WEEK 3 LEVE2 FIVA QUESTION TOPIC:RISK ASSOCIATED WITH INVESTING IN FIXED INCOME

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Raymond Heath
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1 WEEK 3 LEVE2 FIVA QUESTION TOPIC:RISK ASSOCIATED WITH INVESTING IN FIXED INCOME 1 Which of the following statements least accurately describes a form of risk associated with investing in fixed income securities? A. Credit risk has only two components, default risk and downgrade risk. B. Other things equal, a bond is more valuable to an investor when it has less liquidity risk. C. Bonds that are callable, pre-payable or amortizing have more reinvestment risk than otherwise equivalent bonds without these features. D. None of the above. 2 Which of the following statements is true with respect to the types of extra features that may be incorporated into a bond? A. Put provisions allow the holder of the bonds to deliver the underlying bond to the issuer in exchange for some predetermined price. B. Exchangeable bonds allow the holder to exchange the bonds for the common shares of the underlying issuer. C. Indexed amortization notes allow the issuer to accelerate principal repayments if a specified reference interest rate increases. D. Callable bonds allow the issuer to deliver another bond to the holder in place of the original issue when interest rates fall. 3. A zero coupon bond, maturing in 4 years and 3 months at par is currently quoted at 70.70%. Due to a deterioration of the business conditions for the issuer, the credit rating of the bond issuer now gets downgraded. You expect a change of 100 basis points in the yield to maturity for the bond. According to you, the bond should now be quoted at: A. 66.5%. B. 68.0%. C. 72.0%. D. 73.5%. 4. An investor is currently examining the following treasury data: Maturity Coupon Rate Price Yield-tomaturity 1-year % 2-year % 3-year 4.7% % What is the investor s best estimate of the 3-year spot rate? A. 4.25% B. 4.33% C. 4.72%

2 D. 4.91% 5. Which of the following is true with respect to credit-linked notes? A. They are issued as zero coupon bonds. B. They are bonds that return the par value to the investor in the event of default or downgrade. C. They are bonds that pay a higher coupon rate to the investor compared with similar bonds with no credit linkage. D. They are bonds that can be put back to the issuing firm in the event of a default or downgrade. 6. Which of the following statements least accurately describes overcollateralization in the context of collateralized debt obligations (CDOs)? A. Overcollateralization is a form of internal credit enhancement. B. Overcollateralization occurs when too much collateral is used. C. Overcollateralization of senior tranches is greater than for junior tranches. D. None of the above. 7 An investor is currently examining the following Treasury data: Maturity Coupon Rate Price Yield-to-Maturity 6 months % 1.0 year % 1.5 years 4.70% % What is the investor's best estimate of the annualized 1.5 year spot rate? A. 4.25% B. 4.33% C. 4.71% D. 4.91% 8.Which of the following statements is (are) true with respect to reinvestment rate risk? I. Premium bonds will have lower reinvestment rate risk than discount bonds holding all other factors constant. II. If held to maturity, zero coupon bonds have no reinvestment rate risk whatsoever. III. The longer the maturity of the bond, the greater will be its reinvestment rate risk. IV. The greater the frequency of coupon payments, the lower will be the reinvestment rate risk. A. I, III, and IV only B. III and IV only C. I, II and IV only D. II and III only 9. Which of the following statements is (are) true with respect to measuring interest rate risk? I. The full valuation approach would require that new bond prices be calculated whenever there is an interest rate change. II. Duration captures the interest rate risk that can arise from any shift in the yield curve.

3 III. Holding everything else constant, the duration of a bond will be higher at lower level of interest rates than it would be at higher levels of interest rates. IV. All callable bonds have a positive convexity. A. II, III, and IV only B. I and III only C. IV only D. I, II, and IV only 10. A 10-year, 8% coupon convertible bond is currently trading at The conversion price of the bond is The underlying common stock of the same issuer is currently paying a dividend of N1.65 and is priced at Which of the following would best estimate the market conversion premium per share of this bond? A. N8.19 per share. B. N6.76 per share. C. N5.13 per share. D. N5.42 per share. 11. You wish to purchase a 15-year bond today that is trading at par. This bond pays an annual coupon of 6% and you expect to sell it in five years when you believe the yields on similar risk bonds will be 7%. If the reinvestment rate during this period averages out to be 6.5%, how much will your proceeds be when you eventually sell the bond? A. N B. N C. N D. N Which of the following statements is least accurate with respect to the risks faced by an investor who purchases a foreign currency denominated bond? A. If the foreign currency appreciates, the return from the bond will be positively impacted. B. If the home currency depreciates, the return from the bond will be positively impacted. C. The foreign exchange risk will have a bigger impact on the face value payments as opposed to the individual coupon payments. D. The variability of the current spot rate makes the purchase price of the bond difficult to determine. 13. Which of the following statements is/ are true of floating rate notes (FRNs)? I. FRNs are long term securities wherein coupons are adjusted periodically according to changes in a benchmark rate. II. Inverse floaters are FRNs whose floating rate is inversely related to the coupon of the bond. III. FRNs note holders are exposed to interest rate risks more than straight bondholders. A. I and II only B. I and III only

4 C. II and III only D. I, II, and III THEORY QUESTION. 1. Mention and briefly discuss two key issues that should be of interest to an investor, normally taken into consideration in bond rating. 2. You are seriously considering moving a large portion of your investment into bonds in view of the downturn in the stock market. Currently you wish to limit your options to the following bonds recommended by a colleague: Bond Maturity Coupon Yield to Maturity X 2 years 8% 7.842% Y 3 years 9% 8.027% Z 5 years 0% 5.50% (a) Determine the price of bond X, if the following spot rates are applicable: One year spot rate 7.65% Two year spot rate 7.85% Three year spot rate 8.05% 3. You have just resumed at an asset management firm as the head of the Fixed Income Unit. You were immediately confronted with a number of decisions/challenges. 7(a) It is June 30, Your company is considering purchasing one of the following newly issued 10-year AAA corporate bonds shown in the following table. You note that the yield curve is currently flat and you assumed that the yield curve shifts in an instantaneous and parallel manner: Bond Characteristic Description Coupon Price Callable Call price A (due June, ) 6.00% Non-callable Not applicable B (due June 30, 2022) 6.20% Currently callable a1) Contrast the effect on the price of both bonds if yields decline more than 100 basis points (No calculation is required). a2) State and explain under which two interest rate forecasts you would prefer Bond B over Bond A. a3) State the directional price change, if any, assuming interest rate volatility increases, for each of the following: Bond A. a3) II) Bond B. b) Next, your Economic Unit has come up with the following data from prices of zero-coupon bond. Year Forward Rate 1 5% 2 7% 3 8% Required: b1) Compute the spot rates for each of the years.

5 b2) You are looking at the possibility of purchasing a 3-year bond making annual payments of N60 with par value of N1,000. You plan to hold the bond till maturity. Required: Compute, using the forward rates or otherwise, the price of the bond. b2) II) What is the YTM of the bond. b2) III) Compute the current yield of Bond B. What is the weakness of this yield measure? 4. Because of financial stress, the bonds of Connect Telecoms Ltd have been downgraded by Moody s from A to BBB. What is the predicted effect on the bonds price, and the bonds yield to maturity? Justify.

RISKS ASSOCIATED WITH INVESTING IN BONDS

RISKS ASSOCIATED WITH INVESTING IN BONDS 1 Risks Associated with Investing in s Interest Rate Risk Effect of changes in prevailing market interest rate on values. As i B p. Credit Risk Creditworthiness