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


MCQ Practice Test & Solutions: Practice Test: Fixed Income - 2 (30 Questions)

You can prepare effectively for CFA Level 2 Fixed Income with this dedicated MCQ Practice Test (available with solutions) on the important topic of "Practice Test: Fixed Income - 2". These 30 questions have been designed by the experts with the latest curriculum of CFA Level 2 2026, to help you master the concept.

Test Highlights:

  • - Format: Multiple Choice Questions (MCQ)
  • - Duration: 80 minutes
  • - Number of Questions: 30

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Practice Test: Fixed Income - 2 - Question 1

A bond analyst is reviewing spread measures for a callable investment-grade corporate bond. The bond has a Z-spread of 115 basis points relative to the benchmark spot curve. After modeling the embedded call option, the analyst calculates an option-adjusted spread (OAS) of 80 basis points.

The OAS for this callable bond is best described as:

Detailed Solution: Question 1

OAS strips the option cost from Z-spread; remaining spread reflects credit and liquidity risk only.

Practice Test: Fixed Income - 2 - Question 2

An analyst uses a two-period binomial interest rate tree to value a 2-year, 5% annual coupon bond with a face value of $1,000. The inputs are as follows:

  • Year 0 spot rate: 3.00%
  • Year 1 up-node rate: 6.00%
  • Year 1 down-node rate: 4.00%
  • Risk-neutral probability at each node: 0.50

The value of the bond at time zero is closest to:

Detailed Solution: Question 2

V0 = [0.5(990.57+50)+0.5(1009.62+50)]/1.03 = 1050.09/1.03 ≈ $1,019.51.

Practice Test: Fixed Income - 2 - Question 3

A credit analyst is selecting a model to estimate default probabilities for a portfolio of corporate bonds. She compares structural credit models with reduced-form models.

Which feature is most characteristic of reduced-form credit models?

Detailed Solution: Question 3

Reduced-form models use a hazard rate (Poisson arrival process) calibrated directly to observable market prices.

Practice Test: Fixed Income - 2 - Question 4

A fixed income analyst is bootstrapping the spot rate curve from par rates. The relevant data are:

  • 1-year par rate: 3.00%
  • 2-year par rate: 4.00%

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

Detailed Solution: Question 4

4/1.03 + 104/(1+s2)² = 100 → (1+s2)² = 1.08198 → s2 ≈ 4.02%.

Practice Test: Fixed Income - 2 - Question 5

A portfolio manager holds credit default swap (CDS) protection on a corporate issuer. The terms of the CDS are:

  • Notional principal: $10,000,000
  • Recovery rate: 40%

A credit event is subsequently triggered. The CDS payoff to the protection buyer is closest to:

Detailed Solution: Question 5

CDS payoff = Notional × (1 − Recovery Rate) = $10M × 0.60 = $6,000,000.

Practice Test: Fixed Income - 2 - Question 6

An analyst is reviewing the structure of a collateralized mortgage obligation (CMO) that contains both planned amortization class (PAC) tranches and support tranches.

Which statement best characterizes the role of support tranches in this CMO structure?

Detailed Solution: Question 6

Support tranches absorb prepayment variability above and below the PAC collar, stabilizing PAC cash flows.

Practice Test: Fixed Income - 2 - Question 7

A fixed income analyst is evaluating duration measures appropriate for mortgage-backed securities (MBS). She notes that MBS have embedded prepayment options that affect cash flows when interest rates change.

Which statement best explains why effective duration is the preferred duration measure for MBS?

Detailed Solution: Question 7

Effective duration captures cash flow changes from prepayments as rates shift; modified duration assumes fixed cash flows.

Practice Test: Fixed Income - 2 - Question 8

A credit analyst estimates the expected credit loss on a corporate bond position using the following inputs:

  • Probability of default (PD): 2.0%
  • Recovery rate: 40%
  • Notional exposure: $50,000,000

The expected credit loss is closest to:

Detailed Solution: Question 8

EL = PD × LGD × Notional = 0.02 × 0.60 × $50M = $600,000.

Practice Test: Fixed Income - 2 - Question 9

A quantitative analyst is comparing the Vasicek and Cox-Ingersoll-Ross (CIR) short-rate models for use in valuing interest rate derivatives.

Which characteristic is unique to the Vasicek model relative to the CIR model?

Detailed Solution: Question 9

Vasicek uses constant volatility independent of rate level, allowing negative rates; CIR volatility scales with √r.

Practice Test: Fixed Income - 2 - Question 10

A mortgage analyst is analyzing a seasoned mortgage pool prepaying at 100 PSA. Under the PSA benchmark, the conditional prepayment rate (CPR) ramps linearly from 0% to 6% over the first 30 months, then remains constant at 6%.

