FI Flashcards
Q: What are the major types of fixed-income instruments?
A: Fixed-income instruments include loans, which are private and nontradable, and bonds (fixed-income securities), which are standardized, tradable debt investments.
Q: What are the key features specified in a fixed-income security?
A: Bonds specify the issuer, maturity, principal (par value), coupon rate & frequency, seniority, and contingency provisions (e.g., callable or convertible bonds).
Q: How do coupon payments and yield work in bonds?
A: A bond’s coupon rate is the percentage of par value paid as interest. Bond yields and prices move inversely: when prices fall, yields rise, and vice versa.
Q: What does the yield curve represent?
A: The yield curve plots bond yields against maturities. A normal yield curve slopes upward, while an inverted yield curve slopes downward. Credit spreads measure the extra return for taking on credit risk.
Q: What is a bond indenture, and what are covenants?
A: A bond indenture is the legal contract between the issuer and bondholders. Affirmative covenants require issuers to fulfill obligations, while negative covenants restrict certain actions to protect bondholders.
Q: How do different types of bonds get repaid?
A:
Sovereign bonds: Repaid via taxes or currency issuance.
Local government bonds: Repaid through taxes or infrastructure revenue.
Corporate bonds: Secured bonds have collateral; unsecured bonds rely on company cash flow.
Asset-backed securities (ABS): Paid from financial assets in a special-purpose entity.
A bond’s indenture:
A)
contains its covenants.
B)
is only required in the event of a lien on collateral.
C)
relates only to its interest and principal payments.
Explanation
An indenture is the contract between the company and its bondholders and contains the bond’s covenants. (Module 47.1, LOS 47.b)
A clause in a bond indenture that requires the borrower to perform a certain action is most accurately described as a(n):
A)
trust deed.
B)
negative covenant.
C)
affirmative covenant.
Correct Answer
Explanation
Affirmative covenants require the borrower to perform certain actions. Negative covenants restrict the borrower from performing certain actions. Trust deed is another name for a bond indenture. (Module 47.1, LOS 47.b)
Q: What is the difference between a bullet bond and a fully amortizing bond?
A: A bullet bond repays the principal in a single payment at maturity, while a fully amortizing bond repays both interest and principal over time, ensuring the full principal is paid off by the final payment.
Q: What is a sinking fund provision in bonds?
A: A sinking fund requires periodic principal repayments over the bond’s life, reducing credit risk but potentially creating reinvestment risk for bondholders.
Q: How do floating-rate notes (FRNs) determine their coupon payments?
A: FRNs pay interest based on a market reference rate (MRR) plus a fixed margin (credit spread), adjusting with market rates to reduce interest rate risk.
Q: What is the key difference between callable and putable bonds?
A: A callable bond allows the issuer to redeem it early, benefiting the issuer if interest rates fall, while a putable bond allows bondholders to sell it back to the issuer, benefiting them if interest rates rise or credit quality declines.
Q: What is a convertible bond?
A: A convertible bond allows bondholders to exchange it for a predetermined number of shares of the issuing company’s stock, offering potential upside if the stock price rises.
Q: What are contingent convertible bonds (CoCos), and why are they important for banks?
A: CoCos automatically convert to equity when a bank’s capital falls below a required threshold, helping the bank meet regulatory equity requirements.
With which of the following features of a corporate bond issue does an investor most likely face the risk of redemption before maturity?
A)
Floating-rate notes.
B)
Sinking fund.
C)
Term maturity structure.
Explanation
With a sinking fund, the issuer must redeem part of the issue before maturity, but the specific bonds to be redeemed are not known. Floating-rate notes have an unknown future coupon because it relates to a variable market reference rate; however, they have a known maturity date. In an issue with a term maturity structure, all the bonds are scheduled to mature on the same date. (Module 48.1, LOS 48.a)
A 10-year bond pays no interest for three years, then pays $229.25, followed by payments of $35 semiannually for seven years, and an additional $1,000 at maturity. This bond is most likely a:
A)
step-up bond.
B)
zero-coupon bond.
C)
deferred coupon bond.
Explanation
This pattern describes a deferred-coupon bond. The first payment of $229.25 is the value of the accrued coupon payments for the first three years. (Module 48.1, LOS 48.a)
Which of the following most accurately describes the maximum price for a currently callable bond?
A)
Its par value.
B)
The call price.
C)
The present value of its par value.
Explanation
If the price of the bond increases above the call price stipulated in the bond indenture, it will benefit the issuer to call the bond. Theoretically, the price of a currently callable bond should never rise above its call price. (Module 48.1, LOS 48.a)
An investor buys a pure-discount bond, holds it to maturity, and receives its par value. For tax purposes, the increase in the bond’s value is most likely to be treated as:
A)
a capital gain.
B)
interest income.
C)
tax-exempt income.
Explanation
Tax authorities typically treat the increase in value of a pure-discount bond toward par as interest income to the bondholder. In many jurisdictions, this interest income is taxed periodically during the life of the bond, even though the bondholder does not receive any cash until maturity. (Module 48.1, LOS 48.b)
Q: What are the primary segments of the global fixed-income market?
A: Fixed-income markets are segmented by issuer type, credit quality, and time to maturity. Additional classifications include currency, geography, and ESG factors.
Q: How are fixed-income securities classified by issuer type?
A: The main issuer categories are:
Governments (sovereign and non-sovereign)
Corporations
Special purpose entities (e.g., asset-backed securities)
Q: What is the difference between investment-grade and high-yield bonds?
A:
Investment-grade: Rated BBB– (S&P) / Baa3 (Moody’s) or higher
High-yield (junk bonds): Rated BB+ (S&P) / Ba1 (Moody’s) or lower
Q: What are the key differences between fixed-income and equity indexes?
A:
Bond indexes have more constituents due to multiple bond issues per issuer.
Fixed-income indexes have higher turnover due to frequent bond issuance and maturity.
Broad bond indexes have large sovereign bond weights, influenced by issuance trends.
Q: What are the main differences between primary and secondary bond markets?
A:
Primary market: New bond issues sold to investors via underwritten offerings, best-efforts sales, or auctions.
Secondary market: Previously issued bonds traded among investors, mostly over-the-counter (OTC) via dealer networks.
Q: What factors influence investor positioning in the fixed-income market?
A:
Pension funds & insurers: Long-term, investment-grade bonds
Corporations: Short-term instruments (commercial paper, repos)
Central banks: Intermediate-term Treasuries for monetary policy
Bond funds & ETFs: Investment-grade intermediates; hedge funds may invest in high-yield bonds
Funds required by a corporation to finance investment in seasonal working capital are most likely raised through issuing:
A)
secured bonds.
Incorrect Answer
B)
Treasury notes.
C)
commercial paper.
