Which statements are TRUE about CMBs? A. CMBs are sold at par at a regular weekly auction The best answer is D. CMBs are Cash Management Bills. They are sold at auction by the Treasury on an "as needed" basis to meet unexpected cash shortfalls, so they are not part of the regular auction cycle. They are the shortest-term U.S. government security, often with maturities as short as 5 days. They are sold in $100 minimums at a discount to par value, just like Treasury Bills. Which statement regarding Treasury Bills is FALSE? A. T-Bills are original issue discount obligations The best answer is D. Treasury Bills are original issue discount obligations. They are auctioned off weekly by the Federal Reserve acting as agent for the U.S. Treasury. When the bills mature, the difference between the purchase price and the redemption value at par is taxable as interest income. T-Bills are a direct obligation of the U.S. Government. What is quoted in terms of yield and trades at a discount? A. T-Bill The best answer is A. Treasury Bills are short-term original issue discount obligations of the U.S. Government. They are quoted in a discount yield basis, aka a basis quote. Treasury Notes and Treasury Bonds are issued at par and are quoted as a percentage of par in movements of 32nds. Corporate bonds are issued at par and are quoted as a percentage of par in 1/8ths. Which statement is TRUE regarding Treasury Bills? A. T-Bills are issued at par The best answer is D. The U.S. Government issues Treasury Bills in book entry form only. No physical certificates are issued.T-Bills are short term instruments that are issued at a discount and mature to par. Which of the following investments is issued with a stated coupon rate and with a maximum maturity of 10 years? A. Treasury Notes The best answer is A. Treasury Notes are government obligations maturing between 1 year and 10 years which pay interest semi-annually. New issues of Treasury Bonds, are issued by the U.S. Government in which form? A. Book Entry The best answer is A. All Treasury debt obligations are issued in book entry form only.
Which of the following investments is issued with a stated coupon rate and with a maximum maturity of 30 years? The best answer is D. Treasury bonds are government obligations issued with initial 30 year maturities which pay interest semi-annually. Which investment does NOT have purchasing power risk? A. STRIPS The best answer is B. Purchasing power risk is the risk that inflation will cause interest rates to increase; and therefore, bond prices will fall. "TIPS" are Treasury Inflation Protection Securities - the principal amount of these securities is adjusted upwards with the rate of inflation. Even though the interest rate is fixed, the holder receives a higher total payment, due to the increased principal amount. When the bond matures, the holder receives the higher principal amount. Thus, there is no purchasing power risk with these securities. STRIPS are zero-coupon Treasury obligations - these have the highest level of purchasing power risk. If there is inflation, market interest rates are forced upwards, and zero-coupon bonds such as STRIPS fall dramatically in price (Treasury Receipts are broker-created zero-coupon bonds). Long term T-Bonds are also susceptible to purchasing power risk, though not as badly as long-term zero-coupon bonds. The bonds that have the lowest purchasing power risk are short term money market instruments and TIPS.
Which statement is TRUE about TIPS? A. The coupon rate is less than the rate on an equivalent maturity Treasury Bond The best answer is A. The interest rate placed on a TIPS (Treasury Inflation Protection Security) is less than the rate on an equivalent maturity Treasury Bond. For example, a 30 year Treasury Bond might have a coupon rate of 4%; but a 30 year TIPS has a coupon rate of 2.75%. The "difference" between the two is the current market expectation for the inflation rate (1.25% in this example). The coupon rate on the TIPS approximates the "real interest rate" - the rate earned after factoring out inflation. If 30 year T-Bonds have a nominal yield of 4%; and the inflation rate is expected to be 1.25%; then the "real" interest rate is 2.75%. The reason why the TIPS sells at a lower coupon rate is that, every year, the principal amount is adjusted upwards by that year's inflation rate. So there are really 2 components of return on a TIPS - the lower coupon rate plus the principal adjustment equal to that year's inflation rate. Which statement is TRUE regarding Treasury Inflation Protection securities in periods of deflation? A. The amount of each interest payment will stay the same and the principal amount received at maturity is unchanged at par The best answer is B. Treasury "TIPS" are Treasury Inflation Protection Securities - the principal amount of these securities is adjusted upwards with the rate of inflation. Even though the interest rate is fixed, the holder receives a higher interest payment, due to the increased principal amount. When the bond matures, the holder receives the higher