Fixed Income: CFA® Level II

It is 10–15% of the 2027 Level II exam. 50 learning outcomes across 5 learning modules.

100 practice questions and 4 formula cards on this topic in the app.

The Term Structure and Interest Rate Dynamics

• Explain how the yield curve's shape, spot and forward rates, yield to maturity, and expected and realized bond returns relate to one another
• Explain how bootstrapping extracts zero-coupon (spot) rates from the par curve
• Explain what active bond managers assume about how future spot rates will evolve compared with today's forward rates
• Explain the rolling-down-the-yield-curve strategy
• Explain what the swap rate curve is, and the reasons and ways that market participants rely on it when valuing instruments
• Work out the swap spread at a given maturity and explain what it means
• Explain the short-term rate spreads that serve as gauges of credit and liquidity risk across the economy
• Explain the traditional term structure theories and set out what each one implies for forward rates and for the yield curve's shape
• Explain how to measure a bond's sensitivity to each factor that moves the yield curve, and how to use those sensitivities to manage yield curve risk
• Explain the term structure of yield volatility and how it influences the volatility of prices
• Explain how major economic drivers feed into a view on spreads, benchmark rates and shifts in the yield curve

The Arbitrage-Free Valuation Framework

• Explain the idea of valuing a fixed-income instrument so that no arbitrage is possible
• Work out the arbitrage-free value of a straight fixed-coupon bond
• Explain the framework of a binomial tree for interest rates
• Explain how a binomial interest rate tree is calibrated so that it fits a given term structure
• Explain valuation by backward induction, and use it to value a fixed-income instrument from its cash flow at every node
• Contrast valuing with the zero-coupon yield curve and valuing with an arbitrage-free binomial lattice
• Explain pathwise valuation within a binomial interest rate model, and use it to value a fixed-income instrument from its cash flows on every path
• Explain how a Monte Carlo simulation of forward rates works and where it is applied
• Explain term structure models and the uses they are put to

Valuation and Analysis of Bonds with Embedded Options

• Explain bonds and other debt securities that contain embedded options
• Explain how a callable or putable bond's value links to the value of its embedded option and of the equivalent straight bond
• Explain how to apply the arbitrage-free approach when valuing a bond that contains embedded options
• Explain the effect of interest rate volatility on what a callable or putable bond is worth
• Explain the effect of shifts in the yield curve's level and shape on what a callable or putable bond is worth
• Use an interest rate tree to work out what a callable or putable bond is worth
• Explain how option-adjusted spreads are computed and what they are used for
• Explain the effect of interest rate volatility on option-adjusted spreads
• Work out a callable or putable bond's effective duration and explain what it means
• Contrast the effective durations of straight, callable and putable bonds
• Explain how one-sided and key rate durations help assess the rate sensitivity of bonds that contain embedded options
• Contrast the effective convexities of straight, callable and putable bonds
• Work out what a floating-rate bond with a cap or a floor is worth
• Set out the key characteristics of a convertible bond
• Work out the parts that make up a convertible bond's value and explain what they mean
• Explain how to value a convertible bond within an arbitrage-free framework
• Weigh the risk and return profile of a convertible bond against the profiles of a straight bond and the underlying common shares

Credit Analysis Models

• Explain expected exposure, probability of default, loss given default and the adjustment to value for credit (CVA)
• Explain credit ratings and credit scores
• Work out a bond's expected return when its credit rating may migrate
• Explain the structural and the reduced-form approaches to modelling corporate credit risk, covering what each assumes and its strong and weak points
• Work out a bond's value and credit spread from assumed credit risk parameters
• Explain what a change in a credit spread indicates
• Explain what drives the credit spread term structure, and read what a given credit spread curve across maturities shows
• Contrast analysing corporate debt for credit risk with the analysis that securitized debt requires

Credit Default Swaps

• Explain credit default swaps (CDS), covering index CDS as well as single-name CDS, and the terms that specify a particular CDS contract
• Explain what counts as a credit event for CDS and how CDS contracts are settled
• Explain the principles behind how the market prices CDS and the factors that affect that pricing
• Explain how CDS can be used to manage credit exposure and to take views on moves in the level or shape of the credit curve
• Explain how CDS can exploit mispricing between distinct markets, for example loans, bonds, equities and instruments linked to equity