Exam 1
Morning Session
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91.
A high yield bond fund states that through active management, the fund’s
return has outperformed an index of Treasury securities by 4% on average
over the past five years. As a performance benchmark for this fund, the
index chosen is:
A. appropriate.
B. inappropriate, because the index return does not reflect active
management.
C. inappropriate, because the index does not reflect the actual bonds in
which the fund invests.
92.
The change in the intrinsic value of a firm’s common stock resulting from
an increase in ROE most likely:
A. increases the stock’s intrinsic value.
B. decreases the stock’s intrinsic value.
C. depends on the reason for the increase in ROE.
93.
Which of the following statements about short selling is least accurate?
A. A short seller is required to set up a margin account.
B. A short sale involves securities the investor does not own.
C. A short seller loses if the price of the stock sold short decreases.
94.
Compared to an index of 100 U.S. exchange-traded stocks, an index of
100 U.S. government and corporate bonds will most likely:
A. reflect equally timely price data.
B. be more difficult to build and maintain.
C. have less turnover among the securities in the index.
95.
Beth Knight, CFA, and David Royal, CFA, are independently analyzing
the value of Bishop, Inc. stock. Bishop paid a dividend of $1 last year.
Knight expects the dividend to grow by 10% in each of the next three
years, after which it will grow at a constant rate of 4% per year. Royal also
expects a temporary growth rate of 10% followed by a constant growth
rate of 4%, but he expects the supernormal growth to last for only two
years. Knight estimates that the required return on Bishop stock is 9%, but
Royal believes the required return is 10%. Royal’s valuation of Bishop
stock is approximately:
A. equal to Knight’s valuation.
B. $5 less than Knight’s valuation.
C. $5 greater than Knight’s valuation.
96.
An industry in the growth phase of the industry life cycle is most likely to
experience:
A. increasing prices.
B. increasing profitability.
C. intense competition among competitors.
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Exam 1
Morning Session
Questions 97 through 110 relate to Fixed Income. (21 minutes)
97.
Consider the following Treasury spot rates expressed as bond equivalent
yields:
Maturity
Spot Rate
6 months
3.0%
1 year
3.5%
1.5 years
4.0%
2 years
4.5%
If a Treasury note with two years remaining to maturity has a 5%
semiannual coupon and is priced at $1,008, the note is:
A. overpriced.
B. underpriced.
C. correctly priced.
98.
Which of the following is an advantage of a callable bond (compared to an
identical option-free bond) to an investor?
A. Less reinvestment risk.
B. Higher yield.
C. More convexity.
99.
An investor is considering the purchase of Security X, which matures in
ten years and has a par value of $1,000. During the first five years, X has
a 6% coupon with quarterly payments. During the remaining five years,
X has an 8% coupon with quarterly payments. The face value is paid at
maturity. A second 10-year security, Security Z, has a 6% semiannual
coupon and is selling at par. Assuming that X has the same bond
equivalent yield as Z, the price of Security X is closest to:
A. $943.
B. $1,036.
C. $1,067.
100.
The yield spreads between corporate bonds and Treasuries are most
likely to decrease if:
A. liquidity decreases in the market for the bonds.
B. a credit rating downgrade on the bonds becomes more likely.
C. investors increase their estimates of the recovery rate on the bonds.
101.
The full price of a bond:
A. includes accrued interest.
B. includes commissions and taxes.
C. is also known as the “clean” price.
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Exam 1
Morning Session
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102.
Which of the following statements regarding sinking funds is most
accurate?
A. The specific bonds that will be redeemed on each scheduled date are
identified in the indenture.
B. Sinking fund redemptions can be accomplished by making cash
payment to the trustee who will then retire the required proportion of
the bonds.
C. If yields have declined since the bond was issued, companies are
likely to choose to retire the required portion of the debt by delivering
securities to the trustee.
103.
A debt covenant designates one of a holding company’s subsidiaries as
restricted. Which of the following credit-related considerations does
this covenant address?
A. Credit migration risk.
B. Structural subordination.
C. Payments to equity holders.
104.
Consider a 25-year, $1,000 par semiannual-pay bond with a 7.5% coupon
and a 9.25% YTM. Based on a yield change of 50 basis points, the
effective duration of the bond is closest to:
A. 8.73.
B. 10.03.
C. 12.50.
105.