In month 20, the CPR and single monthly mortality (SMM) for this pool are closest to:

Detailed Solution: Question 10

CPR = (20/30) × 6% = 4.0%; SMM = 1 − (0.96)1/12 ≈ 0.34%.

Practice Test: Fixed Income - 2 - Question 11

An analyst applies the Merton structural credit model to evaluate a firm with the following characteristics:

  • Current firm asset value: $200 million
  • Face value of outstanding debt: $150 million (zero-coupon, maturing in 1 year)
  • Asset volatility increases from 25% to 35%

The most likely effect of this increase in asset volatility on equity value and the credit spread is:

Detailed Solution: Question 11

Higher volatility raises call option value (equity) and raises default probability, widening the credit spread.

Practice Test: Fixed Income - 2 - Question 12

A fixed income analyst observes the following spot rates on the benchmark zero-coupon curve:

  • 1-year spot rate (s1): 3.00%
  • 2-year spot rate (s2): 4.00%

The 1-year forward rate one year from today, f(1,1), is closest to:

Detailed Solution: Question 12

f(1,1) = (1.04)2/1.03 − 1 = 1.0816/1.03 − 1 ≈ 5.01%.

Practice Test: Fixed Income - 2 - Question 13

A risk manager is comparing the Heath-Jarrow-Morton (HJM) framework to equilibrium term structure models such as Vasicek for use in pricing interest rate derivatives.

The HJM framework is best distinguished from equilibrium models by which characteristic?

Detailed Solution: Question 13

HJM takes current term structure as input and models forward rate evolution; equilibrium models derive term structure endogenously.

Practice Test: Fixed Income - 2 - Question 14

A credit derivatives desk is evaluating whether to use a structural credit model or a reduced-form credit model to price a portfolio of credit default swaps (CDS).

Which statement best describes an advantage of reduced-form models over structural models for CDS pricing?

Detailed Solution: Question 14

Reduced-form models calibrate hazard rate to observable market spreads; structural models require unobservable firm asset value.

Practice Test: Fixed Income - 2 - Question 15

A portfolio manager holds a bond position with the following key rate durations:

MaturityKey Rate Duration
2-year0.50
5-year1.20
10-year2.80

The portfolio has a market value of $10,000,000. The 10-year spot rate rises by 50 basis points; all other spot rates remain unchanged. The approximate change in portfolio value is closest to:

Detailed Solution: Question 15

ΔP = −2.80 × 0.0050 × $10,000,000 = −$140,000.

Practice Test: Fixed Income - 2 - Question 16

A fixed income analyst is building an arbitrage-free binomial interest rate tree to value interest rate derivatives. She notes that the tree must be consistent with observed market prices.

In the calibration of an arbitrage-free binomial interest rate tree, the interest rate volatility parameter is selected such that:

Detailed Solution: Question 16

Tree is calibrated so model prices of on-the-run benchmark bonds exactly equal observed market prices at each maturity.

Practice Test: Fixed Income - 2 - Question 17

An analyst observes the following market data for a corporate issuer:

  • 5-year CDS spread: 200 basis points
  • Recovery rate: 40%

Using the reduced-form approximation, the annual probability of default implied by this CDS spread is closest to:

Detailed Solution: Question 17

PD ≈ CDS spread / LGD = 0.0200 / 0.60 = 3.33% per year.

Practice Test: Fixed Income - 2 - Question 18

A bond analyst is explaining spread measures to a junior colleague. The colleague asks for a precise definition of the Z-spread as used in fixed income analysis.

The Z-spread is best described as:

Detailed Solution: Question 18

Z-spread is constant spread added to each benchmark spot rate equating PV of all cash flows to market price.

Practice Test: Fixed Income - 2 - Question 19

A portfolio manager is analyzing a callable corporate bond that is currently trading near its call price. She is evaluating the bond's effective convexity relative to an otherwise identical option-free bond.

For this callable bond, effective convexity is most likely:

Detailed Solution: Question 19

Near call price, call caps price appreciation as rates fall, creating concave price-yield profile-negative effective convexity.

Practice Test: Fixed Income - 2 - Question 20

A structured products analyst values a agency mortgage pass-through security using an option-adjusted spread (OAS) framework. A colleague argues that a standard recombining binomial interest rate tree should be used for efficiency.

Which approach is most appropriate for computing the OAS of this MBS, and why?

Detailed Solution: Question 20

MBS prepayments are path-dependent; binomial trees are path-independent; Monte Carlo handles path-dependent cash flows correctly.

