Deck 7: The Term Structure and Interest Rate Dynamics

Question 1

According to the local expectations theory, what would be the difference in the one-
month total return if an investor purchased a five-year zero-coupon bond versus a two-
year zero-coupon bond?

Answer 1

The local expectations theory asserts that the total return over a one-month horizon for a
five-year zero-coupon bond would be the same as for a two-year zero-coupon bond.

Question 2

Give two interpretations for the following forward rate: The two-year forward rate one
year from now is 2%.

Answer 2

For the two-year forward rate one year from now of 2%, the two interpretations are as
follows:
• 2% is the rate that will make an investor indifferent between buying a three-year
zero-coupon bond or investing in a one-year zero-coupon bond and when it matures
reinvesting in a zero-coupon bond that matures in two years.
• 2% is the rate that can be locked in today by buying a three-year zero-coupon bond
rather than investing in a one-year zero-coupon bond and when it matures reinvesting
in a zero-coupon bond that matures in two years.

Question 3

The following information relates to Questions 16-29

The forward rate for a one-year loan beginning in two years is closest to:

A) 6.0%.
B) 7.0%.
C) 8.0%.

Answer 3

C

Question 4

The following information relates to Questions 16-29

The one-year spot rate r(1) = 4%, the forward rate for a one-year loan beginning in one year is 6%, and the forward rate for a one-year loan beginning in two years is 8%. Which
Of the following rates is closest to the three-year spot rate?

A) 4.0%
B) 6.0%
C) 8.0%

Question 5

Compare the segmented market and the preferred habitat term structure theories.

Question 6

The following information relates to Questions 16-29

The forward rate for a two-year loan beginning in one year is closest to:

A) 5.0%.
B) 6.0%.
C) 7.0%.

Question 7

If one-period forward rates are decreasing with maturity, the yield curve is most likely:

A) flat.
B) upward sloping.
C) downward sloping.

Question 8

The following information relates to Questions 16-29

The five-year spot rate is not given above; however, the forward price for a two-year zero-coupon bond beginning in three years is known to be 0.8479. The price today of a
Five-year zero-coupon bond is closest to:

A) 0.7119.
B) 0.7835.
C) 0.9524.

Question 9

Which forward rate cannot be computed from the one-, two-, three-, and four-year spot
rates? The rate for a:
A. one-year loan beginning in two years.
b. two-year loan beginning in two years.
C. three-year loan beginning in two years.

Question 10

describe the relationship between forward rates and spot rates if the yield curve is flat.

Question 11

Explain the strategy of riding the yield curve.

Question 12

A. define the yield to maturity for a coupon bond.
b. Is it possible for a coupon bond to earn less than the yield to maturity if held to maturity?

Question 13

Given spot rates for one-, two-, and three-year zero coupon bonds, how many forward
rates can be calculated?

Question 14

Consider spot rates for three zero-coupon bonds: $S : r ( 1 ) = 3 \% , r ( 2 ) = 4 \% \text {, and } r ( 3 ) = 5 \% \text {. Which }$ statement is correct? The forward rate for a one-year loan beginning in one year will be:

A) less than the forward rate for a one-year loan beginning in two years.
B) greater than the forward rate for a two-year loan beginning in one year.
C) greater than the forward rate for a one-year loan beginning in two years.

Question 15

What are the advantages of using the swap curve as a benchmark of interest rates relative
to a government bond yield curve?

Question 16

A. list the three factors that have empirically been observed to affect Treasury security
returns and explain how each of these factors affects returns on Treasury securities.
b. What has been observed to be the most important factor in affecting Treasury returns?
C. Which measures of yield curve risk can measure shaping risk?

Question 17

What is the TEd spread and what type of risk does it measure?

Question 18

describe how the Z-spread can be used to price a bond.

Question 19

If a bond trader believes that current forward rates overstate future spot rates, how might
he or she profit from that conclusion?

Question 20

The following information relates to Questions 16-29

The rate for a one-year loan beginning in one year is closest to:

A) 4.5%.
B) 5.0%.
C) 6.0%.

Question 21

The following information relates to Questions 16-29

The swap spread is quoted as 50 bps. If the five-year uS Treasury bond is yielding 2%, the rate paid by the fixed payer in a five-year interest rate swap is closest to:

A) 0.50%.
B) 1.50%.
C) 2.50%.

Question 22

The following information relates to Questions 16-29

The one-year spot rate r(1) = 5% and the forward price for a one-year zero-coupon bond beginning in one year is 0.9346. The spot price of a two-year zero-coupon bond is closest to:

A) 0.87.
B) 0.89.
C) 0.93.

