# Fixed Income Flashcards

Explain the credit valuation adjustment (CVA).

Explain the swap rate curve.

Describe the parameters that define a given CDS product.

Describe convexity.

Explain reduced form models, including assumptions, strengths, and weaknesses.

Explain a positive upfront payment.

Describe the process of calibrating a binomial interest rate tree to match a specific term structure.

Describe credit-default swap (CDS).

Describe ratchet bonds.

Calculate the value of a callable or putable bond from an interest rate tree.

Describe the relationship between forward and spot rates and the shape of the yield curve.

Explain the unbiased expectations theory.

Describe credit events.

Describe the assumptions concerning the evolution of spot rates in relation to forward rates implicit in active bond portfolio management.

A bond PM would consider the market price of a bond to be less than its value (undervalued) if expected future spot rates are less than quoted forward rates. That is, the market discounts the bonds cash flows by the higher forward rates rather than the lower expected spot rates.

Explain how changes in the level and shape of the yield curve affect the value of a callable or putable bond.

Describe the downside risk of a convertible bond.

Calculate effective duration of a callable or putable bond.

Explain a succession event.

Explain the maturity structure of yield volatilities and their effect on price volatility.

List types of callable bonds.

An American-style callable bond can be called by the issuer at any time, starting with the first call date until maturity.

A European-style callable bond can only be called by the issuer at a single date at the end of the lockout period.

A Bermudan-style callable bond can be called by the issuer on specified dates following the lockout period.

Describe the local expectations theory.

Distinguish between a physical settlement and a cash settlement.

Describe the option analogy in structural models.

Equity holders have an implied option to either pay off liabilities K at maturity by selling assets and receive AT – K or default on the issue and allow debt holders to assume ownership of assets. The choice depends on whether AT – K is positive (liquidate) or negative (default).

Describe the relationship between expected and realized returns on bonds.

Describe the use of key rate durations to evaluate the interest rate sensitivity of bonds with embedded options.

Define convertible bonds.

Describe the Libor-OIS spread.

Explain loss given default (LGD).

Compare effective durations of callable, putable, and straight bonds.

As interest rates fall, bond value decreases at a decreasing rate due to call option value increases. As the call goes into the money, price appreciation ceases.

As interest rates rise, bond value falls at a decreasing rate due to put option value increases.

Effective duration on both callable and putable bonds will therefore be less than straight-bond duration.

Describe a binomial interest rate tree framework.

Calculate and interpret the components of a convertible bond’s value.

Conversion value involves the market price of shares at conversion and the conversion ratio:

VConversion = P0 × Conversion ratio

= P0 × (#Shares ÷ Bond)

Minimum value equals the higher of conversion value or straight bond value calculated using the arbitrage-free valuation framework:

VMin = Max[Conversion; Straight]

Explain the relationships between the values of a callable or putable bond, the underlying option-free (straight) bond, and the embedded option.

Explain structural models of corporate credit risk including assumptions, strengths, and weaknesses.

Explain the liquidity preference theory.

Distinguish among level, steepness, and curvature risks that affect the shape of the yield curve.

Level – Upward or downward (parallel) shifts in the yield curve.

Steepness – Changes in yield curve slope that occur when short-term and long-term rates have different changes.

Curvature – Changes in shorter rates and longer rates are greater than changes in middle rates.

Describe the Z-spread.

Describe pathwise valuation in a binomial interest rate framework and calculate the value of a fixed-income instrument given its cash flows along each path.

Explain how a bond’s exposure to each of the factors driving the yield curve can be used to manage yield curve risks.

Describe effective duration, key rate duration, and a measure based on the factor model.

Compare the credit analysis required for securitized debt to the credit analysis of corporate debt.

Senior tranches are paid first, followed by junior tranches and with remaining cash going to equity holders. Losses are absorbed first by junior tranches and then by senior tranches.

Analysts must also consider enhancements (underlying collateral, total debt, liquidity) or other constraints that could affect spreads, and the relationship between obligor and originator. Granularity requires valuing individual assets vs homogeneity (statistical).

Describe how the arbitrage-free framework can be used to value a bond with embedded options.

Explain arbitrage-free (AF) models and how they are used.