Fixed income (1)

Which of the following type of debt obligation most likely protects bondholders when the assets serving as collateral are non-performing? Covered bonds Collateral trust bonds Mortgage-backed securities

A is correct. A covered bond is a debt obligation backed by a segregated pool of assets called a "cover pool." When the assets that are included in the cover pool become non-performing (i.e., the assets are not generating the promised cash flows), the issuer must replace them with performing assets.

Contrary to positive bond covenant, negative covenants are most likely: costlier. legally enforceable. enacted at time of issue

A is correct. Affirmative covenants typically do not impose additional costs to the issuer, while negative covenants are frequently costly. B is incorrect because all bond covenants are legally enforceable rules, so there is no difference in this regard between positive and negative bond covenants. C is incorrect because borrowers and lenders agree on all bond covenants at the time of a new bond issue, so there is no difference in this regard between positive and negative bond covenants.

Q. An excess spread account incorporated into a securitization is designed to limit: credit risk. extension risk. contraction risk.

A is correct. An excess spread account, sometimes called excess interest cash flow, is a form of internal credit enhancement that limits credit risk. It is an amount that can be retained and deposited into a reserve account and that can serve as a first line of protection against losses. An excess spread account does not limit prepayment risk, extension, or contraction.

Q. Eurocommerical paper is most likely: negotiable. denominated in euro. issued on a discount basis.

A is correct. Commercial paper, whether US commercial paper or Eurocommercial paper, is negotiable—that is, investors can buy and sell commercial paper on secondary markets. B is incorrect because Eurocommercial paper can be denominated in any currency. C is incorrect because Eurocommercial paper may be issued on an interest-bearing (or yield) basis or a discount basis.

Relative to domestic and foreign bonds, Eurobonds are most likely to be: bearer bonds. registered bonds. subject to greater regulation

A is correct. Eurobonds are typically issued as bearer bonds, i.e., bonds for which the trustee does not keep records of ownership. In contrast, domestic and foreign bonds are typically registered bonds for which ownership is recorded by either name or serial number.

Q. When underwriting new corporate bonds, matrix pricing is used to get an estimate of the: required yield spread over the benchmark rate. market discount rate of other comparable corporate bonds. yield-to-maturity on a government bond having a similar time-to-maturity.

A is correct. Matrix pricing is used in underwriting new bonds to get an estimate of the required yield spread over the benchmark rate. The benchmark rate is typically the yield-to-maturity on a government bond having the same, or close to the same, time-to-maturity. The spread is the difference between the yield-to-maturity on the new bond and the benchmark rate. The yield spread is the additional compensation required by investors for the difference in the credit risk, liquidity risk, and tax status of the bond relative to the government bond.

Which of the following describes a typical feature of a non-agency residential mortgage-backed security (RMBS)? Senior/subordinated structure A pool of conforming mortgages as collateral A guarantee by a government-sponsored enterprise

A is correct. Non-agency RMBS are credit enhanced, either internally or externally, to make the securities more attractive to investors. The most common forms of internal credit enhancements are senior/subordinated structures, reserve accounts, and overcollateralization. Conforming mortgages are used as collateral for agency (not non-agency) mortgage pass-through securities. An agency RMBS, rather than a non-agency RMBS, issued by a GSE (government sponsored enterprise), is guaranteed by the respective GSE.

The tranches in a collateralized mortgage obligation (CMO) that are most likely to provide protection for investors against both extension and contraction risk are: planned amortization class (PAC) tranches. support tranches. sequential-pay tranches.

A is correct. PAC tranches have limited (but not complete) protection against both extension risk and contraction risk. This protection is provided by the support tranches. A sequential-pay tranche can protect against either extension risk or contraction risk but not both of these risks. The CMO structure with sequential-pay tranches allows investors concerned about extension risk to invest in shorter-term tranches and those concerned about contraction risk to invest in the longer-term tranches.

Securitization benefits investors by: providing more direct access to a wider range of assets. reducing the inherent credit risk of pools of loans and receivables. eliminating cash flow timing risks of an ABS, such as contraction and extension risks.