Question 23

The following information relates to Questions 30-36
Jane nguyen is a senior bond trader and Christine Alexander is a junior bond trader for an investment bank. nguyen is responsible for her own trading activities and also for providing assignments to Alexander that will develop her skills and create profitable trade ideas. Exhibit
1 presents the current par and spot rates.
$\begin{array}{l}\text { EXHIBIT } 1 \text { Current Par and Spot Rates }\\\begin{array} { l c c } \hline \text { Maturity } & \text { Par Rate } & \text { Spot Rate } \\\hline \text { One year } & 2.50 \% & 2.50 \% \\\text { Two years } & 2.99 \% & 3.00 \%\end{array}\end{array}$ (continued)
(Continued)
$\begin{array} { l c c } \hline \text { Maturity } & \text { Par Rate } & \text { Spot Rate } \\\hline \text { Three years } & 3.48 \% & 3.50 \% \\\text { Four years } & 3.95 \% & 4.00 \% \\\text { Five years } & 4.37 \% & \\\hline\end{array}$
Note: Par and spot rates are based on nnual-coupon sovereign bonds. nguyen gives Alexander two assignments that involve researching various questions:
Assignment 1: What is the yield to maturity of the option-free, default risk-free bond presented in Exhibit 2? Assume that the bond is held to maturity, and use the rates shown in Exhibit 1.
$\begin{array}{l}\text { EXHIBIT } 2 \text { Selected Data for } \$ 1,000 \text { Par Bond }\\\begin{array} { l c c } \hline \text { Bond Name } & \text { Maturity (T) } & \text { Coupon } \\\hline \text { Bond Z } & \text { Three years } & 6.00 \% \\\hline\end{array}\end{array}$
Note: Terms are today for a T-year loan.
Assignment 2: Assuming that the projected spot curve two years from today will be below the current forward curve, is bond Z fairly valued, undervalued, or overvalued?
After completing her assignments, Alexander asks about nguyen's current trading activ- ities. nguyen states that she has a two-year investment horizon and will purchase bond Z as part of a strategy to ride the yield curve. Exhibit 1 shows nguyen's yield curve assumptions implied by the spot rates.

-based on Exhibit 1, the five-year spot rate is closest to:

A) 4.40%.
B) 4.45%.
C) 4.50%.

Question 24

The following information relates to Questions 16-29

If the three-month T-bill rate drops and the libor rate remains the same, the relevant TEd spread:

A) increases.
B) decreases.
C) does not change.

Question 25

The following information relates to Questions 16-29

The Z-spread of bond A is 1.05% and the Z-spread of bond b is 1.53%. All else equal, which statement best describes the relationship between the two bonds?

A) bond b is safer and will sell at a lower price.
B) bond b is riskier and will sell at a lower price.
C) bond A is riskier and will sell at a higher price.

Question 26

The following information relates to Questions 30-36
Jane nguyen is a senior bond trader and Christine Alexander is a junior bond trader for an investment bank. nguyen is responsible for her own trading activities and also for providing assignments to Alexander that will develop her skills and create profitable trade ideas. Exhibit
1 presents the current par and spot rates.
$\begin{array}{l}\text { EXHIBIT } 1 \text { Current Par and Spot Rates }\\\begin{array} { l c c } \hline \text { Maturity } & \text { Par Rate } & \text { Spot Rate } \\\hline \text { One year } & 2.50 \% & 2.50 \% \\\text { Two years } & 2.99 \% & 3.00 \%\end{array}\end{array}$ (continued)
(Continued)
$\begin{array} { l c c } \hline \text { Maturity } & \text { Par Rate } & \text { Spot Rate } \\\hline \text { Three years } & 3.48 \% & 3.50 \% \\\text { Four years } & 3.95 \% & 4.00 \% \\\text { Five years } & 4.37 \% & \\\hline\end{array}$
Note: Par and spot rates are based on nnual-coupon sovereign bonds. nguyen gives Alexander two assignments that involve researching various questions:
Assignment 1: What is the yield to maturity of the option-free, default risk-free bond presented in Exhibit 2? Assume that the bond is held to maturity, and use the rates shown in Exhibit 1.
$\begin{array}{l}\text { EXHIBIT } 2 \text { Selected Data for } \$ 1,000 \text { Par Bond }\\\begin{array} { l c c } \hline \text { Bond Name } & \text { Maturity (T) } & \text { Coupon } \\\hline \text { Bond Z } & \text { Three years } & 6.00 \% \\\hline\end{array}\end{array}$
Note: Terms are today for a T-year loan.
Assignment 2: Assuming that the projected spot curve two years from today will be below the current forward curve, is bond Z fairly valued, undervalued, or overvalued?
After completing her assignments, Alexander asks about nguyen's current trading activ- ities. nguyen states that she has a two-year investment horizon and will purchase bond Z as part of a strategy to ride the yield curve. Exhibit 1 shows nguyen's yield curve assumptions implied by the spot rates.

-based on Exhibit 1, the market is most likely expecting:

A) deflation.
B) inflation.
C) no risk premiums.