principal amount. In periods of deflation, the principal amount is adjusted downwards. Even though the interest rate is fixed, the holder receives a lower interest payment, due to the decreased principal amount. In the situation where the principal amount has been adjusted below par due to deflation, when the bond matures, the holder receives par - not the decreased principal amount - a real benefit if an investor is concerned about deflation. Which statement is FALSE regarding Treasury Inflation Protection securities? A. In periods of inflation, the coupon rate remains unchanged The best answer is C. Treasury "TIPS" are Treasury Inflation Protection Securities - the principal amount of these securities is adjusted upwards with the rate of inflation. Even though the interest rate is fixed, the holder receives a higher interest payment, due to the increased principal amount. When the bond matures, the holder receives the higher principal amount. A customer buys a $1,000 par Treasury Inflation Protection security with a 4% coupon and a 10 year maturity. If the inflation rate during the first year of the security's life is 5%, the: A. principal amount remains at $1,000 and the coupon rate remains at 4% The best answer is C. Treasury "TIPS" are Treasury Inflation Protection Securities - the principal amount of these securities is adjusted upwards with the rate of inflation. Even though the interest rate is fixed, the holder receives a higher interest payment, due to the increased principal amount. When the bond matures, the holder receives the higher principal amount. Thus, there is no purchasing power risk with these securities. Which of the following is the most likely purchaser of STRIPS? A. Pension fund The best answer is A. Pension funds and retirement accounts are the large purchasers of STRIPS. These zero-coupon bonds are purchased at a deep discount and are held to maturity to fund future retirement liabilities. There is little credit risk, because the U.S. Treasury is a top credit. There is no current income because they don't pay until maturity. They have a huge amount of purchasing power risk as a long-term zero coupon obligation, but this is not an issue if they are held to maturity. Retirement plan managers like STRIPS because they don't have to worry about reinvestment risk - there are no semi-annual interest payments to reinvest! It is an investment that can be "tucked away" for 20 or 30 years, with no further work or worry on the part of the retirement fund manager. Which statement about Treasury STRIPS is TRUE? A. Treasury STRIPS are suitable investments for individuals seeking current income The best answer is D. Treasury STRIPS are government bonds that are "stripped" of coupons. Theses issues are very safe but do not provide current income. STRIPS are often placed into retirement accounts by conservative investors This is a zero coupon obligation with a "locked in" rate of return over the life of the bond (thus, it is not subject to reinvestment risk). Which investment gives the LEAST protection against purchasing power risk? A. 6 month Treasury Bill The best answer is D. Purchasing power risk is the risk of inflation - that the prices of goods and services rises faster than real economic growth. When there is significant inflation, interest rates rise. And this causes bond prices to fall. Treasury "TIPS" are Treasury Inflation Protection Securities - the principal amount of these securities is adjusted upwards with the rate of inflation. Even though the interest rate is fixed, the holder receives a higher interest payment, due to the increased principal amount. When the bond matures, the holder receives the higher principal amount. Thus, there is no purchasing power risk with these securities. Treasury STRIPS are zero-coupon Treasury obligations - these have the highest level of purchasing power risk. If there is significant inflation and interest rates rise, these securities do not provide semi-annual interest payments that can be reinvested at higher and higher rates. Rather, all the value is in the single final payment. And if this is discounted to today's value at increasing interest rates, its present value falls - rapidly. In contrast, 6 month Treasury bills have a low level of purchasing power risk. Since they will mature at par in the near future, their value cannot fall very far below this if interest rates rise. Series EE bonds: A. are issued at a discount to face The best answer is D. Series EE bonds are "savings bonds" issued by the U.S. Government with a minimum purchase amount of $25 (or more). This is the face value of the bond, and any interest earned is added to the bond's value. The interest rate is set at the date of issuance. Interest is "earned" monthly and credited to the principal amount every 6 months. The bonds have no stated maturity - the holder can redeem at any time, however interest is only credited to the bonds for 30 years. Savings bonds do not trade - they are issued by the Treasury and are redeemed with the Treasury. No physical certificates are issued - the