Module 45 +

planned amortization class

-Amortized based on a sinking fund schedule that is established within a range of prepayment speeds called Initial PAC collar -Two prepayment rate schedules - lower rate and upper rate -Bondholders are guaranteed principal payments equal to the lower schedule -Highly predictible life -Planned amortization schedule promised to the PAC tranche is the minimum of the two prepayment speeds -PAC window - time period that principal is expected to be paid -Narrower the window, the more the PAC tranche resembles a corporate bond with a bullet payment

Futures contracts differ from forward contracts in the following ways:

-Futures contracts trade on organized exchanges. -Forwards are private contracts and typically do not trade. -Futures contracts are standardized. -Forwards are customized contracts satisfying the specific needs of the parties involved. -A clearinghouse is the counterparty to all futures contracts. -Forwards are contracts with the originating counterparty and therefore have counterparty (credit) risk. -The government regulates futures markets. ** interest rate swap is a forward because both parties have an obligation, while a stock option and credit default swap only one party has obligations

basic framework for evaluating and assigning a credit rating to sovereign debt includes five key areas

-Institutional assessment includes successful policymaking, minimal corruption, checks and balances among institutions, and a culture of honoring debts. -Economic assessment includes growth trends, income per capita, and diversity of sources for economic growth. -External assessment includes the country's foreign reserves, its external debt, and the status of its currency in international markets. -Fiscal assessment includes the government's willingness and ability to increase revenue or cut expenditures to ensure debt service, as well as trends in debt as a percentage of GDP. -Monetary assessment includes the ability to use monetary policy for domestic economic objectives (this might be lacking with exchange rate targeting or membership in a monetary union) and the credibility and effectiveness of monetary policy.

loan level call protection

-Prepayment lock out - specific period of time, borrower cannot prepay the loan -Defeasance - should borrower insist on making payments, loan proceeds can be received by loan servicer and invested in treasuries, creating collateral against the loan (higher quality) -Prepayment penalty points - penalty fee charged if the borrower prepays the loan. Typically higher in early years. Quoted as a 5-4-3-2-1 which is a decreasing percentage fee -Yield maintenance charges - borrower is charged the amount of interest lost by the lender should the loan be prepaid

The factors that must be considered when estimating the credit risk of a bond include:

-bond rating and recovery rate

2 components of credit risk

-default risk and loss severity

spread risk

-downgrade risk -market liquidity risk

what makes a bond have higher interest rate sensitivity

-longer -lower coupon rate

Character

-soundness of strategy -track record -acconting policies and tax strategies -fraud and malfeasance record -prior treatment of bondholders

are three sources of returns from investing in a fixed-rate bond:

1. Coupon and principal payments. 2. Interest earned on coupon payments that are reinvested over the investor's holding period for the bond. 3. Any capital gain or loss if the bond is sold prior to maturity.

three souces of commodities futures returns are:

1. Roll yield—The yield due to a difference between the spot price and futures price, or a difference between two futures prices with different expiration dates. Futures prices converge toward spot prices as contracts get closer to expiration. Roll yield is positive for a market in backwardation and negative for a market in contango. 2. Collateral yield —The interest earned on collateral required to enter into a futures contract. 3. Change in spot prices—The total price return is a combination of the change in spot prices and the convergence of futures prices to spot prices over the term of the futures contract.

yield spreads on corporate bond are affected primarily by

1. credit cycle 2. economic consitions 3. financial market perforamne 4. broker dealer capitl 5. genreal market demand and supply

relying on credit agencies risks

1. credit ratings are dynamic 2. rating agencies are not perfect 3. event risk is difficult to access 4. credit ratings lag market pricing

Hedge fund strategies

1. event driven ( merger arbitrage, distressed/restructure, activist shareholder, special situations) 2. relative value strategies ( convertible arbitrage fixed income, asset backed fixed income, general fixed income, volatility, mulitistrategy 4. macro strategies 4. equity hedge fund strategies ( market neutral, fundamental growth(high growth), fundamental value, quantitative directional , short bias)

VC life cycle

1. formative stage 2. later stage 3. Mezzanine

capacity

1. industry structure 2. industry fundamentals ( cyclicality, growth prospects, published statistics) 3. company fundamentals (competitive position, operating history, mgmt strategy and execution, ratio analysis)

due diligence

1. orgainization 2. portfolio mgmt 3. operations nad control 4. risk mgmt 5. legal review 6. fund terms

6 factors that determine option prices

1. price of underlying asset 2. teh exercise price 3. the rf rate of interest 4. volatility of the underlying 5. time to expiration 6. costs and benefits of holding the asset

Which of the following bonds would appreciate the most if the yield curve shifts down by 50 basis points at all maturities?