Question 27

The following information relates to Questions 30-36
Jane nguyen is a senior bond trader and Christine Alexander is a junior bond trader for an investment bank. nguyen is responsible for her own trading activities and also for providing assignments to Alexander that will develop her skills and create profitable trade ideas. Exhibit
1 presents the current par and spot rates.
$\begin{array}{l}\text { EXHIBIT } 1 \text { Current Par and Spot Rates }\\\begin{array} { l c c } \hline \text { Maturity } & \text { Par Rate } & \text { Spot Rate } \\\hline \text { One year } & 2.50 \% & 2.50 \% \\\text { Two years } & 2.99 \% & 3.00 \%\end{array}\end{array}$ (continued)
(Continued)
$\begin{array} { l c c } \hline \text { Maturity } & \text { Par Rate } & \text { Spot Rate } \\\hline \text { Three years } & 3.48 \% & 3.50 \% \\\text { Four years } & 3.95 \% & 4.00 \% \\\text { Five years } & 4.37 \% & \\\hline\end{array}$
Note: Par and spot rates are based on nnual-coupon sovereign bonds. nguyen gives Alexander two assignments that involve researching various questions:
Assignment 1: What is the yield to maturity of the option-free, default risk-free bond presented in Exhibit 2? Assume that the bond is held to maturity, and use the rates shown in Exhibit 1.
$\begin{array}{l}\text { EXHIBIT } 2 \text { Selected Data for } \$ 1,000 \text { Par Bond }\\\begin{array} { l c c } \hline \text { Bond Name } & \text { Maturity (T) } & \text { Coupon } \\\hline \text { Bond Z } & \text { Three years } & 6.00 \% \\\hline\end{array}\end{array}$
Note: Terms are today for a T-year loan.
Assignment 2: Assuming that the projected spot curve two years from today will be below the current forward curve, is bond Z fairly valued, undervalued, or overvalued?
After completing her assignments, Alexander asks about nguyen's current trading activ- ities. nguyen states that she has a two-year investment horizon and will purchase bond Z as part of a strategy to ride the yield curve. Exhibit 1 shows nguyen's yield curve assumptions implied by the spot rates.

-based on Exhibit 1, which of the following forward rates can be computed?

A) A one-year loan beginning in five years
B) A three-year loan beginning in three years
C) A four-year loan beginning in one year

Question 28

laura Mathews recently hired Robert Smith, an investment adviser at Shire Gate Advisers, to assist her in investing. Mathews states that her investment time horizon is short, approximately two years or less. Smith gathers information on spot rates for on-the-run annual-coupon gov-ernment securities and swap spreads, as presented in Exhibit 1. Shire Gate Advisers recently
published a report for its clients stating its belief that, based on the weakness in the financial markets, interest rates will remain stable, the yield curve will not change its level or shape for the next two years, and swap spreads will also remain unchanged.
ExHIbIT 1 Government Spot Rates and Swap Spreads
$\begin{array}{l}\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\text { Maturity (years) }\\\begin{array} { l c c c c } \hline& 1 & 2 & 3 & 4 \\\hline \text { Government spot rate } & 2.25 \% & 2.70 \% & 3.30 \% & 4.05 \% \\\text { Swap spread } & 0.25 \% & 0.30 \% & 0.45 \% & 0.70 \% \\\hline\end{array}\end{array}$
Smith decides to examine the following three investment options for Mathews:
Investment 1: Buy a government security that would have an annualized return that is nearly risk free. Smith is considering two possible implementations: a two-year investment or a combination of two one-year investments.

Investment 2: Buy a four-year, zero-coupon corporate bond and then sell it after two years. Smith illustrates the returns from this strategy using the swap rate as a proxy for corporate yields.

Investment 3: Buy a lower-quality, two-year corporate bond with a coupon rate of $4.15 \%$ and a Z-spread of 65 bps.
When Smith meets with Mathews to present these choices, Mathews tells him that she is somewhat confused by the various spread measures. She is curious to know whether there is one spread measure that could be used as a good indicator of the risk and liquidity of money market securities during the recent past.

-In presenting Investment 1, using Shire Gate Advisers' interest rate outlook, Smith could show that riding the yield curve provides a total return that is most likely:

A) lower than the return on a maturity-matching strategy.
B) equal to the return on a maturity-matching strategy.
C) higher than the return on a maturity-matching strategy.

Question 29

The following information relates to Questions 30-36
Jane nguyen is a senior bond trader and Christine Alexander is a junior bond trader for an investment bank. nguyen is responsible for her own trading activities and also for providing assignments to Alexander that will develop her skills and create profitable trade ideas. Exhibit
1 presents the current par and spot rates.
$\begin{array}{l}\text { EXHIBIT } 1 \text { Current Par and Spot Rates }\\\begin{array} { l c c } \hline \text { Maturity } & \text { Par Rate } & \text { Spot Rate } \\\hline \text { One year } & 2.50 \% & 2.50 \% \\\text { Two years } & 2.99 \% & 3.00 \%\end{array}\end{array}$ (continued)
(Continued)
$\begin{array} { l c c } \hline \text { Maturity } & \text { Par Rate } & \text { Spot Rate } \\\hline \text { Three years } & 3.48 \% & 3.50 \% \\\text { Four years } & 3.95 \% & 4.00 \% \\\text { Five years } & 4.37 \% & \\\hline\end{array}$
Note: Par and spot rates are based on nnual-coupon sovereign bonds. nguyen gives Alexander two assignments that involve researching various questions:
Assignment 1: What is the yield to maturity of the option-free, default risk-free bond presented in Exhibit 2? Assume that the bond is held to maturity, and use the rates shown in Exhibit 1.
$\begin{array}{l}\text { EXHIBIT } 2 \text { Selected Data for } \$ 1,000 \text { Par Bond }\\\begin{array} { l c c } \hline \text { Bond Name } & \text { Maturity (T) } & \text { Coupon } \\\hline \text { Bond Z } & \text { Three years } & 6.00 \% \\\hline\end{array}\end{array}$
Note: Terms are today for a T-year loan.
Assignment 2: Assuming that the projected spot curve two years from today will be below the current forward curve, is bond Z fairly valued, undervalued, or overvalued?
After completing her assignments, Alexander asks about nguyen's current trading activ- ities. nguyen states that she has a two-year investment horizon and will purchase bond Z as part of a strategy to ride the yield curve. Exhibit 1 shows nguyen's yield curve assumptions implied by the spot rates.

