Fixed Inc Exam 2
Explain why it is inappropriate to use one yield to discount all the cash flows of a financial asset
There are different cash flow patterns at different points in time so using one rate is not appropriate. Each should be discounted at a unique rate in time.
26. Why is a default rate not a good sole indicator of the potential performance of a portfolio of high yield corporate bonds?
There is large fluctuation in default rates. There are many reasons for default (bankruptcies, missing payments, etc) so it can be hard to be a good indicator for potential performance. It doesn't give a good representation of a company because the calculation does not define that.
In a Treasury auction, how is the price that a competitive bidder must pay determined in a single-price auction format?
A competitive bidder specifies the quantity and the yield they want and purchase at the same price indicating stop-out yield. All competitive bidders place their bids with a certain price and yield. After all are in, the high yield is determined. The high yield is the maximum yield that will be counted. Any bids that are higher than the high yield are disregarded.
1. What type of property is security for a residential mortgage loan?
Residential, commercial can be collateral. Apartments, houses, condos, offices, buildings, etc.
4. Which type of municipal bond would an investor analyze using an approach similar to that for analyzing a corporate bond?
Revenue bonds because it is analyzed like a project (credit analysis, credit risk, rating, etc)
Absolute priority rule
Senior creditor gets paid first, then junior creditors
What is a spot rate?
Spot = contract of buying or selling a security for settlement on spot rate. The settlement rate is the spot rate. It is the starting point for all transactions taking place related to foreign exchange. It is the yield on a zero coupon bond for a certain point in time
How are spot rates related to forward rates?
Spot rate is the present rate for buying a commodity. Forward rate is a rate that is applicable for the future. Forward rates are anticipated spot rates, so spot rates help calculate forward rates.
Suppose that the price of a Treasury bill with 90 days to maturity and a $1 million face value is $980,000. What is the yield on a bank discount basis?
yd= (D/F)(360/t) (1000000-980000)/1000000*360/90=8%
When all Treasury issues are used to construct the theoretical spot rate curve, what methodology is used to construct the curve? a. What are the limitations of using Treasury strips to construct the theoretical spot rate curve? b. When Treasury strips are used to construct the curve, why are only coupon strips used?
A) 1. The strips liquidity is not good. 2. The strips treatment in context with tax is not the same as a coupon securities of treasury. Strips have their accrued interest taxed. 3. There are various sectors of maturities where other than US investors find it more beneficial to deal off yield as they got certain tax advantages which are related to the strip. B) Using coupon strips of treasury becomes easier to acquire spot rates because there is a constant liquidity term, taax treatment, and international demand.
In a Treasury auction, what is meant by a. a noncompetitive bidder? b. the high yield?
A) Noncompetitive bidders accept the rate, yield, and discount. Willing to buy at the auction price. B) The highest yield accepted and awarded in an action. It's aka the stop out yield and it is the highest yield that will be granted in the auction with all other bids. Any higher bids will be disregarded. High yield - rate at which noncompetitive bidders take.
You are a financial consultant. At various times you have heard comments on interest rates from one of your clients. How would you respond to each of the following comments? a. "The yield curve is upward-sloping today. This suggests that the market consensus is that interest rates are expected to increase in the future." b. "I can't make any sense out of today's term structure. For short-term yields (up to three years) the spot rates increase with maturity; for maturities greater than three years but less than eight years, the spot rates decline with maturity; and for maturities greater than eight years the spot rates are virtually the same for each maturity. There is simply no theory that explains a term structure with this shape." c. "When I want to determine the market's consensus of future interest rates, I calculate the forward rates."
A) Slope upward shows that the bond will have a positive response. B) Pure expectation theory- the expected rates in future are represented by the forward rates. Since the given rates can fluctuate, there ca be movement of the curve. Also, investors are not comfortable with the uncertainty so they must be presented with more return's rate for maturities with longer term. C)When an investor wants to calculate future interest rates, they must calculate the forward rate.
a. What is the common hypothesis about the behavior of short-term forward rates shared by the various forms of the expectations theory? b. What is price risk and reinvestment risk and how do these two risks affect the pure expectations theory? c. Give three interpretations of the pure expectations theory
A) expectation theory- share a hypothesis in relation to the nature of short term forward rates which are in relation to short term rates which are expected in future. Long term bond's forward rate are in close relation to short term rates market expectations. B) Price risk- uncertainty in relation to the bond's price at the closing of investment horizon Reinvestment risk- risk caused by uncertainty about return over investment pd. C) 1- investors expect same returns on evert horizon on any investment duration at any maturity pd. 2- bonds with different maturity have the same return over investment horizon of short term. 3- investor will earn same return by witching the bonds with short term when compared to zero coupon bonds.
