Fixed Income: Practice Pack

1. [Credit Default Swaps] The protection seller in a credit default swap (CDS) most
likely:
A. is long credit risk exposure.
B. receives a one-time upfront payment for the life of the contract.
C. pays the notional value of the the security in the event of default.

2. [Credit Default Swaps] With respect to CDS:

A. the protection buyer assumes counterparty risk with respect to the
protection seller.
B. the protection buyer makes a series of periodic, variable payments to the
protection seller.
C. the change in value of the CDS contract fully offsets the change in the value
of the underlying.

3. [Credit Default Swaps] In the event of default, the payout amount for a credit
default swap (CDS) is equal to the notional principal multiplied by:
A. the recovery rate.
B. the loss given default.
C. the probability of default.

4. [Credit Default Swaps] Which of the following statements is most accurate with
respect to the settlement of CDS?
A. Cash settlement is more common than physical settlement
B. The actual recovery rate is typically determined close to the payoff date of
the CDS
C. Settlement typically occurs the business day following the declaration of a
credit event

5. [Credit Default Swaps] An increase in which of the following factors reduces the
value of a CDS?
A. Recovery rate
B. Expected exposure
C. Present value of expected loss

6. [Credit Default Swaps] In a CDS position on a company whose credit spread has
widened, the protection seller:
A. is long credit exposure and would monetize a gain upon unwinding the position.
B. is long credit exposure and would monetize a loss upon unwinding the position.
C. is short credit exposure and would monetize a loss upon unwinding the position.
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7. [Credit Default Swaps] Which of the following participants would most likely be
buyers of protection using CDS?
A. A lender looking to increase exposure to a borrower
B. A trader who believes that the underlying is undervalued relative to the CDS
C. An investor who wants exposure only to the interest rate risk of a company's
debt

8. [Credit Default Swaps] Compared to a bond purchase, a sale of CDS protection on

the bond's issuer most likely:
A. incurs higher transaction costs.
B. establishes a less liquid position.
C. mitigates exposure to interest rate risk.

9. [Credit Default Swaps] A basis trade strategy is based on the difference between
a company's CDS spread and the:
A. company's bond yield.
B. market reference rate.
C. excess of the company's bond yield over the market reference rate.

10. [Credit Default Swaps] The current price of a company's 3-year bond implies a
credit spread of 5%. A comparable 3-year CDS contract has a credit spread of
4%. To best exploit the mispricing, an investor can engage in:
A. a positive basis trade by selling the bond and selling protection through the
CDS.
B. a negative basis trade by buying the bond and buying protection through the
CDS.
C. a negative basis trade by buying the bond and selling protection through the
CDS.

11. [The Term Structure and Interest Rate Dynamics] When the spot rate curve is
downward sloping, the forward rate curve:
A. is below the spot rate curve.
B. fluctuates below and above the spot rate curve.
C. is above the spot rate curve.

12. [The Term Structure and Interest Rate Dynamics] The spot rate for a security
with a maturity of T can be expressed as:
A. a geometric mean of a series of T ‒ 1 spot rates and the one-period forward
rate at T.
B. a geometric mean of the spot rate for a security with a maturity of T = 1 and
a series of T ‒ 1 forward rates.

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C. an arithmetic mean of the spot rate for a security with a maturity of T = 1 and
a series of T ‒ 1 forward rates.

13. [The Term Structure and Interest Rate Dynamics] The process of bootstrapping
is most likely used to:
A. derive the forward rate curve using the spot rate curve.
B. adjust for the shape of the par curve when deriving the spot rate curve.
C. derive zero-coupon rates using the par yields of coupon-paying government
bonds.

14. [The Term Structure and Interest Rate Dynamics] The par curve for US
Treasuries paying annual coupons is presented below:

The 2-year zero-coupon rate is closest to:

A. 4.70%.
B. 5.25%.
C. 5.28%.

15. [The Term Structure and Interest Rate Dynamics] If an investor believes that
future spot rates will be below the rates predicted by the existing forward rates,
the investor should:
A. sell a forward contract.
B. buy a forward contract.
C. neither buy nor sell a forward contract because the forward price will not
change.

16. [The Term Structure and Interest Rate Dynamics] The YTM of a bond provides a
good estimate for expected return if the spot rate curve is:
A. downward sloping.
B. flat.
C. upward sloping.

17. [The Term Structure and Interest Rate Dynamics] All else being equal, the
strategy of rolling down the yield curve delivers the highest relative returns when
the curve is:
A. downward sloping.
B. relatively flat.

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C. upward sloping.

18. [The Term Structure and Interest Rate Dynamics] For an investor expecting
future spot rates to be below the current forward rates, the expected return of
a bond over a 1-year period will be:
A. less than the 1-year risk-free rate.
B. equal to the 1-year risk-free rate.
C. greater than the 1-year risk-free rate.

19. [The Term Structure and Interest Rate Dynamics] Which of the following
statements regarding the swap rate curve is most accurate?
A. It is a type of a spot curve
B. It is derived from default-risk-free rates
C. It is used as a market benchmark when the government bond market is illiquid

20. [The Term Structure and Interest Rate Dynamics] An analyst computes the
following discount factors using a government spot curve:

Based on this information, the 3-year swap rate is closest to:

A. 7.8%.
B. 8.0%.
C. 9.0%.

21. [The Term Structure and Interest Rate Dynamics] A German manufacturing
company has an outstanding bond maturing in five years and trading with a YTM
of 3.90%. If the 5-year Bund is yielding 2.65% and the fixed rate of a 5-year,
fixed-for-float MRR swap is 3.20%, the swap spread is:
A. 55 bps.
B. 70 bps.
C. 125 bps.

22. [The Term Structure and Interest Rate Dynamics] An analyst gathers the
following fixed-income market information for a given maturity:

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Based on this information, the rate paid by the fixed payer in a fixed-for-floating
interest rate swap should be:
A. 4.9%.
B. 5.9%.
C. 6.0%.

23. [The Term Structure and Interest Rate Dynamics] The TED spread is the
difference between the:
A. US T-bill rate and the overnight indexed swap rate.
B. MRR-based Eurodollar futures contract rate and the US T-bill rate.
C. MRR-based Eurodollar futures contract rate and the overnight indexed swap
rate.

24. [The Term Structure and Interest Rate Dynamics] In contrast to the preferred
habitat theory of the term structure of interest rates, the segmented market
theory assumes that:
A. borrowers and lenders have strong preferences for particular maturities.
B. investors will accept additional risk in return for additional expected returns.
C. yields are determined entirely by the supply and demand for funds of a
particular maturity.

25. [The Term Structure and Interest Rate Dynamics] Which of the following
theories of the term structure of interest rates is best represented by both
lender and borrower preferences influencing the shape of the yield curve?
A. Local expectations theory
B. Liquidity preference theory
C. Segmented markets theory

26. [The Term Structure and Interest Rate Dynamics] Short-term yields moving in
the opposite direction of long-term yields primarily represents a change in the:
A. level of the curve.
B. curvature of the curve.
C. steepness of the curve.

27. [The Term Structure and Interest Rate Dynamics] Which yield curve factor
typically has the smallest impact in explaining the total variance in interest rates?
A. Level
B. Curvature
C. Steepness

28. [The Term Structure and Interest Rate Dynamics] Long-term rates are typically:
[Link] volatile than short-term rates.
[Link] volatile as short-term rates.

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[Link] volatile than short-term rates.

