Aug 4 Ch 10
A collateralized debt obligation (CDO) is BEST defined as a type of:
A collateralized debt obligation (CDO) is a type of asset-backed security. A CDO is issued as a bond, which is backed (collateralized) by a pool of bonds, loans, and various other assets. Ownership of this type of security is typically in the form of a tranche (slice), with any given tranche from the CDO carrying a different maturity and risk level. The return an investor can expect from this type of investment is based on the credit quality of the underlying assets contained in the pool. CDOs are similar in structure to collateralized mortgage obligations (CMOs). These investment vehicles are broadly categorized as asset-backed securities.
Broker-dealers must offer customers educational material about the features of CMOs. This material must include:
A discussion of the characteristics and risks of CMOs. This includes: how changing interest rates may affect prepayment rates and the average life of the security, tax considerations, credit risk, minimum investments, liquidity, and transactions costs. A discussion of the structure of a CMO. This includes the different types of structures, tranches, and risks associated with each type of security. It is also important to explain to a client that two CMOs with the same underlying collateral may have different prepayment risk and different interest-rate risk. A discussion that explains the relationship between mortgage loans and mortgage securities A glossary of terms applicable to mortgage-backed securities
Which of the following securities is exempt from state taxes?
All of the choices listed are subject to state taxes except Treasury notes, which are U.S. government obligations and are subject to federal taxes, but exempt from state taxes.
All of the following statements are TRUE concerning both auction rate securities (ARSs) and variable-rate demand obligations (VRDOs), EXCEPT:
Although they are both long-term securities with short-term trading features, only VRDOs have a put feature that permits the holder to sell the securities back to the issuer or third party. Auction rate securities (ARSs) do not have this feature and, if the auction fails, the investor may not have immediate access to her funds. In addition, ARSs use an auction process to reset the interest rate on the securities, whereas the interest rate on a VRDO is reset by the dealer at a rate that allows the securities to be sold at par value.
Collateralized mortgage obligations (CMOs) make interest payments to investors:
CMOs are issued in minimum denominations of $1,000, are backed by pass-through securities (FNMA, GNMA, and FHLMC), and pay interest and principal monthly.
A CMO would be suitable for an investor seeking:
CMOs pay monthly income made up of interest, which is taxable, and principal, which is a tax-free return of capital. Due to the structure of a CMO, a fluctuating amount of principal is returned monthly, not at maturity, which makes CMOs different from most other fixed-income securities.
The PSA Model is used when pricing:
Collateralized mortgage obligations
If interest rates are increasing, the PSA Model will show that prepayment speeds on mortgages are:
Decreasing
Which of the following investors is LEAST likely to purchase a collateralized debt obligation (CDO)?
Due to their highly complex nature, CDOs are generally not suitable for retail investors. A CDO (collateralized debt obligation) is a sophisticated financial instrument that begins with an individual loan (such as a mortgage or corporate debt). These loans are placed in a pool, and investors then purchase a security (bond, tranche, slice) that represents an interest in that pool. Each of these securities has a different maturity and credit risk, depending on the nature of the collateral behind it. This type of investment carries many risks and considerations that make it largely unsuitable for a typical retail investor.
Private label mortgage-backed securities are issued by which of the following entities?
Financial institutions
A GNMA pass-through is quoted 98.10 to 98.18. This quote represents a spread per $1,000 face value of:
GNMA pass-through certificates (as well as T-notes and T-bonds) are quoted in 32nds of a point. The spread of .08 represents 8/32 or 1/4 (.25) of a point. One point (1%) for a bond is equal to $10 ($1,000 x 1%); therefore, 1/4 of a point is equal to $2.50 per $1,000.
Which TWO of the following choices are characteristics of GNMA pass-through certificates?
GNMA pass-through certificates are guaranteed by the U.S. government. Interest and principal payments are received monthly and, therefore, the investor will receive principal payments before, not at maturity. The interest is subject to federal, state, and local taxes.
Which of the following statements is NOT TRUE concerning the Student Loan Marketing Association (Sallie Mae)?
