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CFA Level 1 > Fixed Income > Flashcards

Fixed Income Flashcards

1
Q

Rollover risk

A

Rollover risk is the risk that an issuer who relies on the commercial paper market as a funding source may not be able to issue new commercial paper when an outstanding issue matures.

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2
Q

Full price of bond

A

Full price of bond = clean price + accrued interest

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3
Q

Sinking fund provision

A

A sinking fund provision requires the issuer to retire a portion of a bond issue at specified times during the bonds’ life.

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4
Q

Structure subordination

A

In a holding company structure, a subsidiary’s debt covenants may prohibit the transfer of cash or assets to the parent until after the subsidiary’s debt is serviced. The parent company’s bonds are thus effectively subordinated to the subsidiary’s bonds.

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5
Q

Key characteristics of RMBS

A
  • Pass-through rate, the coupon rate on the RMBS. - Weighted average maturity (WAM) and weighted average coupon (WAC) of the underlying pool of mortgages. - Conditional prepayment rate (CPR), which may be compared to the Public Securities Administration (PSA) benchmark for expected prepayment rates.
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6
Q

Collateralized mortgage obligations (CMOs)

A

Collateralized mortgage obligations (CMOs) are collateralized by pools of residential MBS. CMOs are structured with tranches that have different exposures to prepayment risks.

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7
Q

Sequential-pay collateralized mortgage obligations (CMOs)

A

In a sequential-pay CMO, all scheduled principal payments and prepayments are paid to each tranche in sequence until that tranche is paid off. The first tranche to be paid principal has the most contraction risk and the last tranche to be paid principal has the most extension risk.

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8
Q

Planned amortization class (PAC) collateralized mortgage obligations (CMOs)

A

A planned amortization class (PAC) CMO has PAC tranches that receive predictable cash flows as long as the prepayment rate remains within a predetermined range, and support tranches that have more contraction risk and more extension risk than the PAC tranches.

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9
Q

Underwritten offering

Best effort offering

Shelf registration

A
  • Underwritten offering: Investment banks buy entire issue, sell to public.
  • Best efforts offering: Investment banks act as brokers.
  • Shelf registration: Register entire issue with regulators but sell over a period of time.
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10
Q

Two components of interest rate risk

A
  • Reinvestment risk: Bond investors with long horizons are more concerned with reinvestment risk
  • Market price risk: Bond investors with short horizons are more concerned with market price risk
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11
Q

Yield Spread

A
  • G-spread: Basis points above government yield
  • I-spread: Basis points above swap rate
  • Z-spread: Accounts for shape of yield curve. It is the single spread that, when added to each spot rate, produces a bond value that is equal to the current market value of a bond.
  • Option-adjusted spread: Adjusts Z-spread for effects of embedded options.
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12
Q

current yield

A

Current yield = annual coupon / price

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13
Q

simple yield

A

simple yield = current yield + amortization

where current yield = annual coupon / price

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14
Q

Convert an annual yield from one periodicity to another

A
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15
Q

Pricing formula for money market instruments quoted on discount rate

A
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16
Q

Pricing formula for money market instruments quoted on add-on rate

A
17
Q

Discount Rate vs. Add-on Rate

A

Discount Rate = (Year / Days) x [(FV - PV) / FV]

Add-On Rate = (Year / Days) x [(FV - PV) / PV]

18
Q

Macaulay duration

A

The horizon at which market price risk and reinvestment risk just offset is a bond’s Macaulay duration. This is the weighted average of the number o years until a bond’s cash flows are scheduled to be paid.

