CFA Practice Question

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CFA Practice Question

Two bonds differ in their provision for early retirement. Bond A is a serial bond calling for the retirement of 20% of original principal each year for five years. Bond A is not callable. Bond B is non-callable for the first three years but callable on the first coupon payment date of the third year and is callable every coupon payment date thereafter, for a call price equal to par value plus the scheduled coupon payment.

I. The timing and size of bond A's promised payments are known with certainty.
II. There is a 20% chance that an investment position in bond B will be reversed after the first year.
III. The probability that an investment position in bond B will be reversed before maturity increases as market interest rates declines.
Correct Answer: I and III

A non-callable serial bond's promised payments are specified by the bond's indenture. The issuer of a callable bond is more likely to call the bond (refinance) if interest rates fall.

User Contributed Comments 8

User Comment
jerylewis Why would the callable bond be called upon by the issuer if rates rise? It would become more expensive to refinance the callable bond (with coupon= 5% for ex) if current rates rise to 7%? Am I missing something out? Thanks
Rotigga Hey jerylewis, read the question carefully. It says as rates Decline, not Rise.
steved333 I don't see how I is right. If every year, 20% is to be retired, how can you know anything with certainty about timing of payments? Is it because the question does not specify that the serial numbers are chosen at random?
JimM steved333, a serial bond, by definition, has a fixed percentage of its value retired each year. This is known in advance, so the cash flows are known in advance.
slipleft steved; the 20% for the serial bond is pro rata (each bondholder has 20% retired each year), this opposed to the prior question where 20% of bond holders are retired in full each year
johntan1979 Thanks for the explanation, guys (or gals)! Now I understand why this question's 20% is different from the previous question's.
xp_acctant Can someone explain answer III ( the market interest rate ).
Olesya_CFA @Xp_ acctant If the market interest rate falls, the issuer's payments to bondholders will cost more because the coupon rate will be higher than the market interest rate. That is why the issuer will rather call the bond.
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