CFA Level I Fixed Income Practice Questions

Correct answer: A. Bond C

Yield spread over a benchmark Treasury primarily compensates investors for credit (default) risk, along with liquidity and other risk factors. Lower-rated issuers have a higher probability of default and typically lower recovery expectations, so investors demand a larger spread as compensation. Bond C, rated B (speculative/high-yield grade), carries materially more credit risk than investment-grade Bonds A (AAA) and B (BBB), so it should command the widest spread. Choice D incorrectly assumes that matching maturity and coupon eliminates credit-risk differentiation. It does not, since spread compensates specifically for the risk the coupon and maturity terms don't capture.

• AA. Bond C, the speculative-grade (B-rated) issue, carries the highest default risk of the three, so investors demand the largest yield spread over Treasuries to compensate.
• BB. Bond A's AAA rating reflects the lowest credit risk of the group, so it should trade at the smallest spread over Treasuries, not the largest.
• CC. Bond B's BBB (investment-grade) rating sits between AAA and B, so its spread should be intermediate. Higher than Bond A's but well below Bond C's.
• DD. Credit spreads compensate specifically for default and credit risk, which differs sharply across the AAA/BBB/B ratings here even though maturity and coupon are identical.

• Source: CFA Institute refresher reading: Credit Risk, accessed October 2026

Correct answer: D. Decline 1.0% because all-in yield rises 25 basis points

The bond's all-in yield change is -20 + 45 = +25 basis points, so the price change is about -4 x 0.0025 = -1.0%.

• AA. The 20 basis point benchmark decline only partly offsets the 45 basis point spread widening. The net yield change is +25 basis points, so the price falls rather than staying unchanged.
• BB. This adds the 20 basis point benchmark move to the 45 basis point spread move to get 65 basis points, and 4 x 0.65% = 2.6%. The benchmark decline lowers the yield and must be subtracted, so the net change is +25 basis points, not +65.
• CC. This counts only the benchmark decline: 4 x 0.20% = +0.8%. It ignores the larger 45 basis point spread widening, which turns the net yield change into a 25 basis point rise and a price decline.
• DD. The benchmark falls 20 basis points and the spread widens 45, so the all-in yield rises a net 25 basis points. With duration of 4, the price change is about -4 x 0.25% = -1.0%.

• Source: CFA Institute refresher reading: Yield and Yield Spread Measures for Fixed-Rate Bonds, accessed October 2026

Correct answer: A. First to Tranche A until it is fully retired, then to Tranche B, then to Tranche C

In a sequential-pay structure, all principal (scheduled and prepaid) flows to the earliest, shortest-maturity tranche first; only after Tranche A is fully retired does principal begin flowing to Tranche B, and so on. This redistributes prepayment risk across tranches by average life rather than eliminating it. Choice B describes a pro-rata (not sequential) structure. Choice C reverses the payment order. Choice D introduces an irrelevant criterion. Coupon rate does not determine principal allocation in a sequential-pay deal.

• AA. Correct. In a sequential-pay structure, all principal (scheduled plus prepaid) flows to the earliest tranche (A) until fully retired, then to B, then to C, concentrating prepayment risk in order.
• BB. Incorrect. Pro-rata principal allocation describes a different structure, not the defining sequential-pay mechanism, which retires tranches one at a time in priority order.
• CC. Incorrect. This reverses the actual priority; Tranche C is last, not first, to receive principal, making it the longest and most prepayment-protected tranche rather than the shortest.
• DD. Incorrect. Principal allocation in a sequential-pay CMO is driven by tranche seniority, not by which tranche happens to carry the highest coupon.

• Source: Exam outline: CFA Institute 2026 Level I Topic Outlines (learning outcomes), accessed October 2026

Correct answer: C. -6.70%

The full duration-and-convexity price-change approximation is %ΔP ≈ [−Duration × Δy] + [0.5 × Convexity × (Δy)²]. Here: −7 × 0.01 = −0.07 (−7.00%), and 0.5 × 60 × (0.01)² = 0.003 (+0.30%). Adding these gives −0.07 + 0.003 = −0.067, or approximately −6.70%. Positive convexity always makes the actual price decline smaller (less negative) than the duration-only estimate for a yield increase.

• AA. Incorrect. This subtracts the convexity adjustment instead of adding it, reversing its sign for a bond with positive convexity.
• BB. Incorrect. This is the duration-only estimate, omitting the convexity adjustment entirely.
• CC. Correct. Combines the duration effect (−7.00%) with the positive convexity adjustment (+0.30%) to get −6.70%.
• DD. Incorrect. Overstates the convexity adjustment's magnitude beyond what 0.5 × 60 × (0.01)² actually produces.