29. [The Term Structure and Interest Rate Dynamics] Which of the following
statements is most accurate with respect to the term structure of interest rates
and volatility?
A. Short-term rates are more volatile than long-term rates, and short-term bond
prices are more volatile than long-term bond prices
B. Short-term rates are more volatile than long-term rates, and long-term bond
prices are more volatile than short-term bond prices
C. Long-term rates are more volatile than short-term rates, and long-term bond
prices are more volatile than short-term bond prices

30. [The Term Structure and Interest Rate Dynamics] In a period of economic
expansion, when monetary authorities increase benchmark rates to control
inflation, the yield curve will most likely reflect a:
A. bullish flattening.
B. bearish flattening.
C. bearish steepening.

31. [The Term Structure and Interest Rate Dynamics] Which of the following yield
curve changes would most likely result from a flight to quality?
A. Bullish flattening
B. Bearish flattening
C. Bullish steepening

32. [The Arbitrage-Free Valuation Framework] In the arbitrage-free valuation

framework for a bond with embedded options, the sum of the arbitrage-free value
of the option-free bond and the arbitrage-free value of each of the options is:
A. less than the value of the option-embedded bond.
B. equal to the value of the option-embedded bond.
C. greater than the value of the option-embedded bond

33. [The Arbitrage-Free Valuation Framework] The arbitrage-free valuation of an

option-free corporate bond is equal to the present value of bond's expected cash
flows discounted using the:
A. spot curve.
B. forward curve.
C. bond's yield to maturity.

34. [The Arbitrage-Free Valuation Framework] An analyst gathers the following

information about two annual coupon benchmark bonds:

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The arbitrage-free value of an option-free, 2-year, 6% annual coupon bond with

the same risk and liquidity as the benchmark bonds is closest to:
A. 101.57.
B. 101.88.
C. 101.97.

35. [The Arbitrage-Free Valuation Framework] An analyst gathers the following

information about spot rates:
• 1-year spot rate: 1.50%
• 2-year spot rate: 2.00%
• 3-year spot rate: 4.25%
A 3-year, 5% annual coupon bond with similar risk as the benchmark is trading at
a yield-to-maturity of 4.25%. Compared to the arbitrage-free price, the bond is
currently:
A. undervalued.
B. fairly valued.
C. overvalued.

36. [The Arbitrage-Free Valuation Framework] The creation of a binominal interest

rate tree requires the assumption of:
A. an interest rate model only.
B. the volatility of interest rates only.
C. both an interest rate model and the volatility of interest rates.

37. [The Arbitrage-Free Valuation Framework] In the binomial interest rate tree
framework, under the assumption of lognormal distribution, the probabilities for
the rate going up or down are:
A. equal.
B. functions of the forward rates.
C. dependent on interest rate volatility.

38. [The Arbitrage-Free Valuation Framework] Which of the following statements

regarding the calibration of a binomial interest rate tree to the term structure
is most accurate?
A. The interest rate model used in the process is based on the normal distribution
B. The volatility assumption used in the binomial tree impacts the valuation of an
option-free bond

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C. The interest rate tree is fit to the current yield curve so that the model
produces the benchmark bond values

39. [The Arbitrage-Free Valuation Framework] A correctly calibrated binomial

interest rate tree most likely spreads out around the:
A. spot rate curve.
B. forward rate curve.
C. benchmark rate curve.

40. [The Arbitrage-Free Valuation Framework] An analyst gathers the following data
about a binomial interest rate tree for an option-free, annual coupon bond
maturing in two years.

If the current 1-year spot rate is 1.5% and the bond pays a coupon of 2.0%, the
current value of the bond using the backward induction methodology is closest to:
A. 98.50.
B. 99.96.
C. 100.47.

41. [The Arbitrage-Free Valuation Framework] Using the following binomial interest
rate tree, the value of a 3-year, 5% annual coupon bond is closest to:

A. 81.75.
B. 91.29.
C. 100.83

42. [The Arbitrage-Free Valuation Framework] Pricing an option-free bond using

either an arbitrage-free binomial lattice or the zero-coupon yield curve will result
in the same price because:

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A. both methods use the bond coupon as the discount rate.

B. the application of interest rate volatility is the same for both.
C. the binomial tree is calibrated to the zero-coupon yield curve.

43. [The Arbitrage-Free Valuation Framework] The value of an option-free bond

obtained when discounting cash flows with spot rates will most likely differ from
the value obtained by using a binomial interest rate tree when:
A. interest rate volatility is assumed to be zero.
B. the binomial interest rate tree is not properly calibrated to the spot curve.
C. interest rates are simulated using an insufficient number of potential paths.

44. [The Arbitrage-Free Valuation Framework] When valuing a 4-year zero-coupon

bond using pathwise valuation, the total number of possible paths is:
A. 4.
B. 8.
C. 16.

45. [The Arbitrage-Free Valuation Framework] Based on the following binomial

interest rate tree and forward rates and using pathwise valuation, the present
value of a 3-year, 4% annual coupon bond's cash flows following the path of lowest
rates is closest to:

A. 91.96.
B. 97.60.
C. 99.55

46. [The Arbitrage-Free Valuation Framework] Which of the following statements

regarding the Monte Carlo method to value bonds is most accurate?
A. It is not appropriate for securities whose cash flows are path dependent
B. The greater the number of paths, the closer the model is to the security's
fundamental value

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C. A probability distribution and a volatility assumption are needed to generate

interest rate paths

47. [The Arbitrage-Free Valuation Framework] Which of the following term structure
models is arbitrage-free and uses a binomial lattice approach?
A. The Vasicek model
B. The Ho–Lee model
C. The Cox–Ingersoll–Ross model

48. [The Arbitrage-Free Valuation Framework] Which of the following term structure
models includes a varying short-rate volatility?
A. The Vasicek model
B. The Ho–Lee model
C. The Cox–Ingersoll–Ross model

49. [Valuation and Analysis of Bonds with Embedded Options] Which of the following
bonds has an embedded option that is an investor option?
A. A putable bond
B. A callable bond
C. A sinking fund bond

50. [Valuation and Analysis of Bonds with Embedded Options] Which of the following
type of bond benefits the issuer if interest rates decline?
A. Putable bond
B. Callable bond
C. Extendible bond

51. [Valuation and Analysis of Bonds with Embedded Options] A company that has
issued both a callable bond and a putable bond is:
A. long the put option and short the call option.
B. short the put option and short the call option.
C. short the put option and long the call option.

52. [Valuation and Analysis of Bonds with Embedded Options] When comparing bonds
with embedded options to option-free bonds, which of the following statements
is most accurate? All else being equal, from an investor's perspective:
A. the value of a callable bond is higher than the value of a putable bond.
B. the value of an option-free bond is higher than the value of a putable bond.
C. the value of an option-free bond is higher than the value of a callable bond.

53. [Valuation and Analysis of Bonds with Embedded Options] In an arbitrage-free

framework, the price of an option-free bond is 103.60 and the price of an

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otherwise identical bond with an embedded option is 102.80. An investor in the

bond with an embedded option is:
A. long a put worth 0.80.
B. short a put worth 0.80.
C. short a call worth 0.80.

54. [Valuation and Analysis of Bonds with Embedded Options] In a zero volatility
environment with an upward sloping yield curve, the risk of a callable bond valued
near par being called most likely:
A. decreases over time.
B. remains the same over time.
C. increases over time.

55. [Valuation and Analysis of Bonds with Embedded Options] All else being equal, an
increase in interest rate volatility increases the value of:
A. a putable bond only.
B. a callable bond only.
C. both a putable bond and a callable bond.

