FINN 3053 Exam 3

"High Rate" is also called the

"stop-out rate", because the Treasury would not fulfil any bids that require a higher yield. Once the stop-out rate is determined, every fulfilled bid will get this annual yield rate, even if some bids may have demanded less than that

NCDs are typically of

$1 million denomination and above

The less marketable a security, the higher its yield. (T/F)

True

The shape of the yield curve is at least partly determined by expectations of change in future interest rates. (T/F)

True

A TIPS security's yield is in real terms (T/F)

True (Notes: Recall that the purpose of a TIPS is to strip inflation's effects on security yields.)

Commercial Paper characteristics

Unsecured corporate debt (i.e. no collateral is needed) Maturities are 1 to 270 days. Most have maturities of 1 to 90 days Because of its unsecured nature, only very creditworthy firms would be able to issue commercial papers over 95% of issuers are in either AAA or AA corporate ratings

Bankers' Acceptance

Used to have an active secondary market: Liquidity is good because of low default risks No investor of bankers' acceptance has ever lost principal for over 70 years The use of bankers' acceptance has been declining since early 2000s as more asset-backed securities (ABS) emerge with ABS, firms may raise funding more easily with lower costs Nowadays, bankers' acceptance has fallen out of active use. In 2015, the total volume of outstanding bankers' acceptance in the U.S. was much less than $100 million. In the early 1980s, the same number was about $70 billion

The word "mortgage" means two things:

a lien is put on the property used as collateral for the loan the loan's principal and interests are divided into monthly installments over a fixed amount of time. That is, a loan is amortized

Every bank has two positions in the fed fund market:

federal funds sold and federal funds purchased

A TIPS bond has a

fixed coupon rate while the face value (or principal) adjusts for inflation

All bonds in a term issue

have the same maturity date and coupon rate

Separate Trading of Registered Interest and Principal of Securities (STRIPS)

helps investors to mitigate higher interest rate risks associated with longer maturities of T-notes and Tbonds

Inflation risk is another major risk

in addition to interest rate risk in any bond investment

Traditionally, financial guarantees are sold by

insurance companies

Repos are one type of

investment for lending banks. Securities purchased under agreement to resell at a higher price in future (also called Reverse Repo)

Industrial Development Bonds (IDB)

is a special type of revenue munis, where governments issue public debt to finance private business projects. One way to stimulate local business growth.

Smaller banks (e.g. Bank of Fayetteville) tend to be net

lenders of fed funds (i.e. federal funds sold > federal funds purchased)

Corporate bonds are

long-term debt securities issued by firm in the capital market. One way for firms to obtain long-term financing

Unlike money market munis

long-term munis are accessible to individual investors because of the smaller denominations

Short-term federal agency securities are

major money market instruments

MBSs is one type of Asset-backed securities, whose underlying asset is

mortgages

Mortgage Repayment Risks

mortgages' primary risks regarding repayment mostly come from prepayment risks

GSE Pass-Throughs:

mostly pools of conventional mortgages without government guarantees Underwritten by either Freddie Mac or Fannie Mae for the most part Mortgages in the pools originated from more diverse lenders Interest rates of pooled mortgages vary quite a bit

For long-term capital market instruments, however, inflation risks are

much more tangible

Ginnie Mae is

owned by the Federal Government, specializes in securitizing FHA and VA mortgages

A popular type of MBS is called

pass-through securities on a pool of mortgages

Bankers' acceptance is a guarantee of

payment in the future that banks provide to firms and Mostly relevant in international trade

Negotiable CDs are issued at face value and pay interests

periodically

Securitization is the process of

pooling multiple financial assets to create a new "synthetic" security

Ginnie Mae Pass-Throughs

pools of government guaranteed mortgages (e.g., FHA and VA loans) Mortgages in the pool are similar; little to none variation in interest rates in the mortgage pool

Negative inflation (TIPS)

principal of a TIPS bond adjusts down ➔ coupon payment goes down

Positive inflation (TIPS)

principal of a TIPS bond adjusts up ➔ coupon payment goes up

NCDs typical maturity

ranges from 2 weeks to 6 months

Securitization helps investors to diversify portfolio

reduce portfolio risks. Example: without securitization, investors who want to buy bonds of firms in different industries would have to buy them separately. If not anything else, need to pay more transaction costs. With securitization, bonds of firms from different industries may be pooled into one asset-backed security (ABS). So by investing in this ABS, one effectively invests in a wide range of bonds