It issues securities that can be redeemed to pay for college education
An investor buys T-bonds on Friday, January 16 for cash settlement. This transaction will settle on:
January 16
When evaluating two CMOs backed by GNMAs, one having a 6% yield and the other having a 10% yield, which TWO of the following statements are TRUE?
Prepayment risk measures the possibility that homeowners will refinance (prepay) their mortgages. Historically, the speed of prepayment increases when interest rates fall. If this happens, payments will flow into the CMOs at an accelerated rate, forcing investors to reinvest these monies at lower-than-anticipated rates. Therefore, the CMO with the higher interest rate will have higher prepayment risk. GNMA-backed CMOs are highly rated and, therefore, have little credit risk. Since both CMOs are backed by GNMAs, credit risk is minimal for both pools.
Which of the following is NOT TRUE of private label CMOs?
Private label mortgage-backed securities are issued by financial institutions such as commercial banks, investment banks, and home builders and they contain some agency securities. However, a private label MBS typically contains other types of mortgage loans that are not agency securities. A private label MBS is not an obligation of the U.S. government or any GSE and its credit rating is assigned by an independent credit agency. A private label MBS has higher credit risk and is generally not given a AAA rating. (88238)
If a broker-dealer is preparing sales literature on CMOs, which TWO of the following statements is TRUE?
Retail communications (e.g., sales literature) and correspondence that relate to collateralized mortgage obligations (CMOs) are subject to special rules. The term collateralized mortgage obligation must be included within the name of the product and it must disclose that the backing of a government agency only applies to the face value of the securities (not any premium paid). In other words, if the client paid a premium to purchase a CMO, only the par value is backed by the entity backing the security. Only the actual coupon rate, not the spread above Treasuries, is required to be disclosed. Due to the prepayment risk of CMOs, the yield to average life is required to be disclosed, not the yield-to-call or yield-to-maturity.
A 3-month Treasury bill is issued at a discount to yield 9.5%, and a corporate bond is issued to yield 9.5%. The bond is to mature in 10 years. If both are offered on the same day on a bond equivalent yield basis, which of the following statements is TRUE?
T-bills are issued and quoted on a discount yield basis, whereas corporate bonds are quoted on a yield-to-maturity basis. These yields are calculated in different manners. The bond equivalent yield of a T-bill is always higher than its discount yield.
Federal Farm Credit System
The Federal Farm Credit System is composed of the Banks for Cooperatives, Federal Intermediate Credit Banks, and Federal Land Banks.
Which TWO of the following choices are types of securities that are issued by the Federal Home Loan Bank?
The Federal Home Loan Bank issues two types of securities to raise capital—discount notes with maturities of one year or less and consolidated bonds with maturities of up to 30 years. These funds that are raised are used to provide funds to FHLB member banks that, in turn, lend these funds to their customers.
Student Loan Marketing Association
The Student Loan Marketing Association (known as SLMA or Sallie Mae) provides liquidity to student loan makers by purchasing federally sponsored student loans. It also lends funds directly to educational institutions. Sallie Mae securities are not backed by the full faith and credit of the U.S. government, but the SLMA maintains a direct line of credit with the U.S. government. It does not issue securities that can be redeemed to pay for college education.
T-bills purchased at the weekly auction will have a settlement date on the:
The auction for 13- and 26-week T-bills is held each Monday. Settlement is on Thursday of the same week.
Which of the following bonds has the most interest-rate risk?
The bond with the most interest-rate risk or price volatility is the bond with the longest maturity and the lowest coupon. This price sensitivity is based on the concept of duration. The first step is to identify the bond or bonds that have the longest maturity. In this question, there are two bonds with 30-year maturities, which eliminates the possibility of the three-month and five-year bonds as the answer. The second step is to find the long-term bond that offers the lowest coupon rate. Since a T-STRIP is a form of zero-coupon bond, it clearly has more interest-rate risk than another long-term bond that offers a 6% coupon.
Which TWO of the following statements are TRUE concerning the auction process for Treasury bills?
