Investments

Question 1

The 7 investment risks are? (Capital Markets Handbook)

Answer 1

COSMILL

1. Credit Risk
2. Operational or Transactional Risk
3. Settlement Risk
4. Market Risk
5. Interconnection Risk
6. Legal Risk
7. Liquidity Risk

Question 2

Credit Risk

Answer 2

Possibility of loss due to a counterparty’s or an issuer’s default or inability to meet contractual payment terms.

Question 3

Operational or Transactional Risk

Answer 3

possibility that inadequate internal controls or procedures, human error, system failure, or fraud will cause losses

Question 4

Settlement Risk

Answer 4

possibility of loss due to the delivery of funds or assets before receiving the instrument or proceeds specified in the contract from the counterparty, and the counterparty is subsequently unable or unwilling to perform.

Question 5

Market Risk

Answer 5

Possibility that an instrument or portfolio will lose value due to a change in market conditions, the price of an underlying instrument, an index of financial instruments, changes in various interest rates, or other factors.

Question 6

Interconnection Risk

Answer 6

possibility of decline in an instrument’s value due to changes in interest rates, indices, or values of other instruments that may or may not be held by the investor.

Question 7

Legal Risk

Answer 7

possibility that legal action will preclude contractual performance by one of the parties to a transaction.

Question 8

Liquidity Risk

Answer 8

possibility that an instrument cannot be obtained, closed out, or disposed of in a reasonable time frame without forfeiting economic value.

Question 9

The 4 principal market risks are? (Capital Markets Handbook)

Answer 9

1. Foreign Exchange risk
2. Interest rate risk (primary source)
3. Commodity-Price risk
4. Equity-Price risk

Question 10

What categories of securities are investment quality?

Answer 10

Moody’s – Aaa, Aa, A+ or A, Baa-1 or Baa

S&P’s - AAA, AA, A, BBB

Question 11

What items should the investment policy address?

Answer 11

• Investment goals
• Authorized activities and instruments
• Internal controls and independent review
• Selecting broker/dealers
• Risk limits
• Risk and performance measurement
• Reporting
• Accounting and taxation

Question 12

The total return for an individual bond consists of what?

Answer 12

1. The change in the market value over the measurement period
2. The coupon received
3. The reinvestment interest on the cash flows received during the measurement period

Question 13

PO Strip Characteristics

Answer 13

Rates decline, value increases as cash flow (Principal Pmts) is received sooner

Question 14

IO Strip Characteristics

Answer 14

Rates decline, value decreases, More prepayments, less interest payments

Question 15

Positive Convexity

Answer 15

Option Free Instrument

Question 16

Negative Convexity

Answer 16

Embedded Options in Instrument

Question 17

CMO Residuals – What is the effect when rates change?

Answer 17

Rates Decline, Value Declines

Rates Increase, Value Increases

Question 18

What are deleveraged and leveraged notes?

Answer 18

Floating-rate instruments with coupon payments based on a specific point on the yield curve.

Deleveraged Note - coupon rate will adjust by a fraction of the change in the underlying index:
• Attractive when rates expected to remain stable or decrease
• Market risk increases as leverage factor approaches 1.0

Leveraged Note - coupon rate will adjust by a multiple of the change in the underlying index (LIBOR, COFI, CMT)
• Attractive when rates expected to increase

Examples of a deleveraged note and a leveraged note are below:

Deleveraged: .50 X 10-year CMT + 150 bps
Leveraged: 1.50 X 3-month LIBOR + 100 bps

Question 19

Define a CMO/REMIC and how is it slotted on the Call Report?

Answer 19

Mortgage derivative securities consisting of several classes secured by mortgage pass through securities or whole mortgage loans. Principal and Interest payments from underlying collateral are divided into separate payment streams that repay investors in the various classes at different rates.

CMO Slotting - CMOs are slotted based on their weighted average life, regardless of whether the security is fixed or floating.

Question 20

How do you slot callable securities on the Call Report?

Answer 20

Callable-fixed-rate debt securities - Generally slotted at maturity, and the call option is not reflected; by call date when called.

Question 21

What are some passive investment strategies?

Answer 21

1. Indexing - assembling a portfolio closely resembling the risk and return characteristics of a preferred market index.
2. Immunization - bond portfolio structured so that interest rate risk characteristics (Macaulay duration) match those of the liability stream. Referred to as duration matching and requires frequent calculation and rebalancing.

Question 22

What are some active investment strategies?

Answer 22

1. Gains Trading - purchase and subsequent sale of a security at a profit after a short holding period.
2. 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
3. Pair-offs - An institution commits to purchase a security, but before the settlement date, the bank pairs-off the purchase with the sale of the same security
4. Extended Settlement - Use of a securities trade settlement period in excess of the regular-way settlement period (US Gov’t/Agency – 1 day; Corporate/Municipal – 3 days; MBS- 60 days). This facilitates speculation.
5. Repositioning Repurchase Agreement – Dealer allows bank that has entered into a when-issued or pair off that cannot be closed at a profit to hold its speculative position until the security can be sold at a gain.
6. Short Sale - Sale of a security that is not owned
7. Adjusted Trading - Sale of a security to a broker above the prevailing rate and the simultaneous purchase and booking of a different security, frequently a lower rated or quality issue at a price above its market value.