Junk bonds are much

riskier than investment grade bonds

Debt securities can be issued in two ways:

serial issue and term issue

Most capital market munis are sold as

serial issues, with min. denomination of $5,000

The existence of junk bonds allows

smaller and riskier firms to obtain long-term financing Many of these firm would only be able to get short-term financing without junk bonds

The term "time deposits" just means

that they cannot be withdrawn until a pre-specified date. The pre-specified date is the maturity date of the negotiable CD

Adjustable Rate Mortgage (ARM)

the lender is allowed to adjust interest rate of a mortgage when the market interest rate changes

Negotiable Certificates of Deposits are

the main way for banks to raise funds from firms

Prepayment risks arises when

the mortgage is repaid quicker than the contract specified. If balance of principal is reduced faster, the less interests would be charged

Financial guarantees cover

the payment of principal and interests in the event of default. An insurance against default

Investment Grade

those ranked above (inclusive) Baa by Moody's (or above BBB by Standard & Poor)

Speculative Grade (Junk Bonds):

those ranked below Baa by Moody's (or below BBB by Standard & Poor), yields are much higher than investment grade bonds

Commercial papers are sold either

through dealers or directly by borrowing firms. Dealers underwrite the commercial papers for a firm and then sell to markets Direct sale to market is called direct placement Both ways of sale are considered direct financing

A negotiable CD is a

time deposit issued by a bank to a firm in exchange for the firm's money

Bankers' acceptance is

time draft drawn on and/or accepted by a commercial bank. It is an order to the accepting bank to pay the holder of the acceptance in a future date a liability of the accepting bank

One popular practice of securitization is to slice the "synthetic" securities into

tranches

Senior debt:

unsecured debt, claim priority below secured bonds

Subordinated (junior) debt:

unsecured debt, holders' priority ranked below Senior debt

to compare yields of fed funds to other money market instrument, we need to convert fed fund rate into a bond equivalent yield

ybe= yff (365/360)

Which of the following statements about bonds is NOT true? A. The greater the default risk, the greater the yield B. Bonds selling at premium are especially high quality C. The less marketable a bond, the higher the yield D. Municipal bonds have lower yields than similar corporate bonds

B. Bonds selling at premium are especially high quality

Participants of Money Market

Buy side (investors) v.s. Sell side participants (Issuers) Investors see securities as assets Issuers see securities as liabilities

Major effects of the 2007-08 crisis on money markets included all the following except A. surge in demand for T-Bills B. surge in excess reserves C. widespread runs on banks D. unprecedented Federal Reserve intervention

C. widespread runs on banks

CMO stands for

Collateralized Mortgage Obligations. Tranches differ in orders of receiving payments Tranche A receives payment first If payments from the mortgages are exhausted after paying tranche A holders, lower tranches would not be paid The lower a tranche is ranked, the more prepayment risks it has If a large fraction of pooled mortgages are repaid early, higher tranches get the most interests while lower tranches would not get much interests

Major investors of commercial papers are:

Commercial banks Insurance companies Nonfinancial firms State and local pension funds

Common originators of mortgages include:

Commercial banks Saving & Loan Associations (Thrifts) Credit Unions Non-depository mortgage lending firms (e.g., Rocket Mortgage)

A downward sloping yield curve forecasts higher future interest rates. (T/F)

False

Investors in Collateralized Mortgage Obligations (CMO) securities are not exposed to prepayment risk. (T/F)

False

A STRIPS security is no longer subject to interest rate risks. (T/F)

False (STRIPS securities make it easier for investors to immunize against interest rate risks. However, a STRIPS security itself is still exposed to interest rate risks.)

Treasury Notes and Bonds are money market instruments. (T/F)

False (T-notes and bonds are long-term Treasury securities. Therefore the are both capital market instruments as opposed to money market instruments.)

