Financial Institutions and Markets Test 2

Structure of Interest Rates 1 A) Lots of variation historically in the yield curve in terms of (2):

A) 1) Level - average level of the yield across various maturities 2) Shape - pattern of yield curve -'Ascending/Increasing' -'Descending/Decreasing' -'Flat' -'Hump-shaped'

Mortgage Markets 1 A) Unique features of mortgage markets (5):

A) 1) Mortgage loans are secured by pledge of real property 2) Mortgage loans are made for varied amounts - no standard denomination 3) Issuers of mortgages are usually small family or business entities 4) Weak Secondary Market -Little standardization of contracts and terms -Historically, mortgages were issued and held by lender -Major innovation in mortgage industry involved securitization of mortgages (MBS) 5) Mortgage markets: regulated and supported by federal government policies

Structure of Interest Rates 1 A) There are 4 theories that explain time-varying shapes observed in historical yield curves:

A) 1) The expectations theory 2) Market segmentation theory 3) Liquidity premium theory 4) Preferred habitat theory

Money Markets 3 A) Example 2: The discount yield on a 3-month (91 day) US T-bill is currently 1%. Compute: -The current selling price of the bond (FV = $10,000) -The bond equivalent yield

A) P(0) = P(f) (1 - y(d) x n/360) P(0) = $9,974.72 y(BE) = (100 - 99.7472)/99.7472 x 365/91 x 100% y(BE) = 1.016%

Money Markets 5 A) Formula for repo yield is?

A) y(repo) = [P(repo) - P(0)]/P(0) x 360/n x 100% Notes: *P(repo): the repurchase price of the security - this is the dollar amount that the repo lender ultimately receives. *P(0) is the amount that the borrower receives in return for the securities; this incorporates any haircuts imposed as part of the deal. *Note the odd convention of annualizing using 360 days.

Bond Markets 1 A) The U.S. gov't issues Notes and Bonds. Maturity on each? B) How are they sold?

A) -"Notes:" one to ten-year maturity -"Bonds:" over ten-year maturity B) Sold in auction by the Treasury Department -Auction process similar to that for US T-bills -Both competitive and noncompetitive bids accepted -Treasury accepts best bids (lowest rates) until it sells all notes or bonds it wishes to offer -Coupon rate is set after auction at highest level at which security trades at or under par, in -increments of 12.5 basis points Example: Highest accepted yield = 3.665%; coupon = 3.652%

Bond Markets 4 A) Who holds munis? B) How do banks engage in a form of 'tax arbitrage'?

A) -Households hold a large fraction of munis both directly and indirectly (via mutual funds). Now hold the highest percentage of total compared to other groups =Particularly attractive to high net worth individuals/households -Insurance companies also hold significant amounts of munis (particularly when industry is profitable) B) The banks could engage in a form of 'tax arbitrage' -Could deduct interest on deposits from taxable income used to fund purchases of tax exempt municipal bonds -Tax Reform Act of 1986 mostly put an end to this practice -Commercial banks now hold much smaller fraction of munis

Mortgage Markets 1 A) Other comments on ARMs:

A) -Rates vary within a prescribed range (caps) or without limit -Payments, maturity, or principal may vary ==Some loans with payment caps may be subject to 'negative amortization' if interest due on loan at current rates exceeds maximum allowable payment -Rates may vary based on a previously determined interest rate index or the cost of the funds of the lender =Common rate indices include Treasury rates, fixed-rate mortgage indices, prime rate, and LIBOR -Markets price the extent of interest rate risk assumed by borrower and lender -ARMs have lower starting rates relative to market FRM rates *Slide 7

Money Markets 5 A) What is a repo haircut? B) Repos are often what?

A) -Repos are not riskless transactions -While they are securitized (repo lender holds security), there is risk that counterparty will back out =More likely if rates increase (security value drops) -In practice, repos may be "overcollateralized" - repo borrower receives less than current price of security -This difference is called a haircut B) Repos are also often 'marked to market' -Value of repos updated to reflect current market prices (often on daily basis) -If market prices drop for securities, repo buyer may call for additional cash or securities (margin call)

Money Markets 1 A) Broad characteristics of money markets:

A) -Short-term debt markets - most under 120 days -Informal market centered in New York City -Markets facilitated by brokers and dealers who specialize in one or more money market instruments -Transactions completed electronically or by phone -"Wholesale" markets with large transaction sizes (most involve > $1 million) -Standardized securities -- one security is a close substitute for another. -Payments in "immediately available funds" -Physical possession of securities seldom occurs - centralized safekeeping

Bond Markets 6 A) Regulation of bonds:

A) -The Securities and Exchange Commission (SEC): the principle regulator of capital markets in the US -SEC established in Federal Securities Act of 1933 -Scope ranges from disclosure requirements to proper operation of capital markets -Public firms file regular reports with the SEC -Because information filing is costly and time consuming, some firms use private placements with a limited set of investors =Registration and prospectus are not required, as in a "general public" security offering

Structure of Interest Rates 4 A) Criticism of ratings agencies:

A) -Until early 1970s, agencies paid mostly by investors to produce unbiased assessments of creditworthiness -Starting in 70s, agencies begin to derive fees from securities issuers for whom they issue ratings =Conflicts of interest arise =Issuers 'shop' among the agencies for best rating; charges of inflated ratings =Recent research paper : ratings inconsistent across asset classes -Poor performance in recent housing/financial crisis =Many "structured products" (MBS, CDOs, etc.) were rated as safe (AAA in many cases) by agencies =Agencies forced to downgrade approx. $2 trillion in securities

Mortgage Markets 3 A) Insured mortgages vs. conventional mortgages -What 2 administrations support insured mortgages?

A) 1) Insured mortgages (guaranteed mortgages) are supported by federal and state agencies -Federal Housing Administration (FHA) -Veterans Administration (VA) -Down payments and rates may be lower 2) Conventional mortgages represent lending/borrowing in the private markets -Conventional mortgage borrowers with low down payments must usually buy private mortgage insurance (PMI) -PMI premiums are added to mortgage payments until the uninsured balance of the mortgage is less than, e.g., 75% of the property's value

Bond Markets 2 A) TIPS example: -Original principal amount of $100,000 -10 years to maturity -3% annual coupon (1.5% semiannually) Suppose 6-month inflation rate leading up to first coupon is 1% (CPI for All Urban Consumers). What happens to? 1) Principal? 2) First coupon? 3) If inflation is 1.4% over next 6-month period, principal adjusts upward again to 4) Second coupon would be?

