Quiz 2 Flashcards
(86 cards)
1
Q
Bond price includes
A
accrued interest to the next semi-annual payment date
2
Q
If buyer refunds bond
A
buyer owes seller accrued interest
3
Q
Calc YTM of bond at $105, 15 year semi-annual bond 8% coupon
Calc Bond Price at year 10
Calc Bond Price at year 5:
A
YTM: 3.72%
Price at year 10: 178.95
Price at year 5: 139.55
**PV is ALWAYS NEGATIVE
4
Q
Credit Risk Types
A
Default Risk
Credit spread risk
Downgrade risk
5
Q
Default Risk
A
Borrower does not repay obligation (assessed by credit rating)
6
Q
Credit spread risk
A
Credit spread increases; bond value falls and/or bond underperforms benchmark
7
Q
Downgrade risk
A
Issue downgraded; bond value falls and/or bond underperforms benchmark
8
Q
‘AAA’, ‘AA’, ‘A’, ‘BBB’ Bond Rating
A
Investment Grade
9
Q
‘BB’, ‘CCC’, ‘CC’, ‘C’, ‘D’ Bond Rating
A
Non-investment grade, high yield bonds, junk bonds
10
Q
Credit default swap
A
Insurance on Bond
Derivative forward contract
Insures bond’s rating and price
11
Q
High-yield bond issues
A
Floating rate
Short term
Seniority
12
Q
Floating rate bonds (high-yield)
A
Rate changes, so it is necessary to analyze bond under different rates
13
Q
Short term bond (high-yield)
A
Must analyze the ability to pay off/rollover bond
14
Q
Seniority (high-yield) bond
A
bank debt is repaid first in bankruptcy
15
Q
Corporate Credit
A
Capacity to repay, CF analysis, corp. governance, business/operating risks
16
Q
ABS credit
A
Asset-backed securities: servicer quality, collateral CF generating ability, not-business/operating risks
17
Q
Tax-based municipal credit
A
Similar to corporate except for unique covenants, CF analysis, willingness to repay, industry and employment trends
18
Q
Revenue municipal credit
A
Exactly same as corporate, project CF, regional economic issues affecting CFs
19
Q
Sovereign
A
Economic vs. political risk; two credit ratings
20
Q
Factors affecting treasury returns
A
Rate changes (90% variation in total returns explained, interest rate risk measured with effective duration)
Slope changes (8.5% variation in total returns explained, interest rate risk measured with key rate duration)
Curvature changes (1.5% variation in total returns explained, interest rate risk measured with key rate duration)
21
Q
Market conversion premium ratio:
A
market conversion premium/market price
22
Q
Premium payback period:
A
Period needed to offset market conversion premium with coupons: market conversion premium/favourable income difference
23
Q
Favourable income difference:
A
(annual $ coupons - [CV ratio x annual dividends]) / CV ratio
24
Q
Premium over straight value
A
(MV of bond/straight value) - 1
25
If stock volatility increases, what happens to callable/convertible bond value and call on stock?
bond value increases; call on stock increases
26
If interest rate volatility increases, what happens to callable/convertible bond value and call on bond`?
bond value decreases; call on bond increases
27
If interest rates increase, what happens to callable/convertible bond value and straight bond?
CCBV decreases; straight bond decreases
28
Securitization (Mortgage Pass-through securities):
Pool mortgages to diversify risk
29
Mortgage Pass-through securities:
Many mortgages are pooled together; Pass-through securities backed by the pool are issued to investors.
30
Collateralized Mortgage Obligation (CMO)
a fixed income security that uses mortgage-backed securities as collateral
31
What are tranches?
graduated risk classes that vary in degree based on the maturity structure of the mortgages
32
What is a z tranche
Z tranche is the lowest tranche of a collateralized mortgage obligation (CMO) in terms of seniority. The Z tranche is not entitled to any coupon payments, but the interest still accrues and is paid once the more senior tranches are retired (paid off).
