Question

The following multiple-choice problems are based on questions that appeared in past CFA examinations.

a. A bond with a call feature:

(1) Is attractive because the immediate receipt of principal plus premium produces a high return.

(2) Is more apt to be called when interest rates are high because the interest saving will be greater.

(3) Will usually have a higher yield to maturity than a similar non-callable bond.

(4) None of the above.

b. In which one of the following cases is the bond selling at a discount?

(1) Coupon rate is greater than current yield, which is greater than yield to maturity.

(2) Coupon rate, current yield, and yield to maturity are all the same.

(3) Coupon rate is less than current yield, which is less than yield to maturity.

(4) Coupon rate is less than current yield, which is greater than yield to maturity.

c. Consider a five-year bond with a 10% coupon selling at a yield to maturity of 8%. If interest rates remain constant, one year from now the price of this bond will be:

(1) Higher

(2) Lower

(3) The same

(4) Par

d. Which of the following statements is true?

(1) The expectations hypothesis indicates a flat yield curve if anticipated future short term rates exceed current short-term rates.

(2) The basic conclusion of the expectations hypothesis is that the long-term rate is equal to the anticipated short-term rate.

(3) The liquidity hypothesis indicates that, all other things being equal, longer maturities will have higher yields.

(4) The liquidity preference theory states that a rising yield curve necessarily implies that the market anticipates increases in interest rates

Short answer

a. (3)

b. (3)

c. (2)

d. (3)

Step-by-step solution

Evaluation of scenarios of a bond with callable features (a)

Option (3) is correct because the yield on the callable bond must compensate the investor for the risk of call.

Choice (1) is wrong because, although the owner of a callable bond receives principal plus a premium in the event of a call, the interest rate at which he can subsequently reinvest will be low.

Choice (2) is wrong because a bond is more apt to be called when interest rates are low. There will be an interest saving for the issuer only if rates are low.

Evaluation of scenarios of a bond with callable features sells at a discount (b)

In the option (1), the bond is selling at a premium.

In the option (2), the bond is selling at par

In the option (3), the bond is selling at a discount, as coupon rate is less than the current yield.

Therefore the correct answer is option 3.

Calculation of the price of the bond

A bond with a maturity of 5 years with 10% coupon rate and selling at YTM of 8% will have the price lower than the current price, provided the interest rates remain the same. Therefore the correct answer is option (2)

Evaluation of statements

According to liquidity hypothesis, longer maturity bonds have higher yields. Hence except option (3) all other options are incorrect.