Private Capital Market Regulatory Bodies

Financial Industry Regulatory Authority (FINRA). Organized privately by NYSE and NASDAQ Regulate brokers and dealers Subject to SEC's oversight and rule-making guidance

There are two types of municipal bonds

General obligation and revenue

Common underwriters of MBSs include:

Ginnie Mae (Government National Mortgage Association) Freddie Mac Fannie Mae Special Purpose Vehicles (SPVs of large investment banks)

Both Freddie Mac and Fannie Mae are

Government-Sponsored Enterprises (GSEs) that are implicitly guaranteed by the Federal Government

Munis Investors

Households are the largest investors of municipal bond Tax exemption is a major attraction for munis investors

There are three primary factors a mortgage lender considers in assessing a borrower's qualification

Income, Credit Score, Down payment

Renegotiated Rate Mortgages (RRMs)

Loan terms renegotiated periodically according to prevailing market term at the time of renegotiation Adjustment period is longer than traditional ARMs Payment is fixed while balance may change as a result of renegotiations Popular in Canada but rare in the U.S.

Overview of Capital Markets

Long-term (over 1 year) asset markets Participants' main purposes are mostly related to long-term projects Finance for firms' physical assets or long-term projects Finance for homeownerships Major Issuers in capital markets: corporations, financial intermediaries, governments (federal, state, and local) Major Investors in capital markets: households and financial intermediaries

2008 Financial Crisis on Long-term Bonds Markets

Long-term bonds markets experience a Flight to Safety during the 2008 crisis Investors in this market sell risky bonds to buy safe bonds (e.g. T-notes, T-bonds) Credit spreads between safe and risky bonds spiked

Interest rate risks remain a major concern for long-term bond investors because

Longer maturity means more exposure to interest rate risks

A typical financial asset traded in the money market has the following characteristics:

Low default risk, Short maturity, and High liquidity

Treasury Bills

Maturities up to one year Considered free of default risk Issued to investors through auctions conducted by the Treasury Department T-bills of 4-week, 13-week, and 26-week are offered every week T-bills of 52-week are offered every 4 weeks All offerings happen through auctions where the Treasury Department receive bids from investors for T-bills

Unlike T-bills, T-notes and T-bonds are both long-term securities

Notes - 1 to 10-year maturity Bonds - over 10-year maturity

Mortgage-Backed Securities have promoted the supply of home mortgages (T/F)

True

Mortgage-backed securities are more liquid than individual mortgages. (T/F)

True

General Obligation Municipal Bonds

- backed by taxing power of political entity, no collateral needed. Needs voters' approval before issue

Revenue Municipal Bond

- issued to finance a specific business projects (e.g. toll roads) and backed with cash flows from the project. The project serves as collateral for investors. No voters' approval is needed.

Short-term federal agency securities yield has been

1 to 20 basis points about similar Treasury securities The main reason for this yield spread is not default risks. For the most part it is due to liquidity reasons. The secondary market for federal agency securities are not as developed as similar Treasury securities Reasons for this include that less dealer-brokers are specialized in federal agency securities

Pass-through mortgage securities have standard denominations but uncertain cash flow. (T/F)

True

A T-note of 5% yield under an annual inflation rate of 3% would only give an investor

2% in real return

Banker's acceptance maturaies are standardized:

30, 60, 90, 180 days It is traded as discount and carries no coupon or interests (just like T-bills)

A T-bill trades at a 10% discount from par, maturing in 36 days. The discount yield is A. 1.00% B. 1.39% C. 1.19% D. need more information

A. 1.00% (Notes: discount yield=Par−PricePar×360Days to maturity×100% discount yield=Par−PricePar×360Days to maturity×100% discount yield=0.1×36036=0.1×10=1%discount yield=0.1×36036=0.1×10=1%)

A T-bill trades at a 20% discount from par, maturing in 73 days. The bond-equivalent yield is A. 1.25% B. 0.99% C. 1.01% D. need more information

A. 1.25% (Notes: bond equivalent yield=Par−PricePrice×365Days to maturity×100% bond equivalent yield=Par−PricePrice×365Days to maturity×100% bond equivalent yield=Par−0.8Par0.8Par×36573×100%=0.25×5=1.25%bond equivalent yield=Par−0.8Par0.8Par×36573×100%=0.25×5=1.25%)

Which of the following is not a mortgage-backed security? A. a jumbo mortgage B. a Ginnie Mae pass-through C. a collateralized mortgage obligation D. a stripped Fannie Mae pass-through

