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Free CFA Portfolio Construction Practice Questions & Answers
600 exam-style Portfolio Construction questions. Pick your answer, hit Check answer, and see the worked solution — free to start, no signup.
100% free · No login to startQuestion 61
Fixed-income securities play three primary roles in a multi-asset portfolio. Which role is BEST described as protecting against purchasing power erosion?
Select an option first.
Correct answer: C — Inflation protection — inflation-linked bonds adjust both principal and coupon for inflation, while floating-rate bonds adjust coupons when inflation pushes reference rates higher
Explanation: C is correct: The inflation-protection role of fixed income is provided by specific instrument types. Inflation-linked bonds (like TIPS) adjust par value for inflation — both coupon payments (which are based on the adjusted par) and final principal repayment are inflation-protected. Floating-rate bonds adjust coupon payments when the market reference rate rises with inflation, protecting the income stream but not the principal. Standard nominal bonds offer no inflation protection. A is wrong: Regular cash flows are the second role. B is wrong: Diversification is the first role.
Question 62
For inflation-linked bonds vs. floating-rate bonds, which component of return is protected in each case?
Select an option first.
Correct answer: B — Inflation-linked: BOTH coupon and par are protected because par adjusts for cumulative inflation, making the coupon amount (coupon rate × adjusted par) also increase. Floating-rate: only the COUPON is protected (higher rates increase coupon) but par is not adjusted for inflation.
Explanation: B is correct: For inflation-linked bonds, the mechanism is par adjustment. If $1M par increases to $1.05M after 5% inflation, the coupon amount (e.g., 0.5% × $1.05M = $5,250) also rises, protecting both income and principal. For floating-rate bonds, the coupon rate adjusts (e.g., MRR + 100bps), increasing the dollar coupon when inflation pushes rates up, but the par remains $1M and is repaid at face value regardless of cumulative inflation. A is wrong: This reverses the correct answer. C is wrong: Only inflation-linked bonds protect par. D is wrong: Both provide meaningful protection.
Question 63
'Flight to quality' affects fixed-income correlations during market crises. What happens to the correlation between high-yield bonds and equities during a financial crisis?
Select an option first.
Correct answer: B — High-yield bonds (being credit-risky) behave more like equities during crises — investors sell risky assets (both equities and high-yield bonds) and buy safe-haven government bonds. Correlation between high-yield and equities approaches +1, greatly reducing diversification benefits.
Explanation: B is correct: During market stress, the flight-to-quality phenomenon drives investors to sell all risky assets simultaneously — equities, high-yield bonds, emerging market bonds — and buy developed-market government bonds. This causes high-yield bonds and equities to fall together (correlation approaching +1), eliminating the diversification benefit that normally comes from their different credit vs. equity risk profiles. Investment-grade government bonds (the safe haven) see their correlation with risky assets fall or turn negative during crises. A is wrong: Correlation rises, not falls. C is wrong: High-yield bonds tend to be positively correlated with equities during crises.
Question 64
What is 'contingent immunization' (CI) and what condition triggers a switch from active management to full immunization?
Select an option first.
Correct answer: B — CI is a hybrid strategy where the portfolio is initially overfunded (PVA > PVL, creating a positive surplus). As long as the surplus is positive, the manager can actively manage for higher return. If the active management fails and the surplus is eroded to zero (PVA = PVL), the portfolio must be IMMEDIATELY fully immunized to lock in funding.
Explanation: B is correct: The key mechanics of CI are: (1) require initial overfunding to create a safety cushion (surplus); (2) allow active management while surplus exists (manager seeks alpha); (3) monitor PVA vs PVL continuously; (4) trigger point is when surplus reaches zero — at that moment the portfolio must be immunized immediately to prevent falling below the required funding level. If CI succeeds, the cost is less than initial immunization; if it fails, the cost is more. A is wrong: CI explicitly involves active management, not just bond holding. C is wrong: The trigger is surplus exhaustion, not a specific rate move. D is wrong: Cash flow matching is a separate immunization approach.
Question 65
What is the difference between 'pure indexing,' 'enhanced indexing,' and 'active management' as fixed-income total return mandates?
Select an option first.