-For Assignment 2, Alexander should conclude that bond Z is currently:

A) undervalued.
B) fairly valued.
C) overvalued.

Question 30

The following information relates to Questions 30-36
Jane nguyen is a senior bond trader and Christine Alexander is a junior bond trader for an investment bank. nguyen is responsible for her own trading activities and also for providing assignments to Alexander that will develop her skills and create profitable trade ideas. Exhibit
1 presents the current par and spot rates.
$\begin{array}{l}\text { EXHIBIT } 1 \text { Current Par and Spot Rates }\\\begin{array} { l c c } \hline \text { Maturity } & \text { Par Rate } & \text { Spot Rate } \\\hline \text { One year } & 2.50 \% & 2.50 \% \\\text { Two years } & 2.99 \% & 3.00 \%\end{array}\end{array}$ (continued)
(Continued)
$\begin{array} { l c c } \hline \text { Maturity } & \text { Par Rate } & \text { Spot Rate } \\\hline \text { Three years } & 3.48 \% & 3.50 \% \\\text { Four years } & 3.95 \% & 4.00 \% \\\text { Five years } & 4.37 \% & \\\hline\end{array}$
Note: Par and spot rates are based on nnual-coupon sovereign bonds. nguyen gives Alexander two assignments that involve researching various questions:
Assignment 1: What is the yield to maturity of the option-free, default risk-free bond presented in Exhibit 2? Assume that the bond is held to maturity, and use the rates shown in Exhibit 1.
$\begin{array}{l}\text { EXHIBIT } 2 \text { Selected Data for } \$ 1,000 \text { Par Bond }\\\begin{array} { l c c } \hline \text { Bond Name } & \text { Maturity (T) } & \text { Coupon } \\\hline \text { Bond Z } & \text { Three years } & 6.00 \% \\\hline\end{array}\end{array}$
Note: Terms are today for a T-year loan.
Assignment 2: Assuming that the projected spot curve two years from today will be below the current forward curve, is bond Z fairly valued, undervalued, or overvalued?
After completing her assignments, Alexander asks about nguyen's current trading activ- ities. nguyen states that she has a two-year investment horizon and will purchase bond Z as part of a strategy to ride the yield curve. Exhibit 1 shows nguyen's yield curve assumptions implied by the spot rates.

-by choosing to buy bond Z, nguyen is most likely making which of the following assumptions?

A) bond Z will be held to maturity.
B) The three-year forward curve is above the spot curve.
C) Future spot rates do not accurately reflect future inflation.

Question 31

laura Mathews recently hired Robert Smith, an investment adviser at Shire Gate Advisers, to assist her in investing. Mathews states that her investment time horizon is short, approximately two years or less. Smith gathers information on spot rates for on-the-run annual-coupon gov-ernment securities and swap spreads, as presented in Exhibit 1. Shire Gate Advisers recently
published a report for its clients stating its belief that, based on the weakness in the financial markets, interest rates will remain stable, the yield curve will not change its level or shape for the next two years, and swap spreads will also remain unchanged.
ExHIbIT 1 Government Spot Rates and Swap Spreads
$\begin{array}{l}\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\text { Maturity (years) }\\\begin{array} { l c c c c } \hline& 1 & 2 & 3 & 4 \\\hline \text { Government spot rate } & 2.25 \% & 2.70 \% & 3.30 \% & 4.05 \% \\\text { Swap spread } & 0.25 \% & 0.30 \% & 0.45 \% & 0.70 \% \\\hline\end{array}\end{array}$
Smith decides to examine the following three investment options for Mathews:
Investment 1: Buy a government security that would have an annualized return that is nearly risk free. Smith is considering two possible implementations: a two-year investment or a combination of two one-year investments.

Investment 2: Buy a four-year, zero-coupon corporate bond and then sell it after two years. Smith illustrates the returns from this strategy using the swap rate as a proxy for corporate yields.

Investment 3: Buy a lower-quality, two-year corporate bond with a coupon rate of $4.15 \%$ and a Z-spread of 65 bps.
When Smith meets with Mathews to present these choices, Mathews tells him that she is somewhat confused by the various spread measures. She is curious to know whether there is one spread measure that could be used as a good indicator of the risk and liquidity of money market securities during the recent past.

-The bond in Investment 3 is most likely trading at a price of:

A) 100.97.
B) 101.54.
C) 104.09.

Question 32

laura Mathews recently hired Robert Smith, an investment adviser at Shire Gate Advisers, to assist her in investing. Mathews states that her investment time horizon is short, approximately two years or less. Smith gathers information on spot rates for on-the-run annual-coupon gov-ernment securities and swap spreads, as presented in Exhibit 1. Shire Gate Advisers recently
published a report for its clients stating its belief that, based on the weakness in the financial markets, interest rates will remain stable, the yield curve will not change its level or shape for the next two years, and swap spreads will also remain unchanged.
ExHIbIT 1 Government Spot Rates and Swap Spreads
$\begin{array}{l}\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\text { Maturity (years) }\\\begin{array} { l c c c c } \hline& 1 & 2 & 3 & 4 \\\hline \text { Government spot rate } & 2.25 \% & 2.70 \% & 3.30 \% & 4.05 \% \\\text { Swap spread } & 0.25 \% & 0.30 \% & 0.45 \% & 0.70 \% \\\hline\end{array}\end{array}$
Smith decides to examine the following three investment options for Mathews:
Investment 1: Buy a government security that would have an annualized return that is nearly risk free. Smith is considering two possible implementations: a two-year investment or a combination of two one-year investments.