A. a jumbo mortgage

An increase in prepayment speed of a pass-through mortgage backed security (MBS) will result in A. a reduction in interest earned over the life of the pass-through B. an increase in principal earned over the life of the pass-through C. an increase in the rate of return over the investor's original investment horizon D. no change in principal but an increase in interest earned over the life of the pass-through

A. a reduction in interest earned over the life of the pass-through

The yield curve for AAA-rated municipal bonds should plot A. above that of U.S. Treasuries but below that of AAA-rated corporate bonds B. below that of U.S. Treasuries but above that of AAA-rated corporate bonds C. above that of both U.S. Treasuries and AAA corporates D. below that of both U.S. Treasuries and AAA corporates

A. above that of U.S. Treasuries but below that of AAA-rated corporate bonds

Which of the following is NOT one of money market instrument features A. small denominations B. low default risk C. low price risk D. high liquidity

A. small denominations

If average corporate bond and tax-exempt municipal bond rates were 8.33% and 6.25% respectively, at what marginal tax rate would an investor be indifferent between the two? A. 18% B. 25% C. 30% D. 33%

B. 25%

Suppose the 1-year spot rate is 1% and the 4-year spot rate is 3%. The implied forward rate on a 3-year security of the same risk class originating 1 year from now is A. 2.313% B. 3.676% C. 4.166% D. 3.767%

B. 3.676%

The original purpose of the Federal Home Loan Mortgage Corporation (Freddie Mac) was to A. make home loans to low income individuals. B. purchase conforming mortgages from mortgage originators. C. purchase FHA insured mortgages from financial institutions. D. purchase mortgages created by Ginnie Mae.

B. purchase conforming mortgages from mortgage originators.

A contract designed to use the equity in a home for retirement income without making any required payments is called a(n) A. rollover mortgage B. reverse mortgage C. adjustable-rate mortgage D. home equity loan

B. reverse mortgage

If negative amortization occurs on a mortgage this means that A. the monthly payment due on the mortgage has fallen. B. the amount due on the loan has increased. C. the interest rate on the mortgage has risen. D. the interest rate on the mortgage has fallen.

B. the amount due on the loan has increased.

Reverse Mortgages (RMs)

Banks pay periodically the homeowner to "buy out" the house Use by older people (62 years old and above) whose home mortgage have been paid off Can be thought of banks taking a mortgage from the homeowner, which explains the "reverse" part Banks seize the house when homeowner has to leave the house unless heirs repay the bank what they have paid to the original homeowner

three sub-markets of the capital markets:

Bond markets Mortgage markets Equity markets

Suppose a U.S Treasury note with 10 years to maturity yields 2 percent. An XYZ Corporation Bond with the same term to maturity yields 3 percent. Most of the difference is probably because of A. liquidity premium B. interest rate risk C. default risk D. purchasing power risk

C. default risk

Mortgage refinancing activity varies A. not much over time B. positively with mortgage rates C. inversely with mortgage rates D. at random

C. inversely with mortgage rates

T-bills are auctioned to the bidders who offer the A. highest premiums over par B. highest volumes of orders C. lowest discounts from par D. highest discounts from par

C. lowest discounts from par

A "repo" transaction is essentially A. an unsecured short-term loan B. an option transaction C. riskless D. a secured short-term loan

D. a secured short-term loan (collateralized)

The major determinant of the bond ratings assigned by Moody's, Standard and Poors, or Fitchs is A. marketability B. tax treatment C. term to maturity D. default risk

D. default risk

"Tranches" are not a way of A. allocating different levels of risk to different groups of investors B. allocating different levels of return to different groups of investors C. allocating the income from a securitized pool of assets D. diversifying the holdings of a securitized pool of assets

D. diversifying the holdings of a securitized pool of assets

Agency backed mortgage backed securities (MBSs) have interest rates above Treasury rates because MBSs A. are more liquid B. have substantially more default risk C. are tax advantaged investments D. have prepayment risks

D. have prepayment risks

The actual yield curve is usually more upward sloping than the one predicted by expectation theory because A. interest rate forecasts are usually wrong B. investors are indifferent between short maturities and long maturities C. shorter-term securities are more volatile D. investors usually demand a liquidity premium on longer-term securities