56. [Valuation and Analysis of Bonds with Embedded Options] An investor examines
the price sensitivity of a callable bond and a putable bond and concludes that both
bond prices will rise with an increase in interest rate volatility. Is the investor's
conclusion accurate?
A. Yes
B. No, because the price of the putable bond will decrease
C. No, because the price of the callable bond will decrease

57. [Valuation and Analysis of Bonds with Embedded Options] A portfolio manager
expects the current upward sloping yield curve to flatten due to a decrease in
long-term rates. The manager is considering the following bonds, all with a 5%
coupon rate and ten years left to maturity:

All else being equal, the strategy that would benefit the most from the manager's
expectation is to:
A. buy Bond A and sell Bond B.
B. buy Bond C and sell Bond B.
C. buy Bond A and sell Bond C.

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58. [Valuation and Analysis of Bonds with Embedded Options] A portfolio manager
expects the yield curve to steepen due to an increase in long-term rates. A
strategy that would benefit the most from this expectation is to go:
A. long a putable bond and short an otherwise similar straight bond.
B. long a straight bond and short an otherwise similar callable bond.
C. short a callable bond and long an otherwise similar putable bond.

59. [Valuation and Analysis of Bonds with Embedded Options] A default-free

corporate bond with a 3.60% annual coupon rate and two years left to maturity is
putable at par one year from now. The interest rate tree based on an estimated
interest rate volatility is as follows:

The price per 100 of par value of the putable bond is closest to:
A. 100.95.
B. 101.15.
C. 101.28.

60. [Valuation and Analysis of Bonds with Embedded Options] The OAS of a callable
bond is 75 basis points in a zero volatility environment. As interest rate volatility
increases, the bond's OAS most likely:
A. decreases.
B. remains the same.
C. increases.

61. [Valuation and Analysis of Bonds with Embedded Options] In a zero interest rate
volatility environment, the OAS reconciles the market price of a bond to its
arbitrage-free value when a constant spread is added to all of the 1-year:
A. par rates.
B. spot rates.
C. forward rates.

62. [Valuation and Analysis of Bonds with Embedded Options] All else being equal, if
interest rate volatility increases, the OAS for a callable bond:
A. decreases.
B. remains the same.
C. increases.

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63. [Valuation and Analysis of Bonds with Embedded Options] An analyst gathers the
following prices for a 2-year, 4% annual coupon bond and an otherwise identical
bond callable in one year at par:

The effective duration of the callable bond is closest to:

A. 1.074.
B. 1.425.
C. 1.890.

64. [Valuation and Analysis of Bonds with Embedded Options] An analyst uses the
following binomial interest rate tree to examine the interest rate sensitivity of a
2-year, 4% annual coupon bond callable in one year at par, with a current price of
99.6345:

If she estimates the price of the bond to be 98.9323 if the benchmark yield
curve increases by 50bps, the effective duration of the bond is closest to:
A. 0.9344.
B. 1.0716.
C. 1.4186.

65. [Valuation and Analysis of Bonds with Embedded Options] If the effective
duration of a bond decreases significantly when interest rates fall, the bond
is most likely a(n):
A. putable bond.
B. callable bond.
C. option-free bond.

66. [Valuation and Analysis of Bonds with Embedded Options] The effective duration
of a putable bond is similar to that of an otherwise identical option-free bond,
and is not sensitive to a small yield shift. An analyst should conclude that the
embedded put option is:

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A. in the money.
B. at the money.
C. out of the money.

67. [Valuation and Analysis of Bonds with Embedded Options] A 10-year bond is priced
at 100 and is currently callable at par. Compared to its one-sided down-duration,
this bond's one-sided up-duration is most likely:
A. lower.
B. the same.
C. higher.

68. [Valuation and Analysis of Bonds with Embedded Options] If an investor believes
that the yield curve will steepen significantly over the near term, which of the
following duration measures is most appropriate for analyzing the risk of fixed-
income securities?
A. Key rate duration
B. Effective duration
C. One-sided duration

69. [Valuation and Analysis of Bonds with Embedded Options] Which of the following
bonds is most likely to exhibit negative convexity?
A. A putable bond
B. A callable bond
C. An option-free bond

70. [Valuation and Analysis of Bonds with Embedded Options] Compared to a putable
bond, an otherwise identical callable bond:
A. has less downside risk when interest rates rise.
B. has more upside potential when interest rates decline.
C. has lower convexity when the call option is near the money.

71. [Valuation and Analysis of Bonds with Embedded Options] A 2-year floating rate
bond pays annual coupons of the 1-year reference rate (set in arrears) and is
capped at 5%. Reference rates based on an assumed volatility are given in the
binomial interest rate tree below.

The value of the capped floater (as a % of par) is closest to:

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A. 95.24.
B. 99.55.
C. 100.00.

72. [Valuation and Analysis of Bonds with Embedded Options] A 2-year floating rate
bond pays annual coupons of the 1-year reference rate (in arrears) and has a floor
of 4%. Reference rates based on an assumed volatility are given in the binomial
interest rate tree below:

The value of the floored floating rate bond (as a % of par) is closest to:
A. 100.99.
B. 101.19.
C. 101.67.

73. [Valuation and Analysis of Bonds with Embedded Options] When the issuer of a
convertible bond announces a stock split, an analyst adjusts the conversion price
down and the conversion ratio up accordingly. Are these adjustments correct?
A. Yes
B. No, because the conversion ratio does not need to be adjusted
C. No, because the conversion price does not need to be adjusted

74. [Valuation and Analysis of Bonds with Embedded Options] A convertible bond with
a conversion rate of 25 is selling for $948.72. The price of the issuer's otherwise
identical option-free bond is $952.65 and the underlying share price is $37.20.
The convertible bond is:
A. undervalued.
B. fairly valued.
C. overvalued.

75. [Valuation and Analysis of Bonds with Embedded Options] An analyst gathers the
following information about a convertible bond issue:

If the value of an otherwise identical option-free bond by the same issuer is

$650, the minimum value of this convertible bond is:

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A. $650.
B. $660.
C. $720.

76. [Valuation and Analysis of Bonds with Embedded Options] The value of a callable
convertible bond equals the value of the straight bond:
A. plus the value of the call option on the issuer’s stock plus the value of the
issuer call option.
B. plus the value of the call option on the issuer’s stock minus the value of the
issuer call option.
C. minus the value of the call option on the issuer’s stock minus the value of the
issuer call option.

77. [Valuation and Analysis of Bonds with Embedded Options] In an arbitrage-free

framework, the minimum value of a convertible bond is equal to the:
A. value of an otherwise similar straight bond.
B. the lower of the value of the straight bond and the conversion value.
C. the higher of the value of the straight bond and the conversion value.

78. [Valuation and Analysis of Bonds with Embedded Options] An analyst gathers the
following information about a $1,000 par value convertible bond and the underlying
common stock:

The bond has risk-return characteristics most similar to:

A. a busted convertible bond.
B. the common stock of the company.
C. a straight corporate bond issued by the same company.

79. [Valuation and Analysis of Bonds with Embedded Options] An analyst gathers
information about the following $1,000 par value, 10-year maturity bonds issued
by the same company whose stock currently has a price of $70:

If the share price increases, which bond is likely to increase in value the most?

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A. Bond A
B. Bond B
C. Bond C

80. [Credit Analysis Models] An analyst notes that a bond's loss given default
estimates have increased. This is most likely due to an increase in the:
A. recovery rate.
B. expected exposure.
C. probability of default.

81. [Credit Analysis Models] An analyst gathers the following information about a
bond to calculate a credit valuation adjustment:

If the risk-free rate is 3% for this period, the present value of the expected loss
is closest to:
A. 0.616.
B. 0.635.
C. 0.925.

