C12 - Fixed Income (25-30 Qs C11-C14 'Asset Classes') Flashcards
What is a repo?
A) An agreement to sell an instrument and then repurchase it later
B) A company purchasig its own shares on the market
C) Repossesing securities after counterparty default
D) A government method of raising cash by issuing more of an existing gilt
A - An agreement to sell an instrument and then repurchase it later
A repo, or repurchase agreement, is a financial agreement where one party lends money to another party in exchange for collateral. It’s a type of short-term borrowing that’s often used for government securities.
How it works
* The seller sells an asset to the buyer at a set price
* The seller agrees to buy back the asset at a later date and price
* The buyer receives collateral to protect against credit risk
Why it’s important
* Repos help move cash and securities through the financial system
* Repos provide short-term funding for investors
* Repos help central banks control interest rates and supply reserves
Types of repos
* Gilt repo: A sterling repo that uses UK government bonds as collateral
* Open repo: The seller agrees to buy back the asset on demand
* Reverse repo: The buyer buys an asset and then sells it again
Which theory of interest rates states that “in equilibrium the long-term rate is a geometric average of today’s short-term rate and the expectced short-term rates in the future”?
A) Yield curve
B) Market segmentation
C) Liquidity preference theory
D) Pure expectation theory
D - Pure Expectation Theory
In other words, if the market thinks that short-term rates are going to increase, long-term rates will be high (and vice-versa).
* A yield curve is a graph that shows how interest rates on debt instruments, like bonds, change as the bonds’ maturity dates approach. It’s a visual representation of the cost of borrowing money over different time periods.
* Market segmentation is the process of dividing a market into smaller groups, or segments, based on shared characteristics. The goal is to identify groups of people with similar needs and interests so that businesses can target them with specific marketing strategies
* Liquidity preference theory is a macroeconomic theory that explains how the supply and demand for money determines interest rates. The theory states that people prefer to hold liquid assets, like cash, over less liquid assets, like stocks, bonds, or real estate. Investors are more likely to choose assets that can be easily converted to cash without losing value and will expect a higher premium for taking on a longer-term loss of liquidity. Liquidity preference theory can help people navigate financial and economic changes, especially during crises.
Arran Malts Ltd buys a CD via the secondary market from the Training Company
The credit risk associated with this CD for the Edmonton Energy Company is:
A) The risk of the issuer defaulting
B) The risk of the Training Company defaulting
C) The risk of an increase in interest rates
D) Re-investment risk at the maturity of the CD
A certificate of deposit (CD) is a type of savings account that pays a fixed interest rate on money held for an agreed-upon period of time.
A - The risk of the issuer defaulting
The issuer of Certificates of Deposits (CDs) are banks. The credit risk lies with the issuing bank defaulting and not paying the holder of the CD the proceeds at maturity. Options C and D are not credit risk; they are interest rate risk and re-investment risk respectively.
- Interest rate risk is the possibility of financial loss that can occur when interest rates change. It can affect bond owners, banks, and other institutions.
- Reinvestment Risk is the potential risk where future proceeds, such as the coupon payments or debt principal, will need to be reinvested at a lower interest rate compared to the original yield (i.e. on a debt security).
Which of the following will be the MOST suitable investment for a non-taxpayer who is expecting interest rates to rise and who requires income?
A) Convertible Bonds
B) Low coupon gilts
C) Conventional bonds
D) FRNs
D - FRNs
FRNs are Floating Rate Notes - so the coupons are linke to interest rates.
Who is responsible for auctioning gilts?
A) Bank of England
B) DMO
C) FCA
D) The Treasury
B - DMO
Gilts are UK Government securities issued by HM Treasury. Since April 1998 gilts have been issued by the Debt Management Office (DMO) on behalf of HM Treasury.
Which of the following are TRUE of a gilt?
1. The flat yield is GREATER than the gross redemption yield (GRY) if it is priced above par
2. The flat yield is LESS than the gross redemption yield (GRY) if it is priced above the par
3. The coupon is expressed NET
4. The coupon is expressed GROSS
A) 1 and 3
B) 1 and 4
C) 2 and 3
D) 2 and 4
B - 1 (flat yield is GREATER than gross redemption yield if it is priced above par) and 4 (The coupon is expressed GROSS)
Remember the relationships:
Price > Nominal Value = Flat Yield > GRY (YTM) and vice versa
Yield to Maturity (YTM)
- The gross redemption yield (GRY) also includes the difference between the gilt’s purchase price and its face value at maturity.
