1.If the volatility of the interest rate decreases, the value of a callable convertible bond to an investor:
  A. Decreases
  B. Increases
  C. Stays the same
  D. Insufficient information to determine.
  2.A six-year CDS on anAA-rated issuer is offered at 150bp with semiannual payments while the yield on a six-year annual coupon bond ofthis issuer is 8%.There is no counterparty risk on the CDS. The annualized LIBOR rate paid every six months is 4.6% for all maturities. Which strategy would exploit the arbitrage opportunity? How much would your retum exceed LIBOR?
  A. Buy the bond and the CDS with a risk-free gain of 1.9%.
  B. Buy the bond and the CDS with a risk-free gain of O.32%.
  C. Short the bond and sell CDS protection with a risk-free gain of4.97%.
  D. There is no arbitrage opportunity as any apparent risk-一free profit is necessarily compensation for being exposed to the crcdit risk ofthe issuer.
  Answer:
  1.B
  A decrease in the interest rate volatility will decrease the value of embedded call on the bond and increase the value of the convertible bond.
  2.A
  Because LIBOR is flat, the tixed-coupon yield is also 4.6 % ,creating a spread of 800 - 460= 340bp on the bond. Going long the bond and short credit via buying the CDS yields an annual profit of 340 - 150 = 190bp.