Fixed Income Questions

CFA Level II
#1

Hi All,

I am trying to improve my understanding of Fixed Income. I attempted the following practice questions and ran into a few roadblocks/doubts. Any help/explanations would be much appreciated.

Q1. If the term structure is upward slopping, the liquidity hypothesis implies a) Expected future interest rates will decline over time b) Expected future interest rates will be flat over time c) Expected future interest rates will increase over time d) Investors are indifferent about risk e) All the above answers are incorrect

** My understanding is that liquidity is valuable to the investor; therefore, forward rates incorporate a liquidity premium in addition to the expected future spot rate. Liquidity hypothesis doesn’t necessarily state anything about how expected future interest rates change over time does it ? so is e) the right choice ?

Q2. John and Mary hold the same coupon paying bond with a term to maturity of five years. Both of them reinvest the coupons in the same bond. John plans to sell his bond before Mary does, and both are planning to sell their bonds before maturity. Which of the statements is correct if an interest rate increase was to be announced one day after they bought the bond? I. Both John and Mary will lose money II. If Mary will lose money due to the interest rate decrease so will John III. If Mary will earn money due to the interest rate decrease so will John a) Only I is true b) Only II is true c) Only III is true d) II and III are true e) I, II, and III are true

** I think 1) is true given bond prices fall when interest rates rise. 11) is false as bond prices rise when interest rates fall. 111) I am not sure how to analyze this. So my best guess would be choice a) ??

Q3. Jojen is a green dreamer. It is well known that green dreamers sometimes dream about the next month’s interest rate (and their dreams always come true). Last night Jojen dreamed that the interest rates in both China and India will fall unexpectedly by 1% next month. He decided to break the green dreamers’ oath (not to trade using their dreams) and invest in the bond market in order to pay his debt to the Iron Bank. Which of the statements below is correct? a) He should invest in a one-month T-Bill as this will be a risk free investment b) He should invest in bonds with high term to maturity and low coupon rate. c) If the current interest rate in India is 5% and in China is 8% then, all other things being equal, Jojen is better off investing in India than in China. d) Answers b and c are correct e) None of the above answers is correct.

** I think c) is the right choice since a 1% interest rate decrease is likely to lead to a greater % price increase, in a low interest rate environment compared to a relatively high interest rate environment (all else equal) ?

#2

I am trying to improve my understanding of Fixed Income. I attempted the following practice questions and ran into a few roadblocks/doubts. Any help/explanations would be much appreciated.

Q1. If the term structure is upward slopping, the liquidity hypothesis implies a) Expected future interest rates will decline over time b) Expected future interest rates will be flat over time c) Expected future interest rates will increase over time d) Investors are indifferent about risk e) All the above answers are incorrect

I would say the correct answer is C… because investors will require extra liquidity in form of higher interest rates…

#3

because investors will require liquidity premium for longer maturity. Otherwise C is correct.

#4

_ Frankliving _ and _ Flashback _ thank you for explaining your reasoning for choosing C) in Q1. Much appreciated.

To summarize, we say that to induce investors to invest in relatively illiquid long-term investments (compared to liquid short-term investments), they need to be compensated with a liquidity premium, which increases with maturity.

After some reflection, I just have one question that is bothering me regarding choice C).

Consider the three scenarios below:

First, suppose Expected rates E(r_t) _ increase _ over time AND Liquidity premium L_t _ increases _ over time

=> Upward sloping term structure since ( f_t = E(r_t) + L_t ) , f_t = forward rate

Second, suppose Expected rates E(r_t) _ decrease _ over time AND Liquidity premium L_t _ increases _ over time

=> Could still get an upward sloping term structure (provided liquidity premium increases by more than expected rates decrease across time)

Third, suppose Expected rates E(r_t) are flat over time AND Liquidity premium L_t _ increases _ over time

=> Upward sloping term structure since ( f_t = E(r_t) + L_t )

Therefore, given an upward sloping term structure and the liquidity hypothesis, how can we definitively say expected future rates will increase ? As per above, they could just as well be flat or decrease right ?

Interested to hear your thoughts. I think we can safely eliminate choice d) since being indifferent to risk (risk-neutral) is an assumption for Pure Expectation Hypothesis.

#5

Given liquidity preference theory deviations from upward slope of yield curve are considered as a temporary change.