Correct answer: B — Pure indexing targets zero active return/risk by exactly matching index risk factors; enhanced indexing matches duration but allows modest deviations in sector/quality to add small alpha; active management allows large deviations in ALL risk factors (including duration) to seek maximum alpha
Explanation: B is correct: The three mandates represent a spectrum of tracking error. Pure indexing: matches every risk factor of the index, targeting zero active return — essentially passive. Enhanced indexing: keeps duration matched (controls the primary risk factor) but allows modest sector/quality tilts, targeting small positive alpha with limited tracking error. Active management: no restrictions on risk factor deviations, including duration mismatches, targeting maximum alpha with high tracking error. A is wrong: They have fundamentally different risk-taking approaches. C is wrong: Enhanced indexing restricts, not allows, duration deviation. D is wrong: All three mandates can include corporate bonds.
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Question 66
What does 'spread duration' measure, and how does it differ from modified duration?
Select an option first.
Correct answer: B — Modified duration measures a bond's price sensitivity to a parallel shift in benchmark rates. Spread duration measures the bond's price sensitivity to a 1% change in its credit spread, holding the benchmark rate constant — relevant for bonds with credit risk.
Explanation: B is correct: For investment-grade bonds, modified duration captures sensitivity to changes in risk-free benchmark yields. Spread duration captures sensitivity to changes in the credit spread component of yield. If a bond yields 4% (3% risk-free + 1% spread), modified duration measures the effect of the 3% benchmark changing, while spread duration measures the effect of the 1% spread changing. For high-yield bonds, spread changes are often more important than benchmark rate changes. C is wrong: They are different and measure different yield components. A is wrong: This reverses the definitions.
Question 67
What is 'Duration Times Spread' (DTS) and why does it provide a better measure of spread risk than spread duration alone?
Select an option first.
Correct answer: B — DTS = spread duration × credit spread. It reflects the empirical observation that bonds with higher spreads tend to experience LARGER absolute spread changes. A bond with a 5% spread is likely to change more in basis points than a bond with a 1% spread. Multiplying spread duration by the current spread adjusts for this proportional behavior.
Explanation: B is correct: Empirically, spread changes tend to be proportional to the level of spreads — wide-spread bonds experience larger absolute spread movements. DTS = spread duration × credit spread captures this by giving higher weight to bonds already trading at wide spreads. A bond with spread duration of 5 and a 3% spread has DTS = 15; if spreads widen by 10% (relatively), it widens by 30bps. A bond with duration 5 and 1% spread has DTS = 5; the same 10% relative widening only means 10bps. DTS provides a better ranking of credit risk exposure. A is wrong: This is a different metric. C is wrong: DTS doesn't involve the risk-free rate.
Question 68
A fixed-income portfolio manager believes interest rates will fall over the next year. What action should they take with portfolio duration, and what is the expected effect?
Select an option first.
Correct answer: B — Increase duration — when interest rates fall, bond prices rise, and longer-duration bonds experience LARGER price increases (greater positive convexity benefit). A higher portfolio duration amplifies the price appreciation from falling rates.
Explanation: B is correct: Duration measures price sensitivity to interest rate changes. A bond with modified duration of 10 rises approximately 10% in price for a 1% fall in yields. A bond with duration of 5 rises only 5%. By extending duration (e.g., shifting from short-term bonds to long-term bonds), the manager amplifies the portfolio's return from the expected rate decline. A is wrong: Shorter-duration bonds experience SMALLER price increases when rates fall. C is wrong: Rate changes directly affect bond returns through duration. D is wrong: Floating-rate bonds have very low effective duration and rise little when rates fall.
Question 69
A portfolio manager expects credit spreads to NARROW over the next 6 months. What two actions should they take, and why?
Select an option first.
Correct answer: B — Increase spread duration (to amplify price gains from spread narrowing) and potentially decrease the average credit quality of holdings (shifting to lower-rated, higher-spread bonds that will benefit more from tightening). The manager can use relative value analysis to find the most attractively priced bonds with above-benchmark DTS.
Explanation: B is correct: When spreads narrow, bond prices rise. A higher spread duration amplifies this price gain — the portfolio rises more per basis point of spread narrowing. Additionally, lower-rated bonds (higher current spreads) have more room for spread compression and benefit more in absolute dollar terms. Relative value analysis identifies the specific bonds with the highest DTS that offer the best combination of spread narrowing opportunity and valuation attractiveness. A is wrong: These actions would profit from WIDENING spreads. C is wrong: Government bonds have zero spread duration — no spread exposure. D is wrong: Active managers specifically position for spread changes.
