Equations

T-Bills mature in 52 weeks or less, while Treasury Receipts are long term bonds stripped of coupons (long term zero coupon obligations). Both are guaranteed by the U.S. Government; interest is paid at maturity; and both trade at a discount until maturity.

Once the Federal government started "stripping" bonds itself (in 1986) and selling them to investors, the market for broker-created T-Receipts evaporated. However, you still must know the basics of these securities for the exam.

Which statement is TRUE about private CMOs?

The CMO is rated dependent on the credit quality of the mortgages underlying mortgage backed pass through securities held in trust

Standard and Poor's Bond Guide is published on the web, and gives capsule summaries of every outstanding corporate issue, including recent price, rating, and yield.

The Standard and Poor's Bond Guide includes information on: Correct answer A. You chose this answer A Corporate Bonds

Market uncertainty regarding future interest rate levels would indicate that the yield curve should be:

flat

CDO tranches:

have underlying mortgage collateral that is backed only by the credit quality of those mortgages are rated based on the credit quality of the underlying mortgages

Corporate and municipal bond trades settle in clearing house funds.

hese are funds payable at a registered clearing house, which are usually not good funds for three business days. These trades are settled through NSCC - the National Securities Clearing Corporation.

Purchasing power risk is the risk that:

inflation will reduce the value of future interest payments

During a period when the yield curve is normal:

long term bond prices are more volatile than short term bond prices Whether the yield curve is ascending (normal), flat or descending, long term bond prices always move faster than short term bond prices, as interest rates change. This is due to the compounding effect on the bond's price that occurs, which increases with longer maturities.

When compared to plain vanilla CMO tranches, Planned Amortization Classes have:

lower prepayment risk

CMO investors are subject to all of the following risks EXCEPT:

Default risk

The smallest denomination available for Treasury Bills is:

$100

The minimum denomination on a mortgage backed pass through certificate is:

$25,000

Which investment gives the LEAST protection against purchasing power risk?

10 year Treasury "STRIPS" Treasury STRIPS are zero-coupon Treasury obligations - these have the highest level of purchasing power risk

Which statement is TRUE about a Targeted Amortization Class (TAC)?

A TAC is a variant of a PAC that has a higher degree of extension risk

Which statement is TRUE about PO tranches? Correct answer A. You chose this answer A When interest rates rise, the price of the tranche falls

A PO is a Principal Only tranche. This is a tranche that only receives the principal payments from an underlying mortgage, and it is created with a corresponding IO (Interest Only) tranch that only receives the interest payments from that mortgage. The principal portion of a fixed rate mortgage makes smaller payments in the early years, and larger payments in the later years. Because of this payment structure, it is most similar to a long-term bond, which pays principal at the end of its life. These are issued at a deep discount to face. Its price moves just like a conventional long term deep discount bond. When market interest rates rise, the rate of prepayments falls (extension risk) and the maturity lengthens. Because the principal is being paid back at a later date, the price falls. Conversely, when market interest rates fall, the rate of prepayments rises (prepayment risk) and the maturity shortens. Because the principal is being paid back at an earlier date, the price rises.

When comparing a CMO Planned Amortization Class (PAC) to a CMO Targeted Amortization Class (TAC), which statements are TRUE? I PACs are similar to TACs in that both provide call protection against increasing prepayment speedsII PACs differ from TACs in that TACs do not offer protection against a decrease in prepayment speedsIII PAC holders have a degree of protection against extension risk that is not provided to TAC holdersIV TAC pricing will be more volatile compared to PAC pricing during periods of rising interest rates

A Targeted Amortization Class (TAC) is a variant of a PAC. A PAC offers protection against both prepayment risk (prepayments go to the Companion class first) and extension risk (later than expected payments are applied to the PAC before payments are made to the Companion class). A TAC bond protects against prepayment risk; but does not offer the same degree of protection against extension risk. A TAC bond is designed to pay a "target" amount of principal each month. If prepayments increase, they are made to the Companion class first. However, if prepayment rates slow, the TAC absorbs the available cash flow, and goes in arrears for the balance. Thus, average life of the TAC is extended until the arrears is paid. Therefore, both PACs and TACs provide "call protection" against prepayments during period of falling interest rates. TACs do not offer the same degree of protection against "extension risk" as do PACs during periods of rising interest rates - hence their prices will be more volatile during such periods.

guaranteed corporate bond

A guaranteed corporate bond is one guaranteed by another corporation.

