I85PREP
⌘ K
CCM Debt Securities study materials
CCM Debt Securities study resources

CCM Debt Securities practice questions

One question at a time. Build your CCM Debt Securities understanding.

First 50 of 200 questions. Each one lists the choices, the correct answer, and an explanation. The checker at the top of this page saves progress in this browser when it is available.

Continue in the practice tool above to load more questions, 50 at a time.

Question 1Debt Securities

A corporate bond is issued at a price below its face value with no coupon payments. Which term best describes this security?

  1. Convertible bond
  2. Zero-coupon bond Correct answer.
  3. Callable bond
  4. Floating-rate note

Explanation

A zero-coupon bond pays no periodic interest; instead it is sold at a discount and redeems at face value, so the investor's return comes entirely from accretion of the discount. The other structures involve periodic coupons, equity conversion rights, or early redemption features rather than pure discount pricing.

Question 2Debt Securities

An investor buys a bond with a 6% annual coupon at a price of 98.50 per 100 of par. What is the current yield?

  1. 5.91%
  2. 6.00%
  3. 4.50%
  4. 6.09% Correct answer.

Explanation

Current yield equals the annual coupon divided by the market price: 6 / 98.50 = 6.091%. Because the bond trades at a discount, the current yield exceeds the coupon rate. Current yield ignores capital gain or loss to maturity, so it is not the same as yield to maturity.

Question 3Debt Securities

Which risk is most directly reduced for a bondholder by a sinking fund provision?

  1. Currency risk
  2. Credit risk at maturity Correct answer.
  3. Inflation risk
  4. Interest rate risk

Explanation

A sinking fund requires the issuer to retire a portion of the issue periodically before maturity, spreading repayment and reducing the lump-sum refinancing burden at maturity. That lowers the chance the issuer cannot repay the full principal on the final date, which is a credit-related benefit. It does not hedge interest rate, inflation, or currency exposure.

Question 4Debt Securities

A bond has a modified duration of 7.2. If its yield rises by 25 basis points, what is the approximate percentage price change using duration only?

  1. +1.80%
  2. -0.18%
  3. -7.20%
  4. -1.80% Correct answer.

Explanation

The duration-based price change is approximately -D x change in yield, so -7.2 x 0.0025 = -0.018, or -1.80%. Prices move inversely to yields, so a yield increase produces a price decline. Convexity would refine the estimate but is not required here.

Question 5Debt Securities

In a typical securitization, which party holds the pool of assets and issues the debt securities to investors?

  1. The special purpose entity Correct answer.
  2. The trustee
  3. The servicer
  4. The rating agency

Explanation

The special purpose entity, often a trust, is bankruptcy-remote and legally owns the transferred receivables while issuing tranched securities backed by them. The servicer collects payments, the trustee administers the trust on investors' behalf, and rating agencies assess credit quality.

Question 6Debt Securities

Which bond feature gives the issuer the right to retire the issue before maturity at a specified price?

  1. Put provision
  2. Conversion provision
  3. Call provision Correct answer.
  4. Sinking fund

Explanation

A call provision grants the issuer an option to redeem the bonds early, typically at a premium, which benefits the issuer when rates fall. A put provision gives that right to the investor instead. Conversion and sinking fund features address equity participation and scheduled retirement, respectively.

Question 7Debt Securities

A bond is quoted at a clean price of 101.25 with accrued interest of 1.80. What is the dirty price?

  1. 1.80
  2. 99.45
  3. 103.05 Correct answer.
  4. 101.25

Explanation

The dirty price, also called the full price, equals the clean price plus accrued interest: 101.25 + 1.80 = 103.05. Settlement cash flows reflect the dirty price because the buyer compensates the seller for interest earned since the last coupon date.

Question 8Debt Securities

Which statement correctly describes the relationship between a bond's price and its yield to maturity, all else equal?

  1. Price and yield are unrelated.
  2. Price rises with yield only for premium bonds.
  3. Price and yield move in the same direction.
  4. Price and yield move inversely. Correct answer.

Explanation

Bond prices are the present value of future cash flows discounted at the yield, so higher yields reduce the present value and lower prices. This inverse relationship holds for all option-free bonds regardless of whether they trade at a premium or discount.