Explanation
Corporations are most likely to fund short-term seasonal investment in working capital by issuing short-term commercial paper because its maturity (less than a year) will match the required investment period in working capital. Intermediate-term corporate bonds are usually issued to invest in longer-term working capital requirements and medium-term fixed capital investments. A corporation cannot issue Treasury notes, which are intermediate-term securities issued by governments. (Module 49.1, LOS 49.a)
Compared to equity indexes, aggregate fixed-income indexes are most likely to have a lower:
A)
turnover.
Incorrect Answer
B)
weight in the corporate sector.
C)
number of constituents.
Explanation
Aggregate fixed-income indexes include constituents from all sectors. Hence, fixed-income indexes will have higher weights allocated to sovereign issuers and lower weights to corporate issuers than equity indexes, which are based purely on corporate issuers of equity. A fixed-income index is expected to have higher turnover (due to maturing bonds and frequent re-issues) and a higher number of constituents (due to a single issuer typically having more bond issues in existence than equity issues). (Module 49.1, LOS 49.b)
In which type of primary market transaction does an investment bank sell bonds on a commission basis?
A)
Single-price auction.
B)
Best-efforts offering.
C)
Underwritten offering.
Explanation
In a best-efforts offering, the investment bank or banks do not underwrite (i.e., purchase all of) a bond issue, but rather sell the bonds on a commission basis. Bonds sold by auction are offered directly to buyers by the issuer, typically a government. (Module 49.1, LOS 49.c)
Secondary market bond transactions most likely take place:
A)
in dealer markets.
B)
in brokered markets.
C)
on organized exchanges.
Explanation
The secondary market for bonds is primarily a dealer market in which dealers post bid and ask prices. (Module 49.1, LOS 49.c)
Sovereign bonds are described as “on the run” when they:
A)
are the most recent issue in a specific maturity.
B)
have increased substantially in price since they were issued.
C)
receive greater-than-expected demand from auction bidders.
Explanation
Sovereign bonds are described as “on the run” when they represent the most recent issue in a specific maturity. (Module 49.1, LOS 49.c)
Restrictive covenants are most likely to be placed on borrowers under a:
A)
revolving line of credit.
B)
factoring arrangement.
C)
committed line of credit.
Explanation
Restrictive covenants are most likely to be placed on borrowers using revolving lines of credit because these agreements require banks to commit funds over the longest terms. A factoring arrangement involves selling accounts receivable to a third party. (Module 50.1, LOS 50.a)
A borrower pledges $100 million of securities as collateral for an overnight repo with a repo rate of 4% and an initial margin of 101%. The purchase price of the repo is closest to:
A)
$99,000,000.
B)
$99,009,901.
C)
$101,000,000.
Explanation
Repo purchase price (loan amount) = market value of securities / initial margin
= $100,000,000 / 1
.01 = $99,009,901
A borrower pledges $100 million of securities as collateral for an overnight repo with a repo rate of 4% and an initial margin of 101%. Assuming 360 days in a year, the interest paid under the repo is closest to:
A)
$10,891.
B)
$11,001.
C)
$11,111.
Explanation
Repo purchase price (loan amount) = market value of securities / initial margin
= $100,000,000 / 1
.01 = $99,009,901
Repo interest = $99,009,901 × 0.04 × (1 / 360) = $11,001.10
A borrower pledges $100 million of securities as collateral for an overnight repo with a repo rate of 4% and an initial margin of 101%. The haircut on collateral is closest to:
A)
0.01%.
B)
0.99%.
C)
1.01%.
Explanation
1 – 1 / 1.01 = 0.0099, or 0.99%.
Relative to a long-term high-yield bond issue, an investment-grade bond issue is most likely to have a:
A)
longer maturity.
Correct Answer
B)
greater number of covenants.
Incorrect Answer
C)
higher proportion of its yield related to credit spreads.
Incorrect Answer
Explanation
An investment grade bond is likely to have a longer maturity than a high yield bond because high yield issues tend to be restricted to 10-year maturity or less, while investment grade issuers can issue bonds of any maturity. Investment-grade bond issues typically have fewer restrictive covenants than high yield issues. The proportion of yield that is credit spread is likely to be lower for investment grade issues, where yield is primarily composed of benchmark rates.(Module 50.1, LOS 50.c)
Front: What are the primary short-term funding options for nonfinancial corporations?
Back: Nonfinancial corporations can raise short-term funds through:
Loan financing – Bank lines of credit (uncommitted, committed, and revolving).
Security-based financing – Issuing commercial paper (CP) or asset-backed CP.
Front: What are the differences between uncommitted, committed, and revolving lines of credit?
Back:
Uncommitted: Bank may refuse funding, no fees beyond interest, flexible.
Committed: Reliable, commitment fees (~50 bps), subject to renewal risk.
Revolving: Most reliable, long-term, often includes restrictive covenants.
Front: What are secured (asset-backed) loans, and how do they differ from factoring?
Back:
Secured loans: Backed by collateral (fixed assets, receivables, inventory).
Factoring: Receivables sold at a discount to a lender (“factor”), transferring credit and collection risk.
Front: What is commercial paper (CP), and what risks are associated with it?
Back:
CP: Short-term unsecured debt issued by large corporations.
Risks: Rollover risk – inability to issue new CP to replace maturing paper.
Mitigation: Backup credit lines (liquidity enhancement).
Front: What are the major short-term funding sources for financial institutions?
Back:
Commercial & retail deposits: Checking (demand) deposits, savings deposits, CDs (negotiable/nonnegotiable).
Interbank funds: Banks lend to each other (secured/unsecured) at market rates.
Central bank funds: Excess reserves loaned to banks at the central bank funds rate.
Commercial paper & ABCP: Banks issue CP or asset-backed CP via special purpose entities (SPEs).
Front: What are negotiable vs. nonnegotiable certificates of deposit (CDs)?
Back:
Nonnegotiable CDs: Fixed-term deposits, early withdrawal incurs penalty.
Negotiable CDs: Can be sold before maturity in the open market; used in wholesale funding.
Q: What are the key characteristics of sovereign debt issuance?
A: Sovereign debt is issued by national governments, backed by taxation power, and typically carries the highest credit rating in domestic markets. Developed market debt is stable and denominated in reserve currencies, while emerging market debt may be riskier and subject to currency and economic instability.
Q: What is the difference between domestic debt and external debt for sovereign issuers?
A: Domestic debt is issued in the home currency and held by domestic investors, while external debt is owed to foreign creditors and may be denominated in a reserve currency, reducing currency risk for investors but creating repayment risk for the issuer.
Q: How does fiscal policy influence government debt issuance?
A: Governments issue debt to finance spending, often adjusting issuance based on fiscal policy needs. Expansionary fiscal policies (tax cuts, increased spending) lead to higher debt issuance, while contractionary policies reduce it. Analysts consider cyclical revenues, inflation sensitivity, and debt structure when forecasting issuance.