8. a. What are the three different types of letters of credit in a municipal bond, and how do they differ? b. Which type of letter-of-credit-backed bond provides the greatest protection for investors?
A. Direct Pay LOC- Can go right to the trustee if they do not think the municipality will pay back Standby LOC- Require that the trustee must first request any contractual payment from the municipal issuer before drawing down on the LOC.if a transaction fails and one party is not compensated, the standby letter is payable when the beneficiary can prove that they did not receive the compensation. Must check in with municipality first before going to anyone else and must request payment from issuer first Confirming LOC- guarantee that the buyer gets from a second bank in addition to the first line ofcredit. The second bank promise to pay if the first bank defaults. It reduces risk. B. Direct pay LOC provides the greatest protection because the trustee must use their right to request for payment from the provider without requesting payment from the issuer first.
a. What is meant by a make-whole call provision? B. What is the make-whole premium? C. How does a make-whole call provision differ from a traditional call provision? d. Why is a make-whole call provision probably a misnomer?
A. It allows the issuer to call back the bond at a certain date. The payment is the PV of the remaining payments discounted at a spread. B. The specified small spread that remaining payments of the bond are discounted to arrive at the payment when the issuer calls the bond. Spread above the treasury rate. C. The make-whole call provision provides a make-whole call premium to investors for early repayments, so the call price is not fixed. Traditional call price is fixed D. Because the holders are likely to benefit if the issuer exercises this option; gives the investor a large premium.
a. What is a sinking fund requirement in a bond issue? b. Comment on the following statement: "A sinking fund provision in a bond issue benefits the investor"
A. It is mandatory for an issuer to retire a stated share of an issue annually Ex: retire 10% of outstanding bonds annually. You can either call if rates drop or buy another bond if rates rise. B. Disagree. It does not offer complete call protection because debt can be retired irregularly; call protection benefits the investor by preventing a bond to be retired early
a. What is the difference between a liquidation and a reorganization? b. What is the difference between a Chapter 7 and a Chapter 11 bankruptcy filing?
A. Liquidation is complete sell of assets and paying creditors in order of priority (Ch7) Reorganization is creating a new corporate entity Ex: Nova goes bankrupt and gets rid of liberal arts so it's just VSB. We emerge as a new entity. (Ch 11) B. Chapter 7 is liquidation. Chapter 11 is reorganization.
a. When a prepayment is made that is less than the full amount to completely pay off the loan, what happens to future monthly mortgage payments for a fixed-rate mortgage loan? B. What is the impact of a prepayment that is less than the amount required to completely pay off a loan?
A. The future monthly payment remains the same; the loan is not recast. It pays off more principal and less interest. B. The impact is that the borrower spends less on interest payments than they would have without the prepayment. It still allows the loan to be paid off sooner. There may be some penalties imposed.
a. What is the original LTV of a mortgage loan? b. What is the current LTV of a mortgage loan? c. What is the problem with using the original LTV to assess the likelihood that a seasoned mortgage will default?
A. The original LTV of a mortgage loan is the LTV of the borrower at the time that they borrow. B. Current LTV is the LTV surrounding the current unpaid mortgage balance. C. Because the current LTV uses the estimated current value of the property, so it is more accurate. It may be troublesome to predict a default because it does not show price change.
Explain why you agree or disagree with the following statement: "The debt of government owned corporations is guaranteed by the full faith and credit of the U.S. government, but that is not the case for the debt of government sponsored enterprises.
Agree because the enterprises sponsored by the US government are corporations that are owned by the government, which is different than government owned debt. OR Disagree, regardless of the government corporations or government sponsored enterprises, neither is backed by the full faith and credit of the US.
Explain why a financial asset can be viewed as a package of zero-coupon instruments.
Because if you figure out the amount of payments and how much each payment is, you can treat each cash flow as a zero coupon bond. Like a package of zero coupon bonds because they are paid in one cash flow (interest+principal). The value of the bond should equal the value of all the zero coupons
The bid and ask yields for a Treasury bill were quoted by a dealer as 5.91% and 5.89%, respectively. Shouldn't the bid yield be less than the ask yield, because the bid yield indicates how much the dealer is willing to pay and the ask yield is what the dealer is willing to sell the Treasury bill for?