D. investors usually demand a liquidity premium on longer-term securities

Municipal Bonds Overview

Debt securities issued by state and local governments, also called munis. One of the largest segment of U.S. capital market

Treasury Inflation Protection Securities (TIPS)

In order to help protect investors from inflation risks, Treasury issues notes and bonds that adjust for inflation

Fixed Rate Mortgage

Interest rate of this type of mortgage is fixed throughout the life of the debt Most typical maturities of FRMs are 15 and 30 years Holding interest rate and principal constant, a longer mortgage means: Less payment required each month from the borrower Longer total time where monthly payment is required Cumulatively, more interests paid to the lender, which implies that the borrower pays more in total

Negotiable Certificates of Deposits Yield

Interest rates are negotiated between buyers and sellers. Rates mainly depend on the default risks of the bank: All banks have some default risks (after all, a bank is a firm; and all firms may go bankrupt) Unlike household deposits, NCDs are not insured by FDIC or any other insurance providers Therefore, NCD rates are always above safe debt securities such as T-bills NCDs issued by larger banks pay lower rate because their lower likelihood to bankrupt The spreads between larger banks NCD rates and those of smaller banks become bigger after 2008: the government bailout of large banks in 2008 convinced investors that large banks would never be allowed to fail this is part of the too-big-too-fail problems

Corporate bonds can also be categorized according to default risk ratings:

Investment grade and speculative grade (junk bonds)

Like other capital market deb instruments, mortgages can be securitized to create

Mortgage backed securities (MBS)

Main Characteristics of MBS

Most MBSs in the U.S. have the following characteristics: Issued in standard denominations (e.g., $25,000 a piece) Collateralized by underlying real estate assets Risks of individual mortgages in an MBS are diversified as many are pooled together Usually insured by either private or government entities using instruments such as Credit Default Swaps As a result, unlike individual mortgages MBSs are highly tradable Therefore, MBS secondary market is pretty active and lar

Overview of Mortgage Markets

Most common way to finance real estate purchases/investments: Single-family homes Multifamily homes Commercial real estate Farm lands Largest long-term debt market in the U.S. according to balance outstanding $10.3 trillion mortgage debt outstanding in 2020 Mortgage debt are always secured loans Collateral is the real estate If a borrower defaults, the lender seizes the house and get repaid through the foreclosure process No standard denominations for mortgage loans Depends on the value of the houses and how much home buyer would like to finance

Real Yield=

Nominal Yield-Inflation Rate

Rollover Mortgage (ROMs)

Refinanced at new interest rate every few years (e.g. every 5 years), frequency specified at the signing of contract. Adjustment period is longer than traditional ARMs. Popular in Canada but rare in the U.S.

Risks of Repo

Repos do not have lots of price risks due the short-term nature, prices tend not to change a lot over a repo's life Repos do not have lots of default risks. Repos are collateralized by safe and liquid securities (i.e. Treasury securities) In the event of default, investors seize the collaterals. Repos' risks concentrate on the value of collaterals Value of Treasuries may fall if interest rate goes up To compensate for the risks of collateral value, repo are typically issued with haircuts. A haircut is a discount of collateral value Example: a 10% haircut means that a bank may only get $90 with a $100 T-bill as collateral

Corporate bonds can be categorized according to priority of investor claims:

Secured bonds, Senior debt, and Subordinated (junior) debt

Public Capital Market Regulator:

Securities and Exchange Commission (SEC) Any capital market securities sold to the general public must be registered and approved by SEC. Private placements may get around SEC regulation

Federal Funds Market

Short-term interbank loans, typically overnight interbank loans Market for depository institutions Most liquid of all financial assets Related to monetary policy implementation A market for excess reserves---yields related to the level of excess bank reserves in the system

Prepayment risks may be caused by multiple very common situations:

The borrower simply pay down balance early to avoid paying interests The borrower needs to move and sell the house to pay off mortgage The borrower find opportunities to re-finance at lower interest rate.