82. [Credit Analysis Models] Which of the following factors carries the highest
weight in the FICO score?
A. Payment history
B. Type of credit used
C. Number of hard credit inquiries

83. [Credit Analysis Models] Notching adjustments are typically made to an issuer's
credit ratings based on its:
A. subordinated debt.
B. senior secured debt.
C. senior unsecured debt.

84. [Credit Analysis Models] An analyst gathers the following information on the
following partial 1-year transition matrix for BB rated bonds and credit spread
data:

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Assuming no default, the 1-year expected return on a BB rated bond with a YTM
of 4.25% and a modified duration of 6.52 is closest to:
A. 3.17%.
B. 4.25%.
C. 5.33%.

85. [Credit Analysis Models] An analyst gathers the following 1-year transition matrix
and credit spread data:

Assuming no default, the 1-year expected return on an A rated bond with a YTM
of 4.45% and modified duration of 3.50 is closest to:
A. 4.30%.
B. 4.40%.
C. 4.60%.

86. [Credit Analysis Models] An analyst estimates the following partial 1-year
transition matrix:

The expected price change for an AAA rated bond with a duration of 3.7, when
downgraded to an A rating, is closest to:
A. –6.48%.
B. –3.70%.
C. –0.07%.

87. [Credit Analysis Models] A structural form model of corporate credit risk:
A. treats default as an exogenous variable.
B. can explain the economic reason for default.
C. does not require an estimate of the company's volatility to implement.

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88. [Credit Analysis Models] A reduced-form model of credit risk:

A. can explain the economic reason for default.
B. assumes default is a surprise and can occur at any time.
C. requires a measure of the company's asset volatility to implement.

89. [Credit Analysis Models] Which of the following is the most appropriate
interpretation of debt and equity in terms of options in a structural model of
credit risk?
A. Equity is a purchased call option on the assets
B. Debt is short a risk-free bond and long a put option on the assets
C. Debt is short the assets and long a call option sold by the shareholders

90. [Credit Analysis Models] A 10-year corporate bond with an annual coupon rate of
4.56% is priced at 98.2% of par. The yield on a 10-year government bond is 3.50%.
The credit spread of the corporate bond is closest to:
A. 0.98%.
B. 1.06%.
C. 1.29%.

91. [Credit Analysis Models] An analyst calculates the value of a corporate bond with
an annual coupon rate of 3.25% and three years left to maturity. The analyst
constructs the binomial interest rate tree as follows:

The discount factors for years 1, 2, and 3 are 0.9709, 0.9206, and 0.8623,
respectively. Assuming the recovery rate is 40% and the annual probability of
default is 1.50%, the credit valuation adjustment to the value of the bond
is closest to:
A. 0.8567.
B. 2.4499.
C. 2.6701.

92. [Credit Analysis Models] An analyst calculates the value of a corporate bond with
an annual coupon rate of 3.25% and three years left to maturity. The analyst
constructs the binomial interest rate tree as follows:

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The discount factors for years 1, 2, and 3 are 0.9709, 0.9206, and 0.8623,
respectively. Assuming the recovery rate is 40% and the annual probability of
default is 1.50%, the fair value of the bond is closest to:
A. 92.731.
B. 95.181.
C. 97.631.

93. [Credit Analysis Models] An increase in which of the following will lead to a
decrease in the credit spread of a security?
A. Credit rating
B. Annual default probability
C. Cumulative default probability

94. [Credit Analysis Models] All else being equal, as the credit valuation adjustment
increases, there is a decrease in the bond's:
A. YTM.
B. price.
C. credit risk.

95. [Credit Analysis Models] An analyst gathers the following information about a 4-
year bond with an annual pay coupon of 5.5%:

If the credit valuation adjustment increases to 3.45, the change in the credit
spread is closest to:
A. 0.32%.
B. 0.94%.
C. 1.59%.

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96. [Credit Analysis Models] An upward sloping credit spread term structure for a
company's bonds is best explained by:
A. a company with high-yield bonds facing imminent default.
B. a cyclical company in an economy coming out of a recession.
C. a company with investment-grade bonds operating in a stable industry.

97. [Credit Analysis Models] Which of the following most likely results in a steeper
credit spread curve for a specific credit rating?
A. An increase in equity volatility
B. An improved overall economic climate
C. The issuance of fewer long-term bonds with the same rating

98. [Credit Analysis Models] For which of the following structured finance asset
types is a statistics-based approach the most appropriate credit analysis
approach?
A. Auto asset-backed securities
B. Asset-backed commercial paper
C. Consumer asset-backed securities

99. [Credit Analysis Models] A credit analyst uses a portfolio approach to evaluate a
securitized pool comprised of numerous underlying assets that have widely varying
debt characteristics and a short-term risk horizon. Which of the pool's
characteristics best supports the analyst's approach for credit evaluation?
A. Risk horizon
B. Number of assets
C. Variability of debt characteristics

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Solution
1. A is Correct because the protection seller is long the credit risk exposure and
must pay in the event of default. In a CDS contract there are two counterparties,
the credit protection buyer and the credit protection seller. The buyer agrees to
make a series of periodic payments to the seller over the life of the contract
(which are determined and fixed at contract initiation) and receives in return a
promise that if default occurs, the protection seller will compensate the
protection buyer.

2. A is Correct because in addition, the credit protection buyer assumes

counterparty risk with respect to the credit protection seller. Under CDS
agreements, the credit protection buyer relies on payment from the seller in the
event of the underlying entity's default.

3. B is Correct because the payout amount is determined as the loss given default
multiplied by the notional.

4. A is Correct because CDS can be settled by physical settlement or by cash

settlement. The former is less common and involves actual delivery of the debt
instrument in exchange for a payment by the credit protection seller of the
notional amount of the contract.

5. A is Correct because the recovery rate is the percentage of loss recovered from
a bond in default.
CVA = Σ (PV of Expected Loss (EL))
EL = Loss given default (LGD) × Probability of default (PD)
LGD = Expected exposure × (1 – Recovery rate)
The higher the recovery rate, the lower the loss given default, the lower the
expected loss and the lower the CVA.

6. B is Correct because the protection seller is effectively long the reference

entity. Thus, the credit protection seller is more or less long the company’s bonds
and going back to the example where the credit quality of the reference entity
improved. The implied upfront premium on a new CDS that matches the terms of
the original CDS with adjusted maturity is now the market value of the original
CDS. The premium on the new CDS is smaller than that on the original CDS. The
protection seller in the original transaction could offset his position by entering
into a new CDS as a protection buyer. He would pay an upfront premium that is
less than what he originally received. The original protection buyer monetizes a
loss, and the seller monetizes a gain. Conversely, if credit spreads widen, the
protection seller would monetize a loss.

7. C is Correct because the investor can reduce the credit risk by buying a CDS.
Consider that any bondholder is a buyer of credit and interest rate risk. If the
bondholder wants only credit risk, it can obtain it by selling protection.

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8. C is Correct because any bondholder is a buyer of credit and interest rate risk.
If the bondholder wants only credit risk, it can obtain it by selling protection.

9. C is Correct because the basis trade strategy is based on the difference between
the company's bond credit spread and the CDS spread. A difference in the credit
spreads in these two markets is the foundation of a strategy known as a basis
trade. To determine the profit potential of such a trade, it is necessary to
decompose the bond yield into the risk-free rate plus the funding spread plus the
credit spread. The risk-free rate plus the funding spread is essentially the market
reference rate. The credit spread is then the excess of the yield over the market
reference rate and can be compared with the credit spread in the CDS market.