33
Contraction risk:
Average life decreases when rates fall and prepayments increase
34
Extension risk:
Average life increases as rates rise and prepayments fall
35
CMOs Contraction risk low - high
ZDCBA
36
CMOs Extension risk low - high
ABCDZ
37
CMO Credit Enhancements
External:
Corporate guarantee by seller
Bank letter of credit
Bond insurance
Internal:
Reserve funds
Overcollateralization
Senior/subordinated structure
38
Open-End (Mutual) Funds
- Appeals to wide audience
- New units created and old units redeemed
- Trades at NAVPS
- Can be bought on a front-end or back-end basis (load)
- Sold by simplified prospectus
- National MF rules
- More restrictions than closed-end funds
- Fees can be higher than ETFs
39
Closed-End Funds
- Active management
- Closed pool of funds
- Trades of a stock market
- Can trade above/below NAV but typically below NAV due to liquidity
- Most famous fund is Berkshire Hathaway managed by Warren Buffet and Charlie Munger
- No new units
- Not restricted by mutual fund rules
40
Exchange Traded Funds (ETFs)
- Typically replicates an Index or some type of benchmark e.g. TSX60
- Trades on a stock market but not a closed-end fund—it is similar to a mutual fund
- Can be passive or actively managed
- Passive ETFs fees can be as low as 10bp
- Has dominated the managed asset category
- Used by retail and institutional investors
41
Real Estate Investment Trust (REIT)
- Can be public (.un on TSX) or private
- Flow through structure to own real estate assets
- Active management
- Unitholder pays the tax on EBT
- Asset selection, cash flows, debt and management are key factors
- Valuations can be trick as well as liquidity of underlying assets
- Office, storage, retail, apartment, senior housing and vacation REITS available
42
Sources of Value Creation in Private Equity
- Reengineer firm for more efficient operations—bring expertise
- Obtain lower cost debt financing via access to cheap credit and few covenants
- Parallel goal alignment between management and private equity owners
43
Risks in Private Equity Investing
Liquidity risk—not publicly traded
Competition environment risk—fewer deals with good prospects at low cost
Agency risk—principal agent conflict
Capital risk—withdrawal of capital due to increase in business and financial risk
Regulatory risk—adverse government regulation
Tax risk—treatment of returns changes
Valuation risk—reflects subjective judgment
Diversification risk—poorly diversified across stage, vintage, and strategy
Market risk—long term factors such as interest rates and exchange rates
44
Costs of Private Equity Investing
Transaction costs—due diligence, bank financing, legal fees
Fund set up costs—usually amortized over life of fund
Administrative costs—custodian, transfer agent, and accounting costs charged yearly
Audit fees
45
Private Equity Structure
limited partnership (LP) provides funding, no active role, limited liability
46
Valuation Characteristics of Venture Capital Investments
Cash flow—unpredictable
Product—uncertain future based on new technology
Asset base—weak
Management team—strong entrepreneurial record
Leverage—little debt, mostly equity
Risk assessment—difficult to measure
Exit strategy—unpredictable (IPO or firm sale)
Operations—high cash burn rate
Capital required in growth phase
Returns from few highly successful investments with write-offs from many failures
Not active in public capital markets
Future funding—less scalable
Carried interest most common, no transaction and monitoring fees
47
Hedge Funds Types
```
Equity Market Neutral
Convertible arb
Fixed Income arb
Distressed Securities
Merger arb
Hedged Equity
Global Macro
Fund of Funds (different hedge funds)
```
48
Sharpe ratio
a measure that indicates the average return minus the risk-free return divided by the standard deviation of return on an investment.
49
Sortino ratio
takes the asset's return and subtracts the risk-free rate, and then divides that amount by the asset's downside deviation.
50
For a callable bond, yield-to-call is a more conservative measure of yield whenever:
A. the bond is trading at less than par.
B. the bond is priced at or above its call price.
C. the bond is trading for more than par but less than the call price.
B
The yield to call is the interest rate that will make the present value of the cash flows if the bond is held to the first call date equal to the price of the bond. Conservative investors will compute the yield-to-call and yield-to-maturity for a callable bond selling at a premium and select the lower of the two for the potential return.
51
Which bond would an analyst be most likely to conclude has the highest credit quality?
A. State University Refunding Revenue Bonds (insured by American Municipal Bond Assurance Corporation)
B. Hazard County, Alabama General Obligation Bond
C. Gary, Indiana General Obligation Bond (refunded and secured by U.S. Governments in escrow to maturity)
C In this example, since it is a general obligation bond that is secured by the U.S. government, it deserves the highest credit quality. A city general obligation bond does not have the limitations that a revenue bond has in its ability to pay the bondholders. For general obligation bonds, four specific areas are analyzed: 1. debt burden, 2. budget soundness, 3. tax burden and, 4. overall economy. Whereas, the cash flow is the major consideration for revenue bonds.
52
Holders of unsecured debentures with a negative pledge clause are assured that:
A. the debentures will be secured, but to a lesser degree than any secured debt issued in the future.
B. the debentures will be secured equally with any secured debt issued in the future.
C. no additional secured debt will be issued in the future.
B
If a company has no secured debt, it is customary to provide that debentures will be secured equally with any secured bonds that may be issued in the future. This is known as the negative pledge clause.