A) 1) Principal amount for 1st coupon adjusted to $101,000 2) First coupon is $1,515 = $101,000 x 1.5% 3) If inflation is 1.4% over next 6-month period, principal adjusts upward again to $102,414 = $101,000 x 1.014 4) Second coupon payment would be $1,536.21 = $102,414 x 1.5%

Structure of Interest Rates 1 A) Key factors that influence interest rate structure (5):

A) 1) Term to maturity 2) Default risk 3) Tax treatment 4) Liquidity 5) Flexibility* (options on debt securities)

Money Markets 3 A) Example 1: A 6-month (182 day) US T-bill is currently selling for 98% of FV = $10,000. Compute: -The discount yield -The bond equivalent yield

A) y(d) = (100 - 98)/100 x 360/182 x 100% y(d) = 3.956% y(BE) = (100 - 98)/98 x 365/182 x 100% y(BE) = 4.093%

Structure of Interest Rates 4 A) Default risk premium is what? B) Default risk premiums correlate to the business cycle how?

A) A default risk premium (DRP) is the additional yield earned by bond/security subject to default relative to comparable default-free securities: DRP = i - i(rf) B) Default risk premiums are countercyclical: widen in periods of recession and narrow in expansions -In good times, risky security prices are bid up; yields move closer to those of riskless securities -With increased economic pessimism, investors sell risky securities and buy "quality", thus widening the DRP

Structure of Interest Rates 2 Expectations Theory Example A) Question: What should current 3-year rate be (tR3)? -Current 1-year rate is 2% -Expected one-year rate one year from now is 6% -Expected one-year rate two years from now is 10% In terms of our notation: tR1 = 2% t+1f1 = 6% t+2f1 = 10%

A) Answer: by using short-term (one-year) debt rolled over twice, investors can obtain (approx.) 3-year rate of (2 + 6 + 10)/3 = 6%

Money Markets 3 A) Why is the distinction between discount yield and bond equivalent yield so small in current economic conditions?

A) Answer: look at conversion factor between discount yield and bond equiv. yield: y(be) = y(d) [(365P(f)/360P(0)] Interest rates near zero -> T-bills priced close to par -This means that the correction factor is close to 1

Mortgage Markets 2 A) What are balloon payment mortgages? B) What are rollover mortgages (ROMs) / renogiated rate mortgages (RRMs)?

A) Balloon Payment Mortgages -Traditional loan where interest is paid until a time when the principal is due -Terms can be 3, 5 or 7 years -Interest is based on 15 or 30-year period so payments are no different than an FRM of equal maturity -Rate is fixed over the contract term -Popular with borrowers who may either sell or refinance prior to maturity B) Rollover Mortgage (ROMs) / Renegotiated Rate Mortgages (RRMs) -Refinanced or renegotiated at new rate every few years -Adjustment period is longer than traditional ARMs -Relatively popular in Canada; less so in US

Money Markets 6 A) What are banker's acceptances? B) Where do they mostly arise? C) How are the quoted? D) What is the denomination?

A) Banker's Acceptances -Time draft drawn on and accepted by commercial banks -Bank unconditionally promised to pay face amount of draft at maturity B) Most arise in international transactions (export / import) C) -US mkt mostly dollar denominated -Quoted on discount basis; typically mature in 30-180 days D) Size: Lots of between $100,000 and $500,000 -Fairly complicated institutional details *Less prominent instruments today relative to several decades ago

Mortgage Markets 3 A) What are 3 key ratios banks look at in determining whether a person qualifies for a home loan?

A) Banks look at several key ratios: 1) Mortgage payment / Gross Income (GI) < 25% 2) Mortgage PMT plus property taxes, insurance / GI < 28% 3) Mortgage PMT + prop. taxes + insur. + other debt / GI < 33%

Bond Markets 5 A) What is a bond indenture?

A) Bond indenture: legal contract stipulating rights, privileges and obligations of bond issuer and holder -Trustee (large bank) ensures that bond covenants honored -Collateral is often pledged in bond indenture =Mortgage bonds: real assets pledged =Equipment trust certificates: specific, titled, or identifiable equipment =Collateral bonds: secured by financial assets

Money Markets 3 A) Book entry securities:

A) Bonds (including T-bills) are financial contracts -Old school: Investors received bond certificates -Now: No physical securities; only record entries in a "book-entry" system =Most of marketable Treasury debt is now in book-entry form =Participants in Treasury Direct Program are book-entry accounts

Bond Markets 1 A) Capital market instruments are? B) Their economic purpose is? Allows firms to do what?

A) Capital market instruments: long-term financial instruments with maturity > 1 year B) Economic purpose: fund investment in capital equipment and other long run assets using securities with roughly matching duration -Capital assets usually have long life (several years to decades) -Capital markets allow firms to lock-in borrowing cost -Short Term debt carries substantial risk related to refinancing, so capital markets does the opposite.

Mortgage Markets 5 Types of MBS (5) A) What are Collateralized Mortgage Obligations (CMOs): B) CMO issues have what?

A) Collateralized Mortgage Obligations (CMOs): securities with fixed maturity date and interest pmts. B) like bonds CMO issues have between 3 and 10 "classes" or "tranches" -Investors can choose the class/tranche that matches their maturity preference *CMOs can create tax problems for the originators =Issue is whether originators can legally pass on interest payments tax free (most cannot when they issue multiple debt securities)

Money Markets 4 A) Commercial paper is quoted how? B) What formulas for discount yield and BEY? C) Example: -An investor purchases $1 million of 45-day commercial paper issued by GE Capital for $997,200 Question: Compute discount yield and bond equivalent yield

A) Commercial paper is usually quoted on a discount basis similar to US T-bills B) Same formulas for discount yield and bond equivalent yield apply C) y(d) = (100 - 99.72)/100 x 360/45 x 100% y(d) = 2.24% y(BE) = (100 - 99.72)/99.72 x 365/45 x 100% y(BE) = 2.28%

Money Markets 4 A) Commercial paper may be issued in what 2 ways? B) What is an important component of commercial paper issuances?

A) Commercial paper may be issued: 1) Directly through a sales force of the borrowing firm 2) Indirectly via dealers B) Credit ratings are important components of commercial paper issuance -Over 95% of issues are in the top two rating categories -Backup lines of credit from banks support or guarantee quality

Money Markets 4 A) Commercial paper is? B) Maturities and denominations are? C) Sold at a what?

A) Commercial paper: unsecured corporate debt -Issued by high-quality borrowers -A wholesale money market instrument -Few individual investors B) -Maturities are 1 to 270 days -Large denominations: $100,000 and up C) Sold at a discount from par

Bond Markets 5 A) What are debentures? B) What is the sinking fund and call provisions in the indenture? C) What are convertible bonds?