#6

Further liquidity premium theory states the yield curve can take any shape… does not have to be upward sloaping…

#7

Ok thanks guys. Greatly appreciate it. All the pieces seem to be coming together for me slowly.

In the textbook “Bond Markets, Analysis and Strategies (8th edition) -Frank J Fabozzi”, under Liquidity Theory (page 126) it states:

"an upward-sloping yield curve may reflect expectations that future interest rates either 1) will rise, or 2) will be flat or even fall, but with liquidity premium increasing fast enough with maturity so as to produce an upward-sloping yield curve"

Wouldn’t the above essentially mean the answer to Q1 below should be e), since the term structure being upward slopping isn’t a sufficient condition to necessarily conclude a), b) or c) under the liquidity theory ?

Q1. If the term structure is upward slopping, the liquidity hypothesis implies a) Expected future interest rates will decline over time b) Expected future interest rates will be flat over time c) Expected future interest rates will increase over time d) Investors are indifferent about risk e) All the above answers are incorrect

#8

That would be the case maybe if C wasn’t an option… After doing enough questions, you will have a nap for spotting theese types of responses… trick here is to not over think it and just go with what the cfa books say.

#9

Cool. So moving on to the second question (see below) in the original post. Apparently there was a typo which has been corrected for below (interest rate announcement was a decrease rather than an increase)

Q2. John and Mary hold the same coupon paying bond with a term to maturity of five years. Both of them reinvest the coupons in the same bond. John plans to sell his bond before Mary does, and both are planning to sell their bonds before maturity. Which of the statements is correct if an interest rate decrease was to be announced one day after they bought the bond? I. Both John and Mary will lose money II. If Mary will lose money due to the interest rate decrease so will John III. If Mary will earn money due to the interest rate decrease so will John a) Only I is true b) Only II is true c) Only III is true d) II and III are true e) I, II, and III are true

So for this question I think “C) Only 111 is true” is the correct answer.

My reasoning:

If interest rates decrease -> bond prices go up -> No reason for either of them to lose money. Given Mary sells after John, by the time she sells the price would be lower/closer to Par (bond price approaches Par as we get closer to maturity) compared to when John sells; So if she earned a capital gain, John would have too.

Would this be a reasonable way to address the question or am I missing anything ?

#10

Yes, that’s the correct and only reasoning as far as i am concerned.

#11

Thanks for sharing. And to keep the momentum going. What is your choice for Q3 below ?

I think d).

Reason: bonds with high term to maturity and low coupon rate -> have a higher duration -> which will provide the greatest capital gain from the rate decrease (reason for b); based on the inverse shape of the yield curve, all else equal, a 1% rate decrease from a current level of 5% would lead to a higher price increase than would a 1% rate decrease from a level of 8% (reason for c). Therefore, both b and c are correct.

Q3. Jojen is a green dreamer. It is well known that green dreamers sometimes dream about the next month’s interest rate (and their dreams always come true). Last night Jojen dreamed that the interest rates in both China and India will fall unexpectedly by 1% next month. He decided to break the green dreamers’ oath (not to trade using their dreams) and invest in the bond market in order to pay his debt to the Iron Bank. Which of the statements below is correct? a) He should invest in a one-month T-Bill as this will be a risk free investment b) He should invest in bonds with high term to maturity and low coupon rate. c) If the current interest rate in India is 5% and in China is 8% then, all other things being equal, Jojen is better off investing in India than in China. d) Answers b and c are correct e) None of the above answers is correct.

#12

you are trying to keep the momentum going with the wrong kind of questions. Please note that whoever this study provider is - you are seeing the totally WRONG kind of answer choices. On the real exam you will never see choices like (b) and © are correct etc. etc.

#13

Ok cool CP - thanks for confirming that the real Level 2 exam wouldn’t have those types of answer choices. Not a big fan of them personally.

Yeah the questions aren’t from any provider, but from a Master of Finance course I am taking called Fixed Income. Since I’ve just started looking at Fixed Income in the CFA books, trying to see if I can leverage that knowledge to tackle these questions.

Apologies if the format of the questions would make them a waste of time for other candidates. Apart from knowing there are item sets, I didn’t check the level 2 question style/possible answers in detail yet.

Anyway Only 3 more weeks to go and after that I shall be using only the Institute’s questions and those of the best provider - Wiley :slight_smile: