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Free CFA Fixed Income Practice Questions & Answers
900 exam-style Fixed Income questions. Pick your answer, hit Check answer, and see the worked solution — free to start, no signup.
100% free · No login to startQuestion 751
Effective duration is used instead of modified duration when a bond has embedded options because:
Select an option first.
Correct answer: B — Embedded options cause cash flows to change as interest rates change, so a measure based on cash flow sensitivity to rates is needed
Explanation: B is correct. For callable or putable bonds, cash flows depend on whether the option is exercised—which depends on rates. Effective duration uses actual price changes from rate shocks (±Δy) to measure sensitivity, capturing the option's effect. Modified duration assumes fixed cash flows and is inappropriate.
Question 752
A bond's convexity adds precision to the duration-based price change estimate because:
Select an option first.
Correct answer: B — Duration is a linear approximation; convexity captures the curvature of the price-yield relationship
Explanation: B is correct. The duration estimate of price change is linear. Convexity adds a second-order correction: ΔP ≈ −ModDur × P × Δy + 0.5 × Convexity × P × (Δy)². This is significant for large yield moves. A, C, D are wrong.
Question 753
A callable bond has lower price appreciation potential than an otherwise identical non-callable bond when yields fall because:
Select an option first.
Correct answer: B — The issuer's call option limits the bond's upside price appreciation (negative convexity near the call price)
Explanation: B is correct. As yields fall and the bond approaches the call price, the probability the issuer calls increases—capping the price near the call price. This causes negative convexity. Investors are reluctant to pay above the call price.
Question 754
The key rate duration of a bond measures:
Select an option first.
Correct answer: B — The bond's price sensitivity to a change in yield at a specific maturity point on the curve
Explanation: B is correct. Key rate duration (partial duration) measures price sensitivity to yield changes at individual points on the curve. This helps identify which part of the yield curve most affects a bond's value—useful for non-parallel shift analysis.
Question 755
Portfolio duration is best described as:
Select an option first.
Correct answer: B — The weighted average of the individual bond durations, weighted by market value
Explanation: B is correct. Portfolio duration = Σ (wi × Duri) where wi is each bond's market value weight and Duri is its duration. This gives the portfolio's overall interest rate sensitivity.
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Question 756
Credit risk in bonds includes both default risk and spread risk. The key distinction is:
Select an option first.
Correct answer: A — Default risk is the chance the issuer misses a payment; spread risk is the risk that the bond's yield spread widens, reducing price even without default
Explanation: A is correct. Default risk is the possibility of non-payment. Spread risk (also called credit migration risk) is the price impact of the bond's yield spread changing—even if no default occurs. Both affect bond investors.
Question 757
Loss given default (LGD) in credit analysis represents:
Select an option first.
Correct answer: B — The percentage of the bond's value lost if a default occurs, after accounting for recoveries
Explanation: B is correct. LGD = 1 − Recovery Rate. It represents how much of the bond's value is actually lost in a default. If recovery is 40%, LGD = 60%. Multiplied by the probability of default (PD), you get expected loss.
Question 758
Expected loss in a credit analysis framework is calculated as:
Select an option first.
Correct answer: B — The probability of default multiplied by the loss given default
Explanation: B is correct. Expected Loss = PD × LGD (× exposure). PD is the probability the issuer defaults; LGD is the fraction of value lost if it does. This framework underpins credit pricing and capital requirements.
Question 759
A credit rating downgrade from investment grade to high yield (a 'fallen angel') will most likely cause the bond's price to:
Select an option first.
Correct answer: B — Fall sharply, because the bond must now be held by investors who require higher yields for high-yield bonds
Explanation: B is correct. A fallen angel often sells off sharply because many institutional investors have mandates that prohibit holding below-investment-grade bonds, forcing selling. Higher required yields = lower prices.
Question 760
Securitization benefits the economy primarily by:
Select an option first.
Correct answer: B — Allowing illiquid assets to be converted into tradeable securities, improving capital allocation and credit availability
Explanation: B is correct. Securitization transforms illiquid loans (mortgages, auto loans, etc.) into standardized, tradeable bonds—expanding the pool of investors, improving price discovery, and freeing up bank capital to make more loans. A is wrong—it redistributes, not increases net risk.