10. B is Correct because this would be a negative basis trade. If the spread is higher
in the bond market than in the CDS market, it is said to be a negative basis. From
the perspective of the CDS, its risk premium is too low relative to the bond credit
risk premium. From the perspective of the bond, its risk premium is too high
relative to the CDS market, which means its price is too low. The investor would
buy the bond at a price that appears to overestimate its credit risk and, at the
same time, buy credit protection at what appears to be an unjustifiably low
premium.

11. A is Correct because the forward rates are above spot rates when the spot curve
is upward sloping and below spot rates when the spot curve slopes downward.

12. B is Correct because the spot rate for a security with a maturity of T > 1 can be
expressed as a geometric mean of the spot rate for a security with a maturity of
T = 1 and a series of T ‒ 1 forward rates as per the equation below.
zT = { (1 + z1)(1 + f1,1)(1 + f2,1)(1 + f3,1)...(1 + fT–1,1)}1/T ‒ 1

13. C is Correct because zero-coupon rates are determined by using the par yields
and solving for the zero-coupon rates one by one, from the shortest to longest
maturities using a forward substitution process known as bootstrapping. The par
curve represents the yields to maturity on coupon-paying government bonds,
priced at par, over a range of maturities.

14. C is Correct because to get to the spot rate z2 the following equation needs to
be solved:
1 = [0.0525/(1 + 0.0415)] + [1.0525/(1 + z2)2]
[1.0525/(1 + z2)2] =1 – [0.0525/(1 + 0.0415)]= 1 – 0.050408 = 0.949592
(1 + z2)2 = 1.0525/0.949592 = 1.108371 gives z2 = 5.2792%

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15. B is Correct because if a trader expects the future spot rate to be below what is
predicted by the prevailing forward rate, the forward contract value is expected
to increase and the trader would buy the forward contract.

16. B is Correct because the YTM is generally a realistic estimate of expected return
only if the yield curve is flat.

17. C is Correct because when the yield curve slopes upward, as a bond approaches
maturity or 'rolls down the yield curve,' it is valued at successively lower yields
and higher prices. Using this strategy, a bond can be held for a period of time as
it appreciates in price and then sold before maturity to realize a higher return.
As long as interest rates remain stable and the yield curve retains an upward
slope, this strategy can continuously add to the total return of a bond portfolio.

18. C is Correct because if a portfolio manager's projected spot curve is above

(below) the forward curve and his expectation turns out to be true, the return
will be less (more) than the one-period risk-free interest rate.

19. C is Correct because many countries do not have a liquid government bond market
with maturities longer than one year. The swap curve is a necessary market
benchmark for interest rates in these countries.

20. A is Correct because the three-year swap rate can be determined from spot rates
solving the equation;
s3 /(1 + z1 )1 + s3 /(1 + z2 )2 + s3 /(1 + z3 )3 + 1 /(1 + z3 )3 = 1.
Here, it should be noted that each discount factor,
DFN = 1 /(1 + zN )N. Therefore, the equation above is equivalent to:
s3 × DF1 + s3 × DF2 + s3 × DF3 + DF3 = 1.
Using the values provided in this case:
0.9709 × s3 + 0.8653 × s3 + 0.7938 × s3 + 0.7938 = 1.
2.6300 × s3 = 0.2062.
s3 = 0.0784 ≈ 7.8%.

21. A is Correct because a swap spread is an excess yield of swap rates over the yields
on government bonds, and we use the terms I-spread, ISPRD, or interpolated
spread to refer to bond yields net of the swap rates of the same maturities.
Swap spread = 3.20% – 2.65% = 0.55% = 55 bps.

22. B is Correct because the swap spread is defined as the spread paid by the fixed-
rate payer of an interest rate swap over the rate of the 'on-the-run' (most
recently issued) government security with the same maturity as the swap.
Therefore, the fixed leg of a fixed-for-floating swap will be equal to the on-the-
run Treasury yield plus the swap spread: 5.4% + 0.5% = 5.9%.

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23. B is Correct because "the difference between MRR and the yield on a Treasury
bill of the same maturity, or TED spread, has historically been a key indicator of
perceived credit and liquidity risk. TED is an acronym formed from an abbreviation
for the US T-bill (T) and the ticker symbol for the MRR-based Eurodollar futures
contract (ED)."

24. C is Correct because this is a characteristic of the segmented markets theory.

In summary, the segmented markets theory assumes that market participants are
either unwilling or unable to invest in anything other than securities of their
preferred maturity. It follows that the yield of securities of a particular maturity
is determined entirely by the supply and demand for funds of that particular
maturity.

25. C is Correct because unlike expectations theory and liquidity preference theory,
segmented markets theory allows for lender and borrower preferences to
influence the shape of the yield curve. The result is that yields are not a
reflection of expected spot rates or liquidity premiums. Rather, they are solely a
function of the supply and demand for funds of a particular maturity. That is,
each maturity sector can be thought of as a segmented market in which yield is
determined independently from the yields that prevail in other maturity
segments.

26. C is Correct because the steepness movement refers to a non-parallel shift in the
yield curve when either short-term rates change more than long-term rates or
long-term rates change more than short-term rates.

27. B is Correct because curvature, tends to have a negative impact on intermediate

yields and a positive impact on short- and long-term yields. This variable explaining
the “twist” in the yield curve has the smallest impact of the three.

28. A is Correct because the volatility term structure typically shows that short-
term rates are more volatile than long-term rates

29. B is Correct because the volatility term structure typically shows that short-term
rates are more volatile than long-term rates. That said, long-term bond prices
tend to vary more than short-term bond prices given the impact of duration.

30. B is Correct because during economic expansions, monetary authorities raise

benchmark rates to help control inflation. This action is often consistent with
bearish flattening, or short-term bond yields rising more than long-term bond
yields, resulting in a flatter yield curve.

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31. A is Correct because bullish flattening typically occurs as a result of investor

demand. During highly uncertain market periods, investors flock to government
bonds in what is termed a flight to quality. This term refers to investors’ selling
off higher-risk asset classes such as stocks and commodities in favor of default-
risk-free government bonds. A flight to quality is often associated with bullish
flattening, in which the yield curve flattens as long-term rates fall by more than
short-term rates.

32. B is Correct because a bond with embedded options can be valued in parts as the
sum of the arbitrage-free bond without options (that is, a bond with no embedded
options) and the arbitrage-free value of each of the options

33. A is Correct because the traditional approach to valuing bonds is to discount all
cash flows with the same discount rate as if the yield curve were flat. However,
a bond is properly thought of as a package or portfolio of zero-coupon bonds, also
referred to as zeros or discount instruments. Each zero-coupon bond in such a
package can be valued separately at a discount rate that depends on the shape of
the yield curve and when its single cash flow is delivered in time. The term
structure of these discount rates is referred to as the spot curve. Bond values
derived by summing the present values of the individual zeros (cash flows)
determined by such a procedure can be shown to be arbitrage free.