Question 70
In the fixed-income return decomposition model, what does 'rolldown return' measure, and under what yield curve condition is it maximized?
Select an option first.
Correct answer: B — Rolldown return is the price appreciation (or depreciation) that occurs as a bond's remaining maturity shortens over the holding period, ASSUMING the yield curve remains unchanged. On an upward-sloping yield curve, as a bond's maturity decreases, it is priced at a lower yield, causing its price to rise — this roll-down effect is greatest when the yield curve is steep.
Explanation: B is correct: With an upward-sloping yield curve (longer maturities yield more than shorter ones), a bond that 'rolls down' from, say, a 7-year bond to a 6-year bond is now priced at the lower 6-year yield — its price rises. The steeper the yield curve, the bigger the yield difference between the start and end maturity, and the larger the rolldown return. On a flat yield curve, rolldown return is zero (no yield change as maturity shortens). On an inverted yield curve, rolldown return would be negative. A is wrong: Rolldown is not about inflation. C is wrong: Coupon income is Component 1. D is wrong: Benchmark yield change is Component 3.
Question 71
What is the formula for computing portfolio expected return using the five-component decomposition model?
Select an option first.
Correct answer: B — Expected return = (1) Coupon income + (2) Rolldown return + (3) Price change from benchmark yield change + (4) Price change from spread change + (5) Currency gain or loss. Components 1 and 2 together are called the 'rolling yield.'
Explanation: B is correct: The five-component return decomposition is: (1) annual coupon / current bond price (current yield); (2) (projected end price − beginning price) / beginning price assuming unchanged yield curve; (3) −MD × ΔY + ½ × C × ΔY² for benchmark yield change; (4) −MD × ΔS + ½ × C × ΔS² for spread change; (5) projected currency gain/loss × currency exposure weight. This framework allows prospective return forecasting or retrospective return attribution. Rolling yield = (1) + (2). A is wrong: Return components add, they don't multiply. C is wrong: This is a simplified one-factor approximation. D is wrong: This omits multiple components.
Question 72
How is the price change from a yield change estimated using duration and convexity?
Select an option first.
Correct answer: B — Price change ≈ (−MD × ΔY) + (½ × C × ΔY²). The first term captures the linear duration effect; the second adds the convexity adjustment which is positive for standard bonds regardless of the direction of yield change — it improves returns when yields move significantly in either direction.
Explanation: B is correct: The duration-only approximation (−MD × ΔY) is linear — it underestimates the price rise for rate decreases and overestimates the price decline for rate increases. Adding the convexity term (½ × C × ΔY²) corrects for the curvature of the price-yield relationship. Since ΔY² is always positive, the convexity adjustment always adds to return (for standard non-callable bonds with positive convexity) — larger adjustments for larger yield changes. A is wrong: Duration alone is a first-order approximation that underestimates price gains. C is wrong: This gives modified duration from Macaulay. D is wrong: BPV (DV01) is a dollar-based measure.
Question 73
What is the 'rolling yield' in the context of fixed-income return modeling, and when would you use it as a standalone projection?
Select an option first.
Correct answer: B — Rolling yield = coupon income + rolldown return. It represents the expected return assuming no change in benchmark yields, no change in spreads, and no currency effects. It is a useful baseline projection for a stable rate environment or when the portfolio is held without market views.
Explanation: B is correct: Rolling yield combines the two return components that exist even in a static yield curve environment: the income from coupons (Component 1) and the price appreciation/depreciation from moving down (or up) the yield curve over the period (Component 2). When no rate or spread changes are expected and no currency exposure exists, Components 3–5 are zero, and rolling yield equals total expected return. A is wrong: Rolling yield doesn't include credit spread as a separate component. C is wrong: Multiplication is incorrect — components add. D is wrong: Rolling yield is not derived from duration.
Question 74
What is the primary mechanism of a repurchase agreement (repo) for leveraging a fixed-income portfolio?
Select an option first.
Correct answer: B — In a repo, the portfolio manager 'sells' bonds for cash and simultaneously agrees to buy them back at a specified future date at a slightly higher price. The difference is effectively interest (the repo rate). The cash received is used to buy additional bonds, creating leverage — the portfolio now holds more bonds than it funded with its own equity.