- The income or running yield (sometimes also known as the flat yield) does not take into account any profit or loss made by holding the bond to redemption, and simply assumes the investor will be able to sell the bond at the same price they purchased it for.
Calculate the gross redemption yield (GRY) of a 10% bond priced at £95 with 3 years to redemption
A) 12.21%
B) 12.08%
C) 11.48%
D) 10.00%
B - 12.08%
Solve by trial and error.
The price = the present value of the future cash flows.
£95 = (£10 x annuity factor for 3 years) + (PV of £100 par). Using 12.08 as the discount rate will equate the price to the present value of the future cash flows.
What is the correct order of priority in a liquidation for the following?
1. Liquidator fees and expenses
2. Unsecured creditors
3. Subordinated loan stock
4. Floating charge debentures
A) 1, 4, 2 and 3
B) 4, 1, 2 and 3
C) 3, 1, 4 and 2
D) 1, 2, 4, and 3
A - 1 (fees & expenes), 4 (floating charge debentures), 2 (unsecured loan stock) and 3 (Subordinated loan stock
The liquidators must cover their exposure first. Unsecured creditors include trade creditors, suppliers, customers, contractors, some staff claims, plus HMRC. Prior to 2002, HMRC was ranked as a preferential creditor, but the introduction of the Enterprise Act reduced their status to that of unsecured creditor for all forms of tax.
What does modified duration measure?
A) The extent to which the gross redemption yield (GRY) of a gilt changes given a particular change in price
B) The life of the gilt to maturity
C) The extent to which a gilt price changes given any particular change in the interest rate
D) The life of the gilt to maturity in days, having adjusted for leap years
C - The extent to which a gilt price changes given any particular change in the interest rate
Modified duration is the percentage change in a bond’s price given a 100 basis point (1%) change in yields
A bond has a price of £97. If the modified duration of the bond is 1.51. What is the new price after a 2% increase in yield?
A) £99.79
B) £93.98
C) £95.06
D) £94.07
D - £94.07
Modified duration shows that percentage change in price for EVERY 1% change in yield. Here, you have 2% change in yield, so you have to work out MD X 2.
Fall in price = (2 x 0.0151) x £97 = £2.93.
£97 - £2.93 (deduct as yield went up) = £94.07
Remember, if the yield goes up, the price goes down and vice versa (SEE-SAW)
The different yield between conventional and index-linked gilts may be viewed as reflecting:
A) Long-term inflation rates
B) Future base rates
C) Foreign exchange rates
D) Unemplotment in the future
A - Long-term inflation rates
The price of which of the following is most responsive to changes in interest rates?
A) Irredeemable gilts
B) Long dated gilts
C) Medium dates gilts
D) short dates gilts
A - Irredeemable gilts
- Irredeemable gilts are British government bonds that pay interest but do not repay the original amount borrowed. They are also known as undated gilts.
- Short dated Gilt gilts that are paid back in LESS than seven years
As a gilt approaches maturity, how will its market value change?
A) Tend towards nominal value due to pull to redemption
B) Move away from nominal value due to pull to redemption
C) Flutuate more widely due to pull to redemption
D) Increase above nominal value due to its attractiveness to higher rate tax payers
A - Tend towards nominal value due to pull to redemption
Which is the best decription of a FRN?
A) A secured charge over a debenture
B) A fixed charge over the assets of a business
C) A loan stock which pays a variable rate of interest
D) A future foreign exchange contract
C - A loan stock which pays a variable rate of interest
FRNs are Floating Rate Notes - so the coupons are linke to interest rates.
Which of the following are characteristics of Eurobonds?
1. They are regulated by ICMA
2. Interest is NOT paid on them
3. Settlement is normally on the third calendar day
4. All Eurobond dealers are required to be ICMA members
A) 1 only
B) 1 and 3
C) 1, 2 and 3 but not 4
D) All of the above
A - 1 (regulated by ICMA) only
Eurobonds are T+1 settlement normally
Which of the following are characteristics of UK Treasury Bills?