Q: What are non-sovereign government bonds, and how do they differ from sovereign bonds?
A: Non-sovereign bonds are issued by states, provinces, and municipalities for public projects. They include general obligation bonds (backed by taxes) and revenue bonds (backed by project revenues). Agency bonds, issued by government-backed entities, often have credit ratings aligned with the sovereign issuer.
Q: What are supranational bonds, and why do they have high credit quality?
A: Supranational bonds are issued by international institutions like the World Bank and IMF to promote economic development. They typically have high credit ratings and liquidity due to backing by multiple sovereign governments and strong financial management.
Q: Why do governments issue bonds across different maturities?
A: Issuing bonds across maturities helps manage rollover risk, stabilize funding costs, and provide liquidity in government debt markets. Short-term debt is liquid and low-yielding, while long-term debt serves as a benchmark for interest rate risk and monetary policy.
Bonds issued by the World Bank are best described as:
A)
quasi-government bonds.
Incorrect Answer
B)
global bonds.
C)
supranational bonds.
Explanation
Bonds issued by the World Bank, which is a multilateral agency operating globally, are termed supranational bonds. (Module 51.1, LOS 51.a)
A foreign investor who invests in the USD-denominated external debt of an emerging market government has currency risk that is best described as:
A)
direct.
B)
indirect.
C)
hedged.
Explanation
While the U.S. investor will not have the direct currency exposure of holding foreign-denominated debt, they still face indirect currency exposure from the emerging market government having to raise USD through international transactions to repay their external debt. (Module 51.1, LOS 51.a)
Investors are guaranteed a bond allocation in a Treasury bond auction when:
A)
they submit a noncompetitive bid.
B)
the auction is a single-price auction.
C)
they submit a competitive bid in a multiple-price auction.
Explanation
Investors who make noncompetitive bids in government bond auctions are guaranteed to have their allocations met at a price determined by the competitive bids. Competitive bidders are not guaranteed allocations in either single-price or multiple-price auctions. (Module 51.1, LOS 51.b)
A $1,000 par, 5% coupon, 20-year annual-pay bond has a YTM of 6.5%. If the YTM remains unchanged, how much will the bond value increase over the next three years?
A)
$13.62.
B)
$13.78.
C)
$13.96.
Explanation
With 20 years to maturity, the value of the bond with an annual-pay yield of 6.5% is N = 20; PMT = 50; FV = 1,000; I/Y = 6.5; and CPT → PV = –834.72. With N = 17, CPT → PV = –848.34, so the value will increase $13.62. (Module 52.1, LOS 52.a, 52.b)
Example: Computing simple yield
A 3-year, 8% coupon, semiannual-pay bond is priced at 90.165. Calculate the simple yield.
Answer:
The discount from par value is 100 – 90.165 = 9.835. Annual straight-line amortization of the discount is 9.835 / 3 = 3.278:
simple yield
=(8+3.278)/90.165=12.51%
Holding the effective annual yield constant, if the periodicity of a bond is increased, its stated YTM will:
A)
decrease.
B)
stay the same.
C)
increase.
Explanation
Due to their increased compounding frequency, bonds with higher periodicity will have a lower stated YTM for a certain level of effective annual yield (EAY). For example, for an EAY of 5% and periodicity of 2, the stated YTM must solve [1 + (YTM / 2)]2 = 1.05. Hence, YTM = 2 (1.051/2 – 1) = 4.94%. With periodicity of 4, the stated YTM must solve [1 + (YTM / 4)]4 = 1.05. Hence, YTM = 4 (1.051/4 – 1) = 4.91%. (Module 53.1, LOS 53.a)
A corporate bond is quoted at a spread of +235 basis points over an interpolated 12-year U.S. Treasury bond yield. This spread is a(n):
A)
G-spread.
B)
I-spread.
C)
Z-spread.
Explanation
G-spreads are quoted relative to an actual or interpolated government bond yield. I-spreads are quoted relative to swap rates. Z-spreads are calculated based on the shape of the benchmark yield curve. (Module 53.1, LOS 53.b)
For a callable bond, relative to its option-adjusted spread, its Z-spread is most likely to be:
A)
lower.
B)
the same.
C)
higher.
Explanation
A callable bond will offer a higher yield than an equivalent straight bond because the investor faces the call risk of the option. Hence, the Z-spread, which includes the impact of the option, will be higher than the OAS, which has removed the impact of the option. (Module 53.1, LOS 53.b)
Q: What is the definition of Yield to Maturity (YTM)?
A: YTM is the discount rate that equates the present value of a bond’s cash flows to its market price.
Q: How is the YTM stated for a semiannual coupon bond?
A: The YTM is twice the semiannual discount rate.
Flashcard 1: Floating-Rate Notes (FRNs) Stability
Q: Why are the values of floating-rate notes (FRNs) more stable than fixed-rate bonds?
A: FRNs have their coupon rates reset periodically based on a market reference rate (MRR), reducing price sensitivity to interest rate changes.
Q: What is the difference between the quoted margin (QM) and the discount margin (DM) in FRNs?
A: QM is the fixed margin added to the MRR at issuance, while DM is the margin required to price the FRN at par. If DM > QM, the FRN trades at a discount; if DM < QM, it trades at a premium.
Q: How does a change in an issuer’s credit quality affect an FRN’s price?
A: If credit risk increases, investors demand a higher DM, causing the FRN to trade below par. If credit risk decreases, DM falls below QM, leading to a premium price.
Q: How can you estimate an FRN’s value on a reset date?
A: Discount the expected future cash flows (based on MRR + QM) using the required return (MRR + DM). If DM > QM, the FRN trades below par; if DM < QM, it trades above par.
A floating-rate note has a quoted margin of +50 basis points and a required margin of +75 basis points. On its next reset date, the price of the note will be:
A)
equal to par value.
B)
less than par value.
C)
greater than par value.
Explanation
If the required margin is greater than the quoted margin, the credit quality of the issue has decreased, and the price on the reset date will be less than par value. (Module 54.1, LOS 54.a)
Which of the following money market yields is a bond equivalent yield?
A)
Add-on yield based on a 365-day year.
B)
Discount yield based on a 360-day year.
C)
Discount yield based on a 365-day year.
Explanation
An add-on yield based on a 365-day year is a bond equivalent yield. (Module 54.1, LOS 54.b)
Which of the following money market instruments has the highest bond equivalent yield?
A)
A 90-day Treasury bill quoted with a discount of 1% on a 360-day basis.
B)
A 183-day commercial paper quoted with a discount of 1% on a 365-day basis.
C)
A 91-day certificate of deposit offering an add-on rate of 1% on a 365-day basis.