If market interest rates fall, the homeowners will repay their mortgages faster because they will refinance and use the proceeds to pay off their old high rate mortgages that collateralize this mortgage-backed security. In effect, the maturity will shorten and the investor will be returned principal faster, which will have to be reinvested at lower current rates - another example of reinvestment risk.

A wealthy retired investor is interested in buying Agency mortgage backed securities collateralized by 30-year mortgages as an investment that will give additional retirement income. When discussing this with the client, you should advise him that if market interest rates fall: Correct answer A. You chose this answer A principal will be repaid earlier than anticipated and will need to be reinvested at lower rates, generating a lower level of income

Which statement is TRUE regarding the tax treatment of the annual adjustment to the principal amount of a Treasury Inflation Protection Security?

An annual upward adjustment due to inflation is taxable in that year; an annual downward adjustment due to deflation is tax deductible in that year. If the principal amount of a Treasury Inflation Protection Security is adjusted upwards due to inflation, the adjustment amount is taxable in that year as ordinary interest income. Conversely, if the principal amount of a Treasury Inflation Protection Security is adjusted downwards due to deflation, the adjustment is tax deductible in that year against ordinary interest income. (TIPS are usually purchased in tax qualified retirement plans that are tax-deferred. This avoids having to pay tax each year on the upwards principal adjustment.)

During a period when the yield curve is flat:

B long term bond prices are more volatile than short term bond prices

Current dealer offerings of corporate bonds can be found in:

Bloomberg Quote providers such as Bloomberg and Reuters give dealer to dealer prices (the "wholesale" market) for corporate bonds daily. The Bond Buyer is the municipal new issue newspaper. Moody's and Fitch's rate bonds - they are not quote providers.

Moody's Investment Grade (MIG) rating is used for:

Municipal short term notes

CMBs are Cash Management Bills. They are sold at auction by the Treasury on an "as needed" basis to meet unexpected cash shortfalls, so they are not part of the regular auction cycle. They are the shortest-term U.S. government security, often with maturities as short as 5 days. They are sold in $100 minimums at a discount to par value, just like Treasury Bills.

CMBs are sold at a discount to par CMBs are sold on an "as needed" basis

Which of the following statements are TRUE about CMOs in a period of rising interest rates?

CMO prices fall faster than similar maturity regular bond pricesIII The expected maturity of the CMO will lengthen due to a slower prepayment rate than expected

CMO holders are paid interest semi-annually

CMOs are subject to a lower level of prepayment risk than a pass through certificate

What is the benefit of a zero coupon bond?

Capital appreciation

Arrange the following CMO tranches from highest to lowest yield:

Companion Plain vanilla Targeted amortization class Planned amortization class

Which CMO tranche has the least certain repayment date?

Companion Class Companion classes are "split off" from the Planned Amortization Class (PAC) and act as buffers absorbing prepayment and extension risk prior to this risk being applied to the PAC tranche. The PAC, which is relieved of these risks, is given the most certain repayment date. The Companion, which absorbs these risks first, has the least certain repayment date. A Targeted Amortization Class (TAC) is like a PAC, but is only buffered for prepayment risk by the Companion; it is not buffered for extension risk.

If interest rates rise, their prices will drop, with longer maturity and lower coupon issues dropping much faster than shorter maturity and higher coupon issues

Credit risk for federal agency securities is a bit higher than for U.S. Governments because they are not directly backed, they are only implicitly backed (making Choice C incorrect). Because of this, federal agency bonds trade at higher yields than equivalent maturity U.S. Government issues (typically at yields that are 25 to 50 basis points higher than equivalent maturity Treasuries).

Which of the following would cause the yield curve to be ascending?