Investment 2: Buy a four-year, zero-coupon corporate bond and then sell it after two years. Smith illustrates the returns from this strategy using the swap rate as a proxy for corporate yields.

Investment 3: Buy a lower-quality, two-year corporate bond with a coupon rate of $4.15 \%$ and a Z-spread of 65 bps.
When Smith meets with Mathews to present these choices, Mathews tells him that she is somewhat confused by the various spread measures. She is curious to know whether there is one spread measure that could be used as a good indicator of the risk and liquidity of money market securities during the recent past.

-In his presentation of Investment 1, Smith could show that under the no-arbitrage principle, the forward price of a one-year government bond to be issued in one year is closest to:

A) 0.9662.
B) 0.9694.
C) 0.9780.

Question 33

The following information relates to Questions 16-29

In a typical interest rate swap contract, the swap rate is best described as the interest rate for the:

A) fixed-rate leg of the swap.
B) floating-rate leg of the swap.
C) difference between the fixed and floating legs of the swap.

Question 34

The following information relates to Questions 16-29

Given the yield curve for uS Treasury zero-coupon bonds, which spread is most helpful pricing a corporate bond? The:

A) Z-Spread.
B) TEd spread.
C) libor-oIS spread.

Question 35

The following information relates to Questions 16-29

Which term structure model can be calibrated to closely fit an observed yield curve?

A) The Ho-lee Model
B) The Vasicek Model
C) The Cox-Ingersoll-Ross Model

Question 36

The following information relates to Questions 16-29

A four-year corporate bond with a 7% coupon has a Z-spread of 200 bps. Assume a flat yield curve with an interest rate for all maturities of 5% and annual compounding. The
Bond will most likely sell:

A) close to par.
B) at a premium to par.
C) at a discount to par.

Question 37

The following information relates to Questions 30-36
Jane nguyen is a senior bond trader and Christine Alexander is a junior bond trader for an investment bank. nguyen is responsible for her own trading activities and also for providing assignments to Alexander that will develop her skills and create profitable trade ideas. Exhibit
1 presents the current par and spot rates.
$\begin{array}{l}\text { EXHIBIT } 1 \text { Current Par and Spot Rates }\\\begin{array} { l c c } \hline \text { Maturity } & \text { Par Rate } & \text { Spot Rate } \\\hline \text { One year } & 2.50 \% & 2.50 \% \\\text { Two years } & 2.99 \% & 3.00 \%\end{array}\end{array}$ (continued)
(Continued)
$\begin{array} { l c c } \hline \text { Maturity } & \text { Par Rate } & \text { Spot Rate } \\\hline \text { Three years } & 3.48 \% & 3.50 \% \\\text { Four years } & 3.95 \% & 4.00 \% \\\text { Five years } & 4.37 \% & \\\hline\end{array}$
Note: Par and spot rates are based on nnual-coupon sovereign bonds. nguyen gives Alexander two assignments that involve researching various questions:
Assignment 1: What is the yield to maturity of the option-free, default risk-free bond presented in Exhibit 2? Assume that the bond is held to maturity, and use the rates shown in Exhibit 1.
$\begin{array}{l}\text { EXHIBIT } 2 \text { Selected Data for } \$ 1,000 \text { Par Bond }\\\begin{array} { l c c } \hline \text { Bond Name } & \text { Maturity (T) } & \text { Coupon } \\\hline \text { Bond Z } & \text { Three years } & 6.00 \% \\\hline\end{array}\end{array}$
Note: Terms are today for a T-year loan.
Assignment 2: Assuming that the projected spot curve two years from today will be below the current forward curve, is bond Z fairly valued, undervalued, or overvalued?
After completing her assignments, Alexander asks about nguyen's current trading activ- ities. nguyen states that she has a two-year investment horizon and will purchase bond Z as part of a strategy to ride the yield curve. Exhibit 1 shows nguyen's yield curve assumptions implied by the spot rates.

-For Assignment 1, the yield to maturity for bond Z is closest to the:

A) one-year spot rate.
B) two-year spot rate.
C) three-year spot rate.

Question 38

laura Mathews recently hired Robert Smith, an investment adviser at Shire Gate Advisers, to assist her in investing. Mathews states that her investment time horizon is short, approximately two years or less. Smith gathers information on spot rates for on-the-run annual-coupon gov-ernment securities and swap spreads, as presented in Exhibit 1. Shire Gate Advisers recently
published a report for its clients stating its belief that, based on the weakness in the financial markets, interest rates will remain stable, the yield curve will not change its level or shape for the next two years, and swap spreads will also remain unchanged.
ExHIbIT 1 Government Spot Rates and Swap Spreads
$\begin{array}{l}\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\text { Maturity (years) }\\\begin{array} { l c c c c } \hline& 1 & 2 & 3 & 4 \\\hline \text { Government spot rate } & 2.25 \% & 2.70 \% & 3.30 \% & 4.05 \% \\\text { Swap spread } & 0.25 \% & 0.30 \% & 0.45 \% & 0.70 \% \\\hline\end{array}\end{array}$
Smith decides to examine the following three investment options for Mathews:
Investment 1: Buy a government security that would have an annualized return that is nearly risk free. Smith is considering two possible implementations: a two-year investment or a combination of two one-year investments.