Tranches

Tranches are sold separately to investors with different risk appetites. Typically Tranche A (Senior Tranche) will receive payments first. Tranche B (Mezzanine Tranche) is the in-between tranche. Tranche C (Junior Tranche) will receive payments last In the event of default, the order of absorbing losses is: junior tranches, mezzanine tranche, senior tranche. Junior tranches are sold with lower prices therefore higher yields

T-notes and T-bonds are issued in

Treasury Department auctions, similarly to T-bills

Agency backed CMOs are designed to help investors better choose the amount of prepayment risk they wish to face. (T/F)

True

An investor in the 33 percent tax bracket should buy a 6 percent municipal bond rather than a similarly rated 8.5 percent corporate bond. (T/F)

True

Credit Default Swaps can be used as an insurance against associated with Mortgage-Backed-Securities (T/F)

True

Default risk premiums are usually smaller during periods of high economic growth (T/F)

True

Money market instruments are traded through dealer-broker networks. (T/F)

True

Money market's main function is to satisfy participants' liquidity needs. (T/F)

True

Mortgage interests are computed on the declining principal. (T/F)

True

Repo's yield is also quoted assuming

a 360-day year

Fed funds yield (that is, the fed funds rate) is quoted assuming

a 360-day year (just like the discount yield of Treasury securities)

Securitization also helps increase

access to finance. Smaller firms may be able to borrow if their bonds can be pooled with those of large firms. Less wealthy households may be able to borrow if their mortgages can be pooled with those of wealthy households

As inflation affects real yield of a bond, it will in turn

affect the bond's price

Repurchase Agreement (Repo)

another common money market instrument: Like fed funds, repos are short-term interbank securities, typically over night Unlike fed funds, nonbank dealers can also access repo market and repos are collateralized Most widely used collaterals are Treasury securities

MBSs that are underwritten by government branches or GSEs

are agency securities, while those underwritten by private institutions are non-agency securities

Issues of commercial papers

are of large denominations--- $100,000 to $1 million a piece. A whole sale money market instrument---few direct individual investment. Individuals participate by investing in Money Market Mutual Fund (MMMF)

The word "negotiable" just means this type of CDs

are transferable or tradable before maturity. Firm A may sell its NCD from a bank to Firm B in order to get the money before maturity date. This feature allows the possibility of a secondary market of NCDs

Repos are a source of funding for

banks that need money. Sale of a certain security with agreement to buy it back later at a higher price Funding are raised via proceeds of the sale Securities sold serve as collateral

Larger banks (e.g. Bank of America) tend to be net

borrowers of fed funds (i.e. federal funds sold < federal funds purchased)

Since repos are collateralized, its yield

can be lower than the fed fund rate

Mortgage rates closely track those of

capital market Treasury securities Similarly to those Treasury securities, default risks are not of major concerns

T-notes and T-bonds are

capital markets debt securities issued by the Treasury Department. Like T-bills (money market), they are considered risk-free

Secured bonds:

collateralized by a firm's assets. In the event of default, investors of secured bonds are the first in line to claim on a firm's assets

Secondary market is limited for

commercial papers. Mainly because 98% of investors hold their commercial papers till maturity. Not much second-hand trading

A serial issue

contain different bonds with a range of maturity dates as well as coupon rates

Commercial paper is a major way for

corporations to raise short term funding in the money market

Both T-notes and T-bonds are

coupon bonds while T-bills are zero-coupon bonds

Firms sell their commercial papers through

dealers must pay the dealer an underwriting commission. Typically the commission is a fixed proportion of the sale: one-tenth to one-eighth of a percent. Direct placements on the other hand require the firm to bear legal and marketing costs. Large financial firms (e.g., Bank of America) that issue large amount of commercial paper usually choose direct placement. Avoid large amount of commissions to dealers These large usual have in-house investment banking department to help handle their commercial paper issuance

Commercial papers are sold on a

discount basis (just like T-bills) and carry no coupon

For short-term money market instruments (e.g. T-bills), inflation risks are

e largely negligible. There is unlikely to be much inflation over a short period of time (e.g. a few weeks) in the U.S

A STRIPS, or a strip, separates cash flow components of a T-notes/bonds into stand-alone securities:

each coupon payment and the principal payment become a separate zero-coupon bond These stripped components have distinct identification number (CUSIP) in the market

Income from any munis is

exempt from Federal taxation

Repo rates have been low since COVID-19 as a result of

expansionary monetary policy