Explanation
The bond equivalent yield is defined as the add-on yield quoted on a 365-day basis.
The 90-day Treasury is trading at a 1% × 90 / 360 = 0.25% discount to par. Hence, it is trading at a price of 99.75. The HPR is, therefore, 100 / 99.75 – 1 = 0.2506%, and the bond equivalent yield is 0.2506% × 365 / 90 = 1.016%. The commercial paper is trading at a 1% × 183 / 365 = 0.5014% discount to par. Hence, it is trading at a price of 99.4986. The HPR is, therefore, 100 / 99.4986 – 1 = 0.5039%, and the bond equivalent yield is 0.5039% × 365 / 183 = 1.005%. The quoted return of the certificate of deposit is already in bond equivalent form; hence, no translation is needed here. (Module 54.1, LOS 54.b)
Q: What is a spot rate?
A: A spot rate is the discount rate for a single future payment, observed from zero-coupon bonds. It varies by maturity and is sometimes called a zero-coupon rate.
Q: What is the spot curve?
A: The spot curve is a plot of spot rates against their maturities for a particular type of bond or issuer, such as U.S. Treasury bonds.
Q: What is the no-arbitrage price of a bond?
A: The no-arbitrage price of a bond is the price calculated using spot rates, ensuring that there are no arbitrage opportunities in the market.
Q: How does the yield to maturity (YTM) relate to spot rates?
A: The YTM assumes a single discount rate for all cash flows, while spot rates vary by maturity. If a bond’s price is slightly above par, its YTM is slightly lower than its coupon rate.
A market rate of discount for a single payment to be made in the future is a:
A)
spot rate.
B)
simple yield.
C)
forward rate.
Explanation
A spot rate is a discount rate for a single future payment. Simple yield is a measure of a bond’s yield that accounts for coupon interest and assumes straight-line amortization of a discount or premium. A forward rate is an interest rate for a future period, such as a 3-month rate six months from today. (Module 55.1, LOS 55.a)
Which of the following yield curves is least likely to consist of observed yields in the market?
A)
Forward yield curve.
B)
Par bond yield curve.
C)
Coupon bond yield curve.
Explanation
Par bond yield curves are based on the theoretical yields that would cause bonds at each maturity to be priced at par. Coupon bond yields and forward interest rates can be observed directly from market transactions. (Module 55.1, LOS 55.b)
The 4-year spot rate is 9.45%, and the 3-year spot rate is 9.85%. What is the 1-year forward rate three years from today?
A)
8.258%.
B)
9.850%.
C)
11.059%.
Explanation
(1.0945)4 =(1.0985)3 × (1 + 3y1y)
3y1y=(1.0945)4(1.0985)3−1=8.258%
approximate forward rate = 4(9.45%) − 3(9.85%) = 8.25%
The 1-year spot rate is 1% and the 1y1y rate is 3%. Which of the following statements is most accurate?
A)
The 2-year spot is just below 2%, and the 2-year par yield is just below the 2-year spot rate.
B)
The 2-year spot is just below 2%, and the 2-year par yield is just above the 2-year spot rate.
C)
The 2-year spot is just below 4%, and the 2-year par yield is just below the 2-year spot rate.
Explanation
The 2-year spot rate must reflect the periodic rates of 1% in the first period and 3% in the second period—hence, the 2-year spot will be approximately 2%. Given that forward rates are rising with maturity, spot rates will be rising with maturity at a slower pace, and par yields will also be rising, but slightly below spot rates. So, the correct answer is that the 2-year spot is just below 2%, and the 2-year par yield is just below the 2-year spot rate. (Module 55.1, LOS 55.c)
Q: What are the three sources of returns from investing in a fixed-rate bond?
A: (1) Coupon and principal payments, (2) Interest earned on reinvested coupons, (3) Capital gain or loss if the bond is sold before maturity.
Q: What happens to an investor’s return if they hold a fixed-rate bond to maturity and the YTM remains unchanged?
A: The investor will earn an annualized rate of return equal to the YTM at purchase.
Q: How does a change in the bond’s YTM after purchase but before the first coupon date affect returns for an investor holding to maturity?
A: If the YTM increases, the realized return will be higher than the original YTM. If the YTM decreases, the realized return will be lower.
Q: How does YTM change impact an investor with a short investment horizon?
A: If YTM increases, the investor’s return is lower than the original YTM due to price risk. If YTM decreases, the return is higher due to a price gain.
Q: What is Macaulay duration?
A: The weighted average time until receipt of a bond’s cash flows, where weights are based on the present value of each cash flow relative to the bond’s price.
Q: What is the investment horizon where price risk and reinvestment risk balance each other?
A: The horizon equal to the bond’s Macaulay duration, where gains from price changes offset reinvestment income losses.
The largest component of returns for a 7-year zero-coupon bond yielding 8% and held to maturity is:
A)
capital gains.
B)
interest income.
C)
reinvestment income.
Incorrect Answer
Explanation
The increase in value of a zero-coupon bond over its life is interest income. A zero-coupon bond has no reinvestment risk over its life. A bond held to maturity has no capital gain or loss. (Module 56.1, LOS 56.a)
An investor buys a 10-year bond with a 6.5% annual coupon and a YTM of 6%. Before the first coupon payment is made, the YTM for the bond decreases to 5.5%. Assuming coupon payments are reinvested at the YTM, the investor’s return when the bond is held to maturity is:
A)
less than 6.0%.
Correct Answer
B)
equal to 6.0%.
Incorrect Answer
C)
greater than 6.0%.
Incorrect Answer
Explanation
The investment horizon is maturity, which means that the investor faces reinvestment risk (on average, the cash flows of the bond are received before maturity) and zero price risk. The decrease in the YTM to 5.5% will decrease the reinvestment income over the life of the bond so that the investor will earn less than 6%, the YTM at purchase. (Module 56.1, LOS 56.a)
Assuming coupon interest is reinvested at a bond’s YTM, what is the interest portion of an 18-year, $1,000 par, 5% annual coupon bond’s return if it is purchased at par and held to maturity?
A)
$576.95.
B)
$1,406.62.
C)
$1,476.95.
Explanation
The interest portion of a bond’s return is the sum of the coupon payments and interest earned from reinvesting coupon payments over the holding period:
N = 18; PMT = 50; PV = 0; I/Y = 5%; CPT → FV = –1,406.62
(Module 56.1, LOS 56.a)
An investor buys a 15-year, £800,000, zero-coupon bond with an annual YTM of 7.3%. If she sells the bond after three years for £346,333, she will have:
A)
a capital gain.
B)
a capital loss.
C)
neither a capital gain nor a capital loss.