A) Debentures: unsecured bonds -Debentures have ordered claims on assets in default =Senior debt: first priority to general assets =Subordinated debt: asset claim ranking of unsecured debentures below senior or specific general creditors B) Provisions -Sinking fund provision: the periodic retirement of a number of bonds -Call provision: gives issuer right to retire bonds before maturity =A call provision is an *option* -- the issuer has the right but not the obligation to retire bonds early =Sinking fund provisions often are accompanied by call provisions - this facilitates issuers ability to retire bonds as per sinking fund C) Convertible Bonds -Bonds that can be converted into common stock -Give bondholders an 'upside' in event that firm performs well -Conversion ratio usually set so that stock price must rise significantly (20%) in order for conversion to be profitable

Structure of Interest Rates 4 A) Default risk refers to what? B) Losses from default events can vary how much?

A) Default risk refers to the possibility of the borrower not honoring a loan security contract (bond terms) -"Default" occurs when borrower fails to meet any of the repayment terms specified in the contract -Risk averse investors want adequate compensation for expected default losses. =Manifested in lower prices = higher yields relative to comparable default-free bonds (typically US GOV notes/bonds) B) Losses from default events can vary greatly: -Interest a few days late -Interest payments missed -Complete loss of principal

Mortgage Markets 1 A) FRMs are not desirable to lenders when interest rates are likely to what? B) With ARMs, borrowers' costs vary with what (2)?

A) FRMs not desirable to lenders when interest rates are likely to rise (e.g., expectations of future inflation) B) With ARMs, borrowers' costs vary with inflation and interest rate levels -Lenders shift (some) interest rate risk to the borrower -Compensation to borrower in form of low initial rate ('teaser') -Caps on ARM rates limit interest rate risk to borrowers -Capped ARMs may have a "payment cap", "rate cap", or both =Payment caps limit the maximum amount the payment can increase in any year and over the life of the loan =Interest rate caps or "rate caps" limit the size of the increase in the loan rate in any year and over the loan's life =Example: annual cap 1%, lifetime cap of 5%

Mortgage Markets 5 Types of MBS (4) A) Fannie Mae pass-throughs are what? B) What are privately issued pass-throughs? (PIPs)?

A) Fannie Mae pass-throughs: pools of conventional or insured mortgages. Issued by FNMA. -Securities similar to FHLMC's PC -Can issue pass-throughs for either conventional or federally insured mortgage loans B) Privately Issued Pass-Throughs (PIPs) -First issued in 1977 by Bank of America -PIPs are issued by private institutions or mortgage bankers -Similar to "Ginnie Maes" except that they are backed by conventional mortgages -Typically used to securitize large, non-conforming mortgage loans called jumbo loans

Mortgage Markets 6 A) What are "Fannie Mae" bonds and "Freddie Mac" bonds? B) How do privately issued mortgage-backed bons compare to Fannie and Freddie bonds?

A) Federal agencies like FNMA and FHLMC issue bonds to raise funds using the mortgage loans they own as collateral. These are referred to as "Fannie Mae" bonds and "Freddie Mac" bonds, respectively. B) Private institutions also issue mortgage-backed bonds using pools of mortgages they own -Typically use higher than 100% of mortgage pool as collateral. -Maturities range from 5 to 10 years. -Often rated AAA, thus lowering the required yield. *State and local govt. housing agencies also can issue bonds to fund low income housing developments (type of "muni"  tax exemption)

Money Markets 6 A) What is agency debt? B) What are the 2 varieties of agency debt? C) How are yields, risk, and liquidity?

A) Federal agency = independent federal dept. or federally chartered corp. established by Congress/Govt -Issue LTD; traded as they approach maturity in MM B) Two varieties: -Government-owned agencies (Ginnie Mae, FHA) have an explicit guarantee of the government -Government-sponsored agencies (Fannie Mae, Freddie Mac) are perceived to have an implicit guarantee of the government C) -Yields are higher than T-Bills -Greater default risk & lower liquidity

Bond Markets 6 A) What are financial guarantees?

A) Financial guarantees: arrangements in which a third party (insurer, commercial bank) agrees to cover the payment of principal and interest in the event of default. -Substitutes the credit standing of the guarantor for that of the issuer -Quality of a financial guarantee depends on the reputation and financial strength of the guarantor -Guarantee lowers default risk of the issue and increases liquidity  lower yield to investors -Guarantor earns a fee (usually % of FV of issue) -Crisis of 2007-2008: Guarantors run into trouble

Mortgage Markets 5 Types of MBS (2) A) Ginnie Mae I: pass-throughs secured by a mortgage pool consisting of the same type of mortgage loans. B) Ginnie Mae II: secured by a mortgage pool that exhibits more variation relative to Ginnie Mae I securities

A) Ginnie Mae I: pass-throughs secured by a mortgage pool consisting of the same type of mortgage loans. -Same interest rate. -Originated by the same lender -Minimum pool size is $1 million B) Ginnie Mae II: secured by a mortgage pool that exhibits more variation relative to Ginnie Mae I securities -Mortgages may be issued by multiple lenders -Interest rates may vary over the portfolio of loans by as much as 75 basis points (0.75%) -The minimum pool size is $250,000 for multi-lender pools and $1 million for single-lender pools

Mortgage Markets 5 Types of MBS (1) A) Ginnie Mae Pass-Throughs: are what?

A) Ginnie Mae Pass-Throughs: pools of government insured mortgages -GNMA guarantees timely payment of principal and interest on MBS backed by federally insured or guaranteed loans -GNMA charges issuers of pass-throughs a fee ranging from 0.25 % to 0.75 % to offer its guarantee -Ginnie Mae securities generally earn a lower yield reflecting lower default risk due to dual guarantee by GNMA on the MBS + FHA/VA guaranty on original loans

Mortgage Markets 7 A) How can we price agency pass-through MBS (4 steps)?

A) How can we price agency pass-through MBS? 1) Compute PV of future cash flows just like other bonds 2) Key complication: how rapidly will mortgages in pool repay? 3) For an assumed PSA, we can work out the associated cash flows 4) Discount these CFs using appropriate rate *example of 37, don't have to know how to compute.

Mortgage Markets 7 A) IO and PO strips represent what? B) How does pricing work? C) What does interest rate risk look like for IO/PO strips?

