For a one-period default-free bond, the covariance term (or discount for risk) is zero because the future price is a known constant and the covariance of a random quantity with a constant is zero. Given that issue D is the only security with a zero risk discount factor it is classified as a one-period default-free bond. 57.The most appropriate response to Question 3 is bond issue: A.B. B.C. C.D. Correct Answer: C Reference: Level II of CFA Program Volume 6, Study Session 17, Reading 49, LOS a Bond issue D will be least suitable for investors who expect their income to shrink due to poor economic conditions. This is because a decline in income corresponds to a decline in consumption today which in turn increases the marginal utility of future consumption the intertemporal rate of substitution. In addition, poor economic conditions are associated with declining asset payouts for risky securities leading to declining asset prices. Investors will be exposed to declining asset prices and higher risk of bond defaults. 58.Based on the real GDP growth information presented with respect to Regine’s economy, the analyst should expect: A.a negative relationship between real GDP growth and real default-free interest rates. B.real default-free interest rates to be higher in Regine relative to developed economies. C.real default-free interest rates to be lower in Regine relative to developed economies. Correct Answer: B Reference: Level II of CFA Program Volume 6, Study Session 17, Reading 49, LOS c
Level II of CFA®Program Mock Exam 1 – Solutions (PM)FinQuiz.com © 2019 - All rights reserved. B is correct. The higher rate of real GDP growth in Regine relative to developed world economies suggests that emerging market economy should be characterized with higher real default-free interest rates. The higher rate of economic growth will occur because Regine is below its steady state of growth and so it will grow faster to catch up (as has been anticipated). A is incorrect. Real GDP growth rates are positively related to real default-free interest rates. An increase in the real GDP growth will lead to an increase in real default-free interest rate. An increase in real GDP growth rate will increase expected future income which, in turn, will increase the availability of goods and services in the future relative to today. Consequently, individuals will have less incentive to save for future consumption and so a higher real rate of interest is needed to induce saving for future consumption.
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