Explanation: B is correct: A repo is essentially a secured short-term loan. The bond holder temporarily exchanges bonds for cash (collateral posted by the money lender), uses the cash to buy more bonds, and agrees to repurchase the original bonds at the repo rate. The fund now controls more bonds than it originally owned — it has leveraged its position. The repo rate is the cost of the leverage (the borrowing rate). If portfolio return > repo rate, leverage enhances return; if portfolio return < repo rate, leverage destroys it. A is wrong: Margin accounts are used in equities but not the mechanism described for bonds. C is wrong: Share issuance dilutes, not leverages. D is wrong: Central bank borrowing is available only to banks.
Question 75
How does leverage affect a fixed-income portfolio's interest rate risk exposure?
Select an option first.
Correct answer: B — In a leveraged fixed-income portfolio, the ASSET duration typically exceeds the LIABILITY duration (borrowing is often at short-term floating rates). This mismatch means that if interest rates rise, the asset values fall more than borrowing costs increase — the leveraged portfolio suffers amplified losses. The risk that borrowing costs exceed portfolio returns is the primary leverage risk.
Explanation: B is correct: A key risk of fixed-income leverage is duration mismatch. Bonds have long duration (prices move significantly with rates). Repo borrowing is typically short-term (overnight to a few weeks) — near-zero duration. If rates rise, the bond portfolio falls in value by (duration × rate change) while the repo cost rises only modestly. The net effect is that leverage amplifies losses. Additionally, lenders may demand collateral top-ups or loan repayment if bond values fall, potentially forcing fire sales at depressed prices. A is wrong: Leverage concentrates, not diversifies, risk. C is wrong: Leverage doesn't automatically hedge.
Question 76
What is a 'fire sale' in the context of leveraged fixed-income portfolios, and how can it amplify a financial crisis?
Select an option first.
Correct answer: B — A fire sale occurs when leveraged bond holders are forced to sell bonds rapidly at whatever price the market offers — typically depressed prices — because lenders demand loan repayment after collateral values decline. These distressed sales drive bond prices even lower, causing other leveraged holders to face the same collateral calls, creating a self-reinforcing spiral of selling and price decline.
Explanation: B is correct: Fire sales are a key systemic risk of leverage. The mechanism: bond prices fall → collateral value below required level → lender demands more collateral or repayment → leveraged holder must sell bonds → more selling depresses prices further → other leveraged holders face the same problem. This cascading cycle was prominently observed during the 2008 financial crisis with mortgage-backed securities and during the 1998 LTCM crisis. The vicious cycle can transform a localized credit event into a systemic crisis. A is wrong: Fire sales are not related to natural disasters. D is wrong: Leveraged bond portfolios are highly exposed.
Question 77
In a 'security-driven repo,' what distinguishes it from a standard 'cash-driven repo,' and who benefits from the lower repo rate?
Select an option first.
Correct answer: B — In a cash-driven repo, the borrower delivers any agreed-upon collateral (general collateral) in exchange for cash. In a security-driven repo, the money LENDER specifically wants a particular bond for hedging or arbitrage purposes — the borrower who wants cash can often negotiate a LOWER repo rate because the lender values the specific collateral access, effectively subsidizing the borrower's financing cost.
Explanation: B is correct: When a lender specifically needs a particular security (e.g., for short covering or a specific hedge), they will accept a lower repo rate in exchange for receiving that specific collateral. The borrower (who owns that security and needs cash) essentially receives cheaper financing because the lender values access to the specific bond. This security-driven repo is a form of securities lending from the perspective of the securities owner. A is wrong: The type of bond is not the defining feature. C is wrong: The rate can be lower, not higher, for security-driven repos.
Question 78
What is the 'rebate rate' in securities lending, and when does it apply?
Select an option first.
Correct answer: B — The rebate rate = collateral earnings rate − securities lending rate. It applies when the securities lender receives CASH as collateral. The lender can invest the cash and earn a return; if this return exceeds fair compensation for the securities lent, the excess is rebated back to the borrower. The rebate rate represents what the borrower earns on their posted cash collateral.
