CFA Fixed Income Analysis 2 — Questions and Answers
Question 1: The Z-spread (zero-volatility spread) is best described as:
- The spread over the par yield curve that makes the bond's present value equal to its price
- The constant spread added to each spot rate on the Treasury curve to make the bond's PV equal to its price (Correct answer)
- The spread that adjusts for the bond's embedded option value
- The spread between a bond's YTM and the 10-year Treasury yield
Correct answer: The constant spread added to each spot rate on the Treasury curve to make the bond's PV equal to its price
The Z-spread is the constant spread added to every spot rate on the benchmark spot curve such that the present value of cash flows equals the bond's market price.
Question 2: Which of the following best describes the option-adjusted spread (OAS)?
- OAS = Z-spread + option cost
- OAS = Z-spread – option cost (Correct answer)
- OAS = nominal spread – option cost
- OAS = nominal spread + option cost
Correct answer: OAS = Z-spread – option cost
OAS removes the value of the embedded option from the Z-spread: OAS = Z-spread minus the option cost, isolating the credit and liquidity spread.
Question 3: A mortgage-backed security (MBS) is most exposed to which unique risk compared to a standard corporate bond?
- Credit risk
- Liquidity risk
- Prepayment risk (Correct answer)
- Currency risk
Correct answer: Prepayment risk
MBS are exposed to prepayment risk because homeowners may refinance or sell their homes early, returning principal at inopportune times for investors.
Question 4: Under the CFA curriculum, the term structure of interest rates is best described by which of the following?
- The relationship between credit ratings and bond yields
- The relationship between bond yields and maturities for bonds of the same credit quality (Correct answer)
- The spread between corporate and government bond yields
- The slope of the yield curve over a fixed time period
Correct answer: The relationship between bond yields and maturities for bonds of the same credit quality
The term structure (yield curve) shows the relationship between yields to maturity and time to maturity for bonds with the same credit quality, typically government bonds.
Question 5: Which theory of the yield curve suggests that the shape is determined solely by expectations of future short-term rates?
- Liquidity Preference Theory
- Market Segmentation Theory
- Pure Expectations Theory (Correct answer)
- Preferred Habitat Theory
Correct answer: Pure Expectations Theory
Pure Expectations Theory holds that long-term rates are geometric averages of expected future short-term rates, with no liquidity premium or maturity preference.
Question 6: A bond's full price (dirty price) equals:
- Clean price minus accrued interest
- Clean price plus accrued interest (Correct answer)
- Par value plus accrued interest
- Market price minus accrued coupon
Correct answer: Clean price plus accrued interest
The full (dirty) price is the clean (flat) price plus accrued interest since the last coupon payment; this is the actual amount paid by the buyer.
CFA Fixed Income Analysis 2
The Z-spread (zero-volatility spread) is best described as: