Practice Quiz 1 Solutions — Bond Overview & Interest Rates
Question 1. For a risky corporate bond, which ordering of return measures is correct, from highest to lowest?
Answer: A. Coupon rate > promised yield > expected return > risk-free rate.
The coupon rate is set at issuance to make the bond marketable at par. The promised yield reflects all promised cash flows assuming no default — it is slightly below the coupon rate when the bond trades near par. The expected return is lower than the promised yield because it accounts for the probability of default. The expected return must still exceed the risk-free rate to compensate for bearing systematic risk. In the Golden Sachs example: coupon 10%, promised yield ~9.5%, expected return 7.5%, risk-free rate 5%.
Question 2. You own a Treasury bond. The Fed unexpectedly raises interest rates. Why does your bond’s price fall?
Answer: B. Newly issued bonds offer higher coupons, making your fixed coupons less attractive — buyers will only pay a lower price.
A bond’s cash flows are fixed at issuance — coupons don’t change when market rates move. When rates rise, newly issued bonds offer higher coupons, making your existing bond’s fixed payments comparatively less attractive. Buyers will only pay a lower price until the bond’s implied yield rises to match the new market rate. This is the core inverse price-yield relationship.
Question 3. The U.S. Treasury yield curve inverts. Under the expectations hypothesis, what does this signal?
Answer: C. Markets expect future short-term rates to fall — consistent with economic slowdown and eventual Fed rate cuts.
The expectations hypothesis says a long-term rate equals the average of expected future short-term rates plus a term premium. An inverted curve means the market is pricing in lower future short rates — i.e., the Fed will cut rates. The Fed cuts rates in response to economic weakness, which is why yield curve inversion is one of the most reliable historical recession signals.
Question 4. The Federal Reserve’s dual mandate requires the Fed to pursue:
Answer: D. Maximum employment and stable prices, defined as 2% average PCE inflation.
The dual mandate is embedded in the Federal Reserve Act (1977). “Stable prices” is operationally defined as a 2% average PCE inflation target. The FOMC meets 8 times per year to set the federal funds rate. The Taylor Rule formalizes the balance: raise rates when inflation or output exceeds targets, cut when below.
Question 5. Why did financial markets replace LIBOR with SOFR?
Answer: B. LIBOR was based on self-reported bank estimates and was found to be systematically manipulated; SOFR is based on actual overnight Treasury repo transactions.
LIBOR was calculated by asking a panel of banks what rate they would theoretically borrow at — not actual transactions. Investigations revealed systematic manipulation of submissions to benefit traders’ derivatives positions. SOFR is constructed from hundreds of billions of dollars of real Treasury repo transactions every day, making it nearly impossible to manipulate.
Question 6. A corporate bond is at par with a 7% promised yield. Default probability rises. What happens?
Answer: B. Price falls; promised yield rises — investors demand higher compensation for the increased default risk.
When default risk increases, investors demand a lower price (higher promised yield) as compensation. Crucially, the expected return does not rise by as much as the promised yield — the widening spread between y and r_exp reflects the larger default premium. This is the intuition behind credit spreads.
Question 7. Which correctly lists the primary bond risk categories from Week 1?
Answer: B. Interest rate risk, credit risk, inflation risk, liquidity risk, reinvestment risk, call/prepayment risk, and currency risk.
These are the seven primary bond risks: (1) interest rate risk — prices fall when rates rise; (2) credit/default risk — issuer may not pay; (3) inflation risk — fixed cash flows lose real value; (4) liquidity risk — selling at a price concession; (5) reinvestment risk — coupons reinvested at uncertain future rates; (6) call/prepayment risk — issuer repays early when rates fall; (7) currency risk — for foreign-currency bonds.