For a bond currently priced at $1,018 with an effective duration of 7.48,
if the market yield moved down 75 basis points, the new price would be
approximately:
A. $961.
B. $1,075.
C. $1,094.
106.
Which of the following statements about Treasury Inflation Protected
Securities (TIPS) is most accurate?
A. Inflation adjustments are made annually.
B. Yields on TIPS are effectively real rates of interest.
C. The coupon rate adjusts upward for inflation.
107.
Consider a $1,000-face value, 12-year, 8%, semiannual coupon bond with
a YTM of 10.45%. The change in value for a decrease in yield of 38 basis
points is:
A. $21.18.
B. $22.76.
C. $23.06.
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Exam 1
Morning Session
108.
The minimum data required to calculate the implied forward rate for three
years beginning three years from now is:
A. the 3-year and 6-year spot rates.
B. the 4-year, 5-year, and 6-year spot rates.
C. spot rates at 1-year intervals for the 6-year period.
109.
Consider three bonds that are identical in all features except those shown
in the following table:
Bond
Embedded Option
Amount Outstanding
A
Call
$20 million
B
Call
$80 million
C
Put
$20 million
The bond most likely to have the largest spread to a comparable Treasury
security is:
A. Bond A.
B. Bond B.
C. Bond C.
110.
A 3-year, 6% coupon, semiannual-pay note has a yield to maturity of
5.5%. If an investor holds this note to maturity and earns a 4.5% return on
reinvested coupon income, his realized yield on the note is closest to:
A. 5.46%.
B. 5.57%.
C. 5.68%.
Questions 111 through 116 relate to Derivatives. (9 minutes)
111.
Janet Powers writes a covered call on a stock she owns, Billings, Inc. The
current price of the stock is $45, and Powers writes the call at a strike
price of $50. The call option premium is $3.50. Which of the following
statements regarding Powers’s covered call strategy is most accurate?
A. Powers is trading the stock’s upside potential in exchange for current
income.
B. The price of the stock must rise to at least $48.50 before Powers will
lose money.
C. Powers is eliminating downside risk at the same time she is increasing
her current income with the covered call strategy.
112.
A portfolio manager holds a long position on a forward contract on
$20 million face value 81-day T-bills priced at 1.85% on a discount basis.
At settlement, 81-day T-bills are priced at 1.95% on a discount basis. If the
contract settles in cash, at settlement the portfolio manager will:
A. pay $4,500.
B. receive $4,500.
C. pay $20,000.
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Exam 1
Morning Session Answers
93. CThe short seller loses if the stock price increases. The other choices are accurate
statements. (Study Session 13, LOS 46.e)
94. B
Bond indexes are more difficult to build and maintain than stock indexes for several
reasons. Bonds in an index have to be replaced as they mature, so turnover is likely to
be greater in a bond index than in a stock index. Many bonds lack the continuous trade
data that exists for exchange-traded equities. (Study Session 13, LOS 47.i)
95. B
You can select the correct answer without calculating the share values. Royal is using a
shorter period of supernormal growth and a higher required rate of return on the stock.
Both of these factors will contribute to a lower value using the multistage DDM.
Knight:
royal:
$1(1.10) $1(1.10)2 $1(1.10)3 / (0.09 − 0.04)
+
+
= $24.43
1.09
1.092
1.092
$1(1.10) $1(1.10)2 / (0.10 − 0.04)
+
= $19.33
1.10
1.10
Royal’s valuation is $5.10 less that Knight’s valuation. (Study Session 14, LOS 51.e)
96. B
An industry in the growth stage is usually characterized by increasing profitability,
decreasing prices, and a low degree of competition among competitors.
(Study Session 14, LOS 50.h)
97. BThe market value of the Treasury note is the present value of the remaining coupons
plus the present value of the principal, discounted at the semiannual rates available from
dividing each annual spot rate in the table by two.