D Short term yields declining at the same time as long term yields are increasing

Treasury Receipts pay interest:

D at maturity

The interest received from a Collateralized Mortgage Obligation is subject to:

Federal, State and Local income tax

A Freddie Mac buys conventional mortgages from financial institutions Incorrect answer B. You did not choose this answer. B Freddie Mac is an issuer of mortgage backed pass-through certificates Incorrect answer C. You did not choose this answer. C Freddie Mac is a corporation that is publicly traded

Freddie Mac - Federal Home Loan Mortgage Corporation - buys conventional mortgages from financial institutions and packages them into pass through certificates. Freddie Mac pass through certificates are not guaranteed by the U.S. Government (unlike GNMA pass through certificates). This agency has been partially sold off to the public as a corporation that was listed on the NYSE. Freddie is now bankrupt due to excessive purchases of bad "sub prime" mortgages and has been placed in government conservatorship. Its shares have been delisted from the NYSE and now trade OTC in the Pink OTC Markets.

Which statements are TRUE when comparing Companion CMO tranches to "plain vanilla" CMO tranches?

Holders of Companion CMO tranches have higher prepayment risk Holders of "plain vanilla" CMO tranches have lower prepayment risk

The trust indenture of a bond would include which of the following information?

I Interest rateII MaturityIII Collateral backing the issueIV Call provisions

CMOs are:

I available in $1,000 denominations IV quoted in 1/32nds CMOs are available in $1,000 denominations unlike the underlying pass-through certificates which are available only in $25,000 denominations. CMOs are quoted in 32nds, similar to the underlying pass-through certificates. Often CMO tranches are quoted on a "yield spread" basis to equivalent maturing Treasury issues.

Which of the following statements are TRUE regarding the trading of government and agency bonds?

II The securities are quoted by dealers in 1/32nds III The trading market for governments and agencies is active

Exchange rate risk is a factor to consider when investing in foreign debt issues and the:

II U.S. dollar appreciates in valueIII foreign currency depreciates in value

A declining rate of inflation would lead to:

II higher bond pricesIII lower bond yields

If Treasury bill yields are dropping at auction, then interest rates are falling and debt prices must be rising.

If Treasury bill yields are dropping at auction, this indicates that: I interest rates are falling Treasury bill prices are rising

The purchaser of a CMO tranche experiences extension risk during periods when interest rates: Correct answer A. You chose this answer A rise

If interest rates rise, then homeowners will defer moving at the anticipated rate, since they have a "good" deal with their existing mortgage. Thus, the expected mortgage repayment flows from the underlying pass-through certificates slow down, and the expected maturity of the CMO tranches will lengthen. This is extension risk - the risk that the CMO tranche will have a longer than expected life, during which a lower than market rate of return is earned.

Which statements are TRUE regarding Treasury Inflation Protection securities?

In periods of deflation, the amount of each interest payment will decline In periods of deflation, the principal amount received at maturity is unchanged at par

Which of the following bonds trades "flat"?

Income bonds

Which statements are TRUE regarding Z-tranches?

Interest is paid after all other tranches Principal is paid after all other tranches

Which statement is TRUE regarding the effect of a repurchase of Treasury Stock?

Outstanding sharesare reduced and Earnings Per Share are increased

Which of the following statements are TRUE regarding CMO "Planned Amortization Classes" (PAC tranches)?

PAC tranches reduce prepayment risk to holders of that tranche Principal repayments made later than expected are applied to the PAC prior to being applied to the Companion tranche The PAC tranche is a "Planned Amortization Class." Surrounding this tranche are 1 or 2 Companion tranches. Interest payments are still made pro-rata to all tranches, but principal repayments made earlier than that required to retire the PAC at its maturity are applied to the Companion class; while principal repayments made later than expected are applied to the PAC maturity before payments are made to the Companion class. Thus, the PAC class is given a more certain maturity date; while the Companion class has a higher level of prepayment risk if interest rates fall; and a higher level of so-called "extension risk" - the risk that the maturity may be longer than expected, if interest rates rise.

Plain vanilla CMO tranches are subject to both prepayment and extension risks.