53
A bond analyst at Omnipotent Bank (OB) notices that the prepayment experience on his holdings of high coupon MBS issues has been moving sharply higher. This indicates that:
A. interest rates are falling.
B. the pools held by OB are older issues.
C. the loans comprising OB's pools have been experiencing lower default rates.
A Prepayments, which are payments made in excess of the mortgage payment, are made during re-financing of loans due to falling interest rates.
54
Which of the following statements about mortgage pass-through securities is (are) correct?
I. Pass-throughs offer better call protection than most corporates and Treasuries.
II. Interest and principal payments are made on a monthly basis.
III. It is common practice to use the weighted-average maturity on a pass through in place of its duration.
IV. Pass-throughs are relatively immune from reinvestment risk.
A. II and III only
B. I and III only
C. II only
C Payments are made to security holders each month.
55
The minimum data required to calculate the implied forward rate for 5 years beginning 2 years from now would be:
A. the 2-year and 7-year spot rates.
B. spot rates at 6-month intervals for 2 years and the 7-year spot rate.
C. spot rates at 6-month intervals for the 7-year period.
A The theoretical spot rates are used to compute the implied forward rate. The yield curve can be used to calculate the implied forward rate for any time in the future for any investment horizon.
56
A one percent decline in its yield will have the greatest effect on the price of the bond with a:
A. 10-year maturity, selling at 100.
B. 20-year maturity, selling at 80.
C. 10-year maturity, selling at 80.
D. 20-year maturity, selling at 100.
B With all other factors constant, the longer the maturity, the greater the percentage price volatility. Also the lower the coupon rate, all other things constant, the greater will be the percentage price volatility. Therefore in this example, the longest maturity bond with the lowest coupon will have the greater percentage price change.
57
The risk that has the greatest impact on bond price behavior over time is:
A. purchasing power risk.
B. marketability risk.
C. business risk.
A Purchasing power risk (inflation risk) arises because of the variation in the value of cash flows from a security due to inflation, as measured in terms of purchasing power.
58
Positive convexity on a bond implies that:
A. prices increase at a faster rate as yields drop, then they decrease as yields rise.
B. price changes are the same for both increases and decreases in yields.
C. prices increase and decrease at a faster rate than the change in yield.
A Positive convexity implies that for small, equal and opposite changes in interest rates, the price increase if rates decline will be more than the price decrease if rates increase.
59
If interest rates decrease and stabilize after the purchase of a bond, the realized compound yield for a bond held to maturity will be:
A. greater than the original yield-to-maturity.
B. lower than the new interest rate.
C. between the original yield-to-maturity and the new interest rate.
C
60
An analyst finds that the semiannual interest rate that equates the present value of the bond's cash flow to its current market price is 3.85%. It follows, therefore, that:
I. the bond equivalent yield on this security is 7.70%.
II. the effective annual yield on the bond is 7.85%.
III. the bond's yield-to maturity is 7.70%.
IV. the bond's horizon return is 8.35%.
A. III only
B. I and II only
C. I, II and III only
C The equivalent yield = 3.85% x 2 = 7.70%; Effective annual yield = (1 + Periodic interest rate)^2 - 1 = (1+ .0385)^2 - 1 = 7.85%; Since the semiannual interest rate that equates the present value of the bond's cash flow to its current market price of 3.85%, the yield-to-maturity is 7.70%.
61
A fixed income analyst would be most likely to conclude that changes in which of the following are likely to affect interest rates?
I. Inflation expectations
II. Size of the federal deficit
III. Money supply
A. I and II only
B. II and III only
C. I, II and III
C
62
The discount value of a six-month (182-day) U.S. Treasury bill with a par value of $100,000 and a bank discount yield of 9.18 percent is: *US T-bills use a 360 day vs. Cdn T-bills use 365 day
A. $97,654
B. $97,680
C. $95,359
C Annualized yield (Y)= (Dollar discount(D)/Face value(F)) x (360/number of days remaining to maturity(t)). Therefore, .0918 = (D/$100,000) x (360/182); D = $4,641, $100,000 - $4,641 = $95,359
63
Identify the bond that has the longest duration (no calculations necessary).
A. 20-year maturity with an 8% coupon
B. 20-year maturity with a 12% coupon
C. 10-year maturity with a 15% coupon
D. 15-year maturity with a 0% coupon
D The lower the coupon rate, the greater will be the duration.
