Financial Markets, Instruments and Yield Curves

Introduction and context

Treasury management operates at the intersection of funding, investment, liquidity, market risk and balance-sheet strategy. A bank treasury does not merely buy and sell securities. It transforms maturities, currencies and risks while preserving liquidity, solvency and profitability. To perform this function, treasury professionals must understand how financial markets are organized, how instruments are priced, how market conventions affect cash flows, and how yield curves communicate expectations and risk.

Financial markets are commonly classified by the type of claim traded, the maturity of the claim, the currency involved and whether the transaction is immediate or contingent. The principal markets relevant to banking treasury are:

• Money markets, for short-term borrowing and lending, generally up to one year.
• Debt or capital markets, for medium- and long-term fixed-income financing.
• Foreign-exchange markets, for exchanging currencies and managing currency risk.
• Derivatives markets, for contracts whose value depends on an underlying rate, price, currency, security or index.

These markets are closely connected. A bank may borrow overnight, invest in a three-month bill, issue a five-year bond, hedge its interest-rate exposure with a swap, and use a foreign-exchange forward to protect the value of a dollar liability. The decisions are different in form but linked through discount rates, liquidity premiums, credit spreads and expectations about future interest rates.

Learning objectives

By the end of this chapter, the reader should be able to:

1. Explain the structure and economic role of money, debt, foreign-exchange and derivatives markets.
2. Describe the cash flows and principal valuation methods of major treasury instruments.
3. Distinguish quoted rates, effective rates, discount yields, forward rates and benchmark rates.
4. Construct and interpret spot, forward and par yield curves.
5. Explain the meaning of credit spreads, liquidity spreads and term premiums.
6. Apply market conventions such as day-count fractions, compounding frequency and settlement timing.
7. Evaluate the use, limitations and governance requirements of treasury instruments.

1. Architecture of financial markets

A financial market connects units with surplus funds to units requiring finance. Banks, corporations, governments, central banks, institutional investors and households participate through dealers, exchanges, electronic platforms and clearing systems.

1.1 Primary and secondary markets

The primary market is where a new security is issued. For example, a government may issue a three-year bond through an auction, or a bank may issue a certificate of deposit. The issuer receives funds and the investor receives a claim.

The secondary market is where existing instruments are traded. Secondary-market liquidity allows investors to sell before maturity and provides observable prices for valuation. A liquid secondary market normally has narrow bid–offer spreads, sufficient trading depth, reliable settlement and continuous or frequent price discovery.

1.2 Exchange-traded and over-the-counter markets

Exchange-traded contracts have standardized terms, transparent prices and centralized trading. Futures and listed options are typical examples. Over-the-counter (OTC) contracts are negotiated bilaterally or through dealers. Interest-rate swaps, foreign-exchange forwards and many bonds trade OTC.

OTC markets permit customization but introduce counterparty, documentation, valuation and collateral risks. Central clearing can reduce bilateral counterparty exposure, although it creates dependence on the central counterparty and its margining framework.

1.3 Market participants and functions

Financial markets perform four central functions: mobilizing savings, allocating capital, transferring risk and discovering prices. Their effectiveness depends on information quality, legal enforceability, settlement infrastructure and confidence in market institutions.

2. Money markets

The money market supports short-term liquidity management. Instruments generally mature within one year, although the exact boundary varies by market convention. Money-market instruments are valued primarily through the timing of principal and interest, issuer credit quality, liquidity and the relevant benchmark rate.

2.1 Main money-market instruments

Treasury bills are short-term government obligations usually issued at a discount and redeemed at face value. Their low default risk makes them important liquidity instruments and reference points for the risk-free or near-risk-free curve.

Commercial paper is an unsecured short-term promissory note issued by highly rated corporations or financial institutions. It usually offers a yield above government bills because investors require compensation for credit and liquidity risk.

Certificates of deposit (CDs) are negotiable or non-negotiable deposits issued by banks. A negotiable CD may be traded before maturity, whereas a conventional time deposit is typically held until maturity or withdrawn subject to contractual conditions.