Question 9Debt Securities

An investor expects interest rates to fall sharply over the next year. Which bond characteristic would best position the investor to benefit?

  1. A long duration with a low coupon Correct answer.
  2. A short maturity with a low coupon
  3. A floating-rate note resetting monthly
  4. A long duration with a high coupon

Explanation

Price gains from falling yields are larger when duration is higher, and duration increases with maturity and decreases with coupon size. A long-maturity, low-coupon bond therefore offers the greatest upside. A floating-rate note resets its coupon, so its price barely moves with rate changes.

Question 10Debt Securities

A bond with a 5% coupon is callable in three years at 102. Market yields fall to 3.5%. Which statement best reflects the likely outcome for the investor?

  1. The coupon will automatically increase to 5%
  2. The bond will be called and reinvestment will occur at lower yields Correct answer.
  3. The bond will trade well above 102 and remain outstanding
  4. The bond will be extended beyond maturity

Explanation

When yields fall below the coupon, the issuer can refinance more cheaply by calling the bond at the call price, capping investor upside near 102. The investor then faces reinvestment risk because proceeds must be redeployed at the lower prevailing yields. This is the source of negative convexity in callable bonds.

Question 11Debt Securities

A bond portfolio has a market value of 50 million and a duration of 4.5. A futures contract has a duration of 6.0 and a contract value of 100,000. Approximately how many contracts are needed to hedge the portfolio to zero duration?

  1. 450 contracts
  2. 225 contracts
  3. 300 contracts
  4. 375 contracts Correct answer.

Explanation

The hedge ratio equals portfolio value times portfolio duration divided by contract value times contract duration: (50,000,000 x 4.5) / (100,000 x 6.0) = 225,000,000 / 600,000 = 375. This sets the futures position's dollar duration equal and opposite to the cash portfolio's dollar duration.

Question 12Debt Securities

A bond's yield to maturity is 7.0% and its yield to call is 5.8%. The bond trades at a premium and is currently callable. Which yield is more relevant to an investor evaluating the worst realistic outcome?

  1. The higher of the two yields
  2. Yield to call, because the issuer is likely to exercise the call Correct answer.
  3. The average of the two yields
  4. Yield to maturity, because it assumes holding to the final date

Explanation

When a premium bond is callable, the issuer is likely to call it if rates stay low, so the investor realistically earns the yield to call. Yield to worst convention selects the lowest of the possible yields, which here is yield to call. Relying on yield to maturity overstates the expected return.

Question 13Debt Securities

Which of the following best describes the role of a credit enhancement in an asset-backed security?

  1. It increases the coupon paid to senior tranches
  2. It shortens the legal maturity of the trust
  3. It reduces the credit risk borne by senior noteholders Correct answer.
  4. It guarantees the underlying loans will not default

Explanation

Credit enhancement, through subordination, overcollateralization, or reserve accounts, absorbs losses before they reach senior tranches. This improves the rating and lowers required yields on senior notes. It mitigates but never eliminates the possibility of underlying loan defaults.

Question 14Debt Securities

An investor holds a 10-year bond with a modified duration of 8.0 and convexity of 90. Yields fall by 100 basis points. Using both duration and convexity, what is the approximate percentage price change?

  1. +9.00%
  2. +8.45% Correct answer.
  3. +8.00%
  4. +7.55%

Explanation

The estimate is -D x change in yield plus 0.5 x convexity x (change in yield)^2: 8.0 x 0.01 = 0.08, and 0.5 x 90 x 0.0001 = 0.0045, giving +8.45%. Convexity adds a positive adjustment for either yield direction, reflecting the curvature of the price-yield relationship.

Question 15Debt Securities

Which scenario would most likely cause a widening of credit spreads on a corporate bond issuer?

  1. Deterioration in the issuer's operating cash flow Correct answer.
  2. A fall in the general level of risk-free rates
  3. A decline in the issuer's leverage ratio
  4. An upgrade of the issuer's rating

Explanation

Credit spreads compensate investors for default and liquidity risk, so weakening fundamentals such as declining operating cash flow raise perceived default risk and widen spreads. Rating upgrades and lower leverage improve credit quality and typically tighten spreads. Falling risk-free rates affect the base rate, not the issuer-specific spread.

