CFA Practice Question

CFA Practice Question

An investor is considering investing in several debt securities, which are illustrated below:

I. 10-year 6.25% Treasury Note.
II. 15-year 6.75% Treasury Bond.
III. 5-year 7.25% corporate note.
IV. 20-year 7.50% corporate bond.
V. 15-year 8.25% Collateralized Mortgage Obligation.
VI. 10-year 6.50% Collateralized Mortgage Obligation.

Assuming that the market rate of interest on similar investments is 6.25%, and that a liquid market for each of these securities exists, which of these debt instruments would trade at a premium to par? Choose the BEST answer.
A. III, IV, V, VI
B. None of these answers is completely correct.
C. II, III, IV
Explanation: In order to gain an understanding of debt instruments, it is fundamental to first examine the relationship between the stated, or "nominal" rate of interest, and the required, or "market" rate of interest, and the effect these interest rates have on the prices of bonds. When the nominal rate of interest is less than the market rate of interest, the price of the debt instrument will be below par. This will force the yield on the debt instrument upward toward the market rate of interest. Conversely, when the nominal rate of interest is higher than the required rate of interest, the price of the bond will be bid up, forcing the yield downward toward the market rate of interest. This relationship is applicable to all debt instruments.

Of the bonds listed, only #I features a coupon rate which is not above the market rate of interest. Specifically, the coupon rate of 6.25% possessed by Note #I would merit the issue being priced at par. The remainder of the debt securities listed feature coupon rates that exceed the required market rate of interest and therefore will be trading at a premium to par.

User Contributed Comments 8

User Comment
n9845705 Which of these debt instruments would be trading at premium to par? Answer: "The remainder of the debt securities ... will be trading at a premium to par."
dealsoutlook so if one of the listed answer was II,III,IV,V,VI we would have chosen that right?
jackwez yes
pstebelp So, since choice A) III,IV, V, VI all offer higher coupons than the market requires, wouldn't they trade at a premium? Doesn't choice A meet the premium requirement? Choice C meets the requirement as well, but it is not a "Better" answer than A?.

Oh, I guess choice B, "None of these answers is completely correct" is more correct if it is referring to the other two answers, A or B.
chandsingh Guys, does'nt the fact that i and ii refer to Treasury instruments mean that they cannot be compared to the required market return for corporate bonds? Should'nt A then be right?
andrewmorgan such a trick question and subjective whether a or b is the best answer
enetis wow, just got schooled!!!
GBolt93 I assumed B was referring to I-VI not A and B...
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