The four-week Treasury bill is auctioned on Tuesday of each week, with the issuance made on Thursday of that same week. Both the 13-week and 26-week T-bills are auctioned on Monday of each week, with the issuance on Thursday of that same week. All T-bills are issued (and traded) at a discount. At the auction, non-competitive tenders are awarded first; however, the price they will pay (the lowest price of the accepted competitive tenders) cannot be determined until after the competitive tenders have been awarded.
Which of the following CMOs has the LEAST prepayment risk?
The planned amortization class (PAC) is a type of CMO that is designed for more risk-averse investors and provides a predetermined schedule of principal repayment, as long as mortgage prepayment speeds are within a certain range. This greater predictability of maturity is accomplished by establishing a sinking-fund type of schedule. The PAC tranche has top priority and receives principal payments up to a specified amount. Any excess principal goes to a companion or support tranche that has lower priority. Holders of the companion tranche are generally compensated for this risk with higher yields.
Which of the following risks is considered unique to an investor holding a CMO?
The risk that an investor will receive her principal earlier than projected (prepayment risk) is the most important risk concerning mortgage-backed securities such as CMOs. Although all fixed-income securities will have interest-rate risk, prepayment risk is unique to CMOs. Most CMOs are highly rated due to the underlying mortgages backing these securities.
The tranche with the longest maturity and, therefore, the last to receive interest and principal payments within a CMO, is known as the:
The separate classes of a CMO are known as tranches. The longest maturity is frequently called the Z-tranche or the accrual bond, and does not receive interest or principal payments until the shorter maturing tranches have been retired.
Which of the following statements is TRUE concerning a customer who purchases an original issue discount (OID) U.S. government security?
The upward adjustment in the purchase price of an original issue discount bond is called accretion. The amounted accreted each year is considered interest income, which may or may not be taxable depending on the type of security. The interest on U.S. government securities is subject to federal income tax, but exempt from state and local income taxes.
Which of the following statements are TRUE relating to the auction of T-bills?
Three- and six-month T-bills are auctioned weekly. All T-bills are auctioned on a discount-yield basis with noncompetitive tenders awarded first and receiving the highest yield (lowest price) of the accepted competitive tenders. These securities are highly liquid and may be sold by a purchaser anytime prior to maturity.
An investor purchases a U.S. Treasury bond in the secondary market. When is settlement?
Transactions for Treasury securities in the secondary market settle on the next business day.
Which TWO of the following securities are typically sold at a discount?
Treasury bills and bankers' acceptances are typically sold at a discount. The amount of interest is based on the difference between the purchase price and the face value.
An article in The Wall Street Journal states that yields on Treasury bills have declined in the past month to 4.58% from 4.61%. This indicates that:
Treasury bills are purchased at a discount from the dollar amount on its face. The larger the discount, the higher the discounted yield to maturity. In this example, the discounted yield to maturity has gone down to 4.58% from 4.61% from the previous month. This indicates that buyers of new bills paid more for the Treasury bills (meaning the discount was less) than buyers paid the previous month.
A Treasury bond has increased in value from 98.4 to 98.8. The bond has increased by:
Treasury bonds are quoted in 32nds of a point, and are then calculated as a percentage of the par value ($1,000). The difference between 98.4 and 98.8 is 4/32. One point equals $10, so 4/32 or 1/8 of a point equals $1.25.
If a customer bought $50,000 par value of Treasury notes on July 3, when will payment be due?
U.S. government notes have a next-business-day settlement and delivery date. Therefore, payment is due for the notes on the next business day, which is July 5. Remember, July 4 is a U.S. national holiday and is not considered a business day.
CMOs
have become very popular since investors are able to choose the yield, maturity structure, and risk exposure that best meets their needs. CMOs help minimize the prepayment risk that is associated with traditional mortgage-backed securities by repackaging their principal and interest payments.
Fannie Mae and Freddie Mac
issue bonds and notes that pay interest semiannually and have a fixed maturity date. These notes and bonds have no prepayment risk
tranche
rate of interest, repayment schedule, and priority level.
—non-marketable or non-negotiable
savings bonds
Savings bonds are considered non-negotiable because
they may not be sold in the secondary market; instead, they may be redeemed only by the U.S. government.
