Schweser Bond question

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Greenspan

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Schwesers test bank has the following question:

A 10%, 10 year bond is trading at par. If interest rates remain unchanged where will the bond be trading in 2 years?

A - Above Par
B - Below Par
C - Cannot answer with information given
D - At par


I chose "C - Cannot answer with information given" because they give me no information on the shape of the yield curve, without which I can't answer the question.

In 2 years this will be an 8 year bond (b/c it's 2 years closer to maturity) and given a normally shaped yield curve this should be trading above par because the 8 year market yield will be lower than a longer maturity yield given an upward sloping yield curve, so the price on a 10% coupon would HAVE to rise to get the yield down to a market level for an 8 year final. But they don't give me ANY info on the shape of the curve so i'm not going to answer "A - Above par".

They say the answer is "D - At Par" but that can't be stated either with the information given because that assumes a FLAT yield curve and again, they give no information on the shape of the curve in the question.

AARRRGGGHH! I guess the purpose of this post was to express my frustration. I feel much better now that I've aired this out. I've also sent an e-mail to schweser, I'm not holding my breath on getting a response.
 
The yield shape is given in the quesiton. When it says "interest rates remain unchanged", it means that the market interest rate two years from today is the same as today's. You grasped the concept, but just got confused on the question text.
 
In 2 years, the coupon rate will still equal the market rate of 10%. This means the bond will trade at par.

You can also compute the value:

FV = 100
PMT = 10
I/Y = 10
N = 8
CPT PV = -100
 
"interest rates unchanged" is not the same as a "flat yield curve". A normally shaped yield curve can be "unchanged" two years hence and the 8 year yield will still be lower than the 10 year yield.

For instance the 5 year Treasury is currently at a 4.98% and the 10 year is currently a 5.13%. If rates are unchanged 5 years from now the 10 year will HAVE to yield 4.98% because it will be a 5 year final (it rolls down the curve). The price will HAVE to go up to get the 5.13% yield down the 5 year market yield of 4.98%.

They did not provide enough information to accurately answer that question.
 
mofomo - the bondholders YIELD will still be 10% as long as he holds it. But the MARKET PRICE of that bond can and will change over the course of it's life. In a normal yield curve environment (upward sloping) a normal coupon bond will "roll down the curve".

If the yield curve looks like this:

1 yr - 1%
2 yr - 2%
3 yr - 3%
5 yr - 5%
10y - 10%


Consider this, you own a 10 year 10% coupon bond that you bought at par. The yield curve is upward sloping (as indicated by the numbers above), and rates don't change for two years. With 5 years left on your 10% coupon bond you decide to sell it. Even though RATES have not changed (a ten year issue still yields 10%) you now have a bond with 5 years left to maturity, it is no longer a 10 year bond...it is essentially a 5 year bond, and the market WILL price it accordingly.

From the figures above we see that 5 year bonds are trading at a market yield of 5%...would you sell your 10% coupon at par? Or would you sell it at the required rate of return for a bond with 5 years to maturity and sell it at a gain?

The 10% coupon MUST trade at a premium with 5 years left to maturity under this yield curve scenario.
 
Greenspan,

in reality you can argue that. However, keep in mind, this is regarding a question asked by Schweser and used to prepare for June 3. So, insisting on understanding it as you would in real life does not help. We all have to adopt to the ways questions are worded and accept the fact they may be different than they would in practice.



Edited 1 time(s). Last edit at Monday, May 1, 2006 at 01:59PM by fwvagabond.
 
fwvagabond - I concur that reality must be set aside sometimes to answer things within the context of a CFA L1 Question. If they had left out the "cannot answer" option it would have forced me to choose differently. In the real world of trading bonds, which I do for a living "cannot answer" is the only choice that makes sense. Wish they would have worded that one differently.
 
Nah, Greenspan is right. Imagine his normal upward sloping yield curve and think about how much this bond would be worth right after the penultimate six-month coupon. It's a 6-month bond paying 10% in an environment where 6-month interest rates are less than 1%.

Maybe what they mean by interest rates remaining unchanged is that forward rate expectations have remained unchanged so that the previous 10-year discount rate is now the 8-year discount rate. It's a stretch.

BTW - forget about interest rates. There is nothing in here about credit, optionality, etc... If this is a corporate bond and 1 year after you buy it at par, they default on the debt the interest rate environment is the least of your worries.

The answer is C.
 
The answer is D

Based on the types of question they ask, they don't take into account the yield curve and as such the statement "If interest rates don't change" directly implies a flat yield curve at the T0 ad T1, Greenspan and Joe are being too complex for level 1. If they don't mention the yield curve then they are directly assuming what they state, yields are at 0% still. I have taken CFA question and schweser questions and every question like this is the same; it's an analysis of the inverse yield-price relationship.
 
You can answer C if you want. If you want to pass the exam, you need to answer what the CFA Inst. wants you to answer, not what is correct.

In this case, the only interest rate that matters in the Yield to Maturity. If that rate remains the same, the value of the bond will remain par.
 
Yeah I guess when they said "interest rates don't change" they were implying the yield curve was flat, not upward sloping.

Not sure what I would have put on the test, probably D, but I can see how C is the more correct answer.
 
Lets just put it this way, they are testing basic, static thoery here, they want to know if the candidate recognizes that in a static interest rate environment that a par bond will stay a par bond (same interest rate). In level 1 that is the right answer. But in level 2 if you were writing you can qualify it saying "in a flat yield curve environment the bond will trade at par", however if the yield curve was upward sloping....
 
I got an answer from Schweser on this tonight. I logged on during the Faculty Hours and got this response from the Schweser Level 1 manager regarding this question:


Dr. R. Douglas Van Eaton, CFA - Level 1 Manager: (2006-05-01 21:32:35)
I agree with you. Would you please give me the question number if you have it. the question should say,'if the YTM does not change', then it would be ok as is. For future refererence, I can access online questions by question number so you can save youself some typing. Thanks for catching this, it shows you understand this bond valuation stuff well.
 
Nice, I think the difference is I am immune to being surprised by a question with a bold assumption and simply work around it. I have come across a few schweser questions where you just have to make some pretty bold assumptions for, though, like this one, for instance. In general if they are asking for the effect of X on something, they usually stick with that and don't complicate it by mixing LOSs. This is because many questions are pretty straight forward and don't, generally mix too many LOSs at the level 1, with an olbvious exception of FSA and ratios.

I saw one question that threw me a bit, though. It was on leases and asked about the difference in net income with an operating lease or a capital lease (which one had higher income) but without a reference to earlier income or later income so you had to assume that they were asking about earlier income (which it turns out they did). Anyhow the point is that schweser sometimes leaves some important assumptions out.
 
If it helps, in a PDF document titled Tips for Studying for the CFA Examinations posted on CFAI website, they specifically state:

L1 does not use any of the following distracters (the choices): all of the above, none of the above, I and II only, II and III only, cannot determine, cannot calculate, not enough infomration to determine.
 
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