Free CFA Level I Fixed Income Practice Questions

The coupon rate is the stated annual interest rate expressed as a percentage of the bond's par (face) value. It determines the fixed periodic coupon payments. Choice A describes the current yield (annual coupon / market price), not the coupon rate. Choice B describes the yield to maturity (YTM), which accounts for all future cash flows and any difference between the purchase price and par.

Negative convexity occurs for callable bonds when interest rates decline to a level where the call option is likely to be exercised. At low yields, the bond's price appreciation is capped near the call price, causing the price-yield curve to bend downward (negative convexity).
Choice A is incorrect because at high yields, the call option is unlikely to be exercised, and the bond behaves like a non-callable bond with positive convexity.
Choice B is incorrect because a deep discount implies high yields, where call exercise is unlikely.

For an 8% semi-annual coupon bond priced above par (8% coupon at a yield below 8%), the Macaulay duration will be somewhat below its maturity of 3 years, approximately 2.7 years. Immunization requires Macaulay duration to EQUAL the investment horizon. Since duration (2.7 years) exceeds the horizon (2.5 years), the price effect dominates the reinvestment effect. If rates rise, the price decline more than offsets the benefit of higher reinvestment rates, leaving the investor worse off. To immunize, the investor should reduce the portfolio's Macaulay duration to 2.5 years by shortening duration (e.g., selling this bond and buying a shorter-duration bond).
Choice B is incorrect: when duration exceeds the horizon, price risk (not reinvestment risk) is the dominant concern when rates rise.
Choice A is incorrect: duration exceeding horizon does not create an immunized position; equality of duration and horizon is required.