Repurchase agreements (repos) are transactions in which one party sells securities and agrees to repurchase equivalent securities later at a specified price. Economically, a repo is usually a collateralized loan. The party receiving cash is the borrower; the party providing cash is the cash lender. In a reverse repo, the perspective is reversed.

Interbank deposits and short-term loans allow banks to manage reserve positions and temporary liquidity needs. Their pricing reflects the creditworthiness of the borrower, collateral availability, market liquidity and the relevant policy-rate environment.

2.2 Discount instruments and yield conventions

For a simple discount instrument, the price can be represented as:

where P is the purchase price, F is face value, d is the annualized discount rate, and t is the year fraction to maturity. The formula assumes a simple discount convention and a linear relationship between discount and time. It is not a universal bond-pricing formula.

The money-market holding-period return is:

The annualized simple yield is:

The discount rate and the investment yield are not identical because the discount rate uses face value as the reference amount, whereas the investment yield uses the price paid. For the same positive discount, the investment yield is therefore higher than the discount rate, assuming the same year fraction.

Worked example: treasury bill

Suppose a 182-day treasury bill has a face value of 10,000,000 and is quoted at a discount rate of 5.20%, using a 360-day money-market year.

The year fraction is:

t = 182 ÷ 360 = 0.50556

The price is:

P = 10,000,000 × (1 − 0.052 × 0.50556)

P ≈ 9,736,111

The holding-period return is approximately:

HPR = (10,000,000 − 9,736,111) ÷ 9,736,111 ≈ 2.710%

The annualized simple investment yield is:

y = 2.710% ÷ 0.50556 ≈ 5.36%

The difference between 5.20% and approximately 5.36% results from the different denominators. Treasury staff must not compare quoted rates without first converting them to a common convention.

2.3 Repo pricing

If a security is financed through a repo, the repurchase price under simple interest is commonly expressed as:

where r_repo is the repo rate, d is the number of calendar days, and B is the day-count basis, often 360. The formula assumes a simple interest convention and excludes special collateral adjustments, haircuts and transaction costs.

A haircut requires the borrower to provide collateral whose market value exceeds the cash received. If the haircut is h, then, in a simplified setting:

Haircuts protect the cash lender against market-value declines and liquidation costs. They are often increased for volatile, illiquid or lower-quality collateral.

3. Debt and fixed-income markets

Debt instruments represent contractual claims on an issuer. Their cash flows may be fixed, floating, indexed or contingent. Key dimensions include maturity, seniority, collateral, coupon structure, callability, currency, credit quality and governing law.

3.1 Bonds and notes

A conventional coupon bond pays periodic coupons and returns principal at maturity. The theoretical clean price is the present value of future coupons and principal:

where C is the annual coupon amount, y is the annual nominal yield compounded m times per year, F is face value, n is maturity in years and t indexes coupon periods. In a more direct period notation, if there are N coupon periods and the periodic yield is i:

The formula assumes known contractual cash flows, a constant discount rate for the relevant cash flows, and no default or embedded-option effect. In practice, a bond is often valued by discounting each cash flow at its corresponding spot rate rather than applying one yield to all cash flows.

The coupon rate is the annual coupon divided by face value. The current yield is annual coupon divided by market price. The yield to maturity (YTM) is the single discount rate that equates the present value of promised cash flows to the market price, assuming the bond is held to maturity and coupons can be reinvested at that yield. YTM is therefore a summary measure, not necessarily the investor’s realized return.

3.2 Accrued interest, clean price and dirty price

Between coupon dates, the seller has earned part of the next coupon. The buyer normally compensates the seller through accrued interest. Thus:

A simplified accrued-interest expression is:

The exact calculation depends on the market’s day-count convention. The dirty price is the amount typically exchanged at settlement; the clean price is commonly the quoted price excluding accrued interest.