Practice Test: Fixed Income - 2 - Question 21

An analyst is comparing the mathematical properties of the Cox-Ingersoll-Ross (CIR) model and the Vasicek model for interest rate modeling. She is particularly concerned about the ability of each model to produce economically unreasonable outcomes.

The CIR model ensures non-negative interest rates through which specific model feature?

Detailed Solution: Question 21

CIR volatility = σ√r; as r → 0, diffusion → 0, preventing rates from going negative.

Practice Test: Fixed Income - 2 - Question 22

A credit analyst uses market CDS data to back out the implied hazard rate for a corporate issuer. The relevant data are:

  • 5-year CDS spread: 300 basis points
  • Recovery rate: 40%

Using the standard reduced-form approximation, the annual hazard rate is closest to:

Detailed Solution: Question 22

Hazard rate ≈ CDS spread / LGD = 0.0300 / 0.60 = 5.00% per year.

Practice Test: Fixed Income - 2 - Question 23

An analyst uses the following price data to estimate the effective duration of a corporate bond with an embedded call option:

  • Current bond price (V0): $102.00
  • Price if rates decrease by 50 bps (V): $104.50
  • Price if rates increase by 50 bps (V+): $99.80

The effective duration of this bond is closest to:

Detailed Solution: Question 23

Effective duration = (104.50 − 99.80) / (2 × 102.00 × 0.005) = 4.70/1.02 ≈ 4.61.

Practice Test: Fixed Income - 2 - Question 24

A mortgage analyst is projecting prepayments for a newly originated mortgage pool using PSA multiples. The PSA benchmark assumes that the CPR increases linearly from 0% in month 1 to 6% by month 30, then remains constant at 6% thereafter.

Under a 200 PSA prepayment assumption, the CPR in month 15 is closest to:

Detailed Solution: Question 24

100 PSA month 15: (15/30) × 6% = 3%; at 200 PSA: 2 × 3% = 6%.

Practice Test: Fixed Income - 2 - Question 25

A structured finance analyst is explaining credit enhancement mechanisms in an asset-backed security (ABS) to a client. The ABS has senior, mezzanine, and subordinate tranches backed by a pool of consumer auto loans.

In this ABS structure, subordination provides credit enhancement to senior tranches primarily by:

Detailed Solution: Question 25

Subordination ensures losses are absorbed first by junior tranches, insulating senior tranche holders from initial credit losses.

Practice Test: Fixed Income - 2 - Question 26

A fixed income analyst is explaining different bond spread measures to a trainee. The trainee asks how the Z-spread differs from the nominal spread in measuring relative value.

Which statement best distinguishes the Z-spread from the nominal spread?

Detailed Solution: Question 26

Z-spread uses the entire benchmark spot rate curve; nominal spread uses a single comparable Treasury yield of similar maturity.

Practice Test: Fixed Income - 2 - Question 27

A structured products team is debating whether to use a binomial interest rate tree or Monte Carlo simulation to compute the OAS for a collateral of mortgage-backed securities. A junior analyst argues that binomial trees are computationally simpler and equally valid for MBS valuation.

Which statement best explains why a binomial interest rate tree is generally not appropriate for valuing MBS?

Detailed Solution: Question 27

Binomial trees are path-independent; MBS prepayments depend on the full history of rate movements-requiring path-dependent simulation.

Practice Test: Fixed Income - 2 - Question 28

An analyst calculates the following spread measures for a callable corporate bond:

  • Z-spread: 120 basis points
  • Option-adjusted spread (OAS): 85 basis points

The cost of the embedded call option, expressed in basis points, is closest to:

Detailed Solution: Question 28

Option cost = Z-spread − OAS = 120 − 85 = 35 basis points.

Practice Test: Fixed Income - 2 - Question 29

A credit analyst is using the Merton structural model to evaluate the credit spread on a firm's 5-year zero-coupon debt. She analyzes the sensitivity of the model-implied credit spread to changes in firm-level variables.

In the Merton structural credit model, which change most directly causes the credit spread on the firm's debt to widen?

Detailed Solution: Question 29

Higher leverage raises probability that asset value falls below debt at maturity, directly widening model-implied credit spread.

Practice Test: Fixed Income - 2 - Question 30

A mortgage analyst is reviewing a CMO with PAC tranches structured to provide stable cash flows within a prepayment collar of 100-250 PSA. Actual prepayments have fallen to 60 PSA for several consecutive months, and the support tranche has been fully paid down.

Given these conditions, the PAC tranche is most likely subject to:

Detailed Solution: Question 30

Below lower collar with depleted support tranche, principal returns slowly-exposing PAC to extension risk and longer average life.

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