A) IO and PO strips represent simple way to cut up cash flows to MBS B) Pricing: works same way as pass-throughs -Decompose CFs into interest and principal portions and discount -See MortgageBacked.xls for details for our example MBS C) -IO and PO strips behave differently when interest rates change -PO behaves like regular bond (with long duration) -But IO value falls when interest rates fall =Intuition: rates fall and prepayment increases, reducing principle the serves as basis for interest cash flows =Duration is negative for IO strips

Mortgage Markets 4 A) When was Freddie Mac created? Why? What does Freddie Mac stand for? B) Historically, which of the entities was a government agency? C) Which were considered private corporations?

A) In 1970, the Federal Home Loan Mortgage Corporation (FHLMC, "Freddie Mac") was created to help develop a secondary market for conventional mortgages B) Ginnie Mae was a US govt. agency - securities back by full faith and credit of US government C) Fannie Mae + Freddie Mac were private corporations (with stockholders) although they received some government support -Fannie + Freddie only had "implicit" guarantees of debt/securities -In Sept. 2008, Ginnie Mae, Fannie Mae and Freddie Mac placed under US government conservatorship -Debts were guaranteed, effectively removing any doubt regarding status of Fannie / Freddie issued MBS

Money Markets 2 A) In a non-competitive bid, the investor does what? He agrees to pay what? B) Minimum and maximum bids are what?

A) In a non-competitive bid, the investor simply indicates a quantity of bills -The investor implicitly agrees to pay the ultimate stop-out price (discount rate) of the auction that is determined in the competitive process. -All non-competitive bids accepted prior to the award of competitive bids. So they definitely end up with T-bills. B) -Minimum bid is $100: nod to individual investors -Maximum $5,000,000. -Mostly individuals & small investors

Bond Markets 4 A) Liquidity for munis in secondary market?

A) In general, secondary market for munis is relatively thin and is primarily an over-the-counter market -Limited liquidity can drive up the yields of municipal bonds relative to corporate bonds; particularly larger corporate issues that trade actively -Consequently, the yield on munis may be higher than expected given ratings (credit risk) and tax exempt status

Bond Markets 3 A) What are insured bonds? B) What are taxable munis? C) What are originial issue discount bonds? D) What are conduits?

A) Insured bonds: insured by policies written by commercial insurance companies -The policy provides for the insurer to pay principal and interest payment to bondholders in the event the issuer defaults B) Taxable munis: interest on some munis taxable -Federal govt. will not subsidize the financing of activities that do not provide significant benefit to the public (e.g., stadiums) C) Original issue discount bonds -Difference b/w the issue price and the face value treated as tax-exempt income if bonds held to maturity D) Conduits: -Revenue bonds issued by state agencies acting on behalf of the actual borrowers (often private non-profit (501(c)(3)) entities)

Bond Markets 4 A) How is interest on municipal bonds treated? B) What is the equation for the yield on a municipal bond?

A) Interest on most municipal bonds is exempt from federal income tax -In most states, interest on governmental securities issued by government units within the state is also exempt from state and local tax B) The tax advantage afforded by municipal bonds can be substantial -The yield on a municipal bond (im) equals the (before tax) yield on an equivalent taxable bond (it) times one minus the marginal tax rate: I'm = it(1-T)

Mortgage Markets 2 A) What are interest-only mortgages? B) What are reverse annuity mortgages (RAMs)?

A) Interest-Only Mortgages -Low payments in initial years (10 to 15 years) - only includes interest on borrowed amount -After initial period, payments increase such that entire loan amount is amortized by the end of 30 years -Borrower pays interest for a considerable period on the entire loan balance, but avoids having to pay down balance in initial years B) Reverse Annuity Mortgages (RAMs) -Homeowners borrow against equity on their homes at low rates -Often obtained by older people whose home loans have been paid off: converts home value into annuity stream -Typical term is no more than 20 years and could be for borrower's lifetime as an annuity -Homeowners' equity declines by amount borrowed

Mortgage Markets 6 A) What is WAM and WAC?

A) Jargon in the mortgage world describing the characteristics of MBSs -WAM: weighted average maturity of mortgages in a pool =Take the maturity of each loan in the pool and weight this by the mortgage size -WAC: weighted average coupon of the mortgages in the pool =Take the coupon rate on each loan in the pool and weight this by relative mortgage size

Bond Markets 6 A) What are junk bonds?

A) Junk bonds are low rated (high default risk) corporate bonds. -Development of the junk bond primary market was enhanced by the secondary market maintained by Drexel Burnham and Lambert in the early 1980s =Relatively strong economic environment of 1980s bolstered junk bond market development =But Drexel failed in 1990; denting the junk bond market -Smaller, higher risk firms found they could issue longer term, more flexible securities in the high-yield market rather than borrow from commercial banks.

Mortgage Markets 7 A) What does interest rate risk looks like for agency pass-through MBS? B) See example on slide 38 and 39

A) Key point: prepayment behavior depends on interest rate evolution and complicates interest rate risk

Structure of Interest Rates 4 A) The leading credit raging agencies are (3): B) They measure and grade what? C) What are the 4 letter grades?

A) Leading agencies: 1) Moody's Investor Service (Moody's) 2) Standard & Poor's (S&P) 3) Fitch B) Credit rating agencies measure and grade relative default risk security issuers C) Issue 'letter grades' that capture relative likelihood of default 1) Aaa (AAA) = highest rating / least likely to default 2) Aa (AA) = second highest rating 3) Baa = lowest "investment grade" bonds 4) Ba and below = "junk bonds" or "speculative grade" *Slide 28: Ratings models/process *Slide 29: Default probabilities

Structure of Interest Rates 5 A) Liquidity is: B) What factors limit liquidity? C) Securities with relatively high liquidity have higher or lower prices?

A) Liquidity: concept capturing cost and speed with which investors can resell a security* -Breadth -Depth -Resilience B) What factors limit liquidity? -Cost of trade -Physical transfer cost -Search costs -Information costs C) Key point: securities with relatively high liquidity have relatively high prices = lower yields.

Structure of Interest Rates 3 A) Liquidity premium explanation: B) Liquidiy premium is an augmentation of what?

A) Long-term securities have greater risk and investors require greater premiums to give up liquidity -Long-term security prices are more sensitive to interest rates (have more price risk) -Long-term securities have less liquidity -The liquidity premium theory can explain why the yield curve slopes upward most of the time -Liquidity premiums change over time B) This idea is not a separate explanation, but rather an augmentation of the expectations hypothesis

Mortgage Markets 4 A) Mortgage backed securities (MBS) provide what? B) What are mortgage pass-through securities? C) MBS provide what 3 advantages of basic mortgages?