• Source: Exam outline: CFA Institute 2026 Level I Topic Outlines (learning outcomes), accessed October 2026

Correct answer: D. -3.75%

The approximate percentage price change for a bond given a change in yield is %ΔP ≈ −(Modified Duration) × Δy. Here, %ΔP ≈ −7.5 × 0.50% = −3.75%. The negative sign reflects the inverse relationship between bond prices and yields.

• AA. Incorrect. A decimal/scaling error, understating the price change by a factor of 10.
• BB. Incorrect. Correct magnitude but wrong sign; yields rising should decrease price, not increase it.
• CC. Incorrect. Mistakenly uses the full duration figure (7.5%) as if the yield change were 100 basis points rather than 50.
• DD. Correct. Correctly applies %ΔP ≈ −MD × Δy = −7.5 × 0.50% = −3.75%.

• Source: Exam outline: CFA Institute 2026 Level I Topic Outlines (learning outcomes), accessed October 2026

Correct answer: A. Coupon rate > Current yield > Yield to maturity

For a premium bond (price > par), coupon rate > current yield (coupon/price, and price > par pulls this yield down from the coupon rate) > yield to maturity (which further reflects the capital loss pulling the price down to par at maturity). Choice B is the correct ordering for a discount bond, not a premium bond. Choice C has the middle two terms swapped. Choice D only holds when the bond is priced exactly at par.

• AA. Correct. For a premium bond, coupon rate > current yield > yield to maturity, since a price above par pulls current yield below the coupon, and YTM falls further to reflect the capital loss to par at maturity.
• BB. Incorrect. This ranking, with YTM highest, actually describes a discount bond, not a premium bond.
• CC. Incorrect. Current yield, not yield to maturity, sits in the middle of the ranking for a premium bond; YTM is the lowest of the three.
• DD. Incorrect. The three yield measures are equal only when a bond trades exactly at par, not at a premium.

• Source: Exam outline: CFA Institute 2026 Level I Topic Outlines (learning outcomes), accessed October 2026

Correct answer: A. A call option on the value of the firm's assets, with a strike price equal to the face value of debt

In the Merton model, equityholders retain the upside above the face value of debt (like a call option) while being protected by limited liability if asset value falls below the debt's face value at maturity. Equity's payoff is max(Asset Value − Debt Face Value, 0), a call option's payoff. The put-option description fits the implicit position embedded in risky debt (bondholders are effectively short a put on the firm's assets), not equity. The forward-contract and 'risk-free debt plus written call' descriptions scramble unrelated derivative structures onto the concept.

• AA. Equity holders receive the larger of zero and asset value minus the debt's face value at maturity. That is a call payoff on the firm's assets with the debt's face value as the strike. If assets fall short of the debt, shareholders let the option expire (default) and walk away.
• BB. A put would pay off when asset value falls below the face value of debt, which is a loss-protection payoff that shareholders do not hold. Equity gains when assets rise above the debt, so its payoff is call-like. The put exposure belongs to debtholders, whose risky debt equals risk-free debt minus a put on the assets.
• CC. A forward would obligate shareholders to buy the assets at the debt's face value whatever the outcome, so they could lose more than their stake. Limited liability gives shareholders a right, not an obligation: they can pay off the debt and keep the assets, or default and walk away. That optionality is what a forward lacks.
• DD. This combination does not replicate equity. Equity equals assets minus risky debt, and risky debt equals risk-free debt minus a put on the assets, so equity works out to a long call on the assets. Adding a written call to risk-free debt gives a payoff that is capped above and has no link to shareholders' residual claim.

• Source: Exam outline: CFA Institute 2026 Level I Topic Outlines (learning outcomes), accessed October 2026

Correct answer: A. 6.00%

With one year to maturity, the bond's single remaining cash flow is the final coupon plus principal: $40 + $1,000 = $1,040. YTM solves $981.13 = $1,040 / (1 + YTM), so (1 + YTM) = 1,040 / 981.13 ≈ 1.06, giving YTM ≈ 6.00%. Because the bond trades below par, its YTM must exceed its coupon rate. 4.00% (choice B) is simply the coupon rate and cannot be correct for a discount bond.

• AA. Correct. For a 1-year bond, price = (par + coupon)/(1+YTM); $981.13 = $1,040/(1+y) implies y = $1,040/$981.13 − 1 ≈ 6.00%.
• BB. Incorrect. 4.00% is just the coupon rate; since the bond is priced below par, the yield to maturity must exceed the coupon rate, not equal it.
• CC. Incorrect. 5.00% doesn't reconcile with the given price; discounting $1,040 at 5% would produce a price above $981.13.
• DD. Incorrect. 7.00% would produce a price lower than $981.13; recheck the discounting math using $1,040/(1+y).

• Source: CFA Institute refresher reading: Fixed-Income Bond Valuation: Prices and Yields, accessed October 2026