Explanation
The price of the bond after three years that will generate neither a capital gain nor a capital loss is the price if the YTM remains at 7.3%. After three years, the present value of the bond is 800,000 / 1.07312 = 343,473.57, so she will have a capital gain relative to the bond’s carrying value. (Module 56.1, LOS 56.a)
An investor with an investment horizon of six years buys a bond with a Macaulay duration of seven years. This investment has:
A)
no duration gap.
B)
a positive duration gap.
C)
a negative duration gap.
Explanation
Duration gap is the Macaulay duration minus the investment horizon. This bond has a Macaulay duration greater than six years, and the investment has a positive duration gap. (Module 56.1, LOS 56.b)
Q: What is the formula for Modified Duration (ModDur) for an annual-pay bond?
A: ModDur = MacDur / (1 + YTM)
Q: How do you approximate Modified Duration using bond prices?
A: Approximate ModDur = (V₋ – V₊) / (2 × V₀ × ΔYTM), where V₋ is the price when YTM decreases, V₊ is the price when YTM increases, and V₀ is the current price.
Q: What does Modified Duration represent in relation to a bond’s price and YTM?
.
A: It estimates the percentage change in a bond’s price for a 1% change in YTM
Q: How is Money Duration calculated?
A: Money Duration = ModDur × Full Price of Bond Position
Q: What is the Price Value of a Basis Point (PVBP)?
A: PVBP is the money change in the full price of a bond when YTM changes by 1 basis point (0.01%).
Q: How do you calculate PVBP?
A: PVBP = (V₋ – V₊) / 2, where V₋ is the bond price when YTM decreases by 1 bp, and V₊ is the price when YTM increases by 1 bp.
All else equal, which of the following bonds is likely to have the highest price risk?
A)
A 10-year maturity semiannual-pay floating-rate note.
B)
A 2-year zero-coupon bond.
C)
A 2-year 10% semiannual-pay bond.
Explanation
The price risk of the FRN is very low because at the next coupon payment date, the coupons will reset to market rates, and the FRN price will reset to par. Lower coupons, all else equal, lead to greater price risk. Therefore the 2-year zero-coupon bond will have more price risk than the 2-year 10% semiannual-pay bond.
Q: What is convexity, and how does it improve bond price estimation?
A: Convexity measures the curvature of the price-yield relationship. Adding a convexity adjustment improves price estimates, especially for large yield changes, by accounting for the non-linearity of bond prices.
Q: How do bond characteristics affect convexity?
A: Convexity increases with:
Longer maturity
Lower coupon rate
Lower yield to maturity (YTM)
For two bonds with equal duration, the one with more dispersed cash flows has higher convexity.
Q: What is a key limitation of using weighted average duration for portfolios?
A: It assumes a parallel shift in the yield curve. However, real-world yield changes often involve curve steepening or twists, making this approach less accurate for non-parallel shifts.
Portfolio duration based on weighted average durations of constituents of the portfolio assumes:
A)
yields change uniformly across all maturities.
B)
the portfolio does not include bonds with embedded options.
C)
the portfolio’s internal rate of return is equal
Explanation
Portfolio duration is limited as a measure of interest rate risk because it assumes parallel shifts in the yield curve; that is, the discount rate at each maturity changes by the same amount. (Module 58.1, LOS 58.c)
Q: Why are effective duration and effective convexity the most appropriate measures of interest rate risk for bonds with embedded options?
A: Bonds with embedded options have uncertain future cash flows and redemption dates, meaning they do not have a well-defined yield. Effective duration and convexity measure price sensitivity based on shifts in the benchmark curve, rather than changes in the bond’s YTM, making them more suitable for these bonds.
Q: What is key rate duration and how is it used?
A: Key rate duration measures a bond’s price sensitivity to changes in yield at a specific maturity, holding other yields constant. It is useful for analyzing shaping risk (nonparallel shifts in the yield curve) and the sum of a bond’s key rate durations equals its effective duration.
Q: How do callable and putable bonds differ in terms of convexity?
A: Callable bonds can exhibit negative convexity at low yields because the call option limits price appreciation. Putable bonds always have positive convexity since the put option limits price depreciation at high yields.
Q: What is the difference between empirical duration and analytical duration?
A: Analytical duration is derived from mathematical models assuming constant credit spreads, while empirical duration is based on observed historical data and accounts for real-world factors like changing credit spreads, making it more useful for risky corporate bonds during market stress.
Effective duration is more appropriate than modified duration for estimating interest rate risk for bonds with embedded options because these bonds:
A)
tend to have greater credit risk than option-free bonds.
B)
exhibit high convexity that makes modified duration less accurate.
C)
have uncertain cash flows that depend on the path of interest rate changes.
Explanation
Because bonds with embedded options have cash flows that are uncertain and depend on future interest rates, effective duration must be used. (Module 59.1, LOS 59.a)
When an embedded option has significant value, relative to an equivalent option-free bond, the effective duration of a bond with an embedded option will most likely be:
A)
lower.
B)
the same.
C)
higher.
Explanation
Embedded options decrease the duration of the bond relative to an equivalent option-free bond when the option has significant value. (Module 59.1, LOS 59.b)
Which of the following bonds is most likely to exhibit negative convexity?
A)
Callable bonds in a low-yield environment.
B)
Callable bonds in a high-yield environment.
C)
Putable bonds in a high-yield environment.
Explanation
Negative convexity is exhibited only by callable bonds in a low-yield environment where the call price creates a ceiling on the price of the callable bond, causing the rate of price rises to decrease as yields fall. Putable bonds never exhibit negative convexity. (Module 59.1, LOS 59.b)
A bond portfolio manager who wants to estimate the sensitivity of the portfolio’s value to changes in the 5-year yield only should use a(n):
A)
key rate duration.
B)
Macaulay duration.
C)
effective duration.
Explanation
Key rate duration refers to the sensitivity of a bond or portfolio value to a change in one specific maturity yield. (Module 59.1, LOS 59.c)
Assume that a bond has an effective duration of 10.5 and a convexity of 97.3. Using both of these measures, the estimated percentage change in price for this bond, in response to a decline in the yield curve of 200 basis points, is closest to:
A)
19.05%.
B)
22.95%.
C)
24.89%.
Explanation
Total estimated price change = (duration effect + convexity effect)
= {[–10.5 × (–0.02)] + [1/2 × 97.3 × (–0.02)2]} × 100 = 21.0% + 1.95% = 22.95%
(Module 59.1, LOS 59.b)
Q: What is credit risk?
A: Credit risk is the risk of losses for fixed income investors due to a borrower’s failure to make interest or principal payments, known as default.
Q: What are the key drivers of credit risk?
A: The key drivers are borrower-specific factors (bottom-up) and economic conditions (top-down), also called the Cs of credit analysis.
Q: What are the 5 bottom-up credit analysis factors?
A: Capacity, Capital, Collateral, Covenants, and Character.