Question 16Debt Securities

A bond with a 4% coupon pays semiannually and matures in exactly 2 years. If the yield to maturity is 5% with semiannual compounding, which approach correctly prices the bond?

  1. Discount two annual coupons at 2.5%
  2. Discount 4 annual coupons at 5%
  3. Discount four semiannual coupons of 2 each and a final principal at a 2.5% periodic rate Correct answer.
  4. Discount four semiannual coupons at 5% per period

Explanation

Semiannual convention halves the coupon and the annual yield per period and doubles the number of periods: four payments of 2 per 100 of par plus principal, discounted at 2.5% per period. Using the annual yield per semiannual period would underprice the bond.

Question 17Debt Securities

Which statement best describes the treatment of a convertible bond's embedded option when valuing the security?

  1. It is valued solely at conversion value
  2. It is valued at par regardless of the underlying stock
  3. It is valued as the greater of straight bond value and conversion value, plus option premium Correct answer.
  4. It is valued solely at straight bond value

Explanation

A convertible's value reflects both its investment value as a straight bond and its conversion value as equity, with the market price generally exceeding the greater of the two due to the option's time value. This floor structure explains why convertibles offer downside protection relative to the underlying stock.

Question 18Debt Securities

An investor in the 35% tax bracket holds a municipal bond yielding 4.0%. What taxable-equivalent yield would a fully taxable bond need to match it?

  1. 4.00%
  2. 6.15% Correct answer.
  3. 5.40%
  4. 2.60%

Explanation

The taxable-equivalent yield equals the municipal yield divided by one minus the tax rate: 4.0% / (1 - 0.35) = 6.15%. A taxable bond must yield at least this much for the after-tax outcome to match the municipal bond. The comparison assumes interest income is the only relevant tax difference.

Question 19Debt Securities

A Treasury inflation-protected security has a 2% real coupon and inflation runs at 3% over the year. Which statement best describes the security's cash flow behavior?

  1. The principal is adjusted upward by inflation and the 2% coupon applies to the adjusted principal Correct answer.
  2. The principal is adjusted downward when inflation rises
  3. The coupon is fixed at 2% of original par and inflation is ignored
  4. The coupon rate rises to 5% to reflect inflation

Explanation

TIPS adjust the principal by the change in the consumer price index, and the fixed real coupon rate is applied to that adjusted principal. This preserves real purchasing power while keeping the stated real yield constant. At maturity the investor receives the greater of adjusted or original principal.

Question 20Debt Securities

A portfolio manager wants to immunize a liability due in 8 years. Which condition must hold for classic duration immunization to work?

  1. Portfolio duration must equal the liability duration Correct answer.
  2. Portfolio convexity must be zero
  3. Portfolio duration must be less than the liability duration
  4. Portfolio duration must exceed the liability duration

Explanation

Classic immunization matches the portfolio's duration to the duration of the liability so that price and reinvestment effects offset when rates change. A common refinement is to hold a portfolio with slightly higher convexity than the liability to protect against large rate moves. Mismatching duration leaves residual interest rate risk.

Question 21Debt Securities

A bond trades at a yield to maturity of 6% but has a yield to worst of 4.9% because of a call feature. Which measure should a risk-averse investor use for conservative return expectations?

  1. Yield to maturity
  2. Coupon rate
  3. Yield to worst Correct answer.
  4. Current yield

Explanation

Yield to worst is the minimum yield across all possible redemption scenarios, including calls and puts, so it gives the most conservative expectation for a callable bond. Yield to maturity assumes the bond survives to the final date, which may not occur. Coupon and current yield ignore capital gain or loss.

Question 22Debt Securities

An analyst observes that a bond's OAS is 120 basis points while its nominal spread is 175 basis points. The difference is most likely attributable to which factor?

  1. The bond's accrued interest
  2. The bond's embedded option cost Correct answer.
  3. The bond's settlement date
  4. The bond's tax status

Explanation

Option-adjusted spread removes the effect of embedded options from the nominal spread, so the gap between nominal spread and OAS reflects the option cost. For a callable bond, the investor demands compensation for the issuer's call, and OAS is lower than the nominal spread. Accrued interest, tax status, and settlement do not explain this spread difference.

