Title Fixed Income - Solution.pdf ✅

CFA Program Level I for February 2024 1 Fixed Income (Solution) 1. A. Incorrect because a bond that is currently callable may be retired by the issuer, but the issuer is not required to do 50. B. Incorrect because a step-up note has a coupon rate that increases over time according to a predetermined schedule. C. Correct. A sinking fund provision requires retirement of a portion of the bond's principal every year, rather than retirement of the entire issue at maturity. Fixed Income: describe common cash flow structures of fixed-income instruments and contrast cash flow contingency provisions that benefit issuers and investors 2. A. Incorrect because the yield to maturity converted to a quarterly basis should be expressed in annual terms just like the semiannual yield to maturity: for bonds maturing in more than one year, investors want an annualized and compounded yield-to-maturity. The formula for converting m periods to n periods per year is (1 + APRm /m)m = (1 + APRn /n)n . Thus, (1+0.08/2)2 = (1 + APR4/4)4 <=> APR4/4= 1.98% ≠ APR4 . B. Incorrect because the yield to maturity converted to a quarterly basis cannot be calculated by simply scaling the yield to maturity with a periodicity that is twice longer: APR4 ≠(1 + APR2) 1/2 - 1 = 1.081/2 – 1 = 3.92%. The correct formula for converting m periods to n periods per year is (1 + APRm/m)m = (1 + APR>n/n)n C. Correct because (1 + APR2/2)2 = (1 + APR4/4)4 for annual percentage rates using semiannual and quarterly basis (APR2 and APR4, respectively). This gives (1+0.08/2)2 = (1 + APR4/4)4 = APR4/4 = 1.98% and APR4 = 4 x 1.98% = 7.92%. Fixed Income: calculate annual yield on a bond for varying compounding periods in a year 3. A. Incorrect because this describes modified duration. Modified duration provides an estimate of the percentage price change for a bond given a change in its yield-to-maturity B. Incorrect because the duration of a callable bond is not the sensitivity of the bond price to a change in the yield- to-worst (Le.. the lowest of the yield-to-maturity, yield-to-first-call, yield-to-second-call, and so forth). In contrast to effective duration, key rate durations help
CFA Program Level I for February 2024 2 identify 'shaping risk' for a bond-that is, a bond's sensitivity to changes in the shape of the benchmark yield curve (e.g., the yield curve becoming steeper or flatter). C. Correct because key rate duration (or partial duration) is a measure of a bond's sensitivity to a change in the benchmark yield curve at a specific maturity segment. In contrast to effective duration, key rate durations help identify 'shaping risk for a bond-that is, a bond's sensitivity to changes in the shape of the benchmark yield curve ( e.g., the yield curve becoming steeper or flatter). Fixed Income: define key rate duration and describe its use to measure price sensitivity of fixed-income instruments to benchmark yield curve changes 4. A. Correct because %ΔPVFull = (−AnnModDur × ΔYield) + [(0.5 × Annconvexity × Δ(Yield) 2 ] = (−6.9 × 0.0075) + (0.5 × −212 × 0.00752 ) = −0.05175 − 0.0059625 = 0.0577125, rounded to 5.77%. The percentage decline in price = -0.0577125 x 99.4 = - 5.7366, and the bond price = 99.4 – 5.7366 = 93.6634, rounded to 93.66. B. Incorrect because the price is calculated using par instead of 99.4 Price ≠ 100 - 5.74 = 94.26. C. Incorrect because the convexity adjustment is input as a positive number:(-6.9 x 0.0075) + (0.5 x 212 × 0.00752 ) = -0.05175 + 0.0059625 = 0.04579, rounded to 4.58%. The percentage decline in price = 0.04579 x 99.4 = 4.5515, and the bond price = 99.4 - 4.5515 = 94.8485, rounded to 94.85. Fixed Income: calculate the percentage price change of a bond for a specified change in yield, given the bond's duration and convexity 5. A. Incorrect because a buy-and-hold investor has a higher total return if interest rates rise due to the unexpected excess coupon reinvestment proceeds. If interest rates fall, a buy- and-hold investor realizes no market price returns as he is redeemed at par at maturity. B. Incorrect because a buy-and-hold investor has a higher total return if interest rates rise due to the unexpected excess coupon reinvestment proceeds. If interest rates fall, a buy- and-hold investor realizes no market price returns as he is redeemed at par at maturity. This choice may be attractive to uninformed candidates who focus on the buy-and-hold investor, and not any market interest rate changes. C. Correct because a long-term investor faces coupon reinvestment risk as well as market price risk if the bond needs to be sold prior to maturity. An [buy-and-hold] investor [in a 10- year bond) with a 10-year time horizon is concerned only with coupon reinvestment risk. This situation assumes of course, that the issuer makes all of the coupon and principal
