Practice Questions with Answers - Fixed-income Markets

Practice Questions with Answers – Fixed-income Markets 1. Sovereign bonds will most likely settle on: A. The trade date B. A T+1 basis C. A T+3 basis Answer B: On average, corporate bonds settle on a T+3 basis, government and quasi-government bonds on a T+1 basis, while most money market securities transactions settle on the same day. 2. A structured financial instrument has a coupon rate determined by the following formula: C= 3% - 1.2 LIBOR. The instrument is most likely classified as: A. A leveraged inverse floater B. A deleveraged inverse floater C. A floating-rate note Answer A: The instrument is an inverse floater, as its coupon rate moves in the opposite direction of the reference rate, LIBOR in this case. As the leverage ratio is 1.2 or greater than 1, the inverse floater is specified as a leveraged one. 3. In a repurchase agreement, the percentage difference between the current market value of the debt security and its initial selling price is most accurately described as: A. Repo rate B. Repo term C. Repo margin Answer C: Repo margin is defined as the difference between the current market value of a bond and the initial selling price (amount loaned), in percentage terms. Repo rate does not consider market value, it is calculated as the percentage difference between the selling and repurchase prices. Repo term is not a calculated variable at all, it represents the length of the repo agreement, in days. 4. Which of the following statement is most likely correct in terms of speculative-grade bonds? A. They offer higher yields B. They are less risky compared to junk bonds C. Their credit ratings start from AAA Answer: A Speculative-grade bonds are bonds with a credit quality of BB+ and lower, which offer very high credit risk and high yields. They are also known as junk bonds. 5. Which of the following mechanisms for issuing bonds in the primary markets is best suited for government bonds? A. Underwritten offering B. Best-effort offering C. Auction 1 Answer: C Most sovereign bonds are sold out through public auctions. The auction is a quite useful mechanism for discovering the price of a bond issue by utilizing demand and supply forces. 6. Which of the following securities are most likely associated with narrow bid-ask spreads? A. High-yield corporate bonds B. Bonds issued by supranational organizations C. Government bonds issued by a developing country Answer: B Wider bid-ask spread ranges are associated with illiquid securities. High-yield corporate bonds and developing country sovereign bonds are examples of less liquid securities. Respectively, narrower spreads are an indication of highly liquid securities. Examples are bonds issued by supranational organizations (the World Bank, the European Investment Banks, etc.) 7. Guilts, Bunds, and JGBs are examples of: A. Sovereign bonds B. Non-sovereign bonds C. Emerging market bonds Answer: A Many countries around the world issue sovereign bonds, either in local or foreign currencies. When denominated in the local currency, government-issued debt usually has a country-specific name – US Treasuries, Japanese Government Bonds (JGBs), Guilts in the UK, or Bunds in Germany. 8. Which type of fixed-income security is rollover risk most often associated with? A. Sovereign bonds B. Commercial paper C. Non-negotiable certificates of deposit Answer: B Commercial paper is frequently issued on a rollover basis. The potential risk of not being able to refinance the operations with new debt security, or to roll over the commercial paper, is referred to as a rollover risk. 9. Which type of structured finance instruments aims at increasing the risk exposure of securities in an attempt to realize a higher expected return? A. Yield enhancement instruments B. Capital protection instruments C. Participation instruments Answer: A This is the definition of yield enhancement instruments. 10. Which of the following structured finance instruments do not involve risk/return magnifying strategies: A. Credit-linked notes B. Leveraged instruments C. Capital protected instruments 2 Answer: C Credit-linked notes are an example of yield enhancement instruments, which aim at increasing the risk exposure of securities in an attempt to realize a higher expected return. Leveraged instruments are also structured in such a way as to magnify the expected returns (at the expense of higher risk), thus offering the possibility of higher payoffs for relatively small investments. Capital protected instruments, on the other hand, offer a minimum return value guaranteed at maturity, without changing the risk profile of the security. Therefore, C is the correct answer. 11. Which of the following source of finance provides the cheapest funds to banks: A. Interbank funds B. Central Bank funds C. Certificates of deposit (CDs) Answer: B The exchange of funds among financial institutions is known as the wholesale market for funds, as it usually provides cheaper sources of finance to large institutional entities. Therefore Answer C. Certificates of Deposit is not correct. CDs are not offered on the wholesale market (from a bank’s point of view). Interbank funds are offered by commercial banks, while Central Bank funds are (obviously) offered by central banks. When the Central Bank in a country lends reserves to commercial banks, it usually does that at significant discount rates. Or, in other words, it applies a monetary policy instrument known as the “discount window”. It allows eligible institutions to borrow money on a short-term basis to meet their temporary shortages of liquidity. 3