34. B is Correct because for bonds that are option-free, the arbitrage-free value [is]
the sum of the present values of expected future values using the benchmark
spot rates. The spot rates may be determined using bootstrapping.
The one-year spot rate, z1, is 3%, which is the same as the one-year par rate.
Two-year spot rate, z2, is solved using:
1 = Par rate / ( 1 + z1 ) + (Par rate + 1) / ( 1 + z2 )2 ,
Using the provided values:
1 = 0.05 / ( 1 + 0.03 ) + (0.05 + 1) / ( 1 + z2 )2 ,
( 1 + z2 )2 = 1.103571
z2 = (1.103571)1/2 – 1 = 0.05051 ≈ 5.051%
The arbitrage-free value of the bond is:
P0 = 6/1.03 + 106/(1.05051)2 = 101.877 ≈ 101.88

35. A is Correct because the arbitrage-free price is above the current market price.
To be arbitrage free, each cash flow of a bond must be discounted by the spot
rate for zero-coupon bonds maturing on the same date as the cash flow.
Current price is P = (5 /(1 + 0.0425)) + (5/(1 + 0.0425)2) + (105/(1 + 0.0425)3)
P = 102.0715 ≈ 102.1
Arbitrage-free price = (5/(1 + 0.015)) + (5/(1 + 0.02)2) + (105/(1 + 0.0425)3)
Arbitrage-free price = 102.40664 ≈ 102.4 > 102.1

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The answer can be deduced by the fact that the 3-year spot rate is equal to the
yield to maturity and the other spot rates are lower than the yield to maturity.

36. C is Correct because on a binomial lattice, to obtain the two possible values for
the one-year interest rate one year from today two assumptions are required: an
interest rate model and a volatility of interest rates.

37. A is Correct because in the lognormal model the probabilities for the rate going
up or down are equal.

38. C is Correct because the first step [in constructing a binomial interest tree] is to
describe the calibration of a binomial interest rate tree to match a specific term
structure. We do this to ensure that the model is arbitrage free. We fit the
interest rate tree to the current yield curve by choosing interest rates such that
the model produces the benchmark bond values. Also, finding the rates in the tree
is an iterative process, and the interest rates are found numerically.

39. B is Correct because the binomial tree spreads out around the forward rate curve.
The average is slightly higher than the implied forward rate because of the
assumption of lognormality.

40. C is Correct because both bond values at time 1 have to be discounted by the spot
rate, including the coupon.
Value = ((99.715 × 0.5) + (100.247 × 0.5) + (100 × 0.02)) / (1 + 0.015)
Value = 100.4739 ≈ 100.47

41. C is Correct, the calculations for the value of the bond at time 0 using backward
induction can be found below.

42. C is Correct because the tree was calibrated to the same par curve (and spot
curve) that was used to price this option-free bond using spot rates only, the tree
gives the same price as the spot rate pricing.

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43. B is Correct because the binomial interest rate tree should produce the same
value as when discounting the cash flows with the spot rates. An option-free bond
that is valued by using the binomial interest rate tree should have the same value
as when discounting by the spot rates, which is true because the binomial interest
rate tree is arbitrage free. If the binomial interest rate tree is not calibrated to
the current spot curve, then it is not arbitrage-free and would not produce the
same value as when discounting the cash flows with the spot rates.

44. B is Correct because for a four-year zero-coupon bond, there would be eight
possible paths to arrive at year 4. HHH HHT HTH THH HTT THT TTH TTT.

45. C is Correct because the path of lowest rates is Path 4 below and the present
value is calculated as 4/(1 + 0.03) + 4/[(1 + 0.03) × (1 + 0.046572)] + 104/[(1 + 0.03)
× (1 + 0.046572) × (1 + 0.049127)] = 3.8835 + 3.7107 + 91.9600 = 99.5542 ≈ 99.55

46. C is Correct because interest rate paths are generated on the basis of some
probability distribution and a volatility assumption, and the model is fit to the
current benchmark term structure of interest rates.

47. B is Correct because the first arbitrage-free model was introduced by Ho and
Lee (1986). The model is calibrated to market data and uses a binomial lattice
approach to generate a distribution of possible future interest rates.

48. C is Correct because another important feature of the CIR model is that the
random component varies as rates change. In other words, the short-rate
volatility is a function of the short rate. Importantly, at low rates, rt, the term
becomes small, which prevents rates from turning negative.

49. A is Correct because a putable bond is a bond that includes an embedded put
option. The put option is an investor option; that is, the right to exercise the
option is at the discretion of the bondholder. The put provision allows the
bondholders to put back the bonds to the issuer prior to maturity.

50. B is Correct because a callable bond is a bond that includes an embedded call
option. The call provision allows the issuer to redeem the bond issue prior to
maturity. Early redemption usually happens when the issuer has the opportunity
to replace a high-coupon bond with another bond that has more favorable terms,
typically when interest rates have fallen.

51. C is Correct because for a callable bond, the decision to exercise the call option
is made by the issuer. Thus, the investor is long the bond but short the call option
and the issuer is long the call option. For a putable bond, the decision to exercise

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the put option is made by the investor. Thus, the investor has a long position in
both the bond and the put option and the issuer is short the put option.

52. C is Correct because for a callable bond, the decision to exercise the call option
is made by the issuer. Thus, the investor is long the bond but short the call option.
From the investor’s perspective, therefore, the value of the call option decreases
the value of the callable bond relative to the value of the straight bond.

53. C is Correct because the relationships between the value of a callable bond,
straight bond, and call option that the investor is long the bond and short the call
option. Thus, the value of the call option decreases the value of the callable bond
relative to that of an otherwise identical option-free bond.

54. A is Correct because with an upward sloping yield curve, forward rates increase
faster than spot and par rates. As forward rates rise, the discount rate used to
value the bond also rises and reduces the bonds value, and consequently, call risk.
When the yield curve is upward sloping, the one-period forward rates on the
interest rate tree are high and opportunities for the issuer to call the bond are
fewer. When the yield curve flattens or inverts, many nodes on the tree have
lower forward rates that increase the opportunities to call.

55. A is Correct because as interest rate volatility increases, the value of the putable
bond increases.

56. C is Correct because all else being equal, the call option increases in value with
interest rate volatility. Thus, as interest rate volatility increases, the value of
the callable bond decreases.

57. B is Correct because this position is net long a call, which will benefit if the yield
curve flattens. Position C – B = straight bond – (straight bond – call option) = call
option. All else being equal, the value of the call option increases as the yield curve
flattens.

58. A is Correct because this position is net long a put, which benefits from a
steepening yield curve. Position = (straight bond + put option) – straight bond =
put option. When the yield curve is upward sloping, the one-period forward rates
in the interest rate tree are high, which creates more opportunities for the
investor to put the bond.

59. C is Correct because the bond value at Year 1 when the interest rate is 3.8695%
is (100 + 3.60)/(1 + 3.8695%) ≈ 99.741, in which case the investor will put the bond
at 100. The bond value at Year 1 when the interest rate is 3.1681% is (100 +
3.60)/(1 + 3.1681%) ≈ 100.419, Discounting the coupon payment and the values in
Year 1 to Year 0 to get the price of the bond: (3.60 + 0.5 × 100 + 0.5 × 100.419)/(1
+ 2.5000%) ≈ 101.28.

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60. A is Correct because as interest rate volatility increases, the OAS for the
callable bond decreases.

61. C is Correct because If the bond’s price is given, the OAS is determined by trial
and error. To determine the OAS, we try shifting all the one-year forward rates
in each state by adding a constant spread.

62. A is Correct because as interest rate volatility increases, the OAS for the
callable bond decreases.

63. B is Correct because it is found by applying the formula

EffDur = [(PV–) – (PV+)/[2 × (ΔCurve) × (PV0)].
EffDur = (100.35 – 98.93)/(2 × 0.005 × 99.63) ≈ 1.425.

64. C is Correct and found by first calculating the value for a 50bps downward shift
in rates and then applying the formula EffDur = [(PV–) – (PV+)/[2 × (ΔCurve) ×
(PV0)]. The value for a downward shift is:

Time 0 price = [4 + (0.5 × 99.7156 + 0.5 × 100)]/(1.035) = 100.3457.