Explanation: B is correct: When the borrower posts cash as collateral, the securities lender can invest that cash. If the investment earns 3% and the securities lending rate (fair compensation) is 0.5%, the rebate rate = 3% − 0.5% = 2.5%. This 2.5% is returned to the borrower on their posted cash. From the lender's perspective, net income = securities lending rate = 0.5%. The rebate rate concept ensures the borrower is only paying the net borrowing cost (0.5%), not the full investment earnings of the lender. A is wrong: The rebate flows FROM the lender TO the borrower. C is wrong: This is a bond pricing concept. D is wrong: Rebate rates apply to any securities lending with cash collateral.
Question 79
What are the four types of liabilities used in LDI, from easiest to most difficult to immunize?
Select an option first.
Correct answer: A — Type I: known amount, known timing; Type II: known amount, uncertain timing; Type III: uncertain amount, known timing; Type IV: uncertain amount, uncertain timing
Explanation: A is correct: The four types ordered by complexity: Type I (e.g., fixed-rate bond obligations — known amount AND known date, immunizable with simple duration matching), Type II (e.g., callable bond obligations, term life insurance — known amount but uncertain timing due to option features), Type III (e.g., floating-rate and TIPS obligations — uncertain amount linked to rates/inflation, but known timing), Type IV (e.g., property/casualty insurance, defined benefit pension plans — BOTH amount and timing uncertain). Simple Macaulay/modified duration handles only Type I; Types II–IV require effective duration modeling. B is wrong: These don't describe LDI liability types. D is wrong: Type IV liabilities can be managed (though more complex).
Question 80
What is the key advantage of 'duration matching' over 'cash flow matching' as an immunization approach?
Select an option first.
Correct answer: B — Duration matching provides MORE flexibility in asset selection because the manager only needs to match the duration (interest rate sensitivity) of assets and liabilities — not the specific timing and amount of each cash flow. This flexibility often allows the liability to be funded at LOWER cost by selecting from a wider universe of bonds.
Explanation: B is correct: Cash flow matching requires finding bonds whose specific cash flows (coupons AND par) align exactly with each liability payment — extremely restrictive and often costly or impossible. Duration matching merely requires that the asset portfolio's duration equals the liability duration, allowing the manager to choose from many bonds that are cheaper or more liquid. The tradeoff is that duration matching still has residual risks (non-parallel yield curve shifts) while cash flow matching has none. A is wrong: Duration matching still has reinvestment risk for non-parallel shifts. C is wrong: Cash flow matching works for Type I liabilities but is most applicable when there are multiple known liabilities. D is wrong: Cash flow matching may sometimes actually be achievable at lower cost for specific liability structures.
Question 81
What is the 'cash-in-advance constraint' in cash flow matching, and what risk does it introduce?
Select an option first.
Correct answer: B — The constraint that a bond used to fund a specific liability must mature BEFORE (not exactly on) the liability date. The early maturity means the cash received must be reinvested at short-term rates until the liability date, introducing reinvestment risk — the short-term reinvestment rate may be lower than expected on an upward-sloping yield curve.
Explanation: B is correct: The cash-in-advance constraint is a practical relaxation of exact cash flow matching — bonds maturing slightly before each liability date ensure cash is available, but at the cost of short-term reinvestment. On an upward-sloping yield curve, short-term rates are lower than long-term rates, so the reinvestment income is less than anticipated, creating a small funding shortfall. Exact cash flow matching (perfect timing) avoids this but may be impossible in practice because bonds with exactly the right maturity dates may not exist. A is wrong: Leverage is a separate policy decision. C and D are wrong: These describe regulatory liquidity requirements, not cash flow matching.
Question 82
What are the ADVANTAGES of a laddered bond portfolio compared to a bullet portfolio?
Select an option first.
Correct answer: B — A ladder provides: (1) natural liquidity each year as bonds mature, reducing the need to sell at wide bid-ask spreads; (2) diversification across the yield curve, reducing sensitivity to non-parallel shifts; (3) balance between price risk (longer bonds) and reinvestment risk (shorter bonds); and (4) more convexity than a bullet portfolio due to greater cash flow dispersion.