3.3 Floating-rate notes

A floating-rate note (FRN) pays a reference rate plus a contractual spread:

The reference rate may reset periodically. If the reference rate rises, the coupon generally rises at the next reset, reducing—but not eliminating—the instrument’s interest-rate sensitivity. Credit spread risk, reset timing, basis risk and liquidity risk remain.

3.4 Securitized and structured debt

Asset-backed securities and mortgage-backed securities redistribute cash flows from pools of loans. Their risks include prepayment, extension, default, tranche subordination and model risk. A senior tranche may have credit enhancement, but it is not risk-free. Treasury investment policy should specify permitted structures, concentration limits, stress tests and valuation controls.

Worked example: coupon bond

A three-year bond has face value 1,000, an annual coupon rate of 6%, and annual coupons. If the required yield is 7%, its price is:

P = 60 ÷ 1.07 + 60 ÷ 1.07² + 1,060 ÷ 1.07³

P ≈ 56.07 + 52.38 + 863.11 = 971.56

The bond trades below par because its 6% coupon is less than the required 7% yield. If the required yield falls below 6%, its price would exceed par, all else equal.

4. Foreign-exchange markets

The foreign-exchange (FX) market enables the conversion of one currency into another and the transfer or hedging of currency risk. It is decentralized and largely OTC, with substantial activity among banks, corporations, asset managers, central banks and dealers.

4.1 Spot, forward and swap transactions

A spot transaction exchanges currencies for near-immediate settlement, subject to the market’s settlement convention. A forward transaction fixes an exchange rate today for exchange on a future date. An FX swap combines a near-date exchange with a reverse exchange on a later date. It is widely used for short-term funding and liquidity management.

An exchange rate must identify its quotation convention. If the quote is domestic currency per unit of foreign currency, an increase means the foreign currency has appreciated relative to the domestic currency. Confusing direct and indirect quotations is a common operational error.

4.2 Covered interest parity

Under idealized assumptions of no arbitrage, unrestricted capital movement, aligned maturities and negligible transaction costs, the forward exchange rate is related to interest rates by covered interest parity:

where F is the forward price in domestic currency per unit of foreign currency, S is the spot price, r_d is the domestic interest rate, r_f is the foreign interest rate, and t is the year fraction under the applicable convention. For continuously compounded rates, the corresponding expression is:

The simple formula is an approximation or convention-based expression. Actual forward pricing may include cross-currency basis, funding costs, collateral terms, credit adjustments and transaction costs.

Worked example: FX forward

Assume a spot rate of 1.1000 domestic currency units per dollar, a one-year domestic interest rate of 4%, and a dollar interest rate of 5%, using simple annual compounding. The theoretical forward rate is:

F = 1.1000 × 1.04 ÷ 1.05 ≈ 1.0895

The lower forward quote reflects the higher interest rate in the dollar currency under this quotation convention. A treasury dealer must nevertheless verify the quotation direction before interpreting the result.

4.3 FX risks

Banks face transaction risk from contracted foreign-currency cash flows, translation risk from consolidating foreign operations, and economic risk from longer-term changes in competitive values. FX swaps and forwards hedge known exposures, while options can protect against adverse movements while retaining upside potential. Hedging, however, introduces premium, liquidity, basis, counterparty and documentation risks.

5. Derivatives markets

A derivative is a contract whose value changes in response to an underlying variable. The underlying may be an interest rate, bond price, exchange rate, commodity price, equity index or credit event.

5.1 Forwards and futures

A forward is a customized OTC agreement. A futures contract is standardized, exchange-traded and generally subject to daily variation margin. Futures reduce bilateral credit exposure through clearing and margining but create margin liquidity requirements and potential basis risk between the futures contract and the exposure being hedged.

5.2 Interest-rate swaps

In a plain-vanilla interest-rate swap, one party pays a fixed rate and receives a floating rate on a notional principal; the other party does the reverse. The notional is normally not exchanged. The swap can transform a floating-rate liability into an economically fixed-rate liability or convert fixed-rate exposure into floating exposure.