EffDur = (100.3457 – 98.9323)/(2 × 0.005 × 99.6345) = 1.4186.

65. B is Correct because the effective duration of the callable bond shortens when
interest rates fall, which is when the call option moves into the money and thus
limits the price appreciation of the callable bond.

66. C is Correct because when interest rates are low relative to the bond’s coupon,
the put option is out of the money so the bond is unlikely to be put. Thus, the
effective duration of the putable bond is in this case very similar to that of an
otherwise identical option-free bond.

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67. C is Correct because the bond is more sensitive to interest rate increases than
interest rate decreases because of the call feature. The one-sided up-duration is
higher than the one-sided down-duration confirms that the callable bond is more
sensitive to interest rate rises than to interest rate declines.

68. A is Correct because using key rate durations (also known as partial durations),
which reflect the sensitivity of the bond’s price to changes in specific maturities
on the benchmark yield curve. Thus, key rate durations help portfolio managers
and risk managers identify the "shaping risk" for bonds—that is, the bond’s
sensitivity to changes in the shape of the yield curve (e.g., steepening and
flattening).

69. B is Correct because the effective convexity of the callable bond turns negative
when the call option is near the money.

70. C is Correct because the effective convexity of the callable bond turns negative
when the call option is near the money, while putable bonds always have positive
convexity.

71. B is Correct because the calculation is as follows:

Value = [4.5 + (0.5 × 99.0566 + 0.5 × 100)]/(1 + 4.5%) = 99.5486 ≈ 99.55

72. C is Correct because it is calculated as follows:

Value = [4.0 + (0.5 × 100 + 0.5 × 102.4631)]/(1 + 3.5%) = 101.6730 ≈ 101.67.

73. A is Correct because the conversion price and conversion ratio need to be
adjusted when the issuer splits stocks. Corporate actions—such as stock splits,

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bonus share issuances, and rights or warrants issuances—affect a company’s share

price and may reduce the benefit of conversion for the convertible bondholders.
Thus, the terms of issuance of the convertible bond contain detailed information
defining how the conversion price and conversion ratio are adjusted should such a
corporate action occur during the life of the bond. For example, suppose an issuer
performs a 2-for-1 stock split. The conversion price would need to be adjusted
down (to half) and the conversion ratio would need to be adjusted up (to double).

74. A is Correct because the minimum value of a convertible bond is equal to the
greater of the conversion value and the value of the underlying option-free bond.
The conversion value = $37.20 × 25 = $930.00. Minimum value of the convertible
bond = Maximum ($930.00; $952.65) = $952.65. Since the price of the bond is
$948.72, the bond is undervalued in the market.

75. B is Correct because the minimum value of a convertible bond is equal to the
greater of the conversion value and the value of the underlying option-free bond.
The conversion value = underlying share price × the conversion ratio
= 55 × 12 = 660. This is greater than the value of the equivalent option-free bond
which is 650.

76. B is Correct because the value of callable convertible bond = value of straight
bond + value of call option on the issuer’s stock – value of issuer call option.

77. C is Correct because the minimum value of a convertible bond is equal to the
greater of the conversion value and the value of the underlying option-free bond.

78. B is Correct because when the underlying share price is above the conversion
price, a convertible bond exhibits mostly stock risk–return characteristics. Here
the conversion price is par value/conversion ratio = $1,000/25 = $40, which is
significantly less than the $50 underlying share price.

79. A is Correct because the current share price of $70 is significantly above the
conversion price of $1,000/18 = $55.56 so that the conversion option is in the
money and the bond is more equity-like. In contrast, when the underlying share
price is above the conversion price, a convertible bond exhibits mostly stock risk–
return characteristics. Thus, the bond will move up in value nearly proportional to
the increase in share price.

80. B is Correct because the loss given default is equal to the expected exposure
times (1 – recovery rate). The expected exposure to default loss is the projected
amount of money the investor could lose if an event of default occurs, before
factoring in possible recovery. When the expected exposure increases, the loss
given default increases.

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81. A is Correct because the present value of the expected loss is estimated as loss
given default (LGD) × Probability of default. The LGD = the exposure × (1 –
recovery rate); = 105.80 × (1 – 60%) = 42.32. The expected loss = LGD × probability
of default; = 42.32 × 1.5% ≈ 0.6348. The present value of the expected loss =
0.635/1.03 ≈ 0.616.

82. A is Correct because of the five primary factors that are included in the
proprietary algorithm used to get the FICO score, the largest weight, at 35%, is
given to the payment history: This includes the presence or lack of such
information as delinquency, bankruptcy, court judgments, repossessions, and
foreclosures.

83. C is Correct because the credit rating agencies consider the expected loss given
default by means of notching, which is a rating adjustment methodology to reflect
the priority of claim for specific debt issues of that issuer and to reflect any
subordination. The issuer rating is typically for senior unsecured debt.

84. A is Correct because the expected return on the BB-rated bond over the next
year is its YTM plus the expected percentage price change in the bond over the
next year.
In the following table, for each possible transition, the expected percentage price
change is the product of the bond’s modified duration of 6.52 multiplied by –1,
and the change in the spread, weighted by the given probability:

Expected percentage price change = (0.0266 × 14.344%) + (0.420 × 11.736%) +

(0.8524 × 0.00%) + (0.0790 × –24.776%) = –1.08%.
The expected return on BB rated bond is its YTM plus the expected percentage
price change due to credit migration: Expected return = 4.25% – 1.08% = 3.17%.

85. A is Correct because for each possible transition, the expected percentage price
change, computed as the product of the modified duration multiplied by –1 and
the change in the spread is calculated as follows:
From A to AA: –3.50 × (0.50% – 1.00%) = +1.75%.
From A to BBB: –3.50 × (1.40% – 1.00%) = –1.40%.
From A to BB: –3.50 × (3.25% – 1.00%) = –7.88%.
The expected percentage change in the value of the A rated bond is computed by
multiplying each expected percentage price change for a possible credit transition
by its respective transition probability and summing the products:

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(0.0250 × 1.75%) + (0.8700 × 0.00%) + (0.0975 × –1.40%) + (0.0075 × –7.88%) = –

0.1518%.
Therefore, the expected return on the bond over the next year is its YTM minus
0.1518% ≈ 0.15%, assuming no default, which equals 4.45% – 0.15% = 4.30%.

86. B is Correct because the expected percentage price change is the product of the
negative of the modified duration and the difference between the credit spread
in the new rating and the old rating:
Expected percentage price change = –3.7 × (0.0175 – 0.0075) = –0.0370, or –3.70%.

87. B is Correct because structural models explain the economic reasons for default
while reduced-form models do not.

88. B is Correct because reduced-form models assume that default comes as a

surprise and can occur at any time.

89. A is Correct because E(T) = max[A(T) – K, 0], where A(T) is the random asset
value as of time T and K is the face value of the bonds, and this equation indicates
that equity is essentially a purchased call option on the assets of the company
whereby the strike price is the face value of the debt.

90. C is Correct because the yield to maturity of the corporate bond is 4.79%,
subtracting the 10-year government bond yield of 3.50% to get a credit spread
of 1.29%. The difference between the yields to maturity on a corporate bond and
a government bond with the same maturity is the most commonly used measure of
credit risk. It is called the credit spread and is also known in practice as the G-
spread. For the corporate bond, N = 10, PMT = 4.56, PV = –98.2, FV = 100, solve
for I/Y to get a yield to maturity of 4.79%. The credit spread is thus 4.79% –
3.50% = 1.29%.