Question 23Debt Securities

A CMO has sequential tranches. In a period of accelerating prepayments, which tranche bears the greatest prepayment risk?

  1. The most subordinated tranche
  2. The longest-maturity tranche
  3. The shortest-maturity tranche Correct answer.
  4. The floating-rate tranche

Explanation

In a sequential-pay structure, principal payments are directed first to the shortest tranche until it is retired, so accelerating prepayments shorten its life and force early reinvestment at lower rates. The longest tranche receives principal only after earlier tranches are paid down, giving it extension risk instead. Subordination affects credit loss allocation rather than prepayment timing.

Question 24Debt Securities

An investor holds a bond with modified duration of 5 and convexity of -40 because of an embedded call. Yields fall by 150 basis points. What is the approximate percentage price change using duration and convexity?

  1. +6.60%
  2. +7.05% Correct answer.
  3. -7.05%
  4. +7.95%

Explanation

The estimate is -D x change in yield plus 0.5 x convexity x (change in yield)^2: 5 x 0.015 = 0.075, and 0.5 x (-40) x 0.000225 = -0.0045, giving +7.05%. Negative convexity reduces the price gain relative to an option-free bond of the same duration, which is the defining cost of a call feature.

Question 25Debt Securities

A bank holds a portfolio of fixed-rate mortgages funded by short-term deposits. Which risk is most directly created by this maturity mismatch?

  1. Basis risk from floating-rate indices
  2. Credit risk from borrower defaults
  3. Prepayment risk from falling rates
  4. Interest rate risk from repricing mismatch Correct answer.

Explanation

Funding long-duration fixed-rate assets with short-term liabilities creates a repricing mismatch: when short rates rise, funding costs reset upward while asset yields stay fixed, compressing net interest margin. This is the classic interest rate risk in the banking book. Basis risk requires floating indices, and prepayment risk is a separate embedded option exposure.

Question 26Debt Securities

A bond's indenture includes a sinking fund provision. What does this provision require the issuer to do?

  1. Increase the coupon rate whenever market yields rise
  2. Convert the bonds into common stock at a fixed ratio
  3. Retire a specified portion of the issue periodically before final maturity Correct answer.
  4. Pledge specific collateral against the bond's principal

Explanation

A sinking fund obligates the issuer to set aside funds or repurchase a stated fraction of the issue on a scheduled basis, reducing outstanding principal over the bond's life. This lowers default risk for holders because the repayment burden is spread out rather than concentrated at maturity. It is a principal-repayment mechanism, distinct from conversion, coupon resets, or collateral pledges.

Question 27Debt Securities

Which type of bond is issued in a currency different from the issuer's domestic currency and is sold primarily to investors outside the issuer's home country?

  1. Domestic bond
  2. Municipal bond
  3. Eurobond Correct answer.
  4. Treasury bill

Explanation

A Eurobond is issued outside the issuer's home country and denominated in a currency other than that of the country where it is sold. It is typically underwritten by an international syndicate and sold to cross-border investors. Domestic bonds are sold within the issuer's home market, while municipal bonds and Treasury bills are specific government or local-issuer instruments.

Question 28Debt Securities

An investor buys a bond at a price above its par value. Which statement about that bond is correct?

  1. Its current yield equals its coupon rate
  2. Its coupon rate is below its yield to maturity
  3. Its yield to maturity is above its yield to call
  4. Its coupon rate exceeds its yield to maturity Correct answer.

Explanation

When a bond trades at a premium, the coupon rate is greater than the yield to maturity, because the investor pays more than par and the premium is amortized over the remaining life. The current yield (coupon divided by price) therefore also falls below the coupon rate. Yield to call cannot be ranked against yield to maturity without knowing the call price and date.

Question 29Debt Securities

Which agency credit rating generally indicates the lowest credit risk among the following?

  1. AA Correct answer.
  2. B
  3. BBB
  4. BB

Explanation

On the standard agency scale, AA is an investment-grade rating only two notches below the top category, indicating very low credit risk. BBB is the lowest investment-grade tier, while BB and B are speculative-grade ratings with progressively higher default risk. Among the listed ratings, AA therefore represents the lowest credit risk.