bonds are issued in electronic form. Which security does not earn any form of interest? A. Treasury Strip The best answer is D. Treasury Stock does not earn interest, nor does it receive dividends. It is common stock that a corporation has repurchased and retired. Treasury Notes and Bonds issued by the U.S. Government pay interest semi-annually. Treasury STRIPS are zero-coupon Treasury obligations. The increase in value as it gets closer to maturity is the "interest" earned. Which statement is TRUE when comparing Treasury Notes to Treasury STRIPS? A. Treasury Notes pay interest annually The best answer is B. Treasury Notes are government obligations maturing between 1 year and 10 years which pay interest semi-annually. Treasury STRIPS are notes or bonds "stripped" of coupons, meaning all that is left is the principal repayment portion of the note or bond (sometimes called the "corpus" or body). STRIPS are zero coupon original issue discount obligations that do not have a stated interest rate. The accretion of the discount over the bond's life represents the interest earned. How is the interest income received from U.S. Government obligations taxed? A. Subject to both federal and state income tax The best answer is C. The interest income received from U.S. Government obligations is subject to federal income tax, but is exempt from state and local income taxes (one level of government cannot tax the other’s obligations). The Government National Mortgage Association: A. buys conventional mortgages from financial
institutions for repackaging as pass through certificates The best answer is B. Ginnie Mae buys FHA and VA guaranteed mortgages from banks and assembles them into pools. GNMA then sells undivided interests in these pools as pass-through certificates. The monthly mortgage payments are passed through to the certificate holders. GNMA guarantees the payment of interest and principal on the underlying mortgages and has the direct backing of the U.S. Government. The agencies that have an implied U.S. Government backing are Fannie Mae and Freddie Mac. Which statement is TRUE regarding Government National Mortgage Association pass-through certificates? A. GNMA securities have no reinvestment risk The best answer is B. If the mortgages backing a Ginnie Mae Pass Through Certificate are prepaid (if interest rates have dropped), the certificate holders receive payments that are a return of principal, and that, when reinvested at lower current rates, produce a lower return (this is reinvestment risk). So, prepayment risk leads to reinvestment risk. In contrast, payments received from other Treasury securities consist of interest only, so if interest rates drop over the time period these securities are held, only the interest must be reinvested at lower rates; there is no principal return that must be reinvested until maturity. A security which gives the holder an undivided interest in a pool of mortgages is known as a: A. unit investment trust The best answer is B. The question defines a pass through certificate - an undivided interest in a pool of mortgages, where the mortgage payments are passed through to the certificate holders. A customer with $25,000 to invest could buy: A. 1 mortgage backed pass through certificate at par The best answer is A. Mortgage backed pass through certificates are sold in minimum denominations of $25,000 (instead of the typical $1,000 for other bonds and $100 for Treasury issues). They have a much higher minimum to discourage small investors (who tend to be less sophisticated) from buying them - because they have difficult to quantify risks of shortening or lengthening maturities, due to interest rates falling or rising, respectively. A customer with $25,000 to invest could buy 1 of these certificates at par. Payments to holders of Ginnie Mae pass-through certificates are made: A. monthly and represent a payment of both interest and principal The best answer is A. All pass-through certificates pass on the monthly mortgage payments received from the pooled mortgages to the certificate holders. Thus, payments are received monthly. These represent a payment of both interest and principal on the underlying mortgages. All of the following statements are true about the Federal National Mortgage Association Pass-Through Certificates EXCEPT: A. FNMA is a publicly traded company The best answer is D. FNMA is a publicly traded company. Its stock was listed for trading on the NYSE, but Fannie went "bust" in 2008 after purchasing too many "sub prime" mortgages and was placed into government conservatorship. Its shares were delisted from the NYSE and now trade OTC in the Pink OTC Markets. Unlike GNMA, whose securities are directly U.S. Government guaranteed; FNMA only carries an "implicit" U.S. Government backing, so its credit rating is lower than that of GNMA. Interest received by the holder of a mortgage backed pass through security is fully taxable by both federal, state, and local government. Certificates are issued in minimum $25,000 denominations. For most investors this is too much money to invest, so they buy shares of a mutual fund that invests in these instruments instead. Which of the following is a TRUE statement regarding Fannie Mae? A. Fannie Mae has negotiable debt securities