Bid: 5.91%=D/100000*360/100 D= $1,641.67 100000-1641.87= $98,358.33 Ask: 5.89%=D/100000*360/100 D= $1,636.11 100000-1636.11= $98,363.89 The bid yield is higher than the ask yield; yield has inverse relationship to its price in which higher yield the lower the price
What are the differences between a Treasury bill, a Treasury note, and a Treasury bond?
Bills mature in a year or less, notes range from 1 to 10 years, and bonds can have up to 30 years.
In a collateralized loan obligation, how is protection afforded to the most senior bond class?
Bond classes are labeled in order of their seniority, and interest is distributed in that order. The cash flows waterfall is used to determine who gets paid 1st, 2nd...It helps protect their seniority status.
a. What is the difference between refunding protection and call protection? b. Which protection provides the investor with greater protection that the bonds will be acquired by the issuer prior to the stated maturity date?
Call protection- forbidding issuer to call back security before maturity Refunding protection- prevents issuers from issuing new funds from lower rate bonds to fund bonds with a higher rate. B. A call protection provides the investor with greater protection. It protects the investor from redeeming the whole bond early.
What is the difference between a cash-out refinancing and a rate-and-term refinancing?
Cash out- when the loan amount requested exceeds the original loan amount. Rate and term- the loan balance remains unchanged.
27. What is the difference between a credit rating and recovery rating?
Credit rating provides the user information about default possibilities. Recovery ratings provide the user better information and take into account the collateral, the capital structure, and the value of the issuer and gives notion to if they will recover from defaults.
Comment on the following statement: "A senior secured creditor has little risk of realizing a loss if the issuer goes into bankruptcy."
Disagree bc if its reorganization they have less claim/sway then if liquidation. There is no guarantee that issuer will not go bankrupt, make payments. Senior secured is just the order in which loan will be repaid and it is secured by collateral.
What is a government-sponsored enterprise?
Financial institutions set up by Congress to increase the supply of credit to areas in need. (Freddie Mac, Fannie Mae, etc)
Historically, what have been the causes of municipal bankruptcies?
Government fraud, mismanagement of funds, high interest rates, poorly run projects, economic conditions, natural disasters.
The yield spread between two corporate bond issues reflects more than just differences in their credit risk. What other factors would the yield spread reflect?
Issue type, Issuer perceived creditworthiness, embedded options, taxability of receipt of interest, issue's estimated liquidity.
Explain the role that forward rates play in making investment decisions.
It notifies the investors about their expectations with reference to expectation of the market consensus. They can make decisions based on these rates. Ex: an investor can buy a six month or 1 year bond and he knows both rates. The six month bond allows him to repurchase for another 6 months. Using forward and spot rates, the investor can determine if he wants to repurchase or not.
3. Explain why the higher the loan-to-value ratio is, the greater the credit risk is to which the lender is exposed.
LTV is the mortgage amount divided by the appraised value. So, a higher LTV means that the mortgage value is closer to the value of the property. This means that the loan is extremely large, indicating a higher risk of default. If the value is high there needs more protection and vice versa. Lenders want a higher value to ensure protection as a safety net upon default.
What Treasury issues can be used to construct the theoretical spot rate curve?
On the run treasury issues, treasury coupon strips, and treasury coupon securities.
3. What is the difference between a tax-backed bond and a revenue bond?
Tax backed bonds are issued by some sort of local government with the government promising to repay the bondholder through tax revenue. Revenue bonds, however, are issued to finance projects where the revenue from those projects is used to pay (tolls, bridges, sales).
Comment on the following statement: "An investor who purchases the mortgage bonds of a corporation knows that should the corporation become bankrupt, mortgage bondholders will be paid in full before the common stockholders receive any proceeds."
The common belief is that debt financing usually takes precedence over equity financing. However, upon bankruptcy in liquidation, the results may vary.
Bart Simpson is considering two alternative investments. The first alternative is to invest in an instrument that matures in two years. The second alternative is to invest in an instrument that matures in one year and at the end of one year, reinvest the proceeds in a 1-year instrument. He believes that 1-year interest rates one year from now will be higher than they are today and therefore is leaning in favor of the second alternative. What would you recommend to Bart Simpson?