PACs protect against prepayment risk, by shifting this risk to an associated Companion tranche. Thus, PACs have lower prepayment risk than plain vanilla CMO tranches.

Which statements are TRUE about IO tranches?

Payments are larger in the early years Payments are smaller in the later years When interest rates rise, the price of the tranche risesIII When interest rates fall, the price of the tranche falls

Wide swings in market interest rates would affect which of the following for holders of collateralized mortgage obligations?

Prepayment Rate Market Value If market interest rates drop substantially, homeowners will refinance their mortgages and pay off their old loans earlier than expected. Thus, the prepayment rate for CMO holders will increase. Furthermore, as interest rates drop, the value of the fixed income stream received from those mortgages increases, so the market value of the security will increase. Market interest rate movements have no effect on the stated interest rate paid by the security; and would not affect the credit rating of the issue.

ortgage backed security's "PSA" stands for:

Prepayment speed assumption Mortgage backed pass-through certificates are "paid off" in a shorter time frame than the full life of the underlying mortgages. For example, 30 year mortgages are now typically paid off in 10 years - because people move. This "prepayment speed assumption" is used to "guesstimate" the expected life of a mortgage backed pass-through certificate. Note, however, that the "PSA" can change over time. If interest rates fall rapidly after the mortgage is issued, prepayment rates speed up; if they rise rapidly after issuance, prepayment rates fall.

Which of the following statements are TRUE when comparing CMO PAC tranches to Companion tranches?

Principal repayments made earlier than expected are applied to the Companion class before being applied to the PAC Principal repayments made later than expected are applied to the PAC before being applied to the Companion class

Which statements are TRUE regarding the principal repayments for Companion CMO tranches?

Principal repayments made earlier than expected are applied to the Companion class prior to being applied to the Planned Amortization class principal repayments made later than expected are applied to the Planned Amortization class prior to being applied to the Companion class

U.S. Government Agency securities are:

Quoted in 1/32nds Traded with accrued interest computed on a 30 day month / 360 day year basis

When the yield curve is inverted, which of the following statements are TRUE?

Short term rates are higher than long term rates To maximize income, an investor should invest in short term maturities

A company that has issued first mortgage bonds is declared in default by the trustee. Which statements are TRUE?

The bondholders have legal claim to the property backing the bond The bondholders may sell the property to satisfy the unpaid obligation

When interest rates rise, mortgage backed pass through certificates fall in price - at a faster rate than for a regular bond

This is true because when the certificate was purchased, assume that the average life of the underlying 15 year pool (for example) was 12 years. Thus, the certificate was priced as a 12 year maturity. If interest rates rise, then the average maturity will lengthen, due to a lower prepayment rate than expected. If the maturity lengthens, then for a given rise in interest rates, the price will fall faster. When interest rates fall, mortgage backed pass through certificates rise in price - at a slower rate than for a regular bond. This is true because when the certificate was purchased, assume that the average life of the underlying 15 year pool (for example) was 12 years. Thus, the certificate was priced as a 12 year maturity. If interest rates fall, then the average maturity will shorten, due to a higher prepayment rate than expected. If

Which of the following statements are TRUE regarding corporate obligations?

Though a very small amount of corporate bonds are traded on the NYSE (in a separate trade matching computer), most of the trading volume takes place over-the-counter between corporate bond dealers such as Goldman Sachs and other firms. Corporate bonds are traded on the NYSE Corporate bonds are traded over-the-counter (mostly)

Which security has, as its return, the "pure" interest rate?

Treasury Bill

If interest rates are rising rapidly, which U.S. Government debt prices would be MOST volatile?

Treasury Bonds

The physical securities which are the underlying collateral for Treasury Receipts are:

Treasury Notes The physical securities which are held in trust against the issuance of Treasury Receipts are either Treasury Notes or Treasury Bonds. Treasury Bills cannot be used because their maturities are too short; Series EE bonds (savings bonds) cannot be used because they are non-marketable.

Which of the following trade "and interest" ?