only The best answer is A. Fannie Mae is a privatized agency that is publicly traded. Its stock was listed for trading on the NYSE, but Fannie went "bust" in 2008 after purchasing too many "sub prime" mortgages and was placed into government conservatorship. Its shares were delisted from the NYSE and now trade OTC in the Pink OTC Markets. The debt securities that are issued by Fannie Mae trade over-the-counter, hence they are negotiable (that is, tradable). Which statement is TRUE about the Federal National Mortgage Association (FNMA)? A. FNMA is a publicly traded corporation that issues
pass through certificates guaranteed by the U.S. Government The best answer is B. Fannie Mae performs the same functions as Ginnie Mae except that its pass through certificates are not guaranteed by the U.S. Government; and it has been "sold off" as a public company. Its stock was listed for trading on the NYSE, but Fannie went "bust" in 2008 after purchasing too many "sub prime" mortgages and was placed into government conservatorship. Its shares were delisted from the NYSE and now trade OTC in the Pink OTC Markets. When comparing Fannie Mae certificates to Ginnie Mae certificates, which statement is TRUE? A. Fannie Mae certificates are rated slightly higher than Ginnie Mae certificates and will have a slightly lower yield The best answer is B. Since Ginnie Mae certificates are guaranteed by the U.S. Government, they are rated slightly higher than Fannie Mae certificates - which only have an "implied" government backing. In the same sense, since Fannie Mae certificates have a bit more credit risk (because they are not guaranteed directly by the U.S. Government), they will have a slightly higher yield than Ginnie Mae certificates. GNMA and FNMA securities will pay an interest rate much higher than that found on a T-Bill, mainly because their maturity is much longer. Which of the following agencies issuing mortgage backed pass through certificates is permitted to purchase conventional mortgages that are not VA or FHA insured? A. Fannie Mae only The best answer is C. Freddie Mac - Federal Home Loan Mortgage Corporation - buys conventional mortgages from financial institutions and packages them into pass through certificates. These mortgages are not required to be FHA or VA guaranteed. This agency was partially sold off to the public as a corporation that was listed on the NYSE. Fannie Mae (Federal National Mortgage Association) buys FHA and VA insured mortgages from financial institutions and packages them into pass through certificates. This agency was sold off to the public as a corporation that was listed on the NYSE. Both Fannie and Freddie are now bankrupt due to excessive purchases of bad "sub prime" mortgages and have been placed in government conservatorship. Their shares have been delisted from the NYSE and now trade OTC in the Pink OTC Markets. Ginnie Mae (Government National Mortgage Association) performs the same function as Fannie Mae except that its pass through certificates are guaranteed by the U.S. Government. It remains an agency of the government and cannot be "sold off" as a public company as long as the government continues to guarantee its securities. Sallie Mae securitizes student loans, not mortgages. Interest income received from a GNMA Pass-Through Certificate is: A. taxed the same as for Treasury obligations The best answer is C. Unlike Treasury obligations and regular agency debt, where interest income is subject to federal income tax, but is exempt from state and local tax, interest income from mortgage backed securities is subject to both federal and state income tax. This is the law because the interest payments made on the underlying mortgages are deductible to the homeowner making the mortgage payments at both the federal and state level, therefore the recipient of these payments should be taxed at both the federal and state level. Note that interest income from corporate bonds is also taxable at both the federal and state level, so interest income from mortgage backed pass through securities is taxed in the same manner. Which statement is TRUE regarding the trading of government and agency bonds? A. The trading market is inactive and issues are quoted by dealers in minimum increments of 1/32nds The best answer is C. The government obligation trading market is the deepest and most active market in the world. Due to the great trading activity, dealers trade Treasury and agency bonds at very narrow spreads, quoting them in 32nds (as opposed to corporate bonds that are quoted in 1/8ths). Which of the following designates "primary" U.S. Government securities dealers? A. Securities and Exchange Commission The best answer is B. The Federal Reserve designates a dealer as a "primary" dealer - meaning one entitled to trade with the Federal Reserve trading desk. There are about 20 primary dealers (such as