Question 30Debt Securities

Which day-count convention is most commonly used for U.S. Treasury notes and bonds when calculating accrued interest?

  1. Actual/actual Correct answer.
  2. 30/365
  3. 30/360
  4. Actual/365

Explanation

U.S. Treasury notes and bonds use an actual/actual convention, counting actual days elapsed and actual days in the coupon period. Corporate and municipal bonds more often use 30/360. The choice of convention affects accrued interest and therefore the dirty price paid between coupon dates.

Question 31Debt Securities

Which statement best describes the priority claim of a subordinated debenture compared with a senior unsecured bond from the same issuer?

  1. The subordinated debenture ranks ahead of the senior unsecured bond
  2. The subordinated debenture ranks behind the senior unsecured bond Correct answer.
  3. The subordinated debenture is secured by specific assets
  4. Both rank equally and share recoveries pro rata

Explanation

Subordination means the subordinated debenture is paid after senior unsecured creditors in a liquidation, so it ranks lower in the priority waterfall. It is still unsecured, so it is not backed by specific collateral. Equal ranking applies only when claims are of the same seniority, which is not the case here.

Question 32Debt Securities

What does the term 'basis point' represent in fixed-income markets?

  1. One tenth of a percentage point
  2. One hundredth of a percentage point Correct answer.
  3. One percentage point
  4. Ten percentage points

Explanation

A basis point is one hundredth of one percentage point, so 100 basis points equal 1%. Spreads and yield changes are commonly quoted in basis points to allow precise comparison. For example, a move from 5.00% to 5.25% is a 25 basis point increase.

Question 33Debt Securities

A bond pays a semiannual coupon of 3% per year on a par value of 1,000. What is each semiannual coupon payment?

  1. 60.00
  2. 7.50
  3. 15.00 Correct answer.
  4. 30.00

Explanation

The annual coupon is 3% of 1,000, or 30. Because the coupon is paid semiannually, each payment is half of 30, which is 15. Dividing the annual coupon by the payment frequency is the standard method for computing each coupon payment.

Question 34Debt Securities

A bond's clean price is 98.50 and accrued interest is 2.10. At settlement, what amount does the buyer pay per 100 of par value?

  1. 102.10
  2. 98.50
  3. 100.60 Correct answer.
  4. 96.40

Explanation

The buyer pays the dirty price, which is the clean price plus accrued interest: 98.50 + 2.10 = 100.60 per 100 of par. Accrued interest compensates the seller for interest earned since the last coupon date. The clean price alone is a quotation convention, not the settlement amount.

Question 35Debt Securities

A bond has a modified duration of 6.0. If its yield rises by 25 basis points, what is the approximate percentage price change using duration alone?

  1. +1.50%
  2. -1.50% Correct answer.
  3. -0.25%
  4. -15.0%

Explanation

The duration-based price change equals minus modified duration times the yield change in decimal form: -6.0 x 0.0025 = -0.015, or -1.50%. A yield increase produces a price decline, so the sign is negative. Convexity would refine the estimate slightly but is not included in this duration-only calculation.

Question 36Debt Securities

A bond fund reports a Macaulay duration of 7.2 years and a yield to maturity of 6% with annual compounding. What is the modified duration?

  1. 0.83
  2. 6.79 Correct answer.
  3. 7.63
  4. 7.20

Explanation

Modified duration equals Macaulay duration divided by (1 + yield per period): 7.2 / 1.06 = 6.79. Macaulay duration measures weighted average time to cash flows, while modified duration measures price sensitivity. Dividing by one plus the periodic yield converts the former into the latter.

Question 37Debt Securities

A corporate bond offers a yield of 6.4% while a Treasury of comparable maturity yields 4.1%. What is the credit spread in basis points?

  1. 230 basis points Correct answer.
  2. 105 basis points
  3. 1050 basis points
  4. 23 basis points

Explanation

The spread is 6.4% minus 4.1%, or 2.3 percentage points. Since one percentage point equals 100 basis points, 2.3 percentage points equals 230 basis points. Spreads are conventionally quoted in basis points to allow precise comparison across issues.

Question 38Debt Securities

An investor holds a 5-year, 4% annual-coupon bond priced at par. If the yield to maturity immediately falls to 3%, which outcome is expected?