Investment 2: Buy a four-year, zero-coupon corporate bond and then sell it after two years. Smith illustrates the returns from this strategy using the swap rate as a proxy for corporate yields.

Investment 3: Buy a lower-quality, two-year corporate bond with a coupon rate of $4.15 \%$ and a Z-spread of 65 bps.
When Smith meets with Mathews to present these choices, Mathews tells him that she is somewhat confused by the various spread measures. She is curious to know whether there is one spread measure that could be used as a good indicator of the risk and liquidity of money market securities during the recent past.

-In presenting Investment 2, Smith should show a total return closest to:

A) 4.31%.
B) 5.42%.
C) 6.53%.

Question 39

The following information relates to Questions 30-36
Jane nguyen is a senior bond trader and Christine Alexander is a junior bond trader for an investment bank. nguyen is responsible for her own trading activities and also for providing assignments to Alexander that will develop her skills and create profitable trade ideas. Exhibit
1 presents the current par and spot rates.
$\begin{array}{l}\text { EXHIBIT } 1 \text { Current Par and Spot Rates }\\\begin{array} { l c c } \hline \text { Maturity } & \text { Par Rate } & \text { Spot Rate } \\\hline \text { One year } & 2.50 \% & 2.50 \% \\\text { Two years } & 2.99 \% & 3.00 \%\end{array}\end{array}$ (continued)
(Continued)
$\begin{array} { l c c } \hline \text { Maturity } & \text { Par Rate } & \text { Spot Rate } \\\hline \text { Three years } & 3.48 \% & 3.50 \% \\\text { Four years } & 3.95 \% & 4.00 \% \\\text { Five years } & 4.37 \% & \\\hline\end{array}$
Note: Par and spot rates are based on nnual-coupon sovereign bonds. nguyen gives Alexander two assignments that involve researching various questions:
Assignment 1: What is the yield to maturity of the option-free, default risk-free bond presented in Exhibit 2? Assume that the bond is held to maturity, and use the rates shown in Exhibit 1.
$\begin{array}{l}\text { EXHIBIT } 2 \text { Selected Data for } \$ 1,000 \text { Par Bond }\\\begin{array} { l c c } \hline \text { Bond Name } & \text { Maturity (T) } & \text { Coupon } \\\hline \text { Bond Z } & \text { Three years } & 6.00 \% \\\hline\end{array}\end{array}$
Note: Terms are today for a T-year loan.
Assignment 2: Assuming that the projected spot curve two years from today will be below the current forward curve, is bond Z fairly valued, undervalued, or overvalued?
After completing her assignments, Alexander asks about nguyen's current trading activ- ities. nguyen states that she has a two-year investment horizon and will purchase bond Z as part of a strategy to ride the yield curve. Exhibit 1 shows nguyen's yield curve assumptions implied by the spot rates.

-based on Exhibit 1, the forward rate of a one-year loan beginning in three years is closest to:

A) 4.17%.
B) 4.50%.
C) 5.51%.

Question 40

The following information relates to Questions 16-29

A two-year fixed-for-floating libor swap is 1.00% and the two-year uS Treasury bond is yielding 0.63%. The swap spread is closest to:

A) 37 bps.
B) 100 bps.
C) 163 bps.

Question 41

The following information relates to Questions 49-57
liz Tyo is a fund manager for an actively managed global fixed-income fund that buys bonds
issued in Countries A, b, and
Tyo's assistant should calculate a forward rate closest to:

A) 9.07%.
B) 9.58%.
C) 9.97%.

Question 42

Which of Madison's statement(s) regarding equilibrium and arbitrage-free term structure models is incorrect?

A) Statement 1 only
B) Statement 2 only
C) both Statement 1 and Statement 2

Question 43

laura Mathews recently hired Robert Smith, an investment adviser at Shire Gate Advisers, to assist her in investing. Mathews states that her investment time horizon is short, approximately two years or less. Smith gathers information on spot rates for on-the-run annual-coupon gov-ernment securities and swap spreads, as presented in Exhibit 1. Shire Gate Advisers recently
published a report for its clients stating its belief that, based on the weakness in the financial markets, interest rates will remain stable, the yield curve will not change its level or shape for the next two years, and swap spreads will also remain unchanged.
ExHIbIT 1 Government Spot Rates and Swap Spreads
$\begin{array}{l}\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\text { Maturity (years) }\\\begin{array} { l c c c c } \hline& 1 & 2 & 3 & 4 \\\hline \text { Government spot rate } & 2.25 \% & 2.70 \% & 3.30 \% & 4.05 \% \\\text { Swap spread } & 0.25 \% & 0.30 \% & 0.45 \% & 0.70 \% \\\hline\end{array}\end{array}$
Smith decides to examine the following three investment options for Mathews:
Investment 1: Buy a government security that would have an annualized return that is nearly risk free. Smith is considering two possible implementations: a two-year investment or a combination of two one-year investments.

Investment 2: Buy a four-year, zero-coupon corporate bond and then sell it after two years. Smith illustrates the returns from this strategy using the swap rate as a proxy for corporate yields.

