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CFA Level II Fixed Income Practice Questions

Official outline
CFA Institute 2026 Level II Topic Outlines (learning outcomes)
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8
Updated
Nov 3, 2026

  1. Question 1, medium

    A bond portfolio has key rate durations of 0.60 at 2 years, 1.20 at 5 years, 2.00 at 10 years and 0.40 at 30 years. Only the 10-year par rate rises by 50 bp, and all other key rates are unchanged. What is the approximate percentage change in portfolio value?

    • A.-1.00%
    • B.+1.00%
    • C.-0.50%
    • D.-2.10%
    Show answer and explanationHide answer

    Correct answer: A. -1.00%

    For a shift at one key rate, the approximate price change is -KRD x change in rate = -2.00 x 0.50% = -1.00%. The sum of the key rate durations (4.20) applies to a parallel shift of all key rates, not to one key rate alone.

    • A. Correct: -2.00 x 0.50% = -1.00%.
    • B. Gets the sign wrong; rising yields reduce value.
    • C. Uses a 25 bp shift or half the sensitivity, understating the effect.
    • D. Uses the 4.20 total duration, which applies only if all key rates rise by 50 bp.

  2. Question 2, medium

    Analyst Eli builds a binomial interest rate tree to value bonds with embedded options. Which result confirms that the tree is arbitrage-free and ready to use?

    • A.An option-free bond valued on the tree equals its value discounted at the benchmark spot rates
    • B.The up-state and down-state rates at every date are equal, removing volatility
    • C.Risk-neutral probabilities at each node sum to more than one to reward risk
    • D.A callable bond valued on the tree equals the value of the same option-free bond
    Show answer and explanationHide answer

    Correct answer: A. An option-free bond valued on the tree equals its value discounted at the benchmark spot rates

    A calibrated tree must reprice benchmark option-free bonds to the values implied by the spot curve. Once it does, it can be used to value embedded options. Zero volatility, a callable valued as option-free, or probabilities not summing to one all signal a flawed tree.

    • A. Correct: repricing option-free bonds to the spot curve verifies calibration.
    • B. Equal up and down rates would remove all rate volatility and make options worthless.
    • C. Probabilities at a node must sum to one; they do not carry a risk reward.
    • D. A callable bond should be worth less than the option-free bond, not the same.

  3. Question 3, easy

    Analyst Priya argues that yields in the short, intermediate and long maturity ranges are set entirely by supply and demand from investors who will not leave their own maturity range, so the curve says little about expected future rates. Which theory of the term structure matches her view?

    • A.Preferred habitat theory
    • B.Market segmentation theory
    • C.Pure expectations theory
    • D.Liquidity preference theory
    Show answer and explanationHide answer

    Correct answer: B. Market segmentation theory

    Market segmentation theory treats each maturity range as a separate market with its own investors, whose rigid demand sets yields independent of expected rates. Preferred habitat theory is similar but allows investors to move outside their habitat if compensated with a yield premium.

    • A. Preferred habitat lets investors leave their range for extra yield, which Priya's investors will not do.
    • B. Correct: separate markets with investors unwilling to switch maturities.
    • C. Pure expectations theory ties long yields to expected short rates, the opposite of this view.
    • D. Liquidity preference theory adds a maturity-related premium to expected rates and does not isolate segments.

  4. Question 4, easy

    A bond's credit spread is 1.20% per year. The expected recovery rate on default is 40%. Using the approximation that credit spread equals probability of default times loss given default, what is the implied annual probability of default?

    • A.1.20%
    • B.0.72%
    • C.2.00%
    • D.3.00%
    Show answer and explanationHide answer

    Correct answer: C. 2.00%

    Loss given default = 1 - 0.40 = 60%. Probability of default is about spread/LGD = 1.20%/0.60 = 2.00%. Dividing by the recovery rate is a common slip that mistakes recovery for loss.

    • A. Treats the spread itself as the default probability, ignoring recovery.
    • B. Multiplies spread by LGD, reversing the relationship.
    • C. Correct: spread divided by LGD.
    • D. Divides by the recovery rate rather than the loss rate.