The first has a defined rate but not the second. Rates may change in the future. The spot rate is used to calculate forward rates. The second alternative will be chosen if the spot rate for one year is greater than the forward rate and the rate Bart has in mind. It will not be chosen if the spot rate is lower.
What is the federal income tax treatment of accrued interest income on stripped Treasury securities?
The interest from treasury securities must pay a federal tax but not state or local taxes. A disadvantage to this is that accrued interest is taxed every year even if interest is not paid that year. There is a negative cash flow for each year interest is earned but not received as income, thus, you'd have to pay taxes out of your own pocket
If Congress changes the tax law so as to increase marginal tax rates, what will happen to the price of municipal bonds?
The prices will likely increase because an increase in tax rates will make municipal bonds more attractive because they are generally tax exempt. Prices rise as demand rises
Why is a stripped Treasury security identified by whether it is created from the coupon or the principal?
The reason stripped securities are identified by the coupon or the principal is because they are taxed differently. Accrued interest from the principal is a capital gain, so it is taxed at a lower rate. There are differences between the tax treatment by the US and abroad. Some laws recognize interest as a capital gain and others treat it as an ordinary interest income if the stripped security came from the principal. Both have different ways the taxes are calculated.
What is the significance of a secured position if the absolute priority rule is typically not followed in a reorganization?
The significance of a secured position is that it can allow claims to assets that may not be available to creditors. Senior claimants can use their position to get a good deal in reorganization.
2. What are the two primary factors in determining whether or not funds will be lent to an applicant for a residential mortgage loan?
The two factors are Payment to Interest Ratio and Loan to Value ratio. Payment to Interest (PTI) measures the ability of the applicant to make monthly payments. Loan to Value (LTV) indicates the protection the lender has if the borrower defaults. (credit and employment history)
Credit default swaps, a derivative instrument described in Chapter 32, allow investors to buy and sell protection against the default of a municipal issuer. Why do you think it is difficult to find investors who are willing to buy protection against default of a municipal issuer but a large number of investors who are willing to sell such protection?
There is little appeal to sell the protection because you are hoping for the issuer to default. In this case, municipal bonds have little default risk because they are backed by the government. Because they are less likely to default, protection against it is in little demand. Why pay for the protection if you do not need it?
In the fall of 2010, the author of this book received an offering sheet for very short-term Treasury bills from a broker. The offering price for a few of the issues exceeded the maturity value of the Treasury bill. When the author inquired if this was an error, the broker stated that it was not and that there were institutional investors who were buying very short-term Treasury bills above their maturity value. What does that mean in terms of the yield such investors were willing to receive at that time?
This means that investors are earning a negative return. The yield is computed based on the discount that it is quoted at. Some investors are also willing to pay more than its face value. Also, the yearly number used in calculating is also 360, not 365 which leads to a higher offering price.
Assuming a $100,000 par value, calculate the dollar price for the following Treasury coupon securities given the quoted price: a. 84.14 b. 84.14+ c. 103.284 d. 105.059
a. 84 + 14/32 * (100,000) b. 84 + 14/32 + 1/64 * (100,000) c. 103 + 28/32 + 4/256 * (100,000) d. 105 + 5/32 + 9/256 * (100,000)
a. What is an embedded option in a bond? b. Give three examples of an embedded option that might be included in a bond issue. c. Does an embedded option increase or decrease the risk premium relative to the base interest rate?
a. Bond has an option- a right present with the holder. (call, put option) b. Callable bond: holder can redeem bond at price which is fixed in the future Convertible bond: holder can transform the bond in common stock Sinking fund: issuer company has a right to redeem the principal value of the bond over its life. c. Depends if the option benefits the holder or issuer; based on base interest rate. Increases in favor of issuer. Decreases in favor of borrower
21. a. Why is commercial paper an alternative to short-term bank borrowing for a corporation? b. What is the difference between directly placed paper and dealer-placed paper? c. What does the yield spread between commercial paper and Treasury bills of the same maturity reflect? d. Why does commercial paper have a maturity of less than 270 days? e. What is meant by tier-1 and tier-2 commercial paper?
a. Commercial Paper is a source of short term capital for corporations. This allows corporations to raise capital quickly and the rate is usually lower than what banks require. Helps avoid hurdles/expenses of a conventional loan. b. Directly placed paper is sold directly to investors. Dealer placed paper is sold to an intermediary who sells to investors. c. The spread reflects differences in credit risk, taxability, and liquidity. d. The Securities Act of 1933 requires it. e. Tier 1 is rated as a "1" by at least two of the rating agencies. Tier 2 is defined as a paper security that is not rated as a "!"