64
Regarding convertible bonds, an analyst would be least likely to conclude:
A. The yield on the convertible will typically be higher than the yield on the underlying common stock.
B. A convertible bond can be valued as a straight bond with an attached option.
C. Convertible bonds are typically secured by specific assets of the issuing company.
C Convertible bonds are typically secured by specific assets of the issuing company.
Convertible bonds are often subordinated debentures, meaning that the claims of "senior" creditors must be settled in full before any payment will be made to holders of subordinated debentures in the event of insolvency or bankruptcy.
65
Eurodollar bonds are:
I. denominated in U.S. dollars
II. underwritten by an international syndicate
III. sold at issue to U.S. investors
A. I, II and III
B. I and II only
C. III only
B Eurodollar bonds are: 1. Denominated in U.S. dollars, 2. Issued and traded outside the jurisdiction of any single country, 3. Underwritten by an international syndicate and, 4. Issued in bearer form.
66
How do treasury bills differ from Treasury notes and bonds?
A. Lending institutions always accept them as collateral at par value.
B. They are issued at a discount from par rather than bearing coupons.
C. They offer higher promised yields during the period of investment.
B The Treasury issues all securities with maturities of one year or less as discount securities which pay only a contractually fixed amount at maturity and are issued below maturity value. All securities with maturities of two years or longer are issued as coupon securities.
67
An 8%, 15-year bond has a yield-to-maturity of 10% and effective duration of 8.05 years. If the market yield changes by 25 basis points, how much change will there be in the bond's price?
A. 2.01%
B. 1.85%
C. 3.27%
A Percent price change = -effective duration x yield change x 100 = -8.05 x .0025 x 100 = 2.01%
68
Intuitively and without the use of calculations, if interest payments are reinvested at 10%, the realized compound yield on this bond must be:
Additional information for this question:
```
Par value $1,000
Time-to-maturity 20 years
Coupon 10% (with interest paid annually)
Current price $850
Yield-to-maturity 12%
```
A. 9.8%
B. 12.4%
C. 10.9%
C Since the bond is selling at a discount, the coupon rate must be less than the current yield, which must be less than the yield-to-maturity. Also, the interest payments are reinvested at 10% so there is compounding occurring. The compound yield, therefore, must be above 10%, yet below 12%.
69
When interest rates decline, the duration of a 30-year bond selling at a premium:
A. remains the same.
B. increases.
C. decreases.
B The lower the coupon rate, the greater will be the duration and the percentage price volatility.
70
Interest rate risk means a:
A. rise in interest rates will cause a loss of principal value for bondholder.
B. decline in interest rates will not affect the principal value of the bond.
C. decline in interest rates will cause a loss of principal value for bondholder.
A As interest rates rise (fall), the price of a bond will fall (rise) thereby decreasing (increasing) the principal value for the bondholder.
71
The most likely conclusion that an analyst would make regarding a bond with a call feature is:
A. it is attractive because the immediate receipt of principal plus premium produces a high return.
B. it would usually have a higher yield than a similar non-callable bond.
C. it is more apt to be called when interest rates are high, because the interest saving will be greater.
B The call provision is detrimental to investors because they run the risk of losing a high-coupon bond when rates decline. Because of this reason callable bonds carry higher yields than most bonds than cannot retire before maturity.
72
An analyst would be most likely to conclude, convexity of bonds is more important when interest rates are:
A. low.
B. high.
C. less than the coupon rate on the bond.
B The absolute and percentage price change of a bond is greater when yields decline than when they increase by the same number of basis points.
Convexity measures the rate of change of duration as yields change. For large yield movements, a better approximation for bond price movement is obtained using both duration and convexity. When yields increase, the duration for all option-free bonds decreases. This is a positive attribute because as yields decline, this feature decelerates the price depreciation.
The absolute and percentage price change is greater when yields decline than when they increase by the same number of basis points.
73
An analyst would be least likely to agree with which of the following statements concerning duration?
A. The higher the coupon, the shorter the duration.
B. The higher the yield-to-maturity, the greater the duration.
C. The difference in duration is small between two bonds each maturing in more than 15 years.
B The correct relationship is, the lower the yield-to-maturity, the greater the duration.
74
Which one of the following statements is true?
A. The expectations hypothesis indicates a flat yield curve if anticipated future short-term rates exceed current short-term rates.
B. The segmentation hypothesis contends that borrowers and lenders are constrained to particular segments of the yield curve.
