2013 CFA Level 1 - Book 5
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StudySession 15
Cross-Reference to CFA Institute Assigned Reading #55 - Understanding Yield Spreads
CONCEPT CHECKERS
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6.
Under the pure expectations theory, an inverted yield curve is interpreted as evidence that:
A. demand for long-term bonds is falling.
B. short-term rates are expected to fall in the future.
C. investors have very little demand for liquidity.
According to the liquidity preference theory, which of the following statements
is least accurate?
A. All else equal, investors prefer short-term securities over long-term securities. B. Investors perceive little risk differential between short-term and long-term
securities.
C. Borrowers will pay a premium for long-term funds to avoid having to roll over short-term debt.
With respect to the term structure of interest rates, the market segmentation theory holds that:
A. an increase in demand for long-term borrowings could lead to an inverted yield curve.
B. expectations about the future of short-term interest rates are the major determinants of the shape of the yield curve.
C. the yield curve reflects the maturity demands of financial institutions and investors.
The most commonly used tool of the Fed to control interest rates is: A. the discount rate.
B. the bank reserve requirement. C. open market operations.
For two bonds that are alike in all respects except maturity, the relative yield spread is 7. 14%. The yield ratio is closest to:
A. 0.714.
B. 1.0714. c. 107. 14.
Assume the following yields for different bonds issued by a corporation:
• 1-year bond: 5.50%.
• 2-year bond: 6.00%.
• 3-year bond: 7.00%.
If a 3-year U.S. Treasury is yielding 5%, then what is the absolute yield spread on the 3-year corporate issue?
A. 0.40. B. 100 bp. c. 200 bp.
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12.
Study Session 15
Cross-Reference to CFA Institute Assigned Reading #55 - UnderstandingYield Spreads
Assume the following corporate yield curve:
• 1 -year bond: 5.00%.
• 2-year bond: 6.00%.
• 3-year bond: 7.00%.
If a 3-year U.S. Treasury yielding 6% is the benchmark bond, the relative yield spread on the 3-year corporate is:
A. 16.67%.
B. 1 . 167. c. 14.28%.
If a U.S. investor is forecasting that the yield spread between U.S. Treasury bonds and U.S. corporate bonds is going to widen, which of the following beliefs would he be also most likely to hold?
A. The economy is going to expand.
B.
The economy is going to contract.
C. There will be no change in the economy.
For a Treasury bond and a corporate bond that are alike in all respects except credit risk, the yield ratio is 1.0833. If the yield on the corporate bond is 6.5%, the Treasury (benchmark) bond yield is closest to:
A. 5.50%.
B. 6.00%. c. 8.33%.
Given two bonds that are equivalent in all respects except tax status, the marginal tax rate that will make an investor indifferent between an 8.2% taxable bond and a 6.2% tax-exempt bond is closest to:
A. 24.39%.
B. 37.04%. c. 43.47%.
Which of the following statements most accurately describes the relationship |
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between the economic health of a nation and credit spreads? |
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A. |
Credit spreads and economic well-being are not correlated. |
B. |
Credit spreads decrease during an expanding economy because corporate |
C. |
cash Rows are expected to rise. |
Credit spreads increase during an expanding economy because corporations |
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invest in more speculative projects. |
Which of the following most accurately describes the relationship between |
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liquidity and yield spreads relative to Treasury issues? All else being equal, bonds |
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with: |
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A. |
less liquidity have lower yield spreads to Treasuries. |
B. |
greater liquidity have higher yield spreads to Treasuries. |
C. |
less liquidity have higher yield spreads to Treasuries. |
©20 12 Kaplan, Inc. |
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StudySession 15
Cross-Reference to CFA Institute Assigned Reading #55 - Understanding Yield Spreads
13.
14.
A narrowing of credit spreads would have the least impact on the value of which |
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of the following investments? |
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A. |
AAA corporate bond. |
B. |
30-year Treasury bond. |
C. |
BB+ rated corporate bond. |
Assume an investor is in the 3 1 % marginal tax bracket. She is considering the purchase of either a 7.5% corporate bond that is selling at par or a 5.25% tax-exempt municipal bond that is also selling at par. Given that the two bonds are comparable in all respects except their tax status, the investor should buy the: A. corporate bond, because it has the higher yield of7.50%.
B. municipal bond, because its taxable-equivalent yield is 7.6 1%. C. corporate bond, because its after-tax yield is higher.