5-year 8%, 7.5% YTM. because they assume starts at 8% so would be better rate

key rate duration

A method of measuring the interest rate sensitivities of a fixed-income instrument or portfolio to shifts in key points along the yield curve. also known as partial duration

A waterfall structure

A waterfall structure, where principal losses are allocated first to the lowest priority securities issued, would most likely describe auto loan ABS or credit card ABS, which often have a senior-subordinated structure. Agency RMBS are pass-through securities and do not have a senior-subordinated structure.

HF Note

Adding hedge funds to traditional portfolios may not provide the expected diversification to an equity portfolio because return correlations tend to increase during periods of financial crisis.

Which of the following bonds has the shortest duration? A bond with a:

All else constant, a bond with a longer maturity will be more sensitive to changes in interest rates. All else constant, a bond with a lower coupon will have greater interest rate risk.

macaulay duration

An estimate of a bond's interest rate sensitivity based on years until promised cash flow will arrive; Cannot be used for bonds with options it is less when yield is higher nad maturity is shorter

4 cs of credit analysis

Capacity, Collateral, Covenants, Character

Which of the following classes of asset-backed securities typically includes a lockout period?

Credit card ABS typically have a lockout period during which principal payments by credit card borrowers are used to purchase additional credit card debt, rather than paid out to the ABS holders.

Collateralized Debt Obligation

Debt instrument where the collateral for the promise to pay is an underlying pool of other debt obligations; Tranches are created for seniority of cash flows

american option

Exercisable at any time; Will never have a smaller premium than a European option; More flexible

An institution is most likely to be restricted from investing in which of the following fixed income classifications?

High yield -classifed as non investment grade

Which of the following derivatives positions replicates investing at the risk-free rate?

Holding an asset and a short position in a forward contract on the asset.

The primary motivation for investing in the support tranche of a planned amortization class CMO, compared to investing in another tranche, is that the support tranche offers:

In a planned amortization class (PAC) CMO, the support tranches have more extension risk and more contraction risk than the PAC tranches. Because of these higher risks, the support tranches offer a higher interest rate than the PAC tranches.

non agency RMBS

In the United States, securities issued by private entities that are not guaranteed by a federal agency or a GSE.

call option to be in, out of, or at the money. S is the price of the underlying asset and X is the exercise price of the option.

In-the-money call options. If S − X > 0, a call option is in the money. S − X is the amount of the payoff a call holder would receive from immediate exercise, buying a share for X and selling it in the market for a greater price S. Out-of-the-money call options. If S − X < 0, a call option is out of the money. At-the-money call options. If S = X, a call option is said to be at the money.

brownfield investments

Investments in infrastructure assets that are already constructed

option writer

Long call: the buyer of a call option—has the right to buy an underlying asset. Short call: the writer (seller) of a call option—has the obligation to sell the underlying asset. Long put: the buyer of a put option—has the right to sell the underlying asset. Short put: the writer (seller) of a put option—has the obligation to buy the underlying asset.

duration gap

Macaulay duration - bonds investment horizon

sortino ratio

Measures risk as downside deviation rather than standard deviation.

long forward position

Party to the forward contract that agrees to buy the financial or physical asset

In which of the following ways is an interest rate swap different from a series of forward rate agreements (FRAs)?

The FRAs that replicate an interest rate swap may be off-market contracts.

Which of the following measures is lowest for a callable bond?

The interest rate sensitivity of a bond with an embedded call option will be less than that of an option-free bond. Effective duration takes the effect of the call option into account and will, therefore, be less than Macaulay or modified duration.

short forward position

The party to the forward contract who agrees to sell or deliver the asset

In a repurchase agreement, the repo rate is likely to be higher:

The repo rate tends to be higher for longer-dated repos than for shorter-dated repos. High quality collateral or delivery of the collateral reduces the repo rate.

contraction risk

The risk that when interest rates decline, the security will have a shorter maturity than was anticipated at the time of purchase because borrowers refinance at the new, lower interest rates.

Which of the following statements concerning the support tranche in a planned amortization class (PAC) CMO backed by agency RMBS is least accurate?