1. They usually have lives of 3 months
2. They usually have lives of up to 5 years
3. They are usually issued at a discount to nominal value
4. They usually provide an income stream
A) 1 only
B) 1 and 3 only
C) 3 and 4 only
D) 2 and 4 only
B - 1 (3 month lives) and 3 (discount to nominal)
UK Treasury bills are short-term government bonds that are issued by the UK government. They are a type of debt security that are zero-coupon, meaning they don’t pay interest.
Which of the following BEST describes a Eurobond?
A) A corporate bond issued internationally, via a sydicate of banks
B) A government bond issued in an oversea currency
C) A bond issued internationally, underwritten by a sydicate of banks
D) A bond issued in Europe, typically denominated in Euros
C - A bond issued internationally, underwritten by a sydicate of banks
A Eurobond is a bond issued offshore by governments or corporates denominated in a currency other than that of the issuer’s country. Eurobonds are usually long-term debt instruments. Eurobonds are typically denominated in US Dollars (USD).
Liquidity preference theory implies what about yield curve?
A) People are indifferent about maturity dates
B) People want a premium for a holding longer maturity investments
C) People want a premium for shorter maturity investments
D) Maturity is only important for fixed interest stocks
B - People want a premium for a holding longer maturity investments
Liquidity preference theory is a macroeconomic theory that explains how the supply and demand for money determines interest rates. The theory states that people prefer to hold liquid assets, like cash, over less liquid assets, like stocks, bonds, or real estate. Investors are more likely to choose assets that can be easily converted to cash without losing value and will expect a higher premium for taking on a longer-term loss of liquidity. Liquidity preference theory can help people navigate financial and economic changes, especially during crises.
What is the lowest S&P bond rating, normally regarded as investment grade?
A) AA-
B) A-
C) BBB-
D) B-
C - BBB-
S&P Investment grades go AAA > AA > A > BBB
Speculative Grades then follow on with > BB > B > CCC > CC > C > D
PLUS (+) rank above just the letter ratings, and MINUS (-) rank below just the letter ranking. I.e. AA+ > AA > AA-
Tintagel Trumpet Co. buys a CD from Bugle Brass Ltd. Is the credit risk associated with this:
A) the risk of the issuer defaults
B) the risk of Bugle Brass default
C) the risk of increased interest rates
D) the risk of reinvesting the proceeds after it has matured
A certificate of deposit (CD) is a type of savings account that pays a fixed interest rate on money held for an agreed-upon period of time.
A - the risk of the issuer defaults
A CD is effectively a promissory note from the issuer.
The issuer of Certificates of Deposits (CDs) are banks. The credit risk lies with the issuing bank defaulting and not paying the holder of the CD the proceeds at maturity. Options C and D are not credit risk; they are interest rate risk and re-investment risk respectively.
- Interest rate risk is the possibility of financial loss that can occur when interest rates change. It can affect bond owners, banks, and other institutions.
- Reinvestment Risk is the potential risk where future proceeds, such as the coupon payments or debt principal, will need to be reinvested at a lower interest rate compared to the original yield (i.e. on a debt security).
Which of the following best describes stripping in relation to a bond?
A) Separating responsibility for paying redemption and interest
B) Separating coupons and redemption proceeds
C) Zero coupon bonds
D) Acquiring a mixed portfolio of bonds and selling some off to raise the risk profile of the porfolio
B - Separating coupons and redemption proceeds
A strip bond has its coupons and principal stripped off and sold separately to investors as new securities. An investment bank or dealer will usually buy a debt instrument and “strip” it, separating the coupons from the principal amount, which then becomes known as the residue.
Which of the following is the lowest investment grade as provided by Moody’s?
A) Aaa3
B) B3
C) Baa3
D) Ba3
C - Baa3
Investment grades go:
Aaa > Aa1-3 > A1-3 > Baa1-3
Then Speculative grades follow on with:
> Ba1-3 > B1-3 > Caa1-3 > Ca > C
The lower the number, the higher the rank of that rating.
If a bond is issued initially convertible into 20 shares per £100 nominal, what will be the change in conversion rate if there is a one for one scrip issue?
A) Doubled
B) No change
C) Flawed
D) 4
A - Doubled
A scrip issue (AKA scrip or capitalization issue) is an offer of free additional shares to existing shareholders.
1 for 1 means the shares will be doubled and the conversion rate reflects this.