A) MBS provided a means to develop a secondary market for mortgages B) Mortgage pass-through securities pass through payments of principal and interest on pools of mortgages to holders of MBS -Other types of MBS use pools of mortgages as collateral for debt securities C) MBS provide a number of advantages over basic mortgages: 1) Issued in standardized denominations and are negotiable 2) Issued or backed by sound institutions (in some cases govt.) 3) Usually insured and highly collateralized *See slide 18

Money Markets 6 A) Money market characteristics (3): B) How are money market securities correlated?

A) MM instruments have similar characteristics: 1) Short maturity 2) Low default risk 3) High liquidity *These securities are substitutes, but not perfect substitutes -Ex: Default risk of T-bills vs. commercial paper B) During 'normal times' MM instrument yields / rates are quite similar and co-move closely together -Temporary deviations from typical spreads are quickly eliminated by "interest rate arbitrage" -The financial crisis of 2007-2009: far from 'normal times' ="Flight to quality" => investors fled other securities in favor of safe US T-bills =T-bill yields fell relative to other MM instruments =The precarious position of financial intermediaries caused large divergences of yields among MM instruments. Yield spikes for: ==Commercial paper issued by financial firms ==CDs (also issued by financial firms)

Structure of Interest Rates 2 A) Macroeconomic theory suggests that interest rates relate how to the level of economic activity? B) Combining the idea in (A) with expectations theory:

A) Macroeconomic theory suggests that interest rates will be positively related to the level of economic activity. -Interest rates 'pro-cyclical' B) Combine this idea with expectations theory: -Ascending yield curve forecasts higher interest rates associated with economic expansion and/or inflation -Descending yield curve forecasts lower rates possibly related to slower economic growth or lower inflation rates -Yield curve provides useful information for future macroeconomic growth and asset prices -A number of notable recessions preceded by inverted yield curve *Slide 20

Bond Markets 1 A) Major issuers in the capital markets are (2)? B) Major investors are (2):

A) Major Issuers: 1) Corporations - bonds and stocks 2) Governments - federal, state, and local bonds A) 1) Individuals and households -(directly & indirectly through financial intermediaries) 2) Various financial intermediaries -Pension funds -Mutual funds -Insurance companies

Money Markets 4 A) Who holds commercial paper (5)? B) Commercial banks play what 3 roles in this market?

A) Major investors in commercial paper include: 1) Commercial banks. 2) Insurance companies. 3) Nonfinancial business firms. 4) Bank trust departments. 5) State and local pension funds. B) Commercial banks have an important role in this market: 1)Provide backup lines of credit 2) Act as agents in issuance 3) Hold notes in safekeeping

Money Markets 1 A) What are money markets? B) What are 3 characteristics of money markets?

A) Money markets are markets for short term debt securities that are "money-like" B) 1) Short maturities (typically overnight to 90 days) 2) Very low default risk 3) Highly liquid secondary (resale) markets

Mortgage Markets 3 A) What is usually necessary for borrowers who are unable to come up with the normal 20% down payment?

A) Mortgage insurance: -Acts as insurance policy which compensates lenders for losses due to default -Mortgage insurance can be public or private -The mortgage insurer charges a premium for coverage -Coverage offered by mortgage insurers can vary from 20% to 50% and higher

Bond Markets 5 A) Bond liquidity:

A) Most secondary trading of corporate bonds occurs through dealers as opposed to organized exchanges -Some corporate bonds do trade on organized exchanges such as NYSE -The volume of trading is relatively low - a thin market, and there is a relatively large bid-ask spread -These facts suggest that corporate bonds are less liquid instruments =Less liquid than money market instruments =Less liquid than corporate stock =Generally less liquid than US Treasury notes/bonds

Bond Markets 5 A) What are 4 motivations for holding corporate bonds?

A) Motivations for holding corporate bonds: 1) Long-term investment horizon; duration matching 2) Liquidity not always needed - hold to maturity 3) Safety (at least for investment grade bonds) 4) Tax considerations

Money Markets 6 A) What are CDs? B) How are the denominations, maturities, and risk? C) Who typically buys CDs?

A) Negotiable Certificates of Deposit (CDs) -CDs are time deposits, issued by banks or thrift institutions that are "negotiable" (transferable) -Typically payable in NYC in immediately avail. funds B) -Large denominations (typically > $1m) -- 'jumbo CDs' as opposed to 'retail CDs' -Maturities: 2 weeks - 6 months -Insured by FDIC up to $250,000 - but since denominations larger they are not risk free -Smaller issuing banks pay slight premium due to higher perceived risk C) Mostly purchased by corporate customers

Structure of Interest Rates 3 A) Preferred habitat theory explanation: B) Preferred habitat theory is an extension of what?

A) PH allows market participants to trade outside of their preferred maturity if adequately compensated for the additional risk -PH allows for humps or twists in the yield curve, but limits the discontinuities possible under market segmentation theory -PH is consistent with a smooth yield curve -Somewhat difficult to distinguish from liquidity premium hypothesis -More of a behavioral / heterogeneous traders explanation for preferred trading - not necessarily just liquidity / risk B) The preferred habitat theory (PH) is an extension of the market segmentation theory

Mortgage Markets 6 A) What is prepayment risk? B) Mortgages guaranteed by agencies have yields lower or higher than US Treasury bonds?

A) Prepayment risk: risk that the borrower will repay (call) the debt before maturity -Can cause realized yield to be different from expected yield -When interest rates decline, homeowners (borrowers) refinance, paying off their old mortgage and creating a new one -The mortgage investor then receives the principal back when interest rates are lower B) Mortgages guaranteed by agencies have yields above U.S. Treasury Bonds* -This indicates some additional risk exposure

Mortgage Markets 6 A) prepayment speed is what? B) Conditional prepayment rate (CPR) is what? -How to calculate? C) Public Securities Association (PSA) experience is what?

A) Prepayment speed: rate at which mortgages are prepaid in an MBS B) Conditional prepayment rate (CPR): probability that a mortgage in a particular pool will be prepaid w/in the next year -Take the maturity of each loan in the pool and weight this by the mortgage size C) PSA experience: industry benchmark in description of prepayment speed is 100% PSA. 100% PSA assumes: -CPR = 0.2% for the first month -CPR increases by 0.2% in each of the following 30 months -CPR then levels of at 6% until maturity -Can scale this: e.g., 200% PSA (faster prepayment)

Money Markets 1 A) Why do money markets exist? B) Give 2 examples of when money markets are useful:

A) Provide efficient means for economic units to adjust 'liquidity positions' -Cash receipts and expenditures not perfectly synchronized -Precautionary hording of cash = inefficient -Money markets facilitate efficient liquidity management B) 1) Example #1: Business holds temporary cash surplus -Can invest this cash in money market instrument for a short time to earn interest 2) Example #2: Bank is temporarily short of reserves -Borrow reserves from another bank in Fed Funds market

Bond Markets 5 A) What are the 2 types of public sale of bonds? B) What is a private placement?