Cantor Fitzgerald, Nomura Securities, Citibank, Goldman Sachs, J.P. Morgan, etc.) The rest of the government dealers are termed "secondary" dealers. They do not enjoy a special relationship with the Federal Reserve. If Treasury bill yields are rising at auction, this indicates that: A. interest rates are falling while bill prices are rising The best answer is C. If Treasury bill yields are rising at auction, then interest rates are rising and debt prices must be falling Yields on 3 month Treasury bills have declined to 1.84% from 2.21% at the prior week's Treasury auction. This indicates that: A. Treasury bill prices are falling The best answer is B. If Treasury bill yields are dropping at auction, then interest rates are falling and debt prices must be rising. If Treasury bill yields are dropping at auction, this indicates that: A. Treasury bill prices are rising and interest rates are rising The best answer is B. If Treasury bill yields are dropping at auction, then interest rates are falling and debt prices must be rising. Which statement is TRUE regarding GNMA "Pass Through" Certificates? A. The
certificates are quoted on a percentage of par basis with accrued interest computed on an actual day month/actual day year basis The best answer is B. GNMA certificates are quoted on a percentage of par basis in 32nds. Accrued interest on "agency" securities is computed on a 30 day month/360 day year basis. (Do not confuse this with the accrued interest on U.S. Government obligations, which is computed on an actual day month/actual day year basis). Which statement is TRUE regarding Government National Mortgage Association pass-through certificates? A. GNMA securities are insured by the FDIC The best answer is C. GNMA securities are not insured by the Federal Deposit Insurance Corporation - they are guaranteed by the U.S. Government giving these securities the same credit risk as a U.S. Treasury (none). Dealers typically quote agency securities, including Ginnie Maes, on a basis point differential to equivalent maturing U.S. Governments. A typical quote is 50 basis points above the yield on the same maturity U.S. Government issue. (Please note, that dealers also quote agency securities on a percentage of par basis in 32nds, but this is not given as a choice in the question.) Reinvestment risk is greater for Ginnie Maes than for U.S. Government bonds. Ginnie Mae holders receive monthly payments that must be continuously reinvested while T-Bond holders only receive payments every 6 months that must be reinvested. The greater the frequency of receipt of payments that must be reinvested, the greater the reinvestment risk. All of the following statements are true regarding Government National Mortgage Association pass-through certificates EXCEPT: A. GNMA securities are guaranteed by the U.S. Government The best answer is D. GNMA securities are guaranteed by the U.S. Government. Dealers typically quote agency securities, including Ginnie Maes, on a basis point differential to equivalent maturing U.S. Governments. Reinvestment risk is greater for Ginnie Maes than for U.S. Governments. Reinvestment risk is the risk that over a long-term investment time horizon, interest rates are dropping and payments received from investments are reinvested at lower and lower rates. Ginnie Mae pass through certificates make monthly payments that must be reinvested, as opposed to U.S. Governments which only make semi-annual payments. Furthermore, if market interest rates drop, the homeowners in the mortgage pool prepay their mortgages, and these early principal repayments must be reinvested, again at lower rates. All of the following statements are true regarding GNMA "Pass Through" Certificates EXCEPT: A. the certificates are quoted on a percentage of par basis in 32nds The best answer is B. GNMA certificates are quoted on a percentage of par basis in 32nds, with the minimum denomination of a certificate being $25,000. Unlike Governments on which interest accrues on an actual day month / actual day year basis, accrued interest on "agency" securities is computed on a 30 day month/360 day year basis. All debt instruments that make periodic interest payments trade "and interest," meaning they trade with accrued interest. Which of the following trades settle in "Fed" funds? A. General Obligation Bonds The best answer is C. U.S. Government and agency bond trades settle in Federal Funds, which are good funds the business day of the funds transfer (next business day for regular way settlement of government securities). Ginnie Mae Pass-Through certificates are U.S. Government guaranteed, so trades settle in Fed Funds. These trades are settled through GSCC - the Government Securities Clearing Corporation. Corporate and municipal bond trades settle in clearing house funds. These are funds payable at a registered clearing house, which are usually not good funds for three business days. These trades are settled through NSCC - the National Securities Clearing Corporation. Convertible bonds by definition are corporate issues. Regular way trades of