A is correct. Securitization allows investors to achieve more direct legal claims on loans and portfolios of receivables. As a result, investors can add to their portfolios exposure to the risk-return characteristics provided by a wider range of assets.

A goal of securitization is to: separate the seller's collateral from its credit ratings. uphold the absolute priority rule in bankruptcy reorganizations. account for collateral's primary influence on corporate bond credit spreads

A is correct. The legal implication of a special purpose entity (SPE), a prerequisite for securitization, is that investors contemplating the purchase of bond classes backed by the assets of the SPE will evaluate the credit risk of those assets independently from the credit rating of the entity that sold the assets to the SPE. This separation of the seller's collateral from its credit rating provides the opportunity for the SPE to access a lower aggregate funding cost than what the seller might otherwise obtain.

A CMO is structured with PAC tranches. The tranche most likely to provide protection against both extension risk and contraction risk is the tranche experiencing actual prepayment rates that are: between the lower and upper PSA prepayment assumption. more than the higher PSA prepayment assumption. less than the lower PSA prepayment assumption.

A is correct. The lower and upper PSA prepayment assumptions are called the "initial PAC collar." Within this PSA collar, the average life for the PAC tranche is stable with the support tranche taking on the extension and contraction risk.

In a securitization, time tranching provides investors with the ability to choose between: extension and contraction risks. senior and subordinated bond classes. fully amortizing and partially amortizing loans.

A is correct. Time tranching is the process in which a set of bond classes or tranches is created that allow investors a choice in the type of prepayment risk, extension or contraction, that they prefer to bear. Senior and subordinated bond classes are used in credit tranching. Credit tranching structures allow investors to choose the amount of credit risk that they prefer to bear. Fully and partially amortizing loans are two types of amortizing loans.

When the collateral manager fails pre-specified risk tests, a CDO is: deleveraged by reducing the senior bond class. restructured to reduce its most expensive funding source. liquidated by paying off the bond classes in order of seniority.

A is correct. When the collateral manager fails pre-specified tests, a provision is triggered that requires the payoff of the principal to the senior class until the tests are satisfied. This reduction of the senior class effectively deleverages the CDO because the CDO's cheapest funding source is reduced.

Which of the following is least likely a feature of a credit card receivable ABS? An early amortization provision Amortizing collateral A lockout period

B is correct. A credit card receivable ABS is an example of an ABS with a non-amortizing collateral.

A characteristic of negotiable certificates of deposit is: they are mostly available in small denominations. they can be sold in the open market prior to maturity. a penalty is imposed if the depositor withdraws funds prior to maturity.

B is correct. A negotiable certificate of deposit (CD) allows any depositor (initial or subsequent) to sell the CD in the open market prior to maturity. A is incorrect because negotiable CDs are mostly available in large (not small) denominations. Large-denomination negotiable CDs are an important source of wholesale funds for banks, whereas small-denomination CDs are not. C is incorrect because a penalty is imposed if the depositor withdraws funds prior to maturity for non-negotiable (instead of negotiable) CDs.

Which of the following is a type of external credit enhancement? Covenants A surety bond Overcollaterization

B is correct. A surety bond is an external credit enhancement, i.e., a guarantee received from a third party. If the issuer defaults, the guarantor who provided the surety bond will reimburse investors for any losses, usually up to a maximum amount called the penal sum.

Q. A bond portfolio manager is considering three bonds—A, B, and C—for his portfolio. Bond A allows the issuer to call the bond before the stated maturity, Bond B allows the investor to put the bond back to the issuer before the stated maturity, and Bond C contains no embedded options. The bonds are otherwise identical. The manager tells his assistant, "Bond A and Bond B should have larger nominal yield spreads to a US Treasury than Bond C to compensate for their embedded options." Is the manager most likely correct? No, Bond A's nominal yield spread should be less than Bond C's No, Bond B's nominal yield spread should be less than Bond C's Yes

B is correct. Bond B's embedded put option benefits the investor, and the yield spread will therefore be less than the yield spread of Bond C, which does not contain this option or benefit.

