price
an actively traded bond.
A is incorrect because matrix pricing is most suited to pricing newly

underwritten bonds.
C is incorrect because matrix pricing is most suited to pricing inactively traded

bonds.
Page | 32
Question 17.
In using matrix pricing to estimate the required yield spread on a new

corporate bond issue, the benchmark rate used is most likely to be the:
A. coupon rate on a government bond with a similar time to maturity.

B. yield to maturity on a corporate bond with similar credit risk and time
to maturity.
C. yield to maturity on a government bond with a similar time to
maturity.
Page | 33
Solution :
C is correct.
The benchmark rate is the yield to maturity on a government bond with the
same, or similar, time to maturity.
A is incorrect because the benchmark rate is measured relative to the yield to

maturity and not the coupon rate.
B is incorrect because the benchmark rate is measured relative to the yield to

maturity of a government bond, not a similar corporate bond.
Page | 34
Question 18.
The bond-equivalent yield for a semi-annual pay bond is most likely:
A. equal to the effective annual yield.

B. equal to double the semi-annual yield to maturity.
C. more than the effective annual yield.
Page | 35
Solution :
B is correct.
The bond equivalent yield for a semi-annual pay bond is equal to double the
semi-annual yield to maturity and is lower than the effective annual yield.
A is incorrect because the bond equivalent yield for a semi-annual pay bond is
equal to double the semi-annual yield to maturity and is lower than the
effective annual yield.
C is incorrect because the bond equivalent yield for a semi-annual pay bond is
equal to double the semi-annual yield to maturity and is lower than the
effective annual yield.
Page | 36
Question 19.
The current yield for a 4.5% coupon, 10-year bond, with a maturity par value
of $100 and currently priced at $85.70 is closest to:
A. 4.50%.
B. 5.93%.
C. 5.25%.
Page | 37
Solution :
C is correct.
Current yield is calculated as ($4.5/$85.70) = 5.25%.
A is incorrect because it is the coupon of the bond.
B is incorrect because it is calculated as follows:
Page | 38
Question 20.
If the yield to maturity on an annual-pay bond is 7.75%, the bond-equivalent

yield is closest to:
A. 8.05%.
B. 7.90%.
C. 7.61%.
Page | 39
Solution :
C is correct.
The bond-equivalent yield = 2 × (1.07750.5 − 1) = 0.07605 or 7.61%.
A is incorrect because the bond-equivalent yield is incorrectly calculated as [(1

+ 0.0775)2 − 1]/2 = 0.0805 or 8.05%.
B is incorrect because the bond-equivalent yield is incorrectly calculated as [1 +

(0.0775/2)]2 − 1 = 0.079 or 7.90%.
Page | 40
Question 21.
Which of the following 90-day money market instruments most likely offers
the investor the highest rate of return?
Money Market
Quoted Rate Quotation Basis Day Convention
Instrument
Instrument A 5.78% 360 Discount rate
Instrument B 5.80% 365 Discount rate
Instrument C 5.96% 365 Add-on rate
A. Instrument A
B. Instrument C
C. Instrument B
Page | 41
Answer :
B is correct.
Instrument C provides a bond equivalent yield of 5.96%, compared with 5.946%

for Instrument A and 5.883% for Instrument B.
A is incorrect because to calculate the bond equivalent yield: FV = 100, Days =

90, Year = 360, DR = 0.0578.
PV = 100 × [1 – (90/360) × 0.0578] = 98.555
AOR = (365/90) × [(100 – 98.555)/98.555] = 5.946%
C is incorrect because to calculate the bond equivalent yield: FV = 100, Days =