U.S. Government bonds settle through the: A. National Securities Clearing Corporation on the same day as trade date The best answer is D. Regular way trades of U.S. Government bonds settle through the Federal Reserve System in Fed Funds. Settlement of government securities trades takes place the business day following trade date. "Non-eligible" securities settle through national clearing houses, such as the NSCC - National Securities Clearing Corp., of which broker/dealers are members. These trades settle in 2 business days in clearing house funds. Which of the following statements are TRUE regarding the settlement of trades in U.S. Government bonds? I Trades settle next business day A. I and III The best answer is B. Trades of U.S. Government securities settle next business day in Fed Funds (payment by check is not permitted since the clearance time is greater). Do not confuse this with settlement of the weekly Treasury Bill auctions. The Federal Reserve auctions T-Bills each Monday and Tuesday, with the bills issued, and paid for in Fed Funds, the following Thursday. A customer buys 5M of 3 1/4% Treasury Bonds at 98-8. How much will the customer receive at each interest payment? A. $35.00 The best answer is B. "5M" means that 5-$1,000 bonds are being purchased (M is Latin for $1,000). Annual interest on the bonds is 3.25% of $5,000 face amount equals $162.50. Since interest is paid semi-annually, each payment will be for $81.25. Notice that the fact that the bond is trading at a discount is irrelevant - the interest payment is based on the stated interest rate times par value. A customer buys 5M of 3 1/2% Treasury Bonds at 101-16. How much will the customer receive at each interest payment? A. $17.50 The best answer is C. "5M" means that 5-$1,000 bonds are being purchased (M is Latin for $1,000). Annual interest on the bonds is 3.5% of $5,000 face amount equals $175.00. Since interest is paid semi-annually, each payment will be for $87.50. Notice that the fact that the bond is trading at a premium is irrelevant - the interest payment is based on the stated interest rate times par value. All of the following trade "and interest" EXCEPT: A. Treasury Bonds The best answer is C. Obligations issued at par make periodic interest payments. These issues trade "and interest" - with accrued interest. These include Treasury Notes, Treasury Bonds, and Municipal Bonds. Original issue discount obligations (i.e. T-Bills) trade "flat" - without accrued interest. Every day the issue is held, its value increases towards the redemption price of par. This increase in value is the interest income earned on the obligation. A 5-year 3 1/2% Treasury Note is quoted at 101-4 - 101-8. The note pays interest on Jan 1st and Jul 1st. All of the following statements are true regarding this trade of T-Notes EXCEPT: A. interest accrues on an actual day month; actual day year basis The best answer is B. Because these T-Notes are trading at a premium, the yield to maturity will be lower than the current yield. The current yield does not factor in the loss of the premium over the life of the bond, whereas yield to maturity does. Government bond trades settle next business day; accrued interest is computed on an actual month/actual year basis; and trades settle through the Federal Reserve system in "Fed Funds." All of the following are true statements about U.S. Government Agency securities EXCEPT: A. U.S. Government Agency Securities are quoted in 1/32nds The best answer is C. Government agency securities are quoted in 32nds, similar to U.S. Government securities. Government agency securities have an indirect backing (or implicit) by the U.S. Government. Unlike U.S. Governments, on which accrued interest is computed on an actual day month/actual day year basis, Agency securities' accrued interest is computed on a 30 day month/360 day year basis. U.S. Government and Agency securities never trade flat (meaning without accrued interest), since a default is almost impossible. U.S. Government Agency securities are: A. Quoted in 1/8ths and traded with accrued interest computed on an actual day month / actual day year basis The best answer is D. Government agency securities are quoted in 32nds, similar to U.S. Government securities. Unlike U.S. Governments, on which accrued interest is computed on an actual day month / actual day year basis, Agency securities' accrued interest is computed on a 30 day month / 360 day year basis. An investor in 30-year Treasury Bonds would be most concerned with: A. deflation The best answer is B. The primary risk associated with holding long term U.S. Government obligations is "purchasing power" risk caused by inflation. This is the risk that inflation reduces the value of future interest payments and the principal repayment yet to be received in the future When interest rates rise, which statement is TRUE? A. Shorter maturity bond prices are affected more than longer maturity bond
