Flashcards in Asset (Quality) Securities Deck (31):
What are the elements of an Investment Policy?
Risk and performance measurement
Authorized Activities and Instruments
Internal Controls and Independent Review
Accounting and Taxation
What are factors affecting basis when valuing futures and forward contracts?
Cost of carry
Perception of rate movements
Volatility of interest rates.
Principal risk is that Basis may change from the time the hedge is initiated until termination.
How do you slot callable, fixed rate bonds on the CR?
Slotted at maturity, call option isn't reflected
Slotted by call date when called
How do you slot callable floating-debt securities?
Slotted according to the amount of time remaining until their next repricing date, or maturity, whichever is earlier
Floating rate securities (and loans) at their floor or ceiling are treated as fixed rate until the begin to float again. (slotted at maturity)
What are some types of interest rate swaps?
Forward - hasn't reached its effective date; allowed a bank to initiate a swap with a delayed start/ Based on forward interest rates
Amortizing - has a national amount that declines (amortizes) over the life of the agreement. May be used to hedge amortizing assets or replicate CFs of mortgages products.
Swaptions - combines an option and a swap. 1 party has the option to enter into an interest-rate swap or terminate an existing swap at some future date.
Basic - Counterparties exchange variable-rate CFs based on different market indices. used to reduce basis and yield curve risks.
Accreting - has a notional principal that increased over the life of the agreement and could be used to hedge the increasing IRR in a construction loan. (loan balances increases during the funding of a construction project).
What are some active investment strategies?
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Interest Rate Expectations Strategy - consists of adjusting the Duration of the portfolio
Individual Security Selection Strategy - looking for outperformers
Yield Curve Strategy- Bullet portfolio (concentrated on 1 point on the Yield Curve); Laddered portfolio; Barbell portfolio.
Yield Spread Strategies - trying to profit from expected changes in spread b/t sectors of the bond market. Spread between top quality and lower quality bonds narrows as business conditions improve.
CF matching strategies - trying to match the CF requirements of liabilities with the CF from bonds.
What are characteristics of a bullet, laddered, and barbell portfolio? (Yield curve strategy)
Bullet portfolio - concentrated on 1 point on the Yield Curve
Laddered portfolio - spreads instruments across the maturity spectrum. Equal percentages of the portfolio maturing at different segments on the YC.
Barbell portfolio - concentrates instruments at the short term and long term extremes of the maturity spectrum. Created when long term rates fall more (bond prices increase) than when short term rates rise (bond prices decreases). Ability to reinvest short term at higher rates.
What is a derivative?
marked to market
G/L are recognized in current earnings
If certain criteria is met, banks may defer the recognition in income of gains and losses on derivatives instruments used for hedging until they recognize in income the effects of related changes on the items hedged.
What IRR are created by using off-balance sheet derivatives?
The 7 investments risks are?
Operational / Transactional Risk: inadequate controls or procedures; human error; system failure; fraud
Settlement Risk: possibility that 1 side delivers, but the counterparty isn’t able to perform
Market Risk: loss of value due to a variety of factors
Interconnection Risk: possibility of decline in the subject instrument’s value due to changes in something it’s connected to (interest rates, indices, or values of other instruments)
Legal Risk: possibility that legal action will preclude contractual performance
What is a CMO/REMIC and how it is slotted on the CR?
mortgage derivative securities consisting of several classes secured by mortgages pass thru securities or whole mortgage loans
Slotted in the CR based on their WAL, regardless of whether they/re fixed or floating
What are some factors affecting price?
Put Rodney in the Vortex
Proximity of the underlying index to strike
Remaining term to maturity
Volatility of the underlying index.
The 4 principal market risks are?
Basis Risk: risk that different market indices won’t move in perfect or predictable correlation
IRR (primary source)
Price Risk: threat that a change in the price of a production input will adversely impact a producer who uses that input. Factors include weather conditions, economic conditions, and political developments; futures and forwards hedges are used to combat
Yield Curve Risk: same type of instrument, but different effect depending on its maturity; exposure to unanticipated changes in the shape or slope of the Yield Curve
What are some passive investment strategies?
Indexing - seeking to mirror a particular market segment's performance
Immunization/Duration Matching - Structuring the portfolio so that IRR characteristics (Macaulay Duration) match the liability stream; requires frequent calculation and rebalancing
What is a forward contract?
same as a future contract, but different b/c they're customizable and they're bough and sold OTC.
I/O Strip: what happens when rates decline?
Rates decline = Value decreases bc there are more prepayments and lower interest payments
What kind of limits should be included in an investment policy?
What are unsuitable investments activities?
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Gains trading - purchase and sale at a profit after a short holding period
When-Issued Securities Trading - Buying and selling of securities in the period between the announcement of an offering and the issuance and payment date of the securities. Bank acquires the security but sells it for a profit before having to take delivery and pay for it
Adjusted Trading - sale of a security to a broker above the prevailing rate, and the simultaneous purchase and booking of a different security. Dealer ensured a profit
Short Sale - sale of a security that the bank doesn't own
Repositioning Repurchase Agreement - Dealer allows a bank that's entered into a when-issued or pair-off trade that can't be closed at a profit to hold its speculative position until it can be sold at a profit
Extended Settlement - Typical settlement periods: Agencies 1 day; Corporates/Munis: 3 days; MBS: 60 days
Pair-offs: bank commits to purchase a security, but before the settlement date the bank pair-offs the purchase with the sale of the same security
Classification of securities through Uniform Agreement don't apply to which securities?
equity holdings in SBIC
securities held in trading accounts
What are some types of market risk/value modeling measures? (DG TV)
Delta - change in the value of the option resulting from a small change in the underlying instrument. Higher D = higher price sensitivities
Gamma - measures the rate of change in delta. Delta with higher Gamma will have a higher risk.
Theta - loss of a contract's value due to the passage of time
Vega - measures the risk of gain or loss resulting from changes in volatility. Vega is always positive bc option values increase as volatility rises.
What is a future contract?
A standardized financial contract traded on organized exchanges. Obligates the buyer to purchase an asset (or seller to sell an asset) at a predetermined future date and price.
Contracts are settled in cash before expiration.
More liquid than a forward contract.
CMO Residuals- what is the effect when rates change?
Similar to IODD
rates decline = value declines
rates increase = value increases
Total return of a bond consists of what?
Change in MV over the measurement period
Re-investment interest on the CFs received during the measurement period
Option free investments have?
Embedded options have?
Option free = positive convexity (long the option)
Embedded options = negative convexity (short the option)
What happens when 2 or more ratings list different credit ratings?
Base assessments on the more recently issued findings
What is a deleveraged note?
Floating rate instrument with coupon payments based on a specific point on the YC.
Coupon rate will adjust by a fraction of the change in the underlying index
Attractive when rates are expected to remain stable or decrease
What are factors included in valuing futures and forward contracts?
Prices react to changing market rates just like bonds (rising rates = lower prices)
Basis - the different between the cash (spot) price and price in future market.
How do you classify a security:
Investment grade with temp impairment
Investment grade with OTTI
Investment Grade with temp impairment = no classification
Investment grade with OTTI = impairment is loss
P/O Strip: what happens when rates decline?
Rates decline = value increases because CF received sooner
What is a leveraged note?
Floating rate instrument with coupon payments based on a specific point on the YC
Coupon rate will adjust by a multiple of the change in the underlying index
Attractive when rates are expected to increase