Treasury Notes, Treasury Bonds, Municipal Bonds. not t bills - they trade flat Original issue discount obligations (i.e. T-Bills) trade "flat" - without accrued interest. Every day the issue is held, its value increases towards the redemption price of par. This increase in value is the interest income earned on the obligation. Obligations issued at par make periodic interest payments. They trade "and interest" - with accrued interest. These include Treasury Notes, Treasury Bonds, and Municipal Bonds.

Which security does not earn interest?

Treasury Stock Treasury Stock does not earn interest, nor does it receive dividends. Treasury notes and bonds pay interest semi-annually; Treasury Strips are original issue discount Treasury obligations. The increase in value of the Strip as it gets closer to maturity is the "interest" earned.

Treasury bonds: I are issued in minimum $100 denominations

Treasury bonds are issued at par in minimum denominations of $100 each, and pay interest semi-annually. At maturity, the bondholder receives par.

When comparing the effect of changing interest rates on prices of a CMO issues versus the prices of regular bond issues, which of the following statements are TRUE?

When interest rates rise, mortgage backed pass through certificates fall in price faster than regular bonds of the same maturity When interest rates fall, mortgage backed pass through certificates rise in price slower than regular bonds of the same maturity

During a period when the yield curve is flat: Correct answer A. You did not choose this answer. A short term rates are more volatile than long term rates

Whether the yield curve is ascending (normal), flat or descending, the true statement always is that short term rates are more volatile than long term rates. Short term rates are susceptible to Federal Reserve influence, and move much faster than do long term rates. Long term rates respond more slowly; and reflect longer term expectations for inflation and economic growth, among other factors.

Marketability risk is the risk that a security will be difficult to sell.

Which of the following will increase the marketability risk of a bond? Inactive trading in that security Large block size transaction amount

A government securities dealer quotes a 3 month Treasury Bill at 6.00 Bid - 5.90 Ask. A customer who wishes to sell 1 Treasury Bill will receive:

a dollar price quoted to a 6.00 basis Treasury Bills are quoted on a yield basis. From the basis quote, the dollar price is computed. A customer who wishes to sell will receive the "Bid" of 6.00. This means that the dollar price will be computed by deducting a discount of 6.00 percent from the par value of $100.

Series EE bonds:

are non-negotiable pay interest at redemption Series EE bonds are "savings bonds" issued by the U.S. Government with a minimum purchase amount of $25 (or more). The interest rate is set at the date of issuance. Interest is "earned" monthly and credited to the principal amount every 6 months. The bonds have no stated maturity - the holder can redeem at any time, however interest is only credited to the bonds for 30 years. Savings bonds do not trade - they are issued by the Treasury and are redeemed with the Treasury (a bank can act as agent for the Treasury issuing and redeeming Series EE bonds). No physical certificates are issued - the bonds are issued in electronic form.

Private CMOs are

assigned credit ratings by independent credit agencies based on their structure, issuer, and collateral

A bond that was originally sold at par is now trading in the market at a premium. The bond is called at par. This action will be a detriment to the

bondholder The bondholder, on the other hand, is receiving par value for the bonds and now must reinvest those funds in new bonds to keep receiving income. The only problem is that yields have dropped, so the bondholder will now get less income. Furthermore, the bondholder gets no compensation for this because the bonds are called at par (there is no call premium).

All of the following are true statements about discount bonds

bonds trading at a discount can indicate that the issuer's rating has deteriorated bonds trading at a discount are more likely to be called than bonds trading at a premium a bond trading at a discount can indicate that interest rates have risen If a bond issued at par is trading at a discount, it indicates that either market interest rates have risen; or that the issuer's rating has deteriorated. As interest rates fall, discount bonds will appreciate at a faster rate than will premium bonds. The change in value of the bond's price is a result of an increased "present value" of the remaining interest payments to be received. This increase in the "value" of the remaining interest payments is a larger percentage of a discount bond's price than of a premium bond's price. Thus, as interest rates drop, discount bond prices rise faster than premium bond prices. Similarly, as interest rates rise, discount bond prices fall faster than premium bond prices. If the bond is trading at a discount and is then called, then the issuer will have to pay par for the bonds. Why not, instead of paying par, purchase the bonds at the current market price? It would be better to pay the discount than the full market value. Furthermore, a bond trading at a discount indicates that market interest rates have risen - why would an issuer call in such an issue, when it has a bargain interest rate? The only bonds that are likely to be called are those trading at premiums - meaning that market interest rates have fallen. The issuer can call in the premium bonds at a price close to par, and refund at lower current market interest rates.