prices The best answer is B. The longer the maturity, the more volatile the price movements of the bond as interest rates move (rise or fall). Since T-Bonds have a longer maturity than T-Bills, T-Bond prices are affected more than T-Bill prices. A wealthy retired investor is interested in buying Agency mortgage backed securities collateralized by 30-year mortgages as an investment that will give additional retirement income. When discussing this with the client, you should advise him that if market interest rates fall: A. principal will
be repaid earlier than anticipated and will need to be reinvested at lower rates, generating a lower level of income The best answer is A. If market interest rates fall, the homeowners will repay their mortgages faster because they will refinance and use the proceeds to pay off their old high rate mortgages that collateralize this mortgage-backed security. In effect, the maturity will shorten and the investor will be returned principal faster, which will have to be reinvested at lower current rates - another example of reinvestment risk. The rate of homeowner defaults has no effect on the principal repayments to be received because the Agency guarantees principal repayment - making Choice B incorrect. Maturities will only extend if market interest rates rise and homeowners stay in their houses (they don't move because new mortgages are more expensive), and principal is repaid more slowly than expected. Thus. Choice C is incorrect. In a falling interest rate environment, because the maturity will shorten, these securities will not rise in price at the same rate as conventional long-term bonds. Thus, Choice D is incorrect. Which of the following investments gives a rate of return that cannot be affected by "reinvestment risk"? A. Treasury Notes The best answer is C. Treasury "STRIPS" are bonds which have been stripped of coupons - essentially they are zero coupon Treasury obligations. The rate of return on the bonds is "locked in" at purchase since the discount represents the compounded yield to be earned over the life of the bond. Because no interest payments are received, the bond is not subject to reinvestment risk - the risk that interest rates will drop and the interest payments will be reinvested at lower rates. Which statement is TRUE about the risks associated with federal agency securities? A. Agency securities have market risk and credit risk The best answer is B. U.S. Government Agency Bonds (as with any fixed income security), have market (interest rate) risk. If interest rates rise, their prices will drop, with longer maturity and lower coupon issues dropping much faster than shorter maturity and higher coupon issues. Agencies also have virtually no credit risk since they are implicitly backed by the U.S. Government (with the exception of Ginnie Mae issues which are directly backed). Which risk is NOT applicable to Ginnie Mae Pass Through Certificates? A. Purchasing power risk The best answer is C. Ginnie Maes are guaranteed by the U.S. Government so there is no risk of default. Ginnie Mae is authorized to raid the U.S. Treasury to make up any payment shortfalls, if required. The holder of a certificate is subject to potential loss of principal if interest rates rise, since the market value of the securities will fall. The holder is also subject to early prepayment risk if interest rates drop and the homeowners prepay their mortgages. Because rates have dropped, these prepayments are now reinvested at lower current market rates. What is NOT a risk of investing in a GNMA? A. Receiving principal payments earlier than expected in a declining interest rate environment The best answer is D. The principal value of a security is fixed – it does not fluctuate. It is the market value of the security that will fluctuate due to market interest rate movements. GNMA (Government National Mortgage Association) issues mortgage backed pass-through certificates, that pass through the monthly payment to the certificate holder. Because payments are being received monthly, if rates have dropped, these will be reinvested at lower and lower rates – classic reinvestment risk. GNMAs also have prepayment risk and extension risk. If market interest rates fall, the homeowners in the mortgage pool will refinance and the early repayment of the loan is “passed-through” to the certificate holders. Because market interest rates have dropped, the certificate holder can only reinvest the repayments at lower rates. On the other hand, if market interest rates rise, the homeowners do not refinance their mortgages - they stay in their homes with the existing low rate mortgage. This means that the expected rate of principal repayment now extends out, and the certificate holder is now holding an investment that is paying a lower than market rate of return for a longer time period than anticipated. This is called extended maturity risk, or extension risk. Which statement is TRUE about the liquidity and risk associated with federal agency securities? A. There is minimal market risk The best answer is B. Agency bonds have little marketability risk; the trading market for U.S. Government and Agency Bonds is the most active in the world. As with