CFA Level IFixed IncomeMedium
An analyst needs to estimate the required yield on a newly issued, thinly traded 5-year corporate bond. Two actively traded bonds of similar credit quality are used as benchmarks: a 3-year bond yielding 4.00% and a 7-year bond yielding 5.60%. Using matrix pricing (linear interpolation), the estimated yield on the 5-year bond is closest to:
- A4.00%
- B4.60%
- C4.80%
- D5.60%
Show answer & explanationAnswer & explanation
Correct answer: C. 4.80%
Matrix pricing interpolates linearly by maturity: 4.00% + [(5−3)/(7−3)] × (5.60% − 4.00%) = 4.00% + 0.5 × 1.60% = 4.80%.
Why the other options are wrong
- A. Ignores the higher-yielding benchmark entirely.
- B. Understates the interpolated yield; uses an incorrect weighting.
- D. Ignores the lower-yielding benchmark entirely.
Matrix Pricing
A technique for estimating the required yield or price of an illiquid or newly issued bond by interpolating yields of comparable, actively traded bonds.
- Commonly used for private placements or infrequently traded bonds
- Interpolates by maturity (or duration) between benchmark bonds
- Assumes credit quality and other risk factors are similar
Memory trick: 'Straight line between two known yields finds the missing one'