A bond with 10% coupon has three years (payments) to redemption and is quoted at £97.56. The redemption yield is 11%
What is the (Macaulay) duration of the gilt?
A) 2.53 years
B) 2.73 years
C) 2.93 years
D) 2.13 years
B - 2.73 years
Macaulay duration = sum(PV. of each cash flow x time)/price
Macaulay duration is a measure of how long it takes to receive the cash flows from a bond, weighted by their present value. It’s used to estimate how sensitive a bond’s price is to changes in interest rates.
If a 6% ‘long’ gilt pays interest twice a year, and the quoted price 60 days prior to an interest payment is £45, what is the interest yield?
A) 10.12%
B) 6.67%
C) 12.77%
D) 13.33%
D - 13.33%
The interest yield (AKA the flat yield) = coupon / quoted price x 100. As the quoted (clean) price is given, the accured interest is irrelevant SO:
Interest yield = £6/£45 x £100 = 13.33%
A 5% annual coupon bond redeemable in two years at par currently has a redemption yield of 6%
If the yield rises to 7% by what percentage will the price of the bond change?
A) -1.85%
B) +1.85%
C) -1.82%
D) +1.82%
C: -1.82%
If the yield is 6%, the price is £98.17. If the yield rises to 7%, the price drops to £96.38. The percentage drop is therefore 1.82%.
YIELDS AND BOND PRICE ARE A SEESAW, AS ONE GOES UP THE OTHER GOES DOWN
A bond has a Macaulay duration of 5 years and a yield of 10%, what is its modified duration?
A) 0.45
B) 2.55
C) 4.55
D) 10.45
C - 4.55
Modified duration = Macaulay duration / (1 + Gross Redemption Yield). SO:
Modified duration = 5/1.10 = 4.55%
A bond has a modified duration of 3 and a yield of 6%, what is the Macaulay duration?
A) 3 years
B) 3.18 years
C) 2 years
D) 0.56 years
B - 3.18 years
Modified duration = Macaulay duration / (1 + Gross redemption yield). Therefore Macaulay duraction = modified duration x (1 + gross redemption yield). SO
Macaulay duration = 3 x 1.06 = 3.18(years)
An undated bond with a coupon of 3% has a yield of 6%, what is its price?
A) £25
B) £50
C) £75
D) £100
B - £50
An undated bond (or irredeemable bonds) can be valued using the perpetuty formula: PRICE = COUPON / YIELD. So: £3 / 0.06 = £50.
* Irredeemable bonds are bonds that pay interest but do not repay the original amount borrowed. They are also known as undated bonds.
A zero coupon bond is bought for £64 with three years to maturity
What is the compound annual return on holding the bond?
A) 12%
B) 16%
C) 36%
D) 56%
B - 16%
This requires a trial and erorr approach to find the discount rate that equates the price of the zero coupon bond to the present value of the redemption value.
Presume the redemption value is £100, unless otherwise stated.
To calculate the compound annual return (CAGR) on a bond, you can use the Compound Annual Growth Rate (CAGR) formula:
CAGR = ((FV / PV ) ^(1/n)) - 1 with:
FV: The future value of the investment
PV: The present value of the investment
n: The number of years of investment
(I just did £64 x (1 + r ^3) until I got the one closest to £100
The yield curve is the plot of:
A) Spot rates against time
B) Forward rates against time
C) Redemption yields against time
D) Flat yields against time
C - Redemption yields against time
- Redemption yield (AKA Yield to Maturity or Book Yield) is a financial term that estimates the total return an investor can expect from a bond or other fixed-interest security.
- The flat yield (AKA income or running yield) on a security is the annual amount receivable in interest, expressed as a percentage of the clean price (i.e. the price excluding gross accrued interest)
If interest rates are expected to rise, the yield curve will be:
A) Be flat
B) Downward sloping
C) U-shaped
D) Upward sloping
D - Upward sloping
An upward sloping yield curve is a normal shape for the yield curve, where short-term interest rates are lower than long-term interest rates. This means that yields increase as the maturity of the bond increases.
An inverted yield curve is a downward sloping yield curve that occurs when short-term debt instruments have higher yields than long-term debt instruments.
Which of the following are TRUE in respect of UK government Treasury bills?