91. B is Correct because the credit valuation adjustment is 2.4499. The value of the
bond at each interest rate node assuming no default can be calculated using the
interest rate tree.

The value of the bond at maturity (Year 3) is 100 + 100 × 3.25% = 103.25
At Year 2, the values are:
103.25/(1 + 8.1823%) ≈ 95.4408
103.25/(1 + 6.6991%) ≈ 96.7675

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103.25/(1 + 5.4848%) ≈ 97.8814

At Year 1, the values are:
(100 × 3.25% + 0.5 × 95.4408 + 0.5 × 96.7675)/(1 + 6.0139%) ≈ 93.7180
(100 × 3.25% + 0.5 × 96.7675 + 0.5 × 97.8814)/(1 + 4.9238%) ≈ 95.8547
The value of bond assuming no default (VND) at year 0 is:
(100 × 3.25% + 0.5 × 93.7180 + 0.5 × 95.8547)/(1 + 3.0000%) ≈ 95.1809
The expected exposure, loss given default, probability of default,
expected losses, discount
factor, and credit valuation adjustment (CVA) each year can be
calculated as follows:
For Year 1:
The expected exposure is
100 × 3.25% + 0.5 × 93.7180 + 0.5 × 95.8547 ≈ 98.0364
The Loss given default is 98.0364 × (1 – 40%) = 58.8218
The probability of default is equal to the annual probability of default of 1.50%.
The expected loss is 58.8218 × 1.50% = 0.8823
Discounting the expected loss by one period to get the CVA for Year 1,
0.8823 × 0.9709 ≈ 0.8567.
For Year 2:
The expected exposure is
100 × 3.25% + 0.25 × 95.4408 + 0.5 × 96.7675 + 0.25 × 99.8814 ≈ 99.9643
The loss given default is 99.9643 × (1 – 40%) ≈ 59.9786
The probability of default is 1.50% × (1 – 1.50%) = 1.4755%.
The expected loss is 59.9786 × 1.4755% ≈ 0.8862,
The CVA for Year 2 is 0.8862 × 0.9206 ≈ 0.8158.
For Year 3:
The expected exposure is 100 + 100 × 3.25% = 103.25,
The loss given default is 103.25 × (1 – 40%) = 61.9500,
The probability of default is 1.50% × (1 – 1.50%)2 ≈ 1.4553%.
The expected loss is 61.9500 × 1.4553% = 0.9016,
The CVA for Year 3 is 0.9016 × 0.8623 ≈ 0.7774.
The results are summarized in the following table:

The credit valuation adjustment is the sum of CVA each year = 0.8567 + 0.8158 +
0.7774 = 2.4499.

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92. A is Correct because the fair value of the bond equals the value assuming no
default (VND) minus credit valuation adjustment (CVA). The value of the bond at
each interest rate node assuming no default can be calculated using the interest
rate tree.

The value of the bond at maturity (Year 3) is 100 + 100 × 3.25% = 103.25
At Year 2, the values are:
103.25/(1 + 8.1823%) ≈ 95.4408
103.25/(1 + 6.6991%) ≈ 96.7675
103.25/(1 + 5.4848%) ≈ 97.8814
At Year 1, the values are:
(100 × 3.25% + 0.5 × 95.4408 + 0.5 × 96.7675)/(1 + 6.0139%) ≈ 93.7180
(100 × 3.25% + 0.5 × 96.7675 + 0.5 × 97.8814)/(1 + 4.9238%) ≈ 95.8547
The value of bond assuming no default (VND) at year 0 is:
(100 × 3.25% + 0.5 × 93.7180 + 0.5 × 95.8547)/(1 + 3.0000%) ≈ 95.1809
The expected exposure, loss given default, probability of default,
expected losses,
discount factor, and credit valuation adjustment (CVA) each year
can be calculated as follows:
For Year 1:
The expected exposure is
100 × 3.25% + 0.5 × 93.7180 + 0.5 × 95.8547 ≈ 98.0364
The Loss given default is 98.0364 × (1 – 40%) = 58.8218
The probability of default is equal to the annual probability of default of 1.50%.
The expected loss is 58.8218 × 1.50% = 0.8823
Discounting the expected loss by one period to get the CVA for Year 1,
0.8823 × 0.9709 ≈ 0.8567.
For Year 2:
The expected exposure is
100 × 3.25% + 0.25 × 95.4408 + 0.5 × 96.7675 + 0.25 × 99.8814 ≈ 99.9643
The loss given default is 99.9643 × (1 – 40%) ≈ 59.9786
The probability of default is 1.50% × (1 – 1.50%) = 1.4755%.
The expected loss is 59.9786 × 1.4755% ≈ 0.8862,
The CVA for Year 2 is 0.8862 × 0.9206 ≈ 0.8158.
For Year 3:
The expected exposure is 100 + 100 × 3.25% = 103.25,

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The loss given default is 103.25 × (1 – 40%) = 61.9500,

The probability of default is 1.50% × (1 – 1.50%)2 ≈ 1.4553%.
The expected loss is 61.9500 × 1.4553% = 0.9016,
The CVA for Year 3 is 0.9016 × 0.8623 ≈ 0.7774.
The results are summarized in the following table:

The credit valuation adjustment is the sum of CVA each year

= 0.8567 + 0.8158 + 0.7774 = 2.4499.
The fair value of the bond = VND – CVA = 95.1809 – 2.4499 ≈ 92.731.

93. A is Correct because an increase in the credit rating of a security is negatively

correlated with the credit spread of that security. A higher credit spread implies
more credit risk and a lower credit rating.

94. B is Correct because the credit valuation adjustment (CVA) is subtracted from
the (hypothetical) value of the bond, if it were default risk free, to get the bond’s
fair value given its credit risk. A higher CVA implies a lower fair value of a bond,
given its credit risk.

95. A is Correct because the credit spread with the credit valuation adjustment
(CVA) is estimated by first finding the yield to maturity of the bond when
adjusting the default-free bond value by the CVA; Bond's new price = 105.45 –
3.45 = 102. The yield-to-maturity of a four-year bond with an annual coupon rate
of 5.5% and a price of 102 is 4.937% ≈ 4.94% (PV = –102, Pmt = 5.5, FV = 100, n =
4; cpt I/Y = 4.937%). The resulting credit spread is 4.94% – 4.00% = 0.94%. The
change in the credit spread = 0.94% – 0.62% = 0.32%.

96. C is Correct because positive-sloped credit spread curves are likely when a high-
quality issuer with a strong competitive position in a stable industry has low
leverage, strong cash flow, and a high profit margin. This type of issuer tends to
exhibit very low short-term credit spreads rising with increasing maturity given
greater uncertainty due to the macroeconomic environment, potential adverse
changes in the competitive landscape, technological change, or other factors that
drive a higher implied probability of default over time.

97. A is Correct because greater equity volatility leads to a steeper credit spread
curve. Holding other factors constant, any microeconomic factor that increases

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the implied default probability, such as greater equity volatility, will tend to drive
a steeper credit spread curve, and the reverse is true with a decline in equity
volatility.

98. B is Correct because asset-backed commercial paper has granular and homogenous
commercial discount credits or credit advances as underlying collateral with a
short-term risk horizon. Short-term structured finance vehicles with granular,
homogeneous assets tend to be evaluated using a statistics-based approach to the
existing book of loans.

99. B is Correct because a highly granular portfolio may have hundreds of underlying
debtors, suggesting it is appropriate to draw conclusions about creditworthiness
based on portfolio summary statistics rather than investigating each borrower.
Alternatively, an asset pool with fewer more-discrete or non-granular investments
would warrant analysis of each individual obligation.

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