The support tranches are exposed to high levels of credit risk.

A real estate property valuation would least likely use:

The three approaches to valuing a property are income, comparable sales, and cost. An asset-based approach can be used for real estate investment trusts, but not for valuing individual real estate properties.

Convenience Yield

The value of having the physical commodity for use over the period of the futures contract.

Thus, the price increase when interest rates decline

Thus, the price increase when interest rates decline must be greater than the price decrease when interest rates rise (for the same basis point change).

How can a bank create a synthetic 60-day forward rate agreement on a 180-day interest rate?

To create a synthetic 60-day FRA on a 180-day interest rate, a bank would borrow for 240 days and lend the proceeds for 60 days, creating a 180-day loan 60 days from now.

basis swap

Trading one floating rate payment for another

An agency RMBS pool with a prepayment speed of 50 PSA will have a weighted average life that is:

Weighted average life of a mortgage pool is less than its WAM if there are any prepayments. "50 PSA" means the prepayment speed is assumed to be 50% of the Public Securities Association prepayment benchmark.

backwardation

When a futures price is below the spot price; Caused by hedgers to insure against price declines in the future; Some markets are described as having normal backwardation

open interest

`number of contracts outstanding

synthetic FRA

a bank can create the same payment structure with two LIBOR loans

The value of a call option on a stock is most likely to decrease as a result of:

a decrease in the risk-free rate of interest.

The put-call parity relationship for European options must hold because a protective put will have the same payoff as:

a fiduciary call.

Which of the following is a limitation of the portfolio duration measure? Portfolio duration only considers:

a linear approximation of the actual price-yield function for the portfolio.

leveraged buy outs

a restructuring strategy whereby a party buys all of a firm's assets in order to take the firm private funded primarily by debt

A synthetic European call option includes a short position in:

a risk-free bond.

collateralized mortgage obligations

a type of asset backed security. aka ones whose value and income payments are derived from or backed by a specific pool of underlying assets. Target single family homes. Issued by a private sector financing corp and usually backed by Ginnie Mae, Freddie Mac, Fannie Mae pass through securities. Usually rated AAA. Pays principal and interest from the mortgage pool, however it repays principal to one tranche at a time. In addition to interest payments, investors in a short term tranche must receive all of their principal before the next tranche gets paid. PP are made in $1000 increments to randomly selected bonds with a tranche. Changes in interest rates affect the rate of mortgage payments and in turn affects the flow of interest payment and principal repayment to the CMO investor.

hedge fund return objectives

absolute basis (e.g., 10%) or on a relative basis (e.g., returns 5% above a specific benchmark return)

With respect to European and American options, cash flows from the underlying asset may make:

an American call more valuable than an otherwise identical European call.

credit default swap

an insurance policy on the default risk of a corporate bond or loan

binomial model

an option valuation model predicated on the assumption that stock prices can move to only two values over any short time period

conditional prepayment rate

annualized measure of prepayments

Derivatives pricing models use the risk-free rate to discount future cash flows because these models:

are based on portfolios with certain payoffs.

prices based on durations

are underestimates of actual prices

Portfolio duration has limited usefulness as a measure of interest rate risk for a portfolio because it:

assumes yield changes uniformly across all maturities.

european option

can be exercised only at expiration

One key difference between sovereign bonds and municipal bonds is that sovereign issuers:

can print money

An annualized measure of the prepayments experienced by a pool of mortgages is its:

conditional prepayment rate.

The difference between a convertible bond and a bond with warrants is that a bondholder who exercises warrants:

continues to hold the bond after exercising the warrants.

Diversification benefits from adding hedge funds to an equity portfolio may be limited because:

correlations tend to increase during periods of financial crisis.

A synthetic collateralized debt obligation (CDO) is backed by a pool of:

credit default swaps

adding commodities to a portfolio

decreases portfolio variance

Put-call-forward parity

derived with a forward contract rather than the underlying asset itself

The price of an out-of-the-money option is:

equal to its time value.

Interest rate swaps are:

equivalent to a series of forward contracts.

law of one price

first is based on the law of one price. Two securities or portfolios that have identical cash flows in the future, regardless of future events, should have the same price.

The primary motivation for issuing collateralized mortgage obligations (CMOs) is to reduce:

funding costs

contango

futures price > spot price

A mortgage is most attractive to a lender if the loan:

has a prepayment penalty.