90, Year = 365, DR = 0.058.
PV = 100 × [1 – (90/365) × 0.058] = 98.570

AOR = (365/90) × [(100 – 98.570)/98.5705] = 5.883%
Page | 42
Question 22.
Which of the following statements is most likely correct regarding the spot
and forward curves. The spot curve:
A. can be calculated from the forward curve, and the forward curve can
be calculated from the spot curve.
B. can be calculated from the forward curve, but the forward curve
cannot be calculated from the spot curve.
C. cannot be calculated from the forward curve, but the forward curve
can be calculated from the spot curve.
Page | 43
Solution :
A is correct.
The forward and spot curves are interconnected to each other. The spot curve
can be calculated from the forward curve, and the forward curve can be
calculated from the spot curve. Either curve can be used to value fixed-rate
bonds.
B and C are incorrect because the spot curve can be calculated from the
forward curve, and the forward curve can be calculated from the spot curve.
Page | 44
Question 23.
Using the following US Treasury forward rates, the value of a 2.5-year $100
par value Treasury bond with a 5% coupon rate is closest to:
Period Years Forward Rate
1 0.5 1.20%
2 1 1.80%
3 1.5 2.30%
4 2 2.70%
5 2.5 3.00%
A. $104.87.
B. $101.52.
C. $106.83.
Page | 45
Solution :
C is correct.
A is incorrect because it treats the forward rates as spot rates.
B is incorrect because it does not divide the forward rates by two.
Page | 46
Question 24.
The semiannual bond equivalent yield spot rates for US Treasury yields are
provided below.
Period Years Spot Rate

1 0.5 1.20%
2 1.0 2.10%
3 1.5 2.80%
4 2.0 3.30%
On a semiannual bond equivalent yield (BEY) basis, the six-month forward
rate one year from now is closest to:
A. 4.21%.
B. 3.64%.
C. 2.10%.
Page | 47
Solution :
A is correct.
The x-year forward rate y years from now is
All spot rates are given on a BEY basis and must be divided by 2 in this calculation:
On a BEY basis, the forward rate is 0.021036× 2 = 4.21%.
B is incorrect because it calculates the 1-year forward rate six months from now.
C is incorrect because it doesn’t convert to a semiannual bond equivalent yield
basis.
Page | 48
Question 25.
Assume the yields to maturity on four-year and five-year zero-coupon bonds are
4.67% and 5.35%, respectively, stated on a semiannual bond basis. The “4y1y”
implied forward rate is closest to:
A. 8.092%.
B. 8.114%.
C. 4.046%.
Page | 49
Solution :
A is correct.
By applying inputs to the formula for a forward rate calculation,
Applying a factor of 2 annualizes for a periodicity of 2, for a forward rate of 8.092%.
B is incorrect because it uses the following formula without considering the

semiannual bond basis: [(1 + 0.0535)5/(1 + 0.0467)4] – 1 = 8.114%.
C is incorrect because it does not apply an annualized factor for a period of two.
Page | 50
Question 26.
Assume the following annual forward rates were calculated from the yield curve.
Time Period Forward Rate

0y1y 0.50%
1y1y 0.70%
2y1y 1.00%
3y1y 1.50%
4y1y 2.20%
The four-year spot rate is closest to:

A. 0.924%.
B. 1.348%.
C. 1.178%.
Page | 51
Solution :
A is correct.
The four-year spot rate can be computed as:
C is incorrect because it is computed as:
B is incorrect because it is computed as:
Page | 52
Question 27.
Which of the following is least likely a component of yield spread?

A. Taxation
B. Expected inflation rate
C. Credit risk
Page | 53
Solution :
B is correct.
Building blocks of the yield curve are spread (risk premium) and a benchmark
(risk-free rate of return). Expected inflation rate and expected real rate are
components of the risk-free rate of return (i.e., the benchmark).
A is incorrect because taxation is part of the yield spread providing the investor
with compensation for the tax impact of holding a specific bond.
C is incorrect because credit risk is part of the yield spread providing the
investor with compensation for the credit risks of holding a specific bond.
Page | 54
Question 28.
Using the following information and assuming coupons are paid annually, the
G- spread of the Steel Co. bond is closest to:
Bond Maturity Coupon Price
Steel Co. 2 Years 5.00% 101.70
Treasury bond 2 Years 4.00% 100.50
A. 36 bps.
B. 94 bps.
C. 100 bps.
Page | 55
Solution :
A is correct.
The yield for the Steel Co. bond is calculated as
The yield for the Treasury bond is calculated as
G-spread is calculated as the yield difference between the Steel Co. Bond and the Treasury bond:
4.0974% − 3.7359% = 36.15%, or 36 bps.
B is incorrect because it is calculated as current yield difference: (5/101.70) − (4/100.50) = 4.9164%
− 3.9801% = 0.9363%, i.e., 94 bps.
C is incorrect because it is calculated as coupon rate difference: 5% − 4% = 1%.
Page | 56
Question 29.
All else being equal, the difference between the nominal spread and the Z-
spread for a non-Treasury security will most likely be larger when the:
A. yield curve is steep.
B. security has a bullet maturity rather than an amortizing structure.
C. yield curve is flat.
Page | 57
Solution :
A is correct.
The main factor causing any difference between the nominal spread and the Z-
spread is the shape of the Treasury spot rate curve. The steeper the spot rate
curve, the greater the difference.
B is incorrect because for a bullet maturity security the nominal spread and Z-
spread will be approximately the same, but it will be greater for an amortizing
security.
C is incorrect because when the yield curve is flat the nominal spread and Z-
spread will be approximately the same.
Page | 58