any fixed income security, there is market risk associated with these securities. If interest rates rise, their prices will drop, with longer maturity and lower coupon issues dropping much faster than shorter maturity and higher coupon issues (making Choices A and D incorrect). Credit risk for federal agency securities is a bit higher than for U.S. Governments because they are not directly backed, they are only implicitly backed (making Choice C incorrect). Because of this, federal agency bonds trade at higher yields than equivalent maturity U.S. Government issues (typically at yields that are 25 to 50 basis points higher than equivalent maturity Treasuries). Which of the following securities has the lowest level of credit risk? A. Equipment Trust Certificate The best answer is D. The safest bonds listed are Treasury bonds (backed by the U.S. Government) and General Obligation bonds (backed by unlimited municipal taxing power). The bonds listed with the highest credit risk are Industrial Revenue Bonds and Equipment Trust Certificates. Since ETCs are secured by rolling stock, they are safer than Industrial Revenue Bonds, which are backed by lease payments made by a corporate lessee and the guarantee of that lessee. If the corporate lessee were to default and then declare bankruptcy, the IRB holders would be left with worthless paper. Which risk is NOT applicable to Ginnie Mae Pass Through Certificates? A. Purchasing power risk The best answer is C. Ginnie Maes are guaranteed by the U.S. Government so there is no risk of default. Ginnie Mae is authorized to raid the U.S. Treasury to make up any payment shortfalls, if required. The holder of a certificate is subject to potential loss of principal if interest rates rise, and to loss of interest income if mortgages are prepaid early (these prepayments are passed on to the certificate holders). 100 Basis points equals: A. .01% The best answer is C. One basis point equals .01%, so 100 basis points equals 1%. 20 Basis points equals: A. .002% The best answer is C. Since 1 Basis Point = .01% = $.10, 20 Basis Points = .20% = $2.00. A government securities dealer quotes a 3-month Treasury Bill at 5.00 Bid - 4.90 Ask. A customer who wishes to buy 1 Treasury Bill will pay: A. a dollar price quoted to a 4.90 basis The best answer is A. Treasury Bills are quoted on a yield basis. From the basis quote, the dollar price is computed. A customer who wishes to buy will pay the "Ask" of 4.90. This means that the dollar price will be computed by deducting a discount of 4.90 percent from the minimum par value of $100. This is the discount earned over the life of the instrument. A government securities dealer quotes a 3-month Treasury Bill at 5.00 Bid - 4.90 Ask. A customer who wishes to sell 1 Treasury Bill will receive: A. a dollar price quoted to a 4.90 basis The best answer is B. Treasury Bills are quoted on a yield basis. From the basis quote, the dollar price is computed. A customer who wishes to sell will receive the "Bid" of 5.00. This means that the dollar price will be computed by deducting a discount of 5.00 percent from the par value of $100. A 5-year 3 1/2% Treasury Note is quoted at 98-4 - 98-9. The note pays interest on Jan 1st and Jul 1st. A customer buys 5M of the notes. Approximately how much will the customer pay, disregarding commissions and accrued interest? A. $4,906.25 The best answer is B. "5M" means that the customer is buying $5,000 par value of the notes (M is Latin for $1,000). A customer will buy at the ask price, which is 98 and 9/32nds = 98.28125% of $5,000 par = $4,914.06. A customer buys 5M of 3 1/4% Treasury Bonds at 98-8. The customer will pay how much for the bonds? A. $4,900.25 The best answer is C. The purchase price is 98-8 = 98 and 8/32nds = 98.25% of $5,000 = $4,912.50. Which risk is not applicable to Ginnie Mae pass through?Which risk is NOT applicable to Ginnie Mae Pass Through Certificates? Ginnie Maes are guaranteed by the U.S. Government so there is no risk of default.
What is not a risk of investing in a GNMA quizlet?What is NOT a risk of investing in a GNMA? The best answer is D. The principal value of a security is fixed - it does not fluctuate. It is the market value of the security that will fluctuate due to market interest rate movements.
Which of the following is true regarding GNMA pass through certificates?Which statement is TRUE regarding Ginnie Mae Pass Through Certificates? The best answer is B. Ginnie Mae Pass Through Certificates "pass through" monthly mortgage payments to the certificate holders. Each payment is a combination of both interest and principal paid from the underlying mortgage pool.
What risk is unique to holders of mortgageThe unique aspect of mortgage-backed securities (MBS) is the element of prepayment risk. This is the risk investors take when borrowers decide to pay the principal on their mortgages ahead of schedule.
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Which risk is avoided when making an investment in GNMA pass through certificate?
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