Q: What are the 3 top-down credit analysis factors?
A: Conditions (economic environment), Country (geopolitical and legal systems), and Currency (exchange rate fluctuations).
Q: What is the formula for expected loss from credit risk?
A: Expected loss = Probability of default × Loss given default.
Q: How is loss given default (LGD%) calculated?
A: LGD% = Expected exposure × (1 – Recovery rate).
Q: What do the terms “pari passu” and “cross-default” mean?
A: “Pari passu” means equal ranking among bondholders, while “cross-default” means defaulting on one bond leads to default on all.
Q: How is the credit spread estimated?
A: Credit spread ≈ Probability of default × LGD%.
Q: What are the main risks of relying on credit rating agencies?
A: Ratings lag market pricing, some risks are hard to assess, and rating agencies can make errors.
Q: What factors influence credit spread volatility?
A: Macroeconomic conditions, issuer-specific risks, and market liquidity risk.
Would you like any refinements or additional flashcards?
A)
default risk and yield spread.
B)
probability of default and loss severity.
C)
loss severity and yield spread.
Explanation
Expected loss is composed of probability of default and loss severity. Yield spreads reflect the credit risk of a borrower, but they are a reflection of expected loss rather than a component of it. (Module 60.1, LOS 60.a)
Expected loss can decrease with an increase in a bond’s:
A)
probability of default.
B)
loss severity.
C)
recovery rate.
Explanation
An increase in the recovery rate means that the loss severity has decreased, which decreases expected loss. (Module 60.1, LOS 60.a)
Which of the following factors in credit analysis is least likely a top-down factor?
A)
Capital.
Correct Answer
B)
Conditions.
C)
Currency.
Explanation
Top-down credit analysis factors include country, conditions, and currency. Capital is a bottom-up factor relating to the reliance of the issuer on debt and the availability of other sources of funding. (Module 60.1, LOS 60.b)
Higher credit risk is indicated by a higher:
A)
cash flow/debt ratio.
B)
debt/EBITDA ratio.
C)
EBITDA/interest expense ratio.
Explanation
A higher debt/EBITDA ratio is sign of higher leverage and higher credit risk. Higher cash flow/debt and EBITDA/interest expense ratios indicate lower credit risk. (Module 60.1, LOS 60.a)
Compared to shorter-duration bonds, longer-duration bonds:
A)
have smaller bid-ask spreads.
Incorrect Answer
B)
are less sensitive to credit spreads.
C)
have less certainty regarding future creditworthiness.
Explanation
Longer-duration bonds usually have longer maturities and carry more uncertainty of future creditworthiness. (Module 60.1, LOS 60.c)
Q: What is the primary source of a sovereign government’s ability to service its debt?
A: A sovereign government primarily services its debt through its ability to tax economic activity within its jurisdiction.
Q: What are the five qualitative factors used to assess sovereign creditworthiness?
A:
Institutions and policy – Political and economic stability, legal protections, and willingness to repay debt.
Fiscal flexibility – Ability to adjust tax collection or spending to meet debt obligations.
Monetary effectiveness – Central bank independence and control over inflation.
Economic flexibility – Growth trends, income per capita, and economic diversity.
External status – International standing of currency and geopolitical risks.
Q: What are the three key quantitative factors used to assess sovereign creditworthiness?
A:
Fiscal strength – Low debt-to-GDP and interest-to-GDP ratios.
Economic growth and stability – High real GDP growth and low volatility.
External stability – High foreign exchange reserves and low external debt.
Q: What are the four main types of non-sovereign government debt issuers?
A:
Agencies – Quasi-government entities with implicit government backing.
Government sector banks – Financial intermediaries with government missions.
Supranational issuers – Organizations like the World Bank funded by multiple sovereigns.
Regional governments – States, provinces, and municipalities issuing general obligation or revenue bonds.
Q: What is the key difference between general obligation (GO) bonds and revenue bonds?
A: GO bonds are backed by the issuer’s taxing power, while revenue bonds are backed solely by cash flows from a specific project (e.g., toll bridges, airports).
Q: How is the credit risk of revenue bonds analyzed?
A: By evaluating the project’s cash flows and debt-service coverage ratio (revenue after operating costs relative to required debt payments). Revenue bonds typically have higher credit risk than GO bonds.
One key difference between sovereign bonds and municipal bonds is that sovereign issuers:
A)
can print money.
B)
have government taxing power.
C)
are affected by economic conditions.
Incorrect Answer
Explanation
Sovereign entities can print money to repay debt, while municipal borrowers cannot. Both sovereign and municipal entities have taxing powers, and both are affected by economic conditions. (Module 61.1, LOS 61.a)
All else equal, a sovereign debt issuer with higher credit quality will most likely have a higher:
A)
debt burden ratio.
B)
debt affordability ratio.
C)
foreign exchange reserve ratio.
Explanation
A foreign exchange reserve ratio looks at the level of foreign exchange reserves relative to external debt. A high ratio implies higher credit quality on an external stability basis. Debt burden ratios measure the level of sovereign debt relative to GDP or tax revenue. As such, a higher ratio indicates a more indebted nation and therefore lower credit quality due to less fiscal strength. Debt affordability ratios compare interest payments to GDP or revenue. When these ratios are high, this suggests lower credit quality on a fiscal strength basis. (Module 61.1, LOS 61.a)
Question: What are the five qualitative factors used to assess sovereign creditworthiness?
Answer:
Institutions & Policy – Stability, legal protections, transparency, and debt repayment culture.
Fiscal Flexibility – Ability to raise taxes or cut spending.
Monetary Effectiveness – Central bank independence and inflation control.
Economic Flexibility – Growth trends, income per capita, and economic diversity.
External Status – Currency reserve status, external debt, and geopolitical risks.
Question: What are the three key quantitative factors in sovereign credit analysis?
Answer:
Fiscal Strength – Low debt-to-GDP and low interest-to-revenue ratios.
Economic Growth & Stability – High real GDP growth, large economy size, and low GDP volatility.
External Stability – High FX reserves, low external debt, and current account surplus sustainability.
Question: Name four types of non-sovereign government debt issuers and their characteristics.
Answer:
Agencies – Quasi-government entities with implicit government support.
Government Sector Banks – Finance institutions with specific public missions.
Supranational Issuers – Multinational institutions like the World Bank.
Regional Governments – Local governments issuing general obligation or revenue bonds.
Question: What are four key qualitative factors in corporate credit analysis?
Answer:
Business Model – Stability and predictability of cash flows.
Industry Competition – Less competition is favorable.
Business Risk – Stability of revenues and margins.
Corporate Governance – Fair treatment of debtholders, debt covenants, and accounting policies.
Question: What are the key financial characteristics of a high-credit-quality corporation?