  5. Question 5, easy

    The hazard rate of an issuer is constant at 2.0% per year (continuously compounded). What is the probability the issuer survives five years?

    • A.90.00%
    • B.90.48%
    • C.9.52%
    • D.98.00%
    Show answer and explanationHide answer

    Correct answer: B. 90.48%

    With a constant hazard rate, survival probability is exp(-hazard x time) = exp(-0.02 x 5) = exp(-0.10) = 90.48%. The simple 1 - 0.10 = 90.00% ignores continuous compounding, and 9.52% is the default probability, not survival.

    • A. Subtracts the sum of annual rates linearly, ignoring compounding.
    • B. Correct: exp(-0.10) = 90.48%.
    • C. Reports the cumulative default probability rather than the survival probability.
    • D. Reports the one-year survival probability rather than the five-year figure.

  6. Question 6, medium

    Analyst Dana observes two annual-pay par bonds priced at 100: a 1-year bond with a 2.00% coupon and a 2-year bond with a 3.00% coupon. Using bootstrapping, what is the 2-year spot rate?

    • A.2.51%
    • B.3.50%
    • C.3.00%
    • D.3.02%
    Show answer and explanationHide answer

    Correct answer: D. 3.02%

    The 1-year spot rate is 2.00%. Solve 100 = 3/1.02 + 103/(1+S2)^2, so 103/97.0588 = 1.06121 and S2 = 3.02%. A par yield equals the spot rate only on a flat curve; on an upward-sloping curve the 2-year spot rate exceeds the 2-year par yield.

    • A. Averages the 1-year and 2-year inputs instead of solving for the spot rate.
    • B. Adds the 1-year rate and the coupon step instead of bootstrapping, overstating the spot rate.
    • C. Treats the par yield as the spot rate, which ignores that the first coupon is discounted at a lower rate.
    • D. Correct: discounting the first coupon at the 1-year spot and solving for the 2-year spot gives 3.02%.

  7. Question 7, medium

    Spot rates (annual compounding) are 2.00% for 1 year, 3.00% for 2 years and 4.00% for 3 years. Investor Luca buys a 3-year zero-coupon bond, sells it after one year, and expects the spot curve to be unchanged at that time. What is his expected holding-period return?

    • A.6.03%
    • B.2.00%
    • C.3.00%
    • D.4.00%
    Show answer and explanationHide answer

    Correct answer: A. 6.03%

    Buy at 100/1.04^3 = 88.8996. After one year the bond is a 2-year zero priced at 100/1.03^2 = 94.2596. Return = 94.2596/88.8996 - 1 = 6.03%. The bond rides down the upward-sloping curve, earning more than its 4.00% yield.

    • A. Correct: 94.26/88.90 - 1 = 6.03%.
    • B. Reports the 1-year spot rate, which is the return on a 1-year zero, not this bond.
    • C. Uses the 2-year spot rate rather than computing the holding-period price change.
    • D. Reports the 3-year yield and ignores the roll-down price gain from the unchanged curve.

  8. Question 8, hard

    A standard credit default swap has a fixed coupon of 1.00%. The market spread for the reference entity is 3.00%, and the CDS has an effective spread duration of 4.0. Which statement describes the upfront premium?

    • A.The protection buyer receives about 8.0% of notional upfront
    • B.The protection buyer pays about 2.0% of notional upfront
    • C.The protection buyer pays about 12.0% of notional upfront
    • D.The protection buyer pays about 8.0% of notional upfront
    Show answer and explanationHide answer

    Correct answer: D. The protection buyer pays about 8.0% of notional upfront

    Upfront premium is roughly (CDS spread - fixed coupon) x effective spread duration = (3.00% - 1.00%) x 4.0 = 8.0% of notional. Because the contract coupon is below the market spread, the buyer compensates the seller upfront.

    • A. Reverses direction; the buyer pays when the coupon is below the market spread.
    • B. Omits the multiplication by spread duration.
    • C. Multiplies the full spread, not the spread difference, by duration.
    • D. Correct: (3.00% - 1.00%) x 4.0 = 8.0%, paid by the buyer.

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