Explanation: B is correct: Laddered portfolios distribute maturities evenly across time (e.g., $1M maturing each year for 10 years), creating several specific advantages over a bullet portfolio (all maturities concentrated at one point). The regular cash flows from maturing bonds reduce forced sales of less liquid bonds, maintain stable portfolio duration as each maturing bond is reinvested at long-term rates, and provide broad yield curve exposure. Convexity is greater than a bullet because cash flows are dispersed across maturities. A is wrong: Returns depend on the yield curve environment. C is wrong: Transaction costs depend on implementation. D is wrong: Ladders don't eliminate interest rate risk.
Question 83
How does a barbell portfolio compare to a ladder in terms of convexity, and when is convexity valuable?
Select an option first.
Correct answer: B — A barbell (concentrated in very short and very long maturities) has MORE convexity than a ladder of the same duration, because cash flows are more widely dispersed in time (recall convexity increases with cash flow dispersion). Convexity is valuable when large parallel yield curve shifts are expected — higher convexity bonds outperform lower convexity bonds in both rising AND falling rate scenarios by a second-order amount.
Explanation: B is correct: Convexity is directly related to the dispersion (time spread) of cash flows around the Macaulay duration. A barbell has cash flows at the extreme short and long ends — maximally dispersed — giving it the highest convexity among portfolios of equal duration. A ladder has evenly dispersed cash flows with moderate convexity (more than bullet, less than barbell). Convexity is valuable when yields shift significantly in either direction — the bond price rises more than duration predicts (if rates fall) and falls less than duration predicts (if rates rise). In stable rate environments, convexity has less value. A is wrong: Barbell has MORE convexity than a ladder. D is wrong: Convexity matters for managing asymmetric rate risk.
Question 84
What distinguishes 'Asset-Liability Management' (ALM) from 'Asset-Driven Liabilities' (ADL) in fixed income?
Select an option first.
Correct answer: B — In ALM/LDI, the liabilities are typically taken as given (set by actuaries, legal obligations, or external factors) and the ASSETS are managed to fund those liabilities. In ADL, the ASSETS are taken as given and the liability structure is adjusted to match the characteristics of the assets — for example, a leasing company with fixed-rate assets might issue fixed-rate debt to match.
Explanation: B is correct: LDI (liability-driven investing) is the most common form — pension funds have defined benefit obligations that cannot be changed, so assets must be managed to fund those fixed liabilities. ADL represents the opposite approach — when a company has existing assets (e.g., a portfolio of floating-rate loans) and designs its liability structure (e.g., issuing floating-rate bonds) to match those assets. Banks also use ALM in a bidirectional sense. A is wrong: Both approaches consider both sides of the balance sheet. C is wrong: Both can apply to multiple institutional types.
Question 85
A fixed-income portfolio manager is evaluating two bonds from the same issuer with the same maturity and credit quality, but one has an unrealized gain and the other has an unrealized loss. The portfolio needs to raise cash. If the client is TAXABLE, which bond should be sold?
Select an option first.
Correct answer: B — Sell the bond with the unrealized LOSS to realize a capital loss that can offset other capital gains, reducing the overall tax burden. The bond with the unrealized gain should be retained to defer the capital gains tax.
Explanation: B is correct: This is the classic tax-aware fixed-income decision. Selling the loss bond realizes a capital loss that can offset capital gains elsewhere in the portfolio, reducing current-period taxes. The gain bond should be retained to defer the taxable gain — taxes deferred are taxes avoided on a present-value basis. For tax-exempt investors, the optimal choice reverses: sell the gain bond if it has a slightly better yield substitute, and retain the loss bond for its slightly better yield. A is wrong: Choosing based on market value ignores the tax consequence. D is wrong: Avoiding sale through repo doesn't eliminate the need to eventually close the position.
Question 86
Why is it difficult to exactly replicate a bond index through 'pure indexing' in the fixed-income market?
Select an option first.
Correct answer: B — Fixed-income indexes contain thousands of individual bonds, many of which are illiquid, small in issue size, or infrequently traded — buying every bond in exact proportions is impractical and transaction-cost prohibitive. Instead, managers sample the index by matching its key risk factors (duration, credit quality, sector weights) while using a subset of the actual bonds.
Explanation: B is correct: The bond market is far more fragmented than the equity market. A single issuer may have dozens of different bonds outstanding with unique maturities, coupons, and call features. Many trade infrequently or at wide bid-ask spreads. The Barclays Aggregate contains thousands of securities. Literal replication would require purchasing hundreds or thousands of individual bonds, many at high transaction costs. Instead, pure bond indexers match risk factors — the resulting portfolio tracks the index well without holding every bond. B is the explicit explanation given in the reading. A is wrong: Indexes do change but not daily. C is wrong: Major bond indexes are publicly available.
