Fixed Income - 1 - Free MCQ Practice Test with solutions, CFA Level 2

A bond analyst is comparing spread measures for a newly issued callable corporate bond and a non-callable benchmark Treasury of similar maturity. The callable bond trades at a Z-spread of 185 basis points over the Treasury spot curve.

The option-adjusted spread (OAS) for the callable bond is best described as:

Adriana Voss, CFA, is constructing a binomial interest rate tree to value a 3-year option-free Treasury bond. She states the following:

1. Risk-neutral up-move and down-move probabilities are each set to 50%.
2. The tree is calibrated so that model prices of benchmark bonds match observed market prices.
3. Nodes in the tree are derived using real-world probabilities estimated from historical rate data.

Which of Voss's statements best describes standard arbitrage-free binomial tree construction?

An analyst is bootstrapping spot rates from the following par rate data:

Assuming annual coupon payments and a face value of 100, the 2-year spot rate is closest to:

A portfolio manager notes that the Vasicek interest rate model has drawn criticism in certain low-rate environments. A colleague argues the Cox-Ingersoll-Ross (CIR) model addresses the most significant structural limitation of the Vasicek model.

The limitation of the Vasicek model that the CIR model most directly addresses is:

A credit analyst is assessing the expected loss on a corporate bond position with the following characteristics:

• 1-year probability of default (PD): 2.00%
• Recovery rate in the event of default: 40%
• Notional exposure: $50,000,000

The expected credit loss over one year is closest to:

Marcus Lindqvist, CFA, is presenting two credit risk modeling frameworks to his fixed income team. He describes Framework X as one where the firm's equity is treated as a derivative on the firm's assets, and default is triggered when the asset value falls below the face value of debt at maturity. Framework Y models default as an unpredictable event governed by an exogenous intensity parameter.

Which of the following statements best characterizes Framework X?

An investor purchases CDS protection on $10,000,000 notional of a corporate bond issued by Delray Industries. The CDS contract specifies a recovery rate of 40%. Delray Industries subsequently defaults.

The CDS payoff received by the protection buyer is closest to:

A mortgage-backed security analyst is calculating the conditional prepayment rate (CPR) for a mortgage pool under 150 PSA. The mortgage pool is 20 months old.

Under the PSA prepayment benchmark, the CPR for this pool at month 20 under 150 PSA is closest to:

Evelyn Park, CFA, explains the role of PAC and support tranches in a CMO structure to a group of trainees. She notes that the structure is designed to redistribute prepayment risk among investors.

Which of the following statements best describes the relationship between PAC and support tranches?

A fixed income portfolio manager wants to assess the interest rate sensitivity of a bond portfolio to changes at specific points along the yield curve rather than to a parallel shift in rates.

The measure most appropriate for this purpose is:

Theo Hartmann, CFA, is valuing a 2-year callable bond using a binomial interest rate tree. He has constructed the tree with rates at each node and is now computing the bond's value.

The correct methodology for computing the callable bond's value using the binomial tree is:

A fixed income strategist describes the Heath-Jarrow-Morton (HJM) framework to a colleague who is more familiar with equilibrium models such as Vasicek and CIR.

Which of the following statements most accurately distinguishes the HJM framework from single-factor equilibrium models?

An analyst is evaluating a mortgage-backed security (MBS) with an embedded prepayment option. She notes that the MBS has a Z-spread of 210 basis points over the Treasury spot curve and an OAS of 155 basis points after modeling the prepayment option.

Which statement regarding these spread measures is most accurate?

The following data are available for a putable bond:

The effective duration of the putable bond is closest to:

Sophia Brennan, CFA, is explaining reduced-form credit models to a client. She makes the following statements:

1. Reduced-form models require the analyst to model the firm's asset value and its volatility.
2. In reduced-form models, default is modeled as an exogenous event governed by a hazard rate.
3. The hazard rate represents the instantaneous conditional probability of default given that the firm has survived to that point.

Which of Brennan's statements are correct?

A fixed income quantitative analyst compares the Cox-Ingersoll-Ross (CIR) model with the Vasicek model. She notes that they share a mean-reversion structure but differ in how volatility is modeled.

Which of the following statements regarding the CIR model is most accurate?

A yield curve analyst explains the relationship between spot rates and forward rates to a junior colleague.

A forward rate is best described as:

Damien Cross, CFA, manages a $20 million position in Northgate Corp 5-year senior bonds. He is concerned about potential credit deterioration at Northgate and executes a transaction in the CDS market.

Which of the following actions would most effectively hedge Cross's credit exposure to Northgate?

An analyst is bootstrapping the Treasury spot curve from the following on-the-run par rates, assuming annual coupon payments and face value of 100:

The 2-year spot rate derived by bootstrapping is closest to:

The following prices are observed for a callable corporate bond under three interest rate scenarios:

The effective convexity of this callable bond is closest to:

A credit analyst describes the Merton structural model to the investment committee. He states that the model treats the firm's capital structure as a set of options on the firm's asset value.

Under the Merton model, equity is best described as:

Rachel Soto, CFA, is analyzing a CMO backed by agency MBS. The CMO includes both PAC and support tranches. Actual prepayment speeds are currently running within the PAC collar (between the minimum and maximum scheduled PSA speeds).

Which of the following outcomes is most consistent with this scenario?

A bond dealer explains three spread measures to a client: nominal spread, Z-spread, and OAS. The client asks which measure provides the most complete picture of relative value for an option-free bond by accounting for the shape of the entire Treasury spot curve.

The spread measure the dealer should recommend is:

A structured products analyst is comparing two auto-loan ABS securities with identical credit ratings, maturities, and WAL. Security A has an OAS of 95 basis points, while Security B has an OAS of 115 basis points. The analyst's required OAS for this sector is 100 basis points.

Based solely on OAS analysis, which conclusion is most appropriate?

A credit analyst estimates the fair CDS spread for a 1-year CDS contract on Verton Industries using the following assumptions:

• Annual probability of default: 3.00%
• Recovery rate in the event of default: 40%

Using the simplified CDS spread approximation, the fair CDS spread is closest to:

Nikolai Petrov, CFA, is building an arbitrage-free binomial interest rate tree to value fixed-income securities. He explains to a trainee how the tree is calibrated.

The calibration process for the binomial interest rate tree is most accurately described as:

A mortgage analyst presents the following statements about prepayment conventions to a risk committee:

1. CPR is the annualized prepayment rate, and the monthly equivalent SMM is calculated as 1 − (1 − CPR)^1/12.
2. At 100 PSA, the CPR is constant at 6% from month 1 onward for the life of the mortgage pool.
3. A pool seasoned at 200 PSA will prepay more rapidly than an identical pool seasoned at 100 PSA.

Which of the analyst's statements are correct?

A fixed income research team is selecting a credit risk model to price a portfolio of actively traded corporate credit default swaps. One analyst advocates for a structural model; another recommends a reduced-form model.

The reduced-form model is most appropriate in this context because:

A portfolio manager runs a key rate duration analysis on a fixed income portfolio. The portfolio's key rate durations at the 2-year, 5-year, and 10-year maturities are 0.80, 1.50, and 2.20, respectively. The portfolio's effective duration is 4.50.

Which of the following conclusions is most consistent with these results?

A fixed income strategist is analyzing the behavior of the Vasicek interest rate model when the current short-term interest rate is 7.50% and the model's estimated long-run mean is 4.00%.

Under the Vasicek model, which of the following outcomes is most likely given the current rate environment?