Question 761
Prepayment risk in mortgage-backed securities is the risk that:
Select an option first.
Correct answer: B — Borrowers repay their mortgages faster than expected, returning principal to investors sooner (often when rates are low)
Explanation: B is correct. When interest rates fall, homeowners refinance—repaying their mortgages early. Investors receive principal back sooner, but must reinvest at lower rates. This is reinvestment risk plus extension risk when rates rise (slower prepayments extend the bond).
Question 762
A CMO (collateralized mortgage obligation) is structured to:
Select an option first.
Correct answer: B — Direct the cash flows from a pool of mortgages into different tranches with different risk and maturity profiles
Explanation: B is correct. A CMO takes a mortgage pass-through pool and redistributes its cash flows into tranches—e.g., sequential-pay tranches, PAC tranches, support tranches—giving investors different exposure to prepayment risk and maturity.
Question 763
A senior tranche in an ABS structure is characterized by:
Select an option first.
Correct answer: B — Having the first claim on cash flows and being the last to absorb losses—giving it the highest credit quality
Explanation: B is correct. Senior tranches receive payments first and absorb losses last. They are the most credit-protected and typically achieve the highest ratings (AAA). In exchange, they offer the lowest yield. Junior/equity tranches get the highest yield but bear losses first.
Question 764
What distinguishes a collateralized loan obligation (CLO) from a mortgage-backed security (MBS)?
Select an option first.
Correct answer: A — A CLO is backed by a pool of corporate loans, while an MBS is backed by residential or commercial mortgages
Explanation: A is correct. A CLO pools leveraged corporate loans (typically to non-investment-grade companies) and issues tranched securities. An MBS pools mortgage loans on real estate. Both are securitized products but with different underlying collateral.
Question 765
A PAC (planned amortization class) tranche in a CMO is designed to:
Select an option first.
Correct answer: B — Provide relatively stable, predictable cash flows within a defined prepayment speed range by directing prepayment risk to support tranches
Explanation: B is correct. PAC tranches receive predictable principal payments as long as prepayment speeds stay within a collar. Support (companion) tranches absorb excess/deficit prepayments, protecting the PAC.
Question 766
Sovereign credit analysis focuses primarily on a government's:
Select an option first.
Correct answer: B — Willingness and ability to service its debt obligations on time and in full
Explanation: B is correct. Sovereign credit analysis examines both economic capacity (GDP growth, debt ratios, fiscal balance, foreign reserves) and political willingness to repay. A, C, D are inputs but not the central focus.
Question 767
In corporate credit analysis, EBITDA/interest expense (interest coverage ratio) is used as a measure of:
Select an option first.
Correct answer: B — The company's ability to service its debt from operating cash flow
Explanation: B is correct. The interest coverage ratio measures how many times over the company can pay its interest from operating earnings. A higher ratio indicates stronger debt service capacity.
Question 768
The recovery rate in credit analysis represents:
Select an option first.
Correct answer: A — The proportion of the bond's face value an investor can expect to recover after a default
Explanation: A is correct. Recovery rate is what investors receive (as a percent of face value) in a default, through bankruptcy proceedings, collateral liquidation, or negotiated settlement. Senior secured creditors have higher recovery rates than subordinated bondholders.
Question 769
A credit spread widening implies that:
Select an option first.
Correct answer: B — The market perceives greater risk in the bond relative to the benchmark, pushing the bond's yield higher and its price lower
Explanation: B is correct. Spread widening = higher required yield for the bond = lower bond price. It reflects increased perception of credit risk, decreased liquidity, or a general risk-off environment.
Question 770
Empirical duration differs from analytical (model-based) duration because:
Select an option first.
Correct answer: B — It is estimated from actual historical price and yield data rather than from a pricing formula
Explanation: B is correct. Empirical duration is derived from statistical regression of historical price changes on yield changes—capturing how bonds actually behave in practice, including effects of liquidity, credit risk, and investor behavior.