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Study Session 1 5
Cross-Reference to CFA Institute Assigned Reading #55 - Understanding Yield Spreads
14. B The taxable-equivalent yield on this municipal bond is 5 ·25 |
= 5·25 |
= 7.61 %. |
(1 - 0.31) |
0.69 |
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Because this is higher than the yield on the (taxable) corporate bond, the municipal bond is preferred. Alternatively, the after-tax yield on the corporate is 7.5% (1 - 0.3 1) = 5.175%, which is less than the tax-exempt yield, leading to the same decision.
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The following is a review ofthe Analysis ofFixed Income Investments principles designed to address the learning outcome statements set forth by CFA Institute. This topic is also covered in:
INTRODUCTION TO THE VALUATION OF DEBT SECURITIES
Study Session 16
EXAM FOCUS
Bond valuation is all about calculating the present value of the promised cash flows. If your time-value-of-money (TVM) skills are not up to speed, take the time now to revisit the Study Session 2 review of TVM concepts. The material in this topic review is very important. Calculating the value of a bond by discounting expected cash flows should become an easy exercise. The final material, on discounting a bond's expected cash flows using spot rates and the idea of "arbitrage-free" bond valuation, is quite important as well. A good understanding here will just make what follows easier to understand.
LOS 56.a: Explain steps in the bond valuation process.
CPA® Program Curriculum, Volume 5, page 447
The general procedure for valuing fixed-income securities (or any security) is to take the present values of all the expected cash flows and add them up to get the value of the security.
There are three steps in the bond valuation process:
Step 1: Estimate the cash flows over the life of the security. For a bond, there are two types of cash flows: (1) the coupon payments and (2) the return of principal.
Step 2: Determine the appropriate discount rate based on the risk of (uncertainty
about) the receipt of the estimated cash flows.
Step 3: Calculate the present value of the estimated cash flows by multiplying the
bond's expected cash flows by the appropriate discount factors.
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Study Session 1 6
Cross-Reference to CFA Institute Assigned Reading #56 - Introduction to the Valuation ofDebt Securities
2.
uncertain and will depend to a large extent on the future path of interest rates. For example, lower rates will increase prepayments of mortgage passthrough securities, and principal will be repaid earlier.
The coupon payments are not known with certainty. With floating-rate securities,
future coupon payments depend on the path of interest rates. With some floating-rate securities, the coupon payments may depend on the price of a commodity or the rate of inflation over some future period.
3. The bond is convertible or exchangeable into another security. Without information
about future stock prices and interest rates, we don't know when the cash flows will come or how large they will be.
LOS 56.c: Calculate the value ofa bond (coupon and zero-coupon).
CPA® Program Curriculum, Volume 5, page 449
For a Treasury bond, the appropriate rate used to value the promised cash flows is the risk-free rate. This may be a single rate, used to discount all of the cash flows, or a series of discount rates that correspond to the times until each cash flow arrives.
For non-Treasury securities, we must add a risk premium to the risk-free (Treasury) rate to determine the appropriate discount rate. This risk premium is one of the yield spread measures covered in the previous review and is the added yield to compensate for greater risk (credit risk, liquidity risk, call risk, prepayment risk, and so on). When using a single discount rate to value bonds, the risk premium is added to the risk-free rate to get the appropriate discount rate for all of the expected cash flows.
yield on a risky bond = yield on a default-free bond + risk premium
Other things being equal, the riskier the security, the higher the yield differential (or risk premium) we need to add to the on-the-run Treasury yields.
Calculating the Value of a Coupon Bond
Valuation with a single yield (discount rate). Recall that we valued an annuity using the
time value of money keys on the calculator. For an option-free coupon bond, the coupon payments can be valued as an annuity. In order to take into account the payment of the par value at maturity, we will enter this final payment as the future value. This is the basic difference between valuing a coupon bond and valuing an annuity.
For simplicity, consider a security that will pay $ 1 00 per year for ten years and make a |
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single $ 1 |
,000 payment at maturity (in ten years). If the appropriate discount rate is 8% |
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for all the cash flows, the value is: |
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1 00 |
100 |
100 |
100 |
100 |
1,000 |
-1.08 |
+ --1.082 |
+ --1.083 + |
1.084 |
+ ... + -1 .08-10 |
+1-.08-10 |
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-- |
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= $1,134.20 = present value of expected cash flows
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