A call option that is in the money:

has an exercise price less than the market price of the asset.

Effective duration is more appropriate than modified duration for estimating interest rate risk for bonds with embedded options because these bonds:

have uncertain cash flows that depend on the path of interest rate changes.

notching

iiuer credit ratings vs an issue credit rating

One of the primary benefits of securitization is that it:

improves the legal claims of the security holders to the loans that are securitized.

A decrease in the risk-free rate of interest will:

increase put option prices and decrease call option prices.

Compared to an asset with no net cost of carry, holding costs that are greater than benefits:

increase the no-arbitrage price of the forward contract.

Cash flows related to futures margin least likely include:

interest on the margin loan.

greenfield investments

investments in infrastructure assets that are not yet constructed a

During the lockout period of a credit card ABS:

investors do not receive principal payments.

The underlying asset of a derivative is most likely to have a convenience yield when the asset:

is difficult to sell short.

The price of a fixed-for-floating interest rate swap:

is specified in the swap contract.

A mortgage-backed security has a pass-through rate of 4.3%. The average interest rate on its underlying pool of mortgages is 4.5%. The difference between these rates is most likely due to:

issuance and servicing costs.

Total cash flows to investors in an ABS issue are:

less than the total interest and principal payments from the underlying asset pool.

In a credit default swap (CDS), the buyer of credit protection:

makes a series of payments to a credit protection seller.

collateral analysis

more important for less creditworthy comapnies -intangible assets ( goodwill is a weak intangible) -depreciation (high could mean they are not investing sufficiently) -equity market capitalization (trades below BV is bad) -human and intellectual capital

An American call option is most likely to be exercised early when:

o receive a dividend paid by the underlying asset. Otherwise, there is no benefit to the holder from exercising an American call early because the call can be sold instead for its higher market value.

"investor writes"

opposite of whatever it is (call/put)

A mortgage that includes some repayment of principal in each payment, and has an outstanding principal balance at maturity, is most accuratelydescribed as a:

partially amortizing mortgage.

For the price of a futures contract to be greater than the price of an otherwise equivalent forward contract, interest rates must be:

positively correlated with futures prices.

mezzanine financing

refers to debt or preferred shares that are subordinate to the high-yield bonds issued and carry warrants or conversion features that give investors participation in equity value increases.

term structure of yield volatility

refers to the relation between the volatility of bond yields and their times to maturity

The price of a forward or futures contract:

remains the same over the term of the contract

It is least likely that a forward contract:

requires a margin deposit.

In a commercial mortgage-backed security (CMBS), which of the following is an example of CMBS-level call protection?

residual traunche different than loan call protections bc commercial

In a leveraged buyout, covenants in leveraged loans can:

restrict additional borrowing.

Other things equal, the no-arbitrage forward price of an asset will be higher if the asset has:

storage cost

A collateralized debt obligation (CDO) in which the collateral is a pool of residential mortgage-backed securities is most accurately described as a:

structured finance CDO.

For a forward contract on an asset that has no costs or benefits from holding it to have zero value at initiation, the arbitrage-free forward price must equal:

the future value of the current spot price.

At expiration, the exercise value of a call option is:

the greater of zero or the underlying asset price minus the exercise price.

non recourse loans

the lender has no claim against the assets of the borrower except for the collateral property itself

Maintenance Margin

the minimum margin that must be present at all times in a margin account

call option

the option to buy shares of stock at a specified time in the future

put option

the option to sell shares of stock at a specified time in the future

arbitrage

the process of buying a currency low and selling it high A portfolio of two securities that will produce a certain return that is greater than the risk-free rate of interest.

Securitization

the process of transforming loans or other financial assets into securities

prepayment risk

the risk that mortgages underlying a mortgage-backed security/pass-through will be paid off sooner than expected due to a drop in interest rates. Investors reinvest the principal at a lower rate going forward.

initial pac collar

the upper and lower bound on the actual prepayment rates for which the support tranches are sufficient to either provide or absorb actual prepayments in order to keep the PAC principal repayments on schedule

Arbitrage prevents:

two assets with identical payoffs from selling at different prices.

credit spreads widen

when economic conditions worsen

What is the most likely effect on yield spreads when demand for bonds is high and supply of bonds is low?

yield spreads will narrow

When computing the yield to maturity, the implicit reinvestment assumption is that the interest payments are reinvested at the:

yield to maturity at the time of the investment.