C. The liquidity hypothesis indicates that, all other things being equal, longer maturities will have lower yield.
B This theory recognizes that investors have preferred habitats dictated by the nature of their liabilities. The shape of the yield curve is determined by the supply of and demand for securities within each maturity sector.
75
Which theory explains the shape of the yield curve by considering the relative demands for various maturities?
A. Liquidity premium theory
B. Unbiased expectations theory
C. Segmentation theory
C This theory recognizes that investors have preferred habitats dictated by the nature of their liabilities. The shape of the yield curve is determined by the supply of and demand for securities within each maturity sector.
The market segmentation theory proposes that the major reason for the shape of the yield curve lies in asset/liability management constraints and creditors restricting their lending to specific maturity sectors. The shape of the yield curve is determined by supply of and demand for securities within each maturity sector.
76
The concepts of spot and forward rates are most closely associated with which one of the following explanations of the term structure of interest rates?
A. Segmented Market Theory
B. Liquidity Premium Theory
C. Expectations Hypothesis
A The payments made to the investor consist of scheduled principal and interest and any unscheduled payments of principal resulting from prepayments and defaults.
77
An analyst would be most likely to conclude that call provision on a corporate bond benefits the:
A. government regulators.
B. bondholders.
C. issuer.
C The call provision is detrimental to investors because they run the risk of losing a high coupon bond when rates decline. Callable bonds carry higher yields than most bonds that cannot retire before maturity.
78
Which of the following is false?
A. The absolute percentage change in the price of a bond is the same for both an increase and decrease of the same number of basis points.
B. For a given maturity and initial market yield, the volatility of bond price decreases as coupon rate decreases.
C. The duration of the bond increases as market yields decrease.
A For a given term-to-maturity and initial market yield, the percentage price volatility of a bond is greater the lower the coupon rate. Also, the longer the term-to-maturity, the greater the price volatility. The lower the coupon rate, the greater will be the duration.
79
Yield-to-maturity and current yield on bond are equal:
A. if the coupon and market interest rate are equal.
B. when the expected holding period is greater than one year.
C. if the bond sells at a price in excess of its par value.
A If the coupon rate, current yield and yield to maturity are all equal, the bond will be selling at par.
80
A bond portfolio manager who is looking for mortgage-backed securities that would perform best during a period of rising interest rates should purchase:
A. a 10% MBS with an average life of 8.5 years.
B. a 12% MBS with an average life of 5.6 years.
C. an 8% MBS with an average life of 6.0 years.
B As interest rates increase and prepayments slow down, the yield on a discounted MBS ,selling at a lower coupon, decreases slightly, while the yield on a premium MBS, selling at a higher coupon, increases sharply and then levels off. As interest rates decrease and prepayments accelerate, there is a sharp drop in the yield of the premium MBS and a slight rise in the yield of the discounted
81
The price volatility of a variable rate note may be reduced by:
A. reducing the size of the issue.
B. downgrading the quality rating.
C. resetting the coupon rate frequently.
C Resetting the coupon rate more often will stabilize the price of the issue, maintaining it close to par value.
82
The Liquidity Hypothesis of the term structure of interest rates predicts that the shape of the yield curve will be:
A. upward-sloping.
B. downward-sloping.
C. variable.
A The liquidity hypothesis states that investors will hold longer-term maturities if they are offered a long-term rate higher than the average of expected future rates by a risk premium that is positively related to the term to maturity. Thus, an upward-sloping yield curve may reflect expectations that future interest rates either will rise or will be flat, but with a liquidity premium increasing fast enough with maturity so as to produce an upward-sloping yield curve.
83
An analyst is considering a five-year bond with a 10% coupon that is presently trading at a yield-to-maturity of 8%. If market interest rates do not change, one year from now the analyst would most likely conclude the price of this bond will be:
A. lower.
B. higher.
C. cannot be determined.
A
84
Which one of the following types of long-term bonds would show the most favorable performance during a period of increasing interest rates?
A. Zero-coupon
B. Callable, fixed-rate
C. Floating-rate
C The coupon rate on a floating rate bond is periodically reset based on some predetermined benchmark. A floating-rate bond resets more than once a year and the interest-rate benchmark is a short-term reference rate.
85
How to calculate effective duration
(Pf - Pr ) / [(2)*(P0)*(Yr - Yf)]
P0 = the bond's initial price per $100 of par value
Pf = the bond's price if its yield falls by x basis points
Pr = the bond's price if its yield rises by x basis points
(Yr - Yf) = Change in yield in decimal
86
1 basis point = ___ % or _____
0.01% or 0.0001
