Free CFA Level II Fixed Income Practice Questions
Fixed income on the CFA Level II exam covers term structure models, arbitrage-free bond valuation, credit analysis models (structural and reduced-form), and mortgage-backed securities analysis. Weighted 10-15% (CFA Institute).
Sample Questions
Question 1
Easy
The bootstrapping method is used to derive:
Solution
B is correct.
Bootstrapping is a method for deriving the spot rate (zero-coupon) curve from the yields of coupon-paying bonds. The process works iteratively: starting with the shortest maturity bond (which gives the first spot rate directly), each subsequent bond's coupon payments are discounted using previously derived spot rates, and the final spot rate is solved for. This produces a complete spot rate curve from observed par bond yields.
Bootstrapping is a method for deriving the spot rate (zero-coupon) curve from the yields of coupon-paying bonds. The process works iteratively: starting with the shortest maturity bond (which gives the first spot rate directly), each subsequent bond's coupon payments are discounted using previously derived spot rates, and the final spot rate is solved for. This produces a complete spot rate curve from observed par bond yields.
Question 2
Medium
A negative CDS-bond basis (CDS spread < bond spread) most likely indicates that:
Solution
C is correct.
A negative basis means the CDS spread is lower than the bond spread (or Z-spread). This implies that the bond market is demanding more credit compensation than the CDS market. The bond appears cheap relative to the CDS. A negative basis trade involves buying the undervalued bond and buying CDS protection, which ideally locks in the basis spread as profit if the basis converges to zero.
A negative basis means the CDS spread is lower than the bond spread (or Z-spread). This implies that the bond market is demanding more credit compensation than the CDS market. The bond appears cheap relative to the CDS. A negative basis trade involves buying the undervalued bond and buying CDS protection, which ideally locks in the basis spread as profit if the basis converges to zero.
Question 3
Hard
Based on the vignette, the upfront payment Priya pays at trade inception to enter the Zenith Corp 5-year CDS as the protection buyer is closest to:
Solution
B is correct.
For a standardized CDS where the quoted spread (320 bps) exceeds the standardized coupon (100 bps), the protection buyer pays an upfront amount to compensate the seller for receiving an above-coupon premium going forward. The approximation formula is:
On a $10 million notional, the protection buyer pays $990{,}000 upfront. After the upfront payment the buyer continues to pay the standardized 100 bps coupon for the life of the contract.
For a standardized CDS where the quoted spread (320 bps) exceeds the standardized coupon (100 bps), the protection buyer pays an upfront amount to compensate the seller for receiving an above-coupon premium going forward. The approximation formula is:
On a $10 million notional, the protection buyer pays $990{,}000 upfront. After the upfront payment the buyer continues to pay the standardized 100 bps coupon for the life of the contract.