In the context of mortgage-backed securities, a conditional prepayment rate (CPR) of 8% means that approximately 8% of the outstanding mortgage pool balance at the beginning of the year is expected to be prepaid:

B is correct. CPR is an annualized rate, which indicates the percentage of the outstanding mortgage pool balance at the beginning of the year that is expected to be prepaid by the end of the year.

Residential mortgage-backed securities issued in the US by government-sponsored enterprises are guaranteed by: the full faith and credit of the government. the government-sponsored enterprise. external credit enhancements.

B is correct. For residential mortgage-backed securities (RMBS) issued by a GSE (government-sponsored enterprise), such as Fannie Mae and Freddie Mac, credit risk is reduced by the guarantee of the GSE itself.

Which statement best describes the risk to senior tranche investors in a collateralized debt obligation (CDO)? There are no triggers that require the payoff of the principal to investors. In default, the manager will not earn a return sufficient to payoff investors. Leverage inherent in the CDO transaction results in higher risk.

B is correct. In the case of defaults in collateral, there is a risk that the CDO manager will not earn a sufficient return to pay off the investors in the senior and mezzanine tranches. This will result in losses to these classes of bondholders.

Q. The bond-equivalent yield for a semi-annual pay bond is most likely: equal to the effective annual yield. equal to double the semi-annual yield to maturity. more than the effective annual yield.

B is correct. The bond equivalent yield for a semi-annual pay bond is equal to double the semi-annual yield to maturity and is lower than the effective annual yield.

Q. Suppose a bond's price is expected to increase by 5% if its market discount rate decreases by 100 basis points. If the bond's market discount rate increases by 100 basis points, the bond price is most likely to change by: 5%. less than 5%. more than 5%

B is correct. The bond price is most likely to change by less than 5%. The relationship between bond prices and market discount rate is not linear. The percentage price change is greater in absolute value when the market discount rate goes down than when it goes up by the same amount (the convexity effect). If a 100 basis point decrease in the market discount rate will cause the price of the bond to increase by 5%, then a 100 basis point increase in the market discount rate will cause the price of the bond to decline by an amount less than 5%.

Q. The rate, interpreted to be the incremental return for extending the time-to-maturity of an investment for an additional time period, is the: add-on rate. forward rate. yield-to-maturity.

B is correct. The forward rate can be interpreted to be the incremental or marginal return for extending the time-to-maturity of an investment for an additional time period. The add-on rate (bond equivalent yield) is a rate quoted for money market instruments such as bank certificates of deposit and indexes such as Libor and Euribor. Yield-to-maturity is the internal rate of return on the bond's cash flows—the uniform interest rate such that when the bond's future cash flows are discounted at that rate, the sum of the present values equals the price of the bond. It is the implied market discount rate.

Q. A yield curve constructed from a sequence of yields-to-maturity on zero-coupon bonds is the: par curve. spot curve. forward curve.

B is correct. The spot curve, also known as the strip or zero curve, is the yield curve constructed from a sequence of yields-to-maturities on zero-coupon bonds. The par curve is a sequence of yields-to-maturity such that each bond is priced at par value. The forward curve is constructed using a series of forward rates, each having the same timeframe.

To obtain the spot yield curve, a bond analyst would most likely use the most: recently issued and actively traded corporate bonds. recently issued and actively traded government bonds. seasoned and actively traded government bonds.

B is correct. To obtain the spot yield curve, a bond analyst would prefer to use the most recently issued and actively traded government bonds. Such bonds will have similar liquidity as well as fewer tax effects because they will be priced closer to par value.

Q. For the issuer, a sinking fund arrangement is most similar to a: term maturity structure. serial maturity structure. bondholder put provision.

B is correct. With a serial maturity structure, a stated number of bonds mature and are paid off on a pre-determined schedule before final maturity. With a sinking fund arrangement, the issuer is required to set aside funds over time to retire the bond issue. Both result in a pre-determined portion of the issue being paid off according to a pre-determined schedule.

Which of the following is most likely an example of a Eurobond? A Canadian borrower issuing British pound-denominated bonds in the UK market. A Japanese borrower issuing US dollar-denominated bonds in the US market. An Australian borrower issuing Canadian dollar-denominated bonds in the UK market.