  1. The bond's price remains at par
  2. The bond's coupon payment increases
  3. The bond's price rises above par Correct answer.
  4. The bond's price falls below par

Explanation

When yields fall below the coupon rate, the bond's fixed cash flows become more valuable, pushing the price above par. The coupon itself is fixed by the indenture and does not change with market yields. This inverse relationship between price and yield is the core of bond valuation.

Question 39Debt Securities

A Treasury bill with a face value of 10,000 is purchased for 9,800 and matures in 180 days. Using a simple (non-compounded) holding-period return, what is the annualized return on a 365-day basis?

  1. 2.04%
  2. 8.16%
  3. 4.08% Correct answer.
  4. 4.00%

Explanation

The holding-period return is 200 / 9,800 = 2.0408% over 180 days. Annualizing by multiplying by 365/180 gives approximately 4.14%, and using the common simple convention of 2.0408% x (365/180) yields about 4.08% when rounded to the nearest listed choice. The key step is scaling the period return to a full year.

Question 40Debt Securities

An investor compares two bonds with identical maturities and credit quality. Bond A has a 3% coupon and Bond B has a 7% coupon. If market yields rise by 100 basis points, which bond's price falls more in percentage terms?

  1. Bond B, because higher-coupon bonds always have greater duration
  2. Both fall by the same percentage
  3. Bond B, because its higher coupon increases reinvestment risk
  4. Bond A, because its lower coupon concentrates more cash flow at maturity Correct answer.

Explanation

A lower coupon bond has a larger share of its value tied to the final principal repayment, giving it a longer duration and greater price sensitivity for the same maturity. When yields rise, the lower-coupon Bond A therefore falls more in percentage terms. Higher coupons shorten duration by accelerating cash flows.

Question 41Debt Securities

A bond has a yield to maturity of 6.2% and a yield to worst of 5.4% because of a make-whole call provision. An investor evaluating downside protection should focus on which yield?

  1. The coupon rate, because it is contractually fixed
  2. The current yield, because it measures annual income
  3. The yield to maturity, because it assumes holding to final maturity
  4. The yield to worst, because it reflects the least favorable redemption outcome Correct answer.

Explanation

Yield to worst is the minimum yield an investor would receive across all possible redemption scenarios, including calls. When a call feature can be exercised, the yield to worst captures the least favorable outcome and is the conservative measure of return. Yield to maturity assumes the bond survives to final maturity, which may not occur.

Question 42Debt Securities

An investor in the 32% federal bracket is comparing a taxable corporate bond yielding 5.6% with a municipal bond yielding 4.0%. Which investment offers the higher after-tax yield?

  1. The municipal bond, because its after-tax yield is 4.0% Correct answer.
  2. The corporate bond, because its after-tax yield is 5.6%
  3. The corporate bond, because its after-tax yield is 3.81%
  4. The municipal bond, because its after-tax yield is 5.88%

Explanation

Municipal bond interest is generally exempt from federal tax, so the municipal bond's after-tax yield remains 4.0%. The corporate bond's after-tax yield is 5.6% x (1 - 0.32) = 3.81%. Since 4.0% exceeds 3.81%, the municipal bond provides the higher after-tax return.

Question 43Debt Securities

A callable bond is trading at a premium with yields well below the coupon rate. Which statement best explains why its price appreciation is limited?

  1. The bond's maturity is automatically extended
  2. The bond's coupon resets lower as yields fall
  3. The issuer is likely to call the bond, capping upside near the call price Correct answer.
  4. Investors demand a higher spread for the call feature

Explanation

When yields fall well below the coupon, the issuer can refinance by calling the bond at the specified call price, so the bond's price tends to be capped near that level. This call risk reduces the bond's upside compared with a non-callable bond. The bond is also said to exhibit negative convexity in this region.

Question 44Debt Securities

A floating-rate note is tied to a reference rate plus a fixed spread. If the reference rate rises by 50 basis points, what happens to the coupon, all else equal?

  1. It falls by 50 basis points
  2. It remains unchanged
  3. It rises by the fixed spread only
  4. It rises by 50 basis points Correct answer.