Investment 3: Buy a lower-quality, two-year corporate bond with a coupon rate of $4.15 \%$ and a Z-spread of 65 bps.
When Smith meets with Mathews to present these choices, Mathews tells him that she is somewhat confused by the various spread measures. She is curious to know whether there is one spread measure that could be used as a good indicator of the risk and liquidity of money market securities during the recent past.

-The most appropriate response to Mathews question regarding a spread measure is the:

A) Z-spread.
B) Treasury–Eurodollar (TEd) spread.
C) libor–oIS (overnight indexed swap) spread

Question 44

The following information relates to Questions 49-57
liz Tyo is a fund manager for an actively managed global fixed-income fund that buys bonds
issued in Countries A, b, and
based on Exhibit 2, the implied credit and liquidity risks as indicated by the historical three-year swap spreads for Country b were the lowest:

A) 1 month ago.
B) 6 months ago.
C) 12 months ago.

Question 45

The following information relates to Questions 49-57
liz Tyo is a fund manager for an actively managed global fixed-income fund that buys bonds
issued in Countries A, b, and
With respect to their discussion of yield curves, Tyo and her assistant are most likely dis- cussing which term structure theory?

A) Pure expectations theory
B) local expectations theory
C) liquidity preference theory

Question 46

The most appropriate response to Madison's question regarding the spread measure is the:

A) Z-spread.
B) Treasury-Eurodollar (TEd) spread.
C) libor-oIS (overnight indexed swap) spread.

Question 47

The following information relates to Questions 49-57
liz Tyo is a fund manager for an actively managed global fixed-income fund that buys bonds
issued in Countries A, b, and
based on Exhibit 1 and Tyo's expectations for the yield curves, Tyo most likely perceives the bonds of which country to be fairly valued?

A) Country A
B) Country b
C) Country C

Question 48

The following information relates to Questions 49-57
liz Tyo is a fund manager for an actively managed global fixed-income fund that buys bonds
issued in Countries A, b, and
based on the given Z-spreads for bonds 1, 2, and 3, which bond has the greatest credit and liquidity risk?

A) bond 1
B) bond 2
C) bond 3

Question 49

ExHIbIT 1 Today's Government Spot Rates
$\begin{array} { l c c c } \text { Maturity } & \text { Country A } & \text { Country B } & \text { Country C } \\\hline \text { One year } & 0.40 \% & - 0.22 \% & 14.00 \% \\\text { Two years } & 0.70 & - 0.20 & 12.40 \\\text { Three years } & 1.00 & - 0.12 & 11.80 \\\text { Four years } & 1.30 & - 0.02 & 11.00 \\\text { Five years } & 1.50 & 0.13 & 10.70 \\\hline\end{array}$
Tyo asks her assistant how these spot rates were obtained. The assistant replies, "Spot rates are determined through the process of bootstrapping. It entails backward substitution using,par yields to solve for zero-coupon rates one by one, in order from latest to earliest maturities." Tyo then provides a review of the fund's performance during the last year and comments,"The choice of an appropriate benchmark depends on the country's characteristics. For exam-ple, although Countries A and b have both an active government bond market and a swap market, Country C's private sector is much bigger than its public sector, and its government bond market lacks liquidity." Tyo further points out, "The fund's results were mixed; returns did not benefit from taking on additional risk. We are especially monitoring the riskiness of the corporate bond holdings. For example, our largest holdings consist of three four-year corporate bonds (bonds 1, 2,and 3) with identical maturities, coupon rates, and other contract terms. These bonds have Z-spreads of 0.55%, 1.52%, and 1.76%, respectively."Tyo continues, "We also look at risk in terms of the swap spread. We considered historical three-year swap spreads for Country b, which reflect that market's credit and liquidity risks, at three different points in time." Tyo provides the information in Exhibit 2.
ExHIbIT 2 Selected Historical Three-year Rates for Country b
$\begin{array} { l c c } \text { Period } & \text { Government Bond Yield (\%) } & \text { Fixed-for-Floating Libor Swap (\%) } \\\hline 1 \text { Month ago } & - 0.10 & 0.16 \\\text { 6 Months ago } & - 0.08 & 0.01 \\12 \text { Months ago } & - 0.07 & 0.71 \\\hline\end{array}$
Tyo then suggests that the firm was able to add return by riding the yield curve. The fund plans to continue to use this strategy but only in markets with an attractive yield curve for this strategy.She moves on to present her market views on the respective yield curves for a five-year investment horizon.
Country A: "The government yield curve has changed little in terms of its level and shape during the last few years, and I expect this trend to continue. We assume that future spot rates reflect the current forward curve for all maturities."

Country B: "Because of recent economic trends, I expect a reversal in the slope of the current yield curve. We assume that future spot rates will be higher than current forward rates for all maturities."

Country C: "To improve liquidity, Country C's central bank is expected to intervene, leading to a reversal in the slope of the existing yield curve. We assume that future spot rates will be lower than today's forward rates for all maturities."
Tyo's assistant asks, "Assuming investors require liquidity premiums, how can a yield curve slope downward? What does this imply about forward rates?" Tyo answers, "Even if investors require compensation for holding longer-term bonds, the yield curve can slope downward-for example, if there is an expectation of severe deflation. Regarding forward rates, it can be helpful to understand yield curve dynamics by calculating implied forward rates. To see what I mean, we can use Exhibit 1 to calculate the forward rate for a two-year Country C loan beginning in three years."