For a plain fixed-for-floating swap, the value to the fixed-rate payer may be represented as:

The fixed rate at inception is selected so that the swap has approximately zero value, subject to pricing adjustments:

where K_swap is the par swap rate and the annuity is the present value of one unit of fixed payment at each payment date. Modern valuation uses a discount curve and a projection curve appropriate to the collateral and reference-rate framework.

5.3 Options and caps

A call option gives the holder the right, but not the obligation, to buy an underlying at a strike price. A put gives the right to sell. An interest-rate cap pays when a reference rate exceeds a strike; a floor pays when the rate falls below a strike. Options provide asymmetric protection but require an upfront premium and depend materially on volatility assumptions.

5.4 Derivative controls

A sound derivatives framework requires approved instruments, documented purpose, counterparty limits, collateral terms, independent valuation, sensitivity analysis, confirmation, settlement controls and legal enforceability. A derivative that reduces one risk may increase another. For example, a hedge can reduce interest-rate risk but create collateral calls when market values move adversely.

6. Interest rates, benchmarks and market conventions

6.1 Nominal, effective and continuously compounded rates

A nominal annual rate compounded m times per year has an effective annual rate:

where j is the nominal annual rate and m is the number of compounding periods per year. With continuous compounding:

where r is the continuously compounded annual rate. Rates should only be compared after aligning compounding frequency, day-count basis and payment timing.

6.2 Day-count conventions

A day-count convention converts calendar days into a year fraction. Common conventions include Actual/360, Actual/365, Actual/Actual and 30/360. For Actual/360:

For Actual/365:

The convention affects accrued interest, floating coupons, forward pricing and discounting. It is not a cosmetic detail.

6.3 Reference and benchmark rates

A benchmark rate is a published reference used to price loans, bonds, derivatives or internal transfers. Modern benchmarks increasingly rely on transaction-based or nearly transaction-based overnight rates. A benchmark may be compounded in arrears, observed in advance, term-based or constructed from a waterfall of data sources.

Treasury must monitor benchmark fallback provisions, cessation events, spread adjustments and contractual language. A transition from one benchmark to another can create basis risk: assets, liabilities and hedges may not reprice at exactly the same time or by the same amount.

7. Yield curves and term structures

A yield curve shows the relationship between yield and maturity for instruments of comparable credit and liquidity quality. It is a central analytical tool for pricing, investment allocation, interest-rate risk management and monetary-policy interpretation.

7.1 Spot rates, discount factors and forward rates

A spot rate is the rate applicable to a single cash flow at a particular maturity. The corresponding discount factor is:

for annual compounding, where s_T is the spot rate for maturity T and T is measured in years. Under continuous compounding:

A forward rate is implied by two discount factors. Under annual compounding, the forward rate from T₁ to T₂ is:

This is an arbitrage-consistent implied rate, not a guaranteed forecast of the future realized short rate.

7.2 Bootstrapping

Bootstrapping constructs discount factors from instruments with observable prices. A short-term bill may provide the first discount factor. A coupon bond then supplies an equation containing one unknown later discount factor, which can be solved sequentially. The resulting zero-coupon curve is used to value cash flows more accurately than applying one YTM to every payment.

For a bond with price P and cash flows C₁, C₂, …, C_N:

If earlier discount factors are known, the equation can solve for the final unknown discount factor. In practice, interpolation, settlement conventions, accrued interest and instrument-specific liquidity must be addressed.

7.3 Par, spot and forward curves

A par yield curve shows coupon rates at which newly issued instruments would trade at par. A spot curve shows zero-coupon rates. A forward curve shows rates implied for future periods. They are mathematically related but economically distinct.

A positively sloped curve may reflect expected economic growth, inflation risk, term premium or scarcity of short-term liquidity. An inverted curve may reflect expected monetary easing, recession risk or tight current policy. A flat curve may indicate uncertainty or offsetting forces. No curve shape has a single inevitable interpretation.

