CPT CPT Fixed Income & Bond Trading 2 — Questions and Answers
Question 1: What is the difference between a 'coupon bond' and a 'zero-coupon bond'?
- A coupon bond pays periodic interest throughout its life; a zero-coupon bond pays no periodic interest and is sold at a deep discount to par (Correct answer)
- A coupon bond pays only at maturity; a zero-coupon bond pays monthly interest with no final payment
- A coupon bond is issued by corporations only; a zero-coupon bond is issued exclusively by the U.S. Treasury
- A coupon bond has a floating interest rate; a zero-coupon bond has a fixed rate tied to LIBOR
Correct answer: A coupon bond pays periodic interest throughout its life; a zero-coupon bond pays no periodic interest and is sold at a deep discount to par
Zero-coupon bonds are issued at a discount and appreciate to par at maturity, providing return entirely through price appreciation rather than periodic income.
Question 2: What is 'convexity' in bond analysis, and why does it matter for large rate moves?
- The curvature in the price-yield relationship showing that bond price increases more when rates fall than it decreases when rates rise by the same amount (Correct answer)
- The linear relationship between bond duration and portfolio volatility used for VAR calculations
- The measure of a bond's default probability relative to its spread over Treasuries
- The degree to which a bond's coupon payments are concentrated in the early years of its life
Correct answer: The curvature in the price-yield relationship showing that bond price increases more when rates fall than it decreases when rates rise by the same amount
Positive convexity means duration underestimates price gains when rates fall and overestimates losses when rates rise, making high-convexity bonds more valuable in volatile rate environments.
Question 3: What are 'investment-grade' bonds, and how are they distinguished from 'high-yield' (junk) bonds?
- Investment-grade bonds are rated BBB-/Baa3 or above by major rating agencies; high-yield bonds are rated below that threshold and carry higher default risk (Correct answer)
- Investment-grade bonds have maturities under 10 years; high-yield bonds have maturities over 10 years
- Investment-grade bonds are issued by governments only; high-yield bonds are issued by corporations or municipalities
- Investment-grade bonds pay floating rates; high-yield bonds are fixed-rate instruments
Correct answer: Investment-grade bonds are rated BBB-/Baa3 or above by major rating agencies; high-yield bonds are rated below that threshold and carry higher default risk
The BBB-/Baa3 rating is the dividing line — bonds above it are investment grade (lower yield, lower risk), while those below are high-yield (higher yield, higher default risk).
Question 4: How does the Federal Reserve's Federal Open Market Committee (FOMC) influence bond markets?
- By directly setting long-term Treasury yields through mandatory dealer price controls
- By setting the federal funds rate target, which anchors short-term rates and influences expectations for all maturities along the yield curve (Correct answer)
- By purchasing only municipal bonds to support state and local government financing needs
- By issuing new Treasury securities to fund federal spending, directly competing with corporate bond issuers
Correct answer: By setting the federal funds rate target, which anchors short-term rates and influences expectations for all maturities along the yield curve
The FOMC's rate decisions set the overnight lending rate benchmark, rippling through the yield curve as markets reprice expected future rates and inflation.
Question 5: What is a 'callable bond,' and what risk does it pose to investors?
- A bond that can be redeemed by the issuer before maturity, typically when rates fall, exposing investors to reinvestment risk at lower yields (Correct answer)
- A bond that gives the holder the right to demand early repayment if the issuer's credit rating is downgraded
- A bond convertible into equity shares at the investor's discretion, carrying dilution risk for stockholders
- A bond with a floating coupon that resets every quarter, exposing investors to rising rate environments
Correct answer: A bond that can be redeemed by the issuer before maturity, typically when rates fall, exposing investors to reinvestment risk at lower yields
Issuers call bonds when rates drop to refinance at lower cost, forcing investors to reinvest proceeds at the new (lower) prevailing rates — this is reinvestment risk.
Question 6: What does 'duration matching' (immunization) aim to achieve in a fixed income portfolio?
- Maximizing yield by concentrating holdings in the longest-duration bonds available
- Protecting a portfolio's target value against interest rate changes by matching the portfolio's duration to the investment horizon (Correct answer)
- Eliminating credit risk by replacing corporate bonds with government securities of equal maturity
- Locking in the current yield curve shape by hedging all future rate movements with interest rate swaps
Correct answer: Protecting a portfolio's target value against interest rate changes by matching the portfolio's duration to the investment horizon
Immunization ensures that price losses from rising rates and reinvestment gains (or vice versa) offset each other, preserving the portfolio's target value at the investment horizon.
CPT CPT Fixed Income & Bond Trading 2
What is the difference between a 'coupon bond' and a 'zero-coupon bond'?