The supplemental prospectus of an actual offering by Royal Bank of Canada states the following: Final Level 2 Initial Level Initial Level Participation Rate: 100% Initial Level: 109.0694 Term: Approximately five (5) years a. What type of structured note is this? b. What are the risks associated with investing in this structured note?
a. It is a commodity linked note. b. The investor is exposed to risk of liquidity. There is also risk associated with principal loss due to market movements. Potential underperformance of the index.
a. In what ways does an MTN differ from a corporate bond? b. What derivative instrument is commonly used in creating a structured MTN?
a. MTN have shorter maturities, are sold in lesser amounts, and are beneficial in positions of cost (all in cost of funds). They're sold on a continuous/intermittent basis where corporates are sold in large, discrete amounts. Also, MTNs are usually distributed through agents or an investment banker. b. Swap is the most common derivative used.
a. What is meant by a tax-exempt security? b. What is meant by high-grade issue? c. Why is the yield on a tax-exempt security less than the yield on a Treasury security of the same maturity? d. What is the equivalent taxable yield? e. Also reported in the same issue of the Goldman Sachs report is information on intramarket yield spreads. What are these?
a. Securities in which interest is not taxed. b. Low credit risk compared to other securities (AAA, AA) c. Because the investors benefit from not paying taxes. The yield on a taxable security is highr because it needs to account for the money being lost when paying the taxes d. Yield offered on the issue of a taxable bond to result in the same after tax yield similar to tax exempt issue. e. intramarket yield spread is the spread between two issues in the market
a. What is meant by coupon stripping in the Treasury market? b. What is created as a result of coupon stripping in the Treasury market?
a. The process in which the private sector hsa created zero coupon securities are made available to investors who want them and cannot get them through the treasury department. It separates the principal from the coupon payments b. Zero coupon bonds
The following questions are about TIPS. a. What is meant by the "real rate"? b. What is meant by the "inflation-adjusted principal"? c. Suppose that the coupon rate for a TIPS is 3%. Suppose further that an investor purchases $10,000 of par value (initial principal) of this issue today and that the semiannual inflation rate is 1%. 1. What is the dollar coupon interest that will be paid in cash at the end of the first six months? 2. What is the inflation-adjusted principal at the end of six months? d. Suppose that an investor buys a 5-year TIPS and there is deflation for the entire period. What is the principal that will be paid by the Department of the Treasury at the maturity date? e. What is the purpose of the daily index ratio? f. How is interest income on TIPS treated at the federal income tax level?
a. The return an investor receives while adjusted for inflation; determined by the auction b. A principal that the Treasury Department uses to protect the investor from inflation. Coupon payments and maturity values are adjusted for inflation c. 1. inflation adjusted principal = principal * (1+semi annual inflation rate)*semi annual coupon rate 1000*(1+.01)*(.03/2)=$151.50 coupon interest at end of 6 months 2. 10000*(1+.01)=$10,100 10100*(1+.01)*(.03/2)=$153,015 IAP at end of 6 months d. The principal that will be paid is the maturity value that is equal to principal adjusted to inflation or initial par value (whichever is greater) e. Used to compute inflation adjusted principal f. The coupon payment is based on inflation adjusted principal in which adjustments are taxed yearly. This is at a tax paying disadvantage and limits attractiveness to investors
a. What is a yield curve? b. Why is the Treasury yield curve the one that is most closely watched by market participants?
a. interest rates over time. Helps observe prices an yields in the treasury market. The curve is supposed to measure bonds with identical creditworthiness. Shows realationship with bonds with same credit quality but different maturities b. Treasury securities don't have default risk so they all have same credit worthiness and they are the most active bond as well. No problems with liquidity or trading. It is essentially risk free and rates are based on the treasury.
Suppose that a Treasury coupon security is purchased on April 8 and that the last coupon payment was on February 15. Assume that the year in which thissecurity is purchased is not a leap year. a. How many days are in the accrued interest period? b. If the coupon rate for this Treasury security is 7% and the par value of the issue purchased is $1 million, what is the accrued interest?
a. total days = 14 (Feb)+31(March)+7(April)=52 *don't include settlement date b. total days=181; including Feb 15 → 6 months =August 15 AI=annual dollar coupon/2*days in AI period/days in coupon period 70000/2*52/181= $10,055.25