A) Public sale: open to all interested buyers -Usually coordinated by an investment bank (underwriter) 1) Competitive sale: public auction among underwriters 2) Negotiated sale: underwriting contract signed with specific underwriters; exclusive write to originate, underwrite & distribute B) Private placement: limited number (< 35) of sophisticated buyers, avoiding SEC registration -PPs increasingly popular, particularly in last 20 years -Fraction of PPs increase when interest rates are high and/or when capital market conditions are unstable -SEC Rule 144a (1990) liberalized the regulation of PPs. It allows secondary market trading of PPs =Increases liquidity of PPs and lowers borrowing cost

Mortgage Markets 5 Types of MBS (6) A) What is a Real Estate Mortgage Investment Conduit (REMIC)? B) How do REMICs differ from CMOs?

A) Real Estate Mortgage Investment Conduit (REMIC) -Similar to a trust that can pass through all interest and principal payments to buyers of pass-throughs before taxes are levied -Investor pays taxes on interest B) Ultimately differs from CMOs only in legal status *Now dominant form of "CMO" and sometimes implicitly referenced as CMO

Mortgage Markets 7 A) What is the duration of an agency pass-through? B) What is a potential issue with this thinking? C) See example on 40, 41

A) Recall: Duration related to slope of price with respect to the interest rate / yield B) Potential issue: when interest rates change, prepayment behavior will usually change -Rates rise: prepayment slows -Rates fall: prepayment accelerates

Money Markets 5 A) Repo is short for what? What is a repo? B) What do repos involve? C) What are the maturities for repos? What's the denomination like? D) What is a reverse repo?

A) Repurchase agreement (repo): sale of security with agreement to buy it back later (at a higher price) -Difference in prices is interest B) Repos involving collateralized lending -Securities serve as collateral -Contrast with commercial paper & fed funds lending C) -"Maturity" varies from 1-day to several months -Smallest customary denomination $1 million -Security often T-bill, or other MM instrument -Negotiated rates D) Reverse repo: Other side of repo - buy security today with agreement to sell it back later *Repo agreement example slide 25

Mortgage Markets 2 A) What is a second mortgage? B) What are home equity lines of credit (HELoC)?

A) Second Mortgage -Additional loan extended at time of purchase or later -Collateralized via second lien on home B) Home equity lines of credit (HELoC) -Allow home owners to borrow against the equity built up in their homes -Became popular after 1986 changes in federal tax law (eliminated tax deductions for interest on credit cards)

Bond Markets 6 A) What is securitization? B) What are credit enhancements?

A) Securitization: packaging loans and selling claims to future cash flows of the loans -Originator designs securities (claims) desired by investors. -Returns are derived from the cash flows of the loans packaged in a trust arrangement. -Value of new securities can exceed value of loan cash flows, providing incentives to securitize. -Many asset-backed securities have been created, beginning in the mortgage market and including other types of loans B) Credit enhancements: additional pledges or guarantees against default -- lower costs to issuers and default risk to investors

Bond Markets 3 A) What are STRIPS? B) STRIPS partition a standward U.S. Treasury note or bond into what? C) Why is there interest from investors in STRIPS securities?

A) Separate Trading of Registered Interest and Principal of Securities (STRIPS) B) STRIPs partition a standard U.S. Treasury note or bond into a series of zero-coupon securities -Each coupon trades becomes a separate zero coupon security -The principal also becomes a separate zero coupon security *The US Treasury does not directly issue STRIPS -Dealers buy US notes and bonds and create and sell STRIPs from these. -Dealer contacts US Treasury to recode each coupon and principal payment electronically as a separate security with its own "CUSIP" number. C) To avoid reinvestment and price risk is to hold a zero-coupon bond and hold to maturity. These are zero-coupon bonds that have maturities longer than a year like Treasury Bills.

Money Markets 4 A) Fed funds market is for: B) Who is this market for? C) Yields are related to what? D) Money markets were originally a market for what? Now for what?

A) Short-term interbank loans B) Market for depository institutions -Most liquid of all financial assets -Related to monetary policy implementation -Most are one-day, unsecured loans -Settled in immediately available funds C) Yields related to the level of excess bank reserves -Recall our supply and demand model for reserves D) Originally a market for excess reserves; now a broader source of investment and continued financing -Broader def: overnight loan settled in immediately avail. funds -Many participants do not hold balances at Federal Reserve

Mortgage Markets 5 Types of MBS (7) A) What are stripped mortgage-backed securities (SMBSs)? B) What are the 2 kinds of SMBSs?

A) Similar to pass-throughs, stripped mortgage-backed securities (SMBSs) pass on all payments of principal and interest to investors B) Two kinds - Interest Only (IO) and Principal only (PO) -Investors in IOs receive cash flows only from the interest payments on the mortgage pool. =Cash flows decline as mortgage loans in the pool are paid down. -Holders of POs receive all cash flows from the principal payments on the mortgage pool -Note that these cash flows can vary with prepayment behavior in different ways -See discussion of prepayment risk later in these slides

Money Markets 2 A) Competitive bids are given how? In denominations of what? Who participates? B) What is the 35% rule? C) What kind of price auction is it?

A) Specify price (interest rate) and quantity desired -Minimum $10,000 & in multiples of $5,000 above $10,000 -Mostly professionals: dealers, banks and other financial institutions B) 35% rule: no single participant may bid for more than 35% of the total quantity issued -This rule is intended to prevent strategic attempts to 'corner the market' in a particular issuance. C) Uniform price auction -Orders filled in increasing rates until entire quantity filled -All bidders pay stop-out rate = highest rate accepted. Anyone who bid for a higher interest rate than this rate does not get any bills.

Bond Markets 3 A) State and local gov't bonds are known as what? B) They fund what? C) Interest income is exempt from what?

A) State and local government bonds are known as municipal bonds or "munis" -Debt obligations issued by states, cities, counties, and other public entities B) Fund public projects such as schools, hospitals, highways, sewers, etc. C) Interest income from municipal bonds is generally exempt from federal taxes and may be exempt from state and local taxes

Bond Markets 2 A) TIPS contain important information about what? B) What equation gives you expected inflation? C) Key point is: TIP provide what? D) Example: 5-year TIPS yield = 1.1%; 5-year Treasury note yield = 3.49%. What is expected inflation over next 5 years?