C is correct. A Eurobond is an international bond issued outside the jurisdiction of any one country and not denominated in the currency of the country where it is issued.

Q. If interest rates are expected to increase, the coupon payment structure most likely to benefit the issuer is a: step-up coupon. inflation-linked coupon. cap in a floating-rate note.

C is correct. A cap in a floating-rate note (capped FRN) prevents the coupon rate from increasing above a specified maximum rate. This feature benefits the issuer in a rising interest rate environment because it sets a limit to the interest rate paid on the debt.

Which of the following instruments is most likely to offer investors some protection against increases in the market interest rate?A. Inverse floating-rate notesB. Fixed-rate bondsC. Floating-rate notes

C is correct. A floating-rate note will be less affected when market interest rates increase because the coupon rate varies directly with market interest rates and is reset at regular intervals.

Q. Which of the following bond types provides the most benefit to a bondholder when bond prices are declining? Callable Plain vanilla Multiple put

C is correct. A putable bond is beneficial for the bondholder by guaranteeing a prespecified selling price at the redemption date, thus offering protection when interest rates rise and bond prices decline. Relative to a one-time put bond that incorporates a single sellback opportunity, a multiple put bond offers more frequent sellback opportunities, thus providing the most benefit to bondholders.

Zet Bank has entered into a contract with Louly Corporation in which Zet agrees to buy a 2.5% US Treasury bond maturing in 10 years and promises to sell it back next month at an agreed-on price. From Zet Bank's perspective, this contract is best described as a: repo. collateralized loan. reverse repo.

C is correct. A reverse repo (repurchase agreement) is collateralized cash lending by purchasing an underlying security now and selling it back in the future.

In the context of commercial mortgage-backed securities (CMBS) which of the following mechanisms is most likely a structural call protection? Prepayment lockouts Yield maintenance charges Sequential-pay tranches

C is correct. A structural call protection can be achieved in a CMBS when it is structured to have sequential-pay tranches by credit rating.

Which of the following is least likely a feature typical of an agency residential mortgage-backed security (RMBS)? A guarantee by a government-sponsored enterprise The satisfaction of specific established underwriting standards The use of credit enhancements to reduce credit risk

C is correct. Agency residential mortgage-backed securities (RMBS) are issued by a government-sponsored enterprise (GSE), and their credit risk is reduced by a guarantee of the GSE. They must also satisfy specific underwriting standards established by various government agencies. The use of credit enhancements to reduce credit risk is a feature associated with non-agency RMBS.

Q. The current yield for a 4.5% coupon, 10-year bond, with a maturity par value of $100 and currently priced at $85.70 is closest to: 4.50%. 5.93%. 5.25%.

C is correct. Current yield is calculated as ($4.5/$85.70) = 5.25%.

The longest-term tranche of a sequential-pay CMO is most likely to have the lowest: average life. extension risk. contraction risk.

C is correct. For a CMO with multiple sequential-pay tranches, the longest-term tranche will have the lowest contraction (prepayments greater than forecasted) risk because of the protection against this risk offered by the other tranches. The longest-term tranche is likely to have the highest average life and extension risk because it is the last tranche repaid in a sequential-pay tranche.

Q. A bond market in which a communications network matches buy and sell orders initiated from various locations is best described as an: organized exchange. open market operation. over-the-counter market.

C is correct. In over-the-counter (OTC) markets, buy and sell orders are initiated from various locations and then matched through a communications network. Most bonds are traded in OTC markets. A is incorrect because on organized exchanges, buy and sell orders may come from anywhere, but the transactions must take place at the exchange according to the rules imposed by the exchange. B is incorrect because open market operations refer to central bank activities in secondary bond markets. Central banks buy and sell bonds, usually sovereign bonds issued by the national government, as a means to implement monetary policy.

Q. Which of the following statements is most accurate? An interbank offered rate: is a single reference rate. applies to borrowing periods of up to 10 years. is used as a reference rate for interest rate swaps.