Question 23

What are the recognized nationally recognized statistical rating organizations (NRSROs):

Answer 23

1- Dominion Bond Rating Service, Ltd.
2- Moody’s Investors Service
3- Fitch, Inc.
4- Standard and Poor

Question 24

What are the types of interest rate risks created by using off-balance sheet derivatives?

Answer 24

1. Repricing
2. Basis
3. Option

Question 25

What are some types of interest rate swaps (Purpose-contractual agreement between two counterparties to exchange payments at periodic intervals for a specific time on a notional amount)? * SOURCE: ALM SCHOOL MATERIALS

Answer 25

* Basic – provides for the counterparties to exchange variable-rate cash flows based upon different market indices. These agreements can be used to reduce basis risk for a balance sheet that has rates on assets and liabilities tied to different indices or different maturities of the same index. * Amortizing – has a notional amount that declines (amortizes) over the life of the agreement and may be used to hedge amortizing assets or to replicate cash flows of mortgage products. Usually these are fixed at inception. * Accreting – has a notional principal that increases over the life of the agreement and could be used to hedge the increasing interest rate risk in a construction loan because the loan balance increases during the funding of a construction project. * Forward – is a swap that has not reached its effective date; allows an institution to initiate a swap with a delayed start. These swaps can be used to hedge debt refinancing or anticipated debt issuances. These are based on forward interest rates. * Swaptions – is a contract that combines an option and a swap whereby one party has an option (the right, not an obligation) to enter into an interest-rate swap or terminate an existing swap at some future date.

Question 26

How do you value Swaps?

Answer 26

* Pay-fixed for variable swap = > Short position on fixed rate, Long position on floating rate * Value of the swap equals difference between the NPV of the pmt streams of the two sides * Typically use the Treasury curve at a point equal to maturity plus swap spread * Though NPV of fixed and floating initially same, likely changes over time

Question 27

What are some types of hedging strategies?

Answer 27

* Caps * Floors * Corridors * Collars

Question 28

Caps

Answer 28

equivalent to series of put options. | When the underlying index exceeds the strike rate, the seller pays the difference on the notional amount.

Question 29

Floors

Answer 29

equivalent to a series of call options. | When the underlying index is less than the strike rate, the seller pays the difference on the notional amount.

Question 30

Corridors

Answer 30

strategy used to protect the buyer from a modest rate increase. A corridor is a combination of a long cap and a short cap. The cap is purchased to reduce exposure to rising rates. Another cap, with a higher strike rate, is sold to reduce the expense of the long cap.

Question 31

Collars

Answer 31

combination of a cap and a floor. An investor buys a cap and sells the floor to reduce the cost of the cap.

Question 32

What are some factors affecting price?

Answer 32

* Proximity of the underlying index to the strike * Remaining term to maturity * Volatility of the underlying index

Question 33

What are some types of market risk/value modeling measures?

Answer 33

* Delta – the change in the value of the option (cap or floor) resulting from a small change in the underlying cash instrument (similar to duration). Often used to determine how many contracts to purchase. Contracts with higher deltas will have greater price sensitivities to changes in the underlying instrument. * Gamma – the change in the delta given a change in the underlying index (similar to convexity). Gamma risk is at its greatest when the option as at-the-money. * Theta – the loss of a contract’s value due to the passage of time. * Vega – the change in an agreement’s price resulting from a change in the volatility of the underlying index. Vega is always positive because option values increase as volatility rises.

Question 34

What are futures and forward contracts?

Answer 34

* Futures – standardized, exchange-traded contracts obligating one party to buy, and the other to sell, a specific asset for a fixed price at a future date. These contracts are traded on an organized exchange. * Forwards – a contract obligating one party to buy and the other to sell, a specific asset for a fixed price at a future date. These are bought and sold over-the-counter.

Question 35

What are some types of Rates and Yields?

Answer 35

• Forward Yields – derived from spot yields and indicate the market’s overall expectations for future level of rates and the entire yield curve. • Implied Forward Rates – can give market participants important information about expectations of the direction of future rates. • Forward Rates – critical in determining prices of many hedging instruments, e.g. derivatives, and can provide protection against future volatility in rates or prices. • Option Adjusted Spread – investor can use either the a) spot rate or b) forward yields for this calculation. This is a spread to help determine the relative value for a security that has embedded options, e.g. a MBS.

Question 36

What factors are included in valuing futures and forward contracts?

Answer 36

* Prices move in the same direction as bonds, i.e. rising rates yields lower prices * Cash price is usually different from price in futures market, difference called basis * Factors affecting basis include a) cost of carry, b) economic factors, c) perception of rate movements, and d) volatility of interest rates. * Principal risk is that basis may change from time hedge is initiated until termination