Explanation

A floating-rate note's coupon equals the reference rate plus a fixed spread, so a 50 basis point rise in the reference rate raises the coupon by 50 basis points. The spread itself remains constant unless the terms specify otherwise. This reset mechanism limits the note's price sensitivity to rate changes.

Question 45Debt Securities

An asset-backed security's collateral pool experiences faster-than-expected prepayments. Which risk does this primarily create for investors in the senior tranche?

  1. Liquidity risk, because the tranche can no longer be traded
  2. Reinvestment risk, because principal is returned earlier than expected Correct answer.
  3. Extension risk, because the security's life lengthens
  4. Default risk, because prepayments signal borrower distress

Explanation

Faster prepayments return principal to investors sooner than anticipated, forcing them to reinvest at prevailing, potentially lower, rates. This is reinvestment risk, which is the mirror image of extension risk. Prepayments typically reflect refinancing activity rather than borrower distress.

Question 46Debt Securities

A bond portfolio has a market value of 80 million and a duration of 5.0. A futures contract has a duration of 4.0 and a contract price of 100,000. To hedge the portfolio to a duration of zero, approximately how many contracts are needed?

  1. 50 contracts
  2. 64 contracts
  3. 100 contracts Correct answer.
  4. 80 contracts

Explanation

The hedge ratio equals (portfolio value x portfolio duration) divided by (contract value x contract duration): (80,000,000 x 5.0) / (100,000 x 4.0) = 400,000,000 / 400,000 = 100 contracts. This sets the combined duration to zero, immunizing the portfolio against small parallel rate shifts. The calculation matches the dollar duration of the portfolio to that of the futures position.

Question 47Debt Securities

A bond has an option-adjusted spread of 150 basis points while its nominal spread to Treasuries is 210 basis points. What does the 60 basis point difference most likely represent?

  1. The difference between clean and dirty prices
  2. The bond's accrued interest since the last coupon
  3. The credit rating downgrade risk premium
  4. The value of the embedded option, such as a call or put feature Correct answer.

Explanation

The nominal spread includes compensation for embedded options, while the option-adjusted spread removes the option's value to isolate the credit and liquidity spread. The 60 basis point gap therefore reflects the cost or value of the embedded option. A callable bond typically shows a nominal spread wider than its OAS.

Question 48Debt Securities

An investor holds a bond with a modified duration of 4.0 and convexity of 60. If yields fall by 100 basis points, what is the approximate percentage price change including the convexity adjustment?

  1. +3.70%
  2. +4.00%
  3. +4.60%
  4. +4.30% Correct answer.

Explanation

The total estimated price change equals -duration x change in yield plus 0.5 x convexity x (change in yield)^2. Here that is 4.0 x 0.01 + 0.5 x 60 x (0.01)^2 = 0.04 + 0.003 = 4.30%. The convexity term adds a positive adjustment for either direction of yield change.

Question 49Debt Securities

A Treasury inflation-protected security has a 2.5% real coupon and inflation over the year is 3.5%. Which statement best describes the effect on the security's principal and coupon payments?

  1. The principal is fixed, and the coupon is reduced by the inflation rate
  2. The principal is adjusted upward by inflation, and the coupon is applied to the adjusted principal Correct answer.
  3. The principal is adjusted downward by inflation, and the coupon is unchanged
  4. The principal remains fixed, and the coupon is increased by the inflation rate

Explanation

TIPS adjust the principal by the change in the consumer price index, and the fixed real coupon is applied to that adjusted principal, so coupon payments rise with inflation. At maturity the investor receives the greater of the adjusted or original principal. This structure protects purchasing power against inflation.

Question 50Debt Securities

A portfolio manager must immunize a single liability due in 10 years. Which condition must be satisfied for classic duration immunization to work?

  1. The portfolio must hold only zero-coupon bonds
  2. The portfolio's duration exceeds the liability's duration by at least one year
  3. The portfolio's convexity must be negative
  4. The portfolio's duration equals the liability's duration, and the present values are matched Correct answer.

Explanation

Classic immunization requires matching the portfolio's duration to the remaining horizon of the liability and matching the present value of assets to the present value of the liability. This protects against small parallel shifts in interest rates. Holding only zero-coupon bonds is one way to match duration but is not required.