A) TIPS contain important information regarding "market" expectations of future inflation B)Solve the Fisher equation for expected inflation: (1+i)=(1+r)(1+infl) C) Key point: Yields on TIPS provide a measure of real interest rates -Compare yield on TIPS with yields of standard Treasury instruments to infer expected inflation rate D) Example: 5-year TIPS yield = 1.1%; 5-year Treasury note yield = 3.49%. What is expected inflation over next 5 years? 3.5-1.1 is about 2.4

Structure of Interest Rates 1 A) Term structure definition: B) Yield curve definition: C) Leading example of term structure and yield curve is:

A) Term structure: relationship between yield and term to maturity on securities that differ only in length of time to maturity B) Yield curve: graphical representation of the term structure -Shows the relationship between maturity and a security's yield at a point in time. C) Leading example is term structure (and yield curve) for US Treasuries Just saying "the yield curve" implicitly refers to these US govt. securities

Bond Markets 2 A) US government also issues TIPS. Some characteristics are? B) What does a negative yield on TIPS mean?

A) The US Treasury offers inflation protected securities (TIPS) Treasiry Inflation Protected Securitites -First issued in 1997 -Notes have original maturities of 5 and 10 years -Bonds have original maturities of 20 and 30 years -Issued 3 times per year and can be -purchases in denominations starting at $100 -Principal adjusts for inflation -Fixed coupon rate determined by auction process -Increases in principal due to inflation are taxed every year, even though investor does not received inflation-adjusted principal until maturity B) The real interest rate is negative. By buying TIPS, it's kind of like buying an insurance policy against inflation. If you held cash instead of accepting a negative yield, then you will have a worse negative yield.

Structure of Interest Rates 4 A) US government sued who in 2013 for what?

A) The US government sued S&P in 2013 for allegedly providing knowingly misleading and inflated credit assessments for mortgage-related securities. -This followed other, similar lawsuits filed by Calpers (in 2009) and various states -S&P denied wrongdoing, argued: =Ratings protected under the 1st amendment =Argued lawsuit was retribution for S&P's downgrade of US debt -S&P recently agreed to pay $1.5 billion to settle =Federal government gets only about 2/3 billion - much less than they sought even a year ago =S&P does not admit to violating law, but admits it uncovered no evidence of retaliatory basis for lawsuit

Money Markets 3 A) Bond equivalent yield is what? B) Equation for BEY:

A) The bond equivalent yield is annualized YTM for the zero coupon bond B) y(BE) = [(P(f) - P(0))/P(0) x 365/n x 100% Note: Normalization now by price rather than FV *Note: Annualization assumes 365 days per year rather than 360 Examples 15 and 16

Structure of Interest Rates 5 A) The decision to hold municipal versus alternative bonds depends upon what (2)? B) The after-tax yield is found how (equation): C) These bonds are often held by who?

A) The decision to hold municipal versus alternative bonds depends upon both: 1) Relative prices / yields 2) Investors' marginal tax rates B) i(AT) = i(BT) x (1-T) C) These bonds often held by "high net worth" individuals -Less prominent in holdings of pension funds and other tax-exempt institutions

Structure of Interest Rates 2 A) Expectations theory weaknesses (3):

A) The expectations theory has some weaknesses: 1) The expectations theory does not explain why yield curves typically slope upward -Expected future rates are taken as given -Why should we systematically expect future rates to rise? 2) The expectations theory assumes that market participants are risk neutral -Theory assumes that investors will aggressively move to obtain even slightly higher yields by altering maturities they hold -But some positions are riskier / less liquid relative to others -Should investors really be indifferent? 3) Empirical evidence not particularly favorable -Academic research does not find that the slope of the term structure has positive relation with future yields

Structure of Interest Rates 3 A) The market segmentation theory disavows that there need be what? B) Basic idea of market segmentation theory C) Critic of market segmentation theory:

A) The market segmentation theory disavows that there need be clear connections between yields at different maturities -Stark contrast with expectations theory B) Basic idea: investors on both sides of the markets have very clear and stable maturity preferences - don't trade outside these maturities Discontinuities and spikes are possible in the yield curve In fact, just about any yield curve pattern can be explained by this "theory" C) Criticism: the segmentation hypothesis is just assumed - not clear why such a restriction would be rational for traders -Doesn't explain why rates tend to move together

Mortgage Markets 1 A) The note is what? B) The mortgage is a what?

A) The note is the borrowing agreement. B) The mortgage is a lien on the property used as collateral for the loan -If the contract is broken, the lender may sell or obtain title; use sale proceeds from property to pay the loan -When mortgage is fully paid, the lien is removed and the borrower obtains a clear title to the property

Structure of Interest Rates 2 Expectations Theory A) The shape of the yield curve is determined by what? B) Intuition:

A) The shape of the yield curve is determined by expectations of future interest rate movements -Yield on LT bond will equal average of expected yields on ST bonds over life of the bond -Changes in these expectations lead to changes in yield curve -Ascending: future interest rates are expected to increase -Descending: future interest rates are expected to decrease B) Intuition: Investors have choices with respect to how to hold US govt. debt for given maturity -Hold long term debt OR hold short-term debt and roll-over in future

Structure of Interest Rates 5 A) Taxation effect on bonds:

A) The taxation of security gains and income affects the structure of yields \ rates among securities. -Key point: in the US, all coupon income earned on state and local government debt is exempt from federal taxes -State and local government bonds: municipal bonds or "munis" -Because municipal bonds provide tax-exempt interest income, these bonds have lower yields (higher prices) relative to comparable alternative securities.

Bond Markets 6 A) What are tranches in relation to securitization?

A) Tranches: Tiers of claims in a securitization package; vary from low to very high risk -Etymology: tranche is French for "slice, section or portion" -Securitization documentation (indenture) usually defines the tranches as different "classes" of notes, identified by letter (Class A, Class B, Class C securities), with different ratings -senior tranches have first lien on assets of asset pool -junior tranches have second lien or no lien -mezzanine tranches have intermediate claims -Senior tranches typically held by insurance companies, pension funds, etc. (lower risk) -Junior tranches have a higher risk/return profile

Money Markets 3 A) Treasury bills are priced how? B) The answer to A's equation is:

A) Treasury bills are priced on a bank discount rate basis, a traditional yield measure *IMPORTANT: this is not equivalent to the yield-to-maturity B) y(d) = (p(f) - P(0))/P(f) x (360/n) x 100% n: days to maturity P(f): face value/par P(0): price paid *Note: Note the unconventinoal normalization by face value, rather than price. *Note: annualization assumes 360 days instead of 365.