Question 771
Convexity adjustment for bond price change is most important when:
Select an option first.
Correct answer: B — Yield changes are large, since the convexity term grows with the square of the yield change
Explanation: B is correct. The convexity correction (0.5 × Convexity × (Δy)²) grows proportionally to (Δy)². For small yield changes it is negligible; for large moves it becomes significant.
Question 772
A bond with negative convexity will experience:
Select an option first.
Correct answer: B — Price appreciation less than that predicted by duration when yields fall (the price-yield curve is concave from below in the relevant range)
Explanation: B is correct. Negative convexity (common for callable bonds at low yields) means the price-yield curve bends inward—price rises less than duration predicts when yields fall, and falls more than duration predicts when yields rise. This is an unfavorable asymmetry for the investor.
Question 773
Duration matching in liability-driven investing means:
Select an option first.
Correct answer: B — Setting the portfolio's Macaulay duration equal to the investment horizon (or liability duration) to immunize against interest rate changes
Explanation: B is correct. Immunization against a single liability requires setting the asset portfolio's Macaulay duration equal to the liability's time horizon. This ensures price risk and reinvestment risk offset, locking in the required rate of return.
Question 774
A commercial mortgage-backed security (CMBS) differs from a residential MBS (RMBS) primarily in that:
Select an option first.
Correct answer: B — CMBS are backed by mortgages on commercial properties and analyzed on a property-by-property basis, with a focus on NOI and debt service coverage ratios
Explanation: B is correct. CMBS are backed by loans on commercial real estate (offices, hotels, retail). Credit analysis focuses on each property's net operating income, occupancy, and DSCR. CMBS typically have call protection reducing prepayment risk.
Question 775
An ABS backed by credit card receivables will most likely have which structural feature?
Select an option first.
Correct answer: B — A revolving structure where new receivables replace paid-off ones during a revolving period, followed by an accumulation and amortization phase
Explanation: B is correct. Credit card ABS use a revolving structure: during the revolving period, principal payments from cardholders are reinvested into new receivables. Then an accumulation/amortization phase begins. This is different from amortizing ABS (like auto loans).
Question 776
The spread duration of a bond measures:
Select an option first.
Correct answer: B — The bond's price sensitivity to a change in its credit spread, holding the benchmark rate constant
Explanation: B is correct. Spread duration measures how much the bond's price changes when its yield spread widens or tightens, independent of moves in the risk-free rate. It is particularly important for corporate and emerging market bonds.
Question 777
In a cash flow waterfall, the term 'subordination' refers to:
Select an option first.
Correct answer: B — The priority ordering of payments: senior tranches paid first; junior tranches paid only after senior obligations are met
Explanation: B is correct. Subordination is a key form of credit enhancement in ABS: junior tranche holders agree to absorb losses before senior holders. This protects senior tranches and allows them to achieve higher credit ratings.
Question 778
Duration gap in an immunization context is defined as:
Select an option first.
Correct answer: B — Macaulay duration of the bond portfolio minus the investment horizon
Explanation: B is correct. When immunizing a single-period liability, the portfolio's Macaulay duration is set equal to the investment horizon. The duration gap = Macaulay duration − horizon. A zero gap means price risk and reinvestment risk perfectly offset.
Question 779
Extension risk in mortgage-backed securities is the risk that:
Select an option first.
Correct answer: B — Borrowers pay off mortgages more slowly than expected when interest rates rise, extending the bond's effective maturity
Explanation: B is correct. Extension risk is the flip side of prepayment risk: when rates rise, fewer homeowners refinance. The MBS's average life extends beyond expectations, and investors are stuck with a below-market coupon for longer than anticipated.
Question 780
In corporate credit analysis, the debt/EBITDA ratio is primarily used to assess:
Select an option first.
Correct answer: B — How many years of operating earnings would be needed to repay the company's total debt—a measure of leverage
Explanation: B is correct. Debt/EBITDA measures leverage—how much debt the company carries relative to its earnings generation. A lower ratio indicates less leverage and stronger ability to service debt. It is the most commonly cited leverage metric in corporate credit analysis.
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