1. They carry no rate of interest
2. They are always issued at a discount to par
3. They are issued by way of a tender, each successful tenderer paying a common striking price
4. They are a form of short-term borrowing
A) All of the above
B) 1, 2 and 3
C) 1, 2 and 4
D) 2, 3 and 4
C - 1 (no interest), 2 (always discount to par) and 4 (short-term borrowing)
Treasury bills are routinely issued at weekly tenders, held by the DMO on the last business day of each week (i.e. usually on Fridays), for settlement on the following business day. The issue price of a UK Treasury bill depends on the demand for the bill and the lowest accepted yield. The DMO allocates the bills to bidders in order of priority, starting with the lowest accepted yield.
If interest rates remaing the same, the price of a discount bond will tend to:
A) Fall in value as time passes
B) rise in value as time passes
C) stay the same as time passes
D) cannot tell
B - Rise in value as time passes
All bond prices will tend move to their par value at redemption. This is known as the “pull to redemption”. As the bond is at a discoount (i.e. below par), the price will increase to its par value, asusming yields are constant.
Whih of the following would make a bond more price sensitive to changes in market interest rates?
1. A lower time to maturity
2. A lower yield
3. A lower coupon rate
A) 1 only
B) 1 and 2
C) 2 and 3
D) All of the above
C - 2 (lower yield) and 3 (lower coupon rate)
Generally, bonds with long maturities and low coupons have the longest durations. These bonds are more sensitive to a change in market interest rates and thus are more volatile in a changing rate environment. Conversely, bonds with shorter maturity dates or higher coupons will have shorter durations.
The clean price of a bond:
A) includes accrued interest
B) excludes accrued interest
C) is always lower than the dirty price
D) is always higher than the direcy price
B - excludes accrued interest
A clean bond price is the price of a bond that does not include interest that has accrued since the last coupon payment. It’s also known as the flat bond price. The clean price is the present value of the bond’s future cash flows, including coupon payments and principal repayment. The bond’s yield is used to discount these cash flows back to the present.
An investor purchases a T-bill (nominal value of £100) with 25 days to maturity for £99.23
What is the compounded annualised return if held to maturity?
A) 11.5%
B) 11.8%
C) 11.95%
D) 12.2%
C - 11.95%
Yield over 25 days = (£100 - £99.23) / £99.23 = 0.00776
Compounding to an anuall return = 1.00776^(365/25) - 1 = 0.1195 i.e. 11.95%
If the redemption yield is expected to reduce, which of the following actions should a bond fund manager take?
A) Hold long dated, high coupon bonds
B) Hold short dated, high coupon bonds
C) Hold long dated, low coupon bonds
D) Shold short dated, low coupon bonds
C - Hold long dated, low coupon bonds
Longer dated, lower coupon bonds exhibit the highest interest rate (yield) sensitivity. They therefore have the highest Macaulay and modified duractions.
If a 3 year bond is priced at £92.27 with an annual coupon of £5.00 and the current rate of interest is 8%, what would be the change in the price of the bond if interest rates rose to 10%?
A) Falls by £4.70
B) Rises by £4.70
C) Falls by £4.46
D) Rises by £4.46
A - Falls by £4.70
If the yield rise to 10%, Price = £5/1.1 + £5/1.1^2 + £105/1.1^3 = £87.57
Price would therefore fall by £92.27 - £87.57 = £4.70
Certificate of Deposit are issued by which of the following?
A) Institutions with a credit rating of AAA only
B) Institutions with a credit rating of AA and above
C) Institutions with a credit rating of A and above
D) Institutions with a UK banking licence
D - Institutions with a UK banking licence
In the UK, banks, building societies, and other money market players can issue certificates of deposit (CDs).
Who can issue CDs?
* Banks: Large, small, and online banks can issue CDs
* Building societies: Institutions authorized under the Building Societies Act 1986 can issue CDs
* European authorized institutions: Institutions authorized under the Banking Act 1987 can issue CDs
* Other money market players: Other financial institutions can issue CDs
What are CDs?
* CDs are certificates that promise to pay a certain amount to the holder
* CDs are a type of fixed term deposit with a bank
* CDs can pay interest at a fixed or variable rate
* CDs are often issued with maturities between one month and five years
* CDs are usually more profitable than savings accounts because they require a commitment to leave money in the CD for a fixed period of time
A zero coupon bond with a price of 80 is repayable in 4 years at £110 What is its redemption yield?