-based on Exhibit 1, the results of Analysis 2 should show the yield on the five-year bond:

A) decreasing by 0.8315%.
B) decreasing by 0.0389%.
C) increasing by 0.0389%.

Question 50

ExHIbIT 1 Today's Government Spot Rates
$\begin{array} { l c c c } \text { Maturity } & \text { Country A } & \text { Country B } & \text { Country C } \\\hline \text { One year } & 0.40 \% & - 0.22 \% & 14.00 \% \\\text { Two years } & 0.70 & - 0.20 & 12.40 \\\text { Three years } & 1.00 & - 0.12 & 11.80 \\\text { Four years } & 1.30 & - 0.02 & 11.00 \\\text { Five years } & 1.50 & 0.13 & 10.70 \\\hline\end{array}$
Tyo asks her assistant how these spot rates were obtained. The assistant replies, "Spot rates are determined through the process of bootstrapping. It entails backward substitution using,par yields to solve for zero-coupon rates one by one, in order from latest to earliest maturities." Tyo then provides a review of the fund's performance during the last year and comments,"The choice of an appropriate benchmark depends on the country's characteristics. For exam-ple, although Countries A and b have both an active government bond market and a swap market, Country C's private sector is much bigger than its public sector, and its government bond market lacks liquidity." Tyo further points out, "The fund's results were mixed; returns did not benefit from taking on additional risk. We are especially monitoring the riskiness of the corporate bond holdings. For example, our largest holdings consist of three four-year corporate bonds (bonds 1, 2,and 3) with identical maturities, coupon rates, and other contract terms. These bonds have Z-spreads of 0.55%, 1.52%, and 1.76%, respectively."Tyo continues, "We also look at risk in terms of the swap spread. We considered historical three-year swap spreads for Country b, which reflect that market's credit and liquidity risks, at three different points in time." Tyo provides the information in Exhibit 2.
ExHIbIT 2 Selected Historical Three-year Rates for Country b
$\begin{array} { l c c } \text { Period } & \text { Government Bond Yield (\%) } & \text { Fixed-for-Floating Libor Swap (\%) } \\\hline 1 \text { Month ago } & - 0.10 & 0.16 \\\text { 6 Months ago } & - 0.08 & 0.01 \\12 \text { Months ago } & - 0.07 & 0.71 \\\hline\end{array}$
Tyo then suggests that the firm was able to add return by riding the yield curve. The fund plans to continue to use this strategy but only in markets with an attractive yield curve for this strategy.She moves on to present her market views on the respective yield curves for a five-year investment horizon.
Country A: "The government yield curve has changed little in terms of its level and shape during the last few years, and I expect this trend to continue. We assume that future spot rates reflect the current forward curve for all maturities."

Country B: "Because of recent economic trends, I expect a reversal in the slope of the current yield curve. We assume that future spot rates will be higher than current forward rates for all maturities."

Country C: "To improve liquidity, Country C's central bank is expected to intervene, leading to a reversal in the slope of the existing yield curve. We assume that future spot rates will be lower than today's forward rates for all maturities."
Tyo's assistant asks, "Assuming investors require liquidity premiums, how can a yield curve slope downward? What does this imply about forward rates?" Tyo answers, "Even if investors require compensation for holding longer-term bonds, the yield curve can slope downward-for example, if there is an expectation of severe deflation. Regarding forward rates, it can be helpful to understand yield curve dynamics by calculating implied forward rates. To see what I mean, we can use Exhibit 1 to calculate the forward rate for a two-year Country C loan beginning in three years."

-based on Exhibit 1, the results of Analysis 1 should show the yield on the 20-year bond decreasing by:

A) 0.3015%.
B) 0.6030%.
C) 0.8946%.

Question 51

Is Madison correct in describing key differences in equilibrium and arbitrage-free models as they relate to the number of parameters and model accuracy?

A) yes.
B) no, she is incorrect about which type of model requires fewer parameter estimates.
C) no, she is incorrect about which type of model is more precise at modeling market yield curves.

Question 52

The following information relates to Questions 49-57
liz Tyo is a fund manager for an actively managed global fixed-income fund that buys bonds
issued in Countries A, b, and
based on Exhibit 1 and assuming Tyo's market views on yield curve changes are realized, the forward curve of which country will lie below its spot curve?

A) Country A
B) Country b
C) Country C

Question 53

Is Madison's response regarding the factors that affect short-term and long-term rate vol- atility correct?

A) yes.
B) no, she is incorrect regarding factors linked to long-term rate volatility.
C) no, she is incorrect regarding factors linked to short-term rate volatility.

Question 54

Madison's views on the term structure of interest rates are most consistent with the:

A) local expectations theory.
B) segmented markets theory.
C) liquidity preference theory.

Question 55

The following information relates to Questions 49-57
liz Tyo is a fund manager for an actively managed global fixed-income fund that buys bonds
issued in Countries A, b, and
did Tyo's assistant accurately describe the process of bootstrapping?

A) yes.
B) no, with respect to par yields.
C) no, with respect to backward substitution.

Question 56

The following information relates to Questions 49-57
liz Tyo is a fund manager for an actively managed global fixed-income fund that buys bonds
issued in Countries A, b, and
based on Exhibit 1 and Tyo's expectations, which country's term structure is currently best for traders seeking to ride the yield curve?

A) Country A
B) Country b
C) Country C