Question 87
How does 'matrix pricing' help portfolio managers value illiquid bonds that haven't traded recently?
Select an option first.
Correct answer: B — Matrix pricing infers the fair market value of an illiquid bond by examining recent trade prices and yields of similar bonds (matched on maturity, credit quality, and coupon structure). The YTMs from comparable traded bonds are used to calculate an implied price for the illiquid bond.
Explanation: B is correct: When a bond has not traded recently (a common situation in bond markets where many bonds are held to maturity), its price must be estimated. Matrix pricing uses market information from actively traded comparable bonds — same issuer type, similar maturity, similar coupon, similar credit rating — to derive an appropriate YTM, then calculate the bond's implied price. This is more accurate than stale trade prices. A is wrong: Option-adjusted spread (OAS) models value embedded options — a different technique. C is wrong: Matrix pricing is not an algebraic matrix computation. D is wrong: Averaging stale prices would produce inaccurate valuations.
Question 88
What is the 'bid-ask cost' formula for crossing a bid-ask spread in fixed income, and what does it measure?
Select an option first.
Correct answer: B — The approximate cost of buying and immediately selling (round-trip) a bond = bond duration × (ask yield − bid yield). For a bond with duration 10 and bid-ask spread of 20 bps, the round-trip cost ≈ 10 × 0.002 = 2%. This quantifies the transaction cost the investor pays for lack of liquidity.
Explanation: B is correct: This formula approximates the price impact of crossing the bid-ask spread. The yield spread (ask yield − bid yield) translates into a price impact through duration — longer-duration bonds have larger price impacts for the same yield spread. A 20 bps yield spread on a 10-year bond (duration ≈ 9) = approximately 1.8% round-trip cost. On a 2-year bond (duration ≈ 2), the same 20 bps yield spread = only 0.4% round-trip cost. This shows why illiquid long-duration bonds are much more expensive to trade than short-duration bonds. A is wrong: Coupon rate is unrelated to the spread cost. C is wrong: This is a price-basis calculation, not the yield-basis formula described. D is wrong: Bid-ask spreads exist even in negotiated markets and represent real transaction costs.
Question 89
An investor considering an open-end mutual fund for bond exposure versus a bond ETF — what is a key advantage of the ETF?
Select an option first.
Correct answer: B — Bond ETFs trade continuously throughout the day on an exchange at market prices, providing intraday liquidity. Open-end mutual funds can only be bought or sold at the end-of-day NAV. For investors who may need to sell quickly or trade throughout the day, ETF liquidity is superior.
Explanation: B is correct: The key structural advantage of ETFs over open-end mutual funds is intraday tradability at market-determined prices. Mutual fund investors must submit redemptions by the end of the trading day and receive the next NAV calculation. ETF investors can execute at the current market price at any point during market hours. This provides tactical flexibility for portfolio management. A is wrong: Fee comparisons depend on the specific fund. C is wrong: The number of holdings varies by fund design. D is wrong: ETF structure doesn't affect the credit risk of the underlying bonds.
Question 90
A total return swap (TRS) allows an investor to receive the total return of a bond portfolio. What is the PRIMARY advantage of using a TRS versus directly buying the bonds?
Select an option first.
Correct answer: B — A TRS requires only a small collateral posting rather than fully funding the bond portfolio — providing leverage and capital efficiency. The investor gains full economic exposure to the bond portfolio's return (price appreciation + income) without the capital outlay of direct ownership.
Explanation: B is correct: Under a TRS, the total return receiver gains full economic exposure to the reference bond portfolio by paying a floating rate (e.g., LIBOR + spread) to the total return payer. The investor only needs to post a modest initial margin/collateral, not the full notional value. This provides leverage and is useful when the investor wants bond exposure without balance sheet constraints. Drawbacks include counterparty risk (the payer might default), rollover risk (short-term contracts must be renewed), and potentially higher collateral requirements under regulatory reform. A is wrong: TRS does not eliminate credit risk — the investor still has economic exposure to credit events in the reference portfolio. D is wrong: TRS is used by all types of institutional investors.
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