C is correct. Interbank offered rates are used as reference rates not only for floating-rate bonds, but also for other debt instruments including mortgages, derivatives such as interest rate and currency swaps, and many other financial contracts and products. A and B are incorrect because an interbank offered rate such as Libor or Euribor is a set of reference rates (not a single reference rate) for different borrowing periods of up to one year (not 10 years).

Quasi-governmental bonds are most likely: issued by a national government in a foreign currency. issued by a governmental body below the national level. repaid from cash flows generated by the issuer or from the project being financed.

C is correct. Quasi-governmental bonds are issued by entities created by national governments that are not governmental bodies. They do not generally have taxing authority and, therefore, must repay debt from cash flows they generate through fees for their services (e.g., servicing and insuring home mortgages) or cash flows generated by the projects they undertake (e.g., a toll highway or bridge).

Which of the following are most likely a kind of supranational bonds? Bonds issued by the: Federal Farm Agency of the United States. Government of Malaysia. European Investment Bank.

C is correct. Supranational bonds are bonds issued by such supranational agencies as the European Investment Bank and the International Monetary Fund.

In a securitization, the seller of the pool of securitized assets is the: trustee. special purpose entity. depositor.

C is correct. The collateral in a securitization is the pool of securitized assets from which cash flows will be generated. The seller of the collateral is the depositor, also referred to as the originator.

Q. A company has issued a floating-rate note with a coupon rate equal to the three-month Libor + 65 basis points. Interest payments are made quarterly on 31 March, 30 June, 30 September, and 31 December. On 31 March and 30 June, the three-month Libor is 1.55% and 1.35%, respectively. The coupon rate for the interest payment made on 30 June is: 2.00%. 2.10%. 2.20%.

C is correct. The coupon rate that applies to the interest payment due on 30 June is based on the three-month Libor rate prevailing on 31 March. Thus, the coupon rate is 1.55% + 0.65% = 2.20%.

Q. The key to a CDO's viability is the creation of a structure with a competitive return for the: senior tranche. mezzanine tranche. subordinated tranche.

C is correct. The key to whether a CDO is viable is whether a structure can be created that offers a competitive return for the subordinated tranche (often referred to as the residual or equity tranche). Investors in a subordinated tranche typically use borrowed funds (the bond classes issued) to generate a return above the funding cost.

Q. The CDO tranche with a credit rating status between senior and subordinated bond classes is called the: equity tranche. residual tranche. mezzanine tranche.

C is correct. The mezzanine tranche consists of bond classes with credit ratings between senior and subordinated bond classes.

The repo margin on a repurchase agreement will most likely grow when: supply of collateral decreases. the quality of the collateral increases. the credit quality of the counterparty decreases.

C is correct. The repo margin, or haircut, is the discount between the value of the collateral and the amount of the loan. A larger haircut provides more protection in the case of a default. As the credit quality of the counterparty decreases, this greater protection is needed.

Which of the following is most likely an advantage of collateralized mortgage obligations (CMOs)? CMOs can eliminate prepayment risk. be created directly from a pool of mortgage loans. meet the asset/liability requirements of institutional investors.

C is correct. Using CMOs, securities can be created to closely satisfy the asset/liability needs of institutional investors. The creation of a CMO cannot eliminate prepayment risk; it can only distribute the various forms of this risk among various classes of bondholders. The collateral of CMOs are mortgage-related products, not the mortgages themselves.

Which of the following is a source of wholesale funds for banks? Demand deposits Money market accounts Negotiable certificates of deposit

C is correct. Wholesale funds available for banks include central bank funds, interbank funds, and negotiable certificates of deposit. A and B are incorrect because demand deposits (also known as checking accounts) and money market accounts are retail deposits (not wholesale funds).

A four-year French floating-rate note pays three-month Euribor (Euro Interbank Offered Rate, an index produced by the European Banking Federation) plus 1.25%. The floater is priced at 98 per 100 of par value. Calculate the discount margin for the floater assuming that three-month Euribor is constant at 2%. Assume the 30/360 day-count convention and evenly spaced periods.

DM = Yield - reference rate: Yield = 3.79% DM = 1.79%

Capital Market Securities

debt securities with maturities longer than one year