CFA Program Level I for February 2024 3 payments as scheduled. The buy-and-hold investor has a higher total return if interest rates rise and a lower total return if rates fall Fixed Income: describe the relationships among a bond's holding period return, its Macaulay duration, and the investment horizon; 6. A. Incorrect because the coupon of a step-up coupon bond, which may be fixed or floating, increases by specified margins at specified dates. It does not allow the issuer to pay interest in the form of additional amounts of the bond issue in lieu of a cash payment. B. Incorrect because a deferred coupon bond, sometimes called a split coupon bond, pays no coupons for its first few years but then pays a higher coupon than it otherwise normally would for the remainder of its life. It does not allow the issuer to pay interest in the form of additional amounts of the bond issue in lieu of a cash payment C. Correct because a payment-in-kind (PIK) coupon bond typically allows the issuer to pay interest in the form of additional amounts of the bond issue rather than as a cash payment Fixed Income: describe common cash flow structures of fixed-income instruments and contrast cash flow contingency provisions that benefit issuers and investors 7. A. Incorrect because in contrast [to asset-backed securities], in the case of covered bonds, the pool of assets remains on the financial institution's balance sheet. In the event of default, bondholders have recourse against both the financial institution and the cover pool. B. Incorrect because in contrast [to asset-backed securities], in the case of covered bonds, the pool of assets remains on the financial institution's balance sheet. In the event of default, bondholders have recourse against both the financial institution and the cover pool. C. Correct because a covered bond is a debt obligation backed by a segregated pool of assets called a "cover pool" in the event of default, bondholders have recourse against both the financial institution and the cover pool. Fixed Income: describe characteristics and risks of covered bonds and how they differ from other asset-backed securities 8. A. Incorrect because the seller of the collateral, sometimes called the depositor is the corporation that originated the loans. They are sold to an SPE and held by the trustee
CFA Program Level I for February 2024 4 B. Incorrect because the SPE purchases the loans or receivables and uses them as collateral to issue the ABS After the sale is completed, it is [the SPE], not [the depositor/seller], that legally owns them. The SPE owns the collateral but does not hold the collateral, and although the trustee does not own the underlying collateral it does hold it. C. Correct because a trustee or trustee agent is typically a financial institution with trust powers that safeguards the assets after they have been sold to the SPE, holds the funds due to the ABS holders until they are paid, and provides periodic information to the ABS holders Fixed Income: describe securitization, including the parties and the roles they play 9. A. Correct because a mortgage pass-through security's coupon rate is called the pass- through rate. The pass- through rate is lower than the mortgage rate on the underlying pool of mortgages by an amount equal to the servicing and other administrative fees. The pass- through rate that the investor receives is said to be "net interest" or "net coupon. B. Incorrect because not all of the mortgages that are included in a pool of securitized mortgages have the same mortgage rate and the same maturity. The WAC is calculated by weighting the mortgage rate of each mortgage in the pool by the percentage of the outstanding mortgage balance relative to the outstanding amount of all the mortgages in the pool. This rate, less servicing and other administrative fees, determines the pass- through rate C. Incorrect because a mortgage pass-through security's coupon rate is called the pass- through rate. The pass- through rate is lower than the mortgage rate on the underlying pool of mortgages by an amount equal to the servicing and other administrative fees. The pass- through rate that the investor receives is said to be 'net interest' or 'net coupon" Fixed Income: describe types and characteristics of residential mortgage-backed securities, including mortgage pass-through securities and collateralized mortgage obligations, and explain the cash flows and risks for each type 10. A. Incorrect because the formula converts from an effective annual yield to a semiannual- pay yield: ≠ ((1+ yield)0.5 - 1) x 2 = ((1+0.0366)0.5 - 1) x 2= (1.018136 - 1) x 2 = .036272 ≈ 3.63%. B. Correct because an effective annual rate has a periodicity of one because there is just one compounding period in the year. No calculations are required based on the intuitive idea that due to semi-annual compounding, the effective annual yield must be slightly higher. The formula to calculate the effective annual yield of a semi-annual pay bond is: = (1 + yield/2)2 - 1 = (1 + 0.0366/2)2 – 1 = 1.036935 - 1.036935 ≈ 3.69%