Fixed Income

CFA® Level II, published weight 10–15%. Term structure dynamics, arbitrage-free valuation, embedded options, CDS.

What the outline covers

The Term Structure and Interest Rate Dynamics
The Arbitrage-Free Valuation Framework
Valuation and Analysis of Bonds with Embedded Options
Credit Analysis Models
Credit Default Swaps

Sample questions

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Question 1

A manager expects rates to evolve exactly as implied by the current forward curve. Riding the yield curve will most likely produce:

A. Excess return over a buy-and-hold strategy
B. The same return as any other maturity strategy
C. A loss relative to the benchmark
D. A gain only if the curve is inverted

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B. If rates evolve as the forwards imply, all maturity strategies earn the same return by no-arbitrage. A view only pays if it differs from the forwards.

Reading: Fixed Income — The Term Structure and Interest Rate Dynamics, LOS 1.d

Question 2

The one-year spot rate is 3% and the two-year spot rate is 4%. The one-year forward rate one year from now is closest to:

z₁ = 3% · z₂ = 4%

A. 3.50%
B. 4.00%
C. 5.01%
D. 7.00%

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C. (1.04)² = (1.03)(1 + f), so 1 + f = 1.0816/1.03 = 1.0501 and f = 5.01%. Forward rates exceed spot rates on an upward-sloping curve.

Reading: Fixed Income — The Term Structure and Interest Rate Dynamics, LOS 1.b

Question 3

Relative to an otherwise identical option-free bond, a callable bond has:

A. A higher value and higher effective duration
B. A lower value and lower effective duration when rates fall
C. A higher value and lower effective duration
D. The same value but different convexity

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B. The call belongs to the issuer, so the bond is worth less. As rates fall, the call compresses price appreciation, shortening effective duration.

Reading: Fixed Income — Valuation and Analysis of Bonds with Embedded Options, LOS 3.c

Question 4

Which criticism applies most directly to structural credit models such as Merton?

A. They require an estimation sample of historical defaults
B. They rely on unobservable asset values and volatilities
C. They cannot incorporate the capital structure
D. They assume default is a surprise jump process

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B. Structural models require the firm’s asset value and asset volatility, neither of which is directly observable. Reduced-form models face the estimation-sample criticism.

Reading: Fixed Income — Credit Analysis Models, LOS 4.d

Question 5

A credit protection buyer on a CDS is economically equivalent to:

A. Being long the reference bond
B. Being short credit risk of the reference entity
C. Selling a put on the reference entity
D. Being long the benchmark government bond only

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B. Buying protection pays off when credit deteriorates, so it is a short credit position — the mirror image of owning the bond.

Reading: Fixed Income — Credit Default Swaps, LOS 5.b

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