7.4 Spreads and risk decomposition

A credit spread is the yield difference between a risky instrument and a benchmark of comparable maturity. A simplified decomposition is:

This is an analytical framework rather than an exact accounting identity. The spread may contain default risk, downgrade risk, liquidity risk, tax effects, embedded-option value, funding conditions and technical supply–demand effects.

The term premium is compensation for holding longer maturity rather than rolling over short-term investments. The liquidity premium compensates investors for the difficulty or cost of trading. The basis spread measures the difference between closely related rates or instruments that do not move identically.

8. Interest-rate sensitivity and treasury decisions

Bond prices generally move inversely to yields. Duration provides a first-order approximation of this sensitivity. Macaulay duration is the weighted average time to receive a bond’s cash flows:

where t_k is the payment time, PV(CF_k) is the present value of cash flow k, and P is the bond price. Modified duration under periodic compounding is:

For a small yield change Δy:

Convexity improves the approximation for larger changes:

These relationships assume parallel yield movements and small changes. Actual portfolios face non-parallel shifts, spread changes, optionality and liquidity effects.

Worked example: duration estimate

If a bond has modified duration of 4.2 years and its yield rises by 0.50 percentage points, then:

∆P ÷ P ≈ −4.2 × 0.005 = −0.021

The estimated price decline is approximately 2.1%, before convexity and other effects. If the bond’s market value is 50 million, the estimated loss is approximately 1.05 million.

9. Illustrative case: liquidity and rate-risk management at Meridian Bank

Background

Meridian Bank, a fictional mid-sized commercial bank, funds a portfolio of floating-rate corporate loans with a mixture of overnight deposits, three-month wholesale borrowing and five-year fixed-rate bonds. Its treasury also holds government bills as a liquidity buffer.

Problem

The asset-liability committee observes that a rapid rise in short-term rates would increase deposit and wholesale funding costs immediately, while some fixed-rate assets would not reprice. In addition, the bank has a dollar liability supporting domestic-currency assets, creating FX risk.

Analysis

The treasury maps contractual repricing dates and behavioral assumptions. It identifies three exposures:

1. A short-term negative repricing gap if liabilities reprice faster than assets.
2. Market-value losses on the fixed-rate bond portfolio if yields rise.
3. Currency risk from the dollar liability.

The bank also notes that its loan benchmark and wholesale funding benchmark are not identical, creating basis risk.

Approach and solution

Meridian adopts a layered response. It increases holdings of highly liquid government bills, limits concentration in long-duration bonds, and enters a pay-fixed, receive-floating interest-rate swap against part of its floating-cost exposure. It uses an FX forward to hedge the known dollar repayment. It also establishes stress scenarios involving a 200-basis-point parallel rise, curve steepening, benchmark divergence, deposit outflows and wider credit spreads.

The hedge documentation identifies the exposure, hedge ratio, maturity mismatch, collateral terms and sources of ineffectiveness. Independent valuation compares dealer marks with internally generated discount curves. Treasury operations confirm trades and reconcile cash flows with the general ledger.

Outcome

The strategy reduces sensitivity to a short-term rate increase and removes most of the contracted FX exposure. It does not eliminate risk: the hedge has basis risk, collateral may be required, and the bond portfolio remains exposed to spread widening and non-parallel curve movements. The case demonstrates why treasury decisions must combine instrument knowledge with liquidity planning, governance and scenario analysis.

Learning points

• A hedge should be designed against a clearly measured exposure, not simply against an unfavorable market view.
• Market, liquidity, credit and operational risks interact.
• Benchmark mismatch can make a seemingly effective hedge imperfect.
• Valuation and legal documentation are as important as trade execution.

10. Challenges, governance and contemporary developments

10.1 Model and valuation risk

Discount curves, credit adjustments, prepayment models and volatility estimates contain assumptions. Model risk arises when assumptions are inappropriate, data are poor or implementation differs from approved methodology. Independent price verification, model validation, sensitivity analysis and back-testing are essential.