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CFA LEVEL I

INTRODUCTION TO FIXED-INCOME VALUATION

The market value of an 18-year zero-coupon bond with a maturity value of

A security with 19 semiannual payments of $3 interest and a 20th payment of

A is incorrect because it is equal to $106/1.07.

B is incorrect because it doubles the number of payments to 6, as if the bond

A. decreases then increases.

B is incorrect because the price action is reversed.

The maturity effect is least likely to hold for a:

A. low-coupon, long-term bond trading at a discount.

Consider a five-year option-free bond that is priced at a discount to par value.

A. stay the same.

The option-free bonds of Argus Corporation have a duration of eight years.

A. has a shorter maturity.

The value of the bond is

= 0.9980 + 0.9920 + 0.9851 + 0.9783 + 98.0238 = 101.98

= 1.9881 + 1.9762 + 1.9644 + 1.9527 + 98.9943 = 106.88

= 0.9960 + 0.9842 + 0.9706 + 0.9572 + 95.1522 = 99.06

A two-year spot rate of 5% is most likely the:

A. yield to maturity on a zero-coupon bond maturing at the end of Year 2.

A spot rate is defined as the yield to maturity on a zero-coupon bond maturing

B is incorrect because the spot rate is the yield to maturity on a zero-coupon

C is incorrect because the spot rate is the yield to maturity on a zero-coupon

An investor sells a bond at the quoted price of $98.00. In addition, she

A. par value plus accrued interest.

A is incorrect because flat price is the agreed-upon bond price excluding

C is incorrect because flat price excludes accrued interest.

A security with a present value of 96.47, 19 interest payments of 8, and a 20th

B is incorrect because it is the security’s current yield: ($8/$96.47).

C is incorrect because it is: $8/$108 = 0.0741.

B is incorrect because a bond trades at a premium when the required yield is

C is incorrect because a bond trades at a discount when the required yield is

A. newly underwritten bond.

A is incorrect because matrix pricing is most suited to pricing newly

C is incorrect because matrix pricing is most suited to pricing inactively traded

In using matrix pricing to estimate the required yield spread on a new

A. coupon rate on a government bond with a similar time to maturity.

A is incorrect because the benchmark rate is measured relative to the yield to

B is incorrect because the benchmark rate is measured relative to the yield to

The bond-equivalent yield for a semi-annual pay bond is most likely:

A. equal to the effective annual yield.

Current yield is calculated as ($4.5/$85.70) = 5.25%.

A is incorrect because it is the coupon of the bond.

B is incorrect because it is calculated as follows:

If the yield to maturity on an annual-pay bond is 7.75%, the bond-equivalent

The bond-equivalent yield = 2 × (1.07750.5 − 1) = 0.07605 or 7.61%.

A is incorrect because the bond-equivalent yield is incorrectly calculated as [(1

B is incorrect because the bond-equivalent yield is incorrectly calculated as [1 +

Instrument C provides a bond equivalent yield of 5.96%, compared with 5.946%

A is incorrect because to calculate the bond equivalent yield: FV = 100, Days =

AOR = (365/90) × [(100 – 98.555)/98.555] = 5.946%

C is incorrect because to calculate the bond equivalent yield: FV = 100, Days =

PV = 100 × [1 – (90/365) × 0.058] = 98.570

A is incorrect because it treats the forward rates as spot rates.

B is incorrect because it does not divide the forward rates by two.

Period Years Spot Rate

The x-year forward rate y years from now is

On a BEY basis, the forward rate is 0.021036× 2 = 4.21%.