- CFA Exams
- CFA Level I Exam
- Study Session 14. Fixed Income (1)
- Reading 42. Fixed-Income Securities: Defining Elements
- Subject 4. Structure of a Bond's Cash Flows

###
**CFA Practice Question**

Two bonds differ in their provisions for early retirement. Bond A is a five-year serial bond. Bond B contains a sinking fund provision requiring the issuer to provide the trustee with sufficient funds to retire 20% of the original principal each year for five years. The sinking fund provision calls for the trustee to select the serial numbers of bonds to be retired by random assignment. Neither bond is callable.

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 time to maturity decreases.

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 time to maturity decreases.

A. I and II

B. II and III

C. I, II and III

**Explanation:**The indenture of a serial bond specifies the size and timing of promised payments. The sinking fund provision of the bond adds uncertainty as to the number of cash flows to be received by the bond owner.

###
**User Contributed Comments**
11

User |
Comment |
---|---|

noonah |
The second statement should not be correct! after retiring 20% in the first year, there will remain 80%. Therefore, the prob after first year is 20%/80%=25% |

armanaziz |
It is correct because it can be assumed that the sinking fund provision requires principal payments to be made at the end of each year. |

ElCarnal |
The third statement is incorrect in my opinion...The probability that the bond will be reversed before maturity DECREASES with time.. if the phrasing had been "the proba that an investment position will be reversed THIS YEAR IN PARTICULAR increases" or something like that it would have been correct. |

ravdo |
I love you guys who states the answers are wrong. Why even bother studying for the CFA when you know so much more than the writers of Analystnotes? You should believe in you own opinions and choose answers accordingly. GOOD luck on the exam ! |

StanleyMo |
For the third one, the prob increase as after 1 years, you have 25%, 2 year, you have 33.3% to be called. |

fanfanli |
20% of the principle each year...This amount will stay constant over the 5 years |

u0302638 |
Hi Stanley, how do you calculate to have 33.3% |

chris12345 |
StanleyMo is probably going to fail the CFA and be unemployed |

poomie83 |
StanleyMo has based it on the number of years remaining to maturity - this is correct if there is 20% for the first year and there are 5 years remaining. |

sonicskat |
The prob(retired) increases year on year because 20% of the original principal is retired. After 1 year, there is 80% of the original principal left, meaning that there is a prob of 20/80=.25 that your debt is retired in year two. Then a prob of 20/60 = .333 in year three. Then 20/40 in year four, then probability of 1 in year five. I got it wrong when i tried it, but see the trick here. those familiar with survival analysis should understand. |

alles |
This is how I got this question wrong thinking that I got it right: III says "BEFORE maturity as time to maturity decreases" (or "as maturity approaches" / "time goes by" as I understand - english is not my native language). So at the beginning there's a 80/100 chance that an investment position in bond B will be reversed BEFORE maturity (in the first 4 years of the bond). As the first year passes, there's a 60/80=75% that a position will be reversed BEFORE maturity (at the end of years 2, 3 or 4). As the second year passes, there's a 40/60=66.7% chance that a position will be reversed BEFORE maturity (at the end of years 3 or 4). As the third years passes, a 20/40=50% chance. Therefore, the probability that an investment position will be reversed BEFORE the fifth year decreases as time to maturity decreases. What am I missing here? |