10.2 Liquidity and collateral risk

A derivative may have a negative market value and generate a margin call even when it is economically hedging the bank’s underlying exposure. Treasury therefore forecasts collateral flows under stressed market conditions. Liquidity buffers must be assessed after haircuts and under realistic liquidation assumptions.

10.3 Conduct and market integrity

Manipulation of benchmarks, mis-selling of complex products, misuse of confidential information and inaccurate transaction reporting undermine market integrity. Governance should include segregation of duties, authorized dealing limits, recorded communications, best-execution standards, conflict management and escalation procedures.

10.4 Technology and data

Modern treasury platforms integrate trade capture, risk measurement, collateral management, accounting and regulatory reporting. Automated yield-curve construction and anomaly detection can improve speed and control, but AI-based tools require explainability, data lineage, validation and human oversight. An algorithm should not be treated as authoritative merely because it produces a precise number.

10.5 Best practices

A professional treasury function should:

• standardize rate, currency, settlement and day-count conventions;
• maintain independent market-data sources and documented curve construction;
• reconcile front-office, risk and accounting records;
• measure duration, basis, spread, liquidity and counterparty exposures;
• use stress tests in addition to historical scenarios;
• document hedge purpose, effectiveness and exit conditions;
• impose instrument, issuer, maturity and concentration limits;
• review benchmark fallback language and legal enforceability;
• distinguish accounting treatment from economic risk management; and
• report exceptions promptly to senior management and the asset-liability committee.

Chapter Summary

Financial markets allow funds, risks and cash flows to be transferred among borrowers, lenders and intermediaries. Money markets provide short-term liquidity through bills, commercial paper, certificates of deposit, repos and interbank instruments. Debt markets create fixed or floating contractual claims whose values depend on cash flows, discount rates, credit quality, liquidity and embedded options. FX markets facilitate currency exchange and hedging, while derivatives permit customized transfer of interest-rate, currency, credit and price risks.

Instrument valuation depends on correct cash-flow identification and consistent conventions. Discount yields, investment yields, nominal rates, effective rates and continuously compounded rates are not interchangeable. Day-count rules, settlement timing, accrued interest and quotation conventions materially affect prices and returns.

Yield-curve analysis distinguishes spot, par and forward rates. Discount factors support arbitrage-consistent valuation and can be constructed through bootstrapping. Curve shape reflects a combination of expected short rates, inflation, term premium, liquidity, credit and technical market factors. Duration and convexity provide useful but limited measures of interest-rate sensitivity.

Treasury decisions must integrate market risk with liquidity, credit, counterparty, operational, legal and model risk. Derivatives can hedge exposures but cannot eliminate uncertainty. Strong governance requires independent valuation, clear documentation, reliable data, stress testing, benchmark controls and effective senior-management oversight.

Key Terms

Money market: Market for short-term borrowing, lending and liquidity instruments.

Treasury bill: Short-term government obligation commonly issued at a discount.

Repo: Collateralized financing transaction involving sale and repurchase of securities.

Haircut: Reduction applied to collateral value when determining borrowing capacity.

Commercial paper: Unsecured short-term promissory note issued by an eligible borrower.

Coupon: Contractual periodic interest payment on a debt instrument.

Yield to maturity: Single discount rate equating a bond’s price with promised cash flows.

Clean price: Bond price excluding accrued interest.

Dirty price: Settlement price including accrued interest.

Floating-rate note: Debt instrument whose coupon resets against a reference rate plus a margin.

Spot exchange rate: Current exchange rate for near-term currency settlement.

Forward exchange rate: Contractual rate for exchanging currencies at a future date.

Derivative: Contract whose value depends on an underlying variable.

Swap: Derivative involving exchange of specified cash-flow streams.

Benchmark rate: Reference rate used to price or value financial contracts.

Discount factor: Present value of one unit received at a specified future date.

Spot rate: Rate applicable to a single cash flow at a particular maturity.

Forward rate: Rate implied for borrowing or lending during a future period.

Duration: Measure of a bond’s sensitivity to changes in yield.