A) 5.71%
B) 7.0%
C) 8.29%
D) 9.0%
C - 8.29%
As the calculation involves an iterative apparoach, trial and error is perhaps the best approach for this exam. We need to find the appropriate discount rate that equates the price with the present value of future coupon and redemption value.
£80 = 110/(1+r)^4 = £79.99 rounded to £80.
The government issues a 180 day Treasury bill for a price of £9,500 with a par value of £10,000 What compounded annual return does this represent to an investor who purchases the bill and holds it until maturity?
A) 10.96%
B) 5.26%
C) 10.53%
D) 5.00%
A - 10.96%
Return for 180 days = (£10,000 - £9,500)/£9,500 = 0.0526
Compounded annual return = 1.0526^(365/180) - 1 = 0.1096 i.e. 10.96%
Commercial paper is normally:
1. Discounted
2. Held to maturity
3. Issued by companies
4. Short-term
A) All of the above
B) 2, 3 and 4
C) 1 and 4
D) 1 ,2 and 3
A - All of the above
Commercial paper is an unsecured form of promissory note that pays a fixed rate of interest. It is typically issued by large banks or corporations to cover short-term receivables and meet short-term financial obligations, such as funding for a new project.
A gilt with a 6% annual pay coupon has clean price of £98. It is purchased 42 days after the payment date What price does the investor pay for this gilt?
A) 99.68
B) 99.38
C) 98.35
D) 98.69
D - 98.69
The price paid (dirty price) = clean price + accrued interest
Accrued interest = 42/365 x £6 = £0.69
Therefore the price paid = £98 + £0.69 = £98.69
As a floating rate note (FRN) is revalued frequently it will have a value:
A) close to the coupon
B) Close to par
C) Close to zero
D) Close to £100
B - Close to Par
FRNs are Floating Rate Notes - so the coupons are linke to interest rates.
The rate of return on a one year fixed income security is 6% and the expected rate of a one year security starting in one year is 8% What is the implied annual rate of return on a two year fixed income security with the same risk?
A) 7%
B) 9%
C) 8%
D) 14.5%
A - 7%
The annual rate of return over the two year period shouold be a compounded average of the two annual returns. (1+R)2 = 1.06 x 1.08 = 1.1448
The compounded annual return = [(1.06)(1.08)]^0.05 - 1 = 0.07 i.e. 7%
Which of the following are TRUE:
1. If a bond’s price is higher than the par value, the flat yield is less than the coupon
2. If the bond’s price is higher than the par value, the GRY is less than the flat yield
3. The GRY is a useful measure for non-tax payers
4. The GRY is a useful measure for tax-payers
A) 1 and 3
B) 1 and 2
C) 1, 2 and 3
D) 1, 2 and 4
C - 1 (bond price higher than par = flat yeild < coupon), 2 (Bond price higher than par = GRY < flat yield) and 3 (GRY is useful to non-taxpayers)
If the bond price is greater than par: COUPON > FLAT YIELD > GRY
Find out why GRY are useful for non-taxpayers
What is a call provision is respect of a corporate bond?
A) It allows the issuer of the bond to alter the coupon rate at their discretion
B) It allows the issuer of the bond to alter the par value at its discretion
C) It allows the issuer of the bond to redeem the issue at its discretion
D) It allows the holder of the bond to have the bond redeemed at the holder’s discretion
C - It allows the issuer of the bond to redeem the issue at its discretion
A callable bond allows the issuer of the bond to redeem the issue (i.e. repay and retire it) early and at its discretion. This is usually done when the opportunity arises to refinance cheaper, as in when rates decline.
Which of the following is the best description of an index-lined gilt (ILG)?
A) A gilt whose price is linked to LIBOR
B) A gilt whose price is linked is directly linked to RPI
C) A gilt whose coupons and principal are linked to LIBOR
D) A gilt whose coupons and principal are linked to RPI
D - A gilt whose coupons and principal are linked to RPI
ILGs have BOTH their principal and coupons linked to RPI, which is measured using RPI
Consider a bond with a par value of £100, an annual coupon of £4, three full years to maturity (i.e. three more coupon payments) and a require return (Gross Redemption Yield) of 5%. What is the modified duration of this bond?