Answer:
Strong Operating Profits & Recurring Revenues
Low Leverage – Less reliance on debt.
High Debt Service Coverage – Strong EBIT-to-interest ratio.
High Liquidity – Ability to meet short-term obligations.
Question: How does debt seniority impact credit ratings, and what is notching?
Answer:
Seniority Ranking:
First lien/mortgage
Senior secured
Junior secured
Senior unsecured
Senior subordinated
Subordinated
Junior subordinated
Notching: Adjusting issue credit ratings based on seniority, recovery prospects, and structural subordination. More common for lower-rated issuers.
Which of the following scenarios is most likely to occur as a result of a corporate issuer moving from issuing unsecured debt to secured debt?
A)
The issuer is able to access debt markets that were previously unavailable to them.
B)
The market yield on the debt will increase.
C)
The issuer needs to include fewer covenants in their bond indentures.
Explanation
By offering secured debt, the issuer may attract investments from investors that would have otherwise considered the unsecured bond of the issuer to be too risky. It is likely that the security will decrease the cost of borrowing for the issuer. It is also likely that secured debt will have more covenants stating the legal rights that lenders have over the collateral pledged as security for the issue. (Module 62.1, LOS 62.a)
The absolute priority of claims in a bankruptcy might be violated because:
A)
of the pari passu principle.
B)
creditors negotiate a different outcome.
C)
available funds must be distributed equally among creditors.
Explanation
A negotiated bankruptcy settlement does not always follow the absolute priority of claims. (Module 62.1, LOS 62.c)
Notching is best described as a difference between a(n):
A)
issuer credit rating and an issue credit rating.
B)
company credit rating and an industry average credit rating.
C)
investment-grade credit rating and a non-investment-grade credit rating.
Explanation
Notching refers to the credit rating agency practice of distinguishing between the credit rating of an issuer (generally for its senior unsecured debt) and the credit rating of particular debt issues from that issuer, which may differ from the issuer rating because of provisions such as seniority. (Module 62.1, LOS 62.c)
Higher credit risk is indicated by a higher:
A)
RCF/net debt ratio.
B)
debt/EBITDA ratio.
C)
EBIT/interest expense ratio.
Explanation
A higher debt/EBITDA ratio is a sign of higher leverage and higher credit risk. Higher RCF/net debt and EBITDA/interest expense ratios indicate lower credit risk. (Module 62.1, LOS 62.b)
Front: What are the benefits of securitization to issuers (originating banks or corporations)?
Back: - Increased business activity (frees up capital for more lending)
Improved profitability (fees from origination and securitization)
Lower capital reserves (removes credit risk from balance sheet)
Improved liquidity (converts illiquid loans into cash)
Front: How does securitization benefit investors?
Back: - Tailored risk and return (ABSs designed to fit investor needs)
Access to loan portfolios without needing origination expertise
Increased liquidity (ABSs can be traded more easily than individual loans)
Front: What are the benefits of securitization for economies and financial markets?
Back: - Decreased liquidity risk (ABSs are more liquid than individual loans)
Improved market efficiency (better price discovery)
Lower financing costs for originators
Lower leverage for originators (fund growth without issuing more debt)
Front: What is the securitization process?
Back: 1. The originator (e.g., a bank) creates a pool of debt-based assets.
2. The pool is sold to a separate entity, the Special Purpose Entity (SPE).
3. The SPE issues Asset-Backed Securities (ABSs) to investors, funded by the collateral’s cash flows.
Front: What are the key risks to ABS investors?
Back: - Uncertain cash flows (prepayments can affect returns)
Credit risk (default risk from underlying loans)
Systemic risk (ABS-related crises, like in 2007–2009)
Front: Who are the key parties in a securitization and what are their roles?
Back: - Originator (Seller/Depositor): Creates and sells the loan portfolio
Issuer (SPE/Trust): Buys the loans and issues ABSs
Servicer: Manages loan payments and collections
Trustee: Oversees collateral and cash flows to investors
Economic benefits of securitization least likely include:
A)
reducing excessive lending by banks.
B)
reducing funding costs for firms that securitize assets.
C)
increasing the liquidity of the underlying financial assets.
Explanation
Companies that securitize loans they hold as assets receive cash with which they can make additional loans. The primary benefits of securitization to the economy include reducing firms’ funding costs and increasing the liquidity of the financial assets that are securitized. (Module 63.1, LOS 63.a)
In a securitization, the issuer of asset-backed securities is best described as the:
A)
special purpose entity.
B)
seller.
C)
servicer.
Explanation
ABSs are issued by a special purpose entity (SPE), which is an entity created for that specific purpose. In a securitization, the firm that is securitizing financial assets is described as the seller because it sells the assets to the SPE. The servicer is the entity that deals with collections on the securitized assets. (Module 63.1, LOS 63.b)
Q: What distinguishes covered bonds from asset-backed securities (ABSs)?
A: Covered bonds remain on the issuer’s balance sheet, providing dual recourse to bondholders (claims on both the cover pool and the issuer’s unencumbered assets), whereas ABSs involve a separate special purpose entity (SPE).
Q: What are the main types of credit enhancements used in securitizations?
A: Internal credit enhancements include overcollateralization (excess collateral value), excess spread (difference between collateral income and ABS coupon payments), and subordination (credit tranching).
Q: How does subordination (credit tranching) work in an ABS structure?
A: Losses are absorbed in order from the lowest-ranking (equity) tranche to senior tranches, protecting senior investors and creating a waterfall repayment structure.
Q: How do credit card ABSs differ from other types of ABSs in terms of cash flow structure?
A: Credit card ABSs have a lockout period during which principal payments are reinvested, delaying principal repayments to investors until the amortization period begins.
Q: What are collateralized debt obligations (CDOs), and how do they differ from typical ABSs?
A: CDOs, such as collateralized loan obligations (CLOs), have an active collateral manager who dynamically buys and sells assets to generate returns, unlike static collateral pools in ABSs.
Q: What are the main types of collateralized loan obligations (CLOs)?
.
A: The three main types are cash flow CLOs (cash flows from collateral fund payments), market value CLOs (trading-based returns), and synthetic CLOs (credit derivative exposure without owning collateral)
During the lockout period of a credit card ABS:
A)
no new receivables are added to the pool.
B)
investors do not receive interest payments.
C)
investors do not receive principal payments.
Explanation
During the lockout period on a credit card receivables backed ABS, no principal payments are made to investors. (Module 64.1, LOS 64.c)
A debt security that is collateralized by a pool of the sovereign debt of several developing countries is best described as a:
A)
CLO.
B)
CBO.
C)
CMO.