Basis risk: Risk that related rates, prices or instruments do not move together.

Review Questions

Short Answer Questions

1. Distinguish primary markets from secondary markets.
2. Why is a repo generally considered collateralized borrowing?
3. Explain the difference between clean price and dirty price.
4. What is the economic purpose of a floating-rate note?
5. Why must day-count conventions be specified when comparing interest rates?

Long Answer Questions

1. Explain the structure, instruments and treasury uses of the money market.
2. Discuss the relationship among spot rates, discount factors, forward rates and par yields.
3. Explain how covered interest parity links spot exchange rates, forward exchange rates and interest rates.
4. Analyze the principal risks and governance requirements associated with OTC derivatives.
5. Discuss how yield-curve shape may be interpreted without treating it as a perfect forecast of future interest rates.

Analytical / Application Questions

1. A 90-day bill with face value 5,000,000 is quoted at a 6% discount rate on a 360-day basis. Calculate its price and approximate annualized simple investment yield.
2. A bank holds a bond portfolio worth 80 million with modified duration of 3.6 years. Estimate the percentage and monetary price effect of a 75-basis-point parallel yield increase, ignoring convexity.
3. A bank has domestic-currency assets and a future dollar liability. Design a hedge using an FX forward and identify at least three risks that could make the hedge imperfect.

Multiple Choice Questions with Answers

Question 1

Which instrument is generally a collateralized short-term financing transaction?

A. Commercial paper

B. Repurchase agreement

C. Unsecured interbank deposit

D. Coupon bond

Correct Answer: B. Repurchase agreement

Question 2

A bond trades below par when its coupon rate is lower than the required yield primarily because:

A. Its promised cash flows are discounted at a higher rate

B. Its face value automatically declines

C. Accrued interest is always negative

D. The bond has no maturity date

Correct Answer: A. Its promised cash flows are discounted at a higher rate

Question 3

Using a 360-day basis, what is the year fraction for a 180-day money-market instrument?

A. 0.180

B. 0.360

C. 0.500

D. 2.000

Correct Answer: C. 0.500

Question 4

Under the quotation of domestic currency per unit of foreign currency, covered interest parity implies that the forward rate is generally lower than the spot rate when:

A. The domestic interest rate is higher than the foreign interest rate

B. The foreign interest rate is higher than the domestic interest rate

C. Both interest rates are zero only

D. The spot rate is unavailable

Correct Answer: B. The foreign interest rate is higher than the domestic interest rate

Question 5

Which statement best describes a discount factor?

A. The coupon divided by face value

B. The present value of one unit received at a future date

C. The difference between bid and ask prices

D. The annualized holding-period loss

Correct Answer: B. The present value of one unit received at a future date

Question 6

A bond has modified duration of 5 years. Ignoring convexity, a 1% rise in yield implies an approximate price change of:

A. A 5% increase

B. A 0.2% decrease

C. A 5% decrease

D. No change

Correct Answer: C. A 5% decrease

Question 7

Which rate is normally used as the reference in a floating-rate note coupon?

A. A reference rate plus a contractual margin

B. Only the bond’s face value

C. The issuer’s accounting profit

D. The original issue price minus accrued interest

Correct Answer: A. A reference rate plus a contractual margin

Question 8

What does basis risk mean in treasury management?

A. The risk that a security has no legal documentation

B. The risk that related rates or prices do not move together as expected

C. The risk that face value is always below market value

D. The risk caused only by exchange closure

Correct Answer: B. The risk that related rates or prices do not move together as expected

Question 9

Which curve represents rates applicable to single cash flows at different maturities?

A. Spot curve

B. Coupon curve only

C. Equity curve

D. Haircut curve

Correct Answer: A. Spot curve

Question 10

The dirty price of a bond is generally:

A. The clean price minus face value

B. The clean price plus accrued interest

C. The coupon rate multiplied by duration

D. The yield divided by maturity

Correct Answer: B. The clean price plus accrued interest