Fixed Income

Debt securities that provide regular interest payments.

5 minutes 5 Questions

Fixed Income in CFA Level 2 builds upon foundational concepts with sophisticated analytical frameworks. The curriculum covers key areas like valuation of bonds with embedded options, where techniques such as binomial interest rate trees and option-adjusted spread analysis become crucial for assessi…

Concepts covered

Credit Analysis Models The Term Structure and Interest Rate Dynamics Valuation and Analysis of Bonds with Embedded Options Credit Default Swaps The Arbitrage-Free Valuation Framework

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CFA Level 2 - Fixed Income Example Questions

Test your knowledge of Fixed Income

Question 1

In the arbitrage-free valuation framework, which of the following statements about the Local Expectations Hypothesis (LEH) is most accurate?

The LEH proposes that the expected return on bonds over short horizons is determined by the bond's credit risk premium, in addition to the risk-free rate. The LEH states that the expected return on bonds over short horizons is influenced by the bond's convexity adjustment, along with the prevailing risk-free rate. The LEH assumes that the expected return on bonds over short horizons is equal to the risk-free rate, regardless of the bond's maturity.

Correct Answer: The LEH assumes that the expected return on bonds over short horizons is equal to the risk-free rate, regardless of the bond's maturity.

The Local Expectations Hypothesis (LEH) assumes that the expected return on bonds over short horizons is equal to the risk-free rate, regardless of the bond's maturity. This is the most accurate statement among the given options.

The other two statements are incorrect because:
- The LEH does not consider the bond's credit risk premium in determining the expected return over short horizons.
- The LEH also does not take into account the bond's convexity adjustment when determining the expected return over short horizons.

Therefore, the statement that the LEH assumes the expected return on bonds over short horizons is equal to the risk-free rate, regardless of the bond's maturity, is the most accurate.

Question 2

In the arbitrage-free valuation framework, which of the following statements about the current term structure of interest rates is most accurate?

It has no relation to the market's expectations of future short-term interest rates and is instead driven entirely by supply and demand dynamics in the bond market. It represents the market's consensus view of the path of future short-term interest rates, after adjusting for risk and liquidity preferences. It is determined solely by the market's expectations of future short-term interest rates, with no adjustments for risk or liquidity preferences.

Correct Answer: It represents the market's consensus view of the path of future short-term interest rates, after adjusting for risk and liquidity preferences.

The current term structure of interest rates represents the market's consensus view of the path of future short-term interest rates, after adjusting for risk and liquidity preferences. This is because the arbitrage-free valuation framework takes into account not only the market's expectations of future interest rates but also the risk and liquidity premiums demanded by investors.

The other two statements are inaccurate. It is not determined solely by the market's expectations of future short-term rates, as risk and liquidity preferences also play a role. Additionally, it is not entirely driven by supply and demand dynamics in the bond market, as the market's expectations of future interest rates are a crucial factor in determining the term structure.

Question 3

XYZ Corp. has issued a 5-year bond with a face value of $20 million. ABC Investment Management is considering purchasing a credit default swap (CDS) on this bond to hedge against the risk of default. The annual CDS premium is quoted at 150 basis points. If XYZ Corp. defaults on its bond obligations after 3 years, and the recovery rate on the defaulted bond is 40%, what is the net payoff for ABC Investment Management from the CDS?

ABC Investment Management will receive a net payoff of $8 million from the CDS, which is equal to the recovery amount on the defaulted bond (40% of the face value). ABC Investment Management will receive a net payoff of $15 million from the CDS, calculated as the difference between the face value of the bond ($20 million) and the present value of the remaining CDS premium payments discounted at the risk-free rate. ABC Investment Management will receive a net payoff of $12 million from the CDS, calculated as the difference between the face value of the bond ($20 million) and the recovery amount ($8 million, which is 40% of the face value).

Correct Answer: ABC Investment Management will receive a net payoff of $12 million from the CDS, calculated as the difference between the face value of the bond ($20 million) and the recovery amount ($8 million, which is 40% of the face value).

The correct answer is that ABC Investment Management will receive a net payoff of $12 million from the CDS if XYZ Corp. defaults after 3 years.

The key points are:
- The face value of the bond is $20 million.
- If XYZ Corp. defaults, the recovery rate on the bond is 40%.
- The recovery amount would be $8 million (40% of $20 million).
- The CDS will pay the difference between the face value and the recovery amount.
- $20 million (face value) - $8 million (recovery amount) = $12 million (CDS payoff)

The other answers are incorrect because:
- The $15 million payoff calculation includes the present value of remaining CDS premium payments, which is not relevant for determining the CDS payoff at the time of default.
- The $8 million payoff is simply the recovery amount on the bond, but the CDS should pay the difference between the face value and recovery amount.

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