Flashcards in Fin 4319-Record C1 Deck (58):
what is credit traunching?
what are the assumptions, and inputs, are they using a good model?
how does duration apply to common stocks?
see Macaulay duration
what is equity beta correlates with Macaulay duration?
it has a direct correlation, a longer duration has more beta and a shorter duration has less beta
what is equity beta?
A beta of 1 indicates that the security's price will move with the market. A beta of less than 1 means that the security will be less volatile than the market. A beta of greater than 1 indicates that the security's price will be more volatile than the market. For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the market.
if you're young and you have long time to retirement, what kind of stocks should you buy? growth or public utilities?
growth stocks, investment horizon is longer, invest in long duration assets
what if you're older investor in retirement, shorter investment horizon, which stocks should you buy?
public utilities because you need income, and less risk (more safe), shorter duration
does Macaulay duration measure stock prices sensitive to nominal interest rates?
no, stock prices should move with interest rates, bonds and stocks have a negative correlation
what does Macaulay duration measure for stocks?
sensitivity to stock prices to changes in the risk premium
in Fischer model what is the relationship stock prices and inflation?
In Fischer model stocks and bonds are not correlated to inflation.
If you have higher inflation expectations, nominal interest rates to go up, required return go up, and expected growth rate go up.
what is shiller's excess volatility?
.shiller is an economist so he doesn't understand duration. excess volatility
For common stocks, what causes required return to change independently of expected growth rate?
The market's change in price of risk causes the required return to change. If risk goes up, require return goes up.
what cause the change in the individual companies risk premium?
a change in the individual companies beta
what kind of change in i (nominal rate) - g (growth rate)?
what can cause the market's risk premium to change?
change in the market risk premium is caused by a 1) change in average level of risk aversion or in a change in perceived market risk itself, 2) reprice in risk in overall marketplace, or 3) change of risk in an individual company
what does Macaulay duration measure for common stocks?
sensitivity to stock prices to a change in risk premium
when trading discount of expensive level with duration long, what should be the case?
stock prices should be sensitivity to changes to investors willingness to bear risk. these are small changes in fear and greed.
how is a mortgage different from bond?
mortgage is amortized loan, a bond is a balloon loan.
what is amortized loan?
A loan with scheduled periodic payments of both principal and interest. This is opposed to loans with interest-only payment features, balloon payment features and even negatively amortizing payment features.
if interest rates go from 15% to 4%, what does it do to the value of house?
it increases the value of house greatly
What is LTV?
Loan To Value
What is PTI?
Payment to income ratio. Front end PTI: no more than 28% of AGI on monthly basis, pretax income. Debt, credit card payments, car payments, and mortgage loan.
What is PMI?
Private mortgage insurance (put down 20% to avoid PMI).
Why are house prices low even though interest rates are low?
Because of the recession, people lost a lot of money but normally low interest increase prices.
What will happen in next 20-30 years?
In the next 20-30 years, we'll have headwinds with rising interest rates and values of house will down.
what is a pay option ARM, interest only payment?
payment optional for first 6 months, interest only, payment very small, no amortization, what happens after 5 years you pay the entire loan value.
what if you want to rent an apartment?
they want first and last month deposit and verify income, see tax returns, credit score. it's harder to rent then buy which caused the real estate bubble.
what caused the housing bubble?
lack of underwriting - no one checking default risk - they used credit score to your probability to default
how did they qualify people for loans during 2005?
they used the beginning interest rate which is very low for Adjustable Rate Mortgage (ARM) or interest only loan to qualify people for loan, the idea is people would refinance at the end of the ARM or sell their house for profit before the balloon payment was due.
when people started defaulting, they stopped allowing these loans
why is real estate bubble worse than dot com bubble?
dot come bubble was in equities, when they lost money in stock market, they just lost money and went back to work, but in real estate bubble, they lost their house, and it's harder to come back
convexity of affordability curve.
in the old days 1982, what happened to banks when the yield curve inverted?
when interest rates went from single to double digits the entire industry went under.
they had loans with low interest rate, but had CD's with high yields, so they were losing money
they changed the accounting rules to try to get back to positive net worth
congress passed a law that allowed ARM, adjustable rate mortgages
banks were insolvent so they didn't make ARM loans.
in 1986 they bailed out savings and loans industry
which duration is longer 30 yr bond or 30 yr mortgage?
mortgage is a stream of equal monthly payments, bond is stream smaller monthly or semiannual interest only payments, and after 30 years, one huge cash flow..
bond has longer duration.
zero coupon bond has longest duration.
.what is ARM?
congress passed a law that allowed ARM, adjustable rate mortgages. when interest rates changes, your payments changes. when interest goes up and payments go up.
what is fixed rate mortgage?
it's long duration loan because of continuous payments
what is the advantage of arm for borrower?
1. the ARM advantage is the interest rate is lower than FRM when the yield curve is upward sloping
2. you don't have to pay origination fee for refinancing
in upward sloping yield curve,where is the FRM ?
it's spread above the 10 year treasury because 30 year FRM it has the same duration of a 10 year treasury note
in upward sloping yield curve where is the ARM?
it's a spread above short turn interest rate
why are ARM have lower interest than FRM?
because usually the yield curve is upward sloping
how do you refinance FRM?
you pay loan origination fee, your house has to appraised again, check your credit score again so it may be hard to refinance
when do you want to use ARM and FRM?
use ARM when interest rates are high and FRM when interest rates are low.
what started the housing fall?
when the ARM resets and interest rates are higher, you try to refinance, but the house appraises lower than before and you have to pay the difference but you can't
who got blown out with carry trade in 2008 financial crisis?
wall street bank, real estate market, people using ARM is a carry trade
when savings and loans went under?
fannie and freddie had started MBS
how do mortgage back securities (MBS) work?
take a pool of mortgages and sell shares of it
take 300 mil of loans and put in package and sell people a piece of it.
when savings and loan banks went under, who going make mortgage loans?
who needs long duration paper? life insurance co, pension funds. with securitization, these companies can invest in MBS instead of making mortgage loans which not their business.
what is a pass through certificate?
Mortgage-backed certificates are the most common type of pass-through, where homeowners' payments pass from the original bank through a government agency or investment bank to investors.
why MBS are default FREE risk?
because Fannie Mae and Freddie Mac guarantees to pay investor if people miss payments, they are government entity
what advantage of default FREE risk for MBS?
with default free risk you can sell MBS like bond funds on the secondary markets, life insurance co and pensions can buy MBS.
why do MBS trade at higher yields than other loans?
you have prepayment risk. you dont know how fast prepayment speed is
how long do 30 year mortgages last?
less than 30 years, average life is 10 to 12 years.
what is prepayment risk?
1) people pay faster, or 2) they move to a different city and pay off old mortgage, 3) people refinance.
what happens to prepayment speed if interest rates rise?
prepayment speed slows this causes negative convexity, like a callable bond.
what happens to prepayment speed if interest rates fall?
duration of MBS get shorter, prepayment speed goes faster (accelerates).
what is contraction risk?
prepayment speed can unexpectedly increase
what is extension risk?
prepayment speed can unexpectedly decrease