2016-FRR Premium Exam Questions

Floating rate bonds have coupon payments that are tied to a floating interest rate or index, such as LIBOR. This means their coupon payments adjust periodically with changes in the underlying interest rates. Due to this mechanism, floating rate bonds typically have less price risk compared to fixed-rate bonds because their coupon payments reset in line with current market rates. Hence, floating rate bonds are generally not very sensitive to changes in interest rates since the adjustments in coupon payments help maintain their value. Therefore, the statement that floating rate bonds are very sensitive to changes in interest rates is incorrect.

Mathematical valuation and risk assessment models can be misleading or inaccurate for several reasons:

Missing factors in models: Important variables or conditions might be overlooked.

Bad or wrong data: Incorrect or poor-quality data input can lead to faulty outcomes.

Misinterpretation of results: Users might not correctly understand or use the results.

Errors in the derivation of the model: Mistakes in the mathematical formulation or assumptions can lead to errors.

All these factors contribute to the potential inaccuracy or misleading nature of such models.

To hedge a bond portfolio against small parallel shifts in the term structure, you need to take a position in an instrument with an equal and opposite duration. John has a bond portfolio worth $2 million with a duration of 10. To hedge this, he should take a short position in bonds worth $20 million with a duration of 1. This is because the product of the value and duration of the hedge position should equal the product of the value and duration of the original portfolio (2 million * 10 = 20 million * 1).

Interest rates can vary based on the term of the debt instrument. Generally, short-term interest rates are more sensitive to changes in monetary policy and economic conditions, leading to higher variability compared to long-term interest rates. This is because short-term rates are directly influenced by central bank policies, such as changes in the federal funds rate, which can lead to frequent fluctuations. Long-term rates, on the other hand, are influenced more by long-term economic expectations and inflation forecasts, which tend to be more stable over time.