19
Q

Duration Gap

A

Duration Gap = Macaulay duration - bondholder’s investment horizon

  • Duration Gap > 0, Macaulay duration greater than investment horizon, investor is exposed to market price risk from increasing interest rates.
  • Duration Gap < 0, Macaulay duration less than investment horizon, investor is exposed to reinvestment risk from decreasing interest rates.
20
Q

Internal and external credit enhancement

A
  • Internal credit enhancement: Excess spread, over collateralization, waterfall structure.
  • External credit enhancement: Surety bonds, letters of credit, bank guarantees.
21
Q

Investment Grade and Non-investment grade

A
  • Investment grade: Baa3/BBB– or above
  • Non-investment grade: Ba1/BB+ or below
22
Q

Corporate family rating (CFR)

Corporate credit rating (CCR)

A
  • Corporate family rating (CFR): issuer rating.
  • Corporate credit rating (CCR): security rating.
23
Q

Four Cs

A

Capacity, collateral, covenants, character

24
Q

Expected loss and recovery rate

A

Expected loss = Default Risk x loss severity

Where:

Default risk - probability of default

Loss severity - percent of value lost if borrower defaults

Recovery rate = 1 - expected loss percentage

25
Q

Bearer bonds vs. registered bond

A

Bearer bonds: Most Eurobonds are bearer bonds, meaning that the trustee does not keep records of who owns the bonds; only the clearing system knows who the bond owners are. Some investors may prefer bearer bonds to registered bonds, possibly for tax reasons.

Registered bonds: In contrast, most domestic and foreign bonds are registered bonds for which ownership is recorded by either name or serial number.

26
Q

Ballon risk

A

The risk that a borrower will not be able to make the balloon payment because either the borrower cannot arrange for refinancing or cannot sell the property to generate sufficient funds to pay off the outstanding principal balance is called “balloon risk.” Because the life of the loan is extended by the lender during the workout period, balloon risk is a type of extension risk.

27
Q

Spot Rate

A

A spot rate is defined as the yield to maturity on a zero-coupon bond maturing at the date of that cash flow.

28
Q

Speculative grade bonds

A

Speculative grade bonds, two bonds with the same credit ratings will tend to have the same probabilities of default. They may still trade at very different valuations because for such bonds the market typically begins focusing on the severity of loss in the event of default, which can be quite different for similarly rated bonds.

29
Q

Repo Margin

A

Difference between the purchase price and market price of the underlying bond.

30
Q

Yield Component

A
  • Yield = Benchmark yield for a given maturity + spread to benchmark
    • Benchmark yield for a given maturity = real risk-free rate + expected inflation
    • Spread to benchmark = risk premium = credit risk premium + liquidity risk premium
31
Q

Par Curve

A

Coupon rates that would cause hypothetical bonds at each maturity be priced at par derived from spot rate curve.

32
Q

Price Value of a Basis Point

A

The price value of a basis point is the change in price given a 1 basis point change in the discount rate.

33
Q

Quoted Margin

A

The quoted margin is the percentage (of par) that the bond will pay.

34
Q

Relationships between the Bond Price and Bond Characteristics

A
  • Inverse Effect: The bond price is inversely related to the market discount rate. When the market discount rate increases, the bond price decreases.
  • Convexity Effect: For the same coupon rate and time-to-maturity, the percentage price change is greater (in absolute value, meaning without regard to the sign of the change) when the market discount rate goes down than when it goes up.
  • Coupon Effect: For the same time-to-maturity, a lower-coupon bond has a greater percentage price change than a higher-coupon bond when their market discount rates change by the same amount.
  • Maturity effect: Generally, for the same coupon rate, a longer-term bond has a greater percentage price change than a shorter-term bond when their market discount rates change by the same amount (the maturity effect. Exceptions occur only for low-coupon (but not zero-coupon), long-term bonds trading at a discount.
35
Q

Non-recourse vs. Recourse Loan

A
  • With a non-recourse loan, the only claim the lender has is to the property, which can be sold and the proceeds up to the amount of the amount owed used to satisfy the loan liability.
  • With a recourse loan, the lender has a claim against the assets of the borrower for any excess of the amount owed above the proceeds from the property after it is repossessed and sold.
36
Q

Syndicated loan

A

Syndicated loans are primarily originated by banks, and the loans are extended to companies but also to governments and government-related entities.

CFA Level 1 (11 decks)

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