Money Markets 2 A) U.S. Treasury Bills are? Used for what 2 reasons? B) Bills are sold at a? C) Standard maturities are? D) Minimum denomination is typically?

A) Treasury bills: short term zero-coupon bonds issued by the US Treasury Dept. to 1) cover current deficits and 2) refinance debt B) Sold on discount basis C) Standard maturities: -4 weeks (28 days) -13 weeks (91 days) -26 weeks (182 days) -52 weeks (364 days) D) Minimum denomination typically $10,000 -Smaller investors can invest in multiples of $1,000 through Treasury Direct Program

Bond Markets 3 A) What are the 2 types of state and local gov't bonds? B) The first type of bond requires what? Is usually issued to provide for what? C) The second type of bonds require what? Repayment depends on what?

A) Types of municipal bonds: 1) General Obligation (GO) - backed by taxing power of political entity -Full faith and credit: in event of default, bankruptcy court requires city or local government to raise taxes to pay coupon or principal -Usually issued to provide for basic community services (fire, police protection, etc.) -Issuance tends to be cyclical (harder to get voter approval in 'bad times') 2) Revenue - financed and paid back with cash flows from a specific project -Do not generally require voter approval b/c not backed by 'full faith and credit' of government -Repayment dependent on specific revenue streams, such as user fees, lease payments, occupancy taxes, etc.

Bond Markets 5 A) What are the 2 types of ownership record of corporate bonds? B) What are the 2 types of maturities of corporate bonds?

A) Types of ownership record -Bearer bonds: coupons attached that the holder presents for pmt. when they come due -Registered bonds: recorded ownership, pmt. mailed to holder B) Maturity -Term bonds: all bonds mature on one date -Serial bonds: bonds in the issue mature on different dates -Most corporate bonds are term bonds (most munis are serial issues)

Mortgage Markets 4 A) What creation by the U.S. Congress developed a secondary market for mortgages? When? B) What is Fannie Mae? When was it created? What is it authorized to do? C) When was Fannie Mae split up into two entities? What are they? What was the new entity authorized to do?

A) U. S. Congress initiated development of a secondary market for mortgages in 1934 by creating the Federal Housing Administration (FHA) B) In 1938, the Federal National Mortgage Association (FNMA, "Fannie Mae") was created -Authorized to buy FHA insured loans C) In 1968, FNMA was split up into two entities - FNMA and GNMA (Government National Mortgage Association, "Ginnie Mae") -GNMA was authorized by Congress to guarantee mortgage pools insured by FHA, VA, and other federal agencies

Money Markets 2 A) Which maturity U.S. Treasury bills are issued weekly? B) U.S. Treasry Bills are issued how?

A) US Treasury bills ("T-bills") with 4 weeks, 13 weeks and 26 weeks maturity are issued weekly -52 week bills issued less frequently B) US Treasury bills ("T-bills") are issued through an auction process -The auction is executed electronically by TAAPS (Treasury Automated Auction Processing System) -Results of auction available within minutes of close of bidding -Bidders can either make competitive or noncompetitive bids -Institutions dominate auctions; however, individuals can participate through 'Treasury direct' accounts

Mortgage Markets 6 A) When rates are high and rising, homeowners will be slow to do what? -This extends what? -This extension risk keeps what? B) Variation in repayment rates (prepayment and extension risk) causes what?

A) When rates are high and rising, homeowners will be slow to refinance or trade homes. -This extends the effective length of mortgage financing, keeping the rates to the mortgage lender below market rates. -This extension risk keeps the lender's return below current market yields B) Variation in repayment rates (prepayment and extension risk) causes the actual return of mortgage investors to vary from the expected return?

Structure of Interest Rates 2 Expectations Theory Notation A) tRn is: B) t+kf1 is:

A) tRn = observed (spot) rate at time t for a maturity of n-periods (years) -Example #1: tR1 = observed rate on 1-year security -Example #2: tR3 = observed rate on 3-year security B) t+kf1 = expected one-year interest rate for security originating at t + k -Example #1: t+1f1 = expected one-year interest rate one year from now -Example #2: t+2f1 = expected one-year interest rate two years from now

Structure of Interest Rates 2 Expectations Theory Example A) Question: Turn things around; back out implied future rates: -Current 1-year rate is 2% (tR1 = 2%) -Current 2-year rate is 4% (tR2 = 4%) -Current 3-year rate is 6% (tR3 = 6%) Question: What are t+1f1 and t+2f1 B) Now account for the effect of interest:

A)First use idea that tR2 = (tR1 + t+1f1)/2 -Gives 4% = (2% + t+1f1)/2  t+1f1 = 6% *So far we have been ignoring interest-on-interest... B) Similarly, we can use spot rates on adjacent maturities to back out an implied forward rate for the intervening period: t+n-1 f1 = [(1+tRn)^n/(1+tRn-1)^n-1] - 1 (slide 16) This version accounts for the effects of 'interest on interest' *How close is the approximation to the formal equations?

Mortgage Markets 5 Types of MBS (3) A) Freddie Mac Participation Certification (PCs): -What are they? -Who are they issued by? who are they purchased from? B) PCs are different from GNMA securities how (6)?

A)Freddie Mac Participation Certification: pools of conventional mortgages. -Participation certificates (PCs) are issued by Freddie Mac (FHLMC) and conventional loans are purchased from S&Ls B) PCs are different from GNMA securities: 1) Include conventional mortgages as collateral 2) Mortgages are not federally insured 3) Mortgages pooled by FHLMC, not by private-sector originators 4) Interest rates among pooled mortgages vary 5) Larger individual mortgages 6) Mortgage originators service mortgages (collect payments) for a fee

Money Markets 5 A) Repo example: -Corporate customer with cash demand enters repo agreement with a commercial bank -Bank buys T-bills with current market value of $1million from customer and agrees to resell in 7 days for $1,000,145. Bank charges 5 basis point 'haircut' on deal. QUESTION 1: Who plays role of lender and borrower here? QUESTION 2:What is the repo yield on this transaction? What if there is no haircut?

ANSWER 1: Bank is the lender, corporate customer is the borrower. ANSWER 2: y(repo) = ($1,000,145 - $999,500)/$999,500 x 360/7 x 100% y(repo) = 3.32% *this is with haircut.