A) 2.75
B) 2.88
C) 2.54
D) 3.00
A - 2.75 years
STEP 1 CALCULATE BOND PRICE:
(4 / 1.05) + (4 / 1.05^2) + (104 / 1.05^3) = £97.28
= £3.81 + £3.63 + £89.84 = £97.28
STEP 2 CALCULATE MACAULAY DURATION:
Mac Duration is the (Sum of each PV Cashlow x Timeline of CF) / Bond Price being the sum of the PV of all cash flows SO
( (£3.81 x 1yr) + (£3.63 x 2yrs) + (£89.84 x 3yrs) ) / £97.28 = 2.884 years
STEP 3 CALCULATE MODIFIED DURATION:
Mod Duration is Mac Duration / (1 + GRY) SO
2.884 years / 1.05 = 2.75
Which bond would have the highest duration?
A) Eight-year floating rate note (FRNs) currently paying a coupon of 5%
B) Six-year, 6% coupon
C) Seven-year, 5% coupon
D) Five-year, 5% coupon
C - Seven year, 5% coupon
FRNs have a duration close to zero due to the regular resetting of the coupon rates to market rates. The seven-year has the longest maturity date hence this will have the highest duration given it also has the lowest coupon rate.
When using a bond’s duration to estimate its sensitivity to changes in yields, which of the following is correct?
A) When rates RISE, duration will OVERestimate the new price
B) When rates FALL, duration will OVERestimate the new price
C) When rates rise or fall, duration will UNDERestimate the new price
D) When rates rise or fall, duration will OVERestimate the new price
C - When rates rise or fall, duration will UNDERestimate the new price
The relationship between price and yield in CONVEX, whereas the duration method assumes it is linear. The convex line is ALWAYS ABOVE the straight line and thus duration UNDERESTIMATES (the movement in) the new price irrespective of the direction of rates.
Which credit rating is the highest sub-investment grade on the Standard and Poor’s (S&P’s) credit rating scale?
A) BBB
B) BB+
C) CCC
D) CC
B - BB+
S&P’s and Fitch’s Investment grades go AAA > AA > A > BBB
S&P’s Speculative Grades then follow on with > BB > B > CCC > CC > C > D
PLUS (+) rank above just the letter ratings, and MINUS (-) rank below just the letter ranking. I.e. AA+ > AA > AA-
Moody’s Investment grades go:
Aaa > Aa1-3 > A1-3 > Baa1-3
Then Moody’s Speculative grades follow on with:
> Ba1-3 > B1-3 > Caa1-3 > Ca > C
The lower the number, the higher the rank of that rating.
An investor is considering buying either a two-year bond or two consequetive one-year bonds. The two-year bond has a current price of £100 and a coupon of £5, while the one-year bond has a current market price of £100 and a coupon of £7. If the pure expectation hypothesis of the term structure holds, what is the implied yield (required return) on a one-year bond held during the second year of the two-year period?
A) 5.11%
B) 5.01%
C) 5.21%
D) 5.41%
B - 5.01%
Yield (spot rate 1) on the two-year bond (trading at par) = 6%
Yield (spot rate 2) on the one-year bond (trading at par) = 7%
Pure expectation theory believes the current L/T interest rate (spot rate 1) is the geometic average of the current S/T interest rate (spot rate 2) and the expected S/T rate in the future (being the forward rate you are trying to find) meaning:
(1 + SR2) ^2 = (1 + SR1) x (1 + FR)
SO (1.06) ^2 = (1.07) x (1 + FR)
REARRANGED: 1.06 ^2 / 1.07 = 1.0501= 5.01%
The Government issues a one-month Treasury Bill (T-Bill) for a price of £994, which a face value of £1,000. What is the annualised yield on this investment for an investor who holds the the T-Bill to maturity?
A) 7.34%
B) 8.46%
C) 14.66%
D) 18.32%
A - 7.34%
Using the Simple Interest calculation of:
( (PAR VALUE - PRICE) / PRICE ) x (365 / DAYS TO MATURITY) x 100
SO
( ( £1,000 - £994) / £994 ) x (365 / 30 ) x 100 = 7.34%
If you don’t multiple by the (365 / DAYS) you will get the ONE MONTH YIELD (0.60362%), but it is asking for the annualised yield so you need to add on the (365/DAYS) part.
