Fixed Income A: Instruments and Markets

• Topic 01

  Fixed Income Securities Overview

  45 questions
• Topic 02

  Bond Markets and Issuance

  36 questions
• Topic 03

  Introduction to Bond Valuation

  28 questions
• Topic 04

  Yield Measures and Conventions

  26 questions
• Topic 05

  Spot Rates, Forward Rates, and the Yield Curve

  24 questions
• Topic 06

  Securitisation and Structured Products

  30 questions
• Topic 07

  Introduction to Credit Risk

  24 questions
• Topic 08

  Embedded Options

  24 questions
• Topic 09

  Floating Rate Notes and Inflation-Linked Bonds

  25 questions

A few questions from this unit, with the answer and a full explanation. The complete bank is available when you start practising.

1. Under the Liquidity Preference Theory, why does the yield curve slope upward even if future short-term rates are expected to remain constant?

   • A
     Because long-term bonds are more liquid than short-term bonds due to their larger outstanding volume, demanding a liquidity premium
   • B
     Because investors expect inflation to rise, which typically creates an upward-sloping yield curve in stable economic environments
   • C
     Because the Pure Expectations Theory and the Liquidity Preference Theory predict the same yield curve shape; the upward slope reflects only inflation expectations
   • D
     Because long-term bonds carry more price risk (duration risk) than short-term bonds; investors require a positive term (liquidity) premium to hold long-term bonds, pushing long-term rates above expected future short rates
     Correct answer
   Explanation

   The Liquidity Preference Theory (Keynes/Hicks) adds a term premium to the Pure Expectations Theory framework. Even if markets expect short-term rates to remain constant (implying a flat curve under Pure Expectations Theory), the yield curve slopes upward because:

   • Long-term bonds have higher duration and therefore greater price volatility when rates change.
   • Investors are risk-averse and demand a positive term premium to compensate for bearing this additional price risk over longer horizons.
   • This term premium increases monotonically with maturity, producing an upward-sloping curve even with flat rate expectations.

   The term premium explains why forward rates are consistently upward-biased predictors of future short-term rates.

2. In a uniform-price Treasury auction, what is the 'stop-out price'?

   • A
     The average of all bid prices received in the auction
   • B
     The highest price bid by any single participant in the auction
   • C
     The lowest accepted price (highest accepted yield) at which the entire issue is sold
     Correct answer
   • D
     The price at which the Treasury stops accepting non-competitive bids
   Explanation

   The stop-out price (clearing price) is the lowest price accepted in a uniform-price auction — equivalently, the highest accepted yield. All bidders who submitted bids at or above this price (at or below this yield) are awarded bonds and all pay this single stop-out price, regardless of what they individually bid. This distinguishes the uniform-price format from a discriminatory (multiple-price) auction in which each winner pays their own bid price.

3. What does it mean for an FRN when the discount margin exceeds the quoted margin?

   • A
     It means the FRN's coupon is now above the market rate, so the bond appreciates in value above par
   • B
     It means the FRN is trading at a premium because investors are willing to accept a lower spread than required, reflecting confidence in the issuer
   • C
     It means the market requires more credit compensation than the coupon provides; the FRN must trade at a discount to par to make up the shortfall in spread through price appreciation
     Correct answer
   • D
     It means the FRN will be called by the issuer because the discount margin trigger has been exceeded per the bond indenture
   Explanation

   When DM > QM:

   • The bond's fixed coupon of (Reference Rate + QM) is insufficient to meet the market's required return of (Reference Rate + DM)
   • To bridge the gap, the bond's price must fall below par so investors also earn a capital gain (from the discounted price back to par at maturity) that augments the insufficient coupon
   • The total return (coupon + capital appreciation) then equals the required DM

   This is the pricing mechanism that keeps FRN yields in line with market-required returns even when the fixed quoted margin no longer reflects current credit conditions. It is analogous to a fixed-rate bond trading at a discount when its coupon is below the prevailing market yield.