$25
$25
$25
$1, 025
+
+
+
= $1, 010.05
2
3
(1.015) (1.0175) (1.02 ) (1.0225)4
value of T-note =
At $1,008, the T-note is priced below the present value of its cash flows ($1,010) and is
therefore underpriced. (Study Session 16, LOS 56.f )
98. B
An issuer of a callable bond must compensate the bondholder when the issue is sold
by offering a higher coupon rate or accepting a lower price than if the call feature was
not included. Convexity will typically be much less than for an option-free bond, and
reinvestment risk is greater for callable bonds. (Study Session 15, LOS 53.h)
99. CThe bond equivalent yield rate on the par bond (Z) is 6% or a 3% semiannual rate.
The equivalent quarterly rate, 1.031/2 – 1 = 0.014889. Security X makes 20 quarterly
payments of $15 and 20 quarterly payments of $20. We need to use the cash flow
function as follows: CF0 = 0; CF1 = 15; F1 = 20; CF2 = 20; F2 = 19; CF3 = 1,020;
F3 = 1; I = 1.4889; CPT → NPV = $1,067.27. Note that CF3 contains the final
quarterly payment of $20 along with the $1,000 face value payment. (Study Session 16,
LOS 56.c)
100. C Yield spreads reflect the credit quality of bond issuers and the liquidity of the market
for their bonds. Narrowing (decreasing) yield spreads reflect improving credit quality or
more liquidity. Widening (increasing) yield spreads reflect deteriorating credit quality
or less liquidity. Increased estimates of the recovery rate in the event of default represent
an improvement in investors’ assessment of the issuer’s credit quality and are likely to
narrow yield spreads on the issuer’s bonds. (Study Session 16, LOS 59.a)
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Exam 1
Morning Session Answers
101. AThe full price is clean price plus accrued interest. (Study Session 15, LOS 52.c)
102. BThe issuer may deliver either cash or bonds to the trustee. Specific bonds to be redeemed
are not typically identified in advance. Companies would retire through the delivery of
securities if yields have increased. (Study Session 15, LOS 52.d,e)
103. BRestricted subsidiaries are those whose cash flows and assets are designated to service the
debt of their holding company. Classifying a subsidiary as restricted alleviates structural
subordination by making holding company debt rank pari passu with the subsidiary’s
debt. (Study Session 16, LOS 59.j)
104. BCalculate the new bond prices at the 50 basis point change in rates both up or down and
then plug into the effective duration equation:
current price: N = 50; FV = 1,000; PMT = (0.075/2)1,000 = 37.50; I/Y = 4.625;
CPT → PV = $830.54
+50 basis pts: N = 50; FV = 1,000; PMT = (0.075/2)1,000 = 37.50; I/Y = 4.875;
CPT → PV = $790.59
–50 basis pts: N = 50; FV = 1,000; PMT = (0.075/2)1,000 = 37.50; I/Y = 4.375;
CPT → PV = $873.93.
Deffective =
v− − v+ $873.93 − $790.59
=
= 10.03
2 v0 ∆y
2 (830.54 )(0.005)
(Study Session 16, LOS 58.d)
105. B [1 + 7.48 (0.0075)] 1,018 = $1,075 (Study Session 15, LOS 53.f )
106. B Inflation adjustments to principal are made semiannually. The coupon rate is fixed.
Inflation adjustments make the yields on TIPS good estimates of their real returns.
(Study Session 15, LOS 54.b)
107. CWith YTM = 10.45% (I/Y = 5.225), PMT = 40, N = 24, FV = 1,000, PV = $834.61.
With YTM = 10.07% (I/Y = 5.035), PV = $857.67, an increase of $23.06.
(Study Session 15, LOS 53.f )
108. A If we want the 3-year forward rate in three years, the appropriate formula is:
 (1 + z )6 1/3
6 

−1
3 f3 = 
3
1
z
(
+

3 ) 
z6 = 6-year spot rate and z3= 3-year spot rate. (Study Session 16, LOS 57.g)
109. A The call benefits the issuer, so a bondholder will require a higher yield on a callable
bond, while the put option has value to the bondholder. Therefore a callable bond will
have a higher yield spread to Treasuries than an otherwise identical putable bond. Other
things equal, a bond with less liquidity will have a higher spread to Treasuries than a
bond with more liquidity. Smaller issue size is associated with less liquidity.
(Study Session 15, LOS 55.g, h)
110. A This question does not require calculations. Because the return on reinvested coupon
interest is less than the note’s yield to maturity, the investor’s realized yield on the note
must be less than the YTM. Only Choice A can be correct. (Study Session 16, LOS 57.c)
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