Explanation
A collateralized bond obligation (CBO) is backed by an underlying pool of fixed-income securities, which may include emerging markets debt. Collateralized loan obligations (CLOs) are backed by leveraged loans. Collateralized mortgage obligations (CMOs) are backed by pools of mortgages or mortgage-backed securities. (Module 64.1, LOS 64.d)
A covered bond is most likely to feature:
A)
a fixed cover pool.
Incorrect Answer
B)
recourse to the issuer.
C)
a special purpose entity.
Explanation
Covered bonds differ from ABSs in that bondholders have recourse to the issuer as well as the cover pool. Covered bonds are not issued through special purpose entities. A covered bond issuer must maintain a dynamic cover pool, replacing any nonperforming or prepaid assets. (Module 64.1, LOS 64.a)
The risk that mortgage prepayments will occur more slowly than expected is best characterized as:
A)
default risk.
B)
extension risk.
C)
contraction risk.
Explanation
Extension risk is the risk that prepayments will be slower than expected. Contraction risk is the risk that prepayments will be faster than expected. (Module 65.1, LOS 65.a)
A sequential pay security is structured with three tranches: A, B, and C. Tranche A receives principal first, followed by Tranche B, and finally Tranche C. An investor concerned about extension risk would most likely prefer:
A)
Tranche A.
B)
Tranche B.
C)
Tranche C.
Explanation
An investor concerned about extension risk would prefer to purchase a tranche that is paid back sooner than other tranches; hence, the investor would prefer Tranche A. (Module 65.1, LOS 65.c)
For investors in commercial mortgage-backed securities, balloon risk in commercial mortgages results in:
A)
call risk.
B)
extension risk.
C)
contraction risk.
Explanation
Balloon risk is the possibility that a commercial mortgage borrower will not be able to refinance the principal that is due at the maturity date of the mortgage. This results in a default that is typically resolved by extending the term of the loan during a workout period. Thus, balloon risk is a source of extension risk for CMBS investors. (Module 65.1, LOS 65.d)
Q: What is a derivative?
A: A derivative is a security that derives its value from another security or variable (e.g., interest rate, stock index) at a specific future date.
Q: What is a derivative?
A: A derivative is a security that derives its value from another security or variable (e.g., interest rate, stock index) at a specific future date.
Q: What is the underlying asset in a derivative contract?
A: The security or variable that determines the value of a derivative, such as a stock, bond, index, currency, interest rate, or commodity.
Q: What are key terms of a forward contract?
A: - Underlying asset: Security being bought/sold
Forward price: Agreed-upon price
Settlement date: Future date when the exchange occurs
Contract size: Quantity of the underlying asset
Q: How do gains and losses work in a forward contract?
A: - Buyer gains when the market price is above the forward price.
Seller gains when the market price is below the forward price.
Gains and losses are symmetric between parties.
Q: What is the difference between a deliverable and a cash-settled forward contract?
A: - Deliverable: The underlying asset is physically exchanged.
Cash-settled: Only the difference in value is paid in cash.
Q: How can derivatives be used for hedging and speculation?
A: - Hedging: Reduces existing risk by taking an offsetting derivative position.
Speculation: Increases risk by taking a position to profit from price changes.
A: - Hedging: Reduces existing risk by taking an offsetting derivative position.
Speculation: Increases risk by taking a position to profit from price changes.
Which of the following statements about exchange-traded derivatives is least accurate? Exchange-traded derivatives:
A)
are liquid.
B)
are standardized contracts.
C)
carry significant default risk.
Explanation
Exchange-traded derivatives have relatively low default risk because the clearinghouse stands between the counterparties involved in most contracts. (Module 66.1, LOS 66.b)
Which of the following statements most accurately describes a derivative security? A derivative:
A)
always increases risk.
B)
has no expiration date.
C)
has a payoff based on an asset value or interest rate.
Explanation
A derivative’s value is derived from another asset or an interest rate. (Module 66.1, LOS 66.a)
Q: What is a forward contract?
A: A forward contract is an agreement between two parties where one commits to buy and the other to sell an asset at a specific price on a future date. The buyer benefits if the asset’s price increases, while the seller benefits if the price decreases.
Q: How does a futures contract differ from a forward contract?
A: Futures contracts are standardized, exchange-traded, subject to regulation, and involve daily mark-to-market settlements. They also require margin deposits to mitigate counterparty risk.
Q: What are initial and maintenance margin requirements in futures trading?
A: Initial margin is the minimum deposit required before trading. Maintenance margin is the minimum balance required to keep a position open. If the balance falls below this level, the trader must add funds to restore the account to the initial margin level.
Q: What are call and put options?
A: A call option gives the holder the right (but not the obligation) to buy an asset at a specified price before expiration. A put option gives the holder the right to sell an asset at a specified price before expiration.
Q: What is a swap contract?
A: A swap is a derivative where two parties exchange cash flows based on a predetermined formula, such as fixed vs. floating interest rates (interest rate swaps) or currency exchange (currency swaps).
Q: What are credit derivatives?
A: Credit derivatives are financial instruments used to transfer credit risk from one party to another. Examples include credit default swaps (CDS), where one party pays a premium in exchange for protection against a borrower’s default.
Which type of contract always requires daily marking to market of gains and losses?
A)
Futures contracts only.
B)
Forward contracts only.
C)
Both futures and forward contracts.
Incorrect Answer
Explanation
Futures contracts are marked to market daily. Forward contracts typically are not, but could be if there is central clearing party. (Module 67.1, LOS 67.a)
Compared to a futures contract, an otherwise identical forward contract most likely has greater:
A)
liquidity.
B)
transparency.
C)
counterparty risk.
Explanation
Forward contracts involve counterparty risk; futures contracts trade through a clearinghouse. Because futures contracts trade on organized exchanges, they have greater liquidity and transparency than forward contracts. (Module 67.1, LOS 67.a)
Q: What is a swap?
A: A swap is an agreement between two parties to exchange a series of payments on multiple settlement dates over a specified period, with only the net difference paid at each settlement.
Q: What is a fixed-for-floating interest rate swap?
A: It is a swap where one party makes payments at a fixed rate, while the other pays a floating rate based on a market reference rate, such as SOFR.
Q: How do swaps expose parties to counterparty credit risk?
A: Since swaps trade in a dealer market, parties risk default unless a central counterparty structure with margin deposits and mark-to-market payments is used.
Q: In a $10 million interest rate swap with a fixed rate of 2% and quarterly payments, what is the fixed-rate payment each quarter?
A: The fixed-rate payment is $10,000,000 × 0.02 / 4 = $50,000.
Q: How can a company use a swap to hedge floating-rate debt?
A: By entering as a fixed-rate payer, the company converts its floating-rate liability into a fixed one, reducing uncertainty in future payments.
Q: How can a swap be replicated using forward contracts?
A: A swap is equivalent to a series of forward contracts where the underlying is a floating rate and the forward price is a fixed rate, settling at different points in time.