All of the following are true statements regarding corporate obligations

debentures are usually term issues commercial paper is usually sold at a discount corporate yields are higher than municipal yields Debentures are usually term issues - all bonds having the same interest rate and maturity. Commercial paper is sold at a discount and matures at par - note that this is true for almost all money market securities. Corporate yields are higher than municipal yields because the interest income is fully taxable. Though a very small amount of corporate bonds are traded on the NYSE (in a separate trade matching computer), most of the trading volume takes place over-the-counter between corporate bond dealers such as Goldman Sachs and other firms.

A collateralized mortgage obligation is best defined as a(n):

derivative product

Price volatility of a CMO issue would most closely parallel that of an equivalent maturity: Correct answer A. You did not choose this answer. A Treasury bond

ecause CMO issues are divided into tranches, each specific tranche has a more certain repayment date, as compared to owning a mortgage backed pass-through certificate. Thus, the price movement of that specific tranche, in response to interest rate changes, more closely parallels that of a regular bond with a fixed repayment date. As interest rates rise, CMO values fall; as interest rates fall, CMO values rise.

Yield quotes for collateralized mortgage obligations are based upon:

expected life of the tranche Yield quotes on CMOs are based on the expected life of the tranche that is quoted. Do not confuse this with the "average life" of the mortgages in the pool that backs the CMO. This pool, with say an average life of 12 years, is "chopped-up" into many different tranches, each with a given "expected life." For example, there may be 10 tranches in the pool, with the first tranche having an expected life of 1-2 years, the second tranche having an expected life of 3-5 years, the third tranche having an expected life of 5-7 years, etc.

A bond that was originally sold at par is now trading in the market at a premium. The bond is called at par. This action will benefit the:

issuer If the bond could be trading at a premium, this means that yields have dropped. The issuer can call in the bonds at par and refund the issue at lower current market interest rates, and since the call is at par, the issuer has no cost in calling the bonds. The bondholder, on the other hand, is receiving par value for the bonds and now must reinvest those funds in new bonds to keep receiving income. The only problem is that yields have dropped, so the bondholder will now get less income. Furthermore, the bondholder gets no compensation for this because the bonds are called at par (there is no call premium).

A bond trade that is "flat" means that:

no accrued interest is added to the price of the trade

The nominal interest rate on a TIPS approximates the:

real interest rate

A pass through certificate is best described as a:

security which gives the holder an undivided interest in a pool of mortgages The mortgage payments are "passed through" to the certificate holders.

If investors expect an economic expansion, the best investment strategy would be to:

sell U.S. Government bonds buy U.S. Government bonds

When the yield curve is inverted:

short term rates are higher than long term rates the Federal Reserve is tightening credit When short term rates are higher than long term rates, this is an inverted or descending yield curve. If the Federal Reserve sharply tightens credit, it exerts its influence at the short end of the yield curve, driving up short term rates. If the Fed really "tightens," then short term rates can be driven above long term rates. Long term rates are indirectly influenced by Fed actions - what drives long term rates are long term expectations about economic growth and inflation.

A floating rate CMO tranche is MOST similar to a:

step up step down bond A floating rate CMO tranche has an interest rate that varies, tied to the movements of a recognized interest rate index, like LIBOR. Therefore, as interest rates move up, the interest rate paid on the tranche steps up as well; and when interest rates drop, the interest rate paid on the tranche steps down as well. There is usually a cap on how high the rate can go and a floor on how low the rate can drop. Because the interest rate moves with the market, the price stays close to par - as is the case with any variable rate security.

Regular way trades of U.S. Government bonds settle:

through the Federal Reserve System on the business day after trade date

Homeowners will prepay mortgages:

when interest rates fall so they can refinance at lower rates